Criminal Prosecutions Predicted to Surge Over Financial Crisis

Noeleen G. Walder

New York Law Journal

With public anger reaching a boiling point over plunging stock prices and Wall Street "greed," white-collar defense attorneys are preparing for an inevitable surge in criminal prosecutions.

Stanley S. Arkin, for one, said he expects that the anger, hysteria and economic dislocation fueled by "imprudent credit policies" will "inspire" indictments that would not have been brought in a "calmer and more dispassionate time."

There is "an underlying popular sensibility in this country that someone has to pay for all the jobs lost and the savings extinguished," said Arkin, a partner at Arkin Kaplan Rice. "There's a lynching quality that arises in circumstances of extreme dislocation like this."

Other defense attorneys say they are confident that prosecutors will act responsibly in deciding what, if any, criminal charges to bring.

"I don't think public clamor for executives' heads to roll is going to cause prosecutors to bring charges that they otherwise wouldn't bring," said Alan Vinegrad, a partner at Covington & Burling and a former Eastern District of New York U.S. Attorney.

Lawyers expect heightened scrutiny of maneuvers engaged in by financially beleaguered institutions like mortgage behemoths Fannie Mae and Freddie Mac, investment banks Bear Stearns and Lehman Brothers and insurer American International Group.

Prosecutors were ratcheting up their activities even before Congress passed a $700 billion bailout bill last week. That bill provides that federal financial regulatory agencies must cooperate with the FBI and other law enforcement agencies "investigating fraud, misrepresentation, and malfeasance with respect to development, advertising, and sale of financial products."

According to reports this week by The Wall Street Journal and Bloomberg News Service, U.S. Attorneys in the Eastern and Southern districts of New York and New Jersey are investigating whether Lehman was telling investors that its financial condition was sound at the same time its executives knew the balance sheet was crumbling -- a situation that ultimately resulted in bankruptcy.

Two weeks ago, other reports indicated that the FBI had launched a probe into Fannie Mae and Freddie Mac, AIG and Lehman. FBI Director Robert Mueller previously had told Congress that 24 large financial companies were under investigation.

In June, two former Bear Stearns hedge-fund managers were indicted in New York's Eastern District for allegedly misleading clients about the risk of certain investments.

Other investigations are at a preliminary stage, but even if authorities snare a few "big fish," state and local prosecutors are likely to pursue hundreds of retail-level fraud cases against individual brokers, real-estate agents and buyers. Just last week, three people pleaded guilty in the Southern District of New York to a multimillion dollar subprime mortgage scheme, bringing to 11 the number of defendants convicted so far in the case.

Benton J. Campbell, the U.S. Attorney for the Eastern District of New York, said in an interview that his office has had a local mortgage fraud task force at work since this spring and has been working with the FBI, the U.S. Postal Inspection Service, the Federal Deposit Insurance Corp., the U.S. Securities and Exchange Commission, and the Internal Revenue Service, among other regulatory bodies.

"The types of criminal activity are fundamentally very familiar to us," Campbell said.

He would not comment on specific cases, but said investigations center around "classic cases of securities fraud" in which people willfully make material misstatements about the performance of their public company or investments in violation of Rule 10b-5 of the Securities Exchange Act; valuation issues, including misrepresentations to auditors; and insider trading and other forms of self-dealing.

Criminal statutes that could come into play at a federal level are securities fraud under Titles 15 and 18, mail fraud, wire fraud, bankruptcy fraud and bank fraud.

Campbell acknowledged that the mood of the country might affect decisions on the resources devoted to such investigations, but he maintained that "public pressure doesn't play a role in charging decisions."

He added that his office "spend[s] a great deal [of time] focused on ... isolating market forces that might be at play from what we think may be criminal activity."

'PEOPLE ARE ANGRY'

However, Charles Stillman, a white-collar criminal defense lawyer at Stillman, Friedman & Shechtman, said he was skeptical about the ability of prosecutors to exercise proper discretion during times of economic upheaval like the Enron and options backdating scandals and the current financial crisis.

"People are angry. People are frightened and they need someone to blame, and those are your jurors," Stillman said.

Prosecutors will "start with some basic propositions of securities fraud. They'll throw in mail fraud, wire fraud, and then just take the conduct and blend it into one of those theories," he said.

Meanwhile, Stillman said, New York's Attorney General Andrew M. Cuomo will "haul out the Martin Act." The act gives the attorney general the power to investigate any "fraudulent practice" in connection with the "issuance, exchange, purchase, sale, promotion, negotiation, advertisement, investment advice or distribution within or from [New York] state."

"You may see indictments that are warranted ... and then I think you are going to see indictments that are over the top because of pressure," Stillman said.

"As the climate heats up," executives' mistakes "get escalated into crimes," he said. "Negligence becomes gross negligence, which in turn is ratcheted up to willful blindness. Now you've just hit the bell, because willful blindness gets you to the penitentiary."

But other defense attorneys predicted that prosecutors would remain level-headed in the face of public anger.

Robert G. Morvillo of Morvillo, Abramowitz, Grand, Iason, Anello & Bohrer, said it was too early to tell whether bad indictments would stem from the economic crisis, but added that he did not think local prosecutors would resort to such tactics.

DEFENSES AGAINST CHARGES

Although the current climate will "push" prosecutors to take a hard look at whether executives committed fraud, this does not mean the government will pursue "weak or frivolous cases," said Salvatore J. Graziano, a partner at securities class action firm Bernstein Litowitz Berger & Grossmann.

At the end of the day, he said, it will boil down to whether "executives said certain things ... [when] they really knew that the facts were different."

"You have executives at public corporations making statements and certifying accounting [practices] under Sarbanes-Oxley, so the potential is there for charges," Graziano said. Quarterly press releases issued to investors also will provide clues as to whether insiders misled the public, he said.

Mark C. Zauderer, a partner at Flemming Zulack Williamson Zauderer, agreed that public hostility toward the financial industry could spill over into the government's investigation of executives connected to the mortgage fallout.

"If we saw hostility in [the] Enron climate, we are going to see hostility by a magnitude of tenfold" here, Zauderer said.

He speculated that those facing indictments as a result of the current crisis would rely on defenses similar to those used by former Enron Executives Kenneth Lay and Jeffrey Skilling. They will claim they "did not have deceptive intent, that they relied on other people to report to them any information that was at odds with public positions they were taking," Zauderer said.

Dickstein Shapiro partner Ira Lee Sorkin said that prosecutors will have a tough time making their cases against executives from institutions who purchased tranches of mortgage-backed securities. Executives will claim they relied on the credit rating agencies, who will in turn maintain that they did the best they could to determine "whether some farmer in Kansas could make the mortgage payments on his home."

Moreover, in the case of Lehman, legal observers say it may be difficult to prove that investors were truly misled. Defendants could argue that the company's problems were widely reported, and many sophisticated investors were well aware of them.

Graziano said that as was the case with Enron, prosecutors might target junior-level employees to build their cases against higher-level executives.

While each probe will be "fact-specific," he said he "wouldn't be surprised if criminal charges were filed against executives from a number of companies."

Arkin predicted a more dire fate for executives scapegoated for the subprime crisis.

"Some people will be vindicated, and I think that there will be a lot of people who are going to get their butts kicked very hard, if not plain hung," Arkin said.