A Regulator Cuts New Teeth on JPMorgan in ‘London Whale’ Case

By:  The New York Times - Ben Protess
Source: The New York Times

Lobbying groups for Wall Street’s biggest banks cautioned that a new rule before the nation’s commodities trading regulator “could have myriad unintended adverse consequences.” A hedge fund trade group feared that the rule was “overly aggressive.” And the CME Group, one of the world’s largest futures exchanges, warned that the rule was susceptible to legal action.

Now, roughly two years after the Commodity Futures Trading Commission adopted the rule, lowering the legal requirement for proving that financial firms manipulate the markets, Wall Street is feeling the effects of the rule it fought so hard to tame.

The agency announced on Wednesday that JPMorgan Chase, the nation’s biggest bank, agreed to pay $100 million and admit wrongdoing to settle an investigation into market manipulation involving the bank’s multibillion-dollar trading loss in London.

JPMorgan’s trading activity was so voluminous that the bank was recklessly “employing a manipulative device” in the market for swaps, which are financial contracts that allowed the bank to bet on the health of companies like American Airlines. The bank sold “a staggering volume of these swaps in a concentrated period,” the trading commission said.

The case, which brought JPMorgan’s tally of government fines in the trading loss debacle to more than $1 billion, was a first for the agency. The commission had never before exercised the authority it gained in 2011 from the new rule.

Gary Gensler, the agency’s chairman, called the case “groundbreaking.” He credited the Dodd-Frank Act, the financial regulatory overhaul passed in response to the financial crisis, for including a provision that led to the new rule, giving Mr. Gensler’s agency the same authority that the Securities and Exchange Commission has possessed for decades.

“This rule was a critical component of market reform,” he said.

The JPMorgan case, legal experts say, will only embolden Mr. Gensler’s agency. With the rule beginning to bear fruit in this case, legal experts say, it could portend a wave of other actions against banks and hedge funds that build outsize trading positions.

“It is precedent, there’s no question about that,” said Philip McBride Johnson, a former chairman of the trading commission who is now a consultant in the futures industry.

Senator Maria E. Cantwell, the Washington Democrat who championed the new standard in Dodd-Frank, added that “I hope that the real message is that the C.F.T.C. will be policing the market.” She said that the agency was once a “toothless tiger” that “now has teeth.”

JPMorgan’s admission of wrongdoing, a rarity for a Wall Street bank, also underpinned the importance of the case. Banks are typically loath to make such admissions, fearing that an acknowledgment of bad behavior will open the floodgates to litigation from shareholders. But to resolve the investigation, JPMorgan took the unusual step of admitting to facts that the trading commission outlined in its order. In doing so, the bank acknowledged that its traders acted recklessly.

The trading commission’s demand for an admission nearly derailed the settlement. JPMorgan, arguing that its trading was legitimate, initially resisted an admission.

Under threat of a lawsuit, according to people briefed on the matter, the bank reopened settlement talks. And the trading commission, the people said, agreed to a compromise: the bank would admit committing only one day of bad acts. That was down, the people said, from the trading commission’s initial demand of three days.

JPMorgan’s admission was the latest, and perhaps most significant, phase of a broader policy shift in Washington, where federal regulators are reversing a practice of allowing banks to “neither admit nor deny” wrongdoing. That practice, in place for decades, rankled consumer advocates and lawmakers, who questioned why Wall Street misdeeds generated only token settlements that banks could easily afford.

“Admitting to these findings of fact needs to be something part and parcel to these types of settlements,” said Bart Chilton, a Democratic member of the trading commission. “All too often, a firm will neither admit nor deny any wrongdoing. That needs to stop.”

The trading commission still provided the bank some cover from private litigation. JPMorgan noted that although it admitted to facts in the order, it “neither admitted nor denied the C.F.T.C.’s legal conclusion that there was a violation.” While it is a technical distinction, it could save the bank from shareholder lawsuits.

And some cautioned against reading too much into the case.

“The flip side of this is to really ask what is the ramification of the admission,” said Hugh J. Cadden, a former enforcement official at the trading commissions. “It might be more form than substance.” The trading commission was the sole holdout in settling cases arising from the bank’s trading loss, a debacle last year that has come to be known as the London Whale episode. In September, to resolve accusations that the bank allowed a group of traders to go unchecked as they racked up losses, JPMorgan paid $920 million to four other regulatory agencies: the S.E.C., the Federal Reserve and the Office of the Comptroller of the Currency in the United States and the Financial Conduct Authority in Britain. The bank also admitted to the S.E.C. that it had violated federal securities laws.

The flurry of federal activity cast a pall over the bank. And the trading commission, by striking out on its own, frustrated JPMorgan’s efforts to resolve the regulatory cases all at once.

The case with the C.F.T.C. was different. Unlike the other regulatory actions involving the London Whale, the commission exposed the bank’s actual trading activity.

The agency’s authority to bring such a case traces to Dodd-Frank. For years leading up to the law, the agency was hamstrung in its pursuit of market-manipulation cases. Under existing laws, it had to prove that a trader intended to manipulate the market and successfully created artificial prices.

Even when cases were filed, they rarely panned out. In fact, according to Mr. Chilton, the agency has successfully litigated only one manipulation case in the agency’s 38-year history.

But under Dodd-Frank, the agency must show only that a trader acted “recklessly.”

“In Dodd-Frank, Congress provided a powerful new tool enabling the C.F.T.C. for the first time to prohibit reckless manipulative conduct,” David Meister, the agency’s enforcement director, said in a statement on Wednesday.

The new authority was essential to the JPMorgan case, where it was unclear whether the traders had intended to distort the market. The broader authority also enabled the agency to accuse the bank of “employing a manipulative device,” without proving that the bank actually manipulated the price of swaps.

Homing in on one day in late February 2012, the agency’s order exposed a series of questionable trading practices at the bank’s chief investment office in London.

The traders, seeking to minimize losses and vowing to “defend the position,” sold more than $7 billion of credit default swaps to hedge funds and other traders on Feb. 29.

It was a “staggering, record-setting volume,” the trading commission said. The sales, the trading commission added, “accounted for more than 90 percent of the day’s net volume traded by the entire market.”

The focus of the case sowed some dissent at the agency. The agency’s sole Republican commissioner, Scott D. O’Malia, objected to the narrower framing of the case under Dodd-Frank, arguing that the agency “should have taken more time to investigate whether the company is liable for a more serious violation, namely price manipulation.”

His concerns echoed those that Wall Street raised in 2011. Three banking trade groups — The Futures Industry Association, the Securities Industry and Financial Markets Association and the International Swaps and Derivatives Association — argued that the “reckless” standard was overly broad. They suggested “extreme recklessness.”

The agency rejected the suggestion, arguing that it was hardly different than the existing standard of “intent.” Siding with Wall Street, the agency said, would skirt Ms. Cantwell’s purpose in pushing for the change.

“Wall Street definitely pushed back,” the senator said. But she told the lobbyists that it was a losing fight. “You don’t have the right to artificially manipulate the market.”