Gatekeepers: The Professions and Corporate Governance.

• Author: Fox, Merritt B.
• Position: Book review

GATEKEEPERS: THE PROFESSIONS AND CORPORATE GOVERNANCE. By John C. Coffee Jr. Oxford and New York: Oxford University Press. 2006. Pp. vii, 389. $45.

INTRODUCTION

The United States was hit by a wave of corporate scandals that crested between late 2001 and the end of 2002. Some were traditional scandals involving insiders looting company assets--the most prominent being Tyco, HealthSouth, and Adelphia. But most were what might be called "financial scandals": attempts by an issuer to maximize the market price of its securities by creating misimpressions as to what its future cash flows were likely to be. Enron and WorldCom were the most spectacular examples of these financial scandals. In scores of additional cases, the companies involved and their executives were sued by the Securities and Exchange Commission ("SEC"), and, in a number, executives were criminally prosecuted (p. 15). Hundreds of issuers were forced to restate their financial statements (p. 15). Why did this rash of financial scandals occur and what lessons for reform can be learned from the explanation? These are the questions addressed by Professor John Coffee (1) in Gatekeepers: The Professions and Corporate Governance.

Coffee's focus is on what he calls the "gatekeepers": auditors, lawyers, securities analysts, and credit ratings agencies. Each of these professions can serve as a watchdog for the public. Each, at least in theory, has a particular position that allows for the acquisition of more information than the investing public has about an issuer's prospects and that provides them an opportunity to warn the public when that information is different than the impression given by management in the issuer's disclosures. In each of these financial scandals, the watchdogs failed to bark when the issuer's disclosures obscured the less favorable underlying reality of its economic situation. Because of this en masse gatekeeper failure, Coffee contends, the "United States' much vaunted system of corporate governance was suddenly compromised" (p. 15).

Coffee begins his book by demonstrating that gatekeeper failures played a large role in permitting the Enron and WorldCom disasters. He goes on to explain why such failures have occurred so frequently. For each gatekeeper, his discussion combines a fascinating consideration of its history with a realistic description of the current economic and political environment in which it operates. He concludes with recommendations for reforms, including a requirement that each issuer have its SEC periodic disclosure filings certified by outside counsel.

This is an excellent book. Its unusual combination of conceptual breadth and real-world, practical detail allows us to see what has been right in front of our faces but not fully appreciated. That gatekeeper failures substantially contributed to the Enron and WorldCom scandals is already well recognized. (2) Before this book, however, there was less awareness of the slowly accumulating changes in these professions and the environments in which they work that caused these failures. What awareness did exist was not accompanied by an adequate understanding of either the origins of these changes or their implications for our larger system of corporate governance. Coffee significantly advances this understanding and by so doing aids substantially in finding the most promising avenues for reform.

In this Review, I elaborate on Coffee's analysis in three regards. First, I highlight the links between the gatekeeper failures that Coffee identifies and defects in the U.S. system of corporate governance. Creating and maintaining institutional arrangements that reduce, or compensate for, the informational asymmetries that exist between management and investors is the central challenge for the market-centered, dispersed shareholder system of corporate governance that predominates in the United States. The core function of gatekeeping is the amelioration of these asymmetries. The gatekeeper failures that permitted the wave of financial scandals symbolized by Enron and WorldCom are symptomatic of profound changes in the gatekeeper professions and the environments in which they operate. These changes have had effects that go far beyond the losses incurred by shareholders of the particular companies involved when the truth came out and share price plummeted from the inflated levels prevailing when many shareholders bought. Poor gatekeeping undermines good corporate governance, which results in social-wealth-destroying suboptimal corporate decision making. While Coffee identifies the essential role gatekeepers play in ameliorating the informational asymmetries between dispersed investors and management, the primary corporate governance concern that he chooses to develop is the blind spots that gatekeeper failures create for outside directors. I broaden the inquiry to consider the full breadth of corporate governance problems that gatekeeper failure creates.

Second, I informally model Coffee's discussion of the changes in the professions that led to the wave of financial scandals and consider the implications of this analysis for determining what factors were the primary causes of gatekeeper failure. This exercise reinforces Coffee's fundamental conclusion that reform is needed--and that the reform must be something beyond just changing the rules by which existing gatekeepers operate and the applicable liabilities when the rules are violated.

Third, I discuss what this fundamental reform should be. Coffee correctly argues for the need to improve the quality of periodic disclosures filed with the SEC. He would do so by requiring each issuer to have an outside disclosure counsel certify these filings. In my view, certifying counsel is the wrong player to bring this improvement about. A certifying investment bank that faces measured liability in the event it fails to engage in adequate due diligence is a better alternative.

1. THE LARGER IMPORTANCE OF GATEKEEPER FAILURE

   Professor Coffee defines a "gatekeeper" in functional terms, as a "reputational intermediary to assure investors as to the quality of the 'signal' sent by the corporate issuer" (p. 2). The gatekeeper is a repeat player who has over time developed "reputational capital" by verifying only the statements of corporate issuers that the gatekeeper reasonably believes are accurate (p. 9). Once a gatekeeper develops this reputational capital, its verification of a corporation's statement, by pledging this capital, makes the statement more believable. Thus, an auditor's certification of an issuer's financial statement, an investment bank's willingness to take an IPO to market, a lawyer's "Rule 10b-5" opinion that nothing suggests that a prospectus contains misstatements, a rating agency's credit rating, and a "sell side" analyst's "buy" recommendation all share this verifying pledge of reputation feature.

   A gatekeeper failure occurs when the gatekeeper verifies an issuer statement that it knows, or through reasonable effort could know, is false or misleading. But what are the corporate governance effects of these failures and why are they important?

   1. Leaving Independent Directors in the Dark

      Professor Coffee identifies the core contribution of gatekeepers to corporate governance to be their capacity to reduce information asymmetries between investors and managers. In terms of the corporate governance consequences of gatekeeper failure, however, his primary focus is on its disabling effect on the outside members of the corporation's board of directors. On the book's very first page, Coffee states: "[A]ll boards of directors are prisoners of their gatekeepers. No board of directors--no matter how able and well-intentioned its members--can outperform its professional advisors. Only if the board's agents properly advise and warn it, can the board function effectively" (p. 1).

      The "monitoring board," as the corporate board is typically conceived in modern corporate law commentary, (3) is an important institution in helping to align managerial decision making with what is in the best interests of shareholders. Coffee correctly believes that too much emphasis has been put on the need to reform the board itself, rather than the informational environment in which the board operates (p. 7). He observes that "the sudden outburst of financial irregularity that surfaced in 2001 to 2003" cannot be due to an increase in board failure "because boards have only improved over the interval from 1980 to 2000" (p. 8). Coffee's concern is that when an issuer makes a misstatement, outside directors are often as fooled as outside investors. This is a key element in his argument that more attention should be paid to gatekeeper failure.

      Coffee's decision to focus on outside board members should not, however, obscure the fact that gatekeeper failure has a variety of other important corporate governance consequences as well. There is, in fact, some tension between any suggestion that outside directors' lack of information is at the core of gatekeeper failure's impact on corporate governance and Coffee's own analysis of the origins of gatekeeper failure and the reforms that are needed. While diffuse investors should in theory be the gatekeepers' principals, they are too disorganized to play this role effectively. Managers have filled the void. Because managers hire and fire most gatekeepers, managers have become gatekeepers' real principals. As a result, the watchdogs have become the pets of those who feed them (p. 335). If outside director lack of information were the core of the corporate governance problem generated by gatekeeper failures, the solution would be straightforward. An issuer's outside directors, unlike its shareholders, are a discrete group, easily capable of coordinated action. Outside directors could substitute for management as the gatekeepers' effective principal to fill the void created by shareholder diffusion. Indeed...