Why Rogue Traders Get Jail But Bad Execs Get A Pension

Adjunct Professor Barry Temkin in Forbes, September 15, 2011

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Kweku Adoboli, a 31-year-old UBS trader arrested in London today for allegedly causing $2 billion in losses on ETFs , will likely face criminal prosecution — unlike  his superiors, who three years earlier lost more than $25 billion betting on U.S. mortgage-backed securities.

The difference is subtle, but can equal jail time for traders who don’t understand it. Executives who make spectacularly bad decisions can only be subjected to criminal prosecution if  they engage in fraud or deliberately close their eyes to it.

As long as they operate within company rules — and part of being an executive is having wide latitude to make decisions — they are immune. The head of AIG’s London office, Joseph Cassano, has not been prosecuted for his role in underwriting risky credit-default swaps that helped cause $11 billion in losses.

“The fact that an executive exercised appropriate business judgment and followed procedures is compelling evidence of absence of criminal intent,” said Jacob Frenkel, a white-collar defense attorney with Shulman Rogers in Potomac, Md.

“Merely because there’s been a loss, merely because there’s a bad decision, is not evidence of a crime,” added Ellen Podgor of Stetson College of Law and editor of the White Collar Crime Prof blog.

Traders have it a little rougher. Most operate within a web of risk limits, documentation requirements and other rules that make it easy to turn a bad bet into a criminal matter. Those rules have only gotten stricter under Sarbanes-Oxley and its big brother, the Dodd-Frank reform act.

“Intentional disregard for any one of those is compelling evidence of criminal intent,” said Frenkel, a former Securities and Exchange Commission enforcement attorney. “It’s no different than intentional falsification of records.”

Rogue traders have tried to defend themselves by saying their colleagues were doing the same things, or their bosses secretly encouraged them to swing for the fences with the bank’s money. Societe General trader Jérôme Kerviel promised to expose a culture of crazy risk-taking at the French bank when he was prosecuted for losing $6 billion on an illicit $60 billion gamble on futures.

It didn’t work. Kerviel was sentenced to three years in prison last October, and ordered to repay the $6 billion.

“It’s an outrage,” said Kerviel’s lawyer, Oliveir Metzner, after the sentencing. “The people who created him and used him have been totally exonerated.”

That’s how it goes on the trading desk. Nicholas Leeson, who was sentenced to six-and-a-half years in prison for causing the collapse of the 233-year-old Barings Bank in 1995, told reporters last year that he was disgusted that executives like former RBS Chairman Sir Fred Goodwin didn’t get the same treatment.

Goodwin, who presided over the largest corporate loss in U.K. history, quit the bank with a $500,000-a-year pension. Now he’s embroiled in a scandal over his affair with a top RBC exeutive, which he allegedly failed to disclose to the board. The London Times has reported  Britain’s Financial Services Authority is investigating whether the affair violated RBC’s code of conduct and if it may have contributed to the bank’s collapse.

“If it’s proven they’ve done something criminal then I think they need to be prosecuted,” Leeson said of his better-compensated superiors. “But I think that is unlikely. What will be more likely to be proven is that a) they were reckless and b) some of their decision-making was not short of being stupid.”

The web of rules is getting tighter around financial executives.

“Especially after the crash of 2008, regulators all around the world are expecting and requiring banks, broker-dealers and futures merchants to supervise their traders,” said Barry Temkin, a lawyer with Mound Cotton Wollan & Greengrass in New York and expert on securities regulation at Fordham Law School. Regulators are more concerned with systemic risk, or the risk that one bank’s collapse can take down the entire financial system, and so they are requiring stricter compliance rules and controls on trading desks, he said.

But in order to find themselves in the same criminal dock as a trader, executives must have either been involved in the crime or wilfully ignored it, Podgor said.

“If you have a higher-up who says, `Wait a minute I didn’t know this was going on,’ it becomes very difficult for the government because they must show executive made deliberate steps to avoid getting this knowledge,” she said.

The Supreme Court made it even harder last year with Global-Tech Appliances vs. SEB, oddly enough a patent case. In that decision the court said wilful blindness is more than mere negligence: it require knowing there’s a  “high probability that a fact exists,” and “the defendant must take deliberate actions to avoid learning of that fact.”

Given that traders go rogue on a regular basis, maybe the fact executives are ignoring is their compensation systems. Frenkel noted that not only is a trader’s income, but his continued employment are dependent upon making risky bets that pay off.

“The interesting question is whether compensation is structured in a way that it creates a strong incentive to commit fraud,” Frenkel said.

Given the multibillion-dollar government bailouts of AIG, RBC, UBS in recent years, perhaps regulators should spend more time on that.