US Outlook: Judge Jed Rakoff is not the man you think he is.
For those of you that don't know, he is the Manhattan judge who threw out the Securities and Exchange Commission's proposed $285m settlement with Citigroup, which was accused of misleading investors in one of those toxic mortgage structures at the peak of the US housing bubble. Citigroup was going to pay the cash, which included a $95m fine on top of the return of its ill-gotten gains, "without admitting or denying" the charge of negligence against it.
Judge Rakoff, self-styled friend of the little guy, said the money was a drop in the ocean for a Wall Street giant like Citigroup, and justice demands a proper trial to establish the bank's guilt. Cue cheers around the world. Finally... someone is standing up to the banks... Citigroup to be held accountable for its part in the market's downfall... Wall Street on notice its cosy relationship with the SEC must end... Well done, Judge Rakoff... etc, etc.
Except that this is completely the wrong way to look at what has just happened. Judge Rakoff's ruling, if it stands and if it becomes a legal precedent, changes the balance of power between Wall Street and its regulators all right. But in favour of Wall Street.
The part of the ruling that got quoted most this week was Judge Rakoff's injunction that "in any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth". With these words, the judge clearly aligns himself with those who draw a straight line from moral turpitude on Wall Street to the present state of our economy, and who want to see banks and bankers in the dock.
But by my judgment, it is the banks that have most to gain from going on trial. If they really must choose between "admitting or denying" a regulator's charges against them, banks are going to deny, and not just because they believe they have done nothing wrong. Admitting wrongdoing opens them up not just to fines from the SEC but also to vast losses in civil cases brought against them by investors claiming to have been harmed by their alleged negligence or fraud.
Counter-intuitively, one of the things the SEC has on its side is the relatively small scale of the penalties it can extract. Fines can be up to the level of a bank's ill-gotten gains, but do not extend to clawing back investors' losses. The SEC won $285m from Citigroup, and $550m from Goldman Sachs before it, because the banks calculated these were manageable sums compared with the cost and risks of fighting the regulator in court. And that is what it is, a mathematical calculation. If a settlement came with an admission of legal wrongdoing, the calculation is turned on its head.
As a terrified SEC immediately realised, Judge Rakoff is attacking the modus operandi of regulatory enforcement in this country. The agency concentrates on winning pre-trial settlements because it is outgunned in terms of resources for fighting lawsuits in court. "Obtaining disgorgement, monetary penalties, and mandatory business reforms may significantly outweigh the absence of an admission [of guilt] when that relief is obtained promptly and without the risks, delay, and resources required at trial," the SEC enforcement director, Robert Khuzami, said.
With Republicans in Congress trying to starve the SEC for resources, the regulator will have to dramatically cut back on the cases it pursues, if they must all proceed to trial. The cheers, then, will come from Wall Street.
And there is something else. The SEC is winning settlements in cases where there simply was no fraud or negligence.
I'm sorry to report to the baying mob that there was far less criminality on Wall Street in the run-up to the credit crisis than is generally supposed. Greed, fear, stupidity and group blindness, yes, but not much illegality. Part of the reason for the dangerous complexity of mortgage finance was bankers' desire to get round the rules by legal means, rather than to break them.
Time and again, this has been the experience in court. Ralph Cioffi and Matt Tannin, two Bear Stearns hedge-fund managers, were acquitted by a jury in 2009 when the US government charged them with defrauding investors in their subprime mortgage-stuffed fund. Fabrice Tourre of Goldman Sachs, "Fabulous Fab" he called himself in emails, has been charged personally with the same fraud for which his employer paid that $550m settlement, but the SEC case looks shakier when his incriminating email quotes are read in their proper context.
And in October this year, a judge threw out charges against two State Street executives who the SEC alleged had committed fraud by failing to disclose the risks of the subprime bonds in their portfolio. The important point here is that State Street, making the usual calculation, has already paid $600m to settle nearly identical charges from the SEC and regulators in the state of Massachusetts, among others.
Executives, not just on Wall Street but in every regulated industry, routinely complain that they are hustled into settlements by publicity-hungry regulators, who know how corporations' legal departments do their calculations. These executives would have nodded approvingly at the following part of Judge Rakoff's ruling, in which he explains why he won't rubber-stamp the Citigroup settlement: "The injunctive power of the judiciary is not a free-roving remedy to be invoked at the whim of a regulatory agency, even with the consent of the regulated. 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."
So you see, Judge Rakoff is not the man you think he is. He is the regulator's enemy, the corporation's friend. Who's cheering now?