Dodd-Frank Financial Reform: New “Systemic Risks” for the BPO Industry
Posted July 30, 2010 by Bierce & Kenerson, P.C. · 
Print This Post
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.
Vicarious Liability for Service Providers. The Dodd-Frank law raises the standards for external service providers who support any regulated financial services.
o It imposes vicarious liability on any service provider processing consumer financial transactions as “aiders and abettors” for operational support in some cases.
o It encourages employees of shared service centers and outsourcers to file claims of violation so that they can reap a bounty in an enforcement case.
o It makes mere “recklessness” the equivalent of a “knowing” violation of:
o the Securities and Exchange Act of 1934, Dodd-Frank, Sec. 929O, amending 15 USc 78t(e);
o the Investment Company Act, Dodd-Frank, Sec. 929M, amending 15 USC 77o; and
o the Investment Advisers Act of 1940, Dodd-Frank, Sec. 929N, amending 15 USC 80b-9.
o It extends the extraterritorial jurisdiction of U.S. courts in enforcement of U.S. securities laws.
Whistleblowers Beyond Sarbanes-Oxley. The Sarbanes-Oxley Act of 2002 protects the employment of “whistleblowers” who report to governmental authorities the employer’s violations of the SOX law. Section 922 of the Dodd-Frank law extends protection of “whistleblowers” by appointing them as bounty hunters against securities law violations by banks, financial services companies, insurance companies (BFSI) and by others including credit rating agencies, investment advisers, investment companies (mutual funds), commodities future dealers and others.
The bounty would be manditorily paid, where the Securities and Exchange Commission (SEC) brings any administrative or judicial proceeding that results in monetary sanctions exceeding $1.0 million. 15 USC 78a, Sec. 21F, per Dodd-Frank, Sec. 922. Under future SEC regulations to be adopted, bounties will be awarded to individuals for “original information” not known to the SEC from any other source in an aggregate amount of between 10% and 30% of the total amount collected from SEC-imposed monetary sanctions on the wrongdoer. In deciding how much to award, the SEC must consider the significance of the information to the success of the SEC, the degree of assistance by the whistleblower and his or her “legal representative” and the “programmatic interest” of the SEC in deterring future violations of the securities laws.
The new statute explicitly promotes anonymous whistleblowing by contemplating a scenario where the whistleblower is represented by legal counsel. However, identification of the whistleblower is required, but only “prior to payment of the award.”
The statute extends the usual prohibitions against retaliation for initiating, testifying in or assisting in any judicial or administrative proceeding. Specifically, “no employer may discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner, discriminate against a whistleblower” in terms of employment, by reason of the whistleblowing. The protection applies to any employer, even if the employer is not the violator of the Dodd-Frank law. This protection expires with a new statute of limitations of six years, but not more than ten years if the “materials facts” were not immediately discovered till later. The whistleblower is entitled to reinstatement of employment, 200% of back pay lost plus litigation costs including attorneys’ fees.
The bounty-hunting whistleblower is a new phenomenon. It invites anyone having insider knowledge, including those who process financial transactions under a confidentiality (non-disclosure) agreement, to breach the duty of confidentiality and pursue a bounty by reason of wrongdoing by the client enterprise.
This new law raises the risks for both outsourcers and captives that an employee might become embroiled in whistleblowing. It is not difficult to imagine that an outsourcer’s employee (or captive financial service center’s employee) might identify patterns of trading, and might indeed hear conversations in the course of transactions processing, that might provide evidence of breaches of the new Dodd-Frank restrictions and future SEC implementing regulations.
The bounty-hunting awards were payable for securities violations before the Dodd-Frank act became law. Dodd-Frank, Sec. 924(c).
Aiders and Abettors. The Dodd-Frank law also imposes penalties under the Investment Advisers Act of 1940 (IAA) for anyone who assists a securities violation by a registered investment adviser. Thus, anyone who “knowingly or recklessly has aided, abetted, counseled, commanded, induced or procured a violation of any provision” of the IAA shall be deemed in violation to the same extent as the direct violator. Dodd-Frank, Sec. 929N, amending 15 USC 80b-9, new Sect. 209.
Extraterritorial Jurisdiction of U.S. Courts. The Dodd-Frank law focused on international transactions that could result in violations of U.S. securities laws, even though the “bad acts” are conducted offshore. The new law clarifies and, some would say, extends, the statutory jurisdiction of U.S. federal District Courts to adjudicate any SEC enforcement proceeding alleging a violation of fraud to two international contexts that were somewhat controversial under existing judicial precedents:
o Conduct within the USA that constitutes significant steps in furtherance of the violation, even if the securities transactions occurs outside the USA and involves only foreign investors (i.e., domestic activities); and
o Conduct occurring outside the USA that has a foreseeable substantial effect within the USA (i.e., foreign activities).
In this case, the foreign activities of business intelligence, research, analytics, transaction processing and reporting, customer relationship management, and other tasks could have such a “foreseeable substantial effect.” Thus, foreign activities are thus subject to US judicial jurisdiction, and the foreign service providers engaged in supporting violations by US persons could be governed by US enforcement jurisdiction for direct wrongdoing, recklessness or “aiding and abetting.”
Shared Services Center or Outsourcer’s Risks under Consumer Financial Protection Laws. Outsourcing contracts allocate the risks and responsibilities for compliance with applicable laws. The Dodd-Frank law puts financial services outsourcing on the radar for possible direct enforcement action against the shared services center or outsourcer.
The Dodd-Frank law enumerates the consumer laws that are covered: These consist of:
(A) the Alternative Mortgage Transaction Parity Act of 1982 (12 U.S.C. 3801 et seq.);
(B) the Consumer Leasing Act of 1976 (15 U.S.C. 1667 et seq.);
(C) the Electronic Fund Transfer Act (15 U.S.C. 1693 et seq.), except with respect to section 920 of that Act;
(D) the Equal Credit Opportunity Act (15 U.S.C. 1691 et seq.);
(E) the Fair Credit Billing Act (15 U.S.C. 1666 et seq.);
(F) the Fair Credit Reporting Act (15 U.S.C. 1681 et seq.), except with respect to sections 615(e) and 628 of that Act (15 U.S.C. 1681m(e), 1681w);
(G) the Home Owners Protection Act of 1998 (12 U.S.C. 4901 et seq.);
(H) the Fair Debt Collection Practices Act (15 U.S.C. 1692 et seq.);
(I) subsections (b) through (f) of section 43 of the Federal Deposit Insurance Act (12 U.S.C. 1831t(c)-(f));
(J) sections 502 through 509 of the Gramm-Leach-Bliley Act (15 U.S.C. 6802-6809) except for section 505 as it applies to section 501(b);
(K) the Home Mortgage Disclosure Act of 1975 (12 U.S.C. 2801 et seq.);
(L) the Home Ownership and Equity Protection Act of 1994 (15 U.S.C. 1601 note);
(M) the Real Estate Settlement Procedures Act of 1974 (12 U.S.C. 2601 et seq.);
(N) the S.A.F.E. Mortgage Licensing Act of 2008 (12 U.S.C. 5101 et seq.);
(O) the Truth in Lending Act (15 U.S.C. 1601 et seq.);
(P) the Truth in Savings Act (12 U.S.C. 4301 et seq.);
(Q) section 626 of the Omnibus Appropriations Act, 2009 (Public Law 111-8); and
(R) the Interstate Land Sales Full Disclosure Act (15 U.S.C. 1701).
BFSI outsourcers and shared services centers will be deemed to be providing regulated “financial products or services” if they provide any one or more of the following functions. (There are some exceptions, but for general discussion, the key elements can be summarized here.)
(i) extending credit and servicing loans, including acquiring, purchasing, selling, brokering, or other extensions of credit;
(ii) extending or brokering leases of personal or real property that are the functional equivalent of purchase finance arrangements
(iii) providing real estate settlement services (other than appraisals);
(iv) engaging in deposit-taking activities, transmitting or exchanging funds, or otherwise acting as a custodian of funds or any financial instrument for use by or on behalf of a consumer;
(v) selling, providing, or issuing stored value or payment instruments
(vi) providing check cashing, check collection, or check guaranty services;
(vii) providing payments or other financial data processing products or services to a consumer by any technological means, including processing or storing financial or banking data for any payment instrument, or through any payments systems or network used for processing payments data;
(viii) providing financial advisory to consumers on individual financial matters or relating to proprietary financial products, including–
(I) providing credit counseling to any consumer; and
(II) providing services to assist a consumer with debt management or debt settlement, modifying the terms of any extension of credit, or avoiding foreclosure;
(ix) for others, collecting, analyzing, maintaining, or providing consumer report information or other account information, including information relating to the credit history of consumers, used or expected to be used in connection with any decision regarding the offering or provision of a consumer financial product or service.
Conclusion. The Dodd-Frank law requires further regulations, which could be retroactive.
1. Expanding Scope of Vicarious Liability. Service providers and shared service centers face new risks of direct and vicarious liability for performing certain covered financial service activities. As a matter of policy, the Dodd-Frank act raises the policy question whether, in future laws and regulations, service providers be exposed to more scenarios of vicarious liability.
2. Living in a Climate Protecting Whistleblowers. Whistleblower laws already protect persons who report violations of tax laws and securities laws. The Dodd-Frank act expands the concept of whistleblowers as tools for law enforcement.
o Employment Law. The Dodd-Frank law pushes the boundaries in the field of employer-employee relations. Every employer now has a duty to avoid discrimination against its employees who become whistleblowers as private spies for governmental enforcement of violations of law. Service providers cannot simply adopt a policy of prohibiting whistleblowing. Rather, they now have to define their policies, procedures and contractual risk management in cases where their customers are potentially violating the laws.
o Contractual Design and Risk Allocation. What should a service provider do if an employee poses questions about a financial service company’s operational compliance with Dodd-Frank? Should the service provider encourage the employee to be a whistleblower?
o Relationship Governance. Can the provider deal with the problem through the existing “relationship governance” framework? What are the possible outcomes and costs of dealing with a “whistleblowing” situation in business process management?
o Termination Management. Does the provider have any contractual rights or remedies to terminate the relationship? What process should be initiated before any such right becomes enforceable? Who pays for transition costs in case of termination for alleged breach by the customer of laws that could inveigle the service provider as an “aider and abettor”?
3. The Service Provider’s Price for Moving up the Value Chain. Today, service providers are moving up the value chain by providing end-to-end transaction processing across business functions that are increasingly regulated. Service providers’ business intelligence (BI), deductive and predictive analytics, knowledge-process outsourcing (KPO), legal process outsourcing (LPO) and core finance and accounting functions. In this context, service providers need to put “aiding and abetting” and whistleblower management on their radar for risk assessment, policy development and actions to mitigate risks. This will require investment in compliance analytics, workflow definition and contractual reallocation of risk.
4. Insurance. The increased risk profile for servicing the back-office needs of the BFSI market exposes service providers (and their directors and officers) to significant financial liability. Typically, insurance products are developed to spread risks to cover losses from the rare occasion of catastrophic liability. It is time for risk managers to discuss this issue with their legal counsel, insurance brokers and insurance carriers.
Accordingly, in the consumer financial services sector (and other consumer sectors), it is time for reassessment of the business models for outsourcing and shared services. Redesign of the business models will reflect these pinpoint areas of primary legal risks, identify possible avenues for eliminating or mitigating those risks, and redesign the services and contractual risk allocations.
For further discussion of this article, contact William Bierce in New York.