I know some readers may think that Lehman is 2008’s news. That sort of learned attention deficit disorder works to the advantage of those who participated in or enabled the looting of the average person to the benefit of the banksters. And the degree of questionable behavior of Lehman was so pronounced that if regulators and prosecutors are unable to collect a scalp or two, it provides compelling evidence of deficiencies in our legal regime as far as white collar crime is concerned. And I use the word “crime” deliberately. What went on at Lehman and AIG, as well as the chicanery in the CDO business, by any sensible standard is criminal.
The Wall Street Journal reports that the SEC is ratcheting up its investigation into questionable accounting practices at Lehman. Lehman has long looked to be the poster child of likely accounting fraud. As we noted while the firm was on the ropes, it was engaging in visible dubious marks of major assets (the famed and widely discussed SunCal and Archstone developments). If you are so desperate as to mark assets up in a way that the outside world can see and question, what other questionable valuations lurk elsewhere? The Valkas report unearthed the now infamous Repo 105, a mechanism for moving assets off balance sheet at quarter end to make it appear to be less levered.
It appears the findings of the Valkas report were too damaging for the SEC not to take action, and the agency is in the midst of what appears to be a pretty serious investigation, and the US attorney is also taking a hard look. One metric: the Journal notes, “former Lehman executives have hired armies of lawyers.” The SEC is also looking into the rather notable lack of interest shown by Lehman’s accountant, Ernst & Young, in Repo 105.
While Lehman certainly looks to be a textbook case of excessively creative accounting (how could Lehman show positive net worth of $26 billion as of your last quarterly report and then produce an estimated $130 billion in losses in bankruptcy? The “disorderly collapse” argument is insufficient as an explanation), I would not hold my breath about obtaining criminal indictments. Look at the recent experience with Joe Cassano, of AIG, another obvious target for investigations. His “get out of jail free” card was that he told his accountants what he was up to. One of the huge FUBARs in our current legal regime is that it allows desperate or criminal managements to use compliant accountants and attorneys as cover.
In the sort of thefts that little people engage in, like holding up a store, the person who drives the car is an accessory and can be prosecuted. But white collar crooks can escape if they get their advisors to wink and nod (in both criminal and civil cases, most juries will be very reluctant to find an executive guilty for something his accountant signed off on). Now that would suggest that the logical route is to go after the crooked (or at best criminally incompetent) advisors. But as we wrote in ECONNED:
Legislators also need to restore secondary liability. Attentive readers may recall that a Supreme Court decision in 1994 disallowed suits against advisors like accountants and lawyers for aiding and abetting frauds. In other words, a plaintiff could only file a claim against the party that had fleeced him; he could not seek recourse against those who had made the fraud possible, say, accounting firms that prepared misleading financial statements. That 1994 decision flew in the face of sixty years of court decisions, practices in criminal law (the guy who drives the car for a bank robber is an accessory), and common sense. Reinstituting secondary liability would make it more difficult to engage in shoddy practices.
One factor that would seem to improve the odds of success in pursuing former Lehman executives is they were directly involved in the preparation of the dubious financial statements, while at AIG, the dubious behavior occurred at the operational level, and accounting and management controls appear to have been weak (which serves to give corporate level executives plausible deniability). But you have a thicket of other problems. The biggest is if any of these cases were to go to trial, complex financial fraud cases are very hard to win. As Frank Partnoy explains long form in his book Infectious Greed, defense attorneys can win simply by confusing the jury. And given some of the stunning decisions he recounts, that approach seems to work with some judges too.
An a further obstacle is that the SEC is just not practiced at this sort of case. For many years, they limited their focus to insider trading cases. Their botched suit against Ralph Cioffi, the manager of the Bear hedge funds that blew up in July 2007, has no doubt made them more cautious in their choice of targets.
Despite the obstacles to winning in court (which in turn weakens the government’s ability to extract a juicy settlement), Lehman is such a high profile case that the SEC may feel politically that it has not choice other than to file the best suit it can. If so, it will be revealing to see how they frame it and who they decide to pursue. The Goldman Abacus suit suggests that they will focus very narrowly. And that in turn means its potential to have broader impact is likely to be limited.