Sunday, January 16, 2011

SOX and the financial crisis 

From the always amusing morning links over at Maggie's, this observation from Professor Bainbridge about SOX and the financial crisis:

The strict conflict of interest rules embedded in the new definitions of independence made it difficult for financial institutions to find independent directors with expertise in their industry. A survey of eight US major financial institutions, for example, found that two thirds of directors had no banking experience. Given the inherent information asymmetries between insiders and outsiders, the lack of board expertise significantly compounded the inability of financial institution boards to effectively monitor their firms during the pre-crisis period...

In addition, the need to find independent directors put an emphasis on avoiding conflicted interests at the expense of competence. In other words, the problem was not just that the new definition of independence excluded many candidates with industry expertise, it was also that the emphasis on objective indicia of conflicts dominated the selection process to the exclusion of indicia of basic competence and good judgment.

Indeed, and dare I say, "obviously." With regard to the first point, in complex and intertwined industries competence and experience, on the one hand, and conflicts of interest, on the other, are directly correlated. There is virtually no avoiding it. That is why, for example, command and control regulatory agencies almost inevitably become "captured" by the industries they purport to regulate. Many businesses require such specialization of knowledge that there simply is no way to hire capable regulators (or, in private sector governance, directors) who are free from some technical conflict of interest. The real question in vetting directors or regulators ought not to be whether there are such conflicts, but whether the candidate is of sufficient character that he or she will act responsibly notwithstanding. Unfortunately, the lawyers and journalists who attack these conflicts have a self-interest (winning a lawsuit or attracting an audience) that drives them to ignore considerations that matter -- such as character -- that are difficult to prove. In fact, the directors who have the "cleanest" records from a conflicts point of view -- academics and other theoreticians -- lack the crucial practical experience that is the core requirement of an effective director.

And, I might add, academics and other "conflict-free" directors are a lot more concerned with losing their income from their board seats than currently working CEOs and CFOs, for whom the director fees are unimportant (because they have large incomes anyway). The inherent conflict of incumbency weighs much more heavily on people who are not already rich, and is much more likely to influence their opinions. But that is hard to document, so the natterers ignore it and focus on minor if meaningless financial conflicts that they can "prove."


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