The big question arising from bankruptcy Anton R. Valukas’s report on Lehman Brothers is whether executives from Lehman Brothers will face criminal charges.
Comparisons are already being made to the collapse Enron, whose executives were convicted of charges stemming from Enron’s accounting and compensation practices. Lehman is already being “Enronized” in the mainstream press.
Valukas’s report doesn’t use the language of criminality. It merely asserts that courts could likely find valid claims of breaches of fiduciary duty and negligence on the part of Lehman’s executives, including chief executive Dick Fuld.
But Lehman Brothers executives shouldn’t take too much comfort in that fact. The Enron examiner also did not assert any criminality. That really isn’t a bankruptcy examiner’s job. It typically comes later, when federal and local prosecutors begin digging into the case.
At the very least, civil charges of securities fraud will be very likely brought by the Securities and Exchange Commission. The bar for bringing such cases is much lower than federal criminal cases, and proving civil cases much easier for the government.
The focus of such charges would probably be the statements by chief executive Dick Fuld and chief financial officers Erin Callan and Ian Lowitt about the company’s liquidity, its leverage and the size of its balance sheet—all of which were manipulated by the Repo 105 transactions. It should be pretty easy to show that these statements kept Lehman’s stock higher than it would have been if the market was aware of the complete picture of Lehman’s financial condition. In addition, there could be liability for providing false information to the SEC when the company filed financial statements.
The Sarbanes-Oxley Threat
Unfortunately for the Lehman executives, federal prosecutors have a tool they lacked at the time of Enron. That tool is Sarbanes-Oxley, the accounting and corporate governance reform legislation enacted in the wake of Enron’s collapse. No longer will prosecutors have to stretch existing laws to make their case. They can now bring criminal charges against CEOs and CFOs who they allege falsely certified the accuracy of Lehman’s financial statements and/or absence of deficiencies in internal controls regarding the preparation of the financial statements.
The key to whether criminal charges will be brought and whether they can be sustained will be the quality of the evidence. A successful criminal case against Lehman executives would likely depend on the government convincing at least a few senior executives at Lehman to testify against their former colleagues. After the failure of the case against the two Bear Stearns hedge fund managers, we think prosecutors are unlikely to bring a case based purely on indiscreet emails that a jury may find don’t paint a full picture of events at the firm.
If we had to bet, we’d say that the best bet for prosecutors looking to flip a senior executive would be Erin Callan. She held her title of chief financial officer briefly and was forced out of the office by Fuld. She likely harbors some ill will toward the executives who failed to stand behind her. What’s more, she has announced that she is retired from the securities industry—which means she doesn’t need to worry about finding a new job if she were to rat out her fellow Lehman executives.
The Corporate Crime Lottery
It’s far from clear that a criminal prosecution would be the best response to alleged fraud at Lehman Brothers. In the first place, the alleged fraud is not what brought down Lehman Brothers and did not cause the broader financial crisis. The questionable Repo 105 transactions may have actually forestalled a collapse for several months because they may have concealed Lehman’s failure to improve its financial condition in 2007 and 2008.
What’s more, we may actually learn less about the collapse of Lehman if the case goes criminal. The problem is criminal prosecutions are rarely the best way to uncover facts. The threat of long prison sentences creates an all-or-nothing situation in which top executives refuse to testify in order to avoid self-incrimination. The public might well lose valuable information—information that could be useful to the formation of new regulations or at least investor awareness of the risk of management shading the truth—if prosecutors insist on bringing criminal charges.
The trade-off for the societal cost of this lost information should be the deterrent effect from criminal prosecutions. But it’s not clear that there is much of a deterrent effect at all. The long sentence handed out to Enron’s Jeff Skilling did not seem to deter Lehman executives. It’s doubtful anyone at a major public company or a Wall Street financial firm feel any deterrence effect from the prosecution of Lehman executives.
Why doesn’t criminal prosecution of corporate crime produce the expected deterrence? One reason is that such prosecutions tend to only follow the collapse of the business. Executives who believe that their companies will not collapse—and that’s pretty much all of them—have no reason to fear prosecution. At Lehman, for example, it appears that executives believed that no one would ever find out about how they were manipulating their balance sheet. And, if Lehman hadn’t collapsed, this belief would most likely have been correct.
In this way, criminalizing corporate misdeeds becomes something of a lottery. Only executives who happened to work at firms that failed face prosecution. The accounting practices of those that survived the financial crisis remain murky and their executives remain safe from prosecution.
Criminalizing Business Failure
This is the deepest problem with the criminal prosecution of Lehman executives—it would essentially be punishing business failure with criminal liability. The market does a fine job of punishing business failure by putting the worst failures out of business. The jury of investors vote with their sell orders, and creditors issue sentences of corporate destruction by closing lending windows. Civil cases can mop up what the market missed due to fiduciary breaches or deceptive disclosure from management.
The bailout of Lehman’s rivals compounds the lottery aspect. Many of the survivors arguably were not spared Lehman’s fate because they better managed the crisis. They survived because they outlasted the government’s patience with the liquidation of financial firms in 2008. So we’re not only punishing Lehman’s executives for failing—we’re punishing them for not being bailed out. What kind of justice is that?
“The lesson here is that pursuing high-profile criminal prosecutions in Lehman after the problems with such prosecutions in these situations proved so manifest in Enron would prove that after a decade of hugely costly trials and a massive new law that was supposed to change everything, we still haven’t learned a thing about the unsuitability of criminal liability for these kinds of cases,” University of Illinois law professor Larry Ribstein writes.
In short, one generation of Enrons should have been enough for us. Lehman shouldn’t be Enronized. Instead, it should be normalized, treated as an ordinary case of business failure, perhaps with civil liability for any malfeasance or deception by executives.
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