A tale of two SEC cases
Juries are sometimes told that in the eyes of the law, all Americans are created equal. But if that‚Äôs the case, then why does the Securities and Exchange Commission‚Äôs treatment of former top Fannie and Freddie executives seem to be so much harsher than its treatment of Citigroup and its senior people for what appear to be similar infractions?
Recall that on Dec. 16, the SEC charged six former executives at mortgage giants Fannie Mae and Freddie Mac with fraud for not properly disclosing the companies‚Äô exposure to risky mortgages. In Fannie‚Äôs case, the SEC alleges that former CEO Dan Mudd and two other executives made a series of ‚Äúmaterially false and misleading public disclosures.‚ÄĚ The SEC says, for instance, that at the end of 2006, Fannie didn‚Äôt include $43.3 billion of so-called expanded approval mortgages in its subprime exposure and $201 billion of mortgages with reduced documentation in its Alt-A exposure. In Freddie‚Äôs case, the SEC alleges that while former CEO Dick Syron and two other executives told investors it had ‚Äúbasically no‚ÄĚ subprime exposure, they weren‚Äôt including $141 billion in loans (as of the end of 2006) that they internally described as ‚Äúsubprime‚ÄĚ or ‚Äúsubprime like.‚ÄĚ
There are some gray areas in the SEC‚Äôs case. Start with the fact that there is no single definition of what constitutes a subprime or Alt-A loan, or as Mudd said in a speech in the fall of 2007, ‚Äúthe vague, prosaic titles that pass for market data ‚ÄĒ ‚Äėsubprime,‚Äô ‚ÄėAlt A,‚Äô ‚ÄėA minus‚Äô ‚ÄĒ mean different things to the beholders.‚ÄĚ In Fannie‚Äôs 2006 10(k), Mudd noted that apart from what Fannie was defining as subprime or Alt-A, the company also had ‚Äúcertain products and loan attributes [that] are often associated with a greater degree of credit risk,‚ÄĚ like loans with low FICO scores or high loan-to-value ratios. And in a letter to shareholders in 2006, Mudd noted that ‚Äúto provide an alternative to risky subprime products, we have purchased or guaranteed more than $53 billion in Fannie Mae loan products with low down payments, flexible amortization schedules, and other features.‚ÄĚ These are the very holdings that the SEC says should have been disclosed as subprime exposure.
The SEC‚Äôs case on the Alt-A mortgages is equally tricky. As blogger David Fiderer points out, ‚Äúreduced documentation” can refer to a loan for which the borrower proves his income with a W-2 for last year in addition to a 1040 for the previous year. Or “reduced documentation” can refer to a “stated income/stated asset” loan, otherwise known as a liar loan.‚ÄĚ As of September 2008, the default rate on the loans that the SEC says Fannie should have labeled Alt-A was less than a third of the default rate on those Fannie did call Alt-A. In other words, you could argue that if Fannie had mixed those two groups of loans together, thereby lowering the reported default rate, the company could have been criticized ‚ÄĒ or possibly even sued ‚ÄĒ for making the default rate on its Alt-A loans look artificially low.
Be that as it may, the SEC, which has been under fire for not being aggressive enough, brought its charges. ‚ÄúFannie Mae and Freddie Mac executives told the world that their subprime exposure was substantially smaller than it really was,‚ÄĚ said Robert Khuzami, director of the SEC‚Äôs Enforcement Division, in the press release. ‚ÄúThese material misstatements occurred during a time of acute investor interest in financial institutions‚Äô exposure to subprime loans ‚Ä¶ all individuals, regardless of their rank or position, will be held accountable for perpetuating half-truths or misrepresentations about matters materially important to the interest of our country‚Äôs investors.‚ÄĚ
The companies themselves entered into non-prosecution agreements and agreed to cooperate with the SEC‚Äôs litigation against the former executives. (The SEC said it ‚Äúconsidered the unique circumstances presented by the companies‚Äô current status,‚ÄĚ meaning that because the companies were wards of the state following the government takeover in the fall of 2008, it wasn‚Äôt in taxpayers‚Äô best interests to go after them.) The SEC didn‚Äôt charge any of the more junior employees who were presumably involved in the actual drafting of the disclosures. But the SEC is throwing the book at the former executives, charging them with securities fraud ‚ÄĒ its most serious charge ‚ÄĒ and seeking financial penalties plus a bar on any of the six serving as an officer or director of a publicly traded company. It‚Äôs one of the harshest treatments of big corporate executives in the aftermath of the financial crisis.
Just weeks earlier, a judge in New York had thrown a wrench in another SEC proceeding. Judge Jed Rakoff refused to approve a settlement in which Citigroup (or rather, its shareholders) would have paid $285 million to settle SEC charges that the bank misled investors when it sold a $1 billion subprime CDO, made itself a profit of about $160 million and cost investors about $700 million. The charge involved only negligence, not fraud. In his rejection of the settlement, Rakoff wrote: ‚ÄúIf the allegations of the Complaint are true, then Citigroup is getting a very good deal; even if they are untrue, it is a mild and modest cost of doing business.‚ÄĚ Separately, the SEC filed a complaint against a former Citigroup employee named Brian Stoker, who the SEC describes as ‚Äúprimarily responsible‚ÄĚ for the deal‚Äôs marketing documents. Stoker was charged with fraud ‚ÄĒ but Stoker was a relatively junior guy.
That attempted settlement, though, isn‚Äôt the only deal the SEC has cut with Citigroup. In 2010, Citigroup‚Äôs shareholders paid $75 million to settle charges that Citigroup ‚ÄĒ get this ‚ÄĒ misled investors over its exposure to risky mortgages. According to the SEC, Citi repeatedly told investors that its exposure was only $13 billion and declining, when in reality it was more than $50 billion and not declining. Citi neither admitted nor denied the charges, as was the standard convenience afforded to companies until Judge Rakoff began to derail the settlement machine.
There is probably gray in the Citi complaint as well, but at least on the surface, it‚Äôs harder to find. The allegedly undisclosed exposure consisted of ‚Äúsuper senior‚ÄĚ tranches of subprime mortgage-backed securities (the stuff that was supposed to be really safe, but wasn‚Äôt) and ‚Äúliquidity puts‚ÄĚ (which required Citi itself to buy outstanding commercial paper that was backed by subprime mortgage-backed securities if the paper couldn‚Äôt be sold to investors). According to the SEC‚Äôs complaints, Citi executives didn‚Äôt feel they had to disclose these exposures because they felt the risk of default was low. Yet by the fall of 2007, Citi had had to buy ‚Äúsubstantially all‚ÄĚ of the $25 billion in commercial paper and had started taking losses on the super-seniors. Even then, Citi still didn‚Äôt disclose its exposure, but rather bundled these losses in with others. According to the SEC, ‚Äúsenior management was aware‚ÄĚ that the super-senior tranches were a source of the losses, but the company ‚Äúnevertheless continued to exclude‚ÄĚ the additional exposure. Only on Nov. 4, 2007, did Citi issue a press release in which it acknowledged the existence of this junk ‚ÄĒ and the after-tax losses of $5 billion to $7 billion it would have to take as a result of all of its subprime exposure.
In its own press release announcing the settlement, the SEC summed it up this way: ‚ÄúEven as late as fall 2007, as the mortgage market was rapidly deteriorating, Citigroup boasted of superior risk management skills in reducing its subprime exposure to approximately $13 billion. In fact, billions more in CDO and other subprime exposure sat on its books undisclosed to investors,‚ÄĚ said Khuzami. ‚ÄúThe rules of financial disclosure are simple ‚ÄĒ if you choose to speak, speak in full and not in half-truths.‚ÄĚ Added Scott Friestad, the associate director of the SEC‚Äôs Enforcement Division: ‚ÄúCitigroup‚Äôs improper disclosures came at a critical time when investors were clamoring for details about Wall Street firms‚Äô exposure to subprime securities.‚ÄĚ
In addition to the fine paid by Citi‚Äôs shareholders, the SEC gave two executives, Citi‚Äôs former CFO, Gary Crittenden, and its former head of investor relations, Arthur Tildesley, light slaps on the wrist for their roles in causing Citigroup to make the misleading statements. Crittenden and Tildesley agreed to ‚Äúcease and desist‚ÄĚ from anymore violations of the securities laws, and they paid $100,000 and $80,000, respectively. That‚Äôs a far cry from being charged with fraud and being barred from serving as an officer or director of a publicly traded company. Neither man admitted or denied the charges. Tildesley continued to work at Citi.
The SEC doesn‚Äôt comment on enforcement cases. But it might be worth noting that the Citi charges came at the end of a settlement process, whereas the charges against the Fannie and Freddie executives might be just the beginning of a process that could end in something far less extreme than fraud charges. Nor is the SEC a monolithic agency, meaning that there may not be any coordination between the teams in charge of each case. And there could, of course, be differences between the cases that can‚Äôt be gleaned from the surface of the complaints.
Still, given the leniency seemingly accorded Citigroup‚Äôs people, it‚Äôs hardly surprising that some would charge that Citi received special treatment. In fact, the SEC‚Äôs Office of the Inspector General investigated an anonymous complaint that there were ‚Äúserious problems with special access and preferential treatment‚ÄĚ in the Citi affair. While the OIG did not find that that was the case, its redacted report still offers insight into the vagaries of the SEC‚Äôs process.
Most notably, Tildesley had agreed to settle to a lesser charge of fraud than that faced by the former Fannie and Freddie executives ‚ÄĒ but it was still fraud. Crittenden, however, wouldn‚Äôt settle. After SEC officials had meetings not just with Crittenden and Citi‚Äôs lawyers but even one in which Dick Parsons, Citigroup‚Äôs then-chairman, ‚Äúmade a personal pitch,‚ÄĚ the SEC agreed to the slap on the wrist for Crittenden. So Tildesley‚Äôs settlement was changed to match Crittenden‚Äôs. The SEC enforcement staff had notified other individuals that it planned to recommend charges against them, the report said, but their identities are blacked out, and the non-redacted text doesn‚Äôt explain why those individuals weren‚Äôt charged. But an unidentified SEC official testified that Citigroup was ‚Äútrying to use whatever leverage they had … to get us to … lay off the individuals.‚ÄĚ
These days, Fannie and Freddie, far from having any ‚Äúleverage,‚ÄĚ are political punching bags. And they deserve to be punched: The companies were disasters. In the wake of a crisis the magnitude of the one we experienced, it‚Äôs also probably better that the SEC is too aggressive, rather than not aggressive enough. But above all, the SEC has a duty to be fair. Which means making sure that there can‚Äôt even be the perception that a company‚Äôs ‚Äúleverage‚ÄĚ influences the treatment accorded its employees.