If you want to see a perfect example of how completely broken our regulatory system is, look no further than a speech that Daniel Gallagher, one of the S.E.C.’s commissioners, recently gave in Denver, Colorado.
It’s a speech whose full lunacy is hard to grasp without some background.
It’s by now been well-established that the S.E.C.’s performance in policing Wall Street before, after, and during the crash has been comically inept. It would be putting it generously to say that the top cop on the financial services beat has demonstrated particular incompetence with regard to investigations of high-profile targets at powerhouse banks and financial companies. A less generous interpretation would be that the agency is simply too afraid, too unwilling, or too corrupt to take on the really dangerous animals in this particular jungle.
The S.E.C.’s failure to make even one case against a high-ranking executive involved in the mass frauds leading to the 2008 crash – compare this to the comparatively much smaller and less serious S&L crisis twenty years earlier, when the government made 1,100 criminal cases and sent 800 bank officials to jail – became so conspicuous that by the end of last year, the “No prosecutions of top figures” idea became an accepted meme in mainstream news media coverage of the economic crisis.
The S.E.C. in recent years has failed in almost every possible way a regulator can fail to police powerful criminals. Failure #1 was that it repeatedly fell down on the job even when alerted to problems at big companies well ahead of time by insiders. Six months before Lehman Brothers collapsed, setting off a chain reaction of losses that crippled the world economy, one of Lehman’s attorneys, Oliver Budde, contacted the S.E.C. to warn them that the firm had understated CEO Dick Fuld's income by more than $200 million; the agency blew him off. There were similar brush-offs of insiders with compelling information in cases involving Moody’s, Chase, and both of the major Ponzi scheme scandals, i.e. the Bernie Madoff and Allen Stanford cases.
The S.E.C.’s attitude toward whistleblowers at powerhouse companies has not just been aloof or indifferent, it’s been downright hostile at times. Whistleblowers commonly report being treated as though they're the criminal. The most notorious example probably involved Peter Sivere, a compliance officer at Chase who years ago went to the S.E.C. to complain that Chase was withholding an incriminating email from the agency, which was investigating an illegal trading practice. When Sivere contacted the S.E.C. with the documents, he asked if he would be eligible for an award; they told him no, and he gave them the documents anyway. Subsequently, Sivere was fired by Chase because, in the words of Chase’s attorneys, Sivere had "sought payment from the SEC to provide documents and information to them.”
Sivere had to scratch his head and wonder how his bosses knew about the award request , until it dawned on him: the S.E.C. had ratted him out to Chase! It subsequently came out that the S.E.C. official who’d narked on Sivere was George Demos, who more recently was seen running for Congress in New York.
Since the S.E.C. couldn’t make cases even when insiders handed them to them, it followed that the agency fared even worse when asked to deduce problems by mere analysis and review, which brings us to failure #2: the agency was spectacularly inept at detecting marketplace problems that should have been obvious to anyone with access to a federal regulator’s investigatory tools. It came out after the crash, for instance, that the SEC repeatedly ignored warnings of excessive risk-taking at companies like Bear Stearns; they even censored an IG report to conceal, among other things, their history of non-action.
More notoriously, the SEC stood by and did nothing even after the FBI publicly warned that the incidence of so-called “liar’s loans” – mortgage applications in which income levels and other information were not verified – was “epidemic” and could cause an “economic crisis.” The SEC could have walked into any major mortgage lender’s office anytime in the five years prior to the 2008 crash and in one afternoon’s worth of interviews learned that fraud in the mortgage markets was out of control, but instead they allowed companies like Countrywide and Long Beach to proliferate and pump the economy full of millions of bad loans, nearly destroying the economy.
Failure #3 is that even after the fact, they have so far failed to make cases against even the most obvious targets, from the Deutsche Bank executives who knowingly sold billions in risky mortgages they knew were “pigs,” to the Lehman bankers who hid liabilities and cooked the books in the infamous “Repo 105” case, to the creeps at Barclays who, in what one Wall Street attorney I spoke to described as “the biggest bank robbery in the history of the world,” siphoned off billions of dollars from the rotting hulk of Lehman Brothers just before that company’s collapse. In that deal, executives at Lehman and Barclays essentially sold Lehman assets and operations to Barclays at fractions of their real cost – and some of the Lehman executives involved went to work for Barclays right after Lehman collapsed. Lehman’s creditors unsuccessfully tried to get Barclays to pay back over $11 billion.
Failure #4: one company after another was allowed to settle serious criminal charges without having to admit wrongdoing. Failure #5: in those settlements, the S.E.C.continually allowed companies to avoid having to disclose the exact nature of their crimes, which not only shielded those firms from litigation, but kept the general public, which might otherwise have been warned away from doing business with those firms, in the dark about crucial information. “Truth is confined to secretive, fearful whispers,” federal judge Jed Rakoff complained, talking about the settlements. Failure #6: companies have been allowed to settle cheap on the promise that they would never commit the same crimes again, only to do exactly that – and be allowed by the S.E.C. to get off with the same promise! The Times made a list of firms that got the “Just promise you’ll never do it again, again” treatment:
They read like a Wall Street who’s who: American International Group, Ameriprise, Bank of America, Bear Stearns, Columbia Management, Deutsche Asset Management, Credit Suisse, Goldman Sachs, JPMorgan Chase, Merrill Lynch, Morgan Stanley, Putnam Investments, Raymond James, RBC Dain Rauscher, UBS and Wells Fargo/Wachovia.
All of this is important background for the speech given in Denver on April 13 by S.E.C. commissioner Gallagher. The commissioner was trying to explain the S.E.C.’s thought process in how it decides to allocate its relatively meager resources. The key thing, Gallagher explained, was to make sure that when you send Enforcement staff on a case, you should make sure there’s actually crime there to fight:
It is critically important that our enforcement program be extremely efficient… Recognizing that it is unrealistic to imagine we will ever achieve a one-to-one correspondence between incidents of misfeasance and SEC Enforcement staff, we’d better plan to do everything we can to increase our hit-rate per investigation opened, and should commit our staff resources carefully, which is to say, consciously.
Sounds reasonable, although this does also sound a little odd; how is securing a good "hit rate" in finding crime a problem in an era where even an $11 billion robbery isn’t high enough in the in-box to warrant a criminal investigation? For most of the last ten years, you could walk into any major bank in America and find whole departments committed to the practice of writing false, robosigned affidavits. We’re not talking about crime that is hidden in a line item, or has to be deduced by checking and re-checking the numbers of dozens of accounts: we’re talking about groups of flesh-and-blood human beings, sitting there in plain view with huge stacks of folders on their desks, openly committing fraud and perjury. Walk in any direction in lower Manhattan with a badge, you're going to hit a fraud case whether you want to or not.
But fine, Gallagher’s point is taken: when you commit resources, you want to make sure you get hits. So what’s the solution? He goes on, cheerfully employing a jockish metaphor:
Experience teaches us, for example, that fraud tends to proliferate in smaller entities that may lack highly developed compliance programs. It also means thinking carefully about what we might, borrowing again from the world of sports, call “shot selection.” It can be tempting to tangle with prominent institutions. But chasing headlines and solving problems are two different things. The question is what will do most good – where our focus should be. And the record seems to suggest that we can do most to protect smaller, unsophisticated investors by focusing more attention on smaller entities...
Just so we’re clear about what we’re talking about here: the S.E.C., rather than go after serial violators like Bank of America and Chase, proposes that the best place to find crime is in small-cap companies, because that’s where fraud “proliferates.”
In the last year or so I’ve heard from several attorneys who represent smaller clients who tell me they’re flabbergasted, watching the S.E.C. give the Chases, Goldmans, and Citigroups free ride after free ride while their pockmarked little clients at fledgling public companies get served the whole regulatory meal for minor disclosure violations – even cases that simply involve bad paperwork, where money isn’t even stolen. If you’re a little tech startup and there’s a $100,000 problem in your books, you can expect the full Princess Bride torture machine treatment, with multiple agents assigned to your case, serious criminal penalties, asset seizures, etc.
Want an example of the S.E.C.’s idea of “shot selection”? Every year, a parade of itty-bitty failed public companies lets their paperwork lapse. Dead little companies sitting in the bureaucratic atmosphere doing nothing at all are a major threat to national security, of course, so the S.E.C. flies in to the rescue and feverishly revokes their registrations.
These actions are called “12(j) registration revocations,” and the beauty of them, from the S.E.C.’s point of view, is that it can list each one of those revocations as a separate enforcement action, when it goes before Congress at the end of every year to brag about all the good work it’s done.
Therefore toward the end of every calendar year, you’ll see a rush of these 12(j) revocations. In 2011, about one out of every six S.E.C. enforcement actions – 121 out of 735 – involved these delinquent filings. In the stats they submit to Congress, they list these cases right next to things like market manipulation, insider trading, and financial fraud. “The S.E.C. Enforcement staff takes 10 minutes and shoots a zombie company in the head and then has the guts to call it enforcement,” is how one attorney put it to me.
Just days after 60 Minutes ran its piece last year about the epidemic of unprosecuted fraud on Wall Street, the S.E.C. charged into action. Take a look at the dates on these two documents. While Chase’s "London Whale" was preparing to play billion-dollar faro with federally-insured money and MF Global was still struggling to find its "misplaced" $1.6 billion in customer money, the S.E.C. was gallantly taking on the likes of A.J. Ross Logistics, Inc., Status Game Corp., and Fightersoft Multimedia Corporation. And bragging to Congress about its conquests. It's as clear a case of juking the stats as you'll ever see.
Apparently, this is a better use of the S.E.C.’s time than giving in to the "temptation" of taking on prominent institutions. Anyway, if you want insight into why nothing’s been done to clean up Wall Street, look no further. Why tangle with Goldman and Chase, when you can take on a dead video game startup?