“I really love the American financial markets. There’s nothing like them in the world,” says Lerach. “And if we can play a role in making those markets healthier, we play a constructive role in society. And if we make a lot of money while we do that, then we are like a lot of other people who contribute positively to society, whether it is a brain surgeon or an entrepreneur or a corporate executive.”
You’ve been warning about “accounting rot” and “massive securities fraud” for years. Do you feel vindicated?
Someone once told me that the four worst words in the English language are “I told you so.” But we told people this was coming. And it wasn’t just because we are skeptical by nature or that we represent investors suing public companies. Remember, in case after case, we got to see the internal financial records, the accounting work papers, of these companies that were secreted from public view by protective orders.
What did you observe?
We saw case after case of deliberate falsification of financial results. We saw the way the investment banks got IPO business or secondary business by promising that an analyst would issue a favorable report as soon as the quiet period was over. And while many times the consulting done by the accounting firms was concealed, we saw enough to realize that the fees were way higher than generally thought. But did I think this was going to happen? Honestly, I didn’t really foresee this kind of massive blowup. I don’t think anyone could have.
Obviously, it was a confluence of events that got us to this point. But if you had to name the top three, what would they be?
Stock options, stock options, and stock options! They completely poisoned the system. Misaligning incentives and interests caused corporate managers to become completely focused on short-term results and do whatever was necessary to meet expectations because they were going to exercise stock once the window opened.
Who do you blame for that?
A terrible misjudgment was made in 1991 by the Securities and Exchange Commission. Under pressure from the corporate community, they changed the rule under section 16B of the 1934 act–the short-swing profit rule–which says that if a corporate insider buys and sells stock in six months, it is presumed to be on insider information, and the profit belongs to the company. It was a bedrock insider-trading preventative.
The SEC adopted a regulation that says for 16B purposes, a [stock option] purchase occurs when the option is granted, not when it is exercised–even though when the option is granted it is not vested, the executive does not have the ability to exercise the option, and the executive has no capital at risk. The practical impact of this is that options are granted, six months runs, options begin to vest, executives exercise the options at 8:01, they sell the stock at 8:01:30, they put the profit in their pocket. When people have the opportunity to pocket millions and millions of dollars–in some cases, hundreds of millions–without risk, what do you think they are going to do?