Risky Finance

Do investment banks owe a duty of care to their corporate customers—in a similar way that they do to widows and orphans? Or should the principle of “caveat emptor” remain sacrosanct?

The issue is central to two lawsuits recently filed in London. In one, an Italian company lost its shirt after buying an exotic dollar hedge when it had no dollars to hedge in the first place. In another, a German bank was left nursing losses after buying AAA rated bonds that rapidly plunged to junk. In both cases, the losers are arguing that they were victims of misselling by unscrupulous investment banks.

These cases are important not just for the parties involved, but for the whole market in complex derivative products. And, indeed, for investment banking more generally. At a time when traditional capital markets and corporate finance revenues are under relentless pressure, derivatives make up the shortfall. The profits on structured transactions, can easily match those made in originations or takeovers.

The first case involves Poste Italiane, the state-owned Italian post office. When plans to privatise Poste led to mark-to-market accounting rules being applied to Poste’s books early this year, it emerged that Poste’s finance director, Massimo Catasta, had engaged in unauthorised loss-making derivatives transactions.

He had hedged €250m of Poste’s debt using a “knock-in quanto swap” bought from JP Morgan in July 2003. This exotic derivative contract seemed to magically reduce Poste’s funding costs. Unfortunately, it also turned out to contain a leveraged options bet on the US dollar swap market that soon went deeply underwater. Given that Poste had no US revenues or dollar-denominated debt, the suitability of the deal was clearly open to question. Catasta was duly dismissed, and Poste’s management filed court proceedings against JP Morgan seeking E40m of damages, claiming that the US giant knew full well that Catasta was not authorised to engage in such deals. JP has acknowledged receiving a writ but has not made any further comment

The second case, between German landesbank HSH Nordbank and Barclays Capital, involves the structured derivatives product du jour, the synthetic collateralised debt obligation (CDO). HSH bought over $500m of these products from Barclays in 2000 with the aim of diversifying its north German-focused lending business and making some extra returns too.

By late 2002, the AAA-rated tranches of the Barclays CDOs bought by HSH had plunged to junk levels. HSH now claims that Barclays used its mandate to manage the pool of loans underlying the CDOs to stuff them with other CDOs it couldn’t sell, as well as toxic credits owned by Barclays such as US manufactured housing and aircraft securitisations. Barclays disputes these characterisations.

How are the cases likely to develop? The investment banks’ defence in both cases is that the customer is as sophisticated as they are. JP Morgan used this argument very effectively to win a London high court battle in August against WestLB over Enron-related energy derivative contracts. It is likely to use this defence again.

Unlike the case of retail customers, the investment banks would say it is not their job to keep the likes of HSH Nordbank or Poste Italiane out of the derivatives casino should they choose to play, or check the credentials of the official putting his company’s chips on the roulette table. Derivatives legal documentation reinforces this by ring-fencing the dealers from any suggestion of fiduciary responsibility towards their customers. Indeed, they are known as “counterparties”, implying that both parties to the transaction are equals.

The customers’ response is that invoking watertight documentation misses the point. The derivatives market has grown so complex that the big derivatives houses have an inbuilt advantage—one that they can exploit ruthlessly. Smart customers may stick to simple derivatives products with a clear hedging purpose and price transparency. But smart derivatives salesmen will keep wining and dining their contacts until the likes of Catasta take the bait and allow the bank to profit from a weakness in corporate governance.

A related complaint—likely to be prominent in the HSH/Barclays lawsuit—is that the complexity of derivatives markets allows investment banks to benefit from conflicts of interest that would be ruled out in traditional securities markets with their all-important Chinese Walls. For example, synthetic CDO origination often takes place close to the credit trading desk, which in turn has a mandate to manage the risk of the bank’s loan portfolio. The traders hedge the loan book by buying default protection from oblivious customers, embedding the hedge in an opaque CDO that they arrange or “manage” on the customers’ behalf.

The courts are thought to be likely to favour the banks’ arguments. But even if the banks win, it is unlikely to be business as usual. The bad publicity that almost always comes out in cases like these could make the banks tread more carefully in future. In other cases, out-of-court payoffs have been needed to keep unhappy customers quiet. And, of course, if either JP Morgan or Barclays lost its case, it would send shockwaves through the industry. It would amount to slaughtering a goose that has been laying golden eggs.

This article originally appeared on www.breakingviews.com.

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