Tuesday, March 9, 2010

Legal Abandon: How Corporate Tort Reform Trashed the Economy

Common law tort liability for fraud is a basic protection that all markets need. Private lawsuits are a market-based solution to deterring fraud and providing remedies to the victims of fraud. Combined with contingency fee arrangements, robust civil remedies for fraud create a depoliticized mechanism for policing markets. No government funds are expended and political connections will not serve to deter lawsuits brought by a private contingency fee attorney.

Typically, fraud remedies evolved in courts under the watchful eye of the judiciary. Of course, the judiciary is composed of lawyers meaning they constitute an elite group, which represent elite interests. That is just plain economic reality as lawyers are generally faced with compelling economic incentives for representing wealthy clients. In addition, the wealthy can afford the best lawyers.

As a former private securities litigator and former SEC enforcement attorney, I have represented the government, defendants and plaintiffs in a wide variety of securities lawsuits. I also have served as a securities arbitrator for the NASD. I can tell you that if anything the advantage heavily favored defendants who typically had far superior resources and attorneys that were expert in using those resources to protect their clients' interests. Judges hailed more often from corporate firms, and thus any bias there also favored defendants.

However, just holding more sway before judges and having superior representation and resources was not enough. Monied interests went to Congress and obtained powerful insulation from liability for securities fraud. First came the Private Securities Litigation Reform Act of 1995 (PSLRA). Then came the Securities Litigation Uniform Standards Act of 1998 (SLUSA). The PSLRA and SLUSA for the first time in our history gave special protection to securities fraudfeasors under federal law. This was a fundamental betrayal of the federal securities laws which were enacted after the Great Depression to provide more generous remedies to victims of securities fraud. Huge lobbying expenses turned federal law upside down. The SLUSA act actually eliminated the bulk of liabilities under state law. After the PSLRA and the SLUSA, securities fraud was downright profitable.

The cost of this legal promiscuity has been a non-stop run of scandals culminating in the Great Subprime Securities Fraud of 2005-2007.

Conservatives were bamboozled here. Conservative rhetoric painted securities litigation as oppressive to the most powerful elements of our society--and many conservatives bought it hook, line and sinker--even in the absence of any evidence that innovation was somehow being stifled during the 60 years of prosperity that followed the enactment of the federal securities law. Even today, in the face of compelling evidence of what a fraud-laced securities market looks like and performs like they still lip synch to the tune of corporate elites.

A new white paper has been released recently featuring our own dre cummings. It walks through the whole sordid mess. It is a story of the dangers of conservative rhetoric and the power of ideologues who substitute partisan rants for thought. True conservatives would be deeply suspicious of any special legislative indulgences for fraudfeasors.

Shredding common law notions of accountability never makes sense. Almost always behind the rhetoric is raw economic power seeking to subvert the rule of law. And, almost also allowing the powerful to escape legal accountability will prove costly.


  1. Professor Ramirez,

    Thank you for your post, it was very insightful. Ironically, I was discussing the Private Securities Litigation Reform Act ("PSLRA")today with my students. Specifically, we were talking about the expanded "safe harbor" provisions of the PSLRA and their impact on the Management Discussion and Analysis ("MD&A") portions of '34 Act disclosure documents. Again, your post was very timely. I also enjoyed reading the White Paper featuring Professor cumming's important article on the PSLRA. Congratulations to you Professor cummings! Again, cudos for your excellent and informative post.

  2. “Brokers wouldn’teven exist without wholesalers, and wholesalers wouldn’t be able to fund loans unless Wall Street was buying,” explain reporters Paul Muolo and Mathew Padilla, authors of Chain of Blame: How Wall Street Caused the Mortgage and Credit Crisis. “It wasn’t the loan broker’s job to approve the customer’s application and check all the financial information; that was the wholesaler’s job, or at least it was supposed to be. Brokers didn’t design the loans, either. The wholesalers and Wall Street did that. If Wall Street wouldn’t buy, then there would be no loan to fund.

    Finally, it's nice to see someone on the left concede Peter Wallison's point - Mortgage brokers had to be able to sell their mortgages to someone. They could only produce what those above them in the distribution chain wanted to buy. In other words, they could only respond to demand, not create it themselves. Or , as Muolo and Padilla phrase it - If Wall Street wouldn’t buy, then there would be no loan to fund.

    Of course, Muolo and Padilla, for political reasons, assert that the chain of causation ends with Wall Street. But Wall Street was simply buying and packaging loans to meet demand further up the chain, and pocketing a commission for their trouble. Most of these loans were ultimately purchased by the GSEs, Fannie and Freddie, or by federally insured banks under mandate. So, it wasn't Wall Street that was driving demand, it was the GSEs acting in response to government policy. If the GSEs had not lowered their standards and had not purchased ever increasing numbers of subprime and Alt-A loans, there would have been no demand for the brokers and Wall Street to fill.

    Now that wasn't so hard, was it?

    As to "predatory loans", there is no such thing. When a borrower makes little or no down payment he assumes no risk. In fact, he essentially is making a one way bet using someone else's money. If the property appreciates in value, he can sell the property and keep the capital gain. If the property depreciates in value or he cannot make the payment, he walks away leaving the lender to take possession of the property and suffer the capital loss. Many of the supposed "predatory loans", like those with low teaser interest rates, negative amortization loans and stated income or Alt-A loans actually helped facilitate this speculative behavior and created greater risks for the lender than the borrower. The lender, for his part, had every incentive to negotiate terms that 1) his borrower could meet and 2) that gave him the greatest return for the longest period of time. These two objectives are mutually reinforcing. The claim that the borrower was taken advantage of and a "victim" is just marxist drivel.

    Of course, all the talk about "predatory loans" and Wall Street corruption is just window dressing for the trial bar's real objective which is to repeal tort reform and restart their extortion racket. Let's start with the obvious - evidence of reduced litigation is not evidence of increased fraud. The fact that litigation has fallen off may actually be evidence that tort reform is working. The instances cited by Dr. cummings hardly amount to overwhelming evidence that fraud has increased and the restrictions imposed by the PLRSA and the SRUSA do not seem onerous. Imagine actually having to provide evidence supporting a claim of fraud before being allowed to conduct a fishing expedition through a companies records. What's the world coming too?

  3. Funny, your post and Dr. cummings paper both fail to mention the impetus behind the passage of securities tort reform. It can be summed up in two words - Milberg Weiss. The firm of Milberg Weiss was the driving force behind a tidal wave of class-action securities litigation in the 1980s and 1990s. The PSLRA was enacted, in part, to address their abusive and corrupt behavior. The senior partners of the firm would later confess to paying almost $12 million in bribes to plaintiffs and pocketing hundreds of millions in tainted legal fees. Charged with racketeering, several would find themselves in federal prison. Not surprisingly, Milberg Weiss et al. were big contributors to the Democrat Party. You can read the gory details of the fall and aftermath of the self-proclaimed champions of the little guy here:

    The Fall of America's Meanest Law Firm, CNNMoney

    Weiss sentencing clears way for congressional action, Washington Examiner

    The Trial Lawyer's Enron, WSJ

    Setting The Bar For Corruption, Washington Post

    It seems that it was fraud and corruption on the part of trial lawyers that needed to be addressed and following the Republican Revolution in 1994, it was.

    After having donated billions of dollars to the Democrat Party over the years, the trial bar must feel entitled to a little pay-back. And what would warm their tiny little hearts more than repeal of the laws that ended their lucrative extortion racket. They had better act quickly, come November the party may be over.

  4. Tort Reform is the perennial conservative mantra, right along with "tax cuts = everything will be better."

    To recognize that tort reform is a a buzz-phrase designed to draw the attention away from the real issues is something our policy makers must seize and educate the public that making significant reforms to our nation's economic infrastructure can incorporate many different aspects - including tort reform that is needed; not just because it has a negative connotation.

  5. I agree with the anonymous commenter's assertion that there are no such things as "predatory loans" in principle, but with a few caveats.
    First, there is substantial societal pressure on people to stay in these mortgages they cannot afford. Certainly some walk away, but most end up paying more on ARMs at an interest rate they never understood that they would ever have to pay. This is one reason why a Consumer Protection Agency is so important.
    Secondly, these "predatory" loans were packaged with good loans and securitized. The very clear risk that the commenter says falls on the lender was now passed on to the purchaser of the security as a AAA bond leaving them unaware of the level of risk they were taking on. (Certainly in 2006-07 people knew that these packaged securities were not as secure as they were advertised, but people were not aware of HOW risky or not they would up being, and we still aren't) The ability of financial innovation to divorce risk from the security by hiding it or passing it on to someone else is how these massive institutions collapsed in on themselves.

    So beyond the moral reasons of protecting the financially ignorant from complicated deals - which is either marxist drivel or a step towards protecting people (the basis of all our securities laws) - it is certainly in the interest of the stability of the financial markets to look at the problem beyond the rhetoric and to the pragmatic problems that we clearly face.

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