Gabelli v. SEC: Disincentive to Legislative Action, Market Evolution, Minimal Funding of a Major Regulatory Agency and Plutocratic Law

Considering the Supreme Court’s 9-0 ruling it would seem that despite the prior District Court’s ruling in the Security and Exchange Commission’s (SEC) favor, their case against Bruce Alpert and Marc Gabelli lacked any true merit. Indeed, current legal commentary on the case is sparse, as if it were not deserving of much attention. This lacuna is understandable as the main point on which the case depended regarded simply in establishing whether or not the statue of limitations for the government to seek civil penalties for fraud is the same as that of a private litigant. For the latter, legal precedence clearly established that the statue was five years from reasonable expectation of discovery. As the SEC first began investigating a potential transgression by Gabelli in early 2003 yet did not begin penalties proceedings based upon this knowledge until late in 2008, nor did they seek to enter a tolling agreement with Gabelli that would have extended the statue of limitations under the acknowledgement that any subsequent penalties would be reduced due to his co-operation, the time line is the pivot on which the case turned. The previous, 2nd District Court ruling in the SEC’s favor imposed a penalty of 16 million dollars on Gabelli and followed the reasonable expectation of discovery interpretation. According to the Supreme Court’s ruling that overturned the Gabelli case, however, the SEC is significantly different from an individual due to its status as a government agency and thus the five-year statue of limitations is from when the fraud occurred. When questioned about this long time lapse in the execution of regulatory capacity in oral argument, the council for the SEC admitted that this circumstance was without precedence and added that this was not because of any further deceptive practices on the part of the defendant but simply occurred as a result of an “ongoing exchange” that delayed investigation such that they could have the largest possible amount of information for their case. Ignoring rigorousness to prioritize speediness in his opinion for the majority, Roberts based his judgment on a strict reading of 28 U.S.C. § 2462, and stated that as this government entity is constantly searching for misdoings, it has five years from the occurrence of fraud and not from its discovery to enact penalties proceedings. Judge Roberts’ rationale was that to allow the lower court’s reading of a discovery rule into the securities law would mean that fraudsters would lose their ability to repose. The constant fear which fraudsters would face were this discovery rule “grafted” was conceived to not only be deleterious to those persons involved in prior fraudulent activity, but to have effects across the entire securities and investment market. According to those that supported the petitioner’s case in addition to losing their individual ability to repose, people that had engaged in practices that were once considered legal would risk prosecution for stale charges, individuals and corporations capacity to organize their affairs according to their own wishes would be hampered, the SEC would be encouraged to pursue non-meritorious cases in order to obtain settlements, the change of the discovery rule would make it harder to discern between wrongdoers and the wrongly accused, and the SEC’s “new powers” would lead to increased arbitrariness of practices.

These effects and whether they are desirable or not in a context of widespread questionable financial practices is contestable. That Gabelli acted in a fraudulent manner is not. His fraud was not that he was engaged in market-timing, a practice discouraged by the Financial Industry Regulatory Authority (FIRA) due to the negative effects to long-term investors but that he clearly and repeatedly represented to investors in his Global Growth Fund that he was not engaged in market timing practices. This fraud meant that while one portion of his mutual fund portfolio was actually returning negative growth, the other that was engaged in market-timing was able vastly to be incredibly profitable, around 185%, and thus allowed the whole fund to appear profitable.

Evolution of Financial Services Markets

To understand the importance of this case it is crucial to gain a better understanding of the current market for financial services and it’s role in the American economy. Over the past fifty years the calculation methods informing the financial market has shifted from business school knowledge, with it’s greater, conservative appreciation for long-term investment to those found in university physics, statistics and math departments that promised speedier, short-term profits. The people involved with the latter form of financial investment, sometimes referred to as quants, in turn rely upon advanced calculations and technology to analyze aggregate market data. In the case of Marc Gabelli, the proprietary software modeling used by his Global Growth Fund would determine choices for investments based upon speculation of whether or not they were correctly priced. The “correct” price would be different from the listed price because sometimes their reported valuation would be based upon stale information. Those able to exploit this disconnection has the potential to obtain quick profits from these market miscalculations by purchasing massive amount of shares nano-seconds before the close of trade so they could be immediately resold when the market opened in the morning. It should be noted that while the Financial Industry Regulatory Authority (FIRA) discourages market-timing due to the negative effects to long-term investors, the practice itself is not currently illegal.

This singular example from a wide variety of quantitatively-informed calculation and investment methods is instructive but does not give a holistic picture of the huge impact such financial services have on the composition of the American economy. According to the U.S. Bureau of Economic Analysis, in a 27 year period, from 1984 for 2011, the financial industry’s contribution to total corporate profits has trebled from 11.8% to 32.3% while their contribution to total economic output has doubled from 8.8% to 16.3%. According to the New York Federal Reserve, the financial services sector currently composes around 8.5% of American GDP. These percentages of capital in themselves are significant yet when compared to the off-exchange trading of financial derivatives it pales in comparison. According to April 2010 figures from the Bank for International Settlements and the International Monetary Fund, the trading that occurs here is several times the volume of all shares and bonds traded. This is of extreme significance as while the Gabelli case is framed within the context of the shares and bonds market, with a volume of 87 trillion dollars, the statue of limitations precedent set for the case equally applies to the 601 trillion dollar volume of the derivatives market.  Any potential penalties for fraud by administrators of credit options, derivatives, forward rate-agreements, contract specific structured product accumulators, collateralized mortgage backed or asset backed securities, or a variety of other security products in this much larger over-the-counter (OTC) derivatives market would, in five years, be nullified. While it is a given that the size, significance and political influence of this market should not be underestimated, nor should it’s novelty or the effects it has had on financial markets and other business enterprises.

Cultural anthropologist Karen Ho researched historical trends within the financials market and married it to reflections on her own experiences while working for Bankers Trust in the early 1990’s in her book Liquidated. Her explanation as to why it is that the investment practices radically shifted stems from changes in the legal rulings as to what precisely a corporation is, what it owes to its shareholders and new regulations that allowed for a massive consolidation of what was often vastly different enterprises by holding companies. As part of this “share-holder revolution” corporate executives were now legally required to transition from long-term business strategies based on production of goods to short term ones based on whatever would be the most profitable despite the sometimes profoundly deleterious effects this could have on social and economic relations. Anything that could boost stock prices, especially immediately before quarterly earnings reports, was considered fair game and, as the previous statistics show, financial services increasingly had a role in accomplishing this. As Ho recounts, the relatively stable business environment of the 1950’s and 1960’s transformed into one of asset stripping, purposeful bankruptcy to obtain corporate pension assets for stockholders and other “creative” forms of destruction for profit. Informing and enacting these decisions were the financial market wizards who were, basically, churning sales for percentages. However as merger-mania began to decline following the massive consolidation of disparate enterprises and the realization that this was not always beneficial to investors, new financial services and methods of risk analysis were deemed as necessary to continue the functioning of these advisors. Capital adequacy ratios were lowered, risks increased and people’s social relationships to labor became, like the composition of capital itself, more liquid. Ho uses this term to describe how in this new regulatory environment at any point a nominally profitably business oriented to long-term profit could be preyed upon by junk-bond traders and dismantled for their short-term gain. Michael Lewis describes similar circumstances in his books Liars Poker and The Big Short,and concurs with Ho that these changes incentivized businesses to increasingly invest their capital holdings into financial products, even if they were organized to produce ice cream, rather than reinvestment in productive capacity as to not do so gave corporate raiders or their actual business competitors a potential financial advantage. The controversy over whether or not these instruments are actually productive or just assist in the creation of credit bubbles thus largely get subsumed under their increasing practical necessity for any large business that wishes to remain competitive in the market.

Understanding such a context it becomes clear that while the SEC lacks precedence in taking so long to bring penalties actions such that it would be thrown out and may thus an example of attempted government overreach, the procedures that it uses to deal with these are new and deal with a massive amount of data. What should also be clear from this brief historiography is that the ruling has much wider significance. Specifically, the case had vast implications for a large class of potential civil penalty suits stemming from widespread deceit and financial fraud in various financial sectors. This is because, following the court’s ruling, the SEC was limited to six and a half months to pursue actions against those firms and individuals whose malfeasance played a driving role in the “great recession”. After this time period the statue of limitations would run out and a multitude of private investment firms and investment banks that had engaged in potentially fraudulent practices related to derivatives, credit default swaps and the other new financial instruments could avoid charges or penalties related to it if able to avoid legal action. This, according to the Wall Street Journal, this is precisely what has happened. Since the Gabelli ruling the number of SEC cases against alleged wrongdoers has dwindled precipitously. The SEC pursued 38 cases in 2011 and 48 in 2012. However as of September 11th of 2013, the SEC has only pursued 11 cases. In this regard, the Gabelli case becomes a foundational case as it shows that the Supreme Court will not allow the SEC or other financial regulatory bodies to pursue those individuals or companies involved in the recent, massive upward transfer of wealth while a smaller country like Iceland takes no issue with not just fining but jailing those complicit in such crimes of fraud and misrepresentation.

Composition of the Amicus Curiae Petitioners

Looking to the amicus curiae briefs bolsters the above speculation about the interest of the finance sector involved in the case. The Cato Institute, The National Association of Criminal Defense Lawyers, the American Bankers Association, The National Chamber Litigation Center, the Voice of the Defense Bar, National Association of Criminal Defense Lawyers all filed in favor of the petitioner, Mario Gabelli, to overturn the 2nd Circuit Court’s ruling against him. Not one briefs touches upon the fact that Gabelli did anything wrong, but unanimously state that were he punished for his wrongdoing it would be wrong. Considering that financiers makes up a large percentage of the financiers of these organizations, this is not surprising.

Some content worth noting from Several of the briefs state is that were the court to judge in favor of grafting the five-year discovery ruling to the statue then it would be a pre-empting the prerogative of Congress. In the context of the current electoral system I find this claim to be one of the most interesting as it is no secret that a significant percentage of the funding for much of the Presidential, Senate and Congressional elections comes from large financial institutions. If not similar in size to Gabelli’s comparatively modest $30 billion dollar firm, they are in type. They too view penalties as a small cost of doing business but would still seek to avoid them in any way possible, that is, with the exception of actually following the law. For this reason it is unsurprising that they would encourage conservative, standpatter behavior on regulatory issues such as this.

The only brief actually in support of the SEC’s position was that filed by Occupy the SEC, an outgrowth of the Occupy Wall Street movement that has been one of the few OWS working groups that have pursued policy and regulatory reform. They claimed standing as a representative of the American people as a whole, rather than the class of actors that would most benefit from a ruling favoring Gabelli, and their brief counters the positions stated by Roberts and the briefs above. They state that prior case law favors the reading of the discovery rule based upon its reasonableness component, that lacking explicit Congressional commentary on U.S.C. § 2462 it is in the judiciary’s role to best promote the public interest and not that of the financial elites. They state that the SEC’s enforcement functions are greatly curtailed by these undue restrictions that “hinder them from discharging their regulatory responsibilities in an effective manner” and have allowed the nullification of 40% of family wealth in the period from 2007 to 2011. Additionally, they point to the actual institution of the SEC rather than an idea of it as evidence as to why they need more time to pursue such cases. They held that part of the reason they have not been able to effectively function is the general atmosphere of austerity spending towards government agencies.

To better understand the capacity of the SEC, it’s worth looking at Federal spending on oversight and regulation of the financial market. Comparing spending on regulatory institutions to the amount of transactions and deals that are made within this market allows for some degree of quantitative assessment and discernment over the claim that the SEC is a credible guardian of market fraud. The current tax that funds the SEC’s is equivalent to $.02 per every $1,000 in financial transactions[i]. Considering the size of the market mentioned earlier and the wages required for the institution to attract highly skilled people to the public rather than the private sector this should seem as if there was an interest in the government for it not to enforce regulations. Indeed, while it seems impressive that the SEC has been able to extract 2.88 billion in penalties from financial crisis fraudsters, considering that the cost was between 6-14 trillion, according to the Federal Reserve Bank of Dallas, this is a mere drop in the bucket[ii].

Small Penalties, Bumper Business

This bespeaks a general trend within the investment and banking sector – it is often more profitable to risk getting caught engaging in fraudulent practices than it is to avoid them. It the penalty for 250 million of ill-begotten profits is 100 million, the net gain is worth it – especially if the work to obtain such wealth consists merely of a few phone calls and clicks on the keyboard. The criminal and regulatory statues, supposed to provide incentives for actors to avoid specific actions, thus fail in their capacity and doubly so if the regulatory agency lacks the man and will power to pursue such cases. If such a relationship between regulators and actors isn’t to be considered outright collusion or complicity, than it is only so because of the burden of regulatory change is placed on a Federal legislative system whose elected politicians benefit from such ill-begotten gains through disproportionately high campaign contributions from the financial sector.

In addition to the congressional apathy towards altering laws that would harm their donors, the institution itself bears examination besides just how it is funded. The government-private sector revolving door widely commented on at the upper echelons of government – Dick Cheney, Tim Geitner and Mitt Romney being some of the most widely known in this regard – allows for the transmission of the government’s regulatory knowledge and procedures, not to mention the personal relationships that go along with it. Indeed the current chair of the SEC, Mary Jo White, is one such person with a long background in the private sector with connections to people that have engaged in dubious practices[iii]. While these examples come from the top, it occurs at lower levels as well. Of the five people that were involved in the Gabelli cases’ initial filing in New York, only three of them (Robert B. Blackburn, Jill S. Henderson and Ivonia K. Slade) have thus far stayed with the SEC. Mark Kreitrnan now works for Nixon Peabody and Christoper R. Conte works at Stepto and Johnson, LLP. According to several ranking systems, such as Private Equity Analyst, Nixon Peabody is considered to be one of the leaders in franchise law and private and equity capital ventures while Steptoe and Johnson, LLP offers a wide range of services, specializing in white-collar criminal defense. They proudly and prominently state on their website that, “In the past, the firm has defended senior executives from companies such as Enron, Tyco, WorldCom…”[iv]. This situation thus creates the bizarre situation such that private personages such as myself are barred from obtaining documentation about the progression of an important, precedent setting case with vast effects while those that were intimately involved in its operation are able to move freely to private firms that defend such fraudsters, alleged or otherwise. That the conditions for obtaining information with a significant impact on the manner in which financial investigations transpire are either the time and willingness to work for the institution or the deep pockets to hire the people that once worked for the SEC means that the public itself loses on a crucial oversight function and begs the question: quis custodet ipsos custodies?

Case Law Since Gabelli

The most immediate implications wrought by Gabelli for the SEC is their reformulation of strategic decision-making processes. They are now incentivized to enter into tolling agreements, wherein co-operation with processing investigations are given extension under the understanding that any subsequent discovery of wrong-doing will be given a smaller penalty as well as rushing to complete investigations. This is not, however, the limit of the impact as there already have already three cases citing the Gabelli decision against the SEC. In March of 2013, in the first cases to apply the Supreme Court’s ruling, the Solicitor General made a motion to dismiss the SEC’s certiorari in their case against Bartek. Citing the Gabelli precedent, they were unable to proceed with the case as the crimes had occurred more than five years ago. The SEC’s case against Sam Wyly is another, more ominous examples of the application of the Gabelli ruling and is illustrative of the limiting effects it has on the institution’s capacity to extract penalties. Wyly, a Texas investor perhaps most well known for his Michael’s chain of craft goods, and his now deceased brother were accused of conducting insider trading and developing a fraud that netted them 550 million dollars. While still allowing the SEC to pursue smaller aspects of their case against Wyly, on June 6th, 2013 US District Judge Shira Scheindlin dismissed the majority of their penalties claims against him as having occurred too far back in time. Notable, though not directly related to the case, is the article’s mention that the brothers were also generous donators to “conservative causes.[v]” Another case occurring in the wake of the Gabelli ruling and affected by it has been the SEC case against Pentagram Capital Management PLC. The Second Circuit Judge of the case held that the SEC could not include any profits made from their illicit trading practices prior to the five-year period in their penalties even though there was clear evidence of it. As judges continue to uphold the Gabelli precedent, the SEC will stop pressing such cases of fraud and the likelihood of public knowledge of how endemic such occurrences are will decrease. The Gabelli ruling, is thus, in a few words, a shield to protect ill begotten gains.

As the composition of the financials market and these three cases clearly indicate, The Supreme Court’s ruling is not to maintain widespread social repose and fend off fear but is in fact a ruse to protect a small group of extremely wealthy financial elites who occasionally or consistently use fraud to personally enrich themselves and the wealthy that have the capacity to invest millions in their funds. The implicit recognition in the lower courts previous ruling and Occupy the SEC’s amicus curiae that without a discovery rule would result in the decreased enforcement capacity of an agency already dealing with rapid turnaround and brain-drain to the private sector thus far proves to be true.