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In Search Of A Fraud Firewall

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If we had thought that the swathes of regulation that appeared after these scandals first emerged were sufficient to prevent further large-scale cases, we would have been sadly mistaken. Now, nearly a decade later, we are again debating issues of corporate governance — but this time, in the context of a deep, global financial downturn. Corporate governance is again at the forefront of the policy debate in many countries around the world. Countries with very different types of corporate governance systems, laws for protecting minority investors and different patterns of ownership of their companies, are facing similar crises of confidence. So what has gone wrong?

Few would dispute that the response of policy makers to previous governance crises has been inadequate. Corporate governance rules were tightened, in particular, in the form of the Sarbanes-Oxley Act in the US, to the point where many thought that they were undermining the competitiveness of their domestic financial markets. But the success of these measures has been limited, and the legislation has not prevented major failures from re-emerging in financial institutions around the world.

So what is to be done? Is more and tighter regulation of our financial institutions and markets the answer?

Almost certainly, more regulation will be the response as the pressures on governments to be seen to act increases. In this context, there is the risk that we will see a rash of hastily constructed policy initiatives which do little to address the underlying problems. Certainly there has been nothing in the debate to date to suggest that a coherent or well-designed strategy is about to emerge. If anyone is looking for a response that is both quick and appropriate they will be disappointed. The most useful action that we can urge on our policy leaders is caution — do not repeat the mistakes of history. Instead, resist the temptation to score political points by being decisive in the absence of sufficient information.

The history of past financial crises is littered with cases of governments acting in haste and repenting at leisure. The response to the stockmarket crash of 1929 and the Great Depression is a case in point. In the US, the Glass-Steagall Act separating commercial and investment banking took the best part of 60 years to unravel and in the process created serious inefficiencies in the US banking system which, amongst other things, encouraged an undue reliance on bond rather than bank finance.

As we pause to consider the situation, it is clear that the standard tools of corporate governance have not proved up to the job. Those tools are essentially the board of directors, auditors, analysts, investors and legislation. None of them has succeeded in preventing the extraordinary destruction of shareholder wealth that has occurred in the financial sector over the past year. We can consider the role each has played in corporate governance and suggest how they may best respond to the challenges presented.

The Regulators
Along with bankers, regulators are bearing the brunt of public and political scrutiny in the wake of the financial crisis. But it is easy to be wise after the event. After all, who would have thanked a British Financial Services Authority that undermined the competitiveness of London as a financial centre by imposing tougher regulatory standards than their counterparts in other financial centres? Numerous reports emanating from the City of London pointed out the dangers of excessively stringent regulation. In the US, many argued that an unwelcome consequence of the Sarbanes-Oxley Act was its impact on the country’s competitiveness.


It is clear that regulation has been inadequate to the task and needs to be strengthened but responses must be based on an understanding of the root cause of the problems. While there is no shortage of opinions, facts remain scarce and so long as this remains the case we should not rush into legislative changes.

The Board of Directors
The board of directors is frequently regarded as essential to good governance and the role of the board has featured prominently in many of the corporate scandals. The board is the body charged with having oversight of the operations of the firm and setting its strategy. It is required to ensure that the company is upholding high standards of integrity and conduct, and to provide a probing analysis of the activities of management. Non-executive directors are key to this and are supposed to give an independent assessment of the quality of management. But repeatedly, failures of corporate governance suggest that they do not.

Many countries have sought to separate the roles of chairman and chief executive to militate against the weaknesses inherent in the system, but here too it has not prevented some of the most prominent failures of financial institutions over the last few months.

A range of measures can be taken to strengthen the role of the board. Tighter rules regarding the appointment and rotation of independent directors can be introduced. There can be rules relating to the credentials, experience and training of members of the board. The requirements on members of the board to provide oversight can be clarified. Reporting by the independent members to external investors can be strengthened, and attention can be given to the remuneration and incentives of non-executive as well as executive directors.

The Gatekeepers
Analysts and credit rating agencies are supposed to provide independent assessments of the future prospects for firms and external auditors are in principle expected to identify financial irregularities. The repeated failure of gatekeepers to predict or prevent failures has raised questions about their ability to perform these functions effectively. Some have questioned their degree of independence and others have doubted the adequacy of the information and analysis of information that they undertake.

Increasingly in the light of the deficiencies of many auditors, it is to the investors and shareholders that attention has turned, and here there are signs of the emergence of a more engaged and motivated response to addressing the problems. Institutional investors in particular have been exhorted to take a more active role in the governance of firms and shareholder activism has been trumpeted as a solution to otherwise passive investor involvement. Effective corporate governance requires the direct engagement of investors and attention is being increasingly focused on shareholder activism as an alternative to a reliance on boards.

When Things Go Wrong
One of the best measures of how well corporate governance is functioning in an organisation is how it responds to underperformance? How quickly are problems corrected, who takes action and how effective is the action that they take? Typically it is a combination of the external members of a board, the chairman of the board, the auditors, the analysts and the investors, in particular the institutional investors to whom attention turns. How well do they do?

The evidence on the role of boards in failing firms is quite limited. While in principle non-executives could intervene and replace poor management, they rarely do. The role of boards in poorly performing firms is far more modest than their central function in corporate governance would suggest. Even independent chairmen appear to play a limited role. While separation of chief executives and chairmen of boards is widely advocated, there is not much evidence that it is associated with markedly greater intervention in underperforming firms.

When do directors get fired? The answer is primarily when firms get into financial difficulty. Board turnover is appreciably higher not only when firms are underperforming but in particular when they face financial shortfalls. The reason is straightforward. Faced with a need to raise external finance, investors are in a position to attach conditions to the additional funding being provided. One of those conditions can relate to changes in control of firms. Thus shareholders frequently require changes in management control as a pre-condition for the provision of additional finance. For this reason, attention recently has shifted from directors to investors.

There have been some examples of funds being specifically created to undertake shareholder activism. They have done exactly what other investors have failed to do, namely target underperforming companies, take shares in those firms, engage actively with the board of directors and replace management where necessary. The returns to such activity appear significant but it is only now with a substantial downturn that their performance in bear markets is being tested.

Since corporate governance and financial institutions are so closely related, good governance rests critically on a well performing financial system. The failure of financial institutions, therefore, not only undermines the funding of new investment and new companies but the governance of our well-established corporations as well.

When reflecting on how to restructure financial institutions in response to the recent crisis, policymakers should, therefore, think beyond the confines of what makes for good savings and investment to questions about how the new financial order will affect the governance of firms. Over the last few decades, we have experimented with many forms of governance, from the closely integrated banking and corporate systems of Japan to the much more arms-length relations of the UK and the US. Both have been shown to have their defects and the search is now on for a new financial and corporate governance architecture that will remedy these deficiencies and be fit for the 21st century.
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