Corporate Behavior in the Face of Reform

Treasury Secretary Timothy Geithner has been aggressively peddling the Obama Administration’s plan to reform the financial industry in recent weeks. We as a nation, have a habit of experiencing an economic crisis and then passing reform after the fact in order to try to protect against its recurrence. Interestingly, we often fail to heed the calls for common sense reform or regulation prior to a devastating meltdown (I wrote a law review article warning against unregulated over-the-counter trading of derivatives back when Greenspan was telling Congress that large institutional investors would never leverage themselves to the point of financial failure), waiting instead to clean up the carnage after the fact. In fact, as criticized on this Corporate Justice Blog, often the carnage clean up rescues the malfeasors (recently in the form of government bailout and continuing excessive executive compensation) and leaves taxpayer citizens (the innocent party) shouldering the burden of the economic crisis.

To wit, the Securities Act of 1933 and the Securities Exchange Act of 1934 were both enacted in wake of the Great Depression. Sarbanes-Oxley was enacted in the wake of the Enron, WorldCom, Tyco scandals. Today, the momentum to pass regulatory reform is strong in wake of the devastating market crisis that we continue to feel and attempt to overcome. Still, the broken models that have proved ineffective continue to be used as the baseline for these reform efforts.

In response to the subprime mortgage meltdown, the Obama administration’s reform effort will seek regulatory control that includes (1) broadening the Federal Reserve’s authority to assess risks and overleveraged positions taken by financial firms and taking action to divert failure and (2) the creation of a consumer watchdog type of agency that would oversee mortgages, credit cards and other financial products. So, with Wall Street reform on the table, leaving aside the value or quality of the suggested reforms, what response can we expect from Wall Street and the financial industry in the face of these proposed reforms?

If history is any indicator, the response driven by corporate interests will be forceful and coordinated in an effort to defeat any new regulation or to significantly weaken it if the force of majority is too strong for reform (see Sarbanes Oxley, etc.).

As a point of comparison, Corporate behavior in recent weeks in response to health care reform and climate change legislation has been breathtaking in its audacity and truly underhanded in its application:


Corporate interests in the health care industry have undertaken a strategy of near mob mentality in coordinating efforts to hijack Congressional town hall meetings through astro turf lobbying firm “marching orders” designed to squelch conversation and open debate. As Congresspersons use the recess to openly debate and honestly describe the efforts to reform U.S. health care, a group of citizens will show up with the express purpose to shout down any attempts at an open conversation about changing a health care industry that works extraordinarily well for insurance companies (and their investors) but that is broken for large segments of American society.

Corporate interests in the energy industry hired lobbying firms that have recently forged letters from civil rights groups in an effort to defeat environmental reform. Several Congresspersons received letters ostensibly from the NAACP and a Hispanic Civil Rights organization pressing the representative to vote against climate change legislation, only to later learn that these letters were forgeries sent from a Capital Hill lobbying firm hired by industry corporations to defeat reform.

Corporate justice? With corporations in the insurance and energy industries using scorched earth tactics to defeat reform? The mountaintop (of reaching corporate justice) seems to be extraordinarily steep.

Enron’s Aftermath: This Is Not Just Business News

In this economic downturn, Americans are clear that the business community has a huge impact on the welfare of the entire nation. In part, because our government has rescued private companies with taxpayers’ money, the intersection of Wall Street and Main Street is clearly visible. News stories about corporate governance failures, violations of securities laws and corporate criminality are no longer confined to the business section or financial media. Because average Americans have been asked to save the private sector, business news has become mainstream.

The Savings and Loans debacle of the 1980s was one of the first mainstream business stories. The 1990s “dotcom” bubble and its bursting were reported on the front pages of newspapers and described on television and radio programs that typically devoted little time to business news. And of course, the recent economic downturn and the private sector excesses that contributed to it are reported in all of the major news outlets used by average Americans who are outsiders when it comes to business.

Business news became front page news at the beginning of this decade with the bank failures of important companies such as Enron, WorldCom, Tyco, and Adelphia. The disgraced leaders of these firms became public icons of corporate greed and hubris. Ken Lay, Jeffrey Skilling and Andy Fastow of Enron were tried and convicted. Bernard Ebbers of WorldCom, Adelphia’s John Rigas, and Tyco's Kozlowski were sent to prison. All of this was reported by the mainstream media, resurrecting the confidence of the American public.

Jefferey Skilling’s conviction was confirmed by a federal appeals court, the Fifth Circuit, but his sentence was vacated. It is not surprising that Skilling appealed his conviction. Appeals are routine. Skilling’s sentence was vacated, and a hearing date, July 30th, was set for his re-sentencing. (His re-sentencing, however, was postponed.) None of this surprises me either. But I am surprised that these details have been largely confined to the business media. Most Americans would want to know that one of the key architects of Enron’s downfall may get less jail time. And many of these Americans do not follow business news.

What Role for Institutional Investors?

In my first post on this site, I mentioned that I had planned to write about institutional shareholder roles in corporate governance post-financial markets meltdown. Instead, another topic presented itself (i.e., the SIGTARP quarterly report). On August 1, at an American Bar Association Business Law Section Corporate Governance Committee presentation during the ABA Annual Meeting, a task force on the delineation of shareholder and board roles presented its final report.

The task force report, which is highly readable and balanced, praises shareholders and boards, noting that “shareholders and boards have become increasingly engaged in their roles, and generally this increased engagement has been a positive development.” Also, it gives kudos to institutional investors for actively using their voices and votes. Furthermore, the report praises boards for becoming “more actively engag[ed] in discussions with shareholders on a variety of governance related topics.” For example, “Pfizer, UnitedHealth and Home Depot . . . initiated meetings with large institutional investors to discuss issues ranging from executive compensation to board composition.” The report recognizes “[w]hile the data is not definitive, there is evidence that focus by large, long-term shareholders and greater activation by independent boards is associated with better corporate performance.”

I am particularly interested in the increase in meetings between corporate boards, executives and investors. The report indicates that some corporate executives are willing to discuss issues that are the subject of shareholder proposals during proxy season, such as “nomination of directors, compensation matters, social and environmental issues,” and the like. Might corporate executives be willing to discuss with institutional investors corporate risk management policies, internal control procedures and monitoring of internal auditors, and other hot topics on the border between corporate governance and corporate operations?

The report is available here.

The World Bank and IMF Forgave Ayiti's Billion Dollar Debt as Ayiti Struggles to Reform Public Programs and Policies

A few weeks ago the boards of the World Bank and IMF decided to approve Ayiti’s (Haiti)$1.2 billion debt relief under the enhanced HIPC (Heavily Indebted Poor Countries) Initiative and the Multilateral Debt Relief Initiative (MDRI). The interest payment on Ayiti’s loan had grown to approximately $20 million per month, which is a staggering payment for a poor island-nation with approximately $4.1 billion in GDP and $1,300 per capita.

Ayiti’s debt was relieved because Ayiti had reached the completion point under the enhanced HIPC Initiative. For Ayiti to reach the completion point, Ayiti had to make several reforms despite suffering through a series of humanitarian crises and enduring the devastating impact of four hurricanes, drastic increases in food and energy costs and challenging political conditions. A number of political leaders and organizations urged for the cancellation of Ayiti’s debt. US organizations including Jubilee USA Network, Institute for Justice and Democracy in Ayiti, TransAfrica Forum, the Quixote Center, Center for Economic and Policy Research, the Episcopal Church, and Partners in Health worked together to build the political will in the U.S. for Ayiti’s debt cancellation, in partnership with colleagues in Ayiti, throughout the Americas, across Europe and around the world. Ayiti is now under the MDRI for further debt relief from International Development Association (IDA) the Inter-American Development Bank (IADB). MDRI relief would save Ayiti US$972.7 million in debt service of which US$486.7 million owed to IDA and US$486 million to the IADB.

Several of the reforms that Ayiti has made and will continue to make as part of the debt forgiveness program, include: implementing a national poverty reduction strategy; strengthening public expenditure management; producing audited government accounts; ensuring commitment to an asset declaration law, which requires a country not to nationalize foreign assets; adopting a law on public procurement; strengthening tax and customs administration; improving debt management and financial reporting; establishing a financing mechanism to allow over 50,000 additional children to attend public school; allocating over 20 percent of recurrent spending to education; implementing a national teacher training program; approving an HIV/AIDS prevention and treatment plan; and, improving immunization rates for children under the age of eighteen.

Despite the extensive list of reforms, Ayiti’s public health law and public health program are not included as reform iniatives althougth they are in dire need of renovation. I recently joined a group of approximately 60 doctors, nurses, administrators and educators on a week-long medical relief mission to Les Cayes, Ayiti to provide medical services to residents in one of the poorest areas in Ayiti. Medical doctors came from as far as China, New York, Philadelphia, New Jersey and Florida to volunteer their services. The mission was organized by Gaskov Clergé Foundation which was developed to promote, health, sports, education and science in Ayiti. I was the only lawyer in attendance, and my involvement was originally limited to providing strategic support to the board by interviewing various parties and taking footage of the medical mission for an upcoming documentary. However, within a few hours of arriving in Ayiti, my role expanded as the need from the community extended beyond the group’s initial expectation. As word spread within the community that “doctors from America had arrived,” people came from neighboring provinces to seek free medical services. The week was intense. Each day the doctors consulted with 300-600 patients, and 2-3 surgeries were performed at the national hospital with limited surgical resources. My cutting-edge interviewing skills gave way to my language skills. I placed the camera aside, to a large extent, to fufill the more fundamental need of serving as an interpretator for the non-French speaking doctors and conducting direct patient medical history inquiries of patients who primarily spoke French and Creole.

A few observations became immediately apparent. First, poverty in Ayiti is not at all analogous to poverty in the United States. Poverty in Ayiti is brutal. The concept of health insurance, public funding for hospitals, or effective medical equipment are non-existent, therefore resident do not receive basic medical care. Second, the majority of illnesses that the doctors treated were preventable, if patients had public health information regarding the importance of washing their hands, using clean water to bathe, and drinking parasite-free water because preventive medicine is not accessible. Third, what Americans consider as "basic" necesities to maintain health such as clean water, annual medical check ups, dependable medical equipment and supplies, is not basic provisions provided by the govenment for the residents of Ayiti. Clean water and public health education is a national concern. Things that are viewed as “basic” to Americans are life-giving and extremely precious to residents of developing countries. As Ayiti struggles to reform its macro-economic policies, developed countries such as the United States should continue to encourage the government of Ayiti not to overlook the importance of public health education and the need to provide “basic” preventive care to the poorest of the poor.

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

Call for Papers - The Fall of the Economy and How New York City Can Rise to the Challenge

On Friday March 5, 2010, the St. John’s Journal of Civil Rights and Economic Development will host a symposium on the recent economic downturn and its effect on New York City at St. John’s University in Queens, New York.

Date: Friday, March 5, 2010

Location: St. John's University School of Law Moot Court

The symposium will consist of academics who have conducted research in all areas related to this downturn as well as community leaders and organizers who have dealt first hand with the individuals affected. The goal of this symposium will be to expose the pitfalls that lead to the recession and to determine an approach to avoid a similar situation in the future. Further, through discussion and debate, this symposium will connect all classes and ethnicities in an effort to work together to build a stronger city for the future.

Call for Papers
We invite you to participate in this symposium by sending a short 250-500 word essay by August 12, 2009 on your research and your desired involvement in this discussion. After review, panelists will be invited to speak and potentially asked to submit a paper for publication in the Journal.

Please download the attached call for papers for a more in-depth explanation of the symposium and the paper submission process.

Related Studies
Job Losses Show Wider Racial Gap in New York
By Patrick McGeehan and Mathew R. Warren

Contact Information
Adam Dressler
Research & Symposium Director
St. John’s Journal of Civil Rights and Economic Development
adam.dressler07@stjohns.edu

The Wages of Sin: Ruth Madoff and Bernie's Money Trail

Last week I posted a piece on the Corporate Justice Blog about affinity fraud and the Bernie Madoff scandal. Well, the drama surrounding Bernie Madoff does not cease. A couple of days ago, Ruth Madoff, the wife of Bernie Madoff, was a major item in the news.

As it turns out, Irving Picard, theTrustee appointed to liquidate Bernie's business assets filed suit against Ruth Madoff to recapture and recoup upwards of $45 billion transferred to Ruth Madoff, or companies she controlled, for her own personal benefit. In his Bankruptcy Court filing, Mr. Picard detailed 111 alleged fraudulent transactions and conveyances to Ruth Madoff.

As part of his 150 year sentence, Bernie Madoff forfeited most of his personal assets. The government did not contest Ruth Madoff's claim to $2.5 million. Ruth Madoff continues to enjoy substantial advantage and a relatively lavish lifestyle compared to the individuals and charities that were defrauded by Bernie Madoff, her husband.

The sins of the father are often the sins of the son/daugther. Are the sins of the husband the sins of the wife? This remains to be seen. Will Ruth Madoff have to atone for Bernie's sins? We shall see. Will we ever sort out the Bernie Madoff money trail? We'll find out. I'll keep you posted.

Beware the Zombie Banks!

Zombie banks seem to be killing our economy, just as financier George Soros predicted. Zombie banks do not lend money because they are worried about remaining solvent and staying in business (so they may continue to pay outrageous bonuses and golden parachute payments to their inept CEOs and senior officers). Zombie banks are widely viewed as the root cause of the now 20 year old Japanese contraction. Rather than lending money on reasonable terms zombie banks use government subsidies to soak borrowers and drive out competition. Further, zombie banks squeeze out profits from healthy competitors through the advantages of government subsidies and thereby cause industry-wide stagnation and job losses.

According to the FDIC, bank lending contracted by $116 billion in the fourth quarter of 2008 and $138.5 billion in the first quarter of 2009, as indicated in the chart above. The Wall Street Journal reports that lending fell an additional 2.8% in the second quarter of this year. This coincides with a newly revised GDP numbers that track the contraction in lending; for example, GDP contracted at a rate of 5.4% in the fourth quarter of 2008 and 6.4% in the first quarter of 2008. In the just completed second quarter, the contraction in GDP seems to be slowing, based largely on increased government expenditures now amounting to 20% of the economy.

This is some cause for optimism, but the economic problems posed by zombie banks are not likely to be resolved any time soon. The IMF now projects total toxic assets in the world financial system will reach $4 trillion, and banks have recognized less than half of these losses. Moreover, securitized credit in the US has fallen over 60%. Much of the recent optimism in the financial sector is also the result of changes in accounting rules that allow banks more discretion in valuing assets that previously had to be marked-to-market. Earlier this spring Paul Krugman suggested that we should prepare for a lost decade of zombie banking. Since then he thinks that the risks of a zombie economy have increased; I argue that the greater estimated losses and the use of accounting machinations to conceal deep financial wounds means that a zombie economy is a near certainty. The net result is gross injustice and perverse incentives that are economically corrosive.

I have previously suggested on this blog that a government regulator should have the power to order prudential divestitures to assure that no bank ever becomes too-big-to-fail again. Given the enormous costs of bail-outs generally, and financial bailouts in particular, however, I now suggest that the power to bailout financial firms rest with a separate, non-banking regulator. The non-banking regulator should have the power to organize government assistance for any firm (financial or not) the failure of which would present a severe economic disruption.

Even then the regulator should be required to find that rescuing the firm is highly likely to result in profits to the taxpayers and will result in a viable firm over the long run with substantial certainty. This regulator should be depoliticized, like the Fed, but have no significant ties to any one industry, financial or otherwise. It should be self-funded, through a tax on any economically significant public firm–like a users’ fee. Government assistance should come with severe restrictions with regard to compensation (bonuses and golden parachute arrangements should be dischargable by the bailout agency), and any individual who engages in reckless conduct leading to substantial government expenditures should be subject to fines (commensurate with the cost to the public fisc and the degree of their recklessness) and disbarment from serving as an officer or director of a publicly traded firm–meted out in an administrative proceeding. Criminal sanctions should be reserved for knowing misconduct leading to government assistance. The PSLRA should also be amended so that it does not apply to officers and directors of bailed-out firms. That way, securities fraudfeasors (currently protected by the PSLRA) would at least think twice before defrauding shareholders of an economically significant firm. Senior management of rescued firms should be terminated, unless their service is vital to the success of the firm.

Because creditors could not count on government bailouts under this regime they would not carelessly supply cheap capital to any large firm. The user fee would therefore likely result in a higher cost of capital for firms flirting with too-big-to-fail status. CEOs and directors would find government bailouts distinctively unpleasant. Incentives toward prudence would be restored. This proposal therefore would greatly contract the problems associated with too-big-to-fail.

The problem is not that the law cannot remedy the too-big-to-fail problem; the problem is that the financial sector may have too-much-political-power-to-reform.

Goldman and AIG: Two Strategies, Two Very Different Outcomes

Goldman Sachs (“Goldman”) continues to be a major player in the derivatives market. Unlike AIG, Goldman’s derivative strategy is much more conservative. AIG insured almost $430 billion in credit default swap (“CDS”) contracts; however, it took no offsetting positions against these contracts. As a result, AIG was able to make substantial profits from the premium payments it collected, since it did not pay any premiums to offset these contracts.

While AIG made substantial profits from this strategy, it proved to be one of the decisions that led to the current financial crisis. Conversely, Goldman’s derivative strategy has proven to be more efficient, especially under the current market conditions where competition in the derivatives market has “diminished and the spreads between buying and selling have widened.”
Goldman’s derivative strategy is very straight forward, for every CDS contract it insures, it attempts to secure an offsetting position in an amount equal to or greater than the CDS contract it protects. “A review of Goldman's 10-Q filing for the period ending March 31, 2009, shows that Goldman wrote credit derivative protection for others equal to $3.2 trillion or 12% of the $26 trillion notional value of these derivatives existing. Offsetting that $3.2 trillion position is $3.429 trillion in credit derivative protection in Goldman's name. This gives Goldman Sachs a cushion of $257 billion in notional CDS contracts as protection.” Through this strategy, Goldman makes a profit on the spread between the CDS contract it insures and the offsetting position it secures to cover the CDS contract. While the overall spread under this type of strategy is lower, it has proven to be highly efficient as well as profitable. In fact, “Forbes estimates that Goldman Sachs made about $1.8 billion in gross profits during the first quarter of 2009 from trading 12% of the total nominal amount of credit default swaps that exist. This profit would be the result of collecting only a 1.5 basis points spread on the $3.171 trillion CDS position. This estimate of $1.8 billion is before overhead, interest and taxes. Goldman reported total net profit of $1.8 billion for all of its activities during the first quarter.” Thus, a significant portion of Goldman’s profits from the period ending March 21, 2009 are from its derivative activities.

These two stories beg the question of whether AIG’s board and its officers should suffer sanctions given that AIG’s actions seem more reckless in light of Goldman’s derivative strategy. More specifically, how could AIG’s board and its officers legitimately believe, in good faith, that their strategy created a bottomless pit of money?

whither executive compensation?

Bank Bonus Tab: $33 Billion
Nine Lenders That Got U.S. Aid Paid at Least $1 Million Each to 5,000 Employees

Splashed across the the Wall Street Journal on Friday (7.31.09) was the news that nearly $33 billion in executive and employee performance bonuses were paid out in 2008 by nine Wall Street banks that had accepted government bailout money through the TARP program. Despite near collapse and a necessary rescue from the government, nine investment banks still paid the executives and employees that presided over the catastrophic declines $32.6 billion in bonuses.

This news comes on the heels of reports on Thursday of last week (7.23.09) that Goldman Sachs, Morgan Stanley and JPMorgan Chase had set aside dozens of billions of dollars to pay their executives and other employees for 2009 performance. On the same day that Goldman Sachs announced that it would likely (if the pace of set asides continues this year) pay its executives an average of $775,000 in 2009, more than double that of 2008 and more than bonuses paid in 2007, a report on unemployment indicated that jobless claims increased more than expected, and the Federal Reserve expects the unemployment rate to top 10 percent by year-end.

As unemployment increases on Main Street, over on Wall Street, the song seems to remain the same. Executives and employees will receive significant performance bonuses in 2009 despite receiving government bailout funds and in many instances presiding over a near collapse of the banking industry. More shocking than the plans to compensate for 2009 is the New York Attorney General Andrew Cuomo report that $32.6 billion in bonuses were paid out in the wretched economic performance year of 2008. What gives?

Common sense seems to dictate that if performance is dismal, then bonuses should match that performance (meaning, very little should be paid in bonuses). Remember, that bonuses are paid to executives and employees in addition to salary. In the Sports context, in particular the National Football League, performance bonuses are negotiated in advance between an athlete and a professional club, and those bonuses are simply not paid if the negotiated performance is not met. Many bonuses in professional sports are team based, indicating that if a team reaches a certain level of success, then bonuses will be paid to a particular player. The NFL collective bargaining agreement even breaks bonuses down for purposes of the salary cap, into "likely to be earned" bonuses and "not likely to be earned" and those bonuses count differently toward a team's overall budget and cap number. In the NFL, bonuses are paid for successful performance and are in excess to an athlete's base salary.

Apparently on Wall Street, a much different conceptualization attaches to performance bonuses than in the world of professional sports. Nine investment banks received bailout funds rather than face collapse, and then turned around in that environment of "failure," and paid bonuses to its executives and employees that presided over that dismal performance, above and beyond salary, to the tune of $33 billion. In some ways, one could interpret this payout as taxpayers (through the TARP bailout) subsidizing the performance bonuses that were paid to executives that engaged in breathtaking risk and lost badly. As would be expected, Congress is inflamed. Edolphus Towns, the chairperson of the U.S. House of Representatives investigative panel called the payouts "shocking and appalling" and announced hearings.

Those that defend paying significant bonuses in the face of failed performance typically claim the following: (1) Wall Street must pay to keep talent at their firms; (2) that only a small group of executives or employees are typically responsible for losses and it is unfair to punish employees or executives in other areas of the business.

AG Cuomo stated: "The banks say they pay for performance. . . . Yet in 2008 there was no performance and they still continued to pay out huge sums of money."

I get the argument that individuals that were not responsible for the damning losses and egregious decision making should not be held responsible or "punished" for the "sins" of the few. Still, that argument fails to appreciate the broken executive compensation system in place on Wall Street. Over and over again, Wall Street executives have shown that they exist in a much different space than the rest of America. From the AIG "retreat" to a posh resort moments after receiving bailout funds to the $33 billion in bonus payouts for 2008 performance, those that run Wall Street seem incapable of recognizing Main Street and the human suffering that continues unabated for many based almost wholly on reckless and irresponsible leadership by Wall Street executives.

What to do about executive compensation?

The New CEO of Xerox: When it Comes to Employment Discrimination, African American Executives May Not Make a Difference

For the first time in American history an African American woman became CEO of a Fortune 500 company. Ursula Burns took over Xerox on July 1st, 2009. Her rise to the top of a major U.S. corporation is one of several exciting firsts for people of color in America. This year the first African American U.S. Attorney General was appointed by the first African American president, and Judge Sonia Sotomayor will be the first Latina confirmed to the U.S. Supreme Court. Marc Morial, President and CEO of the National Urban League , compared Obama, Sotomayor, and Burns. All three were raised without fathers, and their success is the result of a hard-earned meteoric rise from the economically-modest family lives into which they were born.

U.S. corporations like Xerox are microcosms of American society and culture. Xerox, like other American companies, reflects American life. Comparing Xerox and the nation invokes another comparison between Burns and Obama. Their success has convinced many that racism and discrimination are no longer serious problems in the U.S. This is reflected in two comments to an article about the new Xerox CEO. One commentator wrote than “many roadblocks” were “taken down” with Burns’ appointment. Another wrote, “Thank you Ms. Burns for clearing the path for my daughter.” And, of course, as far as President Obama is concerned, Americans have engaged in a protracted debate about whether his election proves that we now live in a post-racial society.

Another comparison - President Obama took over an extremely troubled nation, and Burns took over a very troubled Xerox. In an hour-long lecture at the Whitman School of Management in 2008, Burns talked about the need for good corporate citizenship and she described Xerox as a great place to work. Burns also discussed the fact that Xerox had been a troubled company, and she enumerated the ways the company has attempted to address those troubles. She revealed that senior management worried about “every detail” related to some of the troubles the company faced in recent years. At Xerox, “it’s all about the people” she said. “We love difference.” She described the company’s corporate climate as a culture of diversity, mentioning the usual laundry-list of diversity concerns – age, sexual orientation, gender, race and religion.

During her lecture, Burns talked very briefly and superficially about diversity but she was careful not to mention the “D-word” – discrimination. This is surprising because she said that Xerox managers worried about the details that got them into trouble in recent years. One of those troublesome details should have included the corporate climate that led over one thousand African American sales representatives to file a race discrimination suit that had been settled just months before Burns’ speech. Even though Xerox “adamantly” denied wrongdoing, the company paid twelve million dollars to 1,100 African American sales representatives who alleged race discrimination in promotion, pay, and the assignment of sales territories. Some plaintiffs also complained about blatantly racist comments, and the plaintiffs’ expert proved a “statistically significant disparity between the earnings of black and white salespersons at Xerox.” The company’s response to this was that the disparity was the result of “inferior performance.”

Burns never mentioned the race discrimination class action in her speech at Whitman. I cannot find any reports that include any comments she may have made about the litigation, the settlement, or the issue of race discrimination at Xerox. Perhaps Burns agrees with commentators who assert that the U.S. is now post-racial and that roadblocks or impediments that impede the professional advancement of people of color no longer exist. But disparities in income and promotion rates belie the conclusions that racism is no longer a problem, and so do the number of complaints about race discrimination filed with the Equal Employment Opportunity Commission and in courts. Every day life in America for most people of color establishes that racism persists.

Xerox’s response to the race discrimination class action – adamantly denying all allegations and blaming pay disparities on the inferior performance of hundreds of African American sales representatives – ensures that very little will change for the company’s employees of color. Because corporations are microcosms of society in which racism persists, it is very unlikely that there is no discrimination within a company that employs thousands. Even though a task force was established as part of the settlement, it is not likely that things will improve as far as discrimination is concerned if the discrimination problem is not discussed or even acknowledged. Things certainly cannot improve if corporate leaders do not even mention the persisting problem of discrimination.

Burns and other corporate leaders are willing to talk about diversity but are silent about discrimination. In a law review article, I wrote about the important difference between discrimination and diversity. A company that focuses only on diversity efforts, without considering the persistent problem of discrimination, will inevitably and predictably face complaints from, and possibly litigation brought by, employees of color. This is so because American corporations are part of a society that has not eradicated race discrimination. Diversity efforts will increase the numbers of people of color in a corporate workplace, but diversity efforts, without anti-discrimination efforts, make it more likely that the company will have to litigate or mediate disputes about discrimination.

Before Ursula Burns at Xerox, only seven African Americans have served as CEO of Fortune 500 companies - all of them male. None have spoken out against societal or corporate race discrimination. As far as corporate race discrimination is concerned, very little seems to change when the CEO is Black.

The fact that Burns failed to mention discrimination in her 2008 speech that was given just months after Xerox settled a race discrimination class action inspires yet another comparison to President Obama. He too has seemed reticent to talk about race and racism. For example, when asked to comment on the disproportionate impact of the economic downturn on African Americans and Latinos, President Obama’s typical response is that things will improve for people of color when things improve for all Americans, regardless of race. But his answer ignores the many types of economic discrimination that impede the economic advancement of Americans of color. For example, in the years leading up to the current economic downturn, African Americans and Latinos were targeted for predatory loans. Even middle-income African Americans and Latinos were targeted and offered subprime mortgages even though they were creditworthy, and even though similarly-situated white borrowers received prime loans. There is discrimination in retail sales also. African American and Latino consumers pay more for cars, and receive inferior service in many retail stores. And, recent unemployment rates for African Americans and Latinos are significantly and disproportionately higher than the unemployment rate for white Americans.

Look what happened when President Obama did speak explicitly about race. Negative reaction to the president’s comments about the arrest of Professor Henry Gates in his own home eclipsed his attempts to reform health insurance. And, Judge Sotomayor’s “wise Latina” comment in speeches made before her nomination caused some delusional conservatives to call her a racist. These are symptoms of a society in which the discourse about race is frustratingly pallid. No wonder Burns and most African American CEOs stay away from the topic of race.

Consumer Financial Protection, Understandable Disclosure and Financial Education

Congress has developed a 10-member commission to determine the causes of the financial crisis. The commission will be chaired by former California State Treasurer Phil Angelides and former Ways and Means Committee Chairman Bill Thomas will serve as vice chairman. As we await the findings of the report, there are certain observations that we can make. Firstly a “pricing correction” can occur when investors least expect it, in any sector—real estate, insurance, and, of course, banking. Secondly, the federal government will provide an infusion of necessary capital when certain companies that are viewed as “too big to fail” are on the precipice of a financial meltdown. Thirdly, despite federal disclosure laws, investors are not always given “understandable disclosure” that allow investors to adequately comprehend investment options and to make reasonable investment decisions. For example, whether lenders adequately explain the intricacies between a fixed rate 30-year mortgage vis-à-vis a 3-5-or-7-year adjustable rate mortgage to potential homeowners is never clear. Presuming that lenders do provide adequate explanation of loan terms, a fundamental question remains– does the average investor “sufficiently understand” the loan terms to make a “reasonable” decision as to what is best for him or her?

It is this disconnect between disclosure, understandability and reasonable decision-making, which challenged Professor Elizabeth Warren to propose the creation of the Consumer Financial Protection Agency Act of 2009 (“CFP”). Congress has been listening to Professor Warren and it appears as if the proposed Consumer Financial Protection Agency Act of 2009 will likely be adopted. CFP will have regulatory authority over retail financial products including mortgages and credit cards. CFP’s principal directive is to ensure that consumers “have, understand, and can use the information they need to make responsible decisions.” CFP will accomplish its goal by doing more than simply providing information to the public; it will develop “standard” consumer financial products that consumers can compare to financial products offered by the private sector. More importantly, CFP can prohibit the private sector from offering to sell financial products in the marketplace that create “substantial injury to consumers” which is “not reasonably avoidable by consumers” such as the rapid loss of home values, in part due to, underwriters’ over-valuation of homes.

As part of CFP’s consumer protection mandate, it will design standard plain vanilla financial products that should be offered to potential borrowers along with the more exotic financial products offered by private sector lenders. More importantly, CFP has the authority to require that private lenders modify the terms of their financial products that would create “substantial injury to consumers” which is “not reasonably avoidable by consumers. Some commentators have argued that consumers will more than likely select the CFP financial product in lieu of the private sector financial products. However, private lenders that sell CFP designed standard vanilla financial products will be insulated from lawsuits, that is, to say they will be to a large extent, litigation-proof. Protection from litigation is a major advantage for the private lenders, because it shifts the investment risks including interest rate fluctuation, corporate wrongdoing, and poor financial product design, to the consumer. This is not the case for private lenders that sell their financial products despite modifications that CFP may have required the lenders to make to their financial product terms. They are not protected from litigation. Consumers are free to sue such private lenders for any wrongdoing in which a lender may have engaged. We seem to have gone from one extreme to another. I am not certain as to what the correct answer should be. However, a more balanced alternative should at least be considered.

Additionally financial education has been pushed to the forefront of the consumer financial protection debate; the Treasury Department recently issued a white paper that concluded consumer finance can be based on actual data “about how people make financial decisions.” The findings of the research indicated that a majority of consumers do not make reasonable decisions because they cannot understand financial product terms. This should not be a surprising discovery to any one involved with the financial and securities industries. The Financial Regulatory Administration Investor Education Foundation has been providing and sponsoring investor education and research programs for years. [link]Several years ago, I was appointed as the inaugural director of the St. John’s University School of Law Securities Arbitration Clinic (“Clinic”). In addition, to representing small investors in securities disputes with their financial advisors, the Clinic provided financial literacy seminars to the public. The Clinic captured a great deal of empirical data from investor questionnaires, interviews, and intake sheets that reflected a dearth of basic understanding of investment terminology. Nevertheless, these investors were usually categorized by their financial advisors as having an aggressive investment profile with a high risk tolerance. It was always a mystery to me as to how these small investors could be so grossly mis-categorized as to their risk tolerance. Oftentimes, it was simply a matter of an investor misunderstanding what the investment term actually meant. For example, “aggressive profile” does not relate to a personality trait. It relates to whether an investor can withstand the financial and emotional upswings and unpredictable downswings of their investment. It seems almost laughable but many, many investors do not understand the meaning of such basic investment terminology. More importantly, a misunderstanding of this magnitude usually resulted in an investment loss because the investor is inappropriately invested based on his risk profile. Therefore, if consumer financial protection is to be effective, financial education must be an integral part of consumer financial protection.

Financial education should not be left to federal agencies and business schools to provide. Consumer financial protection overlaps commercial, investment and legal issues. Law schools can play a pivotal role in providing financial education programs to the communities within which they are located. I have encouraged law students at St. Thomas University to provide financial education seminars to under-served communities in South Florida with the cooperation of the Federal Reserve Bank of Georgia and War on Poverty FL-Inc. In a time when many law schools are incorporating practicum components to their law school curriculum, financial education programs appear to be the proverbial win-win because the program benefits law students by providing them with a better understanding of the financial world in which they will be practicing attorneys, and the program unquestionably benefits the consuming public.

PRUDENTIAL BANK DIVESTITURES

One of the key failures of the too-big-to-fail approach to systemic financial insolvency is its failure to stem economic catastrophe to any substantial extent. In fact, after the federal government rescued the reckless bankers from their self-created abyss, those same bankers proceeded to strangle the economy by hoarding capital and reducing lending. The chart illustrates the point. After the government expended vast sums to bailout the banks they reduced lending by 23% and hoarded capital at the Fed (where bank reserves soared). Meanwhile, massive capital flowed into the purchase of short term Treasury obligations (driving yields to zero and even into negative territory). This amounts to an historic flight to safety driven by severe risk aversion. This sudden reduction in credit led to GDP contractions of over 6% in both Q4 of 2008 and Q1 of 2009, the worst performance since 1947. The credit crisis caused the economic contraction, not the other way around. The bailouts thus failed. Therefore, avoiding the costs of too-big-to-fail in the future is the critical litmus test of any putative financial reform.

In a forthcoming law review article, entitled “Subprime Bailouts,” I argue that financial elites hopelessly distorted the government’s response to the recent financial calamity. More specifically, I suggest that our political leaders eagerly protected the financial elite from the harsh consequences of failing within a capitalist framework while leaving the taxpayer to pay the bill. Moreover, our leaders neglected the most compelling needs of our society in general, such as rendering aid to the victims of predatory lending or resolving the foreclosure crisis plaguing residential real estate.

I also articulate a minimalist solution to the problem of “too-big-to-fail” that is at the core of the issue. As I previously discussed on this blog, the Obama administration decided to formalize the actions of the Bush administration with respect to very large financial institutions; under both administrations the government ultimately stood behind such financial behemoths and expended trillions to keep them out of bankruptcy or FDIC receivership. Obama takes the Bush approach one step further: under the administration’s proposal the law would now explicitly empower regulators to extend special financial assistance for so-called “tier one financial holding companies.”

One simple solution to the “too-big-to-fail” quandary would be to empower a federal regulatory agency to monitor the systemic risk posed by any large financial institution and to order the divestiture of assets, divisions or particular operations if the financial institution poses a significant risk of requiring federal assistance under the proposal promulgated by the Obama administration. Government ordered divestitures already have a successful history ranging from AT&T in the 1980s to the Standard Oil Company at the turn of the century. Given the very costly bailouts of recent vintage, and the cratering of the economy in the aftermath of the bailouts, the government certainly has a compelling interest in the divestiture of financial institutions that threaten the entire global economy.

The administration’s proposed legislation currently includes a divestiture provision, in section 6A(f)(2)(F). That divestiture provision is only triggered if an affiliate nears insolvency or poses a significant threat to the financial holding company. The power to order divestiture should be expanded to permit regulators to order divestiture whenever a firm becomes or threatens to become too-big-to-fail. Regulators would consequently have the power of paring back any bank that even threatens to become too-big-to-fail. A single additional sentence could achieve this outcome. The solution proposed here supplements the approach of the Obama administration (and others). By focusing on systemic risk (rather than mere size) presented by a financial firm it is the most direct means of dealing with systemic risk. Creditors could not assume that any firm would remain too-big-to-fail and would therefore have the right incentives to secure repayment.

Such divestitures would be highly unlikely to harm shareholders as it could be accomplished through a spinoff of shares to shareholders. Moreover, even before the recent financial crisis there was little proof that these financial behemoths enjoyed real economies of scale. It appears that the real driving force towards concentration in the financial services industry is the elimination of competition and the compensation of CEOs, which increases with each empire-building acquisition.

The financial elite that benefits from the bailouts implicit in too-big-to-fail should support this proposal for prudential divestitures. The system of implied bailouts from a supposed principle of too-big-to-fail spawned enormous excess risk in the global financial system. Numerous firms looked into the abyss of insolvency, and global financial meltdown. Certainly, the outstanding leaders within the financial sector would appreciate the risks of artificially cheap capital flowing into large financial firms combined with an explicit “heads I win, tails you lose” legal framework. Such a system is inherently unstable, and could create enormous political backlash for far more punitive regulatory reform. Only an elite obsessed with short term profits would ignore the dangers of an unfettered too-big-to-fail legal regime. Such an elite ought not to assume that future calamities will operate as beneficially as the recent crisis in terms of their interests.

Professor Steven Ramirez

Loyola University Chicago

What is "Corporate Justice?"

In preparing my first blog post, I began to ponder the meaning of the words “corporate justice.” Immediately, I was reminded of Plato’s book entitled The Republic, detailing Socrates’ dialogue with Thrasymachus, Adeimantus and Glaucon, outside the city of Athens at Polemarchus’ house. It is with this backdrop in mind that I began to contemplate the true meaning of “corporate justice.”

Socrates defined justice as "working at that which he is naturally best suited," and "to do one's own business and not to be a busybody." He further explained that justice must sustain and perfect the three cardinal virtues of temperance, wisdom, and courage. Socrates did not include justice as one of the cardinal virtues. Instead, a close reading of The Republic reveals that Socrates believed justice to be a function of structure, order and control. According to Socrates, justice is not a priori; people are not hardwired for it.

As a result of these fundamental tenants, Socrates reasoned that in order to have a just society, society needs order. To accomplish this ideal society, Socrates created a republic wherein people were divided into three classes; the ruler, the soldier, and the producer. If the members of each class did what they were supposed to do, then justice would prevail. The rulers were responsible for giving orders that were motivated by an interest to benefit society rather than self gain (not surprisingly, in Socrates’ just society, the rulers happened to be the philosophers or what Socrates called the “philosopher kings”), the warriors were responsible for carrying out these orders, and the producers were responsible for obeying these orders. The people that made up each of the classes were separated by their ability to control their “worldly” appetites or indulgences. The rulers had to exercise the greatest level of control. In exercising this responsibility, their primary objective was to put their own selfish motivations aside and to act in the greatest interest of society.

Based on Socrates’ aforementioned conception of justice, in modern society the corporation (really the board of directors) has become the modern day philosopher king (ruler). The officers and upper level management are the “warriors,” and everyone else is a “producer.” Because of the corporation’s role as the ruler, the corporation has a larger social responsibility. Much like, the philosopher kings in Socrates just society, the corporation must control its appetites and avoid the temptation of indulgence.

This begs the question of how a corporation must act within a just society. Extrapolating from Socrates’ discussion in the Republic, a corporation in a just society will “do what it is naturally best suited to do.” This responsibility may include tasks such as selling products, or consulting with clients, etc. In exercising these tasks, corporations in a just society must act with an interest to benefit society rather than an interest solely of profit. Thus, corporate justice should focus on diversity, acceptance, advancement of a global marketplace, and more importantly, the overall interests of society rather than selfish gain because these things focus on societal good and social responsibility.

The prevailing motivation of the corporation in modern times is that of profit maximization and shareholder gain. This system promotes injustice because it often only rewards those corporations that are profitable and reinforces a mantra of “profit at all cost.”

If Socrates’ conception of justice and its relationship to order is accurate, in re-evaluating the way in which we think about corporate justice, should the law impose greater controls to accomplish a more just society? More specifically, does greater corporate governance promote corporate justice? For example, in addition to the duties that a corporation (really the board of directors) owes to its shareholders, should the law go a step further and impose an affirmative duty of care/loyalty from the corporation to society as a whole? If such a duty did exist, would we have experienced the most recent occurrences of financial greed and corruption (Enron, AIG, Lehman Brothers, etc.) ?

AFFINITY FRAUD: INVESTOR BEWARE!!!

Affinity Fraud: A Major Problem that the General Public Knows Little About

With the large downtick in the economy, there has been a noticeable uptick in fraudulent activity. INVESTOR BEWARE!!! Recently, Securities and Exchange Commission (“SEC”) Commissioner Luis Aguilar delivered a speech in Atlanta on May 28, 2009, at the Third Annual Fraud and Forensic Accounting Education Conference where he talked about fraud at home and abroad. Commissioner Aguilar spent time in his speech talking about affinity fraud and Bernie Madoff’s Ponzi Scheme. When you utter the words “affinity fraud” to most members of the general public you undoubtedly draw a blank and a puzzled expression. What is affinity fraud? Well, affinity fraud is the name given to a fraudulent scheme that targets members of a specific demographic. Victims of affinity fraud are often targeted because of their race, ethnicity, age, class, gender, national origin, religion, immigrant status, social, cultural, or professional affiliations. Affinity fraud organizers portray themselves as members of the targeted group or as individuals who can relate to members of the group in order to garner the group member’s trust and money.

Peeling back the layers, Ponzi and Pyramid schemes often exhibit elements of affinity fraud in that a particular demographic is targeted and victimized. A Ponzi scheme is a fraudulent investing scam promising high rates of return with little risk to the investor. The Ponzi scheme generates returns for old investors by acquiring new investors. Eventually, Ponzi schemes collapse when new investors can no longer be acquired. A Pyramid scheme is an illegal investment scam based on a hierarchical setup. “New recruits make up the base of the pyramid and provide funding, or so-called returns, given to the earlier investors/recruits above them.”

The dialogue in an affinity fraud scheme is often basic. “You can trust me because I’m African-American just like you,” the scam artist will often say. The affinity label or demographic identification can go on and on and on. “I’m a Baptist like you.” “I’m a member of your fraternity.” “You know you can trust me because I’m elderly like yourself.” I think you get the picture. The scam artist will conclude by saying “because we share the same experience and background invest your money with me, I’ll get you a fabulous return.”

Affinity fraud has become such a large problem that recently the SEC publicized the problem in a publication designed to educate the public. Affinity fraud is on the radar screen of state regulators, securities and corporate commissions, and attorneys general. Indeed, affinity fraud schemes have been uncovered in Canada, Australia, and New Zealand and throughout the world.

Bernie Madoff and Affinity Fraud

In recent months, unless you have been living under a rock, or lived on a deserted island as a result of a plane crash, we have all heard the name Bernard “Bernie” Madoff at least mentioned and discussed. One thing is certain: Bernie Madoff will live in infamy!!! Usually, in legal circles we lament the leniency of white collar crime sentences. In June, Bernie Madoff was sentenced to 150 years in prison. This month, Madoff was moved to a federal prison in North Carolina, to serve his sentence for his part in a $50 billion Ponzi scheme. This represented an extremely harsh and unprecedented sentence for a white collar crime. United States District Court Judge Denny Chin had no remorse for the 71 year-old Madoff, and balked at the 12 year sentence suggested by Madoff’s lawyers based on his age. Perhaps this time for a white collar criminal, the time fit the crime.

Madoff’s “client” or “victim” list ran over 160 pages in length and included over 13,500 names. The Madoff scandal amounts to “…a $50 billion Ponzi scheme that preyed heavily on fellow Jews and ultimately drained the fortunes of numerous Jewish charities and institutions.” One important factor lost in the Madoff scandal is how he used his religious affiliation and background to target other Jews who trusted him. In some ways, Madoff exploited his religion to extend his fraudulent scheme.

Examples of Recent Affinity Fraud Schemes Investigated by the SEC

A selected group of recent affinity fraud schemes uncovered by the SEC include the following:

Ponzi scheme solicited elderly members of Jehovah’s Witnesses congregations
The SEC complaint alleges that the defendants operated a Ponzi scheme and used investor funds to pay lavish personal expenses. The defendants raised over $16 million from more than 190 investors nationwide. Many of the victims were elderly members of Jehovah’s Witnesses congregations and were promised returns of up to 75 percent.

Ponzi scheme targeted African-Americans and Christians
Defendants perpetrated an affinity fraud, raising at least $16.5 million from mostly African-Americans and Christians by falsely representing they would receive returns through investments in, among other things, real estate, small businesses, and "markets of the world."

"Church Funding Project" costs faithful investors over $3 Million
This nationwide scheme primarily targeted African-American churches and raised at least $3 million from over 1000 investing churches located throughout the United States. Believing they would receive large sums of money from the investments, many of the church victims committed to building projects, acquired new debt, spent building funds, and contracted with builders.

125 members of various Christian churches lose $7.4 million
The fraudsters allegedly sold members non-existent "prime bank" trading programs by using a sales pitch heavily laden with Biblical references and by enlisting members of the church communities to unwittingly spread the word about the bogus investment.

Practical Advice on How to Avoid Affinity Fraud

Often, regulators and governmental authorities move in too late to protect the general public from affinity fraud. The Madoff scandal is a prime example of the late and ineffectual policing of affinity fraud schemes on the part of governmental actors. Ironically, the SEC thought it was important to educate the public about affinity fraud; but ignored or failed to investigate concrete allegations against Madoff that had been brought to the SEC’s attention months and years before the Madoff scandal became public knowledge. The government can’t always help you avoid affinity fraud. YOU MUST PROTECT YOURSELF FROM AFFINITY FRAUD. Here are some tips and suggestions to follow:

· Make sure that the seller/promoter and investment are registered and licensed in your state. Call your state securities regulator.

· Seek the advice of a neutral professional, not affiliated with the investment or group, who you trust to evaluate the risks and merits of the investment. This could be an attorney, accountant, or financial planner you trust.

· Investigate all statements and representations, even those coming from friends or loved ones; after all they may have been duped themselves. Do your own due diligence.

· Be extremely cautious of investments that are “no-risk” offer or “spectacular” and “guaranteed” profits and returns. VIRUTALLY ALL INVESTMENTS INVOLVE RISK. If it is too good to be true, it probably is too good to be true.

· Get it in writing! If an investment is not described in writing this should raise a major red flag. If someone tells you to keep an investment confidential, be cautious. Obtain a prospectus or other written information on the investment.

· Scam artists are tech-savvy. Watch out for unsolicited emails from people you don’t know that introduce you to an investment opportunity.

· Take your time to investigate. Don’t feel pressured to rush into an investment before you have had time to think about it. “Once in a lifetime” opportunities may ruin your financial life and well-being.

Credit Card Accountability Responsibility and Disclosure Act

At President Obama's request, Congress recently passed legislation to protect consumers from rapacious credit card companies practices. I have written at length about how credit card legislation is necessary to protect all Americans, but in particular college students, whose credit card use often leads to overspending and amassing debt.

Every fall, credit card companies descend on college campuses armed with free gifts to entice students to sign up for credit cards. The newly-enacted Credit Card Accountability Responsibility and Disclosure Act of 2009 attempts to curb these practices. In 2010, a credit card company will not be able to issue cards to a consumer under the age of 21 unless the consumer has a consigner or demonstrates he or she is financially capable of repaying credit card purchases. Unfortunately, that means students with limited resources and from economically disadvantaged backgrounds could be shut off from obtaining credit when they need it most (i.e. to purchase books for classes). The Board of Governors of the Federal Reserve System is supposed to propose safe harbor provisions to prevent this problem.

The Board should also come up with guidelines regarding mandatory education. The root of the credit card debt problem among college students is illiteracy. The Board could create a model program that universities could institute to educate their students on responsible credit practices. The kind of education that is necessary is financial education that enables students to make financially wise decisions and protect their credit history – the asset or liability that will follow them the rest of their lives.

Creola Johnson
Professor of Law
The Ohio State University Moritz College of Law