Alison Frankel

For the last three years, since the housing bubble burst, the Securities and Exchange Commission has been investigating the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac). Fannie and Freddie, after all, were the biggest players in the mortgage lending and securitization business, and there’s a lot of sentiment that they deserve a hefty share of blame for encouraging the financial industry’s voracious appetite for mortgage loans, no matter how deficiently underwritten. The problem for regulators hoping to hold Fannie and Freddie accountable, though, is that the previously quasi-private agencies went into public receivership conservatorship in 2008. Any SEC suit against Fannie and Freddie would essentially be one wing of the U.S. government seeking damages against another.

But the people who ran Fannie and Freddie in the run-up to the mortgage meltdown were another story. About nine months ago the SEC issued Wells notices to top Fannie and Freddie executives. I’ve heard there was virtually no give-and-take between regulators and defense lawyers for the executives after initial defense responses. So it was a disappointment but not a big surprise to the defendants when, on Friday, the SEC sued three former top officials from both Fannie and Freddie. (Here’s the SEC’s complaint against Richard Syron, Patricia Cook, and Donald Bisenius of Freddie Mac; and here’s the complaint against former Fannie Mae execs Daniel Mudd, Enrico Dallavecchia, and Thomas Lund.) The SEC complaints charge two defendants in each case with full-on securities fraud (the third official in each complaint faces aiding and abetting claims) for allegedly misleading investors about their agencies’ exposure to subprime mortgages. In the Freddie complaint, the SEC asserts that the agency claimed only $2 to $6 billion of its single-family guaranteed mortgages were considered subprime loans, when, in fact, $140 billion to $244 billion in loans fit that classification. Fannie allegedly reported $4.8 billion in exposure when its subprime lending exceeded $40 billion.

There are a few points to keep in mind about the Fannie and Freddie suits. First, the allegations all center on disclosures. There’s no accusation of accounting manipulation or more obvious fraudulent acts. Yet four of the defendants are accused of intentionally defrauding investors — partly because Fannie and Freddie were not registered entities during the entire period of alleged wrongdoing, which means the execs couldn’t be accused of negligence. That’s a high bar, in which the agency has to show the defense acted with fraudulent intent. Second, the former Fannie and Freddie executives — unlike the Citigroup executives who agreed to an administrative settlement in the bank’s 2010 subprime exposure agreement with the SEC — had no leverage because the SEC wasn’t also negotiating with their employer. There was little reason for financial regulators to reign in aggressive allegations, especially because there’s a strong public-relations incentive for the SEC to charge senior executives of agencies that ended up in such severe straits that they had to be placed in receivership, with taxpayers bearing the burden of management’s overly risky strategy.

But if you parse the SEC’s complaints, you’ll see the weaknesses in the agency’s cases. Let’s start with which sector of Fannie and Freddie’s business the allegations involve. The government-sponsored entities, as they’re known, bought lots of subprime loans for the portfolios they securitized and resold as mortgage-backed notes. But that’s not where the SEC accusations lie. The SEC asserts that the Fannie and Freddie officials misrepresented subprime exposure in the mortgage-guarantee business, in which the agencies offered government backing for individual mortgage loans.

Both Fannie and Freddie had, at least in theory, strict guidelines on these guaranteed loans, in which they required mortgage lenders to assure, for instance, that borrowers met income requirements. Fannie and Freddie also bought guaranteed loans from prime lenders, not traditional subprime lenders.

In 2006, Bear Stearns entered a $250 million settlement of Securities and Exchange Commission allegations that its traders engaged in illicit market timing for certain preferred customers. Like scores of SEC defendants concerned with liability in related civil litigation, Bear insisted on the language that’s become boilerplate in SEC settlements. So “without admitting or denying” the SEC’s findings, the bank agreed to disgorge $160 million and pay a $90 million penalty.

Bear and its successor, JPMorgan Chase, turned to Bear’s insurers to cover the disgorgement. (Penalties aren’t indemnified in Bear’s policy.) The insurance agreements said the bank was covered for damages awards and charges incurred by regulatory investigations, with one catch: The policies excluded claims “based upon or arising out of any deliberate, dishonest, fraudulent, or criminal act or omission,” if there were a final adjudication reflecting that wrongdoing.

No problem, right? The SEC settlement explicitly said that Bear didn’t admit deliberate or dishonest behavior when it agreed to the disgorgement. The insurers, represented by DLA Piper, Drinker Biddle & Reath and several other firms, balked at paying, but JPMorgan, with counsel from Proskauer Rose, sued to enforce the policies. In September 2010, New York State Supreme Court Justice Charles Ramos agreed that Bear hadn’t admitted anything. “An insured’s settlement or consent to entry of an order with the SEC, wherein it did not admit guilt, will not preclude if from disputing those findings in subsequent litigation with its insurers,” Ramos wrote in an order refusing to dismiss JPMorgan’s suit. “The [SEC settlement] does not contain an explicit finding that Bear Stearns directly obtained ill-gotten gains or profited by facilitating these trading practices.”

If there’s one federal jurist the Securities and Exchange Commission absolutely, positively did not want to see at the top of the docket in its $285 million settlement with Citigroup, it was Senior Judge Jed Rakoff of Manhattan federal court. Rakoff has been a festering sore for the agency since 2009, when he rejected a proposed $33 million settlement with Bank of America over failing to disclose bonus payments to Merrill Lynch executives in merger-related documents. In a March 2011 opinion in the Vitesse Semiconductor case, Rakoff took the agency to task for agreeing to settlements in which defendants neither admit nor deny wrongdoing. Then in July he claimed jurisdiction over the SEC’s case against former Goldman Sachs director Rajit Gupta, accusing the agency of forum shopping in filing an administrative action against Gupta. You can only imagine the teeth-gnashing at the SEC when Rakoff was assigned the Citi case. After the SEC tried to argue that Rakoff doesn’t have the power to consider the public interest in his evaluation of the proposed settlement, Monday’s rejection of the settlement was practically a foregone conclusion.

So you may be wondering — as I was — how it is that Rakoff ended up with the Citi case. The answer, according to his chambers and Chief Judge Loretta Preska of the Southern District, is that the assignment was purely random. Yes, there are 41 federal district judges in the district, so the odds of any of them overseeing multiple, unrelated cases filed by the same plaintiff are long. But according to Preska and Rakoff’s chambers, that’s what happened here.

The SEC filed the Citigroup case in federal court in Manhattan, rather than Washington, D.C. (where it filed a $75 million settlement with Citi in 2010) because the new Citi case includes SEC charges against Brian Stoker, a Citi Global Markets employee who allegedly structured and marketed the CDO that’s at the bottom of the case. Unlike the two Citi employees in the 2010 case, Stoker refused to settle with the agency. So in anticipation of litigation with him, the agency filed the entire Citi case in New York.

In 2010, when the Securities and Exchange Commission brought a case against Citigroup for misleading investors about the bank’s exposure to subprime mortgages, the SEC filed the proposed $75 million settlement in Washington, D.C., federal court. Judge Ellen Huvelle gave the agency some gruff about the deal, in which two individual Citi defendants also settled SEC claims through an administrative action, but she eventually accepted the settlement without demanding any big changes.

The SEC and Citi must be looking back with regret at those halcyon days. For reasons the agency has not explained, when it filed a proposed $285 million settlement with Citi last month, it opted for the federal court not in D.C. but in Manhattan. There, the case — which involves claims that Citi defrauded investors in a mortgage-backed CDO — was randomly assigned to U.S. District Judge Jed Rakoff, who has recently been engaged in a highly-publicized campaign of insisting on corporate accountability in SEC settlements. The SEC proceeded to undermine its credibility in Rakoff’s court by arguing, as my colleague Erin Geiger Smith reported, that it’s not the judge’s role to consider the public interest in SEC settlements.

In a 15-page, eminently quotable exercise in rhetoric issued Monday, Rakoff pushed the agency into the grave it dug for itself, rejecting not only the proposed settlement but also the SEC’s assertion that he must heed its assessment of the public interest. “A court, while giving substantial deference to the views of an administrative body vested with authority over a particular area, must still exercise a modicum of independent judgment in determining whether the requested deployment of its injunctive powers will serve, or disserve, the public interest,” Rakoff wrote. “Anything less would not only violate the constitutional doctrine of separation of powers but would undermine the independence that is the indispensible attribute of the federal judiciary.”

On June 28, 2010, the Enforcement Director of the Securities and Exchange Commission, Robert Khuzami, spoke on the phone with Mark Pomerantz, a partner at Paul, Weiss, Rifkind, Wharton & Garrison. Pomerantz and Khuzami had worked together as assistant U.S. attorneys in Manhattan in the 1990s; according to Pomerantz, he was partly responsible for Khuzami’s promotion to chief of the office’s securities unit. But this wasn’t a social call. Pomerantz represented Citigroup, which had agreed to settle SEC allegations that it drastically underreported its subprime mortgage exposure. The deal was held up, however, by the agency’s insistence that Citi CFO Gary Crittenden face fraud claims for allegedly misleading investors.

Pomerantz told Khuzami, as he had many times before, that Citi would suffer collateral damage if Crittenden were accused of fraud. According to Khuzami, he just told Pomerantz to “talk to Crittenden.” But soon after the June 28 call, another Citi lawyer, Lawrence Pedowitz of Wachtell, Lipton, Rosen & Katz, told SEC Associate Enforcement Director Scott Friestad that Khuzami had agreed to back a non-fraud settlement with Crittenden.

In July 2010 the SEC announced its deal with Citi. As part of the settlement, Crittenden and another individual defendant, former Citi investor relations chief Arthur Tildesley, settled administrative actions that didn’t involve fraud allegations. Six months later, an anonymous (but obviously insider) source tipped U.S. Senator Chuck Grassley that Khuzami had forced the agency to drop fraud claims against the execs as a favor to his friends in the defense bar. The SEC’s inspector general, H. David Kotz, undertook an investigation of the complaint.

One of the most controversial aspects of the U.S. Supreme Court’s June 2011 ruling in Janus v. First Derivative Traders was that the Justices rejected the Securities and Exchange Commission’s interpretation of federal securities laws. The SEC said Janus Capital wasn’t liable for the allegedly misleading statements in a prospectus issued by a Janus mutual fund, even though the SEC argued that it was — and even though federal courts traditionally pay deference when they ask agencies to offer their expertise in interpreting the law.

The SEC took another blow Monday, when a three-judge panel of the U.S. Court of Appeals for the Second Circuit affirmed the dismissal of an auction-rate securities class action against Merrill Lynch, despite an SEC brief arguing the case should proceed. The SEC agreed with a Merrill ARS investor who asserted that the boilerplate disclosure Merrill posted after a 2006 SEC consent decree shouldn’t shield it from claims it manipulated the market for ARS. The Second Circuit panel felt otherwise.

To be sure, Judge Robert Katzmann, writing for a panel that also included Judges Robert Sack and Amalya Kearse, said that the Merrill opinion should be read narrowly. “We see no need to fix the ‘exact molecular weight’ of the deference that we owe to the SEC’s position,” Katzmann wrote. “We readily acknowledge that at least some deference to the agency’s position is appropriate, given the SEC’s expertise and accountability. Here, however, we are unable to agree with the SEC’s application of the legal principles governing Merrill’s disclosures.”

Back when former Goldman Sachs director Rajat Gupta’s most pressing problem was the Securities and Exchange Commission’s civil case against him, his defense scored a small victory when the SEC agreed to drop an administrative proceeding against him and brought civil charges in federal court instead. Gupta’s lawyer, Gary Naftalis of Kramer Levin Naftalis & Frankel, had fought to have Gupta’s case heard by a federal judge, rather than an SEC administrative law judge, because the rules of evidence in administrative proceedings favor the agency. Among other things, the SEC can admit hearsay evidence, and defendants don’t have the same rights to depose opposing witnesses. Although the SEC can’t seek the same penalties in administrative proceedings as it can in federal court, they can be an effective way for the agency to make a statement about improper conduct.

Except when the defendants win.

On Friday, the SEC’s chief administrative law judge, Brenda Murray, entered a painstaking 58-page decision that cleared former State Street executives John Flannery and James Hopkins on all of the SEC’s sprawling allegations that they misled investors about the mortgage-backed securities holdings in State Street bond funds. Murray found that the agency failed to show at trial that Flannery and Hopkins violated any securities laws in communicating with investors about the funds’ subprime MBS holdings. She went out of her way to describe the former State Street execs as candid, believable witnesses who were frustrated to be on trial.

Murray’s ruling is yet another courtroom rebuke to the SEC, which in the last few years has seen several high-profile trials end in victory for defendants. Most notably, in 2009 a San Francisco federal judge dismissed stock options backdating charges against Broadcom executives; and in 2010 a Manhattan federal judge exonerated two traders in a landmark SEC case alleging insider trading in credit-default swaps. The State Street loss is perhaps an even bigger black eye for the SEC, given that the loss came in an administrative proceeding, the agency’s home turf.

Former Goldman Sachs director Rajat Gupta and his lawyer, Gary Naftalis of Kramer Levin Naftalis & Frankel, declared what might seem to be a very strange kind of victory last week when the Securities and Exchange Commission agreed to drop its administrative proceeding against Gupta. The two-page stipulation between Gupta and the SEC makes it clear that the SEC isn’t giving up on its claims that Gupta engaged in insider trading when he allegedly passed confidential information about Goldman Sachs and Procter & Gamble to Galleon Group hedge fund chief Raj Rajaratnam. All Gupta won was a pledge that the agency will sue him in federal court. And that is indeed a huge victory.

The SEC chose an anomalous vehicle for its March 1 suit accusing Gupta of helping Rajaratnam engage in insider trading. Instead of bringing a case against Gupta in Manhattan federal court — as the SEC did when it sued 28 other Galleon insider trading defendants — the agency filed what’s known as a public administrative proceeding. Those proceedings take place before an administrative law judge under SEC rules, not the federal rules of civil procedure. There’s no jury, and the first appeal of any adverse ruling goes to the SEC commissioners, not to an appeals court.

As Gupta counsel Naftalis laid out in his March 18 federal court complaint against the SEC, the differences between an SEC administrative proceeding and a federal court case added up to a big pile of prejudice against Gupta. Gupta wouldn’t be able to take depositions or conduct full discovery to counter the SEC’s assertions. The SEC, meanwhile, would be able to introduce hearsay evidence that it might not be able to get into evidence in federal court, according to the Gupta complaint. “The only plausible inference is that the Commission is proceeding how and where it is against Mr. Gupta for the bad faith purpose of shoring up a meritless case by disarming its adversary,” the complaint asserted.

There are few scapegoats more overloaded with blame for all that ails the U.S. economy (at least when we’re not on the brink of defaulting on our loans) than securities class action lawyers and the Securities and Exchange Commission. You know the rap. Class action lawyers are accused of accomplishing nothing more than transferring money out the pockets of corporate shareholders and into their own wallets; the SEC, meanwhile, is derided for failing to detect flagrant fraudsters like Bernard Madoff and letting the true perpetrators of the mortgage crisis off the hook. (Reuters, incidentally, has a great story today about the SEC’s new hotline for fraud tips, so the next Bernie Madoff won’t get away with deceiving investors.) There’s precious little hard data to measure the deterrent effect of SEC enforcement or securities class actions — how can you count averted frauds? — so it’s all too easy to assume securities litigation and SEC enforcement don’t stop corporations from misbehaving.

But a new working paper by a trio of economics number-crunchers concludes not only that SEC enforcement and class action litigation are both associated with “significant deterrence,” but also that “effective deterrence requires sustained SEC activity and litigation in the industry.” In other words, corporations are likeliest to stay out of trouble when both regulators and plaintiffs lawyers are policing their industry. “We were quite surprised by that,” said study co-author Simi Kedia, an economics professor at Rutgers Business School. “In academics, class actions aren’t very well regarded.”

Kedia wrote the paper, “The Deterrence Effects of SEC Enforcement and Class Action Litigation,” with Emory accounting professor Shivaram Rajgopal and University of Washington accounting Ph.D. candidate Jared Jennings. (I heard about it at the Harvard Corporate Governance website.) She told me it’s a working paper they’ve presented at a couple of conferences but are still planning to refine before submitting for publication.