Banks in the Coal Mine: Signature, Silvergate and Other Signs of Recession-Era Fraud—And What Investors Can Do About It

New York Law Journal

March 15, 2023

With the head-snapping implosion of Silicon Valley Bank and cryptocurrency lenders Signature and Silvergate Bank, amidst speculation of independent auditor complicity, this past week, it feels like 2008 all over again.

Only this time, we’re in a post-Dodd-Frank world and Barney Frank is on the board of Signature.

Recession seems all but certain, as the Fed is still expected to push interest rates higher by a 0.25 percentage point later this March, despite the recent run on the banks.

In many parts of the country and industry sectors, it’s already here—from layoffs in the tech sector, which experienced over 95,000 job losses in 2022, up by a whopping 649% from 2021 according to the Challenger Report, a tumbling housing sector, and stalling retail and manufacturing sectors.

In a shrinking economy a few things are certain, as history seems to repeat itself— recessions generally reveal frauds that were previously concealed by rapid growth and fat profit margins, as suggested by Warren Buffet’s famous quote: “When the tide goes out, you see who’s swimming naked.”

Since the 1980s, a recession has occurred on average every six to eight years. In addition to uncovering fraud, recessions have been a catalyst for lawmakers and regulators to re-assess corporate governance reform, the integrity of free markets and investor protections in hopes of protecting investors and the economy from malfeasance.

Notable recessionary reforms to mitigate malfeasance and fraud include the Sarbanes-Oxley Act (SOX) and the Dodd-Frank Act. SOX is the direct result of the ending of the “irrational exuberance” in the stock market—as U.S. Securities and Exchange Commission Chair Alan Greenspan coined it in 1996—which foretold the 2001 implosion of the bubble, as well the revelation that Enron was cooking its books with the help of its auditor, Arthur Andersen.

Dodd-Frank was borne from the subprime mortgage crisis, which flowed into the Great Recession of 2008, and the cascade of revelations of malfeasance from insider trading and fraud at Countrywide, one of the largest subprime mortgage issuers at the time, to the downfall of Bear Stearns and Lehman Brothers. Published in July 2010, Dodd-Frank also addressed the May 2010 flash crash, which erased almost $1 trillion in market value in U.S. stock markets.

One can only speculate that the irrational exuberance in highly unregulated cryptocurrencies and the spectacular collapse of FTX and Alameda Research and technology related frauds like Theranos and Nikola—and the looming government investigations into potential bank-related fraud and improprieties carried out by SVB, Signature, and Silvergate and their auditors—are a preview of schemes that will be hallmarks of the 2023 recession.

This may also, again, result in various regulatory reforms—including increasing safeguards on banks the size of SVB and Signature.

Despite reforms and regulatory patches, Congress and regulators can never seem to keep up with the constant flow of fraud and malfeasance.

This is where investors play a critical role.

Investor Impact

In their efforts to recoup losses, investors can play a key role to hold banks, market makers and other bad actors accountable through civil litigation.

Recessionary fraud has had a staggering impact on investors. The Great Recession, the worst U.S. economic disaster since the Great Depression, wiped out nearly $8 trillion in value in the U.S. stock market between late 2007 and 2009. While the Department of Justice was able to extract $200 billion in civil fines and penalties from culpable financial institutions, little went to investors.

Through private litigation, specifically securities class actions governed by the Private Securities Litigation Reform Act (PSLRA), investors were able to recoup not insignificant losses from banks, mortgage lenders and other complicit financial entities.

For instance, of the 113 mortgage backed securities (MBS) settlements achieved by government agencies, insurers, and investors between 2011 and 2017, 24 were securities class actions filed by investors, who in turn, were able to recover more than $3.9 billion.

Congress has endorsed such investor actions. When the PSLRA was enacted, Congress recognized that ‘‘[P]rivate lawsuits promote public and global confidence in our capital markets and help . . . to guarantee that corporate officers, auditors, directors, lawyers and others properly perform their jobs’’ and are ‘‘an indispensable tool’’ used to ‘‘protect investors and to maintain confidence in the securities markets.’’

The Supreme Court has, in its words, ‘‘repeatedly []emphasized that implied private actions provide ‘a most effective weapon in the enforcement’ ’’ of the securities laws and are ‘‘a necessary supplement to Commission action.’’

The SEC has also been supportive of the efforts of private litigants. For example, in 1995, SEC Chairman Arthur Levitt in his testimony before the Senate on the PSLRA recognized that ‘‘[P]rivate rights of action are not only fundamental to the success of our securities markets, they are an essential complement to the SEC’s own enforcement program.’’

Indeed, empirical analysis confirms the value of private securities litigation in that they ‘‘provide greater deterrence against more serious securities law violations compared with the SEC.’’

Hindsight is the Best Insight

This reliance on private actions holds true for some of the other biggest frauds in recent history. In actions related to the giant Enron fraud, the SEC recovered $440 million, while private attorneys recovered around $7.3 billion for investors. Similarly, in suits related to the accounting fraud at Worldcom, the SEC recovered $750 million, while private attorneys representing investors recovered $6.1 billion for their clients.

In an even more dramatic example, private attorneys recovered approximately $3.2 billion for investors harmed by the massive fraud at Cendant and the SEC recovered nothing—though the Department of Justice did prosecute, convict, and send to prison Cendant’s Chief Executive Officer.

While all of this may sound like ancient history, in the court of law it’s not and provides an important roadmap for investors on how to effectively prosecute such cases going forward.

Read the compelete OpEd by Michael B. Eisenkraft in the New York Law Journal.