Real Clear Markets

Getting Wall Street Accountability Right

When it comes to the financial crisis of 2008, there's certainly no shortage of blame. But who should be legally liable for any wrongdoing that occurred? In my view, enforcement actions should be brought for two primary purposes: to increase accountability and deter future wrongdoing. In most cases, that means focusing attention on the individuals who committed the alleged bad acts, not the corporate entities. Unfortunately, the SEC and other agencies have often brought actions against the corporate entities instead. Here are two particularly egregious examples.

Bank of America and Merrill Lynch

The SEC brought an enforcement action against Bank of America in connection with its acquisition of Merrill Lynch in the fall of 2008. The suit alleged that Bank of America failed to disclose in the merger proxy statement that Merrill was planning to pay $5.8 billion in year-end bonuses to top employees. As a result of this omission, Bank of America shareholders were allegedly defrauded: they might not have approved the acquisition had this information been revealed.

In August of 2009, Bank of America agreed to settle this case with the SEC by paying a $33 million fine. Because corporations are ultimately owned by their shareholders, this fine would have effectively been paid for by the victims of the alleged fraud-the shareholders of Bank of America. The settlement did not involve any enforcement actions against any of the Bank's executives responsible for the material omission in the merger proxy.

With these concerns in mind, Judge Jed Rakoff (a U.S. District Judge in New York) took the extraordinary action of rejecting this proposed settlement. He wrote that, by assigning liability to Bank of America's shareholders, the settlement did not "comport with the most elementary notions of justice and morality."

The SEC argued that such fines would deter future fraud by encouraging shareholders to more actively monitor management's activities. However, Judge Rakoff didn't buy this argument, and neither did John Coffee, a professor at Columbia Law School. In a paper on shareholder litigation, Coffee wrote:

"[E]nterprise liability in this context is akin to punishing the victims of burglary for their failure to take greater precautions. Although this strategy might produce some enhanced monitoring, it offends social norms, including the public's basic sense of fairness, to punish the victim for conduct that it did not cause."

In 2010, Judge Rakoff reluctantly approved a larger, restructured settlement, which was somewhat more effective at repaying the "legacy" Bank of America shareholders that were originally defrauded.

JPMorgan and Bear Stearns

In October, the State of New York filed suit against JPMorgan, alleging serious wrongdoing on the part of Bear Stearns (which JPMorgan acquired in the spring of 2008). The suit alleges that Bear Stearns caused harm to third parties by misrepresenting the quality of mortgages underlying securities that the firm sold to them.

If JPMorgan had purchased Bear Stearns under "normal" circumstances, JPMorgan's shareholders would have been a reasonable target of the lawsuit. Typically, if one corporation (call it A Corp.) buys another (call it T Corp.), A assumes all of T's former liabilities-its bonds, pension obligations, and, yes, its legal liabilities.

The transfer of legal liability relies on the logic that A could have performed due diligence prior to acquiring T, and reduced its offer price to account for any potential legal liability. Thus, the expected cost of future lawsuits flows through to T's shareholders, as it should in the normal case.

But JPMorgan's acquisition of Bear Stearns was different. JPMorgan purchased Bear Stearns at the behest of top federal officials-who needed JPMorgan to quickly announce a deal in order to quell a potential financial panic. Furthermore, the offer price was effectively set by these federal officials. There was no opportunity for JPMorgan to learn about Bear Stearns' legal liability, nor to adjust its offer price accordingly. Indeed, JP Morgan initially walked away from the acquisition because it did not have enough time for due diligence.

Thus, punishing JPMorgan's shareholders does nothing to align incentives-it merely punishes shareholders for acts in which they are blameless. Even worse, this fine discourages companies from engaging in "white knight" acquisitions at the request of federal regulators. In the future, company executives will demand broad guarantees against losses from the government before taking over any troubled institutions.

Target the individuals instead

Government officials should think twice before bringing securities cases against only a corporate entity. That typically punishes shareholders-who are likely to be innocent bystanders, or even victims themselves. Instead, officials should sue the individuals responsible for the alleged bad act

Targeting individuals can certainly be a challenge: criminal prosecutions must meet strict standards. In civil suits, individual damages or fines as part of settlements are usually covered by an executive's insurance policies or the company's indemnification provisions.

However, if officials can assign blame through a civil court judgment (or voluntary admission of culpability), they can generally force executives to pay out of their own pocket. Even if officials decide to settle these cases-allowing the individual to "neither admit nor deny" wrongdoing-they can insist that executives waive their insurance and indemnification rights from the relevant corporate entity. This approach would more effectively deter corporate officials from engaging in socially damaging behavior, while reducing the adverse impact on innocent shareholders.