It really is a war against the poor. The inequity that has existed in the past is going to continue unless civil society is informed, asks the right questions of its government, of its business leadership, and [...]]]> The past few years I’ve tried to find an inspiring quote for the New Year for the blog. There’s a rich vein of insight to be mined from the Carnegie Council podcasts, which I recently discovered on iTunes. One speaker I particularly enjoyed was Krishen Mehta, a former partner with PricewaterhouseCoopers who is now the co-chairman of Global Financial Integrity’s advisory board. Asked about what motivated him to try to stop the shocking abuse of tax havens and mispriced trade by oligarchs, he said the following:

It really is a war against the poor. The inequity that has existed in the past is going to continue unless civil society is informed, asks the right questions of its government, of its business leadership, and asks for more responsibility. One of my favorite writers is Blaise Pascal, who said that “justice and power must be brought together so that whatever is just may be powerful and whatever is powerful may be just.”

A recent study concluded that, “For a salary of between £75,000 and £200,000, tax accountants destroy £47 in value, for every pound they generate.” Mehta, by contrast, is not only creating value, but doing so for the most vulnerable people. How appropriate that a thinker admired by both mathematicians and philosophers would inspire him.

Image Credit: Augustin Pajou. As described on Wikimedia Commons: “Blaise Pascal (1623–1662) studying the cycloid, engraved on the tablet he is holding in his left hand; the scattered papers at his feet are his Pensées, the open book his Lettres provinciales.”

But as Nick notes, equally important is a debtor’s will to pay.  The differences appear in the contrast between the United States and Greece.When  Standard & Poor’s recently lowered its credit rating of the U.S. Treasury by one notch, it registered doubt not so much about the country’s ability to pay its debt, but the will [...]]]> In this week’s New Yorker, Nick Paumgarten, in the Talk of the Town, kindly draws on my work  about the cultural contingency of financial reporting; he quotes me on the need to update the idea of insolvency.  Usually defined as the ability to pay debts as they come due, or assets exceeding liabilities, there has always been a strong objective thrust to the notion.  The emphasis is on measured financial activity reduced to a verifiable expression of ability. 

But as Nick notes, equally important is a debtor’s will to pay.  The differences appear in the contrast between the United States and Greece.When  Standard & Poor’s recently lowered its credit rating of the U.S. Treasury by one notch, it registered doubt not so much about the country’s ability to pay its debt, but the will of its incumbant political class to do so. In contrast, Greece’s political elite seem committed to finding ways to meet that country’s debts; alas, its resources compared to its obligations raise real doubt about their ability to do so. 

Another example of the difference between the ability and the will to pay debts arose in the September 2008 tussle over what to do about American International Group. It was then the world’s largest insurance company and shortly before the crisis  boasted a market capitalization of $180 billion. Much of its trillion-dollar balance sheet was securely housed in walled-off insurance subsidiaries. 

The roiling financial crisis infected two dozen banks with which AIG had financial contracts.  The U.S. Treasury, reeling from a series of bank failures and criticism of its responses to them, feared that those banks could disintegrate one-by-one. It had run out of good ideas to boost their solvency. 

So Henry Paulson, then Treasury Secretary, and his successor Tim Geithner, then head of the New York consortium of private banks misleadingly called the New York Fed, opted to wrest control of AIG in order to rescue those banks.  The government loaned the company $85 billion and the government siezed 80% of its equity.  The government then used that money, along with additional loans about twice that, to pay the two dozen banks off, dollar for dollar, under the financial contracts.

AIG may have been facing a liquidity squeeze while at the center of the financial crisis. But it had ample capital. And it was engaged in heavy negotiations with its counterparties about settling payments under the financial contracts–whose value was highly uncertain given the frozen capital markets.   AIG, in short, had the ability to pay its debts.

AIG’s shareholders, of course, including Hank Greenberg, who built the company from the 1960s to 2005 when he retired as CEO, objected vigorously to the Paulson-Geithner move.  Not only did AIG command ample capital internally, at its super-solvent insurance companies, many investors around the world were lining up to invest more. 

What divided the government and the shareholders was less the question of whether AIG had the ability to pay its debts, but whose will mattered.  The government’s will won out.  It was an ironic result, considering that U.S. culture is generally against governmental nationalization of private business, and that AIG had stood for the principle in fighting nationalization of its property and that of its customers around the world for decades.

Recent revelations in Japan suggest just how important an understanding of accounting may be.

In a post in late March, I related that many Japanese were willing to give the benefit of the doubt to TEPCO, the operator of the damaged Fukushima Dai-Ichi nuclear plant, in the days following the March 11 earthquake and tsunami. The most common excuse in the language, “Shikata ga nai” (“It can’t be helped”), struck most people as apposite, given the historical rarity of 9.0 earthquakes and 15-meter killer waves.

By now, the situation has almost been integrated into the everyday, at least for those of us far from the reactor. People speculate whether the government nuclear agency’s lead spokesperson is wearing a wig, and a cable news channel has a [...]]]>

Recent revelations in Japan suggest just how important an understanding of accounting may be.

In a post in late March, I related that many Japanese were willing to give the benefit of the doubt to TEPCO, the operator of the damaged Fukushima Dai-Ichi nuclear plant, in the days following the March 11 earthquake and tsunami. The most common excuse in the language, “Shikata ga nai” (“It can’t be helped”), struck most people as apposite, given the historical rarity of 9.0 earthquakes and 15-meter killer waves.

By now, the situation has almost been integrated into the everyday, at least for those of us far from the reactor. People speculate whether the government nuclear agency’s lead spokesperson is wearing a wig, and a cable news channel has a daily segment, “Kyou no genpatsu kiiwaado” – “Today’s nuke reactor keyword”. Any goodwill toward TEPCO has long since evaporated, thanks to its management’s sloth in apologizing, its spokespersons’ frequent misstatements and evasions in daily press conferences, and sympathy for the thousands displaced from the evacuation zone, their livelihoods derailed (and their pets and livestock reluctantly left behind to starve, an aspect of the story that has mobilized many activists here). But it turns out that even the initial goodwill was probably misplaced.

Last week, word came out that when Fukushima Dai-Ichi was being planned in the 1960s, it was originally proposed to be sited 35 meters above sea level. However, TEPCO reckoned that this would result in unduly high recurring costs during the lifetime of the plant. In particular, it would increase the expense of pulling sea water up to the plant for use as a coolant, and would increase the cost and complexity of conveying fuel, equipment and other items to and from the small seaside port built to service the plant.

TEPCO’s planning whizzes hit on the idea of digging away 25 meters of soil – possibly a bigger up-front fixed expense, but many decades’ worth of reduced recurring expense. Only “possibly”, because the plant’s foundation had to be anchored to bedrock, so the dig made this simpler, too. Those top 25 meters were mudstone and clay, which was felt not to be so stable in a quake if the plant were built on top of it. The story quotes Masatoshi Toyoda, then a TEPCO VP for planning and now age 87, as saying it seemed a matter of “cost efficiency”. He also suggests that there may have been a way to have built much of the plant within the mudstone layer, so that it could have been safe against both earthquake and tsunami. But, he admits sorrowfully, tsunami risk wasn’t considered at all.

The decision to dig left the facility at a 10-meter elevation. In 2011, it was hit by a 15-meter tsunami. The rest is history.

Reaction so far has been muted. The announcement of this 40-year-old bit of history came in the middle of this year’s 10-day “Golden Week” period of national holidays, when fewer people than usual are paying attention to the news. Even more artfully, it was released on a “press holiday,” May 5, which meant that no newspapers were published the next day. It seems to have been carried by very few major media outlets – to my knowledge, only TV Asahi and the Tokyo Shimbun website. (You can find a rather daffy machine translation of the Tokyo Shimbun story into English here, but running the Japanese version yourself through Babel Fish will give you a more coherent read.). Both the English-language Daily Yomiuri and its parent, the conservative and influential Yomiuri Shimbun, entirely omitted to mention it when they resumed publishing. You won’t find it in this week’s edition of Nikkei Weekly, either. If my mother-in-law hadn’t been watching the morning show on TV Asahi that morning and complained about it over lunch, I might never have heard about it.

TV Asahi contrasted Fukushima Dai-ichi with another nuclear plant more than 100 kilometers north, within the city of Onagawa, Miyagi Prefecture. At that location, the tsunami reached only 13 meters. The difference is a big one, since the Onagawa plant, run by Tohoku Electric, is situated 15 meters above sea level. According to media reports, it was slightly damaged by the quake per se, but shut down safely. (My wife and I attempted to drive to this plant the next day – its PR center is easy to find on most local road maps – but were prevented by police from getting onto the mountain road that leads to it. What we discovered after our forced U-turn was unforgettable and harrowing; I’ll describe that in a future post.)

In a related development, Prime Minister Kan earned rare praise last week when he ordered the closing of the Hamaoka nuclear power plant, because of its location on a major geological fault. Except that, despite what editors around the world wrote in their headlines, he didn’t order, exactly – he doesn’t have the legal authority to do so. Asked, was more like it.

The plant is located not far from Mount Fuji in Shizuoka Prefecture, west of Tokyo — and considerably closer to Tokyo’s 30 million residents than Fukushima is. It’s run by Chubu Electric Power Co., a/k/a ChuDen, whose board of directors was unable to decide at a meeting Saturday whether to grant the Prime Minister’s request. That there is an estimated 87% likelihood of an 8.0 or greater earthquake near the fault within the next 30 years apparently weighed less in their esteem than the loss of around ¥8.3 billion (roughly, $104 million) that was projected to result from a shut-down — though in a move that would make any American PR flack proud, jobs were also gravely mentioned. ChuDen’s board scheduled another meeting for Monday afternoon, leaving the nation to wonder whether the directors would kindly acquiesce. Eventually, they did.

Tokyo has already begun to sweat under what looks to be an early tsuyu – the hot, muggy, rainy season that makes US East Coast summers seem mild. We’re also being told to expect a repeat of last summer, which set the historical record for number of consecutive days above 30°C (86°F). (This is to some extent self-inflicted: not just global warming, but a heat-island effect made worse by the pell-mell construction of high-rise towers near the Shinagawa harbor-front, cutting off breezes from much of the city.) Thanks to the Fukushima situation, available power this summer is expected to fall at least 20% below usual demand. Businesses all over town have voluntarily dimmed their lights, turned off their escalators and set their air conditioning to 27°C (a bit more than 80°F) – including in crowded rush-hour subways and at the gym where I (occasionally) work out.

Should we also have to sweat out the decisions of boards of private companies on matters of public safety? The Tokyo region’s current predicament suggests that a world with insufficient power to regulate business is much closer to an inferno than to a paradise.

Picture credit: Tokyo Shimbun.

Consider first Morgenson & Story’s article, “In Financial Crisis, No Prosecutions of Top Figures:”

As the crisis was starting to deepen in the spring of 2008, the Federal Bureau of Investigation scaled back a plan to assign more field agents to investigate mortgage fraud. That summer, the Justice Department also rejected calls to create a task force devoted to mortgage-related investigations, leaving these complex cases understaffed and poorly funded, and only much later established a more general financial crimes [...]]]> Should they change the motto at the Department of Justice? John Ashcroft modestly covered a statue of lady justice during his tenure as AG. But a series of reports suggests that, at least when it comes to financial heavyweights, Domina Justitia has left the building.

Consider first Morgenson & Story’s article, “In Financial Crisis, No Prosecutions of Top Figures:”

As the crisis was starting to deepen in the spring of 2008, the Federal Bureau of Investigation scaled back a plan to assign more field agents to investigate mortgage fraud. That summer, the Justice Department also rejected calls to create a task force devoted to mortgage-related investigations, leaving these complex cases understaffed and poorly funded, and only much later established a more general financial crimes task force.

To be sure, the DOJ has talked a good game here, unleashing Operation Broken Trust to catch the small fry. But even in December of last year, Andrew Ross Sorkin was ringing alarm bells:

To hear Eric H. Holder Jr. tell it, the Justice Department is aggressively cracking down on financial fraud. . . . But after you get past the pandering sound bites, a question comes to mind: is anyone in the corner offices of Wall Street’s biggest firms or corporate America’s biggest companies paying any attention to Mr. Holder’s “strong message”? Of course not. (I actually called some chief executives after Mr. Holder’s news conference, and not one had heard of Operation Broken Trust.)

What’s the rationale here? Morgenson and Story claim that Tim Geithner worked behind the scenes to get Andrew Cuomo (when he was NY Attorney General) to lay off suspicious financial institutions in order to stabilize the markets. Given how close the highest levels of the Obama administration have been to the TBTF banks, we can imagine similar sentiments expressed to political appointees at other agencies. The same rationale has watered down the proposed settlements over foreclosure fraud, which “leave it largely up to the banks to investigate themselves” on many issues. Justice, we are told, must take a backseat to the whims of bond traders, who might be spooked if officials did something as outrageous as follow legally required procedures.

House Republicans are getting the same Geithner “sky is falling” treatment this week over the debt ceiling. The Administration is quite fond of emergency rationales in foreign affairs as well. Where process threatens order, it must accede to stability.

Stability is Destabilizing

Stability may be quite tempting in the short term. But, as Hyman Minsky observed in a related context, “stability is destabilizing.” How better to tempt our Wall Street nontrepreneurs to cut corners, betray trust, and misrepresent tail risk than to assure that there are no serious consequences for those who did it the last time?

Bill Black, an Associate Professor of Economics and Law at the University of Missouri-Kansas City, is deeply disturbed by these developments. He is no mere ivory tower academic; he worked extensively on the S&L crisis, and has a deep understanding of the criminological, accounting, and legal literatures that have developed out of it. He is incredulous at the lack of sustained government attention to problems revealed in court after court, document after document, report after report:

[Geithner’s “elite frauds go free” doctrine] . . . represents the intersection of the curves of injustice and stupidity at their respective maxima. . . . It is stupidity of truly epic proportions to leave felons in charge of banks. Doing so cannot stabilize a financial system – it is certain to cause recurrent, intensifying crises. When I was a regulator during a financial crisis our agency’s top priority was to prevent frauds from controlling S&Ls. Our second priority was to support the prosecution of those fraudulent leaders.

The injustice of Geithner’s “elite frauds go free” doctrine is every bit as extreme as the stupidity of believing that giving fraudulent CEOs de facto immunity is the road to financial stability. It is a travesty that I have to defend the importance of integrity and justice. No nation can be great if it allows its elites to loot with impunity and prosecutes its whistleblowers. Geithner is destroying the things that made America great. He did so as part of Bush’s wrecking crew and he is doing so now as part of Obama’s wrecking crew.

So we continue to build toward another crisis. Bank executives will capture the upside of whatever “innovations” they can devise, leaving a distended Fed to pick up the pieces with new TALFs, TARPs, TLGPs, and secret discount windows. Perhaps that is why a major university is now taking delivery of $1 billion in physical gold. As Diane Coyle observes in the introduction of her book, The Economics of Enough, “The financial system is the pinnacle of the trust on which all economies and all societies have to operate—and that trust almost evaporated” in 2008. It is rapidly dissipating again.

Image Credit: Chrisafer.

But what if the revolving door is the wrong metaphor? What if, instead, there has been a fusion of state and corporate authority in the banking sector? What if Peter Orszag never left the government when he dropped the OMB Directorship to make at least ten times as much as a vice chairman at Citibank? Gabriel Sherman suggests as [...]]]> Washington’s revolving door is legendary. Everyone knows the connections between lobbyists, members of Congress, staffers, and favored firms. They’ve been mapped in health care, oil, agriculture, and many other industries. Finance journalists chronicle a superclass shuttling from beltway to bourse and back. Yves Smith and Matt Taibbi post on “sleazewatches” and $2,200-a-ticket conferences where the regulated schmooze with the regulators.

But what if the revolving door is the wrong metaphor? What if, instead, there has been a fusion of state and corporate authority in the banking sector? What if Peter Orszag never left the government when he dropped the OMB Directorship to make at least ten times as much as a vice chairman at Citibank? Gabriel Sherman suggests as much when he describes a lucrative cursus honorum for DC elites:

The close alliance among Wall Street and the economics departments of the major universities and the West Wing of the White House is the military-industrial complex of our time. That it has an effect on our governance is beyond question. How pernicious and distorting these effects are, how cynical many of its participants might be, and what might be done to change the system are being fiercely debated in Washington. In fact, to the layperson, the most surprising thing might be the degree to which people like Peter Orszag see the government and Wall Street as, essentially, parts of the same industry.

Conservative Kansas City Fed President Thomas Hoenig has already argued that “big banks like Bank of America Corp and Citigroup Inc should be reclassified as government-sponsored entities.” Texas Republican Randy Neugebauer has called eight banks “TSEs,” or taxpayer-supported entities. And at a recent conference on macroeconomics, Steve Randy Waldman made a legal point fundamental to all the economic dilemmas discussed.

Asked about the most important story “missing from the headlines” of the financial crisis, Waldman concluded that few grasped the startling implications of an institution growing “too big to fail” (TBTF). Such entities may be legally distinct from the government, but everyone knows that Uncle Sam will step in to save them if they run into trouble. Waldman argued that a bank like Goldman Sachs stands in the same relation to the federal government as the “variable interest entities” (VIEs), special purpose vehicles, and conduits set up by Citibank before the crisis stood in relation to Citibank. Those entities were “off balance sheet” legally, but everyone knew that Citibank would ultimately support them. As Jennifer Taub explains, this allowed Citi to take on even more leverage, given that its obligations to the conduits were hidden or disclaimed:

Citigroup’s VIEs were . . . highlighted during Financial Crisis Inquiry Commission hearings. Citi had set up some off balance sheet entities and sold mortgages bonds and other assets to them. The funding to buy the assets came from investors who bought short-term debt securities (commercial paper) of the VIEs. In order to help attract investors, Citi’s traders gave investors a “liquidity put.” This guarantee required Citi to buy back the securities at face value if they became illiquid. As a result, in 2007, Citi had to buy back $25 billion worth of the commercial paper at face value when it was trading at about 33 cents on the dollar. This cost the firm $14 billion. Even though Citi had offered this guarantee, the entities were off-balance-sheet when created.

Similarly, as Waldman notes, a Treasury Department and Fed committed to endless financial “deepening” (and stocked full of big bank alums) will not let the big banks fail.

So Goldman, Citi, et al. are the Fannie Mae’s of our day, routing around government pay scales despite the fact that government backing is crucial to their business models. Just as Lyndon Johnson took Fannie Mae off the government balance sheet in 1968 to avoid the budgetary consequences of direct government adoption of mortgage risk, today’s Treasury and Fed are permitting ever more consolidation in the banking sector without requiring either the capital or the real financial support that that level of risk-taking requires. It’s not that far of a leap from OMB to Citi after all.

Image Credit: Daquellla manera.

My contribution addresses the influence of law and economics on the sub-field of law and accounting, which I suggest takes the form of “two steps forward one step back.”  You can read a draft of my chapter (comments welcome!), available free here, accompanied by the following abstract:

Theory can have profound effects on practice, [...]]]> The hottest book of the century, on corporate law, is in production, thanks to editors Brett McDonnell and Claire Hill, both of Minnesota. As part of a series investigating the economics of particular legal subjects, overseen by Richard Posner and Francesco Perisi, this Research Handbook on the Economics of Corporate Law, promises a comprehensive canvass of the broadest definition of this field of law as it has been structured by economic theories over the past forty years.

My contribution addresses the influence of law and economics on the sub-field of law and accounting, which I suggest takes the form of “two steps forward one step back.”  You can read a draft of my chapter (comments welcome!), available free here, accompanied by the following abstract:

Theory can have profound effects on practice, some intended and desirable, others unintended and undesirable. That’s the story of the influence the field of law and economics has had on the domain of law and accounting. That influence comes primarily from agency theory and modern finance theory, specifically through the efficient capital market hypothesis and capital asset pricing model. Those theories have forged considerable change in federal securities regulation, accounting standard setting, state corporation law, and financial auditing. Affected areas include the nature of disclosure, the measure of financial concepts, the limits of shareholder protection, and the scope of auditor duty.

Analysis reveals how agency theory and finance theory often but not always point to the same policy implications; it reveals how finance theory’s assumptions and limitations are often but not always respected in policy development. As a result, while these theories sometimes produced policy changes that were both intended and desirable, some policy changes were both unintended and undesirable while others were intended but undesirable.  Examination stresses the power of ideas and how they are used and cautions creators and users of ideas to take care to appreciate the limits of theory when shaping practice. That’s vital since the effects of law and economics on law and accounting remain debated in many contexts.

Other contributions to the book similarly available in draft form are by Matt Bodie (St. Louis), David Walker (BU) and Charles Whitehead (Cornell).  The following scholars are also contributing chapters: Bobby Ahdieh (Emory), Steve Bainbridge (UCLA), Margaret Blair (Vandy), Rob Daines (Stanford), Steve Davidoff (Ohio State), Jill Fisch (Penn), Tamar Frankel (BU), Ron Gilson (Stanford/Columbia), Jeff Gordon (Columbia), Sean Griffith (Fordham), Don Langevoort (GT), Ian Lee (Toronto), Richard Painter (Minnesota), Frank Partnoy (SD), Gordon Smith (BYU), Randall Thomas (Vandy), and Bob Thompson (GT).

On the other hand, financial innovation has done wonders to extract purchasing power from the broad middle into the closed circuit at the top. Here, for example, is how one of our leading firms created enormous value in 2006:

Consider the tale of Travelport, a Web-based reservations company. [A] private equity [...]]]> I’ve talked in previous posts about a “closed circuit” economy among the wealthy. A plutonomy at the top increasingly circulates buying power (be it luxury goods, real estate, gold, or securities) among itself. The middle class used to dream that a rising Wall Street tide would lift all boats; as Felix Salmon shows, that hope is fading. Whatever innovations arise out of these companies aren’t doing much for average incomes.

On the other hand, financial innovation has done wonders to extract purchasing power from the broad middle into the closed circuit at the top. Here, for example, is how one of our leading firms created enormous value in 2006:

Consider the tale of Travelport, a Web-based reservations company. [A] private equity firm and a smaller partner bought Travelport in August 2006. They paid $1 billion of their own money and used Travelport’s balance sheet to borrow an additional $3.3 billion to complete the purchase. They doubtless paid themselves hefty investment banking fees, which would also have been billed to Travelport.

After seven months, they laid off 841 workers, which at a reasonable guess of $125,000 all-in cost per employee (salaries, benefits, space, phone, etc.) would represent annual savings of more than $100 million. And then the two partners borrowed $1.1 billion more on Travelport’s balance sheet and paid that money to themselves, presumably as a reward for their hard work. In just seven months, that is, they got their $1 billion fund investment back, plus a markup, plus all those banking fees and annual management fees, and they still owned the company. And note that the annual $100 million in layoff savings would almost exactly cover the debt service on the $1.1 billion. That’s elegant—what the financial press calls “creating value.”

The corporate geniuses at Boeing offer another display of modern-day business acumen.

The more stories like this you read, the more you realize that massive unemployment isn’t a bug in our economic system; it’s a feature. A country can’t have legal rules that permit these moves without expecting to hemorrhage jobs. All the Michael Porter homilies in the world can’t put this Humpty Dumpty back together again.

Global banks are settling US government lawsuits for what looks like big money. Goldman Sachs earlier this year settled a securities fraud claim for $550 million. UBS recently settled tax fraud charges for $750 million. And Deutsche Bank will now fork over $553 million to settle a similar case.

These are large nominal amounts but they will not remotely break the banks. These firms are financial titans, each commanding some trillion in assets and boasting bountiful annual revenue: Goldman Sachs $52 billion; UBS $44 billion; and Deutsche Bank $37 billion. Payments such as those are significant but not crippling.

The same cannot be said of similar amounts if they had to be paid by the world’s global auditing firms. Those [...]]]> Probably $1 billion, but not much more.   Let’s explore.

Global banks are settling US government lawsuits for what looks like big money. Goldman Sachs earlier this year settled a securities fraud claim for $550 million. UBS recently settled tax fraud charges for $750 million. And Deutsche Bank will now fork over $553 million to settle a similar case.

These are large nominal amounts but they will not remotely break the banks. These firms are financial titans, each commanding some trillion in assets and boasting bountiful annual revenue: Goldman Sachs $52 billion; UBS $44 billion; and Deutsche Bank $37 billion. Payments such as those are significant but not crippling.

The same cannot be said of similar amounts if they had to be paid by the world’s global auditing firms. Those firms (Deloitte, Ernst & Young, KPMG, and PWC) command financial assets trivial compared to those of the global banks, with firm value residing primarily in personal and professional reputation (so-called “human capital”). Revenues are much less than at banks too, about $20 billion for E&Y and KMPG and $25 billion for Deloitte and PWC.

That revenue costs more than bank revenue too and is spread across a far larger employee base. E&Y and KMPG employ about 140,000 apiece and the others about 170,000 each. By contrast, Goldman has a mere 35,000 employees, with 65,000 at UBS and 82,000 at Deutsche Bank. In addition, those financial firms have access to insurance to cover at least certain kinds of losses arising from legal liability, whereas the auditing firms lack that resource and instead self-insure.

Even so, the auditing firms have absorbed considerable payments in legal liability claims in the past decade. Each firm incurs up to a dozen or so settlements in the modest range of a few to ten or so million dollars in any given year. Occasionally larger payouts occur, with nine to date exceeding $100 million: $110 million, $125 million, $200 million, $217 million, $229 million, $250 million, $335 million, and $456 million. All those but the last involved single-company frauds—the latter, the record to date, is KMPG’s settlement of tax fraud charges akin to those Deutsche Bank and UBS likewise settled.

No doubt, those figures sting, but are affordable. It’s easy to infer that E&Y, roughly of equivalent capacity to KMPG, could pay $500 million or more, perhaps twice that, if it had to settle the case involving Lehman Brothers.  But amounts exceeding that could be crippling given the comparatively small asset base, fractional revenue, huge payroll,  and reliance on self-insurance.  The risk of a larger demand is realistic too, given the larger size of the  Lehman fraud  compared to the previous single-company cases the firms have settled.

The AG seeks unspecified damages the audit failure caused, certainly running to the hundreds of millions and easily reaching into the billions.  Given that E&Y does not have external insurance to cover such losses, but self-insures, the lawsuit could put the firm’s survival at risk.   Even so, settlement talks, going off-and-on since March, failed, suggesting that the firm is banking on being exonerated.  That is quite [...]]]> Ernst & Young, one of the Big-4 auditing firms left in the world, faces a grave lawsuit filed a couple of hours ago by New York’s Andrew Cuomo, the incoming governor’s last major act as state attorney general.  The lawsuit is based on fraudulent accounting committed by Lehman Brothers, the failed investment bank, that E&Y either overlooked or condoned, as I explained last March.  

The AG seeks unspecified damages the audit failure caused, certainly running to the hundreds of millions and easily reaching into the billions.  Given that E&Y does not have external insurance to cover such losses, but self-insures, the lawsuit could put the firm’s survival at risk.   Even so, settlement talks, going off-and-on since March, failed, suggesting that the firm is banking on being exonerated.  That is quite a gamble. 

As I told the New York Times and readers of this blog in March, if the case impairs E&Y’s viability as a going concern, a corporate financial reporting crisis should be expected.  It would be acute compared to the modest scramble that corporate America faced after government prosecutors a decade ago drove from the profession the Big-5 firm, Arthur Andersen, auditor of Enron Corp.   Then, 1/5 of companies needed to find a new auditor and most were able to count on one of the remaining four with little trouble. 

Today, 1/4 of public companies would be obliged to find a replacement auditor; thanks to rules stated in the federal response to Enron, the Sarbanes-Oxley Act of 2002, about 1/3 of those would be unable to engage any of the 3 remaining firms because of conflicts of interest (those other firms provide internal control or tax advisory services making them ineligible to render financial audits).   Amid such a crisis,  and with only 3 available firms, the existing structure of the auditing profession would be unsustainable.     

It would be reassuring if the Securities and Exchange Commission could tell the nation that is has foreseen this contingency and developed plans for addressing it, as urged last March and in 2006.  Alas, I am not sure that it is prepared to do either.

The Deepwater Horizon oil rig that exploded in the Gulf of Mexico was built in South Korea. It was operated by a Swiss company under contract to a British oil firm. Primary responsibility for safety and other inspections rested not with the U.S. government but with the Republic of the Marshall Islands — a tiny, impoverished nation in the Pacific Ocean. And the Marshall Islands, a maze of tiny atolls, many smaller than the ill-fated oil rig, outsourced many of its responsibilities to private companies.

Now, as the government tries to figure out what went wrong in the worst environmental catastrophe in U.S. history, this international patchwork of divided authority [...]]]> Just when you thought the BP mess could not get more surreal, this comes up:

The Deepwater Horizon oil rig that exploded in the Gulf of Mexico was built in South Korea. It was operated by a Swiss company under contract to a British oil firm. Primary responsibility for safety and other inspections rested not with the U.S. government but with the Republic of the Marshall Islands — a tiny, impoverished nation in the Pacific Ocean. And the Marshall Islands, a maze of tiny atolls, many smaller than the ill-fated oil rig, outsourced many of its responsibilities to private companies.

Now, as the government tries to figure out what went wrong in the worst environmental catastrophe in U.S. history, this international patchwork of divided authority and sometimes conflicting priorities is emerging as a crucial underlying factor in the explosion of the rig.

Sounds a bit like asking a government to certify the safety of investments—and having it effectively delegate the job to Nationally Recognized Statistical Rating Organizations. Keeping authority in the US may have just made matters worse:

MMS depends largely on the self-reporting of oil and gas companies to determine how much they owe in royalties — a system the Interior Department’s former inspector general, Earl Devaney, described as “basically an honor system” in congressional testimony in 2007. . . . The MMS commonly negotiates settlements with petroleum companies over disputed royalties — but the process is often shrouded in secrecy. A 1996 inspector general report found that MMS officials kept no documents on nine out of 10 royalty settlements, to prevent disclosure under the Freedom of Information Act. In one case, the MMS could provide no records to explain why the agency reduced its estimate of a company’s royalty debt by $360 million. . . . [More errors] sparked outrage in Congress and yet another probe by Devaney, the inspector general. He later called the oversight a “jaw-dropping example of bureaucratic bungling” and said it could cost the government as much as $10 billion.

It has become fashionable of late to contrast enlightened, US-style “free market capitalism” with the “state capitalism” of petro-states like Russia. Anyone familiar with the work of David Cay Johnston or James K. Galbraith would suspect that analysis. Recent oil debacles complicate the distinction even further.

Corporate America often hates what FASB requires—on subjects ranging, over the years, from accounting for pensions, mergers, stock options, and, today, financial instruments. It plies friends in Congress to push back against FASB when stakes are high enough. Sometimes that means FASB fights for its life.  (For a scholarly take on this, see Bill Bratton’s insightful BC Law Review piece here.)

An example: in the late 1990s, corporate America got Senator Joe Lieberman [...]]]> Anyone who cares about the reliability of corporate financial information in the US—and everyone should—ought to oppose threatend Congressional action that would expressly politicize accounting standard setting.   Since the 1930s, accounting standards in the US have been set by a private, independent, non-political body called, since the mid-1970s, the Financial Accounting Standards Board (pronounced faz-bee).

Corporate America often hates what FASB requires—on subjects ranging, over the years, from accounting for pensions, mergers, stock options, and, today, financial instruments. It plies friends in Congress to push back against FASB when stakes are high enough. Sometimes that means FASB fights for its life.  (For a scholarly take on this, see Bill Bratton’s insightful BC Law Review piece here.)

An example: in the late 1990s, corporate America got Senator Joe Lieberman to threaten to preempt FASB if it required corporate America to account for stock options—a threat FASB heeded until after that period’s financial frauds restored its insulation from political pressure. (Since, FASB has required corporate America to account for stock options as an expense.  Then-SEC Chair Arthur Levitt recounts the story in his memoir Take on the Street.)

Banks are today’s most vehement proponents of turning accounting standards into political products—detesting FASB’s accounting standards concerning off-balance sheet financing, securitizations, and, especially, measuring financial instruments at fair value.  Banks want to politicize accounting standards because they are extremely good at influencing politicians, but have essentially no power to manipulate FASB directly.  One reason is Washington’s revolving door—banks have teams of lobbyists who formerly worked there, on the Hill or in agencies.

As usual, though, the banking lobby’s arguments are so weak that it should be difficult for all but the crassest politician to accept them. A terrific example appears in an open letter in circulation courtesy of Forbes magazine from a former banking regulator (an FDIC Chair) cum global financial advisor, William Isaac.

The letter begins with these unsupported assertions: (1) “there is no question that [FASB] was a major contributor to the financial panic of 2008” and (2) “Mark-to-market (MTM) accounting senselessly destroyed over $500 billion of capital in our financial system, panicking the markets. . . .” The letter adds ad hominem invective, twice accusing FASB of operating in an “ivory tower” divorced from reality.

That invective is obviously hogwash; more seriously, not only does the letter fail to offer any support for its two sweeping opening assertions, they are unsupportable in fact and are contradicted by several serious empirical studies, including one by the Federal Reserve’s own researcher (Sanders Shaffer) and two others by prominent scholars (one by Laux & Leuz and one by Badertscher, Burks & Easton).   Shaffer’s conclusion is representative of this growing body of research that Isaac’s screed ignores:

Based on this simple analysis it would appear that fair value accounting had a minimal impact on the capital of most banks in the sample during the crisis period through the end of 2008.  Capital destruction was due to deterioration in loan portfolios and was further depleted by items such as proprietary trading losses and common stock dividends. These are a result of lending practices and the actions of bank management, not accounting rules.

Banks are trying to use their considerable political influence to expand it to encompass accounting standards.   Allowing that would be a grave mistake.  Fortunately, their arguments are so weak, backers may not prevail.  But anyone with a voice and interest should let their Congress people know.

Hat Tip: Lynn Turner

My view, reported in today’s New York Times, wonders, suggesting E&Y offers a “technical compliance defense,” when what’s needed is an objective judgment, based on professional skepticism, of whether financials provide a fair presentation.

Though the allegations sound esoteric, it is easy to translate them into simple terms.  When considering the following analogue between Lehman’s deals and your personal finance, think about how an independent accountant would assess what I suppose you are doing.

Suppose you apply for mortgage credit to buy a home. Your assets are cash and a car with a total value [...]]]> Ernst & Young, one of four remaining large auditing firms, allegedly botched its financial audits of Lehman Brothers, the bankrupt investment banking firm. E&Y responds that its audits met legal and professional requirements.

My view, reported in today’s New York Times, wonders, suggesting E&Y offers a “technical compliance defense,” when what’s needed is an objective judgment, based on professional skepticism, of whether financials provide a fair presentation.

Though the allegations sound esoteric, it is easy to translate them into simple terms.  When considering the following analogue between Lehman’s deals and your personal finance, think about how an independent accountant would assess what I suppose you are doing.

Suppose you apply for mortgage credit to buy a home. Your assets are cash and a car with a total value of $20,000; your debt totals $19,000. The difference between those two figures is your net worth, $1,000. Banks decline your application, saying your “leverage ratio,” debt compared to net worth, is too high. The ratio is 19:1 (debt of $19,000 versus net worth of $1,000). Banks say they can only lend to borrowers with leverage ratios below 15:1.

You imagine ways to reduce  your leverage ratio. One is to sell assets for cash and pay off an equivalent amount of debt. Thus suppose your car is worth $5,000, you sell it for that, and use the proceeds to pay down $5,000 of debt. Now total assets are $15,000 and total debt $14,000. Your net worth is still $1,000, so your leverage ratio is down to 14:1. You have made yourself legitimately eligible for your mortgage loan.

But suppose your car is a clunker and no one will buy it. Another way to reduce your leverage ratio is to get someone to take your car off your hands temporarily, giving you $5,000 today, while you promise to reverse the exchange after getting your mortgage and home. Some may be troubled by the two-step, thinking it looks more like a loan—someone lending you $5,000 and holding your car until repaid.

Yet you could convince yourself it really was a sale by observing that the other guy is paying you full value for the car, since most lenders only lend a portion of that. For example, the home you want to buy costs much more than what banks will lend you. You could make it more convincing by upping the amount to $5,250 or so.   

If you could not convince yourself of that, you’d say you borrowed money, secured by your car, and your leverage ratio would increase, not decrease. So you convince yourself it really is a sale and leave it that.

That analogizes allegations made against Lehman, hinging on what it called Re-Po 105 deals. Its leverage ratio, above 17, made borrowing difficult or impossible. It owned assets no one would buy.

So it transferred the assets in exchange for cash equal to or greater than their purported value, often 105% of that.  It simultaneously promised to repurchase them, at roughly the same price.

With the cash infusion, it retired debt.  It accounted for the initial transfer as a sale. The combination decreased its leverage ratio, close to 14, enabling it to borrow. It used borrowings to close out Re-Po 105s.  That returned its leverage ratio to above 17.

Was that legitimate? Is E&Y, Lehman’s outside auditor, liable for any illegitimacy? One technical defense is that of my rationalizing car seller above. Maybe the transfer really was a sale, not a loan, and accounting for it that way in technical compliance with applicable accounting standards.

Another technical defense is it was not the auditor’s business anyway, when it signed its opinions. If, as of that moment, the financials had netted out both sides of the Re-Po, they would still fairly present Lehman’s position then.

But are these technical arguments persuasive? If you got your accountant to sign off on your mortgage application using the Re-Po 105 approach, how would your lender respond?

And the existence of one of them, Ernst & Young, is threatened, as it faces the prospect of billion dollar liability for botched audits of Lehman Brothers, the defunct investment bank struggling in bankruptcy. It is an eerie echo of the fate of erstwhile big auditing firm Arthur Andersen, which dissolved after its culpability in 2001’s Enron fraud emerged.

Today, only four auditing firms have the resources and expertise to audit the vast majority of thousands of large public [...]]]> If you thought the 2008 credit crisis that temporarily froze global debt markets wrought havoc, watch out for the next shoe to drop.  At stake is the viability of global equity and other financial markets that could freeze if one of the four large auditing firms goes extinct.

And the existence of one of them, Ernst & Young, is threatened, as it faces the prospect of billion dollar liability for botched audits of Lehman Brothers, the defunct investment bank struggling in bankruptcy. It is an eerie echo of the fate of erstwhile big auditing firm Arthur Andersen, which dissolved after its culpability in 2001’s Enron fraud emerged.

Today, only four auditing firms have the resources and expertise to audit the vast majority of thousands of large public corporations. If one of those dissolved, its clients would have to scramble to find a replacement. Some of the remaining three lack requisite expertise for some of those corporations and others would be disqualified from auditing due to consulting work they do for them.

The result would be hundreds, possibly thousands, of large corporations who could not get their financial statements audited as required by US federal securities law. Stock markets could go berserk, along with other financial markets. The costs now, of moving from four firms to three, would dwarf those incurred when Andersen’s dissolution moved the total from five to four.

It does not appear that the US government, specifically its Securities and Exchange Commission, has any plans to deal with this prospect. It should. And it should announce them promptly to get ahead of any market crisis the failure of E&Y, or of the other three, would wreak. 

If not, the credit crisis of 2008 will look mild in comparison. After all, the credit crisis was readily addressed by government pumping enormous amounts of capital to rejuvenate liquidity; an auditing crisis cannot by solved by throwing money at it.

Allegations against E&Y are credible, making liability risk meaningful. The magnitude of potential loss certainly approaches $1 billion and may be much higher—alleged manipulations at Lehman ran to scores of billions of dollars.  E&Y, which self-insures against such risks and is unable to obtain significant external insurance, would face dissolution if compelled to pay such amounts.

The SEC should promptly prepare and announce steps to address that possibility. Alternatives, none of which is attractive and all pose costs, include:

* quickly seeking to break up the remaining three firms to eliminate conflicts of interest;

*quickly hiving off partners and resources of the existing E&Y (or other threatened firm) commanding expertise other firms lack, to enable them to continue auditing such clients; and/or

* relaxing auditing requirements or standards, by extending corporate audit deadlines or rules governing requisite auditor independence.

Though none of these is attractive or cost-free, they are far less costly than the probable costs  of market havoc that could result if no plans are made.    Longer term, I have laid out a series of prescriptions, in an article written a few years ago warning of the pending problem.

Observers should also watch the SEC closely as it participates in addressing the allegations against E&Y. SEC Commissioners, whose duties are to protect investors, will face a dilemma in evaluating how tough to be on the firm.

A tough line would be warranted in the name of protecting investors in Lehman Brothers, and signaling a commitment to audits of high quality.

But too tough a line would risk extinguishing E&Y, jeopardizing audit availability, and even equity market efficacy, for at least a meaningful period of time, wreaking havoc on investors.

The strange thing is that no statute says that the President may remove SEC commissioners only for cause. The idea that the President may not remove SEC commissioners except for cause turns out to be only a whopper of an assumption. Removing that erroneous assumption, there is only the PCAOB-SEC firewall to presidential control [...]]]> In his dissent in Free Enterprise Fund v. PCAOB, D.C. Circuit Judge Brett Kavanaugh characterized the SEC – Public Company Accounting Oversight Board (PCAOB) relationship as “Humphrey’s Executor squared.” His analysis assumes that two firewalls shield the PCAOB’s exercise of executive power from presidential control. First, PCAOB members can be removed only for cause by SEC commissioners. That’s clear enough. Second, SEC commissioners can be removed only for cause by the President.

The strange thing is that no statute says that the President may remove SEC commissioners only for cause. The idea that the President may not remove SEC commissioners except for cause turns out to be only a whopper of an assumption. Removing that erroneous assumption, there is only the PCAOB-SEC firewall to presidential control of the PCAOB and so understood that arrangement looks no worse than Humphrey’s Executor to the first power. Unless the Court is prepared to abandon Humphrey’s Executor altogether, this part of the challenge looks like a loser at this point in time.

The significance of the assumption was not lost on the Court during oral argument.

Justice Breyer first raised the issue (Tr. 17, lines 8-12: “What — what restrictions? Because, interestingly enough, my law clerks have been unable to find any statutory provision that says the President of the United States can remove an SEC commissioner only for cause”), but several justices later seconded the concern, including Justices Kennedy (Tr. 51-52) and Sotomayor (Tr. 52).

The only statute that could be interpretively glossed as creating good cause tenure is the provision for fixed commissioner terms. A provision, however, that fixes a tenure for a period of time does not thereby provide for removal only for cause. Examples abound in the U.S. Code. For example, bankruptcy judges are appointed for 14-year terms, 28 U.S.C. 152(a). It is a separate provision that provides bankruptcy judges may be removed only for cause. See 28 U.S.C. 152(e). A fixed term defines the appointment’s length and provides a measure for the quantum of damages should the officer be removed before the end of the term. On the other hand, a “for cause” provision specifies on what grounds an officer’s tenure may be terminated during that fixed term.

An analogy to agency law may be helpful here. A principal may contract with an agent for a fixed period of service, say, 5 years. If the principal should be canned before the agent’s 5 year term ends (agency law places the principal firmly in control of his choice of agents), the length of the term speaks only to the amount of damages that the erstwhile agent could receive for the breach of contract. The fixed term does not give the jilted agent a right to continue to serve in a principal-agent relationship if the removal was for other than cause. It just defines the amount of damages.

This agency approach explains why Wiener v. United States, 357 U.S. 349 (1958), should not be read to create an implied statutory limitation on presidential removal power whenever an officer merely holds an office for a fixed term. Wiener was simply a suit for back pay, not for reinstatement as an officer. The officer’s fixed term was relevant to the determination of the quantum of damages (much as it would be  in agency law).

Ironically, Justice Scalia was dissatisfied with Justice Breyer’s attention to statutory text – or absence thereof – at oral argument. Scalia thought that, notwithstanding the absence of any statute providing for good cause tenure for SEC commissioners, the Court should go along with the parties’ assumption. That position is surprising. Since when can parties stipulate to different statutory language than that which was duly enacted and the Court go along with it? And what is this new law of extra-textual assumptions? Is Scalia appealing to evolving standards of assumption? International and foreign sources of assumption? Assumptions found in legislative history? As Scalia says, the best evidence of what Congress intended is what the text of a statute said. Here it said nothing about limiting presidential power to remove SEC commissioners to good cause shown.

And what conditions for removal should we assume from this extra-textual exercise? Is the good cause that we are to assume the “malfeasance, neglect of duty, and inefficiency” language that created a “here-and-now subservience” in Synar? Or is it something more limited, such as removal only for physical or mental incapacity?

Of course, there is a textual option that avoids the need to assume and lays the problem at the feet of the democratic process. The Court could conclude that the SEC commissioners are removable at will because the statute does not say otherwise and conclude that there is only one removal firewall. To be sure, Congress could react to the Court’s statutory interpretation and create good cause tenure for such commissioners, but that’s the democratically and institutionally appropriate role of Congress. Then, and only then, would “Humphrey’s Executor squared” be truly presented to the Court for its review.

I write from the University of Cincinnati Corporate Law Center’s 23rd Annual Symposium, on the subject of The Globalization of Securities Regulation: Competition or Coordination?

Our host is Professor Barbara Black, and other panelists include Bill Bratton, Chris Brummer, Hannah Buxbaum, Eric Chaffee, Andrea Corcoran, Steve Davidoff, Jim Fanto, Robert Patterson, and my colleague, Fred Tung.

I mention all this because, for those who may be interested, the symposium is being webcast as I type (and listen to Hannah’s presentation, on The ‘Global Enterprise’ in Cross-Border Securities Litigation).  You can find it here:

https://www.uc.edu/ucvision/event.aspx?eventid=245

And if you have questions you’d like raised, you can e-mail them to Barbara here: corporatelawsymposium@law.uc.edu.

Hope you can join [...]]]> Thanks to Danielle, Dan, and entire Concurring Opinions team, for having me back for a return stint.

I write from the University of Cincinnati Corporate Law Center’s 23rd Annual Symposium, on the subject of The Globalization of Securities Regulation: Competition or Coordination?

Our host is Professor Barbara Black, and other panelists include Bill Bratton, Chris Brummer, Hannah Buxbaum, Eric Chaffee, Andrea Corcoran, Steve Davidoff, Jim Fanto, Robert Patterson, and my colleague, Fred Tung.

I mention all this because, for those who may be interested, the symposium is being webcast as I type (and listen to Hannah’s presentation, on The ‘Global Enterprise’ in Cross-Border Securities Litigation).  You can find it here:

https://www.uc.edu/ucvision/event.aspx?eventid=245

And if you have questions you’d like raised, you can e-mail them to Barbara here: corporatelawsymposium@law.uc.edu.

Hope you can join the discussion!

At the outset, I’ll stipulate that I am no expert in health care but that my biases are strongly against the expansion of government entitlements in this or other areas. Discount my meanderings as you see fit. My understanding, however, is that a large part of the problem in health care costs comes in the way in which we price the system. We pay for services rather than outcomes. [...]]]> One of the joys of being a contracts prof is that you get to teach Hawkins v. McGee, the hairy-hand case of Paper Chase fame. Reading this week’s Economist briefing on health care has got me thinking about the meaning of the holding in that case for the current health care debates.

At the outset, I’ll stipulate that I am no expert in health care but that my biases are strongly against the expansion of government entitlements in this or other areas. Discount my meanderings as you see fit. My understanding, however, is that a large part of the problem in health care costs comes in the way in which we price the system. We pay for services rather than outcomes. This creates an incentive for providers to create a system structured around providing expensive procedures rather than providing positive health outcomes. I wonder, however, if Hawkins v. McGee doesn’t provide a way forward.

The case is normally presented as being about the proper measure of damages. Hawkins had a badly burned hand, and McGee promised that if he could perform an experimental skin graft Hawkin’s hand would be a “one hundred percent good hand.” The operation was a horrible failure, leaving Hawkins with a maimed and hairy hand. The court awarded expectation damages, namely the difference between what was promised — a good hand — and what was delivered — a maimed and hairy hand. (It turns out that a hand wasn’t worth much in New Hampshire in 1929; Hawkins got a couple of hundred bucks.) The case is odd because it presents what would ordinarily be a malpractice claim as a contract claim precisely because McGee did more than simply promise to perform services for a fee. He promised an outcome.

Suppose that we replaced the ordinary healthcare contract with the Hawkins v. McGee contract, namely that hospitals promised to deliver healthcare outcomes rather than healthcare services. First, it would align the incentives of health care providers much more closely with patients. Second, it would inject a lot of uncertainty into health care providers liabilities. After all, in many cases they will not be able to deliver particular outcomes, causing a breach of their contracts. This second issue could be controlled in two ways. First, health care providers could specify the amount they would pay in the event of unsuccessful treatment in a liquidated damages clause. Provided the courts enforced these clauses, they would diminish the unpredictability of payouts. Second, and perhaps more importantly, a fee-for-outcome contract would create a powerful incentive for healthcare providers to actuarialize the effectiveness of treatments, carefully compiling data on how likely successful outcomes actually are.

Were this contract adopted, going to the doctor would involve the purchase of a very different bundle of rights. Rather than buying services on the advice of a conflicted expert advisor, one would in effect purchase a form of insurance. In return for a fee, you would be promised a favorable outcome or the payment of some sum of money. The hospitals would then, in effect, be in the position of making bets on the effectiveness of their own treatments, bets that would become more profitable the better the outcomes were.

I’m flattered to have  been asked to serve on the Advisory Board, which boasts many luminous scholars from around the world, including, from the US, Sudipta Basu (Temple, accounting); Jonathan Glover (Carnegie Mellon, accounting); David Kennedy (Harvard, law); my [...]]]> Scholars like me interested in law as it interacts with accounting and economics will be excited to learn of a new joural offering to link these three fields and many others. Called the Journal of Accounting, Economics and Law, this is a welcome new forum to celebrate study of the relation, too often under-appreciated, among these subjects. The journal’s founding editors are three scholars I’ve come to know and admire, Michigan law prof Reuven Avi-Yonah, Yale accounting prof Shyam Sunder and University of Paris business economics prof Yuri Biondi.  

I’m flattered to have  been asked to serve on the Advisory Board, which boasts many luminous scholars from around the world, including, from the US, Sudipta Basu (Temple, accounting); Jonathan Glover (Carnegie Mellon, accounting); David Kennedy (Harvard, law); my colleague Larry Mitchell (GW, law); Roberta Romano (Yale, law); Martin Shubik (Yale, economics); and Lynn Stout (UCLA, law).

Following is a description of the journal.   Manuscript submissions are encouraged!

“The Journal of Accounting, Economics, and Law aims to encourage a comprehensive understanding of the relationship between individuals, organizations, and institutions in economy and society.

Financial, economic and legal techniques and languages play an influential and neglected role in this relationship. Concerns of finance, control, accountability, responsibility, valuation, regulation, and governance will be raised in their connection with accounting, economics, law, sociology, anthropology, history, finance, political science, and the management and policy sciences.

The journal encourages works that seek to recombine disciplinary domains in response to practically relevant issues, while encouraging theoretical advances and insights, and comparative historical perspectives.”

Some of these implications appear in contexts covered by the broad subject called Law and Accounting, topics within securities regulation, corporation law and financial reporting policy. In writing a paper addressing the influence of MFT on L&A, I’m trying to identify the most significant subjects. In outlining a draft, I’ve identified the following as the most [...]]]> Amid the financial crisis, considerable debate attends the enduring validity of Modern Finance Theory, including assumptions of capital market efficiency, reliability of recognized risk measurement tools and models of risk reduction through diversification.  There’s little doubt that MFT has had considerable effects on positive law and legal scholarship in the past three generations.  Looming are questions about whether those policies warrant reconsideration given ongoing discoveries of potential deficiencies in those models.

Some of these implications appear in contexts covered by the broad subject called Law and Accounting, topics within securities regulation, corporation law and financial reporting policy. In writing a paper addressing the influence of MFT on L&A, I’m trying to identify the most significant subjects. In outlining a draft, I’ve identified the following as the most consequential, and would be delighted to hear, through comment or email, alternative suggestions or criticisms of this initial compilation. 

The following is a top ten list of subjects in Law and Accounting that Modern Finance Theory has influenced. In each case, it is difficult to deny the role MFT had in augmenting legal or policy change. In some cases, there is little doubt this has been an improvement but in others the resulting law or policy backfired or is of contested appeal. On balance, the influence of MFT on L&A warrants an uncertain appraisal, with many positive effects along with some offsets.

An interesting issue in each case is how, if at all, changing confidence levels in the validity of MFT would warrant changing the related policy. Notably, at least some of the policies could remain justifiable even were MFT deemed invalid. The appeal of others depends quite heavily on its validity.

1. Establishment of the Forward Looking Disclosure System in Federal Securities Law

2. Rise of Fair Value Accounting in lieu of Historical Cost Accounting

3. Creation and Rise of the Cash Flow Statement and Analysis

4. Proliferation of Pro Forma Reporting and Analyst Earning Estimates

5. Rise of Discounted Cash Flow Analysis in State Appraisal Proceedings

6. Expansion of the Stock Market Exception to the Appraisal Remedy

7. Rise of the Reputation Model of Auditing and Curtailed Ambit of Auditor Liability

8-9. Protraction and Politicization of the Accounting Standard Setting Process with illustrations from accounting for:

(a) Business Combinations and

(b) Stock Option Compensation.

10. The Appeal and Potential of International Financial Reporting Standards.

It appears the tax would be computed based on a bank’s total liabilities other than its insured deposits, although some reports say the tax could be based on profits. Aside from recouping costs, the liability approach suggests creating an incentive for banks to avoid incurring liabilities deemed riskier than insured deposits, though without appearing to distinguish among risk types.

Aside from the inevitably contentious debate about the merits, fairness or efficiency of such a proposal, a particularly strange feature is how, according to a Wall Street Journal report, liabilities other than [...]]]> Christine Hurt and Erik Gerding have several good posts at Conglomerate on how the White House tomorrow will formally propose a tax on banks to recover losses government incurred providing capital infusions under the so-called Troubled Asset Relief Program (TARP).

It appears the tax would be computed based on a bank’s total liabilities other than its insured deposits, although some reports say the tax could be based on profits. Aside from recouping costs, the liability approach suggests creating an incentive for banks to avoid incurring liabilities deemed riskier than insured deposits, though without appearing to distinguish among risk types.

Aside from the inevitably contentious debate about the merits, fairness or efficiency of such a proposal, a particularly strange feature is how, according to a Wall Street Journal report, liabilities other than insured deposits would be calculated. The report says that liabilities would be calculated as “the difference between a firm’s assets and its combined equity and insured deposits.” Isn’t this a convoluted way of speaking?

Anyone vaguely familiar with business or accounting knows that owners’ equity equals total assets minus total liabilities. For five hundred years, bookkeepers have used this relationship to define the fundamental equation of accounting. Contemporary corporate law students describe equity as the residual claim on firm assets, reflecting that same subtraction of liabilities from assets.

Isn’t it confusing and backwards then to propose to measure liabilities as the difference between assets and equity (setting aside insured deposits)? Assets and liabilities are the normative categories forming the substantive content of accounting’s fundamental equation. Equity is only the difference between them.

So if you want to impose a tax on liabilities, there is no need to think of them as the difference between assets and equity. Apart from looking forward to hearing the President tomorrow defend the proposal’s merits and spell out its details, I’d like to know whether this reported feature appears and, if so, why it makes any sense.

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.