Friday, September 23, 2016

Reacting to Wells Fargo

by Roy C. Smith
On Sept 8, 2016, Wells Fargo announced that it had agreed to pay $185 million to settle charges of abusing customers through overly aggressive sales practices.

Two weeks later, Wells Fargo CEO John G. Stumpf was called before the Senate Banking Committee where he received a severe public dressing down from Sen. Elizabeth Warren. According to Sen. Warren, Mr. Stumpf should be “criminally prosecuted,” after, that is, he has resigned and given back his bonuses for failing “to be accountable” for his “gutless leadership.”

Apparently others in the Senate and elsewhere agree with her.  It’s an easy case to pile onto to express outrage against the banks, still America’s number one villains.

But, it is always hard for laymen like us to know enough about the facts in cases like this to form hard-edged judgments. Only the plaintiff’s side of the story has been told publicly, and the defendants are restricted in what they can or want to say. But, based on the reporting on the matter so far, Sen. Warren and the rest of us do know some things.

According to Mr. Stumpf, the bank discovered that some employees in local branches beginning in 2011 secretly opened new accounts for customers without their consent. This was an unexpected response by a considerable number of low-level branch employees to a poorly designed incentive plan to reward them for cross-selling the bank’s products for which there were quotas. This way of gaming the system spread throughout the branch network. As soon as the problem was discovered, the bank closed the unauthorized accounts, offered restitution to affected customers, and began to fire the branch personnel responsible (5,300 were fired over five years out of 100,000 branch employees, or an attrition rate of 1% a year).  Mr. Stumpf said the bank should have found out about the falsified accounts earlier, and addressed the issue more quickly than it did, but it acted in good faith once it discovered the problem.

In 2013 the Los Angeles Times reported on some of such accounts and a local lawyer began to accumulate a list of as many as 1,000 affected customers, presumably for a class action suit. The Los Angeles City Attorney read the story and began an investigation that ended with a civil lawsuit for damages. At this point the Office of the Comptroller of the Currency, a bank regulator, and the Consumer Financial Protection Bureau, (CFPB) a federal agency originally proposed by Sen. Warren and created by the Dodd-Frank Act in 2010, joined the suit as the heavy muscle. The CFPB ended up with $100 million of the $185 million (Los Angeles got $50 million).

By the time of the lawsuit, the bank was already engaged in trying to clean up the problem - responsible parties were fired, and Price Waterhouse was hired to investigate the issue independently from the bank’s own managers. Price Waterhouse found that perhaps 1.5 million unauthorized deposit and 500,000 unauthorized credit card accounts were created on which modest amounts of fees were charged. Over the five years in which the unauthorized activity occurred, fees on the deposit accounts amounted to $2.2 million ($1.50 per account), and $400,000 on the credit cards ($0.80 per account).  Against these fees, the bank paid incentive bonuses, and then had to pay the considerable cost of cleaning up. Last year Wells Fargo reported net income of $22.9 billion, so the amounts involved were not material to the bank’s shareholders.

Some observers have questioned the bank’s policy of creating ambitious quotas for cross-selling, that may have put excessive pressure on some low-pay employees causing the misconduct, though it does appear that the vast majority of branch employees responded to the quotas and incentives without breaking the rules.  Others point to failures in the accounting and control area that did not confirm new accounts with customers, or otherwise identify the problem early enough to keep it from spreading as widely within the bank as it did.  The bank and its board of directors has also been criticized for being slow and passive in pursuing responsible members of management and holding them accountable through clawbacks or other disciplinary measures.

It is clear that there were management mistakes and subsequent failures in the case. But, there is no evidence that management intended this to happen, or tried to cover it up once informed of the problem. By any standard other than Senator Warren’s, the damage done to customers did not constitute what she called a “massive fraud.”

Nevertheless, it certainly has turned out to be an expensive event for the bank, far more expensive than one might think initially.  Right after the announcement, Wells Fargo’s stock price dropped 5% while the stock price of bank’s principal competitor, JP Morgan, rose by 3%. That 8% difference amounts to $20 billion in lost market capitalization.

The market may have overreacted – the customer damages were small and further legal costs are unlikely to reach anywhere near $20 billion.  But, cumulatively the costs to Wells Fargo will be far greater than what they seem to be so far.

After the Senate hearings we learned that three US Attorneys from the Justice Department have opened criminal investigations, and the SEC is looking into civil infractions. The $185 million settlement did not involve the Justice Department – this is its first appearance on the scene.  For criminal charges to be brought against a corporation, the evidence must clear several difficult hurdles set by the Justice Department, but according to James Stewart in the New York Times, the facts in this case may be enough to do so.  Wells Fargo would have no choice but to settle any criminal charges, if made, even for a very large additional sum.  Banks cannot remain in business if convicted of felonies.

There is also the possibility of a class action on behalf of bank customers who were affected by lowered credit ratings and other difficulties as a result of the bogus accounts, and perhaps by employees who were fired for failing to meet quotas or for similar reasons. Such suits first would have to get by customer agreements requiring the use of arbitration for disputes, but sometimes they can. A guilty verdict in  federal case would invite and encourage class action litigation.

The event has surely caused some so far invisible reputation damage to the entity that before this event surfaced was America’s most admired, least sullied, and most valuable bank. In January, Wells Fargo traded at 1.7 times book value and had a market capitalization of $282 billion, in contrast to the much larger JP Morgan, that then, at 1.1 times book value, was worth $247 billion.

Even the generally supportive Wall Street Journal has suggested that Mr. Stumpf may be lucky to keep his job. Public pressure on the Wells Fargo board can only get worse. Threats of criminal investigations by the NY Attorney General of Citigroup and AIG in the early 2000s cost both of them their powerful CEOs at the time, Sandy Weill and Hank Greenberg, respectively. Losing Stumpf and or other top executives could be a further disruption to the bank.

Wells Fargo may argue that its policies and business practices over the years have been exemplary, and that customers have benefitted greatly from its products and cross-selling efforts, but in competitive businesses operated at large scale, mistakes will happen and when they do, the bank will remedy them. This is what we expect “good” corporations to do: to compete hard to get our business with good new products, but also to stand behind them and never try to cheat us. 

Wells Fargo probably believes that it has lived up to that standard for a long time, and is entitled to some benefit of the doubt when an embarrassing mistake is made. But one of the first signs of reputation damage is the loss of the benefit of the doubt.

Sorry, Wells Fargo, it doesn't work that way anymore.

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