SocGen: Kerviel’s State of Mind & Timing his Gains & Losses

by Kurt Schulzke on March 12, 2008

The SocGen debate continues. Thanks to Gaute Solheim who commented yesterday as follows:

[Quoting Kurt Schulzke]: “The gains and losses were all a single product of the rogue behavior of a single trader who was discovered and ushered out of the company very early in 2008.”

I am not able to follow your logic here. If the rogue behaviour had resulted in record gains in early 2008, and he had been ushered out of the company for trading outside his limits, would it then be more “true and fair” to put all the gains from all the different trades he did in the 2007 result since they were “a single product”?

I have a hard time figuring out where in the IFRS a persons intent for “rogue behaviour” is treated as a cause to bundle together independent trades that otherwise would be handled independently. As you understand I am not convinced yet.

I do agree with you that IFRS is a step in the right direction, but I still suspect that SG stepped out of line here.

I take Mr. Solheim’s point, to the extent that Kerviel’s intent seems on the surface to be irrelevant to the timing of SocGen’s recognition of gains and losses from Kerviel’s individual trades.

Restated: What if Kerviel had executed those trades not as an out-of-control rogue, but as a part of his ongoing responsibilities at SocGen? If this were true, then I would agree that SocGen would be bound to follow the nitty-gritty of IAS 10 and IAS 39 (see Note 40) with the result that the gains and losses would face each other separately over the 12-31-07 cutoff.

However, we are presented here with an extraordinary, integrated series of fraudulent moves by a single trader in direct violation of company policy so far out of the usual business of SocGen and so cleverly designed to avoid internal controls that to pretend they were part of SocGen’s routine or that they are likely recur in the future would be fundamentally misleading. SocGen would mislead by reporting this “Kerveil Special Edition” — following the details of IAS 10 and IAS 39 — as if it were an ordinary occurrence. I believe that readers who take time to examine SocGen’s Special Commitee Progress Report (or the subsequent Mission Green Summary Report) can fairly emerge with the view that Kerviel’s fraud should be a once-in-a-lifetime event at SocGen and should be reported as such.

The question is what is the most “true and fair” way and time to recognize the impact of the Kerviel event in SocGen’s financials? Here, we should keep in view the European accounting “principle of prudence” according to which companies have historically been required to recognize contingent liabilities when they are merely “possible.” This view stands in stark contrast to U.S. GAAP which recognizes or “books” liabilities only when they have become “probable of occurrence” and “reasonably measureable” in amount.

SocGen learned of the Kerviel losses — that they were not only possible but an accomplished fact of measurable proportions — before issuing their 2007 financials. A French company like SocGen could quite reasonably take the view that fairness not only allowed but required them to show the impact of those losses immediately, in the 2007 income statement and that resorting to the true and fair view override — an integral, essential element of IFRS accounting — was the only thing to do.

It is fair to mention, as well, that this is not a case in which a company deliberately hid losses to mislead investors. Au contraire. SocGen quickly and exhaustively investigated, thoroughly disclosed and even recognized the resulting losses in income before some commentators wanted them to do so. It is difficult to imagine a company doing any more than SocGen has to provide all material information to the market about this event and its impact on the company.

Most serious analysts don’t rely on “as is” financial statements. They desconstruct — “analyze” — the published financials to get at cashflow and other meaningful measures of performance. Beating SocGen over the head for posting the Kerviel losses in 2007 instead of a few weeks later in 2008 adds noise but no information value.

My sense is that some who are crying “foul” over this event do more out of Schadenfreude and resentment that SocGen posted a sizeable profit in 2007 — a year of banking disaster — even after the Kerviel losses. SocGen’s American counterparts can only wish they had it so good.