Tuesday, February 20, 2007

The SEC's “Bullwinkle” Enforcement and the WABAC Machine

Peabody’s Improbable History [a regular segment on the Rocky and Bullwinkle shows] featured a talking dog genius named Mister Peabody who had a pet boy named Sherman. Sherman and Peabody would use Peabody’s “WABAC machine” (pronounced “way-back[,”] and partially a play on early computer brands such as UNIVAC and ENIAC) to go back in time to discover the real story behind historical events.


Using our own WABAC machine, let’s imagine the beginning of the year 2002: Enron has filed for chapter 11 protection, followed shortly thereafter by WorldCom’s chapter 11 filing (which then surpasses Enron’s chapter 11 as the nation’s largest bankruptcy). The Enron and WorldCom scandals involve accounting fraud on a grand scale. Then tick off the rest of the scandals, including Tyco, Global Crossing, and Adelphia. Market confidence plummets. Congress, in its rush to distance itself from those scandals, enacts Sarbanes-Oxley as a way to tighten up the reports from public companies.

We can spend a lot of time wondering whether Sarbanes-Oxley was even necessary or whether it’s deterred any new fraud. (Personally, I don’t think that Sarbox was necessary, and I doubt that it’s deterred any determined liars or cheats.) But as a symbolic gesture, Sarbox was designed to level the playing field a bit.

Part of that playing field involved the Private Securities Litigation Reform Act of 1995, which was Congress’s reaction to perceived litigation abuses in securities class actions suits. (Michael Perino has written a well-balanced empirical study of the aftereffects of the PSLRA, available here.)

In section 21D(b)(2), the PSLRA ratcheted up the standard of proof for a prima facie case:

In any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.
As any law student could guess, much rides on the interpretation of “strong inference.” Currently, there’s a case in the Supreme Court that should help to decide this interpretation issue. According to the Times (and other stories that I’ve Googled), the SEC is “considering ways to protect accounting firms from large damage awards in cases brought by investors and companies.”

Excuse me? Let’s go into that WABAC machine again. For a long time, we had the Big Eight accounting firms. With some mergers, we went to the Big Six, and eventually to the Big Five. One of those five was the late Arthur Andersen (killed by a successful firmwide indictment, then resurrected—too late—by the United States Supreme Court in Arthur Andersen LLP v. United States). Arthur Andersen gave us major accounting errors in Sunbeam, WorldCom, Waste Management, etc., and, of course, it gave us Enron. Now we have the Remaining Few.

None of the major public accounting firms is error-free, of course, and that’s the point. Reasonable mistakes are one thing, and those shouldn’t be actionable; aiding and abetting is something entirely different. Mind you, it’s the rare company that will police itself. The SEC is one of the two watchdogs the public has to monitor large-scale fraud, and litigation is the other. When the SEC wants to curtail the size of damage awards, it’s telling us that it doesn’t trust juries to weigh the evidence, and it doesn’t trust judges to keep out improper evidence.

What’s the reason that the chief SEC accountant gives for wanting to protect these remaining large accounting firms? Here's the theory: without the biggest firms alive and well, no one's going to be around to do the audits of public companies.

Here’s a suggestion: if the Remaining Few do such a poor job that juries award large damages in cases against them, maybe those companies shouldn’t be the ones doing the bulk of auditing. Maybe other firms could take their place.

I’m not saying that we should beat up on the Remaining Few. There are plenty of talented, ethical lawyers and accountants there, just as there were at Arthur Andersen. But if the Remaining Few get sloppy—or get captured, even after Sarbox has separated the audit and consulting businesses—why should the government protect them? What justifies placing the Remaining Few into a special category?

Mr. Peabody and Sherman used the WABAC machine to go back to famous historical events, interact with the key players, and then return to the present, always ending the episode with a bad pun. The SEC should use its own WABAC machine to remember how stunned we all were by the events of late 2001 and all of 2002. Maybe then it would change its attitude, which appears to be that money doesn’t grow on . . . pleas.

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