Does JPMorgan Have a Culture of Fraud?

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Federal investigators are currently building a criminal case against four key employees involved in JPMorgan Chase's (NYSE: JPM  ) notorious London Whale trade for allegedly failing to provide accurate valuations for their financial statement disclosures. In addition to investigating Bruno Iksil and Julien Grout for allegedly overvaluing their positions, investigators are following up on allegations that London's trading strategy manager Javier Martin-Artajo, and the international chief investment office's top executive, Achilles Macris, pressured Iksil and Grout to price their positions aggressively.

A recent New York Times story discussing the investigation opined that "[the] scope of the inquiry suggests that the problems were isolated to a handful of executives and traders in an overseas division, and did not reflect a fundamental weakness with the bank's culture and leadership."

To quote the phrase of the moment, I think that's a bunch of malarkey.

Even if JPMorgan's top leadership didn't directly encourage the alleged fraud, and wasn't aware it was occurring, that doesn't help them escape broad criticisms of their culture. A corporate culture is defined by the shared understanding of "how things really work" in the organization, and what types of behaviors are allowed and encouraged. And at JPMorgan, the internal controls system would play a major role in the formation of this shared understanding within the chief investment office (CIO), and have the potential to create a "culture of fraud" within the department.

Material weakness
If an organization doesn't have strong internal controls to detect and prevent fraud, that reflects a failure on the part of organizational leadership to take the steps necessary to foster a strong ethical culture. And as JPMorgan revealed in its own filings, it had material weaknesses in its internal controls that allowed traders to mismark the books undetected.

Sarbanes-Oxley expert Michael Crimmins has pointed out that JPMorgan's internal controls process deviates from widely followed practices in the financial industry, which require valuations to be determined by an independent valuations unit, existing outside of the CIO. In contrast, it seems that JPMorgan relied on traders to provide their own valuations, with an internal control group conducting regular checks of the traders' markings to ensure they were honest and accurate.

JPMorgan's CEO Jamie Dimon should have been well aware of these industry standards, and with the consequences faced by AIG (NYSE: AIG  ) for its failure to follow them. At the very least, he should have recognized these key shortcomings in JPMorgan's internal controls by May of this year, when the company acknowledged the inaccuracy of its first-quarter value-at-risk numbers. However, even at that point he still certified the effectiveness of the company's internal controls process.

These statements reflect a shameful oversight on the part of Dimon and other company leaders. Worse, they may reflect a conscious choice to refrain from putting adequate controls in place to eliminate fraud. Either way, this chain of events reflects badly on the organization's leadership and culture as a whole -- not just on the four employees under investigation for criminal misconduct.

Possible collusion?
The lack of adequate internal controls isn't the only thing that makes me skeptical of the suggestion that just four employees are the sole source of the alleged misconduct.

A July article from Bloomberg cites former JPMorgan executives expressing bewilderment at the company's focus on traders as the source of the incorrect valuations. These sources point out that, while traders provide their own valuations on a daily basis, an internal control group checks these valuations at least once a month.

If the sources are to be believed, this suggests that, despite JPMorgan's flawed internal controls process, the CIO's internal control group would be in a position to discover a trader's fraudulent valuations within a month, and that any mismarking occurring for a longer period reflects either ineptitude or collusion on the part of that control group. If the latter is true, then members of the internal control group would be implicated in the alleged fraud along with the traders and managers directly involved in the fraudulent valuations.

A systems failure
That said, don't be fooled into thinking that JPMorgan set up an acceptable internal controls process that was cleverly manipulated by criminal mastermind employees. Several features were aligned that would make it easy for traders to avoid discovery and punishment for their misconduct.

In fact, in addition to making it easy for traders to commit fraud, the flawed internal controls process could also put a great deal of pressure on internal controls employees to play along. As Crimmins pointed out, when a valuations unit resides within the business unit it's examining, "History has shown that staffers preparing the valuation will be subject to pressure from the unit leaders, particularly if the business has losses that the producers hope can be reversed." To support this point, if it's true that Martin-Artajo and Macris successfully pressured Iksil and Grout into exaggerating their valuations, wouldn't they also have the influence to pressure the internal control group, within their own department, to sign off on those valuations?

To create a culture of ethics and compliance, an organization must establish systems that encourage ethical, law-abiding behavior and encourage employees to report misconduct. JPMorgan failed to do this when the London Whale trades occurred. The company has updated its internal controls since the London Whale fiasco. However, some observers have pointed out that management still hasn't given much information about the new system, and the information provided isn't enough to lend confidence that the new system is free of the underlying problems present in the old one.

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