The current financial crisis, plus the Enron calamity earlier this decade, made clear the vitality of having accounting standards, for securitization and similar financial transactions, that make a company’s debt obligations transparent to investors. The Financial Accounting Standards Board has done just that by issuing two new accounting standards governing such deals. As always, FASB did so after extensive study, deliberation, solicitation [...]]]> On Monday, I criticized political interference with US accounting standard setting and this morning I referenced innovative securitization deals that contributed to the credit crisis. Now I read that Rep. Scott Garrett (R-NJ) yesterday offered an amendment to the House financial reform bill to require the accounting standard setter to prepare a written study on the effects of its new accounting standards for securitizations!

The current financial crisis, plus the Enron calamity earlier this decade, made clear the vitality of having accounting standards, for securitization and similar financial transactions, that make a company’s debt obligations transparent to investors. The Financial Accounting Standards Board has done just that by issuing two new accounting standards governing such deals. As always, FASB did so after extensive study, deliberation, solicitation and evaluation of comment letters from anyone interested in providing them.

Garrett’s proposed amendment would now impose a legal obligation on FASB to do a more particular study, in cooperation with various federal regulatory agencies, on the effects of the new standards on companies who do securitization deals. This is objectionable for at least the following reasons: (1) it is inherently objectionable political intermeddling into the independent accounting standard setting process; (2) it is the result of lobbying campaigns by banks and others in the business of securitization; and (3) it caters to those lobbying interests rather than focusing on those for whom accounting standards are written: investors.

Rep. Garrett says he’s worried that making securitizations more transparent to investors would make it more difficult for banks and other financial institutions to do them. That would, in turn, mean reduced availability of consumer credit. It is as if the Representative has not read a single newspaper in the last two years. After all, it does not appear that the biggest problems in the country the past decade were consumers borrowing too little or banks doing too few opaque financing deals.

An old joke says every financial crisis needs an accounting culprit to blame. The current crisis may be attributable instead to the dominance of modern finance theory and subordination of traditional accounting principles. Two generations of finance theorists—in business and law schools—developed elaborate models to measure and manage risk in a theoretical world of efficient markets where accounting is not relevant.

Yet two strange twists have arisen—one showing the intellectual limits of the finance story and the other the dark art of making accounting into a political issue. Both concern debate over how to measure financial assets on a balance sheet—the so-called fair value debate.

First, for decades, proponents of modern finance theory urged standard setters to direct asset measurements using fair value rather than applying traditional [...]]]>

An old joke says every financial crisis needs an accounting culprit to blame. The current crisis may be attributable instead to the dominance of modern finance theory and subordination of traditional accounting principles. Two generations of finance theorists—in business and law schools—developed elaborate models to measure and manage risk in a theoretical world of efficient markets where accounting is not relevant.

Yet two strange twists have arisen—one showing the intellectual limits of the finance story and the other the dark art of making accounting into a political issue. Both concern debate over how to measure financial assets on a balance sheet—the so-called fair value debate.

First, for decades, proponents of modern finance theory urged standard setters to direct asset measurements using fair value rather than applying traditional accounting conventions. The prescription was based on assertions that emphasized the reliability of efficient markets to reveal relevant values. Proponents said traditional accounting conventions, using acquisition cost adjusted over time, were comparatively impoverished.

Amid the crisis, those same people shift their stance, now saying fair value measures in stressful markets are either misleading or put downward pressure on values that could render owners of impaired assets, especially banks, insolvent. On its face, this is an admission about the limits of markets to reveal reliable asset values, that modern finance theory is impoverished.

Second, without opining on the merits of measuring assets at fair value or using historical cost accounting conventions, this issue, once again, is turning accounting standard setting into a political expression rather than a professional one. Politicians in Congress, under heavy bank lobbying, pressured the US standard setter [the Financial Accounting Standards Board] to adopt bank-friendly approaches to asset measurement.   Now, Congressional bills  (here, for example, and noted here) contemplate empowering politicians and/or a new federal agency to oversee US accounting standard setting, equipping them with veto rights over any accounting standards the political power consensus disfavors.

Such politicization of accounting, a recurrent threat in the United States that generally is recurrently defeated, is dangerous, as Bill Bratton has explored. Injecting politics into accounting standard setting would not only turn our accounting system into a version of the politically-pockmarked and incomprehensible US tax code, it would diminish the hard-won emphasis on investors as the primary constituent for which accounting standards are adopted.

Examples of hard-won investor focus, and successful resistance to campaigns to make accounting a political product in the US, include (a) accounting for oil companies during the energy crisis of the 1970s, (b) accounting for mergers in the takeover wave of the 1980s, (c) accounting for pensions and employee benefits in the late 1980s after these proliferated and (d) accounting for stock options in the late 1990s and early 2000s after these mushroomed.

In all those contexts, lobbyists got politicians to pressure the independent accounting standard to steer it off its intended course. In each case, however, eventually the standard setter won, retained its position and achieved adoption of accounting standards focused on the needs of investors, rather than parochial interests of managers.

In the current context, the legislative talk is going much further, to create political watch-dog power to oversee the independent standard setter, even giving the federal agency power to veto any standard it does not like. This is a dangerous proposal that should be rejected out of hand.

There is no accounting culprit in the current crisis, a crisis more a product of modern finance theories. Politicians ought to focus on those theories that failed rather than exploit a period of chaos and confusion to alter practices that have succeeded.

Above all, modern finance theories seduce belief that markets, not accounting, matter. Yet the intense and costly political lobbying about what accounting should be also shows that real-world participants know that finance theory’s intellectual elegance masks important drivers of capital allocation.

Thanks to Donna Nagy, a diverse group of law professors (including me)  join an amicus brief challenging that stance.    We emphasize that we believe that the idea of the Board is appealing but the design Congress chose is flawed.   A copy of the brief is available here.

I’ve completed and submitted the manuscript and am now finishing revisions to the Teacher’s Manual and PowerPoint slides. The wonderful publicity department at West, my publisher, will release some version of the following squib on the book:

Cunningham’s Introductory Accounting, Finance and Auditing, adopted at some 70 schools in its 12-year history, presents accounting, finance and auditing using clear narrative with extensive illustrations. It balances accessibility with rigor.

  Pedagogical features that make it easy to use include a coherent layout, complete set of PowerPoint slides, comprehensive Problems and Solutions, intriguing Conceptual Questions and International Comparisons plus [...]]]> Earlier this summer, teachers using my accounting textbook received an update highlighting developments for use in Fall classes. Changes will appear in the forthcoming fifth edition, due out in time for Spring classes.

I’ve completed and submitted the manuscript and am now finishing revisions to the Teacher’s Manual and PowerPoint slides. The wonderful publicity department at West, my publisher, will release some version of the following squib on the book:

Cunningham’s Introductory Accounting, Finance and Auditing, adopted at some 70 schools in its 12-year history, presents accounting, finance and auditing using clear narrative with extensive illustrations. It balances accessibility with rigor.

 
Pedagogical features that make it easy to use include a coherent layout, complete set of PowerPoint slides, comprehensive Problems and Solutions, intriguing Conceptual Questions and International Comparisons plus a Glossary, Bibliography, Index and Teacher’s Manual.

 
The fifth edition adds material on international accounting and other hot topics. It can be used as the primary book for a one-, two- or three-credit accounting course or to supplement business associations, corporations or corporate finance courses.

Fleshing that out a bit, changes from the fourth to fifth edition are far less extensive than changes made from the third to the fourth edition in 2005. No major overhaul is undertaken and no new chapters are added.

But I have made several pedagogical improvements, added materials on international financial reporting standards (IFRS), and updated a few discrete accounting and auditing topics. The main results are as follows.

First, the most important changes concern the proliferation of IFRS.  This is emphasized in Chapter 1, though the book continues to focus on US GAAP.  

The widespread use of IFRS outside the US, and interest in it within the US, prompted me to create a new pedagogical feature. Each accounting chapter, 3 through 9, now conclude with IFRS Notes.

These highlight salient differences between US GAAP and IFRS on topics covered in the related Chapter.  These are useful as a substantive matter.  But another purpose, a theme of the book in all prior editions,  is to emphasize the role judgment plays in accounting standard setting, application and interpretation.

Other notable changes:

• FASB has killed the old “GAAP hierarchy” that required sorting among numerous levels of accounting authority, in favor a single Codification.  This is reflected in Chapter 1 and elsewhere.

•  Most changes in US GAAP requiring updating concern advanced subjects, concentrated in Chapter 6, such as financial instruments and in-process research and development.

•  The raging policy debate concerning fair value versus cost accounting is treated more extensively in Chapters 5 and 6, both adding new material and perspective

• Changes in auditing practice, particularly concerning the scope of audits of internal control over financial reporting, are noted in Chapter 1 and amplified in Chapter 14.  

•  Chapter 15, on Audit Policy, is reorganized in light of developments many years after Sarbanes-Oxley inaugurated a revolution in the subject. 
 
Details of relevant changes will be mentioned in respective Chapter Notes in the Teacher’s Manual. The full set of PowerPoint slides will be updated.

Thanks to the many teachers and students who have used the book over the years, especially those who have provided feedback to make it better.

Interest heats up after a firm based in California asks people to scan works that have been referenced in the Code of Federal Regulations for inclusion in the firm’s free standards database. This is a bold move for the firm to undertake and a potentially risky one for those responding to its request.   My 2005 Michigan Law Review piece offered a [...]]]> Under what circumstances do privately-generated standards lose copyright protection by virtue of governmental approval, mandate or adoption of them? The law on this subject remains unsettled, with a few somewhat conflicting federal circuit court decisions and no Supreme Court direction. The issue is when standards become functional law so that, under principles of justice dating to Roman times, they must be freely accessible to the public.

Interest heats up after a firm based in California asks people to scan works that have been referenced in the Code of Federal Regulations for inclusion in the firm’s free standards database. This is a bold move for the firm to undertake and a potentially risky one for those responding to its request.   My 2005 Michigan Law Review piece offered a framework for resolving these problems; the following abstracts it a bit and applies it to the California firm’s request.

The leading case potentially favoring the firm’s stance is Veeck (5th Cir. 2002) where a divided en banc court held that copyright to a building code is lost when a legislative body enacts it as law. The majority emphasized that legislative adoption rendered the code law and this, ipso facto, put it in the public domain, ineligible for copyright. Dissents emphasized need to consider incentive effects of such a conclusion on future production of kindred materials.

Important in Veeck was how the building code was created solely for the purpose of being enacted into law by an author having solely that purpose. So even this case does not comprehensively support the California firm’s implicit claim that mention of standards in the CFR deprives them of copyright protection.

Two important cases stand on the other side of the firm’s implicit position. Practice Management (9th Cir. 1997) held that the American Medical Association did not lose copyright in a medical procedure coding system even when government regulations required its use. Notably, these standards were developed for reasons other than enactment as law, chiefly to enable medical practices to manage data. To that extent, basic copyright incentive rationales remain applicable to justify sustained copyright protection.

Similarly, CCC (2d Cir. 1994) found a copier liable for copyright infringement of published information on used car valuations in the Red Book. The copier’s public domain defense to infringement rested on establishment in state insurance law of Red Book values as an alternative standard to set minimum loss payouts. This was insufficient governmental embrace of the standards to render them law in the public domain.

An unresolved variant on these themes occurs when a governmental authority creates the standards or anoints a designated representative to do so. A good example is when Congress directs the SEC on how to recognize FASB as the official setter of accounting standards. Although there is a good case that these should not enjoy copyright protection, being functionally positive law, FASB continues to assert copyright ownership over the standards.

At stake in these cases are hard questions concerning what constitutes law, which can be probed according to the manner and strength of government embrace of given standards, plus perplexing policy issues balancing access to law with incentives copyright provides, hinging in turn on contending factors like the author’s identity, the nature of the work, the identity and nature of the copier, and the relation of the governmental entity to the author, work and copier.

From this array of problems, my earlier article offered a three-part classification scheme.  It describes the strength of government embodiment, for convenience, as weak form, semi-strong form and strong form.  The framework then enables weighing the important factors relevant to policy balancing .

In the framework, the easiest cases are (1) weak-form adoption, embrace by mere reference, as in CCC, and (2) strong-form adoption, embrace by quasi-official promulgation, as with FASB.  Harder are cases in between, certainly like Veeck and even Practice Management.

Despite difficulties for many case types, my best guess, under prevailing law and normative policy, is that mere mention of a work in the CFR does not affect copyright protection in it.  

This is not to rebuke the California firm, however, for its mission appears to be to promote open government, which comports with President Obama’s directive to members of his administration and is, in principle, a valid objective.

In that spirit, moreover, it would seem desirable for Obama administration proponents of open government to consider cases like FASB, where quasi-official authorities continue to promulgate binding standards, but assert copyright over them.

Hat Tip: Robert Richards

In late August 2008 on this blog, I asked whether readers were aware of lists or charts illustrating treatment differences between US and international accounting standards. Comments and other research yielded modest results. The relevant literature tends to focus on differences in bottom lines between the two systems, not treatment differences.

This gap led Bill Bratton (Georgetown) and I to believe that a list or chart of treatment differences, with contextual analysis, would be useful to the literature (in [...]]]> Amid continuing enthusiasm for the US to abandon its traditional accounting standards in favor of those set by an international body in London, insufficient attention is paid to differences in how the two treat particular questions and what those different treatments reflect about political realities.

In late August 2008 on this blog, I asked whether readers were aware of lists or charts illustrating treatment differences between US and international accounting standards. Comments and other research yielded modest results. The relevant literature tends to focus on differences in bottom lines between the two systems, not treatment differences.

This gap led Bill Bratton (Georgetown) and I to believe that a list or chart of treatment differences, with contextual analysis, would be useful to the literature (in both accounting and in law). As a result, Prof. Bratton and I prepared a contribution for the Virginia Law Review, commenting on a related paper by Jim Cox (Duke).

Our piece is now available here. The chart of treatment differences appears as the Appendix, at pp. 17-26. The preceding pages synthesize how these differences reflect deeply divergent philosophical and political realities, despite widespread talk of how the two standards are convergent.

The paper’s abstract reads as follows:

William Bratton & Lawrence Cunningham, Treatment Differences and Political Realities in the GAAP-IFRS Debate, vol. 95 Virginia Law Review (June 2009):

The Securities Exchange Commission has introduced a “Roadmap” that describes a process leading to mandatory use of [International Financial Reporting Standards] by domestic issuers by 2014. The SEC justifies this initiative on the grounds that global standardization yields cost savings and an ultimate gain in comparability, facilitating the search for global opportunities by U.S. investors and making U.S. capital markets more attractive to foreign issuers.

This Comment enters an objection, noting that the stakes include more than the choice of the framework for standard setting. The accounting treatments themselves are at issue, treatments that for the most part concern domestic reporting firms and domestic users of financial statements. We present a treatment by treatment comparison of [US Generally Accepted Accounting Principles] and IFRS and . . . discuss the differences’ implications.

[The US standard setter, the Financial Accounting Standards Board,] maintained its independence during its 35 year history in the teeth of opposition from corporate management, which experienced a steady diminution of its zone of financial reporting discretion. A switch to IFRS would allow management to reclaim some of the lost territory.

Meanwhile, the interest group alignment that protected FASB, comprised of auditing firms, actors in the financial markets, and the SEC, has disintegrated as U.S. capital market power has waned in the face of international competition. Management is the shift’s incidental beneficiary, with possible negative effects for reporting quality in domestic markets.

Hat Tips: For this piece, I thank Bill Bratton and Jim Cox for the idea and opportunity; my research assistants Dan Martin and Chris Davis, for their excellent help; and the editors of Virginia Law Review for their careful attention and interest.

To Readers: We welcome specific suggestions concerning the assembled chart, which may justify continued updating as the two standards continue to change.

If so, according to the logic of new accounting rules the country’s independent accounting standard setter adopted last week, valuation of these items may not accurately be ascertained by using recent comparable home sales or trading [...]]]> Do reasonable Americans today regard housing markets, credit markets, stock markets or collectibles markets to reflect accurately the fair value of their homes, corporate bonds/equity and collectibles? My guess is that a large number could honestly and in good faith say “no, that they do not,” whether correctly or incorrectly. Many might say instead that at least some of these markets are at least periodically distressed (or even inactive in the case of collectibles and some housing markets) and that related prices, if any, “really represent distressed sales.”

If so, according to the logic of new accounting rules the country’s independent accounting standard setter adopted last week, valuation of these items may not accurately be ascertained by using recent comparable home sales or trading prices for corporate debt and common stock or auction sales of collectibles. Instead, they could be ascertained by reference to the owner’s own judgments about what those assets would sell for in an “orderly transaction” and “active market.”

The accounting body (the Financial Accounting Standards Board) last week gave analogous authorization to corporate America (and FASB’s London-based counterpart is being pressured to follow suit). In its plain English version of these new rules, FASB says they are designed “to figure out fair values when there is no active market or where the price inputs being used really represent distressed sales.” FASB continues: “The objective is to reflect how much an asset would be sold for in an orderly transaction (as opposed to a distressed or forced transaction) .”

Although the rule imposes technical restrictions on use of this judgment based valuation, by its logic, if not its sometimes technical language, if people who own homes in economically distressed neighborhoods and debt obligations or common stock of, say, AIG or Citigroup, or other distressed companies, or fine art that simply can’t be sold today, their own personal financial statements may be more accurate if they reflected assumed exchange values in “orderly transactions” rather than the effects of related “distressed” conditions or “inactive markets.”

Accordingly, a large number of people whose net worth appeared to have declined precipitously from say September 30, 2008 to March 31, 2009, can revalue their assets upward. Just because your shares in Citigroup or AIG trade for a few hundred pennies or less, you are entitled to make your own different judgment about what they are really worth. Just because no homes have sold in your region except at fire sale prices half what they were a year ago, you may assume that your home is worth the amount for which your next door neighbor sold her comparable place a year ago absent the distressed conditions. Collectibles can be valued based on an owner’s judgments, even if no one would buy the items now.

On the other hand, of course, even if Citigroup values its assets using a version of this as-if method of accounting, I doubt it will give high credit scores to credit applicants using analogous methods. For me, I think I am better off recognizing that my net worth has fallen nearly by half the past half year, than pretending it is worth twice what current conditions manifest. That remains true even though I also believe that some assets may be selling at prices representing some discount to their intrinsic value.

No consensus appears on what to call the prevailing economic crisis, let alone diagnostics of its causes or prescriptions for cure. It’s not yet so severe to warrant Great Depression II or so mild to be called a mere recession. As something in between, some are tempted to call it a Great Recession.

People seem agreed that an asset price bubble, especially in housing, manifested crisis, but disagree on exact culprits. Consumers and businesses respond by curtailing [...]]]> Amid contending descriptions of the prevailing economic crisis, and candidates for causes and responses, I nominate The Great Repression and, in doing so, point out how unconscious exclusion of painful realities from the conscious mind caused the crisis and continues to infect policy responses to it.

No consensus appears on what to call the prevailing economic crisis, let alone diagnostics of its causes or prescriptions for cure. It’s not yet so severe to warrant Great Depression II or so mild to be called a mere recession. As something in between, some are tempted to call it a Great Recession.

People seem agreed that an asset price bubble, especially in housing, manifested crisis, but disagree on exact culprits. Consumers and businesses respond by curtailing borrowing and spending, but government’s responses are exactly the opposite.

All candidates for culprits ultimately involve false stories that people—citizens, business people, regulators and politicians alike—told themselves. Exemplars: the American dream of home ownership can be made available to all; housing prices tend inexorably upward; massive current borrowing can be repaid from future assumed prosperity; financial risk can be diversified, hedged, securitized away by carving up underlying financial instruments; regulators can let market participants self-monitor and self-correct; and politicians can safely respond to citizen appetites by sustaining all these false beliefs.

Yet these conscious beliefs unconsciously excluded painful truths—the essence of psychological repression. Not everyone can afford or handle burdens of home ownership; housing prices fluctuate according to supply and demand; excessive borrowing is dangerous; financial risk is real and pervasive and cannot be eliminated; markets, like people, including regulators, are imperfect; and politicians act in their short-term self interest in ways that can hurt constituents, not help them.

Equally repressed—excluded from the conscious mind—were recurring examples of similar asset bubbles that eventually burst, including as recently as early 2000’s tech bubble and dating to famous bubbles across the past five centuries.

Asset bubbles are akin to a massive social party of joyous and giddy dimensions. In those times of collective unconscious exclusion of painful memories and realties, party poopers are scarce. Few want to upset the gaiety of frothy markets that suggest flourishing abundance—for nearly all—and runaway riches for the super elite.

The result of the recent repression was a set of pro-cyclical proclivities. Virtually all systemic forces conspired to sustain and reinforce a multi-year boom in housing and financial prices, above what underlying economic attributes warrant.

Repression in economic matters may not always lead to doom. But the scale of unconscious denial of the past five years amounts to a Great Repression. That is the widespread and sustained, if unconscious, denial of economic reality on a scale sufficient so that eventual reckoning spells equally widespread and sustained financial devastation—of which we should now be collectively acutely conscious.

Trouble is, the temptation appears strong to continue to repress rather than to confront. After all, while people seem eager to reduce debt and spending and reset the economy, government’s plan, under the prior and current President, is to respond to the excesses with more excesses, especially massive borrowing and spending.

Perhaps the most acute example of continuing to ignore rather than accept painful realities appears in what Congress did last week on accounting. Traditionally, US accounting standards measured assets at the lower of their original cost or current value, a reliable and conservative way to represent economic exchange. Gradually, in the past few decades, these standards were amended to measure many assets at their prevailing prices, argued as a more relevant way to represent economic reality.

During the recent boom’s run up in market asset prices, those reporting transactions using accounting standards loved the chance to report at prevailing prices, as it made their financial positions look better. They championed this so-called fair value accounting. Now that asset prices have reversed dramatically, they complain that it is misleading to measure assets at prevailing prices. Instead, they want to measure them at imagined prices that would prevail if the current economic downturn were not a reality.

Last week, proponents of this repression accounting got their way. They persuaded Congress to use its political will to meddle in the traditionally professional and independent business of setting accounting standards. Setting accounting standards is usually the province of the Financial Accounting Standards Board (FASB), an independent expert body set up to be outside the reach of Congressional influence, precisely to insulate it from the latter’s political passions.

But now Congress has pressured FASB into letting assets be reported not according to prevailing economic realities but according to what they would be worth if the economy were growing and asset prices stable or rising. In short, Congress has prescribed repression as a solution to repression. They wish to sustain, not confront, The Great Repression.

Hat Tip: Stephanie Cuba

(A) firms: Countrywide, Fannie Mae, AIG, Citigroup, Moody’s, Lehman Brothers, General Motors;

(B) industries: mortgage origination, mortgage finance, insurance, commercial banking, rating agencies, investment banking, automobile manufacturing and finance;

(C) regulators: state mortgage, insurance and banking overseers; Federal Housing Finance Agency; Securities and Exchange Commission and Commodity Futures Trading Commission; Federal Reserve, Treasury, Office of Comptroller of the Currency; Federal Deposit Insurance Commission;

(D) lawmakers: Congress, Congress, Congress, Congress, Congress.

What representations do not appear on this list? Deloitte Touche et al, the auditing industry, and the Public Company Accounting Oversight Board. Three cheers.

True, every scandal needs an accounting or auditing problem to blame, and fair value accounting is [...]]]> A compressed portrayal of US failures evident in the current crisis may arise from the following list of representations:

(A) firms: Countrywide, Fannie Mae, AIG, Citigroup, Moody’s, Lehman Brothers, General Motors;

(B) industries: mortgage origination, mortgage finance, insurance, commercial banking, rating agencies, investment banking, automobile manufacturing and finance;

(C) regulators: state mortgage, insurance and banking overseers; Federal Housing Finance Agency; Securities and Exchange Commission and Commodity Futures Trading Commission; Federal Reserve, Treasury, Office of Comptroller of the Currency; Federal Deposit Insurance Commission;

(D) lawmakers: Congress, Congress, Congress, Congress, Congress.

What representations do not appear on this list? Deloitte Touche et al, the auditing industry, and the Public Company Accounting Oversight Board. Three cheers.

True, every scandal needs an accounting or auditing problem to blame, and fair value accounting is named by some as a culprit. But there is wide debate about that, with many saying fair value accounting is a solution to the problem not remotely a cause. In any event, fair value accounting rules do not come from the firms, the industry or the PCAOB, but from the Financial Accounting Standards Board.

Also true, a few lawsuits targeting these other actors try to blame auditing firms too, but those have been dismissed or seem very unlikely to succeed. [See, for example, my posts, here and here.]

The reason? Just possibly, the Sarbanes-Oxley Act of 2002, which created PCAOB to oversee those large firms and generally created an atmosphere and procedures that strengthened their ability to discharge their professional obligations.

The lesson? As financial regulation reform discussions proceed, there may be some value in studying SOX, PCAOB and the auditing profession, to find out what worked and why.

If sustained after further fact resolution, the result would expose Deloitte US to crushing legal liability—and likewise expand the liability exposure of the other three large auditing firms that use similar structures (Ernst & Young; KPMG; [...]]]> A common form of business organization designed to limit liability of participants may have failed the four largest auditing firms, according to a judicial opinion last week refusing a motion for summary judgment based on the design. The case, involving claims by defrauded investors in the Italian company, Parmalat, seeks to hold liable affiliates of the Italian accounting firm found culpable in the fraud, Deloitte S.p.A. The court refused to dismiss the latter’s US affiliate, Deloitte Touche LLP, and the Swiss entity that unites them, Deloitte Touche Tohmatsu.

If sustained after further fact resolution, the result would expose Deloitte US to crushing legal liability—and likewise expand the liability exposure of the other three large auditing firms that use similar structures (Ernst & Young; KPMG; and PriceWaterhouseCoopers). That, in turn, could increase the risks that one of those four firms may soon fail, which would make it difficult or impossible for many large publicly-listed companies to find outside auditors as required by federal securities laws. Ultimately, this could mean US federal governmental takeover of the traditional process of private audits of listed companies.

At issue in the Parmalat securities case against Deloitte is the standard structure that the four large auditing firms use. They operate as networks of scores of member firms organized as separate legal entities in jurisdictions where they practice. They enter into agreements that enable identifying members with the global brand name and practice of a global firm. These structures are designed to promote a recognizable professional identity while insulating each member from the others’ liabilities. The delicacy of the balance appears in how the court last week questioned its liability limiting efficacy.

The issues involve fundamental principles often taught in the first few weeks of law school courses on business organizations (corporations). The first is the separate entity concept. This means that companies command their own assets and incur their own liabilities. Other participants, including shareholders, lenders and affiliates, are not ordinarily liable for the company’s obligations.

Students also learn early of standard limitations on this privilege. One is how a putative separate party, such as a lender, may be liable for a company’s obligations if it is seen as a principal and the firm as its agent, under traditional principles of principal-agent law. (A good example is Gay Jenson Farms Co. v. Cargill, Inc.) Another is how a putative separate party, such as a corporate parent, may be exposed to liability of its corporate subsidiaries if its exercise of control over the latter deviates from traditional means that shareholders use to exercise corporate control. (A good discussion appears in United States v. Best Foods.) [Another example of control analysis to evaluate a putative third party’s potential liability appears in Martin v. Peyton, concerning partnership.]

The Deloitte firm is organized as a network orbiting around Deloitte Touche Tohmatsu (Deloitte Central), a Swiss business form called a verein, loosely meaning an association, club or union. Among scores of network member firms of this association are Deloitte & Touche LLP (Deloitte US) and Deloitte S.p.A. (Deloitte Italy). Deloitte Italy committed securities law violations in connection with its audits of Parmalat, in a fraud involving potentially $15 billion. Securities holders seek to impose liability on Deloitte Central and Deloitte US.

The argument is that Deloitte Italy acted as an agent of Deloitte Central and/or Deloitte US acting as principal. The Deloitte defendants, acknowledging securities law violations by Deloitte Italy, first deny the existence of any principal-agent relationship between Deloitte Central and Deloitte Italy and second deny that Deloitte US controls Deloitte Central.

A principal-agent relationship arises from agreement that the agent will act for the principal under the latter’s control. Authority can be actual, apparent or implied; control, which is essential, is evaluated according to all surrounding circumstances. Deloitte Central denies giving Deloitte Italy any agency authority or exercising any control over it. But the proffered evidence raises material fact questions about these assertions.

First, all worldwide Deloitte verein members sign a charter document covering the global network. In it, they assent to terms concerning operational activities, especially applicable auditing standards to use in audits. All members sign license agreements concerning trade names and other property rights. Deloitte Central can accept or reject proposed audit engagements. Member firms cannot sue each other; members must accept referral work from each other; and employees can be transferred between members. Deloitte Central conducts network-wide legal and risk management affairs for members; members must buy required amounts of liability insurance.

Second, although such structural attributes alone may not suffice to satisfy the elements of agent authority and principal control, an additional factual contention tips the balance against summary judgment in the case. When two Deloitte member firms (Italy and Brazil) disagreed on the proper treatment of Parmalat accounting matters, Deloitte Central’s senior officials intervened, at their joint request, to resolve it. This was done in accordance with the networks’ joint practice manual. It gives authority to resolve disputes among member firms to Deloitte Central’s CEO or designee, to “arbitrate” them, suggesting a power to control. In the Italy-Brazil dispute, the Deloitte Central official issued a final recommendation, suggesting exercise of that power.

These predicates may be thin reeds upon which to disregard the separate entity status of members of the Deloitte verein network. Usually, far more is required for even a related party to be exposed to the obligations of a separate entity. For example, in the Cargill case noted above, a putative lender was liable as principal of a putative borrower as agent based on some nine separate factual findings clearly demonstrating that the financier made essentially all business and operating decisions of the other, a relation far different from that between Deloitte Central and Deloitte Italy. Still, the settlement value of the Parmalat case has increased even at this stage of denying a motion for summary judgment.

The court in the Parmalat case also rejected a separate argument that Deloitte US asserted to have the claims against it dismissed. Deloitte US argued that it does not control Deloitte Central—apparently as a way to challenge any additional principal-agent relation that could expose it to liability and in part to defend against a separate securities law claim that imposes liability on persons who control another party found liable for violations. The court rejected this argument for three reasons, all of which probe traditional concepts of control found not only in securities law, but also in the law of principal-agent, in corporate law, and in partnership law.

First, Deloitte Central and Deloitte US have overlapping senior executive officers. The court acknowledged that this fact is not conclusive. It referenced the Supreme Court’s opinion in Best Foods, noted above, which examined a corporate parent’s potential liability for obligations of its subsidiary. That case restated the general rule that a corporate parent’s liability for subsidiary obligations is limited under traditional corporate law principles that insulate shareholders from liabilities of their corporate investees.

But Best Foods also said that a subsidiary’s corporate veil can be pierced to hold the parent liable if the parent exercises control over the subsidiary outside the usual norms that shareholders use to exercise corporate control, essentially through the election of directors. In the Parmalat case, additional facts must be developed to evaluate whether Deloitte US’s relation with Deloitte Central adhered to similar conventions or departed from them.

Second, Deloitte Central’s principal source of funds is from contributions made to it by its various member firms. And Deloitte US contributes a significant portion of these. In 2001, for instance, Deloitte US contributed $80 million to Deloitte Central’s total budget, which amounted to $218 million. Beyond that contribution, Deloitte US also made loans to Deloitte Central and guaranteed its bank financing. Again, such financial support alone does not mean that Deloitte US controlled Deloitte Central, but is suggestive and is a factor tending to make summary judgment premature.

Third, additional asserted facts suggest that Deloitte US controls Deloitte Central. An example concerned the procedures and outcomes used when the network evaluated whether to reorganize itself by separating its auditing practice from its consulting practice. Deloitte US partners voted first, before other network members, leading Deloitte Central preliminarily to agree. But, thereafter, Deloitte US changed its recommendation and Deloitte Central followed that reversal, again without soliciting votes of other network members.

As with the Parmalat court’s analysis of whether Deloitte Central and Deloitte US are really principals for which Deloitte Italy acted as agent, these three factual assertions taken alone may be thin reeds upon which to determine that Deloitte US controls Deloitte Central. In the same vein, they do seem enough to prevent granting a motion for summary judgment and the case’s value rises accordingly. Moreover, it would not be impossible for these claims to be sustained when the factual record is developed.

If so, the liability exposure of Deloitte as a network and the other large auditing firms will increase considerably. This may have particular relevance to PWC, which recently found out that its affiliate in India probably committed securities fraud in facilitating the accounting fraud that plagued Satyam, the India outsourcing company. Ultimately, then, some fundamental principles of the law of business organizations may determine the fate of the auditing profession in the United States. Given existing turmoil in capital markets and plans to reform our system of corporate finance, these developments could not come at a worse time.

Differences appear on numerous particular subjects. These reflect a general orientation to re-dedicate the agency to its primary mission of investor protection. Examples from Ms. Schapiro’s letter follow (with full text available here from Investment News):

1. Corporate Governance. Ms. Schapiro favors (a) rules letting shareholders (at least significant, long-time holders) nominate candidates for corporate boards of directors; and (b) rules allowing shareholders to express advisory opinions and votes on executive compensation .

2. International [...]]]> The Senate on Thursday confirmed President Barack Obama’s nomination of Mary Schapiro as Chair of the Securities and Exchange Commission. In Ms. Schapiro’s written answers to questions posed by Senator Carl Levin, she indicates a refreshingly sharp break with many policies of her predecessor, Chris Cox.

Differences appear on numerous particular subjects. These reflect a general orientation to re-dedicate the agency to its primary mission of investor protection. Examples from Ms. Schapiro’s letter follow (with full text available here from Investment News):

1. Corporate Governance. Ms. Schapiro favors (a) rules letting shareholders (at least significant, long-time holders) nominate candidates for corporate boards of directors; and (b) rules allowing shareholders to express advisory opinions and votes on executive compensation .

2. International Accounting. Ms. Schapiro, unlike Mr. Cox: (a) does not believe that the International Accounting Standards Board meets US legal criteria and is not prepared to delegate authority to it; and (b) believes that US authorities must oversee foreign auditing firms auditing financial statements of companies with securities listed in the US.

3. Internal Controls. Ms. Schapiro, unlike Mr. Cox, would enforce laws requiring internal controls as to small and large public companies alike.

4. Accounting. Ms. Schapiro also believes in: (a) maintaining the independence of the US accounting standard setter, the Financial Accounting Standards Board; (b) cracking down against abuses of off-balance sheet accounting; and (c) continuing the requirement that stock options be accounted for as compensation expense.

5. Regulatory Scope. Ms. Schapiro favors: (a) regulating hedge funds; (b) strengthening capital requirements for securities brokers; and (c) strengthening regulation of rating agencies.

So far so great.

From a systemic regulatory standpoint, the Madoff Ponzi scheme remains of limited significance, especially compared to the latest exposed fraud case, at the large Indian software company, Satyam Computers Services Ltd., whose shares trade on the New York Stock Exchange (in the form of American Depository Receipts, or ADRs). Its CEO released a letter yesterday disclosing an elaborate, and apparently simple, billion-dollar fraud that went undetected by the firm’s outside auditors, an India affiliate of PriceWaterhouseCoopers (PWC).

The Satyam fraud presents serious questions about systemic regulatory efficacy, particularly concerning auditing and audit firm oversight. True, it may seem outlandish that Madoff was able to use a rinky-dink auditing firm to review the books of a fund commanding billions of dollars in assets and [...]]]>

From a systemic regulatory standpoint, the Madoff Ponzi scheme remains of limited significance, especially compared to the latest exposed fraud case, at the large Indian software company, Satyam Computers Services Ltd., whose shares trade on the New York Stock Exchange (in the form of American Depository Receipts, or ADRs). Its CEO released a letter yesterday disclosing an elaborate, and apparently simple, billion-dollar fraud that went undetected by the firm’s outside auditors, an India affiliate of PriceWaterhouseCoopers (PWC).

The Satyam fraud presents serious questions about systemic regulatory efficacy, particularly concerning auditing and audit firm oversight. True, it may seem outlandish that Madoff was able to use a rinky-dink auditing firm to review the books of a fund commanding billions of dollars in assets and it may be that even such small auditing firms of even private funds require as much regulatory supervision as larger auditing firms auditing public enterprises.

But the Satyam scandal presents a far more serious problem. Unlike Madoff, the company has shares listed in the United States. Also unlike Madoff, it was audited by a foreign affiliate of a large US auditing firm, PWC, whose operations apparently were outside the scope of review undertaken by the US auditing profession’s regulatory overseer, the Public Company Accounting Oversight Board (PCAOB).

Pending additional information from the newly-revealed fraud, of course, a couple of preliminary issues may prove to be lessons of the Satyam fraud. First, if foreign companies list securities in the United States, their financial statements need to be audited by a firm whose activities are subject to regulatory oversight in the United States.

Second, the fraud implicates the Securities and Exchange Commission’s recent enthusiasm for the concept of mutual recognition. This refers to a policy allowing foreign firms, especially brokers but potentially also companies and auditors, to access US securities markets without regulatory oversight here, so long as they are subject to comparable regulatory oversight at home. (I have questioned this policy before.)

Third, there is some possibility that audit failures by foreign affiliates of US auditing firms could expose the US firm to crushing legal liability. This could lead to the dissolution of one of the four remaining large US auditing firms (see my post here). Should that occur, with only three such firms standing, the country would face an additional blow to its system of corporate finance, with attendant adversity for the real economy and citizens.

Satyam’s CEO now admits that some reported assets at the company simply did not exist, including considerable amounts of cash. Cash was reported to exceed $1 billion but apparently stands at just $78 million!

Ordinarily, the audit work required to verify the existence of cash is among the easiest of all auditing exercises. One wonders how auditors could have failed to identify such false assertions.

It is likewise the case that the integrity of systems of internal controls governing cash are among the easiest to establish, maintain and audit. Satyam’s auditors gave opinions attesting to the veracity not only of management’s assertions about cash balances but also about the effectiveness of the company’s internal controls. So one also wonders how auditors could have given a clean bill of health to a system of internal control that enabled reporting large amounts of fictitious cash.

Some now will say that the PCAOB bears some responsibility for this fraud and must adjust its policies. PCAOB was created in 2002’s Sarbanes-Oxley Act in response to audit failures, chiefly by erstwhile big-five auditing firm, Arthur Andersen, at companies that turned out to be elaborate frauds, especially Enron and WorldCom. Its responsibilities include inspecting all auditing firms responsible for auditing public companies, those registered with the SEC and listing securities on US capital markets.

Reports indicate that while PCAOB conducts extensive inspections of the four largest auditing firms who together audit the vast majority of US public companies, including PWC, the agency does not conduct inspections of the foreign affiliates of those firms, such as PWC’s Indian affiliate that audited Satyam’s books. Problems apparently include that PCAOB lacks sufficient budget, although it is funded by fees imposed on public companies under a budget it submits to the SEC and the SEC approves.

The problem may grow more serious, however, as the four largest US auditing firms appears increasingly interested in outsourcing much of their auditing work to foreign affiliates, including to firms in India. Investors should be concerned about these developments, especially if the SEC were to continue to pursue its program of mutual recognition and if PCAOB mirrored that policy by relying upon foreign auditing oversight authorities to conduct inspections of auditing firms based abroad.

Hat tip: Lynn Turner

If one of the four very largest auditing firms (Deloitte, Ernst, KPMG or PWC) were involved, the world would face an additional crisis by reducing from 4 to 3 the number of auditing firms capable of auditing most global companies. Indeed, such added crisis could occur if one of the next three largest firms (BDO Seidman, Grant Thornton or McGladrey Pullen) were implicated in such a fraud.

Fortunately, Madoff’s vehicle was not audited by one [...]]]> When word of Bernard Madoff’s alleged $50 billion Ponzi scheme broke last Friday, my systemic worry was whether the fund was audited by a prominent auditing firm. Public revelation of an auditor’s involvement in such a fraud would almost certainly destroy it. Cf. Arthur Andersen amid Enron (2002).

If one of the four very largest auditing firms (Deloitte, Ernst, KPMG or PWC) were involved, the world would face an additional crisis by reducing from 4 to 3 the number of auditing firms capable of auditing most global companies. Indeed, such added crisis could occur if one of the next three largest firms (BDO Seidman, Grant Thornton or McGladrey Pullen) were implicated in such a fraud.

Fortunately, Madoff’s vehicle was not audited by one of those 7 firms (it was apparently audited by a storefront neighborhood accountant). Yet there is continuing fallout from this fraud that, some assert, does implicate one of the large 7 firms. In a putative class action lawsuit filed yesterday, New York Law School is suing investment advisor, Ezra Merkin, and his outside auditor, BDO Seidman.

Merkin has reportedly acknowledged that his investment fund, Ascot Partners, was substantially invested with Madoff. But the fund’s disclosure documents never said so. They allegedly described a more comprehensive investment philosophy that, given the acknowledged approach, may well amount to securities law violations (among other problems, such as breach of fiduciary duty).

By also naming, BDO Seidman, the plaintiffs’ lawyers may simply be covering all bases or hunting for a deep pocket. After all, BDO Seidman would be responsible for conducting a financial audit of Ascot. That means probing reported investment holdings, not attesting to the veracity of the fund’s investment philosophy or how it was implemented.

Still, this is a disturbing development. So far, when assigning blame for the current economic upheaval, leading culprits are bankers (charged with stupidity), regulators (charged with laxity) and rating agencies (charged with both and sometimes worse). Traditional financial market gatekeepers, including lawyers and auditors, have been spared rebuke.

But as indirect and remote consequences of the upheaval emerge, including discovery of deceptive or fraudulent practices by the likes of Mr. Madoff, there is rising risk that more and more professionals will be assigned blame.

The deal is a $28 billion LBO for BCE, Canada’s largest telecom firm. A principal lender in the proposed deal is Citigroup, the struggling commercial bank. BCE has made clear it wants the deal to close as scheduled on December 11; Citigroup, like other lenders amid the current financial crisis, may prefer that it does not.

The agreement contains a condition to the lenders’ obligation to close that BCE shall have obtained an opinion from [...]]]> As one of the largest leveraged-buy out deals in history verges on collapse, much attention is being paid to a central condition in the agreement, the target’s solvency; little attention has been given to conflicts of interest facing the firm, KPMG, deciding whether the condition is met.

The deal is a $28 billion LBO for BCE, Canada’s largest telecom firm. A principal lender in the proposed deal is Citigroup, the struggling commercial bank. BCE has made clear it wants the deal to close as scheduled on December 11; Citigroup, like other lenders amid the current financial crisis, may prefer that it does not.

The agreement contains a condition to the lenders’ obligation to close that BCE shall have obtained an opinion from KPMG, or another public accounting firm, attesting to the solvency of the post-LBO company. This may be difficult to deliver, given the considerable debt being used in the LBO and terrible market and economic conditions.

Trouble is, KPMG is the outside auditor for both BCE and Citigroup, presenting it with a potential conflict of interest. One arm of KPMG may wish to bless the deal, to promote favorable relations with BCE, while another may wish to scotch it, to promote favorable relations with Citigroup.

Last week, KPMG told BCE that its preliminary analysis of the post-LBO company would prevent it from providing a solvency opinion. BCE management is reportedly in negotiations with KPMG over whether altering some assumptions or analytical methods the auditor used would enable a different conclusion.

If KPMG kills the deal, BCE will be furious but Citigroup pleased; if it green lights the deal, BCE will be delighted, but lenders, including Citigroup, would have to fund it, unless they can identify another condition, such as a material adverse change clause, to let them out.

KPMG may navigate the apparent conflicts by emphasizing that KPMG, although a global firm, is actually a network of scores of separate firms, of which KPMG (Canada) is one and KPMG (United States) is another. They would say that KPMG (Canada)’s decisions concerning BCE’s solvency are taken entirely on the basis of its independent and objective analysis of the LBO’s terms without any influence from or attention to the effects on KPMG (United States) and its clients, including Citigroup.

That argument is difficult to assess because KPMG, like its three sister global accounting firms, are private and disclose virtually noting about how they are organized and what their internal financial or other relationships look like.

Important potential conflicts of interest like this may put to the test such arguments about the large accounting firms’ independence and generate for public disclosure useful information about the internal relations and operations of the four large global accounting firms.

The unsurprising portion reflects what the Commission reluctantly came to accept last summer: the US is not ready for such a switch and is not likely to be until 2014 at the earliest. Accordingly, the release principally outlines the many obstacles to such a switch and lays out milestones that would have to be met before considering such a radical move.

The surprising portion [...]]]> With surprising absence of fanfare, the Securities and Exchange Commission released over the weekend a 165-page document outlining its delayed and long-awaited proposals for how the US might switch from using its own generally accepted accounting principles to new international financial reporting standards. The release bears a schizophrenic quality. It offers one unsurprising and one surprising proposal.

The unsurprising portion reflects what the Commission reluctantly came to accept last summer: the US is not ready for such a switch and is not likely to be until 2014 at the earliest. Accordingly, the release principally outlines the many obstacles to such a switch and lays out milestones that would have to be met before considering such a radical move.

The surprising portion contemplates allowing selected US issuers voluntarily to make the switch as early as the year after next—2010. This radical proposal would be limited to US issuers whose industry uses IFRS as the basis of financial reporting more than any other set of standards. The release struggles to explain why this special approach for such issuers overcomes the many obstacles facing other US issuers.

It is not obvious that it succeeds. It is possible that the curious pair of proposals is the product of political compromise among internal SEC staff members—many passionately devoted most of their recent several years at the Commission to the project. But given the generally negative reception the SEC’s earlier more ambitious proposals received there is a serious risk that this attempt at a compromise approach will backfire.

Comments on the proposal, which warrants careful study, are due February 19, 2009. Alas, the new SEC release arrives too late for me to say anything about it in my analysis of the SEC’s vision—and obstacles it had not addressed—forthcoming in North Carolina Law Review that is literally being printed this week.

Hat tip: Barbara Black, Securities Law Prof, among the first to report the SEC’s surprisingly low-key release.

The tension is finessed by imaginative design and classification of the two components of the government’s investment: preferred stock and warrants to buy common stock. As to the preferred stock, the solution is designing terms to exploit a gray area [...]]]> Treasury’s latest plan to address the credit crisis by direct investment of $250 billion in US banks has politicians telling Americans one thing and firms telling investors another. Politicians tell Americans the investments are temporary, no threat to private market capitalism in a democracy; thanks to deals brokered by Treasury and the Securities and Exchange Commission this weekend, firms will tell investors the investments are permanent, necessary to account for them as increasing firms’ permanent capital and minimizing dilution of common stockholders.

The tension is finessed by imaginative design and classification of the two components of the government’s investment: preferred stock and warrants to buy common stock. As to the preferred stock, the solution is designing terms to exploit a gray area in accounting dividing debt from equity. Borrowed funds a firm must repay are debt (liability); permanent funds a firm need not repay are equity (capital). Preferred stock is a liability if the firm must repay it and equity otherwise.

Critical to the Treasury’s plan is boosting firms’ equity capital, which means making the securities look as permanent as possible. But if they look too permanent, that would impeach the political story. The result is a term sheet negotiated this weekend calling the preferred perpetual while incentivizing firms to repay it within five years, without an explicit obligation to do so. Examples include a spike in the dividend rate at year five from 5% to 9%, forbidding firms to pay dividends on common stock unless dividends are first paid on preferred and limiting firms’ right to repurchase common stock while the preferred is outstanding.

The warrants pose an additional problem as wsj.online reports. To treat them as permanent equity capital, ordinarily a firm must prepare financial statements as if the warrants had been converted into common stock. But doing so would increase reported common shares outstanding, diluting earnings per share and book value per share. To avoid that, Treasury seems to have gotten the SEC to say it would not object to treating warrants as equity capital now so long as the bank has, or within one quarter obtains, shareholder authority to issue the required number of new common shares.

Must finessing accounting standards play so central a role in Treasury’s plan and balancing political need to sell deals as temporary with regulatory need to say banks have enough permanent capital? If Treasury thinks government’s investments give banks adequate permanent capital, why not simply modify existing capital adequacy rules to support this conclusion instead of manipulating design and classification to get desired accounting treatment?

Finessing accounting treatments tend to exacerbate problems, not cure them. This lesson is frequently re-taught. Examples include 1980s US thrift crisis, 1990s Japanese banking crisis, Enron’s early 2000s fraud, and even this 2008 credit crisis Treasury is trying to fix.

Hat tip: Lynn Turner, Former SEC Chief Accountant

But the prize for crazy claims about the credit crisis must go to former Dallas Fed President Bob McTeer, whose Monday post on the New York Times’ Economix blog claims that: (i) Wall Street banks were the real victims of the crisis; (ii) the real villains were minorities; and (iii) the only thing needed to fix the crisis is to change accounting rules.

I kid you not.

Let’s consider each in turn.

1. Banks are Victims

“[A]ll the focus on C.E.O. salary caps,” he writes “implied [...]]]> The credit crisis has provided ample opportunities for foolishness. Certainly California Republican Darrell Issa’s claim that the House bill would have been a “coffin on top of Reagan’s coffin” was an oddly necrophilic bunkmate to President Bush’s penetrating insight that “this sucker’s going down.”

But the prize for crazy claims about the credit crisis must go to former Dallas Fed President Bob McTeer, whose Monday post on the New York Times’ Economix blog claims that: (i) Wall Street banks were the real victims of the crisis; (ii) the real villains were minorities; and (iii) the only thing needed to fix the crisis is to change accounting rules.

I kid you not.

Let’s consider each in turn.

1. Banks are Victims

“[A]ll the focus on C.E.O. salary caps,” he writes “implied that the holders of illiquid mortgage-backed securities were the villains in this drama rather than the victims. They didn’t package the securities, or sell them; they bought them as an investment.”

Excuse me? I didn’t get that.

Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs, Citibank and many others now in or near trouble did not package or sell these securities? Perhaps the league tables were just lies?

The reality, of course, is that investment banks were both issuers and purchasers. That was the point: To keep the paper moving as fast as possible, hoping that once the music stopped, there would still be a seat. No one realized (or admitted) that this game of musical chairs was being played on the deck of the Titanic.

2. It’s Minorities’ Fault

The real villains, McTeer would have us believe, are minority borrowers. This was because “the government had encouraged the purchase of mortgage-backed securities by giving banks C.R.A. (Community Reinvestment Act) credit for securities that contained mortgages made in ZIP codes.” While he concedes that this lending may not have played a “decisive” role, the implication is clear: It was lending to people who look like, you know, Barack Obama, who are really to blame here.

This is truly outrageous. There is not a shred of evidence that CRA-based lending had anything to do with the credit crisis. The CRA is an extremely weak piece of banking legislation that in theory requires banks to lend in their “communities,” which has usually (albeit mistakenly) been taken to mean “minority” communities. Excess liquidity doubtless resulted in mortgage lending to all sorts of bad risks, including minorities. But it wasn’t the CRA that caused this.

And, while it is true that a disparate amount of subprime lending was to African Americans, it wasn’t by banks. It was by non-bank originators like Countrywide.

You would expect a former Fed branch president to know this.

3. The Magic Cure: New Accounting!

To the extent the credit crisis is not the fault of minority borrowers, McTeer appears to believe it was caused by “mark to market” accounting rules that forced holders of toxic securities to write these assets down if they couldn’t offload them quickly. This is not really McTeer’s insight. Many, including William Isaac, who was the F.D.I.C. chair during the S&L crisis, believe this was a critical part of the problem, since it forces lenders to declare something valueless simply because it is illiquid, which really doesn’t make much sense.

I am not an accountant, so offer no opinion on whether this is true. But what McTeer doesn’t bother to tell us is what should now replace it? “Marking-to-model?” That got us into this problem in the first place, because it enabled sponsors—you know, McTeer’s victims—to claim unrealistical valuations and amortization rates for the securities they issued. Should we go back to that? How would that revive the market for these securities? If you add zeroes to the balance sheet, will the credit market miraculously revive?

4. Who IS this Guy?

McTeer is not only a former President of the Dallas Fed. He has a PhD in economics from the University of Georgia, is a former of Chancellor of Texas A&M, and self-published poet. He is a zealous free marketeer, whose insights include this: “The market system features consumer sovereignty, meaning that the consumer is king. We decide what will be produced by casting dollar votes for the things we want and by not spending on the things we don’t want.”

That may well be true–in a world where people have dollars that are worth something. So far as I can tell, his version of the free market has gone a long way to making sure that we have fewer dollars, and those we have are weaker.

He is also a management guru who’s maxims include this mind-bender: “Too long” and “too short” appear to mean the same thing. Go figure.”

Perhaps he’s right. Only a man who thinks opposites are identical could believe investment banks are victims and minority borrowers villains.

banks and legislators are pushing for a change in accounting rules to end mark-to-market accounting for financial assets. They are sure that market values are too low, so why not just assume they are really higher? That illogic has caught on [as (1) both of this week’s intervention bills encourage the SEC to consider suspending those rules, in a] push for bad accounting [and (2) the SEC [...]]]> Debate intensifies on the topic of my Monday post: accounting as a policy tool. (David Zaring captures divergent views.) The intensity shows in today’s NYT column by Floyd Norris, a columnist noted for accounting acumen. I usually agree with Mr. Norris, but have quibbles with today’s column, excerpts of which follow (emphases added):

banks and legislators are pushing for a change in accounting rules to end mark-to-market accounting for financial assets. They are sure that market values are too low, so why not just assume they are really higher? That illogic has caught on [as (1) both of this week’s intervention bills encourage the SEC to consider suspending those rules, in a] push for bad accounting [and (2) the SEC this week issued a statement giving issuers considerable flexibility in measuring fair value amid distressed market conditions].

The American Bankers Association concluded that [the SEC] had slapped down auditors who were forcing banks to unreasonably reduce the value of assets no one was buying. . . . Auditors cringed, awaiting appeals of clients to let them value assets as they please. [Still, the SEC statement] could persuade Congress not to make things worse, and not really give the banks new permission to fudge their books.

It is possible, perhaps probable, that many mortgage securities are undervalued now, amid [prevailing] uncertainty and fear . . . [Pending legislation] calls for the government to buy securities from banks for more than current market value but less than the government hopes they will be worth someday. Whether it will succeed depends in part on whether banks conclude that other banks are solvent after the money arrives and the dodgy securities depart. . . .

Quibbles:

First, if (a) it is probable, or even possible, that emotional market conditions mean relevant assets are undervalued and (b) government purchases will target a more accurate value, proposals to tailor fair value accounting standards to reflect those dual realities present no “illogic” and do not amount to a “push for bad accounting.”

Second, neither the SEC statement nor alternatives to fair value accounting, which would apply if those rules are suspended, allow firms to “value assets as they please” or “to fudge their books.”

Serious policy is at stake that such language may obscure. Accounting purists, including Mr. Norris, oppose relaxation or suspension of the standard and there is a good case for accounting purity. (I am an accounting purist as well.)

But accounting purity has given way at least once in the past, in the name of resolving the national emergency presented by 1970s energy crisis. Today, Congress considers financial intervention legislation that is unprecedented.

Certainly it would be imprudent to allow “fudging” of numbers, reporting “as a firm pleases”, or otherwise to endorse “bad accounting.” But it is not obvious that the SEC statement, or alternatives to fair value accounting, does any of that.