Two UK-based FX traders have been charged with wire fraud by the US Department of Justice, one of which has been arrested in New York. Galen Stops reports on the case.
On July 19, Mark Johnson, the head of global FX cash trading at HSBC, was arrested at New York’s JFK airport in connection with an ongoing investigation by the US Department of Justice (DoJ) into currency rigging.
Two days later, the DoJ officially brought charges against Johnson and Stuart Scott, former head of FX cash trading for EMEA at HSBC, for wire fraud.
As a senior e-FX figure at one bank observed, the charge of wire fraud can “cover all manner of sins”, while a legal expert in Washington explains: “Wire fraud is kind of like conspiracy, it’s usually the charge that precedes the really offensive allegation”.
In this case, the allegations listed in court documents filed in a New York court are threefold. The first accusation is that Johnson and Scott were front running a client order of $3.5 billion in sterling “in breach of HSBC’s duty of trust and confidence” to the client.
The second is that they executed the $3.5 billion trade in a manner designed to cause the price of sterling to spike, creating profits for HSBC and greater expense for the client, “despite HSBC’s representations to execute the transaction in the best interests of, and to avoid adverse impact to, the Victim Company”.
The third allegation is they made “material misrepresentations and omissions” to the client in order to conceal their behaviour.
“The criminal action against Johnson and Scott for fraud sounds like a securities action for insider trading based on a theory of misappropriation,” notes Gary DeWaal, special counsel at Katten Muchin Rosenman in New York.
This is based on the fact that when the “Victim Company” – widely understood to be Cairn Energy – approached multiple banks, including HSBC, to bid for the right to execute the transaction, it required them to sign confidentiality agreements designed to protect information related to the transaction.
Thus, the court document claims that “Employees of HSBC who were given access to the confidential information were made “insiders” by HSBC to the Victim Company FX Transaction…. As “insiders”, Johnson and Scott knew they had an obligation not to misuse the confidential information, including by front-running”.
The complaint alleges that, despite knowing this, Johnson, Scott, and a figure named as “Supervisor 1” worked to drive up the price of GBP/USD ahead of the client transaction, to the benefit of HSBC and at the expense of its client.
Not only this, but it alleges that “Johnson and Scott also caused other FX traders at HSBC in both London and New York to purchase sterling prior to the Victim Company FX Transaction”. Although it does not specify how much more expensive these actions made the transaction for the client, the court document claims that HSBC profited to the tune of $8 million from this alleged “front running”.
Although the idea that Johnson and Scott were front running plays a central part in the charges leveled against them in the court document, this is a notoriously tricky allegation to actually prove.
“Where does front running start and where does front running stop? It’s probably one of the most difficult and contentious issues of all and it may be one of the issues that you can never actually solve,” says one market source in London.
Similarly, the e-FX banker notes: “It’s a very grey area and there’s lots of differing definitions on what’s front-running versus pre-hedging. Then you need to know how long in advance the positions were taken. Was it two hours ahead of the transaction or one week? Because that can make a difference to how you view it.”
Part of the problem is that in order to prove front running, the prosecution needs to be able to prove the intentions of the traders. “In the absence of some clear and direct evidence there’s always the potential for dispute about what the actual intentions of the trader were,” says David Corker, a partner at Corker Binning.
Market sources have a simpler way of judging the issue. As one trader in London asks, “Who did they buy sterling for? If it was for the client it’s pre-hedging. If it was for themselves – and they sold the sterling back later – it’s front running.”
Another trading source adds, “The traders may argue they were ensuring HSBC wasn’t adversely affected by buying sterling, but you don’t need a huge long position to do that.”
Perhaps more damning in the eyes of the law than allegations of front running are those of deliberate deception. This is a fraud case and therefore must centre around some form of deception, which is why the third allegation might be the most problematic for Johnson and Scott if the case comes to court.
Instead of trying to prove what the traders intentions were, the prosecution has to instead show what Johnson and Scott said to clients and then contrast this with their actions.
The court document claims that Scott and Johnson wanted to push the client to trade at the 3pm fix rather than the 4pm fix because it would be easier to manipulate prices during the former in order to accrue profits for the bank.
Therefore it alleges that Scott “falsely and fraudulently suggested” to the client that the 3pm fix had more liquidity than the 4pm fix and that when pressed on the issue changed his stance to claim that both were actually the same in terms of liquidity.
This is a hard claim to prove, but dealing sources note that while the 4pm fix is widely seen as the busiest, this is not necessarily the best time to execute a large transaction. “There are a lot of prop firms jumping in front of the 4pm fix,” says a trading analyst in London. “For a bigger order it may be better to use the 3pm fix although how you prove that I don’t know.”
Further, the court filing cites Johnson stating that he would “personally” recommend trading at the 3pm fix “so there’s an element of surprise”. This makes his comments subjective and provides a justification for his recommendation which could make it harder to prove fraud because once again the prosecution would have to prove that Johnson did not believe what he was saying, a potentially tricky proposition.
What could potentially prove more problematic for Johnson and Scott is the claim made in the court document that they, along with “Supervisor 1”, blamed the upward swing in the price movement of GBP/USD on a “Russian name” when discussing the currency moves with the client.
“Johnson and Scott, among others, made and caused to be made misrepresentations to the Victim Company and the Advisor to conceal their misconduct with respect to, inter alia, the cause of the upward price movement in sterling/dollar prior to the 3pm fix and the timing and manner in which HSBC handled the Victim Company FX transaction,” it says in the document.
Giving examples of these misrepresentations, the filing alleges that Scott “falsely and fraudulently” attributed the initial jump in the price of sterling to a Russian bank and stated that HSBC began “taking action” in the FX market approximately five minutes before the 3pm fix when he knew that HSBC has been exerting upward pressure on GBP/USD “well prior” to this.
Although it should be noted that the court filing only tells one side of the story, and even then only partially, sources versed in such matters suggest that these misrepresentations to clients about the bank’s behaviour around the transaction of its order could be more damaging than allegations of front running.
“From a prosecutor’s standpoint, that’s an easier case to make,” says the legal expert in Washington. “If you have to go in front of a jury and talk about spoofing and cancelled orders and front running it can become extremely complicated. But if you can build a case saying that they told their customer that they were doing this but their internal emails and calls reveal that they were not, that they were doing something else entirely and making millions of dollars off that, well that’s an easy narrative to understand, particularly if you can find a pool of people that don’t particularly trust large financial institutions.”
Ultimately, it is impossible to know for certain which allegations will prove the most serious or if any of them will result in a conviction until the case goes to trial, but this could take some time to occur.
Corker says that he expects there to be an extradition attempt, not only for Scott but also for the “Supervisor 1” referenced in the court document – assuming that person is domiciled away from the US, but he warns that such extradition cases are “always complicated” and could take some time to be resolved.
In the meantime there are a number of unresolved questions still hovering around this case.
The first and perhaps most obvious question is: who is the “Supervisor 1” referred to in the allegations? Although it does not name the person, the court filing says that they were the head of corporate structuring for EMEA at the time in question and they would clearly represent another big scalp if the DoJ is able to extradite them and bring charges against them.
If there is any truth to the allegations then this in turn will beg the question: how pervasive was such behaviour at HSBC and how high up the ladder did knowledge of such behaviour go?
An intriguing element of this case, however, is that HSBC conducted a review of the trade led by external counsel that concluded that there was nothing wrong with the transaction from a legal standpoint.
“What was said and how it was said could be fundamental to this case. The fact that they had an investigation into it at HSBC and they apparently found the people involved not culpable of anything illegal speaks volumes,” says the London-based source. “I think the authorities have found it extremely difficult to prove individuals have done anything illegal. What they’ve found in the past is a lot of individuals that have behaved badly, but they’ve been unable to prove they’ve done anything specifically illegal, so they’ve fined the banks for inadequate controls instead.”
HSBC declined to comment on the review or the charges leveled against Johnson and Scott.
Another interesting question is: why is case being brought against Johnson and Scott in the US rather than the UK, where both men were based and where the alleged fraudulent activity took place?
Corker says the answer to this question is not clear, especially as he argues, that it is “an ideal case to prosecute” because it is “self-contained, very comprehensible by a jury and has some horrible emails to support and back it all up”.
Another source suggests there could be some competition between the UK’s Serious Fraud Office (SFO) and the DoJ to secure convictions in these types of cases. They point out that the former has made convictions related to financial services scandals, while the latter has not and may be eager to change this.
Yet another source says that although the DoJ is one of the less political government organisations in the US, it is hard to ignore the political backdrop of this case. They note that Jeb Hensarling, chairman of the House Financial Services Comitteee and a strong conservative and outspoken advocate for limited government, is critical of the Obama administration, including the Justice Department, and might argue that failure to bring such cases is evidence that the Dodd-Frank legislation is a failure.
Looking at the other side of the political spectrum they cite the “Elizabeth Warren effect” on the US financial services landscape, which they say has increasingly pushed authorities to pursue individuals rather than financial institutions in cases of financial services misconduct.
The legal expert in Washington says that, regardless of the motives, there would have been some degree of synchronisation between US and UK authorities ahead of the warrants issued for the arrest of Johnson and Scott.
“I imagine that there was a lot of coordination. Sometimes there’s either a lower standard of proof in one jurisdiction or it’s an easier legal regime to navigate. With Libor there was some coordination and they certainly picked which venues to go to first,” the expert says.
Perhaps the final question to be considered is the identity of the “advisory group” hired by the client to help it with the FX transaction that is referred to in the court document.
It was through this advisory firm that HSBC was notified that it had been elected to handle the large order because the client believed that bank had acknowledged the expectation to achieve best execution when putting the order through the market.
Although the court filing alleges the advisor “confronted” Scott over his assertion that the 3pm fix had more liquidity than the 4pm fix, it still allowed its client to accept the recommendation to trade there.
Given that this advisory firm was hired to help ensure that the client got the best deal and the best execution for the transaction in question, if the court filing claims that the client actually paid over the odds while HSBC profited from the transaction are accurate, then questions certainly need to be asked about the competency of that advisory firm in this instance.
Observers of the case will now have to wait and see what further evidence the DoJ produces to support its allegations, whether it is successful in getting Scott over to the US to face the charges and whether “Supervisor 1” or any other HSBC staff become embroiled in the case.
Yet regardless of the eventual outcome and ignoring the fact that the alleged misconduct took place almost five years ago, the short-term impact of this case could be to once again call into question the ethical standards of the FX industry.
The industry has been working to demonstrate it is taking the necessary steps to address conduct issues, in particular, many senior market participants are working on the Global Code in addition to their day jobs in the belief that it will provide clarity and confidence about what constitutes best market practices.
The fact that this case was even brought forward is certainly another PR blow for the industry and shows that FX is not out of the spotlight just yet. All of which should serve to emphasise that the implementation of the Global Code – in a manner in which it can be effectively enforced – is still of crucial importance to the FX market going forward.