JPMorgan’s Internal Control Problems, or HSBC’s Got Nothing On Us!

Josh Rosner (@JoshRosner) is co-author of the New York Times Bestseller “Reckless Endangerment” and Managing Director at independent research consultancy Graham Fisher & Co. He advises regulators, policy-makers and institutional investors on banking and financial services (a more complete bio appears at the end of this column).

This is part 3 of 5; Yesterday evening, we published the Introduction. We will be releasing a different part each evening and morning culminating in the release of Rosner’s complete report on Friday morning. On that date, the Senate Permanent Subcommittee on Investigations will release their final report on JPM’s CIO Group (aka the London Whale).

Prior installments are here: Intro, and part 2

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INTERNAL CONTROL PROBLEMS APPEAR TO BE PERVASIVE

We have chosen not to detail every violation and will only highlight the operational failures that we believe demonstrate management’s inability to effectively manage this “Too Big to Fail” firm.

The repeated violations and the longstanding failures of the Board to remedy many of these problems raising serious questions about the veracity of the CAMELS supervisory examination process[i] and the willingness of regulators to demand corrective actions of our largest firms. Moreover, with apparent justification for the OCC to issue a “Safety and Soundness Order”[ii], one has to wonder whether the Federal Reserve’s “stress test” has placed constraints on the firm.

JPMorgan’s list of regulatory violations over the past five years is long, diverse and crosses legal and regulatory jurisdictions. Many of these infractions are for repeated violations of specific control failures, which the Company had previously agreed to remedy. This calls into question Jamie Dimon’s remarks before the Miami Chamber of Commerce on February 4^th 2013, during which he stated that when JPMorgan makes mistakes “we try and fix those mistakes”.

OCC and Federal Reserve Board

Anti-Money Laundering and Bank Secrecy Act issues

On  January 14, 2013, the Federal Reserve and the OCC issued a Consent Order to JPM designed to remedy deficiencies, which the bank neither admitted nor denied.  The OCC identified deficiencies indicating that JPMC’s firm-wide Bank Secrecy Act (BSA) and Anti-Money Laundering (AML) compliance program failed to ensure the  bank’s compliance with certain requirements.

While the Order does not detail the specific violations or deficiencies that were found, other regulatory actions suggest that either these were tied to new violations or that the OCC and Federal Reserve were, a year and a half later, acting in response to an August 2011 civil settlement[iii]  by the U.S. Treasury’s Office of Foreign Asset Control (OFAC) that found JPM had egregiously violated:

–  Cuban Assets Control Regulations (“CACR”);

–  Weapons of Mass Destruction Proliferators Sanctions Regulations (“WMDPSR”);

–  Executive Order 13382, “Blocking Property of Weapons of Mass Destruction Proliferators and Their Supporters”;

–  the Global Terrorism Sanctions Regulations (“GTSR”);

–  the Iranian Transactions Regulations (“ITR”);

–  the Sudanese Sanctions Regulations (“SSR”);

–  the Former Liberian Regime of Charles Taylor Sanctions Regulations (“FLRCTSR”); and

– the Reporting, Procedures, and Penalties Regulations (“RPPR”)

Beyond these violations, which were determined to be “egregious because of reckless acts or omissions,” the bank was found to have violated several other AML/BSA regulations in non-egregious ways including by an undisclosed transfer of 32,000 ounces of gold bullion for the benefit of a bank in Iran.

If, on the other hand, the recent Consent Orders relate to violations  other than those identified in the OFAC settlement it seems plausible that JPMorgan could have been found to have violated AML/BSA regulations related to its role in the recent Vatican Bank scandal[iv], a drug cartel money-laundering scheme[v] or even tied to the Madoff bankruptcy[vi].

The government’s treatment of foreign banks relative to the seeming deference given JPM raises questions about the infractions relative to the penalties. After all, HSBC recently settled a money-laundering probe for $1.92 billion and Standard Chartered paid $327 million to settle charges relating to Iranian transactions while JPMorgan paid $88.3 million for a civil settlement of these violations.

If one contrasts JPM’s treatment with the FDIC’s recent action against a state bank with two branches[vii], in which the bank’s charter was revoked for violations related to money laundering and the bank was fined $15 million, one must wonder if state-chartered banks are held more accountable than our nation’s largest firms.

Commodity Futures Trading Commission (CFTC)

Segregation of Client Funds

JPMorgan’s handling of customer monies should be another cause for concern.  The Company’s executives and its Board have repeatedly failed to address ongoing problems and have exposed shareholders to the costs associated with repeated fines. The problems appear only to come to light only after being discovered as a result of customer problems but, once discovered the Firm is routinely permitted, without admitting wrongdoing, to make an offer for civil settlement. These offers are accepted on the expectation that internal control violations will be remedied and, as a result, matters that might otherwise have potentially led to criminal charges are settled for fines.

On September 9, 2009, the CFTC sanctioned JPMorgan for failing to properly segregate customer funds and for failing to report these “under-segregations” on a timely basis[viii]. The CFTC accepted JPMorgan’s offer of settlement without requiring the Company to either admit or deny wrongdoing, as a result the firm was able to avoid an administrative proceeding that could have uncovered more regulatory and legal violations. This matter relates to activities that occurred between May and June 2007 but it is unknown if this was the entirety of the period of violations or if it was only the period the regulator chose to identify. According to the CFTC, JPM failed to segregate $725 million of its own money from a $9.6 billion account. The CFTC cited numerous violations resulting from “under segregation”, ”untimely computation of segregation”, “untimely notification of under segregation” and “failures to supervise”. The Company was allowed to settle for $300,000.

In June 2010, in demonstration that the failures to segregated funds that the CFTC had settled were not isolated occurrences, the British Financial Services Authority fined JPMorgan a record 33.32 million British pounds for failing to “adequately protect between $1.9 billion and $23 billion of client money between November 2002 and July 2009.”[ix] In this instance, the FSA determined that the error remained undetected for nearly seven years”.

On April 4, 2012, JPM was again found, by the CFTC, to be in violation of segregation rules. Once again, to avoid administrative proceedings in the face of findings of violations of law, the Company made an offer of settlement that the CFTC accepted without requiring the Company to admit or deny wrongdoing. The Company was fined $20 million in civil money penalties and, once again, directed to remedy control problems[x]. As in prior instances the firm’s internal controls were inadequate and failed to discover these violations before a problem arose.

The CFTC found that from at least November 2006 though September 2008, JPM accepted deposits of customer funds from Lehman Brothers, Inc. In violation of law JPMorgan extended credit to Lehman Brothers for 22 months based on these customer funds because JPM determined, wrongfully, those funds were to be included in Lehman Brothers net free equity. After the bankruptcy of Lehman Brothers, again in violation of law, JPMorgan refused repeated requests by the Trustee and the Commission to release those Lehman customer funds to the Trustee of Lehman’s estate.

While there have been no findings against JPMorgan, ongoing legal wrangling by the Company seems to offer some basis to believe that similar problems in the segregation of funds may have also occurred related to the failure of Peregrine Financial[xi] and MF Global[xii].

Commodities Violations

On September 27, 2012, the CFTC issued an Order[xiii] claiming that JPMorgan violated Section 4a(b)(2) of the Commodity Exchange Act and, for $600,000, allowed the bank to again settle a matter without admitting or denying the violations. The summary of facts suggest, had the CFTC instituted an administrative proceeding and full inquiry, the alleged violations may well have been far more pervasive; encompassing a larger number of commodity assets and a greater occurrence of violations than merely those settled. After all, according to the CFTC, these systems were not relied on only for the trading of cotton, they were “used by commodity traders to track their current positions in partcular futures contracts” [xiv].

Moreover, the underlying actions of JPMorgan that led to the CFTC actions appear to demonstrate either a willful attempt to circumvent the regulations or the  bank’s complete incompetence in the management of its controls.

According to the CFTC, a “deficiency in its newly created automated position limit monitoring system for the commodity business” caused JPM to violate position limits in cotton futures. Since, according to the CFTC’s own statement, the systems appear to have been used for commodities beyond just cotton, it would seem reasonable for the CFTC to have engaged in a deeper inquiry in an effort to ascertain whether the violations had occurred in the trading of other commodities.

More troubling than the breakdown of internal controls that lead to reliance on an obviously failed system is that “after learning of this deficiency, JPMCB utilized a manual position limit monitoring procedure pending correction of the automated monitoring system. Despite adoption of this manual position limit monitoring procedure, JPMCB violated its short-side speculative position limit on several occasions.” So, the breakdown in controls was not limited to the automated system but also occurred during the application of the remedial manual procedures.

These issues lead to obvious questions for which we will likely never have answers:

• Do the violations that occurred when JPMorgan instituted the manual procedures result from negligence or something more?
• Did the OCC review the implementation of these “newly created” automated systems?
• Are there mechanisms in place for regulators to inform each other of violations and control weaknesses in instances where a settlement occurs without an admission or denial of wrongdoing?
  • Is there a formal mechanism within the Financial Stability Oversight Committee?
  • Is there an inter-agency system to record all settled matters with a regulated entity?
• If there are no such effective inter-regulator procedures, then the notion of the “enhanced supervision” of Systemically Important Financial Institutions created by Dodd-Frank has offered the American public false security.

JPMorgan’s violations in commodity markets do seem to extend beyond the cotton market findings by the CFTC. In December 2012, JPM was fined $65,000 by the NYMEX Business Conduct Committee for “inadvertently” overstating open interest in a crude futures contract by 46.9%, and offsetting concurrent long and short positions it held for a customer resulting in an overstatement of open interest of 5.2% for that trade date[xv].

Fictitious Trade/Wash Sale

On March 8, 2012, the CFTC simultaneously alleged and settled with JPMorgan over its belief that the company violated Section 4c(a)(I) of the Commodity Exchange Act [xvi] by, on May 25, 2010, knowingly executing a fictitious trade to sell and buy 11,642 ten-year spreads on behalf of a client. The customer was on both sides of the transaction and JPM was aware of that. In  its filing, the Commission stated its recognition of Congress’s intent in creating the relevant law[xvii] but again, allowed a civil settlement, for $140,000, without a deeper investigation. As a result, it is unclear if this instance represented a one-time failure or if shareholders are at ongoing legal or regulatory risk from future exposures to a more pervasive breakdown of controls.

There is some evidence that, if the regulators engaged in a full and broad investigation, shareholders would likely be exposed to further destruction of shareholder equity resulting from failures of management. In June 2012 the NYMEX found that on 10 separate occasions between January and June 2011 JPM executed wash trades in WTI or gasoline between entities with the same beneficial ownership. In each instance the company’s trader was the sole decision maker for both the buy and sell side of the trade. While the firm was fined only $30,000 to settle these violations (neither admitting nor denying wrongdoing) it is unclear if they have yet addressed the control problems.[xviii].