"Exceptional" Fraud-Societe Generale

Introduction During the period of January 18-24, 2008, the board of directors of Societe Generale confronted a problem of staggering proportions. An internal investigation during the preceding two weeks revealed that Jerome Kerviel, a derivatives trader employed by the bank, had entered into unauthorized and in some cases fraudulent trades involving derivative financial instruments, exposing the bank to losses between 6-7 billion [euro] in a plunging securities market. The bank's internal control system had failed to detect more than 1,000 unauthorized or fraudulent transactions entered into over a period that appeared to encompass more than three years. Even though the annual financial statement audit for the year ended December 31, 2007 was well underway, the auditors appeared to be equally surprised by the discovery of the massive fraud scheme. Media rumors were beginning to emerge and the bank's share price was in a free fall. On Saturday, January 19, 2008, The Times (UK) reported that Market rumours about writedowns at Societe Generale, the second-biggest French bank by market value, pushed its shares down by more than eight percent As fears of losses in the credit market continued to haunt the world's banks, its shares closed down 7.66 [euro] at 85.34 [euro], their lowest since 2005. The bank was among the biggest losers in Europe yesterday. In light of this discovery and the results of the internal investigation, the board of directors needed to identify and prioritize several crucial decisions to minimize the damage to its reputation and to assuage its frantic shareholders. The board needed to decide what information to communicate and how to present the information for the bank regulators, its investors, and to the public. Economic Environment of Societe Generale The most recent financial crisis commenced on a global scale in 2007 and continued, depending on the sources consulted, until 2010. After the burst of the high-tech bubble in 2000, followed by the terrorist attacks in the United States on September 11, 2001, investors had resumed an attitude that Alan Greenspan, former Chairman of the U.S. Federal Reserve, had previously described as irrational exuberance. In its simplest form, this period could be described as one in which investors sought and expected eight percent returns in a four percent market. This was not likely to happen in the absence of large scale shell games often involving derivative financial instruments. By the middle of 2007, there were significant signs of renewed economic stress. Financial analysts were beginning to challenge the true value of certain derivative financial instruments that had come into vogue in the form of collateralized debt obligations (CDO). These instruments, with variations in nomenclature, generally consisted of debt securities backed by collateral in the form of mortgage Many of these mortgage loans were made, with encouragement from the U.S. government, to debtors of questionable credit worthiness. Eventually, these loans were dubbed sub-prime loans. This condition was further exacerbated by a real estate market that appeared to be improving as evidenced by ever increasing real estate prices. CDOs were packaged and repackaged in tranches based on supposed levels of credit risk that the debtor in the underlying mortgage loan would default on the required payments. Because of the novel composition of CDOs, it was nearly impossible to determine any reliable fair value except by using a model based on soft assumptions. However, proponents of CDOs, mostly banks, asserted that investors were fully apprised of the level of credit risk they assumed when investing in these instruments. Banks had a long-standing practice of trading on their own account. This practice was considered to be normal for financial institutions including insurance companies. The activities of in-house trading desks provided banks with rich returns, which in turn provided investors in bank shares significant capital gains and dividend income. …