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Discovery, Damage Control, and Retribution

As soon as 2008's equity markets opened, Kerviel resumed his unauthorized directional trading, confident in his ability to keep calling market movements correctly and hiding his profits. Convinced that the European stock markets would extend their November rally into 2008, he began a series of unauthorized equity index futures purchases that reached a new peak of €49 billion on January 18, offsetting these positions with fictitious trades as before. However, unconnected to this even bolder move, his strategy was about to unravel because of an administrative, not operational, slip. In the first days of 2008, Kerviel changed the counterparty of the fictitious trades concealing his €1.5 billion 2007 profits from a Societe Generale affiliate to an unsuspecting third-party counterparty. During 2007, he had made this kind of change many times without tripping any alarms. On this occasion, however, the counterparty he selected did not have a collateral agreement in place with Societe Generale, which triggered a massive overage in the counterparty's credit value at risk (CVaR) limit.

Caught by surprise when queried by Societe Generale's group risk management department, which was responsible for monitoring counterparty exposures, Kerviel decided to cancel the fictitious trades and create a provision in order to keep his 2007 profits out of sight. Without any signs of concern over this incident, Kerviel calculated an amount for the provision that would leave €15 million of his undisclosed profits to be accounted for in DLP's 2007 yearbook-end trading results and assure him of a high ranking among DLP's traders. Seemingly in the clear again, Kerviel did not know that a second trip wire was about to end his long and eventful trading journey. The query that unraveled his strategy did not come from risk management or operations, but from financial reporting.

January 15 marked the first consolidation of Societe Generale's 2007 year- end financial reporting, which included regulatory capital. It also coincided with another slump in global equity prices, triggered by fears that U.S. and international banks were more exposed to subprime mortgage losses than previously disclosed. As Societe Generale's preliminary risk-weighted asset (RWA) numbers began to be checked, the massive counterparty exposure that had triggered risk management's CVaR inquiry showed up in the bank's RWA numbers. When queried, Kerviel explained that the trades had been canceled, but the financial reporting group was not satisfied with his explanation. A flurry of e-mails and phone calls took place over the next two days between financial reporting and the DLP middle office and back office, during which Kerviel insisted that the trades had been canceled but gave no satisfactory explanation. Finally, a meeting took place where Kerviel discovered that the outsize RWA number was the result of his fictitious counterparty not having a collateral agreement in place; he thereupon changed his explanation, claiming that the wrong counterparty had been entered for the forwards and identifying another counterparty as the correct one. The meeting ended with Kerviel promising to provide documentary evidence of the replacement counterparty's agreement to the trades.

However, the financial reporting team were skeptical of Kerviel's new explanation and decided to escalate the incident to GEDS's senior management, given the very large size of the transactions. The next day, Friday, January 18, Kerviel modified the trades and sent e-mails that appeared to confirm that the forwards had been agreed with the replacement counterparty. Still concerned, representatives of financial reporting, DLP operations, and GEDS's senior management met at the end of the day and decided to independently confirm the existence of the forwards with the replacement counterparty the next morning, which was Saturday, January 19. Meanwhile, the week's close of business brought more gloom to Societe Generale's stock price, which dropped another 8.2 percent as the French central bank announced that Societe Generale and another major French bank would have to further write down the valuation of their U.S. assets. On Saturday, January 19, within hours of the fictitious nature of his December 2007 trades being revealed by the counterparty's negative confirmation response, Kerviel divulged the full extent of his €49 billion directional equity index positions, which was immediately communicated to Societe Generale's executive management. A summary of the queries, conversations, and meetings that resulted in discovery of Kerviel's unauthorized trading is shown in Exhibit 23.5.

Sunday, January 20, began a series of four days of unthinkable consequences for Societe Generale. After being advised of the known facts and extent of Kerviel's unauthorized trading, Bouton notified Societe Generale's board and offered his resignation, which was declined and he was told to take charge of controlling the damage. The following day, Bouton obtained an unprecedented permission from France's Financial Markets Authority (Autorite des Marches Financiers, AMF) to secretly unwind Kerviel's directional equity index position over the next three days before making a public announcement about Societe Generale's unauthorized positions. As GEDS's traders set to work, no matter how discreetly they executed their sales, Societe Generale inevitably suffered heavy losses due to the size of its positions and the equity markets' bearish trend. By close of business on January 23, all of Societe Generale unauthorized equity index positions were gone and a €6.4 billion loss was recorded, equivalent to 13 percent of the notional value of the positions that Kerviel had created just weeks earlier. Recognizing the damage that such a huge loss could have on market confidence in Societe Generale's solvency, Bouton used the time before publicly announcing the losses to secure commitments to raise €5.5 billion of new capital. He also briefed the French, European, and U.S. monetary authorities ahead of the public announcement. On January 24, Bouton held a press conference and issued a letter to Societe Generale's clients briefly describing the incident and declaring it to be under control. The letter also stated that Societe Generale capital was to be replenished by the new equity issuance.

Exhibit 23.5 Sequence of Queries, Conversations, and Meetings Resulting in Discovery of Kerviel's Unauthorized Trading

Date

Parties Involved

Issue

Outcome

Jan. 8, 2008

• Societe Generale Risk

Management

• GEDS middle office

• Kerviel

Exposure (CVaR) over limit for fictitious counterparty

Issue closed – trades canceled by Kerviel.

Jan. 15, 2008

• CIB Regulatory

Reporting (CIB-RR)

• GEDS middle office

Very high RWA and Cooke ratio for fictitious counterparty

CIB-RR sought clarification of Kerviel's previous explanations and trade cancellations.

Jan. 16, 2008

• CIB Regulatory

Reporting

• GEDS middle office

• Kerviel

Correct financial reporting of very large trades, clarification of trader's explanations

Not convinced by further telephone explanations, CIB-RR scheduled meeting with Kerviel for January 17.

Jan. 17, 2008

• CIB Regulatory

Reporting

• GEDS middle office

• Kerviel

Correct financial reporting of very large trades, clarification of trader's explanations

Kerviel advised that the wrong counterparty was entered for the trades and would be corrected. CIB-RR requested supporting documentation.

Jan. 18, 2008

• CIB Regulatory

Reporting (CIB-RR)

• GEDS Trading

Management

(GEDS-TM)

• Kerviel

Trade cancellations, counterparty substitution, unconvincing trader explanations

CIB-RR briefed GEDS-TM, who spoke with Kerviel and received the same unsatisfactory explanations. Kerviel canceled and reentered the fictitious trades with the replacement counterparty and sent CIB-RR a falsified confirmation. CIB-RR and GEDS-TM met in the evening and decided to seek direct confirmation from the replacement counterparty.

Jan. 19, 2008

• CIB Regulatory

Reporting

• GEDS Trading

Management

(GEDS-TM)

• Kerviel

• Societe Generale

Executive

Management

Proof of fictitious transactions, discovery of unauthorized trading positions

Confronted by proof of his fictitious transactions, Kerviel revealed the nature and extent of his past and current unauthorized trading positions that were offset by fictitious trades.

Source: "Mission Green" report, General Inspection Services, Societe Generale.

In a subsequent interview he disclosed that Societe Generale would take a further €2 billion write-down in its U.S. residential mortgage exposures for 2007 year-end. Bouton's revelations were generally greeted by astonishment that a financial institution of Societe Generale's standing could have failed to prevent such egregious risk taking by a single individual.

In the following days, Societe Generale filed a civil lawsuit against Kerviel, and Paris's public prosecutor filed criminal charges against Kerviel. Societe Generale's board formed a special committee to investigate the incident, which commissioned an internal audit report and a diagnostic review of GEDS's internal control environment by Pricewaterhouse Coopers (PwC). The internal audit team's preliminary findings were published on February 21, its final report, and PwC's findings published on May 20. On April 17, Bouton relinquished his role as CEO but remained chairman for another year. On May 30, Mustier relinquished his position as global head of CIB. Several months later, Mustier was reassigned to head Societe Generale's investment management business, but resigned from Societe Generale a year later.

 
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