Will We Finally See Some Prosecutions for Lehman’s Dubious Accounting?

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.

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  1. attempter

    I guess if one is to hope for any kind of reform from within it would have to start somewhere like here. But I don’t see how that’s possible, given the catch-22s described here.

    As Yves says, the law itself and the pseudo-judicial process are heavily rigged to legalize white collar crimes, to dismantle the law of conspiracy, to “confuse” juries and judges (though I don’t see how it’s possible to confuse anyone who doesn’t already want to be confused on a subject like this; at any rate the system makes it very easy to have that desire fulfilled). And where that fails, the appellate courts up to the SCOTUS have long been anti-American renegades ready and willing to “fix” mistakes where a trial court or lower court decision actually went against the enemy and for the citizenry.

    Justice is one of my great passions, but I don’t see any way to achieve it short of acheiving a radical political transformation, in the course of which the people need to convene Nuremburg-style tribunals. History has already proven that’s the only way to deal with this level of crime. The normal law, even where not completely corrupt, rigged, hijacked, and alienated as ours has become, isn’t suited to deal with it.

    1. Francois T

      Here’s something I can’t understand: Delaware has the Court of Chancery. Whatever one may think of it, it is a specialized Court.

      What in the world would prevent Congress and the Executive to devise specialized Courts? Finance, science and medicine would be very logical candidates.

      1. Yves Smith Post author

        I hope some lawyers will pipe up, but let me get the ball rolling. This sort of thing might work for actions against corporations, but not against individuals. We have this idea of being tried by a jury of one’s peers, when our society is so stratified that that no longer has any meaning. But it has been used to gut having suits against individuals go to specialist juries. For instance, New York used to have blue ribbon juries for murders, which would have doctors, former cops, lawyers, psychiatrists, and other experts (one of my buddies, a former DA, said having former cops did not make them pro prosecution. Former cops were very attuned to how often evidence was planted in murder cases). They were found to be unconstitutional.

      2. attempter

        That’s an example of an idea which might be good in the abstract, and might work in a human society, but in a Hobbesian kleptocracy like the US would be perverted to function in a malevolent way.

        (Other examples are things like stimulus, a VAT, “alternative” energy investment, cap and trade.)

        Do you think any “expert” cadre would have a lower proportion of criminals than the general populace? On the contrary, the number is much, much higher.

        And then there’s the fact that most “expertise” has abdicated any legitimate authority whatsoever. We know that experts are generally selected based on

        1. ability to pay bloated rentier “education” costs;

        2. conformism and serviceable “intelligence”, not any capacity for real thinking.

        And then once these flunkeys who are overwhelmingly likely to have been born at least on first or second base are actually ensconced in the system, the whole culture functions to further criminalize them, if they needed any further training.

        So that’s the kind of jury the people should have to submit to after they’ve been forced into these rent-extraction traps? No thanks. That’s little better than flat out forced private arbitration.

  2. Francois T

    Loose thoughts:

    That this incredibly stupid SCOTUS decision (disallowed suits against advisors) took place without having Roberts, and Alito on the bench is very revealing of the extreme sensitivity to wealth our justice system is afflicted with. No wonder people do not believe in justice anymore.

    Slightly OT but related: Glenn Greenwald, a.k.a. Glennzilla is finishing a book on the de facto two-tiered justice system in America. Can’t wait to read it. (I don’t get any penny for this BTW)

    Why don’t the SEC subcontract this case to the meanest, top notch, bad ass legal eagles in the trade damnit?? It’d be much better than blowing up a high profile case AGAIN! But of course, one could cynically posit that it is precisely what they want; no point in jeopardizing relationships with a future benefactor/employer.

    1. attempter

      I wonder if the book will try to further explain his deranged position on Citizens United and corporate free speech.

      But I forgot, while someone like Greenwald may decry two-tiered justice in general, a big picture outlook like that must never get in the way of his myopic ideological obsessions.

      But that’s what happens when someone becomes a fetishizing fanatic about something which ought to be just a tool.

  3. Superduperdave

    There’s also the high likelihood that Rahm Emanuel, when he was shopping then-Senator Obama to Wall Street, made a deal that in return for bankers’ support there would be no criminal prosecutions, and the administration has stood by that. Fat lot of good it’s done them…

  4. CingRed

    In light of the SCOTUS decision and a plethora of other similar acts of high intelligence it is high time we had a new pledge of allegiance. Maybe something like: I pledge allegiance to the banks of the United Sheeple of America, and to the banana republic, which they created, one nation, under water, with liberty to fleece and no justice at all.

    I’ll be surprised if any substantive punishment goes to the persons actually responsible. Someone will be chosen to be the fall guy and he and his family will be well taken care of by the rest of the gang.

  5. Stephen Liss

    Yves, would you please finish the thought you started with “And even worse, the wronged party can’t …”

    James Kwak recently said something to the effect that he didn’t know how you found the time to do what you do. It’s a mystery to me too! Thanks! Please keep up the good work. You are needed, badly.

    1. Yves Smith Post author

      Sorry, it was from an earlier draft, just another go at the secondary liability issue. I didn’t delete it all.

  6. rd

    I think that one of the primary causes of the crisis is that people thought that the Federal gvernment was on the ball with regulation on accounting and trading. 2007-08 showed that the Emperor had no clothes when it came to regulation. The 2009-10 is showing that the Emperor doesn’t even have clothes in the closet because the Feds are unable to prosecute what should be egregious cases of fraud and criminal negligence.

    It appeares that Sarbanes-Oxley was a toothless tiger that came out of the dot.com-tech crash and Dodd-Frank will be a toothless tiger on financial sector malfeasance. It appears that the US has moved to third-world country levels of laissez-faire regulation and corruption of the financial markets with socialist levels of support for major TBTF companies. This is not a combination that will assure future success. We may actually be better off if the SEC and others simply declared that they will not regulate the financial sector and everyone is on their own with real “buyer-beware.”

    At this point, in 2008 there was a major voting out of the politicians that were in charge in the boom years that helped create this mess. It appears that the new crowd is simply engaged in putting lipstick on the pig. It is currently unclear who we can even vote for this November that would provide real change.

    1. readerOfTeaLeaves

      I certainly sympathize with the political expression in your comment; at this point, ‘financial literacy’ appears to be dismal in DC, NY, and the nation at large. And by ‘financial literacy’, I do not mean the outdated neoclassical version; I simply do not see anyone really expressing a new paradigm.

      Part of that ‘new paradigm’ would, it seems to me, require SIMPLER regulations and far more transparency.

      But the idea that such rampant criminal conduct ‘can’t be successfully prosecuted’ is as weenie and cowardly a notion as ‘too big to fail’. Both are a gutless reaction to people who are stealing my lunch (and a damn sight more).

      Sorry, but from what I can glean about human nature, a modicum of ‘justice’ and ‘fairness’ and ‘reciprocity’ are fundamental to functioning culture. If the government fails to successfully prosecute, then clean up accounting rules and regs, then it becomes completely delegitimized.
      That could be a dangerous scenario.

      The notion that there is no downside, socially or politically, of failing to render a little justice in the face of flagrant, rampant fraud is self-deception on the part of people who are reluctant to bring charges because it is ‘too hard’. That is not a ‘strategy’; it’s an abdication.

    2. Paul

      Wow, this is a surprisingly strong point. In 2006 when I first entered Wall St. it was said that U.S. capital markets were the strongest in the world because our markets offered the most investor transparency when researching businesses. You don’t hear this claim anymore.

  7. Independent Accountant

    This is a rare instance in which I disagree with you. In part. Cassano of AIG could never be prosecuted. I always expected the case against him to collapse. Why? There is no way the case against Cassano could be made and not drag in the Vampire Squid. Once the SEC and DOJ realized that Cassano held the equivalent of the Doomsday Device from 1964’s “Doctor Strangelove”, they collapsed. Stonerrridge was a legal abortion. A disagrace for Scalia!

  8. Stephen V.

    More loose thoughts:
    Justice?—You get justice in the next world, in this world you have the law…
    —William Gaddis, A Frolic of His Own (1994)

    And, of course this, attributed to I. Trump:
    The Law is for little people.

    Some actual financial literacy on the part of the Sheeple would moot alot of our troubles. In the meantime, some perp walks might act as a slight deterrent.

  9. John Emerson

    You have to consider the possibility that the US is a failed state. I believe that there should be lots of prosecutions and confiscations, but by that fact I’m a fringe extremist. I’d settle for just disgracing the perps and banning them forever from any position of authority, but that’s more or less equally impossible. My non-negotiable demand is that at least the Democrats shouldn’t nominate Robert Rubin for the Presidency, and my guess at the moment is that I have at least a 50% chance of getting that one.

  10. Siggy


    Nice post that points to the impediments to a prosecution that leads to a conviction.

    Could it be that what is necessary is prosecutions that even if they fail produce a public record that of and by it self is the conviction necessary to mobilize public support for the re-regulation of the financial market playground?

    As to Cassano, I was able to watch him on TV several weeks ago and my impression is that he enagaged in serious torts that had the potential of being criminal. 44,000 Derivative contracts against which AIGFP was unable to perfom strikes me as being a pattern of tortious behaviour if not criminal fraud.

    What I have seen of recent hearings is a lot of soft balls being lobed up to people who probably belong in a criminal court. Lehman’s repo105 is such a blantant act that it is more than curious that it has taken so long for the SEC and the Justice Department to act.

    Carl Levin’s inquiries of Blankfein produced very little in the way of real information. The fact that GS has settled with the SEC and will soon remit some chump change to FSA are real accomplishments in the avoidance of criminal liability. The fate of the French fella is yet to be resolved. Will he be the sacraficial lamb? I wonder.

    I suspect that the GS move to depart the prop desk space is the internal realization that for them, the party is over and it is best to move on.

    The fact that Cassano got a pass leads me to wonder as to just how large the conspiracy by default actually was and is. In my view this is a scandal of immense proportion that reaches far and wide and for which the cure has the potential of killing the patient. In may well be that the patient was terminal sometime ago and that it has been on life support for the past thirty five years.

    We will see prosecutions? Maybe appears to be the current answer. That does not make my day and causes me to wonder, is there a better place to be and live?

  11. MichaelC

    Coincidentely, “The smartest guys in the room” was on tv tonight.

    Today, Enron looks like small beer, yet watching it again, especially the scene with Waxman grilling Prince(!!) was surreal.

    The idea that the SEC and the DOJ today are still too timid (or captive) to enforce the law that was the direct result of that fiasco, when all the elements of that fraud were repeated on a more massive, systemic scale, is breathtaking.

    It’s ironic that we need to rely on the weak indirect lever of judges rejecting settlements, years after the fact, to persuade the SEC and the DOJ to consider enforcing that law, a law which was crafted to prevent another Enron,(or worse), especially when the current crimes are the one’s it was meant to prevent and are orders of magnitude worse than Enron’s.

    We wouldn’t even have needed finreg(only kidding, sort of) if there’d been a perp walk starring Cayne as the SOX trophy in Mar 08., or AIG in Jan ’08, after they restated.

    But hanging Rubin, and Prince or Crittendon and obviously Fuld, by a SOX rope could only be a good thing for financial reform. Hanging Prince would be especially sweet since they didn’t nail him pre SOX for CITIs role in Enron.

    The folks liable under that law have treated it with contempt, figuring that the enforcers of the law (SEC/DOJ) also viewed it contemptuosly, that the accountants (PCAOB) viewed it more as a threat to their oligopoly, than as an incentive to deal honestly (like the ratings agencies), and that captured politicians would keep its constitutionality in play.

    But it is on the books. I see no reason not to use it.

    Now its constitutionality is settled, the accountants have proven to be no better than (actually much worse than) the ratings agencies, and the perps have behaved the same way they did with Enron. Just a reminder, the scandal at Enron was due to the IBs structuring the fraud. (For perspective, structured finance was the most biggest profit center for the big banks in 00-01)

    No one here needs to be reminded these are the same folks structuring this round.

    For all its flaws, the main benefit of SOX is its incentive to disclose. No detailed regulatory disclosure rule is ever going to be as powerful as the simple one at the heart of SOX.

    If you fail to disclose something that your investors really should know, you’re going to jail, and your options expire worthless. Simple as that.

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