Trades by the so-called London Whale have already cost JPMorgan Chase over $6 billion in losses. They could also result in a precedent that will make the transactions live on in the annals of notoriety, if the Securities and Exchange Commission can extract an admission of wrongdoing from the bank.
Far more than any penalty that might be levied in the case, a statement acknowledging violations of securities laws would show that the S.E.C. has responded to the clamor for greater accountability on Wall Street.
As DealBook reported, both the S.E.C. and Justice Department are looking at the bank’s losses from the London Whale, which were outsize derivatives bets in its chief investment office in London. The agencies are also examining how employees in the office understated the value of their trades to hide the extent of the losses from their superiors in New York.
The case may serve as the vehicle for the S.E.C. to put into practice a new practice that departs from the traditional “neither admit nor deny†policy when it settles certain cases. Previously, although a party could not proclaim its innocence, there was no requirement to acknowledge any wrongdoing. That is the equivalent of a tie in which no one is happy with the outcome.
The S.E.C. has come under increased criticism for this policy, even though other federal agencies - and even the Justice Department in some of its civil settlements - permit a party to continue to deny a violation. Judge Jed S. Rakoff of Federal District Court in Manhattan went as far as to describe the S.E.C.’s approach as “hallowed by history but not by reason†in refusing to approve a settlement with Citigroup without an acknowledgment of wrongdoing.
The S.E.C. said this summer that it would modify its policy and require some firms to acknowledge wrongdoing when settling cases. Making JPMorgan the first example of the S.E.C.’s new policy would send a clear message to Wall Street that no financial institution, even one of its largest and most profitable, is immune from being required to admit to a violation.
Taking on the bank over the trading losses would be similar to when the S.E.C. sued Goldman Sachs in 2010 on charges it defrauded investors by misstating and omitting crucial facts about a synthetic collateralized debt obligation tied to subprime mortgages. That case had all the hallmarks of picking out the biggest bully on the block to send a message to others.
After Goldman paid $550 million as part of a settlement, a number of other banks resolved their own issues over selling securities tied to the mortgage market for far less, and without all the fanfare that accompanied the Goldman civil charges.
Although JPMorgan is unlikely to embrace the idea of being the first corporate defendant required to make an admission of wrongdoing, it may not have much bargaining power in the case. The bank issued a restatement in July 2012 to correct its earlier disclosures about its trading positions, acknowledging “a material weakness existed in the firm’s internal control over financial reporting.â€
The derivatives trades are not the only case in which the bank has been the focus of government investigations. On top of its recent $410 million settlement for manipulation of energy prices, JPMorgan disclosed last week that the Justice Department was still pursuing criminal and civil investigations in California about its sales of mortgage securities.
As a strategic matter, JPMorgan should not draw a line in the sand over an admission of wrongdoing in the derivatives case if that means fighting with the S.E.C. in court. The Justice Department may be willing to defer a criminal action about the derivatives trading if the bank is willing to admit to violations in a civil case, which would give the S.E.C. even more leverage in negotiating a settlement.
Moreover, the bank’s chief executive, Jamie Dimon, initially dismissed questions about the bank’s potential trading losses as a “tempest in a teapot,†a statement that could get him dragged into court if there is a claim of securities fraud for misleading investors.
So the stars seem to be aligned for the S.E.C. to make an example of JPMorgan. Wounded by its own admitted missteps and caught up in a number of other investigations, reaching a settlement in this case should be a priority for the bank.
If the S.E.C. decides to seek an admission of wrongdoing, the question then becomes how such an admission will be structured to make it palatable to JPMorgan while showing that the agency’s resolution is a real break from the “neither admit nor deny†policy.
There was actually a very modest admission in the Goldman C.D.O. case, when the firm acknowledged that its marketing materials for the security included a “mistake.†Yet, the consent involved the typical position that there was neither an admission nor denial of liability, so that it could not be used directly against Goldman in private litigation.
The S.E.C. will need to go further than language like the “mistake†to which Goldman admitted, which was not a real admission of wrongdoing. Any resolution can be expected to include a statement of facts detailing the violation, which JPMorgan would be required to acknowledge to show that the new approach was really different and not just a cosmetic change.
This is how the Justice Department settles cases under the Foreign Corrupt Practices Act and for health care fraud, even when there is a deferred or nonprosecution agreement that results in no actual criminal conviction.
The outline of the facts is crucial to any admission of wrongdoing because it goes beyond simply stating that mistakes were made. Thus, the focus of the negotiations between the S.E.C. and JPMorgan will be on crafting that document, which can be expected to be a painstaking process as each word is weighed for its potential ramifications.
The rationale for the S.E.C.’s general policy that a party need not admit to a violation is to protect companies from the “collateral estoppel†effect of a finding of a violation. Under this rule, proof of a violation in a government enforcement case could be used by third parties in related private litigation to establish a company’s liability. Securities class actions often just piggyback S.E.C. cases, and an admission of a violation could result in losing the private case, which can lead to a sizable award for damages.
So JPMorgan will be keen to keep any admission about the trades as far away as possible from the claims by shareholders and purchasers of its securities that they were defrauded. One possibility is to make the focus of the S.E.C. case the failure of the bank’s internal controls to prevent misstating the value of its derivatives, something already admitted in the earnings restatement.
The benefit of making this case about internal controls is that most lower courts do not permit private parties to file a claim for violating those provisions of the federal securities laws. Any admission of wrongdoing would certainly be helpful to the plaintiffs, but at least JPMorgan could try to limit the impact by having the violation relate to a provision that cannot be used directly against it.
Any admission of a violation by JPMorgan could become the template for how cases will be resolved when there is a demand for an acknowledgment of wrongdoing. So the S.E.C. will want to make sure its first case is a solid one that can be used in the future when it decides to ratchet up the cost of a settlement.
