On Monday, a single, ringing court decision gave hope that Wall Street will finally be held to account for its role in causing the financial crisis. Federal District Court Judge Jed Rakoff’s opinion may soon force the SEC, the federal government’s investment regulator, to take big banks to court, rather than continuing to come to terms with them in out-of-court settlements. Millions of Americans are no doubt looking forward to the prospect that deep-pocketed bankers will soon be receiving their comeuppance in open court.
But it’s an entirely open question whether the decision will amount to anything more than a symbolic victory. The court’s demand that the SEC be more aggressive failed to consider just how much the agency’s scope of action is already constrained by policymakers in the federal government. Rakoff wants regulators to redouble their efforts to investigate crimes committed by banks—but he may have inadvertently made the SEC’s job of recovering defrauded investors’ money that much harder.
THERE’S A GOOD REASON that the SEC has pursued out-of-court settlements. Successfully prosecuting white-collar crime is no easy matter, especially for the types of fraud prosecutors and financial reformers suspect were at the heart of the 2008 financial crisis. While federal prosecutors recently won a landmark insider trading case to put top executives behind bars, fraud can be harder to prove. In 2009, a jury acquitted two former Bear Stearns bankers the government charged with deceiving investors about the risks associated with CDOs, complex securities manufactured from packages of mortgage loans. The SEC, in fact, has yet to convict anyone in court on charges related to causing the financial crisis.
Instead, the agency’s main approach to accountability has been to leverage public opinion more than the law, using well-timed prosecutions to force major banks to pay penalties and change business practices in settlements. Of course, such settlements are flawed as instruments of justice. They rarely involve the acknowledgement of wrongdoing; individuals are rarely held accountable. And the sums of money are usually a pittance for the banks involved. In its 2010 landmark settlement, the SEC had Goldman Sachs agree to pay a $550 million penalty after it “misstated and omitted key facts”—a polite, and legally innocuous, way of saying it lied—about its CDOs. That same year Goldman made an $8.35 billion profit after paying its employees $15.4 billion.
Rakoff is not wrong to feel that these kinds of settlements are incommensurate with the injustices they’re addressing. The case he was asked to consider involved a $1 billion CDO sold by Citigroup to investors in 2007, just as the housing markets began to collapse: Not only did investors lose $847 million, but Citi, it turns out, bet against the security, gaining at least $160 million, and perhaps as much as $600 million, in profit. But even though the SEC had evidence strongly implicating the bank in fraud—including emails sent by staffers describing the CDO as “a collection of dogsh!t”—the announced settlement was only for a total of $285 million, and without any admission or denial of the allegation.
Unsatisfied by the facts in the SEC’s settlement, Rakoff said he had no choice but to refuse his judicial approval, rejecting the Citi settlement as “neither reasonable, nor fair, nor adequate, nor in the public interest. … If its deployment does not rest on facts—cold, hard, solid facts, established either by admissions or by trials—it serves no lawful or moral purpose and is simply an engine of oppression.”
And so Rakoff has set a bar for the SEC: It can withdraw the charges in embarrassment, force Citi to admit its faults, or prove them in trial. If the SEC negotiates a new settlement, it will need to be far more specific about what Citi did wrong and what the effects were, something that Citi may be reluctant to agree to, especially if Rakoff will not accept anything short of an admission of wrong-doing, as financial writer Felix Salmon fears.
A particularly risky route for the SEC would be to appeal Rakoff’s decision: If the SEC fails to convince a federal appeals court that its settlement is legally sound, as many observers deem likely, then Rakoff’s standard would become a precedent, potentially threatening all settlements done on the SEC’s terms. “Not admitting or denying the allegations is the main reason to settle,” the Wall Street lawyer says. “If they have to drop that, the SEC loses a major bargaining chip.”
If an appeals court stripped the SEC of its ability to bargain settlements it might, indeed, prove disastrous. But even more interesting is what that simply takes for granted: That the ability to prosecute banks in court hardly provides the SEC any leverage at all.
TO UNDERSTAND WHY that is the case, one need only have checked in on another event taking place this past Monday. As Rakoff was announcing his decision, Representative Barney Frank (D-MA) was announcing his retirement from Congress after three decades. The culmination of his career was the eponymous Dodd-Frank Financial Reform bill, passed last year, which, among many regulatory enhancements inspired by the financial crisis, granted new powers and duties to the SEC. His retirement statement expressed concerns about “right-wing assaults on the financial reform bill,” largely in the form of budget cuts to agencies, like the SEC, charged with implementing it.
SEC Chair Mary Shapiro has repeatedly asked Congress for increases in its budget to handle the new duties and cases that came after the crisis; since taking control of the House in 2010, however, Congressional Republicans have refused to grant regulators more money. As a result, the agency’s credibility has taken a major hit. Critics of the SEC insist that the agency’s unwillingness to take cases to court is simply a matter of will, but the view on Wall Street is that the agency simply doesn’t have the resources to take on major banks in court. “They try most of their cases with like two lawyers and a paralegal,” one Wall Street lawyer familiar with the regulator told me. “They'll get buried by anyone with the money to fight a case.”
That perception may be self-reinforcing. Dennis Kelleher, a former Democratic Senate staffer and securities litigator who now heads Better Markets, a non-profit dedicated to financial reform, points out that the agency has a weaker negotiating position when it comes to settlements if accused banks are skeptical of the SEC’s ability to succeed at trial. The SEC, for its part, says it simply has the best interests of investors at heart, and that its settlements represent a reasonable guess at how much money they could obtain after trial, with the added benefit of avoiding two to four years of process and appeal.
“There's opportunity costs in everything that we do,” Robert Khuzami, Director of the SEC’s enforcement division, told the Senate Banking Committee in November. “If we are prosecuting case A, we are not prosecuting case B. It's cold comfort to other victims of other frauds if we are putting all of our resources taking a case to trial, as one's not settling, when their case is not being prosecuted, if we're getting a package of remedies that are strong and send a meaningful message.”
The debate, then, is whether these settlements are strong and meaningful. If Citi’s apparent recidivism is any indicator—the SEC has accused Citi of fraud five times since 2003, settling in each instance—they are not, and the lack of meaningful financial penalty limits their deterrent factor. But if the SEC enters more prosecutions without a bump in resources, Khuzami could be proven right—rather than handing out many slaps on the wrist, the agency could end up gaining neither accountability nor penalties to bilked investors.
Rakoff’s decision to reject the Citi settlement has taken that choice out of the hands of SEC officials, essentially forcing them to pursue the case more aggressively; the decision will likely affect other enforcement actions as well. The transition from a “settlement mill,” as critics deride the SEC, to a more aggressive template, will likely be messier than either Wall Street or its foes would like—a lost case would be ugly for the agency, and the perils of litigation may soon remind banks why they liked to settle in the first place—but the judge has left little room for excuses.
How the SEC will fulfill these new expectations remains to be seen. With little additional help forthcoming from Congress, the SEC’s best hope may be to look inward and, finally, rise to the occasion. “I’m of the view that the SEC has more than enough authority and more than enough ability to really punish lawbreakers on Wall Street, and there are plenty of lawbreakers on Wall Street,” says Kelleher. “They need to believe it as much as I believe it.”
Tim Fernholz is an editor at GOOD Magazine in Los Angeles.