Remembering Lehman on the Eve of the First Anniversary of Its Collapse: Part I

As we approach the first anniversary of Lehman Brothers’ collapse, a failure that many believe triggered the current global economic crisis, we should perhaps pause and reflect on the topsy-turvy financial year that Americans have survived. This is not an anniversary that Richard S. Fuld, Lehman’s former chairman and chief executive officer is looking forward to celebrating. Fuld has been vilified and humiliated before a congressional panel last October and named in nearly 40 different legal actions. “I’ve been pummeled, I’ve been dumped on, and it’s all going to happen again. I can handle it. You know what, let them line up,” Fuld stated recently. To be fair to Fuld, he took control of Lehman in 1994 at one of Lehman’s darkest hours and rebuilt it into the fourth-largest U.S. investment bank, a Wall Street powerhouse whose massively profitable mortgage banking machine inspired rivals’ envy. The question remains, however, how did it all go wrong? Is Fuld really to blame for Lehman’s demise or was Lehman the first victim of a massive systemic failure in the American financial services industry? Perhaps, more importantly, why didn’t the federal government save Lehman like it saved, Long-Term Capital Management, a hedge fund in the late 1990s, Bear Stearns a mere six months before Lehman’s collapse, Merrill Lynch at the same time that it allowed Lehman to collapse, Bank of America, Goldman Sachs, AIG and countless other financial institutions after it allowed Lehman to collapse, that were deemed too big to fail?

On Friday, September 12, 2008, U.S. Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke assembled thirty of the most powerful figures in the American banking industry to the headquarters of the U.S. Federal Reserve in New York. The group of thirty was told Merrill Lynch and Lehman Brothers were on the brink of collapse. The U.S. government would not bail them out because it was only a week since the U.S. government had agreed to rescue Fannie Mae and Freddie Mac. It was up to the thirty banking executives in the room to save Merrill and Lehman. The future of the entire global banking system was now under threat because the collapse of these two Wall Street giants would deal a huge blow to the world’s confidence in the U.S. financial industry. In particular it would raise questions as to whether American financial service companies could make good on their debts, if Lehman and Merrill were to collapse.

Ken Lewis, chief executive officer of Bank of America, was interested in buying Merrill, but Lehman was out of the question, primarily because no one was really sure of the Lehman’s true financial condition, that is--the true state of the Lehman’s finances, the true worth of thousands of “esoteric contracts” to which Lehman was a counterparty. There could be billions of dollars in liability for the company that eventually purchased Lehman. Lehman’s potential liability for its outstanding loans was not clear and no one wanted to take on such a tremendous risk. Except perhaps Barclays, a 300 year-old British bank, who wanted flagship operations in the United States. The Financial Services Authority and Bank of England were adamant in their belief that the U.S. Federal Reserve would not allow Lehman to fail. They had grave reservations about the idea of a Barclays-Lehman deal. They wanted reassurances from the U.S. government, in particular they wanted guarantees as a condition precedent to the deal. If Barclays were to purchase Lehman blind, unsure of the liabilities Barclays would inherit from the “esoteric contracts,” the U.S. government would have to provide some insurance for Lehman’s and eventually Barclays’ potential losses. The U.S. government refused not because it did not want to save Lehman but because the U.S. government itself did not know what the ceiling of the potential Lehman losses would be. Lehman was too big for the U.S. government to rescue. The Barclays deal was dead and so was Lehman.


On Monday, September 15, 2008, 158 years after it was founded, Lehman filed for bankruptcy. It was a catastrophic event. Shockwaves were felt throughout the global banking industry. Within days, Halifax Bank of Scotland had been rescued by Lloyds of London. Within two weeks, Bradford & Bingley was nationalized. Within a month, the British government had given financial bailouts to Lloyds of London and Royal Bank of Scotland with an unprecedented £37bn. Banks were in crisis everywhere. Not to be outdone, the United States developed a $700bn Troubled Asset Relief Program (TARP) to bailout American banks. On September 21, 2008, Goldman Sachs and Morgan Stanley were given permission from the U.S. government to convert their status from investment banks to regulated commercial banks, marking the end of the last two major independent Wall Street investment banks. It was the end of an era.

A year later, as we remember Lehman, the American banking system is still fragile, recovery is slow, and many questions and lessons exist regarding the near-death experience of the American banking system. "You had an old 19th century-style panic," said Cary Leahey, senior economist at Decision Economics. "There was no single catalyst" for the upheaval. Economists believe that big investment banks and other influential financial market players had taken on massive risks, borrowing heavily to bet on securities tied to subprime real estate loans which were outside the scope of regulators’ authority. As a result, when the U.S. housing market collapsed, this sent the walls crashing down, freezing credit markets and economic activity in the worst crisis since the Great Depression. Hugh Johnson, chairman and chief investment officer at Johnson Illington Advisors stated that "there was a belief that the financial crisis could not be solved and would lead to a second Great Depression.” The U.S. government took aggressive action. The new regulatory focus may curb the excesses that led to the boom and bust of Lehman. However, the current focus on regulation and risk mitigation "have enormous implications for the availability of risk capital in the U.S. and the primacy of the U.S. financial system," said Joel Naroff of Naroff Economic Advisors.

What shall be remembered about the Lehman collapse?

First, although some historic names have vanished forever and others are mere shadows of their former selves, Wall Street hasn't changed all that much. It still operates on the principle of an insider club where disclosure is minimal even to regulators. The best interest of the public is not the primary concern. Business is good and likely to get better. Simply look at the second quarter earnings report for the major financial service firms. Previously on July 22, 2009, I commented on the amazing second quarter earnings of the large banks that had received TARP funds and queried whether they really needed the TARP funds, in the first place? Currently, the burgeoning need for Wall Street’s capital raising services will be a welcomed relief in a world that's suffered trillions of dollars in losses over the past two years.

Second, regulators and central bankers could not save Lehman because Lehman was too big to save. The huge uncertainty of Lehman’s potential losses illustrated that the world's capital markets have become too powerful relative to the central banks. "The U.S. government didn't let Lehman fail; it didn't have the authority to save it," Treasury Secretary Tim Geithner said in an interview with Fortune.
"The fundamental constraint was that the Treasury at that point had no authority" to put capital into Lehman, and "the central bank did not have the ability to fill a capital hole." There was no buyer willing to assume most of Lehman's obligations, as Morgan Stanley did for Bear Stearns. The U.S. government would have been risking unlimited losses because Lehman didn't have enough collateral to back hundreds of billions or trillions of dollars of outstanding loans.

Third, the American financial markets can overwhelm the U.S. government’s resources. Lehman shall remain an unfortunate footnote in U.S. financial history. However, Lehman's collapse underscores for all of us that financial regulation is not only fashionable, it is instrumental for the survival of the American financial system and global economic stability. Despite everything that has transpired, hope is not lost. In the words of Mr. Fuld, “I’m not a defeatist. I do believe at the end of the day that good guys do win.”

Lydie Nadia Cabrera Pierre-Louis
Assistant Professor of Law
St. Thomas University

Pfizer Agrees To Pay Record $2.3 Billion Fine

A couple of days ago, Pfizer entered into a settlement with the federal government whereby the company agreed to pay the largest fine levied against a U.S. company by the federal government. Pfizer agreed to pay a record $2.3 billion and pled guilty to one felony count to settle federal criminal and civil charges in connection with the marketing of the painkiller Bextra, the anti-psychotic drug Geodon, the antibiotic Zyvox, and the epilepsy drug Lyrica . This is the fourth settlement that Pfizer has entered into with the federal government since 2002 over the marketing of its drugs, fines in those previous settlements totaled $513 million. Government attorneys indicated that these previous fines, and Pfizer’s repeated violations, factored into the imposition of such a stiff fine in the current case. Pfizer generated $48.3 billion in revenue last year, so in many ways, this fine represents a small drop in the bucket for Pfizer.

Under federal law, pharmaceutical companies are banned from marketing drugs for other than their approved uses. Promotion and marketing for non-approved purposes is called “off-market” label marketing, and is thus illegal. However, doctors may legally prescribe “off-label” medications to treat illnesses for which the drug was not approved; however, pharmaceutical companies run afoul of the law in their overt marketing of such “off-label” drugs. The criminal complaint against Pfizer charged the company with sending doctors on all-expense paid vacations to resorts, providing free massages, and payments of kickbacks to get the doctors to prescribe Pfizer’s drugs off-label.

In order to resolve the civil charges, Pfizer entered into a five (5) year “corporate integrity agreement” with the Department of Health and Human Services (“HHS”). The corporate integrity agreement gives HHS the ability to monitor Pfizer’s marketing activities.

In terms of deterrent effect, only time will tell whether other companies take heed of Pfizer’s predicament and subsequent punishment. The jury will remain out on the issue of deterrence. In criminal law one of the main underpinnings of harsh punishment is deterrence. Interestingly, in spite of the harsh punishment of one as an example, crime and criminals still flourish and are bountiful. What a novel way to close the budget deficit? Substantially fine corporations that break the law and do bad things!!! Someone in Washington should have thought about this a long time ago.

Dangerous Discourse About the Financial Collapse and Poverty Among Minorities

Several weeks ago, I purchased a book, “Animal Spirits", written by George A Akerlof, the Koshland Professor of Economics at the University of California at Berkeley, and Robert Shiller, the Arthur M. Okun Professor of Economics at the Cowles Foundation for Research in Economics, and Professor of Finance at the International Center for Finance at Yale University. The book, subtitled “How Human Psychology Drives the Economy, And Why It Matters for Global Capitalism”, was published this year by Princeton University Press. In the book’s preface, the authors explain that they draw “on an emerging field called behavioral economics” to describe “how the economy really works.” They claim to explain “why ignorance of how the economy really works has led to the current state of the world economy….”

After looking at the Table of Contents, I decided to read the book’s penultimate chapter first. This chapter, “Why Is There Special Poverty among Minorities?” especially appealed to me because of my interest in the intersection of business and economic issues with racial justice concerns. I was both surprised and pleased to see that a discussion about economics would include consideration of the unique issues with which people of color grapple. In my experience, most discussions about race fail to include an examination of business and economic factors, and almost all of the discourse about business and economics ignores the significance of race and racism in American society.

To say that I was disappointed in this chapter would be a gross understatement. The authors attempted to explain the persistent and seemingly intractable problem of poverty among African Americans without mentioning the economics, behavioral or otherwise, of centuries of slavery and generations of overtly racist economic policies in the decades after slavery ended. Perhaps, I thought while reading the chapter, the authors intended to deal only with recent phenomena that precipitated the current crisis. Maybe delving into an historical account of slavery’s present-day impact was beyond the scope of the book. As I read the short chapter, I searched in vain for some brief explication about this nation’s recent experiences with predatory subprime lending and its impact on communities of color. The authors never mentioned predatory lending. They wrote a chapter about poverty and minorities and the recent financial crisis without mentioning the fact that predatory lending drained billions of dollars from communities of color. They said nothing about predatory lending’s contribution to the destruction of an already fragile black middle class. The authors omitted any discussion of the fact that predatory lenders, some of them public companies and major financial institutions, targeted Black and Latino communities.

What did the authors say in this chapter? They talked about the impact of communal stories and the way narratives create insider and outsider groups – a we and a they. And then, the authors told a story about a group of black men “who hang around a carry-out store in one of Washington’s most blighted neighborhoods.” The authors describe the stories of the lives of these men, and the anger with which they live. They describe a “knife fight” between two of the men, and the refusal of some to commit to long-term relationships with the women in their lives. The authors tell stories of the employment opportunities that some of the men squander. One of the men cheats on his girlfriend and slaps her in an argument. In other words, the authors perpetuate the kind of stereotypes and narratives that inflame racial strife. The stories of these men do not explain the problem of poverty among African Americans. This problem cannot be explained without understanding slavery’s legacy and the recent targeting of Black and Latino communities by predatory lenders.

A Sweet Securities and Exchange Commission Settlement Deal for VeriFone

The Securities and Exchange Commission (SEC) settled charges against VeriFone Holdings Inc. (VeriFone) and a former finance department employee, Paul Periolat, regarding allegations that VeriFone, a provider of electronic pay services, filed false accounting records which boosted the company’s gross margins and income reported to shareholders for three consecutive quarters in 2007. The falsification resulted in an overstatement of earnings by more than $37 million.

VeriFone settled with the SEC without admitting or denying the allegations. VeriFone consented to a permanent injunction against violations of the reporting, internal controls, and other provisions of the federal securities laws. Periolat, now an ex-employee, consented to a permanent injunction against further violations of certain antifraud, reporting, internal controls, and other provisions of the federal securities laws, and Periolat has to pay a $25,000 civil penalty fine. There were no other charges or any monetary penalty assessed against VeriFone.

This is perhaps one of the sweetest settlements for a public company who has breached its fiduciary duty of care to shareholders and presumptively violated Sarbanes-Oxley (SOX) Section 302. The facts concerning VeriFone’s wrongdoing are not unusual but the speed and the terms under which the SEC settled the investigation are unusual. The SEC sued VeriFone on Tuesday, September 1st and the case was settled on the same day.

The SEC alleged that VeriFone made unsupportable alterations to its records to compensate for an unexpected decline in gross margins, overstating VeriFone’s operating income by a total of 129 percent. The SEC further alleged that when internal VeriFone reports showed that gross margins would be markedly lower than previously released guidance to analysts, senior management "was convinced that previously released guidance to analysts were correct and directed finance employees to figure out and fix the problem” so VeriFone could report results in line with forecasts and thereby avoid “an 'unmitigated disaster." The SEC specifically alleged that VeriFone’s former supply chain controller, Periolat, made large manual adjustments to inventory balances on VeriFone’s books each quarter, dramatically increasing both gross margins and operating income. The accounting irregularities came to light during a routine annual audit in November 2007. A few weeks later, VeriFone announced it would restate earnings for the first three quarters of fiscal 2007. VeriFone’s stock fell by 46 percent to $26.03 the day of the announcement, wiping out $1.8 billion from VeriFone’s market capitalization. It is this type of corporate misconduct which encouraged Congress back in 2002 in the wake of historical corporate scandals to adopt comprehensive legislation to increase the accuracy, level of disclosure, and ultimately the accountability for corporate financial mis-reporting.

In 2002, with the seemingly endless financial and management scandals that were then coming to light, including the collapse of Enron and, even more dramatic, the collapse of WorldCom, Congress adopted SOX to remedy the damage that had been caused to investor confidence in the markets. SOX has set the requisite standard for public companies regarding financial transparency and accuracy. The responsibility is on companies’ chief executive officers (CEOs) and chief financial officers (CFOs) to ensure that their financial reporting is transparent and accountable. As such, VeriFone is under a federal statutory duty to implement long-term strategies to establish and evaluate internal control over its financial reporting. It is not enough for CEOs and CFOs to merely sign off on the financials. CEOs and CFOs must certify as to the financial accuracy and effective internal controls currently in place and must to attest to the transparency and accountability of company’s financials. This duty to implement and maintain effective internal controls has long existed under a corporation’s common law fiduciary duty of care. In re Caremark is the seminal case regarding a corporation’s fiduciary duty to implement and maintain effective internal controls. Professor William Gregory’s law review article in the Akron Law Review entitled, The Fiduciary Duty of Care: A Perversion of Words, is an excellent discussion of the confusion that often exist between the duty of loyalty and the duty of care.

SOX Section 302 entitled “Corporate Responsibility for Financial Reports” requires CEOs and CFOs of public companies to certify the information in the company's annual and quarterly reports to the SEC, as well as the company's internal controls are effective. Marc J. Fagel, director of the SEC’s San Francisco regional office stated that through poor oversight and controls, VeriFone senior management allowed an employee to make millions of dollars of unsubstantiated accounting adjustments that enabled the company to meet its guidance to Wall Street. VeriFone maintains that Periolat acted without scrutiny or authorization from more senior management. This means that VeriFone’s internal controls failed and three quarterly reports filed with the SEC in 2007 were inaccurate which violated SOX Section 302 and was a breach of VeriFone’s fiduciary duty of care to its shareholders.

Marc J. Fagel further stated that public companies need to ensure that their financial statements give an accurate assessment of their financial results, and are not improperly adjusted to meet analyst expectations. It is this “tough” language of necessary compliance with federal regulations and, yet “soft” settlement for breach of those regulations which is so perplexing. Perhaps the answer turns on intent. The SEC complaint did not accuse VeriFone of intending to misstate its financial results or to mislead anyone. However, VeriFone’s internal controls were not effective. It is this lack of effective internal controls which should have triggered SOX liability and a breach of VeriFone’s duty of care to its shareholders. These are not issues of intent. These are issues of negligence. VeriFone’s CEO Douglass Bergeron recently stated that “over the past 18 months, the company has substantially improved its governance and internal controls in order to prevent a recurrence of this type of event." Perhaps such sweet reassurances will bring comfort to regulators and shareholders.

Weil Really Gotthem & Mangled Them

Recently a colleague of mine, Susan Hauser, who writes extensively in the area of bankruptcy, sent me a copy of Weil, Gotshal & Manges, LLP’s “Second Interim Fee Application” detailing their fees from the handling of Lehman Brothers’ liquidation. The fee schedule ONLY included fees from February 1, 2009 through May 31, 2009, yet the “total fees allowed” almost totaled $50,000,000.00. Several partners at the firm posted billable hour rates in excess of a $1000.00 per hour. Moreover, there were 2009 grads, without licenses, billing at $355 per hour and paralegals billing at $250 per hour. Even more interesting was the fact that this was the second fee application. The first fee application was approved by Judge James Peck in the amount of almost $55,000,000 from work completed from September of 2008 through the end of January 2009. According to Professor Lynn LoPucki at the University of California, Weil may generate more than $200,000,000.00 in fees from this case.

After thinking about this situation in greater detail, I have come to question whether these types of fees should be awarded in bankruptcy cases. Surprisingly, while some bankruptcy experts have commented on the high amount of the fees, few of these experts have considered the fees excessive. As such, there should be a complete reconsideration of how bankruptcy legal fees are approved as the current approval of such fees highlights a critical flaw in the way in which bankruptcy lawyers are paid. As Professor LoPucki notes, firms representing other interested parties in a bankruptcy case are reluctant to challenge another firms fees, considering the fact that the roles may be reversed in another case. In addition, while a judge must approve of the fees, it is very difficult for her to closely scrutinize the entire bill given the limited resources of the judge’s staff.

Given these issues, the question is whether the law should impose caps on the fees awarded in bankruptcy cases. One argument against the imposition of such caps is that there are only a few firms that are able to do this type work. Thus, if caps are placed on the allowable fees that law firms charge, these firms will be unwilling to do the work which may impair the quality of legal services. Even if there are few firms that can do this type of work, the imposition of caps will not stifle the overall quality of legal service because new law firms will enter the market that are willing to do the same work at the capped fee amount. Over time, these lawyers will develop the same level of experience and expertise as the firms that currently handle the overwhelming majority of the large bankruptcy cases.

shareholder primacy?

One response to the financial market meltdown is a proposed rule by the Securities and Exchange Commission that would allow greater control over corporate board of director nominations by firm shareholders (proposal here). This proposed rule would ostensibly make it easier for shareholders to nominate and elect individual directors to various corporate boards. This rule change seeks to address the criticism that in light of the reckless risk taking engaged in my executives and boards of such companies as AIG, Bear Stearns, Lehman Brothers, Citi, etc., shareholders have very little ability to realistically hold board members accountable for allowing executives to engage in breathtaking risk.

In short, the SEC proposes changes to the proxy rules which would require corporations to include in their proxy materials shareholder nominees for director positions that could make up to 25% of all board members. The SEC summarizes its proposal as follows:

"We are proposing changes to the federal proxy rules to remove impediments to the exercise of shareholders’ rights to nominate and elect directors to company boards of directors. The new rules would require, under certain circumstances, a company to include in the company’s proxy materials a shareholder’s, or group of shareholders’, nominees for director. The proposal includes certain requirements, key among which are a requirement that use of the new procedures be in accordance with state law, and provisions regarding the disclosures required to be made concerning nominating shareholders or groups and their nominees. In addition, the new rules would require companies to include in their proxy materials, under certain circumstances, shareholder proposals that would amend, or that request an amendment to, a company’s governing documents regarding nomination procedures or disclosures related to shareholder nominations, provided the proposal does not conflict with the Commission’s disclosure rules – including the proposed new rules. We also are proposing changes to certain of our other rules and regulations – including the existing exemptions from our proxy rules and the beneficial ownership reporting requirements – that may be affected by the new proposed procedures."

Supporters of the rule change argue that providing shareholders with the right to place director candidates directly onto the proxy card (voted on by all shareholders) would significantly improve director accountability.

Not surprisingly, this rule change proposal has engendered significant opposition from Wall Street. In an unusual move, responding to the Comment period requested by the SEC, seven of the nation's most prominent law firms representing most major corporations, submitted a joint letter opposing the rule change. Mega firms, Cravath, Wachtell, Sullivan & Cromwell, Skadden Arps, Simpson Thatcher, Davis Polk and Latham & Watkins, jointly urged the SEC to proceed with caution in prescribing a "one-size-fits-all" approach to allowing proxy proposals to include director candidacies.







The Comment period for this rule change is now closed.

One thing seems certain now that regulatory overhaul is on the table in light of the economic meltdown: controversial calls for change will be challenged at every quarter. Status quo will be protected at every turn. The United States system of corporate governance and securities regulation is a cottage industry that will be protected fiercely. The Obama administration's attempts to layer the industry with new regulation and the SEC's efforts to propose new proxy rules to improve director accountability will be challenged by the powerful and the entrenched.

At one point, I suspected (hoped) that a silver lining of the economic crisis might be a new impetus to systematically and carefully review U.S. corporate governance and our nations regulation of securities, commodities, derivatives, over-the-counter trading and so forth, with an intended outcome of modern, efficient, investor-protecting reform. Will the powerful allow this regulatory modernization? Will the Obama administration have the steely reserve to challenge the entrenched? Are the right people in place to conduct the systematic and careful review? Will regulatory reform truly occur, or just pacifying window dressing?

This is a story that continues to unfold.

Honoring Ronald H. Brown: Symbol of Economic Justice

Ronald H. Brown, the first African American to become U.S. Secretary of Commerce and Chair of the Democratic National Committee, graduated from St. John’s University School of Law in 1970. The Ronald H. Brown Center for Civil Rights and Economic Development, named after the former Secretary, will celebrate the 40th anniversary of Brown’s graduation from St. John’s by hosting symposia and other events during the upcoming academic year. The first of these events will be a symposium on November 13th and 14th featuring the scholarship of St. John’s Law School faculty writing on themes relating to civil rights, economic development and social justice. The symposium will be held at St. John’s Law School on the Queens campus.

Professor Leonard M. Baynes is Director of the Ron Brown Center. Under his direction, the Center has sponsored symposia focusing on civil rights and economic development, along with extraordinarily successful pipeline programs aimed at increasing racial and socioeconomic diversity on law school faculties and among law students. The Center’s most recent symposium, organized by Professor Baynes and the Center’s Assistant Director Janai Nelson, was entitled Making History: Race, Gender, The Media and the 2008 Elections.

Brown and the Rule of Law

I have always been astounded that a significant number of legal academics suggest that the Brown v. Board of Education decision was somehow contrary to the rule of law.

As Brian Tamanaha states in his excellent text On the Rule of Law the case "plagues mainstream legal theory to this day." Tamanaha quotes Raz: "The law. . .may institute slavery without violating the rule of law."

I posit this: the ultimate lawlessness is the wanton and pervasive destruction of human potential implicit in all forms of oppression, particularly racial oppression, which we know is an irrational basis for classifying individuals. The suggestion that slavery or Jim Crow segregation is somehow consistent with the rule of law renders that concept useless. If law fails to constrain those with power from the destruction of human dignity and potential then it both unjust and economically pernicious. In other words, it is evil and self-destructive all at once.

The rule of law thankfully began to end American apartheid on May 17, 1954. Prior to that date the American legal system was marked by deep seated lawlessness where individuals were unconstrained by law to irrationally destroy the potential of others. Brown strengthened the rule of law in America.

Either the law appropriately restrains power or it does not. That is the ultimate test of a well-functioning rule of law.

What does this have to do with corporate justice?

The consolidation of economic power at the apex of corporate America has also become unjust and economically pernicious.

The answer is the imposition of a rule of law to constrain the currently unbridled exercise of economic power through the domination of the public corporation by a small hyper-elite.

Politically the separation of powers implicit in the US Constitution created the possibility of the rule of law prevailing in the political sphere. We need an economic constitution that fragments corporate power far beyond the capabilities of Delaware and the current system of politicized corporate governance.

Whatever term is used, the law must operate to constrain those with economic and political power from abusing their power by profiting through the domination of the legal system. Individuals must be disempowered from imposing huge costs on society generally in order to achieve personal ill-gotten gains; gains that frequently are much less than the cost to society. If law fails to adequately constrain power, then it cannot be operating as the rule of law.

Capital University Law School Brings Distinguished Alumnus Ronald Shuff, Flowserve SVP/GC, to Visit Law School as Second Alumnus-in-Residence

On October 24 and 25, Ronald Shuff, Senior Vice President - Secretary and General Counsel of Flowserve Corporation will visit his law school alma mater, Capital University Law School, as the second Alumnus in Residence. Capital's Alumni-in-Residence program brings distinguished alumni to the law school to reconnect with faculty and to share career insights with students. Mr. Shuff will engage with students, faculty, staff and alumni through a variety of activities including student organization meetings, attending classes, and delivering a public lecture on his tips for a successful legal career. Mr. Shuff, who also holds an MS from the MIT Sloan School of Management Sloan Fellows program, has over 25 years of significant, personal interaction with board members and over 30 years experience in managing corporate legal and non-legal staff.

Flowserve is a pump and valve manufacturer serving the oil, gas, power generation, chemical processing, water resources and other industries. Flowserve’s common stock is traded on the NYSE. More information will be available in the near future here.

Federal Reserve Bank Leadership Remains Intact Despite the Collapse of the Financial Markets

President Obama nominated Ben S. Bernanke to a second four-year term as chairman of the Federal Reserve Bank, which is the central bank of the United States. Chairman Bernanke has led the biggest expansion of the Federal Reserve Bank’s power in its 95-year history to handle the current financial crisis which many claim is the worst economic crisis since the Great Depression.

The financial industry is thrilled with the decision that Bernanke will remain as Chairman of the Federal Reserve. Morgan Stanley’s Richard Berner who serves as head of Global Economics stated that “it’s not just that he’s done a great job of dealing creatively with the financial crisis but that he brings certainty.” The financial industry applauded President Obama for maintaining the stability of the Federal Reserve by nominating Bernanke for a second term. However, there are many in Congress that are displeased with Bernanke’s decisions especially in terms of the independence that Bernanke has displayed. Bernanke decided to cut the main interest rate almost to zero, he decided to funnel $1 trillion into the crippling banking system and he decided to rescue Bear Stearns Cos. and American International Group Inc. from collapse, although he permitted Lehman Brothers to collapse.

Many members of Congress believe that Bernanke overstepped his authority as Chairman of the Federal Reserve and used “emergency powers” to deviate from sound monetary policy. Bernanke was also criticized as too slow to respond to the housing crisis and inaccurately referred to the housing crisis as “contained” before reversing course in August 2007 and cutting interest rates. As a result, there is pending legislation in the House which would subject the Federal Reserve’s monetary policy to audits by the Government Accountability Office. If the legislation is adopted, the Federal Reserve would need the Treasury Department’s approval before invoking the emergency powers that Bernanke used to coordinate the financial bailouts and to make loans to non-bank financial institutions.

President Obama believes that Bernanke has provided extraordinary leadership during the most difficult financial crisis that America has faced since the 1930s. The President further believes that Bernanke is the person to guide America through renewed growth in the years to come. Recently, at the Federal Reserve Bank’s annual symposium, Bernanke stated that “prospects for a return to growth in the near term appear good.” However, “we have an enormous amount of work to do.”

Systemically Important Financial Institutions: The Cleveland Federal Reserve Turns To YouTube To Show The Way Forward

What should we do about systemically important financial institutions moving forward? Consider implementing a three-tiered regulatory system. Well, that is the approach recently advanced by James Thomson, a Vice President and Financial Economist at the Cleveland Federal Reserve Bank. In an amusing and simple drawing board presentation on YouTube, Thomson spells out and outlines the regulatory approach he deems best for regulating systemically important financial institutions. Yes, the Federal Reserve Bank of Cleveland is turning to YouTube to show us the way forward!!!

In recent months, the term “systemically important financial institution” has garnered a great deal of media attention and news coverage. What is a systemically important financial institution? It is a financial institution that is so large, or interconnected with other institutions, or unique that it poses the risk of pulling the entire financial system down with it should it fail.
How do you gauge whether an institution is systemically important or not? The Federal Reserve Bank of Cleveland has proposed looking at the institutions size and four additional criteria to determine systemic importance. The Federal Reserve Bank of Cleveland calls these additional requirements the four C’s: contagion, correlation, concentration, and context.

How do the four C’s play themselves out? “Contagion” refers to the “too connected to fail” syndrome. For example, if you have swine flu and go to work, church, or a professional baseball game the “bug” can spread rapidly. The same goes for financial institutions: when one is sick it can spread a “bug” that infects other institutions that are interconnected through loans, deposits, or insurance contracts. “Correlation” refers to the “too many to fail” syndrome. If financial institutions see their peers doing risky things, they decide to join the party. Financial institutions assume if everyone is doing something risky then there is no way the government will let the entire industry fail; regulators will step in to offer a bail-out to all. Under this scenario moral hazard is eroded. “Concentration” refers to the “dominant or essential player” syndrome. If a financial institution dominants a particular business or has a high percentage of money leveraged in a particular area that is risky, this could make the financial institution a systemically important institution. AIG is a prime example of such a firm, in relation to AIG’s dominance of the credit default swap market. The final of the four C’s stands for “context.” This is known as the “conditions matter” syndrome. Let’s assume the financial market is antsy or jittery. The failure of one large firm in the system might be interpreted by investors as a bad omen or sign of things to come, or as a harbinger that underlying market conditions will soon erode. Under such a scenario the financial market collapses. The collapses experienced at Bear Stearns and Lehman Brothers illustrate types of "context" failures.

James Thomson proposes a three-tiered approach to deal with systemically important financial institutions. Tier One would cover high-risk institutions. Potentially, the failure of these institutions would pose the greatest risk to the financial system. Tier One would include complex financial institutions like large interstate banks and multi-state insurance companies. Tier One institutions would be subject to the most stringent regulation.

Tier Two would include moderately complex financial institutions. These institutions would be chosen based on their interconnectivity, involvement in critical market functions and activities, and the affect of stress in the overall economy on their condition. Large regional banks and insurance companies would be the market players regulated under Tier Two. In a sense, Tier Two financial institutions would undergo a more moderate level of regulatory scrutiny.

Finally, Tier Three would cover remaining non-complex financial institutions. Community banks would make up the market participants covered by Tier Three. Tier Three institutions would fall outside the watchful eyes of systemic institutional regulators like the Federal Reserve. The notion is that if a Tier Three institution failed it would be unlikely to cause any widespread ripples in economic markets.

The goal of the three-tiered system Thomson proposes is to equate oversight and regulatory activity with the degree of risk involved with the type of financial institution. Thomson hopes that the risk of being a systemically important financial institution may be mitigated. We shall see. YouTube and the Federal Reserve Bank: what a combination we have unleashed!!!

The Financial Crisis: Regulatory and Corporate Governance Critiques and Reforms

The University of Utah S.J. Quinney College of Law will host a financial crisis symposium on September 25, 2009. The event "The Financial Crisis: Regulatory and Corporate Governance Critiques and Reforms" will feature experts on financial regulation and global economies discussing and debating recent efforts to reform the financial industry in the wake of the 2008-09 meltdown.

Per Professor Wade's post yesterday, recent events and commentary from the Obama administration have signaled an end to the broader economic crisis as many are now on record that we have "reached the bottom" of the economic free fall and have begun a real recovery. The capital markets have rebounded in some small measure. This conference will seek to evaluate the measures adopted by the current administration in an attempt to stave off a global economic meltdown and will consider whether these policies offer long-term assurances or protections against a recurring subprime debacle. In addition, this conference will explore the deeper causes of the crisis and will explore whether true reform is taking place that will address the fundamental weaknesses that allowed or enabled the economy to crumble.





Scholars from around the country will seriously debate the merits of suggested reforms, evaluate the actual proposed legislation and enacted policies, and suggest additional solutions to protect against future crises. These scholars have testified before congress, consulted with senators and congresspersons throughout the crisis, and have written aggressively and appeared often in the pages of law reviews and leading newspapers across the world.

More information to come, including webstream details.

Will talk of economic recovery preclude consideration of the causes of the financial collapse?

In the last few months, some have asserted that the economic downturn is slowing. And, this month, The Federal Reserve announced that the economy is improving. Most predict that the recovery will be slow.

The recovery will be slowest in minority communities that were financially vulnerable long before the recent financial collapse. We should not allow the rosy forecasts about the beginnings of an economic recovery to obscure our understanding of the conduct of the corporate actors who precipitated further financial decline in African American and Latino communities.

Nonbank lenders, some of them public companies, targeted minorities for predatory lending schemes during the height of the subprime lending debacle. Their conduct violated Title VIII of the Civil Rights Act of 1968 – The Fair Housing Act (“FHA”). The FHA prohibits discrimination on the basis of race and other factors when making or purchasing loans for purchasing, constructing, or improving a dwelling. We should also examine the governance systems of the financial institutions that did business with the lenders that violated the FHA. To what extent did lax corporate governance prevent Wall Street from engaging in the kind of oversight and decision making that would have avoided the excessive risks that were undertaken in the height of the subprime mortgage market?

Most Wall Street firms did not employ the people who dealt with borrowers and approved predatory mortgage applications. This work was outsourced to independent companies in order to keep costs down. What responsibility did the financial institutions have to ensure that the companies to whom they outsourced this work complied with the FHA? Did financial institutions such as Lehman Brothers, Bear Stearns, Wells Fargo and others owe a duty to ensure that the brokers and nonbank lenders who sold them mortgages complied with the FHA?

We should also take a critical look at the discourse generated by conservatives about the relationship between lending to minorities and the financial collapse. Many conservatives blamed the financial crisis of 2008 on the enactment of the Community Reinvestment Act of 1977 (CRA”). The CRA was enacted to require banks covered by the FDIC to refrain from the discriminatory practice of redlining under which they refused to lend to specific minority and low-income residents. Conservatives argued that the quest for increasing home ownership among minorities and working class Americans caused the economic crisis. This focus on the alleged inadequacies of minority and working-class borrowers eclipses the role that financial and lending institutions played in causing the financial collapse. It precludes consideration of ways to improve the governance and best practices of financial and lending institutions.

Proposed Legislation Will Allow CFTC and SEC to Regulate Derivatives Market

A few years ago, I wrote an article entitled Controlling a Financial Jurassic Park which analyzed the unregulated Forex market, derivative trades, and fraud. The article discussed the cause of Forex derivatives fraud, its rampant increase in the last 10 years, and recommended proposed legislation to regulate and prevent fraud in the Forex derivatives market. One recommendation was for Congress to provide the Commodity Futures Trading Commission(CFTC) and the Securities & Exchange Commission (SEC) expanded authority under the Commodities Exchange Act and the Securities Exchange Act to aggressively regulate and prosecute derivative traders that defraud the public.

Imagine my elation when the Obama administration formally proposed legislation to regulate derivatives. The administration proposed that most derivatives should be traded on regulated exchanges similar to the way stocks and bonds are currently traded. The legislation also proposed tightening the banking regulations that inter-connect with the proposed derivative trading regulations. Additionally, the SEC, the CFTC and the banking regulatory agencies would share responsibility for oversight of the derivatives market. Shared regulation is a crucial element for preventing fraud in the market. As various federal agencies work through complex and sophisticated derivative transactions their shared analysis will allow for a better understanding of the transactions, and will create a better synergy to prevent fraud in the future.

The Rule of Law and 9/9/09

On September 9, 2009, the Supreme Court of the United States will hear re-argument in the case of Citizens United v. Federal Election Commission, which involves the congressional power to limit corporate campaign activities. The Supreme Court ordered re-argument in order to address whether two of its precedents upholding legislation limiting corporate campaign activities should be overruled. The case has aroused much controversy, and many amicus briefs have been filed. The mainstream media has reported on the case to some extent, but most in-depth coverage appeared only in places like the New York Times or specialized publications.

Professor Richard L. Hasen suggests that if “corporate limits fall . . . we may well look back on the 2008 election as a quaint time when the amounts spent on elections were relatively modest.” Professor Michael Dorf argues that the American people already suspect that American politics is a rigged game. If the Court overrules its prior cases limiting corporate campaign activities “the American people could be excused for thinking that the Court too is part of the rigged game.”

Overruling its prior precedents upholding reasonable limitations on corporate campaign activities will subvert the rule of law and further concentrate economic and political power in a corporate elite that has proven itself inept and inadequately constrained by law. It would cripple a great democracy that endured for years on the principle of one person, one vote. The nation already is struggling to avert a government of elites, by elites, and for elites.

Moreover, under our current system of corporate governance, breaking down limits on corporate campaign support would only serve to empower CEOs, at the expense of the corporation and its shareholders. CEOs have proven themselves capable of indulging their own short term interests at the expense of shareholders, most recently in the subprime debacle. Giving CEOs more power to dominate their firms (as well as society generally) is not vindicating free speech—it is entrenching CEOs to coerce shareholders to expend funds for the benefit of the CEO’s interests. Simply put, under the current regime of CEO primacy, CEOs have hijacked corporate speech. Only if the interests of the shareholders and the corporation itself are secured against CEO domination can corporate speech colorably be termed free speech.

Perhaps the Supreme Court should rule that only corporations that charter an independent subcommittee of the board to supervise all lobbying and campaign activities of the firm to assure those activities are for the benefit of the firm (with substantial shareholder input) can expect to enjoy free speech rights. Otherwise the Court is simply cloaking CEO subversion of the firm in First Amendment protection.

The Corporation exists to enrich shareholders. It is chartered to pursue business interests and profits. It was not created to give voice to unbridled CEO power, without disclosure nor authorization of the shareholders. Under this reality corporate speech is no more "free" speech than the words uttered by a tortured individual with a gun to their head.