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Corporate Governance

: The Race to the Bottom

The SEC, Bear Stearns and the Failure of Regulatory Oversight (Part 2)

By J. Robert Brown

Among the failure of the the inspections of investment banking firms, the Report of the Inspector General identified one problem area with respect to the board of directors.  As the report noted:   

• TM [Trading and Markets] took no actions to assess Bear Steams' Board of Directors' and senior officials' (e.g., the Chief Executive Officer) tolerance for risk although we found that this is a prudent and necessary oversight procedure;

In effect the report concluded that the staff should have used discussions of  "risk management practices" and "risk tolerance" to bring to the attention of the board: 

• "evidence that the staff [of Bear Stearns] kept increasing the firm's exposure to mortgage securities. TM [Trading and Markets] staff could also assess whether firms are inappropriately increasing leverage to help meet a revenue level that is tied to compensation that is provided to the CSEs' senior·officers.
  

The issue illustrates a continuing problem with allowing board obligations to be determined under state law and the race to the bottom.  In effect, the conclusion of the report is that federal regulators should have forced the board to focus on risk related practices, including the increasing amounts of debt. 

But the better question is why the board wasn't already fully engaged in the issue.  Under Delaware law, there is little obligation on the part of the board to ask for information or become informed about what is going on inside the company.  The only requirement is that the board have some process for receiving information in order to fulfill its obligations under Caremark and the duty to monitor.  But in fact the Delaware courts have never made the requirements meaningful.  It is, therefore, possible to meet fiduciary obligations without having an actual obligation to supervise or assess internal risks.

Without state law obligations, it falls to federal regulators to ensure that the board remains involved.  In this context, inspectors at the SEC apparently failed. 

Full post as published by The Race to the Bottom on October 02, 2008 (boomark / email).