SYDNEY: 20 May 2013 - A senior judge from the United States has told a financial services forum in Sydney that federal prosecutors have failed abysmally in their obligation to take criminal action against the culprits behind the global financial crisis. Jed Rakoff, judge at the US Federal District Court (SDNY), said that one of the "most egregious economic crimes of the century" had effectively gone unpunished as a result of the failure to take appropriate enforcement action. Judge Rakoff was joined by a number of other industry figures, including the recently retired deputy chairman at the Australian Securities and Investments Commission (ASIC), who said that financial markets had been undermined by the lack of criminal actions against individuals for misconduct.

The senior legal and regulatory industry figures were speaking at a conference hosted by the University of NSW's Centre for Law Markets and Financial Regulation. Judge Rakoff was particularly strident in his criticism of the failure to hold individuals accountable for the "alleged criminal failures" that paved the way for the sub-prime meltdown and ensuing financial crisis. He contrasted this with other financial disasters, such as the U.S. junk bonds scandal in the 1970s or the Enron and WorldCom collapses, which saw prosecutors successfully seek jail time for the key offenders.

Judge Rakoff said that given the statute of limitations in the U.S., it was "highly unlikely" that senior officials at financial institutions would ever face criminal consequences for their part in the financial crisis.

"No one went after the institutions, no one went after the individuals criminally. The result is that what arguably could have been described as one of the most egregious economic crimes of the century has gone unpunished," Judge Rakoff told the industry forum.

Participants in the forum questioned whether the justifications given by the U.S. Department of Justice (DoJ) for deciding not to bring criminal indictments were justifiable. 

Judge Rakoff said there was little question that there were serious allegations that warranted criminal indictments in relation to the "very serious misrepresentations" made about the riskiness of the mortgage pool of derivatives that were sold as securities. He said that even in 2007, as the market began to collapse, these were still being represented as Triple-A products. 

"There are allegations that at the highest level officers at various banks — as required under the Sarbanes-Oxley Act in the U.S. — have signed off on the existence of adequate controls to contain risk and the like when allegedly they knew better. There were allegations about when the banks, often at the best of the behest of the government, took over mortgage originating firms that there was a failure to disclose all the risks involved," he said.

Given that these alleged crimes took place in 2007 and 2008, the five-year statute of limitations in the U.S. is about to expire. Speakers at the event said this meant the public would never know whether there were charges to answer, as the criminality of these acts had never been tested by the courts.

Judge Rakoff said there was a "long history" of these kinds of indictments being brought in similar situations. Back in the 1970s, for example, there was the US the junk bond scandal which he said had a number of similarities to the sub-prime scandal. 

"Michael Milken came up with the perfectly legitimate idea of taking junk bonds which were risky, pooling them so that the risks were spread and were therefore less [risky] than selling securities based on these pools. The problem that arose was that as this became more and more popular items in the securities marketplace, there was a demand for more and more junk bonds. So ever more risky — hugely risky — junk bonds were put together. That risk was disguised so that the purchaser didn't know it was any different from the pools that they had purchased earlier. Eventually the whole bubble burst and a whole bunch of people were convicted, including Michael Milken," Judge Rakoff noted.

It was a similar scenario in the 1980s with the Enron and WorldCom accounting frauds. Panelists said that in those cases the U.S. government did not hesitate to indict at the highest level.

"Those people convicted are there in jail right now. So it is a little strange perhaps that there has been no indictment in connection with this financial crisis," Judge Rakoff said. 

Reasons for inaction 

In terms of the financial crisis, Judge Rakoff said he believed there were a number of reasons why appropriate criminal actions had never been pursued. He said these were less likely to be due to "conspiratorial" claims about regulatory capture and the so-called revolving door between the SEC and the DoJ. He said the main factors were the deep involvement of the government in pushing the U.S. dream of universal home ownership, and the concerns around these entities being "too big to tackle".

"You might say well it's because there is no crime. The main body charged with looking into the causes of the financial crisis in the U.S., the Financial Crisis Inquiry Commission, came out with a report that in great detail suggested that there had been gross misrepresentations. On a more confined level we have Lehman Brothers. When Lehman famously went into bankruptcy the trustee appointed to investigate what happened came up with a report that detailed ... the knowledge of intent among senior management in Lehman Brothers to allow misrepresentations to be made. And no indictment followed," he said. 

The DoJ, as far as Judge Rakoff is aware, has taken the position that no crime was committed in connection with the events leading up to the financial crisis. Their public position is that they could not indict for three reasons.

The first claim is that they cannot prove knowledge and intent at a senior management level. The second reason that the DoJ has given is that there were no immediate victims, in the sense that the purchasers of the sub-prime securities were themselves sophisticated investors. The third argument offered by the DOJ is that the institutions themselves are too big to fail and criminal actions would undermine confidence in a very uncertain financial market.

Judge Rakoff said that all of these justifications were baseless.

In terms of senior management accountability, he said that by 2007 there "all sorts of red flags flying, all sorts of warning signs and signals" that senior management had knowledge of what was happening. In that situation US prosecutors have traditionally made use of the doctrine of "wilful blindness", which is very well established in U.S. law. Essentially this means that a jury can find guilt if a person in a position of authority found it more convenient or profitable to "fail to see" certain facts or warning signs. 

"It's a little surprising that the Justice Department has said well we don't have direct proof of actual knowledge or intent. That's never been what stopped them in the past," he said.

The second claim — that there were no immediate victims — has never been a reason not to purse prosecutions in the past, Judge Rakoff said. 

"I'm not sure it's even true in this case. Certainly a whole bunch of civil lawsuits have been bought by the victims," he said. "Most importantly, it is not an element because the consequences for society as a whole can be devastating from having instruments based on lies that are being sold. The 26 million unemployed Americans know what I mean." 

The third argument from the DOJ — that the institutions themselves are too big to fail — simply does not stack up, according to Judge Rakoff. To the contrary, he said the implications of these institutions engaging in misconduct are so significant to society that they are "too big to ignore", not too big to indict.

"It's irrelevant when it comes to inviting indicting the individuals. No-one I think can seriously pretend that if you indicted the former CEO and most of the senior executives involved here — people who were forced out or retired in 2008 and 2009 — that going after them would somehow have a ruinous effect on the bank itself or on the economy as a whole. So there again I find the rationale unpersuasive," Judge Rakoff said.

Failing the smell test 

Belinda Gibson, former deputy chairman of ASIC, who retired from her regulatory role a week ago, said she agreed that the account described by Judge Rakoff "stinks". She said it was critical to hold individuals accountable as civil actions against individuals simply did not act as a deterrent — particularly when the individual players had collected huge incentives for their role in the lead-up to the crisis.

Gibson also said it looked bad on the part of the regulators when people were not held accountable by public prosecutors in instances of what seemed to be glaring misconduct.

"It doesn't pass the smell text. This is morally bad conduct and someone should pay. In the newspapers they say the regulator has to do something and they must be incompetent if they do not do anything," Gibson said.

She said that in Australia ASIC had been particularly careful to release transparent information on its enforcement decision making process. This was so that the public could gain a clearer understanding as to why some cases were pursued and other were not.

"ASIC has been making big steps, trying to be more transparent about its enforcement. The last one was the cooperation guide that it put out about a month ago, which is about the circumstances in which it would agree to give credit for cooperation," she said.

Gibson also said one of the huge challenges facing regulators was the glacial pace at which these types of cases move through the legal system if they are pursued. She said that during her time at ASIC there were some instances where the challenges around legal professional privilege took a year to resolve before ASIC could even get its hands on the relevant documents. Gibson said these types of delays severely undermined a regulator's key priority of building confidence that the financial markets are fair and orderly.

"In Australia it is about two years in the judicial system to just get a hearing. I can tell you that there is one case where a fellow has agreed to plead guilty, he's back in the jurisdiction, was extradited and it has taken two years to get a hearing date on just the plea of guilty a sentencing. So the judicial system is not a timely system in this jurisdiction," she said.

In the case of the misconduct that occurred in the lead-up to the financial crisis, Gibson said it was important to remember the deterrence role of fast and resolute enforcement action.

"The role of a regulator isn't just about bringing to book wrongdoing. It is about deterrence. It is very clear that deterrence means a timely dose. The real treat outcome of a sentencing years after the event is far more limited and the conduct that was to be impugned, the market is probably moved on," she said. 

In view of all these factors, Gibson said it was critical for authorities to take criminal actions where they are warranted and have a strong likelihood of success. She said governments needed to resource these types of actions adequately — even though they could be risky, expensive and drawn out.

"Most of the cases in the US are settled up simply because people hate the horror of jail so much. The 'horror of jail' is less of a real threat in this jurisdiction for white collar crime it would be fair to say," she noted.

THIS ARTICLE WAS FIRST PUBLISHED BY THOMSON REUTERS ACCELUS ON 20 MAY 2013 AND IS REPRINTED WITH PERMISSION