Source: FX Week
The ACI Financial Markets Association (ACIFMA) is planning to file an amicus brief, supporting the appeal of former HSBC executive Mark Johnson, who was convicted of wire fraud relating to a $3.5 billion foreign exchange order in October 2017.
Amicus briefs are legal documents filed by non-litigant parties who have a strong interest in the subject matter of cases going through appeal, to advise the courts on additional relevant information that might be relevant to the case.
ACIFMA, a trade body representing 9,000 financial market professionals globally, plans to file an amicus brief to argue that upholding the conviction of Johnson could have serious ramifications for the industry.
“Our major concern is that, at face value, this case revolves around pre-trade hedging a large fixing transaction and questions the legitimacy of a bank following the correct risk management approach to such a deal,” says Bruno Langfritz, chairman of ACIFMA.
Opening briefs in the case are due on August 30. Amicus filings must be made within seven days of that date.
“If the appeal is not successful this could have huge implications in the use of ISDA agreements and the concept of principal-to-principal trading that underpins FX trading, and we will have to think about the implications for the market,” says Langfritz.
Johnson, a former global head of foreign exchange cash trading at HSBC, was found guilty of wire fraud and conspiracy in October 2017, for “frontrunning” a large fixing trade that he and his team conducted in December 2011 for the bank’s client, Cairn Energy. He was sentenced to two years in prison in April and is appealing the conviction in the Second Circuit Court.
ACIFMA believes the facts that are on appeal are particularly concerning because the decision made by jurors in the Eastern District Court of New York appears to have altered or overridden the scope of the fiduciary obligations under the ISDA agreement – a standard master contract that underpins several over-the-counter transactions.
There is also unease among ACIFMA members that Johnson has been labelled a criminal for trading in a manner that seems to conform to what the FX Global Code of Conduct has approved as being good industry practice.
While the Code did not exist when Johnson was trading in the market, Principle 11, which outlines best practices around pre-hedging orders, and Principle 10, which is relevant to fixing orders, were the product of two years of work between public- and private-sector representatives.
According to these principles, Johnson acted in line with best practices as they stand today.
“If you impose secondary hindsight type of legal standards – especially criminal standards – to behaviour that at the time it was undertaken, the trader arguably had no reason to believe was wrong, then you’re going to have an impact upon banks’ willingness to take risks, which has a direct impact upon the liquidity available,” Jack Drohan, the New York-based president of ACI America, tells FX Week.
This industrywide impact on risk taking and, in turn, liquidity provision could be where the outcome of the Johnson case creates the biggest reverberations.
“If banks feel [that] because of the legal verdict, they could not pre-trade hedge these orders, the market impact could be significant,” Langfritz says.
Such an outcome could increase the cost of executing fixing transactions and also result in periods of extreme volatility during fixing windows. “This would not be conducive, regarding consideration as to if your actions risk disrupting the market. It also raises profound issues for the concept of principal-to-principal trading,” he adds.
A career-ending deal
In 2011, Cairn sought pitches from about nine banks to covert $3.5 billion (£2.25 billion) in sale proceeds into sterling. These requests for proposals have already contributed to information leakage about the deal, as dealers who had not been selected knew a large deal was in the offing, leaving them on the lookout for the transaction going through.
Cairn chose HSBC and opted to execute the order at the fixing, which the bank offered as one of three possible options with the proviso that Cairn give it two hours’ notice before the transaction, so the dealer could start to pre-hedge.
The FX Global Code states in Principle 10 that, for a fixing order, it is acceptable to transact over time before, during or after the fixing calcu lation window, as long as it does not have an intentionally negative impact on the outcome for the customer.
It is unacceptable, however, to buy or sell a larger amount than is in the client’s interest within seconds of the fixing calculation window, or transact shortly before it in order to have an adverse impact on the price. Traders cannot show a large interest in the market during the fixing calculation window in an attempt to manipulate price. Neither can they inform others of a specific client dealing at the fixing rate or acting with other market participants to either inflate or deflate that rate.
Expert testimony from Johnson’s defence states that none of the HSBC traders overbought sterling. Johnson did loop in a team of traders in London and New York to execute the deal.
Pre-hedging, according to the Code, is allowed when acting as a principal – but not as an agent – and it should be designed to benefit the client with prevailing market conditions such as liquidity, as well as the size and nature of the anticipated order, being considered.
Furthermore, traders are expected to get on with normal business, such as risk management, market-making and the execution of other client orders.
“When considering whether pre-hedging is being undertaken in accordance with the principles above, pre-hedging of a single transaction should be considered within a portfolio of trading activity, which takes into account the overall exposure of the market participant,” the Principle states.
Johnson’s attorneys argue that he followed industry standards and Cairn got what it bargained for, because all the pounds bought were turned over to the oil and gas firm. With Johnson being sentenced to two years behind bars, – he is currently out of prison, pending appeal – his attorneys further claim that his due process has been violated. They point out that Johnson has not violated any law, rule or regulation governing the FX market, and he was not forewarned that he was doing anything wrong.
Finally, Johnson’s lawyers say an existing ISDA agreement outlined that HSBC and Cairn were interacting as principals in essence, disclaiming any fiduciary duty.
“How are foreign exchange traders supposed to know what trading constitutes wire fraud when the government cannot even answer that question for itself?” Johnson’s lawyers asked in court filings.
If the case was decided on the grounds that are being put forward on appeal by the defence – despite apparent contractual, circumstantial and direct disclosures of the bank’s intent to trade ahead of the fixing order – then ACI’s Drohan tells FX Week that “the implications of criminal prosecution solely on those grounds is very disturbing”.
“If that’s what the case was decided on, you’re going to see a massive move toward re-evaluating the scope of fiduciary liability in the standard master agreements that underpin prime brokerage and direct trading accounts,” he says.
“You’re going to be re-evaluating principal-to-client trading models. You may have a greater move towards pure agency models, which has got moral hazards of its own. But, at least with a pure agency model, if you can show that every component transaction was afforded best execution relative to where the market was at the time of trading, you’ve got more of a legal defence to this kind of attack,” Drohan adds.
Should the verdict stand on appeal, Langfritz says the Global Foreign Exchange Committee overseeing the Code would need to reconsider the advice and examples given by the documents around pre-hedging. Similarly, those who use the fix to hedge transactions will have to think carefully about whether it is an appropriate mechanism going forward, especially for larger amounts.
There are also implications for where FX trades happen in the future.
“Consideration will have to be given as to [whether] transacting FX orders within the reach of US jurisdiction is appropriate, given the potentially different legal interpretation compared to other jurisdictions,” Langfritz says.
The deal was between a UK bank and a UK customer, predominantly executed in London.
“That this can lead to a territorial reach leading to a criminal trial in the New York district courts, rather than the British courts, is a worrying development for the market with potentially far-reaching consequences for the US markets,” Langfritz adds.
Traders as magicians?
As far as the US Department of Justice is concerned, Johnson began unlawfully misappropriating and using Cairn’s confidential information against the company in late November 2011 to reap millions in profits for HSBC. The DoJ claims Johnson did not inform Cairn of his plans to pre-hedge the order or that he would tip off other HSBC traders using code words about the timing of the deal.
Because of the pending appeal, the DoJ declined to comment for this article.
Urs Bernegger, founder and adviser at FX consultancy Helvetii, who served as head of FX trading at Swiss bank UBS between 2013 and 2015, and also ran its FX trading desk from 2001 to 2010, says the case should alarm new market entrants.
“It’s a case that sets a very dangerous precedent for anybody who is active in foreign exchange trading or has been active, because we’re talking about a [trade] from 2011,” he says.
Bernegger also argues that Cairn Energy is a large corporate that does not need the sort of protection that individuals do, and, as such, it must be aware of the fact that $3.5 billion cannot be traded within 60 seconds.
“If you can do that, you have a show in Las Vegas that’s sold out every night – you’re a magician,” he adds.