The subprime and related credit crisis has resulted in a multitude of regulatory agencies joining the fray by MissPowerPoint


									Here Come The Regulators
This article first appeared in Directorship, June/July 2008.
by Kirke Hasson and Ernie Patrikis

                                                The fallout from the subprime and        For example, the FBI’s inquiry into
                                                credit crisis continues to highlight     the subprime mortgage crisis is
                                                imperfections in our banking and         focused on approximately 20
                                                finance system. A bright light is        companies suspected of accounting
                                                now being shined on the patchwork        fraud, improperly securing loans,
                                                of regulatory bodies, often with         and insider trading. At least three
                                                overlapping jurisdictions and            of those 20 companies are also under
Kirke M. Hasson                                 prerogatives, tasked with overseeing     investigation by the Securities and
Partner, Litigation                             financial and banking entities.          Exchange Commission, though no
+1.415.983.1077                                                                          one at the SEC could confirm
                                                As news stories multiply daily on the                                                            whether its investigations were
                                                crisis and its related investigations
                                                                                         related to the FBI probes.
                                                by federal, state, and in some
                                                instances, city authorities, there is    Meanwhile, states like New York
                                                understandable confusion for many        are getting into the act: Attorney
                                                board members of public companies.       General Andrew Cuomo is investi-
                                                An even greater challenge is realizing   gating the role of a number of Wall
                                                whose authority has precedence           Street firms in the crisis.
                                                when an investigation begins. An
                                                                                         Even smaller jurisdictions are
                                                alphabet soup of regulators, each
                                                                                         launching investigations. In January,
                                                with its own goals and constituencies
Ernest T. Patrikis                                                                       the city of Cleveland filed lawsuits
                                                and sometimes competitive behavior,
Partner, Finance                                                                         against 21 banks, according to the
                                                has mobilized to address the sub-
+1.212.858.1317                                                                          Associated Press. The suits claim
                                                prime crisis.                                                         that the subprime lending practices
                                                When a major financial scandal           of these banks have left behind
                                                begins to make an impact on a            abandoned homes, creating a public
Kirke Hasson and Ernie Patrikis are partners
                                                significant number of people or a        nuisance that hurts property values
at Pillsbury Winthrop Shaw Pittman LLP,
                                                particular industry, as we are now       and tax collections.
where Kirke co-leads the Litigation practice
                                                seeing with the subprime meltdown
and Ernie co-leads the Financial Services                                                Feds and Friends
                                                and saw less than a year ago with
Regulation practice team. Pillsbury launched                                             When dealing with multiple authori-
                                                stock-options backdating, it’s not
the nation’s first multidisciplinary subprime                                            ties that are engaged in parallel
                                                unusual for multiple regulators to
and credit crisis group in March 2007.                                                   investigations, it is important to
                                                wage independent investigations
                                                against the same company.                understand the modus operandi
                                                                                         of all the players involved and the
                                                                                         overall chain of command.

Pillsbury Winthrop Shaw Pittman LLP                                                               

Federal, state, and local investigatory   stakes for numerous entities.             •	 The role of the credit-rating
mechanisms are often pooled               A board faced with an actual or              agencies, over which the SEC
together in a common effort to            possible encounter with several              gained regulatory authority in
investigate high-priority issues such     authorities may need to organize to          June 2007.
as the subprime crisis. For instance,     address the multitude of issues that
                                                                                    •	 The possibility of violations of the
a new task force met in May in the        will be thrown at it. One solution
                                                                                       securities laws by subprime lenders,
Eastern District of New York              may be for the board to consider
                                                                                       investment banks, broker-dealers,
(Brooklyn), to look into potential        organizing a special committee of
                                                                                       and other market participants.
crimes, including mortgage fraud and      independent directors to keep abreast
securities, trading, and accounting       of developments. The group may be a       The SEC has approached problems
fraud. Led by federal prosecutors, the    separate subcommittee of the audit        in the subprime securities market
task force includes the FBI’s finan-      committee or a temporary panel.           with a wide array of regulatory and
cial institutions fraud unit, the U.S.                                              investigative capabilities. In March
                                          SEC: The Market’s Top Cop
Postal Inspection Service, the U.S.                                                 2007, it formed the Subprime Working
Secret Service, the New York State        The SEC is an independent federal         Group, a task force of more than 100
Banking Department, the New York          government agency with a mission          lawyers, led by Cheryl Scarboro,
City Department of Investigation,         to protect investors; maintain fair,      an associate director in the SEC’s
and the Federal Deposit Insurance         orderly, and efficient markets; and       enforcement division. As of February,
Corporation (FDIC).                       facilitate capital formation. The SEC’s   the SEC has opened more than 30
                                          approximately 3,800 staff members         non-public investigations into firms
The FBI also facilitates multi-agency     are located in Washington, D.C., and      and individuals involved in the
law enforcement collaboration             throughout its 11 regional offices.       subprime securities market. The
through its Office of Law Enforcement     The SEC, which was established by         cases generally involve subprime
Coordination. The SEC, Department         the Securities Exchange Act of 1934,      lenders; investment banks; and other
of Justice (DOJ), and FBI are working     can bring only civil, not criminal        market participants, such as insurers,
as one team to investigate subprime       cases. However, the agency often          retail broker-dealers, credit-rating
lending practices.                        works with law enforcement entities,      agencies, and home builders.
Conversely, the staffs of the New         including the FBI and the DOJ. In
                                          wake of the subprime crisis fallout,      Subprime lenders fall within SEC
York Attorney General’s office and
                                          the SEC is raising questions and          jurisdiction if the lenders are public
the enforcement division of the SEC
                                          investigating the following issues:       issuers or are involved in the
are not known for their close coop-
                                                                                    securitization process. Specifically,
eration. In addition to interagency       •	 The accounting treatment and           the SEC is examining the valuations,
friction, unique challenges that have        assets of special purpose trusts       accounting treatments, and disclo-
emerged for those companies facing           used to package and sell residential   sures surrounding mortgage-backed
investigations include having to             mortgages as securities.               securities. Cases in this area have
provide different types of documen-
                                          •	 The adequacy of capital and            looked into the level of lenders’
tation to different regulators, sharing
                                             liquidity at major investment          involvement in the securitization
the same documentation multiple
                                             banks and the strength of their        process and the truthfulness of
times, or undergoing multiple
                                             risk-management practices.             lenders regarding the quality of
depositions, first by the Attorney
                                                                                    loans. Many securitized products
General’s office, then by the SEC.        •	 The impact on money-market             have “early payment default provi-
Civil enforcement proceedings can            funds from the devaluation of          sions” that require lenders to buy
lead to criminal proceedings. The            presumptively safe assets.             them back under certain conditions.
subprime crisis is one of the most        •	 The quality of issuer disclosure       The SEC is asking whether lenders
emotionally charged situations we            by public companies involved           properly evaluated these provisions,
have seen in many years. And this            in structured finance.                 and if sufficient reserves were taken
is an election year, which raises the                                               in light of the contingent default

Pillsbury Winthrop Shaw Pittman LLP
                                                                                               Here Come The Regulators

risk. A related issue includes the        The FBI is the principal investiga-        probe surrounding Cioffi could
potential motive of lenders to mask       tive arm of the DOJ. The FBI is            “become the highest-profile case
actual defaults or the value of early     authorized to investigate all federal      to deal with the collateral damage
payment default provisions on their       criminal violations that have not          caused to investors by the implosion
books. Finally, the SEC remains           been specifically assigned by              of the subprime-mortgage market.”
focused on insider trading, espe-         Congress to another federal agency.
                                                                                     The DOJ may also pursue civil and
cially in advance of the publication
                                          Subprime fraud investigations              criminal actions under the federal
of bad news relating to subprime
                                          would investigate:                         Truth in Lending Act (TILA), part
                                          •	 Whether there were material             of the Consumer Credit Protection
As for investment banks, SEC cases           misrepresentations and omissions        Act that requires clear disclosure
against underwriters relate to selling,      in connection with the sale of the      of key terms and costs in lending
trading, holding, and the timing of          mortgage-backed securities.             arrangements. Willful and knowing
significant write-downs. Some of                                                     violations of TILA may give rise to
the top issues the SEC is examining       •	 Whether there was an awareness          criminal liability.
include: whether initial valuations          of the true value of the collateral
                                             for the securities.                     OCC: Policing the Banks
and the accounting treatment for
holdings were performed correctly,                                                   The Treasury Department’s Office
                                          •	 Whether there was collusion
whether proper methodology and                                                       of the Comptroller of the Currency
                                             among the market players (i.e.,
internal controls were used for                                                      (OCC) charters, regulates, and
                                             the mortgage loan originator,
valuations, and whether inherent                                                     supervises all national banks. The
                                             servicer, underwriter, and issuer
risks were properly disclosed.                                                       OCC also supervises the federal
                                             of the insurance coverage) regard-
                                                                                     branches and agencies of foreign
Finally, in the retail area, the SEC         ing the true value of the collateral.
                                                                                     banks. In regulating national banks,
is looking specifically at whether        For example, by early February, the        the OCC has the power to take
brokers followed “suitability”            U.S. Attorney’s office in Manhattan        supervisory actions against banks
requirements when they sold their         sought information from the SEC            that do not comply with laws and
securities. In a broader sense, the       with regard to its investigation of        regulations or that otherwise engage
agency is also asking to what extent      Merrill Lynch. The SEC is said to be       in unsound banking practices. The
the current crisis was foreseeable.       investigating whether Merrill Lynch        agency can also remove officers and
DOJ: The Long Arm of Justice              booked inflated prices of mortgage         directors, negotiate agreements to
                                          bonds it held, despite knowledge           change banking practices, and issue
DOJ subprime investigations are
                                          that the valuations had dropped.           cease and desist orders as well as
likely to center on securities fraud
                                                                                     civil money penalties.
and general antifraud provisions.         As another example, Bear Stearns
The DOJ is an executive department        fund manager Ralph Cioffi is being         In the regulatory sphere, the OCC
of the United States government           investigated for fraud by the U.S.         has the authority to issue rules and
with Attorney General Michael             Attorney’s Office for the Eastern          regulations governing bank invest-
Mukasey as its head, operating in         District of New York. Cioffi allegedly     ments, lending, and other practices.
part through U.S. Attorneys who           told participants in an investor call      It employs onsite examiners and its
serve as prosecutors in the 94            that he was “cautiously optimistic”        regulatory coordinating mechanisms
judicial districts of the country. It     about Bear Sterns’ holding of              to monitor market conditions relating
controls all criminal prosecutions        subprime-related securities just one       to the subprime crisis. The OCC has
and civil suits in which the United       month after he moved $2 million of         pledged to work with the Treasury
States has an interest. In addition,      his personal money out of a troubled       Department and other regulatory
the DOJ controls federal law              subprime hedge fund. The Wall Street       agencies to develop policies and
enforcement.                              Journal observed that the criminal         actions in this area.


Going back as far as 2001, the OCC       banking companies. OTS has taken             information about the risks of
has worked with other federal banking    enforcement action against a federal         mortgages that were bundled
regulators to issue supervisory          thrift for failure to manage and control     into securities sold to investors.
guidance on subprime mortgage            loan origination services outsourced
                                                                                    •	 Massachusetts Secretary of State
lending. Because many lending            to an affiliate, and for weaknesses in
                                                                                       William F. Galvin has also been
institutions are not federally regu-     home-mortgage loan activities.
                                                                                       active. He accused a unit of Bear
lated, the OCC has worked with the
                                         Cuomo and Company                             Stearns of failing to disclose to
Conference of State Bank Supervisors
                                         Whether acting under general fraud            investors a conflict of interest in its
and the American Association of
                                         provisions or specific state “blue sky”       trading with two hedge funds man-
Residential Mortgage Regulators to
                                         laws, many state attorneys general            aged by the company. The funds
encourage individual states to adopt
                                         have announced investigations of              collapsed after subprime-linked
and effectively enforce guidelines for
                                         the subprime mortgage industry and            investments soured. In January,
mortgage brokers under their
                                         are issuing subpoenas. New York’s             Galvin subpoenaed municipal bond
                                         Martin Act, for example, is a particu-        insurers MBIA and Ambac Financial
The Fed: Regulation Z                    larly broad and sharp prosecutorial           Group, seeking information on how
The Federal Reserve has supervisory      tool which authorizes the state               much the firms disclosed to cities
and regulatory jurisdiction over state   attorney general to investigate any           and towns about their exposure to
banks that are members of the            “fraudulent practice” in connection           mortgage-related investments.
system, as well as bank holding          with “the issuance, exchange, pur-            On February 1, Galvin filed civil
companies, state-licensed branches,      chase, sale, promotion, negotiation,          charges against Merrill Lynch,
and agencies of foreign banks. The       advertisement, investment advice,             alleging fraud and misrepresenta-
Fed’s supervisory powers are similar     or distribution within or from                tion in connection with mortgage
to those of the OCC. The Fed is also     [New York] of any securities.” As             securities sold to the city of
responsible for various consumer         of mid-February, the following state          Springfield, Mass. This occurred
protection statutes. These are           regulators and cities have filed cases        one day after Merrill Lynch agreed
implemented through regulations,         or disclosed investigations related           to reimburse $13.9 million to
such as Regulation Z (Truth in           to the subprime crisis:                       Springfield in a dispute over a
Lending). On December 18, 2007,                                                        shaky subprime-related invest-
                                         •	 New York Attorney General                  ment.
the Fed issued proposed revisions to
                                            Cuomo has accused a large real
Regulation Z to protect consumers                                                   •	 Ohio Attorney General Marc Dann
                                            estate appraisal company called
from unfair or deceptive home-                                                         recently filed a class-action share-
                                            eAppraiseIT of colluding with
mortgage lending practices.                                                            holder suit, brought on behalf of
                                            Washington Mutual to inflate
OTS: Thrifty Supervision                    the values of homes nationwide,            Ohio’s public employee pension
                                            contributing to the subprime crisis.       plan, against Freddie Mac, alleging
The Treasury Department’s Office
                                            Washington Mutual has since                a number of violations of the
of Thrift Supervision (OTS) has
                                            suspended its relationship with            Securities Exchange Act and
regulatory authority over thrift
                                            |the company. Cuomo also has               SEC rules.
institutions and thrift-institution
holding companies. The OTS’s                subpoenaed Fannie Mae and               •	 Attorneys general in Illinois and
supervisory powers are also similar         Freddie Mac to look at “wide-              Florida are investigating mortgage
to those of the OCC. OTS has stated         spread collusion.” Cuomo, along            lender Countrywide. Additionally,
recently that it could play a role in       with Connecticut Attorney                  state banking supervisors have
protecting consumers and ensuring           General Richard Blumenthal,                supervisory and regulatory authority
a level playing field if it licensed        is investigating whether banks             over state-chartered banks, thrift
mortgage originators and had joint          failed to make sufficient disclo-          institutions, and mortgage bankers
oversight with states over mortgage         sures or intentionally withheld            and brokers. The New York

Pillsbury Winthrop Shaw Pittman LLP
                                                                                                                              Here Come The Regulators

  Banking Department, for example,                        internally what goals for a settle-                     criminal enforcement authorities
  has initiated a number of remedial                      ment might be, including avoiding                       are involved. But it should not be
  actions against mortgage banks.                         commitments that could adversely                        dismissed out of hand.
                                                          affect the company in the longer
•	 Local jurisdictions are also                                                                                •	 Whether it’s accounting irregulari-
                                                          term. Be cognizant of the impact
   bringing litigation through state                                                                              ties, stock-options backdating, or
                                                          that each board decision can have
   courts. In addition to Cleveland’s                                                                             failure to disclose securities
                                                          on the potential for shareholder
   actions, the city of Baltimore sued                                                                            documentation related to subprime
   Wells Fargo, alleging the bank                                                                                 investments, boards should note
   intentionally sold high-interest                    •	 Think about the potential ramifica-                     that federal prosecutors across the
   mortgages more often to black                          tions an investigation and/or                           country have been charged with the
   customers than to whites in                            settlement may have not only on                         formidable task of rooting out
   violation of federal law. More suits                   the stock price, but also on the                        corporate crime in all of its forms.
   from cities and localities are likely.                 company’s reputation with clients,                      Since President Bush created the
                                                          customers, and shareholders.                            Corporate Fraud Task Force to
Tips for Boards
                                                          Consider hiring crisis communica-                       “restore public and investor confi-
When facing multiple investigations,                      tion counsel to assist with manag-                      dence in America’s corporations” in
the board should consider taking the                      ing that reputation, working in                         2002, the task force has recorded
following steps to ensure that it is                      conjunction with the board’s legal                      more than 1,200 convictions,
dealing with the situation properly:                      advisers. Actively discuss whether to                   including 214 chief executive
•	 Become familiar with the jurisdic-                     resist the authority or to take a more                  officers and presidents and 53 chief
   tion of each authority. Retain                         accommodating approach in a                             financial officers. To secure future
   counsel and consultants familiar                       situation where the board believes                      convictions, prosecutors will not
   with the operations of the author-                     that no wrongdoing has occurred.                        hesitate to draw on data and
   ity. Even before it is broached with                   The effect of a decision to resist can                  information gathered from investi-
   a regulating authority, discuss                        be difficult and expensive; it is not a                 gations by multiple regulatory
                                                          path taken lightly, especially when                     agencies.

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