Re:Balance -- Jim Peterson

The Valukas Report on Lehman Brothers: Sarbanes/Oxley's Credibility Takes a Dive

A host of hard questions lurk within all nine volumes and 2200 pages of the report by Lehman Brothers examiner Anton Valukas, released on March 11 (here) – which finds in its executive summary (here) that the company “painted a misleading picture of its financial condition.”

One of them, directed at anyone still harboring the belief that the Sarbanes/Oxley law of 2002 has had a beneficial effect on corporate governance and financial reporting: “Ready to change your mind?”

A lengthy list of potential defendants are teed up as targets for “colorable claims,” for actionable balance sheet manipulations using accounting techniques described in internal e-mails as having no substance, but serving only the purpose of reductions in Lehman’s balance sheet. 

Along with the apologists among the advocates of Sarbox’s efficacy, they will be heard to argue that its aspirations did not extend to the likes of Lehman’s financial machinations – a perspective begging this further question:

How can a regulatory program of the scope of Sarbox be justified, for the cost and complexity it inflicted on public companies and their gatekeepers -- most of whom would have been legitimately law-abiding even if left entirely alone -- while failing to identify, deter and capture the truly outstanding global-scale malefactors?

More simply put, if Sarbox didn’t have an impact on Dick Fuld and Lehman, what possible good has it wrought?

I’ve been in retreat this last week, reading the final papers of my MBA students in Risk Management – a bright and engaged group writing on recent case studies in the failures of risk modeling, assessment, comprehension and regulation.

Their examples cover the three years from the collapse of the Bear Stearns real estate funds, down to Toyota’s recent spiraling loss of both quality control and reputational stature. Even ahead of the Valukas report, it’s a target-rich environment, constantly replenished by the steady supply of newly-displayed examples of human venality, folly and frailty.

Among our course goals is the search for effective regulatory tools by which to shape improved policy-making and enforcement – a particularly challenging proposition, given the manifest inability of bureaucrats and elected officials to escape their inbred limitations of vision and effectiveness.

Depending on the importance of the issues at hand, how much enforcement should be imposed, and at what cost? 

Choices can be as coercive and heavy-handed as a polity will support and enforce. Taken to extremes, for example, teenage drunken driving could be eliminated: all that would be required is to raise the age of licensing to 25, and to impose automatic, non-negotiable twenty-year prison sentences on first-time violators.

Unthinkable, of course. Society is no more prepared for such draconian steps than it is to impose capital punishment on balance sheet manipulators or insider traders or even Ponzi schemers.

At the looser end of the enforcement spectrum, behavioral norms can be largely left to society’s level of tolerance for its own inconvenience. New Yorkers collectively agreed years ago, for example, that recreational marijuana was deemed to be de facto legitimate, thereby literally changing the atmosphere of Central Park. Likewise, no amount of patrolling will affect the dog-minding habits of Parisians, until they decide to alter the customs of a lifetime.

In the same way, the hindsight revelation of the Valukas report is that the inability of Sarbox to reach global-scale problems shows the futility of legislation so politically anodyne that it passed the US Senate by a vote of 96-0. 

The problem is one of closing the gap, between the level of deviance that society will stand and the amount of burden that it will pay for.

That is, a program of airport security will lack credibility, if so broadly applied as to deprive ordinary citizens of their ability to carry a bottle of wine or a tube of toothpaste, but that fails to identify terrorists whose deadly threat is limited only by their inept inability to detonate their shoes or their underwear.

Sarbanes/Oxley suffers the same defect: if it could not detect and deter an “outlier” on the scale of Lehman, then what beneficial effect can its proponents claim it has accomplished, by imposing an intrusive system of box-ticking on the vast bulk of corporate registrants?

As laid out in Richard Thaler and Cass Sunstein’s 2008 book, “Nudge,” which outlines such minimally-intrusive approaches as automatic enrolment options in voter registration, organ donation and retirement savings plans, the challenge to long-term incentives – whether in personal diets or corporate financial disclosure – is the compelling immediacy of short-term rewards. 

Which means it should be no surprise either that the rewards for the purveyors of subprime mortgages and exotic securities were dissociated from the risks of later implosion, or that compensation for executive leadership should be tied to measures based on the latest quarterly results.

Or, depressingly, that the time frame for political reaction to pressing public issues is no longer than the calendar for the next election.    

 

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GAAP/IFRS Convergence: The SEC's Roadmap is a Highway Leading Nowhere

For two reasons I’ve taken a while to step into the fray about the prospects for convergence between Generally Accepted Accounting Principles in the United States and the International Financial Reporting Standards.  

First, it was an honest and necessary but also dreary and time-consuming task to plow through the entirety of the SEC’s statement of February 24, “In Support of Convergence and Global Accounting Standards” – here.

Second, it was a toss-up which was more enervating: to slog through all 68 pages of the SEC’s turgid and repetitive bureaucratic prose, or to contemplate whether anyone thoughtful in that agency really believe in a highly-uncertain timetable that at its most optimistic extends more than halfway through this decade. 

Although the G-20 declared in Pittsburgh last September that global standard setters should complete their convergence project by June 2011 (here), the SEC gives itself all of next year even to be positioned to consider a determination whether to give more support to convergence, much less when or how. Depending on a new staff-level Work Plan that supplants the famous “Roadmap” of 2008 (here), the SEC projects that presently-undefined steps in implementation may be taken no earlier than 2015 or 2016.

The merits of convergence are debated across the spectrum, from industry sycophancy (here and here) to David Albrecht’s professorial patriotism (here) to Tom Selling’s sour challenges to its lack of intellectual substance (here) to the playful irreverence of Going Concern (here).

For me – I am agnostic on this point. First, the whole issue of whether convergence ought to happen is largely academic – because the complexities and judgments within either GAAP or IFRS themselves render the outcomes too challenging and non-comparable for any users except the dedicated experts.    

But second, there are understandable reasons, based entirely on process, why the SEC’s program for convergence has more qualifiers than this month’s NCAA basketball tournament. 

On the European side of the Atlantic, conspicuous on the personal roadmap of IASB Chairman David Tweedie is the stop sign of his June 2011 retirement. Now a lame duck, Tweedie has combined intellectual rigor and prickly Scottish wit, but his ability to achieve harmony among his constituents has been frustrated by the evident limitations on his diplomatic skills.

Disparate nationalistic players in Europe have shown the ability to evade, frustrate and maneuver around attempts at cross-border unification and cooperation at many levels:

• ·      The French bankers, abetted by no less an accounting expert than President Jacques Chirac, led years of lobbying to prevent the applicability of a single international auditing standard on derivatives accounting (here).
• ·      The Swiss judiciary continues to provide home-court advantage in frustrating the on-going efforts of the American IRS to obtain personal data on alleged tax evaders (here).
  
• ·      And eight years on from the passage of Sarbanes/Oxley, the SEC has officially permitted the PCAOB to bail for another three years (here) on its supposed mandate to inject itself into the inspection and oversight of ex-US accounting firms, unable to penetrate the European rules on privilege, privacy and confidentiality.

While on the American side, the SEC’s guidance-writers did not have a great winter:

• ·      Their late-January pronouncement on disclosure of the implications of climate change (here) was a cheerleading exercise in vacuity – see here.
• ·      On the subject of short-selling, the SEC voted 3-2 on February 24 to re-instate an uptick rule (here), but only for shares dropping more than ten percent – a debatable exercise in cosmetics at best, that will impose obnoxious compliance costs while substituting the vacillations of motion for the reality of progress. 
  
• ·      And on the subject of convergence, the flabbiness of a schedule measured in geological time makes clear that compared to a real roadmap, the agency’s navigators couldn’t find first base with a compass and a guide dog.

So on one side, the Europeans can waffle and jawbone the convergence process for as long as it suits – while the SEC's political dithering only kicks the can down the road, far past the tenure of any present office-holders. Which means that the absence of accomplishment half-a-decade from now will become the responsibility of a whole new set of map-readers.   

It’s all enough to speculate how Robert Frost’s 1916 poem, “The Road Not Taken,” would sound, if written by an observer of the GAAP/IFRS process:

Two roads converged in a wood.

And sorry I could not see the forest for the trees,

Long I stood in the undergrowth.

……

I shall be telling this with a sigh

Somewhere ages and ages hence:

Two roads never converged

And that has made absolutely no difference.

 

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The Risk of Crashing on a Slippery Slope: Bankers and Lugers on Parallel Tracks

A Risk Management class of bright, perceptive MBA students devoted their meeting this weekend to Olympic sports – scrutinizing the death on February 12 of Georgian luger Nodar Kumaritashvili, who lost control on the last curve of the world’s fastest track at the Whistler Sliding Centre and crashed into a steel pillar.

The students’ usual focus is on the manifold failures in risk identification, appreciation and evaluation over the last three years. They look to specify and learn from such displays of bias, error and miscomprehension as Jimmy Cayne’s loss of control of the real estate funds of Bear Stearns, the confession by Ramalinga Raju of a multi-billion dollar fiction in the accounts of Satyam Computer Services, and Akio Toyoda’s tone-deaf bungling of the world’s largest vehicle recalls.

What they found was a set of questions with compelling resonance for the financial crisis:

• ·      Was a fatal crash the result of an overly aggressive and under-trained youngster, turned loose in a competitive environment beyond his skills and capabilities?
•  ·      Was there a simple but overlooked design flaw in the structure – in Vancouver, an unpadded steel pillar squarely in the path where a loss of control would eject the 90 mph victim of a small but highly consequential mistake?
• ·      Or did the designers who pushed the limits of knowledge and technology compromise the need for safety to the desire for high-speed achievement, failing to recognize that traditional measures of safety were outmoded and insufficient?

Just like the world’s tightly-linked capital markets, the Whistler track is wonderfully designed for success. Its users describe it as challenging but thrilling – the demands are huge, as are the rewards.

But like any other advanced and sophisticated device designed and operated by humans – whether a space shuttle or a nuclear reactor or this decade’s leading-edge array of exotic financial instruments -- a luge track is subject to the non-zero possibility of catastrophic error.

Even the engineers of the most prosaic highways, who strive to improve both safety and overall speed, are mindful of speeders who will test their design limits. Where pressing the outside limits of speed and safety is the very goal of the participants – recall the Olympic motto: “Citius, Altius, Fortius” – it is hollow and unresponsive to the point of irresponsibility to claim that the track is "relatively safe" (here).

As elsewhere, average performers disappear into the obscurity of the crowd. Outliers achieve prominence in two ways, both beyond the boundaries of ordinary expectations:

At the Games, one athlete wears a gold medal and salutes his national anthem from the victor’s podium. But at the opposite tail of the performance curve, the one who crashes earns only a memorial wreath and a home-town funeral.

In the marketplace, where the gold-medal outlier may be Warren Buffett, the opposite tail is populated by the likes of Dick Fuld of Lehman, Fannie Mae’s Franklin Raines and Countrywide’s Angelo Mozillo.

There is one huge difference between the “failure study” of the Whistler designers – who promptly lowered the luge start, re-shaped the fatal curve and padded the unfortunately-located steel pole – and the finger-pointing scapegoaters of Washington and London and Brussels.

Namely, every failure in the engineering field is an opportunity for learning – even if belated. Thanks to the iceberg, the Titanic’s design was no long the model for generations of at-risk ocean liners. Nor, after 9/11, would high-rise towers ever copy the World Trade Center.

But in the politically-motivated bickering over the allocation of blame for the financial markets’ debacle, by contrast, there is not even a civil forum in which to ask the pertinent questions – much less make progress on a search for answers. 

Which, as I remind my Risk Management students, invokes the observation on learning of the 5^th century BC playwright Aristophanes:

Youth matures

Immaturity is outgrown

Ignorance is curable by education

Only stupidity is forever

 

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