Has the SEC Stepped Up to the Plate on Fraud Enforcement Actions?

The Securities and Exchange Commission’s (“SEC”) mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”  The SEC believes that its “investor protection mission is more compelling than ever” since more first-time investors have turned to the market to invest in their future.  Therefore, it goes without saying that the SEC’s enforcement authority is crucial in maintaining investor protection.  But, has the SEC stepped up to the plate considering the negative impact the 2008 financial crisis has had on investors?

The 2008 financial crisis had devastating effects on our economy which caused massive job losses and a growing number of American families at risk of foreclosure and poverty.  However, some companies made substantial profits from the financial collapse and many top executives received considerable bonuses (some from government bailout money) after millions of families’ investments dwindled or even disappeared. 
Most recently, the SEC filed civil fraud charges in Texas against former Chief Executive Anthony Nocella and former Chief Financial Officer J. Russell McCann of Franklin Bank Corp. for concealing the deterioration of the bank’s finances during the mortgage crisis.  Specifically, the SEC alleged that in 2007, Nocella and Man used aggressive loan modification programs to hide the bank’s non-performing loans and artificially boost profits.  See SEC Complaint. 

Despite having charged over 100 people and firms with fraud tied to the financial crisis, critics of the SEC believe the agency hasn’t buckled down hard enough.  Yet SEC enforcement chief, Robert Khuzami, believe these numbers show the agencies effectiveness in “tackling financial-crisis wrong-doing.”  Of the 74 cases filed against individuals, 55 are chief executives, finance chiefs or other top officers.  Khuzami believes this “sends a strong deterrent message.”  

Many of the SEC critics note that about 24 of the people charged by the SEC have avoided trial by reaching “weak” settlements.  Senator Grassley from Iowa stated, “The lack of accountability from Wall Street encourages recidivism.” 

For instance, Angelo Mozilo, Chief Executive of Countrywide Financial Corp., agreed to a settlement of $67.5 million ($22.5 million penalty and $45 million disgorgement), while denying any wrongdoing.  These sanctions are supposed to compensate investors for their losses.   However, the repayment of illegal profits is tax-deductible and can be covered by some corporate insurance policies.  In Mozilo’s case, nearly half of the $45 million payment came from Countrywide's current owner, Bank of America Corp.  It can be difficult for the SEC to challenge indemnification rights in employment contracts or insurance policies.

According to The Wall Street Journal, in the 24 crisis-related cases where the SEC reached a settlement with an individual, the median sanction was $203,751.  These same defendants paid a combined $80.7 million in penalties.  Most of those penalties came from executives at collapsed mortgage lenders such Countrywide, American Home Mortgage Investment Corp. and New Century Financial Corp.; yet, their investors sustained losses of about $31 billion based on the three companies' peak stock-market value before the financial crisis began.  These penalties arguably pale in comparison to investor losses. 
Even some federal judges have criticized the large gaps between investor losses and the penalty.  For example, U.S. District Judge Frederic Block in New York, said $1.05 million in penalties paid by two former Bear Stearns Cos. hedge-fund managers, Ralph Cioffi and Matthew Tannin, in a proposed settlement of civil-fraud charges against them was “chump change” compared with the $1.8 billion lost by investors. The judge has not yet approved the proposed settlement.

While to some, the above penalties may seem like an inadequate punishment for the charges, Cioffi and Tannin have agreed to a temporary ban from the securities industry.  Khuzami believes the SEC’s power to expel people from the securities industry or from serving as directors of public companies is “probably one of the most powerful sanctions [it has].” 

Furthermore, when reaching settlements, the SEC has to weigh the likelihood of losing to a jury, along with the amount the agency can show was a direct result of the wrongdoing.  In some cases, it can be hard to say with certainty how much of investor losses were caused by fraud or illegal conduct, or if any fraud or illegal conduct actually took place.  Usually, defendants argue the financial losses were due to a failure to predict the meltdown, rather than any fraud on their part.  The answer is not always clear cut and pushing for stricter penalties across the board may not be appropriate for each case. 

Nevertheless, we can only hope that Americans’ trust in our banking and financial systems can once again be restored.