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From Securities Regulation Daily, September 19, 2013

JPMorgan answers for “London whale” control deficiencies with $920 million

By Amy Leisinger, J.D.

JPMorgan Chase & Co. has entered into settlements with the SEC, the Board of Governors of the Federal Reserve System (FRB), the Office of the Comptroller of the Currency (OCC), and the UK Financial Conduct Authority (FCA) in connection with the firm’s Chief Investment Office’s (CIO) “London whale” trading incident. The authorities charged JPMorgan with deficiencies in oversight, management, and controls and failing to effectively respond to and properly escalate concerns related to the risks present in the CIO’s Synthetic Credit Portfolio (SCP) and breakdowns in the CIO’s internal controls. The penalties to be paid to resolve the SEC, FCA, FRB, and OCC investigations total approximately $920 million.

In a press release, JPMorgan Chairman and Chief Executive Officer Jamie Dimon said: “We have accepted responsibility and acknowledged our mistakes from the start, and we have learned from them and worked to fix them. We will continue to strive towards being considered the best bank — across all measures — not only by our shareholders and customers, but also by our regulators."

Background. The violative conduct alleged by the authorities occurred in connection with the $6.2 billion in losses sustained by the CIO in 2012, which arose as a result of what became known as the “London whale” trades. Earlier this year, individual JPMorgan traders were indicted in connection with the trades for allegedly conspiring to hide the massive losses in the CIO’s credit derivatives trading portfolio by manipulating the value of position marks. After the portfolio began to decline significantly in value, senior management commissioned several internal reviews to assess the effectiveness of the CIO’s internal controls and discovered that the valuation control group was ineffective and insufficiently independent from the traders it monitored. In July 2012, JPMorgan announced in a Form 8-K that it would restate its quarterly results for net revenue by $660 million; the write-down was entirely attributable to the losses in the CIO’s SCP.

SEC settlement. In its action against JPMorgan, the SEC alleged that severe breakdowns in the firm’s internal controls resulted in a failure to ensure proper valuation of the CIO’s SCP and that senior management failed to escalate the matter and to share the information with the firm’s audit committee. According to the SEC, the valuation control group within the CIO was ineffective in detecting and preventing trader mismarking, and this issue should have been addressed. The Sarbanes-Oxley Act requires public companies to maintain internal controls that “provide investors with reasonable assurances that their financial statements are reliable, and ensure that senior management shares important information with key internal decision makers such as the board of directors,” the SEC stated, and JPMorgan failed meet these obligations.

JPMorgan settled the SEC’s charges against the bank’s holding company by agreeing to cease and desist from causing violations of Exchange Act Section 13 and certain of its underlying rules and to pay a $200 million penalty that may be distributed to harmed investors in a Fair Fund distribution.

“JPMorgan failed to keep watch over its traders as they overvalued a very complex portfolio to hide massive losses,” said George S. Canellos, Co-Director of the SEC’s Division of Enforcement. “While grappling with how to fix its internal control breakdowns, JPMorgan’s senior management broke a cardinal rule of corporate governance and deprived its board of critical information.”

FRB settlement. The FRB charged JPMorgan with deficiencies in the bank holding company’s oversight, management, and controls governing the CIO. The consent order specifically cites the firm’s failure to inform its board of directors and the Federal Reserve of the problems with its risk management systems that had been identified by management. The FRB noted that, on January 14, 2013, it issued a consent order requiring JPMorgan to implement an effective firm-wide risk management program regarding trading activities and to correct deficiencies in oversight by the board of directors of the risk management, internal audit, and finance functions of JPMorgan.

The firm agreed to pay a $200 million penalty to the FRB to settle the charges.

OCC settlement. According to the OCC, the CIO, on behalf of the bank, engaged in “unsafe and unsound” practices in derivatives trading activities. The OCC also alleged that the bank’s controls failed to identify and prevent these improper activities. During several targeted exams, the OCC noted, it became apparent that the CIO’s overall trading practices lacked: (1) adequate oversight to protect the bank from the material risks of those trading strategies; (2) effective procedures to provide a foundation to identify, measure, and monitor risk; (3) sufficient control over valuation assessments; and (4) adequate internal audit processes and model risk management practices.

JPMorgan agreed to pay a $300 million civil money penalty to the OCC on behalf of JPMorgan Chase Bank, N.A.

According to Comptroller of the Currency Thomas J. Curry in a statement regarding the penalty, “Banks are in the business of managing risk, and bank management must implement the appropriate governance, controls, risk management and audit functions to ensure the bank operates in a safe and sound manner. Bank management must also ensure open and effective communication with supervisors, so that we can effectively do our jobs. Anything less is unacceptable and will not be tolerated.”

FCA settlement. The FCA alleged that the trading strategy for the CIO’s SCP allowed its positions to grow so much that it was at risk from even a small market change, and JPMorgan’s response to breaches of risk limits was to approve limit increases without analyzing the actual cause of the problems. The FCA found that the losses were ultimately caused by ineffective management of a high-risk trading strategy and flaws in valuation controls, coupled with an inadequate response to red flags and a failure to ensure that crucial information reached appropriate decision-makers. The FCA noted that JPMorgan’s conduct “demonstrated flaws permeating all levels of the Firm” and found that the conduct violated the duties of care and basic standards of conduct imposed by the FCA’s Principles for Businesses.

Because JPMorgan agreed to settle early in the investigation, the firm qualified for a 30-percent discount under the FCA’s settlement-discount scheme and agreed to settle the FCA’s charges for £137,610,000.

According to a statement by Tracey McDermott, the FCA’s director of enforcement and financial crime, “This is yet another example of a firm failing to get a proper grip on the risks its business poses to the market. There were basic failings in the operation of fundamental controls over a high risk part of the business. Senior management failed to respond properly to warning signals that there were problems in the CIO.”

Companies: JPMorgan Chase & Co.; JPMorgan Chase Bank, N.A.

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