New Legal Risks

At present, there is an enormous amount of dangerous and thoughtless ' as well as political- and populist-inspired ' media focus on the financial services
industry. We note the remorseless advance of a mindset that seeks to place blame upon, and to obtain various forms of recompense from, professional investors and those who serve the needs of the businesses that they operate. This mindset takes many forms, including an increasingly adversarial attitude among regulators, investigators and prosecutors, and more criminal prosecutions of cases, which, with a better balance, would normally be treated, at most, as regulatory matters.

The political demonization ' or, taken to the extreme, criminalization ' of the financial service profession, is rooted in the justified concerns of both ordinary citizens as well as public officials as to how the industry has operated over the past several years. Developments such as accelerated financial engineering, and the creation of obtuse, highly levered and impossibly complex investment products (many of dubious merit) were certainly contributors to the credit bubble that burst, although any comprehensive analysis must also point toward government-sponsored entities such as Fannie Mae, Freddie Mac, and the elected officials that empowered them, as bearing substantial culpability. Many financial services professionals made kings' ransoms through their participation in these activities, and were not held accountable. Conversely, the general citizenry, whose fortunes are tied to the general economic health, were forced to pick up the tab, creating an extraordinary Petri dish of anger.

Other circumstances, including (at least optically) a cozy but unholy collaboration between government and key financial service constituents, provided fodder for intense media scrutiny and super-charged the anger of many Americans against the custodians of capital markets. Large banks were bailed out at taxpayer expense and, to this day, enjoy funding rates that have distorted the rational allocation of capital between risks and rewards. And then there were the numerous Ponzi schemes that came to light in the downturn, including the one operated for decades (under the very noses of either ignorant or overly compliant regulators) by Bernard Madoff, a former Chairman of the National Association of Securities Dealers. That artifice collapsed, costing thousands of investors, including high-profile charities, billions of dollars.

An Exaggerated Response

All of the above certainly diluted the goodwill and confidence of the general public in the competence and legitimacy of capital markets participants. However, in predictable, Newtonian fashion, there has been a significant over-reaction to these dubious actions.

In 2010, Congress passed an opaque spider's-web set of new laws known as the Dodd-Frank Act, featuring the creation of dozens of new regulatory oversight bodies, many of which have yet to be formed in earnest, and with the substantial majority of regulations contemplated by the Act yet to be written. The Securities and Exchange Commission (SEC) and the Justice Department (DOJ) have also stepped up their efforts to effect more aggressive enforcement actions against market participants. The DOJ faces a nearly daily media drumbeat to indict, as if our regulatory mechanisms are inadequate in their capacity to sufficiently punish.

Perhaps the most high profile of these efforts is the wave of prosecutions associated with insider trading investigations ' a process now entering its fourth year. Enforcement entities are on a roll in this regard, having issued dozens of indictments, and obtaining a better-than-90% rate of convictions against defendants, coupled with very long sentences in comparison to any other civilized country.

Coping with the 'New Normal'

It is our view that the public sector, empowered by the current public mood and enabled by government officials looking to enhance their political capital, have resorted to both investigative and prosecutorial overreach. While these officials may often achieve their desired tactical outcomes, their actions are not necessarily to the net benefit of either the economy or the cause of good governance so central to our nation's values.

However, financial service professionals who cling blindly to the hope articulated by Lincoln in his Second Inaugural Address that the “better angels” of prosecutorial discretion are likely to prevail, proceed at considerable hazard. The time may come again when investors, bankers, brokers and other market specialists are viewed with more equilibrium from the justice perspective. But that time is not upon us. It is therefore imperative that all individuals and entities within the financial sector think and rethink their business strategies, to more closely orient them to the considerable and growing legal risks that confront them. Those businesses that manage their affairs with a watchful eye toward the burgeoning set of legal risks that they face stand to secure and retain a significant competitive advantage over enterprises that fail to be extra careful.

The process of doing so, however, will be neither comfortable nor easy. To effectively navigate the current hostile legal environment ' in which heretofore widely accepted practices are now viewed as either extra-legal, or even criminal activities ' it will be necessary to evaluate operations from top to bottom.

The most important reviews should focus on direct, revenue-generating elements of the business, including the manner in which market information is sourced and shared, the treatment of customers and/or investors, the fees that are charged for services rendered and myriad other elements of the income matrix.

In addition, to fully address the issues at hand, organizations must look at the totality of their business functions, including operations, legal documentation, human resources, technology, corporate governance and other contributors to the efficient functioning of the enterprise. Knowing your counterparties as much as possible is a necessity.

Conclusion

Under the current paradigm, both the public and elected and appointed officials are seeking from financial professionals as many pounds of flesh as they can extract ' often for the sins of others, long gone and suffering no consequences for their malfeasance. And although this angry public mood is unlikely to achieve its objective of ensuring well-ordered, fair and transparent markets for speculation and capital formation, it will unmistakably affect both the present and foreseeable future. Financial service businesses must re-examine and re-orient to conform to the new regulatory reality, with full knowledge that the current mood will demand that investigations and charges continue to be brought.

Eager to court popular approval, to advance their own careers and to try out the vague and untested new powers granted by legislators, regulators and prosecutors will inevitably overreach. If our media and anecdotal perspective is accurate, the defense bar is losing some of its “fight.” This is explainable in part because of the huge potential sentences, mandatory minimums, and heavy costs of defense, but a little more fight is good for all. It is in precisely this type of environment that an ever greater scrutiny of the legal and factual bases for charges will be required. When that occurs, a willingness to stand up to government is crucial, and may serve as a deterrent against additional undeserved prosecutions.

Stanley S. Arkin, a member of this newsletters Board of Editors, is the founding member and the senior partner of Arkin Solbakken LLP. Lisa C. Solbakken is a partner at the firm. Ken Grant is president and founder of Risk Resources LLC.

Throughout history, the public mood, politics, human tensions and conflict have all profoundly affected how justice and other systems of social control are defined and implemented. As defense lawyers and an investment banker, we believe that this country's economic, political and social divisions, as well as the increasing complexity and globalization of financial transactions, have created a historically volatile atmosphere. This situation requires even more wariness and care by those who ply their trade in the markets, and by those who on occasion have the duty of defending them from legal and regulatory attack.

A New Environment

Capital formation and finance has changed dramatically over the last several years, particularly since the financial collapse of 2008. That year's implosion of global credit markets, and the massive attendant economic reversals ' all on a worldwide basis ' have dramatically altered the business landscape and legal exposures for those in the financial services industry.

At present, there is an enormous amount of dangerous and thoughtless ' as well as political- and populist-inspired ' media focus on the financial services
industry. We note the remorseless advance of a mindset that seeks to place blame upon, and to obtain various forms of recompense from, professional investors and those who serve the needs of the businesses that they operate. This mindset takes many forms, including an increasingly adversarial attitude among regulators, investigators and prosecutors, and more criminal prosecutions of cases, which, with a better balance, would normally be treated, at most, as regulatory matters.

The political demonization ' or, taken to the extreme, criminalization ' of the financial service profession, is rooted in the justified concerns of both ordinary citizens as well as public officials as to how the industry has operated over the past several years. Developments such as accelerated financial engineering, and the creation of obtuse, highly levered and impossibly complex investment products (many of dubious merit) were certainly contributors to the credit bubble that burst, although any comprehensive analysis must also point toward government-sponsored entities such as Fannie Mae, Freddie Mac, and the elected officials that empowered them, as bearing substantial culpability. Many financial services professionals made kings' ransoms through their participation in these activities, and were not held accountable. Conversely, the general citizenry, whose fortunes are tied to the general economic health, were forced to pick up the tab, creating an extraordinary Petri dish of anger.

Other circumstances, including (at least optically) a cozy but unholy collaboration between government and key financial service constituents, provided fodder for intense media scrutiny and super-charged the anger of many Americans against the custodians of capital markets. Large banks were bailed out at taxpayer expense and, to this day, enjoy funding rates that have distorted the rational allocation of capital between risks and rewards. And then there were the numerous Ponzi schemes that came to light in the downturn, including the one operated for decades (under the very noses of either ignorant or overly compliant regulators) by Bernard Madoff, a former Chairman of the National Association of Securities Dealers. That artifice collapsed, costing thousands of investors, including high-profile charities, billions of dollars.

An Exaggerated Response

All of the above certainly diluted the goodwill and confidence of the general public in the competence and legitimacy of capital markets participants. However, in predictable, Newtonian fashion, there has been a significant over-reaction to these dubious actions.

In 2010, Congress passed an opaque spider's-web set of new laws known as the Dodd-Frank Act, featuring the creation of dozens of new regulatory oversight bodies, many of which have yet to be formed in earnest, and with the substantial majority of regulations contemplated by the Act yet to be written. The Securities and Exchange Commission (SEC) and the Justice Department (DOJ) have also stepped up their efforts to effect more aggressive enforcement actions against market participants. The DOJ faces a nearly daily media drumbeat to indict, as if our regulatory mechanisms are inadequate in their capacity to sufficiently punish.

Perhaps the most high profile of these efforts is the wave of prosecutions associated with insider trading investigations ' a process now entering its fourth year. Enforcement entities are on a roll in this regard, having issued dozens of indictments, and obtaining a better-than-90% rate of convictions against defendants, coupled with very long sentences in comparison to any other civilized country.

Coping with the 'New Normal'

It is our view that the public sector, empowered by the current public mood and enabled by government officials looking to enhance their political capital, have resorted to both investigative and prosecutorial overreach. While these officials may often achieve their desired tactical outcomes, their actions are not necessarily to the net benefit of either the economy or the cause of good governance so central to our nation's values.

However, financial service professionals who cling blindly to the hope articulated by Lincoln in his Second Inaugural Address that the “better angels” of prosecutorial discretion are likely to prevail, proceed at considerable hazard. The time may come again when investors, bankers, brokers and other market specialists are viewed with more equilibrium from the justice perspective. But that time is not upon us. It is therefore imperative that all individuals and entities within the financial sector think and rethink their business strategies, to more closely orient them to the considerable and growing legal risks that confront them. Those businesses that manage their affairs with a watchful eye toward the burgeoning set of legal risks that they face stand to secure and retain a significant competitive advantage over enterprises that fail to be extra careful.

The process of doing so, however, will be neither comfortable nor easy. To effectively navigate the current hostile legal environment ' in which heretofore widely accepted practices are now viewed as either extra-legal, or even criminal activities ' it will be necessary to evaluate operations from top to bottom.

The most important reviews should focus on direct, revenue-generating elements of the business, including the manner in which market information is sourced and shared, the treatment of customers and/or investors, the fees that are charged for services rendered and myriad other elements of the income matrix.

In addition, to fully address the issues at hand, organizations must look at the totality of their business functions, including operations, legal documentation, human resources, technology, corporate governance and other contributors to the efficient functioning of the enterprise. Knowing your counterparties as much as possible is a necessity.

Conclusion

Under the current paradigm, both the public and elected and appointed officials are seeking from financial professionals as many pounds of flesh as they can extract ' often for the sins of others, long gone and suffering no consequences for their malfeasance. And although this angry public mood is unlikely to achieve its objective of ensuring well-ordered, fair and transparent markets for speculation and capital formation, it will unmistakably affect both the present and foreseeable future. Financial service businesses must re-examine and re-orient to conform to the new regulatory reality, with full knowledge that the current mood will demand that investigations and charges continue to be brought.

Eager to court popular approval, to advance their own careers and to try out the vague and untested new powers granted by legislators, regulators and prosecutors will inevitably overreach. If our media and anecdotal perspective is accurate, the defense bar is losing some of its “fight.” This is explainable in part because of the huge potential sentences, mandatory minimums, and heavy costs of defense, but a little more fight is good for all. It is in precisely this type of environment that an ever greater scrutiny of the legal and factual bases for charges will be required. When that occurs, a willingness to stand up to government is crucial, and may serve as a deterrent against additional undeserved prosecutions.

Stanley S. Arkin, a member of this newsletters Board of Editors, is the founding member and the senior partner of Arkin Solbakken LLP. Lisa C. Solbakken is a partner at the firm. Ken Grant is president and founder of Risk Resources LLC.