The revelations in the U.S. Bankruptcy Court examiner's report on the collapse of Lehman Brothers Holdings Inc., issued March 11, should serve as a warning about the limits of regulatory reform, and the need for pension funds and other institutional investors to have better tools to protect themselves.
Some of those tools are contained in the financial regulatory reform legislation unveiled March 15 by Sen. Christopher Dodd, D-Conn., chairman of the Senate Committee on Banking, Housing and Urban Affairs. Pension funds should welcome provisions in the bill that give them greater ability to monitor, hold accountable and seek to better align interests of companies in which they invest.
The bill would enable shareholders to seek better oversight and accountability of corporate boards of directors by giving the Securities and Exchange Commission authority to grant shareholders proxy access to nominate directors. It also would require directors to win by majority vote in uncontested elections, and an annual non-binding shareholder vote on executive compensation.
These are useful tools for investors. Had they been in place three years ago, perhaps the boards at financial companies would not have failed to protect shareholders from excessive exposure to mortgage-risk lending, and would have ensured that incentive compensation was aligned with shareholder interests and sustainable risk-lending activities, while penalizing risk activities that put companies in jeopardy.
In addition, the bill would end the apparent protection from liability that credit-rating firms enjoyed, and make them subject to civil lawsuits under securities laws for reckless research and conflicts in their analysis.
Pension funds already have sought to test that exemption. Last November, Richard Cordray, Ohio attorney general, sued three major credit-rating companies on behalf of the Ohio Public Employees Retirement System, and four other state retirement systems, alleging the companies wreaked “havoc on U.S. financial markets by providing unjustified and inflated ratings of mortgage-backed securities in exchange for lucrative fees from securities issuers.” The California Public Employees' Retirement System in a suit filed last July makes similar allegations of conflicts and unsupportable rating analysis. Last April, the Council of Institutional Investors issued a paper calling for an end to such protection and tougher oversight of credit-rating firms.
But investors should not assume that the increased regulatory oversight called for in the bill will protect them from fraud, malfeasance or incompetence, especially given the revelations of alleged failures of regulators overseeing Lehman contained in the report of the examiner, Anton R. Valukas, chairman of the law firm of Jenner & Block LLP. Regulators were in position while Lehman slid into collapse, and they failed to detect and prevent the firm's failure.
Mr. Valukas' report pointed to alleged failings of the SEC and other regulators to act on Lehman before its financial condition worsened. The SEC, the primary Lehman regulator, while scrutinizing Lehman's liquidity pool — which was supposed to cover expected cash outflows for 12 months in a stressed environment — “did not look at Lehman's liquidity pool from a disclosure perspective,” the report alleges. In addition, the report contends it “does not appear that any agency required any action of Lehman in response to” the firm's alleged failure of rigorous stress-test scenarios developed by the Federal Reserve Bank of New York “to test Lehman's ability to withstand a run or potential run on the bank.”
The Sarbanes-Oxley corporate reforms of 2002 were enacted in part to bring more transparency to corporate accounting and oversight of auditing firms after the scandal surrounding the collapse of Enron Corp. and Arthur Andersen LLC. Yet, the court examiner's report raises questions about the work of Ernst & Young LLP, Lehman's external auditor.
The examiner found "sufficient evidence exists to support” potential claims against Ernst & Young related to Lehman's activities and reporting on transactions using a vehicle known as a Repo 105. These were complex, off-balance-sheet transactions to temporarily remove securities inventory from Lehman's balance sheet “and to create a materially misleading picture of the firm's financial condition in late 2007 and 2008,” according to the report.
Edwin T. Burton, professor of economics, University of Virginia, points out in “Insights into the Global Financial Crisis,” a newly published book of the Research Foundation of the CFA Institute, the Sarbanes-Oxley reforms elevated the role of auditing firms to regulator from service provider. But as the Lehman report suggests, the auditing firm, like federal regulators, might have come up short in its Lehman oversight. The auditing regulations should be re-examined and rewritten to account for lessons learned in the Lehman and financial market meltdowns.
Another provision in Mr. Dodd's bill would create a Financial Stability Oversight Council “to identify and address systemic risks posed by large, complex companies, products and activities before they threaten the stability of the economy.” It's a grand concept that will be hard to achieve. Looking back, it is clear there was much evidence that the mortgage bubble must soon burst, but regulators and investors, generally, failed to see the financial meltdown of 2008 coming.
The proposed council, as the systemic risk regulator, also will face difficulty in controlling information leaks, rumor and innuendo that could be dangerous to the markets and the economy. Another issue is how soon, and how, the council would release calamitous information to the market to enable investors to act on it before a company collapsed.
At the same time, companies, worried about being identified as being exposed to excessive risk, might lobby in Congress against being so tainted. In addition, the council, by keeping a tight leash on risks, could serve to dampen innovation, and in turn become the target of lobbyists seeking to stifle competition in the financial market.
In addition, a systemic risk regulator would have to define what systemic risk is and how much such risk it must perceive in the economy before action is warranted. In addition, the lack of an action by the regulator might lead Congress, businesses and investors to assume all is well and therefore to take steps that increase risk.
While institutional investors should welcome congressional efforts to revamp and improve financial regulation, they should remember that the first line of defense against fraud and malfeasance, and excessive market optimism, lies in their own research and oversight efforts.
They should also remember there will no doubt be unintended consequences from whatever new regulations emerge from Congress. For example, it is impossible to tell the impact on the markets of the proposals requiring banks to halt proprietary trading and to dispose of their hedge fund and private equity operations.
