Companies don’t commit fraud, people do
One question still puzzling Wall Street pundits is why no high-level US bankers have been charged with criminal fraud in connection with the packaging and sale of sub-prime mortgage-backed securities that collapsed during the financial crisis?
What makes today different from the days when executive wrongdoers were successfully prosecuted following the junk bond bubble of the ‘70s (e.g., Mike Milken), the savings & loan crisis of the ‘80s (e.g., Charles Keating) and the accounting frauds of the ‘90s (e.g., Jeff Skilling and Bernie Ebbers)?
Jed Rakoff, the outspoken judge of the US District Court in Manhattan1, takes a crack at answering that question in the current issue of The New York Review of Books. Judge Rakoff rejects the notion that the sub-prime mortgage meltdown was purely the result of imprudent but innocent risk-taking on the part of bankers who were not therefore amenable to criminal prosecution. Instead, Judge Rakoff asserts that the financial shenanigans that led to the crisis must have involved intentional misconduct since “a sow’s ear couldn’t have been transformed into a silk purse without some dissembling along the way.”
Judge Rakoff also dismisses SEC and DoJ arguments that proving fraudulent intent on the part of senior executives of complex banking institutions is extremely difficult because of their remoteness from the junior personnel who structured and sold the duplicitous securities. If anything, he claims, top management must at least have engaged in what is known as “willful blindness,” which the Supreme Court has consistently approved as a basis for establishing criminal intent.
Just as unpersuasive to the judge is the DoJ’s contention that criminal fraud requires reliance by its victims which would be hard to prove in cases where the buyers of the offending securities were sophisticated institutions. He contends that the financial instruments in question were sold at lightning speed and were structurally far too convoluted for even seasoned mortgage bankers to analyze and evaluate.
Finally, Judge Rakoff does not believe that federal prosecutors have backed away from charging individual bankers because of “revolving door” concerns of their own. Having been a federal prosecutor himself, the judge knows from personal experience that indicting financial celebrities is the best way for a prosecutor to make a name for himself and advance his own professional career.
Instead, Judge Rakoff offers the following reasons for the lack of individual banker prosecutions:
- by 2007, the vast majority of FBI agents previously investigating mortgage fraud had been re-assigned to anti-terrorism duties in the wake of 9/11;
- in reaction to their failure to have detected the Madoff fraud, SEC enforcement staff responsible for investigating securities fraud were concentrating on easier-to-prove Ponzi and embezzlement schemes from 2009 on;
- most US Attorney’s Offices under the DoJ were inexperienced at investigating financial fraud and the one that was – the Southern District of Manhattan – was immersed in the insider trading cases arising from the Raj Rajaratnam tapes; and
- US attorneys were far more likely to pursue insider trading cases that were close to indictment and trial than financial crisis cases that were just getting started and would take years to complete.
Misguided Public Policies
Judge Rakoff further speculates that the government has not pursued the prosecution of individual bankers because of its own involvement in the circumstances that led to the financial crisis.
Judge Rakoff further speculates that the government has not pursued the prosecution of individual bankers because of its own involvement in the circumstances that led to the financial crisis. Congress’ repeal of the Glass-Steagall Act in 1999 enabled banks to profit much more handsomely from securitizing and trading pools of mortgages than simply earning interest from holding them. In addition, through Fannie Mae and Freddie Mac, banks were encouraged to extend credit to low-income earners as a way of fulfilling the American dream of homeownership. With these public policies as a backdrop, Judge Rakoff postulates that thoughtful prosecutors might think twice before indicting bank CEOs who could plausibly claim that they were only doing what they thought the government expected of them.
Lastly, Judge Rakoff points to what he regards as the misguided recent predilection on the part of the government to concentrate its limited resources on prosecuting companies rather than their managers specifically so as to transform their corporate cultures. In order to avoid penalizing innocent employees and shareholders, the government has adopted deferred prosecution and non-prosecution agreements that impose prophylactic measures on target companies which seemingly make everybody happy: the prosecutors feel they have prevented future crimes and both the target companies and their managerial miscreants have avoided devastating indictments.
To Judge Rakoff, however, companies don’t commit fraud, people do — so the deterrent effect of stiffening a company’s compliance culture is far outweighed by successfully prosecuting its top brass. It’s also legally untenable in the judge’s view to indict a company unless you can prove that its top management committed (or consciously disregarded) the alleged crime. If that’s the case, Judge Rakoff concludes, then why not bring the wrongdoers themselves to justice?
1 You will recall that it was Judge Rakoff who, in SEC v. Citigroup (2011), first raised the issue of whether a company should be allowed to settle a securities fraud case with the SEC without admitting or denying the underlying allegations.