Sustainable Finance: Gatekeepers – Halting Fraud, the Corporate Governance Breakdown

When should accountants, lawyers, etc. be held liable in order to deter their client's fraud?

It's confession time. First, “corporate governance breakdown” is search engine optimizationese for something that's usually called “securities fraud”. I know, I know, this is like using faux pas as a synonym for bank robbery. And why is “corporate governance” a hotter search term than “securities fraud” at a time when the SEC suit against Goldman and the bankruptcy examiner's report on Lehman Bros have securities fraud in the headlines? Who knows, but, like the heart, Google wants what Google wants. Second, any good ideas in this column are stolen from Multiple Gatekeepers, by Andrew Tuch, which will appear in the Va. L. Rev. Multiple Gatekeepers (MG for short, I like my law review articles in British racing green) is 77 pages long, with extensive footnotes. Some of these footnotes cite the works of professors who (literally) put me to sleep in law school – not including the ubiquitous Prof. Coffee, who arrived at Columbia long after I left and now seems to be cited repeatedly in every article, including MG, that has anything to do with corporate governance – perhaps “Coffee” is an optimal search term. This column is going to run considerably less than 77 pages, so we promise much oversimplification (sorry Prof. Tuch), for which we will compensate with frequent, obscure references that may be recognizable to a fortunate few as attempts at humor.

MG is not written on a blank slate. Many trees have given their lives to the discussion of topics like: who are gatekeepers – professionals (accountants, lawyers, investment bankers) who “rent their reputation” to assure investors of the quality of information provided by a corporation issuing securities or engaging in some other transaction requiring approval; when should gatekeepers be liable for the client's fraud – always (strict liability), when they fail to exercise due care (fault based liability) or never (since the client perpetrating the fraud is inevitably broke when caught, this answer is beloved only by, well, gatekeepers); and which of these answers will best protect society from the client's potential fraud – a question answered, at least in part, by the application of optimal deterrence theory. Optimal deterrence theory may sound like a branch of calculus used to site missile silos during the cold war, but fear not. Based on the application in MG it seems to be fairly basic game theory requiring only simple arithmetic, an understanding of expected value and an assumption that each gatekeeper will act with omniscience to maximize its utility.

MG's principal contribution is to note that transactions involve more than one gatekeeper, that these gatekeepers have an interdependent capacity to deter fraud, and that once this interdependence is recognized, optimal deterrence theory points to a fault model of gatekeeper liability as most effective in deterring client fraud. This contradicts other observers, who have argued for a strict liability approach based on the application of optimal deterrence theory to each gatekeeper independently. MG then reviews the existing legal bases for gatekeeper liability, noting the existing system is generally fault based, but prescribing greater clarity. As an aside, the 33 Act seems to have anticipated optimal deterrence theory with some prescience, while aiding and abetting liability under Rule 10b-5 lacks predictability. MG also prescribes formal procedures to enhance cooperation and coordination among gatekeepers.

Kudos, Prof. Tuch. All the right answers, for some of the right reasons. The participation of multiple gatekeepers in securities issuances and other major corporate transactions is an unassailable fact. Their interdependent capacity to deter fraud is correctly judged by Prof. Tuch, but with the emphasis on capacity, not practice. Real life gatekeepers often seek to avert liability by narrowing and clarifying the scope of their engagement rather than rooting out client fraud. Understandable, given the history, training, professional rules, fear of liability and desire to maintain a cordial relationship with the client, who is, after all, paying the bill – understandable, but not optimal deterrence. The result is gaps between the coverage of the gatekeepers, gaps through which the client bent upon fraud may creep.

Although I enjoyed the section applying optimal deterrence theory (family and friends claim I watch Star Trek, The Next Generation, but there is no admissible evidence), I did not find it persuasive. The gatekeepers don't seem to have enough information on the cost of liability and deterrence to undertake the calculations called for by the theory. Even if they did, the gatekeepers are driven by history, personal obligation, client loyalty and other factors not fully accounted for in the theory's approach to maximizing utility. Despite this, the conclusions and prescriptions match my own intuition based on experience. Right now the gatekeepers know the cost of liability is huge, even if not readily measurable in advance. They recognize they are already spending, tons, on deterring client fraud. They recognize that the approach of retreating to a narrowed engagement is losing the liability war, and most of the liability battles. Even if the gatekeepers don't have enough data to play Prof. Tuch's optimal deterrence theory game, they can still recognize that it's time to overcome history and follow his prescriptions.