In an earlier column, I wrote about the intersection of equal justice under the law and capitalism. The idea of fair bargain is central to a capitalist economy: Both the buyer and seller in any transaction must believe they fully understand the nature of the good being bought or sold (i.e. no fraud is involved). Since no one is omniscient, the remedy for bargains that the buyer or seller believes are unfair is legal enforcement. At the same time, both parties to the transaction must believe wrongdoing by either party will be enforced with equal vigor.
At the time, I referenced the SEC case against Citigroup and criticized the relatively small fine the SEC had imposed, suggesting it was evidence of a broader problem related to meaningful enforcement of the laws by the agency. As background, SEC settlements must be ratified by the court, and a central aspect of these SEC settlements is that defendants "neither admit nor deny the allegations." Rarely does the court fail to endorse an agreement proposed by the SEC, since it's the prosecuting party. Since then, the Citigroup case has received considerable attention, as U.S. District Judge Jed S. Rakoff rejected the proposed settlement, calling it "neither reasonable, nor fair, nor adequate, nor in the public interest." He both criticized the typical SEC "neither admit nor deny" form of settlement and called the SEC negotiated fine "pocket change" for Citigroup. Today, The Wall Street Journal indicated that the SEC enforcement division is expected to recommend to SEC commissioners that the Judge's decision be appealed.
These recent events beg a deeper look at the system of SEC enforcement. Why has the SEC apparently pursued such minimal settlements? The answers are surprising in that they reflect a wide discrepancy of views.
I found three very different explanations. But they all suggest that we have a broken system that must be fixed so that capitalism can operate properly.
First, the SEC enforcement division is underfunded and therefore lacks the resources to pursue a large number of complex trials. Critics say this reflects a deliberate effort by Congress, influenced by large financial institutions, to prevent punishment for malfeasance. If true, this suggests yet another example of how our largest financial institutions are preventing actual capitalism from functioning, often in ways that are not obvious.
Second, without the no admission of guilt clause, defendants would open themselves up to a stream of well-funded plaintiff actions based on admitted guilt and even risk bankruptcy. In essence, the proponents of this explanation suggest SEC fines are considered a cost of doing business, but if injured customers have an adequate chance of redress then the punishment will more closely relate to the injuries caused by the illegal actions involved and this worries the banks. Judge Rakoff's opinion sharply criticized the settlement in this regard, indicating it "depriv[ed] the pubic of ever knowing the truth in a matter of obvious public importance."
Third, it can be explained by the revolving door, where former SEC enforcement officials are "going to work for the very same firms they used to police." Top SEC enforcement officials represent some the clearest examples of people who move out of government to high paying jobs in the private sector. This has a chilling effect on the efficacy of SEC efforts related to the largest, most powerful institutions. If true, we need to find a fair system that will both attract talent to the SEC but prevent this phenomenon.
There are several implications to these different explanations for what is clearly a broken system. Without the deterrent effect of the credible threat of law enforcement, the financial services industry will continue its malfeasance. The additional deterrent effect of successful private lawsuits based on a pre-existing admission of guilt is lost when the SEC uses the no admission of guilt standard. This raises a central question: Is the SEC's role in our society to punish and deter malfeasance, or is it to help victims more easily recover losses resulting from misconduct? If it is the latter, then finding the actual truth of guilt or innocence would serve a strong societal interest.
Additionally, the knowledge that the SEC always settles suits will inevitably start to enter into the thinking of potential bad actors. Here again the deterrent effect is minimized. It becomes easy to imagine bad actors discussing an issue and saying, "What's the worst that could happen? We will settle with the SEC for far less than we will make on this deal and the details will never become public." Meanwhile, malfeasance by the financial sector has caused millions of people to suffer.
There are solutions to these problems. The Obama administration must insist on far more extensive funding for SEC enforcement. Then we need to remember the famous words of Justice Brandeis, who said, "We can have democracy in this country, or we can have great wealth concentrated in the hands of a few, but we can't have both." Perhaps, as recently discussed by The New York Times, it's time to reconsider the maximum size and concentration of power in our financial institutions, which seem to consistently interfere with the fair operation of capitalism.
Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.