Corporate Governance

Bear Stearns and the SEC: The Enforcement Proceeding that Never Was (Part 2)

By J. Robert Brown

We are discussing the Report of Investigation by the Inspector General at the SEC on the decision by Miami Office of the SEC to not bring an action against, among others, Bear Stearns. 

The Report is a must read for anyone wanting some insight into the investigatory process.  It discusses some of the techniques used to reach a settlement, the interrelationship between the staff and criminal authorities, and illustrates how a case can grow from a relatively narrow concern to a much larger one.  What are some of the highlights? 

First, the case got to the Miami Office as a referral from the Division of Corporation Finance.  CorpFin apparently picked up on W. Holding's use of "internally-derived" estimates of fair value with respect to the debt obligations.  Although only recommending an investigation into a single issue, the Chief Accountant's Office in the Division of Enforcement recommended a more sustained investigation, one that included fraud and insider trading.  The case, therefore, illustrates how an SEC filing can result in an investigation and how the investigation need not be limited to the initial catalyst.  For a report on the CorpFin referral process, go here.

Second, the staff conducted a substantial part of the investigation without first obtaining a formal order.  While the referral from CorpFin was made on May 19, 2003, it took until Feb. 2004 before the matter was referred to the Miami Office.  Between March and the end of July, document requests went out to W. Holding, Deloitte, Bear Stearns, the NYSE, and some analysts, yielding approximately 53,000 documents.  From October 6 until Feb. 14, 2005, testimony was taken from 14 witnesses. 

Only in February 2005 did the staff finally request a formal order.  The significance?  With a formal order, the staff can issue subpoenas.  Moreover, a formal order must be approved by the Commission.  The staff must, therefore, subject its decision to investigate to scrutiny by the Commission.  See   § 202.5 Enforcement activities ("In such preliminary investigation no process is issued or testimony compelled. The Commission may, in its discretion, make such formal investigations and authorize the use of process as it deems necessary to determine whether any person has violated, is violating, or is about to violate any provision of the federal securities laws or the rules of a self-regulatory organization of which the person is a member or participant.").   Indeed, in requesting the formal order, the staff noted that the investigation was "nearly completed" but that the order was necessary because the staff "'was unable to obtain the voluntary testimony of a former Bear Stearns employee who was at the center of the possible fraud in the case."  In other words, if the last witness had been willing to testify, there would likely have been no formal order and no compulsory process. 

The pattern shows the common practice of cooperation with requiring staff to use compulsory methods of acquiring information such as subpoenas.  Of course, with respect to regulated entities such as brokers, they are required to provide the staff with required documents even absent a subpoena. 

It also illustrates how long it sometimes takes for the Commission to become aware of a case.  Until the formal order, there was no need to present the case to the Commission for review.  Moreover, had the formal order not been necessary (because the last witness voluntarily testified), the Commission would not have seen the case until the investigation was finished and the settlements submitted.  This raises issues as to whether investigations should be allowed to proceed with such vigor over such a length of time without any Commission oversight.  

Third, during the investigatory phase of the case, the Miami Office assigned to the case, in addition to the usual investigatory staff, a member of the trial team.  In other words, there was trial team involvement in the case almost from the beginning, potentially alerting the investigatory staff to issues that might come up in subsequent litigation, including the broad question of litigation risk.  In this particular case, the head of the trial team participated in the case.   

Fourth, the case illustrates the sometimes close connection between the Enforcement Division and its alumni.  Some of the lawyers representing the putative defendants had previously worked in the Enforcement Division and were friends with some of the staff in the Miami Office.  The Report noted that:  "The fact that two of the defense counsels in the W. Holding matter were former Enforcement attorneys created the appearance, to some, that they may have obtained favorable treatment from the" Miami staff.

The mere fact that some of the lawyers involved were former staff does not raise concerns.  It's common practice.  In fact, some of the most (if not most) of the outstanding lawyers in the private sector who routinely represent clients under investigation came out of the Division of Enforcement.  Bill McLucas and Gary Lynch are two names who come to mind.  Both were former directors of the Division of Enforcement.  Both knew people at the Commission and both knew the way the Agency worked, skills important in providing highly effective representation to their clients. 

A problem can, however, arise where a personal relationship becomes apparent in the investigatory process.  In this case, the Report stated that after the case was terminated, the head of the Miami Office called counsel for Bear Stearns, a former SEC attorney with whom he had an "ongoing personal relationship," and told the attorney that "Christmas is coming early this year" and that Bear Stearns "can keep their money." 

The Commission does not always tell those under investigation that an investigation has been terminated (although it has recently initiated a "termination letter" practice).  In this case, the notice seems appropriate given the unique posture of the case.  Bear Stearns had actually agreed to a settlement involving a $500,000 payment that would now no longer be required.  Given the personal relationship among the lawyers, however, prudence would have dictated that the call be made by someone without such a relationship, if only for appearance sake.  Having said that, there is nothing in the Report that establishes that the case was treated differently because of the connection between the attorneys. 

Fifth, the Report describes the negotiations with counsel at Bear Stearns over the civil penalty.  The staff, apparently, put the first number of the table ($5 million).  Bear Stearns responded with $250,000, a number described by some staff as "insulting."  Finally, Bear Stearns raised the number to $500,000, which "was something the staff felt they could work with in continuing negotiations."  Ultimately, according to the Report, a settlement agreement was reached with Bear Stearns for this amount.  This sort of process suggests that numbers proposed by the staff need not be taken seriously. 

Sixth, the head of the office decided, despite the fact that settlements had been reached with three of the four proposed defendants, that the case would be terminated.  Whatever the merits of the decision, it was subjected to review by the Chief Counsel of the Division of Enforcement.  In other words, the head of an office couldn't close a case without getting approval of the home office in Washington.  Indeed, in its critique of the Report, the Division has taken the position that not enough weight was given to the case closing process at the central office.

• As a matter of practice, the Enforcement staff prepares a closing memorandum that summarizes the reasons for closing the investigation. That memorandum is then reviewed and approved by Enforcement management before the matter may be closed. Despite the recognized significance of the closing memorandum, the Inspector General?s report does not include the closing memorandum, nor does it acknowledge, in other than cursory fashion, the process by which the decision to close the investigation was reviewed and approved by senior staff before being effected.
  

Seventh, the Miami Office was notified of a criminal investigation into the pricing of CDOs by Bear Stearns.  The investigations involved different companies and different employees at Bear Stearns but were described as investigations of "the same general type," suggesting the possibility of "systematic problems" at Bear Stearns.  Criminal authorities asked to be apprised of the SEC's investigation and made an "access" request for information, which was granted.  The Report noted, however, that "Enforcement failed to follow up with the U.S. Attorney's Office."

The report of the Inspector General is here.  The Memorandum from the Division responding to the Report is here.  We will do one more post on this topic.

Full post as published by The Race to the Bottom on October 20, 2008 (boomark / email).