Current Legal Issues Affecting Central Banks, Volume III.
Chapter

COMMENT

Author(s):
Robert Effros
Published Date:
August 1995
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Author(s)
JOHN K. CARROLL

When a criminal prosecutor is confronted with a situation like the Salomon scandal, two narrow questions come to mind. First, what is the function of federal law enforcement in the government securities market? Second, how should the criminal justice system exercise its discretion in determining whether to bring criminal charges against a large institution such as Salomon?

Role of Criminal Law Enforcement

In response to the former question, it can first be stated that the criminal justice system is a blunt tool for regulation. It is not structured to deal specifically with problems unique to the capital markets any more than it is tailored to deal specifically with the problems of organized crime, racketeering, or narcotics trafficking.

The function of the criminal justice system, and of any prosecutor’s office, when confronted with a problem like the Salomon situation is the same as its function in any other criminal situation. Fundamentally, this function is retrospective not prospective. Prosecutors look at past conduct, seek to find out what happened, and try to determine whether the conduct should be punished with the tools of the criminal justice system. The job of the criminal justice system is to punish for past wrongs. Prosecutors do not, and should not, seek to regulate. That is not to suggest that the actions of the criminal justice system do not affect the future. Indeed, when prosecutors make decisions in cases such as Salomon, they do so with an eye toward the future, but not with the eye of a regulator. The prosecutor’s narrow focus is to deter future unlawful conduct. In that sense, he or she is making decisions with regard to prosecution and punishment that will create disincentives for future unlawful conduct.

It is the prosecutor’s view that the government securities market, and financial and white-collar markets generally, are deterrable communities. If a cost structure is established that convinces market participants that bad conduct is bad business, then institutions and individuals in those markets will take the time and pay the expenses necessary to ensure good business practices. To the extent that a prosecutor assesses the future, it is only to set up systems of deterrence that encourage players to engage in lawful conduct.

The prosecutor’s power to participate in cases like Salomon derives from two sources. The first is general federal statutory authority that touches on frauds against institutional and private investors and other actors in the economic markets.1 These statutes govern broad types of fraud and were not tailored in any sense to the government securities markets. The second, more specific, source of authority is the federal securities laws, in particular the securities legislation of 1933 and 1934.2

The Salomon case did not involve the type of enforcement situation that might arise in an investigation of the debt or equities markets. In the latter type of investigation, the criminal justice system can look to the Securities and Exchange Commission, as an enforcement agency, for guidance. The SEC and the Department of Justice have a history of working with each other, such that the SEC understands Justice Department practices and enforcement needs. This understanding and trust have grown not out of one or two cases but from many cases spanning many years of working together. In the Salomon case, however, the traditionally clear line of guidance was blurred. Several authorities with differing interests in the regulation of the government securities market were competing to see their various theories and agendas implemented, and, as a result, there was no single regulatory voice to guide the investigation.

Determining Whether to Prosecute

In addressing the question of how the criminal justice system exercises discretion with regard to prosecuting individuals who it has determined have committed criminal acts in the government securities market, the first issue that must be resolved is whether the “bad actor” is an individual or an institution. If the criminal justice system is looking at the conduct of a particular person in a particular market, the process is quite simple. The prosecutor will determine whether to investigate that person based on the nature of the conduct. The questions prosecutors face when looking at the conduct of institutions, rather than individuals, are more diverse. As in the Salomon situation, the prosecutor must begin by asking where a particular individual is within the institutional framework? Is a high management official or a member of the executive committee or board of directors involved and is there an individual whose conduct can be construed as the conduct of the firm?

The second issue is whether the firm dealt with the individual in a way that makes the firm itself responsible for the individual’s bad acts. That is, did the firm fail to supervise this individual properly? Did the firm have in place appropriate compliance mechanisms that would anticipate the bad acts that may have been found, and did the firm deal with them? Was the firm in a position to be alerted to potential bad acts before they happened or shortly after they happened and did the firm deal with them efficiently? Or, was the firm taken by surprise or willfully blind to the bad acts of individuals? A final question is how the institution reacted to the bad conduct. Upon its discovery, what did the institution do? Did it act as a responsible market participant and corporate citizen?

The Salomon case provides an interesting example of this last question, because there were two institutional reactions. Upon initially learning of the conduct in the spring of 1991, the institution (that is, its two senior officers) essentially did nothing. They failed to suspend the culpable individuals or to bring the conduct to the attention of the federal regulators who govern the market. To this end, Salomon’s reaction was problematic. Indeed, in some sense, the ultimate crisis that Salomon faced was not caused by the acts of a couple of managing directors who were in charge of trading, but by the failure of its senior management to act when it learned of the bad conduct.

Fortunately for Salomon, and, indeed, for the markets, when Salomon’s board of directors learned of the conduct in August 1991, the company did act responsibly. Salomon promptly disclosed the conduct to government investigators and cooperated meaningfully with the government to determine the extent of the problem and to take action to solve it. To this extent, Salomon’s conduct should serve as a model for other public corporations confronting similar crises.

One factor that does not play a primary role in decisions to prosecute an institution is the potential market impact of the decision. As expected, it was contended that, if the government prosecuted a firm like Salomon, it would jeopardize the viability of Salomon and thus might cause larger market repercussions. Market impact, however, should only come into play secondarily, if the conduct under investigation and if the institutional reaction to that conduct do not argue compellingly in favor of bringing charges. If Salomon had continued to react in August 1991 as it reacted in March and April 1991, when it failed to disclose the conduct to the government, the outcome of the investigation would have been different. Arguably, the reason Salomon was not prosecuted, and another large firm was, is that as an institution Salomon ultimately behaved responsibly when confronted with the discovery of bad acts; the other did not.3

Only if an institution behaves responsibly upon the discovery of individual wrongdoing can a criminal prosecutor consider not prosecuting that institution. Furthermore, only in those circumstances is it appropriate for a criminal prosecutor to consider the market impact of a criminal prosecution.

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