Lessons from the Lehman Autopsy

In 2008, Anton R. Valukas, a trial attorney in Chicago, published a four-page stiletto thrust of an essay entitled "Arrogance: My Favorite Sin." The piece, included in a lawyers' guide to cross-examination, recounted Valukas' delight in using understated questioning to tempt executives into making implausible statements of the sort that reliably alienate jurors. "Frequently, the smartest witnesses—the most sophisticated and the most arrogant—are most susceptible to this type of examination," he wrote.

The piece reads today like a preamble to Valukas' voluminous autopsy of Lehman Brothers, which he performed as the court-approved bankruptcy examiner in the investment bank's formal unwinding. The 2,200-page Lehman report, released on Mar. 11, constitutes the single most penetrating document we have on the recent misbehavior on Wall Street. Valukas' earlier primer suggests why he did such an exemplary job: Although he heads a prestigious corporate law firm, Jenner & Block, the former federal prosecutor just plain resents dissembling by big shots in expensive suits. Not coincidentally, Jenner, a pillar of the Chicago business elite, sues Wall Street institutions as often as it defends them.

In the interest of preventing future Lehman disasters, we might ponder how to transplant Valukas' zeal into Washington's financial beat cops. That could help preclude the need to call him back again as corporate pathologist.

He'd be a hard man to clone. During a four-decade career, Valukas, 66, has represented all manner of white-collar rogues. When called to public service, he used his knowledge of the market's shadowy corners to prosecute well-heeled miscreants. In the late 1980s, as U.S. Attorney in Chicago, he sent agents disguised as commodity traders to clean up the futures exchanges. The probe protected investors and led to a slew of indictments. Some called him the Rudy Giuliani of the Midwest.

Unlike Giuliani, Valukas avoided elective politics and returned to his law firm. He prospered at Jenner, not least in his yearlong assignment as the Lehman examiner. Backed by colleagues from Jenner, he went over millions of pages of documents, interviewed scores of witnesses, and billed the Lehman estate $38.4 million. I'd say it was money well spent. His findings will provide the script for what's likely to be a theatrical airing in April, when Representative Barney Frank (D-Mass.) convenes his House Financial Services Committee to interrogate Lehman's former CEO, Richard S. Fuld Jr., and other participants in the debacle.

Dubious Behavior

What Valukas brought to the endeavor was a no-nonsense lack of deference toward Wall Street game playing, says Francine McKenna, a former managing director at PricewaterhouseCoopers. "That's a Chicago thing," adds McKenna, herself a resident of the city. She now runs an investigative Web site called Re: The Auditors. "The mindset is: I've been around the block, I know how the game is played, and I'm not impressed by fancy names," she says.

As the Lehman examiner, Valukas doggedly unmasked the dubious behavior of executives once lauded as among Wall Street's conquering heroes. Fuld insisted to Valukas that he knew nothing about the accounting trickery called Repo 105, which was used to hide the bank's financial decline. Fuld's self-portrait—a veteran CEO blithely unfamiliar with the workings of his company—was not just implausible; it could support lucrative civil claims that he "was at least grossly negligent," as Valukas wrote. The examiner noted that Fuld's denials were undercut by evidence that he was thoroughly briefed on the chicanery.

Contacted by phone, Valukas declined to comment. Fuld's attorney, Patricia Hynes, has said her client told the truth and did nothing wrong.

There will be time enough to sort out legal culpability for Lehman's demise. The Justice Dept. is investigating, and civil litigation is under way. Valukas lays out facts without playing judge or jury. "There are many reasons Lehman failed," he noted, "and the responsibility is shared."

Beyond the bank itself, Valukas pointed to evidence that Lehman's auditor, Ernst & Young, committed malpractice when it sat on a whistleblower's warnings and failed to keep the bank's board apprised of suspicious executive conduct. Ernst has denied any professional failings or liability.

The regulators also bear blame in Valukas' account. Some of the most unnerving portions of his report explain that while Lehman failed to keep investors informed, staff members from the Securities & Exchange Commission and Federal Reserve Bank of New York did know what was going on—and shrugged their shoulders.

Public-Spirited Pit Bull

Government overseers, some of whom worked on site in Lehman's offices in 2008, had access to the bank's pertinent records. Former Lehmanites told Valukas that the government didn't raise significant objections or direct Lehman to take corrective action. SEC spokesman John Nester said in an interview with Bloomberg News: "We are looking closely at the examiner's findings as part of our ongoing review of the accounting and disclosures of major financial institutions and their role in the financial crisis." This is the same agency, of course, that yawned at warnings about Bernard Madoff's globe-spanning Ponzi racket.

"The unavoidable question is whether the SEC will hold someone responsible for what happened at Lehman," says Michael J. Missal, a partner in Washington with the law firm K&L Gates. Missal, who makes a living defending companies faced with government investigations, is another of those attorneys capable, when asked by a court, of transforming himself into a public-spirited, if generously compensated, pit bull. He published an impressive bankruptcy examiner's report of his own in 2008 in the case of New Century Financial, one of the subprime mortgage giants that, with Wall Street's assistance, recklessly inflated the housing bubble.

So, how do we energize the regulatory ranks with the punch that a Valukas or Missal brings to this kind of work? One fantasy would be to replace wholesale the SEC's Enforcement Division with lawyers drawn from the staffs of past high-level bankruptcy examiners. In addition to the Lehman and New Century cases, solid investigative work was done in the wake of Enron's collapse in 2001 and the 2005 implosion of Refco, a large brokerage.

The obstacles to creating a regulatory Delta Force are familiar ones: pay and prestige. "The law firms offer money and status," says Max Stier, president of the nonprofit Partnership for Public Service. "Even when good people come into government service, many soon leave through the revolving door." Stier's Washington group runs programs to enrich government careers and encourage corporate employees to try public service. He has held legal jobs in all three branches and practiced with a Washington law firm. Stier acknowledges that government salaries will never compete with private-sector compensation. He observes that at many key agencies, the revolving door has spun all the more swiftly for the past generation as a bipartisan consensus celebrated the notion that the financial markets effectively police themselves and regulators should get out of the way. If we didn't know already, the Valukas report reminds us once and for all to drop that delusion. Done right, regulation promotes capitalism by deterring excess and fraud. "Political leaders need to prioritize talent at agencies like the SEC, which historically hasn't happened," says Stier.

One intriguing suggestion for how to put Stier's advice into action comes from Scott McCleskey, a former vice-president for compliance at Moody's Investors Service (MCO). In a Mar. 20 op-ed in The New York Times, McCleskey, who now works for Complinet, a compliance-consulting firm, proposed the creation for financial regulators of an analog to the U.S. Foreign Service. Too many SEC staff members are inexperienced attorneys; the best ones tend to depart after a few years for private practice. McCleskey argued that the Foreign Service model—with its specialized training; attractive pension eligibility after as little as 20 years on the job; and long-term career tracks, allowing for variety and new challenges—would draw more impressive applicants and cut down on turnover.

Perhaps President Barack Obama could persuade Valukas to take a sabbatical and serve as the first dean of a new Federal College of Financial Regulators. It wouldn't hurt to ask.

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