Lessons from the Market Crisis: Two New Cases, the End of Another

The SEC filed two settled actions at the end of last week tied to the residential mortgaged backed securities market. SEC v. J.P. Morgan Securities LLC (S.D.N.Y. Filed Nov. 16, 2012); In the Matter of Credit Suisse Securities (USA) LLC, Adm. Proc. File No. 3-15098 (Nov. 16, 2012). Despite continued clamor from Congress and the public the actions are only against the institutions. No individuals are named as a party in either proceeding.

These actions may reflect an evolving view by investigators that the events which generated the market crisis are not the product of a single individual or even a group of individuals. The Department of Justice has brought few criminal cases tied to the market crisis despite public pressure demanding prosecutions and long prison sentences. The SEC has brought a number of market crisis cases which include prosecutions against individuals. Yet those earlier actions may not represent current thinking.

On Friday, the same day it filed J.P. Morgan and Credit Suisse, the Commission secured the dismissal with prejudice of its market crisis action against Edward Steffelin, a Managing Director at GSCP (NJ) L.P. SEC v. Steffelin, Civil Action No. 11-04206 (S.D.N.Y. filed June 21, 2011). That action was filed in conjunction with another market crisis case against J.P. Morgan Securities, SEC v. J.P. Morgan Securities LLC, Civil Action no. 11-04204 (S.D.N.Y. filed June 21, 2012). Both actions centered on the sale of interest in a largely synthetic collateralized debt obligation known as Squared CDO 2007-1. The Commission’s complaint alleged misstatements in connection with the marketing of interests in the entity tied to the role of hedge fund Magnetar Capital LLC. Mr. Steffelin’s firm served as the portfolio managed on the deal. Although the factual allegations in the complaint appeared to detail an intentional fraud, the charges were negligence based fraud under Securities Act Sections 17(a)(2) & (3). J.P. Morgan settled. Mr. Steffelin did not.

The papers dismissing the proceedings with prejudice against Mr. Steffelin do not disclose any reason for the dismissal. The action follows, however, two losses against individuals by the Commission in market crisis cases. One is the case against Brian Stoker, the Citigroup employee who was responsible for what the SEC claimed were misleading marketing materials used to sell interests in another CDO Squared. SEC v. Stoker, 11 Civ. 7388 (S.D.N.Y. Filed Oct. 19, 2011). There, based on a complaint which appeared to allege intentional contact but charged negligence, a New York jury last August found in favor of Mr. Stoker and against the SEC. In rendering its verdict the jury took the unusual step of issuing a note to the SEC urging the agency to continue its investigations. The Commission’s settlement with Citigroup is pending before the Second Circuit following the refusal of the district court to enter a proposed consent decree.

The SEC also lost the primary charges against the individuals as well as the entities in its action arising out of the demise of Primary Reserve Fund, one of the oldest money funds in the country and the first to “break the buck.” Following contentious discovery and a hotly contested trial, the jury rejected Commission claims that the individual defendants intentionally mislead investors and the markets as they scrambled to save the dying entity following the collapse of Lehman Brothers whose bonds were a large fund holding. The jury did, however, find in favor of the SEC on negligence based claims, hardly surprising under the chaotic circumstances surrounding the collapse of the fund. SEC v. Reserve Management Co., Case No. 1:09-cv-4346 (S.D.N.Y. Filed May 5, 2009).

While the papers dismissing Steffelin do not reference Stoker or Reserve Management Co., the dismissal by the Commission reflects a thoughtful and exemplary process of continually evaluating the merits of its cases and the enforcement program. Continual self-reflection and re-evaluation in view of the verdicts in Stoker and Reserve Management Company reflects the highest prosecutorial, ethical standards.

All of this also points to what may be the critical lesson of the market crisis. Larger monetary penalties and longer prison sentences, while popular and good press, may not be the key to preventing a reoccurrence. If the findings of intensive investigations by the SEC, DOJ and others are correct, the events which caused the crisis are not the work of one individual or even a group. Rather, those events stem from institutional failures. Under those circumstances the key to preventing a reoccurrence is not fines and prison but cultural reform. While bills in Congress seek more authority for larger fines and prison terms, the message from all of the government investigations is that those remedies will not work. Increasing the dollar fine for institutions which can easily pay mult-billion dollar quarterly losses will simply mean the shareholders pay more for the daily business operations of the institution. Likewise, adding a few years to the current top sentence of 20 years for securities fraud is unlikely to increase deterrence. This is particularly true if government investigators are correct – the problem is institutional.

If preventing a reoccurrence of the market crisis is the goal, then the lesson from all the investigations and prosecutions is that reform of those who which created the crisis is required. While that may come in part from legislation like Dodd-Frank, new statutes and rules alone cannot change the culture of institutions which permitted, encouraged and perhaps even rewarded the kind of actions uncovered by government investigators.

Preventing a reoccurrence begins with the SEC focusing its settlement efforts on the creation and institution of procedures and policies driven from the top of the organization which will foster and reward ethical conduct and prudent management rather than the type of conduct uncovered in the market crisis actions. The SEC and the DOJ are already doing this in the FCPA area. The SEC can use its recently created cooperation tools to bring this same focus to settling market crisis and other similar cases. In the end while focusing on these types of procedures may not generate the same kind of headlines as huge penalties, it will bring a new ethics to the market place which is the Congressional mandate of the SEC.

Hurricane Sandy: As we prepare to give thanks this week please remember the victims of Sandy’s destruction with a donation to the Red Cross, here.

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