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Watchdog collars

22 Oct 2013 By Reynolds Holding

The biggest U.S. bank fines involve far more art than science. In theory there are defined, if loose, legal criteria for penalties. But enormous settlements – like the possible $13 billion bite out of JPMorgan – can seem pulled from thin air. While courts occasionally run the rule over the numbers, regulators’ zeal and public outrage outweigh the logic.

The widely reported JPMorgan deal with a slew of U.S. watchdogs isn’t final, but it’s largely based on Justice Department investigations of dodgy mortgages under the Financial Institutions Reform, Recovery and Enforcement Act or FIRREA. The 1989 law penalizes misconduct that “affected” institutions and can cover, say, a bank’s alleged lies that attract costly litigation. Its low burden of proof, lengthy 10-year statute of limitations and harsh civil penalties make it a powerful enforcement weapon.

Penalties under FIRREA can reach $1.1 million per violation, $5.5 million for a continuing breach, or in some cases the total amount a violator gained or its victims lost. Courts have lots of leeway, guided by factors like precedent and the severity of the conduct or harm. To reach the billions being discussed in the JPMorgan example would surely require considering thousands of individual mortgages separately.

Laws covering the Securities and Exchange Commission and other bank regulators are a bit more rigid. They divide financial wrongdoing into three levels, depending on whether fraud or major investor losses were involved. Each level prescribes a maximum fine per violation for individuals and companies. The top tier company fine, for instance, is currently $775,000. The maximum for cases in federal court, as opposed to administrative proceedings, can be the wrongdoer’s total gain.

A lot depends on how violations are counted. Various courts have summed the number of investors duped, statutes violated or transactions gone awry. After the defunct Primary Reserve Fund was found liable this year for misleading investors, the SEC demanded more than $130 million, calculated by counting as a separate violation each of the 200 times investors received inaccurate brochures. The court ruled that sending the brochures was one offense and cut the overall penalty to $750,000.

Determining an alleged wrongdoer’s total gain can be even more subjective. The SEC settled a 2011 case over a dodgy Citigroup collateralized debt obligation for $285 million, including a $95 million penalty. But U.S. District Judge Jed Rakoff rejected the settlement, calling the penalty “pocket change” after calculating the bank’s gain at $160 million. The SEC protested that it couldn’t recover more under the relevant statute.

The Office of the Comptroller of the Currency, the Federal Reserve and other regulators operate under similar rules. The prescribed penalties cover a wider range, however, and are assessed for each day a violation exists. More than a dozen policy considerations, from the bank’s size to the degree of cooperation with officials to whatever “justice may require,” also enter into the mix.

That flexibility can produce unpredictable results. The OCC’s $200 million fine against JPMorgan over its London Whale trades, for instance, was based on a legal provision calling for a maximum penalty of $25,000 a day. The agency declined to say how it arrived at a figure 8,000 times that amount.

In fact, most high-profile civil penalties are heavily negotiated beyond statutory bounds. In broad investigations like the U.S. mortgage-backed securities cases, reaching a settlement first, reporting wrongdoing or being seen as less culpable than peers can prompt a substantial discount. It seems that not being Goldman Sachs, JPMorgan or another institution under particular scrutiny by the public or Congress can also help.

Similar considerations can apply in criminal cases. The federal sentencing guidelines and other laws, however, not only reduce discretion, they also require prosecutors to justify asking for certain penalties. That creates a more predictable and even-handed system of punishment.

Civil fines like those in JPMorgan’s putative settlement aren’t subject to these tighter constraints because, at least theoretically, they aren’t as harsh. That distinction is, however, getting tough to maintain in an era of multi-billion dollar deals with the government.


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