The Socit Gnrale Scandal

"This latest rogue trader scandal is yet more evidence that while rules-based regulation

and controls work for kids in the playground, it won't stop adults doing the wrong

thing. The banking industry used to have a reputation for honesty, trust and prudence.

This latest scandal, on top of the massive losses in credit markets, and the ongoing

incidence of mis-selling to retail customers, indicates that there is a systemic deficit in

ethical values within the banking industry." - Roger Steare ( Professor of

Organizational Ethics at Cass Business School in London)1

Introduction The French financial markets regulators were concerned that on January 24, 2008, Socit Gnrale, the second largest bank in France which was founded in 1864, announced that it had lost USD7.2billion due to unauthorized trades. The bank held Jrme Kerviel, a trader from the Delta One Desk team, of the Global Equities Derivatives Solutions (GEDS) department, in Socit Gnrale responsible for creating a fraudulent trading position that subsequently led to losses. Jrme Kerviel was allegedly involved in an illegal trading scheme amounting to 50 bn., which resulted in a loss of USD7.2billion at Socit Gnrale, the second largest bank in France.

1 Fiona Walsh, David Gow, "Socit Gnrale Uncovers 3.7 Billion Fraud by Rogue Trader,"

www.guardian.co.uk, January 24, 2008. 7

The background Created on May 4th, 1864 under the reign of Napoleon III, Socit Gnrale is one of the very first groups of financial services in the Euro zone with USD67.9 billion market capitalization as of December 31st, 2007. Socit Gnrale S.A. was the second largest French Bank and a major Financial Services company that has a substantial global presence. Its registered office is on Boulevard Haussmann in the 9th arrondissement of Paris, while its head office is in the Tours Socit Gnrale in the business district of La Dfense in the city of Nanterre, west of Paris. The three main divisions are Retail Banking & Specialized Financial Services (particularly in France and Eastern Europe), Corporate and Investment Banking (Derivatives, Structured Finance and Euro Capital Markets) and Global Investment Management & Services. Financial derivatives markets have grown significantly since the 1980s. These are largely unregulated instruments that seem to pass under the radar screens of those tasked with oversight of financial practices and markets. These rogue traders involved in working in the derivatives trading business have resulted in great losses to their banking establishments. Delta One trading desks are either part of the equity finance and/or derivatives divisions of most major investment banks. They generate most revenue through a variety of strategies related to the various delta one products as well as related activities, such as dividend trading, equity financing and equity index arbitrage. In theory such desks should be relatively low risk areas for the banks as the products are generally hedged but Delta One trading as been described as one of the hottest areas in banking and that it is the last domain of prop trading in the banking sector, where via market-making activities, traders can still get away with taking ample risks. Jrme Kerviel, who had graduated from the Universit Lumire in Lyon with a masters degree in finance, joined Socit Gnrale in 2000. He was initially employed at the compliance department and was subsequently promoted to the Banks 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. Jrme 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 Socit Gnrales 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 Jrme Kerviels positions. In November 2007 Eurex, the derivatives exchange, stressed that Jrme Kerviel Kerviels positions showed some irregularities. The Mission Green report stated that compliance and the traders managers were satisfied, without verification, with the traders explanations, in contradiction to Eurexs assertions. Jrme 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 USD7.2billion. An internal 8 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.

The operative mode of the fraud Jrme Kerviel had put together a first portfolio (A) composed of futures and representing the evolution of the European stock indexes 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. Socit Gnrale had established internal controls to manage these risks. The fraud committed by Jrme Kerviel has consisted of evading internal controls or making them inefficient. Jrme Kerviel had registered and then cancelled fictitious transactions in the second portfolio. The fictitious transactions were registered in Socit Gnrale 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.

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 Jrome Kerviel were insufficient and led to additional controls. On January 18th Jrome 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 Jrme 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 Jrome Kerviel. The large bank, mentioned in the e-mail, did not recognize these operations. Jrome 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 Jrme Kerviels trade was closed at 50bn. Socit Gnrale 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. Socit Gnrale began unwinding the rogue traders 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, Socit Gnrale asked for its shares to be suspended as the losses were announced to the world. On January 25, Jrme Kerviels 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. 9

The Role of Criminal and Financial Laws 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 Socit Gnrale 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 Socit Gnrale in Nanterre, the jurisdiction where Socit Gnrale 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 Jrme 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 Jrome Kerviel for attempt of swindle, but it was rejected by the judges. Socit Gnrale, the plaintiff, never declared that Jrome Kerviel had personal ambition in this affair. The prosecutor recognized that Jrme Kerviel had behaved like a financial drug addict as he bet wildly on stock markets and that Jrme 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. Jrme Kerviel could be fined and sentenced to 3 years in jail. Jrme Kerviel is facing: - Multiple charge of forgery, fictitious transactions and falsifying documents to justify his actions, - Hacking into the banks 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 Pariss Sant 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. Jrome Kerviel is, at the present time, the only person indicted in a significant way in the Socit Gnrale affair, Jrome Kerviels assistant, Thomas Mougnard, is also indicted but only for subordinate facts.

The accomplices Two people are suspected being Jrme Kerviels accomplices. Jrme Kerviels assistant, Thomas Mougnard, 24 years old, is suspected of having helped the rogue trader. He registered in the system the "provisions" which allowed Jrme 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 Socit Gnrale and specialized in the derivatives which Jrme Kerviel traded in has been interviewed by French financial police on suspicion of links to Jrme Kerviel. This link between the rogue trader and Moussa Bakir was discovered by the banks own internal investigators, who uncovered previously undetected 10 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 Jrme Kerviels unauthorized trading at Socit Gnrale. There is a strong presumption that many of Jrme Kerviels transactions on the European stock market passed via Fimat. Fimats offices were also searched as part of the investigation.

MANAGEMENT CONTROLS OR THE LACK OF SUCH CONTROLS This case raises important questions about oversight in the financial industry. Why did the system break down in the case of Socit Gnrale in 2008? Where were the checks and balances and the controls? What are the unique issues in banking with respect to the distinctions between front, intermediate, and back offices? There are established perspectives and guidelines with respect to separation of duties at the various levels as well as movement of employees from one area to another with the increased knowledge they would possess of the workings and controls within departments where they were formerly employed. Each time one of Kerviels trades raised an alert at SocGen, it appeared to be an isolated case because those various alerts were not consolidated across different products. There were no cumulative records kept of each traders alert history. Banks commonly force traders to take holiday breaks so that their portfolio can be monitored by other traders as a means to detect fraudulent trading activities. This was not enforced at Socit Gnrale as Kerviel convinced his superiors to allow him to wait to take his leave in January rather than December. Such simple practices as monitoring the vacation schedules of employees and enforcing rules that are already in place can significantly decrease the opportunities for frauds such as this. Socit Gnrale was able to survive its scandal in large part because it was a much stronger institution than some other banks . Additionally, many of its competitors suffered even greater losses from their exposure to mortgage backed securities backed by U.S. subprime loans. Jerome Kerviel has not yet paid a high price for his part in the greatest banking fraud in history. He did not flee the country or try to hide from police. He was charged with fraud, breach of IT controls, falsifying documents and breach of trust on January 28, 2008. These charges carry a maximum five year prison term and 375,000 in fines.

question :Discuss the role of risk taking culture in organizations that encourage such frauds.