Looking Beyond the SEC Circle:
Alpha & Omega of the Global Sub Prime Mortgage Crisis
By: Susan M. Hinds, CPA, MBA, JD
(For Educational Purposes Only- August 2008, amended February 15, 2010)
Аα ALPHA Аα Ωω OMEGA Ωω
Eye of the Storm White Light Transparency
Looking Beyond The
Sub-Prime Long-Term
Liquidity Greed
Crisis SEC Circles Ethics
“I am the Alpha and the Omega, the First and the Last, the
Beginning and the End.” …Revelation 22.13
What are the lessons learned by the SEC, the solutions proposed for effective
regulatory oversight of complex capital markets, and the responses to the increasing
shareholder litigation in the global subprime mortgage crisis?
I. Introduction
II. Historical Highlights: The SEC Born with a Purpose to Restore Public Trust
III. Hypothesis: SEC Ineffective at Regulating Complex Markets, SRO’s are
Conflicted, and Stronger Independent Regulatory Oversight Needed
a. Case Studies: Does the Trend in Current Litigation Support the Need for
Independent Oversight?
i. Global Crossing: A Horizontal Collaboration Leads to a
Telecom Bust
ii. Enron Case: A Horizontal Collaboration led to Wide Spread
Corruption
iii. Tyco Case: “Greed is Good Operand”
iv. Parmalat Dairy Disaster: Lack of Transparency & Price
Fixing Disclosures in the Dairy Industry
v. AIG: Lacks Full Disclosure and Transparency
vi. Countrywide: Sub Prime Bust and Ethical Lapses, Lack of
Transparency, and Conflicts of Interest
vii. Bear Stearns Evaporation: Financial Stocks Crushed by
Liquidity Crisis
viii. Case Study Conclusion: Is Past Litigation a Pathway to
Independent Oversight?
b. Inquire into the Specific Trends and Behaviors that Shape the Morals of the
Market and Establishes an Integrity Baseline for Which all is Measured:
Sarbanes-Oxley Act 2002
IV. Diagnosis: Why did Sarbanes-Oxley Act, with the Creation of the PCAOB,
Result in Market Failure, and Independent Auditors Fail to Timely Detect
and Disclose to the Investing Public?
a. Lacking Real-Time Transparency: The Current Business Reporting Model
Lacks Digitalization and Full Disclosure to Strategy, Risks, and Key Metrics
b. Ongoing Conflicts of Interest & Lack of Independence: Blind Guise Network
c. Regulatory Capture: The Regulators are the Regulated Phenomena Results in
Lack of Strict Enforcement
d. Professional Ethical Lapses: ―Greed is Good‖ Motto is Replaced with ―Long
Term Greed‖ Creed
e. Deliberate Ignorance: Enron Measure of ―Intent‖ or not?
f. Whistleblower Protection: Failing to Protect the Front Line Officers
V. Future Legal & Regulatory Analysis: On the Horizon for the SEC?
a. 2008 SEC Omega Ends with a New Regulatory Schema: Treasury‘s
Blueprint for a Modernized Financial Regulatory Structure
b. SEC Digitalizes the Public Company Financial Filings by Utilizing XBRL and
Voting for Mandatory Regulation Standards in 2008
c. Looking Beyond the SEC Circle: Enforcing Independence in Rating Scores
d. Sunlight Transparency: Auditor Independence and Executive Pay Debacle
VI. Conclusion: Looking Forward to the Next Crash
1
I. Introduction
The question we will explore in this topic paper is whether the Securities and
Exchange Commission (―SEC‖) is effective in regulating complex capital markets, to
avoid another subprime meltdown, when the self-regulatory foundation and licensed
professionals are plagued with unethical behaviors. We will begin with some historical
context that existed at the time of the Great Depression, giving birth to the SEC in 1934.
We will examine some cases relating to the capital market fragility and attempts to avoid
future economic collapses that led to the creation of the Public Company Accounting
Oversight Board (―PCAOB‖), arising from the Sarbanes-Oxley Act 2002 (―SOX‖). We
will examine some of the lessons learned by the SEC, explore the morals of the market,
and examine some reasons for market failure. We will also review a few of the solutions
proposed in the post-SOX era, an era characterized by increasing shareholder litigation
with an emerging bear market, zapping public confidence, and draining pension funds.
We refine our scope to examine if stronger independent oversight is needed, especially
in light of the democratization of the global capital markets that are technologically
networked, demanding increased transparency, stronger corporate governance, and
independent regulatory oversight that protects foreign investment and restores public trust
in the capital markets. Increasingly, the public and investors demand true auditor
independence, no conflicts of interest, and full disclosure of executive pay. This requires
an increase in independent regulatory oversight actively intervening and sanctioning
unethical behavior to enhance public confidence and capital market integrity.
This paper sets out to provide a better understanding of the challenges that the
SEC and regulators face in battling white collar crime and the complexities of these
2
litigations. We will sample some fraud and corruption cases utilizing SOX as the
established integrity baseline, in which all unethical behavior is measured against, so we
may see that enforcing SOX is no easy task. The Omega subprime meltdown leads many
readers to seek answers from the finance community and this paper will shed some light
on the reasons for market failure. Important to prepare the reader for the future changes in
the capital markets which are demanding regulatory and technological advances that will
revolutionize the global capital markets and increase transparency to investors.
II. Historical Highlights: The SEC Born with a Purpose to Restore
Public Trust
In the beginning of the end of a high flying era, complete with the historical Crash
of 1929, the climax of a promising industrial era with a soaring stock market and a
bullish investment crowd, led Irving Fisher, Yale economist, to proclaim, ―stock prices
have reached what looks like a permanent high plateau.‖1 In October 1929, the stock
speculation bubble burst, stocks tanked, and new found wealth, estimated to be half of the
stock market‘s value. At the time of the crash, the Wall Street district of New York was
the prominent financial leader of the world, promoting the prestigious New York Stock
Exchange (―NYSE‖), and all the glory that market capitalism has to offer, with great
wealth residing in stocks. Wall Street was blindsided by lack of transparency, inadequate
regulation, and ethical lapses. Great despair settled in as the economic health of the
1
Edward Teach, The Bright Side of Bubbles, CFO Magazine, http://www.cfo.com, (last visited May 1,
2007).
3
nation appeared ill and financial institutions appeared to be inadequately capable of
providing any financial remedy.
Crowds Gathering
Wall Street Crash
October 1929
The Bubble Bursts:
Shock Waves Markets
Fear, Uncertainty,
Anxiety Grips
Investors
A vision conceived by F. D. Roosevelt, the leader of financial stewardship, via a
newly anointed regulatory agency, the Securities and Exchange Commission (―SEC‖)
was humbly born out of the Great Depression. The objective of the SEC was to restore
public trust and balance the turbulent markets. The Securities Act of 1933 (―Act of ‘33‖)
and the Securities Exchange Act of 1934 (―Act of ‘34‖), which created the SEC, focused
on providing investors with more reliable information, disclosures, and fair dealing rules.
Today, the SEC continues to search for initiatives that provide optimal
transparency of publicly traded firms to the various stakeholders of the publicly traded
organization. Topping the wish list of initiatives of the SEC is digitalization of financial
filings. Perennial flavors of past, present, and future SEC initiatives include the
beckoning cry for ever greater transparency and auditor independence. Both initiatives
are great in theory but have been slow in materializing and elusive to quantify and
enforce.
4
III. Hypothesis: The SEC is Ineffective at Regulating Complex Markets, SRO’s
are Conflicted, and Stronger Independent Regulatory Oversight Needed
This topic paper will explore the SEC‘s origins, its record of effectively
regulating complex capital markets (highlighted by selected cases that point to fallibility
within the current regulatory model), and anticipated changes to avoid future mega
financial meltdowns. Black Monday, October 19, 1987, when the Dow lost 22.6% of its
value in a day, the NASDAQ burst of the nineties, or the 2008 subprime mortgage crisis
are infamous dates in history the financial markets would like to avoid repeating.
Morals and professional stewardship vacillate over time and profound fiscal melt
downs that headlined the last decade impregnates the public‘s impression that both of
these virtuous attributes are trending unfavorably, and corporate stewardship is following
suit. Two common fallacies of corporate scandals in the twenty-first century include
auditors‘ misconceptions of their professional allegiances and duties, and intermittent
ownership of financial information. The zeitgeist for irrational exuberance and mega
financial mayhem was born. A poorly regulated macro environment coupled with weak
corporate governance within a micro economy, a specific industry or company, yields
fertile ground for white collar crime with major economic repercussions to germinate.
This paper supports the view that independent oversight is critical to maintain
public trust in global capital markets. This paper is operating on the premise, as is evident
by the case studies to follow, that the SEC is ineffective at regulating complex markets,
the Self-Regulatory Organization (―SRO‘s‖) are conflicted, and stronger independent
oversight is needed to support the market demands of a global network and to protect the
public interest.
5
a. Case Studies: Does the Trend in Current Litigation Support the Need for
Independent Oversight?
Taking a stroll down memory lane reminds us of some of the significant corporate
meltdowns and shareholder litigations that resulted in billions of lost market wealth. Past
litigation, like current litigation, often is a result of a failure in regulatory oversight
coupled with unresponsiveness to changing industry conditions and market trends that
foreshadowed the trouble. Current market meltdowns and litigation are more
interdependent, a horizontal network linked globally, resulting in more complex
economic woes.
A sample of the significant meltdowns in the early 2000 era, which were often
global in scope, reveals the morals of the marketplace and the ethical temperature of the
business climate. Despite recent legislation, namely SOX, the heightened corporate
governance standards were not taken seriously in the marketplace and jail sentences were
not a deterrent from continued large scale securities fraud, like the greatest heist on
record, the subprime meltdown and resulting litigation. Sudden and substantial stock
losses sent panic through the heart of the investment community, indicative by the recent
losses in 2008 that are estimated at $1.3 trillion from S&P 500‘s financial organizations2
thus leaving many investors nervous and jittery. Let us begin our journey into corruption:
i. Global Crossing: A Horizontal Collaboration Leads to a Telecom Bust
2
Joe Bel Bruno, Crisis wipes $1 Trillion from Financial Stocks, http:// www.money.cnn.com, (last visited
July 7, 2008).
6
The promise of a new technology, providing high speed fiber optic cable and
internet lines with a global network platform that was forecasted with revenues
skyrocketing. Investors poured billions into the telecom industry of which Global
Crossing is a key player, only to fall prey to the morals of the marketplace. The real
motive behind this stock loss was portrayed as excessive speculation coupled with
fraudulent accounting practices, tolerated by a horizontal collaboration3 amongst
networked players.
In February 2002, about six months prior to SOX, it became public that Global
Crossing and their partners, engaged in network capacity "swaps" with other carriers to
inflate revenue, therefore knowingly promoting a mega-million accounting fraud.4 The
company, or its agents, was also alleged to have shredded documents which included
documents related to the accounting practices of Arthur Andersen, LLP (―Andersen‖).5
These "capacity swaps", in which carriers exchange capacity in complementary parts of
the world without actually exchanging money, even though the swap is shown as
revenue, it allows a company a quick method of increasing earnings to make a company
look more profitable on paper.6
Investors filed securities litigation and satisfied the loss causation requirement for
stating a securities fraud claim under § 10(b) through allegations that two minority
shareholders of corporation, Microsoft Corporation (―Microsoft‖) and Softbank
3
For this paper, horizontal collaboration is defined as a horizontally linked, group of individuals or
corporate citizens, who cooperates with a potential competitor or ally alike to achieve a mutual benefit.
4
Penelope Patsuris, Accounting: The Corporate Scandal Sheet, http:// www.forbes.com, ( last visited
August 26, 2002).
5
Id.
6
BBC News, Global Crossing Defends Business Deals, http://www.bbcnews.bbc.com, (last visited March
21, 2002).
7
Corporation (―Softbank‖), agreed to purchase $200 million of bandwidth on the
corporation's newly formed telecommunications network, without intent to do so, that
commitment artificially inflated the price of Global Crossing‘s stock, and that investors
would not have purchased stock, or purchased it at an inflated price, but for false
commitment.7 Securities Exchange Act of 1934, § 10(b), 15 U.S.C.A. § 78j(b). As in this
case, ―the elements of loss causation are (1) that the market reacted negatively to a
corrective disclosure regarding the falsity of prior statements relating to Microsoft's and
Softbank's agreement obligations; or (2) that risks that were concealed by the alleged
misrepresentations or omissions materialized and proximately caused plaintiffs' loss.‖8
Ultimately, Global Crossing filed for Chapter 11, devastating both its
shareholders and its creditors, watching apathetically, the financial draining of their
tangible assets into a an intangible bandwidth pipe dream that assured a ―lifestyle‖ for the
select few who benefited: ―Greed is good.‖ A class action was filed that later settled for
around $450 million, and Citigroup paid $75 million with others totaling $100 million.
This is a horizontal collaborative network, with pre-dated SOX violations lurking
amongst them, foreshadowing a telecom financial bust. In this case, the Morals of the
Market were dominated by conflicted players who operated under the greed is good
theory. The humbled telecom giant richly details the conflict-of-interest offenses
committed by a former accounting executives and scads of internal-control issues.9 A
former vice president of Global Crossing allegedly awarded a contract to a company
owned and controlled by his son; a similar controversy as when he was singled out in a
7
In re Global Crossing, Ltd. Securities Litigation, 471 F.Supp.2d 338, S.D.N.Y., 2006.
8
Id at 348.
9
Stephen Taub, Global Double Crossing? Global Crossing‟s New Annual Report is Replete with Details
About its Warts, http:// www.CFO.com, (last visited December 10, 2003).
8
government filing for conflicts of interest several years ago.10
SOX requirements under Title IV-Enhanced Financial Disclosures, Section 401,
Disclosures in Periodic Reports,11 requires additional disclosures in Section 13 of the
Securities Exchange Act of 1934 (15 U.S.C. 78m) as amended by adding the following:
(i) Accuracy of Financial Reports, and; (ii) Off-Balance Sheet Transactions. The key
point here is that each annual and quarterly report must disclose, if material, all off-
balance sheet transactions and other relationships that can impact the current or future
financial statements of the issuer. The SEC is charged with examining the off-balance
sheet disclosures to determine the extent of the off-balance sheet transaction and that
GAAP rules are reflecting these off-balance sheet transactions to investors transparently.
Pro forma financials are to be presented in a manner as not to contain an untrue statement
or omit a material fact that if known would make the pro forma misleading.
In applying a SOX lesson to Global Crossing, one could say the periodic
disclosures failed to adequately disclose material off-balance sheet transactions. The
failure to fully disclose the nature and extent of these contract swaps, resulted in
significant investor losses. According to several experts, who recant what really
happened was, Global Crossing's woes were largely a reflection of an industry wide
10
Id. Background: In the annual report, is a contract with Perrone Jr. company, Withit.com, hired to co-
market a product with Global Crossing for the financial services industry. For the services, Global Crossing
paid Withit $740,000 but due to budgetary constraints and strategy change, the project was cancelled. In
April 2002, an independent committee of Global Crossing‘s board revealed Perrone influenced the contract
decision with Withit inappropriately, resulting in a $325,000 penalty, and duties reassignment.
11
Sarbanes-Oxley Act, 18 U.S.C. § 1514A (2002).
9
problem.12 Everyone overestimated the demand for these networks; there was a general
presumption that the Internet was doubling every three months.13 "People were building
fibers believing that was the right forecast.14‖ The periodic disclosures, including current
and future expectations, along with investor expectations who believed these disclosures
when making investments, so the pro forma financials were likely misleading to
investors.
ii. Enron Case: A Horizontal Collaboration led to Wide Spread Corruption
In October 2001, the public at large went into shock to learn that Wall Street
Darling Enron was under investigation into what was one of the largest frauds in history.
Specifically, Enron boosted profits and hid debts totaling over $1 billion by improperly
using off-the-books partnerships or Special Purpose Entity‘s (SPEs); manipulating the
Texas power market; bribing foreign governments to win contracts abroad; and
manipulating California energy markets.15 Enron had around $68 billion in market value
before it collapsed in 2001, wiping out jobs and $1 billion dollars in retirement funds
overnight.16
A securities class action, only one of the claims in a larger action alleging
securities fraud, was filed alleging insider trading of current and former directors and
officers of Chapter 11 Enron, and their auditors Arthur Andersen, LLP (―Andersen‖),
12
Wharton.com, Corporate Fraud on Trial: What Have we Learned?,
http://www.knowledge@wharton.com, (last visited March 30, 2005).
13
Id.
14
Id.
15
Penelope Patsuris, Accounting: The Corporate Scandal Sheet, http:// www.forbes.com, ( last visited
August 26, 2002).
16
Bloomberg News, Enron jury to consider 'deliberate ignorance', Ruling echoes WorldCom case,
http://www.boston.com, (last visited May 11, 2006).
10
seeking compensatory damages, imposition of a constructive trust, and other damages.17
The complaint alleged violations of section 10(b) of the Securities Exchange Act of 1934
(―the 1934 Act‖), and Rule 10b-5 against Enron, certain of its officers and directors, and
independent auditors, Andersen.18 The suit further alleged controlling person liability
under section 20(a) of the 1934 Act, against individual defendants Kenneth Lay, Jeffrey
Skilling, and Andrew Fastow, and charges negligent misrepresentation by all
defendants.19 In the end, ex-Enron executive Kopper pled guilty to felony charges,
Skilling, Fastow and his wife were sentenced to prison, and the list goes on. The acting
CEO, was potentially faced with $100 billion in claims and liabilities thus, forcing Enron
into Chapter 11. The Gatekeeper, Andersen, was initially found guilty of obstruction of
justice for destroying Enron documents,20unethical Gatekeeping devastated a partnership.
Apparently, the Gatekeeper function was corrupted in Enron and is the
cornerstone of the accounting professions problem: Ethics. To be specific, ‖Gatekeepers
include the public auditing firms that opine on the propriety of corporate financial
reporting with reference to the accounting profession's own Generally Accepted
17
In re Enron Corp. Securities Litigation, 206 F.R.D. 427, 432 S.D.Tex., 2002.
18
Id. at 438.
19
Id. at 438.
20
In a 9-0 opinion, the Supreme Court overturned the Andersen conviction, concluded that "jury
instructions at issue simply failed to convey the requisite consciousness of wrongdoing." Chief Justice
Rehnquist wrote the opinion, saying, "Indeed, it is striking how little culpability the instructions required."
11
Accounting Principles‖ (―GAAP‖).21 While realizing management, bankers, attorneys,
and a host of others participated in this great collapse; the accountants have a duty to
disclose and professional responsibilities under SOX. The Enron auditors were less than
candid as the case unfolded, auditor Andersen said it had learned of ''the deletion of
thousands of e-mails and the rushed disposal of large numbers of paper documents'' after
a meeting.22 Is deliberate ignorance used to escape requisite consciousness?
A striking legal term, deliberate ignorance, introduced while instructing jurors
during Kenneth Lay and Jeffrey Skilling‘s trial, asking whether the former executives
deliberately ignored accounting fraud as the energy trader fell into bankruptcy.23
Deliberate ignorance occurs when knowledge of the existence of a particular fact is an
essential part of an offense; such knowledge may be established if the person is aware of
a high probability of its existence, unless he actually believes that it does not exist.24 In
other words, a person acted 'knowingly' if either: (1) the person actually knew a particular
fact; or (2) that he deliberately closed his eyes to what he had every reason to believe was
the fact. However, the requisite proof of knowledge on the part of the person cannot be
established by merely demonstrating that he was negligent, careless or foolish.25
21
David Millon, Who "caused" the Enron debacle?, Washington and Lee Law Review, (Winter 2003).
22
Richard A. Oppel Jr. and Kurt Eichenwald, Enron‟s Collapse: The Overview; Arthur Andersen Fires an
Executive for Enron Orders, New York Times, January 16, 2002.
23
Bloomberg News, Enron jury to consider 'deliberate ignorance', Ruling echoes WorldCom case,
http://www.boston.com, (last visited May 11, 2006).
24
Jessica Kozlov- Davis, A hybrid approach to the use of deliberate ignorance in conspiracy cases, MI L.R.
(Nov. 2001).
25
Id.
12
SOX Title VIII primarily focused on the destruction, alteration, or falsification of
records in federal investigations and bankruptcy proceedings under § 1519 and § 1520.26
It is a felony to knowingly destroy documents or to impede, obstruct, or influence any
existing or future federal investigation. The auditors are required to maintain all audit or
work papers for a period of five years. A Gatekeeper function of the auditors is to ensure
that the financial records and supporting work papers are available for pending or current
investigations and litigation. This provision was prompted in part by Andersen which was
charged with destroying evidence of Enron.
In applying a SOX lesson to Enron, one could say it is difficult for prosecutors,
who represent public interests, to prove the culpability standard of ―knowingly‖
destroyed or…impede…federal investigation. The deliberate ignorance theory is a great
defense to a reasonable doubt evidentiary threshold standard. Enron had a horizontal
collaboration, aided and abetted by many professionals in their quest to hobnob with the
Wall Street Darling. When the executives were caught, they claimed ignorance of the law
in hopes of leaving a reasonable doubt in the jury‘s minds as they claim they lack the
requisite culpability for a conviction. The Morals of the Market guided Enron into
bankruptcy.
iii. Tyco Case: ―Greed is Good‖ Operand
White collar crime became sexy with the 1987 film, Wall Street, where Gordon
Gekko uttered the phrase, ―Greed is good‖ to stockholders and it seemed cool to be above
the law. The corporate greed motto became a hallmark of Wall Street, an excerpt:
26
Sarbanes-Oxley Act, 18 U.S.C. § 1514A (2002).
13
“The new law of evolution in corporate America
seems to be survival of the unfittest. I am not
a destroyer of companies. I am a liberator of
them! The point is, ladies and gentleman, that
Gordon Gekko Figure CEO greed -- for lack of a better word -- is good.
“Wall Street”
1987 Movie Greed is right. Greed works. Greed clarifies,
Michael Douglas Actor cuts through, and captures the essence of the
evolutionary spirit. Greed, in all of its forms --
greed for life, for money, for love, knowledge -
- has marked the upward surge of mankind.
And greed -- you mark my words -- will not only
save Teldar Paper, but that other
malfunctioning corporation called the USA.”
Gordon Gekko: Address to
Teldar Paper Stockholders
The recent sub-prime meltdowns are reflective of this mindset, from management to
board rooms surrounded by accountants willing to turn a blind eye, conflicted bankers,
and attorneys who confuse zealous advocacy with breach of professional responsibilities.
Almost in unison, the notion of pay-for-performance and stock options entered the
corporate scene, which in many cases, led to the conflicted management whose quest for
greed was so good that legality takes a backseat. ''This is the first corporate greed case,''
14
said John J. Fahy, a former federal and New Jersey prosecutor, referring to the Tyco case
and their auditors PricewaterhouseCoopers (―PwC‖).27
Around May 2002, the news broke nationwide, that Ex-CEO Dennis Kozlowski
was indicted for tax evasion.28 The SEC investigated whether Tyco was aware of his
unethical behavior including, improper use of funds and related-party transactions, as
well as improper merger accounting practices.29 Tyco‘s response, a delay tactic, was that
it would not certify its financial results until after an internal investigation is completed.30
C-Suite Collusion Circle Broken
Ex-Tyco CEO Dennis Kozlowski & CFO Mark Swartz
received 8-1/3 to 25 years in prison for, in part,
stealing hundreds of millions of dollars from the
manufacturing conglomerate. Judge Obus ordered
Kozlowski and Swartz to pay $134 million back to Tyco,
and Kozlowski was fined $70 million and Swartz $35
million; totaling $239 million.
Later in a scene from a crowded New York state courtroom, the prosecution had asked
for the maximum penalty of 15 to 30 years for both men, while Kozlowski's defense had
focused on his character as a "family man.31" In brief, shareholder plaintiffs alleged that
during the class period of December 13, 1999, through June 7, 2002, defendants
misrepresented the value of several companies that Tyco acquired and misreported Tyco's
own financial condition in ways that artificially inflated the value of Tyco stock.32 These
fraudulent accounting practices, plaintiffs alleged, enabled the individual Tyco
27
Andrew Sorkin, Tyco‟s Ex-Chief Going to Court In “Greed Case”, New York Times, September 29,
2003, p.1 .
28
Penelope Patsuris, Accounting: The Corporate Scandal Sheet, http:// www.forbes.com, ( last visited
August 26, 2002).
29
Id.
30
Id.
31
Grace Wong, Kozlowski gets up to 25 years, Mark Swartz, former Tyco CFO, also gets 8-1/3 to 25;
both men fined, handcuffed, sent to jail, http:// www.money.com, (last visited September 19, 2005).
32
In re Tyco Intern., Ltd. Multidistrict Litigation, 535 F.Supp.2d 249, 252-53 D.N.H., 2007.
15
defendants to reap enormous profits by looting the company through a combination of
unreported bonuses, forgiven loans, excessive fees, and insider trading.33 The looting, in
turn, allegedly fostered a cover-up by means of continued accounting fraud, materially
false and misleading statements, and the omission of material information in various
registration statements, to allegedly cover up the misconduct, all of which further violated
the federal securities laws.34 Meanwhile, PwC allegedly failed to conduct its audits of
Tyco in accordance with Generally Accepted Auditing Standards and falsely certified
that Tyco's financials were fairly presented in accordance with GAAP.35
In June 2005, Kozlowski and Swartz, were found guilty on 22 counts of grand
larceny and conspiracy, falsifying business records and violating business law.36 That
verdict came after the first trial against Kozlowski and Swartz ended in a mistrial in April
2004 when a juror waiting for an acquittal reported receiving threats.37 They are,
however, appealing these convictions. In the first trial, prosecutors focused on the misuse
of other peoples‘ money, such as a $2 million birthday party Kozlowski threw for his
wife on the Italian island and $6,000 shower curtain purchased with company funds.38
Around May 16, 2007, Tyco said it would set up a $2.975 billion fund to pay
shareholder claims against the company arising from actions by ex-CEO Kozlowski and
33
Id.
34
Id.
35
Id.
36
Grace Wong, Kozlowski gets up to 25 years, Mark Swartz, former Tyco CFO, also gets 8-1/3 to 25;
both men fined, handcuffed, sent to jail, http:// www.money.com, (last visited September 19, 2005)
37
Id.
38
Id.
16
other officers convicted of looting the company and falsifying records.39 Tyco provided
80 million e-mails, spreadsheets and other documents as part of discovery, Plaintiffs'
attorneys employed data-mining techniques, and conducted 200 depositions to sift for
evidence showing that fraud had caused the value of Tyco's stock to drop precipitously.40
The SEC seemingly misunderstood the complexity of corruption by failing to detect it,
which can usually be sensed when peeling the onion of conflicts of interest and lack of
auditor independence, exhibited by those with a duty to the profession, like PwC, but
prefer the loyalty to their client, in this case is Tyco.
Flash-forward to July 2007, PwC has agreed to pay $225 million to settle fraud
claims relating to the Tyco International securities class-action suit, according to
attorneys for the plaintiffs.41 A suit was filed in New Hampshire federal court alleging
that PwC, as Tyco‘s auditor, failed in its auditing duties.42 The settlement with PwC,
combined with the Tyco settlement, brings this class-action settlement to around $3.2
billion. 43 The moral of the story regarding the greed is good mantra: ―Watch out! Be on
guard against all kinds of greed; a man‘s life does not consist in the abundance of his
possessions.‖44
39
Tyco to pay nearly $3 billion to settle fraud case claims, Desert News (Salt Lake City, UT), May 16,
2007.
40
Chris Mondics, Tyco case very complex, lawyer says, The Philadelphia Inquirer, May 2007, pg. 1.
41
Ashby Jones, PwC reaches $225 Million Settlement In Tyco Case, Wall Street Journal Law, July 6,
2007, pg. 1.
42
Id.
43
Id.
44
Luke 12.15.
17
The SOX requirement under Title IX: White Collar Crime Penalty Enhancement
is primarily focused on financial certification by the CEO and the CFO, sentencing
guidelines, tampering or impeding with any official proceeding, and the SEC potentially
prohibiting anyone convicted of securities fraud from being an officer or director of a
publicly traded company.45 In applying a SOX lesson to Tyco, the C-Suite refusal to
certify the financials until after the investigation should raise red flags and auditor
suspicion. Interestingly, the ―blind guise‖46 network seems to exist within the bazaar web
of relationships with complexity and legal underpinnings that only sophisticated
individuals can decipher.
Case in Point: At Tyco, PWC-Bermuda signed all of the audit opinions attached
to Tyco‘s financial statements for the 1997- 2001, and was responsible for the report
content but oddly, PWC LLP performed the majority of Tyco‘s audit work.47 Most of
Tyco‘s accounting services were performed by PWC LLP‘s Boston office, headed by
partners Rick Scalzo and John O‘Connor.48 Nevertheless, PWC-Bermuda played a major
role in performing the accounting services in question, including signing all of the audit
reports issued by the PWC Defendants between 1997 and 2002.49 In regards to the audit
reports, however, PWC LLP maintained content control over PWC Defendants‘ public
statements concerning Tyco‘s operations.50 PWC-Bermuda only issued audit reports after
long discussions and being directed to do so by PWC LLP.51 In the absence of auditing
45
Sarbanes-Oxley Act, 18 U.S.C. § 1514A (2002).
46
For this paper, blind guise network is defined as a network or affiliation of those who knew or should
have known about the ethical lapses within the accounting profession or companies, but chose to turn a
blind eye or engage in self-gratifying behaviors such as self-promotion.
47
In re Tyco Intern., Ltd. Multidistrict Litigation, 535 F.Supp.2d 249 D.N.H.,2007.
48
Id.
49
Id.
50
Id.
51
Id.
18
work performed by PWC LLP or PWC LLP‘s express instructions to issue the audit
reports, PWC-Bermuda would not have done anything without instruction52 This appears
to be ―deliberate ignorance‖ in action but due to the complexity of these transactions it
appears to be more of ―deliberate intent‖; settlement value indicates something happened.
iv. Parmalat Dairy Disaster: Lack of Transparency & Price Fixing Disclosures in the
Dairy Industry
ELSIE the COW LEGENDARY ICON
Elsie is one of the Top 10 advertising
icons of all time by Advertising Age
In the dairy industry, unlike securities regulators who are promoting transparency,
anti trust regulators are concerned that transparency of key metrics could lead to price
fixing that would harm consumers. The tradeoff here is that investors demand increased
transparency to reduce risk, while consumers demand concealed metrics in fear of
collusion amongst the industry players, thus leading to higher prices at the cash register.
In Johannesburg, prosecution into alleged price-fixing by certain South African
milk producers leaves the industry in peril if the South African Competition Commission
(―Commission‖) gets its way. Specifically, the key players in the dairy industry would
face an administrative penalty for anti-competitive behavior that could exceed $100
million dollars. Following an investigation that revealed evidence of collusion in
2006,53the Commission found evidence of price fixing after an investigation, beginning
in February 2005 against seven dairy processors; the tribunal found evidence of price
fixing for raw and retail milk and they also found that trading conditions were
52
Id.
53
Ann Crotty, Dairy Firms Face $100m fine in price fixing probe, Business Report, December 8, 2006,
pg. 86.
19
manipulated.54 The seven companies cited, including Parmalat, are collectively charged
with exchanging sensitive information on procurement prices of raw milk in various
ways.55 The Commission said that the exchange of sensitive pricing information enabled
competitors to co-ordinate their pricing strategies to fix the purchase price of milk.56 The
Congress SA Trade Unions stated it was "absolutely outrageous that people can be
profiteering from the sale of such basic foods as bread and milk, on which the poorest
families spend such a high proportion of their small incomes.57
The beginning of the end of Parmalat, price fixing can easily lead to securities
disclosure issues in the areas of contingent liabilities, unethical behavior, fraud, collusion,
and other socially undesirable behaviors. In the case of Parmalat, the shareholders are the
ones left holding the bankruptcy bag in the end. Although price fixing is desirable
initially to stock prices, generally the lack of disclosure of the monopoly pricing and
profits leads to later busts. These ill begotten gains are often funded by unsuspecting
shareholders due to a lack of adequate disclosure regarding contingent liabilities.
Interestingly, sophisticated looters can buy stock positions, with insider knowledge of
monopoly profits, seek lofty stock gains, and sell when the regulators are near.
In February 2008, the trial involving Parmalat began almost five years after the
Italian dairy company collapsed, one of Europe's biggest accounting scandals.58 A
separate Milan trial, of the ongoing fallout of Parmalat‘s collapse, involves five major
foreign banks including, but not limited to; Citigroup, Inc. (―Citigroup‖), Morgan
54
Id.
55
Id.
56
Id.
57
Author Unknown, Milk-Price Fixing Prosecutions To Get Underway Eight Dairy Companies
Investigated, Sapa, Jan 30, 2008, pg. 1.
58
Kevin Reed, GT battles insurers over Parmalat liability cover, Accountancy Age, 07 Feb 2008, pg. 1 .
20
Stanley, Bank of America, UBS and Deutsche bank.59 These investment banks face
charges over their alleged involvement in the collapse. The banks are accused of share
price manipulation because they allegedly knew Parmalat was bankrupt but continued to
lend it money.60 Actions were brought on behalf of the successors of two bankrupt
subsidiaries against many banks and accounting firms for concealing the parent's true
financial condition, thus causing the subsidiaries to incur debt in reliance on
misrepresentations of parent's financial health.61
Citigroup will be facing trial in the United States over accusations of helping
corrupt insiders at Parmalat to siphon off funds from the company before its collapse in
2003.62 Importantly, Enrico Bondi, Parmalat‘s Chief Executive Officer Attorney,
Kenneth Chiate accused Citigroup of greed, cover-up, concealing of loans, and hiding
corruption in order to support an exit strategy.63 Citigroup has been accused of designing
a series of off-balance sheet transactions that helped Parmalat raise cash while making it
appear that the company was not taking loans.64 Those transactions created opaque
financial disclosures that disguised the looting at Parmalat, Chiate said, adding, "They
helped them doctor the financials by concealing the loans.‖65 It appears the regulators
may have failed to realize the extent of the horizontal network collusion that runs through
the veins of corporations and their business partners in the U.S. and abroad.66
59
Id.
60
Id.
61
In re Parmalat Securities Litigation, 501 F.Supp.2d 560, S.D.N.Y., 2007.
62
Citigroup facing trial in $2 billion Parmalat fraud case new, May 20, 2008
63
Id.
64
Id.
65
Id.
66
Id.
21
In late 2008, Citigroup, who was sued for $1.92 billion in damages from
plaintiffs, was vindicated by a New Jersey state court jury that decided that Citigroup did
not help executives at Parmalat commit a massive fraud.67 On Christmas Eve 2003,
Parmalat filed for bankruptcy, with its estimated $18 billion collapse being one of the
worst financial scandals and commonly referred to as the ―Enron of Europe‖. Plaintiff‘s
lawyers for Parmalat CEO Enrico Bondi failed to prove Citi aided in the fraud and jurors
agreed with Citi's counterclaims that Parmalat engaged in fraud, negligent
misrepresentation, and conversion.68 As a result, they ordered Parmalat to pay $364.2
million in damages to Citi.69 Importantly, Bondi's lawyers argued that Citigroup, a banker
for Parmalat from 1994 to 2003, knowingly turned its back to the looting by former CEO
Calisto Tanzi and former Chief Financial Officer Fausto Tonna.70 Conversely, Citi
lawyers argued that its employees didn't know about the looting and its reasonable
safeguards were thwarted, the wire service added.71
The accounting industry is fully entrenched in a scandal, Grant Thornton
International and Grant Thornton, US (―Thornton‖), faces a £5bn claim from Parmalat,
which accuses Thornton of an active role in directing and looting the company.72 The
writ states: ―Grant Thornton and Parmalat insiders hid losses and diverted funds to
67
www.CFO.com, Citi Triumphant: Parmalat Loses, Stephen Taub, October 20, 2008.
68
Id.
69
Id.
70
Id
71
Id
72
GT battles insurers over Parmalat liability cover, Accountancy Age, Kevin Reed, 07 Feb 2008.
22
themselves.73‖ ―However Parmalat alleges fake credit and loan notes were written, a web
of fake front companies were created, and that many of these were based in Thornton
offices around the world, and in some cases with its accountants acting as directors.‖74
Parmalat has partially settled this year with Deloitte‘s £57m settlement proposal put
forward to Parmalat bondholders75. In the long run, be certain that, ―There is nothing
concealed that will not be disclosed or hidden that will not be made known.76‖
In 2009, a district judge has dismissed both cases against Bank of America, Corp.
and Grant Thornton International relating to their alleged involvement in orchestrating a
massive fraud that led to the 2003 bankruptcy. A Parmalat subsidiary sued Bank of
America, while the company's chief executive, Enrico Bondi, sued Grant Thornton
International and its U.S. business Grant Thornton LLP.77 The judge rejected Parmalat's
arguments that Bank of America and Grant Thornton International adversely affected the
company by taking part in the fraud.78
Parmalat “cannot get around the fact” that it “raised and spent millions of
euros for corporate purposes,” the judge said. “The actions of its agents in so doing
were in furtherance of the company's interests even if some of the agents intended at
the time they assisted in raising the money to steal some of it from the company.”79
The judge also ruled that plaintiffs relied on hearsay in building their cases, attempting to
pass it off as ―sworn documents.‖80
73
Id.
74
Id.
75
Id.
76
Luke 12.2
77
Id.
78
Id.
79
Id.
80
Id.
23
SOX requirements under Title IV-Enhanced Financial Disclosures, Section 402,
Enhanced Conflict of Interest Provisions,81 primarily focused on extending preferential
treatment of credit or loans to any director or officer. The transaction, if it is completed,
must be done in the ordinary course of business on the same terms and conditions made
to the general public. The SOX lesson to be applied here is that conflicted fiduciaries,
auditors, and bankers can lead to a complete lack of independence and a complete
corporate governance collapse as in Parmalat. Albeit, legal technicalities allocate liability
differently then ethical professionals, who may question those who should have known
that this behavior was wrong and bring it to the regulatory authority‘s attention rather
than to participate in the activity that was clearly wrong. This requires placing the public
interest before self-interest of the enterprise, as good shepherds of the public trust mantra.
The accounting profession has created this enterprise culture concept promoting
its many benefits such as collaboration or global networking. However, a paper recently
released in the accounting world, one that aims to argue that the enterprise culture, often
warmly referred to as the ‗network‘82 is producing negative effects.83 Companies and
major accountancy firms are seemingly willing to improve their profits through
participation in price fixing, tax avoidance, tax evasion, bribery, corruption, money
laundering and practices that show scant regard for social norms and even laws.84
81
Sarbanes-Oxley Act, 18 U.S.C. § 1514A (2002).
82
Network is used as in business, professional, and personal relationships that are formed by co-
dependency on each other for their very existence. Networks are an intangible asset that cannot easily be
measured but is critical in business development, speaking engagements, book contracts, and consulting
opportunities. Accounting firms may be classified as networked enterprise for business purposes.
83
Prem Sikka, Enterprise culture and accountancy firms: new masters of the universe, Accounting,
Auditing & Accountability Journal, Year: 2008, Volume: 21, Issue: 2 @ 268 – 295.
84
Id.
24
Evidence shows accounting firms are engaged in anti-social behavioral, social
responsibility, ethics, accountability, professionalism, and crime. 85 Often failing to
connect the dots that their culture promotes personal wealth creation, societal value
destructive behaviors of those whom they audit, and fail to adhere to the gold standard
behaviors touted at the high-end conferences. In their pursuit of higher profits, these
accounting firms have allegedly operated cartels that facilitated civil or criminal acts
against the public, not in their best interest.86
v. AIG: Lacks Full Disclosure and Transparency
A recent ad for PwC features a pair of sunglasses, inspiring professionals to join
their club to let the sunshine in for transparency: the Sunshine Club. What is not so
transparent is that the Sunshine Club stands to benefit nicely in consulting and
professional services, which leads to ethical lapses and independence issues.
In May 2008, the SEC announced the start of the process that will return more
than $800 million in Fair Funds to harmed investors in AIG which settled SEC charges of
financial fraud and improper financial reporting and disclosure over a four-year period.87
On Feb. 9, 2006, the Commission filed a complaint alleging that from at least 2000 until
2005, AIG materially falsified its financial statements through a variety of sham
85
Id.
86
Id.
87
SEC.com, SEC Announces Start of Distribution Process in AIG Settlement; Court Approves
Distribution Plan for $800 Million Fair Fund, http:// www.sec.gov., (last visited May 5, 2008).
25
transactions and entities and that AIG reported materially false and misleading
information about its financial condition.88
In 2008, AIG had also recently confirmed that the SEC and the Justice
Department are probing its valuation of financial instruments in the company's credit
default swap portfolio and looking at whether AIG purposely overstated its value of
mortgage-related instruments:89 Long-Term Greed? The critical question is whether AIG
and its financial-products division intentionally overstated the value of contracts linked to
subprime mortgages.90 Sullivan had taken over as CEO of AIG in March 2005 after long-
time chairman and CEO Maurice R. Greenberg was forced to resign following the
revelation of accounting irregularities and AIG‘s stock price battered down.91
In 2007, American International Group Inc (―AIG‖) shareholders renewed claims
in a derivative action on behalf of shareholders against the company's auditor, PwC, and
about four dozen other individuals and companies, seeking to hold them liable for a
financial restatement and a $1.64 billion regulatory settlement.92 AIG shareholders
previously sued in 2004, naming former Chief Executive Maurice "Hank" Greenberg,
former Chief Financial Officer Howard Smith, PwC and others as defendants.93 In the
88
Id.
89
Trading markets.com, Willumstad Replaces Sullivan as AIG's CEO, http:// www.tradingmarkets.com,
(last visited June 16, 2008).
90
Randall Smith , Amir Efrati, & Liam Pleven, AIG Group Tied to Swaps Draws Focus of Probes, Wall
Street Journal, , June 13, 2008, pg. 1.
91
Trading markets.com, Willumstad Replaces Sullivan as AIG's CEO, http:// www.tradingmarkets.com,
(last visited June 16, 2008).
92
Re the auditors.com, Author Unknown, Re: The Auditor, October 1, 2007, AIG Shareholders Sue PwC,
http://www.retheauditors.com, (last visited October 1, 2007).
93
Id.
26
amended complaint, the shareholders seek damages from PwC and others, including
Marsh & McLennan Cos, and AIG directors and officers.94
While the board of directors stated that PwC remains independent, the
shareholders do not share this same view and assert breach of duty and negligence. It
appears that PwC‘s recent sunglass advertisement is deceptive as it promotes
transparency, except if it is for their clients, then a pair of blind guys sunglasses are
provided to company management so they can claim ignorance of any wrongdoing.
Proving culpability is difficult and the ignorance theory has been an effective defense in
prior cases. In this case, the government came to terms in February 2006, a $1.64 billion
civil settlement with state and federal regulators, over alleged accounting improprieties.
AIG‘s board of directors maintained healthy skepticism with AIG‘s accounting
methods, and had trouble with PwC, the auditors; and for years, the audit committee said
that it couldn't vouch for AIG's accounting.95 As reported in an annual corporate filing,
the audit committee's oversight did "not provide an independent basis to determine that
management has maintained appropriate accounting and financial reporting principles nor
could they assure that PwC was in fact ―independent.‖96 AIG's audit committee's
disclaimer has found its way into a 224-page lawsuit filed by Ohio's attorney general
accusing AIG of securities fraud. The lawsuit further claims that PwC turned a blind eye
to key warning signs and, as a result, repeatedly issued "false and misleading" audit
94
Id.
95
Washingtonpost.com, Accountants Missed AIG Group's Red Flags, http://
www.accounting.smartpros.com, (last visited May 31, 2005). Separately, for years,
PricewaterhouseCoopers LLP gave a clean bill of financial health to American International Group Inc.,
only to watch the insurance giant disclose a long list of accounting problems this spring.
96
Id.
27
reports of the insurer's books.97 The complaint says that PwC knew of or "recklessly
disregarded" myriad "illegal" and "improper" accounting irregularities, including the
$500 million so-called finite reinsurance transactions with General Re, which has drawn
the attention of regulators.98 Ohio Attorney General Office is awaiting "more details
about PwC's involvement" when AIG issues its thrice-delayed 2004 annual report, to be
released on May 31 with a restatement of financial results dating to 2000.99 AIG said it
would cut its net worth by $2.7 billion, or 3 percent, because of a series of irregularities
and mistakes.100
PwC, a global giant with over 120,000 employees in 144 countries, has sought to
market itself as an arbiter of corporate governance, but has failed to uphold it‘s own
standards, has left them in an awkward public relations moment.101 In the wake of the
Enron bankruptcy, for instance, PwC CEO Samuel A. DiPiazza Jr. co-wrote a book, with
Robert Eccles, "Building Public Trust," on how to improve public companies' financial
reporting.102 This was aimed at restoring public trust which begs the question- what did
you do to breech the public trust in the first place? Apparently PwC, like other major
accounting firms, has had a few run-ins with regulators.103 PwC paid $5 million to SEC
regulators in 2002 for violating independence standards by engaging in business deals
with audit clients between 1996 and 2001.104 And a PwC partner, Richard Scalzo, in
97
Id.
98
Id.
99
Id.
100
Id.
101
Id.
102
Id.
103
Id.
104
Id.
28
2003 agreed to a lifetime ban from auditing public companies in an effort to settle SEC
allegations relating to the Tyco case.105
SOX requirements under Title IV-Enhanced Financial Disclosures, Section 404,
Management Assessment of Internal Controls,106 requires that each annual report contain
a report over internal controls which shall:
a. State the responsibility of management for establishing and maintaining
adequate internal control process and procedures for financial reporting.
b. Contain an assessment regarding the effectiveness of the internal control
process and procedures for financial reporting.
The SEC requires each company to disclose whether it has adopted a code of ethics,
including the content of that code, for its senior financial officers. The code of ethics in
most organizations will cover areas such as conflicts of interest, lack of independence,
securities laws, anti-trust laws, and employment laws.
The SOX lesson to be applied here is that it is this perceived lack of independence
and conflicted mentality that has led in part to the meltdown underway in the 2000 era;
consulting gigs are more important than professional ethics, and SOX has not slowed this
behavior substantially. The independent auditor‘s paychecks are tied to their clients‘
board of directors and management. SOX also mandates that auditors now are under the
direct control of the audit committees. However, the audit committee often approves the
buying decisions and subsequent payment to the auditors, who are often times paid
through company management accounts, with conflicts certain to arise. This can leave the
auditor in a conflicted relationship with a tendency to interact with management on key
105
Id.
106
Sarbanes-Oxley Act, 18 U.S.C. § 1514A (2002).
29
issues, more so than they are able to effectively involve the shareholders who provide the
capital to fund these buying decisions albeit the board of directors serves this function.
Realizing that SOX specifically prohibits many types of consulting services by auditors,
it has not slowed the pace of consulting business, and many have resorted to setting up
not-for-profits to sell these same or similar services: blind guise network remains.
vi. Countrywide: Sub Prime Bust and Ethical Lapses, Lack of Transparency, and
Conflicts of Interest
Demonstrators hold signs in front of the
Federal Reserve Bank in Los Angeles, CA April
28, 2008. The demonstration was cal led to
raise awareness of the housing market crisis
during a public hearing on Bank of America's
planned acquisition of Countrywide Financial.
On November 28, 2007, a District Judge appointed the New York State
Comptroller and the New York City Pension Funds (―New York Funds‖) as lead
Plaintiffs,107 a consolidated class action asserting claims under the Securities Act of 1933
and the Securities Exchange Act of 1934 against Countrywide Financial Corporation
(―Countrywide‖), certain of its current and former directors and officers, outside
accountants, and underwriters of public offerings of Countrywide securities during a class
period between March 12, 2004 and March 7, 2008.108
“Plaintiffs generally allege, among other matters, that Countrywide violated
securities laws by making false and misleading statements concerning Countrywide’s
business in residential mortgages, and regarding the creditworthiness of borrowers,
underwriting and loan origination practices, loan loss and other accounting
provisions, and by misrepresenting high risk low documentation loans as being
“prime", violating GAAP, and engaging in other false and misleading statements.”109
107
In re Countrywide Securities Litigation, No. CV-07-5295 (C.D. Cal.), 2008.
108
labaton.com, In re Countrywide Securities Litigation,http:// www.labaton.com, (last visited August
2008).
109
Id.
30
A material portion of the Company‘s loans were made to individuals on a ―no-
documentation‖ or ―low-documentation‖ basis, which means Countrywide gave ‗liar
loans‘110 without requiring traditional paperwork, such as income and/or employment or
asset verification.111
Countrywide reported the liar loans as ―prime‖ loans even when they were
substantially riskier than traditional prime loans, while repeatedly, and falsely, touting
Countrywide‘s conservative approach to lending, falsely assuring investors that
Countrywide would prosper as weaker companies fell by the wayside.112 Countrywide‘s
stock was artificially inflated by their false representations, and before the stock price
tanked, insiders allegedly received $867 million from Countrywide stock sales, in which
CEO, Angelo R. Mozilo (―Mozilo‖), allegedly received nearly half.113 In contrast, the
decline in market capitalization suffered by Countrywide investors was in excess of $25
billion and bondholders suffered additional large losses.114
Separately, a shareholder derivative action filed on behalf of Countrywide by
pension fund Plaintiffs, brought for the benefit of Countrywide, against certain of the
Company's senior officers and the members of its board of directors.115 This action
alleges misconduct by the defendants and disregard for their fiduciary duties, including
lack of good faith and lack of oversight of Countrywide's lending practices, financial
reporting, and internal controls, as well as the sale by certain of the Company's officers
110
The lending industry classified ―liar loans‖ because the reported income levels and assets are inflated or
misrepresented in order to obtain credit for loan.
111
Id.
112
Id.
113
Id.
114
Id.
115
blbglaw.com, In re Countrywide Financial Corporation Derivative Shareholder Litigation
(United States District Court, Central District of California), http://www.blbglaw.com, (last visited July 22,
2008).
31
and directors of over $848 million of Countrywide stock at inflated prices while in
possession of material inside information, between 2004 and 2008 during relevant
litigation.116
Countrywide‘s CEO Mozilo was helping many ―Friends of Angelo‖ in obtaining
mortgages with allegedly preferential treatment, although not illegal, clearly not in the
shareholders best interest.117 These mortgages misaligning the risk and return theory of
investment. As the mortgage market was wobbling last year, Mozilo intervened to help a
daughter of a casino manager and her fiancé borrow to buy a Nevada home that would
have ordinarily been disqualified to them.118 CEO Mozilo, a founder, made things worse
by postponing retirement and by making frequent, heavy sales of Countrywide stock.119
These actions undermined confidence in the company, demoralized employees, drew the
SEC into a continuing investigation and a rash of lawsuits from investors, borrowers, and
state regulators.120 In June 2008, a civil lawsuit was filed by the California and Illinois
attorney generals alleging that Countrywide engaged in ―unfair and deceptive‖ practices
that get homeowners to apply for risky mortgages, clearly beyond their means.121
In September 2007, Mozilo forecasted ―continued success and dominance‖ that
forecast was quickly shadowed by the $1.2 billion third quarter loss announced in
October 2007.122 By January 2008, Bank of America agreed to take over and in June
116
Id.
117
James Hagerty & Glenn Simpson, Countrywide CEO Helped Many get Loans, Wall Street
Journal June 27, 2008, pg. A3.
118
Id.
119
James Hagerty, Rainmaker Mozilo Exits Under a Cloud, Wall Street Journal, June 28-29, 2008, pg. B6.
120
Id.
121
Cnn money.com, Illinois to sue Countrywide, http://www.cnnmoney.com, (last visited June 25, 2008).
122
Id.
32
2008 the Countrywide shareholders approve a sale with the stock around $5 per share.123
Unfortunately, Countrywide agreed to sell to Bank of America in January for $4 billion
in stock but the value tanked to $2.8 billion, reflecting a decline in value of Bank of
America‘s stock over the last six months. A lawsuit was filed to block the sale of Bank of
America with settlement talks underway. The dispute is between Countrywide and
individual shareholders who sued in Delaware‘s corporate-law court, challenging the
price of the company‘s sale to Bank of America.124 The settlement is troubling to pension
funds, as a settlement clause stipulates that the class-action lawsuit be dropped.125 A
settlement would stymie separate claims, where shareholders accuse the board of
ignoring the value of lawsuits against senior managers who they say profited personally
while leading the mortgage lender into financial distress through predatory lending and
other practices.126
SOX requirements under Title IV-Enhanced Financial Disclosures, Section 403,
Disclosures of Transactions Involving Management and Principal Stockholders,127
essentially requires disclosure of designated transactions within two business days for
directors, officers, and 10% owners. This means that Mozilo and the board members
liquidated their holdings while leading the public to believe that all is steady. While
realizing their sales were disclosed, this section amends §16(a) requiring reports to be
filed on a more timely basis—quick dissemination of critical information that affects the
markets. The SOX lesson to be applied here is and as the Complaint alleges, senior
123
Id.
124
Peg Brickley, Countrywide Pact Nears Approval, Wall Street Journal, July 5-6, 2008, B6.
125
Id.
126
Id.
127
Sarbanes-Oxley Act, 18 U.S.C. § 1514A (2002).
33
officers and board members, entrusted with the responsibility of serving the best interests
of shareholders, had the greatest and deepest insight into the impending collapse of the
subprime mortgage market.128 While they continued to publicly tout the safety and
security of the company's mortgage lending practices and strategy, they liquidated their
personal holdings as fast as possible.129 Indeed, Mozilo and the board caused
Countrywide to commence a $2.5 billion stock repurchase plan, fooling investors into
believing the stock was undervalued.130 Meanwhile, insiders were selling large portions
of their stock into the repurchase plan.131 The transactions and the intent were not
transparent, thus insiders walked away richer leaving the unsuspecting investor poorer.
vii. Bear Stearns Evaporation: Financial Stocks Crushed by Liquidity Crisis
Wall Street Powerhouse, Bear Stearns Cos. (―Bear Stearns‖)., an investment bank
for almost nine decades, ceased to exist in May 2008, in a meeting that lasted about
eleven minutes to decide the final fate.132 To their horror, executives recall watching the
firm‘s stock plunge as rumors swelled of a liquidity crunch.133 The beginning of the end,
a panic stricken 3 days, that brought this powerhouse to its knees and threatened the
128
blbglaw.com, In re Countrywide Financial Corporation Derivative Shareholder Litigation
(United States District Court, Central District of California), http://www.blbglaw.com, (last visited July 22,
2008).
129
Id.
130
Id.
131
Id.
132
Kate Kelly, Mike Spector & Randall Smith, The Fall of Bear Stearns: Bear‟s Final Moment: An
Apology and no Lack of Ire, Wall Street Journal, May 30, 2008, pg. C1.
133
Id.
34
stability of the global financial system. The previous Sunday was no day of rest for the
Board of Governors of the Federal Reserve System who voted to create a lending facility
to improve primary dealer‘s ability to finance participants in securities markets.134 The
Fed was approving a deal for JP Morgan Chase & Co. to buy Bear Stearns at an
announced acquisition price of $2 per share, an economic fall from grace by most
counts.135 Bear Stearns common stock last closed at $30 and traded as high as $159, over
the last year.136
Litigation has been initiated with a Pittsburgh law firm, announcing alleged
"possible illegal conduct relating to the Bear Stearns Companies Inc. Employee Stock
Ownership Plan, Profit Sharing Plan and Deferred Compensation Plan.‖137 According to
the March 14, 2008 press release, the firm is investigating whether identified plan
fiduciaries knew or should have known that Bear Stearns was concealing its large
exposure to highly risky Collateralized Debt Obligations (―CDO‘s‖), subprime
mortgages, and other poor-quality securities, within its managed funds. The investigation
also involves where securities were offered as low risk investments when they were
really not low risk.138
This led federal prosecutors to arrest Bear Stearns hedge fund managers, Ralph
Cioffi and Matthew Tonnin, who allegedly lied to investors about their once giant
134
Susan Mangiero, Bear Stearns sold to JP Morgan- Real Pain for Employees, http://
www.pensionriskmatters.com, (last visited March 17, 2008).
135
Id.
136
Id.
137
Id.
138
Id.
35
portfolios.139 Prosecutors are fixated on the $4 billion in CDO‘s that the pair enlisted
Bank of America to guarantee and sell; leaving Bank of America with big losses and
harmed investors.140 In June 2008, a SEC civil suit commenced, pointing to criminal
charges, alleging the ex-Bear executives persuaded Barclays to sink $100 million into the
ailing funds in February 2007.141 The SEC suit highlights the $4 billion CDO deal with
Bank of America, who was recruited to market and guarantee the complex pool of
subprime securities, which was needed for liquidity for the hedge funds that tanked
weeks after the deal.142
The SEC is also examining Bear Stearns‘ trading records, leading up to the
company‘s collapse, as shareholders assert that short sellers manipulated the market,
meaning those who borrowed shares in the hope the price will fall.143 U.S.
Representative Barney Frank, House Financial Services Committee chairman, is
requesting the SEC to expand its probe into whether any improper trading in investment
banks‘ shares have occurred recently.144 ―Bear Stearns executives say that short-sellers
are part of the reason the firm collapsed.‖145 ―They also blame circulated false rumors as
a reason that customers abandoned the investment bank, which resulted in its liquidity
crisis‖.146 According to Gary Aguirre (―Aguirre‖), former SEC attorney and
139
Matthew Goldstein & David Henry, Bear Scandal: A Widening Probe, Business Week, July 7, 2008, pg.
22.
140
Id.
141
Id.
142
Id.
143
Unknown Author, Villian Hunt in Bear‟s Cave, Wall Street Journal, May 29, 2008, @
Breakingviews.com/Financial Insight.
144
U.S. Representative Barney Frank Calls on SEC to Widen Investigation of Improper Trading Rumors
Surrounding Bear Stearns‟s Stock, http:// www.stockbrokerfraudblog.com, (last visited April 21, 2008).
145
Id.
146
Id.
36
whistleblower, ―Likewise, the value investor has no clue that an attractively priced small
cap is on its way to bankruptcy via the naked shorting of an $8 billion hedge fund.‖147
SOX requirements under Title IV-Enhanced Financial Disclosures, Section 408,
Enhanced Review of Periodic Disclosures by Issuers,148 requires the SEC to review
disclosures on a regular and systematic basis for the protection of investors, not less
frequently than once every three years. What is troubling is that the SEC was presumed to
have been assured by Bear Stearns management, in their periodic financial disclosures,
that they were a sustainable going concern, with auditor assurances as well that investors
relied upon. So what happened in these critical New York minutes that melted this
enterprise like snow evaporates on a hot August sunny day? Seems an SEC investigation
would help unravel these critical facts, so we may learn the root cause, and deploy future
countermeasures to prevent future collapses. Was it panic-driven or rumor-driven?
Unlike the economic busts of the past, where the damage was contained quickly,
the implosion of Bear Stearns was more toxic.149 A host of other banks, broker dealers,
and hedge funds have played the same game, deploying massive leverage at the top of the
credit bubble to get more profits.150 ―You have to go back to the banking crisis of the
Great Depression to find a moment when the financial system as a whole seemed so close
to the precipice.‖151 Panic selling is much swifter now with technology and transparency.
The Swiss bank, UBS, has suffered subprime losses on a scale to match Merrill Lynch
147
Faulking truth.com, Gary J. Aguirre‟s, former SEC attorney and fired whistleblower, Sept. 2, 2005 letter
to Chairman Cox, www.faulkingtruth.com/Files/acquirre cox0623.pdf, (last visited June 25, 2008).
148
Sarbanes-Oxley Act, 18 U.S.C. § 1514A (2002).
149
By Ambrose Evans-Pritchard, Bear Stearns exposed as a bank saddled with toxic sub-prime debt,
Telegraph.co.uk, March 16, 2008, pg. 1.
150
Id.
151
Id.
37
and Citigroup, thanks to mortgage related securities.152 Debt levels were much higher
than the Great Depression; the complexity of structured credit are more opaque: the $415
trillion nexus of derivative contracts is not known.153
What keeps Federal Reserve officials turning at night is fear that the "financial
accelerator" will now set off a vicious downward spiral in the markets and panic
selling.154 A global strategist at Societe Generale, said the toppling banks are merely a
symptom of a deeper rot that exists within the core of the system.155 "The problem is that
an economic bubble financed by ridiculously loose monetary policy is unraveling," said
Albert Edwards, global strategist.156 "US house prices have a lot further to fall, which
will simply crush the global economy.‖157 Troubling is that the SEC was investigating
Bear Stearns during the relevant period, but dropped the investigation: is this an example
of ineffective enforcement leading to catastrophic market failure?
In March 2008, U.S. regulators announced an investigation into whether traders
illegally sought to force Bear Stearns shares, the fifth-largest U.S. securities firm, into a
tailspin by spreading false information about the firm's finances.158 It‘s alleged that the
SEC probe is focusing on whether hedge funds or other investors bet on a drop in the
company's shares while disseminating rumors that the New York- based firm was nearing
collapse and allegedly the New York Stock Exchange's regulatory arm is also involved in
152
Id.
153
Id.
154
Id.
155
Id.
156
Id.
157
Id.
158
Bloomberg.com, SEC Opens Bear Stearns Stock Manipulation Inquiry, David Scheer, March 18, 2008.
38
the investigation.159 Specifically, speculation about a cash shortage allegedly spurred
customers and lenders to pull money from Bear Stearns, driving the shares down 57
percent between March 7 and March 14, 2008, then was rapidly acquired by JPMorgan
Chase & Co. for $2 a share.160 The company's decline coincided with a surge in investor
bets that the stock price would plunge, which fuels the need to inquire into whether
panic-rumors drove Bear Stearns into the clutches of their competitor, at fire sale prices.
In June 2007, Christopher Cox, then the SEC chairman, testified before Congress
that the agency had ―about 12 investigations‖ under way concerning collateralized debt
obligations (―CDO‘s‖), collateralized loan obligations and similar products.161 About a
year later, Cox told Congress that the number of investigations into the financial industry,
including the subprime mortgage origination business, had ballooned to over 50 separate
159
Id.
160
Id.
161
ProPublica.com, SEC Just Now Seeking Key Information On Meltdown, Jake Bernstein & Jesse
Eisinger, December 16, 2009.
39
inquiries.162 Fast forward to an SEC letter dated October 22, 2009, almost three years
since banks started taking losses that led to the Omega meltdown, the SEC is just
beginning to ask basic questions about what happened.163
The SEC is conducting an information-gathering sweep of the key players in the
market (collateral managers- middlemen between investment banks that created these
complex financial products and investors) for CDO‘s, the bundles of mortgage securities
whose sudden collapse in price was at the center of the meltdown of the global banking
system.164 Allegedly collateral managers had their own in-house investment funds and
may have taken positions that were in conflict with those of the investors in the structures
that they managed.165 Possibly, their hedge funds may have bet against the very slices of
the securities they were managing on behalf of the investors in the structure.166
Underwriting investment banks often had influence over the investment choices some
CDO managers made, giving rise to another possible conflict of interest.167 The agency
may be looking at whether that influence was proper or not. ―The possibility for conflicts
and self-dealing is huge,‖ says Lynn Turner, the former SEC chief accountant.168
viii. Case Study Conclusion: Is Past Litigation a Pathway to Independent Oversight?
The past litigation that we have selectively reviewed above has a common
162
Id.
163
Id.
164
Id.
165
Id.
166
Id.
167
Id.
168
Id.
40
Theme: all of these cases involve ethical lapses, corporate governance failures, lack of
transparency, and ineffective government enforcement. Critical to the sustainability of
robust capital markets is strong public trust in the financial statements that underlie the
stock certificates. Investors are demanding more transparency in areas such as contingent
liabilities, off-balance sheet financing, executive pay, and other financial complexities
that could pose a significant risk to the business. The ethical foundation of this nation
calls for a renewed interest in strong corporate governance, enforced compliance with
SOX act requirements, sanctions for unethical behavior, and an independent division for
stronger oversight. While not advocating regulation, as limited government is preferred, a
real need for transparency into board rooms, audit committees, and SEC enforcement
must be indoctrinated with ―protecting public interest‖ at the core of its being.
Another common theme among the many case studies is their global presence,
interdependence, and a technologically integrated network that is capable of shaking
capital markets globally almost instantaneously due to the speed of information. A recent
CNN Money headline, ―Global Markets Plunge on U.S. Recession Fears,‖ as Asian and
European stock markets plunged January 19, 2008, amid investor pessimism over the
U.S. government‘s $150 billion economic-stimulus plan to prevent a recession.169 This
global interdependence seems to call for stronger transparent oversight, simply to assure
our foreign investors that their investments are safe, thus avoiding political warfare.
What, if any, independent oversight is needed in these complex accounting and
legal constructions that only a room full of attorneys and accountants collaborating can
attest to what is really happening. The creation of the PCAOB and SOX requirements is
169
Money.cnn.com, Global Markets Plunge on U.S. Recession Fears, http:// www.money.cnn.com, (last
visited January 21, 2008).
41
a starting point to seek a deeper understanding of the latest regulatory overhaul and how
it resulted in market failure during the subprime meltdown. While realizing that the
professional accountants were blind, whether by deliberate ignorance, fear or
incompetence, to the risks on the balance sheets of the many companies, their clients.
This trend should have been reflected in the PCAOB enforcement actions within the
broader accounting community and detecting these trends the PCAOB should have taken
more aggressive actions to enforce accountability and professional ethics. A more basic
or implicit problem is the malicious, greedy heart in business, combined with the Morals
of the Market, which shapes the ethical foundation for business and network exchanges.
b. Inquire into the Specific Trends and Behaviors that Shape the “Morals of
the Market” and Establishes an Integrity Baseline for Which all is
Measured: Sarbanes-Oxley Act 2002
The Morals of the Market is a term of endearment that is used loosely until one is
faced with a real professional ethical crisis with no good options but to hold onto one‘s
integrity in the face of the disillusion. Nobody felt that nightmare of disillusion more than
former consultant Keith Schooley, the rising star, who came to the Merrill Lynch in
search of a better future for his family, only to end up as the Lynch whistleblower.170 ―As
the public has so clearly learned in recent years, there are many problems within the
securities industry and investors are the ones being victimized,‖ said Schooley, who
worked at Merrill‘s Private Client Group from July 1991, until his controversial dismissal
in September 1992.171 ―I think it‘s safe to say that if Merrill Lynch has problems, it stands
170
Chandra Niles Folsom, Greed is Good Gone Bad, Mother Merrill and the Robber Barons of the Big
Board, Fairfield County Weekly, May 17, 2007, pg. 23.
171
Id.
42
to reason that the rest of Wall Street has problems, too. Frankly, this is a sad commentary
on the industry.‖172
The Morals of the Market in this era has evolved around the Greed is Good
philosophy which tolerates selective enforcement of earnings management, ethical
violations, conflicts of interest, lack of independence, opaque transparency and
inadequate disclosures. The early 2000‘s brought a series of unexpected corporate
corruption scandals, in some instances assisted by their auditors and others, leaving the
shareholders with empty pockets and lots of unanswered questions. A great shifting of
wealth from investors to the fiduciary‘s hired to protect them; investor confidence tanked,
Congress reacted with sweeping legislation: SOX. Although a lengthy, complex set of
standards, the corporate governance regulation is focused on transparency, full
disclosure, and accountability. These standards include enhanced criminal and civil
sanctions and penalties to encourage compliance.173 The purpose was to restore public
trust; but what was needed was additional legislation to protect public interest.
An over-arching PCAOB was established by the act, which was introduced amidst
a host of publicity. It appears the overwhelming consensus was stronger, independent
oversight was needed thus the arrival of the PCAOB. The troubling news is that in the
midst of this new regulatory regime, in the backdrop was the greatest heist in history, the
subprime meltdown that is premised on long-term greed motto and the repercussions will
likewise be long-term, severe, with liquidity being the capstone of the crisis.
172
Id.
173
Sarbanes-Oxley Act, 18 U.S.C. § 1514A (2002).
43
IV. Diagnosis: Why did the Sarbanes-Oxley Act, with the Creation of the
PCAOB, Result in Market Failure, and Independent Auditors Fail to
Timely Detect and Disclose to the Investing Public?
The PCAOB is fondly called the ‗stepchild of the SEC.‘ In December 2007, the
SEC approved the PCAOB's 2008 budget and the related accounting support fee charged
to public companies, which funds the PCAOB.174 " A debate ensued regarding certain
budgetary items, ―As a matter of policy, the board salaries are disproportionately high,"
said Paul Atkins, SEC Commissioner, adding the rate of increase is higher than
comparable rates.175 Atkins compared the $515,000 PCAOB board member's salary,
which was higher than most key leaders such as: the President of the United States, the
Supreme Court Chief Justice, and CEO level salaries.176 Atkins also grilled PCAOB
Chairman, Mark Olson on use of consultant‘s fees paid by the PCAOB as being
excessive.177 Olson explained some of those fees were for legal experts consulting on
enforcement matters that were anticipated to engage in litigation, as well as IT
consultants that assisted in developing systems, but no specific details were provided.178
These described excessive salaries are troubling in light of the fact that the largest
market failure since the Great Depression that occurred under the highly politicized
government agencies and newly formed PCAOB. Whistleblowers that stepped forward,
to protect the public interest, were allegedly marginalized and professionally crucified
according to the accounts of some, while the PCAOB staff appeared more interested in
174
Edith Orenstein, SEC Approves PCAOB Budget, But Atkins Declines Over Issue of PCAOB Board
Salaries, Journal or .com name, Dec 18, 2007.
175
Id.
176
Id.
177
Id.
178
Id.
44
speaking engagements, networking, and mingling within the SEC circle of friends. The
PCAOB was to be independent but instead ads were run in the Wall Street Journal
recruiting former accounting firm partners to join the PCAOB staff for enforcement.
While this may seem like a strategic staffing decision, it‘s a really bad idea as these
partnerships, whether past or present, are networked with the ability to influence the
outcomes of enforcement actions against their former friends or partners: Conflicted.
The PCAOB has stated that its purpose is to protect the interests of investors and
further the public interest in preparation of independent audit reports. Unfortunately, the
PCAOB, the independent oversight board, does not maintain the appearance of
independence that was anticipated. Simply put, the PCAOB needs to be ―The Enforcer‖
that is not out for popularity contests within the business community but rather to protect
the public interest and enforce strict compliance under SOX. The regulators are the
regulated model179 perpetuated itself at the expense of the greater good of society. In the
end, the independent auditors are auditing themselves with dismal result.
In 2008, the market has dropped around $1.3 trillion in losses over the subprime
meltdown and growing with the latest news of the fall of IndyMac: where was the
PCAOB? The federal regulators seized the bank on July 12, 2008, with about 95%
insured deposits, but leaves about $1 billion uninsured shortfall to be absorbed by
unsuspecting depositors.180 This is a liquidity crisis, enforced by bank regulators;
179
Regulator‘s are the Regulated Model is defined as the regulators, who are to protect the public interest,
are actually conflicted or have a self-interest motive, as they are appointed from their corporate roles to
regulatory roles or vice versa, in an effort to gain undue influence in the regulatory process or influence
investigations or enforcement actions in favor of those in their personal or professional networks.
180
Catherine Clifford and Chris Isidore, The Fall of IndyMac, http:// www.cnn.money.com, (last visited
July 12, 2008).
45
however the independent auditors are the watchdogs of public companies. Additionally,
PCAOB scorecards of auditor performance could have indicated that certain audit firms
have a lot of fraud, material financial restatements, or other red flags that could have
forced a closer look at these financial institutions under the watch of those audit firms.
The question for the independent auditors is how did the CPA‘s fail on such a wide scale
basis or at a minimum ―fail to warn‖ the public or the investment community of these
massive potential losses, unreserved risks, or balance sheet debacles, in light of SOX,
audit committees, and enhanced internal controls and corporate governance?
Let us explore some reasons for the market failures that led the market meltdown,
June 2008 being the worst drop in market value for 1 month, since the Great Depression.
a. Lacking Real-Time Transparency: The Current Business Reporting Model
Lacks Digitalization and Full Disclosure to Strategy, Risks,and Key Metrics
One reason for the recent market failure is that the current business reporting
model has not evolved with changing market demands and key stakeholder requirements.
Recent business failures and increasing financial reporting restatements have adversely
affected the public‘s trust and confidence. This has revived market interest in a review of
the current business reporting model to enhance the communication in real-time, events
that have a material impact to the stock price. The call to provide shareholders with high
quality and transparent information echoes from investors, creditors, analysts, regulatory
agencies, standards setters, boards of directors, and management. There are many issues
driving this demand, perhaps most notably the growing democratization of the capital
markets, growing importance of intangibles as key value drivers and a focus on meeting
short-term performance targets to the detriment of investment in future growth.
46
The purpose of the enhanced business reporting framework (―EBR‖), as written in
the original business plan, is to put structure around external reporting of information not
currently covered under GAAP, including a discussion of management strategy and
plans, risks and opportunities faced by a company, as well as industry-specific, process-
oriented metrics and financial and non-financial key performance indicators. The EBR
framework should be developed with a continuing focus on the reporting of reliable data
that is effectively self-regulated, simplified to enhance efficiency and cost-effectiveness,
timely, digital, scalable by entity size and industry-orientation and transparent, all of
which will contribute to improved comparability and understanding of disclosures.
Successful implementation of an EBR framework will result in manifold positive
outcomes, including better management, better governance and ultimately better markets.
b. Ongoing Conflicts of Interest & Lack of Independence: Blind Guise
Network
Another reason for the recent market failure is that the ethics have not improved
much, in light of SOX, as conflicts of interest and lack of independence is a huge
problem. A conflict of interest arises when what is in the best interest of the investor is
not in the best interest of the auditor, often times involving a conflicted economic
interest. The issue of conflicts of interest and lack of independence is certainly evident in
some of the cases we reviewed, pre-SOX cases such as Enron or Global Crossing or post-
SOX cases such as AIG or Parmalat. These firms have become network or enterprise
firms which have led to horizontal collaborations, strategic partnerships, and shell
companies that allow the blind guise network to operate to the demise of the public
interest and a clear abuse of power.
47
The public accounting firms have a portfolio of services that are offered to clients in
addition to the low profit external audit services that are usually the entry into the door of
the client. The expansion of services, known as horizontal integration, has threatened the
auditor independence and increased the risk for unsuspecting investors. While realizing
that SOX has substantially restricted the use of auditor consulting services; this has not
stopped the accounting profession from continuing with these high-end professional
services. Even if using not-for-profits or shell organizations to hide from the public the
nature of these conflicted consulting services: the blind guise network thrives.
The blind guise network uses grassroots campaigning to assure the public that
these professionals are acting in the public interest. Less transparent is the real motive of
some networks, where individual profits or potential future contracts in high end
consulting services are coveted. Creating the malicious conflict of interest, often times
complimented with high dollar fees, embedded in the heart of the accounting, investment
banking, and other licensed professions with a duty to protect the public interest. Not
only does it jeopardize auditor independence but it impacts antitrust laws as these
partnerships create not-for-profits and other shell companies that are anti-competitive by
design and controlled by large, dominant organizations with potentially ulterior motives.
Troubling is the practice of large, dominant public companies directors or partners who
self-appoint themselves onto key governmental committees that heavily influence the
ability to develop businesses, consulting gigs, or to grow the network for future business
advantage.
In a ground-breaking study analyzing the effects of accounting firms' consulting
business on the objectivity of their auditors, Stanford Graduate School of Business
48
faculty member Karen Nelson and colleagues provided hard evidence showing that the
provision of non-audit services impairs an auditor's independence and dangerously
stretches the bounds of accepted accounting practice.181 The study is relevant to SEC
concerns about the increase in earnings management tricks of the trade such as "big bath"
charges (one-time write offs), "cookie jar" reserves (setting aside funds to manipulate
future earnings), and premature revenue recognition.182 These are legal but grey areas or
questionable practices within the range of GAAP.183
“The researchers looked to see if there was more creative accounting among
companies that paid their accounting firms big consulting bills relative to auditing
fees: There was.”184 "We were interested in whether public accountants really are
performing their role as independent gatekeepers, or has it become a game of winks
and nods between corporate management and the auditors because the auditors don't
want to lose these very lucrative consulting contracts.” 185
Interestingly, the study found corporations with the least independent auditors
were the auditors that were paid the most in consulting fees versus audit fees and were
more likely to just meet or beat earnings benchmarks.186 ―That suggests more earnings
management went on among companies in the sample that paid the highest proportion of
management consulting fees to their auditor‘s.‖187 The results demonstrate that high paid
consulting gigs impair or influence auditor independence, to the detriment of the investor,
which puts a risk premium on investors cost of capital and their rate of return
181
Author Unknown, Stanford Business School Study Finds Consulting Contracts Impair Auditor
Objectivity, Business Wire, August 1, 2001, pg. 1.
182
Id.
183
Id.
184
Id.
185
Id.
186
Id.
187
Id.
49
expectations. The study results suggest that institutional investors and other stock market
investors were discounting the earnings of firms with potential conflicts of interest.188
The conflicts of interest and lack of independence in the auditing profession is a
critical ethical foundational issue. Left unresolved or sup-optimally resolved, is to
threaten the nations financial stability and the integrity of the fragile capital markets. The
solution may be as simple as regulating the accounting industry and allowing them to
perform audit services only in the future. The consulting services, tax services, and other
such services would need to be provided by independent firms that have no ties to the
financials of the organization. This protects the auditor from breaching their fiduciary
duties, especially duty of loyalty that requires full disclosure of the conflicts of interest.189
While realizing SOX Title II purpose and expressed bans on most consulting
engagements by auditors, except tax services. Sorry to say, these bans have not stopped
the auditors from engaging in these services, by the use of loopholes, secret agreements,
and outright defiance to their professional responsibilities: SOX has failed to deter.
c. Regulatory Capture: The Regulators are the Regulated Phenomena
Results in Lack of Strict Enforcement
Another reason for the market failure is the regulatory capture phenomenon that is
sweeping the nation. How do you define this elusive term: regulatory capture? In the
Economist, it is defined as such: ―Gamekeeper turns poacher or, at least, helps poacher,‖
according to the theory of regulatory capture by Richard Posner, an economist, 7th Circuit
188
Id.
189
John L. Colley, Jr., Jacqueline L. Doyle, George W. Logan, Wallace Steffinius, Corporate Governance,
,McGraw-Hill Executive MBA Series, 2003, pg. 30.
50
Judge, and lawyer at the University of Chicago190. Posner argues that ―Regulation is not
about the public interest at all, but is a process, by which interest groups seek to promote
their private interest ... Over time, regulatory agencies come to be dominated by the
industries regulated.‖191 The concept of ‗regulatory capture‘ has been introduced in
modern economic analysis with the seminal article by George J. Stigler in 1971 entitled
The Theory of Economic Regulation.192 The main idea of the article can be summarized
in Stigler‘s affirmation that:
―…as a rule, regulation is acquired by the industry and is designed and operated
primarily for its benefits.‖193
―The basic hypothesis of Stigler is that an industry may use, or rather abuse, the coercive
public power of the State regulators to establish and enforce rules in order to obtain
private benefits.‖194 It is not surprising that the accounting industry is funding shell
companies and not-for-profits to get their economic rents, appear as a good citizen, and
promote themselves and their firms under the guise of restoring public trust.
Of course, if the regulators are the regulated then suddenly the strong
enforcement of laws takes a back seat to influence peddling and focusing on the latest
Sunshine Club technology tools or management practices that can be sold through their
lucrative consulting businesses. The SEC is actively promoting a market for XBRL,
realizing that without sufficient market penetration and scale, the digitalized financial
190
Posner, R.A. (1974): Theories of Economic Regulation. Bell Journal of Economics and Management
Science 5(2), @ 335-358.
191
Id.
192
Stigler, G.J. (1971): The Theory of Economic Regulation. Bell Journal of Economics and Management
Science 2(1), @ 3-21.
193
Id.
194
Stigler, G.J.; Friedland, C. (1962): What Can Regulators Regulate? The Case of Electricity. Journal of
Law and Economics, October, @ 1-16.
51
reporting vision is limited by market realities. According to the Chicago School of
Economics, governments do not accidentally create monopoly in industries.195 Rather,
they too often regulate at the insistence, and for the benefit, of interest groups who turn
regulation to their own ends.196 For them administrative regulation serves the regulated
entities rather than the consumers.197 Regulatory officials can align interests with the
regulated to get a private sector job that enhances the regulators private interest at the
expense of public interest.
For example, Walter Ricciardi (―Ricciardi‖), former SEC Enforcement Director
(during the pre-crisis time period of 2004-08) worked in the general counsel's office at
accounting firm Coopers & Lybrand from 1984 until becoming the litigation practice
group leader in the general counsel's office when Coopers & Lybrand merged with
Pricewaterhouse, LLP in 1998: PricewaterhouseCoopers, LLP (―PwC‖). Interestingly,
Ricciardi was a member of the PwC Compensation Committee and had direct authority
over the principals and partners compensation related decisions within PwC, which likely
includes John O‘Connor, PwC/Tyco Defendant that Ricciardi was later found prosecuting
his former PwC partner in the Boston Office in 2004 and forward.
A perceived conflict of interest, Ricciardi as previous PwC litigator, who sat on
the PwC compensation committee until 2004, was actively engaged in the Tyco
International case that named PwC as defendants in the litigation with John O‘Connor,
then PwC Partner Boston Office. Oddly, in 2004, Ricciardi, was appointed to the SEC
Boston District office, placed in charge of the Tyco investigation, and settled the PwC
195
Posner, R.A. (1975): The Social Costs of Monopoly and Regulation, Journal of Political Economy
83(4), pg. 807-827.
196
Id.
197
Id.
52
action for around $275 million with John O‘Connor, PwC partner walking away free
from criminal liability? Was there a conflict of interest between these former partners,
one who becomes the SEC regulator and the other, the regulated, facing allegations of
fraud relating to Tyco, but somehow through a strange twist of appointments to key
agency spots the regulated became the regulator.
In 2005, Ricciardi was promoted to Deputy Director of the Division of
Enforcement, the SEC National Division of Enforcement; under his reign remains
allegations of lax enforcement, undetected Omega subprime meltdown, uninvestigated
Madoff ponzi scheme, hedge fund and private equity feeding frenzy (i.e. rumor mills,
insider trading, market manipulation, etc.), and the controversial firing of SEC attorney
Aguirre. Of course, as the tidal wave of bankruptcies and securities fraud cases are filed
en masse, again a strange twist of events, with the regulator (Ricciardi) bailing the SEC
Apocalypse and ironically becomes the ―protector‖ of the regulated (profiting nicely) in
the new role of white collar crime defense attorney. Specifically, joining Paul, Weiss,
Rifkind, Wharton & Garrison LLP as announced in June 2008 that Walter G. Ricciardi
will join as a partner in the firm's litigation department, as a member of the Securities
Litigation and White Collar Crime & Regulatory Defense practices. With all those
confidential secrets from both PwC and government roles with the SEC, will Ricciardi be
able to fulfill his ethical duties to protect the public interest or is his duty to his new
clients, white collar criminals?
53
d. Professional Ethical Lapses: “Greed is Good” Motto is Replaced with
“Long Term Greed” Creed
Another possible reason for the market failure is the continuing lapses in
professionalism and unethical behavior within the capital market system. It was the late
free-market economist Milton Friedman, writing in the preface to the 1982 reissue of his
manifesto, "Capitalism and Freedom," who articulated the strategy most succinctly, what
is known as ―disaster capitalism.‖198 This really just means that real change is produced
when a crisis is upon us. The subsequent actions taken are based upon ideas that are
currently lying dormant or a politically motivated off-the-shelf solution waiting for the
disaster to strike. Disaster capitalist see crisis such as the Omega meltdown as an
opportunity to be exploited, to develop business, and to grab market share.
A business strategy known as ‗Give More to Get More‘ allows a corporation to
donate assets as an opportunity to network, to sell more, and to broker deals.
Concentrated power is not rendered harmless by the good intentions of those who create
it according to Friedman.199 Well the motto on the street has been coined as a creed:
Long-Term Greed. That is concentrated power that aims to take greed to a whole new
level as it enslaves the nation‘s workers, stresses pension accounts, evaporates home
198
Naomi Klein, Why the Right Loves a Disaster: Ideologues use times of crisis as an opportunity to foist
their economic policies on desperate societies, LA Times, January 27, 2008, pg. 1.
199
Id.
54
ownership, and implodes the capital system. With this creed, comes the complimentary
lapse of ethical standards, sound business judgments, and unfulfilled professional duties
that become the cornerstone to the real goal of self-interested greed. As Friedman
professes, ―The power to do good is also the power to do harm.‖200 The fiduciary and
professional duties of an independent auditor are conflicted when they utilize disasters or
financial meltdowns as their basis for self-interested greed but marketed as restoring
public trust.
Philip Augar, an insider, who provides transparency into the long-term greed
systems and describes how investment banks expanded into a global monopoly power
game.201 ―Augar claims that investment banks have the advantage of ‗the Edge‘, since
they have an information advantage.‖202 ―To take advantage of that, banks had to put
clients second and themselves first:203 greed is good motto.‖ ―Augar recalls the 90s,
which culminated the dot-com bubble and reminds us of how IPOs took off, and how
analysts provided almost always recommendations to buy, and how creative accounting
became corporate meltdowns.‖204 Enron, Tyco, and the like showed that the system was
rotten from the inside, long-term greed creed, hence the Omega meltdown: subprime
mortgages.205
e. Deliberate Ignorance Standard: Enron Measure of “Intent” or not?
200
Id.
201
Philip Augar, The Greed Merchants - How the Investment Banks Played the Free Market Game,
Penguin Books, 2006.
202
Id.
203
Id.
204
Id.
205
Id.
55
A fifth reason for the market failure is the ability of officers and their boards to
avoid accountability by utilizing the deliberate ignorance defense. A judge stated to the
court that a draft version of the charge that will be read to the jurors that included a
"conscious avoidance" or "deliberate ignorance" instruction for both Jeffrey K. Skilling
and Kenneth L. Lay, former Enron executives.206 The standard, called the "ostrich
instruction,‖207 offers a lower burden of proof to find a person guilty of conspiracy and
fraud related to the collapse in December 2001.208 By allowing the ostrich instruction,
referring to that bird's burying of its head in the sand, Judge Lake is continuing a trend in
which courts increasingly apply the lower standard of criminal knowledge in white-collar
cases.209 The deliberate ignorance standard is more common street crimes like drug deals
where a package is placed in a car and the driver delivers the package, in connection
with, a customer but avoids discovering that drugs are inside but the law uses
constructive possession.210
Jurors in Kenneth Lay and Jeffrey Skilling's trial were instructed to consider
whether the former Enron Corp. executives deliberately ignored accounting fraud as the
energy trader fell into bankruptcy.211 According to the defense attorneys, the critical
issues for the jury were whether the transactions and statements at issue were fraudulent
and whether defendants intended them to be so, not whether defendants purposefully
206
Alexei Barrionuevo, Judge in Enron Case Delivers a Serious Blow to the 2 Defendants, New York
Times, May 11, 2006, pg. 1.
207
Refers to a bird burying its head in the sand.
208
Id.
209
Id.
210
Id.
211
Author Unknown, Enron jury to consider 'deliberate ignorance', Ruling echoes WorldCom case,
Bloomberg News, May 11, 2006.
56
blinded themselves.212 Outside legal experts said they expected the judge to allow the
"conscious avoidance" instruction for Mr. Lay, who some witnesses claimed consciously
avoided acting on information about potential improprieties at the company.213 These jury
instructions did lead to convictions of Lay and Skilling but also allowed for an meritous
appeal from Skilling in 2007. Sadly, Lay died while on appeal.
The lesson learned here is that ignorance of the law is not an excuse but it is a
great defense. Clearly, drug offenders can commonly apply ignorance standards and
avoid criminal liability but that is not possible under the ―deliberate ignorance‖ theory.
As Don Henley, Eagles lead singer says, ―a man with a briefcase steals more money than
a man with a gun.‖ White collar crime can be quite lucrative, much more profitable and
less risky than drug dealing, as the corporation will hire top attorneys to protect the
potential criminal management, including secret negotiations that silence the crime into
the great abyss. The white collar criminals remain free to corrupt again; this is not justice.
f. Whistleblower Protection: Failing to Protect the Front Line Officers
“The stone the builders rejected has become the capstone? Everyone who falls
on that stone will be broken to pieces, but he on whom it falls will be crushed.”
…Luke 20.17-18
A final reason for market failure is the failure of the courts and the agencies to
protect the front line officers, namely whistleblowers, in this white collar war. Title VIII
of SOX is designated as the Corporate and Criminal Fraud Accountability Act of 2002
Section 806 provides protection to employees against retaliation by companies with a
class of securities registered under section 12 of the Securities Exchange Act of 1934
212
Id.
213
Alexei Barrionuevo, Judge in Enron Case Delivers a Serious Blow to the 2 Defendants, New York
Times, May 11, 2006, pg. 1.
57
and companies required to file reports under section 15(d) of the Securities Exchange Act
of 1934 or any officer, employee, contractor, subcontractor, or agent of such companies
because the employee provided information to the employer, a Federal agency or
Congress relating to alleged violations of 18 U.S.C. 1341, 1343, 1344, or 1348, or any
rule or regulation of the SEC, or any provision of Federal law relating to fraud against
shareholders.214 In addition, SOX protects employees against discrimination when they
have filed, testified in, participated in, or otherwise assisted in a proceeding filed
or about to be filed against one of the above companies.215
Unfortunate for those brave hearted employees, especially licensed professionals
such as CPA‘s with a duty to protect the public interest; the harsh reality is only about
one in one thousand whistleblowers see justice in the courts. Whistleblowers have
allegedly experienced psychical threats, induced psychological torture (i.e. fear of
retribution to well-being, safety, or economic livelihood), tarnished professional
reputation, perceived retaliation, or targeted vigilante style street justice, orchestrated by
those employers, agents, or their audit firms, which often times goes unreported due to
fear of escalating retaliatory warfare.
The Professional Code of Conduct for CPAs216 (―Code‖) is characteristic of
―serving the public interest‖ purpose and model. The Code requires CPAs to act in a way
that will serve the public interest, honor the public trust, and demonstrate commitment to
professionalism. This places CPAs at a heightened risk of adverse actions from
214
Sarbanes-Oxley Act, 18 U.S.C. § 1514A (2002).
215
Id.
216
Professional Code of Conduct and preamble to the AICPA Code of Professional Conduct .01 By
accepting membership in the American Institute of Certified Public Accountants, a certified public
accountant assumes an obligation of self-discipline above and beyond the laws and regulations.
The Principles of Professional Code of Conduct are the pillars of the Code, which define the rules, detailed
interpretations, and rulings, the pillars are: 1) Professional Responsibility; 2) Serving the Public Interest; 3)
Highest Integrity; and 4) Maintaining Objectivity and Independence in Discharging Professional Duties.
58
employers, co-conspirators such as audit firms or industry associations, and agents. CPA
whistleblowers are analogous to police officers who more prone to being shot and
critically injured while working to protect the public interest. Unlike police officers,
CPAs may not be injured by shots of a gun, however, the adverse actions and blacklisting
are a form of a weapon that critically injures one‘s livelihood equally effective. A once
famous judge stated, ―Sunlight is said to be the best of disinfectants: electric light the
most efficient policeman.‖217 SOX requires ―increased disclosure and transparency,‖ the
equivalent of electric light, and CPAs are the professionals who have a duty to shed light
on questionable business practices and transactions, to avoid further market meltdowns
such as Global Crossing, Enron, or Bear Stearns. It is the responsibility of the courts to
ensure that CPAs, acting in good faith and within the scope of their professional duties,
be afforded heightened protections due to the increased risks of injuries, just like police
officers.
V. Future Legal & Regulatory Analysis: On the Horizon for the SEC?
During times of crisis and significant market crashes, history has proven that it is
during these times of turmoil that sweeping legislation and regulatory overhauls are to be
expected. According to Stuart Banner's historical research, ―examining the conditions for
securities market regulation in the eighteenth and nineteenth centuries in the United
Kingdom and United States, he reports that legislation was adopted only after stock
market declines, which, by 1837, coincided with economic contractions.‖218 ―Banner
contends the popular suspicion of speculation comes in bad financial times to dominate
otherwise popular support for markets, resulting in the expansion of regulation which
217
Justice Brandeis, Other People‟s Money 62 (1914).
218
Roberta Romano, The Sarbanes-Oxley Act And The Making of Quack Corporate Governance, 114 YLJ
1521, 1593, May, 2005.
59
people support after experiencing financial turmoil.‖219 It seems reasonable that Banners‘
new regulation formula; the impact of a stock market downturn on public attitudes, and
the presence of political entrepreneurs, with off-the-shelf regulatory proposals is a pattern
largely consistent with the making of SOX.220 So what is on the horizon for the SEC: off-
the-shelf regulation or a radical departure from the past?
a. 2008 SEC Omega Ends with a New Regulatory Schema: Treasury’s
Blueprint for a Modernized Financial Regulatory Structure
The first glimpse of the future was found in a recent prepared speech, Treasury
Secretary Henry Paulson stressed that the fall of Bear Stearns has expedited the need for
the government to address the outdated regulatory oversight structure and to strike a
balance between market discipline and market oversight.221 ―We should quickly consider
how to most appropriately give the Fed the authority to access the necessary information
from highly complex financial institutions and the responsibility to intervene in order to
protect the system, so they can carry out the role our nation has come to expect—
stabilizing the overall system when it is threatened,‖ remarked Mr. Paulson.222 In March
2008, the Treasury published a 212-page blueprint of the future regulatory stage.223
As predicted from history, regulation is ushered in after the bear market sets in
and the economic turmoil disrupts public confidence.224 The Treasury laid out the
following vision to modernize the SEC‘s oversight of the futures and the securities
markets.225 The proposals provided ranged from short, intermediate, and optimal goals
219
Id.
220
Id.
221
Kara Scannell, Paulson to Call for New Fed Role, Wall Street Journal, June 19, 2008, pg. A3.
222
Id.
223
Henry M. Paulson, Jr,, Robert K. Steel, David G. Nason, Blueprint for a Modernized Financial
Regulatory Structure, United States Department of the Treasury, , March 31, 2008, pg. 1 to 212.
224
Id. At 106.
225
Id. At 106.
60
that are too complex for the purposes of this paper. Rather, we will examine the self-
regulatory discussion and the conflicts of interest that exist within the SRO ethical
foundation. We will also come to realize that the Treasury endorses the idea of a market
regulator that will intervene in times of crisis, as the Fed did in the Bear Stearns
transaction, to avoid a larger market collapse of confidence. This idea is outside the scope
of this paper and no opinion will be expressed. However, this is a clear signal that the
regulatory structure, including the SEC, is about to undergo significant changes to
advance globalization, technological innovation, potential merger with Commodity
Futures Trading Commission, and stronger regulatory oversight to aid the SEC in the
policing of complex capital markets. This will not resolve the real crisis, the unethical
foundation, as the morals of the marketplace are difficult to regulate indeed.
Regulation is increasingly difficult as wide scale horizontal collaborations are
established. With horizontal collaboration comes the forming of SROs, with their own
rules, to support these new regulatory or compliance cost initiatives. Namely, eXtensible
business reporting language (―XBRL‖) that was promoted by the SEC, along with the
audit firms that the SEC is responsible to investigate and enforce (i.e. Tyco, Global
Crossing), instead were forming a complex web of shell companies, creating an SRO
reminiscent of self-help therapy, and failing to enforce the ethical standards upon the
members of these SROs. Even communications exchanged between audit firms and SEC
personnel was allegedly addressed as ―Friends & Family‖ giving outsiders the feeling
that the relationships have gotten a bit too cozy: conflicted circle of friends & family.
Regulator intervention often times is a reaction to the problem not necessarily a
preventive measure to stop the underlying causes of the problem. Analogous to pulling
61
the top off a dandelion, it will quickly grow back if the root is still resident. Who really is
protecting the public interest if the SROs are conflicted?
The Treasury asserts the effective and efficient functioning of the SRO rule
change process is critical to the integrity and competitiveness of the American capital
markets.226 ―Section 19 of the Securities Exchange Act (―Exchange Act‖) governs the
procedures for approving the SRO rulemakings, including those for the approval of new
products.‖227 Market participants have been critical of the SEC for its delay in approving
SRO rule changes, especially those relating to new products and trading systems.228 The
critics claim that markets and financial products continue to evolve at a pace that the
current SEC‘s procedural practices fail to accommodate thus slowing these SROs from
quickly introducing new products into the markets.229
From my perspective, the real issue is not the new products, or the time to market.
Rather, the principal issue is whether these product and market opportunities are needed
at all. Innovation has sped ahead of regulation, in the 2000 era, leading to dismal results.
The complexity and opaqueness of these new product introductions should be met with
much resistance and deeper questioning to slow the time to market especially in light of
the new products such as CDOs, which contributed to the subprime meltdown. Deploying
Plain English standards and simplifying product offerings maybe a better route to
preserving market integrity.
226
Id. at 112.
227
Id. at 111.
228
Id. at 112.
229
Id. at 112.
62
Self-regulation is the first line of defense in preserving market integrity and
protecting against fraud and abuse.230 SROs serve a purpose but from a critical viewpoint,
self-regulation is susceptible to a wide range of conflicts of interest which includes the
potential that the SRO may have a financial interest in its members or their business
activities.231 The solutions proposed such as independent boards filled with those outside
of the industry will certainly curb abuse but those boards are paid by the SROs and the
new conflict of interest begins as loyalty shifts from protecting the public interest to
protecting one‘s own paycheck and livelihood. Whistleblowing or asking the ―right-
wrong questions‖ is a quick way to be exiled to the door by the SRO who employs the
board member: freeze-outs are quite effective.
Self-regulation is potentially redundant and burdensome with respect to the
industry‘s federal regulator or one or more additional SROs.232 The ethical lapses are
occurring within the SRO foundation and its members and are in need of an overhaul
within the SRO framework. The SROs are competing with each other for members and
are using the SRO as a mass marketing tool, thus keeping their eye off the self-regulatory
mission and ethics enforcement. The federal regulators are not effective in policing
complex markets, relying on SROs to carry this burden, and regulators have historically
been reactionary as the damages are usually flowing in when the regulators step in. The
SEC is in the midst of a regulatory overhaul. But in light of the growing complexities of
global capital markets, the SEC is not positioned now or the immediate future to regulate
these complex markets alone.
230
Id. at 122.
231
Id. at 123.
232
Id. at 123.
63
b. SEC Digitalizes the Public Company Financial Filings by Utilizing
XBRL and Voting for Mandatory Regulation Standards in 2008
The second revelation of the future was announced by SEC Chairman Cox, ―Let
the sunshine in as never before,‖ in a move to file financial statements in an ―interactive
data‖ format.‖233 A proposal, which the SEC approved 3-0, calling for large public
companies that use U.S. accounting to electronically tag financial data starting with
reports covering periods that end on or after December 15, 2008.‖234 The other
companies, such as small companies, will be phased in up through 2010.235 This data
tagging technology uses software called extensible business reporting language
(―XBRL‖) to code individual bits of information, such as revenue, making it easier to
find and compare results across industries, companies, or time periods.236 The benefit to
the market flows from the ease by which investors may compare interactive data. And the
comparison of data, if enhanced in other areas such as the Management Discussion &
Analysis section of financial reports, allows for more informed and thus more efficient
investment decisions.
The use of digitalized data will enable comparison of material changes, should the
SEC decide to exercise the rulemaking authority provided for in SOX Section 409, Real
Time Issuer Disclosures:237
“Each issuer reporting under section 13(a) or 15(d) shall disclose to the public on a
rapid and current basis such additional information concerning material changes in
the financial condition or operations of the issuer, in plain English, which may include
trend and qualitative information and graphic presentations, as the Commission
233
Alan Rappeport, XBRL Suddenly, It‟s Here, CFO Magazine, June 2008, pg. 32.
234
Judith Burns, SEC Votes to Require Data „Tagging‟ in Reports, Wall Street Journal, May 16, 2008, pg.
C3.
235
Id.
236
Id.
237
Sarbanes-Oxley Act, 18 U.S.C. § 1514A (2002).
64
determines, by rule, is necessary or useful for the protection of investors and in the
public interest.” 238
The enhanced disclosure requirement, referred to in Section 409, is that issuers
are required to provide transparency on material changes in operations or financial
condition, on a rapid, somewhat interactive basis. The investors will benefit from this
rapid, real time data transmission of material information. The SEC created a new agency
office of Interactive Disclosure and plans to advance the use of interactive data in
financial reporting worldwide.239 The cost is estimated around $30,000 per
implementation and less for smaller companies. The SEC stated that market innovation
will be needed for XBRL to reach its full potential, meaning a market for XBRL software
and services which is evolving and may now accelerate. A critic, who chooses to remain
anonymous, reported that a conflict of interest may reside in the move from voluntary to
mandatory as certain parties stand to profit nicely from this technological transformation.
This transformation also requires diligence on behalf of management to file the
proper disclosures in real time. The XBRL tools will enable management to proactively
model the changes on the industry, analyzing in multiple ways, before making such
disclosures, thus enhancing the integrity of the comments and the confidence of the C-
Suite. A key metric that can be used in price fixing, commonly cited by a PwC partner
from the dairy industry, is ―retail per square foot‖ calculation (will history repeat itself
from the ―Milk Money Cartel‖ in Florida with a computerized system to aid in the
criminal enterprise or price-fixing allegations in Dairy Farmers of America). One must
realize that providing competitive intelligence to the dairy industry players allows for
convenient access to collusion networks under the guise of increased transparency thus
238
Id.
239
www.sec.gov, SEC Announces New Unit to Lead Global Move to Interactive Data, Release 2007-213.
65
setting the stage for price fixing. This allows for monopoly profits, followed by lack of
disclosure, thus unsuspecting investors can be seduced into buying stocks that have a
high profit potential with an undisclosed liability of anti-trust litigation or other
contingent liabilities.
c. Looking Beyond the SEC Circle: Enforcing Independence in Rating
Scores
The third vision of the future includes looking beyond the SEC circle and
enforcing independence of the rating agencies. In 2006, Congress gave the SEC oversight
of bond-rating firms with rule changes soon to follow.240 Last year the SEC changed the
rules regarding industry behavior, aimed partly as a prod to disclose conflicts of interest
while lowering barriers of entry to new competitors.‘241 The SEC found serious
shortcomings in the practices of the nations 3 largest credit rating firms.‘242 The ten-
month examination uncovered poor disclosure practices, a lack of policies and procedures
guiding analysis of mortgage related debt, and insufficient attention paid to managing
conflicts of interest.243
In light of a 2008 settlement between the three largest rating agencies and the
New York Attorney General Andrew Cuomo, changes are expected in how they collect
fees in order to make them less dependent on winning business from bond issuers.244
Also July 1, 2008, Moody‘s Investors service announced the resignation of a top
executive, which under his governance, had a $1 billion chunk of securities being
240
Dara Scannell & Aaron Lucchetti, , SEC to Seek Rule on Added Disclosure by Bond-Rating Firms,
Wall Street Journal, June 11, 2008, pg. C2.
241
Id.
242
Author unknown, SEC Says Debt Rating Firms Sacrificed Quality for Profit, Wall Street Journal, July 9,
2008, pg. C1.
243
Id.
244
Id.
66
improperly rated AAA when in fact they were junk or were not ratable at all.245 Investors
placed a great deal of weight on these ratings and were buying up complex securities
without understanding what they were buying.246 In a lawsuit against Deutsche Bank, the
plaintiff had written down the value of two CDOs by more than 90%.247 The lawsuit
states that the AAA and AA ratings were major considerations in the plaintiff‘s
determination to invest because the CDO was sold to the plaintiff as safe, stable, and
nearly risk free investments.248
Viewing these conflicts as a principal cause of the subprime meltdown, the SEC
recommended sweeping changes to the bond-rating business.249 Among the proposals, the
SEC would require credit-rating firms to make more information about ratings publicly
available, would ban some practices, and would require clear distinctions in marketing
complex structured products.250 SEC Chairman Cox said the proposals add transparency
and accountability to credit ratings and ―help ensure that investors fully appreciate the
different risk characteristics of structured products, particularly under stress
conditions.‖251
This move towards independence is important to restore public trust and
confidence in the capital markets. Some of the proposed changes the SEC voted on
include:252 1) a rule that would bar firms from rating structured debt they helped design;
2) a proposal that officials who negotiate fees with clients be banned from rating their
245
Jane Sasseen, Why Moody‟s and S&P Still Matter, Business Week, July 14 -21, 2008, pg. 32.
246
Id.
247
Aaron Lucchetti, Kara Scannell, and Craid Karnin, SEC Plans Rules to Widely Diminish Sway of
Credit Ratings, Wall Street Journal, June 24, 2008, pg. C2
248
Id.
249
Kara Scannell & Aaron Lucchetti, , SEC Backs Changes in Rules on Ratings, Wall Street Journal, June
12, 2008, pg. C2.
250
Id.
251
Id.
252
Id.
67
debt; 3) analysts who advise on ratings or methodologies be prohibited from gifts greater
than $25 per meeting, and; 4) firms that rate structured products and are paid by issuers
of that debt must disclose the conflict and how they manage it. These moves are aimed at
the precise problem prevalent in morals of the market because within the SRO regulatory
watchdogs, the conflicts of interest and the lack of independence are commonplace.
Middlemen can influence the ratings at the detriment of market integrity and profit
handsomely from these biased ratings that SROs are reluctant to self-regulate. The
proposed regulatory changes and strong enforcement will instill a new sense of belief in
the integrity of the capital markets: Independence in markets through integrity in
governance.
d. Sunlight Transparency: Auditor Independence and Executive Pay
Debacle
The last revelation of the future is that full disclosure, transparency, and corporate
governance standards are going to continue to play a major role in business processes of
the future. ―Sunlight is the best disinfectant. In other words, full disclosure makes our
securities markets fairer and more efficient.‖253 As former SEC Commissioner Laura S.
Unger explained, ―If there was ever any doubt that sunlight is the best disinfectant the
results from this year's [2001] recently-ended proxy season prove it.254 Our eyes were
opened wide in two particular areas: auditor independence and executive
compensation,‖255 said Unger. These comments were pre-SOX, yet in light of the recent
253
www.sec.gov, , This Year's Proxy Season: Sunlight Shines on Auditor Independence and Executive
Compensation, SEC Acting Chairman Laura S. Unger, U.S. Securities & Exchange Commission, Center
for Professional Education, Inc. June 25, 2001.
254
Id.
255
Id.
68
Omega meltdown and government bailouts estimated in the trillions, nothing has
changed. Bonuses are flowing freely in spite of gross market failures, executive
compensation rewards value destruction, and auditors consulting practices are thriving.
Enron and other recent scandals reveal astonishing-perhaps unprecedented-levels
of executive greed and dishonesty, but there is more to the story than that.256 Certain
features of the current business and legal environment encourage management to raise
share prices by any available means.257 Executive compensation practices heavily rely on
stock options, giving top management a direct and immediate stake in price increases.258
In addition, the still real threat of hostile takeovers creates a powerful incentive on the
part of corporate management to boost stock prices in order to placate investors and
discourage potential hostile bidders by raising acquisition costs.259 This culture of
shareholder value maximization-currently interpreted to require short-term share price
maximization rewards efforts to boost share price whether or not the means are lawful.260
Corporate governance watchdogs received a lot of attention while investors,
institutional shareholders, and the media become fixated with the excesses of executive
pay and perks. A new corporate governance buzzword, clawback provisions, is gaining
traction in the business world as it relates to executive compensation linked to long-term
shareholder satisfaction. Specifically, although the clawback provisions vary by
company, they share the common goal of enabling companies to recover performance-
based compensation to the extent they later determine that performance goals were not
256
David Million, Who“caused” the Enron debacle?, Wash. & Lee L. Rev.,(Winter 2003).
257
Id.
258
Id.
259
Id.
260
Id.
69
actually achieved. Clawback provisions often apply regardless of whether the company
was required to restate financial results.261 Unlike SOX provisions for clawback
provisions, those codified as 15 U.S.C § 7243, a provision which requires that when
misconduct results in a company's violation of financial reporting requirements that calls
for a restatement of its financials, the CEO and CFO must reimburse the company for any
bonus or other incentive-based or equity-based compensation either of them received
during the 12-month period following the filing of the erroneous financials with the SEC,
and pay the company any profits realized from the sale of the company's securities during
that period.262
The concept of auditor independence is conceived as a principal agent
relationship which means true independence cannot be achieved as auditor independence
should not be conceived relationally to the client organization at all.263 Auditor
independence is the capstone of the accounting profession and is the bedrock foundation
that public interest relies upon in the attestation functions of auditors. Yet, the investing
public, whose interest the independent auditors are to protect, neither hires, controls, or
retires the auditors as they are managed by the company‘s board and audit committee.
This tension is worsened when payment is made by the company management, audit
committees, and/or board of directors, and not the investing shareholders; creating a
displaced sense of loyalty. The conflict is further widened when lucrative consulting
contracts are awarded by company management or the board of directors, thus shifting
261
Amy L. Goodman, Andrew Tuch, co-editor, “Clawbacks” of Executive Compensation, Harvard Law
School Corporate Governance Blog, (last visited July 30, 2008).
262
Unknown, Materiality in Sarbanes-Oxley Act Employee Protection Claims, Fall 2007, 27 JNAALJ 339,
401, (Fall 2007).
263
William W. Bratton, Shareholder Value, Financial Conservatism, and Auditor Independence, 53 Duke
L.J. 2, (2003).
70
loyalty to those who pay the rent. Realizing that SOX prohibits many of the consulting
arrangements on its face, however, in practice the auditors consulting businesses are
thriving. The best option is to completely severe all consulting services from auditor‘s
scope of products, commoditize the audits, and instill independent regulatory oversight
(i.e. PCAOB refocused) with strict enforcement of the existing ethical rules that shape the
morals of the market.
VI. Conclusion: Looking Forward to the Next Crash
Humble Market Beginnings Lead to…Next Market Crash maybe a Super-Bubble Bust (2008)?
Super-bubble
Dow Jones Industrial Average (DJIA) Index 1900 - 2008
On June 26, 2008, the Dow Jones Industrial Average dropped 350 points, with all
markets dropping about 3% of market value, as investment banks suffered from a
liquidity crisis, loss of credibility from the sub prime mortgage meltdown, and a global
recession on the horizon. The loss of public confidence in capital markets continues to
plague Wall Street, as investors are recovering from the economic losses of subprime
CDOs being sold as AAA grade investments. The irony is that past federal investigations
with certain investment banks or corporations could have shed light on some of these
71
questionable business practices and prevented or at least slowed the loss of billions of
dollars.
―Ugly‖ was how a Goldman Sachs analyst described the results of the
disappointing financial and liquid assets of Morgan Stanley, under CEO John Mack‘s
leadership.264 The investment bank‘s market value, like others in the liquidity crisis, has
plunged 60%, with confidence sinking in bedrock businesses, with little hope.265 In
December 2007, Morgan Stanley suffered its first quarterly loss as a publicly traded
company, forcing the infusion of $5 billion from China to aid in liquidity and strengthens
the balance sheet.266 The irony is the SEC whistleblower, Aguirre, former SEC Senior
Counsel for Enforcement Division, until the SEC abruptly fired him in September 2005
following his attempt to subpoena John Mack, in an insider trading investigation.267
Eventually Aguirre went before members of Congress over the handling of this
investigation and the retaliation.
Subsequently, the SEC was under investigation for not investigating, or what can
be labeled as ―selectively investigating.‖268 One can only imagine that the Aguirre
investigation and retaliation firing was only one, of likely many, whistleblowers who
suffer injustice. The General Accounting Office (―GAO‖) and Senate concluded that the
264
Susanne Craig & Carrick Mollenkamp, Still “Brutal” at Morgan Stanley, Wall Street Journal, June 19,
2008, pg. C1.
265
Id.
266
Id.
267
David E. Nolte, SEC Investigators Are Themselves Investigated By Whistleblower.
268
For this paper, selective enforcement is the process of enforcing the rules on a select group of companies
or individuals which generally does not include those who are members of key committees, friends,
business associates, ect…within one‘s network, affiliations, family, or friends.
72
SEC was lax in its investigation which helps Aguirre in his quest for justice.269 In 2007,
the Senate issued a 108-page report that strongly criticized the SEC‘s investigation into
the insider trading allegations and internal failures.270
Separately, legislators criticized the SEC for refusing a congressional request to
disclose why the SEC dropped a 2005 investigation into whether Bear Stearns harmed
investors by improperly valuing complex debt securities, missing an opportunity to get
ahead of the subprime war.271 The SEC, Wall Street‘s usual civil-case cop, faces criticism
for not policing the financial world at a critical time: taking a less aggressive stance in
handling the Bear Stearn‘s implosion in March.272 Yet in response to this criticism, the
SEC cites to the fact that over the last 3 years, it has ―achieved the second highest single
year dollar amount of disgorgement and penalties, the second highest single year number
of enforcement actions, and the highest single year number of corporate penalties and
sanctions against an individual.‖273 The debate ensues; regulation without strong
enforcement is meaningless.
In conclusion, based on the awareness gained by the case studies and with the
painful subprime global meltdown that is underway, it is clear that the nation needs
stronger, independent regulatory oversight that begins at the grass roots level of the self-
regulatory bodies on up the chain. SROs must strictly enforce the rules against their
members which is a present day issue due to ethical lapses and conflicts of interest that
269
David E. Nolte, SEC Investigators Are Themselves Investigated By Whistleblower,
270
Id.
271
Amir Efrati & Tom McGinty, You Indictin‟ Who? A Rivalry Grows for Stock Cops in Brooklyn,
Manhattan, Wall Street Journal, June 20, 2008, pg. C3.
272
Id.
273
Id.
73
represent the Morals of the Market. Worse, is the audit industry‘s cozy relationships with
their audit clients, government agencies, politicians, attorneys, perception partners, and
public companies. However, analysts are now placing a risk premium on these companies
stocks, for the conflict of interests that are not always so transparent.
The SOX legislation is a good start down the path of strengthened corporate
governance but it is only the beginning. Our nation needs to modernize its business
reporting model to meet the investor community‘s demands for transparency and full
disclosure. The Treasury‘s regulatory overhaul is needed to digitalize financial reporting
and increase transparency. What should be addressed is the regulatory capture issue as
well as lack of independence in bond-rating firms, along with the corresponding conflicts
of interest that arise.
Whatever the rules of engagement, strict enforcement of the rules is necessary to
sanction the ―Long-Term Greed‖ creed and to be on guard for the deliberate ignorance
defense. The Whistleblower protections need to be enhanced as these folks are putting
their livelihood and professional credibility on the line when they fulfill their professional
and ethical duties to shed light on questionable business transactions. For the SEC to
effectively regulate complex capital markets, professional standards and ethics must be
further engrained into the world of stock markets, transparency within the arena
augmented, and independent auditing oversight maintained to ensure a vibrant capital
market. America, formerly a free market enterprise, the land of the free and the home of
the brave, was founded on ―Independence‖ with a fourth of July holiday to celebrate it
annually. Are the fireworks over as we give way to a new rule of engagement that was
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thrust on the nation without a vote, ―privatizing profits while socializing liabilities‖? The
answer is ―no‖ as long as we reach deep into our hearts to passionately pursue the goal,
“Independence in markets earned through integrity in governance.”
Double-Trouble
Bubble (watch out)
Taxpayer Funded
Future Debt Model
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