Thursday, December 20, 2012

Banks convicted of fraud in Italian derivatives case

The Wall Street Journal reports that four banks including Deutsche Bank, JP Morgan and UBS were found guilty of fraud in selling derivative contracts to the city of Milan.

This case is interesting because it highlights the difference between a customer and a counter-party.

  • A bank customer relies on the bank to make recommendations that are in the customer's best interests.

  • A counter-party relies on the bank to disclose all the useful, relevant information and knows that it is responsible for assessing this information as it is entering into a trade with the bank where the counter-party is responsible for all gains and losses.
Please note, that a bank customer can be large enough to be considered a sophisticated investor, but might not understand that it is being treated as a counter-party.
An Italian judge convicted four big banks of fraud in the sale of derivatives contracts to the city of Milan in the mid 2000s, a criminal-case ruling that legal experts said could set a precedent for related civil cases across the country. 
Judge Oscar Magi fined UBS AG, UBSN.VX -1.11% Deutsche Bank AG,DBK.XE -0.50% J.P. Morgan Chase JPM -0.78% & Co. and Depfa Bank PLC, part of Germany's Hypo Real Estate Holding, €1 million ($1.32 million) each and gave nine of their employees suspended jail sentences of up to eight months. Mr. Magi also ordered that a combined €90 million be seized from the banks. 
During the trial, prosecutor Alfredo Robledo had argued that the banks defrauded Milan by tricking officials into believing the city would save money on its debt repayments by entering interest-rate swaps that affected payments on €1.68 billion of bonds it had sold in 2005. Mr. Robledo also said the city was defrauded because the banks didn't disclose that they made an aggregate total of around €90 million in profits from the deals. 
The four banks denied the charges during the trial. On Wednesday, the banks reiterated that neither they nor their employees had engaged in wrongdoing and said they would appeal their verdict. Italian law allows up to two appeals in criminal trials; during the appeals process, the financial penalties are likely to be suspended. 
"In JPMorgan's view, the evidence at trial demonstrated conclusively that the individuals behaved entirely honestly and appropriately throughout and that the transactions complied with Italian and English law," the bank said in a statement. The other banks issued similar statements....
In Italy, the ruling could prompt prosecutors in other cities to seek to press criminal charges against banks that entered into derivatives contracts in other municipalities. For much of the 2000s, a number of Italian cities entered into swaps linked to interest rates, seeking to hedge risk they had taken on by borrowing at a time when Italian and international banks were granting credit easily. 
Municipalities often got locked into deals—and future payments—that they scarcely understood or expected. In 2008, the government banned the use of derivatives by Italian municipalities. 
Municipalities have taken action in civil court against banks, alleging that they didn't properly disclose the risks of derivatives deals. In March, the four banks in Wednesday's verdict had settled with the city of Milan, agreeing to unwind the interest-rate swaps ahead of their maturity in 2032. 
"The sentence poses for the first time the issue of the need of transparency when dealing with public entities," Mr. Robledo said after the verdict was delivered. "There are tens of local authorities in this situation and they have never been assisted by adequate professional advice," 
Tommaso Iaquinta, a Milan-based lawyer who has worked on a number of cases involving local authorities, but not the Milan one, said the decision sets "a very dangerous precedent for the banking world." The decision could lead to more criminal cases, as well as additional civil action, Mr. Iaquinta said.

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