Jon Stewart v. Jim Cramer

In case you missed all the "dust-up" between Jon Stewart (Daily Show) and Jim Cramer (from Mad Money), there are a couple of videos you might want to watch. Jon Stewart hit Cramer pretty hard for his part in the news business putting entertainment over accuracy. Stewart really complained heavy about the accuracy of the reporting and argued that the news media like Cramer are actually "guilty of a sin of commission" not one of "omission." Stewart was pretty angry and admitted it saying this is "not a $$%%^ game."

First, the background of the sparring before Jim Cramer's appearance on Comedy Central:

Second, the comedy central appearance. This full show is available at over at The Daily Show. Here are some of the highlights:

The Daily Show With Jon StewartM - Th 11p / 10c

Jim Cramer Unedited Interview Pt. 1

Daily Show Full Episodes
Important Things w/ Demetri Martin

Political Humor
Jim Cramer

So, what is the role of cable news financial reporting? Not to be too hard on Mad Money, which does present in an entertainment style, but Jon Stewart has a valid point about responsibility. Not just with Jim Cramer, but with business news on a greater scale. Jim Cramer explains at one point that we all should have seen this coming (including him). That is, people began to believe that the market would just continue to go up. Listening to the video, there is still an impression that part of Stewart's message did not get through. That Cramer perhaps doesn't get it. A lot of people lost a lot of money, many of them ordinary people saving for their children's college or retirement or those already in retirement. For sure, Cramer's Mad Money is supposed to be targeted at money invested for purposes other than retirement, but does that exculptate him (and others) from careful reporting?

The business media should be held to a higher standard of reporting due to its ability to influence financial decision-making. Again, this is not a game. Tough night for Jim Cramer.

— JSM

The Death of [the] Contracts [Course]... Maybe that's a good thing

The AALS Contracts list-serve two months ago carried a stream of interesting comments around the question whether contracts should be taught in four or six hour blocks of time. These discussions have been brought by the need to inject other things into the first year curriculum, such as skills courses, constitutional law, etc... (which I am all for). However, I want to offer a different proposal than a mere reduction of hours -- maybe we shouldn't teach contracts to first year students at all. Instead perhaps we should teach students in the first semester Article 2 of sales. Here are my reasons, in no particular order of significance. By the way, you can disparage me in person if you are going to the Contracts Panel at SEALS this summer, as this will be the basics of my presentation...

1. Its a Legislative World and I'm a Legislative.... The same argument I consistently hear justifying common law contracts as a First Year Course is that it teaches students how to read cases. First, doesn't Torts, Property, Criminal Law, and Civil Procedure do equally fine jobs of teaching students how to read cases? Second, and more importantly, where in the first year curriculum are we teaching students how to read statutes and Codes. We are not, and as a result, when students come to take a code based course, they repeat their first year growing pains again by by having to learn how to read and analyze statutes. Sales provides a great opportunity to fill the legislative gap and still .....

2. Introduce Students to the basic principles of contracting. Offer, assent, parole evidence, statute of frauds, battle of the forms (of course) impossibility, remedies... Its all there. The difference is two fold: one, the material is in a more concrete format in the form of a code; and two, the material becomes more understandable because students have a familiar and definite context for understanding specific rules like parole evidence, statute of frauds exceptions and the battle of the forms. As I tell my UCC students, we have all bought candy bars by the time we get to law school and we know the essence of the process --I give you money and you give me a Snickers. We now are putting definite terms to that process.

3. Is Common Law Contracts that relevant anymore? Sure the basic principles of offer, acceptance, etc.... in some form stretch the gambit of contracting. But our legal system has created so many different types of contracts that each vary in nuanced ways from each other. Employment contracts are different from sales contracts which are different than construction contracts, which are different from licenses and so on and so on. The idea that we are teaching general principles that stretch through the curriculum falls apart when students learn that each of these different contracts have their own unique language and terminology that renders the common law of contracts at best a quaint introduction to the sport of creating obligations. Add to that fact that much of contracting gets reduced to form-negotiations and contracting as an art becomes mostly irrelevant. If contracting were taught as an exercise in transacting, I believe it would be far more effective. One of the comments from the contracts list-serve discussion that I really appreciated came from Peter Linzer, in which he said:

At a less abstract, but much more practical level, I have for a long time been advocating a shift from Contracts as a course in busted deals to a course in what real contracts lawyers do, advising clients, helping them to plan, and getting the plan on paper through good drafting. I’m still trying to slip a bit of that into my four-credit course, but I can’t really change much. Some parts of Contracts must be taught from the cases (interpretation, the parol evidence rule, remedies, the click-wrap issues (which, of course, are also part of the transactional part of the process)). But the real task of preparing students to be transactional lawyers needs to be taught differently, and can’t be covered well in a four credit course. I can teach a class of 100 how to draft, but I can’t review their work to raise them beyond the very basics. That has to be covered in a more advanced course. But if we can sensitize students to what contract lawyers really do, and the important role of drafting and planning, we can greatly improve the abysmally low level of quality among most business lawyers, especially those dealing with small businesses. That, however, needs much more time than is available in a four hour course.

I concur.

4. Teaching common law contracts does not necessarily prepare students for the bar exam. First of all, students rarely retain what the parole evidence rule is versus the statute of frauds between the end of their contracts course and the beginning of their second year (or they may just deny any knowledge of those things in class). Moreover, we have pretty well ceded bar preparation to Bar-Bri, Mishmash, or what ever other cram course students are willing to fork out $2500 to cram long-forgotten doctrines in their minds. Have we all of a sudden become less confident in bar-review's capacity to teach contract doctrine as well? It seems to me that most professors I talk to vehemently deny that they are teaching for the bar (which I do as well). So why would we teach a course on that basis.

5. For that matter, Sales does not prepare students for the bar exam either, but there is a trickle down effect. In the same way that contracts does not necessarily create a long-term knowledge of contracts doctrines, neither will Sales. Though, at least by teaching sales early, we open the door for other UCC courses to be more accessible to students. Students that take Article 9 or Article 3-4, are more likely to be prepared for courses like bankruptcy, debtor and creditor rights, taxation, and corporations. Getting students in the sales curriculum earlier rather than later aids that process.

6. Wouldn't we all be happier teaching a perspectives-esque upper level course on the theory of contracts. Really isn't that what we all really want to teach anyway. This to me is the best use of the contracts course and one that often gets pushed aside for lack of hours or because students are not quite ready to understand these nuances. This is the art of preparing lawyers: equipping them with the intellectual tools to make rational decisions regarding how contracting should be undertaken. Forcing students to struggle through Law and Economics views of contracting, moral theory of contracting, etc... before they truly understand the contracting process seems to me to be reversed. Students will learn more and professors will be happier with the result.

The only upside to the contracts course is it might make the classic movie, The Paper Chase irrelevant, though I think I can live with that -- I think.

Marc (MLR)

Good Commercial Faith and the City

Thank you welcoming me into this space to talk out loud about some of the aspects of commercial behavior that I have been thinking of for sometime. I'm delighted to be blogging here. In addition to talking about my article on consumer behavior, I hope to write some on other aspects of consumer decision making. But today, I want to talk about commercial virtues.

One of the troubling aspects of commercial dealings today is the focus on ethics. Truthfully, I despise the topic (perhaps because I was never very good at the subject in either theological classes or law classes -- like professional responsibility for one). But the real reason I despise ethics, my own discordant academic performance in the subject aside, is I think we are often times asking the wrong questions. We assume that by ethics, we mean some form of social responsibility, but more often than not, that responsibility is defined by communities of interest, rather than greater social values. Consider the problem with UCC 1-201 and the definition of good faith. Do we really mean good faith is "honesty in fact" when we combine that with the observation of "reasonable commercial standards of fair dealing". Which takes precedence -- clearly the latter. The secured lender that tells only part of the story to his debtor (your income statement is a mere formality) has not been completely operating with "honesty in fact" though his actions may well fit within the constraint of reasonable commercial standards of fair dealing -- after all, fudging your income was hardly the act of just a few bad apples. The subjective element of good faith gives way to the relevant community that defines what good faith means.

Deirdre McCloskey in her defense of capitalism, aptly named, the Bourgeois Virtues, makes many debatable claims that Capitalism makes the world better (many of which I will not attempt to defend). But what McCloskey does get is that commerce (and commercial law) urges the continued development of social structures for the betterment of the individual within a community that is itself working to be better. Quoting Rabbi Starks, McCloskey writes:

It is the market -- the least overtly spiritual of contexts -- that delivers a profoundly spiritual message... The free market is the best means we have yet discovered... for creating a human environment of independence, dignity and creativity.

McCloskey's message of capitalism as a movement of social ingenuity is at its core the spiritual message of hope we find in some of our best religious literature. The prophet Jeremiah admonished the Israelites in Captivity:

This is what the Lord Almighty, the God of Israel says to all those I carried into exile from Jerusalem to Babylon: 'Build houses, settle down; plant gardens, eat what they produce, Marry and have sons and daughters; find wives for your sons and give your daughters in marriage so that they too may have sons and daughters. Increase in number there do not decrease. Seek the peace and the prosperity of the city to which I have carried you into exile. Pray to the Lord for it, for if it prospers, you too will prosper.

Ralph Waldo Emerson also saw that hope comes from capitalist engagement but only when the mind is able to reflect upon its work. Emerson distinguishes between the Brute Economy, in which labor and strength build vast empires of material longing only (i.e. its good to spend money to relieve us of the pain of 911), with the capitalist economy which employs intellect in an analytical expansion of labor, material and wealth. What Emerson says the Capitalist lacks is the moral and spiritual wisdom of the poet - "who acts upon nature with his entire force -- with reason as well as understanding."

The virtue of McCloskey's work is that Commerce (and capitalism) share a common goal of enhancing our social order, instilling the hope that we might reshape "the city" into an image that is not of ourselves as we currently stand, but of the selves that we might one day hope to be, both individually and collectively. And that actions should be weighed and measured against both of these standards. Whether we segregate capitalists from capitalist poets, we nonetheless, come to the same conclusion as Emerson and McCloskey -- that commerce creates the potential for humans to be good.   

Which brings me back to 1-201. Do we really want good faith to be watered down by community constraints or is there a moment for reflection of the aspirational norms that commercial dealings might adhere to? I was much happier when good faith was simply "honesty in fact" without the burden of community differences, whatever that might mean -- even if the aspirational view of good faith was nearly impossible to enforce.

Marc (MLR)

Commercial Law Welcomes Marc L. Roark!

Commercial Law welcomes guest blogger Marc L. Roark, a visiting associate professor of law, at University of Missouri teaching torts, secured transactions and sales. Marc will join University of LaVerne next year. Marc's recent paper, Limitation of Sales Warranties as an Alternative to Intellectual Property Rights: An Empirical Analysis of iPhone Warranties' Deterrent Impact on Consumers, considers whether limitation of warranties may actually have a deterrence effect on consumers that manufacturers desire; said differently, the article weighs whether manufacturers can achieve their goals of preventing consumers from using their products in an unauthorized manner by removing warranty protections from the consumer. Marc concludes that warranties do matter to consumers and that companies could use them better to their advantage to encourage desired consumer behavior by restricting warranty access for consumers who misuse products.

Welcome Marc!

In Defense of the Debit Card

Jason beat me to the punch by blogging on charging fees for debit cards loaded with unemployment insurance benefits. Like Jason, I have always been puzzled by the use of debit cards given their high fee structure. Indeed, I wandered all around Midtown Manhattan last month in search of a proprietary ATM which I could use without being levied with those annoying charges, which hover around $4 per withdrawal lately. Nor is the EFTA approach toward losses due to fraudulent debit card use something that really survives any critical evaluation, in my view. So Jason and I agree there, I would bet.

I have found two super-fantastic uses for the debit card, and thus I must beg to differ with Jason that the payment device is all evil. They are:

1. Cash back at the merchant: You can use this (add on cash to your store purchase) to circumvent the nasty fees that the banks charge for simply withdrawing at a non-proprietary ATM. I survived a whole semester in South Bend, Indiana a few years ago without paying any fees using this debit card function, which with my bank is free. I would bet sooner or later this loophole will be closed. In the meantime I find it sweet to be cleverly manipulating my knowledge of the payment system to deprive my bank of $1.50 in fee revenue, which makes cash-back transactions even more delightful.

2. Foreign Exchange when Traveling Abroad: Any serious traveler who remembers the old days and trips to the American Express office abroad can tell you that this is the most amazing thing: Local currency is available with any Cirrus or Maestro-branded ATM with just a swipe of the debit card. True, you have to pay a fee, but generally it is no worse than those fees (and the bad exchange rates) for USD or traveler's checks. I have used ATMs from Kathmandu to Kunming, Prague to Perth, and each time I get local currency I swear it is the best payment systems invention in the last 50 years. My only advice is that before you leave, check the exchange rate and find out the local currency equivalent of the dollar amount you want to withdraw. That saves some jet-lagged confusion at arrival at the destination, trying to figure out exactly how much in local currency you should withdraw.

So, in every evil there is some good.

"The best and the brightest"

AIG has gotten more than $170 billion in bailout money from the Treasury and the Federal Reserve. And now AIG has paid about $165 million in bonuses to the executives who brought the company to its knees.

A more politically foolish use of 0.1 percent of available cash can scarcely be imagined.

AIG chairman Edward G. Liddy's defense of these bonuses may be even more outlandish:

We cannot attract and retain the best and the brightest talent to lead and staff the A.I.G. businesses — which are now being operated principally on behalf of American taxpayers — if employees believe their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury.

Raw intelligence is vastly overrated; elite educational credentials, even more so. But eclipsing these exercises in overpaying is the longstanding assumption that the very best talent in our society responds, in strictly Pavlovian fashion, to overwhelming sums of cash.

And even if you disagree with everything I've written so far, surely you would endorse this recommendation: It is time to retire the phrase, the best and the brightest, in all senses except the ironic, even sarcastic, sense in which that phrase was originally intended.

The Best and the Brightest was the title of a 1972 exposé by David Halberstam of foreign policy miscalculations by the Kennedy and Johnson administrations. For much of the next two decades, American geopolitics, crafted by none less than "the best and the brightest," wreaked havoc throughout Indochina:





It will take years, decades, perhaps lifetimes to shake American business culture of the fallacy that outrageous salaries are what valuable talent truly demands and deserves. In the meanwhile, I'll settle for a split second of humility regarding the true origins of the best and the brightest.

Madoff's Guilty Plea

"Here was a man with all the duties of seeking large money. He concocted a scheme which, on his counsel's admission, did defraud men and women. It will not do to have the world understand that such a scheme as that can be carried out ... without receiving substantial punishment."

This statement could have been made at the hearing for Bernard Madoff this week. It wasn't. This quotation is attributable to Judge Clarence Hale, who made the statement before sentencing Charles Ponzi back in 1920. Ponzi never seemed to "get it" passing a note to reporters as he was led to prison stating: "Sic transit gloria mundi," or "Thus passes worldly glory." In an interview shortly before his death Ponzi apparently still had little remorse for his deeds, commenting:

"Even if they never got anything for it, it was cheap at that price.
Without malice aforethought I had given them the best show that was ever staged in their territory since the landing of the Pilgrims! It was easily worth fifteen million bucks to watch me put the thing over."

So, will Madoff get it? Madoff did say that he was "sorry" for directing the large Ponzi scheme. The sentence as it stands now is 150 years. But has he really confessed to all the wrong-doing? Even with Madoff's guilty plea, much uncertainty exists about whether Madoff really acted alone in this scheme. Moreover, the $70 million that Ruth Madoff claims as separate assets in her name is staggering. One must wonder how sorry Madoff really is if his family retains assets while the clients will recover little.

Bloomberg's coverage of the guilty plea:

And the coverage of Madoff's immediate trip to jail until his sentencing in June:

— JSM

Evil Debit Cards and Unemployed Victims

Rarely would a story about payment devices make the marquee on CNN.com, but this story has moved from the money section to the front page . . . presumably because it's so outrageous. Some states are apparently foisting upon their unemployed citizens the fee-ridden abuse of debit cards. Want your money faster (don't we all?!), accept benefits on a pre-loaded debit card--sounds attractive. I doubt the states tell their UI benefit applicants about the dark underbelly of this device. Fee revenue is now the center of the card payment world. States allowing banks to impose these fees (sub silentio) on their hapless unemployed citizens is almost as bad as Bobby Jindal rejecting an increase in UI benefits for Louisiana citizens from the feds!

A bit of good news: for the first time, my poll of my Payment Systems class revealed that fewer people use debit cards rather than credit cards, and those who do have a good explanation--banks require at least 6 debits per month to waive the account maintenance fee for their "free" checking accounts. Death to debit cards and the crappy EFTA and Reg E consumer non-protection regime!

Larry Summers Remarks at the Brookings Institution

Among many other good observations, Larry Summers , Director of the National Economic Council, today stressed to everyone in his speech "Responding to an Historic Economic Crisis: The Obama Program" that there is one thing that is known about every financial crisis: "They all end." Seems like simple advice, but with the markets fluctuating so greatly and people being so worried about the economy, a bit of simple advice is well placed. 'No one can know' when the crisis will end, but it will. Summers believes that fear in the market places has created unhealthy, untrusting cycles based on a lack of confidence. Here is the link to the Bloomberg.com video: http://www.bloomberg.com/news/av/

The text of Summer's speech can be found here.

— JSM

Great Video: "The Crisis of Credit Visualized"

Can be found here (courtesy of one of my Real Estate students). The way in which the video conceptualizes how mortgage-backed securities lose value due to the foreclosure crisis is absolutely amazing in its lucidity.

If Peter Piper picked a peck of pickled peppers . . .

Well maybe this post is not about Peter Piper from the old Mother Goose nursery rhyme, but it is about peppers. Co-blogger Robyn Meadows and I just finished the Sales Survey for the ABA's Business Lawyer that will be out in August 2009. And, it contains a wonderful case about, of course, peppers. The case, Florists’ Mutual Insurance Co. v. Lewis Taylor Farms, Inc., 2008 U.S. Dist. Lexis 24445 (M.D. Ga. 2008), raises classic issues about the scope of Article 2.

Lewis Taylor Farms, Inc. (LTF) is a “greenhouse” that grows seeds (some of which are provided by farmers) to seedling plants and then sells the seedlings to farmers. LTF contracted with DL&B Enterprises, Inc. (DL&B) for some pepper plants for the fall. DL&B supplied some of the seeds for one variety of pepper and LTF supplied the seeds for two other pepper varieties. The contract required DL&B to pay LTF per transplant seedling with the cost per seedling being higher for the pepper varieties that LTF provided both seeds and growing to reflect the cost of the seeds. Although the LTF invoice did not itemize the cost of the seeds separately from the cost of raising the seed to transplant, the cost of the seeds themselves was less than 30% of the contract price.

After the DL&B received diseased seedlings from LTF, DL&B filed suit claiming breach of the warranty of merchantability. LTF moved for summary judgment, asking the court to rule that Article 2's warranties did not apply. The trial court used the “predominant” purpose test to hold that where DL&B provided most of the seeds, the cost of the seeds and the services were divisible even though not segregated in the invoice and the context indicated that DL&B emphasized the growing of the plants in conversations, the contract was one predominantly for services, not goods. Therefore, common law outlined the scope of damages.

Overall, this case seems correct, perhaps for reasons peculiar to the industry or at least the arrangements here. I have my doubts, though, about what DL&B really thought they were getting. That is, what really was the purpose of the contract? Thinking about my own purchases of pepper plants for my summer gardens, how do you really divide the growing from the product when it comes to vegetables? A fun case for sure, which I will be sure to pitch to my students the next time I teach sales.

— JSM

Declines in university applications?

Bloomberg reported this week that applications are down this year at 7 of 8 top liberal arts colleges, some colleges down as much as 20%. Only Wellesley College was up, about 2%. What about law schools? Early reports are that law school applications are flat overall, but some schools are actually reporting increases. For instance University of Pennsylvania Law School is reporting an almost record increases in applications of 6%.

So, what will happen to law school applications and enrollments by fall 2009? Normally we might expect more people to go to law school during hard economic times. But the current economic woes are pretty unprecedented. At the undergraduate level, it seems that private schools with the highest tuition are being hit the hardest in terms of application declines this year. Moreover, students looking for bargains may attend more state schools and make fewer applications. After all, law school is hardly an inexpensive endeavor. For instance, University of Pennsylvania at $41,960 for tuition is not exactly a bargain.

The high cost of law school, general economic uncertainty and the difficulty of getting loans would seem to favor some of the state schools that are bargain oriented. Early application numbers tell a mixed story. The good news is that law schools so far don't seem to be experiencing the deep declines present at the liberal arts colleges. The big problems at law schools may not be less applications, but rather lower budgets due to declining endowments and support from state revenues. At least at this point, these latter problems may have the greatest impact on law school education going forward.

What news for law schools going forward? Warren Buffet remarked recently that the economy “has fallen off a cliff.” The World Bank expects the world economy to contract in 2009. The market's pattern recently can best be described simply as one of uncertainty. The uncertainty/volatility in the markets will continue to affect the budgets available at law schools for some time to come. While this might seem grim in terms of university budgets, the impact may turn out to be harsh but manageable so long as law school applications remain somewhat stable. Like Americans generally, the law schools may simply find themselves tightening their belts to ride out lean budgetary times. As Franklin D. Roosevelt remarked:

When you come to the end of your rope, tie a knot and hang on.

Probably good advice for deans trying to balance the law school budget.

— JSM

Quality Woodworks' Embezzlement

Annette Yeomans, chief financial officer for California-based Quality Woodworks, Inc. was recently arrested in a classic case of embezzlement of $9.9 million of company funds, causing the company to lay-off workers and restructure operations. The scheme apparently lasted more than seven years and Yeomans used more than $6 million for gambling and other funds for clothing, shoes, home improvements and the like. Yeomans would charge up to $25,000 on her company credit card each week and then issue a company check the next week to pay off the balance.

Yeomans' case is one that makes a great law school classic. Under 1-201(43) an "unauthorized signature" includes a "signature made without actual, implied, or apparent authority." Yeomans' signatures on company checks over the course of seven years would be unauthorized under the code. Section 4-406(d)(2)'s "same wrongdoer" rule precludes the customer (QWI) from claiming the loss from the bank for the acts of those like Yeoman where the customer did not notify the bank of the forgery within thirty days. With a longstanding scheme like Yeoman's, QWI will shoulder the load. It looks like about $2 million is recoverable from Yeoman, but apparently she lost the rest gambling. This becomes another case of faulty internal procedures resulting in a huge corporate loss. That Yeomans will likely spend some time in jail is small comfort for company employees at a time when jobs are already hard to come by.

— JSM

When Small Clerical Errors Explode Into Big Problems

Photo by chrishusein

Two recent big stories may mean greater interest for the types of classes that we here on the Commercial Law blog teach. First came the spectacular UCC-3 filing error involving bank creditors of the law firm Heller Ehrman ("Oh, did I say 'termination,' I meant 'continuation!'") and the very serious consequences that this "clerical" error caused when the debtor went into bankruptcy. Now we have more press on an older and more serious problem. The New York Times this weekend reported on the lax assignment protocol followed (or rather, not followed) in the transfer of hundreds and thousands of mortgage notes into securitization pools. When the rare but brave judge (often in bankruptcy court) asks the foreclosing bank for proof of its ownership of a transferred/negotiated note, this proof is often unavailable--very good news for defaulting homeowner-debtors (as consumer advocates around the country are now informing their colleagues at CLE meetings), very bad news for banks. Perhaps lawyers-to-be will become more interested in following the nitty-gritty details of these transactions in the future to avoid spectacular losses. This interest will lead them right into our waiting hands!

Nitty-gritty details--that's what we commercial law profs are all about!

There's Something Happenin' & U Don't Know What It Is, Do You, Mr. Cardholder

The credit card industry's explanation for the failure of smart cards to emerge in the United States is well known. To be economically viable, the industry has argued, smart cards must provide substantial cost savings. In Europe, they were justifiable because they significantly reduced fraud losses through point-of-sale PIN authentication. In the US, however, cheaper telecommunications costs enabled the card systems to guard against fraud almost as successfully through magnetic stripe point of sale authorization. The system worked through complex algorithms that enabled card issuers to identify and block potentially fraudulent transactions. I was personally saved from fraudulent transactions on a couple of occasions as a result of these systems. Although recently, one card company blocked some of my own legitimate transactions because my wife had tried to buy a plane ticket to Europe using the card. Perhaps they are becoming overly cautious.
In addition to tightening their fraud protections, the New York Times recently reported that the largest card issues may be using similar systems to monitor the credit worthiness of their own cardholders. These issuers review hundreds of data points, including home prices in the cardholder's area, the type of mortgage lender used, and whether small-business cardholders work in a distressed industry. Although the most significant factor continues to be overall debt in comparison to financial resources, some issuers may be incorporating spending patterns into their credit worthiness algorithms.
According to the Times, American Express "has been looking at how you spend your money, searching for patterns or similarities to other customers who have trouble paying their bills." When the indicators are bad, cardholder credit lines are reduced. AmEx recently sent letters to cardholders, explaining that "[o]ther customers who have used their card at establishments where you recently shopped have a poor repayment history with American Express." The letters, however, failed to identify the problematic merchants.

Initially, AmEx defended the practice. “We’re just doing this to manage risk,” an AmEx spokeswoman is quoted as saying, "customers who make transactions with certain merchants tend to have a higher proportion of credit issues or a higher probability of default.” When approached by Times columnist Ron Lieber, however, AmEx claimed that it had stopped using spending patterns to predict credit losses and never actually based decisions on a cardholder shopping at a particular merchant. Last year, however, sub-prime lender Computer Credit was shown to have looked at merchants including marriage counselors, tire retreaders, pool halls, pawnshops, and massage parlors in considering whether to lower its customers' lines of credit. The curious message may be that changing your spending patterns in response to economic conditions -- say by having your tires retreaded instead of buying new ones or buying tools at a pawn shop rather than Sears -- may lead to an overall reduction in your available credit.

Clawback

"Should executives get to keep lavish pay packages when the profits that generated their compensation go up in smoke?" A growing, grumbling chorus says "yes":

With losses mounting at the nation’s largest financial institutions, years of earnings have been erased, investors have lost billions, thousands of employees have been let go, and taxpayers have been tapped to rescue the financial system. But executives who helped set the problems in motion, or ignored them as they mounted, are still doing fine. Humbled, perhaps, but well paid for their anguish.

Executives at seven major financial institutions that have collapsed, were sold at distressed prices or are in deep to the taxpayer received $464 million in performance pay since 2005 . . . Almost half of that consisted of cash compensation.

Yet these firms have reported losses of $107 billion since 2007, a result of their own missteps and the ensuing economic downturn. And $740 billion in stock market value has been lost since these companies’ shares peaked in 2007, just before the housing bubble burst.

Against that landscape, a growing chorus is demanding that executive compensation snared shortly before problems emerged be given back.

“There is a line that separates fair compensation from stealing from shareholders,” said Frederick E. Rowe, a money manager in Dallas and a founder of Investors for Director Accountability, a nonprofit group. “When managements ignore that line or can’t see it, then hell, yes, they should be required to give the money back.”

Corporate boards that awarded lush executive pay packages almost always justified them by saying they encouraged superior performance and were directly tied to benchmarks like profitability.

But now, with a public backlash against excessive pay and taxpayer lifelines extended to crippled companies, the idea of recouping compensation, known as “clawback,” is gaining traction.

Currently there is no legal mechanism for forcing the regurgitation of past pay, so such efforts would need to be bolstered by new legislation. Clawbacks also promise to be a hot-button issue at shareholder meetings in coming months.

Other Consumer Financial Transactions

At the University of Memphis Symposium, a panel on consumer financial transactions addressed a number of issues, including how consumer issues are related to crisis containment and general regulatory reforms. The panel was moderated by Professor Adam Feibelman, University of North Carolina School of Law.

Professor Donna Harkness, who supervises the Elder Law Clinic at University of Memphis, spoke to consumer issues presented by the elderly, who typically have a fixed income. This group, Harkness explained are often targets for fraud and overreaching. Many of the programs pitched to elders are not always those that are appropriate for retirees. Moreover, credit card debt has become a problem for the elderly, including co-signing for credit cards and other loan instruments with younger relatives. According to a Federal Reserve study, the elderly had the greatest increase in consumer debt in recent years. Moreover, much of the disclosure on lending products, even where required, is not always understood by the elderly. Professor Harkness argued that lending practices to the elderly need reform to curb lending to those who cannot possibly repay the amounts. Professor Harkness advocated for a capping of late fees that go on indefinitely, universal default provisions, mandatory arbitration and more stringent consumer protections generally. Of course, the convenience users may end up paying more.

Bankruptcy Judge David S. Kennedy spoke about bankruptcy and the housing crisis. In particularly, the Homeowner Affordability and Stability Plan just announced designed to make mortgages more affordable, reach at-risk homeowners and address declining neighborhood values. As to bankruptcy modifications of home mortgages, the so called "cramdown," Judge Kennedy predicted that the initiative will succeeed, perhaps soon. Several bills are pending already (H.R. 200, H.R. 225 and S. 61). CitiGroup and about twenty state attorneys general are supporting the measures.

Judge Kennedy argued that bankruptcy judges already do write-downs on second homes, vacation homes and other real estate. As such, this is something bankruptcy judges already have experience doing. The bills would allow judges to extend the loan term, change the interest and write down the amount of the secured portion of the loan to the home value. The unsecured portion of the home loan would be folded into a debtor's other unsecured debt and eventually discharged if a Chapter 13 plan is completed. Ultimately, Judge Kennedy observed, the other unsecured creditors may complain the loudest as the total amount of unsecured debt in a Chapter 13 plan will increase.

All of this comes down to what Americans can afford. A serious consideration must be had about how we extend credit and how we fix credit issues for consumers. I agree with Judge Kennedy that the sky will not fall if mortgage cramdowns are allowed and will Professor Harkness that more needs to be done for the elderly. With respect to bankruptcy, lenders might be more likely to come to the table earlier if a bankruptcy judge is waiting in the wings.

I want to thank everyone at University of Memphis School of law for hosting this Symposium. Special thanks to Symposium Editor Jera Bradshaw for her efforts to make this happen today so successfully and Baker Donnelson P.C. and First Tennessee for their support of the program.

— JSM

Keynote Speech by John Dearie of Financial Services Forum

Over at University of Memphis' Symposium on Financial Services Reform, John Dearie of the Financial Services Forum gave the keynote speech. Mr. Dearie agreed with earlier presenters that we must first decide what is to be regulated and, second, determine what is the point of regulation. That is, what are the objectives to be obtained.

Mr. Dearie discussed the changes in financial products that have altered our marketplace and urged that a number of factors require consideration in establishing a new supervisory framework. Among those:

• Global financial systems. The global nature of our marketplace requires consideration due to the interconnectedness of markets.
• Innovation. Mr. Dearie also cautioned against putting financial institutions in a "regulatory box." As such, the supervisory function can only be successful if innovation is not discouraged or impacted in a way that impairs competitiveness.
• Risk. The supervisory objective to help identify and manage risk and be responsive to changes in the marketplace to ensure safety and soundness.
• Cost. Moreover, the cost of the supervisory system must be considered. Mr. Dearie argued that the American supervisory system costs many times over that of other countries, such as the U.K.

How to accomplish this? Rather than scrapping the current structure, Dearie's plan is dubbed GLBA plus (named after the 1999 Gramm-Leach-Bliley Financial Services Modernization Act, Pub.L. 106-102) Federal, state and local supervision would continue under this model. This plan would preserve the specialization of current regulatory agencies. Regarding federal bank examinations, bank examination powers should be consolidated into one agency, the Office of the Comptroller of the Currency (with the Office of Thrift Supervision folded into the OCC). To the extent that non-traditional entities do not have an existing designated regulator, like hedge funds, such entities would only have intervention in an emergency. The Federal Reserve would remain as an overseer of the financial system as a whole as an umbrella supervisor. This will result in: lower costs; focus on a single regulator for the financial system as a whole; comprehensive supervision; preservation of regulatory specialization; more consistency; increased principles based supervision; and more likelihood of political success.

So, will this work? The mood at the Symposium was mixed. There is a lot to like about having the Federal Reserve keeping an eye on the financial system as a whole. After that, though, it gets a bit murky on how state and federal agencies might coordinate particular challenges. This is not intended to be overly critical of Mr. Dearie's position, as he is just thinking this through himself and how financial products will develop is uncertain to all. The GLBA plus proposal might be a modest regulatory fix with big results or merely perpetuate a system of limited oversight without substantial changes. For the time, it is good to have the discussion take place to ensure that attempts are made not only toward the current, but also any future crisis.

— JSM

Sukuks: Islamic Debt Instruments

Similar to conventional bonds, sukuks are Islamic debt instruments. Sukuks are also known as “trust certificates” or “participation securities.” Sukuks are part of an emerging Islamic financial market that, per Moody’s Investor Service estimates, will hit $4,000 bn. In the legal academy, sukuks are unfamiliar debt instruments. The purpose of this post is to explain the Islamic law behind sukuks.

Sukuks share some constitutive elements with conventional bonds but they are not the same as bonds. A conventional bond also known as a fixed-income security is a promissory note obligating the issuer to pay to the bondholder a fixed sum of money, including principal and interest. For most bonds, the annual interest rate is fixed in advance at the time the bond is issued. The annual interest rate is also known as coupon rate or nominal rate. The rate varies depending on a host of factors, including the life of the bond (maturity), creditworthiness of the issuer, and the expected inflation during the life of the bond. According to one estimate, fixed-income securities carry investments of more than $10 trillion.

Just like conventional bonds, sukuks too are issued in exchange for loans to the issuer. Both are debt instruments. Both serve as market devices to raise funds. Governments and businesses issue sukuks to obtain monies from investors. Technically, the sukuk too is a promissory note obligating the issuer to pay to the sukuk-holder a sum of money.

The sum of money promised to the sukuk-holder, however, must contain no interest (riba). It cannot be fixed. This is the critical difference between bonds and sukuks. Bonds pay interest. Sukuks cannot pay interest. Islamic law allows extending loans to individuals and businesses. It, however, prohibits charging and receiving riba on loans. Riba is severely condemned, calling it war against God.

To overcome the prohibition of riba, Islamic finance markets must design debt instruments to facilitate loans but without riba. Since Islamic law allows profit on investments, the design of debt instruments can allow profit but not interest. Designing debt instruments compliant with Islamic law has been a practical challenge for Muslim jurists and financial experts. A mere change in name, that is, calling interest profit, will be deceptive and contrary to the letter and spirit of Islamic law. Similarly, debts instruments cannot be designed to conceal the payment of interest. Jurists and experts cannot play games with God’s Law.


Ideas have been presented to make Islamic debt instruments as certificates of secured loans with specific collateral supporting a series of instruments. It is not acceptable that instruments are collateralized with the entire property that the issuer owns. A more specific identification of the collateral supporting debt instruments, whether the property is real or personal, will be more consistent with Islamic law. Furthermore, the collateral must be capable of generating income. When debt instruments are linked to income-generating assets, lenders can share the income that the assets produce. This income may be calculated annually and distributed to lenders. Lenders, however, take the risk that the collateral supporting debt instruments would produce loss, and not profit. In the case of loss, the principal is at risk as well.

Sukuks are modern efforts to structure lending on the basis of Islamic law. While Muslim jurists advise the issuance of these debt instruments, not everyone agrees that these instruments comply with Islamic law. The sukuk market is nonetheless thriving in many Muslim and non-Muslim financial markets.

--LAK

University of Memphis Symposium on Financial Services Reform

Today I am at the University of Memphis Symposium on Financial Services Reform. One of the early speakers was Professor Saule Omarova, from University of North Carolina School of Law. Her paper, co-authored with Professor Adam Feibelman, also from UNC, "Risks, Rules and Institutions" takes up the Treasury Blueprint's proposals for reforming our regulatory structure. Professor Omarova advocates a triple peaks framework for financial regulation: a market regulator (the Federal Reserve), a supervisory regulator and a market conduct regulator. Professor Omarova urges that regulatory action should be taken up soon before political and market will lapses when the immediate crisis is contained.

Crisis prevention is oft put off, but is an important part of addressing the underpinnings of the reasons that have led to the current crisis. The general framework is important because many of the particular financial products that contributed to the current crisis will not present in the same way, but different products can create problems. Prior to restructuring the financial industry, greater understanding of the current (and perhaps future) activities that might lead to market failures is needed. Our past notions of industry business may not lead to the optimal structure. The main concern is that in the rush to act, we might make the wrong regulatory choices.

I tend to agree that the political will to make change may be overshadowed by the fighting of the crisis itself. Moreover, financial products change over time. We really don't know how these products will be packaged in the future. Securitization itself, for instance, might not be the root of the financial problems. Rather, the way in which securitization has been used and the particular modelling of risks.

Professor Amarova's paper will appear in the Memphis Law Review.

— JSM

New Rules Proposed For Debit Cards

In a temporary break from all the financial crisis, how about an update on overdraft fees charged by banks on debit card transactions (See Citizens Bank - Not Your Typical Bank, But Typical Overdraft Fees Apply)? According to the Consumer Federation of America, the average national overdraft fee on at the top ten banks is $34.65, with $1.75 billion in fees paid by consumers to banks on overdrafts for checks, debit card purchases, ATM withdrawals and preauthorized transactions.

The Federal Reserve, along with the Office of Thrift Supervision (OTS) and the National Credit Union Administration (NCUA) (collectively, the “agencies”) in May 2008 initially proposed regulations that would have imposed notice requirements and a broad opt-out option for consumer overdraft programs reaching all consumer account transactions, including checking, automated clearinghouse (ACH), recurring, POS debit and ATM transactions and a more limited opt-out option as well (the “May 2008 Proposed Rules”). The May 2008 Proposed Rules also addressed the issue of debit holds placed on consumer accounts. Apparently unable to decide exactly which type of proposal is the government’s preferred response to the issues of overdrafts, the Agencies recently abandoned the May 2008 Proposed Rules and, instead, proposed new rules that contain both opt-in and opt-out alternatives for bank overdraft services(the “January 2009 Proposed Rules”).

If one accepts the need for either an opt-in or opt-out alternative for overdraft services, there remain considerable issues about the extent to which banks will be able to nevertheless encourage consumers, subtly or overtly, to choose overdraft protection that covers the ATM and POS debit transactions that incur the highest amount of fees. No matter which program the Agencies adopt, issues of the extent to which consumers will understand the model forms provided by the Agencies is also of concern. Because the Agencies do not propose to treat overdraft fees as loans subject to the Truth-In-Lending Act (TILA), consumers may not understand that a $27 overdraft fee charged on a $20 debit transaction for two weeks represents 3520% APR. The APR on $4 cup of coffee would be substantially more, especially if a consumer makes the account right the very next day.

Moreover, even if the Agencies adopt the more stringent opt-in proposal, a number of other issues still remain. First, under either approach consumers who choose are not enrolled in overdraft protection may find that banks will impose less favorable terms on those accounts. Second, the January 2009 Proposed Rules only address the holds that are placed by banks on POS transactions occurring at gasoline stations, restaurants and similar short term holds. It fails to address the issue in all cases and does not attempt to address issues related to check deposit holds that might cause funds availability problems and overdraft fees to consumers. Finally, the January 2009 Proposed Rules do not attempt to alter current bank practices such as batch reordering which will result in the highest number of overdraft fees for consumers who do ultimately want some overdraft protection.

All of this said, it is good for the Agencies to have scrapped the May 2008 Proposed Rules as they wouldn't have done much for consumers. And, the January 2009 Proposed Rules, even with their failings, are a step forward.

— JSM

Should Bail Out Money Fund Large Mergers?

In a letter to U.S. Attorney General Eric Holder, the American Antitrust Institute urges federal regulators to take a hard look at the Pfizer-Wyeth merger. One ground for concern is typical. The two companies are said to have competitive overlaps in anti-depressant treatment drugs and animal health pharmaceutical products, including vaccines, parasite controls, and growth implants. If the merger goes forward, those who need these sorts of pharmaceutical products could face higher prices. But the solution would be a relatively straight-forward divestiture of one company's product line whenever an overlap exists.
The second, and more intriguing ground for AAI's opposition to the merger is that it is being funded in part by banks that received federal bail out money. A consortium of banks, including Goldman Sachs, JP Morgan Chase, Citigroup, and Bank of American are said to have committed $22.4 billion in debt toward the $68 billion transaction. According to the AAI report, these banks have received cash injections of $95 billion and another $345 billion in credit guarantees from the federal government. AAI argues that this federal assistance has enabled the banks to provide the marginal funding necessary for this transaction. That assistance, however, was intended to stimulate lending that would alleviate the credit crunch and thereby stimulate the economy. Funding the Pfizer-Wyeth merger, AAI contends, has the primary effect of handsomely rewarding shareholders, many of whom are extremely wealthy already, while providing little real economic stimulus. If committing so much debt to fund this merger crowds out loans that would otherwise go to build new plants, conduct research and development, maintain needed inventory, and the like, federal taxpayers could end up funding an investment windfall for shareholders rather than stimulating the economy.
Fittingly, a Wyeth spokesperson contacted about the AAI report replied, "The transaction is a compelling one for Wyeth shareholders that is in their best interests."

The Blame Game

Time magazine this week has a great, enjoyable piece on "25 People to Blame" for the financial crisis, a sort of media perp walk of the notables of the financial crisis, led by Angelo Mozilo, the founder of Countrywide. Readers' rankings of the relative culpability of the slate of suspects can be found here. Advocating deregulation seems to be an important component of being considered for this list, as the Phil Gramm (#2), Alan Greenspan (#3), Bill Clinton (#13), and George W. Bush (#14) nominations demonstrate. The Era of Deregulation continues to wane.

It is interesting how high "American Consumers" ranked on the blame list (#5 on Time's list, although they are ranked much lower in responsibility by readers). And, the addition of the programming director at HGTV seems a bit of a stretch, at least for a top 25 list. If a critical component of the crisis was deregulation (and in my view that is accurate), placing such high culpability on consumers for taking out loans that really ought to have been regulated, if not banned, in the first instance seems at rough glance to be misplaced, or perhaps exaggerated, blame.

The Wacky World of Investment Holding/Transfer

Photo by FaceMePLS

I've been struggling with the "new" rules for perfecting security interests in investment property for several years now, and the latest edition of my secured trans text deepened my confusion. Luckily, I found a couple of great articles that confirmed, I believe, that I had properly understood the inordinately complex world of establishing "control" over certificated, uncertificated, and most importatly, indirectly held securities (securities entitlements in securities accounts). Readers of this blog in particular might appreciate David Donald's advocacy piece here (and his descriptive piece here, in German), as well as the excellent introductory notes to the 1994 revisions of Article 8 of the U.C.C., all of which are invaluable navigational aids. If you are having trouble with endorsements, re-registration, and control agreements, check out these fine resources.

Tax Break for Auto Purchases

The proposed stimulus plan includes some incentives for new car purchases by giving a tax deduction for the sales and excise taxes on the vehicle as an above-the -line deduction (Stimulus: How It May Affect Your Wallet). There is a phase out for those making more than $75,000 per year ($150,000 for dual income couples). The original proposal also included write-offs for loan interest on new auto purchases. Who will the tax break benefit?

As to the plight of the auto manufacturers, there is serious doubt whether such a modest incentive will have any meaningful effect. For starters, the benefit to a family purchasing a new auto in the mid-$20,000 range who is under the phase-out income level will only save about $400 on their taxes. This level of tax benefit is not likely to send droves of consumers out to purchase new autos. And should they? Time magazine released its Twenty-Five People to Blame for the Financial Crisis and included consumers on the list. Consumers are rightly faulted for living beyond their means to a whopping 130% of income.

It might be good to worry if the Congress had gone for the tax write-off on the loan interest for car purchases. Tax-deductible or not, many consumers purchasing new autos would simply be incurring new debt that they might not be in a position to repay. Kathleen Keest wrote today on CreditSlips about The Other Underwater Loans: Negative Equity in Auto Finance. Kathleen cautions against the practice of rolling over the remaining loan on a trade-in auto into the new car purchase which results in a LTV of 120-140% on many auto loans, which Kathleen dubs "Drive One, Pay for Two" practice. The estimate that 25% of car loans may be underwater actually seems low to me. With all the talk of stimulus packages and TARP monies, the major thing still lacking is a new thinking about lending practices. While giving consumers tax breaks for auto purchases might increase the number of purchases made, I remain unconvinced that tax breaks focused on loan interest will ultimately benefit the American consumer. This is particularly true when the purchase may include for some consumers the negative equity from their prior auto.

Add to all of this the risk associated with car loans which is still hampering the issuance of such loans and the forecast remains gloomy for the auto industry.

— JSM

French Tortoise Beats U.S. Hare?

Photo by gnoble760

Do we not learn or do we not care? Over 2600 years after Aesop told his famous fable of the tortoise and the hare, we in the U.S. continue to insist that explosive speed punctuated by spectacular slowdowns is the best model for our economy, rather than a slow-and-steady approach to constant growth. Apparently, France has internalized the notion that "slow and steady wins the race." The W$J today has an intriguing story about how France has been spared the worst of the current global economic meltdown thanks, perhaps counterintuitively, to its restrictions on mortgage lending, a dominant public employment sector, and lack of reliance on a few sectors to drive impressive year-on-year economic growth. These characteristics of the French economic model have been criticized mercilessly by economists in recent years, but now who's eating crow? Or rather, who SHOULD be eating crow, as I'm sure few economists are abandoning their disproven theoretical models (which is ironically one reason why many are apparently finding it hard to find jobs)--after all, empirical data about what has ACTUALLY happened to the world economy seems to be less important to most economists than what their models predict SHOULD have happened (if you haven't heard the joke about the economist and the can opener, check it out). The final paragraphs of the article, of course, conclude with dire warnings from an economist that France will "return to a pattern of slower growth" after the world economy recovers. These guys just don't get it. Perhaps WE're the ones who should consider embracing "slower growth" to avoid having to recover from the next inevitable economic breakdown caused by our maniacal focus on above average growth.

Islamic Business and Commercial History Reading Rec

Photo by seier+seier+seier

I've found myself drawn again and again to discussions of Islamic finance in recent months. I'm reading a great paper now that lays the foundation for what I hope will be my better appreciation of its contribution and continuing role in the modern world. Timur Kuran was kind enough to share with us through SSRN his fascinating paper, The Scale of Entrepreneurship in Middle Eastern History: Inhibitive Roles of Islamic Institutions. This is not the short-sighted, xenophobic rant that one has come to expect of western commentary on Islamic institutions in the post-9/11 world (indeed, I apologize for revealing that the title gave me that impression). Instead, Prof. Kuran lays out a level-headed exploration of how and why Islamic law facilitated early entrepreneurialism, based as it was on personal, short-lived business arrangements, but it impeded modern entrepreneurialism after the transition to more impersonal, longer-term business arrangements. I'm not finished with the paper yet, but its central argument seems to be one I've seen before: the central role played by the corporate form in collecting and locking in long-term capital, catapulting European (and U.S.) commerce, was not available in Islamic law until much later, thus critically inhibiting growth.

We in the West obviously have much to learn about Islam and its role in facilitating and restricting business and commerce (the amount of money flowing through Islamic law-compliant banks and funds is impressive and growing). Prof. Kuran's paper helps novices like me to take a comfortable first step in the direction of better objective, non-judgmental understanding. Check it out!

Bernanke Testifies on Federal Reserve Programs

Ben Bernanke, Federal Reserve Chairman, testified today before the House Financial Services Committee about the Federal Reserve's emergency assistance to the financial markets. Stressing the difficulties to policy makers around the world, Bernanke warned in his opening statement that "[a]lthough the provision of ample liquidity by the central bank to financial institutions is a time-tested approach to reducing financial strains, it is no panacea." Bernanke also fielded questions on the appropriate role of the Federal Reserve and whether it has too much power. Specifically, the Committee questioned the lack of oversight on transactions entered into by the Federal Reserve.

The question of the appropriate limits on Federal Reserve power is a fair one. How much restrictions should be imposed on the Federal Reserve in its position as a central bank to intervene in a financial crisis? The Federal Reserve might wield power responsibly, but that does not mean the power should be without limit. The lack of accountability and oversight for specific Federal Reserve decisions is a valid point, but it is hard to argue that the Federal Reserve operates with complete autonomy either. Bernanke does get to testify about decisions made (albeit after the fact). Bernanke did stress the efforts that the Federal Reserve is taking to keep Congress and the public involved in its decisions and programs.

Further, the Treasury provided funding for some of the extraordinary measures the Federal Reserve has undertaken. The increase in the balance sheet of the Fed has not occurred without the involvement of the Treasury. As such, the Federal Reserve must act in concert with the Treasury Department in order to accomplish significant new programs. The Federal Reserve's autonomy is certainly large for the new programs it administers, but it still must act within the program limitations. Moreover, other measures, such as announcing interest rates, are expected from the Federal Reserve without congressional intervention in its role as the central bank.

It is easy to see why Congress would be uncomfortable with the Federal Reserve having a great deal of autonomy. But, it is a central bank. On the whole, a certain amount of autonomy appears appropriate for the Federal Reserve in this capacity. Will we eventually arrive at a point where the role is too great? Perhaps.

— JSM

Gambling and Investment Banking--Redundant?

Photo by waffler

A story on the front page of today's W$J reinforced a feeling I've had for a while now. Does the nature of the people who are drawn to working as traders at investment banks explain the rise of such ultra-risky (insane?) gambles as naked (speculative) CDS, subprime CMBS, and other derivatives and the spectacular losses that they created? I think so. Yesterday, Deutsche Bank announced its first yearly loss in a half-century. The loss was attributed to the roller-coaster investment returns of one trader, Boaz Weinstein, whose losses for 2008 wiped out the gains for the two previous years and produced a $1.8 billion annual loss for DB as a whole!

The take-home line for me was the description of Weinstein: "a chess master, poker and blackjack devotee and top trader at Deutsche Bank AG." I read a paper last night about credit default swaps, and it characterized perhaps the most common usage of that "product" as little more than gambling on the fate of third-party-owned credit products. This gambling meme has come up time after time, and I think it explains so much. Perhaps this is obvious, but it seems to me to warrant explicit observation: those who are attracted to the high-intensity job of Wall Street trader are likely to be the kind of people who like to gamble . . . and gamble big. What better way to catch the ultimate gambling rush than to trade with billions of dollars of other people's money. I don't mean this as a criticism of traders. I do mean this as a reminder that when regulators let these markets loose (as they did in the 2000 Commodity Futures Modernization Act), we should not be surprised when the stake rise sky high, and eventually the sky actually does fall.

Class Action Waiver in Credit Card Merchant Agreement Held Invalid

In In re: American Express Merchants' Litigation, 2009 WL 214525 (2nd Cir. 2009), the Second Circuit recently held that American Express cannot enforce a class action waiver provision in its contracts with merchants that accept AmEx cards. The so-called collective action waiver purports to compel merchants to individually arbitrate any claim arising from their contracts with American Express. A group of small merchant plaintiffs had filed an antitrust action alleging that American Express unlawfully tied acceptance of its corporate and charge cards to acceptance of credit cards issued by AmEx and its bank partners. The merchants argued that American Express's relatively higher merchant fees were originally secured because its corporate and charge card holders were particularly valuable to merchants. AmEx's credit card holders, and particularly those of AmEx's bank partners, by contrast, are indistinguishable from Visa and MasterCard cardholders. Forcing merchants to accept the credit cards to get access to the corporate and charge cards, the merchants allege, violated the antitrust laws. American Express responded by invoking the arbitration provision. Although willing to arbitrate, the merchants objected to the prohibition on class adjudication, arguing that it would effectively eliminate their statutory rights. No individual merchant, they contended, could justify the cost of complex antitrust litigation given the relatively small individual damages suffered by each merchant. The district court held that the validity of the class action waiver was a matter for the arbitrator, and that eliminating class adjudication did not effectively prohibit the merchants from advancing their claims, because the Clayton Act permited the recovery of costs and attorneys fees. The Second Circuit reversed, holding that the validity of the class action waiver raised a question as to the validity of the arbitration clause itself and was thus subject to the federal substantive law of arbitration. That law, the court held, barred arbitration provisions that as a practical matter would prevent the enforcement of statutory rights. The court concluded that the class action waiver in AmEx's merchant contracts had this effect. It explained that the District Court erred in its interpretation of the Clayton Act's remedial provisions, because that Act would not permit individual plaintiffs to recover the extensive expert witness costs that would be required to litigate a complex antitrust case. Because of those costs, individual merchants would effectively be barred from enforcing their rights if class adjudication were not permitted. The Second Circuit cautioned that it was not holding that class action waivers were either "void or unenforceable per se," even in antitrust cases. Rather, a court must decide on a case-by-case basis whether a class action waiver effectively bars the enforcement of statutory rights. Because the merchants had expressed a willingness to litigate the claim, and AmEx had indicated that it might not invoke the arbitration clause if class treatment were permitted, the Second Circuit remanded the case to determine the forum. Plaintiffs' counsel issued a statement following the ruling that suggested the case could have broad applicability. “The policy of putting anti-class action rules in consumer and merchant agreements," the statement claimed, "has been growing enormously in recent years. . . .The decision will no doubt be used by plaintiffs in dozens of other cases where defendants have attempted to ban class actions.”

Problems for Secondary Lenders?

I received a call today asking whether a local company in Louisville should be worried that its secondary lender on its real estate filed a lawsuit to foreclosure due to default. In some ways an odd question, but perhaps not. Imagine this, Company X owns real property worth $750,000 at the time of financing. First Bank holds a mortgage for $500,000 and Second Bank holds a mortgage for $225,000. If both banks have properly recorded their mortgages, all would seem to be in order. But, in a declining real estate market, we could imagine the property now being worth about 20% less (here, just $600,000). First Bank is still secured, but Second Bank is now undersecured. If Company X stops paying Second Bank, but is in good standing with First Bank, then what are Second Bank's options? Foreclosing on the real estate might ordinarily be a good call, but what happens in a declining market if the real estate has to be sold at auction?

Second Bank seems now to be undersecured. If real estate values have fallen dramatically, Second Bank could be in even worse shape. Its options? Perhaps Second Bank might try to renegotiate the terms of the mortgage to get Company X back on track. Alternatively, the loan might be sold to First Bank at a deep discount if First Bank is interested. If Second Bank obtained any guarantys from the owners of Company X when it issued the loan, that might help . . . if the individuals have enough assets to cover the loan. Forcing Company X into bankruptcy also might not work out so well if there are not sufficient assets to pay the creditors.

In the end, should Company X be worried about any lawsuit by Second Bank? It is a tough market out there. Secondary lenders on real estate may as a group be finding themselves with less bargaining power than in the past. If Company X is not worried about the situation about Second Bank it could be that good corporate news is around the corner that will allow them to pay the lender. In this market, though, Company X might know that Second Bank has rights, but little to enforce them against.

— JSM

Scrooge and Other Recommended Reading

Photo by raymaclean

Two recent pieces of scholarship should not escape the attention of our readers. First, Alireza Gharagozlou has a fun little piece coming out in the Nova Law Review entitled When did Scrooge Become a Role Model? Why Criticism of America's National Debt is Misplaced. It's a nice, basic introduction to the macro-economics of saving versus spending, written in a very lucid, accessible, and entertaining way (yes, this is an entertaining paper about macro-economics). Gharagozlou offers a rare critique of saving (at least over-saving) and explains how spending drives the broader economy. In my view, the paper gives relatively short shrift to the benefits of saving (at least on the individual level, as insurance cannot effectively address the dangers of unemployment and health care crisis to which more and more Americans are exposed today), and it mildly overstates the backstopping effect of bankruptcy (though the explanation of the purpose of bankruptcy within a capitalist system is spot on). But because the paper focuses on sovereign debt and spending, these criticisms do not go to the heart of the paper, which is a quick and well-worthwhile read.

My second shout-out goes to a paper by Gail Hillebrand of Consumers Union (the publisher of Consumer Reports). Published in volume 83 of the Chicago-Kent Law Review, Hillbrand's insightful article is entitled Before the Grand Rethinking: Five Things To Do Today With Payments Law and Ten Principles To Guide New Payments Products and New Payments Law. The strongest part of this very strong paper is its detailed discussion of the application of the Electronic Fund Transfers Act and Reg E to the panoply of plastic cards out there today. This is a topic with which I've struggled as a teacher of Payment Systems, and Hillebrand's paper does a great job of explaining why EFTA and Reg E are or are not clearly applicable in light of the growing areas of uncertainty as new products emerge (see especially the discussion at pp. 789-96 on prepaid debit cards, payroll cards, flex spending account cards, and "bank in your pocket" general spending cards). The first part of the paper also marches through the key differences among (and complaints about) the various payment devices. There's even a rare discussion of funds availability and Reg CC--how often do you see that?! For teachers and students of modern payments law, this paper is a strong buy!

While I hate to end on a sour note, I feel a duty to my fellow Payments teachers to point out an annoying aspect of the latest edition of a book I know many of us use. Ronald Mann did all of us a great favor by enlivening and bringing down to earth the study of payments law and practice in his book Payment Systems and Other Financial Transactions. I adopted the book in my first year of teaching, and I have loved it . . . until now. I still like it, but the fourth edition is a major step back. First, unlike the careful and detailed transition guide for Warren & LoPucki's book on Secured Transactions (and Warren & Westbrook's book on Bankruptcy--all of which are in new editions!), Mann's TM contains a rather weak transition guide. It refers to the third edition when it means the fourth, it refers to an incorporation of electronic commerce materials, which happened in the previous edition, not this one, and while it mentions a number of new or edited problems, it doesn't mention all of them! For example, the location of the second bank in Problem 3.1 is different in the latest edition, with no warning in the TM, and the TM discussion refers to a third location for that same bank! More seriously, Problem 23.4 (former Problem 26.4) now has four subsections (a-d), as opposed to three before, and the subsection (c) now elminates the discussion of anomalous indorsements (which I rather liked). Neither the transition guide nor even the introduction to assignment 23 in the TM mentions this (indeed, the intro to assignment 23 in the TM still indicates that problem 23.4 has three parts). Moreover, Mann has eliminated former assignments 19, 20, and 21 altogether, with no explanation. I very much liked these assignments, and students year after year have thanked me for covering this material on interest rates, usury, and pre- and late payments. Nothing is added to fill the void left by these assignments' omission (the total page count is more or less the same, it appears, thanks to more cases). In addition, while the TM offers detailed notes for how most of the problems should play out in class, for the new ones, Mann often simply notes, for example, "This problem was added for the Fourth Edition. It is designed to underscore the way that the notice requirement limits opportunistic reliance on the availability exceptions. It is a true story (with names changed)." No elegant explanation of how the law achieves this limitation, as with other problems. New Payments professors beware--the latest edition is not as user-friendly as earlier ones. And some of the problems contain funny holdover errors. On p. 23, the character's name in Problem 1.1 is Terry, while on p. 24 (in the middle of the same problem), his name changes to Tertius (his name in the earlier edition). While I'm not ready to abandon this book yet (I know others who have), I'm now on the lookout for a reasonable replacement that contains nice textual explanations of the systems and fun problems. Any suggestions?

Update on Home Mortgages

Thanks to the Federal Reserve, the benchmark interest rate will remain near zero. LIBOR remains around 1.17 percent. Home prices in twenty American cities dropped 18.2% in November from the prior year (this rate is lower for areas below the conforming mortgage rate of $417,000). Mortgage rates are at about 5.48% in the last week. What does this mean for home buyers? For mortgages? As we've said here before, the indicators suggest mortage rates should be lower than ever leading to more people buying homes and refinancing (see More Trouble For Home Refinancing; Refi No Good --- A Lesson in "LTValuation").

So, what does the mortgage news really mean? There is talk that the Senate will include housing relief in the economic stimulus plan. The discussion includes: (1) making available to home owners a 4% 30 year mortgage, either for buyers or refinancers; (2) increasing the first time home buyer credit; and (3) a ninety (90) day moratorium on foreclosures. Yippee! At least for my home, lenders cannot do too much better than the mortage we already have. So, the strategy for some home owners is shop around for better rates and wait. As much as I might like to see a 4% mortgage rate, though, the cost of this housing relief may become quite expensive. The cost for such a government program hasn't yet been publicized, but is likely to be the impediment to my dreams of a 4% mortgage rate.

Home purchase credits might help to encourage those who have been staying out of the market to buy a home. The structure of the credit needs to have the effect of home purchases by those who would not purchase otherwise. Timing and limits on eligible purchasers are also issues. Moreover, the word of caution with encouraging home purchases is avoiding the same problems that led us to the current crash. That is, to what extent should we encourage purchases of homes if some purchasers would not have their downpayment but for the credit? The same concerns about lenders repeating policies that created the housing crisis apply to home buyers. Throwing money at the housing crisis may well help in the short to medium term, but the stimulus plan should not forget the lending and borrowing implications for the longer term.

As to moratoriums on foreclosures? There are many open questions on the housing crisis. A little more time is probably warranted.

— JSM