January 07, 2009

Over 45 attendees gathered at Jenner & Block’s New York office for a breakfast seminar titled "The Search for Culprits and Recoveries in the Credit Crisis,” which discussed the potential criminal and regulatory fallout as well as civil litigation issues arising out of the credit crisis.  Partners Stephen L. Ascher, Thomas C. Newkirk, Andrew Weissmann and Richard F. Ziegler spoke along with Joseph J. Floyd, Vice President and Managing Director, and James M. Lukenda, CIRA, Managing Director, both of Huron Consulting Group.

Mr. Ziegler opened the first panel, titled “The “Enronization” of the Credit Crisis: Potential Criminal and Regulatory Liability for Inaccurate Valuations and Market Assurances,” by mentioning some of the root causes and effects of the current credit crisis.  “Credit default swaps enabled market participants to tremendously leverage exposure to the mortgage market,” said Mr. Ziegler, which ultimately grew to an estimated $50-$60 trillion market.  Swap sellers were allowed to take on huge derivatives risk without the need to post any reserves, and the market lacked transparency, he said, and so when the real estate market declined, the consequences were tremendously magnified.  According to Mr. Ziegler, former General Counsel at 3M Company, the current climate indicates “a failure of enterprise risk management by the economic system as a whole, as well as on an individual financial institution level.”

Mr. Floyd utilized recent examples of companies affected by the credit crisis to discuss whether the situation was the result of “culpability, or the confluence of market chaos,” that is, “did people do things that were wrong or did we end up in a situation where there was irrational behavior, a collapse of the system and systemic risk?”  While it seems that there were a number of market forces at play, he said, it is important in analytical assessment to gauge culpability and to identify compliance and valuation issues.

Fundamentally, the situation at Enron and other scandals do not truly compare to what we know now of the current situation, said Mr. Weissmann, who is the former Director of the Enron Task Force.  He said, we may see “disclosure issues being investigated and prosecuted or one-off products, but I don’t think we’ve seen anything that suggests that there was criminality at the core of the problem.”  To the extent that it can be determined now, the crisis deals more so with public disclosure issues, he stated, and not fundamental corruption on Wall Street.

Among the key players within the crisis, Mr. Newkirk discussed the role of credit rating agencies, which play key roles in the credit market. According to Mr. Newkirk, formerly Associate Director of Enforcement with the U.S. Securities and Exchange Commission, the credit ratings agencies provided ratings for securities that turned out ultimately to not be what they appeared to be, due in part to credit default swaps. Due to the current situation, he predicts that “we are going to see perhaps some legislation or discussion with respect to the credit rating agencies and how their models work, when Congress undertakes a comprehensive look at all participants in the financial markets and how they are regulated.”

The second panel, titled “Recovering Credit Crisis Losses: Civil Liability for Structured Finances Investments; Credit Default Swaps--Parties and Counterparties; Clawing Back Executive Pay,” discussed the civil fallout of the current credit crisis.  Mr. Ascher discussed that the fundamental issue with collateralized debt obligations (CDOs) is that while they were “originally developed as a way of reducing risk; they were instruments that would help to diversify, hedge and otherwise reduce risk,…they have ended up multiplying risk.”  CDOs are special-purpose vehicle created for the purpose of issuing notes, he said, and these notes are divided into different “tranches” or classes, based upon their risk factor.  However, according to Mr. Ascher, within a synthetic CDO or a hybrid CDO structure, the transaction has been leveraged to a much larger extent because of unfunding in the upper-most tranche; thus, the structure produces the same amount of income with much less actual funding.

Credit default swaps (CDS), said Mr. Lukenda, is a contract in which for a series of payments from the buyer, the seller guarantees a pay-off if a credit instrument encounters a specified credit event or goes into default.  The notional value of CDS has grown from $900 billion in 2000 to $62 trillion in 2007, which is an 81% increase over 2006, according to Mr. Lukenda, yet the underlying net value remains in question.  If derivatives contracts are not collateralized or guaranteed, the creditworthiness of the counterparties determines the value of the entities, he said, and within these counterparties, “[the question remains of] who is going to be the buyer and who is going to be the seller.”

There has been an intense spotlight on executive pay, said Mr. Ziegler, including the Troubled Assets Relief Program’s (TARP) “Claw back” requirement, which indicates that if the performance metrics that are used to award incentive compensation are proven to be materially inaccurate then the financial institution subject to TARP must have a provision for recovery.  In comparison to SOX, “TARP’s Claw back, whether advertently or otherwise, is much broader than the SOX provision,” he stated, with a key difference being that SOX provides that the SEC only has standing to enforce the provision, while TARP allows for financial institutions and derivative shareholders to enforce the provision.

Please click here to view the program materials.