Politics & Policy

The Integrity of The Process

Checks and balances must make a triumphant return.

The mutual fund scandals provide more evidence that things have been amiss in the investment business for some time. Didn’t mutual fund firms review their procedures with a fine-tooth comb in the aftermath of the Enron debacle? Didn’t they make sure their ships were sailing straight? Apparently not.

#ad#When the CEOs and boards of financial firms do not search out problems, and when the investment analysts and bankers do not uncover them either (or choose not to disclose them), how are shareholders to protect themselves? And why is that investors cannot rely on a firm’s internal and/or external auditors and their legal teams to provide the proper checks and balances?

For most companies, a CEO is hired to provide “faithful service.” The CEO and his board have the same mission: to serve the company, the shareholders, the employees, and the clients, with the CEO and the board providing checks on one another.

The other key players in the corporate balancing act are the CFO, the auditors (internal and/or external), and the lawyers (internal and/or external). When these balancers are out of whack, bad things can and do happen.

Power politics, power plays, or simply greed on the part of any of these entities can derail the integrity of the business process. And when integrity is lost, the core of an institution is violated. (Of course, this is not only valid for public and private companies, but also for government.)

So, as a democratic society, how do we ensure that the integrity of the process remains in intact (in the lion’s share of cases) within the corporate world and the investment community? One answer is that the response regulators must be truly independent and properly funded.

For instance, regulators such as the SEC and the International Accounting Standards Board need separate charters and separate funding from both the government and industry lobbyists. Their annual reviews should only come from independent boards and must be made public. A good idea would be to raise fees substantially for corporate non-compliance and violations, index the fees to inflation, and then use these monies to help fund regulatory budgets.

For the corporation, the legal counsel for the board of directors needs to be separate from the company’s internal legal counsel. The audit function — both internal and external — should report directly to the board, with only a dotted line (i.e., a working relationship) connecting the company with the internal audit function. The board should have the charge to hire and fire both the head of the internal audit and the external audit firm (which should be rotated every three to five years). All audit/legal reports should go directly to the board with the company’s response to follow.

As for the investment industry, the above practices should also be implemented — but other issues must be addressed.

It’s more difficult to ensure that checks and balances are in place in the investment business due to the lack of simplicity within the sector, as well as the tremendous egos that exist throughout its organizations. A firm lacks oversight when it’s afraid of losing people who make the firm a lot of money. This is mainly a cultural issue, one that was allowed to grow over the years. Nevertheless, it needs to be rooted out.

And it can be done. Here’s how:

– The investment industry, as a group, should pledge to eliminate conflicts of interest, which include late trading and unethical or immoral pressure on clients to generate unnecessary fees. (This can be done with some fanfare, as in publicly signing a list of principles.)

– Soft-dollar commissions and expense fees for marketing should be phased out as they result in thwarting true competition and distorting true business expenses. (These have always been controversial as they are additional layers to fee charges and harm investor asset returns.)

– Compensation should be tied to judgment performance and client service, not only fee generation.

– The non-disclosure of complex fees and fines, the layering of unnecessary fees, and the lack of stated measurements on the value of services should all be reversed — becoming instead standard ethical practices, standard forms, and standard disclosures. (This is a good job for the SEC, which is supposed to protect the individual.)

Once such badly needed reforms are implemented, and properly overseen by regulators, asset growth and returns will get a boost. This is especially important if one looks to the day when the $10 trillion Social Security liability becomes properly funded, possibly through private accounts, in the financial markets.

The investment industry and its individual companies will ultimately be judged by business integrity, not daily stock prices. That’s why a sound, non-conflicted board structure will go a long way toward ensuring the integrity of the process.

Society demands integrity, and business will thrive under its umbrella.

Patricia A. Small is a partner with KCM Investment Advisors and is the former treasurer of the University of California.

NR Staff — Members of the National Review editorial and operational teams are included under the umbrella “NR Staff.”

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