SEC’s “re-markable” action against Credit Suisse traders

By Guest Contributor
February 10, 2012

By Thomson Reuters Accelus – Staff

NEW YORK, Feb.10 (Business Law Currents) - A new SEC complaint against former Credit Suisse (CS) employees shines a harsh light on an underappreciated aspect of the financial crisis: mark-to-market manipulation. Charging four traders and investment bankers with violating securities laws, the commission’s civil action (“the complaint”) alleges a “colossal fraud” to misstate the value of bonds held in the bank’s portfolio. U.S. Attorney Preet Bharara of the Southern District of New York also filed a criminal indictment against CS investment banker David Higgs, a managing director of the bank’s London office. Bharara likewise filed a criminal information against CS trader Salmaan Siddiqui, who held the title of vice president.

Unlike more high-profile litigation revolving around the residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs), this particular case is noteworthy in that it attacks the accounting behind publicly filed documents, rather than allegations of material misrepresentations in the sales of securities.

Noteworthy, too, is the manner in which the commission gathered its evidence. According to the complaint, “At all relevant times, it was Credit Suisse policy to tape the telephone lines of UK-based trading professionals.” The result, according to the SEC, is “a real-time narrative of [the defendants’] colossal fraud.”

This alleged fraud had its genesis in August 2007, when the bank’s AAA bond portfolio came under stress. Traditionally, banks marked the value of bonds on their books by the actual transaction price on a given day. The absence of active trading for bonds would necessarily make their valuation a more nuanced art. According to the complaint, “as the credit markets became more distressed and less liquid, CS senior management directed structured products traders and supervisors to consult the pricing levels of the ABX Index when recording the fair value of bonds. This instruction applied to the subprime bonds in the ABN1 book.”

“Prior to August 2007,” the complaint explains, “the daily fair values of the bonds in ABN1 were set by using the bond prices provided by an automated pricing service called Financial Times Interactive Data (FTID).” With bonds trading near par, there was little cause for alarm. As the divergence from par grew, however, this reflected “a weakening market for these securities.” On August 28, 2007, a trading assistant input bond prices using the FTID metrics, and found “that deteriorating FTID prices had caused a loss of approximately $75 million” on a profit and loss report (P&L).

Faced with such a dramatic loss, the defendants re-marked some of the bonds, manually inputting inflated prices such as to reflect a higher value for the bonds than actually existed. The idea, at least initially, was to artificially “flatten” the P&L until such time as losses might be more easily absorbed. CS’s internal procedures captured a series of phone calls in which these manufactured prices, were fine tuned by a trial and error method until a composite net “flattening” was reached

The defendants went so far as to enlist traders outside the company to submit false buy/sell pricing for inclusion into the ABN1. The third party would be sent a list of bonds and target prices to be input. The result allowed the CS traders to maintain the fiction that their bond portfolio was substantially sound. Moreover, with this artificial P&L, the traders were able to shift losses in the value of other securities in order to present a healthier picture overall.

Predictably, the scheme became more brazen as the insiders “began to routinely manipulate bond prices in ABN1 to achieve P&L results.” Recorded conversations reveal a cavalier attitude toward mismarking bond values to achieve daily P&L positions.

As the market grew increasingly frayed, the CS bonds remained marked at or slightly below par. Understanding they would at some point need to sell off the securities, the defendants realized they couldn’t “keep picking up pennies in front of the steamroller.” The defendants knew that not only would writing down even modest losses on nearly $3.5 billion in subprime bonds be catastrophic, in reality, the bonds had been artificially marked dramatically higher—in some cases more than 20 points higher—than the actual ABX Indices.

Following some “inconclusive efforts” to sell their bonds, the defendants opted for a $1 billion short position against the ABX Index to hedge their long AAA position. “The short position,” said the complaint, “was essentially a bet against the housing market, and would make money if the prices of the ABX Index continued to decline.”

Even though the short position was intended to function as a hedge against price declines in the AAA bonds, Defendants did not write down their AAA bonds as they should have, which would have offset the profit earned on the ABX hedge, which was generated as the subprime market continued to decline. Instead, Defendants recognized positive P&L on these ABX hedges and left the pricing of the AAA bonds at artificially inflated levels.

The shenanigans went on throughout 2007, with fourth quarter and year end results continuing to overvalue bonds in the CS portfolio. “On February 12, 2008, CS Group issued a press release announcing that the bank ‘had contained the impact of the credit market dislocation in Investment Banking and increased revenues from the previous quarter.’” The bank reported $7.12 billion in 2007 earnings, with fourth quarter earnings of $1.16) billion. Indeed, so strong was the balance sheet, that the following day, CS announced a $2 billion debt offering.

On February 19, however, CS issued a correction. “The bank estimated that the fair value of certain positions held by CS would have to be reduced by about $2.85 billion, lowering previously announced net income by $1.0 billion.” (emphasis added) As a result, “the price of CS’s ADRs [American Depositary Receipts] dropped 5.23% to $48.22 from its previous day’s close of $50.88.”

The largest portion of the write-downs came from the ABN1 book: $1.3 billion. Of this, “approximately $648 million for the fourth quarter of 2007, and the remainder was attributed to the first quarter of 2008.” The bogus valuations in the ABN1 book “overstated the bank’s income before taxes by approximately 33 percent for the fourth quarter and by approximately 4 percent for the year.” [Emphasis added.] CS fired or suspended the employees involved with the traders responsible for the mispricing.

The SEC charged the defendants with five claims including violation (or aiding and abetting the violation) of §§10(b), 13(a), 13(b)(5) and 13(b)(2)(A) & (B) of the Securities Exchange Act, as well as violations of Rules 10b-5, 13b2-1, 12b-20, 13a-16. In addition to injunctive relief, the claims seek disgorgement and civil fines. The Higgs indictment also seeks forfeiture, as well as a conviction for conspiracy to falsify books and commit wire fraud.

The case is significant at a number of levels. First, the civil complaint named only individuals, not CS itself. The conduct spelled out in the complaint suggests that the machinations involved were all aimed at deceiving bank higher-ups, rather than individual investors. Consequently, CS itself was victimized by the purported conduct.

Second, the evidence the SEC used to present its case came not from judicially approved wiretaps, but from an internal CS policy to record phone conversations from its U.K. trading desk. Presumably a defensive measure to protect the bank against claims of wrongly executed trades, the recording policy in this case was actually used offensively by regulators to snare alleged rogue traders.

Third, unlike the welter of litigation involving RMBS, CDO’s and other synthetic derivatives, this action focuses on internal accounting procedures, rather than on misstatements to investors as to the soundness of specific securities for sale. Although ultimately CS shareholders were victims of the alleged scheme, the violations stemmed from mismarking and misreporting the value of the bank’s own portfolio.

This last offensive may be gaining traction as seen recently in the SEC’s cases against UBS Global Asset Management and BankAtlantic Bancorp. UBS paid a $300,000 civil fine following a finding the bank had misstated the net asset value of securities—in some cases by as much as 1000% of their transaction value. BankAtlantic’s parent holding company allegedly “defrauded investors by ‘not timely disclosing a known trend regarding extended and downgraded loans in its commercial residential real estate land acquisition and development portfolio … selectively disclosing problem loans; and engaging in improper accounting treatment of loans they were attempting to sell.’”

Finally, ever since the controversial court decision of the Southern District of New York to refuse to sanction a settlement in the Citibank case, each subsequent action now merits a view through the lens of its impact on potential estoppel claims by wronged investors. In this case, CS shareholders lost more than 5% of their shares’ value in a single day. The case itself could spark a raft of investor claims with the defendants potentially estopped from denying liability. Moreover, even though not named in the SEC action (and thus not bound by estoppel), could civil plaintiffs make a claim of negligent oversight on the part of CS itself? Were such a theory to take root, the bank’s deep pockets could make it an attractive target, especially in light of the financial hits likely to be taken by the individual defendants.

Resolving all the claims from the securitization of residential mortgages and other debt will take years. Novel theories are likely to emerge. Each one will smooth the way for prospective plaintiffs in the next financial scandal.


(This article was first published by Thomson Reuters’ Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Business Law Currents online at )


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