How the Revolving Door Leaves Investors Out to Dry

Why would banks like Citigroup (NYSE: C  ) , Morgan Stanley  (NYSE: MS  ) , JPMorgan Chase  (NYSE: JPM  ) , and Goldman Sachs  (NYSE: GS  ) have policies that offer special financial benefits to employees taking government positions -- financial benefits that are usually reserved for employees who continue to work for the company?

Like most business decisions, I suspect these businesses are guided by the expectation that they will get a return on their investment in these former employees. The question is -- what are these businesses getting? And do these compensation policies fuel a revolving door that compromises investors' interests?

Public policy influence
The Project on Government Oversight (POGO) presents a compelling argument that the revolving door between the SEC and the private sector played a significant role in derailing tighter regulation of money market funds proposed last year. Several SEC alumni helped financial institutions lobby to derail the regulation. Key actors included:

  • Justin Daly, who formerly served as a counsel to an SEC Commissioner, lobbied against the rules on behalf of industry association Investment Company Institute.
  • Karrie McMillan formerly worked in the SEC's Division of Investment Management, which is responsible for overseeing money market funds. McMillan also objected to the proposed rules on behalf of the Investment Company Institute.
  • Susan Ferris Wyderko, who once occupied the top job in the SEC's Division of Investment Management, objected to the rules on behalf of industry group Mutual Fund Directors Forum.

In the end, POGO argues that the financial industry tipped the balance against the regulation by convincing Democratic commissioner Luis Aguilar to break ranks and join the Republican commissioners against the new regulations.

How did this happen? POGO argues that it has something to do with Aguilar's close ties to the financial industry.

In early 2012, representatives from Aguilar's former employer, Invesco (NYSE: IVZ  ) , met with Aguilar to present its argument  that the proposed regulations were "extreme," that the "current reforms are working," and that the new regulations would "disrupt market functioning and damage a fragile economic recovery."

When Aguilar presented his own arguments against the legislation, he repeated Invesco's worry that the regulations could harm "the fragile state of the economy." He also shared concerns that that the proposed regulations would cause investors to move their money to less-transparent and less-regulated markets -- a common industry objection also pushed by SEC alumni Wyderko and McMillan

Regulatory capture
While this case doesn't necessarily involve a financial exchange, it highlights the risks associated with the revolving door between the public and private sectors. It suggests that public officials may be more receptive to arguments posed by the industry they previously worked for.

If this is the case, it would help explain why the big banks mentioned above may benefit from offering special financial favors to employees leaving to work for the government.

But if a large number of high-level regulators have ties to the industry they regulate, this receptiveness may be against the best interests of investors. Specifically, investors should be concerned that this revolving door can help businesses derail the creation of laws that protect us from executives who wish to engage in many of the same risky behaviors that tanked our portfolios in 2008.

Also, as I discussed in a previous article, revolving-door practices can undermine enforcement of laws that protect investors by creating loyalties between regulators and the managers at their previous places of employment.

The Foolish takeaway
It's possible that the special financial treatment many big banks accord to employees shifting to the public sector isn't motivated by a desire to manipulate policy in their favor. However, it's reasonable to expect that such compensation practices will promote a loyalty between the government workers and their former employers -- one that could lead to policies that do a better job of protecting executives than they do of protecting investors. As a result, I believe we should be wary of companies with policies that fuel the rotation between the public and private sectors.

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