Capital market: The role of multiple gatekeepers

Descriptions of gatekeepers typically focus on their ex ante role. One common definition of gatekeeper is a reputational intermediary who provides verification or certification services to investors. Another is one needed before a transaction can close. Gatekeepers, however, also engage in ex post monitoring designed to uncover misconduct after it occurs, initiate an investigation, and report the misconduct or take enforcement measures. Also, many gatekeepers perform an advisory role with respect to structural or regulatory issues regarding a transaction without necessarily providing verification, certification, or approval. Such advisers are gatekeepers too because we expect them to advise a client to avoid illegal conduct. Taking these considerations into account, a gatekeeper is defined as a person or firm that provides verification or certification services or that engages in monitoring activities to cabin illegal or inappropriate conduct in the capital markets. The expanding interest in positive incentives for capital market gatekeepers dovetails with a broader and older trend in the regulation literature. This reflects a philosophical shift away from traditional deterrence-oriented strategies toward more cooperative and rewards-oriented systems to promote compliance. This approach joins market and regulatory accountability mechanisms that are described using various terms such as cooperative compliance, interactive compliance, responsive regulation, collaborative governance and cooperative implementation. An important inspiration for this shift is empirical psychological evidence suggesting that positive incentives may be more likely to promote desired behavior than negative threats.
Existence of corporate gatekeepers: Theoretically, the services of gatekeepers can be performed from within or outside the corporation. Legally, corporations undertaking business transactions must have their accounts audited by an external auditor but are otherwise free to choose whether to rely on the market for gatekeeping services. Typically, they choose to rely on external gatekeepers. Analysis of the question begins with Ronald Coase's seminal insight that a firm will make products or services internally until the costs of doing so exceed the costs of relying on the market. In applying this criterion to the market for gatekeeping services, the firm will weigh production cost advantages of relying on the market against the transaction cost disadvantages of doing so. Transaction costs are the costs of searching for, contracting with, and monitoring the market providers of the services.
In the gatekeeping context, corporations must also weigh the information cost advantages of relying on the market. The production cost advantages of relying on the market arise from economies of scale, scope, and experience. Economies of experience -- the cost advantages resulting from the accumulated experience over an extended period of time, also known as "learning by doing" -- can be substantial in industries involving complex labour-intensive activities. For example, bankers will develop skill in structuring and negotiating transactions, in applying valuation techniques, and in conceiving business transactions, lawyers will become more adept at negotiating and drafting underwriting and acquisition agreements, responding to regulatory hurdles, and conducting due diligence, a process involving the review of hundreds, even thousands, of documents, many of which adhere to standard forms. Economies of scale -- the decrease in production costs that occurs as volume of production increases -- may also be realised by relying on the market for gate keeping services. With a large transactional flow, gate keeping firms will build up a greater reservoir of knowledge of transaction structures and standard form agreements and thus be able to provide their services more cheaply than could a corporation with a weaker transactional flow. The need for indivisible units, such as document management systems and physical libraries, the costs of which are invariable to the number of users, would also favour relying on external firms, since unit costs would decrease as output (or the number of users) increases. Further cost advantages stem from the ability of external gatekeeping firms to absorb the risk of lumpy demand for professional services more effectively.

The Dhaka Stock Exchange Building. — FE Photo

Existence of multiple gatekeepers: Having decided to rely on the market for gatekeeping services for a transaction, corporations will turn to multiple distinct gatekeeping firms rather than a single multidisciplinary firm that bundles legal, accounting, financial, and other services. This phenomenon is the immediate result of legal regulation. The relevant professional bodies have "fought zealously to protect their professional autonomy," prohibiting their practitioners from forming multidisciplinary firms and preventing other professions from making incursions onto their turf.. These measures may be explained as the product of demand for favorable regulation by the professions acting as political interest groups. The legal profession, in its Model Rules of Professional Conduct, prohibits lawyers from forming partnerships or professionally associating with non-lawyers, including auditors and underwriters. Accountants are subject to strict rules preventing them from simultaneously providing auditing services and other services that may be seen to impair the auditor's independence of judgment. An auditor cannot, for example, venture into the investment banking field, such as by underwriting a securities offering for one of its auditing clients. These rules requiring auditor independence were reinforced by provisions of the Sarbanes-Oxley Act of 2002. While the Financial Industry Regulatory Authority, the securities industry's self-regulatory body, does not similarly restrict the activities of investment banks, the rules of the legal and accounting professions, together with the legislative over- lay of the Sarbanes-Oxley Act, effectively prevent investment banks from providing auditing and legal services for business transactions.
Whether the legal framework preventing the formation of multidisciplinary gatekeeping firms simply reflects economic forces or stands in opposition to them is a more difficult issue to assess. One economic explanation for the lack of multidisciplinary firms is the concern among corporations about conflicts of interest that would afflict the independence of judgment of gatekeepers. While the provision of multiple products and services may provide economies of scale and scope, it also produces conflicts of interest that risk impairing a gatekeeper's judgment and thus the certification role the gatekeeper performs. In an extreme case, one could imagine lawyers or auditors in a multidisciplinary gatekeeping firm acquiescing in corporate conduct (which they might otherwise oppose) for the purpose of facilitating a transaction that would be particularly lucrative to the firm's investment banking unit. This tension between multi-product or multidisciplinary practice and the potentially adverse effects of conflicts of interest has been particularly evident in the accounting profession. The concern stems from pressures facing auditors to skewaudit reports where doing so could win their firm other, more lucrative business, such as consulting work. Parallel issues arise in the debate concerning the merits of financial conglomeration. In the investment banking context, client concerns about conflicts of interest are manifested in corporations increasingly hiring so-called independent investment banks as "a counterpoint to the advice of integrated firms". Client concerns may also explain the failure of multidisciplinary firms, which arose in continental Europe from combinations of accounting and law firms, to break into advising on global securities offerings, a context in which the reputation of advisers is of considerable importance.
Cost advantages, or synergies, and conflicts of interest may well be two sides of one coin, a point suggested by the now disgraced former securities analyst Jack Grubman, who was quoted as saying (before his ban from the securities industry), "What used to be a conflict [of interest] is now a synergy." Conflicts of interest afflicting gatekeepers, and the corresponding lack of independence, can impair a gatekeeper's reputation and the quality of its certification as to the accuracy of a corporation's disclosures. For this reason, doubt exists as to whether, if the existing legal barriers were removed, multidisciplinary firms would evolve and be relied upon by corporations undertaking business transactions. While this issue need not be pursued for present purposes, it is sufficient to note that particular consequences associated with the multiple gatekeeper phenomenon, which are discussed next, are the immediate product of legal rules and might therefore be alleviated if market forces were given greater reign.
Independent and dependent gatekeepers: Differentiating independent from the dependent gate keepers: The emphasis on gatekeepers in the financial markets is not new. The early securities laws recognised the difference between independent and dependent gatekeepers in the context of directors. The Securities Act of 1933 placed responsibilities on gatekeepers such as auditors, underwriters, and company directors, and the legislative history to the Securities Act highlighted their role. In the 1970s, Securities and Exchange Commission actions against gatekeepers such as lawyers and accountants were based on the so-called access or passkey theory of liability, under which access to the securities markets was controlled by certain professionals like lawyers and accountants. Today such actions often fall under the rubric of "aiding and abetting" or "secondary liability," and the SEC has broad authority to impose sanctions against those who aid and abet violations of law. This section distinguishes independent from dependent gatekeepers by examining the roles of four types of gatekeepers: auditors, analysts, lawyers, and underwriters.
Independent gatekeepers: Gatekeepers are retained as agents to perform a task or a series of tasks for a principal. In the course of doing so, they receive information, as the access theory suggests, that puts them in a unique position to evaluate whether the principal has violated, or is about to violate, the law. But the tasks they perform and the relationships with their principals vary. Some gatekeepers are supposed to be independent of their clients in order to critically evaluate a set of facts and render an unbiased opinion for an unknown audience. The normative qualities of independent gatekeepers are illustrated through a closer look at auditors and analysts.
a. Auditors
The auditor of a public company should be the archetypal independent gatekeeper. Federal law requires that financial information filed by public companies be audited by an independent public accountant. In the world of auditing, independence has a special meaning beyond exercising independent judgment required of most professionals. Independence calls for independence of the audit client. The Supreme Court contrasted the roles of the auditor and the lawyer with respect to independence. In deciding whether the work-product privilege applies to auditors, the Court explained:
The Hickman work-product doctrine was founded upon the private attorney's role as the client's confidential advisor and advocate, a loyal representative whose duty it is to present the client's case in the most favorable possible light. An independent certified public accountant performs a different role. By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client.
An auditor cannot be the client's advocate. The Court in the Arthur Young case concluded by saying that the "'public watchdog' function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust." Indeed, the courts have stated that accountants have disclosure obligations because of their "special relationship of trust vis à-vis the public" and their duty to "safeguard the public interest." An accountant who knows of, or recklessly disregards, fraud can be liable for aiding and abetting it. The law discourages auditors and clients from developing long-term relationships. An auditor's long-term relationship with a client can jeopardise independence, something accounting literature refers to as a trust threat. Under SEC rules required by Sarbanes-Oxley, audit partners must "rotate off" an audit engagement after no more than seven years -- presumably to cut short the relationship between auditor and client before it can blossom into a trust relationship that can impair independence.
b. Securities Analysts
A second example of an independent gatekeeper is the securities analyst. An analyst is supposed to research a company to judge its value as an investment. The analyst's role should be to review corporate information and present an unvarnished view of the company to investors or potential investors. The analyst's role should not be to advocate on behalf of the company, but rather, like the auditor, to objectively analyse the facts. Conflicts of interest must be disclosed. The Supreme Court noted that the analyst's role in many cases is to expose negative facts the company may wish to withhold. Like with auditors, long-term relationships between analysts and issuers are discouraged. Evidence indicates that the longer an analyst follows a company, for example, the more likely he is to evaluate the company positively. Longevity leads to error. Over the past several years, the principal criticism of analysts has been that they have slowly lost their independence and become adjuncts of the investment banking departments of the firms that employ them. These criticisms are valid and reinforce the view that the norm for the analyst is independence. If independence were not expected, analysts would not be denounced for losing their objectivity.
Dependent gatekeepers
While some gatekeepers like auditors and analysts are supposed to be independent of their principal, others are not. Dependent gatekeepers provide advice and recommendations to assist a client in meeting its goals. They often act in a fiduciary capacity, owing both a duty of loyalty and a duty of care to the client. As a fiduciary, these agents must act for the client's benefit, furthering its ends. Courts maintain that the essence of the fiduciary duty is to act with "utmost good faith for the benefit" of the principal and "single-mindedly pursue the interests of those to whom a duty of loyalty is owed." Regardless of the context, fiduciary cases are replete with language about how the fiduciary must act to further the objectives of the principal.
A fiduciary relationship is characterised by values such as longevity and mutual trust, and fiduciary cases refer to a close bond that exists between the fiduciary and the principal. Those same bonds, however, are anathema to relationships held by independent gatekeepers, such as auditors and analysts. And an auditor is not considered a fiduciary to the client when performing the audit function. The differences in the type of relationships independent and dependent gatekeepers have with their clients are striking. The characteristics of dependent gatekeepers are illuminated by examining more closely the role of attorneys and underwriters.
a Attorneys
A prime example of a dependent gatekeeper is the lawyer. Lawyers have a special place in the adversary system, which recognises that conflict is inevitable and cannot always be resolved through consensus. In the adversary system, lawyers are not meant to be impartial. An attorney is required to "advance the client's lawful objectives and interests." Every lawyer knows about the duty of zealous advocacy. As Geoffrey Hazard has written, "A lawyer's service consists of guiding affairs for the client's private and often selfish purposes, with an eye to legal requirements that have been designed for the very purpose of limiting or regulating selfish purposes."
The relationship between client and lawyer is akin to an "informal partnership." They work together toward a common goal, although the client, not the lawyer, ultimately calls the shots. This is particularly true of in-house lawyers because of their long-term role as employees or subordinates of the client. In describing the lawyer's role, it is useful to contrast it with the role of the judge. The traditional figure of justice - blindfolded -- represents the court or the judge, not the lawyer. The lawyer, particularly in litigation, seeks to achieve success for his or her client to the disadvantage of the opposing client; the judge interposes herself between the two positions, seeking justice. The judge's ethical norm is impartiality; the lawyer's is loyalty.
Notwithstanding the role of zealous advocate, the attorney's duty of loyalty is not unlimited. Courts and commentators have recognised the tension between the lawyer's fidelity to his client on the one hand, and his role as gatekeeper on the other -- and lawyers are at the centre of the corporate governance debate. ABA rules provide that a lawyer cannot "counsel a client to engage, or assist a client, in conduct the lawyer knows is criminal or fraudulent." ABA rules permit an attorney to withdraw from representation where the client "insists upon taking action that the lawyer considers repugnant." Recent changes to the ABA Model Rules, which expand the circumstances when a lawyer may breach client confidentiality, illustrate the complexity of the lawyer's role. Certain states, such as New Jersey, go farther than the Model Rules and require lawyers to disclose information to prevent a client "from committing a criminal, illegal or fraudulent act that the lawyer reasonably believes is likely to result in death or substantial bodily harm or substantial injury to the financial interest or property of another." Studies suggest that attorneys do not take this language completely seriously. Particularly with regard to financial injury, only a small percentage of lawyers make the required disclosure. This is not surprising as the overall role of the lawyer is to promote the aims and objectives of his client. The unwillingness to make such disclosures is consistent with the insights from behavioral psychology, explored below. As one writer noted, "In the law, bias is a professional obligation." While lawyers are occasionally found liable for wrongdoing, the facts of those cases are generally egregious.
A lawyer's independence from the client, however, is different from the auditor's or analyst's independence. Hazard explains that a lawyer's independence from the client means forbearing from assisting a client in violating the law or from rendering advice that encourages a violation. Such conduct ultimately would harm the client and be tantamount to a violation of the duty of loyalty. Independence in this special sense, therefore, is better described as a corollary of the duty of loyalty, not opposed to it. A lawyer also is said to be morally independent from his client in the sense that while the lawyer acts on behalf of the client, the actions and responsibilities of the two are distinct. Moral independence in that regard does not detract from the thesis of this paper; it supports it because it demonstrates that lawyers, as zealous advocates, make arguments that they may feel uncomfortable making on their own behalf.
The lawyer's role as gatekeeper is clearest when giving legal opinions; it is there one should look to determine whether a lawyer is independent of his client. A legal opinion is an informed judgment, usually reduced to writing, on discrete legal issues. An opinion generally provides the recipient with the lawyer's judgment on how a particular court would resolve a discrete issue. Lawyers provide opinions to clients and non-clients on a number of matters that allow a transaction to go forward.
b. Securities Underwriters
An investment bank acting as an underwriter in a public securities offering plays an important gatekeeping role but, as we shall see, the underwriter is a dependent gatekeeper in many respects. This may be surprising because the underwriter is said to play a special role as the only participant who, as to matters not certified by the auditor, has the background and knowledge to conduct sufficient investigation to protect the investor. Section 11 of the Securities Act names the underwriter, unlike the lawyer, as a potential defendant in a private lawsuit if a registration statement is misleading. Section 11 also provides a due diligence defence to the underwriter, who must undertake a "reasonable investigation" to assure itself that statements made in the registration statement are true. The underwriter must perform this responsibility on its own. It cannot rely on information provided by the issuer. "Tacit reliance on management assertions is unacceptable; the underwriters must play devil's advocate." Thus, there is a sense in which the underwriters are acting independently of the issuer to perform the due diligence required by the Securities Act. The role of the underwriter, however, is more complex.
Notwithstanding the emphasis on due diligence, the underwriter is not meant to be wholly independent of the issuer in the same way the auditor is independent. The issuer engages the underwriter to promote the distribution of its securities. In that regard, the underwriter's role, as an adviser to the issuer, usually predates the offering itself. In many cases, the managing underwriter provides advice on a number of issues pertinent to the offering, such as the type and amount of securities sold, the timing of the offer, and steps the issuer can take to make itself more attractive. As a result of advice given, some courts have begun to recognise a fiduciary relationship between an underwriter and an issuer. In addition, an underwriter often has a direct or indirect financial interest in an offering. Some underwriters invest directly in their clients, which is prohibited for independent accountants. Also, many underwritings are performed on a so-called best efforts basis where the underwriter will not receive a fee unless some or all of the securities are sold. In a recent Second Circuit case, the court summarised the underwriter's incentives as follows:
Underwriters have strong incentives to manipulate the IPO [initial public offering] process to facilitate the complete distribution and sale of an issue. Underwriting is a business; competitive forces dictate that underwriters associated with successful IPOs will attract future issuers. Moreover, because underwriters assume a large measure of risk in the event an IPO fails, they have a direct interest in the IPO's success. Moreover, underwriters perform multiple services for their clients. Performance of such services, notwithstanding the due diligence responsibility under section 11, distinguishes underwriters from auditors and makes them dependent in a way that auditors now cannot be. Unlike auditors, which are restricted in the performance of non-audit services, underwriters continue to have an interest in cultivating the client relationship to obtain additional consulting and other work. The very provision of advice can turn a non-fiduciary relationship into a fiduciary one by dint of reliance by the principal on the skills and expertise of the agent and the trust and confidence reposed in him.
COLLECTIVE BLAME FOR RECENT BUSINESS FAILURES HAS FALLEN ON GATEKEEPERS.
The conventional view is that auditors, lawyers, underwriters, analysts, and others have shirked their responsibilities and permitted illegal conduct. This claim traditionally depended on a rational actor model under which a gatekeeper would prevent misconduct by a primary violator because the gatekeeper's expected liability or reputational harm from failing to prevent misconduct exceeded the benefits gained in fees. While this model has merits, it fails to distinguish among gatekeepers, who are likely to respond differently to incentives. It also fails to appreciate differences in the character of a gatekeeper's relationship with a primary violator and to consider whether such differences bear upon gatekeeper behavior. All gatekeepers are not alike. They vary widely in the functions they serve, skills necessary for the job, relationships with their principals, and duties they owe. There are differences in their approaches as well. Accounting determinations, for example, are often formalistic and unambiguous, while legal advice is said to be more nuanced, requiring an attorney to explore a range of options with a client, who evaluates the lawyer's advice and then makes up her own mind. The securities analyst, unlike the accountant or lawyer, makes predictions, which are frequently wrong. Distinguishing among the character of gatekeepers' evaluations is helpful, but it masks deeper differences in the structure of gatekeepers' relationships with their clients. Under the strict liability regime, irrespective of fault, the gatekeepers would face liability for the wrongdoing of their corporate client. The gatekeepers must share the liability in some proportion, and because fault is of no moment under a strict liability regime, they will do so in some fixed proportion unrelated to their respective contributions to the risk of wrongdoing.
This section shows the nature and patterns of corporate gatekeeping in Bangladesh. Some are independent and some dependent. Theoretically and legally respective roles and responsibilities are defined in the corporate statutes, however, in reality, these remains unimplemented. As a result, the corporate scandals are frequently taking place creating a burden on the economy. For example, banking scandals like those involving BASIC Bank, Hall Mark, Bismillah Group and others could not take place, if regulatory authorities, corporate gatekeepers like the board and audit, risk management and corporate governance committees as well as those responsible for the operation of business process were diligent in performing their roles. If the central bank, Insurance Development and Regulatory Authority (IDRA), Bangladesh Telecommunication Regulatory Commission (BTRC), Bangladesh Energy Regulatory Commission (BERC), Registrar of Joint Stock Companies, Bangladesh Securities and Exchange Commission (BSEC), Dhaka Stock Exchange (DSE), monopoly commission, independent auditors, law firms, credit rating agencies, IPO managers, valuation firms, merchant bankers, stock brokerage firms, financial analysts and other players in the capital market demonstrated their due diligence from statutory context and compliance to the principles on conflict of interest, then we could avoid the damaging corporate, stock market, banking scandals in Bangladesh. Regulators are to run based on the defined statutory principles. If regulators are dictated by the Bankers Association, Brokers Association, Vested Interest Association, Defaulters Association and so many, then no corporate gatekeeper, either Independent or Dependent, can work and be effectively functional. Moreover, the parliamentary standing committees assigned in line with the Rules of Business must play their due roles as parliamentary gatekeepers. If any parliamentarian involves himself with business in a ministry where he is a member of that particular standing committee, then he is violating the conflict of interest principles and should be liable for punishment. In the absence of independence of the regulatory gatekeepers in the financial, capital, utility and technology markets, true corporate governance does not work and hence corporate gatekeeping is being obstructed at all levels.
CONCLUSION: Gatekeepers are not alike, and the distinction between independent and dependent gatekeepers is important for understanding of gatekeeper behaviour. Independent gatekeepers, like auditors and analysts, should critically evaluate a set of data and render an opinion for an unknown audience. Dependent gatekeepers, such as lawyers and underwriters, act on a client's behalf providing advice and recommendations to a known audience -- the client itself -- in reaching its goals. Consequently, independent gatekeepers will be better monitors than dependent gatekeepers, and perform a more robust gatekeeper role. That conclusion is consistent with research in the area of social and behavioral psychology, which teaches that people's behaviour is influenced by others and that goals and motives can influence our thinking. Accountability to a known audience and commitment to a course of conduct can alter a rational evaluation of the facts. These phenomena appear more starkly in the case of dependent gatekeepers and are more likely to influence their behaviour. The differences between independent and dependent gatekeepers, and the lessons from social and behavioral psychology, help explain many of the recent reforms for gatekeepers, including auditors and analysts. Moreover, the same lessons can help with additional reforms in the case of dependent gatekeepers, such as lawyers. One tentative proposal that bears additional consideration is to require certifications to the BSEC or state bar by securities lawyers stating positively that they are unaware of evidence that would necessitate a "reporting up" under the BSEC's lawyer rules.
RECOMMENDATIONS: For private sector-led economic development, operation of an efficient capital market is essential featuring effective corporate governance. The rules of corporate governance are normally embedded within the relevant acts, statutes, and laws guiding the corporations defining rights and obligations including the dos and undos of different stakeholders of business life. The whole business environment is influenced by complying with the rules of business crafted within the rules and procedures for every manufacturing, financial, service, utility, infrastructure and technology business. These finally create an environment for business. It is popularly known as creating a better environment for doing business as well as for locals and foreigners. In the context of Bangladesh the following are the recommendations for improvement of corporate gatekeeping.
1. To ensure compliance with existing rules and procedures of corporate governance and corporate gatekeeping activities to minimise economic damages arising from gate keeping failures and introduce incentives for reduction of gatekeeping failures.
2. To conduct a study on the existing provisions of all corporate statutes framed for public and private sector entities, regulatory agencies to test the compatibility of relevant provisions for corporate gatekeeping in line with the current market-led economic philosophy and recommend the desired changes to make those market-friendly.
3. To increase coordination among the gatekeeping agencies to share the information so that the gap between the gatekeepers get reduced. To organise workshops and seminars for the cross-interest groups on the liabilities of independent and dependent gatekeepers of the corporate environment.
4. To conduct extensive research on the comparative study among selective gatekeepers, both dependent and independent, to assess their roles, responsibilities and liabilities within the country and compare them with developed market economies and emerging developing countries and competing regions of the globe.

Jamaluddin Ahmed PhD FCA is a member of the Board of Directors of Bangladesh Bank and General Secretary of Bangladesh Economic Association. jamal@emergingrating.com