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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I see the point in arguing about the efficacy of Sarbox, however, at least due to the fact that it was in place, there is now documented liability on E&Y and the Engagement Partners that signed off on the reports.
Should be interesting to see what develops
Posted by: tweetivism | March 15, 2010 at 10:29 AM
Very nice post. Lehman's case is a "perfect" example of not only management fraud and regulatory weakness, but also of poor internal controls, and ineffective internal and external audit.
In 2002, before becoming the US Fed Chairman, Ben Bernanke pronounced that the world is getting more stable... in such a world we could indeed focus on fine-tuning. And this is all what SOX and Basel II did. But Mr Bernanke was very very wrong...
Posted by: Joe Erl | March 17, 2010 at 01:38 PM