Caiola v. Citibank, N.A., New York

Decision Date27 June 2002
Docket NumberDocket No. 01-7545.
Citation295 F.3d 312
PartiesLouis S. CAIOLA, Plaintiff-Appellant, v. CITIBANK, N.A., NEW YORK, Defendant-Appellee.
CourtU.S. Court of Appeals — Second Circuit

Rory O. Millson, (Thomas G. Rafferty, on the brief), Cravath, Swaine & Moore, New York City, for defendant-appellee, Citibank, N.A., New York.

BEFORE: SACK, B.D. PARKER, and GIBSON,* Circuit Judges.

B.D. PARKER Jr., Circuit Judge.

Plaintiff-appellant Louis S. Caiola brought federal securities fraud and state law claims against defendant-appellee Citibank, N.A., New York arising from extensive physical and synthetic investments. The District Court (Denise L. Cote, Judge) granted Citibank's motion to dismiss the Complaint under Federal Rule of Civil Procedure 12(b)(6), finding that Caiola lacked standing under Rule 10b-5 to allege a violation of section 10(b) of the Securities Exchange Act of 1934 (the "1934 Act") because he was not a purchaser or seller of securities, his synthetic transactions were not "securities" as defined by the 1934 Act, and he failed to plead material misrepresentations. The District Court declined to exercise supplemental jurisdiction over Caiola's state law claims. Caiola v. Citibank, N.A., 137 F.Supp.2d 362 (S.D.N.Y.2001). Caiola appealed. We find that Caiola sufficiently alleged both purchases and sales of securities and material misrepresentations for purposes of Rule 10b-5 and therefore reverse and remand.

BACKGROUND

Because the Complaint was dismissed under Rule 12(b)(6), we accept its factual allegations for purposes of this appeal. See Kalnit v. Eichler, 264 F.3d 131, 135 (2d Cir.2001). The allegations in the Complaint are as follows. Caiola, an entrepreneur and sophisticated investor, was a major client of Citibank Private Bank, a division of Citibank, from the mid-1980s to September 1999. (Compl.¶¶ 29-31, 149.) During this relationship, Citibank assisted Caiola with a wide range of business and personal financial services. (Id. ¶ 32.) As a result of these transactions, which involved hundreds of millions of dollars, Caiola became one of Citibank's largest customers. (Id. ¶¶ 34-37.)

Beginning in the mid-1980s, Caiola undertook high volume equity trading, entrusting funds to Citibank who in turn engaged various outside brokerage firms. (Id. ¶ 38.) Caiola specialized in the stock of Philip Morris Companies, Inc. ("Philip Morris") and regularly traded hundreds of thousands of shares valued at many millions of dollars. (Id. ¶¶ 4, 39.) To hedge the risks associated with these trades, Caiola established option positions corresponding to his stock positions. (Id. ¶ 39.)

As Caiola's trades increased in size, he and Citibank grew increasingly concerned about the efficacy of his trading and hedging strategies. Caiola's positions required margin postings of tens of millions of dollars and were sufficiently large that the risks to him were unacceptable unless hedged. (Id. ¶¶ 8, 40, 55.) But the volume of options necessary to hedge effectively could impact prices and disclose his positions — effects known as "footprints" on the market. (Id. ¶¶ 8, 74.) In early 1994, Citibank proposed synthetic trading. (Id. ¶¶ 41, 57.) A synthetic transaction is typically a contractual agreement between two counterparties, usually an investor and a bank, that seeks to economically replicate the ownership and physical trading of shares and options. (Id. ¶ 42.) The counterparties establish synthetic positions in shares or options, the values of which are pegged to the market prices of the related physical shares or options. (Id. ¶¶ 4, 43.) The aggregate market values of the shares or options that underlie the synthetic trades are referred to as "notional" values and are treated as interest-bearing loans to the investor. (Id. ¶ 43.) As Citibank explained to Caiola, synthetic trading offers significant advantages to investors who heavily concentrate on large positions of a single stock by reducing the risks associated with large-volume trading. (Id. ¶¶ 5-6, 55.) Synthetic trading alleviates the necessity of posting large amounts of margin capital and ensures that positions can be established and unwound quickly. (Id. ¶¶ 6, 56(f).) Synthetic trading also offers a solution to the "footprint" problem by permitting the purchase of large volumes of options in stocks without affecting their price. (Id. ¶ 56(b).)

Taking Citibank's advice, Caiola began to engage in two types of synthetic transactions focusing on Philip Morris stock and options: equity swaps and cash-settled over-the-counter options. (Id. ¶ 44.) In a typical equity swap, one party (Caiola) makes periodic interest payments on the notional value of a stock position and also payments equal to any decrease in value of the shares upon which the notional value is based. See Note, Tax-Exempt Entities, Notional Principle Contracts, and the Unrelated Business Income Tax, 105 Harv. L.Rev. 1265, 1269 (1992). The other party (Citibank) pays any increase in the value of the shares and any dividends, also based on the same notional value. See id.

For example, if Caiola synthetically purchased 1000 shares of Philip Morris at $50 per share, the notional value of that transaction would be $50,000. Because this notional value would resemble a loan from Citibank, Caiola would pay interest at a predetermined rate on the $50,000. If Philip Morris's stock price fell $10, Caiola would pay Citibank $10,000. If the stock price rose $10, Citibank would pay Caiola $10,000. Citibank also would pay Caiola the value of any dividends that Caiola would have received had he actually owned 1000 physical shares.

Caiola also acquired synthetic options, which were cash-settled over-the-counter options. (Compl. ¶ 44.) Because these options were not listed and traded on physical exchanges, their existence and size did not impact market prices. (Id. ¶¶ 55(a), (b), 74.) Caiola and Citibank agreed to terms regarding the various attributes of the option in a particular transaction (such as the strike price, expiration date, option type, and premium). They agreed to settle these option transactions in cash when the option was exercised or expired, based on the then-current market price of the underlying security. (Id. ¶¶ 69(g), 101(a).)

Caiola and Citibank documented their equity swaps and synthetic options through an International Swap Dealers Association Master Agreement ("ISDA Agreement")1 dated March 25, 1994. The ISDA Agreement established specific terms for the synthetic trading. (Id. ¶ 63.) After entering into the ISDA Agreement, Caiola, on Citibank's advice, began to enter into "coupled" synthetic transactions with Citibank. (Id. ¶ 47.) Specifically, Caiola's over-the-counter option positions were established in connection with a paired equity swap, ensuring that his synthetic options would always hedge his equity swaps. This strategy limited the amount he could lose and ensured that his risks would be both controllable and quantifiable. (Id. ¶ 6.)

Citibank promised Caiola that as his counterparty it would control its own risks through a strategy known as "delta hedging." (Id. at ¶ 45.) Delta hedging makes a derivative position, such as an option position, immune to small changes in the price of an underlying asset, such as a stock, over a short period of time. See John C. Hull, Options Futures, and Other Derivatives 311-12 (4th ed.2000). The "delta" measures the sensitivity of the price of the derivative to the change in the price of the underlying asset. Id. at 310. Specifically, "delta" is the ratio of the change in the price of the derivative to that of the underlying asset. Id. Thus, if an option has a delta of .5, a $1 change in the stock price would result in a $.50 change in the option price. Caiola's synthetic positions contained a number of components, such as a stock position plus one or more option positions. For each of these coupled or integrated transactions a "net delta" was calculated which helped Citibank determine the amount of securities necessary to establish its "delta core" position. (Compl.¶ 48.) By maintaining a "delta core" position in the physical market, Citibank could achieve "delta neutrality," a hedge position that would offset Citibank's obligations to Caiola. (Id. ¶¶ 47-49.)

Effective delta hedging is a sophisticated trading activity that involves the continuous realignment of the hedge's portfolio. Because the delta changes with movements in the price of the underlying asset, the size of the delta core position also constantly changes. (Id. ¶ 50.) Although a certain delta core position might sufficiently hedge Citibank's obligations at one point, a different delta core position may become necessary a short time later. See Hull, supra, at 310-11. Thus, as markets fluctuate, the net delta must be readjusted continuously to ensure an optimal exposure to risk. Id.; Adam R. Waldman, Comment, OTC Derivatives & Systemic Risk: Innovative Finance or the Dance into the Abyss?, 43 Am.U.L.Rev. 1023, 1044 (1994). Citibank told Caiola that as his counterparty it would continuously adjust its delta core positions to maintain delta neutrality. (Compl.¶ 50.) Also, Caiola routinely altered his transactions to account for their effect on Citibank's delta core positions. (Id. ¶ 51.) This arrangement was satisfactory so long as Citibank adhered to its delta hedging strategy, which involved comparably small purchases in the physical market. However, if Citibank fully replicated Caiola's stock and option positions in the physical market instead of delta hedging, the benefits of synthetic trading would disappear and he would be exposed to risks that this strategy was designed to avoid. (Id. ¶ 54-55.)

Each synthetic transaction was governed by an individualized confirmation...

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