Federal Reserve Governor Daniel K. Tarullo delivered a speech at the Association of American Law Schools’ Midyear Meeting, in which he discussed how finance and financial regulation affect corporate governance and why special measures are needed as part of an effective prudential regulatory system. Stressing the need for further collaboration between corporate and financial law scholarship, Governor Tarullo emphasized the centrality of risk in his description of the relationship between financial regulation and corporate governance.
In his remarks, Governor Tarullo paid particular attention to: (i) the ways in which the nature of financial activities and regulation affect the operation of key mechanisms of corporate governance, and (ii) the motivations behind prudential regulation and what it seeks to accomplish.
Governor Tarullo concluded by offering the following three types of regulatory and supervisory measures, which may better align corporate governance of financial firms with regulatory objectives:
- regulatory requirements directed at changing the incentives of those who make decisions within a financial firm;
- substantive requirements or constraints to be placed upon decisions made within a firm; and
- regulatory requirements that seek to affect the institutions and processes of corporate governance, rather than change incentive structures or regulate decisions directly.
Lofchie Comment: Governor Tarullo argues that directors of large financial institutions ought to bear responsibility for decision-making not only as to the failure of the institutions, but also for “systemic” damage that may be done. This would, presumably, hold directors to some higher standard than would ordinarily apply to directors of a corporation; i.e., regulators should “broaden the fiduciary duties of boards and management.” Among the potential effects of that heightened and inherently ambiguous standard would be that (i) successful people would shy away from sitting on financial institution boards for fear of financial liability and (ii) directors would become completely adverse to any risk-taking, since the personal risks would be so great as to discourage their willingness to have the financial institution take additional risks; e.g., make loans or enter into new activities.
As a practical matter, it would be prudent for directors of financial institutions to consider the consequences of Governor Tarullo’s approach including the risks that they bear, or that the regulators may believe that they should bear, as well as measures to mitigate those risks. These may include (i) considering whether all appropriate skill sets are represented on the board and (ii) documenting the reasons for senior-level compensation arrangements in light of the incentives that such arrangements may create.