Lehman: Criminal Prosecution Possible, Says Pitt

Over the weekend I had the opportunity to put some questions in email to Harvey Pitt, who was head of the Securities & Exchange Commission from 2001 to 2003, regarding the bankruptcy examiner’s report on Lehman Brothers released last Thursday.

Mr. Pitt is now CEO of consulting firm Kalarama Partners in D.C. I’m reprinting his remarks in their entirety.

STWT: Are you satisfied with the conclusions reached in the report?

Pitt: The Report appears to be quite thorough. It’s difficult to assess how accurate the conclusions are without doing a great deal of work. But, the conclusions seem quite apt, given all that I know.

STWT: How serious is the finding of “colorable claims” against Richard Fuld, Lehman management, and Ernst & Young?

Pitt: I think the finding of “colorable claims” is quite serious. The Report starts with what I refer to as “surface credibility.” The author had no reason to slant his findings one way or the other, and every reason to want to get it right. Fuld and E&Y have a daunting task in front of them. If they want to avoid the logical consequences of the Report’s conclusions-and none of those consequences are at all good for either Fuld or E&Y-they will need to come forward quickly with a very plain, easily understandable explanation of the errors or their defenses. The longer it takes them to do that, the less likelihood they will have of mitigating the publicity the Report’s allegations have already received.

STWT: What might the consequences be?

Pitt: The most significant consequence is that this may finally prompt the government-in the form of the DOJ and the SEC-to take action. Many are wondering why there hasn’t been any action taken, and why the government hasn’t reported on the same events itself. Criminal prosecutions are possible, as are SEC civil actions. For Fuld, an SEC action could mean that he would forfeit his right to participate in the securities industry and possible disgorgement of monies he received over the years from Lehman. For E&Y, the SEC has the power to suspend their right to practice accounting, limit their ability to take on new clients, and impose remedial sanctions.

STWT: What is your impression of the actions of the regulators involved and their response to Lehman in the spring and summer of 2007?

Pitt: It is hard not to be critical, but it is important to start with the recognition that the regulators found themselves in a very difficult set of circumstances, with limited knowledge of the structured synthetic securities instruments Lehman had purchased, or the markets for them. The fact is, however, that there is more than enough blame to go around. By the time Lehman started tanking, the government had made it clear that it did not intend to “save” every troubled firm, but what it failed to do was indicate what the criteria were. Lehman had valuable assets, but its demise was ensured because those who might have purchased them kept waiting for the government to facilitate those purchases, but that never occurred.

STWT: Are there clear implications from the Lehman case for how financial regulation should be conducted in future with respect to large financial institutions?

Pitt: There are, although George Bernard Shaw may have had it right when he said “the only thing we learn from history is that we never learn from history. So, there are clear implications if we want to see them, but the likelihood is that those who need to understand those implications may not choose to do so. The proof of that is that we have been at this for over a year already (since the onset of the new Administration), and we have yet to address the next crisis that awaits us (there’s always a next crisis). All of the current efforts seem designed to respond to last year’s crisis, rather than the crisis just on the horizon. I think there are several critical and operative implications that need to be learned:

• Regulators need a constant flow of significant data about all aspects of our financial and capital markets, including new instruments and the markets that grow up around them. This was sorely lacking throughout the 2007-2009 crisis.
• Regulators need to develop analytical ability to understand and massage the data they receive, and to inform the markets (and other regulators) of the trends and directions indicated by that data.
• There is a need to vest regulators with what I refer to as “residual regulatory authority”-the ability to create so-called “trip wires” and, when those are tripped, to have the ability to halt trends in mid-development until it can be ascertained whether the trends are moving in a direction that could cause systemic difficulty or damage.
• The SEC needs dramatically to improve its ability to conduct frequent examinations of all entities that take funds from the public or can have a significant impact on our financial and capital markets. In February 2003, I proposed a system by which wholly qualified and independent firms in the private sector would perform annual (or, for smaller firms, biennial) examinations, pursuant to standards the SEC would articulate-a compliance audit similar to the financial audits performed by the accounting profession for public companies.

STWT: Are there any other lessons we can draw about the financial industry from the report?

Pitt: The collapse of our economy, the virtual destruction of our credit markets, and the lack of internal transparency at many firms (not just Lehman) suggests the need for increased internal vigilance and a critical need for improved risk management capacity. Unfortunately, even today, having seen such economic destruction, the financial industry seems content to practice what I call a form of “reverse laissez faire”-waiting for the government to tell it what it is doing that is wrong, why it is wrong, and how to fix it-and then is shocked, shocked (like Captain Renault in Casablanca) to learn that they do not like the government’s answers.

Previously: Twilight of the Fuld: Those Who Told You So, March 12, 2010.