Harvard Business Law Review (HBLR)

The Harvard Business Law Review (HBLR) aims to be the premier journal covering the laws of business organization and capital markets. HBLR will publish articles from professors, practitioners, and policymakers on corporate law and governance, securities and capital markets law, financial regulation and financial institutions, law and finance, financial distress and bankruptcy, and related subjects.

You are here: Home

By

Memorandum to the Compliance Counsel, United States Department of Justice

Download PDF

Jonathan J. Rusch†

Introductory Note

Since 1977, with the enactment of the Foreign Corrupt Practices Act, the United States Department of Justice has played a leading role with the Securities and Exchange Commission in applying the Act’s anti-bribery, books and records, and internal controls provisions in enforcement proceedings against numerous companies and individuals worldwide. In November 2015, the Department of Justice took the unprecedented step of hiring a Compliance Counsel with experience in both federal prosecution and corporate compliance. Her role is to guide its prosecutors in decision-making in corporate prosecutions, including the existence and effectiveness of a company’s compliance program, and in benchmarking corporate compliance. This Memorandum is composed as an open letter to the Compliance Counsel, focusing on how she and the Department of Justice should go about that critical benchmarking function.

* * *

Dear Compliance Counsel Chen,

Congratulations on your appointment as the Department of Justice’s Compliance Counsel.[1] As you know, the Department of Justice (the Department) has earned a global reputation for aggressively pursuing corporate misconduct through the Foreign Corrupt Practices Act (FCPA) and other major corporate investigations such as the London Interbank Offered Rate (LIBOR) and foreign exchange market (FX) investigations.[2] Its track record in FCPA cases includes successful criminal prosecutions of individuals and companies, record criminal penalties, and substantial civil sanctions by the Securities and Exchange Commission (SEC).[3] Contrary to claims “that foreign bribery is committed by salespeople in the field, breaking the law despite strong compliance policies and robust supervision,”[4] the Department’s prosecution record includes many examples of corruption schemes that senior corporate leadership authorized, and in some cases even directed, including bribery of foreign officials over extended periods.[5]

You are charged with two primary duties: (1) providing expert guidance to the Fraud Section prosecutors regarding the prosecution of business entities, including those entities’ current compliance programs; and (2) assisting prosecutors in establishing appropriate benchmarks for corporate compliance.[6] Both of these functions are important for effective anti-corruption enforcement. As an ex post function, the former is of substantial interest to individuals and companies under criminal investigation. As an ex ante function, the latter should be of even greater interest to a vast spectrum of companies, here and abroad. As your Section Chief indicated, you are expected to be “benchmarking with various companies in a variety of different industries to make sure we have realistic expectations . . . and tough-but-fair ones in various industries.”[7]

This Memorandum will not offer guidance to the Department on how to exercise prosecutorial discretion in FCPA investigations—not least because the Yates Memorandum[8] has made clear how substantially the Department has changed its approach to conducting corporate investigations.[9] Rather, it will provide an outline of how you and the Department could perform the ex ante function of benchmarking and guidance. If some of the steps outlined here seem obvious, please consider that elaborating the obvious, along with the subtle, would be beneficial for both the Department and companies in setting clear expectations for corporate compliance programs.

I.          Define What the Department Means by “Benchmarking”

Although the term “benchmarking” is commonly used in corporate compliance discussions,[10] it can mean several different types of comparisons, and the choice of benchmarking type can have significantly different effects on the expectations that it creates in the mind of the organization doing the benchmarking.

Department policy states that one of the fundamental questions a prosecutor should ask about a corporation’s compliance program is whether it is “well designed.”[11] To make that determination, the policy refers prosecutors to five factors:

[T]he comprehensiveness of the compliance program; the extent and pervasiveness of the criminal misconduct; the number and level of the corporate employees involved; the seriousness, duration, and frequency of the misconduct; and any remedial actions taken by the corporation, including, for example, disciplinary action against past violators uncovered by the prior compliance program, and revisions to corporate compliance programs in light of lessons learned.[12]

These factors clearly are intended as ex post factors to be applied in deciding whether a company’s compliance program is so deficient that criminal prosecution may be appropriate. Compliance professionals also need the Department to issue clearly articulated ex ante guidance and standards on which companies can rely as examples of responsible corporate conduct. As a 2015 KPMG global survey of corporate risk leaders found, there has been “a sharp increase in the proportion of respondents who say they are highly challenged by the issue of [Anti-Bribery and Corruption]” compared with a survey four years earlier.[13]

Here are some of the principal categories of business benchmarking that the Department should consider:

External Benchmarking. This involves analyzing “best in class outside organisations, providing the opportunity to learn from those at the leading edge.”[14] This is the type that probably comes most readily to mind, and seems the most intuitively appealing—“Why not learn from the best?,” so to speak. But three caveats are in order. First, this type of benchmarking can involve implicit decisions about what makes certain organizations “best in class” for certain corporate compliance functions. Second, the Department’s own experiences with corporate investigations show that companies with a general “best in class” reputation (in terms of size or profitability) can still have significant deficiencies in their compliance programs. Third, solutions that work effectively for very large companies may not be practicable for smaller companies that cannot afford the necessary resources or technology to implement them. What is “best in class,” then, may not be intuitively obvious.

Internal Benchmarking. This “involves benchmarking businesses or operations from within the same organisation (e.g. business units in different countries).”[15] On first reading, this type of benchmarking may not seem worthwhile to pursue. If a compliance program is found deficient in one business unit within a company, examining how that program works in other business units of that company might seem pointless. Intra-corporate benchmarking, however, could be useful to the Department. If, in examining a particular company’s compliance program, the Department finds significant variations between units or product lines, those variations could be instructive in identifying flaws the company should fix or enhancements the company should adopt, and in determining whether ongoing monitoring is necessary. The Department may also find that, within the same company, one type of compliance program has “best in class” features that could be transplanted into other compliance programs—say, anti-money laundering or Bank Secrecy Act program features that could work in the anti-corruption context.

Performance Benchmarking. This “looks at performance characteristics in relation to key products and services in the same sector.”[16] Although the Department does not set production performance standards—for example, how many units per hour should be produced—it could use performance benchmarking to identify features of compliance programs that yield quantitatively measurable results, such as above-average detection of instances of potential misconduct or numbers of corruption-related Suspicious Activity Reports (SARs).

Strategic Benchmarking. This “involves examining long-term strategies, for example regarding core competencies, new product and service development or improving capabilities for dealing with change.”[17] Standard components of corporate compliance programs, such as risk assessment processes and internal controls, may come to mind first here. But the Department’s methodology could also include strategic approaches recommendable to companies developing or improving compliance programs. This concept is already reflected, to a limited degree, in the Department’s Principles for Prosecution of Business Organizations, which states that prosecutors should determine “whether the corporation’s employees are adequately informed about the compliance program and are convinced of the corporation’s commitment to it.”[18]

II.          Decide How The Department Will Benchmark with Companies

If you are to benchmark with various companies in different industries in order to set “realistic” and “tough-but-fair” expectations,[19] the Department might want to consider actual in-person meetings with companies to elicit information. In-person meetings are likely to yield far more information than just open-source research into compliance programs. And detailed information about compliance programs is unlikely to be available in open-source materials. That may be because companies see competitive advantages in keeping their competitors guessing about what makes their compliance programs successful, or simply are cautious about disclosing potentially sensitive information.

If the Department wants in-person meetings with companies that move beyond superficial pleasantries, it should inform companies of the ground rules it sets for such meetings. Companies need solid assurances that if they are to be candid and specific about their programs, the Department will not publicly share that specific data.[20] If you need to tell companies that their statements are not “off the record”—that is, that there is no immunity for any statements that they make during these benchmarking sessions—you need to be clear about that, too. Such clear ground rules may deter some companies from participating, but encourage many other companies to benchmark.

One approach that may appeal to some companies is to offer benchmarking discussions in group meetings. Of course, if asked to meet with the Department when their competitors are present, companies in the same industry may become concerned about disclosure of confidential or sensitive information and therefore provide only generic statements. On the other hand, some companies may find comfort in knowing that they are receiving the same information from the Department as their competitors. The Department should therefore consider holding exploratory discussions with representatives of industry associations, and see whether individual companies would prefer individual or group benchmarking sessions.

If the Department decides to consider group benchmarking, you should also consider opening some of those meetings to organizations other than the Department and industry representatives. Unlike the traditional notice-and-comment process in federal agencies—where advance notice and opportunity for public comment on proposed rules are routine[21]—the Department does not make it a practice to provide the public with an opportunity for advance comment on its key enforcement policy statements and compliance guidance.[22] In this case, however, an additional infusion of transparency into your process could enhance the Department’s private sector credibility.

III.          Set Priorities for Your Benchmarking

In its process, the Department has to set limits on how many industries, and how many companies within those industries, it can benchmark. With tens of thousands of companies listed on major exchanges throughout the world,[23] it realistically cannot obtain a representative sample across all leading industries. Nor should it try to do so. As a starting point, you might consider drawing on external sources, such as the OECD Foreign Bribery Report[24] and related records of corporate prosecutions, to select an initial list of industries. The Department could then decide where to concentrate, based in part on its experience with industries that face the greatest bribery and corruption risks—for example, those industries encountering regulatory barriers to entry created by foreign agencies with vast and unconstrained discretion.

Whichever industries you select, if the Department expects you to provide more specific guidance on what level of compliance program is appropriate for a business’s risk level, you also need to set realistic expectations on how specific your guidance can be, absent a vast increase in your staffing. As the Department’s and the SEC’s FCPA Resource Guide properly notes, “each compliance program should be tailored to an organization’s specific needs, risks, and challenges”:[25]

Individual companies may have different compliance needs depending on their size and the particular risks associated with their businesses, among other factors. When it comes to compliance, there is no one-size-fits-all program. . . . [S]mall- and medium-size enterprises likely will have different compliance programs from large multi-national corporations, a fact DOJ and SEC take into account when evaluating companies’ compliance programs.[26]

For that reason, your best approach may be to urge the Department to take key concepts of corporate compliance that it has previously issued—such as the FCPA Resource Guide’s often-cited “Hallmarks of Effective Compliance Programs”[27]—and explore those to see what additional guidance may be most useful to businesses. Here are some of those concepts:

A.          Commitment from Senior Management and a Clearly Articulated Policy Against Corruption[28]

The FCPA Resource Guide and public remarks by Department officials stress the importance of corporate commitment to a “culture of compliance.”[29] These statements typically fall into one of three categories.

1.          Statements About Organizational Process. These are generic admonitions stating that senior management must make a commitment to a “culture of compliance” and see that their commitment is reinforced and implemented at all levels of their business with process steps such as the following: “clearly articulate company standards, communicate them in unambiguous terms, adhere to them scrupulously, and disseminate them throughout the organization.” [30]

2.          Statements About the Benefits of a Culture of Compliance. These are comments of a predictive and aspirational nature, such as: “A strong ethical culture directly supports a strong ethical compliance program. By adhering to ethical standards, senior managers will inspire middle managers to reinforce those standards. Compliant middle managers, in turn, will encourage employees to strive to attain those standards throughout the organizational structure.”[31]

3.          Statements About the Causes of Process Failure. These are more admonitory statements, intended to distinguish well-designed and executed compliance programs from programs where corporate behavior fails to measure up. For example, according to the FCPA Resource Guide, failure of effective implementation “may be the result of aggressive sales staff preventing compliance personnel from doing their jobs effectively and of senior management, more concerned with securing a valuable business opportunity than enforcing a culture of compliance, siding with the sales team.”[32]

However, each of these categories lacks a definition of “culture of compliance.” In this regard, the Criminal Division is not alone. Other Department components and agencies have talked around the concept, without coming any closer to the heart of the idea.[33] Perhaps these representatives have in mind a functional definition of “culture of compliance;” that is, if an organization adopts and implements a detailed compliance program, and vigorously and consistently enforces that program, that constitutes a “culture of compliance.” The Department, however, should aspire to more than that, if it means those words to be more than a casual buzz phrase.

Your challenge, then, is to decide how the Department could meaningfully define “culture of compliance.” One starting point is a classic definition of “culture”: “that complex whole which includes knowledge, belief, art, morals, law, custom, and any other capabilities and habits acquired by man as a member of society.”[34] Each of the elements of this definition stacks up nicely in relation to the basic requirements of corporate compliance. Knowledge of relevant laws and corporate policies are essential for effective compliance programs. But so is the belief that such laws and policies must be followed not only because of the penalties for noncompliance, but also because the company’s values and principles align with that law and policy, and are grounded in basic moral principles (such as, “We don’t need to lie to customers or the public, or bribe people, to do business.”). And company values, if thoroughly communicated and reinforced by senior executives and middle managers in intra-company communications, can become custom over time, and become so much a part of everyday behavior inside the company that law-abiding actions become habitual. As one financial services company puts it, culture is

understanding our vision and values so well that you instinctively know what you need to do when you come to work each day.

Culture is the attitude we bring to work every day—the pattern of thinking and acting with the customer in mind. It’s the habit of doing the right things, and doing things right. It’s a thousand behaviors inherited from team members who came before us, behaviors that we model today and then pass on as our legacy for team members who come after us. It’s behaviors and attitudes that are core to who we are . . . .[35]

If this approach rings true with you, consider also that the Department will need to proceed carefully in defining “culture of compliance.” Enforcement officials and compliance experts often refer to “building a culture of compliance.”[36] With respect, no organization can “build” an internal and sustainable culture like assembling a set of Lego® blocks. Like a garden, an organizational culture requires cultivation—preparation of the ground, seeding, fertilization, regular supplying of nutrition, and constant scrutiny to weed out unwanted hosts and to control invasive species.[37] The best approach for the Department, then, would be to see what it can learn from benchmarking from various companies—seeing how they define their key organizational values and translate those into elements of their compliance programs—and then identify examples of how companies, regardless of size, can articulate and implement their own “cultures of compliance.”

B.          Code of Conduct and Compliance Policies and Procedures[38]

The next hallmark in the FCPA Resource Guide that warrants discussion stresses the importance of a corporate code of conduct and compliance policies and procedures.[39] The FCPA Resource Guide states: “As DOJ has repeatedly noted in its charging documents, the most effective codes are clear, concise, and accessible to all employees and to those conducting business on the company’s behalf.”[40] Clarity, of course, is always important, but concision may not be achievable in every case. Depending, among other things, on a company’s size, geographic dispersion, and complexity of its operations, a company may need to be relatively more prescriptive and terse in stating its requirements for law-abiding conduct. Further guidance on how to strike a suitable balance between clarity and concision—again, drawn in part from your benchmarking sessions—would therefore be useful.

The FCPA Resource Guide’s paragraph on compliance policies and procedures is more instructive because it concisely identifies key components of such policies and key risks that such policies should address. Because the FCPA Resource Guide notes that “[t]hese types of policies and procedures will depend on the size and nature of the business and the risks associated with the business,”[41] your benchmarking efforts should seek to identify factors that would justify differences in the length and detail of such policies and procedures.

C.          Oversight, Autonomy, and Resources[42]

The next FCPA Resource Guide hallmark states the need for one or more senior executives, with appropriate autonomy and resources, to oversee a corporate compliance program.[43] Because what constitutes “appropriate autonomy and resources” may vary widely for smaller and larger companies, the language in this section is too general and laden with contingency—for example, a single paragraph in this section indicates three times that it will “depend” on circumstances.[44] Benchmarking on this hallmark would be more useful if it concentrates on identifying examples of suitable practices to ensure sufficient oversight, autonomy, and resources in companies of different sizes. For example, while a number of large companies have now separated their risk and compliance functions from their legal departments, smaller companies may need to decide whether and how they can leverage their legal departments to be effective overseers of risk and compliance.

In conducting its benchmarking on this hallmark, the Department should assume that many companies may be willing to discuss who is overseeing and implementing compliance programs, but skittish about sharing data on how many dollars they put into their compliance resources. If you can look into the latter topic, you may be able to identify percentage data that could be useful for companies of various sizes. For example, “We found that for companies with annual revenues of less than $50 million, those companies that appeared to have effective compliance programs typically devoted between A and B percent of their annual budgets, while for companies with annual revenues of $500 million or more, those companies that appeared to have effective compliance programs typically devoted between C and D percent of their annual budgets.” Guidance that suggests a range of acceptable resource commitments, with appropriate caveats, could be particularly meaningful.

D.          Risk Assessment[45]

The next hallmark, on assessment of risk, may be both the most valuable and the most frustrating guidance in the entire FCPA Resource Guide. This section contains a number of helpful comments that emphasize the need for a risk-based approach to risk assessment: underscoring the importance of avoiding “too much focus on low-risk markets and transactions to the detriment of high-risk areas”; warning that “performing identical due diligence on all third-party agents, irrespective of risk factors, is often counterproductive, diverting attention and resources away from those third parties that pose the most significant risks”; and noting that “[w]hen assessing a company’s compliance program, DOJ and SEC take into account whether and to what degree a company analyzes and addresses the particular risks it faces.”[46]

What makes this section frustrating is the fact that it offers no guidance on how to construct and conduct the risk assessment process, which it emphasizes “is fundamental to developing a strong compliance program.”[47] This is a noteworthy deficiency, as the 2015 KPMG Survey reported that “executives admit that an [Anti-Bribery and Corruption] risk assessment is one of their companies’ top challenges.”[48]

On this issue, the Department could benchmark with various companies, and consult outside experts on risk assessment, to better understand how companies are creating risk assessment processes and methodologies.

That benchmarking should also address how companies should decide what types of data and analysis are appropriate in determining what constitutes a high-, moderate-, or low-risk market for their companies. Many companies appear to rely exclusively on Transparency International’s Corruption Perceptions Index (CPI),[49] perhaps the longest-running measure of corruption risk country-by-country. While the CPI methodology is sound and well-defined for its stated purpose of presenting perceptions of corruption based on expert opinion,[50] the Department should consider offering guidance on the appropriateness of using the CPI as the sole basis to identify high-risk markets, given the FCPA Resource Guide’s emphasis on a company’s addressing “the particular risks it faces.”[51] Other types of bribery and corruption-related risk data may deserve serious consideration, as companies seek to refine their risk assessment processes to identify their particular risks with greater clarity.[52]

E.          Training and Continuing Advice[53]

This hallmark discusses the importance of training and certification “for all directors, officers, relevant employees, and, where appropriate, agents and business partners.”[54] It notes the approach of “many larger companies” in implementing a “mix of web-based and in-person training conducted at varying intervals,” and offers broad comments on the content of such training.[55] What this does not clearly address is the extent to which companies should be adopting a risk-based approach in deciding what quantity, depth, and formats of training should be provided to various officers and employees. U.S.-based finance and human resources employees, for example, likely do not need the same depth of third-party risk training that managers and executives operating in foreign markets need. Nor do executives in low-risk business lines need the same depth and frequency of training as executives in high-risk business lines. Your benchmarking efforts should therefore explore how the Department can provide more specific guidance on this point.

F.          Incentives and Disciplinary Measures[56]

This hallmark heavily emphasizes companies’ effective enforcement of their compliance program. It notes that “DOJ and SEC will . . . consider whether, when enforcing a compliance program, a company has appropriate and clear disciplinary procedures, whether those procedures are applied reliably and promptly, and whether they are commensurate with the violation.”[57] Here, your benchmarking activities could focus on identifying examples of what the Department considers “appropriate and clear disciplinary procedures,” “reliabl[e]” and “promp[t]” application of such procedures, disciplinary measures that would be “commensurate with the violation,” and fair and consistent application of disciplining and incentivizing across the organization.[58] The easy case, from an enforcement perspective, would be a situation in which a company fires or otherwise sanctions lower-level employees for wrongdoing, while leaving untouched high-level executives who authorized a course of wrongdoing. Responsible senior management, however, would want no part of such a situation, and therefore would welcome some more specific examples of best practices for disciplining misconduct and incentivizing exemplary conduct.

G.          Third-Party Due Diligence and Payments[59]

This hallmark properly notes the frequency with which third parties are used as conduits, cutouts, or “bagmen” to conceal the transmission of bribes to foreign officials, and specifically refers to the need for “[r]isk-based due diligence” with third parties.[60] Even though this section contains an extended discussion of guiding principles for conducting risk-based due diligence,[61] you should consider conducting extensive benchmarking on this topic, including identifying specific best practices that address those principles. The 2015 KPMG Survey reported that, according to its respondents, “management of third parties poses the greatest challenge in executing [Anti-Bribery and Corruption] programs,”[62] and that “more than one[-]third of the respondents do not formally identify high-risk third parties.”[63]

Moreover, guidance on what constitutes appropriate due diligence with regard to third parties needs to acknowledge that third parties vary widely in their size and complexity. For example, companies whose operations depend on third parties with multiple tiers, such as distribution channels, would appreciate clear guidance on law enforcement agencies’ expectations about how far due diligence should go through those levels.[64]

H.          Confidential Reporting and Internal Investigation[65]

This hallmark briefly discusses the need for a mechanism for employees to report suspected or actual misconduct confidentially and without fear of retribution, and a suitable process for investigating such allegations and documenting the company’s response.[66] Even if this discussion seems to raise points requiring no further explanation, your benchmarking could be useful in identifying examples of effective confidential-reporting approaches and of organizational designs that ensure prompt and effective investigations of reported misconduct.

I.          Periodic Testing and Review[67]

This hallmark correctly states that “a good compliance program should constantly evolve.”[68] Senior executives need to recognize that systematic misconduct within a company does not spring up spontaneously, but is the outcome of an evolving process that can owe as much to gradual erosion of business ethics as to individual decisions by corporate executives.[69] Sound compliance programs should be continuing processes that change as business lines expand, and risks and risk appetites change.

Here, your benchmarking on this subject could include a search for examples of sound internal controls that companies of different sizes could effectively implement, including a detailed examination of data analytics as a key component of internal controls. The 2015 KPMG Survey found that even though “data analytics is an increasingly important and cost-effective tool to assess [Anti-Bribery and Corruption] controls,” “only a quarter of respondents use data analysis to identify violations and, of those that do so, less than half continuously monitor data to spot potential violations.”[70] The Department should therefore underscore its interest in data analytics and provide guidance to companies on that topic.

J.          Mergers and Acquisitions, Pre-and Post-Acquisition[71]

The final hallmark in the FCPA Resource Guide has two key elements. First, it broadly identifies the risks that a company creates when it conducts inadequate pre-transaction due diligence in mergers and acquisitions. Second, it highlights the Department’s and the SEC’s interest in prompt post-acquisition integration of the merged or acquired entity into the remaining entity’s internal controls, including its corporate compliance program.[72]

Considering how substantial the risks may be to acquirers, including the prospect of imposition of successor liability, the guidance in this section is overly thin. Your benchmarking here should seek to identify the types of constraints under which law-abiding companies must operate in a pre-transaction environment, where corporate executives overseeing the negotiations may be operating under intense time pressures, and highlight compliance practices and approaches that are likely to be effective in identifying or discouraging potential misconduct despite those constraints.

This section also does not address whether the Department considers this guidance to reflect a risk-based approach. The Department should clarify its views on that issue after benchmarking, as the logic of its insistence on a risk-based approach to compliance in other areas should apply to the M&A context as well.

IV.          Publish the Results of Your Benchmarking and Compliance Guidance in a Single Document

This is the final step, on which the credibility and value of the other steps in your process will largely depend. Improving the Department’s knowledge base is always a useful exercise, but the Department needs to share the fruits of its labors—more precisely, the specific conclusions and expectations that it develops from the benchmarking process—with the public, by publishing it in a single document.

Last year, a senior Department official stated that “[w]henever possible, we try to communicate clear guidance to the corporate community through our criminal resolutions, our interactions with companies and their counsel during an investigation or prosecution and other channels such as [public] conferences . . . .”[73] With due respect, that approach does not result in clear ex ante guidance to companies. In individual cases, documentation of a corporate criminal resolution can be illuminating about certain actions that led to, or constituted, criminal conduct. But it tells interested readers only what went wrong—not why things went wrong, or how law-abiding companies should improve their compliance efforts to avoid the same fate.

As for interactions with companies during investigations and prosecutions, whatever guidance Department prosecutors convey to corporations in nonpublic negotiations stays behind closed doors for most of the corporate world. That guidance may be useful to an individual company under investigation—though it will likely oppose disclosing any details of its alleged wrongdoing or the remedial steps it is required to take, other than what the resolution of that investigation requires it to disclose. And it will certainly be useful to the outside counsel representing the company, who can use the knowledge gained behind closed doors to represent other companies in future Department investigations. But if the guidance does not find its way into public documents, other companies not involved in the proceeding will not benefit from it.

Finally, the Department’s willingness to allow its prosecutors to speak and write publicly about corporate compliance issues is commendable. The problem here is not the quality or good intentions of the speakers, but the randomness of the creation of additional fragments of guidance, especially when different officials make different points about compliance at different times. As a result, companies and lawyers must pore over a farrago of data sources, like Roman haruspices poring over the entrails of sacrificial animals, to divine what the Department means to say about corporate compliance. And such divination is no easy matter. Public remarks by Departmental officials of various ranks must be scrutinized and compared with numerous press releases and supporting documents for criminal prosecutions, while exploring the Department’s more general public guidance, ranging from the Fraud Section’s FCPA published opinions[74] to the Antitrust Division’s Business Review Letter process.[75]

None of this implies that Department officials should stop announcing corporate criminal resolutions, providing closed-door feedback to companies under investigation, or writing and speaking about corporate compliance. But the Department and the SEC should also collect their cumulative experience and guidance on corporate compliance into as few places as possible, and periodically update that collection. For foreign bribery and corruption matters, the FCPA Resource Guide has been a substantial step in that direction, but has proved to be too brief in presenting its much-touted hallmarks of compliance. Whether incorporated into a revised FCPA Resource Guide or maintained as a separate public document, your benchmarking efforts should seek to make the information costs for companies as low as possible.

In conclusion, the best of luck to you in your work. Although some have been dubious about the concept of a Compliance Counsel, you can make a significant contribution by helping the Department to develop clarified, refined, and clearly communicated expectations about compliance practices.
Sincerely,

Jonathan J. Rusch

 

† Senior Vice President and Head of Anti-Bribery & Corruption Governance, Wells Fargo, Washington, D.C.; Adjunct Professor, Georgetown University Law Center; Lecturer in Law, University of Virginia Law School. Formerly Deputy Chief for Strategy and Policy, Fraud Section, Criminal Division, U.S. Department of Justice. The views in this paper—which stem from an October 2, 2015 presentation at the American Society of International Law Anti-Corruption Interest Group Workshop—are solely those of the Author, and do not necessarily represent those of Wells Fargo or the U.S. Department of Justice.

[1] On November 3, 2015, the Department retained Hui Chen, a former federal prosecutor and global head of anti-bribery and corruption at Standard Chartered Bank, as compliance counsel in the Fraud Section of the Department’s Criminal Division. In addition to her service as a Department of Justice Trial Attorney and an Assistant United States Attorney, Chen also served as an Assistant General Counsel of Pfizer and a senior attorney at Microsoft. See Press Release, U.S. Dep’t of Justice, New Compliance Counsel Expert Retained by the DOJ Fraud Section (November 3, 2015), https://www.justice.gov/criminal-fraud/file/790236/download.

[2] See LIBOR and FX, U.S. Dep’t of Justice, http://www.justice.gov/criminal-fraud/libor-and-fx (last updated June 12, 2015).

[3] See, e.g., Press Release, U.S. Dep’t of Justice, VimpelCom Limited and Unitel LLC Enter into Global Foreign Bribery Resolution of More Than $795 Million; United States Seeks $850 Million Forfeiture in Corrupt Proceeds of Bribery Scheme (February 18, 2016), https://www.justice.gov/opa/pr/vimpelcom-limited-and-unitel-llc-enter-global-foreign-bribery-resolution-more-795-million; Press Release, U.S. Dep’t of Justice, Alstom Sentenced to Pay $772 Million Criminal Fine to Resolve Foreign Bribery Charges (November 13, 2015), https://www.justice.gov/opa/pr/alstom-sentenced-pay-772-million-criminal-fine-resolve-foreign-bribery-charges; Press Release, U.S. Dep’t of Justice, Hewlett Packard Russia Agrees to Plead Guilty to Foreign Bribery (April 9, 2014), http://www.justice.gov/opa/pr/hewlett-packard-russia-agrees-plead-guilty-foreign-bribery.

[4] Joel Schectman, Compliance Counsel to Help DOJ Decide Whom to Prosecute, Wall St. J.: Risk & Compliance J., (July 30, 2015), http://blogs.wsj.com/riskandcompliance/2015/07/30/compliance-counsel-to-help-doj-decide-whom-to-prosecute/.

[5] See, e.g., Press Release, U.S. Dep’t of Justice, Louis Berger International Resolves Foreign Bribery Charges (July 17, 2015), http://www.justice.gov/opa/pr/louis-berger-international-resolves-foreign-bribery-charges; Press Release, U.S. Dep’t of Justice, IAP Worldwide Services Inc. Resolves Foreign Corrupt Practices Act Investigation (June 16, 2015), http://www.justice.gov/opa/pr/iap-worldwide-services-inc-resolves-foreign-corrupt-practices-act-investigation; Press Release, U.S. Dep’t of Justice, Managing Director of US Broker-Dealer Sentenced for International Bribery Scheme (Mar. 27, 2015), https://www.justice.gov/opa/pr/ceo-and-managing-director-us-broker-dealer-sentenced-international-bribery-scheme.

[6] U.S. Dep’t of Justice, supra note 1 (explaining that the two primary duties of the Department’s Compliance Counsel are (1) “provid[ing] expert guidance to Fraud Section prosecutors as they consider the enumerated factors in the United States Attorneys’ Manual concerning the prosecution of business entities, including the existence and effectiveness of any compliance program that a company had in place at the time of the conduct giving rise to the prospect of criminal charges, and whether the corporation has taken meaningful remedial action, such as the implementation of new compliance measures to detect and prevent future wrongdoing” and (2) “help[ing] prosecutors develop appropriate benchmarks for evaluating corporate compliance and remediation measures and communicating with stakeholders in setting those benchmarks.”); see also Leslie R. Caldwell, Assistant Att’y Gen., U.S. Dep’t of Justice, Remarks at the SIFMA Compliance and Legal Society New York Regional Seminar (Nov. 2, 2015), http://www.justice.gov/opa/speech/assistant-attorney-general-leslie-r-caldwell-speaks-sifma-compliance-and-legal-society.

[7] Schectman, supra note 4.

[8] See Memorandum from Sally Quillian Yates to the Assistant Attorney General, Antitrust Division et al. on Individual Accountability for Corporate Wrongdoing (Sept. 9, 2015), http://www.justice.gov/dag/file/769036/download.

[9] See Sally Quillian Yates, Deputy Att’y Gen., Dep’t of Justice, Remarks at New York University Law School (Sept. 10, 2015) (stating new requirements that, inter alia, (1) “if a company wants any credit for cooperation, any credit at all, it must identify all individuals involved in the wrongdoing, regardless of their position, status or seniority in the company and provide all relevant facts about their misconduct”; and (2) Department attorneys “are to focus on individuals from the start of an investigation, regardless of whether the investigation begins civilly or criminally” and “once a case is underway, the inquiry into individual misconduct can and should proceed in tandem with the broader corporate investigation”), http://www.justice.gov/opa/speech/deputy-attorney-general-sally-quillian-yates-delivers-remarks-new-york-university-school.

[10] See, e.g., Kaiser Associates, Beating the Competition: A Practical Guide to Benchmarking (1988).

[11] U.S. Dep’t of Justice, U.S. Att’y’s Manual § 9-28.800 (1997 ed., rev. Nov. 2015), http://www.justice.gov/usam/usam-9-28000-principles-federal-prosecution-business-organizations.

[12] Id.

[13] See Jimmy Helm et al., KPMG, Anti-Bribery and Corruption: Rising to the challenge in the age of globalization 1, 3 (2015) [hereinafter KPMG Survey], https://www.kpmg.com/NL/nl/IssuesAndInsights/ArticlesPublications/Documents/PDF/Forensic/Anti-Bribery-and-Corruption.pdf.

[14] Types of Benchmarking, British Quality Foundation, http://dev.bqf.org.uk/sustainable-excellence/benchmarking-types (last visited March 2, 2016).

[15] Id.

[16] British Quality Foundation, supra note 14.

[17] Id.

[18] U.S. Dep’t of Justice, supra note 11.

[19] Schectman, supra note 4.

[20] Such assurances, of course, may be more challenging to provide if companies provide written information to the Department in good faith and then find that other entities seek to obtain copies of that information under the Freedom of Information Act.

[21] See, e.g., Office of the Fed. Register, A Guide to the Rulemaking Process, https://www.federalregister.gov/uploads/sites/18/2011/01/the_rulemaking_process.pdf (last visited March 28, 2016).

[22] See, e.g., U.S. Dep’t of Justice, U.S. Att’y’s Manual § 1-1.100 (1997 ed., rev. May 2009), https://www.justice.gov/usam/united-states-attorneys-manual.

[23] See Monthly Reports – Latest Statistics (January 2016 data), World Federation of Exchanges, http://www.world-exchanges.org/home/index.php/statistics/monthly-reports (last visited March 28, 2016).

[24] Organisation for Economic Co-operation and Development, OECD Foreign Bribery Report (2014), http://www.oecd-ilibrary.org/docserver/download/2814011e.pdf?expires=1458940182&id=id&accname=guest&checksum=0B60F084099B54ABA23EAE8512B65786.

[25] Criminal Div., U.S. Dep’t of Justice & Enf’t Div., Sec. and Exch. Comm’n, A Resource Guide to the U.S. Foreign Corrupt Practices Act 57 (2012) [hereinafter FCPA Resource Guide], https://www.justice.gov/sites/default/files/criminal-fraud/legacy/2015/01/16/guide.pdf.

[26] Id.

[27] Id. at 57–62.

[28] Id. at 57.

[29] See, e.g., id.; Marshall L. Miller, Principal Deputy Att’y Gen., Remarks at the Advanced Compliance and Ethics Workshop (October 7, 2014), http://www.justice.gov/opa/speech/remarks-principal-deputy-assistant-attorney-general-criminal-division-marshall-l-miller-0; Stuart F. Delery, Assistant Att’y Gen., Keynote Address at CBI Pharmaceutical Compliance Congress (January 29, 2014), http://www.justice.gov/iso/opa/civil/speeches/2014/civ-speech-140129.html; Brent Snyder, Deputy Assistant Att’y Gen., Remarks at the International Chamber of Commerce/ United States Council of International Business Joint Antitrust Compliance Workshop: Compliance is a Culture, Not Just a Policy (September 9, 2014), http://www.justice.gov/atr/file/517796/download.

[30] FCPA Resource Guide, supra note 25, at 57.

[31] Id.

[32] Id.

[33] See Snyder, supra note 29; U.S. Dep’t of the Treasury, Financial Crimes Enf’t Network, No. FIN-2014-A007, Advisory to U.S. Financial Institutions on Promoting a Culture of Compliance (August 11, 2014), http://www.fincen.gov/statutes_regs/guidance/pdf/FIN-2014-A007.pdf.

[34] 1 Edward B. Tylor, Primitive Culture: Researches Into the Development of Mythology, Philosophy, Religion, Art, and Custom (6th ed. 1871).

[35] Our Culture, Wells Fargo, https://www.wellsfargo.com/invest_relations/vision_values/5 (last visited March 25, 2016).

[36] See, e.g., Snyder, supra note 29, at 5; Charles H. LeGrand, Building a Culture of Compliance (2005), http://www.qualitymag.com/ext/resources/QUAL/Home/Files/PDFs/Building%20a%20Culture%20of%20Compliance.PDF.

[37] See generally U.S. Dep’t of Agric., Nat’l Invasive Species Info. Center, http://www.invasivespeciesinfo.gov/index.shtml (last modified March 16, 2016).

[38] FCPA Resource Guide , supra note 25, at 57.

[39] Id. at 57–58

[40] Id. at 57.

[41] Id. at 58.

[42] Id.

[43] Id.

[44] Id.

[45] Id. at 58–59.

[46] Id. at 59.

[47] Id. at 58. It should be noted that individual FCPA corporate resolutions routinely include detailed provisions on the elements of a required corporate compliance program—sometimes known to FCPA practitioners as “Attachment C”—that include some limited language on the basic elements of a risk assessment process.

[48] KPMG Survey, supra note 13, at 3.

[49] See Corruption Perceptions Index 2015, Transparency International, http://www.transparency.org/cpi2015 (last visited March 25, 2016).

[50] See, e.g., Corruption Perceptions Index 2014: In Detail, Transparency International,

http://www.transparency.org/cpi2014/in_detail#myAnchor2 (last visited March 25, 2016).

[51] FCPA Resource Guide, supra note 25, at 59 (emphasis added).

[52] See, e.g., Richard Rose & Caryn Peiffer, Paying Bribes for Public Services (2015); Karlyn D. Stanley, Elvira N. Loredo, Nicholas Burger, Jeremy N. V. Miles, & Clinton W. Saloga, Business Bribery Risk Assessment (2014), http://www.rand.org/content/dam/rand/pubs/research_reports/RR800/RR839/RAND_RR839.pdf.

[53] FCPA Resource Guide, supra note 25, at 59.

[54] Id.

[55] Id.

[56] Id.

[57] Id.

[58] Id.

[59] Id. at 60.

[60] Id.

[61] See id. at 60–61.

[62] KPMG Survey, supra note 13, at 3.

[63] Id.

[64] Id. at 7–9.

[65] FCPA Resource Guide, supra note 25, at 61.

[66] Id.

[67] Id. at 61.

[68] Id.

[69] See id. at 61–62.

[70] KPMG Survey, supra note 13, at 3.

[71] See FCPA Resource Guide, supra note 25, at 62.

[72] See id.

[73] Leslie R. Caldwell, Assistant Att’y Gen., U.S. Dep’t of Justice, Remarks at New York University Law School’s Program on Corporate Governance and Enforcement (April 17, 2015), http://www.justice.gov/opa/speech/assistant-attorney-general-leslie-r-caldwell-delivers-remarks-new-york-university-law.

[74] See FCPA Opinions, U.S. Dep’t of Justice, http://www.justice.gov/criminal-fraud/fcpa-opinions (last updated June 17, 2015).

[75] See Business Review Letters and Request Letters, U.S. Dep’t of Justice, http://www.justice.gov/atr/business-review-letters-and-request-letters (last updated March 25, 2016).

By

Can Voluntary Price Disclosures Fix the Payday Lending Market?

Download PDF

Jim Hawkins†

I.          Introduction

Eric J. Chang’s provocative article, www.PayDayLoans.gov: A Solution for Restoring Price-Competition to Short-Term Credit Loans, offers a simple, market-based solution to the fundamental problem in payday lending markets—high prices.[1] Chang’s core contribution in the article is to propose “creating a federally operated online exchange (Exchange) for payday lenders to post their rates and for borrowers to apply and receive payday loans.”[2] There is a lot to commend in his approach: it is low-cost, does not infringe on borrowers’ or lenders’ liberties, probably will not constrict small-dollar credit markets, and, perhaps most importantly, tackles the perennial problem of price competition in payday lending markets.

Texas provides evidence that Chang’s approach could be effective. Texas law requires lenders to post pricing information on their websites.[3] Unlike other states, where payday loan prices aggregate near the highest legally permissible rate,[4] Texas appears to have significant price differentiation.[5] If the federal government could establish a successful Exchange, Texas offers hope that disclosures could generate price competition.

This Response, however, offers some evidence from recent empirical research to suggest that an Exchange is unlikely to succeed in facilitating price competition. It also argues that lenders are unlikely to voluntarily participate in the Exchange and, even if they did, many borrowers are unlikely to use the Exchange.

II.          It is Unlikely Payday Lenders Will Voluntarily Participate in a Website Focused on Price Disclosure.

Chang suggests that the law should not coerce lenders into participating in the Exchange.[6] Indeed, a primary selling point of his suggestion to lenders and taxpayers is that “the Exchange imposes neither new laws nor legal regulations on any party . . . and taxpayers will be minimally burdened.”[7] Instead of being forced into disclosing prices on the Exchange, Chang predicts that “payday lenders will voluntarily register with the Exchange in order to reach these potential customers.”[8]

This prediction seems implausible for several reasons. First, payday lenders historically have not voluntarily produced price information for borrowers in other contexts. In the case of payday and title lending storefronts in Houston, Texas, for example, a recent study demonstrated that outdoor advertising contained information about a variety of things: the speed of getting the loan, the loan amounts, and the simplicity of the application process.[9] Even 15.24% of storefronts claimed to have low loan prices.[10] However, not a single storefront portrayed price information in its advertisements that complied with federal law.[11]

Payday lenders have also failed to comply with laws requiring posting price information on the Internet.[12] Texas law mandates that lenders post certain information on their website, including fees, contact information for the state agency that regulates payday loans, and a notice that the loans are intended to be short-term.[13] Out of a sampling of 30 payday lending websites as of the fall of 2014, only 70% contained information about the regulator, 73.3% provided notice that the loans were short-term, and 80% had the required price information.[14] The regulations implementing the law also require that the pricing information be displayed “immediately upon the consumer’s arrival at the credit access business’s website that includes information about a payday or auto title loan.”[15] Shockingly, only 30% of the payday lending websites followed this rule.[16] Thus, even when compelled by law to disclose price information, many payday lenders failed to do so, making the prospects of voluntary disclosure bleak.

Second, it seems unlikely payday lenders will voluntarily post pricing information because, as Chang recognizes,[17] lenders do not think the Truth in Lending Act’s (TILA) APR disclosures fairly communicate price information for payday loans.[18] Borrowers do not borrow money using payday loans for an entire year, even considering rollovers, so lenders understandably dislike using APRs as the baseline to measure the price of these loans.[19] Because a federal website would require disclosures that comply with TILA, payday lenders would have to consciously choose to use what they consider to be a misleading measurement of price.[20] Given their failure to embrace this approach in other areas of business acquisition, it is hard to see them coming to the Exchange to do so.

That said, this problem seems easy enough to solve. The Consumer Financial Protection Bureau (CFPB) could implement rules that make posting prices on the Exchange obligatory in order to obtain the price comparison benefits that Chang seeks. While some lenders likely would violate the law as they do in Texas, more would comply with a mandated disclosure regime than a voluntary one, especially if the consequences of noncompliance were substantial. Implementing the Exchange by force does undermine some of the benefits of Chang’s proposal, but given lenders’ aversion to coughing up price information voluntarily, it seems essential.

III.          Many Borrowers Will Not Use a Web-Based Exchange.

In order to have any substantial positive effect, the Exchange would have to attract a significant portion of the overall payday lending market. A web-based platform, however, would be useless for all the consumers who access payday loans at storefronts. Only around one-third of payday loans are conducted purely online; the rest involve physical trips to storefronts.[21] Thus, at best, Chang’s proposal would enhance price competition for only this third of the market.

Chang anticipates this objection and argues that lenders will have to lower their rates to attract an informed minority of borrowers, so all payday lending customers will benefit.[22] The problem, however, is that lenders could adapt by offering one price online and another price in the storefront.

If a substantial number of borrowers are still obtaining loans in person, lenders will still have to incur all the costs of maintaining storefronts, despite the existence of the Exchange. These continued costs will limit the downward pressure on prices that Chang anticipates.[23]

Slightly tweaking Chang’s proposal might solve this problem. The CFPB could require lenders to post their prices prominently on the outside of their storefronts, much like how gas stations post pricing information in large numbers visible from the road.[24] This complementary solution could reinforce the Exchange’s price competition goals, although lenders’ operating costs would remain relatively high.

IV.          Conclusion

The idea of using the payday lending market to fix the payday lending market is extremely attractive. The problem, however, is that lenders have demonstrated a reluctance to disclose accurate price information even when compelled by law. While skepticism of the efficacy of the CFPB’s proposed regulations in this market should be maintained,[25] more is needed than a purely voluntary regime. If the CFPB mandated disclosures on an Exchange like the one Chang envisions and required lenders to display the same pricing information prominently on storefront signs, Chang’s market-based solution could potentially improve price competition in the payday lending market. As it stands, however, it seems clear that fixing payday lending markets will take more than relying on voluntary price disclosures.

 

† Associate Professor of Law, University of Houston Law Center. I’m thankful to David Kwok, Megan Neel, and Teddy Rave for comments on this Response.

[1] Eric J. Chang, www.PayDayLoans.gov: A Solution for Restoring Price-Competition to Short-Term Credit Loans, Harv. Bus. L. Rev. Online, https://journals.law.harvard.edu/hblr//2015/12/www-paydayloans-gov-a-solution-for-restoring-price-competition-to-short-term-credit-loans/; see Jim Hawkins, Credit on Wheels: The Law and Business of Auto-Title Lending, 69 Wash. & Lee L. Rev. 535, 592 (2012) (arguing that “price is a powerful justification for banning title lending”).

[2] Chang, supra note 1, at 11.

[3] Tex. Fin. Code § 393.222(a)(1)–(3) (2015).

[4] Sheila Bair, Univ. of Mass. at Amherst, Isenberg Sch. of Mgmt., Low-Cost Payday Loans: Opportunities and Obstacles 29 (2005), https://folio.iupui.edu/bitstream/handle/10244/101/FEs3622H334.pdf (“The vendors we studied charged the maximum allowed in states where the product is permitted.”).

[5] After several hours looking for prices in Houston one day, I found rates ranging from a 271% annual percentage rate (APR) to a 1,151% APR. Jim Hawkins, Are Bigger Companies Better for Low-Income Borrowers?: Evidence from Payday and Title Loan Advertisements, 11 J.L. Econ. & Pol’y 303, 315 (2015).

[6] Chang, supra note 1, at 14.

[7] Id.

[8] Chang, supra note 1, at 11.

[9] In the fall of 2014, I gathered information about the advertising outside 189 payday and title lending storefronts in Houston, Texas. Jim Hawkins, Using Advertisements to Diagnose Behavioral Market Failure in the Payday Lending Market, 51 Wake Forest L. Rev. (forthcoming 2016) (manuscript at 20) (on file with author). Six research assistants took pictures of all the signs on or around the storefronts between September 14 and October 30, 2014, and we categorized the content of the advertisements. Id. at 19–21.

[10] Id. at 30.

[11] See id. at 34 (“6.71% (n=11) of the storefronts we visited stated the price of the loan, and this number includes 2 storefronts of a company that advertised ‘0% interest loans on select products,’ although this advertisement most likely is just a teaser rate. The remaining 9 storefronts were all with the same company, and the advertisement of the price stated an inaccurate price in large font with the correct price in extremely small font.”). Under the Truth in Lending Act, if a lender states the price of a loan in an advertisement, the lender must state the price in terms of an annual percentage rate. 15 U.S.C. § 1664(d) (2012) (requiring that, in any advertisement stating “the dollar amount of any finance charge,” the rate of the charge be “expressed as an annual percentage rate”).

[12] Hawkins, supra note 5, at 311.

[13] Tex. Fin. Code § 393.222(a)(1)–(3) (2015).

[14] Hawkins, supra note 5, at 311.

[15] 7 Tex. Admin. Code § 83.6007(f) (2016).

[16] Hawkins, supra note 5, at 311.

[17] Chang, supra note 1, at 5 n.29.

[18] Ronald J. Mann & Jim Hawkins, Just Until Payday, 54 UCLA L. Rev. 855, 903–04 (2007).

[19] Id.

[20] Because consumers think of these loans in terms of fees and not interest rates, laws should require lenders to advertise using dollar amounts, not APRs. Id.

[21] Pew Charitable Trusts, Fraud and Abuse Online: Harmful Practices in Internet Payday Lending 3 (2014), http://www.pewtrusts.org/~/media/Assets/2014/10/Payday-Lending-Report/Fraud_and_Abuse_Online_Harmful_Practices_in_Internet_Payday_Lending.pdf.

[22] Chang, supra note 1, at 14–15.

[23] See Chang, supra note 1, at 16 (“As borrowers begin to use the Exchange as the ‘one-stop destination’ for payday loans, lenders will face less incentive to continue spending money on advertisements or expensive leases at busy locations.”).

[24] Mann & Hawkins, supra note 18.

[25] See generally, Jim Hawkins, Regulating on the Fringe: Reexamining the Link Between Fringe Banking and Financial Distress, 86 Ind. L.J. 1361, 1368 (2011).

By

King Henry II and the Global Financial Crisis

Download PDF

James W. Giddens†

I.          Introduction

“Will no one rid me of this turbulent priest!” lamented King Henry II, which to his purported surprise led four knights to murder Thomas Becket, the Archbishop of Canterbury.[1] To the knights, the King’s wishes were clear. But the wording of his statement and its ambiguity allowed King Henry to deny that he authorized, or even knew of, the barbarity committed on his behalf. Following the financial crisis of 2008, the financial industry has arguably experienced a number of such “King Henry moments,” where senior executives have allegedly been aware of, or turned a blind eye to, questionable actions that occurred on their watch.

Headlines abound with recent examples of senior executives channeling their inner King Henry and tacitly allowing, if not silently encouraging, their employees to undertake improper and systematically harmful actions—often for the executives’ own personal benefit.[2] For example, supervisors at JPMorgan Chase encouraged employees to push sub-standard, toxic mortgages, which were among the precipitating causes of the 2008 financial crisis, in order to increase the supervisors’ own bonus pool. At the same time, they prohibited diligence managers from using emails and took other steps to obscure their own involvement in the improper scheme.[3] However, no senior executives were held accountable for these actions or the damages to which they contributed. Senior executives at MF Global claimed ignorance when, in direct response to their oblique request to their employees for funding, hundreds of millions of dollars of customer assets were used to support the firm’s proprietary transactions, resulting in the eighth largest bankruptcy in history.[4] No senior executives were held accountable for these actions or the resulting customer losses.[5] Executives of Barclays Plc looked the other way when its traders manipulated Libor in order to increase the bank’s profits, despite the significant negative impact on worldwide financial markets.[6] No senior executives were held personally accountable for these actions or the resulting market impact.[7] Senior executives at Standard Chartered Bank and ING Bank N.V. processed (and collected fees on) transactions for internationally sanctioned countries, thereby contributing to money laundering and terrorism financing.[8] Again, no senior executives were held accountable for their actions or the resulting societal harm.[9]

The collapse of MF Global and other events following the 2008 financial crisis have fueled populist complaints that senior executives are never held accountable and that Wall Street was bailed out rather than penalized.[10] Admittedly, the financial institutions referenced above, as well as many others, have faced substantial fines as a result of their improper behavior, but these fines have been levied against the corporations themselves and not against the senior executives who actually allowed these improper actions to occur. As the continual stream of headlines demonstrates, fines against corporate entities fail to dis-incentivize individual executives who personally benefit from improper and illegal actions, and overall, there has been systemic failure to bring senior executives to heel for their “King Henry moments.”

These events have properly led to calls to reform existing legal structures so that liability would be imposed on senior executives for similar future incidents.[11] Although recent headlines highlight the need for reform,[12] it is important to recognize that the improper behavior generating these headlines represents a very small fraction of overall financial industry behavior. Reforms should balance the need to dis-incentivize excessive risk-taking and other behavior with the need to preserve and promote healthy, active, and well-functioning financial markets. With this purpose in mind, this Article outlines the current state of the law governing senior executive liability, summarizes recent headline events in the financial industry, and provides a series of recommendations for proportionate reforms to correct current incentive imbalances.

II.          The Current Framework for Executive Liability

Understanding the limitations of the current legal framework governing executive liability is essential to appreciating recent populist calls for reform. The framework is geared toward insulating executives from shareholder lawsuits that question legitimate business decisions. It is neither intended nor equipped to address incidents of fraud and failures of senior management to properly supervise subordinates.

Generally, the individual executive who authorizes a corporate action is shielded from personal liability—even when that action has negative consequences for the corporation and its shareholders.[13] For example, when a shareholder alleges that a board of directors’ decision constitutes a breach of fiduciary duty, courts generally defer to the decision-making ability of the directors—rather than second-guess their decision—under the doctrine known as the business judgment rule.[14] This deference holds unless the shareholder can establish a lack of careful board deliberation, self-dealing, or bad faith.[15] The business judgment rule reflects the idea that directors are motivated to act in the best interests of the corporation and its shareholders.[16] It allows corporate executives to fulfill their duty to make a corporation profitable without fear that an informed but ultimately costly decision will result in exposure to liability.

Under this legal framework, an individual executive often will only be prosecuted for financial or other white-collar crime (or be found civilly liable on related theories) if it can be demonstrated that he had actual knowledge of the actions that harmed his corporation or clients, or willfully blinded himself to such knowledge.[17] Because of this high bar to individual prosecution, regulatory enforcement actions typically focus on corporate entities. Although these efforts sometimes produce large monetary settlements,[18] they illustrate the shortcomings of the current legal framework that make it difficult to hold individual executives culpable for improper management or supervision.

In addition to inhibiting the prosecution of individuals,[19] the current legal framework tends to misalign the interests of executives, shareholders, and the public, because it discourages internal investigation and reporting of wrongdoing while simultaneously incentivizing risk-taking by the financial institutions’ employees. For example, an executive in an oversight role who investigates and uncovers wrongdoing but fails to act may expose himself to liability. That same executive, however, might avoid personal exposure if he simply fails to investigate, or distances himself from the wrongdoing—despite the fact that this “see no evil” posture may cause substantial damage to his corporation. This problem is magnified when the improper or reckless behavior may produce a bonus of millions of dollars if the bet, made with shareholder funds, wins.

III.          An Overview of Recent Headlines Regarding Misconduct in the Financial Industry

Recent headlines highlighting allegedly improper actions of individuals at major financial institutions illustrate the problems that stem from the limitations of the current legal framework and associated incentives that prioritize profit-seeking and risk-taking by individuals.

A prime example of the problems that can emerge is the $13 billion settlement between JPMorgan and the Department of Justice (DOJ), which freed JPMorgan from any civil liability associated with the bank’s alleged fraudulent mortgage operations that may have played a role in the 2008 financial crisis.[20] The settlement agreement is the result of federal and state claims against the bank for issuing residential mortgage-backed securities that JPMorgan represented as being in compliance with underwriting guidelines. The employees are alleged to have known of the misrepresentations, but pushed them through anyway in order to increase compensation awards.[21]

The incentive of senior managers to seek immediate profits at the potential expense of their firm’s long-term health is also illustrated by the recent settlement between Standard Chartered Bank and the DOJ.[22] U.S. federal and state prosecutors investigated Standard Chartered for processing thousands of allegedly illegal transactions through the U.S. financial system on behalf of sanctioned entities (Iran, Sudan, and others), which allegedly made Standard Chartered millions in transaction fees.[23] Emails from the investigation revealed that the senior managers were warned that the transactions could result in “very serious or even catastrophic reputational damage to the bank,” but continued to process and collect fees on the questioned transactions.[24] This was not Standard Chartered’s first settlement related to the same illegal schemes, as the bank had previously settled similar charges with state regulators.[25] Regulators have also investigated and reached settlements with other banks whose senior management actively pursued and concealed similarly improper but profitable transactions with sanctioned entities.[26]

The reports of the manipulation of ISDAfix exemplify how limitations on imposing liability on individuals can also pose a systemic risk to the financial markets. The lawsuit against these banks alleges that the defendants rigged the ISDAfix, a benchmark used to set rates for interest rate derivatives, and thereby were in a position to profit in separate derivatives trades with clients that sought to hedge against moves in the interest rates.[27] In order to see such financial gain, the ISDAfix only needed to be “manipulated by as little as . . . 0.0025 percent” of a point of the overall rate for the banks to potentially earn millions.[28] On May 20, 2015, the Commodity Futures Trading Commission (CFTC) settled charges against Barclays Plc for $115 million as a penalty for the attempted manipulation of the ISDAfix.[29] Though the settlement required Barclays to take remedial steps that would help “detect and deter trading intended to manipulate swap rates and improve internal controls,” no individuals were held personally liable.[30]

The 2008 financial crisis as a whole serves as an illustration of the potential systemic risk created by the current legal framework. The Financial Crisis Inquiry Report found that the 2008 financial crisis was avoidable, but that “the captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks.”[31] The Report recognizes this misalignment, explaining that the compensation systems at “important financial institutions” rewarded the “quick deal” without considering future consequences, and “encouraged the big bet” that would yield a huge upside to compensation with limited downside.[32] The Report showed egregious examples of individuals putting their compensation at the forefront while taking risks with others’ money.[33]

The collapse of Lehman Brothers—which remains today the largest chapter 11 filing in history—is a prime example of how the “King Henry” problem contributed to the 2008 financial crisis. First, the investment bank business model, which was not unique to Lehman but shared by the major investment banks at the time, followed a “high-risk, high-leverage model” that “rewarded excessive risk taking.”[34] In order to instill confidence in the market, Lehman exceeded its own risk limits and became significantly over-leveraged.[35] When the sub-prime mortgage crisis emerged, instead of reducing its risk, “Lehman made the conscious decision to ‘double down’” in an attempt to make a profit.[36] Further, the business judgment rule protected the decisions of Lehman executives, which allowed them to make “serious but non-culpable errors of business judgment.”[37]

IV.          Surgical Reform Proposals

These recent headlines, combined with the ongoing examination of the events that led to the 2008 financial crisis, have contributed to increasingly vocal calls to reform the legal framework for individual liability. Serving as the trustee for the Securities Investor Protection Act liquidation of MF Global, Inc., the Author witnessed the damage inflicted on innocent parties when senior management advances a policy of excessive risk-taking while simultaneously failing to properly supervise the risk-takers. These experiences may be helpful as a guide on how potential reforms to the existing legal framework could realign incentives and better permit regulators and other entities to hold senior managers responsible for fraudulent and otherwise improper actions. The following sections provide an overview of four specific proposals, which, if adopted, would advance these goals.

A.          Proposal One: Require executives to certify financial statements with strict civil liability in the event of regulatory shortfall

Following a liquidity crisis that precipitated a “run on the bank” scenario, MF Global filed for bankruptcy on October 31, 2011.[38] A thorough and detailed investigation showed that MF Global’s collapse, and the resulting shortfall in segregated customer assets, was caused by the failure of MF Global’s senior management (i) to install sufficient monitoring and internal compliance systems, (ii) to maintain integrated systems for tracking liquidity and the movement of funds, (iii) to properly supervise key treasury functions, (iv) to avoid the fragmentation of responsibility, and (v) to pay adequate attention to the details of maintaining the segregation of customer funds.[39] These failures occurred at senior levels of the company and led to the improper use of customer property, which was an attempt to shore up liquidity drains caused by an overly risky investment strategy.[40] This tactic was calculated to increase profits and grow MF Global.

The first lesson to be learned from the collapse of MF Global, as well as the other events detailed above, is that there must be stronger incentives for senior management to actively monitor and supervise their employees. This can be accomplished in part by imposing greater requirements on senior executives to ensure the accuracy of their internal monitoring and reporting. For example, CFTC regulations require futures commission merchants (FCMs) to segregate customer funds at all times.[41] Accordingly, it would be an appropriate reform to impose civil fines on the executives responsible for signing the firm’s financial statements in the event of a regulatory shortfall, such as the failure to segregate customer funds as seen in MF Global. In addition, the chief executive officer, the chief financial officer, the chief compliance officer, and the general counsel of an FCM should be required to certify on a frequent and continuing basis not only the company’s financial statements, but also their compliance with customer segregation requirements. It is also necessary to impose certain internal compliance measures, such as requiring these executives to establish and oversee the company’s internal controls and procedures, and to further certify that they have done so.[42] Upon a shortfall in customer funds, Congress should make these individuals personally and civilly liable for their certifications. Similar certification requirements are imposed by the Sarbanes-Oxley Act.[43] In these circumstances, executives should be held strictly liable without a proof of intent requirement, and without the defense that they delegated these essential duties and responsibilities.

Similar calls for reform for executive personal liability have been heard in the United Kingdom. These calls led to reform proposals by the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA),[44] which included provisions aimed at increasing the individual accountability of senior managers in the United Kingdom.[45] The new regulatory framework introduces the concept of a “senior management function,” and any individual performing such a function must obtain pre-approval by the relevant regulator.[46] The reforms also require that each application for approval to perform a senior management function is accompanied by a “statement of responsibilities” document which sets out the senior manager’s roles and responsibilities along with a “responsibilities map” that describes the firm’s overall governance framework.[47] Additionally, the new regime imposes criminal liability on senior managers making a decision (where that decision falls far below what could reasonably be expected of a person in their position) that causes a firm to fail.

The proposed reforms initially included a “presumption of responsibility” whereby senior managers would be deemed guilty of misconduct unless they could show that they had taken all reasonable steps to prevent a particular contravention from occurring. However, following a backlash from the financial sector, the U.K. regulators revised the proposals such that regulators must now prove that a senior manager did not take all reasonable preventative steps.

The purpose of the U.K. reforms is to encourage senior executives to take greater responsibility for their actions, which, in turn, should make it easier for both firms and regulators to hold them accountable. Although there has been a retreat from the original, more draconian proposals, the U.K. regulators are able to look to senior managers’ statements of responsibilities to determine the areas for which they are responsible. The threat of criminal liability should act as an ultimate deterrent to overly risky behavior and decision-making by senior executives.

B.          Proposal Two: Obligate misbehaving executives to pay a portion of any regulatory fine

Imposing liability on senior executives, in circumstances where relevant certifications turn out to be incorrect, addresses the failures that led to the collapse of MF Global and other recent financial improprieties. However, such action does not address the more general failure to monitor and report improper activities that allowed, for example, the rate manipulation events at the Standard Chartered Bank and ING Bank, among others.[48] To address these situations, individual executives should be obligated to pay a portion of any regulatory fine issued against the organization they manage in incidents of fraudulent actions. As noted above, under the current framework, penalties issued by regulatory agencies are paid directly by the relevant corporation,[49] a cost that is borne by innocent shareholders but not the managers who failed to prevent the fraudulent action. This provides little incentive for executives to change their behavior or prevent fraudulent activities. This proposal is supported by Professors Claire Hill and Richard Painter who have suggested changing this incentive by making highly compensated bank officers personally liable for a portion of the SEC fines.[50] In an effort to align the competing interests, Hill and Painter propose to make the personal liability proportionate to the officers’ compensation.[51] Interestingly, this reform would represent a return to when investment banks were established as partnerships, and partners were liable for the institution’s obligations.[52]

C.          Proposal Three: Extend Park liability to the financial services industry

The two preceding proposed reforms are prospective only, and intended to incentivize senior management of financial institutions to more actively manage and supervise their employees. However, they fail to sufficiently address the practical legal difficulties in bringing effective enforcement actions against responsible individuals after the fact. To deal with these concerns, former attorney general Eric Holder outlined potential reforms to the current framework aimed at (i) reducing the difficulty of proving the requisite intent in lawsuits against individual executives and (ii) incentivizing reporting of wrongdoing in the first instance.[53] First, Holder suggests considering revisions to relevant financial fraud statutes that would extend the “responsible corporate officer” doctrine, also known as Park liability, to the financial services industry.[54] This doctrine states that an individual can be prosecuted absent any culpable intent or knowledge of wrongdoing, so long as he or she was in a position to have prevented the wrongdoing and failed to do so.[55] Application of the responsible corporate officer doctrine to the financial industry would limit the protections of the business judgment rule and eliminate problems associated with proving the requisite intent. Second, Holder proposes increasing whistleblower incentives aimed at motivating more individuals to report financial wrongdoing and provide information to aid prosecutions against responsible individuals.[56] Holder explains that the whistleblower provision of the “little-used” Financial Institutions Reform, Recovery, and Enforcement Act, which caps any award at $1.6 million, is insufficient considering that the median executive pay in the relevant industry was $15 million and the collective bonus pool was greater than $26 billion in 2013.[57]

Although these proposed reforms would make prosecutions of senior executives easier, they may be unneeded. Judge Jed S. Rakoff, who has presided over a number of financial fraud cases, has argued that what is needed is the more wholehearted application of existing tools as opposed to the creation of new standards and rules.[58] In discussing the alleged difficulties of proving intent, Judge Rakoff noted:

Who, for example, was generating the so-called “suspicious activity reports” of mortgage fraud that, as mentioned, increased so hugely in the years leading up to the crisis? Why, the banks themselves. A top-level banker, one might argue, confronted with growing evidence from his own and other banks that mortgage fraud was increasing, might have inquired why his bank’s mortgage-based securities continued to receive AAA ratings. And if, despite these and other reports of suspicious activity, the executive failed to make such inquiries, might it be because he did not want to know what such inquiries would reveal? This, of course, is what is known in the law as “willful blindness” or “conscious disregard.”[59]

In light of the actions of senior management in the headline making events described above, ranging from systematic failure to monitor to active discouragement of communications, one would expect that showing willful blindness or a conscious disregard would not be an insurmountable hurdle.[60] However, it is important that any reform strike a balance between permitting legitimate risk-taking and providing for punishment of improper actions. As such, calls for the full implementation of the Park doctrine should be tabled until a more complete use of the current array of prosecutorial tools proves lacking.

D.          Proposal Four: Limit the use of “Cooperation Credit” if responsible individuals are not identified

Historically, the DOJ has given “cooperation credit” to banks and corporations that cooperate with DOJ investigations and provide information regarding wrongdoing.[61] In gauging cooperation, prosecutors were previously able to consider the corporation’s willingness to provide material information about the relevant actors as a mitigating factor.[62] Now, new DOJ guidelines have made cooperation with the DOJ the threshold for allowing any cooperation credit.[63] On September 9, 2015, Deputy Attorney General Sally Quillian Yates sent a memo to all U.S. Attorneys and Assistant Attorney Generals setting forth new guidelines to strengthen the pursuit of individual corporate wrongdoing. The Memo explains that “in order to qualify for any cooperation credit, corporations must provide to the Department all relevant facts relating to the individuals responsible for the misconduct.”[64] In addition, the guidelines state that the DOJ “will not release culpable individuals from civil or criminal liability when resolving a matter with a corporation.” These guidelines shift the focus to the individuals responsible for the wrongdoing and should assist in more thorough investigations by the DOJ, thereby deterring such behavior from the start. The success of these guidelines, however, will of course depend on how they are implemented and to what extent corporations comply.

IV.          Conclusion

The proposals contained herein, if adopted, would significantly ameliorate the “King Henry” problem and incentivize senior management to adopt a more active role in rooting out and resolving any improper actions before they metastasize into larger scandals. These proposals will also preserve the appropriate level of risk-taking behavior necessary for healthy financial markets. It is the Author’s position that this can be accomplished by creating more stringent requirements for executives to certify financial statements, holding individuals personally liable for regulatory fines imposed on their respective corporations, and extending Park liability to the financial sector. The DOJ’s amended guidelines for cooperation credit also may help to ensure individuals are held accountable to deter corrupt practices in the first place. Whatever proposals are adopted, now is the time to focus and evaluate this area of the law.

† James W. Giddens is a partner at Hughes Hubbard & Reed LLP and serves as the chair of the firm’s Corporate Reorganization and Bankruptcy Group. Mr. Giddens has also served as trustee on several of the largest and most complex financial liquidations in history, including the liquidations of Lehman Brothers Inc. and MF Global Inc. The views expressed in this Article are those of Mr. Giddens and do not necessarily represent the views of, and should not be attributed to, Hughes Hubbard & Reed LLP. Mr. Giddens thanks Dustin P. Smith and Lauren A. Lipari for their help in the preparation of this article.

[1] Ben Johnson, Thomas Becket, Historic UK: The History and Heritage Accommodation Guide, http://www.historic-uk.com/HistoryUK/HistoryofEngland/Thomas-Becket/.

[2] See, e.g., Gretchen Morgenson, Behind Insurer’s Crisis, Blind Eye to a Web of Risk, N.Y. Times (Sept. 27, 2008), http://www.nytimes.com/2008/09/28/business/28melt.html?pagewanted=all (explaining that “[i]n the case of A.I.G., the virus . . . flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models” and contributed to the vulnerable financial system that caused the financial crisis); see also All In With Chris Hayes (MSNBC television broadcast Nov. 10, 2014), available at http://www.nbcnews.com/id/56403976/ns/msnbc-all_in_with_chris_hayes/t/all-chris-hayes-monday-november-th/ (discussing bank executives’ improper practices with Alayne Fleischman and Matt Taibbi).

[3] For example, a whistleblower at JPMorgan explained that at the bank, supervisors acted to distance themselves from actions that could lead to accountability, in part because individual compensation was tied to the quantity of mortgages the bank purchased, without regard to the quality of those mortgages. See All In With Chris Hayes, supra note 2.

[4] See Sarah N. Lynch & Aruna Viswantatha, Mf Global Execs Ignorance, Silence Stymie Congress, Reuters, Mar. 28, 2012, http://www.reuters.com/article/us-mfglobal-idUSBRE82R0YI20120329; see also Alex Howe, The 11 Largest Bankruptcies in American History, Business Insider (Nov. 29, 2011, 12:33 PM), http://www.businessinsider.com/largest-bankruptcies-in-american-history-2011-11; Lisa Du, Report: Jon Corzine Ordered $200 million of MF Global Customer Funds to be Moved Before Bankruptcy, Business Insider (Mar. 23, 2012, 4:20 PM), http://www.businessinsider.com/report-jon-corzine-ordered-200-million-of-mf-global-customer-funds-to-be-moved-before-bankruptcy-2012-3.

[5] See H.R. Rep. No. 113–­­469, at 5 (2014) (“After MF Global filed for bankruptcy, it was revealed that in the final days before the firm’s failure, customer segregated funds . . . were used to fund the company’s liquidity needs . . . .”); see also Mark Gongloff, Here’s Why There Will Be No Criminal Charges In the MF Global Case, Huffington Post (June 28, 2013, 1:35 PM), http://www.huffingtonpost.com/2013/06/28/criminal-charges-mf-global_n_3516652.html.

[6] Jonathan Stempel, Barclays Settles With U.S. Investors Over Libor Manipulation, Reuters, Nov. 25, 2015, http://www.reuters.com/article/2015/11/25/barclays-libor-settlement-idUSL1N13K1MA20151125#E1SWEfgMBP5u1GhJ.97.

[7] Alexandra Alper & Kirstin Ridley, Barclays paying $453 million to settle Libor probe, Reuters, June 27, 2012, http://www.reuters.com/article/us-barclays-libor-idUSBRE85Q0J720120627 (discussing the involvement of Barclays and other banks in Libor manipulation and noting that “no criminal charges have been filed”).

[8] See Press Release, U.S. Dep’t of Justice, Standard Chartered Bank Agrees to Forfeit $227 Million for Illegal Transactions with Iran, Sudan, Libya, and Burma (Dec. 10, 2012), http://www.justice.gov/opa/pr/standard-chartered-bank-agrees-forfeit-227-million-illegal-transactions-iran-sudan-libya-and (“[F]rom 2001 through 2007, SCB violated U.S. and New York state laws by moving millions of dollars illegally through the U.S. financial system on behalf of Iranian, Sudanese, Libyan and Burmese entities subject to U.S. economic sanctions.”); Press Release, U.S. Dep’t of Justice, ING Bank N.V. Agrees to Forfeit $619 Million for Illegal Transactions with Cuban and Iranian Entities (June 12, 2012), http://www.justice.gov/opa/pr/ing-bank-nv-agrees-forfeit-619-million-illegal-transactions-cuban-and-iranian-entities-0 (explaining that “ING Bank knowingly and willfully engaged in . . . criminal conduct, which caused unaffiliated U.S. financial institutions to process transactions that otherwise should have been rejected, blocked, or stopped . . . .”).

[9] See Brett Wolf, Bankers to Be held Personally Responsible for Sanctions Violations” Treasury, Reuters, Mar. 22, 2013, http://www.huffingtonpost.com/2013/03/22/bank-sanction-violations_n_2934839.html (“Since 2005, OFAC and its U.S. law enforcement partners have targeted HSBC, Standard Chartered Bank, ING Bank NV, Credit Suisse, Barclays, Lloyds TSB Bank and ABN AMRO for sanctions violations. Still, no individual bankers were held to account.”).

[10] See, e.g., Editorial Board, The Case of the Missing White-Collar Criminal, Bloomberg View (June 22, 2014 6:02 PM), http://www.bloombergview.com/articles/2014-06-22/the-case-of-the-missing-white-collar-criminal (“The evidence strongly suggests that prosecutors could have done more to identify and punish the people who caused a crisis that has visited suffering on millions.”); see also Gretchen Morgenson & Louise Story, In Financial Crisis, No Prosecutions of Top Figures, N.Y. Times (Apr. 14, 2011), http://www.nytimes.com/2011/04/14/business/14prosecute.html?_r=0.

[11] See, e.g., Michael S. Barr, The Financial Crisis and the Path of Reform, 29 Yale J. on Reg. 91, 92–108 (2012) (explaining that the “[financial] crisis demonstrated the need for comprehensive financial reform” and identifying areas for reform beyond the Dodd-Frank Act); Eric C. Chaffe, A Panoramic View of the Financial Crisis that Began in 2008: The Need for Domestic and International Regulatory Reform, 35 U. Dayton L. Rev. 1, 2 (2009) (discussing “the importance of reform in international securities regulation as a means of preventing or lessening any future financial crisis”).

[12]  See, e.g., Henry Engler, Global finance leaders to banks: reform culture and conduct or face more regulation, Reuters: Financial Regulatory Forum (Aug. 3, 2015), http://blogs.reuters.com/financial-regulatory-forum/2015/08/03/global-finance-leaders-to-banks-reform-culture-and-conduct-or-face-more-regulation/.

[13] The business judgment rule amounts to “a presumption that ‘in making a business decision the directors of a corporation acted on an informed basis . . . and in the honest belief that the action taken was in the best interests of the company [and its shareholders].’” In re Walt Disney Co. Derivative Litig., 907 A.2d 693, 747 (Del. Ch. 2005) (quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)), aff’d, 906 A.2d 27 (Del. 2006); see also In re Caremark Int’l, 698 A.2d 959, 967 (Del. Ch. 1996) (“[W]hether a judge or jury considering the matter after the fact, believes a decision substantively wrong, or degrees of wrong extending through ‘stupid’ to ‘egregious’ or ‘irrational,’ provides no ground for director liability, so long as the court determines that the process employed was either rational or employed in a good faith effort to advance corporate interests.”).

[14] In re Walt Disney Co., 907 A.2d at 747 (explaining that, under the business judgment rule, the court presumes that a director of a corporation made a decision on an informed basis, and that the presumption can be rebutted by a showing that the board violated its fiduciary duties).

[15] Ryan v. Gifford, 918 A.2d 341, 357 (Ch. Del. 2007) (finding that a complaint, which alleged breach of duty of loyalty by directors who approved or accepted backdated stock options, stated a claim sufficient to rebut the business judgment rule); In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 67 (Del. 2006) (explaining that the business judgment rule would not apply “where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties”) (internal citation omitted).

[16] In re Caremark Int’l, 698 A.2d at 967–68 n.16 (“The corporate form gets its utility in large part from its ability to allow diversified investors to accept greater investment risk. If those in charge of the corporation are to be adjudged personally liable for losses . . . such persons will have a strong incentive at the margin to authorize less risky investment projects.”).

[17] In re Walt Disney Co., 906 A.2d, at 67 (agreeing with the lower court’s post-trial opinion in its explanation of actions that constitute a failure to act in good faith).

[18] For example, Bank of America agreed to a $16.65 billion settlement with the DOJ to resolve claims against the bank for financial fraud. See Press Release, U.S. Dep’t of Justice, Bank of America to Pay $16.65 Billion in Historic Justice Department Settlement for Financial Fraud Leading up to and During the Financial Crisis (Aug. 21, 2014), http://www.justice.gov/opa/pr/bank-america-pay-1665-billion-historic-justice-department-settlement-financial-fraud-leading.

[19] The DOJ, however, has not hesitated to require banks to plead guilty to criminal charges.  In May 2014, Credit Suisse pleaded guilty to conspiracy for aiding its customers in hiding accounts overseas to avoid taxes. Also, BNP Paribas entered a guilty plea to a charge of conspiracy to violate economic sanctions in June 2014.  See Peter J. Henning, The Prospects for Pursuing Corporate Executives, N.Y. Times (Sept. 14, 2015), http://www.nytimes.com/2015/09/15/business/dealbook/theprospects-for-pursuing-corporate-executives.html?_r=0.

[20] See Press Release, U.S. Dep’t of Justice, Federal and State Partners Secure Record $13 Billion Global Settlement with JPMorgan for Misleading Investors About Securities Containing Toxic Mortgages (Nov. 19, 2013), http://www.justice.gov/opa/pr/justice-department-federal-and-state-partners-secure-record-13-billion-global-settlement. As part of its settlement with the DOJ, JPMorgan acknowledged that it made serious misrepresentations to the public and to investors about numerous residential mortgage-backed securities transactions.

[21] See id. (noting that the settlement agreement alleges JPMorgan employees knew the loans in question did not comply with underwriting guidelines, but represented otherwise to investors).  A whistleblower and former securities lawyer for JPMorgan provided her view on how the misalignment of interest of the bank employees and those responsible for diligence allowed the practice of pushing toxic mortgages to emerge. She explained that supervisors pushed quality control managers to approve sub-standard mortgages because individual compensation was tied to the quantity (without regard to quality) of mortgages the bank purchased. See All In With Chris Hayes, supra note 2. In early 2015, JPMorgan and the DOJ entered into another settlement, which required JPMorgan to pay over $50 million to over 25,000 homeowners in bankruptcy as a result of the bank filing more than 50,000 payment change notices that were improperly signed.  See Press Release, U.S. Dep’t of Justice, Trustee Program Reaches $50 Million Settlement with JPMorgan Chase to Protect Homeowners in Bankruptcy (Mar. 3, 2015), http://www.justice.gov/opa/pr/us-trustee-program-reaches-50-million-settlement-jpmorgan-chase-protect-homeowners-bankruptcy.

[22] See Press Release, U.S. Dep’t of Justice, Standard Chartered Bank Agrees to Forfeit $227 Million, supra note 8.

[23] Jessica Silver-Greenberg, Standard Chartered Agrees to Settle Iran Money Transfer Claims, N.Y. Times (Dec. 10, 2012), http://dealbook.nytimes.com/2012/12/10/standard-chartered-agrees-to-settle-iran-money-transfer-claims/; see also BBC News, Q&A: Standard Chartered Iran Allegations, BBC (Dec. 10, 2012), http://www.bbc.com/news/business-19157426.

[24] Dominic Rushe & Jill Treanor, Standard Chartered bank accused of scheming with Iran to hide transactions, The Guardian (Aug. 6, 2012, 19.34 EDT), http://www.theguardian.com/business/2012/aug/06/standard-chartered-iran-transactions.

[25] See Press Release, N.Y. Dep’t of Financial Services, Statement from Benjamin M. Lawsky, Superintendent of Financial Services, Regarding Signing of Final Agreement with Standard Chartered Bank (Sept. 21, 2012), http://www.dfs.ny.gov/about/press/pr1209211.htm; see also Jessica Silver-Greenberg, supra note 23. Still, it seems that these large settlements may not have been large enough to deter Standard Chartered as reports indicate that the bank may still be processing transactions for entities tied to sanctioned countries. Andrew Zajac & Richard Partington, Standard Chartered Iran-Trade Oversight Extended 3 Years, Bloomberg (Dec. 9, 2014 3:51 PM), http://www.bloomberg.com/news/articles/2014-12-09/standard-chartered-extends-us-prosecution-deal-over-sanctions.

[26] See Press Release, U.S. Dep’t of Justice, ING Bank N.V. Agrees to Forfeit $619 Million, supra note 8; Press Release, U.S. Dep’t of Justice, HSBC Holdings Plc. and HSBC Bank USA N.A. Admit to Anti-Money Laundering and Sanctions Violations, Forfeit $1.256 Billion in Deferred Prosecution Agreement (Dec. 11, 2012), http://www.justice.gov/opa/pr/hsbc-holdings-plc-and-hsbc-bank-usa-na-admit-anti-money-laundering-and-sanctions-violations; see also Annie Lowrey, ING Bank to Pay $619 Million to Settle Inquiry Into Sanctions Violations, N.Y. Times (June 12, 2012), http://www.nytimes.com/2012/06/13/business/ing-bank-to-pay-619-million-over-sanctions-violations.html; Ben Protess & Jessica Silver-Greenberg, HSBC to Pay $1.92 Billion to Settle Charges of Money Laundering, N.Y. Times (Dec. 10, 2012 4:10 PM), http://dealbook.nytimes.com/2012/12/10/hsbc-said-to-near-1-9-billion-settlement-over-money-laundering/.

[27] Class Action Complaint, Alaska Electrical Pension Fund v. Bank of America Corp. et al., Case No. 14-CV-07126 (JMF) (Sept. 4, 2014) (Docket No. 1); see also Bob Van Voris and Matthew Leising, Barclays, BofA, Citigroup Sued for ISDAfix Manipulation, Bloomberg (Sept. 5, 2014, 1:02AM), http://www.bloomberg.com/news/articles/2014-09-04/barclays-bofa-citigroup-sued-for-isda-fix-manipulation; Mary Tonkin, et al., Claims for ISDAfix manipulation, Lexology (Oct. 23, 2014), http://www.lexology.com/library/detail.aspx?g=f443ea5a-7afd-4eff-9de5-eb9b6a32c53f.

[28] Matthew Leising, Banks Rigged Rate at Expense of Retirees, Bloomberg (Aug. 2, 2013, 2:00 AM), http://www.bloomberg.com/news/articles/2013-08-02/swaps-probe-finds-banks-manipulated-rate-at-expense-of-retirees.

[29] Press Release, U.S. Commodity Futures Trading Commission, CFTC Orders Barclays to Pay $115 Million Penalty for Attempted Manipulation of and False Reporting of U.S. Dollar ISDAFIX Benchmark Swap Rates (May 20, 2015), http://www.cftc.gov/PressRoom/PressReleases/pr7180-15.

[30] Id.

[31] Fin. Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report, at xvii (Jan. 2011), http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf.

[32] Id. at xviii­­–xix.

[33] See id. at xix. Such examples include AIG senior management ignoring the “risks of the company’s $79 billion derivatives exposure to mortgage-related securities” and “Fannie Mae’s quest for bigger market share, profits, and bonuses, which led it to ramp up its exposure to risky loans and securities as the housing market was peaking.” Id.

[34] Report of Anton R. Valukas, Examiner, In re Lehman Brothers Holdings Inc., Case No. 08-13555 (JMP) (S.D.N.Y. Mar. 11, 2010), available at https://jenner.com/lehman/VOLUME%201.pdf.

[35] Id. at 4 (“In 2006, Lehman made the deliberate decision to embark upon an aggressive growth strategy, to take on significantly greater risk, and to substantially increase leverage on its capital . . . . Lehman significantly and repeatedly exceeded its own internal risk limits and controls.”).

[36] Id.

[37] Id. at 3.

[38] Voluntary Petition For Bankruptcy, In re MF Global Holdings Ltd., No. 11-15059 (MG) (Bank. S.D.N.Y. Oct. 31, 2011) (No. 11709).

[39] Report of the Trustee’s Investigation and Recommendations, In re MF Global Inc., No. 11-02790 (MG) (June 4, 2012) (No. 1865).

[40] Id. at 15 (“[T]he actions of management and other employees, along with lack of sufficient monitoring and systems, resulted in FCM customer property being used during the liquidity crisis to fund the extraordinary liquidity drains elsewhere in the business . . . .”).

[41] Futures customer funds to be segregated and separately accounted for, 17 C.F.R. § 1.20(a) (2014) (“A futures commission merchant must separately account for all futures customer funds and segregate such funds as belonging to its futures customers.”).

[42] See Trustee for the Securities Investor Protection Act Liquidation of MF Global Inc.: Hearing Before the S. Comm. on Banking, Hous. & Urban Affairs, 1­­­­­­–2 (2012) (statement of James W. Giddens, Trustee for the Securities Investor Protection Act).

[43] See 18 U.S.C. § 1350 (2002).

[44] The PRA and the FCA are the successor entities to the Financial Services Authority. The PRA is responsible for the prudential regulation and supervision of banks, building societies, credit unions, insurers, and major investment firms operating in the United Kingdom, while the FCA is responsible for retail and wholesale conduct of business regulation, regulation of markets, and the prudential regulation of firms not authorized by the PRA.

[45] See Taylor Wessing, et al., Accountability, Risk and Reward: The New Regulatory Framework for Senior Managers, Lexology (Oct. 2, 2014), http://www.lexology.com/library/detail.aspx?g=22a66309-f216-4fbe-8fa2-efaaaa9416a7.

[46] See id.

[47] See id.

[48] See Press Release, U.S. Dep’t of Justice, ING Bank N.V. Agrees to Forfeit $619 Million, supra note 8; see also Press Release, U.S. Dep’t of Justice, HSBC Holdings Plc. and HSBC Bank US N.A. Admit to Anti-Money Laundering and Sanctions Violations, supra note 26.

[49] See supra Part B.

[50] Claire A. Hill & Richard W. Painter, Why SEC Settlements Should Hold Senior Executives Liable, N.Y. Times Dealbook, (May 29, 2012, 11:28 AM), http://dealbook.nytimes.com/2012/05/29/why-s-e-c-settlements-should-hold-senior-executives-liable/ (“[A]ll of a bank’s most highly compensated officers — those making more than $1 million a year — should be personally and collectively liable for paying a significant portion (perhaps 50 percent) of S.E.C. fines levied against their bank . . . in proportion to the size of their compensation that year.”).

[51] Id.

[52] See, e.g., Alan D. Morrison & William J. Wilhelm, Jr., The Demise of Investment-Banking Partnerships: Theory and Evidence, 63 J. FIN. 311 (2008), https://www.law.virginia.edu/pdf/olin/0506papers/morrison_wilhelm.pdf.

[53] Eric Holder, Att’y Gen., U.S. Dep’t of Justice, Remarks on Financial Fraud Prosecutions at NYU School of Law (Sept. 17, 2014), http://www.justice.gov/opa/speech/attorney-general-holder-remarks-financial-fraud-prosecutions-nyu-school-law.

[54] See id.; see also Helen Cantwell et al., DOJ Proposal Shows Focus on Individuals in Corporate Crime, Law360 (Sept. 30, 2014 10:14 AM), http://www.law360.com/articles/582045/doj-proposal-shows-focus-on-individuals-in-corporate-crime.

[55] See United States v. Park, 421 U.S. 658, 670–71 (1975).

[56] See Holder, supra note 53 (explaining that in order to better equip investigators, there must be incentives for witness cooperation and whistleblowers at financial institutions).

[57] Id.

[58] See Jed S. Rakoff, Why Have No High Level Executives Been Prosecuted in Connection With The Financial Crisis?, The New York Review of Books (Jan. 9, 2014), http://www.nybooks.com/articles/archives/2014/jan/09/financial-crisis-why-no-executive-prosecutions/.

[59] Id.

[60] Cf. Global-Tech Appliances, Inc. v. SEB S.A., 131 S. Ct. 2060, 2068–­69 (2011) (“Many criminal statutes require proof that a defendant acted knowingly or willfully, and courts applying the doctrine of willful blindness hold that defendants cannot escape the reach of these statutes by deliberately shielding themselves from clear evidence of critical facts that are strongly suggested by the circumstances.”).

[61] See U.S. Dep’t of Justice, U.S. Attorneys’ Manual 9-28.700 (1997), available at http://www.justice.gov/usam/usam-9-28000-principles-federal-prosecution-business-organizations#9-28.700 (“Cooperation is a mitigating factor, by which a corporation . . . can gain credit in a case that otherwise is appropriate for indictment and prosecution.”).

[62] See id. at 9-28.740 (stating that a corporation’s willingness to cooperate is not determinative but may be considered in conjunction with other factors).

[63] Memorandum from Deputy Att’y Gen. Sally Quillian Yates, Individual Accountability for Corporate Wrongdoing (Sept. 9, 2015), http://www.justice.gov/dag/file/769036/download.

[64] Id. at 2.

By

The Role of Section 20(b) in Securities Litigation

Download PDF

William D. Roth*

I.          Introduction

In May 2014, Securities Exchange Commission (SEC) Chair, Mary Jo White, announced that the SEC would pursue actions under Section 20(b) of the Securities Exchange Act of 1934, which broadly prohibits violating federal securities law through the means of another person.[1] White cited the Supreme Court’s ruling in Janus Capital Group, Inc. v. First Derivative Traders[2] as the impetus for this endeavor.[3] In Janus, the Court held that, to be liable for a material misstatement or omission (MMO) under Section 10(b) of the 1934 Act, the main securities anti-fraud provision, the maker of the statement must have “ultimate authority” over the statement’s content and formulation, as well as whether to issue the statement.[4] This ruling effectively prevents using Section 10(b) to charge a defendant who directs or advises another person to make an MMO, but lacks “ultimate authority” over the statement. Therefore, the SEC seeks to use Section 20(b) as the cause of action in such cases where Section 10(b) is no longer available.

Part II of this Article explains in detail the gap that the Janus ruling creates in securities anti-fraud cases, specifically those involving “innocent instrumentalities.” The Article explains the doctrinal limitations of using other, potentially related 1934 Act provisions, such as control person liability (Section 20(a)) and aiding and abetting (Section 20(e)). Recognizing these limitations is important for understanding how Section 20(b) would need to be interpreted by courts in order to be an effective tool that can fill this gap.

Part III of this Article explores Section 20(b)’s overall function and purpose. These issues are specifically analyzed in terms of Section 20(b)’s relationship to Section 20(a), which is the provision governing control person liability. Identifying Section 20(b)’s overall function and purpose can shed light on the underlying doctrinal issues outlined in Part IV, most specifically on whether Section 20(b) requires a control relationship.

Because Section 20(b) has rarely been used in securities litigation, its scope and practical application remain unclear. Whether Section 20(b) can be an effective tool for the SEC and private plaintiffs by filling the gap described in Part II of this Article depends on the resolution of several doctrinal questions: whether Section 20(b) (A) imposes primary or secondary liability, (B) has a scienter requirement, (C) requires the defendant to “control” the active party, and (D) creates an implied private cause of action. In reviewing each of these doctrinal questions, Part IV of this Article presents the relevant cases that discuss these questions, recognizing that none fully resolves the doctrinal issues because of the courts’ brief, and often tangential, treatment of them. In addition to presenting the relevant case law, this Article offers the strongest arguments, largely based on textual analysis of the 1934 Act, for each position on each of the doctrinal questions.

Part V presents different contexts—including two securities fraud cases brought by the SEC currently pending before federal district courts—that exemplify how Section 20(b) can be used when other causes of actions are not applicable. Identifying viable circumstances in which Section 20(b) can be applied can help clarify whether Section 20(b) can be an effective anti-fraud tool.

Considering the lack of clarity in the case law and the paucity of extant opinions, the path that the courts take on these matters ultimately will dictate how effective of an anti-fraud tool Section 20(b) can be for the SEC. While the provision’s statutory construction and legislative history suggest that it imposes primary liability and does not require a control relationship, courts inexplicably have ruled (and likely will continue to rule) against this view. Since these qualities are necessary if Section 20(b) is to fill the gap created by Janus, the SEC’s intended use ultimately may be judicially constrained.

II.          The Gap Created by Janus

In Janus, the Court held that to be liable for an MMO under Section 10(b), the maker of the statement must have “ultimate authority” over the statement’s content and formulation, as well as whether to issue the statement.[5] The Court’s ruling effectively prevents Section 10(b) from supporting actions against a defendant who commits fraud through the means of another innocent person or entity to shield himself from the scheme. As long as the ultimate decision regarding whether, what, and how to issue the statement lies in someone else’s hands, the defendant has not “made” the MMO, despite his involvement and influence.[6]

This newly created gap in Section 10(b) litigation leaves securities fraud schemes involving an “innocent instrumentality” unaccountable. Typically, this consists of schemes that are knowingly orchestrated by one person, but are actually executed, unknowingly, by another. While the 1934 Act imposes forms of secondary liability, such as control person liability under Section 20(a) and aiding and abetting under Section 20(e), together they do not stop the gaps. Control person liability holds liable only one who “effectively controls” the primary perpetrator of the fraud. However, absent such control, as well as a primary violation, such liability cannot be established. Aiding and abetting also requires a separate primary violation that a secondary party substantially assists. In cases involving an innocent instrumentality, however, no primary Section 10(b) violation exists because the party acted unknowingly, thereby not meeting the scienter requirement. And sometimes the orchestrating party does not have ultimate control over the innocent actor, such as in Janus, where the two parties were separate legal entities, with the former merely advising, albeit intimately, the latter.

To fill this hole, the SEC seeks to use Section 20(b). Section 20(b)’s broad, general language avoids Janus’ linguistic restrictions. Section 20(b) states, “It shall be unlawful for any person, directly or indirectly, to do any act or thing which it would be unlawful for such person to do under the provisions of this chapter or any rule or regulation thereunder through or by means of any other person.”[7] This provision does not contain the term “make,” thereby obviating the need for the defendant to have ultimate control over the issuance of a statement. Further, at first glance, the provision does not require a separate primary violation by the “other person” to impose liability. Indeed, White reads this provision as imposing primary liability, not secondary liability.[8] Therefore, the SEC views Section 20(b) as a potentially effective tool for cases that Section 10(b) no longer covers.

III.          Section 20(b)’s Purpose and Function

Whether Section 20(b) can be an effective anti-fraud tool depends on the resolution of various doctrinal issues. However, determining the purpose and function of Section 20(b) is helpful for understanding the doctrinal questions outlined in Part IV. Indeed, the varying rigidity and flexibility that courts have demonstrated in interpreting this provision stems from their respective understandings of Section 20(b)’s purpose.

A central question in the discussion regarding Section 20(b)’s purpose and function is how it relates to Section 20(a). The circuit courts are split on whether Section 20(a), which governs control person liability, is available for SEC enforcement proceedings. The Sixth Circuit held that the SEC cannot use Section 20(a),[9] but instead must use Section 20(b) for control person liability.[10] The Sixth Circuit seemingly reads these two provisions as imposing the same kind of liability, each to be used in a different type of action: Section 20(a) is to be used in private actions and Section 20(b) in enforcement actions. Under this approach, Section 20(b) is read as somewhat of a catchall for control person liability, or at least read in tandem with Section 20(a). Because Section 20(b) is interpreted as being the version of Section 20(a) for the SEC to use, liability under Section 20(b) would require a control relationship and may even allow for a good faith defense.[11] The Sixth Circuit understands these two provisions as two sides of the same coin because, otherwise, Section 20(b) could be used to hold corporate directors liable for the actions of inferior agents. The Sixth Circuit seems unwilling to recognize such expansive liability, claiming that Congress never intended for such broad liability.[12]

Conversely, the Second and Third Circuits held that Section 20(a) is available for SEC enforcement proceedings.[13] This has been recognized as the view of the majority of courts.[14] Under this approach, Section 20(b) is not read as the SEC’s provision for Section 20(a) liability, nor as a mere catchall. Rather, the two provisions have their own goals. Indeed, the Third Circuit read Sections 20(a) and 20(b) as targeting “different forms of wrongdoing.”[15] It noted that Section 20(a) covers cases that Section 20(b) does not, such as where the control person induces a transfer to himself, but does not participate in the underlying violations.[16] The court implied that Section 20(b) requires that the defendant participate in the fraud in some way, even though his violation is primarily through the means of another.[17]

The Eighth Circuit presents a third approach to the relationship between Sections 20(a) and 20(b). Section 20(a) states,

Every person who, directly or indirectly, controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable . . . unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.[18]

The court held that controlling persons, who are the “intended beneficiaries” of a transaction executed by a controlled person through making MMOs, are liable under the “directly or indirectly inducing the act” clause of Section 20(a).[19] Consequently, the controlling persons need not know of the specific violations committed by the controlled persons and are not entitled to the good faith defense. The court reasoned that “[t]o hold otherwise would vitiate the plain meaning of Section 20(b).”[20] The court seemingly believes that, where the defendant “induces” another to commit an action consisting of a securities violation, it is viewed as the defendant committing the fraud through the means of another. Therefore, even if in such a case a control relationship exists between the parties, it is not governed under typical control person liability principles—the defendant is not entitled to a good faith defense. Rather, it is viewed as a Section 20(b) violation. This approach views Section 20(b) as broader than Section 20(a) and not solely a form of control person liability.

IV.          Section 20(b)’s Doctrinal Issues

The Court’s decision in Janus created a need for an additional anti-fraud tool for the SEC and private plaintiffs to use. Whether Section 20(b) can be that tool depends on the resolution of several doctrinal questions that remain unresolved due to a dearth of case law regarding Section 20(b). The doctrinal issues include whether Section 20(b) (A) imposes primary or secondary liability, (B) has a scienter requirement, (C) requires the defendant to “control” the active party, and (D) creates an implied private cause of action.

A.          Does Section 20(b) Impose Primary or Secondary Liability?

If SEC Chair White’s assertion that Section 20(b) imposes primary liability on a defendant[21] is correct, Section 20(b) can be a potent tool for the SEC because there would be no need to first establish a primary Section 10(b) or similar violation. In a case like Janus, where a Section 10(b) violation could not be levied against the investment adviser, using Section 20(b) as an alternative, independent source of liability would potentially be the only avenue through which to pursue litigation.

Despite White’s confidence, the issue is not clear. The Majority in Janus declined to address whether Section 20(b) creates liability for those who act through innocent intermediaries.[22] However, the Dissent stated that if Section 20(b) is available for the plaintiffs, the Court should remand the case to allow for an amended complaint,[23] thereby suggesting Section 20(b)’s applicability to the case.

The statute does not explicitly address the matter. The phrase “any act or thing which it would be unlawful for such person to do under the provisions of this chapter or any rule or regulation thereunder”[24] is ambiguous. It could mean an act, which would otherwise be unlawful for such a person to commit on his own, is prohibited when executed through the means of another. Or it could mean an act, which is committed unlawfully by another person under a different provision or rule, is prohibited secondarily to the one who orchestrates it. Although she did not offer her reading of the statute, given White’s position that Section 20(b) imposes primary liability, White likely reads the statute the first way.

The ambiguity in the statute’s language notwithstanding, the context of this provision may be instructive. Section 20(b) is between two of the main secondary liability provisions in the 1934 Act. Section 20(a) establishes secondary liability for controlling persons, and Section 20(e) establishes secondary liability for aiding and abetting securities law violations. On the one hand, placement of Section 20(b) between these two provisions suggests that it too establishes secondary liability. However, a comparison of the language of these three provisions indicates that Section 20(b) is to be understood differently from the other two. Section 20(a) and Section 20(e) explicitly require a pre-existing violation by another person to attach a second level of liability.[25] Section 20(b)’s lack of such explicit language and its placement between two provisions in which Congress used unequivocal formulations suggest that Congress intended for Section 20(b) to establish primary liability.

Few courts address this issue outright. Two federal district courts each ruled that a complaint alleging a Section 20(b) violation cannot be sustained without a sufficiently plead primary violation, such as a Section 10(b) violation.[26] These courts understand Section 20(b) as establishing secondary liability, like its counterpart, Section 20(a). The Sixth Circuit, in SEC v. Coffey, also read all of Section 20 as establishing secondary liability.[27] Therefore, considering the direction of the case law, to have Section 20(b) impose primary liability, the SEC will need to support any linguistic argument by addressing the provision’s purpose or speculating Congress’s intent in enacting it.[28]

B.          Does Section 20(b) Have a Scienter Requirement?

Even if primary liability can be pursued under Section 20(b), such liability may require the showing of scienter.[29] Although Section 20(b) does not explicate whether the defendant must be of a certain state of mind when committing or directing the unlawful acts, the Second, Sixth, and District of Columbia Circuits require that a defendant knowingly use another person to violate the law.[30]

In most cases, such a requirement can easily be met.[31] Although a scienter requirement prevents using Section 20(b) against a corporation’s top executives that are unaware of any fraud, the SEC’s current goal is to use it against those who knowingly use innocent intermediaries to violate securities law. Therefore, the scienter requirement does not impede the SEC’s planned use of Section 20(b).

C.          Does Section 20(b) Mandate that the Defendant Control the Third Party?

The plain language of Section 20(b) does not require a control relationship between the defendant and innocent intermediary. This is in contrast to Section 20(a), which imposes liability on “[e]very person who, directly or indirectly, controls any person liable under any provision of this chapter.[32] Furthermore, the legislative history indicates that Congress intentionally left out a control requirement. The original bill introduced in the Senate that was the basis for the 1934 Act limited liability under Section 20(b) to controlled persons.[33] However, Congress ultimately expanded the statute to cover parties that lack control over the one executing the fraud. Nevertheless, the Second, Sixth, and District of Columbia Circuits held that liability under Section 20(b) requires the “knowing use of a controlled person by a controlling person.”[34] Otherwise, “every link in a chain of command would be personally[,] criminally[,] and civilly liable for the violations of inferior corporate agents.”[35] And the Coffey court believed that Congress did not intend Section 20(b) to impose such expansive liability.[36]

A control requirement would significantly constrain the SEC’s intended use of Section 20(b). First, it could not be used in cases like Janus, where the investment adviser and its mutual fund client did not have a control relationship, but were separate legal entities.[37] Additionally, by requiring control under Section 20(b), the courts read Section 20(b) in conjunction with Section 20(a), which requires a control relationship between the defendant and corporate agent. However, such a reading raises the question whether the good faith defense under Section 20(a) applies to Section 20(b). Although, to date, no courts have recognized this defense, if Section 20(b) is indeed an application of control person liability, such a defense could be raised and would present an additional hurdle for the SEC.

D.          Does Section 20(b) Create an Implied Private Cause of Action?

Whether Section 20(b) creates an implied private cause of action is an important question in considering the potential scope of Section 20(b) actions. Although the SEC seeks to use Section 20(b) in enforcement actions, if a private cause of action can be implied from the statute, Section 20(b) can be available for private parties as well.

The Supreme Court historically authorized implying private causes of action from the 1934 Act,[38] but the Court most recently has been reluctant to do so.[39] Consequently, it will be difficult for private parties to pursue litigation under Section 20(b). The statute contains no language that indicates congressional intent to create such an action. Furthermore, courts have been reluctant to establish private causes of action for neighboring provisions of Section 20.[40] And, in 1976, the United States District Court for the District of Massachusetts in McLaughlin v. Campbell ruled that no private cause of action exists under Section 20(b).[41] In reaching its decision, the court highlighted both the lack of legislative history and statutory language supporting a private action.[42]

Nevertheless, an argument exists for implying a private cause of action. Although the Fourth Circuit refused to create a private cause of action under Section 20(a), other circuits seem to disagree. Class certifications have been granted, or would have been granted if other class requirements were met, to private actions that pursued violations of Section 20(a).[43] However, because these cases predate the Supreme Court’s narrowing of implied private causes of action, which began in 2001, further case law is needed to clarify the current landscape of Section 20(a) class actions.

Furthermore, in McLaughlin, part of the court’s reasoning for refusing to create a private Section 20(b) cause of action was that, because Section 18 explicitly creates a private cause of action, implying one under Section 20(b) is unnecessary.[44] Section 18 allows for private litigation against a person who makes a false or misleading statement in a statutorily mandated document. [45] However, it does not support a cause of action in a case where the MMO was made in a document or statement that a company or fund has no legal obligation to issue. In such cases, a plaintiff could argue that a private cause of action under Section 20(b) is needed. Nevertheless, given the McLaughlin court’s holding, as well as the Supreme Court’s recent reluctance to imply private causes of action, it is unlikely that private parties will be able to bring actions under Section 20(b).

V.          Contexts in Which Section 20(b) Could Apply

Assessing whether Section 20(b) can be a useful anti-fraud tool in securities litigation requires not only the resolution of the doctrinal questions presented above, but also identification of specific contexts in which Section 20(b) can be applied.

A.          Tippee Liability in Insider Trading

The Supreme Court has already understood Section 20(b) as governing tippee liability in insider trading cases. In Dirks v. SEC, the Supreme Court ruled that a tippee, who receives information from an insider, has a duty to disclose or abstain from acting on that information, much like the insider himself.[46] The Court grounded the basis for this duty in Section 20(b), which it read as prohibiting an insider from disclosing inside information to an outsider, or tippee, to exploit the information for his personal gain.[47] The Court seems to understand the tippee’s duty to disclose or abstain as a function of the prohibition against the insider committing fraud through the means of another.[48] Furthermore, the Court established tippee liability under Section 20(b) without requiring the showing of a control relationship or a primary violation.[49] Instead, the Court seemingly understands Section 20(b) as imposing primary liability on the insider.[50] Therefore, the Court’s formulation in Dirks serves as strong support for the SEC’s plan for using Section 20(b).

B.          Hiring a Third Party to Draft Fraudulent Reports

Section 20(b)’s utility is further highlighted by the SEC’s allegations in a case currently pending before the United States District Court for the Northern District of Georgia, SEC v. Strebinger.[51] The SEC alleges that the defendants “coordinated a . . . campaign to promote the [s]tock” of a company in which each owned more than 5% of the outstanding stock.[52] According to the complaint, the defendant promoted the stock primarily by hiring third parties to draft stock promotion reports and mail them to potential investors. Specifically, it claims that the defendant arranged for various third parties to draft reports to be sent to potential investors, knowing, or at least recklessly not knowing, that they contained MMOs.[53] However, as argued in the motion to dismiss, it is not clear that the defendant had the “ultimate authority” over these reports as required by Janus to be deemed the “maker” of these statements under Section 10(b).[54] If the defendant lacked such authority, Section 20(b) would serve as the only form of primary liability that could be assigned to the defendant. By hiring third parties to draft and mail reports without retaining the authority to oversee their contents, the defendant committed fraud solely through the means of another person. While the motion to dismiss cites the case law discussed above that requires a control relationship under Section 20(b), which does not exist in this case,[55] if such a relationship is not necessary, Section 20(b) would directly apply to this case.

C.          Inducing a Business Partner to Make MMOs

A slight variation of the allegations made by the SEC in SEC v. Plummer, which is currently pending before the United States District Court for the Southern District of New York, further demonstrates how Section 20(b) can be a useful tool for the SEC.[56] Essentially, CEO A of company A, formed a business relationship to engage in a joint venture with the CEO of two other companies, B and C. CEO A supplied CEOs B and C with fraudulent information regarding company A’s business activities and financial statements, which CEOs B and C included in press releases of their respective companies. The goal was to drive up the stock prices of the respective companies, especially of Company A, which was failing. Although CEOs B and C could be liable under Section 10(b) for issuing the press releases containing the MMOs (assuming they had the requisite scienter regarding the fraudulent character of the information), under Janus, CEO A could not because he did not have the ultimate authority over issuing the releases. Although he could be held liable for aiding and abetting, that establishes only secondary liability and thus would be contingent on the success of the Section 10(b) claims against CEOs B and C. However, under Section 20(b), CEO A would be liable for committing fraud through CEOs B and C. Since he supplied them with fraudulent information, and he would be liable under Section 10(b) had he included this information in a press release issued by Company A, he would be liable under Section 20(b) for committing this fraud through CEOs B and C.

VI.          Conclusion

More case law needs to be written to determine how effective a tool Section 20(b) can be in pursuing actions against defendants who cannot be held liable under Section 10(b). Only a case that uses Section 20(b) as its sole or even primary cause of action will force the courts to properly delve into the doctrines outlined above.[57] As discussed, to fill the gap created by Janus, Section 20(b) needs to be interpreted as imposing primary liability and not requiring a control relationship. The statutory construction and legislative history both strongly support such a view. Courts, especially the Sixth Circuit, have nevertheless ruled against this view without much explanation, holding that Section 20(b) imposes secondary liability and requires a control relationship. Given courts’ seemingly blind acceptance of this view, it appears unlikely that any court presented with these questions in the future will hold otherwise.

*J.D. Candidate, Harvard Law School, 2016. B.A., M.A., Yeshiva University. I wish to thank Prof. Robert Clark for his insights and Martin Gandelman for inspiring my interest in this topic.

[1] Mary Jo White, Chairwoman, Sec. and Exch. Comm’n, Three Key Pressure Points in the Current Enforcement Environment, Address Before the NYC Bar Association’s Third Annual White Collar Crime Institute (May 19, 2014) (transcript available at http://www.sec.gov/News/Speech/Detail/Speech/1370541858285#.U6xknqHD_vI).

[2] 131 S. Ct. 2296 (2011).

[3] White, supra note 1.

[4] Janus, 131 S. Ct. at 2302.

[5] Id. at 2302. There, Janus Investment Fund, a mutual fund owned entirely by its investors, hired Janus Capital Management (JCM), an entirely separate legal entity, as its fund manager and administrator. Id. at 2299–302. The fund issued legally mandated prospectuses that allegedly contained misleading information. Id. However, the Court held that JCM could not be held liable under Section 10(b) for the misleading statements in these prospectuses because it did not have ultimate control over the fund’s issuance of those statements. Id. at 2304–05. Although JCM was the fund’s investment advisor and administrator, the ultimate decision as to whether to issue the prospectuses and what to include therein rested with the fund. Id. The Court rooted its decision in Section 10(b)’s language, which prohibits a person “to make any untrue statement of a material fact.” Id. at 2302. The Court reasoned that to “make” a statement, a person must have ultimate control over it. Id. Otherwise, one merely suggests or drafts a statement, but does not “make” it. Id.

[6] It should be noted that the Fourth Circuit held that the Janus holding is limited to implied private causes of action and does not apply to criminal actions for securities violations. Prousalis v. Moore, 751 F.3d 272, 276 (4th Cir. 2014). Even though the statutory language “make” in Section 10(b) serves as the basis of criminal actions just as in private actions, the Fourth Circuit believes that the Supreme Court’s limitation of liability under Section 10(b) was due to its recent general trend of limiting implied private causes of action. Id. at 276–77; see generally supra p. 10–11. However, other courts have held that Janus applies to SEC enforcement proceedings as well. The Fourth Circuit’s analysis notwithstanding, the SEC has conceded that Janus governs its enforcement proceedings as well. See, e.g., SEC v. Kelly, 817 F. Supp. 2d 340 (S.D.N.Y. 2011); SEC v. Sentinel Mgmt. Grp., 2012 WL 1079961 (N.D. Ill. Mar. 30, 2012). Indeed, the plain reading of Janus is that the basis for the holding is a linguistic argument that the term “make” requires ultimate authority.

[7] 15 U.S.C. § 78t(b) (2011).

[8] White, supra note 1. But see infra p. 7–9.

[9] SEC v. Coffey, 493 F.2d 1304, 1318 (6th Cir. 1974).

[10] See SEC v. Savoy, 587 F.2d 1149, 1170 (D.C. Cir. 1978) (interpreting the Sixth Circuit’s ruling in Coffey).

[11] See infra p. 10–11.

[12] See Coffey, 493 F.2d at 1318.

[13] SEC v. J.W. Barclay & Co., 442 F.3d 834, 842 (3d Cir. 2006); SEC v. First Jersey Sec., Inc., 101 F.3d 1450, 1472 (2d Cir. 1996).

[14] See e.g., SEC v. Hawk, No. 03:05-CV-00172-LRH-VPC, 2007 U.S. Dist. LEXIS 57414, at *6–7 (D. Nev. Aug. 3, 2007).

[15] J.W. Barclay, 442 F.3d at 845.

[16] Id.

[17] Id.

[18] 15 U.S.C. § 78t(a) (2011) (emphasis added).

[19] Myzel v. Field, 386 F.2d 718, 738–39 (8th Cir. 1967).

[20] Id. at 739.

[21] White, supra note 1.

[22] Janus Capital Grp., Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2304 n.10 (2011).

[23] Id. at 2311.

[24] 15 U.S.C. § 78t(b) (2011).

[25] Section 20(a) states, “Every person who, directly or indirectly, controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person.” 15 U.S.C. § 78t(a) (2011) (emphasis added). Section 20(e) states, “[A]ny person that knowingly or recklessly provides substantial assistance to another person in violation of a provision of this chapter, or of any rule or regulation issued under this chapter, shall be deemed to be in violation of such provision to the same extent as the person to whom such assistance is provided.” 15 U.S.C. § 78t(e) (2011) (emphasis added).

[26] See Espinoza v. Whiting, 8 F. Supp. 1142, 1157 (E.D. Mo. 2014); Shemian v. Research in Motion, Ltd., No. 11 Civ. 4068 (RJS), 2013 U.S. Dist. LEXIS 49699, *72 (S.D.N.Y. Mar. 29, 2013), aff’d, 570 F. App’x. 32 (2d Cir. 2014); Union Cent. Life Ins. Co. v. Credit Suisse Securities (USA), LLC, No. 11 Civ. 2327 (GBD), 2013 U.S. Dist. LEXIS 48984, *29–30 (S.D.N.Y. Mar. 29, 2013).

[27] 493 F.2d 1304, 1316 (6th Cir. 1974).

[28] See generally infra p. 5–7.

[29] The control requirement will be discussed in the following section.

[30] Coffey at 1318; Moss v. Morgan Stanley, Inc., 553 F. Supp. 1347, 1362 (S.D.N.Y. 1983), aff’d, 719 F.2d 5 (2d Cir. 1983); Cohen v. Citibank, 954 F. Supp. 621, 630 (S.D.N.Y. 1996); see also SEC v. Savoy Indus., Inc., 587 F.2d 1149, 1170 (D.C. Cir. 1978).

[31] In Janus, the investment adviser allegedly directed the fund to issue prospectuses containing MMOs. Janus Capital Grp., Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2300 (2011). This allegation suggests that the investment adviser acted intentionally with regards to disseminating the fraudulent statements.

[32] 15 U.S.C. § 78t(a) (2011) (emphasis added).

[33] It stated,

It shall be unlawful for any person, directly or indirectly, to do any act or thing which it would be unlawful for such person to do under the provisions of this Act or any rule or regulation thereunder through or by means of any other person who is controlled by such person by or through stock ownership, agency, or otherwise or through or by means of any other person who is controlled by such person and one or more other persons by or through stock ownership, agency of other otherwise for the purpose of avoiding any provisions of this Act or any rule or regulation made thereunder.

  1. 2693, 73rd Cong. § 19(b) (1934) (emphasis added) (In this bill, the current Section 20(b) is contained in Section 19(b).). The final version of the 1934 Act did not contain the italicized language.

[34] Coffey, 493 F.2d at 1318; Cohen, 954 F. Supp. at 630; Savoy Industries, Inc., 587 F.2d at 1170; see Moss, 553 F. Supp. at 1362.

[35] Coffey, 493 F.2d at 1318.

[36] Id.

[37] See Janus Capital Grp., Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2299 (2011).

[38] In a 1964 landmark decision, the Supreme Court in J. I. Case Co. v. Borak ruled that Section 27 of the 1934 Act authorizes private parties to bring a direct or derivative suit against a company for issuing a false or misleading proxy statement in violation of Section 14(a). 377 U.S. 426, 431–32 (1964). Although Congress did not explicitly reference a private cause of action in Section 14(a), the Court ruled that Section 27, which grants the federal courts jurisdiction over “all suits in equity and actions at law brought to enforce any liability or duty created,” under the Act supports a private cause of action because it furthers the purpose of Section 14(a), namely, to protect investors. Id. This ruling opened the door for implied private causes of action under the Act. In 1971, the Court confirmed the consensus of the lower federal courts that an implied private cause of action existed for Section 10(b). Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 730 (1975); Superintendent of Ins. v. Bankers Life & Cas. Co., 404 U.S. 6, 13 n.9 (1971).

[39] The Court’s expansion of the Act to include private causes of action even where Congress did not indicate that one existed eventually regressed. In 2001, the Court emphasized that private rights of action to enforce federal law must be created by Congress. Therefore, it ruled that a private action can be implied only when it determined that Congress intended for one to exist. Alexander v. Sandoval, 532 U.S. 275, 286 (2001). The Court believed that, absent congressional intent, a court’s attempt to imply a cause of action constitutes judicial overreaching into the realm of Congress, and undermines the constitutional directive that Congress establish the content of federal jurisdiction, not the Judiciary. Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 164–65 (2008). Therefore, while an implied private cause of action for a Section 10(b) violation still exists, see Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398, 2407 (2014), the Court’s reluctance to imply private causes of action where Congress has not intended to do so informs their interpretation and application of Section 10(b). Indeed, the Supreme Court’s narrow interpretation of Section 10(b) in Janus was partially due to its reluctance to expand it when Congress did not. 131 S. Ct. 2296, 2302 (2011).

[40] The Supreme Court refused to create a private cause of action for aiding and abetting under Section 20(e). See Stoneridge Inv. Partners, 552 U.S. at 164–66. The Fourth Circuit refused to create one for control person liability under Section 20(a). See Data Controls N., Inc. v. Fin. Corp. of America, Inc., 688 F. Supp. 1047, 1050 (D. Md. 1988), aff’d, 875 F.2d 314 (4th Cir. 1989).

[41] See 410 F. Supp. 1321, 1325 (D. Mass. 1976).

[42] See id.

[43] See e.g., In re W. Union Sec. Litig., 120 F.R.D. 629, 634–35 (D.N.J. 1988); Snider v. Upjohn Co., 115 F.R.D. 536, 542 (E.D. Pa 1987); Koenig v. Benson, 117 F.R.D. 330, 340 (E.D.N.Y. 1987); Katz v. Comdisco, Inc., 117 F.R.D. 403, 413 (N.D. Ill. 1987).

[44] See 410 F. Supp. at 1325.

[45] 15 U.S.C. § 78r(a) (2011).

[46] Dirks v. SEC, 463 U.S. 646, 659 (1983).

[47] Id.

[48] See id.

[49] Id.

[50] See id.

[51] Complaint for Injunctive and Other Relief at 2, SEC v. Strebinger, No. cv-03533 (N.D. Ga. Nov. 3, 2014).

[52] Id.

[53] Id. at 9, 19, 25.

[54] Memorandum in Support of the Motion to Dismiss of Defendants Bruce D. Strebinger, et al. at 17–18, SEC v. Strebinger, No. cv-03533 (N.D. Ga. Feb. 17, 2015).

[55] Id. at 29–30.

[56] Cf. Complaint, SEC v. Plummer, No. 1:14-cv-05441 (S.D.N.Y. July 18, 2014).

[57] While the cases currently pending before various district courts contain counts that cite Section 20(b), none of the alleged violations are being pursued solely on the basis of Section 20(b). Consequently, the courts treatment of the issues relating to Section 20(b) may not provide the final word on Section 20(b)’s parameters.

By

The Swaps Pushout Rule: Much Ado About the Wrong Thing?

Download PDF

John Crawford* and Tim Karpoff**

A notably bitter battle over financial reform in the wake of the crisis of 2008 has centered on a mandate that federally insured depository institutions—i.e., banks—refrain from entering into certain derivatives contracts.[1] The mandate was included as a provision of the Dodd-Frank Act and prohibited banks from entering into particular types of “swaps,” or contracts in which parties promise to pay each other based on defined events such as a bond default.[2] The prohibition was popularly known as the Swaps Pushout Rule (the “Rule”). Bank holding companies (BHCs) could continue to transact in these instruments, but had to do so out of different legal entities, such as broker-dealers.[3] Several of the largest financial institutions in the United States recently led a successful lobbying effort to roll back the Rule—which had not yet taken effect—so that banks can continue to enter into the vast majority of these swaps.[4] The Rule’s rollback has inspired intense criticism, but the critiques have not accurately reflected what is really at stake for the banks or the public. The Rule was sold as an anti-bailout measure;[5] however, this Article argues that the Rule would have been ineffective as a means to prevent bailouts of the largest, most complex BHCs—those that deal in these swaps. The Rule does, however, matter for prudential regulatory purposes—just not for the reasons put forward by critics.[6] What matters is not whether swaps are booked at a BHC subsidiary that enjoys formal access to the federal safety net,[7] but rather the size of the loss-absorbing capital “buffer” the BHC must use to fund its swap positions. It turns out that the size of the required buffer for the swap may vary depending on the legal entity in which it is booked.[8] This has important implications for what the appropriate response to the rollback should be.

This Article explains the practical impact of the Rule and its rollback—an essential step to informing further regulatory efforts. Part I provides a detailed description of the Rule, and Part II explains why the notion that it would have prevented bailouts is misguided. Part III explores possible reasons the systemically important BHCs (SIBs) that dominate the market in the relevant swaps lobbied for the rollback.[9] We argue that the principal reason SIBs care about the Rule is that the relevant swaps are subject to different capital charges based on whether they are booked in the SIBs’ bank or non-bank subsidiaries.[10] Put simply, it costs more to fund these swaps if they are booked at a broker-dealer rather than at a bank.

I.          The Rule

The Dodd-Frank Act was drafted in an environment of widespread public anger about the bailouts that occurred during the financial crisis; the Act promised, inter alia, to “end ‘too big to fail’ [and] to protect the American taxpayer by ending bailouts.”[11] The Rule was written as a provision of the Dodd-Frank Act and purported to serve this end. As drafted, the Rule would have prohibited insured depository institutions from entering only certain swap contracts: uncleared credit default swaps (CDS);[12] most types of equity swaps;[13] and swaps referencing most physical commodities.[14] These swaps were forbidden only to the degree that they did not aim to mitigate risks assumed in other (permissible) parts of the bank’s portfolio.[15] Interest rate swaps[16] and foreign exchange swaps[17]—which in aggregate represent the vast majority of SIBs’ swap portfolios in terms of market value[18]—would not have been subject to the Rule.

It is important to emphasize that while the Rule would have pushed the swaps out of the SIB’s bank subsidiary, it would not have pushed the swaps out of the SIB entirely; the swaps would have remained permissible if they were simply migrated to an affiliate entity in the same SIB’s holding company.[19] Figure 1 illustrates a typical SIB structure, consisting of a parent holding company atop an array of operational subsidiaries, including banks and broker-dealers.[20] What was at stake with the Rule, therefore, was not whether JPMorgan Chase & Co. (a holding company) could enter swap agreements, but rather which of its subsidiaries would house the swaps: JPMorgan Chase Bank, N.A. (an insured depository, or bank) or J.P. Morgan Securities LLC (a broker-dealer).

Figure 1: Illustrative SIB Holding Company[21]

Figure 1

As noted, the Rule was part of a legislative effort to end bailouts; the central plank of this effort was the creation of a mechanism to resolve failing financial institutions without the commitment of taxpayer funds.[22] The legislation left in place, however, an explicit promise by the federal government to “bail out” bank depositors (subject to an account-based cap) in the event of bank failure.[23] While deposit bailouts remain a central feature of our financial system, certain reform efforts have focused on lessening the likelihood of such bailouts by imposing heightened risk constraints on banks, including higher capital and stricter liquidity requirements.[24] The Rule represented an additional effort at risk constraint, inspired perhaps by one of the most salient and troubling crisis events: the bailout of the insurer AIG in September 2008.[25]

II.          The Rule’s Ineffectiveness as an Anti-Bailout Measure

Critics suggest that the Rule protected taxpayers from paying for bank risk-taking.[26] Whether taxpayers are on the hook for a bailout, however, is unlikely to turn on whether a SIB books its swaps in its bank subsidiary or its broker-dealer subsidiary. The key conceptual assumption driving this Article is that for the largest financial institutions—those that dominate the relevant swaps markets[27]—the relevant unit of analysis for thinking about potential taxpayer bailouts is the SIB as a whole, not its subsidiaries.

If a SIB subsidiary is insolvent but the SIB as a whole is not, the SIB parent company will almost certainly recapitalize the subsidiary; it does not matter whether it is the commercial bank or the broker-dealer.[28] If, on the other hand, the SIB as a whole is insolvent, the default option is to put it into bankruptcy. For the largest financial firms—those that dominate the relevant swap markets and that lobbied for the rollback of the Rule—however, it is highly likely that regulators would instead resort to the Single Point Of Entry (“SPOE”) strategy authorized by Title II of Dodd-Frank. The reason is straightforward: SPOE resolution is much less likely to spark a panic than a bankruptcy proceeding.[29]

The SPOE approach takes advantage of the organizational structure of U.S. SIBs: as noted above, they tend to have a parent holding company that issues equity shares and long-term debt in public capital markets and an array of subsidiaries that carry out the SIBs’ actual operations.[30] The Federal Deposit Insurance Corporation’s strategy under SPOE is to resolve only the holding company.[31] If the approach works, the subsidiaries will be transferred en masse and without any hiccup to a “bridge” holding company.[32] All SIB losses will be borne at the parent holding company level, by long-term debtors and shareholders; to ensure that there is enough loss-absorbing capacity at the parent holding company level, the Federal Reserve is preparing a rule that will require SIBs to issue a minimum amount of long-term holding-company debt as part of its “total loss-absorbing capital.”[33]

If this strategy works, it should not matter which subsidiary has booked the SIB’s derivatives. To be concrete, the debate over the Rule concerns whether certain swaps will be booked at a SIB’s commercial bank subsidiary, or its broker-dealer subsidiary. In either event, the subsidiaries will continue operating, and their third-party creditors and counterparties will suffer no losses or delays.[34] Taxpayers will not be on the hook: all losses will be borne by the long-term creditors and equity claimants of the SIB holding company.

But what if there is insufficient capacity at the holding company level to absorb all the SIB’s losses in a resolution? The formal requirement in this case is to resolve the subsidiaries that remain insolvent even after being recapitalized in the SPOE resolution process.[35] If regulators actually followed this approach, then in theory it could matter to taxpayers which subsidiary was insolvent.[36] However, we believe this scenario is unlikely. Required total loss-absorbing capacity at the holding company level is expected to be somewhere near 20% of risk-weighted assets. Should losses outstrip that amount, banking regulators will likely be more concerned about containing broader risks to the financial system than about imposing losses on subsidiary creditors. Resolving a SIB subsidiary and giving its creditors haircuts can generate the precise crisis-like dynamics—panic and its pernicious consequences—that Title II is meant to help avoid.[37] Regulators who invoke Title II will have strong incentives to prevent this outcome by effectively bailing out the SIB subsidiaries.

Despite the formal prohibition on bailouts, Title II provides some latitude for regulators to prevent contagion by engaging in a de facto bailout. If a newly capitalized SIB under a bridge holding company is facing a liquidity crunch, the Treasury is authorized to lend to the SIB.[38] The SIB has to be solvent in order to receive such loans.[39] The distinction between insolvency and illiquidity in a crisis can, however, be impossible to draw with confidence; it necessarily depends on a large number of assumptions, and a few optimistic (yet plausible) assumptions will often be enough to ground a solvency determination. If Treasury fails to recover its loans, it must impose an ex post levy on other SIBs, thus ensuring that taxpayers do not suffer losses.[40] Again, in this scenario—which we consider the likeliest in the event a SIB fails and its losses do, in fact, outstrip the loss absorbing capacity of the parent holding company—it should not matter ex post whether the swaps were booked at the bank or the broker-dealer.

III.          What Is at Stake for SIBs?

If the controversy surrounding the Rule’s rollback focused erroneously on the likelihood of bailouts of SIB subsidiaries, then the question remains why the big banks cared about the issue. What factors made it important enough for SIBs to lobby against the Rule? Below, we look at several possibilities, considering transition costs and collateral before zeroing in on capital as what is likely of greatest concern to the SIBs.

A.          Transition costs

One possibility is that there may be transition costs related to things such as rewriting contracts. These one-time costs may be substantial in the short-term, but in the long-term would likely be relatively small and should not be a major concern from a public policy perspective.

B.          Collateral

Another potential motivation relates to collateral requirements. Collateral is security against the future performance under a contract. In a CDS transaction, the contract is executory: both parties have yet to fully perform. Here it will help to provide a stylized example of a CDS for illustrative purposes.

Figure 2: 10-year CDS on Inc. Bonds

 

Figure 2

Figure 2 illustrates the structure of a typical CDS: a SIB (“Big SIB”) sells $10 million worth of protection to a hedge fund (“Hedgie”) against default by a corporate bond issuer (“Inc.”).[41] The CDS has a duration of 10 years, and to purchase the protection, Hedgie agrees to pay $125,000 per quarter to Big SIB.[42]

By construction, the CDS will be valued at zero at inception. This means that the expected present value of Hedgie’s premium payments to Big SIB perfectly offsets the expected present value of Big SIB’s contingent payment to Hedgie in the event of Inc.’s default.[43] As Inc.’s creditworthiness and other market conditions change over the life of the CDS, however, the value of the contract is unlikely to remain at zero. If, for example, the cost of buying $10 million worth of protection against Inc.’s default rises to $250,000 per quarter, then a default by Big SIB would impose a significant “replacement” cost on Hedgie: Hedgie would have to pay twice as much for the same level of protection with another dealer. If, on the other hand, the cost of buying $10 million worth of protection fell to $62,500 per quarter, then Hedgie’s default on its premium payments would be costly to Big SIB: Big SIB would have to take on twice the risk, guaranteeing $20 million worth of Inc.’s bonds, in order to replace the revenue stream it lost from Hedgie. Each party’s cost of replacing the position in the event of counterparty default is referred to as “current exposure,” and parties may post collateral as security for these replacement costs.[44]

Parties may also post collateral for “potential future exposure,” which reflects factors such as the volatility of Inc.’s bond spreads and counterparty creditworthiness.[45] The parties will generally use credit ratings as a proxy for creditworthiness.[46] Because of the interplay between credit ratings and collateral requirements, the entity in which a CDS transaction is booked can have a substantial impact on a broker-dealer’s profit margin. If there is a difference in the credit ratings assigned to a SIB’s broker-dealer subsidiary and its bank subsidiary, then the SIB will, all else equal, have an incentive to book derivatives at the higher-rated subsidiary. Higher credit ratings will generally translate into lower collateral requirements, which effectively lower the cost of the transaction. Some news reports cited this as a motivating factor behind SIBs’ lobbying for the Rule’s rollback.[47]

However, if our analysis of the likely fallout from SIB failure is correct, then the credit ratings of the bank and broker-dealer subsidiaries—which relate to uninsured debt such as long-term bonds—should generally be the same.[48] And indeed, there is no difference between the credit rating on long-term debt at the broker-dealer and commercial bank subsidiaries for four of the five SIBs that, in aggregate, account for 95% of total notional derivatives in the United States.[49] The broker-dealers and commercial banks of, respectively, JPMorgan Chase & Co., Goldman Sachs Group Inc., Bank of America Corporation, and Morgan Stanley, have received the same ratings from every credit ratings agency that has rated both.[50] Again, this is consistent with the discussion above suggesting that the probability of default on uninsured debt is likely not higher in a SIB’s non-bank subsidiaries than in its bank. There is one outlier: for Citigroup Inc., Moody’s rating for the broker-dealer is three notches below that of the bank; and S&P’s and Fitch’s respective ratings for the broker-dealer are one notch below their ratings for the bank.[51] We find this somewhat puzzling, given the realities of Title II. In any event, it was reported that Citigroup was particularly active in seeking the rollback of the Rule, and the impact of credit ratings on its collateral requirements may help (partly) explain Citigroup’s motivation, though it does not explain the motivations of other SIBs.[52]

C.          Capital

While transition costs and collateral concerns may have played some role in SIB lobbying for the rollback, we believe the central motivation was much simpler: a desire for more favorable capital treatment. What counts as “capital” for regulatory purposes can be extraordinarily complicated in operational terms but is simple at a conceptual level: it is a measure of the difference between a bank’s assets and its liabilities, between what it owns and what it owes. A larger capital buffer makes default—that is, failing to pay what is owed—less likely, holding all else equal.

Why, then, might SIB decision-makers want to minimize capital? The key reason is that if one holds equity constant, then taking on more debt—which translates to a thinner capital buffer in relative terms—can amplify the returns on equity (i.e., shareholder profits). This holds true as long as the return on assets—e.g., the interest on the loans the SIB makes to others—exceeds the interest the SIB pays to its lenders. In contrast, having to fund a business with more capital depresses a SIB’s return on equity. As a result, SIB decision-makers tend to view capital as an “expensive” way to fund the SIB’s activities, and thus have an incentive to minimize it.[53]

The bank capital regime is very different in its details from the “net capital” rules that apply to broker-dealers.[54] In many cases, but not all, the same position (such as contractual rights and obligations under a swap contract) will draw a larger capital requirement at a bank than at a broker-dealer. One might think that the SIB would want to book as many of these positions as possible at the broker-dealer instead of the bank. However, SIBs must apply bank capital rules on a consolidated basis throughout the entire holding company family, so that for most practical purposes the SIB cannot escape bank capital rules by parking assets at its non-bank subsidiaries. In contrast to positions where the bank capital charge exceeds the net capital charge, uncleared derivatives represent one limited subset of interests where the capital requirement at the broker-dealer, all else equal, may exceed the capital requirement for the same position at the bank.[55] This is especially the case under a new rule proposed, but not yet finalized, by the Securities and Exchange Commission.[56] It is our view that this was the most significant factor driving efforts to roll back the Rule.

To illustrate this, we will draw on the hypothetical CDS between Big SIB and Hedgie outlined above in Figure 2.[57] Assume the following two stylized facts: (1) the contract is struck with a value of zero at inception; and (2) Big SIB is precisely at its regulatory thresholds with respect to its bank capital, consolidated bank capital, and net capital requirements.

The CDS will require Big SIB to raise extra capital no matter where it is booked, but the swap will require Big SIB to raise more new capital under the SEC’s proposed net capital rule than under bank capital rules.[58] Both capital regimes—net capital and bank capital—require two calculations: (i) required capital and (ii) actual capital. Compliance demands that actual capital be greater than or equal to required capital (assumption (2) in the paragraph above means that the two are equal at Big SIB). If required capital goes up, or if actual capital goes down, Big SIB will have to raise new capital.

Consider first bank capital. As noted, at a high level, capital measures the difference between assets and liabilities. Because the contract is valued at zero, the swap leaves actual capital unchanged. The swap adds to the bank’s required capital levels, however: it must treat its exposure to the underlying reference asset—Inc.’s bonds—as if it had loaned cash to Inc. directly.[59] The $10 million exposure would receive a 100% risk weight,[60] and under rules being implemented now, a total capital charge of up to 15% would apply.[61] If the swap is booked in the bank, then, Big SIB will have to add as much as $1.5 million in capital to cover the position.

What about broker-dealers’ net capital? For broker-dealers that carry customer accounts which include all the largest broker-dealers, required net capital is computed as a percentage of customer debits.[62] Let us assume Hedgie is not a customer; the swap would then not add to Big SIB’s required net capital.[63]

The swap would, however, have an impact on Big SIB’s actual net capital: it would reduce actual net capital, meaning Big SIB would have to raise new capital to cover the shortfall. Actual net capital is calculated by computing a broker-dealer’s net worth and then making a number of adjustments, including deductions for various assets based on perceived risk.[64] The swap, valued at zero, would not add to the broker-dealer’s net worth, but would require new deductions. Under the rules that apply to Big SIB’s broker-dealer subsidiary,[65] the swap will require (1) a “market risk” deduction to account for the possibility that Big SIB will lose on the position due to Inc.’s performance or other market factors; and (2) a “credit risk” deduction to account for counterparty risk vis-à-vis Hedgie.[66] We consider the effect of each type of deduction in turn.

1.          Market Risk

The largest broker-dealers, including the broker-dealer subsidiaries of the SIBs affected most by the Rule and its rollback, use “alternative net capital” (ANC) rules that permit them to use their own internal financial models rather than mandatory haircuts to compute the necessary market risk deductions.[67] These models are visible to regulators but not to the general public. When the SEC proposed the rule permitting the use of internal models in 2004, however, it estimated the ANC rules would reduce deductions for broker-dealers by an average of 40%.[68] We may, then, be able to get a very rough estimate of the market risk deduction that would apply to Big SIB’s net capital if it booked the swap at its broker-dealer by calculating the mandatory deduction under the new rule and applying a 40% discount. Under the new rule, the mandatory deduction for the swap will be 25% of the notional value of the position,[69] or $2.5 million.[70] Applying a 40% discount as a rough proxy for the effect of Big SIB’s ability to use internal models, this would translate to a $1.5 million market risk deduction—as a practical matter, $1.5 million of additional capital that the broker-dealer will have to raise. As described below, however, several factors beyond the market risk deduction could have the effect of increasing the net capital charge for the position—potentially to much more than $1.5 million.

2.          Credit risk and collateral

Assume first that the position is fully collateralized on a net basis.[71] If Big SIB ends up having to post collateral with Hedgie, this collateral will count as an unsecured receivable which receives a 100% capital deduction under proposed rules.[72] This would, of course, create a significant capital charge if the market moved against Big SIB’s position. For example, if Inc.’s creditworthiness deteriorated one year after our illustrative CDS was struck, so that the cost of attaining the same level of insurance rose to $175,000 per quarter, then Hedgie’s current exposure to Big SIB—reflecting the replacement cost of the contract if Big SIB defaulted—would be very large: assuming a 5% annual discount rate, it would rise to approximately $1.44 million.[73] If Big SIB’s broker-dealer posted this as collateral, it would almost double the capital charge from $1.5 million to $2.94 million.[74]

It is also worth noting that the proposed rules for broker-dealers do not require that their own (net) exposure to swap counterparties be fully collateralized; if, however, the counterparty is a financial entity such as Hedgie, the broker-dealer’s unsecured exposure also receives a 100% deduction.[75] Thus, if Inc.’s creditworthiness improves instead of deteriorates, but Hedgie does not post collateral, the credit risk deduction could make Big SIB’s net capital charge just as onerous.

In any event, booking this swap in the broker-dealer will often require Big SIB to raise more—perhaps considerably more—new capital than it would have to raise if the swap were booked in the commercial bank. It is worth emphasizing again that changing the assumptions could radically change this outcome. The point of the example is to show that the net capital charge can be significantly greater than the bank capital charge, and SIBs have an incentive to maintain flexibility in where they book a swap in order to minimize the capital charge that applies to it. The Rule would have forced SIBs to book swaps where they would often require a larger capital charge; this is the principal reason SIBs pushed for the Rule’s rollback.

IV.          Conclusion

Despite critics’ claims in the wake of the rollback,[76] the Rule was oversold as an anti-bailout measure. If swaps give rise to negative externalities by increasing the risk of taxpayer bailouts, there are at least two ways to mitigate the cost: prohibition and forcing dealers to internalize more of the risk through higher capital requirements. The Rule was unsatisfying on either measure. For those in favor of prohibition, our analysis suggests that the Rule would have been ineffective as a way to protect taxpayers from risks arising from swaps dealing. An effective rule from this point of view would push the swaps out of the entire SIB holding company family, as the Volcker Rule does for proprietary trading.[77]

Higher capital requirements, on the other hand, are a standard prudential regulatory tool for mitigating risk. Requirements vary, depending on the type of legal entity in which a particular transaction is booked. Such variances drive much behavior for SIBs and it may be appropriate to harmonize these requirements across the various types of legal entities. In any event, those who believe swaps pose substantial risks, but who hesitate from calling for a SIB-wide prohibition, should focus on capital. The Rule may, as a practical matter, have achieved higher capital as a side effect, but it would have done so in an inefficient and opaque manner. If legislators or regulators believe capital requirements should be higher, they should raise them directly.

* Associate Professor, University of California, Hastings College of Law.

** Partner, Jenner & Block; Counsel to the Chairman, Commodity Futures Trading Commission, 2009–2012; Director, United States Department of the Treasury’s Office of Financial Institutions Policy, 2012–2014.

[1] See Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, § 716, 124 Stat. 1376 (2010) [hereinafter Dodd-Frank Act] (codified at 15 U.S.C. § 8305) (amended 2014).

[2] Id.

[3] Section 3(a)(4) of the Securities Act of 1934 defines a broker as a person or entity “engaged in the business of effecting transactions in securities for the accounts of others,” and Section 3(a)(5) defines a dealer as a person or entity “engaged in the business of buying and selling securities for his own account.” Securities Act § 3(a). Most major firms engaged in brokering and dealing do both, and are routinely referred to as “broker-dealers.” Securities Exchange Act of 1934, 15 U.S.C. § 78 (1934) (amended 2012).

[4] See Text of House Amendment to Senate Amendment to H.R. 83 at 615–18 (2014), http://docs.house.gov/billsthisweek/20141208/CPRT-113-HPRT-RU00-HR83sa.pdf. A comparison of the amended provision to the original Rule can be found at http://www.davispolk.com/sites/default/files/DFA_Section_716.pdf.

[5] Senator Elizabeth Warren, for example, declared that the rollback would put “taxpayers right back on the hook for bailing out big banks.” See, e.g., ‘Enough is enough’: Elizabeth Warren launches fiery attack after Congress weakens Wall Street regs, Wonkblog, Dec. 12, 2014, http://www.washingtonpost.com/blogs/wonkblog/wp/2014/12/12/enough-is-enough-elizabeth-warrens-fiery-attack-comes-after-congress-weakens-wall-street-regulations/.

[6] It is important to note that the rollback was criticized based on process as well as substance: some saw it as evidence of unhealthy influence by big banks. See id. Our focus, however, is exclusively on the substance of the Rule.

[7] This “safety net” consists of deposit insurance and access to emergency lending from the Federal Reserve.

[8] See infra Part III.

[9] Five SIBs account for 95% of the market in swaps dealing: JPMorgan Chase & Co., Citigroup Inc., Goldman Sachs Group Inc., Bank of America Corporation, and Morgan Stanley. See John Carney, Ratings Game Behind Big Banks’ Derivatives Play, Wall St. J., (Dec. 12, 2014), http://www.wsj.com/articles/ratings-game-behind-big-banks-derivatives-play-heard-on-the-street-1418417119?cb=logged0.08315180937852862. We restrict our analysis in this Article to SIBs because they dominate the market, were most active in pushing for the rollback, and have been the focus of criticism and “bailout” fears. If smaller banks’ market share of swaps dealing grew, it might affect one’s view of the appropriate regulatory response. See infra note 77 and accompanying text.

[10] See infra Part III.

[11] Dodd-Frank Act pmbl.

[12] For a description of CDS, see infra Part III. Uncleared swaps exclude swaps “cleared by a derivatives clearing organization . . . or a clearing agency . . . that is registered, or exempt from registration, as a derivatives clearing organization under the Commodity Exchange Act or as a clearing agency under the Securities Exchange Act, respectively.” Dodd-Frank § 716(d)(3).

[13] An example of an equity swap is one in which party A makes fixed payments to party B in exchange for payments that mimic the return on a particular corporation’s stock.

[14] Dodd-Frank Act, Pub. L. No. 111-203, § 716, 124 Stat. 1376 (2010) (codified at 15 U.S.C. § 8305). Note that swaps based on precious metals have always been exempt from the Rule.

[15] Id.

[16] In an interest rate swap, parties exchange different interest payments on a notional principal amount. One party will usually pay a fixed rate and the other party a floating rate. See, e.g., The valuation of US Dollar interest rate swaps, Bank for Int’l Settlements (Jan. 1993), http://www.bis.org/publ/econ35.htm.

[17] A foreign exchange swap involves the exchange of principal and interest in one currency for principal and interest in another currency; it is typically used by firms trying to “lock in” the value in currency A’s terms of future payments due to them in currency B. See, e.g., The basic mechanics of FX swaps and cross-currency basis swaps, Bank for Int’l Settlements (Sept. 2008), http://www.bis.org/publ/qtrpdf/r_qt0803z.htm.

[18] See BIS Quarterly Review, Bank for International Settlements, 141 (June 2015), http://www.bis.org/publ/qtrpdf/r_qt1506.pdf.

[19] As noted above, the Rule is different in this respect from the Volcker Rule, which forbids proprietary trading throughout the entire SIB.

[20] “Banks” in this Article refers to deposit-taking institutions. “Broker-dealers” include the classic Wall Street firms (often called—perhaps confusingly—“investment banks”) involved in activities such as underwriting securities offerings, buying and selling securities on their own or clients’ accounts, and advising corporate clients on mergers and acquisitions. SIBs engage in both types of activity, but out of different subsidiaries.

[21] See Title II Resolution Strategy Overview 14, Aug. 2012, https://www.fdic.gov/resauthority/sifiresolution.pdf.

[22] See Dodd-Frank Act, Pub. L. No. 111-203, § 214, 124 Stat. 1376 (2010) (codified at 12 U.S.C. 5394).

[23] This is, of course, deposit insurance. See Deposit Insurance at a Glance, Fed. Deposit Ins. Commission, https://www.fdic.gov/deposit/deposits/brochures/deposit_insurance_at_a_glance-english.html.

[24] See, e.g., Regulatory Capital Rules, 78 Fed. Reg. 62018 (codified at 12 C.F.R. parts 208, 217, and 225); Liquidity Coverage Ratio, 79 Fed. Reg. 61440 (codified at 12 C.F.R. parts 50, 249, and 329).

[25] AIG sold CDS on bonds backed by mortgages. These CDS were a bit like insurance: buyers promised to make periodic premium payments to AIG, and AIG promised to pay out on the CDS in the event the bond being “insured” suffered a defined “credit event,” such as a default. The CDS were unlike insurance, however, in that the “protection buyers” were largely taking speculative short positions rather than insuring against losses—they did not necessarily have an “insurable interest.” In addition, AIG was careful to structure the CDS so that they would not technically qualify as insurance contracts, which would have required AIG to set aside capital reserves against potential losses. In large part because of its failure to provide adequately for losses on its CDS portfolio, AIG required a massive bailout from the federal government. The Rule was intended to protect taxpayers from covering AIG-like losses at institutions whose creditors—i.e., depositors—continue to enjoy explicit federal insurance against losses. For an account of AIG’s bailout, see Fin. Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report, 19 (2011), available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf [hereinafter FCIC Report].

[26] See, e.g., supra note 5 and accompanying text.

[27] See supra note 9.

[28] The holding company is legally required to support the bank subsidiary. Dodd-Frank Act § 616(d), (codified at 12 U.S.C. 1831o-1). The holding company is not legally required to recapitalize the broker-dealer subsidiary, but failing to do so is likely to cause immense reputational damage to the SIB, and could constitute institutional suicide. See, e.g., Julie Creswell & Vikram Bajas, $3.2 Billion Move by Bear Stearns to Rescue Fund, N.Y. Times (June 23, 2007), http://www.nytimes.com/2007/06/23/business/23bond.html?pagewanted=all&_r=0. It is important to note, of course, that there are strict limits on the holding company’s ability to shift resources from banks to other subsidiaries. See Federal Reserve Act § 23A (codified at 12 USC 371c). If a SIB that was solvent on a consolidated basis—due to a well-capitalized bank—were unable to support a non-bank subsidiary, it would likely trigger the SPOE resolution discussed in this section.

[29] The failure of a SIB could trigger runs on sister SIBs if short-term creditors feel they are at risk of suffering delay and/or a haircut in recovering their principal. Preempting this dynamic requires meeting “no delay” and “no haircut” conditions for short-term creditors of a failed SIB. A SPOE resolution can plausibly meet these conditions, bankruptcy cannot. For a fuller discussion, see John Crawford, “Single Point of Entry”: The Promise and Limits of the Latest Cure for Bailouts, 109 Nw L. Rev. Online 103 (2014).

[30] See Dodd-Frank Act Title II; see also Resolution of Systemically Important Financial Institutions: The Single Point of Entry Strategy, 78 Fed. Reg. 76614, 76615 (proposed Dec. 18, 2013) [hereinafter Proposed SPOE Rule].

[31] Id. at 76615–17.

[32] Id. The new “bridge” holding company would be structurally just like the old holding company, but with fewer obligations and different claimants. The old shareholders would likely be wiped out; the old long-term creditors would likely have their debt claims on the original holding company converted into equity claims on the new bridge holding company—almost certainly representing a significant diminution in value. The term “bridge” reflects the provisional status of the claims on the new holding company during the resolution process; the new holding company serves as a “bridge” between the pre-resolution SIB and the post-resolution SIB.

[33] See Fin. Stability Bd., Adequacy of Loss-Absorbing Capacity of Global Systemically Important Banks in Resolution (2014), http://www.financialstabilityboard.org/wp-content/uploads/sites/87/TLAC-Condoc-6-Nov-2014-FINAL.pdf.

[34] Traditional cross-default provisions in swaps could disrupt this strategy, but major swap dealers have adopted a protocol to opt into resolution regimes that override these cross-default provisions. See Resolution Stay Protocol – Background, ISDA (2014) https://www2.isda.org/attachment/NzA0Mw==/RESOLUTION%20STAY%20PROTOCOL%20Background%20FINAL.pdf.

[35] See Proposed SPOE Rule, supra note 32, at 76623.

[36] It is possible that the government would be legally obligated to cover (some) losses at the bank if (i) the bank’s losses outstripped all the bank’s uninsured liabilities—otherwise, the uninsured depositors and bond holders could absorb all losses—and (ii) losses on insured deposits outstripped the funds available from the Federal Deposit Insurance Fund, which is capitalized by industry fees rather than taxpayer dollars. The government would be under no legal obligation to cover losses at the broker-dealer.

[37] Panic is a phenomenon that affects short-term funding; short-term funding is used by SIB subsidiaries but generally not the SIB holding company.

[38] Id. at 76616.

[39] Id.

[40] Id. at 76617. The “ex post levy” means that the government will collect any money it loses on the loans it makes to the bridge holding company through a fee or tax on remaining SIBs.

[41] It is important to note that the $10 million is notional: it does not actually change hands upfront.

[42] This represents a cost of protection of 500 basis points, or 5% per annum: four annual payments of $125,000 equals $500,000 per year, or 5% of $10 million.

[43] This assumption is stylized for ease of analysis; the reality is usually a bit more complicated. See, e.g., David Mengle, The Value of a New Swap, ISDA Res. Notes (2010), http://www.isda.org/researchnotes/pdf/NewSwapRN.pdf (“The pricing of derivatives transactions is based on the theoretical concept of pricing at mid-market, that is, zero net present value at inception. In practice, the mid-market price is generally not the actual price transacted with a counterparty, but is instead a benchmark against which the actual price is set.”). In general, the divergence from zero is likely to be small. Id. at 2, note 1 (“The small initial divergence from par is the dealer’s profit on making the market.”). A notable counter-example of a large divergence involved a derivative transaction in 2006 between the government of Greece and Goldman Sachs. The deal was struck “off-market” such that Greece’s day one position on the transaction was significantly negative. In return, Goldman Sachs made a substantial upfront payment to Greece, which had the effect of making the Greek government’s fiscal position look healthier than it was. This transaction was, however, unusual.

[44] Collateral posted to cover current exposure, or the cost of replacing the position, is referred to as “variation margin.” See Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers, 77 Fed. Reg. 70214, 70257 n.475 (proposed Nov. 23, 2012) [hereinafter Proposed Capital Rule] (“In the Dodd-Frank Act, collateral collected to cover current exposure is referred to as variation margin.”).

[45] See id. at 70241 (“[P]otential future exposure” covers “the risk, among other things, . . . that the current exposure may increase in the future and the counterparty will default on the obligation to provide additional collateral to cover the increase . . . .”). In practice, of course, the parties will generally net out both their current and potential future exposure in posting collateral. See, e.g., id. at 70243 (“For internal risk management purposes, the ANC broker-dealer monitors and controls its exposure to the counterparty on a net basis.”). Parties will typically net out their obligations across all derivatives contracts they have entered with each other. It is worth noting that prior to the financial crisis, parties were generally not required to collateralize these counterparty credit risks. However, even in that period, as market conditions and the creditworthiness of the counterparties changed, the parties would often exchange collateral to account for these shifts. Following passage of the Dodd-Frank Act, and corresponding enactment of similar measures in Europe and Asia-Pacific, most transactions require financial parties to collateralize their transactions.

[46] Collateral terms between two counterparties for swaps are set forth by the International Swaps and Derivatives Association (ISDA) in a document known as the Credit Support Annex. The specific terms can be customized, but the form is standard across the industry. Credit ratings are a typical factor in determining the amount of collateral that counterparties must post under different scenarios, given that current exposure and potential future exposure are essentially other forms of the extension of credit. As such, a party to a CDS will generally have to post more collateral the lower its credit rating. Assets posted as collateral translate to less funding for other productive and profitable purposes.

[47] See Carney, supra note 9. The SIB’s counterparty will often be a smaller bank, and Carney astutely observes that the smaller bank may itself be required to take a higher capital charge the lower the SIB’s credit rating due to heightened counterparty risk, and that this will affect pricing adversely for the SIB. Id. Of course, if the position is fully collateralized, it will not require a higher capital charge for the small bank, but either way, the small bank will demand more generous terms from the SIB, cutting into the SIB’s profit margin.

[48] This is because there is little practical difference in the likelihood of default by different SIB subsidiaries, given the realities of Title II.

[49] See Carney, supra note 9. JPMorgan Chase & Co. alone accounts for 44% of credit default swaps.

[50] The relevant credit rating for derivatives purposes is the rating on long-term debt. See JPMorgan Chase & Co., Fixed Income Information: Credit Ratings, http://investor.shareholder.com/JPMorganChase/fixedIncome.cfm (comparing JPMorgan Chase Bank, N.A. to J.P. Morgan Securities LLC); Goldman Sachs Credit Ratings, http://www.goldmansachs.com/investor-relations/creditor-information/gs-entity-rating.pdf (comparing Goldman Sachs & Co. to Goldman Sachs Bank USA); Bank of America, Fixed Income Overview: Credit Ratings Summary, http://investor.bankofamerica.com/phoenix.zhtml?c=71595&p=debtoverview#fbid=nfXFTZgx57A (comparing Bank of America, N.A. to Merrill Lynch, Pierce, Fenner & Smith Incorporated); Morgan Stanley Investor Relations, Creditor Information: Current Credit Ratings, https://www.morganstanley.com/about-us-ir/creditor-presentations.html (comparing Morgan Stanley Bank, N.A., to Morgan Stanley & Co. LLC).

[51] Citigroup Credit Ratings, http://www.citigroup.com/citi/investor/rate.htm (comparing Citibank, N.A., to Citigroup Global Markets Holdings Inc.).

[52] See Carney, supra note 9 (noting that the provision rolling back the Rule “was reportedly authored by lobbyists for Citigroup,” but “J.P. Morgan Chase chief Jamie Dimon [also] called to lobby lawmakers”).

[53] There are strong critics of banks’ claim that “capital is expensive.” See generally Anat R. Admati et al., Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive (Stanford Graduate Sch. of Bus. Research Paper No. 13-7, 2013). These critics argue that capital is expensive relative to debt only because of social subsidies such as implicit government guarantees of the largest financial institutions and the deductibility of interest payments (but not dividends). Id. They do not, however, question that capital can be at least privately expensive for SIBs, thus creating the incentive to minimize it.

[54] We will assume that the relevant choice of subsidiaries for the SIB is either a bank or a broker-dealer, but it is worth noting that any non-bank entity dealing in swaps will face capital requirements that are largely identical to those applying to broker-dealers. See Proposed Capital Rule, supra note 46.

[55] Unlike bank capital requirements that apply on a consolidated basis to the entire SIB, the net capital requirements apply only to the broker-dealer.

[56] Proposed Capital Rule, supra note 46.

[57] To be clear, for the purposes of this Article we use a highly simplified example and ignore a number of factors related to how precise capital requirements for a broker-dealer or bank would be calculated. These simplifying steps are adopted as a matter of convenience and do not affect our ultimate conclusion—that capital requirements for a given credit derivatives transaction booked at a broker-dealer would be higher than they would be if the positions were booked at a depository institution.

[58] It is important to emphasize that different assumptions will yield different results. In some cases, the net capital charge may be even greater than the bank capital charge; in others, bank capital will exceed net capital requirements. Our goal here is not to map out the relative capital charges under a wide range of scenarios, but simply to illustrate how the net capital charge can, under plausible assumptions, prove more onerous.

[59] 12 C.F.R. 3.34(c)(2) (“A national bank or Federal savings association that is the protection provider under an OTC credit derivative must treat the OTC credit derivative as an exposure to the underlying reference asset.”). Counterparty credit risk need not affect capital requirements for the bank as protection seller, and we assume for ease of exposition that it does not here. See id. (“The national bank or Federal savings association is not required to compute a counterparty credit risk capital requirement for the OTC credit derivative under § 3.32, provided that this treatment is applied consistently for all such OTC credit derivatives.”). Collateral also does not generally affect capital for the bank as posted collateral remains on the balance sheet of the bank and received collateral is segregated so it does not appear on the bank’s balance sheet. The treatment of collateral for broker-dealers is different. See infra note 77.

[60] See 12 C.F.R. 3.32(f) (“A national bank . . . must assign a 100% risk weight to all its corporate exposures.”). Risk weights are a way of adjusting required capital to the perceived riskiness of a bank’s assets. In this example, where the capital requirement is 15%, infra note 61, a 100% risk weight means that the bank has to apply the 15% capital requirement to the full face value of the position. A 50% risk weight would mean that the bank would apply the 15% capital charge to 50% of the face value of the position, effectively halving the required capital. And if the risk weight were zero—as with Treasury bonds, the traditional paragon of a “safe” investment—it would mean that there would not be a capital charge at all for the position.

[61] Under rules that will come fully into effect at the beginning of 2019, all banks are subject to capital requirements—consisting of a “minimum total capital ratio” plus a “capital conservation buffer,” and expressed as a percentage of risk-weighted assets—of 10.5%. See Regulatory Capital Rules, 78 Fed. Reg. 62018, 62075 at tables 5 & 6 (Oct. 11, 2013). In addition, the largest SIBs will be subject to an additional SIB capital “surcharge” of up to 4.5 percentage points. See Board of Governors for the Federal Reserve System, Press Release, July 20, 2015, http://www.federalreserve.gov/newsevents/press/bcreg/20150720a.htm (“[E]stimated surcharges . . . range from 1.0 to 4.5% of each firm’s total risk-weighted assets.”).

[62] 17 C.F.R. 240.15c3-1(a)(1)(ii).

[63] If Hedgie is a customer, then Big SIB’s broker-dealer could face even higher capital requirements, as required net capital would rise as a result of any collateral that Hedgie posted with the broker-dealer (since such collateral would constitute customer debits).

[64] 17 C.F.R. § 240.15c3-1(c)(2) (2015).

[65] See infra note 67 and accompanying text.

[66] 17 C.F.R. § 240.15c3-1e(b) & (c) (2015).

[67] 17 C.F.R. § 240.15c3-1e (2015). See also Removal of Certain References to Credit Ratings Under the Securities Exchange Act of 1934, 79 Fed. Reg. 1522, 1532 n.162 (Jan. 8, 2014) (“Currently, there are six ANC broker-dealers: Barclays Capital Inc.; Citigroup Global Markets, Inc.; Goldman Sachs & Co.; J.P. Morgan Chase Securities LLC; Merrill Lynch Pierce Fenner & Smith Incorporated; and Morgan Stanley & Co. Incorporated.”).

[68] See Alternative Net Capital Requirements for Broker-Dealers that are Part of Consolidated Supervised Entities, 69 Fed. Reg. 34428, 34455 (“In the Proposing Release, we estimated that broker-dealers taking advantage of the alternative capital computation would realize an average reduction in capital deductions of approximately 40%.”).

[69] See Proposed Capital Rule, supra note 46, at 70335. The market deduction for the protection seller in a CDS is determined by length to maturity and the basis point spread (that is, the premium paid by the protection buyer). The rule requires a deduction of 25% of the notional amount of protection for 10-year contracts with a 500 basis point spread (as in our example with Big SIB and Hedgie).

[70] The notional value is $10 million; $10 million x 25% = $2.5 million.

[71] This means that, after netting, the party with current or potential future exposure to the other party receives collateral to cover the entire (net) exposure.

[72] See Proposed Capital Rule, supra note 46, at 70241.

[73] Again, this is an estimate for purposes of the stylized example; the replacement cost—i.e., the current exposure that needs to be collateralized—should be calculable based on the present value of the difference between the stream of the premium payments Hedgie is currently making and the stream of premium payments it would have to make if it struck a new contract for the same degree of protection. This would presumably be discounted by some estimate of the likelihood that the premium payments will stop due to Inc.’s default, but we ignore this to keep the example (relatively) simple. Under these assumptions, current exposure can be determined by the equation , where CE = current exposure; D = the difference between the periodic (quarterly) payment, i.e., $175,000 minus $125,000, or $50,000; i = the discount rate, i.e., 1.25% per quarter (equivalent to 5% per annum); and n = the number of quarterly payments, i.e., 36, as one year has elapsed and there are nine years left on the original CDS.

[74] Big_SIB’s bank would have to post the same collateral, but it would not have to take a capital deduction for it.

[75] See Proposed Capital Rule, supra note 46, at 70241.

[76] See, e.g., supra note 5; see also Emily Stephenson & Sarah N. Lynch, Sen. Feinstein working to reinstate U.S. swaps ‘push-out’ rule, Reuters, Feb. 6, 2015, http://www.reuters.com/article/2015/02/06/usa-congress-swaps-idUSL1N0VG26G20150206 (Senator Diane Feinstein stated she was “appalled that we are again opening the door to the trading of risky derivatives backed by a taxpayer guarantee.”); Heidi Moore, Congressional budget welcomes big bank bailouts once more despite White House opposition, The Guardian, Dec. 10, 2014, http://www.theguardian.com/business/2014/dec/10/congressional-budget-big-bank-bailouts (Dennis Kelleher, president of Wall Street watchdog Better Markets, claimed the Rule “was saying US taxpayers should not be paying for risky trading activities.”).

[77] This may be the appropriate approach if, contrary to the current market configuration, swaps dealing becomes a large and widespread problem among non-SIB banks. On the other hand, such a move might prove counterproductive if it pushed systemically risky activities into unregulated corners of the market. See, e.g., Cheyenne Hopkins & Silla Bush, Dodd-Frank Swaps Pushout Would Be Eased by Bipartisan Bills, Bloomberg Business, (Mar. 6, 2013), http://www.bloomberg.com/news/articles/2013-03-06/dodd-frank-swap-pushout-would-be-limited-under-bipartisan-bills (“Fed Chairman Ben S. Bernanke and Sheila Bair, the former Federal Deposit Insurance Corp. chairman, opposed the provision and argued that it would drive derivatives trading to less-regulated entities.”).

By

www.PayDayLoans.gov: A Solution for Restoring Price-Competition to Short-Term Credit Loans

Download PDF

Eric J. Chang†

I.           Introduction

Disclosure has been the primary mechanism for federal credit regulation[1] since the passage of the Truth in Lending Act (TILA) in 1968.[2] By mandating lenders to disclose key terms, TILA attempts to empower borrowers by enabling them to compare different lenders’ rates before choosing one. As a result of this “comparison-shopping,” lenders, in theory, price-compete among each other to offer the best rates or terms in order to attract the business of the borrower.[3] Legislators, regulators, and the credit industry have long favored disclosure-based rules because they are less costly and burdensome than traditional interest rate caps or other forms of direct regulation.[4]

Unfortunately, TILA has been ineffective with regards to payday lending. As explained below, payday loan borrowers have been unable to use the mandated disclosures to comparison-shop, and consequently, lenders have had no incentives to price-compete.[5] Without price-competition, payday loan interest rates have remained exceptionally high.[6] As a result, millions of payday loan borrowers end up owing more money to their payday lenders than to their original debtors.[7]

The Consumer Financial Protection Bureau (CFPB) has recently concluded that this lack of price-competition among payday lenders means that more direct regulation is needed.[8] In March 2015, the CFPB released an advanced notice of proposed rulemaking and announced that it was considering two options in their forthcoming rules.[9] Before issuing loans, lenders would either be required to verify a borrower’s ability to repay the loan or else be required to provide affordable repayment options, such as a “no-cost” extension if borrowers default on their loans more than two times.[10] However, these types of regulations have not only been proven ineffective in the few states that have already experimented with them,[11] but also run contrary to the principles of free-market economics and would thus further increase the cost of loans to borrowers.[12]

Instead, this Article argues that price-competition among payday lenders may be easily restored by creating an online exchange platform for them to voluntarily post their rates and offer their services to borrowers.[13] By listing lenders’ interest rates side by side, this website can facilitate comparison-shopping by providing borrowers with a tool to easily compare the rates and terms of different lenders. A federally operated website with a “.gov” web address will stand out amidst the myriad of for-profit comparison websites that currently dominate Internet searches.[14]

Part II provides the background for this Article by defining the payday loan, examining its dangers, and introducing TILA. Part III argues that TILA has failed to facilitate price-competition among payday lenders, and identifies three factors contributing to this problem. Part IV proposes the creation of an online comparison site and argues that this solution will directly address the three previously identified factors. Part V discusses and rebuts potential criticisms of this solution. Part VI addresses the CFPB’s recent proposal and argues that it will be less effective than this Article’s proposal.

II.          Background: Payday Lending in America and the Regulatory Landscape

A.          Defining the Payday Loan

Despite being labeled by one lawmaker as “the worst financial product out there,”[15] the literal definition of a payday loan is simple: a short-term, small-dollar loan that is paid back in a single lump sum.[16] Payday loans are particularly attractive to low-income individuals who do not qualify for traditional forms of credit,[17] and they are less costly than informal credit options such as overdraft protection, bounced checks, or late payment fees.[18]

A variety of independent studies have extensively documented America’s need for some level of short-term, small-dollar loans.[19] For instance, a 2011 study by the National Bureau of Economic Research found that nearly half of all American households could “probably not” or “certainly not” come up with $2,000 to deal with a financial shock of that size—even if given thirty days.[20] Another report from the National Foundation for Credit Counseling concluded that to pay for an unplanned expense of $1,000, sixty-four percent of households would have to seek credit elsewhere, such as borrowing from friends or family, or disregarding other monthly expenses.[21] A report by the Federal Reserve Bank of New York further showed that states that have banned payday lending suffer from higher rates of bankruptcy and bounced checks than states in which payday lending is permitted.[22]

With such a well-documented need, it is no surprise that the payday lending industry has seen exceptional growth throughout the country. Emerging in the early 1990s,[23] the number of payday lenders in America grew to over 10,000 by the year 2000.[24] Just ten years later, this number has doubled, and there are now twice as many payday lenders as Starbucks coffee locations.[25] In 2012, storefront lenders processed roughly 90 million transactions and provided nearly 30 billion dollars in loans.[26] Today, payday lenders provide loans to over nineteen million American households, particularly those households that suffer from poor credit scores and lack access to more traditional forms of credit.[27]

B.          The Danger of Payday Lending

Despite serving a legitimate need, the current payday lending landscape is undoubtedly problematic. The vast majority of payday loans in America tend to carry extremely high interest rates with a median rate of fifteen percent for a fourteen-day period,[28] which translates to an annual interest rate of around 391%.[29] These high interest rates are a primary contributor to nearly every real-life example of “payday lending gone bad.”[30]

A recent federal study helps illustrate this danger by providing a few more data points.[31] First, the report shows that in 2012, the median payday loan principal was $350.[32] Using the fourteen-day median interest rate from above, the cost of the loan is approximately $52.50 for just two weeks. If at the end of the two-week term, the borrower cannot fully pay off the entire sum of $402.50, the loan must be extended for another two weeks and another fifteen percent fee. Simple math shows that when a typical borrower misses the loan deadline just once, perhaps due to another financial emergency, the borrower ends up owing a total of $105 on top of the original principal. For these borrowers already facing financial difficulties, this is a huge sum that may potentially trap them in a debt cycle or “debt treadmill,” where borrowers must continually take out loans with multiple lenders to pay off debts from other lenders.[33]

C.          The Truth in Lending Act

In the face of this growing danger, the Federal Reserve Board officially included payday lenders as a covered entity under TILA in March of 2000.[34] TILA remains the primary body of law governing payday lenders today.[35] Originally passed in 1968, TILA is a disclosure statute that does not control what terms a creditor must offer, but requires that those terms be uniformly disclosed to the consumer. TILA presumes that rational consumers who are given “accurate and meaningful disclosure of the costs of consumer credit” will be able “to make informed choices”[36] and borrow money at the best price available.[37] Subsequently, as informed borrowers begin to gravitate towards the “best price,” other lenders are forced to lower prices to match or beat the “best price” or “best terms” to stay competitive.[38]

To demonstrate, suppose there are two gas stations that are located at the same street corner. Both gas stations advertise their prices for drivers to see. Since antitrust laws prevent the stations from cooperatively setting high prices, price disclosure facilitates market competition by eliminating the possibility that any station can charge an unfair price. In order for either station to remain competitive, the station must set the price as low as possible so that it does not lose business to the neighboring station, but high enough that it still earns a fair profit. As a result, consumers who buy gas at either station are able to obtain it at what economists call the “equilibrium price,” the price where supply meets demand perfectly; both gas stations make fair income, and further government regulation is unnecessary.[39] This scenario demonstrates the primary presumption that drives all disclosure-based regulation, which has been affirmed in law reviews,[40] social science literature,[41] treatises,[42] administrative regulations,[43] U.S. Supreme Court decisions,[44] and a wide variety of other sources.[45]

III.          Recognizing the Problem: Why TILA has Failed to Facilitate Price-Competition among Payday Lenders

Unfortunately, TILA’s mandated disclosures have not effectively facilitated price-competition for payday lending.[46] While the number of lenders in the marketplace has increased,[47] payday lending prices remain remarkably high.[48] Scholars repeatedly cite three factors as the primary contributors to TILA’s ineffectiveness in facilitating price-competition among payday lenders: (A) consumers’ inability to understand disclosures,[49] (B) high transactions costs of comparison-shopping,[50] and (C) deception by payday lenders.[51]

A.          The First Factor: Many Borrowers Do Not Understand TILA’s Disclosures

The first contributing factor has been discussed at length both before and after the passage of TILA: consumers may purchase credit even when they do not fully understand the costs of doing so.[52] One study by the University of Michigan’s Survey Research Center has gone so far as to state that most “consumers are wholly unaware” of the rate they pay for credit.[53] In addition, while many studies have established that consumer awareness of the “annual percentage rate” (APR) has significantly increased, these studies also reveal that consumers have difficulty processing that information.[54] For instance, one leading study indicates that as consumers become more knowledgeable about the APR, their knowledge of other equally important terms, like the finance charge, decreases.[55] Therefore, many scholars conclude that TILA has “succeeded in making consumers increasingly aware, but . . . has not managed to explain to them what . . . they have been made aware of.”[56] As a result of borrowers’ difficulty in deciphering what price or terms are actually in their best interest, the lenders’ incentive to price-compete is removed, and the market is prevented from ever reaching the “equilibrium price.”

Regrettably, this problem has proved particularly difficult to solve for low-income borrowers. They often have trouble understanding the English language and have general financial literacy or educational problems that may further limit their understanding of credit disclosures.[57]

B.          The Second Factor: Transaction Costs of Comparison-Shopping Are Too High for Payday Loan Borrowers

Comparison-shopping also requires significant upfront costs of time and effort. A prospective borrower is often required to fill out a loan application and verify his employment before the interest rate is ever disclosed to him.[58] By definition, comparison-shopping requires multiple rates for comparison, so a prospective borrower looking to comparison-shop would have to repeat this loan application process multiple times.[59] Given that the majority of borrowers tend to turn to payday lending out of a need for emergency credit, these upfront costs of time and effort are impractical, if not unmanageable.[60]

Furthermore, privacy concerns may impose additional costs on the transaction. For instance, many studies have reported that verifying a borrower’s employment is often conducted by calling the borrower’s supervisor.[61] Visiting multiple lenders and having each of them call a borrower’s supervisor to verify employment can be understandably unfavorable.[62]

C.          The Third Factor: Deceptive Practices by Lenders to Hide Disclosures

Lastly, even if borrowers were able to understand the disclosures and could afford comparison-shopping’s transactions costs, many payday lenders would still use deceptive practices to manipulate borrowers.[63] For example, lenders have been reported to accompany disclosures with comments that marginalize the information by describing the terms as “just standard language” or purposely providing nonresponsive answers.[64] Aggressive salesmen might also intimidate borrowers by convincing them that they are the only possible loan source for a person like the borrower.[65] Lastly, some lenders provide no disclosures at all; instead, they offer the borrower a document with blanks that will be “completed later.”[66] Given a combination of borrowers’ deference to lenders’ expertise, and borrowers’ insecurity or fear of appearing ignorant, these marginalizing disclosures and nonresponsive explanations are rarely questioned.[67]

IV.           The Proposed Solution: Facilitating Price-Competition with an Online Exchange

To address these three factors, this Article proposes creating a federally operated online exchange (Exchange) for payday lenders to post their rates and for borrowers to apply and receive payday loans. By listing dozens of lenders’ rates side by side, the Exchange restores comparison-shopping by providing borrowers with a tool to easily compare the rates and terms of different lenders. A federally operated online exchange with a “.gov” web address is not only less susceptible to moral hazards, but will stand out amidst the for-profit comparison sites and advertisements that currently dominate a borrower’s web search for payday lenders.[68] The Exchange will aim to be a “one-stop” destination for prospective borrowers looking for payday loans, and payday lenders will voluntarily register with the Exchange in order to reach these potential customers.[69]

While the technical details of the Exchange’s user interface are not the subject of this Article, it is not difficult to visualize how the hypothetical Exchange might operate: prospective borrowers visiting the Exchange’s web address will be prompted to enter a loan amount, location, loan duration, and other necessary facts similar to the information currently required by traditional storefront or online lenders. Borrowers will then be provided with a list of lenders and the total cost of each loan. They will then select a lender and confirm to complete the loan. This simple system will address all three flaws in TILA’s disclosure regime.[70]

A.          The Exchange Helps Borrowers Understand Disclosures

First, the Exchange directly addresses a borrower’s inability to understand disclosures or contract terms. The Exchange can offer standard disclosures and contract terms in virtually every language and afford the borrower as much time as necessary to digest the information. Likewise, the Exchange can provide definitions of confusing terms and improve the financial literacy of a subpopulation that arguably needs it the most.[71]

More importantly, it realizes an additional layer of protection for borrowers. With the total costs of different lenders’ loans side by side, a borrower’s misunderstanding of contractual or financial terms is much less relevant. As long as the borrower selects the lowest total cost available, it matters little whether he truly understands what an interest rate or finance charge actually includes.[72]

B.          The Exchange Severely Reduces Transaction Costs of Comparison-Shopping

The Exchange also addresses the current reality that the costs of comparison-shopping are prohibitively high for prospective payday loan borrowers. By providing near instant comparisons, the Exchange significantly reduces the costs of comparison-shopping. Borrowers are required to fill out necessary loan information just once and are no longer required to seek out or travel to different lenders to compare rates and terms.

With the transaction costs reduced, borrowers will have more incentive to comparison-shop, and lenders will be re-incentivized to price-compete.[73] Professor Chris Peterson, Senior Counsel for Enforcement Policy and Strategy at the CFPB,[74] noted the high transaction costs of comparison-shopping:

Until there is proof that [comparison] shopping costs . . . do not swamp the benefits of shopping, there can be no safety in the belief that market forces will drive down prices. For example, if seven lenders were all lined up in a row, each with clearly described prices, we might feel confident that debtors had a financial incentive to compare the prices of each lender, and in turn, each lender would have an incentive to price-compete. But, if each lender were spread out, one on each of the seven continents, no debtor would bear the cost of shopping at each location.[75]

While Peterson uses the hypothetical row of seven lenders as an intentionally unrealistic “ideal scenario,” this is the very reality that the Exchange creates. Only instead of seven lenders side by side, the Exchange could host hundreds.

C.          The Exchange Reduces Deceptive Sales Tactics by Lenders

Lastly, the Exchange addresses the current problem of lenders using deceptive sales tactics to prevent borrowers from benefiting from disclosures. The Exchange addresses this problem by removing any interaction between the borrower and lender prior to loan commitment.

Without any interaction, lenders have no opportunity to intimidate borrowers or evade and marginalize disclosures. Similarly, borrowers can overcome uninformative or confusing disclosure terms by hovering a cursor over a confusing term or simply opening a new tab and consulting Google.

Moreover, by originating payday loan transactions over a government-controlled medium, federal regulators would have more access to statistical data, which would allow them to better address bad actors with enforcement actions. For instance, a recent federal report on consumer-submitted complaints revealed that of all the payday loan borrowers submitting complaints, thirty-eight percent of the claims were for borrowers who were “charged fees or interest [they] did not expect,” while another twenty percent “applied for a loan, but [did not] receive money.”[76] Other common complaints included claims that the “[l]ender charged [the borrower’s] bank account on the wrong day or for the wrong amount” and that borrowers “received a loan [they] did not apply for.”[77] While industry professionals have criticized federal agencies for basing enforcement actions on these “unverifiable” consumer complaints, implementing the Exchange would allow regulators to cross-reference these complaints against the Exchange’s records. This would result in reduced costs and improved accuracy for federal regulators looking at payday lenders.[78]

V.          Addressing Potential Obstacles and Criticisms

Before addressing potential criticisms, it is important to recognize that the Exchange imposes neither new laws nor legal regulations on any parties. Lenders will voluntarily offer rates on the Exchange to reach prospective borrowers;[79] consumers will voluntarily visit the Exchange in search for lower prices; regulators will voluntarily use the information gathered by the new platform; and taxpayers will be minimally burdened.[80]

Nonetheless, one consideration is that a significant percentage of payday loan customers may lack Internet access and thus would be unable to access the Exchange. Studies have shown that among low-income households with a median salary under $30,000, nearly twenty-three percent of adults do not use the Internet,[81] though nearly a third of these adults attribute their non-usage to a lack of interest, rather than a lack of access.[82] However, even accounting for the continually decreasing percentage of non-users year-after-year, the current percentage of non-users is not insignificant.[83]

However, even those borrowers without access to the Exchange will benefit from its existence. Neoclassical economists have long maintained that not all consumers must comparison-shop in order for the markets to function effectively.[84] As Professors Ted Cruz and Jeffrey Hinck explain, “if a sufficient number of buyers are well-informed regarding the price and quality of a product, then it will [benefit] the seller to sell . . . at the competitive price to all buyers.”[85] Essentially, a small number of “well-informed consumers can ‘police the market’” as long as lenders are not able to differentiate between the informed and uninformed consumers.[86]

Lastly, this paper has admittedly operated on the assumption that TILA has been ineffective in regulating payday lenders thus far. While this assumption represents the majority view,[87] the minority argues that payday loans, while expensive for consumers, are not actually overly profitable for lenders.[88] These scholars and industry advocates argue that while payday loans are expensive, they are necessarily so, and further price-competition will not change this.[89] For instance, one study argues that payday lenders face substantial costs because payday loan transactions suffer from significantly higher rates of loan defaults.[90] Similarly, payday loan institutions have higher store operating costs because they must maintain longer hours than typical financial institutions.[91] Critics of the Exchange may point to these costs and argue that the Exchange will not reduce payday loan interest rates to the equilibrium price because these rates are already at equilibrium.

However, even assuming the validity of these reported costs, the Exchange will still drastically reduce payday loan interest rates by shifting lenders’ incentives to forgo certain inefficiencies. For example, while lenders currently have no incentives to compete on price, they do face incentives to compete on “location of store, flashy signs . . . and name recognition” in order to attract business.[92] Implementing the Exchange will change these incentives. As borrowers begin to use the Exchange as the “one-stop destination” for payday loans, lenders will face less incentive to continue spending money on advertisements or expensive leases at busy locations. In addition, as more borrowers go online to the Exchange, the incentive for online lenders to pay for costly advertisements and search-engine-optimization, and for brick and mortar lenders to maintain costly storefronts, might be further reduced for those lenders not serving significant numbers of in-person borrowers. These reductions in overhead costs for lenders, coupled with increased price-competition, should yield lower interest rates.

To illustrate the magnitude of these interest rate reductions, consider a few useful statistics from an article written by William M. Webster, IV, chairman of two major national payday lenders. In his article, Webster defends the high rates of his stores by stating that in a typical hundred-dollar loan, the lender generates eighteen dollars.[93] From this amount, $9.09 is spent on store operating expenses, including property leases, employee salaries, as well as radio, television, and online advertisements.[94]

These figures demonstrate the magnitude of the potential reductions in interest rates that restoring price-competition with the Exchange could bring. If lenders were no longer incentivized to advertise or operate brick and mortar stores, the advent of the Exchange would immediately reduce interest rates by nearly sixty percent—even if lenders maintained the same amount of profit as they currently do. Therefore, regardless of the debate on whether payday loan profits are unfairly high, the Exchange can be an effective solution to high payday loan interest rates by reducing lender costs and passing those savings to consumers.

VI.           The CFPB’s Recent Proposal

In contrast to the Exchange’s emphasis on lowering loan costs for borrowers, the CFPB appears to be moving in a different direction. On March 26, 2015, the CFPB publically announced that it would be considering rules that would impose one of two requirements on lenders making short-term loans: before issuing loans, lenders would either be required to verify a borrower’s ability to repay the loan or else be required to provide borrowers with affordable repayment options, such as a “no-cost extension” on their loans if borrowers defaulted more than two times.[95] Essentially, the CFPB’s two proposals make no attempt to address the price of current payday loan fees, only their recurring nature.

To illustrate, the CFPB’s first requirement that lenders verify borrowers’ ability to repay would specifically mandate that lenders go beyond verifying borrowers’ income and verify borrowers’ “major financial obligations . . . borrowing history . . . living expenses . . . [and] other outstanding covered loans with other lenders.”[96] According to the CFPB, these requirements would require the verification of “housing payments (including mortgage or rent payments), required payments on debt obligations, child support, and other legally required payments.”[97] This extensive verification process would not only significantly lengthen the application process, but would also require borrowers to submit a wide variety of documentation to meet these ability-to-repay requirements. This would further increase the transaction costs of comparison-shopping, and because of the lack of price-competition, the actual costs of this verification process would be passed on to the borrower. Moreover, requiring borrowers prove their ability to repay would result in many low-income families being left without their “lender of last resort.”[98] Similarly, imposing a requirement that lenders offer a “no-cost extension” on defaulted loans would likewise incentivize lenders to increase initial loan charges to compensate for the loss of would-be renewal fees.

While CFPB action demonstrates federal recognition of the problem, the CFPB’s proposals are an imperfect solution. Their emphasis on reducing the “debt treadmill” effect of recurring payday loan fees ignores the issue of loan price entirely and thus comes at the expense of increasing loan costs. As a result, while borrowers may pay fewer loan fees, each fee will cost more.

VII.          Conclusion

Along with exponential growth, the payday lending industry continues to face serious scrutiny and criticism. The rhetoric for federal action grows stronger as scholars, consumer advocates, and regulators emphasize high APRs and the repayment difficulties associated with them. However, despite the criticism and the need for change, it is important to recognize that the payday lending industry serves a genuine need for disenfranchised consumers.

As the discussion on possible solutions continues to grow, this Article offers one solution—creating a federally operated online exchange. This solution will facilitate the economic rationales that drive the Truth in Lending Act: inexpensive government enforcement costs, fair profits for lenders, and low prices for consumers.

† J.D., The George Washington University Law School. B.A., University of California, Los Angeles. My gratitude to Dean Alan Morrison for his guidance and insight. Thank you to Professors Lesley Fair and Darren Long for their comments. I would like to acknowledge Jonathan Tse for his editorial assistance and H. Joshua Kotin Esq. for his comments and mentorship that helped inspire this paper’s thesis. All errors are my own.

[1] Thomas A. Durkin & Gregory Elliehausen, Disclosure as a Consumer Protection, in The Impact of Public Policy on Consumer Credit 109, 110 (Thomas A. Durkin & Michael E. Staten, eds., 2002) (“[M]andatory disclosure has become the main financial consumer-protection approach.”); see also Griffith L. Garwood, Robert J. Hobbs & Fred H. Miller, Consumer Disclosure in the 1990’s, 9 Ga. St. L. Rev. 777, 777 (1993) (discussing the pervasiveness of disclosure in consumer protection law).

[2] 15 U.S.C. §§ 1601–67 (2012).

[3] See infra text accompanying notes 38–39.

[4] See, e.g., Howard Beales, Richard Craswell, & Steven Salop, Information Remedies for Consumer Protection, 71 Am. Econ. Rev. 410, 411 (May 1981) (“Information strategies tend to be more compatible with incentives, less rigid, and do not require regulators to compromise diverse consumer preferences to a single standard.”); Christopher L. Peterson, Truth, Understanding, and High-Cost Consumer Credit: The Historical Context of the Truth in Lending Act, 55 Fla. L. Rev. 807, 881–83 (2003) (“Although . . . neither industry nor consumer advocates have been entirely satisfied, the disclosure approach has in general garnered wide acceptance . . . high cost creditors have advocated disclosure rules to deflect legislative pressure for more substantive rules.”); see also Lynn Drysdale & Kathleen E. Keest, The Two-Tiered Consumer Financial Services Marketplace: The Fringe Banking System and Its Challenge to Current Thinking About the Role of Usury Laws in Today’s Society, 51 S.C. L. Rev. 589, 659 (2000) (“The most frequently articulated view of usury . . . [is that] they interfere with matters best left to ‘The Market.”’); Kathleen C. Engel & Patricia A. McCoy, A Tale of Three Markets: The Law and Economics of Predatory Lending, 80 Tex. L. Rev. 1255, 1314 (2002) (“Ultimately, price controls . . . restrict the flow of credit, thereby hurting the very individuals they are designed to serve.”).

[5] Lauren E. Willis, Decisionmaking and the Limits of Disclosure: The Problem of Predatory Lending: Price, 65 Md. L. Rev. 707, 751–54 (2006) (expressing that disclosures are not enough to motivate consumers to seek alternative sources of credit).

[6] See infra note 8, at 9.

[7] Cf. Jim Hawkins, Regulating on the Fringe: Reexamining the Link Between Fringe Banking and Financial Distress, 86 Ind. L.J. 1361, 1384 n.128 (2011) (discussing how payday lending creates a “cycle of debt” and “traps consumers”).

[8] Consumer Fin. Prot. Bureau, Payday Loans and Deposit Advance Products 45 (Apr. 24, 2013), http://files.consumerfinance.gov/f/201304_cfpb_payday-dap-whitepaper.pdf (stating that “further attention is warranted to protect consumers”) [hereinafter CFPB White Paper].

[9] Consumer Fin. Prot. Bureau, Factsheet: The CFPB Considers Proposal to End Payday Debt Traps 2­–3 (Mar. 26, 2015), http://files.consumerfinance.gov/f/201503_cfpb-proposal-under-consideration.pdf [hereinafter CFPB Proposal Factsheet].

[10] Id.

[11] See Paige Marta Skiba, Regulation of Payday Loans: Misguided?, 69 Wash. & Lee L. Rev. 1023, 1043–45 (2012) (surveying the ineffective solutions attempted by different state regulators).

[12] See Dwight Jaffee & Joseph Stiglitz, Credit Rationing, in 2 Handbook of Monetary Economics 838, 847 (B.M. Friedman & F.H. Hahn eds., 1990) (discussing how price controls create severe economic threats by interfering with supply and demand).

[13] Perhaps one of the greatest advantages of this solution is that payday lenders are not legally required to sign up. Instead, as more borrowers head to this website, payday lenders will be motivated to sign up simply because they want to reach this growing group of potential customers.

[14] A simple web search for “payday lending” will reveal dozens of paid advertisements and websites that review and compare different lenders. See, e.g., Top 10 Payday Lenders, http://www.top10paydaylenders.com (last visited Nov. 5, 2015); Top 10 Personal Loans, http://www.top10personalloans.com (last visited Nov. 5, 2015); Payday Loan Comparison, http://paydayloancomparison.org (last visited Nov. 5, 2015); Compare USA Payday Lenders, http://online-payday-loans.org/compare/ (last visited Nov. 5, 2015).

[15] See 151 Cong. Rec. E1386 (daily ed. June 28, 2005) (statement of Rep. Gutierrez) (“Those who claim to support the troops should agree to restrict the worst financial product out there.”); see also Christine Dalton, John Oliver’s 14 Greatest Takedowns on ‘Last Week Tonight’, Huffington Post, (Nov. 11, 2014, 10:26 AM) (“Payday loans are like the Lay’s Potato Chips of finance. You can’t have just one and they’re TERRIBLE for you.”) (quoting Last Week Tonight: Episode 14 (HBO television broadcast Aug. 10, 2014)).

[16] What is a Payday Loan?, Consumer Fin. Prot. Bureau, http://www.consumerfinance.gov/askcfpb/1567/what-payday-loan.html [hereinafter What is a Payday Loan?] (last visited Oct. 19, 2014); see also Ronald Mann & James Hawkins, Just Until Payday, 54 UCLA L. Rev. 855, 857 (2007) (explaining the mechanics of a typical payday loan).

[17] See Aaron Huckstep, Payday Lending: Do Outrageous Prices Necessarily Mean Outrageous Profits?, 12 Fordham J. Corp. & Fin. L. 203, 209 (2007) (discussing credit requirements and the lack of viable alternatives to payday lending).

[18] See Aimee A. Minnich, Rational Regulation of Payday Lending, 16 Kan. J.L. & Pub. Pol’y, 84, 91–92.

[19] See, e.g., Fed. Deposit Ins. Corp., Nat’l Survey of Unbanked & Underbanked Households 10 (Dec. 2009) (finding that about 7.7% of U.S. households, approximately nine million individuals, were “unbanked,” and approximately another 17.9%, about twenty-one million individuals, were “underbanked”).

[20] See Annamaria Lusardi, Daniel J. Schneider & Peter Tufano, Financially Fragile Households: Evidence and Implications 2 (Nat’l Bureau of Econ. Research, Working Paper No. 17072, 2011), available at http://www.nber.org/papers/w17072.pdf.

[21] See William M. Webster, IV, Payday Loan Prohibitions: Protecting Financially Challenged Consumers or Pushing Them over the Edge?, 69 Wash. & Lee L. Rev. 1051, 1057–58 (2012).

[22] See Donald Morgan & Michael Strain, Federal Reserve Bank of New York, Payday Holiday: How Households Fare after Payday Credit Bans 3 (2008), available at http://www.newyorkfed.org/research/staff_reports/sr309.pdf.

[23] See Charles A. Bruch, Taking the Pay Out of Payday Loans: Putting an End to the Usurious and Unconscionable Interest Rates Charged by Payday Lenders, 69 U. Cin. L. Rev. 1257, 1270 (2001).

[24] See Mark Flannery & Katherine Samolyk, Payday Lending: Do the Costs Justify the Price?, FDIC Center for Financial Research 1 (June 2005), https://www.fdic.gov/bank/analytical/cfr/2005/wp2005/CFRWP_2005-09_Flannery_Samolyk.pdf (showing that in 2000, there were approximately 10,000 payday lenders in America).

[25] 10 Shocking Facts About Payday Loans, Payday Loans Blog (Oct. 26, 2009), http://www.paydayloans.org/10-shocking-facts-about-payday-loans.

[26] Carter Dougherty, Payday Loans Curb Considered By Three Regulators, BloombergBusiness (Apr. 24, 2013, 12:01 AM), http://www.bloomberg.com/news/2013-04-24/payday-loan-curbs-considered-by-three-u-s-regulators.html (stating “storefronts made $30.1 billion of the $48.7 billion in total payday loans made in 2012”).

[27] Glen Fest, A Case of Payday Loans, The American Banker (July 1, 2011), http://www.americanbanker.com/magazine/121_7/kansas-city-feds-case-for-payday-loans-1039318-1.html.

[28] See CFPB White Paper, supra note 8, at 9.

[29] It should be noted that the payday lending industry advocates claim that the APR does not accurately describe the cost of payday loans because of the loans’ short terms. See Michael S. Barr, Banking the Poor, 21 Yale J. on Reg. 121, 155 (2004).

[30] See, e.g., Bruch, supra note 23, at 1279–80 (arguing that it is the high interest rates that makes payday loans unconscionable); Benjamin D. Faller, Payday Loan Solutions: Slaying the Hydra (and Keeping It Dead), 59 Case W. Res. L. Rev. 125, 139 (2008) (stating that “[t]he primary problem is that competition has not driven down prices.”); Creola Johnson, Congress Protected the Troops: Can the New CFPB Protect Civilians from Payday Lending?, 69 Wash. & Lee L. Rev. 649 (2012) (arguing for an interest rate cap of thirty-six percent as a solution to payday lending); Chris Peterson, Failed Markets, Failing Government, or Both? Learning from the Unintended Consequences of Utah Consumer Credit Law on Vulnerable Debtors, 2001 Utah L. Rev. 543, 546–47 (2001) (explaining the “consequences the high cost consumer credit market poses”).

[31] See CFPB White Paper, supra note 8.

[32] Id. at 17.

[33] See, e.g., Bruch, supra note 23, at 1279–80 (2001).

[34] Robert W. Snarr, No Cash ’til Payday: The Payday Lending Industry, Federal Reserve Bank of Philadelphia (2002), http://www.philadelphiafed.org/bank-resources/publications/compliance-corner/2002/first-quarter/q1cc1_02.cfm#one.

[35] Id.

[36] Elizabeth Renuart & Kathleen E. Keest, Truth in Lending § 1.1.1, 33 (4th ed. 1999).

[37] See Alan Schwartz & Louis L. Wilde, Intervening in Markets on the Basis of Imperfect Information: A Legal and Economic Analysis, 127 U. Pa. L. Rev. 630, 638 (1979) (“The competitive price is the lowest price a market can sustain, and all consumers would, other things equal, prefer to purchase at the lowest price.”).

[38] See Patrick E. Hoog, Acceleration Clause Disclosure: A Truth in Lending Policy Analysis, 53 Ind. L. J. 97, 101 (1977) (stating that the purpose of disclosure requirements is to “promote comparative shopping by consumers among creditors in the pursuit of increased competition among credit extenders”).

[39] Joseph E. Stiglitz, Economics 87–88 (2d ed. 1997) (“[Equilibrium is] a situation where there are no [reasons] for change. No one has an incentive to change the result.”).

[40] See, e.g., Peterson, supra note 4, at 814 (“The hope was that with uniformly disclosed prices, consumers would be able to shop for the best deal, thus better protecting themselves and forcing creditors to offer lower prices.”).

[41] See, e.g., Richard Hynes & Eric A. Posner, The Law and Economics of Consumer Finance, 4 Am. Law & Econ. Rev. 168, 192–93 (2002) (“The stated goals of the Truth in Lending Act are to increase economic stability, to enhance the ability of consumers to shop for attractive loan terms, and to prevent inaccurate and unfair billing.”).

[42] See, e.g., Ralph J. Rohner & Fred H. Miller, Truth in Lending 4 (Robert A. Cook et al. eds., 2000) (“The primary purpose of [TILA] is to promote the informed use of credit.”).

[43] See 12 C.F.R. § 226.1(b) (2010) (stating that Regulation Z is meant “to promote the informed use of consumer credit by requiring disclosures about its terms and cost”).

[44] See Ford Motor Credit Co. v. Milhollin, 444 U.S. 555, 559 (1981) (“The Truth in Lending Act has the broad purpose of promoting ‘the informed use of credit’ by assuring ‘meaningful disclosure of credit terms’ to consumers.”) (citing 15 U.S.C. § 1601 (2012)).

[45] Government regulation of securities also uses disclosure as the primary means to protect investors in the same manner. See Stephen M. Bainbridge, Mandatory Disclosure: A Behavioral Analysis, 68 U. Cin. L. Rev. 1023, 1023 (2000) (“Mandatory disclosure is a—if not the—defining characteristic of U.S. securities regulation.”); Troy Paredes, Blinded by the Light: Information Overload and Its Consequences for Securities Regulation, 81 Wash. U. L.Q. 417, 421 n.11 (2003) (describing the literature on mandatory disclosure in securities law as “voluminous”).

[46] Cf. Pearl Chin, Note, Payday Loans: The Case for Federal Legislation, 2004 U. Ill. L. Rev. 723, 739–42.

[47] See 10 Shocking Facts About Payday Loans, supra note 25.

[48] See Paul Chessin, Borrowing from Peter to Pay Paul: A Statistical Analysis of Colorado’s Deferred Deposit Loan Act, 83 Denv. U. L. Rev. 387, 408–09 (2005) (describing how payday lending competition is not determining prices); Faller, supra note 30, at 139 (describing the payday lending market as a failed one).

[49] See, e.g., 152 Cong. Rec. S6405, S6406 (daily ed. June 22, 2006) (statement of Sen. Talent) (“[T]hese young men and women, many of whom are just out of high school, are not financially sophisticated and fall way behind in these payments.”); Matthew A. Edwards, Empirical and Behavioral Critiques of Mandatory Disclosure: Socio-Economics and the Quest for Truth in Lending, 14 Cornell J.L. & Pub. Pol’y 199, 224 n.136 (2005) (discussing criticism of unnecessarily complex contracts in the industry); Peterson, supra note 30, at 571 (listing borrowers’ failure to understand disclosures as the first of five factors leading to ineffective regulation).

[50] See Peterson, supra note 30, at 572–73 (arguing that economic models relied upon in regulating payday lending do not properly account for transaction costs); see also Bruch, supra note 23, at 1282–83 (stating that payday loan consumers are often in dire financial straits and that lenders subsequently benefit from a “captive market”); Chessin, supra note 48, at 409 n.93 (describing borrowers as “rate insensitive”); Scott Andrew Schaaf, From Checks to Cash: The Regulation of the Payday Lending Industry, 5 N.C. Banking Inst. 339, 344 (2001) (stating that borrowers are not “price driven”).

[51] See Faller, supra note 30, at 140–41 (listing “abusive practices” by lenders as one of two problems with implementing regulations against payday lenders); see also Edwards, supra note 49, at 200–05 (discussing how lenders use “information asymmetry” to take advantage of borrowers).

[52] See, e.g., Edward L. Rubin, Legislative Methodology: Some Lessons from the Truth-in-Lending Act, 80 Geo. L.J. 233, 243–64 (1991) (discussing the legislative debates prior to Congress’s passage of the TILA).

[53] See id. at 244 (citing S. 2755, 86th Cong., 2d Sess. (1960), reprinted in Consumer Credit Labeling Bill, 1960: Hearings on S. 2755 Before the Subcomm. on Production and Stabilization of the S. Comm. on Banking and Currency, 86th Cong., 2d Sess. 803–14 (1960)).

[54] Id. at 235–236.

[55] Id. at 236 (citing William K. Brandt & George S. Day, Information Disclosure and Consumer Behavior: An Empirical Evaluation of Truth-in-Lending, 7 U. Mich. J.L. Ref. 297, 303–07 (1974)).

[56] Id. at 236.

[57] See, e.g., Jeffrey Davis, Protecting Consumers from Overdisclosure and Gobbledygook: An Empirical Look at the Simplification of Consumer-Credit Contracts, 63 Va. L. Rev. 841, 842 (1977) (stating that the benefits of disclosure laws “have been experienced almost entirely by those consumers who least need the protection—middle and upper class consumers”).

[58] See Peterson, supra note 30, at 573. While TILA requires lenders to make clear and conspicuous loan disclosures on a written form before the lender extends the loan, 12 C.F.R. § 226.17(a)–(b) (2015), in both the Fourth and the Seventh Circuits, however, lenders do not have to make these until immediately before consummation of the loan. See Spearman v. Tom Wood Pontiac-GMC, Inc., 312 F.3d 848, 851 (7th Cir. 2002); Gavin v. Koons Buick Pontiac GMC, Inc., 28 F. App’x 220, 222 (4th Cir. 2002) (unpublished opinion).

[59] Even borrowers using Internet lenders instead of store fronts must not only sift through hundreds of thousands of payday lender websites, but also must differentiate between real and fake lenders. See, e.g., Carter Dougherty, Data From Payday Loan Applicants Sold in Online Auctions, BloombergBusiness (Jun. 8, 2012, 12:01 AM), http://www.bloomberg.com/news/articles/2012-06-08/data-from-payday-loan-applicants-sold-in-online-auctions (describing a fake payday lender that merely sold applicant’s data). Then after finding a genuine lender, borrowers must differentiate between lenders with legitimate endorsements and those with fake or paid-for ones. To complicate matters further, borrowers that find a website that seemingly offers the opportunity to compare many payday lenders’ interest rates side by side, must differentiate between a website offering a genuine comparison service and one with for-profit or other ulterior motives. Some of these sites are simply aggregators that gather your information to sell.  See Colleen Tressler, Loan Aggregators, or Loan Aggravators?, Fed. Trade Comm’n Consumer Info. Blog (Feb. 20, 2013), http://www.consumer.ftc.gov/blog/loan-aggregators-or-loan-aggravators. Others are paid-for or owned by one of the lenders they purport to compare. See, e.g., Payday Lender Reviews, Top 10 Payday Lenders, http://www.top10paydaylenders.com/doc/reviews (last visited Nov. 6, 2015) (providing reviews and comparison charts for the site’s own “lending partners”).

[60] See supra Part II.A.

[61] See Peterson, supra note 30, at 573.

[62] Michael Bertics, Fixing Payday Lending: The Potential of Greater Bank Involvement, 9 N.C. Banking Inst. 133, 140 (2005) (describing the risk of “potential embarrassment and employment risk that bombardment of confirmation calls by multiple payday lenders would pose”).

[63] See Edwards, supra note 49, at 227 (describing how salesman may use “high-pressure” tactics to discourage consumers from walking away); Peterson, supra note 30, at 573 (describing how lenders may purposefully or unconsciously increase shopping costs for borrowers to discourage comparison-shopping).

[64] Lloyd T. Wilson, Jr., Effecting Responsibility in the Mortgage Broker-Borrower Relationship: A Role for Agency Principles in Predatory Lending Regulation, 73 U. Cin. L. Rev. 1471, 1500 (2005).

[65] Id. at 1500–01.

[66] Id. at 1501.

[67] See Kathleen C. Engel & Patricia A. McCoy, A Tale of Three Markets: The Law and Economics of Predatory Lending, 80 Tex. L. Rev. 1255, 1309 (2002) (discussing questions that are “likely to result in self-serving answers”).

[68] The Internet is currently littered with privately operated lender-comparison websites. Unfortunately, the vast majority are owned by self-serving payday lenders. See supra Part III.C.

[69] Lenders will not be legally forced sign up with the Exchange; however, the market will incentivize them to sign up if they want to reach the Exchange’s growing group of potential customers. See infra note 79–83 and accompanying text.

[70] See supra Part III.

[71] See, e.g., Megan S. Knize, Payday Lending in Louisiana, Mississippi, and Arkansas: Toward Effective Protections for Borrowers, 69 La. L. Rev. 317, 325 (2009) (“Payday lenders know where to find their desired customers: economically disadvantaged areas, towns near military bases, and minority neighborhoods.”); Wei Li et al., Ctr. For Responsible Lending, Predatory Profiling: The Role of Race and Ethnicity in the Location of Payday Lenders in California 10 (Mar. 26, 2009), http://www.responsiblelending.org/california/ca-payday/research-analysis/predatory-profiling.pdf (finding that Californian payday lenders concentrate their storefronts in predominantly minority neighborhoods).

[72] This process essentially operates as the interest rate cap that many scholars currently advocate for. See, e.g., Johnson, supra note 30, at 713 (arguing for CFPB guidelines to cap interest rates at thirty-six percent); Nathalie Martin, Public Opinion and the Limits of State Law: The Case for A Federal Usury Cap, 34 N. Ill. U. L. Rev. 259, 297–304 (2014) (arguing for a federal interest rate cap of thirty-six percent). For example, if there are two lenders, the one that offers a lower interest rate functionally sets an interest rate cap, as the consumer has no incentive to select the higher rate. The higher-cost lender must either lower his price to equilibrium or leave the market.

[73] See supra Part II.C.

[74] Christopher Lewis Peterson, Faculty Profile, Faculty.Utah.edu, https://faculty.utah.edu/u0045920-CHRISTOPHER_LEWIS_PETERSON/biography/index.hml (last visited Oct. 23, 2015).

[75] Chris Peterson, Failed Markets, Failing Government, or Both? Learning from the Unintended Consequences of Utah Consumer Credit Law on Vulnerable Debtors, 2001 Utah L. Rev. 543, 572–73 (2001).

[76] Consumer Fin. Prot. Bureau, Consumer Response: A Snapshot of Complaints Received 26 (July 2014), http://files.consumerfinance.gov/f/201407_cfpb_report_consumer-complaint-snapshot.pdf.

[77] Id.

[78] See Alan S. Kaplinsky, CFPB Expanded Consumer Complaint Database Raises Concerns, 67 Consumer Fin. L.Q. Rep. 189 (2013) (stating that “none of the complaints on the database have been or will be verified”); see also Consumer Fin. Prot. Bureau, Supervision and Examination Manual UDAAP 9 (2d ed. 2012) (“Consumer complaints play a key role in the detection of unfair, deceptive, or abusive practices [and] have been an essential source of information for examinations, enforcement, and rule-making for regulators.”).

[79] Even without an initial critical mass of consumers using the Exchange, lenders will be incentivized to use the Exchange for the opportunity to be listed on a “.gov” web address. See supra text accompanying note 67. As discussed, lender’s advertising costs are substantial because the payday lending business model relies upon being the first to reach customers that do not have time to comparison-shop. The opportunity to promote on a “.gov” web address provides real monetary value.

[80] First, much of the infrastructure for the Exchange can be copied from the government’s already-implemented exchange platform, www.healthcare.gov. Second, posting rates on a “.gov” web address significantly reduces a lender’s operating costs. See infra text accompanying notes 92–95. The agency operating the website can charge lenders an operation fee, and so long as the fee charged to lenders is less than what lenders currently spend on advertising, there is value to be had. A number of states currently maintain databases of lenders, funded wholly by lender fees of one dollar per transaction. See, e.g., Fla. Stat. Ann. § 560.404(23). The Exchange could further drive this cost down through economies of scale.

[81] Susannah Fox & Lee Rainie, The Web at 25 in the U.S., Pew Research Ctr. 18 (Feb. 27, 2014), http://www.pewinternet.org/files/2014/02/PIP_25th-anniversary-of-the-Web_0227141.pdf.

[82] Kathryn Zickuhr & Aaron Smith, Digital Differences, Pew Research Ctr. 7 (Apr. 13. 2012), http://www.pewinternet.org/files/old-media//Files/Reports/2012/PIP_Digital_differences_041312.pdf.

[83] Fox & Rainie, supra note 79, at 18; see also Monica Anderson & Andrew Perrin, 15% of Americans don’t use the internet. Who are they?, Pew Research Ctr. (Jul. 28, 2015) http://www.pewresearch.org/fact-tank/2015/07/28/15-of-americans-dont-use-the-internet-who-are-they/.

[84] See, e.g., Richard Hynes & Eric A. Posner, The Law and Economics of Consumer Finance, 4 Am. Law & Econ. Rev. 168, 172–73 (2002).

[85] R. Ted Cruz & Jeffrey J. Hinck, Not My Brother’s Keeper: The Inability of an Informed Minority to Correct for Imperfect Information, 47 Hastings L.J. 635, 646 (1996) (emphasis added).

[86] See Edwards, supra note 49, at 242 (quoting William K. Brandt & George S. Day, Information Disclosure and Consumer Behavior: An Empirical Evaluation of Truth-in-Lending, 7 Mich. J. L. Ref. 297, 327 (1974)). Of course, some scholars contend that sometimes lenders are in fact “able to differentiate between the informed and uninformed consumers” and thus are able to “offer less attractive terms to some consumers without risking the loss” of the informed. Id. at 243; see also Michael I. Meyerson, The Reunification of Contract Law: The Objective Theory of Consumer Form Contracts, 47 U. Miami L. Rev. 1263, 1270-71 (1993) (“[T]here is no evidence that a small cadre of type-A consumers ferrets out the most beneficial subordinate contract terms, permitting the market to protect the vast majority of consumers.”). For example, at least one study demonstrates differentiation on the part of sellers by showing that poorly dressed men received average price quotes on cars that were significantly higher than the price quotes given to their well-dressed counter-parts. See Schwartz & Wilde, supra note 37, at 682 n.82 (citing Gordon L.Wise, Differential Pricing and Treatment by New-Car Salesmen: The Effect of the Prospect’s Race, Sex and Dress, 47 J. Bus. 218 (1974). Similarly, critics might argue that payday lenders may submit one price to the Exchange, but still offer another higher price to those uninformed borrowers that visit the lender’s brick and mortar location or directly visit the lender’s website. Admittedly, the validity of this argument remains to be seen. However, even if the uninformed borrowers do not benefit immediately, those uninformed should progressively move away from their local lenders and towards the Exchange in search of lower prices.

[87] See, e.g., Bertics, supra note 62, at 148 (“Sadly, TILA has failed to provide real protection to payday borrowers.”); Faller, supra note 30, at 142 (arguing that TILA and its “market ideology” represents “the federal government’s failure to deal with payday lending”).

[88] See, e.g., Huckstep, supra note 17, at 231 (“High profits for payday lenders . . . may be more myth than reality.”); Webster, IV, supra note 21, at 1085 (arguing that “payday lenders are not overly profitable organizations”).

[89] See, e.g., Flannery & Samolyk, supra note 24, at 21 (“[T]he ‘high’ APRs implied by payday loan fees can be justified by the fixed costs of keeping stores open and the relatively high default losses suffered on these loans.”).

[90] See id. at 2. But see Chessin, supra note 48, at 408–09.

[91] See Huckstep, supra note 17, at 222.

[92] See Bertics, supra note 62, at 143.

[93] See Webster, IV, supra note 21, at 1084; cf. CFPB White Paper, supra note 8, at 9 (stating the average fee is fifteen dollars per hundred-dollar loan).

[94] See Webster, IV, supra note 21, at 1084.

[95] See CFPB Proposal Factsheet, supra note 10, at 2–3.

[96] Id.

[97] Consumer Fin. Prot. Bureau, Outline of Proposals Under Consideration and Alternatives Considered 11–12 (Mar. 26, 2015), http://files.consumerfinance.gov/f/201503_cfpb_outline-of-the-proposals-from-small-business-review-panel.pdf.

[98] See Glen Fest, A Case for Payday Loans, The American Banker, (July 1, 2011), http://www.americanbanker.com/magazine/121_7/kansas-city-feds-case-for-payday-loans-1039318-1.html. (stating that payday lenders meet the credit needs of borrowers who otherwise lack the credit scores necessary to attain credit).