Below is a summary of the cases reviewed by the researcher to enable him to select the cases for the case study. The cases selected were not summarised herein in order to avoid repetition. In addition, for different reasons, not all cases may have been reported and therefore important lessons might have been lost. Therefore, it is very difficult to know the full population of cases in which derivatives were blamed for problems caused. Moreover, as already noted these cases, although large in value only represent a small proportion of users and controllers of derivatives (in size and value).
1. Aracruz Celulose S.A
Chris Lang (2009), in an article in Bloomberg (December 2008), noted that Aracruz's the Brazilian pulp maker, in 2008 reported losses on the currency-derivatives amounting to US$2.13 billion. Barreto (2008) continued to note, in a Reuters Article that this followed the company's closure of the majority of its exposure to toxic foreign exchange derivatives with a group of banks and that the company held currency forward contracts with an average strike price of 1.76 reais per dollar and average maturity of 12 months. With these contracts, the company agreed to pay double the difference between the strike price and Brazil's currency, when it was trading at weaker levels than the strike price. As the real value plunged against the dollar, the company's losses mounted.
According to Barreto (2008), Aracruz reached an agreement with certain unnamed banks, which sold its foreign exchange derivatives in order to enable the restructuring of overdue debts by unwinding 97 percent of the contracts. Aracruz was one of several Brazilian companies that reported huge foreign exchange losses when the country's currency plunged against the dollar.
Barreto, (2008), claims that what happened is that in 2007 the real rose against the dollar by 20 percent and again by another 14 percent in 2008 from early August. This prompted many companies to bet the currency would remain strong. "Those bets turned sour as the turmoil in global markets deepened and concerns over a worldwide recession led to sharp capital outflows from emerging markets. The real fell more than 27 percent since reaching a nine-year high in early August 2008, causing massive currency losses" (Barreto, 2008).
Chris Lang (2009) in an online paper on 'Pulp.Inc.' states, that on 24 November 2008, the company held a Special Shareholders Meeting "with the participation of representatives of 96.5% of its voting capital. In this meeting they were to discuss a proposal for filing a responsibility lawsuit involving Isac Zagury, the company's former CFO." He notes that holding people responsible for the mess might be a good thing. However, the only reason anything had been done, was because the value of the Brazilian real collapsed against the dollar. If this had not occurred, the board and the shareholders would not have complained about the derivative trading, although they might have known about these abuses of the derivatives investments. He argues rather cynically that this might be because they were making money.
2. Showa Shell Sekiyu K.K.
One of Japan's leading oil refiners and petroleum products distributors. It forms part of the Royal Dutch Shell Group, which holds a half of the stake in Showa Shell. In February of 1993, the company revealed that it had unrealised losses of ¥125 billion ($1.05 billion) brought about by speculative foreign-exchange contracts amounting to $6.4 billion worth of bets on the value of the dollar versus the yen. This loss later reached ¥166.3 billion since there was a further fall in the U.S. currency's value. Two leaders, resigned later on in August of the same year taking responsibility for the large loss on foreign-exchange futures contracts (Reszat, 1998). According to Beate Reszat (1998), the company wrote off these losses over the next few years and compensated by selling securities and property to raise the necessary cash. The foreign exchange losses went out of control because of the rolling over of forward positions, which was permitted and normal until April 1994 (after which the Ministry of Finance changed the rules). Accounting rules (in Japan) allowed firms to hide unrealised losses by reporting these trades at historical values.
In fact, as Reszat (1998) relates, in 1989, Soya Shell had started to buy dollars forward at an average cost of ¥145. When the yen/dollar rate fell it rolled over its position to postpone settlement so as not to reveal the losses. In principle, this practice could have continued indefinitely if it were not for the rollover costs, which can become prohibitively high.
3. Kashima Oil
A medium-scale oil refiner disclosed an unrealised loss of ¥152.2 billion ($1.5 billion) in April 1994 from trading in foreign currency derivatives. Hachiro Obata, who resigned from his post as boss, took responsibility for this. Kashima refines imported oil for the Japanese market; the strong yen meant that the inputs were less expensive and so the profits were higher. The company's currency dealers entered into binding forward contracts, which resulted in unrealised losses of ¥100 billion, by 1988. These losses increased around the time of the Iraqi invasion of Kuwait in 1990. In anticipation of future purchases of oil, Kashima Oil did, what many other Japanese commodity importers did, and increased their dollars holdings. When the dollar fell, so did the firm's expected profits (The Economist (US), 'Determined Loser (Kashima Oil)', 1994).
The firm said it would sell ¥100 billion worth of property and securities to make up for this loss. Four parent firms (Kashima is unlisted) were expected to bring in new capital and a group of 29 banks, which included the Industrial Bank of Japan, Kashima's main bank, helped. This taught Japan's company treasurers a lesson. Currency hedgers were now switching from forward contracts (which carry the risk of great losses if the currency moves the wrong way) to options (which do not lock the buyer into a loss-making position). Company chiefs began to understand the need to control traders even more closely. Also, as noted in the case of Showa Shell Sekiyu K.K., in April 1994, the Ministry of Finance banned rollovers on new forward contracts and stated that existing positions were to be unwound as soon as possible. This was further enforced by a new ministry directive issued in 1995 insisting that historic positions are to be unwound by March 1995 at the end of that financial year (The Economist (US), 'Determined Loser (Kashima Oil), 1994).
4. Groupe Caisse d'Epargne
A mutual savings bank suffered a €600 million ($807m; £466m) derivatives trading loss (unauthorised trades for the bank's own account) in October 2008, which it blamed partly on the high market volatility at the time. Saltmarsh (2008) noted that the spokeswoman indicated that the derivatives involved were based on equity indexes. She added that, the bank's operating company, Caisse Nationale des Caisses d'Épargne would write off the loss. The bank's internal auditors discovered the positions.
The group of employees responsible for making the unauthorised trades were dismissed. Saltmarsh (2008) noted that according to a spokeswoman, a team of "around six traders" from the proprietary desk was responsible for the trades and that they had been suspended pending inquiries.
In a statement, the bank said that the losses would not threaten its financial viability or affect its customers. The bank, which is unlisted, added that it retained more than €20 billion in shareholder equity (Saltmarsh, 2008). It blamed the "extreme volatility" in the markets in the week of 6th October for the incident. According to the BBC News article (2008), a Caisse d'Epargne spokesman said a "small team" had caused the loss, which had been sanctioned for exceeding its trading risk limit. The bank said that it had sacked one of the assistants to the finance director Julien Carmona (BBC News, 'French bank admits trading loss'2008).
5. Sadia S.A.
a major Brazilian food producer founded in 1944. It is among the world's leading producers of frozen foods, and is Brazil's main exporter of meat-based products. The Company operates distribution centres in Brazil, Argentina, Chile, Uruguay, Paraguay and Bolivia, and representative offices in the United Kingdom, Italy, Japan and Dubai. Its shares trade on the Sao Paolo Exchange and its American Depository Receipts ("ADR's") trade on the New York Stock Exchange under the symbol "SDA".
The Company's disclosed a loss of approximately R$760 million ($410 million U.S. dollars) emanating from bets on currency derivatives that went bad. This prompted a huge sell-off of 37% of Sadia shares in a single trading session, wiping out more than$800 million in market capitalisation. Accordingly, the Company decided to liquidate in advance certain financial transactions, resulting in losses of approximately R$760 million ($410 million U.S. dollars).
According to Sadia this loss was caused because of transactions carried out that were speculative in nature, undisclosed and larger than necessary (that is transactions not carried out so as to hedge the activities of the company exposed to exchange variation). The transactions were not consistent with publicly disclosed hedging practices of the company (the contracts covered export-forward exposure from twelve months' worth of sales when the policy called for only six months' worth of coverage).
Moreover, Sadia's policy stated that it engaged in derivative contracts in currency markets solely in order to hedge market risks and these risks were suppose to be closely monitored (that is measured systematically through an analysis of Value at Risk or VAR). Nevertheless, it was noted that the Company's financial statements failed to account for the company's massive exposure to currency market fluctuations (that the company had declared less than $150 million of exposure in these instruments) and the Company lacked adequate internal and financial controls.
As a result of this scandal the CFO was immediately dismissed and the Chairman and Vice Chairman resigned from their posts (Bernstein Litowitz Berger & Grossmann LLP Attorneys at Law, 2009).
6. China Aviation Oil (Singapore) Corporation Ltd ("CAO")
This is the largest purchaser of jet fuel in the Asia Pacific region and the key supplier of imported jet fuel to the civil aviation industry of the People's Republic of China ("PRC"). The company caught public attention in 2005 when it was embroiled in a trading scandal, involving its chief executive Chen Jiulin (later arrested with the charge of insider trading, and was sentenced to 51 months imprisonment). The losses from the scandal cost up to $550m and the subsequent collapse of the company.
Derivatives were at first being used to hedge its risk inherent in its primary business of physical oil procurement and trading. However, taking the view that the market price for oil would continue tracking upwards, CAO later entered into speculative option trades where its aim was to profit from favourable market movements.
It purchased calls and sold puts, thereby effectively creating a geared long position. As oil prices increased, the purchased calls were exercised and profits were made. The sold puts were not exercised and the company gained from the premiums. However, in the fourth quarter of 2003, Chen Juilin changed strategy and signed contracts with a number of banks, speculating on a bid on the oil price for $38 per barrel. He believed that the oil price would not go above that price. It closed 2003 with a short position having sold calls and bought puts. However, oil prices did not decrease and there was a large increase over the speculated bid price by October 2004. This left CAO facing significant margin calls on its open (short) derivative positions.
As noted in the PRIMIA Professional case studies section (n.d.), according to a CAO press release dated the 30 November 2004, 'it was unable to meet some of the margin calls arising from its speculative derivative trades, resulting in the company's being forced to close the positions with some of its counter parties'. In the same press release, CAO announced that the accumulated losses from these closed positions amounted to approximately US$390 million. In addition, the company had unrealised losses of about US$160 million, bringing the total derivative losses to $550 million. Moreover, it was also noted that Chen Juilin and other senior executives had for some time manipulated the company's financial statements to conceal the losses (PRIMIA, n.d.).
7. Union Bank of Switzerland (UBS)
The bank announced equity derivatives losses of 625 million Swiss francs in 1997. This forced the merger with Swiss Bank Corp, writing-off another 760 million Swiss francs for the equity derivatives losses after the merger in 1998 (Schütz 2009). Schütz's (2009) in his book 'The Fall of the UBS: The Reasons Behind the Decline of the Union Bank of Switzerland', accounts for how Goldstein - the man behind the equity derivatives dealings - set up a global equity derivatives (GED) group which was outside the bank's risk management controls. He earned very large profits for the bank, and bonuses for himself, which went into multimillions of dollars. He relates that UBS created two separate and overlapping risk control functions and both of which reported to the heads of business units, rather than to the bank's senior management. These large profits, and the inherent conflicts of interest within the bank, helped insulate Goldstein from any efforts to control his trading group:
There was strong recognition of the problem - and there were plans to address it - but the effort was too little too late. While the bank was moving toward developing an independent structure, the GED was pushing ahead and making money (Schütz, 2009).
However, Dick Schütz (1998) notes that there was no indication that Goldstein's colleagues suspected him of illegal dealings or unethical conduct. They described him as a professional who abided by the rules. To his colleagues he appeared to act within the limits of accepted practice, even though this was not the case. He was also aggressive in recognising income on complex, long-term deals, where profits could be booked up front on everything without putting up the proper reserves. It seems that somebody like the risk managers or other controllers could have stopped him. However, nobody did. Schütz (1998) described the situation at UBS as being 'a complicated story involving power, ambition and vanity.'
8. Calyon
The investment banking unit of Paris-based Credit Agricole SA, France's second-largest bank, showed losses of €250 million (US$320 million) on 18 September 2007. These losses - which were the cost to unwind the unauthorised positions - were blamed on Richard Bierbaum, a Crédit Agricole CIB New York trader. He was later fired, with five of his superiors, for taking positions beyond his authorisation and delegating on trades on indexes linked to derivatives (that is credit-default swaps that would profit if the Federal Reserve cut interest rates, causing investor perception of credit quality to improve) (Paulden et al 2007). Paulden et al (2007) note that the trader said that his bosses knew what he was doing and considered him a "golden child"' of the New York office and positions were reported on a daily basis.
9. CODELCO (Corporación Nacional del Cobre de Chile or, in English, the National Copper Corporation of Chile)
The Chilean State owned copper mining company was a victim of a derivatives desk without proper structures and controls. CODELCO reported trading losses of $207 million, made up of $164 million in copper, $31 million in silver and $12 million in gold when the books were drawn-up in January 1994. Former head trader, Juan Pablo Davila, was blamed for $30 million lost when he made a computer error and bought instead of sold futures contracts at the London Metals Exchange (LME). Davila then tried to make up the loss by shorting one million tons of copper (40,000 LME contracts) or more, betting the metal would go down and speculated in gold and silver on the Commodity Exchange of New York. Copper futures rose about 10 cents per pound from September 1993 to January 1994. The controls of the company failed since the guidelines were breached that only permitted Davila to lose a maximum of $1 million and limited his net positions to 20,000 tons of copper (or 800 LME contracts). After the company fired Davila, his direct superiors resigned including the senior vice president of marketing, the sales manager and his deputy (All Business, 1994).
10. National Westminster Bank Plc
On 28 February 1997, NatWest Markets (NWM), the corporate and investment banking arm of one of the UK's major banks, exposed a GB£50 million loss, in its trading books of interest rate options and swaptions. Following investigation this loss figure was increased to GB£90.5 million. The problems commenced because of a systematic mispricing of a number of options and swaptions by its rate risk management group traders. The traders, Kyriacos Papouis, who traded Deutschemark (DEM) and his superior, Neil Dodgson, who traded Sterling (GB£), began to mismark positions in options, in the bank's books in a effort to cover up the losses made. It was later noted by regulators at the time, the Securities and Futures Authority (SFA) (now the UK Financial Services Authority (FSA)) that they lacked the due skill, care and diligence to carry out the task. Following the discovery of the losses, Papouis, who by then moved on to Bear Stearns and a few senior managers, including Dodgson resigned. The internal controls and risk management were criticised and questioned and the regulator imposed a penalty of £420,000. Papouis and Dodgson, were fined and reprimanded for breaches of SFA principles. This case is a classic example of the risk that sophisticated pricing and risk management models pose on today's modern banks. The SFA said that a clear case of mispricing went undetected by risk management for almost a year and they did not spot the cover up of losing positions, mainly because of non-compliance with internal minimum control standards (Ambit Erisk, 2001).
11. MF Global
Officially known as '''Man Financial,'' and a major global financial derivatives brokers, announced a bad debt provision amounting to $141.5 million. This provision was the result of unauthorised trading by a representative in a MF Global branch office, who on 27 February 2008, while trading in the wheat futures market in his personal account, substantially exceeded his authorised trading limit. MF Global was fined $10 million by the CFTC over the incident and an unrelated Natural Gas incident from 2003 and $495,000 by the CME Group over the wheat incident. Evan Dooley, who made living trading commodities like wheat in his home state, Tennessee, was accused by MF Global of making unauthorised trades that led to this loss. Dooley, the firm said, wagered on wheat futures with money he did not have. He had bought as many as 15,000 wheat futures, the equivalent of about 10 percent of the market for these contracts for any given month. When MF Global discovered the trades, Dooley was dismissed and they ran up the losses to desperately unwind the positions in a volatile market. MF Global has an electronic system designed to prevent brokers from trading beyond their means. Nevertheless, the safeguards failed because they had curiously been deactivated for certain traders, including Dooley. The reason stated was because the controls slowed transactions (Grynbaum, 2008).
12. Morgan Stanley
America's second-biggest securities firm was yet another financial services group who fell victim to a rogue trader, supposedly the London-based Matt Piper in 2008. They admitted to suspending the credit trader in London for trying to conceal losses of about $120 million (£61.3 million). The FSA had been conducting a full investigation into the conduct of an unnamed employee, when it uncovered a $120 million negative adjustment to marks. The adjustment had been previously taken in a trader's book that did not comply with the firm's policies. This related to short-term trading in credit index options that may have dated back to the year before. The trades were believed to have been in CDX indices, complex derivatives used to hedge risk on credit investments such as bonds (Bawden, 2008).
13. CITIC Pacific
In October 2008, a Beijing-backed steel-to-property conglomerate, announced $2 billion in losses from unauthorised bets on volatile forex markets. The company finance executives made unauthorised trades on the value of the Australian dollar and euro. The firm entered into contracts, known as "accumulators," which allow investors to exit if the currency they are betting on strengthens, but not if it depreciates. "An 'accumulator' is a type of derivative contract in one form, an investor agrees to buy a specified amount of currency at a fixed price which often represents a discount to the spot market" (Santini, 2008). Before Citic Pacific's loss became known, "accumulators were planted like land mines throughout the investment landscape. Among hedge funds and financial investors that signed these high-risk contracts exposure, hedging arrangements were made to lock in maximum risks." Market analysts argue that Citic Pacific signed an accumulator contract, when the Australian dollar's (AUD) value was on the rise. This contract set high gains, which did not include a floor for losses. The risks on it were difficult to estimate since the contract's pricing model was a complex one.
Citic Pacific made money, as the exchange rate increased above 1 (AUD) to 0.87 U.S. dollars (USD). However, although the U.S. currency weakened since the start of 2008, market players still made wrong bets on the exchange, believing that the AUD would continue to grow stronger. The company's losing position, could have been reversed if the latter happened. However, they decided to mark to market the accumulators and other derivatives and unwind some derivatives contracts, realizing losses of HK$807.7 million (US$104.2 million) in December that year. Citic Pacific had also held similar contracts linked to the value of the euro and Chinese yuan (Santini, 2008).
14. Parmalat
It was noted by Michael Edward (2004) in his online article, 'Fraudulent U.S. Bank Derivatives Behind Parmalat's Insolvency', that the Italian food group active in milk, dairy products and fruit-based beverages, held an estimated US$17 billion of funds which could not be accounted for. These funds have been mainly attributed to a complex and risky derivatives based on valueless bonds founded through offshore shell companies. Since the year 1997, the company has engaged in acquiring several businesses from the South and North America. These resulted in debts with financial institutions including JP Morgan Chase, Bank of America, and Citicorp (these held the highest amount of derivatives). By 2001, the losses became increasingly apparent and the banks initially used interest-rate swaps to protect themselves from the losses. However, the risky speculation on interest and exchange rates increased the losses even further. In this light, the banks implemented a Ponzi scheme with derivatives that they brokered to other financial institutions and investors; all based on valueless Parmalat bonds. This effectively served as the means through which they could hide the debts and losses. Things grew even worse as greed took over and the banks shifted the full blame onto Parmalat. The same banks that victimised Parmalat and many other investors, that had rated the Parmalat derivative-based bonds as "sound financial paper" and helped with this scam. The banks continued to broker these derivatives-based on other worthless bonds because of the falsely created paper (Edward, 2004).
Michael Edward (2004) continued to note that former Parmalat CEO Tanzi stated to Italian prosecutors that, "[the fraudulent bond system] was fully the banks idea." Parmalat's former financial manager, Fausto Tonna, following a proposal made by the Bank, had altered the books to provide a fake security for the bonds (Edward, 2004).
In June 2003, Luca Sala, who arrived from Bank of America (BOA) was appointed as the new board Director. Edwards (2004) noted that BOA announced that a Parmalat account supposedly worth $3.9 billion did not exist in order to hide the fraudulent bond-based derivatives. This made the Parmalat insolvency public. Moreover, at the same time Alberto Ferraris from Citibank was appointed the as financial manager at Parmalat (Edward, 2004).
15. National Australia Bank
In January 2004, the bank lost hundreds of millions of dollars in unauthorised foreign currency derivatives. This exposure cost the bank A$360 million, and wiped out almost A$2 billion from bank's market capitalisation. Following this event, many senior staff members lost their jobs, the board was restructured and the Chairman, Charles Allen, and the Chief Executive, Frank Cicutto, resigned. The traders Luke Duffy, David Bullen and Vince Ficarra in Melbourne and Gianni Gray in London, later deemed as "rogue traders", were dismissed and were investigated by the Australian Federal Police. In October 2003, the traders at NAB were trading highly leveraged call options on the Australian and New Zealand dollar in the anticipation that these currencies would fall against the US dollar. However, these currencies went in the opposite direction from that expected and NAB were losing millions of dollars every day. Instead of closing off the positions, the traders doubled their bets in order to recover initial losses. They also entered fictitious currency transactions in the bank's books to cover up their losses. These fictitious transactions and trading limit breaches were not detected by internal controls. It was only some months later that a fellow alerted management when discrepancies were noticed in trading accounts (Singh, n.d.).
