Procter & Gamble versus Bankers Trust

A formula dressed as a swap

In late 1993, interest rates in the United States sat near generational lows, and corporate treasuries were looking for ways to lock in cheap borrowing before the moment passed. Procter & Gamble worked with its bank, Bankers Trust, to structure two interest rate swaps that promised savings over plain borrowing, provided rates stayed low or fell further. On 2 November 1993, the two firms traded the first of these, a five-year, $200 million notional swap that the case literature calls the "5s/30s" swap. Bankers Trust paid P&G a fixed 5.30%. In exchange, P&G paid a floating rate tied to commercial paper plus a spread, and that spread was not a simple markup. It was set six months later by a formula linked to the yield on the 5-year Treasury note and the price of the 30-year Treasury bond, built so that a small adverse move in rates would produce a much larger move in the spread P&G owed.

On 14 February 1994, the two firms confirmed a second, similar trade, a four-year swap referencing the German Deutschmark swap rate, with a notional of DM 162.8 million (about $93 million equivalent). This swap carried its own trigger: if the Deutschmark swap rate ever moved outside a band of 4.05% to 6.01%, the spread P&G paid would reset using a leverage factor of 10 on the size of the breach. Both formulas shared the same design. They paid P&G a modest advantage while rates stayed calm, and they turned against P&G hard the moment rates moved.

Rates turn

On 4 February 1994, ten days before the Deutschmark swap was even confirmed, the Federal Reserve raised its federal funds rate target by 25 basis points, to 3.25%. It was the Fed's first rate rise in five years, and markets had not expected it so soon. The Fed kept tightening through the year, and the 10-year Treasury yield rose by roughly 200 basis points over the following nine months. In absolute terms, this was an ordinary monetary tightening cycle, the kind that recurs regularly in interest rate history. P&G's exposure was anything but ordinary. The leverage built into both swap formulas meant that this routine rate rise did not produce a routine cost increase; it produced a very large one.

The charge

On 12-13 April 1994, P&G announced the damage. Its press release disclosed a $102 million after-tax reduction to third-quarter earnings, described as a charge to close out the two swap contracts. Chairman and chief executive Edwin L. Artzt did not soften the message: "Derivatives like these are dangerous and we were badly burned. We won't let this happen again." The company's Form 10-K for that fiscal year confirmed the pre-tax figure behind the after-tax number, a $157 million charge, and its own language named the problem precisely: it described the loss as coming from "the option portion of the two out-of-policy leveraged interest rate swaps." That phrase is P&G itself admitting these trades did not fit inside the company's normal risk-management policy, whatever their label said.

The lawsuit and the tapes

P&G did not simply absorb the loss and move on. On 27 October 1994, it sued Bankers Trust in the US District Court for the Southern District of Ohio, alleging fraud, misrepresentation, breach of fiduciary duty, negligent misrepresentation and negligence. The lawsuit unfolded alongside a separate, related case, Gibson Greetings v. Bankers Trust, in which discovery produced thousands of hours of taped phone calls between Bankers Trust salespeople. Journalists who later obtained these tapes found employees discussing, in blunt terms, how much of a swap's value the bank was keeping for itself. Those tapes came from a different lawsuit, but they did P&G's public case no harm at all.

The settlement

The court ruled on summary judgment on 9 May 1996, and the two sides settled the same day. Bankers Trust had been claiming P&G still owed it about $200 million on the two contracts. Under the settlement, P&G agreed to pay $35 million of that, with Bankers Trust absorbing the rest, about 83% of the total claim. Most of P&G's tort claims, including breach of fiduciary duty, did not survive the court's scrutiny: the court found Bankers Trust owed P&G no fiduciary duty as an arm's-length counterparty. Being one of the largest, most sophisticated corporate treasuries in the world did not give P&G a legal remedy for having traded a product its own staff did not fully understand.

Separately from the P&G matter itself, BT Securities Corporation paid the CFTC and SEC a $10 million civil penalty in December 1994, arising from its derivatives sales practices in the related Gibson Greetings case. That penalty belongs to Bankers Trust's story, not P&G's, but it marks the P&G lawsuit as one episode in a broader reckoning over how Wall Street sold complex swaps to corporate treasuries in the early 1990s.

Lecture 7 builds a plain-vanilla interest rate swap as a strip of forward rate agreements, where one side pays a fixed rate and the other pays a benchmark rate that resets each period. Its value can be sliced two ways, as a strip of forwards or as a pair of bonds, and the two slices agree because of the law of one price. This case is what happens when a swap's floating leg stops being a benchmark and becomes a designed payoff instead.

P&G's two swaps kept the fixed-versus-floating shape on the surface. Underneath, the floating leg was not "the benchmark plus a spread" in the ordinary sense. It was a formula: a leveraged function of the 5-year Treasury note yield and the 30-year Treasury bond price on the first swap, and a leverage-10 knockout-style formula on the German swap rate on the second. The key teaching point of this case is that the confirmation defines the payoff, not the label on the trade. A contract can be called a swap and still net cash flows the way a swap does, while its floating leg behaves like a short position in volatility or a leveraged bet on a formula. P&G's own treasury staff, and its board, treated the trade inside their existing policy for managing interest cost with swaps, when in substance the payoff had far more in common with a leveraged option position.

The second concept this case illustrates is leverage magnifying a market move that would otherwise be survivable. The Fed's February 1994 rate rise, just 25 basis points, was an unremarkable move by historical standards, and the tightening cycle that followed was not extreme either. What turned a routine tightening cycle into a nine-figure charge was the leverage multiplier built into the spread formulas, not the size of the underlying rate move. Set against the vanilla swap mechanics taught earlier in Lecture 7, the lesson is plain: complexity is a design choice, and it carries a price, usually paid by whoever did not design the formula.

pretax_charge  = 157e6   # P&G 10-K FY1994: "$157 charge" pre-tax
aftertax_charge = 102e6  # P&G 8-K, 13 Apr 1994
claimed_by_bt  = 200e6   # P&G 10-Q Q3 FY1996 / press release, 9 May 1996
pg_absorbed    = 35e6    # same press release
bt_absorbed    = claimed_by_bt - pg_absorbed

implied_tax_rate = 1 - aftertax_charge / pretax_charge
bt_share = bt_absorbed / claimed_by_bt
pg_share = pg_absorbed / claimed_by_bt

print(f"Implied tax rate: {implied_tax_rate:.1%}")
print(f"Bankers Trust share of claim: {bt_share:.1%}")
print(f"P&G share of claim: {pg_share:.1%}")

Implied tax rate: 35.0%
Bankers Trust share of claim: 82.5%
P&G share of claim: 17.5%