Syllabus Globalization: Business, Legal and Public Policy Issues January Term, 2017 — January 3-6, 9-13, 17-18

1. 
   David H. Autor et. al., National Bureau of Economic Research, The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade (2016), http://www.nber.org/papers/w21906.
   

2. 
   Robert Z. Lawrence and Tyler Moran, Peterson Institute for International Economics, Adjustment and Income Distribution Impacts of the Trans-Pacific Partnership (2016), https://piie.com/system/files/documents/wp16-5.pdf.
   

3. 
   Bloomberg, Justin Fox, Free Trade Doesn’t Have to Devastate Workers (2016), https://www.bloomberg.com/view/articles/2016-03-14/free-trade-doesn-t-have-to-devastate-workers
   

4. 
   Council on Foreign Relations, The Future of U.S. Trade and the Trans-Pacific Partnership: A Conversation With Michael Froman (June 20, 2016), http://www.cfr.org/trade/future-us-trade-trans-pacific-partnership-conversation-michael-froman/p37973.
   

5. 
   Elaine McArdle, “Trade Pluses and Pitfalls: Trade Experts Weigh in on Whether the US Should Join the Trans-Pacific Partnership” (Oct. 21, 2016), http://today.law.harvard.edu/feature/trade-pluses-pitfalls/.
   

6. 
   Jeffrey J. Schott, Barbara Kotschwar & Julia Muir, Peterson Institute for International Economics, Understanding the Trans-Pacific Partnership (2013).
   

7. 
   Council on Foreign Relations, Trans-Pacific Partnership (November 4, 2015). http://www.cfr.org/trade/trans-pacific-partnership/p37113
   

8. 
   Washington Post, Lydia DePillis, “You can now read the text of a major Trans-Pacific trade deal. Read this TPP explainer first,” (November 5, 2015). https://www.washingtonpost.com/news/wonk/wp/2015/11/05/you-can-now-read-the-text-of-a-major-trade-deal-read-this-first/
   

9. 
   Public Citizen, Initial Analysis of Key TPP Chapters (November, 2015). http://www.citizen.org/documents/analysis-tpp-text-november-2015.pdf
   
   
   
10. 
    The Economist, Free-trade pacts: America’s big bet (2014). http://www.economist.com/news/special-report/21631797-america-needs-push-free-trade-pact-pacific-more-vigorously-americas-big-bet
    

11. 
    William F. Jasper, “Globalists Now Pushing To Bring China Into TPP” (publication on The New American, June 29, 2015). http://www.thenewamerican.com/usnews/foreign-policy/item/21156-globalists-now-pushing-to-bring-china-into-tpp
    

12. 
    USTR, TPP: Summary of US Objectives
    http://www.ustr.gov/tpp/Summary-of-US-objectives
    

13. 
    USTR, TPP Trade Minister’s Report to Leaders, Nov. 10, 2014
    http://www.ustr.gov/about-us/press-office/press-releases/2014/November/Trans-Pacific-Partnership-Trade-Ministers-Report-to-Leaders
    

1. 
   Edward Aiden, Failure to Adjust: How Americans Got Left Behind by the Global Economy, Council on Foreign Relations (Oct. 16, 2016).
   

Anti-corruption legislation is one of the foremost areas in which the US has come to aggressively assert its jurisdiction across transnational lines. The US Foreign Corrupt Practices Act (FCPA), enacted in 1977, is one of the strongest codified bodies of law on foreign corruption. The FCPA imposes criminal penalties on US companies and foreign issuers of US stock that bribe foreign government officials, thus exporting US legal standards to foreign countries that often have different business cultures and practices. Since the mid-1970s, US businesses have complained that the FCPA puts them at a disadvantage in many foreign markets, where competitors face fewer legal constraints and may engage in questionable business practices (e.g., bribery) that are prohibited under US law. Multinational corporations face a complicated legal landscape, in which aggressive extraterritorial enforcement of the FCPA overlaps with a growing body of foreign anti-corruption laws. This case explores the issues confronting multinational companies that are subject both to the reality of corruption in many markets and to a range of anticorruption enforcement risks.

• 
  Post WWII – Siemens has difficulty competing for business in many Western countries and seeks opportunities in certain less developed countries where corruption is more common.
  

• 
  Pre-1999 – Bribery at Siemens companies is largely unregulated. German law does not prohibit foreign bribery and allows tax deductions for bribes paid in foreign countries. Company not listed on U.S. stock exchange and thus not subject to U.S. regulation. Uses cash and off-books accounts to make payments as necessary to win business. Uses network of payment mechanisms to funnel money via third parties in a way that obscures purpose and ultimate recipient of funds.
  

• 
  1998-2004 – A Siemens company pays over $40 million in bribes to senior officials in government of Argentina to secure project to produce national identity cards.
  

• 
  2/15/1999 – German law implementing Organization for Economic Cooperation and Development (OECD) Convention on Combating Bribery of Foreign Public Officials in International Business Transactions comes into force.
  

• 
  3/1999 – Policy circulated reminding employees of general need to observe laws and regulations.
  

• 
  2000-2002 -- Siemens companies awarded 42 contracts under Iraqi Oil for Food Program, for which they pay $1,736,076 in kickbacks to the Iraqi government.
  

• 
  2000-2002 – A Siemens company pays more than $5 million in bribes through consultants in Bangladesh in connection with communication projects.
  

• 
  4/25/2000 – Managing board rejects proposal by the general counsel to create a company-wide list of business consultants and a committee to review these relationships.
  

• 
  6/2000 – Legal department forwards memo to supervisory board chairman and CFO identifying certain off-book accounts and saying they had to be maintained “in harmony with principles of orderly accounting.” Identifies three bank accounts in Switzerland which are run as trust accounts and for which confiscation was ordered by the Swiss courts. CFO does not respond.
  

• 
  7/5/2000 – Circular issued requiring operating Siemens groups and regional companies to include anti-corruption clause in all contracts with third parties, e.g., agents, consultants, brokers.
  

• 
  2001-2007 – Siemens companies pay estimated $16.7 million in bribes to Venezuelan government officials in connection with the construction of metro transit systems in the cities of Valencia and Maracaibo.
  

• 
  3/12/2001 – Company lists on New York Stock Exchange.
  

• 
  7/2001 – Company establishes position of corporate officer for compliance and expands existing antitrust compliance system to cover anti-corruption issues. Officer works part-time on compliance, and until 2004, has a staff of just two lawyers.
  

• 
  7/18/2001 – Company issues business conduct guidelines that say: “No employee may directly or indirectly offer or grant unjustified advantages to others in connection with business dealings, neither in monetary form nor as some other advantage.” Also provides that gifts to business partners should “avoid the appearance of bad faith or impropriety” and no gifts should be made to public officials or other civil servants.
  

• 
  2002-2003 – A Siemens company pays approximately $25 million in bribes funneled through intermediaries to government customers in connection with two projects for installation of high voltage transmission lines in South China.
  

• 
  2002-2005 – A Siemens company pays approximately $30 million in bribes to a former director of the state-owned Israel Electric Company in connection with four contracts to build and service power plants. Payments made through a “consultant” which turned out to be a Hong Kong-based clothing company with no expertise in power generation.
  

• 
  2002-2007 – A Siemens company pays approximately $22 million to business consultants who use some portion of the funds to bribe officials in connection with seven projects for the construction of metro trains and signaling devices on behalf of government customers in China.
  

• 
  6/13/2002 – Company issues principles and recommendations, not mandatory policies, regarding business-related internal controls and agreements with business consultants, including that such agreements should be in writing, transparent, and as detailed as possible. Contains no discussion of how to conduct due diligence on consultants or agents.
  

• 
  2003-2007 – A Siemens division pays approximately $14.4 million in bribes to an intermediary in connection with sales of medical equipment to five Chinese-owned hospitals, as well as to fund lavish trips for Chinese doctors.
  

• 
  7/2003 – News media reports that prosecutors in Milan are investigating bribes paid to energy company partly owned by Italian government in connection with two power plant projects. Siemens managers made €6 million payments to officials through slush funds in Liechtenstein using a Dubai-based business consultant.
  

• 
  9/9/2003 – U.S. law firm submits memo to company concluding that there is ample basis for either the SEC or DOJ to start at least an informal investigation of the company’s role in the Italian energy matter and that the U.S. government would expect an internal investigation to be carried out on behalf of senior management.
  

• 
  10/2003 – Outside auditor KPMG identifies and flags for review €4.12 million in cash that was brought to Nigeria by the communications business group. Compliance attorney at the Company conducts a one-day investigation and writes a report indicating that communications employees admitted the payments were not an isolated event and warned of numerous violations of the law.
  

• 
  11/2003 – CFO reviews compliance report on Nigerian cash, but no further action is taken. Bribes continue to be paid until employees arrested in November 2006.
  

• 
  11/2003 – To comply w/ Sarbanes Oxley, company issues Code of Ethics for Financial Matters.
  

• 
  11/2003 – Compliance officer drafts memo describing deficiencies in compliance organization which is forwarded to officers of company.
  

• 
  2004 – Corporate finance audit employee raises concerns about use of intercompany accounts. He is phased out of his job.
  

• 
  2004-2006 – A Siemens division pays approximately $5.3 million in bribes through business consultants to government officials in Bangladesh in connection with a contract with the country’s telegraph & telephone board.
  

• 
  4/24/2004 – Judge in Milan issues written opinion concluding that company viewed bribery as “at least a possible business strategy.” Liechtenstein and Emirates bank accounts had been “disguised deliberately.” Legal memo about ruling sent to managing board, which included CEO and CFO, on 5/4/2004. Company and its managers enter into plea bargain with criminal authorities in Italy and pay €0.5 million fine and disgorge €6.2 million in profits.
  

• 
  7/2004 – CFO delivers anti-bribery speech to high level business managers.
  

• 
  8/4/2004 – Company promulgates its first company-wide policy on use of bank accounts and external payment orders, restricts bank accounts controlled by employees and third parties.
  

• 
  6/29/2005 – Company issues mandatory rules governing use of consultants, prohibiting success fees and requiring compliance officers to sign off on business consulting arrangements.
  

• 
  3/2006 – Siemens Greece manager admits €37 million “bonus payments” to government officials.
  

• 
  4/2006 – KPMG audit identifies over 250 suspicious payments made through an intermediary.
  

• 
  11/2006 – Criminal authorities raid company offices in Munich.
  

• 
  Siemens engages Davis Polk to represent the company and Debevoise & Plimpton to conduct an independent investigation for the audit committee. Debevoise hires Deloitte & Touche, translators, computer experts, litigation support firms, and other third parties to assist in the investigation. Investigation will be extensive and unimpeded. Government will give company credit for cooperation. Nearly all senior management, including chair of supervisory board, CEO, GC, head of internal audit, and chief compliance officer, are replaced. New position created on board with specific responsibility for legal and compliance matters. FCPA compliance training implemented.
  

• 
  10/31/2007 to 2/29/2008 – Company-wide amnesty program underway. Senior employees who voluntarily disclose to Debevoise truthful and complete information about possible violations will be protected from unilateral employment termination and company claims for damages. Not binding on prosecutors or regulators. Company would bring employee to the attention of authorities if subject of a government investigation.
  

• 
  10/2007 – In connection with charges relating to corrupt payments to foreign officials by Siemens’s telecommunications operating group, the Munich Public Prosecutor’s Office announces a settlement with Siemens under which the company agrees to pay €201 million, or $287 million, including a €1 million fine and €200 million in disgorgement of profits.
  

• 
  12/15/2008 – Siemens and three of its subsidiaries plead guilty to violations of the FCPA. As part of the plea agreements, Siemens agrees to pay a $448.5 million fine; and Siemens Argentina, Bangladesh, and Venezuela each agree to pay a $500,000 fine, for a combined total criminal fine of $450 million. Siemens agrees to retain an independent compliance monitor for a four-year period to oversee the continued implementation and maintenance of a robust compliance program and to make reports to the company and the Department of Justice.
  

• 
  Siemens reaches a settlement with the SEC, charging the company with violating the FCPA’s anti-bribery, books and records, and internal controls provisions and agrees to pay $350 million in disgorgement of profits.
  

• 
  Siemens agrees to resolve the investigation by the Munich Public Prosecutor’s Office of Siemens operating groups other than the telecommunications group and agrees to pay €395 million or approximately $569 million, including a €250,000 corporate fine and €394.75 million in disgorgement of profits.
  

• 
  Siemens has paid a combined total of more than $1.6 billion in fines, penalties and disgorgement of profits, including $800 million to U.S. authorities, making the combined U.S. penalties the largest monetary sanction ever imposed in an FCPA case since the act was passed by Congress in 1977. Siemens also incurred $800 million in forensic costs to investigate itself across the globe. It had to restate more than $500 million loses for bribes that had been improperly booked as business expenses. The cost of “in kind” time and resources is large, but incalculable.
  

1. 
   Why should the US be able to regulate business activities in other countries?
   
2. 
   Does it make sense to prevent US companies from entertaining foreign government officials when that is common practice in the local market and the company's competitors are not bound by such restrictions? If, in the short term, such rules put US companies at a competitive disadvantage, what is the long term goal of such policies? Are such goals realistic?
   
3. 
   What are other examples of legal restrictions on US companies that put them at a competitive disadvantage with foreign companies? Have such restrictions proved beneficial to US companies and/or the United States as a whole in the long run? Consider sanctions regimes, e.g., against apartheid-era South Africa.
   
4. 
   Should it make a difference whether the government official who is receiving the lavish entertainment is functioning in a regulatory or commercial capacity?
   
5. 
   Should it make a difference if the company can prove it simply cannot compete in a particular market without making these kind of payments?
   
6. 
   Should the US Justice Department care whether the company is paying police officers and customs officials in Saudi Arabia to do their job?
   
7. 
   Should the Justice Department be encouraging in-house lawyers to act as whistleblowers? Why or why not?
   
8. 
   What are the options of a company with an employee who is about to be disciplined for legitimate reasons, but then threatens to become a whistleblower?
   
9. 
   Consider the criticism that the FCPA is really just a licensing fee.  If company X engages in bribes and gets enough contracts to drive out local competition in a market and becomes the dominant player as a result, it well be much better off having done so and paying tens or even hundreds of millions of dollars to achieve that market position.  What should regulators and prosecutors do in those situations to deter future similar conduct?
   
10. 
    What were the major FCPA violations and compliance program failings of Credit Suisse? What aspects of a “model” compliance program were missing?
    
11. 
    What are the most significant adverse impacts of this kind of corruption scandal on a multinational corporation like Credit Suisse? Fire top officers? Internal time/resources? Fines/penalties? Forensic investigatory costs? Lost business? Reputation?
    
12. 
    Must (or should) the company investigate other markets once evidence appears of systematic bribing in a single market? Consider the implications of investigations spreading from one jurisdiction to another, e.g., with GlaxoSmithKline.
    
    
13. 
    What was the value in legal proceedings: (a) to Siemens of its effort to investigate its bribery around the globe starting in 2006; (b) to Morgan Stanley in having a robust anti-bribery compliance program?
    
14. 
    How does the current landscape of anti-corruption legislation (FCPA, UK Bribery Act, OECD Convention) encourage/discourage fair competition among corporations? What are the pros and cons of the United States binding its corporations to laws like the FCPA that do not apply to foreign corporations?
    
15. 
    Which anti-corruption statute (FCPA, UK Bribery Act, OECD Convention) best balances corporate incentives and regulatory/social policy goals? In light of the different consideration given to an MNC’s internal compliance program under the FCPA and the UKBA, consider the pros and cons of adopting some form of compliance defense—e.g., should compliance procedures be a factor in determining a corporation’s liability, or should they be relevant only at the sentencing phase?
    
16. 
    In situations in foreign markets where bribery is covered by the FCPA but competitors are routinely bribing to get business, should a company engage in a calculus that weighs the benefit of obtaining the business against the probability of such bribery being uncovered and the costs to the company if the bribery is uncovered? Why not bribe if the commercial benefits outweigh the compliance costs?
    
17. 
    If bribery is not covered by the FCPA—either in public settings where certain elements are not satisfied or in purely private settings—should a company engage in such activity in corrupt nations where competitors are bribing officials to win orders? What are: (a) other legal considerations; (b) ethical considerations relating to the internal operation of the company and effect on corporate culture; (c) public policy considerations relating to the developing nation. If corruption is rampant, is withdrawal from a country necessary?
    
18. 
    Should a company prohibit facilitating payments—payments in a foreign country to induce an official to carry out a ministerial duty—that are lawful under the FCPA but may be illegal, if unenforced, under the laws of the foreign nation?
    
19. 
    If you were the CEO, General Counsel or a Director of Siemens, what would you do to prevent, deter, detect, and sanction future violations of anti-bribery laws and regulations?
    

Consistent with the group assignments and instructions below, please prepare a group memo and upload it to the “Assignments” folder on iSites by Sunday, January 10 at 9 pm.

Group Assignments

Group 1: Siemens

Please address your memo to the following two questions:

1. If you were the CEO or general counsel of this company, what would you do to prevent, deter, detect, and sanction a similar problem in the future?

2. Stepping back, can the U.S. government regulate effectively in this space? Should it? To what extent? Consider how regulations affect corruption levels, the competitive and economic effects of anti-corruption regulations, and the consequences of different regulatory regimes in the U.S., Europe, China, and other jurisdictions, among other factors.

1. 
   DOJ Criminal Division and SEC Enforcement Division, A Resource Guide to the U.S. Foreign Corrupt Practices Act, (Nov. 14, 2012), pp. 2-19, 23-26, 38-45, 68-69, 82-83, http://www.justice.gov/sites/default/files/criminal-fraud/legacy/2015/01/16/guide.pdf.
   

2. 
   U.K. Ministry of Justice, Bribery Act 2010: Guidance (2011), pp. 1-31, http://www.justice.gov.uk/downloads/legislation/bribery-act-2010-guidance.pdf.
   
   
   
3. 
   A Tale of Two Laws, Economist, Sept. 17, 2011, http://www.economist.com/node/21529103.
   

4. 
   Robb Adkins, Benjamin Kimberley, “The Globalization of Anti-Corruption Enforcement: Recent Trends and Developments,” International White Collar Enforcement, 2014 Edition (Aspatore 2014), 2014 WL 10502. [see attached PDF]
   

5. 
   David M. Zornow, et al., The United States Foreign Corrupt Practices Act: SEC and DOJ Enforcement Trends, Skadden, Arps Memorandum, April 22, 2013, pp. 8-11, http://www.law.yale.edu/documents/pdf/cbl/Skadden_FCPA_SEC_and_DOJ_Enforcement_Trends.pdf.
   

6. 
   2014 Year-End FCPA Update, Gibson, Dunn Memorandum, Jan. 5, 2015, pp. 2-7, http://www.gibsondunn.com/publications/pages/2014-Year-End-FCPA-Update.aspx
   

7. 
   FCPA Digest: Recent Trends and Patterns in FCPA Enforcement, Shearman & Sterling Memorandum, Jan. 2014, pp. 1-6, http://www.shearman.com/~/media/Files/Services/FCPA/2014/FCPADigestTPFCPA010614.pdf
   

Note: Updated, Jan 2015 http://www.shearman.com/~/media/Files/NewsInsights/Publications/2015/01/Recent-Trends-and-Patterns-FCPA-Digest-FCPA-LT-010515.pdf

8. 
   RAND Center for Corporate Ethics and Governance, New Markets, New Challenges: Dealing with Anti-Corruption Regulation in Emerging and Expeditionary Markets, Conference Proceedings (Jan. 12, 2012), pp. iii, 5-10, 15-20, http://www.rand.org/content/dam/rand/pubs/conf_proceedings/2012/RAND_CF304.pdf.
   

9. 
   Ashby Jones, FCPA: Company Costs Mount for Fighting Corruption, Wall St. J., Oct. 12, 2012, http://online.wsj.com/news/articles/SB10000872396390444752504578024893988048764.
   

10. 
    Ashby Jones, Extradition is Hurdle in FCPA Prosecutions, Wall St. J., Oct. 2 2012, http://online.wsj.com/articles/SB10000872396390444004704578028430536186670.
    

11. 
    Samuel Rubenfeld, Small Bribes, Big Problems: What’s a Company to Do?, Wall St. J., June 27, 2014, http://blogs.wsj.com/riskandcompliance/2014/06/27/small-bribes-big-problems-whats-a-company-to-do-to-stop-them/.
    
12. 
    Samuel Rubenfeld, New Corruption Laws May Level the Field for US Business, Wall St. J., March 15, 2013, http://blogs.wsj.com/corruption-currents/2013/03/15/new-corruption-laws-may-level-the-field-for-us-business/.
    

13. 
    U.S. Chamber Institute for Legal Reform, Comments on FCPA Guidance, 2013, http://www.instituteforlegalreform.com/uploads/sites/1/Coalition_Letter_to_DOJ_and_SEC_re_Guidance_2-19-13.pdf.
    

14. 
    David Barstow, Vast Mexican Bribery Case Hushed Up By Walmart After Top-Level Struggle, N.Y. Times, April 21, 2012, http://www.nytimes.com/2012/04/22/business/at-wal-mart-in-mexico-a-bribe-inquiry-silenced.html?_r=3&.
    

15. 
    Elizabeth A. Harris, After Bribery Scandal, High-Level Departures at Walmart, N.Y. Times, June 4, 2014, http://www.nytimes.com/2014/06/05/business/after-walmart-bribery-scandals-a-pattern-of-quiet-departures.html?rref=business&module=Ribbon&version=context®ion=Header&action=click&contentCollection=Business%20Day&pgtype=Blogs&_r=0.
    

16. 
    Ben W. Heineman, Jr., “Who’s Responsible for the Walmart Mexico Scandal?”, Harvard Business Review, May 15, 2014, http://blogs.hbr.org/2014/05/whos-responsible-for-the-walmart-mexico-scandal/.
    

17. 
    Ben W. Heineman, Jr., “Walmart Bribery Case Raises Fundamental Governance Issues,” Harvard Law School Forum on Corporate Governance and Financial Regulation (2012), http://blogs.law.harvard.edu/corpgov/2012/04/28/wal-mart-bribery-case-raises-fundamental-governance-issues/.
    

18. 
    Ben W. Heineman, Jr., “News Corp, Walmart and CEO Failure to Investigate Wrong-Doing,” Harvard Business Review (2012), http://www.law.harvard.edu/programs/corp_gov/articles/Heineman_HBR_05-04-12.pdf.
    

19. 
    Ben Protess and Jessica Silver-Greenberg, Chinese Official Made Job Plea to JPMorgan Chase Chief, N.Y. Times, Feb. 9, 2014, http://dealbook.nytimes.com/2014/02/09/chinese-official-made-job-plea-to-jpmorgan-chase-chief/.
    

20. 
    Aruna Viswanatha, U.S. expanding corporate foreign bribery probes to include hiring, Reuters, April 25, 2014, http://www.reuters.com/article/2014/04/25/us-usa-corruption-hiring-idUSBREA3O25Z20140425.
    

21. 
    Ben Protess and Jessica Silver-Greenberg, On Defensive, JPMorgan Hired China’s Elite, N.Y. Times, Dec. 29, 2013, http://dealbook.nytimes.com/2013/12/29/on-defensive-jpmorgan-hired-chinas-elite/.
    

22. 
    Chad Bray, GlaxoSmithKline Under Investigation by Serious Fraud Office, N.Y. Times, May 28, 2014, http://www.nytimes.com/2014/05/29/business/international/glaxosmithkline-under-investigation-by-serious-fraud-office.html.
    

23. 
    Robert Radick, The Glaxo-China Bribery Scandal: A New Policeman Walks the Beat, Forbes, July 25, 2013, http://www.forbes.com/sites/insider/2013/07/25/the-glaxo-china-bribery-scandal-a-new-policeman-walks-the-beat/
    

24. 
    Amy Conway-Hatcher, “The Big Three FCPA Lessons from the Morgan Stanley Case,” Corporate Counsel (2012). [see attached PDF]
    

25. 
    Neal Batson, Final Report of Court Appointed Examiner in Enron Bankruptcy Case, pp. 6-13, 48-55, http://www.concernedshareholders.com/CCS_ENRON_Report.pdf.
    

26. 
    Peter Lattman, The Vinson & Elkins Enron Connection: The Plot Thickens, Wall St. J., June 1, 2006, http://blogs.wsj.com/law/2006/06/01/the-vinson-elkins-enron-connection-the-plot-thickens/.
    

1. 
   Introduction
   

The financial crisis began in the summer of 2007 with the “bursting” of the U.S. housing bubble.⁵⁹ While many believed it would remain confined to the U.S. mortgage market, by 2008, it had turned into a full-fledged financial crisis that froze up credit markets around the world and threatened the global financial system.⁶⁰ Former Federal Reserve Board Chairman Ben Bernanke described it as “the worst financial crisis in global history, including the Great Depression,” and former Treasury Secretary Timothy Geithner described the economy as essentially “in free fall.”⁶¹ By 2009, the world economy had entered a global recession, the “deepest post-WWII recession by far.”⁶²

2. 
   Background
   

1. 
   The Subprime Mortgage Crisis
   

The U.S. housing bubble began with the market for mortgage loans made to “sub-prime,” or low-income, borrowers, which boomed between 2001 and 2006. Innovations in securitization, easy access to credit, sometimes without customary evidence of income, credit balance practices and speculative bursts of investments in additional homes, especially in resort communities, helped spin a run-up in housing prices, allowing people to buy houses at prices they might not have previously thought they could handle. Many of these borrowers, however, depended on loans with variable interest rates and low initial “teaser” rates. When it came time to reset the loans, rising interest rates and a weakening economy made it difficult for them to meet their mortgage obligations.⁶³ This inability to pay, combined with a general decline in housing prices, led to the “bursting” of the housing bubble in 2007⁶⁴, and the recession that followed depressed the ability to meet housing and other obligations for millions of homeowners.

The financial innovations that had facilitated easy credit for subprime borrowers were the same financial innovations that also served to spread the risks associated with these subprime loans globally. Securitization of mortgages allowed trillions of dollars in risky mortgages to become embedded throughout the financial system through pooled mortgage securities, largely in the form of collateralized debt obligations (CDOs).⁶⁵ The CDO market grew from $275 billion in 2000 to $4.7 trillion by 2006.⁶⁶ At the same time, the spread of credit default swaps (CDS) allowed investors to hedge against the risk of nonpayment, and these CDS were then traded on secondary markets. In 2001, the notional value of CDS outstanding was $919 billion; by the end of 2007, CDS volume was $62 trillion. Moreover, derivative dealer banks had moved from using CDS to hedge against the risk of nonpayment on their investments to pure betting on the likelihood of default. In 2008, about 80 percent of CDS outstanding were “naked”—that is, pure financial bets. The widespread use of mortgage-backed securities and their transformation into credit default swaps thus served to magnify greatly the underlying mortgage risk represented by a declining housing market.⁶⁷

The “burst” of the bubble—the realization by market participants that subprime mortgages and then certain other credits like credit card obligations, student loans, car loans and long term consumer loans were seriously deficient in their underwriting and disclosures, combined with the decline in housing prices—led financial institutions to suffer large credit losses that were increasing at a rate that made projected reserves required to cover losses difficult to assess accurately.⁶⁸ In October 2007, at the Economic Club of New York, Federal Reserve Chairman Ben Bernanke warned of a weakness in structured financial products, namely the difficulty in coming up with valuations in periods of stress, and joked that he wanted to know “what those damn things are worth.”⁶⁹ Moreover, the most widely-used financial modeling formulas—used by everybody from bond investors and Wall Street banks to ratings agencies and regulators—began to fail when markets during 2008 and 2009 began behaving in ways nobody expected, with losses far in excess of the most severe stress assumptions.⁷⁰

2. 
   Spillover Effects
   

The financial crisis quickly evolved into an economic recession, highlighting the extent of the integration of the housing market into the regular economy. U.S. gross domestic product (GDP) contracted by 0.3 percent in 2008 and 3.5 percent in 2009, before growing again by 3.0 percent in 2010 and 1.7 percent in 2011.⁷¹ Low consumer spending—due to the huge decrease in household wealth, followed by heightened insecurity and tighter lending standards—slowed significantly the recovery, which took place at less than half the average rate exhibited during other recoveries in the United States since the end of World War II.⁷²

The crisis also spilled over into other markets, as both international and local financial institutions and investors around the globe discovered they had significant exposure to the U.S. subprime market and actively used short-term wholesale funding markets.⁷³ The effects were exacerbated by the excessive rise of short term funding to cover longer duration liabilities. In turn these developments spread the recession to other countries creating a vicious cycle of adverse economic consequences to households and businesses. Many of the factors that led to the U.S. subprime crisis were present in other advanced economies, including, for example, home-grown real estate bubbles in many European countries and elsewhere.⁷⁴ Furthermore, as advanced economies suffered, their trading partners—including the export-driven economies of Asia and the more commodity-based economies of Africa and Latin America—were also hit hard.⁷⁵ The global effects of the crisis prompted a global policy response, notably through the G-20 and the Financial Stability Board (FSB), which have assumed more responsibility for coordinating international financial policy reform.⁷⁶

3. 
   U.S. Government Response
   

As rumors of Bear Stearns’ weakness—due to its large exposure to the U.S. mortgage market— spread through the end of 2007 and beginning of 2008, its stock plummeted and creditors refused to roll over maturing credits, beginning a true run on the bank. By the night of March 14, 2008, Secretary of the Treasury Paulson and then-President of the Federal Reserve Bank of New York Geithner told CEO Alan Schwartz that he had to make a deal to be taken over. Bear agreed to be taken over by JPMorgan, facilitated by significant assistance by the Federal Reserve Board, which agreed to loan JPMorgan $30 billion to fund Bear’s assets.⁷⁷ This rescue of Bear Stearns represented the first time in history that the Federal Reserve had helped to rescue an investment bank;⁷⁸ Federal Reserve Chairman Bernanke defended the move—which was authorized under the Fed’s emergency lending authority—on the grounds that “the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions . . . and could have severely shaken confidence” in U.S. financial markets.⁷⁹

Around the same time, Fannie Mae and Freddie Mac, the two government-sponsored enterprises that held or guaranteed more than $5 trillion in U.S. mortgage debt, were headed for failure. In July 2008, Congress passed the Housing and Economic Recovery Act, giving the Treasury Department “almost unlimited authority” to inject capital into Fannie and Freddie, as well as giving the newly-christened Federal Housing Finance Agency (FHFA) authority to take them over.⁸⁰ By the morning of September 8, the FHFA had forced Fannie and Freddie into conservatorship and replaced the CEOs, while the Treasury Department had committed up to $200 billion in government capital to prevent them from defaulting.⁸¹

The Fannie and Freddie rescues were not sufficient to ease investor fears, and the next weakest of the large investment banks, Lehman Brothers, was on the brink of failure. Geithner and Paulson tried to facilitate an acquisition by Bank of America or Barclays, but Paulson made clear that the government would not subsidize a purchase like it had for Bear.⁸² To the surprise of many—including Lehman’s CEO Dick Fuld—the Fed and the Treasury Department refused to supply credit support, the British regulators refused to approve an acquisition by Barclays, and Lehman filed for Chapter 11 bankruptcy protection on September 15, 2008, the biggest bankruptcy filing in U.S. history.⁸³

Two days after Lehman declared bankruptcy, the Fed did provide funding to avert a bankruptcy of AIG⁸⁴ without private sector support, lending up to $85 billion in exchange for what was effectively a 79.9% equity stake in the giant insurance company.⁸⁵ This seeming about-face was widely understood to be a result of fear that AIG actually was so interconnected with virtually every major financial institution in the world that it’s collapse would lead to a disastrous string of failures in the global system.⁸⁶

That same day, the Reserve Primary Fund—a money market fund that had heavily invested in Lehman commercial paper—“broke the buck,” casting suspicion on all money market funds,⁸⁷ creating an even more intense liquidity crisis for financial institutions, and forcing the Treasury Department to guarantee all investors’ account balances in MMFs for a year.⁸⁸ This guarantee helped prevent other funds from “breaking the buck”, although it did not solve the risk of similar runs by counterparties or of runs on other stand-alone investment banks, such as Merrill Lynch, Morgan Stanley, and Goldman Sachs,⁸⁹ which were heavily reliant on short-term funding markets, including commercial paper and money market funds, and the growing threat to the stability of even larger banks like Citigroup, Bank of America, JP Morgan Chase and Wells Fargo.⁹⁰ The Fed and Treasury officials agreed to convert Morgan Stanley and Goldman Sachs into bank holding companies, which would give them the umbrella of Fed protection, so long as they raised the requisite amount of capital.⁹¹ The Fed and Treasury were not able to arrange a merger of Goldman Sachs or Morgan Stanley with one of the universal banks, but GS received a capital infusion from Warren Buffet’s Berkshire Hathaway, and Morgan Stanley succeeded in arranging a capital investment by the Mitsubishi Group.

On October 3, 2008, President Bush signed the Emergency Economic Stabilization Act (passed, again, by a Democratic-controlled Congress), which provided for the injection of up to $700 billion in government funds into financial institutions through the Troubled Assets Relief Program (TARP).⁹² Treasury used TARP to inject capital into nine “systemically important” financial institutions—Citigroup, Bank of America, JP Morgan, Wells Fargo, Goldman Sachs, Morgan Stanley, State Street, Bank of New York Mellon, and Merrill Lynch. Citi received $25 billion from TARP in October 2008; $20 billion in November 2008; and a capital boost through the conversion of preferred into common shares in February 2009.⁹³ On December 19, 2008, the Treasury used TARP funds to bail out the auto industry, through a $13.4 billion loan to General Motors and a $4.0 billion loan to Chrysler.⁹⁴

The Treasury Department finished exiting its TARP investment in Citigroup in January 2011, realizing a $12.3 billion profit.⁹⁵ In December 2012, the Treasury Department announced the sale of its final shares of AIG common stock,⁹⁶ yielding an overall positive return of $22.7 billion on the Federal Reserve and Treasury’s combined $182 billion commitment to AIG.⁹⁷ While the Treasury Department has recouped much of its investment in the auto industry, unlike the bank and AIG investments, the TARP auto industry bailout will likely remain a net cost to the government.⁹⁸ Nevertheless, the estimated cost of TARP in August 2009 was $341 billion; by 2014, the estimated cost had decreased to $27 billion.⁹⁹

3. 
   Reform
   

In the wake of the financial crisis, arguably the leading item on the list of reform issues was correcting the notion that certain institutions that were “too big to fail,” or “too interconnected to fail.”¹⁰⁰ The U.S. reform effort—primarily through the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010—sought to fix this through a variety of means: boosting capital and liquidity requirements so that financial institutions are less leveraged and less prone to liquidity crunches; banning proprietary trading and certain principal investing and management of prime equity and real estate funds; and devising plans to allow an institution to fail, but to ensure that it happens in an organized manner rather than the chaotic global bankruptcy process of Lehman.¹⁰¹ The U.S. reforms largely track the global reform effort, not coincidentally, as finance ministries, central bankers, and regulators around the world have undertaken a sweeping and ambitious coordinated reform effort in this area over the past several years. In addition, the reform effort has taken note of and sought to change practices related to compensation and recruitment in the financial industry, as well as consumer protections, and enhanced research on data collection in Treasury so it will have the data on capital, investment and risk across all participants in the financial system.

1. 
   Systemic risk regulation
   

The financial crisis exposed, among other things, the degree of complexity and interconnectedness of the global financial system, and the dangers resulting therefrom—namely, that one triggering event, such as the failure of a large financial firm, could provoke a liquidity shock that would seriously impair financial markets and harm the broader economy.¹⁰²

In the United States, the Dodd-Frank Act created a new regulatory body—the Financial Stability Oversight Council (FSOC)—charged with identifying risks to the financial stability of the United States; promoting market discipline; and responding to emerging risks to the stability of the financial system.¹⁰³ Under the new regulatory regime, bank holding companies with $50 billion or more in assets are considered Systemically Important Financial Institutions (SIFIs) and subject to enhanced prudential standards. In addition, FSOC has the authority to classify nonbank financial companies as “nonbank SIFIs” and subject them to supervision by the Federal Reserve based on a finding that their material financial distress—or the nature, scope, size, scale, concentration, interconnectedness, or mix of their activities—could pose a threat to U.S. financial stability.¹⁰⁴ The FSOC have designated certain non-banks as systemically stringent, including GE, Prudential Financial, AIG and Met Life.

In addition to this new regulatory mandate in the United States, governments around the world sought to coordinate action related to systemic risk, including through the adoption by the Basel Committee on Banking Supervision (BCBS) of higher capital requirements for global systemically important banks (G-SIBs) (discussed in more detail below).¹⁰⁵ The Basel Committee put forth a number of other initiatives designed to mitigate systemic risk, including countercyclical capital buffers, liquidity requirements, increased capital charges for exposures to large financial institutions, large exposure rules, and deductions from capital for equity investments in banks.¹⁰⁶ The G-20 is also working to reduce risk in OTC derivatives markets by enacting reforms to improve transparency and decrease counterparty exposures among market participants, including through mandated central clearing for standardized OTC derivatives, and setting new standards for margin requirements on non-centrally-cleared derivatives.¹⁰⁷

2. 
   Capital and liquidity
   

The crisis also revealed the fact that banks and other financial institutions had been allowed to operate with too much leverage and too little capital.¹⁰⁸ After the crisis, there was nearly universal agreement that existing capital requirements should be higher, and that new requirements should be put in place to ensure that financial institutions had in place sufficient liquidity buffers.¹⁰⁹

Due to a much longer history of international cooperation in this area, questions regarding the levels at which capital and liquidity ratios should be set are resolved largely by the Basel Committee, comprised of the membership of the G-20 and a few others. Following the crisis, the BCBS adopted the Basel III agreement, which strengthened minimum capital requirements, introduced a minimum “leverage ratio,” and introduced two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets (HGLA) to cover its total net cash outflows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period.¹¹⁰

The United States has adopted and is in the process of implementing stricter requirements than the Basel Committee minimum requirements, including a risk-based capital surcharge for global systemically important banks (G-SIBs), a higher leverage ratio for G-SIBs, and a requirement that foreign banking organizations form U.S. holding companies that will be required to meet these capital requirements.¹¹¹ In addition, the United States has led the charge on regulatory initiatives designed to limit the risks of overreliance on short-term wholesale funding by banks and non-bank financial actors. The Federal Reserve has long raised concerns about the systemic risk posed by the short-term wholesale funding market, and particularly by securities financing transactions (SFTs)—repos, reverse repos, securities borrowing and lending, and securities margin lending.¹¹² Federal Reserve Board Governor Daniel Tarullo has outlined three initiatives currently under works to address this issue: (i) a proposal to incorporate the use of short-term wholesale funding into the risk-based capital surcharge applicable to U.S. G-SIBs; (ii) proposed modifications to the BCBS’s NSFR standard to strengthen liquidity requirements that apply when a bank acts as a provider of short-term funding to other market participants; and (iii) numerical floors for collateral haircuts in SFTs to help address the risk that post-crisis reforms will drive systemically risky activity toward areas of the financial system where prudential standards do not apply (i.e., to non-banking organizations).¹¹³

3. 
   Recovery and Resolution
   

One of the most important measures of the financial reform program dealing specifically with large banks has been the work on resolution mechanisms for SIFIs. Dodd-Frank in the United States provided the FDIC with Orderly Liquidation Authority (OLA), a regime to conduct an orderly resolution of a financial firm if the bankruptcy of the firm would threaten financial stability.¹¹⁴ Internationally, the FSB adopted in 2011 the Key Attributes of Effective Resolution Regimes for Financial Institutions, a new standard for resolution regimes for systemic firms that was largely modeled on the U.S. approach.¹¹⁵ Nevertheless, one of the biggest remaining challenges in this area concerns the development of adequate and transparent cooperation mechanisms for ‘home’ and ‘foreign’ regulators for the purposes of conducting orderly cross-border resolutions.¹¹⁶

Closely associated with the work on orderly resolution mechanisms is the “living will” exercise for SIFIs.¹¹⁷ Under Dodd-Frank, SIFIs and nonbank SIFIs must periodically submit resolution plans—a.k.a. “living wills—to the Federal Reserve and the FDIC. Each living will must describe the company’s strategy for rapid and orderly resolution in the event of material financial distress or failure of the company, and include both public and confidential sections.¹¹⁸ In August 2014, the FDIC and the Fed rejected the living wills of all eleven financial institutions that submitted them in 2013, on the grounds that “the plans provide no credible or clear path through bankruptcy that doesn’t require unrealistic assumptions and direct or indirect public support.”¹¹⁹ The regulators encouraged the banks to make their bankruptcy plans more credible by “establishing a rational and less complex legal structure,” showing they can quickly produce reliable information about their exposures, and amending derivatives contracts to make them easier to bring through bankruptcy.¹²⁰

4. 
   Consumer Protection
   

In a now-famous article published in 2007, then-Harvard Law School Professor Elizabeth Warren outlined a plan for a Financial Product Safety Commission, a consumer protection commission dedicated to financial products.¹²¹ The Dodd-Frank Act created this new independent agency in 2010 as the Consumer Financial Protection Bureau (CFPB), and in 2013, the Senate confirmed President Obama’s appointee, Richard Cordray, as the first Director of the CFPB.¹²² The CFPB’s authority extends over banks, credit unions, mortgage brokers and servicers, foreclosure relief services, credit card issuers and many other businesses deemed to provide consumer financial goods and services.¹²³ Since its inception, the CFPB has set up a consumer complaint process; pioneered a data-based method for assessing which institutions deserve the most scrutiny; undertaken a wide range of enforcement actions against companies engaged in deceptive lending practices, including for-profit educational institutions; and met every rulemaking deadline set by Dodd-Frank.¹²⁴

5. 
   Talent and Compensation
   

Another much-discussed area of reform revolves around compensation practices for professionals in the financial industry, and in particular, the concern that executive compensation in the industry encourages excessive risk-taking. As Former Chairman of the Federal Reserve Paul Volcker observed in 2008:

Citi pre-announced 3Q earnings, writing down $1.4 billion of leveraged loan commitments and $1.3 billion in subprime mortgage holdings. It also announced a $2.6 billion charge for anticipated losses in consumer credit.

Citi formally reported earnings for 3Q with profits of $2.2 billion, down 58% from 3Q2006. Citi reported its exposure to subprime assets in the Collateralized Debt Obligations (CDO’s) was about $13 billion.

Citi announced Charles Prince’s departure as Chairman and CEO and also reported that its CDO exposure was $55 billion, not the $13 billion reported three weeks earlier. The difference was $43 billion of the “super senior” tranche of CDO’s, which included $25 billion of “liquidity puts” financing client purchases of “super seniors”, the highest rated tranche of CDO’s. Through the “liquidity puts”, Citi had essentially retained the risk of ownership when it sold the securities to clients.

Bear Stearns, on the brink of failure, is acquired by JP Morgan with assistance from the Federal Reserve Bank of New York which loaned $30 billion to JP Morgan to facilitate the merger.

The FDIC and the Office of Thrift Supervision shut down and seized Indy Mac, a sizeable California savings bank.

Congress passes a law authorizing Treasury to bail out the GSE’s Fanny Mae and Freddy Mac, placing oversight and management in the Federal Housing Finance agency. The CEOs of both agencies were replaced on Labor Day and Treasury committed $200 billion.

Lehman Bros filed for bankruptcy at 1:45am on Monday, September 15, 2008. It had been unable to work out a take-over by either Barclay’s or Bank of America and the US Government refused to extend federal support.

AIG, the largest international insurance company, could not attract new private capital and faced a dramatic loss of confidence from counter-parties based on mounting losses from structured investment products. The Fed stepped in and ultimately loaned AIG $180 billion, taking back 79.9% of the equity as well as security for the loan and an interest rate charge of 14%.

Citi and Wachovia Corp, which was on the brink of failure, agreed that Citi, with assistance from the FDIC, would acquire Wachovia for $1 a share. Five days later, after encouragement from the FDIC, Wachovia agreed instead to a merger with Wells Fargo, which paid $7 a share and required no FDIC assistance.

The stock market fell 18%, the biggest weekly drop since 1933.

On Columbus Day, October 13, 2008, Secretary of Treasury Henry Paulson, Fed Chairman Ben Bernanke, NY Federal Reserve Board President Tim Geithner and other US government officials summoned CEO’s of nine large financial institutions to the Treasury and gave them an hour to sign documents accepting a government investment of $225 billion of preferred stock--$25 billion each in Citigroup, JP Morgan, Wells Fargo; $15 billion in Bank of America, $10 billion in Morgan Stanley, Goldman Sachs, Merrill Lynch; $3 billion in Bank of New York and $2 billion in State Street.

In November, the US government invested an additional $20 billion from TARP funds into Citi and at the same time protected Citi’s “tail risk” by insuring $306 billion of its assets subject to Citi taking the first $39.5 billion in losses, and 10% of the losses after that; Treasury agreed to absorb $5 billion of additional losses if they occurred, the FDIC took the next $10 billion and the FRB took responsibility for the rest.The market responded positively to the rescue plan with Citi’s stock price increasing 58% and the price of its credit default swaps declining 50%.

The US government did a similar rescue deal for BAC, which also had acquired Merrill Lynch.

Citigroup announced it would divide its assets and operations between its “franchise of the future”, Citicorp, and a collection of troubled assets and operating businesses available for sale, “Citi Holdings”, more than $800 billion assets of its $2.3 trillion balance sheet were put into Citi Holdings.

Citi’s stock price fell to $2 and days later to $1. Bank of America’s credit default swaps – the cost of insuring its bonds – rose to 15%. Although both Citi and BAC had enough “regulatory capital” under the prevailing regulatory requirements, the market and regulators were moving to a new capital standard under which only common equity counted. By that measure, Citi’s leverage ratio was 60:1 and BAC’s was 40:1 - $60 or $40 in assets for every dollar of common equity. The market was refusing to treat as capital even the preferred stock investment made by the US government four months earlier when each of Citi and BAC had received first $25 billion and later $20 billion from the US government..

Inside the White House, and among former Central Bank Governors there was a lively debate about whether nationalization of the banks was needed and inevitable.

Secretary Geithner and National Economic Council Director Larry Summers advised the President in a memo that Citigroup, Bank of America and Wells Fargo were all in severe distress and that AIG’s deep problems could soon spread to both Met Life and Prudential.

The US government committed an additional $30 billion to AIG to enable it to meet its current obligations.

Public outrage over AIG payments of contractual commitments to pay bonuses to managers involved with the company’s troubled investment products led to the appointment by Secretary of Treasury Geithner of Ken Feinberg as the compensation czar under TARP with responsibility to set the compensation for the highest paid 25 people in each of the companies with outstanding TARP investments from the US government.

The first positive reaction occurred in the markets after the Treasury disclosed its “Public Private Investment Program” (PPIP) with federal funds up to $1 trillion available to buy troubled assets from the banks. The announcement helped calm the market and restore confidence in the financial system and was the first hopeful sign that the crisis might be slowing. Private investors were attracted to these assets because they began to see potential gains as the economy recovered. As a result, only $22 billion of government investments were made under the asset purchase program.

Citi gradually recovered, regaining profitability slowly and its stock recovered from the $1 low of February 2009 and returning from time to time to the equivalent of $5.50 after adjusting for a 10:1 reverse stock split. By the end of 2010, Citi had repaid the US government in full plus a gain for the Treasury of $13 billion.

The Treasury authorized a conversion of its preferred stock in Citi to common equity side by side with a conversion of preferred to common stock by certain private investors including the Government of Singapore and Prince Al-Waleed bin Talal of Saudi Arabia. The US Government and private investors’ conversion of preferred into common stock was targeted to add up to an additional $58 billion in new common equity capital. After the conversion, the US government owned 34% of Citi’s common equity.

4. 
   Discussion Questions