Infectious Greed

by Frank Partnoy

  An approach using general standards could also require that companies publish their financial statements on the Internet and update them over time, according to changes in their businesses, rather than continue to focus on the strict requirement of reporting specified financial results once every quarter. If the reporting periods were more frequent, or perhaps were even staggered across different periods—a week here, a month there—investors and analysts would lose their obsession with end-of-quarter numbers, and the conflicts of interest associated with meeting quarterly expectations would dissipate.11

  The idea of using broad standards in the financial context is not new. In 1969, the well-respected Judge Henry Friendly, in a case called United States v. Simon, found that accountants who technically had complied with Generally Accepted Accounting Principles could nevertheless be held criminally liable if the disclosures created a fraudulent or otherwise misleading impression among shareholders. In the Simon case, a footnote in Continental Vending’s annual report had resembled the opaque disclosures in footnote 16 of Enron’s 2001 annual report. As Judge Friendly put it, “the jury could reasonably have wondered how accountants who were really seeking to tell the truth could have constructed a footnote so well designed to conceal the shocking facts.”12

  Unfortunately, the Simon case has influenced few market participants—in part because the defendants paid small fines and later were pardoned by President Richard M. Nixon.13 Nevertheless, Judge Friendly’s reasoning is wise and powerful advice for regulators considering how to deal with the chaos of modern financial markets.

  3. Eliminate the oligopoly lock of gatekeepers, especially credit-rating agencies.

  One specific instance of how regulators inadvertently created rules corrupting the financial markets is the pervasive power of gatekeeper institutions—accounting firms, law firms, banks, and credit-rating agencies—even given their abysmal performance in assessing and reporting risks. The securities laws recognize that managers of companies will always have an incentive to be aggressive in reporting their financial data. Instead of trying to dictate what managers can and cannot do, the U.S. regulatory regime creates and subsidizes these gatekeepers, who are supposed to monitor the inevitable conflict between managers and shareholders. This regime assumes that accounting firms actually do audits, law firms and banks actually perform due diligence, and credit-rating agencies properly analyze information about a company’s debts. If the gatekeepers do their jobs, investors can look to them for an impartial, third-party perspective on corporate managers.

  Gatekeepers benefit greatly from legal rules requiring that companies employ accounting firms to certify their financial statements, banks to underwrite their securities, law firms to examine the underlying documents and opine that they are legitimate, and credit-rating agencies to rate their bonds.14 Moreover, legal rules permit managers to insulate themselves from liability by involving gatekeeper firms in their transactions.

  In other words, gatekeepers do not survive on the basis of their reputation alone, contrary to the assumptions of many academics. Economists have assumed a gatekeeper would not take advantage of investors, because if it did so, its reputation would suffer and no one would use its services. That view has proven as naïve as the belief that a twenty-dollar bill lying on the ground was not really there. During the past twenty years, gatekeeper institutions have performed unimaginably disreputable acts, but their reputations have suffered only a little—and their profits have not suffered at all. Gatekeepers will continue to earn substantial profits as long as rules supporting them persist. For example, no matter how poor the credit-rating agencies are at predicting defaults, companies will still pay these agencies for ratings, because legal rules effectively require the companies to do so. (Recall the importance that Allen Wheat and CSFP placed on obtaining an AAA rating.) The same is true, to a somewhat lesser extent, for other gatekeepers.

  One possible response to the failure of gatekeepers is to punish and reform them, as parents might try to change an unruly child. Beginning in 2002, the U.S. government attempted to do this for accountants, by imposing rules that constrained their behavior, and by prosecuting Arthur Andersen.

  Such a punitive approach is doomed, unless it also addresses the oligopoly lock that gatekeepers have on their respective businesses. Put simply, gatekeepers do not have proper incentives to police corporate managers, because these institutions do not suffer sufficient reputational consequences even when they do a poor job of monitoring. The barriers to entry are too high: most corporate executives will not hire a low-cost competitor to Merrill Lynch, Ernst & Young, or Moody’s, because the regulatory system punishes them for doing so, depriving them of an argument that they did their due diligence in a particular deal, or—in many instances—making their securities less attractive to outside investors by removing valuable regulatory entitlements. When prosecutors killed off Arthur Andersen, they only made the franchise associated with a top “Final Four” accounting firm more valuable. In the case of credit-rating agencies, only a few are approved for regulatory purposes, and the barrier to entry can be insuperable.

  The bottom line is that reputation alone does not constrain the behavior of gatekeepers. They can acquire a bad reputation, so long as the structure of the financial system continues to require the use of their services. The legal rules that effectively require companies to hire gatekeepers are the answer to the oft-asked question about why gatekeepers make so much money.

  There are two possible solutions. One is to eliminate the legal rules that effectively require that companies use particular gatekeepers (especially credit-rating agencies), while expanding the scope of securities-fraud liability and enforcement to make it clear that all gatekeepers will be liable for assisting companies in transactions designed to distort the economic reality of financial statements. This approach would require that Congress eliminate the regulatory reliance on credit ratings and remove the restrictions on securities lawsuits imposed during the mid-1990s, so that gatekeepers could be held responsible for aiding and abetting financial fraud. Such changes would encourage new intermediaries to attempt to fill the shoes of the accountants, bankers, lawyers, and credit raters who have failed during the past decade.

  The other possibility is to require that gatekeepers act in the public interest as “professionals,” and not merely for private gain. This suggestion might seem laughable to accountants and bankers, as the trend during the past decade has shifted from professionalism to profit. But if the markets are to be reformed without radical changes in law, then gatekeepers will need to improve practices on their own and prove they are deserving of their special place in financial regulation. Only then should the legal rules giving them such special status remain in place.

  A reasonable middle-of-the-road approach might be first to open up to competition the market for credit ratings and to require that regulators use some dividing line other than credit ratings for determining whether specified institutional investors can buy particular bonds. There are numerous available substitutes (the spread between the yield of a bond and a similar, risk-free U.S. Treasury bond, or even the market value of credit default swaps).15 If the experiment with credit-rating agencies worked well, regulators could consider removing the special entitlements for other gatekeepers. In any event, gatekeepers should not continue to have their cake and eat it, too, by benefiting from legal rules while avoiding responsibility for their actions.

  4. Prosecute complex financial fraud.

  Prosecutors could relieve some of the burden on gatekeepers by bringing cases against corporate executives for complex financial fraud. Such cases have been notoriously difficult to prosecute, and the government has avoided them during the past decade, thereby creating incentives for executives to commit such fraud. Even when regulators are tipped off to fraud, as they were repeatedly about Bernie Madoff, they frequently do nothing, either because they do not understand the tip or because they cannot summon the political will to bring a c
ase.

  In general, people are not deterred from criminal activity unless they view it as morally wrong or perceive that its expected costs—including the possibility of jail time and fines—outweigh the benefits. In the financial markets, the question of whether an action is morally wrong is typically irrelevant; the relevant consideration is profit, with reputation being a secondary restraint on behavior. In other words, participants in the financial markets are rational economic actors: they violate legal rules not because they are evil people, but because it makes economic sense for them to do so. If the gain from cooking the books is substantial, and the probability of punishment is zero, the rational strategy is to cook, cook, cook. Unless the probability of punishment increases, the additional penalties won’t do much to deter. Not surprisingly, in 2002, when Congress doubled the maximum prison term for financial fraud to twenty years, it barely registered in the financial markets. Legislators might as well have added the death penalty, given the low probability of conviction for complex financial fraud.

  In the criminal cases brought since 2002, prosecutors did little to persuade market participants that the probability of punishment for complex financial fraud was much greater than zero. Instead, the government reinforced the message that the more complex the scheme, the lower the probability that the perpetrators will be punished. By making the prosecution of Arthur Andersen for obstruction of justice its first case after the financial calamities of 2001, the government killed that firm. But instead of sending a warning to other accounting firms that they should be more careful in approving controversial accounting treatment for complex transactions, the government’s action merely signaled that firms should take more care in their document “retention” policies.

  Moreover, the government nearly lost the case against Andersen, and the jurors’ ultimate verdict was based on an internal memorandum from an Andersen lawyer—a memo that the prosecution had not even featured in its arguments. The verdict hardly frightened anyone involved in a financial scheme. Likewise, the indictment of Andy Fastow focused on simple kickback schemes, which were easy to prove, but did not send a warning to anyone engaged in a more complex fraud. Nor did Bernie Madoff’s confession strike fear in the hearts of future pyramid schemers. If Madoff hadn’t come clean, prosecutors might still be struggling to bring him to justice.

  The May 2003 indictment of Frank Quattrone was an object case; no one on Wall Street was higher paid, or more infamous, than Quattrone. But instead of charging him with crimes related to his highly publicized IPO dealings, prosecutors focused on an obscure e-mail exchange related to document destruction. They ultimately failed.

  In simple terms, Quattrone was alleged to have caused other unnamed employees of his investment banking firm, CSFB, to destroy evidence related to the firm’s alleged rigging of the IPO market for its own benefit. The facts didn’t look great. Richard Char, a CSFB banker, sent Quattrone and others an e-mail eerily similar to the one Andersen’s Nancy Temple sent in 2001 telling employees “it would be helpful” if they were in compliance with the firm’s document retention policy. Char’s message was similar, but more colorful: “Today, it’s administrative housekeeping. In January, it could be improper destruction of evidence.”16

  Quattrone wasn’t amused. He admonished Char: “You shouldn’t make jokes like that on e-mail!” and forwarded to CSFB employees a tamer version of the e-mail, which said, “We strongly suggest that before you leave for the holidays, you should catch up on file cleaning.” The criminal complaint alleged that some of those employees destroyed documents during December 2000, after they received the e-mail.

  The key questions in the case involved timing and intent. It seemed clear what Quattrone knew and when he knew it. He was informed of three separate investigations by regulators into his technology group’s practices of allocating shares in IPOs to favored clients. But it isn’t clear whether he had the necessary criminal intent to obstruct justice as of early December 2000. Just the day before the key e-mail flurry, Quattrone asked a CSFB lawyer, “Are the regulators accusing us of criminal activity?”

  In addition to these legal and factual weaknesses, the government’s case against Quattrone had a more serious flaw. Although U.S. Attorney for Manhattan James Comey said he brought these charges to signal the importance of voluntary compliance with regulatory inquiries, any document destruction was irrelevant to the government’s investigation of CSFB.

  For years, prosecutors had ample evidence of CSFB’s practice of “spinning” IPOs to favored clients who then kicked back a portion of their instantaneous profits after the IPO price shot up during the first day of trading. The government didn’t need a few more notes, e-mails, or “pitch books” as proof. As discussed in Chapter 9, key facts establishing the IPO kickback scheme were set forth in a detailed civil suit by the SEC, which CSFB quietly settled for a $100 million fine (paltry, relative to CSFB’s profits from “spinning”) during the aftermath of September 11, 2001.

  Whatever the legality of “spinning”—and if it was illegal, it certainly was widespread—there wasn’t any cover-up, certainly not an effective one. The Quattrone criminal complaint described two IPOs, involving VA Linux and Selectica, Inc. But there were mountains of documents proving CSFB received kickbacks for allocations of other IPOs, too. Even if CSFB had destroyed all of the documents related to VA Linux and Selectica, there would still be plenty of fodder for cases against the firm, as plaintiffs’ lawyers suing CSFB happily pointed out in related civil cases.

  Recall Gadzoox Networks, for example, the Internet company that hired CSFB as the lead underwriter for its IPO. On July 20, 1999, CSFB sold shares in the Gadzoox IPO for $21. By the end of the day, the shares had more than tripled, and the lucky clients who bought at the IPO price (and made $180 million in all) were trading frenetically in stocks unrelated to Gadzoox (Allstate, Coca-Cola, Conoco, and Philip Morris) at sky-high commission rates of $1 per share or more, in order to kick back one-third to two-thirds of their profits to CSFB. Investors who bought at $76 that day were left holding the bag.

  The barrier to a “spinning” prosecution wasn’t document destruction or lack of evidence. Instead, prosecutors shied from bringing such a case for the same reason they often avoided complex financial prosecutions: they feared being outmatched by clever defense lawyers and bankers who could credibly argue, like a shrewd teenager, that everyone was doing it. Why devote a dozen lawyers to a case you might well lose? In this case, Quattrone was represented by the legendary John W. Keker, the aggressive lawyer who successfully prosecuted Oliver North in the Iran-Contra trial (and who also represented former Enron CFO Andy Fastow in his criminal case)

  Not surprisingly, Quattrone pleaded not guilty. After a hung jury and appeals, prosecutors finally dropped the case in 2006. Today, Quattrone is a free man, and is back advising on financial deals.

  Is “spinning” criminal? No one knows, and the prosecution of Quattrone didn’t lead to an answer. That is why it is the wrong case. Nabbing Quattrone, Al Capone-like (Capone committed every crime in the book, but was nailed only for tax evasion), for causing another person to obstruct justice wouldn’t affect the financial markets, except possibly to send a signal that bankers should destroy documents more systematically, and earlier. If prosecutors indeed wanted to try to vilify Quattrone, they should have fought fair, with more than an obstruction-of-justice prosecution.

  If prosecutors believed IPO kickbacks violated the law, they should have prosecuted willful violations as crimes, with Quattrone at the head of the pack. But if they couldn’t muster such a case, they shouldn’t have complained that Quattrone caused someone to destroy evidence they never planned to use. Quattrone’s case was far from a warning; it sent the message to people committing financial transgressions that they will be punished only if they also engage in some additional, easier-for-a-prosecutor-to-prove crime.

  The recent financial crisis presents even higher hurdles than the Quattrone case did. Were senior executives
aware that their institutions were exposed to collapse if housing prices declined? Did they know about hidden credit risks? Did they set up compensation systems designed to create incentives for lower-level employees to commit fraud? Were the executives willfully blind or criminally negligent?

  These questions are tough. Although investors have cried for the heads of the major banks and AIG, it is unclear that prosecutors will be able to mount cases against many of them. The lesson of the last two decades is that prosecutors will help the efficiency and integrity of markets tremendously if they can do so. But the more likely outcome is that these senior executives, like Quattrone, will go free.

  5. Encourage informed investors to bet against stocks.

  Given that the above measures may take some time, regulators should immediately allow and encourage informed investors to bet against stocks when they have reason to do so. This proposal is counterintuitive, but the best way to prevent speculative bubbles that lead to financial crises is to permit smart and informed people to bet against financial assets whenever a bubble starts to build.

  Short sellers—people who bet against stocks—have had a bad reputation for decades, and some officials even held them responsible for recent market declines. In 2008, regulators imposed restrictions on short selling of financial company stocks, after bankers, including John Mack of Morgan Stanley, blamed short sellers for the collapse of banks. Congress reacted similarly to stock price declines in 2002; Representative John LaFalce specifically blamed short sellers for the plunge in prices and asked Harvey Pitt, then SEC chairman, to close down short selling, at least temporarily. There even was evidence—later questioned—that short sellers and options traders had profited from bets against stocks in advance of the terrorist attacks on September 11, 2001.