Sunday, September 25, 2011

Hard Questions About State Sponsored Fraud

You can tell whether a man is clever by his answers. You can tell whether a man is wise by his questions.- Naguib Mahfouz Egyptian writer who won the 1988 Nobel Prize for Literature

Several weeks ago I asked the question of whether we need to be concerned about the problem of state sponsored fraud.  The Oxford English Dictionary (OED) defines the word “sponsor” to mean “To promote and support.”  The OED defines promote “To advance the interests of, move to a stronger or more prominent position.”  The OED defines support to mean “To endure without opposition or resistance” or “tolerate.” 

Thus the terms state sponsored fraud means actions by government officials that promote or support fraud.  It includes such actions that advance the interests of fraudsters that move fraudsters to a stronger or more prominent position.  It also includes actions by government officials who endure fraud without opposition or resistance.   

State sponsored fraud can also be said to include fraud practiced or permitted by a government against its own people or against others in foreign countries. It includes the calculated use of fraud against civilians to obtain financial goals.  Fraud includes misrepresentation, concealment, dishonest business or government services, corrupt campaign contributions, and fraudulent schemes.

We are living through an unprecedented era of massive fraud.  What makes today so troubling is not the existence of fraud but our failure to cleanse and recuperate from it after it was discovered. "Inside Job" director Charles Ferguson was right when he began his Academy Award acceptance by reminding the audience: "Forgive me, I must start by pointing out that three years after our horrific financial crisis caused by financial fraud, not a single financial executive has gone to jail, and that's wrong." 

A catalog of actions by government officials raises the question of whether we have state sponsored fraud in the United States.  I reach no conclusions but ask only the question of whether what follows raises any concerns that fraud is state sponsored in the US:

1 The Federal Reserve Bank:

In 2008 the Federal Reserve Bank of New York provided banks over $80 billion for collateral debt obligations and residential mortgage backed securities without conducting a fraud investigation despite widespread reports of fraud.

2. United States Supreme Court

A.  Honest Government and Corporate Services Law 

The Supreme Court ruled that a key manager at Enron Jeffrey Skilling could not be prosecuted for dishonest corporate services.  The Supreme Court refused to find that undisclosed self-dealing by a public official or private employee -- i.e., the taking of official action by the employee that furthers his own undisclosed financial interests while purporting to act in the interests of those to whom he owes a fiduciary duty" was criminal.  The Supreme Court referred to such conduct as “a mere failure to disclose a conflict of interest.”  The Supreme Court ruled that only if bribes and kickbacks were covered.  The Supreme Court said that "ambiguity concerning the ambit of criminal statutes should be resolved in favor of lenity." The Court said that honest-services fraud does not encompass conduct more wide-ranging than the paradigmatic cases of bribes and kickbacks.  The Supreme Court said it needed a clear instruction from Congress to rule otherwise. 

The Supreme Court said that "If Congress desires to go further," we reiterate, "it must speak more clearly than it has." The Congress has not acted. See, Skilling v. United States Supreme Court 130 S. C. 2896, 2933 (2010)
B.  Aiding and Abetting Securities Fraud 

The Supreme Court found in 1994 that the Securities Fraud statute § 10b of the 1934 Securities & Exchange Act does not extend to aiders and abettors of fraud. The Supreme Court’s rationale: “to allow the aiding and abetting action the defendant could be liable without any showing that the plaintiff relied upon the aider and abettor's statements or actions.”  The Court said that allowing plaintiffs to circumvent the reliance requirement would disregard the careful limits on 10b-5 recovery mandated in its earlier cases. Central Bank of Denver, N. A. v. First Interstate Bank of Denver, N. A., 511 U.S. 164, 191, (1994)

C. Fraudulent Securities Scheme

The Supreme Court ruled that participation in a fraudulent securities fraud scheme could not be prosecuted under federal securities fraud law. In this case the defendant could not have perpetrated the fraud absent the knowingly fraudulent actions by the defendant participating in the fraud.  Nevertheless, the Supreme Court ruled the aider and abettor was not liable because its actions “took place in the marketplace for goods and services, not in the investment sphere.”  The Court said in these circumstances the investors cannot be  said to have relied upon any of respondents' deceptive acts in the decision to purchase or sell securities; and as the requisite reliance cannot be shown, respondents have no liability. See, Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 167-168.

D. Unlimited Corporate Campaign Contributions 

The Supreme Court also prohibited Congress from restricting corporate campaign contributions.  The Supreme Court ruled restricting corporate campaign contributions violated the First Amendment because it would fine or jail citizens, or associations of citizens, for engaging in political speech.  The Court said that all speakers, including individuals and the media, use money amassed from the economic marketplace to fund their speech, and the First Amendment protects the resulting speech. The Court said the prevention of corruption was not a sufficient reason to limit corporate expenditures.  Citizens United v. Federal Election Commission, 558 U.S. __ (2010)       

E. No Public Financing for Political Campaigns 
           The Supreme Court also did away with public financing of elections.  In 2011 the Court struck down Arizona’s public campaign financing law.   The Court again found that Arizona’s public financing scheme violated the First Amendment. Arizona Free Enterprise Club’s Freedom Club Pac v. Bennett _ U.S. _ (2011)

3. United States Congress 

A. Repeal of FDR Banking Act of 1933 (Glass Stegall Act)

The Banking Act of 1933--forever known as Glass-Steagall in recognition of its sponsors, Senator Carter Glass and Representative Henry B. Steagall-- required banks to spin off or shut down their brokerage and investment operations. These operations had lost huge sums in the 1929 stock market crash and in the early years of the Depression. The banks, for example, would underwrite corporate stock offerings, and if they had trouble selling the stock they would buy it with money drawn from depositors’ accounts, sometimes without a depositor’s knowledge.

The restrictions imposed by Glass-Steagall kept bank deposits, and banks themselves, at a safe distance from the markets. The distance gradually shrank in the heady, free-market days of the late 1990s.  In 1999, Glass-Steagall itself was formally revoked with the passage of the Gramm-Leach-Bliley Act.

So commercial banks — the big ones, at least — returned to the Wall Street marketplace. This time they got into trouble by engaging in proprietary trading — that is, the buying and selling of securities for their own account, particularly subprime mortgages packaged as bonds. When that market crashed in 2008, the federal government bailed out the banks, and now the president is asking Congress to bar banks from proprietary trading.

Congress refused to reenact the Glass-Steagall Act because of the domination of the Congress by banking lobbyists. 

B. Raising Fraud Pleading Requirements While Reducing Access to Discovery  

In 1995 former SEC Chairman then an Orange County, California Congressman authored a bill that made it so hard to bring a securities fraud case in federal court so that many valid cases were dismissed. The new law was called the 'Private Securities Litigation Reform Act of 1995' (PSLA).

Under the PSLA any private action in which the plaintiff alleges misrepresentations or omissions the complaint must specify each statement alleged to have been misleading, and the reason or reasons why the statement is misleading.  The complaint must also with respect to each act or omission alleged to violate this title, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

While the law requires strict pleading requirements it prohibits plaintiffs from obtaining the facts needed to satisfy the pleading requirements because discovery is stayed until after any motions to dismiss are resolved. 

C. Prohibiting Securities Fraud Cases in State Court  

In 1998 the Congress passed the “Securities Litigation Uniform Standards Act of 1998" (“SLUSA”) This law prohibits any securities fraud case against a “covered” security.  A covered security is one issued by the nation’s largest corporations.  This law directly protects large corporations from suit in state court even if they commit securities fraud in those states.  


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