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French Disconnection — “Terrorist” Trader is Toast, Bank Relatively Unscathed Despite Risk-Taking Culture and Glaring Lack of Controls

By Edward Pekarek, Esq. and Bryn Fuller

Well before the failures of Bear Stearns and Lehman Brothers, and well after the collapse of Barings Bank and the scandals involving Allied Irish Banks (AIB) and Vienna-based BAWAG bank,[1] along with its imploded U.S. trading partner and co-conspirator, Refco,[2] financial markets were somehow surprised to learn billions in trading losses were realized by Société Générale (“Soc-Gen”), the result of proprietary trades made by the now 32-year-old Jérôme Kerviel, a bank trader who exposed Soc-Gen to €50B ($69B) in uncovered trading activity that inexplicably went undetected for years. Much like the original “Rogue Trader,” Barings’ Nick Leeson,[3] Mr. Kerviel was from a working class upbringing and learned how to conceal leveraged losses from supervisors using knowledge he gained as a former low level back-office employee. On October 5th, Mr. Kerviel was convicted by the Paris Criminal Court of computer fraud, forgery, and abuse of confidence.

Concealment by common tactics

In the early 1990s, Mr. Leeson plowed roughly £827M ($1.4B) in futures and options losses into account “88888,”[4] an administrative account the British bank established to hold errant trades off the books temporarily while the discrepancies were resolved. Wolfgang Flöttl, son of then CEO of the Austrian bank BAWAG, PSK, racked up more than a billion in off-shore currency trading losses, well after Leeson’s activities came to light, and the Austrian bank’s executives facilitated concealment of the losses through off-balance sheet transactions at the end of each reporting period in cooperation with the U.S. commodities broker, Refco. John Rusnak operated a trading desk from Allied Irish Banks’ Allfirst Bank subsidiary in Baltimore, Maryland, and hid close to $700M in currency gambling losses.[5] Like Leeson, Kerviel and BAWAG executives, Rusnak used a host of seemingly complicated schemes, that were in reality relatively simple, to hide his mounting losses; Rusnak falsified documents, committed office technology misuses, made fraudulent accounting system entries (e.g., fictitious securities positions that appeared to hedge his risk-taking and created “assets” on the Irish bank’s balance sheet to offset the very real losses incurred) and he intimidated office personnel to forestall the scandal from being unleashed.[6]

Leeson’s scheme unfolded in Singapore, Rusnak’s was an ocean away from AIB and Flöttl furtively traded currencies from his Bermuda getaway. Unlike the other recent “rogue trader” cases, Kerviel was trading in France, operating squarely under the noses of his supervisors.[7] In fact, the bank failed to heed 74 different alerts regarding Kerviel’s suspect trading activities,[8] and some of those warnings came directly from Eurex, the German derivatives exchange.[9] It seems the bank’s ambitious culture and pursuit of profits permitted Kerviel’s ruse to remain intact with only modest concealment efforts. In stark similarity, with a no questions asked approach, Leeson requested additional funding to continue trading and Barings executives provided multiple capital infusions for his Singapore Monetary Exchange (SIMEX) trading desk as his losses grew exponentially.[10]

Working Class Walter Mitty?

Mr. Leeson, the son of a plaster contractor, appears to have perceived himself as something of a working-class hero. He landed a back office position with a British bank, despite the lack of a college education, made a brief stop at Morgan Stanley and was then on to Barings where he resolved clearing issues for trades others made and in so doing, he learned how futures and options markets functioned.[11] Barings was the United Kingdom’s oldest investment bank, the esteemed centuries-old lender that had financed the Napoleonic Wars and the Louisiana Purchase, that counted the Queen of England among its aristocratic clientele.[12]

That someone so decidedly hoi palloi could be positioned to bring down the Queen’s bank seems to have pleased Mr. Leeson greatly.[13] He preferred to assign blame to his former supervisors, who, in his view, possessed “more blue blood than brains, and who failed to spot some clear signs of fraud.”[14] The Financial Times has reported that French society now views Kerviel “as a latter-day ‘Robin des Bois,’” an outsider who thumbed his nose heroically at an elitist Paris bank”; the UK Mail reported that he has become an “anti-establishment folk hero” and an internet sensation, although “both [Leeson and Kerviel] were eager to cross the financial tracks.”[15] However, a British newspaper has also reported that investigators located approximately $35M in bank accounts connected to Leeson, but his attorney denied the claims.[16]

The gash Flöttl cut into BAWAG’s balance sheet with his failed risk-taking was surreptitiously funded by the bank his father ran for decades. His losses were hidden for years with accounting chicanery undertaken in partnership with the largest commodities brokerage firm to ever seek bankruptcy protection.[17] Refco collapsed as the accounting scheme unraveled on both sides of the Atlantic. The commodities brokerage with a checkered past[18] initiated Chapter 11 proceedings less than three months after its Initial Public Offering,[19] the result of widespread looting by its CEO, Phillip Bennett and his lieutenants in conjunction with the accounting gimmickry used both by the brokerage and the bank, each to create the false impression of financial health.[20]

Bennett and a host of others were prosecuted in the U.S., including the brokerage president Tone Grant and outside counsel, a Mayer Brown partner, for their complicity in the scheme. Refco’s general counsel, “Sandy” Maggio, cooperated with federal investigators in order to avoid prosecution.[21] Almost a dozen BAWAG executives, board members and an auditor, as well as the junior Flöttl, were prosecuted in Vienna based on a 109-page indictment during the aftermath of the €1.4B ($1.9B) scheme.[22]

A key difference between BAWAG/Refco and the others is that Mr. Flöttl was the CEO’s son, married to a grand-daughter of former U.S. President Dwight D. Eisenhower and a well known Manhattan socialite.[23] His scheme was fueled by unmitigated avarice. When his “rogue trader” ruse had failed, after repeatedly receiving new capital from BAWAG, there were still people with the bank who were willing to further assist Flöttl by concealing the fraud. Those “crony” bankers faced criminal and civil consequences as a result. Unlike the BAWAG scandal, the other “rogue traders” discussed here acted alone and were not apparently motivated to the same extent as Flöttl by personal profit. It seems that other than Flöttl, each was in pursuit of social advancement and upper crust approval far more than any monetary gain, although each did garner executive-level salaries and bonuses as they continued their gambling, unfettered.

A History of Misconduct?

Mr. Kerviel was hired by Soc-Gen in 2000 to work in the back office, but was later promoted to a low-level trading position at the bank’s “Delta One” desk in 2005.[24] He was chastised in 2005 for conducting unauthorized dealings.[25] Despite the sanctions in his early days as a trader, the bank did not discover his ten figure misconduct until a week before the losses were realized in 2008. According to Daniel Bouton, Soc-Gen’s former Chairman, Mr. Kerviel’s fraudulent trades began sometime in 2007.[26] According to Soc-Gen, it “failed to spot the trading gain because Mr. Kerviel had masked it with a series of fictitious trades generating a virtual loss of €1.4 billion.”[27] The bank was able to determine that Mr. Kerviel was able to circumvent controls, just like Leeson, because of his “back office” work experience and he then placed huge leveraged wagers using futures while trading from the Pacific Rim on European stock indexes.

Similarly, Leeson was able to bury his mounting losses in a thinly veiled error account, while engaging in even more risky trading. Barings employed minimal checks on Leeson’s behavior, making him chief trader in their Singapore office and sporadically sending London employees over to monitor operations, whose idea of investigative quality control was apparently fraternal binge drinking.[28] It is not surprising that both Kerviel and Leeson’s gigantic losses were not isolated incidents.

Second Tier Spin

Much like Barings, Soc-Gen immediately distanced itself from the looming scandal by characterizing Mr. Kerviel in the Parisian press as a “terrorist” at worst, and a “rogue trader” at best.[29] France’s second-largest bank positioned itself publicly as a victim and distinguished Mr. Kerviel’s misconduct from the Soc-Gen image with its former CEO, Mr. Bouton, describing Mr. Kerviel as an “‘evil genius’ who managed to outwit the bank’s internal controls and computers in a dastardly fashion.”[30] Although the bank was required to pay the French regulatory banking authority a nominal fine for its sloppy supervisory systems, and has since undertaken various internal control system improvements, it seems the bank dodged any real accountability for the multi-billion trading disaster resulting from Mr. Kerviel’s heavily leveraged and unbalanced €50B trading book.[31]

Where a notable difference arises between Mr. Kerviel’s “rogue” trading and the other recent scandals is the nature of the institutions involved. Soc-Gen is a global money center bank with depth in its financial services exposure and expertise.[32] By contrast, AIB, Barings and BAWAG were all lower tier banking entities with little or no meaningful experience in trading currencies, derivatives and the like. In each such instance, the “rogue” was able to portray the activity as complex and profitable to executives who may have been embarrassed by their shallow knowledge of the securities traded to challenge the trader. According to the Financial Times, “Messrs Kerviel, Leeson and Rusnak all fooled senior executives by pretending to be doing something complex when they were really only punting.”[33]

Kerviel Sentenced, Soc-Gen Unscathed

In a decision issued by the Paris Criminal Court on October 5, 2010, Mr. Kerviel was convicted of all three charges he faced: (1) computer fraud; (2) forgery; and (3) abuse of confidence.[34] Soc-Gen was not named as a defendant and no fault whatsoever was attributed to the bank in the judgment. Instead, the court imposed a restitution penalty of €4.9B ($6.8B) on Mr. Kerviel for losses Soc-Gen realized as a result of his trades. The court sentenced him to five-years of imprisonment and barred him from working in the French financial industry for life.[35]

Besides the regulatory slap on the wrist received from the French regulatory banking authority, Soc-Gen has survived this debacle without much of a loss. French shareholders were not as fortunate as they were blocked from seeking a civil remedy from the bank in a class action suit in the United States, which dismissed the action due to the U.S. Supreme Court’s recent Morrison holding.[36] Additionally, Jacques Burhart, the head of Herbert Smith’s corporate group in Paris noted that Soc-Gen investors would have a difficult time recovering damages for their losses as a result of this affair because it would be hard to show a causal link between Kerviel and the fall in value of Soc-Gen shares.[37]

The allegations based in fraud brought against Mr. Kerviel hint at a possible extension of liability to Soc-Gen. However, the bank was not so much as mentioned in the judgment. At the very least, it seems conceivable that Soc-Gen could be held liable for negligent supervision, or perhaps exposed to prospective liability under a respondeat superior theory. The attorney for a dozen Soc-Gen shareholders stated that by absolving Soc-Gen of any blame, the Paris court’s award makes “the entire French judicial system look ridiculous.”[38]

Does Moral Hazard Mushroom if Soc-Gen is Without Blame?

It seems as though warning signs regarding Mr. Kerviel’s conduct were discoverable, and as discussed here, there have been a number of substantially similar “rogue trader” cases in the last two decades. However, the bank contends, and the court concurred, that Mr. Kerviel was an “evil mastermind” behind his ten figure bets and that in his incredible brilliance he was able to hide his wagers from the bank’s risk managers, auditors and other gatekeepers and altogether avoid detection while running a €50B ($69B) leveraged trading book.

Mr. Kerviel’s main defense at the criminal trial may have been somewhat ill-advised, specifically averring that his supervisors were aware of his behavior and actively encouraged rampant risk-taking in its corporate culture. However, the bank terminated several of Mr. Kerviel’s supervisors summarily in the scandal aftermath, and Mr. Bouton, Soc-Gen’s Chairman, resigned, but only after Bank of France Governor Christian Noyer criticized Soc-Gen's porous risk-control systems and French President Nicolas Sarkozy stated publicly that Mr. Bouton was not fit to continue leading the country’s second-largest bank.[39] Eventually Mr. Bouton acquiesced, and while he did not receive a severance package with his resignation, he does reportedly receive a roughly $1M annual pension.[40]

Although the absence of effective supervision should not be equated with a “tacit green light to engage in wild speculation;”[41] it is surprising that Soc-Gen evaded any blame for the trades. The French regulatory banking authority fined it a nominal $5.6M, when compared to the $7.2B in restitution that Mr. Kerviel was ordered to pay the bank. It seems the bank’s regulatory penalty and its self-initiated security upgrades, along with various increased risk management and other internal controls, none of which is tantamount to an acknowledgment of responsibility, was deemed sufficient to effectively exonerate the bank from criminal and perhaps civil liability.

The result also seems to have placated most critics of note, at least enough to allow Soc-Gen to escape any meaningful reputational consequences related to the Kerviel scandal. In fact, the bank expects to realize approximately €3B in net profits this year, roughly equivalent to the amount of largess it received from the French government in 2008 as the banking crisis unfolded.[42] The Paris-based bank also received roughly $4B in a U.S. bailout, which provided Soc-Gen with one hundred cents per dollar for arguably worthless Credit Default Swaps it purchased from AIG.[43]

One reporter noted that Soc-Gen “seems to have learned its lesson”[44] but it is unclear just what lesson if any was genuinely learned. Was it a “lesson” that is somehow different from those “learned” in the last two decades by AIB, Barings or BAWAG? Did Soc-Gen executives learn that prudent risk-management begins with the culture a corporation fosters or was it that massive spigots of government-funded aid would flow into the coffers of the biggest, most reckless risk-taking institutions, not as reward for folly, but rather because we lack any pragmatic answers about how to effectively deal with the too big to fail… or jail? Did Soc-Gen shareholders learn that moral hazard is an official global governing policy, provided there is at least one scapegoat to pillory? Or was it the lesson that sometimes elusive loss causation is a sine qua non that allows grossly derelict issuers to escape civil securities fraud liability? Or perhaps it is that the new era of a lack of extraterritoriality for the 1933 and 1934 Acts closes the door to U.S. federal courts for overseas investors.

One pundit recently characterized the French court’s decisions as being “among history’s most ludicrous white-collar crime rulings,” which is perhaps one of the more salient lessons of the Soc-Gen saga. Mr. Norris, writing for the New York Times in 1996 regarding Mr. Leeson’s autobiography, noted that ROGUE TRADER How I Brought Down Barings Bank and Shook the Financial World was “a dreary book, written by a young man very taken with himself, but it ought to be read by banking managers and auditors everywhere.”[45] It seems unlikely that many if any did, as the bubble inflates again and again and perhaps that is the real lesson, and tragedy, that what is past truly is prologue.

1 See Edward Pekarek, The BAWAG Banking Scandal: How Over a Billion in Concealed Currency Trading Losses Caught Up with an Austrian Bank Almost a Decade Later, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1145902 (last visited Oct. 13, 2010).
2 See Edward Pekarek, The Due Diligence Defense and the Refco IPO, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1145930 (last visited Oct. 13, 2010).
3 See Nick Leeson, ROGUE TRADER, Sphere Publishing (1997); see also Rogue Trader, Granada Film Productions (1999), more information available at http://www.imdb.com/title/tt0131566/ (last visited Oct. 15, 2010).
4 The number 8 in Chinese numerology is perceived by some as a source of luck. See http://www.chinesefortunecalendar.com/luckyNum.htm (last visited Oct. 12, 2010); see also, Peter Culshaw, ‘Why didn’t they learn the lessons?’ Peter Culshaw talks to Nick Leeson, the rogue trader whose exploits foreshadowed today’s string of banking scandals, DAILY TELEGRAPH, Jan. 9, 2009, available at 2009 WLNR 438321.
5 Sharon Burke, Currency Exchange Trading and Rogue Trader John Rusnak, Department of Mathematical Sciences, Villanova University, available at http://www.publications.villanova.edu/Concept/2004/John_Rusnak.pdf (last visited Oct. 12, 2010).
6 Id.
7 Jerome Kerviel, the world's biggest rogue trader, allowed to leave prison under heavy restrictions, UK MAIL, Mar. 18, 2008, available at http://www.dailymail.co.uk/news/article-538588/Jerome-Kerviel-worlds-biggest-rogue-trader-allowed-leave-prison-heavy-restrictions.html#ixzz12AnAWGvj (last visited Oct. 12, 2010).
8 Rick Mitchell, Société Générale Trader Convicted; Shareholders to Appeal Bank’s Exoneration, SECURITIES LAW DAILY, Oct. 7, 2010, available at http://news.bna.com/sdln/SDLNWB/split_display.adp?fedfid=17880257&vname=sldbulallissues&wsn=498558000&searchid=12618347&doctypeid=1&type=date&mode=doc&split=0&scm=SDLNWB&pg=0 (last visited Oct. 12, 2010).
9 David Gauthier-Villars, Carrick Mollenkamp & Alistair MacDonald, French Bank Rocked by Rogue Trader: Société Générale Blames $7.2 Billion in Losses On a Quient 31-Year-Old, WALL STREET JOURNAL, Jan. 25, 2008, available at http://online.wsj.com/article/SB120115814649013033.html.
10 Nick Leeson, Biography – In Brief, available at http://www.nickleeson.com/biography/index.html (last visited Oct. 12, 2010).
11 Id.
12 John Darnton, Inside Barings, a Clash of Two Banking Eras, N.Y. TIMES, Mar. 6, 1995, available at http://www.nytimes.com/1995/03/06/us/inside-barings-a-clash-of-two-banking-eras.html?pagewanted=3 (last visited Oct. 14, 2010).
13 Floyd Norris, Upper-Class Twits Made Me Do It, N.Y. TIMES, Mar. 31, 1996, available at http://query.nytimes.com/gst/fullpage.html?res=9C03EFDF1239F932A05750C0A960958260 (last visited Oct. 12, 2010).
14 Id.
15 John Grapper, Kerviel is a Symptom of a Banking Malaise, FIN. TIMES, Oct. 6, 2010, available at http://www.ft.com/cms/s/0/467121f4-d17a-11df-96d1-00144feabdc0.html (last visited Oct. 14, 2010).
16 Norris, supra, note 12.
17 See Pekarek, supra, notes 1 and 2.
18 See Pekarek, supra, note 2.
19 Refco filed for Chapter 11 bankruptcy in October 2005. See Pekarek, supra, note 2; see also Jonathan Stempel, Ex-Refco Directors Forfeit $39 mln Tied to Fraud, Reuters.COM, May 7, 2010, available at http://www.reuters.com/article/idUSN0721234120100507 (last visited Oct. 14, 2010).
20 Mayer Brown Others Sued for More Than $2 Billion in Refco Case, Law.com, Aug. 23, 2007, http://www.law.com/jsp/article.jsp?id=900005489402 (last visited Oct. 14, 2010).
21 First Amended Consolidated Class Action Compl., In re Refco, Inc. Secs. Litig., No. 05 Civ. 8626 (S.D.N.Y. 2006), available at 2006 WL 1627495.
22 Boris Groendahl, Trial begins Monday for suspects in Austrian bank scandal, N.Y. TIMES, July 13, 2007, available at http://www.nytimes.com/2007/07/13/business/worldbusiness/13iht-bawag.4.6652290.html (last visited Oct. 14, 2010).
23 See, e.g., The 500 People Who Most Impact the Hamptons (2007), available at http://www.danshamptons.com/list/2007/500/500_3.html (last visited Oct. 15, 2010); see also Carol Vogel, Auction Houses Are Set Back By Conviction In Price-Fixing, NY TIMES, Dec. 7, 2001, available at http://query.nytimes.com/gst/fullpage.html?res=940CEED9133CF934A35751C1A9679C8B63&sec=&spon=&pagewanted=2 (last visited Oct. 15, 2010).
24 Gauthier-Villars, supra, note 9.
25 Id.
26 Id.
27 Id.
28 Culshaw, supra, note 3.
29 Irene Frat, French Kissed: Tough Verdict for Kerviel, FUTURESMAG.COM, Oct. 6, 2010, available at http://www.futuresmag.com/News/2010/10/Pages/French-kissed-Tough-verdict-for-Kerviel-.aspx (last visited Oct. 12, 2010).
30 Grapper, supra, note 15.
31 Gauthier-Villars, supra, note 8.
32 See, e.g., Deidre Sullivan, Quotient Software Focuses on Back-Office Overload, 156 AM. BANKER 221 (Nov. 15, 1991), available at 1991 WLNR 1998249.
33 Grapper, supra, note 15.
34 Mitchell, supra, note 7.
35 Id.
36 See Mitchell, supra, note 8; see also Morrison v. National Australia Bank Ltd., No. 08–1191, ___ U.S. ___ (June 24, 2010), available at http://www.supremecourt.gov/opinions/09pdf/08-1191.pdf (last visited Oct. 12, 2010).
37 Scheherazade Daneshkhu, Kerviel’s Verdict to Cast Light on Soc-Gen, FINANCIAL TIMES, Oct. 3, 2010, available at http://www.ft.com/cms/s/0/d0150f20-cf1c-11df-9be2-00144feab49a.html (last visited Oct. 12, 2010).
38 Mitchell, supra, note 8.
39 World's biggest rogue trader, supra, note 7.
40 Greg Keller, Daniel Bouton, Societe Generale Chairman, to Resign Over Criticism, HUFFINGTON POST, Apr. 29, 2009, available at http://www.huffingtonpost.com/2009/04/29/daniel-bouton-societe-gen_n_192810.html (Oct. 12, 2010).
41 Id.
42 Daneshkhu, supra, note 35.
43 Press release, AIG Discloses Counterparties to CDS, GIA and Securities Lending Transactions, Mar. 15, 2009, available at
http://www.scribd.com/doc/13294757/AIGs-Biggest-Counterparties (last visited Oct. 12, 2010).
44 Daneshkhu, supra, note 35.
45 Norris, supra, note 13.

Mr. Pekarek is a Visiting Professor and Supervising Attorney at Pace Law School who serves as Assistant Clinic Director for the non-profit Pace Investor Rights Clinic of John Jay Legal Services, Inc.

Ms. Fuller is a third-year law student at Pace Law School and a student-intern for the non-profit Pace Investor Rights Clinic. She was a paralegal at the law firm of Milbank, Tweed, Hadley & McCloy LLP and participated in aspects of its representation of Official Committee of Unsecured Creditors during the administration of the Refco and Lehman Brothers bankruptcy estates.

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