2d Compliance & Anti Money Laundering Seminar 23d and 24th March 2010

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

What is financial crime? • Trading • Debt • Equity

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

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

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

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

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

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

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

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.

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

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

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

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

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

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

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

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)

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

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.

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)

… and financial crime is not a poor performer‘s activity • Watch the high performers. • Watch the hard workers. • Watch the good friends.

Thank you for your attention. Stay tuned. www.transparency.org

2d Compliance & Anti Money Laundering Seminar 23d and 24th March 2010