Should “proactive” duties on be imposed on lawyers to investigate the financial statements of their clients? After the collapse of Enron, due in part to dodgy securitization deals that had been reviewed by lawyers at Vinson & Elkins, a number of academics have voiced support for something like a “duty to investigate” their clients. Your guest blogger is on an Enron kick, so I thought I’d be remiss in relating at least part of the state of play, as seen by this only vaguely informed observer.
I recently attended a stimulating lunch talk by Steven Schwarcz, in which he weighed the merits of a proactive paradigm against a “reactive” approach, which could trigger duties for further inquiry by lawyers, but only once a specified – and limited – series of conditions were met. I won’t try to characterize Steven’s views – his paper will be available soon, and this piece touches on similar issues – but it strikes me that there are functional differences between accountants, who often have on-site teams working with their corporate clients, and lawyers, who are – perhaps – more likely to be hired for discrete matters, like the review of a series of securitization deals.
So would efforts to make lawyers do more investigating change the traditional relationship they have with their clients? And if so, how – getting right to the point – would it affect fees? Perhaps Enron’s collapse will in fact be a beautiful thing for corporate lawyers.
For William McDonough, I assume that (relative) anonymity is a sign of success. He was appointed to chair the Public Company Accounting Oversight Board (PCAOB) in the wake of the SEC's mishandled appointment of William Webster. While the PCAOB has not run without controversy, that controversy has swirled around an honest and healthy debate about the proper regulation of auditing firms, not about the integrity of the regulator. That is as it should be. Now McDonough is resigning, and the SEC will appoint a successor. The glare of public attention has mostly faded, but I will be watching.
That is the breaking news on the W$J.
The executive summary: the collapse of KPMG would be a bad thing, and even though KPMG is hypocritical (for firing the head of its tax-services division and two partner/board members), this whole controversy over fraudulent tax shelters is overblown.
The settlement was reportedly reached yesterday and will be announced publicly on Monday.
Here is an interesting study of the publication records of 212 faculty who were promoted from assistant professor to associate professor or from associate professor to full professor at the top 75 accounting research programs from 1995-2003. The study was motivated by the observation that "accounting scholars have relatively fewer publication outlets and fewer publications than colleagues in other business disciplines." (Why is that?)
Some of the results ...
* The promotion track for accounting professors is substantially longer than for law professors. "On average, professors included in the study took 6.29 (std. dev. = 1.2, median = 6.0) and 11.78 (std. dev. = 1.65, median = 12.0) years to achieve rank advancements to associate and to full, respectively." Although law schools vary, I would guess that those numbers are 4 years and 7-8 years, respectively, with the tenure decision coming after 6-7 years.
* Professors at top schools placed more articles in top accounting journals, but published fewer total articles than their peers at lower-ranked schools. The authors observe, "Consistent with commonly-accepted anecdotal evidence, these results suggest that professors at top schools focus their efforts on publishing articles in academic journals considered the highest quality rather than publishing a greater number of articles in professional or other academic journals."
* No matter how many articles you publish, you had better get some of them in top journals if you want to be promoted. "At the time of full promotion, every professor in the study had published at least one article in a journal ranked in a top 15 or top business journal and only about 5 percent of the promoted full professors in the study did not have a top 3 or top business publication at the time of promotion. At the high end of the spectrum, more than 15 percent of the promoted full professors had published 10 or more articles in top 3 accounting or top business journals and almost 30 percent had published 10 or more articles in a top 6 accounting or top business journal at the time of promotion."
One of the biggest differences between publishing legal scholarship and publishing business scholarship is that law journals do not have the same well-recognized hierarchy as other disciplines. As I explained here, we tend to think of the journals as falling into relatively rough prestige groupings that are highly correlated with the prestige of the sponsoring institutions. Also, we tend not to make strong inferences about the quality of scholarship based on its placement within the hierarchy because students are making the publication decisions without reference to well-accepted methodological standards. Of course, all of this strikes our colleagues in other university departments as insane, but there it is.
I was interested in the authors' observation that accounting scholars tend to have fewer publications than other business scholars. (Associate professors at top schools have roughly 6-11 publications and full professors have 15-21 publications.) These numbers seem high relative to law professors, who do not have a tradition of publishing co-authored articles (though that is becoming more common) and whose articles tend to be ridiculously long.
A common question following the revelation of accounting frauds (such as those at WorldCom and Enron) is how such frauds developed within the complex U.S. system of accounting regulation. One answer is that accounting rules themselves are the problem; or rather, the reliance on a rules-based system contributes to complicated schemes designed to get around the rules.
A nice discussion of this idea is found in the congressional testimony of Roderick M. Hills (Chairman of the SEC from 1975-1977) in a hearing on "Accounting and Investor Protection Issues Raised by Enron and Other Public Companies." Hills argues that today's regulatory environment lays out precise rules that simply provide executives with guidance on what they can get away with. Hills quotes Paul Brown of New York University's accounting department: "It's the old adage of a F.A.S.B. rule. It takes four years to write it, and it takes four minutes for an astute investment banker to get around it."
And given the existence of the rules, getting around them is seen as acceptable: "The system has been so precise so many times in saying what cannot be done that it has created an implication that whatever is not prohibited is permitted. In law school this phenomena has long been known as: 'Expressio unius exclusio alterius.' "
Hills also cites my colleague Roman Weil, who has made similar arguments: "Weil, Professor of Accounting at the Graduate School of Business of the University of Chicago...has pointed out that today auditors, confronted with a somewhat different transaction, ask either FASB or the Emerging Issues Task Force (created by FASB and the SEC) for a new rule. Instead of making their own judgement drawn from a conceptual framework, they seek the comfort of specificity..."
Hills states: "The sad truth is that the profession has lost sight of the significance of the signature line of the opinions they give to all their clients. That line reads: 'In our opinion, the financial statements [prepared by management] fairly present, in all material respects, the financial position of the company.' Today that broad statement means only: 'We have looked but have found no material violation of applicable rules and regulations.' Auditors should be more willing to qualify their opinion by saying: 'The company has satisfied all the rules but its financial statements do not fairly present its financial position.' "
Hills goes on to discuss the role of audit committees in preventing fraud as well as possible solutions to the problem of "too many rules." One cautionary note: Although I mentioned WorldCom at the start of this post, it is not a good example of this problem. WorldCom concerned a blatant mis-application of accounting rules. Enron, in contrast, involved (among other things) complicated structures designed to satisfy the rules even though they mis-represented the company's financial position. Roman Weil described this contrast wonderfully: "Enron is complicated; WorldCom is something we teach in week one."
One of the potentially big innovations in SOX was the creation of the Public Company Accounting Oversight Board (PCAOB), which has been relatively quiet (except for the bit about internal controls) since the kerfuffle surrounding the appointment of William Webster as the Board's first chair. Things may be about to get more interesting, as the SEC inadvertantly disclosed a PCAOB investigation of Deloitte & Touche in connection with the audit of Navistar. This is the latest in a string of bad news stories for Deloitte, which include a big fine in the Adelphia case and an adverse ruling in the Parmalat litigation.
In addition to creating additional questions about Deloitte, this action raises questions about the effect of PCAOB sanctions on accounting firms. If the PCAOB imposes sanctions here, it will be the first such action against one of the Big Four. (The PCAOB's first disciplinary action is discussed here.) How will Deloitte's clients react? It seems to me that the PCAOB needs to find a means of enforcing the accounting standards without making one firm seem much worse than the others ... unless, of course, that one firm is much worse than the others. Interesting that Deloitte is the only Big Four firm that did not change its business model after Enron to split consulting and auditing. Is that relevant here?
Thanks to the White Collar Crime Prof Blog for the tip.
By the way, my friend Donna Nagy just published an article entitle Playing Peekaboo With Constitutional Law: The PCAOB and its Public/Private Status, in which she writes:
In creating the PCAOB, Congress provided the Board with a guaranteed source of funding, the means for subpoening documents, official immunity from civil liability, privileges from third party discovery, and a comprehensive system of oversight by the Securities and Exchange Commission (SEC or Commission)....
Notwithstanding its governmental creation, its governmental objectives, its governmental powers and privileges, and its governmentally appointed Board members, Congress established the PCAOB as a private, not-for-profit corporation. Congress’s determination to situate the PCAOB in the private sector could not have been clearer. In a section entitled “status,” the Act provides that “the Board shall not be an agency or establishment of the United States government and that “[n]o member or person employed by, or agent for, the Board shall be deemed to be an officer or employee or agent for the Federal Government by reason of such service.” The PCAOB’s public/private status renders its sardonic nickname “peekaboo” more than a bit profound.
Richard Scrushy was acquitted of all charges in his criminal trial but he's not off the hook yet. Two years ago, the S.E.C. pressed a civil case against him that has been on hold for the duration of his criminal trial. His acquittal has now given the green light for the civil case to resume.
According to the Wall St. Journal, the civil case alleges "accounting fraud, insider trading, and other violations." The sought for penalties are huge: "The SEC is seeking $785 million in civil fines and restitution to shareholders plus interest from Mr. Scrushy...".
Another twist in the Scrushy saga is his pursuit of his former position at HealthSouth, a job he lost when the fraud came to light. Scrushy has stated he wants his old job back to which the current CEO, Jay Grinney, replied: "[the] board has made it absolutely clear under no circumstances will he be coming back in any form or fashion." That prompted this statement from one of Scrushy's lawyers: "If I was Mr. Grinney, I would keep a moving van close to my house because he's never been in a fight with us. And we know how to fight and win." The SEC's civil case may make the fight moot; in addition to the fines, the SEC is seeking "to have [Scrushy] barred from serving as an officer or director of any publicly traded company."
And last, all of this is in addition to a possible trial on perjury charges stemming from his comments to the SEC when the HealthSouth fraud was first investigated. When I think of Scrushy's lawyers and the business he gives them I'm reminded of the hot dog vendor who follows Homer Simpson around. When Marge asked why he keeps showing up, the vendor replies: "Lady, he's putting my kids through college!"
It's not exactly the next Enron, but Krispy Kreme is well on the road to accounting scandal infamy. I have been getting calls from reporters recently to comment on Krispy Kreme because I wrote a case study of the company for my casebook. Yesterday, the company lost six more executives as a result of an investigation by an independent committee of directors.
When Krispy Kreme was on the rise, I posted on The Battle of the Fads: Krispy Kreme v. Atkins Diets. Now it appears that Atkins was not Krispy Kreme's only problem. According to the W$J, "Other areas being probed include the accuracy of a company profit warning in 2004 that blamed low-carbohydrate diets for slowing growth in doughnut sales." It looks like waistlines are not the only thing being padded by Krispy Kreme.
Last year, about one of every eight public companies retained three or more Big Four firms for audit and nonaudit work, according to a survey of 400 companies by J.D. Power & Associates. A July 2003 report by what is now called the Government Accountability Office found that the Big Four -- KPMG, Deloitte & Touche LLP, Ernst & Young LLP and PricewaterhouseCoopers LLP -- audited more than 78% of public companies in the U.S.
This looks like an opportunity for an accounting entrepreneur to create, probably via mergers and acquisitions, a new "big" accounting firm.
The WSJ reports today that the DOJ is threatening individual partners and KPMG the entity with indictments regarding the sale of abusive tax shelter products and (of course) obstruction of justice. These musings may be designed to elicit a settlement from KPMG because indicting KPMG may be a little like catching a tiger by the tail. If KPMG is treated with the same fate as Arthur Andersen, then the number of large public accounting firms will drop to three, bad news after SOX created a string of work for public accounting firms. So, even if KPMG is more worthy of indictment than Andersen, the firm may escape simply by virtue of being second. Prof. Ribstein and Prof. Bainbridge have also weighed in here and here.
I am intrigued by the fact that a company may be sufficiently innovative and entreprenurial to create a legal scheme designed to reduce taxes, but when the scheme is later declared "abusive," the company can then be served with a criminal indictment. Was the scheme clearly abusive from the beginning? Did the scheme clearly violate a tax code provision, regulation, bulletin, revenue ruling or private letter ruling? Did KPMG attempt to get a private letter ruling? I get the feeling that we encourage tax accountants and tax attorneys to distinguish themselves by being creative with tax planning, but if they get to creative and cost the treasury too much money, then we threaten indictments.
In our exchange about the Andersen case (Gordon then Larry), Larry Ribstein chided me for missing the big picture. In addition to our public exchange, we had an email exchange on the real lesson that we should learn from Andersen. In Larry's view, Andersen now stands as a symbol of the folly of corporate criminal liability. I agree that Andersen has symbolic value, but I would define it slightly differently than Larry.
Some people have been framing the question in terms of Andersen's "vindication," though I have never seen Larry take this tack. Christine doesn't go that far, either, but challenges Steve Bainbridge's point that Andersen's collapse was just desserts because it was a rotten egg anyway. (This reminds me of reactions to the realization we wouldn't find WMDs in Iraq, but that's another story.) Let's make this simple: the vindication angle is misguided. The obvious point here is that the Supreme Court did not exonerate Andersen of wrongdoing, but held that the jury instruction under which it was convicted was infirm. Moreover, as noted by Steve Bainbridge, Enron was not Andersen's only troubled client. "Vindication" obviously overshoots the mark.
If not vindication, then what? Larry emphasizes the fact that Andersen was a unanimous decision, and I agree that this could be an effort to signal the Court's disapproval with the DOJ for bringing this case. But for Larry, this is about more than one prosecution, it is about the senselessness of corporate criminal liability. In his initial reaction to the decision, Larry wrote: "this is yet another nail in the coffin of the misbegotten idea that corporate criminal liability is the way to better markets." The big lesson from Andersen for Larry, therefore, is that the government should not use criminal law as a corporate governance mechanism.
When I first posted on this case, I observed, "Although the resolution of these issues will have important legal consequences, the case is more important for symbolic reasons." I still think that was right, and I understand Larry to be advocating for a particular symbolic interpretation of the case. Is he right? I just looked at the opinion again, and nothing in the Court's decision would lead me to read the case as an overarching condemnation of corporate criminal liability.
If I read Andersen partly as a symbolic gesture by the Court, I would read it more as a condemnation of the post-Enron regulatory ferver than as a general repudiation of corporate criminal liability. The government's case against Andersen was not extremely strong (though I think it's possible that Andersen would have been convicted even under the stricter jury instruction mandated by the Court), and the Court's message seemed to be: you need more than that for a criminal conviction!
The difference between my view and Larry's view has to do with the future of corporate criminal liability as a means of corporate governance regulation. Larry would rely primarily on markets supplemented by the threat of civil liability. I remain open to the possibility that corporate criminal liability can be useful.
[T]he government's prosecution of Andersen did not deter professionals from helping their clients engage in risky transactions. That is why such deterrence should be left to the markets, which are much better than the government at efficiently sorting out the type of risk that is good from that which is not.
In response to such reasoning, I wrote:
In my view, it is not enough to say that criminal law isn't good at policing agency costs. The question inevitably follows: compared to what? In this case, the issue is whether the threat of criminal sanctions can accomplish something that is not accomplished by markets or the threat of civil liability. In my view, the jury is still out.
Comparative institutional analysis simply is not as easy as Kirkendall implies. The fact is that no mechanism will completely "deter professionals from helping their clients engage in risky transactions." We are choosing among imperfect options, and as the complexity of the task increases, all of the options find deterrence correspondingly more difficult. For a more sophisticated analysis of the tradeoffs, see -- guess who? -- Larry Ribstein!
My MarketWatch email alert system tells me that the Supreme Court has overturned the Andersen conviction. The WSJ has just posted a quick blurb as well and adds that the opinion was unanimous.
Gordon gave his thoughts earlier here, and I talked about the cert grant here. Note (ahem) that I predicted a reversal based on opinions of others. I am happy with the result, mostly because I am very skeptical of the trend of prosecuting corporate crime using "second order" charging crimes. So far, the prosecutions of corporate scandals of this century have added nothing to the jurisprudence of corporate crime, only to the fine art of obstruction of justice.
Of course, how do you reverse a death penalty that has already been inflicted? This reversal is as heartwarming as your high school boyfriend confessing that now that he thinks about it, he shouldn't have broken up with you. Thanks.
I just finished writing the teacher's manual for the chapter on SOX in my casebook, so I am particularly attuned to stories about the Public Company Accounting Oversight Board. The W$J is reporting that the PCAOB has taken its first disciplinary action, "stripping auditor Goldstein and Morris CPAs of
its registration and barring the New York firm's co-founder from audits
of public companies." The problem was that the firm both prepared and audited the financial statements of two public companies, New York Film Works Inc. and RTG Ventures Inc. Sort of rips the "independence" right out of "independent auditor."
Oh yeah, and to make matters worse: "after learning of the upcoming inspection [by the PCAOB], the
auditors created and back-dated documents and placed them in its audit
files for New York Film Works and RTG in order to conceal their failure
to comply with certain auditing standards."
The firm is still allowed to perform audit services for non-public companies, but shouldn't this sort of action have a severe reputational effect? If you are a third party relying on the audited financials of a Goldstein and Morris client, aren't you concerned that they have proven themselves willing to cheat?
Yesterday the Securities and Exchange Commission ("SEC") settled charges against Deloitte & Touche in connection with the financial scandal at Adelphia Communications Corp. Deloitte agreed to pay a $50 million fine -- the highest ever assessed by the SEC against an accounting firm -- then promptly reported that Adelphia "deliberately misled" Deloitte's auditors. The SEC was not pleased.
Under the settlement, Deloitte could neither admit nor deny the SEC's charges. But the same strictures apparently do not apply to the SEC. The WSJ is reporting that Mark K. Schonfeld, director of the SEC's Northeast Regional Office, remarked: "Deloitte was not deceived. They didn't just miss red flags, they pulled the flag over their head and then claimed they couldn't see." Ouch!