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Federal regulation generally is overseen by government agencies responsible for areas of particular concern, such as the Environmental Protection Agency, the Federal Trade Commission, and the National Transportation Safety Board. But not all regulations are made by the government. Agencies sometimes engage in “private ordering” — delegating regulatory authority to experts in the private sector. 

Private ordering is generally done for economic efficiency, under the idea that private institutions can operate more cost-effectively and with greater expertise than government. But private ordering can lead to conflicts of interest wherein experts make rules that favor their own industry over the interests of the government or the public, warns Duke financial law expert Steven L. Schwarcz. 

In new research, Schwarcz suggests the Securities and Exchange Commission’s unrestrained outsourcing of accounting standards for financial disclosure may harm investors by making it easier for corporations to hide weaknesses on their balance sheets.

“When you look at notorious cases like Enron and Lehman Brothers, you see how private ordering can create flaws in the system,” said Schwarcz, the Stanley A. Star Distinguished Professor of Law and Business at Duke Law School. 

“Allowing the accounting industry to set their own rules can create loopholes that are easier to be exploited.”

Enron’s 2001 collapse and the 2008 bankruptcy of Lehman Brothers are two of the cases Schwarcz examines in his forthcoming paper Rethinking Private Ordering: The Financial Disclosure Quandary. Their collapses resulted in thousands of job losses and billions of dollars wiped out of pension and retirement funds. Moreover, Lehman’s bankruptcy helped tip off the 2008 global financial crisis.

Private ordering is most often employed by commercial and financial regulators, both in the U.S. and abroad, to lower costs, improve efficiency, and draw on experts with specialized knowledge not available in the agency, Schwarcz says. In limited-delegation private ordering, government delegates the authority to formulate rules that still require government implementation; whereas in full-delegation private ordering—which is effectively the model behind financial disclosure—private sector parties can not only create rules but also implement them. 

The SEC, which is responsible for promoting fairness, preventing fraud, and protecting investors in securities markets, delegates limited authority to oversee brokerage firms to the private Financial Industry Regulatory Authority (FINRA) and can review and override FINRA’s actions. But the SEC has, in practice, delegated full authority over financial disclosure to the Financial Accounting Standards Board (FASB), an independent, private sector body that both sets and promulgates the rules underlying the generally accepted accounting principles (GAAP) for reporting corporate financial information, Schwarcz says.

And the very structure of FASB undermines its independence and legitimacy, Schwarcz argues. Its seven-member board is composed primarily of accountants and financial statement preparers who serve full time for a five-year term. While they may be specially qualified to craft accounting standards, Schwarcz argues that stacking the board with representatives of the profession can disadvantage investors — the very people the rules are supposed to protect.

The board, he writes, routinely votes on matters that serve its own interests — and those of special interest groups like corporate auditors and financial statement preparers — with less attention paid to investors. Long-standing investor requests to update the standards for intangible assets and reform the statement of cash flows have sat unaddressed for decades, Schwarcz notes.

Moreover, FASB’s membership of accountants is tasked with creating the very accounting standards it must comply with. And because the SEC has effectively ceded full control, FASB enacts its rules without a final opportunity for government scrutiny, Schwarcz says. That can lead, at least indirectly, to corporate failures like the collapse of Enron and its auditor, the accounting firm Arthur Andersen. 

Enron had exploited loopholes in GAAP rules to create Special Purpose Entities (SPE) that allowed it to obscure billions of dollars in potential liabilities. While technically in compliance with GAAP, many investors were in the dark about Enron’s full financial picture. It was only after the company’s bankruptcy, one of the largest in U.S. history, that FASB modified the standard requiring disclosure of SPE assets and liabilities. 

Similarly, Lehman Brothers manipulated a GAAP accounting standard to conceal tens of billions of dollars in liabilities and mislead investors, all while being technically in compliance. In both cases, loopholes in GAAP rules promulgated by FASB allowed the companies’ financial reports to distort economic reality, leading to their eventual collapse, Schwarcz says. 

Possible solutions

To mitigate the risks of full-delegation private ordering, Schwarcz proposes that FASB be given only a limited delegation of authority. Under that model, the SEC would be required to review and approve financial-disclosure standards prior to their becoming effective. He also recommends rebalancing FASB’s seven-member board, on which financial statement preparers and auditors hold the majority, by replacing one or more of those members to ensure adequate investor representation. 

Schwarcz also proposes that material liability risks be included in the management discussion and analysis section of annual reports, which are more likely to be read by investors, rather than buried in footnotes.

Finally, Schwarcz considers whether GAAP’s rigid rules-based framework could benefit from giving preparers more flexibility when disclosing corporate transactions and an obligation to deviate from GAAP when doing so would mislead investors. 

He concludes that the legitimacy of FASB as an institution, as well as the legitimacy of the private ordering of financial disclosure, depends on protecting investors. The current full delegation of authority to FASB fails to ensure that protection.