Institutional Investor

Harvey Pitt Says Onus On Biz Leaders, Not Regulation

04/18/06

It’s perhaps an understated cliché to observe that we live in interesting times. The curse plaguing the financial community is thought by most folks to be Chinese. The hex, “May you live in interesting times” dates to 1900 and was one of three curses used by Ernest Bramah in his book, “The Wallet of Kai Lung,” a series of tales set in an imaginary version of China. The others were “May you come to the attention of those in high places,” and “May the Gods grant your prayers,” which today might be rephrased as “Be careful what you wish for”. All three have roiled the financial community for the last five years.

The astounding parade of scandalous transgressions by companies, institutions and individuals has been breathtaking, reflecting a failure of corporate governance as well as corporate malfeasance, misfeasance and nonfeasance. The infringements reflect a fairly widespread abandonment of adherence to ethical, moral and legal obligations. As scandal after scandal hit the front pages, it’s no wonder investors began to doubt the integrity of all businesses, not just those involved in the scandals.

Moreover, these scandals occurred as more Americans than ever were invested in the stock market. More than 53% of American households participate in our securities markets, and they demanded action. The result was the Sarbanes-Oxley Act of 2002, or S-Ox, as we lovingly call it in DC. This hastily drafted and rapidly enacted legislation had both intended and unintended consequences.

At the time S-Ox was overwhelmingly enacted, the private sector hadn’t really taken the initiative to solve some of the ugliness we’d seen in corporate governance and transparency. That, perhaps more than anything, contributed to the public’s actual loss of confidence, a tremendous misfortune as true reforms must — and can only — come from the private sector.

True reforms can only occur when those on whom the obligation falls meet two essential criteria: First, the agents of reform actually have to know what they’re doing; second, the agents of reform must actually learn that it is in their own self-interest to produce reform. This is a simple message, but many are slow to embrace and inculcate it.

Yet it’s imperative that the private sector take the lead. Confidence only comes when investors and customers believe they are cared about. Regulation can’t substitute for people doing their jobs honestly. This places a premium on having the private sector reform its conduct and culture not just to meet, but to exceed, the highest standards of conduct.

Ultimately, marketplace forces will require companies to pursue full transparency and good compliance policies. Much of this impetus will flow from financial services companies, which have learned the hard way that they can’t rely solely on their own due diligence efforts. Moreover, rating agencies now rate governance in determining debt ratings. This, of course, will also have a direct, bottom line impact on the cost of raising capital in non-equity markets. Similarly, insurance companies that have been hit hard in making payments on behalf of those companies that have surfaced with problems, will condition the granting of directors and officers and errors and omissions insurance policies, and the premiums for those policies, on the extent to which good compliance and risk assessment prevails.

Companies lacking transparency and good governance are also being abandoned by the Big Four accounting firms, who are under enormous pressure to shed their “losers” before another bad audit blotches their own balance sheets. Companies that don’t set, and then meet, higher standards, will also be abandoned by commercial banks when seeking loans and will find it hard to attract quality directors.

What this means is that, wittingly or not, corporations and financial institutions will be compelled to meet new governance standards in order to survive and prosper. More than any government regulation or prosecution, these are the factors that will, and should, drive the push toward better governance, more accountability, and greater transparency. Businesses should assume the initiative in cleaning up their own acts.

Contributor Harvey Pitt helmed the Securities and Exchange Commission from 2001 to 2003, playing a major role in the creation and enactment of the Sarbanes-Oxley Act. Pitt is currently the CEO and Founder of Kalorama Partners, a global consulting firm.