Re:Balance -- Jim Peterson

The SEC Turns Up the Heat on Climate Change -- Or Just More Gas?

The Securities and Exchange Commission in Washington voted by 3-2 last week to issue an “interpretive release” aimed at public company disclosures of the impact of climate change – ranging from new regulations and legislation, to changes in economic trends or physical risks (here).

Yet another layer of mandated environmental platitudes?

In her announcement speech, Chairman Mary Schapiro disavowed any intent to “create new legal requirements or modify existing ones,” and stated (her emphasis) that the Commission is “not making any kind of statement regarding the facts as they relate to the topic of ‘climate change’ or global warming’.” 

Further pounding down another nail of obvious banality, she noted that “it is neither surprising nor especially remarkable for us to conclude that of course a company must consider” possible events which “under our traditional framework” it must evaluate and disclose if material.

So the SEC’s cheerleading on climate change will be right there with the influence of the pom-pom girls on the outcome of the Super Bowl.

The SEC has been in rehabilitation mode since the prior administration, for everything from being caught out by Bernie Madoff’s spectacular Ponzi scheme to its virtual absence during the credit crisis. (see Andrew Ross Sorkin’s thoroughly engaging “Too Big To Fail” (Viking Penguin 2009), for the shared view that the then-Chairman was a clueless and ineffectual lightweight.)

The agency’s October 8, 2009 strategic plan has been followed by an outpouring: creation of a division for Risk, Strategy and Financial Innovation (November 5), borrowing of “cooperation incentives” from the toolkit of serious criminal prosecutors (January 13), and re-shuffling of bodies and titles within the Division of Enforcement (also January 13). Here then, the appearance of another release du jour. 

Or so it seems – because it can hardly be justified on the substance. Rather than real regulation, it’s the Potemkin façade of illusion – animated by the same optics-oriented spirit that inflicted on the user community the costs, disruptions and distractions of the Sarbanes/Oxley law. 

With details still to come, the SEC’s release offers four so-called “triggers’ whose impact could lead to disclosure – legislation and regulation, international accords, indirect consequences of regulation or business trends, and physical impacts of climate change – each of which would already have been unexceptionally viewed as an appropriate disclosure category under pre-existing guidance.

It offers a fair question: where the carbon set-offs will be found, for the acres of forest and tankers of jet fuel that will be consumed and emitted, to support all the round-tables, seminars and symposia, expensive legal opinions and auditor box-ticking, that will enable registrants to react to this latest burst of regulatory hot air.

What might be some of the new language, on top of disclosures that are already vaporous enough?

•  “The company safeguards its portfolio of exotic derivatives in an eco-friendly black box, which is regularly re-valued by marking to a market that is completely organic.”
• “While the company’s internal control structure may not prevent our shopping-addicted CFO from stealing us blind, we are pleased that our corporate credit card accounts are now settled by paperless invoicing.”
  
• “Any facilitating payments made to public officials by our off-shore subsidiaries will be delivered in brown paper bags made of no less than 60% recycled material.”

Kidding aside, validation of the importance of climate change is plain from its prominence in the marketing of each of the Big Four (here, here, here and here) – so nearly identical and undifferentiated as to be products of the same publicity shop.  

The accountants had best be ready, because the financial and reporting issues around climate change will become real – from the complexities sure to arise when the inventive wonks in the derivatives markets develop exotic ways to re-package emissions permits for speculative purposes, to the management and audit issues of identifying and controlling pollution sources for purposes of permit measurement and compliance.

But for now, with the SEC already fully occupied with credibility-stretching issues, it is hard to see its exercise in non-substantive flag-waving as anything more than a needless contribution to the already-elevated level of Washington’s noxious fumes.  

 

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Medical Check-Ups and Annual Audits: What if Your Doctor Reported Like Your Accountant?

Now being the winter of our discontent, the political scene in American is dominated by the rancorous wrangling over health care and insurance reform legislation.

In that context, I was exchanging notes with my friend the insurance industry risk-manager, over our recent annual physicals, and fell to musing about the comparability of a financial statement audit and a personal physician’s examination.  

Raise the question of personal health around a table of the reasonably responsible. The “organ recitals” of those surveyed will include familiarity with their own particular concerns – whether blood pressure, good and bad cholesterol levels, resting pulse, bone density, or hormone levels.

To achieve that awareness, on a periodic and routine basis, patients are poked and prodded and invaded in various intrusive and unpleasant ways – they give up samples of fluids and tissue for laboratory scrutiny, and they are screened and hitched and wired to exotic and expensive diagnostic machinery

The population of the diligent will also be subjected to inquiry by their doctors about their major behavioral risks – does their personal “control structure” include taking their medications, watching their cocktail intake, wearing their seatbelts, and avoiding handguns.

And then they receive several pages of detailed results, calibrated to standard norms of tolerance, and a briefing on what their trends are and what they might need in aide of maintaining or improving their well being.

Suppose instead, along with a bill whose magnitude is itself a threat to good health, the physician delivers this report:

“We’ve done a number of tests, the scope and results of which you don’t have, and we chose not to do a number of other, unspecified procedures.

“We’re not sure, but we think you’re unlikely to die of natural causes any time soon.

“Thanks -- we’ll see you next year. Be sure to pay on the way out. And have a nice day.”

Unacceptable – even with the multiple dysfunctionalities that render American health care an embarrassment among the world’s developed countries.

Does an audit report convey anything more about the health of a corporate body?

A company’s management may be well informed or sclerotic. Its products and strategies may be world-class, or senescent. It may be the equivalent of a gold-medal athlete, but with a malign and life-threatening growth lurking or metastasized. 

But the only available opinion is that, within the tolerance of undisclosed measures of materiality, its financial health is generally fair.

Does the company need the corporate equivalent of a slimming regime of diet and exercise? Are prescriptions indicated to bring the basic operational chemistry within tolerable limits? Something surgically targeted like joint replacement or a major arterial by-pass? Radical intervention or experimental drugs?

At the cost of millions of dollars, no such diagnosis is on offer – but only a single anodyne page, in the same language handed out once a year to every other patient who passes through the annual audit clinic.

An auditor’s report tells less about a public company’s health than a doctor’s report tells about an individual – in scope, detail and precision. And if investors and other financial information users are not happy, they are doing nothing to make their dissatisfactions effectively known.

It may be, as Mary Poppins puts it, that “a spoonful of sugar makes the medicine go down.” But in the audit environment, patients are getting only sweets and placebos – and still paying for the dubious privilege.

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Market Concentration of the Big Four Audit Firms: The Feasibility of a Suggested Trade -- Divestiture for Liability Limitations

“No such thing as a failed experiment …. only experiments with unexpected outcomes.”-- American engineer-architect R. Buckminster Fuller

 Is the Big Four’s concentrated control of large company audits a real problem? Persistent voices of concern and attention extend back at least to the 2006 study for the Financial Reporting Counsel (here), recently joined by global leadership of BDO and Grants (here and here).

If so, is there a credible case to incentivize their exchange of market dominance for liability limitations?

Those issues were addressed this month in a paper from the American Antitrust Institute – here. In an all-too-rare burst of clarity, the AAI forthrightly recognizes that:

With pending claims totaling billions of dollars, the Big 4 audit firms face serious threats to their survival…. (L)iability exposure substantially exceeds the combined partner capital of the Big 4 firms… (They) contend that liability limits are necessary to prevent the loss of another Big 4 firm, which would throw the global financial system into chaos. (footnotes omitted)   

The AAI’s suggestion would be a legislated trade-off: “government incentives to break up the Big 4 into smaller, more competitive firms” – namely, a liability cap conditioned on a firm divesting itself of, say, 20% of its domestic revenue and the personnel serving the surrendered clients.

Can’t work – because of the many problems with the underlying but unachievable assumptions. 

But before getting there -- the AAI deserves credit at least for recognizing the completeness of the Big Four’s market dominance – auditing “nearly all of the world’s public companies with annual sales over $250 million” (emphasis in original) – with even tighter limitations on auditor choice in such industries as metals and mining, energy, air transportation and financial services.

Start with the political unacceptability of liability capping at a level that can assure Big Four survival. I have spelled out before (here) the financial limits of the large firms’ private partnership structure and their membrane-thin working capital, under which they cannot withstand litigation shocks above the $1 - $2 billion range – a tiny fraction (by either amount or percentage) of the exposures in their pending lawsuit inventory.

As the AAI paper summarizes, critics of liability protection point to the firms’ average litigation payouts, as a percentage of revenues and as compared to the far larger total of alleged damages. They fail to recognize – as do the arguments for capping from the profession itself -- that averages are meaningless when the “outlier” of a single verdict, falling outside the misleading comfort zone of a bell-curve model, could and would be devastating.   

So: because American politics offers no cover for protection at those levels, that side of the proposed AAI bargain is no solution. What of the other side -- the plausibility of large-scale competitors emerging from the suggested divestiture program? The facts dictate otherwise.

First, an abundance of small practices already exist. Why they have not coalesced into global-scale practices is a long-familiar story of limited geographic scope, expertise, risk appetite and readiness to invest.

Second, the smaller sector does not inspire confidence in its strength or capacity for quality growth to global scale. Of the largest, BDO’s Seidman firm in the US is on a deathwatch, facing the post-appeal enforceability of its $521 million jury verdict in Miami. Grant Thornton – not yet fully disengaged from the Refco matter in which lawyer Joe Collins just received a seven-year prison sentence – now faces the fall-out of being fired by Koss, its public but family-dominated Milwaukee client, whose CFO managed for years to steal amounts in excess of the company’s total net revenue (on which, to read Francine McKenna in unusually high dudgeon, see Re:The Auditors.)

Third, as a practical matter, how would global-scale competition emerge? If a Big Four firm were to hive off a small geography-based practice, that newcomer would suffer handicaps of capacity and expertise no different that those of the current smaller firms.  If a large firm were to shed an entire industry practice, no new competition is added to serve that industry. And if instead, it were to divide a viable large-scale practice, then each of the two sub-practices would be burdened with shortages of expertise, personnel and the capital strength necessary to build to scale and withstand their risks.

In summary, the AAI’s aspirations fall victim yet again to the Nirvana Fallacy – the defect in logic I described (here) in the comparison of a failing situation against an idealized state, without recognizing that the assumed achievement is impossible under real-world limits, flaws and constraints.

The large firms grew that way for service-based reasons. And dreams of expanding the population of pygmies do not, sadly, increase the likelihood of evolving a giant.

At bottom, the AAI’s most seriously under-examined assumption is that the “catastrophic” disintegration of another Big Four firm “would throw the global financial system into chaos.”

Why so? To the contrary, if the now-standard auditors’ report were suddenly not to be obtainable from any source, who would miss it?

Regulators and politicians would have convulsions, to be sure. But as the financial crisis itself has shown, that is daily practice for office-holders in the hermetic confines of Washington and London and Brussels.  

Should the stock exchanges be closed, if a Big Four failure meant that one-quarter of the large listed companies lacked an audit report? Could those companies’ securities be barred from trading? Unthinkable. Out where capital really flows and trade is actually engaged, the world’s markets would shrug, start the process of designing new forms of assurance from a blank page, and move on.

And the splintered pieces of the former Big Four would provide ample building blocks for a new assurance structure – without, pace the AAI, any need or use for the unintended and unpredictable hazards of another failed experiment.

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On the Midwestern Calendar for March: Two Events Addressing the Audit Profession

An alert for those in the Midwest looking to warm up the chill of late winter: I am looking forward with enthusiasm to joining Duane Kullberg, retired managing partner of Arthur Andersen, who will be the Chapman Executive-in-Residence at Carthage College in Kenosha, Wisconsin, on March 2 and 3.

 On Tuesday evening the 2^nd, Duane and I will be on a panel on the “Future of the Audit Profession,” joined by Bill Goodman, CPA and president of Schenck Business Solutions and chaired by Dennis Tomorsky, CEO of the Wisconsin Institute of CPAs. At the college’s Todd Wehr Center, 7.30 pm.

 On Wednesday the 3^rd, the Kenosha/Racine area Business and Professional Coalition’s regular luncheon will feature Duane’s presentation and our taking questions on the “Rise and Fall of Arthur Andersen.”  Noon, also at the Todd Wehr Center.

 Any further details will be forthcoming, so drop me a line to be advised, or are available through David Brunn, Carthage’s Rogers Palmer Professor of Business Administration (tel: 847-256-2287 or e-mail: dbrunn@Carthage.edu).

The SEC Whacks Ernst & Young Over Bally Total Fitness -- Now for the Spoils of Victory

The SEC’s proceedings last month against Ernst & Young and six of its partners, relating to the financial statements of Bally Total Fitness, for the long-ago years 2001 – 2003 (here), threaten a double hazard under the axiom attributed to Winston Churchill, that “history is written by the victors.”

It’s not just tough enough for the accounting profession’s risk and quality managers, seeking to understand what really happened in Bally -- not only because the entire narrative is drafted by the enforcers, but also because without recourse to a public forum, the “consent decree” process acts as a muzzle on the targets. 

Worse – conceding that the only script available is written by the SEC itself – the array of sanctions and undertakings inflicted on E&Y signals that the environment for application of quality-oriented judgments has just become a lot more volatile, unpredictable and challenging.

This cannot be the place to debate either the facts or the justice of Bally; offered an exit from the SEC’s eternal grip, a target’s only strategy is to grit the teeth and roll over in silence.

Questions for the profession worth attention post-Bally, rather, are what to expect in the future, and how will behaviors be changed.

To start, with all other government agencies coming off the back foot in the financial crisis aftermath, the SEC carries three extra pieces of baggage: defensive reaction to its blinkered short-comings in failing to unmask Bernie Madoff, the passage of a half-decade in bringing the ancient Bally proceedings, and the lurking reality that pursuing a death-threat outcome against a Big Four firm itself would risk disintegration of the entire large-company assurance franchise.  

From these, it can be predicted – and the accounting profession should expect – that going forward, the SEC will aggressively aim its macho enforcement testosterone at the big firms’ individual personnel. Nuances and subtleties of professional judgment be damned, the agency will seek to show that its gun-slingers clank when they walk.

Which means, as Bally itself shows, that professional decisions will be second-guessed to the last degree. Where credit might be earned for careful risk considerations, E&Y had identified Bally as one of its highest risk clients – a sorting-out effort reflective of a profession-wide aspiration to differentiate levels of client complexity and reduce the commodity nature of the audit itself.

And E&Y also brought into consultations an entire circle of senior help, beyond the engagement and review partners – the geographic area manager, national practice quality assistance and even the firmwide head of practice and risk.

These actions should be encouraged. Picture the counter-factual: if Bally’s problems had gone as wrong as they did, and E&Y had not done so. The enforcement hounds at the SEC would have bayed to the skies. Instead, now, the firm’s personnel suffer individual censures and bar orders of up to three years, for conduct worthy of respect – albeit for results now deemed unsatisfactory.

What messages are sent to the profession’s quality and risk functions? Ought they to reduce the exposure of their senior personnel, by hanging out the line operators to struggle on their own? And by the way, who would aspire to the headaches of a consultative role, if only to finish a long career by dangling from the SEC’s noose?

One of E&Y’s undertakings in Bally is to re-visit, under the scrutiny of an outside examiner, its documentation of higher-level issue consultations.

So, under a sanction that only a bureaucrat could love, Bally will impel the Big Four’s national office boffins to “re-audit” information they receive from the field, and to build a fortress of memoranda to defend against the assaults of later second-guessing.

With the secondary effect that the time and energy available for real problem assessment must now be side-tracked to the same kind of self-protective file stuffing that is strangling American enterprise ranging from product safety to medical treatment to airport security. 

The SEC’s goal in the Bally settlements may not have been deliberately to degrade the large firms’ risk management capabilities. But the direction and effect will all go that way.

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Auditors Missing in the Financial Crisis -- Readers Offer their Thoughts

To greet the new year, instead of a backwards look at a dreary 2009, this will revisit last month’s lively exchange, initiated by Francine McKenna’s provocative post of December 7, “They Weren’t There: Auditors and the Financial Crisis.” My response of December 13 is here, and hers of the 14^th is here.

Highly compressed, the gist of our mutual concern is, as Francine put it, “the auditors’ failure to be a force either before, during, or after the financial crisis.” The depressing explanation, said I, is that “their core product has long since been judged irrelevant. The standard auditor’s report is an anachronism – having lost any value it may once have had, except for legally-required compliance.”

Our invitation to a conversation drew forth an exceptional level of reader interest and a cascade of comments. They ranged from the acute and perceptive to the callow and credulous – but all were seriously intended and deserve broader exposure and responses.

So picking a sample of some half dozen, and inviting the discussion to continue: 

PF noted to Francine that “the idea has been floated of having each exchange traded company purchase insurance against the financial impact of future restatements or fraud, but for that to work you would merely replace the auditors with the insurance industry, who would need to do their own “audits” before they would agree to underwrite such large risks.”

And David wrote similarly, that, “maybe each firm performing audits should have to put up a bond that would be available to creditors in the event of malpractice lawsuits. Let’s say that bond was equal to at least two years of the firm’s audit revenues. … You could even have an experience rate type of adjustment….”

Sorry – we've been there. If feasible, the idea of outside sureties would already be in place by now (here). The marketplace reality is that the insurance industry – which suffered massive losses on its coverage of the accountants during the savings & loan debacle of the 1980’s – learned enough to avoid a repetition.

It’s not just that the Big Four tetrapoly fail the essential tests of insurability, although they do – because of sector concentration, unpredictability of losses and inability to quantify exposures. It’s also that if any such “super-audits” actually existed, the auditors would surely be performing them already. The sad fact, instead, is that the poor profession is operating today to the best of its unfortunately limited capability.

On user expectations, Robert accurately observed that, “an audit is supposed to provide reasonable assurance, not absolute. An audit firm has many engagement teams…some good…some bad. The whole system can’t be vilified because of isolated events.”

“Vilified” – perhaps not. But it is precisely the isolated events – highly-consequential and destructive as they can be – that will bring down another large firm.

On this there are two points: First, because the accounting profession lacks an effective forum by which to scrutinize and learn from its failures and short-comings, it has been unable to avoid repeating the same performance deficiencies from one generation to the next. It's a failure in historical perspective, to miss the instructive comparisons between Parmalat, say, and Equity Funding – or between Satyam and ZZZBest.

Second, the community of financial statement users is unimpressed by the profession’s proclamations of its successes. Virtue is not preserved by an accumulated preponderance of generally good behavior – rather, it is dissipated and lost altogether by individually corrosive, culpable acts. For most of their life spans, John Edwards and Tiger Woods were credibly decent – as were Jimmy Cayne and Dick Fuld and even Conrad Black and Bernie Ebbers -- except for certain nasty instances when they were not.   

I had this note from JD: “The auditors were there and just got it wrong. They will feel the pain from this trying to defend the lawsuits. Whether they can be successfully sued is another matter. If one or more big firms fail as a result then so be it. In the long run there are enough other audit firms who will eventually step up.”

The problem is the last sentence. Under the large firms' presently dysfunctional model of litigation exposure, independence constraints, limited capital and concentration of resources and expertise, it is just not the case that alternative providers might emerge to replace a failed Big Four firm. That discussion can be expanded at greater length, and has been, but the only answer is "no way."

Francine had this interesting proposition from TT:  “the first firm to focus on quality, and to deploy and consistently follow standards that enforce quality regardless of other factors and metrics, will rise above the others. … But the sad fact is right now that the clients don’t perceive any differences between the firms, and it would take a significant difference to catch the clients’ attention.”

The standard audit report now being an undifferentiated commodity, TT’s point was answered by Geoff, who wrote that, “From 1933 until now, there hasn’t really been a evaluation of the core assumptions around audited financials. The requirements have evolved and become more detailed, stringent, as we go through the motions of continually fighting the last war. Add to it the institutionalization of the main players (audit firms, regulators, accounting designation self-regulatory bodies), and it’s easy to see how we’ve lost the plot.”

To conclude, the widespread inchoate desire for “something better” resounds in Esa’s plaintive note:

If you know of a better model that allows us to hold someone responsible for unforeseen future events, I’m all ears but that’s not a job I want.

A lot of people think the model is relevant though it certainly has flaws. The SEC, institutional investors, financial analysts, etc. all think the model requires tweaking but none suggest wholesale changes.

If fact, I haven’t heard anyone propose something that even comes close to a reasonable alternative that is actually feasible. If you have ideas on that front, please share them.

That’s an echo of the call from Francine and me. Progress will come neither from the self-interested parties' reticence to “suggest wholesale changes,” nor their continued pointing of fingers and weapons. Instead, as a first step at least, let the wide-open conversation continue.

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Previewing 2010 -- And a Note of Thanks

As the old year winds down to the winter solstice and all those rituals by which we mark the holiday season, a brief look ahead.

Depending on reckoning, the New Year will either end an old decade or begin the next one. Whichever, here are a few events that will feature in 2010 among the on-going challenges to the global structure of large-company assurance:

• The Supreme Court in the US may well declare the PCAOB to have been illegally constituted (here or here). If so, predictable spasms of re-enactment and ratification by the SEC cannot successfully encompass such issues as the viability of pending investigations, the legitimacy of past inspection reports, or the need to re-register all the foreign accounting firms.

In the context of those issues of contention, the legislative mischief to be wrought by a Congress offered a blank page on which to re-debate the Sarbanes/Oxley law can scarcely be imagined.

• The fits and starts of accounting standards convergence will have no more traction than a pig on roller skates. The announced retirement of Sir David Tweedie as head of the IASB (here) will take one prickly personality off-stage, but will not solve the antagonisms among competing country and industry level interests. And as the scope of complexity and judgments within both GAAP and IFRS figure to be as significant as those between reporting systems, the achievability of comparability and comprehension will remain as elusive as ever. 

• Attempts to impose liability on the large accounting firms’ international structures will continue apace. The success of BDO International in confining the Bankest verdict in Miami to the Seidman firm alone (here) means that if that $521 million exposure becomes enforceable, BDO may need to find a new US member firm – a tactic painful enough for that organization but which none of the Big Four could achieve under like conditions.

Flashpoints for structural threats will include the Madoff-related feeder funds litigations, concentrated in the US but also spread around the world, and PwC’s exposure on Satyam.  And with PwC’s Indian partners on Satyam about to observe their first full year of local imprisonment, that network's attempts to extract itself from class action exposure in the American court system (here) raise the interesting question whether submission to Indian justice is really a preferred strategy.

• Tempting as it might be to be lured into the speculation about identifying which of the Big Four firm is most likely to disintegrate under the combined pressures of litigation and government threat, in 2010 or otherwise (here), I will decline – since the determining factor is the unpredictable timing of the cases themselves. Specify the judges’ scheduled trial dates for the 25 biggest cases hanging in Damoclean fashion over the large firms – and only then would I be able to offer a view.

• More broadly, strategic decision makers in the world of financial information will continue to confront the volatility of government conduct – an under-recognized factor in their overall risk assessment methodologies.
  

The reactive nature of public officials has been marked in recent years by an ad hoc cascade of unpredictable and unintended consequences – ranging in scope and scale from the back-of-envelope bank bail-out schemes to the bonus supertax in the United Kingdom to the first-ever invention in Dubai of a default-driven debt reorganization scheme of uncertain application or reliability.

So life in the forthcoming year will not be boring. 

Meanwhile, in this space, Re:Balance observes its second birthday. Launched in January 2008, this venture was the evolution from “Balance Sheet,” the column I had the six-year privilege and good fortune to write for the International Herald Tribune.

The challenges have been fascinating, starting with the anxiety-inducing migration from old-style print. No less than the accounting firms, the IHT itself -- like the other newspapers -- pursues its fading struggle in search of a sustainable niche business model. While in the world of rapidly mutating media platforms, the near-term impact of the likes of Twitter, Facebook and Kindle will continue at a dizzying pace to re-define the information landscape.  

It has been most gratifying over these two years, both to participate in community with an expanding group of smart and incisive commentators, and to experience steady growth in readership and especially in subscribers.

For these opportunities, I thank you all for your interest, your insights and your inputs.

Merry Christmas -- best holiday wishes -- and a healthy, peaceful and prosperous New Year to all. 

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Invitation to a Conversation: If the Auditors Were Missing from the Financial Crisis -- Let's Ask Why

 

Last night I saw upon the stair

A little man who wasn’t there

He wasn’t there again today

Oh, how I wish he’d go away

 -- Hughes Mearns, 1899

 An under-appreciated power of the bloggers is the capacity for a two-way conversation, right out in full public view.

 That was my reaction, anyway, to Francine McKenna’s December 7 post, “They Weren’t There: Auditors and the Financial Crisis” – the gist of which is that the Big Four firms, who audited every one of the institutions complicit in the financial crisis, have been absent not only from visible influence on the catastrophe, but also from the post-mortem recriminations and accountability.

 Any regular reader here should also be subscribing to Re:The Auditors, where Francine airs a central theme:

“The auditors should have been there, as a last stop, where the buck should have stopped, as gatekeepers, watchdogs, advocates, and the last bastion of standards and expected values shareholders can look to.”

Here – in response to the always tart-tongued Francine -- is why the auditors weren’t there:

The simple if depressing reason is that their core product has long since been judged irrelevant. The standard auditor’s report is an anachronism -- having lost any value it may once have had, except for legally-required compliance (here). 

If that single page disappeared from corporate annual reports, no honest user of financial information would admit to missing it. Nor, offered the choice, would any rational CFO pay the fees to obtain it.

There is plenty of assurance that users would value and pay for – that much is clear from the debates about the largely unrealized usefulness of reports on governance, sustainability and intangible assets outside the scope of historical cost-based reporting (for specifics, this column of mine goes back to April 2006).

But not in the current liability environment, where the large accounting firms are captive to their business model and paralyzed from innovation by their twinned lack of vision and influence.

On the other side, the regulators’ mantra that “audits are essential” is no more than the unexamined and self-reflexive assumption that audit reports will simply and always be there – like air or water or electricity. Whereas, if another fragile Big Four firm does trip into disintegration, nothing within the capacity of any regulator on earth will be able to put the shattered networks back together again, or compel the delivery of audits when there is nobody left to perform them.

If there is to be an adult conversation around this issue -- and along with Francine, there are real participants -- for general examples, Tom Selling's stimulating Accounting Onion, Dennis Howlett's acerbic AccMan, or Richard Murphy's Tax Research UK -- there are at least three other chapters to be aired, at whatever length is needed for credibility:

First, it is past time to put final closure to the talk of unachievable structural “solutions” to the Big Four’s complete dominance of large-company global audits. None of these can happen – as sketched out here – whether it be growth to competitive scale of a Five or Six, break-ups to restore a new but even further weakened Eight, mandatory rotation, new insurance or outside capital, liability limitations, or government take-over of the entire function.

Second, the financial structure of the private Big Four partnerships must be recognized as too weak and limited to sustain their current exposure -- here. Unlike the banks, their franchise is not “too big to fail” – the question is whether there is a better cliché than “too weak to survive.”

Finally, as a message to the Big Four leadership who have no choice but to get out in front, the private sector must acknowledge that no help will be forthcoming from government. Legislators – whose essential DNA bars them from any activity other than belated over-reaction – cannot be counted on for anything other than interference (here).

Worse, coordinated regulatory strategies are impossible at the global level – witness the floundering over GAAP / IFRS convergence as a simple example – while in the United States, a populist-oriented administration is not about to provide relief to a white-collar profession perceived to be overpaid and under-performing.

So there is no falling back upon the fallacious assumption that “’they’ won’t let another firm fail.” There is no “they” – no regulator or politician with the vision, interest or authority to prevent a debacle.

Francine’s massive army of readers is a potential force to be reckoned with – and has plenty at stake, whether as practitioners with careers-at-risk or users in search of better quality financial information. 

With their engagement, the evolution to a sustainable, achievable new model of reporting and assurance is possible – however unlikely, absent real commitment to a fresh and holistic approach.

But the dialog has to move beyond whiny finger-pointing, and the simplistic recitation of unrealistic “solutions.

And the sooner, the better.  

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Measuring Corporate Stewardship by the Century -- A Lesson from the Oak Groves

"I know a bank where the wild thymes blow" --

    Oberon, Shakespeare's "Midsummer Night's Dream," II,i

A few words further (after these of November 10th and 17th), on corporate stewardship, and the ability to assess management's commitment to long-term sustainability.

The context is the measure of dysfunctionality in the dialog, with Lloyd Blankfein’s year-end bonus at Goldman Sachs expected to establish a compensation benchmark for the entire financial services sector.

Despite his vilification for both Goldman’s off-message diversion of $500 million to the aid of small businesses, and his own tone-deaf joke about “doing God’s work,” there is no other banking CEO being publicly fitted for a halo. And his company’s record is compelling, even though unless poor Blankfein suddenly develops the political savvy to foreswear all pay for this year, he is going to catch media hell no matter what take-home figure he tries to justify.

To take a long step back in history, consider the vision, commitment and behavior of the great canal-building companies of Victorian England.

These innovators not only joined with the newly-constructed railroads in making possible the Industrial Age, by achieving the first inland transport break-throughs in human history – re-writing the limits of bulk and speed that had been constrained by the capacity of an ox-cart and the pace of a horse and rider.

Knowing that the great oaken beams and timbers in the intricate gates of their lock systems would eventually require replacement, the canal developers had the foresight to plant groves of oak saplings around the huts of the lock-keepers – not for the shade and the aesthetics, but to assure a ready supply of mature trees when needed, many decades into the future.

That their legacy is now picturesque rather than practical owes only to the unforeseeable over-taking of technologies based on electricity, internal combustion, silicon and rocketry.

But sadly, it is no less unthinkable that their modern successors – the chief executives of the large airlines or trucking companies – or their counter-parts in banking, industry and professional services -- should invest and manage for their future based on such long-range planning.

Instead, there is a disconnection between managements’ incentives and long-term sustainability strategies -- as laid out by the guru of game theory, Bruce Buena de Mesquita, in his provocative and challenging new book, “The Predictioneer’s Game.” (For reviews, see the book's website. For the lite version, see his September 28 appearance on John Stewart’s Daily Show.)

His chilling example is the loss of vision of the Arthur Andersen leadership in the period leading up to the Enron debacle:

As he puts it -- under the grim caption, “Incentivizing Ignorance” (pages 116 et seq.) -- Andersen’s senior management “helped foster their own demise by not erecting a good monitoring system to protect their business from the misbehavior of their audit clients,” chiefly because ”Andersen’s most senior management genuinely did not seem to understand the risks they were taking.”

And why? Because as he puts it, “costly litigation … would not be settled until ten or so years after the initial prediction of risk.” But by that time “the engagement partner who brought in the business in his early to mid-fifties was retired and enjoying the benefits of his pension.”

Which creates the disconnection: by then, “the money for the defense was coming out of the pockets of future partners,” so “the financial incentive to know was weak indeed.” 

Recent years have shown the pervasively destructive influence of short-term incentives – from the exploding volumes of unsustainable subprime mortgages, to the proliferation of incomprehensibly risky financial instruments, to the current stripping of seasoned employees for the sake of expense reductions -- putting at risk the retention of expertise and capacity as the economic cycle turns.

It’s a sorry statement on leadership that Lloyd Blankfein is one of the few left standing, when so many short-visioned leaders have been shown unwilling to show the kind of commitment to maintenance and stewardship of the 19^th century canal builders.   

 

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Hand Washing and Swine Flu -- A Hospital That Could Avoid Failing Risk Management

Risk management is, for better or worse, a constant business challenge. As examples, I’ve given recent attention to the timing mis-alignment between senior-level compensation and litigation exposure – here – and the perils of failing to assure a long-term plan for business sustainability – here.

How about a major unmanaged public health risk – the threat of wider-spreading swine flu – that exists right now at the heart of the health system. A large regional hospital is ignoring our mothers’ most basic admonition: “Hey, wash your hands!”

I spent last weekend visiting a loved one, who is recovering remarkably from complex, life-threatening and brilliantly executed surgery. That much, the hospital had right.

Outside his room, and all along the wards, there were dispensers of hand-sanitizing gel – which the staff all used in diligent compliance with the posted signs.

Frequent use of soap-and-water or alcohol-based sanitizers is a low-cost, front-line tool in the fight against contagion (see here and here). So what was missing?

It was the complete lack of attention to the hundreds of daily visitors – a steady stream of arrivals from who knows what cesspits of contamination, spreading out through the hospital to hug and pat the patients, fluff the pillows, handle all the medical playthings, and shake hands with the doctors and nurses.

There was not one word of direction or support to disinfect this parade of the unwashed, before they acted as a delivery service for infectious pathogens from the ugly and germ-ridden outside world.

In my business school course on Risk Analysis and Management, we spend time on the problems of incentives – how to recognize and adjust the influences that lead to good or bad choices.

Personal issues include the difficulty of balancing immediate consumer spending against saving for future retirement, and succeeding with the well-intended plans for diet and exercise that fall victim to daily distractions and temptations. On the business side, as recent history has shown, mortgage brokers paid for volume will push subprime loans on unqualified buyers, and banks that off-load dodgy financial products pay out huge bonuses despite the inevitability of catastrophic future reckonings.

My class looks at the kind of cost-effective and minimally intrusive techniques laid out in the book “Nudge,” by the University of Chicago’s Cass Sunstein and Richard Thaler – here -- who explore situations ranging in complexity from the location of sweet desserts in a cafeteria line to retirement plan investment options to carbon mitigation techniques affecting climate change.

Which has what to do with promoting germ-reduction in a hospital? My students would zero in on the hospital’s unanswered question:

Why was there not a hand sanitizer conspicuously located at the reception desk – a control point where visitors must pass? What would it take?

There would be no cost to the hospital, since the devices are already stocked for staff use. No visitors would resist, since no fee or other imposition is involved, and in any event their wish for admittance creates ample motivation to cooperate.

In terms of Thaler and Sunstein’s search for the gentlest possible nudges toward hand-hygiene compliance, a research opportunity could test and evaluate for the most effective among the various levels of encouragement:

•       No sign at all might be needed, besides the clear and present reminder of the dispenser itself.
  
•     There could be a simple sign: “Please help prevent the spread of flu.”
  
•     Or the more aggressive: “It’s state law – visitors must use sanitizers.” 
  
•     Or the truly coercive – ultimately effective if perhaps a bit harsh: “Failure to use hand sanitizers is liable to punishment, including amputation.”

Broader lessons may lurk in the “teaching moment” of this hospital’s readily achievable illness-reduction opportunity, for the identification of “clean hands” incentives to promote fiscal or economic or corporate health and safety. 

For now, I concede my ambiguous emotions about going into hospitals -- because they’re always full of sick people. I would feel better, though, only knowing at least that by nudging everyone on their premises to use proper hand-cleaning techniques, they would be lowering my risk of leaving with my own case of swine flu. 

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Sheep Dogs and Stewardship -- Why Groom the Next Generation?

Reader reaction indicates that I touched a sensitive subject, when I suggested on November 10 – here – that there was a mis-alignment in the compensation models of the large accounting firms, who distribute immediate profits to their current partners while the potentially devastating impact of related litigation takes years to befall the succeeding generations.

Which suggests the broader personnel picture and the range of attitudes and strategies involved in obtaining, maintaining and retaining the staff necessary for an enterprise to thrive and survive.

Among the large accounting firms, the topic of cut-backs, lay-offs and treatment of subordinates is under-reported but acutely felt – scrutinized by the bloggers and their exploding audiences (see Re:TheAuditors and Going Concern), if mainly ignored by the mainstream media.  

As a way to measure corporate management’s behavior in the areas of governance, incentives and sustainability, consider a couple I know well, who in their “retirement“ are ranchers in southwestern Oregon. They tend the largest flock of Soay sheep in America – one of the oldest domesticated breeds known to human history – for which they have the indispensable aid of one spry border collie and a quartet of massive Anatolian sheep dogs.

This fall, as they do every other year, they made a two-day round trip to fetch a new puppy from their specialized breeder – bringing home an already formidable bundle of energy, who will quickly grow to 125 pounds and demand enormous quantities of both food and training. 

With a quarter-ton of canine appetites already deployed around their pastures, why do they add this burden to their back-bending task of hauling dog food by the truckload of hundred-weight sacks?

Because eagles and coyotes find special allure in the scent of baby lambs, and predators are kept at bay only by the imposing presence of a four-footed guard force on 24/7 postings at their fences.

The demands on the recruiting directors of the banks and law firms and accountants are not different. They manage their personnel pipelines because, as a senior Big Four partner put it in a moment of candor, “the only reason we hire new staff is so we can re-stock our need for managers.”

There is a crucial difference. An Anatolian has an average ten-year life span. And when the inevitabilities of age or accident claim one of their veterans, the ranchers cannot just drop into the nearest Pups-R-Us and charge a replacement to their Amex card. “Staff maintenance” is not just a slogan, when safe-guarding the inventory is quite literally a matter of life and death. 

But whereas it takes about the same length of time to train a sheep dog as it does to convert a university graduate into a decent staff accountant or associate lawyer, there are a whole lot more of the latter on supply, and the sources are numerous and diverse.

I’ve largely been of the view that the world’s anxious regulators should resist intrusion into corporate hiring and compensation structures – there being almost nothing in fragile and volatile business environments that cannot be further distorted or broken by the tinkering of an over-eager bureaucrat.

But all interested parties – employees and shareholders and, yes, the public overseers of taxpayers’ bail-out funds – should at least evaluate whether a company’s bonus arrangements and staffing strategies extend over the length of a business cycle or are focused only on this year or this quarter.

How else could anyone assess the credibility of pious recitals about the importance of preserving and maintaining morale, tenure and talent? 

So it is not a cynical observation that – unlike the coddled shepherd puppy whose specialization makes him uniquely difficult to replace – rookies in the professional services firms should both sign up and stay on with the open-eyed expectation that their tenure is likely to be limited.

A strategic suggestion for the realistic perspective of both new hires and young partners at the large firms, then, is that all concerned should investigate and share a common understanding -- whether promotion and retention prospects and decisions will be made over time spans of the length used by a careful shepherd.

Well and good, if so.

And if not, there are always greener pastures.

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Re-Posting -- Internal Control Reports Under Sarbanes-Oxley: Hazards Out of Washington

In my first job in journalism, back on a small-town newspaper, the last critical deadline risk was a break-down of our creaky old press. Now it's that the elves of the internet somehow got Monday's post out via Twitter and my news groups, but failed to feed it to e-mail subscribers.

This re-posting is with my appreciation to all, and my apologies for either the delay or the duplication.

What’s in store for reporting on internal controls under the Sarbanes-Oxley law? The most important Washington development was not last week’s legislative merry-go-round over possible small-company exemption.

As discussed here, the SEC had earlier pushed back its deadline under Section 404(b) for auditor reports. Impelled by White House Chief of Staff Raum Emanuel, the House Financial Services Committee responded with approval of a permanent exemption, as proposed by Representatives Scott Garrett (R-NJ) and John Adler (D-NJ) (teed up in Edith Orenstein’s post of November 4 on her FEI Blog).

What may yet emerge from Congress is anybody’s guess – considering the opposition of Committee Chairman Barney Frank (D-Mass) and SEC Chairman Mary Schapiro and Commission Luis Aguilar. Their view is championed by Floyd Norris of the New York Times, quoting ex-SEC chief Arthur Levitt – here – in whose hyperbolic antagonism the climb-down on Section 404 would rank with repeal of the Bill of Rights or perhaps the Ten Commandments.  

Much more ominous, across the country in Seattle, was the October 27 opinion and order of federal district judge Marsha Pechman. As discussed by Kevin LaCroix (D&O Diary), Judge Pechman has sustained most of the shareholders’ class lawsuit against fallen home lending giant Washington Mutual, along with its senior executives and Deloitte, its auditors.

The case is based not only on the usual array of claimed false financial and other statements, but on WaMu’s allegedly defective internal controls and the opinions of management and the auditors – claims that WaMu “misrepresented the state of its internal controls, which were weakened in order to facilitate WaMu’s reckless lending practice,” and that Deloitte “made the false and misleading statement that its internal control reports were audited ‘in accordance with the PCAOB’s standards’.”

From the very passage of Sarbanes-Oxley in 2002, its requirement for opinions on internal controls has been an under-appreciated time bomb. Under Judge Pechman’s Order, the fuse is now lit, live and sparkling.

WaMu presents a major survivability hazard for Deloitte -- and by extension, for the viability of the entire big-firm assurance franchise. The investor claims involve securities totaling more than $ 4 billion -- well above the destruction threshold of Deloitte or any of the large accounting firms (see here).

And the plaintiffs are represented by the veteran law firm of Bernstein Litowitz Berger & Grossman – reported to have achieved five of the ten largest securities fraud recoveries in history, and to have collected over $ 20 billion on behalf of investors – here – thus no strangers to the extraction of serious amounts from their adversaries.

In the early years of Sarbanes-Oxley, while the accounting firms were reaping major revenues from their work on big-client compliance, two topics largely dominated the discourse: whether the cost was actually achieving any real value to the capital markets, and whether there could be a screwing down of the escalated fee increases felt to be windfalls to the large firms.

Two other themes were either lost or absent in the discussion. The first was that Section 404 reports and opinions comprised a new class of publicly-accessible statements on which investors might claim reliance to their detriment – no less than traditional financial statements and audit reports – a chicken now come home to roost in Seattle.

The second was the ultimate but eventual day of reckoning, with the certain arrival of large internal control failures. There a crucial mis-alignment lay concealed: the accounting profession’s cash-based business model involves immediate profit distribution to reward current partners, while the related litigation burden lies inchoate and deferred until inflicted years later on succeeding generations.

This kind of disconnect is broadly familiar:

• ·      The immediate benefits of large public works are consistently over-stated, for failure to recognize, for example, the future radioactive waste disposal costs of a de-commissioned nuclear plant, or the environmental disaster of a strip mine or a silted-up hydroelectric project.
• ·      Only now are the re-cycling impacts of consumer goods becoming visible – whether in the recoverability of scrap auto components or the packaging of home appliances or the extraction of metals and chemicals from old computers and refrigerators.
  
• ·      Closer to home, it’s a fair bet that the strategists in the law and accounting firms responsible for the tax shelter strategies so aggressively sold to their clients a decade ago did not include in their business plans the costs of their legal defenses, criminal trials, fines and civil settlements.
• ·      And nowhere is the timing mis-match more acute than in the legislative arena, where the sleight-of-hand calculations for health reform proposals or military hardware procurement or tax code revisions are fanciful exercises in advocacy.

In the same way, it is no small understatement that the profitability of the Big Four’s Sarbanes-Oxley compliance work would have been unpleasantly re-calculated, when the law was enacted in 2002, if future litigation exposures running into WaMu’s billions had been taken into account.

So concerning the yes-or-no desirability of Sarbanes-Oxley 404 for smaller companies, there is this interesting question:

With the potentially catastrophic impact of a WaMu trial now pending, and claims among the roster of failed financial institutions lurking in the background – why would a young partner in a Big Four firm think that more such expanded Sarbanes-Oxley work is a good idea?

Those who may think so are invited to explain why – especially to their dependents and their creditors.  

 

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Internal Control Reports Under Sarbanes-Oxley: Hazards Out of Washington

What’s in store for reporting on internal controls under the Sarbanes-Oxley law? The most important Washington development was not last week’s legislative merry-go-round over possible small-company exemption.

As discussed here, the SEC had earlier pushed back its deadline under Section 404(b) for auditor reports. Impelled by White House Chief of Staff Raum Emanuel, the House Financial Services Committee responded with approval of a permanent exemption, as proposed by Representatives Scott Garrett (R-NJ) and John Adler (D-NJ) (teed up in Edith Orenstein’s post of November 4 on her FEI Blog).

What may yet emerge from Congress is anybody’s guess – considering the opposition of Committee Chairman Barney Frank (D-Mass) and SEC Chairman Mary Schapiro and Commission Luis Aguilar. Their view is championed by Floyd Norris of the New York Times, quoting ex-SEC chief Arthur Levitt – here – in whose hyperbolic antagonism the climb-down on Section 404 would rank with repeal of the Bill of Rights or perhaps the Ten Commandments.  

Much more ominous, across the country in Seattle, was the October 27 opinion and order of federal district judge Marsha Pechman. As discussed by Kevin LaCroix (D&O Diary), Judge Pechman has sustained most of the shareholders’ class lawsuit against fallen home lending giant Washington Mutual, along with its senior executives and Deloitte, its auditors.

The case is based not only on the usual array of claimed false financial and other statements, but on WaMu’s allegedly defective internal controls and the opinions of management and the auditors – claims that WaMu “misrepresented the state of its internal controls, which were weakened in order to facilitate WaMu’s reckless lending practice,” and that Deloitte “made the false and misleading statement that its internal control reports were audited ‘in accordance with the PCAOB’s standards’.”

From the very passage of Sarbanes-Oxley in 2002, its requirement for opinions on internal controls has been an under-appreciated time bomb. Under Judge Pechman’s Order, the fuse is now lit, live and sparkling.

WaMu presents a major survivability hazard for Deloitte -- and by extension, for the viability of the entire big-firm assurance franchise. The investor claims involve securities totaling more than $ 4 billion -- well above the destruction threshold of Deloitte or any of the large accounting firms (see here).

And the plaintiffs are represented by the veteran law firm of Bernstein Litowitz Berger & Grossman – reported to have achieved five of the ten largest securities fraud recoveries in history, and to have collected over $ 20 billion on behalf of investors – here – thus no strangers to the extraction of serious amounts from their adversaries.

In the early years of Sarbanes-Oxley, while the accounting firms were reaping major revenues from their work on big-client compliance, two topics largely dominated the discourse: whether the cost was actually achieving any real value to the capital markets, and whether there could be a screwing down of the escalated fee increases felt to be windfalls to the large firms.

Two other themes were either lost or absent in the discussion. The first was that Section 404 reports and opinions comprised a new class of publicly-accessible statements on which investors might claim reliance to their detriment – no less than traditional financial statements and audit reports – a chicken now come home to roost in Seattle.

The second was the ultimate but eventual day of reckoning, with the certain arrival of large internal control failures. There a crucial mis-alignment lay concealed: the accounting profession’s cash-based business model involves immediate profit distribution to reward current partners, while the related litigation burden lies inchoate and deferred until inflicted years later on succeeding generations.

This kind of disconnect is broadly familiar:

• ·      The immediate benefits of large public works are consistently over-stated, for failure to recognize, for example, the future radioactive waste disposal costs of a de-commissioned nuclear plant, or the environmental disaster of a strip mine or a silted-up hydroelectric project.
• ·      Only now are the re-cycling impacts of consumer goods becoming visible – whether in the recoverability of scrap auto components or the packaging of home appliances or the extraction of metals and chemicals from old computers and refrigerators.
  
• ·      Closer to home, it’s a fair bet that the strategists in the law and accounting firms responsible for the tax shelter strategies so aggressively sold to their clients a decade ago did not include in their business plans the costs of their legal defenses, criminal trials, fines and civil settlements.
• ·      And nowhere is the timing mis-match more acute than in the legislative arena, where the sleight-of-hand calculations for health reform proposals or military hardware procurement or tax code revisions are fanciful exercises in advocacy.

In the same way, it is no small understatement that the profitability of the Big Four’s Sarbanes-Oxley compliance work would have been unpleasantly re-calculated, when the law was enacted in 2002, if future litigation exposures running into WaMu’s billions had been taken into account.

So concerning the yes-or-no desirability of Sarbanes-Oxley 404 for smaller companies, there is this interesting question:

With the potentially catastrophic impact of a WaMu trial now pending, and claims among the roster of failed financial institutions lurking in the background – why would a young partner in a Big Four firm think that more such expanded Sarbanes-Oxley work is a good idea?

Those who may think so are invited to explain why – especially to their dependents and their creditors.  

 

Thanks for joining this dialog. Please share with your friends and colleagues. And if not a subscriber, you are invited to sign on at the Main page – easy, free and non-commercial.

Sarbanes-Oxley 404(b): Auditors' Reports on Internal Controls -- A Shot in the Arm, or a Poke in the Behind?

What’s to be made of the US Securities and Exchange Commission’s grant, on October 2, of yet another extension of its deadline for small companies to have reports on their internal controls by their independent auditors? (See Edith Orenstein’s FEI Blog – here and here.)

As the autumnal season for influenza raises alarmist cries of epidemic, the comparison with an improved but experimental vaccine seems apt.

The mandate of section 404(b) of the Sarbanes-Oxley law is criticized as a boondoggle for the accounting firms, or worse, by Tom Selling (The Accounting Onion), and the whole issue of auditors' work on controls is thoroughly raked over by Francine McKenna (Re:The Auditors). And there were short-lived legislative moves in Washington to extend or make permanent the small-company compliance exemption -- see the October 30 Compliance Week.

In this context, there is much to contemplate.

To start – just as with the question whether to submit to a shot against uncertain exposure to a new type of swine flu – is there any real upside?

Veteran readers here know my deeply skeptical view that Sarbox was never more than a knee-jerk political feel-good exercise – going back to my July 20, 2002 column in the International Herald Tribune: “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.”

In the general population, most will never even catch the flu at all, or at worst will spend a few days of bed-ridden discomfort. Most public companies, likewise, operate honestly and with generally satisfactory controls, or require only modest treatment of their symptoms in order to return to good corporate health.

There are sectors at special risk, to be sure. With new vaccines, officials struggle to identify and set priorities and to deliver to the right targets – the elderly, the infirm, the weakened. That’s tough enough, for expert epidemiologists and public health professionals. Errors and oversights are unavoidable, as with any system under human design, and there will be casualties.

No less, the episodic outbreak of corporate malfeasance is unpreventable, and will strike a percentage of the most exposed. But no regulatory system yet conceived has been able to identify the “at risk” targets or find a way to avoid a non-zero victim count.

Secondly, there are the false negatives. Just as no vaccine provides protection against all strains, especially the newly emergent and opportunistic, the large-company experience with Section 404 has shown that Sarbanes-Oxley has failed to inoculate the corporate world against continued out-breaks of business dishonesty.

Attempts to legislate virtue have been no more effective than a mandatory vaccination program – whether among foreign companies with US-traded securities (Parmalat and Satyam), or individual perpetrators (the convicted Bernie Madoff, the accused Alan Stanford, and the recently-charged Raj Rajaratnam), or the long list of fallen financial institutions (Bear, Citi, Lehman, AIG, Merrill, etc.) whose cleanly-reported controls did not protect them from the fatal infection of the credit market collapse.

Third and most pernicious, there are the inevitable side effects.

It is mis-directed and erroneous to ask whether corporate behavior has improved since the post-Enron legislative spasm of 2002. Rather, Sarbox has never been fairly measured for its negatives – extravagant costs, severe disruption of the auditor-client dialog and relationship, and diminution of real value contributed by the assurance process. Just as most flu victims recover full good health, whether treated or not, the proper question is how the side effects of Sarbox weigh against the evolved corporate governance and controls that would have emerged in the normal cycle, had the law never been enacted at all.

Discussion of the Sarbox cost-benefit analysis typically omits recognition that the equivalent of “good health” practices was always in place. Just as preventive hand-washing and use of Kleenex will fend off most routine contagions, the prohibitions on false statements to investors under the American securities laws have a long tradition of deterrence – imperfect, to be sure, but nothing is. So the proper question is whether imposition of a universal requirement for additional measures under Sarbox could justifiably alter the prevention calculus for the better.

To conclude -- leave for another day, and soon, scrutiny of the potentially devastating litigation exposures run by small companies and their auditors when the next round of control failures show up in a renewed wave of investor litigation.

For now, compare with a health-delivery marketplace where individual choice still counts. Conscientious consumers can weigh the potential benefits of an experimental new vaccine. They can consider the risks of side effects and possible false comforts, absorb the publicity from a profit-driven drug industry, and decide accordingly.

With Sarbox 404(b), by contrast, unless a re-evaluation occurs while this latest deadline extension is pending, small listed companies will have no choice but to bend over and offer a fat and juicy target – to be stuck by a needle-wielding bureaucrat with the fear-inducing cry, “I’m from the SEC, and this shot is for your own good.”

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Why the Bankers' Models Failed in Crisis: A GPS Program is Not the Same as Real Traffic

Lost, trapped and at risk of a serious crash.

That could very well describe the participants in the financial markets turmoil of the last two years. Instead it was my experience last Saturday afternoon – as an anxious and helpless rear-seat passenger during a frustrating hour fighting the exit traffic after a major college football game.

Autumn weekends in America are given over to exotic rituals. Cult-like herd behavior, irrational devotion to long-odds causes, microscopic analysis of esoteric game plans, prayerful invocations of last-minute rescues, and the frequently-literal intoxication of victory and defeat -- all the ways that bankers and investors behave during the routine work-week are migrated on Saturdays to tail-gate barbeques and stadium hoopla.  

Among a hundred thousand fans choking the bottle-necks of the parking lot, our driver was hopelessly conflicted. We were trying in futility to drive against the overwhelming flow toward the tollway. Normal daily street patterns were closed against us, and stern patrol officers blocked our turnings and waved off our intentions.

Trying at the same time to cope with the double distractions of his co-pilot working a cell phone and the urgently artificial voice of the dashboard GPS that insisted we should be taking forbidden routings, he also faced the threatening reality of aggressive crossing traffic at each frustrating intersection.

The recent banking and credit markets crisis was perfectly reflected in our dilemma: ordinary daily transaction flow was overwhelmed by an exceptional one-time event – an unruly horde in single-minded escape mode had nowhere to go – and an on-board warning system could not comprehend the disruptive effects of events beyond its programming.

The disconnection for the driver between the seductive directions of the GPS, to plunge into the systemic dysfunctionality of the streets, would perhaps have resembled the state of market unreality, going back to Jimmy Cayne’s dislocation as the presumptively risk-managed real estate funds of Bears Stearns spun into collapse.

Think of a traffic-guidance system as a risk management tool, in other words: it can start as an aide – but becomes a dependence -- and then an addiction. However luxurious the vehicle, it is a dangerous instrumentality when the driver’s ability to reckon direction has atrophied under commitment to a model that seizes up under stress.  

In short – as the data loaded in a GPS cannot imagine or replicate a post-game traffic jam, neither can a triple-A rating or a quantitative calculation of daily ValueAtRisk hope to capture the no-exit entrapment of an interlinked portfolio of subprime mortgage-based securities.

There are three further comparisons – one being the common and universal nature of the predicament. Equally pinned in the single-lane mess were the limousines of the VIP alumni, the high-end sports vans of the tail-gaters, and the boisterous bus-loads of drunken end-zone fans – all were as captive as Citi’s Chuck Prince and the feckless vision he imposed on the entire industry in July 2007, to keep dancing “as long the music is playing.”

Also, with every state trooper and traffic monitor devoted to prodding the crowd on its way out of town, the overload on law enforcement was evident. Marauding gangs could have been looting the Food King or emptying the town’s ATM’s – while the over-stressed constables echoed the SEC’s paralysis during the banks’ disintegrations or its curbside blinking at the predations of Bernie Madoff.

And finally: dispersion of the congestion was inevitable, and we eventually broke free. Accelerator down at last, our driver was excited: “Full speed at last,” he crowed.

“Yes,” said the still-befuddled navigator from behind his map. “Unfortunately, we have no idea which way we’re going.”

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