Reluctant Guardians:Reluctant Guardians:The Responsibility of The Responsibility of

Gatekeepers for Effective Gatekeepers for Effective Corporate GovernanceCorporate Governance

John R. BoatrightJohn R. Boatright

Loyola University ChicagoLoyola University Chicago

Who Are Gatekeepers?Who Are Gatekeepers?

Third-parties (intermediaries)Third-parties (intermediaries) Whose cooperation is essentialWhose cooperation is essential Who can prevent misconduct by withholding Who can prevent misconduct by withholding

cooperationcooperation

ExamplesExamples Accountants and lawyersAccountants and lawyers BankersBankers Rating agenciesRating agencies Physicians, ISPs, bartenders, gun dealersPhysicians, ISPs, bartenders, gun dealers

Role in Corporate GovernanceRole in Corporate Governance

GatekeepersGatekeepers Provide information and certification for Provide information and certification for

directors and investorsdirectors and investors Have ability to detect and deter misconductHave ability to detect and deter misconduct Are relied on for effective corporate Are relied on for effective corporate

governancegovernance

Recent corporate scandals (Enron, etc.) Recent corporate scandals (Enron, etc.) due to multiple gatekeeper failuredue to multiple gatekeeper failure

Properly understood, Enron is a demonstration of gatekeeper failure, and the question it most sharply poses is how this failure should be rectified.

John C. Coffee, “Understanding Enron:It’s about Gatekeepers, Stupid”

The failure of this network of gatekeepers was a recurring theme in the business scandals. In too many instances, the gatekeepers in pursuit of their own financial self-interest compromised the values and standards of their professions. . . . In the recent round of corporate scandals, the first tier—the managers—failed, and then the gatekeepers failed as well.

AAA&S, Report of the American Academy’s Corporate ResponsibilitySteering Committee

Responsibility of GatekeepersResponsibility of Gatekeepers

Gatekeeper roleGatekeeper role is largely a by-product of providing for-fee is largely a by-product of providing for-fee

servicesservices Imposes a cost on gatekeeper institutions and Imposes a cost on gatekeeper institutions and

the economythe economy

What responsibility do gatekeeper What responsibility do gatekeeper institutions have beyond providing institutions have beyond providing contracted services competently?contracted services competently?

Main ConclusionsMain Conclusions

Each intermediary institution is different; Each intermediary institution is different; no “one-size-fits-all” answer is possible.no “one-size-fits-all” answer is possible.

Moral responsibilities are linked to legal Moral responsibilities are linked to legal responsibility/liability.responsibility/liability. What (morally) should the law be?What (morally) should the law be?

The appropriate moral and legal principle The appropriate moral and legal principle is what investors would choose.is what investors would choose.

Answer: Cost-effective deterrenceAnswer: Cost-effective deterrence

Legal and Political BackgroundLegal and Political Background

Gatekeeper role is currently unsettled and Gatekeeper role is currently unsettled and highly controversial.highly controversial.

Scandals have been blamed on Scandals have been blamed on gatekeeper failure.gatekeeper failure.

Hence, reforms to make gatekeepers Hence, reforms to make gatekeepers stronger (e.g. Sarbanes-Oxley).stronger (e.g. Sarbanes-Oxley).

But previous actions weakened incentives But previous actions weakened incentives by reducing legal liability.by reducing legal liability.

Weakening of Legal LiabilityWeakening of Legal Liability

Private Securities Litigation Reform Act Private Securities Litigation Reform Act (1995) and Securities Litigation Uniform (1995) and Securities Litigation Uniform Standards Act (1998) made investor suits Standards Act (1998) made investor suits more difficult.more difficult.Central Bank of Denver v. First Interstate Central Bank of Denver v. First Interstate Bank of DenverBank of Denver (1994) virtually eliminated (1994) virtually eliminated aiding and abetting liability.aiding and abetting liability.Motivation was to reduce “litigation tax,” Motivation was to reduce “litigation tax,” but may have led to scandals.but may have led to scandals.

Further (Mixed) DevelopmentsFurther (Mixed) Developments

In re Enron: In re Enron: Prosecution of intermediaries Prosecution of intermediaries as primary violatorsas primary violators based on SEC definition of what it means to based on SEC definition of what it means to

“make” a false statement“make” a false statement

Legal doctrine of “deprivation of honest Legal doctrine of “deprivation of honest services”services” at issue in prosecution of Merrill Lynch at issue in prosecution of Merrill Lynch

bankers in Nigerian barge casebankers in Nigerian barge case

More (Mixed) DevelopmentsMore (Mixed) Developments

Aggressive federal prosecution guidelinesAggressive federal prosecution guidelines Pressure on potential defendants to Pressure on potential defendants to

cooperate and settlecooperate and settle Recent revision of prosecution guidelinesRecent revision of prosecution guidelines

The backlash against Sarbanes-OxleyThe backlash against Sarbanes-Oxley ““Paulson Commission” recommendationsPaulson Commission” recommendations Challenges to the constitutionality of PCAOBChallenges to the constitutionality of PCAOB

3 Arguments for Responsibility3 Arguments for Responsibility

ComplicityComplicity: An obligation not to be : An obligation not to be knowingly complicit in (aid and abet) knowingly complicit in (aid and abet) wrongdoing of clientswrongdoing of clients

ContractContract: An obligation to fulfill a contract : An obligation to fulfill a contract to serve as a gatekeeperto serve as a gatekeeper

WelfareWelfare: An obligation to protect others : An obligation to protect others from the harm of client’s misconductfrom the harm of client’s misconduct The “good Samaritan” argumentThe “good Samaritan” argument

3 Objectives of Responsibility3 Objectives of Responsibility

RectificationRectification: To ensure that perpetrators : To ensure that perpetrators of fraud are rightly punishedof fraud are rightly punished

CompensationCompensation: to ensure that victims of : to ensure that victims of fraud are fairly compensatedfraud are fairly compensated

DeterrenceDeterrence: To ensure that potential : To ensure that potential perpetrators are deterred from committing perpetrators are deterred from committing fraudfraud

The Complicity ArgumentThe Complicity Argument

There is a moral (and legal) obligation to There is a moral (and legal) obligation to avoid avoid knowingknowing substantialsubstantial participationparticipation..How much effort should be made to know:How much effort should be made to know: Whether client is engaged in wrongdoing?Whether client is engaged in wrongdoing? The extent to which services enable the The extent to which services enable the

wrongdoing?wrongdoing?

Answering each of these questions involve Answering each of these questions involve considerable costsconsiderable costs Which are paid by investors.Which are paid by investors.

Costs of Avoiding ComplicityCosts of Avoiding Complicity

To avoid complicity, intermediaries mayTo avoid complicity, intermediaries may Gather considerable amounts of informationGather considerable amounts of information Remain purposefully ignorantRemain purposefully ignorant

Costs of high standards of liabilityCosts of high standards of liability Litigation and settlement costsLitigation and settlement costs ““Ripple effects”: avoidance of risky clients, Ripple effects”: avoidance of risky clients,

higher costs of capital (“litigation tax”)higher costs of capital (“litigation tax”)

The Investor’s BargainThe Investor’s Bargain

If investor’s could write the law, what If investor’s could write the law, what would it be?would it be?

Why should investors’ preferences by Why should investors’ preferences by considered?considered? They bear the costs and accrue the benefits.They bear the costs and accrue the benefits.

Principle: There is no justification for more Principle: There is no justification for more stringent gatekeeper responsibility than stringent gatekeeper responsibility than investors would choose (and pay for).investors would choose (and pay for).

What Would Investors Choose?What Would Investors Choose?

To forgo compensation if deterrence is To forgo compensation if deterrence is more cost-effective.more cost-effective. Cf. no fault automobile insuranceCf. no fault automobile insurance

To have the most cost-effective system of To have the most cost-effective system of deterrence.deterrence.

The most cost-effective system involvesThe most cost-effective system involves How much deterrence?How much deterrence? What means of deterrence?What means of deterrence?

The Means of DeterrenceThe Means of Deterrence

Gatekeepers are only one meansGatekeepers are only one means

Other means includeOther means include Direct sanctions on primary violatorsDirect sanctions on primary violators Structural rules, e.g. PCAOBStructural rules, e.g. PCAOB Safeguarding rules, e.g. on conflict of interestSafeguarding rules, e.g. on conflict of interest Empowerment rules, e.g. independenceEmpowerment rules, e.g. independence Market incentives. e.g. reputationMarket incentives. e.g. reputation

Challenge: to find the optimal total systemChallenge: to find the optimal total system

Contractual/Fiduciary DutiesContractual/Fiduciary Duties

What contractual/fiduciary duties does an What contractual/fiduciary duties does an intermediary have toward a client?intermediary have toward a client?Merrill Lynch case: What is entailed by a Merrill Lynch case: What is entailed by a duty to provide “honest services”?duty to provide “honest services”?Principle: What contracts would be written Principle: What contracts would be written by shareholders/investors?by shareholders/investors?To what extend should intermediaries be To what extend should intermediaries be able to rely on assurances of top able to rely on assurances of top management?management?

Arguments from WelfareArguments from Welfare

When may the law justifiably create a duty When may the law justifiably create a duty for intermediaries to act as gatekeepers to for intermediaries to act as gatekeepers to protect investors?protect investors?

Kraakman:Kraakman: Ineffectiveness of direct deterrenceIneffectiveness of direct deterrence Inadequate market incentivesInadequate market incentives Gatekeepers who can be induced by legal Gatekeepers who can be induced by legal

rules to deter reliably at low costrules to deter reliably at low cost

ImplicationsImplications

Developing a cost-effective system of Developing a cost-effective system of deterrence requires information deterrence requires information processing that can be done only by processing that can be done only by government and markets.government and markets.

Intermediaries should not determine their Intermediaries should not determine their responsibility unilaterally but abide by legal responsibility unilaterally but abide by legal rules and market incentives.rules and market incentives.

The EndThe End