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Greed is not for the Greater Good - Part II

A different way of looking at Regulations

Following on from Part I which discussed the increasing interest by national regulators and politicians to consider a global currency and a global monitoring capacity, we continue with a review of regulations in Part II. I recently wrote an article called "Necessity, who is the mother of invention" on our website, which relates to an area which I have worked in for the past 20 years, internal audit. In it I describe an unintended consequence of the Sarbanes Oxley Act introduction in 2002, which did not strike me until I wrote the article, just recently. You will see in that article that I believe that the introduction of regulations may actually be much more risky than generally believed because it provides a false sense of security.

I walked up the local mountain, 1500 metres above sea level today, to make sure my sons and their friend were OK. They had left early in the morning but I had heard no news on their progress for 6 hours which is a fairly long time. It is thirteen kilometres up the hill station that was built in 1870 and the reason why it takes so long to the top of the hill is that in 1870 there were no cars for the British Residents that established a tea plantation on the top of the hill. So the road had to be graded in such a way that the horses and carts that would go up and down the hill would not find it too difficult or take two steps back for every one forward. It's a bit like regulations and laws. They are adapted and created for the particular environment at the time to provide comfort. Currently the road to the top is only for pedestrians and the population of my town walks there with gusto, from young to old. But off course, the road is long and the temperature is high and to reduce the time to the top many have created little jungle tracks with markers that are faster but steeper. No one has any plans to change the course of the road, as it would be a major investment. The road creates a comfort that we will always be able to get to the top. And so, similar to laws that are passed and lose their relevance over time and are not updated in a timely fashion, the road lies there losing a little relevance over time, warts and all, while we find loopholes to go faster and get to the top less sweaty. But the interesting thing is that the jungle tracks all have little exits connecting to the road. Because it is always comfortable to do something a little out of the ordinary, but just in case you find a big green python on your path you might find it useful to get back to the straight and narrow.

(Source: Walt Disney)

A CFO or CEO states that the company has complied with all the necessary financial reporting regulations, so therefore they must have taken care of all the risks and stayed on the straight and narrow. This is likely to divert much needed resources from more complex and risk related audits, which happens when the internal auditors are all assigned to ensure compliance with Sarbanes Oxley Act provisions is achieved within reporting deadlines. That this actually happened in the past 7 years is confirmed by recent reports that Internal Audit Departments in the USA are now claiming that they have no resources or insufficient resources to do any other work but compliance audits (Read SOX, FCPA, AML etc). Compliance audits are designed to ensure that we are actually following the rules, and are in fact some of the most mind dulling exercises there are as all you do is check whether a particular requirements is complied with or not. In essence this means there are now fewer experienced operational auditors, few enterprise risk management specialists, not many creative thinkers to take on thorny high level issues, and we are suffering a lack of fraud specialists. They are all reluctant or unable to face the possibility of a thorny obstacle like a green python on the track.

The belief that the regulation or rule, as issued by a regulator or government body, is our ultimate safeguard finds its expression in the recent TV Interview when two women MPs in the UK announced their resignation and claimed they had "not done anything against the rules". I am sure they hadn't so why were they resigning and why is the public so angry? It sounds very familiar to the claim of many defendants at the Nuremburg trials. "I was just following orders".

If you consider the basis of our global company regulatory systems, you will find it starts somewhere in the early part of the 1800's, when the concept of a limited liability company and its separation from its owners was first recognized in a landmark case called Solomon vs Solomon which I have described in our article "The impact of cultural paradigms on Internal Control frameworks." The essence of this case is that it also defined the obligations a company, as a separate legal entity, has towards its owners, and paved the way for a separation between a company's management and shareholders, and the concept of fiduciary duty. I believe all subsequent regulations and laws are a fine tuning and greater detailing of the original concept of fiduciary duty. That is, a Board of Directors and executives of a company must work for the interest of the shareholders, who have put their capital at risk.

Let's say I am the CEO of company X, and have a fiduciary duty to act in the best interest of the shareholders, including managing risks appropriately. Now let's say I have a problem showing profits in one year and I am worried about the perception outside the company, by the shareholders, as well as my bonus for the year which is part of my remuneration package. As a result I resort to a sleight of hand, by selling a piece of property that I am holding for development 10 days before the year end reporting date, at an inflated price to a related party, then book an extraordinary profit which pushes the results in the black, and then buy the same piece of property back at market value 15 days into the New Year. (A real case I experienced with a listed company). In response to this type of breach of fiduciary duty, regulators could create a further regulation detailing exactly how and when properties could be sold by listed companies, and create a Public Oversight Committee or POC for such cases, to vet each and every sale of property between 15 December and 15 January of the old and the next year.

One could also create a new branch of auditing called "Year End Property Audit Specialists" or YEPAS which would create employment for the audit profession. But the reality is that as soon as I create this law and its separate regulatory bodies knows as POC and YEPAS, the same sleights of hand will once again be perpetrated, this time by the miscreants selling the relevant properties in November each year and buying them back in February of the next year. The concept of not cheating shareholders is actually already well covered by the theory of fiduciary duty in the first place, including the idea that executives must work in the interest of the shareholders. In my example above that was clearly not the case, so why is an additional detailed piece of legislation required, which is in any case full off loopholes as I described in a very simplified manner above.

I think this example illustrates the dire need for individual thought and questioning which we are doing via these emails and essays, and which I hope is happening all around the world. This is much preferable to the attitude that the government or regulators know best, that regulations will solve all ills, and that we are just waiting for the return of the good times (why is it that so many in the world are hanging on the words of those who are supposed to know best but have proven they are not, when the latest announcement comes out regarding "the end of the recession"). It's as if brains are universally disengaged, and as soon as the "recession ends" we will all be on our merry way again without a further thought to live a happy life.

The movie V for Vendetta makes an interesting point. Crisis allows governments and regulators to regulate with unbridled power as a response to a perceived state of emergency. The case made in the movie is somewhat excessive (or is it?), based on an emergency which has been deliberately created with predictable results. I emphasize the wholesale disengagement of the brains of UK's citizens in the movie which to me echoes the way we see this happening currently and which I will discuss in Part III of this essay. Who knows, maybe the current financial crisis was somehow a collective attempt by those in power to ensure we move towards a global system of governance sooner than later? And as per Part I which questions the moral framework within which those regulators, business leaders and politicians operate, are they in the best position to take us there? And finally, how many will find different tracks to get to the top of the mountain, as it appears a human to do so, as evidenced by the numerous little tracks through the jungle up the mountain near my house.

Click here for PART III