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Standard Chartered Hedge Funds Lawsuit Highlights Derivatives Risk

The British bank faces a lawsuit after underwriting a convertible bond deal that left investors with worthless stock.

A case before the U.K.’s High Court of Justice could cast a chill over the ASCOT market, and we don’t mean betting at the British racecourse. In early August it was revealed that seven Cayman Islands–based hedge funds — Arrowgrass Master Fund, Basso Holdings, Highbridge International, Northwest Fund, Northwest Warrant Fund, Pine River Asia Master Fund and Pine River Master Fund — had sued British bank Standard Chartered. The complainants allege they were party to convertible bonds that were converted to shares based on fraudulent prices, leaving them stuck with virtually worthless stock.

At the center of the London lawsuit is an Indian company named Castex Technologies, which manufactures parts for that country’s automakers. In 2012, Castex issued $130 million worth of convertible bonds underwritten by Standard Chartered. The hedge funds in the suit bought asset swapped convertible option transaction, or ASCOT, bonds, effectively a call option on the convertibles.

The bond agreement allowed the funds to exercise the option, provided they were willing to pay the value of the bonds. However, the deal also contained a clause giving Castex the ability to force a conversion if its stock price exceeded 130 percent of the bonds’ value for 30 straight days. That event seemed unlikely — until it happened.

Castex had historically traded at about 55 rupees (roughly 80 cents) on the Indian exchanges. But over the past year, the company’s share price spiked, topping 170 rupees for the 30 days required to trigger a forced conversion of the bonds and reaching as high as 360. Soon after Castex made the conversion, the stock fell back to 40 rupees.

Having received the Castex shares for underwriting the bonds, Standard Chartered issued them to the hedge funds in July 2015. As of this August the stock was trading in the low teens on the Bombay Stock Exchange. In court filings the bank maintains that because the hedge funds bought the derivative on the bonds, they must take the shares and absorb the ASCOT loss.

The complainants argue that the stock price was manipulated, possibly by Castex management. They also contend that the risk of any mandatory conversion lies solely with the bank and that receiving worthless shares when they were paying a 5 percent annual fee to keep the option is unfair and violates the derivatives contract.

“Our clients take the position that they bought a call option on a convertible bond and don’t accept that they should be compelled to exercise that call in these circumstances,” says Richard East, a co-managing partner in the London office of law firm Quinn Emanuel Urquhart & Sullivan and lead counsel for the hedge funds.

Standard Chartered and Castex declined to comment on the lawsuit or accusations of share price manipulation. In a statement the Bombay Stock Exchange has said that it found no evidence of wrongdoing.

The court will need to answer two key questions, according to East. “First, did a manipulation occur? If the answer to that is yes, then everything else falls away,” he says. “Second, ought Standard Chartered be entitled to exercise a forced call, in respect of a mandatory hard conversion by the company?”

The second consideration has other investors watching closely. “The hedge funds in this case bought the option to convert the bonds into equity, but they also appear to have sold an embedded option that gave Castex the right to mandatorily convert the bonds into equity itself,” explains Pradeep Yadav, a finance professor and derivatives expert at the University of Oklahoma’s Price College of Business.

For Yadav, the question is whether the funds knew about that option position and its potential hazards. If so, “they should have priced in or hedged that risk more aggressively,” he asserts.

The fact that Castex is a small company in a developing economy raises more concerns. “Funds have to be aware of the risks they take when entering into transactions where the companies are single-person- or family-controlled,” Yadav says. “You may have to price the risk differently because the share price volatility and other risks could be substantial.”

In a case that could run into next year, Standard Chartered’s relationship to Castex is fraught with potential conflict. The bank was responsible for selling and marketing the convertible bonds, which arguably gave it an incentive to make Castex look good.

At an initial hearing on July 29, Standard Chartered failed to persuade the court to split the two questions underpinning the lawsuit into separate cases. Doing so would have diverted scrutiny of the bank’s sales and marketing efforts from any question of stock price manipulation by Castex.

Attorney East and his colleague Sue Prevezer successfully argued that Standard Chartered had a close sales and marketing relationship with Castex that included advice and lending. The bank denies this characterization, but the result of the first skirmish with the hedge funds makes it harder to push off their claim that it should end up with the shares.

A second case against Standard Chartered is going ahead in the U.S. New York–based Och-Ziff Capital Management, which had no comment, also held the same derivatives on the Castex issue, but its bonds were governed by New York state law.

“I don’t think this is necessarily a one-off case,” finance professor Yadav says of the U.K. lawsuit. “Funds that transact in any [sold] option positions have to be conscious of both explicit and implicit risk and manage both accordingly.”

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