“Ocean’s 11” Redux

When it comes to financial fraud, “deep fakes” are the new game in town.  Think “Ocean’s 11” comes to your bank and you are the victim, like casino-owner Terry Benedict in the movie.  “Deepfake technology uses artificial intelligence (AI) software to make convincing impersonations of voices, images and videos. AI-based neural networks generate a counterfeit of a photo, audio recording or video while another tries to identify the fake version.”[1]  Two publicized cases involved banks operating in Dubai and London, which lost tens of millions to deep fake schemes.  Most cases go unreported.

Analyst Kelley M. Sayler, of the Congressional Research Service, put it this way: “The use of AI to generate deepfakes is causing concern because the results are increasingly realistic, rapidly created, and cheaply made with [widely available] software and the ability to rent processing power through cloud computing.  Thus, even unskilled operators [can] download the requisite software tools and, using publicly available data, create increasingly convincing counterfeit content.”[2]

In the Dubai case, perpetrators used software to mimic the voice of a company executive well known to a local banker.  The executive told the banker he was completing an acquisition and needed funding from the bank to do so.  The bank obliged and $35 million vanished into accounts around the world.  The case became known only when Forbes magazine uncovered legal pleadings involving the loss.

Deep fake schemes are proliferating in other fields.  One circulating presently shows Ukrainian President Zelensky exhorting his compatriots to put down their arms and surrender to the Russians.  Another took the first place blue ribbon and $300 cash prize in the Colorado State Fair’s juried art exhibit, category of “digital art.” Titled, "Théâtre D'opéra Spatial,” the man who created it used artificial intelligence software and written prompts to create what he describes as a "lavish sort of space opera scene."  One of the exhibit’s jurors said he was unaware AI was used to create the image.

When it comes to financial fraud losses, the risks to business owners are difficult to quantify.  Non-depository financial companies today comprise a growing share of our financial system.  Newly hatched fintech companies proudly claim to be disrupting the status quo.  That attribute makes them magnets for fraud schemes, as PayPal’s founders discovered in their early, high-growth years.

Nondisclosure is the norm when fintech companies suffer fraud losses.  Public securities filings frequently include bland statements that fraud is a risk of the business.  Government authorities have been slow to require companies to publish aggregate data about losses and risks of loss.

Law enforcement is swamped with cases.  When I ask U.S. Attorneys, the FBI and other agencies to investigate clients’ losses due to financial fraud, I am repeatedly told, “This happens every day to lots of people; we can only do so much.”

Given these limitations, I recommend the following precautions.

• Be vigilant.  Slow down.  Ask questions.  Look for little details that do not make sense in the context of what you are being asked to do.

• Know technology countermeasures can always be defeated.  Think cops and speeding drivers in their cat-and-mouse game of ever-improving radar guns and detectors.  That game has been going 50 years and there is always a new device or tactic being promoted as a game-changer.

• Recognize ego and emotion are as important to financial fraud as greed.  In the movie, the Oceans 11 team considers scuttling their plan when they learn Danny Ocean’s ex-wife is now Terry Benedict’s mistress.  Effective crooks know they need to think clearly, unimpeded by emotion.  So do their targets if they are to avoid being victims.

• Understand successful deceptions require a drama as their foundation.  A story is created.  It is plausible, presented in a way that is convincing, and invites the victim to draw a false conclusion and then act on that conclusion.  “Invites” is the key word.  Victims are not told what to believe.  They are seduced to believe what their captors want them to believe.  They are then captives of their own beliefs.

AI will not replace human agency during the lifetime of anybody now in the workforce.  To have AI work for us rather than against us, we must design complex adaptive systems that serve human needs while recognizing we are bound to the machines we create for the betterment of all of us.    

[1] https://www.shrm.org/resourcesandtools/hr-topics/technology/pages/deepfake-scams-may-be-on-the-rise.aspx#:~:text=Deepfake%20technology%20uses%20artificial%20intelligence,to%20identify%20the%20fake%20version.

[2] Id.

Chips Ahoy

In a November post-election blog post, we wrote, “The pandemic and its effects have taught us we can and must rebalance our economy to recapture industrial capacity we have exported to low-wage economies.  Only a shared sense of purpose will allow us to do that.”

Our argument was rooted in a Brookings Institution report, which found, “Jobs in blue America disproportionately rely on national R&D investment, technology leadership, and services exports.  By contrast, [in red America] prosperity remains out of reach for many . . . .  This is not a scenario for economic consensus or achievement.”

We suggested big technology companies like Google are best positioned to rejuvenate our manufacturing economy.  And we argued the Great Lakes region is where that activity should take place.  Available there are large, inexpensive tracts of land, a well-educated work force, moderate cost of living and plentiful fresh water.

  Last week, Ohio media outlets reported Intel will spend $20 billion to create a semiconductor manufacturing hub northeast of Columbus, Ohio, on 3,200 acres of farmland: that is five square miles, or ¼ the size of Manhattan.  A significant portion of the funding will likely come from taxpayers, as Congress considers the CHIPS Act, a bill that will feed $65 billion to the U.S. semiconductor industry.

Although the pandemic-induced chip shortage is the immediate cause for Intel’s Ohio gambit, infrastructure that makes it possible was built by the federal government 50 years ago in response to another crisis—river flooding.  Intel was incorporated in 1968, as semiconductors entered the mainstream economy.  In the same year, the Army Corps of Engineers and the State of Ohio began work on Alum Creek Dam, the newest of three large water reservoirs north of Columbus. 

In the mid-19th Century, Alum Creek was known to travelers on the Underground Railroad as the Sycamore Trail, due to the abundance of that distinctive tree species along the creek.[1]  Enslaved people seeking freedom followed the creek upstream due North for 58 miles through Central Ohio.  They waded in the stream to put slave catchers’ dogs off the scent.  They took shelter in hollow trunks of sycamore trees, which can live 500 years and become hollow as they age.  Safe houses also provided sanctuary, including an 1830s farmhouse just down the street from my childhood home. 

  Alum Creek Dam was completed in 1974 as part of the network of dams that control flooding on the Ohio River.  The five square miles of land behind the dam are now a state park, which the Army Corp of Engineers floods as needed to prevent flooding downstream.  Meanwhile, Columbus and nearby communities draw their drinking water from the reservoir at Alum Creek Lake and the other two flood control reservoirs nearby.  Since Alum Creek Dam was commissioned, Columbus’s population has doubled to nearly 1 million.

Intel, Google and their peers grew up in the Western U.S.  Today, that region’s limited water resources make big tech companies problematic neighbors.[2]  Intel’s Ohio project is expected to be a clone of its Chandler, Arizona, fab plant, which consumed 1.8 billion gallons of water in Q4 2020.[3]  

Intel and the city of Chandler have spent hugely to build a water recycling plant to reduce the burden Intel places on the city’s water resources.  Even so, residents, city and company officials are wary.  Chandler’s Drought Management Plan calls for rationing water if deliveries from the Colorado River fall by 30% or deliveries from the Salt River Project fall by 60%.  Either scenario is plausible if population growth continues its current trajectory.

Intel’s and other big tech companies’ embrace of the Great Lakes states is also politically astute.  Ohio’s Congressional delegation greeted last week’s news with calls for Congress to pass the CHIPS Act.  The runner-up to Ohio in the Intel bidding was New York, whose Senator Schumer lobbied for an Upstate New York location that also has ample water nearby.

The general public understands the current chip shortage, but not how the global semiconductor business has morphed.  Since 2000, U.S. companies, Intel excepted, have quit manufacturing chips.  They design chips, but contractors manufacture them in what the industry calls foundries.  Samsung in South Korea and Taiwan Semiconductor Manufacturing Co. (TSMC) control more than 70% of global chip manufacturing.[4]  More worrisome, Samsung and TSMC have taken the lead over Intel in the race to fit the greatest number of circuits on the thinnest, smallest silicon wafers.

Samsung and TSMC enjoy 30% government subsidies.  Chinese government subsidies are even larger.[5]  Although Chinese chip makers are not yet competitive at the high end of the market, the Chinese government’s heavy investment poses the risk that gap will close within a decade.[6]

The need to find a new equilibrium to sustain a U.S. manufacturing economy is the dominant question of our day.  Reestablishing domestic semiconductor fabrication is an obvious strategic need.  Also important is making in America furniture, household appliances, medical supplies, pharmaceuticals, construction tools and countless other more ordinary goods.  Time and again in our work at Renaissance Partners over the last three decades, we have encouraged U.S. business executives and government officials to recognize the economic value of domestic manufacturing. 

As the semiconductor industry trade association says, the choice between U.S. production and Asian production is not binary.

While we should take seriously [Chinese semiconductor industry challenges], the answer cannot be the wholesale decoupling of our economies.  The semiconductor industry is truly global, and access to global markets is critical for U.S. firms to sustain high levels of investment in R&D and capital expenditure. . . .  The right approach to addressing market-distorting Chinese industrial policies is to work closely with our allies to both compel China to change its ways, as well as to develop new global rules and standards that improve market access and ensure fair competition.[7]

This position can be read as self-interested—don’t close off the great market opportunity China represents for U.S. firms.  The better view is it as realistic.  It is impossible not to deal with China in today’s economy.  The need is to define the terms of trade in a way that creates mutual benefit.  A vital American manufacturing sector is essential to that equation.

[1] https://www.columbusmonthly.com/story/news/2015/02/23/city-quotient-what-part-did/22795383007/.

[2] https://www.nytimes.com/2021/07/09/technology/big-tech-community-impact.html

[3] https://www.wranglernews.com/2021/05/27/chandler-intel-pact-preserves-citys-water-resources-as-drought-lingers/

[4] https://www.cnbc.com/2021/04/12/us-semiconductor-policy-looks-to-cut-out-china-secure-supply-chain.html

[5] https://www.semiconductors.org/taking-stock-of-chinas-semiconductor-industry.

[6] “Chinese chip producers are focusing on making a breakthrough in memory and mature node logic foundries to gain an edge in the global market. Since 2016, the Chinese government has invested at least $16 billion into state-owned memory fabs to develop China’s domestic 3D-NAND Flash and DRAM industry, and the efforts have begun to yield some success. In addition, leading Chinese foundries and several foundry start-ups have accelerated their pace of building trailing-edge fabs. According to VLSI, China’s memory and foundry capacity is expected to grow at a CAGR of 14.7% over the next 10 years.”  Id.

[7] Id.

Conquering Codes

                Nearly 70 years after the fact, the British Secret Intelligence Service (SIS, or MI6 in James Bond movie jargon), released details of the agency’s creation of the world’s first programable digital electronic computer, Colossus.  Known since 1974 has been the story of British success decrypting German WW II signals intelligence encrypted using four and five rotor Enigma machines.  The German high command, however, used more complex 12-rotor Lorenz technology.  Britain’s cracking of that code remained top secret until recently.[1]

The Lorenz SZ cipher attachments implemented a Vernam stream cipher, using a complex array of twelve wheels that delivered what should have been a cryptographically secure pseudorandom number as a key stream.  The key stream was combined with the plaintext to produce the ciphertext at the transmitting end using the exclusive or (XOR) function.  At the receiving end, an identically configured machine produced the same key stream which was combined with the ciphertext to produce the plaintext, i.e., the system implemented a symmetric-key algorithm.[2]

The total possible number of coded patterns was two to the power of 501.  That fact made it physically impossible for humans to decrypt the volume of messages that the German high command was sending and receiving.   By building Colossus, the British solved that problem only weeks before the D-Day invasion of Europe.  Reading German Lorenz signals intelligence told the Allies all they needed to know to finish the war in 11 months rather than 2-3 years.

The relevance of Colossus today is this: even at the dawn of the digital age, humans were no match for programmable machines’ computational power, which is why humans invented computers.   It took the concentrated resources of whole nations to create digital machines.  The U.S. Navy’s ENIAC computer debuted in Philadelphia just after the war ended.

Intervening decades have extended that power into every nook and cranny of human experience—for good and for ill.  What was once attainable only by marshaling the intellectual, engineering and financial wealth of nations is now available as a $300 wristwatch.

The discomfiting corollary is that the forces that now control $300 wristwatches thereby control our lives to a degree most of us do not recognize or care to admit.  When that power is exercised inappropriately, we as individuals are at its mercy.  This is the phenomenon academic observers have named surveillance capitalism.[3] 

Today as in 1944, government action is the only realistic countermeasure to abuse of power on the scale now held by corporate tech titans.  Cue the Consumer Financial Protection Bureau, an agency in search of its mission since Congress created it in response to the banking crisis of 2008. 

In late October, CFPB issued orders demanding non-bank operators of payment systems turn over information about their systems.  Targeted were Amazon, Apple, Facebook, Google, PayPal and Square.  The agency said it also will study the practices of Chinese payment systems Alipay and WeChatPay.  CFPB’s stated areas of inquiry are consumer behavior targeting, coercion of merchants to participate in payment networks, and deficient compliance with consumer protection requirements.

Last month, CFPB shut down lending operations of LendUp, a company that claimed to serve “the emerging middle class” by making payday and other short-term loans.  Investors in LendUp included A-List venture capitalists such as Andreessen Horwitz, Kleiner Perkins, Google Ventures, PayPal and QED Investors.  LendUp’s brief corporate history included violations of the Military Lending Act, which prohibits charging armed services personnel more than 36% APR on loans, and documented deception of consumers about the benefits of repeated borrowing from LendUp.

CFPB is also reviewing “buy-now-pay-later” retail loans offered by companies with catchy names like Affim, PerPay, Splitit and Klarna.  Sold to consumers as alternatives to credit card debt, the BNPL product looks to all outward appearances as if it is the latest gimmick to induce consumers to spend themselves into insolvency. 

CFPB’s focus on fintech companies is where the agency’s energy should be centered.  These companies are geared to gin up business regardless of the consequences to their customers and have none of the regulatory constraints or risk averse culture of conventional banks.

Surveillance capitalism will not be the death of human agency as critics like Professor Zuboff suggest.  It is, however, a force that must be moderated in the same way the Interstate Commerce Commission brought railroads to heel in the early 20th Century.  Government can and must be a force for good.  Thoughtful exercise of those powers by public-minded individuals is an abiding strength of the American republic.  May it always be thus.

[1] Price, David A.  Geniuses at War: Bletchley Park, Colossus, and the Dawn of the Digital Age, New York: Random House (2021).

[2] https://en.wikipedia.org/wiki/Cryptanalysis_of_the_Lorenz_cipher.

[3] See, e.g., Zuboff, Soshana.  The Age of Surveillance Capitalism: The Fight for a Human Future at the New Frontier of Power, New York: Public Affairs (2019).

Gaining Consensus and Achievement

Political election post-mortems have the usefulness of a divining rod in search of water.  Media commentators were shocked, shocked last week to discover Democrats’ lack of appeal in small town and rural America.  Huh?

In the 1960s small town Ohio of our youth, Democrats had zero chance to win local elections.  That reality is as old as the Volstead Act.[1]  The reasons for it today are fresh, however.  In the words of a Brookings Institution report,

Jobs in blue America disproportionately rely on national R&D investment, technology leadership, and services exports.  By contrast, [in red America] prosperity remains out of reach for many . . . .  This is not a scenario for economic consensus or achievement.[2]

As if to prove the generalization, former United Steelworkers official and mayor of Monessen, Pennsylvania, Lou Mavrakis in 2016 invited candidate Donald Trump to visit.  Fellow Democrats objected.  Mavrakis responded, “Whenever you’re desperate, you ain’t got no place to go, you take your chances.  I want to get something for the people I represent and for my city that I love.  Just some glimmer of hope, that’s all I want.”

The quoted Brookings report notes President Biden won just one-sixth of the nation’s counties, but those counties represent 71% of the nation’s GDP.[3]  That is a problem—for all of us.

Manufacturing employment’s peak year was 1975.  The knowledge economy’s birth year was 1946, when ENIAC debuted at the University of Pennsylvania.  Which is to say the dichotomy identified by Brookings has deep roots that defy simple solutions. 

So how do we create “economic consensus and achievement” that serves the whole nation?  Manufacturing’s rise to economic primacy offers clues.

1.       As Industries Grow, They Spread Out.  Pittsburgh became the center of the steel industry because natural resources were handy or could be brought here efficiently.  Coal, natural gas and rivers were nearby.  Ore from the Iron Range could be shipped across the Great Lakes and moved by rail from Conneaut, Ohio, to Monessen and similar Mon Valley communities. 

As the industry matured, it diversified production and distribution to reflect localized demand for products, new product development, resource availability, and national security objectives.  Alabama, Indiana, Ohio, Detroit, St. Louis, California, Utah, Philadelphia and Baltimore all became important steel production centers as a result.  Today one can add to the list North Carolina, Arkansas, Texas and Mississippi.

The auto industry evolved in the same way.  Detroit was headquarters; but the Big Three built plants in a majority of states.  The companies thereby served customers where they lived and worked, diversified risks and attained political influence in those locales and in Washington.

Google today is following the same playbook.  It now operates data centers in 14 locations spread across the nation.  All centers are situated in rural areas where land is inexpensive, workers are disinclined to unionize and the Google payroll has an outsized local impact, inclining political office holders to do the company’s bidding.  The company’s recently announced exurban Columbus, Ohio, location is its first one east of the Mississippi and north of the Mason Dixon Line. 

The data centers’ need for hundreds of millions of gallons of water a year to cool them has made residents of Western U.S. locations increasingly less welcoming.[4]  So the Great Lakes beckon as a region where plentiful water and human resources can meet the needs of Google and similar technology companies.

Manufacturing’s growth again is a useful reference.  Before WW II, Ford Motor Company built a water tunnel three miles long and 15 feet in diameter under the streets of Detroit to bring water from the Detroit River to Ford’s 1,100 acre Rouge Complex.  The Rouge then employed 85,000 people.  The water tunnel fed 600 million gallons of water a day to run the in-house power plant and steel mills that served the world’s largest industrial complex.[5]  Google data centers’ water requirements pale by comparison.

2.       International Relations Shape Facility Locations.  In July 1942, a German submarine landed saboteurs at Jacksonville, Florida, with munitions and instructions to blow up ALCOA operations in Illinois, Ohio and New York.  The saboteurs were soon captured.  The company erected anti-aircraft machine gun emplacements on the roof of its New Kensington, Pennsylvania, R&D center.  Also constructed were tunnels to the Allegheny River to evacuate ALCOA engineers if need be.  To increase aluminum production tenfold for the war effort, the federal government paid ALCOA to build and operate a series of aluminum smelters widely dispersed throughout the nation. 

During the aughts, as Renaissance Partners, we met with officials in charge of the DuBois (Pennsylvania) Regional Airport.  Their facility was first class, they owned many adjacent acres of undeveloped property, but they struggled to identify potential users.  We pointed out the airport was an hour or less by air from five of the twelve Federal Reserve banks, making it an ideal location for a remote site to be used in emergencies or even in the day-to-day operation of the nation’s financial system. 

3.       Politics Can Work for Communities of all Sizes.  To prevent manufacturing plant closures and job losses at Standard Steel (Mifflin County, PA), C/G Electrodes (Elk County, PA), Brockway Pressed Metals (Jefferson County, PA), Horsehead Industries (Beaver County, PA), American Alloys (Mason County, WV) and many other businesses, Renaissance Partners has often enlisted federal and state elected officials’ assistance.  They have uniformly been active and helpful participants in our projects.  A television advertisement from Sen. Arlen Specter’s last reelection campaign featured him in standing on the plant floor at C/G Electrodes in Saint Marys, Pennsylvania with the facility running at full production behind him.  He was proud to have helped his constituents, and justly so. 

The pandemic and its effects have taught us we can and must rebalance our economy to recapture industrial capacity we have exported to low-wage economies.  Only a shared sense of purpose will allow us to do that.  Achievement will follow.

[1] Okrent, Daniel, Last Call: The Rise and Fall of Prohibition (2010).  Okrent’s history of Prohibition is a fascinating account of the movement’s birth among Midwesterners fearful of the growing political influence of cities teeming with Eastern and Southern European immigrants, Southerners intent on reinforcing Jim Crow strictures, and educated, civic-minded, newly-enfranchised women committed to helping working class women escape the destructive effect on families of drunkenness and alcoholism among working class men.  The same women were the first to call out the failure of Prohibition and mobilize to repeal it.  During Prohibition’s heyday, though, the movement’s leaders held as much political sway over both parties as Trump backers did during his presidency.

[2] www. Brookings.edu/blog/the-avenue/2020/11/09. 

[3] “Just 31 counties, or the top 1% by share, made up 32.3% of U.S. gross domestic product in 2018 . . . . That's despite these counties only having 26.1% of employed Americans and 21.9% of the population last year.”  https://www.bloomberg.com/graphics/2019-us-gdp-concentration-counties/ (citing data published by the federal Bureau of Economic Analysis).

[4] https://www.ny1.com/nyc/all-boroughs/ap-online/2021/10/22/big-tech-data-centers-spark-worry-over-scarce-western-water.  See also https://www.bloomberg.com/news/features/2020-04-01/how-much-water-do-google-data-centers-use-billions-of-gallons.

[5] Dulmage, William W. “THE RAW WATER SUPPLY OF THE FORD MOTOR COMPANY.” Journal (American Water Works Association) 30, no. 1 (1938): 67–77. http://www.jstor.org/stable/41231945.

Fintech’s Great Reckoning: Crowdfunding

From the Chinese government’s crackdown on Ant Financial beginning late last year to U.S. banking agencies’ recent rumbling they will take a closer look at banks’ outsourcing business partners, heightened scrutiny is coming to financial technology companies, which style themselves as “fintechs.”   

“Fintech” has positive connotations—innovative, sleek, deserving of lofty stock valuations and, most of all, is not to be confused with stodgy, outmoded and financially lackluster banking institutions.  This perceptual map is now coded into investors’ outlook.  Anything with “tech” in its name is worth a gander.  That is where the game is.  Bill Gates, Peter Theil, Elon Musk and others are our Michaelangelos, and now our Medicis. 

  Contrary indicators surface occasionally.  The 2008 banking crisis occurred because bankers, lawyers and accountants were too clever by half.  Without fancy algorithms to slice and dice subprime mortgage loan portfolios, they could never have wrought the havoc they did.  Facebook, now Meta, has been revealed to serve mammon at least as well as God.  And PayPal founder Peter Thiel has made it his mission to repeal New York Times v. Sullivan,[1] having failed to enlist fellow billionaires to help him create a man-made island cum tax haven in the Pacific Ocean, where he planned to rule wealthy residents’ lives using software algorithms as a substitute for civil laws.

  Crowdfunding is a fintech innovation that still wears a halo.  Championed as a Woodstock-like festival of neighborly capitalism, it uses the Internet to connect borrowers with lenders, and entrepreneurs needing equity with people willing to provide it.  Unlike platforms such as LendingClub and Prosper, which make no claim of altruistic purpose, crowdfunding’s promoters cloak their offerings in populist rhetoric. 

  Congress in 2012 included crowdfunding in the JOBS Act.  The SEC finalized Regulation CF in 2016, laying down crowdfunding rules of the road.  Based on five years of data, crowdfunding’s most ardent adopters reside in metropolitan New York City, California and Texas.  The table below shows activity in Ohio and Pennsylvania.[2]  No Regulation CF offerings have been made in West Virginia.  In the tri-state region, Pittsburgh has the highest number of offerings, while Philadelphia and Cleveland rank 1 and 2, respectively, in the amount of funds raised.

Hospitality (e.g., restaurants, microbreweries) and personal service businesses (e.g., hair salons) predominate when it comes to types of crowdfunded enterprises.  Although the SEC raised the maximum amount of a crowdfunding offering to $5 million from $1 million, most campaigns raise modest amounts, $824 on average.[3]  For campaigns that reach their goal, the average amount rises to $28,656.[4]

  Crowdfunding serves a useful purpose; but it is a niche play only, enabling entrepreneurs to attract funding from a wider universe of people than immediate family and close friends.  More capital-intensive businesses and non-consumer-oriented ones continue to be better served by Regulation D offerings.  These offerings require more effort, cost more, and are made to “accredited investors”—those with a personal net worth greater than $1 million or annual income greater than $200,000 ($300,000 for couples) for the last two years and the expectation of earning at that level in the current year.

  Mirroring practices followed in IPOs and Reg D offerings, crowdfunding platform operators profess to have conducted due diligence on the entrepreneurs they sponsor.  Investment risks though are relegated to fine print on crowdfunding websites.  No oversize, bold type disclosures here, as in Regulation Z truth-in-lending bank loan documents.  Nor is any disclosure typically made about (i) whether platform sponsors have any funds invested in the businesses they sponsor and, if so, whether they stand to get their money back before crowdfunders do, (ii) the one, three and five year survival rates for businesses that source capital through the platform, (iii) the high failure rates generally of restaurants, microbreweries and other business types that gravitate to crowdfunding, or (iv) the reality that what are sold as high yield loans will become  illiquid equity investments if the businesses do not succeed as planned.

  Crowdfunding remains a work in progress.  The inherent limitations of using social networks of middle-income individuals are the best protection against fraud, if not business failure and consequent loss of principal.  In a former time, community bankers, ward politicians and even clergy served as intermediaries between people needing capital and those who had it to invest.  If capital providers and users approach crowdfunding as an economic utility, rather than as manna from heaven, then all can help one another prosper.  Realism is the key ingredient.

[1] 376 U.S. 254 (1964).  The case held that a newspaper or other media outlet did not libel a “public figure” unless the statement made was known to be false or was made with reckless disregard for its truth or falsity.  PayPal co-founder Peter Thiel funded WWE star Hulk Hogan’s Florida lawsuit against website Gawker, which was bankrupted by the judgment Hogan won at trial.  Public figures including Justice Clarence Thomas and ex-President Donald Trump have called for the U.S. Supreme Court to reverse its decision in the Sullivan case.

[2] https://www.crowdfundinsider.com/wp-content/uploads/2020/09/Regulation-Crowdfunding-by-Congressional-District.pdf

[3] https://www.fundera.com/resources/crowdfunding-statistics

[4] https://thecrowdspace.com/how-much-can-you-raise-through-crowdfunding

Mothers of Invention

“Necessity is the mother of invention,” goes the proverb.  A gender neutral variant occurs in Plato’s Republic.  By the Sixteenth Century though, the proverb was established in both English and Latin with Necessity having a female persona.

               Sixty years ago, the post office of my Ohio childhood installed a curbside mail box with a chute.  My mother observed that although the drop box was an improvement, it required a 5’ 4” woman like her to put the car in “Park,” slide across the bench seat, over the transmission hump and reach an uncomfortable distance to deposit mail. So she wrote a letter to the local newspaper saying that.  The postmaster thereupon reconfigured his parking lot to place the drop box on the driver’s side of a newly created drop-off lane. 

                Another of my mother’s wished-for improvements was a kitchen shower stall.  She said a mother with small children should be able to finish dinner, step into the stall with her child(ren), draw a circular curtain hung from an overhead track, disrobe, pull the chain connected to an overhead water tank, and wash off food that found its way onto clothes or body parts other than kids’ mouths, with a drain in the center of the floor to catch the runoff. 

                The point of the examples is that useful devices women might create are off the radar of businessmen who lead new product initiatives and experience the world differently.  Stated simply, women remain underrepresented in the innovation economy and our world is poorer for it.

                This truth came to mind as I read a white paper, “Manufacturing a High-Wage Ohio,” published by The Century Foundation.  The paper’s author, Michael Shields, identifies troubling trends:

•        “Despite dramatic job losses, Ohio grew its share of the nation’s manufacturing workforce over the past quarter-century, as manufacturing jobs became more concentrated in the [Midwest] region.”

•        “Ohio was once among the nation’s wealthiest states . . . .  Yet, Ohio is no longer a destination [for people or companies]—the state’s growth rate has lagged the nation’s by three quarters since the Great Recession.  Ohio’s cities are actually shrinking.”

•         “Wage growth in Ohio has been nearly flat for nearly four decades.  Since 1979, the bottom 60 percent of workers has lost ground compared to their counterparts a generation ago.”

•        “While manufacturing remains a better paying sector, factory wages have not kept pace with economic growth, and the manufacturing premium—the wage bump that manufacturing workers receive above other wage-earners—has shrunken.”

•        “Advanced manufacturing industries hold enhanced potential to create good jobs . . . .  Yet the trends in advanced manufacturing jobs spell trouble for Ohio [because the rate of loss of these jobs (43% since 1990) exceeds the rate of loss of other manufacturing jobs (30%)].  Policymakers should be deeply concerned with the long-term viability of manufacturing jobs in general, but especially of advanced manufacturing jobs.”

The causes of these trends are firmly established and durable.  They include automation, foreign competition, government currency manipulation and corporate capital allocation in favor of rapidly growing emerging markets.  For example, Midwest-stalwart Caterpillar, Inc., today has 76 manufacturing plants overseas compared to 62 plants in the U.S.  Since building its first plant in China in 1994, CAT now has 25 plants there.

Plato’s wisdom about necessity mothering invention should guide us.  Ohio remains a prolific center of innovation.  Residents of its principal cities and Pittsburgh created the fifth largest number of patents issued in the United States since 2000.  Only cities in California, Boston and New York City surpass the Ohio/Pittsburgh cohort. 

What if women had greater material incentives and technical support to invent new products?  What would they create that we men overlook? 

Ohio state government has an active economic development team, Jobs Ohio, funded by sales tax on liquor.  Of nine Jobs Ohio directors, one is a woman.  Of five regional staff team leaders, one is a woman.  Of the 11 industry teams, two (military and government, and healthcare) are led by women.

Asian and European business cultures prefer men over women to an even greater degree than American business culture.  So why not turn that to our advantage by incentivizing American women to create, patent and commercialize more products? 

Ohio participates in the Invention Convention, a nonprofit organization intended to nurture children’s interests in innovation. https://inventionconvention.org/ohio/about/invention-convention-worldwide.  Why not do more to encourage adult women to be innovators?

We cannot reclaim an economy in which hundreds of thousands of men and women earn top tier wages and salaries by operating tools and machines to mass produce goods. That era is over. Computer programmed machines, wherever located, are more efficient and require fewer operators. We can, however, harness the brain power of all our citizens to invent and patent-protect useful tools for living in our time. That is the necessity we face.

Reduce, Reuse, Recycle

“First Commonwealth Bank in Leechburg to shut its doors Dec. 11, the victim of increased online traffic,” headlined a local newspaper Saturday.  

  For our non-local readers, Leechburg is a picturesque town of 2,200 people, on the Kiskiminetas River (a tributary of the Allegheny), 35 miles northeast of Pittsburgh.  According to Wikipedia, its reason for being was as “a major port on the Pennsylvania Canal,” which was eclipsed by the Pennsylvania Railroad in 1852. For many years thereafter, the railroad had a whistle stop in Leechburg.   Small industrial users located there due to the river and the railroad.  Their heyday, though, ended at least 50 years ago. Still, “The First National Bank of Leechburg” remains carved in ten foot high letters at the top of the bank building’s facade, long after industry consolidation led the local bank to be absorbed by larger ones, including most recently, First Commonwealth.

  “Online traffic” is but a pretext for closing banking facilities that have not been profitable to operate since the last century.  The news article concluded saying “bank officials continue to work with the borough to find a best use for the building.”  In our experience, that is not Mission Impossible.

  Our friend Jim Mitnik repurposed the former Bank of Aspinwall building into a combination office and retail building by removing four successive dropped ceilings in the century old building, and by installing a second floor and an elevator.  That floor provides office space for multiple online business ventures, while the ground floor has been reconfigured for multiple retail tenants.  

PNC’s decision to close that banking location after it acquired National City Bank in the financial crisis 12 years ago led to the same sort of hand wringing by Aspinwall’s political and business leaders that Leechburg is now experiencing.  Mitnik told me, “they were worried, but now they are delighted.”  That is to say successful redevelopment of former bank properties is necessary to keep small retail districts vital.  When done well, it accomplishes that purpose.

Essential is the imagination and capital to support repurposing these structures.  Some communities, including Aspinwall, have demographics that will support reimagined retail and office uses.  Elsewhere, less obvious solutions are needed.  

  Franklin, Tennessee, outside Nashville, is home to a pre-Civil War church that lacked a parish hall type facility.  During that conflict, the church sanctuary became a hospital for Confederate wounded soldiers.  In the early 1990s, when the bank branch across the street closed, the church bought the land and building.  Today it serves as a parish hall on Sundays and as a community center during the week.   Problem solved.  A similar repurposing occurred in the Ohio town where I lived as a child.  Here too, a local church was the new owner/operator of what is now a community center.

  Some people may say taking commercial property off the tax rolls in this way is not in the community’s interest.  The alternative--vacant central business district property--is worse.  

 The current Covid-19 pandemic is forcing businesses everywhere to reevaluate their need for office and retail space.  Closings and bankruptcies will be next year’s business epidemic--one for which no vaccine can or will exist.

  “Reduce, reuse, recycle” is the mantra of environmentally-minded citizens.  It is an equally useful touchstone for those of us who are stewards of financial institutions and the communities they serve.

Digital Now

                Community banks have long differentiated themselves based on the “personal touch” they offer.  Yet bankers’ consensus opinion is that the ongoing pandemic is accelerating customers’ embrace of digital banking.  One regional bank recently touted the ease of using its new electronic mortgage loan application software.  The innovation’s limitation, in my opinion, is its erosion of the “personal touch” the same bank claims is its special sauce. 

                Five years ago, Jamie Dimon warned, “Silicon Valley is coming.”  JP Morgan in recent years has spent $10 billion per year on technology, 1/3 of which is devoted to “new initiatives.”  JP Morgan is engaged in an arms race with Apple, Amazon and their peers.  They must reinvest or risk irrelevance.

Regional and community institutions must find different ways to win and hold business.  The value of “personal touch” must be made real and fresh for customers in ways that touch them at their core.  The pandemic has put a spotlight on gaps in our social fabric.  Why not help fill the gaps in ways that create durable customer loyalty?   Consider a few examples.

                1.            Child Care.          High quality child care is a scarce and expensive social good.  It is also a need that most mortgage borrowers must fill.  Suppose a group of community banks in a metropolitan area pool their CRA grants and loans to support quality non-profit agencies’ child care programs.  The agencies in turn offer group discounts to those banks’ customers.  Advertising the mutual assistance effort creates good will for the banks and reminds customer prospects of the “personal touch” the bank brings to serving its clientele. 

                Hurdles to such a reimagining of the “personal touch” are real.  “Solving social problems is not why I went into banking as a career.”  “Child care is the government’s problem to solve.”  “My customers and prospects don’t have difficulty finding and paying for quality child care.”  Yet economists from all perspectives acknowledge the drag on the nation’s economy recovery is significant and growing as 1/3 of the U.S. workforce struggles to balance work and childcare duties.[1]  And what matters more to banks and bankers than having a healthy U.S. economy?

                2.            Senior Care.       Same model, except the featured products would be savings accounts and trust services.  Senior citizens need liquidity to pay for medical and social services not covered by Medicare.  Their children need a place to park mom and dad’s money, usually for medium and long duration.  For the busy children—in the prime of their lives—good service for mom and dad’s benefit is of greater value than the last 50 bps of deposit pricing.  The children need the help; so do mom and dad; the bank reaps multi-generational loyalty, which it can advertise to remind people the “personal touch” has not been lost despite the march of technology.

                3.            529 Accounts.    Customers attracted by child care benefits are well positioned to shift that spending into savings accounts when their children are in K-12 school years.  The economic disruptions of the pandemic and the financial crisis a decade ago are part of Millenial Generation’s life experience.  They should find attractive the opportunity to save some portion of the cost of their children’s higher education in FDIC insured accounts. 

                4.            Buy Fresh/Buy Local.      Community bankers know the deposits they gather are put to work as loans in the communities they serve.  Customers and prospective customers take that aspect of banks’ work for granted.  Why not make a bigger push to remind them?  The “buy fresh/buy local” theme has been effective in agriculture.  Even Wal-Mart now features local and regional products as a way to appear more connected to communities.  In our bank consulting practice, we have stemmed deposit outflows by framing campaigns that remind communities of the tangible benefits they receive from their local financial institutions.  The campaigns need to speak in clear and direct terms, like the Lee Iacocca line about Chrysler products, “If you can find a better car, buy it!” 

Digital financial services is a means not an end. It does not belong on a pedestal, however much dedicated personnel do to make it real and effective. Survival will require improving the customer experience in ways people value. Better technology is part of the value equation; but is the lesser part compared to preserving and extending the “personal touch.”

[1] https://www.washingtonpost.com/business/2020/07/03/big-factor-holding-back-us-economic-recovery-child-care/

Hard Cases

“Hard cases make bad law,” is a legal maxim Justice Oliver Wendell Holmes popularized in his 1904 dissenting opinion in Northern Securities Co. v. United States.[1] The Theodore Roosevelt Administration sued under the Sherman Act to block J.P. Morgan’s plan to consolidate three important Western railroads, saying the combination would create an illegal monopoly.  The case was the opening salvo in Roosevelt’s trust-busting campaign. Every U.S. Supreme Court justice knew his vote would make history.  Splitting 5-4, the Court blocked the railroad merger and laid down a series of rules that shaped business conduct for decades.  Northern Securities marked a turning point in the Supreme Court’s conception of the public interest.

Writing for four dissenting justices, including Chief Justice Fuller, Holmes opened with a rhetorical flourish that trivialized the case and denigrated the majority’s decision.   “Great cases like hard cases make bad law.  For great cases are called great, not by reason of their importance . . . but because of some accident of immediate overwhelming interest which appeals to the feelings and distorts the judgment.”[2]

Holmes presented his argument as one delivered from a jurisprudential Mt. Sinai.  Neither the plain words of the Sherman Act nor legal precedent supported the Court majority’s decision to expand federal authority over railroad combinations.  He was correct on both counts.  The Sherman Act outlawed contracts in restraint of trade, but not stock acquisitions or statutory mergers that had the same effect.  In the leading case precedent, United States v. E.C. Knight Co.,[3] the Court in 1895 ruled 8-1 against the government’s effort to break up the sugar monopoly created when U.S. Sugar bought a series of competitors.  The Court said manufacturing was a local enterprise rather than interstate commerce, and so was beyond the reach of the Sherman Act.  Chief Justice Fuller authored the majority opinion.

What Holmes’ dissent in Northern Securities failed to say was that the Sherman Act predated widespread revision of state corporation laws to facilitate corporate mergers and acquisitions.  Previously, corporation laws were restrictive, e.g., requiring an act of the state legislature to create a company.  Beginning in New Jersey in 1893, state legislatures rewrote corporation laws to be permissive rather than restrictive, including by making stockholders, directors and officers (rather than state legislatures) the arbiters of how corporations functioned.  Indeed, Northern Securities Co. was incorporated under the 1893 New Jersey corporation law.

Had the Sherman Act been written after corporation laws were modernized, the Act likely would have been drafted to reflect the new paradigm.  As for the Knight precedent, public opinion coalesced against monopoly power following a wave of corporate mergers and acquisitions that created monopolies in oil, steel, agricultural implements, tobacco and many other industries.  Lady Justice is blind; but justices read the newspapers.

J.P. Morgan was the villain of Northern Securities.  Three years later, he was a hero when he provided extraordinary liquidity to a collapsed financial market, staving off a depression.  The Panic of 1907 revealed the private sector’s limitations in the face of financial pandemic.  When Morgan died six years later, Congress created the Federal Reserve System to undergird the national economic enterprise.  The decade from Northern Securities to birth of the Federal Reserve System set the stage for seven decades that followed. 

Big government and big business skirmished often, but mostly they worked as partners that needed one another.  The federal government served and protected business by fiscal appropriations and legal regulation—from agricultural price stabilization to geographic and product price protection for banks, to engineering programs that sustained military and civil contractors, and their suppliers.  Big business made sure big government got what it needed—taxes, production and full employment.  Big government tolerated big business oligopoly power and pricing as long as it did not get out of hand.  

Manufacturing employment peaked in 1975.  Congress in 1979 heard testimony from General Electric, Caterpillar and other big companies that urged extension of the Sherman Act and other laws to block foreign government-sponsored businesses’ anticompetitive behavior in the U.S. market.  Nothing came of the effort.  U.S. companies shifted production to low-wage Asian nations.  Meanwhile technology companies rose, displacing manufacturers as the primary source of new jobs, just as manufacturers displaced agriculture a century earlier.  Similarities between the two periods of U.S. history prompted commentators to call ours the Second Gilded Age, the last decades of the 19th Century being the first.

Has the Second Gilded Age run its course?  Are we at an inflection point like Northern Securities, when the Supreme Court tacitly overruled its decision in Knight only nine years later?   In my opinion, we are there.  The precipitating events are not oft-cited economic conditions of the moment, such as income inequality, export of manufacturing jobs and big tech companies’ tax avoidance by keeping large cash balances offshore.  The cause is pandemics and, particularly, the scale of the required response.

Covid-19 is the second pandemic of our time.  We imported it from China by way of Europe.  We—most of us—gave it short shrift, because it was there and we are here.  But the world is smaller now than it was.  Today’s longest range commercial aircraft can fly nonstop nearly half way around the world, twice the distance Boeing’s 747 planes could fly when introduced in 1970. 

The first pandemic was the Global Financial Crisis of 2008.  We created and exported that one to other nations.  The interconnectedness of financial institutions around the world caught us by surprise.  Then as now, only trillion-dollar-scale, multi-nation-state action ended the contagion.  Now as then, private sector action is necessary, but not sufficient.  And the private sector’s return to health requires unprecedented public investment.  Eventually, the public will earn a return many times its investment—as civilian employment recovers and governments collect taxes and reap other benefits.  In the meantime though, the federal government needs to shoulder the load because nobody else has shoulders broad enough to bear it.

The current crisis is so fresh, its scale and lasting effects are yet to be fully absorbed.  Likely, a vaccine will emerge to blunt Covid-19’s effect.  What will not change is our newfound sense of vulnerability to international contagion.  That will remain, just like the bollards that now ring fence federal buildings in every American city. 

In Knight, Chief Justice Fuller wrote confidently for his 8-1 majority. He was certain about the verities of his world.  Outvoted 5-4 in Northern Securities, he allowed Justice Holmes, the second most junior justice on the Court, to author the stronger of the two dissenting opinions.  For Fuller, the defeat must have been a bitter pill.  Seldom has a chief justice seen his work in a landmark case reversed during his own Court tenure.[4]

The different result from Knight was not due to change in Court personnel.  The four associate justices seated after the Court decided Knight split 2-2 in Northern Securities.  Rather, the difference was Justices Brewer and Brown, who were in the majority in both cases.  To them, the world had changed around them and their decision changed with it.  Fuller stoically, silently remained rooted in the Gilded Age.  By 1910, he was dead. 

Like the Court in Northern Securities, we are called to reconsider beliefs and behaviors we have experienced as normative for a lifetime.  We are also called to create new patterns for our future and that of our descendants.  The world will adapt.  Will we?

[1] 193 U.S. 197 (1904).

[2] 193 U.S. at 400.

[3] 156 U.S. 1 (1895).

[4] Other examples include the Supreme Court’s switch during the Great Depression from scotching New Deal legislation on constitutional grounds to upholding it (see West Coast Hotel Co. v. Parrish, 300 U.S. 379 (1937)(the so-called “switch in time that saved nine”)) and the Legal Tender Cases, Hepburn v. Griswold, 75 U.S. 603 (1870) and Knox v. Lee, 79 U.S. 457 (1871).

Redefining Control

Banks and businesses have a symbiotic but occasionally fraught relationship.  The great industrial enterprises of 100 plus years ago made substantial banks necessary and possible.  They also imperiled the nation’s financial system during the Great Depression.

The immediate cause of the banking crisis of 1933-34 was Henry Ford’s refusal to bow to the Treasury Department’s demand that he convert his deposits in Detroit’s Union Guardian Trust Company (which the Ford family controlled) to capital so the bank remained solvent.  Treasury Undersecretary Arthur Ballantine and Commerce Secretary Roy Chapin (an industrialist himself, who had run the Hudson auto company) traveled to Detroit, met with Ford and pleaded with him to adopt the plan Treasury formulated. They said if he did not relent he would destroy every bank in Michigan.  Ford replied, if people had to endure a banking crisis, it would make them work harder, which would be good for them.  Within days, deposit runs escalated at Union Guardian and other Detroit banks, then across Michigan and eventually nationwide.  Within 48 hours of taking office, Franklin Roosevelt put the nation’s banks on holiday, where they stayed for 15 months.

Fast forward 22 years to 1956.  Fearing the economic power of merged industrial and banking interests, and remembering the roots of the banking crisis of 1933-34, Congress passed the Bank Holding Company Act (the “Act”) to prevent such mergers.  The Act set a low bar for what constituted control of a bank: ownership of 25% of a bank’s voting securities or the power to elect a majority of directors.  Any party that acquired such control was legally deemed to be a bank holding company, subject to regulation as such by the Federal Reserve System.  To industrialists, that was a fate worse than death.

In 1970, Congress added a third test, saying control existed when the Fed “determines after notice and opportunity for hearing, that the company directly or indirectly exercises a controlling influence over the management or policies of the bank.”  This addendum transformed “control” into a “facts and circumstances” test, further expanding the Fed’s power.  The Fed also narrowed the zone of permitted investments by establishing rebuttable presumptions of control that kick in at 10% ownership of voting securities or, in limited circumstances, at 5%.   As a Fed-imposed condition to making their investment, investor-owners of 5% or more of a bank’s voting securities are frequently required to sign “passivity commitments” agreeing not to take an active role in bank management or governance. 

All these strictures served the purpose of requiring bank ownership to be widely distributed.  They also put banks off limits to many of the nation’s most important sources of capital investment in the last 40 years—private equity firms, technology companies and the people who accumulated wealth in both those venues.

   One can argue this arrangement serves the public interest by insulating banks from Henry Ford-like behavior and from predatory speculations of the sort that wrecked many industrial companies at the hands of the recently-pardoned Michael Milken and his brethren.  But the arrangement also had unintended, and arguably undesirable, consequences. 

1.       Industry Consolidation. JPMorgan Chase, Citibank, Wells Fargo and Bank of America today operate as an oligopoly that controls two-thirds of the nation’s banking business.  The industrial pillars that supported regional banks were wiped away in the late 20th Century.  With them went most regional banks.  Too, the Fed under Alan Greenspan venerated the efficiency they believed bank consolidation created and discounted the risks that came with it. So the concentrated economic power that Congress sought to prevent in 1956 came to pass anyway.  The result has been a witch’s brew for all parties, as Wells Fargo’s recent history best demonstrates.

2.       Capital Starvation.           By number, community banks predominate—5,500 of them, more or less, across the nation.  Many customers, including me, prefer to deal with them because of the personal nature of banking relationships one can develop.  But the challenges of sustaining profitability, growing the business and replacing shareholders who grow old and desire liquidity make community banking one of the most difficult briefs to fill in the financial services business today.  Public share ownership is not worth the expense.  Private equity investment is unavailable due to the Fed’s restrictive definition of control.  Technology continues to erode profitability.  And competition from non-banks is ever present and growing.

3.       Business Innovation.      Sometimes innovation works well, or at least well enough, e.g.,PayPal.  Other times innovation fails, e.g., NextBank, N.A., an Internet-only credit card bank that flamed out as PayPal took wing 20 years ago.  The Fed’s control rules stifle innovation, or at least ensure it will be done predominantly by non-bank enterprises.  The resulting risk to banks is competitive disadvantage compared to tech firms and more nimble non-bank financial firms.

In the face of these constraints, effective April 1, the Fed will modestly liberalize its control presumptions to make non-control investments in banks more feasible.  The principal change is to create a matrix of progressively greater restrictions as the size of an investment rises from 5% to 25% of a bank’s equity capital.  Intermediate breakpoints are 10% and 15%.  For example, a company that owns 15% of a bank’s voting shares is presumed to control the bank if the company can appoint or elect the bank’s board chair or someone from the company is a “senior management official” of the bank.  Below 15%, however, those restrictions do not apply.[1] 

Some requirements are graduated.  Thus, intercompany transactions between a bank and another company cannot represent 5% or more of the bank’s total annual revenues or expenses when 10% of the bank’s equity securities are owned by the company.  At the 15% ownership level, 2% or more of annual revenues or expenses is the level at which control is presumed to exist. 

      These and other changes to the control standards are baby steps, to be sure.  They represent a shift in the wind at the Fed and other regulatory agencies.  Bankers and investors too must adjust their thinking and behavior rather than always doing what they have always done.  The financial sector remains the foundation of our economy.  It needs renewed strength from within, not just vendors bringing new products and services from outside boundaries the Fed sets.

[1] 12 C.F.R. § 225.32(f).

Caremark Duties and the Careful Observer

Most company directors understand the fiduciary duties of care and loyalty they owe to the companies they lead.  Two recent Delaware law decisions, involving what are colloquially called Caremark duties, bolster the idea that directors must thoughtfully monitor regulatory compliance by their companies. 

Caremark duties consist of the board of directors’ responsibility to make sure management reporting systems are in place and are followed so that the board has knowledge of company performance.  In re Caremark Litigation Inc. Derivative Litigation[1] involved Caremark’s payment of $250 million to settle a Department of Justice investigation into Caremark’s illegally paying medical professionals for patient referrals.  Delaware Chancery Court Chancellor Allen wrote,

[A] sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists—will establish the lack of good faith that is a necessary condition to liability [for breach of fiduciary duty].[2]

This expression of the duty deliberately set a low bar for director performance, lower even than gross negligence.  As a result, in the two decades since Caremark, derivative litigation plaintiffs have enjoyed scant success.  Even the most egregious board governance failures of the 2008 Financial Crisis did not lead to plaintiff victories.  For example, the Chancery Court dismissed Caremark-based derivative litigation against Citigroup directors, even though the company would have failed catastrophically but for its federal bailout.[3]

Two recent cases, Marchand v. Barnhill,[4] and In re Clovis Oncology, Inc. Derivative Litigation,[5] reveal Delaware courts have just raised the Caremark duties bar.  In Marchand, ice cream manufacturer Blue Bell Creameries USA suffered a listeria outbreak in 2015, leading to three deaths, recall of the company’s products and temporary shutdown of its manufacturing operations.  Plaintiffs grounded their fiduciary duty claims on food safety standards set by the Food and Drug Administration (FDA).  FDA regulations require companies like Blue Bell to have a written food safety plan, including having a process for identifying and analyzing hazards, implementing preventative controls and sanitation protocols, and having management monitor implementation of these measures.

Beginning in 2009, FDA and state food safety inspections of Blue Bell facilities showed repeated violations, including positive tests for listeria bacteria.  Management withheld this information from the board of directors.  The board of directors meeting minutes reflected only brief discussion of “operational issues” and only one specific mention of food sanitation inspection findings.

The Delaware Chancery Court dismissed the plaintiff’s case against Blue Bell, saying “[w]hat Plaintiff really attempts to challenge is not the existence of monitoring and reporting controls, but the effectiveness of monitoring and reporting controls in particular instances.”[6]  Shades of Citigroup.

On appeal, the Delaware Supreme Court reversed.  Although the ruling was procedural rather than a decision on the merits of the case, the court made plain its intent:

If Caremark means anything, it is that a corporate board must make a good faith effort to exercise its duty of care.  A failure to make that effort constitutes a breach of the duty of loyalty.  Where, as here, a plaintiff has followed our admonishment to seek out relevant books and records and then uses those books and records to plead facts supporting a fair inference that no reasonable compliance system and protocols were established as to the obviously most central consumer safety and legal compliance issue facing the company, that the board’s lack of efforts resulted in it not receiving official notices of food safety deficiencies for several years, and that, as a failure to take remedial action, the company exposed consumers to listeria-infected ice cream, resulting in the death and injury of company customers, the plaintiff has met his onerous pleading burden and is entitled to discovery to prove out his claim.

As in Marchand, directors in Clovis Oncology were sued for not addressing regulatory-related problems in their business.    They did not fail to establish a system to monitor mission critical conditions though.  They failed to act on information that showed the company’s mission itself was failing.

  Clovis Oncology had three developmental stage drugs.  The most promising, Roci, was designed to treat a previously-untreatable type of lung cancer.  AstraZeneca was simultaneously bringing to market a competing drug, Tagrisso.  The addressable market was $3 billion annually.  For its clinical trial of Roci, Clovis Oncology chose a standardized and well-known clinical trial protocol named “RECIST”.  A key metric for measuring drug success using RECIST is the “objective response rate” (ORR)—the percentage of patients who experience meaningful tumor shrinkage when taking the medication.  For reporting purposes in the RECIST protocol, only after tumor shrinkage is “confirmed,” i.e., measured again and found again to be shrunken, can it be counted toward ORR.

In its race with AstraZeneca, Clovis Oncology management fudged its clinical trial results by including unconfirmed tumor scans and reporting a 58% ORR rate.  “Management told the board . . . ORR would improve ‘as patients get to their second and third scans.’  By definition then, the ASCO ORR was partially based on unconfirmed results (i.e., it was not RECIST compliant).  Notwithstanding this revelation, the board did nothing.”[7]

For two years, Clovis Oncology overstated to both the FDA and its stockholders the ORR rate for Roci by including both confirmed and unconfirmed data.  The board of directors knew about this sleight of hand, but let it stand.  The Board also learned that Roci had “serious, undisclosed side effects and that the [clinical] trial had been compromised by other clinicial trial protocol violations.”[8]  Writing for the Chancery Court, Vice Chancellor Slights concluded,

ORR was the crucible in which Roci’s safety and efficacy were to be tested.  Roci was Clovis’ mission critical product.  And the Board knew, upon completion of the [clinical] trial, the FDA would consider only confirmed responses when determining whether to approve Roci’s NDA per the agency’s own regulations.  As pled, these regulations, and the reporting requirements of the RECIST protocol were not nuanced.  The Board was comprised of experts and the RECIST criteria are well-known in the pharmaceutical industry.  Moreover given the degree to which Clovis relied upon ORR when raising capital, it is reasonable to infer the Board would have understood the concept and would have appreciated the distinction between confirmed and unconfirmed responses.  The inference of Board knowledge is further enhanced by the fact the Board knew that even after FDA approval, physicians (i.e., future prescribers) would evaluate Roci based on its ORR. . . .  I am satisfied [plaintiffs’] have well-pled that the Board consciously ignored red flags that revealed a mission critical failure to comply with the RECIST protocol and associated FDA regulations. [9]

The common denominator of these two cases—director performance in a regulated business—makes the plaintiff’s case easier to make out and gives the Delaware courts’ extension of Caremark liability greater purposefulness.  The regulatory framework is an objective, publicly available index of required behaviors.  Directors’ disregard of it makes the plaintiff’s case for him or her. 

Too, the public policy reasons for the regulatory framework—protecting public health and safety—makes the case stronger for holding directors to a higher standard of performance in their fiduciary role.  Vice Chancellor Slights summed the Chancery Court’s view in 16 words: “The careful observer is one whose gaze is fixed on the company’s mission critical regulatory issues.”  Interesting to watch will be whether courts in Delaware and other jurisdictions apply the Marchand/Clovis Oncology reasoning in cases touching other regulatory regimes—financial services, telecommunications, consumer product safety and more.  Our bet is they will. 

---

[1] In re Caremark Int’l Inc. Derivative Litigation, 698 A.2d 959, 971 (Del. Ch. 1996).

[2] Id.

[3] In re Citigroup Inc. Derivative Litigation, 964 A.2d 106 (Del. Ch. 2009).

[4] 212 A.2d 805 (Del. 2019).

[5] C.A. No 2017-0222-JRS (Del. Ch. Oct. 1, 2019).

[6] Marchand, 2018 WL 4657159 at *18 (emphasis in original).

[7] Clovis at 16.

[8] Id. at 23.

[9] Id. at 43.

When Software Fails

            A bank client found itself in a world of hurt after a lending officer detected and exploited a defect in the bank’s loan accounting software.   The lending officer “lent” money to his accomplices far in excess of the bank’s dollar limit for individual loans. 

When the scheme collapsed, the bank sued the banker and his accomplices.  The bank should have sued the software vendor.  The software was written to enable lending.  It should also have been designed to flag the obvious risk of over-lending to individual borrowers.  This defect was a product failure, no less than the software failures that crashed Boeing 737 Max aircraft recently. 

For both the bank and Boeing, the process that went haywire was standard operating procedure: manufacturing loans at the bank or flying commercial aircraft at Boeing.  Along the way, people got sloppy.  They met sales goals and delivery date targets at the expense of serving mission critical objectives.  The difference is we do not think of bank software-induced crises as being products liability cases in the way we do Boeing’s failure.  We should.

Given the regulatory regimes that apply to banks and commercial aircraft, it is tempting to look there for a solution—to regulate bringing financial software to market the way the Federal Aviation Administration does commercial aircraft.  Public pressure for that result is growing, framed mostly in terms of protecting consumer privacy.[1]  The Boeing story though is a reminder that regulators can be fooled no less than end users.  And the last century’s experience of regulatory capture by the largest companies in regulated industries reminds us regulation can stifle innovation and useful competition.

Our view is that financial companies can and should face the problem head on.  Here are a few measures that are available within the resource set most financial companies have at hand.

1.         “Think outside the box” is a cliché.  It is also a useful discipline.

Just published, A Game of Birds and Wolves[2] recounts how a cadre of college age women in WW II England helped keep the nation’s citizens from starving in the face of German U-boat attacks on supply ship convoys crossing the North Atlantic.  As tonnage losses mounted and economic collapse loomed, the Admiralty tasked a disabled officer and dozens of women serving in the naval auxiliary to study the problem.  The Wrens (as the women called their group) created a theatre-sized board game that allowed them to replay sea battles based on after action reports.  To represent the North Atlantic, they painted a grid on the floor of the large room they used for their work.  They marked individual ship movements with chalk.  They made game players—admirals, merchant marine captains and others—stand behind screens with slits cut in them, replicating the view from the bridge of a convoy ship.  The players then called out moves of their ships as the battle evolved on the floor in front of them. 

The Wrens discovered the Allied command misunderstood German tactics.  Navy men believed U-boats were attacking from outside a convoy’s perimeter.  Positioned along the perimeter, each Navy destroyer ship would chase any U-boat it spotted and fire depth charges in an effort to sink it.

In actual practice, German U-boats attacked en masse from the rear of a convoy, surfaced within it, fired torpedoes at point blank range, then dove to allow the convoy to pass over the U-boats’ positions.  Upon making this discovery, the Wrens redesigned the Navy’s tactical response.  Destroyers were instructed to break from the convoy in a group and mount a coordinated counterattack.  The destroyers’ routes were plotted and tracked on a grid to cover the entire area where the U-boats likely were hiding.  When the tactic worked and cargo tonnage losses declined, skeptical Navy men became believers and the U-boat threat receded.

In business, taking that sort of “let’s step back and think about it” approach is not an accounting exercise.  Or a legal one.  It’s a matter of imagining alternative, possible events rather than considering only those judged to be actual or likely.   In the realm of software, it requires not only being excited by what newly purchased software can do, but asking what needs to be done that the software does not do, or does not do as well as we need it to be done? 

2.         “Just because the software says it, does not make it so.”  Beware false positives, and identify where, how and why they arise.  Published last week on the Internet was a video of a man pulling a child’s red wagon loaded with 99 smart phones down a three lane street in Berlin, Germany.  The video showed almost no vehicular traffic.  Yet Google Maps showed extreme traffic congestion.  We all take software-generated output as gospel.  We need to be appropriately skeptical.

3.         Proper risk management requires rethinking a company’s approach to negotiating software licenses.  Map and view the topology of all company software.  Create a licensing template of acceptable business and legal terms, and follow it.  Escrows and reserves for negative IT surprises should be the norm, no less than for credit losses.  Do not blithely cave in to warranty and damages limitations in software contracts.  Financial companies have standards and procedures for everything from colors used in advertising to financial reporting.  Why is software any different? 

4.         Think expansively about relationships you can use for help when you encounter a problem.  Verizon told a bank client it would be “a couple days” before Verizon could address a software problem that threatened to shut down the client’s branch banking business.  I telephoned a former partner who had also been a state public utility commissioner.  Within three hours the problem was solved.  The client did not know who I knew when it called me; but the client though enough to ask what I might be able to do to assist.

5.         Do think about products liability law to redress software failures.[3]  To have a viable case, one must have negotiated rights and remedies defensively, as suggested in paragraph 2 above.  But that is not a bridge too far by any means.  The 20th Century saw American law move from permitting financial recoveries only when one could prove negligence, to a rule of strict liability in tort in some cases.  The shift came because industrial products and the stream of commerce became so complex that it was no longer possible to prove negligence.[4]  Software will increasingly be subjected to the same legal standards that apply in the realm of complex manufactured goods like automobiles.

As software continues to become more mission-critical in financial companies, failures will be more complex and damage more widespread.  In early January, multiple large U.K. and European banks curtailed foreign exchange operations after money transmitter Travelex was crippled by a ransomware attack.  One expert observed, “If there was ever any doubt that a cyber attack could have a significant effect on financial markets, this proves otherwise.”[5]

Up next: What do new developments in electronic financial services mean for the Board of Directors’ evolving “duty of oversight”?

 

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[1] “The Government Uses ‘Near Perfect Surveillance’ Data on Americans--Congressional hearings are urgently needed to address location tracking,”  https://www.nytimes.com/2020/02/07/opinion/dhs-cell-phone-tracking.html.

[2] S. Parkin, A Game of Birds and Wolves: The Ingenious Women Whose Secret Board Game Helped Win World War II (2020).  

[3] For an early argument that software should be treated the same as industrial products for legal liability purposes, see https://resources.sei.cmu.edu/asset_files/TechnicalReport/1993_005_001_16187.pdf.   

[4] When Gladys Escola stocked bottles of Coke in the refrigerator at the restaurant where she worked as a waitress, one bottle exploded in her hand, injuring her severely.  The California Supreme Court said she deserved to be compensated for her loss even though she could not prove the Coca Cola bottler was negligent when it packaged the soda in the bottle.  Escola v. Coca Cola Bottling Co., 24 Cal. 2d 453 (1944).  

[5] https://www.insurancejournal.com/news/international/2020/01/08/553885.htm

A Matter of Experience

“The life of the law has not been logic; it has been experience. . . .  The law embodies the story of a nation’s development through many centuries, and it cannot be dealt with as if it contained only the axioms and corollaries of a book of mathematics.”  --Oliver Wendell Holmes, Jr., The Common Law (1881).         

Many Americans recognize Oliver Wendell Holmes’ above-quoted statement as a civic touchstone.  Most understand it as a bromide promoting stability in the law, rooted in human experience “through many centuries.”  In truth, Holmes’ argument was to an opposite end.  He acknowledged the need to consider centuries of legal precedent, but viewed the nation and its laws as evolving together. 

Holmes cloaked his forward-look in reverence for precedent to win support for novel legal positions he took.  In 1881, he was 40 years old, only 15 years into a 65 year career as a lawyer and, later, a jurist.  The U.S. government had yet to observe its centenary and had barely survived the Civil War.  But the war-time expedient of a national currency, the “greenback,” had succeeded, helping foster westward expansion via a growing network of railroads through the nation’s midsection.   In 1881, the United States numbered 36; another nine states joined the Union before century-end.  The country was filling out its frame like a teenager, and the adult nation was coming into view.

            The four decades since 1980 reflect a parallel shift, one made by an economically mature nation, on an international scale, and with information technology rather than steam, oil and electricity as the means of transformation.  Pundits have called ours the Second Gilded Age, as pioneers like Peter Thiel, Elon Musk and Mark Zuckerberg make rules they desire the rest of us to live by.  Thiel even funded efforts to establish a man-made island nation in the Pacific Ocean, where technology rather than civil law would set all rules of human engagement.  The effort failed dismally.

            After publication of The Common Law, Holmes’ career reflected a successful balancing of old and new.  Ironically, though, many legal issues arising now in the technology-shaped economy have antecedents in Holmes’s time on the bench.  Consider, for example, two cases 113 years apart, each of which upended prevailing law governing sale of dangerously defective products.

            In McPherson v. Buick Motor Company,[1] McPherson sued Buick after a rear wheel of his automobile collapsed while he was driving, injuring people in the vehicle.  Buick defended the case on the then-prevailing legal rule that a party injured by a defective product could make claims against the party that sold him the product, but not against its manufacturer if the manufacturer was not the immediate seller.  Buick said it purchased the wheel from a supplier and did nothing but install it on the vehicle, which it then sold to a Buick dealer, which sold it to McPherson.  Because no direct contractual relationship existed between Buick and McPherson, no lawsuit could be maintained.

            At trial in New York state court, the trial judge instructed the jury it could find Buick liable to McPherson if Buick failed to inspect wheels it installed on its vehicles.  On appeal, the New York Court of Appeals (the highest court in the state) sustained the trial judge’s jury charge and the jury’s verdict against Buick.  Judge Benjamin Cardozo’s majority opinion marked a sea change in American law and the industrial economy.  He wrote,

We think [Buick] was not absolved from a duty of inspection because it bought the wheels from a reputable manufacturer. It was not merely a dealer in automobiles. It was a manufacturer of automobiles. It was responsible for the finished product. It was not at liberty to put the finished product on the market without subjecting the component parts to ordinary and simple tests. Under the charge of the trial judge nothing more was required of it. The obligation to inspect must vary with the nature of the thing to be inspected. The more probable the danger, the greater the need of caution.[2]

            Last year, in Oberdorf v. Amazon.com, [3] Amazon made, and the Third Circuit Court of Appeals rejected, the argument Buick made in McPherson.  Via Amazon, Ms. Oberdorf bought a dog leash.  When it broke, hardware on the leash snapped back, her eyeglasses broke and she was blinded in one eye.  The dog leash’s seller, the Furry Gang, sold the dog leash via Amazon and shipped it from the Furry Gang’s Nevada location.  By the time of the litigation, the Furry Gang was defunct.  The Third Circuit applied Pennsylvania law in deciding the case.  Its opinion is a reprise of Judge Cardozo’s discussion.

Amazon's role extends beyond that of the sales agent [in a precedential case cited by the Court], who in exchange for a commission merely accepted orders and arranged for product shipments. Amazon not only accepts orders and arranges for product shipments, but it also exerts substantial market control over product sales by restricting product pricing, customer service, and communications with customers.  Amazon's involvement, in other words, resembles but also exceeds that of the sales agent labeled a "seller" in [the case precedent].

At oral argument, Amazon contended that it should not be likened to a sales agent because it lists products and collects payment on behalf of various third-party vendors, whereas a sales agent typically represents a single seller or manufacturer. This is a distinction without a difference. Pennsylvania state courts have repeatedly found that large retailers who offer a range of different products are "sellers" within the meaning of [ Pennsylvania law governing liability for defective products].  Amazon is not exempted from strict products liability simply because its website offers a variety of products.

Like McPherson in relation to the 1916 universe of cases involving defective automobiles, the Oberdorf decision is the first appellate level decision to go against Amazon and similar Internet-enabled businesses.  In our view, Oberdorf reflects judicial recognition of the pervasiveness of e-commerce as well as growing public support for greater accountability of e-commerce giants like Amazon.  Other areas of the law are undergoing a similar shift: tax (both sales and corporate income tax), antitrust and trade regulation, and health and safety laws, to name a few.

The implications of Oberdorf are particularly significant for electronic financial commerce—for banks, for businesses and for consumers.  Today, most of us buy the financial services equivalents of Ms. Oberdorf’s dog leash without considering, or without having the negotiating power able to modify, limitations of warranty and liability imposed by the seller or the e-commerce platform company through which we acquire the product or service.  Only when the product or service fails, do we read the fine print and discover our rights are few and prohibitively expensive to enforce.  This problem is as great for the average American bank as it is for consumers.  Who among them has the means to litigate against First Data, FiServ or Salesforce?

Products liability and remedies in the financial services arena will be the subject of our next column.  We will explore how precedent can be useful, as well as its limits.  In the meantime, thank you for again reading our work.  We look forward to continuing our conversation and welcome your feedback.

[1] McPherson v. Buick Motor Co., 217 N.Y. 382 (1916).

[2] Id. at 394-395 (1916)(citation omitted; emphasis added).  Notably, until the mid-20th Century, the New York Court of Appeals (the state’s highest court) was the most influential state court in the nation, both because of its judicial precedents and because it sent the greatest number of judges to the Supreme Court  of the United States.  Aware of the significance of the McPherson decision when the Court of Appeals published it, Chief Judge Willard Bartlett filed a lengthy dissent.  He cited English precedents that Cardozo rejected (which involved wheel failures on horse-drawn carriages) and said there was no reason to treat automobile-caused injuries and horse-drawn carriage injuries differently.  The last two quoted sentences of the majority opinion implicitly reject Bartlett’s argument and set a higher standard of care where complicated manufactured goods are involved.

[3] Oberdorf v. Amazon.com Inc., 930 F. 2d 136 (3rd Cir. 2019),  available at https://scholar.google.com/scholar_case?case=15553864645444846673&hl=en&as_sdt=6&as_vis=1&oi=scholarr

Does Financial Privacy Have a Future?

 Of all words, “privacy” holds the top spot for being honored in the breach more than in the observance.  Virtually every Terms of Service document published in the last five years opens with a proclamation of the vendor’s commitment to “transparency” and respect for user “privacy.”  Inevitably there follow pages of legal permissions and disclaimers by which the user acknowledges he or she has no privacy protection and absolves the Terms of Service vendor of responsibility for theft of user data.   

                When faced with this reality, our first instinct as user/citizens is to seek boundaries to protect important categories of information—health data, financial data, demographic data, and so forth.  Congress occasionally obliges.  The Health Insurance Portability and Accountability Act and the Right to Financial Privacy Act are examples.  Without defining permissible and impermissible uses of data, however, any protection of private information is a dead letter.  Since uses of information are innumerable and their purposes range along a continuum from beneficent to evil, trying to establish permissible uses of sensitive information threatens to become overwhelming.

Another hurdle arises when information that is of no particular value in one context becomes invaluable in another.  During WW II, 20 year old Freddie Heineken passed to the Allies the Wehrmacht’s beer requisitions for its troops on the Western Front.  This information gave the Allies a daily reckoning of troop locations and strength during and after the D-Day invasion. 

In the 1987 movie Wall Street, ambitious young Bud Fox motorcycles to the airport to learn a wealthy investor’s destination from airport employees who dispatched the private plane carrying the investor.  “Erie, Pennsylvania,” is all they say.  The tip enables Fox’s mentor Gordon Gecco to identify the soon-to-be-target of a corporate tender offer, accumulate the target’s stock and make a financial killing.  In real life, the target was Erie’s Hammermill Paper.  Gecco’s real life counterpart, Paul Bilzerian, was convicted of securities fraud and tax evasion on the $31 million profit he made trading Hammermill stock in 1986.

                 Until 50 years ago, legal privacy claims were mostly the subject of criminal cases, especially Fourth Amendment challenges to searches and seizures.  In Hoffa v. United States (1966), Jimmy Hoffa appealed his 1964 conviction on jury tampering charges, claiming the government’s evidence was gathered in the privacy of his hotel suite by a criminal informant whom Attorney General Robert Kennedy’s team infiltrated into Hoffa’s inner circle of aides at a 1962 trial for racketeering.  Rejecting Hoffa’s argument, Justice Stewart wrote for the Court:

“What the Fourth Amendment protects is the security a man relies upon when he places himself or his property within a constitutionally protected area, be it his home or his office, his hotel room or his automobile. There he is protected from unwarranted governmental intrusion. And when he puts something in his filing cabinet, in his desk drawer, or in his pocket, he has the right to know it will be secure from an unreasonable search or an unreasonable seizure. So it was that the Fourth Amendment could not tolerate the warrantless search of the hotel room in Jeffers, the purloining of the petitioner's private papers in Gouled, or the surreptitious electronic surveillance in Silverman. Countless other cases which have come to this Court over the years have involved a myriad of differing factual contexts in which the protections of the Fourth Amendment have been appropriately invoked. No doubt the future will bring countless others. By nothing we say here do we either foresee or foreclose factual situations to which the Fourth Amendment may be applicable.”

In United States v. Miller (1976), the Court applied those words from its Hoffa opinion to bank customer records required to be retained under the then new Bank Secrecy Act.  Defendant Miller and his friends made and sold moonshine.  The federal government subpoenaed his bank account records, but did not obtain a search warrant.  The records showed he purchased equipment and supplies useful for building and running a distillery.  At trial, the federal judge overruled Miller’s motion to exclude the bank records as evidence for lack of a search warrant.  The Fifth Circuit Court of Appeals reversed, writing, “a compulsory production of a man's private papers to establish a criminal charge against him . . . is within the scope of the Fourth Amendment [protection against warrantless searches and seizures].”  The U.S. Supreme Court reversed the Court of Appeals’ decision:

 “We think that the Court of Appeals erred in finding the subpoenaed documents to fall within a protected zone of privacy.

On their face, the documents subpoenaed here are not respondent's ‘private papers.’ Unlike the claimant in Boyd [the Supreme Court decision cited by the Court of Appeals as precedent], respondent [Miller] can assert neither ownership nor possession. Instead, these are the business records of the banks. As we said in California Bankers Assn. v. Shultz, ‘[b]anks are . . . not . . . neutrals in transactions involving negotiable instruments, but parties to the instruments with a substantial stake in their continued availability and acceptance.’

The records of respondent's accounts, like ‘all of the records [which are required to be kept pursuant to the Bank Secrecy Act,] pertain to transactions to which the bank was itself a party.’”

Three years later, in Smith v. Maryland (1979), the Court took the same approach in a case involving government access to citizens’ telephone records.  Where consumers “voluntarily” provide their personal information to third parties, the Court said, they have no constitutional entitlement to privacy.  Thus was born what came to be called the “Third Party Doctrine.”

In both Miller and Smith, the Court’s focus on banks’ or the phone companies’ role as custodians of business records gave the Court’s decisions a more neutral cast than they deserved.  For the only protectable privacy interest at stake belonged to the defendants.

In Hoffa, Chief Justice Warren dissented, arguing the government’s conviction of Hoffa was fatally tainted by the false pretenses under which the government gathered its evidence.  In Smith, Justice Brennan dissented, saying it defied common sense to suggest late 20th Century Americans have a choice whether to use banks or telephone companies.  Both dissents resonated then and now.  Nevertheless, the Third Party Doctrine became a pillar of government investigations and prosecutions, from 1980’s Mafia cases to today’s Robert Mueller-led investigation.  Then, in June of this year, the Supreme Court signaled a shift in direction.   

In Carpenter v. United States, the Court heard the appeal of Mr. Carpenter, who was convicted of being part of a seven man armed robbery team that relieved Radio Shack and T-Mobile stores of their smart phone inventories.  The government’s case against Carpenter relied on cell phone location data that placed Carpenter in proximity to the robbery sites when the robberies occurred.  Carpenter challenged use of this information on Fourth Amendment grounds.  The Court held 5-4 that the government cannot access historical records containing the physical locations of cell phones without a search warrant.  Signaling the case’s importance, Chief Justice Roberts authored the majority opinion.  Sounding like Justice Brennan dissenting in Miller, Roberts wrote:

“[S]eismic shifts in digital technology made possible the tracking of not only Carpenter’s location but also everyone else’s, not for a short period but for years and years. Sprint Corporation and its competitors are not your typical witnesses. Unlike the nosy neighbor who keeps an eye on comings and goings, they are ever alert, and their memory is nearly infallible. There is a world of difference between the limited types of personal information addressed in Smith and Miller and the exhaustive chronicle of location information casually collected by wireless carriers today.”

In our view, what the Chief Justice said is less important than what he left unsaid but clearly had in mind as the foundation for the majority’s ruling:  The wealth and power that technology and media companies have amassed is fearsome, whether in the hands of the government or industry, and constraints on its use are appropriate.  The C.J. included in his opinion the obligatory disclaimer—this opinion is to be read narrowly and limited to its facts.  He also said the decision does not change the applicability of the Third Party Rule to financial institution records.  Do not bank on that.

Also in our view, the Third Party Doctrine’s hourglass has been inverted.  The only question is how quickly the sand will flow.  Verizon bought Yahoo and AOL last year. With them, it acquired financial applications like Yahoo Finance and Tech Crunch.  If a latter day Gordon Gecco uses Yahoo Finance to trade Facebook stock based on inside information, will the SEC follow Carpenter and obtain a search warrant to probe the user’s Verizon Wireless account?  Or will the SEC adhere to Smith and the Third Party Rule, and issue a subpoena duces tecum to obtain Yahoo Finance financial records?  Is there any difference?  Not according to Verizon.  On its website, the company’s privacy policies cover both media and telecom properties as an integrated product and service package.

The boundary conflict over technology’s transformation of our world promises many legal twists and turns ahead.  Carpenter is a reminder that sometimes out of favor ideas regain favor.  Or principles liberals champion in one era conservatives may embrace in another. 

As businesses and consumers transition to electronically delivered financial services, providers will do well to monitor non-financial legal trends involving data and its use.  No matter the industry, customer loyalty depends on trust.  In the digital world, that is an asset whose acquisition can be breathtakingly rapid, as can its loss.  Just ask Facebook.

“We’ve Got Other Challenges”

“We are history,” said Michael O’Neill, Citigroup’s Chairman, as he prepares to leave at year-end. “Today I would not want to try and create Citigroup or any of the other large banks. We are—I won’t say we are an accident of history—we are history. And unfortunately time changes and the environment changes, and so today we’ve got other challenges. We’ve got fintech, potential disruptors. We’ve got cybersecurity. We’ve got all sorts of risks that we did not have before.” The Wall Street Journal, Nov. 24-25, 2018, page B5.

Mr. O’Neill is hardly alone in his assessment of the financial services industry’s changed circumstances. Today’s lead story is not industry consolidation, which dominated the last 30 years' news. It is the juggernaut of technology-based product and service innovation, and the associated risks and rewards.

Many technologists imagine they are creating a more efficient and virtuous social order, one that institutionalizes rational behavior and rewards technology’s righteous disciples. They reflect the bias of Star Wars character C-3PO, who says of Luke Skywalker, “He’s quite clever . . . for a human being.”

Framing and managing risks of the emerging financial services economy is neither as obvious nor as binary as the Star Wars contest between good and evil. That is Chairman O’Neill’s message, and ours too.

Fintech providers cherry pick legacy providers’ profit centers. They portray themselves as brash upstarts, unbound by convention. Business and consumer customers sometimes discover too late the upstarts are also unbound by routine risk management practices.

Old alliances are upended. Freddie Mac now provides liquidity lines of credit to non-bank mortgage lenders, biting the hands of banks that have fed Freddie since its inception nearly 50 years ago.

Via this website, we will expand our coverage of issues we have previously written about under the heading, “Bauerle’s Bank Notes.” Given the proliferation of new products and distribution channels, the BBN title is obsolete. Our work, and others’ published or cited here, will highlight not just emerging stars of the new financial order, but its dark corners and blind alleys too.

We thank you for your readership and your patronage as our clients. We look forward to continuing to serve you.