Re:Balance -- Jim Peterson

Foreign Auditor Inspections? "China Syndrome" Strikes the SEC

 

Confidence in the American securities and accountancy regulators was not raised, w

hen a press release on December 3 announced -- under the headline “SEC Charges China Affiliates of Big Four Accounting Firms …In Refusing to Produce Documents” – a proceeding against the five largest global networks.

For the first time in its eleven-year history, this column calls upon a graphic to illustrate the folly of a gang that couldn’t count straight:

 

   The PCAOB has been stymied for a decade in its futile attempts to enforce in China its asserted mandate under Sarbanes/Oxley to inspect and obtain working papers from auditors, including those in foreign countries, which audit more than twenty percent of a registrant’s assets or revenue (here). And the SEC itself has been piddling along with company-specific subpoena enforcement and administrative proceedings against Deloitte and its Shanghai affiliate.

So now they have called in the heavy artillery, in the person of Robert Khuzami, director of the SEC’s Division of Enforcement, who says that non-complying firms “face serious sanctions.”

Khuzami cannot be faulted for zealotry. He arrived on the scene of an agency whose Cox-era somnolence had missed not only Bernie Madoff’s predations on the domestic front but the internationally destructive tsunami of “reverse mergers” by which Chinese companies gained access to the world’s capital markets. That scorecard, a decade late and billions short, now includes more than 50 de-listings by the SEC and 40 fraud actions – and, elsewhere, a flurry of civil litigations, and most recently an agreement by Ernst & Young to settle civil litigation (but not a disciplinary proceeding) relating to Sino-Forest, by agreeing to pay C$ 117 million, the largest auditor settlement in Canadian history.  

(As an aside, those disposed to see darkly conspiratorial revolving doors in the place of Chinese fire drills will note that this is the same Khuzami whose predecessor at SEC Enforcement from 1998 to 2001, Richard Walker, thereafter went in-house at Deutsche Bank, where he hired Khuzami in 2002. So the latter, before becoming the top American securities cop in 2009, was on-scene at DB when the bank – as now reported – according to three whistle-blowers concealed losses of up to $ 12 billion for failure to “mark-to-market” the exposure gap on a notional $ 130 billion of exotic derivatives known as “leveraged super-seniors.”)  

Calling in Khuzami’s troops may look like the last act of desperate regulators – but it will actually play as the next act in “The Comedy of Errors.”

That’s not because it’s so little so late. Or because frustration of the PCAOB’s aspirations to access Chinese auditors and work papers would attract retaliation against their own ambitious plans to re-structure the global audit market by building and unleashing global-scale Chinese audit firms – an ambition otherwise unachievable both for want of competence in personnel and standards but also because, in reciprocal hostility, other countries will be no less protective of their local prerogatives.

It’s mainly that the US regulators’ only weapon of significance – banning Chinese affiliates of the large global accounting networks from qualifying to work on audits of American-listed companies – would ripple far beyond the toxic roster of China-based companies.

There are potential consequences for global-scale companies with significant operations in China that go far beyond the inability of the PCAOB to inspect their local audit firms, whether or not maneuvered to keep below the 20% threshold.

Consider just two examples: Caterpillar, whose annual filing with the SEC does not set forth results by geography but discloses total 2011 sales of over $ 60 billion and elsewhere reports its China sales to be 3% of its total. Or HSBC, which does report by region including $ 3.6 billion in profits from China in 2011 and whose mainland Chinese operations include 133 outlets including 27 branches, even after the announced sale of its interest in giant insurer Ping An.

A barrier to the use of Chinese audit firms would make it impossible for those companies to include audited results from their Chinese operations in their global accounts. The result would be top-level consolidated financial statements with a huge unaudited portion, and auditors forced in their opinions to confront the professional standards for limitations on their audit scope.

Across the globe from KPMG in London and its top-level opinion on HSBC, to PwC in Peoria, Illinois for Caterpillar – unable to rely on their excommunicated Asian brethren – auditors would have no choice but to use the dread “qualify or disclaim” language -- never seen for a public company because anathema under the rules of the SEC itself.

Or, in extremis, PCAOB de-registration of the whole of an audit network deemed non-compliant would render a company’s entire financial filing unacceptable.

Restoration of adult-level expectations and the pursuit of a non-litigated resolution process is essential, although a fading hope – since calling in the police as a last resort means an escalation of hostilities due to the one-dimensional DNA of their approach to problem-solving.

For good reason, then – under the latest blows from SEC Enforcement – the large accounting firms must feel like a bunch of nails in a hammer-testing factory.  

 

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Sarbanes-Oxley, Ten Years After -- Are We Having Fun Yet?

It has not been difficult, through this summer of discontent and turmoil in the world’s financial markets, to ignore with enthusiasm the comprehensively vacuous observations of the tenth anniversary of the Sarbanes-Oxley law. 

Readers will recall my long-held skepticism about that knee-jerk post-Enron exercise, going back to my July 20, 2002 observation in the International Herald Tribune about the preliminary Senate vote, that “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.”

Nor has the decade horribilis given any reason to change.

Of the smug and fatuous self-congratulations of the bill’s eponymous sponsors (webcast on July 30, 2012), the less said the better. As the English essayist Charles Lamb wrote about a blame-worthy poetic effort:

“It would be an insult to my readers’ understandings to attempt anything like a criticism on this farrago of false thoughts and nonsense.”[1]

Rather, some unasked questions should be advanced.

Regarding the self-interested back-patting of those with careers to be served by the inflictions of Sarbox –- the PCAOB’s members and staff and the spokesmen for the accounting oligopoly dependent on its compliance revenue:

“Would the elves in Santa Claus’s toy shop be expected to vote against Christmas?”

As for those purporting to see some claim of benefit, yet propounding no solutions to the continued eruptions of financial chicanery (here, here and here), the challenge remains that the cyclical nature of market bubbles makes inevitable a post-scandal period of cleansing and temporary return to virtue – political dynamics notwithstanding.  

Put another way, the storm of both scandal and outrage after Enron and WorldCom was bound to clear, no matter what. So instead of the wrong question, whether post-Enron corporate behavior is now improved, under both the Sarbanes-Oxley law and the law of unintended consequences, the proper operative question should be:

“Would financial reporting and assurance not be better if Sarbanes-Oxley had not been passed at all?”

First, American law since 1934 has pronounced it illegal to make false statements in connection with the purchase or sale of securities. So – as confirmed by the absence of prosecutions under the redundant Sarbox requirements for executive certifications of financial results (summarized by Michael Rapaport and Francine McKenna) -- that exercise has from the outset never been more than optics and cosmetics.

Second, a decade of PCAOB intrusion into the relationships between auditors and clients has engulfed the corporate reporting process in cost, paperwork and degradation of the assurance function (here and here) – while, into the bargain, failing either to advance coordinated global-scale assurance regulation and oversight in most of the world’s major capital markets (here) or to prevent (among others) the wave of securities malfeasance of off-shore origin, notably from China.

Third, as to the law’s centerpiece obligations on internal controls reporting and assurance, it was always true, even pre-Sarbox, that most decently-controlled companies would do reasonably well on compliance, most of the time – while a parade of horribles since then has made it clear that, for reasons of scope limitation or plain enforcement dysfunction, the law has been ineffectual against the rare but all-too-frequent and truly consequential cases.

A brief post-Sarbox sampler illustrates that – as generally true of large-scale challenges to risk identification and management -- it is the “outlier” cases that really matter:

• The control failures that brought down Bear Stearns and Lehman Brothers

• The “buco nero” at Parmalat and the ghost employees at Satyam

• The in-house looting by the chief financial officers of Koss in Milwaukee and the city of Dixon Illinois

• The undetected Ponzi schemes of Bernie Madoff and Alan Stanford, unremarked by gate-keepers, regulators and out-of-control client advisors and abettors alike 

• The valuation fantasies behind the window-dressing at Fannie Mae and Freddie Mac

• The incentives-driven perversions in the mortgage businesses models of Washington Mutual, Countrywide and New Century

• The derivatives and trading fiascos at UBS, JP Morgan Chase, MF Global and now Knight Capital

What then is the purpose of law-making? Sarbanes-Oxley has manifestly not ameliorated the flaws persistent in the nation’s corporate reporting and assurance structures -- then of what use or benefit has it been? 

And, if only the mis-leading politically-motivated placebo that it appears, what more should be expected both of our elected representatives and of those aspiring to hold them to account?

 

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[1] “On the Tragedies of Shakespeare,” 1811.

Will the Auditors' Real Clients Please Stand Up? You're Lost Among the Mixed Messages

I try to raise the sense of my students in Risk Management for trends, patterns and common themes – early awareness being an opportunity for effective strategy.

So when the muddied state of auditor-clients relations was twice and separately further obscured in recent days, attention should be paid.

First, a reader sent me a lament overheard at a Thanksgiving table -- a second-year audit staffer at a Big Four firm, who had been trying without success to persuade his 38-year-old supervisor that there was a defect in the results of their engagement performance. The futility of his efforts was leaving him with the dispirited feeling, as he put it, that he had become in effect an employee of the client.

The second, at the AICPA’s Washington conference on SEC and PCAOB developments, was SEC Chief Accountant James Kroeker (here) – advocating “a change to our collective vocabulary…. (D)on’t use the word ‘client’ to refer to the management of companies under audit…. (I)t is time to give serious consideration to changing the perceived ‘client’ in audit relationships.” 

The uneasy dilemma of the beleaguered young staffer is no surprise, because among the many pernicious effects of Sarbanes-Oxley has been a three-fold degrading of the auditor/client relationship. From an advisory role to one of adversity and compliance – and so forms-and-process based that young professionals lack the environment in which to learn and absorb actual client business -- under on-going stress on revenues and profitability, the firms’ clear imperative to their staff is to complete the work needed to issue another commodity report, “on time, within budget, and without making waves.”

The dynamic for an eager but career-sensitive young professional is no better put than by my senior-level friend: “When you raise a problem, then by definition you become the problem.” No wonder, then, when “client satisfaction” – the long-popular mantra across the spectrum of commercial activity – readily elides to “client capture.”

While back in Washington, the vagueness of Kroeker’s musings became truly misleading as picked up and re-broadcast under the 140-bit limits of the profession’s twittering critics – mutated to the direct question “who is the client?” as if the auditor’s “primary responsibility was to investors, not the companies they audit.” 

Kroeker and his agency are of course entitled to advocate for a nationalized audit function carried out by civil servants. If so, let them say so with candor, and let the debate be engaged – it will be revealed quickly enough how the community of financial information users would compare the value of today’s archaic and obsolete report with an equivalent document delivered by federal agencies distinguished by their inaction during the tumultuous events of the last three years.

Until then, it requires recalling that it has been a basic premise since the 1930’s passage of the American securities laws, when the profession lobbied successfully for private control of the assurance franchise, that the company under audit does the hiring and pays the bills.

Indeed, the disregarded consequences of that plain election in favor of an unambiguous definition of “client” are amply shown in the vast amount of time and energy wasted in the intellectually ineffective attempt to define with precision what constitutes an “appearance of independence,” in light of the contractual and economic linkage of direct auditor engagement.   

It is also readily recognized that important rights and obligations arise outside the strict confines of a provider-client relationship. Concepts based in agency, trust and fiduciary duty are familiar – as is legislative authority to create duties based on extra-contractual reliance and expectations, whether for investors, consumers or even innocent by-standers.

But it does no favors to the complex challenges to evolve a valuable and sustainable audit function, to blur the lines of accountability with careless invocation of an ill-defined shift in client identity.

Or as I also try to instill in my MBA students, the guidance is still relevant as laid down by 18^th century lexicographer Samuel Johnson, that “sloppy language is a mark of sloppy thinking.”

As the poor staff auditor is learning under career-threatening pressure, the issues facing the role of auditors are already sufficiently profound. From the senior regulators in Washington, they deserve clearer articulation than they now receive.

 

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Dodd-Frank Lets Small-Company Auditors Off the Internal Controls Hook: Putting a Partial Lid on the Sarbox

At least one piece of the Dodd-Frank legislation now has a ribbon neatly tied around it: the Securities and Exchange Commission has issued its rules to exempt small companies – generally those with less than $75 million of common equity – from having a separate independent auditor’s report on their internal control assurance under Section 404 of the Sarbanes-Oxley law.

(For her customarily concise and lucid summary, see Edith Orenstein’s FEI Blog.)

I’ve been quiet on Dodd-Frank. Why not? Unmanageable in its creation, incomprehensible in its enactment, unpredictable in its consequences, as it was. Who could work up an appetite to ingest such a pigs’-breakfast of law-making?

Small companies may say, with the night watch in Hamlet’s Elsinore, “For this relief much thanks.” But marginal tinkering with the mis-begotten obligations of Sarbox 404 will matter less, and for different reasons, than are usually put on view.

To start, the toxic post-Enron environment in which Sarbanes-Oxley was enacted in 2002 has effectively immunized its impositions from critical cost-benefit evaluation. Persistently asking the wrong question – “Has the quality of corporate reporting actually improved since the days of WorldCom and HealthSouth?” – not only ignores the built-in cyclicality by which outbursts of scandal are purged by self-cleansing returns to virtue. It also leaves unasked the proper question: “Is that reporting better than if Washington had done something else – including doing nothing at all?”

More importantly, can any scarred survivor of the last three years of Bear-Lehman-Fannie-Freddie-AIG-Merrill – the most disruptive economic period since the Great Depression – argue seriously that auditors’ reports on the “out-of-controls” of those fallen industry giants actually made any positive contribution to systemic safety, stability or credibility?

In that dreary context, of course, it makes perfect rational sense to give small companies a “Get Out Free” card.

That’s because, as I was advised about parenting strategy when our daughter was born: “Little kids, little problems; big kids, big problems.” A new father’s worries escalate, from the essentially trivial inconvenience of an infant’s colic or spilled oatmeal, on to little league injuries and a teenager’s driving safety, up to college admission and the launch to the challenges of adulthood.

In the same way, the fewer zeroes on a balance sheet, the lessened likelihood of systemic impact of mis-behavior that makes a difference. “Out-of-control” at a Koss or an American Apparel may be inconvenient for a limited constituency, and provide grist for the mill of the plaintiffs’ securities class action lawyers – but otherwise doesn’t matter in the great scheme of things. It’s altogether different when the entire global financial system can seize up under the effects of a threatened, undetected and undeterred collapse at an AIG or a Lehman.

History and experience teach that regulatory systems designed and applied under motives of political correctness over the fat part of the compliance curve are wasteful and ineffective – whether aimed at school truancy, auto emissions or corporate disclosures. Instead they will fail to identify and address the “outliers” that actually prove disruptive – the SEC’s sorry performance in regard to Bernie Madoff and Allen Stanford make the case. 

Section 404 reports on small companies were never any more likely to be effective by way of detection or deterrence for small companies than they have proved for the large. So it was an inevitability that inflicting Sarbox 404 auditor reports on small companies would have been largely an exercise in even further futility. If regulation has not worked for the big and dangerous, in other words, how can it be good or useful for the small and irrelevant?

Drab as it may seem, finding negative comfort that at least our legislators have stumbled into a way to avoid making a weak situation even worse, there is both logic and benefit in leaving bad enough alone.

 

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Happy Vacation -- Even the Crooks Are Taking a Break

When a felon’s not engaged in his employment,

Or maturing his felonious little plans,

His capacity for innocent enjoyment

Is just as great as any honest man’s.

-- Gilbert and Sullivan, “Pirates of Penzance,” 1879

I’m about to be off for several weeks, for that nearly-sacred ritual of summer holiday, so beloved in Europe and observed with enthusiasm.

Predictions of the unexpected that might arise while I’m gone are impossible, of course: human mis-handling of complex events ranging from BP’s Deepwater Horizon to the Gaza blockade to the quality of World Cup officiating show that timing pays no respect to environmental disasters or tribal violence or even soccer’s off-side rule.

But reasonable expectations are that life may be calm for a while at least in the space that is watched over here. 

That’s because:

• The world of financial information and public accountancy was left untouched either by the Dodd-Frank regulatory legislation now clanking toward passage through the U.S. Congress, or by the Supreme Court’s ruling on the constitutionality of the Sarbanes-Oxley law (here)
  
• Invited to inaction, then, rather than to further public mischief-making, American legislators are now off for the summer to abuse their subordinates or their constituents or their expense accounts.
• Summer is not typically the time for the eruption of financial scandal, which is rather pressured into public view by the stresses of year-end reporting and the eventual and unavoidable escalation and collapse of Ponzi-style machinations.
  
• Instead, the next generation of white-collar financial criminals are beavering away, beneath the screens of visibility, always and ever searching out the exploitable weaknesses in the world’s fragile systems of corporate governance and reporting.  

So, while it is no time for naïveté or diminished diligence, it may justifiably be time for a little pause. The challenges of this fall’s new season of discontent will arrive soon enough – so enjoy the summer while we can.

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Sarbanes-Oxley and the PCAOB: The Supreme Court's Own Goal

On this last Monday there were two non-events, both with heavy political overtones:

First was the announced resignation of Jean-Pierre Escalettes, president of the French soccer federation, after Les Bleus’ disgraceful crash out of the first round of the World Cup with two losses and a draw.

Second, by a five-four vote (here), the United States Supreme Court upheld all significant aspects the Sarbanes-Oxley law of 2002 and the structure and operation of the Public Company Accounting Oversight Board, save only for the means of removal of PCAOB members.

There was always something strained and artificial about the constitutional attack mounted by a dinky accounting firm and an anti-Sarbox advocacy organ, raising points of eye-crossing abstraction about the scope of presidential power to appoint and remove subordinate officials.

So perhaps not surprisingly, the Court’s constipated decision is in kind – leaving entirely in place the law, the agency and its members, and satisfying nobody except court scholars perched in the highest of ivory towers.

Because, for all the anticipatory sound and fury --

• There is this much disruption of the PCAOB’s business: None.
• There is this much need for legislative re-visiting of Sarbanes-Oxley: None
• There is this much likelihood that, with Congress on its way to summer recess and mid-term election season around the corner of the calendar, there is any political appetite to take up the multiple short-comings in the present scheme for the regulation of the delivery of accountancy services to public companies: None.
  

For completeness, however, although the nature of the status quo has been righteously endorsed as robust, across the spectrum of the satisfied – from the Sarbanes-Oxley authors themselves (here) to the lobbying arm of the large accounting firms (here) to the head of the increasingly marginalized AICPA (here), to the SEC chairman herself (here) –

• Eight years and billions of dollars down the Sarbox drain, the amount of demonstrably beneficial deterrent effect on the global financial crisis and the performance of the principal actors: None.
• The extent to which the cries for revisions in the PCAOB’s remit or ability to act effectively in relation to the global market for useful and valuable audited financial information (see, e.g., my friends Francine McKenna and David Albrecht) have any chance of achieving results: None.
• The probability that rational heads will constructively address the existential crisis facing the survivability of the Big Four’s franchise of privately-provided assurance to global-scale companies, ahead of the catastrophic collapse of their business model: None.

Scholars of the Supreme Court’s deliberations will debate endlessly the nuances of its powder-puff result. Meanwhile the conversations amongst the Court’s majority wing can be re-constructed thus:

“We can’t let this law stand. When the Constitution was written, independent auditors hadn’t even been invented. This is not the crystalline path of our gun-control logic (here), from muskets in the militia to Uzis in Starbucks.”  

“No, but if we trash the whole statute, just think of what Chris Dodd and Barney Frank might legislate in its place, that we might just have to live with.”

“Right. Scary. And our Wall Street friends are living just fine with an agency that is toothless and clueless.”

“So if we do as little as possible, it may not resemble intellectually honest conservative orthodoxy, but it might just sell as restrained and reasonable.”

“You’ve got my vote, Chief. But only because we can’t bring back the guillotine.”

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Summertime, And The Living Is Easy -- At Least For Now

      “If you’ve nothing nice to say…. come sit by me.”

 -- Dorothy Parker

With the change of seasons, I am just back from a two-week break in Russia, including a stretch so deep in the countryside as to be beyond all connectivity.

An annual break is probably no less important in the ink-spreading trades than elsewhere – although more for health and re-focus than for risk control (witness the “vacation rule” violations now part of the Paris trial of Société Générale’s rogue trader Jérôme Kerviel).

In any event it’s a good time for a pause:

• BP’s agonies in the Gulf and in Washington have pushed off the front pages the mis-adventures of Goldman Sachs and Lehman Brothers, showing once again that the capacity for public outrage is both finite and subject to “proximity bias.”

• The late-stage negotiations in the US Congress over financial institutions reform legislation include not one word of attention to the survivability plight of the global audit franchise of the Big Four firms – leaving that multi-dimensional problem to leap onto the public screen with the next (and inevitable) outbreak of financial scandal.
  

• Two significant court decisions still await the leisurely pace of the judiciary: the Florida appellate ruling in the Bankest matter, which could determine the fate of the Seidman accounting firm, and the United States Supreme Court’s now overdue ruling on the constitutionality of the Public Company Accounting Oversight Board (see here) – the latter having potential to unleash onto the world of financial information regulation all the mischief that Messrs. Frank, Waxman and Dodd can muster.

• And above all, outside the US at least, the season of the Coupe du Monde attracts far more interest and attention -- especially with the French team crashed out early in a spasm of mediocrity, petulance and politics -- than the soporific pronouncements from the accounting standards-setters about GAAP/IFRS convergence.

There being nothing worth tooting a vuvuzela about, in other words, let respect be paid to the quiet of summer.

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The SEC Strikes Goldman Sachs -- Now Will Goldman Strike Out?

As the great baseball umpire Bill Klem said, about whether a pitch was a ball or a strike:

“It ain’t nothin’ ‘til I call it.”

Which, as a lesson in political science, is being taken to heart by only some of those holding forth on the April 16 charges of fraud lodged by the Securities and Exchange Commission against Goldman Sachs and one of its employees (here), alleging misstatements and omissions in the structure and marketing of a synthetic collateralized debt obligation tied to residential mortgage-backed securities.

The SEC’s enforcement director, Robert Khuzami, dealt a high fastball -- avoiding complexity in packaging his advocacy for public soundbite-scaled consumption (here):

“The product was new and complex but the deception and conflicts are old and simple.”

Goldman itself played its defensive position the same way, but to different effect (here). Its terse one-liner fouled off the pitch: “We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact.”

Give Goldman points for a sense of reality, recognizing both that the judicial process will be unaffected by public posturing, and that the court of public opinion itself will not be in a mood for hand-wringing.

For it remains a mystery what inspires any claim to credibility by the typical spinners of over-played corporate protestations, when initial impassioned pleas of innocence give their inevitable way to plea bargains and outsized settlements to “put it all behind.” 

Meanwhile, the purple clouds of “I told you so” commentary from the bloggerati are as noxious as the volcanic spews from Iceland, and should only be dispersed as rapidly into inconsequence. 

Not least, the self-righteous are – as customary – conflating an initial law enforcement complaint with an adjudicated conclusion. Consider:

• ·      Much as public opinion had convicted O.J. Simpson of his wife’s murder, before his trial, the jury found otherwise – and he remained at large until the outbreak of his predictable recidivism.
• ·      It was financial and structural weakness that felled Arthur Andersen, not its indictment – remembering that procedural flaws in its conviction led to the Supreme Court’s reversal, but with no element of vindication or rehabilitation.
• ·      Even the now-jailed Bernie Madoff was presumed innocent (although charged) until the entry of his guilty plea, and entitled to bail and at least a measure of his liberty.

Respect for due process requires a measured recognition that the SEC case is at the top of the first inning – though there may well be further cases, additional claimants and private claims as well (see Kevin LaCroix’s always helpful D&O Diary). 

But Charlie Green also has it right, at Trust Matters. That is, if as Charlie suggests, the SEC’s case “resonates easily with Main Street as also being unethical,” and as corrosive to credibility, motives and trust, then the capital markets community will hold Goldman accountable for the state of its franchise in ways that the judicial process can never address.

A final constituency is yet to be heard from, about we should worry. Eight years ago, when the collapse of Enron was trailed by WorldCom, a stampeded Congress inflicted Sarbanes/Oxley and its massive demonstration of the law of unintended consequences.

Given its head, a legislature bent on retribution against the financial services sector is capable of twinning up the bankruptcy examiner’s report on Lehman Brothers (see here) with the SEC’s complaint against Goldman.

In which case, anxiety should run very high.

Because the result, in Bill Klem’s terms, will most likely be a wild pitch.

 

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A PCAOB "Reminder" on Significant Unusual Transactions: Is the World of Audit Guidance Now a Better Place?

Rumack: “Can you fly this plane and land it?”

Striker: “Surely you can’t be serious.”

Rumack: “I am serious … and don’t call me Shirley.”

-       “Airplane” (1980)

 There was at least one bit of good news implicit in the otherwise-dispiriting April 7 alert from the Public Company Accounting Oversight Board, “Auditor Considerations of Significant Unusual Transactions” (here). 

Which is that, although the large accounting firms may well not survive the wounds of their own exposures (see Francine McKenna’s March 23 compilation), they are in no present danger from their American regulator.

It is not clear, because neither auditors nor their overseers are recognized for their humor or their irony, whether it is cause for laughter, or perhaps tears, that the functionaries in Washington have so little respect for the profession, as to believe it useful to “remind auditors of public companies about …the risk …posed by significant unusual transactions.” 

Behind the text of the alert – which offers not a single example or illustration to suggest that the PCAOB itself has a clue – is another “reminder,” for anyone still thinking that government-provided audit guidance might supplant private assurance, in the event of Big Four disintegration and collapse: The PCAOB shows itself ill equipped to lead from Point A to Point B. 

It was never credible, that the very government that imposes on its citizens the Postal Service, Fannie Mae and the IRS should be capable of delivering assurance of any value on the complexity of global-scale corporate financial statements.

The PCAOB’s insult to intelligence now makes that crystal clear. The best advice on offer – eight years after the Sarbanes/Oxley law begat the PCAOB and a regulatory regime for which the world was not holding its breath – is the stunningly obvious proclamation (page 2) that “although the economic conditions have changed since December 2008, the risk factors, including the risks of unusual transactions, that existed in December 2008 continue to exist today….”

Whew – thanks for that insight, for sure.

Justification for an alert is said to be the highlighting of “new, emerging, or otherwise noteworthy circumstances.” By its own terms the alert fails on the first two, so the question is what might be “noteworthy” (page 2) about “compiling selected, relevant requirements from existing PCAOB standards … into one document.”

Does the PCAOB believe that audit professionals cannot read their basic literature, without their attention failing or their lips getting tired? 

With expectations that low, where do they expect the professional wisdom and judgment be found, in an audit engagement team out on the job, to comprehend the subtleties of whether “the form of transactions is overly complex” (page 5) or if “management is placing more emphasis on the need for a particular accounting treatment than on the underlying economics of the transaction”? (page 6, emphasis added) 

If so, the next expected step in the dumbing-down of regulation will be “GAAS for Twitter” – auditing such tough subjects as related parties and special-purpose-entities and complex derivatives, 140 characters at a time. Not, we should fear, a recipe for enhancing the value of the audit process.

Further, one seriously nasty hostage to politics in the PCAOB release is the admonition to engagement teams to “consult with individuals having appropriate levels of knowledge, competence, and judgment regarding significant unusual transactions.”

Not only does that finger-waving come with the warning that “the engagement quality reviewer cannot provide concurring approval of issuance if he or she is aware of a significant engagement deficiency, including those regarding significant unusual transactions.”

More importantly, as noted here, the PCAOB’s minders at the SEC in December besmirched an entire senior consultation hierarchy at Ernst & Young, announcing enforcement sanctions against the firm and six of its partners over the quality and risk review process followed for Bally Total Fitness – a shot across the bow of professional quality consultation that cannot be encouraging to the kind of consultative practices now urged by the PCAOB.

Regulatory “reminders” at the PCAOB’s elementary level may be an inevitable nuisance in a nanny-state environment of excessive bureaucratic intrusion, but their real impact will be a further degrading of the agency’s own stature and credibility. 

At this rate, the PCAOB’s next release will be a “reminder” that debits must still equal credits.      

 

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The SEC's New Rule 201 on Short Sales: Taking a Bear Position on Over-Regulation

(Paris, France) – Second thoughts on first impressions: a revisiting of my early disdain (here) for amended Rule 201 of the U.S. Securities and Exchange Commission – a new restriction on short selling that imposes an “uptick rule” – a circuit breaker that would be triggered by a one-day stock price drop of ten percent or more.

The reflective mood may itself have been triggered by my vernal equinox relocation to this European base, for the spring and summer – with possible impact on my publication schedule, but also a refreshed exposure to perspectives on this side of the Atlantic.

(At this point, it would be obligatory for mainstream media to pause for a white-bread definition of short selling and a summary of the SEC’s rule. Happily in an evolved environment, all that is needed is this link to the SEC’s release of February 24, which in turn leads to Chairman Mary Schapiro’s speech, and the supporting staff paper – to all of which the curious are referred for details.)

I have observed the debate on short sales restrictions to be binary and polarizing – that, as with handgun control or gay marriage or abortion rights, coherent but non-negotiable views reside at the ends of the spectrum, with compromising positions difficult to articulate inside the black-or-white extremes.

Events over the last two years leave me less sure. On the one hand, it’s hard to generate much sympathy for the special pleading of John Mack of Morgan Stanley, or of Lehman’s Dick Fuld before its September 2008 collapse – especially with the recent release of the Proustian-length exposition by bankruptcy examiner Anton Valukas (here). 

Nor, in pursuit of honest symmetry, is there any popular sentiment for reining in the pernicious speculative effects of upside exuberance. Imagine the vitriol that would be poured on a regulatory rule imposing a “downtick rule” before buying a stock experiencing a daily uplift of ten percent.     

And yet, even the ursaphobic are deserving of respect – some days, the bear really does eat you.

Which leads to the hard and subtle question: how much regulation is the right amount?

And there, I suggest, the SEC’s “10% price drop” is a filter with much too large a mesh.

As its staff paper spells out, on an average day from 2001 to 2009, a 10% trigger would have hit some 4% of covered securities – and nailed some 1.3% even during an interim period of supposed low volatility.

For a sympathetic but skeptical observer, government interference at the two-sigma level is just way too much. 

Not least, the administrative burdens on both market participants and the regulatory agencies themselves will be enormous, yet with no more than SEC's repeated say-so on the benefits to broad-based legitimate activity, while consuming energy and resources better deployed to the real problem cases.

Many examples demonstrate that where a sector’s violations emerge from a very small part of the population, enforcement efforts that are imposed universally achieve only massive waste and minimal effect -- where targeted programs would be more effective at far less cost and disruption: 

• Most modern automobiles are essentially clean and non-polluting; the bulk of vehicle emissions come from a very small number of “dirty” cars and trucks – which can be effectively identified by mobile, low-cost “drive-by” monitors rather than broad and expensive inspection programs.
• Recall the Clinton-era imposition on personal charitable donations, requiring useless acknowledgement letters that have done nothing but stuff files and eat up time, paper and postage while adding no benefit to IRS tax enforcement.
  
• Transportation “security” in the post – 9/11 era has reduced the effectiveness and civility of air and rail travel at every level, all to the anxiety and unease of the general public -- but at the imposition of full body pat-downs and loss of gels and toothpastes, has failed to identify dangerous shoes and underwear – when contrasted with the nearly-invisible (and when well-used) highly-focused intelligence.

And closest to the subject, as I asked recently (here), what good has been accomplished by all the expenditure of corporate and agency time and budgets required under the Sarbanes/Oxley law – ostensibly functional for six full years as of the undeterred collapse of Lehman Brothers and the worldwide financial markets oscillations that followed?

Recent research brings forth the learning that the causal factors for the types of problems cited above are not uniformly spread through a population, but cluster within a small sub-set of the whole – a proposition that calls for dramatic re-engineering of law enforcement and regulatory policy.

A good place to start would be with short-sale limits calibrated to the really impactful – not 4% per average day, but perhaps 4% per year – situations that would be recognizably dramatic, readily identifiable and agreed as worth attention on a consensus basis, while generally leaving alone both the markets’ longs and shorts.

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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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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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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.  

 

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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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