In Defense of JP Morgan

  Richard Epstein

JP Morgan Chase (JPM) just had a bad week dueling with the federal government. First, it got slapped with a $5.1 billion settlement with the Federal Housing Finance Agency (FHFA) for its mortgage dealings with Fannie Mae and Freddie Mac; then, it got wrapped into a criminal investigation involving Bernie Madoff’s Ponzi scheme, which the government now insists that JPM should have detected in its role as Madoff’s banker before the scandal broke.

The financial toll of the various government initiatives against the bank is likely to top $25 billion, a sum that places a substantial dent even in the bank’s hefty capital structure. The reputational and business losses could amount to far more. The adverse consequences could wreak havoc on thousands of employees, customers, and shareholders. In both civil and criminal proceedings, the Department of Justice is bringing to heel a bank that came into two major mistakes. First, the bank did business with the federal government. Second, it was regulated by it.

The FHFA Settlement

Last week, JPM entered into a $5.1 billion settlement with FHFA, which took over the operation of both Fannie and Freddie when the two companies were forced into an unwanted conservatorship by FHFA and the Treasury at the height of the financial crisis. I have commented critically in an earlier column, Grand Theft Treasury, on the high-handed and indefensible nature of this transaction, which was crammed down the throats of Fannie and Freddie’s preferred and common shareholders on terms all too favorable to the federal government.

On this matter, I have acted as a consultant to several hedge funds not involved in the current litigation. The gist of my criticism of the government position is that Edward DeMarco, then the acting head of FHFA, engineered a deal with Timothy Geithner, then Secretary of Treasury, which consciously enriched the Treasury by the onerous terms of the initial conservatorship. To be sure, the 2008 transfer is subject to rival interpretations. But the same cannot be said of the notorious Third Amendment to that 2008 agreement, in which DeMarco and Geithner by fiat simply announced that all dividends of Fannie and Freddie, which had returned to profitability, would from then on generate “a full income sweep . . . to benefit taxpayers for their investment.”

The size of that sweep amounted to about $59 billion. In his comments on the recent settlement, DeMarco continued the farce, reiterating his job was “preserving and collecting Fannie Mae’s and Freddie Mac’s assets on behalf of taxpayers,” without bothering to mention that his fiduciary duties as conservator ran to the shareholders of Fannie and Freddie whose pockets he helped to pick.

Unfortunately, JPM does not get the kind of preferential treatment that the DOJ gives to other government agencies. Indeed, the terms of the FHFA/JPM settlement agreement are warped themselves, given that $4 billion of the basic liabilities were for actions undertaken by Bear Stearns and Washington Mutual before they were taken over by JPM in March and September of 2008 respectively—when no one else was willing to buy them and the government in fact encouraged JPM to save them.

At this point, another dispute has arisen about whether the FDIC may have to repay JP Morgan for some of those losses. The normal rule is to hold the successor corporation responsible for the wrongs of the predecessor (unless such liabilities have been clearly assumed, which doesn’t seem to be the case). But in the circumstances here, the FDIC bears that loss for getting JPM to make the acquisitions necessary for preserving the health of the U.S. economy.

The situation is worse still because it was well known that, starting with the Housing and Community Development Act of 1992, the United States imposed on Fannie and Freddie “an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families in a manner consistent with their overall public purposes,” while at the same time “maintaining a strong financial condition and a reasonable economic return . . . .”

The two goals are deeply incompatible. The initial target was for low- and moderate-income housing to constitute 30% of the total market, a figure that actually amounted to 55% in 2007, just before the housing market collapsed. It was no great mystery that those aggressive programs had to result in a deterioration of loan quality. What does remain unexplained is how DeMarco can claim that Fannie and Freddie were innocent victims of a scandal that federal legislation helped create.

The entire episode is an embarassment. Fannie and Freddie should not get this money; and, if they get it, they should not turn it over to the taxpayer, which is just what will happen. The entire system is flawed from top to bottom.

The Ponzi Scheme Investigation

The only ray of light resulting from the FHFA’s litigation was that the settlement agreement did not constitute “an admission by any of the JPMorgan Defendants of any liability or wrongdoing whatsoever . . . .” That critical point helps insulate JPM from criminal charges here.

The specter of criminal charges against the bank remains live, however, thanks to an overzealous United States Attorney for the Southern District of New York, Preet Bharara.  Bharara is now thinking of bringing criminal charges against JPM for its alleged involvement in the massive fraud that Madoff committed against his multiple investors.

Bharara’s basic theory is that JPM (and its predecessor Chemical Bank) was Madoff’s banker during this period and thus should have known that he could have been involved in a Ponzi scheme. Therefore, JPM should have referred the entire matter over to government officials for further investigation. Bharara does not appear to deny the categorical statement of JPM’s General Counsel Stephen Cutler that JPM “did not know about or in any way participate in the fraud.”

If that statement remains uncontested, criminal charges against JPM should be off the table. But Bharara seems to think that a criminal case could be brought because key JPM employees had suspicions about Madoff’s possible misconduct, which they should have reported to government officials sooner than they did. That is thin gruel for a criminal case, given that JPM had no private information about Madoff’s illegal schemes. It is worth noting that in the exhaustive SEC study on its own woeful performance, the Office of Inspector General cleared all SEC employees of “any financial or other inappropriate connection with Bernard Madoff or the Madoff family that influenced the conduct of their examination or investigatory work.”

Thereafter the OIG found that the SEC had ample information in the form of “detailed and substantive complaints” from 1992 to 2008, all of which raised “significant red flags” about Madoff’s operations that the SEC then overlooked in “three examinations and two investigations” that turned up nothing. JPM is not mentioned once in that 457-page study. Why then does Bharara single the bank out for potential criminal investigation over four years later? Of course JPM knew that Madoff’s auditor, Friehling & Horowitz, was a penny-ante firm not equal to the task. But so too did the SEC and everyone else. Perhaps JPM knew that Madoff reported returns that were “too good to be true.” But again, so too did the SEC and everyone else.

Nonetheless, Bharara stokes this possible criminal investigation to leverage a favorable deferred prosecution agreement (DPA) with JPM. Under these agreements the government agrees to delay a deadly prosecution, but only if the target corporation plays ball. The basic set up runs as follows. Bharara, as prosecutor, has complete discretion on whether to press criminal charges. Those charges, without more, can easily trigger the suspension of JPM’s charter by the Office of the Controller of the Currency (OCC), which is running a parallel civil investigation of JPM. The OCC has met with Bharara, but “didn’t try to dissuade” him from considering a criminal investigation of JPM. The two parties thus seem to be working the same angle.

This cooperation between the OCC and Bharara is wholly intolerable. Any criminal conviction requires proof beyond a reasonable doubt, and normally carries with it a modest fine. Given the known collateral consequences, Bharara can impose heavy sanctions on JPM without proving anything in court. For the threat of prosecution to be credible, moreover, it has to be exercised at least once.

Just that happened when Arthur Andersen closed its doors in August 2002 after it was criminally indicted for its lax oversight of Enron, which went into bankruptcy in 2001. Nearly four years later the Supreme Court in 2005 unanimously tossed out that ill-conceived indictment for not alleging “the consciousness of wrongdoing” needed to support a conviction. Andersen’s ultimate vindication was of scarce comfort to the 85,000 employees who lost their jobs in the meantime.

Don’t expect, however, that this precedent will slow down Bharara and the OCC. For comfort, they need only to look at the sordid 2006 DPA agreement that then-New Jersey District Attorney Chris Christie extracted from Bristol-Myers Squibb in a securities case, which I denounced at the time as “The Deferred Prosecution Racket.” Christie used his leverage to gain a seat in the BMS Board Room and reserved the right to haul BMS on the carpet for an informal mini-trial in his office to decide whether the company had violated the terms of its DPA. To top it all off, he also required BMS to make a special gift (a practice since banned) to his alma mater, Seton Hall Law School, to support its ethics program.

Alas, the OCC and Bharara are following the same script to exert control over JPM that they could never get under ordinary government oversight. Such use of the DPA is often defended as the best means to restore public confidence in corporations that would fold if subjected to criminal prosecution. Not here. It is hard to see how dragging JPM through the mud is anything more than a crude attempt to force CEO Jamie Dimon to resign.

To be sure, it remains an open question whether the DPA is ever an appropriate government tool, or whether the entire notion of corporate criminality should be scrapped in favor of a policy that restricts criminal liability to corporate officers and directors who consciously orchestrated company misdeeds.

These fine points of corporate criminal responsibility are a side-show in Bharara’s threadbare investigation. A decade ago, then-Deputy Attorney General Larry Thompson wrote a notorious 2003 memorandum that listed nine squishy factors to guide prosecutors on corporate criminal indictments. But his memo never did explain how he planned to guard against the inversion that arises when the simple indictment is more deadly than an ultimate conviction. So it turns out there is indeed much to investigate after the early stages of this case against JPM.

Bharara should turn his not inconsiderable prosecutorial skills to ask whether he and the OCC should be subject to criminal or civil sanctions for their evident abuse of their extensive prosecutorial powers. While he is at it, he might prod his boss Attorney General Holder to probe Edward DeMarco for his blatant abuse as conservator in the ongoing Fannie and Freddie saga. The Obamacare rollout is not the only mess on the government’s plate.