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.

U.S. Business Law

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Increased Antitrust Merger Enforcement: Considerations for Your Next Deal

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Michael B. Bernstein, Justin P. Hedge, and Francesca Pisano†

I.               Introduction

Antitrust merger enforcement has become increasingly aggressive in recent years with the Federal Trade Commission (FTC) and Antitrust Division of the Department of Justice (DOJ) (collectively, the U.S. antitrust authorities) demonstrating that they are ready to litigate to block deals they believe will harm competition. Political figures, from President Barack Obama and President-Elect Donald J. Trump to senators, have called for government action to protect and promote competition.[1] Indeed, a recent speech by the head of the Antitrust Division made clear that the government will not shy away from bringing cases even when enforcers might lack “particularized and quantified proof of consumer harm” or a precise “measur[e] [of] the effect on price and output”—instead, “experience” and other evidence such as “company documents and customer testimony” can be sufficient.[2] This suggests that robust agency scrutiny of potential mergers and acquisitions is likely to continue in the future.

While an increasing number of mergers have been challenged and blocked in federal court,[3] some are prevailing at trial or managing to find a path to clearance without litigation.[4] This Article reviews the trends that have emerged in federal merger enforcement and discusses some key differences between deals that have been cleared and those that have faced government opposition. In particular, the antitrust authorities are focusing on (1) the use of narrow price-discrimination markets to analyze competition, (2) the credibility of future competition, and (3) the complexity of any remedy package. Understanding how the antitrust authorities analyzed and reached different conclusions in these areas is critical for assessing the antitrust risks of future transactions and forming the best strategy to obtain antitrust clearance.

II.              Standards Applied in Federal Merger Investigations

Mergers and acquisitions are governed by section 7 of the Clayton Act, 15 U.S.C. § 18. This provision prohibits acquisitions of “the whole or any part of the stock in any line of commerce . . . [where] the effect of such acquisition may be substantially to lessen competition, or tend to create a monopoly.”[5] The DOJ and FTC are the primary government enforcers of section 7.[6] Their review of acquisitions is facilitated by the Hart-Scott-Rodino Act (HSR Act), which requires merging parties to give notice of their merger to the DOJ and FTC, if valued above certain thresholds, and to observe a waiting period before closing.[7] The HSR Act also allows the U.S. antitrust authorities to request additional information from the parties and extend the waiting period to evaluate whether or not to challenge the transaction.[8]

The DOJ and FTC also have published the Horizontal Merger Guidelines (Guidelines), which set forth the government’s framework for analyzing acquisitions.[9] According to the Guidelines, the U.S. antitrust authorities undertake a fact-specific inquiry into each merger that considers all evidence relevant to potential competitive harms, including market shares, head-to-head competition between the merging parties, whether the merger is eliminating a “maverick” that has been driving competition (including through innovation), the presence of actual anticompetitive effects, and the ability of the merged entity to price discriminate against “certain targeted customers.”[10]

III.              Key Enforcement Trends

A.             Narrow Price-Discrimination Markets

Recent merger cases demonstrate that the U.S. antitrust authorities are willing not just to investigate, but also to litigate market definition issues centered around a narrow set of customers subject to price discrimination. U.S. antitrust authorities typically define markets narrowly and are more likely to engage in an extended investigation if they believe a particular class of customers might be harmed by a merger—that is, if there is a group of customers for whom the merged firm can raise prices.[11] Price-discrimination markets are not new—the 2010 Guidelines specifically discussed such markets and noted that the anticompetitive effects from a merger might vary significantly for different customers if there are some for whom the merged firm can profitably raise prices because of the customers’ particular needs.[12] In recent cases, district courts have accepted such narrow markets, validating the U.S. antitrust authorities’ analysis and putting future merging parties on notice to carefully examine a deal’s potential impact on all types of customers in assessing its risks.

Three recent cases, in particular, highlight the increased importance regulators are placing on price-discrimination market definitions. First, in its 2015 challenge to Sysco’s acquisition of US Foods, the two largest food distribution companies, the FTC focused on the acquisition’s impact on national customers (for example, large chain restaurants).[13] Given the specific purchasing needs of such customers—a supplier with a national distribution footprint, private-label products, a system to ensure consistency of ordering, pricing, and products, and a “high level[] of customer service”[14]—the FTC found that Sysco and US Foods were the only two “broadline” competitors who could serve as a “one stop shop” for these national customers.[15]

The court accepted the FTC’s national market definition, relying on the long-standing Supreme Court case Brown Shoe, which provides a set of indicia or factors to test and define the boundaries of markets.[16] As the court summarized, application of this test frequently includes an analysis of “the product’s peculiar characteristics and uses, unique production facilities, distinct customers, distinct prices, the existence of special classes of customers who desire particular products and services, ‘industry or public recognition’ of a separate market, and how the defendants’ own materials portray the ‘business reality’ of the market.”[17] The court was persuaded by the FTC’s market definition, in large part, based on broadline customers’ testimony.[18]

Second, in its case against Staples’ acquisition of Office Depot, two of the largest office-supply companies, the FTC also staked out a narrow customer-specific market definition, alleging the merger would harm “business-to-business” customers, rather than the more common concerns related to “direct-to-consumer” customers.[19] In doing so, the FTC similarly emphasized such customers’ “distinct” needs,[20] including, again, a national distribution footprint, private-label product offerings, product consistency, and a “high level[] of customer service.”[21] The FTC alleged that the combined firm would have accounted for 70% of the narrow business-to-business office supply market, giving rise to a presumption of anticompetitive effects from the merger under the Guidelines.[22] The court found in favor of the FTC, also relying on the Brown Shoe standard.[23] And in reaching its decision, the court relied on the merging parties’ internal documents that recognized a category of large, business-to-business customers as a distinct group.[24]

Lastly, the 2015 acquisition of Trulia by Zillow,[25] two online real estate portals, demonstrates that although the U.S. antitrust authorities may investigate whether a proposed deal might harm a particular class of customers, narrow price-discrimination markets are not always present. After a six-month review, the FTC cleared the Zillow/Trulia acquisition without requiring divestitures. In its closing statement, the FTC noted that it did scrutinize the deal for potential impact on price-discrimination markets.[26] The FTC specifically considered whether real estate portals were a relevant market to certain groups of real estate agents willing to pay to list on the merging parties’ websites.[27] The FTC ultimately concluded that while there was some evidence supporting narrow price-discrimination markets, it was “inconclusive,” in part, because there was no evidence of actual price discrimination prior to the merger.[28] While this transaction was able to close, the FTC’s statement clearly identified that price-discrimination markets were top of mind in the agency’s analysis.[29]

As these recent cases indicate, courts have been receptive to the government’s arguments that mergers might harm certain classes of customers. However, as the Zillow/Trulia investigation demonstrates, if parties can show that there is no evidence of price discrimination before the merger, there is a better chance that the U.S. antitrust authorities will close the investigation and clear the deal.

Given the U.S. antitrust authorities’ success in Staples and Sysco, the enforcers are likely to continue to closely investigate narrow market definitions in future mergers. As such, there are several issues counsel and merging parties should consider heading into a new deal.

First, anticipate that the DOJ or FTC will define narrow customer segments, even if they represent a relatively small portion of a company’s business. The Staples court noted that “[a]ntitrust laws exist to protect competition, even for a targeted group that represents a relatively small part of an overall market.”[30] The FTC was not only willing to bring a case where the alleged market represented only 1.4% of the parties’ overall sales, but also successful in blocking the transaction based on that narrow market definition.[31]

Second, determine if there is evidence that either party is pricing differently to specific segments of customers. Counsel and merging parties should seek to understand as early as possible in the merger process whether there is any particular business channel or subsegment of customers who may be especially vulnerable to post-merger price increases, even if those customers or lines of business are ancillary to the deal rationale.

Third, do not assume that the U.S. antitrust authorities will discount harms to sophisticated customers. The U.S. antitrust authorities have recognized that the strength and sophistication of merging parties’ buyers can mitigate a merger’s potential anticompetitive effects.[32] But, as demonstrated in Sysco and Staples, even where customers are large corporations and arguably can protect themselves, the FTC successfully has blocked mergers by defining the relevant market around the provision of products and services to such customers and focusing on price-discrimination markets.

B.             Future Competition

Another trend in recent merger enforcement is the high level of proof expected by the U.S. antitrust authorities, as well as courts, for any party asserting claims of future competition.[33] Arguments without evidence of concrete steps to enter or minimal foothold entry in the relevant market are more likely to be rejected as mere speculation.

In Staples’ proposed acquisition of Office Depot, the parties argued that regional competitor W.B. Mason and recent entrant Amazon would be able to expand their business-to-business sales and replace any competition lost as a result of the merger.[34] The FTC, however, argued that entry would not be successful, and the court agreed. It found particularly persuasive the testimony of regional competitor W.B. Mason that it was not interested in expanding into the national market.[35] With respect to Amazon, the court was troubled that it had an online sales model that had never actually won a bid in response to a business-to-business customer’s Request for Proposal (RFP).[36] The court concluded that it would be “sheer speculation” to expect Amazon to compete with Staples/Office Depot within three years.[37] The court also expressed concern that the structure of Amazon—a marketplace with third-party vendors who each controlled their own product price—would make it difficult for the retailer to bid for large corporate contracts; the court concluded that Amazon’s model was “at odds” with the RFP method business customers used.[38]

In contrast, the FTC in 2013 cleared Office Depot’s acquisition of Office Max without divestitures because the “explosive growth of online commerce . . . had a major impact on this market.”[39] In that investigation, the FTC’s focus was on retail customers, and the FTC found that stores were losing sales to online retailers and frequently were forced to match their lower prices.[40] The key distinction between the two cases is that in Office Depot/Office Max, online competitors already enjoyed some success as competitors in the retail office supply market, so their future competition was given significant weight.

The U.S. antitrust authorities’ treatment of online competition in other contexts further illustrates how the similarity of offerings will be key in determining whether to credit future online competition arguments. For example, in the 2015 Dollar Tree/Family Dollar merger, the FTC rejected arguments that online retailers were competitively significant.[41] The FTC determined that the “primary appeal” of dollar stores was a “combination of value and convenience,” which could not be met by internet-based retailers given the time required to process and ship online orders.[42] Similarly, in the 2015 merger between two subprime consumer loan companies, Springleaf and OneMain, the DOJ concluded that online banks were unlikely to act as a significant competitive constraint post-merger.[43] Although the DOJ noted that online lenders had successfully entered the market for loans made to prime borrowers, the online lenders “face[d] challenges in meeting the needs of and mitigating the credit risk posed by subprime borrowers.”[44] The DOJ focused on three main reasons that online lenders were unlikely to compete directly with Springleaf or OneMain: (1) lack of close customer relationships, (2) inability to conduct in-person meetings that may reduce fraud or risk, and (3) a slower loan application, processing, and distribution speed.[45]

The need for substantial evidence in support of future competition arguments extends to the government as well, in particular when it alleges a transaction will eliminate such future competition. In 2015, the FTC filed a complaint to block the merger between Steris and Synergy—two medical sterilization providers—but ultimately lost its challenge.[46] The FTC argued that Synergy was an “actual potential entrant” into the x-ray sterilization industry, which the FTC alleged would have competed directly with Steris’ gamma radiation sterilization method.[47] The FTC cited internal Synergy documents, dating back to 2012, in an effort to prove that the business had moved from “planning to implementation,” obtained a number of customer letters of interest, and was poised to have a “large and lasting competitive impact” on the sterilization market.[48] The merging parties disagreed that entry was likely, in part relying on Synergy documents reflecting a lack of customer support for expansion into x-ray sterilization and a low projected rate of return—3%, rather than the targeted 15%—and the court agreed.[49] Indeed, Synergy discontinued its x-ray sterilization project in early 2015, which the court found was unrelated to the merger.[50] After failing to block this transaction, the FTC acknowledged “just how difficult a potential competition case is to win.”[51] But it made clear it would still consider bringing them where there is strong evidence entry would occur but for the merger, such as approved capital investment plans as opposed to mere evidence of the capability to enter.[52]

Given these cases, it is important to consider the extent to which the merger’s success relies on arguments of future competition and the quality of evidence supporting such claims.

First, it is clear the U.S. antitrust authorities (and courts) require a significant amount of evidence that the future competitor has plans to enter and that it is likely to be successful upon entry. Even when merging parties point to large, successful companies like Amazon as competitive constraints, if those companies have neither expressed an interest in competing for the business at issue nor had any success on recent entry, the U.S. antitrust authorities (and the courts) are likely to give less weight to entry and expansion arguments.

Second, it should not be assumed that internet-based competitors offering the same products and services as the merging parties are necessarily competitive constraints. In both Staples and Springleaf, the regulators were not convinced that internet-based companies could adequately compete with brick-and-mortar stores, whether because of how pricing is set (for example, Amazon’s marketplace allows third-party vendors to set individual prices)[53] or how features of the market might disadvantage online companies (for example, online subprime lenders unable to meet customers face-to-face).[54] Accordingly, merging parties who seek to rely on arguments of internet-based competition should ensure that there are no market realities that might prevent online businesses from fully competing in the relevant market.

Finally, it is important to consider whether the U.S. antitrust authorities or the courts will consider the merging parties as competitors, even if the parties are not currently competing today. The FTC’s recent loss in Steris illustrates that a merger challenge based on potential competition between the two businesses faces high evidentiary hurdles. FTC Commissioner Maureen Ohlhausen noted the Steris/Synergy case “ought to give the agency pause in pursuing potential competition cases in the future.”[55] However, the U.S. antitrust authorities routinely have required divestitures where products are likely to be in future competition with each other, and such a position is likely to continue. As a result, it is important to consider future product innovation and product pipelines when advising on a transaction.

C.             Preference for Simple Remedies and Divestiture Packages with a Proven Track Record of Success

As a final consideration, U.S. antitrust authorities have become increasingly critical of remedy settlement packages that are complex and would not create competitors of the same scale. Yet, where the parties have crafted comprehensive remedy proposals, the U.S. antitrust authorities still are willing to accept them to resolve competition concerns if the divestiture creates a player ready to compete on “day one” post-merger.

During the DOJ’s investigation of the merger of Halliburton and Baker Hughes, two of the largest oil-field services providers, the parties offered a divestiture package to address the DOJ’s concerns. Though the package represented up to $7.5 billion in sales, the DOJ rejected it as “wholly inadequate” and filed suit to block the transaction in April 2016.[56] Indeed, the DOJ characterized the proposed fix as “among the most complex and riskiest remedies ever contemplated in an antitrust case” as it was a “collection of assets selected from various . . . business lines,” rather than a stand-alone business unit.[57] The DOJ also was concerned that the divestiture structure would leave the buyer dependent on Halliburton for “crucial” services and thus, unable to compete independently.[58] And there were gaps in the package’s scope and scale such that the DOJ felt it would not “replicate the [lost] competition.”[59] Not only did the proposed divestiture not cover several key product areas, but the DOJ also had concerns that the divested business would “be less efficient, have less research and development . . . and be less able to offer integrated solutions” than the pre-merger parties.[60]

Similarly, in July 2016 when the DOJ challenged the merger of Aetna and Humana, two of the largest health insurance companies, it expressed concerns regarding the parties’ proposed divestiture. The companies offered to divest Humana’s Medicare Advantage business, which the DOJ criticized as merely pieces of contracts rather than a stand-alone business.[61] The DOJ also highlighted that the divestiture buyer would remain “dependent on Aetna—potentially for years—for providing basic services.”[62] Ultimately, the DOJ concluded that no buyer of the proposed package would be able to compete as effectively or be as well positioned to expand as the two merging parties.[63]

In contrast, the day before suing Aetna and Humana, the DOJ approved the merger of two of the largest beer manufacturers in the world, AB InBev and SABMiller, with a remedy package that included not just divestitures but also conduct conditions.[64] From the outset, the parties committed to divesting SABMiller’s equity and ownership stake in MillerCoors, a joint venture through which SABMiller operated in the United States, as well as other assets.[65] In the end, the parties further agreed to give MillerCoors international rights to the Miller brands of beer and perpetual, royalty-free licenses for certain products. The parties also committed to non-discriminatory practices in their distribution arrangements, which were aimed at protecting the distribution of independent craft beer brands.[66]

Similarly, in the merger of cigarette manufacturers Reynolds and Lorillard that closed in 2015, Reynolds negotiated a remedy up front.[67] Contingent on Reynolds’ acquisition of Lorillard, Reynolds committed to sell a number of Reynolds and Lorillard brands and a manufacturing plant to a third cigarette manufacturer, ITG.[68] The FTC ultimately concluded that the divestiture not only addressed the competitive concerns raised by the merger, but also provided ITG “a robust opportunity . . . to grow its market share.”[69] In particular, the FTC noted that the divested cigarette brands—Winston, Kool, Salem, and Maverick—were already accepted brands in the U.S. market and had a collective established market share of about 7%.[70] The FTC also noted that ITG had greater incentive to promote the growth of the divested brands than Reynolds because “incremental sales of these brands are unlikely to cannibalize sales from more profitable cigarette brands in its portfolio.”[71]

Close agency scrutiny of any proposed divestiture is likely to continue in the future. While arguments on the merits may be strong, companies considering mergers may ultimately decide to settle for various reasons, including timing. In preparation for a potential investigation, companies should carefully evaluate a number of facets related to potential divestiture remedies in order to have a proposal be as effective as possible.

Parties should consider remedies early. As the approval in Reynolds/Lorillard demonstrates, negotiating a remedy concurrently with the original transaction can pay dividends. Such fix-it-first remedies are worth considering, particularly to ease agency review of a complicated merger. And even if a fix-it-first remedy is impractical, it is important to begin thinking about structural remedies early in the merger process.

Also, remedies need to be structured so the divested entity resolves the U.S. antitrust authorities’ competition concerns and can effectively compete on day one. The U.S. antitrust authorities will look closely at any proposed remedy to ensure the competition lost from the transaction is replaced by a proposed divestiture. This will include scrutiny of both the size and the scope of the divestiture as well as the buyer’s ability to effectively replace the lost competition. Where a divestiture package would not create a competitor able to compete in product scope and service offerings for the particular product and geographic markets at issue, the U.S. antitrust authorities are unlikely to accept that divestiture as a fix for any competitive concerns. Moreover, where assets are cobbled together and the divestiture does not position the proposed divestiture buyer to compete on day one and beyond, the U.S. antitrust authorities are unlikely to accept the proposed remedy.

IV.              Conclusion

Merger review has been, and will continue to be, fact-specific. However, the recent cases that the DOJ and FTC have brought and won in federal court are informative on what it takes to get a deal done in today’s regulatory environment.

As a result, parties should consider the antitrust issues up front, including narrow customer-centric product markets and the way in which future competition will affect the merger. By doing this, parties will understand these issues early and be better equipped to consider what remedies are workable from a business perspective as well as from an antitrust perspective.

 

† Michael B. Bernstein is a Partner in the Washington, D.C. office of Arnold & Porter LLP, where he concentrates his practice on obtaining antitrust clearance for transactions, representing corporations in government investigations and civil litigation, as well as counseling on antitrust implications of business practices.

Justin P. Hedge is an Associate in the Washington, D.C. office of Arnold & Porter LLP, where his practice focuses on representing companies before the federal antitrust authorities in the review of mergers and other investigations, antitrust litigation, and day-to-day counseling on antitrust compliance and training.

Francesca M. Pisano is an Associate in the Washington, D.C. office of Arnold & Porter LLP. Her practice focuses on government review of mergers and acquisitions, complex civil antitrust litigation, and counseling clients in relation to antitrust issues.

[1] In April 2016, President Obama issued an executive order for federal agencies to “identify specific actions” to detect abuses, enhance competition, and reduce burdens on competition. Exec. Order No. 13,725, 81 Fed. Reg. 23,417, 23,417­–18 (Apr. 15, 2016), https://www.whitehouse.gov/the-press-office/2016/04/15/executive-order-steps-increase-competition-and-better-inform-consumers. Some politicians have sharply criticized consolidation in various sectors of the economy. See, e.g., Senator Elizabeth Warren, Reigniting Competition in the American Economy, Keynote Remarks at New America’s Open Markets Program Event (June 29, 2016), http://www.warren.senate.gov/ files/documents/2016-6-29_Warren_Antitrust_Speech.pdf; Letter from Senator Al Franken et al. to Tom Weeler, Fed. Commc’n Comm’n Chairman, and Eric Holder, Att’y Gen., Dep’t of Justice (April 21, 2015), http://www.franken.senate.gov/files/documents/150421ComcastTWC.pdf.

[2] Renata Hesse, Acting Assistant Att’y Gen., Dep’t of Justice Antitrust Div., And Never the Two Shall Meet? Connecting Popular and Professional Visions for Antitrust Enforcement, Remarks at the 2016 Global Antitrust Enforcement Symposium (Sept. 20, 2016), https://www.justice.gov/opa/speech/acting-assistant-attorney-general-renata-hesse-antitrust-division-delivers-opening.

[3] Complaint at 4–5, FTC v. Sysco Corp., 83 F. Supp. 3d 271 (D.D.C. 2015) (No. 1:15-cv-00256(APM)); Complaint at 3, 12, FTC v. Staples, Inc., 2016 WL 2899222 (D.D.C. Dec. 9, 2015) (No. 15-2115(EGS)).

[4] FTC v. Steris Corp., 133 F. Supp. 3d 962, 971­–72, 982 (N.D. Ohio 2015); Fed. Trade Comm’n, FTC File No. 141-0168, Analysis of Agreement Containing Consent Order to Aid Public Comment, In re Reynolds American Inc. and Lorillard Inc. 3 (2015), https://www.ftc.gov/system/files/documents/cases/ 150526reynoldsanalysis.pdf.

[5] Clayton Act § 7, 15 U.S.C. § 18 (2012).

[6] See 15 U.S.C. § 26 (2012). Other federal agencies, such as the Surface Transportation Board and the Federal Communications Commission, have jurisdiction to enforce section 7 in their respective areas of expertise. See 15 U.S.C. § 21(a) (2012).

[7] See 15 U.S.C. § 18a (2012).

[8] Id.

[9] U.S. Dep’t of Justice & Fed. Trade Comm’n, Horizontal Merger Guidelines (Aug. 19, 2010), https://www.ftc.gov/sites/default/files/attachments/merger-review/100819hmg.pdf.

[10] Id. at §§ 2.1, 3.

[11] Id. at § 3.

[12] Id.

[13] Complaint at 4–5, FTC v. Sysco Corp., 83 F. Supp. 3d 271 (D.D.C. 2015) (No. 1:15-cv-00256(APM)).

[14] Id. at 3.

[15] Id. at 4–5.

[16] FTC v. Sysco Corp., 113 F.Supp.3d 1, 23 (D.D.C. June 26, 2015) (citing Brown Shoe Co. v. United States, 370 U.S. 294 (1962)).

[17] Id. at 23–33 (emphasis added).

[18] Id. at *28.

[19] Complaint at 3, 12, FTC v. Staples, Inc., 2016 WL 2899222 (D.D.C. Dec. 9, 2015) (No. 15-2115(EGS)) [hereinafter Staples/Office Depot Complaint].

[20] FTC v. Staples, Inc., No. 15-2115(EGS), 2016 WL 2899222, at *10–11 (D.D.C. May 17, 2016).

[21] Staples/Office Depot Complaint, supra note 19, at 13.

[22] Id. at 16–17.

[23] Staples, 2016 WL 2899222, at *25–26.

[24] See id. at *9–10.

[25] See Press Release, Zillow Announces Acquisition of Trulia for $3.5 Billion in Stock (July 28, 2014), http://investors.zillowgroup.com/releasedetail.cfm?releaseid=862266.

[26] See Fed. Trade Comm’n, FTC File No. 141-0214, In the Matter of Zillow, Inc. and Trulia, Inc. (2015), https://www.ftc.gov/system/files/documents/public_statements/625671/150219zillowmko-jdw-tmstmt.pdf.

[27] See id.

[28] See id.

[29] See id.

[30] FTC v. Staples, Inc., No. 15-02115 (EGS), 2016 WL 2899222, at *16 (D.D.C. May 17, 2016).

[31] Defendants’ Brief in Opposition to Plaintiffs’ Motion for a Preliminary Injunction at 14, FTC v. Staples, Inc., 2016 WL 2899222 (D.D.C. May 17, 2016) (No. 15-02115 (EGS)), http://www.appliedantitrust.com/ 14_merger_litigation/cases_ftc/staples2015/1_ddc/staples_ddc_pi_opp3_16_2016redacted.pdf.

[32] U.S. Dep’t of Justice & Fed. Trade Comm’n, Horizontal Merger Guidelines (Aug. 19, 2010), https://www.ftc.gov/sites/default/files/attachments/merger-review/100819hmg.pdf (“Powerful buyers are often able to negotiate favorable terms with their suppliers . . . . The [a]gencies consider the possibility that powerful buyers may constrain the ability of the merging parties to raise prices.”).

[33] Consideration of future competition is always relevant to merger analysis, though it can take many forms. In the past, the antitrust agencies have challenged deals where one company seeks to acquire another company that is poised to enter a relevant market as a new competitor. See, e.g., Press Release, Fed. Trade Comm’n, FTC Issues Administrative Challenge to Polypore International, Inc.’s Consummated Acquisition of Microporous Products L.P. and Other Anticompetitive Conduct (Sept. 10, 2008), https://www.ftc.gov/news-events/press-releases/2008/09/ftc-issues-administrative-challenge-polypore-international-incs (announcing the FTC’s decision to challenge Polypore International’s acquisition of Microporous Products, which had been “preparing to enter” the relevant market).

[34] FTC v. Staples, Inc., No. 15-02115 (EGS), 2016 WL 2899222, at *2, *24–25 (D.D.C. May 17, 2016).

[35] See id. at *24–25. The determination that a regional competitor was insufficient to replace the lost competition is similar to the conclusion in the Sysco/US Foods litigation. See FTC v. Sysco Corp., 113 F.Supp.3d 1, 40–41 (D.D.C. 2015). In Sysco/US Foods, the FTC alleged, and the court agreed, that regional competitors were insufficient to constrain national competition on their own. Id. And while there was an organization through which regional competitors could jointly bid for national contracts, the court found it to be an ineffective alternative to the merging parties because of inherently higher costs and logistical complexities. Id.

[36] Staples, 2016 WL 2899222, at *22–24.

[37] Id. at *24.

[38] Id. at *23.

[39] Fed. Trade Comm’n, FTC File No. 131-0104, Statement of the Federal Trade Commission Concerning the Proposed Merger of Office Depot, Inc. and Office Max, Inc. (2013).

[40] Id.

[41] Fed. Trade Comm’n, No. 141-0207 n.4, Analysis of Agreement Containing Consent Orders to Aid Public Comment, In the Matter of Dollar Tree, Inc. and Family Dollar Stores, Inc. (2015), https://www.ftc.gov/system/files/documents/cases/150702dollartreeanalysis.pdf.

[42] Id.

[43] Competitive Impact Statement at 6, United States, et al. v. Springleaf Holdings, Inc., et al., No. 1:15-cv-01992 (RMC) (D.D.C. Nov. 13, 2015), https://www.justice.gov/opa/file/793141/download.

[44] Id.

[45] Id.

[46] FTC v. Steris Corp., 133 F. Supp. 3d 962, 963, 984 (N.D. Ohio 2015).

[47] Complaint at 6, 17, FTC v. Steris Corp., 133 F. Supp. 3d 962 (N.D. Ohio 2015) (No. 1:15-cv-01080-DAP).

[48] Id. at 7–8.

[49] FTC v. Steris Corp., 133 F. Supp. 3d 962, 971–72, 982 (N.D. Ohio 2015).

[50] Id. at 981, 984 (noting that “problems . . . plagued the development of x-ray sterilization” since 2012).

[51] See Maureen Ohlhausen, Comm’r, Fed. Trade Comm’n, Antitrust Tales in the Tech Sector: Goldilocks and the Three Mergers and Into the Muir Woods, 8–9 (Jan. 26, 2016), https://www.ftc.gov/system/files/documents/ public_statements/910843/160126skaddenkeynote.pdf.

[52] Id.

[53] FTC v. Staples, Inc., No. 15-02115 (EGS), 2016 WL 2899222, at *23 (D.D.C. May 17, 2016).

[54] Competitive Impact Statement, supra note 43, at 6.

[55] Id. at 9.

[56] Complaint at 5, United States v. Halliburton Co., No. 1:16-cv-00233-UNA (D.D.C. April 6, 2016), https://www.justice.gov/atr/file/838661/download.

[57] Id. at 4.

[58] Id.

[59] Id. at 5.

[60] Id.

[61] Complaint at 20–21, United States. v. Aetna Inc., 2016 WL 3920816 (D.D.C. July 21, 2016) (No. 1:16-cv-01494), https://www.justice.gov/opa/file/877881/download.

[62] Id. at 21.

[63] Id.

[64] Competitive Impact Statement at 2, United States v. Anheuser-Busch, No. 1:16-cv-01483 (D.D.C. Jul. 20, 2016), https://www.justice.gov/opa/file/877511/download.

[65] Press Release, Department of Justice, Justice Department Requires Anheuser-Busch InBev to Divest Stake in MillerCoors and Alter Beer Distributor Practices as Part of SABMiller Acquisition (July 20, 2016), https://www.justice.gov/opa/pr/justice-department-requires-anheuser-busch-inbev-divest-stake-millercoors-and-alter-beer.

[66] Competitive Impact Statement, supra note 43, at 2.

[67] Fed. Trade Comm’n, FTC File No. 141-0168, Analysis of Agreement Containing Consent Order to Aid Public Comment, In re Reynolds American Inc. and Lorillard Inc. 3 (2015), https://www.ftc.gov/system/files/documents/ cases/150526reynoldsanalysis.pdf.

[68] Id. at 3.

[69] Id.

[70] Id.

[71] Id.

By

Bitcoin and Virtual Currencies: Welcome to Your Regulator

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Matthew Kluchenek†

I.               Introduction

Among all the U.S. regulators interested in regulating Bitcoin and virtual currencies, the Commodity Futures Trading Commission (CFTC) is determined to be at the forefront. Since the announcement by CFTC Chairman Timothy Massad in late 2014 that Bitcoin derivatives should fall within the scope of the CFTC’s jurisdiction,[1] the CFTC has been aggressive in addressing not only wrongful conduct involving Bitcoin derivatives, but also wrongful conduct involving certain spot Bitcoin transactions.

The CFTC’s actions are a clarion call for market participants to understand the broad breadth of the CFTC’s jurisdiction, and to take notice of the requirements that may apply both to derivatives and to certain physical transactions involving Bitcoin and other virtual currencies.

II.              Scope of CFTC’s Jurisdiction

The U.S. Commodity Exchange Act (CEA),[2] as amended by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act),[3] regulates transactions in “commodity interests.”[4] The CFTC, an independent federal agency, is charged with administering the CEA and has exclusive jurisdiction over transactions involving commodity interests.[5] Throughout the history of the CFTC, and particularly with respect to the Dodd-Frank Act, Congress has ceded broad power to the CFTC to interpret and promulgate rules regarding commodity interest products, transactions, and market participants.[6]

As a general matter, the CFTC’s jurisdiction flows from the definition of a “commodity” under the CEA.[7] At bottom, if a “commodity” is not involved in a contract, agreement, or transaction, the CFTC lacks the statutory basis to regulate the contract, agreement, or transaction.[8] The definition of a “commodity,” however, is exceedingly broad under the CEA. The definition delineates a laundry list of agricultural products, but also sweeps in “all services, rights, and interests (except motion picture box office receipts, or any index, measure, value or data related to such receipts) in which contracts for future delivery are presently or in the future dealt in.”[9] As a result, almost anything except onions[10] and movie box office receipts[11] can constitute a “commodity” under the definition, including bottles of wine, baseball cards, reference rates, indices, mathematical permutations, services, intangibles, and contingencies that would not seemingly fall within the traditional view of a commodity.[12]

If, however, a commodity is involved, then the CFTC may only assert jurisdiction if a “commodity interest” is based on the commodity.[13][ A “commodity interest” refers to the types of instruments that are subject to the CFTC’s regulation, which are: (i) futures contracts, (ii) options on futures contracts, (iii) swaps, (iv) leveraged retail foreign exchange contracts, (v) leveraged retail commodity transactions, and (vi) certain other leveraged products.[14] Importantly, the CFTC’s jurisdiction is thus not—as many assume—limited to “derivatives,” but rather also extends to certain spot, or physical market, transactions.

As a result, in seeking to assert jurisdiction over a contract, agreement, or transaction involving a commodity, the CFTC’s jurisdictional hook is premised upon whether a commodity interest is involved. If so, and assuming that no exclusions or exemptions apply, the CFTC has a basis to assert regulatory authority.

III.             Bitcoin as a “Commodity” under the Commodity Exchange Act

In the context of Bitcoin (and other virtual currencies), the threshold issue is whether Bitcoin is a “commodity.” If Bitcoin is a commodity, then the CFTC may regulate commodity interests based on the commodity. If Bitcoin is not a commodity, then the CFTC lacks the authority to so regulate.

In December 2014, CFTC Chairman Timothy Massad telegraphed the CFTC’s intent to regulate Bitcoin derivatives, stating that “derivatives contracts based on a virtual currency represent one area within [the Commission’s] responsibilit[ies].”[15] Little elucidation was given. However, in September 2015, the CFTC took a significant step in asserting jurisdiction when it issued an order determining that “Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.”[16]

The CFTC’s determination did not arise out of a rulemaking or an interpretation, but rather via an enforcement action against an online Bitcoin trading platform called “Derivabit,” which was owned by Coinflip, Inc.[17] Coinflip operated the trading platform, which was designed for risk management purposes, in an effort to bring together buyers and sellers of Bitcoin option contracts.[18] Coinflip was not registered with the CFTC.

In making the pronouncement that Bitcoin is a commodity, the CFTC effectively determined that Bitcoin is not a currency. According to the CFTC, “Bitcoin and other virtual currencies are distinct from ‘real’ currencies, which are the coin and paper money of the United States or another country that are designated as legal tender, circulate, and are customarily used and accepted as a medium of exchange in the country of issuance.”[19]

Importantly, the CFTC’s determination is not limited to Bitcoin, but extends to “other virtual currencies,” which the CFTC broadly defines as “a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but does not have legal tender status in any jurisdiction.”[20] Thus, the definition of “virtual currency” could also engulf Litecoin and Dogecoin, among others yet to be created.

Based on its determination that Bitcoin is a commodity, the CFTC applied the CEA’s provisions to the Derivabit trading platform, finding that Coinflip unlawfully offered commodity options by operating a facility for the trading of such options without being registered as a designated contract market (that is, a futures exchange) or a swap execution facility (SEF).[21] Importantly, because Coinflip offered commodity options, which are derivatives, the CFTC had an ostensibly clear basis to assert jurisdiction once the agency determined that Bitcoin is a commodity.[22]

Just one week after the Coinflip settlement, and armed with its determination that Bitcoin is a commodity, the CFTC brought its second Bitcoin-related enforcement action, this time against TeraExchange, LLC (Tera), an SEF.[23] In the action, the CFTC alleged that Tera failed to enforce its prohibition on wash trades by facilitating the prearrangement of a single Bitcoin swap transaction.[24]

As with the Coinflip matter, the CFTC’s enforcement action against Tera involved a derivative—that is, here, swaps based on Bitcoin. The presence of the swap, coupled with Tera’s provisional registration with the CFTC as an SEF, provided the CFTC with an unambiguous pathway to assert jurisdiction. Soon thereafter, however, the CFTC’s path would take a different, and more aggressive, turn.

IV.             The CFTC’s Enforcement Action Against Bitfinex

In June 2016, the CFTC filed charges against a Hong Kong-based company called Bitfinex, which operates an online platform for trading in cryptocurrencies, including Bitcoin.[25] Unlike Coinflip and Tera, however, Bitfinex did not list or permit the trading of derivatives, such as futures, options, or swaps.[26] Rather, Bitfinex merely facilitated spot transactions in cryptocurrencies.[27] Generally, a “spot” transaction is the everyday transaction of buying and selling a good, much like one does when purchasing an item on eBay. Payment is made for the item, and the item is promptly delivered to the buyer. The CFTC is generally not authorized to regulate spot transactions.[28] However, by adding a couple of characteristics to an otherwise vanilla spot transaction, the transaction can be transformed into a commodity interest transaction subject to the full panoply of provisions under the CEA.

The basis for the CFTC’s authority to regulate certain spot transactions derives from the jurisdictional hook that the agency has used so successfully to prosecute retail precious metals transactions[29]—the so-called “retail commodity transaction” provision under the CEA.[30] The retail commodity transaction provision is a relatively short provision set forth in CEA section 2(c)(2)(D). It provides:

(D) Retail commodity transactions

(i) Applicability[.] Except as provided in clause (ii), this subparagraph shall apply to any agreement, contract, or transaction in any commodity that is—

(I) entered into with, or offered to (even if not entered into with), a person that is not an eligible contract participant or eligible commercial entity; and

(II) entered into, or offered (even if not entered into), on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.[31]

The elements of a retail commodity transaction are thus threefold—the agreement, contract, or transaction must:

(1)  involve a commodity;

(2)  be entered into with, or offered to, a person that is not an eligible contract participant (ECP);[32] and

(3)  be entered into, or offered, on a leveraged, margined or financed basis.[33]

All three elements must be present for there to be a retail commodity transaction. Any person that deals in commodities subject to the retail commodity transaction provision is required to be registered with the CFTC as a futures commission merchant (FCM).[34]

While a retail commodity transaction is a form of commodity interest, such a transaction is fundamentally different from a derivatives transaction, the latter of which derives its value from an underlying commodity and contains an element of futurity. Critically, where a derivative is not involved, market participants are often caught off-guard with respect to the broad scope of the CFTC’s jurisdiction.

Like so many requirements under the CEA, however, there are exceptions to the retail commodity transaction provision. One such exception involves the timely “actual delivery” of a commodity to the buyer.[35] If a seller offers to enter, or enters into, a commodity transaction with a non-ECP on a leveraged basis, the transaction will not fall under the retail commodity transaction provision if the seller actually delivers the commodity to the buyer within 28 days of the date that the contract is entered into.[36] The meaning of “actual delivery” has been the subject of extensive interpretation by the CFTC.[37]

In determining that Bitfinex violated the CEA, the CFTC’s order found that the transactions executed on the Bitfinex platform fell within the purview of the retail commodity transaction provision, and that no “actual delivery” occurred. According to the CFTC:

  • Bitcoin is a commodity;
  • Bitfinex did not limit its customers to ECPs, but rather sold Bitcoins to retail persons;
  • Bitfinex facilitated the financing of Bitcoin transactions;[38] and
  • Bitfinex did not actually deliver Bitcoins to the buyers.[39]

In addressing the most controversial aspect of the order—whether actual delivery of the Bitcoins occurred—the CFTC explained that Bitfinex held its customers’ Bitcoins in an omnibus private wallet that was controlled solely by Bitfinex, not the customers.[40] Through the use of a private key, only Bitfinex had access to the omnibus wallet.[41] Consequently, because Bitfinex solely controlled access to the wallet, the CFTC found that Bitfinex’s customers did not actually receive delivery of any Bitcoins.[42] The CFTC’s explanation seems to suggest that satisfying the requirement of “actual delivery” would require that virtual currencies be delivered to a deposit wallet for which the recipient controls the private key.[43] However, neither the CEA, the CFTC’s rules, nor the CFTC’s guidance on “actual delivery” discuss or contemplate the delivery requirements of virtual currencies.[44]

Nonetheless, based on the satisfaction of the elements of the retail commodity transaction provision, coupled with the absence of actual delivery, the CFTC found that Bitfinex violated the CEA’s retail commodity transaction provision by failing to register as an FCM.[45] The CFTC’s action against Bitfinex marks the agency’s initial foray into the regulation of Bitcoin via the retail commodity provision transaction. If the history involving the CFTC’s regulation of retail precious metals transactions is any guide, more enforcement actions should be expected.

V.              What’s Next?

In at least one respect, the CFTC should be given credit for taking the lead in seeking to regulate a novel product under its jurisdiction. With such an effort, however, comes responsibility. The CFTC should clearly articulate, through an interpretation rather than ad hoc enforcement actions, the manner in which the agency intends to apply the actual delivery exception to virtual currencies. Such an interpretation is necessary so as not to stymie innovation.

At the same time, the CFTC should strive to coordinate the regulation of virtual currencies with other federal agencies, some of which have shown an interest in regulating such products.[46] For example, if the Securities and Exchange Commission were to classify Bitcoin or another virtual currency as a “security,” market participants could be compelled to comply with two fundamentally different, and in some ways redundant, regulatory regimes. We have seen dual jurisdiction applied to certain other products—security futures and mixed swaps come to mind—and the outcomes have not been ideal. Here, as before, the CFTC should be aggressive in seeking to address regulatory harmonization.

Finally, for market participants, the CFTC has sounded the bell. In offering virtual currencies to customers, market participants must understand and be sensitive to the scope of the CFTC’s jurisdiction. If a swap or futures contract is involved—including a seemingly innocuous embedded option in which the customer has the right to cancel or offset a purchase—or a retail spot transaction involves any form of financing, margin or leverage, the CFTC has shown its willingness to take action—even in the absence of allegations of fraud or other wrongdoing.

 

† Partner, Global Head of Derivatives, Baker & McKenzie LLP.

[1] The Commodity Futures Trading Commission: Effective Enforcement and the Future of Derivatives Regulation Before the S. Comm. on Agric., Nutrition, and Forestry, 111th Cong. 55 (2014) (statement of Timothy Massad, Chairman of the Commodity Futures Trading Commission).

[2] Commodity Exchange Act of 1936, Pub. L. No. 74–675, 49 Stat. 1491 (codified as amended in scattered sections of 7 U.S.C.) (replacing the Grain Futures Act of 1922).

[3] See generally Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111–203, 124 Stat. 1376 (2010).

[4] See 17 C.F.R. § 1.3(yy) (2016).

[5] See Commodity Futures Commission Trading Act of 1974 § 101, 7 U.S.C. § 2(a)(1)(A) (2012). When Congress created the CFTC in 1974, it “confer[red] on the CFTC ‘exclusive jurisdiction’ over commodity futures and options thereon, which means that these instruments cannot be regulated by any other federal or state agency (except in certain limited circumstances where the CEA explicitly contemplates shared authority between the CFTC and another agency).” President’s Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act (1999). The purpose of the exclusive jurisdiction provision “was to separate the functions of the new CFTC from those of the SEC and other regulators.” Leist v. Simplot, 638 F.2d 283, 314 (2d Cir. 1980).

[6] See, e.g., Binyamin Appelbaum, On Finance Bill, Lobbying Shifts to Regulation, N.Y. Times (June 26, 2010), http://www.nytimes.com/2010/06/27/business/27regulate.html? (noting that the Dodd-Frank Act is “basically a 2,000-page missive to federal agencies, instructing regulators to address subjects ranging from derivatives trading to document retention” and observing that “it is notably short on specifics, giving regulators significant power to determine its impact—and giving partisans on both sides a second chance to influence the outcome”).

[7] See 7 U.S.C. § 1(a)(9) (2012).

[8] See id. at § 2(a)(1)(A).

[9] See id. at § 1(a)(9).

[10] In 1958, as a result of rife manipulations in the onion market, Congress enacted the Onion Futures Act to ban futures trading in onions. Id. at § 13-1; see also Bd. of Trade of Chi. v. SEC, 677 F.2d 1137, 1142 n.9 (7th Cir. 1982) (discussing the onion carve out from the CEA).

[11] As part of the Dodd-Frank Act, Congress banned—at the urging of associations representing the motion picture industry—the trading of derivatives on motion picture box office receipts. See 7 U.S.C. § 13-1 (2006), amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.L. No. 111-190, § 721(e)(10), 124 Stat. 1376, 1672 (2010); see also Daniel Frankel, 10 Key Moments in the Life of Movie Derivatives, THE WRAP (Aug. 13, 2010, 6:53 PM), http://www.thewrap.com/movies/article/10-key-moments-life-movie-derivatives-20122.

[12] See 7 U.S.C. § 1a(9).

[13] See 7 U.S.C. § 2(a)(1)(A).

[14] See 17 C.F.R. § 1.3(yy) (2016) (“Commodity interest . . . means (1) Any contract for the purchase or sale of a commodity for future delivery [a futures contract]; (2) Any contract, agreement or transaction subject to a Commission regulation under section 4c [commodity options] or 19 of the Act [leveraged contracts]; (3) Any contract, agreement or transaction subject to Commission jurisdiction under section 2(c)(2) of the Act [retail foreign exchange and commodity transactions]; and (4) Any swap as defined in the Act, by the Commission, or jointly by the Commission and the Securities and Exchange Commission [a swap as defined in CFTC Rule 1a(47)].”).

[15] The Commodity Futures Trading Commission: Effective Enforcement and the Future of Derivatives Regulation Before the S. Comm. on Agric., Nutrition, and Forestry, 111th Cong. 55 (2014) (statement of Timothy Massad, Chairman of the Commodity Futures Trading Commission).

[16] In re Coinflip, Inc., CTFC No. 15-29, 2015 WL 5535736, at *3 (Sept. 17, 2015).

[17] Id. at *2.

[18] Id.

[19] Id. at *n.2.

[20] Id.

[21] Id. at *3–4. A swap execution facility is a trading system or platform, other than a designated contract market, in which multiple participants have the opportunity to enter into swaps by accepting bids and offers made by multiple participants on the facility. See Commodity Exchange Act of 1936 § 1a(50), 7 U.S.C. § 1a(50) (2012).

[22] See id. at *5 (explaining that under the terms of settlement, the defendants agreed to cease and desist from future violations of the CEA and the CFTC’s rules, but no financial penalty was imposed).

[23] In re TeraExchange LLC, CFTC No. 15-33, 2015 WL 5658082 (Sept. 24, 2015).

[24] Like the Coinflip matter, the CFTC and the defendants agreed to a settlement involving a cease and desist order, but no financial penalty. Id. at *8–9.

[25] In re BFXNA Inc., CFTC No. 16-19, 2016 WL 3137612 (June 2, 2016).

[26] See id. at *2.

[27] See id. at *3.

[28] The CFTC staff has defined a spot transaction as one where immediate delivery of the product and immediate payment for the product are expected on or within a few days of the trade date. See CFTC No-Action Letter, CFTCLTR No. 98-73, 1998 WL 754623 (Oct. 8, 1998). The Supreme Court has defined a spot transaction as a purchase or sale agreement for a commodity that is intended to settle in the period that is ordinary for dealings in the relevant type of commodity. See Dunn v. CFTC, 519 U.S. 465, 472 (1997). As noted by the Sixth Circuit, “because the CEA was aimed at manipulation, speculation, and other abuses that could arise from the trading in futures contracts and options, as distinguished from the commodity itself, Congress never purported to regulate ‘spot’ transactions (transactions for the immediate sale and delivery of a commodity) or ‘cash forward’ transactions (in which the commodity is presently sold but its delivery is, by agreement, delayed or deferred).” CFTC v. Erskine, 512 F.3d 309, 321 (6th Cir. 2008). Spot transactions are, however, subject to the anti-manipulation provisions under the CEA and the CFTC’s rules to the extent that such attempted or actual manipulations affect prices in commodity interests. See, e.g., 7 U.S.C. §§ 9, 15 (2012); 17 C.F.R. § 180.1(a) (2016); see also CFTC v. Atlantic Bullion & Coin, Inc., C.A. No. 8:12-1503-JMC (D.S.C. 2010), http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfatlanticcomplaint060612.pdf.

[29] See, e.g., CFTC v. Hunter Wise Commodities, 21 F. Supp. 3d 1317 (S.D. Fl. 2014); CFTC v. Palm Beach Capital, No.14-cv-80636 (S.D. Fl. 2014), http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfpbeachorderdf073114.pdf.

[30] See 7 U.S.C. § 2(c)(2)(D).

[31] Id.

[32] An ECP is defined to include, among others, (i) an organization with total assets in excess of $10 million; (ii) a corporation that (a) has a net worth in excess of $1 million and (b) uses commodity interests in connection with its business or to hedge commercial risk; (iii) an individual who has amounts invested on a discretionary basis, the aggregate of which is in excess of $10 million; or (iv) an individual who has amounts invested on a discretionary basis, the aggregate of which is in excess of $5 million, where such individual is using the instrument in order to manage the risk associated with an asset owned or liability incurred, or reasonably likely to be owned or incurred, by the individual. 7 U.S.C. § 1a(18). An eligible commercial entity is defined in § 1a(17).

[33] The CFTC takes a broad view of the scope of this element. Essentially, if the purchaser of the commodity is not required to fully pay for the commodity upon purchase, then the CFTC will likely presume that leverage or financing is involved in the transaction. See Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426, 52,426 (Aug. 23, 2013) (to be codified in 17 C.F.R. pt.1) (“New CEA section 2(c)(2)(D) of the CEA broadly applies to any agreement, contract, or transaction in any commodity that is entered into with, or offered to (even if not entered into with), a non-eligible contract participant or non-eligible commercial entity on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.”) (emphasis added).

[34] See 7 U.S.C. § 6d.

[35] See Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426, 52,426 (Aug. 23, 2013) (to be codified in 17 C.F.R. pt.1).

[36] See id. at 52,427.

[37] See Retail Commodity Transactions Under Commodity Exchange Act, 76 Fed. Reg. 77,670 (Dec. 14, 2011) (to be codified in 15 C.F.R. pt. 922); Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426 (Aug. 23, 2013) (to be codified in 17 C.F.R. pt.1).

[38] The Bitfinex platform permitted maximum leverage of 3.33-to-1 (that is, a 30% initial margin requirement). See In re BFXNA Inc., CFTC No. 16-19, 2016 WL 3137612, at *2 (June 2, 2016).

[39] Id. at *5.

[40] Id.

[41] A “private key” is a secret number associated with a deposit wallet that allows Bitcoins in that wallet to be accessed and spent. The private keys, which are randomly assigned, are mathematically related to all Bitcoin addresses generated for the wallet. See Private Key, Bitcoin Wiki, https://en.bitcoin.it/wiki/Private_key (last visited Oct. 26, 2016).

[42] See In re BFXNA Inc., 2016 WL 3137612, at *5.

[43] See Letter from Steptoe & Johnson LLP to Commodity Futures Trading Comm’n (July 1, 2016) (on file with author).

[44] Cf. In re BFXNA Inc., 2016 WL 3137612. The Bitfinex order prompted a petition that requests the CFTC to clarify the “actual delivery” requirements in the context of virtual currencies. See Letter from Steptoe & Johnson LLP to Commodity Futures Trading Comm’n (July 1, 2016) (on file with author).

[45] Under the terms of the settlement, Bitfinex agreed to pay a civil money penalty of $75,000 and cease and desist from further violations of the subject CEA provisions. Id. at *6.

[46] See, e.g., Investor Alert: Bitcoin and Other Virtual Currency-Related Investments, U.S. Sec. & Exch. Comm’n (May 7, 2014), https://www.sec.gov/oiea/investor-alerts-bulletins/investoralertsia_bitcoin.html.

By

It Ain’t Broke: The Case For Continued SEC Regulation of P2P Lending

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Benjamin Lo†

Introductory Note

In 2008, the Securities and Exchange Commission made waves by deciding to regulate the nascent peer-to-peer lending industry. Only two lending platforms survived the SEC’s entry into a previously lightly-regulated market. Under this regulatory setup, the SEC would regulate the lending-investing process, while other agencies like the Consumer Financial Protection Bureau and Federal Trade Commission would regulate the borrower side of the business. In subsequent years, entrepreneurs, academics, and lawmakers struggled with the question of whether this bifurcated approach should be replaced by a consolidated regulatory approach, supported by an exemption of P2P lending platforms from federal securities laws. This Article argues that the existing bifurcated system works and is continually getting better as the SEC amends existing exemptions and introduces new regulations to smooth the path for financial innovation. It uses data and empirical methods to further examine the relative welfare of borrowers and retail lenders in P2P transactions. It concludes that (i) unlike brick-and-mortar transactions, retail lenders require more protection than borrowers in the P2P world and (ii) the SEC is uniquely suited to protect these retail lenders and should continue to do so, with some recommended modifications.

* * * 

I.               Introduction

In 2006, a company called Prosper had an audacious idea: helping people borrow thousands of dollars online from strangers. News coverage at the time was slightly incredulous, describing the startup as “ingenious and faintly surreal – its premise is that strangers . . . will come together to execute meaningful, serious[,] and risky transactions in a self-consciously anonymous environment.”[1] Ten years later, peer-to-peer (P2P) loan platforms in the United States have issued $5.5 billion in loans.[2] In a significant departure from traditional bank-based lending, individual retail lenders (“lenders” or “individual lenders”) are loaning money to anonymous borrowers on P2P loan platforms, often based on a combination of verified and unverified data. This is how it works: borrowers register on a P2P loan platform and submit information in a loan application;[3] the loan platform then assigns the loan a quality score before posting the loan anonymously to their platforms to attract lender funding.[4]

This novel industry has been the subject of intense regulatory debate, due to concerns over consumer protection. The early days of P2P lending were fraught with risk to lenders, who were largely individuals rather than traditional institutional creditors.[5] Even as the industry grew, lenders bore painfully high default rates―Prosper was charging off more than 20% of loans issued before 2008, while Lending Club fared better, but still had 8.5% of its pre-2008 loans in default.[6] In comparison, consumer loan charge-offs and delinquencies at commercial banks averaged around at 5.5% and 4.7% respectively during the same period in 2009.[7]

Regulatory ambiguity ended in 2008; the Securities and Exchange Commission (SEC) fatefully intervened on November 24 and entered a cease-and-desist order (the Order) against Prosper.[8] According to the SEC, Prosper (and by extension, other for-profit P2P loan platforms) were selling “securities” and thus came under the ambit of the 1933 Securities Act. These P2P loans thus had to be registered with the SEC to comply with federal securities laws.[9] This caused a massive industry shakeout. Prosper and Lending Club successfully registered their offerings with the SEC, but other P2P loan platforms such as Loanio, Virgin Money, and Pertuity soon folded under the burden of complying with the SEC’s Order.[10]

The SEC’s Order had far-reaching implications for the P2P lending model. Lending Club and Prosper faced significant registration and reporting requirements. These for-profit P2P loan platforms had to shelf-register each loan (known as a “note”) ahead of any given lender’s investment.[11] They had to record details of each funded loan with the SEC in a “posting supplement” placed on EDGAR (the SEC’s disclosure archive),[12] thus publicly storing the borrower’s data and disclosures for the public to see. Unsurprisingly, these registration requirements were difficult to implement for incumbents, and are nearly insuperable for new entrants.

The SEC’s Order also fundamentally changed the transactional relationships among the borrower, lender, and platform. Prior to the SEC’s Order, when borrowers and lenders matched, “Prosper would signal WebBank, a Utah-chartered industrial bank, to make the loan to the borrower. WebBank would assign the note to Prosper, which then assigned it to the lender.”[13] Effectively, the platform merely intermediated a loan between the borrower and the lender. The transaction has become significantly more complicated after the SEC’s Order. Today, the lender starts the process by signaling interest in a prospective borrower. When the loan receives enough indications of interest, WebBank funds the borrower but assigns the loan to the platform, not to the lenders. The platform then sells a separate debt instrument backed by the original loan to the lenders, who become creditors of the platform rather than the borrower.[14] The approach is cumbersome and exposes lenders to additional risk, as it entirely eliminates any status lenders may have as secured creditors of the platform.[15] Unfortunately, offering lenders a partial or whole security interest in the loan would potentially make them registrants or underwriters of the security, and thus this workaround resulted.[16]

Despite these restrictions, P2P lending has taken off. Lending Club and Prosper have issued more than $13 billion in loans since 2006, with the majority of loan growth concentrated in the past three years.[17] These online marketplaces for personal loans have also benefited both borrowers and lenders by stripping some costs out of the transaction. For example, Lending Club claims that “the traditional banking system is burdened by its high fixed cost of underwriting and services, in part due to its physical infrastructure and labor- and paper-intensive business process . . . .”[18] These platforms may drive additional benefits, such as the potential to harness the “collective intelligence of potential lenders” and its function as an alternative source of capital during the 2008 credit crunch.[19]

One of the central questions gripping the industry has been that of the optimal regulatory structure. As P2P lending took off, entrepreneurs, academics, and lawmakers struggled with deciding who should regulate the industry. Should they allow the SEC to retain jurisdiction alongside other regulators (the bifurcated approach), or should they consolidate oversight under the Consumer Financial Protection Bureau (CFPB) and exempt platforms from federal securities laws (the consolidated approach)? This Article answers that question with the benefit of new data and developments. Section I describes the battle between the bifurcated and consolidated approaches. Section II refutes criticisms of the bifurcated approach. Section III explains the novel risks individual lenders face in P2P lending markets, thus justifying SEC involvement. Section IV outlines modest proposals for the SEC to improve their oversight of the industry.

II.             Concerns Around An Ill-Fitting Regulatory Approach

In 2011, a Government Accountability Office (GAO) report studied two distinct approaches toward regulating P2P lending. The status quo involved a bifurcated regulatory regime, with the SEC and state securities regulators protecting lenders through disclosure requirements, and prudential regulators such as the Federal Deposit Insurance Corporation and CFPB focusing on borrower protection.[20] The alternative consolidated regulatory regime “would assign primary federal responsibility for borrower and lender protection to a single regulator, such as [the] CFPB[,] . . . [and] would require exempting person-to-person lending platforms from federal securities laws.”[21] The report noted that “[t]he key distinction between the two primary options for regulating person-to-person lending is how they would protect lenders.”[22]

Shortly after the GAO report was published, Andrew Verstein, who is now a Wake Forest Law School professor, published the first comprehensive study analyzing the shortcomings of SEC regulation of P2P lending.[23] Broadly, Verstein advances three criticisms of SEC regulation. First, the cost of SEC compliance would selectively burden certain P2P business models and restrict industry growth. Second, the SEC had no mandate to protect borrowers and might privilege lenders over borrowers when requiring information disclosure. Third, SEC involvement actively hurt lenders by imposing additional risks.

On the first issue, Verstein describes how for-profit P2P loan platforms would continue to be harmed by the registration process. P2P loan platforms cannot sell notes before the registration statement becomes effective, and must continue to amend their SEC filings in the post-effective period at great effort.[24] Verstein notes, “The costs and delays from SEC regulation of P2P lending resulted in a substantial reduction in the number of P2P platforms . . . . In this climate, many P2P platforms have found it difficult to compete and grow.”[25] As for borrowers, Verstein worries that mandatory disclosures in SEC filings compromised borrower privacy with little benefit to the lenders, since even the SEC admitted that few people use EDGAR to access information about P2P investments.[26] The SEC has no mandate to protect borrowers and could potentially “ossify a ruthlessly pro-lender bias for P2P disclosure.”[27] Finally, securities registration may have made lenders worse off. P2P loan platforms were forced to opt for shelf registration under Securities Act Rule 415, which is the only way for issuers to register a group of securities far in advance of their issuance.[28] However, shelf registration meant that the platform had to serve as the issuer, rather than the individual borrowers, thus exposing the lender to the credit risks of both borrowers and the platform.[29]

Verstein believes that the better solution would be to consolidate regulation of P2P loan platforms under the CFPB. This new agency could craft tailored disclosures that balanced borrower privacy against misleading advertising and disclosures for lenders. The CFPB’s prudential regulatory scheme could further negate some of the unwanted side effects of a purely disclosure-based regime.[30] This perspective helped clarify two opposing positions on the “optimal regulator” for the P2P lending industry. One camp strongly supported the CFPB, since it would impose none of the registration costs outlined above, while also furnishing the additional benefit of being better placed to apply federal consumer protection laws on behalf of borrowers.[31] In contrast, the opposing camp argued for a “wait-and-see” approach that permitted the bifurcated regime to continue. Chief among their reasons were concerns that experienced securities and lending regulators would be foreclosed from applying their expertise to a rapidly evolving industry, instead replacing joint oversight with a single new regulatory entity potentially subject to regulatory capture.[32] Proponents of the bifurcated regime also argued that it was too early to claim that the industry was “stifled by overregulation” and that unchecked growth might foretell a crash.[33] The bifurcated regime has turned out to be the correct choice, due to changes in the SEC’s approach, as well as new empirical data suggesting that lenders require more protection than borrowers in P2P lending markets.

III.           The SEC’s Approach Ain’t Broke No Longer

Four years later, the dire shortcomings of the bifurcated approach have failed to materialize. Proponents of a consolidated approach under the CFPB had fretted that the cost of SEC regulation was simply too high and would halt industry growth in its tracks.[34] Yet the SEC has expanded private placement exemptions and put in place new regulations to lower the regulatory barrier to entry, effectively exempting new P2P loan platforms from the dreaded registration burden. The bifurcated approach will also likely benefit borrowers, since the centrality of loan platforms in P2P transactions offers an easier single point of application of consumer financial protection laws. But perhaps the most powerful argument in favor of the SEC’s continued role comes from protections that disclosure rules may offer lenders. Empirical analysis shows that the tables have turned on lenders. Unlike traditional credit markets, lenders require more protection than borrowers in P2P lending transactions due to their retail status. Thus, each of the original arguments against the SEC’s involvement have been mitigated or even overturned with time.

A.             Rule 506(c) and Regulation Crowdfunding Lower Barriers to Entry

At the outset, the notion that P2P lending growth has been chilled by regulation should be dispelled. P2P lending volumes at Prosper and Lending Club (both of whom collectively controlled 98% of the P2P market in 2014) grew from $871 million in loans in 2012 to $2.4 billion in 2013.[35] By one estimate, P2P loans in the U.S. reached $5.5 billion in 2014, and are projected to reach $150 billion by 2025.[36] By any measure, growth has been rapid.

The remaining concern should thus be whether new entry is still significantly challenged by regulatory barriers to entry. But, since 2013, the SEC has adopted new rules that lower these barriers. The main hurdle faced by for-profit P2P loan platforms, following the SEC’s application of the Howey test,[37] was the need for costly and burdensome registration regardless of business size. In 2011, there were several exemptions that could have removed P2P loans from the ambit of federal securities laws (and, correspondingly, eliminated the need for registration), but most had aggregate offering amount caps which were too low to support the scale of a P2P lending operation.[38] An exemption under Rule 506, which does not have an aggregate offering limit, could have permitted the platforms to execute private placements but for the prohibition on “general advertising” and “general solicitation” (stemming from the Rule 502(c) limitations on the manner of offering).[39] A securities offering made over the Internet—a fundamental sales channel for a P2P loan platform—might be deemed by the SEC to involve general advertising or general solicitation and thus would not qualify for the Rule 506 exemption.[40] Thus, to avoid registration, P2P loan platforms would either have to stay extremely small and give up any economies of scale, or would have to avoid marketing the securities through standard sales channels—both untenable propositions for any consumer-focused business.

Fortunately, the SEC implemented Rule 506(c) in September 2013, which “permits issuers to use general solicitation and general advertising . . . when conducting an offering pursuant to [Rule 506(c)], provided that all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that such purchasers are accredited investors.”[41] What this means is that as long as the platforms make a reasonable effort to ensure that lenders are “accredited investors,”[42] they should be able to offer and sell an unlimited amount of loans to lenders without going through registration.

The dominant lending platforms, Lending Club and Prosper, do not need this exemption since they already have a shelf-registration process in place. But new entrants into the P2P lending arena may yet take advantage of this exemption, especially as it grows in popularity. General use of Rule 506(c) is still small. More than 900 new offerings were conducted in reliance on Rule 506(c) in 2014, raising more than $10 billion in new capital.[43] But this is small compared to the 9,200 offerings valued at $233 billion sold under the old “private” Rule 506 exemption.[44] As the Rule 506(c) exemption gains popularity, it could emerge as a powerful tool to incubate new platforms among informed lenders, thus undercutting concerns around insuperable regulatory barriers to entry. Previous commentators have noted that P2P lending startups are in a catch-22: they cannot legally begin operating without registration or afford registration without venture funding, but they will not get venture funding without acquiring customers through their operations.[45] This exemption dispels some of those concerns. The new entrants can start with Rule 506(c) to grow their customer base. Once they obtain funding, they can then transition to shelf-registration to ensure that their securities enjoy the full benefits of a registered offering, such as the ability for buyers to freely resell their securities.

In a related development, the SEC recently implemented a separate crowdfunding exemption pursuant to the CROWDFUND Act of 2012.[46] Some provisions of the SEC’s final rule regarding crowdfunding (Regulation Crowdfunding) appear to further ease entry into the P2P lending market. Borrower companies may raise up to $1 million in a 12-month period, from both accredited and unaccredited investors, subject to individual investment limits and certain financial statement disclosure requirements.[47] The offering must also be made through a broker or funding portal.[48] Regulation Crowdfunding allows platforms to match borrowers and lenders on a marketplace, without requiring the platform to register any securities. This partially resurrects the original transaction structure proposed by lending platforms: lenders can lend money directly to borrowers, with the platform only providing a marketplace in which the transaction can take place. Admittedly, Regulation Crowdfunding does not fully open the door to the original model, since the exemption exempts small business issuers from registration, and further requires issuers to file certain disclosures with the SEC.[49] But while this exemption would not necessarily benefit new entrants seeking to replicate Lending Club or Prosper’s business model, it opens the door to currently unavailable P2P lending structures such as a platform for crowdfunded small business loans.[50] The increasing availability of exemptions for all aspects of P2P funding is evidence that the slow-growth and barrier-to-entry concerns are unwarranted.

B.             Single Point of Application for Consumer Financial Protection Regulation

Proponents of the consolidated approach were justifiably concerned that the SEC would focus on protecting lenders at the expense of borrowers.[51] Holding aside that the status quo involves a multi-agency approach that includes the CFPB, there have been additional benefits accruing to borrowers due to the SEC’s involvement. The SEC’s registration requirement forces the lending platform to issue loans to borrowers in the platform’s own name. Essentially, the platforms have stepped in to act as a clearinghouse. This structure may be detrimental to lenders since they no longer retain a security interest in the borrower’s loan.[52] However, it may have the happy, and likely unintended, consequence of providing additional protections for borrowers. Many of the major consumer financial protection laws, such as the Truth-in-Lending Act (TILA) and the Equal Credit Opportunity Act (ECOA) can be more effectively applied against a lending platform than against individual lenders. By issuing lenders a borrower-dependent payment note instead of assigning the borrower’s obligation to the lender, the platform truly assumes the role of “creditor” in each transaction. The platform thus provides a single point of application for the enumerated consumer financial protection laws.

To highlight how this works, consider creditors’ obligations under TILA. A covered creditor must “disclose any finance charge; report interest rates as annual percentage rates; identify the creditor; list the amount financed; enumerate the payment schedule; describe late fees; and suggest that the consumer consult a tax adviser.”[53] However, not everyone who lends money is a covered creditor. A creditor is only subject to TILA requirements if he “regularly extends . . . consumer credit” and “is the person to whom the debt arising from the consumer credit transaction is initially payable on the face of the evidence of indebtedness. . . .”[54] An entity “regularly extends” credit if it did so more than twenty-five times in the preceding year.[55] In the original transaction structure where the notes were made payable to the individual lender, attaching TILA obligations to the platform or the funding bank could be difficult if the debt was initially payable to the individual lender. It would be even more difficult to attach TILA obligations to individual lenders—logistics of forcing lenders to comply with TILA aside, the lenders have to regularly extend credit to be covered under TILA. Having the borrowers be clearly obligated to the funding bank or platform provides a logical and sensible party to which TILA duties can attach.

The benefits of a single point of application for ECOA are even clearer. One of the key ECOA requirements is the adverse action notice: if the borrower’s application for credit is denied, he is entitled to an adverse action “providing statements of reasons in writing as a matter of course to applicants against whom adverse action is taken.”[56] In the original transaction model, lenders might arguably have been required to issue adverse action notices, as ECOA creditors include “any assignee of an original creditor who participates in the decision to extend, renew, or continue credit.”[57] This requirement would have been unworkable, and potentially imposed civil liability on lenders, as ECOA provides a private right of action.[58] However, the present model appropriately places the full weight of ECOA compliance on lending platforms and funding banks since they are the creditors actually making the loans.[59]

The above arguments posit that borrowers receive better protections because of the transactional structure imposed by the SEC. However, they do not directly address the issue of borrower privacy and the potential ossification of a “ruthlessly pro-lender bias” that so concerns Verstein.[60] In Section III-A, this Article describes how empirical analysis shows that borrowers are getting a good deal and face a relatively low risk of exploitation by lenders and the lending platforms.

C.             Lenders, Not Borrowers, Need Help in the P2P Lending Market

The traditional borrower-lender dynamic has typically favored lenders over borrowers due to the disparity in negotiating leverage between the parties. Borrowers often pit themselves against banks selling financial products with “incomprehensible terms and sharp practices that have left families at the mercy of those who write the contracts.”[61] This does not appear to be the case here. Based on loan data provided by Lending Club, it appears that in P2P lending transactions, borrowers are doing quite well. They are not subject to the same risks as those in the brick-and-mortar lending world. Conversely, lenders have entered the lending market for the first time, and are making small but significant mistakes when processing the reams of data made available to them. The tables have turned on lenders, and the SEC is uniquely suited to protect these neophyte investors through better disclosure.

IV.           The Tables Have Turned On Lenders

The following analysis is based on an empirical study of 391,888 of Lending Club’s loans made from 2007 to 2013, of which 33,592 are matured and have been fully paid down or charged off.[62] Each loan contains significant borrower disclosures that lenders rely on to make an investment decision. This appears to be the first empirical contribution to the bifurcated versus consolidated regulatory approach debate. Results show that borrowers appear to enjoy better rates than they would have obtained on their immediate source of credit—credit cards. They are also well protected from lender exploitation by a combination of Lending Club collection policies and the collective action problem of collecting on small loans. In contrast, lenders may need to be protected from themselves, since they often misinterpret key information offered by borrowers. Summary statistics are reproduced below.

Table 1: Lending Club Loans By Grade And Year
Table 1
Table 2: Loans by Selected Verified Borrower Information Variables

Table 2

Table 3: Loans By Borrower Disclosure Information (Discrete Variables)

Table 3

A.             Borrowers Get Better Rates While Subject to Fewer Abusive Practices

To evaluate whether Lending Club borrowers are getting better interest rates, the empirical study regresses average Lending Club rates for 36-month loans on alternative sources of credit from 2007 to 2012. Controlling for individual borrower characteristics, the study shows that for every 100 basis point (bps) increase in rates for comparable credit products—for example, personal loans, existing credit card APRs, and new card APRs—Lending Club’s average rates rise between eight and thirty bps. Thus, Lending Club’s average rates appear less sensitive than bank rates, which would have benefited borrowers during the 2008 to 2010 credit crunch. During this period, credit card interest rates stayed mostly flat, between 13% and 14% APR—though personal loan rates fell, likely due to rapidly tightening loan issuance standards.[63] Lending Club’s rates stayed relatively flat at 11% to 12% over the same period, resulting in relatively better rates for the average borrower during the credit crisis. It is possible that Lending Club was capturing higher credit-quality borrowers from banks during this period, generating a compositional shift that dampened rate increases. However, banks were implementing tighter lending standards, and fewer borrowers were qualifying for traditional bank credit.[64] Thus, Lending Club may have been able to offer lower rates for equivalent- or greater-risk customers who were unable to obtain bank loans.[65]

Most Lending Club borrowers also appear insulated from overpayment exploitation. Overpayment occurs when missed payments and late fees begin compounding, increasing the borrower’s outstanding obligation. This is a common concern in payday lending.[66] Table 1 analyzes just-matured loans, showing the breakdown of overpaying borrowers and the amount overpaid relative to loan size. Lower quality borrowers have a higher risk of overpaying as they are more likely to be miss payments, consistent with their poorer credit quality. Yet on the whole, only 3.8% of borrowers—1,277 out of 33,592 borrowers whose loans terms were completed—paid more than the contracted installments, including charged-off loans. This is in line with the overall delinquency rate on consumer loans at commercial banks, which ranged from 2.4% to 4.9% from 2007 to 2012.[67] Further, borrowers overpaid from 0.4% to 1.5% of the amount borrowed. These overpayment amounts are unremarkable. For comparison, credit card accountholders with FICO above 660 (non-subprime borrowers) historically paid 2-4% of their average daily balance in late fees and over-limit fees, which indicate that overpayment ratios on P2P loan platforms are reasonable.[68]

Table 4: Borrower Overpayment By Loan Grade

Table 4

 

Borrowers also appear relatively free from predatory penalties and collections practices. Lending Club’s collection and recovery process appears fairly forgiving. Borrowers are given a fifteen-day grace period, after which they are charged a $15 flat fee or 5% of the missed monthly payment, whichever is greater.[69] This charge only occurs once per missed payment, avoiding potential pyramiding charges.[70] If the borrower is thirty or more days late, the loan is often turned over to an external collection agency; at 150 or more days late, it is charged off the investors’ portfolios.[71] However, Lending Club does not make a policy of aggressively pursuing recoveries, and notes that “recoveries on previously charged-off loans are infrequent.”[72] Table 4 shows the results of these comparatively lenient policies: average late fees per loan range between $14 and $32. Recoveries rarely exceed 1% of total loan amounts and are typically less than $60 per loan; the only anomaly is a large recovery in Grade G loans, which dramatically skews the small sample of Grade G loans. Correspondingly, it is reasonable to conclude that P2P borrowers have significantly different experiences from payday loans and other forms of predatory lending. The P2P borrower experience is far more in line to that of a typical consumer loan customer or credit card customer with solid credit at a commercial bank.

Table 5: Breakdown Of Total Payments Made By Overpaying Borrowers

Table 5

B.             Lenders Are Confused by Their Options

While borrowers are getting a good deal, lenders still misinterpret certain borrower disclosures when choosing which loans to invest in, resulting in suboptimal investment decisions. This may be particularly true for the pre-2012 lending population, which was largely composed of individual lenders.[73] In short, lenders are given a dizzying array of information upon which to base a lending decision, but may need more verification and platform guidance to correctly process the data. These are policies that the SEC is well-suited to require of lending platforms.

The empirical analysis discussed below was conducted based on the following procedure. A series of regressions evaluating the effect of various borrower disclosures on three independent variables were run to deduce how lenders treat each piece of information.[74] The well-informed, rational investor should invest more quickly in attributes that predict better loan performance, resulting in matching signs between Column 2 and Columns 3 and 4. Table 6 provides an overview of congruencies and discrepancies between lender interest and loan performance.

The need for greater lender protections and clearer disclosures becomes evident when the regression results are compared. On the one hand, Lending Club grading criteria appear to be accurate, and lenders can profitably rely on Lending Club’s grades. Table 6 highlights this in Columns 3 and 4, where Lending Club’s grades are strongly predictive of default probability and loss severity. Additionally, the signs on disclosed information in Column 1 closely match those in Columns 3 and 4, implying that Lending Club is correctly incorporating disclosed information into its assessment of loan quality. Yet lenders do not rely solely on Lending Club’s grades. Instead, they revisit borrower disclosures and assign their own interpretation to those data, sometimes resulting in higher default probabilities.

Table 6: Borrower Information Influencing LC, Lenders And Loan Performance[75]

Table 6

The key takeaways from Table 6 are summarized in the following Exhibit A. The items in the center column describe mismatches between lender expectations—as represented by the variables’ effect on time-to-fund—and actual loan performance.

Exhibit A: Relationship Between Lender Investing Speed And Loan Outcomes
Significant outcome in Columns 3 & 4, matching sign in investor response Significant outcome in Columns 3 & 4, not matching sign in investor response Insignificant sign in Columns 3 & 4, cannot be compared
LC assigned outcomes

§  Assigned LC grade

§  Interest rate

§  Loan amount

 LC assigned outcomes

§  N/A

 LC assigned outcomes

§ N/A
Lender responses

§  Time to fund

§  Number of investors

 Lender responses

§  N/A

 Lender responses

§ N/A
Verified information

§  Verified annual income

§  Public record derogations

§  Revolving balance

 Verified information

§  Inquiries in the last six months

§  Earliest credit line

§  Revolving utilization

 Verified information

§ FICO score

§ Number of delinquencies

§ Number of open accounts

§ Verified income source

§ Annual verified income
Unverified information

§  Unverified annual income

§  No employment info

§  Purpose / moving

§  Purpose / other

§  Purpose / small business

 Unverified information

§  Employment length (1 – 10)

§  Purpose / credit card

§  Purpose / education

§  Purpose / medical

§  Purpose / renewable

§  Narrative length

 Unverified information

§ Debt-to-income

§ Homeownership / mortgage

§ Homeownership / rent

§ Homeownership / other

§ Homeownership / N/A

§ Homeownership / none

§ Purpose / debt consolidation

§ Purpose / house

§ Purpose / major purchase

§ Purpose / vacation

§ Purpose / wedding

§ Narrative available

The most significant lender mistakes appear to be around interest rates and credit inquiries, which are respectively categorized as Lending Club-assigned outcomes and verified information. Lenders aggressively seek higher interest rates—a 1% increase in interest rate within the same subgrade will reduce time to fund by nearly half a day. However, higher rates are associated with higher charge-offs even controlling for all other factors, possibly due to the effect on borrower ability-to-pay—an effect well-established in the literature.[76] Additionally, lenders appear to disregard inquiries made in the last 6 months, despite a significant impact on default risk. Lenders also disdain higher FICO and prefer higher revolving utilization. Unfortunately for them, lower FICOs and higher revolving utilization lead to higher charge-offs.

For unverified information, lenders make fewer “mistakes” but could still benefit from clearer guidance. They appropriately stay away from borrowers who do not disclose employment, and are correctly wary of borrowers whose stated loan purpose is “moving,” “small business,”[77] and “other.”[78] However, lenders may be missing certain indicators of poor performance. For example, they do not respond significantly to medical and education loans, even though those tend to charge off at a greater rate with higher severity. Conversely, they also tend to base their decisions on attributes that do not seem to have a significant impact. In particular, lenders lend more quickly to borrowers paying rent or mortgages, relative to borrowers who own their homes. Yet these types of homeownership are not associated with significantly better or worse loan performance than that of a home-owning borrower. When it comes to borrower narratives, lenders care about whether descriptions are offered, but appear to care less about the quantity of information disclosed in those descriptions. Having a description reduces time to fund by 0.1 days, but does not significantly affect loan performance. Conversely, the amount of information volunteered by borrowers in their descriptions does impact charge-off probability and loss severity, which lenders fail to take into account. Longer borrower narratives are correlated to lower charge-off probability. Borrowers may be, somewhat surprisingly, using this section to establish their bona fides, rather than tricking soft-hearted lenders into extending foolish credit.

Lenders need the SEC’s help. Admittedly, the SEC’s involvement is not uniformly beneficial to lenders. Lenders’ inability to receive a security interest in the underlying loan surely puts them at greater risk should a P2P loan platform become insolvent. But the preceding analysis shows that this may be a necessary cost to keep the SEC involved and protective of lenders. Lenders are offered literally dozens of categories of information, which can be material or immaterial, verified or unverified, voluntary or mandatory. This is a scenario that fits well in the SEC’s wheelhouse, despite playing out in a novel P2P setting. The SEC’s mission to “protect investors, maintain fair, orderly and efficient capital markets, and facilitate capital formation”[79] applies neatly to P2P lending transactions, especially as platforms begin moving upmarket into bigger loans—for example, small business loans.[80] Keeping the SEC front and center, alongside other agencies such as the CFPB and state lending agencies, ensures that lenders who invest in the booming P2P lending market will continue receiving the disclosure protections they need most.

V.             Proposals To Fine-Tune The Existing Disclosure Regime

Lenders need additional protections and better disclosure to flourish in the brave new world of P2P lending. The SEC has identified several strategic goals (the Strategic Plan) that are relevant to lenders. Chief among them is “work[ing] to ensure that investors have access to high-quality disclosure materials” containing initiatives such as “design[ing] and implement[ing] new disclosure regimes for specialized categories of issuers so that investors in these products have relevant and useful information to make informed investment decisions.”[81] While the Strategic Plan did not specifically call attention to P2P financing, the rapid growth of this market means that it cannot be overlooked as the SEC implements its initiatives under this goal. The SEC should consider two reforms that would encourage production of reliable information to assist lenders in their decision-making.

First, the SEC should direct P2P loan platforms to improve their verification processes. Lenders appear to rely on much of the unverified information when making lending decisions. Currently, platforms focus verification efforts on income data, with useful results. Borrowers with verified income are typically considered worse risks, since poor quality borrowers are required to, or may volunteer, additional information such as tax returns or pay stubs to verify their disclosed income.[82] This is only one example of how verification improves material information. To build on these informational benefits, P2P loan platforms should be required to verify all income disclosures, and take reasonable steps to verify other material disclosures such as employment and homeownership.[83] For less-easily verifiable information, such as loan purposes, platforms might be able to increase truthfulness by highlighting the borrower’s potential antifraud liability for misrepresentation. While these would be difficult to enforce privately, it might nonetheless increase truthful disclosure on the margin.

Second, the SEC should direct P2P loan platforms to provide more explanatory disclosures to its lenders. Exhibit A shows several examples of relevant borrower disclosures that seem to be ignored by lenders. For example, certain unverified information (such as borrowing to pay off credit card debt) and even verified information (such as number of inquiries in the last six months) do not appear to affect lender enthusiasm. The platforms’ risk-scoring algorithms are closely-held secrets, and may already account for these attributes during the loan-grading process. However, lenders might benefit from clear and prominent summaries by the platforms about which attributes tend to predict better or worse loan performance, all else held equal. Notably, this disclosure will only help if all material information is verified, since doing otherwise would invite borrowers to game the system by manipulating their information.

Finally, the SEC itself needs a more targeted approach towards defining materiality. The SEC’s “basic perspective is as follows: if a platform gives lenders any shred of information, it must matter to lenders; if it matters to lenders, it must be material to their lending decision; and if it is material to the lending decision, it must be posted on the EDGAR system.”[84] But by forcing all borrower-disclosed information onto EDGAR, the SEC may have chilled certain valuable disclosures from ever being made. Table 5 shows that borrower narratives tend to reduce charge-off probability and loss severity. Yet over the past few years, narratives have nearly disappeared from the platform. According to Table 6 below, 98% of loans had narratives in 2007. By 2014, less than 10% of loans contained narratives. One possible reason might be borrowers’ increasing unwillingness to disclose more than they have to, since these personal stories are etched into EDGAR for eternity.

Table 7: Frequency of loans with voluntary borrower narratives

Table 7

Any regulatory effort to further protect lenders must take these tradeoffs into account. One approach would be to define a tighter materiality standard. A standard based on the classic “total mix of information available” formulation could be assessed via the statistical significance of investor responses.[85] An alternative materiality standard based on the size of the misstatement could also be applied. For example, the SEC could evaluate the effect on expected losses (default probability multiplied by loss severity) should the borrower misstate or misrepresent a particular loan attribute, to provide a preliminary assessment as to whether the erroneous disclosure is material. In either case, the platforms would have to collaborate closely with the SEC to correctly identify material items. This narrower reading of materiality would bring several benefits. First, it would quantify “materiality” of disclosures in P2P loan offerings and bring it in line with the SEC’s “rules of thumb” on materiality for other securities.[86] Second, it would allow the SEC to select only the most “material” information to capture in EDGAR, and potentially relieve some of the reporting burdens shouldered by the platforms.

To truly ameliorate privacy concerns, however, the SEC should provide some discretion to P2P loan platforms regarding how borrower disclosures that contain personally identifiable information get captured in the shelf registration. For example, it may not be necessary to capture the entire borrower narrative—instead, platforms might be allowed to categorize the narrative under one of several different narrative types. Herzenstein et al. finds six “identity claims” in narratives provided by Prosper borrowers, such as “trustworthy,” “moral,” and “economic hardship.”[87] Using these categories may better protect borrower privacy by preventing inadvertent over-disclosure.

VI.           Conclusion

When the GAO issued its P2P lending report, commentators worried that the SEC’s dominant role in the industry would chill growth and block new market entrants; it would fail to protect borrowers and would only harm lenders. But the SEC’s approach has managed to address many of those concerns. It has implemented new exemptions to help people more easily access capital markets. Rule 506(c) and Regulation Crowdfunding should permit other novel transactional structures to fill consumers’ need for capital. The SEC’s required transactional structure may also have had the unintended consequence of making consumer financial protection laws easier to enforce, since it provides regulators with a single point of application to attach relevant obligations. Finally, while the lack of a security interest is indeed unfortunate, the SEC’s role is not uniformly detrimental to lenders. Lenders in this market, more than ever, need better disclosure and information verification, and the SEC is the right agency to continue building those protections.

This does not give the SEC a free pass. More must be done to tailor the disclosure regime to be maximally useful to lenders. Reforms such as more platform verification of borrower information, and plain English descriptions of borrower information and its effects, could help lenders make better decisions. In addition, the SEC must define a better materiality standard to strike the right balance between borrower privacy and lender information. The approach may not be broken, but that doesn’t mean it couldn’t use more fine-tuning.

 

† J.D. Candidate, Yale Law School, 2017. B.A. in Economics, Dartmouth College, 2010. The Author would like to thank Professor Ian Ayres and Adriana Robertson for their invaluable assistance in developing and reviewing this research, and Professor John Morley for his insights on recent developments in securities regulation.

[1] Farhad Manjoo, The Virtual Moneylender, Salon (May 22, 2006, 9:00 AM), http://www.salon.com/006/05/22/prosper/.

[2] See PriceWaterhouseCoopers LLP, Peer Pressure: How Peer-to-Peer Lending Platforms are Transforming the Consumer Lending Industry 2 (2015), http://www.pwc.com/us/en/consumer-finance/publications/assets/peer-to-peer-lending.pdf.

[3] U.S. Gov’t Accountability Off., GAO-11-613, Person-To-Person Lending: New Regulatory Challenges Could Emerge as the Industry Grows 10–11 (2011).

[4] Id. at 11 (noting that the same process applies to Lending Club, the only other major for-profit P2P lending platform).

[5] Lending Club’s investor base was mostly comprised of individuals until 2012. See How Has Lending Club’s Investor Base Changed?, Lending Club (last visited May 24, 2016), http://kb.lendingclub.com/investor/ articles/Investor/How-has-Lending-Club-s-investor-base-changed/?l=en_US&fs=RelatedArticle (hereafter “Lending Club Investor Base”).

[6] Amy Barrett, Peer-to-Peer Lending Pain, Bloomberg Business (Apr. 2, 2009, 12:00 AM), http://www.bloomberg.com/bw/stories/2009-04-02/peer-to-peer-lending-pain.

[7] See Charge-Off Rate On Consumer Loans, All Commercial Banks, Economic Research Federal Reserve Bank of St. Louis (Feb. 19, 2016, 2:06 PM), https://research.stlouisfed.org/fred2/series/CORCACBS (place cursor over graph where it indicates “2010 Q2”).

[8] Prosper Marketplace, Inc., 2008 WL 4978684 (2008).

[9] See Andrew Verstein, The Misregulation of Person-to-Person Lending, 45 U.C. Davis L. Rev. 445, 475–76 (2012).

[10] Id. at 476 n.144.

[11] Shelf registration allows an issuer to offer securities on a delayed or continuous basis, unlike a standard registered offering, which must typically be offered and sold within a short period of time. See 17 C.F.R. § 230.415 (2015). This is particularly important for high-volume P2P loan platforms, since they can rely on a single effective registration to offer and sell many securities, instead of going through the registration process for every subsequent security offering. See Valerie Demont, Show Me the Money and How to Get It: The Speed and Flexibility of Universal Shelf Registrations, Pepper Hamilton LLP (May 28, 2009), http://www.pepperlaw.com/publications/show-me-the-money-and-how-to-get-it-the-speed-and-flexibility-of-universal-shelf-registrations-2009-05-28/.

[12] LendingClub Co., Member Payment Dependent Notes (Rule 424(b)(3) Filing) (Dec. 20, 2010).

[13] Verstein, supra note 9, at 476–77.

[14] Id. at 477.

[15] Prosper Marketplace, Inc., Amendment No. 3 to Registration Statement (Form S-1) 8 (Apr. 14, 2009).

[16] Id. at 7.

[17] See Prosper Marketplace Surpasses $2 Billion in Personal Loans on Its Platform, Prosper Media Room (Oct. 27, 2014), https://www.prosper.com/about-us/2014/10/27/prosper-marketplace-surpasses-2-billion-in-personal-loans-on-its-platform/; see also Lending Club Statistics, Lending Club (last updated Jun. 30, 2015), https://www.lendingclub.com/info/statistics.action.

[18] LendingClub Co., Annual Report (Form 10-K) 5 (Feb. 27, 2014).

[19] Eric C. Chaffee & Geoffrey C. Rapp, Regulating Online Peer-to-Peer Lending in the Aftermath of Dodd-Frank: In Search of an Evolving Regulatory Regime for an Evolving Industry, 69 Wash. & Lee L. Rev. 485, 503–05 (2012).

[20] See U.S. Gov’t Accountability Off., supra note 3.

[21] Id.

[22] Id.

[23] Verstein, supra note 9.

[24] Verstein, supra note 9, at 51–511.

[25] Verstein, supra note 9, at 512–13.

[26] Verstein, supra note 9, at 501.

[27] Verstein, supra note 9, at 506.

[28] See 17 C.F.R. § 230.415 (2008).

[29] See Verstein, supra note 9, at 491.

[30] See Verstein, supra note 9, at 524–26.

[31] See Paul Slattery, Square Pegs in a Round Hole: SEC Regulation of Online Peer-to-Peer Lending and the CFPB Alternative, 30 Yale J. on Reg. 233, 265–73 (2013).

[32] See Chafee & Rapp, supra note 19, at 529–30.

[33] See Chafee & Rapp, supra note 19, at 530.

[34] See, e.g., Slattery, supra note 31, at 256–258; Carl Smith, If It’s Not Broken, Don’t Fix It: The SEC’s Regulation of Peer-to-Peer Lending, 6 Am. U. Bus. L. Brief 21, 23 (2010).

[35] Banking Without Banks, The Economist, Mar. 1, 2014, http://www.economist.com/news/finance-and-economics/21597932-offering-both-borrowers-and-lenders-better-deal-websites-put-two.

[36] PriceWaterhouseCoopers LLP, supra note 2, at 1.

[37] SEC v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946) (describing the test for whether a financial instrument is an investment contract under the SEC’s jurisdiction―that is., “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party”).

[38] See 17 C.F.R. § 230.504 (2015) (providing a $1 million annual limit on Rule 504 exempt offerings); see also 17 C.F.R. § 230.505 (2015) (providing a $5 million annual limit on Rule 505 exempt offerings).

[39] See 17 C.F.R. § 230.506 (2015).

[40] Peter Manbeck & Marc Franson, Chapman and Cutler LLP, The Regulation of Marketplace Lending 7 (Apr. 2015), https://www.aba.com/Tools/Offers/Documents/ChapmanRegulationofMarketplaceLending WhitePaper040815.pdf.

[41] Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, Securities Act Release No. 33-9415, 2013 WL 3817300 (Jul. 10, 2013).

[42] See 17 C.F.R. § 230.501 (2015) (defining a natural person as an accredited investor if his net worth exceeds $1 million, excluding the value of his primary residence, or if his individual income exceeding $200,000 in each of the past two years and he has a reasonable expectation of reaching that same income in the current year).

[43] Keith F. Higgins, Director, SEC Div. of Corp. Fin., Keynote Address at the 2014 Angel Capital Association Summit (Mar. 28, 2014), http://www.sec.gov/News/Speech/Detail/Speech/1370541320533.

[44] Id.

[45] Slattery, supra note 31, at 256.

[46] Pub. L. No. 112-106, 126 Stat. 306, §§ 301–305 (2012).

[47] See Crowdfunding, Securities Act Release No. 33-9974, Exchange Act Release No. 34-76324, 80 Fed. Reg. 71388, 71390 (Oct. 30, 2015).

[48] See id.

[49] See id. at 71390, 71398–418.

[50] But see Christine Hurt, Pricing Disintermediation: Crowdfunding and Online Auction IPOs, U. Ill. L. Rev. 217, 251–58 (2015) (describing challenges associated with equity crowdfunding, many of which apply to debt crowdfunding).

[51] See Verstein, supra note 9, at 506.

[52] See Verstein, supra note 9 at 491–92.

[53] Slattery, supra note 31, at 266 (citing Truth in Lending Act, 15 U.S.C. §§ 1605(a), 1667(a), 1638(a) (2012)).

[54] 15 U.S.C. § 1602(g) (2012).

[55] 12 C.F.R. § 226.2(a)(17)(v) (2016).

[56] 15 U.S.C. § 1691(d)(2)(A) (2012).

[57] 15 U.S.C. § 1691a(e) (2012).

[58] 15 U.S.C. § 1691e (2012).

[59] Slattery argues that even now, the path to ECOA compliance remains confusing because either the platform or funding bank would have to provide a reason for refusing credit, and “P2P lending platform members [deciding] not to fund you” is unlikely to satisfy adverse action notice requirements. See Slattery, supra note 31, at 269. In any case, the present setup is certainly clearer than the alternative under a model with privity between borrowers and lenders.

[60] Verstein, supra note 9, at 506.

[61] Elizabeth Warren, Unsafe at Any Rate, 5 Democracy 8, 16 (2007).

[62] A brief description of the data is in order. Lending Club has made available a rich dataset of 391,888 individual loans made from 2007 to 2014. This dataset contains mature loans (loans that have been fully paid back or charged off) and unmatured loans (loans still outstanding). The mature loan dataset spans from 2007 to 2012, while unmatured loans span from 2010 to 2014. Each loan is associated with six major categories of information: (i) Basic loan characteristics (for example, term, amount requested, date submitted); (ii) Verified information about the borrower obtained from a credit bureau (for example, FICO score, earliest credit line opened, revolving balance, zip code); (iii) Unverified information furnished by the borrower (for example, annual income, job title, employment length, home ownership, loan purpose); (iv) Self-narrative provided by borrower (for example, self-provided voluntary description of borrower’s character, needs or any other information that may convince lenders); (v) Lending Club’s assigned grades (for example, assigned grades indicating loan quality, interest rate); and (vi) Loan performance (for example, loan status, payments collected to date, recoveries collected, recovery fees charged). Two variables not disclosed by Lending Club were also collected: the amount of time taken to fund a loan (the difference between the loan’s submission date and issuance date) and the total number of investors funding each loan. Since Lending Club fixes interest rates, the primary indicator of investor interest or demand will be the speed at which the loan is funded. All else equal, a “better” loan should be funded more quickly. Several caveats and conditions apply. Lending Club performs loan vetting in parallel with the funding process. If Lending Club has a standard period that is binding on loan funding speed, time to fund would be a weaker proxy for investor demand. However, there is no clustering around specific periods, indicating an absence of strongly-binding standard vetting periods. Additionally, hedge funds and other institutional investors began investing on the Lending Club platform in late 2012. Since the dataset does not contain information on lender identity, the lender welfare analysis is restricted to loans made from 2007–2012 to avoid capturing lending activity from sophisticated institutions during this time period.

[63] See Consumer Credit, Fed. Reserve Board (Dec. 7, 2010), http://www.federalreserve.gov/releases/G19/20101207/.

[64] See The January 2010 Senior Loan Officer Opinion Survey on Bank Lending Practices, Fed. Reserve Board (Jan. 2010), http://www.federalreserve.gov/boarddocs/snloansurvey/201002/default.htm (“[S]ubstantial net fractions of banks indicated that they had reduced credit limits on credit cards and had become less likely to issue cards to customers not meeting credit scoring thresholds.”).

[65] No direct data is available to compare Lending Club borrowers against equivalent-risk bank borrowers during the 2007 to 2012 time period. However, Lending Club’s own surveys offer some evidence for better rates in later years. See Personal Loans, Lending Club, https://web.archive.org/web/20141218193735/ https://www.lendingclub.com/public/credit-card-loans.action (stating that 23,716 borrowers surveyed from January 1, 2014 to September 30, 2014 who received a loan to consolidate existing debt or pay off their credit card balance, received a rate that was 6.6% lower than their outstanding debt or credit cards).

[66] See Factsheet: The CFPB Considers Proposals to End Payday Debt Traps, CFPB Newsroom (Mar. 26, 2015), http://www.consumerfinance.gov/newsroom/cfpb-considers-proposal-to-end-payday-debt-tra/.

[67] See Federal Reserve Economic Data, Delinquency Rate On Consumer Loans, All Commercial Banks (Feb. 19, 2016), https://research.stlouisfed.org/fred2/series/DRCLACBS. Consumer loan delinquency rates proxy for P2P loan overpayment rates, since delinquencies similarly trigger late fees and additional interest on unpaid balances.

[68]See Sumit Agarwal et. al, Regulating Consumer Financial Products: Evidence from Credit Cards, 130 Q. J. Econ. 111, 137 (2015).

[69] Compare Lending Club Rates, LendingClub, https://www.lendingclub.com/public/borrower-rates-and-fees.action (last visited Mar. 30, 2016).

[70] Id.

[71] Collection of Monthly Payments, LendingClub, https://www.lendingclub.com/public/collections-process.action (last visited Mar. 30, 2016).

[72] What Happens When a Loan is Charged Off, LendingClub, http://kb.lendingclub.com/investor/articles/ Investor/What-happens-when-a-loan-is-charged-off (last visited Mar. 30, 2016).

[73] See Lending Club, supra note 5 (showing only 2% of standard program loans going to institutional investors in 2012, and predominantly self-managed individual investors (that is, retail lenders) funding loans in 2010 and 2011).

[74] The independent variables are Lending Club’s proprietary score (Column 1), the level of lender interest (time taken to fill the loan request, denoted as “time to fund”) (Column 2), probability of default (Column 3), and loss severity (Column 4). An ordered probit was used to evaluate how Lending Club assigns grades and interest rates based on borrower information. A linear regression was used to analyze how quickly lenders respond to that same information. Finally, a probit and linear regression were used, respectively, to assess how that information predicts loan charge-offs and loss severity. Time to fund is the key variable of interest here. A negative time to fund coefficient on an attribute implies that lenders “fill” loans with those attributes more quickly.

[75] Green cells (marked with a “+”) are “desirable” loan outcomes, implying that an increase in the associated variable (for example, FICO score) results in a better Lending Club grade, lower default rates (We don’t use “etc.”) Red cells (marked with a “-”) are “undesirable” loan outcomes. “*” denotes significance at the 10% level, and “**” denotes significance at the 5% level. Coefficients have been omitted for brevity, as the table is meant primarily to illustrate investment patterns. Specifications were tested for multicollinearity, yielding an acceptable level of multicollinearity with mean VIF between 6.9 and 7.3.

[76] See, e.g., Joseph E. Stiglitz & Andrew Weiss, Credit Rationing in Markets with Imperfect Information, 71 Am. Econ. Rev. 393 (1981).

[77] “Small business” is a use category voluntarily chosen by borrowers, and does not imply that the loan receives different treatment (for example, as part of an SBA 7(a) loan program). Lending Club has recourse against these small business borrowers since they are still treated as personal loans. See, e.g., Terms of Use, LendingClub, https://www.lendingclub.com/info/terms-of-use.action (last visited Mar. 30, 2016).

[78] See supra Table 6 and Exhibit A.

[79] The Role of the SEC, Investor.gov, https://www.investor.gov/introduction-markets/role-sec (last visited June 21, 2016).

[80] See Robb Mandelbaum, How Lending Club Is Shaping the Future of Small-Business Loans, Inc. (May 2015), http://www.inc.com/magazine/201505/robb-mandelbaum/lending-club-money-on-demand.html (describing Lending Club’s 2014 entry into providing small business loans).

[81] Sec. and Exch. Comm’n, Strategic Plan Fiscal Years 2014–2018 Draft for Comment 38–39 (2014), https://www.sec.gov/about/sec-strategic-plan-2014-2018-draft.pdf.

[82] Income Verification, Lending Club, https://www.lendingclub.com/public/income-verification.action (last visited Mar. 30, 2016).

[83] This echoes previous calls for greater verification efforts. See Jack R. Magee, Peer-to-Peer Lending in the United States: Surviving After Dodd-Frank, 15 N.C. Banking Inst. 139, 170 (2011).

[84] Slattery, supra note 31, at 258.

[85] TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976) (“[T]here must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”).

[86] SEC Staff Accounting Bulletin No. 99, Release No. 99 (Aug. 12, 1999) (“The use of a percentage as a numerical threshold, such as 5%, may provide the basis for a preliminary assumption that – without considering all relevant circumstances – a deviation of less than the specified percentage with respect to a particular item on the registrant’s financial statements is unlikely to be material.”).

[87] Michal Herzenstein et. al , Tell Me a Good Story and I May Lend You Money: The Role of Narratives in Peer-to-Peer Lending Decisions, 48 J. Marketing Res. (Special Issue) S138–49 (2011).

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?

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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

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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.