Recoupment under Dodd-Frank: punishing financial executives and perpetuating "too big to fail".

• Author: Mitts, Joshua
• Position: COMMENT

In July 2011, the Federal Deposit Insurance Corporation (FDIC) promulgated new rules implementing Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules define a cause of action to recoup compensation paid to senior executives and directors of failed nonbank financial institutions placed into the FDIC's "orderly liquidation authority" receivership. An action for recoupment is based on a negligence theory of liability, but it does not require establishing that an executive's conduct caused the financial institution any harm. The rules presume liability merely for having held executive responsibility prior to the firm entering receivership. The executive may rebut the presumption of negligent conduct, but not causation. Put simply, a senior executive or director can lose two years of pay even if he or she could conclusively establish the total absence of any link between his or her conduct and the firm's failure.

This Comment argues that disconnecting recoupment from causation leads to overdeterrence and perpetuates the dangerous phenomenon of "too big to fail." In particular, executives may abstain from taking optimal risks that may be mischaracterized later as negligent should other factors cause the firm's failure. Such overdeterrence is likely to cause talented executives to gravitate toward financial institutions that have the lowest risk of failure. Recoupment thus imposes a cost concomitant with a firm's perceived risk of failure, giving large, interconnected institutions an advantage when competing for managerial talent. Indeed, the liquidation of firms perceived as "too big to fail" may be so improbable that they can credibly offer executive compensation with little to no risk of recoupment.

The remedy for this deficient rule is to make causation a rebuttable presumption. Because executives can cheaply show that other factors were responsible for the firm's failure, they would discount potential recoupment liability chiefly by the likelihood of causing actual harm. This probability would not vary between firms, promoting healthy competition among financial institutions and reversing the arbitrary advantages conferred by the current regime on "too big to fail" firms. Retaining a presumption of causation would still ease the evidentiary burden of holding financial executives accountable for reckless behavior.

1. TITLE II AND RECOUPING EXECUTIVE COMPENSATION

   Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act grants the FDIC the authority to conduct an "orderly liquidation" of "failing financial companies that pose a significant risk to the financial stability of the United States." (1) Under Title II, the FDIC may "act as the receiver" for a "covered financial company." (2) A "covered financial company" (3) must meet a series of criteria, including (1) being "in default or in danger of default" (4) (as defined in the statute (5)); (2) posing such a risk that "failure of the financial company and its resolution under otherwise applicable Federal or State law would have serious adverse effects on financial stability in the United States" (6); and (3) leaving no choice but a public rescue because "no viable private sector alternative is available to prevent the default of the financial company." (7) As receiver, the FDIC succeeds to the financial company, (8) operates it with the goal of maximizing the value of its assets, (9) and ultimately must "liquidate, and wind-up [its] affairs." (10)

   The statute does not, however, limit the FDIC's powers to operate the failed financial institution. Title II also provides:

   The Corporation, as receiver of a covered financial company, may recover from any current or former senior executive or director substantially responsible for the failed condition of the covered financial company any compensation received during the 2-year period preceding the date on which the Corporation was appointed as the receiver of the covered financial company .... 11 On July 15, 2011, the FDIC promulgated rules implementing this recoupment authority. (12) The rules empower the FDIC to "file an action" to recover any compensation paid in the preceding two years as provided in the statute. (13) The rules provide that a "senior executive or director" shall be "substantially responsible" for the financial company's failure if he or she:

   (1) Failed to conduct his or her responsibilities with the degree of skill and care an ordinarily prudent person in a like position would exercise under similar circumstances, and

   (2) As a result, individually or collectively, caused a loss to the covered financial company that materially contributed to the failure of the covered financial company under the facts and circumstances. (14)

   These conditions reflect a negligence theory of liability, which requires establishing failure to act with reasonable care, causation, and injury. (15) But the rules establish a presumption that allows for recoupment without proving causation:

   It shall be presumed that a senior executive or director is substantially responsible ... under any of the following circumstances: (i) The senior executive or director served as the chairman of the board of directors, chief executive officer, president, chief financial officer, or in any other similar role regardless of his or her title if in this role he or she had responsibility for the strategic, policymaking, or company-wide operational decisions of the covered financial company prior to the date that it was placed into receivership under the orderly liquidation authority of the Dodd-Frank Act .... (16) In essence, these executives are presumed liable solely based on title and responsibility. Moreover, this presumption may only "be rebutted by evidence that the senior executive or director conducted his or her responsibilities with the degree of skill and care an ordinarily prudent person in a like position would exercise under similar circumstances." (17) Such language indicates that an executive may disprove only the first element of recoupment--negligent conduct-but not causation. (18) Put simply, a senior executive or director can lose two years of pay even if market forces like tightening credit conditions or employee misconduct like fraud or embezzlement caused the firm to fail. (19) Liability attaches even if the executive can conclusively establish the total absence of any causal link between his or her conduct and the firm's failure.

   The FDIC has provided little explanation of the rationale behind the conclusive presumption of causation. It has merely stated that the rule is "aligned with the intent shown in the statutory language." (20) The history of the statutory provision for recoupment indicates that it was driven by a popular backlash against executives of failed firms receiving substantial compensation alongside government support. (21) When introducing the amendment providing for recoupment, Senator Robert Corker stated:

   No question, the bonuses and things we saw, after getting taxpayer money to make sure they survived, no doubt that created a backlash. As a matter of fact, the Senator from Virginia and I are working on an amendment that would say, if this ever happens again and we have to take one of these firms through resolution, which is part of the Dodd bill right now, the bonuses and other types of things in recent years would all be clawed back. You cannot make huge sums of money, take your company down the tubes, and do things to America in that way without paying a price) (22). While liquidation under Title II is not a bailout, (23) Senator Corker's statement suggests that the rule was intended to further a similar populist policy of denying compensation to executives of failed institutions under government-supervised liquidation.

2. INEFFICIENT OVERDETERRENCE OF INDIVIDUAL EXECUTIVES

   Liability without causation is dangerous because causation promotes economic efficiency. In A Theory of Negligence, Judge Richard Posner explained why this is so:

   If the defendant was negligent but the accident would have occurred anyway, it would be incorrect to view the costs of the accident as the consequence of his negligence since they would not have been avoided by the exercise of due care.... Punishment for negligence would close an important safety valve in the negligence system. A standard of care is necessarily a crude approximation to optimality. Allowing enterprises a choice whether to comply or pay the social costs of violation may permit a closer approximation. (24) Awarding monetary damages equal to actual injury permits the defendant to internalize the social cost of his or her conduct. This promotes...