Wednesday, January 26, 2011

Rules versus Principles

The American legal system – including self-regulating organizations designed to police member bodies – is rife with specifics and rules. And so much of our legal profession has been charged with examining these rules, and, most importantly, how to find ways of interpreting and side-stepping those rules so that corporations and special interests can avoid their clear intent. And if the rules are too tight, the same advisors help lobbyists shape new statutes foisted on the recipients of big campaign contributions, to create either direct exemptions or sufficient ambiguity so that the side-stepping can resume.

You can see these efforts if you are truly bored and sufficiently sleep-deprived – or you are a practicing securities or tax lawyer – in reading complex statutes, particularly in the Internal Revenue Code (better than an ambient-laced cocktail!). “Except as set forth in Subsection 3(b) of Section 234…; provided however, that ___________, and further provided that the provisions of Subsection 3(c) of Section 234… shall be deemed to supersede said….” Yeah well, the average layperson will read that passage straight through, while the patient legal expert will stop and carefully refer to each referenced subsection (which themselves carry additional references, which need to be traced), before finishing the paragraph. Takes hours sometimes, and only those paid to review all the links in detail ever figure it out… if they do.

Where would our legal profession – already suffering an employment slump due to reduced demand and more rigorous cost control by cautious and financially-impaired clients – be without such labyrinthian quests to pursue? But trust me, in the worst economic times, well-heeled mega-rich clients will always be willing to overpay specialists who can circumvent the rules.

On the other hand, we could actually legislate through principles – where objectives are the governing focus and not the path to achieve such objectives – but that does leave a lot of discretion in the courts or other governing bodies… discretion which our Congress frequently grants to administrative bodies, most notably the Department of Homeland Security, which cabinet body has used this discretion to avoid enforcement of many federal statutes in the interest of national security.

In the seemingly mundane world of accounting regulation, for example, there is a stark contrast between the American and British regulations imposed by their private governing bodies as they set rules for certified or chartered accountant to live by – to create uniformity of presentation of financial information across comparable financial statements. Nodding off, are we? Remember, our recent financial collapse was in large part triggered by a failure of transparency – companies were able to hide the salami and avoid reporting their impending demise through accounting tricks. U.S. accountants are self-regulated by the Connecticut-based Financial Accounting Standards Board, and U.K. green-eye-shade wearers by the London-based International Accounting Standards Board. The former is rule-obsessed – predicated on the axiom that financial r ules need to be precise – while the latter is principle-driven – based on the overriding notion that financial statements should be an accurate assessment of a company’s actual financial state. Put another way, Americans prefer form over substance, and the U.K. folks prefer substance over form.

The January 21st theDeal.com explains: “This tension between rules- and principles-based approaches surfaced after the Enron Corp. scandal in 2002. Since then, FASB appears to have definitively settled on the rules-based side. [One leading financial expert] says professionals like him prefer this because it allows clearer guidance in advising clients. A principles-based regime, he adds, creates uncertainty.

“Of course, having clear rules with bright-line tests allow them to be circumvented, or, as the New York state [Attorney General] alleges in the civil lawsuit [against Ernst & Young LLP, alleging accounting fraud in the firm's work for Lehman Brothers Holdings Inc. using an infamous ‘Repo 105’ accounting rule]. Take the Lehman case: Repo 105 refers to the accounting treatment that allowed the firm in late 2007 and 2008 to temporarily remove billions of dollars from its balance sheet by using repurchase agreements, a short-term financing technique in which a borrower ‘sells’ collateral to a lender and promises to buy it back later. Repos are normally accounted for as liabilities, but Lehman used Repo 105 to characterize its borrowing as a sale. That allowed it to reduce its balance sheet by jettisoning assets on paper and using the money it received to repay short-term debt. All this was done just in time to report earnings, and was then conveniently reversed.” In English – bad liabilities that would have made the company look bad were temporarily transferred to another related structure where the liabilities could be buried and hidden, and after the reports issued, transferred back where they belonged in the first place.

So in this sphere of accounting transparency, would you prefer clear rules which can easily be obviated by the machinations of “seasoned professionals” or a simply the best estimate, based on all available information, presenting a clear and reasonably accurate picture of the truth? Is this a trick question? The United States has opted for the former. It took a massive conspiracy of folks looking the other way – from debt-ratings agencies to Wall Street financial institution to certified public accountants – to bring down the global financial markets.

I’m Peter Dekom, and I am picturing a green-shade accountant plying his “three-card-Monte” game on a street corner in downtown Manhattan.

No comments: