New York Attorney General Eric Schneiderman’s recent decision to sue JPMorgan Chase & Co. for allegedly selling fraudulent mortgage-backed securities is excellent news - for the city of Stamford, Conn.
Unfortunately, it’s bad news for pretty much everyone else, and very bad news for Schneiderman’s home state.
Stamford, which is about 20 miles northeast of New York City, is dangling state incentive programs to convince white-collar businesses in Manhattan to make the outbound commute on a permanent basis. Schneiderman’s suit will give the effort a boost by pushing businesses away from New York just as Connecticut is working to pull them in.
The case is a strange one. For starters, the alleged fraud did not actually occur at JPMorgan, the company named in the suit. It happened at Bear Stearns, before JPMorgan took over the failing investment bank in 2008. Furthermore, when JPMorgan did acquire Bear Stearns, it did so at the express urging of then-Treasury Secretary Henry Paulson, his successor Timothy Geithner - who, at the time, was the head of the Federal Reserve Bank of New York - and current Federal Reserve Chairman Ben Bernanke. JPMorgan also required, as part of the deal, that the federal government take on $30 billion of Bear Stearns’ most problematic mortgage-related securities. JPMorgan CEO Jamie Dimon answered an urgent call from his country; Schneiderman's lawsuit is his thank-you.
A second, even more bizarre, aspect of the case is that alleged fraud against its customers is what led Bear Stearns to destruction in the first place. If the incident in question in the current case was a case of fraud, it was a particularly stupid one.
The complaint alleges that Bear Stearns misled investors about the quality of $212 billion in loans it packaged in its mortgage-backed securities in the lead-up to its collapse. According to Schneiderman’s office, Bear Stearns “systematically failed to fully evaluate the loans, largely ignored the defects that their limited review did uncover, and kept investors in the dark about both the inadequacy of their review procedures and the defects in the underlying loans.”
I have little doubt that Bear Stearns understated the risks inherent in the mortgages that were behind the securities it sold, but that was because the company itself, like nearly everyone else who participated in the real estate market during the boom years, underestimated the risks - especially the risk that housing prices could drop substantially. Bear Stearns suffered the consequences along with its investors.
When a company errs in an assessment, as Bear Stearns did, and passes its bad information on to others in good faith, that is a mistake. To commit fraud, on the other hand, a company must intentionally use false information to deceive another party. Alternatively, it has to be located in New York State. Bear Stearns had the misfortune to meet the second criterion.
A 1921 New York law known as the Martin Act makes it possible for prosecutors to level securities fraud charges against a defendant who never had any desire to deceive or defraud anyone. Under the law, when the attorney general prosecutes a securities fraud case, he or she only need show that an act “tending to deceive or mislead the public” occurred, not that one was intended. In fact, the misleading act does not even need to be something that occurred, since material omissions can also be considered fraud under the Martin Act. The Act differs dramatically from other laws related to fraud, which almost universally require prosecutors to show that defendants intended to mislead their victims.
The Martin Act also departs from most definitions of fraud by removing the requirement that the defrauded parties must have relied on the false information they received. The false information still must be “material,” in the sense that a reasonable person would consider it to be important in making a decision, but it does not need to have actually resulted in any decisions. This is important since, in the case of Bear Stearns, most of the investors who bought the faulty products were other large institutional investors that were entirely capable of performing their own due diligence.
While the Martin Act has been on the books for nearly a century, its current use is a modern invention. According to The Wall Street Journal, the law reappeared in public life after years of dormancy only in 2001, when a top aide told then-Attorney General Eliot Spitzer about its existence.
In addition to offering a looser definition of fraud, the Martin Act grants state attorneys general an array of other powers unheard of elsewhere in the country. The law is an artifact of another era, and I have serious doubts about whether it would survive a Supreme Court challenge. Rather than working to put New York back in line with national norms, however, Schneiderman has embraced the resurrected statute.
It’s hard, at first, to see what Schneiderman has to gain from wielding the Martin Act in this case. No harm was intended; the company that committed the alleged fraud has already paid the price of its mistakes; and the target of the suit, JPMorgan, got itself involved at all primarily as a favor to the U.S. government.
But in addition to being the New York Attorney General, Schneiderman is also a politically ambitious Democrat and co-chairman of a group called the Residential Mortgage Backed Securities (RMBS) Working Group. The group was, according to a press release, “created by President Obama earlier this year to investigate those responsible for misconduct contributing to the financial crisis through the pooling and sale of residential mortgage-backed securities.”
In non-press-release language: The RMBS Working Group’s one goal is to find someone, anyone - other than politicians - to blame for the financial crisis.
The case against JPMorgan is the first to be launched by the group, and Schneiderman has been careful to include plenty of political buzzwords in his comments to the press. “This lawsuit will bring accountability for the misconduct that led to the crash of the housing market and the collapse of the American economy,” he explained. The group has also promised that the case against JPMorgan will be only the first of many.
While Schneiderman is busy staying on message for the benefit of the American voting public (and his party), he is also sending a clear message to businesses in New York. In New York, it seems, intent doesn’t matter, but politics does. Businesses that would prefer to be held accountable only for actual misdeeds would do well to go elsewhere.
Stamford will be happy to have them.
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