The Illusion of Wall Street Reform

The following op-ed was co-authored by Situationist contribtor Jon Hanson and a Situationist fellow. “In crisis, beware illusion of reform” was published in the Providence Journal.

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IN CASE you missed it, global financial markets have been rocked by a series of unsettling events. The collapse of Lehman Brothers and the $700 billion government bailout package are only the latest in a string of shocks — a string that, if investors’ worst fears are realized, represents the beginning of a much more dramatic unraveling of the global financial fabric.

Seven years ago, American markets were in similar turmoil. Such companies as Enron were using “aggressive accounting,” “special-purpose entities” and other balance-sheet tricks to hide risks and represent themselves as healthier than they were.

The accounting scandals of the early 2000s and the reform that followed have much to teach us about our approach to the current crisis. Then, as now, the problem stemmed from convoluted financial instruments that few people could disentangle. Then, as now, corporate behemoths that had seemed invincible came crumbling down (Enron was the biggest bankruptcy in history until WorldCom, which was the biggest bankruptcy in history until Lehman Brothers).

Then, as now, virtually everyone agreed that a big part of the solution was to be found in some sort of additional regulation. Today, Barack Obama calls for “regulatory reform,” while John McCain (a long-term proponent of deregulation) has called for “comprehensive regulations that will apply the rules and enforce them to the full.”

It was that sort of regulatory impulse that, in Enron’s aftermath, gave us the Public Company Accounting Oversight Board and the Sarbanes-Oxley Act of 2002 (“SOX”), which President Bush called the most far-reaching overhaul of America’s business practices since the Great Depression.

Sure sounded promising. The latest bailouts and scandals will no doubt lead to similar reforms, some of which are already in the works. An important question, then, is what those reforms should be — a topic that will occupy many scholars, policymakers and commentators in the upcoming months.

Unfortunately, there is a good chance that those reforms will not have much long-term effect. The real risk is that we get the illusion of reform, not meaningful, substantive and lasting reform. Calls for change come loudly when a crisis rears its head. Inevitably, however, the fervor fades, as workaday duties, dentist appointments, American Idol and the pennant races distract the public and, in turn, policymakers.

While the rest of us turn to other matters, the regulated entities themselves will maintain a steady focus on one question: existing regulations and how to weaken them.

In the aftermath of Enron and WorldCom, corporations, to maintain their legitimacy, initially expressed outrage and wholeheartedly supported new regulations. Members of the Business Roundtable were “appalled, angered and, finally, alarmed” about the problem. President Bush was right, in their view, to berate the bad-apple business executives and to call for more rigorous regulatory standards for all. “We must and will be at the forefront of supporting these reforms,” the Roundtable concluded.

Riding the wave of that consensus, lawmakers took a series of steps, patted themselves on the back, and moved onto other matters, and we all assumed the problem was solved. With that, what had been implicit resistance turned to explicit pressure from the business community to minimize and undo the “reform.”

Consequently, the post-Enron reforms never lived up to the post-Enron rhetoric, and the regulatory teeth that Sarbanes-Oxley initially flashed have been blunted by pro-business revisions. Some provisions never made it into SOX, such as a requirement that lawyers report to the Securities and Exchange Commission if a company’s board failed to respond to warnings about misconduct.

Other provisions exist only on paper, such as Section 404’s “assessment of internal controls,” the compliance date for which has been repeatedly delayed (for nonaccelerated filers) and now stands at Dec. 15, 2009. The Committee on Capital Markets Regulation, with the blessing of Treasury Secretary Henry Paulson and in the name of “U.S. competitiveness,” has promoted several reforms that make it harder for companies to be sued and more difficult for the SEC and others to regulate.

The committee’s members include heavy hitters from the world of business and finance, including Thomas A. Russo, the vice chairman and chief legal officer of Lehman Brothers.

If history is any guide, the same sort of dynamic will unfold this time around. The reforms that we see will be largely procedural, not substantive — check this, sign that, certify here, jump a hoop there — and they will not fundamentally change the situation that produced this crisis. The reform will look sweeping, because it will be broad-based and ballyhooed as “tough.” Soon enough, the business elite will complain that, indeed, it is too tough. We will learn that small-business owners and entrepreneurs, not to mention Fortune 500 firms, are being tangled and tripped up in overregulation and needless compliance costs.

The mantra of “markets good, regulation bad” and the primacy of shareholders will return. Erstwhile concerns about third parties — such as the taxpayers who are bailing out companies — will gradually be eclipsed by claims that those very groups are the most harmed by the new regime. After all, these burdensome regulations go too far and “hurt American competitiveness,” “drive business, jobs and tax revenues overseas,” “increase costs for consumers,” and so forth.

Such is the “law of unintended consequences,” which apparently applies to only regulations and regulators, never markets.

The reform, which might look promising initially, will be rolled back, whittled away and watered down (corporate lobbyists are already positioning themselves to grab a piece of the $700 billion bailout).

That’s the thing about illusions: What appears to exist doesn’t. To address the financial crisis, regulatory reform is certainly needed. But no less important will be mechanisms for girding those regulations against the influence of the regulated. Beware the illusion of reform.

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For a related Situationist post, see “The Situation of Illusion.”

Self-Handicapping and Managers’ Duty of Care – Abstract

David Hoffman‘s intriguing new article, “Self-Handicapping and Managers’ Duty of Care,” just came out in Wake Forest Law Review. It is also available on SSRN. Here’s the abstract.

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This symposium essay focuses on the relationship between managers’ duty of care and self-handicapping, or constructing obstacles to performance with the goal of influencing subsequent explanations about outcomes. Conventional explanations for failures of caretaking by managers have focused on motives (greed) and incentives (agency costs). This account of manager behavior has led some modern jurists, concerned about recent corporate scandals, to advocate for stronger deterrent measures to realign manager and shareholder incentives.

Self-handicapping theory, by contrast, teaches that bad manager behavior may occur even when incentives are well-aligned. Highly successful individuals in particular come to fear the pressure of replicating past success. To avoid the regret associated with the future failure that they anticipate, such individuals then create hurdles (through active or passive self-sabotage) or excuses. When failure comes, individuals hope to shift attention from their merits to the handicap. Research shows that self-handicapping works. Indeed, managers in failing firms who self-handicap may escape with their reputations and compensation burnished.

In this essay, I summarize an extensive body of research on self-handicapping that surprisingly has not been well explored by corporate law theorists. I then suggest that modern corporate scandals traditionally understood as products of failures of monitoring – like Enron – might be better explained in part as a function of self-handicapping by managers. This explanation supports recent efforts to move beyond a purely carrot-and-stick model of corporate governance. Finally, I briefly discuss mechanisms to reduce self-handicapping by corporate officers, in particular, making them self-aware and selecting executives less prone to engage in this type of wasteful activity. The law has a potential role to play in this process, but its proper focus is directors’ negligence in hiring, not managers’ failures in taking business risks.