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London Whale Settlement Sets Legal Precedent

Kyle Colona
September 27, 2013

JPMorgan Chase (NYSE: JPM) settled charges last week with a number of federal regulators in connection with the London Whale fiasco. The big bank will pony up $920 million in penalties to the Securities Exchange Commission (SEC), the Federal Reserve, the Office of the Comptroller of Currency (OCC) and the U.K.'s Financial Conduct Authority.

The widely reported busted deals involved a series of synthetic credit swap derivatives executed by the bank's London unit, which lost about $6 billion.

The London Whale settlement
The bank settled not only by paying the penalties, but also publicly acknowledging it violated the federal securities laws.

JPMorgan agreed that the swap blunder "occurred against a backdrop of woefully deficient accounting controls" in its Chief Investment Office. The firm also acknowledged senior managers failed to advise its board of directors. The SEC's order also states the bank "acknowledges that its conduct violated federal securities laws."

"J.P. Morgan failed to keep watch over its traders as they overvalued a very complex portfolio to hide massive losses," said George S. Canellos, Co-Director of the SEC's Division of Enforcement. "While grappling with how to fix its internal control breakdowns, J.P. Morgan's senior management broke a cardinal rule of corporate governance..."

In short, the settlement sets a new legal precedent. This could expose the bank to more lawsuits in addition to claims by investors already in play. While the bank did not admit to any misstatements of its financial reports, the SEC's order noted "the Sarbanes-Oxley Act of 2002 established important requirements for public companies and their management regarding corporate governance and disclosure."

Other legal headaches for JPMorgan
JPMorgan's troubles are far from over. The Commodity Futures Trading Commission (CFTC) has a separate probe under way to determine whether the bank's London unit manipulated the market with heavy derivative trading in 2012. Also, the Justice Department intends to bring another case against the bank involving $1 billion in mortgage losses for loans sold to Fannie Mae.

Finally, last week, the Consumer Financial Protection Bureau (CFPB) ordered JPMorgan to refund about $309 million to more than 2.1 million customers for illegal credit card practices. This enforcement action was initiated by the OCC, which the CFPB joined in 2012.

The federal watchdogs found JPMorgan engaged in unfair billing practices for certain credit card "add-on products" by charging consumers for credit monitoring services they did not receive. JPMorgan will also pay a $20 million penalty payment to the CFPB, while the OCC is separately ordering restitution of approximately $309 million from the firm. The OCC's order also requires JPMorgan to pay another $60 million to the agency.

What does new precedent mean for the big banks?
This case continues a wave of settlements involving JPMorgan and other banks. Until now, these legal actions often settled without the banks acknowledging wrongdoing. But admitting to faulty internal controls exposes the bank to more legal woes.

Moreover, this precedent leaves other banks exposed. For example, Bank of America (NYSE: BAC) currently faces SEC charges regarding the BOAMS 2008-A series of mortgage-backed securities. The securities watchdog claims Bank of America defrauded investors by failing to disclose delinquencies, defaults, and prepayments of the underlying loans.

The agency contends the bank only disclosed the percentage of defaults in this offering of jumbo loans to a small group of institutional players. The commission further contends the bank did not file this information as required by federal securities laws (a Sarbanes-Oxley violation).

While proving fraud is a relatively high bar since the agency needs to show intent rather than negligence, the Chase settlement could support the SEC's case. And the Department of Justice has filed a separate suit against Bank of America concerning this matter.

Meanwhile, the London Whale settlement could cause Citigroup (NYSE: C) more legal headaches stemming from its settlement with Fannie Mae in July.

In that episode, the bank agreed to pay about $968 million to cover pre-existing loans and any potential future claims on loans originated and sold to the housing agency between 2000 and 2012. The case centered on 3.7 million mortgage loans that had already defaulted as well as others on the edge of