The dramatic escalation in enforcement activity by federal agencies against large financial institutions since the financial crisis is well known. These days the latest multi-billion dollar deal between regulators and Wall Street banks has lost blockbuster status and hardly even makes front page news. In my forthcoming article, Regulation by Settlement, I take stock of the broader significance of this development for both the financial system and the regulatory process. The main claim is that settlements have emerged as a primary tool for setting policy in financial regulation.

“Regulation by settlement” refers to a specific enforcement tactic that has been adopted by federal regulators: By pursuing settlements that are premised on novel legal theories and target certain areas of the financial system on a comprehensive basis, agencies effectively establish new legal standards of general applicability. Settlements are thereby used as vehicles for policymaking rather than the resolution of particular disputes. As a result, the framework that governs the post-crisis financial system consists of more than the regulations produced under the Dodd-Frank Act. It also includes a substantial body of implicit rules promulgated through the precedential effect of settlements between agencies and financial institutions.

My article presents a number of case studies that illustrate how regulation by settlement operates. Among these are distinct waves of settlements relating to the securitization of asset-backed securities and collateralized debt obligations, administration of financial benchmarks such as Libor and foreign exchange indices, mortgage origination and servicing procedures, and the development of internal controls responsible for detecting money laundering activities or transactions with countries subject to U.S. foreign sanctions. In each instance the same basic pattern appears. A series of enforcement actions are initiated and then concluded with settlements that are negotiated in rapid succession. Agencies cobble together the underlying theories of liability with creative exercises in statutory interpretation. No big bank goes unscathed, as regulators settle with every major firm engaged in a particular industry practice. Penalties for each institution reach billions of dollars. When enforcement takes place on such a scale, agencies set rules-of-the-road for a given portion of the financial sector.

The rise of regulation by settlement reflects more than a one-time crackdown on Wall Street. Rather it has been made possible by the confluence of a number of changes in the enforcement environment over the past two decades or so. These include an increased emphasis on corporate (as opposed to individual) liability, skyrocketing monetary penalties, and the nearly exclusive imposition of those penalties through innovative legal instruments that are subject to limited or no judicial review. Although each of these developments has received attention from legal practitioners and academics, that commentary tends to take a piecemeal perspective and focus on particular agencies, settlement instruments, or legal prohibitions. What has been obscured is the striking fact that all three trends have occurred on a nearly contemporaneous basis, across every agency with jurisdiction over financial institutions, and in connection with both criminal and civil corporate liability. Regulators at the Office of the Comptroller of Currency now wield civil settlement instruments such as consent orders in a way that is functionally indistinguishable from the use of criminal deferred prosecution agreements by prosecutors in the Department of Justice. An implication, I argue, is that there has been a reorientation of the relationship between the financial system and the administrative state as a whole, with regulatory settlements now occupying a central role.

Is the rise of regulation by settlement good or bad? By removing most of the conventional legal constraints on agency action, regulation by settlement has an unruliness that is reminiscent of administration during emergencies and other unorthodox styles of executive branch policymaking. Many have decried this feature as contrary to traditional rule of law values. The procedural looseness that accompanies regulation by settlement carries some under-appreciated advantages, however. Most important, it gives agencies greater flexibility to respond to rapidly evolving policy problems than is available under standard modes of administrative action, such as notice-and-comment rulemaking or formal adjudication. It is therefore no coincidence that regulation by settlement has centered on the banking industry, where constant technological change and the potential for regulatory arbitrage place fluid policymaking at a premium.

Even if regulation by settlement can be justified, there is still the question of reform. It is usually possible to improve policy at the margin. By far the most common proposal is for enhanced judicial review of regulatory settlements. Prominent advocates of such an approach include Judge Jed Rakoff of the Southern District of New York, along with a handful of other federal district judges who have rejected proposed settlements. It has also been embraced by leading legal academics.

My article closes by suggesting that this emphasis on greater judicial scrutiny is misplaced. Once regulation by settlement is understood as a novel form of agency policymaking, it becomes clear that procedural protections aimed at individual settlements will be less effective than proposals that focus on broader patterns of enforcement. In other words, the relevant model for reform should draw from administrative law rather than civil or criminal procedure. This means that when regulators undertake a concerted series of settlements, the decision to do so should be subject to the same kinds of centralized oversight that executive branch entities like the Office of Information and Regulatory Affairs (OIRA) currently apply to the rulemaking process. In the banking regulation context, it would also make sense to delegate responsibility on this front to the Financial Stability Oversight Council, which the Dodd-Frank Act established to monitor the financial sector on a systemic level. 

This post comes to us from Matthew C. Turk, Assistant Professor of Business Law at Indiana University’s Kelley School of Business. It is based on his recent article, “Regulation by Settlement,” forthcoming in the University of Kansas Law Review and available here.