Friday, August 28, 2015

Debtor Can't Explain Millions in Missing Protein Powder

Ultimate Nutrition, maker of Pro Star Ultimate Whey Powder, filed for chapter 11 bankruptcy last December in Hartford, Connecticut.  The debtor is in a headlock with TD Bank NA over a  $13 million loan.  Millions of dollars worth of powdered protein shake supplement ingredients are missing from Ultimate's warehouse and TD Bank is trying to find out what happened.  

TD has asked the bankruptcy court for an investigation into the whereabouts of the missing inventory.  Brian Rubino, Ultimate's CEO, says he destroyed the missing powder, about 40% of the company's inventory worth about $3.8, because it was "unsaleable."   Perhaps the powder was never really in stock, but Ultimate reported it to pump up its inventory.  Or, the powder is out there somewhere still subject to TD's lien.  The possibility that really scares me is that Rubino dumped the mountain of "unsaleable" powder into the Hog River that runs underneath the City of Hartford.

Tuesday, August 25, 2015

Not Too Big to Jail

Presidential hopeful Hillary Clinton said in a recent speech on economic policy that individual bankers should go to jail for their role in the 2008 financial crisis.  In May 2015, JP Morgan  and Citibank, along with several foreign banks, plead guilty to conspiracy to manipulate the foreign currency exchange spot market.  The banks agreed to pay criminal fines of $2.5 billion.   That's not enough justice for Ms. Clinton. Individuals must go to jail and she promised that they will on her watch.  

A Morning Consult poll in April 2015 showed that about 58% of Americans surveyed think individual bank employees should be prosecuted, convicted and imprisoned for financial crimes and 44 % said that criminal sentences and fines for financial institutions is not sufficient to deter "Wall Street" from engaging in financial misdeeds.  So far, although banks have taken a beating, no individuals have been jailed for unlawful conduct contributing to the 2008 crisis.  The reasons why we haven't seen video of Wall Street bankers in orange jumpsuits remain the subject of speculation and debate.

Last week, the U.S. Attorneys' Office for the Southern District of New York announced a guilty plea and jail time for a banker.  Charles Antonucci, Sr., former president of The Park Avenue Bank, was sentenced to 30 months for his role in a massive fraud involving self-dealing, bribery, embezzlement of bank funds, and a scheme to steal about $11 million from the Troubled Assets Relief Program (TARP), a federal program established in the aftermath of the 2008 crisis to help banks stabilize and address liquidity problems.  (The press release is a fascinating read for those interested in how to rob a bank without a gun).  It's not the widespread humiliation of individual bankers that so many Americans seem to want, but it proves that if the evidence is there, bankers are not too big to jail.

Tuesday, August 11, 2015

The Chips Are in the Mail: EMV Liability Shift in October 2015

A few weeks ago I got a new credit card with a microchip.  Last weekend, when I swiped it at Target, I got a lesson on how to use the microchip reader in the checkout line.  The new technology is called "EMV" which refers to a technical standard developed in the 1990's for payment instruments that store data on integrated circuits (chips) rather than magnetic stripes. The term comes from the names of the three companies that created the technical standards: Europay, Mastercard and Visa.  These three companies, along with JCB, American Express, China UnionPay and Discover formed a consortium managed by EMVCo.  The six member organizations work together with banks, merchants, payment processors and other stakeholders.

Use of chip technology reduces fraud relative to use of magnetic stripe technology because the chip permits "dynamic authentication" of the payment.  Put very simply, a magnetic stripe embeds a unique identifier, but all it does when swiped through a reader is show the identifier, which is always the same.  A dynamic authentication protocol authenticates the payment by computing a unique response to a challenge which uses both the data presented in the challenge (from the authentication server) and the secret data contained in the chip.   A thief can steal the credit card number, but without the chip-enabled dynamic authentication, the number is useless.

In August 2011, Visa announced its plans to implement the "Global POS (point of sale) Liability Shift Policy" for the US. For most counterfeit card fraud at a retailer's in-store locations ("card present" transactions), liability for an unauthorized transaction has always fallen on the card issuing bank and not the merchant. Effective October 1, 2015, the new policy shifts liability to the party in the payment process that has not made the investment in EMV chip cards or readers.  Each payment network (e.g., Visa, MasterCard, Discover) has its own rules, but they all implement the same cheaper loss avoider principle.  According to a paper by EMV Migration Forum that summarizes information collected from payment networks, the party supporting the most secure technology for each fraud type will prevail, and in the case of a technology tie, the fraud liability will remain with the card issuing bank. So, if the issuing bank hasn't switched to chip enabled cards, the issuer will bear the loss even if the merchant hasn't switched to a chip reader.  However, the merchant will bear the loss from use of data copied from a chip-enabled card if the data is used on a counterfeit card at the merchant's swipe card reader.  The merchant could have prevented that loss by switching to a chip reader that would have blocked approval of the counterfeit magnetic swipe transaction.

Chip technology will reduce counterfeit loss in "card present" transactions. But, it won't affect counterfeit fraud in "card-not-present" (CNP) transactions, e.g., via internet, mail (snail and e) and telephone.  So far, there is no single, simple solution to eliminate CNP fraud.  According to the EMV Migration Forum Card-Not-Present Working Committee, the best practice is multi-layered. The key is to authenticate the identity of the person who initiates the CNP transaction. The best practice is to adopt an authentication protocol that requires at least two of these three authentication factors:  1) ownership --something the authorized user has, such as a credit card; 2) knowledge -- something the authorized user knows (such as a PIN); or 3) inherence --something the authorized user is or does (such as a fingerprint).

Banks Beat Back New York City Regulation

The New York Bankers Association (NYBA) scored a win over the City of New York in federal court last week.  In NYBA v. City of New York,  the court granted NYBA's motion for summary judgment.  The District Court for the Southern District of New York found that City Local Law 38 (the Responsible Banking Act) was preempted by both federal and state law.   The RBA would have required New York banks to submit information to a community advisory board, which would in turn submit a report to the City Banking Commission for its consideration in deciding whether to permit the banks to accept any part of New York City's $6 billion in deposits.  The opinion sets out the long and fascinating history of the legislation through two mayoral administrations (Bloomberg who thought it was both misguided and preempted, and De Blasio who supported it).

Wednesday, July 29, 2015

Treasury Speaks to Puerto Rico's Debt Problem But Doesn't Say Much

Treasury Secretary Jack Lew sent a letter yesterday responding to questions posed by Sen. Orrin Hatch (R. Utah) about Puerto Rico.   Lew notes that the Obama administration is not considering a federal bailout for Puerto Rico. He said that returning Puerto Rico to a sustainable economic path requires "development of a long-term comprehensive fiscal plan" that addresses Puerto Rico's financial challenges (high unemployment, "labor market challenges" and high energy and transportation costs, "exacerbated by a history of less than adequate fiscal policy choices").  The plan must include input from stakeholders, be based on credible projections for revenue, expenses and growth, and include a "realistic and robust economic growth strategy that encourages new private investment, increases Puerto Rico's competitiveness, and strengthens its economic structure."  Lew said that Puerto Rico's situation requires "a collective action" and "the immediate attention of Congress."  Puerto Rico has about 18 different debt issuing entities that together owe about $72 billion.  Each entity's liability is unique based on the terms of individually negotiated and issued debt.

Puerto Rico's representative (non voting) in Congress has proposed legislation that would permit Puerto Rico's public bond-issuing entities to file for protection under Chapter 9 (H.R. 870). Chapter 9 of the Bankruptcy Code is titled "Adjustment of Debts of a Municipality."  Chapter 9 does not provide a way for a state government to adjust its debts.  Instead, only "a political subdivision or public agency or instrumentality of a State" (a "municipality") may be a debtor under Chapter 9, and only if the municipality is "specifically authorized... to be a debtor under such chapter by State law" or by a State officer empowered by State law to authorize it.  11 U.S.C. sec. 108(c) (requiring also that the debtor be insolvent, wants a plan to adjust its debts in Chapter 9, and has made an effort to work out the debt problem outside of bankruptcy).  The term "State" includes both D.C. and Puerto Rico "except for the purpose of defining who may be a debtor under chapter 9..."  11 U.S.C. sec. 101(52).  So, the proposed legislation amends current law to make Puerto Rico a State for purposes of access to Chapter 9 by Puerto Rican "municipalities". 

Even if Congress acts to amend 11 U.S.C. sec. 101(52) to open chapter 9 to Puerto Rico's municipalities, it's hard to imagine a bankruptcy court-supervised process that might yield economically and politically feasible plans of reorganization for Puerto Rico's municipalities.   Secretary Lew noted in his letter to Senator Hatch the mainland political issue ticking like a bomb within the Puerto Rican debt crisis.  Lew stressed that special bankruptcy legislation is not a "federal bailout."  And, he noted that a court supervised restructuring in a "tested legal bankruptcy regime" could mitigate "further harm [to] retiree investment portfolios across the country" that hold Puerto Rican debt.   More than 20% of mutual bond funds own Puerto Rican bonds according to Morningstar (377 funds out of 1, 884),  In 2012, Puerto Rican government agencies were the second busiest borrowers in the municipal bond market.  Only municipal bond issuers in California were busier.  (California's population is 10 times bigger than Puerto Rico's). Puerto Rican public agency bonds have long been popular because of high yields and triple tax exempt status (federal, state and local).  

How would municipal bond funds fare as creditors in chapter 9 relative to their chances outside of Chapter 9?  In Detroit's bankruptcy, bondholders were happy that the bankruptcy court ruled that union pension claims were not entitled to priority in payment, notwithstanding Michigan law which protected them.  (Contrast the preferred treatment United Auto Workers got in the GM restructuring in its June 2009 bankruptcy, which was achieved with significant Obama Administration intervention outside of bankruptcy.)   On the other hand, bondholders under Detroit's bankruptcy plan did take less than the full amount of their claims  and ultimately settled their objections to the confirmation of the plan on grounds it favored city pensioners over bondholders.  Even in a "tested legal bankruptcy regime" like Chapter 9, politically powerful groups can press their advantage and unlovable "Wall Street" creditors will absorb disproportionate pain.  

Several groups have considered Puerto Rico's financial situation and proposed in very general terms,  pathways out of the current financial disaster:  The New York Federal Reserve, Update on the Competitiveness of Puerto Rico's Economy (2014, updating 2012 report); Anne Kreuger, Rajut Teja, and Andrew Wolfe, Puerto Rico- A Way Forward (June 29, 2015); Centennial Group International, For Puerto Rico, There is A Better Way (July 2015).  The Centennial Group prepared its report for a group of hedge funds that hold Puerto Rican bonds.  Not surprisingly, the report recommended fiscal austerity and structural reform rather than write down of bond debt.

Tuesday, July 28, 2015

Thursday, July 23, 2015

Student Loan "Abuses?"

The CFPB got Discover Financial Services to enter into a $18.5 million settlement to resolve CFPB's claims that its subsidiaries engaged in illegal student loan servicing practices.  Discover did not admit or deny the conduct alleged.  It just agreed to pay $16 million in compensation and $2.5 million in penalties to end the CFPB action against it.

News reports yesterday described Discover's conduct as  "harassment" and "lying" to student loan borrowers.  I thought it would be interesting to see exactly what CFPB alleged that Discover's subsidiaries did.  So I dug up the Consent Order.

In late 2010, Discover's subsidiaries acquired substantially all of Citibank's private student-loan portfolio (about 800,000 loan accounts) and took over as servicer on those loans.  Here is the misconduct CFPB alleged:

  • With respect to the Citibank loans, Discover failed to notify borrowers properly of the amount of interest they paid on their loans for purposes of claiming a federal tax deduction.  CFPB conceded that Discover notified borrowers on their loan statements that they would not get a form 1098-E (reporting interest paid) unless those borrowers first submitted a form W-9S (certifying that the loan proceeds were used solely to pay for qualified higher ed expenses).  That wasn't enough, according to the CFPB, and was "likely to mislead borrowers into believing that they had not paid interest qualifying for the tax deduction...." 
  • For some of the Citibank loans, Discover misstated the minimum amount due by improperly including in the minimum payment calculation interest accrued on loans still in deferment.  Apparently Discover credited all payments properly.  (The agreed redress for borrowers is an account credit equal to $100 or 10% of the overpayment up to $500 per borrower.)
  • Between late 2010 and February 2013, Discover made about 150,000 collection calls at improper times (too early or too late) because, it appears, Discover timed its calls using only the time zone associated with the borrower's cell phone number area code rather than both the area code and the borrower's mailing address.  CFPB alleged "[o]ver 1000 consumers received dozens of calls at inconvenient hours."
  • Discover engaged in collection activity with respect to 252 of the Citibank loans that were in default, and failed to comply with the consumer information requirements imposed on "debt collectors" under the Fair Debt Collection Practices Act.
Discover may have made some mistakes probably because it plunged into a politically sensitive and highly regulated line of business before it had acquired the back office capability to handle it.  Harrassment and lying?   "Abuse" of student loan borrowers?  I don't think so. 

Discover Financial Service stock held steady yesterday and it reported second quarter net income of  $599 million or $1.33 per share