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JPMorgan Sold An Equity Derivative To A Tulsa Oil Heiress Too Unsophisticated To Appreciate Its Beauty

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A core belief here at Dealbreaker HQ is that we'd be really good rich people.1 No conservative 401(k)s and unborn-children-college-funds for us; we'd dedicate ourselves to lives of sybaritic excess. For me, that means that if someone wants to die and leave me an oil fortune, I'll be putting Morandis on the wall, DRCs in the cellar, and variable prepaid forwards in the trust fund. Everyone needs a little beauty in their life, and also in their trust fund.

That must have been what motivated JPMorgan to pitch Skelly oil heiress and "acute stress syndrome" sufferer2 Ann Fletcher to enter into variable prepaid forwards on the Exxon Mobil stock in her trust. That or:

The value of the Trust prior to entering into the May 2000 VPF was $14,392,000. As of June 30, 2003, the sum of the Trust's repayment obligations under the three VPFs had grown to $10,336,050. The value of the Trust at the time the Bank resigned as co-trustee [in March 2006] was $12,515,085.57. The Trust's associated decline in principal was $1.88 million.

The Bank produced emails and spreadsheets to show that the Bank earned $1,127,189 from the VPFs. Expert testimony indicates that the Bank earned as much as $2,000,000 in profit.

So, I dunno, I feel like 7.8% in profits over 6 years is a not bad result on a pretty vanilla equity financing trade?

You can read the opinion, some of which strikes me as being pretty clearly wrong but hey I am not an Oklahoma trusts lawyer,3here. Baaaaaasically there was a trust, and it had stock, and the idea was to pay the dividends of the stock to Fletcher during her lifetime and then, when she died, to give half the stock to her children and the other half to charity. At some point someone - JPMorgan? Fletcher? - conceived the idea that Fletcher should get much more money during her lifetime, basically by selling stock and pocketing the proceeds, leaving of course much less stock for the children and charity. So that happened.

Ten years later everyone freaked out and it came to court, and the court concluded among other things that (1) JPMorgan should not have helped Fletcher take money from her children and charity,4, but (2) it wasn't Fletcher's fault because she is old and unsophisticated and stressed, so (3) she gets to keep the money that JPMorgan gave her but JPMorgan has to pay it back to her heirs. More or less. Or something.

But for our purposes what's of interest is the way that JPMorgan helped her take money from her kids and charity. And that brings us to the time that JPMorgan, in the form of its Oklahoma trust banker Jeff Morrow, approached Fletcher and the individual co-trustee, a securities lawyer named Rufus Griscom:

In the spring of 2000, the Bank approached Fletcher about using "variable prepaid forward" (VPF) contracts with the Trust assets to increase income. Although the Bank employees characterized the VPFs as uncomplicated and "simple transactions," Griscom described the VPF transactions as "extremely" complex. He testified "I'm a securities lawyer for decades [and] this is the most complicated documentation I have ever seen." The Court finds that the VPFs are complex and were difficult to understand for both the individual Trustee and employees of the Bank. VPFs were not suitable for the Trust because of the risks and costs to the Trust. Morrow had never administered a VPF in a trust and the VPFs in the Burford Trust were the first utilized by the Bank. Morrow did not do an independent inquiry as to whether the VPFs were reasonable, but instead relied only on statements by Bank investment officers.

Now I have no trouble believing that a variable prepaid forward was the most complicated thing Rufus Griscom had ever seen. It is not, though, a particularly complicated thing; it happens all the time. Here is one! JPMorgan caps and floors the value of the trust's stock, and then gives the trust the floor value today. The trust gets cash today, no downside risk, some upside, and a deferral of taxes until the forward settles several years in the future. It can use the cash to buy higher-income-producing things for Fletcher, or just give her the cash I guess.

But ... what was the point here? Why not just sell the stock and buy income-producing things? There are sort of three reasons you might do a derivative trade like this:
(1) you and your bank are working arm-in-arm to deceive someone else - the IRS, say, or, like, the eurozone;
(2) your sophisticated banker is deceiving you to get tons more fees; or
(3) the elusive "neither you nor your banker have any idea what is going on."

This is (3), no? I mean, the fees, yes, the JPMorgan guy was happy to clip the fees, but other than that, what is this trade? Basically JPMorgan went to Fletcher and said "hey let's have the trust sell some stock and then you'll have more money," and ... she actually did that ... but then they mostly came up with a better idea, which is "hey let's have the trust sell some stock in a variable prepaid forward, so you'll get money now and defer taxes and not have a sale now in some loose sense." And that's fine if you want to defer taxes, but there's no particular evidence that anyone did.5

My model of this trade goes something like this:

  • Slick JPMorgan New York derivatives guy flies to Oklahoma, pitches local Tulsa trust banker on variable prepaid forwards as a way for clients to diversify stock positions while deferring capital gains taxes.
  • Maybe he notes that this is a sale for some purposes - like, cash raising purposes - while not a sale for other purposes - like, tax purposes.
  • Local guy raises hand, says "I don't know about that, but I have a client who isn't supposed to sell her stock. Can I use this whatchamacallit, VPF, to let her sell the stock (to get money) while not selling the stock (under the terms of the trust)?"
  • Slick guy says "um, I dunno, maybe?"
  • Tulsa guy adds "and you said the fees here are ... what, 7% of assets?"
  • Tulsa guy takes it to Fletcher and Griscom, who certainly don't know either.
  • Everyone in Tulsa confuses themselves into thinking that, while selling the stock directly and giving the proceeds to Fletcher would not be okay, doing it through a derivative that pays JPMorgan piles of money somehow is.
  • The JPM derivs guy in New York has $1mm on his PnL that maybe he feels a little twinge of guilt about but, whatever, Tulsa.

Or something! There are other possibilities, but I like this one. I'm not sure anyone connected with the trust, at JPMorgan or elsewhere, could articulate the point of doing this trade as a prepaid variable forward, with $1-2mm of fees to JPMorgan, instead of as just a sale of the stock, but that's okay. Sometimes the most beautiful objects are the ones with the least practical purpose.

JPMorgan Must Pay $18 Million to Heiress Over Derivatives [Bloomberg]
J.P. Morgan Ordered to Pay $18 Million to Oil Heiress’s Trust [DealBook]
In the Matter of the Trust of Carolyn Burford [via SLCG]


2.That's from the court decision. Again, keeping with my good-rich-person pledge, if you leave me an oil fortune, I promise not to stress acutely.

3.Boring, but the general rule in trusts is that you have to diversify: the days of just putting the entire trust in Exxon Mobil stock are pretty much over. Except when this trust was set up in the '50s it specifically recommended that the trust hang on to the Skelly Oil and Scoony Mobil stock put in it:

Because of the high regard which the Grantors hold for the common stocks placed in this trust as an investment, they specifically recommend that, except for unusual circumstances, the Trustee retain all such stocks throughout the term of the trust and regardless of whether or not such retention may appear to offend against what might ordinarily be considered a sound trust investment practice and the usual principles of investment diversification.

The court reads this (1) to apply not only to Skelly Oil and Scoony Mobil stock, which are both long gone, but also to the Getty Oil (also gone!) and Exxon Mobil stock that replaced them and (2) to not permit or recommend but require non-diversification. And then penalizes JPMorgan for selling Exxon stock because it then went up. This strikes me as a weird, weird reading of this nonbinding recommendation regarding entirely other stocks, but, again, not an Oklahoma trusts lawyer.

4.Again, not an Oklahoma trusts lawyer, but: that seems right!

5.Actually the court blames JPMorgan for incurring taxes by selling the stock.

The failure of the Bank to properly consider the expected tax consequences of its investment decisions or strategies constitutes a breach of the duty of prudence. The sale of XOM stock in 1999 and the settlement of VPF contracts in 2005 and 2006 caused the Trust to incur substantial capital gains tax liability.

This has nothing to do with the VPFs, really: if you sell appreciated stock, you incur capital gains taxes. Again not a trusts lawyer but I assume the point is that if you don't sell the stocks then they pass to the heirs with a basis step-up, so they mostly don't pay the taxes, so yes, selling the stocks during Fletcher's lifetime is tax-inefficient. Anyway, I guess the real point is, nobody at JPMorgan seems to have given a ton of rational thought to tax planning here.