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.

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).

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.

Senate Judiciary Committee Considers Dodd-Frank Act Constitutionality

The hearing on July 23, 2015 was entitled:  The Administrative State v. The Constitution:  Dodd-Frank at Five Years."  The Committee website has the testimony.

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. 

California Supreme Court Decides "Separate and Apart" Requires Separate Residences

In Davis v. Davis, decided Monday, the California Supreme Court held that spouses must live separately in different residences to claim that property they accumulate is not community property.  California Family Code section 760 makes all property acquired by spouses during a marriage community property "[e]xcept as otherwise provided by statute," including section 771(a): "earnings and accumulations of a spouse...while living separate and apart from the other spouse, are the separate property of the spouse."  The court held that spouses are not "living separate and apart" when they live together.

Mr. and Mrs. Davis married in 1993 and had two children. Mrs. Davis testified that by 2004, they were "living entirely separate lives" but in the same house.  When Mrs. Davis petitioned for divorce in December 2008, she listed their date of separation as June 1. 2006.  Mr. Davis listed the date of separation as July 1, 2011.

The California Supreme Court considered the history of the 1870 Act in which section 771(a) originated entitled "An Act to protect the rights of married women in certain cases."  The first section of the 1870 Act provided that "[t]he earnings and accumulations of the wife...., while the wife is living separate and apart from her husband, shall be the separate property of the wife."  And, it provided that a wife who was living "separate and apart from her husband" had "sole and exclusive control [over] her separate property," and could sue and be sued without joinder of the husband. Section 4 of the Act provided a means for a wife "living separate and apart" to convey her separate real property without her husband's consent by recording a declaration containing a description of her real estate, the name of her husband, and stating "her own place of residence" and that she is "living separate and apart from her husband." 1870 Act sec. 4.

Before the 1870 Act was adopted, married women had no control over separate or marital property. The husband had absolute right of "management and control" of community property, including the power to sell assets.  Under the predecessor 1850 statute, "rents and profits of separate property" were deemed community property subject to the husband's sole control, and the husband had the exclusive right to manage the wife's separate property "during the continuance of the marriage" subject only to the requirement that to sell or encumber the wife's separate property, the transaction must be documented in an instrument signed by both spouses.  The court concluded that the 1870 Act provided married women some protection from the oppressive effect of the prior law.  As a result of the 1870 Act, a married women who was not physically living with her husband could control her own earnings and control and dispose of her separate property.  Early cases interpreting the scope of the exception in section 771(a) considered not whether separate residences were required, but whether the wife had to show something more, e.g., whether one spouse had "abandoned" the other as part of a "separation which [they] intended to be final."  Tobin v. Galvin, 49 Cal. 34, 36-37.  A married couple was not "living separate and apart" if they were residing in separate places for economic or social reasons, but only when they were living in separate locations and have "no present intention of resuming marital relations and taking up life together under the same roof."  Makeig v. United Security Bank &Trust Co., 112 Cal. App. 138 (1931).

Mrs. Davis cited the dissent  in In re Marriage of Norviel, 102 Cal. App. 4th 1152 (2002) as support for her contention that spouses can be "living separate and apart" while living together.  In that case, the majority recognized that under California law, spouses may live apart (in separate residences) and not be separated.  But, the Norviel majority held, the reverse is not true.   However, the dissent in Norviel found that the evidence introduced at trial supported the trial court's finding that the date of separation predated the husband's physical departure from the marital home, because the husband had communicated his intent to end the marriage before he moved out, and the parties' conduct thereafter was consistent with that expressed intent.  The dissent thought that the majority rule requiring that the couple live in separate residences would not permit the couple "a transition period to take the necessary steps to untangle the financial, legal and social ties incident  to their decision."  Id. at 1166.

The California Supreme Court considered the policy implications of a bright line rule requiring physical separation to establish "living separate and apart."  Mrs. Davis argued as a matter of public policy that spouses may need to reside together in the same residence as "roommates" after they mutually intend an end to their marriage for pressing financial reasons, and one spouse who wants to separate and stay in the marital home may find it difficult to compel the other spouse to move out. The court held that although the rule may impose hardships, it does what a bright line rule does-- it provides predictability of outcome and clear guidance to judges. And, it reduces strategic behavior invited by a more flexible standard.  The bright line rule requiring physical separation "retains the presumption of community property for earnings and accumulations acquired during marriage during a period of time likely to be prior to the institution of court proceedings and any court order of support, thereby protecting the lower earning spouse."

The bright line may not be all that bright.  In a concurring opinion, Justice Liu agreed that "living separate and apart" refers to separate residences, but noted that the majority did not foreclose the possibility of circumstances where a couple could live "separate and apart" with the requisite separate residences "even though they continued to literally share one roof."  Justice Liu added to the history of California's community property laws amendments in the 1970's through which the Legislature afforded both spouses equal control rights in community property, and adopted no-fault divorce, with the effect that by the end of the 1970's the "living separate and apart" exception was not necessary to protect married women.  Rather, the exception now serves to recognize that separation before divorce ends the community "in situations where the spouses have effectively though not formally ended their marriage."  Justice Liu noted that "countervailing considerations of family economics and parenting suggest that the physical separation need not assume the precise form that the Legislature in 1870 envisioned, namely, separate addresses."  Citing the dissent in In re Marriage of Norviel, Justice Liu wrote that the test for whether the parties are "living separate and apart" is whether they can demonstrate not only intention to separate, but also unambiguous, objectively ascertainable conduct amounting to physical separation under the same roof."