By Craig J. McCann, PhD, CFA
Yesterday, the Oklahoma District Court in Tulsa, OK ordered JP Morgan Chase Bank to pay the Burford Trust over $18 million. In addition to this payment, JP Morgan is responsible for attorneys’ fees and punitive damages to compensate the trust for the diminution in value resulting from a series of 11 variable prepaid forward contracts (VPFs) JP Morgan entered into with the Trust starting in May 2000. The news of this decision has been picked up by Bloomberg, the New York Times as well as Reuters.
VPFs are complex securities containing embedded put and call option contracts on a stock position as well as a loan secured by the stock and option positions. VPFs can partially hedge concentrated stock positions and raise funds to make additional investments. At initiation of a VPF, the investor receives proceeds in exchange for a commitment to return these proceeds plus an implied interest. At maturity, VPFs can be settled by delivering shares of stock or with cash. Sometimes, as in this case, the cash settlement of a VPF is funded with the proceeds from entering into a subsequent “roll over” VPF.
The proceeds received when a VPF is entered into are typically invested in other assets. The net effect of the VPF and the other investments is to place a collar on a stock position using derivative contracts plus a leveraged investment made on margin. If the proceeds are invested in assets which earn exactly the same return as the interest charged in the VPF, the contract reduces to a collar.
The 11 VPFs JP Morgan sold to the Trust transferred over $2 million from the Trust to JP Morgan on the dates they were executed according to expert testimony provided by SLCG in this case. Incurring these costs neither fully diversified the Exxon-Mobil shares covered by the VPFs nor dealt with the embedded capital gains tax liability.
Some of the loan proceeds from the VPFs were used to fund bond investments. The bonds provided no diversification of the firm-specific risk in the Exxon-Mobil stock and had much lower expected returns than the implied interest charges on the loan portion of the VPFs. Moreover, the interest earned on the municipal bonds was paid out to the income beneficiary and so, predictably, the VPFs covered more and more of the Exxon-Mobil stock as they were rolled over. Once all the stock was covered, further roll overs were likely to require stock sales. The VPFs converted Exxon-Mobil stock into distributable income effectively circumventing the settlor’s intentions.
The VPFs JP Morgan sold to the Trust violated the Prudent Man Rule because they caused the Trust to incur unnecessary costs, enter into derivatives contracts, make additional investments on margin and needlessly dissipate a portion of the Trust’s assets. For additional information on the Prudent Investor Rule, see here (PDF) and here (DOC). The court found in particular that JP Morgan's "failure to adequately investigate and inform the beneficiaries of the risks and costs associated with VPF contracts was a breach of the duty of prudence."
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