Mr. Chairman and Honorable Commissioners
You have solicited comments on the Commission's comprehensive proposal to amend ten exemptive rules to require any fund that relies on any of them to adopt certain fund governance standards. As a registered professional engineer (PE) and member of the Institute of Internal Auditors (IIA), the venerable challenges of applied corporate governance are central to a vocation in "internal control." As you well know, governance has been positioned by society as a watchdog profession, legally bound to resist the forces of organizational conformity. The institutions of governance, from the information assembled by internal control, define the environment of the institution.
Building blocks for the rationale of governance
There are as many definitions and elaborations of the term "corporate governance" as there are institutions that claim some authority or stake in the matter. The NYSE has been agonizing in recent years over governance requirements for listing that will preserve both the status quo and regulatory cooperation. The term itself was invented to describe sundry responses to the economics of litigation stemming from scandal - fraud writ large.
From the beginning, corporate governance has been the promotional matter offered to assist stakeholders in composing their intellectual alibi for trusting the institution, at their economic peril, one more time. After endless cycles of trust and betrayal, the debris of litigation accumulated into a comprehensive fiduciary duty assigned to the board of directors - but aggressively unenforced. In the CalPERS version of governance, it is written that director candidates should have "core competencies in crisis response." This esteemed talent is, exactly, what corporate governance has come to.
The institutions of governance operate at the level of individual transactions. For economic efficiency with the quantities involved, the various legal obligations of corporate governance and its risk derivatives are implemented, institutionally, through the management-designed functionality of "internal control." The production of this "organized" transaction-information complex defines management's take on the prevailing economics of liability. Corporate governance by senior management can be no more astute than the intelligence supplied to it by the internal control affair it directs.
The long, wide record established by corporate governance, like the war on drugs, speaks for itself. Both the internal control system and the independent auditors of internal control account for less than twenty percent of fraud detected. The spin-off profession especially configured to find the fraud that routinely escapes the sweep of internal control and its auditors adds but a few percentage points to the scorecard. The performance history validates, as it must, the inherent limitations of governance by time-displaced hindsight, hierarchy, and investigative techniques. The lesson yet to be learned by Congress is that no system of governance confined to looking backward in time through delays and hierarchical diffusion is capable of safeguarding the future of stakeholders.
Management, governance and regulation
Responsible corporate governance focuses on constantly improving the system of intelligence used by the organization to select activities that attain goals while avoiding peril. In order to identify, explicate and mitigate contractual hazard, any well-managed institution will already have everything informational for regulatory oversight installed and humming away. All effective project management begins with timely, reliable information about resources consumed for progress made. The more complex the operation and its context, the more intelligence is critical to success. To think about backfitting intelligence after its time for use in choosing activity is absurd. Information for appropriate selection of activity will not keep.
It is only when operational decisions are inappropriately made by management discretion instead of facts that corporate governance stands in conflict with the intent of SEC regulation. Any management team making business decisions on whim and caprice is rightfully hostile toward any mandate to backfit evidence of a rationale. The requisite intelligence effort for proficient goal-seeking operations is seen as a total waste of resources to command by authority.
The preoccupation with various director character qualifications is a dead giveaway that your scheme of corporate governance is not driven by appropriate business intelligence - the terror-engendering "transparency" heralded by 404. Avoiding the informational core of decision-making is why, exactly, pressures to defer crossing the SEC Rubicon of 404 escalate. With two deferrals already attained, the non-compliant continue to dazzle stakeholders, including me, with blue smoke and rear-view mirrors. The SEC is caught in the same arrogant squeeze box management places the internal auditors.
The operational reality
If the governed do not have their intelligence-gathering act together, with horizontal and vertical fact-driven coherency, and the definitions promulgated by the SEC for that are as good as any, fiduciary responsibility is impossible. The regulatory obligation assigned to corporate governance, confined to hindsight, cannot be attained at any price. In the end, fussing over independence and ethics, while 404 lies dormant, perpetuates the agitated, lose-lose condition we have.
From the trenches of individual transactions, the coliseum of corporate governance is experienced as the arena where the business judgment rule routinely subdues internal control. There, the tyranny of discretion serves leaders as a quasi-jurisdictional barrier to prevent courts from exercising regulatory powers over the activity selection process used by corporate managers. As a manifestation of forbearance doctrine, the business judgment rule is the opaque engine that drives the chain of command. All the graduate business schools I attended taught that arranging activity on the basis of appropriate intelligence undermines the efficacy of the hierarchy. It does.
Design governance regulations as you wish. But you waste your time trying to fool the professional workers on the front lines of internal control. They are keenly aware of the utility and reliability of the informational produce consumed by financial reporting. The view up at the SEC strategy of independent board composition, staff, chairman, and separate meetings without management leaves no doubt about the outcome. Management gets the internal control system it wants.
With board self-assessments spaced a year apart, there is plenty of time for raiding the corporate treasury before your compliance examiners arrive on the scene. I doubt that your intrepid examiners facing yet another too little too late condition have any more job satisfaction than a professional internal auditor. In governance restricted to hindsight information controlled by management, all the conditions essential for scandal to occur are preserved.
The alien realm
For society to survive, the hindsight realm covered by institutional regulation is necessary but insufficient. As the arrow of time travels forward, effective societal preservation requires anticipating some of the possible scenarios residing within the cone of the future. The realm of tort law, now grinding away over the Enron class of corporate scandals, is predicated on forward-looking activity. Tort liability is immersed in the negligence of failing to anticipate that which was reasonably foreseeable - prior to the circumstances of damage. It is why we look for asteroids on a collision course with Earth. Good move.
The conditions of the PE license have always focused on competency with foreseeability. Between mindless compliance to rules of action and design responsibility for the future, the PE has no choice. He must apply the best available technology in the process of engineering to anticipate the various conditions of use, including oligarchical excesses. He must maintain a running forecast of project success so reliable that remaining associated with what will turn out to be a loser is automatic malpractice. The duty of foreseeability is, exactly, the driving force for comment.
It is the great material advances in the process of engineering (foreseeability) that have so radically and permanently altered the economics of tort liability. Regardless of apparent complexity, there is no event of damage that cannot be shown contemporaneously, or retroactively in tort court, to be foreseeable. Accident reconstruction, now routinely part of litigation, is exactly the same engineering feat with control theory as accident foreseeability. All dynamic simulations that take system debris back in time go forward in time equally as well. In a looping calculus, the status of the system at one instant is the platform for computing the state of the system in the next instant. The individual system characteristic equation driving the transition is called the transfer function. All control systems designed to seek goals are extremely sensitive to activity consequences and other disturbances. Fraud appears as just another disturbance to be nipped in the bud.
Crisis management and damage response as the impetus for changing rules of corporate governance is not the stuff of control. It is obedience to authority and it is linear. Making alterations in the internal control "system" based upon material deficiencies discovered by audit is not goal-seeking control, it is management by total improvisation. For any corporation selecting activity by a method inappropriate to the circumstances of its mission, backward-looking corporate governance of any stripe can make no difference in outcome. It may be your professional duty, as it is certainly for the PE, to know that that is the case.
Frames of reference
As defined by the SEC, internal control is the corporate transaction information system, an irrevocable responsibility of management, for contemporaneous regulatory compliance. By assigning supremacy to a management fully shielded by the business judgment rule, management discretion takes care of the threat to its command. The internal control system it designs is a reflection of how much intelligence is going down the chain of command.
The record showing what intelligence management actually uses to run the company is available to the public. Internal audit veterans keep a running account of the incessant abuses and violations of corporate governance on forums maintained by the IIA. Anyone, including the SEC, can join the discussion groups and review the record as it is compiled (http://www.theiia.org). The documented experience in the trenches of transactions speaks for itself. All industries, all sizes, and all managements are included. As with any viable system, the purpose of internal control is what it does.
Loop over linear for governance
The US National Institute of Standards and Technology, in NIST T1393, defines corporate governance as "The system of management and controls exercised in organizational stewardship. It includes the responsibilities of corporate owners/shareholders, board of directors, and administrative leaders. Corporate charters, by-laws, and policies document the rights and responsibilities of each of the parties and describe how the organization will be directed and controlled to ensure (1) accountability to all stakeholders, (2) transparency of operations, and (3) fair treatment of all stakeholders. Governance processes include approving strategic direction, monitoring and evaluating senior leader performance, financial auditing, managing risk, disclosure, and shareholder reporting. Ensuring effective governance is important to stakeholders' and society's trust and to organizational effectiveness."
The Institute of Internal Auditors (IIA) in their ubiquitous "Red Book" defines corporate governance as "The procedures used by the governing body to provide oversight of risk and control processes administered by management." Risk management is defined as "A process designed to identify, manage, and control potential events to provide reasonable assurance regarding the achievement of organizational objectives."
Both of these definitions of corporate governance revolve around the functionality of "control" using anticipation. As any PE must know, regulation by rules of action is not capable of anticipatory control. Developing the intelligence for appropriate selection of activity is an assault on complexity.
Power and control
As a profession, auditing "internal control" is not organizationally neutral. There is a blazing conflict of interest in the duties of governance when the considerable cost of maintaining layers of governors is invoiced to the governed. There is no difference in the ethical torque between the CEO and his board and the board and its internal controls auditor. Your concern that the fund advisor dominates the board is just one instance in a large set. Every engagement of the internal auditor presents a choice - your Red-Book principles or your job. The equilibrium state of governance is attained, as you aptly described, when it is aligned as "a passive affiliate of management." Whatever rules of action; whatever shifts in tension the SEC proposes will not change that requisite condition for equilibrium. Why on earth would senior management finance a governance team with enough clout to attenuate its business judgment rule privileges?
Bottom line, whatever the SEC does about the boisterous mess with corporate governance is not the final say for the stakeholder's future. The SEC, of course, can do as it chooses regarding the new operational reality of complexity management (foreseeability) and ignore how it has forever changed the standard of corporate governance for limiting liability. However, neither rapid advances in the competency of the process of engineering nor the financial supremacy of tort litigation will be altered by scandal-driven SEC rules of action. The reckoning time is being deferred but it will not be avoided. It may be your professional duty, as it is certainly for the PE, to know that that is the case.
The SEC is to be commended for providing this convenient means for posting rule-making commentary.
William L. Livingston, P.E