The headlines are replete with stories of financial mismanagement, rogue traders and huge losses associated with capital markets trading. In the wake of volatile financial markets, several corporate end-users, municipalities, hedge funds and financial institutions have disclosed multi-billion dollar losses.

Often, the response to these losses has been a series of derivatives-related or class-action lawsuits from shareholders, regulators, mutual fund unit-holders, customers and counter parties. Accordingly, derivatives-related losses have heightened the awareness of directors, senior managers, regulators, customers and shareholders to the potential risks associated with trading activities and the need for more efficient risk management practices to mitigate and transfer risk.

Understanding the big picture risk

The use of the capital markets and derivatives to manage market, credit and financial risk or proprietary trading to achieve a profit is far from peril-free. Significant trading losses often cause customers or shareholders to seek recovery for their economic losses. The allegations made by parties against directors and officers can include breach of their common law duty of care, breach of contract, failure to supervise their traders, or unsuitability of the derivative instruments or financial products for the customer. In addition to these lawsuits, the allegations may invite investigations by regulatory authorities concerned about the adequacy of a firm's disclosures to customers and shareholders.

News of regulatory scrutiny or a lawsuit may have an immediate adverse effect on a financial institution's reputation. Customers may lose confidence in a firm's ability to manage its frontline traders and salespeople, prompting a “run on the bank” or movement of capital to institutions that investors perceive as more secure or trustworthy. Likewise, public corporations run the risk of losing shareholders and collapsing stock prices when there is a perception of managerial weakness.

The consequences can tear a firm apart. In many cases, the reputational damage can result in poor employee morale and staff defections. At its worst, the damage can force a firm to sell out to a competitor.

The case for risk management

Given the potential exposure to financial loss, legal and reputational liabilities, it is imperative that directors and officers implement best practices to mitigate exposures they and their companies face. Directors may reduce the exposures by monitoring trading activities, sales practices and money management, disclosing trading risks to customers and shareholders and seeking insurance to cover derivatives-related losses.

To formulate effective risk management policies, the board must first understand the needs of the enterprise and the risks involved in its trading activities. Then it must put in place procedures that prevent anyone from exceeding its mandate for acceptable risk. The board can generally accomplish this by:

  • empowering certain directors to set risk management policies and oversee compliance;

  • drafting a risk policy statement which quantitatively and qualitatively describes the board's risk tolerance levels;

  • designing reporting structures consistent with its risk policy;

  • requiring regular qualitative reports;

  • developing appropriate compensation incentives; and

  • requiring board members and employees to abide by a code of ethical conduct.

    Boards can begin the process by establishing a risk management committee to actively manage risk on an enterprise-wide basis or assign this function to its finance or audit committee. The committee will work with other board and senior management committees, such as the “market risk committee” and the “credit risk committee,” to develop a holistic approach to managing the risks associated with a portfolio of derivatives and financial instruments. The risk management committee will have primary responsibility for adopting standards and procedures for dealing with specific risk management tasks. The board's audit committee can ensure that risk policies are adhered to throughout the firm.

    With the responsibilities assigned, the board is now ready to formulate its risk policy. A risk policy statement can be a comprehensive summary of acceptable investments, position limits, procedures, reporting structures, credit and liquidity rules and settlement guidelines. It can address operational, financial, credit, legal, liquidity and other risks. A successful reporting structure involves the complete segregation of front and back office responsibilities. The front office makes trading decisions in accordance with the board's risk policies. Traders must be prevented from having access to the systems that might allow them to manipulate trade information, price data or pricing models. The back office supports the transactions and ensures that all trades are recorded for administrative and oversight purposes. A third unit, compliance, monitors the trades and reports to senior management on the front office's level of compliance with risk policies. These independent groups should be present at all locations where derivatives or financial products are traded.

    Each operating group should report independently to senior management. The information collected from these groups will form the contents of the board reports prepared and presented by a chief risk officer.

    Senior managers need to be kept informed about firm-wide risk and capital market trading activities on a frequent basis. Capital market trading activities involve substantial assets and occur quickly. Overnight, financial products can become illiquid or impossible to hedge. Directors may need to require reports on a daily or hourly basis. The production of these reports should not preclude any ad hoc information flow or inquiry.

    Generally, board reports should include a list of current positions, names of traders and their market performance and clear descriptions of position goals (e.g., enhancing yield or hedge), their economic effects, the firm's current risk profile, market and news factors, market- to-market valuations and explanations of exceptions, limit breaches or violations of risk policies. In analyzing reports, directors should look for unusual trading activities identified by the firm's senior risk managers.

    To develop qualitative reports, management information systems must capture all trades. Because of the high-speed nature of financial innovation, there may be some lag time before tracking systems are able to monitor new products. The board should be aware of this technology limitation and consider requiring a daily exception report for new products.

    Boards also should take a look at human resources issues, including large variable or bonus compensation, that cause traders to value profits above all. Firm-wide compensation should be based on furthering the board's goals, not only on a trader's profitability. To achieve a balance between risk policy and trading activities, the board can adjust compensation formulae to reflect the risk taken to achieve a particular result.

    Compensation policy is only one means of achieving ethical behavior in capital market trading activities. Management must demonstrate, through actions and communications, that it is committed to high ethical standards.

    Boards should distribute a code of conduct that describes an employee's responsibility to the firm and its shareholders. Employees should sign an acknowledgment that they will abide by the code and the firm's risk policies. When the board creates a sense of integrity throughout the enterprise, employees will be more willing to provide ad hoc information about positions, events and market risks.

    Transfer remaining risks

    When directors are fully informed before they make important business decisions, the business judgment rule protects them if an educated decision proves unsuccessful. Yet the vagaries of human nature may not leave them entirely immune from liability arising from derivatives trading activities. Directors and officers can fill the gaps left by rule by procuring adequate insurance tailored to the firm's risk profile. These products include professional liability insurance, directors' and officers' liability insurance, fidelity (crime) insurance and unauthorized (rogue) trading insurance.

    Also known as errors and omissions insurance, professional liability policies protect the directors, officers, employees and the corporate entity against claims for “wrongful acts” in the performance or failure to perform professional services, usually fee-based. These “all-risk” policies cover management liability arising out of trading losses that “injure” a customer.

    Although the policies provide broad protection with respect to who and what is covered, not all the allegations in a complaint may be covered. Many policies exclude fraud and dishonesty, securities trading, liability assumed under contract and lenders liability. Direct financial losses of the institution arising out of trading solely on its own account are not typically covered.

    Directors' and officers' liability policies protect the individual directors and officers from liability arising out of claims for corporate mismanagement. Increasingly, the policies provide coverage to the corporate entity for litigation arising out of securities law violations, particularly violations of Rule 10b-5 of the Securities Exchange Act of 1934. As with professional liability policies, the coverage is quite broad.

    Directors also should be aware that trading losses are generally excluded from fidelity coverage under the Surety Association of America's (SAA) standard form 24 financial institution bond, except when the dishonest or fraudulent act is committed with “the intent to cause the insured to sustain a loss and to obtain improper financial gain.” Improper financial gain does not include salary, commissions, fees, bonuses, promotions, awards, profit sharing or pension. Losses at Barings, Daiwa and elsewhere suggest that most employees initially do not intend to cause a loss to the company. More often, their trades are based on errant decisions or are moves to cover up errors. In other instances, their intent may be to increase the company's profits or to earn higher bonuses. Therefore, not all unauthorized trades fall within the definition of employee dishonesty under the bond.

    Recently, some fidelity insurers have modified the dishonesty coverage grant under the SAA form to broaden coverage for certain proprietary trading losses. These underwriters are requiring that only one of the two loss triggers, to intend to cause the insured to sustain a loss or to obtain an improper financial gain, be met, rather than both conditions being satisfied simultaneously.

    An innovation, a standalone unauthorized trading product, contemplates that traders may not be acting dishonestly to cause a loss or to obtain improper financial gain but are acting beyond their designated authority. It precisely defines an “unauthorized trade” to include a trader who knowingly commits a limits breach of authority or trades with unapproved counterparties. The trader also must attempt to conceal his actions from management or falsely record trades in the books of account.

    Several potential problems exist with this approach. For example, there is a problem distinguishing proprietary trades from customer-driven trades. A trader may execute an unauthorized proprietary trade and then hedge the position with a trade on behalf of a customer. If a trader executes trades with unauthorized counterparties, but completely hedges the deal with trades for which he or she has authority, is this trade still “unauthorized”? What if the trader is trading in authorized products, and within prescribed authority limits, but willfully fails to hedge, or improperly hedges, the position?

    But the greatest challenge may be in the computation of loss. The protocol incorporates the fundamental principle of insurance to make one whole for a loss. This differs from the reimbursement of unrealized or reduced profits due to unauthorized trading. In insuring unauthorized trading losses, all profits should be netted against all losses. Further, since many firms engage in risk management hedging of positions on a portfolio-wide basis, it may be difficult to demonstrate a direct link between a series of unauthorized trades and corresponding hedging transactions. Profits from authorized trades may end up compensating for losses arising out of commingled unauthorized trading.

    The valuation of traded securities and instruments with no market price also complicates the picture. Many leveraged structures, exotics and other derivative products only trade over-the-counter. The pricing of these instruments is usually proprietary and model-based. How can these instruments be valued at the point of loss? The computation of loss could vary greatly, depending on whether the valuation convention is bid, mid or ask.

    Despite the complexities, directors and officers have a duty to participate in risk management. They must prevent a breakdown in internal controls and make sure the corporation has purchased adequate insurance to protect themselves and the entity from the likelihood of lawsuits and regulatory scrutiny. Investing the time in preserving corporate and personal assets is a proven commodity.

  • Jeffrey S. Grange and Evan Rosenberg are vice presidents in the Department of Financial Institutions at Chubb & Son, Warren, NJ.