Where Were the Lawyers? One is Found

“Where were the outside accountants and lawyers when these transactions were effectuated?”

This is a now famous refrain made by former SEC Director of Enforcement and U.S. District Court Judge Stanley Sporkin in his opinion in Lincoln Savings & Loan Ass’n v. Wall, 743 F. Supp. 901, 920 (D.D.C. 1990), as well as during his term as Enforcement Director. For investors and for Refco, a defunct New York financial services firm, at least one lawyer was discovered far too late. Today, the U.S. Attorney’s Office for the Southern District of New announced an eleven count indictment naming attorney Joseph Collins, former head of Mayer Brown’s derivative practice, as a defendant, alleging he was a key player in the financial demise of Refco. U.S. v. Collins, Case No. 1:07-cr-01170-LBS, (S.D.N.Y. Filed Dec. 18, 2007); SEC v. Collins, Case No. 07 CV 11343 (S.D.N.Y. Filed Dec. 18, 2007).

The indictment naming Mr. Collins is the latest in a series of actions arising out of the demise of once high-flying Refco. At one time, Refco was a major provider of execution and clearing services for exchange-traded derivatives and prime brokerage services in the fixed income and foreign exchange markets. In August 2004, approximately 53% of the firm was acquired by a group headed by Thomas H. Lee Partners, L.P. in a $1.9 billion leveraged buyout. The next year, the firm conducted an initial public offering of its shares, raising about $583 million from the public. Within weeks of the IPO, the true financial condition of Refco began to emerge and the company collapsed in bankruptcy.

Previously, Phillip Bennett (Refco’s former CEO), Robert Torsten (the former CFO) and Tone Grant (an owner and president) were indicted on charges stemming from the debacle. Those cases are scheduled for trial on March 17, 2008. In addition, Thomas H. Lee Partners has filed a civil suit. Thomas H. Lee Equity Fund v. Mayer Brown, Civil Action No. 07 CIV 6767 (S.D.N.Y. Filed July 2, 2007); see also Krischner v. Grant Thorton, Civil Action No. 07CV 5306 (N.D. Ill Filed Sept. 19, 2007).

The charges filed against Mr. Collins today are based on his role as longtime outside counsel for Refco. According to the indictment, Mr. Collins was a key participant in a massive financial fraud which concealed the true financial condition of Refco from its investors, lenders and the public. The charges allege, for example, that Mr. Collins facilitated “round trip” lending transactions, in which a company controlled by Mr. Bennett would loan funds to Refco over the end of a period and then borrow them back after the closing to conceal huge debts of Refco. At other times, according to the charge, Mr. Collins would edit deal documents to conceal references to Refco’s massive debts from investors and others. Specifically, the indictment charges that Mr. Collins:

• assisted Mr. Bennet in concealing Refco’s debt, which had ballooned to over $1 billion dollars with the “round trip” lending transactions;

• falsely represented to Thomas H. Lee Partners and others that all material contracts and related party transactions had been disclosed when in fact he knew that the “round trip” transactions had been concealed;

• made affirmative misrepresentations and prepared contracts in such a manner as to mislead others into believing that CEO Bennett’s holding company that was involved in the round trip loan transactions only owed about $108 million, rather that at least $ 1 billion;

• misled Thomas H. Lee Partners and its representatives into believing that Refco had about $500 million in excess working capital when it did not; and

• assisted in the preparation of a registration statement filed with the SEC for Refco’s IPO which falsely concealed related party transactions, the round trip loan transactions and thus the true financial condition of the company.

Overall, the indictment claims that Mr. Collins acted “hand-in-hand with Bennett … [making] affirmative misrepresentations, material omissions, and … [telling] deceptive half-truths, all to assist Bennett’s scheme to seal more than $2.4 billion from potential investors and lenders.”

The indictment contains eleven counts, including one count of conspiracy to commit securities fraud, wire fraud, bank fraud and money laundering and making false statements to auditors, two counts of securities fraud, two counts of making false filings with the SEC, a count of wire fraud and a count of bank fraud.

The SEC’s complaint is similar to the indictment. It is also keys to the critical role Mr. Collins played as the long time outside lawyer to Refco and his excellent reputation and that of his firm which he used to further the scheme. The factual allegations focus on claims related to the filing of the IPO. The compliant contains a single count of fraud in violation of Exchange Act Section 10(b)and seeks an injunction and monetary penalty for relief.

Collins gives new meaning to the comments of Judge Sporkin by again highlighting the critical role attorneys perform and the meaning of their position as “gatekeepers.” At the same time, it reemphasizes the important obligations of counsel. The case also serves to highlight the issues in Stoneridge (discussed here) which is under consideration by the Supreme Court. There, the Court is considering the scope of Section 10(b), scheme liability, and who can be named as a primary violator. That issue of course does not exist for the SEC, which can bring cases for aiding and abetting following the amendments to the Exchange Act in the PSLRA. Despite the key role that the U.S. attorney’s office and the SEC claim Mr. Collins played in the Refco scandal, the SEC’s complaint only charges aiding and abetting.

The SEC, Efficiency and Investor Protection

The Government Accountability Office (GAO) will issue a report today critical of the SEC. The report focuses on the relationship SEC and Self Regulatory Organizations (SROs) which police the markets and frequently conduct the initial portion of inquiries insider trading cases. Specifically, the GAO report notes that the SEC fails to review SRO internal audit reports and that the agency lacks the computer capability to efficiently analyze data provided by the SROs from their insider trading and other inquiries, according to an article in the New York Times by Gretchen Morgenson. “Quick, Call Tech Support for the SEC,” New York Times, December 16, 2007, Sunday Business at 1. The GAO report, entitled “Opportunities Exist to Improve Oversight of Self-Regulatory Organizations,” was prepared at the request of Senator Charles E. Grassley following Pequot Capital Management debacle and hearings discussed here. While the report raises questions about efficiency, Ms. Morgenson’s article ends by noting that if the inefficiencies are not remedied it is “one more data point for those who increasingly wonder whose side the SEC is on.”

It is not surprising that a GAO study (or any study) would find that the SEC is inefficient. That does not mean, however, that the agency is not doing a good job which is the usual implication of such a finding. Likewise, that finding says nothing about “whose side” the agency is on, as suggested by the Times article.

The SEC is a relatively small regulatory agency. Nevertheless, it has long enjoyed a reputation for excellence and efficiency. This well-deserved reputation does not come from superior systems, model internal procedures or other similar advantages that many Wall Street players may enjoy. Nor does it come from having armies of highly paid lawyers, paralegals and expert consultants like most of the law firms which defend the investigations and enforcement actions brought by the SEC and conducted by its enforcement division.

As Ms. Morgenson acknowledges at the beginning of her article, the SEC has long been overwhelmed by the number of professionals and the amount of talent and money those which it regulates, investigates and litigates against can throw at any matter. That fact has been true since the days of its first Chairman, Joseph Kennedy, and will continue to be true long after Chairman Cox is a distant memory.

The SEC’s well-deserved reputation for excellence and efficiency has come from the dedication of its people. The small band of dedicated professionals who work at the agency are charged with overcoming the well-known inefficiency of its internal procedures, outdated computer systems and lack of resources. And they do. Time after time the Commissioners and staff rise above these limitations and produce excellent results. This is a reason the U.S. capital markets are the envy of the world.

This is not to say that the agency does not make mistakes, have its short coming, or need improvement. It does. Posts in this blog have repeatedly pointed out shortcoming of the SEC and its enforcement program. There is no doubt the SEC needs better equipment, more staff, and that it needs to be more efficient, bringing cases which are based on solid evidence more quickly.

The GAO report is thus clearly correct in suggesting that computer and other systems at the SEC need improvement. That might start by returning to the agency a fraction of the huge fees it pays to the pays to the U.S. Treasury each year. A return of even part of those fees can enable the SEC to upgrade its systems and make them more efficient.

At the same time, any suggestion that system inadequacy or the lack of a quick fix of its inefficiencies reflects a lack of dedication to investor protection is simply wrong. Over the past year there has been endless speculation over whether the agency is properly protecting investors stemming from the botched Pequot Capital investigation to its positions in Tellabs and Stoneridge. The botched Pequot inquiry is not only hard to understand, but inexcusable. The flurry of discussion about the two Supreme Court cases is keyed to the debate about the propriety and usefulness of private securities class actions and their contribution to policing the markets, not the efforts of the SEC.

The focus of the GAO report is SEC efficiency in policing the markets. While the SEC may be inefficient and lack resources, there should be little doubt that it is aggressively policing the markets. This past year, as has repeatedly been discussed here, the SEC has been very aggressive in bringing insider trading cases. There is every indication that the agency intends to continue its aggressive war on insider trading. Giving the SEC more money and more resources can only help it win that fight.