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Dueling Public Interests In Policing Rescued Firms
SEC Actions Could Weigh on U.S. Stakes

By Zachary A. Goldfarb
Washington Post Staff Writer
Tuesday, August 4, 2009

Late last month, the Securities and Exchange Commission was poised to file suit against a subsidiary of Alabama-based Regions Financial for selling nearly $1 billion in troubled investments.

But the agency faced a new dilemma: Regions was on the list of the nation's most troubled large banks and had received $3.5 billion in taxpayer aid. SEC officials considered that filing suit to force Regions to buy back the troubled investments could hurt the bank. Should the agency act, or should it hold off to protect the government's investment?

The SEC decided to file. But the quandary shows the difficulty facing the nation's top Wall Street cop at a time when the economic crisis has left the U.S. government as the part-owner or controller of an unprecedented array of financial companies. Protecting investors on the one hand could mean harming taxpayer-owners on the other. And some troubled firms could wind up paying penalties with taxpayer money from the federal bailout.

"Normally the SEC's focus is on the protection of investors -- that is, people who are trading securities in capital markets," said James Cox, a securities law professor at Duke University. "With the government being a substantial stockholder, you could well think the SEC's consideration could extend to matters that relate to the financial success of the firm itself."

On Monday, the SEC faced another awkward question: How to pursue cases when government officials may have played a role in alleged wrongdoing? The agency charged Bank of America with violating securities laws for hiding from investors plans to pay billions of dollars in bonuses to employees of Merrill Lynch, the troubled investment bank it bought. The charges, which Bank of America settled, intensified concerns on Capitol Hill that the Treasury Department and the Federal Reserve may have been involved in efforts to avoid the disclosure of facts that could have derailed the deal.

As the SEC pursues numerous investigations into major financial firms, agency officials say they expect to wrestle with the competing demands of punishing wrongdoing and keeping financial firms healthy to support the economic recovery. In particular, they plan to take into account whether companies have received assistance from the government's signature bailout initiative, the Troubled Assets Relief Program. Officials said they are evaluating the size of fines and redress sought and the impact these could have on the financial system beyond the specific firms.

Robert Khuzami, director of the SEC's enforcement division, said in an interview that these considerations are not likely to have a major effect on the SEC's approach. "TARP status may come into play in only a few cases, but is unlikely to dictate the outcome," he said.

Khuzami said the SEC already had a policy to "consider an entity's distressed financial situation in deciding a monetary sanction." Government ownership of companies under investigation has not yet affected a case outcome, he said.

Last summer, before the government started bailing out banks, the SEC was planning massive, multibillion-dollar suits against the nation's biggest financial firms, including Merrill Lynch and Citigroup, for selling problematic bonds known as auction-rate securities.

The SEC enforcement staff pushed for the cases. But some agency officials and others at the Fed raised concerns that the suits could wound the banking sector. SEC and Fed officials discussed whether forcing banks to give billions of dollars back to investors could push several banks off the cliff, perhaps necessitating government action to save them, according to one current and one former SEC official.

In the end, after several conference calls, the officials concluded that the settlements would not cause a crisis.

But to Brian G. Cartwright, the SEC's general counsel at the time, the episode highlighted the delicate position in which the agency is increasingly finding itself.

"There is an inherent tension in the regulator's interest in bringing claims for the benefit of injured investors in the auction-rate cases and the government as a whole's interest in not becoming involved in a bailout that has systemwide consequence," Cartwright said.

The government has brought few cases against high-profile companies so far in connection with the financial crisis. In June, the SEC sued former executives of Countrywide Financial, the big mortgage lender that Bank of America acquired last year, alleging that they concealed from investors the risks associated with home loans it offered.

The SEC now has multiple investigations underway into the largest financial companies. According to disclosures, investigators are looking into the sale of derivatives by American International Group, which has received more than $100 billion in government aid, and into disclosures by mortgage giants Fannie Mae and Freddie Mac, which together have received $85 billion in aid. Also facing investigations related to a variety of possible infractions of securities laws are Citigroup and Bank of America, which have received tens of billions of dollars in federal aid.

The SEC's job is not only to enforce the securities laws. It also must rule on difficult questions about the rights of shareholders, the decisions of boards of directors, the disclosures of companies and other complex issues.

Bank of America's acquisition of Merrill is posing questions because U.S. officials played an outsize role in closing the deal. On Monday, Bank of America agreed to pay a fine of $33 million while not admitting or denying allegations that it had concealed the pending bonuses from investors.

Bank of America chief executive Kenneth D. Lewis has said he was pressured by Fed Chairman Ben S. Bernanke and then-Treasury Secretary Henry M. Paulson Jr. to close the acquisition, even though he had concerns about the fast-declining financial health of Merrill Lynch.

Lewis and the government forged an agreement of additional support for Bank of America if it went through with the deal, which officials saw as necessary for the stability of the financial sector. Some lawmakers have accused both Lewis and government officials of working to conceal important elements of the deal from the public.

"Bank of America had an absolute obligation to bring relevant information to the attention of its shareholders," said Rep. Darrell Issa (Calif.), the top Republican on the House Oversight and Government Reform Committee. "Federal officials share that same obligation to not exert inappropriate pressure or limit disclosure of a private transaction that might not have been in the best interest of shareholders. In both instances, it appears these obligations were not fulfilled."

Lewis, Bernanke and Paulson have all insisted that they acted properly.

But experts say cases like Bank of America's create a problem for the SEC.

The SEC has no legal authority to investigate government officials for actions taken in carrying out their jobs, said Harvey Pitt, a former SEC chairman. "It raises a question about how would the SEC protect one of its principal constituencies -- namely public shareholders -- if it cannot go after the people that led to the conduct that allegedly violated the law," he said. "That would raise a very difficult policy conundrum."

The government's stake in firms and its varying levels of control in AIG, General Motors, Fannie Mae and Freddie Mac creates an an additional challenge because the SEC might end up having to adjudicate between government shareholders and private shareholders.

Tensions arise "if the government has a significant stake in an entity, sufficient to give it influence and control, and wants to use that influence so that the entity pursues courses of action that may be politically attractive," Cartwright said. "There, the government is interested in the entity accomplishing public ends that are not aligned with the interests of the other stockholders."

Under the Treasury's watch, Fannie and Freddie, for instance, were seized by their regulator, the Federal Housing Finance Agency, in September, and placed in a temporary legal status known as "conservatorship." This period was described as a "timeout" during which the companies could be used to help the housing market while Congress figured out their futures.

Since then, they have been used essentially as wards of the state -- tools to carry out public policy geared at reducing foreclosures and lowering interest rates on home loans. The FHFA argued that this course was best for the businesses and for the nation.

Christopher Cox, who was chairman of the SEC until Jan. 20, expressed concerns that the companies were not being restored to profitability as quickly as possible. In a letter first reported by Bloomberg News, he wrote, "the statutory and publicly stated goal for the conservatorship is to restore these institutions to financial health." He added that not working toward that "would undercut the Conservator's responsibility to run these entities prudently and toward restoring their financial health."

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