Infectious Greed (72 page)

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).
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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.

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 case.

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.”
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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.

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.

The bad reputation and blame are undeserved. In fact, legal rules already make short selling difficult and expensive, and these restrictions have contributed to an “irrational” upward bias of stock prices. To
short a stock, you need to borrow shares, which often are in limited supply, and you can't trade many stocks unless the previous trade in the market has occurred while the price of the stock was rising, because of the so-called uptick rule. Some savvy investors figure out ways to avoid these legal rules, using put options—the right to sell stock—which effectively are bets against the stock. For example, some hedge funds buy a stock along with a put option and then sell the very same stock. The effect is to buy the stock once and sell it twice, because the terms of the put option—the right to sell the stock—can be set so that the holder almost always would sell the stock when the option expired. By using these trades, called
bullets
, traders don't need to borrow stock and can avoid the uptick rule because, technically, these trades are not short sales, even though they are economically equivalent.

However, the bullet rigmarole is complex and expensive, and many traders remember the pain from betting against stocks when prices soared during the late 1990s. As the Internet boom demonstrated, it is dangerous to get in front of an investing herd. The result—as research in behavioral finance confirms—is that stock prices frequently reflect the trading of optimistic investors more than pessimists, at least until optimists finally learn that the value of a company is lower than they believed, at which point they all sell and prices crash.
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One way to make stock prices more accurate is to do the
opposite
of what some regulators have suggested: make short selling easier. In fact, Congress had attempted to do just this in December 2000, when it passed a law legalizing the trading of
single-stock futures
, derivatives that essentially are bets on how stocks will perform at future dates.
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The restrictions on short selling don't apply to single-stock futures, so investors could more easily use these instruments to bet against stocks. Investors can also use swaps and other derivatives to bet against stocks. This is an area where harnessing the power of derivatives could make markets fairer and more efficient.

Another way to encourage betting against stocks would be to permit insiders to tip others as to negative information about their companies. Negative information tends to remain bottled up within companies, in part because of a Supreme Court case that spelled out when it was illegal for insiders to tip others about problems at their companies. In that case, Raymond Dirks, a securities analyst during the 1970s, had been prosecuted for giving his clients negative, but true, information he had learned about Equity Funding, a company involved in a massive financial scam;
his clients then profited from trading on the basis of this information. The Supreme Court exonerated Dirks, and a decade later, he was still betting against stocks and advising others to do the same.
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But the Dirks case cast a shadow over anyone who traded on an insider's negative tip about a company, and most market participants cautiously avoided such trading.