NEW YORK TIMES

March 15, 2012

Paving Path to Fraud on Wall St.

By FLOYD NORRIS

Nearly 20 years ago, Bankers Trust was riding high. The bank, based in New York, had become known as an expert in then-newfangled derivative securities, and the profits were flowing in. In an era where commercial banks were often viewed as stodgy and unimaginative, it stood out as a shining light. Corporate treasurers sought its insights about ways to maximize income from idle cash. Wall Street firms scrambled to compete.

Then the tapes came out.

On those tapes, recorded in 1993 and 1994, Bankers Trust executives were heard to discuss how they were misleading customers who did not understand what they were doing. Speaking among themselves, bankers used the term “R.O.F.” It stood for “rip-off factor,” the amount the bank could take from unsuspecting clients.

Those clients included Procter & Gamble and Gibson Greetings, which had entered into contracts with Bankers Trust for complex interest-rate swaps that would raise the companies’ incomes a little if interest rates continued to fall — as the conventional wisdom then said they would — but result in enormous losses if rates rose only a little bit. Rates rose more than a little, and the companies soon found evidence they had been told lies and sued. Eventually, Bankers Trust was forced to settle.

Bankers Trust was never the same after that. It was still a swashbuckling trading firm, but in 1998 it made some bad bets of its own. It wound up being acquired by Deutsche Bank. On the way out, the company pleaded guilty to defrauding the state of New York by seizing abandoned funds that should have gone to the state.

The fate of Bankers Trust came to mind this week when a midlevel Goldman Sachs banker chose to leave the company with a blast delivered through the Op-Ed page of The New York Times. “I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients,” wrote Greg Smith. “It’s purely about how we can make the most possible money off of them.”

Bankers Trust gave us the term “R.O.F.” Mr. Smith says Goldman referred to its clients as “Muppets,” talked about “ripping eyeballs out” and rewarded employees for “hunting elephants,” a term he said meant persuading clients to do whatever would be most profitable for Goldman.

In finance, acting like a shark who will rip your opponents into little pieces has long been viewed as a positive thing. Such a reputation will even draw in clients who want to harness those tactics for their own benefit. The catch for Goldman could be, as it was for Bankers Trust, that the clients will flee if they think the firm intends to rip them off.

Goldman has a far stronger market position now than Bankers Trust ever did. Its competitors may not be as publicly aggressive as Citi was back in the 1990s, when it went after Bankers Trust customers with an ad proclaiming, “You expect derivatives to solve problems, not create them.” But they will be quietly courting clients by saying they will work for the customer, not against him.

Mr. Smith will be offered opportunities, possibly by clients whose trades did not work out, to get specific about how Goldman ill-served its customers. If he takes any of them, Goldman’s pain may endure.

One of the amazing stories of this year has been the fact that Wall Street, for all its public opprobrium, is on the brink of a major legislative victory to roll back decades of regulation and rules aimed at preventing underwriters from ripping off customers.

Last week, the House of Representatives, with the support of every Republican and most Democrats — as well as a White House endorsement — passed something it called the “Jump-start Our Business Start-ups Act,” or JOBS for short. The logic is that if we can just make it easier for companies to raise capital, they will hire more people.

Do you remember the scandals of the dot-com era? Then Wall Street firms got business by promising companies that they would write positive research reports if the company would only hire them to underwrite an initial public offering of stock. Companies went public at a feverish pitch, often rising to amazing heights without much in the way of sales, let alone profits. Then it all came crashing down.

In the aftermath, the brokers were forced by the Securities and Exchange Commission, as well as the New York attorney general, to mend their ways. No longer would analysts be allowed to go on such I.P.O. sales calls.

This bill would end that rule for all but the biggest new offerings — those that involved companies with sales of over $1 billion. And it would go much further. As the law stands now, to keep underwriters from making sales pitches that go beyond what companies are allowed to say, the underwriters are prohibited from publishing research on a company while its initial public offering is under way. This bill would allow such research, and would say that the company bore no responsibility for what was said in it. Effectively, there would be a second prospectus — one largely immune to securities laws and free to hype the offering by making forecasts not otherwise allowed.

Why is this needed? Advocates point to the fact there are fewer initial public offerings now than there were during the Internet bubble. That most of those offerings were horrible investments is conveniently ignored. Nor is any consideration given to the idea that once-burned investors might be more wary. The explanation must be excessive and unreasonably expensive regulation.

The bill also relaxes rules for new offerings in other ways. There are limits now to keep private offerings private, rather than allow them to be pitched widely. Forget that. The bill endorses the wonderful concept of “crowdfunding,” in which anyone can post an idea on the Web and raise money for it. If you raise only $1 million that way, then you don’t even have to provide financial statements. You are under no obligation whatever to keep investors informed. If you are willing to put out a financial statement when you seek the money, you can get up to $2 million.

One interesting aspect of the bill is that while it would make it a lot easier for companies to raise capital without disclosing very much, it would also make it easier for companies that are public — and have the capital — to “go dark” and stop providing financial information to their shareholders. The basic message to investors would seem to be: Give us your money and then don’t bother us any more.

Last year, the S.E.C., worried about a spate of frauds, required Chinese companies to follow the same rules that American ones do, with prospectuses made public as soon as they were filed. Since last summer, there have been no new Chinese initial public offerings in the United States. That tightening of regulation would be reversed by this bill.

“If you like those e-mails from Nigerian scammers, wait until you see the new round about to come from shady Chinese companies looking for investment — and they will be legal,” said Paul Gillis, a former auditor for PricewaterhouseCoopers in China who is now a visiting professor of accounting at Peking University.

In an interview, Mr. Gillis praised Section 404, the part of the Sarbanes-Oxley Act of 2002 that requires companies going public to have effective internal controls, and for auditors to certify them. “When companies list, they hire consultants to help them design internal control systems to provide integrity in their reports,” he said. “These control systems are new to these countries. They have helped significantly. There have been only a couple of Chinese companies subject to 404 that have been frauds.”

As a result of intense lobbying by small businesses, Section 404 never was enforced on American companies with market values under $75 million. The new bill would exempt any newly public company for five years, unless it grew to the point that it had shares worth $700 million in public hands or had revenue of over $1 billion.

Any company that chose to go public in the conventional way, with a prospectus, could file privately with the S.E.C., so the public would see the offering only when it was cleaned up after commission review. If the commission missed something, there would be little time for anyone else to notice.

Securities regulators were almost invisible when the House passed its bill last week. This week a group of state regulators — concerned in part by the way state regulation is pre-empted — and Mary Schapiro, the S.E.C. chairwoman, wrote to senators seeking changes to make the bill less outrageous. They failed to get any changes made before the bill went to the floor this week, but the Senate is slated to vote Tuesday on a substitute that would add some investor safeguards, proposed on Thursday by three Democratic senators, Jack Reed, Carl Levin and Mary Landrieu.

It gives some flavor of just how far the House bill goes that one of the changes the three senators are pushing would force a company trying to raise money from the public to show investors an audited balance sheet. Even if their substitute is adopted, we will still get “crowdfunding,” but with a few extra safeguards. Wall Street will still have a major victory, and investors will have less protection than they do now.

“In three years, or maybe five years, they’ll be back to fix these loopholes, because there will be a huge amount of fraud,” Mr. Gillis forecast.

He suggested the bill be renamed the “Jump-start Our Bilking of Suckers Act.”

Floyd Norris comments on finance and the economy at nytimes.com/economix.