Balancing act: regulation and ethics.

Will interaction between corporations and regulatory bodies change in the coming decade? Will regulation be more burdensome or less?

In the September/October issue of Financial Executive, a number of executives reflected upon regulatory issues. Among those reflections were several I'd like to address. Here is the first:

* "Companies in the next decade will interact with regulatory bodies much as they have in the past. If an issue affects a company, then that firm will get involved. I don't see any proactive initiative developing on the part of individual companies of their lobbying agencies."

I agree that, for the most part, the business community will go on interacting with regulatory bodies much as it has in the past. But there is one area in which the corporate financial community has the obligation, and the opportunity, to do more.

Members of the corporate financial community go to Washington to talk to senior staff and commissioners at the SEC. They comment on SEC rule proposals, as well as on FASB and AICPA exposure drafts. They also talk to elected leaders and their staffs in the halls of Congress--sometimes effectively, as happened with the Wyden bill last year. But their sights should now be raised in Washington, as they long have been raised at the FASB.

Why? Because not only does the corporate financial community need input into SEC decisions, the SEC needs the input that the financial community can provide. The SEC has had, in my memory, only one in-house corporate lawyer as a commissioner. It has never had a professional financial executive as a commissioner. There hasn't even been a commissioner with an accounting background for a number of years. Input into the SEC requires a seat on the Commission.

Yes, it will be a long political pull, but the game is very much worth the candle. And since it won't be achieved quickly, the time to start is now.

THE BURDEN OF REGULATION

In the Financial Executive article, other executives made these comments about interacting with regulators:

* "Regulation will no doubt become more and more burdensome and expensive. It's a function of big government, and it would be very difficult for the system to change. Too many people have too much to lose, and these are the same people who are changed with orchestrating the changes."

* "Our challenge is to ameliorate the excesses of recent years without reverting to counter-extremes or regulatory strangulation. For example, the sensationalist media and the demigods of Washington have condemned junk bonds. Nevertheless, the basic premise of these bonds, to create a new source of funding for small and less creditworthy companies, promotes the growth of many new business, expands research, encourages innovation, increases employment, and improves the economy in general. Those who criminally abused this new instrument deserve to be just where they are, but the fundamental idea of junk bonds was good."

* "My greatest worry about the future of corporate finance is the potential crush of regulation. More and more energy and resources are being spent on conforming with and reacting to regulatory intervention. Some regulation certainly is needed in today's worldwide marketplace, but it should be intelligent and resourceful, not anti-competitive."

I have become somewhat notorious for agreeing with those sentiments.

Regulatory intrusion lays on the regulated a set of costs. Those costs are borne by the regulated entities initially, but then they ripple outwards and are borne by the public. When unrecognized, those costs can be insidious; when unrestrained, they can be suffocating. It is therefore essential that regulators estimate those costs and balance the benefits sought against the costs to be incurred.

Moreover, that balance should be reassessed periodically, as benefits and costs become more tangible. The objective is to promote the most effective functioning of the regulated activities, while offering the least intrusive regulatory burden. The work of two Nobel laureates, Merton Miller and Ronald Coase, in identifying the inefficiencies that stem from regulatory efforts, should have taught us the value of that objective.

When financial disclosure is imposed by rule-making, the initial balancing appears all too often to reflect hoped-for benefits without real consideration of anticipatable costs. And it is a rare occasion (despite the Regulatory Flexibility Act) when re-balancing is undertaken after regulatory requirements have been in place for a while.

When financial disclosure is imposed by prosecutory enforcement (normally by consent order deemed applicable to every reporting entity in a similar situation), hardly even a pretense of balancing is observed. In my view, financial regulators who fail to analyze --and continually re-analyze--the costs as well as the benefits of their regulatory actions misperform their function. And by so doing, they justify the criticism that the entire system of regulation is unduly burdensome, expensive, strangulating, and anti-competitive in the world marketplace.

Secretary of the Treasury Nicholas Brady put these matters in focus for me in a speech to the International Organization of Securities Commissions last September. With reference to events that were roiling the government securities markets, he called for "swift and fair justice from balanced and consistent regulators." He pointed up the choice, and temptation, among enforcement alternatives. "In the desire to seek out criminals and build our reputation as tough enforcers," he said, "let us not forget that there are many honorable people in our financial institutions [and, I would add, nonfinancial enterprises] who are as appalled as we are at recent events." He also said: "We in the regulatory community will have the laboring oar in creating new regulations [and, I would add, new enforcement policies]. If they are sensible, they will improve our chances to avoid this kind of fraud in the future. But ... if the system we create is too onerous, the money and the markets will work around it [or away from it] or not work at all."

A STRONG CODE OF ETHICS 

A further crucial factor must be taken into consideration. In testimony before the Senate Securities Subcommittee in June 1991, the SEC took a position on reporting entities that may be paraphrased as follows: While the laws and regulations applicable to financial disclosure are complex, and while good faith problems may occur even in the best firms, it is not a valid ethical standard for a firm simply to try to avoid prosecution by the SEC for violating applicable rules. Rather, it is the highest duty of business leaders to establish an environment in which a strong code of ethics determines what is to be disclosed. A strong code of ethics should prohibit a firm from approaching even the edge of unlawful conduct.

In the view of this former commissioner, every executive should see it as a personal obligation to make an immediate, full investigation when problems do occur within his or her business enterprise. The discovery, investigation, correction, and (if material) subsequent reporting of financial wrongdoing, when performed by executives under supervision by the board of directors rather than by the government's investigatory forces, encourages compliance with the law throughout the reporting system and in the financial markets generally.

Not the public's and the media's acclaim for muscle-flexing regulators, but rather the effective spreading of the contagion of law compliance, creates the best and safest market system Cith the most genuine protection for investors.