Procter & Gamble Co. v. Bankers Trust Co.

OPINION AND ORDER (1) DISMISSING SECURITIES, COMMODITIES AND OHIO DECEPTIVE TRADE PRACTICES CLAIMS; (2) GRANTING SUMMARY JUDGMENT ON BREACH OF FIDUCIARY DUTY, NEGLIGENT MISREPRESENTATION AND NEGLIGENCE CLAIMS; AND (3) SETTING FORTH DUTIES AND OBLIGATIONS OF THE PARTIES

I. Introduction

Plaintiff, The Procter & Gamble Company (“P & G”), is a publicly traded Ohio corpora *1274 tion. Defendant, Bankers Trust Company (“BT”), is a wholly-owned subsidiary of Bankers Trust New York Corporation (“BTNY’). BTNY is a state-chartered banking company. BT trades currencies, securities, commodities and derivatives. Defendant BT Securities, also a wholly-owned subsidiary of BTNY, is a registered broker-dealer. The defendants are referred to collectively as “BT” in this opinion.

P & G filed its Complaint for Declaratory Relief and Damages on October 27, 1994, alleging fraud, misrepresentation, breach of fiduciary duty, negligent misrepresentation, and negligence in connection with an interest rate swap transaction it had entered with BT on November 4, 1993. This swap, explained more fully below, was a leveraged derivatives transaction whose value was based on the yield of five-year Treasury notes and the price of thirty-year Treasury bonds (“the 5s/30s swap”).

On February 6, 1995, P & G filed its First Amended Complaint for Declaratory Relief and Damages, adding claims related to a second swap, entered into between P & G and BT on February 14, 1994. This second swap was also a leveraged derivatives transaction. Its value was based on the four-year German Deutschemark rate. In its First Amended Complaint, P & G also added Counts alleging violations of the federal Securities Acts of 1933 and 1934, the Commodity Exchange Act, the Ohio Blue Sky Laws and the Ohio Deceptive Trade Practices Act. I permitted P & G to file a Second Amended Complaint, which it did on September 1, 1995.

BT now moves, under Federal Rule of CM Procedure (“Fed.R.Civ.P”) 12(b)(6), to dismiss the following nine Counts of P & G’s Second Amended Complaint:

Count VII Fraudulent Sale of a Security Under Section 17 of the Securities Act of 1933

Count VIII Violation of Section 10(b) of the Exchange Act of 1934 and Rule 10b-5

Count IX Fraud in the Sale of Security in Violation of Section 1707.41 of the Ohio Revised Code

Count X Violations of Section 1707.42 of the Ohio Revised Code

Count XI Violations of Section 1707.44 of the Ohio Revised Code

Count XII Willful Deception, Fraud and Cheating in Violation of the Commodity Exchange Act, § 4b

Count XIII Scheme or Artifice to Defraud in Violation of the Commodity Exchange Act, § 4o

Count XIV Deception, Cheating and Violation of Section 32.9 of the Rules of the Commodity Futures Trading Commission, 17 C.F.R. § 32.9

Count XV Ohio Deceptive Trade Practices

This motion involves questions of first impression whether the swap agreements fall within federal securities or commodities laws or Ohio Blue Sky laws. These are questions of law, not questions of fact. “The judiciary is the final authority on issues of statutory construction....” Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 843 n. 9, 104 S.Ct. 2778, 2781-82 n. 9, 81 L.Ed.2d 694 (1984). Mr. Justice Powell stated, in determining Congressional intent, “[t]he task has fallen to the Securities and Exchange Commission (SEC), the body charged with administering the Securities Acts, and ultimately to the federal courts to decide which of the myriad financial transactions in our society come within the coverage of these statutes.” United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 848, 95 S.Ct. 2051, 2058-59, 44 L.Ed.2d 621 (1975).

I conclude that the 5s/30s and DM swap agreements are not securities as defined by the Securities Acts of 1933 and 1934 and the Ohio Blue Sky Laws; that these swap agreements are exempt from the Commodity Exchange Act; that there is no private right of action available to P & G under the antifraud provisions of that Act; and that the choice of law provision in the parties’ agreement precludes claims under the Ohio Deceptive Trade Practices Act. Therefore, P & G’s claims in Counts VII through XV of its Second Amended Complaint are dismissed.

BT also moves for summary judgment on Counts III — V (Negligent Misrepresentation, Breach of Fiduciary Duty, and Negligence). I conclude that as a counterparty to swap *1275 agreements, BT owed no fiduciary duty to P & G. P & G’s claims of negligent misrepresentation and negligence are redundant, as I have set forth the duties and obligations of the parties under New York law. Therefore, summary judgment is granted as to Counts III—V.

II. Background

Financial engineering, in the last decade, began to take on new forms. A current dominant form is a structure known as a derivatives transaction. It is “a bilateral contract or payments exchange agreement whose value derives ... from the value of an underlying asset or underlying reference rate or index.” Global Derivatives Study Group of the Group of Thirty, Derivatives: Practices and Principles 28 (1993). Derivatives transactions may be based on the value of foreign currency, U.S. Treasury bonds, stock indexes, or interest rates. The values of these underlying financial instruments are determined by market forces, such as movements in interest rates. Within the broad panoply of derivatives transactions are numerous innovative financial instruments whose objectives may include a hedge against market risks, management of assets and liabilities, or lowering of funding costs; derivatives may also be used as speculation for profit. Singher, Regulating Derivatives: Does Transnational Regulatory Cooperation Offer a Viable Alternative to Congressional Action? 18 Fordham Int’l. Law J. 1405-06 (1995).

This case involves two interest rate swap agreements. A swap is an agreement between two parties (“counterparties”) to exchange cash flows over a period of time. Generally, the purpose of an interest rate swap is to protect a party from interest rate fluctuations. The simplest form of swap, a “plain vanilla” interest-rate swap, involves one counterparty paying a fixed rate of interest, while the other counterparty assumes a floating interest rate based on the amount of the principal of the underlying debt. This is called the “notional” amount of the swap, and this amount does not change hands; only the interest payments are exchanged.

In more complex interest rate swaps, such as those involved in this case, the floating rate may derive its value from any number of different securities, rates or indexes. In each instance, however, the counterparty with the floating rate obligation enters into a transaction whose precise value is unknown and is based upon activities in the market over which the counterparty has no control. How the swap plays out depends on how market factors change.

One leading commentator describes two “visions” of the “explosive growth of the derivatives market.” Hu, Hedging Expectations: “Derivative Reality” and the Law and Finance of the Corporate Objective, Vol. 73 Texas L.Rev. 985 (1995). One vision, that relied upon by derivatives dealers, is that of perfect hedges found in formal gardens. This vision portrays

the order—the respite from an otherwise chaotic universe—made possible by financial science. Corporations are subject to volatile financial and commodities markets. Derivatives, by offering hedges against almost any kind of price risk, allow corporations to operate in a more ordered world.

Id. at 994.

The other vision is that of “science run amok, a financial Jurassic Park.” Id. at 989. Using this metaphor, Hu states:

In the face of relentless competition and capital market disintermediation, banks in search of profits have hired financial scientists to develop new financial products. Often operating in an international wholesale market open only to major corporate and sovereign entities—a loosely regulated paradise hidden from public view—these scientists push the frontier, relying on powerful computers and an array of esoteric models laden with incomprehensible Greek letters. But danger lurks. As financial creatures are invented, introduced, and then evolve and mutate, exotic risks and uncertainties arise. In its most fevered imagining, not only do the trillions of mutant creatures destroy their creators in the wholesale market, but they escape and *1276 wreak havoc in the retail market and in economies worldwide.

Id. at 989-90.

Given the potential for a “financial Jurassic Park,” the size of the derivatives market 1 and the complexity of these financial instruments, it is not surprising that there is a demand for regulation and legislation. Several bills have been introduced in Congress to regulate derivatives. 2 BT Securities has been investigated by the Securities and Exchange Commission (“SEC”) and by the Commodities Futures Trading Commission (“CFTC”) regarding a swap transaction with a party other than P & G. In re BT Securities Corp., Release Nos. 33-7124, 34-35136 and CFTC Docket No. 95-3 (Dec. 22, 1994). Bankers Trust has agreed with the Federal Reserve Bank to a Consent Decree on its leveraged derivatives transactions.

At present, most derivatives transactions fall in “the common-law no-man’s land beyond regulations — ... interest-rate and equity swaps, swaps with embedded options (‘swaptions’),” and other equally creative financial instruments. Cohen, The Challenge of Derivatives, Vol. 63 Fordham L.Rev. at 2013. This is where the two highly specialized swap transactions involved in this case fah.

III. The P & G/BT Swap Agreements

Those swaps transactions are governed by written documents executed by BT and P & G. BT and P & G entered into an Interest Rate and Currency Exchange Agreement on January 20, 1993. This standardized form, drafted by the International Swap Dealers Association, Inc. (“ISDA”), together with a customized Schedule and written Confirmations for each swap, create the rights and duties of parties to derivative transactions. By their terms, the ISDA Master Agreement, the Schedule, and all Confirmations form a single agreement between the parties.

During the fall of 1993, the parties began discussing the terms of an interest rate swap which was to be customized for P & G. After negotiations, the parties agreed to a swap transaction on November 2,1993, which is referred to as the 5s/30s swap; the written Confirmation is dated November 4,1993.

In the 5s/30s swap transaction, BT agreed to pay P & G a fixed rate of interest of 5.30% for five years on a notional amount of $200 million. P & G agreed to pay BT a floating interest rate. For the first six months, that floating rate was the prevailing commercial paper (“CP”) interest rate minus 75 basis points (0.75%). For the remaining four-and-a-half years, P & G was to make floating interest rate payments of CP minus 75 basis points plus a spread. The spread was to be calculated at the end of the first six months (on May 4,1994) using the following formula:

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In this formula, the “5 year CMT” (Constant Maturity Treasury) represents the yield on the five-year Treasury Note, and the “30 T Price” represents the price of the thirty-year Treasury Bond. The leverage factor in this formula meant that even a small movement up or down in prevailing interest rates results in an incrementally larger change in P & G’s position in the swap.

The parties amended this swap transaction in January 1994; they postponed the date the spread was to be set to May 19,1994, and P & G was to receive CP minus 88 basis points, rather than 75 basis points, up to the spread date.

In late January 1994, P & G and BT negotiated a second swap, known as the “DM swap”, based on the value of the German Deutschemark. The Confirmation for this swap is dated February 14, 1994. For the first year, BT was to pay P & G a floating interest rate plus 233 basis points. P & G was to pay the same floating rate plus 133 basis points; P & G thus received a 1% premium for the first year, the effective *1277 dates being January 16, 1994 through January 16, 1995. On January 16, 1995, P & G was to add a spread to its payments to BT if the four-year DM swap rate ever traded below 4.05% or above 6.01% at any time between January 16, 1994, and January 16, 1995. If the DM swap rate stayed within that band of interest rates, the spread was zero. If the DM swap rate broke that band, the spread would be set on January 16,1995, using the following formula:

Spread = 10 * [4r-year DM swap rate — 4.50%]

The leverage factor in this swap was shown in the formula as ten.

P & G unwound both of these swaps before their spread set dates, as interest rates in both the United States and Germany took a significant turn upward, thus putting P & G in a negative position vis-a-vis its counterparty BT. BT now claims that it is owed over $200 million on the two swaps, while P & G claims the swaps were fraudulently induced and fraudulently executed, and seeks a declaratory verdict that it owes nothing. 3

IV. Federal Securities Claims (Counts VII and VIII)

In the 1933 Securities Act, Congress defined the term “security” as

any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferrable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or a certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

15 U.S.C. § 77b(l). The definition section of the 1934 Act, 15 U.S:C. § 78c(a)(10), is virtually identical and encompasses the same instruments as the 1933 Act. Reves v. Ernst & Young, 494 U.S. 56, 61 n. 1, 110 S.Ct. 945, 949 n. 1, 108 L.Ed.2d 47 (1989).

P & G asserts that the 5s/30s and DM swaps fall within any of the following portions of that definition: 1) investment contracts; 2) notes; 3) evidence of indebtedness; 4) options on securities; and 5) instruments commonly known as securities.

Congress intended a broad interpretation of the securities laws and flexibility to effectuate their remedial purpose of avoiding fraud. SEC v. Howey, 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946). The United States Supreme Court has held, however, that Congress did not “intend” the Securities Acts “to provide a broad federal remedy for all fraud.” Marine Bank v. Weaver, 455 U.S. 551, 556, 102 S.Ct. 1220, 1223, 71 L.Ed.2d 409 (1982). The threshold issue presented by P & G’s securities fraud claims is whether a security exists, i.e., whether or not these swaps are among “the myriad financial transactions in our society that come within the coverage of these statutes.” Forman, 421 U.S. at 849, 95 S.Ct. at 2059.

Economic reality is the guide for determining whether these swaps transactions that do not squarely fit within the statutory definition are, nevertheless, securities. Reves, 494 U.S. at 62, 110 S.Ct. at 949-50. In order to determine if these swaps are securities, commodities, or neither, I must examine each aspect of these transactions and subject them to the guidelines set forth in Supreme Court cases.

A. Investment Contracts

For purposes of the federal securities laws, an “investment contract” is defined as “a contract, transaction or scheme whereby a person invests his money in a common enterprise.” Howey, 328 U.S. at 298-99, 66 S.Ct. at 1102-03. Stated differently, the test whether an instrument is an investment contract is whether it entails “an investment in a *1278 common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” Forman, 421 U.S. at 852, 95 S.Ct. at 2060. The U.S. Court of Appeals for the Sixth Circuit has interpreted the Howey test as a “flexible one ‘capable of adaptation or meeting the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.’ ” Stone v. Kirk, 8 F.3d 1079, 1085 (6th Cir.1993), quoting Howey, 328 U.S. at 299, 66 S.Ct. at 1103.

BT argues that the swaps are not investment contracts because 1) neither P & G nor BT invested any money; rather, they agreed to exchange cash payments at future dates; 2) the swaps did not involve an investment in a “common enterprise,” which involves the pooling of funds in a single business venture, Deckebach v. La Vida Charters, Inc. of Fla., 867 F.2d 278, 281 (6th Cir.1989); and 3) any gains to be derived from the swaps were not “profits,” which are defined as “capital appreciation” or “participation in earnings” of a business venture. Forman, 421 U.S. at 852, 95 S.Ct. at 2060; Union Planters Nat’l Bank of Memphis v. Commercial Credit Business Loans, Inc., 651 F.2d 1174, 1185 (6th Cir.), cert. den. 454 U.S. 1124, 102 S.Ct. 972, 71 L.Ed.2d 111 (1981) (profits must be derived from the “managerial or entrepreneurial efforts of others”). BT contends that cash payments to be made arise not from the efforts of others, but from changes in U.S. and German interest rates.

P & G counters that the swaps are investments of money because an investment exists where an investor has committed its assets in such a way that it is subject to a financial loss and that the commitment to make future payments is sufficient to constitute an investment; further, that the swaps meet the “common enterprise” tests because its swaps, when combined with those of other parties, became part of the capital used to support BT’s derivatives business. Specifically, P & G argues, BT combines its sales in one hedge book to offset all of its customers’ transactions, and unwind prices reflect BT’s overall portfolio risk. P & G further contends that its profit motive was its desire to reduce its overall interest costs and that it expected to derive profits from the efforts of BT in structuring and monitoring the swaps.

While the swaps may meet certain elements of the Howey test whether an instrument is an investment contract, what is missing is the element of a “common enterprise.” P & G did not pool its money with that of any other company or person in a single business venture. How BT hedged its swaps is not what is at issue — the issue is whether a number of investors joined together in a common venture. Certainly, any counterparties with whom BT contracted cannot be lumped together as a “common enterprise.” Furthermore, BT was not managing P & G’s money; BT was a counterparty to the swaps, and the value of the swaps depended on market forces, not BT’s entrepreneurial efforts. The swaps are not investment contracts.

B. Notes or “Family Resemblance” to Notes

BT asserts that the swaps are not notes because they did not involve the payment or repayment of principal. P & G responds that the counterparties incurred payment obligations that were bilateral notes or the functional equivalent of notes.

As with the test whether an instrument is an investment contract, these swap agreements bear some, but not all, of the earmarks of notes. At the outset, and perhaps most basic, the payments required in the swap agreements did not involve the payment or repayment of principal. See Sanderson v. Roethenmund, 682 F.Supp. 205, 206 (S.D.N.Y.1988) (promises to pay a specified sum of principal and interest to the payee at a specified time are to be analyzed as “notes” for the purposes of the Securities Acts).

In Reves, 494 U.S. at 64-67, 110 S.Ct. at 950-52, the Supreme Court set out a four-part “family resemblance” test for identifying notes that should be deemed securities. Those factors are: 1) the motivations of the buyer and seller in entering into the transaction (investment for profit or to raise capital versus commercial); 2) a sufficiently broad *1279 plan of distribution of the instrument (common trading for speculation or investment); 3) the reasonable expectations of the investing public; and 4) whether some factor, such as the existence of another regulatory scheme, significantly reduces the risk of the instrument, thereby rendering application of the securities laws unnecessary.

In explaining the first prong of the “family resemblance” test, the Court in Reves distinguished between the motivations of the parties in entering into the transaction, drawing a line between investment notes as securities and commercial notes as non-securities. The Court said:

If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.” If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, on the other hand, the note is less sensibly described as a “security.”

Reves, 494 U.S. at 66, 110 S.Ct. at 951-52.

There is no “neat and tidy” way to apply this prong of the test, in part because P & G and BT were counterparties, not the typical buyer and seller of an instrument. BT’s motive was to generate a fee and commission, while P & G’s expressed motive was, in substantial part, to reduee its funding costs. These motives are tipped more toward a commercial than investment purpose. As to P & G, there was also an element of speculation driving its willingness to enter a transaction that was based on its expectations regarding the path that interest rates would take. Thus, this prong of the Reves test, standing alone, is not a sufficient guide to enable one to make the determination whether the 5s/30s and DM swaps were notes within the meaning of the Securities Acts.

The second prong of the Reves test examines the plan of distribution of the instrument “to determine whether it is an instrument in which there is ‘common trading for speculation or investment.’” Id, quoting SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351, 64 S.Ct. 120, 123-24, 88 L.Ed. 88 (1943). While derivatives transactions in general are an important part of BT’s business, and BT advertises its expertise in putting together a variety of derivatives packages, the test is whether the 5s/30s and DM swaps in particular were widely distributed. These swaps are analogous to the notes that were held not to be securities on the basis that the plan of distribution was “a limited solicitation to sophisticated financial or commercial institutions and not to the general public.” Banco Español de Credito v. Security Pacific Nat’l Bank, 763 F.Supp. 36, 43 (S.D.N.Y.1991), aff'd 973 F.2d 51 (2d Cir.1992). The 5s/30s and DM swaps were customized for Procter & Gamble; they could not be sold or traded to another counterparty without the agreement of BT. They were not part of any kind of general offering.

Thus, I conclude that the 5s/30s and DM swaps were not widely distributed and do not meet the second prong of the Reves test.

Application of the third Reves factor — the public’s reasonable perceptions — does not support a finding that these swap agreements are securities. They were not traded on a national exchange, “the paradigm of a security.” Reves, 494 U.S. at 69, 110 S.Ct. at 953. I recognize that some media refer to derivatives generally as securities and that some commentators assume that all derivatives are securities. Other commentators understand that many swap transactions are customized, bilateral contracts not subject to regulation. Cohen, 63 Fordham L.Rev. at 2013. However, what is relevant is the perception of those few who enter into swap agreements, not the public in general. P & G knew full well that its over-the-counter swap agreements with BT were not registered with any regulatory agency. P & G’s “perception” that these swap agreements were securities did not surface until after it had filed its original Complaint in this case.

Thus, I conclude that the 5s/30s and DM swaps do not meet the third prong of the Reves test..

The fourth Reves factor is whether another regulatory scheme exists that would control *1280 and thus reduce the risk of the instrument, making application of the securities laws unnecessary. At about the time these swaps were entered into, the guidelines of the Office of the Comptroller of Currency (“OCC”) and the Federal Reserve Board went into effect. OCC Banking Circular 277, Risk Management of Financial Derivatives, Fed.Banking L.Rep. (CCH) ¶ 62,154, at 71,-703 (Oct. 27-, 1998); Federal Reserve Board Supervisory Letter SR 98-69, Examining Risk Management and Internal Controls for Trading Activities of Banking Organizations, Fed.Banking L.Rep. ¶ 62-152, at 71,-712 (Dec. 20, 1993); OCC Bulletin 94-31, Questions and Answers for BC-277: Risk Management of Financial Derivatives, Fed.Banking L.Rep. ¶ 62-152, at 71,719 (May 10,1994).

While these guidelines are useful in regulating the banking industry, their focus is the protection of banks and their shareholders from default or other credit risks. They do not provide any direct protection to counter-parties with whom banks enter into derivatives transactions. While the 5s/30s and DM swaps may meet this prong of the Reves “family resemblance” test, this is not enough to bring these transactions within the statutory definition of a “note” for purposes of the securities laws.

Balancing all the Reves factors, I conclude that the 5s/30s and DM swaps are not notes for purposes of the Securities Acts.

C. Evidence of Indebtedness

P & G argues that if the swaps are not notes, they are evidence of indebtedness because they contain bilateral promises to pay money and they evidence debts between the parties. It argues that the counterparties promised to pay a debt, which consists of future obligations to pay interest on the notional amounts. Indeed, BT now claims that it is owed millions of dollars on the swaps. P & G points out that the phrase “evidence of indebtedness” in the statute must have a meaning other than that given to a “note” so that the words “evidence of indebtedness” are not redundant. Thus, it argues, without citation to authority, that if the swaps are not notes, then they should be construed as an evidence of indebtedness “either because they may contain terms and conditions well beyond the typical terms of a note and beyond an ordinary investor’s ability to understand, or because the debt obligation simply does not possess the physical characteristics of a note.”

The test whether an instrument is within the category of “evidence of indebtedness” is essentially the same as whether an instrument is a note. Holloway v. Peat, Marwick, Mitchell & Co., 879 F.2d 772, 777 (10th Cir.1989), judgment vacated on other grounds sub nom. Peat Marwick Main Co. v. Holloway, 494 U.S. 1014, 110 S.Ct. 1314, 108 L.Ed.2d 490 (1990), reaff'd on remand, 900 F.2d 1485 (10th Cir.), cert. den. 498 U.S. 958, 111 S.Ct. 386, 112 L.Ed.2d 396 (1990) (passbook savings certificates and thrift certificates were analyzed under the “note” or “evidence of indebtedness” categories, as they represented a promise to repay the principal amount, plus accrued interest); In re Tucker Freight Lines, Inc., 789 F.Supp. 884, 885 (W.D.Mich.1991) (The Court’s “method [in Reves] seems applicable to all debt instruments, including evidences of indebtedness.”).

I do not accept P & G’s definition of “evidence of indebtedness” in large part because that definition omits an essential element of debt instruments — the payment or repayment of principal. Swap agreements do not involve the payment of principal; the notional amount never changes hands.

D. Options on Securities

An option is the right to buy or sell, for a limited time, a particular good at a specified price.

Five-year notes and thirty-year Treasury bonds are securities; therefore, P & G contends that the 5s/30s swap is an option on securities. 4 It argues that because the 5s/30s swap spread was based on the value of these *1281 securities, it falls within the statutory definition: “any put, call, straddle, option or privilege on any security, group or index of securities (including any interest therein or based on the value thereof).” It describes the 5s/ 30s swap as “a single security which can be decomposed into a plain vanilla swap with an embedded put option. The option is a put on the 30-year bond price with an uncertain strike price that depends on the level of the 5-year yield at the end of six months.”

BT contends that the 5s/30s swap is not an option because no one had the right to take possession of the underlying securities. BT argues that although both swaps contained terms that functioned as options, they were not options because they did not give either parly the right to sell or buy anything. According to BT, the only “option-like” feature was the spread calculation that each swap contained; that any resemblance the spread calculations had to options on securities does not extend to the underlying swaps themselves, which had no option-like characteristics. I agree that the 5s/30s swap was not an option on a security; there was no right to take possession of any security.

The definition of a “security” in the 1933 and 1934 Acts includes the parenthetical phrase “(including any interest therein or based on the value thereof),” which could lead to a reading of the statute to mean that an option based on the value of a security is a security. Legislative history, however, makes it clear that that reading was not intended. The U.S. House of Representatives Report (“House Report”) on the 1982 amendments that added this parenthetical phrase provides that the definition of “security” includes an option on “(i) any security, (ii) any certificate of deposit, (iii) any group or index of securities (including any interest therein or based on the value thereof), and (iv) when traded on a national securities exchange, foreign currency.” H.R.Rep. No. 626, 97th Cong., 2d Sess., pt. 2, at 4 (1982), reprinted in 1982 U.S.C.C.A.N. 2780, 2795. Thus, even though the statute jumbles these definitions together, it is clear from the House Report that the parenthetical phrase “( ... based on the value thereof)” was intended only to modify the immediately preceding clause—“group or index of securities”—and not the words “any option” or “any security.”

Two Orders by the Security and Exchange Commission must be considered. These rulings involve transactions between BT and Gibson Greetings, Inc. in swaps that have some similarities to the 5s/30s swap. In re BT Securities Corp., Release Nos. 33-7124, 34-35136 (Dec. 22, 1994), and In the Matter of Mitchell A. Vazquez, Release Nos. 33-7269, 34-36909 (Feb. 29, 1996). In these cases, the SEC ruled that a “Treasury-Linked Swap” between BT and Gibson Greetings, Inc. was a security within the meaning of the federal securities laws. The SEC stated: “While called a swap, the Treasury-Linked Swap was in actuality a cash-settled put option that was written by Gibson and based initially on the ‘spread’ between the price of the 7.625% 30-year U.S. Treasury maturity maturing on November 15, 2022 and the arithmetic average of the bid and offered yields of the most recently auctioned obligation of a two-year Treasury note.”

These SEC Orders were made pursuant to Offers of Settlement made by BT Securities and Vazquez. In both Orders, the SEC acknowledged that its findings were solely for the purpose of effectuating the respondents’ Offers of Settlement and that its findings are not binding on any other person or entity named as a defendant or respondent in any other proceeding. They are not binding in this ease, in part because of the differences between the transactions; nor do they have collateral estoppel effect. See also SEC v. Sloan, 436 U.S. 103, 118, 98 S.Ct. 1702, 1711-12, 56 L.Ed.2d 148 (1978) (citations omitted) (The “courts are the final authorities on the issues of statutory construction and are not obliged to stand aside and rubber-stamp their affirmance of administrative decisions that they deem inconsistent with a statutory mandate or that frustrate the congressional policy underlying a statute.”).

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