Lessons from the Credit Crisis a subtle shift in the long reach for top executives
As the extended aftermath of the 2007-2008 subprime mortgage and global financial crisis continues to unfold, financial markets regulators have been criticized for missed opportunities to charge senior executives.
But we can now observe a change in approach in the words and actions of the financial market regulatory enforcement agencies. In a widely reported speech on September 26, 2013, U.S. Securities and Exchange Commission (SEC) Chair Mary Jo White articulated a "subtle shift" in pursuing "responsible individuals," noting that the SEC wants to be sure "we are looking first at the individual conduct and working out to the entity, rather than starting with the entity as a whole and working in".
Chair White remarked that this approach is "one that could bring more individuals into enforcement cases."
Those words are reinforced by two notable enforcement actions in 2013, the Commodity Futures Trading Commission's (CFTC's) civil action against MF Global and its chief executive officer Jon Corzine, and the SEC's administrative proceeding against Steven A. Cohen, the founder and owner of SAC Capital Advisors. Both cases seek to impose liability on top executives of financial firms based on failure-to-supervise theories, as opposed to theories of primary wrongdoing. Thus, the stated subtle shift may translate into less traditional theories of enforcement that focus on elements of failure-to-supervise, control person liability and wilful blindness.
The continuation of policy by other means
Early efforts to charge and prosecute senior Wall Street executives met with little success, forcing authorities to adapt and reshape prosecution strategies under the weight of public pressure. At the midpoint of the crisis, and close on the heels of JPMorgan's federally assisted acquisition of Bear Stearns, two senior managers of failed Bear Stearns' hedge funds were arrested and indicted for fraud in June 2008. This initial foray into assigning individual blame for the crisis failed, however, and in November 2008, just a month after Lehman Brothers filed for bankruptcy protection, a federal jury acquitted both former Bear Stearns employees at trial.
The SEC appeared to shift tactics in 2010, bringing a trio of cases in the federal courts against Goldman Sachs, Citigroup and JPMorgan asserting fraud charges in relation to three failed collateralized debt obligation (CDO) transactions while naming an individual associated with the CDO transaction in each of the three cases. The claims against the individuals in those three cases were notable in two respects: first, they were primary claims for fraud, rather than "secondary" or "vicarious" claims asserting that the charged individuals controlled or supervised other employees responsible for fraud. Second, and perhaps as a result, the three individuals charged were only low- or mid-level employees rather than senior management.
The SEC's modified tactics met with mixed results, particularly in the short term. The three banks each settled, or attempted to settle, their charges in the early, going in some cases for record figures. But each of the three individuals opted to litigate rather than settle the SEC charges against them. The first to trial was Brian Stoker, a vice-president in Citi's structuring group, who won acquittal by jury in July 2012 following a trial that focused on his relatively junior position in Citi's overall executive structure. In the press that followed Stoker's acquittal, the jury foreman was quoted as saying "I wanted to know why the bank's CEO wasn't on trial." The case against Edward Steffelin, an employee of the firm that advised JPMorgan on the structuring of its CDO transaction, languished on the docket until, a week or so after the 2012 presidential election, the SEC moved to voluntarily dismiss its own charges with prejudice. The SEC was ultimately successful at trial against Fabrice Tourre, a Goldman vice-president, but did not obtain its verdict until August 2013, after a new chairperson and new enforcement heads had been installed at the SEC.
Meanwhile, as those cases ran their course, the background was set for the regulators' 2013 charges against Corzine and Cohen. In March 2010, Corzine, the former Goldman Sachs CEO and senator and then-governor from New Jersey, became chief executive officer of MF Global, the established futures and commodities brokerage house. When MF Global experienced its sudden collapse in October 2011, the inquiries that followed focused closely on Corzine's conduct, and in particular on his role in MF Global's bets on European sovereign debt.
In this same time period, over the course of 2011 and 2012, several portfolio managers from Cohen's firm, SAC Capital, were criminally prosecuted for insider trading. In early 2013, the SEC brought charges against the firm – but not Cohen individually – for the conduct of its portfolio managers. In March, the SEC announced a record USD 616 million settlement resolving all charges against SAC. Despite the large penalty figure, the settlement, in which neither SAC nor Cohen himself admitted to any wrongdoing, was greeted with public frustration, with one prominent columnist, John Cassidy of The New Yorker, asserting that Cohen had "bought off" the U.S. government.1
As it turned out, however, the CFTC and SEC pivoted to return to the question of Corzine's and Cohen's individual liability. In July 2013, shortly after Mary Jo White was confirmed as its Chair, the SEC launched an administrative action against Cohen individually, seeking to permanently bar Cohen from the securities industry on the charge that he had failed to adequately supervise two portfolio managers then facing criminal charges. The SEC charged Cohen under the Investment Advisers Act, claiming that Cohen "failed to take reasonable steps" to prevent his employees from insider trading in violation of the federal securities laws. For one set of trades, the SEC contends that Cohen "encouraged" one of his portfolio managers "to speak with the doctor who Cohen had been told may have seen Phase II Trial results information that any reasonable hedge fund manager should have known might be material and nonpublic." For a second set of trades, the SEC contends that Cohen "failed to take prompt action" after receiving a "highly suspicious email" which "reflect[ed] the clear possibility" that one of his portfolio managers possessed material non-public information and the manager might trade on that information.2
Likewise, in June 2013, the CFTC launched an enforcement action in federal court on the MF Global collapse, charging that Corzine was liable as a controlling person of MF Global and also, like Cohen, for failure to prevent the alleged violations through adequate supervision. In framing its control-person claim under the Commodity Exchange Act, the CFTC avers that "Corzine did not take sufficient steps to ensure that the Firm's daily draws of cash from [Futures Commission Merchant] FCM customer accounts did not result in an unlawful use of customer funds," and that "Corzine did not direct anyone to determine whether MF Global was under-segregated." The failure to supervise claim merely reframes these issues, stating that Corzine "had the power and ability to control cash transfers involving MF Global's accounts and controlled the employees responsible for making wire transfers involving its accounts." The CFTC also maintains that Corzine, purportedly with knowledge that MF Global violated its internal policy regarding use of excess secured customer funds, "did not take sufficient steps in response to ensure that proper controls were established and implemented to prevent any further violation of a Firm policy designed to protect customer funds."
Old Theories, Recast
The law defining the contours of supervisory liability took shape in the aftermath of the last major mortgage-related market failure in the U.S. – the so-called Savings and Loan Crisis.
Though the SEC had been empowered to assert administrative claims for "failure to supervise" since passage of the amendments to the Securities Act in 1964, such claims were seldom brought until 1990, when the SEC's enforcement powers were broadly expanded to permit the agency to respond appropriately to the crisis. Following the recommendations of an independent commission report issued in October 1987, the month of the "Black Monday" stock market crash, Congress in 1990 enacted the Securities Enforcement Remedies and Penny Stock Reform Act. This legislation, commonly known as the "Remedies Act," permitted the SEC, for the first time, to assess real monetary penalties – rather than mere disgorgement of profits – in proceedings brought before the SEC's own administrative law judges.3
As the crisis-fuelled economic recession deepened in the early 1990s, the SEC filed steadily more administrative proceedings on "failure to supervise" theories, with the number of such cases increasing 400% between 1991 and 1993.4 The failure to supervise theory greatly eased the regulators' burden in bringing cases against senior executives who, due to the nature of their positions, might otherwise be insulated from liability under alternative theories.
A failure-to-supervise violation merely requires a showing that the senior executive possesses the "power to control" the violator and, if such control can be shown, mere negligence as to whether the violator was adequately supervised. Two administrative decisions from the 1990s established this control test broadly.
A Shift in Application
In light of this history, practitioners will observe a few important strands in the regulators' recent enforcement actions against Corzine and Cohen.
To begin, both cases appear to be attempts by the regulators to take advantage of the lower burden associated with supervisory liability to assert claims more aptly brought under other higher-burden theories. The case against Cohen has all the hallmarks of a willful blindness case, with allegations that Cohen not only ignored "red flags" with regard to his employees' trading, but also took affirmative steps to shield himself from knowing the true source of certain pieces of information on which the portfolio managers traded. In a willful blindness case, on these facts, the SEC would need to prove at least recklessness on Cohen's part, and also that the danger that the portfolio managers were trading on inside information was "so obvious" to Cohen that he "must have been aware of it."5 Recast loosely as a supervisory liability claim, however, the SEC need only show negligence that Cohen did not exercise ordinary care in supervising his employees to the extent of being sure of the source of their information. In fact, recent developments in the SAC Capital criminal case illustrate the difficulty in proving intentional misconduct by top executives. On November 3, 2013 SAC Capital Advisors agreed to plead guilty to wire fraud and securities fraud charges, pay an aggregate financial penalty of USD 1.8 billion (which included a USD 616 million credit against the USD 900 million stipulated forfeiture amount) and terminate its investment advisory business. Cohen was not personally charged with any crime.
Likewise, the negligence-based supervisory claim the CFTC asserts against Corzine adds nothing substantive to the higher-burden "controlling person" claim in the same complaint. Indeed, the CFTC's supervisory allegations fail even to identify which employees, precisely, Corzine failed to supervise. Rather, those allegations do little more than attempt to establish that Corzine should have been aware that MF Global's internal controls protecting customer segregated funds were inadequate. Such a showing might have relevance to a good faith inquiry in the context of a controlling person claim, but does not address actual supervisory procedures, their adequacy, or whether Corzine himself exercised any direct supervisory control over the unidentified primary violators.
Next, though SEC officials indicated that future investigations would look first at the individual conduct and work out to the entity, these two cases clearly do not reflect that approach, having each begun as investigations into violations at the firm.
What they may reflect, however, is a plan to use the investigation and prosecution of key individuals as a medium for disciplining their employer entities.
The Cohen case may be the ultimate example of such a strategy, as a permanent securities industry bar against Cohen is likely to usher in a complete end to SAC Capital as a going concern and Cohen's ability to manage the money of outside investors through another company. But even apart from this extreme case, the ability more generally to seek similar bars against high-profile senior executives on a low-burden liability theory like failure-to-supervise, may become the regulators' chosen instrument for inflicting lasting reputational damage upon larger, more complex institutions that prove more difficult to reach by other means.
The SEC's decision to bring a failure-to-supervise claim against Cohen as an administrative proceeding, rather than by filing a complaint in the federal courts reflects a trend as the SEC seeks to litigate cases, perhaps involving untested theories, in what is widely perceived as a more friendly forum.
SEC administrative proceedings are tried before an administrative law judge without extensive discovery, the traditional rules of evidence, and a right to a jury trial.
Scrapping the limitations instituted in the Remedies Act, the Dodd-Frank Act broadly permits the SEC to seek fines and other remedial measures in administrative procedures against any public company and its employees, and not just against SEC registrants. As the SEC's co-director of enforcement recently said, "[o]ur expectation is that we will bring more administrative proceedings given the recent statutory changes."6
In the event that a violation is established favorably in administrative decisions within the SEC, the SEC may then use that precedent to influence and broaden the contours of that violation in the decisions of the federal courts.
The coming months will reveal whether financial market regulators can make effective gains with this approach. Non-fraud based liability, in the form of failure-to-supervise theories, may be a tempting avenue for regulators seeking to condemn the acts of senior executives who exercised overconfidence or a lack of critical attitudes. The question remains, however, whether it is good public policy to pursue such individuals in the absence of intentional or reckless misconduct and in the context of persistently stressed economic conditions where hindsight bias often prevails.
A version of this article was first published in the December, 2013 issue of "Wall Street Lawyer" (Volume 17, Issue 12), a U.S. publication owned by Thomson Reuters.
1. See John Cassidy, Did Steve Cohen Buy Off the U.S. Government?, The New Yorker, March 28, 2013.
2. The SEC's order instituting administrative procedures against Cohen is available at www.sec.gov/litigation/admin/2013/ia-3634.pdf.
3. The CFTC's penalty powers were similarly expanded in the 1992 Futures Trading Practices Act.
4. See Jonathan Eisenberg, Where Were the Supervisors? The Recent Surge in SEC Failure-to-Supervise Cases, American Law Institute, July 17, 1994.
5. Novak at 308.
6. Gretchen Morgenson, At the SEC, a Question of Home-Court Edge, New York Times, October 5, 2013.
there is the potential for a very broad array of regulated and unregulated entities to be swept up into the new regime
"…there is the potential for a very broad array of regulated and unregulated entities to be swept up into the new regime."