Systems and controls failures
The two main aspects in which the systems and controls at Toronto were found to be inadequate related to its independent price verification (“IPV”) and trading supervision policies. Although Toronto had three documented policies in place relating to IPV, the policy relating to trading portfoliosmerely stated that each individual business line should create its own specific documented IPV procedures and that globalmiddle office was responsible for doing so. However, Toronto failed to create procedures specific to the business onMr Brignall’s book and the higher level IPV processes, set out in Toronto’s fair value accounting policy, were never implemented. This led to a situation whereby Mr Brignall was responsible for valuing his own position, and was therefore able to exploit this responsibility by reporting fictitious trades and false valuations. The FSA noted thatMr Brignall had employed “unsophisticated” techniques for disguising the losses he wasmaking on his book, which proper systems and controls would have picked up with relative ease. As it was,Mr Brignall was able to falsify his book for almost two years without detection.
A further systems failure was the absence of any escalation procedure for the reporting of trade breaks which occurred onMr Brignall’s book until October 2006. Concerns that trade inputting errors had occurred onMr Brignall’s book together with the increasing amount of time that was being taken to deal with trader corrections had led to the documentation of an escalation procedure, although Toronto then failed properly to implement and follow those procedures. In addition, Toronto failed to ensure that there was a proper level of supervision of trade break procedures. Again, had these procedures been effective, Mr Brignall would not have been able to cover up his true trading position for such an extensive period of time.
The FSA found that, overall,Mr Brignall’s book did not benefit fromany effective supervision.When the London markets closed for the day there was no handover to traders in North America to supervise the positions taken byMr Brignall. Furthermore, Toronto’s fixed income business was governed by amatrixmanagement structure where each trader is supervised locally by a colleague from the same office, and functionally by a colleague who understood the products being traded. However, Toronto’s failure to ensure that either supervisor properly reviewedMr Brignall’s bookmeant that the escalating proportion of trades which were subsequently broken towards the end of February 2007 remained undiscovered.
The FSA also criticised the incomplete implementation of the firm’s holiday policy, whichmeant thatMr Brignall’s book was not activelymanaged during his absence. This contravened the firm’s fair value accounting andmarket risk policies and allowed profit and loss statements to be signed off by junior personnel who lacked a full understanding of what was being reported. Again, the FSA pointed out that effective operation of these policies would have exposed the trader’s fictitious trades and misevaluation of his position. Two further features of the failings in Toronto’s systems and controls were also held by the FSA to have contributed to the trader’s success in concealing his position fromthe bank for so long – a lack of reporting on operational statistics relating to deal cancellations, corrections or late trades to front office management, and the lack of any narrative as to whether those artefacts were attributable to operational error, trader error or client activity. Finally, the FSA noted that Toronto had failed to establish a standardised broker reconciliation process along its business lines, which would also have allowedmanagement to pick up on the true position onMr Brignall’s books.
In determining the level of penalty to be levied on Toronto, the FSA was trenchant in its criticismof the “serious and systemic weaknesses” in Toronto’s systems and internal controls which allowed the rogue trader readily to disguise his position and potentially left Toronto vulnerable to exploitation by financial criminals. Nevertheless, the FSA also took into account Toronto’s conduct on discovering the trader’smisconduct, which includedmaking an immediate report to it, commissioning an internal audit investigation, reviewing its procedures and implementing an action plan to put revised policies in place, instigating training for all London office employees, augmenting the management of its fixed income business worldwide, putting new independent verification procedures in place, improving supervision of staff and improving links between the functional and local supervisors. Toronto received the maximum30%discount available under the FSA’s executive settlement scheme.
On the basis of the findings set out in the notices, there is little doubt that the trader’s conduct in this instance deserved punishment and that the systems and controls failings within Toronto were so severe that they could not rightly be disregarded by the FSA. To that extent, this enforcement action hardly takes the development of Principle 3 to any greater level and indeedmust have been one of the easier cases for enforcement tomake. Nevertheless, and despite the basic failings of Toronto’s systems and controls it is interesting to note that no members of the bank’s seniormanagement have been disciplined for the flawed oversight of the fixed income business. This runs contrary to the FSA’s commitment to pursuing seniormanagement to ensure that they are fully engaged in embedding processes into their business which are Principles-compliant. Even in such an obvious case of systems and controls failings, this highlights the evidential difficulties still facing the FSA in finding named individuals upon whomto pin responsibility. Inmany ways this enforcement action sees the FSA returning to its SFA roots in seeking to punish an individual trader where inmore recent years it would have been content to leave the bank itself to deal with its employees. Nevertheless, the FSAmay have taken the view that the behaviour here was so serious that it could not let it go unpunished and that a strong message had to be delivered to themarket. A further interesting aspect of the FSA’s comment is its focus on the “matrixmanagement” techniques employed by Toronto. It highlights the risks inherent in such management structures, commenting that it is possible for a trader’s business to fail to be picked up on by either supervisor (here the local and functional supervisors did not liaise) because both assumed that the other was doing so. This Final Notice should be read alongside the Dear CEO letter of 19 October 2007, in which the FSA required details of the investment banks regarding the way in which they manage their compliance risks, including how they structure theirmanagement functions.