Opinion: JPMorgan Gets A Break Where Goldman Got Nailed

By Jonathan Weil
Bloomberg News Columnist

Once again the Securities and Exchange Commission has filed a complaint against a too-big-to- fail bank that hinges on the meaning of one word: "selected." Last year, the bank was Goldman Sachs, which the SEC accused of intentional fraud. This week, the defendant was JPMorgan, which got far easier treatment.

Why the different approaches? The agency isn't saying. Judging by the allegations, both companies in essence did the same thing. Yet JPMorgan caught a break, and Goldman didn't.

The SEC says the securities arm of JPMorgan Chase & Co. defrauded investors in a $1.1 billion bond deal called Squared CDO 2007-1. The SEC didn't accuse the bank of defrauding anyone intentionally, however, only negligently. One quirk of the Securities Act of 1933 is that the courts have said the SEC need only show negligence to establish violations of the statute's less-serious antifraud provisions. Hence, one of the great oxymorons of American legalese: "negligent fraud."

The critical misrepresentation JPMorgan made was that the portfolio of mortgage-related investments underlying Squared was "selected" by a collateral manager named GSCP, according to the SEC's complaint. That statement, contained in JPMorgan sales materials, wasn't true, the SEC said.

In fact, a hedge fund that shorted more than half of Squared's portfolio, Magnetar Capital, had a significant role in selecting the collateral. That was something JPMorgan knew and that other investors weren't told, the SEC said.

Squared defaulted in January 2008, eight months after the deal closed. Magnetar made a killing. JPMorgan lost $880 million on its holdings and would have lost more had it not sold $150 million of Squared's notes to institutional investors, including a nonprofit insurance group for Lutherans. Their stakes became almost worthless. The SEC didn't sue anyone who worked for JPMorgan and said it doesn't expect to.

Compare that with the regulator's lawsuit against Goldman Sachs Group Inc.'s securities arm last year over another synthetic collateralized debt obligation tied to the housing market, called Abacus 2007-AC1. In that case, the SEC said Goldman committed fraud with scienter, meaning with intent or knowledge of wrongdoing.

The agency said Goldman's main offense was telling investors that the underlying collateral for Abacus had been "selected" by an independent company called ACA Management. That wasn't true, the SEC said, because Goldman knew the hedge fund Paulson & Co., which was shorting the deal, had helped pick the collateral. The Abacus notes that Goldman sold to investors lost almost all their value. Paulson made $1 billion.

The SEC also sued an individual, low-level Goldman executive, Fabrice Tourre, accusing him of the same misconduct as Goldman. Tourre has denied the allegations in court, while Goldman, after initially vowing to fight the SEC, settled last year for $550 million, without admitting or denying the fraud claims.

Why did the SEC decide that JPMorgan's actions amounted only to negligent fraud and not fraud with scienter? The head of the SEC's enforcement division, Robert Khuzami, didn't answer that question when I put it to him in a conference call with reporters this week. I also asked him if JPMorgan's willingness to settle the case played a role in the SEC's decision. He said it didn't.

Under the accord, JPMorgan will pay $153.6 million, pocket change for a bank that earned $17.4 billion last year. The agreement includes a $27.7 million fine, as well as restitution for harmed investors, who the SEC says will be made whole.

The SEC did sue one individual in the Squared matter, Edward Steffelin. He worked for the collateral manager, GSCP, which filed for bankruptcy last year. The SEC said he was seeking employment with Magnetar at the time in question. Steffelin's attorney, Alex Lipman, told Bloomberg News he didn't understand "how the SEC can charge Mr. Steffelin with a failure to disclose in the case where he didn't even work for the underwriter, who has the responsibility for the disclosure."

As for Magnetar, the SEC said it wasn't sued because it didn't have any disclosure obligations to other investors. The SEC gave similar reasons last year for why it didn't sue Paulson over the Abacus transaction.

In an interview this week with Bloomberg Television, Khuzami said the SEC had sent a message to Wall Street: "If you mislead investors, you're going to pay a fine or a penalty that's a multiple, in some cases many times a multiple, of the money that you thought you made in the deal."

That's not quite what happened at JPMorgan, though. Perhaps if "you" are a bank, then you might pay a fine. However, if "you" are a banker who did the misleading that caused your bank to be fined, there's a good chance you'll get off scot-free.

The SEC can boast it filed a fraud claim against a Wall Street powerhouse, though it's fraud in name only. JPMorgan, without admitting or denying the SEC's claims, gets to say it wasn't accused of any intentional violations of the law, or even any reckless ones. And aside from the SEC's unproven allegations, the public has little idea what really went on.

There's still a chance we'll find out more. Sometime in the coming weeks the U.S. district judge assigned the case, Richard Berman of Manhattan, will have the opportunity to hold a hearing on the SEC's proposed settlement, if he wants to, before deciding whether to approve it. And maybe if we're lucky he won't be a rubber stamp. Too many unanswered questions remain. Here's to hoping he puts the SEC through the wringer.