There has been a consistent debate for the past thirty-two years concerning the issue of government regulation of business and finance and the effect it has on the national economy. In fact, this subject has been hotly contested since the days of Alexander Hamilton and Andrew Jackson and became the lightening rod issue during the 1932 presidential election and the centerpiece of Franklin Roosevelt’s “New Deal”.
As always, history is the great teacher. We pause to study the past as we assess the present and again debate the subject of government regulation of business and economic policy in the 2012 presidential election.
The Enron, World Com, Adelphia, Marsh and McClennan, AIG, Health South and other corporate investigations, administrative actions and prosecutions of the past decade created another swing in the regulatory and law enforcement pendulum, concerning the oversight, regulation and prosecution of business and financial conduct in the United States, and what would soon follow, the 2008 “sub-prime mortgage” crisis and near collapse of the global financial industry, which seemed to take everyone by surprise but the industry players who created the turmoil.
Once again, corruption in the marketplace and public outcries for government action led to the conclusion by many that self-regulation had failed and that federal prosecutors and regulators, should take dead aim at corporate and entrepreneurial America.
In mid-2006, the Senate Judiciary Committee began to consider legislation to stabilize business and entrepreneurial activity by striking a proper balance between criminal and civil enforcement practices. (N.Y. Times, National, Sunday October 29, 2006, “Businesses Are Seeking New Protection On Legal Fronts.”)
America has swung back and forth from the 1920’s laissez-faire approach to the redefinition of capitalism that was the “New Deal” to the growth of the national bureaucratic and regulatory framework of the 1960s and 1970s to the 1980s “Morning in America” Reagan era deregulation of business.
Franklin Roosevelt and the “New Deal”
Government regulation of business, as we have known it, began in earnest in 1932 with the onset of Franklin Roosevelt’s “New Deal”. F.D.R. had strong intellectual and ideological ties to the “trust busting” principles and policies of his cousin Teddy Roosevelt. T.R. ‘s steadfast efforts in regulating and controlling the corporate and business behavior of his day was indeed the foundation of “New Deal” regulatory philosophies and served as the paradigm for all government regulation to follow.
By 1929, it was starkly apparent that self-regulation had failed. Cloaked in the blanket of the free market system Wall Street had gone fully unregulated. Businessmen made fortunes by gaining full, unscrupulous advantage over a wide open, unaccountable financial system. Banks failed, mortgages defaulted in the thousands, threatening farms and homesteads alike. Jobs became scarce. Basic necessities of life were left wanting and bread winners were begging for jobs and food on the streets. Trust in the government was at an all-time low, and regard for the entrepreneur and businessman nonexistent. Families were broken and lives ruined. It became incumbent on the government to embark upon a course of action and establish core values in overseeing business conduct and ensuring proper business practices and behavior and a fair and equitable national economy.
The “Great Juggler”, as Franklin Roosevelt described himself, was elected to the American Presidency by a landslide in 1932. This was no cyclical aberration in the economy, as the incumbent Herbert Hoover had insisted. It was endemic international collapse of the capitalist system, which, unlike the financial crisis if 2008, had its underpinnings in the European arena. Franklin Roosevelt had two choices; preside over the collapse of American capitalism and the onset of socialism or modify capitalism in order that it could survive. Modify, he did, and the first hundred days of his administration would set the standard for accomplishments for new administrations for generations to come.
Roosevelt assembled a “brain trust” of legal, financial and political operatives largely from the east coast and academia. Faced with massive withdrawals of funds from banks and bank failures and an avalanche of mortgage foreclosures on homes and farms, he issued an executive order declaring a “bank holiday”, and another declaring a moratorium on bank foreclosures. These extraordinary steps were stop gap measures to give his administration the time it needed to propose the legislation to create the massive federal bureaucracy that would be required in order to implement legislative delegations of power to the new president to act on such problems.
The financial and business markets were directly impacted, but relieved that action was being taken. Wall Street was horrified, as were bankers who referred to the new president as “that man Roosevelt” and “a traitor to his class”. The President used his “fireside chats” to explain the bank holiday and moratorium to a frightened public on radio and, as humorist Will Rogers would later comment, did so with such clarity and simplicity that “even the bankers understood it”.
Undaunted, Roosevelt pressed on and lobbied in his weekly radio addresses and gave hope to a people starved for action. In short order, pure necessity and public opinion, as well as some well-placed judicial appointments by Roosevelt, saw to the development by the Supreme Court of practical constitutional standards for delegation of the legislative power to the Executive by the Congress. The Court initially began to uphold, in decision after decision, the creation of the New Deal bureaucracy by requiring Congress to include “standards and guidelines” as well as “intelligible principles” to be included in legislation delegating its authority to the Executive Branch and its departments and agencies. One of the first such agencies created was the Securities and Exchange Commission, under the Securities Act of 1933, to address and correct the excesses of Wall Street, which caused the crash of 1929.
Leaving no doubt about his resolve to enact and enforce serious regulation and control over the securities industry, Roosevelt appointed Wall Street financier Joseph P. Kennedy, who had a reputation as a hard-bitten and ruthless operator as Chairman of the S.E.C. Roosevelt nonchalantly commented that he indeed wanted “Briar Rabbit in charge of the cabbage patch”.
Kennedy did not disappoint Roosevelt. The SEC was organized, staffed and empowered to deliver practical substantive procedural and operational reform to the securities and financial industries, and by the time Kennedy resigned to make way for his successor, William O. Douglas, he had substantially succeeded in halting abuses, establishing strong mechanisms for accountability and control and had won the respect of industry operatives.
Roosevelt would soon accomplish similar results in the areas of banking, communications, trade, transportation, commerce, insurance, food and drugs, environment, labor and industry. Congress made progress in providing the oversight over the new agencies and businesses it had created, but could scarcely keep up with the mountains of rule-making and policy requirements, which were in constant creation and operation. With the help of mobilization for World War II, the Depression was subdued and a new regulatory framework was firmly set into place, often including industry players in the regulatory and oversight roles, which up to the 1980s had kept the economy in check and altered American capitalism forever.
Truman’s “Fair Deal” to LBJ’s “Great Society”
President Truman, who succeeded FDR after his death in April 1945, expanded federal authority over labor and production literally nationalizing the steel industry. Dwight Eisenhower, who campaigned on a platform of dismantling the New Deal bureaucracy, enlarged it while the economy expanded and Wall Street flourished. His main legacy was the creation of the nation’s Interstate Highway System. John Kennedy and Lyndon Johnson, continued to centralize power in the Federal Government, and like Roosevelt, used the Federal Government proactively to regulate the economy and provide a safety net for those left behind in the American post war expansion. Kennedy’s economic initiatives included a tax cut which stimulated economic growth. Johnson’s “Great Society” surpassed even New Deal social programs and Medicare, its center piece, to this day stands as perhaps one of the greatest government sponsored assistance programs in our history. Not even FDR would take on the American Medical Association. The masterful Johnson however, literally hoodwinked the doctors by initially coaxing them into agreeing to help provide medical care for third world senior citizens and then publicly extending the proposition to include the introduction of Medicare in the United States.
Richard Nixon And The “New Federalism”
Richard Nixon, known for his skill and attention to foreign policy, produced great domestic social achievements in the economy by furthering the federal bureaucratic role. He appointed a special domestic counsel and produced programs and reforms in the area of intergovernmental relations, revenue sharing and “the new federalism” which stand to this day as some of the most progressive federal economic and domestic initiatives in the nation’s history.
Ford and Carter, In The Short Term
Gerald Ford sought to utilize the federal bureaucracy to stop widespread inflation and to assist cities, such as New York, which were teetering on bankruptcy. Ford’s urban relief programs were grossly mischaracterized in the press, and his accomplishments understated. Jimmy Carter continued the policy of strong Federal involvement, especially in the field of energy. However, Carter’s grip on business and economic policy slipped considerably, with revelations of scandel surrounding his Budget Director, Bert Lance.
Post New Deal Policies
Every successor to Roosevelt, Republican or Democrat alike, up to Ronald Reagan, not only failed to reduce the size of the Federal Government and reverse the “New Deal”, but expanded it. For the most part, these policies acceded. While a bloated bureaucracy had indeed been created and Congress had blatantly and most likely unlawfully delegated much of its power to the chief executive, the economy grew in unprecedented fashion, and the defects in the regulatory system which resulted in the collapse of 1929 were rectified. Banks were now safe places to deposit money and obtain and maintain mortgages. Wall Street knew and adhered to the rules. Trade, communications, and labor were placed in a sound framework of accountability programs like the W.P.A. and C.C.C. created real work and self sustaining jobs and a system of financial support for the elderly, Social Security, was firmly established. Once and for all the principle was established that government could best enforce integrity and transparency in the market place and provide the social safety net that every moral society must secure for its people.
Critics came and went, but no one tampered with the new capitalism. Self-regulation had failed and this was underscored by the failure of anyone in the banking and finance industry, pre-New Deal, to admit and call attention to the fact that serious problems existed prior to the 1929 collapse. Our 2008 scenario was eerily similar.
With really two possible exceptions; presidents from F.D.R. to Barak Obama, have not only resisted pressure to reduce the federal regulatory apparatus, they have increased and heavily relied upon it.
Ronald Reagan, “Morning in America”
The first real attempt to follow through on a campaign promise to reduce the level, intensity and size of the Federal Regulatory System was advanced by the affable but doctrinaire Ronald Reagan in the 1980s. The Reagan economic “brain trust” was led by former Budget Director David Stockman. The Reagan Administration focused on banking, securities and insurance regulation. Under Reagan’s leadership, legislation was passed removing restrictions on federally insured banks to expand into the insurance business and allowing federally chartered banks and savings and loans to engage in direct investments and equity participations in the real estate collateral it extended credit on, and to also offer insurance industry products and services. Self-regulation was back it seemed.
The insurance industry was granted reciprocal latitude by the same legislation. The customary congressional oversight mechanisms to monitor these now lightly regulated industries was not utilized fully, and no study of the potential impact of the deregulation legislation on parallel Federal Deposit and Insurance Corporation claims was undertaken, nor were even the most fundamental provisions made for the eventual consequences. As in the pre-New Deal era, at no time did industry operatives call attention to the fact that problems existed which required immediate remedial action.
Impact of Reagan Era Deregulation on the Real Estate and S&L Industries
Commercial banks and savings and loans expanded rapidly into the real estate and insurance markets. This sacrifice of credit and collateral protection became a trade-off for the S & L’s receiving “equity kickers” or profit participations for commercial and real estate development loans. As a result, mortgages which would ordinarily require developers to maintain 20 – 40% cash, “hard equity” in projects, were approved and disbursed in excess of 100% loan to value. The same transactions, which had theretofore required extensive credit background checks and personal guarantees of principles and significant borrower net worth and equity contributions, were structured as purely asset based transactions with no credit personal guarantee enhancements or borrower equity stake requirements. The banks justified these transactions on the basis of the project equity it negotiated for with the developer and appraisals, which reflected not the existing fair market value of the properties on a “quick sale” basis, but value as if and when approved, improved, operated or sold. Vast amounts of savings and loan depositor moneys and life savings were advanced to developers on vacant land, prior to final approval of site plan and subdivision requirements having been obtained. “Hard and soft costs” of the project development were funded, leaving the developers and banks and their depositors at the mercy of the local planning and zoning authorities. Loans were booked in massive amounts in this fashion for office and retail projects based upon projected, not actual cash flow and developers routinely front ended their “development fees”. The savings and loans likewise extracted and booked fees at closing and entered on its books vast amounts of phantom income, based upon fees it had funded itself from its depositors’ money and projected “equity” in projects that were not even close to the point of completion, profit or even value.
The S & L’s took their paper gains and sold their banks for sums equal to percentages over “revenue”. Officers, employees, directors and shareholders participated richly in the resale profits, while uninformed depositors, received notices that their banks had been purchased or absorbed by new institutions.
The residential mortgage market was equally affected. Due to the deregulation and elimination of conventional credit and equity requirements, in the mid-1980s, savings and loans and commercial banks introduced the no income, no credit and “jumbo” loan. Prices of residential real estate during this period soared. Increases in appraisals of over 75 – 100% in a matter of a year or two were not uncommon. The flow of money from the new loan products heated up the market and inflated values. There seemed to be no end or limit in sight. Once again, banks sold their mortgage portfolios and stock at huge profits.
Relaxation of Securities Industry Regulation Under Reagan
On Wall Street, insatiable seekers of venture capital were swimming in cash raised by the invention and sale of “junk bonds” by individuals like Michael Milken. No rule, statue or regulatory custom existed which prohibited the formation and sale of this particular hybrid of security, and capital providers and recipients alike, took while the taking was good. New business and industries abounded. Wall Street players made fortunes overnight from the brilliant Milken to neophytes who barely had the experience to follow the paper flow. The trophy homes in Greenwich, Connecticut, luxury cars, boats and posh New York City condominiums were just some of the symbols of this accidental wealth. Investors collected the bonds and relied on the authenticity of the presumed equity that backed them. Little or no appraisal or due diligence was conducted on the prospect of success of the businesses or finance of some ventures nor was there any meaningful review or administrative oversight mechanisms of accountability put into place to monitor ongoing operations and performance of the securities. Hedge funds, a rapidly growing source of private equity placement, were essentially free from direct administrative regulation. Former Federal Reserve Chairman Greenspan cautioned Congress that these newly formed and capitalized companies lacked real basis in value.
The object of the game, as in the case of the commercial banks and S & L’s, was to generate fees and book phantom equity to support inflated stock or bond value. At the same time, budget deficits ran up at alarming rates, as did the national deficit. Supply side economics and deregulation created an aura of entrepreneurial invincibility that seemed to have no end. It was “Morning in America” and no one seemed concerned over the fallout of the economic nightfall that would soon follow.
Reagan Era, Savings & Loan And Insurance Industry Deregulation
By the late 1989, commercial real estate failures and foreclosures soared at alarming rates. Similarly, residential mortgage loan foreclosures rapidly rose. By 1991, budget deficits and rising interest rates gave way to increasing unemployment and recession. Foreclosures increased significantly. Borrowers who had little or no equity in the real estate they had just handsomely paid for with depositor’s money, abandoned properties. Commercial lenders likewise took back on account real estate they had permitted developers to “leverage out” on. Banks and savings and loans rapidly took in “REO” (“real estate on account”), in lieu of foreclosure. Bank inventories of commercial land developments, residential developments and office buildings as well as luxury and middle range residential properties accumulated dramatically. Markets were glutted with such properties placed on the market for resale by the banks. Real estate values declined. Properties valued at inflated prices at the time of loan origination were now routinely appraised and resold at values significantly below the amount of the principal of loans. Sound familiar?
For the first time since pre-New Deal days, the term “deficiency” had real meaning to lender and borrower. So foreign had this concept been, that banks such as Dime Savings Bank of Brooklyn, which pioneered the no income, no asset loan, became deluged with deficiency losses when their attorneys in Connecticut failed to observe applicable procedural requirements to preserve that bank’s residual rights against borrowers.
Banks such as the former Westchester Federal Savings and Loan in New Rochelle, New York, which sold its loans and stock to Marine Midland Bank of Rochester, New York, were later discovered to be for the most part, worthless depositories of bad paper.
Again for the first time since the New Deal and FDR’s declaration of the “Bank Holiday”, S & L’s began to fail at alarming rates. Commercial bank failures soon followed. The Federal Deposit Insurance Company was called upon to make good on substantial sums of depositor’s lost money up to the $100,000 limit on each institutional account. Attorneys who made it a practice to concentrate huge sums of client funds in the S & L’s lost vast sums of their funds, uninsured in excess of the $100,000 threshold, triggering personal hardship for clients and professional liability for lawyers.
The F.D.I.C. and Controller of Currency began to take control of Savings and Loans and Commercial Banks at a rapid rate and Congress created the Resolution Trust Corporation, under the Controller of the Currency to take possession and management and control of the “REO” (Real Estate Owned) properties, which were accumulating. The RTC, having little or no staff or expertise in the real estate development, marketing or management business, was staffed initially, with deposed officers of Texas S & L’s which were the first victims of the S & L debacle. The Resolution Trust Corporation grew in size and assets. It spent and wasted billions of dollars in public money. It overpaid for goods and services, mismanaged properties, mismarketed assets and made often corrupt and inefficient deals. As in the days of the New Deal, those who preserved their liquidity made fortunes. Properties were bought on the cheap. Non-recourse borrowers, in default on their own, now RTC owned properties, frequently repurchased them from the agency at huge discounts often reselling them for significant profits.
The F.D.I.C. began to the process of forced acquisitions of weaker banks by stronger ones, which themselves became weak and were in turn swallowed up by mega-banks like Citi Bank and Bank of America. With some exceptions, usually in the form of well managed privately owned state chartered community banks, small to mid-sized banks became extinct. This was the breeding ground for what would become the “too big to fail” banks, the public came to know in 2008.
From all this, minimal prosecutions such as involved Lincoln Savings and Loan and Silverado Bank followed. Indictments ensued for a period of time. The Silverado Bank defendants’ Michael R. Wise and Neil Bush were acquitted. Wise would later go to prison on another scheme. Lincoln Savings’ Keating was convicted only to have his verdict set aside by an appellate court some months later. Other sporadic prosecutions commenced, few convictions resulted, and prosecutorial interest in the banking, S & L and RTC scandals waned.
“Reaganomics” And Wall Street
In December 1987, Wall Street suffered its greatest setback since the crash of 1929. The new companies and ventures fueled with deregulated junk bond capital, crashed as well. Michael Milken and others, who just a year before were hailed as innovators and champions of venture capitalism, were prosecuted and convicted on what amounted to borderline criminal activity, which, a few years earlier, had been considered cutting edge legitimate venture capital tools.
George H.W. Bush And The Responsibilty of Power
The Reagan attempts at deregulation and dismantling the New Deal, resulted in serious economic reversals. The law enforcement and regulatory consequences of all of this were remarkably light, low profile and short lived. It fell to Reagan’s successor, George H.W. Bush, to preside over the effects of the financial libertarianism of the Reagan era. The deficits were growing exponentially, unemployment was on the rise and interest rates were escalating.
Not even “Desert Storm” could save his presidency from the effects of what he had so preciently labeled as “voodoo economics” in 1980. President Bush, seeing the handwriting on the wall, and compelled to deal with reality, supported the Revenue Act of 1991 sponsored jointly by some Republicans and then Democratic Ways and Means Committee Chairman Dan Rostenkowski.
The measure was passed and taxes were raised over a period of several years. Bush had flawlessly conducted and won a war, but broke his “read my lips” pledge, raised taxes, and increased the federal bureaucracy with the failed RTC and its successor administrative structures.
For all this, President Bush lost the presidency to Bill Clinton, having laid the foundation for the economic boom to follow by creating the tax revenue that would fuel the Clinton recovery and launch an extraordinary period of economic growth.
Bill Clinton And The “New Democrats”
Bill Clinton was a master of the development and understanding of the use of public policy. He used his appointments to the Treasury and Controller of the Currency posts as well as many other high and mid-level departmental and bureaucratic positions to relax the national regulatory apparatus. He expand the economy, eliminated debt, and promoted international and domestic entrepreneurial and business growth.
“Building The Bridge”
Clinton effectively used government to informally relax regulation and provide incentive for economic expansion. What is extremely noteworthy is that Clinton did not have a business background and by his own admission, “never had a quarter” until he left government. His skill was almost academic in nature but very shrewd in practice. His annual “Clinton Global Initative” confernce continues to this day. He left it to his Treasury Secretary, Robert Rubin and others, to design and implement a plan for economic recovery. Rubin himself set the tone of self-proclaimed quiet skill, and a disdain for the trappings of the massive wealth, he was so adept at helping to create. Clinton accomplished, with what seemed to be ease, the growth of the economy by promoting economic expansion and entrepreneurism and relaxing actual government regulation.
The results were by most account, successful: elimination of the deficit, balancing of the budget and expansion of the economy globally, in unprecedented fashion; indeed, “building a bridge to the 21st century”.
Clinton, “New Democrat” or “Pro-Choice” Republican
Like all progress, the great Clinton expansion period had its costs. The Welfare Reform Act of 1996, a political tradeoff, essentially eliminated substantial portions of social safety net created from as far back as the New Deal, the Great Society and even the Nixon Administration. Like no Republican before him, Clinton outsourced jobs, eliminated aid to families with dependent children, grants in aid, school breakfasts for inner city children and other traditional and innovative social welfare programs and literally eviscerated Federal Habeas Corpus and access to the federal courts on civil rights claims for the nation’s incarcerated, the majority of whom are poor, African-American and Hispanic. As difficult as it became for inner-city and rural poor, that is how easy Clinton made it for Wall Street, the investor and middle class to thrive.
Entrepreneurs and businessmen, especially in high technology fields and the emerging “dot.com” industry, which ultimately gave rise to enterprises such as Google and Facebook, made mega fortunes with minimal government regulation. Republican businessmen privately worried that Clinton would be impeached over the Starr investigation and that the “party would be over”. Clinton survived. As to his inner city base, the victims of welfare and federal litigation reform, he “apologized for slavery”, and now has an office in Harlem, where he pursues some very significant philanthropic endeavors.
George W. Bush, An Unlikely Destiny
George W. Bush had no trouble creating the single largest new Federal Bureaucratic structure since the New Deal, the Department of Homeland Security, a virtual “ministry of the interior”. Politics, policy and public passions, not party ideology, decree the use and extent of the government’s regulation of business, law and enforcement policies. Bush’s attempt to alter the prize of the New Deal, Social Security, by converting a portion of it, for some future retirees, into individual investment accounts, failed to even reach a vote in Congress in spite of his full use of the “bully pulpit” to generate public support.
As to the use of the regulatory process by the Bush Administration, the aftershock and government action following the tragic events of September 11, 2001, were compounded by startling revelations concerning the unraveling of Enron and other public companies and the unveiling of allegations of massive fraud in corporate accounting and reporting requirements. Eventually the investigations reached to the underlying transactions of the companies, in the form of limited partnership ventures and to excessive executive compensation.
Beyond this, the activities, relationships and compensation structures of the investment banking and service related industries came under scrutiny along with the mutual funds and insurance industries. Washington and Wall Street were taken by storm.
Bush’s tax cuts of 2001 and 2003, especially for those earning $250,000 or more, were calculated to increase savings and investment but people spent the money instead. Consumer debt reached an all-time high and the income gap continued to grow between the top one percent and the other ninety-nine percent of Americans.
The Bush Administration was busy at work attempting to protect and defend against terrorism and was caught fully by surprise by the enormity of the Enron and related scandals. Harvey Pitt, the Bush Chairman of the Securities and Exchange Commission, had little inkling as to the depth and magnitude of the issues and no suitable regulatory apparatus existed to deal with it at the time. Litigation, investigations and prosecutions multiplied. Demands for corporate accountability appeared in the press daily and great pressure was brought upon national law enforcement and regulatory officials to act.
The nature of the corporate wrongdoing or misdeeds can only be generalized here. Enron booked assets and profits, non-existing limited partnership interests, which were concocted by their management and executive teams or their operatives. The company’s accountants were found to be complicit, charged and made to pay civil penalties for their part in disguising and misstating corporate debt in order to exaggerate equity. Former Enron Chairman/CEO, the late Kenneth Lay and former President/CEO Jeffrey Skilling were convicted on charges stemming from accounting and mail fraud at Enron. Former CFO Andrew Fastow plead guilty and served a term of six years. Kenneth Lay died before his conviction became final and so it was expunged. Jeffrey Skilling’s conviction was reversed by the United States Supreme Court in 2010 and he awaits re-trial.
Enron executives drew large salaries and bonuses, options and fees in cash and stock. Stock was sold by the corporate insiders immediately before the filing of chapter 11 proceedings. Shareholders and employees alike were hyped on the value of the stock and general condition of the company and the truth about the company’s financial difficulties and distress was deliberately withheld. In the midst of it all, Enron’s executives and operatives cashed in to the tune of hundreds of millions of dollars, while shareholders and employees whose life savings were invested in the company, were misled and lied to. The company accountants directly participated in the wrongdoing and obstructed justice, by destroying evidence in the process.
The regulators were asleep: Harvey Pitt was accused of “not understanding his job” and for producing “structurally flawed analytical work” and the Bush Administration of “representing the interest of the ownership society”. These were harsh words but difficult to dispute under the circumstances.
Although Enron’s ties to the Bush Administration were well known, the origins of the Enron related activities in question dated back to the Clinton Administration and Enron’s executives were equally generous to both comps.
The WorldCom and other scandals were similar in nature and magnitude to Enron. Questionable accounting practices and failures to disclose the nature, extent and weight of corporate debt to investors and employees rocked the company and the corporate bankruptcy filing was equally contentious. Bernard Ebbers, the ex-CEO of WorldCom, was convicted of an $11 billion accounting fraud and lost his appeal. He is now serving a long prison term.
Officials of Health South Corporation were accused of bid rigging. Former Health South CEO Richard Scrushy was convicted in Federal Court in Birmingham, Alabama, and like Jeffrey Skilling, his conviction was vacated due to the vagueness of the federal mail fraud statute he was prosecuted under. A total of fifteen Health South employees, including five former CEOs, plead guilty to taking part in a $2.7 billion accounting fraud there.
The Adelphia Cable Company scandals were even more direct and concentrated. Senior directors and major shareholders, a father and two sons, advanced themselves hundreds of millions of dollars in the form of unauthorized loans and direct investments and purchases from third parties. Tyco, another case of excessive diversion of corporate funds to executives as loans or compensation, was another high profile prosecution. Former Tyco CEO Dennis Kozlowski and CFO Mark Swartz were prosecuted by the New York County District Attorney and convicted of stealing hundreds of millions of dollars from the company for their own account, and spent years in New York State prison before being approved for temporary release. Tyco itself continues to perform well. Richard Grasso, former chairman of the New York Stock Exchange, was also prosecuted for excessive compensation but his judgment was vacated when his attorneys, Williams and Connolly of Washington, D.C., proved that former New York State Attorney General Eliot Spitzer had acted without jurisdiction in the case.
The entire mechanism and process of stock option compensation to CEOs has now come under full scrutiny. “Change in control” provisions, monitoring CEOs when they trigger stock options, as well as a complete overhaul of ratios for CEO profit and compensation are now required. A New York Times’ report of February 13, 2007, gave another good indication that we have failed to learn from our past, reporting that the SEC sought to impose restrictions on investor suits concerning allegations of excess C.E.O pay.
In the face of all of this, 2006 compensation and bonuses to CEOs on Wall Street were reported to be in the billions of dollars and so disproportionate to employee compensation and other American wealth achievement levels, as to be unexplainable in moral or economic terms.
Investment Advisors and Profiteers
The investment banking and services related investigations involved other more subtle issues, which challenged the very nature of the transactions and the very care of the industries. The fundamental regulatory proposition is now that a firm engaged in the money management business cannot have an investment banking arm because of inherent conflicts of interest, real or potential.
Historically, investment-banking houses were part of a larger firm, activity engaged in the money market and securities business. Bankers and money managers found themselves under investigation and subject to severe criminal penalties. In order to avoid the prospects of the regulators transforming to the criminal law enforcement mode, companies settled, agreeing to pay huge fines and eliminating any conflicting activities or divisions. Citibank, Merrill Lynch and many others fell quickly into line. In some cases, offending executives and managers like Citigroup’s Sanford I. Weill, were banned from the industry by local regulators in their particular jurisdiction. Practices of predatory lending and overreaching had come under fire by regulators and investment bankers were cited for failure to adhere to notions of fiduciary duty. A complete severance of the investment banking and securities functions is now required. Hedge fund managers however continued to operate essentially without regulation.
Ex Post Facto Prosecutions?
Late trading became the next taboo. An industry standard practice, which existed for years, was criminalized, and enjoined. Once again, hefty fines and consensual cease and desist orders, avoided prosecution of the individuals involved.
The mutual funds industry was also affected. Marsh and McClennan agreed to pay enormous civil fines and enter into consensual cease-and-desist orders to avoid federal criminal prosecution. Regulators charged that insurance premiums were too high because insurance companies had formed illegal cartels, and that corruption was rife throughout the industry.
Practices such as timing of trades, late trading fees, and the over-charging of fees of $70 billion per year paid as fee income to mutual fund managers, were investigated and regulators brought an $850 million lawsuit against the company. Marsh and McClennan settled issues of civil and criminal liability with federal regulators for a $40 million sum (one year’s fee income) and entered into a cease- and-desist order. The company did not acknowledge criminal wrong doing but agreed to new management and leadership and to new transparent business policies. Contingent payments that had driven insurance fees way up have been eliminated. However, in 2010, the convictions of the Marsh and McClennan executives secured by the New York State Attorney General, who, notwithstanding the federal civil settlement, brought state criminal charges against them, were vacated by the convicting New York State court on grounds of unlawful disclosure violations by former New York State Attorney General Eliot Spitzer in prosecuting the case. The executives now have a multi-million dollar personal lawsuit pending against Mr. Spitzer.
In all of these instances, the majority of the enormous fines paid were not distributed to clients or investors but rather kept in government coffers.
As beneficial and necessary as these results were, in terms of stability and fairness, the means employed to effect them need to be examined. To accomplish these enforcement measures the rules were changed in the middle of the game.
When Horatio Alger Becomes Jesse James
Some have said, that white collar, post-Enron law enforcement policies, have now created an environment of selective prosecution, an insufficiently defined vague statutory and regulatory apparatus and an enforcement model which will gradually have the effect of criminalizing ordinary commerce.
CEOs are now called upon, under penalty of criminal prosecution, to guarantee the accuracy of financial reports. Accountants and attorneys are directly in the fray of derivative and direct criminal liability.
AIG’s former CEO Maurice Greenburg’s resignation was demanded and received after it was alleged that he had personally initiated a complex questionable transaction that regulators believed boosted AIG’s earnings. Greenburg and his successors invoked the Fifth Amendment in the face of investigation of the company concerning earnings manipulation. They were found liable, but again, a New York State court vacated the judgment secured by the former New York State’s Attorney General Eliot Spitzer, for lack of jurisdiction. Mr. Greenburg now has a multi-million dollar lawsuit pending against Mr. Spitzer.
New theories of criminal culpability now replace customary industry standard practices, while aggressive prosecutors promise investors retribution, reform and compensation. The slippery slope of post-Enron regulatory and law enforcement is in full swing. Indeed the Times report of October 29, 2006 noted earlier, explained that “Congress now recognized the need to strike a balance between civil and criminal sanctions imposed on business practices”.
Indentured America – the “Sub-Prime Mortgage” Crisis
Incredibly, with all of these cases, controversies and difficulties still underway, beginning in the late 90s, bankers and brokers, with the help the regulators, in an ambitious effort to expand home ownership and mortgage borrowing, developed the “sub-prime mortgage”, which went beyond the relaxed standards of the 80s and set the stage for the mass borrower defaults which followed. These new products utilized appraisals which were based on inflated property values which were in turn based on distorted valuations proffered by portfolio driven lenders. Because values kept rising with each distorted sale, lenders had no problem recovering properties from defaulting borrowers or avoiding foreclosure by reselling properties, making new distorted loans. Sub-prime lenders lured borrowers with variable rate mortgages which began with affordable payments which spiraled into impossible burdens. Quasi Federal entities such as “Fannie Mae” and “Freddie Mac” not only failed to ensure that these transactions were sound, they joined in the speculation and floated huge revenues, fees and profits in the process.
To make matters worse, as the Clinton recovery advanced, Wall Street bankers applied “new age” academic theories which they used to package or “securitize” millions of devalued sub-prime mortgages, into insured debt instruments to be sold and re-sold in the private and public equity markets. In the process, essential original loan origination documentation and transfer instruments went unaccounted for and in many cases were never placed on public records as required by statute. Again, inflated home values, fueled by made-to-order appraisals on questionable loans enabled the banks to sustain the momentum in the marketplace and satisfy the regulators by refinancing bad paper or strictly foreclosing on defaulted loans and reselling the properties for sums sufficient to satisfy the outstanding accumulated debt.
Barak Obama, “New, New Deal”, “American Gorbachev” or “New, New Democrat”
This all came to an abrupt end in the late 2008 when rapidly increasing oil prices and other economic factors created a spiral of mortgage defaults which trashed not only the underlying mortgage debt but also the securitized packages purchased by the investment bankers and guaranteed by the insurance companies. The entire financial system was at the brink of disaster and the late Bush Administration Troubled Asset Recovery Program (TARP), and ensuing Obama “Stimulus”, the American Recovery and Reinvestment Act, focused on providing immediate relief to the banking and insurance and other industries but did little or nothing to restructure or relieve the mortgage debt burden on homeowners, farmers and businesses. The results were that not only were the “sub-prime” mortgage borrowers losing their homes but so were the conventional borrowers who had responsibly acquired and serviced their debt. The reason for this is that the crisis caused a collapse in home values across the board. As a result, over 51% of American homeowners and farmers are now in foreclosure, pre-foreclosure or serious arrears, this compared to 33% of property owners in that category during the Great Depression of the thirties, when, far different from today’s federal policies “New Deal” home loan policies and regulations placed the priority on bailing out the homeowner before the banker. President George W. Bush’s “TARP” relief plan bailed out the banks because they were “too big to fail”, and to the surprise of many of his grass roots supporters, President Barack Obama’s policies essentially mirrored the Bush “too big to fail” philosophy. Liberals expecting the “New, New Deal”, and fiscal conservatives who feared that Obama would take on the dimensions of the “American Gorbachev” and “loosen the bolts”, as it were on our political and economic systems, were taken aback by the ease with which the Obama Administration fell in line with Clinton and Bush 43 regulatory and economic policies.
Financial Industry Regulation Under Obama
The Obama Consumer Financial Protection Bureau, expected to be headed by Elizabeth Warren, who was left at the alter by President Obama in 2011 when he named Richard Cordray to the position instead in the face of fierce congressional opposition to her appointment, has yet to be fully staffed and its full agenda awaits post-election implementation. There has not been a single prosecution of any of the bankers, investment bankers, hedge fund operators, attorneys or accountants responsible for the deliberate creation and distribution of the hybrid of mortgage, and security that became known as the “sub-prime mortgage”. President Obama himself has reasonably stated that it would not be proper to prosecute individuals for exercising “bad business judgment”. Bank of America, Countrywide, Citibank, and Wells Fargo, to name a few, have stonewalled Obama Administration programs encouraging loan modifications for affected borrowers and the federal government has left itself without the enforcement tools needed exact a reasonable quid pro quo from the banks to in turn bail out the homeowner and farmer. “Private Investor” funds have been encouraged by Treasury Secretary Timothy Geithner to participate in rehabilitating defaulted mortgage loans. Translated, that means that “vulture funds” buy defaulted paper at about seven cents on the dollar, feign attempts at loan restructure, foreclose on the homeowner and warehouse millions of properties until the market comes back, ten or more years from now and sell them at a profit. The Standard and Poor’s 500 index is up 65% under President Obama, the largest gain for any first term president since Dwight D. Eisenhower. Post-stimulus Banker and CEO bonuses and compensation exceed even 2006 levels and the Obama administration has now positioned the Treasury Department to infuse billions more in stimulus money into the banks.
The President’s historic health care reform law has begun to make badly needed changes in the area of national health care and the administration’s intervention in the automobile industry, while initially drawing great criticism, has in fact saved millions of jobs and repositioned American automakers to successfully and responsibly compete.
Achieving the Balance – The “Real Deal”
In order to stabilize the national regulatory apparatus, courses of government action, pursuing core values in the form of clear, well defined laws, rules and regulations, which are evenhandedly administered and enforced, are required. Free market advocates must recognize that more is at stake than free market survival and advocates of government primacy in ensuring integrity and transparency in the marketplace must accept the re-imposition of “standards, guidelines and intelligible principles” as well as fundamental fairness and uniformity in identifying, regulating and prosecuting companies and individuals suspected of departing from norms of acceptable business behavior. Both the regulated and the regulator must be made to periodically account to Congress as to their respective roles in the process and the predictability factor which is the mark of true due process must be ever present.
Each and every defaulted residential and farm loan in the country must be modified and “crammed down” so that homeownership can be once again stabilized. We must recognize that collectively, the American homeowner and farmer are “too big to fail”. Banks should not receive any further federal funds without an enforceable commitment to restructure defaulted loans, declare a moratorium on residential and farm foreclosures and use the funds to lend to homeowners and businesses.
Government must not be so aggressive or arbitrary in its application of legal and administrative enforcement policies, as to dampen and even criminalize the American entrepreneurial spirit and defeat economic growth.
Like F.D.R. we must strike the right balance, and temper free enterprise with prescriptions for transparency, oversight, predictable accountability, and social responsibility.
Like F.D.R. we must use the laws and the economic and regulatory apparatus at our disposal to humanize capitalism.
We must look to the past to create a clear path to the future in achieving competitive, fair and just economic and regulatory policies.