Corporate Governance

Rule 14a-8, the Ordinary Business Exclusion, and the Need for Reform: Bank Policies and Loan Foreclosures (Part 2)

By J Robert Brown Jr.

The NYC Pension Funds submitted a proposal to at least three financial institutions, Citigroup, Bank of America, JP Morgan and Wells Fargo.  The proposals contained a preamble reviewing the mortage crisis in the US (the entire resultion is set out below) then provided the following operative resolution:

• Resolved, shareholders request that the  Board have its Audit Committee conduct an independent review of the Company's internal controls related to loan modifications, foreclosures and securitizations,  and report to shareholders,  at reasonable cost and omitting  proprietary information, its findings and  recommendations by September 30,  2011. 

• The report should evaluate (a) the Company's compliance with  (i)  applicable laws and regulations and (ii) its own policies and  procedures; (b) whether management has allocated a sufficient number of trained staff; and (c) policies and procedures to address potential financial  incentives to foreclose when  other options may be more consistent with the Company's long-term interests. ?

The porposal bears some observations.  First, it was a "request" so, as usual, it was not mandatory but precatory.  Second, the proposal merely asked for a "review" and a "report," not substantive changes, although some could have followed any findings resulting from the review/report. 

Third, the proposal did not require an examination of past practices but essentially asked for information about current compliance ("has allocated").  In other words, the proposal did not seek to flay the company for past violations but sought to ensure, on a going forward basis, that sufficient policies and procedures were in place.

An appropriate approach to the proposal would have been to embrace it and give management's full support.  Who wouldn't be in favor of current compliance?  A second best response would be to allow the proposal to go forward, oppose it, but explain what the company was doing to ensure current compliance.  The Funds disclosed that, of the three financial institutions, Wells Fargo opted not to trigger the no action letter process will presumably include it in the proxy statement.  JP Morgan excluded it but only because it was duplicative of a proposal submitted by another group of shareholders. 

Citigroup and Bank of America, however, took the third approach.  They sought the blessing of the SEC staff to delete the proposal from the proxy statement. 

The issues surrounding the "ordinary business" exclusion and some proposed reforms are discussed in much greater detail in Essay: The Politicization of Corporate Governance: Bureaucratic Discretion, the SEC, and Shareholder Ratification of Auditors.

Whereas:

Citigroup,  Inc. is a leading originator, securitizer and servicer of home mortgages.

Reports of widespread  irregularities in the mortgage securitization, servicing and foreclosure practices at a number of large banks, including missing or faulty documentation and  possible fraud,  have exposed the Company to substantial risks.

According to these reports, the specialized needs of millions of troubled  borrowers overwhelmed bank operations that were designed to process routine mortgage payments. As the New York Times (10/24/10) reported,  "computer systems were outmoded; the staff lacked the training and numbers to  respond properly to the flood of cal/s. Traditional checks and ba!ance-s on dooumentation stipped away as fifing  systems went electronic, and mortgages were packaged into bonds at a relentless pace."

Morgan Stanley estimated as many as 9 million U.S. mortgages that have been or are being foreclosed  may face challenges over the validity of legal documents.

Mortgage servicers are required to act in the  best interests of the investors who own the mortgages.   However, a foreclosure expert testified  before the Congressional Oversight Panel that perverse financial  incentives lead servicers to foreclose when other options may be more advantageous to  both homeowner and investor.

Fifty state attorneys general opened a joint  investigation and major federal  regulators initiated reviews of bank foreclosure  practices, including the Federal Reserve's examination of the  largest banks' policies,  procedures, and  internal controls related to  loan modifications, foreclosures and securitizations to determine whether systematic weaknesses  led to  improper foreclosures.

Fitch Ratings warned the "probes may highlight weaknesses in the processes, controls and procedures of certain [mortgage] servicers and may lead to servicer rating downgrades."

"While federal  regulators and state attorneys general  have focused on flawed foreclosures," reported Bloomberg (10/24/10), "a bigger threat may be the cost to  buy back faulty  loans that banks bundled into securities."

Mortgage repurchases cost Bank of America,  Citigroup, JP Morgan Chase and Wells Fargo $9.8 billion in total as of September 2010, according to Credit Suisse.    Goldman Sachs estimated the four  banks face  potential losses of $26 billion, while other estimates place potential losses substantially higher.

The Audit Committee of the  Board of Directors is responsible for ensuring the Company has adequate internal controls governing  legal and regulatory compliance.     With the Company's mortgage-related practices under intensive legal and regulatory scrutiny, we believe the Audit Committee should act proactively and independently to reassure shareholders that the Company's compliance controls are robust.

Resolved, shareholders request that the  Board have its Audit Committee conduct an independent review of the Company's internal controls related to loan modifications, foreclosures and securitizations,  and report to shareholders,  at reasonable cost and omitting  proprietary information, its findings and  recommendations by September 30,  2011.

The report should evaluate (a) the Company's compliance with  (i)  applicable laws and regulations and (ii) its own policies and  procedures; (b) whether management has allocated a sufficient number of trained staff; and (c) policies and procedures to address potential financial  incentives to foreclose when  other options may be more consistent with the Company's long-term interests. ?

Full post as published by The Race to the Bottom on March 30, 2011 (boomark / email).