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Monday, January 23, 2006

Fanto, Ribstein, and New Models for Regulating Governance

Jim Fanto of Brooklyn Law has a new paper up on SSRN, Paternalistic Regulation of Public Company Management: Lessons from Bank Regulation.  The paper argues that the regulation of the banking industry offers insights into regulating the governance of public companies post Sarbanes-Oxley.  Fanto notes that the federal regime of bank regulation is much more encompassing and more involved in everyday business decisions than the federal scheme of securities regulation.  Given the strict penalities Sarbanes-Oxley levies for noncompliance, Fanto argues that the SEC should have better means of communicating with directors and officers about what is permitted and what is illegal.  His article proposes that the SEC appoint a corporate governance monitor, similar to a bank examiner, at large public corporations in order to catch malfeasance and offer counsel about the law's requirements.  Along with better regulatory enforcement, Fanto argues that his proposal would better manage management's risk of prison or industry expulsion by offering a conduit for information between corporations and the agency.

Larry Ribstein criticizes Fanto's proposal as a "disturbing new vision of the corporation."  He argues that banks deserve to be treated differently than other corporations (thanks to deposit insurance) and that SEC monitors will further dampen the dynamism and freedom necessary to American enterprise.  However, Fanto's proposal does serve Ribstein's interests in foreshadowing a brave new world of corporate regulation.  As Ribstein notes, "It’s quite possible . . . that Fanto has seen the future of corporate governance reform: the big corporation as bank. "

While I agree that big corporation need not be regulated like FDIC-insured banks, I don't think Fanto believes they should be either.  His proposal is intended to remedy two problems with the current level of regulation.  First, the sanctions for crossing the fuzzy line between legality and illegality are now much more severe.  Second, even with these sanctions the ability of the SEC to root out fraud is significantly compromised.  An SEC monitor would help on both of these fronts: the monitor could help a company determine exactly where the legality line is, while at the same time helping the SEC have access to better information about corporate compliance. 

Fanto's proposal is a laudable effort to generate new approaches to improving corporate governance.  Yes, the thought of a government monitor snooping around may seem a little frightening.  But aren't accountants also supposed to be policing the corporation in the interests of the investing public?  Accountants are imperfect watchdogs for innumerable reasons; for more on this subject, see Sean O'Connor's articles here and here, among others.  It may make sense to have more functionally independent watchdogs, even including government officials.

Ribstein believes that some level of fraud is inevitable to a free economy, and that reforms such as Fanto's would fail to overcome their costs in reduced productivity.  Yes, it is true that the optimal level of agency costs is not zero, if such a result is dwarfed by productivity losses and compliance costs.  But I also disagree with the assumption that new models of regulation will inevitably fail to justify their costs.  If Fanto's model were paired with lower criminal penalities, fewer SEC investigations, and even less public disclosure, it might be something in which even management groups would take a interest.

Posted by Matt Bodie on January 23, 2006 at 01:17 AM in Corporate | Permalink


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The paper has to speak for itself. But I am grateful to Matt for emphasizing the "positive" side of the monitor: e.g., to give executives some give-and-take with the SEC before the iron fist of enforcement or prosecution falls upon them. Admittedly, it is always kind of utopic (and thus academic) to call for yet another monitor of management of public companies. We have the existing market "gatekeepers" so beloved by many. It would be nice if they lived up to their roles. However, until the ethical standards, culture and practice of accountants, lawyers and bankers are strong enough to give them a social identity that will enable them to resist the attraction of destructive management groups, it is necessary to look elsewhere for an outsider with independence and authority (thus, the monitor proposal).

Posted by: James Fanto | Jan 23, 2006 12:18:36 PM

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