Regulatory investigations and the credit crisis: the search for villains.

• Author: Ceresney, Andrew J.
• Position: Twenty-Fourth Annual Survey of White Collar Crime

Many commentators have remarked that 2008 will be known as the modern financial system's annus horribilis. (2) Certainly, the current upheaval in the financial markets is unprecedented. Assumptions about the U.S. financial system that have gone unquestioned since the Great Depression have been shown--in some cases overnight--to be invalid. Former pillars of the financial community have collapsed, been taken over, or been humbled into begging for federal government aid as part of the Troubled Assets Relief Program ("TARP"). (3) Economists are predicting the current recession likely will be the worst since the 1930s. (4) And across the country, citizens are asking angrily how this happened and who is to blame.

Amidst this wreckage, as legislators consider proposals for sweeping regulatory reforms, prosecutors and regulatory agencies have begun the arduous and time-consuming process of determining whether any criminal wrongdoing led to the credit crisis. (5) The fundamental question that prosecutors and regulators face is whether the breakdowns in the American financial system--such as the pandemic of mortgage defaults, writedowns on structured products, massive plummeting in financial institutions' stock prices, and the failures of some of those institutions--were caused by intentional or reckless misconduct, or whether they were simply the result of errors in business judgment. This question will occupy criminal and regulatory enforcement for the coming years. If these breakdowns were the result of criminal misconduct, wrongdoers may face prosecutions and other regulatory sanctions; if, however, the breakdowns were caused merely by poor business decisions, sanctions will be more appropriately limited to the extensive media criticism corporations and executives have already received.

This article surveys the various facets of the credit crisis, the responses of federal and state prosecutors and regulators, and the challenges law enforcement faces in addressing the problems that have arisen in the financial system. Law enforcement agencies have been essentially reactive to these problems, even as they have publicized their efforts extensively. For example, at the federal level, the first credit crisis investigations, into the issuance of subprime mortgages, (6) were initiated after several subprime mortgage lenders began to report large losses due to widespread mortgage defaults. (7) Federal regulators then shifted their focus to Collateralized Debt Obligations ("CDOs") (8) after leading financial institutions announced massive writedowns arising from their exposure to these complex products. After the collapse of several of these institutions, including Lehman Brothers, AIG, Fannie Mae, Freddie Mac, and Washington Mutual, federal regulators shifted their attention to investigating the accuracy of the companies' public disclosures regarding liquidity and asset valuations. (9) And when allegations surfaced that illegal short selling had contributed to the precipitous stock price drops preceding some of these institutions' collapse, short sellers became the primary regulatory focus. (10)

The same reactive pattern has occurred at the state level. Accusations that deceptive and fraudulent lending practices had contributed to widespread subprime mortgage defaults led state regulators to investigate predatory lending at major mortgage lenders. (11) After the leading credit rating agencies announced downgrades on securities backed by subprime mortgages in July 2007, causing a steep drop in the prices of many equity and fixed income securities, state regulators began investigating the propriety of the procedures agencies had used in rating mortgage-backed securities. (12) And when the credit crisis spread from the mortgage-backed securities market to the auction rate securities ("ARS") market in early 2008, state investigations of ARS issuers followed. (13) In all of these areas, ex ante regulation failed to prevent the financial crisis, and state and federal agencies have been playing catch up ever since. To underscore the point, the latest regulatory push--or perhaps more accurately, regulatory windfall (14)--as we go to press has been uncovering Ponzi schemes, sparked by Wall Street investment manager Bernard Madoff's revelations in the closing weeks of 2008. (15)

Despite the number of credit crisis-related investigations that law enforcement agencies have opened over the last two years, there have been remarkably few major regulatory actions or prosecutions to date. (16) As this article explains, public anger and the resulting pressure on regulators to find culprits aside, serious hurdles confront successful law enforcement actions relating to wrongdoing that may have occurred during the credit crisis. The financial instruments and arrangements at issue in the credit crisis investigations are highly complex. In many of the areas being investigated, there simply may not have been intentional misconduct or criminally reckless behavior, but rather plain bad judgment on the part of market actors. Even in situations where there was wrongdoing, the time and resources required to mount investigations and the burden of proving intent to defraud are formidable obstacles for prosecutors and regulators to surmount, except in the most straightforward of fraud cases. In sum, in its search for credit-crisis villains, law enforcement may not be able to bring successful criminal or regulatory enforcement cases to punish wrongdoing, at least in connection with the most complicated areas of financial transactions involving the largest dollar amounts. At the very least, these investigations will be highly time and resource intensive.

Part I of this article provides a brief chronology of the credit crisis to provide background and context for the resulting law enforcement investigations. Part II discusses the various DOJ, SEC, and other federal law enforcement investigations that have emerged from the crisis; the many challenges federal prosecutors and regulators face in making cases; and the few criminal and regulatory cases that have been brought thus far. Part III provides an overview of state law enforcement investigations. The credit crisis has witnessed, often behind the scenes, an intense competition between different state and federal agencies under pressure to demonstrate aggressive action in addressing the breakdowns in the financial system; a comparison of the different general approaches and focus of state and federal regulators provides an interesting contrast in enforcement tools, tactics and goals. The federal approach of conducting thorough, historical investigations in search of individual and corporate wrongdoers, while advancing the important goals of deterrence and upholding the rule of law, has produced few cases thus far because of the substantial obstacles to uncovering wrongdoing noted above. By contrast, some state investigations (sometimes in partnership with federal regulators like the SEC) have avoided these obstacles by focusing on consumer relief and systemic reform. This approach has yielded some immediately visible results, although it may be questionable whether the corporate conduct involved has always justified the type of relief or reforms imposed. After comparing the federal and state investigations, the article concludes with some tentative predictions of what the future holds for law enforcement actions relating to the credit crisis.

PART I: THE CREDIT CRISIS UNFOLDS

Financial commentators have competed to find language sufficiently hyperbolic to describe the events of the last two years. Most would probably agree with John Lipsky, First Deputy Managing Director of the International Monetary Fund ("IMF"), who has described the recent events as "the worst financial crisis since the Great Depression." (17) Similarly, John C. Dugan, Comptroller of the Currency, has described the financial crisis as "stunning, mind-boggling, earth shaking, eye-popping," but conceded that "even these words ... don't adequately capture what's happened." (18)

In short, the last two years have completely reordered the global financial system. Financial institutions have suffered unparalleled losses. More than $800 billion in asset writedowns and credit losses at more than one hundred of the world's largest banks and securities firms had been announced by February 2009, most of which stemmed from mortgage-related products. (19) Some commentators have predicted that the worst is not over, and that additional asset writedowns are in the offing. (20) Since early 2008, there has been a severe lack of liquidity in nearly every corner of the credit markets, (21) including mortgage-backed securities, (22) auction rate securities, (23) commercial paper, (24) and municipal and corporate bonds. (25) Established financial institutions, including Bear Stearns, Lehman Brothers, AIG, Washington Mutual, Fannie Mae, and Freddie Mac, have gone bankrupt, undergone fundamental reorganizations, or at best, continue to hobble along in a state of near-bankruptcy. (26) The American financial system has undergone an historic restructuring, as "the big five" independent investment banks have essentially disappeared, (27) and independent financial institutions such as American Express and CIT Group (28) have restructured or applied to restructure themselves as bank holding companies in order to access billions in aid from the TARP. (29) Under President Barack Obama, the U.S. Government has pledged nearly $800 billion in stimulus spending, (30) but as this article goes to press, the U.S. government and governments around the world continue to struggle with how to respond to these events and restore the vitality of the global economy. (31)

These developments did not arise overnight. The proliferation of subprime adjustable-rate mortgages, the ensuing pandemic of defaults in the subprime sector, and the collapse of the housing market...