Too Big to Pay for Their Breaches?

If the government won't hold "senior executives and companies responsible for igniting the subprime meltdown" responsible for criminal wrongdoing, then private lawsuits must be used to try to fill the void:

Too Big to Fail or Too Big to Change, by Chad Johnson, Harvard Law Forum on Corporate Governance and Financial Regulation: Two and half years removed from the worst financial crisis since the Great Depression, the investing public has grown increasingly frustrated with the lack of criminal prosecutions of, and absence of truly significant fines levied against, the senior executives and companies responsible for igniting the subprime meltdown ... despite significant evidence of intentional misconduct.

For decades, the public’s trust in the integrity of U.S. capital markets was a source of economic stability and unparalleled prosperity. To maintain this trust, investors must believe that they compete on a relatively equal playing field and that the laws governing the markets will be strictly enforced. In furtherance of these goals, violators of federal rules face civil penalties from the SEC or criminal prosecution by the DOJ. ...

Now, more than ever, private lawsuits are needed to supplement the existing regulatory structure, both to ensure that shareholders are adequately compensated for their losses and to send a strong message that fraudulent conduct will not be tolerated. Indeed, institutional investors continue to vigorously prosecute suits against the companies and executives at the heart of the mortgage crisis, well after the SEC and DOJ have shuttered their civil and criminal investigations. ...

Wrongdoers Have Largely Escaped Government Penalties

While the SEC has reached several settlements in connection with misconduct related to the financial meltdown, those settlements have been characterized as “cheap,” “hollow,” “bloodless,” and merely “cosmetic,” as noted by Columbia University law professor John C. Coffee in a recent article. Moreover, one of the SEC’s own Commissioners, Luis Aguilar, has recently admitted that the SEC’s penalty guidelines are “seriously flawed” and have “adversely impact[ed]” civil enforcement actions. ...

The DOJ has faced similar criticism for its lack of prosecutions. ...

The ... recent report from the Financial Crisis Inquiry Commission (“FCIC”) makes clear that the mortgage meltdown was an avoidable event born of fraud, as well as of failures in corporate governance and risk management. Significantly, the FCIC explicitly concluded that banks selling mortgage products failed to disclose critical information to investors. ...

Nevertheless, in response to this accumulating evidence, the SEC and the DOJ have remained largely silent. Are large, systemically important institutions and their ilk too big to be threatened with sanctions that approximate the size of the frauds perpetrated against the public? Has “too big to fail” transformed into “too big to challenge?”...

Simply put, without forcing executives to answer for their misconduct, no amount of financial reform will restore public trust in government or the markets.

Regulatory Impediments

While many accuse the SEC and DOJ of being “gun shy” with regard to cases against high profile executives, several commentators note that the SEC and DOJ are significantly underfunded. The funding problem is especially acute at the SEC...

Beyond underfunding, many observers point to the free flow of SEC and DOJ officials between the government and private sector as contributing to lackluster regulatory enforcement. This “revolving door” of personnel fosters “regulatory capture,” which aggravates the conflicts of interest that materialize between regulators and the regulated. ...

Further, to the bewilderment of numerous observers,... the SEC’s general policy going forward to act as “middle man” between the DOJ and Wall Street financiers and to provide potential defendants with information as to whether the DOJ plans to pursue litigation arising from their alleged misconduct—a procedure that critics have described as conflicting with the SEC’s own enforcement manual. Recognizing the inherent conflicts in this practice, Senator Charles Grassley ...  explained that “[a]ll the promises of financial regulatory reform ring hollow if the administration is allowing the top enforcement official at the SEC to relay to potential targets of an investigation exactly what the Justice Department has in store for them.” ...

How Institutional Investors are Filling the Void

It has increasingly fallen to institutional investors to hold mortgage lenders, investment banks and other large financial institutions accountable for their role in the mortgage crisis... For example, sophisticated public pension funds are currently prosecuting actions involving billions of dollars of losses against Bank of America, Goldman Sachs, JPMorgan Chase, Lehman Brothers, Bear Stearns, Wachovia, Merrill Lynch, Washington Mutual, Countrywide, Morgan Stanley and Citigroup, among many others. In some instances, litigations have already resulted in significant recoveries for defrauded investors.

Historically, institutional investors have achieved impressive results on behalf of shareholders when compared to government- led suits. Indeed, since 1995, SEC settlements comprise only 5 percent of the monetary recoveries arising from securities frauds, with the remaining 95 percent obtained through private litigation as demonstrated by several examples in the chart at right.

Institutional investors must continue to lead the charge and prosecute fraud to send a strong message that such misconduct will not be tolerated and to guarantee that shareholders are fairly compensated for their losses. ... While originally intended as a supplement to government regulation, recent events demonstrate that institutional investors may now be the entities best positioned to protect investors’ rights. Without such protection, and if Wall Street bankers are permitted to profit from their frauds without a proportionate retributive response, we may be fated to repeat the same economic calamity that has defined our generation.

[The full post has many more details.]