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A specialist in Philip Morris Co. stock cannot sue Citibank N.A. for its handling of a huge volume of “synthetic trades” that he made based on the company’s share price, a Southern District judge has ruled. In a case of first impression, U.S. District Judge Denise Cote found that synthetic trades, which allow an investor to gamble on a stock price without actually purchasing stock on the market, did not fall under the definition of a “security,” in Section 10(b) of the Securities Exchange Act of 1934. In Caiola v. Citibank, 00 Civ. 5439, Cote dismissed investor Louis S. Caiola’s claim against Citibank, ending his quest for $40 million in actual damages and much more in punitive damages. Unfortunately for Caiola, Cote noted that the type of transactions at issue in his case would have been considered “securities” had they occurred after the passage of the Commodities Futures Modernization Act (CFMA). The CFMA became law four months ago. Caiola began synthetic trading in 1994 after signing a standard form called an International Swap Dealers Association Master Agreement, which stipulated that Citibank was under no obligation to register the transactions under the securities laws. Caiola opted for synthetic trading, in part, because the sheer volume of his trades in Philip Morris, if made on the market, would have affected the share price of the stock. By 1998, he was maintaining huge positions in the stock and his trading volume equaled about one-quarter of the worldwide trading in the company’s options on the market. While Caiola employed a hedging strategy, Citibank did some hedging of its own to protect itself. However, Caiola charged that, between November 1998 and March 1999, Citibank abandoned its usual hedging system and began hedging by buying the same securities on the market. “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,” Cote said. “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.” Moreover, Caiola alleged that Citibank told him in March 1999 that it would no longer accept synthetic trades, which he claimed made it hard to reduce his exposure from his recent trades. The result, he charged in his lawsuit, is that he lost tens of millions of dollars. Judge Cote first dismissed Caiola’s charge that Citibank’s actions had created an agency relationship, saying, pursuant to his contract with the bank, both parties were principals and neither was an agent. NOT ‘SECURITIES’ She then turned to the definition of “security,” under the act, noting that the U.S. Supreme Court has said that lower courts faced with unusual instruments not easily classified as securities should examine the underlying economic reality of a transaction. At the same time, she said, the nation’s highest court has also cautioned that the securities laws are not intended to provide a broad federal remedy for all fraud. “Apparently, no court has addressed whether the types of transactions at issue in this case constitute securities,” she said, with the closest case being a Southern District of Ohio ruling that certain interest rate swap contracts were not “securities.” That case is Procter & Gamble Co. v. Bankers Trust Co., 925 FSupp 1270 (1996). Judge Cote said that “for many of the same reasons offered in Procter & Gamble, the transactions at issue here are not securities.” Caiola had argued that his agreements for synthetic trading with Citibank fall under the act because they were “investment contracts,” which involve the investment of money in a “common enterprise” with the expectation that profits will be produced by the promoter or a third party. COMMON ENTERPRISE Cote said that a “common enterprise” can be shown by demonstrating “horizontal commonality,” which is the “tying of each individual investor’s fortunes to the fortunes of the other investors by the pooling of assets.” Caiola said a common enterprise was involved here because, in the words of the judge, Citibank “hedged its own risks by trading securities,” and the “existence of buyers and sellers on the opposite side of Citibank’s securities trades is sufficient to establish ‘horizontal commonality.’ “ However, Cote said, there was “no sharing or pooling of funds between Caiola and those other investors in the securities markets that would establish horizontal commonality.” Moreover, she said, Caiola did not allege that the synthetic transactions were “notes,” “evidence of indebtedness,” or “options on securities,” all of which would have come under the act. She said Caiola relied “heavily” on the fact that the Securities Exchange Commission “has recognized some swap transactions as securities protected by the federal securities laws where the value of the transaction was based on the value of the securities,” and that the SEC disagreed with the result in Procter & Gamble. But, Judge Cote said, the CFMA, which became law in December, specifically excluded security-based swap agreements of the type at issue in Procter & Gamble. “On the other hand,” she said, the CFMA amends Section 10(b) to prohibit “any manipulative or deceptive device or contrivance” committed “in connection with the purchase or sale of any … security-based swap agreement.” “Thus, while it is beyond dispute that, under the amended securities law, the transactions at issue in this case would not be ‘securities,’ ” she said. “ [T]he amended Section 10(b) would indisputably cover the transactions at issue in this case.” Finally, she said, the CFMA’s legislative history indicates that “the authority to pursue fraud in connection with security-based swaps did not exist prior to the CFMA.” David Boies, Philip C. Korologos and Eric Brenner, of Boies, Schiller & Flexner, represented Caiola. Rory O. Millson, of Cravath, Swaine & Moore, represented Citibank.

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