On March 26, 2009, Treasury Secretary, Timothy Geithner, released a statement that our financial system “require[s] comprehensive reform. Not modest repairs at the margin, but new rules of the game.”
Geithner’s statement contains two very telling positions:
- The first is that “[f]inancial products and institutions should be regulated for the economic function they provide and the risks they present, not the legal form they take.” His premise is that past regulation has not been sufficient.
- The second is that “oversight” was insufficient to constrain dangerous levels of risk-taking [by financial institutions] throughout the financial system.” His premise is that the first line of oversight of the these financial institutions, their governing boards, is not sufficient to supervise these risks.
History of past regulation
Historically, major adverse economic events have resulted in legislation by Congress addressing its perception of mismanagement or fraud:
- The stock market crash of 1929 resulted in the Securities Act of 1933 requiring greater disclosure of information by companies before offering their securities in public markets and the Securities Act of 1934 to require continued dissemination of information as long as those securities remained publicly held;
- Reporting under-the-table payments to foreign officials as deductible for tax purposes and as legitimate for GAAP purposes resulted in the Foreign Corrupt Practices Act of 1977 requiring the maintenance of books and records and reconciliation of financial statements to those books and records that eventually became known as internal controls;
- The failure of illegal acts and third-party transactions to be detected during the audit process resulted in the Private Securities Litigation Reform Act of 1995 requiring audit of public companies to contain audit procedures designed to detect illegal acts, material related party transactions and continuation as a going concern; and
- The failure of the audit process to result in adequate disclosure of liabilities incurred by Enron, WorldCom, and others in the late 1990s and early 2000s resulted in the Sarbanes-Oxley Act of 2002 requiring oversight of the financial preparation and audit process of public companies by independent directors.
The focus of these regulations is disclosure with the underlying assumption being that knowledge of the facts will prevent mismanagement and fraud. Opponents of regulation argue that the cost of complying with these disclosure requirements has outweighed any benefit, resulting in public companies going private or changing their domicile to off-shore in order to avoid such costs. Proponents of regulation argue that these regulations have not gone far enough: instead of requiring disclosure, the regulations should regulate the substantive fairness of the operations of business and their transactions.
Mr. Geithner apparently falls within the class of proponents of regulation. His statement proposes regulation of the capital requirements, compensation incentives, and even the size of financial institutions, but also of the products offered by these institutions.
Responsibility for oversight
In the American corporate model, the responsibility for oversight has been traditionally vested in each organization’s governing board. The basic premise of Sarbanes-Oxley is that the best defense against corporate mismanagement is independent oversight of management by independent directors with counsel of independent advisers and holding management accountable for the information provided.
Opponents of regulatory oversight argue that independent directors know more about, and are closer to, the businesses of their organizations, and can take corrective action more quickly and knowledgeably, than any government official or agency. Proponents of regulation argue boards have become a social clubs of the CEO’s best friends and as a result few directors see their interests as separate from those of the CEO and management.
A wish for the future
Although regulation having the breadth of that proposed by Mr. Geithner as with past expansive regulation will directly benefit every lawyer and similar professional, I wish the focus would be on fixing, rather than changing, oversight in the American corporate model.
This focus should be the expertise either present among, or available to, the members of the board not only to provide direction of the organization, but also to oversee risks to the organization’s stakeholders. To me, a better regulatory paradigm is to require disclosure of:
- Whether and, if so, how frequently boards evaluate the collective skills, experience and other expertise of each of their members;
- What expertise each board member is believed to contribute to the collective expertise of the board; and
- What actions are being taken to enhance the collective expertise of the board through education, recruitment of other members, or access to expert advisers.
Requiring disclosure by each organization of the collective expertise, and steps being taken to enhance that expertise, of those responsible for direction and oversight will empower shareholders and other stakeholders of the organization to protect themselves by making intelligent decisions whether to continue being invested in, employed by, or otherwise relying upon soundness of the organization.