Third in a series on "too big to jail"

WASHINGTON — The failure to prosecute bankers as a result of the financial crisis has sparked an ongoing debate about whether enforcement officials lacked the will to move forward with any cases—or didn't have enough proof that any crimes had been committed.

Far from fading into the background, the issue remains in the forefront as policymakers debate how to address "too big to jail." A lack of will could be addressed by more forceful leadership, but a lack of proof might call for changes to the way financial crimes are prosecuted.

On the one side are Wall Street critics who argue that if the Justice Department acted more vigorously and dedicated more resources to investigating the banks and uncovering violations, the agency could have brought charges and won convictions.

"If they were serious — if they put two or three dozen of their best [Assistant U.S. Attorneys] and a couple hundred of their best FBI agents on this, you would have seen a bunch of handcuffs and a bunch of prison sentences," said Dennis Kelleher, president and chief executive officer of Better Markets, a public advocacy group. "Essentially you had a corporate defense bar mentality pervasive at the SEC and the DOJ, which was populated by corporate defense lawyers who found corporate defense lawyers' arguments being made to them … incredibly persuasive."

But banks and many industry representatives on the other side vigorously disagree with that assessment. Wayne Abernathy, vice president of regulatory affairs at the American Bankers Association, said that the reason no bankers were prosecuted for crimes related to the financial crisis is because DOJ couldn't make a case they felt they could win.

Criminal charges — financial or otherwise — must be proven beyond a reasonable doubt, and DOJ didn't charge because they couldn't meet that evidentiary burden, Abernathy said. Any assertion that federal prosecutors under Attorney General Eric Holder were pulling their punches is "not credible," he said.

"I don't get the sense that the Holder Justice Department was like that at all," Abernathy said. "If anything, I think the feeling was they were overly harsh."

Holder himself largely confirmed both accounts, first by telling the Senate Judiciary Committee in March 2013 that prosecutors were reluctant to move forward with criminal cases against banks because "it will have a negative impact on the national economy, perhaps even the world economy." Later Holder walked back those comments, insisting that "there's no bank, there's no institution, there's no individual that cannot be prosecuted" and that the Justice Department has brought "thousands of financially based cases over the last four years."

But even among former prosecutors and enforcement officials, there is a diversity of opinion.

David Slovick, counsel with Cahill Gordon & Reindell and former enforcement official with the Commodity Futures Trading Commission and the Securities and Exchange Commission, said that when an agency or federal prosecutor is deciding to bring a case, there are many factors besides the strength of the case that get taken into consideration. Agencies have limited enforcement resources, and when the firm you're investigating has the ability to fight a case in court more or less indefinitely, a case has to be extremely firm in order to warrant being brought to trial.

Public outrage doesn't come into that equation, Slovick said, because if you bring a case and you lose, or it gets overturned on appeal, you've wasted agency resources and achieved either the same result as if you had not brought the case or a lesser result than if you had settled. Strength of evidence is the key, he said.

"Pursuing a criminal prosecution requires a careful evaluation of the evidence, and the DOJ must prove its case beyond a reasonable doubt," Slovick said. "While there may be natural, visceral reaction to business decisions that result in losses, those decisions do not always equate to violations of law."

But other enforcement officials have a different view.

Gene Murphy, a former Illinois Assistant State's Attorney, said there is little doubt that the DOJ could have prosecuted the banks and their executives. The Attorney General has almost unlimited power to acquire business records from banks under investigation, Murphy said, and the recordkeeping requirements that banks are subject to as part of their charters are so legion that there is little reason to believe that a paper trail could not be found, especially given the size and breadth of the fallout. The only explanation for no prosecutions, Murphy said, is "someone not wanting to put a case together."

"Financial institutions don't collapse without bad behavior," Murphy said. "I'm not saying 'stealing money' bad behavior … but they were certainly making the business decisions, they were certainly making investments, they were certainly doing things that were beyond the parameters of what their business license allowed them to do."

Murphy added that DOJ may have had good reason to fear that simply issuing indictments or subpoenas could bring down a bank. In 2002 the successful prosecution of accounting firm Arthur Andersen for fraud related to its auditing of failed energy company Enron led it to give up its accounting licenses, effectively dissolving one of the largest U.S. accounting and consulting firms almost overnight.

"I think they were very — rightfully or wrongfully — very cautious about not bringing down the entire banking system because Arthur Andersen fell so quickly, so fast, so hard," Murphy said. "I think the federal government quite frankly pussyfooted around the whole issue. In essence, it might have been too big to fail not because the institutions themselves are too big to fail, but because of the unintended consequences and the domino effect — maybe that was the fear."

Another former prosecutor who spoke on condition of anonymity disagreed, and said that the assumption of wrongdoing related to the mortgage bubble and the related calamities in derivatives and insurance is based on a fundamental misunderstanding of finance and the prosecution of financial crime. The mortgage bubble was a wave of countless transactions, the prosecutor said, each of which may or may not be tainted by fraud.

The former prosecutor also noted that it's not the case that zero cases were ever brought by DOJ or regulators. For example, the SEC in 2010 brought charges against Goldman Sachs for fraud related to a mortgage-backed collateralized debt obligation called Abacus 2007-AC1. The bank later settled the charges for a record $550 million in penalties and restitution, but former Goldman trader Fabrice "Fabulous Fab" Tourre — who opted not to settle — was found liable for misleading investors and was ordered to pay more than $825,000 in fines and disgorgement of bonuses he earned related to the deal.

"There are data points out there that people who are critical of the DOJ can use: people lost a lot of money, no one was prosecuted, look at Iceland," the former prosecutor said. "But the idea of [there being] a case like 'U.S. vs. the financial crisis players' doesn't make sense to me. [DOJ] didn't investigate 'the crisis' — they investigate scenarios, individual stories."

But Camden Fine, president and CEO of the Independent Community Bankers of America, said that after the crisis, the individual scenarios that involve small community banks seemed to lead to criminal and civil enforcement actions against individuals while those that involved the largest and most systemically risky banks lead to nothing, or to a settlement and a fine paid by the bank.

Fine acknowledged that community bankers should be punished when they break the law, but said that because small banks are "prosecutorial low-hanging fruit," they face the consequences of misdeeds while the biggest banks "can violate laws and regulations with impunity."

"It enrages my members," Fine said. "This really hits a nerve among community bankers. [They have] cease-and-desist orders put out against them, they have their assets frozen, they're barred from banking, they're humiliated in their local communities, and nothing happens to directors and officers of megabanks" who may be committing far more serious crimes.

Financial bubbles are all different, but they follow a basic formula. An asset begins to perform well and is considered a safe and profitable investment. As the asset's value grows, more investors are convinced of its value and its ability to appreciate in value further. This incentivizes less scrupulous brokers to create new or exotic products to sell to investors eager to buy into the bull market — and that is when laws most often get broken. Eventually investors get over-leveraged, the market overheats, and the bubble pops.

Federal investigators generally uncover wrongdoing after the fact, and file charges based on what they can prove — be it securities fraud, wire fraud, market manipulation, insider trading or some other violation. Bad actors sometimes stand trial and serve jail time, or face other sanctions, like as being barred from the banking or finance industry. In the 1980s, scores of individuals went to jail or were barred from finance in relation to the savings and loan bubble, for example.

The former prosecutor said that the statutes for mail fraud, wire fraud and bank fraud are similar and fairly easy to apply in cases where one can prove intent. But since most written communications include disclaimers noting that funds can lose value, it makes it hard to show that intent even when the content of that communication may say otherwise.

"If on the one hand you have a communication saying that they personally think that this stuff doesn't have value, but they also have disclosures saying, 'This stuff may not have value,' it's pretty hard to bring a criminal case," the former prosecutor said. "What's a jury supposed to do with that?"

And not every bubble has a criminal element at its heart. No one went to jail in connection with the 1929 stock market crash, for example, because none of the activities that led to the crash were illegal. But in that case — as was also the case following the 1907 "Knickerbocker Crisis" and the savings and Loan crash — Congress passes new laws to make stop up any loopholes that may have led to or exacerbated the crash.

In that respect, the 2008 crisis is no exception. The Dodd-Frank Act drastically recast the U.S. financial regulatory and compliance apparatus. But it did little to amend the criminal statutes or modify the evidentiary standards that apply to financial crimes for individuals or institutions. (Even if they had, criminal codes cannot be applied retroactively).

Karen Shaw Petrou, managing partner of Federal Financial Analytics, said that there were attempts early on to go after bad actors related to the financial crisis. In 2008, DOJ tried former Bear Stearns executives Ralph Cioffi and Matthew Tannin on charges of fraud and insider trading, but a federal jury found both men not guilty in November 2009, largely because the email evidence that the prosecution relied on was too flimsy to demonstrate guilt beyond a reasonable doubt. That loss may have warned off other prosecutors who were looking to build a case, Petrou said.

"I think that chastened prosecution," Petrou said. "There are significant obstacles to the kind of prosecutions that … people would like to see. The U.S. bank regulators have much less flexibility to do that — but Congress could."

Congress did amend the evidentiary standard in one important respect after the crisis. Dodd-Frank amended the Commodities Exchange Act — the authorizing statute for the Commodity Futures Trading Commission — to substantially ease the standard of evidence for the CFTC to charge firms and individuals with market manipulation.

Prior to Dodd-Frank, the agency would have to demonstrate not only that a firm or individual had actually manipulated a commodity or related futures market, but also that they had intended to do so. But Dodd-Frank expanded that definition to make it more similar to the SEC's authorities in prosecuting inflated stock prices, making it illegal to even attempt to manipulate a covered market or to act recklessly in such a way that leads to market manipulation. The new law also expanded the definition of what qualifies as a "false or misleading" statement to investigators.

Since that standard has changed, the CFTC has brought scores of market manipulation and attempted manipulation cases against firms and individuals. In 2012, CFTC and the Justice Department charged several of the world's biggest banks with fraud based on their manipulation of the London Interbank Offered Rate, or Libor, a core interest rate that is referenced in innumerable financial transactions. Those charges led to several banks, including Barclays, UBS, the Royal Bank of Scotland and Deutsche Bank paying billions of dollars in penalties to settle the charges. Charges related to manipulation of similar interbank rates have also moved forward.

The CFTC and Justice Department last November agreed to settle charges against six banks — Citigroup, JPMorgan Chase, Bank of America, HSBC, RBS and UBS — for manipulating a critical foreign exchange benchmark. The government levied more than $4 billion in penalties against those banks, and additional settlements are expected.

JPMorgan Chase also agreed to settle an elaborate electricity market manipulation case brought by the Federal Energy Regulatory Commission, paying a total of $410 million in penalties and forfeiture in 2013. And in April, the CFTC brought market manipulation charges against Kraft Foods for attempting to corner the wheat and wheat futures markets and filed a suit against a UK resident for manipulating and spoofing an S&P 500 futures contract.

Slovick said that the uptick in enforcement actions and criminal cases by CFTC is a direct result of the changes in Dodd-Frank. The agency's willingness to bring those charges — even if they are ultimately settled — demonstrates that DOJ and other agencies don't pull punches against banks or anyone else when they have sufficient evidence, he said.

"Plea agreements and settlements allow the DOJ and regulators to efficiently resolve cases while minimizing the inevitable risks associated with a trial," Slovik said.

Holder himself recently defended his approach of pursuing fines over lengthy trials, telling the Financial Times in a July interview that he thought "the cultures have changed" at the largest banks after they agreed to "record-setting penalties" to settle cases of fraud and other violations. That approach is ultimately more productive than "trying to make examples of people," Holder told the newspaper.

Murphy, however, called those plea deals "toothless", saying that because the penalties are borne by the firms and not the individuals responsible, the deterrent effect is lost. While accepting a settlement makes sense from a risk management perspective, it forfeits the entire purpose of an enforcement action, he said.

"From an allocation of resource standpoint, it absolutely makes sense," Murphy said. "From a justification of talent standpoint, it absolutely makes sense. From an economic perspective, it absolutely makes sense. The only point of view [from which] it doesn't make sense is, you have not held the wrongdoers accountable, and you want to deter bad behavior in the future."

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Corrected August 24, 2015 at 9:24AM: An early version offered the wrong title for David Slovick.