The real Wall Street problem US prosecutor Preet Bharara is trying to solve

January 7, 2014
January 7, 2014

US Attorney Preet Bharara—the man with effective jurisdiction over white-collar crime on Wall Street—is about to announce yet another settlement with JP Morgan. The bank is expected to pay some $2 billion for failing to notice that one of its clients, Bernard Madoff, was running a Ponzi scheme.

While much of the money will be going to the victims of Madoff’s fraud, the win for Bharara is the deferred prosecution agreement, a tool rarely deployed against US banks. It will allow prosecutors to monitor an overhaul of the controls the bank uses keep an eye out for illicit activity. The government can criminally indict the institution if it is not up to snuff within two years.

These controls are already required under the Bank Secrecy Act, but that didn’t stop JP Morgan from failing to report some extremely blatant signs of trouble, including a decision by the bank’s own investors to pull out of Madoff’s funds. Nor did they stop HSBC from laundering money for drug cartels, terrorists and other criminals before it, too, was caught and fined.

But compliance controls did lead to one of the biggest coups of Bharara’s career so far—the insider trading investigations that put Steven Cohen’s hedge fund, SAC, out of business. Tonight, the US television magazine Frontline will present a report tracking this case from its origins to the present today, and it underscores that the case began when UBS reported that a small hedge fund called Sendant was intermingling its own money with that of its clients, giving them the losing trades, and making suspiciously well-timed bets.

Sendant was managed by a man named Rengan Rajaratnam. He soon closed it to go work for his brother, Raj Rajaratnam, at another hedge fund, Galleon. Investigations into the brothers’ activities (which wound up with Raj in jail and Rengan facing indictment) eventually led to the SAC case.

So why did UBS decide to comply with the rules and alert regulators about the doings of a small hedge fund? No doubt UBS is a very upstanding and law-abiding institution—but the decision was probably made easier by the fact that UBS wasn’t a big player in the prime brokerage business (i.e., handling trades for hedge funds) and that Sendant was only a small part of that business.

But Madoff paid hundreds of millions in fees to JP Morgan. And SAC paid huge fees to its brokers on Wall Street—Morgan Stanley, Goldman Sachs, JP Morgan, Credit Suisse  and Barclay —as it provided as much as 2% of daily equities trading. Those extra-high commissions helped SAC’s traders get access to the “first call” from salesmen at these banks, but also made for a pretty clear conflict of interest. The decision to pass along a warning to regulators about potential crime is complicated when you’re also benefitting from it.

Today’s settlement, like HSBC’s before it, is a message to the biggest banks that they’ll pay a price if they don’t turn in criminals whose activities help the bank’s bottom line. Whether that price will be enough to change behavior—much less change the management—remains to be seen, but Bharara clearly understands the benefits of making banks comply.

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