By Yves Smith
For most citizens, one of the mysteries of life after the crisis is why such a massive act of looting has gone unpunished. We’ve had hearings, investigations, and numerous journalistic and academic post mortems. We’ve also had promises to put people in jail by prosecutors like Iowa’s attorney general Tom Miller walked back virtually as soon as they were made.
Yet there is undeniable evidence of institutionalized fraud, such as widespread document fabrication in foreclosures (mentioned in the motion filed by New York state attorney general Eric Schneiderman opposing the $8.5 billion Bank of America settlement with investors) and the embedding of impermissible charges (known as junk fees and pyramiding fees) in servicing software, so that someone who misses a mortgage payment or two is almost certain to see it escalate into a foreclosure. And these come on top of a long list of runup-to-the-crisis abuses, including mortgage bonds having more dodgy loans in them than they were supposed to, banks selling synthetic or largely synthetic collateralized debt obligations as being just the same as ones made of real bonds when the synthetics were created for the purpose of making bets against the subprime market and selling BBB risk at largely AAA prices, and of course, phony accounting at the banks themselves.
Louise Story and Gretchen Morgenson lament this sorry state of affairs in an article today on a $10 billion lawsuit expected to be filed today by AIG against Bank of American over dodgy mortgage securities:
The private actions stand in stark contrast to the few credit crisis cases brought by the Justice Department, which is wrapping up many of its inquiries into big banks without filing any charges. The lack of prosecutions — the Justice Department has brought three cases against employees at large financial companies and none against executives at large banks — has left private litigants, mainly investors and consumers, standing more or less alone in trying to hold financial parties accountable.
“When federal authorities don’t fulfill their obligation to enforce the law, they essentially give an imprimatur to the financial entities to do whatever they want and disregard the law,” said Kathleen C. Engel, a professor at Suffolk University Law School in Boston. “To the extent there are places where shareholders and borrowers can pursue claims, they are really serving the function of the government. They are our private attorneys general.”
But this isn’t really true. Even when the plaintiffs in these suits prevail, it just transfers funds from one company to another. The real perps, the executives and line managers involved in the bad behavior, almost always get off scot free. The few cases where we have seen individual executives targeted, such as Angelo Mozilo of Countrywide and Gary Crittenden of Citigroup, the fines are chump change compared to their compensation.
This sorry situation parallels the aftermath of the Great Crash in 1929. Precisely because the securities laws were weak to non-existent, conduct that was fraudulent by common sense standards (“deceit, trickery, sharp practice, or breach of confidence, perpetrated for profit or to gain some unfair or dishonest advantage“) was kosher under the law. The only high profile case in the wake of that crisis was the remarkable fall from grace of patrician Richard Whitney, former head of the New York stock exchange. As the marvelous book Once in Golconda recounts, Whitney had the unfortunate combination of having a very costly lifestyle and being a terrible speculator. He filled the gap for a while by borrowing from friends but finally resorted to embezzlement. Whitney, unlike our modern miscreants, ‘fessed up to his crimes when they came to light, took responsibility for them, and went to Sing Sing.
But that era’s publicity and investigations did lead to well though out, durable financial reforms that served the US well for over 50 years Why have they proven to be useless in the new millennium?
It would take a book to recount how once well regulated financial markets were turned back into a casino, and one of the best one stop accounts of the legal changes is Frank Partnoy’s Infectious Greed. But let me describe some of the major culprits.
The first measure, and its effects go well beyond the financial markets, was to make the courts far more friendly to business. A well funded effort dates back to the early 1980s to change the teaching of law to produce more pro-business attitudes. An overview of the law and economics movement from “ECONNED”:
The third avenue for promoting and institutionalizing the “free market” ideology was inculcating judges. It was one of the most far-reaching actions the radical right wing could take. Precedents are powerful, and the bench turns over slowly… While conservative scholars like Richard Posner and Richard Epstein at the University of Chicago trained some of the initial right-leaning jurists, attorney Henry Manne gave the effort far greater reach. Manne established his “law and economics” courses for judges, which grew into the Law and Economics Center, which in 1980 moved from the University of Miami to Emory in Atlanta and eventually to George Mason University.
Manne had gotten the backing of over 200 conservative sponsors, including some known for extreme right-wing views, such as the Adolph Coors Company, plus many of the large U.S. corporations that were also funding the deregulation effort….
Manne approached his effort not simply as education, but as a political movement… The program expanded to include seminars for judges, training in legal issues for economists, and an economics institute for Congressional aides…
It is hard to overstate the change this campaign produced, namely, a major shift in jurisprudence. As Steven Teles of the University of Maryland noted:
Moving law and economics’ status from “off the wall” to “controversial but respectable” required a combination of celebrity and organizational entrepreneurship. . . . Mannes’ programs for federal judges helped erase law and economics’ stigma, since if judges— the symbol of legal professional respectability—took the ideas seriously, they could not be crazy and irresponsible.
Now why was the law and economics vantage seen as “off the wall?… The law and economics promoters sought to colonize legal minds. And, to a large extent they succeeded. For centuries (literally), jurisprudence had been a multifaceted subject aimed at ordering human affairs. The law and economics advocates wanted none of that. They wanted their narrow construct to play as prominent a role as possible.
The second route was getting more conservative judges on the bench. Most readers are probably aware of the ongoing fight over Federal judicial appointments, as both Democratic and Republican administrations seek to install sympathetic jurists, and the opposing party, when it can, fights the effort. But less well known is the state and local analogue to this effort, and here again, the campaign by corporate interests has paid off handsomely.
My favorite illustration is the Alabama Supreme Court. Alabama was once one of the favored states for launching class action litigation, since Alabama residents were particularly keen on handing out big damage awards. The Alabama Supreme Court elections are now the most expensive state supreme court elections in the nation, with the spending exceeding that of Alabama gubernatorial campaigns. And the effort has provided a great return on investment. The Alabama Supreme Court is guaranteed to reduce any punitive damages award to at most $1 million. In the financial arena, the difficulty of launching criminal cases is both statutory and bureaucratic. Securities law, thanks to the Depression-era reforms, is the most favorable grounds for action, since it sets forth a very high standard for disclosure. The critical language come in Rule 10b-5 of the Securities Act of 1934:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
The requirement in (b) is particularly important, the prohibition against making material omissions. Now with this great weapon, why hasn’t the SEC done more? One basic reason is it can’t pursue criminal prosecutions on its own. It needs to go through the Department of Justice. Needless to say, the DoJ has been missing in action for pretty much all of the Obama administration.
A second reason is that the statute of limitations on securities litigation is effectively three years. Since the market for subprime dreck died permanently in July 2007, it’s too late to file claims using securities law theories (unless they relate to continuing statements in SEC filings). Wronged parties can still use contract law theories, but the standards for fraud are higher (more on that shortly).
The third is that the SEC has been kept budget starved for years, starting in the Clinton Administration. Former SEC chief Arthur Levitt, who was generally industry-friendly but was serious about protecting consumers, was regularly threatened by the Senator from Hedgistan, Joe Lieberman. As a result, the SEC has become incompetent at pursuing anything other than insider trading cases (it did score a big success in Enron, but seemed unable to build on that).
A fourth barrier is the use of lawyers and accountants as shields. Do you remember the Lehman Repo 105 chicanery, in which it moved over $50 billion off its balance sheet at the end of the quarter in what was pure and simple accounting chicanery? The bankruptcy examiner Anton Valukas concluded there was no basis for criminal charges, and the reason was simple: they’d gotten a UK law firm to bless the ruse.
So even if you aggressively shopped for a dubious opinion to give you cover for something that didn’t pass the smell test, you as executive can bat your baby blues and say, “Gee, I’m just a businessman, I defer to experts on these matters,” and you are home free as far as fraud is concerned.
But….you may squawk, what about going after the unscrupulous lawyers and accountants? Well, it just so happens we can’t bust any more accounting firms, since we are down to four and so they are all too big to fail, and no prosecutors seem willing to sue big white shoe law firms (perhaps because they aren’t terribly well staffed and a large firm would seek to engage in a costly war of attrition, as well as enlist all of its deep pocket fancy firm peers to fund his opponent in the next election). And private plaintiffs are barred from action. As incredible as it seems, if an investor loses money, say because a crooked accounting firm cooked the books, he can’t sue the accountant. Only his client, meaning the company that hired him, can. Again from “ECONNED”:
[The Supreme Court, via a 1994 decision, reduced investor protection. In a stunning show of illogic, the court ruled in Central Bank of Denver v. First Interstate Bank of Denver that plaintiffs could not sue advisors like investment bankers, accountants, and lawyers for aiding and abetting securities fraud. A suit against them could only proceed if the defendant was charged with primary liability, meaning the damaged party was his client. This was a radical decision, reversing sixty years of court and administrative rulings. Thus, for instance, if an accountant signed off on fraudulent financial statements that an investor relied upon, the investor could no longer pursue the accountant to recover any losses that resulted from the unraveling of the fraud. Yet in criminal law, an accessory, like the car driver in a bank robbery, is subject to prosecution along with the gunmen who took the cash.
In theory, the SEC has another big weapon it could use, Sarbanes Oxley. Since Sarbanes Oxley became law in 2002, Sections 302, 404, and 906 of that act have required executives to establish and maintain adequate systems of internal control within their companies. In addition, they must regularly test such controls to see that they are adequate and report their findings to shareholders (through SEC reports on Form 10-Q and 10-K) and their independent accountants. “Knowingly” making false section 906 certifications is subject to fines of up to $1 million and imprisonment of up to ten years; “willful” violators face fines of up to $5 million and jail time of up to 20 years.
This makes for a politically less risky path for the SEC. It could file a civil claim, and if it prevailed, it has what would seem to be a virtual slam dunk in then filing criminal charges, since the language of the two sections (302 and 906) track each other.
It is blooming obvious that for a financial firm, “internal control” has to include risk controls, and at virtually all the big financial firms, they were woefully deficient, by design. Risk management is politically weak; the staff are typically trying to curry favor with the business side to get more lucrative jobs with them; risk managers are generally loath to tangle in a serious way with profit centers. It’s almost certain that you can’t have an adequate system of internal controls if you all of a sudden drop multi-billion dollar loss bombs on investors out of nowhere. Banks are not supposed to gamble with depositors’ and investors’ money like an out-of-luck punter at a racetrack. It’s pretty clear many of the banks who went to the wall or had to be bailed out because they were too big to fail, and we can toss AIG in here as well, since they had no idea they were betting the farm every day with the risks they were taking.
So why hasn’t the SEC used Sarbox? Our reading is they were deterred by a widely overlooked ruling in SEC v. Mozilo, in which the judge (with no explanation) nixed that the SEC could file both securities laws charges and Sarbox charges in that case (the judge treated it as double dipping). The judge’s negative ruling on a separate Sarbox charge on securities violations does not rule out other types of Sarbox charges, but the SEC incorrectly seems to have reacted this way. Remember, the part of Sarbox that gave a lot of boards fits was that the CEO and the CFO certify the adequacy of internal controls (Section 404). That goes above and beyond traditional SEC representations.
What about legal theories for fraud ex securities law? If a party is suing for fraud in most other commercial contexts, they must establish intent, that is, that they meant to deceive. That isn’t as easy as it sounds. Even if you find damning-sounding e-mails, as the SEC did in its failed effort to sue the managers of two Bear Stearns hedge funds, there are often other communiques in the same time frame that can muddy the waters. It is frequently possible for people who have engaged in bad conduct to offer up plausible-sounding rationales and point to actions that appear to support it.
So the only solution, it seems, is to go back and have another go at rewriting the rules. It’s worth noting that Dodd Frank got at none of these issues, so it appears we need to have another crisis to create a second opportunity. And it may be starting as we speak.
Yves Smith is the creator of the blog Naked Capitalism and author of “ECONNED: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism“