U.S. Securities and Exchange Commission investigators may issue a public rebuke of Lehman Brothers Holdings Inc. and its former executives instead of suing them for actions that led to the firm’s 2008 failure, three people with direct knowledge of the matter said.
SEC enforcement lawyers, who have struggled for more than two years to find definitive evidence that the company and its leaders violated securities laws, are concerned that a legal attack on Lehman’s accounting practices would likely fail, the people said, speaking on condition of anonymity because the deliberations aren’t public.
Instead, the enforcement staff may recommend that the agency take the rare step of publishing a so-called report of investigation, also known as a 21(a) report. The commission would have to vote on whether to issue a report and it’s still possible that the SEC may decide to bring legal claims in court, the people said. The 21(a) reports, which lay out allegations of misconduct without imposing penalties, have only been issued six times in the past decade, according to the SEC’s website.
“The SEC can claim that this is decisive action and that they’re on record as to the wrongdoing. It doesn’t meet the inevitable resistance that civil action meets -- the possibility of failure,” said Robert Hillman, a professor at the University of California, Davis, School of Law.
Kimberly Macleod, a spokesman for Lehman, declined to comment. Patricia Hynes, an attorney at Allen & Overy LLP for Lehman’s ex-chief executive officer Richard Fuld, and Robert Cleary, a lawyer at Proskauer Rose LLP for former finance chief Erin Callan, didn’t respond to e-mails. Florence Harmon, an SEC spokesman, declined to comment.
Lehman, which filed the biggest bankruptcy in U.S. history in September 2008, was faulted along with its former executives in a report by Anton Valukas, the court-appointed examiner, who said they misled investors with “accounting gimmicks.” Valukas alleged that Lehman used the technique, known as Repo 105s, to hide billions of dollars in assets and artificially reduce the firm’s leverage. The actions may not have violated accounting rules, making it difficult for the SEC to pursue fraud claims.
If the SEC determines it can’t bring a case, airing its findings may be the best option for fending off criticism from lawmakers and investors who say the agency hasn’t been aggressive in pursuing wrongdoing that fueled the financial crisis, Hillman said.
James Cox, a securities law professor at Duke University School of Law, said it would be “disappointing” if the SEC didn’t bring fraud charges against Lehman and its executives.
The rebuke is “about the least harmful sanction anybody could get,” Cox said.
Congress gave the SEC discretion to publicize findings of investigations in the Securities Exchange Act of 1934. The reports were meant to be a flexible tool to shine a spotlight on questionable conduct that may not support an enforcement action, said Steve Crimmins, a former SEC attorney who’s now a partner at K&L Gates LLP in Washington.
“It was adopted to help get the SEC where it needed to go when the path was not all that clear,” Crimmins said. “The reports tend to be used in borderline situations, where the SEC feels the need to speak out about the broader significance of something but for whatever reason feels it’s just not right to bring a case.”
While the agency continues to weigh the possibility of bringing civil fraud claims, it faces several hurdles, according to the people.
In April, the Financial Accounting Standards Board changed its rule for how firms have to account for the short-term transactions that let Lehman temporarily remove about $50 billion in assets from its balance sheet by treating them as sales. FASB’s move may bolster the defense that the rule, not Lehman’s application of it, was faulty.
Since Lehman is defunct, any enforcement action would likely target individuals, such as Fuld and Callan, said Cox.
“The executives had to sign off that the financial statements fairly presented the firm’s financial position,” Cox said. “Even though the Repo 105s were perhaps in technical compliance with GAAP, they were distorting the true economic image of the firm.”
Ernst & Young LLP, Lehman’s auditor, was sued in December by then-New York Attorney General Andrew Cuomo, who’s now governor, for signing off on Lehman’s quarterly financial statements. The firm disputes the claims and hasn’t been accused of wrongdoing by federal regulators.
In a May statement, Ernst & Young said regulators have made “a series of changes to accounting and disclosure rules” since the financial crisis that, “with the benefit of hindsight, are significant improvements to the system that existed prior to Lehman’s demise.”
The SEC could also focus on whether Lehman’s executives deceived investors by falsely describing the treatments being used, two people said. In September, the SEC proposed a rule that would require companies to provide “a comprehensive explanation of short-term borrowings.” Defense lawyers could argue that the change shows that Lehman’s disclosures weren’t deficient under current rules.
In response to Valukas’s report, Ernst & Young said Lehman’s management discussion and analysis “were the responsibility of management, not the auditor.”
In testimony to Congress last year, Fuld said Lehman shouldn’t be criticized for complying with existing repo accounting rules. He also said he had “absolutely no recollection whatsoever” of hearing about the Repo 105s.
Defense lawyers for Lehman would likely try to turn any allegations by the SEC back on the agency. Referring to his interviews of executives, Valukas wrote that “a recurrent theme in their response was that Lehman gave full and complete financial information to government agencies” and that regulators “never raised significant objections or directed that Lehman take any corrective action.”
SEC examiners monitored Lehman’s financial health as part of the Consolidated Supervised Entities program, which had been set up in 2004 to guard against the collapse of systemically important investment banks. The voluntary program was halted after Lehman declared bankruptcy.
The commission issued two 21(a) reports last year. In August, the SEC published results from a probe of Moody’s Corp. that found the company had chosen not to downgrade inflated ratings on almost $1 billion of debt in 2007 out of concern for the company’s reputation. The SEC said it didn’t pursue fraud claims because the conduct occurred in Europe, raising uncertainty as to whether the agency had jurisdiction.
In March 2010 the agency posted details of a probe involving a JPMorgan Chase & Co. vice chairman, faulting him for raising money for former California Treasurer Phil Angelides. A JPMorgan subsidiary underwrote certain California bonds within two years of the donation, even though securities rules bar banks from doing so. The SEC used the report to reaffirm guidance on the rule, warning banks that it also applies to executives of parent bank holding companies.
The SEC has already made some public remarks about Lehman’s accounting. After Valukas released his findings, the SEC sent letters to financial firms in March 2010, asking for information on their use of repos as it sought to “better understand” their decisions. The agency hasn’t found evidence that “inappropriate practices were widespread,” Chief Accountant James Kroeker said at a May 2010 congressional hearing.
“So much of what went on here was neither clearly legal nor clearly illegal,” the University of California’s Hillman said. “It fell through the cracks in this case, and that makes civil actions very, very difficult. The 21(a) report would be an opportunity for the SEC and everyone else to move on.”