Lawyer explores corporate governance issues in financial technology firms and proposes reforms.
Recent scandals involving major financial technology firms have one thing in common: a severe lack of internal controls over senior leadership.
Whether the scandals involve illegal business relationships or misappropriated funds, major corporate governance failures contributing to the collapse of financial technology, or “fintech,” firms, such as FTX and Wirecard, continue to baffle investors and the public.
Even though these recent failures have already cost investors billions of dollars, at least one lawyer suspects that an even more catastrophic event could be on the horizon. In a forthcoming article, Isa Alade, a partner at Banwo & Ighodalo, explains that the corporate governance problems afflicting fintech firms today are strikingly similar to those challenges major financial institutions faced prior to the 2008 global financial crisis.
Fintech firms rely on specialized software and algorithms to provide financial services. Through the integration of these technologies, fintech firms assert that they can offer specialized products to customers, provide better and faster services, and reduce their own operational costs. Reports estimate that revenues in the fintech industry will grow almost three times faster than those in traditional banking sector in the upcoming years.
Fintech firms, however, can create major financial shocks that ripple throughout the economy, notes Alade. These systemic risks arise from fintech’s reliance on innovative technology and its widespread integration within the financial system. Alade argues that technology is core to these firms’ offering, making it essential for the financial system’s functionality. And because of fintech firms’ interconnectedness in the global economy, the threat of any technological or individual fintech firm failure could have a domino effect across multiple banks, companies, and jurisdictions, Alade claims.
Alade argues that regulations and laws adopted following the 2008 financial crisis are ill-equipped to address the unique corporate structures and challenges within fintech firms. He cautions that, unless the corporate governance regime for fintech firms is redesigned to account for these differences, another global financial crisis may be on the horizon.
Alade identifies similarities between governance weaknesses in fintech firms and weaknesses in financial institutions that led to the 2008 crisis.
For example, prior to the financial crisis, executive directors were not only underqualified for their roles but also failed to devote sufficient time to their positions’ duties. Chief executive officers operated without internal accountability, leading to excessive risk-taking, a lack of shareholder focus, and other poor decision-making, Alade contends.
Lack of oversight also lies at the heart of the recent criminal allegations against Sam Bankman-Fried, the former Chief Executive Officer of the fintech firm, FTX. FTX allegedly operated largely without a formal board and never conducted a board meeting. Control of the $32 billion dollar company was reportedly left in the hands of a small group of inexperienced individuals, contributing to the firm’s downfall, Alade claims.
Furthermore, financial institutions that failed in the 2008 crisis disregarded shareholder interests, Alade states. Operating without an oversight board, executives of these failed institutions focused instead on short-term performance at the expense of shareholder interests and frequently overlooked the viability of their financial products. Managers also allegedly rewarded themselves with substantial bonuses and paychecks despite the negative impact these bonus allocations had on shareholder value.
Similarly, according to prosecutors, FTX insiders illegally diverted billions in customer funds to cover expenses, debts, and risky trades and to make lavish real estate purchases and large political donations. FTX has not yet returned this money to its investors.
In the aftermath of the 2008 financial crisis, the federal government passed regulations and laws to address the corporate governance issues within financial firms. These changes, however, cannot manage the problems in fintech firms because of the peculiarities of their corporate structures, Alade explains.
Many of the post-crisis reforms granted corporations legal personhood to hold corporations accountable for certain adverse outcomes.
Fintech firms, however, rely heavily on algorithms for decision-making, including risk management and regulatory oversight and compliance, Alade notes. He argues that certain liability requirements within existing laws make it difficult for regulatory agencies and shareholders to hold directors, and the fintech firms over which they have authority, accountable for the decisions that algorithms make.
Alade proposes re-evaluating liability frameworks to hold corporate directors and fintech firms accountable for the decisions of their algorithms. Alade argues this update will increase the likelihood of legal liability of fintech firms and their management, which will aid in controlling excessive risk-taking and make them responsible for poor decisions regardless of whether an algorithm or a manager made such decisions.
Lawmakers also added new disclosure requirements on financial institutions after the 2008 crisis, including publicly releasing information “relating to securitization, use of structured investment entities, and liquidity commitments.”
Alade points out that, although these requirements address information asymmetries between managers and shareholders, they fail to address the technology asymmetry present in fintech firms. For example, managers have insight into the functions of its firm’s algorithm, but shareholders may not be privy to such information. And the complexity of fintech technology makes it challenging to provide useful information to shareholders and to conduct audits of the technology, Alade notes.
Alade proposes that financial regulators more effectively use technology to audit fintech firms. He notes that available applications can assist agencies with tasks related to regulatory compliance, risk management, and reporting, as well as monitoring, assessing, and supervising fintech firms. Regulators can leverage technology to oversee fintech firms, thereby mitigating compliance risks and protecting consumers, Alade argues.
Finally, Alade points out that the regulatory structure established after the 2008 crisis currently operates through a single financial services regulator, which oversees all financial corporation activity.
Alade observes that the current structure is ill-suited for fintech regulation, which blurs traditional agency boundaries separating the financial industry from other industries. Alade recommends a cross-agency approach to fintech regulation that would require collaboration among regulators in various industries, both financial and non-financial. A cross-agency approach would help regulators establish a uniform policy governing fintech that maintains standards and avoids inconsistent regulatory approaches, according to Alade.
As fintech solidifies its place in the economy and continues to expand into new uses, Alade warns that the vulnerabilities in corporate governance, which recent fintech firm failures exposed, could trigger a significant financial crisis. To mitigate this risk, Alade urges that financial oversight agencies and the U.S. Congress make changes to the regulatory structure governing the fintech industry that address accountability issues among fintech directors and officers.
