OUTSOURCING LAW & BUSINESS JOURNAL (™) : Strategies and rules for adding value and improving legal and regulation compliance through business process management techniques in strategic alliances, joint ventures, shared services and cost-effective, durable and flexible sourcing of services. www.outsourcing-law.com. Visit our blog at http://blog.outsourcing-law.com for commentary on current events.
Insights by Bierce & Kenerson, P.C., Editors. www.biercekenerson.com
Vol. 10, No. 7 (July 2010)
1. Dodd-Frank Financial Reform: New “Systemic Risks” for the BPO Industry.
1. Dodd-Frank Financial Reform: New “Systemic Risks” for the BPO Industry. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, H.R. 4173, signed by President Obama on July 21, 2010, invites a rethinking of the traditional outsourcing model in the financial services sector. The new law adopts new requirements to limit systemic financial risks. It calls for new regulations to delineate prohibited transactions and to implement new certain reporting and operational restrictions. The regulations apply to broker-dealers, banks dealing with hedge funds, commodity brokers, swap dealers and participants and credit rating agencies. It establishes a Bureau of Consumer Financial Protection to ensure compliance.
The traditional outsourcing model does not involve legal liability of service providers for legal wrongdoing by their enterprise customers. The Dodd-Frank law shifts the risk profile of service providers in the financial services sector. This could have a chilling effect on outsourcing for financial services companies and their external service providers. For more, click here.
Whistleblower, n. (1) in sports, the umpire; (2) in law enforcement, the policeman; (3) in business process management, the employee who sees the emperor is wearing no clothes; (4) in false advertising in the tobacco industry, a retired researcher; (5) under Sarbanes-Oxley, a self-appointed member of a spy network; (6) under Dodd-Frank, a bounty-hunter.
Aiding and abetting, n. In LPO, a “regulatory process” transformation that automatically converts the back office transaction provider into a front-office crook.
September 13-15, 2010. 5th eDiscovery for Pharma, Biotech and Medical Device Industries, Philadelphia, Pennsylvania. Presented by IQPC, this event will bring together industry leaders from in-house eDiscovery teams, expert judges and outside counsel as they discuss:
- How the new Pension Committee decision will effect eDiscovery professionals in the life science industries
- The unique challenges biopharmaceutical and medical device companies face with respect to social media content
- Preparing and responding to FDA inquiries, patent issues, and other types of pharmaceutical litigation
- A progress report on the 7th circuit eDiscovery pilot program and its implications for Pharma and Biotech
- Reducing patient privacy risks and unnecessary disclosures due to indiscriminate document retention
- Discovering new technologies to reach your goal of gaining proactive control over all your data
To register and view the whole program, click here.
September 26-28, 2010. IQPC Shared Services Exchange™ Event, 2nd Annual, to be held in The Hague, Netherlands. Shared Service Centres have long been seen as the cost saving centre of HR, Finance & Accounting and IT processes, but with changing employment trends and global challenges facing organisations, how can SSC’s continually offer service value?
Unlike typical conferences, the Shared Services Exchange™, which will be co-located with the Corporate Finance Exchange™, focuses on networking, strategic conference sessions and one-on-one meetings with solution providers. The Exchange invites strategic decision makers to take a step back from their current operations, see what strategies and solutions others are adopting, develop new partnerships and make investment choices that deliver innovative solutions and benefits to their businesses.
To request your complimentary delegate invitation or for information on solution provider packages, please contact: email@example.com, call +44 (0) 207 368 9709, or visit their website at http://www.sharedservicesexchange.co.uk/Event.aspx?id=263014
September 28-30, 2010, SSON presents Finance Transformation 2010, Chicago, Illinois. If you are facing challenges to meet your finance end-to-end and top quartile requirements, consider Finance Transformation 2010 – the most comprehensive event for anyone managing finance back office operations looking for end-to-end capability.
The main themes explore the strategic views of true transformation across the entire finance supply chain and highlight the roadmaps which will help you to achieve top quartile business outcomes you aspire to. Sessions will cover the key tenets that all of you in the industry – large and small, beginner and established, vendor and buyer, private and public – are required to confront. For more information and to register, visit Finance Transformation.
October 21-22, 2010, American Conference Institute’s 5th National Forum on Reducing Legal Costs, Philadelphia, Pennsylvania.
The essential cross-industry forum for corporate and outside counsel who are truly motivated to create value and reduce legal costs through innovative fee arrangements, enhanced relationships, and streamlined operations
Come join senior corporate counsel responsible for cost-reduction success stories, as well as leaders from law firms that have pioneered the use of alternative fee arrangements and other innovative cost-reduction initiatives, as they provide a roadmap for navigating the complexities of keeping legal department costs in check. Now in its fifth installment, this event offers unique networking opportunities with senior practitioners from around the nation, including in-house counsel from a wide range of companies and industries.
Reference discount code “outlaw” for the discounted rate of $1695! To get more information, visit www.americanconference.com/legalcosts
October 25-27, 2010, The 8th Annual HR Shared Services and Outsourcing Summit, Orlando, Florida. This will be a gathering for corporate HR & shared services executives from companies across North America to exchange ideas, develop new partnerships and discuss the latest tools, technologies and strategies being employed in the profession to enhance departmental efficiencies and propel corporate growth. The event will focus on the most current topics in the HR shared services industry including metrics, automation, outsourcing, globalization, compensation & rewards, benefits and an overall focus on the new strategic role of HR shared services. We will review how to tackle change management, analyze current and future projects and further develop the instrumental key areas within HR shared services. Outsourcing Law contacts can receive 20% off the standard all access price when they register with the code HRSS5. Register by calling 212-885-2738. View the program brochure for more details by clicking here.
FEEDBACK: This newsletter addresses legal issues in sourcing of IT, HR, finance and accounting, procurement, logistics, manufacturing, customer relationship management including outsourcing, shared services, BOT and strategic acquisitions for sourcing. Send us your suggestions for article topics, or report a broken link at: firstname.lastname@example.org. The information provided herein does not necessarily constitute the opinion of Bierce & Kenerson, P.C. or any author or its clients. This newsletter is not legal advice and does not create an attorney-client relationship. Reproductions must include our copyright notice. For reprint permission, please contact: email@example.com . Edited by Bierce & Kenerson, P.C. Copyright (c) 2010, Outsourcing Law Global LLC. All rights reserved. Editor in Chief: William Bierce of Bierce & Kenerson, P.C. located at 420 Lexington Avenue, Suite 2920, New York, NY 10170, 212-840-0080.
The financial services industry is facing major regulatory changes following the global sub-prime credit crisis and ensuing recovery plans. These changes will have a major impact on outsourcers that deal with consumer financial information or in back-office support for financial investment transactions that are deemed unfair, deceptive or abusive. The adoption of a new Consumer Financial Protection Agency Act would have a significant negative impact on the risks and costs of outsourcing of IT and business process functions by companies that deal with consumers. It would invite a new view of risk allocation between enterprise customers and independent contractors as outsourcers, increasing the costs of doing business by putting the service provider into a new role of whistleblower. It remains to be seen whether the analysis of public policy in this arena will spill over into other industries and other types of outsourcing.
Draft Consumer Financial Protection Agency Act
As of mid-May 2010, the U.S. Congress was considering possible enactment of financial regulatory reform. Among the proposals is the draft “Consumer Financial Protection Agency Act,” as inserted into another draft law, H.R. 4173, “Wall Street Reform and Consumer Protection Act of 2009,” referred to Senate committee after being enacted by the House. This consumer protection bill was originally H.R. 3126, 111th Cong., 1s Sess.; H. Rept. No. 111-367 (Dec. 9, 2009) (“Draft CFPAA”). As the dissenting Republicans observed in that December 2009 House report:
- Rather than address the failure of banking regulations related to consumer protection and the failure of the States to police activities under their purview (e.g., mortgage brokers and real estate agents), the proposed legislation to create the CFPA seeks to consolidate the consumer protection jurisdiction of all banking regulators into one new agency and regulate many new activities and persons that largely are unrelated to the financial markets or the crisis of 2008. (Dissenting views).
General Scope. If enacted, this proposed reform would transfer enforcement of consumer financial protection laws from various existing agencies (including the SEC). The new commission would regulate:
- (1) brokers and dealers registered under the Securities Exchange Act of 1934;
(2) investment advisers under the Investment Advisers Act of 1940;
(3) investment companies (mutual funds) under the Investment Company Act of 1940;
(4) national securities exchanges under the ‘34 Act;
(5) a transfer agent under the ’34 Act;
(6) clearing corporations under the ’34 Act;
(7) municipal securities dealers and self-regulatory organizations registered with the SEC;
(8) national securities exchanges and the Municipal Securities Rulemaking Board.
Regulation of “Financial Activity.” Under H.R. 4173, Sec. 4002 (19) (A), the term `financial activity’ means any of many activities. (The list is long, so we have put it in a separate document.) 1
Liability of “Covered Persons” and “Related Persons.” Under the proposed law, a “covered person” subject to regulation would include “any person who engages directly or indirectly in a financial activity, in connection with the provision of a consumer financial product or service.” This definition is so broad, and governmental involvement in financial operations so extensive, the draft specifically excludes the Secretary, the Department of the Treasury, any agency or bureau under the jurisdiction of the Secretary (H.R. 4173, Sec. 4002 (9)(A)(B)), or any federal tax collector.
Vicarious Liability on Certain “Consultants” and “Independent Contractors.” The proposed law would treat “related persons” in the same manner, and impose the same punishments, as for “covered persons.” By adopting a sweeping definition of “covered person” and an equally sweeping definition of “related person,” the proposed law puts outsourcers at risk of direct liability and for merely doing the tasks assigned under a Master Services Agreement in the ordinary course of business. There would be a distinction between consultants and service providers. A “related person” would include either:
- a “consultant” that, in the view of the new Consumer Financial Protection Commission determines (whether by regulation or on a case-by-case basis), “materially participates in the conduct of the affairs of such covered person” (H.R. 4173, Sec. 4002 (33)(A)(ii)); or
- “any independent contractor (including any attorney, appraiser, or accountant), with respect to such covered person, who knowingly or recklessly participates in any–(I) violation of any law or regulation; or (II) breach of fiduciary duty.” ( H.R. 4173, Sec. 4002 (33)(A)(iii)).
Liability of Outsourcers for “Unfair, Deceptive or Abusive Acts or Practices.” The proposed Consumer Financial Protection Agency Act would not require “related persons” to register with the commission. However, they would be liable for “unfair, deceptive or abusive act or practice in connection with any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product or service.” (H.R. 4173, Sec. 4301(a)). The proposed law would impose federal criminal liability on anyone (including outsourcers as “related persons”) if they are shown to “knowingly or recklessly provide substantial assistance to another person in violation” of the new statute and regulations on “unfair, deceptive or abusive acts or practices.” “Related persons” would be “deemed to be in violation of that section to the same extent as the person to whom such assistance is provided.” (H.R. 4173, Sec. 4308(3)).
Outsourced Business Functions that Would be Exempt. The draft law would exclude certain functions that are typically outsourced from the scope of “financial activity “ that would be regulated.
- “Financial data processing” would be excluded from the definition of “financial activity.” H.R. 4371, Sec. 4002(19)(A)(xi). However, even assuming that the mechanical conditions of processing were satisfied under this exclusion, there remains a subjective standard that could ensnare the outsourcer in an ITO or BPO context: Does the outsourcer provide “a material service to any covered person in connection with the provision of a consumer financial product or service.” (H.R. 4173, Sec. 4002 (19)(A)(xi)(II)(cc))
- Providing certain “information products or services” that are “incidental and complementary” to any activity that the new commission defines as a “financial activity” would be excluded. (H.R. 4173, Sec. 4002 (19)(A)(xvi)(I)(bb)) Specifically, there would be no regulation of such ITO or BPO services that are for identity authentication, fraud or identify theft detection, prevention, or investigation; document retrieval or delivery services; public records information retrieval; or for anti-money laundering activities. That exposes BPO providers of other business functions, such as mortgage and credit card origination, credit verification, and virtually everything else that is not clearly excluded by the draft law.
Neither of these exclusions addresses the growing use by the financial services industry of third party ITO, BPO and LPO services for labor-intensive or labor-value services. This draft law could bring vicarious liability for providers of such services as due diligence for investment banking and finance usually has some consumer financial impact, either in the design of analytics, the design and structuring of financial products or services, document review in an acquisition, divestiture or financing (where “consumers” might be investors in one of the deal participants).
Outsourcers as Auditors and Whistleblowers: The “Knowing or Reckless” Standard of Care for Outsourcers. The draft law would cover independent contractors providing services in support of “financial activity,” but only if their conduct were “knowing” or “reckless.” This standard could establish vicarious liability when the outsourcer “knew” that its actions would be unfair, deceptive or abusive, or because the outsourcer failed to become informed on the legality of its support for its financial institution customer’s unfair, deceptive or abusive practices. In effect, the consultants and outsourcers (other than data transmitters) are enlisted as surrogate auditors and whistleblowers with a duty to cease rendering their services if they “knowingly” or “reckless” participate in their customer’s unfair, deceptive or abusive practices.
Additional Costs of Outsourcing. This role would be a new one. It would entail additional costs of legal reviews and audits by the service provider’s own independent regulatory experts (more lawyers and accountants) and additional premiums for new “directors and officers” liability insurance (if indeed such insurance would cover such vicarious liability). It would add hidden costs on the outsourcer that would have be added to the service charges in order to segregate service costs from legal compliance costs.
Additional Risks of Termination. Under these circumstances, regulated financial institutions and financial service enterprises would face the risk that a whisteblowing outsourcer could unilaterally terminate an ITO or BPO services agreement. Lawyers would argue about the conditions and consequences of when an outsourcer could do so. Relationship governance would involve a new discussion about illegality.
- Service providers would want the right to terminate if, in their good faith opinion, the enterprise customer was engaged in any violation of this draft law or its regulations.
- Financial services enterprises would want a slower trigger. One can imagine a series of steps that delay termination, with notices, opportunity to cure, maybe an independent legal opinion as a letter of comfort (thus escaping “recklessness” as a risk but not necessarily escaping “knowingly” risk).
Due Diligence Process. If this draft law is enacted, it would force service providers to clients engaged in any “financial activity” to conduct due diligence into the legality of the proposed customer’s business practices for the protection of consumers’ financial rights. Such an investigation would normally include questions about existing and future practices as well as information on the actions or recommendations of incumbent service providers who might have sought termination to avoid vicarious liability.
Adverse Impact on Business Process Transformation, Process Change and Operational Innovation. The draft law would impose direct liability on “consultants” who “materially participate” in a financial business. The concepts of “materiality” and “participation” are so broad that any outsourcer who administers any of the “affairs” of its enterprise customer will be treated as such a “consultant” if the outsourcer proposes changes in the “covered person’s” business. This would stifle any proposals by outsourcers for business process transformation, even simple process changes, since the outsourcer might no longer be treated under the “independent contractor” standard of knowing or reckless violation or breach of fiduciary duty.
Spill Over to Other Industries and Outsourcing Services. For perhaps the first time, the draft CFPAA raises the specter of service providers worrying about the risk of vicarious liability because they support a criminal enterprise. “Aider and abettor” liability exists already in relation to the sale or distribution of “securities.” The question now is whether service providers should change their current practices and contract risk allocation in light of such a specter. Informed executives will get more information as this political process unfolds.
Mortgage Loan Servicing and Other Outsourcing by TARP-Assisted Entities: Criminalization of Contract Fraud under Government Contracts
Do you know whether you are a subcontractor receiving payments from an entity assisted under the U.S. Troubled Assets Relief Program or the American Recovery and Reinvestment Act of [February] 2009? You should be aware of the criminalization of contract fraud and the protection of whistleblowers denouncing contract fraud in your operations.
Mortgage and other TARP-Related Fraud Claims. The U.S. federal Fraud Enforcement and Recovery Act of 2009 (“FERA”) identified fraud in mortgage origination as a key systemic risk in the financial system. P.L. 111-10, S. 386, 111th Cong., 1st Sess. So it extended the definition of criminal fraud affecting financial institutions to include frauds by mortgage lending businesses that finance or refinance any debt secured by an interest in real estate, including private mortgage companies, so long as their activities “affect interstate or foreign commerce.” And “major fraud against the Government” was extended to include any fraud involving “any grant, contract, subcontract, subsidy, loan, guarantee, insurance or other form of Federal assistance, including through the Troubled Asset Relief Program [“TARP”], an economic stimulus, recovery or rescue plan, provided by the Government, or in the Government’s purchase of any troubled asset as defined in the Emergency Economic Stabilization Act of 2008.” 18 U.S.C. § 1031(a), as amended by FERA.
Budget for Prosecutions. The presumption is that there are criminal frauds in TARP operations. For the initial year, FERA appropriated $265 million for prosecution of such frauds: $75 million for the FBI to investigate mortgage fraud, $50 million for U.S. Attorneys, $35 million for the Department of Justice (allocated $20 million to the Criminal Division and another $15 million for the Civil Division), $5 million for the Tax Division of the Department of Justice, $30 million to combat postal fraud, $30 million for HUD, $20 million for the Secret Service and $20 million for the SEC.
Liability. FERA imposes triple damages liability (plus fines plus the Government’s costs of prosecution) on an extended scope of frauds under the False Claims Act, 31 U.S.C. § 3729(a), as amended. While an element of “knowing” action is involved in such frauds, it may be hard to distinguish between a knowing intention to complete a record that is vague or incomplete with “knowingly making, using or causing to be made a false record or statement to an obligation to pay or transmit money or property to the Government.” If you find you made this mistake, you can cleanse your sins and pay only double damages by confessing in 30 days.
Scienter. So what level of consciousness is required to have criminal “knowledge?” By definition, the terms “knowing” and “knowingly” means that a person “has actual knowledge of the information; [or] acts in deliberate ignorance of the truth or falsity of the information; or acts in reckless disregard of the truth or falsity of the information.” To prove a “knowing” fraud, the prosecutor does not need to prove a specific intent to defraud. FERA, 31 U.S.C. § 3729(b), as amended.
The Government as Customer. Under FERA, anyone who submits a payment request to “a contractor, grantee or other recipient” is subject to a claim of criminal fraud, provided that the money or property to be spent is to be used “on the Government’s behalf or to advance a government program or interest” where the U.S. Government provides “any portion” of the money or property.
Whistleblower Protection. FERA protects “any employee, contractor or agent” from being “discharged, demoted, suspended, threatened, harassed, or in any other manner discriminated against in the terms of conditions of employment because of lawful acts” to stop violations. Such protection includes 200% of back pay plus interest on back pay, special damages and litigation and attorneys’ costs. 31 U.S.C. § 3730(h) as amended.
Impact on Mortgage Loan Servicers. In companion legislation, the “Helping Families Save Their Homes Act of 2009” defines guidelines for “servicers” of mortgage loans who have conflicting duties of serving the interests of investors and the Governmental interest in limiting needless foreclosures that destabilize property values and damage State and local economies. P.L. 111-22, S. 896, 111th Cong., 1st Sess. (2009). “Servicers” provide the services of collecting and paying over to lenders the principal and interest on mortgage loans. Where the loans are bundled and sold as securities (CDO’s, trusts, special purpose entities, participation certificates) or otherwise bundled as a pool of residential mortgage loans, the “servicers” act on behalf each of the lenders across a spectrum of loans.
In the “Helping Families” act, Congress authorized mortgage loan services to “modify mortgage loans and engage in other loss mitigation activities” consistent with Treasury guidelines and defined a “safe harbor” under the Truth in Lending Act (15 U.S.C. § 1472(h), as amended) to do so. In essence, Congress rewrote the mortgage loan servicing contracts.
First, the servicer has some duty to maximize the net present value of the mortgages. In such case, the Helping Families law redefines that duty as not to maximize the value of any single mortgage, but across all mortgage holders combined.
Second, the service is not liable if it implements a “qualified loss mitigation plan” (for residential loan modification or workout, such as by loan sale, real property disposition, trial modification, pre-foreclosure sale, or deed in lieu of foreclosure). This plan needs to meet three criteria: (i) the borrower has defaulted, or default is imminent or reasonably foreseeable, (ii) the borrower occupies the property as the principal residence, and (iii) the servicer determines (under Treasury guidelines) that the loss mitigation plan is “more likely to provide an anticipated recovery on the outstanding principal debt” than the anticipated recovery through foreclosure. By acting under these “safe harbor” principles, the servicer “that is deemed to be acting in the best interests of all investors” is statutorily exempt from liability to any party and is not subject to equitable remedies such as a stay or injunction.
The Perilous “Safe Harbor.” This is not much of a “safe harbor,” since the law is riddled with the tests of “reasonableness” as to the likelihood of the borrower’s future default and as to whether the “loan mitigation” (restructuring or workout) plan is truly in the best interests of the majority of lenders. In mid-September 2009, the Treasury Department issued new “guidance” tax rules that make it easier for distressed property owners to restructure their loans that were bundled into mortgage pools and sold to investors as securities, since earlier “guidance” prevented delinquent commercial developers from talking to servicers about restructuring, and similar “guidance” applied to residential mortgages. (Note: the “Helping Families” law does not apply to commercial mortgage-backed securities, “CMBS”).
Lessons for Service Providers Exercising Business Judgment, such as Loan Servicers. Loan servicing, particularly for bundled or pools of residential mortgages, constitutes a classic outsourcing transaction for well-defined scope of services. While the Real Estate Settlement Procedures Act has traditionally governed loan servicing, the global recession of 2007 and after has placed loan servicers in a unique conflict of interest beyond the usual need to occasionally restructure a loan under pre-recession conditions. The service remains in the challenging position of having to make judgments about whether loan modification will have a higher yield to investors than loan foreclosure. Their job is to identify and work with financially sound borrowers to pursue alternative “loss mitigation” for those who are not. The servicer remains subject to liability for errors in judgment, even if made in good faith. In short, the economics converted the exception into the rule: most loans now need some “loan mitigation.”
In the case of residential and commercial mortgages, the servicers came under Treasury regulations governing defaulting, or imminently defaulting, loans.
Lessons can be learned for those providing “financial and accounting” services, particularly services where mistakes can be seen as possible frauds:
- Using Tools and Business Process Automation to Support Business Judgments. Where a service provider is hired to deliver services that exercise business judgment, the risks of mistake can be reduced by “automating” those business processes that support the exercise of judgment. In the case of mortgage loan servicers, the use of “net present value” computations (which assumes certain market factors such as interest rates and future payment streams) set the framework for deciding whether loans in the loan portfolio would have a higher value if restructured than if foreclosed. In other services, the use of metrics, software tools and other automation techniques help not only with predictive diagnostics, but also with remediation of errors in judgment or service quality. In all services where regulatory compliance is a part of the provider’s role, the policies and procedures manuals should establish decision trees and work flows that meet the regulatory framework.
- Avoiding Fraud Claims. Fraud claims offer a claimant an easy way to pursue an aggressive litigation strategy. Being inherently based on unique facts, each case of “fraud” defies the usual motion by a defendant for summary judgment. By adopting legally compliant workflows and having more than one person responsible for making business judgments, a service provider has a better chance of avoiding fraud liability for “rogue” decisions. While outsourcing is based on well-defined business processes that can be automated or performed by one person, the exercise of business judgment should be a team sport to avoid risks of weak judgment, bad judgment or bad faith (“scienter”).
- Multiple Customers, Conflicting Duties. When the scope of services includes any services that require the exercise of business judgment, prudence or good faith, the service provider should identify how it can legitimately serve the interests of “multiple masters.” The “Helping Families” act gives some leeway by allowing the servicer to act for the general advantage of all “masters,” even though some masters (lenders) will not be getting pari passu equal treatment with the others. Pari passu does not work for multiple customers in a bundle or pooled service.
- Contractual Safe Harbors. Similarly, when the scope of services requires such business judgment or even fiduciary duty, the service provider and enterprise customer should define contractually what considerations and processes should be adopted to reach a “satisfactory” outcome.
- “Change of Control” + “Force Majeure” = Increased Risk. When collateralized debt obligations became unmarketable as “toxic,” the government stepped in and imposed a new framework. Parties to an outsourcing relationship should carefully consider the possibility of such intervention and changes in risk and reward structures by governmental fiat.