Today, the Supreme Court took on health care, and, by commentators' accounts, it wasn't pretty. The transcript is available here. Some snap thoughts:
1) The Solicitor General, Donald Verrilli, didn't do a very good job advocating the law today. Surprising, given that he's a perfectly good attorney. But the line of questioning from the usual suspects (Scalia, Alito) was predictable, and he didn't seem too well-prepared. A lot of the time, reading the transcript, I thought the left-leaning justices (Ginsburg and Breyer especially) did a better job of advocating the law than Verilli did.
2) Having said that, I'm somewhat surprised at how hostile some of the conservative justices were toward the law-- everyone and their mother knew Clarence Thomas wouldn't be voting to uphold the mandate (since he's stuck somewhere in the 19th century), but, going in, I thought Scalia (given some of his past votes in commerce clause cases) and Chief Justice Roberts were possibilities to vote to uphold. I thought a 7-2 decision with Thomas and Alito in dissent wasn't out of the question. Now, Scalia is an absolute no, and the swing justice, Anthony Kennedy, seemed pretty hostile, especially when Verrilli was arguing the case.
3) The decision certainly comes down to how Kennedy's feeling. And Kennedy is a very unpredictable vote-- he has long, philosophical debates in his head, then makes decisions based on the weather. OK, maybe that's a little unfair, but only a little. He didn't seem to internalize the arguments in the briefs, and looked like he wanted to find a "limiting principle" for restricting the government's power to regulate commerce. Never mind that the "limiting principle" was staring him straight in the face in the brief... Having said that, if Kennedy goes along, I think Chief Justice Roberts will too. Roberts absolutely wants to strike down the law, but if it gets upheld, I'm almost certain he'll join the majority so that he can write the majority opinion. Otherwise, I think it's a 5-4 decision with the predictable justices (Breyer, Ginsburg, Sotomayor, and Kagan) in dissent.
4) The limiting principle that Kennedy is looking for should be pretty straightforward. Health care is the only market that 1) everyone in the country besides Christian Scientists participates in, 2) has expenditures that are necessarily unpredictable, and 3) is provided to everyone as a matter of course. While it's true that there are certain markets with 100% participation, health care is the only one in which participation is mandatory. Take something like food-- everyone who is alive eats, but if I show up to the grocery store starving, the grocery store doesn't have to feed me. Contrast that with health care. Insurance or not, if I get hit by a bus tomorrow, I'll be taken to the hospital, I will be given emergency surgery to keep me alive, if my bones need surgery to be repaired, it will be done, and if I need pain medicine, I will get it. If I don't have insurance and don't have the funds to pay for my medical care... the hospital will swallow the costs. Except that it won't. It will raise prices for those who can afford to pay. In turn, insurers (who end up bearing those costs) will raise premiums. In other words, those who do have insurance will subsidize those who don't.
The government, then, can very clearly regulate market participation, even if it can't mandate participation. But, even if I don't consume any medical services for 10 years, I'm still a market participant because I am always a potential consumer of medical services, since I will be treated in hospitals regardless of whether I "choose" to be (or regardless of whether I can pay). That isn't the case in many other markets. The government can't, then, require that I buy a cell phone or that I buy a car or that I buy broccoli, as the conservative justices disingenuously suggested, because I'm not necessarily participating in those markets. Right now, I ride the subway everywhere. I am in no way in the auto market, even though I undoubtedly consume transportation services quite frequently. Similarly, I communicate with plenty of people, but I don't necessarily consume communication services. And, even though I'm in the food market multiple times a day, my participation is regular, it's predictable, and it's not necessary-- no one is providing me with food regardless of my ability to pay, and no one is required to feed me if I'm starving (though we tend to think it's a nice thing to do).
So distinguishing health care is easy, and the opinion should write itself. Now we'll see if Kennedy wakes up on the right side of the bed in June...
Showing posts with label Law. Show all posts
Showing posts with label Law. Show all posts
Tuesday, March 27, 2012
Monday, March 26, 2012
Debating Health Care
Today, the Supreme Court heard the first day of arguments on the constitutionality of the health care reform bill Congress passed last year. It's kind of the Super Bowl for legal dorks-- the Court scheduled six hours of oral arguments over three days on four constitutional issues. Overruling the law would be a huge step-- it would overturn 70 years worth of Commerce Clause jurisprudence. It would, in a broad sense, probably the most substantial Commerce Clause decision since World War II.
The Court, rather than hearing the law as a whole, will actually hear four distinct issues related to the Affordable Care Act (ACA), two of which I actually think are pretty boring. Probably the least interesting issue before the Court will be argued Wednesday afternoon, and concerns a part of the law that mandates the expansion of Medicaid coverage. Medicaid operates as a federal-state partnership: the Feds provide some funds and instructions that the states are charged with carrying out. The expansion would have required states to pick up a share of the costs, and 28 Republican-led states sued, arguing that the expansion is "coercive" to the states. This is probably the least contentious of the issues, and the states will almost certainly lose-- the Feds have a well-recognized power to threaten to pull funds for states that don't comply with a federal program. Usually, this takes the form of the federal government pulling highway funds from states that lower the drinking age below 21 (which explains why there aren't any states that let you drink at 18). The Medicaid case would, in essence, pull federal Medicaid funds from states that don't participate in the expansion, which is a perfectly constitutional federal program-- states, after all, technically don't have to participate in Medicaid; they're free not to accept federal funds and pull out of the program. The real issue, of course, being that no one would be too excited about living in a state that doesn't provide Medicaid. But it would be shocking to see the Court overturn the Medicaid fix, so I doubt it will be an issue.
The second least interesting issue was argued this morning. It concerns the Anti-Injunction Act of 1867, which prevents constitutional challenges to taxes that have yet to go into effect. Since the penalty for failing to obtain health insurance doesn't kick in until 2014 (or maybe 2015; I don't remember exactly), deciding on this issue would give the Court a way out; it could say that it lacks the jurisdiction to hear the crux of the case until the penalty goes into effect. This one is kind of curious, since both the Administration and opponents of the law contend that it's not a tax. Over their objections, the Fourth Circuit decided that it was, so the Court appointed a private lawyer (Robert Long from the DC law firm Covington & Burling) to argue the opposing side. The early indication from the morning's argument seems to be that the Court will be rejecting the Anti-Injunction Act argument. Which I find a bit curious, since it seems to me that the easiest way for the Administration to win the argument on the individual mandate is to argue that the penalty for failing to obtain coverage is simply a tax (which is the crux of a brief filed by Columbia Law professors Gillian Metzger and Trevor Morrison and joined by a number of prominent Constitutional Law scholars) which can be waived by obtaining health care coverage. But that doesn't seem to be the route that the Administration is traking. We'll see if it's a mistake...
Now, the two most interesting issues are set to be argued tomorrow and Wednesday morning. The big one is the constitutionality of the individual mandate. Opponents of the ACA have built their argument on the contention that a mandate requiring individuals to buy a private product is an unprecedented infringement on personal liberty, and that upholding the mandate would give the federal government the power to regulate anything and everything under the Commerce Clause. It's entirely accurate to characterize this as a fringe position. Going back to the Court's decision in Wickard v. Filburn (1942), the Commerce Clause has covered essentially all economic activity reasonably related to a national market. In that case, the Court decided that a law regulating wheat production could enjoin a farmer from exceeding his quota even if he used the wheat for consumption on his own farm, the perfectly reasonable rationale being that, even if the wheat was not sold directly into the market, growing wheat for personal consumption directly impacted the national market by displacing wheat that would have been bought in that market. Since then, the Court has pushed back on Wickard only modestly, holding most significantly in United States v. Lopez (1995) that a statute barring people from carrying guns in school zones was not sufficiently related to interstate commerce to be covered by the Commerce Clause.
The health care case is as close to airtight as there is. While the law, on its face, requires people to buy a private product, the relation to interstate commerce is very clear and straightforward. To start with, everyone in the country participates in the health care market all the time, whether they are consuming medical services at a particular moment or not. Whether I am insured or not, and whether I have the means to pay for health care or not, if I were to be hit by a car tomorrow, I would be transported directly to the hospital, where I would receive medical treatment. The question would not be whether I am in the health care market, but who would pay for my health care services. If I had insurance, it would be my insurer. If I didn't, my health care provider would eat the cost. But not really, because the story doesn't stop there. If uninsured people are going to keep being given treatment (and that's an unavoidable proposition, unless you think doctors should ignore the Hippocratic Oath and start digging through people's wallets at the hospital before giving them life-saving treatment), health care providers will continue to do what they're already doing-- they will raise the rates they charge those who can pay to compensate for those who don't. Since we overwhelmingly pay for medical care through insurance (really, it's the only way to do it; for economic reasons, medical care markets really only function when insurers pay), insurance companies will raise premiums, since providers will charge them more for procedures. Consequently, at the end of the day, those who do buy insurance end up paying for those who don't.
Failing to buy health insurance, then, is a direct economic act. The position advanced by opponents is that we all participate in the food market, so the government can require us to buy broccoli. But that's a complete non-sequitur. Yes, we all end up getting food, but, for one thing, food providers don't have to give us food if we need it-- we might think it's a good thing for the grocery store to feed me for free if I'm starving and can't afford food, but the law doesn't recognize that as an imperative. And food is not a market with adverse selection issues that has to be paid for through insurance; I can't put off eating because I figure the food provider will feed me anyway, and food isn't something whose costs will bankrupt me-- an emergency surgery after a car wreck that insurance doesn't cover can easily bankrupt someone; a Big Mac at McDonald's most definitely can't. So, in a particular sense, health care is a unique market in that people both constantly participate in it, and can really only pay for it through an insurance rather than out-of-pocket mechanism. All of which makes it pretty plainly within Congress's powers under the Commerce Clause.
The last issue, which will be argued Wednesday morning, concerns the ACA's severability-- that is, if the individual mandate were found to be unconstitutional, the Court would have to decide whether it can be "severed", or detached, from the rest of the law. My view is that it's, plainly, not severable. ACA rests on a three-legged stool: a requirement that insurers not be able to refuse coverage to those with so-called pre-existing conditions, subsidies for people who can't afford insurance to get it, and a requirement that everyone purchase coverage or pay a penalty. The reason it's a stool is that all three features are necessary for the law to function. If you require insurers to cover everyone and provide subsidies to those that can't afford it, but get rid of the mandate for individuals to purchase insurance, the predictable result will be that no one will actually get health insurance until they need coverage-- after all, if the government is picking up the tab for their purchase of insurance, and companies can't turn them down for coverage, there's no reason to pay premiums until they actually need coverage. As a result, costs will skyrocket, as insurers will have to charge a fortune just to be able to cover costs. The result would be an absurdity. You similarly need subsidies, since you can't squeeze water from a stone-- requiring someone with no income (or very little income) to get insurance is an obvious absurdity. And, if insurers can reject applicants on the basis of pre-existing conditions, the individual mandate becomes essentially meaningless-- those people's premiums will be so high that very few will be able to afford them, which means subsidies for those people will have to be sky-high.
But the Court shouldn't even have to get to severability, because the law is so clearly constitutional. Frankly, even though this is the most reactionary Supreme Court we've had since the 1930s, this shouldn't even be a close decision-- Clarence Thomas will certainly vote to invalidate the law (but then, Clarence Thomas is an army of one-- a weirdo whose views are as far outside the mainstream of the legal profession that no one really subscribes to them besides Thomas himself), and Antonin Scalia might as well (though I have my doubts). But even far-right justices like John Roberts and Samuel Alito will have a hard time finding that the law is unconstitutional. I think it'll be a 6-3 upholding the individual mandate.
The Court, rather than hearing the law as a whole, will actually hear four distinct issues related to the Affordable Care Act (ACA), two of which I actually think are pretty boring. Probably the least interesting issue before the Court will be argued Wednesday afternoon, and concerns a part of the law that mandates the expansion of Medicaid coverage. Medicaid operates as a federal-state partnership: the Feds provide some funds and instructions that the states are charged with carrying out. The expansion would have required states to pick up a share of the costs, and 28 Republican-led states sued, arguing that the expansion is "coercive" to the states. This is probably the least contentious of the issues, and the states will almost certainly lose-- the Feds have a well-recognized power to threaten to pull funds for states that don't comply with a federal program. Usually, this takes the form of the federal government pulling highway funds from states that lower the drinking age below 21 (which explains why there aren't any states that let you drink at 18). The Medicaid case would, in essence, pull federal Medicaid funds from states that don't participate in the expansion, which is a perfectly constitutional federal program-- states, after all, technically don't have to participate in Medicaid; they're free not to accept federal funds and pull out of the program. The real issue, of course, being that no one would be too excited about living in a state that doesn't provide Medicaid. But it would be shocking to see the Court overturn the Medicaid fix, so I doubt it will be an issue.
The second least interesting issue was argued this morning. It concerns the Anti-Injunction Act of 1867, which prevents constitutional challenges to taxes that have yet to go into effect. Since the penalty for failing to obtain health insurance doesn't kick in until 2014 (or maybe 2015; I don't remember exactly), deciding on this issue would give the Court a way out; it could say that it lacks the jurisdiction to hear the crux of the case until the penalty goes into effect. This one is kind of curious, since both the Administration and opponents of the law contend that it's not a tax. Over their objections, the Fourth Circuit decided that it was, so the Court appointed a private lawyer (Robert Long from the DC law firm Covington & Burling) to argue the opposing side. The early indication from the morning's argument seems to be that the Court will be rejecting the Anti-Injunction Act argument. Which I find a bit curious, since it seems to me that the easiest way for the Administration to win the argument on the individual mandate is to argue that the penalty for failing to obtain coverage is simply a tax (which is the crux of a brief filed by Columbia Law professors Gillian Metzger and Trevor Morrison and joined by a number of prominent Constitutional Law scholars) which can be waived by obtaining health care coverage. But that doesn't seem to be the route that the Administration is traking. We'll see if it's a mistake...
Now, the two most interesting issues are set to be argued tomorrow and Wednesday morning. The big one is the constitutionality of the individual mandate. Opponents of the ACA have built their argument on the contention that a mandate requiring individuals to buy a private product is an unprecedented infringement on personal liberty, and that upholding the mandate would give the federal government the power to regulate anything and everything under the Commerce Clause. It's entirely accurate to characterize this as a fringe position. Going back to the Court's decision in Wickard v. Filburn (1942), the Commerce Clause has covered essentially all economic activity reasonably related to a national market. In that case, the Court decided that a law regulating wheat production could enjoin a farmer from exceeding his quota even if he used the wheat for consumption on his own farm, the perfectly reasonable rationale being that, even if the wheat was not sold directly into the market, growing wheat for personal consumption directly impacted the national market by displacing wheat that would have been bought in that market. Since then, the Court has pushed back on Wickard only modestly, holding most significantly in United States v. Lopez (1995) that a statute barring people from carrying guns in school zones was not sufficiently related to interstate commerce to be covered by the Commerce Clause.
The health care case is as close to airtight as there is. While the law, on its face, requires people to buy a private product, the relation to interstate commerce is very clear and straightforward. To start with, everyone in the country participates in the health care market all the time, whether they are consuming medical services at a particular moment or not. Whether I am insured or not, and whether I have the means to pay for health care or not, if I were to be hit by a car tomorrow, I would be transported directly to the hospital, where I would receive medical treatment. The question would not be whether I am in the health care market, but who would pay for my health care services. If I had insurance, it would be my insurer. If I didn't, my health care provider would eat the cost. But not really, because the story doesn't stop there. If uninsured people are going to keep being given treatment (and that's an unavoidable proposition, unless you think doctors should ignore the Hippocratic Oath and start digging through people's wallets at the hospital before giving them life-saving treatment), health care providers will continue to do what they're already doing-- they will raise the rates they charge those who can pay to compensate for those who don't. Since we overwhelmingly pay for medical care through insurance (really, it's the only way to do it; for economic reasons, medical care markets really only function when insurers pay), insurance companies will raise premiums, since providers will charge them more for procedures. Consequently, at the end of the day, those who do buy insurance end up paying for those who don't.
Failing to buy health insurance, then, is a direct economic act. The position advanced by opponents is that we all participate in the food market, so the government can require us to buy broccoli. But that's a complete non-sequitur. Yes, we all end up getting food, but, for one thing, food providers don't have to give us food if we need it-- we might think it's a good thing for the grocery store to feed me for free if I'm starving and can't afford food, but the law doesn't recognize that as an imperative. And food is not a market with adverse selection issues that has to be paid for through insurance; I can't put off eating because I figure the food provider will feed me anyway, and food isn't something whose costs will bankrupt me-- an emergency surgery after a car wreck that insurance doesn't cover can easily bankrupt someone; a Big Mac at McDonald's most definitely can't. So, in a particular sense, health care is a unique market in that people both constantly participate in it, and can really only pay for it through an insurance rather than out-of-pocket mechanism. All of which makes it pretty plainly within Congress's powers under the Commerce Clause.
The last issue, which will be argued Wednesday morning, concerns the ACA's severability-- that is, if the individual mandate were found to be unconstitutional, the Court would have to decide whether it can be "severed", or detached, from the rest of the law. My view is that it's, plainly, not severable. ACA rests on a three-legged stool: a requirement that insurers not be able to refuse coverage to those with so-called pre-existing conditions, subsidies for people who can't afford insurance to get it, and a requirement that everyone purchase coverage or pay a penalty. The reason it's a stool is that all three features are necessary for the law to function. If you require insurers to cover everyone and provide subsidies to those that can't afford it, but get rid of the mandate for individuals to purchase insurance, the predictable result will be that no one will actually get health insurance until they need coverage-- after all, if the government is picking up the tab for their purchase of insurance, and companies can't turn them down for coverage, there's no reason to pay premiums until they actually need coverage. As a result, costs will skyrocket, as insurers will have to charge a fortune just to be able to cover costs. The result would be an absurdity. You similarly need subsidies, since you can't squeeze water from a stone-- requiring someone with no income (or very little income) to get insurance is an obvious absurdity. And, if insurers can reject applicants on the basis of pre-existing conditions, the individual mandate becomes essentially meaningless-- those people's premiums will be so high that very few will be able to afford them, which means subsidies for those people will have to be sky-high.
But the Court shouldn't even have to get to severability, because the law is so clearly constitutional. Frankly, even though this is the most reactionary Supreme Court we've had since the 1930s, this shouldn't even be a close decision-- Clarence Thomas will certainly vote to invalidate the law (but then, Clarence Thomas is an army of one-- a weirdo whose views are as far outside the mainstream of the legal profession that no one really subscribes to them besides Thomas himself), and Antonin Scalia might as well (though I have my doubts). But even far-right justices like John Roberts and Samuel Alito will have a hard time finding that the law is unconstitutional. I think it'll be a 6-3 upholding the individual mandate.
Tuesday, July 19, 2011
Bank Directors and the Financial Collapse
As some people might have heard, the economy had a massive meltdown a couple of years ago that started in the housing market and moved into the financial sector. A bunch of banks were bailed out. Some didn't need it. Plenty did. A few might still be insolvent. There's been plenty of talk about how to keep it from happening again. Congress passed the Dodd-Frank Act to curb certain bank activities. The right whined about Fannie Mae and Freddie Mac a bunch, since that was about the closest they could come to blaming it on the government. But not much has been answered.
This summer, I've been doing some research on the specific role of directors at banks, and I'm trying to think through some issues relating to this question. So it's gonna be a long post... Directors in corporations are essentially charged with overseeing management's activities. They're supposed to serve shareholders, and protect their interests. Historically, they were held to a higher duty of care than other corporate directors were. Where directors at, say, Wal-Mart could not be held personally liable (i.e. you couldn't sue them for their own funds) unless they were grossly negligent, directors at banks were held to a higher duty of care. Up to the decision in Litwin v. Allen in 1940, the idea was that they could be held liable for negligence, which the courts defined as acting outside the realm of the way a reasonably prudent businessperson would act.
Litwin caused a bit of an uproar in that it was willing to actually go back and evaluate the consequences of a bank's decision after the fact and decide that it was negligent. In that case, they claimed a transaction had no "profit potential," which many commentators have pointed out isn't necessarily true (they didn't have much upside, but they did extract a fairly high interest rate, though the specifics of the case itself are mostly neither here nor there). While Litwin was controversial, not many directors were actually held liable for negligent decisions for a few decades, so the case kind of went by the wayside until about the mid-1980's.
But here, I think it's useful to pause and consider the reason why bank directors could be held liable more easily than other directors. The common thread running through the relevant cases seems to be that banks have depositors. And this justification does make sense. A typical public company has two sources of funding-- equity and debt. Put simply, equity is an ownership stake in the company. It usually comes with a regular dividend, and potential upside if the company grows, but it can also fall in value, and is the first part of the corporation that's wiped out in bankruptcy. Debt is exactly what it sounds like-- a corporation issues bonds, which investors buy, getting a fixed interest rate based on demand for the bond, and, when it expires, the principal. But banks are different in that they have a third source of debt-- depositor funds. Now, consumers like to think of deposits as being exactly what they sound like: you send your paycheck to the bank, the bank puts it in a vault, and you go to the ATM and get it out. But, really, deposits are just short-term loans made by the public to the banks. The banks take those deposits and reinvest them in longer-duration assets and earn a spread. Because the interest rates on your checking account might get you 3 Happy Meals a year, but the income stream from the Martinez family's mortgage that your deposits bankroll pays for way more Happy Meals. But deposits are especially volatile-- if too many depositors want to take their funds out, the bank will have to dump its assets, and if it has to dump enough assets at fire -sale prices (which, let's be real, it will probably have to do because there aren't all that many investors sitting around the market thinking that the Martinez family's mortgage is THE BOMB, and they need to buy it), it might lose enough money that it can't pay you back. Of course, all of this is an extreme oversimplification-- banks don't keep many whole mortgages that they originate on their books anymore, and definitely didn't around 2008, but the basic principle is the same-- a deposit is a source of funding that's unique to banks.
And the relevant jurisprudence compares bank directors to trustees-- it says that bank directors have a duty to safeguard not just shareholders, but also depositors. The idea is if they're not extra-careful, depositors will lose faith in the safety of their deposits, and there will be bank runs which will knock the entire banking sector to its knees. And that's exactly what happened pretty regularly for years. Then the Great Depression happened, and the Glass-Steagall Act in 1933 created the FDIC and federal deposit insurance. What that means is deposit-taking banks pay a premium, and in exchange the FDIC guarantees the first $X in deposit accounts (this limit gets pushed up regularly). Instantly, bank runs disappeared. If the government guarantees deposits, then your deposit is safe so long as the US government didn't collapse. And if it did, there would be much bigger problems than the bank losing your deposits. But the consequence of that became that any deposit-taking bank got free liquidity from consumers. The reason is pretty straightforward. If I know that my deposits could be wiped out if a bank went bust, I would think three times before depositing my money there. But if the government guarantees my deposits, I could care less which bank gets my money. So long as there's an "FDIC Member" sticker in the window, my deposits are backed by the full faith and credit of the US.
But in recent years, we've run into an interesting issue. While banks pay deposits, the amount they pay isn't all that big. Take Citigroup. It's a big deposit-taking bank (though it has WAY less in deposits than JP Morgan Chase and Bank of America). In 2008, it had about $208 Billion in deposits. And the FDIC fund was at around $45 Billion (I have a cite for this, but I'd have to dig it up; just trust me, these are the numbers). If Citi were to collapse, depositors MIGHT be able to get all of their deposits back through a combination of the liquidation of the bank's assets in bankruptcy (depositors get paid before bondholders and shareholders) and the FDIC reserve fund, but I doubt it. But even if Citi alone could be paid, a Citi collapse would have disastrous system-wide consequences. Because Citi going down wouldn't be an isolated event. Banks deal with each other all the time, and a collapse in one bank has consequences for others. There are plenty of these transactions, but the simplest one is an insurance contract (I'm throwing it out strictly to illustrate the point). If, say, JPMorgan were to buy $100 million of insurance from Citigroup on the possibility of oil dropping below $50 a barrel, but when oil dropped to $45, Citi didn't have the cash to perform, the impact would be pretty significant. JPMorgan would lose its hedge, which would expose it to more risk than it thought it had. And while losing $100 million isn't a big deal for JPMorgan, the entirety of its dealings with Citi could well have been enough to bring it down (as Citi's counterparties, who are also JPMorgan counterparties, found themselves in trouble from Citi's collapse). And if JPMorgan were to go, its $337 billion deposit base would have to be bailed out, too. While the FDIC might be able to do Citi alone, a $45 billion fund is gonna have a hard time covering almost $550 billion in deposits. So who picks up the bill? Well, the FDIC guarantee isn't contingent on the FDIC having enough on reserve to actually cover deposits-- the bill would end up on the Treasury's desk. So, in the end, taxpayers would be bailing out depositors (who are also taxpayers, but the point is that neither depositors nor the taxpayers have any share in the upside if banks do well, but they DO have the potential downside of systemically significant banks like Citi and JPMorgan going bust.
But what does this have to do with the duty of care? Well, in 1985, Delaware courts handed down the Smith v. Van Gorkom decision, which held directors liable for another bad deal. While there was a settlement, and the amount they were on the hook for was barely more than their liability insurance, this spooked directors. So the legislature passed Section 102(b)(7) of the Delaware code, which allows corporations to protect directors from liability for violating their duty of care, provided they act in good faith. Since more or less every large company in the US is incorporated in Delaware (and most states passed similar statutes), bank directors became the same as non-bank directors: essentially judgment-proof if they acted in good faith. The distinction drawn by Litwin between bank directors and other directors essentially disappeared overnight.
My thinking is that, given the taxpayer subsidy banks get through the existence of the FDIC, there need to be additional incentives in place to keep banks from taking undue risks with depositors' money. And the best way to encourage good risk-taking is by making sure that directors have skin in the game. I think potential liability is the best way I can think of to do that. Now, it might not be enough-- I doubt, say, Citi's directors would get into trouble for violating their duty of care for driving it into the ground in the run-up to the financial crisis, since the risks they took weren't necessarily substantially different from the ones much of the banking industry took (and the economists warning of a housing bubble were far from the dominant voice in public discourse).
But it DOES seem to me that if deposit-taking banks are going to get the liquidity guarantee that comes with FDIC membership, at the very least the FDIC member banks that are publicly held should not be allowed to incorporate with 102(b)(7) provisions. In other words, if a bank is public, the threat of liability should be in place to encourage directors to protect not just depositors, but also taxpayers from potentially footing the bill of a collapse.
Now, I'm sure there are some holes in this argument, so I'd be interested in hearing feedback, just in case anyone actually reads it.
This summer, I've been doing some research on the specific role of directors at banks, and I'm trying to think through some issues relating to this question. So it's gonna be a long post... Directors in corporations are essentially charged with overseeing management's activities. They're supposed to serve shareholders, and protect their interests. Historically, they were held to a higher duty of care than other corporate directors were. Where directors at, say, Wal-Mart could not be held personally liable (i.e. you couldn't sue them for their own funds) unless they were grossly negligent, directors at banks were held to a higher duty of care. Up to the decision in Litwin v. Allen in 1940, the idea was that they could be held liable for negligence, which the courts defined as acting outside the realm of the way a reasonably prudent businessperson would act.
Litwin caused a bit of an uproar in that it was willing to actually go back and evaluate the consequences of a bank's decision after the fact and decide that it was negligent. In that case, they claimed a transaction had no "profit potential," which many commentators have pointed out isn't necessarily true (they didn't have much upside, but they did extract a fairly high interest rate, though the specifics of the case itself are mostly neither here nor there). While Litwin was controversial, not many directors were actually held liable for negligent decisions for a few decades, so the case kind of went by the wayside until about the mid-1980's.
But here, I think it's useful to pause and consider the reason why bank directors could be held liable more easily than other directors. The common thread running through the relevant cases seems to be that banks have depositors. And this justification does make sense. A typical public company has two sources of funding-- equity and debt. Put simply, equity is an ownership stake in the company. It usually comes with a regular dividend, and potential upside if the company grows, but it can also fall in value, and is the first part of the corporation that's wiped out in bankruptcy. Debt is exactly what it sounds like-- a corporation issues bonds, which investors buy, getting a fixed interest rate based on demand for the bond, and, when it expires, the principal. But banks are different in that they have a third source of debt-- depositor funds. Now, consumers like to think of deposits as being exactly what they sound like: you send your paycheck to the bank, the bank puts it in a vault, and you go to the ATM and get it out. But, really, deposits are just short-term loans made by the public to the banks. The banks take those deposits and reinvest them in longer-duration assets and earn a spread. Because the interest rates on your checking account might get you 3 Happy Meals a year, but the income stream from the Martinez family's mortgage that your deposits bankroll pays for way more Happy Meals. But deposits are especially volatile-- if too many depositors want to take their funds out, the bank will have to dump its assets, and if it has to dump enough assets at fire -sale prices (which, let's be real, it will probably have to do because there aren't all that many investors sitting around the market thinking that the Martinez family's mortgage is THE BOMB, and they need to buy it), it might lose enough money that it can't pay you back. Of course, all of this is an extreme oversimplification-- banks don't keep many whole mortgages that they originate on their books anymore, and definitely didn't around 2008, but the basic principle is the same-- a deposit is a source of funding that's unique to banks.
And the relevant jurisprudence compares bank directors to trustees-- it says that bank directors have a duty to safeguard not just shareholders, but also depositors. The idea is if they're not extra-careful, depositors will lose faith in the safety of their deposits, and there will be bank runs which will knock the entire banking sector to its knees. And that's exactly what happened pretty regularly for years. Then the Great Depression happened, and the Glass-Steagall Act in 1933 created the FDIC and federal deposit insurance. What that means is deposit-taking banks pay a premium, and in exchange the FDIC guarantees the first $X in deposit accounts (this limit gets pushed up regularly). Instantly, bank runs disappeared. If the government guarantees deposits, then your deposit is safe so long as the US government didn't collapse. And if it did, there would be much bigger problems than the bank losing your deposits. But the consequence of that became that any deposit-taking bank got free liquidity from consumers. The reason is pretty straightforward. If I know that my deposits could be wiped out if a bank went bust, I would think three times before depositing my money there. But if the government guarantees my deposits, I could care less which bank gets my money. So long as there's an "FDIC Member" sticker in the window, my deposits are backed by the full faith and credit of the US.
But in recent years, we've run into an interesting issue. While banks pay deposits, the amount they pay isn't all that big. Take Citigroup. It's a big deposit-taking bank (though it has WAY less in deposits than JP Morgan Chase and Bank of America). In 2008, it had about $208 Billion in deposits. And the FDIC fund was at around $45 Billion (I have a cite for this, but I'd have to dig it up; just trust me, these are the numbers). If Citi were to collapse, depositors MIGHT be able to get all of their deposits back through a combination of the liquidation of the bank's assets in bankruptcy (depositors get paid before bondholders and shareholders) and the FDIC reserve fund, but I doubt it. But even if Citi alone could be paid, a Citi collapse would have disastrous system-wide consequences. Because Citi going down wouldn't be an isolated event. Banks deal with each other all the time, and a collapse in one bank has consequences for others. There are plenty of these transactions, but the simplest one is an insurance contract (I'm throwing it out strictly to illustrate the point). If, say, JPMorgan were to buy $100 million of insurance from Citigroup on the possibility of oil dropping below $50 a barrel, but when oil dropped to $45, Citi didn't have the cash to perform, the impact would be pretty significant. JPMorgan would lose its hedge, which would expose it to more risk than it thought it had. And while losing $100 million isn't a big deal for JPMorgan, the entirety of its dealings with Citi could well have been enough to bring it down (as Citi's counterparties, who are also JPMorgan counterparties, found themselves in trouble from Citi's collapse). And if JPMorgan were to go, its $337 billion deposit base would have to be bailed out, too. While the FDIC might be able to do Citi alone, a $45 billion fund is gonna have a hard time covering almost $550 billion in deposits. So who picks up the bill? Well, the FDIC guarantee isn't contingent on the FDIC having enough on reserve to actually cover deposits-- the bill would end up on the Treasury's desk. So, in the end, taxpayers would be bailing out depositors (who are also taxpayers, but the point is that neither depositors nor the taxpayers have any share in the upside if banks do well, but they DO have the potential downside of systemically significant banks like Citi and JPMorgan going bust.
But what does this have to do with the duty of care? Well, in 1985, Delaware courts handed down the Smith v. Van Gorkom decision, which held directors liable for another bad deal. While there was a settlement, and the amount they were on the hook for was barely more than their liability insurance, this spooked directors. So the legislature passed Section 102(b)(7) of the Delaware code, which allows corporations to protect directors from liability for violating their duty of care, provided they act in good faith. Since more or less every large company in the US is incorporated in Delaware (and most states passed similar statutes), bank directors became the same as non-bank directors: essentially judgment-proof if they acted in good faith. The distinction drawn by Litwin between bank directors and other directors essentially disappeared overnight.
My thinking is that, given the taxpayer subsidy banks get through the existence of the FDIC, there need to be additional incentives in place to keep banks from taking undue risks with depositors' money. And the best way to encourage good risk-taking is by making sure that directors have skin in the game. I think potential liability is the best way I can think of to do that. Now, it might not be enough-- I doubt, say, Citi's directors would get into trouble for violating their duty of care for driving it into the ground in the run-up to the financial crisis, since the risks they took weren't necessarily substantially different from the ones much of the banking industry took (and the economists warning of a housing bubble were far from the dominant voice in public discourse).
But it DOES seem to me that if deposit-taking banks are going to get the liquidity guarantee that comes with FDIC membership, at the very least the FDIC member banks that are publicly held should not be allowed to incorporate with 102(b)(7) provisions. In other words, if a bank is public, the threat of liability should be in place to encourage directors to protect not just depositors, but also taxpayers from potentially footing the bill of a collapse.
Now, I'm sure there are some holes in this argument, so I'd be interested in hearing feedback, just in case anyone actually reads it.
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