(July 19): The gatekeeper is an outside professional services firm which has a contractual relationship with a client. Gate-keeping has traditionally been a firm’s specialisation, where it provides certification (such as a legal opinion from a law firm or audit letter from an accounting firm) that is needed to consummate the client’s securities or a corporate transaction. And the specific mechanism has traditionally been the gatekeeper’s professional duty to withhold services when it finds that it cannot vouch for the veracity of the client.

The regulators expect that the process of submissions for the completion of a transaction is overseen by the gatekeeper, and so does the investing public who rely on the integrity of this oversight.

The rationale that justifies such a role played by gatekeepers has been explained by John C Coffee Jr as "a strategy for law enforcement which posits that it is sometimes easier and less costly to deter the agent than the principal. Because the corporation and its controlling officers and shareholders may anticipate substantial gains (or hope to avert substantial losses) from materially misleading disclosures, they are often not easily deterred. High penalties on the firm also fall on innocent shareholders. But outsiders, who expect only modest gains, have less incentive to acquiesce in fraud and thus are more easily deterred. To the extent that the cooperation or acquiescence of such an outside agent is legally mandated before a transaction can be consummated, such agents make the ideal gatekeeper".

The expectation then is that the ideal gatekeeper is an outside agent who combines the quality of objectivity, so that there are three elements: i) the agent's approval is legally mandated, so that his or her non-acquiescence will prevent any attempted fraud and is a condition of the principal's continued access to the capital markets; ii) the outside agent faces a risk of liability either by way of regulatory penalty or exposure to civil liability for failure to detect and prevent an unlawful or non-complying transaction; and iii) the agent expects only modest gains from the principal for giving its approval. Such an agent also faces a loss of reputational capital. The main focus for decades since the late 1990s through to the 21st century of the failure of gatekeepers has been the integrity of the certification made by the independent public accountant. This is not to say that investment bankers, legal advisers and share analysts are exempted from critical focus, but the failure of the auditors to detect fraudulent accounts and transactions continues to bedevil capital markets.

The board of directors relies heavily on management and also outside professionals, and failure in governance may not be wholly attributable to their lack of vigilance in discharging their duties. Hence, in many cases when directors are faced with potential legal liabilities, they will also bring action against gatekeepers to make them contributorily responsible. The still-unfolding Autonomy saga in the UK/US, where Hewlett Packard has to write down an investment of US$11 billion (RM51.46 billion) by US$8.8 billion, comes to mind. In the investigation over the audit process, the major accounting gatekeeper firm was fined a record £15 million (RM90.71 million), and personal fines of a combined £760,000 were imposed on two audit partners in charge of the accounts. There was a telling finding by the UK Financial Reporting Review Panel that the desire to raise 20% in earnings from the audit work on Autonomy had impaired the “objectivity” demanded from the audit process — also that a senior auditor who signed off on Autonomy’s accounts engaged in wordsmithing (a trait one would think lies in a lawyer’s craft) which facilitated the UK software firm to hide its hardware sales from the market.

As a result, Autonomy was bought by Hewlett Packard for US$11 billion and shortly had to write down its value by US$8.8 billion. Our 1Malaysia Development Bhd (1MDB) saga, where two major audit firms were fined by the Securities Commission Malaysia and also paid a huge, unprecedented settlement sum of over RM300 million each, is evidential of the continuing failure of gatekeepers. The advent of the so-called multi-disciplinary practice of accounting firms also further raises issues of the erosion of independence expected from the audit process.   

Accounting irregularities abound, and if left unchecked, the trust that is the glue that cements the running of an efficient market for both corporates and the capital markets will be eroded. This weakens the raising of equity and debt capital for our economy.

It is paradoxical that we now have professionals subject their professional judgement to business imperatives while businesses are trying to be more “professional”. In the case of Malaysia, one may conjecture that because of dispersed shareholdings, with the major shareholders monitoring management closely, we have witnessed fewer accounting scandals than the US and European Union. Nonetheless, professional bodies which exercise discipline over respective gatekeepers must be vigilant and vigorous. This is important, so that gatekeepers who are reputation intermediaries will not lose their legitimacy in playing their role in society and in capital markets.

Philip TN Koh is an advocate and solicitor of the High Court of Malaya and adjunct professor of Universiti Malaya and the School of Business, Monash University Malaysia.