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1 Reprint January 2014 Vol. XXVII Number 1 Journa ournal Your source for professional liability education and networking Here We Go Again? Financial Institutions Face Heightened Regulatory Scrutiny Over Forex and Other Unregulated Rates by Eric C. Scheiner and Jennifer Quinn Broda Eric C. Scheiner and Jennifer Quinn Broda are partners in the Chicago offi ce of Sedgwick LLP where they represent insurers and reinsurers in investigating and litigating claims under various types of professional and commercial lines of coverage. They can be reached at Eric.Scheiner@ sedgwicklaw.com and Jennifer.Broda@ sedgwicklaw.com. On the heels of the London Interbank Offered Rate (Libor) scandal, regulators appear to have found a new area of potential improprieties with regard to the foreign exchange market (frequently referred to as Forex or FX ). The Forex market fluctuates, but can reportedly reach a value of up to $4.7 to $5.3 trillion per day. 1 To date, at least fifteen banks are reportedly under investigation by various regulators regarding the Forex market. 2 Moreover, more than a dozen currency traders have been suspended or put on leave as a result of the ongoing investigations. Some banks have already hired criminal defense attorneys to represent employees with regard to the investigations. While these investigations remain in the preliminary stages, and no wrongdoing has been announced to date, there are indications that regulators and plaintiffs attorneys are ramping up their scrutiny of unregulated rates. This article will provide background as to how the Forex market works, the conduct at issue and the special role chat rooms may be playing with regard to the investigations. Further, we will discuss how the investigations first started, how they have developed to date (including what banks have suspended or put individuals on leave), and the recently filed Forex civil litigation. Finally, given the largely unregulated nature of setting certain types of benchmark rates, this article will explore other potential areas that are already under investigation or which may be the subject of investigations going forward (e.g., the precious metals market, including gold) and the potential coverage implications these investigations and civil suits may have on insurers. Background In essence, the Forex market is the market on which currencies are traded. It is a global and decentralized market. Much like when an individual wants to buy foreign currency in anticipation of international travel, a common method for a company or investor to make a large currency transaction is to review information posted by various banks about their prices for a given currency and pick the best rate. However, as with making a trade in the stock market, for larger currency exchanges, the banks will post two different prices: the bid price and the offer (or ask) price. The bid price is the price the market would pay for a given currency and the ask price is the price at which the market would sell the currency. The difference between these two prices is how the banks profit on these transactions (commonly called the bid/ask spread). In essence, the banks try to buy currency at a lower rate and sell it later at a higher rate for a profit. There are other pricing issues that can play a factor in whether a person wants to make a currency trade. For example, the banks commonly charge various forms of commission. 3 Further, the price can depend on the size of the transaction, whether the currency is being bought and sold, and even the nature of the relationship between the bank and the client looking to make the trade. In light of these various issues and complexities, the companies and investors who are not as concerned with trying to squeeze the best rate out of the banks seek to use a benchmark rate. For example, index funds that track the market may use currency benchmark rates in order to keep their returns in-line with the indices. 4 While this may not sound like a particularly significant issue, even small fluctuations may impact these funds value. Given that Morningstar Inc. estimates $3.6 trillion in index funds track global indices, there may be a large pool of potentially impacted investors. 5

2 The most common benchmark rates in the currency market are set at 11:00 am and 4:00 pm London time. 6 This is because London is considered to be the global center of the Forex market, with an estimated 40% of trades taking place there. 7 These rates, commonly referred to as fixes, are essentially daily rates that can be used to trade currency. Of these fixes, the most commonly used one is computed at 4:00 pm by a joint venture between State Street s WM unit and Thompson Reuters (Thompson Reuters was also involved with setting the Libor rates). 8 However, at least one recent article discussed potential investigations into Tokyo fixing, referring to Japanese currency benchmarks (which are set at 9:55 each morning in Tokyo). 9 The potential attempted manipulation of these fixes appears to be the focus of regulators investigations. For the currencies that are traded more frequently (21 in total), the WM/ Reuters fix is calculated by reviewing currency trade data from various trading platforms for 60 seconds at 4 pm. 10 Since the currency market is very large, it could be difficult to manipulate these fixes. However, with enough coordinated large trades in the one minute window (in a process known as banging the close ), it could be possible to manipulate the fixes. Assuming these fixes were manipulated, and the banks knew in advance the direction the rates were going to be fixed, traders could clearly profit from that knowledge. The Investigations to Date It appears that the Forex investigations began in April of 2013, when the U.K. Financial Conduct Authority (FCA) asked certain banks for information regarding potential manipulation. 11 From there, the investigations picked up steam, with more and more banks being identified as potentially involved or publicly acknowledging that they have received inquiries from regulators. The banks that have been identified or made announcements regarding Forex regulatory investigations to date include: Barclays, Citigroup, Inc., Credit Suisse AG, Deutsche Bank, Goldman Sachs Group, HSBC, JP Morgan Chase & Co., Morgan Stanley, Royal Bank of Scotland, Standard Chartered and UBS. The various regulators investigating the issue include the U.S. Department of Justice, the Commodity Futures Trading Commission, the European Commission, the Swiss Financial Market Supervisory Authority, the Hong Kong Monetary Authority, the Monetary Authority of Singapore and regulators in Brussels. 12 Significantly, over a dozen currency traders reportedly have been suspended or put on leave while the inquiries take place at Barclays (6), Citigroup (1), JP Morgan (1), Standard Chartered (1), Royal Bank of Scotland (2) and UBS (1). 13 These traders were located in New York, London and Tokyo. Also, Barclays and UBS have reportedly hired criminal defense lawyers to represent employees with regard to the investigations. 14 For the most part, the regulators that have made public statements about the investigations have only stated that the investigations remain in the early stages. Barclays, Royal Bank of Scotland and Deutsche Bank have indicated that they are cooperating with various regulators. From various reports, it appears that regulators are requesting s, instant messages and phone records of several employees at these banks looking for evidence of potential wrongdoing. 15 A spokesman for the U.S. Department of Justice has stated that the criminal division has started a far-reaching probe, and that they are responding aggressively and taking it very seriously. 16 The Use of Chat Rooms Several media reports have indicated that the regulators are, in part, investigating the use of chat rooms that are available via Bloomberg trading terminals. Some of the names of the chat rooms appear suspect enough, with titles such as the Cartel, the Bandits Club and the Dream Team. In addition, and as can be common in trading chat rooms and message boards, the banter between traders reportedly includes boasts about the ability to manipulate the market, as well as sharing market-sensitive information. 17 Whether those comments are actually true or not, the potential implications will be taken seriously by regulators given the climate and recent issues concerning rate manipulation surrounding Libor. Several of the traders that participated in these chat rooms are also reportedly past or present members of a Bank of England committee that oversees the currency market (the Foreign Exchange Joint Standing Committee chief dealer s subgroup). 18 UBS, Barclays, Citigroup and RBS have now banned or significantly limited the use of all chat rooms, and other investment banks are reportedly considering similar options. 19 Further, Deutsche Bank executives are warning employees to be cautious about the words they choose to use in s and chat rooms, as their comments can be taken out of context. 20 Forex Civil Lawsuits Not surprisingly, civil lawsuits are now starting to be filed against a number of banks asserting investors have been damaged by the alleged manipulation of the Forex market. To date, there have been at least two purported class action lawsuits filed against Barclays, Citigroup, Credit Suisse, Deutsche Bank, JP Morgan Chase, Royal Bank of Scotland and UBS in the United States District Court for the Southern District of New York. The first of these was filed on November 1, 2013, by pension fund Haverhill Retirement System and alleges a single cause of action for antitrust violations under the Sherman Act. 21 The second purported class action was filed on November 8, 2013, by the Korean electronics firm Simmtech Co., Ltd. In addition to alleged antitrust violations, the Simmtech action also alleges violations of the New York General Business Law. 22 Despite numerous Forex traders having been suspended at many of the defendant banks, neither complaint names any individuals as defendants. The allegations in each complaint are substantially similar and allege that the defendant banks traded ahead of client orders and rigged the WM/Reuters Rates by pushing through trades before and during the 60-second window when the benchmark is set. By pushing a 2 Professional Liability Underwriting Society

3 concentration of orders through during this 60-second window, it is alleged that the traders colluded to push the rate up or down, via the process referred to above as banging the close. As a result, the complaints allege that the returns class members received from the currency trades tied to the WM/Reuters Rate were fixed or stabilized at levels lower than the free market would have returned absent the alleged manipulation. Further, the lawsuits assert that class members were deprived of the benefits of free, open and unrestricted competition in the currency trading market. The lawsuits remain in the very early stages, and whether they ultimately obtain class certification remains to be seen. However, damages have the potential to be significant, with some speculating that the impact of the alleged Forex market manipulation could rival the recent Libor-rigging scandal. 23 Further, as the alleged Forex market manipulation becomes more widely reported on, additional civil lawsuits are all but guaranteed to be filed against the banks participating in the Forex market. In fact, a lawyer representing Simmtech recently stated that several South Korean companies have inquired about joining the Simmtech action. 24 That said, to date the plaintiffs firms have had problems making the antitrust allegations in the Libor litigation stick. In the consolidated Libor litigation, the judge overseeing those cases pending in the Southern District of New York (Judge Naomi Reice Buchwald) dismissed the antitrust claims on the grounds that the plaintiffs failed to allege antitrust injury. Such a claim requires a loss that stems from an anticompetitive aspect of the defendants business practices. Specifically, the court found that while the plaintiffs may have suffered a vertical loss (i.e., harm resulting from the Defendants conduct), they had not plausibly alleged a horizontal effect (i.e., that the process of competition was harmed because the defendants failed to compete with each other). In other words, the court found that no competition was actually harmed as a result of the defendants alleged behavior. While that ruling is in the process of being appealed, given the size and nature of the Forex market, the plaintiffs in the cases filed to date will likely face similar arguments. Another possible allegation by potential plaintiffs would be violations of the Commodities Exchange Act (CEA). CEA claims were brought by one class of plaintiffs in the consolidated Libor litigation and the district court overseeing that litigation has allowed some of those claims to go forward. 25 One of the key issues the Libor district court reviewed with regard to the CEA claims was whether the plaintiffs could plead actual damages on their specific (in that case, Eurodollar) futures contracts as a result of the defendants manipulation. If there was manipulation of the Forex fixes, it likely would require large coordinated trades. In this regard, it may be possible for an individual investor, or combined group of investors, who made large trades based on the fixes to show damages if there was indeed manipulation. However, much would depend on the size of the trades and level of purported manipulation. Aggrieved investors may also attempt to rescind agreements and/or trades that were tied to the Forex fixes. We have seen this in the Libor arena in the U.K. civil action entitled Graiseley Properties Ltd v. Barclays Bank plc, generally known as the Guardian Care Homes case (there is a similar action in the U.K. pending against Deutsche Bank, entitled Deutsche Bank AG v. Unitech Ltd.). In both the Guardian Care Homes and Unitech cases, the investors are arguing that they would not have entered into the financial transactions at issue with each bank had they known that Barclays and Deutsche Bank, respectively, were manipulating the benchmark underlying the transactions (i.e., Libor). If successful, the claimants may be able to use Libor manipulation as a basis to rescind the contracts, walk away from the deals and potentially receive damages. In this regard, if any index funds or other investors had agreements with any of the banks being investigated for manipulation of the Forex market that tied some component of the deal to the Forex fixes, similar allegations could be made against those banks if there was manipulation. Similarly, U.S. investors who may have had large investments tied to the Forex fixes may make individual allegations of fraud against the banks. The discussion above of potential claims that may be brought against the banks involved in the Forex investigations is not intended to be exhaustive. Since these investigations are still in the early stages, it is possible that other types of allegations of wrongdoing could arise that would lead to different claims being made in civil litigation. However, much has yet to be revealed with regard to these investigations. The Metals Market and Other Potential Areas of Concern Other markets have received some press concerning potential manipulation, including the metals markets, and other commodities such as oil, as well as interest-rate swaps and derivatives. 26 Reports have surfaced that European Union regulators have searched the offices of a unit of McGraw-Hill Financial that assess the price of Dated Brent, which is the benchmark rate for greater than half of the crude oil worldwide. 27 However, of these various other markets of potential concern, the one that has received more press as of late is the gold market. 28 Similar to the Forex market, the benchmarks for gold are also called fixes. The London gold fixing is conducted twice a day (10:30 am and 3:00 pm, London Time) by Barclays, Bank of Nova Scotia, Deutsche Bank, HSBC and Societe Generale over the telephone and after reviewing recent orders. 29 According to reports, the U.K. FCA has recently heightened its review of the metal markets generally, including the hiring of outside consultants to assist in its investigations. Germany s financial regulator, BaFin, is also reportedly investigating suspected manipulation of gold and silver benchmark rates. 30 The gold fix price is used by investors and companies alike to value their holdings, but is also used in derivative markets for purposes of pricing and trading options, swaps and futures. 31 January 2014 PLUS Journal Reprint 3

4 Insurance Implications Given the amount of electronic information that is likely being requested from the various banks involved to date, the costs of these investigations are likely to be significant. For example, it has been reported that Deutsche Bank is currently sifting through tens of millions of pages of transcripts of electronic chats, messages and other communications to determine whether its employees engaged in improper conduct in the foreignexchange markets. 32 That said, costs incurred in connection with the regulatory investigations may not be covered or only provided on a limited basis depending on policy wording. If regulators determine that manipulation did in fact occur and additional civil litigation follows, defense costs could be substantial for many of these banks. However, coverage available under a Banker s E&O policy could be limited by the claims being asserted. For instance, many E&O policies specifically exclude antitrust claims and similarly exclude fraud (though fraud exclusions now more commonly have varying adjudication provisions). If fines or penalties are levied for wrongdoing, and those fines rival the $3.6 billion in fines that have been levied to date with regard to the manipulation of Libor, it could impact the stock price of a given bank. Moreover, there have been several reports that the suspension of traders at the various banks may cause disruption in the Forex market, which could lead to allegations of lost profits. Such circumstances could set the stage for either U.S. securities class actions or derivative actions being asserted not only against the banks, but also the directors and officers. As such, both D&O and E&O policies have the potential to be implicated, depending on the wording of the policy and the specific allegations asserted. Finally, employment practices liability policies may also be impacted in light of suspensions of senior traders. These traders are often highly compensated, and as such are not able to easily find comparable employment. If a suspended trader believes they are the fall guy for conduct the bank knew about, and possibly even encouraged, then employment practices claims for wrongful termination may also be brought against the banks. Conclusion The regulatory investigations are still in the preliminary stages, and there has been no admission of wrongdoing by any of the banks to date. However, in light of the ongoing investigations, as well as the suspensions of traders by multiple banks, it appears likely that regulators will find some wrongdoing occurred. Additionally, the plaintiffs bar is obviously already paying attention with the filing of at least two civil cases to date and more are expected to follow. As a result, any issues relating to potential manipulation of the Forex fixes and other unregulated rates should be closely watched by insurers going forward. 4 Professional Liability Underwriting Society

5 Endnotes 1 Liam Vaughan, Gavin Finch and Ambereen Choudhury, Traders Said to Rig Currency Rates to Profit Off Clients, Bloomberg.com, June 12, 2013, 2 Daniel Schafer, Alice Ross and Delphine Strauss, Foreign Exchange: The big fix, Financial Times, November 12, 2013, cms/s/2/7a9b85b4-4af8-11e3-8c4c-00144feabdc0.html. 3 The issue of charging inappropriate commissions is the subject of other Forex-related litigation. See BYN Mellon s FX Lawsuit to Proceed Analyst Blog, Nasdaq.com, August 7, 2013, Katie Martin, Chiara Albanese and Clare Connaghan, Banks Scour s Amid Probes Into Currency, Wall Street Journal, October 9, 2013, Liam Vaughan, Gavin Finch and Ambereen Choudhury, Traders Said to Rig Currency Rates to Profit Off Clients, Bloomberg, June 12, 2013, traders-said-to-rig-currency-rates-to-profit-off-clients.html. 6 See Jill Treanor, Financial Conduct Authority Launches Currency Markets Investigation, The Guardian, October 16, 2013, (noting that The benchmark rates are published hourly for 160 currencies and half hourly for the 21 biggest currencies, including sterling... ). 7 Chiara Albanese, Barclays Scrambles to Plug Staff Gap After Suspensions, Wall Street Journal, November 5, 2013, online.wsj.com/news/articles/sb Martin, et al., Banks Scour s Amid Probes Into Currency. 9 Ben McLannahan and Jeremy Grant, Threat of Currency Probes Stepping Up Pace In Asia, Financial Times, November 21, 2013, 10 Martin, et al., Banks Scour s Amid Probes Into Currency (noting that a spokesman for WM referred a reporter to a document on the company s website that describes the methodology for computing the fixes ). 11 Edward Ballard and Margot Patrick, U.K., Hong Kong Widen Forex Market Probe, Wall Street Journal, October 16, 2013, ; Currency-Rigging Probe Widens, Business Spectator, November 2, 2013, businessspectator.com.au/news/2013/11/2/financial-services/ currency-rigging-probe-widens. 12 Citigroup Faces Forex Probe, Zacks.com, November 4, 2013, An Jani, Singapore Joins Global Currency-Market Probe, Wall Street Journal, October 24, 2013, com/news/articles/sb ; Katie Martin and Chiara Albanese, CTFC Asked Major Forex Banks to Scrutinize Records, Wall Street Journal, October 21, 2013, ; Martin, et al., Banks Scour s Amid Probes Into Currency. 13 Currency-Rigging Probe Widens, Business Spectator, November 2, 2013, news/2013/11/2/financial-services/currency-rigging-probewidens; David Enrich and Katie Morgan, Currency Probe Widens as Major Banks Suspend Traders, Wall Street Journal, November 1, 2013, Enrich, et al., Currency Probe Widens as Major Banks Suspend Traders. 15 Tom Schoenberg, U.S. Said to Open Criminal Probe of FX Market Rigging, Bloomberg.com, October 11, 2013, bloomberg.com/news/ /u-s-said-to-open-criminalprobe-of-fx-market-rigging.html. 16 John Letzing, Chiara Albanese & Katie Martin, Currency-Trading Probe Gains Momentum, Wall Street Journal, October 30, 2013, Enrich, et al., Currency Probe Widens as Major Banks Suspend Traders. 18 Currency-Rigging Probe Widens, Business Spectator, November 2, 2013; Duncan Mavin and Katie Martin, Leave for Two Who Helped Oversee U.K. Forex Trade, Wall Street Journal, October 30, 2013, Giles Turner, David Enrich & Ben Wright, UBS Restructuring Forex Unit, Wall Street Journal, November 28, 2013, com/news/articles/sb ; James Shotter and Daniel Schafer, UBS Joins Crackdown on Staff s Use of Chat Rooms, Financial Times, November 27, 2013, ffd6de e3-86d feabdc0.html?siteedition=intl #axzz2ngi7jrgl. 20 David Enrich, Katie Martin & Jenny Strasburg, FBI Tries New Tactic in Currency Probe, The Wall Street Journal, November 20, 2013, Haverhill Retirement System, et al. v. Barclays Bank PLC, et al., Case No , United States District Court for the Southern District of New York (filed Nov. 1, 2013). 22 Simmtech Co., Ltd. et al. v. Barclays Bank PLC, et al., Case No , United States District Court for the Southern District of New York (filed Nov. 8, 2013). 23 Virgina Harrison, Bigger than Libor? Forex probe hangs over banks, CNNMoney, November 20, 2013, com/2013/11/20/investing/forex-probe-lawyers/. 24 Chiara Albanese, Katie Martin and David Enrich, Banks Fix on Sales Probes, Wall Street Journal, November 19, 2013, online.wsj.com/news/articles/sb See FTC Capital GmbH, et al. v. Credit Suisse Group AG, et al., Case No , United States District Court for the Southern District of New York (filed April 15, 2011). 26 Tom Schoenberg, U.S. Said to Open Criminal Probe of FX Market Rigging. 27 Id.; see also Mavin, et al., Leave for Two Who Helped Oversee U.K. Forex Trade. 28 Liam Vaughan, Nicholas Larkin & Suzy Ring, London Gold Fix Drawing Scrutiny After Forex, Libor Probes, Bloomberg Businessweek, November 26, 2013, com/news/ /gold-fix-drawing-scrutiny-amidknowledge-tied-to-daily-eruption. 29 Patrick Jenkins and Jack Farachy, Regulators Urged to Probe Metals Markets Abuse, Financial Times, November 10, 2013, feabdc0.html#axzz2nrha8Blb; Suzy Ring, Gold Benchmarks Said to Be Reviewed in U.K. Rates Probe, Bloomberg.com, November 20, 2013, com/news/ /gold-benchmarks-said-to-be-underreview-by-u-k-as-probe-widens.html. 30 Ludwig Burger, German Watchdog Starts Probe Into Gold Price Fixing: Report, KDAL610, November 26, 2013, com/news/articles/2013/nov/26/german-watchdog-startsprobe-into-gold-price-fixing-report/. 31 Matt Clinch, Gold Benchmark Price Review Launched: Report, CNBC, November 20, 2013, gold-benchmark-price-review-launched html. 32 Enrich, et al., FBI Tries New Tactic in Currency Probe. The mission of the Professional Liability Underwriting Society is to be the global community for the professional liability insurance industry by providing essential knowledge, thought leadership and career development opportunities. As a nonprofi t organization that provides industry information, it is the policy of PLUS to strictly adhere to all applicable laws and regulations, including antitrust laws. The PLUS Journal is available free of charge to members of the Professional Liability Underwriting Society. Statements of fact and opinion in this publication are the responsibility of the authors alone and do not imply an opinion on the part of the members, trustees, or staff of PLUS. The PLUS Journal is protected by state and federal copyright law and its contents may not be reproduced without written permission. PLUS Journal Reprint Professional Liability Underwriting Society 5353 Wayzata Blvd., Suite 600 Minneapolis, MN phone or