I recently listened to the Great Courses series of lectures, entitled Crashes and Crisis: Lessons form a History of Financial Disasters, hosted by Professor Connel Fullenkamp. It was so entertaining that this week I am considering some great economic disasters from history to see what lessons they might impart for the compliance professional. So far, I have considered the Dutch Tulip Bubble from the 1630s, the South Sea Bubble of 1720 and the Mississippi Bubble of 1720. Today I conclude with the Panic of 1907.
Primary causes of the Panic included a retraction of market liquidity by a number of New York City banks and a loss of confidence among depositors, exacerbated by unregulated side bets at bucket shops. The Panic was triggered by the failed attempt in October 1907 by the Knickerbocker Trust Company to corner the market on stock of the United Copper Company. When this bid failed, banks that had lent money to the cornering scheme suffered runs that later spread to affiliated banks and trusts, leading, a week later, to the downfall of the Knickerbocker Trust Company, which was then New York City’s third-largest trust. The collapse of Knickerbocker spread fear throughout the city’s trusts as regional banks withdrew reserves from New York City banks. Panic extended across the nation as vast numbers of people withdrew deposits from their regional banks.
Fullenkamp said of the Panic, “From American independence through the 19th and early 20th centuries, panics were a recurring feature of the domestic financial market. They occurred with astonishing regularity and often were followed by serious recessions, and even depressions. This lecture digs into the concept of financial panics by focusing on one that changed the course of American economic policy: the panic of 1907, which introduces us to one of the most famous financiers in American history—John Pierpont Morgan—and brought about an end of the era of financial panics.”
The Panic was caused by a series of steps, initiated by the principals of Knickerbocker which led to a run on the financial house. As news spread, other banks and trust companies were reluctant to lend any money. The interest rates on loans to brokers at the stock exchange soared to 70% and, with brokers unable to get money, stock prices fell to a low not seen since December 1900. The panic quickly spread to two other large trusts, Trust Company of America and Lincoln Trust Company. By Thursday, October 24, a chain of failures littered the street: Twelfth Ward Bank, Empire City Savings Bank, Hamilton Bank of New York, First National Bank of Brooklyn, International Trust Company of New York, Williamsburg Trust Company of Brooklyn, Borough Bank of Brooklyn, Jenkins Trust Company of Brooklyn and the Union Trust Company of Providence.
This is where JP Morgan stepped. Initially, he injected $3MM into the Trust Company of America to keep it solvent. Two days later, the US Secretary of the Treasury contacted Morgan and placed $25 million at his disposal for injection into the monetary system. The money was a surplus from federal import tariffs that the government had not spent. Two days after that pledge, the president of the New York Stock Exchange informed Morgan that at least 50 brokerages would fail that day if $25 million weren’t made immediately available and that he planned to close the exchange early that day. This was dire news, because the brokerages would fail, possibly causing the panic to spiral out of control. Morgan covered the full amount. Morgan later put another $10MM into the NY banking system to shore it up.
Morgan was almost single-handedly able to save the NY financial system. There were several reasons why he was successful but one of the key reasons was that he understood the US banking and financial system as well as anyone in the country. This technical expertise informs today’s compliance topic of why a corporate Board of Directors need compliance expertise. Every Board of Directors need a true compliance expert sitting at the table. Almost every Board has a former Chief Financial Officer (CFO), former head of Internal Audit or persons with a similar background and often times these are also the Audit Committee members of the Board. Such a background brings a level of sophistication, training and subject matter expertise (SME) that can help all companies with their financial reporting and other finance-based issues. So why is there not such compliance SME at the Board level?
An arm of the US government has recognized the need for such expertise at the Board level. In 2015 the Office of Inspector General (OIG) called for greater compliance expertise at the Board level. The OIG said that a Board can raise its level of substantive expertise with respect to regulatory and compliance matters by adding a compliance member. The presence of a such a compliance professional sends a strong message about the organization’s commitment to compliance, provides a valuable resource to other Board members, and helps the Board better fulfill its oversight obligations.
In a 2016 Corporate Compliance Insights (CCI) article, entitled “Compliance Expertise in the Boardroom”, Mike Volkov looked at it from both a practical and business perspective stating, “I have witnessed firsthand that companies that have a board member with compliance expertise usually have a more aggressive and effective compliance program. In this situation, a Chief Compliance Officer has to answer to the board for the company’s compliance program, while receiving the resources and support to accomplish compliance tasks.”
The Department of Justice (DOJ) continually speaks about the need for companies to operationalize their compliance programs. Businesses must work to integrate compliance into the DNA of their organization. Having a Board member with specific compliance expertise, heading a Board Compliance Committee can provide a level of oversight and commitment to achieving this goal. The DOJ enshrined this requirement in the FCPA Corporate Enforcement Policy. This means that when your company is evaluated by the DOJ, under the factors set out in the 2019 Guidance and FCPA Corporate Enforcement Policy, to retrospectively determine if your company had a best practices compliance program in place at the time of any violation, you need to have not only the structure of the Board-level Compliance Committee but also the specific SME on the Board and on that committee.
I hope you have enjoyed this study of great financial disasters. It once again shows that the lessons of history inform today’s compliance regime.
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