Re:Balance -- Jim Peterson

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Two roads converged in a wood.

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

Long I stood in the undergrowth.

……

I shall be telling this with a sigh

Somewhere ages and ages hence:

Two roads never converged

And that has made absolutely no difference.

 

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The 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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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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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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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.  

 

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.

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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On the Calendar: What Every Auditor Should Know About Litigation

The fall speeds on, and the calendar is packed. I am looking forward with enthusiasm to being at Baruch College in New York on Wednesday, December 2, for the Robert Zicklin Center for Corporate Integrity's 4th Annual Audit Conference, "Ensuring Integrity."

Information on the agenda and registration is here. It will be an interesting day, led by Professor Doug Carmichael and including senior staff members of the SEC and the PCAOB as well as representatives of the large firms.

I will be on the last panel of the day -- deliberately scheduled, I suspect, so as not to put anyone off their lunch -- "What Every Auditor Should Know About Litigation." Professor Carmichael will moderate, and I will be joined by Jim Sabella of the hot plaintiffs-oriented law firm of Grant & Eisenhofer, and Willkie Farr & Gallagher partner Mike Young, probably the accounting profession's best-known adviser/spokesman.

The content for our panel will be under development in the next few weeks. I have some ideas of my own -- but I invite you to write with your thoughts. What would you like to have addressed? On what litigation topics should auditors know more -- or other than -- they do now? For that matter, to bend the topic a bit, what should other constituencies know about auditor litigation.

I'll welcome and take up your suggestions -- and will report back later with more to say.

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Global Convergence of Accounting Standards? In Whose Lifetime?

A senior member of the fraternity of pundits touchingly spoke, recently, about one effect of the passage of time: “The older I get,” he said, “the more care and respect I have for the phrase “not in my lifetime…’.”

There’s a grain of sense -- however frustrating it is, that decent respect for the elderly means that we have to pay attention to the superannuated, however unwilling they are to surrender their microphones. Truth to tell, there is usually an inverse relationship between advancing age and advanced intelligence -- examples would be gratuitous but readily available on request – suggesting a requirement that pontificators come with staleness warnings or prominent display of a sell-by date.

That said, there is a recent media flurry around the long-dated estimate for convergence to a single set of global accounting standards – centering on the dialog between the Financial Accounting Standards Board in the United States, responsible for GAAP in that country, and the International Accounting Standards Board, responsible for IFRS as now mandated in the European Union and adopted to varying degrees in 100+ countries around the world.

The recent G-20 meeting in Pittsburgh was the context for a leaders’ statement by the great and the good, calling for completion of a convergence project in 2011 – a date also targeted for the US SEC’s decision to require IFRS adoption (for a helpful review of the state of play, see Edith Orenstein’s FEI Blog.)

Meanwhile in furtherance of the accounting profession’s party line, Ernst & Young’s global chief Jim Turley is quoted (in the Going Concern blog), flogging a single set of standards as “imperative.”

The chorus for convergence is not singing in unison. No critic is more trenchant or persistent than Tom Selling (The Accounting Onion) – although in an era of commentators’ ranting for ratings, sound reasoning and intellectual rigor have limited weight.

It matters much more that the reluctant Europeans will likely have their way. The Financial Times reports – here – that Henri de Castries, chief of French insurance giant AXA, views the setting of standards as “a matter of political sovereignty” and that French finance minister Christine Lagarde has put it to EU financial services commissioner Charlie McCreevy to “’ensure the safeguard’ of European public interest.”

Which sounds entirely like dressed-up cover for another version of the European capacity for protracted refusal to yield up national autonomy – foreshadowing a de facto continuation of country-based “mark to management” accounting, however pious the leaders’ pronouncements in favor of convergence.

Not that it may matter all that much, in a financial reporting world where comprehension and comparability are already elusive.

A generation ago, one of my then-colleagues – the world’s expert on accounting for complex financial instruments – maintained a list, on which he always included one entirely fictitious product. His standard wager of a full year’s bonus was that even a knowledgeable practitioner would not find the bogus item – and he never found a taker.

In practice today, he would say that there is already so much slack, judgment and overnight obsolescence in the tough issues of recording and reporting, even within single systems – whether the best-in-class among the major countries’ local GAAP or under IFRS itself – that the prospects for true convergence at any level of detail will remain perpetually elusive.

Add in the politically-motivated local vetoes being retained by the likes of the recalcitrant French, exemplified by the spirit of M de Castries and reflected in the measurements of European progress over spans of geological time: the deeply-embedded antagonisms and resistance recall the lesson from high-school geometry, that parallel lines only converge at infinity.

If only for these purposes, how delicious it would be if Ernst & Young were AXA’s auditors in France. Armed with the opposing attitudes of their bosses, if the client’s chief financial officer and the audit engagement partner were put to a debate on convergence, which one would emerge alive?   

One thing for sure – considering that the footnote in AXA’s 2008 annual report that sets out its choices and description of accounting principles already runs to sixteen pages (here): for anyone tempted to estimate a future date on which AXA might issue financial statements under a single converged set of globally-applicable accounting standards, it would be a safe bet to go with “not in our lifetime.”

 

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What To Read (Two): How To Know Today, "That's the Way It Is"

In a time when channels for the distribution of news and commentary are mutating faster than can be tracked, may I offer this suggestion:

The news feed of the Securities Litigation and Enforcement Group -- here -- gathers thirty sources giving concentrated attention to issues involving securities law, regulation, enforcement and litigation in the United States. It was developed and launched as an extension of the group's base on LinkedIn by Bruce Carton, who goes from strength to strength with his blog, Securities Docket, and his series of always-informative webcasts (latest, here).

The feed is a knowledge tool that would have been unknowable in the world of the old media. I am pleased to be included as a contributor -- and even more enthusiastic to recommend its breadth and depth as a vital resource.

(Note for non-US readers: the on-going deterioration in mainstream ex-US media coverage of these matters in that country makes this compilation all the more valuable for your benefit.) 

Being obliged this weekend to say a sad farewell to Walter Cronkite, those of us presumptuous enough to issue our thoughts for public consumption owe his memory the respect of a pause to consider the standards he set and against which we strive.

The gravitas of early broadcast journalism as led by Fred Friendly and Ed Murrow has given way to the bombastic posturing of Lou Dobbs and the politicized ranting of Rush Limbaugh and the sarcastic smirks of Rachel Madow. Just try to picture Walter Cronkite tracking the count of his Facebook friends, or Eric Sevareid reduced to Twitter. Imagination fails.

So -- that's the way it isn't. And we are the poorer.    

   

OK -- It's Agreed: There's a Crisis in Audit. So When Do We Get Down To It?

The city-bred sportsman hires a local fishing guide, who promises great results as they anchor in a remote spot. From the tackle locker, the guide pulls out a stick of dynamite, lights it, and throws it over the side. A huge explosion, and dozens of stunned fish float to the surface. As the guide nets the fish, the tourist begins to rant about poor sportsmanship and illegality.

The guide calmly lights another stick of dynamite and hands it over. “Are you going to keep running your mouth?” he asks as the fuse sputters. “Or do some fishing?”

Readers here are well advised to invest an hour catching up with last Thursday’s webcast, “2009 Mid-Year Review – Securities Litigation and Enforcement” (archived and available here).

This edition of Bruce Carton’s valuable extensions of his vital news source, Securities Docket, assembled four of the bloggers on my must-read list – Lyle Roberts (10b-5 Daily), Tom Gorman (SEC Actions), Francine McKenna (Re:The Auditors) and Kevin LaCroix (D&O Diary).

It was barren times for the subject indeed, back in 2002 when the Paris newspaper launched my financial and accountancy column. But since then the family of commentators continues to grow, who contribute substantially to the consensus of crisis in the entangled relationships among issuers of financial statements, their auditors, and the hyena herd of regulators, politicians and hostile lawyers.

Along with those noted above: Edith Orenstein (FEI Blog), Dennis Howlett (AccManPro), Tom Selling (The Accounting Onion), and Broc Romanek (CorporateCounsel.net) – and, with apologies, some I’ve surely missed.

The webcast is useful, on a variety of relevant fact-gathering and predictions; so too all the other increased attention. But concerning the on-going threats to the survivability of the large-company audit function, the discussion has yet to go past voyeurism, scape-goating and finger-pointing.

Here it is, seven years since the collapse of Arthur Andersen and the infliction of the ill-considered Sarbanes/Oxley law and its malign effects -- and two years and counting into a financial markets crisis of epic proportions. And not a constructive word is heard on the shape of the future.

Calling the dis-honor roll of those accountable:

The large firms’ leaders are handcuffed to a business model that they are powerless to change, under the combined constraints of the securities compliance regimes and their own partners’ appetites for the status quo of short-term profits. 

Their most vocal critics, among the commentariat, bay the cry of the profession’s self-serving venality, without taking even a first step down the path to re-design an assurance system now presumed (but not proved) to be important or worth working to save. 

The noisiest and most enthusiastic reader comments, meanwhile, range unconstructively from the punitive (“let them fail” and “jail them all”) to the self-destructive (“break up the Big Four” and “up with the little firms”) to the wildly impractical (“mandatory rotation” and “let the government do audits”).

Traditional debate platforms are empty. Former Treasury Secretary Henry Paulson’s Advisory Committee dissolved into insignificance without a trace, a year ago, behind a thin veil of posturing and animosity. The PCAOB, successful at least in perpetuating its own existence, is dribbling on the conflagration with an eye-dropper. Business lobbyists and academics alike are pre-occupied elsewhere.

And with no sign of a politician or a regulator in Washington or London or Brussels having either the vision, the interest or the initiative to take a lead, neither are there any other jurisdictions having the maturity or the salience to provide any influence.

The requirements for a useful forum ought to be within the grasp of the expanding collective of New Media mavens.

Ground rules and administrative questions should be modest enough: on-site or virtually distributed – freely accessed or modestly moderated to minimize the bickering and partisanship – live and real-time or via postings and dialog threads – open only to the credentialized or anonymous – sponsored or subscription or wide open.

Here’s the challenge: If this dynamite stick explodes, it will sink the boat and all in it. So it’s time to fish.

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Future Directions for Accounting and Audit: Can Anyone Get There From Here?

   

Recall the frustrated Irish villager, trying to direct a befuddled tourist toward Dublin:

        “If I was to be going there, I wouldn’t be starting from here at all.”

Last week came the news that Mark Olson is resigning as chairman of the American audit regulator, the Public Company Accounting Review Board.

Timely of Olson. He paddles away from a leaking ship, likely to be scuttled next year by a predictable Supreme Court ruling that the agency’s basic authorization under Sarbanes/Oxley back in 2002 was constitutionally flawed.

Also: Paul Boyle is departing as chief executive of the Financial Reporting Council, the United Kingdom’s audit regulator. Charlie McCreevy’s time is shortening as EU Markets Commissioner, whence comes what passes in Brussels for guidance on the topic. And Mary Schapiro and her crew of SEC newbies are fully pre-occupied with agency rehabilitation.

Along with the turn-over in all these seats, Treasury Secretary Tim Geithner this week may propose a “council of regulators” whose inevitable internecine squabbling will dilute even further the alphabet soup of American financial oversight.

So this long-pending question takes on renewed freshness:

Where is the leadership with the focus, vision and stature to bring about the fundamental and necessary re-structuring of both financial reporting and the related assurance – existing models having proved so ineffectual in the global financial crisis?

For dismal context, all this shuffling comes while a death-watch gathers around the continuing Bankest trial in Miami. There, a looming $ 522 million liability threatens to drop the final curtain on both the Seidman firm and BDO, its global network – here – proof to come that the mantra of “too big to fail” has no application to the large private accounting networks.

The likely legislative reconstruction in 2010 of a freshly-authorized PCAOB will present a one-time opportunity to write on a blank page, especially if Seidman has by then been hauled off to the knackers' yard. But the prospects are grim for grown-up guidance or perspective.

Certainly not from government. William McDonough, Olson’s predecessor at the PCAOB, left office in 2005 with the candid if pessimistic concession that “None of us (regulators) has a clue what to do if one of the Big Four failed”-- here. Four years on, and no clues have been revealed -- nothing has changed.

And as discussed almost a year ago – see here and here -- the gathering of talent known as the Treasury Department’s Advisory Committee on the Auditing Profession, convened by then-secretary Henry Paulson, limped into oblivion -- without managing even to agree that privately-provided large-company audits faced a serious threat to survivability, much less offering any hint of a blueprint for an achievable future.

Nor are there signs of life in the Big Four executive suites, where a managing partner would be deposed by immediate revolt for daring to propose serious change to the current model, creaky and obsolete as it is.

And the lobbying muscles flexed by issuing companies, over such contentions as mark-to-market and GAAP/IFRS convergence, have shown their allegiance to the status quo – preferring diminished transparency and reduced user value as the trade-off for their own control and dominance over the reporting and standard-setting process. 

The essential elements of a functional financial information regulatory structure are in principle not so complex:

•    Sufficiency of input to the setting of accounting and reporting standards.

•    Licensing and oversight of the audit function by which assurance is delivered.

•    Investigative and enforcement resources for the level of detection, prevention and deterrence of irregularity that society is prepared to pay for.

•    Finally, a last-resort structure for investor protection to supplant a liability regime that has run beyond the limits of sustainability.

Unhappily, the incremental nature of government evolution – including the certainty that the first priority for any agency is its own self-renewal and perpetuation – means there is only one true blank page: if the slate were wiped clean by the collapse of the Big Four networks and their consequential elimination as the only available source for large-company audit delivery.

That highly disruptive scenario is not one that any reasonable participant in the dialog could want or wish for.

But how else, the ominous question remains hanging, is a guiding force to come forth – one to map a future reachable by intelligent public exploration, discourse, negotiation and agreement?

As in the Irish village, there is no choice but to start from here. 

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Antagonisms Among the Audit Regulators -- A Warning Bell, or a Final Toll for the Profession?

There’s a gaping disconnect between the pieties on coordinated regulation of the global financial markets, espoused at last week’s G20 conference in London, and the contrary behavior of the national-level minions on the ground.

Recall Aesop’s simple little tales, where the Greek storyteller often leaves a hanging question. For today, it’s the conundrum that ends the debate among the mice -- just who is to bell the cat?

It is unremarked in fabulist scholarship that from the perspective of the large and dangerous cat, the rodents’ vacillations are inconsequential. Whereas, a seriously threatened interest goes unrecognized – namely, who is looking out for the cheese?

The same dissonance continues in the trans-Atlantic mouse-tussling among the various national agencies that claim to oversee the global accounting firms.

I wrote recently about the Securities and Exchange Commission as international spoilsport, for its hostile declaration that financial statements of a United Kingdom company would be unacceptable for American compliance, if using the legitimate UK rules permitting negotiated limits of auditor liability (here).

In so doing, I had missed an earlier shot aimed the other way. On February 19, EC Internal Markets and Services Commissioner Charlie McCreevy shut down further discussion about mutual recognition and reliance by the various national accountancy oversight bodies – here -- until the Commission receives the Obama administration’s views as to the attitude of the US regulators.

McCreevy may have a long wait.

Back in 2002 when the unfortunate coupling of Senator Paul Sarbanes and Representative Mike Oxley begat the Public Company Accounting Oversight Board, the world of regulatory oversight was not really crying out for the birth of a hegemonic American agency. But it got one anyway, under the “go it alone” attitude of the Bush era.

The resistance made it unsurprising that long-outstanding proposals on cross-border relations – here – have languished unapproved by the Americans:

•    From the passage of Sarbox down to date, as recently as PCAOB Chairman Mark Olson’s platitudinous speech to the Fédération des Experts Comptables Européens in December 2008 – here -- there has been no more than cosmetic attention to the unresolved issues of competing legal systems in such compelling areas as client confidentiality and personal data privacy.

•    Meanwhile the PCAOB has been obliged, faute de mieux, to adopt rules deferring its inspections of a roster of non-US audit firms, in the face of unfinished dialog to resolve the very outstanding issues that have been pending since 2002 -- here.

To an observer interested in the nourishment of international comity, the compound adjective “mickey mouse” is appropriate to characterize nearly seven years of murine antagonism.

While the regulatory mice play cross-border tit-for-tat, unfortunately, the world is not sitting still:

•    Last week’s billion-dollar lawsuit against KPMG by the liquidating trustee of New Century Financial (here) is not the first of the new wave of auditor mega-claims, but it does show that the predatory plaintiffs’ bar continues its aggressive prowling for appetizing targets.

•    And although troubling questions about the role of the accounting profession in the tumult of the global credit and financial markets have largely gone unasked, the question “where were the auditors?” is increasingly heard. There’s the business press – here. The always-trenchant Tom Selling (The Accounting Onion) is as skeptical on the dysfunctionality of accounting standards as I am about assurance. The idea of some form of nationalization is even floated, by both bloggers and academics -- here and here.

The American regulators cannot progress global auditor oversight on their own, beyond and despite all the threat and saber-rattling -- among other places, the PCAOB faces unsolved inspection impasses in China and Hong Kong. For his part, Commissioner McCreevy has put down the marker that continued American bluster means nothing more than further stalemate. But whether Mary Schapiro as President Obama’s new SEC head can cut a path out of the diplomatic swamp – or even wants to – remains to be shown.

This period of uneasy quiet is not a sign of stability – quite the opposite. Nothing has happened since the collapse of Arthur Andersen in 2002 to address, much less to reduce, the potential for a systemic shock to the franchise of privately-provided large company assurance. Yet the continued squabbling among the regulators makes plain their lack of vision or authority by which to collar the many challenges to auditor survivability.

All the while the deliverability of ostensibly valuable audit services to global-scale companies – the block of cheese in this little folktale – sits unprotected and exposed – nibbled away by hostile forces and showing signs of the furry mold of neglect.

Parenthetically, I plead no contest to the several weeks passed in sniffing out McCreevy’s statement, among the emanations from the bilge-pump of the European Commission’s publicity machinery. Oscar Wilde observed that when good American die, they go to Paris – while the city of Brussels, modest as its other virtues may be, must surely be the graveyard of effective regulators’ press.  

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Another Blow to Limited Auditor Liability -- A Non-Surprise from the SEC

As reported in the on-line Financial Times for March 10 – here – the Securities and Exchange Commission has declared that financial statements are unacceptable for US purposes, where UK companies have followed that country’s recent rules permitting negotiated agreements for the proportionate liability of their auditors.

The only surprise about the SEC’s position – which effectively slams the door on the world’s only remotely influential action affecting the large auditors’ deadly litigation exposure – is that it took so long to arrive.

The British initiative was uncertain enough from the outset, but was bound to be dead on arrival. It is not just that Washington’s attitude toward British rule has been revolting since 1776. London had every reason to see the SEC’s hostility right out in broad daylight.

For as I wrote last July – here – the new UK rules were “hostage to the unremitting hostility of the SEC to any attempts to reduce unlimited auditor liability exposure, as well as the uncertain application by US judges of limits contracted under foreign laws.”

Since the 1860’s, when Mr. Deloitte himself led the Victorian-era pioneers of independent audit in fighting off potential government take-over of their newly defined function, the principle has been established that auditor engagement and payment directly by clients were acceptable.

Despite endless futile debates since, no intellectually certain or solid basis has emerged upon which to measure the elusive and ever-shifting “appearance” of impaired independence (see here). So the SEC’s passionate history of opposition to auditor liability limits is matched only by its irrationality.

Which should be a signal to the stiff upper lips in London, whose fallback proposal is to seek the same package via British legislation: Forget it. Fold the hand.

Because the SEC is not about to accept limitation agreements, even in the doubtful case that the UK profession might succeed in shepherding an enabling law through Parliament, it is an immovable opponent. So move on to something productive.

Trans-Atlantic struggles over conflicting regulatory schemes are the common stuff of impasse. Look only at the state of extra-territorial examinations by the Public Company Accounting Oversight Board, still close to immobilized, nearly seven years after the passage of Sarbanes/Oxley, by cross-border conflicts over secrecy laws and client confidentiality. Or listen to the inflamed rhetoric with which UBS is opposing the identity disclosure of 25,000 of its clients – banking secrecy being one of the few topics to arouse observable dudgeon among the phlegmatic Swiss, even with the early signs of reluctant easing.

More importantly, even a UK “success” would be hollow. Proportionate auditor liability – along with its companion, monetary liability caps – are both politically unachievable in the US and, in any event, are ineffectual to solve the fundamental problem, namely the crying fragility of the auditors’ financial capacity to answer litigation claims of death-blow magnitude.

The capital structure of the Big Four partners can be calculated to have upper limits on a worst big case of under $2 billion – here. Yet the size of the recent failures that embroil the auditors extend from the Lehman Brothers bankruptcy, where with $635 billion of assets there is an estimated quarter-trillion dollar recovery shortfall, to the ever-shifting $50 or $67 billion involving the feeder funds to now-jailed Bernard Madoff – and lists of other claims, complex to maintain but readily accessible (here). 

With those numbers over-hanging, no reasonable Big Four chief executive could with confidence send a team of trial lawyers into court, with the life of his firm in their hands, but depending for survival on achieving a jury’s fault allocation at a percentage in the low single digits.

So – taking note of the dictionary definition of a chimera as “an impossible or foolish fancy” – the SEC’s entrenched if churlish animosity should inspire the large audit firms to re-deploy the well intentioned but misdirected resources they have devoted to this futile exercise.

For the large firms, “liability caps” is a losing position – whether as skirmish, battle or campaign. Better to select a ground for change on which there is some non-zero possibility for success.  

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Bernard Madoff -- Voyeurs Around the Investor Pool

There’s a rich new context for the aphorism forever linked to Warren Buffett, that “when the tide goes out, you learn who’s been swimming naked.” And it’s not a pretty sight.

In the social cliques of the Hamptons and around the pools of Palm Beach, there’s agony aplenty among those pink-cheeked with embarrassment at being fleeced by Bernard Madoff. It’s not just that he was one of their own, but that the credulous actually paid for the chance to be invited into the privileged circle of his victims.

As with so many of this decade’s scandals, the Madoff scheme differs only in scale from predecessors dating to time immemorial. The accounting shenanigans at Enron and Parmalat hark back decades to those of Penn Square and Equity Funding, and the subprime mortgage meltdown echoes the savings and loan debacle of the 1980’s. The methods of the schemers don’t change – only the number of zeroes.

Scam artists have forever used the same four techniques to skin their constituents, starting with the suppression of intelligence that goes with membership in a shared and exclusive community. The investment advisers who work over a church roster or an Elks lodge or a society of county dentists are no different from Madoff – and more’s fool the over-eager who suspend belief in favor of the comfortable but dangerously irrelevant rituals of insider familiarity.

The second tool is the “admission threshold” – the bogus entry ticket by which the victim is lulled into feeling special. As proved lately by the hedge fund stampede of the medium-rich, the enticement of “I’ll take your $5 million, although my usual minimum is $10” can be remarkably seductive.

Third, recall the 1989 tax evasion trial of the late Leona Helmsley, hotel queen and über-bitch that she was – an event defined by her pronouncement that “Only the little people pay taxes” – her cluelessly insulated attitude now revealed as extending to disregard and disrespect for the basics of skepticism and due diligence as well.   

Fourth and most pernicious, accountability and transparency are quashed by the enticement of secrecy: Returns may seem inexplicable, and strategies opaque –- but ask too many questions, or break the code of silence, and risk expulsion from the circle of initiates.

That model has ugly antecedents – the same coercive rules have enabled pedophile clergy, corrupt police rings and gangster clans.

If this late-arriving exposé of another “story too good to be true” does not exactly elicit outcries of sympathy for the lambs willingly prepared to be sheared by Madoff, some hostile reaction might well be directed at the banks and hedge funds who ran “feeder” funds, taking a fee rake-off with a compliant lack of curiosity at Madoff’s apparent lack of technology infrastructure, oversight or a comprehensible investment strategy.

The very concept of “funds of funds” has always suggested a structure designed primarily for the enrichment of the fee-collectors, especially for those with memories extending to the Geneva-based wheeler-dealer Bernard Cornfeld, whose 1960’s Fund of Funds had a Ponzi-like flame-out that differed from Madoff’s only in the size of his elaborate sales force.

Lastly, as for the notion of regulatory alertness or prevention of Madoff’s eye-popping piracy, it’s been clear for two years now that Washington’s bureaucrats would not recognize a crisis unless a Black Swan flew up and kissed SEC Chairman Christopher Cox on the ear. And in any event, with the Congress on the eve of adjournment and the Bush administration in its final exhausted weeks, its place-holders will be able to slink out of town before the forces of blame can assemble.

If past is prelude, there are two safe predictions as the Madoff story brings a sorry year to its welcome close.

The first is the safe but unfortunate bet, at this still-early writing, that at least one remorse-driven suicide will further color an already tawdry tale.

The second is that before the books are closed on the reporting of dismal corporate results for 2008, an entirely new multi-billion dollar operational and accounting scandal will erupt somewhere in the world – outside the investment scams and the already battered financial services sector.

That’s because with the tide already fallen so far, and still receding, the exposure means that the gauzy swimsuits peddled by the Emperor’s clothier are still in the process of dissolving.