(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

Federal Reserve Official Addresses Corporate Governance, Disclosure

According to New York Federal Reserve Board President William J. McDonough, the three main ingredients of good corporate governance are capable officers and directors, a coherent strategy and business plan, and clear lines of responsibility and accountability. In addition, he said that execution of the overall objectives of the firm must be supported by rigorous internal controls and effective risk management. In remarks at the William Taylor Memorial Lecture in Washington, he also called for a major rethinking of the entire disclosure framework.

In his view, effective risk management is based on a foundation of good corporate governance and rigorous internal controls. While taking calculated risks is part of any business enterprise, he acknowledged, it is also necessary that each firm be able to identify the risks associated with its activities and effectively measure, monitor, and control them. An effective risk management and control structure is not sufficient, however, if it is not accompanied by an institutional culture that ensures that written policies and procedures are actually translated into practice.

In turn, he continued, an effective internal control apparatus is critical to provide reasonable assurance that the information produced by the organization is timely and reliable and that errors and irregularities are discovered and corrected promptly. Such an apparatus is also needed to promote the firm's operational efficiency and to ensure compliance with managerial policies, laws, regulations, and sound fiduciary principles. Finally on this point, Mr. McDonough said it is vital that managers make certain that their commitment to an environment that includes effective risk management and rigorous controls filters fully down the line to all employees.

The Federal Reserve president also postulated that effective market discipline must be supported by meaningful public disclosure and sound accounting standards. Knowing a company's appetite for risk and its approach to managing risk is essential to understanding the risks of being a shareholder, a creditor, or a counterparty. In this regard, he sees a need for dramatic progress in improving disclosure practices, adding that a full appreciation of risk cannot be achieved without sufficient information.

Progress on the disclosure front, however, will be limited until accounting standards are enhanced to ensure proper valuation and to reflect innovations over the past decade, in terms of both new products and modern risk management techniques. Accounting systems serve a variety of purposes, he opined, but the most important is helping creditors and investors make informed decisions as to which enterprises meet the market tests of efficiency, competitiveness, and profitability.

On the question of independent directors, which is crucial to corporate governance, the Federal Reserve official noted that finding such outside directors can involve a dificult balancing act. Directors who are paid too little or who are kept at the perimeter of the corporate structure may be truly independent but have little incentive or insufficient knowledge about the organization to govern effectively. By contrast, directors who are paid well or who are fully integrated into the corporate structure may have the incentive and the knowledge to govern effectively but lack the desired independence to discipline incompetent or dishonest management.

The risk is that as the pay of outside directors increases their independence may wane and, instead of being watchdogs for shareholders, they may increasingly function as lapdogs for management. Thus, Mr. McDonough sees a great challenge in getting the right balance of expertise and independence so that the board does not rubberstamp management decisions. Given what has transpired over this past year, he said there may be a need to reconceive the role of directors. In this regard, he noted that some firms are already moving away from the tradition of choosing the CEO of another company as a director to choosing people who are equipped with more specialized and technical knowledge.