Angelo Mozilo’s SEC Victory

Angelo Mozilo must be feeling pretty good these days. The guy with the perpetual tan earned well over a half billion dollars transforming Countrywide Financial into one of the nation’s leading mortgage lenders and then ran it into the ground by saddling the company with dubious mortgages that nearly led to the country’s ruin. And what is his SEC punishment for alleged insider trading and misleading shareholders?

A $67.5 million fine, of which about one-third will be paid by Countrywide’s acquirer, Bank of America, along with his legal fees. What’s more, Mozilo didn’t even have to admit any wrongdoing. In Wall Street parlance, he made one heck of a trade.

Yes, Mozilo also was banned for life from serving as an officer or director of a company, but given his track record and the fact he’s 71, his career working at public companies was pretty much over to begin with. Managing his hefty billion dollar portfolio should keep him pretty busy, particularly if Mozilo wants to judiciously avoid public companies managed by greedy executives like himself who put their interests ahead of shareholders.

By any measure, Mozilo’s penalty amounts to a wrist slap and will hardly serve as a deterrent. And the sad truth is the SEC can hardly be faulted for letting Mozilo off virtually scott free. The agency simply doesn’t have the resources to take on companies or individuals with extensive means. Prosecuting Mozilo would have been a formidable and high risk challenge; even if the agency garnered a win in court — and a victory was far from assured — he has the means to file appeals and drag the case on for years. Ditto for Goldman Sachs, which the SEC let off for a measly $550 million fine for securities fraud and no required admission of wrongdoing.

Admittedly, Mozilo still reportedly faces possible criminal charges and federal prosecutors have the talent and wherewithal to go the distance with Mozilo’s legal army. If prosecutors do bring charges, let’s hope they do a better job convincing a jury than they did prosecuting Ralph R. Cioffi and Matthew M. Tannin.

In the meantime, Mozilo can continue enjoying the good life with his Wall Street enablers. Sadly, there is no public shame being accused of wrongdoing by the SEC. Despite charges that ultimately led to a $6 million fine and a two-year ban from the securities industry for his role in a pay-to-play scandal involving New York State’s pension fund, former Quadrangle Group head Steven Rattner was feted last week at a reception attended by an impressive bevy of bold-faced names.

People with power on Wall Street don’t take the SEC all that seriously. The Goldman and Mozilo settlements give them ample reason not to.

The SEC Needs a Win Against Mozilo

As a New York Times story suggested earlier this week, Federal Judges are no longer rubber stamping the SEC’s settlements with Wall Street. This has put the SEC in an almost impossible situation: drive harder bargains and risk facing off in court against Wall Street’s limitless legal resources or bow to their wishes and risk more rejected settlements.

It all started with Judge Jed S. Rakoff’s denouncement of the SEC’s settlement with Bank of America for allegedly misleading shareholders about losses pending at Merrill Lynch, which at the time was in the process of being acquired. Judge Ellen Segal Huvelle then refused to accept a settlement with Citigroup, which also was accused of misleading shareholders about tens of billions of dollars in potential losses.

Judges are frustrated that the SEC’s settlement patterns harm shareholders who actually bear the brunt of the fines. They also want the SEC to negotiate stiffer penalties holding executives personally liable for fraudulent acts.

There are many reasons why large Wall Street firms are able to negotiate such generous terms with the SEC. One reason is the so-called “revolving door,” where former SEC officials representing Wall Street sit across from their past colleagues who themselves might be eying lucrative Wall Street jobs. But another is that Wall Street knows that the SEC is at a disadvantage if push comes to shove and a trial is scheduled.

The SEC rarely argues cases in a courtroom and even more rarely prevails against large Wall Street banks. With a track record like that, Wall Street’s legal representatives have the leverage they need to protect senior management and continue practices that exploit investors.

But that could all change in October when the trial against former Countrywide Financial CEO Angelo Mozilo is scheduled to begin.

A settlement agreement has yet to be struck between the SEC and senior executives of mortgage giant Countrywide Financial, including Mr. Mozilo. The SEC has accused them of misleading investors about their lending standards. It’s conceivable that an agreement may prevent a trial or that a judge could dismiss the charges, but considering the judicial scrutiny of late, the terms of a settlement would not be favorable to Mr. Mozilo and his former colleagues. Thus, it certainly looks like a civil fraud trial will get started this October.

The symbolic importance of the trial has been noted by several experts including former SEC chairman Harvey Pitt, who said that the case is “significant because it is a reflection of the SEC’s commitment to go after people who have been involved in the financial meltdown.”

I agree with Chairman Pitt, and I’d take it a step further: a win for the SEC would provide its enforcement team with the leverage they need to negotiate stiffer terms for settlements. Future settlements could and should include admissions of liability, as well as personal financial liability of the wrongdoer and his or her manager if applicable.

For the SEC, this is a “bet the farm” lawsuit and one that could lay the groundwork for the future of enforcement on Wall Street.

Morgan Stanley, Complex Structured Products… and Nuns

Wall Street never ceases to amaze me. Financial News reported last week that two Catholic nunneries and more than 80 other investors, have filed a lawsuit in London against Morgan Stanley alleging the firm inappropriately managed a complex structured bond it sold them called a “constant maturity swap,” causing an estimated $6.5 million loss.

Specifically, the suit alleges that Morgan Stanley, in cooperation with Saturns, an Irish bank, neglected to redeem the bonds when a mandatory redemption was triggered after they were downgraded in late 2008 as the financial markets imploded. The suit further alleges that Morgan Stanley and Saturns may have deliberately waited to redeem the bonds several months later so that their firms could earn a fee that they otherwise would have lost if the bonds had been redeemed earlier.

In what could be a public relations nightmare, Morgan Stanley is apparently contesting the suit, claiming it sold the the product to Bloxham, an Irish brokerage firm that represented the nuns. However, the suit alleges that the delay Morgan Stanley ostensibly caused prevented Bloxham from hedging losses from the depreciated bonds and thus caused further losses.

While this case is especially shocking given the victims, it’s unfortunately, very common: Wall Street continues to put their own interests ahead of their clients by peddling structured products to retail investors at an alarming rate.

The structured product market is ballooning out of control and is poised to pop.  According to StructuredRetailProducts.com, Wall Street has sold an estimated $30 billion in structured products to retail investors so far this year. Chris Whalen, a risk expert and co-founder of Institutional Risk Analytics, calls structured products the “next investment bubble.”

I’ve advocated that before a structured product can be sold to a retail investor, parties must sign a simple, “plain English,” one-page agreement akin to what Wall Street uses when entering into a derivatives contract, the so-called “Master Agreement.” Obviously, this added measure alone will not solve the problem. The SEC and FINRA also need step up and enforce penalties to the fullest extent possible on those firms that inappropriately sell structured products to individual investors.

So long as the status quo remains intact, individual investors remain extremely vulnerable to Wall Street’s seemingly endless supply of structured products.

The SEC and FINRA Need to Level the Playing Field in Structured Products

Before a derivatives dealer and its counterparty agree on a trade they must enter into a written contract called a “Master Agreement”. The European Union also has an agreement for derivatives trades called a Key Information Document (KID).

Derivatives and structured products are both complex financial instruments and can sometimes, nearly look alike. So, why are contracts similar to the “Master Agreement” not compulsory when Wall Street sells structured products to retail investors? The short answer is that Wall Street’s money isn’t at stake; it’s investors’ hard earned cash that’s at risk.

According to Stacy Marie Ishmael of the Financial Times, “The ISDA Master Agreement is fundamental to, and provides a template for, the derivatives market.” The derivatives market couldn’t exist without the Master Agreement.

Yet the structured products market exists, nay thrives, without any such agreement.

Unfortunately, Wall Street has no interest in fixing something when it works perfectly well….for them. According to Bloomberg, Wall Street banks have sold a record $22 billion in structured products to retail investors so far this year and are expected to top the 2008 high of $38 billion by the end of the year.

To be sure, not all structured products are toxic and some do make sense for the right “accredited investors”. However, investors need to understand what to expect when they are on the other end of a trade. They need to understand that these products carry hidden risks and fees, and in many cases the upside is limited, while the downside isn’t. Before investors purchase a structured product they need a “plain english,” one-page document that clearly spells out the terms and risks of that particular product.

With so much money at stake, regulators desperately need to step in and require that investors truly understand what they are buying. FINRA and the SEC need to fix this issue because Wall Street most certainly will not.

More Half-Baked Justice from the SEC

Last year, Judge Jed Rakoff of the United States Southern District of New York struck a blow on behalf of all investors when he ordered the SEC and Bank of America back to the negotiating table. He deemed the settlement agreement the SEC submitted for Bank of America’s alleged failure to disclose billions of dollars of losses at Merrill Lynch as inadequate and poorly constructed. When the SEC and Bank of America went back to the drawing board and agreed to somewhat stricter terms, still without admission of guilt, Judge Rakoff reluctantly approved. But not without a last salvo.

Judge Rakoff proclaimed that the revised settlement represented “very modest punitive, compensatory, and remedial measures that are neither directed at the specific individuals responsible for the nondisclosures nor appear likely to have more than a very modest impact on corporate practices or victim compensation…While better than nothing, this is half-baked justice at best.”

The same “half-baked justice” Judge Rakoff described last year was evident in the SEC’s recent settlement with Citigroup. The SEC alleged Citigroup executives hid $40 billion in toxic mortgage industry assets from its shareholders. Citigroup paid a $75 million fine for what might be one of the biggest accounting scandals on record and managed to avoid using the word “fraud” to describe its actions. Carefully crafted by Citigroup’s attorneys, the terms of the settlement were clearly designed to protect executives from liability and undermine shareholder’s seeking to recover their losses.

Goldman Sachs executives similarly managed to escape blame stemming from the SEC’s accusation that the firm inappropriately constructed the ABACUS CDO transaction. To recall, Goldman created ABACUS so that its clients would unknowingly invest in securities design to fail. To avoid admitting fraud and spare the reputations of senior-level executives, Goldman paid a fine of over $500 million. The settlement was so favorable to Goldman Sachs that its stock price rose 5% percent.

The SEC’s lackluster enforcement record during the financial crisis stands in stark contrast to the country’s state regulators. Attorneys General and securities regulators from many states have done all the heavy lifting, and have extracted meaningful settlements along the way. Most notable is Massachusetts Secretary of State William Galvin. Among Mr. Galvin’s accomplishments is ordering Bear Stearns to pay back 100 percent of any losses suffered by Massachusetts residents who invested in the firm’s infamous, sub-prime laden, hedge funds that spectacularly collapsed in 2007. He also was among the earliest regulators to take action against Wall Street for misleading investors about auction rate securities and he has ordered the Madoff feeder-fund Fairfield Greenwich to pay its investors every penny they lost.

Another active state enforcement official is Mark Connolly, Director of Securities Regulation for New Hampshire, who has accused UBS of fraud for its sales practices related to Principal Protected Notes issued by Lehman Brothers. His case is especially notable because unlike the SEC, he isn’t afraid to use the word “fraud” to describe “misleading investors.”

I could write for hours about all of the significant cases filed by state regulators, but there is a common theme: state securities regulators help investors recover losses from fraudulent schemes and seek to deter it from happening again within their borders.

Unfortunately the same cannot be said of the SEC.

SEC Settlements Lack Personal Accountability

When a corporation commits fraud, should the S.E.C. just go after the corporation, or should corporate executives also be held personally accountable? That is a question the SEC is apparently struggling with.

After the SEC announced its $75 million settlement with Citigroup for failing to disclose $40 billion worth of toxic subprime mortgage investments to shareholders, SEC enforcement director Robert Khuzami touted that his settlement “sends a message within the company,” and “it sends a message to the industry.”

I disagree that company fines alone deter wrongdoing. I believe the SEC needs to hold high-ranking individuals liable.

Just a few days before the Citigroup settlement was announced, the SEC announced it had reached a $100 million settlement with Dell for overstating its earnings. Michael Dell and Kevin Rollins, the current and former CEO, were each fined $4 million, and James Schneider, Dell’s CFO, was fined $3 million. In announcing the settlement, Mr. Khuzami’s stated that, “Accuracy and completeness are the touchstones of public company disclosure under the federal securities laws. Michael Dell and other senior Dell executives fell short of that standard repeatedly over many years, and today they are held accountable.”

Though Mr. Dell and his cronies probably got off easy, at least they were asked to pony up more than a few thousand bucks. The only Citigroup executives that were fined were the CFO and the IR executive, who paid a paltry $180,000 collectively.

A great example of how personal liability can send shockwaves throughout an industry is the WorldCom class action case, which was led by former plaintiff’s attorney and current candidate for New York Attorney General Sean Coffey. He recovered $6 billion for shareholders and forced WorldCom’s directors and officers to contribute $24.75 million, which was 20 percent of their net worths.

Commenting about Mr. Coffey’s settlement, the CEO of Glass Lewis said, “This may be one of the most important steps toward reinforcing the importance of performing the directorship duties with fidelity toward shareholders. It’s going to be very sobering to board members around the country.”

Corporate executives, especially on Wall Street, could use a similarly sobering moment after operating with impunity for years.

Making a Mockery of Financial Reform

According to a recent New York Times report, the very same people that allowed investors to be exploited over the past decade at the SEC are being rehired by Wall Street to carve out loopholes in the Dodd-Frank financial industry reform bill. It’s what’s known as the “revolving door.”

Their objective is to water down the approximately 243 financial rules and 150 “studies” the bill calls for. Of course, this comes after the devastating influence Wall Street lobbyists have had on shaping the bill from its inception. It’s a one-two, knockout punch for investors.

A “fiduciary duty” standard for brokers probably doesn’t stand a chance even though its the one Dodd-Frank provision that affects nearly every investor. Dodd-Frank calls for the SEC to “study” what effect a broad application of the fiduciary standard for brokers would have. You can bet Wall Street lobbyists will work their former colleagues behind the scenes so that the new standard will only be applied in special circumstances, making it effectively meaningless.

The battle between financial regulators and Wall Street over Dodd-Frank will be a David versus Goliath story. Unfortunately, because of the revolving door, Goliath is getting bigger every day.

Ethical Showdown: Goldman vs. Bear

Goldman Sachs has long reigned supreme on Wall Street because of the widespread perception and belief that they employed the smartest guys in the business.  But the SEC’s fraud charges against the firm have exposed another possible reason for the firm’s stratospheric success: The firm is more ethically challenged than some of its rivals.

We will let the courts decide the legal merits of the fraud charges the SEC filed against Goldman last week, but let’s consider the moral propriety of the firm selling its clients mortgage securities that hedge fund powerhouse John Paulson had determined were most likely to fail.  Goldman steadfastly maintains that it had no legal obligation to disclose that Paulson was the designer of the CDOs, but at least one competitor reportedly couldn’t stomach concocting such an arrangement.

In his book, “The Greatest Trade Ever,” Wall Street Journal reporter Greg Zuckerman discloses that Paulson first approached Bear Stearns trader Scott Eichel to structure  a package of highly toxic securities with a high likelihood of failure, but Eichel and his colleagues apparently wouldn’t do the deal.  According to Zuckerman:

Mr. Eichel said he felt it would look improper for his firm. “On the one hand, we’d be selling the deals to investors, without telling them that a bearish hedge fund was the impetus for the transaction, Mr. Eichel told a colleague; on the other hand, Bear Stearns would be helping Mr. Paulson wager against the deals.”

Zuckerman says that Deutsche Bank and other unnamed banks also worked with Paulson to structure CDOs that he could short, which, if true, raises the question as to why the SEC has singled out only Goldman for fraud.  Bears Stearns was hardly the paragon of ethical propriety (it marketed hedge funds filled with dubious subprime mortgage securities to unsuspecting retail investors), but its impressive that they chose to turn down a lucrative fee arrangement rather than engage in a transaction they perceived as morally wrong. Goldman and Deutsche Bank apparently had no such ethical compunctions.

Ironically, Eichel now reportedly works for Royal Bank of Scotland, which acquired a business unit of ABN AMRO that was on the losing side of the Paulson designed instruments.  Goldman maintains that it also lost $90 million on the deal, but I’m skeptical about the validity of the claim; the firm has long bragged about its risk management and its ability to hedge its trades. So while perhaps Goldman did indeed lose $90 million on one side of the transaction, it’s more than likely that they made it up on another.

Cleaning up Wall Street Corruption

One of the givens of Las Vegas is that the odds are always stacked in favor of the house.  But to the credit of Nevada’s gaming commission, aggressive measures are taken to ensure that only individuals with squeaky clean records are allowed to operate casinos.  Just associating with someone of questionable repute can lead to a revocation of a casino license.

The arrest yesterday morning of 14 more individuals accused of insider trading serves as yet another reminder as to why Wall Street must be regulated with the same aggressiveness and diligence as state-licensed casinos.  With more than three decades of experience representing individual investors who were deceived or cheated by Wall Street firms I can say with considerable authority that unmitigated greed and dishonesty is rampant in the securities industry.   While Federal prosecutors are to be commended for collaring nearly 24 alleged cheaters connected with Galleon Group for trading on inside information, they simply don’t have the resources to root out the legions of crooks that permeate the stock marts.

The latest arrests include yet another well known hedge fund and an attorney from a prestigious law firm and underscore how insider trading activity typically involves a tangled web of conspirators who often work at well known and seemingly respectable organizations.  What is especially alarming is that Galleon founder Raj Rajaratnam and some of his accused cohorts have allegedly been involved in other questionable and possibly illegal activities but nonetheless were allowed to continue to operate unfettered.   Rajaratnam’s earlier problems with the SEC and the IRS quite possibly could have prevented him from getting a Nevada gaming license, but it didn’t stop him from taking in institutional assets and being one of Wall Street’s most active players.

Contrary to what some economists and academics theoretically argue, insider trading amounts to criminal theft and it is not a victimless crime.  For every buyer of a stock there has to be a seller, and if someone has material inside information about a company, he or she has a decided advantage determining an appropriate price for the security.  Insider trading is somewhat akin to card counting - a practice that will get you permanently barred from Las Vegas casinos.  It cannot be allowed or tolerated in the securities industry.

What is needed on Wall Street is a suitability rule to determine who is qualified to work in the securities business.  Demonstrating character should be a major criterion and repeated SEC and other regulatory violations should be grounds for a permanent ban.  I appreciate that a character standard would forever bar countless Wall Street executives, but we need to dramatically raise the securities industry’s admission bar to facilitate meaningful change and ensure a level investor playing field.

The regulation of state casinos is admirably above politics, as state elected officials understand and appreciate that if character standards aren’t required and enforced, organized crime will ultimately gain control of the gaming industry.  It’s high time that both parties in Congress come to realize that Wall Street is rife with corruption and a task force should be created to figure out how best to clean it up. The SEC clearly isn’t up to the task.

President Obama promised us “Change We Can Believe In,” and the Democrats control Congress.  Ironically, Senate Majority Leader Harry Reid is a former chairman of the Nevada Gaming Commission whose unwillingness to be compromised by a gangster was featured in the Martin Scorsese film Casino.  Mr. Reid has since been accused of some personal ethical lapses, but he could easily redeem himself if he used his gaming regulation expertise and spearheaded a movement to take on Wall Street’s powerful lobby and create a no-nonsense regulatory agency akin to the Nevada Gaming Commission.

Now that would be real change we could believe in.

SEC Enforcement: The More Things Change…

In my last post I was downright jubilant that Wall Street endorsed the fiduciary standard for brokers. And don’t get me wrong, this is a major development. But, as they say, one step forward…two steps back.  To wit, I read with great dismay two recent cases where the SEC enforcement division levied fines equivalent to a love tap for what appears to be serious wrongdoing.

In what I’m sure was a delight to Morgan Stanley’s PR office, the first case was buried in the Wall Street Journal in a five paragraph blurb on page C4. So allow me to give you some background.

Morgan Stanley was recently censured a paltry $500,000 by the SEC for allegations that one of its former financial advisors misled his clients and failed to disclose conflicts of interests. According to the SEC, William Keith Phillips, who was based in a Nashville, Tennessee branch of Morgan Stanley, breached his fiduciary duty when he allegedly recommended “unapproved” money managers to clients.  Under the terms of a proprietary program, Morgan Stanley would provide custody, execution, performance reporting, and, importantly, due diligence on money managers for their clients.

The SEC alleged that Mr. Phillips had a financial incentive to recommend these three money managers, after developing a relationship with them and negotiating $3.3 million in commissions.  Moreover, two of the unapproved money managers convinced some clients to open advisory accounts with the Morgan Stanley Nashville branch, generating an additional $200,000 in fees and commissions, a portion of which was paid to Morgan Stanley.

Investors harmed by this will no doubt file arbitration cases.  And while I’m sure Morgan Stanley wasn’t happy to sign a check to the United States Treasury for $500,000, I’m pretty sure they did the math a realized they were still ahead.

The second case involved Perry Corp., a $6.6 billion hedge fund managed by Richard Perry.  According to the SEC, Perry Corp. withheld a critical regulatory filing which serves to give the market notice when an investor has amassed more than a 5 percent stake in a public company.  The goal of the rule is to ensure investors understand if there is another investor that could influence company decision making.  In this instance, it is alleged Mr. Perry bought a 10 percent stake in Mylan Inc. in order to throw his weight behind a potential merger in which he stood to profit.

Representing Mr. Perry was William McLucas, who ran the SEC’s enforcement division for eight years before leaving the agency in 1998. When I say the there is a “revolving door” phenomenon between the SEC and Wall Street, this is precisely what I mean.  Mr. McLucas negotiated a measly $150,000 fine with his old employer.

Not surprisingly, Mr. Perry called the settlement a “satisfactory conclusion.” What is “satisfactory” to Mr. Perry most assuredly isn’t for other shareholders in Mylan Inc.  Nor will it likely deter anyone else from playing the same game.

On the other side, David Rosenfeld, associate director of the SEC’s New York regional office, who oversaw the case, said he “[hopes this] will deter others from engaging in this type of conduct.” I wish I could be so hopeful but I’m afraid the fines are a far cry from a deterrent.

What happened to “getting tough” on Wall Street?