September 21, 2015
Volcker’s Covered Fund Rules: When Banking Law Borrows from a Securities Law Statute
Posted by Erik Gerding

The Volcker Rule’s covered fund provisions have not received the attention they deserve. Like the more well-studied proprietary trading rule, the covered funds rule restricts bank investments in the name of limiting their risk-taking and mitigating their contribution to systemic risk. As with proprietary trading, legislators and regulators faced a decision with covered funds on how to define those bank activities that would be off-limits. However, unlike with prop trading, Congress, and federal regulators subsequently, chose to define the scope of the covered funds rule largely by reference to an existing statute.

In a recent short article just published in The Capital Markets Law Journal (an earlier ssrn draft is available here), I examine this decision by Congress and federal regulators. In crafting the statutory provision and the final rule respectively, Congress and federal regulators chose to apply the covered funds rule to bank investments in entities that would otherwise be investment companies but for the exemptions in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act. This importation from the Investment Company Act – in what I call a trans-statutory cross reference – has profound consequences.

A first cut

Using Investment Company Act exemptions to set the scope of the covered funds rule has advantages. The Investment Company Act exemptions set boundaries that have already been defined by regulators and market expectations. These particular trans-statutory cross references work to circumscribe bank investments in, and sponsorships of, a wide range of entities. Congress appears to have concluded that private equity and hedge fund investments posed inordinate risks for banks and the government safety net. Since those two types of funds typically use those two Investment Company Act exemptions, the trans-statutory cross references seem to accomplish Congress’s intended purposes. A range of other entities also use these two exemptions, but the five federal regulators that promulgated the final rule ultimately carved many of those entities out. Still, many non-real-estate-related securitization vehicles would be covered by the rule.
On the other hand, prohibiting banks from investing in particular exempted funds does not necessarily mean that banks will move their money to safer locales. Many real estate securitizations, for example, are not covered by the rule. Banks could move capital to other exempted funds or even restructure existing investments to fall under other Investment Company Act exemptions not covered by Volcker. More on this in a moment.

When securities law serves banking law purposes

Stepping back from its immediate market consequences: the trans-statutory cross references at the heart of the covered funds rule highlights the ways in which the Investment Company Act, in particular, and securities regulation, more broadly, can and cannot regulate effectively the systemic risk posed by banks and other financial institutions. In other words, the tools of securities relation are in some ways aligned and in some ways mismatched with the purposes of prudential regulation. The trans-statutory cross references exacerbate Volcker’s problems of under- and over-inclusiveness in limiting the risk-taking of banks. The portions of the Investment Company Act most useful for systemic risk are its restrictions on leverage, which are somewhat unique in the pantheon of securities laws and function most similarly to banking rules.

Trans-statutory cross references can delegate power from one agency to another

Volcker’s trans-statutory cross references have not only policy but also political implications. By using a securities law to define the scope of a banking law, the covered funds rule effectively transfers critical policymaking functions from one group of agencies (banking regulators) to another (the SEC). This has potentially profound implications given the differing statutory missions, cultures, and personnel of those agencies. Securities regulators also face different interest groups and have different institutional pressure points compared to their banking counterparts.

Shifting battlegrounds

How the SEC will wield this power to define the scope of a banking law remains to be seen. Some commentators have doubts as to the SEC’s interest and ability to pursue systemic risk regulation alongside its traditional investor protection role. The covered funds rule will provide one test of the SEC’s resolve. Banking industry interest will likely now focus on other Investment Company Act exemptions. SEC decisions to narrow or expand other Investment Company Act exemptions – particularly Section 3(c)(5) or Rule 3-a-7 – now have cascading consequences by virtue of Volcker’s covered fund provisions. After Volcker, banks and other parties in securitization markets may seek to structure securitizations to rely on one of these other exemptions. Efforts to narrow these exemptions will likely meet strong opposition from banks and the securitization industry. In considering whether to narrow or enlarge these exemptions, the SEC must now consider not only whether investors in collective investment funds are protected. It must also consider the effects on bank risk-taking and systemic risk.

A larger lesson

The political dynamics outlined in my paper point to lessons for policymakers considering using trans-statutory cross references in the future. Trans-statutory references may take power from one regulatory body and give it to another. In the case of the covered fund rules, power over prudential rules was, perhaps unintentionally, delegated to a securities regulator. This works well if the statutory drafters trust the agency from whom power was taken less or trust the agency to whom power was given more. It works if the concern is to check potentially overzealous pursuit of policy objectives by the traditional regulator or to remedy potential shirking by a captured body. However, trans-statutory cross references may fail if the newly empowered regulator works at cross purposes to the statute it now has authority over. Trans-statutory cross references reflect a lesson that is old but one that bears repeating nonetheless: technical drafting decisions can have outsized and unintended political consequences, particularly with respect to the most important question of all – who decides policy going forward.

Cross-posted at Columbia's Blue Sky Blog.

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September 18, 2015
The Doomed Lawsuits Against ALJs
Posted by David Zaring

I think they're doomed, but opponents of the 25 year old tradition of SEC administrative proceedings have had a good couple of days.  Distressed Debt Diva (or whatever the right sobriquet is) Lynn Tilton has convinced the Second Circuit to hear her claim that appearing before an ALJ would be unconstitutional, which, if the court ruled in her favor, would create a circuit split with the 7th Circuit.  

Also, the Wall Street Journal made much of a colloquy before Judge Richard Berman, who is one of the few judges who has ruled that ALJ proceedings are unconstitutional.  He wanted to know more about the farcical decision by the SEC to send one of its ALJs a letter inviting him to tell them whether he was biased against defendants.  He quite properly refused to answer, and they promptly reassigned him to another case.  "You'll want to come up with a good explanation why," Judge Berman approximately told the agency.  

I can't claim to understand what the SEC was doing with that missive to its ALJ, though it's always worth observing that ALJs work for the commissioners (much to their displeasure, ordinarily), and it isn't totally obvious that it is wrong to send a missive to an employee asking him to explain himself.  But, oddly, adjudicative subordinates have a great deal of independence, to the point where I think we could consider them to be comparable to those most independent of regulators, bank supervisors.  We wouldn't expect Janet Yellin to bother filing an affadavit explaining her thinking on interest rates if President Obama instructed her to do so, and there's no question that he is her boss.

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September 04, 2015
Lisa Fairfax for SEC Commissioner!
Posted by David Zaring

The Wall Street Journal reports that the White House is considering our colleague for the SEC.  Bainbridge thinks she'd be an excellent choice, and so do we.  I won't gush, but Lisa has it all - she would be perfect for the agency.

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September 01, 2015
Are SEC ALJs Too Tough On Defendants?
Posted by David Zaring

I wrote in DealBook about SEC ALJs.  Here's a taste:

I read every decision issued by the S.E.C.’s administrative law judges from the enactment of Dodd-Frank in 2010 to March of this year. Graded toughly – on whether the S.E.C. received everything it wanted from the case – the agency’s rate of success is high, but not unblemished.

In those decisions where at least one of the defendants was represented by counsel, the agency received everything it asked for only 70 percent of the time; that is not too different from the “rule of thumb” rate for victories by any federal agency in a federal court.

Of course, there is not getting everything the agency asks for, and there is losing the case. It is true that S.E.C. administrative law judges are willing to reduce the penalties sought by the agency’s enforcement division, either by reducing the amount of money that the defendant must pay to the S.E.C. or by reducing the length of their bar from practicing in their industry.

But in my sample, the agency rarely lost cases that it pursued to the point at which an administrative law judge would issue a decision. I identified only six of the first 359 decisions issued since Dodd-Frank was enacted that rejected the arguments of the enforcement division wholesale.

Go read the whole thing!  And here's a link to the underlying paper.

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August 31, 2015
Enforcement Discretion At The SEC
Posted by David Zaring

I wrote a paper on the SEC's ALJs, which I think are plenty independent and not at all unconstitutional. They cite federal judges and write sentences with the same degree of difficulty, and though the SEC usually wins before them, there are plenty of reasons for that.

It's forthcoming in the Texas Law Review, and here's the abstract.  Do give it a look and let me know if you have any thoughts.

The Dodd-Frank Wall Street Reform Act allowed the Securities & Exchange Commission to bring almost any claim that it can file in federal court to its own Administrative Law Judges. The agency has since taken up this power against a panoply of alleged insider traders and other perpetrators of securities fraud. Many targets of SEC ALJ enforcement actions have sued on equal protection, due process, and separation of powers grounds, seeking to require the agency to sue them in court, if at all.

This article evaluates the SEC’s new ALJ policy both qualitatively and quantitatively, offering an in-depth perspective on how formal adjudication – the term for the sort of adjudication over which ALJs preside – works today. It argues that the suits challenging the SEC’s ALJ routing are without merit; agencies have almost absolute discretion as to who and how they prosecute, and administrative proceedings, which have a long history, do not threaten the Constitution. The controversy illuminates instead dueling traditions in the increasingly intertwined doctrines of corporate and administrative law; the corporate bar expects its judges to do equity, agencies, and their adjudicators, are more inclined to privilege procedural regularity.



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August 26, 2015
A CEO Is Told To Wait On Claims That The SEC ALJs Are Unconstitutional
Posted by David Zaring

In what I think is the first appellate decision on the issue, the Seventh Circuit held that timing problems prevented courts from entertaining collateral attacks on SEC administrative proceedings.  It means that defendants have to raise their constitutional claims before the ALJs, and then the SEC itself on appeal, before they can get into court on appeal from that.

These timing issues have always looked really problematic for the plaintiffs.  Essentially, they have been arguing that they think the SEC is about to open an administrative case against them, and that a court should tell the SEC that it can't do that, because administrative cases are unconstitutional. Usually, claiming that you think the government is about to do something isn't a very good reason to sue the government.  Why not wait and see?  You'll save the court's time and keep it from issuing an advisory opinion.

Put that way, it's not surprising that a CEO anticipating administrative proceedings against her was told to make her constitutional arguments to the agency, if the agency does, in fact, file papers against her, before trying to get the courts involved.

On the other hand, the case that has ginned up these suits, Free Enterprise Fund v. PCAOBlet a couple of accountants make their constitutional claims against PCAOB before it had lifted a finger against them.  So the Seventh Circuit basically said "we don't think the Court meant to get rid of the doctrines of standing, finality, and exhaustion in that case," which is sort of hand waving, but probably true.

Anyway, it increases the likelihood that we will soon get an initial decision from an SEC ALJ ruling whether SEC ALJs are unconstitutional.  I'm very much looking forward to that.  You can find a gloss on the opinion here, and a link to the actual opinion at the end of the gloss.

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August 14, 2015
A Modest Response to Wallach
Posted by David Zaring

I'm enjoying Philip's guest blogging with us.  I think I particularly like this part of his last post:

If it sounds condescending to suggest that the government barely even thought about legitimacy issues during the last crisis, perhaps it is fitting that I end with an obligatory presentation of Wallach’s Law, which is that everything is more amateurish than you think, even after accounting for Wallach’s Law. Everything: financial crisis responding and post-response analysis are no exceptions.

At the end of my review of his book, I said:

one of the reasons I like thinking about the financial crisis, and like reading books like Wallach’s about it, is because it was an enormous almost-disaster that was averted for thousands of different, interlocking reasons. The government’s response to it was both wise, unreflective, tremendously unfair, and highly successful, and a million other things as well.

We may never sort out what exactly happened, and we'll certainly never know whether it was the best possible approach, or three removed from best, or 17, or whatever.  Given so many inputs, what can we say about the legal output?

I think we can say a few things.  First, that the law mattered, and provided constraints, even when it shouldn't have or was just used as an excuse (ahem, Lehman Bros.).  Second, one of the ways it mattered is because it cabined the government's thinking of precisely how it could get creative.  We can't save a bank through X, so let's push through a merger to save it that way.  We may never want the government too cabined in the middle of a crisis, but there is room to impose constraints afterwards, too.  So if you're inclined, for whatever reason, to look at the world through "law only" glasses, I think you can gain some useful perspectives on what happened during that hectic period six years ago.

Though, as we found out today, they're still litigating it all!

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August 06, 2015
More On Wallach And The Fed During The Financial Crisis From Peter Conti-Brown
Posted by David Zaring

My colleague Peter Conti-Brown is interested in Philip Wallach's legal history of the financial crisis, as am I. He's got a post up on it over at the Yale J. on Reg. blog, and go give it a look.  They've debated, over there, whether the Fed had the authority to rescue Lehman Brothers; it rather famously claimed that it did not, only to give AIG a massive bailout a couple of days later:

One of the features of Philip’s stint here was a debate we had on the Fed’s claim that it lacked the legal authority to save Lehman Brothers. I say that’s a post-hoc invention; Philip thinks it’s not, or at least,not so obvious. What do we learn from this fascinating exchange?


I still think those inside the Fed—whether at the Board of Governors or the Federal Reserve Bank of New York—had the authority to do whatever they wanted with Lehman. And given the political maelstrom they faced, I’m not sure I would have done a thing differently than they did. My critique of their legal analysis is not a critique of their crisis decision-making. But the legal arguments are distracting from the bigger question, about the appropriate levels of discretion that a central bank should have in using its lender of last resort authority. What the debate with Philip has shown me is that, even if I’m not wrong—and, well, I’m not—the law is something of an omnipresence in the way the government faced the financial crisis. That omnipresence may even have brooded from time to time.

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August 03, 2015
A Review Of A Financial Crisis
Posted by David Zaring

Over at the New Rambler Review (which I'm really enjoying), I've got a review of Philip Wallach's legal history of the financial crisis.  The kick-off offers a riff on the crisis:

The government’s response to the financial crisis was an example of messy policymaking that occasioned a happy ending, although not everyone sees it that way. Some are unsure about the ending – they have decried the very modest meting out of punishment that followed the recovery of the economy. Others are unsure that the policymaking was messy – they are likely to think of the government’s response to the financial crisis as an inevitable manifestation of executive preeminence as the doer of last resort, institutionally capable of acting when courts and legislatures cannot.

But I will take a stable economy over a few prison sentences, especially when it is possible that you can’t have both at the same time. And you won’t convince me that the things government officials did during the crisis – last minute deals, concluded late at night and paired with creative reimaginings of underused statutes and regular resorts to Congress for more legislation – was the mark of the smooth progress of an imperial presidency.

Go over there and read the whole thing!

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July 29, 2015
Peter Conti-Brown on the Fed's Regional Banks
Posted by David Zaring

My colleague Peter Conti-Brown has an op-ed in the Times today regarding the Fed's crazy regional bank system.  A taste:

Congress should let the Board of Governors appoint and remove the 12 Reserve Bank presidents, as they may do with other employees of the board. The 12 regional Feds would then become branch offices of our central bank, continuing to do research and data analysis, while leaving policy making to Washington.

This plan has several benefits. First, the next time the Fed makes an egregious mistake — like failing to predict the meltdown of the housing market — we would know for certain whom to hold accountable. Second, it would allow the Fed to modernize the distribution of the 12 Reserve Banks. There is strong evidence that the cities for the 12 banks were chosen as much for politics as economics. In 2015, do we really need two regional Feds (Kansas City and St. Louis) in Missouri, but only one (San Francisco) west of Texas?

Everything Peter writes about the Fed is worth reading, and this is no exception.  Give it a look here.

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July 28, 2015
Shadow Everything
Posted by David Zaring

I was looking at Dan Scwarcz's lastest paper on Shadow Insurance, which is a thing:

Shadow insurance – defined as life insurers’ reinsurance of policies with captive insurers that are not “authorized” reinsurers and do not maintain a rating from a private rating agency – creates important risks to policyholders, the insurance industry, and potentially even the broader financial system. Although the standard state regulatory safeguards help mitigate some of these risks, they leave other hazards of shadow insurance largely unchecked. Even granting that shadow insurance likely helps reduce the cost of insurance associated with the excessive conservatism of some state reserving rules, the practice ultimately undermines insurance markets by impeding accurate risk assessments and tradeoffs by policyholders, regulators, and other market participants.

It's a nice paper, but it made me think we're at peak shadow.  There's Shadow Banking, Shadow Bankruptcy, and there if a firm called Shadow Financial Systems.

Of course, there may be a real world reason for this - shadow institutions are in theory nimbly entering markets that heavily regulated incumbents can't serve well.  This is the regulation is bad story of the growth of shadow finance.

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July 13, 2015
Cost Benefit Analysis at the SEC
Posted by David Zaring

Over at DealBook, I have a piece up on the state of cost-benefit analysis at the SEC.  Inadequacies in the CBA were how the SEC used to lose all its rulemakings in the D.C. Circuit; its latest rulemaking on clawbacks sets the stage for how seriously the agency takes cost-benefit analysis now, and how much it believes that analysis should be quantified.  A taste:

Throughout the cost-benefit analysis, the agency warns that it is “often difficult to separate the costs and benefits,” and that various effects of the rule are “difficult to predict.”

I suspect the agency thinks it doesn’t need to blow the court of appeals away with some numbers to survive, though of course the S.E.C. can do more cost-benefit analysis in the final rule. It does, however, believe that a lengthy consideration of the costs and benefits of a rule should be part and parcel of any proposal.

For those who think that cost-benefit analysis slows the pace of regulation, this may not be good news. Economists might wish that numbers were being appended to the discussion.

But I am happy enough to see rules without numbers. Justifying rules only with regard to their costs and benefits is pretty routine. As routines develop, it may become difficult for regulators and judges to consider new sorts of costs, and unforeseen benefits contained, for example, by the simple expression of what the rule favors and what it discourages.

Go give it a look!

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July 08, 2015
The Definitive Story On Bank Supervision
Posted by David Zaring

Banco Santander's American sub is in trouble.  Big trouble with the government.  Supervisors think it is undercapitalized, doesn't adequately keep track of its money, and is led badly.  The Wall Street Journal put the story about their concerns on A1.

So, what's next?  A takeover?  A fine?  A lawsuit?

The Federal Reserve issued a stinging lecture to Spanish bank Banco Santander SA,faulting the lender’s U.S. unit for failing to meet regulators’ standards on a range of basic business operations.

Oh.  A lecture.  Well that doesn't...

The Fed didn’t fine the bank but reserved the right to do so later and required the bank to write a series of remedial plans.

So a warning or whatever...

the Fed had already scolded Santander for paying an unauthorized dividend earlier in 2014 without the Fed’s required permission.

[Santander CEO] Ms. Botín spoke for 15 minutes by phone with [Fed Governor] Mr. Tarullo on Nov. 10.

She met with him again in Washington on Dec. 10, when they talked privately for an hour

Oh, and meetings.  Still, there have been resignations and promises to change the whole governance structure of the company.  So these talking-tos must have been absolutely hair-raising.  For drama, you really can beat bank supervision, amiright?

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July 06, 2015
The SEC's Clawback Rule
Posted by David Zaring

The rule, authorized by Dodd-Frank, would permit companies to claw back compensation from executives if things go south.  Or, more specifically, the rule will "require national securities exchanges and national securities associations to establish listing standards that would require each issuer to implement and disclose a policy providing for the recovery of erroneously paid incentive-based compensation."  Clawbacks would happen when, well: "the trigger for the recovery of excess incentive-based compensation would be when the issuer is required to prepare an accounting restatement as the result of a material error that affects a financial reporting measure based on which executive officers received incentive-based compensation."

The rule had the usual two dissenters, independent statements by each of the commissioners.  The SEC is a divided agency.  But I'm interested in how the staff hope to close the deal, assuming that the rule will be litigated.

First, even though this is a proposed rule, the agency is already responding to plenty of comments from prior concept releases, &c.  Second, 50 of the 198 pages of the rule are devoted to the cost benefit analysis that so stymied the SEC when the DC Circuit had a majority of Republican judges.  But the analysis isn't heavy on quantitative cost-benefit, but rather an assessment of the implications on a variety of affected components in the agency.  I think the agency thinks it doesn't need to blow the court of appeals away with some numbers to survive, though of course the agency can do more cost-benefit analysis in the final rule.

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June 29, 2015
Law And Custom On The Federal Open Markets Committee
Posted by David Zaring

My article on the administrative law and practice of the FOMC is available on SSRN, and has come out as part of a great symposium in Law and Contemporary Problems, with articles by Jim Cox, John Coates, Kate Judge, and many other people smarter than me.  Do give the paper a download, and let me know what you think.  Here's the abstract:

The Federal Open Market Committee (FOMC), which controls the supply of money in the United States, may be the country’s most important agency. But there has been no effort to come to grips with its administrative law; this article seeks to redress that gap. The principal claim is that the FOMC’s legally protected discretion, combined with the imperatives of bureaucratic organization in an institution whose raison d’etre is stability, has turned the agency into one governed by internally developed tradition in lieu of externally imposed constraints. The article evaluates how the agency makes decisions through a content analysis of FOMC meeting transcripts during the period when Alan Greenspan served as its chair, and reviews the minimal legal constraints on its decisionmaking doctrinally.

In addition to being your one stop shop for the legal constraints on the FOMC, the paper was an opportunity to do a fun content analysis on Greenspan era transcripts, and to see whether any simple measures correlated with changes in the federal funds rate.  In honor of Jay Wexler's Supreme Court study, I even checked to see if [LAUGHTER] made a difference in interest rates.  No!  It does not!  But more people may show up for meetings where the interest rate is going to change, tiny effect, but maybe something for obsessive hedge fund types.  Anyway, give it a look.

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