MELBOURNE: 21 August 2013 - In the last year or so there has been a deluge of financial scandals on a massive scale, especially involving banks, exposing harmful behaviour inflicted by some of their employees upon markets and/or consumers.  In response there have been some huge penalties imposed by regulators, especially in the US and UK.  The biggest scandal has involved the manipulation over many years of the London Interbank Offered Rate (Libor), prompting then Assistant Attorney General of the US Department of Justice (DOJ) Lanny A. Breuer to predict in January 2013 that: ‘Libor will prove to be one of the largest, if not the largest white-collar case in history’. For its role in the Libor scandal, in June 2012 one of several miscreant banks, Barclays agreed to pay to the US Commodities Futures Trading Commission (CFTC) a $200 million civil penalty, a DOJ penalty of $160 million, and to the UK Financial Services Authority (FSA) a fine of £59.5 million. Another UK bank RBS was fined £90 million by the FSA and £300 million by the CFTC and the DOJ for its role in the Libor scandal. Similarly Swiss bank UBS in December 2012 as part of its agreement with the DOJ agreed that UBS Japan not only had signed a plea agreement admitting its criminal conduct and would pay a fine of US$100 million, but also that two UBS former traders would face criminal charges.  In addition, UBS AG (the Swiss parent company of UBS Japan), had entered into a non-prosecution agreement under which it would: admit and accept responsibility for its misconduct; pay a DOJ penalty of US$400 million; US$700 million due to CFTC action; US$259.2 million due to the FSA action; and $64.3 million due to the Swiss Financial Markets Authority (FINMA) action for a combined total of more than US$1.5 billion.

In the latest UK mis-selling of pensions scandal, regulatory action has yet to run its full course but already UK banks have set aside more than £12 billion to cover compensation to their customers for systematically mis-selling them payment protection insurance, Lloyds Banking Group alone has set aside £5.3 billion. Little of the regulatory response to these scandals, and indeed the Global Financial Crisis (GFC) more generally, has involved the criminal law, because there is uncertainty about whether many of the harmful behaviours were illegal and associated evidentiary difficulties.  It is in this environment in mid-2012 that the JP Morgan Whale Scandal emerged and the regulatory response has been unfolding since.  For a discussion of the key figures and events in the London Whale scandal see an opinion piece I posted on this CLMR portal last week.

What is not yet clear is whether the Whale Scandal is just a case of yet two more new bad apple rogue traders, or an almost inevitable manifestation of the structural incentives seemingly hard-wired into the DNA of the financial industry. Nevertheless two former JP Morgan employees were indicted by the DOJ on 14 August 2013: Mr Martin-Artajo, former Managing Director and Head of Europe and Credit & Equity in JP Morgan’s Chief Investment Office (CIO), and a more junior ex-colleague of Mr Martin-Artajo at JP Morgan, Mr Julien Grout, a Vice President in CIO’s London office whose key role was to mark positions to market.  The DOJ alleges that both men falsified books and records, engaged in wire fraud and conspiracy, as well as causing false statements to be made in JP Morgan’s filings to the Securities and Exchange Commission (SEC).

It is helpful in trying to disentangle what may have happened in the London Whale scandal to examine the complaint of the SEC against Mr Martin-Artajo and Mr Grout, because it provides detail of what the SEC alleges is the harmful behaviour by both men.  In its complaint, the SEC alleges that both men engaged in ‘..fraudulently mismarking investments’ (p.1), contravened JP Morgan’s policy for its Synthetic Credit Portfolio (SCP) by deliberately choosing to minimize losses rather than represent fair value in accordance with US Generally Accepted Accounting Principles – GAAP (pp.2,7), leading to sustained mismarking of the SCP in March and April 2012 by Mr Grout at the instruction of Mr Martin-Artajo (pp.8-18).  There is some uncertainty about precises figures but it appears that over the course of one day alone (10 April 2012), the SCP declined in value by US$700 million, yet: ‘Despite the staggering decline, on the evening of April 10, Grout disseminated a report, at the direction of Martin-Artajo, showing a daily mark-to-market loss for the SCP of only $5.7 million. An hour and a half later, Grout replaced this report with another one that reported a much higher daily loss of $395 million’ (p.17).  These alleged activities by Mr Martin-Artajo and Mr Grout have resulted in the SEC laying four claims against the two men.

1. Violating Section 10(b) of the Exchange Act and Rules 10b-5(a) and (c) because they ‘knowingly or recklessly, employed devices, schemes and artifices to defraud and/or engaged in acts, practices and courses of business which operated or would have operated as a fraud or deceit upon purchases of securities or upon other persons’ (pp.19-20).

2. Violating Section 13(b)(5) of the Exchange Act and Rule 13b2-1 because they knowingly circumvented a system of internal accounting controls and knowingly falsified, directly or indirectly, or caused to be falsified books, records and accounts of JPMorgan that were subject to 13(b)(2)(A) of the Exchange Act [15 U.S.C. § 78m(b)(2)(A)]  (p.20).

3. Aiding and Abetting Violations of Section 13(b)(2)(A) of the Exchange Act because they knew, or were reckless in not knowing, of JPMorgan’s violations of Section 13(b)(2)(A) of the Exchange Act [15 U.S.C. § 78m(b)(2)(A)] and substantially assisted those violations (p.21).

4. Aiding and Abetting Violations of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-11 and 13a-13 because they knew, or were reckless in not knowing, of JPMorgan’s violations of Section 13(a) of the Exchange Act [15 U.S.C. § 78m(a)] and Rules 12b-20, 13a-11 and 13a-13 thereunder [17 C.F.R. 240.12b-20, 240.13a-11 and 240.13a-13] and substantially assisted those violations (p.22).

The SEC’s claims equate to allegations of sustained deceptive conduct by Mr Martin-Artajo and Mr Grout.  The complaints of the SEC, and indeed the future case of the DOJ against Mr Martin-Artajo and Mr Grout, if their trial does indeed proceed, rest heavily upon the evidence of Cooperating Witness 1, (not named in the SEC complaint and referred to in that complaint as CW-1).  CW-1 is assumed to be the London Whale himself Mr John Iksil.  The DOJ and the SEC are not commenting officially on Mr Iksil, but it is being widely reported that he has negotiated immunity from prosecution by the DOJ and SEC in return for cooperating in their proceedings against Mr Martin-Artajo and Mr Grout. When the SEC complaint is examined this seems a pretty reasonable deduction, because the SEC document details numerous alleged interventions by CW-1 to dissuade Mr Martin-Artajo and Mr Grout from pursuing the strategies that they followed.  For example: ‘CW-1 became uncomfortable with Martin-Artajo’s directive not to disclose losses. CW-1 repeatedly expressed concerns to Martin-Artajo about the existence and size of this gap, which Martin-Artajo ignored’ (pp.10-11); ‘CW-1 made several efforts to alert management about the declining value of the SCP, only to be rebuffed by Martin-Artajo’ (p. 13); and ‘CW-1 told Grout, “you tell [Martin-Artajo] because it’s not my business anymore . . . it pisses me off . . . tell him it’s more than 500 [million] . . . Tell him it’s more than 500 [million] so he gets it”’(p.14).

Only an insider to the SCP trading position could make such observations and it is quite likely that CW-1 is Mr Iksil.  However, it is by no means certain that any court proceedings would find Mr Martin-Artajo and Mr Grout guilty because there is enormous uncertainty about values associated with the CIO’s SCP and not all has been revealed about hierarchical exchanges of information between JP Morgan employees within the CIO.  Much of the SCP was composed of Credit Default Swaps (CDSs) which are intrinsically insurance contracts on underlying credit risk and subject to multiple value interpretations.  If Mr Martin-Artajo and Mr Grout do go to trial this is sure to be one line run by their defence lawyers.  The underlying trades made by JP Morgan were not illegal and the indictments are not premised upon the losses those trades sustained but the alleged misstating of the scale of the losses to superiors within the CIO.  Also as Eavis notes: ‘..in the first quarter of 2012 alone, JPMorgan added more than $390 billion of such derivatives, according to regulatory filings.  JPMorgan was effectively the market at the time. In theory, then, its traders should have had no problem finding market prices to value the size of their loss.' Similarly, defence lawyers for Mr Martin-Artajo and Mr Grout are also likely raise doubts about who else within the CIO had knowledge of these trading positions and could have taken different action.  Not only Mr Iksil, but also for example Mr Marton-Artajo’s superior at the CIO Mr Achilles Macris.  As Flitter and Henry report: ‘Macris, who ran the London division of the CIO and was Martin-Atajo's supervisor, is not cooperating with investigators and long ago returned to his native Greece, according to a person familiar with his situation.’

Zeitlin reports not only that: ‘Preet Bharara, the U.S. Attorney for the Southern District, has said that…”there are other people who remain under investigation’,.” [but also that] on March 1, Macris sent another email to Martin-Artajo, telling him that he should “focus on the metrics and P+L [profit and loss] of the synthetic book.” He also told Martin-Artajo that if they actually reduced the size of the trades, they would “not be able to defend our positions.” Macris also wrote that it “would be important to focus on the P+L.”’ So Mr Macris may yet come under further scrutiny from the DOJ.  Also, the SEC complaint states: ‘Both Martin-Artajo and Grout engaged in this scheme to enhance the SCP’s apparent performance, and thereby curry favour with their supervisors and enhance their promotion prospects and bonuses at JP Morgan’ (pp.9-10). One of those supervisors may well have been Mr Macris and seen from this perspective the London Whale takes on some similarities to the manipulation of Libor or some of the more well-known rogue trader cases.  For example: Kweki Adoboli at UBS (2011), Toshide Iguchi at Daiwa Bank (1995), Joseph Jett at Kidder Peabody (1994), Jérôme Kerviel at Société Générale(2010), Nick Leeson at Barings Bank (1995) and John Rusniak at Allied Irish Bank (2002).

What these infamous rogue trader cases, the systematic manipulation of Libor and the London Whale scandal all highlight is how the normative contexts of financial institutions allied with their incentive structures can foster dangerous risk environments in which individual traders see only small downside for their behaviour because they do not internalise the costs of their actions.  Apologists for an organisation’s connivance, negligence or ineptitude for such trading scandals may trot out the bad apple explanation about the rogue individual but it is rare that structural factors are not also present.  The reality is that normative issues in business and regulation are highly influential variables in the risk paradigm.  The bottom line regarding trading scandals and militating against them is the bottom line.  Finance sector firms, especially banks, have profit maximisation as their overriding goal and historically their compensation and remuneration systems have been a key driver to achieve this goal.  Impacting upon these and other operational systems of financial firms is the ultimate end-game for regulatory actors and is a significant driver in their increasing use of Non-Prosecution and//or Deferred Prosecution Agreements which currently seem to be benefiting Mr Iksil.  As the DOJ proceedings against Mr Martin-Artajo, Mr Grout and perhaps others evolve, it will be interesting to see whether JP Morgan itself is required to submit to mandatory organisational change at the behest of regulatory agencies.