Learning the ABC of Market Regulation

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John Robertson

The challenge posed by last week's ABC Learning catastrophe is to work out how to anticipate regulatory failures in the future.

There is little doubt that the market should have been informed about the margin borrowing arrangements put in place by ABC Learning directors before the unfolding catastrophe put the wealth of small shareholders at risk.

The argument for fuller disclosure is threefold.

The directors had transferred at least partial control over their shares to another party without this being made known to the broader market which had been assuming otherwise.
The other party was not guided in its decisions to sell stock by the normal requirements placed on directors to trade only during specific windows.
The passing of control had the potential to disrupt orderly market arrangements on which individual investors had come to depend.

The ABC Learning episode has coincided with growing disquiet about the impact of margin lending practices on market volatility and the role of so called hedge funds in short selling. Hedge funds are now acting in corporate situations much like George Soros did in taking on the Asian central banks in the 1990s. There were two elements to his success:

the existence of an individual or group trying to shore up a position against the momentum of the market; and,
the hedge funds, sensing vulnerability and having enough financial firepower to take on the other side, being prepared to ruthlessly push their targets past critical financial thresholds without much regard to the broader consequences.

No doubt, there will be pressure on governments and regulators to 'do something'. ASIC and the ASX will probably step up surveillance of short selling and another layer of regulation will be imposed on directors. The aggression of lenders might also end up being circumscribed.

Future directors will be saved the indignity suffered by Eddy Groves. However, his position is not commonplace. Relatively few directors have founded the companies for which they continue to be responsible. Many of the most egregious governance failures leading to changes in the regulatory framework are based on unusual or even unique circumstances.

Perhaps the most important lesson from the ABC Learning episode is how bad we are at anticipating risks or, more accurately, how poorly we react to the possibility of recognised risks being realised.

With the benefit of hindsight, we now recognize with little dissent that fraudulent accounting practices and poor governance can lead to Enron-like outcomes. But it took the Enron experience to teach us the lesson.

With the benefit of hindsight, we can also see that ABC Learning was a governance accident waiting to happen. Directors supplying services, relatives occupying positions of influence and former politicians on the board should be on any risk assessment checklist.

However, too frequently, regulators and investors give executives too much leeway.
Without an explicit example of wrongdoing or dangerous market practices, there is also little constituency for change.

Many high profile directors are close enough to the politicians making decisions about their regulatory framework that they can dissuade them from anything too constraining. Many of those same politicians aspire to be directors themselves and have a preconceived view about how they would like to be treated when they reach the boardroom.

Moreover, executives will always attempt to downplay the risks associated with their businesses. If any are admitted, they are always going to be manageable. The lead up to the recent events surrounding Tricom, Centro, MFS and Allco bear out this point.

Prominent businessmen will argue that policymakers cannot assume every executive is a crook or an incompetent without undermining the animal spirits which drive a market economy.

Consequently, action is usually taken only after egregious failure.

How can we change this tendency to chase after bolted horses? Logically, there is only one way. Here is a simple ABC of corporate regulation.

A. Get the smartest regulators to think about the risks to our market arrangements in much the same way that others pour over potential tax loopholes to prevent revenue losses.
B. Start working on the assumption that if risks can be identified (however low their probability) they will happen - at some time, somewhere. Don't be fooled by sophistry to the contrary.
C. Put new rules in place as soon as new risks are identified. Don't wait for them to happen.

Nothing else will work. If you don't like that sort of interference, be reconciled to the occasional stench of a new corporate carcass (and the accompanying hits to the wealth of innocent bystanders).

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