Law and Financial Disorder

Despite calls for C.E.O. perp walks, building a criminal case will be very difficult.

"Failure does not equate to a crime," said Kenneth Lay, the chief executive of Enron, as he proclaimed his innocence in the 2001 collapse of the company.

With investors and the economy reeling from the financial crisis, there is much public clamoring for an Enron-like crackdown, complete with executives in handcuffs being paraded before the cameras. (A federal jury convicted Lay of fraud and conspiracy charges, but he died before he was sentenced.)

Most legal experts, however, predict that it will be tough to establish that crimes were committed. Failure, in form of the financial tsunami that rocked nearly every bank and institution around the world, will be an effective defense this time around. Hundreds of billions of dollars have been lost, banks and Wall Street firms have disappeared, stocks of financial companies have tumbled. "Why would everybody have the same fraudulent thought?" notes Robert Giuffra, a securities litigator at Sullivan & Cromwell.

Still, that won't stop prosecutors, says Robert Plotkin, a lawyer with the Washington office of McGuire Woods and who worked for the defense in the Enron investigation. "A lot of this is going to be politically motivated," he says. "Almost as a condition for any kind of loans or bailouts, there already has been a ratcheting up of investigations."

The prime target for the prosecutorial cross hairs is the collapse of Lehman Brothers, the Wall Street firm that filed for bankruptcy protection on September 15. Its demise is at the center of at least three criminal investigations - by federal prosecutors in Manhattan, Brooklyn, and in New Jersey.

In an unusual move, Manhattan federal prosecutors announced in October that they were cooperating with investigators from the office of the New York attorney general, Andrew Cuomo, to investigate the trading in credit-default swaps that contributed to Lehman's meltdown. With $600 billion in assets, the Lehman bankruptcy was the largest in U.S. history.

"There is a decent chance that Lehman will be the poster child" of these prosecutions, says Peter Henning, a professor of criminal law at Wayne State University and the founding editor of the White Collar Crime Professors blog. "When that much money gets lost, someone has to get the blame, and so it would not surprise me if there was a prosecution of Lehman management for misleading investors."

But Henning expects a case very different than those that focused on the complex accounting schemes that caused the collapse of Enron and WorldCom. "In the dying gasp at Lehman, they painted too pretty a picture: It will be a disclosure case as opposed to accounting fraud."

A good comparison, says Henning, is the pending criminal prosecution of David Stockman, the former Reagan administration official and former chief executive of Collins & Aikman, the auto parts supplier, who is headed to a trial early next year on fraud charges. The indictment against him portrays a chief executive engaged in a web of lies and fraud about the financial forecasts of his company to gain access to credit, which filed for bankruptcy in May 2005.

Such cases are built by sifting through the trail of emails and internal communications and contrasting them with what is said to the public. "Part of the Enron case was the same thing," Henning says. "What did they know and what were they telling to the public. That is the great thing about white-collar cases. It is never a factual dispute, it is 'what did you know and when did you know it and what did you say?'"

The financial crisis has created another hurdle for prosecutors: A lack of resources. When the Enron task force was put together, no expense was spared.

"There aren't going to be these grand enterprises to allow the prosecutors to put together more nuanced, complex malfeasance cases," says John Hueston, one of the lead prosecutors of the Enron Task Force and now a partner at Irell & Manella of Newport Beach, California. "What they are left with is trying to make quick-hit cases --- narrowly burrowing into emails to see if there is chatter contrary to public disclosures."

The only prosecution to date, the June indictment of two former Bear Stearns hedge fund managers, zeros in on emails and internal conversations. Critics of that case say that those communications, boiled down to a debate about the state of the subprime mortgage market between the two executives who oversaw the funds. The indictment against the two managers, Ralph Cioffi and Matthew Tannin, was unsealed the same day that the F.B.I. announced it was launching a crackdown against abuses in the mortgage business, called "Operation Malicious Mortgage." The F.B.I.'s press release cites charges against 406 people, but mentions only the Bear Stearns executives by name.

Prosecutors seemed very much in a rush in the Bear Stearns case, for they were demanding to interview witnesses at nine o'clock at night, according to a lawyer involved in the case.

"That was prosecution that was brought in great haste, and I worry about that," says John Carroll, who as an assistant U.S. attorney led the case against Michael Milken. He has recently joined Skadden, Arps, Slate, Meagher & Flom, where he and David Zornow, who also worked in the U.S. attorney's office in Manhattan, are now reunited on the defense side.

The process of sifting through the evidence should take months if not years, but the public appetite for blame is much more impatient than that, Carroll says.

The June 19 charges in the Bear Stearns case show Tannin complaining in an email that to Cioffi "we are in bad bad shape" and that the "subprime market looks pretty damn ugly," while cautioning his boss against disclosing anything that could hint at the extent of the funds' troubles. Days later, in an April 25, 2007 conference call with investors, Tannin sang a different tune, noting, "we're very comfortable with where we are." Also on the call, Cioffi ducked the question of whether there had been large redemptions from the funds, failing to mention that a redemption of about $57 million had been made just days before the call.

Prosecutors had suggested that a grand jury would hand up a superseding indictment, but at a pretrial conference on December 5, they added no new charges. A trial has been set tentatively for next September. And it is, to the mind of defense lawyers, the simplest case to make.

"Valuation cases, to my mind, are the toughest cases to make," Zornow of Skadden says, who noted that the Bear Stearns case eschewed that problem: "They are charging, they knew X, but they told the public Y."

Will that be enough to win a conviction? There is a fine line between trying to seem positive and being deceptive. Surely, lawyers for Richard Fuld, Lehman's former chief executive, last seen in public scowling before a congressional committee and debating whether his compensation has amounted to $430 million or $300 million in recent years, must be contemplating this question.

Fuld's compensation would figure into motive, as prosecutors try to explain that "the pressure was to present as rosy a picture as possible," Professor Henning says. "As the C.E.O. of a company, do you have to come out and say, 'We are dead?' You are allowed to put a positive spin on the news, but when do you cross over from spin to fraud?"

That question may be answered in the months and years to come if Fuld and others are put on the spot for the financial turmoil. But the law puts a heavy burden of proof on the prosecution.

"For a criminal prosecution, it has to be willful," says Jill Fisch, a professor of securities regulation and litigation at the University of Pennsylvania Law School. "What does willful mean? It means you knew you were materially mischaracterizing. You have to cross that line."

With so many cases of poor judgment by financial executives proving that the line was crossed will be difficult to prove. "It looks less like greed and more like horrible mistakes in judgment. And the problem is that is much harder to prosecute criminally," Fisch says.

There will certainly be prosecutions of fraudulent mortgage originators and brokers, but those nickel and dime prosecutions will do nothing to quench the public appetite for an Enron-like case.

"There will be a lot of investigations, and there may not be many successful cases made," Giuffra of Sullivan & Cromwell says. "Extreme and unprecedented market forces caused massive losses. These would be classic 'fraud by hindsight' cases if they were brought. If they knew it was toxic, why didn't they just short the market?"

Both Bernard Madoff, who has admitted to $50 billion Ponzi scheme, creating the basis for his arrest, and Marc Drier, a law firm chief with a gift for impersonation and a drawer full of cell phones at his fingertips, have recently given prosecutors fish in a barrel by comparison.

Bigger Wall Street fish will be much harder to catch.

There may not be any point to the pursuit. John Carroll says: "Most white-collar crime is good people who are like gamblers at Atlantic City. They lose a hand and they double and they double and the double. And so mistaken decisions turn into bad decisions and really bad decisions."

Michael Garcia, who was at the center of many of the financial investigations, as United States attorney in Manhattan until November, says "If anything comes out of this, it is going to be a long haul, to unravel this is going to take a long time-a year or two years."

And this time around, the cases are spread around the country, and many of the offices conducting investigations "do not have the size or experience" to at many federal prosecutors offices that do not have the size or experience of the Southern District, says Garcia, now in private practice at Kirkland & Ellis.

And while prosecutors send out a rash of subpoenas and collect information, the public appetite for blame has not abated. "Some people are getting a bit hysterical," he says.

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