Kidder Peabody: phantom trades cost $350 million

Joseph Jett graduated from MIT in 1983, worked for General Electric until 1985, went to Harvard Business School until 1987, worked for Morgan Stanley until laid off in 1989, and was fired from CS First Boston Corp. in 1990 for poor performance. In July 1991 Kidder Peabody hired him as a bond trader. He worked long hours and by year-end 1992 revenues from his zero-coupon bond trading nearly doubled to $30 million, compared to the previous record of $16 million in 1990. When the previous head of the firm's "government desk" switched to another job, Jett, the top performer in the group was chosen as head even though some colleagues questioned his knowledge of trading. In 1993 the government desk accounted for around 20% of the firm's operating profit of $439 million. He was paid a $9 million bonus for 1993, promoted to managing director (one of 135), and awarded Kidder's coveted Chairman's Award.

By 1993 Kidder's rivals on Wall Street were wondering how Jett could rack up $15 to $20 million per month in trading revenues doing legitimate bond trades that appeared to be unprofitable when tracked in the market. Managers within Kidder became suspicious in early 1994 when Jett's revenues soared to $100 million in the first quarter alone. By April, Kidder accountants concluded that Jett actually had $90 million in losses from legitimate trades and $350 million in fake profits from phantom trades. Jett was fired and Kidder Peabody was forced to restate its earnings for 1993. A subsequent investigation by an outside law firm reported that questions about the unusual trading profits were "answered incorrectly, ignored, or evaded." As the inexperienced trader's apparent profitability increased, "skepticism about [his] activities was often dismissed or unspoken."

Kidder concluded that Jett had created phony profits by taking advantage of a flaw in Kidder's accounting system. Lawyers involved in the investigation say that Jett set up two custodial accounts for the Federal Reserve Bank, and used these accounts for phony trades involving zero coupon bonds, government bonds in which future return of the capital and future interest stream are divided into two separate instruments that can also be recombined. Instead of performing typical trades that would settle in a day, he apparently set up a large number of "forward" trades that settle in up to 90 days, thereby generating a situation in which Kidder's accounting system would register a false profit. When settlement time came, he apparently rolled these contracts over into other forward contracts. Initially there was much speculation about Jett's possible defense if Kidder took legal action against him. It seemed likely he would claim he was following orders because his direct boss and another top trader had access to daily reports about his trading positions and because part of their respective $10 and $12 million bonuses was determined by his performance.

Questions:

1. Use the WCA framework to organize your understanding of this case and to identify important topics that are not mentioned.

2. Explain how information quality, accessibility, and presentation are pertinent to this situation.

3. Explain how personal incentives might have been related to the use of information in this situation.

Sources: Freedman, Alix M., and Laurie P. Cohen. "How a Kidder Trader Stumbled Upward Before Scandal Struck." Wall Street Journal, June 3, 1994, p. A1;
Spiro, Leah Nathans. "What Joseph Jett's Defense Will Look Like." Business Week, June 13, 1994, p. 70;
Paré, Terence P. "Jack Welch's Nightmare on Wall Street." Fortune, Sept. 5, 1994, pp. 40-48.

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