As Deadlines Loom for Financial Crisis Cases, Prosecutors Weigh Their Options

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For more than four years, authorities have struggled to successfully prosecute a Wall Street bank or its executives for alleged misconduct during the financial crisis. Now, time may be running out.

Under federal securities law, the statute of limitations in fraud cases normally lasts five years. Given that the bulk of the mortgage-related securities that precipitated the crisis were created in 2006 and 2007, the window of opportunity for authorities to bring new charges is rapidly closing.

“So much sand has fallen out of the hour glass, now there’s not much left,” said James Cox, a professor of corporate and securities law at Duke University. “I think the government has had plenty of chances to bring high-profile cases and haven’t.”

As of Jan. 9, the Securities and Exchange Commission had charged 153 entities or individuals in crisis-related cases, and won $2.68 billion in penalties. The largest penalty was a $550 million agreement with Goldman Sachs to settle claims it misled investors over a mortgage-related security called Abacus 2007-AC1. In its complaint, the SEC charged that Goldman never revealed that the hedge fund manager who created Abacus, John Paulson, was betting against the same mortgage bonds that made up the security. Though Goldman did not admit to the SEC’s allegations, it acknowledged that marketing material for Abacus “contained incomplete information.” 

But government watchdogs are quick to remind that enforcement has focused mainly on civil penalties, rather than criminal charges against executives from any Wall Street firm. The government’s first criminal case, a nine-count indictment against two former Bear Stearns executives for securities, mail and wire fraud, ended in November 2009 with a not guilty verdict on all counts.

The verdict was the first of several high-profile setbacks for the Justice Department. In 2010, investigators dropped a two-year probe of American International Group executives centered on the credit default swaps that nearly bankrupted the insurer and forced a $182 billion bailout. Nine months later, prosecutors ended a criminal investigation of Angelo Mozilo, the former chief executive of the mortgage lender Countrywide Financial without bringing charges. In e-mails cited in a separate SEC investigation, Mozilo described Countrywide’s mortgage products as “toxic” and “poison.” He would later settle that case for $67.5 million, but did not admit nor deny the allegations against him.

With the clock winding down to bring new cases, the government has begun the search for a way around the usual time limit for fraud charges.

Earlier this month, the SEC argued before the Supreme Court that the five-year clock should not begin when the alleged fraud took place. Instead, the government said, the clock should begin when investigators are reasonably able to detect a crime. A victory could make it easier for investigators to pursue litigation stemming from the crisis, although the justices appeared skeptical in oral arguments. The court’s decision in the case, Gabelli et al v. SEC, is expected by June.

In the meantime, regulators may have other options. In October, a federal mortgage task force established by the Obama administration brought a suit against JPMorgan Chase under the Martin Act. The act, once described as “the legal equivalent of King Arthur’s Excalibur”, allows the government to pursue criminal or civil charges. More importantly, it sets a lower burden of proof by not requiring prosecutors to demonstrate that a defendant intended to commit fraud or that fraud actually took place.

“In other words, you have to be less guilty,” said Jonathan Macey, a professor of corporate law, corporate finance, and securities law at Yale University.

In 2003, New York attorney general used the Martin Act to secure a $1.4 billion settlement from 10 banks over allegations that their analysts inflated ratings.

A second option is to enter a “tolling agreement.” Under such a scenario, the individual or company grants the government a waiver to the statute of limitations to keep it from rushing an indictment. In return, the agreement offers the individual or firm the opportunity to explain why they should not face charges.

The government “would say, ‘we’d like you to agree, and if you won’t … then we’ll just indict you and sort out the rest of the case later. Whereas if you give us more time, that will give you a chance to argue that we shouldn’t charge you,'” explained Peter Henning, a professor of law at Wayne State University.

Attorneys at both the Department of Justice and the Commodity Futures Trading Commission are said to have reached such deals in their investigations into alleged rigging of the London Interbank Offered Rate, or LIBOR, according to reports from Bloomberg and Reuters.

Prosecutors have also begun testing a statute passed in the wake of the savings and loan crisis known as the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA).

The upside of FIRREA, explained Jay Williams, a partner with Schiff Hardin LLP, is that it offers the government a path to bring civil actions against misconduct typically addressed through criminal charges. In doing so, it extends the statute of limitations to 10 years while lowering the burden of proof needed to win a case. Whereas guilt must be established beyond a reasonable doubt in criminal cases, in FIRREA suits, violations must only be proven by a preponderance of the evidence. In other words, a jury must only determine that a violation is more likely than not.

The use of FIRREA in mortgage-related cases is somewhat uncharted territory. The law was first passed to prosecute individuals who defrauded federally insured deposit institutions, but as Williams noted, the government has been encouraged by early victories in its broadening interpretation of the statute. Last February, for example, a Citibank subsidiary agreed to $158 million settlement with the Department of Justice in a FIRREA case. The bank’s Citimortgage unit was accused of submitting faulty loans to a federal-mortgage insurance program.

“That is certainly something that is likely to embolden the prosecutorial use of this statute,” Williams said.

Of course, for critics of the government’s legal response to the financial crisis, FIRREA also carries a significant downside:

“They don’t get to throw people in jail,” said Williams.

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