Broker-Dealer Sales Practice in DerivativesTransactions: A Survey and Evaluation ofSuitability Requirements

"These guys have done some pretty wild stuff. And you know, they probably do not understand it quite as well as they should. I think that they have a pretty good understanding of it, but not perfect. And that's like perfect for us."(1)I. IntroductionA derivative financial instrument (derivative) is a bilateral contract that is linked to, or derives its value from, the value of an underlying security, index, or reference rate.(2)The derivative securities industry has "boomed" in the past two years.(3) Merrill Lynch & Co., the nation's largest brokerage firm, experienced a fifty-seven percent increase in derivatives trading revenue from 1992 to 1993.(4) The notional value(5) of all derivatives contracts entered into by United States-based commercial banks increased from $11.8 trillion at the end of 1993 to over $15.5 trillion in September of 1994.(6)Enthusiasm about derivatives, however, has turned to paranoia because of recent staggering losses sustained by derivatives end-users.(7) In December 1993, a New York unit of Metallgesellschaft AG, a German company, reported a loss of over $1 billion resulting from trading in oil-based derivatives.(8) In April 1994, Proctor & Gamble Co. (P&G) disclosed that P&G would take a $157 million charge to cover interest rate derivatives losses sustained over a period of less than two months.(9) In the aftermath of P&G's announcement, Commissioner Richard Roberts of the Securities and Exchange Commission (SEC) correctly predicted that more companies would soon reveal losses attributable to derivatives trading.(10) Indeed, by the end of 1994, several mutual funds, municipalities (most notably Orange County, California), and companies had announced losses, some of them staggering, that resulted from derivatives transactions.(11) By August 1994, derivatives trading had accounted for nearly $6.4 billion in losses since 1943.(12)A number of end-users that suffered large losses due to derivatives transactions filed suit against the dealers that sold them the derivatives.(13) The end-users claimed that they had not understood what they were buying and accused the dealers of taking advantage of the end-users' ignorance.(14) In November 1994, one such end-user, Gibson Greetings, Inc., settled its suit against BT Securities Corporation, a derivatives dealer, for $14 million.(15) " On May 18, 1994, the General Accounting Office (GAO), in response to a request from Congress, issued a report(GAO Report) on derivatives activity.(16) The GAO Report concluded that current over-the-counter (OTC) derivatives trading practices posed a serious danger to the financial system of the United States and called for formal regulations governing OTC derivatives trading.(17)In response to the heightened concern about insufficient OTC derivatives controls, members of Congress introduced six bills during the first seven months of 1994 that would provide for enhanced supervision of, and limitations on, OTC derivatives trading." The bills propose a wide range of solutions, ranging from the creation of a Federal Derivatives Commission(19) to a general prohibition forbidding banks from engaging in derivatives transactions that do not qualify as "hedging."(20) The 103d Congress, however, never voted on the proposals. Early in 1995, members of the House of Representatives introduced two more bills governing derivatives.(21)This Note analyzes the state of OTC derivative securities sales practice, including the current regulatory scheme and proposed revisions. Part II of this Note defines derivative financial instruments and describes their associated risks and benefits.(22) Part III examines the current regulatory framework governing broker-dealer sales practice in OTC derivatives transactions and analyzes the GAO Report and pending legislation providing for stricter regulation.(23) Part IV evaluates the present and proposed schemes for regulating broker-dealer sales practice in OTC derivatives transactions. …