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Judge Rakoff on Prosecution of Financial Executives

High profile District Court Judge Jed Rakoff recently gave a speech in which he explored theories on why few financial professionals have been criminally prosecuted in the wake of the recent financial crisis.  Judge Rakoff is well known for rejecting settlements in cases brought by the SEC on the grounds the settlements did not require sufficient accountability.

Judge Rakoff’s remarks articulated, then rebutted, three possible “explanations” he said he has heard from high government officials for why few individuals have been prosecuted for their role in the financial crisis.  His first “explanation” is the difficulty in proving intent on the part of high level management of the banks and companies.  Judge Rakoff doubts this explanation, saying that while high level management personnel were not putting together the packages of mortgage securities, those personnel had to have “willful blindness” or “conscious disregard” when banks were aware of increased mortgage fraud but did not ask why the why the “bank’s mortgage-based securities continued to receive triple-A ratings.”

The second explanation that Judge Rakoff has heard for why few individuals have been targeted for prosecution is that “the institutions to whom mortgage-backed securities were sold were themselves sophisticated investors,” and thus could not have relied on sellers’ assurances that the securities had value.  However, Judge Rakoff believes that the sellers of “dubious mortgage backed securities” should be prosecuted, whether or not the buyers in truth understood what they were purchasing.

The third explanation Judge Rakoff explores is what he terms the “‘too big to jail’ excuse,” meaning that prosecuting the culpable financial institutions would cause harm to the economy.  Judge Rakoff notes that, however valid the worry may be as to the institutions themselves, no “big financial institution would collapse if one or more of its high level executives were prosecuted.”

Having refuted others’ explanations, Judge Rakoff posits his own theory of why few high-ranking financial services executives were prosecuted for actions taken in the financial crisis.  His theory has two components.  The first is that prosecutors simply had other priorities.  He notes the criminal authorities’ shift in resources from anti-fraud investigations to anti-terrorism after September 11.  With respect to the agency “that is the primary investigator of fraud in the sale of mortgage-backed securities,” he charges that the SEC, “trying to deflect criticism from its failure to detect the Madoff fraud,” began concentrating on Ponzi-like schemes as well as “smaller, easily resolved cases that will beef up their statistics when they go to Congress begging for money.”

The second component of his explanation is “the Government’s own involvement in the underlying circumstances that led to the financial crisis.”  Judge Rakoff finds fault with Congress for deregulating the financial services area, with GSEs such as Fannie Mae and Freddie Mac for creating a market for mortgage-backed securities, and with government agencies for tacitly approving mortgage loans with little meaningful documentation.

Judge Rakoff posits that all of these factors have brought about a shift in emphasis, away from focusing on prosecuting individuals, to prosecuting companies and other institutions.  He suggests that the “future deterrent value of successfully prosecuting individuals far outweighs the prophylactic benefits” of suing corporations and obtaining agreements to put in place additional compliance measures.