JPMorgan Chase & Co. (JPM)’s claim that it found possible employee intent to misprice trades in a unit that lost $5.8 billion may put distance between management and any wrongdoers while providing a road map for U.S. investigators.
“E-mails, voice tapes and other documents, supplemented by interviews” were “suggestive of trader intent not to mark positions where they believed they could execute,” the bank said in a presentation July 13 as it reported net income fell 9 percent to $4.96 billion. “Traders may have been seeking to avoid showing full amount of losses,” the bank said, noting management had concerns about the integrity of the prices used. The bank didn’t provide evidence to support the allegations.
The U.S. Department of Justice and the Federal Bureau of Investigation in New York in May began a probe of the bank’s trading losses, a person familiar with the matter said. The Securities and Exchange Commission and the Commodity Futures Trading Commission, which regulates derivatives trading, are also examining New York-based JPMorgan’s trading activities, according to people familiar with those probes.
The largest U.S. bank by assets restated first-quarter results to reduce net income by $459 million after a review of the prices used in the unit. Yet multibillion-dollar losses and an internal report by the bank are just the beginning of any federal case, said Sam Buell, a former U.S. prosecutor in New York who worked on the Enron Corp. Task Force and is now a professor at Duke University School of Law.
“You can’t just say, ‘hey, this is bad, there are billions of dollars in losses, let’s prosecute someone,”’ Buell said. Eight weeks after Enron collapsed, the company’s board of directors produced a report about what transpired at the energy trader. Prosecutors, however, weren’t able to bring charges for two more years, he said.
JPMorgan’s statement “suggests they are trying to isolate this as a problem that occurred below the management level,” Buell said. Any attempt to reach beyond traders to management would be difficult for prosecutors, he said.
“In U.S. criminal law, we very rarely do hold people criminally responsible for failure to supervise,” he said. “You need to show not only outright knowledge but also willful blindness -- having a strong suspicion that there is wrongdoing and then taking steps to avoid it.”
Jennifer Zuccarelli, a spokeswoman for JPMorgan, declined to comment on whether the bank was suggesting traders had broken the law. JPMorgan didn’t name any employees involved in the potential mismarking of positions.
The discrepancy between prices used by the chief investment office and JPMorgan’s credit-swaps dealer, the biggest in the U.S., was first reported May 30. The trades in question, made by a Chief Investment Office group that included Bruno Iksil, nicknamed the London Whale because his positions grew so large, were on so-called tranches of credit-swap indexes, people familiar with the matter said at the time. All declined to be identified because they weren’t authorized to speak publicly.
Tranches allow investors to wager on varying degrees of risk among a pool of companies. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. Because JPMorgan had amassed such large positions, even a small change in how the prices were marked may have generated a big difference in the value of the trades, one of the people said.
Banks use internal or external groups to independently verify that prices used by traders to value their investments are accurate, and firms typically use one price for an asset that may be traded in different parts of the bank, according to Brad Hintz, a brokerage firm analyst with Sanford C. Bernstein & Co. in New York who is the former chief financial officer of Lehman Brothers Holdings Inc.
JPMorgan shut down synthetic trading in its CIO unit with the exception of an $11 billion short position in “basically liquid indexes” to hedge other credit assets, Chief Executive Officer Jamie Dimon said last week. Positions in Series 9 of the Markit CDX North America Investment Grade Index, a credit-swaps benchmark known as IG9 that’s at the heart of much of the loss, were cut by 70 percent, Dimon said.
The residual portfolio, largely in so-called tranches of indexes that wager on the degree to which companies will default together, was transferred to the investment bank, where they have “the expertise” to manage it, Dimon said.
The bank transferred about $30 billion of risk-weighted assets to the investment bank, an amount that is “down substantially” from the peak and back to levels at the end of 2011, he said.
The e-mails and voice recordings that JPMorgan claims to have would be particularly important to proving securities fraud, said Peter Henning, a professor at Wayne State University Law School in Detroit and a former enforcement attorney for the SEC between 1987 and 1991.
“That’s all very helpful to prosecutors,” he said. “It’s what the person had in their mind at the time. Their own words are the best way” to show intent, he said.
Henning agreed with Buell that JPMorgan is seeking to distance itself from the traders in the unit.
“This seems to point the finger at individuals in the bank who misled the bank,” he said.
JPMorgan restated in a regulatory filing its first-quarter net income to $4.92 billion, rather than the $5.38 billion previously reported. The CIO was responsible for trading losses that the bank estimated at $2 billion in May.
“Restatement is significant, too, because it says what we did is wrong because it’s no longer defensible, here’s what went wrong. We were lied to,” Henning said. “That was a way of mitigating Dimon’s comment about a ‘tempest in a teapot.’ It really was a tempest.”
Dimon dismissed initial reports about the loss as a “tempest in a teapot” when the bank reported first-quarter earnings on April 13. He reversed course less than four weeks later, disclosing a $2 billion loss that he said could grow to $3 billion or more during the quarter.
The release of the details last week may also be a way for JPMorgan to dissuade employees from fighting the bank as it seeks to take back salary and bonus payments to the traders and executives in the CIO unit, Henning said.
Ina Drew, the former head of the unit, will forfeit her pay and other managers were ousted following the bank’s internal inquiry. The bank accepted Drew’s offer to return about two years of compensation, the maximum clawback allowable under employment terms, said Joe Evangelisti, a company spokesman. Drew didn’t respond to a request for comment.
Other London-based managers of the CIO’s synthetic-credit bets left without severance and will be required to forfeit as much as two years of pay, including restricted stock and options, the bank said in a presentation.
“JPMorgan is sending a message,” Henning said. “You have much bigger issues to face than a clawback suit. The employees will certainly be looked at by the SEC and DOJ.”
John Moscow, a former prosecutor in the office of Manhattan District Attorney Robert Morgenthau, said the statement by the bank about “intent” was unusual.
“They are tripping over themselves to suggest the possibility the conduct may have been criminal,” Moscow, now with Baker Hostetler LLP in New York, said. “This is quite strong for a corporation that is not formally accusing its people of crimes.”
As for the speed of the federal investigation, it’s too soon to know how prosecutors will proceed, said Daniel Richman, a former U.S. prosecutor in New York who now teaches at Columbia Law School.
“Here you have an interested party making a not-so-veiled allegation of improper behavior by subordinates. It serves the bank’s interest to identify them as rogues,” he said. “While they in fact may be rogues, the most important thing for the government has to be sort out what’s in this report and the bank’s statements and determine for themselves what the facts were and what inferences of criminal intent can be made.”
To bring a criminal case, “the burden is heavy,” Richman said, and requires evidence someone knowingly and willfully intended to break the law.
“What is required is to look into the mind of the person who is being charged,” Richman said. “The fact that mistakes were made is certainly nowhere near enough for a crime or even civil fraud.”
Prosecutors can use a bank’s internal investigation as a tentative road-map, he said, but they will want to hear the traders’ side of the story if at all possible. And the government may also have to get access to people and information that the banks don’t have at this point, said Richman.
“There’s no way to make this happen fast,” said Buell. “Just because there is a report there is still a criminal investigation that must be done,” he said. “There’s this mosaic; it’s not a smoking gun. You can’t put all the pieces together until you gather up all the millions of pieces.”