Conglomerate Blog: Business, Law, Economics & Society

January 29, 2015

The Intracorporate Conspiracy Doctrine and D&O Litigation Incentives

Posted by Josephine Sandler Nelson

My previous blogposts (one, two, three, four, five, six, seven, and eight) discussed the dangers of granting intracorporate conspiracy immunity to agents who commit coordinated wrongdoing within an organization. The last two blogposts (here and here) highlighted the harm that public and judicial frustration with this immunity inflicts on alternative doctrines.

In addition to exacerbating blind CEO turnover, substituting alternative doctrines for prosecuting intracorporate conspiracy affects an executive’s incentives under Director’s and Officer’s (D&O) liability insurance. This post builds on arguments that I have made about D&O insurance in articles here and here.

In traditional conspiracy prosecutions, the Model Penal Code (MPC) provides an affirmative defense for renunciation. The MPC’s standard protects the actor, who “after conspiring to commit a crime, thwarted the success of the conspiracy, under circumstances manifesting a complete and voluntary renunciation of his criminal purpose.” This means that the executive who renounces an intracorporate conspiracy faces no charges.

In contrast with conspiracy prosecutions, responsible corporate officer doctrine and its correlates fail to reward the executive who changes course to mitigate damages or to abandon further destructive behavior. Although the size of the damages may be smaller with lesser harm if the executive renounces an organization’s course of conduct, the executive’s personal career and reputation may still be destroyed by entry of a judgment. Modest whistle-blower protections are ineffectual.

Specifically, because of the way that indemnification and D&O insurance function, the entry of judgment has become an all-or-nothing standard: an employee’s right to indemnification hinges on whether the employee is found guilty of a crime or not. To receive indemnification under Delaware law, for example, an individual must have been “successful on the merits or otherwise in defense of any action, suit or proceeding.” Indemnification is repayment to the employee from the company; D&O insurance is a method that companies use to pass on the cost of indemnification and may contain different terms than indemnification itself.

Indemnification and D&O insurance are not a minor issues for executives. In fact, under many circumstances, employees have a right to indemnification from an organization even when the alleged conduct is criminal. Courts have acknowleged that “[i]ndemnification encourages corporate service by capable individuals by protecting their personal financial resources from depletion by the expenses they incur during an investigation or litigation that results by reason of that service.” And when hiring for an executive board, “Quality directors will not serve without D&O coverage.” Because of this pressure from executives, as many as ninety-nine percent of public U.S. companies carry D&O insurance.

So what does this standard mean for executives prosecuted under responsible corporate officer doctrine instead of for traditional conspiracy? Executives are incentivized either not to get caught, or to perpetrate a crime large enough that the monetary value of the wrongdoing outweighs the potential damage to the executive’s career. Because an executive’s right to indemnification hinges on whether he is found guilty of a crime or not, he has an enormous incentive to fight charges to the end instead of pleading to a lesser count. Thus, unless the executive has an affirmative defense to charges, like renunciation in traditional conspiracy law, there is no safety valve. Litigating responsible corporate officer doctrine cases creates a new volatile high-wire strategy. Moreover, as discussed in my last blogpost, responsible corporate officer doctrine imposes actual blind “respondeat superior” liability. Regardless of the merits, the executive may be penalized. So you can see the take-home message for executives: go ahead and help yourself to the largest possible slice pie on your way out the door.

I argue that in sending this message, and in many other ways, our current law on corporate crime is badly broken. My last blogpost for the Glom will introduce the book that Lynn Stout and I propose writing to give better direction to business people in search of ethical outcomes.

January 28, 2015

The Intracorporate Conspiracy Doctrine and CEO Turnover

Posted by Josephine Sandler Nelson

My previous blogposts (one, two, three, four, five, six, and seven) discussed why conspiracy prosecutions were the best method to penalize coordinated wrongdoing by agents within an organization. Using alternative doctrines to impose liability on behavior that would otherwise be recognized as an intracorporate conspiracy results in flawed incentives and disproportionate awards.

The fundamental problem with substituting responsible corporate officer doctrine and control person liability for reforming the intracorporate conspiracy doctrine is that these alternative doctrines represent exactly what Professor Martin objects to: actual imposition of blind “respondeat superior” liability. For example, under these doctrines, “in most federal courts, it is not necessary to show that the corporate official being charged had a culpable state of mind.” Instead, the issue before the court is merely whether the officer had control and responsibility for the alleged actions. Accordingly, it is not a defense to control person liability that the officer did not “knowingly participate in or independently commit a violation of the Act.”

But simply penalizing the officer who is in the wrong place at the wrong time does little to define and encourage best practices. Moreover, with these and other explosive hazards for corporate service, it should be no surprise that top executives are demanding and receiving ever-increasing compensation for often short-term positions. Since 2009, the year that the NSP case establishing “control person” liability was settled, the discrepancy in pay between top management and the average worker has been growing dramatically. In 2013, the CEO of J.C. Penny Co., for example, was exposed for making 1,795 times what the average U.S. department store employee made. From 2009 to 2013, as measured across Standard & Poor’s 500 Index (S&P 500) of companies, “the average multiple of CEO compensation to that of rank-and-file workers” has risen to 204, an increase of twenty percent.

It is true that the financial crisis did reduce executive compensation packages before 2009, and that there has been a historical trend towards the growth of executives’ salaries as a multiple of average workers’ salaries. For example, “[es]timates by academics and trade-union groups put the number at 20-to-1 in the 1950s, rising to 42-to-1 in 1980 and 120-to-1 by 2000.” But the jump in executives’ salaries from 2009 has been extraordinary. The new emphasis on vicarious liability for individuals under the responsible corporate officer doctrine since that date must be considered part of executives’ demands for such high compensation in exchange for their risky positions.

The average duration of a CEO’s time in office has diminished as well. In 2000, the average tenure of a departing S&P 500 CEO in the U.S. was ten years. By 2010, it was down to eight years. In 2011, merely a year later, the average tenure of a Fortune 500 CEO was barely 4.6 years. In 2013, that former CEO of J.C. Penny Co. served for only eighteen months.

With an eighteen-month tenure, how much can the chief executive of a large company discover about the wrongdoing that his or her new company is committing? Furthermore, how much can that person design and institute good preventative measures to guide his or her subordinates to avoid that harm? A blindly revolving door for CEOs does not help those interested in effectively reducing the wrongdoing of agents within the corporation. Incentives without intracorporate conspiracy immunity would be different because they would reward the agent who abandons a conspiracy. (More about this argument here, here, here, and here.)

My next blogpost will examine how substituting alternative doctrines for prosecuting intracorporate conspiracy affects incentives under Director’s and Officer’s (D&O) liability insurance.

January 27, 2015

Frustration with the Intracorporate Conspiracy Doctrine Distorts Other Areas of Law

Posted by Josephine Sandler Nelson

My previous blogposts (one, two, three, four, five, and six) discussed why conspiracy prosecutions should be used to reach coordinated wrongdoing by agents within an organization. The intracorporate conspiracy doctrine has distorted agency law and inappropriately handicaps the ability of tort and criminal law to regulate the behavior of organizations and their agents.

My Intracorporate Conspiracy Trap article argues that the intracorporate conspiracy doctrine is not properly based in agency law, and that it should most certainly not be applied throughout tort law and criminal law. As a result of the immunity granted by the doctrine, harmful behavior is ordered and performed without consequences, and the victims of the behavior suffer without appropriate remedy. My Corporate Conspiracy Vacuum article argues that public and judicial frustration with the lack of accountability for corporate conspiracy has now warped the doctrines around it.

Courts have used a wide variety of doctrines to hold agents of enterprises responsible for their actions that should have prosecuted as intracorporate conspiracy. Some of these doctrines include:

• piercing the corporate veil,

• responsible corporate officer doctrine, and related control person liability,

• denying the retroactive imposition of the corporate veil, and

• reverse piercing of the corporate veil.

But the new applications of these alternative doctrines are producing distortions that make the doctrines less stable, less predictable, and less able to signal proper incentives to individuals within organizations.

An example of how piercing the corporate veil has been used to defeat intracorporate conspiracy immunity can be seen in the Morelia case. A previous blogpost discussed how the intracorporate conspiracy doctrine has defanged RICO prosecutions of agents and business entities. In Morelia, which was a civil RICO case, the federal district court, obviously outraged by defendants’ behavior in the case, explicitly permitted plaintiffs to pierce the corporate veil to avoid application of the intracorporate conspiracy doctrine. In a creative twist invented from whole cloth to link the two doctrines, the Morelia court overruled its magistrate judge’s recommendation to announce:

"Since the court has determined that plaintiffs have properly alleged that the corporate veil should be pierced, the individual defendants may be liable for corporate actions and any distinction created by the intra-corporate doctrine does not exist."

Regarding its test for piercing the corporate veil, the Morelia court further overruled its magistrate’s recommendation by focusing on plaintiffs’ arguments regarding undercapitalization, and its decision included only a single footnote about the disregard of corporate formalities.

The Morelia court is not alone in its frustration with the intracorporate conspiracy doctrine and in its attempt to link analysis under the intracorporate conspiracy doctrine with the stronger equitable tenets of piercing the corporate veil. More subtly, courts across the country have started to entangle the two doctrines’ requirements as intracorporate conspiracy immunity has become stronger and courts have increasingly had to rely on piercing the corporate veil as an ill-fitting alternative to permit conspiracy claims to proceed. Even large public companies should take note. No public company has ever been pierced, but a bankruptcy court recently reverse-pierced corporate veils of the Roman Catholic Church, which is far from a single-person “sham” corporation. My Corporate Conspiracy Vacuum article discusses additional examples and repercussions for incentives under each of these alternative doctrines.

My next blogpost will examine how frustration with intracorporate conspiracy immunity has led to volatility in responsible corporate officer doctrine and related control person liability. Ironically, executive immunity from conspiracy charges fuels counterproductive CEO turnover.

January 26, 2015

The Silenced Connecticut Sex-Abuse Case

Posted by Josephine Sandler Nelson

My previous blogposts (one, two, three, four, and five) introduced why conspiracy prosecutions should be used to reach wrongdoing by agents within an organization. The 2012 prosecution of Monsignor Lynn for twelve years of transferring predator priests from parish to parish at the command and for the benefit of the Archdiocese of Philadelphia was defeated by the intracorporate conspiracy doctrine. Moreover, this was not the first time that the Roman Catholic Church had used the doctrine to help its bureaucrats escape liability for suppressing sex abuse cases.

In 1997, employees of the Roman Catholic Church in Connecticut were alleged—very much like Lynn—to have covered up the sexual misconduct of a priest, enabling him to continue to abuse children entrusted to the Church’s care by virtue of his office. When sued for civil conspiracy by the victims, the employees’ defense was that they were acting in the best interest of the corporation.

The Connecticut court found that the test for whether an agent is acting within the scope of his duties “is not the wrongful nature of the conspirators’ action but whether the wrongful conduct was performed within the scope of the conspirators’ official duties.” If the wrongful conduct was performed within the scope of the conspirators’ official duties, the effect of applying the intracorporate conspiracy doctrine is to find that there was no conspiracy. Because covering up the priest’s sex abuse was in the best interest of the corporate organization, the court found that the employees were all acting on behalf of the corporation. The court never reached the issue of whether the employees’ actions rose to the level of a civil conspiracy. Under the intracorporate conspiracy doctrine, it was a tautology that no conspiracy could be possible.

This case is interesting not only because it documents the way that the intracorporate conspiracy doctrine protects enterprises from inquiry into conspiracies, but also because of the subsequent history of its allegations. The full extent of the Bridgeport Diocese’s wrongdoings—if current public knowledge is indeed complete—only came to light in December 2009, twelve years after the 1997 case. It took twelve years, the combined resources of four major newspapers, an act displaying public condemnation of the Roman Catholic Church by members of the state legislature, and finally a decision by the U.S. Supreme Court to release the documents that could have become the basis of the intracorporate conspiracy claim in 1997. There is still no conspiracy suit or any criminal charge against the Diocese. Additional details about the case are available in my article The Intracorporate Conspiracy Trap. The article will be published soon in the Cardozo Law Review, and it is available in draft form here.

Astonishingly, none of the extensive news coverage about the sexual abuse cases in Bridgeport over those additional twelve years has connected these facts to the original 1997 case defeated by application of the intracorporate conspiracy doctrine. If the intracorporate conspiracy doctrine had not provided immunity, the case might have revealed the Diocese’s pattern of wrongdoing long beforehand and in a much more efficient way.

My next blogpost reveals additional dangers from the spread of the intracorporate conspiracy doctrine: frustration with the intracorporate conspiracy doctrine has started to distort other areas of law.

January 23, 2015

How We Should Have Tried Monsignor Lynn

Posted by Josephine Sandler Nelson

My previous blogposts (one, two, three, and four) introduced why conspiracy prosecutions should be used to reach wrongdoing by agents within a business organization. The same legal analysis applies to religious organizations.

We should have been able to charge Monsignor Lynn and the Archdiocese of Philadelphia that directed his actions to hide the sexual abuse by priests with criminal conspiracy. Instead, Pennsylvania charged Lynn with two things: child endangerment and conspiracy with the priests.

As international news outlets later reported, Lynn could not be guilty of child endangerment because the state’s statute could not apply to an administrative church official who did not directly supervise children.

Lynn could not be guilty of conspiracy with the priests because he did not share their “particular criminal intent.” As the jury understood, Lynn was not trying to help a predator priest get from parish to parish so that “he can continue to enjoy what he likes to do.” Lynn was trying to protect the reputation of his employer, the Archdiocese—if the priests benefitted, that was a side issue.

So why didn’t the prosecution charge Lynn and the Archdiocese with conspiracy? It was the Archdiocese that directly coordinated and profited from Lynn’s actions. The intracorporate conspiracy doctrine, as discussed before, would bar that prosecution. In Pennsylvania, it is “well-settled that a corporation cannot conspire with its subsidiary, its agents, or its employees.”

Finally, considering other options, Lynn could not have been charged with possible crimes such as obstruction of justice. Lynn was too good: Lynn and the Archdiocese were so successful at covering up the sexual abuse and silencing victims, there was no ongoing investigation to obstruct. “Aiding and abetting” the Archdiocese’s cover-up of the sex abuse would have been difficult to pursue (see more here) and is not allowed under RICO in the Third Circuit.

My next blogpost will demonstrate that the Monsignor Lynn case was also part of a pattern by the Roman Catholic Church in America to use the intracorporate conspiracy doctrine to hide the coordinated wrongdoing of its agents to cover-up sexual abuse by priests. Fifteen years before prosecutors attempted to try Monsignor Lynn, the silenced Connecticut sex-abuse case showed the Church how effective this defense could be.

January 22, 2015

Sex Abuse, Priests, and Corporate Conspiracy

Posted by Josephine Sandler Nelson

My previous blogposts (one, two, and three) introduced the topic of how the intracorporate conspiracy doctrine prevents the prosecution of coordinated wrongdoing by individuals within organizations. This post illustrates the doctrine’s effect in the context of a specific organization—here a religious one: the Roman Catholic Archdiocese of Philadelphia and the systematic transfer of predator priests. This post is based on my article The Intracorporate Conspiracy Trap to be published soon in the Cardozo Law Review. The article is available in draft form here.

For twelve years, from 1992 to 2004, as Secretary for Clergy, Monsignor William Lynn’s job within the Philadelphia Archdiocese was to supervise priests, including the investigation of sex-abuse claims. In 1994, Monsignor Lynn compiled a list of thirty-five “predator” priests within the archdiocese. He compiled the list from secret church files containing hundreds of child sex-abuse complaints. On the stand, Lynn testified that he hoped that the list would help his superiors to address the growing sex-abuse crisis within the Archdiocese. But for twelve years Lynn merely re-assigned suspected priests, and he hid the abuse within the church. His superiors never acted on the list that Lynn gave them—in fact, they ordered all copies of the list destroyed—and Lynn never contacted outside authorities. As late as 2012, one of the “predator” priests on Lynn’s list was still serving in a parish.

All parties agree that Lynn’s actions in transferring priests who molested children allowed those priests to continue to abuse children, sheltered the priests from potential prosecution, and directly protected the Philadelphia Archdiocese’s reputation.

In fact, Lynn’s actions had been ordered by the archbishop on behalf of the Archdiocese. Lynn reported what he was doing to his superiors, who rewarded Lynn with twelve years of employment and a prominent position within the Archdiocese for doing his job as they saw it. Moreover, the archbishop himself inadvertently revealed the existence of the number thirty-five “predator” priests to the media, and he was the one who ordered all copies of the list to be shredded to keep it from being discovered in legal proceedings.

The instinct here is that this behavior—the transferring of predator priests to cover-up the sexual abuse of children—should have been illegal for Monsignor Lynn to pursue. But the Commonwealth could not prosecute Monsignor Lynn and the Archdiocese for conspiracy. Furthermore, immunity for Lynn’s behavior is now the rule in most state and federal jurisdictions around the country. As described in an earlier blogpost, the intracorporate conspiracy doctrine provides immunity to an enterprise and its agents from conspiracy prosecution, based on the legal fiction that an enterprise and its agents are a single actor incapable of the meeting of two minds to form a conspiracy.

My next blogpost will further investigate why this behavior was not illegal under our current system, and how we should have tried Monsignor Lynn.

January 21, 2015

Where are the Prosecutions for Corporate Conspiracy?

Posted by Josephine Sandler Nelson

My first and second blogposts introduced why conspiracy prosecutions are particularly important for reaching the coordinated actions of individuals when the elements of wrong-doing may be delegated among members of the group.

So where are the prosecutions for corporate conspiracy??? The Racketeer Influenced and Corrupt Organizations Act of 1970 (“RICO”, 18 U.S.C.A. §§ 1961 et seq.), no longer applies to most business organizations and their employees. In fact, business organizations working together with outside agents can form new protected “enterprises.”

What’s going on here? In this area and many other parts of the law, we are witnessing the power of the intracorporate conspiracy doctrine. This doctrine provides immunity to an enterprise and its agents from conspiracy prosecution, based on the legal fiction that an enterprise and its agents are a single actor incapable of the meeting of two minds to form a conspiracy. According to the most recent American Law Reports survey, the doctrine “applies to corporations generally, including religious corporations and municipal corporations and other governmental bodies. The doctrine applies to all levels of corporate employees, including a corporation’s officers and directors and owners who are individuals.” Moreover, it now extends from antitrust throughout tort and criminal law.

What is the practical effect of this doctrine? The intracorporate conspiracy doctrine has distorted agency law and inappropriately handicaps the ability of tort and criminal law to regulate the behavior of organizations and their agents. Obedience to a principal (up to a point) should be rewarded in agency law. But the law should not immunize an agent who acts in the best interest of her employer to commit wrongdoing. Not only does the intracorporate conspiracy doctrine immunize such wrongdoing, but the more closely that an employer orders and supervises the employee’s illegal acts, the more the employer is protected from prosecution as well.

My next blogpost illustrates how the intracorporate conspiracy doctrine operates to defeat prosecutions for coordinated wrongdoing by agents within an organization. Let’s examine the case of Monsignor Lynn.

January 20, 2015

Corporate Conspiracy Charges for the Financial Crisis

Posted by Josephine Sandler Nelson

In my previous blogpost, I granted the merit of defense counsel’s argument that the actions of discrete individual defendants—when the law is not permitted to consider the coordination of those actions—may not satisfy the elements of a prosecutable crime.

But what is the coordination of individuals for a wrongful common purpose? That’s a conspiracy. And, for exactly the reasons that defense counsel articulates, these types of crimes cannot be reached by other forms of prosecution. The U.S. Supreme Court has recognized that conspiracy is its own animal. “[C]ollective criminal agreement—partnership in crime—presents a greater potential threat to the public than individual delicts.” When we consider the degree of coordination necessary to create the financial crisis, we are not talking about a single-defendant mugging in a back alley—we are talking about at least the multi-defendant sophistication of a bank robbery.

Conspiracy prosecutions for the financial crisis have some other important features. First, the statute of limitations would run from the last action of a member of the group, not the first action as would be typical of other prosecutions. This means that many crimes from the financial crisis could still be prosecuted (answering Judge Rakoff’s concern). Second, until whistle-blower protections are improved to the point that employees with conscientious objections to processes can be heard, traditional conspiracy law provides an affirmative defense to individuals who renounce the group conspiracy. By contrast, the lesson Wall Street seems to have learned from the J.P. Morgan case is not to allow employees to put objections into writing. Third, counter to objections that conspiracy prosecutions may be too similar to vicarious liability, prosecutors would have to prove that each member of the conspiracy did share the same common intent to commit wrongdoing. The employee shaking his head “no” while saying yes would not be a willing participant, but many other bankers were freely motivated by profit at the expense of client interest to cooperate with a bank’s program.

My next blogpost will ask: where are the prosecutions for corporate conspiracy?

J.P. Morgan’s Witness and the Holes in Corporate Criminal Law

Posted by Josephine Sandler Nelson

It is a pleasure to be guest-blogging here at The Glom for the next two weeks. My name is Josephine Nelson, and I am an advisor for the Center for Entrepreneurial Studies at Stanford’s business school. Coming from a business school, I focus on practical applications at the intersection of corporate law and criminal law. I am interested in how legal rules affect ethical decisions within business organizations. Many thanks to Dave Zaring, Gordon Smith, and the other members of The Glom for allowing me to share some work that I have been doing. For easy reading, my posts will deliberately be short and cumulative.

In this blogpost, I raise the question of what is broken in our system of rules and enforcement that allows employees within business organizations to escape prosecution for ethical misconduct.

Public frustration with the ability of white-collar criminals to escape prosecution has been boiling over. Judge Rakoff of the S.D.N.Y. penned an unusual public op-ed in which he objected that “not a single high-level executive has been successfully prosecuted in connection with the recent financial crisis.” Professor Garett’s new book documents that, between 2001 and 2012, the U.S. Department of Justice (DOJ) failed to charge any individuals at all for crimes in sixty-five percent of the 255 cases it prosecuted.

Meanwhile, the typical debate over why white-collar criminals are treated so differently than other criminal suspects misses an important dimension to this problem. Yes, the law should provide more support for whistle-blowers. Yes, we should put more resources towards regulation. But also, white-collar defense counsel makes an excellent point that there were no convictions of bankers in the financial crisis for good reason: Prosecutors have been under public pressure to bring cases against executives, but those executives must have individually committed crimes that rise to the level of a triable case.

And why don’t the actions of executives at Bank of America, Citigroup, and J.P. Morgan meet the definition of triable crimes? Let’s look at Alayne Fleischmann’s experience at J.P. Morgan. Fleischmann is the so-called “$9 Billion Witness,” the woman whose testimony was so incriminating that J.P. Morgan paid one of the largest fines in U.S. history to keep her from talking. Fleischmann, a former quality-control officer, describes a process of intimidation to approve poor-quality loans within the bank that included an “edict against e-mails, the sabotaging of the diligence process,… bullying, [and] written warnings that were ignored.” At one point, the pressure from superiors became so ridiculous that a diligence officer caved to a sales executive to approve a batch of loans while shaking his head “no” even while saying yes.

None of those actions in the workplace sounds good, but are they triable crimes??? The selling of mislabeled securities is a crime, but notice how many steps a single person would have to take to reach that standard. Could a prosecutor prove that a single manager had mislabeled those securities, bundled them together, and resold them? Management at the bank delegated onto other people elements of what would have to be proven for a crime to have taken place. So, although cumulatively a crime took place, it may be true that no single executive at the bank committed a triable crime.

How should the incentives have been different? My next blogpost will suggest the return of a traditional solution to penalizing coordinated crimes: conspiracy prosecutions for the financial crisis.

January 22, 2012

Credit Scoring: The Next Frontier

Posted by Kathleen Engel

Credit scoring has greatly reduced the cost of credit to the benefit of industry and borrowers, and has minimized concerns about intentionally discriminatory underwriting. Despite these gains, there remain questions about the integrity of the data used to determine borrowers’ scores and the fairness of the models used by credit reporting agencies (CRAs). These concerns are amplified as credit scores take on increasingly important roles in the society. Indeed, they have become a form of collateral. In this post, we muse about areas in which credit scoring needs further investigation.

Credit scoring unquestionably predicts borrower creditworthiness; however, scores could be more accurate and, thus, more fair. In particular, there is evidence that: (1) there are errors in the inputs on individual consumers; (2) some of the variables and the weights given to them are not predictive; and (3) models omit variables that would help predict borrower creditworthiness. For example, medical debt is often treated the same as credit card debt in scoring models. As a result, borrowers with unexpected, delinquent medical debt will be “dinged” on their credit reports just as people who took on debt buying discretionary consumer goods.

The Consumer Financial Protection Bureau’s bailiwick includes the authority to write rules that would further the purposes of the Fair Credit Reporting Act. The CFPB is already collecting credit report information on 200,000 individuals from each of the three major CRAs for the purpose of analyzing variations between the scores sold to consumers and those sold to creditors (http://www.consumerfinance.gov/wp-content/uploads/2011/07/Report_20110719_CreditScores.pdf). These efforts could expand to include requiring that CRAs and entities, like FICO, that develop scoring models provide the CFPB with their algorithms, including the inputs and the weights given each variable. This would enable the CFPB to test how well the CRAs predict default risk and the accuracy of their inputs.

The three national CRAs are not the only entities that collect and sell data on consumers. Smaller enterprises collect discrete data on individual borrowers that are not necessarily captured in traditional credit scores. Another role of the CFPB should be to identify these providers, evaluate their methods, and subject them to regulatory oversight.

There is a need to understand the market for the provision of accurate credit scores. In a well-functioning market, you would expect that competition among CRAs would lead to ever more accurate credit scoring models. However, if the marginal gains from: (1) including omitted, predictive variables, (2) insuring the accuracy of data with precision, and (3) scrutinizing weights, is small relative to the efficiency of slightly more crude scoring, CRAs and their clients might prefer the latter course. The result would have a potentially adverse impact on borrowers who are at the cusp of creditworthiness, which would implicate fairness concerns.

With lenders increasingly cautious about granting credit to people with less than pristine credit scores, there is a need to survey and evaluate models other than traditional scoring. This should include approaches taken in other countries, with an emphasis on programs that help low-income borrowers build credit and demonstrate creditworthiness.

I am sure there are other areas in which more understanding is needed and hope people will comment on this post so I can expand my catalog.

Stay tuned: Suffolk Law School Law Review will have a special issue on credit scoring and reporting later this year. (http://www.law.suffolk.edu/highlights/stuorgs/lawreview/index.cfm)

January 18, 2012

Preemption Litigation: What to Expect

Posted by Kathleen Engel

The debate about the legality of Richard Cordray’s appointment to head the Consumer Financial Protection Bureau is just one of many brewing power battles. Another, and the one I am writing about today, is the Office of the Comptroller of the Currency’s preemption ruling.

The OCC has absorbed the Office of Thrift Supervision and, thus, has dramatically increased the number of institutions subject to its enforcement, supervisory and rule-writing authority, which translates into more and louder voices crying for preemption of state lending laws. The OCC already is a poster child for regulatory capture because of its 2004 blanket preemption rule shielding national banks from state laws that were aimed at curtailing costly, unaffordable loans, and deceptive lending practices. It was in response to the OCC preemption rule (and a similar one by OTS) that the Dodd-Frank Wall Street Reform and Consumer Protection Act included provisions aimed at limiting preemption.

Dodd-Frank restricts OCC preemption to situations in which a state consumer financial law: (1) discriminates against national banks in favor of banks chartered in the state; (2) “prevents or significantly interferes with the exercise by the national bank of its power;” or (3) conflicts with federal laws that expressly preempt state laws. Dodd-Frank also requires that any preemption determinations be made case-by-case, based on substantial evidence, and on the record. http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_public_laws&docid=f:publ203.111.

As many of you know, on July 21, 2011, the OCC revised its preemption provisions as required under Dodd-Frank. http://www.occ.treas.gov/news-issuances/news-releases/2011/nr-occ-2011-97.html. Many features of the new OCC rule were in accord with Dodd-Frank’s mandates, but the process that the OCC employed in issuing the rule did not follow the requirements set out in Dodd-Frank.

The OCC did not look at individual state consumer financial laws to determine whether they were preempted on the grounds that they “prevent[ed] or significantly interfere[d]” with national banks’ exercise of their power. The OCC’s position is that the process for issuing preemption rulings is only for prospective rules and that the agency had no obligation to review existing rules. As a result, the OCC kept intact a list of preempted state laws that it had assembled under its former and broader preemption standard. The effect boils down to continued field preemption of state consumer financial laws.

So, why should we expect a battle ahead? When the OCC issued its proposed rule, both the Department of the Treasury—of which the OCC is an arm—and the National Association of Attorneys General opposed the proposed rule. The OCC did not yield. Bets are that Obama’s nominee for Comptroller of the Currency, Thomas Curry, won’t yield either.

Whether Treasury and the CFPB, with Cordray in the driver’s seat, will try to win Curry over is hard to say. The CFPB has its own preemption battle to contend with as consumer advocates protest its interim rule on the Alternative Mortgage Transaction Parity Act, which preempts state laws that restrict nonbank lenders from making loans with balloon payments and other “nontraditional” features. http://www.nationalmortgagenews.com/nmn_features/criticize-cfpb-preemption-1028266-1.html.

The field of play will be the courts where state Attorneys General will likely try to enforce laws that are subject to earlier OCC preemption rules. It will take years for courts to determine the legality of the OCC’s process and its 2011 rule. While the courts sort out these issues, neither lenders nor consumers will know exactly which laws matter.

July 22, 2010

Dodd-Frank: Thanks for a great forum!

Posted by Usha Rodrigues

On behalf of the Glom, we'd like to thank our Masters for a great forum on the Dodd-Frank Act. It's hard for anyone to make sense of 2,300+ pages, but I think we've all come away with a richer understanding of what's in there, why, and what's coming next. You can find all of the posts consolidated here.

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Dodd-Frank Forum: Proxy Access and Judging Success

Posted by Lisa Fairfax

So yesterday Erik asked me how I would judge whether proxy access is a success. It is a question I have been thinking about for some time. And not just with respect to proxy access, but also with respect to the overall bill--but I will leave the latter one for another day! Especially because I ultimately think it may be difficult to judge whether or not proxy access has proved successful. On the one hand, while proxy access advocates certainly insist that such access will enhance corporate governance and reduce instances of corporate malfeasance, I am pretty sure that none of them would measure the success of proxy access in terms of whether or not it served to prevent the next crisis or otherwise led to dramatically enhanced corporate performance at most public companies. Indeed, it is entirely possible that any "success" will only be at the margins, and hence very difficult to measure. On the other hand, it is probably the case that many opponents of proxy access do not expect that it will single-handedly bring about the demise of the public corporation as we know it. However, it is also completely possible that proxy access will enable some shareholders to gain influence over corporate affairs and directors in a manner that is counter-productive and even potentially harmful. So I suppose we measure success with a balancing test: have shareholders been able to hold directors accountable without holding them hostage, or otherwise undermining the best interests of the corporation as a whole? I am not sure how one answers that question (which means in answer to one of Erik's other questions--I definitely will be teaching the reform bill and issues related to proxy access). However, I am fairly sure that, if implemented by the SEC, the debate over whether or not proxy access has been a success will be as hotly contested as the debate about the benefits of proxy access.

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Dodd-Frank Forum: Reforming Asset Securitization

Posted by Christine Hurt

So, a million years ago I worked on a few asset securitizations. Our assets were used car loans, which actually have a really high default rate. But there wasn't any used-car securities crisis. But, following the 2008 Financial Crisis, asset-backed securitizations (ABS) seemed extremely dangerous, particularly securitizations of residential mortgages. (If there is anyone out there who hasn't read Michael Lewis' description of the growth of this industry in Liar's Poker, please remedy this right now.) Mortgage-backed securities (MBS) because the "special purpose vehicle" of the 1008 crisis. But what made them so dangerous?

First of all, it was an extremely large market, so when the stress hit the underlying asset, mortgages, it affected a large number of investments, all in the same way. Also, the housing market works in tandem with the economy as a whole, so downturns in the housing market seems very sensitive to stresses int he economy as a whole. OK, but a lot of investments go bad. Why are these special? One argument is that the the underlying assets were a lot worse than the investors thought. First, the incentives of the loan broker/originator to originate a risky loan and pass it off as OK. Then, the incentives of the "securitizer" (a new word from Dodd-Frank) to pass of a bunch of risky loans to investors as OK. Then, the credit ratings agencies did a bad job of rating the securities. Then, the investors who suspected the risk of the asset thought they hedged their risk with credit default swaps, perhaps not realizing that everyone else was swapping with the same, not-so-creditworthy counterparties. So, any reform would at the very least need to fix the incentives of the originators and securitizers and the transparency of the asset. (I'll leave the credit ratings agency reforms to someone else!)

And Dodd-Frank actually seems to hit the nail on the head here. Section 941 requires securitizers and originators to retain a portion of the credit risk for any asset securitized or any slice of a slice of a slice of an asset that is securitized. For many ABS, this will mean not less than 5% of the credit risk. Now, how will this be measured? Not sure. But, I do know that the securitizer/orginator may not hedge that retained risk. So, theoretically, if you have to hang on to the underlying assets, you will be somewhat picky about what assets you securitize. But, here's the kicker. There will be an exception for "qualified residential mortgages." These mortgages will be the least risky, so if your asset pool is made up entirely of qualified residential mortgages, then you are exempt from risk retention.

In addition, Section 941 authorizes the SEC to promulgate new regulations on disclosures of registered ABS, including risks at the asset level or loan level, if the assets are loans. Also, disclosures would identify loan brokers and originators and the compensation system for the brokers and originators. Also, issuers would disclose their level of risk retention. These seem like good disclosure requirements.

One of Larry Ribstein's threshold questions for Dodd-Frank is whether the market would have regulated this better. This could be an empirical question. For issuances of ABS or MBS in the past 18 months, what have disclosures looked like? Have issuers begun to compete by claiming that their underlying loans are particularly strong on various fronts or that the issuer is retaining ownership in the assets or in the risk of the assets. I'm not sure if this market has rebounded enough for us to measure what investors are demanding in bond indentures for these types of issuances, for example.

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July 21, 2010

Dodd-Frank Forum: The Role of Derivatives in Failing Firms

Posted by Michelle Harner

Erik correctly sensed my wariness regarding the treatment of derivatives under the U.S. Bankruptcy Code and the new resolution authority granted the federal government under the Dodd-Frank Act. (By the way Erik, great job posing thoughtful questions and fostering additional discussion in the forum; thanks!) In my previous post, I noted that both resolution schemes contain exceptions (a/k/a “safe harbors”) for derivatives and counterparty obligations, and I provided a link to Mark Roe’s article concerning potential issues with that treatment. Accordingly, Erik posed the following question:

Michelle: What do you think of Mark Roe’s argument that providing various exemptions in Ch. 11 (from the automatic stay) for derivative counterparties exacerbated the crisis? Did these exemptions warp the incentives of derivatives counterparties to monitor and discipline debtors? Is this a hole in Dodd-Frank?

I generally agree with Mark Roe’s characterization of the derivative exceptions and the need to remedy this problem under the Bankruptcy Code. As it stands, counterparties have the ability basically to dismantle a financial institution by invoking netting, liquidation, termination and other rights under their derivative contracts as that financial institution becomes more distressed and even after it files for bankruptcy. As Erik’s comment implies, the automatic stay, the prohibition against the enforcement of ipso facto clauses and the threat of avoidance actions in bankruptcy generally do not apply to counterparties. As a result, counterparties can protect their economic interests at the direct expense of the debtor and its other stakeholders.

The Dodd-Frank Act incorporates similar exceptions for counterparties and allows counterparties to exercise many of their contractual rights after a short grace period (one business day). Nevertheless, the Act does impose some limitations on counterparties that are uncertain under the Bankruptcy Code (see, e.g., here). For example, the Act restricts the enforcement of walkaway provisions—i.e., provisions that allow the nondefaulting party to suspend obligations owed to the defaulting party or forego any payments due to the defaulting party upon termination of the contract. So perhaps the Act recognizes some of the vast inequality created by the derivative exceptions, but I do not think it goes far enough.

From my perspective, inequality and the resulting consequences are the real reasons for concern. One of the bedrock principles of the Bankruptcy Code is similar treatment for similarly-situated creditors; it helps protect both the debtor and its stakeholders by, for example, ensuring that creditors are not rewarded for high-pressured tactics immediately before bankruptcy and providing some incentive for creditors to work together to maximize their collective return. The derivative exceptions undercut this principle and grant counterparties far greater rights than ordinary secured or unsecured creditors. I recognize that counterparties face challenging issues in a bankruptcy or liquidation scenario, but I do not believe that the burden of those issues should be placed on the shoulders of the debtor and its other stakeholders.

As to Erik’s other questions, I am uncomfortable grading the legislation as I view it as largely incomplete. The extent of its success (and it could be successful at the end of the day) depends so heavily on things yet unknown—e.g., who writes the rules; the content of the rules; and if and how they are enforced. Would I have voted for the legislation? It depends (yes, the dreaded lawyer answer). Analyzing a piece of legislation as an academic versus a politician requires similar yet very different considerations. Among other things, it would depend on the interests of my constituents and what I thought was best for my district. And finally, I will absolutely incorporate the legislation into my fall courses. I think it is important for our students to understand the import not only of this piece of legislation, but also the legislative process more generally, for businesses and consequently their future clients.

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