Infectious Greed

by Frank Partnoy

  Charlie Sanford wasn’t prosecuted or fined, but his reputation was tarnished forever. He deserved credit for having the vision and intelligence to transform Bankers Trust from a dying, old-line commercial bank into a sophisticated risk manager. But in implementing this dramatic change, he had turned the ship too far, creating the mercenary culture that led to the aggressive practices of the early 1990s. Sanford had wanted Bankers Trust’s board of directors to appoint his chosen successor, Eugene Shanks—the assistant he had chosen over Allen Wheat several years earlier. But when the board refused to give Sanford the last word, Sanford resigned.

  For the sake of balance, the board insisted on replacing Sanford with Frank Newman, the Treasury official who had opposed derivatives regulation in an earlier “job interview.” Compared to Sanford, Newman was a feeble and short-sighted manager who seemed more interested in his own personal gain than in the future of the bank. While he was CEO, Bankers Trust was directionless and sustained huge losses, especially in Russia in 1998. It also pled guilty to a crime: illegally diverting funds from various accounts, although Newman was not implicated in any way in that case. When Deutsche Bank offered to buy Bankers Trust for $10 billion in 1999, Newman eagerly supported the deal, and when Deutsche Bank refused to let Newman make any high-level business decisions, he happily resigned,79 a consensus failure in every way except one: Newman had very skillfully negotiated a guaranteed 5-year pay package of $55 million—which would be paid regardless of whether he was working for Bankers Trust or not—in addition to millions of dollars of compensation he already had received, plus a multimillion-dollar payment he was due for selling Bankers Trust to Deutsche Bank, plus a multimillion-dollar severance payment.80 Even with the derivatives scandal, Sanford had been a much better value.

  The prosecution of Piper Jaffray and its employees didn’t go any better than the Bankers Trust cases. The SEC investigated Piper’s misconduct for more than four years, compiling more than one million pages of documents and taking thirty-seven days of deposition testimony.81 The hearing in the case took eight weeks in 1999, and involved more than forty witnesses and over 1,000 exhibits. The hearing transcript was 4,969 pages.82

  The issues in the case against Piper were especially difficult, because the mortgage derivatives Piper had bought were incredibly complex. Essentially, the SEC was arguing that Piper had misrepresented the instruments’ unusual payoff profile. For example, one issue that took a great deal of time in the case revolved around negative convexity, a concept resembling deceleration in physics. (If you must know, negative convexity is essentially the tendency of a portfolio to become volatile by a greater amount when interest rates rise than the amount by which it becomes less volatile when interest rates fall.)

  The case against Piper did not involve criminal charges, did not involve a federal prosecutor, and was not even heard before a U.S. district court judge. Instead, the SEC brought the Piper case before an administrative-law judge, H. Peter Young, who did not have the authority to order criminal sanctions. Judge Young found that Piper employees had committed minor securities-law violations in valuing their mortgage derivatives in early April 1994, when the markets were collapsing as Askin Capital Management fell into bankruptcy. Piper was fined $2 million for these violations. Judge Young also found that Worth Bruntjen had lied to the SEC about his educational background, and imposed an additional $5,000 fine for this misrepresentation.83 In March 1996, Piper also paid a $1.25 million fine in a separate case brought by the National Association of Securities Dealers, which charged Piper with improper sales practices. In total, the fines were about the same size as the fee on one large derivatives deal.

  The SEC also brought a civil suit against NationsSecurities for selling Term Trusts that owned risky inverse floaters under the guise of a safe investment managed by NationsBank. But the punishment was a civil censure and a penalty of just $4 million. Again, no one went to jail.

  The Orange County prosecutions were the least effective of all. The SEC had interviewed Treasurer Robert Citron and knew about his investment strategies several months before the county collapsed, but decided it did not have jurisdiction to take any action at that time. Although the financial instruments involved in the Orange County collapse were similar to those Bankers Trust had sold, the SEC and the Department of Justice decided not to press the issue of whether Orange County’s structured notes were “securities,” and instead conceded that the federal government did not have jurisdiction to prosecute anyone for Orange County’s losses. Whereas ISDA had persuaded the Wall Street Journal that the structured notes Orange County bought were merely securities, not derivatives, the federal securities regulators decided the opposite. (The SEC did have jurisdiction over the sale of Orange County’s bonds, and it sued the investment bankers involved in the offering and sale of those bonds for securities fraud.)84

  That left state prosecutors to bring cases against Robert Citron and his assistants. In April 1995, Citron pled guilty to state securities fraud, and faced up to fourteen years in prison. But his attorney asked the court to be lenient, telling the judge that Citron had suffered from dementia for several years.85 Instead of serving prison time, Citron agreed to work in a jail commissary during the day for nine months, as part of a state work-furlough program.86

  Prosecutors had no success against anyone else at the county. A jury found Assistant Treasurer Matthew Raabe guilty of securities fraud and misappropriation, and he was sentenced to three years in prison; but, an appeals court overturned the conviction in 2001, and the district attorney dropped the case, returning the $10,000 fine Raabe had paid.87 In the prosecution of Citron’s budget director, a jury was hung in favor of acquittal. No one working at any of the investment banks, credit-rating agencies, or government institutions involved in the Orange County debacle spent time in jail. Raabe was the only person to do any time—the forty-one days he had spent in jail before he was released on bail, pending appeal.

  The examples of Bankers Trust, Piper, NationsSecurities, and Orange County were typical. Most cases of financial malfeasance were complex, and the defendants had plausible arguments about why what they had done was legal or fell outside the scope of existing law. Prosecutors did not bring many criminal cases, and they lost when they did. The only individuals criminally punished for the losses of 1994 were those who had engaged in truly blatant fraud. For example, James Martignoni, a 27-year-old Australian trader at ABN AMRO Bank, was convicted of fraud in a New York federal court for buying currency options, inflating their volatility, and recording false profits (much as Bankers Trust was alleged to have done regarding Andy Krieger’s trades). Martignoni left a clear trail of proof; he even had concealed losses by asking his assistant to move a decimal point in a trade one to the right, magically turning a $1.8 million sale into an $18 million sale.88 Similarly, Nicholas Leeson of Barings Bank was sentenced to serve six years in a Singapore prison for a fraudulent scheme that involved Leeson using a pair of scissors to cut and paste false profit reports (more on Leeson in Chapter 8). But those guilty few were the exceptions.

  With the paucity of criminal cases, most of the disputes among various parties to the losses of 1994 were left to be resolved in civil lawsuits. In litigation related to Bankers Trust, Piper, and Orange County, there were only a few written judicial opinions resolving the cases, but defendants nevertheless agreed to pay hundreds of millions of dollars to settle the claims. To the extent anyone was deterred from aggressive sales practices related to derivatives, it was these lawsuits—not any government prosecution—that created the potential threat of liability.

  Several clients of Bankers Trust, including Procter & Gamble, sued to recover their losses. P&G and Gibson Greetings weren’t the only clients to settle with Bankers Trust on favorable terms. Bankers Trust had made about $25 million in profits from a series of derivatives deals with Sandoz Corp., the first of which was especially ill-timed, on January 31, 1994, just five days before the Fed’s rate hike. Bankers Trust had t
hen persuaded Sandoz to amend the derivative nine times, each time taking out a fee. Sandoz reached a confidential settlement with Bankers Trust, as did Jefferson Smurfit Corp., a company that amended its swap agreement eleven times before it was finally unwound at a loss in September 1994. Bankers Trust also paid $67 million to settle its dispute with Air Products and Chemicals.

  The litigation revealed that some supposedly sophisticated companies—such as P&G—were, in fact, babes in the woods. Edwin Artzt, formerly P&G’s chairman and CEO, had stated publicly, “Derivatives like these are dangerous and we were badly burned. We won’t let this happen again.” In handwritten notes that were discovered in the litigation between P&G and Bankers Trust, Artzt wrote about P&G’s treasurer, “Didn’t penetrate—didn’t ask the right questions. Simply went to sleep.” The treasurer, Raymond Mains, took early retirement in 1994, at P&G’s suggestion. These discoveries prompted Michael D. Greenbaum, a general partner of the O’Connor Partnerships (the Chicago firm Andy Krieger had first worked for during business school), to write a letter to Forbes magazine, saying, “As a general partner of a firm specializing in derivatives trading, I don’t attempt to make soap, and therefore think it only equally smart for the treasurer’s office of Procter & Gamble to avoid trying to make derivatives a profit center.”89

  In the most notable written decision in any derivatives case to date, an Ohio judge, John Feikens, in the Procter & Gamble v. Bankers Trust lawsuit, found that the swaps were not securities, and therefore were not subject to federal regulation.90 This decision was not binding on the New York courts, where most financial disputes were litigated, but it was a noteworthy success for derivatives dealers, who—now that they had a favorable legal ruling on the books—quickly settled remaining disputes, before a judge in another case issued a conflicting ruling.

  Piper spent more than $100 million resolving its lawsuits. Once they were resolved, Bruntjen left immediately. (Companies frequently keep employees involved in questionable schemes on their payroll during litigation, so they have some control over the employees’ testimony, and because firing them looks like an admission of guilt.) Once the suits were resolved, Piper was an attractive acquisition target, and U.S. Bancorp bought Piper the next month for $730 million.

  The investment banks that had sold structured notes to Orange County paid hundreds of millions of dollars to settle their lawsuits. Orange County also sued McGraw-Hill Companies, owner of the Standard & Poor’s rating agency, but S&P defended itself by arguing that the First Amendment protected its ratings as free speech. In assessing these arguments, Judge Gary L. Taylor wrote that “S&P’s expression is entitled to First Amendment protection.”91 Judge Taylor allowed some of Orange County’s claims to proceed; but, ultimately, the county settled its suit against S&P for fractions of pennies on the dollar.

  Orange County also sued Sallie Mae, the student loan firm, arguing that Sallie Mae failed to disclose to Orange County all of the profits being made on $913 million of structured notes the county bought.92 Sallie Mae had disclosed an “underwriting discount” of 15 to 50 basis points as the compensation for Sallie Mae and Merrill Lynch, which underwrote the notes. But, in reality, Merrill Lynch had reimbursed this fee, and made its money the same way Bankers Trust profited from the deals with Gibson Greetings—on related swap transactions.

  The Sallie Mae case raised an issue that would become crucially important during the upcoming years. Securities rules required borrowers to disclose compensation to underwriters, including “all other items that would be deemed by the National Association of Securities Dealers to constitute underwriting compensation for purposes of the Association’s Rule of Fair Practice.”93 The NASD Rule of Fair Practice 44(c) stated the compensation must be fair and reasonable and that “all items of value . . . which are deemed to be in connection with or related to the distribution of the public offering . . . shall be included.”94 The rules also stated that compensation in addition to the underwriting discount had to be referenced in a footnote on the cover page of the offering.95 Just as Merrill Lynch had not disclosed all of its fees, numerous investment banks would receive undisclosed kickbacks from clients who bought IPOs (Initial Public Offerings) at sweetheart prices. According to the allegations in the Sallie Mae case, those undisclosed kickbacks also were illegal. In fact, CS First Boston would later pay $100 million to settle a case related to the kickbacks, and similar dealings would plague numerous investment banks.

  The various derivatives disputes were mostly resolved on terms favorable to investors. However, during the mid-1990s, there were numerous obstacles thrown in the path of plaintiffs in future cases. By the end of 1995, corporate defendants would be much better protected from litigation than they had been in 1993. Ironically, government officials chose to make securities lawsuits more difficult at precisely the time such lawsuits were most needed to deter financial misconduct.

  A major obstacle to lawyers pursuing financial fraud cases came from the U.S. Supreme Court in 1994. The Court ruled in a case called Central Bank of Denver v. First Interstate Bank of Denver96 that plaintiffs could not sue accounting firms, investment banks, and law firms for aiding and abetting securities fraud. In the future, these “gatekeeper” firms would be immune from secondary liability, and a plaintiff could recover from them only by showing they were primarily liable for fraud, something that was much more difficult to do.

  The Central Bank case was argued in November 1993, and the justices had completed much of their work on the case before the Fed’s rate hike, so it seems unlikely that they were influenced by the losses of early 1994. It was a radical decision, and the Supreme Court largely ignored hundreds of judicial and administrative proceedings over sixty years, when parties had assumed that accountants could be liable for aiding and abetting securities fraud.

  Instead, the case focused on the potential abuses of securities litigation. In a 5-to-4 decision, Justice Anthony Kennedy argued for the majority that liability for securities fraud demanded “certainty and predictability,” citing testimony that in 83 percent of cases, accounting firms paid $8 in legal fees for every $1 paid in damages to investors. Just a few years after the decision, few people would have such a sympathetic view of accounting firms.

  In 1995, Congress joined the Supreme Court in limiting securities lawsuits. The legislative limitations had been in the works since 1991, when Richard C. Breeden, the previous SEC chairman, had testified before Congress that “because baseless securities litigation amounts to a ‘tax on capital,’ which undermines economic competitiveness, there is a strong public interest in eliminating meritless suits.” In 1992, Representative W. J. “Billy” Tauzin, a Democrat from Louisiana, had introduced legislation limiting liability for securities fraud.

  Arthur Levitt supported these limitations. In January 1994, Levitt began arguing in speeches that abusive litigation imposed tremendous costs on issuers of securities. He said the legal system failed to distinguish between strong and weak cases. Many lawyers viewed Levitt—in his words—as “the single greatest threat to the continued viability of private remedies against fraud.”97

  The proposed legislation was directed at one lawyer in particular, Bill Lerach, a well-known and much-feared litigator in the San Diego office of the law firm known as Milberg Weiss. Lerach had recovered billions of dollars for shareholders, although his reputation had been tarnished by some less meritorious suits. Companies commiserated about being “Lerached,” which meant they had been sued by Bill Lerach for securities fraud. As the cost of defending these suits increased, the support for restrictions increased.

  (Surprisingly, Lerach and Milberg Weiss were largely missing from the lawsuits related to derivatives. The cases were extremely complicated and costly to pursue, and it wasn’t at all clear they would succeed. At the time, Lerach preferred simpler suits involving insider trading or blatant financial fraud.)

  When Republicans captured the House of Representatives in November 1994—for the first time since the Eis
enhower era—securities-litigation reform was assured. In a January 1995 speech, Levitt outlined the limits on securities regulation that Congress later would support: limiting the statute-of-limitations period for filing lawsuits, restricting legal fees paid to lead plaintiffs, eliminating punitive-damages provisions from securities lawsuits, requiring plaintiffs to allege more clearly that a defendant acted with reckless intent, and exempting “forward looking statements”—essentially, projections about a company’s future—from legal liability.98

  The Private Securities Litigation Reform Act of 1995 passed easily, and Congress even overrode the veto of President Clinton, who either had a fleeting change of heart about financial markets or decided that trial lawyers were an even more important constituency than Wall Street. In any event, Clinton and Levitt disagreed about the issue, although it wasn’t fatal to Levitt, who would remain SEC chair for another five years.

  The PSLRA, as the law became known, made securities-fraud suits more difficult for plaintiffs to sustain. Many legislators believed that result was a positive one; investors’ advocates thought it was a negative. Although there were arguments on both sides, it seemed that, with the government no longer aggressively pursuing criminal prosecutions for financial fraud, and with new limits on plaintiffs’ lawyers, corporations and their managers would be governed more by their own moral values and reputations than any legal constraint.

  One money manager, James S. Chanos, was skeptical that the markets alone would provide sufficient discipline to Wall Street, major corporations, accounting firms, and lawyers. Reflecting on the dramatic increase in financial fraud from 1995 through 2001, he told the House Energy Committee that the PSLRA was responsible for many of the abuses that followed: “That statute, in my opinion, has emboldened dishonest managements to lie with impunity, by relieving them of concern that those to whom they lie will have legal recourse. The statute also seems to shield underwriters and accountants from the consequences of lax performance.”