Corporate Governance

Corporate Governance, the Bailout and a Lost Opportunity (Part 1)

By J. Robert Brown

The massive failures of financial institutions and the need for extraordinary government interference in the markets if nothing else illustrate serious flaws in the current system of regulation.  Most have focused on the federal agencies responsible for overseeing the financial markets, whether the Securities and Exchange Commission or the Federal Reserve Board.  

But as the facts gradually emerge, the fundamentally unanswered question has to be where was the board?  In the report by the SEC Office of the Inspector General on the failures associated with the inspection of Bear Stearns, it was clear that the SEC knew about the possibility of overexposure by the investment banking firm to the mortgage markets.  As the report noted:

• Although TM [Trading and Markets] was aware, prior to Bear Stearns becoming a CSE firm, that Bear Stearns' concentration of mortgage securities was increasing for several years and was beyond its internal limits, and that a portion of Bear Stearns' mortgage securities (e.g., adjustable rate mortgages) represented a significant concentration of market risk, TM did not make any efforts to limit Bear Stearns' mortgage securities concentration;
  

How much of this, one might wonder, did the board know?  Presumably, as the law suits are filed and the FBI investigates (among others), we may learn some of the answers. 

Most likely, the board didn't know and herein lies the failure of the Bailout Bill.  Directors are not required to assess risk within a company or even be alerted to violations of internal limits or the establishment of other high risk positions.  Why not?  Because the duties of the board depend upon the fiduciary obligations of directors and these are interpreted by the Delaware courts.  The Delaware courts have, as we have noted, evidenced a resolutely pro-management bias in their decisions. 

These courts have declined to impose meaningful obligations on directors.  As a result, the people responsible for looking over the shoulder of the CEO and executive management to look out for shareholders usually do not.  They receive the information given to them at board meetings, meetings invariably chaired by the CEO.  They hear about the issues put on the agenda by the Chairman who is also ordinarily the CEO.  If risk related issues are not put on the agenda by the CEO, they are not addressed.  And, needless to say, top executives often lack any real incentive to fully develop these issues for the board.  They would do so if the law required but it does not.  The failure to change the duties of the board and overrule the approach employed by the Delaware courts was the largest failure of the Bailout Bill. 

We will discuss these in another post. 

Full post as published by The Race to the Bottom on October 06, 2008 (boomark / email).