Remember all of that talk about how fair-value accounting was exacerbating the financial crisis? A new paper by Christian Laux and Christian Leuz examines that argument and concludes that it is "unlikely that fair-value accounting added to the severity of the 2008 financial crisis in a major way."
If you are attentive to qualifiers -- "unlikely" and "major" -- you can see that the argument is not a slam dunk, but the authors do a nice job of walking through the fair-value accounting rules and explaining the exceptions and safeguards that would have muted their effect. If you don't want to wade through the whole paper, you may prefer the blog post.
I read a WSJ op-ed last week, and it's still bothering me. The SEC vs. CEO Pay bubbles with outrage from its opening sentence: "A lawsuit filed on July 22 by the Securities and Exchange Commission (SEC) should send a mid-summer chill down the spine of every chief executive and chief financial officer of a U.S. public company."
What's amiss in corporate America, you ask? Well, the problem is a change in the SEC's enforcement of Sarbanes-Oxley Section 304, the clawback provision. Section 304 provides that if a company issues an accounting restatement "as a result of misconduct", and the CEO or CFO received bonuses or made money on stock sales based on numbers that were later proved to be inflated (thus necessitating the restatement), then those bonuses or stock sales could be "clawed back," i.e., paid back to the company.
Until recently the SEC only went after CEOs that perpetuated or were aware of the "misconduct" under 304, but a few weeks ago the agency sued a CEO without alleging that he himself engaged in the fraud. Russell Ryan, author of the op-ed, is outraged, asserting that the SEC has "stretched the law". But elsewhere he acknowledges that
in its haste to “do something” about the scandal of the day, Congress muddied the question of whether the “misconduct” required for such a clawback had to be committed by the executive himself (or at least known to him), or could be that of a subordinate, completely unbeknownst to the executive.
Because of these "muddy waters," it wasn't entirely clear what 304 meant, and "[m]any executives and legal advisers have cautiously assumed that bonuses and stock proceeds were at risk only for executives who actually engaged in misconduct themselves—or at least were aware of it and acquiesced." An all-too-familiar story these days: hasty legislation that leaves executives walking on eggshells, unsure of exactly what the law requires.
Ryan concludes: "On a visceral level, it seems shocking that a U.S. law enforcement agency could take more than $4 million from any citizen without so much as an accusation of personal misconduct, or at least knowing acquiescence in someone else’s misconduct."
Are my viscera out of step with everyone else's? I'm just not all that fussed. I mean you could interpret SOX 304 to say to executives, "If you get a bonus because you meet a goal, and it later turns out that the goal wasn't really met because someone messed with the numbers, then you need to give the money back. Even if you didn't do anything wrong, you didn't really earn that money." As I read them, this is how the newer vintage TARP clawback provisions work: financial institutions can recover any bonus or incentive compensation paid to senior executives based on statements of earnings or gains later proven to be materially inaccurate--no misconduct needed.
What's troubling to me is that the SEC suddenly changed its interpretation. After 5 years, expectations become settled, and changing course seems arbitrary. This point underlines the amount of discretion the agency has over enforcement, which might be the biggest lesson to come out of my recent work with Mike Stegemoller: there's the law on the books and then there's the law as enforced. But Ryan seems to me to be barking up the wrong tree by attacking the SEC's interpretation of 304. Or is my gut wrong?
Gordon pointed you to Donna Nagy's brief (and Larry Ribstein's) yesterday for the Free Enterprise Fund v. PCOAB case, in which she and a number of other eminent law professors point out the constitutional problems with the Board, which, they argue, is inconsistent with constitutional separation of powers principles.
I wanted to follow up a bit here, because the Board is a strange entity indeed - a pretty independent creature of the SEC, which is itself pretty independent from presidential control. There are not many (or even any) agencies set up like it. How did Congress think it up? I think the Nagy brief has an interesting point here:
So in other words, PCAOB is set up like an SRO, which is constitutional, but SROs are private entities, while PCAOB is a public entity. It is the public-private distinction which she thinks has tripped up the government - and it wouldn't be the first time. While I don't know if this is a dealbreaker, it is an interesting exercise in how laws get made by looking to the old models ... something that would be rationalizers of our financial regulatory system are realizing to their chagrin.
UPDATE: And yes again.
The Court just granted cert. on the case raising the question whether PCAOB's structure interferes with the President's removal powers. PCAOB's members can only be fired for cause, and are appointed by the SEC, whose members can also only be fired for cause. That insulates them from politicization, but conservatives think it interferes with the "unitary executive" theory by which the president must have a great deal of control over his bureaucracy, due to his responsibility for taking care that the laws be executed.
PCAOB survived D.C. Circuit review over a fiery dissent by a former aide to independent counsel Ken Starr. I don't think it is very difficult to justify the board on constitutional grounds - the unitary executive theory's best day was when Myers v. United States was decided, in 1926, and ever since, various impositions on the President's removal power have been permitted. But I'd bet on it being thrown out by this Court, given this grant, considering the plaintiff (a libertarian public interest group), and the bona fides of the dissent. PCAOB's defenders will have to make a strong case for the functional necessity of the agency (centrist justices may not wish to throw out a unit that is actually performing a critical function or two); that's what saved the SEC itself from the unitary executive theory during the 1930s. It also saved the independent counsel in the mid-1980s, much to everyone's regret later. HT: Volokh
UPDATE: Rick Pildes, who knows a great deal about separation of powers and has represented some former SEC commissioners in the case, makes the case for constitutionality over at Balkinization.
According to the WSJ, the Financial Accounting Standards Board (FASB) is changing its mark-to-market rules tomorrow, "allowing banks to set their own values for certain hard-to-value troubled mortgages, corporate loans and consumer loans...The change was meant to assist U.S. banks after bankers complained current mark-to-market accounting rules forced them to undervalue their assets, by setting prices at deeply discounted, fire-sale values."
The most alarming part of the article is the observation that there is a "disconnect" between this accounting change and the Treasury Plan for banks. Both try to address the central problem of valuing so-called
toxic assets legacy funds. Everyone seems to believe that these assets are "really" worth more than they're selling for now, and therefore that anyone who sells now is losing money they don't have to, because at least some will increase in value.
What do we want banks to do? Hunker down until the storm passes and the assets can be sold for more money than they can get now? If so, and banks are hindered by an accounting rule that forces them to "mark" them down to an artificially low "market" price, then FASB's change of heart could help them eventually see more money. But if we want banks to get rid of these assets, then Treasury's Public-Private Investment Fund (PPIF) could help banks. But then PPIF investors and taxpayers would get the benefit from the expected up-tick in value.
I favor the PPIF idea, on the theory that relaxing mark-to-market gives banks an incentive to "wait it out," rather than deal with the central problem of valuation and facing up to losses. Still, I'd hate to have sell anything--a house, a car, a teacher's manual--in this market. Actually, if you're looking for that last one...
The SEC has now chargedFriehling & Horowitz, P.C. with securities fraud in connection with acting as auditor for Bernard Madoff Investment Securities LLC. Press release here.
Whatever this accounting firm did since 1991, it didn't seem to audit anything in connection with BMIS. I can't even imagine a defense that the firm would have in a situation in which it signed off on financial statements that were completely fabricated. In the words of the press release: "Friehling essentially sold his license to Madoff for more than 17 years."
Early reports of accounting fraud at Indian outsourcing giant Satyam Computer Services sound eerily familiar:
The final blow came in the past few days. The lenders who had loaned money to Mr. Raju to keep the company running began to sell the pledged shares to meet margin calls, or the forced selling of shares to cover losses.
The leader for the WSJ:
The chairman of one of India's largest information technology companies admitted he concocted key financial results including a fictitious cash balance of more than $1 billion.10 years ago I was a lowly paralegal, fresh from an abortive career in literature, working on a securities class action against a California chip-maker. I had always thought business was mysterious and impenetrable, and that financial fraud must be sophisticated beyond my ken. It was a revelation that smart, powerful businesspeople occassionally decide that it's a good idea to make numbers up, trusting that "gaps" will close and everything will turn out okay in the end. I may be naive, or even gullible, but my reaction is still, "You really thought no one was going to notice? A billion dollars? Really?"
We've told you that valuing assets ain't easy these days. Indeed, "these the times that try one's sells" (love that line). Bainbridge thinks that the SEC advice on mark to market flexibility doesn't do anything. Larry Cunningham thinks it could, but it's a novel use of accountancy. Ribstein thinks it is corrupt, John Carney thinks it requires guessing how the government will price the assets, and well-known short James Chanos says that valuation flexibility will just mean that the banks overprice them more.
The SEC revisited its fair value accounting standards today, as Usha predicted. Here's the SEC statement, and Floyd Norris has insights here and here. We speculated that the bailout would eventually take a criminal tinge, Doug Berman agrees.
Since the collapse of Bailout 1.0, I've been wondering when critics would seize on mark-to-market accounting. It turns out that Newt Gingrich and Mark Cuban (never thought I'd use those two names in the same sentence) have been calling for a suspension of the rule. From Newt:
Mark-to-market accounting (also known as "fair value" accounting) means that companies must value the assets on their balance sheets based on the latest market indicators of the price that those assets could be sold for immediately. Under such a rule, declining housing prices don't just reduce the value of defaulting mortgages. They reduce the value of all mortgages and all mortgage-related securities because the housing collateral protecting them is worth less.
Moreover, when a company in financial distress begins fire sales of its assets to raise capital to meet regulatory requirements, the market-bottom prices it sells out for become the new standard for the valuation of all similar securities held by other companies under mark-to-market. This has begun a downward death spiral for financial companies large and small.
More foreclosures and home auctions continue to depress housing prices, further reducing the value of all mortgage-related securities. As capital values decline, firms must scramble to maintain the capital required by regulation. When they try to sell assets to raise that capital, the market values of those assets are driven down further. Under mark-to-market, the company must then mark down the value of all of its assets even more.
I'm not a tax gal. Anyone care to weigh in on this one? I know mark-to-market was the response to accounting hanky panky at Enron, WorldCom, et al. Was the cure worse than the disease?
Do you know that acronym? If not, you need to learn it. Moving the US toward the International Financial Reporting Standards will be a top priority of the new SEC commissioners -- including Troy Paredes -- once they are confirmed later this year. The Senate Committee on Banking held hearings on the new commissioners on Tuesday, and Chairman Dodd gave the right signals for confirmation: "I want to get people in place and start making decisions. Too much is at stake with this housing mortgage crisis, the economic crisis.... The SEC needs to function. We've got some huge issues out there."
The SEC hasn't abandoned its ever faltering mutual recognition efforts for foreign regulators and the markets they supervise. The last time it tried this seriously, the agency only got as far as Canada - sorta. But perhaps globalization - and the new impetus to harmonize accounting standards - will prove more inspiring this time. Here is the SEC's plan going forward:
The Commission contemplates taking the following actions:
- Exploring initial
agreements with one or more foreign regulatory counterparts, which
would be based upon a comparability assessment by the SEC and by the
foreign authority of one another's regulatory regimes.
- Considering adoption of a formal process for engaging other national regulators on the subject of mutual recognition. This process could be accomplished through rulemaking or other appropriate mechanisms, possibly informed by one or more initial agreements with other regulators.
- Developing a framework for mutual recognition discussions with
jurisdictions comprising multiple securities regulators tied together
by a common legal framework, including Canada (which has no national
securities regulator, but rather provincial regulators) and the
European Union (whose national securities regulators are subject to
supranational legislation and directives).
- Proposing reforms to Rule 15a-6 in order to improve the process by which U.S. investors have access to foreign broker-dealers.
Eat your heart out, Larry! I am sitting in a room filled with accountants at the BYU Accounting Research Symposium. The presenters are mostly doctoral students and new faculty, and one of the express purposes of the symposium is to provide feedback on early-stage work, so I won't blog about any particular projects.
Two quick observatons. First, though I was an accounting major as an undergraduate at BYU, this is my first academic accounting conference of any kind, and though the nature of this gathering is unusual because of its focus on work by newbies, I am pleasantly surprised by the level of audience participation. Lots of comments and questions. This must be a great help for the presenters.
Second, lots of law-talk in the papers and presentations. SOX, Reg FD, and other securities regulations of all kinds have a prominent place here. Very easy entry for an securities professor with some knowledge of accounting.
P.S. Former Conglomerate guest blogger Darren Roulstone is sitting nearby and is an active participant in the discussion. He is obviously a rock star here, no doubt because of his guest blogging.