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While many of us have been focusing on mortgage
meltdowns, stock surges and inflation indicators, several of our
distinguished financial leaders have been looking for ways to improve the
marketplace.
Using the argument that rules tend to squash innovation and do little
to lure the rest of the globe to our financial shores, the call for more
principles and less regulation is quietly making its way out of the backroom
and closer to reality.
The gap between a principles and rules is quite wide. Rules imply a
lack of trust based on previous experience where trust has failed –
when no one was looking. And principles suggest that all of our corporate
leaders are men and women of character who would never mislead shareholders
or auditors with financial statements that were not really truthful.
Federal Reserve Chairman Ben Bernanke has been concerned of late about
this and he is not alone. With so many voices gathering together, does that
mean the strength of our financial system is truly in jeopardy?
The target of all of this fuss is Sarbanes-Oxley. It has been
mentioned with increasing frequency as the culprit, the legislation that is
effectively pushing foreign companies to other stock exchanges beyond
America.
The first attacks were made several years ago in a report by R. Glenn
Hubbard, the then Chairman of Council of Economic Advisers to President Bush
and has continued adding critics the latest of which include the Fed
chairman, Treasury Secretary Henry Paulson, S.E.C. Chairman Christopher Cox,
former S.E.C. head Arthur Levitt and former S.E.C. accountant Donald
Nicolaisen.
Evidently, the wind of change is finally blowing in the right
direction as the economy slows down enough to garner our attention. This
esteemed group of economic leaders has deemed the financial markets as
“in trouble” despite a seemingly endless advance in stock
prices.
At the heart of their crusade is the regulatory process that came with
Sarbanes-Oxley’s passage. It has forced companies to own up to their
financial statements or face penalties. These regulations are, they suggest,
the reason why numerous IPO’s are now making their way for less
regulated and somewhat wilder frontiers overseas.
Sarbanes-Oxley or as it has been lovingly rechristened, SarbOx has
been the focus of many unnecessary assaults. True, the initial cost of the
regulation was high but as with all costs associated when services utilize
technology, they are decreasing.
Productivity, as Mr. Hubbard once suggested in report dated October
23, 2002 is determined by amount of the restraint regulation placed on its
growth. And while it is true that reducing regulations may in some instances
increase productivity in many industries, in the field of business accounting
and corporate audits, the cost goes down as time moves on.
The accounting industry has streamlined the processes required by the
2002 legislation incorporating many of the requirements into their software. This is a classic example of technology
complimenting services. The accounting industry foresees those costs falling
further.
So what has spurred the
effort of late? Henry Paulson is the short answer. Believing that the
financial health of the United States is at risk, he has pointed the finger
at overregulation as the marketplace villain.
SarbOx, to its credit,
has forced over 464 restatements of earnings in the past three years. This is
quite the shift from the previous ten years, which saw a combined average of
45 restatements a year.
Several factors could be
at play in this latest attack on the regulation.
The cautious approach
auditors have taken of late is worrisome to Mr. Paulson. Unfortunately, the
reason for the heighten caution is not due to SarbOx but because of the
implied threat of litigation should those statements be less than factual. In
effect, the regulation the SarbOx has created for many accounting firms has
been overseen by the threat of shareholder action should they sign-off on
phantom write-offs.
According to CFO.com, the
reasons behind many of the restatements are almost always known to the
companies and hidden from the audit process. “Improper revenue-
recognition” is cited as a primary culprit in the restatement process
followed by “improper inventory valuations and inadequate allowances
for bad debt”. Mr. Levitt is no stranger to this type of restatement
calling it “accounting hocus-pocus”.
What really worries this
group is the crushing blow such accounting shenanigans have on a
company’s share value. Restatements can cause a stock to plummet and
this, Mr. Paulson believes is not very accommodative to overseas companies
looking to tap the US financial system.
Unfortunately, many of
the proposed changes are already taking shape. The S.E.C. is now in the
process of slicing and dicing the best protection an investor might have. The
simple fact that restatements have skyrocketed in recent years should be
reason enough to believe that the regulation is doing exactly what it was
designed to do.
Had principle ruled
rather than regulation and had it been the guiding light for the 157 companies
who restated over the past year taking another look at their financial
statements, we as shareholders would not have known that the house of cards
constructed by these principle-less corporate heads was outside of generally
accepted accounting practices. True, the value of these companies did drop
but that value was misrepresented as more than it was.
Changes in SarbOx will
not increase competitiveness in the US marketplace. The real reason for
foreign companies to list overseas dates back to a pre-SarbOx Congressional
action concerning litigation against companies who misrepresent themselves to
our capital markets.
Demanding strict
accounting allows our markets to thrive where principles are conveniently
thrown to the wayside. Robert Pozen, chairman of MFS Investment Management
recently suggested in a recent Wall Street Journal Op-Ed that
“regulatory system needs a mix of general principles and detailed
rules”.
That is exactly what is
in place now Mr. Paulson, Mr. Bernanke, et al.
As we inch closer to a global
marketplace, the rules and regulations guiding the US markets should be
adopted globally and not demoted in favor of a seemingly less lawless
system.
Principles can stand
taller than the regulations. But neither can standalone. Detailed rules
protect all parties and create a transparency that will prove to be enviable
to overseas exchanges. The risk may not be as attractive to foreign investors
but the result will protect many risk-adverse investors here in the US.
Paul Petillo
www.BlueCollarDollar.com
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