How Have the Lawyers Escaped Culpability?

(thanks to OneForAll)

The BBC showed a documentary tonight about the banking crisis and casino capitalism, which ties in nicely with another documentary released recently called "Inside Job". The BBC covers the British scene while Inside Job is mostly American coverage.

In both films the bankers are shown to be reckless gamblers who have yet to show any remorse for their actions despite Bob Diamond's (CEO of Barclay's) plea that the time for remorse and apology is over. It was encouraging to see the Deputy Governor of the Bank of England assert that capitalism that doesn't permit banks to fail is awry. Probably the politicians haven't quite got that yet.

Chris Blackhurst, the City journalist for the Evening Standard, makes the point in his review of Inside Job:

But if there's a criticism of Inside Job, it's that you're left supposing a group of bankers acted on their own. Of the accountants and others who supported them, there is no mention. Nor of the uncritical media.

For a long time now I have wondered why the lawyers involved in the financial world have escaped blame and culpability for their roles. It was brought home to me when discussing Gillian Tett's Fool's Gold with an ex-general counsel/CEO of a large investment bank. He said Tett completely ignored the lawyers and others. And he didn't know why.

I accept it is unlikely that the lawyers were the masterminds. Their mentality wouldn't allow it. And I'm sure they would claim only to be following orders, mere underlabourers. If Stanley Milgrim's experiments on authority teach us anything, it is that people are unfortunately easily gulled into following authority and the crowd. I suppose it might include lawyers, those masters of hyperrationality.

It was the lawyers who drafted the agreements that made it all possible. It is perhaps feasible they, along with so many others, didn't understand what the hell was going on because it was too complex. Yet lawyers thrive on complexity.

In Tett's book they appear implicitly. The banks strived to have regulation reduced or eradicated in the sphere of derivatives. It had to have been the lawyers who were drafting those new regulations or opinions decrying over-reaching regulation.

Is there hope? A glimmer. The New York Times reported recently that

In numerous opinions, judges have accused lawyers of processing shoddy or even fabricated paperwork in foreclosure actions when representing the banks.

Maybe this is the beginning of an accounting that must occur. Sure, these cases concern individuals' homes and livelihoods and not the big institutions. But it is at the behest of those institutions that this situation was initially created. It's like a Mexican Wave through a football stadium.

So the media is beginning to catch up and let's hope the regulators don't chicken out. I'm sure they will be watched.

(Robert Peston)

How Have the Lawyers Escaped Culpability?

"The Power of Yes" (Or the Fear of Saying No)

In the Power of Yes a playwright tries to find out the causes and explanation for the financial crisis. David Hare populates the stage with bankers, hedge fund managers, MPs, lawyers, journalists and the occasional journalist. (Background pack here which includes a good timeline on the crisis.)

He asks them why this happened and Myron Scholes "explains" why the Black-Scholes options pricing theorem should always work. Long Term Capital Management is mentioned almost as a passing embarrassment. A minor blip on the smooth horizon of the derivatives radar. The fault of the 1998 Russian economic collapse not the model. Models play an unfortunate role throughout the crisis, whether it's Black-Scholes or the Gaussian Copula. They seemed to inspire unquestioning faith in their adherents.

As the various characters come forward to explain their roles or why they should be exonerated of blame, the playwright's anger, and hence ours, rises at the utter cupidity and stupidy of these City folks given such freedom by the regulators and government. One of them aptly says which government minister will willingly criticize the City when a warm seat on the board of an investment bank beckons when he steps down. They were frightened of saying no.

Gillian Tett--unnamed in the play but clearly recognizable--analyzes, perhaps the most hated man in the crisis, Fred Goodwin and his response to the collapse of RBS and the scorn hurled at him. He wasn't to blame; it was the fault of the market... Nor could he say sorry. (I've reviewed Gillian Tett's book on the crisis, Fool's Gold.)

The message of the play pushes the lack of responsibility by the main players in the system, their lack of acceptance of culpability, that they did anything wrong. Indeed William Keegan in the Observer noted, and this should send shivers down anyone's spine:

It is still not clear that the commercial bankers have appreciated the rightful degree of public anger. But central bankers have. In Istanbul (at an IMF meeting) Paul Tucker, the deputy governor of the Bank of England responsible for financial stability, told the Institute of International Finance: "We can't continue with a regime where, to put it crudely, the downside is picked up by the taxpayer and the upside is picked up by bank shareholders and executives."

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If you would like more information, Mark Thomas, a guerilla comic, has put together a fine video of his understanding of the crisis recorded at the National Theatre.

The play won't run much longer so go and see it--it's well worth it.

"The Power of Yes" (Or the Fear of Saying No)

Use of Credit Ratings in Financial Regulation

Last month the Joint Forum of the Basel Committee on Bank Supervision released the results of the survey on the use of credit ratings by its member authorities in the banking, securities, and insurance sectors. The survey answered the call of the G7’s “Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience” to review whether the current regulations and/or supervisory policies unintentionally give credit ratings an official seal of approval that discourages investors from performing their own due diligence. The survey’s questionnaire was designed to elicit information regarding member authorities’ use of credit ratings in legislation, regulations, and supervisory policies. The goal of the survey was not only to collect information on internal references to “credit ratings,” “credit rating agencies,” or any references to specific credit rating agencies, but also to assess whether the use of credit ratings has had an effect of implying an endorsement of such ratings and rating agencies or discouraging investors from performing their own due diligence. The Joint Forum collected 17 surveys from member authorities, representing 26 separate agencies from 12 different countries, as well as five responses describing international frameworks.

Both in the U.S. and in Europe, credit ratings are generally used for five key purposes: (1) determining capital requirements; (2) identifying or classifying assets, usually in the context of eligible investments or permissible asset concentrations; (3) providing a credible evaluation of the credit risk associated with assets purchased as part of a securitization offering or a covered bond offering; (4) determining disclosure requirements; and (5) determining prospectus eligibility.

The first regulatory reference to the ratings in the U.S. is found in 1931 in the Office of the Comptroller of the Currency (OCC) and Federal Reserve examination rules, and was mainly based on distinction between investment grade securities, generally rated BBB/Baa and above, and securities of below-investment grade quality. Over time, regulators in the U.S. and globally have incorporated credit ratings into laws and regulations to set capital requirements for regulated entities, provide a disclosure framework, and restrict investments. Recognizing possible unintended consequences of the regulatory use of ratings, in the summer of 2008 the SEC in three separate releases proposed and sought public comments to amendments to most of the SEC’s rules that rely on security ratings with alternative requirements.

Sixty three comments were submitted in response to the SEC's call. The analysis of the responses highlights a high level of dependency of all market constituents on the CRA ratings as a common measure of creditworthiness, especially in the world of less transparent structured credit securities. The behavior of market constituents, including investors, issuers, and regulated entities has been affected by such dependence. The SEC proposal came about to address the perceived failure of the CRA to accurately indicate riskiness of structured credit securities. Still, the feedback to the SEC proposals to eliminate references to credit ratings assigned by CRAs in its rule indicates that the market participants are not ready to accept responsibilities for an independent credit risk assessment. We infer that investors, fiduciaries, and regulated entities are looking to regulators to offer a common measure of risk, accurate and free of conflict of interests. At the very minimum, the market participants expect the SEC and European regulators to assume a more important role in controlling the integrity of the credit rating process.

Please, see the fuller version of the analysis here. The paper can be downloaded from SSRN.

Use of Credit Ratings in Financial Regulation

Lawyer-Client Relationships

Banker on Bishopsgate
(Darrell Berry)

I have just posted on SSRN the final revised version of my paper on lawyer-client relationships. It is "Ambiguous Allegiances in the Lawyer-Client Relationship: The Case of Bankers and Lawyers".

The paper deconstructs the prototypical dyadic lawyer-client relationship in the context of corporate transactions. Most lawyer-client analyses view the relationship as a direct unmediated one between the two. I argue this is illusory and that without understanding the context of business transactions, much about the relationship is omitted or missed from analysis.

At a minimum the relationship is triadic. If, for example, a client is borrowing funds from a bank for an investment, even though the client's lawyer's primary duty is to the client, the lawyer always has an eye on the future business that might come from the bank. The lawyer's allegiances are pulled more ways than one.

For example, Jonathan Knee in The Accidental Investment Banker: Inside the Decade That Transformed Wall Street (2006), wrote of one deal:

This episode highlights an important and inherent conflict between banker and client in sales processes. After a successful transaction, the client disappears and any future business will come from the universe of suitors. This creates a sometime irrestible incentive to provide, or give the appearance of providing, some form of subtle preferential treatment to those most likely to offer something in return at a later date.

The paper uses a mix of interview data, ethnography, and documentary sources. I would appreciate any comments and feedback.

Lawyer-Client Relationships