I need a Summary for the attached case.
C A S E
Mark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt
L EA R N ING OB JE C T IVE S
After completing and discussing this case you should be able to
[1]
[2]
[3]
Understand the importance of effective risk
assessment and risk management
Understand the difference between effective
design and operation of controls
Understand the importance of proper controls
and the potential magnitude of loss associated
with poor controls
[4]
[5]
Evaluate control deficiencies and consider how
the controls could have been improved
Understand the conditions necessary to commit
fraud
INTRODUCTION
On January 24, 2008, Société Générale, France’s second largest bank announced the largest trading
loss in history, a staggering 4.9 billion Euro ($7.2 billion U.S.), which it blamed on a single rogue
trader. The trader, Jérôme Kerviel, worked at what Société Générale considered a low-level, low-risk
trading desk. The announcement sent a shock wave through the global financial services community
and immediately triggered memories of a another rogue trader, Nick Leeson, who, 13 years earlier,
single-handedly bankrupted the 233-year old Barings Bank of London.
LESSON FROM THE PAST
Nick Leeson was seemingly infallible. In 1993, his already legendary trading prowess was responsible
for approximately 10% of Barings Bank’s bottom line. Barings Bank, headquartered in London, was
one of the world’s oldest and most respected banks. What the bank’s leadership did not realize was
that Leeson, stationed in Singapore, was trading outside of established company policies. Rather
than seeking gains via futures contract arbitrage (his assigned job), he was engaging in extremely
risky speculation without any offsetting hedge to protect against massive loss.
By early 1995 Leeson had lost $512 million. Rather than admit his mistakes, Leeson gambled
bank resources in a vain attempt to overcome the loss. Essentially, Leeson “doubled-down” by
betting big that Japan’s main stock index would not fall below 19,000. This seemed like a relatively
safe gamble as Japan had been rebounding off a thirty-month recession. However, on January 17,
1995, a devastating earthquake hit the city of Kobe, Japan. The tragedy caused the Japanese stock
index to tumble. When Leeson realized his gamble had failed, he attempted to move the market by
placing orders to sell 20,000 contracts, each worth approximately $180,000. Ultimately, Leeson’s
gambling cost the bank $1.3 billion.
In analyzing what went wrong, the bank discovered that Leeson had been hiding his massive
losses in a secret account. In the process, the bank identified serious control deficiencies that
allowed Leeson to make massive speculative trades and hide his losses. The most serious flaw was
The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and
Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. It is not intended to illustrate either effective or ineffective
handling of an administrative situation.
©
195
that Leeson was allowed to function both as Chief Trader and to settle his own trades; functions
that are typically segregated. This weakness in the design of controls at Barings proved fatal to the
storied bank. For his crimes, including taking unauthorized actions that he did not disclose to his
employer, Leeson served nearly 5 years in prison.
Many believed Leeson’s $1.3 billion debacle would be the last of its kind as banks learned
through Barings’ demise how important appropriate risk assessment and strong controls are to the
health of a bank. However, Jérôme Kerviel’s trading losses would dwarf Leeson’s.
BACKGROUND ON THE TRADER
Jérôme Kerviel, a 31-year-old low-level trader in Société Générale’s European equities arbitrage
unit, covered up unauthorized speculative trades that led to $7.2 billion loss. Kerviel claimed he
didn’t want to hurt the bank or embezzle funds; he was just out to enhance his reputation as a trader
and increase his bonuses.
Kerviel was assigned to the “Delta One” desk, comprised of traders who specialized in lowrisk, low-return trades. Kerviel’s job was to limit the bank’s risk by placing trading positions on
whether a stock market index would rise or fall. However, Kerviel was required to have offsetting
positions to limit the bank’s exposure. Such hedging requirements not only limit the potential loss
but also the potential gain from any single transaction; profits are generated through large volumes
of transactions. While Kerviel’s hedged positions would not completely offset, he was required to
keep his net exposure to under 500,000 Euros.
Kerviel earned $147,0000 a year, a far smaller amount than the millions earned by higherflying traders. Ironically, Kerviel was so low on the bank’s pecking order that many didn’t consider
him a trader at all. That perception motivated him, and in some ways may have allowed him, to pull
off the large-scale fraud. Kerviel confessed to police that he gambled in the markets and hid his
activities from superiors because he wanted to be a star trader.
Société Générale’s traders held little regard for the Delta One desk. For Mr. Kerviel, just
getting to Delta One had been an achievement. For his first five years at the bank he labored in
the back office, a place other traders derisively referred to as “the mine.” While toiling away in the
back office, Kerviel became expertly familiar with the bank’s trading operations as well as internal
controls and monitoring activities associated with trades.
Had Kerviel been one of the A-league traders in Société Générale’s most prestigious trading
area – the desks that handle complex equity derivatives – his actions likely would have drawn more
attention. But the Delta One desk on the seventh floor of the bank’s headquarters in western Paris
dealt with a “boring” corner of the equities market. “We all lived in fear that something within the
exotic products would blow up in our face. It never came to our mind that we might have a problem
with Delta One,” said a top Société Générale official.1
HOW HE CONCEALED FAKE TRADES
Kerviel was confident that he could make his mark if he were allowed to place bets on market
movements without being constrained by offsetting trading positions. However, Kerviel knew
he had to show offsetting trades in his book of business in order to make it look like he was
following his company’s guidelines. Kerviel decided to use his knowledge of the trading system
and related controls to enter fake trades into the system to offset his real trades. While the
bank’s risk management group did monitor the overall positions closely, it did not verify the
data Kerviel entered into the bank’s trading system, accepting his fake contracts at face value.
Kerviel’s superiors focused on his net trading positions to ensure he had appropriate offsetting
trades, but they had no mechanism to detect fictitious entries. For over 2 years, Kerviel built up
1
196
David Gauthier-Villars and Carrick Mollenkamp, “How Kerviel turned fake trades into real losses,” Wall Street Journal, January
28, 2008.
© 2015 Pearson Education, Inc.
massive exposures by placing unhedged real trades on stock index futures as well as buying options
and warrants on individual stocks. This went undiscovered because he was always able to balance
his books for the Delta One desk and never report a net large profit or loss (when his fictitious
trades were considered).
Kerviel knew that certain nightly system checks and reconciliations built into the trading
controls would check for particular features of trades that would likely reveal his fictitiousfictitious
trades. Because of his back-office experience, he knew when these reconciliations and other systems
checks took place. To elude the controls, he simply erased all of his fictitious trades just before
the system checks took place and then he re-created the fictitious positions immediately after the
checks to keep his trading positions in balance. Temporary imbalances did not trigger alerts within
the system. According to an internal probe on Kerviel’s fraud compiled by 40 bank employees with
oversight by PricewaterhouseCoopers (who was not Société Générale’s external auditor), he was
able to hide his losses and gains by entering pairs of fictitious transactions, one a purchase and the
other a sale, for equal amounts of equities but for different prices; thus creating a fictitious loss or
gain to cover his real losses and gains.2
Kerviel’s trading volume grew beyond what would normally be expected of a Delta One
trader. He knew that back-office controllers were organized into teams monitoring specific types of
financial instruments and that they would be sensitive to abnormally large volumes of trades running
through their balance sheets. Kerviel was careful to spread his trades, both real and fictitious, across
a range of different financial instruments. Thus, even when one of Kerviel’s trades did raise an alert,
it appeared as an isolated incident associated with only one type of financial instrument.
Kerviel also avoided detection by using forward instead of futures contracts. Futures
contracts are agreements to pay a certain price for a given commodity in the future. For example,
the trader could enter into a futures contract for oil at $130 a barrel in 3 months. If oil is trading for
more than $130 in 3 months, the trader has a gain; if the price is lower than $130, the trader has a
loss. Futures contracts are usually zeroed or balanced daily with cash flows to cover the difference
in prices. In contrast, forward contracts are only settled on the final day of the contract. Thus, by
using forward contracts, Kerviel ensured that no money exchanged hands until the settlement date.
To avoid having his fictitious contracts sent to actual institutions for approval, Kerviel “cancelled
fictitious trades before they gave rise to any confirmation, settlement or control. In order to do so,
he used features that left him time to cancel these trades and to replace them with new false trades.”3
When documentation was required to support a trade, Kerviel would fabricate support. For
example, Kerviel confessed that “I fabricated fake mail using a feature in our in-house messaging
system, a function which allows you to reuse the electronic letterhead I had received and change
the body of the text,” he said.4 Kerviel also told investigators that he frequently used logins and
passwords of colleagues.
Kerviel’s tactics to enter into large speculative bets on market movements, without an
offsetting position, initially paid off handsomely. Questions from securities regulators in late 2007
made him nervous and Kerviel closed all his positions and locked in an actual gain of 1.6 billion
Euros ($2.35 billion U.S.). Quite an amazing feat for someone at the Delta One desk! However, he
was frustrated because he was not able to report the full gain without revealing his unauthorized
activities, and he felt his superiors did not recognize and appreciate his trading skill and success. Just
a few short weeks later, Kerviel’s strategy would lead to the largest trading loss in history.
2
3
4
Société Générale General Inspection Department, “Report Part 3,” May 20, 2008.
Ibid.
David Gauthier-Villars and Stacy Meichtry, “Kerviel felt out of his league,” Wall Street Journal, January 31, 2008.
© 2015 Pearson Education, Inc.
197
CONTROLS AND ALERTS
Perhaps the first clear warning of Kerviel’s activities came in late 2006 or early 2007, when Kerviel
made a 500,000 Euro profit on a one-way bet. Kerviel’s role on the Delta trading desk did not allow
him to speculate with the bank’s money, and he was reprimanded by his bosses, who said his profit
would not be included in his year-end bonus calculation. This incident alone should have been
sufficient grounds to fire Mr. Kerviel. However, French banking experts have indicated that this
reaction to inappropriate behavior was consistent with a culture of risk taking at Société Générale.
It wasn’t uncommon for traders to be rewarded for making a profit on risky investments with the
bank’s money, even if they had exceeded their trading limits in doing so.
Another warning sign came in November 2007, when the surveillance office at Eurex,
the derivatives exchange, sent two email messages to Société Générale’s compliance department
questioning large positions held by Kerviel that were entered into after regular trading hours. In
the same correspondence, Eurex asked what Kerviel’s trading strategy was. This inquiry led to
questions directed to Kerviel and Delta One supervisors. Société Générale responded on November
20 indicating no irregularities and that volatility in the U.S. and European stock markets explained
the need for afterhours trading. Eurex was not satisfied and requested more information. Société
Générale responded on December 10, and Eurex considered the second response adequate.
Société Générale’s system of controls was designed to alert compliance officers of unusual
or unexpected trades and Kerviel’s fictitious trades clearly should have triggered alarms. In fact,
a subsequent internal probe indicated there were at least 75 alerts between June 2006 and the
beginning of 2008 that should have led to the investigation of Kerviel’s unauthorized trading activity.
Some of the unusual or unexpected aspects of Kerviel’s trades that triggered alerts included:
A trade with a maturity date that fell on a Saturday
Trades without identified counterparties
Trades with counterparties within Société Générale itself
Trades that exceeded the limits of counterparties
Broker names missing or listed as “pending”
Large increases in broker fees.
“Several times, Mr. Kerviel’s supervisors spotted mistakes in the trader’s books. But Mr.
Kerviel would claim it was a mistake and fix it,” said Jean-Pierre Mustier, head of Société Générale’s
investment banking arm. “Société Générale got caught just like someone who would have installed
a highly sophisticated alarm… and gets robbed because he forgot to shut the window,” said the
Société Générale manager.5
The internal investigation found that Kerviel increased the size of his fraudulent positions in
January 2007 after the resignation of his direct manager. The manager was not immediately replaced
and for two-and-a-half months there was little effective control over the desk. When a replacement
manager was hired, he did not carry out any detailed analyses of trader’s earnings or positions
thereby failing to fulfill one of the main tasks expected from a trading manager. Kerviel’s exposure
continued to grow.
According to the internal inspection report, throughout the period when Kerviel was
concealing fake trades, there was an absence of certain controls that might have identified the
fraud. However, even when the bank’s controls did properly identify fraud-risk factors, compliance
inspectors often conducted only routine reviews and “did not systematically carry out more detailed
checks” to validate Kerviel’s assertions, even when they lacked plausibility. In early 2008 when
compliance inspectors did ask for additional information regarding a Kerviel trade, Kerviel’s response
was accepted and the inspector later apologized to Kerviel for his excessive zeal in investigating the
trade. Insiders have described the relation between traders and back-office staff as difficult or even
5
198
David Gauthier-Villars and Carrick Mollenkamp, “The Loss Where No One Looked; How Low-Level Trader Cost Société
Générale,” Wall Street Journal, January 28, 2008.
© 2015 Pearson Education, Inc.
antagonistic. The bank’s inspectors only received vague answers from traders or their supervisors.
As one bank employee explained, “the name of the game is to say as little as possible to the [internal]
inspectors.”6
The internal report indicated that back-office staff did not inform supervisors when they
noticed irregularities in Kerviel’s transactions, even when the trades involved abnormally high
amounts, “because this was not specifically part of their job description.”7 When managers were
alerted of seemingly suspicious behavior, the report indicated that, in some cases, they simply did
not react.
One of the key failings was that bank controllers were instructed to monitor only the net,
rather than the gross, risk exposures of the Delta One traders’ activities. Furthermore, the controllers
relied on the balances recorded in Kerviel’s books.
For more than two years, Kerviel used his knowledge of the control procedures to hide his
speculative bets with roughly equal fictitious trades supported by forged documents and e-mails.
Transcripts of email conversations between Kerviel and another trader, Moussa Bakir, reveal
that Kerviel was well aware of the gravity of his actions. After being questioned by Société Générale
compliance inspectors about Eurex’s concerns, Kerviel indicated he was so nervous he had trouble
sleeping and eating. Bakir wrote, “You absolutely must take a vacation.”
“In jail,” Kerviel replied.
Later, Kerviel bragged to Bakir about his trades. “This will show the power of Kerviel,” he wrote.
Bakir relied, “Or his irresponsibility…a simple and discreet boy. Unassuming. Who makes a pile of
dough. And not recognized for his true value.”
On January 17, the day compliance officers began asking questions, Kerviel felt the noose tightening
and he wrote to Bakir, “I’m dead in the water.”
Later that same day, Bakir replied, “Good luck pal.”
“This pal is dead,” Kerviel wrote.8
DISCOVERY OF THE FRAUD
Mr. Citerne, Société Générale’s co-chief executive described how Kerviel was caught: “He changed
a tactic he had been using to conceal his trades and taking a position that prompted a possible
margin call (or demand for funds). That triggered some alerts.”9 At about the same time the bank’s
controls flagged a trading partner whose account showed abnormally high levels. When asked about
it, the partner denied knowing anything. Further investigation led to Kerviel.
The bank soon learned of the fictitious contracts and that Kerviel had secretly exposed the
bank to $73.5 billion in speculative one-sided positions—more than the total market value of the
bank. Over a three-day period, the bank closed these positions, resulting in a $7.2 billion loss.
Kerviel is accused of stealing computer passwords, sending fake e-mail messages, and
illegally accessing the bank’s computer system to exceed trading limits and cover up his actions. He
bought futures contracts but ignored requirements to offset them with countervailing buys.
6
7
8
9
Nicola Clark, “More questions for bank chief; Société Générale leader to face lawmakers,” The International Herald Tribune,
April 9, 2008.
David Gauthier-Villars, “Société Générale Details Lapses; Probe Says Staff Entrusted to Verify Kerviel’s Trades Failed to Dig
Deep Enough,” Wall Street Journal, February 21, 2008.
Katrin Bennhold, “Transcript Reveals Details of French Trader’s Actions,” The New York Times, February 10, 2008.
David Gauthier-Villars, “French Bank Rocked by Rogue Trader,” Wall Street Journal, January 25, 2008.
© 2015 Pearson Education, Inc.
199
AFTERMATH
Société Générale recognized the massive losses resulting from the fraud in fiscal year 2007. Chief
executive officer Daniel Bouton resigned in the wake of the trading fraud. The governor of the Bank
of France has said that central bank officials warned Société Générale before the trading scandal
that its back offices were insufficiently staffed. Unlike peer banks, Société Générale was not shy
about taking proprietary trading risks (i.e., trading with bank’s money rather than just facilitating
customer trades) and such trades represented a large percentage of the bank’s revenue. Experts
believe the business grew faster than risk management could cope.
Société Générale announced in April 2008 that it expected to spend as much as 100 million
Euros in 2008 to improve the bank’s risk-management systems. However, the bank cautioned that
the additional investment could never fully guarantee against frauds. Société Générale said that riskcontrol employees represent 62 percent of its investment banking division; up from 55 percent in
2002 and that it is tightening controls after the trading scandal.10 Société Générale has also set up
a dedicated internal fraud investigation group of around 20 people that will be independent of the
front- and back-office operations.
Kerviel told police that his supervisors in the Delta One office were aware that he had
overreached his trading limits. He said he was told to “straighten it out.”11 Kerviel said he believes
his supervisors knew about his fictitious trades, but as long as he was making money, they didn’t
care. He said, “I cannot believe that my superiors did not realize the amount I was risking. It is
impossible to generate such profit with small positions. That’s what leads me to say that while I was
in the black, my supervisors closed their eyes on the methods I was using and the volumes I was
trading.”12
At a trading conference in London in April 2008, Nick Leeson said, “There’s not enough
investment that goes into control functions. A lot of money is still targeted at the front office where
the actual money is made and that creates dangerous imbalances.” Leeson, in comparing his trading
activities to Kerviel’s, indicated that much of the blame should go to poor systems and controls. He
went on to say that, “There was also a lack of understanding in the organization of what I was doing
so there was no one around to challenge me. That was similar to Jérôme Kerviel.”13
While waiting trail, Kerviel took a job at a suburban computer company, and in a media
campaign he depicted himself as a regular guy from a modest background. In 2010 a French judge
found Kerviel guilty of breach of trust, forgery, and unauthorized computer use. He was sentenced
to 3 years in prison and ordered to pay restitution of 4.9 billion euros to the Société Générale. A
spokeswoman for the bank said the damage award was “symbolic” and the bank did not expect it
would be collected.14 Kerviel appealed the decision and in March of 2014, France’s highest court upheld
the prison sentence, but ruled that Kerviel would not have to pay the 4.9 billion euros. The court
reasoned that the bank had also committed faults in overseeing Kerviel and was partly responsible
for the losses, so Kerviel should not be held solely responsible for the full amount of the loss.15
Nicola Clark, “Société Générale tightens controls after trading scandal,” International Herald Tribune. Paris: April 10, 2008.
Nicola Clark, “French Trader’s Bets Said to Have Set Off Alarms,” The New York Times, February 15, 2008.
David Gauthier-Villars and Stacy Meichtry, “Kerviel felt out of his league,” Wall Street Journal, January 31, 2008.
Nicola Clark, “More questions for bank chief; Société Générale leader to face lawmakers,” The International Herald Tribune,
April 9, 2008.
14 Nicola Clark, “Rogue Trader at Société Générale Gets 3 Years,” The New York Times, October 5, 2010.
15 “French court upholds rogue trader Jérôme Kerviel’s prison sentence”. The Guardian. 19 March 2014.
10
11
12
13
200
© 2015 Pearson Education, Inc.
R EQ U I R E D
[1]
The term “tone at the top” is typically associated with a firm’s control environment. How would
you characterize Société Générale’s tone at the top and what effect do you believe that had on
oversight at the trading-desk level?
[2]
Using auditing standards or your textbook, define the following control-related terms:
[a] Control environment
[b] Segregation of duties
[c] Restricted access
[d] Preventative and detective controls
[e] Design and operating effectiveness
[3]
In an independent audit of the financial statements of a large bank, why do auditors typically
follow a controls reliance strategy (i.e., obtaining some audit assurance via controls testing)?
In the case of Société Générale, do you believe the external auditors gathered much controlsrelated evidence regarding the Delta One trading desk? Why or why not?
[4]
Fraud research indicates three conditions must exist before a fraud occurs: Pressure/Incentive,
Rationalization, and Opportunity.
[a]
[b]
What do you think were Jérôme Kerviel’s incentives and rationalizations for committing
fraud?
What created the opportunity for fraud?
[5]
What do you believe were the three most serious control deficiencies at Société Générale? For
each deficiency listed, indicate whether the deficiency related to poor design or poor operating
effectiveness. Describe how you would remediate or fix each of the deficiencies listed.
[6]
What are the advantages and disadvantages of promoting personnel across functional areas
within a company (e.g., from risk and controls to operations)?
[7]
The loss from Kerviel’s rogue trading resulted in a loss many times greater than audit materiality.
The external auditor did not discover the misstatement. Was this an audit failure? Conduct
internet research to determine if the external auditors, Ernst & Young Audit and Deloitte &
Associés, were named in law suits associated with the loss due to the trading fraud.
© 2015 Pearson Education, Inc.
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