Editor:The current credit environment or "credit crisis" resulting from subprime loan defaults and related securities losses has impacted businesses of all types and the global economy. Please describe the challenges companies are now facing.
Morris: There are a number of "credit crisis" issues affecting companies in the financial services sector as well as investors who might have invested knowingly or unknowingly in products that contain subprime mortgages. Generally, there has been a reduction in capital expansion in terms of new securities issuance, which has had the effect of increasing the cost of raising capital while causing mark-downs in current holdings of certain mortgage-backed securities. This, in turn, has caused companies to reflect the significant declines in financial asset carrying values. Another aspect is that companies have had to retool their risk-management systems - the procedures, the documentation, that formerly placed importance on debt ratings. Lastly, boards of directors and management have been challenged by their shareholders and in certain cases by regulators to clarify how risk is assessed, the control processes in place, and how these controls are monitored. The credit crisis and its many ripples has spread over a wide area.
Editor: What do you see are the challenges for general counsel, particularly in the financial services firms?
Massam: The general counsel is being called upon to constantly evaluate exposure presented by the company's involvement in the capital markets, more specifically in the subprime and structured finance sectors. The SEC, the FBI and certain state attorneys general are all actively investigating and evaluating criminal and civil remedies for a variety of topics, including securities fraud, insider trading and violation of fiduciary duties. The immediate effects of the crisis include the requirements of responding to subpoenas and records requests, often coming from multiple different regulators as well as litigation that is already being initiated. Litigation includes class action litigation on behalf of borrowers, securities class action from investors, matters from regulators and corporate litigation by and among commercial parties. So there is simply no way around the fact that this is a very challenging time for the chief legal officer in many of the Wall Street firms and banking centers.
Editor: Even if a company is not affected by a write-down, shouldn't all general counsel take a look at what their investment procedures are for their pension funds or any of their operating funds in terms of setting up criteria for risk assessment?
Massam: I would agree that this is a time when you would expect the general counsel to not only be in direct conversation with business line heads, the chief risk officer, the chief compliance officer, internal audit and other key members of the management team, but you would also expect that there would be extensive conversations with the board and various oversight committees. There's a mutual interest in reaching agreement on how much exposure to risk should be allowed.
Morris: In addition to touching base with executives heading key lines of business, there is another step the general counsel should undertake - helping to identify certain investigations or fact-checking of areas that should be undertaken which may not have caused litigation to date but have some nexus or link to the subprime credit markets. There are now prospects of an ever widening band of potential litigation. General counsels can play proactive roles to see if there are other exposures that a given company might face.
Editor: What is Ernst & Young's role in working with inside and outside counsel?
Morris: We often work at the direction of counsel as part of teams comprised of outside as well as internal counsel and at times working with internal auditors. Our efforts can be structured to help clients preserve the attorney/client privilege. We can help counsel determine and map out a scope of work as well as improve the understanding of issues and areas that require additional technical review or examination.
Massam: A nswering this question more broadly, not in terms of the current credit crisis but in terms with what the financial services marketplace has dealt with over the recent past, such as market timing, conflicts of interest, etc., we assist corporate counsel in a variety of ways. These ways include - forensic investigative, fact-finding type work, traditional litigation support and economic analysis type assignments. We have had considerable experience in working with companies and law firms in applying these skills to the credit crisis. The common elements are always a significant amount of data that requires massaging. Our financial services clients obviously deal with high volumes of transaction activity and information that needs to be reviewed as part of an investigation. That is one of the prime skills we bring to bear: we collect information that is relevant, we can do the appropriate screening, and we can come to conclusions that address what has happened. As an example: if the questions is - were loans that were included in a securitization transaction compliant with the underwriting standards of the institutions that originated that loan, we can readily put together a work plan and a team that would review underlying loan files as a means of forming statistically valid conclusions about the compliance with underwriting criteria. On the financial analytics and on the litigation support side we are very experienced in developing financial impact models which are critical to resolving disputes either in advance of litigation, or as expert witnesses in litigation. For example, in the current situation there have been settlements between investment firms and investors relative to investments that failed in certain respects to meet the expectations of investors. We have done financial impact analysis in this area to help parties resolve disputes in advance of litigation.
Editor: What is your role in the risk assessment process? Are you involved in the setting up of control procedures within the corporation to prevent future problems?
Morris: We play a variety of roles. Certainly those roles include assisting our audit clients as well as our non-audit clients. We have a range of advisory skills which we refer to as our Risk Advisory Services, of which our investigatory services is one component. We help clients with risk and control assessments, corporate compliance assessments, updating of their risk-rating models given current market conditions, loan loss reserve assessments (including helping clients with impairment calculations), taking a look at client's hedging strategies, valuation model assessments, development and recalibration of models as needed and helping clients perform assessments of their loan servicing operations, including non-performing loan dispositions, foreclosure processing and other loss mitigation elements. When a client is looking at the risks posed by certain liquidity events, there is a wide range of activity that Ernst & Young is capable of performing in addition to what we do in our investigative and e-forensic technology, which is part of our computer analytics capabilities. Editor: How do you tie in these services with your assistance to general counsel?
Massam: As a general matter we offer an expert set of extra hands to manage through the current situation. That can mean a lot of different things: at the highest level we can be helpful in responding to the information requests coming from the regulators and from parties in litigation; we can perform the complex data analysis to understand where risk exposure lies or what historical practices have been; we can provide assistance with any type of data production that might be required for legal processes, such as subpoena and records request responses involving e-discovery; we do independent investigations and fact-finding; we can reconstruct transactions; forensic due diligence is another area that we can get involved in. With potential M&A transactions our team can function as part of a diligence effort to evaluate legal exposure in a target company.
Editor: What is the benefit of engaging a neutral third party to conduct an investigation or perform fact-finding?
Morris: At times boards of directors require that there be a third party, independent investigation; it can also be required by parties involved in a dispute. Some of the other reasons include the ability to tap into a readily available and experienced pool of resources that can respond quickly to investigative situations. This can serve also to lessen some of the burden on management while helping navigate situations in the current and challenging operating environment. Lastly, and not unimportant, is having a third party investigate a matter reduces the chance for a "cover-up". This is another factor for use of third parties for investigations.
Editor: What is the current focus of the major regulatory investigations?
Massam: Investigations have been launched at the federal and state level and even by a few municipalities, focusing on multiple topics, depending on the nature of the business which is the subject of the investigation. Many inquiries are looking into predatory lending practices and investigation into Home Mortgage Disclosure Act compliance- those types of investigations are very focused on loan origination activities - whether it was subprime or prime mortgage lending. Other investigations are looking into securities fraud under the '33 Act or in New York State under the Martin Act. When you peel back the onion, investigative work is looking into whether loan pool securitization includes individual loans that are non-compliant with the underwriting criteria of the originating institutions, whether there was appropriate transparency, and broadly speaking, whether the disclosures that were made both to investors and to rating agencies regarding the structured securities were appropriate based on the underlying risks. Concerns about insider trading and front-running as well as concerns about whether valuations on a company's books and records are the same as valuations provided to customers and investors are being reviewed. There are potential ERISA violations that are the subject of investigations. Investigations cover a variety of different topics, depending on the nature of the operation being scrutinized.
Editor: What other types of legal action are taking place or likely to take place? What about the rating agencies?
Morris: The time frame for the maturing of litigation is going to be months and maybe several years - we're clearly in the early stages of that cycle. As we move into litigation and damages assessments, we expect the following to ensue: breach of fiduciary duty may be a cause of action, securities fraud, insider trading, perhaps resulting in criminal allegations, investor and shareholder class actions. We are at the stage now where companies with fiscal years ending 12/31/07 are finalizing financial statements so that there are possibilities of additional shareholder suits once this information is released.
Editor: What are the new long-term priorities for businesses resulting from the credit crisis?
Massam: This is a longer term issue which will take time. An important priority for our clients is to marshal the information as to what has happened along with existing practices that have led to this point. It is critical for our clients to be prepared to respond to any kind of legal process in order to defend against any litigation that is brought against the firm. In addition, most of our clients are taking the opportunity to enhance their regulatory corporate compliance procedures and guidelines. This issue has brought some important challenges to light and has provided an opportunity to enhance current practices, such as improving risk management tolerances and the internal reporting capabilities. It is also the case that many of our clients are looking at the market and asking: what sort of merger and acquisition activities might be appropriate for us? There are strategic opportunities that will make great sense for certain of our clients.
Editor: How would you like to see the issue resolved?
Morris: A return to more normal activity within the capital markets is not only good for the economy but has benefits of helping improve consumer confidence levels. The subprime mortgage issue has caused additional consumer and investor anxiety about something as fundamental as home ownership. Home ownership as a pillar of U.S. economic activity has been shaken. We would like to see a return of investor and consumer confidence that can only come from certain improvements in the financial markets and more education as well.
Massam: We've already come to appreciate the substantial risks associated with complex financial instruments backed by mortgages that were being actively traded in the marketplace and we stand to benefit from that increased awareness, but we do need to get back to a greater degree of investor and consumer confidence in the financial marketplace.
Published March 1, 2008.
