Lessons from a French scandal

The French really are different. Consider how the United States would have dealt with Jérôme Kerviel, the 31-year-old trader at Société Générale who managed to lose more than $7 billion through unauthorized trades in stock index futures.

Had this debacle occurred in this country, it almost certainly would have triggered the creation of a blue-ribbon congressional panel that would have devoted months of time and hundreds of thousands of dollars to dissecting the problem. That effort would be followed by the publication of a report of no less than 300 pages.

Now, look at the French way of handling a “scandale.”

On Feb. 4, after an investigation of just eight days, French Finance Minister Christine Lagarde issued an 11-page report, which the Washington Post aptly described as a mild rebuke of Société Générale. The report addressed the need for better internal controls, improved operational risk management and bigger fines for banks that don’t adhere to regulations.

While the report itself may have amounted to a non-event with little more than a scolding, it was Ms. Lagarde’s interview with Maria Bartiromo, published in BusinessWeek five days before the official report was released, that provided the most profound insights on the lessons learned from the scandal.

Ms. Bartiromo asked what could be done “to ensure that something like this never happens again?”

Ms. Lagarde’s extraordinary reply was: “We’re talking about, I think, three levels of transparency. Transparency of financial instruments, and that addresses the subprime issue … The second has to do with disclosure. Financial institutions, insurance companies, all of them have to be transparent and disclose regularly the entire reality of their balance sheets and accounts. The third level of transparency is relationships within trading rooms and between trading rooms and control areas.”

Keep in mind that the questions posed by Ms. Bartiromo focused exclusively on the SocGen scandal. Yet, in this particular question, Ms. Lagarde references two seemingly unrelated industry nightmares — the subprime lending crisis and the implosion of off-balance-sheet in-vestments like structured investment vehicles.

Another telling interview response came from Ms. Lagarde when she was asked, “What do you think the implications of all this will be?”

She replied: “I think it will bring a sense of urgency for everyone. I was delighted to see [Britain’s] Prime Minister [Gordon] Brown also advocating better regulation, more transparency, and improved governance.”

So how is this relevant to the financial services business in the United States?

Clearly, the world’s economic leaders recognize that lack of transparency is largely responsible for the biggest investment crises we face. The three levels addressed by Ms. Lagarde are precisely where major regulatory reforms must be made.

Financial instruments cannot be valued properly if the underlying securities are unknown or are not exposed to objective or competitive pricing. Expect regulators to require better disclosure of holdings and pricing methodologies. Fiduciaries must become much more vigilant about avoiding, or requiring a high-risk premium on, investment vehicles that are so complex or convoluted in structure that they cannot be valued by conventional means.

Financial institutions will be called on to disclose and acknowledge their role in serving clients. Those acting in a fiduciary capacity should be expected to acknowledge that fact in writing, as required for fiduciary advisers under Title VI of the Pension Protection Act of 2006. Institutions also will be expected to bring off-balance-sheet vehicles onto the balance sheet if the sponsoring organization is at risk for the vehicle.

Perhaps most important, relationships among service providers must be disclosed, along with all compensation arrangements among the providers.

The Department of Labor in December proposed regulations that would require such disclosures for providers of services to retirement and welfare plans.

These changes are necessary in light of the extensive damage that has been done by non-transparent and abusive practices in the financial services industry. It is unfortunate that regulatory initiatives are now inevitable because financial services professionals and leaders in the field of investment management have not demonstrated the willingness or ability to consistently apply fiduciary standards of care that would have accomplished the same result.

Blaine F. Aikin is president and CEO of Fiduciary 360 LP in Sewickley, Pa.