The SEC frequently does not read financial statements and public filings from companies. You read that right


U.S. securities investigators raised repeated concern over how Bernard Madoff could be running an honest business, but never followed through on the many red flags they uncovered. Hundreds of documents released on Friday by U.S. Securities and Exchange Commission’s portray an agency at times skeptical or dismissive of evidence that the now imprisoned mastermind of the world’s largest Ponzi scheme was up to no good. At other times, it appeared the agency knew that goings-on at Bernard L. Madoff Investment Securities LLC were improper but never followed through on their discoveries or on the allegations of chief whistleblower Harry Markopolos.

After the collapse of Enron, it came to light that the SEC had never read any of Enron’s public filings in 1997 – 1999. If it had, the fraud would (presumably) have been revealed earlier. Why? According to Congressman Brad Sherman in 2002.

The SEC has two approaches to reviewing financial statements.

If one is a small company trying for the first time to raise 10 or $20 million, then they file their red herring, their first draft. The SEC reviews it carefully; they issue a comment letter. If there is anything confusing, misleading or incomplete, they have to bring their filing up to specifications and only then do they go to the public; but if they are one of the biggest and richest companies in America, if they are already a publicly traded corporation, if they are raising or responsible on the market for 60 or 80 or $100 billion in capitalization, if they are Enron, then the SEC just does not read what they file, as they did not read Enron’s financial statements for 1997, 1998, 1999. They did not read those statements until the collapse.

What would have happened if they read those statements? They would have seen a number of footnotes in the financial statements that are utter gobbledy gook. I know to the average layperson all of the footnotes are gobbledy gook, but these were incomprehensible to an analyst, the CPAs. If the SEC had bothered to read these footnotes, they would have demanded clarification. Instead, they did not read them at all.

The SEC, however, at least its chairman, is hostile, believe it or not, to the idea of reading the financial statements of the 500 largest companies. That is because there is an element at the SEC that believes that investors need to be protected from Joe Inventor who is trying to raise 5 or $10 million, but that we do not need any protection from Kenneth Lay because, after all, those in the tallest buildings of the biggest companies are inherently so honest that the SEC does not need to review what they file.

And so Congress passed the Sarbanes Oxley Act in 2002, and *supposedly* the SEC is now mandated to do *some* sort of review of each reporting company at least once every three years:

SEC January 2009

As required by the Sarbanes-Oxley Act of 2002, the Division undertakes some level of review of each reporting company at least once every three years and reviews a significant number of companies more frequently. In addition, the Division selectively reviews transactional filings — documents companies file when they engage in public offerings, business combination transactions, and proxy solicitations.

In deciding how to allocate staff resources among filings, the Division undertakes a substantive evaluation of each company’s disclosure in what it calls a preliminary review. To preserve the integrity of the selective review process, the Division does not publicly disclose its preliminary review criteria. Based on its preliminary review, the Division decides whether to undertake any further review of the company’s filings or whether the company’s disclosure appears to be substantially in compliance with the applicable accounting principles and the federal securities laws and regulations.

The SEC does not disclose what or how much it will review. This is smart from the point of view of catching fraudsters — you don’t want them to know where you are looking or what you are looking for. But it also allows the SEC a lot of room for incompetence, and, apparently (as shown in the Madoff case) the incompetence expanded to fill the available space.

How much information does the SEC review? What is the quality of that review? Congress should order the GAO to conduct a study of the SEC’s review procedures and their adequacy. But this is unlikely. In fact, Congress is going the other way … toward *less* regulation:

A House committee, under pressure from the White House, voted Tuesday to exempt small public companies from part of a federal law designed to prevent financial fraud, despite objections from regulators and key Democratic leaders.

White House Chief of Staff Rahm Emanuel lobbied members of the House Financial Services Committee to exempt small public companies from a provision in the landmark Sarbanes-Oxley bill that was passed in 2002 in response to the Enron and WorldCom corporate accounting scandals, according to a lawmaker and several other sources familiar with the effort.

Emanuel’s position was at odds with that of committee chairman Barney Frank (D-Mass.), who opposed the exemption and called for another vote today on the matter.

The amendment passed by a voice vote Tuesday would cover public companies worth less than $75 million, up to half of all public companies. It is part of an investor bill the committee is working on to reform financial regulation.

The amendment would exempt those companies from having to comply with a provision of the Sarbanes-Oxley law that requires that companies hire auditors to examine their internal systems to ensure compliance with accounting reporting rules.

The costs of compliance “are very burdensome. It really cuts into their ability to grow and hire new people,” said Rep. John Adler (D-N.J.), a sponsor of the amendment.

Sob! It costs *so* much to hire auditors! Boo hoo. Listen, I’ve worked as a SOX auditor. The pay averages about $80K a year (but you don’t work a full year at many smaller companies, they don’t have volumes of transactions to audit.) Compare $80K each for a handful of auditors to the multi-millions going out to top executives. *Always* there are executives, *everywhere* I’ve audited, who express open contempt for internal controls and auditing. The truth is that they don’t want to comply with the rules. They prefer the “magic of the marketplace”, which unaudited allows them to MSU (make shit up) and bend/break rules.

As a recent Washington Post op-ed states, our real problem is that we live in a society that does not value accountability and regulation. If we want real improvement, our outlaw culture has to change:

After years of Republicans (and some Democrats) insisting that the market was always right, that it was always self-correcting, that it was both magical and sexy, a manifestation of God and what he intends, and that government, that foul-breathed picker of your pocket, could do nothing right, you finally got a government that, at least in this case, actually could do nothing right. Talent went into the private sector, where not only the money was but the prestige as well. The respected public servant morphed into the loathed bureaucrat — not the solution to any problem, but the problem itself, in the simplistic formulation of Ronald Reagan, whose contributions to the woes of our times have yet to be fully appreciated.

Reading Kotz’s testimony is just plain sickening. Lives were ruined. Charitable people were bankrupted and the philanthropies themselves closed their doors. Congress is looking at what happened and how it happened — and it will certainly, as is its wont, blame this or that person or agency. But unless Congress is determined to make structural changes, to approach this debacle as the vaunted private sector would and establish a system where talent is recruited and paid well, and where government work is again honored, then it will have learned nothing from the Madoff calamity. Madoff expected more from government. Why shouldn’t we?

  • Head in their ass is more like it…

    If i stole a pair of jeans from the GAP i’d be prosecuted and do time… and how much would it cost to prosecute and jail me… but if i steal billions i live fat and get taxpayers to bail me out… and i get to change the rules so that i can come back and steal more without the threat of ever having to answer for it…

  • DJ

    Sounds like they review for form, not content anyway. Much like correcting the grammar and leaving the thesis unchallenged.

    As for the “outlaw” mentality, IMO the soft Left has at least as much to blame for this. In its quest to legislate a utopia, it adopted the theory that what is wrong should be illegal, which inevitably suggests that what remains legal is right.

    The so-called right has its share of responsibility, but mostly for invoking left-leaning practices like trying to regulate how people behave (drugs are illegal, sex is immoral, you can’t disrespect the flag, etc.). Making such things illegal doesn’t stop people from doing them. Combine that with a lack of enforcement and a contempt for authority originating in the 1960s, and anything is okay if you don’t get caught.

    Legalism, the elevation of the law to the level of morality, orginated in ancient China where it brought down a dynasty. How about we get back to the basic relationship between people and get government out of our morality? Just because it may be legal for me to screw you over doesn’t make it right.

    It’s worth noting that folks like the Wall Street bankers wouldn’t last long in a small town, where everyone knows everyone and trust still has value.

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