In the wake of the subprime mortgage meltdown and the ensuing financial crisis, the question being asked is why bankers, money managers, auditors, securities lawyers and credit rating agencies failed – individually and collectively – to conduct the sort of “due diligence” necessary to detect and prevent detrimental investment practices. On March 31, Brooklyn Law School sponsored the Abraham L. Pomerantz Lecture on “Due Diligence: Failures and Remedies,” which explored this question and suggested legal reforms to avert future crises.
Bernard S. Black, the Hayden W. Head Regents Chair for Faculty Excellence at the University of Texas School of Law and Professor of Finance at the University of Texas at Austin, delivered the lecture to an audience of legal scholars, practitioners, and students. Commentators John C. Coffee, Adolf A. Berle Professor of Law at Columbia University and Marc Gross, a partner at Pomerantz Haudek Block Grossman & Gross LLP, provided additional insights.
The participation of various corporate actors – investment bankers, auditors, securities lawyers and sometimes rating agencies and other professionals – is crucial to both public and private securities offerings. Each is expected to conduct “due diligence” – to investigate various aspects of the company’s business and its disclosures to investors and follow up if and when the investigation yields red flags. Yet, Professor Black suggested that key players routinely neglected their responsibilities.
Lawyers only examine what bankers and issuers tell them to look at, and that is often not much. Bankers, facing profit pressure from above and an “eat-what-you-kill” culture, had incentives not to ask probing questions about risky mortgage-backed securities. Money managers, too, were encouraged to shy away from knowledge that could prove damaging to their careers. At the same time, NRSRO credit rating agencies operated in a highly concentrated market with a few big players all engaged in the same game of “investment grade” inflation, without disclosing the unverified assumptions on which their structured finance models were based. The upshot, Professor Black argued, was a financial climate in which “the (willfully) blind sold to the (willfully) blind.”
In his comments Professor Coffee clarified that the right question to ask is not why lenders made bad loans, but rather why investment bankers bought the risky loans. The answer indicates failure on the part of the gatekeepers, he said. Bankers bought the loans, because they knew they could securitize them on a global basis – so long as they obtained an investment grade rating from an NRSRO credit rating agency. With the rise of structured finance, obtaining a good rating became increasingly easy, as the rating agencies relaxed their standards and did not submit their models to independent verification. While the role of rating agencies is important, however, it is not the full story. Gross suggested that there needs to be structural change in the way financial institutions manage other people’s money, perhaps through reforms to compensation.
Professor Black also suggested possibilities for reforms, which might encourage corporate actors to catch and prick future bubbles before they become destabilizing. In particular, Professor Black proposed a “web of diligence,” an overlapping set of explicit diligence standards and liability rules for the various corporate actors engaged in public, private, and semi-private deals. Although reputational concerns may have some effect on corporate behavior, Black warned, “In the land of financial giants, it is not so easy to kill a reputation.” Furthermore, by placing the responsibility for due diligence failures on those who have the information and the ability to act, liability rules may better compel adequate due diligence.
The Pomerantz Lecture honors the life and work of Abraham L. Pomerantz, a 1924 graduate of Brooklyn Law School. The lecture series focuses on topics of corporate securities law and related issues of professional responsibility. The law firm of Pomerantz Haudek Block Grossman & Gross LLP, of which Abraham Pomerantz was the founding partner, provides continuing support for this series. Professor James A. Fanto organized the event and moderated the question-and-answer session.