From: William Livingston [vitalith@earthlink.net]
Sent: Tuesday, March 09, 2004 1:38 PM
To: rule-comments@sec.gov
Subject: S7-03-04: IC-26323 Governance

Mr. Chairman and Honorable Commissioners:
You have solicited comments on the Commission's comprehensive proposal to amend 
ten exemptive rules to require any fund that relies on any of them to adopt 
certain fund governance standards. As a registered professional engineer (PE) 
and member of the Institute of Internal Auditors (IIA), the combination of 
competencies applied to "internal control" builds an extraordinary professional 
duty to benchmark governance. When receiving your professional license from 
society, in a complete flip from the "yours is but to do or die" mindset of 
academic training, you had to pledge "to question why."
 
My previous response reviewed indigenous immutable limitations, set by natural 
law, for any rule-based approach to corporate governance. It reminded you that, 
in times of speedy technological advance, the order of battle that got you 
through the last war spells defeat in the next. As Darwin showed, you cannot 
remain viable with a response cycle time longer than the arrival rate of new 
threats. When challenge-response time delays are mismatched, the content of your 
rules doesn't matter. More industrious self-assessing independent watchdogs, 
make matters worse.
 
The regulatory agency was Establishment-contrived to constrain business as usual 
for stakeholder safety. The current codes that restrict the design of engineered 
artifacts, for example, are the direct result of a standards-making response to 
protracted man-caused catastrophe. This generic safety net for stakeholders has 
a checkered history. Regulating industry by rules of action has served society 
well in some applications, such as for pressure vessels that don't explode even 
when mal-operated (1895 ASME). For corporate governance, however, more rules of 
action are now counterproductive to the SEC intent.

Your own research and background documentation on corporate governance attests 
that the SEC is quite aware of the inflection-point limits to hindsight-based 
rules. While you are already working on the next round of rules to respond to 
the next round of enforcement actions by the Commission and state regulators, 
there is Congressional foreboding that the fix isn't. The trial lawyers 
gleefully prepare for another windfall.

The wholesale failure of the regulatory ghetto to safeguard stakeholders is 
compensated, in part, with the automatic tort parachute. The record shows a 
direct and clear connection between the financial growth of tort litigation and 
the shrinking regulatory influence to prevent national economy-wrecking scandal. 
If stakeholder safety actually attained is measured by lawyer body count, 
regulatory action is background noise. With the liability economics of tort 
litigation more than a hundred times larger than regulation, does it make sense 
for corporate governance to operate by rules of action that encourage the very 
consequences you seek to avoid? It may be your professional duty, as it 
certainly is mine, to know that that is the case.

Incompatible methodologies- bifurcated law
The regulatory tradition is a pre-understanding that defines the space of 
possible actions. It is concealed by its obviousness. It is both a set of rules 
and a way of understanding within which organizations interpret and act. This 
pre-understanding of governance is determined by the history of 
regulator-regulated interactions exhibiting the tradition. Rules represent a 
particular structural coupling of the organization to the world in which it 
exists.

Institutionalized regulation faces backwards in time frame. Remote control by 
rules of action, hierarchically enforced, is based on disconnected discontinuous 
hindsight. Rules are created and shaped by programmed institutional reaction to 
wreckage caused during events already transpired. Crisis management makes 
heroes. 

The governance spotlight on tort-compliant operation, rather than on conformance 
to the rules of action imposed by a remote regulatory body, automatically 
switches the principal time frame of reference from hindsight to foresight. In 
tort, negligence is established by the retroactive benchmarking of the PE 
standard of care to the time span prior to damage. The court task is to 
objectively frame the "foreseeability" of the enabling circumstances of damage. 
Engineer the risks, before damage, to get your immunity.
 
In any "control" system, a strict sequential work procedure short-circuits 
control functionality. When the choice for action is confined to a linear set of 
rules, the original system goal disappears. As soon as the real goal switches to 
following orders, consequences of action cannot matter. For any hierarchical 
organizational structure supervising action at the work face by a chain of 
command, rule-based regulation is the only form of control that works. What you 
get is your rules, not your compelling purpose. Whoever picks the rules, owns 
the consequences. Regulation is as regulation does.

The requisites of foresight, a feature controls engineers call anticipation, 
involve loop-wise activity, a form of recursion. In a viable control loop, 
consequences obtained by the last cycle of work are compared to the original 
work goal as intelligence for improving the goal-seeking potency of the next 
cycle of work. Foresight demands intelligence (appropriate selection) and is 
organizationally punished. Strict compliance to rules forbids intelligence 
(selection authoritatively imposed) and is rewarded.

Intrinsic incompatibility makes classification of internal control type in use a 
trivial task. In practice, it is impossible to mistake one method system for the 
other. Lawyers for the DOJ routinely determine corporate governance 
effectiveness for the USSC Guidelines assignment in a couple of days.

Divided loyalties
There are reasons in common for the allocation of efforts towards stakeholder 
safety to be so disconnected from the operational reality. The exclusive focus 
of attention on a regulatory system proven to fail is no fluke. Cooperative 
preoccupation with rules of action follows every wave of scandal because 
switching the operational benchmark of corporate governance to the tort standard 
of care means the end of business as usual. Tooling now being hawked to move the 
enterprise along the required "transparency continuum" of 404, touting the 
"competitive advantage" and the "revolutionizing of business," has put senior 
management in shock. The pressure on you will be escalated until you defer 404 
again.

While society has always considered the mindless defense of the status quo as an 
honorable occupation, for corporate governance the strategy of defense is doomed 
to fail. The obstruction to preserving business as usual indefinitely is the 
escalating benchmark of tort law. Corporate activity is evaluated 
simultaneously, but asynchronously, by two methodologically incompatible legal 
standards. Regulatory compliance is calendar driven and audited on a periodic 
basis. Compliance to the tort standard of care is event-triggered, retroactive 
and asserted by protracted litigation. A penalty for regulatory non-compliance 
is both likely and economically trivial. Tort presents an opportunity to wager 
the whole company.
 
Institutions that set regulatory compliance (hindsight) equal to liability risk 
management are able to defer the day of reckoning with the tort benchmark 
(foresight) for years. The risks of contemporaneously violating tort law by an 
exclusive focus on hindsight-based operations are selectively carried by the 
stakeholders. Management has pre-arranged tunnels to escape with the booty when 
the corporation gets caught in the tort safety net. Until serious stakeholder 
damage is inflicted, business as usual rolls on.

Hindsight erosion
The recent, but fatal, flaw in the strategy of corporate governance limited to 
hindsight is that the societal balance point between historical and future 
watchdogging advances with method technology. If you had a complete 3-D map of 
the path ahead, locating all the hazards and perils, why would you steer by the 
rear view mirror? When the ship can locate itself to a three-foot circle in any 
weather, it is professional negligence for the Captain to collide with a hazard 
to navigation marked on the map. As the technology of precise location has 
forever altered the responsibility profile of ship management, the technology of 
foreseeability, i.e., the process of engineering, has permanently altered the 
responsibility profile of corporate governance.
 
Society is now witnessing and enjoying the effects of a "perfect storm" of 
quantum leaps in the capability of the process of engineering to assault 
complexity. About five years ago, the relentless march of Moore's Doubling Law 
finally boosted the available computational horsepower so high that engineers 
could tackle the full socio-technical complexity of "real" systems on design 
engineering terms. The process of engineering has surged into foreseeability so 
far that, for all practical legal purposes, no stakeholder damage caused by an 
engineered system is unforeseeable. For the PE, failure is not an option. While 
the rule of law still provides the terms for PE judgmental immunity, there's 
nothing left in the realm of stakeholder safety for the PE to select by opinion. 
Nothing.

Other than professional engineering itself, the only part of institutional 
society attentive to the escalating competency of foreseeability is tort law. It 
is to the obvious advantage of lawyers for the plaintiff to elevate the standard 
of care for foreseeability, the core of engineering methodology, as high as the 
best available technology will allow. It doesn't matter that society despises 
engineering process and its spotlight on damage prevention. The leap in PE 
competency has already taken place. Society is permanently addicted to the 
fruits of foreseeability gone ballistic. You're not going to give up your cell 
phone. Short wars save lives. NASA enjoys being on Mars.

Liability insurance fade-out
Corporate governance ineffectiveness, for the first time, is being hammered by 
tort law success. Its corporate liability insurance market is directly coupled 
to the balance of power between hindsight governance and the tort foreseeability 
standard of care. When liability insurance was umbrella and cheap, corporate 
governance didn't matter. Whatever the consequences from business as usual, 
scandals and all, insurance served as the paymaster of stored funds to all 
parties - all belonging to the same section of the ABA (TIPS).

The blazing wealth transfer success of tort litigation has radically altered the 
economic tradition. For all practical purposes, liability for governance 
failures no longer meets the criteria for an insurable risk. The evaporation of 
liability insurance for corporate mal-governance means that things will be quite 
different when the next wave of scandals breaks over your watch. The race to 
bankruptcy will occur as usual, of course, but there will be no pantry full of 
insurance money to bankroll class actions. Crisis managers, bearing the bad 
news, will appear as villains. The stakeholders will be furious. 

The PE corporate governance audit
The engineering of internal control is not rocket science. Apparent complexity 
in the internal control application is achieved by quantities of simple 
relationships, not by mysterious fields of subatomic force. The process of 
engineering is quite capable of engulfing the complexity of corporate governance 
and bringing it into a rational realm of effective control. The same assault on 
complexity is, exactly, how we get cell phones to work. There is no 
distinguishable difference between the process of engineering, effective 
management, and corporate governance.

The term "internal control," was selected by business to create an illusion that 
"it" was "in control" of corporate affairs to assure stakeholder safety. The 
diverse array of stakeholders scattered about the social landscape, including 
the SEC, need have no reason for concern as long as corporate internals were 
being "controlled" to protect their interests. In the engineering sense of 
control, where ends are specified and means are varied as appropriate to achieve 
them, the typical internal control apparatus of the institution doesn't control 
anything. It is a linear transaction reporting system driven by an algorithm. 
Scandals do not signal a "breakdown" in internal control. The control 
functionality never existed in the first place. To the PE practitioner in the 
trenches of internal control, demonstration of that fact is incessant and 
painful.

Frames of reference
To the corporation parking in the legal compliance zone, involving the PE 
framework in internal control (governance) secures two key assets.  First, the 
PE is sensitized to the intrinsic limits of institutional regulation by rules of 
action. The PE keeps a running measurement of status relative to the unavoidable 
regulatory impact inflection point. The PE is legally bound to warn the 
institution when responding to crises with more rules means less effectiveness 
in risk management.

For instance, it is the PE duty to inform the SEC that the addition of another 
layer in the regulatory hierarchy, the PCAOB, means a reduction in overall SEC 
regulatory performance of 8%. In engineering jargon, the added communication 
overhead of the PCAOB hierarchical layer consumes that much more resources than 
the value of anything it can contribute to the SEC mission. This best possible 
bottom line outcome is provided automatically by natural law (control theory). 
The mathematical physics derivation of this relationship and the graph of 
effects as a function of hierarchical layers in any organization is shown on 
page 156 of Rudolf Starkermann's seminal book "Feedcross"  ISBN: 3-908730-29-5 
(2003). It might be your professional duty, as it certainly is mine, to know 
that that is the case.

The second asset that comes with the PE conditions of license, is a continuous 
evaluation of the engagement risk profile against the supreme benchmark of an 
expert witness for plaintiff in tort court. The PE worries endlessly about the 
foreseeable stakeholder exposures to damage associated with the engagement. He 
labors to define those associated risks that are not foreseeable with the best 
available technology. In the course of work, if significant foreseeable 
stakeholder risks appear that will not be addressed by internal control prior to 
damage, the PE is obliged to withdraw.

What serves stakeholder safety best, as you go, is the same methodology that 
serves their class-action lawyers so effectively after the damage is done. The 
internal auditor, operating in the hindsight rules-based realm, may legally 
remain employed in the engagement from Hell, no matter the consequential 
wreckage and mayhem. The PE, operating in foreseeability's zone, may not remain 
associated with a project headed towards failure - and he is legally bound to 
determine immediately when that becomes the case. Either way, an engaged PE is 
an insurance policy for management that the governance mission is on target and 
the institution is immune to liability from regulatory and tort law.

Independent validation
In corporate governance affairs, research exists on the sociology why both the 
regulated and the regulator deliberately choose a method of operations that 
collides head on with the tort standard of care. "The Mechanisms of Governance," 
by O. E. Williamson (Oxford) is one of several textbooks that cover this 
governance perspective.

For research on the link between the process of engineering (foreseeability), 
the tort standard of care, and internal controls, a solid technical platform was 
provided in "Business @ the Speed of Thought" by Bill Gates in 1999 (Warner 
Books). Here you will find the template of corporate governance by (internal) 
control in the engineering sense - before the class of Enron graduated. Just 
like the disaster of the "In Search of Excellence" craze, where the champions of 
excellence promptly plunged into bankruptcy, the five years since Gates' book 
have not been kind to his examples. So much for revealing the secret formula of 
business success.
 
The SEC is to be commended for providing this convenient electronic means for 
posting rule-making commentary.

William L. Livingston, PE