According to the U.S. Securities and Exchange Commission, the principal laws that protect investors and preserve business integrity are (i) the Securities Act of 1933, (ii) the Securities Act of 1934, (iii) the Trust Indenture Act of 1939, (iv) the Investment Company Act of 1940, (v) the Investment Advisers Act of 1940, and (vi) the Sarbanes-Oxley Act of 2002.
With the exception of the Sarbanes-Oxley Act (SOX), the above statutes are products of the New Deal. Congress enacted them in response to the country’s greatest financial crisis to date. The factors that produced the Great Depression and the present economic situation are too numerous to list and complex to adequately analyze. It must not be overlooked, however, that the causes were global in nature and undermined confidence in all economic sectors and among the population as a whole.
Unlike in the 1920s, large numbers of Americans today are “investors” – as purchasers (i.e. shareholders) of individual stocks, mutual funds, etc. In recent months, both individual and institutional investors have witnessed the decline in the value of their portfolio. This situation has made many people ponder: what is the appropriate role of governmental bodies and international institutions when regulating the private sector.
For more than fifty years, most western governments generally evinced considerable faith in the market system, albeit subject to varying degrees of government regulation and social welfare benefits. In addition, policy makers are questioning the roles of private self-regulating organizations in our financial system since many perform quasi-governmental functions.
Central to U.S. thinking about our economic model of organization is the belief that private corporations should have a central role in the economy. Unfortunately, our corporate model is based on the myth of shareholder control. In reality, most shareholders do not monitor the corporations they own part of (much less vote their shares). More annual reports and proxy statements are tossed into the garbage than are analyzed.
In lieu of shareholder control a cozy relationship between management and boards of directors has developed that effectively controls the way corporations operate. Unfortunately, many Chief Executive Officers are also Chairmen of the Boards that employ them – an obvious conflict of interest as is recognized by many countries, including England.
The U.S. and its political subdivisions do not limit an individual from serving on numerous boards of directors (though some countries do, such as Colombia – not a country well-known for having a well-developed system of corporate governance). The procedures and other requirements governing the number and substance of corporate board meetings are seldom set out in great detail. Furthermore, there is no education or training requirements for persons to serve as board members. Board members typically are nominated by senior management or existing board members; it is rare that shareholders are successful in choosing a majority of the board – the costs and dedication needed to organize are significant impediments.
Recent events have demonstrated that corporate oversight can be lax. Furthermore, federal and state government regulators frequently lack the resources and political support to perform effective oversight functions or bring enforcement actions. Finally, there seems to be recognition within Washington that existing laws and regulations have not kept pace with business practices – the need to regulate derivatives and hedge funds is no longer a matter of whether, but how.
After the passages of SOX, many people were lulled into complacency that the factors contributing to corporate governance scandals had been addressed by assigning greater responsibilities to corporate board of directors. In fact, this is only partially the case as recent events have shown. It is not possible to regulate morality and frequently companies have incentives not to rigorously carry out internal compliance systems as they do not generate a profit.
A good share of the blame for corporate governance failures (and poorly performing corporations in general belong to passive boards of directors (the members of which are often handsomely remunerated). These individuals frequently serve on numerous boards while spending very little time examining the activities of the corporation – the details of which are frequently supplied by management.
Even the so-called independent directors are often only independent in the sense of not being employees of the company. Of course, investors should have understood that it is not logical for the increasing value of stock portfolios to greatly outpace the GNP growth or gains in worker productivity. Now is the time for people to remember to live within their means.
According to New York University Professor Nouriel Roubini, the Anglo-Saxon model of supervision and regulation of the financial system has failed – the same may be true for numerous corporations. Professor Roubini remarks, “Indeed, it seems that for approximately nine years, the U.S. Securities Commission’s Enforcement Division chose to ignore “red flags” that Bernard Madoff was orchestrating a large scale financial fraud”. Congress’ seeming inability to pass laws and for the executive branch to issue effective regulations in large part can be attributed to effective lobbying by corporations.
For corporate governance to be effective, steps must be taken to ensure that directors, managers, and professionals working for companies are made more accountable. At times it seems that the higher one rises in a corporation (or the public sector as well), the less accountable they become.
Another problem is that corporation managers and board members are sometimes reluctant to file law suits on behalf of the corporation when it has been injured by third parties. This can be explained by numerous factors, including not wanting to damage personal relationships, fearing shareholder law suits or reducing the value of the corporation’s stock (which depending on the manner in which individuals are compensated, creates a divergence between their interests and those of the shareholders).
At present, it is cumbersome for shareholders to obtain the right to file derivative lawsuits. Perhaps, individual or groups of shareholders should be permitted to file claims in court when management and board members fail to investigate thoroughly potentially meritorious claims against third parties who cause through their negligence or wrongdoing harm to the corporation.
Professionals working on behalf of corporate clients may be influenced by what could be characterized as conflicts of interest. At present, certified public accountants continue to be hired by the corporations they are supposed to scrutinize. Lawyers are expected to exercise independent professional judgment, particularly. In reality, both accountants and lawyers are frequently asked to bless questionable corporate actions and in fact even devise them.
Imagine if the SEC or federal Public Company Accounting Oversight Board (PCAOB) assigned accounting firms to companies. Do you think that the auditors might have shown some skepticism when individuals were being approved for mortgages for amounts greatly exceeding three times their income? Would questions have been raised about “no doc” loans?
Since many shareholders vote with their feet rather than attempt to assert their rights through the procedures set out in the corporate documents, senior management and board members can often act with impunity (and in any event, corporations typically pay for their errors and omissions insurance).
One way corporate governance could possibly be strengthened would be if Congress were to legislatively overturn the U.S. Supreme Court’s unfortunate decision in Stoneridge Investment Partners vs. Scientific-Atlanta, Inc., issued in January 2008. Recent events illustrate that the existing laws relating to corporate governance as well as regulatory scheme cannot achieve the goals for which they were created. Resources in this area are almost always inadequate to investigate, identify and when appropriate ensure the prosecution of financial crimes.
Stoneridge concerned whether plaintiffs had the right to bring private causes of action based on the theory of “scheme liability,” where the actions of third parties allowed the corporation “to mislead its auditor and issue a misleading financial statement affecting the stock price” (i.e. commit a fraud on the market).
Justice Kennedy, writing for the Court’s five judge majority, ruled that the plaintiffs had no right to bring such a lawsuit since federal securities law did not create any implied right of action – and in any case the plaintiffs were precluded from bringing their case since they did not rely upon the statements of the third-parties. This meant that shareholders are not permitted to file lawsuits against third-parties that allegedly aided and abetted a fraud such as assisting in the preparation of a deceptive financial statements in the absence of “reliance” on the third parties’ deceptive actions. Furthermore, Justice Kennedy asserted that only the SEC and not private parties were authorized under US. securities law to bring claims for aiding and abetting liability, that is, not by private parties. Of course private parties may have a greater incentive to bring such a claim than a federal regulator.
In his dissenting opinion, Judge Stevens (joined by three other justices, Judge Breyer did not participate) rejected the majority’s opinion. Not only did Judge Stevens believe that Justice Kennedy misconstrued existing precedent he ignored “the history of court-created remedies and specifically the history of implied causes of action under § 10(b) . . . .” Judge Stevens was very direct when he wrote that “the Court is simply wrong when it states that Congress did not impliedly authorize this private cause of action “when it first enacted the statute” and that when “Congress enacted § 10(b)” it did so “with the understanding that federal courts respected the principle that every wrong would have a remedy.”
As a practical matter, to restore investors’ faith in the market, Congress must amend existing laws that permit regulators or plaintiffs’ attorneys to aggressively take action against those who facilitate corporate wrongdoing to prevent future financial meltdowns.