Re:Balance -- Jim Peterson

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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Seidman Gets a New Trial in Bankest -- And How Does Winning Feel?

“Never mud-wrestle with a pig. You end up covered with pig-shit. And the pig actually likes it.”

There was palpable relief on June 23 in the halls of international accounting network BDO’s firm in the US, née Seidman. The Florida Court of Appeals, reversing a potentially devastating $521 million jury verdict, ordered a new trial of the claims by Banco Espirito Santo relating to alleged faulty audits of the irregular accounts of Seidman's factoring company client Bankest.

Updating earlier attention to this threat hanging over Seidman’s existence since 2007 (here, here and here), it is now right to look beyond the predictable chest-thumping press releases of the adversaries (see here), and contemplate just who has won what.

Notably, to start, Seidman lives to fight on.

Even though the opinion (available here) makes clear that the appellate court would not have let stand the $321 million in punitive damages imposed by the jury for its finding of Seidman’s egregious conduct, the Seidman firm was still facing disintegration. Being forced to pay only the $159 million of compensatory or “ordinary” damages would have inflicted on its 273 partners the unsustainable obligation to work for nothing for a year or more (based on industry profit margin data and Seidman’s reported fiscal 2009 revenue of $620 million - here). 

Dealing not with the merits, but only with the defects in procedure it found in the lower court’s trial management, the appellate tribunal held that the claims of Seidman’s grossly negligent conduct were inextricably “intertwined” with issues of “causation, reliance, and comparative fault” – that is, in lay terms, that Seidman’s allegedly bad behavior should have been evaluated by the jury in context of the bad behavior of all the other actors in the sordid story of Bankest.

So the press-release confidence of Seidman’s CEO, that it “acted at all times consistent with its professional obligations,” has been neither established nor vindicated, but remains to be re-tested in another fulsome public proceeding.

As for the Banco plaintiffs, the obligation to re-try the case is another reminder of the lawyers’ caution, to be careful of getting your wish from a trial judge. A lawyer who rings the bell for a huge jury verdict, when the judge has put the bell-rope in his hands, may walk with a little more clank in his swagger. But a judgment only really counts as bankable when affirmed on appeal and collected.  

And while both sides will claim to have learned of their courtroom strengths and weaknesses from the original trial, the very rationale of the appellate rulings that require a new trial also gives a road-map for the other side by which to by-pass the perceived speed-bumps the first time.

So with the learning process a bi-lateral one, another go-round will feature re-treaded strategies on both sides.

Which reinforces the attitude of courtroom veterans, that second trials have the inevitably stale air of re-cycled themes, witnesses and evidence – the very reason they happen so seldom.

That sentiment plus traditional analysis suggest that, under the appellate court’s signals about the extent of the penalty against Seidman that it would sustain, the parties will reach a settlement – one that to Seidman would be highly painful but tolerable – in effect, the number of months its partners might stand to work without take-home pay before they bolt for the exits.

On the other hand, trials of life-threatening claims against the large accounting firms are so rare as to make impossible either patterns or reliable predictions.

The Florida court did make one observation of unintended and presumably un-ironic import:

“An accounting firm that must distribute its net income and net worth to judgment creditors rather than the partners who produced that income will not have partners (or clients) for long.”

In other words, even a small state’s intermediate judiciary recognizes that so long as the large accounting networks are put to the hazard of litigating for their survival, the entire global franchise of privately-provided assurance is at risk.   

Critics of that structure, who in essence dispute the very legitimacy of the firms’ business models (here), remain challenged to articulate an achievable alternative that will offer sustainable value to the community of financial statement users.

If the prolonged and now-extended agony of Bankest teaches nothing else, it is that the auditor-viability dialog is still not satisfactorily engaged.

 

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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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Drilling Down Into BP's Risk Management: A Process As Blown As The Well

“I never went to bed with an ugly woman. But I’ve sure woke up with a few.”

-- Country songwriter Bobby Bare

The failure of BP to “top kill” the Deepwater Horizon well brings to mind Blaise Pascal’s difficult question, how to strategize the unanswerable question whether God exists.

As he came out, to assume the positive and be right is marvelous, and to be wrong is of little effect; to assume the negative and be right is no worse than neutral – but to be wrong is damning.

Looked on as a matter of risk management – rather than as a much-debated philosophical or spiritual conundrum – Pascal’s challenge sits on top of the list of lessons from the events just ahead of the catastrophic blow-out in the Gulf of Mexico.

That is, if it were a final examination question in my MBA class – where we search for the lessons from failures in decision-making across a broad range of business and personal activity -- it would be hard to improve on the Deepwater Horizon disaster. The catalog of avoidable errors in analysis and performance is long and troubling – for example:

• Increased safety measures can mask heightened risk, especially where early signs of trouble are ignored as “close calls.”
• Increased complexity of technology alters the risk profile at the frontier of safety margins. 
• Management over-ride of on-the-spot warnings discourages honest communication and conceals bad news under the pressure to deliver success.
• Group-think and herd behavior are exacerbated by the over-confidence that mistakes past achievement for future safety.
  

Briefly put, the central theme in BP’s failed process was the consistent mis-measure, in its concededly risky choices, of Pascal’s potential up and downside gains and losses – related to what the statisticians confuse us all by referring to as Type 1 and Type 2 errors.

Examples abound, from the modestly consequential to the highly destructive. Consider:

A driver is low on gas. If he chooses to stop immediately, he gains the certain security of a full tank, foregoing the possibility of a modest savings. Whereas, if he carries on in search of a station with a lower price, his maximum upside is a few dollars gained, but his downside is to be marooned awaiting rescue by the roadside, or worse.

Or this: The space agency NASA must decide whether a shuttle launch can safely proceed in cold weather. Postponement to a warmer day means a modest loss of time, for the sake of mission safety – whereas pushing for a “go” decision can at best achieve budget and reputational success, but only with the risk that the frigid conditions will cause an explosive failure of the rocket’s booster (q.v., the 1986 loss of the shuttle Challenger and the lives of its seven astronauts).   

How extensible are the lessons of BP’s questionable decisions – the use of a riskier well casing, under pressures of time and budget, or the premature substitution of lightweight seawater for heavier drilling fluid, under delays costing $500,000 per day (here)?

At the level of individual risk tolerance, consider two insurance scenarios: Taking a pass on auto collision insurance saves the premiums, and puts at risk only the replacement cost of a total wreck. But choosing not to buy long-term health care insurance runs the uninsured risk of a debilitating and devastatingly expensive illness.

Or for investors: excess portfolio concentration in pursuit of incremental performance ignores the question, “How bad could this possibly get?” – as learned to their sorrow by Bernie Madoff’s clients and employees with their savings in Enron’s retirement program.

Consequences vary. Pick a bad restaurant, and the only loss is an evening’s sub-standard dining. But fail to hedge a naked short, and the losses could be ruinous. 

Corporate risk management depends for success on similar decision-making dynamics: Is a bet-the-company strategy acceptable? Is it even recognized?

Whatever the assessments made by Bear’s Jimmy Cayne or Lehman’s Dick Fuld or Countrywide’s Angelo Mozilo, they mis-evaluated their exposures to disastrous downsides – no less than the bureaucrats of NASA or the over-seers at BP.

On the other hand, betting Pascal’s wager the wrong way risks the wrath of an angry deity – which in the long run may be worse.

 

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