One of the more distressing side effects of the recent dramatic events in the global financial markets has been the sudden and unexpected reversal of fortune on any number of financial transactions and positions, particularly with respect to commodities and currencies. These developments have proven to be particularly troublesome for market participants that sought to protect themselves from commodities or currency exposure through financial hedges, only to find themselves suddenly stuck in wrong way bets as commodities prices or currency exchange rates moved quickly in unexpected directions.
At least in connection with several companies, the consequences from these adverse hedge transaction developments have included the arrival of securities class action lawsuits.
The most recent of these lawsuits have both involved foreign domiciled companies. Sadia, S.A. is a Brazilian meat products and processing company whose shares trade on the Brazilian exchange and whose ADRs trade on the NYSE. According to their November 5, 2008 press release (here), plaintiffs’ lawyers have initiated a securities class action lawsuit against Sadia and certain of its directors and officers in the Southern District of New York, on behalf of persons who bought both shares and ADRs of Sadia between April 30, 2008 and September 26, 2008. A copy of the complaint can be found here.
According to the press release, the complaint alleges that during the class period:
Sadia entered into undisclosed currency derivative contracts to purportedly hedge against the Company’s U.S. dollar exposure. The Company characterized the amounts of these contracts as "nominal." However, these contracts violated Company policy in that they were far larger than necessary to hedge normal business operations and resulted in a loss of $365 million. As a result of Defendants’ admission of violating Company policy regarding currency hedging, the American Depository Receipts of Sadia S.A. closed at $9.50 per share, down from the previous day’s close of $15.27, a decline of 38%.
The second of these recent lawsuits involved Britannia Bulk Holdings, a U.K.-based drybulk shipping and maritime logistics services company that conducted a $116.2 million IPO on June 17, 2008. According to their November 6, 2008 press release (here), plaintiffs’ lawyers have initiated a securities class action in the Southern District of New York against the company and certain of its directors and officers, as well as against its offering underwriters. A copy of the complaint can be found here.
According to the press release,
on October 28, 2008, Britannia Bulk issued a press release announcing that the Company expected a significant net loss for the third quarter of 2008 compared to the net income achieved during the second quarter of 2008. The loss was due to problems with hedges the Company had entered into earlier in the year. In addition, the Company announced it would not pay a dividend on its common shares for the quarter ended September 30, 2008, or for the foreseeable future.
Following this disclosure, the Company’s stock collapsed to $0.16 per share. The following day, the Company disclosed that it had been notified by its lenders that they were accelerating all of its subsidiary’s obligations under a $170 million lending facility. This would ultimately result in the subsidiary being placed into administration under U.K. insolvency laws.
According to the complaint, the Registration Statement failed to disclose the problems in the Company’s activities in the forward freight agreements ("FFAs") market. Specifically, the Registration Statement concealed that the Company failed to institute and enforce controls that would prevent Company personnel from buying FFAs not purchased to hedge identifiable ship or cargo positions. FFAs were represented to only be used as a hedge for work Britannia Bulk’s ships engaged in. However, in fact, FFAs were used outside of these guidelines, exposing the Company to significant risks. Moreover, the Company had not entered into appropriate fixed price contracts given the dramatic fluctuation in crude oil and bunker fuels.
Add to these two the securities lawsuit recently filed against Pilgrim’s Pride (about which I previously wrote here), which also included allegations of an ill-timed hedge designed to control price increases for its feed materials, that hurt the company when feed prices unexpectedly plunged.
While the companies and specific transactions involved are very diverse, the common thread among these cases is that in each case the company was harmed as a result of a wrong-way bet on commodities or currencies. In each case, the sudden and dramatic events in the financial markets during September and October 2008 produced a magnified impact on financial condition of these companies. To be sure, in the Sadia and Brittania Bulk cases, the circumstances appear to have been exacerbated by allegedly unauthorized trading, but nevertheless in all three cases the financial harm resulted from hedging or hedge related activities that suddenly and unexpectedly went very wrong.
These companies are far from the only companies that attempted to protect themselves from rising commodities prices or currency exposures through hedge transactions, and that are also likely far from the only companies that found themselves in wrong-way bets when the commodities and currency markets moved unexpectedly and materially in unexpected directions in recent weeks.
Indeed, a November 6, 2008 Wall Street Journal article (here) described the steep losses some investors (including several large companies) have incurred in connection with their investment in a relatively new derivative investment called an "accumulator, which obligates the investor to buy a fixed quantity of a security, commodity or currency at a fixed price and at regular intervals. This approach works when prices are rising, but can be devastating when prices fall. The article specifically mentions VeraSun, which recently filed for bankruptcy, and which experienced huge losses on accumulator contracts for the price of corn. The article also mentions Citic Pacific, which recently experience losses of as much as $2 billion on an accumulator contract linked to the Australian dollar.
Another common thread among these companies is that most of them are not involved in the financial services industries. Each of these company’s circumstances represents an example of the ways that the turmoil in the global financial markets during September and October 2008 has altered the prior wave of subprime and credit crisis-related litigation, which before that time had been largely been confined to the financial services and real estate industries, to spread into the larger economic and financial marketplace.
The fallout from the disruptive events of the past few weeks has already included significant litigation activity outside the financial sector. While it still remains to be seen how extensive the litigation activity beyond the financial sector ultimately will prove to be, at this point it seems increasingly likely that a diverse range of companies could become involved.
In making this observation, I am not limiting my prognostication just to companies that have engaged in hedging transactions, but rather I am contemplating the entire universe of companies that have experienced a significant reversal of fortune due to the this fall’s disruptive events. So, in addition to companies that have experienced unexpected reversals on wrong-way bets on commodities or currencies, there are companies that were adversely affected by Lehman Brothers’ failure (refer here) or by the sudden seizing up of the credit markets that followed (refer here). In the days to come, there will be an increasing number of companies reporting problems due to these and other concerns. While not every company reporting these problems will sustain a securities class action lawsuit, a significant number will, and many of them, like the companies mentioned above, will be outside of the financial sector.