1 2d Compliance & Anti Money Laundering Seminar 23d and 24th March 2010 Riyad, Kingdom of Saudi Arabia A few considerations on financial crime.

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2d Compliance & Anti Money Laundering Seminar

23d and 24th March 2010

Riyad, Kingdom of Saudi Arabia

A few considerations on financial crime

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What is financial crime?

• Trading

• Debt

• Equity

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What is financial crime?

• Trading

• Debt

• Equity

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Long-term dealings /Accumulating trading losses

– A trader makes big profits and becomes a star

– His strategy is no longer questioned

– He starts losing money but tries to trade his way out of the losses in order to conceal them and go back to profit

– Losses quickly accumulate to build up massive amounts

– Leeson (Barings), Kerviel (Soc Gen)

– Lack of internal controls

– Collective greed in trading teams

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Long-term dealings / Short and distort: taking advantage of poor internal controls on traders and lack of investigation resources of the regulator

– Traders acting in a loose cartel enter into short-selling contracts for the shares of a potentially controversial company. Number of shares: 100,000. Price: $100

– They borrow 100,000 shares from custodians who accept not to keep adequate records of it

– They sell the 100,000 shares in the cash market, resulting in high liquidity and slight drop in share price: Sale proceeds: 100,000x$95= $9,500,000

– They invent bad news and spread them to bring down the price (no e-mails, but cell phone text or internet instant messages)

– Price falls from $95 to $80– They buy 200,000 shares at $80 ($16,000,000), settle the short-selling

contract for 100,000 shares at $100 ($10,000,000), and return the borrowed 100,000 shares to the custodian

– Profit for the traders: $9,500,000 + $10,000,000 - $16,000,000 = $ 3,500,000

– Traders are often left on their own– They may use trusts and offshore centers– Regulators do not have adequate investigation resources

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Long-term dealings /Stocks with poor liquidity, or small stock exchanges, on which a few players can exert a significant influence

• „Old-boy networks“

• The fewer players, the riskier the game

• Some emerging economies, or poorly developed economies only have a few dominant players

• Those players most often wear several hats: they own, they manage, they trade, they buy and sell to the expense of minority shareholders

• Poorly regulated exchanges

• Weak governance

• Conflicts of interest

• Private / Public collusion

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Intra-day trading / Cross-trading: adjusting a client‘s order to a trader‘s own strategy

– A trader has to execute a sale order of a client within a day

– He executes the sale order at the lowest price and takes a speculative position buying the same amount at the same price

– He uses a trust for doing so

– Lack of internal controls

– Use of trusts and off-shore centers

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Intra-day trading /Protected trading: a trader caps his losses with a client‘s order

– A trader has an order to sell at a $ 100 price, slightly above current $ 98 market price

– He thinks that price will go down

– He sells short at the $ 98 price

– If price goes up, he can limit his losses by „crossing“ and buying back the contracts at $100

– Lack of internal controls

– Use of trusts and off-shore centers

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Intra-day trading /Front-running: taking advantage of knowing the client‘s order

– A trader has a substantial order to sell

– He knows that the order will probably push market price down

– He sells short for himself before executing the larger order

– After price has decreased, he buys back with a profit

– Lack of internal controls

– Use of trusts and off-shore centers

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Intra-day trading /Use of dual accounts: the losses to the clients, the profits to the trader

– A trader controls more than one account with the same bank or broker

– At the end of trading, he allocates the best trades to his personal trust-controlled account, and the others to the bank‘s or clients‘ accounts

– Lack of internal controls

– Use of trusts and off-shore centers

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What is financial crime?

• Trading

• Debt

• Equity

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Corporate debt/Use of confidential client information against a client

• A commercial banker has a client with a healthy company but temporary cash problems

• Another part of the bank (local branches) is also a significant client of this company (design, architecture…)

• The banker spreads the word to the retail network which differs contracts and toughens payment terms

• The banker cannot obtain additional credit but introduces a buyer to the client

• The buyer, linked to the banker, buys the company at a cheap price

• Chinese wall broken, banking secrecy violated.

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Structured finance / Executives of a lending bank may be shareholders of a buyer (through a trust) and approve a highly leveraged acquisition

• Buying a company with low equity is every investor‘s dream

• This dream can become reality if the lending banker is part of the acquisition scheme

• Leverage can be affected, and also the degree of protection and/or potential upside for the bank (debt-equity swaps)

• Risks will therefore be underestimated, to the potential detriment of the bank

• Lack of internal controls

• Abuse of managerial position

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Cartels in banking

• Depending on countries, cartels can be observed on terms and conditions offered to clients for various accounts, loans or investment opportunities

• Pakistanese banks fined for agreement on fees and transformation of base accounts into fee-paying accounts

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Project Finance /Loans pocketed by bankers

– A financial institution lends $ 7 m to a specific project

– The project only requires $ 5 m

– The project does not perform adequately

– The $ 2m are shared between the client and the executives who had approved the loan

– Due diligence was non existent

– Internal controls were non existent

– The executives used trusts and off-shore centers

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What is financial crime?

• Trading

• Debt

• Equity

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Private equity & IPOs /Finding new Eldorados

– When oil prices were reaching all-time highs, alternative energy markets were booming

– Companies with „new“ technologies but no industry expertise were trying to raise money, even on regulated markets

– Quite often, the managers involved had already managed dotcoms in the late 90‘s

– Collective greed and blindness

– Amnesia

– Lack of adequate due-diligence

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Private equity & IPOs / False valuation of assets

• Inventories or receivables may receive false valuations

• In booming markets, those false valuations can help obtain debt or equity financing, or even access to an IPO

• Bankers may receive equity interests or even kick-backs to favor those companies

• Lack of internal controls

• Collective greed

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Mergers & Acquisitions /Profits hidden before an LBO

– Managers interested in an LBO may want to hide profits from their management

– Aggressive provision and depreciation policy, as well as differed profit, may be observed

– Double language will then be adopted, one with the mother company, the other one with financial investors

– M&A advisors may help in that game

– Lack of internal controls

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Mergers & acquisitions /The seller is the buyer

– The CFO or a top executive of the seller may be one of the shareholders of the acquiring entity through a trust

– He or she will badly negotiate the deal with the acquiring entity

– M&A advisers may be involved in the scheme

– One of the major risks of LBO deals from the seller‘s point of view

– Lack of internal controls

– Use of trusts and off-shore centers

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Mergers & Acquisitions /Hiding a buyer to a client on a sell-mandate

• A bank obtains a sell mandate from a client

• Knowing a potential acquirer, the bank does not approach this acquirer, or in such a way that the discussions quickly abort, and the bank ends up selling the target to one of its investment funds at a reduced price

• One or two years later, the target is resold with a substantial profit

• „Chinese wall“ broken

• Fraud may be institutional, but may also result from a network of individuals (M&A banker and investor friends)

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Mergers & Acquisitions /False urgency to buy or invest

• An investment opportunity is always limited in time

• The investor however has to conduct appropriate due-diligence, or has to be informed of the risks associated with a listed security

• Time pressure cannot be exercized on a client to the detriment of appropriate risk awareness

• Conflict of interest may be at stake if undue time pressure is exercized

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Let us not forget AML and KYC

• The use of trade finance to obscure the illegal movement of funds includes methods to misrepresent the price, quality or quantity of goods.

• Generally these techniques rely upon collusion between the seller and buyer.• Over Invoicing: by stating price above the true value, the seller gains excess

value. • Under invoicing: by stating price below the true value, the buyer gains excess

value. • Multiple invoicing: by issuing more than one invoice for the same goods a

seller can justify the receipt of multiple payments. • Short shipping: the seller ships less than the invoiced quantity or quality of

goods. The effect is similar to over invoicing: the seller gains excess value. • Over shipping: the seller ships more than the invoiced quantity or quality of

goods. The effect is similar to under invoicing: the buyer gains excess value. • Deliberate obfuscation of the type of goods: this may simply involve

omitting information from the relevant documentation or deliberately disguising or falsifying it, so that financial flow is no longer connected to actual shipping.

• Phantom Shipping: no goods are shipped and all documentation is completely falsified.

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Financial crime is much about making things easier and quicker…

• By-passing risk controls:– Easier trading – Easier borrowing– Easier selling and buying of companies

• Confidentiality and Chinese walls are assets but also create opportunities for quiet crime.

Importance of confidential whistle blowing and protection of whistle blowers.

4-eye policy: engagement by credit + industry

Traders: access forbidden to information system

Run tests on publicized cases (ex: Kerviel)

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… and financial crime is not a poor performer‘s activity

• Watch the high performers.

• Watch the hard workers.

• Watch the good friends.

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Thank you for your attention.

Stay tuned.

www.transparency.org