Since the financial crisis, there have been plenty of arrests, prosecutions, and convictions of shady characters in the financial industry. Hedge funds, traders, money managers, and others have gone to jail for extended terms. They've kept the FBI, the SEC, and various attorneys general quite busy.
But hedge funds and traders were only peripheral players in the buffoonery that led to the financial crisis in the first place. The core of the crisis sat in the executive management offices of the nation's banks, and shockingly few of those individuals have personally faced legal repercussions.
The cast of characters
It's not that prosecutors haven't tried. Angelo Mozilo, the chief executive of subprime lender Countrywide, faced a criminal investigation in 2012. That investigation was eventually abandoned after prosecutors failed to uncover sufficient evidence of illegal activity.
Last year, prosecutors revisited Mozilo's case and put his attorneys on notice of a pending civil case. That case has yet to be filed, but the worst Mozilo could face is a fine. He won't see the inside of a jail cell.
The acquisition of Mozilo's Countrywide is largely blamed for the near-collapse of Bank of America (NYSE:BAC) as the real estate market collapsed in 2008 and 2009. Bank of America's market cap fell as much as 90% from its 2007 high. It has since recovered, but it still sits 29% below where it stood on Jan. 1, 2007.
The bank has paid a fortune in fines and settlements to regulators and prosecutors, but those fines have been levied against the corporate entity. The bank's management and board of directors remain unscathed.
The pattern is similar across the industry. JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), and dozens of others have already paid billions in fines. One study by Keefe, Bruyette & Woods found that banks have paid $184 billion in fines thus far, with 174 cases still pending. High-ranking executives, though, haven't felt nearly as much personal financial pain.
For smaller banks, the story is somewhat different, but the end result is similar. For example, the former CEO and four board members of Integrity Bank, a Florida regional, agreed to settle claims made by the FDIC by paying a $1.8 million fine. That fine was levied against the chief and the directors individually, but it will almost certainly not come out of their pockets: These five individuals cited have liability insurance, which banks buy to protect management in just such a situation, so an insurance company will pay this fine.
The reason why is obvious but nevertheless frustrating
The FDIC's post-mortem examination of Integrity Bank cited a lack of effective oversight, excessive risk-taking, and inconsistent executive management as the reason for the bank's failure. Yet none of those failures are illegal; they're mistakes made by an inexperienced board. They're failed bets on risky assets, symptoms of poor management.
A Ponzi scheme is a crime. Insider trading is a crime. But poor management is perfectly legal, and it's a great excuse for plausible deniability. That's why chief executives at banks such as HSBC, Barclays, and RBS won't go to jail for traders and middle managers who rigged the interest-rate benchmark LIBOR across global markets, for example. The traders and actual fraudsters executing the schemes may see time behind bars, but not upper management.
The same goes for executives at Goldman Sachs (NYSE:GS), who won't see jail time after the bank sold toxic mortgage securities to clients while simultaneously betting against those securities with the bank's money. Goldman will pay the $550 million fine and go back to business as usual. The business model was slimy and unethical, but the country's sharpest prosecutors can't find a way to hold the individuals managing the show responsible. Unethical doesn't always equal illegal.
A vital lesson for investors
The bottom line is that everyday investors like you and I can't count on the legal system to bring justice when managers hide behind incompetence or ignorance. If the top executive leads the company off a cliff, odds are he or she did it legally. And even when laws are broken, the company is more often than not on the hook for the punishment.
And either way, shareholders are likely to lose in the bargain.
That's why it's so critical to thoroughly evaluate the management of any company you invest in. Seek to find out not only whether executives are talented, but also whether they're trustworthy.