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.
Why spend the time to attack TED’s reasoning and post ? Because TED’s posts lovingly expose the deep flaws in too many members (not all members) of the the top tiers (by dollar volume) of the financial sector. Indeed, TED’s posts are wonderful for their almost absolute candor about how business is done by global financiers. To say the least, the posts argue (not just admit) that global finance is full of very smart, very amoral individuals seeking to make enough money to retire, regardless of how it gets done. TED’s latest foray is the same – bluntly candid. And by his candor, TED illustrates exactly why society should be actively enforcing the duty of good faith and fair dealing. Enforcing that rule is one way to start repairing the damage caused by immoral or amoral financial engineers.
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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.
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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.