naked capitalism

Bloomberg’s Jonathan Weil, who is normally an effective critic of bank chichanery and weak regulatory oversight, may have missed the mark on a key issue in an article last week, “Moral for CEOs Is Choose Your Fraud Carefully“. In it, he criticizes the SEC for failing to attack accounting fraud:

It seems the Securities and Exchange Commission won’t be doing anything to challenge that pretense, either, and that this may be by design. The SEC for years has been bending over backward to avoid accusing major financial institutions of cooking their books, even when it’s obvious they did. So much for upholding financial integrity.

Weil cites a series of object lessons where the SEC has not gone after financial firms executives for accounting fraud: Fannie Mae’s Donald Mudd, Countrywide’s Angelo Mozilo, and three executives at Indy Mac. Weil charges them with “see no accounting evil”.

Let’s be clear: I’m no fan of the SEC’s actions in the wake of the crisis. The regulator has been kept resource starved. Under Arthur Levitt (hardly the most aggressive of SEC chiefs) any effort at enforcement led to threats from Congress of budget cuts (Joe Lieberman was particularly aggressive). Chris Cox was put in charge, as far as I can tell, to make sure the agency did at little as possible. So the SEC only knows how to do insider trading cases, and on any other type of action, it seeks to get a settlement, when a trial in some cases might have more value as a deterrent (plus you don’t get to be good at litigating if you never litigate).

Moreover, the SEC also seems to believe it needs to win pretty much all of its cases to be perceived as a threat. That isn’t true either. Look at the Green Bay Packers, who were correctly the favorites to win the Super Bowl despite having a lousy win/loss record prior to the playoffs. But all those losses had been close, in hard-fought, well-played games. In litigation, embarrassing revelations in discovery or on the stand can also have deterrent value, and can serve as building blocks for future cases.

Let’s deal with the misconstructions in Weil’s article. He argues:

There’s a pattern here. When the SEC in 2009 accused former Countrywide Financial Corp. CEO Angelo Mozilo of securities fraud, it claimed the lender’s management foresaw as early as 2004 that the company would suffer massive credit losses on the home loans it was making. The SEC’s complaint accused Mozilo of “disclosure fraud” for hiding such information from investors.

Later he points out

Yet if the SEC’s allegation were true, it would mean Countrywide had been overstating its earnings for years, by delaying the recognition of losses long past the point when management knew they were probable. That would be an accounting violation. The SEC never made that connection in its complaint, though, and clearly had made a decision not to. Mozilo later paid $67.5 million to settle the suit, without admitting or denying the regulator’s claims.

But this is flat out wrong, that they missed the connection and that they made a decision not to prosecute. As a result he, and just about everyone else, misses a key story.

The SEC did make the connection, clearly and explicitly in the complaint.

Most Countrywide coverage focused on the fact that the agreement settled securities fraud and insider trading charges. What’s missing from the reporting is that the original complaint, which was ready to go to trial, contained three elements, securities fraud, insider trading AND violations by the CEO and CFO of the key element of Sarbanex Oxley law (Section 302). Yet the settlement is silent on the Sarbox charges.

The SEC apparently chose not to wade into the ‘accounting violation’ bog in the Sarbox portion, and instead complained of false of disclosures of the risks in the portfolio. That was a defensible tactical decision if the objective is to go after top executives. Look at Anton Valkas’ detailed discussion of where the thinks “colorable claims” lie in Volume 3 of the Lehman report. Note, for instance, that while CFO Erin Callan was aware of and uncomfortable with Repo 105, Valkas argues that she is liable for breach of duty of care and failure to notify the board of directors; the accounting liability sits with Ernst & Young, for professional malpractice. As law professor Franks Partnoy stressed in his book Infectious Greed, executives can use complicit accounting and law firms as liability shields. Now Weil can argue the the SEC should pursue them in addition to key decision-makers at failed financial firms, but the compliant about accounting seems a little wide of the mark in piece focused on cases against top executives.

There’s no need to go after the consequential accounting violations (which would drag external audit and regulatory forbearance into the mix) when it’s much easier to explain the equally egregious risk disclosures to a jury. The Sarbox penalties are the same, since the violations are equivalent. The obvious strategy would be to choose the risk disclosure violations.

The SEC complaint against Mozilo builds a compelling case that Countrywide was guilty failure to disclose portfolio risks, and that they were non trivial disclosure violations. Weil observation that that the disclosure violations would result in accounting violations is correct but irrelevant to the SEC’s strategy.

So, the question is what went wrong? It’s bad enough that the SEC settled for such a trivial amount but with Mozilo why did the SEC also drop the Sarbox question from the settlement? A Sarbox victory in Countrywide would have opened the door to Sarbox prosecutions for everyone else. I doubt that was lost on anyone involved in the litigation. Indeed, he IndyMac case looks very similar to Countrywide. The glaring difference is that the IndyMac complaint does not include Sarbox violations.

The Freddie litigation is at a much earlier stage; Wells notices have been sent ,so we can’t compare complaints yet, but it’s a safe beet they’ll look more like the IndyMac than the Countrywide complaints

This appears to be the missed smoking gun: the order denying summary judgment:

Order Denying Summary Judgment in S.E.C. v. Mozilo

The germane section:

D. Violation of Rule 13a-14 of the Exchange Act

In the Fourth Claim for Relief, the SEC alleges that Mozilo and Sieracki violated Rule 13a- 14 of the Exchange Act, requiring them to certify that Countrywide’s 2005, 2006, and 2007 Forms 10-K did not contain any material misstatements or omissions.See 17 C.F.R. § 240.13a-14.

Mozilo and Sieracki move for summary judgment, arguing that a violation of Rule 13a-14 of the Exchange Act cannot be pled as an independent claim for relief. The Court agrees with the reasoning of SEC v. Black, 2008 WL 4394981, at *16-17 (N.D. Ill. Sept. 24, 2008), and concludes that a false Sarbanes-Oxley certification does not state an independent violation of the securities laws. Accordingly, the Court GRANTS Mozilo and Sieracki’s Motions for Summary Judgment as to the SEC’s Fourth Claim for Relief

The Fourth Claim for Relief was the Sarbox violation.

Unfortunately, this leaves us in the dark since because the SEC v. Black decision was unreported. Here is portion of the SEC’s brief where they argued that Mozilo’s motion for summary judgment on this issue should not be granted:

H. Violation of Rule 13a-14(b) Is A Stand Alone Cause Of Action In This Circuit

Mozilo and Sieracki argue that they are entitled to summary judgment on the SEC’s Rule 13a-14(b) cause of action because it is not an independent cause of action. Their sole support for this contention is an unreported case from of the Northern District of Illinois, SEC v. Black, 2008 WL 4394891 (N.D. Ill. Sept. 24, 2008). Other courts, including one in this Circuit, have allowed stand alone causes of action for violation of Rule 13a-14(b).SEC v. Sandifur, Fed. Sec. L. Rep. (CCH) P93,728; 2006 U.S. Dist. LEXIS 12243 at *23-25 (W.D. Wash. Mar. 2, 2006) (cause of action for violation of Rule 13a-14(b) pled with sufficient particularity to withstand a motion to dismiss); SEC v. Brady, Fed Sec. L. Rep. (CCH) P93,885; 2006 U.S. Dist. LEXIS 29086 at *17-18 (N.D. Tex. May 12, 2006) (“SEC has adequately pleaded that. . . [defendant] committed a primary violation of Rule 13a-14(b)”). The violation of Rule 13a-14 results from the certification of a periodic report that is false or misleading.SEC v. Kalvex, Inc., 425 F. Supp 310, 316 (S.D.N.Y. 1975) (Section 13(a) embodies the requirement that periodic reports be true and correct, and a failure to comply with such section would result in violations of the securities laws). Mozilo and Sieracki signed Sarbanes-Oxley certifications for each Form 10-Q from Q1 2005 through Q3 2007 and each Form 10-K for the years ended 2005, 2006, and 2007, and signed the Forms 10-K for the years ended 2005, 2006, and 2007. For all of the reasons set forth above, those reports were misleading. Accordingly, Defendants’ motion for summary judgment on this cause of action must be denied.

Now as a non-attorney (but my sources agree on this reading) it appears that the judge was saying that if you argue for SEC violations (which this case did) you don’t get to double dip and add a Sarbox charge. That’s far more significant than it appears. As we argued in an earlier post, the language in Section 302 (civil violations) tracks the language in Section 906 (criminal violations). A win on a Section 302 case would thus set up what would appear to be a slam dunk criminal case.

The judge’s action is what I call a “BS ruling”. The judge does not explain his reasoning, and this is a ruse when a judge does not want his decision challenged. I’m told lawyers might more politely call it “gutless”.

Now does this make Weil wrong and get the SEC off the hook? Hardly. The judge’s negative ruling on a separate Sarbox charge on securities violations does not rule out other types of Sarbox charges, but the SEC incorrectly seems to be reacting this way. Remember, the part of Sarbox that gave a lot of boards fits was that the CEO and the CFO certify the adequacy of internal controls (Section 404). That goes above and beyond traditional SEC representations. As securities lawyer/litigator Bob H argued:

It may be important that the Black and Mozilo claims were all about fraudulent disclosure and not failure to maintain an adequate system of internal controls. The latter was not in play in either case. It’s one thing for a court to say that two claims do not arise when it is alleged a Form 10-K includes a fraudulent statement and then say another claim arises because the SarbOx certification (saying there were no fraudulent statements) was wrong.

However, I don’t think this logic applies with regard to Section 404 of SarbOx. Here the statement made by the certifiers is that a system of internal controls is in place and is adequate. There are two things in play here and they are different. One, it is alleged the document contained a violation of Rule 10b-5 (contained a false or misleading statement or omission). Two, the company’s system of internal controls was other than represented in the certificate (i.e. it was false). In other words, I don’t believe either court would have dismissed the certification claim on summary judgment if it was about the system of internal controls (as opposed to straight out disclosure).

It does not take a lot of imagination to assume that many of the banks that cratered had deficient risk management systems and controls, which in a firm with trading operations is clearly one of the most important control systems. Some readers may believe that putting a case before a jury on risk management deficiencies will simply allow the defense to introduce all sorts of confusing technicalities, and confused juries don’t convict. However, in many cases the risk management systems were obviously, grossly deficient. Lehman was running over 120,000 derivatives positions, on systems that didn’t talk to each other or reconcile nicely; it didn’t even know to within 10,000 how many derivatives positions it was carrying! Similarly, it appears that the banks’ system of internal controls over their mortgage backed positions only went as far as looking at the ratings.

In other words, the SEC looks to be quitting far too easily. It isn’t a reasonable expectation to win cases in new areas on maiden efforts. That’s great if it happens but the more likely result is some stubbed toes and partial victories before perfecting how to argue these issues. But the SEC is no doubt enjoying its high profile thanks to the Galleon case, and is too likely to keep pursuing what it knows how to do than go after how a handful of banks blew up the global economy yet got to keep their winnings, which is a matter of much greater consequence for all of us.