Question: Bankers Trust (BT) was one of the
Bankers Trust (BT) was one of the most powerful and profitable banks in the world in the early 1990s. Under the stewardship of chairman Charles Sanford Jr., it had transformed itself from a staid commercial bank into “a highly-tuned manufacturer of high-margin, creative financial products— the envy of wholesale bankers.â€1 BT prided itself on its innovative trading strategies, which used derivatives to manage risks; its performance-driven culture; and its profits: the bank made a profit of over U.S.$1 billion in 1993.2
Key to BT’s success was the dominance of its business in derivatives—contracts in which companies make payments to each other based on some underlying asset, such as a commodity, a financial instrument, or an index.3 The value of the payments—and thus the contract—is derived from those assets. Companies can use derivatives to lower financing costs, manage risk, or speculate on interest and currency rates. It is estimated that almost $400 million of BT’s 1993 profits came from its leveraged derivatives business.
Derivatives, with their high margins, held a preeminent position with BT management, with their fervent focus on the bottom line. At BT, each product and each trader was given a value that was based on what income the product or trader could bring the firm.4 The bank’s intense focus on the bottom line decreased attention on products and services that had low mar- gins but that fostered and nurtured client relationships. BT was known for courting customers only insofar as they would buy high-margin products.5 In 1990, Charles Hill, former cohead of merchant banking, left with thirty members of his department because he saw no room at BT for offering clients impartial financial advice and deal structuring. One source within the company explained, “We got rid of the nurturers and builders—the defensive guys—and kept the offensive guys.â€6 Those who remained describe a firm driven by intense internal rivalry, endless politick- ing, and discussions about profit and losses. They describe a “coliseum†mentality at the top level: “we look on while the guys are out there fighting the lions.â€7 What remained was a bank where the customer’s interests appeared to come second to the bank’s.
It was within this context that BT, once one of the most powerful banks in the world, was disgraced by a series of highly publicized lawsuits brought forth by several of its clients in 1994 and 1995 over losses they incurred as a result of derivative products sold to them by BT. The clients con- tended that BT sold them the derivatives without giving them adequate warning and information regarding their potential risks. BT countered that these derivative deals were agreements between the bank and sophisticated clients who were now trying to escape from their loss-making contracts by crying foul.8 At issue was whether the clients were naive and should have known what they were getting into or whether BT deliberately deceived them (p. 110).9
There were more than half a dozen companies that suffered losses as a result of derivatives due to BT’s allegedly fraudulent sales practices (see table below), but the Procter & Gamble (P&G) case is represen- tative of the other cases.
![Bankers Trust (BT) was one of the most powerful and profitable banks in the world in the early 1990s. Under the stewardship of chairman Charles Sanford Jr., it had transformed itself from a staid commercial bank into “a highly-tuned manufacturer of high-margin, creative financial products— the envy of wholesale bankers.”1 BT prided itself on its innovative trading strategies, which used derivatives to manage risks; its performance-driven culture; and its profits: the bank made a profit of over U.S.$1 billion in 1993.2
Key to BT’s success was the dominance of its business in derivatives—contracts in which companies make payments to each other based on some underlying asset, such as a commodity, a financial instrument, or an index.3 The value of the payments—and thus the contract—is derived from those assets. Companies can use derivatives to lower financing costs, manage risk, or speculate on interest and currency rates. It is estimated that almost $400 million of BT’s 1993 profits came from its leveraged derivatives business.
Derivatives, with their high margins, held a preeminent position with BT management, with their fervent focus on the bottom line. At BT, each product and each trader was given a value that was based on what income the product or trader could bring the firm.4 The bank’s intense focus on the bottom line decreased attention on products and services that had low mar- gins but that fostered and nurtured client relationships. BT was known for courting customers only insofar as they would buy high-margin products.5 In 1990, Charles Hill, former cohead of merchant banking, left with thirty members of his department because he saw no room at BT for offering clients impartial financial advice and deal structuring. One source within the company explained, “We got rid of the nurturers and builders—the defensive guys—and kept the offensive guys.”6 Those who remained describe a firm driven by intense internal rivalry, endless politick- ing, and discussions about profit and losses. They describe a “coliseum” mentality at the top level: “we look on while the guys are out there fighting the lions.”7 What remained was a bank where the customer’s interests appeared to come second to the bank’s.
It was within this context that BT, once one of the most powerful banks in the world, was disgraced by a series of highly publicized lawsuits brought forth by several of its clients in 1994 and 1995 over losses they incurred as a result of derivative products sold to them by BT. The clients con- tended that BT sold them the derivatives without giving them adequate warning and information regarding their potential risks. BT countered that these derivative deals were agreements between the bank and sophisticated clients who were now trying to escape from their loss-making contracts by crying foul.8 At issue was whether the clients were naive and should have known what they were getting into or whether BT deliberately deceived them (p. 110).9
There were more than half a dozen companies that suffered losses as a result of derivatives due to BT’s allegedly fraudulent sales practices (see table below), but the Procter & Gamble (P&G) case is represen- tative of the other cases.
The relationship between P&G and BT’s derivatives unit was established in January 1993 when the company set up a broad agreement with the bank for derivatives contracts. In November 1993, P&G agreed to buy a leveraged derivative product; P&G would make large profits if interest rates decreased and would lose money if interest rates increased. Leveraged derivatives products are a complex type of derivative, and their value can fluctuate to a greater degree than ordinary derivatives. The derivative worked fine at first, and P&G was sufficiently satisfied to agree to a second lever- aged derivative contract in February 1994. However, interest rates began to rise that same month, significantly increasing P&G’s payments to BT.
It is unclear whether P&G knew the cost of getting out of the contract, and P&G has since acknowledged that its internal procedures were not followed when it agreed to this derivative. P&G claimed that Bankers fraudulently induced it to buy complex derivatives, misrepresented their value, and then induced P&G to buy more for alleged gains or to staunch losses. However, P&G appeared to be an active market player. It had $5 billion in long-term debt, and its treasury managed a large, sophisticated portfolio of derivatives. P&G has acknowledged that its internal procedures were not followed when it entered into the derivatives contracts in November 1993. Ed Artzt, P&G’s CEO, said the executives who bought the derivatives ignored policies against such speculation and were “like farm boys at a country carnival.” His treasurer, Ray Mains, did not read the contract he signed, did not ask the right Questions, and did not assess risk by seeking outside help. Artzt also said Mains “failed to tell his boss when he knew he had a problem, … delayed while losses piled up, … and misled his boss into believing the loss was much smaller than it was.”10 P&G’s CFO, Erik Nelson, relied on Mains instead of getting outside advice and did not inform Artzt or the board of the problems with the deal.
P&G’s court filings include taped conversations that took place at Bankers Trust. In November 1993, Kevin Hudson, a man- aging director and salesman on the P&G deal, told his fiancée that the transaction would bring BT a profit of $7.6 million. She asked, “Do they understand that? What they did?” He replied, “No. They under- stand what they did but they don’t under- stand the leverage.” She warned Hudson that the deal would blow up on him. He replied, “I’ll be looking for a new opportu- nity at the bank by then anyways.” When the Fed raised interest rates in February 1994, P&G lost $157 million, and when asked if “they were dying,” Hudson replied, “They don’t know.” He was even then trying to sell P&G a second leveraged derivative and said, “Let me just get the deutsche mark trade done first; then they can ask.” By April 12 that year, P&G announced a $157 mil- lion derivatives bath. Hudson’s bonus for 1993 was $1.3 million. (He and his fiancée were married on November 5, 1994; live in London; and are still working for BT.11)
P&G contended that, when it asked for an explanation of the costs, it learned that the bank was using a proprietary model to calculate the costs that it would not share with P&G.12 P&G alleged that, in April, BT gave the company charts that showed that it would have had to pay a penalty to get out of its November contract almost from the day it was initiated.
Further evidence points to taped conversations between BT employees in which a BT salesman, discussing P&G’s decision to enter into the November contract, says “we set ’emup.”13 P&G finally locked in interest rates on both the derivatives; how- ever, it claimed that by the time it finished doing so, its financing costs were $195.5 million higher than they should have been (p. 110).14
P&G asserted that BT employees were trying to deceive it from the day the derivatives contract was initiated. As evidence, P&G points to a taped conversation between Bankers employees about the November contract where one asks, “Do they [P&G] understand that? What they did?”15 The other employee replies, “No.
They understand what they did but they don’t understand the leverage, no.”16 The first employee then says, “But I mean… how much do you tell them. What is your obligation to them?”17 The second employee responds, “To tell them if it goes wrong, what does it mean in a payout for- mula.”18 P&G sued BT in October 1994, alleging that the bank “deliberately misled and deceived it, keeping the company in the dark about key aspects of the derivatives the bank was selling (p. 106).”19
BT countered that P&G was an active and sophisticated player in the financial markets and knew how its derivatives would perform. In court filings, BT described P&G as “sophisticated, experienced, and knowledgeable about the use of interest- rate derivative contracts and the risks presented by those contracts (p. 109).”20 It added, “Although P&G would like this court to believe that it is a naive and unsophisticated user of derivatives transactions, the fact is that as part of its regular course of business and with authorization from top management, P&G’s Treasury Department managed a large and sophisticated portfolio of derivative transactions (p. 109).”21 BT asserted that P&G knew how the derivatives would perform and had included a taped conversation in its court filings in which a BT employee shows a P&G treasury employee how to calculate its rate on the November derivative.22 BT also produced evidence in court filings that P&G top executives blamed their own personnel for the investments. “Rather than putting its own house in order, and accepting its losses, P&G chose instead to bring this law- suit (p. 111).”23
On September 1, 1995, P&G filed a motion in U.S. District Court that was approved to add RICO (Racketeer-Influenced and Corrupt Organization) charges to the allegations against BT. A company found guilty of RICO charges is liable for three times the damages and plaintiff ’s legal costs. Banker’s counterfiling called this “black- mail,” saying P&G was hoping to vilify BT by the sheer number of its charges.
The lawsuit was settled out of court in May 1996.
Questions
1. What do you think the basis of settlement should have been?
2. Did BT have a duty to disclose all the information it had regarding the trans- actions to P&G, including pricing, mark to market value, and risk, or should P&G, a multi-billion-dollar company, have ensured that it knew and under- stood these figures and risks prior to engaging in the transactions?
3. Did BT have an ethical duty to ascertain the suitability of these products for P&G, or did its responsibilities end with providing its client with the product it demanded?
4. Was the maxim of “buyer beware” more appropriate than “seller beware”?
5. What other ethical issues are raised by the case?](../images/bankers-trust-bt-was-one-of-the-most-powerful-and-268073-1.jpg)
The relationship between P&G and BT’s derivatives unit was established in January 1993 when the company set up a broad agreement with the bank for derivatives contracts. In November 1993, P&G agreed to buy a leveraged derivative product; P&G would make large profits if interest rates decreased and would lose money if interest rates increased. Leveraged derivatives products are a complex type of derivative, and their value can fluctuate to a greater degree than ordinary derivatives. The derivative worked fine at first, and P&G was sufficiently satisfied to agree to a second lever- aged derivative contract in February 1994. However, interest rates began to rise that same month, significantly increasing P&G’s payments to BT.
It is unclear whether P&G knew the cost of getting out of the contract, and P&G has since acknowledged that its internal procedures were not followed when it agreed to this derivative. P&G claimed that Bankers fraudulently induced it to buy complex derivatives, misrepresented their value, and then induced P&G to buy more for alleged gains or to staunch losses. However, P&G appeared to be an active market player. It had $5 billion in long-term debt, and its treasury managed a large, sophisticated portfolio of derivatives. P&G has acknowledged that its internal procedures were not followed when it entered into the derivatives contracts in November 1993. Ed Artzt, P&G’s CEO, said the executives who bought the derivatives ignored policies against such speculation and were “like farm boys at a country carnival.†His treasurer, Ray Mains, did not read the contract he signed, did not ask the right Questions, and did not assess risk by seeking outside help. Artzt also said Mains “failed to tell his boss when he knew he had a problem, … delayed while losses piled up, … and misled his boss into believing the loss was much smaller than it was.â€10 P&G’s CFO, Erik Nelson, relied on Mains instead of getting outside advice and did not inform Artzt or the board of the problems with the deal.
P&G’s court filings include taped conversations that took place at Bankers Trust. In November 1993, Kevin Hudson, a man- aging director and salesman on the P&G deal, told his fiancée that the transaction would bring BT a profit of $7.6 million. She asked, “Do they understand that? What they did?†He replied, “No. They under- stand what they did but they don’t under- stand the leverage.†She warned Hudson that the deal would blow up on him. He replied, “I’ll be looking for a new opportu- nity at the bank by then anyways.†When the Fed raised interest rates in February 1994, P&G lost $157 million, and when asked if “they were dying,†Hudson replied, “They don’t know.†He was even then trying to sell P&G a second leveraged derivative and said, “Let me just get the deutsche mark trade done first; then they can ask.†By April 12 that year, P&G announced a $157 mil- lion derivatives bath. Hudson’s bonus for 1993 was $1.3 million. (He and his fiancée were married on November 5, 1994; live in London; and are still working for BT.11)
P&G contended that, when it asked for an explanation of the costs, it learned that the bank was using a proprietary model to calculate the costs that it would not share with P&G.12 P&G alleged that, in April, BT gave the company charts that showed that it would have had to pay a penalty to get out of its November contract almost from the day it was initiated.
Further evidence points to taped conversations between BT employees in which a BT salesman, discussing P&G’s decision to enter into the November contract, says “we set ’emup.â€13 P&G finally locked in interest rates on both the derivatives; how- ever, it claimed that by the time it finished doing so, its financing costs were $195.5 million higher than they should have been (p. 110).14
P&G asserted that BT employees were trying to deceive it from the day the derivatives contract was initiated. As evidence, P&G points to a taped conversation between Bankers employees about the November contract where one asks, “Do they [P&G] understand that? What they did?â€15 The other employee replies, “No.
They understand what they did but they don’t understand the leverage, no.â€16 The first employee then says, “But I mean… how much do you tell them. What is your obligation to them?â€17 The second employee responds, “To tell them if it goes wrong, what does it mean in a payout for- mula.â€18 P&G sued BT in October 1994, alleging that the bank “deliberately misled and deceived it, keeping the company in the dark about key aspects of the derivatives the bank was selling (p. 106).â€19
BT countered that P&G was an active and sophisticated player in the financial markets and knew how its derivatives would perform. In court filings, BT described P&G as “sophisticated, experienced, and knowledgeable about the use of interest- rate derivative contracts and the risks presented by those contracts (p. 109).â€20 It added, “Although P&G would like this court to believe that it is a naive and unsophisticated user of derivatives transactions, the fact is that as part of its regular course of business and with authorization from top management, P&G’s Treasury Department managed a large and sophisticated portfolio of derivative transactions (p. 109).â€21 BT asserted that P&G knew how the derivatives would perform and had included a taped conversation in its court filings in which a BT employee shows a P&G treasury employee how to calculate its rate on the November derivative.22 BT also produced evidence in court filings that P&G top executives blamed their own personnel for the investments. “Rather than putting its own house in order, and accepting its losses, P&G chose instead to bring this law- suit (p. 111).â€23
On September 1, 1995, P&G filed a motion in U.S. District Court that was approved to add RICO (Racketeer-Influenced and Corrupt Organization) charges to the allegations against BT. A company found guilty of RICO charges is liable for three times the damages and plaintiff ’s legal costs. Banker’s counterfiling called this “black- mail,†saying P&G was hoping to vilify BT by the sheer number of its charges.
The lawsuit was settled out of court in May 1996.
Questions
1. What do you think the basis of settlement should have been?
2. Did BT have a duty to disclose all the information it had regarding the trans- actions to P&G, including pricing, mark to market value, and risk, or should P&G, a multi-billion-dollar company, have ensured that it knew and under- stood these figures and risks prior to engaging in the transactions?
3. Did BT have an ethical duty to ascertain the suitability of these products for P&G, or did its responsibilities end with providing its client with the product it demanded?
4. Was the maxim of “buyer beware†more appropriate than “seller beware�
5. What other ethical issues are raised by the case?
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> On June 20, 2005, “John Rigas, the 80-year old founder of Adelphia Communications Corp., was … sentenced to 15 years in prison and his son Timothy, the ex-finance chief, got 20 years for looting the com- pany and lying about its finances.”1 These were th
> By the late 1990s, Nortel Networks Corporation, headquartered in Brampton, Ontario, Canada, was one of the giants of the telecommunications industry. Seventy- five percent of North America’s Internet traffic was carried by Nortel equipment,1 which was ma
> Satyam Computer Services Ltd was founded in 1987 by B. Ramalinga Raju. By 2009, it was India’s fourth-largest information technology company with 53,000 employees, operating in sixty-six countries. It provided a variety of services, including computer sy
> Employee stock options allow company executives to buy shares of their company at a specified price during a specified time period. They are given to executives as a form of noncash compensation. The option or “strike price” is normally equal to the mark
> Pierre Garvey, the CEO of Revel Information Technology, sat back in his chair and looked at his assistants. He frowned. “My son has been diagnosed with MLD,” he said. They all looked at him with shock. “Its proper name is metachromatic leuko dystrophy, a
> Walt Pavlo joined MCI in the spring of 1992. At that time, MCI was a growth company in the booming long-distance tele- communications industry that had 15% of the long-distance market, with revenues of $11 billion. In the 1990s, the major telecommunicati
> On November 17, 2005, Conrad Black and three other executives1 of Hollinger Inter- national, Inc., were charged with eleven counts of fraud with regard to payments allegedly disguised as “noncompete fees” or, in one case, a “management agreement breakup
> Tiger Woods, once probably the world’s greatest golfer, lost his number one ranking in October 2010, the same year that his marriage to Elin Nordegren blew up when she chased him out of the house and broke the windows of his vehicle with a 9 iron. His po
> In January 2006, the chair of Hewlett-Packard (HP), Patricia Dunn, hired a team of independent electronic-security experts to determine the source of leaked confidential details regarding HP’s long-term strategy. In September 2006, the press revealed tha
> Kelly Brown had been a member of the Board of Governors of the Wolfson General Hospital (WGH) for two years and had been asked to consider becoming the vice chair of the board. She had been a nurse before leaving to raise her family and now enjoyed parti
> The discussion between Don Chambers, the CEO, and Ron Smith, the CFO, was get- ting heated. Sales and margins were below expectations, and the stock market analysts had been behaving like sharks when other companies’ published quarterly or annual financi
> On September 30, 2004, Merck voluntarily withdrew its rheumatoid arthritis drug (Vioxx) from the market due to severe adverse effects observed in many of its users (Exhibit 1). As a result, Merck’s share price fell $11.48 (27%) in one d
> Johnson & Johnson (J & J) enjoyed a halo effect for many decades after their iconic precautionary recall of Tylenol capsules in 1982, which was greatly facilitated by the famous Johnson & Johnson Credo1 that stipulated patient well-being to be para- moun
> One of the world’s largest oil spills began on April 20, 2010, in BP’s Deepwater Hori- zon/Macondo well in the Gulf of Mexico. Although the world did not take significant notice until the next day, an estimated 62,000
> The NFL has known for some time that serious brain damage could be caused by the head trauma that is part of a normal football game. The sudden serious jarring of a football player’s head in normal tackling and blocking has been suspected for decades of
> The Kardell paper mill was established at the turn of the century on the Cherokee River in southeastern Ontario by the Kardell family. By 1985, the Kardell Paper Co. had outgrown its original mill and had encompassed several facilities in different locat
> In order to meet strong competition from Volkswagen as well as other foreign domes- tic subcompacts, Lee Iacocca, then president of Ford Motor Co., decided to introduce a new vehicle by 1970, to be known as the Pinto. The overall objective was to produce
> Antismoking advocates cheered in the summer of 1997 when the U.S. tobacco industry agreed to pay out more than U.S. $368.5 billion to settle lawsuits brought by forty states seeking compensation for cigarette-related Medicaid costs. Mississippi Attorney
> In June 2012, Jerry Sandusky was convicted of sexually abusing ten boys while he was an assistant football coach at Pennsylvani State University. His abuse of children went back almost fourteen years and was known by his superior, Joe Paterno, the head f
> In 1984, when he was eighteen years old, Cesar Correia murdered his father, killing him with a baseball bat. Cesar then dumped the body in the Assiniboine River. The body was eventually found, and Cesar confessed to the crime. He pleaded guilty to mansla
> Alex McAdams, the recently retired CEO of Athletic Shoes, was honored to be asked to join the Board of Consolidated Mines International Inc. Alex continues to sit on the Board of Athletic Shoes, as well as the Board of Pharma-Advantage, another publicly
> Adverse selection occurs when one party has an information advantage over the other party. In the case of insurance, people taking out insurance know more about their health and lifestyle than the insurance company. Therefore, in order to reduce informat
> Throughout 2009, the world was plagued with the H1N1 swine flu epidemic. The H1N1 influenza virus, which began in Mexico, spread rapidly. In June, the World Health Organization (WHO) declared it to be a global pandemic. Those who caught the virus suffere
> On October 1, 2012, IKEA apologized for removing women from the photographs in the IKEA catalogs that were shipped to Saudi Arabia. IKEA is a Swedish company that was founded in 1943. It is now the world’s largest furniture retailer with stores in over f
> Eric Hebborn (1934–1996) was an English painter and art forger. Hebborn attended the Royal Academy of Arts and then the British School at Rome, two of the most prestigious fine arts schools at the time. Underappreciated as an artist, he turned his hand t
> In the airline industry, passenger load capacity is the proportion of seats filled on each flight. The objective is to have all air- planes at full-load capacity on all flights. In October 2000, Jeffrey Lafond, a former Air Canada employee, joined WestJe
> On September 5, 2007, Steve Jobs, the CEO of Apple Inc., announced that the spectacularly successful iPhone would be reduced in price by $200 from $599, its introductory price of roughly two months earlier.1 Needless to say, he received hundreds of email
> Deutsche Bank (DB) is the largest bank in Germany and world’s sixth-largest investment bank.1 Unfortunately, the bank suffered from lackluster leadership, a poor organizational culture, and a complicated governance structure that result
> In 2006, Mercedes-Benz introduced Blue- TEC, an advanced system to trap and neutralize harmful emissions and particulates that allowed Mercedes to market “clean diesel” cars. VW and Audi made agreements to share the technology to enable all three compani
> In January 2002, the Boston Globe began a series of articles reporting that Fr. John Geoghan had been transferred from one parish to another in the Archdiocese of Boston, even though senior church officials knew that he was a pedophile. There was outrage
> On a fateful day in 2001, a GM engineer realized during preproduction testing of the Saturn Ion that there was a defect that caused the small car’s engine to stall with- out warning.1 This switch was approved in 2002 by an engineer, Raymond DiGeorgio, wh
> Should executives and directors be sent to jail for the acts of their corporation's employees?
> Why didn’t some corporations protect women employees from sexual abuse before 2017–2019?
> How can corporations ensure that their employees behave ethically?
> Why is it important for the clients of professional accountants to be ethical?
> Why might ethical corporate behavior lead to higher profitability?
> On any given day, a bank may have either a surplus or a deficiency of cash. When this occurs, banks tend to lend to and borrow from other banks at a negotiated rate of interest. These interbank loans could be as short as one day and as long as several mo
> What could professional accountants have done to prevent the development of the credibility gap and the expectations gap?
> Why are we more concerned now than our parents were about fair treatment of employees?
> Why have concerns over pollution become so important for management and directors?
> Should organizations that have a risk-taking culture, such as the one developed by Stan O’Neil at Merrill Lynch, enjoy the gains and suffer the losses, without recourse to government bailouts?
