Two Overlooked Lessons From the Financial Crisis

In the year-end reflections two contributing factors deserve more attention. First, "prophetic warnings" from religious groups on the dangers of subprime loans via shareowner resolutions. Second, a call from Sanford Lewis for boards to revoke implicit policies of "don’t ask, don’t tell" with regard to liability issues.

The current financial meltdown should remind us of the importance and interconnections between ESG issues. Fully a dozen years before Wall Street experts and regulators reluctantly recognized the contribution of subprime mortgages to the current financial crisis, faith-based organizations urged major corrective action. The summer 2008 issue of The Corporate Examiner, a publication of the Interfaith Center on Corporate Responsibility (ICCR), carried an extensive review entitled The Buck Stops Here: How Securitization Changed the Rules for Ordinary Americans.

Subprime mortgages came about as a way to extend credit to lower-income people after passage of the federal Community Reinvestment Act in 1977, which encouraged banks to lend money in their local communities. Many ICCR members had pushed for the Act because subprime mortgages can give low income applicants access to home ownership when the cost and terms of conventional mortgages would be prohibitive. However, IRRC members were also on the forefront calling for subprime loans to be used responsibly, with reasonable terms.

As early as 1993, ICCR members filed six resolutions to more closely regulate subprime mortgages. “When our institutional investor members view their holdings through the lens of justice and sustainability, the priorities for action that emerge frequently anticipate market moves. Time and time again, the prophetic voice of faith has allowed our members to anticipate emerging areas of corporate responsibility, in investment policy as well as in social, economic and environmental policy. For more than a decade before anyone else, our visionary members have been expressing concerns related to predatory lending practices, inappropriate underwriting standards and the potential consequences of securitization of debt instruments," says ICCR Executive Director Laura Berry.

If financial markets had paid more attention to ICCR, perhaps we wouldn’t have gotten into the financial meltdown… certainly, it wouldn’t have been as big. Boards and shareowners would do well to pay more attention to this "early warning" system.

Earlier this year, I had the pleasure of providing editorial and substantive advice to Sanford J. Lewis, Counsel to the Investor Environmental Health Network, on his paper Don’t Ask, Don’t Tell: A Poor Framework for Risk Analysis by Both Investors and Directors (HLSCG&FR, 11/15/09) Lewis describes a growing clash between the needs and duties of directors and investors to manage risks, and attorneys who advise “don’t ask; don’t tell,” in order to minimize corporate liability in any possible future litigation. He warns that a strategy based on culpable deniability serves no one well.

Accounting principles for reporting environmental liabilities, for example, include subjective language such as “to the extent material,” “when necessary for the financial statements not to be misleading,” and “encouraged but not required.” At the same time, section 302 of Sarbanes-Oxley requires the CEO or CFO to certify the financial statement “fairly presents” the company’s financial condition, regardless of whether the financial statement is technically in compliance with generally accepted accounting principles.

Directors are caught between a rock and a hard place. If they report only “known minimum” liabilities, they risk violating SOX. However, a "fair presentation," could be used as evidence in court and raise possible settlement costs.

Lewis recommends a principled approach to “prejudicial” information, where a balancing test is used to weigh how prejudicial and how useful information will be. Under federal and state rules, evidence which might be considered prejudicial will nevertheless be found to be admissible in evidence if it is “more probative than prejudicial.” "A similar balancing test should be applied by accounting and securities rulemakers in considering the types of required disclosures to support the needs of investors."

Boards who listened too closely to the advice of their attorney’s may have been ignorant of potential risks but they can hardly be though blameless. We need to move from "don’t ask, don’t tell" to a careful weighing of the evidence and accounting standards that provide for more in the way of disclosure.

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