Jerome Kiervel-Societe Generale Case



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Jérôme Kerviel was allegedly involved in an illegal trading scheme amounting to €50 bn., which resulted in a loss of €4.9 bn at Société Générale, the second largest bank in France.

I. The issue

Significant deficiencies in internal controls, unauthorized trading activities, computer hacking and the breach of trust involving a conscious effort by the rogue trader to deceive his managers were noticed. Jérôme Kerviel is accused of creating a huge loses by a single unauthorized trader in financial history. In the course of 2007 he made unauthorized trade worth € 30 bn. on European stock market futures, winning € 1.4 bn. by the end of the year. Having disguised the importance of his exposure, and earnings, with fictitious trades, he went on in January 2008 to make even bigger trades. The bank stated that he deliberately set out to lose money in 2008 to bring down the suspicious size of his 2007 earnings.

II.The background

Created on May 4th, 1864 under the reign of Napoleon III, Société Générale is one of the very first groups of financial services in the Euro zone with 46.2 billion euro from market capitalization as of December 31st, 2007. He was graduated from the Université Lumière in Lyon with a master’s degree in finance. Jérôme Kerviel joined Société Générale, the second largest bank of France, in 2000, where he obtained a position in the compliance department. He was promoted to the Bank’s Delta One trading team in 2005, which specialized in the futures markets. In theory, this strategy does not allow the trader to take on significant directional risk, as any directional positions are hedged.

Jérôme Kerviel declared that he began to take bets on the market in 2005. He used to take genuine directional positions and created fictitious hedges, buying securities and warrants with deferred start dates and futures with a counterparty that did not require instant confirmation. Using other employees’ access details, he was able to later delete trades from Société Générale’s system, leaving him with massive exposures, but fooling the monitoring tools into thinking that his portfolio was relatively flat. An internal investigation, the Mission Green, commissioned by the bank showed it had failed to follow up on at least 75 warnings on Jérôme Kerviel’s positions. In November 2007 Eurex, the derivatives exchange, stressed that Jérôme Kerviel Kerviel’s positions showed some irregularities. The Mission Green report stated that compliance and the trader’s managers “were satisfied, without verification, with the trader’s explanations, in contradiction to Eurex’s assertions.”

Jérôme Kerviel is alleged to have used his considerable computing skills and inside knowledge gained during his five years working in the bank compliance department to hide € 50 bn. of illegal trading which resulted in the loss of € 4.9 bn. An internal investigation showed a total of some 1,000 cases in which the trader was involved in the entry and then cancellation of fictitious transactions, concealing market risks and the latent earnings from unauthorized directional positions.

A. The operative mode of the fraud

Jérôme Kerviel had put together a first portfolio (A) composed of futures and representing the evolution of the European stock indexes (Eurostoxx, Dax, FTSE….) while at the same time he was establishing a second portfolio (B) composed of warrants which had the same characteristics as those of the futures but with a different value, these variances in value explain the losses or the gains of such activities. Because of their close characteristics, these two portfolios compensate each other and lower the market risks. Société Générale had established internal controls to manage these risks. The fraud committed by Jérôme Kerviel has consisted of evading internal controls or making them inefficient. Jérôme Kerviel had registered and then cancelled fictitious transactions in the second portfolio. The fictitious transactions were registered in Société Générale systems but were economically unreal.

Within the framework of this fraud the financial instruments of portfolio (A) were seemingly compensated with the fictitious operations accommodated within portfolio (B) which showed only a very little residual risk. He gave to his fictitious operations some characteristics which limited the opportunities of control. He usurped computing access codes belonging to operators to cancel certain operations. He falsified the documents allowing him to justify his fictitious operations. He made sure that his fictitious operations related to a financial instrument different from those which he had just canceled to avoid control.

B. The discovery of the fraud

The discovery was Friday, January 18th. Few days before, an abnormally high position of a risk of counterpart was detected. The explanations given by Jérome Kerviel were insufficient and led to additional controls. On January 18th Jérome Kerviel's hierarchy was informed of this problem and alerted the hierarchy of the department. An e-mail supposedly from a large bank involved in a trade with Jérôme Kerviel was found to have been falsified. A team was established to perform full scale investigations. On January 19th the hierarchy did not obtain clear explanations from Jérome Kerviel. The large bank, mentioned in the e-mail, did not recognize these operations. Jérome Kerviel admitted having committed irregularities and, in particular, having created the fictitious operations. The investigators soon detected the true situation. On January 20, the total exposure of Jérôme Kerviel’s trade was closed at €50bn. Société Générale Chairman, Daniel Bouton, informed the Governor of the Banque de France, the other members of his board and then the General Secretary of the AMF, the French markets regulator. On January 21, Asian markets collapsed. Société Générale began unwinding the rogue trader’s positions as European markets went into free fall. On January 23, as the sell-off was completed the French government and the world major central banks were informed of the affair. On January 24, Société Générale asked for its shares to be suspended as the losses were announced to the world. On January 25, Jérôme Kerviel’s name was confirmed as the “rogue trader” and on January 26, he was brought in for questioning to the headquarters of the French financial police. On January 28, the rogue trader admitted to hacking into computers and creating false documents, he was charged by a French prosecutor on four counts.

III. The Role of Criminal and Financial Laws

A. The Role of Criminal Law

The French justice has never examined such a fraud. No French case law relating to similar situation exists. Except for the fact that there was no breach of trust by bank officials the Société Générale affair is comparable in its impact and in some of its facts to the Daiwa Bank scandal which occurred in New York in 1995, and is also similar to the John Lusnak case which occurred in Maryland in 2003.

A criminal complaint for falsification of banking accounts and computer hacking was issued by Société Générale in Nanterre, the jurisdiction where Société Générale Headquarters is located. A second criminal complaint of swindle, breach of trust and forgery, was issued in the name of the group of shareholders in Paris. The scale of the swindle Jérôme Kerviel is accused of is usually sanctioned with 5 to 15 years prison term. Originally, the Public prosecutor's office would have asked to indict Jérome Kerviel for attempt of swindle, but it was rejected by the judges. Société Générale, the plaintiff, never declared that Jérome Kerviel had personal ambition in this affair. The prosecutor recognized that Jérôme Kerviel had behaved like a financial drug addict as he bet wildly on stock markets and that Jérôme Kerviel had not swindle the bank but had hoped to secure a higher salary and large bonus and expected to increase his reputation as an “exceptional trader”. Jérôme Kerviel could be fined and sentenced to 3 years in jail.

Jérôme Kerviel is facing:
- Multiple charge of forgery, fictitious transactions and falsifying documents to justify his actions,
- Hacking into the bank’s computer to input falsified informations,
- Breach of trust, in a usual way, concerning the properties of third party, (taking positions that exceeded his trading limits),

The rogue trader, served 5 weeks in preliminary detention at Paris’s Santé prison, during which he was fired, to ensure his availability to investigators and prevent contamination of evidence or witnesses. Since then he has been placed under official investigation but allowed to walk free on condition he remain in France. He is now working at a computer services company owned by a specialist who had counseled his defense.

In the United States, in New York, the procedure would have been similar to the French one. The bank would have immediately informed the New York Federal Reserve Bank about the rogue trader’s trading losses. The New York Federal Bank would have alerted the U.S. District attorney, who would have arrested the rogue trader. The trading losses would have been made public and the rogue trader would have been charged with fraud.

In the United State the sanction of such a fraud would probably be more severe. Jérôme Kerviel’s case is similar to John Rusnak’s. In 2002, this rogue trader was caught concealing $ 691 million in currency markets losses at Allied Irish Bank (Maryland). He was sentenced in January 2003 to a seven and a half year prison term. His punishment included a $60.000 fine, mandatory counseling and a lifetime trading ban. During his time at Allied Irish Bank, John Rusnak made bad bets on the yen, sought cover with riskier trades, his losses, falsified profits and protected undeserved bonuses. John Rusnack could have faced up to 30 years in prison. The seven and a half year sentence was part of a plea bargain with the US prosecutors. Upon his release, he must start paying US$ 1.000 a month for five years of probation. John Rusnak still must refund the full amount of the loss, but the prosecutor stipuled the amount he pays back will depend on how much money he is able to earn after leaving prison.

Jérome Kerviel is, at the present time, the only person indicted in a significant way in the Société Générale affair, Jérome Kerviel’s assistant, Thomas Mougnard, is also indicted but only for subordinate facts.

B. The accomplices

Two people are suspected being Jérôme Kerviel’s accomplices.

Jérôme Kerviel’s assistant, Thomas Mougnard, 24 years old, is suspected of having helped the rogue trader. He registered in the system the "provisions" which allowed Jérôme Kerviel to feign the result of his unauthorized positions, in 2007 and in the year 2008. Thomas Mougnard was already indicted on August 1st, 2008, for "complicity of fraudulent introduction of data in a computer system".

In February 2008, Moussa Bakir, a 32 year old sale trader at Fimat, a firm of brokers owned, at this time, by Société Générale and specialized in the derivatives which Jérôme Kerviel traded in has been interviewed by French financial police on suspicion of links to Jérôme Kerviel. This link between the rogue trader and Moussa Bakir was discovered by the bank’s own internal investigators, who uncovered previously undetected communication between the two traders. There is a suspicion that they had been working in tandem in this affair. Moussa Bakir is suspected of being aware of Jérôme Kerviel’s unauthorized trading at Société Générale. There is a strong presumption that many of Jérôme Kerviel’s transactions on the European stock market passed via Fimat. Fimat’s offices were also searched as part of the investigation.

C. The financial consequences

Further to the Daiwa Bank scandal in 1995, the President of the Federal Reserve Bank of New York which has significant regulatory responsibility has observed :

“based on our experience, we believe that a successful risk management system should satisfy at least four basic principles:
- first, it should be subject to active oversight by the board of directors and senior management of the financial institution,
- second, it should embody well-conceived risk identification measurement and reporting system,
- third, it should include comprehensive internal controls emphasizing the clear separation of duties,
- and, fourth, it should incorporate a well-defined structure of limits on risk taking.”

A review of Société Générale’s case confirms that there was a significant failure in the design or implementation of one or more of these basic principles.

The fraud which lasted one year has been blamed by the Banking Commission, a collegial agency chaired by the Governor of the Banque de France and in charge of the control of credit institutions in France. The Banking Commission fined Société Générale € 4 million in July 2008 for failure of internal controls. Regarding the control of the risks this failure constitutes malpractices against the banking regulations. In the U.S these investigations would have been conducted by U.S. Federal Reserve, the Federal Deposit Insurance and the State Banking Department.

The maximum penalty that the Banking Commission can impose is € 5 million that is to say that the one imposed on the Société Générale is very severe. The decision of the Commission states important deficiencies of internal control system were made. These deficiencies which exceed the repetition of simple individual failures have facilitated the fraud and its grave financial consequences. These deficiencies continued over a long period, the year 2007, and the internal controls were unable to reveal them and also to correct them. The Commission questioned " the follow-up and the control of first level " clarifying that the detailed and daily follow-up of Jérome Kerviel's activity " was not ensured " as well as the permanent controls exercised by the other services of the bank " which were insufficiently made aware of the problems of frauds and diversion ". According to the Commission, the variances which appeared repeatedly in 2007 did not arouse in depth investigations, while the explanations given by Jérome Kerviel contained abnormalities and deficiencies.

The Commission highlighted the grave failings of the bank’s computer system of security, in particular, at the level of the system of information. The banking Commission judged that the fact that these gaps were not known by the management, which could not remedy it, cannot be invoked by the SG to exempt itself from its responsibility towards the banking regulations. The bank broke several essential provisions of the banking regulations.

If this fraud had occurred in the United States the deterrent for an institution in a similar situation would have probably been the class action litigation. The link between the class action and the regulatory sanction exists. In the United States, because of the exposure to litigation, most regulatory sanctions are agreed upon without admission of culpability and therefore liability. In France, the settlement of regulatory actions does not exist at the present time.

Several shareholders of the bank filed a complaint with the French financial markets regulator after it appears that a member of Société Générale board sold shares worth € 86 million on January 9, 2008. The investigations are on going.

Bibliography

Reports:

Note explicative concernant la fraude exceptionnelle, Société Générale 27 janvier 2008
Rapport de synthèse de la Mission Green, Société Générale, 20 mai 2008
Rapport du Conseil d’Administration de la Société Générale, 22 mai 2008
Rapport du Comité Spécial du Conseil d’Administration à l’Assemblée Générale, Société Générale, 23 mai 2008
Extraits du Procès Verbal d’audition de Jérôme Kerviel devant la Brigade financière, Lexinter.com, 30 janvier 2008
Décision de la Commission bancaire sur l’affaire Société Générale, 3 juillet 2008
Congressional Research Service: Report for Congress, 95-1164E.The Daiwa Bank problem, background & policy issues by Dick K. Nanto, William D. Jackson, and F. Jean Wells, Economics division, November 30, 1995

Articles:

Global investing « Rogue » culture should share blame for trading losses, Allison Beard, Financial Time,January 25, 2003
L’affaire Société Générale. Que doit penser le grand public? in La Finance pour tous, 28 janvier 2008
Société Générale devient une affaire d’Etat, Raoul Sachs, in La Vie financière, 29 janvier 2008
Chronology of the affair,Lain Dey, in Telgraph, January 30, 2008
Société Générale failed to control Jérôme Kerviel, Henry Samuel, in Telegraph, February 5, 2008
“Rogue trader” Jérôme Kerviel breaks his silence to say he will no be made a scapegoat, John Lichfield, in The Independent, February 5, 2008
SocGen’s Jérôme Kerviel jailed pending trial, David Litterick, in Telegraph, February 10, 2008
Société Générale fraud: second man held, Bonnie Malkin, in Telegraph, February 10, 2008
Société Générale: L’affaire Kerviel fait plonger le bénéfice annuel, Joël Saget, in La Dépêche, 21 Février 2008
Avoiding wreckage in high risk culture, Phillipe Carel & Chris Long, Reuter, March 2008
Rogue trader: the aftershocks and the role of criminal law, Robert Turner & Nick Benwell in Fraud & Corporate Crime, Simmons & Simmons, London, March 2008
The rogue to ruin, by Robert Falkner, Head of the Securities & Financial Services Litigation Group at Morgan Lewis & Bockius in London, March 2008
La liberation de Jérôme Kerviel change l’enquête de la Sociéé Générale,Thierry Lévêque, in Boursier.com, March 2008
Affaire Kerviel : des contrôleurs allemands accusent la Société Générale, in TendancesTrends.be, 25 avril 2008
Rogue trader ‘did not act alone’, Maaragreta Pagano, in The Independent, May 25, 2008
Affaire Kerviel: Quatre millions d’amende pour la Société Générale, in L’Express.fr, 4 Juillet 2008
France’s Banking Commissionfined Société générale € 4 million in July for failure of internal controls, Heather Smith, July 2008, Bloomberg.com
Jérôme Kerviel mouille la SocGen, Maud Pierron, in Le JDD, 3 Septembre 2008
Chronologie de l’affaire Société Générale, in Challenge, 12 Décembre 20

ABOUT THE AUTHOR: Ryan Blanch
Ryan Blanch is the Founding Partner of The Blanch Law Firm, P.C. in New York City. Mr. Blanch is a seasoned white collar criminal defense attorney and commercial litigator, handling complex government investigations and business disputes.

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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.



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