Re:Balance -- Jim Peterson

Société Générale’s 2007 Annual Report – Jérôme Kerviel Is So Last Year

The recurring claim of French exceptionalism got a big boost early this month – at a price. Société Générale asserted that the only fair way to report its loss of € 4.9 billion, inflicted in January by junior trader Jérôme Kerviel, was as an event occurring in 2007.

Deep down in footnote 40 of SocGen’s massive annual report – to get the English version -- here – ou bien la VO Française ici – the bank discloses that Kerviel was in a net positive position of € 1.471 billion as of the end of 2007. His blow-up came on January 18, and the unwinding losses in the following days came to an eventual € 6.382 billion.

Over-riding the compelling guidance of the International Accounting Standards Board, that would book the effects of Kerviel’s mischief as they fell, would be rare enough under the UK’s high-level “true and fair view” rubric, much less under the American guidance of “present fairly in accordance with generally accepted accounting principles.”

But that didn’t stop the French bank – supported by its national banking and securities market supervisors, as well as the two Big Four accounting firms -- Ernst & Young and Deloitte & Touche -- who share responsibility for its audit.

There is at least behavioral history on the French side: for years the European practice of booking the effect of deliberate errors in the year of discovery rather than in the year of perpetration has avoided the litigation hazard of the American requirement to re-state erroneous financial statements for prior years.

And on the recent and highly political side, the French have been vocal and steadfast in resisting the international standard for marking financial derivatives to market – the infamous IAS 39 – arguing the difficulty of valuation models other than historical cost but also conveniently retaining the flexibility of corporate management to time their recording of results to suit their discretion.

SocGen’s tone-deaf approach starts with its footnote description of Kerviel’s trading “plain vanilla” financial instruments – a colloquialism lacking both a usable French translation and a common understanding in the industry. Nor is there any positive spin to the term, since the more ordinary Kerviel’s scope and job description, presumably the more effective SocGen’s oversight and control of his desk should have been.

As I am told by the technical accountancy wonks, SocGen may – just barely – have a straight-faced justification, that its year-end balance sheet should reflect the € 4.9 billion body blow that struck only three weeks later.

Fair enough, on a casual first glance. But the argument for evading a well-known body of international standards, under an exception so obscure and elastic that prior examples are virtually unknown, fails on three grounds – technical, strategic and political.

First, on the technical side. Moving around Kerviel’s impact cannot lessen its prominence or significance. As a post-closing event it is comprehensively discussed for three pages in the SocGen report. A pro forma balance sheet presentation right there would do as much for disclosure as the roll-back could.   

Even if it can be done, in other words, doesn’t mean that it should be.

Strategically, then, what’s the point? The known facts are so notorious that no one will be diverted or misled. Whether CEO Daniel Bouton survives – whether the bank itself survives – or how much the bank will ultimately pay out to the shareholders who are now at the courthouses with claims that the bank was running a “culture of risk” – none of these will be affected by the choice of years. So if SocGen can achieve no good for itself, what constructive purpose could there be in adopting a lightning-rod position?

And politically, the bank has succeeded only in setting back the global arguments for international accounting convergence, harmonization and improvement. If a “fair reporting” excuse can be made for Kerviel, there is no intellectually defensible line-drawing guidance by which investors can anticipate where the next similar exception will be invoked.

The size of the event can’t be a factor. A knock of € 4.9 billion is big, to be sure, but consistency in the reporting of small things is of little use if it’s the really worrisome big problems that qualify for revision and exception.

And with a French tradition to favor management’s opportunity to manage the timing of bad news, agreed by the supporting players, predictability of reporting at the global level is out the window.

So vive la difference – but let it be kept to matters of local impact only. 

Societe Generale -- Of Internal Controls and Risk Management

Published in the IHT on February 1, 2008 (here)

SocGen: When Risk Management Fell Asleep at the Switch

Since the first story is seldom the whole story, it will take time and police work to get to the bottom of the €4.82 billion euros in financial trading losses racked up by the French bank Société Générale in unwinding unauthorized positions taken by a trader, Jérôme Kerviel.

Will Kerviel emerge as an evil genius disguised as a 30-something slacker? The ring leader of a clever gang of financial scamsters? Or, more likely, an average-to-dull employee who exploited the weaknesses of his employer's systems and the credulity of his overseers?

The answer to the question "How did he do it?" appears routine enough. Kerviel's exploits seem not very different from those of the wrong-way traders who have popped up like mushrooms in the back offices of trading institutions from Barings to Sumitomo to Allied Irish Bank to Penn Square.

The scenario is almost always the same: An early burst of irregular but winning trades, motivated by bonus envy or simple testosterone, later spirals the wrong way - briefly matched by a daisy chain of falsified counterdeals and an accelerating but ultimately futile concealment of old losses covered by new ones.

The more demanding question - "How did he get away with it?" - will become answerable only through SocGen's accountability to investigators; to President Nicolas Sarkozy of France, who is not amused; and to its shareholders.

Outside auditors have been summoned. But since there is no forensic process so banal as the after-the-fact sweeping of the dust off the wrong-doer's trail, the interesting question they will likely not address is this: "Where were the curious, persistent and demanding managers ahead of the wreck?"

It's too early to tell, but enough is knowable to suggest that a relative of Inspector Clouseau was seconded to the risk management and compliance function of the hapless bank.

My first and best mentor in the scrutiny of financial fraud made a point of extending his inquiry beyond the immediate problem. Called to investigate an irregularity in one corporate corner, he would search for other possible outbreaks. Instead of assuming a system to be foolproof, he would speculate about ways to stress-test it for vulnerabilities.

He had a first principle: Any system of recording and reporting transactions is suspect. As a product of human design and operation, it is vulnerable not only to simple error but also to deliberate subversion.
In the SocGen situation there are some basic risk management tools, implicated by Kerviel's apparent mode of operating.

First is the vacation rule: Everyone who processes transactions should be taken off his desk at intervals, so that a chain of successive falsifications, if one exists, can be discovered and broken. This has been an article of faith since long before it became the centerpiece of a landmark 1976 U.S. Supreme Court decision in the Hochfelder case. That case dealt with the right to sue under the securities laws, but it started as a dispute over the application of a simple tool in internal control: the realization that an employee who never takes a vacation may be hiding something.

A low-level French employee who declines to take his vacation entitlement is already an extraordinary anomaly, enough that Kerviel's superiors should have gone on immediate and full alert. As Kerviel himself acknowledged to French police investigators, "It's one of the elementary rules of internal control. A trader who doesn't take any days off is a trader who doesn't want to leave his book to another."

A second risk management premise is that you don't net positions before quantifying risk. The exposure in a portfolio with €50 billion euros of puts and €49 billion of calls is emphatically not limited to €1 billion. At least since the Continental Vending case in the 1960s, where criminality was charged over the improper offset of accounts receivable against payables before setting a reserve, "netting" has been recognized as a recipe for concealed disaster.

Especially in a trading environment, combining the ostensible effects of "buys" and "sells" subverts the very essence of safeguarding against the possibility that one leg or the other might somehow go wrong - or even, as here, be falsified altogether.

A third is that back-office compliance cannot be only a little bit broken. Whether Kerviel was known to take irregular trading positions as far back as 2005, as he says, or only starting in 2006, as the investigator suggests, either one indicates a tolerance at SocGen for a back-office error rate greater than zero. But as the effect of financial leverage in Kerviel's dealings makes clear, there is no such thing as small or controlled leakage in a commodities operation.

Back-office compliance does not work to the same margin of error as, say, audited financial statements, which need only be stated fairly within the broadly judgmental range of "materiality" - or, in laymen's terms, "close enough." For systems capable of going awry to the tune of billions of euros, that level of tolerance for error cannot pass a credibility test.

Finally, and indicative of the SocGen attitude of mind, is the report that Kerviel talked his way out of an external alert by producing falsified documents by way of excuse. Once the red flag is raised, going to the target himself for an explanation suggests a box-ticking mentality that is out of place in a compliance function.

"Rogue trader" is probably too colorful an epithet for Kerviel. For the functionaries in SocGen's risk management, "asleep at the switch" probably doesn't go far enough.