Quoth the Raven: The Maryland Law Faculty Blog

Teaching the Dodd-Frank Act

Michelle Harner

It’s official; the President signed the Dodd-Frank Wall Street Reform and Consumer Protection Act yesterday.  President Obama commented that the Act “is designed to make sure that everybody follows the same set of rules, so that firms compete on price and quality, not on tricks and not on traps” and that the reforms “represent the strongest consumer financial protections in history.“  Well, maybe.  The Act certainly is historic and introduces the most sweeping financial reform concepts since the Great Depression.  Nevertheless, lobbyists did succeed in exempting certain players (e.g., auto dealers, end-users, etc.) and clawing back certain provisions (e.g., funding for resolution authority, limits of accredited investor status, etc.).  Moreover, the impact of many provisions depends largely on who is appointed to lead the charge (particularly with respect to the Consumer Financial Protection Bureau) and the content and enforcement of many yet-to-be-written rules.  (Notably, one account estimates that the Act contemplates 243 new rules and 67 new studies.)

Bank of Evil?

Michelle Harner

I took our kids to see Despicable Me yesterday.  Although they really enjoyed the little yellow minions in the movie, I was struck by a scene in which the lead character (a career villain) visits his local bank to request a loan.  The bank’s name is displayed as “Bank of Evil,” with the following notation underneath:  “formerly known as Lehman Brothers.”

I chuckled a little when I saw this reference, as did a few of the other adults in attendance.  I then spent most of my remaining time at the theater, however, reflecting on the demonization of those associated with the financial crisis.  Clearly, the financial crisis wreaked havoc not only on our financial system, but also on the lives of millions of people.  And people are still hurting, as evidenced by the unemployment and foreclosure numbers and talk of a double-dip recession.  So I understand the human need to vent frustration and point the finger at someone or something.

Financial Reform: Are We Up to the Task?

Michelle Harner

As anticipated, the House of Representatives passed the financial reform compromise bill (the Dodd-Frank bill) last week.  (For summaries of the bill, see here and here.)  The Senate, however, has postponed its vote until mid-July.  Proponents expect a much closer vote in the Senate, and Democrats are scrambling to secure the required votes.  Further compromise on the bill likely will be necessary to reach that goal.

That being said, many believe that the Dodd-Frank bill ultimately will pass.  And it is quite an undertaking—this bill itself is over 2,000 pages.  The task of implementing and enforcing most of the bill’s provisions is delegated to federal agencies, many of which are already overwhelmed, understaffed and underfunded.  Moreover, the recent performance of some of these agencies is underwhelming (see also here, here and here).  So where does that leave us?

BP and the Economic Crisis: Déjà vu?

Michelle Harner

The similarities between the BP oil spill in the Gulf of Mexico and the recent economic crisis are striking.  The unthinkable happened to trigger both disasters—a blowout preventer on a deepwater oil rig fails in the former and the housing market bubble bursts in the latter.  Formidable corporations are at the center of controversy regarding disclosure, compliance and resulting liability.  Bankruptcy is being discussed.  And the short sellers are circling (see here and here for BP).

I am not the first to suggest similarities between these two events (see here).  (I of course also recognize that there are differences, including the tragic loss of life associated with the oil spill.)  I want to take a moment, however, to reflect on the extensive risk management failures evident in both.

My colleague Robert Rhee posted an excellent discussion regarding how to teach the BP case, and he suggests, among other things, using BP as a case study to teach the importance of “legal risk in the context of a broader risk analysis, which increases the lawyer’s effectiveness and situational awareness.”  I completely agree with Robert.  I also think commentators and policymakers can use BP and the economic crisis to evaluate best practices in corporate governance and applicable law (in the U.S. and abroad) with respect to overall risk management practices.

Financial Reform: Compromise Got It Done

Michelle Harner

Deadlines can compel action.  That certainly appears to be the case with financial reform legislation and this weekend’s G8 and G20 summits.  President Obama wanted to walk into the summits with financial reform in hand, and he got exactly that (see the President's comments here).  Although the bill must still receive final approval from the House and the Senate, the compromise reached by the conference committee early this morning suggests that the Democrats may be able to line up the necessary votes as early as next week.  (For a summary of the bill, see here.)

I have not yet seen the language of the conference committee’s report, but it appears that last minute compromises within the Democratic party got the job done.  (Indeed, no Republican member of the House and Senate panels voted in favor of the report (see here).)  For example, Senator Lincoln’s proposal to force banks to spin off all derivatives operations was softened, allowing banks to maintain certain trading operations for derivatives with lower risk profiles such as “interest-rate swaps, foreign-exchange swaps, and gold and silver swaps” (see here).

The compromise facilitating the conference committee’s report also included some punts.  For example, the report does not endorse creating the Credit Reporting Agency Board.  (For a discussion of the CRAB, see my prior post here.)  Rather, it directs the SEC to study the matter to determine whether such an oversight board is warranted (see here).  Likewise, the report gives the SEC discretion to raise standards governing broker dealers (after further study) and to grant shareholders proxy access with respect to director nominations.  (For an explanation of different approaches to governance issues in the reform legislation, see here.)

Even with the compromises and punts, the Dodd-Frank Act (the name given to the financial reform bill coming out of the conference committee) is the most significant overhaul of financial regulation since the Great Depression.  It undoubtedly is going to shake up the financial sector, and firms will be spending millions of dollar to comply with the new standards.  What remains uncertain, however, is whether the new regulations will in fact address the systemic risk and human factors that contributed to the severity of the recent recession.  I look forward to addressing some of those issues in future posts.

The Battle at Lions Gate

Michelle Harner

Carl Icahn—whether you prefer to view him as a corporate raider or an activist investor—has been very busy the past several years.  For example, as a debt investor/bankruptcy participant, he has gained control of Tropicana Casino & Resort and Fontainebleau Las Vegas Holdings LLC and waged an aggressive battle for Trump Entertainment.  As an equity investor, he has worked to influence decisions at companies such as Yahoo, Biogen and Genzyme.  And most recently, he has been sparring with the board of directors of Lions Gate Entertainment Corp.

Lions Gate is a Canadian company, doing business primarily in Santa Monica, California, and perhaps best known for producing movies such as the new release Killers and the horror franchise Saw and the hit television show Mad Men.  Carl Icahn has owned stock in Lions Gate since 2006 and has recently stepped up his efforts for control of the company.  Interestingly, the markets have rebuffed Mr. Icahn’s pursuit at most every turn.  First, bondholders accepted a deal with the company over Mr. Icahn’s debt tender offer in 2009.  Next, shareholders responded in a similar fashion to Mr. Icahn’s equity tender offer in 2010, with only 13.2% of Lions Gate’s shareholders tendering their shares to date.  And in the middle of all of this action has been the looming threat of a “poison put” in Lions Gate’s $340 million credit facility. 

A poison put or change of control covenant typically gives lenders the ability to declare a default under the loan documents upon a change of control at the company.  There are numerous ways to draft these covenants—e.g., based on stock ownership, board composition, etc.—and the percentage trigger can vary.  For example, the Lions Gate covenant trigger reportedly was defined as “a shareholder gaining more than 20% ownership.”  Consequently, Mr. Icahn’s takeover pursuit raised issues under Lions Gate’s credit facility; a fact that both sides tried to exploit to their respective benefit.  Lions Gate raised the covenant and potential default as a reason for shareholders to reject Mr. Icahn’s tender offer (see here).  Mr. Icahn argued that his inevitable ownership of more than 20% of the stock and the resulting default deserved the board's immediate attention (see here).  Mr. Icahn further explained, “What I find to be the most egregious part of this problem is the fact that it was created entirely by you—had the board not agreed to these controversial ‘poison put’ provisions in the first place, shareholders would not be in the dire situation in which we now find ourselves.” 

The CRAB

Michelle Harner

I thought it would be appropriate for my first post on our new blog at the University of Maryland School of Law to discuss the CRAB—no, not the succulent crustacean that you can experience in restaurants throughout our great state, but rather the proposed Credit Rating Agency Board.  And for those of you who are not fans of the acronym (or think it is a product of Senator Franken’s humor), as one of my good friends pointed out, it is probably better than Credit Rating Agency Panel. (I of course recognize that some of you may think that a more appropriate acronym.)

So what is the CRAB?  Senator Franken proposed the concept as an amendment to the Senate’s Restoring American Financial Stability Act of 2010.  Under the amendment, the Securities and Exchange Commission would appoint an independent board to determine which credit rating agencies are qualified to provide ratings and then randomly assign issuers to these agencies.  (For a general description, see here and here.)  The primary thrust of the amendment is to mitigate the acknowledged conflict of interest created by the issuer-pay model currently used by the big three agencies—Standard & Poor’s, Moody’s and Fitch—and others.  Under that model, the issuer of the security to be rated selects and pays the credit rating agency, thereby providing incentive for the agency to provide the desired rating.  There are of course similar problems with the primary alternative to this model, i.e., the investor- or subscriber-pay model.  (See here and here.)

Although I think the CRAB might be a slight improvement over the current system, it really does not address some of the key contributors to the financial crisis—e.g., greed and ignorance.  I know that sounds harsh, but let’s face it, the desire to earn more money drove traders, bankers, credit rating agencies and others to ignore warning signs and cede to the pressures to keep the good times rolling as long as they could.  (For comments on this conduct and the related criminal investigation, see here.)  As one employee from Standard & Poor’s put it, "Let's hope we are all wealthy and retired by the time this house of cards falters." (See here for more emails.) Moreover, blind reliance on assurances from traders, bankers and credit rating agencies and a wide-spread failure to understand the true nature of the investment products facilitated and prolonged the charade.  (For a tragic illustration of these two points, see here.) 

Yes, the CRAB may prevent some of the horse-trading that undoubtedly goes on under the issuer-pay model, but it will not eliminate all pressures placed on credit rating agencies to deliver good ratings.  It also does not provide any resources or incentives for credit rating agencies to implement substantive internal changes that might improve methodologies, analyses and the accuracy of ratings.  Notably, there are no sanctions or other consequences for inadequate procedures, conflicts or mistakes.  In fact, unlike the House financial reform bill, the Senate version would not revoke the liability exemption for credit rating agencies under the 1933 Securities Act.  (For comparisons of the bills, see here, here and here.)

So is the CRAB a necessary reform?  (For arguments against and recent attempts to quash it, see here and here.)  On balance, I think the oversight, transparency and liability measures in the House bill, as well as the provision in both bills eliminating the reference to Nationally Recognized Statistical Rating Organizations in legislation, are more significant.  (For an excellent overview of the issues and potential solutions, see Frank Partnoy’s whitepaper here; Lisa Nicholson also gave an outstanding presentation on issues relating to reliance on credit rating agencies and computer models at the 2010 Law & Society Annual Meeting.)  Nevertheless, the concept underlying the CRAB—trying to keep the agencies honest—still has a role to play.  Perhaps a modified version of the concept, like a random audit format where the board (or body charged with oversight) periodically identifies issuances to undergo a second rating by a randomly-selected qualified agency, might instill discipline without chilling competition and innovation. 

Credit rating agencies are and will continue to be key players in our global economy, as evidenced by the impact of the recent downgrades of Greek and Spanish debt and the EU’s efforts to adopt its own ratings reform.  As U.S. ratings reform works its way through the conference committee, I hope we stay focused on reducing reliance and increasing meaningful oversight and accountability.  Otherwise, little is likely to change.  Remember Enron and the Credit Rating Agency Reform Act of 2006?