Monday, November 28, 2011

Sarbanes-Oxley

This law has been mentioned several times in the news recently.  It is not the most popular subject but it is a good illustration of what's wrong with our system.  In our modern society anything that happened more than 15 minutes ago seems to be completely forgotten.  It's not even like ancient history.  Some people know ancient history.  Sarbanes-Oxley was passed in 2002 and was a huge deal at the time.  But I would bet that if you polled 100 people over 30 easily 95 would not have a clue as to what Sarbanes-Oxley is.  That is really depressing.  So here is my attempt to remedy the situation.

To understand Sarbanes-Oxley you have to understand the Enron scandal.  But it happened in the still more ancient era of 2001.  So probably 96% of the over 30 set have already forgotten about Enron.  And it is useful in explaining Enron to go even further back.  In 1923 Edwin Lefevre published "Reminiscences of a Stock Operator" (still in print), a thinly disguised account of the activities of a notorious stock manipulator named Jesse Livermore.  Along the way Lefevre documented many of the ways to cook a market so that a speculator "in the know" could make a lot of money.  It turns out that "Reminiscences" can be thought of as the bible that guided the actions of the executives at Enron.

I am going to just sample one aspect of the Enron scandal.  If you want a more complete picture of the  entire scandal read "The Smartest Guys in the Room:  The Amazing Rise and Scandalous Fall of Enron".  For those who are visually oriented there is a documentary (now available on DVD) called "Enron:  The Smartest Guys in the Room" that is based on the book and covers essentially the same material albeit more briefly.  So what I am going to cover is indicative of the whole scandal but only covers one aspect of it.  And my story starts in the 1930s.

In an effort to get the economy back on track during the great depression the Roosevelt Administration undertook several major capitol construction projects.  The projects I am interested in were in the form of large dams.  The principal reason for the dams was flood control/irrigation and irrigation revenues were the principle source of revenue to cover payment of the bonds used to finance the projects.  But it cost little more to add hydroelectric generation capacity to the dams.  And, since most of the cost was covered by irrigation fees, the resulting electric power was extremely cheap.  Many of these dams were built in the states of Washington and Oregon.  Neither state had enough population or industry to soak up the electric power.  California did.  So, since the additional cost was relatively modest, long haul power lines were built connecting the entire West Coast together.  This allowed load balancing between Washington/Oregon and California as the timing of their peak power needs differed.  So it became common to sell electric power up and down the West Coast.

For many years the players in this power market were electric utility executives whose chief concern was servicing their own local customer base.  So the market was operated in an informal and gentlemanly manner.  It worked well for all the participants in spite of the fact that it was essentially unregulated.  This is because the players behaved honestly and ethically with each other and did not try to take advantage of or "pull one over on" each other.  But the market did not operate using "modern (e.g. Wall Street) business practises".  Standard analysis in some political circles assumes that "gentleman's" markets are inefficient.  The theory is that converting the market to a modern business-like approach will result in lower costs and greater efficiencies.  The new players playing by the new rules will be able to wring inefficiencies out of the system and cut better deals resulting in everyone benefiting.

Executives at Enron made these kinds of arguments to politicians.  "Let Enron in and we will shake everything up and everyone will win", they said.  And "free market" oriented politicians (e.g Republicans) bought these arguments.  They let Enron into the market for trading electricity up and down the West Coast.  And they did it in an essentially unregulated manner.  "The invisible hand of the market corrects all inefficiencies and punishes all bad behavior", the argument went.  And if the Enron executives and the traders they worked for had been honest and ethical there is a small chance that the market could have operated more efficiently than it had in the past.  Unfortunately, the Enron people saw their job as making vast amounts of money for Enron and giant commissions for themselves.  I don't know if they had read "Reminiscences" but they acted as if they had.  And for the first few years they were wildly successful.  They made pots of money for Enron and for themselves.  And, since success is proof of brilliance, they styled themselves as "the smartest people in the room".  I don't think any of them ever figured out, or at least were willing to admit in public, that all they were really doing was following in the footsteps of Jesse Livermore, someone who had done it all before roughly a hundred years earlier.

What actually happened when Enron traders took control of the West Coast power market was that prices went up, way up, and the whole system became unstable.  Enron traders literally had power plants shut down to create artificial shortages so that they could jack the price up by 1000% and more.  So the West Coast, and particularly California, got the worst of both worlds, way higher prices and many more brownouts and blackouts.  So much for the "efficient market" theory.

Eventually events caught up with Enron and it failed spectacularly.  Before it crashed Enron got into a number of markets, not just West Coast power.  And not all their schemes worked out as well.  And it turned out that they were cooking the books.  So Enron left a giant mess behind when it finally crashed.  A lot of what Enron did was illegal.  But it turned out that most of what it did was completely legal.  And it turned out that the Anderson accounting firm had made a lot of money advising Enron management as to how to do what they wanted to do legally or at least in such a way that they were unlikely to get caught.  Meanwhile Anderson was Enron's "auditor of record".  The "auditor of record" is supposed to represent stockholders.  The "audited financials" are supposed to tell stockholders how well the company is doing.  But stockholders were getting conned along with everyone else.  Anderson did this because they were making a lot more money from the advising business than they were for the auditing business.

The Enron scandal, and a number of others that happened at about the same time, caused the U.S. Congress to decide it had to do something.  The result was Sarbanes-Oxley. SOX, as it is commonly referred to, was supposed to fix a number of problems that came to light as a result of Enron and the other scandals.  The first thing was to make certain practices illegal.  The second thing was closely related to this.  Many Enron executives pleaded ignorance.  They said "I did not know that illegal thing was happening.  Subordinates did it without my knowledge".  And, of course the subordinates claimed that they had kept their seniors completely informed.  SOX said it was the responsibility of senior executives to know about illegality that was happening below them.  In essence, ignorance was no longer a permitted defense.  The third thing that SOX did was make it illegal for the same company to consult and audit.  In future, the "independent" auditor would then catch the bad behavior.  That was the idea.

SOX is now generally reviled.  It is said to impose draconian requirements that are expensive to implement without actually fixing the underlying problems.  No one, including its original proponents, are currently big fans of SOX.  How did this come to be?  Here's where I point my finger at the current system.

SOX tried to do big complicated things.  Enron proved that there were big problems that needed to be fixed and most people believed that the fixes would be complicated.  Lobbyists know how the system works.  They know that sometimes there is an avalanche coming down the mountain and you just can't stop it.  But you can divert it.  So lobbyists, when confronted with an avalanche, don't try to stop it.  They try to divert it.  They know that no one gets points for working through the fine print and figuring out what it means.  So instead of trying to stop things they cause complex provisions to be added.  There is always some ostensible reason for replacing a simple provision with a complex one.  But the complexity makes it easy to insert loopholes into the bill.  The loopholes allow people in the know (the lobbyist's clients, for instance) to continue to do what they want to.  This strategy goes by the name of the "swiss cheese" strategy.  Make sure there are enough holes inside the cheese so that apparently solid cheese is actually filled with air.

This "swiss cheese" strategy always works.  It has been used successfully for decades by the National Rifle Association to make sure that Federal gun control legislation is ineffective.  Many other laws that appear tough on the outside have been hollowed out by lobbyists from all parts of the political spectrum.  Business lobbyists are perhaps better at it than others but everyone uses it.  There are literally thousands of provisions in the Federal Tax Code that benefit a single company.  No one takes the time to work through all the provisions of a thousand page bill to figure out where the loopholes are and, more importantly, who benefits from them.  This is because no one cares very much when something like this is exposed.  And removing the loophole is nearly impossible.  The beneficiary of the loophole will spend a lot of time and money defending it.  Every one else eventually decides closing the loophole is too much trouble and moves on.

It would be nice if the "reduce regulations" Republicans were serious about this.  Vast numbers of regulations are in place to benefit a single individual or company.  We'd probably all be better off if these regulations (and the single beneficiary laws they are often based on) were eliminated.  But the Republicans have never actually done this.  Instead they go after regulations like "clean air" and "clean water" that benefit citizens but make it harder for businesses to make a buck.

As I indicated, even the proponents of SOX see that it has serious problems.  In actuality it doesn't work very well due to all the swiss cheese it contains.  The obvious thing for supporters to do would be to undertake a substantial revision to SOX to make it more effective and less needlessly burdensome.  The problem is that they are afraid.  They are afraid that if they make a major effort to fix SOX the lobbyists will swoop in and create even more swiss cheese making things even worse than the bad present situation.  So they decide that their best option is to just leave things alone.  And they are right.  And the fact that they are right perfectly illustrates what is wrong with the current system.  The system needs to be changed so that the "swiss cheese" strategy stops being a strategy that always works.

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