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Hunting for Bear (Stearns) With the Martin Act

Today’s announcement by the elegantly named Residential Mortgage-Backed Securities Working Group that it was suing over fraud allegedly perpetrated by the late, if unlamented, Bear Stearns notes that the group’s weapon of choice is the Martin Act.

Faithful readers may recall that the act is not a federal law but a New York state law enacted in 1921 to crack down on “blue-sky” stock manipulators, i.e. pump-and-dumpsters whose equities were backed by nothing more than the open air. (Geez, at least today’s abusers of collateralized debt obligations had a horrible, but genuine, credit risk behind their bum paper.)

As law professor David Skeel explained to us in the spring, the Martin Act for most of its lifetime served as impediment to private investors suing since a quirk in its interpretation in effect reserved that right to the state. But with a new generation of fiscal chicanery to explore, a new breed of ambitious New York state attorney generals and favorable court ruling, the act was reshaped and redeployed as the weapon of choice—even for the feds—in prosecuting errant companies and executives.

Why exactly? Again, I rely on Skeel to explain:

New York courts construed the act’s key terms in the most sweeping fashion possible. Nearly anything could be a “security,” for instance, not only stocks and bonds but even bags of silver coins or fake Salvador Dali lithographs. In 1955, then-Attorney General Jacob Javits persuaded New York lawmakers to add criminal penalties to the law, and, as he put it in a letter to the governor, “to bring within the condemnation of the statute any false promise which tends to deceive.” By prohibiting any false promise, and not requiring actual fraud as a condition of liability, these amendments made the Martin Act far broader than almost any other securities law in the country.

So in the case of Bear Stearns, whose $2-a-share bones were swallowed whole by JPMorgan, the wrongdoing was thus, according to NY Attorney General Eric T. Schneiderman:

Bear Stearns led its investors to believe that the quality of the loans in its mortgage-backed securities had been carefully evaluated and would be continuously monitored. In fact, Bear Stearns did neither. Instead, it systematically failed to evaluate the loans, largely ignored defects that its limited review did uncover, and kept its investors in the dark about the inadequacy of the review procedures and defects in the loans. Even when Bear Stearns executives were made aware of these problems, the company failed to reform its practices or disclose material information to investors.

Schneiderman references the Martin Act in the first sentence of his announcement, but never mentions it again. So for a fuller accounting of the law, and its Byzantine history, I really recommend Skeel’s lengthy exposition.  As our own Michael Fitzgerald wrote, “In a world where most financial regulators have small-bore weapons, the Martin Act is like an elephant rifle. “ And in this case, the elephant gun is for hunting Bear.