Judge Jed Rakoff, who sits on the Federal District Court in Manhattan, has been extremely busy since the financial crisis. He has presided over the two most high profile insider trading cases – Goldman Sachs director, Rajat Gupta, and Raj Rajaratnam of Galleon Group – the “Tiger Woods” of insider trading. In 2011 Judge Rakoff sent ripples throughout the financial community when he rejected a $285 million fraud settlement between the SEC and Citigroup that included boilerplate language that Citigroup “neither admits to nor denies wrongdoing.” In November 2013 he made headlines again when he wrote an opinion piece for the New York Review of Books where he looked askance on the dearth of white collar prosecutions during the financial crisis.
Judge Rakoff has been called everything from “iconoclastic,” to “populist firebrand,” to “perhaps the most important judge not on the Supreme Court.” One adjective observers failed to add was “cagey,” defined by Webster as, “not willing to say everything that you know about something.” In that vein, there are three things Judge Rakoff knows about Wall Street that the Justice Department may not.
People, Not Companies, Commit Fraud
In the Citigroup case, the SEC accused the company of creating a billion dollar mortgage bond deal – Class V Funding III – to sell off worthless assets to unsuspecting investors; not only did Citigroup market the fund as safe, it took a short position in the assets. Clients who purchased the soured mortgages suffered $600 million in losses. In rejecting the settlement, Judge Rakoff implied that the SEC (i) was looking for a quick headline and (ii) had a duty to "see that the truth emerges." In previous fraud cases involving firms (Goldman Sachs, J.P. Morgan) who sold soured collateralized debt obligations (“CDO”) to clients after marketing them as a safe, firms also paid a fine and neither admitted or denied wrongdoing.
By not requiring an admission of guilt, the SEC would have the public believe that corporations – not their agents – commit crimes. Furthermore, Judge Rakoff’s critique of the Citigroup settlement may be supported by legal precedence. In 1994 when I was an associate at GE Capital, Kidder Peabody, an investment bank owned by General Electric, imploded from $350 million of investment losses. GE’s CEO, Jack Welch, was determined that “somebody” was going to pay for it. GE labeled Joseph Jett, Kidder’s head government bond trader, a “rogue trader” and accused him of manipulating Kidder’s accounting system to maximize his bonuses. He was subsequently brought in front of the NASDAQ, SEC and New York Stock Exchange. The new book, Shock Exchange: How Inner-City Kids From Brooklyn Predicted the Great Recession and the Pain Ahead, describes the complex scheme that led to Jett’s trading losses, “Kidder had been breaking the bonds into interest and principal payments and making a market in them separately. Jett entered into forward contracts where the strips of bonds would be exchanged at a later date. However, the exchange never took place as Jett rolled them forward. The quirk in Kidder’s accounting system was that “it allowed him to capture the profit on the price of the strip – the interest portion of the bond – before it was ‘reconstituted,’ or turned back into the original bond.” It was these bogus profits, generated from thousands of trades, upon which Jett’s annual bonus was based. Jett had earned a $9 million bonus in 1993 and received the “chairman’s award” as Kidder’s star employee at a meeting of Kidder senior executives that same year. His acceptance speech was made for Hollywood – “This is war … You do anything to win. You make money at all costs.” However, it was not until the bonds’ interest and principal strips were reconstituted that one could ascertain whether profits had been made.”
The SEC ruled that Jett’s actions did not constitute fraud because they were not in connection with the purchase and sale of securities; however, it found him guilty of intending to defraud Kidder and charged him with a books-and-records violation. He was barred from associating with any registered broker-dealer, fined $200 thousand and ordered to disgorge over $8 million in bonuses and compensation.
Shareholders Deserve Protection From Wall Street Wrongdoing
In a February 2013 hearing before the appeals court in Manhattan, lawyers for the SEC and Citigroup argued to a three-judge panel that Judge Rakoff did not have the authority to reject the Citigroup settlement. The SEC’s negotiating posture raises several questions. When Jack Welch brought charges against Joe Jett in 1994, he was acting on behalf of GE’s shareholders. Since losses from Class V Funding III will be borne by Citigroup shareholders, is Judge Rakoff not taking the same position as Jack Welch in protecting them? And if Judge Rakoff does not have the authority to provide said protection, who does? Implicit in Judge Rakoff’s stance is that Citigroup shareholders, taxpayers or the public deserve no less protection from fraudulent trading activity than the shareholders of GE.
Wall Street is Incorrigible
In the 1980s Michael Milken of Drexel, Burnham headed what was then the country’s largest insider trading ring. Milken’s network included the likes of arbitrageur Ivan Boesky, Denis Levine (Lehman Brothers), Ilan Reich (Wachtell, Lipton), Robert Wilkis (Lazard Freres), and Martin Siegel (Kidder, Peabody). Observers attribute Judge Rakoff’s crusade to prosecute high level executives amid the financial crisis to his iconoclastic nature. However, his rabid search to see that the truth emerges most likely stems from his familiarity with the Milken insider trading ring. The first person in the ring to be discovered was Denis Levine, Lehman’s merger star who claimed to have gleaned takeover targets from reading unusual activity on a company’s ticker tape; all the while he had been receiving confidential information from Wilkis and Reich. After being confronted by the feds, Levine rolled on Boesky who then rolled on Siegel. Siegel’s first choice for legal representation, Wachtell, Lipton, did not take the case due to a conflict of interest. His second choice was a partner at Mudge Rose Guthrie Alexander and Ferdon – Jed Rakoff. Rakoff advised Siegel to cut a deal with the securities fraud unit of the U.S. Attorney’s office. Thinking he was doing something good for society, Siegel provided incriminating evidence on other insider traders in exchange for a lesser sentence.
By flipping lower-level operatives, the feds were able to reel in the big fish – Milken – who was indicted on 98 counts of racketeering charges and stock manipulation, sentenced to ten years in prison, fined $600 million and barred from the securities industry. However, compared to the progenitors of the 2008 financial crisis, Milken and his cohorts were boy scouts. According to Shock Exchange, Judge Rakoff knows more about Wall Street than he may not be willing to say publicly, “Decades later, after prosecutions for Levine, Milken, Wilkis, Reich, Siegel and Freeman, nothing has changed. If anybody can understand the culture of the Street – entitled, incorrigible – it is Rakoff.”
Ralph Baker has spent over a decade in corporate finance and mergers & acquisitions. He is currently the Executive Director of the New York Shock Exchange (www.newyorkshockexchange.com), a financial literacy program based in Brooklyn, NY that teaches kids competitive basketball skills and the fundamentals of investing. Baker is also the author of Shock Exchange: How Inner-City Kids From Brooklyn Predicted the Great Recession and the Pain Ahead.