Regulation of FInancial Markets - The Pursuit of Principles

By: Paul_Petillo

While many of us have been focusing on mortgage meltdowns, stock surges and inflation indicators, several of our distinguished financial leaders have been looking for ways to improve the marketplace.

Using the argument that rules tend to squash innovation and do little to lure the rest of the globe to our financial shores, the call for more principles and less regulation is quietly making its way out of the backroom and closer to reality.

The gap between a principles and rules is quite wide. Rules imply a lack of trust based on previous experience where trust has failed – when no one was looking. And principles suggest that all of our corporate leaders are men and women of character who would never mislead shareholders or auditors with financial statements that were not really truthful.

Federal Reserve Chairman Ben Bernanke has been concerned of late about this and he is not alone. With so many voices gathering together, does that mean the strength of our financial system is truly in jeopardy?

The target of all of this fuss is Sarbanes-Oxley. It has been mentioned with increasing frequency as the culprit, the legislation that is effectively pushing foreign companies to other stock exchanges beyond America .

The first attacks were made several years ago in a report by R. Glenn Hubbard, the then Chairman of Council of Economic Advisers to President Bush and has continued adding critics the latest of which include the Fed chairman, Treasury Secretary Henry Paulson, S.E.C. Chairman Christopher Cox, former S.E.C. head Arthur Levitt and former S.E.C. accountant Donald Nicolaisen.

Evidently, the wind of change is finally blowing in the right direction as the economy slows down enough to garner our attention. This esteemed group of economic leaders has deemed the financial markets as “in trouble” despite a seemingly endless advance in stock prices.

At the heart of their crusade is the regulatory process that came with Sarbanes-Oxley's passage. It has forced companies to own up to their financial statements or face penalties. These regulations are, they suggest, the reason why numerous IPO's are now making their way for less regulated and somewhat wilder frontiers overseas.

Sarbanes-Oxley or as it has been lovingly rechristened, SarbOx has been the focus of many unnecessary assaults. True, the initial cost of the regulation was high but as with all costs associated when services utilize technology, they are decreasing.

Productivity, as Mr. Hubbard once suggested in report dated October 23, 2002 is determined by amount of the restraint regulation placed on its growth. And while it is true that reducing regulations may in some instances increase productivity in many industries, in the field of business accounting and corporate audits, the cost goes down as time moves on.

The accounting industry has streamlined the processes required by the 2002 legislation incorporating many of the requirements into their software. This is a classic example of technology complimenting services. The accounting industry foresees those costs falling further.

So what has spurred the effort of late? Henry Paulson is the short answer. Believing that the financial health of the United States is at risk, he has pointed the finger at overregulation as the marketplace villain.

SarbOx, to its credit, has forced over 464 restatements of earnings in the past three years. This is quite the shift from the previous ten years, which saw a combined average of 45 restatements a year.

Several factors could be at play in this latest attack on the regulation.

The cautious approach auditors have taken of late is worrisome to Mr. Paulson. Unfortunately, the reason for the heighten caution is not due to SarbOx but because of the implied threat of litigation should those statements be less than factual. In effect, the regulation the SarbOx has created for many accounting firms has been overseen by the threat of shareholder action should they sign-off on phantom write-offs.

According to CFO.com, the reasons behind many of the restatements are almost always known to the companies and hidden from the audit process. “Improper revenue- recognition” is cited as a primary culprit in the restatement process followed by “improper inventory valuations and inadequate allowances for bad debt”. Mr. Levitt is no stranger to this type of restatement calling it “accounting hocus-pocus”.

What really worries this group is the crushing blow such accounting shenanigans have on a company's share value. Restatements can cause a stock to plummet and this, Mr. Paulson believes is not very accommodative to overseas companies looking to tap the US financial system.

Unfortunately, many of the proposed changes are already taking shape. The S.E.C. is now in the process of slicing and dicing the best protection an investor might have. The simple fact that restatements have skyrocketed in recent years should be reason enough to believe that the regulation is doing exactly what it was designed to do.

Had principle ruled rather than regulation and had it been the guiding light for the 157 companies who restated over the past year taking another look at their financial statements, we as shareholders would not have known that the house of cards constructed by these principle-less corporate heads was outside of generally accepted accounting practices. True, the value of these companies did drop but that value was misrepresented as more than it was.

Changes in SarbOx will not increase competitiveness in the US marketplace. The real reason for foreign companies to list overseas dates back to a pre-SarbOx Congressional action concerning litigation against companies who misrepresent themselves to our capital markets.

Demanding strict accounting allows our markets to thrive where principles are conveniently thrown to the wayside. Robert Pozen, chairman of MFS Investment Management recently suggested in a recent Wall Street Journal Op-Ed that “regulatory system needs a mix of general principles and detailed rules”.

That is exactly what is in place now Mr. Paulson, Mr. Bernanke, et al.

As we inch closer to a global marketplace, the rules and regulations guiding the US markets should be adopted globally and not demoted in favor of a seemingly less lawless system.

Principles can stand taller than the regulations. But neither can standalone. Detailed rules protect all parties and create a transparency that will prove to be enviable to overseas exchanges. The risk may not be as attractive to foreign investors but the result will protect many risk-adverse investors here in the US .

By Paul Petillo
Managing Editor
http://bluecollardollar.com

Paul Petillo is the Managing Editor of the http://bluecollardollar.com and the author of several books on personal finance including "Building Wealth in a Paycheck-to-Paycheck World" (McGraw-Hill 2004) and "Investing for the Utterly Confused (McGraw-Hill 2007). He can be reached for comment via: editor@bluecollardollar.com

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