Cops on the Beat: Measures Taken to Enforce Bailout Regulatory Changes and Prevent Fraud

December 2008

IN THIS ISSUE

— Taking on Frauds, Politicians and Other Undesirables: Enacting the Bailout’s Regulatory Changes
— “How Costly Hidden Risk Can Be”: Efforts to Protect Investors
— In the next issue

GREETINGS!

Welcome to the December 2008 edition of our newsletter! In this issue, as a tumultuous 2008 draws to a close, we’ll examine what the investigative and enforcement agencies charged with overseeing the new regulations of the bailout have done since it became law.

TAKING ON FRAUDS, POLITICIANS AND OTHER UNDESIRABLES: ENACTING THE BAILOUT’S REGULATORY CHANGES

It’s a simple axiom of American life: there is no way to regulate or out-legislate human ingenuity. The same drive and talent that has fueled so many legitimate enterprises also motivates fraudsters and unscrupulous actors of all kinds. When the intellect of the average American is geared towards nefarious ends, it can be a very difficult obstacle to overcome. What can regulators and law enforcement officials do?

The true answer to that question is an ever-evolving one, and this process is made more fluid by the crisis-level situation America finds herself in today. In an atmosphere of unrepentant fear, doubt and uncertainty, the natural advantage goes to the shyster looking to prey on those fears, whether in equity markets or mortgage refinancing. But regulators have several tools at their disposal to prosecute frauds that have occurred as well as preventing them from happening in the future.

“HOW COSTLY HIDDEN RISK CAN BE”: EFFORTS TO PROTECT INVESTORS

For even the most free-market thinkers, like Securities and Exchange Commission chairman Christopher Cox, the crisis has been a clarion call that market regulation is not always analogous to restraint of commerce. ” Investors have a right to know the truth – and the risks – about the securities that trade in our public markets,” he said in a statement. “Never in this agency’s history has this fundamental mission been more relevant, and more urgent. The current credit crisis has shown the importance of transparency to a healthy marketplace – and how costly hidden risk can be.”

To that end, the SEC has increased prosecutions and civil penalties regarding market manipulations, as well as massive settlements regarding the sale of “auction rate securities,” a lesser-known market that paralleled the subprime mortgage linked credit default swaps discussed in our last newsletter.

Other agencies have stepped up their efforts as well: in a recent speech to his board of managers, the head of the Office of Comptroller of Currency, John C. Dugan, said valuable lessons were learned regarding flaws in previous risk management systems. “CDOs backed by subprime mortgages were the prime example” of lax risk management, he said. “There, the triple A ratings for super-senior tranches lulled banks and their regulators into a false sense of security, notwithstanding the inherent risk of the underlying collateral. Some of the exposure was masked in off-balance sheet vehicles in ways that clouded the full extent of exposure for senior management, the Board of Directors, and us. Indeed, some senior bank management thought they had avoided subprime risk by deliberately choosing to avoid originating such loans in the bank – only to find out after the fact that their investment banks had purchased subprime loans elsewhere to structure them into CDOs. … The lessons to be learned from all this regarding complex instruments: too much reliance on triple A ratings; not enough transparency and risk aggregation; and too much tolerance for concentrations.” To that end, Dugan emphasized thorough evaluations of a bank’s viability in both the short and near terms, before the OCC would recommend closure of any institution.

Where does that leave your individual and corporate clients, who have been at risk as this process has unfolded? Perhaps still uncertain, but hopefully confident that the right people are starting to do the right things to help unravel the processes that helped create this mess. Retention of a fraud examiner to work with regulators making inquiries to your clients can bolster their confidence that they will navigate the changing landscape in the best manner possible.

IN THE NEXT ISSUE

In our January 2009 edition, we’ll look at the role fraud can play at companies that enter the bankruptcy and liquidation process.