APRIL 2000

METALLGESELLSCHAFT

INVESTIGATION OF A RISK MANAGEMENT

STRATEGY

By:

FARHAD MIAN

THE TABLE OF CONTENTS:

Introduction

Chain of Events

Structure of the Delivery Contracts

Hedging and Exposure to Risk

The Involvement of German Banks

The Role of Management and Public Disclosure of Information

10

Financial Rescue and Reforms

13

Bibliography

16

INTRODUCTION:
MG Refining and Marketing, Inc. (MGRM), a subsidiary of Metallgesellschaft, a
German metal and oils conglomerate pursued an aggressive strategy wherein they
contracted to supply heating oil and gasoline products to users on the east coast of the
US. The contracts were for 5 to 10 years in the future and the contract price was 6 to 8
cents above prevailing market prices at that time. By September 1993, MGRM had sold
forward the equivalent of over 150 million barrels of petroleum products in its long term
flow delivery contracts They attempted to hedge the forward cash market exposure, at
least in part, with futures contracts on the NYMEX. One difficulty they encountered was
that the futures offered on the exchange only went out around 24 or 36 months;
nonetheless, MG carried tremendous net long futures positions. Although MG, had OTC
type hedges in place, it can be certainly argued that the futures length and the far forward
cash shorts were two distinct positions--especially given the difficulties and relatively
high costs associated with a hedging activity ten years into the future (an illiquid market).
The energy markets were in a bear market in late 1993 and the futures went into a deep
contango, which exacerbated their losses on their longs. Markets are said to be in
contango when the futures prices are higher than spot pri ces.
It cost MG a significant amount of money just to roll their long position in the expiring
front month into the next few months due to the negative carry present at that time.
Adding to this was the fact that the news of their positions got out over time and the
market made them pay. Locals on the floor of the exchange would line-up in the days
leading to expiration and put on bear spreads in advance of MG's rolling thousands of
contracts. A bear spread is defined as a combination of futures position, where long
positions are taken on longer term maturities and short positions are taken on shorter
term maturities. Depending on the focus, it can be verified by analyzing the spread and
outright activity during that time and looking for any patterns of spread distortion and
volume. Right around the time MG was forced to liquidate, the market made its low
around $13.90 a barrel and rallied sharply for a period. Some argue that if only the
exchange, banks, and regulators hadn't stepped in, MG would have done just fine since
oil prices rallied into 1994, but the hard cold fact is that they had tremendous "paper
losses" that needed to be recovered. The losses had been accumulated due to huge margin
calls made by the exchange as well as the huge rollover costs that came as a result of the
contango. It has been debated as to what would have happened if MG hadn't been forced
to close out its hedge positions; crude could have fallen even further and the exchange,
its members, and the banks could have been faced with allegations of negligence and a
billion dollars in default payments. The primary banks involved were Deutsche Bank and
Dresdner Bank. Their representatives appear to be, at separate times, on MGs
supervisory board. In addition these banks had been holding tremendous debt as well as
equity holdings with MG. In order to prevent closing out of the futures positions held by
MG, Dresdner Bank -- and later Deutsche Bank -- had been arranging extensions of
multicurrency credit facilities. Most importantly these arrangements had been kept away
from the knowledge of the public and the disclosure of the default of MGs position

would have meant investigation of questionable management of MG by these banks. This

later lead to restructuring of German corporate management regulations.

CHAIN OF EVENTS:
December 1993 - Early 1994

Beginning of December 1993: MG started having extreme difficulty meeting margin

calls on NYMEX. MG required liquidity support of $1 billion to finance futures and
swap positions.
December 6, 1993: Revelations of losses appeared in German press. MG share price
fell 13 percent.
December 10, 1993: Deutsche Bank and Dresdner Bank agreed to provide a DM1.5
billion collaterized bridge loan.
December 10, 1993: NYMEX notified MG that it could not expand its futures
positions and that higher margin calls would be assessed.
December 17, 1993: MGs supervisory board fired four members of MGs
management board including the CEO and CFO.
Late December, 1993: Some counterparties in OTC swap transactions refused to roll
over position with MG Crop. without significant collateral. Some banks showed
hesitance to lend money for financing MGs position, while others canceled credit
lines.
December 28, 1993: NYMEX notified MG that it had to reduce positions on the
exchange, and that in the future, positions could not exceed limits imposed by
NYMEX.
December 30, 1993: By this date, approximately 80 percent of the firm-flexible
supply contracts had been terminated.
End December, 1993: Share price had fallen an additional 20 percent since December
6.
January 5, 1994: MGs new management announced revised losses of DM1.8 billion,
stating that the concern would require a sizable capital injection to avoid bankruptcy.

This paper deals with this case from the following aspects:
The trading strategy used by MG using energy futures.
The structure of the contracts offered by MG to its customers.
The role of German Banks in the scenario.
The role of MG management during the course of the strategy.

STRUCTURE OF THE DELIVERY CONTRACTS:

MG had decided to enter US oil markets in 1980s, because after the oil crisis of the late
70s, the retailers and wholesale suppliers had become cautious and were willing to enter
into long term supply contracts with large suppliers of heating oil. At that time, the major
supplier of the contracts in US was Enron. So MG also started to offer heating oil and
gasoline supply contracts to retailers. The contracts had a term of maturity up to 10 years
and the contracts were fixed-price, i.e. they promised to deliver a certain volume at a
fixed price upon delivery. The fixed-price contracts, however, were being offered by MG
in three forms.
Firm-fixed Contracts
Firm-flexible Contracts
Guaranteed Margin Contracts
Firm-fixed Contracts:
The firm-fixed contracts -- as the name implies -- were fixed supply contracts. These
contracts involved MG delivering a specified volume of heating oil or gasoline during a
specified time period for an agreed upon price. Under these contracts the buyer, or MGs
customer had to accept the delivery of the oil and purchase it at the specified price every
month for the duration of the contract. The term of the delivery was mostly 5-10 years.
This, however, has been subject to much debate by the analysts as to how was MG able
to determine the creditworthiness of the firm which was obligating itself to buy oil from
MG at a certain price within certain time period. Obviously MG appeared to have
exposed itself to a credit risk on behalf of their customers. MG never disclosed how the
firms qualified to enter into these contracts. However it has been speculated that these
firms were able to obtain letters of credit from the bank or use a collateral to qualify to
enter into these contracts.
The most important aspect of the firm-fixed contracts was the determination of the price
by MG. The contract price was calculated on the basis of the prices of the futures
contracts expiring within next 12 months. The contract price was simply the average of
the futures price plus a fixed premium which was determined by MG. The strange aspect
of the pricing formula was the fact that the prices of the contracts was being determined
by the same near term futures prices -- regardless of the maturity of the supply contract.
It means that the price of the 5-year contract was same as 10-year contract. This formula
disregards the time valuation as well as the credit risks of the firms in the long term as
compared to the firms who were buying oil in the short run. MG did not offer an
explanation or the rationale behind determination of the prices. They also never
explained whether the fixed premium should have been different based on the riskiness
of the firm in terms of having enough liquidity in order to take the delivery.
One of the more attractive feature of these contracts was the fact that many of these
contracts included a automatic closeout option. These options allowed the customer
firm to close out the contract, if the spot prices rose to or above the contract price. If the
spot prices did go above the contract price, the contract could be closed at the contract
price. In addition the difference of the nearest month futures price and the contract price
4

and multiplied with the volume of the undelivered oil. At the time of closeout, the
customer would receive half the amount of the difference and MG would receive the
other half.
Later, from mid 1993, MG decided to modify the structure of the fixed-firm contracts.
MG started to repurchase the automatic closeout options from the oil buyers. Under this
modification, now cash settlement would be done as soon as the near month futures
prices went above the contract price. The loss of the option to closeout by the firms was
being compensated by the new discount contract price which replaced the existing higher
contract prices.
Firm-flexible Contracts:
MG began to offer firm-flexible contract in mid 1993. Like the firm-fixed contracts,
these contracts also involved delivery obligations for 5-10 years at the firm prices. But
unlike firm-fixed contracts, now the buyers could now defer acceptance of the delivery
of the oil by MG indefinitely. However the delivery could not be deferred any later than
the expiration date of the contract. In other words, now the firms had an option of
extending the duration of their contractual obligation to purchase oil from MG. Now they
had more flexibility, in case short term liquidity constraints did not permit the firm to be
able to finance the delivery of the oil. It also helped the firms because if the prices of the
oil were low at that time, the firms did not have to purchase oil from MG at higher
prices.
However, this option exposed MG to higher credit risks. As the firms were able to defer
taking the delivery and paying MG the agreed upon price, it meant that the duration of
the payoff had been extended and longer term meant more risk of default from the
customer firms. MG got compensated for bearing additional credit risk in the form of
higher contract prices. The pricing of these contracts was based o n the same formula used
to determine the prices for firm-fixed contracts. The only difference was that now a
higher amount of premium was being charged to the customers in addition to the average
of the near term futures prices.
Some of the firm-flexible contracts also contained automatic closeout options. The
payoff after the settlement was, however, different from firm-fixed contracts. After the
contract was closed, the difference between the second-nearest futures price and the
contract price was calculated. This amount was then multiplied to the volume of
undelivered oil. In contrast to the firm-fixed contracts, now the buyer also had an option
of choosing any volume of undelivered oil up to the total volume of undelivered oil.
There was another difference between the settlement of firm-fixed contracts and firmflexible contracts at the time of closeout. In firm-fixed contracts, the customers received
only half the amount of the difference between the futures price and the contract price
multiplied by the volume. In the firm-flexible contracts, however, the buyer would
receive the entire amount of the difference between the futures price and the contract
price multiplied by the volume of the undelivered oil chosen by the buyer.

 Guaranteed Margin Contracts:

In contrast to other two types of contracts being offered by MG, guaranteed margin
contracts were short term supply contracts. However these arrangements could be
extended on MGs discretion. The premiums charged on these contracts were much
lower than the other two. It also reduced MGs exposure to credit risks to a great extent
because MG now had an option to discontinue the extension of the contracts, if they felt
that there was an increased probability of default on the buyers part. The number of the
guaranteed margin contracts was much lower than the firm-fixed or firm-flexible
contracts.

HEDGING AND EXPOSURE TO RISK:

MG used short-dated futures to hedge its long term delivery commitments against spot
price increases simply by purchasing a stack of short-dated futures equivalent to its
remaining delivery obligations. The strategy involves risk other than principal risk.
Principal risk is the risk that spot prices would erode the gross profit margins on its
fixed price forward sales. The mechanics of stacked hedging strategy are such that on
first delivery date, the firm buys in the spot market for delivery, offsets all its maturing
futures contracts, and reestablishes a long position in the new front-month futures
contract. On the next settlement date, the hedger again decreases the size of its futures
position by the amount delivered and rolls the rest forward to the next maturing onemonth futures contract. And so on, month by month.
Under the circumstances, MGs strategy seemed clear. They had positioned themselves
for the highest payoff in case of the increase in the spot prices of heating oil and
gasoline. The energy markets, historically, had been in backwardation, i.e. the spot prices
being higher than the futures prices. This leads to a negative slope for the oil futures
curve, which means that the futures contract prices for the longer term maturities are
lower than ones with shorter term maturities. This pattern is attributed to the fact that
convenience yields exceed the physical storage costs plus interest. In other words, it is
also due to the fact that current demand for oil is high relative to the current supply and
the spot prices rise above the futures prices due to the firms needing physical oil in order
to have oil on hand rather than inventory shortages. So, as long as the oil prices rose
along with continued backwardation of the oil futures market, MG would receive the
highest payoff. This payoff had two fold aspects. In case of spot prices being higher than
the futures prices, MG would have negative rollover costs of its stacked hedge. Moreover
the supply contracts were manufactured in such manner that the contract prices were
being determined by near-term futures prices for all contracts, regardless of the their
maturity. As short term futures prices were higher, it ensured highest contract price for
MG. In addition, in case of closeout of the contract under automatic closeout options,
the profit would be maximum because the calculated difference was between short-term
futures prices and the contract prices. This difference would be maximum as long as the
oil futures slope was negative. Looking at the structure of the strategy, many have
argued that MG was being speculative in the terms of determining the future structure of
the market. As it is obvious, the whole strategy would have benefited MG, if the energy
markets would have stayed in backwardation. Unfortunately that did not happen.

However, the main cause leading to the failure was the liquidity problems, that the
managers of MG had neglected to address, because they never expected the markets to go
in deep contango.
It has been argued that the crushing impact of MGs monthly rollover costs made the
hedging method a basically flawed strategy. The rollover cost is the difference between
the price of maturing futures contract and the price at which the new futures position is
established times the size of the stack. As long as the rollovers are in front-month
contracts and occur near the maturity date, the price of the expiring futures contract is
essentially the spot price, because the two must converge at maturity in order to prevent
an opportunity for arbitrage. Because the front month rollover cost per contract is simply
the basis in lump sum, the rollover costs incurred by MG started to rise sharply at the oil
prices started to fall and market went into deep contango in 1993. The declining oil prices
are demonstrated by the graph below.
The declining oil prices (1993):

(source: www.turtletrader.com)

Futures prices being higher than the spot prices (contango) was unusual for energy
markets. Energy markets, as opposed to most commodity markets, tend to carry a
negative basis, thus the spot prices being higher than the futures prices because the
convenience yield exceeds the cost of physical storage plus the interest cost. For crude
oil, in November 1993, mid-month rollover cost was $0.33/bbl, compared to a mean of
-$0.2091/bbl. For heating oil, the rollover costs at that time were $0.0021 per gallon as
compared to an average value of $-0.0076 per gallon. In gasoline, the costs were $0.187
per gallon in contrast to -0.0082 per gallon. The hedge was taken off in late 1993, based
on the argument that rollover costs were becoming increasingly difficult to finance due to
the liquidity problems faced by MG at that time. Though taking the hedge off relieved
MG of net costs of oil storage and thus huge rollover costs, it exposed MG to spot price
7

risk on its outstanding flow contracts. Spot price risk is huge relative to the basis risk.
Moreover, it is argued that if the management had waited till early 1994, MG would have
made up for most of the initial losses. Oil prices began to rise in early 1994 and rollover
costs (basis), which move inversely with the spot prices, began to fall. These price
movements, however, justified MGs initial strategy which revolved around the fact that
energy markets tended to revert to backwardation.
The examination of the MG case done by Franklin Edwards and Michael Canter involves
comparing the results if MG had chosen to maintain dynamic hedging strategy or
maintaining minimum variance hedge instead of stacked hedge. Minimum variance
hedge requires determining the volatility or the variance of the spot prices of oil as
compared to the futures prices of oil. The correlation between the movements in the
futures markets and spot markets in also determined to maintain a minimum variance
hedge. Then the number of futures contracts are chosen so that there is minimum
variance between the movements of futures prices and spot prices. For example if the
futures markets are twice as volatile than the spot markets and the markets are in perfect
correlation, then the hedge ratio is 0.5. In other words, one would need to take a position
in the futures market for an amount equal to half the amount of asset actually being
hedged.
The analysis - therefore - concludes that when MG decided to maintain a stacked hedge
as in contrast with minimum variance hedge, they had exposed themselves to additional
risks. Moreover these increased risks were unnecessary if they were just trying to hedge
against the price movements. First of all MG assumed increased rollover risk. Rollover
risk is related to increased needs of liquidity, in case the futures prices rose more than
spot prices. At the same time, in case of decline in spot prices there would have been
increased non-performance or funding risk from MGs counterparties for supply
contracts. It means that credit quality of these customers was very sensitive to the fall in
energy prices. Therefore, MG was willing to assume increased risks in exchange for the
possibility that they could benefit more from higher prices because maintaining a
minimum variance hedge would not have allowed MG to benefit as much from rising oil
prices or lose as much from declining oil prices. In essence minimum variance hedge in
intended to lock in certain profit as well as limit the possibility of losses. These facts - as
Franklin and Canter concluded - tend to deduce that MGs strategy was of speculative
nature.

THE INVOLVEMENT OF GERMAN BANKS:

The analysis of MGs case also points out to the possible agency problems associated
with this situation. As MG had not provided any explanation as to how the
creditworthiness of the counterparties was determined. They also had not provided any
explanation for why the prices of long term contracts were same as short term supply
contracts. Moreover MG had exposed itself to higher rollover risks. The choice of the
contractual terms by MG as well as the structure of the hedge would have typically
intensified demand of direct information by the stakeholders in MG in order to evaluate
the quality of MGs ability to manage counterparty credit risk as well as liquidity needs

of MG. In US system, individual investors are responsible for determination as well as

evaluation of information and making a decision. In German corporate management
system, however, the responsibility of acquiring the information and evaluating the
information on behalf of the stakeholders was shifted primarily to German Banks
responsible for managing the firm. The primary banks bearing that responsibility were
Dresdner Bank followed by Deutsche Bank. This later raised many questions as to
whether these banks had information about the liquidity problems MG was facing by
1993 and chose not to disclose it to the public. The issue of disclosure is dealt with in the
next section of this paper.
First question is that despite the financial problems MG was experiencing, how was MG
able to retain its access to financial markets as a borrower as well as counterparty in OTC
futures transactions in NYMEX. The analysis done by Frankel and Palmer in 1996
provides evidence which suggests that MGs continued access to financial markets was
based on its relationship to Deutsche Bank and Dresdner Bank. Throughout the 1980s,
these two banks were constantly involved in arranging and financing MGs planned
acquisitions. Although these banks were not responsible for financing all the transactions
conducted for expansion, these banks still acted as counterparties when dealing with
other banks for extended credit as well as direct loans on MGs behalf. Nonetheless,
Dresdner Bank as well as Deutsche Bank combined with other lender banks held huge
MG debt issues as well as substantial equity positions in MG within their portfolio.
The two banks, themselves, provided substantial credit (over DM700 million) to MG for
the planned acquisitions mentioned above. Their involvement can be shown by the fact
that the banks agreed to hold investment positions in Dynamit Nobel, which MG had
planned to acquire. The two banks managed equity issues and equity-related public debt
issues for MG in the late 1980s and early 1990s, totaling more than DM 1 billion. In May
1992, Dresdner Bank received a mandate from MG to arrange a DM1 billion
multicurrency credit facility for MG. It was arranged by Dresdner Bank involving many
other German as well as non-German multinational banks. Two months later, the
arrangement was revised to a DM1.5 billion facility, which by now involved a total of 46
German and non-German creditor banks. The stated purpose of the public facility was to
provide liquidity in support of general corporate operations. Hedging is considered, by
most firms involved in the business of supplying of certain commodity, as a general
corporate operation. Therefore, in a way, MG was disclosing the true purpose of the
facility. The only strange aspect is why no one was able to infer that the credit was being
extended for financing the hedge in place. The special Auditors report point points out
that later, there was an article in MGs internal newsletter, which mentioned that the new
credit facility was in fact being used to finance the liquidity needs of MGs oil
operations. This information certainly suggests that German Banks were in fact aware of
the problems being experienced by MG.
The first public disclosure of MGs financial troubles is believed to be an article
published in Frankfurter Allgemeine Zeitung on December 6th, 1993. The article
quickly grabbed attention and raised public concerns. As an immediate result, MGs free
access to market sources of finance and to transaction counterparties in OTC futures

markets was closed down. To avoid immediate closeout of its NYMEX positions, MG
turned to Deutsche Bank in early December that year for a bridge loan. By the end of
December, Deutsche Bank and Dresdner Bank had advanced $900 million. In early 1994,
the amount advanced by the two banks was increased to assist in the repayment of over
DM800 million of maturing commercial paper issued earlier by MG to finance the
transactions and the rollover costs.
Just the fact that Deutsche Bank and Dresdner Bank took the initiative to arrange such a
risky lending operation to MG on such a short notice suggests that representatives of both
banks were on MGs supervisory board. But then the question is, if they were on the
supervisory board, then how would they have permitted MGs management to close out
the hedge positions while providing MG with the funds to finance the rollover costs at
the same time. The issue is not the presence of German Banks on the supervisory board
but the events that followed. Under German Corporate law, banks were always allowed
to act as financial organizers and rescuers of non-financial firms without much concern
about legal risks. In US, however, the courts have always prevented banks from
organizing or planning rescues for financially troubled corporate customers.
There is an additional factor which needs to be considered when evaluating the role of
German Banks in the management of MG. The question is how much the concern the
counterparties of MGs futures transactions should have shown in the involvement of
Deutsche Bank and Dresdner Bank in MGs operations. It is suggested that the financial
market participants concern was not the banks relationship with MG specifically, but
rather German banks ability to manage all its corporate clients. It was widely accepted
that German Banks would assume responsibility for financing the rescue of any
financially troubled firm. So as long as the German banks were playing their role, the
counterparties had no apparent reason to raise concern about one firm, na mely MG.

THE ROLE OF MANAGEMENT AND PUBLIC DISCLOSURE OF

INFORMATION:
Since the MG case was disclosed, there has been a very long debate as to how the role of
the banks should be determined in the management of non-financial firms. In contrast
with the US corporate law, where the banks have been prevented from management of
non-financial firms, Frankel and Palmer have argued that there are various factors which
justify the role German banks have played in this scenario and the management of nonfinancial firms. Three of the main factors are as follows.
First of all, it is argued, that concentration of financial claimholder relationships help
effective exercise of control over the operations of the firm. Concentration of
financial claim means few institutions holding large positions in the company instead
of very large number of small shareholders. Having a large number of small
shareholders can lead to free rider problem. It discourages the claimholders from
having to gather costly information and analyze it due to the concern that other
claimholders will be able to benefit from their analysis free of cost. This loop,
therefore prevents the effective implementation of policies and exercise of proper
control in the firm. Thus, large banks having large positions in a company like MG
10

should overall result in more information being exchanged between the claimholders
and will result in better management of the firm.
The second argument is that there should be enough incentive for the banks to
willingly participate in the financial management and rescue of their corporate
customers. It means that there should be a promise of a long term relationship
between the firm and the bank as a form of compensation for all the costs involved in
the credit valuation and risk undertaken by extending credit by the banks to their
corporate customers. It is also a reward for all the contingencies that have not been
outlined in the contractual agreement between the firm and the bank. So, Deutsche
Bank and Dresdner would have never extended so much financial help to MG, if they
were not allowed to hold a long-term relationship with MG.
The third factor is probably the most debated topic of all. It is the issue of banks
holding both debt and equity positions in the same company. This is the most related
issue to the crisis of MG. As mentioned earlier, both Deutsche Bank and Dresdner
Bank along with other major banks held large debt and equity positions in their
portfolios. It is suggested that by holding both debt and equity positions in a
company, the banks can consolidate the scope of having a long term relationship with
the company. It also reduces the conflict of interest that can arise between equity and
the debt holders, especially in the times of financial trouble. The focus of a debt
position is upon having enough liquidity to make interest payments as well as the
principal amount, whereas the primary concern of a typical equity holder is to boost
the earnings and growth of profitability of the company.

All the factors discussed above support the argument that there should not be any
constraints on the managing capabilities of the banks in their relationship with their
corporate clients like MG. In addition the evidence also suggests that Deutsche Bank was
well-informed about MGs trading activities. However, the question is the disclosure of
accurate information by MGs management personnel to private shareholders as well as
Deutsche Bank. The analysis done by Frankel and Palmer allows us to analyze the
process of information transfer about MGs oil operations between MG management and
Deutsche Bank as well as between MG and the supervisory board, which was responsible
for public relations and therefore responsible for communicating the accurate information
to the public. Following is a table showing the transfer of information between MG and
the claimholders. The table deals with the exchange of information in two aspects. The
qualitative portion of the disclosure deals with the general explanation of the strategy and
discussion of different forms of risks that MG was exposing itself to during the course of
the hedging strategy. It also involved explanation of the derivatives being used in the
hedge. The quantitative portion of the disclosure deals with the estimated value of the
positions held by MG as well as the credit exposure in long -term contracts.

11

Type of Disclosure

Qualitative Disclosures:
General explanation of the strategy
Discussion of the derivatives used
Discussion of credit risk
Discussion for limiting risk exposure
Discussion of market risk
Explanation of accounting principles
Quantitative Disclosures:
Nominal derivatives position
Maturity profile
Estimate of credit exposure in long term
delivery contracts
Estimated market value of the positions

Public
Disclosure
Annual Reports
1990-91
1991-92

Private Disclosure
Disclosure to
Supervisory
Board

Disclosure to
Deutsche
Bank

Yes
Limited
No
No
No
No

Yes
Limited
No
No
No
No

Yes
Limited
No
No
No
No

No
No
No
No
No

No
No
No
No
No

No
No
No
No
No

Source: The Management of Financial Risks at German Nonfinancial Firms: The Case of Metallgesellschaft by
Frankel and Palmer (1996).

As it can be seen from the table above, the disclosure of information about MGs oil
operations by MG management board to Deutsche Bank and the supervisory board was
no different than what was being disclosed to the public. All in all, MGs management
board was not disclosing any useful information about MGs trading activities to anyone.
They were not providing any information about the different types of the risks MG was
exposing itself to and how MG was managing those risks. They also did not disclose the
liquidity problems being faced by MG at that time. An independent study conducted by
Ronaldo Schmitz (member of Deutsche Bank and member of MGs supervisory board
1992-93), based on a special audit conducted by KPMG in 1993, confirmed that MGs
management board started to improve the quality and the timeliness of information
passed to the supervisory board in late 1993 and early 1994. It is important to note that
most of the members of old MG management board were fired in December 1993 and
the quality of public disclosure improved only after a new management board was
formulated at MG in December 1993.
The fact that members of Deutsche Bank and Dresdner Bank were on MGs supervisory
boards at different times does not imply that they had access to all the information about
MGs oil operations even if they wanted to obtain it. In addition, even if they had the
information, they were not at liberty to share that information with the public. Under
German corporate law, the supervisory board members of MG had to treat all the
information received from MGs management board as strictly confidential. As the
members of supervisory board, Deutsche Banks nominees were not permitted -- under
German law -- to pass on bank-confidential information to MGs management board
even if the information was related to MGs operations. So now the banks nominees had
two sets of information which had to be kept separate. First was the set of information
that was being shared among the members of the supervisory board and the second set of
12

information was shared among the members of the board of Deutsche Bank. Although
being on the supervisory board of MG allowed the banks nominees to have access to
technical information about MG, it certainly does not imply that all the technical
information was being transferred to Deutsche Bank just because their nominee was on
the supervisory board of MG. It has been suggested that there was no request for
technical information from Deutsche bank from MGs management board based on the
well-informed questions passed by the banks to their nominees. For example, the
Special Auditors Report completed by KPMG in 1993 suggests that MGs increased
use of credit facilities for the hedging strategy was not discussed in the meetings of the
supervisory board of MG. The argument has arisen whether this was just the German
corporate laws preventing the flow of information or the banks nominees having little
incentive to actively manage the ongoing operations of MG.
It is important to note the supervisory boards response to the Special Auditors Report
by KPMG in late 1993. At that other press reports were also coming out which reflected
MGs losses in NYMEX trading positions. These press releases raised many concerns
from the claimholders. The supervisory board of MG responded by relieving the existing
management board. The new management board was formulated in late December 1993,
then approached Deutsche Bank and Dresdner Bank and requested them to coordinate the
creditors committee. The creditors committee then went on to put forward a financial
rescue plan for MG.

FINANCIAL RESCUE AND REFORMS:

After MGs losses from its oil-trading operations were disclosed to the public, Deutsche
Bank and Dresdner Bank agreed to coordinate the creditors committee and participated
in the restructuring of MG. It involved DM3.4 billion financial rescue originally
proposed on January 6, 1994 and accepted on January 15, 1994 and subsequent
amendments (added through March 1995). The highlights of the proposed rescue
included converting the existing debt into convertible certificates and could be sold back
by other creditor banks to Deutsche Bank and Dresdner Bank. It also involved offering of
new shares of equity to the participant banks and institutions. The proposal suggested
selling the new shares to these institutions and banks based on their already existing
equity positions held in MG. However, later small creditor banks and institutions such as
Investment Office of Kuwait, Daimler-Benz and Allianz decided to sell off their
participation in the new issue to Deutsche Bank and Dresdner Bank proportionately. In
addition some institutions like MIM Holdings decided to also sell their existing equity
positions in MG. So the two banks ended up purchasing more equity position in MG than
they had planned to buy earlier. The proposal also required the creditor banks to open e
new credit line for DM500 million. The proposal specifically asked Deutsche Bank and
Dresdner Bank to not participate in providing new line of credit to MG. However, the
final agreement involved Deutsche Bank and Dresdner Bank providing a new credit
facility to MG for a total amount of DM300 million (DM150 million each). Other
creditor banks agreed to provide a credit facility of DM400 million instead of proposed
DM700 million. The details of the proposed rescue and agreed terms of the rescue
13

operations were compiled together by Allen Frankel and David Palmer in their analysis
of financial rescue of MG in 1996. The table is shown below.

Shareholder Banks
Deutsche Bank
Dresdner Bank

Other Credit Banks

Proposed Rescue
Set to convert existing bank debt
into convertible certificates.
Set to participate in new share
offering proportional to MG share
capital held (Deutsche 10.65%,
Dresdner 12%)
No participation in DM 500
million line of new money
credit.

Set to convert existing bank debt

into convertible certificates.
To purchase 38 percent of new
share offering.
Set to provide entire DM500
million in new credit.

Non-bank
Shareholders

Major shareholders (including the

Investment Office of Kuwait,
Allianz and Daimler-Benz) set to
participate in proportion to MG
share capital held. Together with
the major banks, they would
assume total of 62 percent of the
capital increase.

Agreed Rescue
Agree to assume an additional
DM50 million each from other
creditors banks position. They
paid DM100-200 million to buy
out positions of 12 banks.
Agree to increase participation
(Deutsche
16.6%,
Dresdner
17.2%)
Agree to provide DM150 million
each for line of credit, raised to
DM700 million.
Some credit banks negotiate
arrangements to reduce their
participation in bank debt
conversion.
Deutsche
and
Dresdner
paid
DM100-200
million to buy out positions of 12
banks.
Smaller participation in new
share purchase
Scale back participation in credit
line from DM500 million to DM
400 million (new money).
Major shareholders agree to the
original plan. Small shareholders
given the choice to maintain their
relative share of MG Capital.
In May 1994, MIM Holdings n
Australia sold its 3.5 % stake in
MG.

Source: The Management of Financial Risks at German Nonfinancial Firms: The Case of Metallgesellschaft by
Frankel and Palmer (1996).

As it is evident from the table above, there is a sizable difference between the proposed
rescue and the terms of the rescue operation which were agreed upon in the end. The
final terms of the plan provides the evidence that greater responsibility was assumed by
Deutsche Bank and Dresdner Bank. It also suggests that the solution was not imposed on
other creditors. On the contrary, other creditor banks were given the flexibility to
voluntary participate in the financial rescue of MG. In the end, Deutsche Bank and
Dresdner Bank agreed to purchase convertible positions from other creditor banks. It
resulted in an increase in the equity positions held by Deutsche Bank and Dresdner Bank
in MG. The new ownership of the MGs outstanding shares by these two banks now
amounted to 27 percent as compared to 23 percent previously. The MG case has raised
different issues on the two sides of the Atlantic. In the United States, MG was viewed as

14

another instance of sizable losses associated with derivatives trading. In Germany, the
MG case led to renewed interest in German corporate governance and calls for reform.
One proposed set of reforms focuses on improving information flows to the supervisory
board, for example, to enhance the responsibility and independence of firm auditors. The
auditors would be charged to keep the supervisory board sufficiently well informed so
that it can provide ongoing oversight of management. Related proposals call for the
creation of audit committees by supervisory boards. The committees would presumably
force supervisory board members, to spend more time examining a firms risk
management strategies and controls. A second set of reforms aims at improving
accountability to shareholders by reducing or removing the ability of banks to vote the
proxies of nonbank shareholders. Advocates of such reforms, e.g. the German
Shareholders Association, view them as a means of encouraging supervisory board
accountability to shareholders.

15

BIBLIOGRAPHY:

Metallgesellschaft And The Economics Of Synthetic Storage by Christopher L.

Culp and Melton H. Miller, University of Chicago (1995).
The German Banking System And Its Impact On Corporate Finance And
Governance by M. Aoki and H. Patrick.
W. Arthur Benson, complaint filed against MG and MGRM in 1994.
Hedging A Flow Of Commodity Deliveries With Futures: Lessons Learnt From
Metallgesellschaft by Culp and Miller.
Top Executives, Turnover And Firm Performance In Germany by Steven Kaplan
(1994).
MGs Trial By Essay by William Falloon (1994)
The Metallgesellschaft Affair: Risk Management In The Real World by Michael
Hitchinson Jr. (1994).
Metallgesellschaft Annual Report 1993-94.
Special Auditors Report, An Investigation of Metallgesellschaft by KPMG (1993)
The Management Of Financial Risks at German Nonfinancial Firms: The Case of
Metallgesellschaft by Frankel and Palmer (1996).
The collapse of Metallgesellscahft: Unhedgable Risks, Poor Hedging Strategy or
Just Bad Luck? by Franklin Edwards and Michael Canter (1995).
US Futures Trading Commission: Penalty Against MGRM (1995)
The press conference releases of Ronald Schmitz, member of MG supervisory board
and nominee of Deutsche Bank on the board.
http://www.turtletrader.com
http://quote.bloomberg.com
http://www.futurescharting.com
http://www.lexus-nexus.com
Cover page image: http://www.metallgesellschaft.de

16