Broken Trust and Bankers Trust

5/2/2019 - Monocle Journal

In a newsroom in 1995, Business Week journalists eagerly scanned sealed court documents that included transcriptions of several scandalous conversations between employees of Bankers Trust – then a well-recognised leader in the derivatives business, and now part of Deutsche Bank. “It’s like Russian roulette,” trader Kevin Hudson had been recorded saying, “and I keep putting another bullet in the revolver every time I do one of these.” Hudson was referring to the complex and highly-leveraged derivatives deals between his firm and consumer goods multinational Procter & Gamble, and he was not the only one caught on record undermining his own business and client. Several of his colleagues had joined in the banter, boasting about how much profit they were making off these trades and how little Procter & Gamble seemed to understand the degree of risk that they had willingly opened themselves up to. Ironically, the most damning evidence had been provided by Bankers Trust’s own internal surveillance system, which routinely recorded conversations so that any later disputes about transactions managed by their employees could be easily settled. Over 6 500 tapes of similar conversations were submitted to the court in Procter & Gamble’s bid to sue Bankers Trust over two transactions that had caused them to lose $102 million in April 1994, and these had been leaked to Business Week. “They would never know. They would never be able to know how much money was taken out of that,” another Bankers Trust employee was recorded saying, referring to the profits earned by her firm in the deals that had proven so catastrophic for Procter & Gamble. “Never, no way,” her colleague replied, “that’s the beauty of Bankers Trust”.


At the centre of the case were two complex interest rate swaps. On 4 November 1993, Procter & Gamble reached an agreement with Bankers Trust involving a principal amount of $200 million and a five-year swap. It was decided that Procter & Gamble would, for the first six months of the trade, pay a floating rate on the principal amount that was 75 basis points below commercial paper rates. From 4 May 1994, for the remaining 4½ years of the deal, the company would pay a floating rate determined by a complex formula created by Bankers Trust, which was based on five-year and thirty-year Treasury rates. In the best-case scenario, if interest rates remained low and within a fairly narrow range, Procter & Gamble would save a total of $1.5 million annually on their interest bill. Assured that it was unlikely that interest rates would change substantially, in February 1994, Procter & Gamble entered a second highly-leveraged interest rate swap with Bankers Trust. With a principal amount of $93 million and a term of 4¾ years, in the best-case scenario the swap would yield a total saving of $940 000 for Procter & Gamble. But the company found themselves in serious trouble just two weeks later, when interest rates did the unthinkable and started to rise.

Procter & Gamble argued that Bankers Trust had purpose fully distorted key aspects of the deals to encourage the firm into a high-risk position that they had been misled to believe was fairly safe. And this was not the first time Bankers Trust had been accused of underhanded behaviour – just a month before, greeting card producer Gibson Greetings had filed a similar lawsuit, claiming that Bankers Trust had misrepresented the extent of the potential losses involved in several of their interest rate swaps. Gibson Greetings believed that Bankers Trust had knowingly sold them an abnormally high-risk position – one whose risk they were not fully aware of and whose failure was almost certain. Bankers Trust reached a settlement with Gibson Greetings – with the latter ultimately paying only $6.2 million of the $23 million in losses they had accrued in the transaction in which Bankers Trust was the counterparty. Bankers Trust was fined $10 million by regulators for their actions in this transaction.

Unlike Gibson Greetings, however, Procter & Gamble agreed that they had been fully cognisant of the risks involved in their trades, even if interest rates were to move unfavourably for them. Instead, in this case, the company’s complaint was that Bankers Trust had not been transparent about the terms of the deals. Procter & Gamble asserted that a lock-in provision had been agreed with Bankers Trust, which would allow the company to lock in the interest rate that payments would be based on at any time within six months of making the first deal, to protect them from an unexpected rise in interest rates and to limit their losses. When interest rates started climbing in March 1994 – just four months after the initial deal was made – Procter & Gamble understood it to be the ideal moment to exercise the lock-in provision. However, the firm claimed that they were cautioned against doing so by Bankers Trust, who argued at the time that this would be a costly move. Owing to the highly leveraged nature of the swaps, if Procter & Gamble exercised the lock-in they would lose far more money than they had initially expected – $157 million to be exact, as they would be paying an interest rate that was 14.12% above the commercial paper rate. Procter & Gamble would be better off to wait and see if interest rates would fall within the next two months, Bankers Trust advised, and use the lock-in then.

However, unfortunately for Procter & Gamble, interest rates continued to rise in the following weeks. With no reprieve in sight, by April 1994, Procter & Gamble decided to exercise the lock-in, which resulted in the firm having to pay an interest rate that was 16.4% above the commercial paper rate. Refusing to pay, Procter &Gamble filed a lawsuit against Bankers Trust, claiming that the latter had purposefully obfuscated the degree of risk associated with the trades and encouraged a false sense of safety through the lock-in clauses. Bankers Trust filed a counter suit, demanding that the money be paid and argued that Procter & Gamble’s misfortune had merely been the result of unpredictable and uncontrollable market forces. Bankers Trust maintained that all their dealings with Procter & Gamble had been “legal, proper and appropriate” and insisted that the firm had understood all the risks of the deal before agreeing to it. Indeed, unlike the guileless Robert Citron of Orange County, according to both Business Week and Fortune, Procter & Gamble had a reputation for being a sophisticated player in financial markets during the 1990s, having successfully navigated several trades with Bankers Trust and others by this time. And, as many commentators pointed out, surely the end-users of derivatives should be responsible for the products they willingly buy.

The US District Court judge overseeing the case, Judge John Feikens, appeared to agree with this and ruled against Procter & Gamble on several points. However, before he could make his final ruling, Bankers Trust decided to settle with Procter & Gamble, with the latter required to pay only $35 million of the value of their losses. Judge Feikens made a point of highlighting that as the trades involved derivatives and not more highly regulated securities, Bankers Trust did not have a fiduciary obligation to protect Procter & Gamble’s interests. However, it was obvious that Bankers Trust had nonetheless been driven to the settlement by the reputational harm that had been caused by the leaking of the tapes to the press. This would no doubt only be compounded if a trial dragged on and the tape recordings of their cynical employees were heard in a court room. The tapes revealed Bankers Trust employees blatantly mocking Procter & Gamble, with their comments consistently focused on how Procter & Gamble’s ignorance – and not their bad luck, as the company’s official statements had insisted – had placed them in a position that basically ensured profits for Bankers Trust. What Bankers Trust had done may not have been technically illegal, but the recordings of their employees communicated a clear ethos of “profit at all cost” that had eroded trust both in the company, and the investment banking industry at large.

Bankers Trust attempted to defend themselves in the court of public opinion by maintaining that the ruthless attitude portrayed on the tapes was specific to the individuals recorded, rather than representative of the firm’s corporate culture and values. But it would be a significant task for the company to restore credibility with their customers. One undoubtedly made more challenging when just a few years later, in 1998, the company pleaded guilty to criminal charges of institutional fraud. Auditors had noticed that $19.1 million of unclaimed funds had mysteriously disappeared off Bankers Trust’s books. Unclaimed funds are bank accounts that are left dormant for several years and these are required by law to be handed over to the State, which will attempt to locate the account holders. However, an investigation revealed that senior management members at Bankers Trust had diverted the unclaimed funds to inflate company profits. The firm payed $63.5 million in fines to regulators and was forced to return the $19.1 million it had diverted, and the individuals involved were barred from working in securities markets by the Securities and Exchange Commission (SEC). However, perhaps the most severe punishment the company faced was that it was no longer allowed to transact with most municipalities and many companies because of its conviction. Later that same year, Deutsche Bank purchased Bankers Trust for $10.1 billion, saving the company’s shareholders from the financial losses that went hand in hand with its reputational ruin.

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