The USAO in the SDNY is beginning to hold banks accountable for the financial crisis, and the critical legal move has been to go after them pursuant to the False Claims Act, an issue because the government entities (more on this later) Fannie, Freddie, and HUD underwrote all those mortgages sold on by the banks. If they fraudulently misrepresented the quality of the mortgages, or their oversight of same, that could be a false claim made to the government. Today, the False Claims Act suit was made against Countrywide, since bought up by Bank of America.
- Basically, the argument in the complaint is that Countrywide's "Hustle" program, started when the housing market had collapsed, and the company really needed some mortgage-related revenue, removed an underwriting and compliance check from its screening process, even for stated income (that is, the borrower just named her income, and the bank didn't verify it) loans. That way, it could originate and sell on a ton of loans.
- But that's not fraud - the fraud is to do it and not tell the government entity that is ensuring the mortgages you originate that you have changed your review. So the problem was not just that this program existed - it is that Fannie didn't know about it. Or so the government argument must go.
- The federal civil frauds statute includes provisions providing for treble damages, and the USAO has asked for them in this case. It requires that that the statement be made to a government entity, and that the defendant "knowingly presents, or causes to be presented, a false or fraudulent claim for payment or approval."
- The USAO does like to rely on the work of others. This time there was a relator involved, so this is a qui tam action. He gets a chunk of any profits, and here, that could easily end up being tens of millions of dollars. The latest in qui tam research that I know about comes from David Freeman Engstrom at Stanford.
- One legal wrinkle here might turn on whether Fannie and Freddie are government entities, pursuant to the False Claims Act. The colorable argument to the contrary would turn on cases like Nevada ex rel. Hager v. Countrywide Home Loans Servicing, LP, 812 F. Supp. 2d 1211, 1217 (D. Nev. 2011) ("Fannie Mae and the federal government have not become so interdependent with each other as to make Fannie Mae's actions the actions of the federal government.") (D. Nev. July 9, 2012); Roberts v. Cameron-Brown Co., 556 F.2d 356, 358-60 (5th Cir. 1977) (Fannie Mae acts are private action); A. Michael Froomkin, Reinventing the Government Corporation, 1995 U. Ill. L. Rev. 543, 634 (1995). But there may be more on point law here that I don't know about.
The SEC’s impasse over money market mutual fund reform may provide a test of some of the Financial Stability Oversight Council’s powers under Dodd-Frank. The FSOC has met to consider how to regulate the systemic risk posed by mutual funds. The FSOC, chaired by Treasury Secretary Geithner, has two options to try to jumpstart reform of a critical market that froze during the Panic of 2008.
Option 1: Declare Certain Large Funds as Systemically Significant
The first and more drastic action would be for the FSOC to use its powers to designate larger money market mutual funds as systemically significant under Section 113 of Dodd-Frank. This, in turn, would allow the Federal Reserve to regulate those institutions. Even the threat of losing power might be enough to spur the SEC to act (or convince Commissioner Aguilar to change his mind).
Wholesale designation of money-market mutual funds as per se systemically significant is not an option. When Dodd-Frank was passed, I heard some scholars talk about how Section 113 might be interpreted to allow for designation of an entire category of financial institution. That is not how the FSOC interpreted the statute when it promulgated regulations governing its process for designating non-banks as systemically significant. The FSOC Final Rules set a three stage procedure for determining when individual firms are systemically significant. At the first stage, the FSOC will only consider if a nonbank is systemically significant if it has $50 billion in total consolidated assets and meets one of five other quantitative thresholds (which range from notional value of credit default swaps in which the nonbank is the reference entity to a leverage ratio).
These thresholds – and the firm-by-firm approach generally – restrict the scope of the FSOC’s power considerably. An individual money market mutual fund would have to be both large enough and pose systemic concerns on its own to trigger a systemic designation. It is unclear whether designating only the largest money market funds – even if designation is actually accomplished – would achieve enough in terms of reducing the systemic threat of runs on money market funds as a class.
Indeed, the collective systemic risk of money market mutual funds would not allow the FSOC to act with respect to the entire industry. The too-big-to-fail concern may have overshadowed other problems like “too-correlated-to-fail” and the problems of herd behavior affecting financial firms. Many small non-banks can pose just as great dangers in terms of liquidity and solvency crises as one behemoth. But herd behavior does not elicit the same kind of visceral reaction as “bigness.”
Thus far, FSOC has not used its Section 113 power. (A number of large banks were automatically deemed systemically important under Dodd-Frank by virtue of their size. In July, FSOC designated several financial market utilities (think clearing companies) as systemically significant under Section 804 of Dodd-Frank.) However, the FSOC's latest minutes indicate that the council is proceeding to the third and final stage with respect to a number of non-bank financial companies.
Option 2: Issue Recommendations
Alternatively, FSOC could issue an official but a recommendation to the SEC. Dodd-Frank gave the FSOC the power to issue recommendations to financial regulatory agencies “to apply new or heightened standards and safeguards for financial activities or practices that could create or increase risks of significant liquidity, credit, or other problems spreading” among bank holding companies, nonbanks, and financial markets. (Dodd-Frank Section 112(a)(2)(K)); see also Section 120).
Personally, I have been skeptical about how much punch this recommendation power packs. Dodd-Frank provides that the agency "shall impose the standards recommended" but can also decline to follow the recommendation. (Dodd-Frank Section 120 (c)(2)). It is less clear what happens if the receiving agency does not "determine" that it will not follow the recommendation, but is instead deadlocked.
At conferences, my colleagues at other schools have been more exuberant about the ability of recommendations to shape agency behavior. The money market mutual fund case will provide a test. Would an FSOC recommendation carry enough policy heft, moral suasion, political cover, and potential for embarrassment to cause the SEC (including Commissioner Aguilar) to change course?
(A recommendation from the FSOC might also help the SEC with the cost-benefit hurdle in the DC Circuit).
Both options carry considerable risk for the FSOC. What happens is the FSOC begins either the systemic designation or recommendation process and fails to get enough votes in the council? What would happen if the FSOC tries the systemic designation route, but suffers a loss in the appeals process in Federal court? The recommendation path also poses dangers for the council: what would happen if the SEC declines the recommendation?
The first time for anything means considerable risk. However the FSOC acts, it will set a political and reputational -- if not a legal -- precedent. At the same time, not acting sets a mighty precedent too.
At midnight, several hours before Vikram Pandit resigned, Bloomberg ran a story about a speech in which Pandit criticized federal regulators for not addressing the shadow banking system. I have previously expressed some views on shadow banking. I told Bloomberg about the irony of the CEO of a global investment bank calling for more regulation of a system in which investment banks not only actively participate but, moreover, serve as central hubs.
Events in Mr. Pandit's career today overtook the story.
But it is useful to remember the key role that shadow banking markets (asset-backed securities, asset-backed commercial paper, money-market mutual funds, repos, credit derivatives) played in the financial crisis and in Citi's operations. These markets served many of the same economic functions as traditional depository banks (providing credit and theoretically safe and liquid investments). The crisis revealed that these markets suffered the same types of crises as banks (shadow bank runs). The federal bailouts then deployed the same conceptual tools that governments historically used to address banking crises (government as lender-of-last-resort and effective deposit insurance). Now the question is whether these markets should be regulated to reduce moral hazard, just like banks are.
Pandit's abrupt resignation may have deprived us of having a clearer sense of what shadow banking is and the risks it poses. It is not a rhetorical device to hint at some unspecified set of institutions that sit outside regulation. Shadow banking is actually very much about investment banks and regulated entities at play in less regulated markets.
The principals behind the US civil fraud suit against Wells Fargo are the US Atty's Office for the SDNY, which you know best for its insider trading investigation against hedge funds (it has been much less active on the financial crisis front), HUD, and HUD's IG (two institutions that do not always work so great together). Some observations about this interesting suit:
- This is another dead-bang heart of the financial crisis suit. The US is arguing that Wells Fargo processed a ton of mortgages that HUD insured with fraudulently lackluster diligence. Which is basically the argument you must make if you think that financial institutions were responsible for the financial crisis. In this sense it parallels New York's suit against JPMorgan.
- Wait, HUD insures mortages? Yes, indeed, its Federal Housing Authority arm insures mortgages for low income homebuyers, and somewhat surprisingly, did not suffer the problems that Fannie and Freddie or the private insurers suffered during the financial crisis.
- Some of the allegations made against Wells Fargo are the kinds of allegations that could be made against any number of banks. From the press release, cribbing in turn from the complaint:
- WELLS FARGO aggravated its widespread underwriting violations by: hiring temporary staff to churn out and approve an ever-increasing quantity of FHA loans; failing to provide its inexperienced staff with proper training; paying improper bonuses to its underwriters to incentivize them to approve as many FHA loans as possible; and applying pressure on loan officers and underwriters to originate and approve more and more FHA loans as quickly as possible. In addition, WELLS FARGO senior management repeatedly ignored its own Quality Assurance department’s efforts to have management correct the practices leading to the material violations it found in a significant portion of WELLS FARGO’s retail home loans, and failed to report loans to HUD that it knew were rife with serious violations or fraud
- This suggests that more complaints could be coming, and to be fair to the SDNY, it has brought five other such claims over FHA misstatements, suggesting that this is a relatively wide-ranging investigation.
- The federal civil frauds statute includes provisions providing for treble damages. It requires that that the statement be made to a government entity, and that the defendant "knowingly presents, or causes to be presented, a false or fraudulent claim for payment or approval." Passed during the Civil War, it has that 19th century breadth that is absolutely terrifying, and without the protections of criminal procedure.
- Nonetheless, big reputable companies fall afoul of the statute frequently, and continue to do business with the United States. Name your large health care provider, and I'll name you a company that has paid a penalty to the United States for defrauding it.
- HUD is shaping up to be a relatively active litigator on both this and other financial crisis related fronts.
- So: how has the financial crisis been addressed in the courts so far? We've got these cases. The state of New York under the Martin Act. Private counterparties of bailed out auto companies and AIG. And almost no criminal activity. We may be beginning to see a a developing pattern, as the crisis begins to approach some statutes of limitation.
It is quite a literary one. Neil Barofsky has a book where he talks about how he and the Treasury Secretary had it in for one another. As the Huffington Post wrap has it - edited for family friendliness - one meeting got so shouty that Barofsky thought Geither would "throttle" him:
"I said that I thought our capacity as a nation to deal with what could be a continuing financial crisis was being undermined by a loss of faith in government," Barofsky writes. "Then I said that the current loss of government credibility could be traced to Treasury's mishandling of TARP."
"Geithner got dramatic," Barofsky writes: "'Neil, you think I don't hear those criticisms? I hear them. And each one, they cut me,' he said, pausing and then making an emphatic cutting motion with one hand as he said 'like a knife.'"
"'No one has ever made the banks disclose the type of s--- that I made them disclose after the stress tests. No one! And now you're saying that I haven't been f---ing transparent?'"
But if you can't persuade them when you're in the government, at least you can make it look bad when they're out of it.
Only a month prior to the international meeting, Geithner had been shooting for a 6% capital ratio and putting pressure on Bair to concede.
He had "lobbied me intensely on lower numbers for the Basel III calibration, knowing full well that our healthy banks will be just fine with a high numbers, but of course Citi and BofA will get killed," Bair wrote in a memo after an Aug. 6 meeting with Geithner, which is cited in the book. "Why do we keep making banking policy to accommodate weak institutions? Keep hoping our relationship will improve, but this was a new low."
Ultimately, Bair sees the entire episode as a power play by Geithner. She argues he was trying to blow up the meeting between international regulators so that the issue would be kicked higher to the Group of 20 finance ministers who were set to meet in November. If the G-20 took over negotiations, Geithner would be leading the U.S., not Bernanke.
About this charge, Felix Salmon is pretty skeptical, and despite his apparent sensitivity to cutting criticism, Geithner can probably live with having his biggest enemies in the book-writing, rather than regulatory, business. One can only imagine what Elizabeth Warren's memoir will look like - and one may have to, if she becomes a senator.
- The suit is really about the financial crisis - nothing orthagonal about it. It alleges that Bear Stearns (now JPM) systematically failed to inspect the quality of the mortgages it put into its mortgage related products (RMBS), which it then sold on to investors.
- Parts of the complaint read like a political document: consider "Faced with the promise of immediate, short-term profits and no long-term risks, originators began to increase their volume of home loans without regard to prospective borrowers’ creditworthiness – including their ability to repay the loan." Is this true? Germaine to JPMorgan?
- Or try "In fact, numerous originators who were top contributors to Defendants’ RMBS were on the Comptroller of the Currency’s “Worst Ten” mortgage originators in the “Worst Ten” metropolitan areas due to their loans’ high rate of foreclosures during the period 2005 to 2007." Seems like a newsy factoid more than a bit of data for the complaint. I'd be interested in knowing if this was different for JPM than anyone else, proportions, etc.
- The complaint spends a great deal of time (paragraphs 33-69 of an 85 paragraph complaint) arguing that the due diligence the bank made into its RMBS was insufficient, and that tells you something about a presumable defense to Martin Act fraud claims.
- Something new: part of the complaint relies on the fact that JPM sued and settled with mortgage originators, but failed to share the settlement proceeds with RMBS investors.
- The Martin Act is a fraud statute, and it used to be used to go after penny ante mountebanks. Elliot Spitzer, however, turned the act into a cudgel that could be used against Wall Street, aided by the fact that the Martin Act doesn't require intent or reliance, as federal fraud statutes do, even for crimes (which is amazing, and would raise visions of due process challenges to convictions in my head). The NYCtApp: the Act “includes all deceitful practices contrary to the plain rules of common honesty and all acts tending to deceive or mislead the public.” That means you only need to show that a material misstatement or omission occured (the link is to a handy memo from Dechert).
- The suits is a civil one, which means that the statute allows the AG to sue those "engaged in, is engaged or about to engage in any of the transactions heretofore referred to as and declared to be fraudulent practices."
It is not too early to start thinking about the 2013 AALS Annual Meeting in New Orleans in January. The Securities Regulation and Financial Institutions & Consumer Financial Services sections have joined forces to put together a Joint Program on the “The Regulation of Financial Market Intermediaries: The Making and Un-Making of Markets” on Friday, January 4th from 2 pm to 5 pm.
The program will give us a chance to look at the intersection of capital markets and financial institution regulation, a sweet spot that was overlooked until the global financial crisis hit. The program will include a panel of scholars who have been looking at this intersection for quite a while, including, Onnig Dombalagian (Tulane), Claire Hill (Minnesota), Tamar Frankel (Boston University), Donald Langevoort (Georgetown), Geoffrey Miller (NYU), David Zaring (Univ. of Pennsylvania – Wharton School of Business), David Min (UC Irvine and author of How Government Guarantees in Housing Finance Promote Stability) and Kimberly Krawiec (Duke) (Moderator).
The program will also include the following four papers picked from a large response to our Call for Papers:
- “The Federal Reserve’s Use of International Swap Lines,” Colleen M. Baker (Notre Dame);
- “Investment Company as Instrument: The Limitations of the Corporate Governance Regulatory Paradigm,” Anita K. Krug (Univ. of Washington); and
- “The Case for Decentralizing Financial Oversight: A Strategy for Overseeing the Derivatives Industry,” Jeffrey Manns (George Washington Univ.).
Saule Omarova (North Carolina) will moderate the call for papers panel.
The takeover of AIG was fraught with problems, and has birthed a Takings Clause suit that shouldn't be taken lightly. But once taken over, there was plenty of concern that AIG would be run like a Soviet factory. That concern now appears to have been misplaced, and I'm looking forward to apologies from those convinced we were on the road to insurance serfdom, or, at the very least, the relocation of all of the company's investments to the states of Ohio and Virginia by 2012.
Instead with AIG, what we saw was that the government, like any investor laying down an uncomfortably large bet, looked to maximize its returns and get out quickly. Governments - the largest investors, given pensions plans and the like - almost always do plain old risk-adjusted return maximization almost all the time, and it looks to me like the stake-taking during the financial crisis had been no exception to the rule.
Sure, you can wonder about the auto companies. I wonder about the Chevy Volt. But let's not kid ourselves. The 1% of the time that politics may have affected the way the government ran our bailouts should not obscure the 99% of the time it played it straight down the middle. That doesn't mean we should be psyched about bailouts. But it does introduce a little bit of realism about one of the alleged downsides.
As in a bad horror movie (or a great Rolling Stones song), observers of the current crisis may have been disquieted that one of the central characters in this disaster also played a central role in the Enron era. Is it coincidence that special purpose entities (SPEs) were at the core of both the Enron transactions and many of the structured finance deals that fell part in the Panic of 2007-2008?
Bill Bratton (Penn) and Adam Levitin (Georgetown) think not. Bratton and Levin have a really fine new paper out, A Transactional Genealogy of Scandal, that not only draws deep connections between these two episodes, but also traces back the lineage of collateralized debt obligations (CDOs) back to Michael Millken. The paper provides a masterful guided tour of the history of CDOs from the S&L/junk bond era to the innovations of J.P. Morgan through to the Goldman ABACUS deals and the freeze of the asset-backed commercial paper market .
Their account argues that the development of the SPE is the apotheosis of the firm as “nexus of contracts.” These shell companies, after all, are nothing but contracts. This feature, according to Bratton & Levin, allows SPEs to become ideal tools either for deceiving investors or arbitraging financial regulations.
Here is their abstract:
Three scandals have fundamentally reshaped business regulation over the past thirty years: the securities fraud prosecution of Michael Milken in 1988, the Enron implosion of 2001, and the Goldman Sachs “Abacus” enforcement action of 2010. The scandals have always been seen as unrelated. This Article highlights a previously unnoticed transactional affinity tying these scandals together — a deal structure known as the synthetic collateralized debt obligation (“CDO”) involving the use of a special purpose entity (“SPE”). The SPE is a new and widely used form of corporate alter ego designed to undertake transactions for its creator’s accounting and regulatory benefit.
The SPE remains mysterious and poorly understood, despite its use in framing transactions involving trillions of dollars and its prominence in foundational scandals. The traditional corporate alter ego was a subsidiary or affiliate with equity control. The SPE eschews equity control in favor of control through pre-set instructions emanating from transactional documents. In theory, these instructions are complete or very close thereto, making SPEs a real world manifestation of the “nexus of contracts” firm of economic and legal theory. In practice, however, formal designations of separateness do not always stand up under the strain of economic reality.
When coupled with financial disaster, the use of an SPE alter ego can turn even a minor compliance problem into scandal because of the mismatch between the traditional legal model of the firm and the SPE’s economic reality. The standard legal model looks to equity ownership to determine the boundaries of the firm: equity is inside the firm, while contract is outside. Regulatory regimes make inter-firm connections by tracking equity ownership. SPEs escape regulation by funneling inter-firm connections through contracts, rather than equity ownership.
The integration of SPEs into regulatory systems requires a ground-up rethinking of traditional legal models of the firm. A theory is emerging, not from corporate law or financial economics but from accounting principles. Accounting has responded to these scandals by abandoning the equity touchstone in favor of an analysis in which contractual allocations of risk, reward, and control operate as functional equivalents of equity ownership, and approach that redraws the boundaries of the firm. Transaction engineers need to come to terms with this new functional model as it could herald unexpected liability, as Goldman Sachs learned with its Abacus CDO.
The paper should be on the reading list of scholars in securities and financial institution regulation. The historical account also provides a rich source of material for corporate law scholars engaged in the Theory of the Firm literature.
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Now that DOJ has dropped its investigation of Goldman Sachs, he suspects that the cases are, basically, over.
A friendly reminder that the AALS Program for the Securities Regulation and Financial Institutions/Consumer Financial Services Sections is fast approaching. Here is the call again:
Call for Papers
AALS Joint Program of the Securities Regulation Section and
Financial Institutions & Consumer Financial Services Section
The Regulation of Financial Market Intermediaries:
The Making and Un-Making of Markets
AALS Annual Meeting, January 4, 2013
The AALS Section on Securities Regulation and the Section of Financial Institutions & Consumer Financial Services are pleased to announce that they are sponsoring a Call for Papers for their joint program on Friday, January 4th at the AALS 2013 Annual Meeting in New Orleans, Louisiana.
The topic of the program and call for papers is “The Regulation of Financial Market Intermediaries: The Making and Un-Making of Markets.” The financial crisis witnessed numerous market failures involving an array of financial market intermediaries, including banks, broker dealers, and various kinds of investment funds (from money market mutual funds to hedge funds). The crisis came at the end of a decades-long transformation of the U.S. financial services sector that blurred the boundaries between banking and securities businesses. During this period a range of new intermediaries emerged and connected individuals and firms seeking financing to investors in capital markets. At the same time, capital markets became increasingly dominated by financial institutions and other institutional investors. Intermediaries devised and “made markets” for new and often highly illiquid and opaque financial instruments. Many of these new markets froze or crashed in the financial crisis. In response, Dodd-Frank and other financial reforms have imposed a grab bag of new rules on financial intermediaries.
Yet the effects of these financial reforms remain unclear. Moreover, policymakers and scholars often disagree about the precise problems that these reforms are meant to address. For example, the SEC’s headline-grabbing suit against Goldman Sachs over the ABACUS transactions focused on conflicts of interest for large financial conglomerates with different stakes in a transaction. Meanwhile, other financial reforms have focused on the opacity of pricing in financial markets or on the solvency or liquidity risk faced by intermediaries.
The tangle of potential market failures has led to a range of policy responses. Often banking and securities scholars seem to look at the same set of market practices through radically different lenses. Banking scholars focus on solvency crises and banking runs and debate the application of prudential rules on the risk-taking, leverage, and liquidity of intermediaries. At the same time, securities scholars emphasize the problems of conflicts of interest and asymmetric information. They then look to the traditional policy tools in their field such as disclosure, fiduciary duties, and corporate governance.
The dearth of dialogue between these two fields creates the risk of confusion in identifying both problems and solutions for financial intermediaries and the markets in which they operate. To move the discussion forward, scholars in both fields may have to move outside their comfort zones. The study of financial institutions cannot be limited to deposit-taking banks. Similarly, securities regulation involves more than securities offerings and litigation, but the regulation of broker-dealers, investment advisers and funds, and the regulation of trading and markets.
Form and length of submission
The submissions committee looks forward to reviewing any papers that address the foregoing topics. Abstracts should be comprehensive enough to allow the review committee to meaningfully evaluate the aims and likely content of papers they propose. Eligible law faculty are invited to submit manuscripts or abstracts dealing with any aspect of the foregoing topics. Untenured faculty members are particularly encouraged to submit manuscripts or abstracts.
The initial review of the papers will be blind. Accordingly the author should submit a cover letter with the paper. However, the paper itself, including the title page and footnotes must not contain any references identifying the author or the author’s school. The submitting author is responsible for taking any steps necessary to redact self-identifying text or footnotes.
Papers may be accepted for publication but must not be published prior to the Annual Meeting.
Deadline and submission method
To be considered, papers must be submitted electronically to Erik Gerding at firstname.lastname@example.org. The deadline for submission is August 10, 2012.
Papers will be selected after review by members of a Committee appointed by the Chairs of the two sections. The authors of the selected papers will be notified by September 30, 2012.
The Call for Paper participants will be responsible for paying their annual meeting registration fee and travel expenses.
Full-time faculty members of AALS member law schools are eligible to submit papers. The following are ineligible to submit: foreign, visiting (without a full-time position at an AALS member law school) and adjunct faculty members, graduate students, fellows, non-law school faculty, and faculty at fee-paid non-member schools.
Please forward this Call for Papers to any eligible faculty who might be interested.
Yes, yes, I'm two chapters into Capital, by John Lanchester, and it's looking very good. But I began my 2012 tour of the novels of the financial crisis with Fiona Neill's What The Nanny Saw, a British book about a family headed by Lehman's fictional European head of structured products. It was - just barely - good enough to finish, a bit too mopey for my taste, with a pretty hollow center of an observant young nanny, but it offers a touching faith that even chick lit readers will still find the sins of derivatives traders interesting. Here's the video. Here's Publisher's Weekly on it.
And here's Felix Salmon, with some interesting observations about financial crisis novels more generally.
The constitional challenge has been filed by a Texas bank, alleging, a C. Boyden Gray suggested might be the way to go - that Dodd-Frank violates the nondelegation doctrine. That doctrine has only had, rather famously, one good year and 200 bad ones (the Supreme Court invoked it twice in 1935, just before the "switch in time that saved 9"). And the bank will have all sorts of standing problems getting to the merits. But still, these days, big signature legislation might be a bit more constitutionally suspect than you thought. The complaint is here.
Longtime readers will remember that Dain Donelson and I did a modest study of the Office of Thrift Supervision's performance during the financial crisis; I've summarized the work over at RegBlog, for those interested in a recap.