The majority of pundits and market observers have only tuned into the effectiveness of the SEC as financial market regulator since 2008, when the financial system nearly collapsed. So far, criticism has been relatively shallow. But when one of the most influential securities attorneys in America, Columbia University’s John Coffee, weighs in on the effectiveness of the SEC’s enforcement actions, we should all take note. Coffee’s SEC biography gives some background on his preeminence:
According to a recent survey of law review citations, Professor Coffee is the most cited law professor in law reviews in the combined corporate, commercial, and business law field.
And what does Professor Coffee have to say about the efforts of the SEC to prosecute financial market lawbreakers? He wrote on the CLS Blue Sky Blog:
A disturbingly persistent pattern has emerged in U.S. Securities and Exchange Commission enforcement cases that involves three key elements: (1) The commission rarely sues individual defendants at large financial institutions, settling instead with the entity only; (2) when it does sue individual defendants, it frequently loses; and (3) the penalties collected by the commission from corporate defendants are declining and, in any event, are modest in proportion to the profits obtained.
Coffee’s first and second observations are the ones that commentators most often focus on. Why haven’t any bankers, who caused the global financial system to collapse, gone to jail? Coffee contrasts the SEC’s approach with another financial overseer, the FHFA, which has been indicting individuals:
In November, the SEC sued and settled with JPMorgan Chase & Co. and Credit Suisse Group A.G. for a collective $417 million, but named no individual defendants. This continues a pattern under which the only senior executive at a truly major bank named as a defendant by the SEC in a case growing out of the 2008 crisis appears to be Angelo Mozilo, the former chief executive officer of Countrywide Financial Corp., who settled while under a threat of criminal indictment (which made going to a prior civil trial unthinkable).
In sharp contrast, the Federal Housing Finance Agency (FHFA) also sued JPMorgan in a suit that similarly focused on the activities of Bear Stearns (which was acquired by JPMorgan) in packaging collateralized debt obligations (CDOs), and the FHFA named 42 individual defendants, including some high-ranking Bear Stearns executives. In a series of other cases against major banks, the FHFA has also sued a host of individual defendants.
And then Coffee really lets the axe drop:
All in all, the SEC’s batting average is close to “zero for 2008″ in the few cases that it has taken to trial stemming from that financial crisis.
And he has an explanation why:
What explains this pattern? First, the SEC is an overworked, underfunded agency that is subject to severe resource constraints. It knows that suits against senior executives will often drag on, consume considerable resources, and deprive it of manpower that could be employed elsewhere. In contrast, major financial institutions almost always settle with the SEC at an early point (as even Goldman Sachs did) to avoid reputational damage. Thus, the more the SEC needs quick, publicity generating settlements, the more it becomes inclined to forgo individual actions against executives who would be unlikely to settle.
Second, the SEC seems highly risk averse. Suits against high-profile executives who will resist fiercely could backfire, thereby interfering with the SEC’s broader program to repair the reputational damage it suffered as a result of the Madoff fiasco.
Third, the SEC needs to be able to use objective metrics to justify its request for budget increases. By bringing many actions and settling them cheaply, it can point to an increase in the aggregate penalties collected, even if the median penalty is at the same time decreasing. This may impress Congress, but from a deterrence perspective, it is similar to issuing modest parking tickets for major frauds. So long as the expected gain is not canceled, the incentive to commit fraud persists.
What does Coffee suggest the SEC do to become a more effective regulator? Essentially, he says the SEC must hire bounty hunters, private litigators who work on a contingent fee basis, to prosecute complex cases:
What then is a feasible answer? The most logical response would be for the SEC to retain private counsel on a contingent-fee basis in those large cases that it cannot staff adequately itself. This is exactly what the FHFA has done in retaining Quinn Emanuel Urquhart & Sullivan to sue the major banks for the losses it sustained on toxic CDOs.
Such a strategy kills at least three birds with one stone: (1) It allows the SEC to acquire highly experienced trial counsel for big cases (without having to pay their salaries for the long term); (2) it economizes on the SEC’s budget by paying the attorney fees only out of any recovery obtained; and (3) it enables privately retained counsel to invest greater time and effort, getting “deeper into the reeds” of a complex case (at least if the potential fee is large enough to justify such an effort).
Finally, the attorney-fee formula could be adjusted so as to encourage private counsel to pursue actions against individual defendants (for example, counsel might receive 30 percent of the recovery from individuals but only 20 percent of a recovery from the corporation).
Coffee analyzes the weakness of SEC enforcement and, more importantly, charts a useful solution. He knows that law enforcement must punish individual wrongdoers and it must be a deterrent to other market participants. Coffee is one of the nation’s most brilliant thinkers on securities regulation. Maybe President Obama could charm him into serving as a commissioner on the SEC. The markets need a rigorous overseer.
This post was originally published by Reuters.com on January 4, 2012.