Credit Card Holders Bill of Rights

In the midst of all the bailout activity, the House passed the Credit Cardholders' Bill of Rights Act of 2008 with virtually unanimous support from Democrats and 84 Republican votes. Although passage of the bill in the Senate was always iffy, and is now extremely unlikely, the new Congress is likely to revisit these issues.

The "Bill of Rights" title might lead one to think that the bill incorporated a short list of broad principles. In fact, it addresses a number of specific issues in a particularized and technical way. What follows is a summary of the main provisions:

1. Card issuers would be prohibited from increasing the interest rate on existing balances, unless (a) the rate is tied to a publicly available index that is not under the issuer's control; (b) the increase is the result of (i) the expiration or loss of a promotion rate for a reason that was disclosed in an account agreement; or (ii) the cardholder's failure to make the minimum payment more than 30 days past the due date.

2. Issuers would be required to permit cardholders with existing balances at the time of a rate increase to amortize the existing balance over at least a 5-year period and the percentage of the existing balance that was included in the required minimum payment cannot be more than doubled.

3. Rate increases would require 45 days notice, must be complete and conspicuous, and explain the extent to which they apply to an existing balance.

4. Double cycle billing would be prohibited.

5. Where a cardholder fully pays a balance and only interest accrues during the billing period, the bill would prohibit (a) any fee in connection with the interest-only balance and (b) the issuer from treating a failure to make timely payment as a default. The cardholder would remain responsible for paying the interest.

6. Issuers would be prohibited from furnishing information to a consumer reporting agency until the card is used or activated, except that the issuer may furnish information about any application for a credit card account.

7. Issuers would be required to treat any payment received, or transferred by wire over a web-based or telephone system, by 5PM on the due date as timely. A receipt showing that the payment was mailed not less than 7 days before the due date would also constitute presumptive payment by the due date, unless the issue shows fraud or dishonesty on the part of the cardholder with respect to the mailing date.

8. Where an account has multiple interest rates, the bill would require that the issuer allocate payment among the outstanding balances in the same proportion as each such balance bears to the total outstanding balance. Issuers would be permitted to allocate a higher percentage to higher interest rate balances, but they would be prohibited from engaging in the now common practice of allocating the entire payment to the lowest rate balance.

9. If an account includes a grace period, cardholders taking advantage of promotional offers could not be denied the benefit of the grace period.

10. Issuers would be required to offer cardholders the option to elect not to permit the bank to authorize an over-the-limit charge and thereby avoid fees for going over the limit. Issuers would be permitted to authorize charges going over the limit by a small amount, but they could not charge a fee.

11. Over-the-limit fees could be charged only once during a billing cycle.

12. Additional information would be collected on rates and fees.

13. Issuers would be prohibited from financing up front fees in excess of 25% of the credit authorized on the account.

14. Credit cards could not be issued to anyone under 18 unless emancipated under state law. A signed application indicating that the applicant is 18 would protect the issuer.

The provisions in the bill resemble those proposed by the FED last May, which have generated a record 56,000 comments. Some opponents of the bill, including the White House, contend that regulators are better equipped to deal with these sorts of issues. Proponents contended that controls on the credit card industry require the force of legislation.
The industry, not surprisingly, came out strongly against the bill. A statement from the American Bankers Association argued that the provisions in the bill would limit the banks ability to manage risk and therefore raise prices and restrict the availability of credit to consumers and businesses.

The bill would not address the issue of merchant credit card acceptance fees that are currently being challenged in a nationwide class action. In August, the House Judiciary Committee reported a bill dealing with merchant fees, and the new Congress is likely to take up that issue.

Blog-Symposium Honoring Richard E. Speidel (1933-2008)

The Commercial Law Blog is sponsoring a commercial law tribute to Richard Speidel during the month of October. Accordingly, we are pleased to announce a "mini" blog-symposium (or "mob-blog") to honor him and his work. This mob-blog is open to all in terms of participation and we hope that many will participate with a posting. We especially hope that some of Dick's colleagues and collaborators will participate in this venture. All those wishing to post simply should send an email at jenni.martin@louisville.edu to receive guest access rights to post on the blog.

We hope that this forum will serve as a memorial of kinds to his work.

— JSM

Some Damn Foolish Thing in the Balkans

That's what Bismark predicted would set off the war that seemed inevitable. The trigger turned out to be the assasination of Archduke Franz Ferdinand, heir to the Hapsburg throne. The assassins were seven young men. All were members of a secret Serbian nationalist movement. All had tuberculosis which was a death sentence in 1914. The rest, as they say, is history.

Two days ago, at a Brookings Institute conference on Turmoil in Housing and Financial Markets, former Treasury Secretary Lawrence Summers (now at Harvard's Kennedy School) observed that there is no single root cause of the current financial crisis and no simple single solution. The fix, he said, requires "multiple instruments targeted to multiple objectives." One response to the housing crisis currently getting most of the attention is to regulate institutions so they won't make mistakes again. People and businesses make mistakes and they always will, whether government regulates them or not. Summers offered another approach --reforming the financial system to make it safe for institutions to fail. The goal should be reduction of systemic not individual risk of failure.

Summers noted that even without subprime mortgages, the US economy was still vulnerable to leverage bubbles and might still have found itself in crisis. Blaming the current financial crisis on submprime mortgages, he said, is like blaming World War I on the assassination at Sarajevo.

Impossibility Doctrine Under CISG 79

Thanks to Meredith Miller over at ContractsProf Blog for pointing out the case of Hilaturas Miel S.L. v. Republic of Iraq, --- F.Supp.2d ----, 2008 WL 4029713 (S.D.N.Y. 2008). Before the Iraqi War, Hilaturas Miel S.L. (“Hilaturas”), a Spanish company, agreed to sell yarn to the Republic of Iraq ("Iraq")under the U.N. Oil For Food Program ("OFFP"). The OFFP provided letters of credit to beneficiaries (sellers), but required independent inspection of goods when received on the ground in Iraq. When the fighting broke out, the approved United Nations independent inspectors left the country, so that there was no one to inspect the Hilaturas yarn. Shortly thereafter, the government of Iraq ceased to function. Still later, the letter of credit for the Hilaturas yarn expired. Hilaturas sold the yarn at a loss and sued for its damages.

The Southern District of New York (Sweet, J.) decided the case, Hilaturas having brought suit under the Foreign Sovereign Immunities Act. The Court granted Iraq's motion for summary judgment. Applying CISG Article 79, the court concluded that the since the contract required inspection, the withdrawl of the inspectors created an impossibility of performance. That is, payment for the yarn under the letter of credit could only be made after presentation of the required documents, including the inspector's report.

The Court, in an interesting twist, remarks that United States courts often look to analygous provisisions in the U.C.C. to resolve issues arising under the CISG. The Court goes on to conclude that UCC 2-614 on substituted performance due to impracticability of delivery or payment is such a provision. Important to the Court, the official comment explains that “a reasonable substituted performance tendered by either party should excuse that party from strict compliance with the contract terms which do not go to the essence of the agreement.”

Hilaturas argued that Iraq should have provided an alternative means of performance. That would seem to be an alterative inspection procedure or simply waiving that provision of the letter of credit. Of course, it is doubtful that alternative inspection as acceptable to the United Nations, so that payment under the OFFP letter of credit would not have been forthcoming. In the end, the inability to have the goods inspected during the letter of credit period results in performance being impossible.

CISG 79 only allows parties to excuse performance for certain impediments, namely ones beyond their control. The Court clearly dodges the lurking issue particularly in CISG 79 regarding whether the inspection impediment was "beyond the control" of Iraq and whether it could have "avoided or overcome it or its consequences." The issue is tricky since the former Governmet of Iraq no longer exists in a way to make it accountable for the breach of contract or the creation of the impediment. Hilaturas has a point that Iraq,not it, should have found a substituted performance. I am not as convinced as the Court that all of this mess was "unforeseen." Nevertheless, the Court seems right in the end here as both parties knew they were operating under the OFFP restrictions, which made the inspection provision part of the "essence" of the contract as anticipated by UCC 2-614 cmt. 1.

— JSM

If You Follow Only One Issue In This Bailout . . .

Photo by stopnlook

Amid all the noise about limits on executive comp and other distractor issues, one central important issue stands out, in my view, as the most worthy of attention as Congress and the Fed wrestle over the terms of the proposed bailout: How much will Treasury pay for the mortgage-related assets/securities it proposes to unload from troubled banks? Put more pointedly, how much of a discount will the Fed impose on the supposed value of these asset to try to find a baseline from which the market can rebound? To (1) put the pain on the too-clever folks who caused this financial mess in the first place, (2) avoid the Fed taking on assets that will continue to fall in value and produce losses for all of us taxpayers, and (3) put the Feds in a position of maximum maneuverability to modify the mortgage assets they buy, we would like to see sales at a significant discount from "nominal" or "book" or whatever other misleading "value" the banks had previously put on these things. Of course, we don't want to exacerbate the crisis by forcing banks to destroy the asset side of their balance sheets and further seize up credit markets, either, but I don't get the sense that this is a significant danger (yet).

We haven't heard much on this big question, but early indications are mixed. Bernanke and Paulson today reiterated that some sort of reverse auction might be the best way to go; that is, have the banks compete to offer the lowest sales price, and the low bidder gets the toxic assets off its books, to be replaced by crisp, relatively-clear-value U.S. greenbacks. My sense is that this structure would serve the concerns mentioned above and produce an acceptable result for most reasonable-minded observers. On the other hand, another report out today suggest that Treasury is less sanguine about an auction, fearing that banks might compete too aggressively with each other to drive down prices to deeply depressed "fire sale" levels. This latter report interprets Paulson's comments as suggesting that Treasury intends to pay something closer to undiscounted long-term value ("hold-to-maturity") as opposed to current distressed value for the bad mortgage-related assets. This would, of course, raise the risk level for a big loss by Treasury and pose a serious threat to the value of the U.S. dollar.

We should all watch quite closely as Treasury reveals (one would hope soon) which of these valuation/auction methods it intends to pursue if the bailout proposal makes its way through Congress. In my view, the evaluation of the entire bailout rests on the resolution of this issue.

The $700 billion mystery

Here in Louisville last week, many were making their way through the week without electric and other utility services. At my home, it thankfully was only the Internet and cable down. A big week to be slow on getting speedy financial news updates. At this same time, with the Washington, D.C. wrangling on-going, Congress, Treasury and the Federal Reserve are scrambling to bailout the financial industry. Treasury Secretary Paulson commented on Friday:

"Right now, our focus is restoring the strength of our financial system so it can again finance economic growth. The financial security of all Americans – their retirement savings, their home values, their ability to borrow for college, and the opportunities for more and higher-paying jobs – depends on our ability to restore our financial institutions to a sound footing."

Waiving the five day waiting period, Goldman Sachs and Morgan Stanley will become bank holding companies (or financial holding companies, as applicable) and have the extension of federal credit against their assets. The Board cited "unusual and exigent circumstances affecting the financial markets, and all other facts and circumstances" in its conclusion that emergency conditions justify the speedy formation of the bank holding companies.

The Bank Holding Company Act ("BHC Act") directs the Board to certain factors in the establishment of a bank holding company or acquisition of a bank:

1. the competitive effects of the proposal in the relevant geographic markets;


2. the financial and managerial resources and future prospects of the companies and banks involved in the proposal;


3. the convenience and needs of the community to be served, including the records of performance under the Community Reinvestment Act (12 U.S.C. § 2901 et seq.) ("CRA") of the insured depository institutions involved in the transaction; and


4. the availability of information needed to determine and enforce compliance with the BHC Act and other applicable federal banking laws.

The Board in a general way deemed these factors satisfied and waived public notice due to the same emergency conditions.

While I am being quite general as to what has transpired, this is out of necessity. The web site for the Federal Reserve reports on the Board's actions, with the Orders of the Board posted. Same over at Treasury. The press releases and orders themselves are general in nature and lack specifics. I find myself agreeing with Bob Lawless over at Creditslips in his recent post that detail is lacking (and this is problematic). While the Federal Reserve and Treasury are moving speedily to take control of the financial industry to stablize markets (hopefully), Congress is still working on the terms. There is talk of making sure that the government gets shares of the companies to essentially create accountability. Moreover, there is speculation (expectation?) that the legislation will address home mortgage foreclosures.

Though discussions are on-going, the financial industry bailout seems like a done deal, with the Treasury ready to dole out about $700 billion in Treasury securities to purchase troubled assets. Although the Treasury Fact Sheet states that borrowing will be publicly reported, this does little in terms of oversight. While decisive action seems important at this time, the lack of transparency leaves me with a sense that the United States will come to regret this later and have no recourse.

Maybe . . . a little like a train leaving the station without knowing if it has enough fuel to get to the destination.

— JSM

The One Thing Markets Hate Worse Than Losses?

The last two days offer a vivid illustration of the raison d'être of the UCC (and commercial law generally). The one thing that markets hate worse than losses is . . . uncertainty.

The Dow has risen 779 points--over 7%--over the past two days (really, the past day-and-a-half), with financial stocks enjoying impressive gains (from the CNN story: "Merrill rose 28%, Bank of America gained 17%, AIG rose 51%, Morgan rose 25%, Goldman rose 20% and WaMu rose 28%."). All this on news that these very financial companies are going to be allowed to sell their worst assets to a newly created federal entity at a huge loss. Wait, can that be right? Hooray for losses???

The CNN story quotes one financial expert as saying that "the fundmentals have changed and that's going to support markets going forward." What fundamentals could this odd loss-accelerating proposal implicate?

Well, the most important fundamental, apparently: certainty, or at least the lack of obvious uncertainty. On Wednesday, the bailout of AIG created not certainty that the end of this crisis was nigh, but fears about which financial giant would be next on the Fed's discount shopping spree through Wall Street. No one knew who would be the next victim of uncertainty with respect to the value of the mortgages and mortage-backed securities at the heart of this problem. Beginning with rumors yesterday and confirmed today, the market finally started to glimpse the light at the end of the tunnel. If we have to run over hot coals barefooted to get to that light, so be it, but just tell us when we've hit rock bottom! Though the details remain shrouded in secrecy, the thrust of the plan is to drill down to bedrock by goosing some sort of market mechanism that will force banks and investors to admit once and for all how depressed the value of their mortgage-related assets really is (i.e., auctions to see who can offer these toxic assets to the Feds for the lowest price--I'll sell for 50% face value; no I'll sell for 40% . . . what a spectacle that will be!). Once the culprits of the housing crisis are forced to eat crow and turn over these assets, one hopes the feds will follow the FDIC-IndyMac example and start responsibly writing down the principle on overvalued mortgages, keeping people in their homes, and stopping the downward spiral in home prices. The end is near . . . . ?

O.K., O.K., another fundamental is involved here, too, I guess: liquidity. A Fed purchase of these uncertain payment streams will result in a huge infusion of liquidity into the market, having the double benefit of easing fears about the value of the assets and dousing loan markets with the cash that they have so desperately needed to get back to financing business and consumption on reasonable loan terms. That being said, my sense is that the infusion of certainty is much more central to this recovery (one hopes, long-term) than the expected infusion of liquidity.

It's hard for us to offer ready examples to students of why the certainty of HIDC status or Article 9 so facilitated the growth of commerce in the olden days, so let's point out the amazing effects of the promised exorcism of uncertainty this week.

Long-Term Solutions, Deleveraging, and Mortgage Modification

Photo by Jonny Thirkill

So the Dow has bounced back over 400 points in the latest roller-coaster move. It's hard in these trampoline-like days to tell at any given moment whether we're still falling or bouncing back. Apparently, investors were heartened by rumors that the Feds are considering longer-term solutions to the credit crisis, including a "new government entity to help Wall Street unwind its disastrous credit bets" (a "bad bank" or latter-day Resolution Trust Corporation to take on the worst toxic mortgage-related securities and other investments). The basic idea seems to be that banks need to jettison once and for all the disastrous investments they have made, put the losses behind them, and go and sin no more.

Or banks could just get a reality check! That this crisis is of their creation is now clear. That they continue to foster the illusion that they need not act rationally to cooperate in its resolution is maddening. One of the most informed and engaging experts on the mess in the home mortgage market, Alan White at Valparaiso, has a fantastic new post today over at the Consumer Law & Policy Blog reminding us of just how irrational and stubbornly unwilling to accept reality the major mortgage banks are being. Though they claim to be on board with the notion of acknowledging reality and writing down mortgages to the (vastly lower) value of the collateral-homes, they are backing up these words with action in only a small fraction of cases. Sure, they'll cut people a break on interest and maybe fees, but modify mortgages to reduce principle--Heaven forbid! White presented to Congress evidence that banks are taking the necessary bottom line action and writing down mortgage principle in only 2% of cases. As White explains, the half-hearted Hope for Homeowners program is a cruel joke, offering relief to those facing foreclosure only if their banks were willing to accept the reality of property values and forego some of the principle on their mortgage loans (which has, not suprisingly, not happened in most cases). The FDIC is doing the right thing and setting an example by aggressively modifying IndyMac mortgages (FDIC is now the conservator of IndyMac), so why can't this reality check be extended to the broader market?

When asked about their willingness to take decisive action along the lines of the FDIC-IndyMac program, major commercial bank representatives explained, according to White, "take 10% off the loan balance, rather than foreclose at a 40% loss? This was described as the least-preferred option, and none were willing to answer what percentage of their loan mods involved any principal write-down." Ridiculous, even reckless in this era when the bottom line--the point at which the financial crisis will hit bottom and truly bounce back--depends on establishing that mortgage collateral is fairly valued at levels that allow folks to stay in their homes or allow the banks to recoup real value in foreclosure sales (rather than evicting people, taking huge losses, externalizing even further losses onto communities and the entire housing market, and then asking for redemption from the Feds in the form of a new RTC . . . revolting!). Entertaining the fantasy that the housing market will bring back the losses that are causing this spiraling financial crisis (the root of all the ills from sub-prime bond investments and credit-default swaps, etc.) is, in a word, irresponsible.

So what's the Fed to do? Well, the Fed can't do much, judging by yesterday's stock dive (Dow up 140 points on Tuesday on rumors that the Fed wills save AIG; Dow down 450 points on Wednesday because the Fed saved AIG!!??). A higher authority should step in and do at least one simple thing: amend § 1322(b)(2) of the Bankruptcy Code to treat claims secured by home mortgages just like most other secured claims; that is, allow the claim to be written down to the value of the collateral (the home), rather than forcing the law to continue to entertain the fantasy that the claim and the home are worth the inflated price originally paid. Better yet, allow mortgages to be forcibly written down to the value of the home without bankruptcy, but in any event, the special-interest gift to mortgage lenders and MBS investors in § 1322(b)(2) seems increasingly unwarranted. The notion that subjecting mortgages to "lien stripping" in this way would drive up rates was refuted, in my view quite convincingly, by a clever analysis presented in a recent paper (versions one and two) by Adam Levitin and Joshua Goodman, in which they explain that allowing forcible modification of mortgages in bankruptcy would likely result in an interest rate increase of at most 15 basis points (0.15%)!

Rather than waiting for Treasury and the Fed to turn the financial system upside-down based on questionable regulatory authority, the real regulatory power center of our political system, Congress, should introduce law(s) based on a new policy for mortgage bankers and investors in mortgage-backed securities: GET REAL!

Retailer Warranty/Replacement Plans: more than a matter of reading the fine print

Typically, I purchase many of my consumer electronics at Circuit City because I have had mostly success in getting them to honor their product replacement plans (when I purchase them). Point in case, I purchased an in-car dvd system through Circuit City not that long ago and did buy the replacement plan. Having young children, I depend on the dvd system. So, when the system blue-screened after about six months of use, I hurried into Circuit City and they replaced the unit and had me back on the road in less than thirty minutes. Whew! Dodged that bullet with my three year old. Consumer happy.

Last Friday I stopped in Best Buy to look at IPods. I settled on an IPod Nano and was set to go. The sales clerk recommended that I purchase for $20 the Best Buy replacement program. Having heard my student's complaints about Best Buy replacement programs for years now, I was wary, but asked for an explanation about the program. The clerk told me that the program for IPods was "different" and that if my IPod broke, I would bring it to them and they would just give me a new one, no hassle. I said great, sounds like you are now matching your competitor, Circuit City. So, I purchased the program and went home (they did conveniently put the details into my bag only after the purchase).

Upon arriving home, of course, I read the details and discovered that the program is simply one where if my Ipod breaks, I must bring it to them and they will mail it for me to the manufacturer under the warranty. After one year, they will mail it away to a repair center for me, so long as a "covered defect" is found. This is not what I was sold, so I went back to the store, asked for and was given a refund. The manager at Best Buy informed me that no one sells replacement plans on IPods, not even Circuit City. So, of course, I called Circuit City while I was standing there at Best Buy. Of course, the Circuit City replacement plans are available for the IPod. Consumer not-happy with Best Buy.

Surely, the outright deception is disturbing (see Rant #13: Retail Warranty at Best Buy, but be cautioned about the language). Of course, product warranties are uniform across retailers (see Apple's IPod warranty). Yet, there can be a marked difference not only amongst companies honoring their own warranties, but also amongst retailers who sell these "replacement" or "warranty extension" plans. The heart of the matter is that while companies may offer warranties, the track record of the company either making good products or performing warranty service if it fails is what matters.

While I am a big believer in reading the fine print, this goes to remind me that the business practices of sellers should matter to consumers. Deception in the sale of warranty extension plans is obviously unacceptable. While the plans themselves often differ (perhaps for market reasons), how and whether companies honor their plans ultimately determines the value of the plan. As for me, you know who I will be getting service from if my IPod needs it.

— JSM

Lehman/Merrill/AIG the Day After--What Crisis?!

Photo by bucklava

Not to say "I told you so," but notice that stocks are up the day after all of that hoopla broke on Wall Street (granted, not as much as they were down yesterday, but give it some time). If the biggest impact of this imbroglio on the "little guy (or gal)" will be a hit to the value of 401(k) and other retirement savings, the fact that stocks are already headed back up should come as a relief. And again, with crude futures headed toward the $90 mark, the economic future for Mr. and Ms. Average U.S. Consumer seems notably brighter.

In other good news, it looks like Barclay's is back at the Lehman bargaining table after all (as a surprise to no one who knows the Chapter 11 process). This breaking story from the W$J has it exactly right when it notes that shepherding the sale of Lehman's investment-management and capital-markets businesses through Chapter 11 allowed the parties to get what they wanted (walling off the toxic assets from the good ones) with less complication (and therefore probably a higher price). Would it be putting too sharp a point on it to call this "laundering"? By the way, if Barclay's is buying these crown jewels for $2 billion, one wonders how Lehman arrived at its $639 billion valuation of its assets, as mentioned in its bankruptcy petition (hat tip to CreditSlips and Steven Lubben). Indeed, could it be that Lehman was actually $20 billion in the black (in light of the reported $613 billion debt) when it filed yesterday (or at least as of May 31, 2008, the date of the valuation statement)? Doubtful. These valuation figures must be the sort of fairytale numbers that GAAP allows companies to get away with. For shareholders pouring over the Lehman petition hoping to find some ray of hope for a distribution, don't get your hopes up. The asset figure must be wildly on the high side, and though the Chapter 11 process will likely enhance the value that buyers like Barclay's are willing to pay for Lehman's "good" assets, the total kitty at the end of the day is likely to be nowhere in the region of $600 billion. The lawyers and other professionals who will have to manage this humongous case (ten times larger than Enron; six times larger than WorldCom) and sort out the millions of swaps, repos, and other complex contractual arrangements certainly will make out like bandits, though.

Lehman et al.'s Limited Impact on Main Street

Lots of ordinary folks seem to be in an uproar about the fallout on Wall Street, and they deserve some reassurance NOW! In last night's text poll on WGN News, nearly 90% of the respondents said they were worried about the state of the economy.

What we all have to bear in mind, it seems to me, is that this is a financial crisis, not an economic crisis. Yes, Lehman and many others made bad bets on mortgages and related securities, as I mentioned yesterday, and yes, the consequences of that bad bet will be visited on investors far and wide (and on the people who got themselves into unaffordable mortgages), especially as the stock market continues to plunge (note that I am intentionally not linking to the hysterical stories about world markets plummeting!). But this doesn't mean the medium- to long-term view is dim for the broader economy. The markets are fickle and have short memories--they will bounce back. Notice, by the way, that crude oil futures are also in free-fall (nearing $90 a barrel!), which seems more likely to impact us commoners far more than the goings-on in lower Manhattan.

For a reality check, see this discussion on the all-things-banking BankRate.com and this post on the business-oriented Conglomerate blog. Don't take rash action on investments or deposits. Don't go crazy. It's too late to run from this storm, but it will not be nearly as bad as the doomsday soothsayers are suggesting.

Lehman Chapter 11 = Reorganization?

Photo by jurvetson

The 158-year-old Lehman Brothers investment bank has gone up in smoke in the biggest bankruptcy filing in U.S. history . . . or has it? One of my students today observed that Lehman had filed for protection under Chapter 11 rather than Chapter 7 of the Bankruptcy Code. Does that mean the firm intends not to liquidate and go out of business, but rather to remain in operation, reorganize its business, and emerge as a leaner, meaner firm still operating under the august Lehman name? This topic lies at least on the periphery of the commercial law, and besides, how can any self-respecting business and financial blog avoid discussing today the events of this past weekend?!

The Lehman case offers us a nice opportunity to make an often forgotten observation about the fluid division between reorganization (Chapter 11) and liquidation (Chapter 7) in U.S. business bankruptcy. Yes, the holding company at the top of what must be a mind-bogglingly complex Lehman org charge has filed under Chapter 11, but this does not mean that the firm intends to rehabilitate itself and reemerge as so many other companies have done. If Lehman intends to have an orderly sell-off of its assets and units, why not just file for chapter 7 and be honest about it, one might ask. So-called "liquidating Chapter 11s" and other strategies involving the use of Chapter 11 to administer asset sales are not at all uncommon. Chapter 11 offers at least two substantial and related advantages over Chapter 7 under Lehman's circumstances (and there are doubtless others): First, while a Chapter 7 filing would most likely mean a turnover of the company's assets to an appointed trustee with little or no connection to or knowledge of Lehman's complex activities, the "debtor-in-possession" model of Chapter 11 will allow the firm's managment, who are intimately familiar with the firm and its business, to wind down operations and negotiate asset sales from a position of maximum strength and knowledge. They can carefully and deliberately choose to sell assets in productive, related units (e.g., the broker-dealer and investment management units), maximizing their value in part by ring-fencing them off from the "bad" assets that have laid low Lehman and so many other investors recently. Chapter 11 will provide time (at least several months, if not longer) for emotions to cool, assets to be surveyed, and values to stabilize. Announcing a turnover to a trustee and a piecemeal firesale might well spook the markets even further into believing that a wholesale loss of value is at hand, depressing the value of Lehman's assets (and similar assets held by others) and disrupting Lehman's other operations. Second, Chapter 11 allows Lehman to remain in largely uninterrupted operation. Its talented employees can continue to administer the firm's operations (to a limited extent) and maintain their value to squeeze as much return as possible from the firm's assets and minimize a piling-on of further debt and loss. At the end of the day, a filing under Chapter 11 here in all likelihood will lead to something of the same result as Chapter 7 (sell-off), but in a much more orderly, flexible, potentially creative and value-maximizing way, still under the chaos-minimizing effects of the automatic stay and court supervision.

Does it make sense here to leave the same scoundrels whose poor judgment created this mess in charge? Shouldn't a disinterested trustee step in and take charge? More so than in many other cases, it seems to me, this mess wasn't all the fault of Lehman management. Yes, they made a bad bet in choosing to go all-in on mortgage-backed bonds, but investment banking is all about taking on stomach-wrenching risk. I have neither seen nor heard of any indication that Lehman's woes are in any way tied to accounting scandal or fraud of any kind--which is a breath of fresh air after the sad events of recent years. Lehman became the leading underwriter of mortgage-backed bonds, which as we all know now turned out to be toxic investments when scads of ordinary borrowers started defaulting on their mortgage loans, which given the unexpected (and unheard of) downward trend in home values led to a serious and spiraling crisis. Oops! A bad call, yes; mismanagement, not so much, it seems to me. Worse yet, Lehman and other banks had ratcheted up their risk by increasing their leverage (the ratio of outstanding debt to assets) to by some accounts as much as 100-to-1. The leverage scissors basically shredded Lehman. On the debt side, losses on credit-default and interest-rate swaps and other complex investments it had made with borrowed money translated into huge losses through the magic of leverage (each dollar of loss was effectively amplified by 100 at a leverage ratio of 100:1), and on the asset side, mortgage-backed securities that it carried on its books turned out to be worth even less than it had thought (reducing the "1" in the leverage ratio to a fraction, severely exacerbating the problem).

So even with the value-maximizing effects of Chapter 11 rather than Chapter 7, the last-in-line shareholders seem almost sure to receive no distribution in a Lehman bankruptcy, and even the holders of Lehman debt (perhaps even preferred unsecured debt) might get very little if the leverage ratio is as high as I have heard. A penny on the dollar is not an overly pessimistic expectation for unsecured debt holders, it seems to me. I guess even a penny is better than nothing, and the choice to file under Chapter 11 may produce that penny that a Chapter 7 might well have left on the table.

An experiment: Cruxlux F675

Greetings to all readers of Commercial Law. I've decided to implement a widget referring readers to Commercial Law's Cruxlux.com page, known within Cruxlux.com as F675. We welcome feedback on this little experiment.

Two Great Escapes Into Commercial Law History

Photo by Kivanç

I guess I'm just an escapist at heart. If I'm not escaping to some foreign locale to compare its commercial law with ours, I'm escaping into history to compare yesterday's commercial law with today's. This weekend, I am escaping with two marvelously interesting papers on the history of commercial law.

The first is now one of my very favorite history papers, by a new professor at Texas Law School, Emily Kadens, who is quickly becoming one of my favorite historians. I can't do the paper justice here, but briefly, in Merchants, Kings, and the Codification of Commercial Law, Kadens challenges the conventional story of collision and opposition between the law merchant and the beginnings of state regulation of commerce. In fact, Kadens reveals in her lucid and incisive way, merchants might well have been all-too-happy to see state regulation impose a bit of certainty and stability on a system of customs that, even if they had worked for trading within confined networks earlier, they were ill-suited to governing the burgeoning inter-network (proto international) trade. Kadens's wonderfully clear description of the operation of bills of exchange shows that she is not only a talented and entertaining historian, but a gifted commercial law professor. This paper is a strong buy! Besides, the audience of this blog must contain that small subset of people who might have a special interest in a paper about bills of exchange in the 17th century.

The second is one I just discovered, thanks to Mary Dudziak's fabulous Legal History Blog. Earlier this week, Daniel Klerman uploaded his paper to SSRN, entitled "The Emergence of English Commercial Law: Analysis Inspired by the Ottoman Experience" (hence the picture I chose to accompany this post). With a title like that, you can't go wrong! Klerman contrasts the development of English and Ottoman commercial law to suggest that the former's approach is a better model for modern reformers interested in stimulating domestic engagement with global trade (my extrapolation from the intro--not explicit in the paper). English law supported the implementation of special institutions (esp. mixed foreign-domestic juries and streamlined debt collection) that offered equal benefits to foreign and domestic traders alike, jump-starting the economy on a level playing field and integrating strong foreign trading practices domestically. Ottoman law, on the other hand, created special institutions (especially dispute resolution mechanisms) exclusively for foreign merchants, ring-fencing the foreigners off from the locals and putting domestic traders at a competitive disadavantage. Klerman's consideration of why English and Ottoman law headed in different directions is fascinating.

Happy reading!

How Commercial Law Can Save the Law School Curriculum

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Over at Prawfsblawg earlier this week, a Con Law professor (Marc Blitz) discussed a teaching "experiment" that he calls The Case-Free Class Day. I felt almost smug reading his post, as we commercial law professors have been successfully conducting this "experiment" for years now. We call it The Problem Method, or something similar. In Payment Systems, Secured Transactions, and Bankruptcy (and to a lesser extent, Corporations), I tell my students on the first day of class that we will not be reading and discussing cases; rather, we will do every day what most main-street lawyers do: solve problems. Unlike Blitz's approach (which sounds like a good one for public law, jurisprudential courses), every day in most of my classes is "case-free." Leveraging the pedagogical truism that the best learning is active learning, students are thrust into actual situations (well, at least conceivably realistic scenarios) and challenged not only to understand some concept or doctrine of statutory law, but to apply that doctrine/statute and their appreciation of the motivations of the actors involved to understand the real-world problem, explain how the law affects it (or not), and come down with a piece of advice (which may well be, often to the students' chagrin, "there's nothing the law can do for you, so can we find a business or social solution?"). This makes class totally fun for me, even the umpteenth time that I've taught the perfection requirements and the funds availability rules, and it accomplishes what everyone seems to want from us in the legal academy--making students not just think like lawyers, but to actually be lawyers, in the sense of making decisions and formulating advice not limited to the particular narrow legal issue at hand.

As a simple example, one day this week in Payment Systems, we covered the "accord and satisfaction" rules (for using a check with a "full satisfaction" legend as a simple settlement device) and a problem that challenged students to think broadly about their client advice. A small business person (lessor) had deposited a check from a disgruntled renter for half of the rent owed. The check contained the "full payment" legend, and the question was whether the landlord's depositing the check was a problem. The obvious answer, of course, was that this might well be a problem, as the check seemingly satisfied the requirements for "accord and satisfaction," so the landlord might have (inadvertently) agreed to accept half payment. The harder questions came next, much to the surprise of students trained to focus on one legal provision at a time. The client doesn't want to hear "you probably have a problem"; it wants to know "what do I do now?" This question always sets the students back on their heels. Well, someone generally says, you might refund the money if 90 days have not yet elapsed (another part of the A&S statute). Good! Problem potentially identified and solved. Assuming we're beyond 90 days, then we get to delve into the stickier questions--did the renter act in good faith in issuing the full payment check (yet another sub-requirement of A&S); i.e., was there a bona fide dispute as to the amount owed? On what basis? You mean we have to remember something about contracts and landlord-tenant law to think about whether constructive eviction is a bona fide claim here?? Yes! And the client doesn't want to hear "we could litigate that issue"! Small business people hate lawyers, our waffling, and especially our fees, and (consequently?) some 98% of all civil litigation settles today, so we need to think concretely about what we would actually say to opposing counsel (or the renter) about solving the problem efficiently. Can we convince opposing counsel that our case is strong and/or the renter's case is weak? Can we squeeze out a compromise? On what terms? Extended discussions of law, business, ethics/professionalism, and actual lawyering arise daily in my problem-based classes. What a joy! Lest we forget that commercial law affects folks from all walks of life, our exploration later this week of the negotiation rules in the context of a check-cashing outlet allowed us to discuss the business model of such an establishment and some of the characteristics and motivations of its often "unbanked" customers.

All of which brings back to mind a post by Jim Chen in the early days of this blog: Teaching (commercial) law. With this post, Jim earned himself the undying adoration of all commercial law professors by observing that our courses involve "real-world problem-solving techniques" for which "clients are most likely to be willing to pay," and they expose students to statutory law and analysis in a very real, down-to-earth way. My classroom is a no-abstraction zone. What a judge or someone else might do is relevant, but the real question for my students is "what do you actually do in light of the messy uncertainties and exigencies of real business/consumer clients in real life?" When students begin to feel like, view themselves as, and act like lawyers, formulating strategy and action based on law and the realities of life, that's a fantastically satisfying experience for a teacher.

By the way, for those at schools like mine where the Bar Exam looms large in every curricular discussion, I have made lemonade out of lemons by using actual bar exam questions (often edited to make them more challenging, realistic, or fun) as problems to be solved in class (see also here and here and here). Many states (and to a limited extent, the NCBEx) make their bar exams available online, sometimes with invaluable examiner commentary (and lecturing and writing model answers for BarBri is a wonderful way to stay current on what the bar examiners are doing). Nothing grabs your students' attention more than saying that a particular classroom exercise is a verbatim reproduction of a question from the bar exam--wanna know "the answer"? O.K., but you'll have to walk through how the problem might be solved in real life, too. Welcome to the bar!

Payment Card Hokey Pokey

Photo by The Consumerist

Two seemingly unrelated stories in this morning's news demonstrate the lengths to which credit and debit card issuers are now going to market their wares and squeeze out income.

First, the Wall Street Journal's "Personal Journal" today explains that card issuers, responding to a campus clamp-down on marketing credit cards, have begun hawking prepaid debit cards to college students (D1, D6, "The New Card On Campus: Prepaid Debit"). The W$J report contains a very sophisticated discussion of the EFTA and Reg E fraud protection rules (fail to report the loss within 48 hours, liable for up to $500, unlimited liability after 60 days), contrasting them with the much more protective TILA and Reg Y protections for credit cards (max $50, period). Perhaps giving up some fraud protection is a small price to pay for avoiding the horrors of college-student debt chronicled in, e.g., James Scurlock's fabulous and disturbing documentary, Maxed Out.

But perhaps not. The subtitle of the story tells it all: "Issuers Push High-Fee Alternatives." It turns out that these limited-fund, pre-paid debit cards don't allow users to incur interest or most overdraft charges, but these cards are "often laden with transaction fees," such as enrollment/activation fees, monthly account fees (that are waived if the card balance exceeds $1000!!), ATM fees (in addition to fees charged by the ATM's bank-owner), and my favorite--monthly inactive-account fees; that is, if the card isn't used within a 90-day period, the overly-miserly user is charged $5 per month of inactivity! Interest income is just too straightforward and oh so 20th century, while fee-based income runs under the radar and kills silently, bit by bit. My sense is that these kinds of cards will become very common, as parents try to limit their college kids' spending, but this array of fees will eat away at balances in a hurry. Caveat emptor, indeed!

So what are issuers doing with all of those extra credit cards? Sending them to small business people, of course! The American Bankruptcy Institute's daily headline service alerted me to this story in today's New York Times. It explains that more and more small businesses are turning to credit cards for liquidity because credit lines and other "prime" sources of financing have dried up. Isn't one source of credit the same as any other in this context--surely businesses can negotiate for favorable treatment. Nope! Small business credit cards are like sub-prime predatory lending in the consumer context, "offering" higher interest rates and unpredictable terms for changing (read: increasing) those rates at the drop of a hat (or the drop of Fannie & Freddie's stock price). One small business owner explained that her rate had jumped from 3.9% to 27.9% after her payment allegedly arrived one day late, and another's jumped from 16.99% to 34.99% (where do they come up with these numbers?!) when the financial aftermath of a home fire increased his debt-to-income ratio and decreased his credit score. Banks are worried about their bottom lines these days, too (capital requirements and the like), so if they can't squeeze college kids, they've moved on to a segment of the market that is even more desperate for large amounts of liquidity--and a segment that can and will pay big interest charges to carry them through to the next "in the black" period.

So what's a parent or small entrepreneur to do? The best and only advice seems to be, "Shop around."

The Joy of Comparative Commercial Law

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Thanks so much to the Commercial Law blog folks for inviting me to be their guest for a while! I am thrilled to have a chance to discuss topics outside my primary area of scholarship, though I am delighted to have been granted license to talk about bankruptcy and comparative insolvency law, as well. In my first post, then, I thought I'd mention something at the intersection of commercial law stricto sensu, bankruptcy, and my love for all things comparative law.

In the course of researching for the book I'm co-authoring on international bankruptcy, I got to explore the different approaches to the treatment of secured creditors in bankruptcy around the world. I have to admit that I was surprised to find that in many countries, when the rubber really meets the road (i.e., in the borrower's bankruptcy), secured creditors are not the king of the hill, as in U.S. law. Quite a few bankruptcy laws subordinate secured claims to (1) administrative claims arising in the reorganization/liquidation process (e.g., fees for trustees, lawyers, appraisers, auctioneers, etc.), (2) taxes and other public debts, (3) employee wage and benefit claims, and even certain kinds of other unsecured claims (in the Czech Republic before January of this year, secured creditors enjoyed priority in insolvency cases in only 70% of the value of their collateral, with the remaining 30% reserved for unsecured creditors!). One of my favorite curious subordination laws is section 134(4) of the new Russian Bankruptcy Law, which subordinates secured claims to two kinds of unsecured claims if they arose before conclusion of the security agreement: (1) compensatory tort claims for personal injury and associated "moral harm" (emotional damages) and (2) claims for compensation for the use of intellectual property. One wonders whether the unique IP exception was designed to buttress Russia's bid to join WIPO or some other international IP or trade pact.

Along similar lines, I sheepishly admit that after teaching Secured Transactions for years, I was unaware of the substantial differences between "fixed" and "floating" charges (consensual liens) in English law. As a gross over-generalization, a "floating" charge is a blanket lien, generally on all of an enterprise's property, which "crystallizes" into a "fixed" charge and divests the debtor of unfettered control over the property upon default--for a more detailed exploration of the not-altogether-clear distinction between fixed and floating charges, see here. Floating charges are often subordinated to a variety of different unsecured claims in places like England, Australia, Bermuda, and the Cayman Islands, and in England, floating charges created after 15 September 2003 are subordinated to general unsecured claims as to a percentage of the collateral proceeds, capped at £600,000 [this clause has been edited--see comments]. Indeed, in Sweden, the equivalent of floating charges (företagshypotek on immovables and företagsinteckning on movables) created after 1 January 2004 are limited to 55% of the value of the debtor-company’s unencumbered assets (with the remaining value reserved for unsecured claims).

These kinds of significant limitations on secured creditors' rights are anathema in the United States, and given my U.S. training, I had been a strident "secured creditors über alles"-type guy. Having been exposed to these very different approaches from countries that I regard as populated by reasonable-minded, intelligent, generally commerce-friendly people, however, really opened my mind and made me think twice. For more of this kind of mind-opening study, take a look at the proceedings from a recent World Bank conference on secured transactions and insolvency law reform here.

We have a lot to learn from our friends around the world, and it's so darned FUN to travel (at least mentally) to exotic places with unfamiliar commercial and insolvency law systems. I hope to share some of my joy in the travel-and-learning process during my visit. Thanks again for having me!

Commercial Law Welcomes Jason Kilborn as Guest Blogger

Commercial Law is pleased to welcome Jason Kilborn as a guest blogger. Kilborn is an associate professor of law at the John Marshall Law School and a leading expert on comparative bankruptcy -- with a book in the works on cooperative cross-border bankruptcy. His two most recent articles are Comparative Cause and Effect: Consumer Insolvency and the Eroding Social Safety Net and Out with the New, In with the Old: As Sweden Aggressively Streamlines Its Consumer Bankruptcy System, Have U.S. Reformers Fallen Off the Learning Curve?

We look forward to Kilborn's insights on comparative and domestic topics!

UCC Legislative Update

Nearly three months after both houses of the Illinois legislature passed SB 2080, Governor Rod Blagojevich signed it into law on August 22, making Illinois the 34th state to enact Revised UCC Article 1 and the 31st state to enact Revised UCC Article 7.

As have all thirty-three prior state enactments, and consistent with the ALI's and NCCUSL's promulgation earlier this year of a substitute for the original version of uniform R1-301, Illinois Public Act 95-0895 (neé SB 2080) rejects the 2001 uniform version of R1-301 in favor of language generally tracking its version of pre-revised 1-105. Act 95-0895 also rejects the uniform good faith definition in R1-201(b)(20), joining Alabama, Arizona, Hawaii, Idaho, Indiana, Nebraska, Rhode Island, Tennessee, Utah, and Virginia in opting to retain the bifurcated good faith standard of pre-revised 1-201(19) and 2-103(1)(b).

Act 95-0895 will take effect January 1, 2009.

In Memoriam: Richard E. Speidel (1933-2008)

The fields of contracts and commercial law (as well as ADR) lost an important scholar and a wonderful gentleman Saturday. At the time of his death, Dick Speidel was the Beatrice Kuhn Professor Emeritus at Northwestern University School of Law and a half-time professor at the University of San Diego School of Law. A longtime collaborator of James J. White and Robert Summers, with whose UCC hornbook and treatise I assume all our readers are familiar, Dick served from 1991-1999 as reporter for Revised UCC Article 2 — an experience he recounted in Revising UCC Article 2: A View from the Trenches, 52 Hastings L.J. 607 (2001). Among his many other books and articles are Studies in Contract Law (7th ed. 2008), which he co-authored with Ian Ayres (and previously with the late Edward J. Murphy), Commercial Transactions: Sales, Leases, and Licenses (2d ed. 2004), which he co-authored with Linda J. Rusch (who served from 1996-1999 as associate reporter for Revised Article 2).

USD Law Dean Kevin Cole posted this brief tribute.

Destined to be a "Heartless" Barracuda?

The Republican National Convention rocked last week to Heart's 70's hit Baracuda when Sarah Palin took center stage. Apparently, the Wilson Sisters who make up the band are none to happy with the use of their song by the Republicans. "I think it's completely unfair to be so misrepresented," singer Nancy Wilson told Entertainment Weekly. "I feel completely f****ed over." The McCain campaign responded that all license fees were covered under U.S. copyright law by the blanket fee paid by the St. Paul venue.


The barracuda, of course, is a large fearsome fish known for its strong jaws! Wilson commented "[Barracuda] was written in the late 70s as a scathing rant against the soulless, corporate nature of the music business, particularly for women ... There's irony in Republican strategists' choice to make use of it there." Harsh! Unfortunately for Heart, the tune does seem to be covered by the BMI/ASCAP blanket license. Under the blanket licensing, the artists do not retain any moral or political rights to object to the use of licensed music. Of course, the U.S. Supreme Court long ago blessed the blanket license practices in Broadcast Music, Inc. v. Columbia Broadcasting System, Inc.
As a matter of commercial law: no breach of contract, no damages. Simple as that.

Even if Heart can persuade the McCain campaign to cease and desist, another problem for Heart is that fans have adopted the "Barracuda" image (complete with song) for Sarah Palin as well.



So, at least for now Palin can have her barracuda tune and campaign to it, so long as the blanket license applies. Perhaps ABBA is next in line to raise a complaint?

— JSM