For a global perspective on corporate fraud and good governance, the Securities Fraud Monitor turned to Dr. Justin O’Brien, who runs the Corporate Governance Programme at the School of Law, Queen’s University, in Belfast, Northern Irleland.
O’Brien is the editor of a new essay collection, Governing the Corporation: Regulation and Corporate Governance in an Age of Scandal and Global Markets. Published this September, the book brings together leading practitioners, regulators and academics from the U.S., Europe, Canada and Australia to debate the implications of corporate governance reform and financial regulation.
The essayists include William J. McDonough, outgoing chairman of the Public Company Accounting Oversight Board; David M. Walker, comptroller general of the United States and head of the Government Accountability Office; and Paul Appleby, who runs Ireland’s Office of the Director of Corporate Enforcement.
A former investigative journalist for the BBC and other broadcasters, O’Brien specializes in corporate governance and the politics of regulation. He has also written about the counterinsurgency campaigns in Northern Ireland. A prolific author, his current projects include a book on New York State Attorney General Eliot Spitzer and another on regulatory regime change in global financial markets.
O’Brien spoke to the Monitor from his home in Northern Ireland.
SECURITIES FRAUD MONITOR: What were you setting out to accomplish through this new collection of essays?
JUSTIN O’BRIEN: Undoubtedly, it has been the case that the United States has been particularly hit by corporate scandal, but corporate scandal is a global phenomenon. One can see that there are significant problems within the corporate governance paradigm irrespective of whether a regulatory regime uses an enabling or mandatory framework or whether it privileges a shareholder or a stakeholder approach. I was very interested in finding out where those design flaws were.
In order to do that, I thought it was very important to bring together academics, practitioners and policymakers from the main markets. It was essential that we moved away from insular academic silos and communicated in a language that they all could understand. It was important to move beyond technical jargon or the minutiae of legislation like Sarbanes-Oxley and look at how or why the principles of the legislation take the form that they take, who has a voice in that process and how does this influence policy outcomes. Ultimately, given the fact that ethical change has now become a corporate priority, at least in terms of rhetoric, the critical question pivots on how to institutionalize values into value.
SFM: So how do you institutionalize values into value?
JO: Alan Greenspan was right when he said that you can’t legislate for ethics. But what you can do is change the cost-benefit analysis. Just look at what happened with KPMG and the tax shelters. KPMG had calculated the cost of each illegal shelter and decided it would pay the cost of the fine. For KPMG, the cost was minimal in terms of gain from the product. So again, you’ve got to change the cost-benefit. For a long time, a lot of financial intermediaries could pay the fines and write off the costs. This libertarian concept of ethics is fundamentally dangerous and I think there is now recognition by the regulators that things have to change.
SFM: Are corporate governance issues high on the agendas of European regulators?
JO: It is as big an issue as it is in the United States, but the methods chosen to deal with the problem are very different. Take the United Kingdom as an example. Many within the U.K. are interested in retaining a governance framework that is informed by the articulation of general principles. If you trace the development of corporate governance reform in the U.K., what you see is that each major change is linked to a domestic U.K. scandal, which undermined the validity of the principles-based argument. The Combined Code, introduced in 2003, is merely the latest manifestation of that process. The problem is that the principles can be gamed just as easily as the rules. That is to say, both variants face intractable problems precisely because they privilege shareholder value. Neither approach takes into consideration the cost to the corporation itself of short-term profit taking. What you have to do is find a way to neutralize the game.
SFM: But haven’t the regulatory changes in the U.S. also been reactionary to Wall Street’s scandals?
JO: Absolutely. The key thing becomes one of how to ensure that this latest manifestation is actually going to make a difference. In both the United States and the U.K., you find that basically there is a technical compliance with the law. In the U.S., if something is not explicitly proscribed, it is legal and therefore acceptable. In the U.K., you have a problem of creative interpretation. Neither one actually works as an effective control mechanism. The problem is made much worse because neither approach looks beyond the corporation nor the auditing profession. Targeting directors and auditors alone with changing the priorities of the securities and corporate bar or investment banking, for example, merely displaces the risk. It does not obviate it.
The solution must be based on a tripartite approach. The question is how to ensure that corporations, the markets and the financial and reputational intermediaries that provide essential services are governed by principles of honesty and integrity.
SFM: This is a question that many of the essayists in your book grapple with.
JO: William McDonough, for example, is very clear on this issue. He argues that many people within the corporate world lost sight of a “moral compass.” I thought this was an interesting and useful metaphor. How do you navigate your way through the system in which the ultimate metric is Wall Street’s metric and where the most important thing was meeting that quarter’s number?
The problem is that, in so many ways, all of the internal and external gatekeepers failed. As a consequence, we have to reconfigure the corporate governance paradigm by expanding it to include the other key associational actors.
SFM: Can you illustrate some of the problems you are seeing in other countries?
JO: I’m just back from Australia where I was researching the major scandal at the insurer Gen Re, a subsidiary of Berkshire Hathaway. This case has been through the investigative process, the regulatory process and now the criminal process in Australia and in the U.S. In essence, General Re was using its Dublin office to design finite reinsurance contracts. These sophisticated contracts were a form of financial engineering that manipulated capital valuations of major corporations in both Sydney and New York.
Ireland may have the form of a credible enforcement regime to limit this kind of transaction but the dismal reality is that competing imperatives – such as the need to develop the financial services industry – have limited its effectiveness. The situation has deteriorated to such an extent that regulators condemned their Irish counterparts for facilitating anarchy in the marketplace. Here you’ve got a problem where you have a global market but national and sometimes fragmented regulatory regimes. To be effective, corporate governance must be a global public policy priority as well as a global corporate policy.
One of the most senior regulators in Australia said to me: ‘Let’s face it. Sarbanes-Oxley is a global law.’ This was recognition that the only way to deal with a global problem is to have shared regulatory norms and Sarbanes offers a useful departure point.
SFM: What do you make of that regulator’s viewpoint?
JO: I think it is an accurate assessment. What the Australians recognize was that they had a limited part in dealing with the Gen Re scandal. The executives who engineered the transactions were in Dublin, and they couldn’t extradite them to Australia. Ireland would not deal with the problem. There was nothing the Australians could do. The U.S. Department of Justice managed to secure a guilty plea for the chief designer. The Australians recognize that it is really only when the United States moves that the systemic risk can be dealt with. They also recognize that Sarbanes-Oxley provides a mechanism now whereby companies can be held to account.
SFM: Do you believe Sarbanes-Oxley is helping the markets act accordingly?
JO: I think it represents a start but one has to remember that it is not enough to have legislation on the stature books. To be effective it needs to be enforced. One has to look at the reality of how legislation is created in the United States. In many ways, Sarbanes-Oxley could be an exercise in symbolism. The hope is that it will actually change the fundamentals of the marketplace. The fact that [WorldCom’s] Bernie Ebbers is going to jail sends a very clear message that there is now a means to hold companies to account. But we all know that the SEC is a very political organization. The question in the longer term is will the energetic enforcement that we have seen over the last few years be continued, especially with the departures of [SEC Chairman William] Donaldson and [Enforcement Director] Steven Cutler.
SFM: Do you see much of a future for securities class actions in Europe?
JO: To a certain extent. But obviously, you are going to get a much better hearing on a fraud case in the United States. What you are going to see more of is close cooperation between the SEC and other regulatory bodies in Europe. As this convergence takes root, I think that offers opportunities for more rigorous enforcement.
As Steve Cutler said to me, there’s no point in having one major law and one major priority if it is not a priority in another jurisdiction.
What you need to do is find a mechanism whereby you can link all the markets together.
SFM: In the context of your essay on New York State AG Eliot Spitzer, you remark upon the elusiveness of effective corporate control. Can you pin this elusiveness on one thing versus another?
JO: Effective corporate control is all based on a premise that markets act efficiently and that markets act rationally. I think basically markets don’t act efficiently and markets don’t act rationally. If you look at the price-earnings ratios in the U.S., you wouldn’t on a rational basis invest in any of them.
The idea that boards can control managers has been falsified in quite a devastating form in the U.S. and elsewhere. The rules of the game have to be changed and changed fundamentally, and I think that process has begun to happen.
SFM: Are you hopeful that the situation is improving for investors?
JO: I think there are grounds for optimism, but I think one has to be cautious about a number of things. One has to be cautious that regulators don’t take prosecution too far. That is something to guard against. There’s also the risk that, once the media and political spotlight move away, regulators will have to deal with very powerful and influential interest groups who continue to fund Congress to an inordinate degree.
It’s not a question of the game has been won, so everyone can stand up and go home. What has happened is a temporary realignment. But that temporary realignment has the potential to change the rules of the game if – and only if – businesses interpret the lessons of past failures.