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Don't Say Anything Bad

— Everybody knows what happened on 9/11/2001. Very few know that on 9/26/2001, the Securities and Exchange Commission told American municipalities that when they issue bonds for public projects, they should voluntarily "go beyond the limits of disclosure mandated by law."

Still fewer know that on 10/23/2001, the SEC released a position paper meant to "encourage self-policing," in the agency's words. In effect, if a company would do its own investigation, cooperate with the securities agency, and take remedial action, among other things, it could get leniency for fraudulent behavior. Those were the days when Harvey Pitt, then head of the agency, was calling for kinder and gentler corporate regulation. But financial fraud billowed, and in November of 2002, Pitt resigned under pressure. Unfortunately, much of his legacy -- regulatory leniency and so-called self-policing -- remains.

The principles embodied in the 10/23/2001 document came to be known as the "Seaboard framework," named for the company that got off easy. Seaboard fired a controller who was committing fraud, but because it launched its own investigation, shared its information with the government, and supposedly rectified things, Seaboard was not hit with an enforcement action.

Now, for the first time, a municipality -- San Diego -- seeks leniency under the Seaboard framework. Last February, the city hired Paul Maco, a former SEC official, to find out why its government, by its own admission, gave inaccurate information to potential investors in bond prospectuses dating back to 1996. There are two criminal probes of what happened, and one civil probe by the securities commission. Maco's law firm, Houston's Vinson & Elkins (under fire as Enron's former law firm), has already received $1.3 million for the report.

San Diego may become Seaboard's quagmire -- if not Waterloo -- for two reasons, both related to the myth of self-policing. First, Maco's recently published report has much solid information but strains credulity in concluding that city employees didn't intend to do wrong.

Second, Seaboard came into play in another high-profile San Diego case: Peregrine Systems. A report that Peregrine submitted to the SEC is considered suspect and self-serving by attorneys who are pursuing civil suits against former company officials.

In mid-2002, after Peregrine revealed that its books had been cooked and Padres majority owner John Moores returned as chairman (even though he had dumped almost all of his stock), I interviewed Lawrence West, an SEC official in Washington, D.C. He explained what Peregrine would have to do to qualify for lenient treatment under the Seaboard guidelines. West reeled off the requirements, including an internal probe, cooperation with the agency, remedial action, waiving of attorney-client privilege, and the like.

Peregrine did a purported internal investigation. But that investigation was coordinated by San Diego attorney Charles La Bella, one of the longtime Moores servants who had been recruited by the company right after the bad news hit. "The preparation of this report was overseen by Mr. Moores's personal attorney Charles La Bella," said the committee of unsecured creditors in the Peregrine bankruptcy. La Bella was one of Moores's "closest associates" and had "previously represented Moores in connection with an investigation of insider trading, bribery, and other charges." The first law firm to work on the report was replaced. The second, Latham & Watkins, which had done legal work for the Padres, cranked out 250 pages of text that, the committee said, serve "no purpose other than to whitewash the directors' prior performance."

Gwendolyn Giblin, an attorney with the San Francisco law firm that is suing former Peregrine officials in federal court, says the Latham & Watkins report "was clearly a whitewash." The suit itself says the report was an attempt by Moores "to exonerate himself and his business cronies who had served as his eyes and ears on the Peregrine board."

One of Moores's attorneys, Los Angeles-based John Quinn, says the Latham & Watkins report indicates that "there is no evidence that any outside directors had involvement in the fraud." Therefore, he has tried to get it unsealed in three different courts, but it has not been publicly released.

Today, West is an associate director of enforcement at the SEC. He won't say whether his agency has accepted the Latham & Watkins report in whole or in part. However, on June 30 of last year, the SEC settled its fraud suit against Peregrine and noted that the company had taken remedial action and had cooperated with the agency. It's possible that Peregrine has qualified at least partly under the Seaboard framework. If true, many people with knowledge of the Peregrine fraud will be astounded. However, last year's settlement was with the company, not with Moores and the outside directors, who have been sued for fraud by the bankruptcy-court-appointed litigation trustee, with the cooperation of the company's current management. "The [SEC's] investigation continues as we speak," says West.

Over the years Moores has been represented by a Vinson & Elkins attorney, but Maco says that had nothing to do with his firm's selection by the city. Maco's investigation is good but flawed. First, there are conflict-of-interest questions, although none so egregious as in Peregrine. As a footnote reveals, before he was hired, Maco had provided legal advice to the city on securities law issues. He had served "as a sounding board" on securities questions, he says. Maco says the SEC approached neither him nor the city on a possible Seaboard arrangement. But he was hired on a Wednesday evening, and "both the SEC and Justice Department requested documents [the following] Friday."

The report says that, under the law, the city must avoid "material misstatements and omissions." There is a whopper of a misstatement in prospectuses: "State legislation requires the city to contribute to [the pension fund] at rates determined by actuarial valuations." This is "apparently without foundation," says the report. Moreover, the city was not making actuarially determined donations. There was a flagrant sin of omission: prospectuses didn't point out that the health-care system was underfunded by anywhere from $500 million to close to $1 billion.

The big problem with the Maco report is its untenable conclusions. It correctly portrays an incompetent and dysfunctional city government, citing "meager disclosure," "confusing footnote," "vague outline," "inaccuracies," "failures in the city's disclosure process," "careless manner," "check-the-box mentality," and "poor lines of communication." The city attorney's office, auditor, city manager's office, city council, and others dropped the ball continuously, the report emphasizes.

The report says, "The city administration had adopted a minimalist approach to public disclosure, providing the public with negative information only when it has felt legally required to do so." (Italics mine.) So much for the SEC's call on 9/26/2001 to "go beyond the limits of disclosure mandated by law."

City officials "don't say anything bad unless they absolutely have to," says Maco.

Despite all this, the report says it's hard to pin "intentional misconduct" on anyone.

Oh? The report itself belies that. It gives short shrift to pension-board member Diann Shipione's 2002 warnings to the mayor and council that finances were in bad shape, and there was an odor of corruption. If the report had stressed her warnings, it would have been difficult to conclude that misconduct arose from ignorance.

The report relates how several city financial officials were expressing their unhappiness with outside counsel Paul Webber, who was insisting on disclosure of litigation. Says the report, "The city was reluctant to openly share information with counsel [Webber] for fear its disclosure would be required, creating risk for both the city and its investors."

That's not intentional? "It speaks more of bad judgment," insists Maco. On Monday, the city manager said Webber's law firm will no longer be the city's disclosure counsel.

His report sees no intent, but it doesn't examine motivation. Maco should know that knaves disguise themselves as fools. Employees who were supposedly so incompetent had motivation to preserve their fat benefits. People with something to hide don't put things in writing; they communicate with winks and nods. The employees could have been fired, demoted, or permanently sidelined if they didn't play along with higher-ups. "I have no idea whether they could have been fired," says Maco.

Perhaps unknowingly, he has fingered the problem with purported self-policing.

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— Everybody knows what happened on 9/11/2001. Very few know that on 9/26/2001, the Securities and Exchange Commission told American municipalities that when they issue bonds for public projects, they should voluntarily "go beyond the limits of disclosure mandated by law."

Still fewer know that on 10/23/2001, the SEC released a position paper meant to "encourage self-policing," in the agency's words. In effect, if a company would do its own investigation, cooperate with the securities agency, and take remedial action, among other things, it could get leniency for fraudulent behavior. Those were the days when Harvey Pitt, then head of the agency, was calling for kinder and gentler corporate regulation. But financial fraud billowed, and in November of 2002, Pitt resigned under pressure. Unfortunately, much of his legacy -- regulatory leniency and so-called self-policing -- remains.

The principles embodied in the 10/23/2001 document came to be known as the "Seaboard framework," named for the company that got off easy. Seaboard fired a controller who was committing fraud, but because it launched its own investigation, shared its information with the government, and supposedly rectified things, Seaboard was not hit with an enforcement action.

Now, for the first time, a municipality -- San Diego -- seeks leniency under the Seaboard framework. Last February, the city hired Paul Maco, a former SEC official, to find out why its government, by its own admission, gave inaccurate information to potential investors in bond prospectuses dating back to 1996. There are two criminal probes of what happened, and one civil probe by the securities commission. Maco's law firm, Houston's Vinson & Elkins (under fire as Enron's former law firm), has already received $1.3 million for the report.

San Diego may become Seaboard's quagmire -- if not Waterloo -- for two reasons, both related to the myth of self-policing. First, Maco's recently published report has much solid information but strains credulity in concluding that city employees didn't intend to do wrong.

Second, Seaboard came into play in another high-profile San Diego case: Peregrine Systems. A report that Peregrine submitted to the SEC is considered suspect and self-serving by attorneys who are pursuing civil suits against former company officials.

In mid-2002, after Peregrine revealed that its books had been cooked and Padres majority owner John Moores returned as chairman (even though he had dumped almost all of his stock), I interviewed Lawrence West, an SEC official in Washington, D.C. He explained what Peregrine would have to do to qualify for lenient treatment under the Seaboard guidelines. West reeled off the requirements, including an internal probe, cooperation with the agency, remedial action, waiving of attorney-client privilege, and the like.

Peregrine did a purported internal investigation. But that investigation was coordinated by San Diego attorney Charles La Bella, one of the longtime Moores servants who had been recruited by the company right after the bad news hit. "The preparation of this report was overseen by Mr. Moores's personal attorney Charles La Bella," said the committee of unsecured creditors in the Peregrine bankruptcy. La Bella was one of Moores's "closest associates" and had "previously represented Moores in connection with an investigation of insider trading, bribery, and other charges." The first law firm to work on the report was replaced. The second, Latham & Watkins, which had done legal work for the Padres, cranked out 250 pages of text that, the committee said, serve "no purpose other than to whitewash the directors' prior performance."

Gwendolyn Giblin, an attorney with the San Francisco law firm that is suing former Peregrine officials in federal court, says the Latham & Watkins report "was clearly a whitewash." The suit itself says the report was an attempt by Moores "to exonerate himself and his business cronies who had served as his eyes and ears on the Peregrine board."

One of Moores's attorneys, Los Angeles-based John Quinn, says the Latham & Watkins report indicates that "there is no evidence that any outside directors had involvement in the fraud." Therefore, he has tried to get it unsealed in three different courts, but it has not been publicly released.

Today, West is an associate director of enforcement at the SEC. He won't say whether his agency has accepted the Latham & Watkins report in whole or in part. However, on June 30 of last year, the SEC settled its fraud suit against Peregrine and noted that the company had taken remedial action and had cooperated with the agency. It's possible that Peregrine has qualified at least partly under the Seaboard framework. If true, many people with knowledge of the Peregrine fraud will be astounded. However, last year's settlement was with the company, not with Moores and the outside directors, who have been sued for fraud by the bankruptcy-court-appointed litigation trustee, with the cooperation of the company's current management. "The [SEC's] investigation continues as we speak," says West.

Over the years Moores has been represented by a Vinson & Elkins attorney, but Maco says that had nothing to do with his firm's selection by the city. Maco's investigation is good but flawed. First, there are conflict-of-interest questions, although none so egregious as in Peregrine. As a footnote reveals, before he was hired, Maco had provided legal advice to the city on securities law issues. He had served "as a sounding board" on securities questions, he says. Maco says the SEC approached neither him nor the city on a possible Seaboard arrangement. But he was hired on a Wednesday evening, and "both the SEC and Justice Department requested documents [the following] Friday."

The report says that, under the law, the city must avoid "material misstatements and omissions." There is a whopper of a misstatement in prospectuses: "State legislation requires the city to contribute to [the pension fund] at rates determined by actuarial valuations." This is "apparently without foundation," says the report. Moreover, the city was not making actuarially determined donations. There was a flagrant sin of omission: prospectuses didn't point out that the health-care system was underfunded by anywhere from $500 million to close to $1 billion.

The big problem with the Maco report is its untenable conclusions. It correctly portrays an incompetent and dysfunctional city government, citing "meager disclosure," "confusing footnote," "vague outline," "inaccuracies," "failures in the city's disclosure process," "careless manner," "check-the-box mentality," and "poor lines of communication." The city attorney's office, auditor, city manager's office, city council, and others dropped the ball continuously, the report emphasizes.

The report says, "The city administration had adopted a minimalist approach to public disclosure, providing the public with negative information only when it has felt legally required to do so." (Italics mine.) So much for the SEC's call on 9/26/2001 to "go beyond the limits of disclosure mandated by law."

City officials "don't say anything bad unless they absolutely have to," says Maco.

Despite all this, the report says it's hard to pin "intentional misconduct" on anyone.

Oh? The report itself belies that. It gives short shrift to pension-board member Diann Shipione's 2002 warnings to the mayor and council that finances were in bad shape, and there was an odor of corruption. If the report had stressed her warnings, it would have been difficult to conclude that misconduct arose from ignorance.

The report relates how several city financial officials were expressing their unhappiness with outside counsel Paul Webber, who was insisting on disclosure of litigation. Says the report, "The city was reluctant to openly share information with counsel [Webber] for fear its disclosure would be required, creating risk for both the city and its investors."

That's not intentional? "It speaks more of bad judgment," insists Maco. On Monday, the city manager said Webber's law firm will no longer be the city's disclosure counsel.

His report sees no intent, but it doesn't examine motivation. Maco should know that knaves disguise themselves as fools. Employees who were supposedly so incompetent had motivation to preserve their fat benefits. People with something to hide don't put things in writing; they communicate with winks and nods. The employees could have been fired, demoted, or permanently sidelined if they didn't play along with higher-ups. "I have no idea whether they could have been fired," says Maco.

Perhaps unknowingly, he has fingered the problem with purported self-policing.

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