The unstable financial environment is fueling the public and political demand for justice that, as in times past, will create an increase in the number of investigations of institutions and individuals who may be suspected of wrongdoing in the financial crisis. As the credit meltdown causes pain on Main Street, the political world will demand villains to blame on Wall Street, provoking both very public congressional investigations and more private but more perilous criminal grand jury investigations.

Individual executives are likely targets, especially well-compensated executives of troubled institutions who may be inviting targets for congressional hearings. Executives who were exposed to non-public information that could be construed to be information material to stock values and failed to timely disclose it, spoke publicly in contravention to the information, or acted in their own financial self-interest on it are very likely targets for enforcement investigations and criminal inquiries.

Companies and firms are equally exposed based on legal theories of vicarious liability for acts of officers and employees. This makes it essential that current management as well as boards and their audit committees address aggressively any red flags that indicate the existence of these and other circumstances that may give rise to allegations of wrongdoing and/or liability for legal violations. Recent events and reports demonstrate that the investigative response has already begun, as Congress holds hearings and the FBI and other agencies announce investigations.

Organizations with potential litigation risk arising out of this crisis should consider proactively reviewing their potential exposure and likely sources of liability. Should such organizations become involved in congressional inquiries or the subject of nascent criminal investigations, they will be in a much better position to respond and defend if they have proactively obtained relevant facts and formulated a response. Failing to do so could easily turn a financial crisis into a legal one. Both legal and reputational risks dictate a prudent, proactive response.

Criminal Investigations Launched as a Result of the Crisis

According to federal law enforcement officials, the FBI is investigating at least 26 cases of potential corporate fraud related to this year’s collapse of the US mortgage lending industry. The FBI’s wide-ranging probe covers companies across the financial services industry, from the mortgage lenders to the investment banks that bundled home loans into the securities sold to investors. On September 23, 2008, the FBI announced investigations into Freddie Mac, Fannie Mae, Lehman Brothers, Washington Mutual Bank, and AIG for potential mortgage fraud. Additionally, the FBI is investigating failed bank IndyMac Bancorp Inc. for possible fraud, as well as Countrywide Financial Corp., formerly the largest US mortgage lender.

According to Director Robert Mueller, the FBI is focusing on suspected accounting fraud, insider trading, and failure to disclose the value of mortgage-related securities and other investments by these companies. More specifically, investigators are trying to determine whether anyone in those companies, including senior leadership, had any responsibility for providing “misinformation” to the investing public. In testimony before the House Judiciary Committee, Director Mueller vowed to pursue corporate executives if warranted in the current mortgage fraud investigations.

Summary of Reported Investigations

  • Bear Stearns: Federal prosecutors in New York have charged two of Bear Stearns’s former hedge funds managers, Ralph Cioffi and Matthew Tannin, with fraud for misleading investors about the condition of two hedge funds that had heavy exposure to subprime mortgage-backed securities—funds that helped spark the worldwide credit squeeze when they filed for bankruptcy last July, resulting in investor losses estimated at US$1.6 billion. Tannin and Cioffi are the first executives to be criminally 2008charged in the subprime market debacle. Federal prosecutors have expanded their probe to include the activities of banks and lenders with regard to two funds, to determine if those institutions, along with the fund’s investors, were also defrauded. Investigators are also looking at private financial memoranda to see if the firm defrauded wealthy investors.

The Securities & Exchange Commission and the US Attorney’s office in Brooklyn are also looking into allegations that certain Bear Stearns insiders were pulling their personal money out of the investment vehicles at the same time the funds’ managers were urging other investors to stay put.

  • Freddie Mac & Fannie Mae: A federal grand jury in New York is investigating accounting, disclosure, and corporate governance issues at Fannie Mae and Freddie Mac dating back to 2007. Fannie and Freddie received subpoenas from the US Attorney’s office in Manhattan as well as requests from the Securities and Exchange Commission that they preserve documents.
  • Lehman Brothers: New Jersey Attorney General Anne Milgram recently announced that state securities investigators were “actively looking” at Lehman Brothers following Lehman’s bankruptcy filing. The state is considering a lawsuit after losing more than half of the US$180 million it invested with the bank in June because, state officials charge, they are not sure they were given accurate information before they paid into the company.
  • Washington Mutual Bank: On October 15, 2008, the FBI publicly announced that it had been investigating WaMu’s operations for several months. The FBI went public because WaMu depositors cannot be further hurt by adverse publicity after their bank’s failure. Reports indicate that the FBI is closely following the progress of several consolidated class actions against WaMu. As with the other investigations, a critical question is whether WaMu had knowledge about the quality of its investments that it should have disclosed but failed to do so.
  • AIG: On September 16, 2008, AIG accepted an US$85 billion loan from the federal government in exchange for an 80 percent government stake in the troubled insurance company. On October 7, 2008, the House Committee on Oversight and Government Reform held a hearing on the causes and effects of the AIG bailout. Ten days later, Committee Chairman Henry Waxman sent a letter to AIG Chief Executive Officer Edward M. Liddy requesting additional information to aid the committee’s investigation into the insurance giant. Separately, on October 15, 2008, New York State Attorney General Andrew Cuomo informed AIG that it was under investigation for “irresponsible and damaging” expenditures related to executive compensation packages that were not cut even as AIG drew down on the new transfusion of federal funds.
  • IndyMac: IndyMac Bank FSB was seized by the FDIC on July 11, 2008, after investors withdrew US$1.3 billion in funds. Five days later, federal investigators said that it would look into whether the bank engaged in fraud when it made home loans to high-risk borrowers. According to the former head of the DOJ’s fraud section, Josh Hochberg, investigators are interested in bad appraisals and bad underwriting that might have caused false statements to be made on loan applications, and any false statements made to the general investing public in violation of federal securities regulations. Unlike many of the other investigations in the collapse of the mortgage lending market, the IndyMac investigation does not appear to be focusing on any individuals.
  • Countrywide Financial: Countrywide Financial was purchased by Bank of America on January 11, 2008, for US$4 billion in stock. In March 2008, investigators announced preliminary investigations into whether Countrywide officials misrepresented the company’s financial position and the quality of its mortgage loans in securities filings.

Proactive Responses to This Enforcement Environment

The financial crisis will severely test organizations in the financial services industry, even organizations that are not under investigation. Financial services organizations will have to face the unexpected consequences from federal and state legislative and administrative responses to the crisis, as well as a public and a law enforcement community looking to determine whom to fault for the crisis.

Options for response worthy of consideration include:

  • Self-assessment of potential legal exposure and liabilities;
  • Identification and undertaking of remedial measures;
  • Marshaling facts and legal arguments necessary to respond and defend against allegations potentially arising in congressional hearings, administrative enforcement proceedings, or criminal inquires;
  • Monitoring of investigations and hearing developments in order to continue to assess risk and respond accordingly; and
  • Preparing an action plan to address any government investigation on the first day it becomes known to the company.