My friend Scott, who actually worked for Bear Stearns years ago, sent me one of the more down to earth explanations of a liquidity trap that I have heard of late. Imagine that you had a mortgage on your house for 50% of its current value. Then suppose that in this alternate mortgage world, you had to renew your mortgage every week. Most of the time, you are fine -- you still have good income and solid underlying asset values, so you get renewed with a rubber stamp. But suppose something happens - say 9/11. What happens if your renewal comes up on 9/12? It is very likely that in the chaos and uncertainty of such a time, you might have trouble getting renewed. Your income is still fine, and your asset values are fine, but you just can't get anyone to renew your loan, because they are not renewing anyone's loan until they figure out what the hell is going on in the world.
Clearly there are some very bad assets lurking on company books, as companies are still coming to terms with just how lax mortgage lending had become. But in this context, one can argue that JP Morgan got a screaming deal, particularly with the US Government bending over and cover most of the riskiest assets. Sigh, yet another government bailout of an institution "too big to fail." Just once I would like to test the "too big to fail" proposition. Why can't all those bankers take 100% losses like Enron investors or Arthur Anderson partners. Are they really too big to fail or too politically connected to fail?
Anyway, Hit and Run has a good roundup of opinion.
Update: I don't want to imply that everyone gets off without cost here. The Bear Stearns investors have taken a nearly total loss - $2 a share represents a price more than 98% below where it was a year or two ago. What I don't understand is that having bought Bear's equity for essentially zero, why an additional $30 billion guarantee was needed from the government.
With Eliot Spitzer going down for what shouldn't be a crime (paying for sex) rather than what should be (abuse of power), now is as good a time as ever to focus on prosecutorial abuse. As in the case of Spitzer, the media seems to have little desire to investigate overly-aggressive prosecution tactics. In fact, in most cities, the local media cheer-leads abusive law enforcement practices. It makes heroes of these abusive officials, whether their abuses be against the wealthy (in the case of Spitzer) or the powerless (as is the case of our own Joe Arpaio here in Phoenix).
Tom Kirkendall continues to be on the case of the Enron prosecution team for their abuses, which have been ignored in the media during the general victory dance of putting Jeff Skilling in jail and running Arthur Anderson out of business. But, guilty or innocent, Skilling increasingly appears to have solid grounds for a new trial. In particular, the Enron prosecution team seems to have bent over backwards to deny the Skilling team exculpatory evidence. One such tactic was to file charges against every possible Skilling witness, putting pressure on them not to testify for Skilling. Another tactic was more traditional - simply refuse to turn over critical documents and destroy those that were the most problematic:
The controversy regarding what Fastow told
prosecutors and FBI agents who were investigating Enron became a big
issue in the Lay-Skilling prosecution when the prosecution took the
unusual step of providing the Lay-Skilling defense team a "composite
summary" of the Form 302 ("302's") interview reports that federal
agents prepared in connection with their interviews of Fastow. Those
composites claimed that the Fastow interviews provided no exculpatory
information for the Lay-Skilling defense, even though Fastow's later
testimony at trial indicated all sorts of inconsistencies.
I have spoken with several former federal prosecutors about this issue
and all believe that the government has a big problem in the Skilling
case on the way in which the information from the Fastow interviews was
provided to the Lay-Skilling defense team. None of these former
prosecutors ever prepared a composite 302 in one of their cases or ever
used such a composite in one of their cases. The process of taking all
the Fastow interview notes or draft 302's and creating a composite is
offensive in that it allowed the prosecution to mask inconsistencies
and changing stories that Fastow told investigators as he negotiated a
better plea deal from the prosecutors.
the Enron Task Force's apparent destruction of all drafts of the
individual 302s of the Fastow interviews in connection with preparing
the final composite is equally troubling. Traditionally, federal agents
maintain their rough notes and destroy draft 302s. However, in regard
to the Fastow interviews, my sense is that the draft 302s were not
drafts in the traditional sense. They were probably finished 302's that
were deemed "drafts" when the Enron Task Force decided to prepare a
composite summary of the 302's.
Note that showing how a person's story has changed over time is a key prosecution tactic, but one that is being illegally denied to Skilling. Apparently Skilling's team has now seen the actual interview notes, and believe they have found "a sledgehammer that destroys Fastow's testimony" against Skilling. Stay tuned, a new trial may be on the horizon.
Last week, Milberg-Weiss and two of its partners were formally charged with bribery and fraud surround their aggressive pursuit of class-action lawsuits, often against companies with falling share prices. Walter Olson helps describe in detail what was going on, but the short answer is that the firm, as many of us suspected for years, appears to have been generating class action suits against large companies mainly for the benefit of itself and the legal fees generated. A few months ago, I questioned shareholder suits and their fundamental logic when I was guestblogging at Overlawyered.
So I am happy that this particular rock is finally being turned over. However, there are substantial problems on the prosecution side of this as well. The Justice department is using the abusive Thompson Memo guidelines to go after Milberg-Weiss. Larry Ribstein is concerned with the firm death penalty approach being taken here that was used to bring down Arthur Anderson.
Milberg is a different story. The case seems to be based on the
alleged misconduct of a couple of partners. If the partners did what
they are accused of, they should go down. Moreover, the firm will have
earned fees under questionable circumstances and should bear civil
consequences for that. But the criminal indictment casts a shadow on
the entire firm that it will have a hard time surviving, given the need
to establish its credibility for courts and institutional investors in
the highly competitive class action industry. Moreover, unlike AA, it's
not clear the indictment reveals a continuing public policy problem,
given the post-PSLRA reliance on unbribable plaintiffs.
We (and I) may not like Milberg's business. But the class action
part of it was one enabled by legal rules. The right way to deal with
the problems of this business is to change the rules, as I've argued
for securities class actions in my Fraud on a Noisy Market.
When we criminally condemn firms like Milberg because we don't like
their business, we set a precedent for other firms in controversial
lines of work -- e.g., Drexel Burnham.
More seriously, the power to criminalize a firm puts a potent tool
in the government's hands to get the firm to cooperate in sacrificing
the rights of criminal defendants. Here the cure seems patently worse
the disease. The questions are no less in Milberg than in KPMG just
because Milberg was in an unpopular line of work.
The government tactic de jour, as outlined in the Thompson memo, is to threaten a large company with extinction, telling them they might get off the hook but only if they agree to throw a number of their employees to the wolves. These steps include the unbelievable step of forcing companies to waive attorney client privilege, including privilege between any company-paid attorney and any employee. Does anyone doubt that if the company who employs you was given the choice of having the government prosecute them or you, who they would choose? In this context, Arthur Anderson should be commended for not sacrificing its employees for its own survival. KPMG survived, because it chose to roll over on its employees. I commented on many of the problems with the AA takedown here, and on the dangers of the Thompson Memo here and here. Tom Kirkendall is all over the story.
The recent government pursuit of Enron, Frank Quattrone, Arthur Anderson, and any number of other firms has established one "principal" being followed by the government in all of these cases: They will let large corporations off the hook with fines but no criminal charges IF the corporation agrees to sell out all of its employees. A large part of this deal, being cut all over the place (and for which Arthur Anderson was destroyed mainly for not agreeing to) is that the corporation will waive attorney client privelege for discussions between employees and corporate attorneys. Frank Quattrone has been tried twice and will likely get tried a third time mainly based on evidence of emails he sent back and forth with corporate council. Tom Kirkendall has other examples.
Ten years ago, I would have naively given the advice "don't break the law." Still good advice, but nowadays in business its hard to tell just what is the law and what is illegal (antitrust is a great example). So my new piece of advice is "when in doubt, don't use corporate council." Get your own lawyer. If the company will pay for it, all the better but do it even if it's out of your own pocket, because it is clear that corporate lawyers are NOT your lawyers, and they will cooperate with the corporation who employs them to put you in jail if that helps protect their real client who pays their salary.
The firm of Arthur Anderson was put to death by government prosecutors. Unlike human beings, Anderson was killed without ever receiving a trial, and was dead long before any appeal was mounted. Many a media tear have been shed for Enron employees who lost their savings in the Enron 401-K, where they invested in Enron by choice, but I have seen few people sympathizing with the tens of thousands of people who lost their savings in the AA collapse, the vast vast majority of whom never touched the Enron account.
Mary Morrison has a nice analysis (pdf) of why Anderson was probably killed unfairly. Her central argument is that the main fraud at Enron was perpetrated in the off-balance sheet special purpose entities, or SPE's, when third parties put up capital that the SPE called equity, but was in fact really a loan with a verbal (non-written) promise to repay by either the entity or Enron. By disguising a loan as equity, and by by disgusing related parties as arms-length investors, Enron was able to avoid consolidation of the SPE's with its financial statements.
Ms. Morrison argues persuasively that since Anderson was not the auditor for any of these SPEs, it had no way to uncover the true nature of these sham financing agreements, since these SPEs were effectively different corporations with different auditors. AA had to rely on signed statements by each deal's principals that the financing for the SPE was as described (which is standard practice in this type situation and is considered to represent adequate due dilligence). Anderson had no way to know what was going on in the SPE's, and since the SPE's were separate legal entities from Enron, it had no legal right to poke around in these entities and of course no subpoena power. It had no way to know about the hidden verbal second part of the financing agreements. She argues AA was a victim of the fraud and of false statements by Enron and the SPE managers and investors.
It is interesting to note that the prosecution of the Enron case is prosecuting Enron managers right at this minute for making such fraudulent statements to AA and for hiding the nature of the SPE's from AA. In other words, the prosecution team that first gave AA the death penalty for allegedly conspiring with Enron to hide their problems is now prosecuting Enron managers on the legal theory that AA was innocent and duped by the managers, which was AA's defense before they were wiped out.
Tom Kirkendall has more on AA's martyrdom here. He also continues his scary series of articles on prosecutorial abuse here. The pressure brought to bear to prevent defense witnesses from testifying is particularly frightening. When you read this, you are really left wondering how the auditors for the SPE's, which may include KPMG, escaped unscathed (in fact escaped richer, since they got their share of the now-defunct Anderson's clients) when Anderson was put to death.
Remember Enron? One of the aspects of the Enron case that the media latched on to was the document destruction at Arthur Anderson, destruction AA claims was routine but prosecutors and many in the media tried to classify as obstruction of justice. So I thought this bit from Reason was interesting:
For decades, newsrooms have
shredded or thrown away notes some time after using them both to save space and
to prevent prosecutors like Fitzgerald from demanding them as part of an
investigation. This "routine expungement is a longstanding practice in many
news organizations," says Sandra Davidson, a professor of communications law at
the University of Missouri School of Journalism.
Hmmm, sounds familiar, huh? The article goes on to point out the obvious - that the Sarbanes-Oxley provisions rushed into law and cheer-led by most journalists may come back to bite the media:
And for the press, the "obstruction of justice" provision [of Sarbanes-Oxley]
may cover more than just withholding notes from the government once an
investigation has begun. It may also endanger the common practice of routinely
destroying notes to protect anonymous sources.... Sarbanes-Oxley, because it
covers document destruction even "in contemplation" of a federal investigation,
could apply to the press's "routine expungement" practices, scholars say. "If
you're destroying documents to prevent them from being subpoenaed," says
Rotunda, "you have a risk that a vigorous prosecutor will think of that as
obstruction of justice."