Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Rakoff on financial crisis prosecutions

Judge Rakoff who is best known for rejecting SEC settlements against Bank of America and Citigroup for not going far enough, has come out with a devastating critique of the US failure to prosecute high level executives for frauds related to the financial crisis.

Rakoff points out that the frauds of the 1970s, 1980s and 1990s all resulted in successful prosecutions of even the highest level figures.

In striking contrast with these past prosecutions, not a single high level executive has been successfully prosecuted in connection with the recent financial crisis, and given the fact that most of the relevant criminal provisions are governed by a five-year statute of limitations, it appears very likely that none will be.

First of all, Rakoff dismisses the legal difficulties in prosecuting crisis crimes:

  • the doctrine of “willful blindness”or “conscious disregard” ameliorates the difficulty of proving fraudulent intent;
  • the fact that the counterparties were sophisticated is irrelevant because in criminal fraud cases, it is never required to prove reliance;
  • the “too big to jail” excuse reflects a disregard for equality under the law.

Rakoff thinks that there are three reasons why there have been no prosecutions:

  1. Prosecutors have other priorities –
    • the FBI’s resources were diverted to fighting terrorism;
    • the SEC was focused on Ponzi schemes and accounting frauds;
    • the Department of Justice was bogged down with the prosecution of insider trading based on the Rajaratnam tapes
  2. “[T]he Government’s own involvement in the underlying circumstances that led to the financial crisis … [and] in the aftermath of the financial crisis … would give a prudent prosecutor pause in deciding whether to indict a C.E.O. who might, with some justice, claim that he was only doing what he fairly believed the Government wanted him to do.”
  3. “The shift that has occurred over the past 30 years or more from focusing on prosecuting high-level individuals to focusing on prosecuting companies and other institutions.”

Rakoff is known for his strong views on the last point and he lays out the case brilliantly:

If you are a prosecutor attempting to discover the individuals responsible for an apparent financial fraud, you go about your business in much the same way you go after mobsters or drug kingpins: you start at the bottom and, over many months or years, slowly work your way up. Specifically, you start by “flipping” some lower or mid-level participant in the fraud … With his help, and aided by the substantial prison penalties now available in white collar cases, you go up the ladder. …

But if your priority is prosecuting the company, a different scenario takes place. Early in the investigation, you invite in counsel to the company and explain to him or her why you suspect fraud. He or she responds by assuring you that the company wants to cooperate and do the right thing, and to that end the company has hired a former Assistant U.S. Attorney, now a partner at a respected law firm, to do an internal investigation. … Six months later the company’s counsel returns, with a detailed report showing that mistakes were made but that the company is now intent on correcting them. You and the company then agree that the company will enter into a deferred prosecution agreement that couples some immediate fines with the imposition of expensive but internal prophylactic measures. For all practical purposes the case is now over. You are happy …; the company is happy …; and perhaps the happiest of all are the executives, or former executives, who actually committed the underlying misconduct, for they are left untouched.

I suggest that this is not the best way to proceed. Although it is supposedly justified in terms of preventing future crimes, I suggest that the future deterrent value of successfully prosecuting individuals far outweighs the prophylactic benefits of imposing internal compliance measures that are often little more than window-dressing. Just going after the company is also both technically and morally suspect. It is technically suspect because, under the law, you should not indict or threaten to indict a company unless you can prove beyond a reasonable doubt that some managerial agent of the company committed the alleged crime; and if you can prove that, why not indict the manager? And from a moral standpoint, punishing a company and its many innocent employees and shareholders for the crimes committed by some unprosecuted individuals seems contrary to elementary notions of moral responsibility.

Rakoff concludes with a scathing criticism:

So you don’t go after the companies, at least not criminally, because they are too big to jail; and you don’t go after the individuals, because that would involve the kind of years-long investigations that you no longer have the experience or the resources to pursue.

After the series of frauds in the late 1990s and early 2000s in the US (Enron, Worldcom, Tyco and Adelphia), Europe (Lernout and Hauspie, Vivendi, ABB and KirchMedia) and India (Tata Finance), I wrote that: “ The US has shown that it can prosecute and punish wrong doers far more speedily than most other jurisdictions.”. I am not at all sure about this today.

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