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TWO: OUTCOME AND LESSONS LEARNED

Part Two of this case study reveals the outcome of the trial and its consequences, provides a prepared list of critical questions on page 487 to compare with those compiled by the reader at the end of Part One (Exhibit 23.6) and additional learning materials in the form of: (1) a list of the reference materials used to compile this case study, (2) Societe Generale's full-year 2006 and 2007 financial statements (Exhibits 23.7), and (3) a chronology of events leading up to, during, and after the period in which Kernel's unauthorized trading took place (Exhibit 23.8).

Societe Generale's 2006 and 2007 Summary Income Statement

Exhibit 23.7 Societe Generale's 2006 and 2007 Summary Income Statement

(Continued)

Exhibit 23.7 (Continued)

Exhibit 23.8 Chronology of Events

Date

Internal/

External

Description

1991

Internal

Daniel Bouton joined Societe Generale (SG) as EVP, after serving in a number of different positions in the French Finance Ministry, including that of Budget Director, from 1988 to 1991, Chief of Staff of Alain Juppe, Deputy Minister in charge of the budget from 1986 to 1988, in the Budget Department from 1977 to 1986, and in the Finance Inspectorate from 1973 to 1976.

1993

Internal

Bouton appointed CEO of SG Group.

Nov. 1997

Internal

Bouton appointed chairman and co-CEO of SG Group.

1999

External

SG's proposed friendly merger with Banque Paribas torn apart by hostile bid for both banks from BNP. SG escaped but Paribas succumbed, leaving SG's growth strategy in disarray.

1999

Internal

Jean-Pierre Mustier promoted from head of CIB equity options trading in SG's Corporate and Investment Banking (CIB) to head of fixed income, FX, commodities, and derivatives.

Aug. 2000

Internal

Jerome Kerviel (JK) hired to do modeling and process automation in CIB's middle office, aged 23.

July 2002

Internal

JK promoted to trader assistant in SG's Delta One equity derivatives product team, responsible for valuations, provisions, and risk analysis.

May 2003

Internal

Daniel Bouton appointed CEO of SG bank.

2003

Internal

Mustier promoted to head of CIB, beginning a period of aggressive and successful expansion in securities underwriting, derivatives, and proprietary trading. Over the next five years, CIB's glamor and earnings eroded SG's traditional control-oriented, retail banking culture.

March 2004

Internal

JK promoted to junior trader in Delta One Listed Products (DLP) team.

June 2005

External

A handful of U.S. investment banks set up short residential mortgages positions, even as their own and other banks' fixed income desks continue to source, warehouse, structure, and distribute subprime mortgages and MBSs.

July 2005

Internal

First unauthorized trades by JK, offset by fictitious trades with counterparties either SG subsidiaries, unidentified/pending, or third parties. JK's fictitious trades had deferred start dates, which did not require immediate confirmation.

Jan.-Dee. 2006

Internal

JK continued sporadic unauthorized trading, with insignificant gains or losses.

May 2006

External

First cutbacks and failures among U.S. subprime mortgage lenders; Merrill Lynch, unable to sell super-senior tranches of new subprime CDOs, set up a buy-and-hold trading desk. Some investment banks started producing CDOs designed to fail, so they could buy and profit from the investors' credit protection.

Aug. 2006

Internal

JK's unauthorized trading volume moved up a notch to €140 million (U.S.S179 million) in equity index futures.

Sep. 2006

External

U.S. residential housing construction index down 40 percent year-over-year. Some investment banks began reducing their securitization activities and limiting their exposures to U.S. residential mortgages.

Jan. 2007

Internal

JK's immediate CIB trading manager left SG and was not replaced until April by another CIB manager who had no prior experience of trading management and received no detailed direction on his responsibilities until November 2007.

Feb.2007

External

Trickle of losses and failures in U.S. subprime lending sector turned into a flood – Ownit, American Freedom Mortgage, Network USA, HSBC, Accredited, New Century, DR Horton, Countrywide.

Feb-March 2007

Internal

Anticipating a stock market crash, JK progressively built up unauthorized short equity index futures positions amounting to €5.5 billion (U.S.$7.3 billion), masking the directionality of these trades with fictitious offsetting trades.

April-June

2007

Internal

JK further increased his unauthorized short equity index futures positions amounting to €30 billion with a cumulative P&L of €2.2 billion (U.S.$3 billion). Between February and June, 39 instances of discrepancies in settlement details, accounting entries, and broker commissions were flagged by SG's controllers, but deflected by JK's trade amendments, cancellations, and explanations.

May 4, 2007

External

SG's stock hit its peak of €140.55 per share.

June 2007

External

Bear Stearns halted redemptions in two CDO hedge funds, which immediately become insolvent.

July 2007

External

Equity markets slumped.

July 2007

Internal

JK unwound substantially all of his short equity index futures positions in the last week of July, having erased all of his

losses.

Aug. 2007

External

Onset of credit crunch as traces of subprime MBSs in bank portfolios around the world set off a counterparty exposure panic that caused interbank and repo markets to freeze up. Investors everywhere started liquidating other assets in order to take refuge in U.S. Treasuries. The U.S. Federal Reserve made the first of many liquidity interventions, followed by the European Central Bank (ECB).

Sep. 2007

External

First month of negative U.S. job growth since August 2003.

Sep.-Nov.

2007

Internal

JK's remaining short equity index futures positions accumulated €750 million of profits before he unwound them in November 2007 when equity markets began to recover.

Oct. 2007

Internal

First effects of financial sector crisis on CIB revenues: €230 million write-down in SG's U.S. residential mortgage-related assets.

Oct. 24, 2007

External

Merrill Lynch announced Q3-07 loss of U.S.$5.5 billion, later revised to U.S.$8.4 billion.

Nov. 2007

Internal

JK built a €30 billion portfolio of unauthorized long equity futures positions matched by fictitious offsetting trades. An alert from Eurex about a large (€1.2 billion) purchase of equity index futures went unheeded.

Dec. 2007

Internal

JK liquidated his unauthorized portfolio of long equity futures positions, concealing the resulting €1.5 billion of profits in fictitious forward trades with an SG affiliate.

Dec. 2007

External

SG's market capitalization down 23 percent since June 2007 on fears that its exposure to U.S. subprime mortgages was much greater than disclosed.

Jan. 2-10, 2008

Internal

On January 2 JK switched his December 2007 fictitious forward counterparties from the SG subsidiary to a third party, unaware that the third-party counterparty he chose did not have a collateral agreement with SG, thus causing a huge CVaR exposure to show up in risk reports. Note: This issue did not occur in early 2007 when JK's unauthorized trades were losing money and SG's risk reports showed negative counterparty credit exposure to fictitious third parties. When the massive CVaR exposure was queried, JK canceled the fictitious forwards and instructed his (24-year-old) trading assistant to create a valuation provision of €1.485 billion to conceal the bulk of his 2007 gains, resulting in €15 million reported year-end trading profits versus actual trading profits of €1.5 billion.

Jan. 2-18, 2008

Internal

JK rebuilt a €49 billion portfolio of unauthorized long equity index futures positions with fictitious offsetting trades.

Jan. 14-17, 2008

Internal

The fictitious CVaR exposure disappeared from SG's daily counterparty credit risk reports but was still queried for 2007 year-end RWA and Cooke ratio reporting. JK met with SG's financial reporting group and explained that the counterparty he recorded for the forwards was incorrect and should have been a different third party (with a collateral agreement).

Jan. 15,2008

External

Global slump in equity markets triggered by fears that U.S. and international banks were more exposed to subprime mortgage losses than disclosed.

Jan. 18,2008

External

SG's stock dropped another 8.2 percent as Banque de France announced that SG and another major French bank would have to write down the valuation of their U.S. assets.

Jan. 18, 2008

Internal

SG's financial reporting group escalated their concerns about JK's unusual transactions and explanations to CIB senior management. Meanwhile, JK canceled the fictitious December 2007 forwards, reentered them with the replacement counterparty, and falsified a confirmation document from the replacement counterparty. JK's supervisors decided to call the replacement counterparty to verify the existence of JK's forwards.

Jan. 19, 2008

Internal

SG's replacement counterparty advised that the forwards recorded by JK did not exist.

Jan. 19, 2008

Internal

JK's current portfolio of unauthorized long equity index futures positions with fictitious offsetting trades was discovered, amounting to €49 billion, equivalent to 181 percent of SG's capital of €27 billion, and already €2 billion underwater.

Jan. 20, 2008

Internal

SG's chairman and CEO Daniel Bouton tendered his resignation, which was rejected by the board and SG's union leaders, who insisted that he stay to resolve the rogue trading problem.

Jan. 21, 2008

External

European equity markets suffered further heavy declines (-6 percent). Bouton received approval from SG's regulator, Autorite des Marches Financiers (AMF), to withhold disclosure of SG's unauthorized equity index portfolio for three days so that it could be liquidated without panicking already nervous equity markets.

Jan. 21-23, 2008

Internal

JK's €49 billion portfolio of unauthorized long equity index positions was liquidated, crystallizing losses of €6.4 billion.

Jan. 23, 2008

External

Bouton briefed France's President, Economy Minister, the ECB president, and chairman of the U.S. Federal Reserve on the origin and extent of SG's rogue trading losses.

Jan. 24, 2008

External

SG filed a civil lawsuit against JK for fraud.

Jan. 24, 2008

Internal

An investigation by SG's General Inspection Services (internal audit) was commissioned by the Executive Committee of the board to: (1) determine the exact nature and methods used by JK to conduct his unauthorized transactions, (2) verify the accuracy of the positions and subsequent losses, (3) investigate JK's motives and the role of any possible accomplices, (4) identify the cause of and responsibility for the internal control breakdowns, (5) verify the nonexistence of similar practices anywhere else in CIB.

Jan. 24,2008

External

Trading in SG's shares was temporarily

suspended as Bouton issued a public letter and newspaper interview describing the origin and extent of the losses and remedial actions being taken, including legal action against JK, separation of employees responsible for supervision and control of the department where JK's unauthorized trading occurred, and raising €5.5 billion of new capital.

Jan. 25,2008

External

Police raided JK's apartment and SG's offices to seize JK's computer records.

Jan. 26, 2008

External

JK voluntarily surrendered to the police and was held in custody.

Jan. 28,2008

External

JK was charged by the Paris prosecutor with forgery, abuse of trust, and illegal use of computers, and was released on bail.

Jan. 30,2008

Internal

Independent board committee formed to investigate JK's unauthorized trading. Operational review of the circumstances and control failings commissioned from PwC.

Feb. 21, 2008

Internal

SG announced a Q4-07 loss of €3.4 billion, due to JK's unauthorized trading and increased its December 2007 write-downs on U.S. residential mortgage-related exposures to €2.3 billion.

Feb. 21, 2008

Internal

Preliminary findings of investigation by SG's General Inspection Services (internal audit function) published.

Feb-March 2008

External

A steady stream of public sparring took place between senior SG, banking, and government officials regarding a possible takeover bid for SG and Bouton's responsibility for SG's rogue trading scandal.

March 16,2008

External

Bear Stearns rescued by JPMorgan Chase with U.S.$30 billion New York Fed backstop.

April 2008 May 13, 2008

Internal

Bouton resigned as CEO, but remained as SG chairman.

SG announced another €596 million write-down to its U.S. residential mortgage-related exposures and completion of its €5.5 billion new equity raising.

May 20, 2008

Internal

The investigation report by SG's General Inspection Services entitled "Mission Green" was presented to SG's board of directors. Key findings: (1) JK's unauthorized trading progressed through five stages – (i) intraday directional trades, (ii) overnight directional positions, (iii) disguising overnight directional positions with fictitious offsetting trades (947 instances), (iv) concealing gains from unauthorized directional positions with fictitious loss-making buy-sell trades (115 instances), and (v) concealing gains from unauthorized directional positions with valuation provisions (9 instances); (2) in 2007 JK built and liquidated two €30 billion unauthorized portfolios of equity index futures, concealed by fictitious offsetting trades, which generated net profits of €1.5 billion, and between January 2 and 18, 2008, he built a €49 billion portfolio of unauthorized equity index futures with fictitious offsetting trades, which was liquidated by the bank at a loss of €6.4 billion; (3) JK's 2007 incentive compensation would have been based on his reported 2007 trading P&L of €25 million, which resulted from €3 million in legitimate gains from his turbo warrant trading plus €22 million in gains generated by his unauthorized trades less €1.475 billion gains from his unauthorized trades concealed by his fictitious trades and provisions (Note: The seven valuation provisions and almost 15 percent of the fictitious trades were entered by JK's trading assistant); (4) the two factors that most contributed to SG's prolonged failure to detect JK's unauthorized and fictitious trading were: (i) ineffective trading management oversight represented by tolerance of intraday trading; disinterest in reconciling JK's profits, margin, and cash movements to his authorized trading activity; indifference to system and counterparty alerts; and, from April 2007, lack of trading oversight experience; and (ii) control procedures that were focused on reporting rather than investigating anomalies, were fragmented among different control groups, and had no triggers for deferred start dates, values, counterparties, trade modifications and cancellations, or mandatory vacation periods; (5) no other evidence was uncovered of similar fraudulent activities in SG's CIB.

Note: The report contained no attribution of responsibility to SG's Risk Management, whose role as a second line of defense in managing trading risk was not clearly specified in SG's policies or procedures.

May 21, 2008

Internal

PwC delivered its diagnostic review of SG's unauthorized trading losses and remedial action plan. PwC endorsed the GIS report's findings and added several more:

(1) There were no clear policies or procedures for escalation of queries; (2) trading oversight and control personnel were not trained or instructed to be alert for fraud; (3) trading oversight and control personnel were slow to respond to and lax in resolution of queries; (4) the rigor of DLP's front office oversight diminished as trading volume increased, allowing unauthorized activities such as day trading, P&L smoothing, and position transfers between traders to proliferate; and (5) trading oversight policy omitted to require monitoring of cash movements. PwC also endorsed SG's two-part action plan, consisting of a series of immediate fixes and longer-term structural changes, specifically: (1) immediate strengthening of GEDS's front office supervision across all equities, fixed income, derivatives, and commodities trading desks by means of heightened awareness of responsibilities, along with introduction and use of monitoring tools; (2) immediate strengthening of GEDS's middle and back office controls by means of remedying controls found to be missing or ineffective; (3) immediate strengthening of system access controls and IT security; (4) immediate strengthening of governance by specifying roles, responsibilities, and escalation protocols across all relevant positions; (5) a four-part transformation strategy to improve GEDS's control infrastructure, culture, and IT security, consisting of: (a) more control-sensitive operations processes; (b) creation of a cross-divisional operational surveillance program designed to identify and rectify anomalous situations and chronic conditions that could be symptomatic of or conducive to fraud;

(c) long-term IT security improvement plan; (d) professional ethics and accountability education program for traders and their support staff; and (6) formation of two committees tasked with ensuring implementation of these initiatives.

May 30, 2008

Internal

Mustier resigned as CIB head and voluntarily surrendered his bonuses for 2007 and 2008; however, he remained with SG.

June 20, 2008

External

The French Banking Commission (Comission Bancaire, CB) interviewed SG officers in the course of investigating JK's unauthorized trading.

July 2, 2008

External

JK switched legal counsel to a more aggressive firm.

July 4, 2008

External

The CB found that SG violated banking regulations by not having adequate financial controls, and imposed a fine of €4 million, close to its maximum allowable penalty. The CB's key observations were: (1) poor supervision,

(2) monitoring staff inattentive to fraud, (3) deficiencies in IT systems, and (4) inadequate limits and policies.

July 11,2008

External

IndyMac Bank placed into receivership.

Aug, 1, 2008

External

JK's trading assistant was indicted on a relatively minor charge of complicity.

Aug. 5, 2008

Internal

SG announced year-to-date losses and write-downs on exotic credit derivatives of €789 million.

Sep. 7, 2008

External

Fannie Mae and Freddie Mac placed into receivership.

Sep. 14-18, 2008

External

Merrill Lynch sold to Bank of America, Lehman Brothers filed for bankruptcy, AIG downgraded and rescued by New York Fed with a U.S.$85 billion borrowing line, money market mutual fund Reserve Primary Fund suffered such catastrophic losses on its asset-backed commercial paper holdings that its net asset value "broke the buck," and commercial paper market seized up.

Sep. 19-29, 2008

External

U.S.$700 billion "take-it-or-leave-it" Paulson rescue plan voted down by Congress, Washington Mutual seized by FDIC and its banking assets sold to JPMorgan Chase, Wachovia seized by FDIC, and sale of banking assets to Citigroup negotiated.

Sep.2008

Internal

Mustier appointed CEO of SG's investment management business with €350 billion assets under management.

Nov. 3, 2008

Internal

SG announced a further of €370 million of losses and write-downs on exotic credit derivatives and €754 million of write-downs on its U.S. residential mortgage monoline insurance, provided mainly by AIG.

Nov. 1-30, 2008

External

Fed provided emergency US$ liquidity to foreign banks (most notably Depfa and Dexia), negotiated Troubled Asset Relief Program (TARP) equity stakes in second wave of U.S. banks, rescued Citigroup with another U.S.$20 billion of capital on top of U.S.$25 billion already injected, pledged U.S.$600 billion to buy MBSs guaranteed by Fannie Mae and Freddie Mac.

Dec. 2008

External

U.S. economy officially declared in recession since December 2007.

Feb. 18,2009

Internal

SG announced its full-year 2008 results, which included €792 million losses and write-downs on exotic credit derivatives, €1.0 billion write-downs on its U.S. residential mortgage monoline insurance, and €1.2 billion losses and write-downs on its European asset-backed security (ABS) underwriting and distribution business. These losses were partially offset by €2.2 billion of mark-to-market gains on credit default swaps held for portfolio protection.

May 2009

Internal

Daniel Bouton ended his tenure as chairman of SG Group.

May 2009

External

France's economy declared officially in recession since Q3-08.

Aug. 2009

External

France's recession officially declared ended Q2-09.

Aug. 2009

Internal

Mustier resigned from SG Group.

2010

External

Regulatory and investor lawsuits emerged, aimed at deceptive residential mortgage securitization practices, flawed mortgage foreclosure practices, and misrepresentation of mortgage borrowers' creditworthiness.

May 2010

External

Publication of JK's memoir L'Engrenage: Memoires d'un Trader (The Spiral: Memories of a Trader).

June 8, 2010

External

JK's trial commenced.

Sep.2010

External

U.S. recession declared officially ended as of June 2009.

Oct. 5, 2010

External

JK was convicted of the charges, sentenced to five years in prison with two years suspended, and ordered (symbolically) to repay SG's €4.9 billion in losses. JK filed an appeal and remained free pending its hearing.

2011

External

Markets became anxious over EU banks' exposure to peripheral EU countries.

2012

External

U.S. banks able to repurchase TARP stakes with new stock

issuance.

Oct. 23, 2012

External

JK's appeal denied and his conviction upheld.

July 4, 2013

External

Paris employment tribunal denied JK's request to void his dismissal, levy a €4.9 billion fine on SG, and form an inquiry to question the justification of his conviction.

 
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