The SEC still needs to escape regulatory capture. Here's how.

sec_building.gi.top.jpg By Eleanor Bloxham, contributor


FORTUNE -- It's a natural human tendency to rely on the opinions of friends. We all do it, but, given the right circumstances, that impulse can endanger anything from interpersonal relationships to world economies.

The more responsibility people have for the welfare of others, the more perilous the consequences of this habit can be. Our society has learned this through hard experience.

Take for example the ongoing financial crisis.

The Warning, a film about the events leading up to the crisis, tells the story of former CFTC Chair Brooksley Born's early warnings and prescient arguments for tougher regulation, regulation that might have averted the disaster. Former SEC Chair Arthur Levitt courageously discusses on camera what he learned from the meltdown. His takeaway? He wished he had known Brooksley Born better-if so, he might have heeded her warnings. But Mr. Levitt's affiliations were with Messrs. Summers, Greenspan, and Rubin-and that is what swayed his opinion to stand with them and against her, as the film illustrates. (Today, she sits on the Financial Crisis Inquiry Committee combing through the debris.)

In my talks on governance, I refer to this habit of listening to those you know as the "classic governance problem," a recurring trap that regulators, boards, and companies would do well to avoid. This classic failing comes down to making decisions based on "who" rather than "what." It happens when boards don't seek out input beyond the management they are hired to oversee. For regulators, it's failing to look for input beyond those they must regulate. The BP (BP) disaster and Mineral Management Service's coziness with BP showed the importance of regulators looking outside industry for input. Congress found that many of the oil firms used the same adviser to produce inadequate disaster and crisis plans: a textbook industry example of this phenomenon.

In The Warning, the reliance on a small number of close sources is a matter of happenstance or context-one that clearly had a major impact in contributing to the crisis. In other instances, though, this reliance on a small group is actually formalized, embedded in the way regulators write the rules or in the procedures they follow in their jobs.

Seeking to address this issue, the USDA in 1995 conducted a study of food-safety inspectors and processes, resulting in a 600-page study. One of the issues they focused on was the pressure of allegiances government inspectors suffered from when imbedded in the meat or poultry plant they were inspecting. The reforms described in the industry report were meant to ensure a new kind of relationship between the regulated and the regulator: "[I]nspectors will be told where they inspect is not my plant and operators will be advised that the person handling [Food Safety Inspection Services] FSIS functions is not my inspector. A new identity relationship of arm's length relationships is in the cards."

Two weeks ago Fortune's story on the SEC whistleblower revealed that, for securities laws, not everyone has learned this lesson: The SEC only allows pre-clearance of control frameworks by companies and their auditors-in other words, the people the SEC regulates with respect to those matters, and the least likely parties to have suggestions for improvement. As the article explains, companies and auditors did not come forward with suggested changes, but an outsider did.

The SEC followed their customary procedures and dismissed the outsider's view. Discounting the relevance of his statements may have contributed to the crisis, and continuing to ignore his calls, because he doesn't fall within the predetermined specified groups, may mean we will see more of the same.

Somehow, despite everything we should have learned, when seeking to address the financial crisis, we seem to be making the same mistakes with regard to the way regulators write the rules and procedures they follow.

On July 2, I responded to comments on a proposal by the FDIC related to the way banks will be assessed from a risk perspective going forward. The proposal included this language: "The FDIC also anticipates that any final rule issued pursuant to this notice of proposed rulemaking would be followed by discussions with the industry on ways to improve the system adopted, as well as coordination with other regulators." I wrote that they need to reach out more broadly, to gain knowledgeable outsider perspectives, in addition to industry's, on how the systems are working and can be improved.

The financial reform bill has provisions (in Sections 748 and 922-924) to encourage whistle-blowing as a mechanism to help prevent meltdowns and potential financial scandals. But the individuals paid and protected in the final bill are employees-those with "original information," and protected to the extent that: "No employer may discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner discriminate against, a whistleblower in the terms and conditions of employment because of any lawful act done by the whistleblower" in providing information or assisting an investigation.

This is unfortunate when we look at examples like that of the Madoff fraud, where an outsider, Harry Markopolos, was the whistleblower and the one who gave up his own time and energies pursuing the case. Many lapses of oversight involve information in the public domain that is not "original" but that law enforcement does not have the ability or time to review. Yet those outsider perspectives are not encouraged in the new reform measures.

While employees of companies being regulated are a useful source (as are companies and auditors in the case of the control frameworks), these are the individuals who are least likely to come forward. The new bill fails to address, to compensate, or to protect consultants, analysts, clients, investors, vendors, analysts, activists, or others whose information might be beneficial in alerting securities regulators and aiding them in enforcing cases.

It has always been true that good ideas come from many sources, but this is even truer in the US today, with our highly mobile and educated population, skilled, analytical, and capable of providing useful information. Regulators, corporations, and boards fail at their jobs when they rely on narrow sets of sources. Fifteen years on-and given the depth of this current crisis, it seems to be a lesson we need to learn once again.

Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance, a board advisory firm.  To top of page

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