ConflictontheTradingFloorCase.pdf

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Research Assistant Jerry Useem prepared this case under the supervision of Professor Joseph Badaracco as the basis for class discussion rather than to
illustrate either effective or ineffective handling of an administrative situation. This case is based on a paper written by a recent MBA graduate of the
Harvard Business School, and has been partially disguised.

Copyright © 1993 President and Fellows of Harvard College. To copies or request permission to reproduce materials, call 1-800-545-7685,
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photocopying, recording, or otherwise—without the permission of Harvard Business School.

Conflict on a Trading Floor (A)

And before a blind person you shall not put a stumbling block.
-Leviticus, 19

Background

From March of 1986 through May of 1988, I worked on The FirstAmerica Bank’s main trading
floor in New York. I began as an assistant and eventually became a salesperson on the non-dollar
derivative products desk, where futures, options, and other items whose values are based on another
security are traded in foreign currencies. I specialized in cross-currency interest rate swaps.

As an assistant, I had worked with three vice presidents, and particularly closely with a top
salesperson named Linda. In fact, Linda had been instrumental in recruiting me to the bank in 1986.
She had a reputation on the floor for her extremely volatile and hot-tempered nature, but was highly
respected for her ability to close deals. She was very aggressive, both in pursuing new business and
in ensuring that she received full credit for any profitable transactions.

After about six months on the job, in September 1986, I began to work with Linda on a new
transaction for one of her largest accounts, Poseidon Cruise Lines. I had assisted her with a number
of clients by that point and had become familiar with her working habits and idiosyncrasies. During
the year and a half that Poseidon had been a client of FirstAmerica, Linda had developed a close
relationship with the treasurer and the chief financial officer of the cruise lines. Poseidon had
transacted many small, simple deals through FirstAmerica—mostly short-term financing transactions
that involved borrowing $20 million or $30 million from a credit line. The new Poseidon deal,
however, was the largest transaction I had seen at the bank and it had a fairly complex structure.
Essentially, Poseidon wanted to finance the construction of a new cruise ship to be built by a French
shipyard. The ship would be one of the largest and most luxurious in their fleet. Construction was to
be completed over a five-year period at a total cost of approximately $700 million.

Poseidon faced several challenges in this undertaking. First, the French shipyard had provided a
schedule of the payment dates and amounts that comprised its bid for the project. Poseidon was
obligated to make these payments in francs. As a U.S. corporation with most of its cashflow in
dollars, these payments exposed Poseidon to significant currency risks. Second, the French
government had agreed to subsidize the transaction by allowing Poseidon to borrow the francs it

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394-060 Conflict on a Trading Floor (A)

2

needed at a below market rate. The government did this with many major construction contracts.
While Poseidon’s executives felt that the ability to borrow francs cheaply definitely helped offset their
risk, they were uncertain how to value this benefit. Third, while the treasurer and CFO of Poseidon
were fairly active in the currency markets, neither of them had executed transactions of this size or
complexity. They were uncertain about the French currency markets and about the possibility of
hedging exchanges several years in the future. They were also unfamiliar with complex financial
structures.

The Transaction

Over a period of approximately three months, Linda worked with the CFO to devise a structure
that would result in the lowest possible all-in cost in dollars. They agreed that Poseidon should be
completely hedged from all currency exposure. The structure Linda developed had three main
components. First, Poseidon was obligated to make a 10% downpayment to the shipyard at the time
the contract was signed. FirstAmerica, with the largest currency trading operation in the world at the
time, would work to obtain the best possible spot price for this purchase of approximately $70 million
of francs. Second, over the first three years of the transaction Poseidon was obligated to make a series
of equal monthly interest payments to the shipyard on the outstanding balance of the purchase.
FirstAmerica and Poseidon would enter into a “cross-currency interest rate swap,” in which
FirstAmerica would pay to Poseidon, on each payment date, the francs it needed to make its
payments. In return, Poseidon would pay FirstAmerica an even stream of U.S. dollars, on the same
dates, in predetermined amounts. This would effectively convert Poseidon’s franc obligation into a
dollar one. The third part of the structure involved the actual principal payments which were to be
made at the end of the years three, four, and five. These were large individual payments which
Linda proposed to hedge by having Poseidon purchase the francs from FirstAmerica in three
“forward” contracts, effectively locking in the future exchange rates.

Although they had looked at a number of hedging alternatives, including ing foreign currency
options, ing French government bonds or exclusively using forwards, Linda tried to convince the
CFO that this combination made the most sense. She told him that by hedging through large, long-
term contracts, Poseidon would save on transaction costs because there would be fewer transactions
to make. Linda also argued that Poseidon could save significantly by giving FirstAmerica sole
responsibility for the financing. There was very little liquidity in the forward franc markets further
than one year out, she explained, and the Poseidon deal was so large it could dramatically move the
entire franc market. She argued that if Poseidon “shopped” the deal, market participants would
certainly try to profit from the knowledge and, by positioning themselves in front of the deal, they
would dramatically increase Poseidon’s costs. Impressed with her arguments, the CFO agreed to
Linda’s plan. From an objective standpoint, the plan was probably as least as good as the other
hedging options. However, the crucial matter of how much Poseidon would pay for these
transactions was still under discussion.

The Questions

As I assisted Linda throughout this process, I became aware of several issues that led me to
question the way she conducted business. First, by dramatically exaggerating the need for secrecy in
the transaction, she managed to convince Poseidon not to speak with other investment banks. This
meant that Poseidon, because it lacked the sophistication and the market contacts to effectively price
the structure itself, had to trust Linda on the fairness and accuracy of the pricing. While any

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Conflict on a Trading Floor (A) 394-060

3

salesperson would love to have a customer in this position, I wondered about the way Linda had
achieved it. There was some truth to her argument that shopping the deal would disturb the market,
but I learned from the franc traders that the cost of such “slippage” would probably not exceed 10
basis points (1/10 of 1%) on the transaction. Since Linda planned to use her exclusive relationship to
charge Poseidon significantly more than that, I questioned the propriety of her argument.

The second issue that troubled me was the actual price that Linda quoted. Since forward points
and swap rates are both determined by the interest rates in the relevant countries, the prices Linda
quoted for the transaction can best be expressed in terms of interest rates. She told Poseidon that she
could effect their transactions at a three-year franc rate of approximately 12.80% and a five-year rate
of approximately 13.40%. While these rates represented significant premiums above current French
government bond rates, Linda explained that the differential existed because of the credit risk of
dealing with a corporate counterpart and because of market illiquidity. While there was a kernel of
truth to these arguments, I knew that the rates Linda quoted were on average 80 basis points higher
than the rates the traders needed for FirstAmerica to profitably hedge its positions. This profit
margin, on the average size of the exchanges over their average lives, meant that Linda was charging
Poseidon a fee of roughly $12.5 million to hedge their risk. The most profitable transaction I had ever
heard of at the bank until that point had earned fees of $2.3 million, and there was no clear reason
why the Poseidon deal should be worth that much more. Most disconcerting of all, however, was the
fact that Linda explained to the CFO that FirstAmerica would net profits on the deal of
approximately $1.2 million.

The Dilemma

As we prepared to execute the trades, we were in almost constant contact with the treasurer and
CFO. I performed and sent numerous analyses illustrating the benefits of the transaction under a
wide variety of possible economic scenarios. Ultimately, though, the two executives still had doubts
about the structure and the fairness of the pricing. They told me they would not execute the trade
unless they could see for themselves that three to five-year French borrowing rates for a corporation
with Poseidon’s credit rating were actually hovering in the 12.50% to 13.50% range.

When I told Linda about this condition, she was visibly shaken. She told me to stay at my desk
and watch the phones. Then she went to speak with one of the forward franc traders for about half
an hour. When she returned, she still looked extremely nervous and agitated, but she seemed to have
recovered some of her infectious confidence. She told me to pull up a particular Telerate page, print
it out, and fax it to Poseidon. Telerate was a widely used computer information service that listed
up-to-the-moment trading prices and interest rates from around the world. Linda said I should also
call the CFO to let him know the information he wanted was on the way. When I commented that,
with the transaction hanging in the balance, it might look better if she called herself, she became quite
angry. She told me to just do it and stop asking questions.

I called up the page, which was in a part of the information system I had not used before. I
noticed that the section was for non-dollar bonds with trading restrictions. The French bonds in
question, it appeared, were subject to a 10% government withholding tax if held by foreign investors.
Although it was not mentioned on the page, the rates incorporated the return of the withholding tax,
effectively increasing the yields by 100 to 120 basis points. This withholding tax would not apply to
an off-balance-sheet transaction like a swap or a forward. I picked up the printout and returned to
my desk. After thinking for a few seconds, I leaned over to Linda’s desk and asked if she was aware
of any withholding tax on the bonds. She told me to stop interrupting and send the fax immediately.

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394-060 Conflict on a Trading Floor (A)

4

I opened my Rolodex to get the CFO’s fax and phone numbers and then picked up the phone. As
I started to place the call, I wondered if I could actually send the fax.

I was truly torn at that moment. My immediate reaction was to follow the instructions I had been
given—for four reasons. First, Linda was my direct superior at the bank and her instructions had
been very clear. I strongly believe that it is important to respect the wishes and requests of people in
positions of authority. (My background in team sports, my family, and my religious upbringing each
reinforced this commitment.) Second, despite the fact that I disliked many of Linda’s habits and
attitudes, I felt indebted to her for helping me get my job. She was the first FirstAmerica employee to
interview me as a college senior and, ignoring my lack of experience or training, she recommended
me for a position that is normally held by someone with an MBA. I felt that since she had been
willing to “bend the rules” to help me, I certainly owed her enough to return the favor.

Third, as an employee of the bank, I had a responsibility to help my desk make as much money as
possible. A transaction like the Poseidon one would noticeably increase all of our bonuses; this deal
alone could add $500,000 to $1 million to Linda’s bonus, and I stood to make an extra $30,000 to
$40,000, or as much as 70% of my base salary. The transaction would also help the bank show
positive earnings at an extremely difficult time (the North American real estate market was
deteriorating rapidly), and might even improve the bank’s share price. In this sense, by helping to
ensure that the transaction was completed, I would provide clear benefits to the employees,
managers, and shareholders of the bank.

Finally, and perhaps the most pressing of all, I had just begun my new job and felt that I had a
great deal of potential. It was extremely important for me to be seen as a dedicated professional who
could be completely trusted. To challenge my boss directly and to risk losing an extremely large and
profitable transaction would almost certainly end my career at FirstAmerica. In addition, if I could
not help execute a large and profitable transaction because of nagging doubts, I had to wonder if I
could ever hope to be successful in the industry.

On the other hand, there were four good reasons why I felt I could not send the fax or call the
CFO. First, I firmly believe that all people have an obligation to be honest. I am an observant Jew, as
well as (I’d like to think) a generally decent human being. I feel that basic honesty in human
interactions is a crucial building block for an enjoyable and happy world. Although I did not
consciously formalize the dilemma into a religious question at the time, the religious beliefs that my
family instilled in me did affect the way I looked at the problem. Having grown up in a small but
tightly-knit Jewish community, I was raised in the modern orthodox tradition, which holds that
people should obey the laws of the Torah while interacting with the modern world as much as
possible. The experience that most strengthened my commitment to Jewish belief was the year I took
off from college to go to Israel in to work and study in a small settlement south of Jerusalem.
There, I spent 10-12 hours a day at a Yeshiva, or Jewish seminary, studying Jewish law and tradition.
I recalled from my studies that there are several specific commandments in the Jewish tradition that
prohibit lying or intentionally misleading others. The one that seemed most directly applicable is
“And before a blind person you shall not put a stumbling block” (Leviticus, 19). While Linda was not
asking me to lie directly, the information I was asked to convey was certainly misleading enough to
make me uncomfortable.

The second reason I felt I should not send the fax was my professional responsibility to the client.
I felt that when I, as a person in a service industry, accepted a new job, I was committing myself to
acting in that client’s best interest. In banking, there is always a tremendous tension because every
dollar the banker earns ultimately comes out of the pockets of his clients. I knew that I would have to
live with this conflict in every transaction I pursued, but the harm being done to Poseidon Cruise
Lines seemed too large to ignore.

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Conflict on a Trading Floor (A) 394-060

5

Third, while I knew that the transaction could have significant benefits for the bank’s employees
and shareholders in the short term, it was quite possible that gouging a major client could have a
tremendous negative impact in the long run. In addition, if the amount of profit Linda had built into
the trade ever became public knowledge, many of our other clients would almost certainly turn
away. Linda evidently felt that the risk of a negative outcome was great enough that she did not
want to call the CFO herself. Last of all, it was possible that there might be professional benefits from
staying completely honest and guarding the client’s interest. Perhaps a senior person at FirstAmerica
would be outraged by Linda’s behavior and would reward me for not getting involved.

I reflected for a moment on the various senior people I might talk to. I had already spoken with
the person most closely involved with the details of the transaction, the floor trader, Roger. Roger
was a very bellicose individual who did not take kindly to interference from junior salespeople.
Nonetheless, overcoming my reluctance to approach him, I asked him what he thought about the
prices Linda was quoting. “Hey, whatever she wants to do, it’s her deal,” was his response. Roger
was aware of Linda’s tactics, and was surprised that she would take such a risk, but his attitude was
that if she could get away with it, she should do it. Her methods worried him somewhat, but only
from the standpoint that Poseidon might discover the profits we were making and back out of the
deal.

Next up in the company hierarchy was the sales manager for derivatives, Peter. Unfortunately,
Peter was a totally ineffective manager. He had been an undistinguished salesperson for 25 years,
and had been promoted to sales manager simply by virtue of the fact that he was the oldest person on
the trading floor. Having built his career by executing the same simple transactions over and over
again, Peter did not have a good feel for the more complicated derivative products that had appeared
on the market in recent years, especially anything not based in U.S. dollars. As a result, he exercised
very little control over salespeople like Linda. If he had wanted to investigate Linda’s deal, he would
have had to ask a trader to examine the numbers for him. Essentially, he would have been over his
head, and I knew from his risk-averse disposition that he would not want to put himself in such a
controversial situation. Thus, although it was Peter’s job to prevent the people under him from
committing improprieties, I felt that alerting him to Linda’s intentions would not be an effective
course of action.

Finally, if I had wanted to take the issue still higher up the management ladder, I could have gone
to the senior vice president who managed FirstAmerica’s entire 550-member trading floor team. I
had seen this man only once, at a breakfast for new hires where he delivered a brief talk to 50 of us.
For me, a junior salesperson, to approach him with the intention of “blowing the whistle” on my boss
would have been incredibly intimidating. In fact, I could hardly contemplate it at the time.

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