Hired Guns: Outsourced Regulation Comes Under Fire

Some federal regulators are outsourcing parts of their oversight duties.

Over the years, regulators, including the SEC, Federal Reserve, and the Office of the Comptroller of the Currency, have paid out millions of dollars to private consultants, offloading work that agencies either don't have the internal resources or expertise to complete or don't want to.

The Securities and Exchange Commission, for example, has traditionally ordered independent compliance monitoring in consent degrees. Banking regulators rely on outside help to oversee the institutions under their purview. From 2008 through 2012, the Office of the Comptroller of the Currency required banks to retain independent consultants in approximately 190 of 600 formal enforcement actions, nearly one-third of its caseload.

Such arrangements have been attracting plenty of criticism. Last summer, the New York State Department of Financial Services alleged that when a banking unit of Standard Chartered concealed billions of dollars in illegal Iranian transactions, its independent consultant, Deloitte, looked the other way. Deloitte Financial Advisory Services denied the charge, issuing a statement saying that it “performed its role as independent consultant properly and had no knowledge of any alleged misconduct by bank employees." It said the accusation failed to "present a full and accurate picture of the facts".

That controversy pales in comparison to the scrutiny leveled on independent consultants following a much maligned review of banks' foreclosure actions. In January, 10 mortgage servicing companies, all subject to consent orders issued by the Office of the Comptroller of the Currency and Federal Reserve over improper practices, agreed to pay $3.3 billion in direct payments to eligible borrowers. The high cost and questionable independence of the consultants hired to conduct the process has since come under fire.

“The top consultants are staffed by scores of former regulators and big bank employees that reportedly charge as much as $1,500 per hour to give banks their expertise,” says Sen. Sherrod Brown (D-Ohio). “And because most consulting firms are private companies, there is little transparency—to the public or to Congress—and we can only speculate about the financial incentives and business relationships that consultants have.”

Questions are now being raised as to the transparency and effectiveness of independent consultant arrangements.  There is the matter of how much influence over regulatory matters these external consultants wield, especially given the “revolving door” of former regulators who jump ship to private firms and, sometimes, back again. Budget battles are also behind an increasing reliance on outside consultants.

“There are not enough people to be the watchdogs,” says Sidney Shapiro, law professor at Wake Forest University and vice-president of the Center for Progressive Reform. “It's a matter of resources. There are just not enough inspectors to get the work done.”

The question is: When is it reasonable and appropriate for government functions to be delegated to private parties? “If, for one reason or another, we think they can do it better, you still have to have oversight to make sure they are doing what they are supposed to do,” he says.

As deficit hawks fight to shrink budgets and minimize government payrolls, outsourcing regulatory duties becomes an increasingly attractive option, Shapiro says. “The numbers don't show up as government employment, so you are not adding to the size of government, so to speak,” he says.

Amid the “serious problem that agencies are so slowed down by these continuous budget cuts,” there is an increase in regulatory functions, especially given the many new rules imposed by the Dodd-Frank Act. “There's been a push to engage in privatization,” Shapiro says. “It's either encouraged or you don't have any choice. It doesn't seem unreasonably necessarily, if it's a pretty standard function,” he adds. “But you also have to check to make sure they are doing it, and that certainly looks like the step that was lost in the foreclosure review process.”

“It's a matter of resources. There are just not enough inspectors to get the work done.”

—Sidney Shapiro,

Law Professor,

Wake Forest University

While Washington officials have focused on the specifics of the foreclosure reviews, they have also begun to consider the broader issue of outsourced regulation and compliance oversight. In a statement, Sen. Brown said that “a lack of transparency and disclosure threatens to continue the same risky practices and widespread errors that undermine the public's confidence in the financial system.”

“It's particularly alarming when regulators outsource oversight activities to independent consultants,” he said. “We need more clarity in the way our public regulators utilize private consultants to better understand these arrangements and identify ways to counteract the potential risks of conflicts of interests and misaligned incentives.”

During a recent hearing before members of the Committee on Banking, Housing, and Urban Affairs, Daniel Stipano, deputy chief counsel  for the OCC, said his agency has “found the use of independent consultants useful in many circumstances” and particularly valuable for community banks “which may lack the necessary expertise and resources to correct problems on their own.”

Although he conceded to flaws in the foreclosure review process, he dismissed accusations that the OCC lets consultants, or the banks they work with, go unsupervised. “Independent consultants are not substitutes for the supervisory judgment of the OCC,” he said.

The OCC requires banks to retain independent consultants for a number of reasons, Stipano explained. Consultants may have subject matter and process knowledge in dealing with certain situations and can apply that knowledge and experience to focus on the supervisory issue, identify its scope, and work with bank personnel to correct the bank's conduct.

More recently, “in a substantial number of cases,” the OCC has ordered banks of all sizes to retain independent consultants to address deficiencies in compliance with the BSA and anti-money laundering laws and regulations, Stipano said. Consultants have been called upon to conduct a review of a bank's staffing, risk assessment, and internal controls.

Hired Watchdogs

The OCC would never be able to handle a project as large as foreclosure reviews on its own, Stipano said. “It would be beyond the means of any federal banking agency to do this,” he said. “It's not a question of bringing on more examiners, we would probably have to triple or quadruple the size of our staff or pretty much shut down our bank supervision operations, and that is not an option.”

FUTURE USE OF INDEPENDENT CONSULTANTS

The following is from Congressional testimony presented by Daniel Stipano, deputy chief counsel for the Office of the Comptroller of the Currency, in April. In his remarks, he addressed his agency's future use of independent consultants.

The use of independent consultants has generally served the agency well in promoting banks operating in a safe and sound manner and in compliance with law. Given the experience with the IFR, the OCC is currently evaluating its use of independent consultants and exploring ways to improve the process, particularly for situations involving significant consumer harm or law enforcement implications.

While the OCC believes its authority and use of independent consultants is generally appropriate, there is one area where we believe legislative action could be helpful. Under the current statutory scheme, the OCC faces significant jurisdictional obstacles if it seeks to take an enforcement action directly against an independent contractor.

In order to take an enforcement action against an independent contractor, the OCC is required to prove that the contractor engaged in knowing or reckless misconduct that “caused or is likely to cause more than a minimal financial loss to, or a significant adverse effect on, the insured depository institution.”

A recent court decision has further elevated the standard for taking such enforcement actions.

In Grant Thornton v. Office of the Comptroller of the Currency, (D.C. Cir. 2008), the court held that the OCC must prove that the contractor was involved in the “business of banking” to meet the statutory jurisdictional requirements. Despite the fact that Grant Thornton was retained by the bank as a result of an agreement with the OCC to engage a nationally recognized accounting firm to conduct an audit of the bank's mortgage program and related records, the court held that the work performed by Grant Thornton did not fall within the business of banking and, therefore, the OCC had no jurisdiction to proceed.

The OCC would welcome a legislative change in this area that would facilitate our ability to take enforcement actions directly against independent contractors that engage in wrongdoing. Such a legislative change would be useful not only with respect to the use of independent contractors in an enforcement context but also, and perhaps more importantly, in cases where a bank has chosen to outsource significant activities to an independent contractor.

Source: United States Senate Committee on Banking, Housing & Urban Affairs.

Konrad Alt, managing director of Promontory Financial Group defended the use of private consultants by regulators. Those assignments have involved over a dozen different regulatory authorities, including securities regulators, banking regulators, and other law enforcement authorities, both domestically and internationally. “Private consultants, independent or otherwise, are advisors, nothing more. We don't make regulations. We don't issue guidance. And we don't bring enforcement actions. We can make recommendations to regulators but we cannot and do not perform regulatory activities.”

Given budget resources and logistical hurdles, it's unlikely that regulators will shy away from the ongoing use of private help. In fact, one prominent academic voice, Columbia Law School Professor John Coffee, says using private law firms might offer a solution for complaints about the SEC's sluggish track record for post financial crisis enforcement. Critics, including Coffee, say the SEC has mostly failed to pursue individuals guilty of crisis-era malfeasance, instead fining big banks and other entities monetary settlements often compared to as mere “speeding tickets.”

“The SEC is an overworked, underfunded agency that is subject to severe resource constraints, he wrote. “It knows that suits against senior executives will often drag on, consume considerable resources, and deprive it of manpower that could be employed elsewhere.”

Coffee's proposal is that the SEC do what other financial regulators, notably the FDIC, are doing and hire independent counsel on a negotiated contingent fee basis for large cases that it cannot staff adequately itself. Under his plan, the SEC would conduct the initial investigation and decide whether a suit was justified. Attorneys' fees would be earned only if a recovery was obtained, and only out of the recovery.

The Federal Housing Finance Agency has taken a similar approach in the past, notably hiring the firm Quinn Emanuel Urquhart & Sullivan in 2010 to sue 17 financial institutions for the sale of mortgage-backed securities to Fannie Mae and Freddie Mac. That effort, however, was criticized at the time because the representation agreement, along with other case-specific information, was not initially made public.

Amid the recent debate over consultants, Rep. Maxine Waters (D-Calif.) has introduced legislation to reform the use of independent consultants in banking regulation and enforcement.  

The Stop Outsourcing Banking Enforcement and Examination Act would require that consent orders between federal banking regulators and companies subject to their oversight be made public whenever the use of outside consultants in involved. The bill also requires the disclosure of any business relationship between consultants, banking regulators, and financial institutions. The bill also requires that all consultants be paid directly by the government, rather than the company or companies subject to the consent order, and allows regulators to claw back fees paid to independent consultants in the event that they fail to carry out a consent order.

“There are clear conflicts of interest in the use of private consultants which are paid by the companies they oversee,” Waters says.  “This is not ‘independence'—it is work for hire.”