Caiola v. Citibank, N.A.

• Decision Date: 02 April 2001
• Docket Number: No. 00 Civ. 5439(DLC).,00 Civ. 5439(DLC).
• Parties: Louis S. CAIOLA, Plaintiff, v. CITIBANK, N.A., Defendant.
• Court: U.S. District Court — Southern District of New York

137 F.Supp.2d 362

Louis S. CAIOLA, Plaintiff, v. CITIBANK, N.A., Defendant.

No. 00 Civ. 5439(DLC).

United States District Court, S.D. New York.

April 2, 2001.

David Boies, Philip C. Korologos, Eric Brenner, Boies, Schiller & Flexner LLP, Armonk, NY, for Plaintiff.

Rory O. Millson, Cravath, Swaine & Moore, New York City, for Defendant.

OPINION AND ORDER

COTE, District Judge.

This motion addresses whether synthetic trading of stocks and options was governed by the federal securities laws prior to their amendment in December 2000. Defendant Citibank, N.A. ("Citibank") has moved to dismiss the complaint in this securities fraud action on the ground, among others, that the transactions at issue did not constitute trading in securities. For the reasons that follow, Citibank's motion to dismiss is granted.

BACKGROUND

The complaint and the documents integral to it reflect the following. Plaintiff Louis Caiola ("Caiola") has been a client of Citibank for sixteen years. Beginning in 1986, Citibank began arranging trades for Caiola with the same brokerage houses that it used to enter into trades for itself. Through an arrangement with Citibank and these brokerage houses, Caiola placed equity trades and hedged his positions in the options market.

In 1994, Citibank proposed to Caiola an investment strategy involving the "synthetic" trading of stocks and options. A synthetic transaction is a contractual agreement between an investor and a counterparty, often a bank, that gives the investor the economic equivalent of a position in a certain security without the investor actually buying that security. The contractual or synthetic positions taken by the investor are pegged to the economic value that the actual stock or option has in the securities markets, but the investor does not buy or sell any security. According to Citibank's representations to Caiola, synthetic trading permits an investor to approximate large positions in securities without having to meet margin requirements, risk affecting a stock's value by making a large trade, risk not being able to find a seller or buyer when trying to establish or unwind a large position, or pay for or receive actual stock. Pursuant to their contract, each party is a principal in the transaction, and neither acts as the other's agent.

On March 25, 1994, Citibank and Caiola signed the standard form contract that would govern the synthetic transactions, called an International Swap Dealers Association Master Agreement ("ISDA Agreement"). A Schedule to the ISDA Agreement provides, among other things, that Caiola understands that Citibank "has no obligation or intention to register any Transactions under the Securities Act of 1933, as amended, or any state securities law or other applicable federal securities law." Each synthetic transaction was also confirmed in writing. In a confirmation which is representative of the confirmations used in connection with the synthetic trading ("Confirmation"), Caiola acknowledged that he was not relying on any advice from Citibank, that he had the independent ability to evaluate the transaction and its risks, that Citibank was not his fiduciary, and that the transaction would not be registered under the securities laws. It states:

9. Representations

(a) In connection with this Confirmation, the Transaction to which this Confirmation relates and any other documentation relating to the [ISDA] Agreement, each party to this Confirmation represents and acknowledges to the other party that:

(i) It is not relying on any advice, statements or recommendations (whether written or oral) of the other party regarding such Transaction, other than the written representations expressly made by that other party in the Agreement and in this Confirmation in respect of such Transaction;

(ii) it has the capacity to evaluate (internally or through independent professional advice) such Transaction (including decisions regarding the appropriateness or suitability of such Transaction) and has made its own decision to enter into such Transaction;

(iii) it understands the terms, conditions and risks of such Transaction and is willing to accept those terms and conditions and to assume (financially and otherwise) those risks;

(iv) it is entering into such Transaction, as principal and not as an agent for any other party;

(v) it acknowledges and agrees that the other party is not acting as a fiduciary or advisor to it in connection with this Transaction;

....

(b) [Caiola] represents to [Citibank] that ...

(iii) it understands that [Citibank] has no obligation or intention to register this Transaction under the Securities Act of 1933, as amended, or any state securities law or other applicable federal securities law;

....

(v) IT UNDERSTANDS THAT THE TRANSACTION CONTEMPLATED HEREUNDER IS SUBJECT TO COMPLEX RISKS WHICH MAY ARISE WITHOUT WARNING AND MAY AT TIMES BE VOLATILE AND THAT LOSSES MAY OCCUR QUICKLY AND IN UNANTICIPATED MAGNITUDE AND IS WILLING TO ACCEPT SUCH TERMS AND CONDITIONS AND ASSUME (FINANCIALLY AND OTHERWISE) SUCH RISKS.

(Emphasis in original.) Nevertheless, Caiola asserts that Citibank assured Caiola that, despite the language in the Confirmation, Citibank's "fiduciary umbrella" continued to operate "at the cornerstone of the synthetic trading relationship (apart from Mr. Caiola's individual investment decisions) between Citibank and Mr. Caiola."

After entering into the ISDA Agreement, Caiola, an expert in Philip Morris' stock, designed and established synthetic positions in Philip Morris stock and options. These positions grew to be enormous and had "notional" values of as much as $350 million.

Citibank made money from this contractual arrangement by charging Caiola interest on the "loan" that represented the notional value in Caiola's positions and premiums for any synthetic options he chose to include in the arrangement. In addition, each party stood to make or lose money depending on whether Caiola's investment strategies turned out to be correct.¹

Each party was responsible for managing its own risk. Caiola frequently managed his risk by hedging, that is, by combining synthetic stock and options or offsetting options strategies. Indeed, in Caiola's view, synthetic trading meant that he could pursue his investment strategies while ensuring that any risk was always quantifiable and controllable. Citibank informed Caiola that it would hedge its own risk by making investments for itself in the securities markets through a strategy called "delta hedging," based upon the ratio by which a derivative instrument (say, an option) trades relative to an underlying asset (say, a stock). For each transaction made by Caiola, Citibank informed Caiola that it would manage its investments to achieve "delta neutrality," a hedge position by which Citibank would off-set its obligations to Caiola in the event Caiola's trading strategy required Citibank to pay Caiola. Citibank informed Caiola that it would need to invest in only a fraction of the securities reflected in the synthetic trading in order to achieve delta neutrality. Citibank also represented that it would perpetually monitor Caiola's investments in order to maintain delta neutrality.

By 1998, the volume of Caiola's synthetic trading in Philip Morris options was approximately equal to one-quarter of the worldwide volume of physical trading in Philip Morris options. By the Fall of 1998, Caiola had taken synthetic positions that were almost fully hedged so that he stood to lose at most approximately $2 million of the roughly $40 million he had then invested through synthetic trading.

In October 1998, Citibank's parent company merged with Travelers Group, Inc. ("Travelers"), and Travelers' investment banking and brokerage unit, Salomon Smith Barney ("Salomon") assumed certain Citibank functions. At a November 18, 1998 meeting, Citibank informed Caiola that Salomon would become involved in handling Caiola's synthetic trades. Citibank assured Caiola, however, that Citibank would oversee his synthetic trading relationship on exactly the same basis as it had prior to the merger, and that Caiola could continue his investment strategy. In reliance on Citibank's representations, Caiola entered into new, speculative positions from November 30, 1998 to March 1999, that exposed his portfolio to substantial risk, including positions that did not expire until the year 2000.

Plaintiff asserts that, between November 1998 and March 1999, Citibank decided to hedge its risk from Caiola's trading not by "delta hedging" but by buying on the securities exchanges the very securities in which Caiola invested synthetically. Caiola contends that Citibank's secret hedging strategy robbed him of one of the chief benefits of synthetic trading since the market now felt the full impact of his strategies. Specifically, Citibank executed trades in millions of Philip Morris puts, which had the effect of depressing the price of Philip Morris stock. While these trades corresponded to the synthetic positions Caiola had taken, Caiola had not authorized them and they were done without his knowledge. Caiola alleges that Citibank had executed trades in Philip Morris securities that replicated Caiola's synthetic trading even before the merger with Travelers, that is, in March 1998. Then, in March 1989, Citibank advised Caiola that it would no longer engage in synthetic trading. As a consequence, Caiola was unable to reduce the risk to which his recent trading had exposed him. Caiola asserts that Citibank's pressure on the Philip Morris stock price through its substantial options trading, coupled with its refusal to allow Caiola to continue synthetic trading and thereby hedge his losses, caused him to suffer losses in the tens of millions of dollars.

In his complaint, Caiola has brought six causes of action against Citibank, three of which assert that Citibank violated Section 10(b) of the Exchange Act of 1934 and Rule 10b-5 thr...