With this terse order by the D.C. Circuit, it is official, the SEC's conflict minerals rule is unconstitutional ... but only to the extent that it requires public issuers who did make use of conflict minerals to state on their disclosures that their products have “not been found to be ‘DRC conflict free.’”
The idea is that this was forcing firms to declare that they had blood on their hands, and I find it all pretty unconvincing. The SEC can require firms to make disclosures in particular ways, it can require firms to make climate change disclosures, and it can tell them to identify, say, risk factors of participating in a securities offering that make the issuer look bad. This is all forced speech, and a disclosure based agency couldn't function if it couldn't require disclosures, including uncomfortable disclosures, permitting an inference that the issuer is incompetent, naive, whatever, and that the speaker would rather not say.
There may be a line that can be drawn - the SEC can require firms to say uncomfortable things, but it can't require them to say an exact set of words that make them look bad. I guess that would be a rule, but it wouldn't be much of a rule.
For example, consider the conflict minerals rule itself, which is both unconstitutional and very much in effect. Although companies do not have to attest that the products they make are not DRC-conflict free, they do have to do everything else: investigate their supply chains, describe their investigation, and report on the results of that investigation, including whether it revealed that they make products involving conflict minerals.
Anyway, Congress hasn't lost its taste for conflict minerals, and bills have been introduced in the House and Senate to add to the SEC's policing in this area. That's something that will not overjoy those in the agency who never thought of it as the tip of the spear in the spreading of human rights values.
One of the amazing things that has happened in the wake of the financial crisis is that international bank regulators have moved from measuring two things - capital adequacy and the leverage ratio of banks - to measuring a lot of different things which must be computationally hard to keep in balance. In addition to the two extant measures, banks have to establish a net stabled funding ratio (NSF) designed to deal with long term assets, a liquidity coverage ratio (LCR) designed to deal with short term assets, and let's not forget the work being done in the US by the stress tests, labelled DFAST and CCAR, or Europe's MiFID.
Into the mix the Financial Stability Board has added a total loss absorbing capacity rule, or TLAC. The best way to think of this rule is as an alternative measure of the capital adequacy of very big banks, with an eye to the moment of failure; it requires banks, in addition to holding common stock and cash, to hold financial instruments like convertible bonds (or maybe plain old unsecured debt) that can be used to bail-in the bank - bail-in means that the bank looks to its creditors to provide it with resources to stabilize it, bailout means it looks to the government to provide those resources. Or, if you like, here's the FSB:
G-SIBs will be required to meet the TLAC requirement alongside the minimum regulatory requirements set out in the Basel III framework. Specifically, they will be required to meet a Minimum TLAC requirement of at least 16% of the resolution group’s risk-weighted assets (TLAC RWA Minimum) as from 1 January 2019 and at least 18% as from 1 January 2022. Minimum TLAC must also be at least 6% of the Basel III leverage ratio denominator (TLAC Leverage Ratio Exposure (LRE) Minimum) as from 1 January 2019, and at least 6.75% as from 1 January 2022.
Without going too far down this road, I think that these varied sorts of capital measurement are basically supposed to discourage regulatory arbitrage, though it also suggests how puissant big banks must be in handling their regulatory requirements. Not a place for a financial startup. TLAC is also a tax on big banks, of course, and a disincentive to become one of the thirty largest institutions in the world. Here's the WSJ with an explainer.
This all has to be adopted by the G20 at its next meeting, proving once again that in finance, the rules that really matter are set by an international, non-treaty based form of administration.
Rep. Scott Garrett has introduced a bill that would make administrative proceedings optional for all defendants, and also change the standard of proof for them. It would basically kill things for SEC ALJs, and the enforcement division's new policy of directing cases their way (with one caveat that I bring up below). The bill's introduction suggests that not everyone is happy with the agency's attempt to hold onto its discretion to bring enforcement actions administratively or judicially by lengthening the time for proceedings to eight months (from four), and permitting a smidgen of discovery.
Check out the language of the bill:
“(a) Termination Of Administrative Proceeding.—In the case of any person who is a party to a proceeding brought by the Commission under a securities law, to which section 554 of title 5, United States Code, applies, and against whom an order imposing a cease and desist order and a penalty may be issued at the conclusion of the proceeding, that person may, not later than 20 days after receiving notice of such proceeding, and at that person’s discretion, require the Commission to terminate the proceeding.
“(b) Civil Action Authorized.—If a person requires the Commission to terminate a proceeding pursuant to subsection (a), the Commission may bring a civil action against that person for the same remedy that might be imposed.
“(c) Standard Of Proof In Administrative Proceeding.—Notwithstanding any other provision of law, in the case of a proceeding brought by the Commission under a securities law, to which section 554 of title 5, United States Code, applies, a legal or equitable remedy may be imposed on the person against whom the proceeding was brought only on a showing by the Commission of clear and convincing evidence that the person has violated the relevant provision of law.”.
I've never heard of another place where a defendant has the discretion to insist that an enforcement action against her be dismissed - not move for it, just send notice that the defendant will be dismissing the action. And I've never heard of this clear and convincing stuff before - the argument has been that the SEC has advantages before ALJs, but not particularly because of the burden of proof. In one way, the bill would make the defendant's decision a bit more difficult. On the one hand, she can have court whenever she wants, but on the other, administratively, she gets the benefit of a clear and convincing standard, more demanding (in theory) than a preponderance of the evidence standard. Decisions, decisions.
I've expressed some sympathy for the whistleblowing bank examiner Carmen Segarra in the past, and I wrote up my concerns over at DealBook. A taste of the argument:
The bank whistle-blower statute was part of the changes passed after the savings and loan crisis of the 1980s, when hundreds of financial institutions had to be “resolved” – that’s bank terminology for taken through a quick bankruptcy – by the Federal Deposit Insurance Corporation. The statute covers a “person who is performing, directly or indirectly, any function or service on behalf” of the F.D.I.C. The appeals court said that it was “frankly silly” to suggest that Fed employees were working for the F.D.I.C.
But I don’t think it is frankly silly. The purpose of the statute is to protect whistle-blowers who work at, among other places, Federal Reserve banks who bring information to light about mismanagement in a way that performs a service to the F.D.I.C. Moreover, the statute is supposed to be broadly construed.
Goldman Sachs is a bank holding company, but it does not have depositors.
Nonetheless, the F.D.I.C. is a full voting member of the Financial Stability Oversight Council, which has designated Goldman a systemically important financial institution, subject to heightened supervision and its particular attention. Moreover, the F.D.I.C. would play a role in resolving Goldman, if it came to that, under the Dodd-Frank law’s overhaul of the government’s resolution powers.
So I do think that supervising Goldman counts as performing a service to the F.D.I.C.
Do go over there and give it a look.
I blogged a little more about the SEC and its ALJs at the Harvard Corporate Governance Forum. Do check it out!
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.
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.
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.
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.
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.
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.
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. PCAOB, let 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.
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!
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.
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!
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.