Slouching Towards Wall Street… Notes for the Week Ending Friday 2 December 2011
Manfully committing to do everything in his power to strengthen the economy, President Obama delivered the “surprise” news that unemployment stands at 8.6%, the lowest reading since the spring of 2009. However, the figure bears an asterisk: 315,000 people stopped looking for work in the month of November and thus have vanished from the ranks of the unemployed. This reminds us of the administration of New York City Mayor Ed Koch, when the city planned to distribute official ID cards to homeless people — no one without a card could call themselves Homeless. This would close them out of homeless shelters and was intended to prevent the undocumented indigent from begging and squeegeeing windshields at red lights. (If you think New York has used up its allotment of wacky ideas, look at the new “Myanmar Shave” program of traffic haikus. Maybe they should use the idea for homeland security. We envision signs at the borders. “Climb through barbed wire / Without papers or visa / We will shoot you. Dead”…) Anyway, it is an odd characteristic of government statistics that when people go from desperately trying, to giving up in defeat, the readings improve.
More data come from our corrupt home state of New Jersey (we gave you back John Corzine — you’re welcome). The John J. Heldrich Center for Workforce Development at the Rutgers School of Public Policy reports that, of those who lost their jobs after the financial crisis, only 7% have found work at an equivalent, or better, level of earnings, benefits, and skill. Currently only 64% of those who qualify to be in the workforce are actually either working, or actively looking for work. Unemployment is not down to 8.6 per cent, Mr. President. Now who’s surprised?
This smoke and mirrors exercise triggers two thoughts. One: this could lead to social unrest. And two: There Oughta Be A Law.
We thought rising unemployment should cause crime to increase. This completely intuitive notion is not borne out by some recent studies, as noted for example in the Wall Street Journal earlier this year (28 May, “Hard Times, Fewer Crimes”) which said the doubling of the unemployment rate coincided with an 8% decline in robberies, and a 17% drop in auto theft. This is countered by pundits who argue we are looking at the wrong metrics, but they have yet to figure out the right ones. The Journal theorizes that America’s extremely high level of incarceration means those inclined to crime are mostly off the streets. We suspect there may be something to this.
Acclaimed criminal law scholar William J. Stuntz taught at Harvard until his untimely death this year at age 52. His The Collapse of American Criminal Justice, just published posthumously, is very troubling.
America’s current rate of incarceration is way off the charts, both relative to our own historical measures, and vis-à-vis the rest of the world. Imprisonment rates in England and Scotland in 2007 were 132 per 100,000 of the population, and 114, respectively. That year, the US rate was 506. Lest you think this a selective statistic, Stuntz says “the British are more punitive than their Western European neighbors,” citing figures of 78 for the Netherlands, 74 in Germany, and 72 for France. The Ukraine had a rate of 252. America’s only real competition in tossing its own citizens in the slammer was Russia which, at 513 per 100,000, beat us by a slender margin (another gold medal for Putin).
Stuntz makes a forceful case against inequality in the American criminal system. The black imprisonment rate for 2000 was 25% higher than the highest incarceration rate in Stalin’s Russia in 1930. Stuntz’ “collapse” resides largely in the systemic inefficiency which trades justice for reportable outcomes. One way this arose, Stuntz argues, is that inner cities, nested within larger and more prosperous voting districts, have Tough On Crime sheriffs, prosecutors and judges foist upon them. Thus residents of the inner cities — who are overwhelmingly black, and who vote in far fewer numbers than the overwhelmingly white communities surrounding them — are forced into a bind that, without malicious intent, perpetuates racial, social and economic inequities.
Those who do vote elect familiar and comforting types to be sheriffs and judges. The most crime-ridden neighborhoods come to be policed by outsiders — neither residents of, nor of the same ethnicity or culture as the people they oversee, and those police are often as afraid of the residents as the residents are of them. The mechanism of automatic plea bargains means that an arrest is often a de facto conviction — cops on the beat end up deciding who will go to jail because the system is not structured to investigate cases. The deterrent effect of punishment unexpectedly declines as a stint behind bars becomes a rite of passage on a black youth’s path to adulthood.
According to Stuntz, by 1860 the structure of today’s criminal justice system was already in place: “plea bargaining was becoming an ordinary means of disposing of criminal cases and thereby keeping a lid on crowded dockets.” America’s practice of not investigating criminal cases is enshrined by a century and a half of practice and court approvals. The theory behind plea bargaining is that there is too much work for the courts to process efficiently. The majority of cases can be pled away, freeing the courts’ resources to thoroughly try important cases. The person entering the plea accepts certain punishment which may be more than if they had tried the case, society gets a statistically likely positive outcome — most people who accept a plea bargain are thought to be guilty of something, even if not the crime to which they plead. And the state gets a prosecutorial win, without the expense of a trial or the risk of losing. Plea bargaining, which was supposed to increase judicial efficiency, has instead become the law of the land.
Now to our second point — where are the legal protections for the 99%?
Enter Judge Jed Rakoff of the Southern District of New York. By now you have surely heard of Judge Rakoff. The SEC has also heard of him — earlier this year he lambasted them quite publicly over a $33 million settlement with Bank of America. Thus it is odd that they would elect to bring a settlement with Citibank to the Southern District looking for a judge to sign off. We understand that judges are on a rotation. There was no certainty that the Citibank case would be assigned to Rakoff — but neither was there any way of preventing it. It appears the Commission could have brought this settlement to a court in Washington DC, but reports are they chose New York because they are combining it with a related case. Down in Washington, Mary Schapiro must be asking “whose idiotic idea was that?!” We wonder whether Enforcement Chief Khuzami has something up his prosecutorial sleeve.
Judge Rakoff is having none of it. The Wall Street Journal writes (1 December, “Rakoff’s SEC Rebuke”) Rakoff’s rejection of the proposed settlement between the SEC and Citi “is playing in some circles as a great populist victory against Wall Street. But it looks to us more like a rebuke of the cozy relationship between regulators and the regulated that too often leaves justice as an orphan.”
In the halcyon days of the “cold calling cowboy” stockbrokers, when young men with slicked back hair, an outer-boroughs accent and (maybe) a high school education were screaming into the phones all across America, telling people to “Buy! Buy! Buy!” a number of small brokerage firms became effectively halfway houses for brokers who perpetrated serial fraud on their customers. Most common among these activities were overtrading of accounts to generate excessive commissions — “churning” — and the purchase of wildly unsuitable securities when small firms floated their own tiny offerings of highly illiquid stock. Because the float in these issues was so small, the firm that underwrote them generally controlled trading. One effect was that they needed their brokers to dump large quantities of shares on the public, who would never have an opportunity to re-sell them (“pump and dump”). To incentivize the pump and dump, firms built in a large credit — the “chop” — to pay the broker for unloading this junk. It was not uncommon for some firms to pay their brokers twenty-five per cent or more of the price of the stock they unloaded. The NASD guideline specified commissions should generally not exceed 5% of the total value of the transaction, thus the “chop” was hidden in the market maker’s price and hardly mattered, since the customers would never be able to sell anyway.
After getting churned and chopped regularly by their brokers, some customers actually complained to the firms that employed them. Regulations require that firms make a formal report of customer complaints. Such report generally becomes part of the broker’s public record. The problem is, it also becomes part of the employer’s record. Firms with large numbers of complaints against their brokers risked being shut down for failure to supervise. So they chose not to report complaints. Instead, it became common practice to call the complaining customer and make an off the record monetary deal. Customers were generally incentivized to accept these offers, since the NASD had a poor record of actually returning cash to injured investors. The broker would then be called into the manager’s office where he would be told that (a) the cost of making the settlement was being deducted from his commissions, (b) the firm would withhold the rest of his commissions because he had caused them such aggravation and (c) his voluntary resignation was accepted and he was free to seek employment elsewhere in the industry.
It took the regulators some time to figure out that, if a broker worked for ten firms in the course of one year, something was wrong. Finally, these individuals became pegged in the regulatory systems as Rogue Brokers. Still, it took a long time for the firms who serially employed these individuals to come under serious scrutiny. The whole time the wheels of justice were slowly turning, brokers were chopping and churning, and the firms that employed them were raking it in.
Before hiring a broker, a firm is required to call the previous employer and ask whether there were any problems. No firm that washed its hands of a criminal was about to rat themselves out to anyone else. In effect, allowing a broker who routinely abuses his customers to resign voluntarily, with no negative entry on his public record, becomes a fraudulent referral.
The SEC has become a rogue regulator, allowing serial offenders to walk from abuse to abuse with only minor consequences. Enforcement Chief Robert Khuzami’s rebuttal of Judge Rakoff’s order is merely peevish. He does not address any of the judge’s fundamental points. We suspect that is because he can not.
Khuzami esentially regurgitates and justifies everything that Judge Rakoff slammed in his Order (SEC press release, 28 November, “Public Statement by SEC Staff: Court’s Refusal To Approve Settlement In Citigroup Case”). Khuzami argues that the Order “ignores decades of established practice throughout federal agencies.” Actually, a reading of Judge Rakoff’s order shows he understands only too well what that established practice has led to.
We are not judges or legal scholars. We are not prosecutors or securities regulators. We are, however, taxpaying citizens of this nation, which means we have a profound vested interest in seeing our financially system run properly. Let’s face it, it has already cost us trillions. In a settlement the regulators extract a promise from the party that, even though they do not admit to the wrongdoing specified in the complaint, they will not do it in the future. This looks great on paper, but in a legal revolving door where firms only settle and never admit to anything, it is impossible that the punishment for violating such undertakings will ever be imposed. In short, this is a free gift to the offending company, a scam on the taxpayer and a fraud on the marketplace.
The practice of issuing serial settlements encourages patterns of repeat fraudulent behavior — just like those small brokerage firms that allowed brokers to resign. Both Khuzami and Schapiro have a point: the SEC does not have the power to impose fines that would be so onerous as to be truly punitive — so punitive as to be a real deterrent before the fact to fraudulent behavior. Whose idea was it to curtail the SEC’s power? Congress. The folks who are allowed to trade on inside information. Schapiro has been on the Hill asking for greater powers and more money, but with her agency viewed so poorly, she stands slight chance of achieving either.
The solution should be to allow the SEC’s case to proceed. If Citi wins, so be it. If not, the judgment will establish wrongdoing which would serve as a cause of action for private civil suits. In the present instance, a finding against Citigroup would likely unleash lawsuits totaling the billion dollars or so of principle value of the fund in question, plus treble damages for allegations of fraud. Judge Rakoff cites the action (SEC v. Stoker) covering the same transactions, where the Commission says Citi “knew in advance that it would be difficult to sell the fund if Citigroup disclosed its intention to use it as a vehicle to unload its hand-picked set of negatively projected assets.” Judge Rakoff says this appears to be “an allegation of knowing and fraudulent intent.” In law this is called “scienter,” and it is what the prosecutor must prove to get a fraud conviction. Scienter is difficult to prove in a fraud case. But in a civil case the jury weighs the preponderance of the evidence, and the evidence against Citi, assuming a negative judgment in the SEC action, would likely be a foregone conclusion.
The SEC has taken on the role of coddling bad actors. It was not always so, but it sure is today. This is part of the blatant cronyism that has developed, with lawyers using the Commission as a launch pad for their Wall Street careers. It is clearly also the result of two generations of the increasingly passionate incestuous embrace of Washington and Big Money. The massive wave of deregulation that now threatens to sweep us down the sewer is not a partisan phenomenon. Acrimonious accusations being tossed around on the Hill are a classic Washington lookoaway — they want us to believe the economic troubles were caused by the Other Party. The fact is, deregulation started in a major way under no less a left-wing liberal than Jimmy Carter. And while the corporate largesse unleashed under President Reagan is trickling rather more slowly than promised, it was President Clinton who signed the Gramm Leach Bliley act into law — the death warrant for Glass Steagall.
Gramm Leach Bliley was created specifically to accommodate one large transaction that was not legal under Glass Steagall. We refer, of course, to the merger that created Citigroup. Citicorp and Travelers Group actually merged in 1998, the year before Gramm Leach Bliley became law. How could two such monster behemoths have merged when there was a law prohibiting it? Simple. The Federal Reserve granted the resulting entity, Citigroup, a temporary waiver. Chairman Greenspan, that is, who famously maintained the markets could take care of themselves without oversight. Until the day he realized he had been wrong. And what a shock that was!
Today we are still reeling from that shock. Indicators of public opinion say the majority of Americans agree with what they see as a fundamental message of Occupy Wall Street: that crony capitalism, unfettered corporate greed and government corruption must end. In this environment, Judge Rakoff has picked his battle deftly. Just as the Judge has lifted the blanket to show the nasty entanglement between the industry and its own regulators, OWS has reminded folks that We The People are the neglected inner city of our society. As surely as black inner city youths are incarcerated at globally astoundingly high levels, America’s wage earners and middle class pay the price for corporate malfeasance and unbridled greed. It is a grave error for a society to behave as though there were a level below which the common process of justice need not apply. If justice does not apply to some, it will not apply to any. While the middle class were busy ignoring the rights of the poor, the One Per Cent have been deliberately eviscerating everyone else’s protections for decades.
Graft and venality know no party lines. Over $3.5 billion of largely tax deductible money was spent on political lobbying last year, a figure that does not account for campaign contributions. Major business executives give amply to both parties, paying protection money paid to ensure that, whichever gang wins the turf war, the shop owners will stay in business. Business As Usual.
Like the courts, the SEC says they do not have the resources to try every case, so they go the settlement route. We do not think Congress is about to give the Commission another few billion dollars so they can hire more lawyers (although without a fresh crop of SEC lawyers, where will the next decade’s investment bankers come from? And without the bankers, who will pay for the political campaigns?) As with plea bargains, the concept of efficiency is to not overly burden the Commission’s resources, in order to permit truly important cases to get a full hearing. The Citigroup merger represents a pinnacle of a generational undoing of the laws of this nation. One of the nation’s highest appointed officials undercut existing law to encourage an unlawful combination, then urged Congress and the President to trash hard won protections in the financial markets. And Congress and the President all fell over one another to kiss Greenspan’s ring and shake Sandy Weill’s hand. Some of the purportedly fraudulent activity alleged by the SEC appears to date to Robert Rubin’s tenure at Citigroup — Mr. Rubin, who subsequently became Treasury Secretary and took a leading role in rewriting the laws governing (“failing to govern,” more accurately) the nation’s banking industry and investment markets.
We can not think of a case more deserving of the full resources of the courts and the regulatory agencies. We hope that Mr. Khuzami allows Judge Rakoff to be the Brer Fox who will throw the SEC into the briar patch. There is disagreement among legal commentators as to whether Rakoff’s Order can even be appealed. It may be Khuzami’s secret wish that he actually try the Citi case. It would be an unprecedented win, nicely capping his prosecutorial career. Those who follow things prosecutorial tell us Khuzami has got the chops to do this. From what we know of his background, he appears to have the intestinal fortitude. With Occupy Wall Street waiting in the wings, perhaps this time will be different after all.
Judge Rakoff may, or may not have it in for Citigroup. He may, or may not despise the SEC and its pandering to the inverted totalitarianism of American democra-capital-ocracy. But Judge Rakoff has done something the judiciary, the legal profession, the legislators, a passle of cabinet officials, and a succession of presidents have failed to do: he has stood up for the notion that, in order for the law to work, the law must do its work.
It will be hard for Judge Rakoff to stay the course. There will be tremendous pressure to allow Citigroup to settle. They will say that Citi is too important to the proper functioning of the economy. They will say that the uncertainties of a protracted court case, and possibly a decision against Citi, would be a blow to the already precarious global financial markets. It’s always something with these people, isn’t it?
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