Thursday, March 20, 2008

Prosecutorial Misconduct in the Enron Case...and the Scourge of Sarbanes-Oxley

It is now looking as if the prosecutors in the Enron case may have been engaging in gross prosecutorial misconduct--which could conceivably free Fastow and Skilling from their "obligation" to society. This is in itself sad, but the real travesty in the Enron case was the overreaction to it by our own government.

It is safe to say that the downfall of Enron has caused the pendulum to swing way too far in the direction of over-regulation of US businesses. Sarbanes-Oxley has exacted such an enormous cost on public corporations in the US, that now many large privately held companies (not subject to SOX) are choosing to go public offshore. This is one of the factors behind the alarming rate at which London and Hong Kong are slowly but surely chipping away at New York's claim as the World's financial capital. And it is a much larger factor in sending American jobs overseas than are anti-protectionist free trade agreements.

What we have here is a lesson in Economics 101: anytime government tries to interfere with free markets--even with the best of intentions--the law of unintended consequences almost always makes the ramifications of that regulation far worse for the economy than the conditions which brought it about. In the case of Sarbanes-Oxley, the only real beneficiaries are those who want more central control of our economy (i.e. more government and regulation) and their patrons in the Public Employee Unions.

99.99% of the time, stockholders and Boards of Directors enable business to be a much more efficient self-policing and self-correcting mechanism than government regulation ever could hope to approach; certainly any business is more efficient at correcting its own inefficiencies than are big government bureaucracies--have you ever tried working with the IRS when they have gotten their information wrong?

In the free marketplace, if the shareholders of a public company are not pleased with its performance, they can sell their stock, which lowers the value of the company (and its executives' compensation); and it also puts pressure on its Board to make changes in management if necessary, etc.

Similarly if the independent Accounting firm chosen to audit a public company finds irregularities in that company's books, pressure is exerted to correct the problem internally, because the shareholders get to see the financial statements--and if they are displeased, they can again sell stock, lose confidence, etc.. Audits also serve to show executives where money is being spent efficiently...and inefficiently.

Sarbanes-Oxley was created in a vain attempt to "protect the public" from 0.01% of cases (and that may be overestimating the number) where you might have collusion between the offending company and its auditors. It reality, the purpose of SOX was to show the public and investors that it was "safe" to invest in US companies again. But the unintended consequence is that the burden imposed by this law has in reality made it less safe for such investors, because now US companies have to devote more of its resources and assets towards a process that is more cumbersome and less flexible to the changes of the marketplace. As a result, investment in US companies suffers, and the ripple effects spread from there. Lower stock prices. Lower profits. More layoffs. More relocation of jobs overseas. And so the vicious cycle continues.

It needn't have happened, especially when one fully understands how rare an Enron really is. Yes, greed and corruption do exist and always will, but even before Sarbaanes-Oxley there were checks and balances to root out such behavior. At Enron the good of the company became a secondary concern to their own lavish lifestyles for several high-placed executives; but even the Enron executives could not have gotten away with their fraud were it not for the corrupt and shoddy auditing (and later shredding of the evidence) by the Arthur Andersen auditors assigned to police the company's books. So you actually had collusion between a giant Natural Gas company and representatives of a giant, highly esteemed accounting firm. Very, very rare. And: the resulting lawsuit by the shareholders of Enron against Andersen put that "Big Five" company--which had been in business for over a hundred years--out of business.

Had Arthur Andersen been "straight up" and diligent in inspecting Enron's books from the beginning--which all auditors are required to do--then the Enron executives' malfeasance and excesses would have been flagged by the auditors, and as a result changes would have been made internally to correct the excesses long before the real lasting damage to the shareholders and employees was done. And while this may have meant fewer "heads on a plate" for the business-hating media to vilify, it also would have cost the public far less money than did the collapse of Enron, the collapse of Andersen, a long, drawn-out legal struggle on the public's dime (which now appears to have been bungled as well..), the resulting loss of confidence in US markets, and the onset of the recession in the last quarter of the Clinton Presidency.

Sure, had the books been audited properly, Enron might have had to cut back, as many companies do, and shareholders would undoubtedly lost some of the value of their stock; but it needn't have been "all or nothing". If it were not for the collusion of the auditors, this would have been a much softer landing for all.

Instead, a huge accounting firm with a very strong reputation--which had been in place for over 100 years (full disclosure: and where I used to work as a Consultant...)--went out of business, costing tens of thousands of jobs. If that is not a "self-policing" mechanism--and a dire warning to all other Accounting firms to play it straight--then what is? Why do you need government bureaucrats and huge business overhead imposed on Americans trying to compete with the rest of the world, when the downside and ultimate cost of such collusion has now become so starkly clear to all other major auditing firms?

Instead, to protect the 0.01% of companies where such collusion "might" be going on, Government regulations are now costing US business hundreds of millions (if not billions) of dollars; a cost that reverberates throughout an already fragile US economy.

If all this weren't enough, now it appears that the Enron prosecutors also ran roughshod over the law in building their case. It is probable here that--much like Mike Nifong--prosecutorial egos raised their own individual interests "above" the law--and their resulting excesses may end up setting free the very criminals who participated in the fraud, not to mention to deal yet another blow to the public's "confidence" in its government.

Another factor which cannot be understated is that the United States has the second highest corporate tax rate in the WORLD. Therefore, all those companies which would like nothing better to provide more Americans jobs are having their profits obscenely confiscated by a bureaucracy-mad Federal government. And yet the unions--whose artificially high wages are part of the reason jobs go offshore--blame open trade for their own plight.

Ask any left-leaning person this question: "do you get more satisfaction if a poor or middle-class person gets wealthy, or for a wealthy man to fall on hard times?" I would argue that most Leftists, given the choice between allowing more people and companies to retain more of their own income (and for small businessmen like myself, the two are synonymous), would prefer instead to sock it to "the rich" to grow an already mammoth Government--thus effectively removing all of that wealth that would otherwise be available to our economy and/or investment. Only--now that "progressive" rates have all but eliminated the poor from paying any taxes--it is the middle class that gets hit hardest when rates go up on the so-called "rich". Class warfare not only is dishonest, it is also extremely harmful to American jobs and competitiveness.

And so now, with Sarbanes-Oxley, we have the costs of an enormous, inefficient internal and external bureaucracy which public companies in the US now must incur, which make US businesses' flexibility in doing business in a dynamic worldwide economy much more difficult than, say their competitors overseas in places like China.

Even some Socialist-lite governments like the UK have less onerous restrictions on their business than does the United States. Why else would companies and investors be taking their business to London instead of New York?

When one looks at the big picture, Sarbanes-Oxley was a huge overreaction to Enron. Our businesses need fewer--not more--regulations in order to compete with the Chinas and Indias of the world. Placing enormous artificial burdens on US business like the SOX Act (and our obscenely high corporate tax rates), and then asking those businesses to compete with Global companies who do not have these onerous regulatory burdens to contend with is to add a 100 lb. backpack to a talented athlete about to compete for Olympic gold in the 100 meter dash--it severely hampers what otherwise might be a competitive advantage. In the case of SOX, it is the metaphorical equivalent of slowly destroying a lush forest to save one large tree. And it is especially this: a textbook case of why Big Government is not the solution--it is almost inevitably the problem.

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