<html><body>When Federalism Works-Why Kill It? Federal Initiatives on Corporate and Financial Regulation October 9, 2003 Unedited transcript prepared from a tape recording <TABLE width="100%" border=0> <TBODY> <TR> <TD vAlign=top align=left width="25%"> 1:45 p.m.</TD> <TD vAlign=top align=left width="75%" colSpan=2> Registration</TD></TR> <TR> <TD vAlign=top align=left width="25%">2:00</TD> <TD vAlign=top align=left width="75%" colSpan=2>Corporate Law: Demise of the Delaware Principle?</TD></TR> <TR> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="25%"> Panelists:</TD> <TD vAlign=top align=left width="50%">Jonathan F. Pedersen, Kirkland & Ellis</TD></TR> <TR> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="50%"> Charles Elson, University of Delaware Law School</TD></TR> <TR> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="50%"> Bruce Johnsen, George Mason University Law School</TD></TR> <TR> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="25%"> Moderator:</TD> <TD vAlign=top align=left width="50%">Peter J. Wallison, AEI</TD></TR> <TR> <TD vAlign=top align=left width="25%"> 3:30</TD> <TD vAlign=top align=left width="25%">Coffee Break</TD> <TD vAlign=top align=left width="50%">  </TD></TR> <TR> <TD vAlign=top align=left width="25%"> 3:45</TD> <TD vAlign=top align=left width="75%" colSpan=2>Financial Regulation: Marquette and Markets or Federal Uniformity?</TD></TR> <TR> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="25%"> Panelists:</TD> <TD vAlign=top align=left width="50%">Wright Andrews, Butera & Andrews</TD></TR> <TR> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="50%"> Phil Lehman, Office of the Attorney General, North Carolina</TD></TR> <TR> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="50%"> Todd Zywicki, Federal Trade Commission</TD></TR> <TR> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="25%"> Moderator:</TD> <TD vAlign=top align=left width="50%">Michael S. Greve, AEI Federalism Project</TD></TR> <TR> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="25%">  </TD> <TD vAlign=top align=left width="50%">  </TD></TR> <TR> <TD vAlign=top align=left width="25%"> 5:30</TD> <TD vAlign=top align=left width="75%" colSpan=2> Adjournment and Reception</TD></TR></TBODY></TABLE> Proceedings: MR. GREVE: Good afternoon, everybody. I'm Mike Greve. I'm with the American Enterprise Institute in its Federalism Project, and I welcome all of you to an afternoon of discussion on recent federal initiatives in the area of corporate governance and federal financial and, in particular, mortgage regulation. As most members of this audience no doubt know, either one of these subjects could make for a fun-filled afternoon. I thought I'd just spend a few minutes on explaining our rather idiosyncratic thought process in joining these two issues. The usual federalism debate as it's understood in the United States, at least, always runs along the following lines. Should the Federal Government regulate this or should the States regulate this? There's lots of debate about that vertical distribution of power. There'll be a lot of it, including today. But, of course, the vertical debate, the Feds versus the States, doesn't really exhaust the range up. Federalism wants you to say, well, how about should the States regulate this? You have at least two options. You can give the power of regulation either to every State where any given company does any of its business, or you could say you assign the right, the State right to regulate any given business to the State where the company has its headquarters or its charter. And that arcane jurisdictional point makes all the difference in the world. The 50-State option is really an option to regulate, to have the strictest State regime and a lot of conflicting State regimes regulate any given company, which is the reason why every corporate official recoils in horror when federalism is mentioned, whereas the home State option is in many ways the heart and soul of the common market, and the competitive federalism order illustrates the profoundness of the difference at stake here. Two weeks ago, the European Court of Justice dealt with the question of suppose somebody is incorporated in England. Does he have to comply only with the incorporation laws of England to do business in Holland and Germany, or does he have to comply with the incorporation requirements of all the States where his company might do business? The European Court of Justice, extending a long line of precedents by now, said no, the home state regime governs. The European Court of Justice calls that the "origin principle," or sometimes the principle of reciprocity. If you look through the EU treaties, you won't find that principle there, or at least it wasn't here until the ECJ put it there. And why did it do so? Well, said the court, look, we're supposed to have a common market here in Europe and if all 15 or soon 25 member states got to regulate corporations that do business within their boundaries, that's not a common market, that's just a collection of fiefdoms. And so, therefore, unless the European Commission tells us otherwise, we'll go with the home state origin principle. And what that means is that this origin principle has the real potential to crush the encrusted economic structure of Germany and France. So, for example, in Germany, if your company gets to be above a certain size, you have to hand over half of it to the trade unions on the notion that that might improve the economic performance. If the same company that does business can incorporate in England, which has no quota termination laws on that scale, that would obviously be an advantage to everybody except the trade unions. For precisely that reason, the European Commission is busily trying to harmonize or preempt the ECJ's rulings in these matters. From that far-flung example, it's, in fact, a small step to today's topic, or topics. The general United States federalism option has become, at least over the past 60 years, the 50-State option. Anywhere you do business, anywhere you have minimum contacts, you can be regulated by the State. Sometimes that takes place under uniform preemptive federal rules, sometimes it doesn't. But there are two big exceptions to that lamentable state of affairs. One is corporate law where it's called the Delaware Principle, where the home State charter governs no matter where the shareholders live. And the other one is financial markets, where the principle of origin is called the Marquette Principle after a 1978 Supreme Court ruling that established the principle as binding under the National Bank Act. In both areas, the principle of State choice, State corporate choice, is now beleaguered and very, very heavily criticized in the wake of scandals and alleged abuses in the financial markets, and what we're here to discuss is whether this principle is worth saving, worth extending, whether it's on its way out, and so forth. I should admit at the front end that the American Enterprise Institute and I, myself, come to this debate with rather unclean hands because this institution and its members have unambiguously advocated home State and origin-based principles in a variety of contexts. It's fair to say that the authoritative defense of the Delaware Principle in corporate law, Professor Romano's book on The Genius of American Corporate Law. It looks like this. It is available out there. Professor Romano last year elaborated on that principle and has said, look, we should not just organize corporate law along these principles of corporate choice but also certain aspects of securities regulations. That book is called The Advantage of Competitive Federalism for Securities Regulation. It looks like this. Beyond that context, to ensure in its regulation, Peter Wallison, who will moderate the first panel, has been one of the leading lights in the debate over optional federal charters, which is a variation on the choice scheme, in insurance regulation. A book by Peter that was edited--when did that come out, '91? No, 2001?--Optional Federal Chartering and Regulation of Insurance Companies. In the context of banking and finance, one of the basic defenses of the Marquette Principle in that context was penned by Chris DeMuth, who is here today, prior to his engagement at AEI. That's an article in the Yale Journal of Regulation which I don't have with me, but maybe we can reprint that if somebody has it. And the Federalism Project itself has, over the past three years, done a lot of work in this area and pushed the principle of corporate choice, single State regulation in a variety of contexts. Some of these letters, you'll find in the materials that are there. The latest work that pushes that principle, as some members of this audience believe, Beyond the Breaking Point, is this little booklet that was just published, authored by myself, on the extension of origin regulation in the context of sales taxation and, in particular, Internet taxation. That having been said, after that long-winded introduction, I'll hand the first panel over to the capable hands of Peter Wallison, who will introduce the participants. Between the panels, we will adjourn and then move on to the second panel. During the Q&A period, Kate Crawford, my assistant who is in the back, will--you will have the microphone? Okay, and she paid for it. If on that occasion you would kindly, if you ask a question, introduce yourself because the entire event is being taped. Peter? CORPORATE LAW: DEMISE OF THE DELAWARE PRINCIPLE? MR. WALLISON: Thank you very much, Michael. We are very fortunate to have an excellent first panel to lead off on this subject. An amazing thing happened, actually, in July 2002. Shortly after the disclosure of the WorldCom affair, there was kind of a frantic effort on the part of a Republican Congress to pass a law which has had substantial adverse effect on the rule of law in the corporate area by States, and that, of course, is the Sarbanes-Oxley Act. It was virtually unanimous in both Houses of Congress and reflected, I think, an assumption on the part of the U.S. Congress that whenever there is a serious problem of some kind, or at least they perceive it's serious politically or substantively, that it's an opportunity for and, in fact, a requirement that the Federal Government take some kind of action. Since that law has passed, the SEC, of course, has implemented it as required, but then has gone somewhat further with proposals concerning shareholder rights, modifying the proxy rules in order to provide shareholders with a better opportunity to influence the members, the membership, I should say, of the boards of directors of public companies. And the Chairman of the SEC has connected that to Sarbanes-Oxley, saying that what these rules do is simply go a little bit beyond the spirit of what has already been embodied in Sarbanes-Oxley by providing a greater opportunity for shareholders to have a say in their companies. Our panel today consists of two professors of law and one practitioner. They have many diverse views on this subject and come at it from different angles, and I think it will be interesting for all of us to see how they analyze this question of the continuing viability of State law as the principal set of rules for governing corporate activities as compared to the development of some kind of federal law in this area. Let me introduce them very briefly. You have in your material a much fuller biography than I will give and you should refer to that. This will be the order in which I'll ask them to talk. After they speak, I think maybe I'll ask a question or two of the panel and get them to talk a little bit among themselves, five minutes or so, and then we'll open it up to questions. So make note of your questions, please. We'll have plenty of time for that during the question period. The first speaker will be Charles Elson, who is the Edgar S. Woolard, Jr., Professor of Corporate Governance and the Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. He formerly served as a professor of law at Stetson University College of Law in St. Petersburg, Florida, from 1990 to 2001. Bruce Johnson is a professor of law at the George Mason University, which is a leading center for law and economic scholarship. Mr. Johnson's scholarship focuses on law and economics, privacy rights, corporate finance, financial institutions, and business ethics. And John Pedersen, who is now a partner of Kirkland and Ellis in its New York office, is a capital markets partner, a specialist in corporate law, has represented underwriters, boards of directors, and others. He's our practitioner. So we'll start off first with Charles Elson and proceed from there. Thank you. MR. ELSON: I first of all have to say it's great to be back at AEI. I haven't been here since 1979. I was a summer intern here in 1979, working for Ben Wattenberg and David Gergen. I guess that was in the days when summer interns were a good thing. [Laughter.] MR. ELSON: It was a good summer and a very defining summer. It's sort of fun to be back, because I can remember going to these sorts of things as an intern going, wow, that's really interesting. So it's good to be on the other side of the mike and back at AEI. This is a great topic and it's actually turned out to be a rather seminal topic in this whole sort of federalism debate. Let's start off just historically. Delaware, as it turns out, is the situs of most incorporations of most of the largest U.S. publicly traded companies. The figure is something like 80 percent of the New York Stock Exchange listed companies, traded companies, are incorporated in Delaware. I mean, a vast, vast number of publicly traded companies find their legal homes in Delaware and the question is why. The answer is actually quite accidental and historical. Originally, most companies were incorporated in New York, where most commerce was back in the 1860s, 1870s. But following the--or the beginning of the Progressive Era and the rise of the trusts, New York got a little bit angry and said, no more, and changed their corporation law to make it rather less hospitable than it was to these creatures and they moved across the river to New Jersey, where they found hopefully happier climes. Unfortunately for them, around 1900, a fellow was elected--an academic was elected Governor of New Jersey named Woodrow Wilson and Wilson wasn't particularly pleased at having this stuff in his State, either. The law changed making it again less hospitable and the question is, where do we go now? Well, you jump across the river to New Jersey. Well, what is across the river from New Jersey? Either Delaware or Pennsylvania, and I guess Delaware was a little bit closer. Maybe it was narrower. But Delaware corporate law was just New Jersey's, so simply companies picked up and moved to Delaware. But then something kind of interesting happened because Delaware from a juridical standpoint had an unusual system. In the Delaware corporate code, which as I said was sort of modeled on New Jersey's which was modeled on New York's, it provided for a process by which review of corporate disputes would be done in a court known as the Court Chancery. It was an old court, a court of equity dating back a long, long time. And Chancery's sole purpose, as it turns out, or almost sole purpose, was to resolve corporate disputes. Chancery was an equity court and it had vast powers over these disputes, and it turned out that Delaware fostered its court appropriately and ended up peopling it with really quite good business judges. Companies were incorporated there. Results or disputes were debated and resolved in Chancery. And you developed a really superb body of law with great precedent to sort of address almost every conceivable corporate dispute. Additionally, it was adjudicated by a group of judges who were traditionally business lawyers who, unlike most judges, were particularly adept at business problems because they had, in fact, been business lawyers prior to going on Chancery. And so you developed a rather interesting system where you had an unusually sophisticated body of law administered by an unusually sophisticated body of judges, and as it turns out, it worked. Now, again, what typically happens, Delaware had two great businesses. One was duPont--actually, three great businesses. One was duPont, the second were chickens, and the third were corporations. Most people incorporated there and Delaware built an industry around servicing corporate and corporations and resolving corporate disputes. And what effectively happened, as some have argued, Delaware, it was suggested, became, oh, some would say captive or captured by those who ran the great corporations that happened to be incorporated there. Delaware's goal was to keep them there, keep them happy, and one result of keeping them happy and keeping them there was developing a legal regime, it was argued, that favored the managers, who typically determined where the company ended up. Well, this was not such a good thing if you were, I guess, on the progressive side of corporate law and it stirred a lot of rather nasty comments about Delaware, particularly emanating from one William Kerry, who at that time was at Columbia Law School and certainly at the SEC. He identified Delaware as the "Pygmy State." We like to think of ourselves as the "Diamond State," not the "Pygmy State," but he called us the Pygmy State and suggested that progressive corporate reform would only take place when the corporate agenda was snatched from the hands of this little captured State and put in the hands of the Federal Government. That was sort of a nice 1960s principle. There was an effort in the early 1970s to create a national federal corporate statute. It did not succeed, fortunately, as I will talk about, and the issue, one had hoped, would die away. But like all bad things, cicada bugs and what not, things like this do reappear and it reappeared. It reappeared at the time of these great controversies, Enron et al, and starting a few years ago, you saw some very serious corporate scandals that a lot of people felt found their, I guess, cause in poor boards of directors dominated by managers who were not effectively overseeing management appropriately and that was sort of given emphasis by this corporate law of the States, particularly Delaware, which seemed to, it was suggested, empower managers over boards. And the argument was, well, the only way to fix this is move to a federal standard. Well, along came Sarbanes-Oxley. Now, you can recall typically the regulation of corporations was done at the State level. The SEC's involvement was really around disclosure. I mean, they could require disclosure of certain information but the internal affairs of the company were effectively the province of the States. There was some good case law on this, the Business Roundtable case, I think it was 1991, or 1990--is Amy Goodwin out there? Do you remember when it was? Ninety-one? That effectively said, look, the feds control disclosure. The States, a la Delaware, controls internal doctrine, internal affairs. Anyway, then comes Sarbanes-Oxley. What Sarbanes-Oxley did, for the first time, it broke through that philosophical barrier of the Federal Government's object is disclosure versus internal affairs that the States control, and Sarbanes-Oxley actually, by addressing certain requirements and compositional requirements particularly, and procedural requirements of audit committees, effectively got the Federal Government into the regulation of the internal workings of corporate boards, composition and procedures. Additionally, as you know, it prohibited corporate loans to executives, which also was typically a State law issue. Now, from a personal shareholder-type perspective, I had no problem with the, I guess what, in fact, Sarbanes-Oxley was trying to do vis-a-vis sort of rethinking the way boards work or creating independent audit committees or well-functioning audit committees. My concern, however, was how they did it. The question was, should it be at the federal level or the State level, and I'm sort of a dyed in the wool, when it comes to corporate law, Federalist in the sense that I think that the States do a pretty decent job of it and the secret is the States. Well, a lot of folks saw the Sarbanes-Oxley as getting us into this new regime of regulating corporate conduct, hence the new attempt by the SEC that came out yesterday of shareholder access, if you will, to a company's proxy, which is another incursion. None of this has actually supplanted State corporate law but these are big inroads, big philosophical inroads that I think a lot of folks hope will lead eventually to a federal corporation statute, pulling the plug, if you will, on Delaware. Now, the question is, is this a good thing or not? Well, from a philosophical standpoint, I kind of think it's not because I think for reasons I'll tell you, Delaware makes a lot of sense. But, you know, actually, I think in the long run, those who see that the federalization of corporate law will lead to more, quote, "progressive procedures" in corporate law, I think are a bit mistaken. I think the problem of moving away from a State regime to a federal regime is problematic in two respects. Number one, I think, as I'll say juridically, it doesn't make a lot of sense and will cause a lot more harm than good. And secondly, if the ultimate goal is a greater shareholder democracy, I'm not so sure--and avoidance of the capture, if you will, of the regime by managerial interests, I don't think necessarily moving to a federal regime solves that issue at all. In fact, I think it makes it a lot worse, oddly enough. Let's start with the juridical. The problem with, I think, a federal statute is that a statute would have to be enforced by federal courts, right? And unfortunately, as we all know, there are quite a few federal courts, lots of federal courts. There are federal courts all over the place. There are effectively 13 federal circuits that you've got to appeal to and you've got a Supreme Court that I don't think has been particularly well known for resolving corporate disputes. In fact, I think the last real corporate lawyer on the Supreme Court was John Marshall Harland, and he's been out of the picture for quite a long time. No one makes their way to the Supreme Court these days because they're a hotshot corporate lawyer. Frankly, very few people make it onto the federal bench because they're hotshot corporate lawyers. They have other talents and skills. I, first of all, am concerned that, number one, most federal judges don't have the background or real interest in this area to create the kind of decision making that we're going to have to have to create the consistency to create effective regulation of the corporate business. Number two, I think because you have this system where we have 13 different circuits and the Supreme Court, you can have a lot of conflicting law developing, and as we know in the business arena, consistency is critical. You've got to have consistency. I don't think we'll get it. And finally, you've got a Supreme Court who probably won't resolve some of this inconsistency, at least not particularly willingly. It's just not an interest point for them. And I think that, frankly, is a recipe for a disaster, juridically a mess. Now, how does Delaware solve it? Easy. Delaware has but two courts dealing with corporate issues, each court comprised of five judges. You have the Court of Chancery, five Chancellors, and the Supreme Court of Delaware with five Justices. In both courts, the majority--certainly all the Chancellors and a majority of the Supreme Court, came out of the corporate bar and their expertise, and they were raised on Detra, if you will, are resolving corporate disputes. They're effective, quick acting, and most importantly, rather fair. Let me get to this point. This is an important one. You know, the problem--traditionally, I think the argument has been that the States are susceptible to political influences. The concern is the State may be dominated by a managerial body. I think you just saw a case in Michigan where the corporate law was changed in response to a very specific takeover situation where the takeover was effectively blocked through a change in Michigan law. In other words, the corporate process became politicized, and the concern is a State is much more susceptible to political influence than the Federal Government, or the influence of one group. I don't think it's necessarily true. Frankly, federal judges are citizens of the places in which their courts happen to lay and they typically come from those communities and have the same biases as most people in those communities. On the Delaware scene, however, it's a little bit different because Delaware's business is one thing. It's the regulation of corporations, and it always has had to be above the fray, if you will, always, I think, had to be sensitive to all the constituencies in the corporate puzzle or corporate game, meaning shareholders, management, boards, and others. I think it's always managed to remain above the fray because its only political constituency is maintaining a system that will continue to bring in the revenue stream that it needs to survive as a State, so it has--which is sort of interesting, too. But it had to be, I think, rather fair, balanced, and really viewed by most in the community as above reproach. I mean, most people, whether they're from the institutional investor side or from the management side, have always suggested they get a fair shake in a Delaware court. There's no local agenda in Delaware other than the, I guess the continuance of the Delaware franchise, which means they've had to be very sensitive on all angles, which brings me to my next point, which is the practical. If the idea of the reformers or the federalizers is to create a progressive federal regime, the idea is, well, obviously, the fed will do it, and B, the States will not. I don't think that's necessarily true. I mean, the federal regime is just as susceptible, frankly, to influences of different interest groups and what not to prevent reform from moving forward. States, on the other hand, particularly Delaware, has demonstrated a commitment not necessarily to maintain the world the way it is, or was, but I think maintaining a capital system that is most efficient and effective. If you look--almost done. Winding down. MR. WALLISON: Good. I won't pound the desk. MR. ELSON: No, no, no, just a last point. Delaware has been very effective, I think, in maintaining that. As I said, its central business is the regulation of corporations and if it's going to continue to maintain that leadership position, it's got to be sensitive to all sides. If you look at the case law coming out of Delaware the last two years or so, it's reflected a much more, at least in my view, balanced approach between shareholder and managerial interests, signifying a shift in Delaware to reflect popular opinion, if you will, or popular viewpoint on the appropriate power source in the corporation itself. I think that Delaware happens to be a little more sensitive to those issues and less susceptible to outside influence, one way or the other, than, unfortunately, I think, a federal scheme. And so for that reason, I think the federalization of corporate law is, in the end, be careful of what you wish for. You may get it. And if you get it, I think in the end, you will not get the proper result. Thank you. [Applause.] MR. WALLISON: Bruce? MR. JOHNSEN: I don't much care for microphones or sitting down when I talk, so I'll move on over here. What I'm going to talk about today follows on Dr. Elson's comments, which I pretty much wholeheartedly agree with, but I'll find something to disagree with. Obviously, individuals in their private ordering are capable of solving problems. Any time there's a market failure, that's a profit opportunity. So people in their private ordering have an incentive to take care of people. Of course, they'll always make errors, right, and then we may benefit from regulation or law. Oh, I've got it. I've got to speak into the mike. I'm sorry. We might favor some type of oversight. Now, we get oversight from boards of directors. Of course, boards of directors make errors. We get oversight from State law, Delaware State law in particular. Well, Delaware courts sometimes make errors. Federal regulators sometimes make errors, as do federal courts. And the question is, how do you best address the situation and handle how these errors are addressed and reduce or minimize their incidence over time? So if you wanted to, I could characterize my discussion today based on an early article by William O. Douglass. He wrote in 1934 an article called "Protecting Investors," and my talk today is really titled, "Investing Protectors." So what we want to do is we want to give our protectors some kind of stake, and I think importantly in this context, that stake comes by way of competition, regulatory competition in a system of competitive federalism. Now, one thing you might want to ask is who's really being protected here. I know this is part and parcel of everything the SEC does. They have this vision of some little guy out there. Quite frankly, I don't think arbitragers and people who have a lot of capital and place big bets and spend time rummaging through dumpsters to gather a little bit of information to identify mispriced securities need anyone's help. At the end of the day, in the event of financial default, I think our political system can look them in the eye and say, you know, you messed up. You trusted us. Too bad. But there's a whole class of investors out there for which that's not true and I think those investors are really better characterized as savers, all right. They are Americans who have accumulated wealth for retirement. They're not looking, or should not be looking to make a killing in the stock market. They want a nice, stable store of value and it's important that we care for them because at the end of the day, if there is financial default, our political system cannot look them in the eye and say, too bad. It just--we'll be incapable of doing that, and that could be very, ugly. So as I say, errors are inevitable and one of the nice things about competitive federalism is it has a preference for placing regulatory oversight in State hands, and the nice thing about that, of course, State regulators or State law makers are going to make errors. But from the standpoint of American savers, those are diversifiable, unsystematic errors. To the extent the Federal Government controls these decisions, we'll ultimately have financial default. We're never going to avoid financial default, right. American investors cannot escape. They can't diversify their portfolio against marketwide systemic failure. Of course, I think a lot of the SEC's mandatory disclosure regime has led investors slowly down the primrose path. Don't worry. We'll protect you. But I just want to go down a litany, or a short list of errors that the SEC has clearly made in the past and is clearly making in the current setting and argue that these kinds of errors, because they apply uniformly across all investors in the country and investors have no choice, risks a very dangerous situation, which is just a systematic default that can't be diversified away. Now, what are some of those errors? Vaguely, this notion that full disclosure or mandatory full disclosure will solve all the problems, which basically got its start in the 1963 case of SEC v. Capital Gains Research Bureau, where the court said the purpose of the Securities Act is to replace caveat emptor with a regime of full disclosure. In other words, investors can be perfect idiots and we'll protect you. No. It's not going to happen. There will be default. There will be error. Now, that case, interestingly enough, involved the publication of a newsletter by the Capital Gains Research Bureau in which it recommended the purchase of certain securities. Allegedly unbeknownst to its subscribers, Capital Gains invested in the security that it was recommending, and it didn't invest contrary. I mean, it didn't sell short what it was recommending investors buy. It took a position in those securities. No investor was ever harmed. There was no allegation that any investor was ever harmed. This practice is known as scalping and the court condemned it at the behest of the Securities and Exchange Commission. It's not at all clear to me that this is a better world. I can imagine investors empowering some central investment manager to go ahead and do this kind of thing for them, maybe subject to some kind of disclosure. One kind of disclosure that would work would be simply blanket disclosure in the masthead of the newsletter that said, "We from time to time take positions in the securities we're recommending." Is it plausible that investors would buy into such a scheme? I think it absolutely is plausible, but, of course, the SEC does not allow blanket disclosure. It always insists, say in this case, that the Capital Gains Research Bureau would say, "We have taken a position in this stock and we recommend it to you." Well, guess what. If you read the Giarella case, you know that before that thing even goes to the printer or when it goes to the printer, the news is going to leak out and, boom, the price is going to rise on buy recommendations and investors aren't going to get the benefit of that advice. Okay. So there's one kind of problem I have with mandatory full disclosure. It, in essence, makes the mistake of--or it falls into the trap of basically death by disclosure. There are a lot of entrepreneurial activities out there that involve creating information for investors, but that needs to be private in order for the people who create the information to have an incentive to do so. And the SEC, of course, routinely ignores this. Most people have an expression, hey, it's raining cats and dogs. As far as I can tell, the SEC's favored expression is, it's raining information. That's where information comes from. It doesn't get produced. It isn't the result of the sweat of people's brow. It falls from the sky and, therefore, it should be shared equally by everyone. That's the model as far as I can tell. If you look at the case law and the SEC's administrative rulings, you'll see that a lot of them are consistent with that. Okay. What about the Enron disaster? I think there's a possibility of fundamental error in how this has been addressed. I've never seen anyone stop and say, whoa, wait a second. Let's take a good, dispassionate look at this. This is fraud. We don't need to look dispassionately at anything. What really happened there? I think what happened is American corporations essentially were part of this tech bubble. Everybody had irrational exuberance. They bid up stock prices. Stock prices were trading at huge multiples of current earnings. Corporate managers looked at page 262 of Greeley and Myers and said, look, it says here that means we have growth opportunity. We better start making some investments. So they made investments. They borrowed money to make investments, right? Invest, invest, invest. Many of those at the time, I'm sure, were reasonable, you know, sincere and profitable, or expected to be profitable, investments. Well, eventually the market tanked. There are a lot of explanations for why it tanked. I think I follow Jeremy Seegal's explanation, which was this tech revolution is going to create a lot of value, but guess what. No particular firm can capture that value, and as soon as people recognize that, these stock prices are going to come down. I think that's pretty much what happened. Well, if you were a corporate manager and your earnings had turned down and things were looking badly, all right, and you see yourself as a fiduciary for your investors, what do you do when the market turns down? What do you do when you see your balance sheet heading toward the red? You roll the dice. You put off the bad state of the world as long as you possibly can. That is in the interest of investors. You take risks. Now, somebody loses. Who? Lenders. Lenders are the ones who lose from that, not investors. It's in investors' interest for their corporate managers to do this. It's called asset substitution in the finance literature. In other words, default carries an option and that option increases in riskiness, and so if you increase risk, you increase the value of the firm. The bad state of the world came to pass nonetheless, and I'm not suggesting that somebody shouldn't be called on the carpet to pay, but what I am saying is I haven't heard any discussion of what really was going on there in the passage of Sarbanes-Oxley. What about Sarbanes-Oxley? I'm not an accounting guru, but I know enough to know that we can't rely so much on accounting numbers. They are a false promise. And I kind of follow Judge Geesey [ph.] of the Delaware Court of Chancery in saying that accounting figures are useless predictors of market value and are at least as likely to mislead stockholders as to enlighten them. So I think we would be mistaken to place quite so much reliance on financial accounting to get us out of anything. It just wasn't created to uncover some kind of fundamental truth. All right. What about executive compensation? We've lately heard a lot about that. Well, a long time ago, or not a long time ago, several years ago, the SEC capped executives' salaries at $1 million a year. Of course, this was part of the common or current trend to pay corporate managers in stock options. Give them a huge equity stake. Incentivize them. Get them out there to be risk takers, right? Well, at the time, I was actually working in the Office of Economic Analysis at the Securities and Exchange Commission and I didn't really buy it, and the reason is because salary as a payment looks a lot like debt. It has a debt-like payoff and, in fact, a debt-like priority in bankruptcy. I thought, maybe it's no accident that we've been paying managers in salary because, in essence, it might kind of dampen their zeal in acting on behalf of shareholders. Well, I certainly didn't get my way and what we got were stock options, and I think possibly that's one of the causes for executives wanting to really roll the dice when the bad state approaches. Let me see, what else about executive compensation. Oh, gratuitous pensions and loans to executives. Nobody has talked about the fact that executives face a terrible last period problem. Look at the data or the event studies. In some cases when CEOs die unexpectedly in office, their stock prices go down. But in many other cases when they die unexpectedly in office, their stock prices go up. What's happening? Well, a plausible explanation is you've got a CEO who's got control of this firm and he's driving it into the ground, not necessarily because he's insincere. He may believe what he's doing is absolutely correct. But he doesn't face the long period and so he has no particular incentive to look down the road particularly far. How do you get this person out of his office? Well, it may be that you have to dig him out with a generous financial compensation plan, incidentally, which according to Delaware law, such gratuitous pension promises are not enforceable and presumably then are voidable at the option of the corporation. So ex-post misbehavior by CEOs who, say, want to go talk to their firms' competitors afterwards and say, well, here is how we did it at General Electric, they can have their compensation packages yanked or their gratuitous executive loans yanked or required to be paid back. So obviously, there are any number of cases where Securities and Exchange Commission federal regulation has erred and this ultimately is likely to lead to financial default. At some point in time, it's going to happen. Now, the question is, if financial default is inevitable, do we want it to happen on a small, sporadic, local scale, maybe scattered across various States--Delaware is, of course, preeminent in corporation law but there's no reason why it has to be. It could be as Delaware snatched the spotlight from New Jersey and New Jersey had snatched it from New York, there's no reason that we can't have effective competition and that some kind of potential competition isn't exactly what's constraining Delaware to be efficient. So do we want systematic market-wide default in the bad state of the world, which may come along less frequently, or do we want small, manageable, diversifiable defaults, and I think all else equal, I vote for the latter and favor continued preeminence of Delaware. Thank you. MR. WALLISON: Thank you very much, Bruce. [Applause.] MR. WALLISON: John? MR. PEDERSEN: I am the practitioner, I guess, on the panel, not someone who thinks at great theoretical length about federalism, but I think I've got some light to shed on it. I'd like to talk a little bit about what it's like to work in a world where there is a choice of regulatory regimes. I spent most of the last 15 years in Asia, where I was a corporate finance lawyer representing issuers and underwriters from India to Korea to Indonesia and China, raising capital all around the world, U.S., Europe, and in the local markets. One of the interesting things about the regime out there is that companies could effectively choose what regulatory regime to subject themselves to. It's a little bit unfair to say that the home markets in each of these countries were completely without regulation, but it's not entirely unfair. In some countries, there were no regulations at all, such as China when we first got out there. There was no corporate law. They didn't have a concept yet really of--private property was being introduced, but there were none of the trappings for a real legal system. In some countries, such as Indonesia, you might as well have not had a corporate law. They had something that the Dutch left behind in the 1800s, but there's really no enforcement mechanism. So in most of these countries, corporate governance was not a matter that was strictly regulated. It was not something that was--where managers of the company spend a lot of time thinking about increasing shareholder value for the public shareholders. They spend a fair amount of time thinking about increasing shareholder value for the private shareholders who control these companies. But it was really relatively regulation-free. Now, when they decided--and there are a lot of big companies out there and they decided that they needed to raise some capital. They could do that in their local markets. Most of those local markets were pretty constrained in the amount of money they could raise. You can do some big deals, you know, you can raise a billion dollars in the Chinese domestic market, but you can't do that very often-- [Break between sides of recorded tape.] MR. PEDERSEN: --like me and the investment bankers came into play. We become the--you know, you've got a menu of options. And what was the menu we would present to them? We could say, well, you can go to your regional market, so that would be Singapore--effectively Singapore or Hong Kong. Both of the Singapore and Hong Kong markets have a respectful regulatory regime. It's not backed up by a lot of enforcement, not backed up by any private, real private oversight. The markets are characterized, and this is a little unfair to Singapore, but they're characterized by speculation, insider trading, all kinds of capitalism run rampant. But there is a framework, there's a disclosure framework. So that was one option, probably the least challenging option and maybe the one that got you the least dollars. Step two up the food chain was going to the Euro markets. You could always go to Europe and get a little bit of money. You can always get $100, $150 million out of the Europeans no matter what your story was. It's an institutional market, slightly regulated, limited disclosure. The investors were not particularly analytical in their approach. They had diversified portfolios. You'd go up to Scotland and you meet somebody and they'd buy, you know, $5 million of whatever Korean deal you had on the market that day, and they had a diversified portfolio of convertible bonds from all around the world and they didn't really spend a lot of time caring about the details of any particular operation. They were taking a general bet upon the general story of Asian growth or whatever the story. You'd have sort of the flavor of the month, depending on what country was hot, and that's how they approached things. You know, they got home early, they didn't work too late, and they had a beer at lunch, and it worked for everybody. The next step up, the 144(a) market here in the U.S., institutional market. That was something good the SEC did back in the early 1990s. They made it possible to come and sell to institutional investors who are very sophisticated. That market required significant disclosure, high standards, analytical investors who took a hard look at your numbers and they took a hard look at your business and they took a hard look at the character of the management, and probably I got it in reverse order because that was probably the most important thing, one that people often got wrong. But it was also a flexible market. You didn't have the SEC. You didn't have to cross every "t" and dot every "i" the way the rule said. You could do things a little bit differently if it was needed for the company. You didn't have to present U.S. GATT financials. You could go out with the financial statements that were done in the home country. But the investors were smart and you had to explain things to them, but they'd give you a pass on some of the technical requirements. And also, they'd ask you for some things that the SEC wouldn't let you give them. They'd want to see projections. They'd want to see the stuff that they really are interested in, which is the stuff about the future, not the stuff about the past. We specialize in writing history, legal journalism. But they would focus on forward-looking information and you could do some of that in the context of a 144(a) offering. Then last year, SEC public offering, high standards of disclosure, inflexible standards of disclosure, high legal risks. You can get sued for just about anything. A high degree of supervision by the SEC, which takes its job very seriously in this respect. And analytical investors, but also a public U.S. market, although often the public U.S. market was really not the principal target for some of these Asian investors. So that was the menu. What was really interesting about that, and I think this is something that does speak to the federalism debate here, is that companies in Asia didn't just go for the lowest possible disclosure standard. The companies would tap different markets at different times for different purposes, and clearly, going into the U.S. market was considered a big step. But they often did it at great expense to themselves. They often chose to opt into a regime that was very, very imperfect but imposed very high standards. What were the considerations? They thought about where the money was, and to some extent, to get to the U.S. money, you had to come to the U.S., but the fact of the matter is, money is awfully mobile and you could do big deals and get access, in fact, with the U.S. money in Europe. You could even do it in China. You didn't have to come. So there were ways to get your money without coming here. So that wasn't the only reason they came here. They looked at transaction costs and timing, and I can tell you, the SEC was on the expensive and long side of that equation, which was good for my business but it wasn't always good for the companies that were doing it. They looked at disclosure obligations and legal risks. You know, the culture of corporate disclosure in Asia is underdeveloped, I would say. The instincts that a lot of the management have were not what you would expect of a U.S. company, and so that was a big consideration for them. They would look at the reputational benefits of regulation. It was considered kind of a blue ribbon to be at the SEC. And they would also look at the benefits of regulation, regulatory process and disclosure process, on business processes. In a lot of these companies, the accounting systems and the internal controls were weak, and actually probably weaker than they needed to be for the companies to grow to the size that they were growing. Some of the shrewder management saw these transactions as an opportunity to bring in outside advisors and to really change and upgrade the quality of the internal systems. So the regulatory stuff was a catalyst for internal improvement. So a lot of these companies ended up coming here to the States. The London market also got more sophisticated. The listing process got more sophisticated over the years and that became sort of a reputable choice, as well. You saw it in Korea, India, China, all over. The Chinese deals were fabulous. You'd go into these companies--they weren't companies, they were towns that had steel mills and hospitals and schools and all of that stuff and you say, well, we have to make a company out of this before we can take it to the New York Stock Exchange, separate out all the pieces and introduce these concepts. Or you'd go to India and you'd say, well, you need an accounting system, and you'd find out that the Russians had left over some production cost accounting but they had no idea what a financial set of accounts or a managerial set of accounts was and you'd help them do these things. You know, over time, more and more of these deals came to the United States, especially after 1997 when the bottom fell out of the financial markets and a lot of these companies ran into difficulty. The investors started to speak up and the investors started to say, look, for certain deals of a certain size, you had to come to the U.S. You had to be registered because we want that level of disclosure and oversight. So there was a real dialogue going on between issuers, the regulatory regimes, the investors, and sort of intermediated by the lawyers and bankers. So what do I think the overall lessons of that are? A couple of things. First, regulatory choice doesn't necessarily lead to the lowest common denominator. If you think that the production of information is the objective of regulation, it turns out that people choose companies under many circumstances in dialogue with investors, will choose a regime of higher disclosure to provide analytical information to analytically-oriented investors, and there is a real genuine dialogue there. The other observation, though, I'd make is that there were plenty of times when alternative and less expensive and less intrusive regulatory regimes were attractive, not just to the issuers but also to investors. It's not a one-way street. You know, when you try to sell something in Scotland, in the Euro markets using a three-page prospectus, the Scots are pretty shrewd. They're not being cheated by the foreigners. The Scots had an approach to investing that worked for them and part of their money was invested in this kind of transaction. It was a low-cost way of doing things. And so the lower standard, what we think of as the lower standard, might well have been an appropriate standard for a certain kind of capital raising, a certain kind of capital allocation process. So it's not necessarily a bad thing that not every deal was going to the New York Stock Exchange. So is it worth fixing? You know, the SEC, the argument about the SEC is always, nobody does it better right, in the words of the great James Bond song, and I think it's true. Nobody does what they do better. The SEC, I deal with all the time. They're serious, they're dedicated, I think they're good at what they do. They are not corrupt, which is something we should not underestimate the importance of. They really are not. And I think the regulatory system there creates a pretty healthy tension between various participants that elicits pretty good information. But it's not a perfect system by any stretch of the imagination. Some of these things were very hard to explain to foreigners, very hard to justify in a situation where people were looking at their options. Why can't we put projections in the prospectus? First question, every time you sit down with a company, the investors come in and they want to know, what are you going to do next year? What are you going to do five years from now? What they want to know is what does management think. Well, the first job that lawyers have, well, you can't tell them that. There's an SEC policy that favors projections, but it's not true. It's not real. The reality is, if you give projections, you're going to get sued, so you can't do it. So the first thing the lawyers and the bankers have to do is prevent the companies from giving out the real information the investors want. Now, that's probably not the best system of securities regulation. There are problems if you just let people give out projections randomly. The instinct is going to be to inflate things and all that stuff. So there's a real issue there, but it's not a perfect system. U.S. GATT, you know, U.S. GATT is not--it's a complicated system. It ain't perfect, and there are plenty of issues where U.S. GATT doesn't illuminate the situation, and there are plenty of other metrics that investors and companies like to look at. Again, we have to bury these things in the prospectus. You can't give the kind of cash flow information investors are looking at. I mean, there are a whole range of things like that where I think there are some real weaknesses in the current system that we have under, effectively, an SEC monopoly. I guess a practitioner's view on all this, it's not the end of the world to introduce competition. There are some radically different kinds of regulatory regimes that we could have and could experiment with. We run the risk, I think, especially after Sarbanes-Oxley--as the regulations accumulate over the years, the system tends to get sclerotic. We all talk about trying to protect investors. I'm not really even sure that's the right objective. It seems to me that what we ought to be doing is try and have an efficient capital allocation system. I spent 15 years in Asia trying to figure out why the United States is a rich country. Are we smarter than everybody else? No. Are we better educated? No. Do we work harder? No. What is it? Part of what it is is that we've had a pretty good, pretty efficient system for allocating capital and part of that has to do with SEC regulation. We need to make sure that it doesn't get too rigid, because if it gets too rigid, we're going to lose some of that advantage and the more nimble places are going to have economic benefit that surpasses us and we'll regret it. So I think there's, in a practitioner's view, a strong case to be made that Mao Tse Tung, the great federalist, let a thousand flowers bloom. I think it's a pretty good idea and we ought to give it a try. [Applause.] PANEL DISCUSSION MR. WALLISON: Thank you very much, John. Let me ask a few questions of the panelists, just to get the discussion going, and then, as I said, we'll turn it over to your questions. I'm going to start first with Charles. You made a strong argument, I thought, Charles, that Delaware was fair because Delaware--this is the business of Delaware. Delaware is a corporate law with a State attached to it. But doesn't this argument really say that, since the decision on incorporation is made by management, doesn't this argument really say that Delaware has an incentive to be favorable to corporate managements as opposed to, we'll say, shareholders? MR. ELSON: I think it did traditionally, because I think what traditionally happened was that corporate--frankly, there wasn't--the capital formation in this country took place for the largest companies a long, long time ago, and the choice of incorporation or maintenance of incorporation rested in the hands of management. That's pretty clear, and I think that's why for a long time Delaware had a pro-management bias. But a funny thing happened. Between the--and this goes back to separation of ownership from control, right, the few shareholders, management running the show, shareholders never get together, managers nominate directors, et cetera, et cetera, et cetera. That was before the rise of institutional investors, and what happened was you began to see, starting a number of years ago, a concentration of share ownership back in the hands of single groups. Traditionally, it was large investors dominated most companies. By the '20s and '30s, most public companies, there was anonymistic shareholdings. It was very spread out. But the last couple of years, you see concentrations returning in the hands of large institutions, so the balance has changed. And you've also seen with a growth in the economy that new, I guess, acquisition--or necessity for acquiring capital. You're not simply going to a marketplace that is simply comprised of individual investors who don't know one another. You're now having to go to--this 144, as well, is sort of interesting--you have to go to large institutional holders, and large institutional holders have certain demands. Number one, that they're going to be treated fairly by the people in whom they invest their funds, that they will be guaranteed or at least promised a decent return and certainly fair treatment. And I think Delaware recognizes that in this capital formation process, there are two actors. There is the company, right, that needs the capital, and there are the providers of capital. To stay ahead of both groups, you have to balance your approach. While years ago the management was there, they didn't need to go raise capital, or if they did, they went to retail investors who really could not aggregate and create sort of effective bargaining. Not true anymore. I think that Delaware, if you look at the opinions the last four or five years, they've really shifted to recognizing the wisdom and intelligence of the institutional investor, because traditionally, the view was, look, investors don't know what they're doing. Managers have access to better information, they're smarter. The investors, we have to protect investors from their own stupidity, if you will, and the way to do that is to allow management to do what they have to do. They're there to protect the holders. And then there was a realization starting a few years ago that, wait a second, the investors are just as smart, if not maybe smarter in certain circumstances, on capital allocation than management and we have to sort of amend the corporate law, if you will, bend it to reflect that reality. And that's why I think Delaware--in other words, the constituency of Delaware aren't just the managers, they're the investors, and the investors today are no longer millions of individuals. They are aggregations of individuals in the form of institutions. And so in Delaware--we had a meeting recently, about eight months ago, of the Council of Institutional Investors and the Delaware Court of Chancery. It was extraordinary. It was a meeting of the investors and the Chancellors, typically not something you would have seen 15, 20 years ago. So in answer to your question, you have a greater strength in each of the constituencies which I think forces this market-based State, if you will, to respond effectively to all parties. MR. WALLISON: Have there been any studies that indicate that companies that organize in Delaware have lower capital costs as a result? That would seem to be the suggestion you're making about institutional investors being more favorable to Delaware? MR. ELSON: Well, there was a study, I think it was done by Rob Baines [ph.] at NYU, that looked at the Delaware effect and the idea that Delaware--a Delaware incorporation meant something. It certainly means something globally. I think investors around the world know that a Delaware court is not going to be--let me give you an example. In the takeover business, the fear is that you end up in a State court in the home State of a company you're trying to take over, which means you're not going anywhere because the judge lives next door to the CEO or everyone doesn't want the company to leave. Delaware, nobody is there. DuPont, but other than DuPont and MBNA, that's about it. It's a little State, only 700,000 people. The big deal in that State is making sure those companies stay incorporated there. There is not the same hometown fear that you get in other States. If you look at the Wachovia-First Union decision, which was a North Carolina decision, there was some view, at least in the academic-legal community, that this was a--there was a home State advantage there and that wasn't such a good thing. That would not have happened in Delaware. So I think the investors have said, look, we want to be in Delaware because we know if a dispute comes up, there won't be any of this sort of politics you see typically in other States, hence the reputation. And the judges, I think, have done a very good job in ensuring that. If you look at each in the court system, it's equally balanced, constitutionally, oddly enough, Democrat and Republican. The way it works is there cannot be--one party cannot have an advantage over the other in our judicial system. It's an extraordinary smart regime to maintain that balance and to take politics out of it. So it's actually quite smart. MR. WALLISON: Okay. Let me ask Bruce, then, Bruce, you were making the argument that what we need is diversification in corporate law, and we've just heard Charles argue that, no, we don't. We really need it only to come from one State that does it right. How do you respond to that? MR. JOHNSEN: Well, as I said in my closing, Delaware at least faces potential competition, right? There are some large publicly-held corporations that aren't incorporated in Delaware and there are many, many, many closely-held corporations that tend to be incorporated in the State in which they do business. So that essentially provides a competitive environment and any of those other States are certainly free to attempt to surpass Delaware and I think that keeps Delaware honest. MR. WALLISON: How could they-- MR. JOHNSEN: Now, does that give us real diversification? No, but it does give us potential diversification. And also, I don't see Delaware courts being anywhere nearly as active in insinuating themselves into the board room, so essentially what we do is we allow mistakes or errors to be diversified across firms, where, as opposed to the SEC who wants a one-size-fits-all and any errors on the SEC's part are not diversifiable. MR. WALLISON: If we have a system of potential competition, how are States supposed to make themselves true competitors for Delaware when all of the litigation is really occurring in Delaware and the Delaware court is the only one that has an opportunity to expose itself, declare itself to be the fair arbiter, much like the Federal system, where you've got only one set of courts that is doing this? How would a State go about making a name for itself as a corporate-- MR. JOHNSEN: Well, I think experience shows it hasn't been all that easy. I think Nevada has tried-- MR. WALLISON: Right. MR. JOHNSEN: --and my understanding is we've got a kind of a perverse result in Nevada, which I won't go too far into. And there's no question that Delaware is preeminent in promulgating what appears to be efficient law. All the studies I know of can show no indication of a race to the bottom, and Lucien Debchuck [ph.], who is by no means a right-wing lunatic, has essentially said it's really more of a kind of a slow shuffle to efficiency, or something along those lines. So the absence of actual, how do I say actual competition--the absence of large publicly-held corporations fleeing Delaware or preferring other jurisdictions doesn't bother me, because as I said, what that does is it shifts some of that decision making down to the boards of directors, right-- MR. WALLISON: If Delaware were to inject itself into corporate governance issues, would you feel differently? MR. JOHNSEN: It already has. It already has. MR. WALLISON: Well, I think Bruce's argument was-- MR. JOHNSEN: Would I feel differently-- MR. WALLISON: --that Delaware hasn't been doing that. MR. JOHNSEN: --I would expect competition--I mean, if it was a terrible thing, I would expect competition from other States, then. But as Charles says, they seem fairly concerned about losing their franchise in this regard. MR. ELSON: Again, it's competition. You know, there was that time in the late '80s with the anti-takeover statutes, I mean, a lot of States had stakeholder statutes which they argued was going to rob--Delaware wouldn't do it. Delaware had a very, very mild form of an anti-takeover statute and a lot of people said, oh, oh, Pennsylvania law makes it a lot easier to fend off the bad guys. Let's move to Pennsylvania. The problem was, to do that, you had to get the support of the large institutional investors who said, absolutely no way. That was the Delaware advantage there. A lot of States have tried. I mean, Nevada actually took Delaware law. It was really amazing. They said, we are actually, we are adopting all the traditional precedent of Delaware but we're in Nevada, a warmer place in the winter, I guess, and come here. The problem was, they didn't have the infrastructure, the juridical system, to do it, and Delaware was pretty smart about it. That's competition at its best. The question is, if you go to a federal system, what then happens, and that's my concern, obviously. I think the whole thing comes apart. MR. WALLISON: That's exactly what I'm trying to get to, you see. If Delaware--the argument that Bruce was making seemed to me to have some real force to it, and that is we have to worry about systemic risk here, that if every corporation is governed by the same kind of law, and I presume what you mean is the involvement of the jurisdiction in corporate governance, we could have all corporations organized and governed the same way and, thus, if there's a failure in that mechanism, and certainly I agree with this, then all corporations would fail in the same way because of their poor corporate governance. That's why I asked the question about whether if Delaware were forcing companies to be organized a particular way, the way the SEC seems to be doing, or the New York Stock Exchange or Nasdaq, for that matter, are we facing--and this is a question for both of you--are we facing the same problem with Delaware as we would face if the jurisdiction were the Federal Government? MR. : Well, there are checks even at the State level. I know in response to Smith v. VanGorkam [ph.], the Delaware General Assembly stepped in quickly and limited the liability of directors, or at least gave corporations the ability to opt out of massive director liability. And, of course, that same process has a potential to take place in any State in the country and for any corporation that's incorporated and governed by the law of that State. So-- MR. : Well, look, if Delaware messes it up too bad, you can pick up and move to Pennsylvania, or pick up and move to Virginia, your next stop, the next State down the road. [Laughter.] MR. : Not true in a national system, and I think you're right. With a unitary system, you've got that problem, and that's why I think there's a lot of--there's a lot of very positive wiggle room, if you will, under the current regime and I think makes a lot of sense. I think if you go to a federal standard, I think you're going to create--I think you may be very upset by what you end up creating. In other words, I agree, oddly enough, with a lot of the goals that the federalists, or not federalists-- [Laughter.] MR. : --I should say the federalization folks have been pushing. I'm very sympathetic on a number of the governance points vis-a-vis shareholder activism, shareholder rights, things like that. I'm just from a juridical standpoint, or a philosophical standpoint, a little concerned that they may not be getting there in the way--they may end up buying a result they're not going to be very happy with in the end. QUESTIONS AND ANSWERS MR. WALLISON: Okay. Let's turn to questions from the audience. Richard, is that you? Could you identify yourself, please, for the audience? AUDIENCE MEMBER: Thanks. I'm Richard Willard [ph.] from the Gillette Company. I would just like to respond to Charles' comment about the rise of the institutional shareholders and shareholder rights. I agree that institutional shareholders are just as smart as management, but they're not as knowledgeable as management because management knows a lot about the company's confidential business plans, proprietary research and development results, and things like that. So there's a knowledge that the company has that it can't share with institutional shareholders without also giving it to the competition. So they may be just as smart, but they don't know as much. Furthermore, many of the institutional shareholders are actually politicians who may be more interested in short-term political agendas rather than maximizing long-term shareholder value. So I have some skepticism about the appropriateness of this rise of shareholder rights, but it is certainly happening. MR. : Well, you make a good point on the institutions. I mean, I think what you're referring to, certainly those outside the company don't have the access to the information inside the company. I just--I'm a director of a couple of companies and I am amazed sometimes at what I--you go to these forums and hear the institutions talking. The analysis they do, I'm often quite surprised. It's really pretty good. I know what I know because I'm inside the business. But listening to them, usually, I find them pretty on the money in a lot of areas. But as to your comment about the political sort of domination of the institutions, I think you're right. Some of the public pension funds, because they're State funds, are susceptible to political influence. I think for a long time they weren't and there was always an unspoken rule, the State pension fund was over here, the politicians were over here, and the two didn't cross. You began to see, and in one or two States in particular, that line became a little blurred, and I think, unfortunately, it did diminish a bit, not the authority, but I think the way those particular institutions were viewed by some others, that they felt that the political process had affected a little bit the way they were doing business, which I don't think is a healthy thing. But I don't think the majority are like that, number one. And number two, frankly, the majority of investors really are the mutual funds, the Vanguards and the Fidelities. I mean, if you look at any proxy statement, your biggest holders are probably going to be Fidelity, you know, ten, 11 percent mixed up on their funds, and they're certainly not coming from the public sector. But even those public sector funds that are there, a lot of them are still pretty plain vanilla. You know, you and I know which ones we're talking about that aren't so plain vanilla, but I don't think they represent the majority at this point, and I hope, frankly, they will down the road go back to a more investor versus political side, so I don't think that's helpful. MR. : Although I query whether if we introduce greater shareholder democracy, is that going to encourage them to go back into their apolitical hole or is that going to bring more politicization into the system. It concerns me greatly that the latter will occur. Again, my perspective of having sorted out systems that were completely politicized, they're very good at politics but they're not very good at producing effective businesses and that's a real danger here. You know, managers have a hard enough time running a business effectively. If they have to start considering a bunch of non-business issues, it's going to be very, very difficult, and that's what the political system--there are legitimate issues, but not in the context of corporations. MR. : One thing I neglected to mention on my list of SEC errors is, was it last spring or earlier that the SEC has now mandated that mutual funds disclose how they vote their proxies. Well, I mean, this is going to subject mutual funds to the same politics that CalPERS is subject to. I read an article in the Wall Street Journal a couple of days ago. CalPERS had invested in a company that essentially had privatized the busing system in a school district and this is--I mean, this has come to political light and now CalPERS says, well, we're very concerned about investing in companies that privatize public jobs. Well whose interests are being served there and whose interests are being served, by the way, by making sure that mutual funds disclose how they vote proxies? It's not investors. It's labor unions and socially responsible funds. That's it. It's not about investors. MR. : For a long time, they've remained pretty much insulated from that, and they may, in fact, move back to it. I mean, I think that if you run a fund-- MR. : They being mutual funds? MR. : I think the CalPERS or some of the political ones. I don't think mutual funds would be subject even--I mean, I favored, frankly, disclosing their votes. I think they create more accountability, but-- MR. WALLISON: Bill Nascanon [ph.]? Wait for the mike, Bill. AUDIENCE MEMBER: Bill Nascanon of CATO. Three simple points. Sarbanes-Oxley was the consequence of federal politicians who felt compelled to be seen to be doing something about a shared problem. There is very little in Sarbanes-Oxley, however, that had not been previously recommended by the Business Roundtable and by the exchanges. We still don't have a very good explanation as to why leading business organizations proposed a substantial nationalization of federal corporate law. Second point, we should not assume that a Federal role of any kind is necessary. Canada has no SEC. All of the regulatory authority is in the provinces and almost all the regulation is done by the exchanges. They have had very few scandals. Their market is perfectly liquid. So we should not assume somehow that we have to start with the SEC. And third, for whatever relevance, Enron was incorporated in Oregon. WorldCom was incorporated in Georgia. MR. WALLISON: Thank you, Bill. How about responding to that? I mean, why do we have an SEC and is it necessary? MR. PEDERSEN: Well, I think-- MR. WALLISON: Go ahead, John. MR. PEDERSEN: I think we have an SEC for precisely the reason you pointed out, which was in the '30s, it was felt necessary to do something, so they did something, and we've now gone down this path and I gather there are differing views--studies have come up with different conclusions as to whether or not the '30s were rife with the kinds of fraud that the SEC was set up to prevent. There were other issues going on, I gather, in the '30s. Similarly, it's not entirely clear to me that a lot of the things that are in Sarbanes-Oxley are directly responsive to the kinds of corporate frauds that we have uncovered over the last few years. So it's not so clear that we need an SEC. On the other hand, I think we have to deal with the fact that we have it, right, and it is a regime and it has served its purposes, certain purposes. MR. WALLISON: That is a practical answer, but let me-- [Laughter.] MR. WALLISON: --let me point up Bill's question a little bit. MR. : I talk to them every day. MR. WALLISON: I know. [Laughter.] MR. : I think they're great. [Laughter.] MR. WALLISON: We've heard some discussion of the power of institutional investors, and I think Bruce and Charles talked about that. And yet here we have in the rules that the SEC has made and the rules that the New York Stock Exchange is insisting on things that institutional investors, if they really had the power that they are supposed to have, could have gotten for themselves if they thought it was important. If you think an independent board of directors or a fully--or an audit committee made up completely of independent directors is important, I presume an institutional investor group would have the power to get that done simply by selling the shares, right? Why hasn't that happened? And does that argue for a need for something like what the SEC did? The institutions just never thought they were that important when it really got down to it. I mean, I think that for a long time, people did not view corporate governance as being particularly relevant to anything but the corporate lawyers and there was a belief that there was no connection between the way the board was structured. It was always called the parsley on the fish. If the fish swam okay, who cared about the parsley. I think that what effectively happened was there began, I'd say starting about ten years ago, the view that actually the way the board was structured vis-a-vis independence had a lot to do with how management performed, that if you created a decent independent monitoring board, you create a better accountability on the part of management and a better run company. I think that it's only relatively recently--and look, there are still a lot of portfolio managers who don't buy this. But I think after Enron, WorldCom, and the others, if you boiled them all down, they all have the same thing in common. They had boards that a lot of people would say weren't particularly independent and people began to say, gee, maybe there's a connection between an independent long-term equity holding board and better--not better performance, certainly a circuit breaker if something goes wrong. And I think you finally have seen institutions beginning to buy this. Hence, that's why up to now, they really weren't particularly active. MR. : Although it's not really entirely clear that it was the lack of independence as opposed to the lack of diligence on the part of the board that failed to uncover these things. Again, in my world out in Asia, boards were stacked like you can't believe because the controlling shareholder put on the people he wanted. That didn't necessarily mean it was an inefficiently run business. There were other incentives, and-- MR. : Except when something went wrong, and then the question is, would the board be able to react to a problem, and you're not going to stick it to your best friend or the person who put you there. MR. : Right. Right. No, I agree. MR. : It's hard for me to understand. I mean, are you saying that before Enron, you could have predicted that the Enron board was not as independent as it should have been, or just the fact that something bad has happened and now, looking back in hindsight, we can say, my God, they weren't as independent as they should have been. MR. : No. The problem was, you didn't have effective--disclosure wasn't all that effective. The relationships that came out following the meltdown were not particularly disclosed by proxy, nor were they required to be disclosed-- MR. : Right. Right. I mean-- MR. : --that was the problem. MR. : The notion that somehow, outside directors should have this adversarial stance with officers or inside directors, I think--I mean, if the insiders want to play "hide the peanut," they can do that forever. The directors have really no constituted authority and their effective power in any event is very limited. MR. : Well, you fire them. MR. : One way you can overcome that is by establishing relationships, right, relational investing. To do that, you have to engage in trust. You have to give people a presumption of sincerity and so on and so forth, and then what it looks like is, hey, these guys aren't independent enough, so-- MR. : Well, no, I think you have to be a cooperative skeptic, really. You know, you have to be friendly but you have to have a little skepticism, and that's the importance of the independent monitors. That's why the Sarbanes-Oxley chunk on the accountants, I think was rather important, because the board relies on the external auditors, and the internal auditors, frankly, to help them to determine whether or not what's being represented to them is correct. You talk to the Enron directors, a number of them will say, look, we were lied to. That was part of the debate. They misrepresented the company's true state of affairs. But your question is, okay, well, how would you determine whether you were lied to? Well, you use the external audit. Well, there you had an external auditor who had some interesting issues in and of itself that made it a little more difficult, one would argue, for them to report to the board these potential irregularities. That's the issue. So as a director, yes, I think you can't be obnoxious to management. Of course not. They work for you, basically, and you have to work with them because they're running the company. Their success at managing the company is your success as a director and your shareholders' success. But, on the other hand, you've got to be a little bit of a skeptic sometimes, and how do you become a skeptic? If you're not independent, it's very hard to be a skeptic when you have these either financial or quasi-financial relationships. I think that's the problem. MR. : Well, the ultimate-- MR. : That never came out-- MR. : The ultimate goal is to create value, of course. I quoted Judge Geesey in the Clang v., what is it, Smith Food and Drug [ph.], saying essentially accounting figures--this was a case in which two firms wanted to do or did a merger and it made the merger, the way they accounted for it made it look like they had actually impaired their capital, which is contrary to Delaware law. And Judge Geesey said, essentially, look, this is creating a lot of value. Delaware law is worried about economic value, not financial numbers, accounting numbers, and so the reality here is that there is value being created. And I think in the wave of exuberance that we had there, that was going on across the lands, right. And I think a lot of what this hiring, financial, or, excuse me, accounting firms to engage in consulting was all about, was trying to get a grip--or at least here's the innocent explanation--trying to get a grip on how really to understand that economic value independent of financial accounting. Of course, everything went to hell in a handbasket and now ex post we can say there wasn't enough independence. MR. WALLISON: Well, I think we have to avoid misinformation for this audience about when this panel is going to end. MR. : Oh, yeah, good point. [Laughter.] MR. WALLISON: So I think it has come to an end and I think we are going to go into a break now, as I understand it, so people will have an opportunity to come up and lay their questions on you. But that you very much. You did a wonderful job. [Applause.] FINANCIAL REGULATION: MARQUETTE AND MARKETS OR FEDERAL UNIFORMITY MR. GREVE: As they say on "Monty Python," now for something completely different, we'll move on to our second panel on financial regulation and in particular the recent interest in the regulation of so-called subprime or sometimes called predatory lending. I'll briefly introduce the panel. There's additional information on all the panelists in your package. The format of the panel will be precisely the same as the preceding one. That is to say, all the speakers will talk for about 15 minutes. I may or may not have some questions for the participants, and then we'll move to discussion. We begin with Todd Zywicki, who's the Director of the Office of Policy Planning at the Federal Trade Commission and he's on leave from George Mason University School of Law, where he has taught and will presumably again teach in the areas of bankruptcy, contracts, and law and economics. Next, we'll have Phil Lehman, and we are particularly pleased and grateful that he's agreed to come up here. He's a senior attorney in the Consumer Protection Division of North Carolina's Department of Justice. North Carolina was the first State to enact a rather comprehensive predatory lending law in 1999, I guess it was, and Phil Lehman was the principal author and negotiator for the State in that proceeding. And Wright Andrews is a senior partner at Butera and Andrews, a firm that specializes in federal and State legislative and government relations matters. He's been very, very active in the debate about the possibility of a federal predatory--preemptive federal predatory lending laws and regulations. We'll start with Todd, please. MR. ZYWICKI: Thanks, Mike. I'd like to make clear that any comments I make are mine alone and do not represent--necessarily represent the views of the Federal Trade Commission, its Commissioners, or its staff. Being both a professor before I became a bureaucrat, sometimes I am wont to go off the reservation, so I want to make sure that that's clear. I think that the anti-predatory lending debate on the State level and the local level is interesting both from sort of the economics of consumer lending as well as what it tells us about federalism. In my remarks, which are going to brief so I won't be able to flesh it out completely, I want to raise the possibility that I think one of the things we can see here is in some sense an opportunity to reconceive of how we think of federalism and in some sense go back to a different vision of federalism that prevailed throughout the 19th century into the 20th century that we kind of got abandoned under the Erie view of the world and how we get there, I'll come back around to at the end. But that's where I think is an interesting question. And I think it starts with sort of thinking about federalism, which as you'll recall that basically federalism does two things. Madison refers to it as the auxiliary protections, federalism and separation of powers are the auxiliary protections for individual liberty, first. And second--and that basically goes with the idea of being able to escape burdensome or rent-seeking legislation when it arises. And then second is this sort of Brandeisian view of sort of variation-experimentation-regulation in solving collective action problems, but it's really both of them. And we also should remember that the Framers themselves are very concerned about credit-type issues, not predatory lending, obviously, but the Constitution itself was driven in many ways by the ability of--by credit issues, full faith and credit. The bankruptcy clause itself was actually a creditor protection, not a debtor protection, which was the ability of creditors to be able to collect from out-of-State debtors. The contracts clause always seems related to credit-type issues, and so it was clear from the very beginning that credit is--that there are some aspects of credit collection that implicate the Federal Government. The current controversy and the one I want to talk about primarily is the proposal by the Comptroller of the Currency to preempt certain State anti-predatory lending laws that really would--that basically regulate or forbid certain terms and loans, usually tied to high-cost or subprime loans, and that they would preempt them with respect to their application to nationally charted banks, and the OCC claims that this falls within its traditional powers going all the way back to McCullough v. Maryland, which of course was a case involving the attempt to tax a federal bank, the Bank of the United States at the time. And so given--leaving aside the real question of whether or not it's efficient or not, what the OCC wants to do, it raises a question of is it consistent with federalism. At first glance, and I'm sure Mr. Lehman will argue that it's not, that it's inconsistent with federalism. I want to argue that in some more profound sense, it is consistent with federalism, or we could think of sort of super-federalism that has deep roots in the American constitutional tradition. And think about these two policies, which is first, individual liberty and the ability to escape rent-seeking or unwise legislation, and second, variation and experimentation of regulatory regimes. I think a fully independent dual banking system of sort of completely independent national and State chartered banking systems does this. It effectuates these two policy goals of federalism. In fact, what it does, whereas traditional federalism arguments say, if you don't like it, you can move, what this says is if you don't like it, you can go to a different bank and you don't have to move. You can choose between a State chartered bank on one hand, which will give you all these regulations that you have, you know, limitations on prepayments, penalties, and all these sorts of things, or you can choose a nationally chartered bank which doesn't have those restrictions. You don't have to move. And in some sense, there's an irony in sort of invoking traditional federalism concerns here because what we're primarily concerned about is subprime mortgage lending, which is, of course, using your house. And so as I would understand sort of the traditional federalism argument, it goes something like, well, if you don't like the rules that govern your ability to get a home equity loan on your house, you can sell your house and move to another house where you can get a home equity loan. In some sense, there's kind of a perverse irony in the idea that in order to get a home equity loan on your house, you have to move to another house in another jurisdiction. It seems somewhat unusual. But basically, what this does then is prevents the possibility of a real market test, which is basically set up two completely independent systems, a State system of State chartered banks for which State regulations would apply on one hand, the nationally chartered banks on the other hand which would be regulated by the OCC and guys like the Federal Trade Commission. Now, the question then becomes, well, what would likely happen from this competition between these two independent systems? What do we think people would do? Well, anti-predatory lending regulations essentially act as usury laws the way this works, which is they're not necessary usuary laws in the sense they say you can't charge above X percentage. Some of them completely prohibit certain terms. Some of them just make it more expensive to use certain terms. So, for instance, if you charge too high of an interest rate, a lot of these are modeled after HOEPA, and I'm not going to talk about HOEPA directly, but a lot of these are modeled after HOEPA and let me just focus on the State level. But a lot of these are modeled after HOEPA, which basically is invoked--it triggers all these disclosure and other provisions if the loan becomes above a certain interest rate or above certain costs and that sort of thing, and essentially a world of pain comes raining down on lenders if they happen to get into the HOEPA box by charging an interest rate that's too high. Now, usury regulations, we know, have three effects. The first effect is the intended effect, and they usually work pretty well on this, which is if you say, you can't impose any prepayment penalties, people are not going to impose prepayment penalties. If you can't charge above a certain interest rate, people are not going to charge above a certain interest rate, or we're going to tax you if you charge above a certain interest rate, people are going to not go above a certain interest rate. So there is always the intended effect that's sort of a benefit of these laws. There's always also these two costs that go along with usury-style regulations. The first is termery pricing, which is essentially what you do--a loan is a multi-term contract and so if you only regulate some terms and leave 45 other terms unregulated, what you're going to get is a substitution away from the regulated terms. It's a variation on the unregulated terms. As somebody, a friend of mine said, money is like water, which is if you block up some of the things, prepayment penalties, interest rates, that sort of thing, you're going to get substitutions of other terms on the other side in order to try to clear the market. A good example of how this worked was credit cards prior to the Marquette decision in 1978. Basically, there what it was is you had strict usury caps at the State level on interest rates. So what do we see at that time? Something that's unheard of essentially now, which is annual fees, right, which is if you couldn't charge the market rate of interest, what you would do if you were a lender is you just impose an annual fee of $40, $50 a year in order to try to make up for the fact that you couldn't charge a market-clearing interest rate. Now that interest rates have been deregulated, you don't get--there are basically no credit cards that charge annual fees unless you get ancillary benefits, like frequent flyer miles or something like that, and then the annual fee is usually to process those accounts. But basically, annual fees have disappeared, and that's a good example of the way in which usury restrictions on interest rates distorted that market. A second repricing mechanism we saw in the usury was the tying in department stores of a credit purchase to a goods purchase. So, for instance, Sears could take a loss on their credit accounts and basically make up for it in charging a higher price for their goods, and there's ample empirical evidence that that's exactly what they did, that they would charge more for goods in States that had lower usury caps. So all this is is just a term repricing. Another thing it would do is reduce costs, so banks in States with strict usury regulations would have shorter hours, or they would tie your ability to get some benefits to having to get other things from the bank. Now, note one of the things that happens here. It is not just the repricing, but the repricing makes the whole loan more confusing, right, which is as opposed to just monitoring your interest rate, now you're going to monitor things like annual fees. That's an easy one. The other thing they would do in order to get around it was they would tinker with the way they would calculate your balance or what your grace period would be. I mean, there are a million--just think of all the different little terms that you could tinker with in a loan agreement. But the fact is that you're not just repricing but you're repricing from more obvious terms that people want you to compete on to less obvious and more obscure terms that are more difficult to monitor and more difficult to track. The third thing, but we don't have to dwell on this, is to the extent that you can't fully reprice, you're going to get credit rationing. I think I see Michael Staten here, but Mike and others have done research on the effect of some of these things and found that there has been credit rationing in this market, but usury laws have always been known to create credit rationing. We more frequently forget that it also leads to this term repricing. Marquette changed all that. The effect on the credit card market has been profound, and, in fact, Marquette created exactly the kind of federalism competition we want to see, right? Basically, after Marquette, which said we charge the interest rate of the lending State rather than the consumer's State, basically, there were two regimes that were in effect then. You could have the Arkansas regime, which had very strict usury ceilings, give you a credit line of about $800, approved about ten to 20 percent of the people who applied for their credit cards. If you get one, it was a sweet deal if you didn't need too much credit, but that was one option, where you could have the strict usury ceiling States that had all these other effects. Or, you could have the South Dakota regime, which was basically unregulated interest rates. Most of us probably don't even know that there were credit card issuers in Arkansas anymore because the South Dakota and Delaware regimes have basically swept the field, which perhaps says something about whether the bulk of consumers preferred the Arkansas regime or the South Dakota regime. I think that in the regulation of subprime lending, we could see the same sort of experimentation if we see the kind of world that the OCC envisions, and we're seeing the same sort of things at work involving State law, which is, first, undoubtedly, but to the extent that the term is called predatory and regulated out of existence, we're going to see less of it, right. No doubt, there's not going to be--if you say, you can't do prepayment penalties. you're not going to get prepayment penalties. The State can't do single premium credit insurance, you're not going to get single premium credit insurance. So it's going to have that benefit, and that's the thing is that's where the competition has been But we're also seeing term repricing, right, big-time term repricing, which is, for instance, as soon as you outlaw single premium credit insurance, what you see is basically single premium debt cancellation, which is the lender says, we're not going to have a third party insure the debt. What we're going to say is you can buy it from us, but if you die, we'll just cancel the debt, but it's just you and me so it's not insurance. But then you've got to go and you've got to regulate that. Another thing they're doing is in order, I understand, in order to avoid APR triggers is you charge 23 percent on the loan for the first five years and eight percent on the loan for the last 25 years and the APR magically comes out, over the life of the 30-year loan, comes out to be less than the insurance triggers. Since most people are going to prepay in this market anyway, you end up essentially getting a substitute for a prepayment penalty. The result of all this loan repricing, though, I think in part has been to make these loans incredibly complex and heterogenous products in the subprime market, which as opposed to competing on interest rates and costs like you see in the prime market, what you see is competition on about 35 different terms in the subprime market. They're loaded up with all this junk that in part is response to the heterogeneity. The borrowers in the market, I think as a part, as a response to this attempt to reprice terms so that you don't run afoul of these triggers and their HOEPA and State laws. We're also seeing, as I mentioned, some credit rationing. But basically, as I said, we've got two worlds, then, that consumers can choose between if the OCC comes through. They could go to a State chartered bank that would say, no prepayment penalties and the like, or they could go to the OCC, the nationally chartered bank, which would say basically do whatever the market, you know, whatever you bargain for in the market. In theory, if the State regulators believe that they are protecting consumers and giving consumers what they want, that should be a competitive advantage for the State chartered banks. They should be able to say, we don't charge prepayment penalties at our bank because we're not allowed to. If we charge above X interest rate, you get all these rights which you don't get if we don't. If that's a good law, then in theory, State chartered banks should have a competitive advantage against nationally chartered banks. I don't want to be flippant, but I do ask the question of, so what are they afraid of? If they believe in their law, then it seems like the State chartered banks should be able to prevail in the end. One other aspect of the market test that seems a bit unusual are these parity laws, which basically says that if the law is preempted with respect to nationally chartered banks, it gets automatically preempted with respect to State chartered banks. If it's the case that these are terms or regulations that consumers actually want, those laws seem somewhat unusual to me. So I'm going to just close with some final reflections on federalism, because I'm sure I'm over time probably. No? MR. GREVE: Not yet. MR. ZYWICKI: Not yet. What I'm proposing, then, is if the core values of federalism is individual liberty and experimentation, I think that this system of allowing competing banking systems within the same State seems plainly consistent with both of those goals, which is that it empowers consumers to choose which regulatory regime they want. It allows banks to choose which regulatory regime they want to be part of. Do they want to be a State chartered bank that will be governed in this way or do they want to be a federally chartered bank that will be governed under the other rules? And in a sense, what I think this is reminiscent of is the old version of federalism which prevailed in the Swift v. Tyson in the 19th century up until Erie Railroad in the 20th century, and Erie created this new idea of identifying federalism with the powers of States. What I want to say is federalism is about the powers of individuals and maximizing individual choice and it's not about the power of States to do X, Y, and Z, and I think Erie has gotten us thinking in that way rather than the Swift v. Tyson kind of world which allowed parties to--leaving aside Swift got expanded beyond its proper scope, but in theory, at least, Swift allowed a choice of contractual terms between federal common law or the State common law. And so I think that there is a logic of federalism here which is deeper rooted and more profound than American history that's consistent with the idea of a fully dual system in banking. MR. GREVE: Thank you very much, Todd. [Applause.] MR. GREVE: Phil Lehman? MR. LEHMAN: Thank you, Michael. This is a very appropriate time to have a symposium on predatory lending and federalism and preemption. It's difficult for me to get that word out of my throat, preemption. It's caused those of us in the State law enforcement community a lot of heartburn over the past year, but that's what we're here to talk about today so I'll have to talk about it, too. There's a lot happening now at the federal level, particularly in the federal agencies and in litigation around the country on banking regulations and preemption and federalism. One of the most current things is the OCC's proposed rules on preemption and their recent order preempting the Georgia Fair Lending Law. I think there are copies of the materials. The Attorneys General filed comments to those proposed rules a couple of days ago, and in a nutshell, we don't like them at all, and I'll talk more about that later. This is a very difficult time for States' rights and for those of us in State law enforcement. There are a lot of--we've had traditional authority in a lot of areas that are being challenged now, such as mortgage company licensing, abusive loan restrictions in our predatory lending laws, and in general, just consumer protection enforcement as it deals with national banks and federally chartered banks. All these are being threatened in very short order by federal agency action. In our view, the pendulum is swinging very fast and very hard to a regime of exclusive federal control and the elimination of traditional States' rights and regulation in enforcement of banking activity. I am not an expert on banking law. I'm a consumer protection enforcement attorney. I wouldn't normally need to get into all the arcane details of federal banking law, but it has become a part of our regular practice. For example, a year ago, we filed a case against a check casher that was doing payday lending against North Carolina law. The check casher was licensed by our Commissioner of Banks and was doing business as a check casher, but it was also doing payday lending in association with a national bank. We did not name the national bank in the lawsuit because we did not want to get into all those questions of federal preemption, but we immediately got removed to federal court with contentions that federal courts had exclusive jurisdiction over the case and that the locally licensed check casher, as an agent of a national bank, was entitled to full federal preemption and the benefits of Marquette and Section 85 of the National Bank Act. So this kind of thing is coming up a lot for us so it's requiring us at the State level to become familiar with federal banking law, agency opinions, and the National Bank Act. We're not unrealistic about preemption, I don't think. I mean, we recognize that there's a fair amount of preemption for national banks and that there always has been and there should be. And we don't have any desire to supervise or examine banks. We don't discriminate, don't have any intention of discriminating or obstructing national banks and their lawful operation. For a long time, we have coexisted and cooperated with the federal agencies that do have jurisdiction over national banks and over federal agencies like the Federal Trade Commission, which we have a very excellent working relationship with and have for some time. But the point for us is, we should all have the same objectives, to protect the marketplace and to protect the public from abusive practices and bad actors and we would simply like to continue that complementary role that we've enjoyed in the past and that we think we've been relatively effective in. The problem is that, particularly in the last year or two, we at the State level feel that we are being pushed farther and farther off the playing field. I mean, to us, it's like these national banks now are having the equivalent of diplomatic license plates so they feel free to drive and operate as they see fit in States without--with total immunity from State laws and State enforcement. We think that this is going to change. There's been a radical change. It's been a very recent change. It's not something that we have dealt with over the past 30 years, or at least the past 15 years that I've been with the Attorney General's Office. I want to also make a brief mention about North Carolina's predatory lending law, because we did have the first law in the country and it's become the model for other State laws and I think it's our predatory lending law and others that have, I think sort of stimulated this preemption zeal at the federal level, which I think is misguided. I think our law was a real, very good example of the benefits of federalism, that this was truly a laboratory of innovation by the States, the way we came up with this law and the way it's been implemented and the way it has worked. At the time that we were working on our law, which was beginning in early 1999, there had been a federal task force consisting of representatives, I think from HUD and the FRB, industry groups, consumer advocates that have been meeting for about two years to try to get reforms and to get some both consumer protections and some streamlining of HOEPA and Truth in Lending and RSPA. But that group, as I understand it, just met with gridlock. Nothing happened. Nothing came out of it despite all the work that they put into it. And I think that's one of the problems with the Washington culture, is if you've got--you've got trade associations on the one hand that have sort of the philosophy of the camel's nose under the tent, you know, sort of opposition to any kind of regulation. They've got to just sort of massively oppose. You have consumer groups taking very hard lines on the other side and very little room for compromise. There isn't the attitude of we have a problem, let's fix it, and that, I think, is the way that we went about it in North Carolina. The bill in North Carolina was not something that just came out of nowhere or was proposed by some outside group and worked its way through the legislature. This was a collaborative process that we worked on for a period of months. Our office got together and basically assembled our own working group of representatives from the State, community banks, the national banks based in North Carolina, the mortgage brokers, the mortgage bankers, and a coalition of consumer advocates. And I think one of the reasons we were able to do this is that we had worked together in the past. There was a sense of trust that we were able to negotiate in good faith. There was very little posturing. There was a recognition on all sides, including the banking industry, that there were very, very serious problems out there and those problems needed to be addressed. And I think that threshold question was one that was very important, to convey to responsible lenders that there were very, very serious problems with predatory lending. I mean, it's fine to talk about market economies and efficiencies and loan origination, but there were horrible, horrible practices going on. I mean, I was seeing them all the time. There were bad actors out there. It was getting worse. There was very little regulation, and one of the things I found is that they were--you know, one of the mantras we often hear from industry groups is there are plenty of laws on the books. All we need is more and better enforcement. I don't agree with that at all. There are laws on the books. Most of them are purely disclosure laws, like HOEPA and Truth in Lending and RSPA, for the most part. At the level of the marketplace that we were dealing with with predatory lending, where you've got the most unsophisticated borrowers, disclosures do not do much good at all. In fact, in my experience and as an enforcement attorney is those disclosures, in fact, are the first refuge of the scoundrel, and I've had cases like that where people have gotten just absolute unconscionable loans, but they've signed all the appropriate disclosures, and you can have the defense attorney up there saying, "Ms. Jones, is that your signature at the bottom of the paper?" "Oh, yes." Then she'll agree to a ten percent origination fee, another $200 in junk fees, a balloon payment after 15 years, $5,000 worth of single premium credit insurance. Well, she signed it. She agreed to it and it was all disclosed. So on paper, that was a perfectly legal transaction, but it was not a good or a fair transaction and nobody in the group that we were working with thought that that was fair and everybody agreed that there ought to be some lines drawn. So we did, and we went about it, I think, with some very clear overriding objectives. The first was that the market works very well in real estate lending for the most part. It's very competitive. The information is out there. It's a very well functioning market, except at the very lower ends of that marketplace, where people are unsophisticated and don't understand what's going on. So our objective was to narrowly tailor the relief in our statute to those bad practices without affecting the rest of the marketplace, which was working well. I hope we've done that. I think we have. I'm sure there's some disagreement about that. The second idea was that we need substantive protections. There were things that were going on, as I said, that were perfectly legal, that needed to be addressed, things like financing single premium credit insurance, the practice of flipping and those kinds of things which had not been adequately addressed in any law in the past. The other thing we had to work with was that we didn't want to put direct restrictions on interest rates or fees. For one thing, we were very aware of preemption and we didn't want to cross those lines. One, we didn't want to do it anyway, but also that brought up a lot of preemption problems under Marquette and other cases. So under the conventional wisdom that was prevailing in 1999, we thought we had made the statute relatively preemption-proof, and this was agreed to by us and by the bank lawyers who were working on it. Unfortunately, four years later, the playing field has changed and that is no longer the case. But I want to emphasize that the people working on this, including the bankers, did not feel themselves drastically affected by this law. I mean, their attitude was, these are bad loans. We don't make them. The law is going to draw some lines. We're not going to cross over them, so our business is not affected. So we weren't looking upon this as something that was going to have any significant interference or any obstruction of the bank's ability to operate. And another thing we did was impose some pretty bright line tests, which is something the lenders were telling us they wanted. They are uncomfortable with general prescriptions against unfair and deceptive trade practices, so we made an effort to draw specific lines that could be complied with. In my opinion and in many others, the law has worked very well. It's eliminated the worst predatory lending abuses that we had seen in North Carolina before the law took effect. The CEO of a major subprime lending company told my Attorney General that at the time the law was being enacted, he didn't like it, his company opposed it, but now they've learned to live with it and they think the law is a good one and that it has driven some of the worst actors out of the marketplace and done a lot to clean it up. So we come now fast forward to 2003 and we are seeing the federal agencies taking very strong actions against predatory lending laws that were created with a lot of work and cooperation and effort at the State level. And according to the OCC's opinion on the Georgia law and its proposed preemption rule, it appears to me that every single protective provision in our laws would be preempted for national banks and non-bank subsidiaries of national banks. Despite the fact the OCC says that their national banks don't make predatory loans, well, if they don't make predatory loans then the law shouldn't have any significant impact on their ability to make loans in general. The main argument we hear about this is that, oh, there's a balkanization of State laws and that it is difficult and inconvenient for national lenders to comply with a variety of State laws, and I think there's some truth to that to some extent. But basically, balkanization is just another word for federalism and many businesses of all kinds that do business in States have to comply with State laws. Certainly in the area of real estate, a person's home, property, is profoundly--there are many laws that relate to the title searches, to the registration and recordation of deeds that have to be complied with at the State level, so there already is a lot of specific State differentiation in laws. Anyway, that's an overview. The comments that you have were filed, and this is unusual, it was signed by all 50 State Attorneys General. Those are Attorneys General of all political stripes and different political parties and I think you can see from the tone of the remarks how frustrated State enforcement officials feel about the level of and the aggressiveness of federal preemption that is going on right now. Thank you. [Applause.] MR. GREVE: Thanks very much, Phil. MR. ANDREWS: Okay. Let me start, too, with the usual disclaimer. What I say today doesn't represent the views necessarily of any clients, my family, friends, or anybody else, or necessarily me tomorrow. I may change my mind-- [Laughter.] MR. ANDREWS: --especially if we have a good debate here today. I'll mention, at the back of the room, I brought several handouts that I thought might be useful and relevant to this, some of them publicly available, but one is a very interesting paper prepared by a good friend and colleague of mine, Don Lamp [ph.], who is a North Carolina attorney who represents many of the non-prime lenders and he gives an interesting perspective on the North Carolina law. I'll let you read that at your leisure. Another is I brought the OCC's working paper, which if you haven't read it and are interested in the nonprime lending area, I'd strongly recommend that you do so. Among other things, I think it certainly does a good starting job making the point that a lot of the studies, and perhaps from both sides, have got incredible numbers of holes in them, but I think it comes out a little better on my side, so, therefore, I like it more. I also want to start out by stipulating that I, for one, as one of the more active industry players, and I think the clients that I represent today feel very strongly that legislation is needed. This is not a question of whether there needs to be statutory regulation of a number of practices out there. It does. Congress clearly left some gaps in the '94 HOEPA law. Nothing was done. I quite frankly don't blame North Carolina or any State for going in, certainly on an interim basis, and trying to plug some of these gaps. Let me make a few points about housing and housing credit here. We all, those of us in the Washington area, every time I turn on the damn television, there's a Fannie Mae or Freddie Mac ad on the American dream. Okay, so we all know what the American dream is, but housing is important to us. It's important for a whole lot of reasons and credit housing equity is important. Our economy, many economists would suggest, has been sustained in no small part during some recent times by people being able to draw on their home equity. It's kept the economy going. People's ability to have housing credit, including people in the non-prime area, people who have less than perfect credit or who otherwise can't qualify for a Fannie-Freddie loan, often especially need it. I want to make a point or two about nonprime, subprime, however you want to call it. You know, what you read in a lot of the articles out there and the perception is not necessarily the reality of the market. If you read a lot of the articles, you would think that the loans are marketed primarily to elderly, minorities, people of extremely low incomes, et cetera. What you would find if you looked at the real market is that the average borrower is, oh, in their 40s or 50s. They're making 50 or 60 grand a year. They are--the majority are non-minorities. If you looked at the overall tracking numbers, you would see that basically it breaks out about the way the population breaks out on a racial ethnic mix basis, at least as far as the very HMDA data that critics cite is there, if you look at that. Now, this is not to say that there might not be some problems in there, but just a general point. Tremendous market growth in this area. A few years ago, you could not get access to your home equity nor could you necessarily buy a home in the first instance because subprime credit wasn't available. Last year, it had shot up to $213 billion in credit. The folks in much of that market are at the upper end of the non-prime market, the A-minus folks. A lot of people in the market, far more than those at the very low, low end. I just make that point. Again, capital has been incredibly central to this market development. The flow of capital in since about 1990 has made this market. You used to be able to get a loan, if at all, at very high interest rates. Now, the subprime rates average about two points, two percentage points over the prime rate. Some of them are the equivalent of prime rates, depending on your situation. About 62 percent of that $213 billion was securitized. The money is flowing in through the national capital markets, through the global capital markets. Those markets are easily disrupted, as I'm going to talk about more in a minute. I think it's fair to say that today, the mortgage market and certainly the non-prime market where this debate is centered is really a national lending market. The finance is coming out of the national and global capital market-- [Break between sides of recorded tape.] MR. ANDREWS: --the low rates that we've seen in the prime market tend to be coming in no small part from the commoditization. Today, subprime loans are much more commoditized than they were just a few years ago. However, that said, a lot of the laws that are varying from State to State are really causing some problems with anything approaching commoditization. There are, depending on how you count it, roughly 40 States and localities that have already passed some type of anti-predatory lending law. Now, every one of them is different. A lot more is pending. There's a chart back there that goes through some of this. I would submit that a lot of them aren't a better mousetrap, they're a different mousetrap and a lot of times they're just a little different mousetrap, but they're different enough to keep companies from being able to operate in a standardized way. They are difficult enough--different enough that companies are putting a huge amount into compliance. Smaller companies, quite frankly, they're flying by the seat of their pants, okay. Smaller companies are not going to be able to keep up and effectively comply with many of these laws. The capital market disruption we have seen has been most evident in the State of Georgia. It was when, above all, S&P and the rating agencies came in and said, hey, we're not going to rate loans and loans, therefore, aren't going to be bought in Georgia. The market shut down. You did have some correction through, I suppose, federalism on that. But we find that the provisions, particularly with respect to assigning liability, are really causing havoc and potentially a lot more havoc. You'll see a meltdown in New Jersey pretty soon. I represent some of the biggest non-prime lenders. I've talked to them. I haven't seen public announcements of it, but what I am told is that 60 to 70 percent of the loans that they are making in New Jersey, they will no longer be making, at a minimum. I don't think that's a very good thing for folks. The points have already been made that these are functioning as de facto usury ceilings. I think that is fair, definitely indeed. I think many were specifically crafted to have the effect of avoiding any usury limitations. The States, the panacea that they might be--I'll admit a little bit of personal bias here, now, because I come from, with my accent, as you can tell, sort of the area that might like States' rights and always have. But I also find that in many cases, States aren't necessarily enforcing some of the laws, and I'm not one to say that you have to just enforce existing laws. I think that would help a heck of a lot, but we definitely have to have a lot more. But I'm also one who has spent a good bit of time in the last three years going on into State legislatures and dealing extensively at the State level with some of the legislation. It has boggled my federal mind, based on the Washington experience, how some of these things are considered It's absolutely incredible, but I won't go into some of that. In any case, I think that what you have occurring in one State here very clearly can and does impact on the national aspects of the housing market and the capital flows. You have some bit sometimes of collective craziness and uncertainty, but with enough folks doing this, it really, really does matter. I would suggest that you can have an easier market functioning here from a finance point. I think that it would be vastly easier for brokers, for lenders to comply. The secondary market, I think, is much less likely to be disrupted. There's a great deal of expertise and sensitivity in Congress on these issues, far more so than what I've seen in talking with a lot of State legislators. I think that, you know, we've had some discussion here about the State roles and so forth. I believe it's important that States play a vital role at least in enforcing the laws. Whatever is out there, you guys feel at the State level. I think it's critical that you be involved in enforcement. I would suggest that the OCC-OTS situation is--it has its good and bad depending on how you're looking at it, interestingly, and I think maybe it was you, Phil, that made that comment. Who's making these laws? Do you think the national banks are making the laws? Wrong. Time out. No. The loans are made primarily by institutions that are either national securitizers, say the Option Ones, the New Centuries, or a Countrywide that is not operating as a bank, or if they do have a bank affiliation, they are not subsidiaries in the operating subsidiary sense that has the benefit of the preemption. So most of these loans are being made by a group of folks here who are nationally operating, that they're doing so without a banking charter. Again, I think it's beyond question Congress has the power to do so. I think Congress has acted on preemption in a number of areas. I know, Michael, you have some questions as to whether we would get what we think we will get at the Congressional level, that we may ask for it and get an absolutely crazy thing. But I think certainly the lenders are perfectly willing to take that chance. I think there are enough Republicans and Democrats that can reasonably address this. I'd also submit in closing that some of the agendas here and arguments that have been made, not in this room but in the debate, at least some of us would think that they may have to do with turf protection for some of the State regulators or political grandstanding by some politicians. There is a very definite fear that some of the advocacy groups--some of my friends have told me, Wright, look, we're arguing we don't want preemption, but the real reason is we think that Republicans are going to pass something crazy here that will take away protections and we don't think we can get a good bill. Trial lawyers may certainly have some interest in preserving as many ways to sue as possible in this, and I would also say that the number of lawsuits flowing out of the State laws is just going to be awesome in the future. There's a whole lot of a long time before some of those come, but they're there. There's a lot of lack of clarity. And we've got some folks that think that it would be better to shut off non-prime credit, have it subsidized in some way through governmental sources, you know, there are some of those reasons. Again, lots of different agendas. The agendas of the lenders that I'm working with certainly are for a national standard and legally, that's the best way not only for their business, but for their customers. [Applause.] PANEL DISCUSSION MR. GREVE: Thank you very much, Wright. I'm really very, very grateful to all of the participants for their very informative and stimulating contributions and especially for staying within the preassigned time limits because that gives me an opportunity to shamelessly use my own portfolio here to ask some questions. And please, I'll ask questions of all of you and please, if you'd rather respond to another participant rather than the question, feel free to do so. But let me start with Todd and play devil's advocate here. You say, hey, this is really--we'll have federal institutions and then we'll have State institutions and consumers are given a choice between those two and that's the glory and the beauty of federalism. But that seems to me--I mean, why isn't the State's response to that, why isn't the layman's response to that, look, that approach rests on utter confidence in contracts, every consumer's right to contract no matter what the terms are, and that precisely is the problem we're having, right? That's the problem North Carolina was trying to address, that some consumers, for whatever reason, signed contracts that they really shouldn't have signed and it was unconscionable to make them or induce them to sign them. Now, you may agree with that argument as a matter of--on the merits or you may not, but why isn't an answer to say, and so, therefore, we'll have this sort of ersatz contract regime and call it federalism, because that is the--right? Or does the federalist arrangement in that sense, that is, the choice between federal and State institutions, add some protection that a pure contractual regime doesn't have? MR. ZYWICKI: Yes. I think that's a point and there are two parts to this. First is I only talked about two of the players in this and there are actually three players. You've got nationally chartered banks, State chartered banks, and then you've got these sort of personal finance companies that Wright Andrews is describing, which are sort of these securitized guys out there who aren't banks at all. They're a whole different ball game in terms of--and this is where the States are incredibly important. These are the guys who keep us at the FTC up, awake at night, right. These are the guys who are just truly out there. They're the ones who aren't falling under any sort of regulatory scheme and they're the ones who are a large part of this. So with respect to them, we're talking about a different category. My remarks were addressed to whether or not nationally chartered banks should, if it were governed by national law and the national regulatory bodies, whether that should be good enough as opposed to the States. And then the personal finance companies are governed by State law. But more fundamentally, there's been a dramatic legal scholarship in recent years. They're talking about choice of law. The general consensus is that the choice of law among, say, 50 States works great. There's almost no reason to think that you shouldn't be able to elect the law of pretty much any State to govern your contract or disputes that arise under your contract or that sort of thing, very much like what we heard on the last panel, where there's nothing wrong with some company in Delaware doing business in Oklahoma and being governed by Delaware law. And why is that? Why are we not concerned in the choice of law context? Well, because we believe that within the American system, the State government, the Federal Government, all the different States, they all sort of establish a baseline that's not outrageous. And so all I'm saying is that if it's good enough for 50 States, and we think choice law is fine for 50 States, why not allow people to choose between a State and the Federal Government, a regulatory regime by the Federal Government, which seemingly looks the same way to me, which is it's held by responsible people. And that's basically all this is, is sort of to my mind, the next step in that chain. So it's not pure freedom of contract. It's contract among sort of all these different regimes who we all think operate more or less okay. MR. GREVE: I want to pursue this point a little further, but not with you. I'm through with you now. [Laughter.] MR. GREVE: It's just I have actually three questions and they're all sort of by way of information and by way of revealing my own ignorance about this. The first question goes to what Todd just mentioned. Suppose you have institutions, non-federal institutions in North Carolina and it's after the enactment of your predatory lending statute and these institutions sign contracts with North Carolina lending institutions or with any other lending institution, but citizens of North Carolina and the contract, the mortgage contract says in big bold letters that any disputes arising in, under, around this agreement shall be governed by the laws of, I don't know, Delaware or Florida, in any event, somebody outside, not in North Carolina. Is that legal? Can one have a mortgage contract like that and would the State of North Carolina honor those terms, and by State, I mean both the courts and the Office of Consumer Protection. Because if that is true, then it seems--I mean, if that were possible, to just contract out of the regime, then it seems to me a lot of this debate is somewhat--is more, I won't say pointless, but is a little misguided. The second question I simply have is this. I notice, and it's about the AG's comments on the OCC's proposed regs. There were several points the AGs had difficult with. The predatory lending proposals were one issue, but there were other issues about visitorial rights in State AGs' offices, and in particular a third issue, as I recall, is the ability of heretofore non-federal institutions to practically avail themselves of the federal charter and its benefits or protections in a very cheap way, non-bank banks and that sort of thing. So if you could give the audience a little sense of the priorities among the AGs with respect to these three issues, predatory lending, the visitorial rights, and the scope of application of federal preemptive norms. If you have to rank them, what would the rank order be? What's particularly important to you there? MR. LEHMAN: On your first question about the choice of law provisions in contract, at least under North Carolina law, that would not be permissible under our--at least under our lending laws. It says that the law of North Carolina controls on any loan to a North Carolina citizen. So the only thing that comes into play is federal preemption. Otherwise, if there's no federal preemption, then North Carolina law would control. One of the problems is, when you're dealing with consumers, they don't make the distinction. They don't know if they're dealing with a subsidiary of a national bank or they're dealing with a finance company or State, because these entities that are making loans often have very different names. They're subsidiaries of a bank and they're called something mortgage company. Legally, the consumers ought to feel that regardless of the institution that they're dealing with, they ought to have the protection of North Carolina law, at least on the predatory lending side, even though we can't do it with respect to interest rates and fees. On the Attorney General comments, it's hard to prioritize what all those are because, I mean, they're all beginning to blend together. I mean, these are coming in different steps. The OCC earlier this year issued proposed rules on visitorial powers, so that's already in the works. We replied to that and objected to those, also, and we think that the OCC is vastly over--just taking the term, visitorial powers, and stretching it just to undue proportions to prevent Attorneys General from enforcing consumer protection laws against national banks. To us, visitorial powers means the right to supervise, examine, and clearly, the OCC has that authority. But for years, we've had co-extensive authority to enforce State laws against national banks. So that is very, very important because that is our enforcement authority that the OCC is taking away. It's something we've always had. The predatory lending laws are very important. I think there are only still a handful of States--I think there are about, and Wright knows the answers a lot better than I do, but at least eight States that have what I would consider strong predatory lending laws. So a lot of AGs are not impacted by that. But I think the tenor of the OCC's objections to the State predatory lending laws, both in preempting everything in them--I mean, it's very troubling to watch for anything else that we might choose to do in consumer protection, and also, I think they've gone beyond just their regulatory interests and position papers and speeches. They are attacking the basis of those predatory lending laws, which I think is inappropriate and inaccurate. And the final thing is on subsidiaries. That's something that's particularly important, more to the Attorney Generals, but also to State banking and financial regulators, because for years, they've had mortgage companies that may have been subsidiaries of national banks that have been licensed and regulated by the State banking supervisor without any controversy. But in the last year, they, the banks and the OCC, have been taking the position that State banking supervisors have no authority to license and supervise these non-bank subsidiaries of national banks, even though they've done it without any objection for years and years. So that's sort of an example of how the playing field is being pushed further and further along. MR. ANDREWS: Michael, I just want to make a couple of points on this, just to clarify. People should not think that the non-bank lenders are not regulated. If I said that to any of the clients, they would just burst into hysterics. There is a wide range of both federal and State regulation for their lending practices. Many of the folks, depending on how they're licensed in a particular State, operate either through the banking department, the real estate department, or whatever. Now, most of them are not in a supervisory regime the way a national bank or something would be, so there's some different operation there. With respect to State laws, again, to emphasize the point, a lot of them are nonexistent. Some of them are very weak. They're very uneven and many more proposed. On this issue of could you basically contract your way to a favorable State or whatever, I've heard some people argue that the way to deal with this in a federalism context and so forth would be to come up with some system where the States could allow you to essentially export your whole law on this. Again, from a policy point of view, I would say that what would happen? You would get some very poor laws that wouldn't have nearly the amount of protection, quite frankly, that's needed. Again, I go back to my view that we need in this area a uniform standard that applies to the federally chartered institutions and everyone else. I don't think that the OCC-OTS institutions should be regulated under any different standard. MR. ZYWICKI: Let me just say a couple words. First, yes, there are limits on choice of law here when I was describing the sort of the law professors gabbing about what choice of law rules should be. Second, with respect to people don't know whether they're dealing with a national bank or a State chartered bank or something else, I mean, I kind of go back to the idea that if these are laws that people want, there's nothing that would stop a State chartered bank from saying, "Come do business with us. We are governed by State law and that means that there are no prepayment penalties at our bank. That means we will not sell you single premium credit insurance. That means we will not engage in these predatory practices, whereas those guys down--and if you don't come to us, ask those other guys whether or not they're a State chartered bank." You know, that doesn't seem beyond sort of the realm of possibility to me if these are pro-consumer. So the bottom line on this is how this works, and there are some natural experiments out there with respect to municipal laws. A good example I found was a report in the Parma Sun Post in July 10. One of the economists at the FTC, who's from a suburb of Ohio, of Cleveland, had this. It involves this guy David Sanderson [ph.]. He lives in Fairview Park, which is a suburb of Cleveland, and he admits he didn't have very good credit. He's kind of middle class. And he says he went around and kept applying to banks for loans, for a home equity loan, and they kept turning him down. Finally he said, "What's the deal? My credit's not that bad, is it?" And they said, "Well, no, the problem is you live in Cleveland and Cleveland has this law that means we really can't lend to people like you." And he said, "I don't live in Cleveland. I live in Fairview Park." And they said, "Well, your zip code says Cleveland. So finally he had to go back and he had to get the mayor of Fairview Park to write a letter to the bank to say he doesn't live in Cleveland. As a result, he is not subject to the Cleveland anti-predatory lending law. He lives in Fairview Park. I remember it was the seventh letter that she had to write at that point on behalf of people. Now, the State of Ohio has preempted their local municipal laws, such as in Cleveland. But that's an example of sort of two jurisdictions right beside each other with different lending policies. MR. GREVE: Just one last quick questions, and I apologize for my obnoxiousness, but we'll have questions in a second. Wright, I wanted to ask you, you mentioned this little piece I wrote about the predatory lending debate and my concerns about what comes out of Congress. It's not just what comes out of Congress, it's also what goes into Congress by way of demands, and here is what I have in mind. You mentioned that the industry you represent for the most part accepts the need for some additional regulation, right? But the need for--I mean, the form that this additional federal regulation takes is, I take it, amendments to HOEPA to allow--or something along the lines of let's tighten HOEPA a little more. And what we know about HOEPA is that it acts already, as you put it, as a kind of a usury ceiling. So to explain it a little more, there are almost no HOEPA loans out there, okay, and if you observe that, you have to believe that the lenders have already repriced these products on the margins and that means that, as Todd says, they've made them more complex and too confusing for anybody. So why isn't the industry demand that, look, if you really want to make subprime lending more efficient and simpler, repeal that statute, repeal those de facto usury ceilings. That's the opening bid and let's go. Instead, the industry goes in there at the front end saying, let's have more regulation of that kind, and if that's the opening bid, I wonder what the closing bid is. MR. : Sorry. I don't mean to be combative, but-- MR. GREVE: No, no, no. MR. : There's a very good point, and in a sense you're absolutely right. The current HOEPA law does not work, okay. HOEPA has three basic problems which are pretty common to the State laws, too. One is a lack of clarity. Two, not an effective right to cure. Three are very excessive penalties. And four, you've got to assign the liability there. Now, in the old days when you didn't have but a few loans subject to that, you know, big whoopee-do. Most of industry would say, hey, that's not getting into my market, et cetera. What you're talking about here from industry's point of view is fixing HOEPA to make it a workable law for all parties. You've got to have a law that does not serve as a de facto usury law in prohibiting the making of the loans. The consumer groups want a lot more loans covered. Some of us say, fine, let's cover a lot more, but let's make it workable, and I would submit that's doable. Now, as to whether it comes out that way at the end of the day, I certainly can't guarantee. But I have some faith that it will. QUESTIONS AND ANSWERS MR. GREVE: Sorry. We'll go the audience. Again, Kate Crawford has a microphone. When you ask a question, please identify yourself by name and affiliation. John? AUDIENCE MEMBER: John Ryan with the Conference of State Bank Supervisors. Todd, I guess I just would take issue with your description of our dual banking system because it isn't a pure State regulated, federally regulated system. An applicable law, particularly in the area of consumer protection, when Congress writes law in this area, they apply it to all insured depositories or even broader in some cases. So a concern here would be--is really the model you're suggesting, is nationalizing all rulemaking here, not one of federal choice, because the OCC doesn't write the laws. They interpret the laws, and by now, preempting and filling a void with really a creation of a law not based on any existing law, they're creating federal law, in a sense, and setting a model that would just federalize all law here and the only duality will be in enforcement based on the preemption the OCC is also suggesting as it relates, and enforcement not just for banks but anything potentially to do with a bank. It could become a subsidiary, a finance company, a leasing company, and all that. So it's nationalizing rulemaking as it applies to all these financial services and then the only duality is in the enforcement, and from a State's perspective, we believe we do enforcement--at least we have a lot of people, cops on the beat at a local level, and that that's a recipe for problems and overreaction when problems--if it's only enforced at the federal level, then when problems occur, then Congress steps in a la Sarbanes-Oxley and you have heavy rulemaking and maybe not as good enforcement. MR. ZYWICKI: It's my understanding that absent--it's my understanding that these parity laws were State laws and that absent a State parity law, the State's regulatory scheme remains in place. Is that not correct, that these laws would remain in place with respect to State chartered banks and that they are under their own regulatory regime? Is that not correct? AUDIENCE MEMBER: Well, I think the parity laws, sometimes referred to as wildcard laws, that you're referring to have more to do with powers than consumer protections and they don't necessarily preempt interpretations of preemption of consumer protection at the federal level. But what I'm saying is, is that consumer protection laws at the federal level apply uniformly to all insured depositories and beyond. They don't just say, you States, you create law for State chartered institutions. We create law at the Congressional level for federal institutions. They apply them uniformly. And what the OCC is doing is now creating a new standard of federal consumer protection and the OTS for insured depositories. That won't stand long. Eventually, it will turn into federal law and by preempting the field, going beyond what we're talking about with predatory lending, all consumer protection laws really are just federalizing the whole landscaping of consumer protection. The rulemaking and enforcement will be the only difference. MR. : Yes. I mean, I guess I'd have to think about more exactly what you're saying, but, you know, what I understood you to be saying is that this doesn't automatically happen with debts, the slide that it runs onto, and I'd be perfectly consistent with, or I'd be happy with--let me say it this way. The ideal system would be one that drew lines between those two. And so if the OTC system preemption overreaches and interferes with State laws that applies to State chartered institutions, that strikes me as going too far. But perhaps I'm a bit confused on the mechanics as to whether or not this automatically does it or whether you're saying this leads us into a slippery slope to which we end up with Sarbanes-Oxley, and I think those are two different situations. MR. GREVE: Actually, it seems to me a hugely important point, because if it is in facto that as a matter of the political dynamics, whatever OTS or OCC does for federal institutions or its institutions then becomes sort of the Congressional standard for the entire planet. I mean, the United States planet. Maybe somebody on the panel can help me out on that. Is that the historical experience, and is this just a matter of political dynamics? Do we known this or-- MR. : What I can say, when they set up the federally chartered banks, the nationally chartered banks in the mid-19th century, they thought they were going to kill off all the State chartered banks. They basically were setting up--it had to do with currency clearance and that sort of thing around, what, 1864, and the dual banking system has prospered since 1864. There is sort of an interesting issue that we haven't addressed which is that there's actually sort of a two-by-two matrix here. One is State versus federal. The other is legislation versus regulation. One of the interesting things here is whether or not the quadrant of federal regulation by OCC, how that compares to the quadrant of federal legislation versus State legislation, and I think historically in the American experience, is the quadrant of State legislation has been the not-so-good quadrant in terms of sort of populism and bank regulation and the things that the Framers were concerned about. That's obviously a crass generalization. But there is an interesting question about, of those four quadrants, which place are we likely to end up and what are the different dynamics, because clearly, the dynamics driving the OCC process at the federal level are completely different dynamics than what would drive the legislative process at the federal level versus what drives the regulatory or legislative process at the State level. I don't know that we know enough about how those dynamics necessarily play out. MR. GREVE: Thanks. AUDIENCE MEMBER: The problem of listening to the whole thing, you're writing your question down and you're not sure you can read it anymore. I'm Fred Smith, Competitive Enterprise Institute. Lenders, of course, of any kind, and home equity is not unusual, face this difficult choice. If they raise their standards too high, they deny a person a loan, and if they go the other way, they pick a guy who's going to actually go bankrupt and they're going to lose their net. And that problem gets to be a lot worse as you move towards the economic frontier where the database is weaker, the riskiness is higher in most cases, and there is certainly more risk of default. And then you get into the kind of--although we're democratizing credit by the process, which is a good thing, we're also leading to the kind of excesses because crooks, scandals, and entrepreneurs all operate in that frontier region, and that gets us to predatory pricing, which is something you're dealing with, predatory lending. But then on the other hand, you're redlining. So we have this delicate balancing act between saying if you give them a loan, you're a criminal, and if you don't give them a loan, you're a criminal. It seems to me getting all this right is complicated, and you all have dealt with some of the issues, but it seems to me there are five choices, though. There is the competing State regulatory issue where the States essentially capture all the customers in their State, which is sort of, I think, Phil's model he thinks might work better. There's a competing State, but the feds can sort of preempt that, which is something Todd suggested. There's the Marquette concept, where we sort of have every State's ability, sort of a choice of law rule where you preempt it. And then we have something we haven't talked about but, in fact, seems to be emerging, a kind of quasi, in between federal and State, the NAG, NIC, NEREC [ph.] rule where effectively we create groups who coordinate State rules to create an independent rule. And then, of course, there's the one we haven't talked about at all, a free market, which might work better than all these kind of ideas. But can we--to what extent are we--why hasn't the Marquette rule, for example, been extended to things like predatory lending so at least we had a choice of law option? MR. : I'm not sure where to start on your questions. If you focused on one--I mean, in our experience, we had to draw a line somewhere. At what point do we think these loans are really, really problematic? In my opinion, I think we drew it in the appropriate place. I mean, I think there are standards that should govern the entire marketplace, standards like unconscionability and unfair trade practice. It ought to be universal whether a federal or State institution, and there were plenty of examples like that out there. So one of the points I was trying to make is that in this sector of the marketplace where the predatory abuses have occurred, free market doesn't work. There need to be controls, because the stakes are too high. This is not somebody buying a used car. This is somebody, in many cases, their entire life's savings. This is their only source of equity or savings is in their house, and some of these practices were stripping that away. So I think because of the consequences, stricter measures needed to be brought in. I have no idea if that was responsive to you, but I tried. AUDIENCE MEMBER: Harsha Marthy [ph.], Value Equivalent Associates. Is this issue of State activism here essentially a losing battle? Would you say that you can't really contain this cost and benefits of State regulation for just the State because the overall trend in financial services is consolidation of providers and commoditization of the financial instrument? So picking up on Wright Andrews' point, I would like to address it to Phil and Todd. MR. LEHMAN: Well, to this point, the States have been fighting a losing battle. I mean, it is a problem for us and it is true that in the majority of cases where some of these issues have come up with preemption versus State control in courts, the courts have traditionally deferred to the opinion of the OCC. The OCC gives the opinion. They favor the federal, which we think is not in keeping with the OCC's traditional role, but the court follows it and it becomes a self-fulfilling prophesy for the OCC. The other point I was trying to make is that there are very strong countervailing considerations. On the lenders' side, they want a simple national market. They want to be able to make the same kind of loans, the same kind of procedures, same kind of forms in 50 States. The States say, we've got a right to protect our citizens against abusive practices so you've got to modify your forms and procedures a little bit to operate in our State, and I don't think the costs are all that high. I mean, what I will do is when I get those kind of questions, I refer them, or I will, to Mr. Andrews's law firm and say, he's got charts. He can tell you what the laws are in every State. Just retain him and it'll be very easy to accommodate your practices to the laws of the particular State. MR. ANDREWS: It's amazing how much I agree with Phil, you know-- [Laughter.] MR. LEHMAN: I'm trying to help you out here. MR. ZYWICKI: I think that's a great question, too. I mean, there's two devices. One is basically the retail market we're describing, but I think what you're getting at and what Wright was getting at is the secondary market, which is both the capital that flows in and the loans that flow out go into a national or even international market and you've got this one sort of block in there. And I don't--I certainly can't--I certainly don't know how we resolve that tension between sort of this localized federal sort of thing, but it's a very good question. As was suggested by Fred Smith, as well, the Marquette model in credit cards seems to have worked extraordinarily well in terms of being something much more like that because of the ability--and they've got the same sort of securitization going on with credit cards, whereas here, you know, that's where the breakdown comes is the securitization and the effect that has on reducing the cost of capital and that sort of thing and sort of assembling critical masses of loans in order to get those benefits in the secondary market. AUDIENCE MEMBER: And I won't ask this long complicated question this time. It's Fred Smith still. The fact that the Attorney General letter was signed by all 50, getting back to Marquette, if we were dealing with usury laws, you might get a large number of States saying the fed should have stayed out of this, but South Dakota wouldn't have signed. To what extent are we dealing with a denial of the experimental value to States when all 50 States seem to agree? It seems to me this is more like a non-experimental approach than an experimental approach. Some of the States could have said, we agree but we want a rule of law, or we agree but we want something else. But they all seem to have agreed we've got everything perfect. Stay out. MR. : No, no. I think you're mischaracterizing it. I think what 50 States are saying is that we ought to be free to experiment the way we want to. It's like somebody in the last panel said. It's like the let 1,000 flowers bloom approach. It is up to us to decide what to do to protect our citizens and not some federal agency. We've got the right to enforce our consumer protection laws. We've got the right to enact laws that may have some incidental effect on a national bank, but that doesn't mean they ought to be preempted by a federal agency. MR. : Which-- AUDIENCE MEMBER: I just think all of these things, I mean, in a sense, the burden of this--you're making some political points and you might well be protecting some of North Carolina's citizenry, but much of the burden of that is going to be on the national institution. But as somebody said, you're exporting the cost of your regulatory regime outside of State and does any State have an incentive to say we will allow a rule of law unless they can have that rule of law observed in other States? Unless you get something like Marquette, to what extent do you ever really get fair experimentation? MR. : I mean, I think we do have--that's the problem now. We do have fair experimentation and I don't--I mean, I don't think because a bank has to comply with a North Carolina law that's going to increase the cost significantly for a borrower in Nevada or something like that. I think one of the problems with the Marquette principle is what you have is not really federal preemption but it's preemption by Delaware. So you've got one or two, Delaware and South Dakota initially, all the bank credit card operations moved to those States and it was like whatever Delaware law is is the law for the whole country. I don't think that is appropriate, either, but that's what the law is and we accept it. But credit cards are more portable and they're a whole lot different from somebody's home, and I think that's something we need to stress here is we're talking about people's houses and equity and that kind of thing. There are very important considerations on the other side that are very, very significant consumer protection considerations that are much more important than paying a $20 annual fee on a credit card. MR. ANDREWS: Just two very quick points. One, the North Carolina law was a heck of a lot better than some of its progeny. It was like mutations that have occurred with some really strange things. I think North Carolina or any of the States can and does have an effect on the availability in other jurisdictions, Phil, when you have a significant number of States imposing substantial regulatory schemes on major markets that are different, that have a lack of clarity, and so forth. I mean, I know what my clients are being told by the Wall Street investors and it's frightening as to the potential for what this could do to the market. Another thing in terms of experimentation, for those of you who like experimentation, and I've experimented a few things myself, I guess, but if we got the 50 flowers blooming, think about the 10,000 or however many cities and counties we have in here. You know, we don't have any limitation in California. I just wonder what's going to happen in Arnold's regime as more and more the California cities and towns start passing some kind of crazy law and you're going to see people pulling out. So, you know, sometimes you experiment a little too much. MR. GREVE: I just want to pursue this in connection with the question about consolidation. The difficulty I have, or the question I have about that argument is the following. That's true, and undoubtedly, it would be, for national lenders, it would be cheaper and better and more convenient, and for their customers, it would be in the end cheaper to have a uniform standard so that you don't have to have 50 compliance policies, et cetera, et cetera. But it seems to me that's true about all sorts of things. Let's take an example. It would be better for Hooters if we have a uniform national sexual harassment policy or a uniform national policy governing the sale of liquor to inebriated customers, right? You'd have one training program for every bar in the country. Sorry. So and there we say, no, let's have local experimentation. There again, I mean, there, at least, we're willing to pay the cost and we're willing even to say that if some State turns out to be extremely stringent with respect to the sartorial standards of Hooter waitresses, the company will have to call its place then Looters or it will have to move out or something, right, and that's, as Phil said, yes, look, you can call that balkanization, but that's the price we pay for federalism and for giving people the choice in these matters. And the way that ties in with the disciplining point is the following. Georgia had a terrible law, but it had to repeal it precisely because you can't securitize that stuff, right? The entire market keeled over and they said, oops, we're sorry, and they backed, or effectively repealed it. Now, it's true New Jersey is now making the same mistake. They, too, will learn. My question is, why is that not discipline enough? Why do you have to have a federal discipline on top of it? MR. : Michael, if I could respond briefly in two ways. One, it's not simply the convenience and the efficiency. Why I started out talking about the importance of housing here, the capital markets make or break the availability of low-cost credit here. This is having an impact on Wall Street, okay. All right, Georgia. I'll just make an observation in Georgia. Yes, as one who went to law school in Georgia, worked for a Georgia Senator, I thought the Georgia folks had more damn sense. But they made a mistake, didn't listen, and so forth, and you say they came back and corrected it. They corrected part of it. Do you know what they did? MR. GREVE: Of course. MR. : You basically have in Georgia a scheme that says--they took away, above all, the covered loan category. So most or the vast majority of what you were able to write, you can write so people are going back in. What is happening in Georgia, and unfortunately a number of other States, is that the lenders are not being able to make loans that cross that threshold-- [Break between recorded tapes.] MR. : --in all too many cases, as you cross that threshold, the responsible lenders aren't making them, and for some people in some jurisdictions that are making them, they don't have much incentive not to really gouge the poor consumer. So those thresholds are having a real limiting effect on some consumers. MR. : Let me just add, Fred suggested that there's a cost externalization going on here. In fact, one of the reasons why the Ohio State Legislature preempted their own law is that basically all the lenders had pulled out of Cleveland. So, I mean, there is an exit option here. The exit option is much more expensive on the State level than it would be on the municipal level, and I think Mike, Ed, and I would have said basically the market keeled over, which is that lenders in D.C. threatened to pass one of these laws and all the lenders basically said, we're gone if you do, and then they, before it went into effect, they came back and renegotiated and that sort of thing. So there is some discipline there of the lenders being able to pull out. I just want to add one other thing because Mr. Lehman keeps stressing the idea that these are people's houses. One thing we have to remember here is that if somebody can't get a home equity loan, it doesn't mean they're not going to get credit, right? What that means and what we know that means is they're going to go to a pawn shop or they're going to go to some personal finance company or they're going to go somewhere else. At least some of them are going to go somewhere else. You know, I'm not comfortable necessarily telling people that because they're so concerned about their home they need to go to a pawn shop, for instance. So it is one of these things where there's not only term repricing, but there's loan repricing, which is to say people will substitute into other forms of credit, whether it's payday lending or pawn shops or whatever the case may be. AUDIENCE MEMBER: Just to clarify that point, I think the issue I was raising was less the cost to the provider of State regulation but rather our tolerance for State activism in this area, because if we say the litmus test, to Mr. Smith's point here, externalization of costs, the question I was asking is just a factual one. Will there come a time when we cannot just limit the effect of any State experimentation to just that locality, and by definition these are going to be spread, which means it ultimately gets passed back to consumers. Does it matter if it's Elliott Spitzer doing securities regulation in New York, which we may regard as a more important societal benefit, than a non-commoditized subprime loan in the State of Georgia? MR. GREVE: Maybe Wright knows this. Is it possible as a practical matter for lenders to say, okay, the State of Georgia, North Carolina, what have you, just imposed these requirements, and putting aside whether they can make the loan at all or not, just the administrative stuff, the development of compliance programs, can you charge that to the customers in those States? Can you compartmentalize it in that fashion or does it rattle through the entire lending portfolio and is sort of priced to every borrower all over the country? MR. ANDREWS: I think realistically there's a lot of rattling and some cross-subsidization that would go on. That would be my view. MR. : In most of these loans, when they're closed, there has to be a certification if there's an attorney involved, closing attorney, that the loan complies with the State law in any kind of real estate law. We're not asking for something out of line. And on the availability of credit, I think, and I can speak with experience about our law, and I think it applies to most other laws, is no intent by anybody to draw unrealistic lines to dry up credit. I mean, everybody agrees that subprime credit ought to be available, but it ought to be available on fair terms. And so the purpose is to draw a line and kind of compartmentalize what are the most abusive kind of loans, and there are loans that people shouldn't get into. It's just bad. MR. : Absolutely. MR. : I mean, some of these loans are just as bad as going to a pawn shop and a whole lot worse. I mean, we can disagree about where those lines are and whether it's restricting reasonable credit or not, but, I mean, I think there ought to be some agreement that there are a lot of bad loans out there that ought to be restricted. Even pawn shops and finance companies are regulated strictly. MR. GREVE: I'd like to end on that note of harmony. Please join me in thanking our panel for what I thought was a terrific discussion and join us for refreshments outside. [Applause.] [Whereupon, the proceedings were adjourned.]</body></html>