RBC, Canada’s biggest bank, made the $517 million loan to a subsidiary of Enron called Heracles Trust in November 2000. To hedge out the credit risk of the loan, RBC entered into a total return swap with Rabobank for the entire value of the loan. A total return swap is a form of credit derivative where a counterparty transfers its credit exposure on an asset to another counterparty that in exchange receives a premium equal to the cost of holding the specified asset on its balance sheet. Hence the hedger, in this case RBC, would have to pay the protection seller, Rabobank, any positive change in the value of the asset – in this case the interest payments. The protection seller in turn would pay the hedger a Libor spread plus any negative changes in the value of the asset – in this case defaulted interest payments or the principle.
Rabobank took the $517 million exposure onto its own balance sheet, agreeing to pay any negative change on the value of the loan. Although it has made all the interest payments on the loan to date, Rabobank now contends that the swap transaction was entered into on a fraudulent basis and is refusing to repay the principle that it owes following Enron’s collapse. A spokesman for RBC told RiskNews that Rabobank's decision to sue RBC came as an “absolute surprise”.
“We are flabbergasted,” he said. “Rabobank is a major financial institution, and yet it is portraying itself as a victim.”
Rabobank, in turn, claims that RBC knew of “massive corruption and self-dealing” by Enron’s senior management. Perhaps more seriously, Rabobank stated: “RBC possessed this knowledge through key operatives in RBC’s structured finance operations who had, for a prior employer, themselves participated in the creation of these corrupt insider transactions.”
RBC countersued Rabobank on Monday in retaliation to Rabobank’s earlier lawsuit filed on Friday last week. RBC is aiming to claim damages for the breach of contract contained in the total return swap agreement as well as for any “other relief that the court considers necessary or appropriate”. But there is no specific mention made of seeking damages relating to loss of reputation.
Rabobank’s allegations that RBC tried to defraud it using the total return swap contract centred around the participation of three ex-employees who worked in RBC’s structured finance team and who were directly involved in the Enron transaction. The men, Gary Mulgrew, ex-head of global banking for RBC in Europe, David Bermingham and Giles Darby, left RBC last year following the transaction, though RBC categorically insisted they were not fired: “Claims that they were fired are patently untrue,” said RBC’s spokesman, Paul Wilson. “While they worked for us they did a damn good job.”