Dodd-Frank VIII: Reimposing Rational Incentives Thru Private Actions?

The recent announcement of the $600 million settlement of the shareholders' action against Countrywide managers and directors should be put into perspective. The CEO of Countrywide Financial, Angelo Mozilo, garnered over $470,000,000 in compensation between 2001 and 2006, according to the Wall Street Journal. During that period shareholders lost 91% of their investment. Mozilo was named the second worst CEO of all time, right up there with Ken Lay and Dick Fuld. Nevertheless, on June 17, 2010 a securities fraud lawsuit against Mozilo and others was dismissed with prejudice before any discovery. And, the $600 million settlement just announced requires no payment whatsoever from Countrywide's former management.

Nor is this case alone in failing to meet subprime conduct with meaningful legal sanctions, as the LA Times reports that "nearly all" of a recent $90 million settlement of claims against New Century's management also was paid for by insurers. Delaware courts used the business judgment rule and Delaware General Corporation Law section 102(b)(7) (which authorizes directors of public firms to be infinitely careless) to insulate both Citigroup management and AIG management from accountability for the huge losses those firms sustained. While the massive Citigroup securities litigation is still pending, it appears that "courts are showing more evidence of subprime fatigue and a greater willingness to grant motions to dismiss even in cases that do not require proof of scienter" in the private securities litigation realm.

The upshot is that senior managers may profit mightily from precisely the conduct that caused the subprime debacle with apparent impunity in terms of their own monetary interests. After all, as I have previously shown Countrywide, AIG and Citigroup were at the very center of the storm. Courts are strongly and clearly affirming the misconduct that got us into this mess. We should not be surprised to see the misconduct at the center of the crisis to repeat itself, as courts have essentially broadcast to senior managers that may continue to profit from crashing capitalism.

The judiciary simply seems determined to let agency costs run amok in the American publicly held corporation. There is no case, economically or legally, for failing to rein in agency costs through sound corporate governance standards. For sixty years after the Great Depression bank managers were held accountable for losses due to negligence and directors of ordinary corporations could face liability for gross negligence. Law provided rational economic incentives for board directors and we lived in a prosperous and stable economy. Further managers faced the prospect of jury trials for allegations of securities fraud under the federal securities laws, a prospect that frequently led to settlements on the eve of trial on the courthouse steps. Securities fraud therefore resulted in monetary sanctions and our securities markets worked well.

So does Dodd-Frank do anything on this score to return us to a rational corporate and financial marketplace like that which prevailed from 1933 through the 1990s? Not really, is the disappointing answer.

Section 929Z requires the GAO to study the problem of secondary liability and the "types" of cases decided under the PSLRA.

Section 933 clarifies that credit rating agencies may be held liable for securities fraud on the same basis as accounting firms and securities analysts, and clarifies and apparently eases scienter pleading requirements.

Section 210(f) allows the FDIC to pursue gross neglignece claims against directors and officers of firms placed in the orderly liquidation process, apparently statutorily abrogating Delaware section 102(b)(7) provisions (as well as similar provisions from other states).

Certainly, it is helpful that managers of firms that are too-big-to-fail understand they could face massive liability for gross negligence if their firm is taken into the orderly liquidation process of Title II. But, much depends upon the regulators to enforce this liability. Overall, given the catastrophic track record of corporate governance in America after the onset on the PSLRA and 102(b)(7) provisions, Dodd-Frank only nibbles around the edges and kicks the can down the road to the regulators.

As I have previously argued, "the benefits [of private litigation] include the following: the creation of private “incentives to ferret out” fraud that public investigators miss; private enforcement immunity from political influence; the probability that investor remedies are more likely to repair investor confidence than mere criminal or administrative remedies; and the lack of any public financing requirement for enforcement efficacy." The beauty of private litigation is that it restores market incentives without costing the government a dime. Moreover, private litigation regulates markets without political interference as private litigants are first and foremost concerned with acheiving recovery of losses and could not care less about the political clout of defendants--like that of Bernie Madoff. Dodd-Frank, I fear, will prove to be a lost opportunity to restore rational market incentives for fraud and ineptitude through costless private actions.