The Difference Between Wrong and Illegal

Do you know the difference between a wrong action and an illegal action? If you don’t, you are not alone. But neither are you to be trusted. 

The Valukas Report

The Valukas Report was commissioned by a US court to determine the causes of Lehman’s bankruptcy. Made public last week, it has caused a bit of stir in certain quarters—including Wall Street, lawyers and accountants.

In a nutshell, the report accuses Lehman of using an accounting technique (called Repo 105) to temporarily move assets off its balance sheet just before quarter’s end, in order to show lower leverage ratios, then moving the assets back on-balance-sheet shortly after the end of the quarter. See details here.

The auditors of Lehman Brothers were Ernst & Young. Lehman’s source of legal advice for the Repo 105 tactic was the venerable British law firm Linklaters. Both are critized in the Valukas report.

The Financial Times headlined the story thusly: "Damning Insight into Corporate Culture Sheds Light on Fall of a Wall Street Giant." The story quotes one ‘senior Wall Street executive’ as saying, "I almost threw up when I read the report; it makes me sick of this industry."

Let’s stipulate that this is the language of “wrong,” at least for Valukas, the Financial Times, and one Wall Street executive. What should be the response of the various parties?

Responses to Charges of Wrong Doing

Let’s start with Dick Fuld, Lehman’s former CEO. His lawyer is quoted as saying

Mr Fuld did not know what those transactions were – he didn’t structure or negotiate them, nor was he aware of their accounting treatment. Furthermore, the evidence available to the Examiner shows that the Repo 105 transactions were done in accordance with an internal accounting policy, supported by legal opinions and approved by Ernst & Young, Lehman’s independent outside auditor.

And what does auditor Ernst & Young have to say

Last week, the group defended its signing-off of Lehman’s 2007 accounts and maintained the books were "fairly presented in accordance with [US] generally accepted accounting principles."

The Valukas report also criticized Linklaters, saying that “Lehman’s … turned to Linklaters for a legal opinion blessing the use of so-called "Repo 105" transactions when it could not obtain a suitable opinion from US lawyers.”

Here’s what Linklaters has to say

"The examiner’s report into the failure of Lehman Brothers includes references to English law opinions which Linklaters gave in relation to a number of Lehman transactions. The examiner . . . does not criticise those opinions or say or suggest that they were wrong or improper. We have reviewed the opinions and are not aware of any facts or circumstances which would justify any criticism."

Wrong is from Mars, Illegal is from Venus

Pick your own planetary metaphor: the point is that “wrong” is a moral concept, “illegal” is a legal concept–and key players in our global economy have come to brazenly deny the distinction.

The Valukas report resonates as a moral indictment. But the responses are from Planet Law.

When the charge of “wrong” is routinely answered by “it’s not illegal”—and we accept it–it means something is seriously wrong with our moral culture.   

The Financial Times blames the “US box-ticking culture.” 

It is far easier for an accountancy firm to retain a lucrative relationship with its clients if it does not sit in judgment on their activities, but simply adheres to a set of blind rules. Auditors can more easily defend lawsuits when things do go wrong if a rule book can be appealed to. But this is precisely why the whole system is so frustrating from the investors’ perspective. The more rule-driven auditors are, the less valuable their work is as due diligence.

Jim Peterson, a noted accounting commentator, talks about the failure of the massive Sarbanes/Oxley legislation to prevent just this moral meltdown:

A program of airport security will lack credibility, if so broadly applied as to deprive ordinary citizens of their ability to carry a bottle of wine or a tube of toothpaste, but that fails to identify terrorists whose deadly threat is limited only by their inept inability to detonate their shoes or their underwear.

Sarbanes/Oxley suffers the same defect: if it could not detect and deter an “outlier” on the scale of Lehman, then what beneficial effect can its proponents claim it has accomplished, by imposing an intrusive system of box-ticking on the vast bulk of corporate registrants?

Some recommend changing regulations.  Others suggest structural changes.  Still others recommend more enforcement.  But all these solutions have limitations; in particular, they are trying to solve a moral problem with more laws.  But this only exacerbates the issue.

You can’t solve a moral dilemma with more laws. There will always be a Dick Fuld, or a Lehman, willing to push beyond moral boundaries using absence-of-illegal as a sleight of hand.  It’s up to us to call them on it.

NYTimes columnist, David Brooks, is right in saying, “The only way to restore trust is from the local community on up.”  It starts with people explaining to politicians, lawyers, newspaper editors and managers that just because it isn’t illegal, doesn’t mean it isn’t wrong.

Get mad: but get morally, not legally, mad.