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How Lawyers Enabled The Meltdown

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Note: Register for this month’s CLE, “Legal Fallout from the Financial Crisis,” from 1-2 p.m. ET on Wednesday, Jan. 21.

In the game of blame that followed the deepest financial implosion since the Great De­pression, bankers and money managers have borne their share of attention. But how much blame should lawyers bear? Plenty.

As legislators, they helped remove restrictions on commercial banks that allowed them to get involved with subprime mortgage-backed securities.

As regulators, they allowed leverage at investment banks to increase largely unchecked. As judges, they made it harder for shareholders to bring suits to stop the financial shenanigans.

As counsel, their legal opinions gave sanction to deals that, in the words of the analysts behind them, “could have been structured by cows.”

There were also lawyers who did their jobs, only to find their voices lost in torrents of money, rationalization or plainspoken hostility toward the rule of regulation.

Lawyers will have their say in the recovery. There will be lawyers aplenty to prosecute the culpable, rescue the bankrupt and reconfigure legislation that will attempt—yet again—to stimulate profits while throttling pure greed.

And there is another class of lawyers—the plaintiffs attorneys—who believe that their practice specialty would have provided a safety net of sorts for regulators whose hands were tied by Congress, or for investors who tagged innocently behind what they believed was due diligence, only to find that a whole global marketplace had been built on unsupportable loans.

“We could well have seen someone file suit years ago over these derivatives, but nobody could [today] because the hurdles are so high and the risks so great,” says Jonathan Alpert, a semiretired securities lawyer from Tampa, Fla.

Deregulation meant looser laws and even looser enforcement, they argue, and the credible threat of lawsuits might have helped derail the popularity of the credit risk marketplace—or, at least, expose the frailty of the assets on which it was based.

In recent years, the legal and political tide has turned against the use of the courts as a backdoor regulator of questionable lending practices, faulty consumer products or even the safety of food and drugs.

Could lawsuits have helped us avoid the massive credit meltdown? Did tort reform go too far? Regula­tors and plaintiffs lawyers are certain the questions are worth debating. Even defenders of tort reform are split on the value of their own success: some questioning whether the pendulum swung too far to endure as public policy and others wondering why the question is even being asked.

Of Boom and Bust at the core of any debate about what went wrong is the issue of deregulation—a matter of economic philosophy often in conflict with the law.

“One of the early causes of today’s problems was the deregulatory ripple that started in the Reagan administration,” says Meyer “Mike” Eisenberg, who held two high-level jobs in the Securities and Exchange Com­mis­sion over a span of almost 40 years, and now lectures at Columbia Law School in New York City. “That included the appointment of people who didn’t believe in regulation.”

Introduced in the early 1980s, the role of deregulation was quickly tested in the financial markets by the plight of savings and loans. Because of high interest rates in the late 1970s and early 1980s, the so-called thrift banks were struggling to make profits from low-interest, long-term home loans based on money gathered from regulated passbook savings accounts, as well as money borrowed from the Federal Reserve.

All that changed in 1982 with the enactment of the Garn-St. Germain Depository Institutions Act. Thrifts were suddenly free to act more like banks: making commercial loans, issuing credit cards and getting involved in real estate investments far more risky and complex than traditional 30-year mortgages.

The problem proved twofold: By being allowed to take substantial upfront profits just by approving the loans, thrifts lost their incentive to vet the deals accordingly; and though their lending powers had been made similar to those of banks, they had no comparable level of oversight. Examiners accustomed to approving title insurance and fair housing practices were suddenly required to evaluate multimillion-dollar commercial loans for shopping centers, office buildings and casinos.

Jonathan Alpert
Photo by Steven P. Widoff

Short-term profits, however, became long-term head­aches, as thrifts and their borrowers used federally insured deposits for troubled—even fraudulent—financial instruments and real estate projects. During the mid-1980s through the early 1990s, 747 thrifts failed. Funded mostly by federal taxpayers, the bailout cost more than $160 billion, a figure that seems almost quaint by current standards.

As the thrift scandal unfolded, names emerged as ce­lebrity symbols of the untethered greed that had driven it. Perhaps best known were Ivan Boesky and Michael Milken, who made high art of insider trading: Boesky in corporate takeovers, Milken with junk-level bonds.

“Those were not systemic, however,” says Eisenberg. “It was far-reaching and very dramatic, but they just went too far too fast and screwed a lot of people. There wasn’t a need for new legislation or regulation.”

Banking institutions eventually absorbed the savings and loan system. But as they began to compete for business with investment banks and brokerages, chartered banks demanded a larger view of their fundamental services. And the answer was, once again: deregulation.

The Gramm-Leach-Bliley Act of 1999 repealed the Glass-Steagall Act, which had been passed in 1933 in reaction to bank failures triggered by the Great De­pression. The new regulatory structure permitted commercial banks many of the same powers as brokerages and investment bankers. Banks and their holding companies—leaving home loan due diligence to largely unregulated brokers—concentrated on mergers and acquisitions, retail brokering, and the underwriting of securities based on subprime loans and collateralized debt obligations.

The sheer scale of these subprime deals led to larger and larger packages (and larger and larger fees and commissions), which in turn led to even less incentive to scrutinize the underlying loans and assets on which these packages were based.

In 1997, Brooksley Born, a former Arnold & Porter partner who chaired the Commodity Futures Trading Commission, asked for public comment on a proposal to force more transparency and nominal supervision over derivative markets. Testifying before Congress, she expressed concern that if left unregulated, derivatives could become a threat to “our regulated markets or, indeed, to our economy without any federal agency know­ing about it.”

Treasury Secretary Robert Rubin and Federal Re­serve Chairman Alan Greenspan were fiercely opposed. Disclosure of the increasingly complicated derivative trades, they feared, would lead to a demand for increases in capital reserves against potential losses. And strict­er regulation would drive the highly profitable derivative markets overseas.

Born, unfazed by increasingly scathing criticism, pressed forward with the CFTC derivative proposal. By June 1998, Greenspan and Rubin had taken their complaint to Congress, urging it to intervene. Congress obliged in late 1998 with a six-month moratorium on any action on derivatives to be taken by the CFTC.

After Born resigned as CFTC chair in 1999, Green­span and Rubin asked Congress to make permanent their ban on CFTC supervision of derivatives. Without Born’s persistence behind it, the proposal simply died.

Born retired from Arnold & Porter, and she has refused all comment about the recent credit crisis.

Meyer “Mike” Eisenberg
Photo by Max Taylor


When the derivative markets did become regulated, it was in a rule finalized by the SEC in 2004 that many believe may have supersized subprime losses from problematic to catastrophic.

The rule has one of those names that is salve for insomniacs: Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Super­vised Entities. Significantly, the rule resulted from a request for regulation by five of the meltdown’s largest losers: Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns.

To repeat: They asked to be regulated.

Well, sort of.

The rule was tailored in such a way that it pertained only to those who had requested it. And it came in response to a 2002 decision by the European Union to regulate subsidiaries of foreign investment banks—particularly those from the U.S.—out of concern about financial scandals. There was, however, a loophole: Foreign entities would be exempt from the EU’s rules if they had equivalent oversight in their own countries. In order to avoid EU oversight, the five investment houses asked that the SEC begin to regulate them—if in name only.

Essentially, the SEC let the financial concerns regulate themselves, under the scrutiny of SEC staffers assigned to each company. That allowed investment bankers and bank holding companies to greatly expand their debt-to-capital ratio requirement. The resulting growth proved disastrous.

As a leading expert in securities regulation, John C. Coffee, a professor at Columbia Law School, is blunt: “The staffers were probably junior lawyers up against dozens of quantitative Ph.D.s from MIT working the computer models, and it was a mismatch from day one. It was not a level playing field.”

Sure enough, the investment companies didn’t just go beyond the usual limit of 15-to-1 debt ratio; they more than doubled it. The computer models, however, reflected less leverage, a practice greatly discredited in the scandal that followed the failure of Enron.

“Increasing leverage is the best way to increase profitability,” says Coffee. “Unless you fail.”

And fail they did. Spectacularly.

Last year the government forced Bear Stearns to merge with JPMorgan Chase; Lehman went into bankruptcy; Bank of America acquired Merrill Lynch; Mor­gan Stanley and Goldman Sachs morphed into what amounts to another species as a bank holding company, and now are regulated by the Federal Reserve.


Why take such risks? coffee says it is because executive compensation is equity-based with stock options and similar incentives. Thus they are more likely to “make decisions based on short-term stock-price reactions. If you made them hold on to stock options until two years after leaving the company, they’d have a very different view.”

Whatever the reason, risk ruled.

Last September the SEC’s inspector general released a report saying the agency had failed to sufficiently monitor Bear Stearns, which had collapsed six months earlier. The agency’s chairman, Christopher Cox, issued a statement saying the consolidated supervised entity program was being shut down. It had become, he said, “abundantly clear that voluntary regulation does not work.”

Critics say that regulation and enforcement were curtailed during Cox’s tenure, which began in 2005, when corporations were fuming about the strictures of the Sarbanes-Oxley Act. Passed in 2002—after a spate of accounting scandals at Enron, Adelphia, Tyco Interna­tional and WorldCom—the Public Company Account­ing Reform and Investor Protection Act sought to renew transparency in publicly traded companies.

But publicly traded firms began to argue that renewed transparency made strict regulation by the SEC unnecessary. Given the proper information, they argued, the market could punish wrongdoers on its own.

The SEC under Cox reduced fines and penalties dramatically. Last January, the Morgan Lewis law firm issued an analysis saying the SEC had reduced penalties by “a staggering degree.” They dropped from $1.5 billion in 2005 to $507 million in 2007.

According to the law firm’s analysis, “the numbers suggest a philosophical shift by the Cox commission in what constitutes an appropriate penalty.” Whether part of a philosophical shift or not, the agency pursued fewer big fish during Cox’s tenure and went after smaller operations, such as Ponzi schemes.

Cox has responded to such criticism, saying it resulted from a change in the kinds of cases brought to the agency’s attention after the big accounting scandals were dealt with.

Whether transparency was inadequate or laws were ineffective or regulators were simply failing to regulate, plaintiffs lawyers say they were marginalized from every direction—to the point that a lot of them simply disappeared.


Tampa lawyer Alpert had grown his law firm to a dozen or so lawyers in the early 1990s, doing some employment law and insurance defense work. He sued the Tampa Bay Buccaneers on behalf of season ticket­holders and the Rays baseball team to get use of Tropi­cana Field for an annual festival honoring Martin Luther King Jr.

In 1993, he brought a class action against what was then NationsBank, saying it sold uninsured securities to customers who were led to believe they were FDIC- insured.

“It was complex as the dickens,” Alpert says.

The class action was in some way related to the changes in the banking system that took place in 1987 when the Federal Reserve removed restrictions on federally chartered banks, allowing them to deal in some securities.

Fed Chairman Paul Volcker had voted against the meas­ure that passed 3-2, arguing that the banks might drastically lower standards and cause problems. Volcker resigned a few months later and was replaced by Alan Greenspan, who had always favored innovation in fi­nancial markets.

Alpert’s lead clients included a tollbooth operator and a retired military policeman. They charged that Nations­Bank, like many other banks, had sold securities such as mutual funds in their lobbies—often to older and more vulnerable customers who were led to believe the investments were FDIC-insured when they actually were not.

Alpert filed a class action in Tampa federal court. Eventually, the bank settled for $60 million: 100 cents on the dollar for the plaintiffs, which was on top of Alpert’s fees.

There were a spate of similar cases around the country against other banks. And by 1998 the self-regulating National Association of Securities Dealers adopted a rule requiring prominent disclaimers on bank products not federally insured—a standard subsequently adopted by the Federal Reserve, the FDIC and the Office of the Comptroller of the Currency. The lawsuits, Alpert says, had actually influenced policy.

But in 1995, a Republican-controlled Congress passed the Private Securities Litigation Reform Act, which was designed to raise the bar on plaintiffs and lawsuits like Alpert’s.

The PSLRA required that the lead plaintiff in a class action have the largest loss, replaced joint and several liability with proportionate liability, and offered safe harbor for forward-looking statements. The act also restricted discovery until after a complaint survives a motion to dismiss.

In effect, the PSLRA restricted lead plaintiffs to institutional investors and their big-firm lawyers.

“Lawyers like me definitely got pushed out of securities litigation by the PSLRA,” says Alpert. “And the individual consumers did, too.”

Only a handful of firms now are handling the bulk of securities class actions, owing in no small way to the tightening brought on by the PSLRA and the subsequent Securities Litigation Uniform Standards Act of 1998 that limits securities class actions to the federal courts.

The PSLRA was intended to thwart what had become a rush to the courthouse by one and all to become lead counsel, which often enough led to suits that were not well thought out.

“The dynamic has changed somewhat,” says Elliott J. Weiss, a professor emeritus at the University of Arizona James E. Rogers College of Law. “I do think the litigation tends to be more merit-driven and client-driven than before.”

Weiss co-authored an article in 1995 that was adapted by Senate committee staffers from galley proofs as the basis for the PSLRA.

Three years ago, Weiss entered the trenches himself after years in academia. He is of counsel to Bernstein Litowitz Berger & Grossmann, one of the handful of firms now handling major securities class actions.

“Right now I’m looking at a response to a motion to dismiss, and my firm spent $150,000 on experts just for work incorporated into an amended complaint,” says Weiss. “That’s different from dashing off boilerplate complaints when a stock price drops. It now takes serious research, private investigators and a lot of energy up front to develop enough facts to survive a motion to dismiss.”

Weiss says he has no idea how many meritorious cases might have been shut out by the PSLRA. “I don’t think a lot of them get thrown out,” he says. “But I’m sure some get chucked.”

Adam C. Pritchard, who teaches securities law at the University of Michigan Law School, says it is wrong to assume that weak cases have been chased out of the system. Big cases brought by institutional plaintiffs with big settlements often follow SEC investigations or earnings restatements and tend to be meritorious, he says.

But the median settlement value is only about $7 million, he explains. “And you cannot defend a securities lawsuit for less than $7 million. If half the settlements are for what looks like less than settlement costs, it gives reason to think a lot of them don’t have substantial merit.”

Photo by iStockPhoto.com


The courts have taken up where Congress left off. For instance, no specific law provided for private litigation over securities regulated by the Securities and Exchange Com­mis­ sion until 1964, when the U.S. Su­preme Court found an implied right to sue in Case v. Borak. The opinion noted that “private enforcement of the proxy rules provides a necessary supplement to commission action.”

But for the past dozen years, the court has been tightening requirements for such litigation, requiring more and more knowledge of wrongdoing and causation—particularly regarding suits that seek deeper pockets when the primary defendants are asset poor or defunct.

In Central Bank v. First Inter­state Bank in 1994, the Supreme Court ruled there was no liability for merely aiding and abetting, but that such liability still would obtain for anyone who “employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies.”

In 2005, the Supreme Court ruled in Dura Pharmaceu­ticals v. Broudo that plaintiffs must show a direct link between their economic loss—the value of their securities—and a defendant’s misrepresentations.

Then in 2007 the court continued raising the bar—even for filing a lawsuit. In Tellabs v. Makor, the court said it was not enough to allege facts that might cause a “reasonable person” to infer fraudulent intent. Infer­ences of wrongdoing must be “cogent, and at least as compelling as any opposing inference of nonfraudulent intent.”

And a year later, the Supreme Court issued what many have called one of the biggest securities-fraud victories for business interests in many years—in effect, shielding lawyers, accountants and bankers as secondary parties in securities litigation.

In Stoneridge Investment Partners v. Scientific-Atlanta, a cable TV provider enlisted two cable-box suppliers to help create sham transactions and backdated documents to inflate its apparent revenues by $17 million so the company would not fall short of Wall Street estimates.

The Supreme Court ruled 5-3 that investors did not show that they relied on that deceptive behavior behind the scenes in deciding to buy stock in the company. Justice Anthony M. Kennedy wrote in the majority opinion that such behavior was not “communicated to the investing public during the relevant times.”

Even within the Bush administration, the case was viewed as highly volatile. In a friend-of-the-court brief prepared by the Justice Department on behalf of the SEC, the agency had sided with Enron investors.

But the brief was never filed. Following a complaint to the White House by Secretary of Treasury Henry Paulson, the solicitor general reversed field and filed a brief for the other side.

“As far as any of us can recollect, and I’ve been around a long time, the White House has never before interfered in a securities case,” says former SEC staffer Eisenberg, who filed an amicus brief favoring the investors on behalf of several former SEC officials.

Stoneridge had immediate impact. Just days after its decision, the court threw out a similar claim of $40 billion by Enron investors against Merrill Lynch & Co. and other firms and banks that made loans to Enron—claiming they had helped the troubled company inflate revenues and hide debt.


There are many who don’t see the Stoneridge decision as an aria by a metabolically challenged diva.

“The door is still cracked open a bit,” says Larry Ribstein, a securities law expert who teaches at the University of Illinois College of Law. “There still are questions about what exactly needs to be proven in terms of lost causation and what allegations are sufficient to prove liability on the part of nondirect participants.”

Coffee suggests that the role of credit agencies in the meltdown might be a good place to start.

“The credit rating agency was the gatekeeper that failed most [in the recent derivatives scandal] and they’ve never been held liable for malpractice, negligence or securities fraud,” Coffee says. “That could change.”

Jonathan Macey, a professor at Yale Law School and noted libertarian scholar on corporate issues, thinks the importance of Stoneridge lies in the eye of the beholder.

“If you’re in the bubble fantasy world of the plaintiffs bar and think there’s social value in bringing suits, then Stoneridge was wrongly decided,” says Macey. “It permitted people who were pretty active participants in an accounting fraud to be let off as defendants.

“But if you say these suits are like kudzu or cancer on corporate America, with massive amounts of costs and no benefits, then Stoneridge cuts away massive amounts of civil suits against extraneous parties.”

Ribstein, however, says he doesn’t think the credit meltdown, at its core, can be solved by either litigation or regulation. “It was a failure of judgment, a failure to recognize the obvious risk,” he says. “The fact that a lot of executives bet their companies, like at Lehman, on the proposition that real estate prices will always go up, seems to indicate a governance failure, and I’m not sure how we fix that.”

Greenspan might well agree. He admitted to Congress that in his own analyses, he had failed to account for human nature. “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity—myself especially—are in a state of shocked disbelief.”

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