"A former member of The Goldman Sachs Group's board of directors was charged today with giving confidential tips to Galleon Management hedge fund founder Raj Rajaratnam. It was the latest allegation in a far-reaching Securities and Exchange Commission investigation of insider trading."
Go here for one of many iterations of the story.
Why do we find plainly so many immoral or amoral actions (and inaction) taken by so many of the people running some (not all) of the top tiers of various entities in the financial sector ? The question is posed in light of this February 5 post at The Epicurean Dealmaker (TED). According to TED, financial instruments are just products, and TED argues that fraud is legal when selling products, based on the rule of caveat emptor. TED is wrong. Like many others, TED does not know the law applicable to sellling products. TED also does not know that the law of New York - and every other state - implies a duty of good faith and fair dealing in ALL contracts, including contracts to sell products. There are no exceptions for contracts involving financiers.
TED is who or what? TED is a fascinating blog presenting the occasional writings of an anonymous, blunt, smart banker who writes with candor and passion regarding the financial sector, and the habits and nature of its denizens. I usually do not respond to or quarrel with TED. To the contrary, the posts at TED are usally enjoyable and insightful (not to mention erudite and sometimes humorous). GlobalTort therefore includes several prior links and cites to TED, usually for his candid statements about the real wold ways of parts of the financial sector. For examples, read this post on Goldman Sachs' self-dealing, or this one on ineffective regulation. Also enjoy this additional post on Goldman Sachs. Best of all, read my personal favorite – TED's thoughts after the world’s best and brightest bankers told Congress they did not and could not foresee the financial fiasco. In short, TED argued that the claimed lack of foresight was self-induced because foresight was simply not relevant to the players due to their pursuit of profit in a manner that rendered everything else immaterial and irrelevant. Of course, TED was correct. And, others have shown that indeed the financial fiasco was in fact foreseen - and written about - decades ago; read here. See also this prior post on the financial sector's truly belated insight that perhaps it must think about conflicts of interest, and perhaps should even disclose them.
Where did TED go wrong in his latest post ? In some ways, it's mundane because it starts with TED once again noting yet another admitted example of financial fraud by bankers. This time, however, TED went further and played lawyer, but not well. In short, TED used the rest of the post to argue that fraud and half-truths are a permitted part of the process of selling "a product." According to TED, bankers are selling products and all is fair when selling " a product."
TED's argument is wrong on the law. Way wrong. Dangerously wrong. Indeed, trial lawyers dream of events such as trying a case against TED's employer, and putting TED and his last post in front of a jury. For the financial sector, TED's writings are worse for the defendant than anything from corporate files that I've seen in almost 30 years of litigation, excluding the decades of damning tobacco documents.
TED's legal blind spots? To start, he apparently never learned that snake oil nake oil sales were long ago banned. TED can expand his appreciation of the law and history of product sales by reading Ann Anderson's book tracing the rise of the FDA to end snake oil sails and other acts of knowing or reckless fraud. TED might also want to read the United States Code section providing criminal penalties for fraud conducted by wire or mail. Also relevant is New York's Martin Act, a favorite of prosecutors. TED's education on fraud may then move forward to reading articles by Professor Twerski to learn that courts tossed out privity of contract limits back in the mid-century, and imposed implied product warranties far stronger than TED grasps.
As to product sales, TED also needs to learn that the 1960s brought section 402(a) of the Restatement of Torts, and its rules requiring product makers to design and warn against foreseeable harms in their products. TED probably will be shocked to know that product makers suffer liability when their product designs fail, even if the harm was not foreseeable. Imagine if TED and his friends were actually required to pay for all the losses caused by their defectively designed CDOs and swaps. On the product liability law, Wikipedia provides the basic rules here. For more detailed learning on the history and law of product sales, TED might profit from this article by Professors Henderson and Twerski, widely-known product liability gurus.
TED also needs to understand that product makers and sellers labor under post-sale duties to warn about and/or recall defective products, and that liability applies to resellers of products made by others. The rules are described here in an article from Ken Ross, one of the earliest and most respected writers on product liability prevention and planning. Under the post-sale duty rules, TED and friends should have issued warnings about their defective products, and then should have paid to take them all back. (That process is sort of underway, in some settings, as Freddie and Fannie sue the banks for selling defective CDOs, as covered here by the NYT's Dealbook, and here on GlobalTort.)
TED's education is not yet complete. To continue, perhaps an excursis on punitive damages imposed when product makers marketed unsafe products despite knowledge of actual or possible flaws. Today we are drowning in books and the FDIC report detailing the many ways in which TED and his friends knew or were warned that their products were flawed, and that failure was on the horizon. TED will not want to be there to feel what happens if 6 or 12 average Americans are given a chance to vote on punitive damages in a trial against a large bank for most any of the frauds.
Next for TED, a lesson that the law actually does require business partners to act in good faith toward each other. For starters, a jump to Chicago-Kent's law website to read or watch the arguments on the appeal from the Campbell v. State Farm award of $ 145 million of punitive damages when an insurer acted in bad faith in failing to to pay a claim. That number is big enough it might even get TED's attention. (Yes, ultimately; the award was overturned because there was simply too much evidence of bad faith actions by State Farm in cases all across the country, instead of just the state involved.)
To conclude? A banker-focused lesson from Judge Rakoff in a recent case and context TED can readily grasp. In short, the case arose from bankers at JP Morgan acting with exactly the kind of lack of ethics advocated by TED as they sought to achieve unfair ends but claimed they were acting within the letter of law. The case is know as Empresas, and is summariized and linked in this post by Michael Collins at the Economic Populist. Better yet, however, is Felix Salmon's post covering the opinion under the apt title: "How JP Morgan treats its clients: scandalously and in bad faith." Unlike TED, Judge Rakoff did not excuse JP Morgan for just selling a product, and instead issued an injunction to stop JP Morgan in its tracks. The Judge's lesson for TED ? Every contract includes "an implied promise of good faith and fair dealing." The news may crush TED, but it is well-settled law, even in New York.
TED's post is best read at the TED blog. But for those who want to see the gist here, key quotes are set out below.
But there are hybrid businesses within investment banking, as you might expect from an industry which never discovered a profit-making opportunity it didn't like. One of the most important of these is structured products, in which banks take off-the-shelf and proprietary securities and derivatives and slice, dice, and recombine them into customized instruments that they can then sell to corporations or investors. For corporate customers, these are usually marketed as the solution to some particular asset or liability management problem the company has—like, in the simplest instance, turning a fixed rate borrowing into a floating rate obligation via a fixed-to-floating swap. For (usually institutional) investors, structured products are developed to create a customized or semi-customized investment return tied to various indices, underlying securities or commodities, or almost anything under the sun an investor wants to capture. Investment banks tend to be really good at creating structured products, both because they understand the underlying financial instruments and markets as well or better than anyone and because they have hired a raft of really, really smart propeller heads from academia and elsewhere who can manipulate the complicated maths required to structure them.
But look very, very carefully at the preceding description, O Dearly Beloved, and see if you can detect the pivotal distinction. Did you see it? Did you catch the sleight of hand?
But of course you did, because you are so clever. Structured products are just that: customized products, that are manufactured, marketed, and sold to customers. Now they may in fact be (and usually are) sold as solutions to some problem or opportunity the customer wants to address, but they are products nevertheless. And this bears crucially on the proper understanding of the relationship and obligations between the bank which creates and sells them and the customer which purchases them.
***
But in structured products, we are talking about manufactured goods. The bank purchases the raw materials for a trade, creates a structure around these components which delivers a certain advertised set of performance behaviors and characteristics, and sells them to its customer. It sells a product. Accordingly, the customer which purchases a structured product from an investment bank is no more a "client" of that bank—benefiting from a trusted fiduciary advisory relationship—than I am when I buy a can of soda or an automobile. Now it's true that both regulation and norm require that the seller of a manufactured product deliver a good which performs as advertised, and which does not cause unforseen harm or adverse consequences. But Coca Cola or General Motors do not owe me, as the purchaser of their products, any sort of fiduciary obligation or particular duty of care.1
Investment banks are guilty of blurring this distinction themselves, by casually insisting on using the term "client" to describe almost every entity they transact with, whether it is an M&A advisee or the purchaser of a forward start swap. But we are not alone in doing this. Remember the first time you went to look at houses or apartments with a real estate broker, and he or she called you a valued client? Do you also remember how soon you discovered that real estate brokers work for the seller or landlord, who are their real clients, and that you were just a sucker patsy customer? But no matter the particular circumstances, the economic and transactional roles are clear: if someone is selling you a product or a "solution," you are not a client. You are a customer.
And customers do not usually have the right or the ability to see into a seller's manufacturing process to see how the sausage gets made, what type and quality of ingredients are used, and whence the various sources and magnitudes of the resulting profit margin come. I don't know the kind and cost of ingredients that go into my Diet Coke, or the source and cost of the wiring harness in my Range Rover. Do you? Of course not. Manufacturers manufacture things to make a profit. The magnitude and source of that profit is, for me as a consumer, not even a secondary concern. My concern is to get a reasonable quality product which satisfies my needs for the best possible price.
I can try to mitigate the fundamental information asymmetry between the manufacturer of a product and me as buyer in one of two basic ways: I can try to educate myself about the product, and become a more sophisticated consumer, or I can set the seller up in price competition with one or more other sellers to get a better price. Both of these approaches become more difficult for structured products the more customized the product or solution at hand is. And both of these approaches are resisted heartily by the manufacturer, whether it be an investment bank, a soda pop company, or an auto OEM. (Since when did you see any business offer to forgo profits on its activities?) Unless a consumer can manufacture the good she requires herself, she is ineluctably at the mercy of the seller, mitigated only by her negotiating skills.
So count me among the distinctly underwhelmed and non-outraged over Mr. Rosen's tale of woe. Show me examples of for-profit manufacturers that cheerfully offer their customers complete visibility on all their embedded sources of profit, or who refrain from a little game of hide and seek with customers who press them. The information games Mr. Rosen relates arise exactly because some investment bank customers try to become more sophisticated about their purchases, in order to increase their negotiating leverage over price. Some clients are indeed very sophisticated, and those tend to get the best terms and the best price. Most customers are not; they are price takers. But that is true of any market.
I strenuously disagree with anyone who contends that apologists like me are trying to "retroactively apply caveat emptor principles" to this corner of the financial markets. They have always been in effect here. It is only the foolish and incompetent customer who did not realize it. I would like some of the self-appointed defenders of Corporate America or the assembled hedge funds and pension fund investors in the structured products market to go toe-to-toe with these alleged "victims" over the terms and price of a moderately structured security or derivative. Most Treasurers or portfolio managers I know would kick their asses six ways from Sunday. These are not dumb, lily-livered creampuffs who buy our stuff.
Remember when Paul Krugman was exploding with outrage after Goldman' Sach's Mr. Blankfein testified to Congress that the financial meltdown was like a hurricane no one could foresee ? Remember the Epicurean Dealmaker's admonition that the lack of foresight was self-induced?
Perhaps Mr. Blankfein drank his own Kool-Aid. But he was in fact dead wrong, according to this Jason Zweig article in the Wall Street Journal, which includes its own links to other materials. As the article describes, the CDO melt-down was foreseen in concept about seven decades ago by a University of Chicago economist named Melchior Palyi. (One can reasonably wonder if the "find" on Mr. Palyi's work is related to litigation.) In a similar vein, the bloggers at The Conglomerate were last April writing about a 2002 University of Illinois law review as very prescient. That discussion is here.
Back to the merits. A fundamental problem according to Mr. Palyi? Lousy ratings of the safety of bonds. Key excerpts from the article are as follows:
Mr. Palyi, then teaching at the University of Chicago, was a vocal skeptic from the outset. Looking back into the 1920s, he found that investment-grade bonds went bust with alarming frequency, often in the same year they were rated. On average, he showed, a bank that followed the new rules would end up with a third of its bond portfolio going into default.
The record was so unreliable that it would be "still more responsible," Mr. Palyi growled, to "stop the publication of ratings altogether." He was especially troubled that the new banking rules switched the responsibility for credit safety from bankers—and even bank regulators—to ratings firms.
"From there," he warned, it "will have to be shifted again—to someone else," presumably taxpayers. Liquidity, Mr. Palyi argued, was being replaced by what he scornfully called "shiftability," a new kind of risk that could someday "be magnified into catastrophic dimensions."
In response to his criticism, government researchers studying how to apply bond ratings changed their method for calculating the performance of investment-grade bonds. By 1943 they had come up with an oddly contorted median that magically improved the track record of the ratings providers.
This switcheroo, recently documented for the first time by economists David Levy of George Mason University and Sandra Peart of the University of Richmond, legitimized the new regulatory model and flushed Mr. Palyi's criticism down the memory-hole of history. Credit ratings, in the words of economist Lawrence White at New York University, acquired "the force of law."
With today being a holiday in the US for Dr. King's birthday, I decided to take a holiday on the usual torts in favor of a little excursis on bankers, litigation and "litigation reform." The main point? Recent events exemplify why some but not all of the "litigation crises" in the financial sector may be laid squarely at the door of major bankers and financiers.Therefore, one might well conclude that it's wise to think critically before drinking too much Kool-aid poured from the pitcher full of "litigation reform." It also seems wise to drink - carefully - from the pitcher full of real regulatory reform.
Today, the focus is on litigation and crises in the financial sector. A stunning body of evidence continues to mount to prove that litigation in the financial sector keeps growing because too many highly placed business persons consider litigation just natural fallout from money making activities. They see litigation and crises as just a part of the process, and really don't give a damn because the reality is they are making money from present deals, and don't care what happens in five years because by then they will have made a huge pile of cash, and may have exited the scene.
Proof ? Start with Paul Krugman's January 15 "Clueless Bankers" column in the NYT that dissects as follows some of last week's Congressional testimony from various leading luminaries on the Street:
"There were two moments in Wednesday's hearing that stood out. One was when Jamie Dimon of JPMorgan Chase declared that a financial crisis is something that "happens every five to seven years. We shouldn't be surprised." In short, stuff happens, and that's just part of life.
***
As an aside, it was also startling to hear Mr. Dimon admit that his bank never even considered the possibility of a large decline in home prices, despite widespread warnings that we were in the midst of a monstrous housing bubble.
Still, Mr. Dimon's cluelessness paled beside that of Goldman Sachs's Lloyd Blankfein, who compared the financial crisis to a hurricane nobody could have predicted. Phil Angelides, the commission's chairman, was not amused: The financial crisis, he declared, wasn't an act of God; it resulted from "acts of men and women."
Was Mr. Blankfein just inarticulate? No. He used the same metaphor in his prepared testimony in which he urged Congress not to push too hard for financial reform: "We should resist a response ... that is solely designed around protecting us from the 100-year storm." So this giant financial crisis was just a rare accident, a freak of nature, and we shouldn't overreact."
To quote Colonel Potter: it is "horse hockey" to suggest the causes are not known and were not foreseeable. Numerous books and articles have documented the realities - I like best Judge Posner's book - A Failure of Capitalism. It seems pretty plain we need to listen when a University of Chicago "free markets" guru is telling us that the markets failed us and we need meaningful reforms. To Judge Posner and others, it's quite plain that the financial fiasco was predicted by some (who made a lot of money from doing so), it did arise from bankers and lawyers severing risk from responsibility via CDOs and various derivatives, it did arise from rating agencies issuing groundless ratings, and it did arise from AIG and other entities buying and selling purported contracts without regard for whether the parties could honor the obligations. And, all of that does not even address the outright frauds and intentional cheating exemplified by Parmalat, Madoff, Galleon, Enron, and so many others, not to mention the subprime scandals from the various banks that knew they were selling real junk.
I'll also cite a good friend who is probably one of the smartest people in the world when it comes to understanding and managing risks. He spent some 20 years in incredibly senior positions in banking and finance where he put to use his stunning grasp of math, combined with common sense and humble roots. His view? Much of the Street is rotten to the core (especially AIG) and it was eminently obvious to anyone smart who bothered to look (at the time, he was looking at g AIG's 2008 SEC filings and finding them completely inscrutable). He also says the financial system will melt down again "soon" unless derivatives and other like contracts are forced onto regulated exchanges.
A final piece of proof ? Go to the Epicurean Dealmaker's latest priceless and candid post. The theme ? He largely accepts Mr. Krugman's rant about super giant financial entities taking society back towards future a financial fiasco, but then draws a line that only makes things worse According to the Dealmaker, the global bankers are far from clueless. Instead, he says, most investment bankers simply don't give a damn, and will work hard to find a way around the milk toast reforms presently on the table, as is set out in the following excerpts from the post:
"Wednesday, January 13, 2010
I'm Dancing as Fast as I Can
"Good morning, class.
* * *
I recalled this quote to mind today when I read Paul Krugman's latest broadside against all things--and people--financial in The New York Times. In his jeremiad, "Bankers Without a Clue," Mr. Krugman picks apart the recent testimony by four Wall Street CEOs at the Financial Crisis Inquiry Commission and asks the rhetorical question
Do the bankers really not understand what happened, or are they just talking their self-interest?
He concludes that it does not matter, and answers his own question thusly:
Wall Street executives will tell you that the financial-reform bill the House passed last month would cripple the economy with overregulation (it's actually quite mild). They'll insist that the tax on bank debt just proposed by the Obama administration is a crude concession to foolish populism. They'll warn that action to tax or otherwise rein in financial-industry compensation is destructive and unjustified.
But what do they know? The answer, as far as I can tell, is: not much.
By happy coincidence, I enjoyed a quiet morning in the office this past Wednesday free of client obligations. I took advantage of my liberty to view a good chunk of the televised testimony of Messrs. Blankfein, Dimon, Mack, and What's-his-name on C-SPAN. I have to admit that I too was underwhelmed by the bankers' grasp of and ability to explain the recent crisis. At one point, for example, Commissioner Johnson asked Jamie Dimon why the financial industry had attracted so many bright and talented individuals away from other, presumably more productive pursuits. The lackadaisical and uninformative reply Mr. Dimon returned revealed in stark detail a critical fact: he neither knew nor cared to know the answer.
And this example cuts to the heart of the matter: it's not his job to know such things.
* * *
Let there be no mistake: Mr. Dimon, Mr. Mack, and Mr. Blankfein are not stupid or uninformed. (The jury is still out on What's-his-name.) They are damn smart; scary smart, in fact. You don't get to the top of the greasy ladder of a major global investment bank's executive suite by being dull, incurious, or lethargic. People like that get sliced to ribbons and thrown into the chum bucket in my industry before they reach Managing Director, if they ever get inside in the first place. These guys got game, people. Serious game. You would be foolish to doubt it.
But they also have absolutely no interest whatsoever in the whys and wherefores of the financial crisis, the proper size and role of banks and investment banks in the domestic economy, or the moral imperatives inherent in stewarding the financial plumbing undergirding the daily lives and livelihoods of six billion people. For one thing, they don't have time to worry about such things. Most of a senior bank executive's time is consumed competing against other scary-smart investment bankers and executives at other firms, who are hell-bent on grinding his bones into dust beneath their bloody heels, while trying to prevent his own firm from flying apart under the internal stresses generated by thousands of egotistical prima donnas all scrapping for more than their fair share of the pie. There is too much going on, and unrelenting change comes too fast and furious to allow quiet contemplation of the order of things.
Most thoughtful people would agree: it's not wise to try to classify boreal flora and fauna when you have a tiger by the tail, much less think about how you would like to turn the forest into a time share resort.
For another thing--and because the volatile, high velocity nature of the business attracts such people--the people who go into the industry are not really interested in thinking deeply about why things are the way they are. You will almost never find an investment banker "sicklied o'er with the pale cast of thought." It's just not in their genetic makeup to be reflective, introspective, or speculative in an intellectual sense. Investment bankers have almost no interest in why things are the way they are. Rather, they spend all their considerable intellectual and psychological resources on understanding how they can take advantage of the way things are.
***
This explains not only their obvious lack of intellectual curiosity about the sources of the crisis--nothing remotely unconventional or even interesting on that topic left the mouths of any of the CEOs present at the hearing--but also their resistance to any major change in the way the industry or the markets are regulated. Why should they support change? It's hard enough just trying to keep ahead of the buzz saw of unbridled competition and unrelenting demands for profitability from lenders, shareholders, and employees without having to cope with changes in the rules as well. Of course they want to preserve their current profitability and size. Who wouldn't? But they do not assume--and neither, Dear Reader, should we--that changing regulations will necessarily make the industry less profitable. Investment bankers have well-justified confidence in their ability to turn new regulations to their advantage. It's just that, being in an industry that is constantly creating, reinventing, and destroying itself, investment bankers have a very healthy respect for change. You might even say we fear it.
So yes, Mr. Krugman, you are basically right. Don't look to investment bankers for answers on how we got here. We don't know and we don't care. We take the world as we find it and try to make money."
_____________________________________________________________________________
So, tell me again: why it is our nation offers the financial sector the protections of Iqbal/Twombly, CAFA and other "reforms?
It was just a matter of time. Seeking a civil remedy for the oft-criticized credit ratings issued by the various ratings agencies, The Ohio Attorney General retained private counsel and has filed suit "on behalf of the Ohio Public Employees Retirement System, the State Teachers Retirement System of Ohio, the Ohio Police & Fire Pension Fund, the School Employees Retirement System of Ohio and the Ohio Public Employees Deferred Compensation Program.""Attorney General Cordray is drawing on the expertise of the law firms Entwistle & Cappucci LLP; Lieff Cabraser Heimann & Bernstein LLP; and Schottenstein Zox & Dunn Co., LPA to assist with the litigation." The Lieff Cabraser firm is well-known for its class action work for plaintiffs. The Entwistle firm has significant experience in securities claims for pension funds and others. The Schottenstein firm is an Ohio commercial law firm. No doubt others will explore all the political connections. The complaint is here. The claims are for negligent misrepresentation and violation of Ohio statutes. The suit is in federal court, so one assumes the first issues will be Iqbal/Twombly motions. I went through the complaint this morning and it seems to this observer more than adequate in laying out a compelling and logical claim backed by evidence garnered during Congressional investigations.Big picture conclusions/thoughts/questions ? This suit is the latest example of how investigations by federal and state officials and agencies are increasingly used to generate evidence and facts to survive Iqbal/Twombly motions. Second, my personal belief is that there ultimately will be a flood of these lawsuits. with many filed by overseas entities. One question is whether and how these claims will be expanded to include "aiding and abetting" claims against law firms and other professionals. "Choice of law" questions also seem inevitable.
An Amlaw article here details global government cooperation with respect to potential claims arising from the Madoff ponzi scheme. Accoridng to the article:
"Gerhard Jarosch, spokesman for the Vienna public prosecutor's office, told The Associated Press his office is aiding the U.S. Justice Department and Britain's Serious Fraud Office in separate investigations of Bank Medici AG and its chairwoman, Sonja Kohn."
***
"The Wall Street Journal, citing affidavits filed in the case, reported Friday that prosecutors from all three investigations believe Madoff -- sentenced a week ago to 150 years in prison -- paid Kohn in exchange for allegedly funneling billions of dollars in European investments to Madoff. "
The AmLaw blog post here describes and includes a link to a newly filed complaint that seeks $ 1 billion and a class action for Mexican investors hurt by the Stanford ponzi scheme. The complaint invokes aiding and abetting claims against Willis and an insurance broker. Of note, the complaint was not filed by a typical class action firm and instead was filed by Strasburger & Price, an old-line and full-service Texas law firm typically aligned with corporate interests that some might think would indicate the firm would not file a class action suit. According to the article:
"The complaint states that the defendants gave Stanford Financial "safety and soundness" letters designed to help it market its investments. "Willis and BMB crossed the line from being mere insurance brokers for the Stanford Financial Group," the complaint alleges. "In creating and submitting these letters into the stream of commerce, [the defendants] actively and materially aided Stanford Financial to perpetrate the massive Ponzi scheme now alleged by the SEC."
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