Did MF Global Outwit Regulators and Prosecutors?

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A failure to bring criminal charges arising from the disappearance of $1.6 billion of customer funds from MF Global will be a damning indictment of the financial regulatory system in the United States.

We know this one basic fact: around $1.6 billion of MF Global's customers' cash went missing from their accounts in the days or weeks leading up to the bankruptcy of the firm. It has not been recovered. It probably never will.

The odds are that the money went out as loans or collateral for loans to MF Global counterparties. The MF Global executives who somehow tapped into customer funds to float their operations during the firm's liquidity crisis almost certainly expected they'd get the money back. They didn't really believe that the firm was going to die, that the money would be lost forever. In fact, the very act of tapping into customer accounts seems to indicate that they had a misplaced sense of confidence that they'd pull through this.

We also know the money isn't "gone." Funds do not vanish. They do not evaporate. They get transferred. Most likely, in this case, they were transferred to counterparties. Most likely to big creditors both in the U.S. and abroad. There are wire transfer records of these funds being moved. We can find out where they went.

But MF Global's customers may never be able to recover them. If the counterparties were unaware of the source of the funds, which they almost certainly were, then they have "clean hands" and it should be legally impossible for courts or regulators to demand that the funds be returned.

Requiring the return of the funds, in fact, could be worse for the public's interest in a robust financial system than the blow to confidence from the loss of the funds. If counterparties must investigate the sources of the collateral they are given for loans, many transactions will become impractical. The financial system will start to seize up as a new risk of collateral clawbacks is introduced.

The way to prevent this sort of thing isn't by going after MF Global's counterparties. It's by going after MF Global and its executives.

Over the past several years, I've been a big critic of criminalizing business failure. I thought going after Ralph Cioffi and Matt Tannin, the two men who ran the failed Bear Stearns hedge funds, was a mistake. I suspect that Ken Lay and Jeff Skilling were wrongfully convicted. I don't think Dick Fuld or Jimmy Cayne belong in jail. I've criticized criminalizing insider trading, back-dating stock options, and naked shorting.

So I've got a pretty good record of resisting popular urges to tar and feather businessmen.

But MF Global's apparent misuse of customer funds calls out for prosecution.

I am in nearly complete accord with Joe Nocera's thoughts on this (with the exception, as noted, of the case of Dick Fuld):

But is it really plausible that you can take $1.6 billion — nearly 25 percent of the customer assets under management — and not know you’ve used customer money? It is not. One theory, which is implicitly suggested in the trustee’s report, is that the executives “borrowed” the money thinking they would be able to replace the funds quickly, which they then couldn’t because the counterparties wouldn’t give back the collateral. That’s still a crime.

I understand that bringing complex financial cases in front of a jury is not easy. But what prosecutors don’t seem to understand is that the country needs them to bring these cases. When they took a pass on Angelo Mozilo, the former chairman and chief executive of Countrywide, and Richard Fuld, who was chief executive of Lehman Brothers when it went bankrupt, they sent a signal that the highly paid executives who gave us the financial crisis would not be held to account.

A failure to prosecute anyone at MF Global would be, if anything, even worse. It would mean that executives at a broker-dealer can indeed steal customer money and get away with it — so long as it was “unintentional.” And it would only deepen the cynicism so many people feel about government. I’ve heard it suggested, for instance, that the Justice Department won’t prosecute Corzine because it would hurt President Obama. (Corzine, the former governor of New Jersey, had been a big fundraiser for the president.) I don’t happen to subscribe to that theory, but I certainly understand why others might.

To be sure, it is early yet. Federal investigators are still digging into the facts surrounding MF Global’s failure, no doubt searching for that elusive smoking gun. But if, in the end, they decide they can’t make a case, I hope they understand what they are telling the rest of us. Giving the big guys a pass isn’t good for the financial markets. And it isn’t good for democracy either.

This brings to mind William Black's recent column on applying the Broken Window theory of crime prevention to business crime.

James Q. Wilson was a political scientist who often studied the government response to blue collar crime. The public knows him best for his theory called “broken windows.” The metaphor was what happens to a vacant building when broken windows are not promptly repaired. Soon, most of the windows in the abandoned building are broken. The criminals feel little compunction against petty destruction because the building’s owners evince no concern for the integrity of their building. Wilson took social norms, community, and ethics seriously. He argued that as community broke down fewer honest citizens were active in monitoring and policing behavior...

Taking Wilson’s “broken windows” reasoning seriously in the elite white collar crime context would require us to take a series of prophylactic measures to restore integrity and strengthen peer pressures against misconduct. Indeed, we have implicitly tested the applicability of “broken windows” reasoning in that context by adopting policies that acted directly contrary to Wilson’s reasoning. We have adopted executive and professional compensation systems that are exceptionally criminogenic. We have excused and ignored the endemic “earnings management” that is the inherent result of these compensation policies and the inherent degradation of professionalism that results from allowing CEOs to create a Gresham’s dynamic among appraisers, auditors, credit rating agencies, and stock analysts. The intellectual father of modern executive compensation, Michael Jensen, now warns about his Frankenstein creation. He argues that one of our problems is dishonesty about the results. Surveys indicate that the great bulk of CFOs claim that it is essential to manipulate earnings. Jensen explains that the manipulation inherently reduces shareholder value and insists that it be called “lying.” I have seen Mary Jo White, the former U.S. Attorney for the Southern District of New York, who now defends senior managers, lecture that there is “good” “earnings management.”

This is, in some ways, an important challenge to my view that we risk "over-criminalizing" business transgressions. Perhaps by not going after more of the marginal cases, for fear of deterring desirable risk-taking and innovation, we've created a crimogenic atmosphere that leads MF Global executives to believe they can loot their customer accounts.

But regardless of whether we should go after the broken windows on Wall Street, certainly we can all agree that we should go after the people actually exploding the vaults and running off with the cash.

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