Release the Hounds: NY Attorney General's Office Pursues Wall Street (Again)

    As common as it is to find thin greasy pizza in Brooklyn, it is just as common to hear that the New York Attorney General's office is launching a zealous high-profile prosecution of Wall Street. One need only whisper the name "Spitzer" in lower Manhattan to receive a response of colorful epithets and conjure up a regime that has been described as, "the most egregious and unacceptable form of intimidation we've seen in this country in modern times."[1] That is quite a statement considering some of the actions undertaken by the U.S. Justice Department in recent years. However, Mr. Spitzer is safely ensconced in the N.Y. Governor's office; are not the days of feasting on Wall Street over? Not so fast, this past week current Attorney General Andrew Cuomo's office indicated it will pursue firms suspected of "mortgage abuses" linked to the national subprime mortgage fiasco.[2] This article will explore the legal and substantive basis of the AG's interest in these Wall Street firms.

    During the week of January 27, 2008, the New York Attorney General's Office issued subpoenas to at least a half-dozen Wall Street financial firms concerning their possible involvement in securities fraud.[3] Specifically, the subpoenas are issued under the Martin Act of 1921 in order to gather information into whether these firms intentionally disregarded warnings indicating that some of the home mortgage loans that the firms repackaged as securities were in fact bad.[4] The subpoenas are a culmination of an inquiry that began last summer[5] and was given a recent push after a participant agreed to cooperate with NY authorities.[6] The Connecticut-based home loan reviewer Clayton Holdings Inc. agreed to provide important documents and testimony of key officials pertinent to its involvement with the Wall Street firms.[7]

    Clayton Holdings is a home mortgage vetting firm that reviewed thousands of loans for investment banks over the past few years. New York officials are specifically looking for key disclosures concerning certain "exception" loans that these Wall Street firms accepted and later collateralized.[8] "Exceptions" are loans that do not even meet minimum lending standards.[9] NY officials are concerned that Clayton's disclosures will reveal that such exceptions, "accounted for a 'significant' or 'substantial' portion of the loans contained in the securities" that the Wall Street firms created.[10] What made the exception loans attractive to Wall Street firms is that such low grade loans could often be purchased at discount rates, which potentially increased their margins once the loans were collateralized into high-rated securities.[11]

    Consequently, since the Wall Street firms did not regard the exceptions when collateralizing the loans, Moody's and Fitch claim they were not privy to this crucial information when gave the securities triple-A ratings.[12] The subtle implicit allegation is that the Wall Street firms concealed from the credit-rating firms Clayton's due-diligence reports concerning the exceptions, "in a bid to bolster ratings of mortgage securities and make them more attractive to buyers...which often required AAA...ratings on potential investments in securities containing risky mortgages."[13]

    To be sure, New York is not the only state curious about Wall Street's mortgage re-packaging deals; other states such as Florida, California, and Illinois have launched their own investigations through their particular attorneys general.[14] The F.B.I. has even opened a very broad inquiry into possible accounting fraud, insider trading, and other violations concerning subprime loans made to risky mortgagors.[15] However, what distinguishes these investigations from the NY AG's inquiry is that it was made pursuant to the Martin Act of 1921.[16]

     The Martin Act was enacted in 1921 in order to punish securities fraud and is regarded as one of most "potent" legal tools in the nation.[17] The Act's potency is provided by its broad scope as well as providing the NY AG with muscular enforcement and investigative powers unparalleled at the federal level.[18] In fact, prior to 2001, the AG used the Martin Act to ferret out low-level "boiler-room frauds" involving small time individual defendants while, "It was generally acknowledged within the securities industry and the law enforcement community that the SEC, the NASD and the US Department of Justice had primary responsibility for securities regulation and enforcement."[19] That understanding drastically changed with the combination of an aggressive AG by the name of Elliot Spitzer and the high profile corporate financial frauds that began in late 2001 and early 2002.[20]

    Mr. Spitzer used his enforcement powers under the Martin Act to take on big financial industry players, such as Merrill Lynch, to obtain eventual settlements because of their involvement with various securities frauds.[21] Some of the powers afforded to the AG under the Martin Act include authorizing the AG to commence an investigation on the basis of suspected "fraudulent practices" related to "the advertisement, investment advice, purchase or sale" of securities within New York state.[22] Moreover, the definition of "fraudulent practices" is much broader than the definition under federal securities laws[23]; the former definition encompasses, "devices, schemes, artifices, fictitious or pretended purchases or sales of securities or commodities, deceptions, misrepresentations, concealments, suppressions, frauds, false pretenses, false promises, practices, transactions and courses of business..."[24]

    Additionally, a defendant does not need to purchase or sell actual securities to be found liable, which is also a much broader provision than under the federal securities laws.[25] Further, the Martin Act does not require "proof of intent to defraud, reliance, or damages" to establish misdemeanor liability; felony liability does require proof of intent but not customer reliance.[26] Unlike the SEC, which only possesses civil litigation powers, the Martin Act empowers the NY AG with both civil and criminal enforcement authority.[27] For instance, the NY AG can state a claim seeking full restitution on behalf of defrauded investors, which is a power federal prosecutors do not possess except upon a conviction or guilty plea.[28]

    It is unclear whether the most recent subpoenas issued by the NY AG's office to several Wall Street firms relate to either criminal or civil matters.[29] Nevertheless, subpoenaed firms including Bear Stearns Cos., Deutsche Bank AG, Morgan Stanley, Merrill Lynch & Co., and Lehman Brothers[30], face an AG's office that is empowered under the Martin Act with strong investigative and evidentiary compulsion powers. For instance, in a procedure known as a "Martin Act hearing", the AG can "subpoena witnesses, examine them under oath, and compel the production of any relevant documents...[and] failure to comply with a Martin Act subpoena constitutes a misdemeanor."[31] Further, if for instance Merrill fails to comply with the subpoena, it "constitutes prima facie proof that the defendant has engaged in the suspected fraudulent activities and, standing alone, can provide the basis for a permanent injunction order."[32]

    Wall Street doubtless knows the Martin Act practices and procedures all too well after seven years with Eliot Spitzer at the helm. More specifically, the Street firms are pointedly aware of the broad scope and investigative authority provided to the attorney general's office. However, with Spitzer now gone and a new high-profile controversy embroiling Wall Street (this time involving subprime debt collateralization), it will be interesting to see how NY Attorney General Cuomo uses his Martin Act powers to ferret out cases of securities fraud.

[1] U.S. Group is Taking on Spitzer, INT'L HERALD TRIB., January 6, 2005, http://www.iht.com/articles/2005/01/05/business/spitzer.php.

[2] Kate Kelly et al., State Subprime Probe Takes a New Tack, WALL ST. J., January 31, 2008, at A3, available at http://online.wsj.com/article/SB120173938230430417.html.

[3] Id.

[4] Id.

[5] Vikas Bajaj & Jenny Anderson, Inquiry Focuses on Banks' Withholding of Loan Data, N.Y. TIMES, January 12, 2008, at http://www.nytimes.com/2008/01/12/business/12lend.html?pagewanted=1&_r=1&sq=Inquiry%20Focuses%20on%20Banks'%20Withholding%20&st=nyt&scp=1.

[6] Jenny Anderson & Vikas Bajaj, Loan Reviewer Aiding Inquiry Into Big Banks, N.Y. TIMES, January 27, 2008, at http://www.nytimes.com/2008/01/27/business/27subprime.html?scp=4&sq=vikas+bajaj&st=nyt.

[7] Id.

[8] Id.

[9] Kelly, supra note 2, at A3.

[10] Anderson, supra note 6.

[11] Bajaj, supra note 5.

[12] Id.

[13] Kelly, supra note 2, at A3.

[14] Ruth Simon, Subpoena Deepens Countrywide's Woes, WALL ST. J., January 31, 2008, at A12, available at http://online.wsj.com/article/SB120174792324430933.html.

[15]  Vikas Bajaj, FBI Opens Subprime Inquiry, INT'L HERALD TRIB., January 30, 2008, http://www.iht.com/articles/2008/01/30/business/30fbi.php.

[16] Kelly, supra note 2, at A3.

[17] Id.

[18]  Dietrich L. Snell & Wendy T. Wu,  New York State's Martin Act: An Outline of the New York Attorney General's Powers and Practices, PRACT. LAW INST. PLI Order No. 14655 (2008).

[19] Id.

[20] Id.

[21] Id.

[22] Id.

[23] Id.

[24]  N.Y  GEN. BUS. LAW § 352(1) (2008).

[25] Snell, supra note 18.

[26] Id.

[27] Id.

[28] Id.

[29] Kelly, supra note 2, at A3.

[30] Id.

[31] Snell, supra note 18.

[32] Id.