''A huge win for derivatives dealers," says Richard Klotz, partner in charge of global risk management consulting at Coopers & Lybrand. He is speaking about Judge John Feikens's ruling on the dispute between Bankers Trust (BT) and Procter & Gamble (P&G), made only hours before the two parties agreed to a settlement in which P&G will pay $35 million of the amount BT claims it owes on two highly leveraged swaps that went against it.

In a 41-page opinion Judge Feikens tackled some of the most significant issues that have divided dealers and end-users of derivatives, and reduced the legal debates surrounding complicated financial products to the bare essentials of contract law. Most significantly, he ruled that an arm's length relationship existed between the two counterparties and that BT did not owe any kind of fiduciary responsibility to P&G because it was a simple business transaction.

"The judge appropriately reduced the case to a contract dispute before its settlement," says Daniel Cunningham, a partner at Cravath, Swaine & Moore and chief legal counsel to the International Swaps and Derivatives Association (ISDA). "The judge also eliminated state and federal securities claims on the grounds that swaps are not securities; dismissed the federal commodities claims on the grounds that P&G did not have a private right of action under the federal commodities laws; dismissed claims based on an alleged fiduciary relationship because the parties were in a business relationship; and dismissed claims of negligent misrepresentation due to the absence of a special relationship that would support such a claim."

Others, however, argue that this is not the last word in the debate. In a memo to clients, Sullivan and Cromwell, which represented BT in its wrangle with P&G, calls Judge Feikens's rulings "milestones in the debate over the legal and regulatory standards governing over-the-counter derivative transactions." However, the memo also stresses that these decisions need to be upheld by other courts before the issue can be considered settled. The memo continues that dealers can feel free from apprehension that their clients will drag them off to court when a transaction goes wrong: ONLY "If the other courts agree that derivatives dealers generally do not owe fiduciary duties to their counterparties." Elsewhere, the memo says that Feikens's analysis should preclude application of securities laws to swaps "if adopted by other courts."

The judge went further than merely handing down a decision. In the comprehensive opinion he also reviewed the background of various statutes and recent case law to establish a definitive legal framework for dealing in derivatives. A decision that takes these extra steps is recognized throughout the legal community as having considerably more bearing on future cases than one that does not.

Voices on both sides of the dealer/end-user debate were eager to characterize the opinion as nothing new. Warren Davis, a partner with Sutherland, Asbill and Brennan and legal counsel for the End-Users of Derivatives Association (EUDA), minimizes the sweeping nature of the decision. "It basically places dealers in the position they already thought they were in," he says. An ISDA spokesperson concurs: "The judge's decision basically supports the position that the dealers have enunciated with our Principles and Practices guidelines."

Disclosure duties

One key element of the decision that some end-users have fastened onto was the court's opinion that under New York contract law, BT had a duty to disclose material information to P&G both before the parties entered into the transaction and during its performance, and this obligation arises out of the "duty to deal fairly and in good faith during the performance of the swap transactions." According to Davis, this opinion indicates that "there are certain disclosure obligations for dealers that apply whether or not the dealer is acting in a fiduciary capacity." The Sullivan & Cromwell memo admits that these words "may cause some concern among derivatives dealers."

Many dealers, however, are reading the opinion much more narrowly. They claim that the decision merely recognizes the duty of good faith and fair dealing and the limited duty of disclosure that exists under New York contract law, when one party has a superior knowledge of facts that can not be obtained elsewhere and when one party knows the other is acting based on mistaken knowledge. To Coopers & Lybrand's Klotz, this reading comes with an unmistakable message to end-users: "Buyer beware."

Against the grain

Several aspects of Judge Feikens's ruling are not consistent with earlier positions taken by the courts and regulators. For example, the judge decided that the swaps in question were not securities, or even options on securities, even though they included option-like features, and thus could not be regulated by the SEC. This opinion contradicts the stance taken by the SEC in the consent orders following the settlement of the Gibson Greetings case in November 1994.

The view is disputed by sources at the SEC. "This is not a major court, it's not in New York or any other financial center, or a Federal appellate court," says one senior official. "It is just a district court decision. We've established our position in many of these matters, based on the Gibson Greeting­Bankers Trust consent decree in which certain swaps are treated as securities. We expect to go forward with this position in future cases." An SEC spokesman adds that the commission is standing by its position that "certain types of transactions can still be classified as securities."

Judge Feikens also ruled that the antifraud provisions of the Commodity Exchange Act (CEA) did not apply to BT because it was acting as a counterparty, not a broker or a commodity trading advisor. This ruling questioned the ability of the Commodity Futures Trading Commission (CFTC) to extend its regulatory reach to the trillion-dollar swaps industry. However, in the Gibson Greetings case, the CFTC decided BT was a commodity trading advisor. Feikens claimed that his ruling did not contradict the CFTC's ruling because P&G, unlike Gibson, "used their own independent knowledge of market conditions in forming their own expectation as to what the market would do." The CFTC has their lawyers looking over the opinion, but is not commenting at present.

Washington lawmakers have been unmoved by the decision. Terri Burchfield, a professional staffer for the House Banking Committee, says that no one in the industry, either dealer or end-user, has brought the decision or any of the key points to the attention of the committee or its chairman, Rep. James Leach.

Of course, Judge Feikens's ruling on the nature of counterparty/end-user relationships is not the first to favor dealers and affirm that an arm's length relationship is assumed to exist, coming on the heels of the Dharmala case (Bankers Trust International Plc v. PT Dharmala, Queens Bench 1995). The judicial precedent has now been firmly established both in English law and U.S. case law for swaps to be treated as an arm's length dealing between sophisticated businesses that have no more judicial recourse when things go wrong than would be available in any other contract dispute.

Although Bankers Trust has settled its case with Procter & Gamble, it is difficult for the troubled derivatives shop to stay out of the news. On June 11 the Securities and Exchange Commission (SEC) announced the imposition of a $100,000 fine on an ex-BT derivatives marketer. While doing so the agency took a swipe at some of Judge Feikens's celebrated judgments that preceded the conclusion of the dispute with P&G in early May.

In addition to the fine the SEC order bars Gary Missner, 37, of Chicago, from having anything to do with the financial services industry for the next five years and requires him to desist from any future violations of federal securities law. Missner simultaneously settled a similar proceeding with the Federal Reserve Board, and the fine was jointly imposed by the two agencies.

Missner was penalized for his fraudulent conduct when selling a variety of derivatives instruments to Gibson Greetings, the greeting card manufacturer based, as is P&G, in Cincinnati, Ohio. The lies that Missner told to Gibson about the value of certain derivatives trades caused Gibson to incorrectly report losses on its annual statement. The discovery of the deception through taped telephone conversations led to the settlement of the dispute in November 1994 and to BT's incurring federal fines of $10 million. Missner left the firm soon after.

Security definitions

In its description of the instruments sold to Gibson, the SEC took the opportunity to knock the views of the Court of the Southern District of Ohio. The Ohio Court had held that the so-called five-30 swap sold to P&G was not a security within the meaning of Section 3(a)(10) of the Securities Exchange Act. While conceding that there are differences between the five-30 swap and the Treasury-linked swap that BT sold to Gibson, the SEC says it "disagrees with the Court's analysis and reiterates its position that the Treasury-linked swap is a security within the meaning of federal securities laws because it is actually a cash-settled put option on the spread between the price and yield of two different Treasury securities." If the swap sold to Gibson is a security under law because it is in essence an option, then so is the swap sold to P&G, and Judge Feikens's reasoning is flawed.

BT also sold Gibson a knock-out call option, which was a European-style cash-settled call option the return of which was based on the yield of the 7.125 percent 30-year bond maturing in February 2023. As this deal was expressly an option, it should be classified as a security without dispute, claims the SEC, referring to the earlier case of BT Securities v. Vazquez. In what seems like another dig at Feikens, it notes that the Ohio court did not consider any of the instruments it examined to be comparable to the knock-out call option.

Both instruments were securities under federal law, and thus Missner violated Section 17(a) of the Securities Act and Sections 10(b) and 13(a) of the Exchange Act by making "material misrepresentations and omissions in the offer and sale of these derivative securities to Gibson." Missner settled the order without admitting or denying its findings, as is customary in such cases.

Consistent with the Ohio court's judgment, however, is the SEC's view that Gibson did not have the expertise or the models needed to value the instruments, that Missner knew it was dependent on information provided by BT, and that Gibson was thus different from P&G. In cases like these, Feikens said, banks have a duty to disclose relevant pricing information.

Bankers Trust declined to make any comment on whether there are any more cases pending against past or present employees, but sources at BT say that they think this is the last. Officials at the SEC confirm that it has no further litigations against BT to pursue.