Gary DeWaal and Associates LLC


Reflections on the JP Morgan's Settlements -- Human Nature, Internal Controls, and the CFTC's Broad New Anti-Manipulation Authority

Valuable Lessons Learned    My View    News Developments    Culture and Ethics    Between Bridges   
Published Date: September 20, 2013

On September 19, 2013, as widely reported in the media, JP Morgan consented to and was assessed fines by four international regulators totaling US $920 Million related to what has been colloquially referred to as the "London Whale" trades during 2012.These trades caused the Bank to suffer losses of US $6.2 Billion. The four regulators were the Financial Conduct Authority (FCA) in the UK (GB £137,610,000 (US $220 Million); the US Federal Reserve Bank (US $200 Million); the US Office of the Comptroller of the Currency (US $300 Million), and the US Securities and Exchange Commission (SEC; US $200 Million).

According to a Form 8-K filed by the Bank with the SEC on September 19, apparently three regulator investigations related to this matter continue, ones conducted by Massachusetts Securities Division, the US Commodity Futures Trading Commission (CFTC) and the US Department of Justice. The Bank has disclosed, in fact, that the CFTC has provided a so-called "Wells" notice to it notifying the Bank that the Commission staff intends to recommend an enforcement action related to the London Whale incident. JP Morgan has indicated that it will respond to the CFTC's notice in due course.

Previously, the US Attorney for the Southern District of NY filed criminal charges, and the Securities and Exchange Commission filed civil charges against two JP Morgan employees -- Julien Grout, and his supervisor, Javier Martin-Artajo — for over-valuing certain trading positions they initiated to hide the trading losses that are at the heart of the London Whale incident.

There is little I can add to the facts of this matter that already are set forth in detail in all the regulatory complaints, especially those of the FCA and SEC; JP Morgan's own study of this incident issued during January 2013; and the media reports.

However, the reported history of this matter, as well the apparent pendency of an action by the CFTC, makes me think of two things:

  1. no matter how good they are, all financial services firms remain vulnerable to individual employees doing bad things. Unless a firm's culture and infrastructure are sufficiently robust, these bad things can go undetected for a period of time causing big losses and profound regulatory expense (not to mention potential private litigation expenses and a loss of reputation harming business too); and

  2. new anti-manipulation authority given to the CFTC in 2010 as part of Dodd Frank is very broad, and the way the Commission has implemented this authority through rule adoption is broader still. Industry participants must carefully consider their proprietary trading activities where intent and proof of an artificial price may no longer be required for a successful CFTC manipulation prosecution.

Internal Controls

In the financial services industry, history has provided us with numerous examples of dishonest firms anchored by dishonest persons, including Charles Ponzi, Bernard Madoff, Allen Stanford, and Russell Wassendorf, Jr., among others.

However, there also have been many other examples where well-regarded financial services firms have been damaged profoundly by employees acting well outside their authority, including Societe Generale by Jerome Kerviel, Barings Bank by Nick Leeson and UBS by Kweku Adoboli, to name a few.

In these latter circumstances, an employee was typically able to obviate a required procedure by exploiting a manual process or other system weakness, and internal risk systems were either tricked or not designed well in the first place to identify the rogue activity. In some cases other normal checks and balances failed or had never been set up properly which delayed detection and understanding of the problem by senior management. And sometimes senior management was slow to react comprehensively even when it received information regarding the problematic activity. The results of all this were large losses and significant regulatory sanctions.

What's frustrating is that most everyone in senior management in the financial services industry understands the importance of maintaining a strong control environment that includes separating front office and support functions, and placing both within a robust internal control framework that helps detect problems promptly before they get out of hand. However, for one reason or another, typically pressures to increase revenue or decrease costs, or simple human fallibility or arrogance, these structures sprout weaknesses and are exploited.

As a result, the London Whale incident should remind us all again of the need for financial services firms to ensure that:

  1. front office and support functions are separated and are performed by different persons under different supervisors, who receive ongoing training regarding relevant company policies and procedures and applicable law.
  2. strong risk functions, including at least Credit and Market Risk, Internal Audit, Compliance, Legal, and Operational Risk, implement and regularly use robust surveillance tools to monitor for breaches of company policies and procedures and report promptly to independent managers (and where relevant, a Board Audit or equivalent committee) when there are potential issues, especially material ones; and
  3. a company culture is continually supported to encourage speaking out when employees perceive issues, and management acts promptly to address them.

Each of these matters must be supported by comprehensive and updated policies and procedures, regular training, and appropriate financial incentives, as well as empowering managers in support functions to have more equivalent status as top traders and producers.

CFTC Anti-manipulation Authority

When the Dodd Frank law was adopted in 2010, one provision (Section 753) made it unlawful for any person, directly or indirectly in connection with:

  1. a swap;
  2. cash commodity contract; or
  3. a regulated futures (or related options) contract,

to engage in any "manipulative or deceptive device or contrivance" in violation of any rule or regulation the CFTC was instructed to adopt related to this provision. Shortly afterwards the CFTC instituted two new rules prohibiting fraud-based manipulation that went into effect during August 2011.

One rule (CFTC Rule 180.1) prohibits any person from intentionally or recklessly engaging in deceptive or manipulative practices in connection with any of the enumerated products without regard to price or market effect. These practices include,

  1. using or attempting to use any device or artifice to defraud;
  2. making or attempting to make  any untrue statement of a material fact (or omit a material fact necessary to make a statement true or not misleading); or
  3. engaging or attempting to engage in any act that would operate as a fraud or deceit upon any person.

Even before the recent matter involving the London Whale, the CFTC signaled it would take a very broad view of the reach of this law and rule (i.e., "not technically and restrictively, but flexibly to effectuate its remedial purposes"), rejecting industry arguments that the proposed rule was vague and failed to provide market participants' sufficient notice regarding potentially prohibited conduct. The Commission stated that it considers reckless conduct, "as an act or omission that ‘departs so far from the standards of ordinary care that it is very difficult to believe the actor was not aware of what he or she was doing'."

The other rule (CFTC Rule 180.2) codifies more traditional tests regarding manipulation, including a finding of specific intent and non-bona fide prices. However, when adopting this rule, the CFTC indicated that artificial prices could, in certain circumstances, be "inescapably" presumed by the actions of the alleged manipulator not on analysis of the artificiality of the price itself. In such cases the artificial price would be "conclusively presumed." (The new Dodd Frank provision and this new rule were enacted in addition to provisions of law already existing prohibiting manipulative activity.)

Potential monetary penalties for manipulative conduct were also increased as a result of Dodd Frank.

Although it is premature to assess what might be the nature of a CFTC action against JP Morgan (if any), the FCA action against the Bank describes in a section entitled "Market Misconduct" (sections 4.71 - 4.77) certain specific trading by the Bank in February 2012 in a certain Credit Default Swap index that it suggests was done nefariously to help limit the damage of certain existing positions, as opposed to engaging in ordinary trading activities. It relies on this trading these to charge the Bank with violating Principle 5 of FCA's Principles of Businesses that require a firm to observe "proper" standards of market conduct.

Also this week, in an entirely unrelated factual matter, DRW Investments Ltd and its principal, Don Wilson, filed an action against the CFTC in Federal Court in Chicago seeking to prevent the agency from filing an enforcement action against them for unlawful manipulation related to certain orders they placed during January through August 2011. According to the complaint, the orders were bona fide orders that sought to take advantage of certain anomalies in the relevant interest rate swap futures contract cleared by the International Derivatives Clearing House. Apparently the CFTC may view those orders as manipulative conduct.

In either case, it is clear, that the CFTC now has multiple options to prosecute a manipulation claim, and one (CFTC Rule 180.1) permits the CFTC to prosecute persons with a significantly lesser standard of proof than traditional manipulation actions required.

Absent a court setting aside the new relevant provision of Dodd Frank and the new CFTC's anti-manipulation rules for vagueness, industry participants must be mindful not to engage in trading strategies that could after the fact be caught by the broad reach of these new provisions.

Conclusion

The JP Morgan London Whale incident is regrettably yet another example of internal controls breaking down in the financial services industry. Given the staggering fines and other consequences firms face in connection with rogue trading and other miscreant conduct, firms are encouraged regularly to review their internal control systems and company culture to ensure that material problems – which will never cease to exist because of the nature of humans -- are promptly identified and addressed. In connection with potential conduct that may be considered manipulative, this is especially the case given the CFTC's new expanded authority to prosecute manipulation without proving intent or an artificial price.

For questions or assistance, do not hesitate to contact Gary DeWaal and Associates at (212) 382-4615 or at http://www.garydewaalandassociates.com/request/

For more information see:

JP Morgan regulatory actions:

Board of Governors of the Federal Reserve System:
http://www.federalreserve.gov/newsevents/press/enforcement/enf20130919a.pdf
CFTC: Adoption of Rules 180.1 and 180.2:
http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-17549a.pdf
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/amaf_qa_final.pdf
Financial Conduct Authority:
http://www.fca.org.uk/static/documents/final-notices/jpmorgan-chase-bank.pdf
Office of the Comptroller of the Currency:
http://www.occ.gov/static/enforcement-actions/ea2013-140.pdf
Securities and Exchange Commission:
http://www.sec.gov/litigation/admin/2013/34-70458.pdf
JP Morgan Report on the London Whale:
http://files.shareholder.com/downloads/ONE/2628206174x0x628656/4cb574a0-0bf5-4728-9582-625e4519b5ab/Task_Force_Report.pdf
SEC Form 8-K filed September 19, 2013; access at:
http://investor.shareholder.com/jpmorganchase/sec.cfm?Doctype=

The DRW matter referred to in this article is:
DRW Investments LLC v. U.S. Commodity Futures Trading Commission, 13-cv-06630, U.S. District Court, Northern District of Illinois (Chicago)

The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of September 20, 2013, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.

 

 


© 2022 Gary DeWaal and Associates LLC | 1 (212) 382-4615 | 1180 Avenue of the Americas, Suite 809, New York, NY 10036