The Emperor Has No Clothes

11/02/2011 09:01 pm ET | Updated Jan 02, 2012

Much of the recent media coverage and Internet chatter about financial industry reform has focused on the Occupy Wall Street movement. If we ever end up with the kind of reforms needed, that movement would certainly deserve some of the credit.

If we look back on the Fall of 2011 a few years from now, however, I suspect we may trace the beginnings of real reform from two events that occurred last week with little fanfare.

The first of the two events was when Federal District Court Judge Jed S. Rakoff refused to approve a settlement with Citigroup that the S.E.C. had proposed. The second was the lawsuit filed by Delaware Attorney General Beau Biden in the Delaware Court of Chancery accusing the Mortgage Electronic Registration System (MERS) of deceptive trade practices. (Full disclosure: I have been a friend of Beau's his entire life.) Together, these two initiatives do the equivalent of exposing that the emperor has no clothes.

Judge Rakoff had earlier refused to approve an S.E.C.-endorsed settlement of $33 million with Bank of America. When he finally did approve a $150 million settlement, he described even that as "inadequate." Last week, he dropped a second shoe on the major banks. Refusing to approve the S.E.C.'s $285 million settlement with Citigroup, which was accused of fraud in the sale to investors of $1 billion of Collateralized Debt Obligations, Judge Rakoff demanded that, before any settlement was approved, the S.E.C. first answer a number of questions. They are great, commonsense questions -- exactly the ones that should have been asked in a whole strong of prior big bank settlements. Among them:

• Why should the Court impose a judgment in a case in which the S.E.C. alleges serious securities fraud, but the defendant neither admits nor denies wrongdoing?

• Why is the penalty in this case to be paid in large part by Citigroup and its shareholders rather than by the 'culpable individual offenders acting for the corporation? ... If the SEC was for the most part unable to identify such alleged offenders, why was this?

• What specific 'control weaknesses' led to the acts alleged in the Complaint?... How will the proposed 'remedial undertakings' ensure that those acts do not occur again?

• How can a securities fraud of this nature and magnitude be the result simply of negligence?

Do you think for a moment that the average target of an investigation would get a deal that did not include answers to these questions? Stay tuned.

Merscorp was founded in 1995 and is owned by the major financial institutions involved in the mortgage market, including Citigroup, Chase, Bank of America, Wells Fargo, FNMA, FMAC and others. MERS tracks mortgages and was established to reduce the charges of recording home ownership in local communities, thus making the widespread securitization of residential mortgages possible.

AG Biden's suit is the result of concerns he and New York AG Eric Schneiderman have expressed for some time about the potential settlement between the banks and the 50 State AGs. Those settlement talks began after the exposure of widespread problems with MERS and the banks' foreclosure procedures, including the practice of filing affidavits in court in which the lenders' employees claimed they had personal knowledge when they did not. Many documents had been "robo signed" or signed without being read. Essential documents were lost or destroyed. Files simply disappeared. Evidence of falsified documents is widespread.

A lot of the AGs seem to be willing to impose some monetary penalties on the banks and reach a settlement without any more investigation. That settlement would allow the banks to move on without any admission of guilt or wrongdoing.

Biden, Schneiderman and a few other AGs see it differently. They have been insisting on further investigations before any settlement is reached. The charges in Biden's suit against MERS include a series of allegations based on his investigations to date. Among them:

• Hiding the true mortgage owner and removing that information from the public land records.

• Creating a systemically important, yet inherently unreliable, database that created
 confusion and inappropriate assignments and foreclosures of mortgages.

• Failing to ensure the proper transfer of mortgage loan documentation to the securitization
 trusts, which may have resulted in the failure of securitizations to own the loans upon which
 they claimed to foreclose. (This is called "securities fail" and is the theory that allows put backs that crush the bank/originators.)

• Initiating foreclosures in the name of MERS without authority to do so or without appropriate
controls to ensure the actions were being carried out by the actual owner of the mortgage.

• Allowing the entry and management of data by those MERS members who are identified as 
owners or servicers in the MERS System, instead of controlling entry and management itself.

• Initiating foreclosure actions in which the real party in interest was hidden, thus preventing
homeowners from ascertaining who owned their mortgage in order to challenge whether or not 
they had a right to foreclose and limiting their legal defenses.

Again, stay tuned. Together, Judge Rakoff and Attorney General Biden are finally demanding much of the information we need to truly reform Wall Street.