TCS Daily


Power and the Presidency

By Stephen Bainbridge - June 29, 2006 12:00 AM

On April 6, 1780, the British Parliament famously took up the motion of Mr. Dunning "that the influence of the crown has increased, is increasing, and ought to be diminished." Here, in the United States, our Founding Fathers sought to ensure that the powers of the Chief Executive, while considerable, were hedged and bounded by a series of checks and balances. Yet, since 9/11, the Bush Administration has consistently pushed the edge of the constitutional envelope, repeatedly asserting a broad conception of Presidential power under the so-called unitary executive doctrine.

Few observers have noted the latest exercise of unilateral Presidential authority, but it is one that is fraught with the potential for the same sort of abuses that gave rise to the corporate scandals of 2001-2002.

In May, President Bush quietly signed a "Memorandum for the Director of National Intelligence," which reads in full:

"By virtue of the authority vested in me by the Constitution and laws of the United States, including section 301 of title 3, United States Code, I hereby assign to you the function of the President under section 13(b)(3)(A) of the Securities Exchange Act of 1934, as amended (15 U.S.C. 78m(b)(3)(A)). In performing such function, you should consult the heads of departments and agencies, as appropriate. You are authorized and directed to publish this memorandum in the Federal Register."

The vague and ambiguous wording of the memorandum wouldn't tell the casual reader that anything significant had happened. Even most securities lawyers (and, I'd bet, securities law professors) likely are unaware Securities Exchange Act § 13(b)(3)(A) provides that "with respect to matters concerning the national security of the United States" the President can exempt public corporations from their obligations under the Sarbanes-Oxley Act to maintain "books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer" and to maintain an effective system of internal controls designed to ensure that such transactions receive proper accounting treatment.

BusinessWeek did pick up the story, but improperly reported that Bush delegated authority to National Intelligence Director John Negroponte "to excuse publicly traded companies from their usual accounting and securities-disclosure obligations." In fact, as just noted, § 13(b)(3)(A) does not grant companies a blanket exemption from disclosure requirements. Instead, it only exempts companies from having to comply with the Sarbanes-Oxley internal controls rules.

The necessity for some exemptions under § 13(b)(3)(A) is obvious. Suppose, for example, that a corporation was hired by the Pentagon to build a military base in Saudi Arabia. To avoid exacerbating Islamist fundamentalists who object to the presence of foreign troops on Saudi soil, the Pentagon wishes to keep the base top secret.

If the contractor were obliged to run such transactions through the usual Sarbanes-Oxley mandated internal controls processes, the transaction necessarily would come to the attention of the company's internal audit employees and, likely, the outside auditor. The risk of a security breach would escalate dramatically.

Conversely, however, the Sarbanes-Oxley rules were put into place precisely because many corporations' internal control processes broke down in the late 1990s. Recall the tale of Enron, for example. Enron CFO Andrew Fastow set up a number of so-called special purpose entities (SPE), typically limited liability companies or partnerships, which entered into complex transactions with Enron. Under arcane accounting rules, as long as someone other than Enron owned at least 3% of the SPE's equity, the assets and debts of the SPE did not have to be disclosed as part of Enron's consolidated financial statements. Hence, these SPE investments were "off balance sheet." By thus concentrating debt in these off balance sheet SPEs, Enron hoped that both its credit rating and stock price would remain high despite its increasingly precarious financial situation.

The SPEs weren't just part of an accounting game, however. CFO Fastow owned an equity stake in the SPEs. Despite the obvious conflict of interest inherent in related party transactions between a corporation and one of its officers or directors, Enron's board routinely waived its ethics rules to allow Fastow to participate in the SPE deals. According to a subsequent internal investigation, Fastow made over $30 million in profit from these deals. Several other Enron executives also participated in these deals and likewise made millions. In most of these transactions, Enron's internal controls proved inadequate, not least because Enron managers did not even bother to follow the accounting controls the firm had established.

The SOX internal control rules adopted in response to the meltdown at Enron have been criticized by many (including yours truly) for being too costly, especially for small business. Yet, while the SOX rules may not be perfect, some system of internal controls is necessary to ensure that the accounting trickery and frauds of the 1990s are not repeated.

The solution is oversight. Negroponte should not be allowed unilaterally to decide what projects implicate national security or we could end up with the proverbial bridges to nowhere being exempted from SOX. Negroponte should not be allowed to go beyond his limited exemptive authority under § 13(b)(3)(A), such as by allowing companies to avoid their disclosure obligations (most national security projects likely would not be sufficiently material to require individual mention in corporate disclosures, so there is little risk of a security breach if such transactions are rolled up into the corporation's overall earnings statement). Instead, there should be Congressional oversight to ensure that Negroponte is using his authority properly. In addition, because there often will need to be a balance struck between investor protection and national security, Congress ought to consider going back and amending § 13(b)(3)(A) to give the SEC some role in deciding whether exemptions under that Section ought to be granted on a case-by-case basis.

Steve Bainbridge is a Professor of Law at UCLA. He writes two popular blogs: ProfessorBainbridge.com and ProfessorBainbridgeOnWine.com.

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5 Comments

Wrong on SOX
“Yet, while the SOX rules may not be perfect, some system of internal controls is necessary to ensure that the accounting trickery and frauds of the 1990s are not repeated.”

On this matter, I must take issue with the professor. The implicit idea behind SOX was that Congress would be able, through legislation resolve and correct a suddenly broken corporate financial reporting system deus ex machina. Never mind that by 2002, Congress had been attempting this since the 1930’s. Additionally, internal controls have always existed-SOX merely requires that they conform to an established framework, usually COSO and be certified and attested to.

Having recently worked for one of the “big four” and always suspicious of legislation that hurdles through Congress when the whims of the day turn legislators into a granstanding mob - wielding laws as leaders of a pitchforks rebellion, I must tell you in all candor, SOX is not the answer. SOX never addressed basic problems that have existed for decades. Nor will SOX or any other framework ever “ensure that the accounting trickery and frauds of the 1990s are not repeated.” To believe that SOX will do so demonstrates why lawyers should not practice accountancy, which is another unfortunate by-product of the Enron era scandals. The problems are as follows:

First is that the nature of the highest level corporate financial officer has changed. In the old days, the buck stopped at a “Comptroller’s” desk-an individual who learned his job and demonstrated his integrity with a long ascent to the office held. The title implied a public responsibility. Those who “kept the books” attempted, within the imperfect constraints that are necessarily entailed in such “significant estimates by management” as depreciation and reserves -to measure results of operations, not create measurements of results of operations. Today, outside of government, the title ‘Comptroller” and is as anachronistic as a mechanical adding machine.

The second problem is the nature of external auditor. A modern corporation is an incredibly complex piece of machinery. However, the vast majority of the work performed is done by bright individuals but usually with fewer than five years of work experience. The relationship between staff auditors and partners is an exercise in mutual usury. A common joke is how staff auditors are prostitutes being sent from client to client by their pimp. However, most people use their big 4 experience to obtain an imprimatur so they can get hired by a company that doesn’t think work needs to resemble a fraternity hazing or a concentration camp. Still AICPA and state accounting journals are filled with articles on attracting staff while ignoring the obvious-long hours, uncertain schedules and high pressure aren't recipes for retention, unless you are unusually acquisitive and possessed of unusual physical vitality.

The pressure to churn out reams of “work papers” is unreal. Reflecting back on my experience, I see why there was not enough professional skepticism or need to obtain sufficient competent evidence. The “integrated” SOX audits are adventures in checking boxes on charts of “critical” controls. Good auditors don’t need SOX, they need to return to the basics. Good auditors have known for years that verbal assurances from clients should not be accepted without other supporting forms of evidence. However, there is an ever present and overwhelming pressure to meet budget deadlines and keep the client happy; so many times explanations were accepted with a smile. Interestingly, the incapacity of verbal assertions to be acceptable audit evidence on their own have now been codified with the new audit standard “SAS 103”. If the government wants truly sound auditing, it needs to have auditors hired by somebody other than the company. Duh.

Finally PCAOB is run by lawyers and staffed by big 4. No matter how you cut it SOX specified that 3 of 5 individuals should not now or ever have been CPA’s. Ergo, your sole qualification to oversee the profession is to be unqualified. They have done very little except reinvent the wheel. The inspections of audits is withheld from the public and of course there’s the TCS


of course there’s the TCS
of course there's TCS noted constitutional issues with "peekaboo".

Market failures
Do not prove that govt intervention is needed.
Only when you can show that the cost and likelyhood of govt failure is less than the known cost of market failure, does govt intervention become justified.

To date, such a thing has never happened, but that will never stop those who love to tell others how to live their lives from acting.

You missed my point
There's been a SEC since the 1930's. They had 70 years to prevent ENRON. If SOX was so great and they could cook it up so fast, they should have done so long before.

SOX
I'll bet that you think of youself as a proponent of free markets.

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