Synthetic Trades Not Securities – Judge Rules

April 5, 2001 ( - A federal judge has ruled that synthetic trades are not considered "securities" under Section 10(b) of the Securities Exchange Act of 1934.

As a result, the plaintiff in Caiola v. Citibank, had his suit for $40 million in actual – and more in punitive – damages dismissed.

Unfortunately for plaintiff Caiola, U.S. District Judge Denise 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.

Case History

Plaintiff Caiola was a specialist in Philip Morris stock who began synthetic trading, a hedging strategy, in 1994.

At that time he signed 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, according to

Caiola opted for synthetic trading, in part, because the sheer volume of his trades in Philip Morris, if made on the market, would have moved the share price. 

In fact, by 1998, his trading equaled roughly a quarter of the worldwide trading in the company’s options on the market.

Synthetic trades, such as puts, allow an investor to gamble on a stock price without actually buying the stock. A put option gives the buyer the right to sell a specified number of shares of a company at a predetermined price for a preset time period.
Caiola charged that, between November 1998 and March 1999, Citibank began hedging by buying the same securities, puts on Philip Morris stock.  That activity had the effect of lowering the price of Philip Morris stock, allegedly diminishing the value of Caiola’s strategies.

Arguments For

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. 

Caiola argued that the fact that he and Citibank were engaged in similar activities tied their interests, creating that common enterprise.

However the judge found no sharing or pooling of funds.  She also noted that Caiola had not alleged that the synthetic transactions were “notes,” “evidence of indebtedness,” or “options on securities,” all of which would have come under the act.