Getting Serious About Sanctions-Busting Banks

Roy C. Smith and Ingo Walter

(Wall Street Journal,  June 27, 2014)

BNP Paribas is expected any day to admit to criminal violations of U.S. sanctions against Iran and Sudan. This is likely to mean that the giant French bank will pay a fine of between $8 billion and $10 billion to the U.S. government, dismiss several executives, and temporarily cease its dollar-clearing business. The case has dramatically elevated the liability of global banks to the regulatory enforcement of U.S. law.

Trade and financial sanctions have long had a place in international affairs—from the high-profile sanctions applied to South Africa under apartheid to their increasing use as a substitute for military intervention in countries including Iraq, Libya, Iran, Cuba, Sudan and most recently Russia, where they are pending. They’ve attempted to discourage countries from building nuclear weapons, abuse human rights or invade their neighbors. Such sanctions, however, have been controversial because they have appeared to lack the cohesion and determination of allies to make them work effectively.

The U.S. prosecution of a major international bank for evading sanctions has changed the game. BNP allegedly stripped out identifying information from wire transfers to disguise sanctioned countries as origins or destinations of international payments. By raising the cost of violating the rules to significant levels, the Justice Department has insured that U.S. sanctions will be complied with and effective.

Foreign banks and their home governments may or may not agree with the policies underlying the U.S. sanctions. But like it or not, in the dollar world U.S. law is the law. Banks around the world must comply or face consequences that have been escalating steadily since 2005. Banks including HSBC, ABN Amro, Standard Chartered, Lloyds, Barclays, Credit Suisse and now BNP have ponied up more than $20 billion to settle money laundering and tax evasion charges. The stocks of these banks also lost significant amounts of market value as a result of the settlements. BNP shares lost about 4% of their value after it was reported to be in settlement discussions.

More important than the size of the fines, however, is that the most recent lawsuits against Credit Suisse and BNP were brought under criminal, not civil, law. Technically the guilty plea by Credit Suisse was from a non-U.S. subsidiary that does not hold a U.S. banking license. But the two cases are warning shots. If a license-holding financial-services entity is convicted of a criminal offense, it may lose the right to do business in the U.S. The Justice Department reportedly sought the assurance of state regulators that admissions of guilt would not require the banks to surrender their licenses. But future cases might be handled differently.

Global banks today settle most of their trade and financial transactions in U.S. dollars. This is a large and profitable business for these banks, and one that it is necessary for them to service client transactions. They must have access to the U.S. clearing and settlement apparatus to conduct it.

Sanctions that restrict access to the dollar market can be very burdensome for targeted countries, particularly those with mineral resources that need to be sold abroad. Sanctions on countries like North Korea may have been ineffective, but those applied to Iran have been significant. Russia may be next, and because Russia depends on dollar-priced oil exports, it is vulnerable.

Russian President Vladimir Putin recently said he hopes to switch Russia’s enormous dollar trade in oil to Chinese yuan, in order to reduce the impact of financial sanctions. That may be difficult, since the yuan is neither convertible nor widely used as a currency for international trade.

Mr. Putin may assume he can find banks willing to help subvert sanctions via the yuan and drive wedges between the U.S. and more sympathetic European governments. But such banks would put at risk their U.S. business and their ability to undertake clearing other currencies for U.S. dollars. Beijing may also want to think twice before putting Chinese banks’ access to the dollar market at risk to help Mr. Putin.

Many bankers and lawyers believe that the Justice Department has applied its considerable powers unfairly against BNP Paribas. The lawsuits are against the shareholders of the banks, not individuals deemed to be responsible for the alleged misconduct. Fair or not, the case demonstrates how much power the government has when it wants to enforce its rules.

Several major U.S. banks, including Bank of America and Citigroup, are trying to avoid paying massive fines related to their sales of mortgage-backed securities, and, conceivably, might go to trial rather than settle. These cases are subject to civil law and their licenses to do business are not at stake.

Sanction and tax evasion cases are a different matter. U.S. banks have not been among the offenders, but some foreign banks apparently assumed they could get around U.S. sanctions with impunity. They haven’t. The Justice Department has made it clear it will use the criminal law to enforce the rules even when the banks’ government officials have attempted to intervene.

BNP Paribas shows that the U.S. can and will impose financial sanctions unilaterally in the dollar market without the broad agreement that is typically required for other international policy issues. By pursuing this case, the U.S. government has dramatically boosted the credibility of financial sanctions that banks around the world now need to take very seriously.

 

Busting the Sanctions Busters

Ingo Walter

It looks now like BNP Paribas will plead guilyy to a criminal violation of US payments sanctions and an accompanying $9 billion fine and temporary suspension from dollar clearing business - coming only a few months after the guilty plea by Credit Suisse to a criminal charge of aiding and abetting tax evasion - elevates the real-world exposure of financial institutions to US regulatory enforcement.

Like it or not, in the dollar world, US law is the law. Banks must comply or face severe consequences. Since 2005 they have been fined heavily to settle civil violations of US tax or money laundering laws. Some bankers and investors may consider this a cost of doing business, It becomes another matter entirely when the legal venue transitions from civil to criminal.

Trade and financial sanctions have long had a place in international affairs – from the high-profile sanctions applied to South Africa under Apartheid to their increasing use as a substitute for military intervention in countries like Iraq, Libya, Iran, Cuba, Sudan, and most recently Russia, where they are still pending. The objective is to encourage targeted countries not to build nuclear weapons or engage in human rights abuses or invade their neighbors. Sanctions are both serious and controversial. Serious because the alternative may be boots on the ground and people dying. Controversial because lack of international cohesion may undermine the effectiveness of sanctions and because it has not always been easy to tell whether they actually work.

One thing is certain: Evading sanctions can be a very profitable business. Money is made in imperfect markets, and sanctions can be an excellent source of market imperfections. The global arms trade, “conflict minerals,” smuggling, aiding and abetting tax evasion, and money laundering have long been growth businesses and there are well-developed, adaptable transaction conduits around the world to facilitate them. As long as there are sanctions there will be sanctions-busting.

So it is with “wire-stripping,” a practice in international financial transactions to falsify the origin or destination of international payments, often routed through multiple intermediaries – a form of money laundering without which evading trade and financial sanctions would be much more difficult and costly. The falsification has to be executed by one or more intermediary banks willing to engage in transactions that are illegal in one or more countries. Presumably the idea of banks collaborating in sanctions-busting must have been to turn the routine business of global transactions banking into a much more profitable activity by intentionally skirting the law. Was this the work of a few rogue employees or deliberate bank strategy?

In 2005, ABN Amro’s Dubai branch was tagged for fraudulently bypassing US controls of financial transactions with Iran and Libya. In agreement with the Dutch Central Bank, ABN Amro was subject to a cease and desist order, permitted the bank to enter a no-contest plea, and was fined €65 million plus €1 million clawed-back from the previous year’s bonuses earned by the bank’s Management Board. Acquisition of parts of ABN Amro by the Royal Bank of Scotland led to a further $500 million fine imposed on RBS in 2010, and continuing probes by the Federal Reserve and Department of Justice. The wheels of justice sometimes turn slowly, but they do turn.

In 2012, Standard Chartered was alleged to have engaged in $250 billion of wire-stripping through its New York branch, almost all of which management initially attributed to “clerical errors.” StanChart briefly fought the charges, but in the end settled for a no-contest plea, $667 million in fines and a humiliating in-person apology in Washington by senior management. Its shares dropped 15% on announcement of the money laundering charge.

As well, HSBC was fined $1.9 billion and ING $619 million in civil money laundering settlements, joined by Lloyds, Credit Suisse, Barclays and others. Did bankers decide not to take US law seriously, or were they oblivious to risk exposure that accompanies circumventing the rules? Not entirely. An e-mail from Standard Chartered’s US CEO to headquarters in London noted that the US wire-stripping inquiry had the “…potential to cause very serious or even catastrophic reputational damage to the Group and expose senior managers to criminal liability.”

BNP Paribas may be no better or worse than some of its competitors in its alleged wire-stripping activity, but the enormous cost of the settlement indicates that the goalposts have now shifted in several ways.

First, US authorities have greatly improved their ability, both unilaterally and in cooperation with other countries, to monitor international dollar transactions and detect violations.  They have the ability to subpoena bank records and email traffic in building cases against firms that break the law and possibly show “intent.”

Second, US authorities, both state and federal, have abundant political support for no-tolerance enforcement policies, and are willing to threaten withdrawal of operating licenses to do business. Lingering public resentment over the financial crisis and its consequences continues to provide plenty of political cover.

Third, the US Justice Department has elected to bring criminal charges against banks deemed to be less that fully cooperative in order to force them into compliance and acceptable behavior going forward. This is a powerful weapon, because any bank on the wrong end of a US criminal indictment will normally be forced to shut down. For the time being, this weapon remains in its holster, with key regulators agreeing not to pull the trigger and revoke US operating licenses of both Credit Suisse and BNP Paribas in their criminal guilty pleas.

Along the way BNP Paribas did itself no favors. It allegedly obstructed the US investigation. It put forward an “advice of counsel” defense that some of the wire-stripping was done outside the US and therefore was technically not illegal when the funds passed through US payment system. It argued that the fine was excessive compared with previous money laundering cases and would force the bank to raise capital, suspend dividends and defer expansion plans. And it engaged the big guns - including the President of France, the Foreign Minister and the Governor of the Banque de France - in its “Chicken Little” defense based on the systemic importance of BNP Paribas in Europe. Overhanging everything was the threat of damage to US-European and Franco-American relations, a theme taken up by the US Chamber of Commerce in support of lighter punishment. The Obama Administration stuck by its guns.

Credit Suisse may have been able to swallow its criminal tax evasion “guilty” plea and accompanying $2.6 billion fine with relative impunity -- at least according to CEO Brady Dougan, who suggested that CS’s criminal conviction would have “no material effect” on the bank’s business and that no management or board changes were contemplated. Investors seemed to agree, with CS stock up by 2% in an otherwise flat market. That is not the case with BNP Paribas, which lost heavily in market value and will sacrifice about 30 senior management positions in connection with the settlement. Nor will it be for future violators. 

Global banks today continue to rely on the dollar market, the world’s largest for trade and financial transactions. Sanctions that restrict access to this market can be very burdensome for targeted countries, particularly those with mineral resources that need to be sold abroad. Whereas sanctions imposed on countries like North Korea may have been relatively ineffective, those applied to Iran are thought to be quite significant. Russia is next, and because of its dependence on dollar-priced hydrocarbon exports is highly susceptible.

For its part, Russia has announced that it hopes to switch its dollar trade in oil to Chinese Yuan in order to reduce the impact of any US sanctions. That may be a naïve, since the Yuan is neither convertible nor widely used as a currency for international trade. Russia may assume it can find banks willing to help subvert sanctions via the Yuan and drive wedges between the US and more sympathetic European governments. How China will react when its own banking regulations are subverted is anybody’s guess.

The BNP Paribas case shows that the US can still impose and enforce sanctions unilaterally in the dollar market without the kind of broad international agreement required for trade treaties and banking regulations. And it has the ability and the willingness to detect and punish those who violate its laws, including denial of access to its financial market - something that no major international bank can endure. This may change in the future. But for now it is the reality.

Argentina Upsets the Restructuring Model, Again

 Roy C. Smith

The Supreme Court’s refusal on June 16^th to hear an appeal of lower court rulings upholding Argentina bond investors’ claims for payment has thrown a monkey wrench into sovereign debt restructuring, which for thirty years has been an important part of the international financial system.

The ruling, which entitles the hedge funds that bought defaulted Argentine debt to be paid full value, is actually a fairly narrow one. It applies only to Argentine debt issued under US law that was not exchanged in restructuring offers made by Argentina in 2005 and 2010. The lower courts held that under the “equal-treatment promise” inherent in US law, unexchanged “old” debt holders must be paid on their claims as long as “new” debt holders are being paid.

The hedge funds, which bought the bonds for pennies on the dollar at various times since 2001 have been very aggressive in pursuing their claims against Argentina. They have pursued activist strategies through litigation designed to force Argentina to buy back their bonds at a price approximating full value. Argentina’s president Christina Fernandez has repeatedly referred to them as “vultures,” and has insisted she will not pay “extortion” of as $15 billion in principal and accrued interest owed on the defaulted bonds. Since the Supreme Court’s decision, she will be forced to make payments on the held-back bonds if Argentina is to continue to pay on the rest of its debt.

Sovereign Immunity is Thrown Out

The ruling upset Argentina’s (and much of the rest of the world’s) expectation that the long-held notion of “sovereign immunity” would be upheld.

The highlights the difference between two classes of sovereign debt – those issued under local government laws with unquestioned sovereign immunity, and those issued under laws of established international financial jurisdictions such as the US and the UK, in which sovereign immunity had been presumed but not really tested.

Government debt issued under local laws is as sovereign as it can be – sovereign states are above the law. There is no bankruptcy law that applies to sovereigns, so creditors are stuck (as they have been since the Middle Ages) when they default and must accept whatever the sovereign offers in its effort to “restructure” the debt.

However, sovereign debt issued under US law, the Supreme Court has made clear, is hardly sovereign at all.  Creditors are entitled to the equal-treatment provision and may seek to discover and impound overseas assets of the defaulting government.

The Market Evolves

Prior to the 1980s, there was no market for bonds of Emerging Market countries because so many had defaulted in the 1930s and it took more than a decade to work out investors’ claims.

In the 1980s, many Emerging Market countries borrowed “petrodollars” from banks. This was money deposited in the banks by oil exporting countries after the four-fold price increase imposed in 1973. The price rise led to a world economic slowdown, and a shortage of foreign exchange that these countries needed to import oil. The banks, needing to lend out the petrodollars, offered Emerging Market governments dollar loans subject to US law. The countries, however, did not manage their finances well, and a decade later many of them defaulted.

During the 1980s, thanks to a plan designed by the US Treasury Department, banks could exchange their defaulted loans for new bonds issued by the countries that were collateralized by long-term zero-coupon US Treasury bonds. Because interest did not have to be paid until maturity, the bonds could be acquired at a very steep discount. The new collateralized bonds (called Brady Bonds after US Treasury secretary Nicholas Brady) were issued in exchange for the old loans, at a “haircut” (discount) of about 30% of the face value of the defaulted bonds. $70 of new bonds would be offered to replace $100 of old loans. The banks had already written the loans down to about that level.

As a relatively small group of international banks (not a bunch of hedge funds) were the loan holders, there were few holdouts that did not accept the terms of the exchange, though there were some. The countries were able to reduce the old debt on their books by 30%, to end their defaults and renew their access to markets. The new bonds traded actively and several went to premiums. Henceforth, market prices would reflect the economic conditions of the country, reflecting a probability of default.

After this, the market for Emerging Market sovereign debt expanded rapidly, and provided access to financing sources for dozens of countries they were quick to utilize.

After Brady Bonds

There were a number of defaults or near-defaults along the way that resulted in restructuring operations, in which the governments involved would offer new bonds to replace old ones. There was always a haircut in the process of between 30% and 40% depending on the market price of the old bonds at the time.

The exchange offers were always conditional on a minimum percentage of the old bonds being tendered for exchange. As most investors estimated the market value of the new bonds to be somewhat greater than the market value of the old, most were happy to participate in the exchange.

The net result was that exchange offers could reset a sovereign’s credit position, from bad to better, over a relatively short time period that would enable countries to regain access the markets quickly. The terms of the exchange would depend on negotiations between creditors and the governments, often with IMF oversight and endorsement. These would require some improvement in the economic and financial management practices of the countries. It wasn’t the same as a bankruptcy proceeding, but it had a similar effect. 

But some hedge funds thought they could do better by buying old bonds, often at discounts from their market prices, and not exchange them – in the hopes that they could negotiate quietly with the government to buy back the old bonds at a profit. This process might involve a few years of waiting, with no return on the bonds in the meantime, and some additional cost in litigation expense, but it they made enough nuisance they could expect to be bought out sooner or later. Many were.

Argentina Upsets the Norms

Argentina, however, upset things when in defaulted in 2001 on $90 billion of foreign debt, requiring the world’s largest restructuring. Argentina did not follow standard procedures of negotiating with creditors with IMF assistance. In 2004, it took a much more aggressive position, offering a 70% discount. It refused to accept a “traditional” discount of 30%; it wanted to maximize debt reduction in the exchange, which meant a much larger discount. The creditor committee, backed by the IMF, was furious but the market price of the outstanding old debt was about 30 percent of face value, justifying Argentina’s notion of a 70% haircut.

Seeing no better alternative, investors gave in; 75% of the bonds were tendered and the deal went through. There were a few hedge fund holdouts that figured that they could pressure the government into buying them out at a profit.

In 2010, Argentina offered the holdouts a slightly better deal, but the funds rejected this offer too. Instead, they increased their legal harassments, commencing the suit that was declined for review by the Supreme Court and suing to impound Argentine assets abroad.

Then Greece

Also in 2010, the sovereign bond market’s attention had turned to Greece, a member of the EU and therefore not generally considered an Emerging Market country. It was, nonetheless, in great financial difficulty following the global financial crisis that began in 2008, and in 2012 it needed to restructure its $200 billion outstanding foreign debt then trading at 30 cents on the dollar. The debt was not in default, but was getting close.

The Eurozone countries had already provided some assistance to Greece, but more was needed. Some thought they would ultimately bail out the debt, but others thought German reluctance to do so would prevent it.  In time there was a compromise – Greece would restructure its debt and do a number of other things to improve its financial position, and the Germans would go along. The exchange offer involved new bonds supplemented by a note of the European Financial Stability Fund and that package was determined to have a net present value of 70% of face value (but the cash vale was more like 55%.

But the Greeks realized that even with the EFSF note, the exchange might not meet the 75% minimum exchange that was required, so the parliament enacted a law that added a retroactive “collective action clause” (CAC) to outstanding debt issued under Greek law. As an EU and Eurozone member country, Greece had been able to issue most of its debt under Greek law. A collective action clause provides that if a supermajority of the bonds held are voted in favor of some action affecting all the bonds, the majority may bind the minority to accept the action. Naturally investors do not like CACs, so most Emerging Market sovereign bonds don’t have them.

Doing this retroactively, of course, is contrary to the law just about everywhere, but in Greece, sovereign immunity would prevent contesting it. As a result, the exchange offer went through. Tellingly, the Greek government later bought out at 100% of par value a small portion of Greek debt issued under UK law rather than face a lawsuit in the UK similar to the ones that the hedge funds were pursuing against Argentina in the US.

Argentina in a Bind

The Supreme Court’s action puts Argentina in a bind. In order to continue paying principal and interest due on its previously restructured bonds, it must make similar payments on the old bonds, which Argentina claims would amount to $15 billion. It floated a scheme to force a conversion of restructured bonds (issued under US law) to new bonds issued under Argentine law, but doing so would not escape the US lower court rulings. Defying these would expose Argentina to having government assets held in the US and elsewhere being impounded.

For the Future

The significance of the Supreme Court’s action is that future Emerging Market sovereign debt restructurings have been made more difficult and expensive, and investors are now more aware of the difference between US and local law and will be reluctant to give up the added protection of US law which substantially limits sovereign immunity

It also should result in sovereigns insisting on including CACs in their loan agreements to be sure they can eliminate holdouts in any future restructuring. For now, anyway, while interest rates are low they should be able to do so as the market for high yield Emerging Market sovereign debt is hot. When markets are hot, investors agree to almost anything.

Are Major Banks Really Too Big to Jail?

Ingo Walter

It used to be that financial institutions indicted on a criminal charge went out of business long before they had their day in court in a proper jury trial, which is their right. Instead, clients and employees would flee and regulators would be forced to withdraw their operating licenses. Unlike individuals convicted on a criminal charge, this is as close as things ever came to jailing an institution. Not anymore.

By sowing fear and intimidation among its regulators and law enforcement officials - based entirely on its own vulnerability to punishment - the Credit Suisse pleaded guilty to a criminal offense and emerged as a convicted felon clean as a whistle, with no apparent effect on its business, its management or its shareholders.

Having confessed to one count of criminal fraud, CEO Brady Dougan told a press conference on May 20^th he didn’t think there would be any effects on the bank – no “material impact on our operations or capabilities.” There was the small matter of $2.6 billion in fines and penalties, but he said that could be earned back by the end of the year and wouldn’t affect the bank’s regulatory capital. No serious changes in strategy. No senior management changes. No discernible boardroom reaction. No client defections. No investor flight. Just business as usual. Credit Suisse stock in Zurich was up 2% on the day in an otherwise flat market.

Except for some media commentators, nobody seemed to care very much. The corporate-speak wordsmiths trotted out the importance of “putting the matter behind us.” Life goes on.

We like to think market discipline works. Corporate boards are supposed to be serious guardians of long-term shareholder value and oversee to the best of their ability and judgment the “market-economy trinity” that drives it – revenue growth, cost control and risk management. When things like market share losses or operating inefficiencies or excessive risk exposures pose a threat, directors presumably agitate for corrective action and in extreme cases change the management. Most shareholders in turn rely on institutional investors to watch out for their interests and vote their proxies. So owners ultimately depend on both asset managers and boards to do their jobs properly – the so-called “double agency” problem.

Especially in the case of large “systemic” financial institutions, regulators have an additional voice in corporate governance. They are supposed to represent the public interest and protect the taxpayer, the ultimate guarantor of financial system integrity. If the taxpayer must bear the risk, the taxpayer must have a voice. So the CS case can be considered a remarkable quadruple governance failure - the management, the board, institutional investors and the regulators. But if nobody really does care it may not be a failure at all, just a new chapter in the rules of the game.

At the other end of the spectrum, people worried about integrity of the financial system may consider the CS case a serious challenge to the institutional underpinnings of the liberal market system. Credit Suisse stood accused, certainly not alone, of aiding and abetting tax evasion (not tax avoidance) by tax residents of the United States, a country that taxes income earned globally and considers willful tax misreporting a criminal offense. Unlike its rival UBS, which settled civil charges of aiding and abetting tax evasion with the IRS back in 2010 - in a proceeding that included a $780 million fine and release of client information approved by the Swiss government. CS was late to the party. It had already been charged by the time a 2013 agreement was reached to extract “voluntary” disclosures and settlements with other Swiss banks that are now being individually negotiated.

As well, CS stood accused of obstruction and failure to cooperate with US authorities in their investigations (never a good idea), while two of its employees had already pleaded guilty to criminal charges and six more cases were pending.  

Obstruction, conspiracy, evasion ... these are not good words, especially after politically charged remarks by US Attorney General Eric Holder that criminally prosecuting systemically important financial institutions may impossible due to the unacceptable economic risk of their own demise – and voilá, the now famous term “too big to jail” was coined. Right after the CS guilty plea, Holder somehow concluded: “This case shows that no financial institution, no matter its size and global reach, is above the law.” Really?

The Credit Suisse case breaks new ground on the slippery slope of accountability failures in the financial sector since the effective end of criminal prosecutions (subject to appropriately high standards of culpability) in cases like Daiwa Bank, Drexel Burnham and Arthur Andersen, firms which apparently were not considered “systemic” or immune from criminal prosecution at the time. All disappeared.

Each of these firms’ collapse involved significant damage to their stakeholders. But it’s a good guess that the thousands of talented, loyal and honest employees who lost their jobs soon found new ones, and for many it was the best thing that ever happened to them. Competitors quickly circled to take advantage of a golden opportunity to recruit. The market for talent actually works. Financial functions are immortal. Financial firms are not. 

Like Voodoo, the concept of “too big to jail” is probably nothing more than a myth. But like Voodoo, though, it is a powerful one. Over the years has deflected regulatory enforcement into produced a waterfall of civil suits against prominent financial businesses. Most of the time they ended in negotiated “no contest” pleas, combining hefty fines and “deferred prosecution” agreements. Allegations of overzealous prosecutors extorting settlements from targeted banks were balanced by lots of repeat offenders - to the point that expected litigation costs now seem to be routinely provisioned in bank financial statements and operating budgets, just like any other costs, and have become part of the business model. Financial analysts and investors don’t appear to see anything unusual about litigation costs, and get nervous only when they turn out to be eye-watering.

Looking for the good news? Even with all the fault-lines in internal and external governance, there is a last line of defense - the threat to a firm’s reputational capital. But banks and other financial firms that require trust and confidence to operate presumably have valuable reputations at stake. First-rate clients prefer to deal with first-rate banks, so serious losses in reputational capital ought to be reflected in the share price. This in turn ought to catch the attention of management, boards, investors, and ultimately regulators.

Studies of the stock price impact of reputational losses have in fact shown that there are serious and immediate share-price effects triggered by an array of negative reputational events. In one study these averaged 7% of market capitalization. Still, reputations can be reestablished over time, and there’s no way of estimating the longer-term consequences. In an industry where the long term is often after lunch, stakeholders may not care very much about reputations - even in criminal cases - as long as they remain “fit and proper” to do business, which means that  exemptions from regulatory decertification have to be negotiated in advance.

The Credit Suisse case is a feat of superb lawyering and regulatory acrobatics, vaulting substance and plain old common sense. It probably spells the end of “mortality” of systemic financial firms. It puts the last nail in the coffin of holding entire firms accountable by inflicting meaningful pain in hopes of changing behavior in an industry where violations are often “industry practice” rather than firm-specific aberrations.

So what’s the other good news? Cumulating outrange among a long-suffering and already testy public almost six years after the financial crisis with little apparent improvement in the conduct of financial firms raises the likelihood that in the next round of transgressions the focus will be on individuals rather than firms themselves – including officers and directors. Real people must have made decisions that led to prosecutable criminal behavior. Even in the organizational labyrinth of global financial conglomerates, meetings were held and people took positions, and in the end they can be traced. Those who are tagged for committing or conspiring in criminal violations will have to face due process, and most likely will be hung out to dry by their employers. In criminal cases, the recent Credit Suisse outcome suggests this may be the only way to go.

Prosecuting Banks May Be Great Politics But It Is Lousy Economics

Roy C. Smith

The action of the US Justice Department against BNP Paribas and other foreign banks is not, as some in Europe think, a protectionist effort – US banks have suffered even more.

In fact, it is an exercise in political showboating that started 15 years ago.

In 1999, when Eric Holder was Bill Clinton’s Deputy Attorney General, he wrote a memo on “Bringing Criminal Charges Against Corporations”. It set standards for Federal prosecutors when considering charges against large corporations for which normal civil penalties seem insufficient.

Until then, corporations had been charged with criminal offenses only if their actions were deemed to be a “criminal enterprise” – something so corrupted by management that it was the same as racketeering.

Holder’s idea was that boards should be responsible for avoiding criminal actions and for co-operating with the Justice Department in its investigations. His memo has been amended by successors, to ease the conditions of full co-operation, but retains the threat of criminal indictment for insufficient co-operation. It puts a lot of power in the hands of politicians. It played its part in the collapse of Enron and its auditor Arthur Andersen, which exoneration came too late to save.

When the financial crisis occurred, the banks were vilified and Holder was back as Attorney General. President Barack Obama was under a lot of pressure to show that he was tough on them.

Much of the damage they experienced was due to mark-to-market write-offs, as opposed to fraud or criminal misconduct. No culpable senior executives could be found to indict. But the public wanted someone to blame, or it would blame the government.

So Holder came up with civil (not criminal) fraud indictments, not of top-level individuals who would have fought the charges, but of corporations, which almost assuredly, after Arthur Andersen, would not. Goldman Sachs, then Bank of America and JP Morgan Chase, succumbed to what looked like shakedowns for corporate offenses to which no senior individuals were linked. They paid about $25 billion in settlements, fines and legal fees.

That was a lot, but not enough for many bank critics who still wanted bankers to be jailed.

So the new chair of the Securities and Exchange Commission, Mary Jo White, a former federal prosecutor, said she would seek admissions of guilt from banks that had agreed to settle. Despite the banks’ concern that stakeholder litigation would ensue, some such admissions were obtained.

Even that was not enough to satisfy the authorities. So in May, Holder gave his “banks are not too big to jail” speech, which presumably meant that banks as corporations would be charged with criminal offenses.

Criminal Charges

The next bank on the legal assembly line was Credit Suisse, seeking to settle a long-standing tax-evasion case. Here the Justice Department, which had already indicted eight employees (though no senior managers), decided to seek a guilty plea. A settlement for $2.6 billion was agreed, plus a meaningless criminal admission of guilt by a non US subsidiary of the bank.

Credit Suisse chief executive Brady Dougan said the settlement would have no material adverse effect on the bank, and it would replace the lost capital with asset sales and other measures. Holder claimed victory, but he probably could have got the same or even more from a civil case.

Now BNP Paribas is being pushed to pay $10 billion to settle criminal charges that it abused US money-handling rules for clients in Iran and other sanctioned countries. The charges are similar to those settled for $1.9 billion by HSBC in 2012, but that case was civil, not criminal.

Whatever its political appeal, the stream of high-profile legal actions by US political officials is destabilizing to the banks, and largely unfair. They reduce bank capital when regulators want it increased. Further, the uncertain, almost whimsical, nature of banks’ exposure to government litigation makes investors question their creditworthiness – never good in a bank. Further still, the penalties are assessed on the shareholders of the banks, not on executives, who should be prosecuted if there is evidence.

It is time to end this form of symbolic litigation and let banking get back to normal. Economic recovery depends on it.

Published in eFinancial News, June 2, 2014