The ability to disrupt misconduct

One of the criteria for determining whether a subject could be a gatekeeper, and further a successful gatekeeper relates directly with the likelihood that gatekeepers will uncover and prevent misconduct.⁸²¹ The focus is here on the ability as well as willingness of a gatekeeper to influence a wrongdoer to forgo misconduct.⁸²² Interdicting wrongdoing can take the form either of exclusion or prohibition of someone from entering a particular market or in the form of detecting and disrupting wrong behaviour after the subject has entered a particular market.⁸²³ In both cases, the ability of gatekeepers to play their interdicting role and how much wrongdoing will they prevent will depend on several factors.

a) The nature of contracting between gatekeeper and wrongdoer

Usually, the performance of a gatekeeping function will require a transaction, contractual or non-contractual, between the gatekeeper and would-be wrongdoer.⁸²⁴ Through the transaction, gatekeepers are in a position to access at low-cost information about existing or would-be wrongdoer and thus allow him to perform the monitoring role that is required from a gatekeeper.

Since the gatekeeper is a repeat player and a reputational intermediary that has built up its reputation over a long period of time and by serving many clients, it is assumed that gatekeepers and their clients will aim long-term business relationships. The gains of long-term relationships are valid for both sides. On the one side, when developing long-term business relationships, gatekeepers can reduce their information costs due to becoming familiarized with the firm, and thus can refer to their past experiences when transacting for future deals.⁸²⁵ Additionally also the risk of liability for failure of the gatekeeper to detect misstatements or faulty representations by the client is also reduced because the long-term relationship facilitates more accurate monitoring.

On the other side, developing long-term relationship with a gatekeeper provides for the client

820 Ibid., p. 66.

821 Kraakman, Journal of Law, Economics and Organization, 1986, 53, p. 62.

822 Kraakman, Yale Law Journal, 1983-1984, 857, p. 890.

823 Kraakman, Journal of Law, Economics and Organization, 1986, 53, p. 62.

824 Ibid.

825 Williamson, Journal of Law and Economics, 1979, 233, p. 248. See also Heukamp, Zeitschrift für das gesamte Handels- und Wirtschaftsrecht, 2005, 471, p. 486 in the context of auditing services.

the benefit of lower costs when “renting” the reputation of reputational intermediaries. A gatekeeper will require higher guarantees before pledging its reputation for new clients than for long-term clients. In long-term relationships, both gatekeeper and client make firm-specific investment on each other, and therefore the relationship grows more enduring, as the duration of their relation gives also a signal about their seriousness as market actors. In the meantime, when contracts grow more enduring, they become also more costly to break.⁸²⁶ Therefore, gatekeepers will perform their gatekeeping role to ensure that the reputation they pledge reflects the accurateness and truthfulness of the client’s representations, whereas the client will find it expensive to shop for gatekeepers who are willing to risk their reputation by vouching for their client’s false representations. However, this assumption is subject to two qualifications: the existing gatekeeper gains more from preserving its reputation⁸²⁷ than from giving in to the client’s requests for underperformance and the client’s gains from searching a compliant gatekeeper justify the cost of breaking the ties with the existing gatekeeper.

The encouragement of long-term business relationships between gatekeepers and clients should however consider also the potential conflicts of interests that arise thereof. More specifically, when gatekeepers develop a bonding relationship with a client through mutual investments, they tie themselves to the client’s success and face incentives to make decisions that align their interest with those of the firm they are monitoring.⁸²⁸ As a result, the gatekeeper might shift its focus from protecting the investing public to satisfying the client. This raises issues of gatekeeper’s independence.

b) Gatekeeper’s independence and diversification of investment

Can investors rely on the independence of gatekeepers to deliver accurate and free-from-conflicts-of-interests information when the gatekeeper is paid by the subject it is supposed to monitor?⁸²⁹ Could the watchdog “bark” against the one that one that feeds him? Here two assumptions are valid, albeit opposing each other. The first assumption is that the gatekeeper could fail to perform its gatekeeping role when it depends substantially on a client or retrieves major portions of its gains from few clients. The fear of losing these important clients if they do

826 Kraakman, Journal of Law, Economics and Organization, 1986, 53, p. 63.

827 Coffee, Gatekeepers, p. 6 states a possible decline in the value of the gatekeeper’s reputational capital could lead to the result that gatekeepers will no longer protect their reputation as zealously as before.

828 Ebke, in: Ferrarini et al. Reforming company law, p. 525. See also Heukamp, Zeitschrift für das gesamte Handels- und Wirtschaftsrecht, 2005, 471, p. 486.

829 Habersack, Zeitschrift für das gesamte Handels- und Wirtschaftsrecht, 2005, 185, p. 195.

not acquiesce to the clients’ misconduct exerts pressure on gatekeeper to underperform.⁸³⁰ The logical explanation behind this assumption seems to be that the gatekeeper can gain more in the short term from depleting its reputation than from protecting it. A related issue with this assumption, albeit not valid for all kinds of gatekeepers⁸³¹ is the case where a gatekeeper draws a larger portion of its earnings from related services provided to a single or fewer clients. A typical example to illustrate this problem are the consulting services provided by auditing firms, where firms use modest audit fees as a door opener for more attractive consulting business.⁸³² This raises concerns about the independence of auditors,⁸³³ who in order to retain lucrative contracts for consulting services may be more willing to accommodate demands from the management of audited firm to present the firm in a better situation that it really is.⁸³⁴

The second assumption is that the gatekeeper will perform its gatekeeping role accurately because in the long-term it can benefit more from protecting its reputation.⁸³⁵ In favour of this argument speaks also the fact that due to the principal-agent relationship between a gatekeeper and a client, the gatekeeper obtains only a small pay-off for its services compared to the gains that a client would make from misconducting and therefore has no interest in wasting his reputation for any single client. Additionally, a gatekeeper is interested in ensuring the longevity of their clients through careful examination of their information, because they depend on the clients’ success and satisfaction for getting paid, and certainly for their existence.⁸³⁶ However, as practice has shown satisfying the client does not necessarily mean observing the interest of the public and gatekeepers will deplete their capital also for one single client.⁸³⁷ If it is suggested that dependence on a single or few clients could increase incentives to gatekeepers to acquiesce to a client’s misconduct for fear of losing him, then a possible solution to this problem should

830 According to Kraakman, Journal of Law, Economics and Organization, 1986, 53, p. 71 this is the least costly and most likely bribe to gatekeepers, namely that of continuing or extending established business relationships.

831 More often seen at auditors or securities analysts.

832 Doralt/Hellgardt/Hopt/Leyens/Roth/Zimmermann, The Cambridge Law Journal, 2008, 62, p. 65.

833 Bratton, European Business Organization Law Review, 2004, 7, p. 8 “The auditors had sold their independence in exchange for consulting rents.”

834 Ebke, in: Ferrarini et al. Reforming company law, p. 520 and Bratton, European Business Organization Law Review, 2004, 7, p. 12 and p. 28. However, Coffee, Business Lawyer, 2002, 1403, p. 1411 claims that with or without consulting services, an auditing firm is already conflicted by the fact that the client pays its fees. Moreover, the audit partner responsible for a large is particularly conflicted by the fact that he depends on this single client as if he were running a one-client practice. Nevertheless, the fear or losing a major client provides incentives to gatekeepers to underperform.

835 Coffee, in: Ferrarini et al. Reforming company law, p. 461.

836 Ebke, in: Ferrarini et al. Reforming company law, p. 518.

837 Coffee, Business Lawyer, 2002, 1403.

be a diversification of a gatekeeper’s contracting. Kraakman suggests that diversified gatekeepers are less susceptible to corruption because they have less at stake in relationships with particular clients.⁸³⁸ Therefore, the loss of a single client or customer will not threaten substantially their returns whereas the reputational losses and the financial liabilities related to those losses would exceed all of the gatekeeper’s profits and therefore provoke his demise.⁸³⁹ Although it sounds reasonable, this argument does not always hold. In explaining the demise of the auditing firm Arthur Andersen in 2002 after being involved in the accounting irregularities that lead to the collapse of the American company Enron in 2001, Coffee points out to the paradox that following the logic above, Arthur Andersen should have resisted temptation to acquiesce to Enron’s misconduct because it was well diversified and it drew its profits from a larger clients base.⁸⁴⁰ However, despite the diversification of contracting and the fact that the reputational losses were larger than the fees it was getting from a single client, the gatekeeper failed to perform its monitoring role. According to Coffee, reasons for gatekeeper failure in these cases, apart from a reduction in the exposure to litigation,⁸⁴¹ might rest also on a decline of the value of gatekeeper’s reputation especially in periods of market euphoria where investors manifest herd behaviour in believing that a course of events that has occurred in the past⁸⁴² will continue to occur also in the future.⁸⁴³ In such a context, gatekeepers are more interested in joining the crowd and making their portion of gains, even if that will mean risking their reputation.⁸⁴⁴

Additionally, another factor seems to affect a gatekeeper’s ability to detect and disrupt misconduct, namely the size and structure of the of the gatekeeping firm.

c) Gatekeeper’s size and structure – agency conflicts within the gatekeeper (i) Gatekeeper’s size

If diversified contracting seems to affect gatekeeper’s ability to detect and disrupt misconduct, then it is reasonable to expect that large gatekeeping firms may be better gatekeepers than smaller

838 Kraakman, Journal of Law, Economics and Organization, 1986, 53, p. 71.

839 Ibid., p. 71.

840 Coffee, in: Ferrarini et al. Reforming company law, p. 461 points out to the fact that Arthur Andersen had approx. 2300 auditing clients, and each client paid a fee that was modest in proportion to the firm’s overall revenues.

841 Coffee, Gatekeepers, p. 6.

842 E.g. extraordinary returns on investments.

843 Coffee, in: Ferrarini et al. Reforming company law, p. 473-6. See also Coffee, Gatekeepers, p. 325.

844 Ibid., p. 475. “Put more bluntly, it is dangerous to be sane in an insane world.”

gatekeeping firms or individual gatekeepers.⁸⁴⁵ The logical explanation for this assumption is that larger gatekeeping firms indicate considerable reputational capital and a large client base.

As already noted above, considerable reputational capital provides the gatekeepers with the incentive to defend it because it is their most valuable asset, whereas a large client base ensures gatekeeper’s diversification of investment to reduce reliance on few clients for a larger portion of their returns, hence increasing gatekeeper’s independence. However, consider the following assumption: a large gatekeeper has more reputational capital to lose, and that’s why it is incentivized to protect it. A smaller gatekeeper firm has less reputational capital to lose, but nevertheless, it depends in the same way as a bigger gatekeeper on the reputation for its economic survival. Therefore, also a smaller gatekeeper is incentivized to protect reputation, except when the gains from short-term underperformance substantially exceed the costs of depleting reputation. Nevertheless, this not a phenomenon limited only to smaller gatekeepers, but it is a problem that affects larger gatekeepers as well. One could go even further to assume that smaller gatekeeping firms are perhaps more incentivized to perform their gatekeeping role diligently because they have an interest in building their reputation further. Nevertheless, this assumption might be true only for gatekeepers who operate in a competitive market, but not for others who operate in near monopolistic markets.⁸⁴⁶

Other benefits from employing larger gatekeepers in the activity of disrupting misconduct relate to the fact that these gatekeepers could possess more know-how and expertise and therefore are in a better position to perform its role professionally. The concentration of the market in the hands of a few gatekeepers could produce specialisation that could in turn reduce misstatements by gatekeepers.⁸⁴⁷ However, this argument refers primarily to the professional capabilities of gatekeepers rather than to their incentives to perform their task professionally. The incentive or will to perform the gatekeeping tasks and the capacity of gatekeeper for such tasks are two different issues. For a successful performance, gatekeepers need to incorporate both elements.

Last but not least, the size of the gatekeeper influences gatekeeper’s ability and willingness to monitor and interdict wrongdoing when seen from a moral hazard perspective. Thus, as with

845 Kraakman, Journal of Law, Economics and Organization, 1986, 53, p. 72.

846 E.g. the market for credit rating market which is dominated by three firms or the market for auditing services which is dominated by the Big-Four. See Coffee, Gatekeepers, p. 35. However, see also Husisian, Cornell Law Review, 1990, 410, p. 441-2 suggesting that also between rating agencies there is a strong competition to preserve their considerable investments in their rating infrastructures.

Additionally, smaller-sized competitors, willing to fill in the gap should the major rating agencies falter, exert pressure that major rating agencies keep their investment in accuracy near the optimal level.

847 Cunningham, Columbia Law Review, 2006, 1698, p. 1719.

larger banks, which experience moral hazard problems due to the “too-big-to-fail” approach, also larger gatekeepers can experience similar problems. These moral hazard problems tend to be experienced there where the gatekeeper market is concentrated and consequently allows for the dominance of only few market players with relatively large market shares. Should one or several of these few gatekeepers be allowed to fall, the gatekeeper market would be in danger of unravelling, which in turn would increase the risks in that market as well as the costs to market participants.⁸⁴⁸ The belief that a gatekeeper is too big to be allowed to fall could tempt the gatekeeper to think that they will not have to face the disciplining hand of the market when they fail to perform their gatekeeping tasks. In the absence of liability threats and reputational threat constraints, it is not obvious why these gatekeepers should worry to always get it right with their duties. On the contrary, the fear of fall because there will be no saving hand to rescue when they fail to perform their tasks diligently provides an incentive, although of a threatening nature, to smaller gatekeepers with no dominant position in the market. However, as already mentioned above, simply the threat of fall alone cannot provide sufficient motivation for gatekeepers to avoid malpractice, especially where the gains from lax monitoring behaviour exceeds the costs of failure. Moreover, the practice of rescuing “too-big-to-fail” gatekeepers would not only provide wrong incentives to these gatekeepers and encourage them to take more risk than the market would allow or to apply lax monitoring practices, but would also prejudice smaller gatekeepers’ interests by making it more difficult for them to compete with larger gatekeepers.⁸⁴⁹ Therefore, it is necessary that ex-ante restrictions are put in place to limit intervention by state bodies to rescue gatekeepers deemed as “too-big-to-fail”, and thus counter negative incentives to these gatekeepers for suboptimal performance.

(ii) Gatekeeper’s structure

With regard to the gatekeeper’s structure, attention is drawn here to the agency conflicts experienced within the gatekeeping firm. Larger gatekeeping firms who delegate gatekeeping tasks to individual partners or employees are presumably more prone to reputational capital loss than are smaller gatekeeping firms or individual gatekeepers. Thus, even if for the large gatekeeping firm it would be unreasonable to sacrifice its reputational capital, it might not be so for the individual employee.⁸⁵⁰ The reason for the misalignment of incentives might rest in the assumption that because the individual employee or partner in a gatekeeping firm receives only

848 Ibid., p. 1699.

849 Cunningham, Columbia Law Review, 2006, 1698, p. 1723.

850 Coffee, Gatekeepers, p. 325.

a small fraction of the fees obtained by the gatekeeping firm,⁸⁵¹ they might be more willing to accept bribes if they would be sufficiently high to justify the personal costs they will suffer.

Hence the earlier suggestion that the depletion of reputational capital is a reasonable decision by a gatekeeper⁸⁵² if the short-term gains exceed reputational losses plays out within the gatekeeping firm context. The incentives the gatekeeping firm faces in this case are valid also for the employee within the gatekeeping firm. If the gatekeeping is not able to adequately address agency conflicts within the firm and monitor its agents effectively, the problem of incentives misalignment might exacerbate further. Having this consideration in mind, a smaller gatekeeping firm or an owner-gatekeeper might make a better gatekeeper because of less agency problems⁸⁵³ or because being the owner himself, the gatekeeper will retain the whole profit and reputation building incentives are higher. Nevertheless, larger gatekeeping firms could offer advantages in reducing the risk of colluding with the client and thus improving their ability to disrupt misconduct because of two reasons. First, especially in gatekeeping firms that function as partnerships with partners bearing several and joint liability, partners become natural monitors of each other in order to reduce risk of liability, unless they all work for the same client and depend heavily on him for generating profit.⁸⁵⁴ Second, large gatekeeping firms could employee gatekeeping mechanisms within the firm to monitor their employees and partners to avoid collusion of individual persons with the client they are supposed to monitor.⁸⁵⁵

d) The market for gatekeeper’s services – (non-)competitive markets and regulatory licences

(i) (Non)competitive gatekeeper markets

The assumption put forward suggests that in some gatekeepers’ markets where there is absent competition for gatekeeper’s services, the quality of the monitoring declines. As typical markets with absent or low competition are for example the auditing market for auditors delivering services at a global level to larger companies and the rating market. Both markets for these services are dominated respectively by the “Big Four” and the “Big Three”.⁸⁵⁶ It is therefore argued that absent competition in the market for gatekeeper services, gatekeepers may have little

851 Kraakman, Journal of Law, Economics and Organization, 1986, 53, p. 72.

852 Partnoy, Washington University Law Quarterly, 2001, 491, p. 498.

853 Partnoy, Washington University Law Quarterly, 2001, 491, p. 500.

854 Kraakman, Journal of Law, Economics and Organization, 1986, 53, p. 72.

855 Ibid., p. 72.

856 Perhaps even “Big Two”, i.e. Moody’s Ratings and S&P Ratings, if one does not consider Fitch Ratings as a big rating agency.

incentive to invest in improving their services and the quality of their information because they face no competition.⁸⁵⁷ Gatekeepers face thus the perverse incentive to underperform, because the client will return to them anyway, due to the limitation of choices in that market. There is nevertheless another side to the argument of competition. It has been suggested that competition could do more harm than good, in that it can force acquiescence instead of resistance to clients’

demands because of fear that the client will choose a competitor gatekeeper who is willing to deplete some or all of its capital in return for sufficiently high gains.⁸⁵⁸ As a result a race-to-the-bottom could be the result of a more competitive gatekeeper market and gatekeeping standards will be lowered.⁸⁵⁹ Therefore, in a monopolistic market⁸⁶⁰ gatekeepers could be better positioned to resist pressure from the client to underperform, and therefore, they should do better gatekeepers.⁸⁶¹ Also, it has been suggested that in non-competitive gatekeeper markets, gatekeepers compete more on the basis of reputation for integrity than on the basis of price and quality of their services. Gatekeepers need to maintain their reputational capital if they want to be perceived by investors as credible.⁸⁶² This implies that gatekeepers have already invested considerably to build up their reputational capital before being able to acquire clients. Therefore, non-competitive markets increase instead of decrease the quality of gatekeeper’s information.

However, the collateral effect of considerable investment in reputation and infrastructure is that raises entry barriers into the gatekeeper markets. These high entry barriers are according to Coffee the real reason for the dominance in some gatekeeper markets by only few subjects.⁸⁶³

Considering the above, the benefits of competition regarding gatekeeper’s incentives to perform accurately the gatekeeping role are uncertain. While in some markets, competition among gatekeepers could provide incentives for them to invest in building up their reputational integrity and serve as credible providers of information, in some other markets, increased competition

857 Coffee, Gatekeepers, p. 318.

858 Ibid., p. 319.

859 Coffee, Gatekeepers, p. 320 mentions the market for attorneys’ services or securities analysts as an example of competitive markets where acquiescence is higher than in the rating market. See also Deipenbrock, Betriebs Berater, 2003, 1849, p. 1854.

860 However Husisian, Cornell Law Review, 1990, 410, p. 442 suggests that even in seemingly monopolistic markets, such as rating services, gatekeepers are very competitive at protecting their considerable investments in reputation.

861 Coffee, Gatekeepers, p. 318. Nevertheless, this assumption is subject to the costs of gatekeepers if they choose to give in to client’s pressure, either in the form of reputation loss or exposure to litigation from investors.

862 Coffee, Gatekeepers, p. 319. See also Choi, Northwestern University Law Review, 1998, 916, p. 961.

863 Coffee, European Corporate Governance Institute Working Paper Series in Law, 2010, p. 55.

Im Dokument Basel II and the Protection of Creditors in Company Law (Seite 146-156)