This is the second installment in a three-part series correcting the NYT propaganda that seeks to transmute the SEC's refusal to hold any of Lehman's looters accountable for their myriad frauds. For the purposes of this article I assume that the reporters have accurately represented the SEC officials' positions. I discuss the journalists' analytical flaws. In my next column I'll address critical facts excluded by the SEC and the reporters. Those facts demonstrate that Lehman was an "accounting control fraud." The NYT article ends with this morality play about the SEC's anti-enforcement "team":
"The S.E.C. team also concluded that Repo 105 would not have been "material' to investors because the firm's leverage ratio was trending downward regardless of Repo 105.
That conclusion set off a wave of dissent inside the S.E.C. Senior accountants and the head of the S.E.C. unit that oversaw corporate disclosures questioned the findings. Ms. Schapiro urged Mr. Canellos to keep digging.
But Mr. Canellos, a former federal prosecutor who is now the co-head of the S.E.C.'s enforcement unit, did not budge. Despite the political pressure, he told colleagues at one of the meetings, they could not bring a case if the evidence was lacking.
"Our job is to seek justice,' he said."
It gets better, the reporters claim that Cannelos and his teams' "careers likely would have benefited from bringing such a prominent case." So, they are not only uniquely ethical, they are selfless. As I will explain in the next installment, Cannelos failed to investigate Lehman's largest frauds and concluded he would lose the case if he brought it. That would have harmed his career. But the article unintentionally allows us to see how the SEC leakers spun their heroic morality tale and how the reporters swallowed it whole. I am a former enforcement director and head of litigation for a federal financial regulatory agency that conducted real investigations.
To understand this example of non-enforcers pretending to virtue requires a bit of context. The Department of Justice (DOJ) and the SEC focused their "investigations" solely on Lehman's quarter-end "Repo 105" transactions that were entered into for the sole purpose of deceiving investors and the SEC about Lehman's liquidity, earnings, and leverage crises -- crises that would soon cause it to collapse. A "repurchase obligation" (REPO) is a short-term borrowing that is nominally structured as a "sale" with a "repurchase obligation." Lehman improperly treated these short-term borrowings as if they were a true sale with no repurchase obligation, which caused Lehman to report lower debt levels.
Note that the journalists report that the SEC's experts on whether such deceit was "material" to investors ("senior accountants and the head of the S.E.C. unit that oversaw corporate disclosures") concluded that it was material. The fact that Lehman was so desperate to deceive its investors about the crises that would soon cause it to collapse that it sought out a legal opinion in the City of London (which "won" the ethical race to the bottom) to bless the deceit and proceeded to recurrently make large transactions near the end of quarters for the sole purpose of deceiving its investors and the SEC demonstrates that Lehman knew its deceit was material to its investors. That is a central reason why publicly traded firms engage in accounting fraud.
If you are wondering, no, it is not (remotely) normal for a U.S. investment bank to go to a UK firm to obtain a legal opinion on U.S. law. Nevertheless, the cynical act by Lehman's leaders of legal dumpster diving to obtain a legal opinion blessing an obvious fraud was not treated by the Department of Justice (DOJ) as it should have been as an aggravating factor, but rather as a "get out of jail free card." Consider the implications of that DOJ policy briefly so that you can, unlike the NYT reporters, test the depth of the rot at DOJ and why they embraced "too big to jail" as their mantra. Under the DOJ position reported by the journalists, a large publicly traded company can search all over the world for the least ethical law firms and buy an opinion from them that will immunize the company and its officers from liability for any act of fraud because they "relied" on the legal opinion. Let's extend that doctrine to street gangs. I'm sure they could get legal opinions on justifiable homicide in advance of their next murders.
Cannelos' reported basis for denying that investors would have considered Lehman's REPO 105 fraud scheme to be "material" is that "the firm's leverage ratio was trending downward regardless of Repo 105." It is difficult to respond to a claim that is a non sequitur because it has no logical relationship to the conclusion. As best one can guess, Cannelos is claiming that investors would have considered it irrelevant what Lehman's true leverage ratio (debt:equity) was and would have only been interested in the direction of the trend in that ratio. Because Cannelos (falsely, as I will explain in my next column) believes that Lehman's leverage ratio was falling as it approached collapse he asserts that investors would have considered the actual leverage ratio irrelevant. That assertion assumes that investors are incompetent. A rational investor would care about the actual ratio, not simply the direction of the trend in the ratio. Lehman collapsed due to the interaction of its severe credit losses and a liquidity crisis. As its credit losses surged its liquidity needs became far more acute because of collateral demands by its creditors and, eventually, the unwillingness of creditors to roll their loans to Lehman. Lehman's true leverage ratio, therefore, would have provided critical information to its investors, which is precisely why it used the REPO 105 scam to deceive its investors about its debt exposure.
The reporters try to picture the scam as trivial, with this unsourced claim about the DOJ and the FBI's alleged findings about Lehman's Repo 105 scam.
"They discovered that Repo 105 had nothing to do with Lehman's failure and was technically allowed under an obscure accounting rule. Noting that London lawyers had approved Repo 105, prosecutors in Manhattan also worried they could not prove that executives intended to mislead investors."
First, an accounting scam does not have to "cause" a "failure" to be a crime or a violation of rules. Accounting frauds are frequently undertaken to cover up the failing firm's problems. That is why Lehman engaged in the REPO 105 scam. So the first sentence was fed to the NYT reporters for the purpose of deceiving the reader. REPO 105 is an obscure accounting rule -- that does not mean that Lehman was allowed to use it to deceive investors. I've explained why the desperate search by Lehman's officers for an attorney willing to give them the opinion they were shopping to obtain. The attorney shopping actually confirms that Lehman's officers intent to deceive investors.
Canellos, an SEC enforcement attorney, overruled the SEC's experts on interpreting "materiality" and insisted on employing his own idiosyncratic view that investors would not have considered it important to know the truth that Lehman's officers intended to hide through deceit. The journalists do not understand the implications of an enforcement attorney arrogating onto himself the ability to determine the agency's interpretation of the agency's rules. Instead, they mischaracterize Cannelos' actions as evidence of his brave devotion to justice in the face of improper pressures from the head of his agency. Under the version of the facts presented by the journalists, however, this interpretation is untenable.
Cannelos is an attorney representing a client, the SEC. The SEC has experts in what "material" means. Cannelos' ethical duty is to represent his client's position unless that position cannot be argued in good faith. Cannelos is wrong -- terribly wrong -- about materiality for the reasons I have explained, but that does not begin to capture how wrong his refusal to act against Lehman's senior officers' recurrent frauds was. Cannelos' refusal to enforce the law as his clients interpret the law could only be justified if there was no good faith basis for arguing that Lehman's frauds were "material" to investors. The reality as I have said is that the SEC's experts were correct about materiality, but Cannelos could not have believed that the SEC's position that Lehman's frauds were material was an interpretation of the agency's rules that was so unreasonable that he could not ethically represent his client's views. Even then, his proper course of action was to step aside and let another enforcement attorney present the agency's position. Only if he believed that Lehman's senior officers were the victim of some deliberate form of abuse prompted by illegal considerations (e.g., discrimination or a politically-driven effort at retaliation) should he have sought to block the agency from bringing the action against Lehman's senior officers by blowing the whistle to the SEC's Inspector General.
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