Tougher regulation

Tougher regulation Three years ago, in 2002, new strict corporate governance was created by Congress in the form of the Sarbanes-Oxley Act. The goal was that tougher regulations would be able to detect and hopefully prevent fraudulent behavior. The cost of complying with Sarbanes-Oxley is much higher than it was before the act came into existence. The average audit fees, for example, for companies in the S&P Mid-Cap 400 in 2001, before the act was passed, were $716,000, now they are more than three times that figure, or $2,177,000 (Wall Street Journal, 10/17/05, page R3). You would think investors would be better protected now that companies have to fork over more fees to accountants and compliance officers. I like what Samuel DiPiazza, CEO of PwC, said: “All the regulations and standards in the world are not going to make us safe from bad behavior…If there is fraud and it is collusive and third parties are engaged, it is very hard [to detect].” Through this whole mess, I think there are two lessons that investors can learn from the Refco implosion: 1. After looking at all the numbers, don’t forget to look at management: Many investors get fixated on the numbers. Of course, earnings per share, operating margins and profit margins are important, but don’t lose sight of the people running the company. Refco was able to fool regulators and very knowledgeable investors by disguising the fact that an entity that Bennett controlled owed Refco hundreds of millions of dollars. There is no real smoking gun that could have foreseen this fraud, but that doesn’t mean you should not try and find out as much as you can about the people who control the numbers you see. 2. No amount of oversight can prevent fraud: If someone wants to commit fraud, all the oversight and signoffs by big-name accounting firms will not stop them. We still don’t know when Bennett began his fraudulent ways, but I’m sure he didn’t wake up one morning and say: “I want to commit fraud on a grand scale and bring down a great company too.” It probably started out small and then took on a life of its own. Warren Buffett once said: “The CEO who deceives others in public would likely deceive himself in private.” When management wants to deceive, all bets are off. There are not going to be many signs that one could point to before the fact.

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