S.E.C. Gets Encouragement, but Needs Something More

When you are unable to win a prize playing a carnival game, the attendant usually says, “Better luck next time!” as you pony up for another round. That is pretty much what a federal jury told the Securities and Exchange Commission when it urged the government to continue to pursue financial fraud cases involving Wall Street while finding the agency had not proven that a former Citigroup banker, Brian H. Stoker, had violated securities laws.

The S.E.C. sued Mr. Stoker and Citigroup, accusing them of misleading investors in the sale of a collateralized debt obligation, or C.D.O., based on subprime mortgages in 2007. The bank bet against its own security, which lost most of its value in only a few months and had been described by one of the bank's own traders as the equivalent of dog excrement and “possibly the best short EVER!”

Citigroup reached a settlement with the S.E.C. to resolve civil charges, agreeing to pay a $285 million penalty, but Mr. Stoke r successfully fought the case in a trial before Judge Jed S. Rakoff of the Federal District Court in Manhattan. The judge had already drawn the S.E.C.'s ire by refusing to accept the settlement with the bank, a decision that is being appealed.

The S.E.C. did not pull out its biggest securities fraud weapon â€" Rule 10b-5 â€" against Mr. Stoker, which would have required proving he acted intentionally or at least recklessly. Instead, it accused Mr. Stoker of breaching Section 17(a)(2) and (3) of the Securities Act of 1933, which only require showing negligence in making misleading statements.

Mr. Stoker was a director in Citigroup's C.D.O. structuring group, responsible for putting together the offering materials for the security. He operated well below senior management, however, and can hardly be described as having significant authority over the transaction.

Although it had to show only that Mr. Stoker knew or should have known the statements in the o ffering documents were misleading, the S.E.C. could not prove even that minimal level of intent for a violation.

Mr. Stoker's lead lawyer, John W. Keker, offered what will forever be known in the securities field as the “Where's Waldo?” defense by arguing that his client should not be the only one held responsible when he was a minor player in a much larger process.

The defense appeared to have convinced the jury. In an interview with DealBook's Peter Lattman, the jury foreman, Beau Bendler, said, “I wanted to know why the bank's C.E.O. wasn't on trial. Citigroup's behavior was appalling.”

This is likely to become a featured defense for others who operated below the senior management level when they are accused of misconduct, pointing the finger at others up the corporate ladder as the ones truly responsible for any misconduct.

The obvious beneficiary of this approach would be Fabrice Tourre, accused of securities fraud for putting together a similar C.D.O. at Goldman Sachs. Like Mr. Stoker, he had little real authority at the firm, so do not be surprised to hear “Where's Waldo?” asked at his trial. And the S.E.C. has accused him of violating Rule 10b-5, so it will have to show the higher level of intent for that violation, posing an additional challenge to winning its case.

While finding in favor of Mr. Stoker, the jurors added a note to their verdict that stated, “This verdict should not deter the S.E.C. from continuing to investigate the financial industry, review current regulations and modify existing regulations as necessary.”

According to Mr. Bendler, “We were afraid that we would send a message to Wall Street that a jury made up of regular American folks could not understand their complicated transactions and so they could get away with their outrageous conduct.”

Although the jury's statement is a nice gesture, and perhaps made the S.E.C. feel better about the outcome, it does not address the real issue of trying to hold individuals accountable for misconduct in large corporations. The perennial problem is proving who was responsible for a violation when any decision is made through multiple layers of an organization so that no one can be held accountable for the final decision.

For lower-level workers who might be accused of misconduct, asking “Where's Waldo?” can be employed to deflect charges by claiming they were not primarily responsible for the violation. This should not be confused with the so-called Sgt. Schultz defense, named after a character from the “Hogan's Heroes” television show who claims to know and see nothing going on around him.

The “Where's Waldo?” defense does not rely on ignorance because it admits to some participation in the transaction but seeks absolution based on the person's limited authority within an organization. This works best when no one from senior management is accused of a violat ion, much like the cases against Mr. Stoker and Mr. Tourre, because it buttresses the argument that the person has been made the scapegoat for corporate wrongdoing.

Proving cases against senior managers, especially chief executives, can be equally challenging because they rarely get involved in the day-to-day operation of a complex business. There is a measure of truth to a claim of ignorance about a particular transaction, and it is often difficult to find a paper trail showing more than tangential involvement in the misconduct.

In the Citigroup case, it is unlikely the bank's former chief executive at the time of the transaction, Charles O. Prince, had any knowledge of the C.D.O. And its current chief executive, Vikram S. Pandit, had only just joined the company when the sale was made.

So the lower-level workers point the finger up the chain, and the senior managers disclaim responsibility for the misconduct of those beneath them. And even when there i s misconduct, like what occurred at Barclays in the manipulation of the London interbank offering rate, or Libor, any involvement by senior officers can be sloughed off as a mere “miscommunication.”

Holding only the organization responsible for misconduct is unsatisfying because the result is the payment of a monetary penalty â€" which comes out of the pockets of shareholders â€" that can be viewed simply as a cost of doing business.

The jury telling the S.E.C. that it should not be discouraged from pursuing financial fraud is a nice sentiment, but actually winning cases against individuals for cases arising from the financial crisis has proven to be an almost insurmountable barrier.

Peter J. Henning, who writes White Collar Watch for DealBook, is a professor at Wayne State University Law School.