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Peter Young, a fund manager at Morgan Grenfell, used money invested in the company's three largest European funds to purchase highly speculative stocks. These included a $30 million stake in Solv-Ex, a company with "a rather checkered past and nothing more tangible than ambitious plans for exploiting Canada's Athabasca tar sands for oil and minerals" (Barron's, 4 November 1996), whose stock Young bought not at a discount, but at a premium. In addition, Young established paired holding companies in order to circumvent Securities and Investment Board Regulation 5.14, which forbids a fund from owning more than 10% of any company, allowing him to increase the size of his risky stakes even further.
After Morgan Grenfell became suspicious of the large quantity of unlisted shares in Young's portfolios, it shut down trading on the three funds and replaced the questionable investments with cash provided by parent company Deutsche Bank, an unusual move designed to maintain investors' confidence in the funds. When trading resumed, however, 30% of investors withdrew their money. The fiasco cost Morgan Grenfell an estimated 400 million pounds sterling, including compensation to some 80,000 investors for money lost due to trading irregularities. The damage to Morgan Grenfell's reputation was no doubt even more costly. |
In early 1995, Morgan Grenfell Asset Management appeared to be an increasingly successful asset management firm. In 1994, the company's Investment Services division had grown the assets in the pension funds it managed from $7.6 billion to $10 billion. An article in the Institutional Investor of May 1 1995 praised the company for its "international expertise." However, trouble was brewing under the surface.
At some time during 1995, fund manager Peter Young began purchasing large quantities of stocks in little-known companies. One such company was Xavier, a "thinly capitalised Alberta shell company [whose] most conspicuous assets are some disputed claims to oil fields in southern Russia and western Siberia, an in situ pipe-repair business and a Nasdaq listing" (Barron's, 4 November 1996). Another speculative investment involved a $30 million stock purchase from Solv-Ex, a company with "a rather checkered past and nothing more tangible than ambitious plans for exploiting Canada's Athabasca tar sands for oil and minerals" (Barron's, 4 November 1996). Even more surprising was the fact that this transaction was made not at a discount, but at $2-a-share premium.
Securities and Investment Board Regulation 5.14 forbids a fund from owning more than 10% of any company. Yet by setting up paired holding companies that owned 90-95% of each other, with Young's fund owning the remaining 5-10% of each, the fund was effectively able to exceed this restriction with respect to companies in which the paired entities invested.
When the London regulators began investigating the valuation of assets in Morgan Grenfell's three largest European funds, Morgan Grenfell shut down trading on the funds for three days, and only resumed trading after its parent company, Deutsche Bank, replaced the questionable assets in the fund with $300 million in cash. When trading resumed, however, 30% of investors left the fund within a few weeks, taking $400 million with them.
The destruction in the wake of this scandal was enormous: as of mid-April 1997, its estimated cost was 400 million pounds. This included 3 million pounds in fines levied by City of London regulators and compensation paid to 80,000 investors for money lost due to the trading irregularities.
Losses in mutual funds are normally borne solely by the investors, not by the mutual fund company. However, because Young's trades were so egregiously speculative, Deutsche Bank felt compelled to bear the loss itself in order to avoid alienating investors in the future. However, reputational damage still occurred, despite its action, as illustrated by the flight of investors when the fund reopened.
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May 1994: Peter Young is given control of the European Growth trust two years after joining Morgan Grenfell.
July 1995: Young begins to buy stock in Xavier, a "thinly capitalized Alberta shell company. . . [whose] most conspicuous assets are some disputed claims to oil fields in southern Russia and western Siberia, an in situ pipe-repair business and a Nasdaq listing" (Barron's, 4 November 1996).
21 March 1996: Solv-Ex, an obscure company with ambitious plans to obtain oil and minerals from Canada's Athabasca tar sands (an endeavour called into question by oil and metal specialists in the US and Canada), announces that it has sold $30 million in stock to "a group of diversified European investors" at a $2-per-share premium. Later investigation will reveal this 'group' of investors to be none other than Peter Young.
22 March 1996: Massive selling of Solv-Ex stock occurs following a report in The Wall Street Journal that the FBI and SEC are investigating Solv-Ex due to the possible involvement of convicted stock swindlers.
18 April 1996: Despite the alarm expressed by other Solv-Ex investors, Peter Young continues with the deal.
Late April 1996: Unlisted shares in Young's funds have hit three and a half times the legal limit.
2 September 1996: Morgan Grenfell halts trading on its three main European equity funds, worth $2.25 billion. Two of the funds are managed by Young and one by a colleague; Young is suspended and City of London regulators begin an inquiry into the valuation of the funds' assets.
5 September 1996: Shares in the three European funds resume trading following the replacement of the unlisted securities with $300 million in cash provided by Deutsche Bank.
Late September 1996: About 30% of investors leave the fund within a few weeks, taking $400 million with them. The stampede slows after Deutsche Bank promises to buy as many of the funds' shares as are offered and to pay any compensation that regulators decide is owed to investors.
17 April 1997: City of London regulators fine Morgan Grenfell two million pounds sterling and order it to pay costs of more than 1 million pounds.
29 April 1997: Morgan Grenfell informs 80,000 investors how much money they will receive in compensation for money lost due to trading irregularities. The compensation was individually determined, using a computer model created by a team of 100 specialists from Ernst and Young, shadowed by 100 accountants from Arthur Anderson.
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Lessons to be learned:
Make sure that checks and balances are actually carried out thoughtfully, rather than merely being part of the routine
Young's immediate boss and Morgan Grenfell's compliance department were both supposed to sign off on each of Young's purchases of unlisted shares. However, it was not until April of 1996, when unlisted shares hit three and a half times the legal limit, that Young was first told to reduce these holdings.
Provide swift and certain penalties for those who exceed limits
If Young had been reprimanded and investigated as soon as unlisted shares passed the legal limit, the damage could have been contained.
Segregation of duties is a key operational risk control
A key operational risk control for any trading environment is segregation of duties, such as investment and trading activities. The fact that Young was able to set up paired holding companies and trade with these companies over an extended period to time suggest that this basic control was not effectively in place.
If something looks too good to be true, it probably is
Young's fund performance had been at the top of its category for a long time, yet this apparently did not prompt close scrutiny from Morgan Grenfell, as it probably should have. Exceptional profits should have prompted at least some internal scrutiny.
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