White Collar Time

I’ve been enjoying the show Billions, which is about the U.S. Attorney for the Southern District of New York (Paul Giamatti) investigating a hedge fund titan (Damian Lewis) for insider trading. It’s loosely based on Preet Bharara’s efforts to nail Steven A. Cohen of SAC Capital on similar charges. Bharara was featured on the cover of Time magazine with the headline “This Man is Busting Wall St.” As it turned out, the government did manage to convict two lower-level employees on insider trading, but could only settle with Cohen on a minor charge of “failure to supervise” those employees. SAC Capital ended up paying $1.8 billion in fines and has renamed itself.

Jesse Eisinger’s new book about white collar prosecution argues that the SAC case is about as good as it gets for the government. The title is quite direct: The Chickenshit Club: Why the Justice Department Fails to Prosecute Executives. Preet Bharara didn’t bust Wall Street after the financial crisis; no one did. Bharara did convict several hedge funds executives for insider trading, but Eisinger argues that these cases are easier and less important than cases for alleged securities fraud which were central to the financial crisis.

Here’s a good example of what he means by securities fraud. Perhaps the biggest winner in the financial crisis was John Paulson, whose hedge fund (Paulson & Co.) made over $4 billion betting against the housing market. A quarter of that profit came from a financial instrument called Abacus. Abacus was a collection of subprime home loans packaged into bonds. Paulson selected the bonds–the worst ones he could find–with an express interest in betting against them.

But how to get someone else to take the other side of the bet? So Paulson hires Goldman Sachs to pitch the deal to some other investor. Goldman finds a German bank, IKB, which is interested in buying the mortgages on the condition that some third party helps pick them out. Enter ACA, a bond insurer, to do just that. But ACA doesn’t know that Paulson has already picked out the mortgages, or that Paulson is going short on the deal. Goldman doesn’t tell them. So ACA happily outsources much of the work to Paulson, rubber-stamping its careful choices. The SEC would conclude that Goldman misled ACA about the nature of the deal and Paulson’s role. ACA and IKB  took major losses.

James Kidney, the lead lawyer working the case for the SEC, thought the government should charge Goldman and Paulson with “scheme liability:” essentially, conspiring to build a product they knew would fail and selling it to unwitting investors. Kidney was rebuffed by his supervisors. The reasons, in this particular case, are a pretty good microcosm for the broader forces hampering white-collar criminal prosecution throughout the book.There was institutional and personal timidity: Kidney’s bosses feared they might lose. There was a vicious cycle, where failure to prosecute top executives in previous cases had eroded the subtle investigative skill of flipping lower-level employees against their bosses (watch Paul Giamatti’s character to see how it’s done). The courts had impeded white-collar prosecutions after backlash from the defense bar; in this case, the Supreme Court had neutered scheme liability law with a 2008 ruling (Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc.) that “private investors could not sue a secondary participant in a fraud scheme, unless that participant had made misleading statements directly to the plaintiff.”

But such rulings don’t happen in a vacuum; it didn’t help that the Bush-era Justice Department and SEC had written briefs in Stoneridge against allowing private investors to hold such fraud participants liable. The government was actively trashing the tools used to hold executives accountable.

At least in the case of scheme liability, the government itself was still allowed to bring charges. The same cannot be said for the “honest service” charge, another arrow removed from the prosecutorial quiver in the last few years. Until recently, the government could charge executives who secure personal benefits at their company’s expense with depriving their shareholders of “honest services.” Critics say this charge was used as an overly broad catch-all for any conflict of interest or self-dealing. It was one of the charges used against Enron executives Kenneth Lay and Jeffrey Skilling. In Skilling v. United States (2010)–which was decided 9-0, please note–the Supreme Court narrowed the reach of the charge only to “bribery and kickback schemes,” removing self-dealing from its ambit.

Within a week of the Skilling verdict, courts across the country dismissed charges and vacated convictions of businessmen and politicians accused of fraud. But the really striking thing about the honest services charge is the selective effort the government made to reinstate it. A few months after the ruling, Lanny Breuer, the chief of the criminal division for Obama’s Department of Justice, testified in Congress to advocate for a statutory fix to the honest services clause. But he only asked Congress to strengthen the law for public corruption cases, content to let the private sector equivalent wither and die.

Breuer is one of the main targets of Eisinger’s criticism. Some of the criticism is personal to Breuer: that he meddled in active cases (U.S. Attorneys usually have significant autonomy from Washington) and that he cared too much about how the Department’s cases made him look. E.g.: “Gary Grindler, Breuer’s first deputy, would emphasize to prosecutors that losing cases would reflect poorly on the front office. Grindler told Pelletier [a hard-charging prosecutor] one day, “You know, if you lose this case, Lanny will have egg on his face.” “I don’t give a shit about that!” Pelletier yelled. The sentiment jolted him. He was apoplectic. “Nobody had ever said anything like that to me in more than twenty-five years of prosecuting federal cases.””

But the more systemic charge is that Breuer, like many government lawyers, was a product of the revolving door culture between white-collar defense firms and the DOJ, and was thus unduly sympathetic to corporate executives and their lawyers. Eisinger depicts a bizarre scene where, as the government was deciding whether to indict HSBC for money laundering, Breuer pulled aside HSBC’s lawyer at a meeting and asked him when he thought it was appropriate for the government to indict a major bank. When people talk about “regulatory capture” they rarely have something so literal in mind.

Breuer has spent his whole career alternating between jobs in Democratic administrations and stints at Covington & Burling, as is the norm for elite lawyers with an interest in public service, increasing their cash-out value, or both. I’ve long been skeptical of this arrangement, and The Chickenshit Club is a helpful book for illustrating exactly how it breeds a culture of gentlemanly compromise between regulators and corporate America. The government seeks to settle most cases even before interviewing key witnesses or putting in the work necessary to charge individuals.

The book includes plenty of billion dollar fines, which the government sells to the public as mission accomplished. But, as far as Eisinger can tell, these fines serve neither justice nor deterrence. Big fines hit shareholders, not the culpable individuals. Companies see such fines as the cost of doing business. In the Goldman / Paulson case I described, the only individual found liable was Fabrice Tourre, a 20-something Goldman trader from the London office. He was the only person foolish enough to write about deceiving the German bank over email, but surely not the only person at Goldman to know about the scheme. Across the board, only one executive–Kareem Serageldin of Credit Suisse–went to jail in the wake of the crisis.

The counterargument from revolving door beneficiaries is that their experience on the defense side helps them understand the intricacies of corporate operations and thus become better public officials. It’s a rather one-sided definition of better. You don’t see these same people spending a stint as public defenders to learn the intricacies of criminal law. Or working in housing court, or in bankruptcy court, to better understand the consequences of financial fraud on the public. We’re all products of our experience, and it’s no surprise that people who spend half their careers defending the rich and powerful carry that mindset into public service.

In any case, the argument is shaky in its own right. Two of the heroes of Eisinger’s narrative, Stanley Sporkin at the SEC and Paul Pelletier at DOJ, spent most of their careers in unbroken government work, becoming more and more expert in the ways of corporate fraud and how to uncover it. Pelletier only moved to the private sector, reluctantly, when he lost an internal battle with Breuer over whether to prosecute executives at AIG Financial Products.

Eisinger’s reporting on financial crimes and prosecutorial inaction is top-notch–he won a Pulitzer for it in 2011–and The Chickenshit Club is great fun if you like picking apart securities fraud. It’s also the most useful thing I’ve read for understanding the culture and process of U.S. Attorney’s offices, especially the Southern District. In Eisinger’s depiction (and in every other one), Southern District prosecutors are extremely proud of themselves and the work they do. When it’s working–when they’re actually holding Wall Street accountable–I have trouble blaming them. It’s not that they’re so great (I really don’t know how great they are), it’s that we have almost no other mechanisms for doing what they do. Especially after the Stoneridge case which limited the private right to sue for securities fraud, we’re pretty much dependent on public prosecutors to do it.

Financial fraud is really complicated! Like, many times harder to prove than murder. And investigators will always have the deck stacked against them when the people perpetrating the fraud employ ten times as many lawyers making ten times the money each (these numbers seem in the ballpark, based on the book).It would be great to pay government investigators more, but it might be more realistic to pay corporate lawyers less. That could happen for two reasons, I think: decreased efficacy of white-collar legal assistance and lobbying, or lower corporate profits. I’m increasingly of the opinion that the courtroom and the statehouse are the key terrain where corporate America makes its money, so these avenues are mutually reinforcing. An alternative strategy would be to change the culture within the legal profession to make it shameful to build a career defending securities fraud. I’m looking forward to making friends in law school.

1. Cool paper by Nathan Wilmers finds industries that rely heavily on high-income consumers have greater wage inequality due to vertical differentiation. “Our intuitions about the effect of wage inequality on consumer welfare rely on an increasingly outdated picture of a mass consumption economy.”
Here’s a good figure: 
2. In discussions of globalization and neoliberalism, people like me often frame the problem as a loss of democratic control over the economy. So I was intrigued and challenged by this essay from Jacob Levy arguing that there never was such control. In challenging the notion of economic sovereignty, Levy’s main point is that
“The modern state is a creation of the bond market, and so is the modern democratic state. Medieval mercantile cities had long been able to borrow money at better interest rates than other political units. In early modernity, states that were relatively representative and relatively commercial learned that they could do the same. First Holland, then England, gained crucial advantages in international competition from their ability to borrow cheaply.” 

It’s a good point whose historical dimensions I’d like to study further. If you can suggest any reading on the relationship between international banking and state capacity in the age between Medici and Rothschild, I’m all ears. For now I’ll just observe that even when a state has debt, there are degrees of freedom within the tax and public finance systems as to how that debt will be paid, and ultimately by whom.

3. If you haven’t seen anything about the controversy over Democracy in Chains, a new book on the intellectual history of public choice economics, the Koch brothers, and conservative ideology, you should probably skip this and go on living your life. If you have been following, I recommend this essay as the closest approximation to where I’ve landed. And once you’ve lost (Nixon scholar) Rick Perlstein, you’ve lost me.

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