Justice, Deferred

During the early aughts, the financial sector freely gambled with money implicitly or directly guaranteed by taxpayers, selling securities based on worthless subprime mortgages to their customers. We all know how that turned out. Yet those responsible for the worst recession since the Great Depression have for the most part escaped federal prosecution. Given this context, it is easy to understand why United States District Court Judge Jed Rakoff angrily rejected a proposed deal between the Securities and Exchange Commission (SEC) and Citigroup over the company's practice of selling toxic mortgage-backed securities to its customers at the same time it bet against them. His decision to reject the settlement—in which Citigroup would have to pay $285 million but not have to admit any wrongdoing—was praised as a win, at least in spirit, for the Occupy Wall Street crowd, and indeed it may have some positive effects, including letting banks know they can't get off that easy. But it is important not to lose sight of the underlying reason executives so often go unpunished: the legal and financial constraints that make the SEC no match for the companies it is regulating.

The settlement Rakoff rejected arose out of charges that Citigroup had sold collateralized debt obligations (CDOs)—securities that bundled risky outstanding mortgages—to customers without disclosing that the bank was betting against them. The result? The suckers who trusted their bank lost more than $700 million. Like Goldman Sachs and JPMorgan, Citigroup reached a settlement with the SEC to avoid prosecution. All of these deals between banks and the SEC involve an increasingly common type of settlement called a “deferred prosecution agreement” (DPA). In a DPA, the government agrees not to pursue a viable prosecution in exchange for changes in behavior and/or financial penalties (generally along with retaining the ability to prosecute should companies breach the agreement). These agreements, which generally do not require companies to admit wrongdoing, have become increasingly common.

DPAs have some obvious benefits, allowing the government to obtain commitments to change behavior and garnering immediate, certain restitution for wronged investors without a prolonged legal battle. But the trend toward using DPAs to deal with corporate malfeasance has serious downsides. DPAs often allow companies to get away with relatively light penalties, don’t provide sufficient disincentives against future lawbreaking, and cause crucial facts to remain hidden from public sight.

As reflected by Judge Rakoff’s opinion, the DPA with Citigroup seems to reflect all the potential downsides. The $285 million that Citigroup paid to settle looks like a slap on the wrist for a company that—with the help of an extremely generous taxpayer bailout—generated more than $86 billion in revenue and $10 billion in profits in 2010; the sum is little more than a third of the money lost by the investors the company misled or defrauded. Even worse, by allowing Citigroup not to admit wrongdoing, the agreement denies the ability of the public to scrutinize the actions that helped lead to the Great Recession. As Judge Rakoff argued, “The S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges.” By neither getting to the bottom of Citigroup’s misdeeds or forcing it to pay a penalty that would be strong enough to deter future fleecing of investors, the DPA with Citigroup does indeed fail to meet the goals that the SEC should pursue.

As one might expect, the defense offered by Robert Khuzami, the director of the SEC’s enforcement division, is in most respects unconvincing. Khuzami, however, does make at least one important point. If the judiciary rejects SEC deals because they do not involve an admission of guilt, he argues, it “would divert resources away from the investigation of other frauds and the recovery of losses suffered by other investors not before the court.” One reason for the increasing use of DPAs is that the SEC is starved of resources; to avoid being outgunned in court by companies with massive legal departments, it must pick its battles carefully. Given the scarcity of the SEC’s enforcement resources, every case that goes to a full trail may mean that many more cases cannot be pursued at all. Corporate lawbreakers are surely aware of this, which is one reason many of the penalties in DPAs seem relatively light.

In addition to not being adequately funded and staffed, the SEC is often entering hostile territory when it takes cases into federal court. Judge Rakoff is hardly a typical member of the Republican-dominated, heavily pro-business federal judiciary. Whatever their ideological predisposition, federal judges are generally charged with applying statutes that have become increasingly favorable to corporate interests. And the outcome of prosecutions against even egregious offenders is inevitably uncertain. As Gretchen Morgenson and Louise Story note in their superb analysis of the increasing use of PDAs, a major impetus for the move toward deferred prosecutions was a 2005 Supreme Court case, Arthur Anderson v. U.S., in which the Supreme Court overturned a conviction against the disgraced Enron collaborator Arthur Andersen. In light of this case, the SEC has often come to the conclusion that, given its resources and the unpredictable results of going after companies, some sanctions are better than none.

None of this is to say that Judge Rakoff’s decision was wrong. A trial and the valuable public information about the practices that have ruined countless lives would be beneficial. And setting a precedent that excessively weak settlements may be rejected may give the SEC desperately needed leverage in future negotiations. But the problems with the regulation of the finance industry go deeper than any particular agreement. Given the SEC’s lack of resources, there are going to be a lot of cases where DPAs are the worst outcome except for all the others. As long as the SEC lacks adequate resources and a better statutory framework, prosecutions of financial rule-breakers are going to be few and far between. Despite the catastrophic consequences of failing to regulate in the 2000s, we are still guarding the public interest with a toothless watchdog.

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