Co-Authored by David J. Reiss, Professor of Law, Brooklyn Law School
Recent civil suits filed by the New York Attorney General and the U.S. Department of Justice and an Australian court's ruling against Standard and Poor's arise from events that took place during the subprime boom and seek to fix liability for the significant losses from that debacle. Now, statutes of limitations will soon bar nearly all remaining claims arising from that mess. But many people wonder why none of the individuals who profited from the debacle faced criminal charges. Although some reasons may appear to support prosecutorial abdication, the size and scope of damages suggest individual wrongdoing must have led to the subprime crisis and that individuals should be prosecuted.
One depressing reason for prosecutorial abdication is that a lot of bad behavior is still legal. Lenders, for instance, often took steps to ensure that their loans complied with relevant statutes like the Truth in Lending Act. Unfortunately, the relevant consumer protection statutes and regulations were often out of date. As a result, lenders had wiggle room and could make loans that were clearly inappropriate for millions of people but that complied with the letter of the law.
Another, almost counterintuitive, reason is that parties to sophisticated contracts contemplated a lot of bad behavior. The litigation brought by mortgage insurers like Syncora against Wall Street firms such as Bear Stearns subsidiary EMC provides a great example. Syncora claims that EMC enticed it to provide insurance on a lot of fraudulent mortgages, but the agreement between the parties says that Syncora's only remedy is to return the mortgages to EMC. EMC employees would argue they did not commit fraud.
A third reason is that a lot of the bad behavior may have been driven by greed, not criminal intent. Michael Lewis's The Big Short illustrates that greed in detail. Wall Street executives and managers saw their bonuses go from six figures to eight figures during the subprime boom because they took advantage of uninformed investors who unwittingly relied upon rating agencies and offering documents to make investment decisions. Greed is not, however, criminal. Juries seem to have seen things this way too, at least with respect to two Bear Stearns hedge fund managers whom the jury failed to convict, even though they were clearly part of the industry.
The last reason -- prosecutorial discretion -- cuts both ways. Large scale financial crimes are very difficult to prove in the absence of a smoking gun or an informant. Each investigation requires extraordinary manpower to sift through hundreds of thousands of documents. Intent can be very hard to prove. For every email that describes a pool of mortgages as a "sack of shit" there is another fifty that discuss how well the market had done historically and how the firms' complex computer models indicated that the pool would perform well, based upon past performance.
Prosecutors may realize that they can indict but may have a hard time convicting. Prosecutors may also be considering their other serious priorities in making these decisions (even though it is difficult to imagine many things more important than the world economy). They may believe that civil lawsuits, with their lower burden of proof, provide sufficient justice. They may also believe that regulators like the SEC and the IRS are in a better position to investigate and respond to these complex financial disasters. These all may appear to be good, measured reasons not to pursue criminal charges, but the lack of convictions still bother many people.
For every million underwater homeowners, there is also one Dick Fuld, Lehman Brothers CEO during its worst excesses in the mortgage markets. While he lost his equity in the firm when it went under, he earned a half billion dollars in compensation during his time there. That is troubling.
While the complexity of the transactions that led to the subprime crisis is almost beyond comprehension, even a basic definition of fraud, which would appear to apply to many who created the subprime boom and crisis, is relatively clear. Certainly the behavior of some of the people who made tens (or hundreds) of millions of dollars off of the subprime boom met the definition of fraud because they had to know that the information in offering materials was inaccurate and would harm investors. Nonetheless, they presented the information and harm resulted.
The fact that prosecutors across the country have not gone after more of the individuals within the organizations that sold bad mortgage instruments and who oversaw the machinery that produced millions of terrible mortgages is disconcerting. The financial services industry almost sent the global economy into a death spiral. Its participants should account for their roles in that destructive pursuit. If prosecutors continue to refuse to proceed on general criminal charges, the IRS should move forward with criminal investigations for representations parties made with respect to arrangements that could not qualify for claimed tax treatment.
Our laws should encourage managers on Wall Street to scrutinize their decisions before acting and understand that the pursuit of short-term profits have long-term consequences for all of society. Successful prosecutions of individuals who deceived investors and borrowers would help deter future bad behavior. We applaud prosecutors for filing civil suits against institutions, but if they do not take actions against individuals, individual actions will, no doubt, lead to our next boom and bust when greed and bad behavior once again overwhelm a well-ordered market.