Inside the End of the U.S. Bid to Punish Lehman Executives

At a closed-door meeting in early 2011, Wall Street regulators were close to throwing in the towel on their biggest case.

The Securities and Exchange Commission’s eight-member Lehman Brothers team, having hit one dead end after another over the previous two years, concluded that suing the bank’s executives would be legally unjustified. The group, noting that prosecutors and F.B.I. agents had already walked away from a parallel criminal case, reached unanimous agreement to close its most prominent investigation stemming from the financial crisis, according to officials who attended the meeting, which has not been reported previously.

But Mary L. Schapiro, the S.E.C. chairwoman, disagreed. She pushed George S. Canellos, who supervised the Lehman investigation as head of the S.E.C.’s New York office, to explain how executives who presided over the biggest bankruptcy in United States history could escape without a single civil charge.

“I don’t get it,” she said during a tense exchange with Mr. Canellos in her private conference room in Washington, according to the officials, who were not authorized to speak publicly. “Why is there no case?” she continued, staring at Mr. Canellos, instructing him to continue investigating whether Lehman misled investors. “The world won’t understand.”

She was right. Five years after Lehman’s collapse hastened a worldwide economic panic, the government faces lingering questions about the decision to spare executives like Richard S. Fuld Jr., who ran Lehman for 14 years until its demise. Not a single senior executive from any Wall Street bank faced criminal charges from the crisis, either. And the government’s deadline for filing most charges will expire this month, the anniversary of Lehman’s collapse, providing a reminder of the case and its unpopular outcome.

Federal prosecutors and the S.E.C. have never officially announced its decision to close the Lehman investigation.

But a New York Times examination of the case, based on interviews with more than a dozen lawyers and officials involved in the inquiry and a review of bankruptcy court documents, pulls back a curtain on private deliberations and clashing philosophies surrounding the decision not to bring charges. The S.E.C. quietly reached the decision in 2012 after officials sparred for months over whether Lehman omitted “material” information in disclosures to investors, an important legal standard. Mr. Canellos argued that the omissions were not material. And those who questioned that reasoning â€" like Ms. Schapiro, as well as some accountants and enforcement officials â€" acquiesced to Mr. Canellos’s team, which was closest to the evidence.

The S.E.C. also debated the culpability of top Lehman executives. But Mr. Canellos’s team argued that Mr. Fuld did not know that Lehman was using questionable accounting practices despite testimony from another Lehman executive that suggested otherwise. Ms. Schapiro did not override his judgment after S.E.C. officials cautioned her that it could be unethical to do so. Mr. Canellos also had the backing of Robert S. Khuzami, who ran the S.E.C.’s enforcement unit at the time.

But at a 2011 meeting of senior S.E.C. officials, Lorin L. Reisner, then the No. 2 enforcement official, suggested preparing a draft of potential charges so the agency could have a concrete document to review. Mr. Canellos’s team balked, officials who attended the meeting said.

Mr. Canellos, the officials said, instead proposed that the S.E.C. publish a report that would publicly explain the decision to forgo charges. Ms. Schapiro and other S.E.C. officials rejected that option, concerned that Mr. Canellos’s first draft was too sympathetic to Lehman.

While declining to comment on the Lehman case specifically, an agency spokesman said: “There are healthy discussions and debate about legal and factual issues at many levels of the agency in investigations of significance. But in the end decisions are based on the evidence and the law.”

The S.E.C.’s decision came in stark contrast to a report by Lehman’s bankruptcy-court examiner, who accused executives of using an accounting gimmick to “manipulate” the balance sheet.

“There were many instances where the S.E.C. had information and didn’t act,” the examiner, Anton R. Valukas, a former federal prosecutor who is now chairman of Jenner & Block, said in an interview.

There is widespread agreement that Lehman failed under the weight of risky real estate investments and an inability to finance itself amid the economic turmoil of 2008. It has been less clear whether the government did a thorough review of the firm’s collapse.

Yet The Times’s examination reveals new details about the breadth of the government’s effort â€" S.E.C. officials reviewed more than 15 million Lehman documents and interviewed some three dozen witnesses. The decision not to bring charges, the officials said, came despite early hope among investigators, whose careers likely would have benefited from bringing such a prominent case.

The S.E.C., which has a lower burden for proving its cases than criminal authorities, has brought civil cases against 66 senior officers in cases linked to the financial crisis. The agency also extracted nine-figure settlements from banks like Goldman Sachs. According to new research by Stanford University’s Securities Litigation Analytics, the S.E.C. has declined to charge individual employees in only 7 percen of its securities fraud cases.

The agency’s enforcement unit, overhauled by Mr. Khuzami after the crisis, has struck an even harder line in recent months under its new chairwoman, Mary Jo White. A former federal prosecutor, Ms. White has pushed the enforcement unit to seek rare admissions of wrongdoing from defendants.

Yet the continued absence of parallel criminal cases against top executives reflects the challenge of white-collar investigations in which prosecutors struggle to pinpoint where risky dealings cross the line into illegality. When the evidence is murky, prosecutors sometimes hesitate to charge top executives, who have the money to fight rather than settle.

“It’s not like a murder case, where you have a dead body and you know a crime has been committed,” said Rita M. Glavin, a former federal prosecutor who is now a defense lawyer at Seward & Kissel.

The Lehman case once seemed like the exception. Federal prosecutors in Manhattan, Brooklyn and New Jersey, in addition to the F.B.I. and the S.E.C., all swarmed Lehman in the days after its collapse. The S.E.C.’s eight-person team included senior lawyers and accountants, several of whom were assigned exclusively to the Lehman case.

Top Lehman executives feared the fallout. One executive, who spoke on the condition of anonymity, said he occasionally met with a former colleague in Queens and would wear a disguise so he would not draw attention.

At the time, authorities had no shortage of leads. Federal prosecutors divided some of the work â€" prosecutors in New Jersey handled the question of whether Lehman defrauded the state’s pension fund â€" though they overlapped on most pursuits.

The prosecutors and the S.E.C., for example, both focused on whether Lehman executives misled shareholders by offering upbeat assessments of the firm’s health, as little as five days before the firm collapsed. The authorities also scrutinized whether Lehman executives overvalued its commercial real estate portfolio.

But it was Lehman’s accounting practices that probably drew the most attention. In his report on Lehman’s failure, a rebuke that spanned more than 2,200 pages, Mr. Valukas, the bankruptcy-court examiner, outlined accounting maneuvers that he called “balance sheet manipulation.”

The practice allowed Lehman to transfer securities off its balance sheet, presenting them as collateral to an outside lender, which in turn offered Lehman a short-term loan. Lehman treated the transactions as sales rather than as debt, which meant the firm looked as if it had less debt than it actually did. “Unable to find a United States law firm” to approve the maneuver, Mr. Valukas said, Lehman hired a law firm in London to bless it.

One Lehman executive, in an e-mail to a colleague, declared that the practice was “another drug” they were on.

Lehman often used the practice, known as Repo 105, at the end of its fiscal quarters just before reporting results. At the end of Lehman’s first quarter 2008, its total Repo 105 use was $49.1 billion, so big that it reduced Lehman’s leverage ratio.

Lehman highlighted the reduction in a public earnings call but never disclosed that it partly stemmed from Repo 105. As such, Mr. Valukas outlined possible civil claims against Mr. Fuld and his chief financial officers, including Erin Callan, who was the C.F.O. during much of the year in which Lehman collapsed. Mr. Fuld, he said, was “at least grossly negligent” for allowing Lehman to make “materially misleading” statements about the firm’s health.

The Valukas report, released in March 2010, appeared to provide a road map for the federal investigation into Lehman executives. But soon after its release, according to the officials involved in the inquiry, prosecutors and the F.B.I. lost interest in the case. They discovered that Repo 105 had nothing to do with Lehman’s failure and was technically allowed under an obscure accounting rule. Noting that London lawyers had approved Repo 105, prosecutors in Manhattan also worried they could not prove that executives intended to mislead investors.

The S.E.C. continued its investigation. But by early 2011, Mr. Canellos’s team had run out of leads. It ruled out suing Lehman itself, because the firm was in bankruptcy. The team also decided not to sue Mr. Fuld for failing to supervise the firm’s risk-taking, believing that the S.E.C. did not have the authority to do so.

So instead, the investigators focused heavily on Repo 105. They needed to prove that Lehman executives intentionally used the accounting practice to mislead investors, or did so recklessly. Ms. Callan had been C.F.O. for only about six months, they concluded, making their burden of proof high. She did not reply to requests for comment for this article.

Mr. Fuld’s role was harder to ferret out. Bart H. McDade, another Lehman executive, told Mr. Valukas that Mr. Fuld “was familiar with the term” Repo 105 and “knew about the accounting.” But Mr. Fuld told the S.E.C. that he had never heard of Repo 105, officials said, undermining a potential case. A lawyer for Mr. Fuld declined to comment.

The S.E.C. team also concluded that Repo 105 would not have been “material” to investors because the firm’s leverage ratio was trending downward regardless of Repo 105.

That conclusion set off a wave of dissent inside the S.E.C. Senior accountants and the head of the S.E.C. unit that oversaw corporate disclosures questioned the findings. Ms. Schapiro urged Mr. Canellos to keep digging.

But Mr. Canellos, a former federal prosecutor who is now the co-head of the S.E.C.’s enforcement unit, did not budge. Despite the political pressure, he told colleagues at one of the meetings, they could not bring a case if the evidence was lacking.

“Our job is to seek justice,” he said.