08 May 2008

Legal Ecosystem: Survival of the Fittest...

The life cycle of monetary policy and financial fraud is being mapped once again in concert with new investigations into corporate malfeasance. As economic trends run their systemic course so do the highs and lows of human behavior to create new schemes to defraud customers, partners and even fellow employees.

Prosecutors in the Eastern District of New York in Brooklyn are stepping up their scrutiny of players in the subprime-mortgage crisis, focusing on Wall Street firms and mortgage lenders, the Wall Street Journal said on its Web site.

A task force of federal, state and local agencies will look into potential crimes ranging from mortgage fraud by brokers to securities fraud, insider trading and accounting fraud, the Journal said.

The Federal Bureau of Investigation is already targeting major corporate insiders and criminal groups in its investigation of fraud in the mortgage lending industry. The FBI has said it is investigating 19 companies in mortgage cases.

The formation of the task force amplifies efforts already under way in Brooklyn, where prosecutors are investigating whether investment bank UBS AG (UBSN.VX: Quote, Profile, Research) improperly valued its mortgage-securities holdings, the report said.

Also being investigated are the circumstances surrounding the failure of two hedge funds at Bear Stearns Cos (BSC.N: Quote, Profile, Research), which collapsed last summer because of losses tied to mortgage-backed securities, the report said.

Fraud, like other crimes of opportunity, have three common attributes:

  1. A growing supply of motivated offenders
  2. The availability of prospective or ideal targets
  3. The lack of consistent oversight mechanisms—control systems or someone to monitor the business

Beyond the typical motivations for initiating deceptive practices and fraud are the underlying mind sets. "Neutralization" creates the road map for nullifying internal moral objections. The type of fraud is not the issue here as much as that offenders seek to justify or rationalize their actions and methods. Grace Duffield and Peter Grabosky have captured the four main categories of fraud in their paper, "The Psychology of Fraud."

  • Fraud committed against an organisation by a principal or senior official of that organisation
  • Fraud committed against an organisation by a client or employee
  • Fraud committed against one individual by another in the context of face-to-face interaction
  • Fraud committed against a number of individuals through print or electronic media, or other indirect means

Now the IT departments will be buzzing as they will be under orders to preserve e-mail archives as evidence as soon as notices arrive on the doorsteps of not only the large funding institutions themselves, but the hundreds of organizations in the corporate supply-chain.

The duty to preserve attaches immediately once the company is on notice. Once an investigation or lawsuit is reasonably anticipated or a complaint is received, the requirement to preserve materials attaches and preservation efforts need to be undertaken as soon as possible. There are no cases that provide definitive guidance as to how quickly litigation hold notices must be sent once the duty is triggered, but any such case will be evaluated in hindsight, i.e., after relevant materials have been destroyed, and very little if any delay is likely to be tolerated by the courts.

Let's do some simple math here. Multiply the number of banking branches x the number of mortgage brokers for each branch x the number of appraisal firms and you start to understand the magnitude of the volume of data. While some larger banking institutions have centralized underwriting operations for all of the branches, they still rely on a supply-chain of small businesses in the local market to address the valuations and appraisals of property.

The next trend line we will see is the up tick in court filings and the litigation wars for the next few years to come. One fact remains obvious. Organizations large and small will be drawn into these Operational Risk Management challenges without the proper policies, practices and behavior to prevail. In any "legal ecosystem" we know about the phrase "Survival of the Fittest" comes to mind and this one, will be no different.

"Survival of the fittest" is sometimes claimed to be a tautology. The reasoning is that if one takes the term "fit" to mean "endowed with phenotypic characteristics which improve chances of survival and reproduction" (which is roughly how Spencer understood it), then "survival of the fittest" can simply be rewritten as "survival of those who are better equipped for surviving"

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