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Rogue trader case shows serious risk management flaws

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Banking institutions still have risk management lessons to learn in preventing rogue traders from racking up billions of dollars in losses, but experts say the problem is not entirely avoidable.

The latest rogue trading unfolded in recent weeks, with reports that London-based UBS A.G. trader Kweku M. Adoboli's scheme triggered $2.3 billion in losses at the Swiss-based firm. The situation also led to last week's resignation of UBS CEO Oswald J. Grübel.

UBS has $200 million of directors and officers liability coverage—$70 million of which is Side A, covering individual directors and officers—with Zurich-based ACE Ltd. leading the program on the primary side, a source confirmed.

ACE and New York-based Marsh Inc., which is the broker on the account, declined comment.

Other rogue trader incidents include the $7.62 billion fraud by trader Jerome Kerviel of Paris-based Société Générale S.A. in 2008. In 1995, Barings P.L.C., one of the most respected banks in London, collapsed after more than $1.3 billion in losses that were blamed on the activities of a single trader in its Singapore office, Nicholas Leeson.

Meanwhile, any U.S. litigation in connection with the UBS incident may be limited at least in part because of a U.S. Supreme Court decision last year.

Mr. Adoboli has been charged with one count of fraud and two counts of false accounting in the United Kingdom in connection with the loss, which UBS said stemmed from “unauthorized speculative trading.”

According to reports, the alleged fraudulent UBS trading dates back to October 2008.

“One has to wonder” why the telltale signs “for one reason or another were missed,” said Thomas O. Gorman, a partner at Dorsey & Whitney L.L.P. in Washington.

Peter Taffae, a D&O liability insurance expert at Los Angeles-based wholesale brokerage Executive Perils Inc., said rogue trading “is a problem that has always existed.” Firms introduce controls and establish checks and balances, “but I don't think anybody's ever going to eliminate it 100%.”

Geography may play a role, say observers. In many cases, including Messrs. Leeson and Adoboli's, losses occurred in locations “remote from the home office,” where “risk management and audit functions are most robust,” said Jeff Grange, senior vp and chief underwriting officer of global professional lines at Torus Insurance Group in Jersey City, N.J.

UBS' culture also may have been a factor, said Mr. Gorman, referring to reports that Mr. Adoboli did not profit personally from the trades.

Many observers say the industry overall could have done more.

The latest incident may “demonstrate the banking industry has not learned its lessons about dealing in higher-risk securities and proprietary trading,” said Edward Kirk, a partner with law firm Clyde & Co. in New York.

A governing structure is needed to prevent, or at least minimize, the risk of rogue trading, said risk management consultant James Lam, president of James Lam & Associates Inc. in Wellesley, Mass.

A risk officer with the authority “to challenge key business lines...all the way down to individual business units and back-office operations, to make sure the right people are in place to provide the checks and balances” is what is needed, he said.

Experts also stressed the need to have separate back-office and trading operations. Edward Pekarek, visiting law professor and assistant director at the Pace Law School's Investor Rights Clinic in White Plains, N.Y., said all three traders had extensive back-office experience before they became traders.

That is where they “learned where the cracks were in the system,” he said. Then, when promoted to the front office, they “traded beyond their abilities and found themselves deep in a hole and kept digging, and used their back-office training as the shovel” to disguise their activity, Mr. Pekarek said.

Perry S. Granof, of counsel at law firm Williams Kastner in Chicago, said, “Financial institutions, especially, have to have adequate controls in place to make sure there's a complete separation” between the back-room and trading operations to prevent unauthorized trading, or to at least “make sure the unauthorized trading is identified in a relatively short time frame.”

In the cases of the three traders, “it appears these trades have gone on for years without a proper check,” Mr. Granof said.

Make sure there are good compliance procedures in place and “that in fact they're being implemented correctly,” said Mr. Gorman. “You could have the best procedures in the world, but if they're not being followed up on, if they're not being properly applied, they're not worth the paper they're written on.”

“Where you have trades going on year after year without a proper check on those trades, plaintiffs can create a very strong and effective case for negligence in the context of a derivative action,” where shareholders sue on behalf of the corporation, Mr. Granof said.

In cases where there are stock drops because of unauthorized trading, a potential class action could be based on the theory “there was misrepresentation in the financials with respect to the checks and balances” employed to prevent it, he said.

But foreign investor plaintiffs, in particular, could be limited as a result of the U.S. Supreme Court's June 2010 decision in Robert Morrison et al. vs. National Australia Bank Ltd. The court held in that case that foreign plaintiffs cannot use the U.S. Securities and Exchange Act of 1934 to sue foreign and U.S. defendants for misconduct in connection with securities traded on foreign exchanges.

To date, no foreign appellate courts have ruled on the issues raised in Morrison, said Luke Green, Norman, Okla.-based head of research for Securities Class Action Services.

He noted, however, that Morrison was cited in a September ruling by New York federal judge in In Re USB Securities Litigation, in which the court dismissed a putative class action filed by shareholders in 2007 claiming violation of the SEC Act.

However, even U.S. investors may not find a warm welcome in U.S. courts in the UBS case, say some observers.

“Generally, although not uniformly, courts take the position” that a company's internal affairs should be subject to the laws of jurisdiction where it is incorporated and where the conduct took place, said Kevin LaCroix, executive vp at OakBridge Insurance Services L.L.C. in Beachwood, Ohio.

“The courts have become highly sensitized to adjudicating controversies where another state or foreign country has a particularly well-developed interest,” said Fred T. Isquith, a partner with Wolf Haldenstein Adler Freeman & Herz L.L.P. in New York.