Re:Balance -- Jim Peterson

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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Guest Post at the FEI Blog: When Litigation Kills the Accounting Profession -- Don't Say You Weren't Warned!

Edith Orenstein's FEI Blog is a "must read" -- a thorough and lucid map of the goings-on in Washington among the  legislators, regulators and agencies of law enforcement. I have the pleasure this week of taking up Edith's kind invitation for a guest post, while she is on vacation:

With the devilish details of the Dodd-Frank Act now to be worked out and many special interests weighing in, legislative activity in the American financial sector returns to a standstill – probably until after the elections of November 2012.

So what would bring to the forefront a topic that to most is sleep-inducing, although it keeps some few from sleep: namely, the very viability of the large accounting firms and their fragile franchise to audit the world’s global companies?

Nothing less, presumably, than an existential shock to the stability of one of the Big Four tetrapoly – an unresolvable criminal investigation or a “bad case” outcome in one of their nightmare civil cases. . . . . For the entire post, and to see the scope and quality of Edith's own work -- please see here.

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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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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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Repo 105: Was Lehman's Accounting Only Ticking Boxes? Or Is It A Ticking Box?

I’m not often inspired to take issue with my colleagues in the ink-distribution trade – mainly because the antics of regulators, politicians and senior leaders of business and the professions are usually more tempting targets. 

But the analyses of the bankruptcy examiner’s report on Lehman Brothers, released on March 14 (here), show a number of serious shortcomings in reasoning or conclusions – none so difficult to have gotten right as to be tolerable without comment.

Take the misperception repeatedly put forward by the Financial Times, that the “rules-based” nature of accounting principles in the United States, ostensibly contrasted with the broader principles as articulated in the United Kingdom, are effective to mitigate the large accounting firms’ litigation risk (see here and here).

Simply -- wrong. That a “culture of box ticking … helps firms defend themselves against law suits” is both unsupported and contrary to the accounting profession’s exposure to devastating claims in the American courts.

Empirically, first: the large firms have no track record of successful trial outcomes in the billion-dollar US cases that threaten their survival – precisely because their leaders cannot tolerate the risk of actually going to trial in a bet-the-firm contest before a jury.

Which, secondly, is for good strategic reasons: there is no legal defense or “safe harbor” in American law based on proof of compliance with professional standards – box ticked or otherwise – a proposition established in a criminal prosecution over forty years ago. 

The lightweight insight of the salmon-colored London press could be attributed to the appearance, as a matter of comparative jurisprudence, that British legal standards of liability might be more stringent. Superficially comparing the two forms of auditors’ opinion language on audited financial statements reveals a non-trivial difference: a UK report delivers the unmodified opinion of a “true and fair view,” whereas the American version speaks of “fairly presented in accordance with” applicable standards. 

But the difference is elided, and the far lower level of UK-based exposure is significantly explained, by the absence of an auditor’s duty to the general population of UK investors – where by contrast, auditors of companies issuing US-registered securities are exposed to the world, under its securities laws, for publicly-accessible statements determined to be false either affirmatively or by omission.

So the assertions of the Financial Times, that auditors’ reports are of “diminished authority” or “less valuable as due diligence,” must find their credible support elsewhere than in the professional standards. 

As they do – but which the FT does not grasp: the vulnerability of the profession’s core product – the assurance it delivers on its clients’ information -- is not reinforced by such legalistic assessments as are advanced in Ernst & Young’s letter regarding Lehman to its clients’ audit committees, quoted at length in Re: The Auditors for March 20.

Charlie Green’s Trusted Advisor goes a good way toward the reason why spin does not yield substantive relief: “’wrong’ is a moral concept, ‘illegal’ is a legal concept.” Yet – and this takes the last and necessary step – the conflation of the two can be deadly.

That is, the problem for Dick Fuld, Lehman and its gate-keepers including E&Y, is that the Valukas report is not the end of the process, but only the beginning: because there is no other forum for public moral accountability, the law courts are the venue of last resort.

And there, unfortunately, although E&Y’s last audit of Lehman was for fiscal 2007, its reports on Lehman’s first two quarterly resorts for 2008 (here) put it on the scene of the conflagration. Even if not full audits, they are all that will be necessary to underpin a nightmarish litigation exposure.

In other words, “not illegal” suffers a two-fold shortcoming in persuasiveness – being both irrelevant to and missing the point of a disturbed public moral sense, and requiring vindication through the trial process to be effective at law – a process for which in recent years the large accounting firms have shown neither the fortitude nor the resources. 

With the depth and complexity of its challenges posing issues of viability and survival, the accounting profession deserves better treatment in the mainstream media than it typically receives, including now under the Lehman spotlight.

Responsibility for typical press coverage that is both superficial and simplistic would not readily be laid at the auditors’ door, however, but for the profession’s own contribution through its reluctance to address with candor and clarity the unclosed gaps between its aspirations to a sustainable future and its role in an unsatisfactory current dialog.  

 

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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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Congress Looks at the Fall of Lehman Brothers: Was it a Sequel to Arthur Andersen?

For low-grade political theater, Monday in Washington was sadly typical: Richard Fuld, ex-CEO of the bankrupt Lehman Brothers, spent two hours under ritual excoriation by a panel of self-righteous legislators.

The play ran in several predictable acts:

•    The outlandish and unseemly “fairness” of Fuld’s nine-figure compensation history, in context of the firm’s disintegration and the erasure of equity value for public shareholders and trapped employees alike.
•    The absence of timely leadership responsibility and Fuld’s finger-pointing at exterior forces -- the rumor-mongers and the short sellers.
•    The whining over Lehman’s solitary fate, while the government supported “rescues” – if such they can be called – of such fallen institutions as Bear Stearns, Fannie Mae, Merrill Lynch and AIG.

Melodramatic scenes of tearfully innocent ex-employees hauling off boxes of personal effects and the pathetic invocation of antagonistic government treatment invite comparison of Lehman’s downfall with Arthur Andersen’s speedy demise in 2002.

They’re equally unfortunate, especially in the personal and systemic disruptions caused by the disintegration of once-noble institutions, but neither fits well the classic model of tragic definition.

Just as with the failure of Fuld’s leadership to admit the mounting evidence of compelling weakness in Lehman’s business model, the belated calls for stabilizing steps at Andersen came too late to escape its death spiral of departing personnel, fleeing clients and global structural break-up.

Likewise, Fuld’s invocation of the influence of darker forces corresponds with the self-inflicted aspects of Andersen’s demise, despite the clinging among members of Andersen’s alumni and sympathizers to a sinister plot line driven by vengeful prosecutors.

That is, while Fuld is chargeable with denial and delayed recognition of reality and a lack of credibility in his case for last-minute rescue, Andersen was reportedly perceived by the government prosecutors as a firm of arrogant and unrepentant recidivists and repeat offenders – not a tactful attitude conducive to amiable treatment by agents holding the power of indictment.

Finally, while the enterprise value of Lehman and Andersen alike rested critically on the continued repose of trust and confidence by both clients and personnel alike, neither management saw on a timely basis the fraying of the fragile fabric of reputation which -- once torn -- was damaged beyond repair.

The Lehman / Andersen comparison should not be pushed too far – Lehman became its own house of cards, for one thing, while Enron as a business fiction served that role for Andersen.

More to the point are differences as to the treatment of successor institutions. Last week’s US bail-out legislation and the programs emerging daily from other governments around the world amply demonstrate that “too big to fail” has broad resonance for the world’s trading and financial systems – for the benefit of troubled enterprises trailing in the wreckage of Lehman.

But for the surviving large accounting firms, confidence in their assured future viability remains a goal that has eluded the limits of their political and lobbying skills.

And in any event, the break-up and migration of the bankers’ brands, corporate structures and business teams – whether Lehman or any of the others – has no correspondence in the ability to preserve the Big Four’s private partnership organizations or their requirement for global presence to serve their large-company clients. 

Richard Fuld may be the least appealing villain of that name since Shakespeare’s king – who at his end at least had the consistency of character to go down in battle, crying, “My kingdom for a horse!” rather than “I’ll keep my millions – now where was my bail-out?”

But he was not redeemed either by the windy pontifications of the likes of Congressmen Henry Waxman or Dennis Kucinich – whose own troubled constituents might well have watched Monday’s posturings while wondering about their public guardians soundly asleep at the switches.

Meanwhile, the fates of both Lehman and Andersen make clear that vitality based on trust and loyalty will not survive the evaporation of either – in which case, it’s curtains.

Special thanks on this one for the advice and support of Charlie Green – whose general wisdom on these matters is at Trust Matters.

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