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Friday, October 21, 2011

Conflicts of Interest at the Federal Reserve

The Huffington Post reports that “(m)ore than a dozen members of the regional Federal Reserve boards have had ties to banks or companies that received emergency funds during the [2008 financial] crisis, according to [a GAO report]. The report highlights a close relationship between the Fed's regional banks and many of the institutions they were lending to, adding credence to concerns that the financial sector enjoyed a largely consequence-free rescue in the wake of the crisis, thanks to its connections with the federal government.” Meanwhile, mortgage borrowers with houses “under water” got hammered. From the crisis to the release of the GAO report in October 2011, there were millions foreclosures in the United States, with very little in the way of mortgage modifications or refinancing for those homeowners who needed relief. In other words, the bankers had connections in the banking regulatory agency while Congress left the troubled homeowners—constituents—at the mercy of the bankers. Their agency having their backs, the bankers could afford to take a hard line on the mortgages. The playing field, in other words, is not at all level.

Dean Baker, co-director of the Center for Economic and Policy Research, hit the nail on the head on the Federal Reserve in saying that the report's findings reflected "an institutionalized conflict of interest" within the Fed. “We don't let Comcast appoint people to the FCC. We don't let Pfizer appoint people to the Food and Drug Administration,” he noted. The degree to which bankers, on the other hand, can assume regulatory responsibility for their own industry through their connections at the Fed is "without precedent." Considering the impact of systemic risk in the financial system over the entire economy—indeed, over the global economy—banking ought to be the last industry where a structural or institutional conflict of interest is tacitly permitted that can compromise the regulatory function. In other words, regulatory capture, wherein the regulated industries capture their regulatory agency, is particularly dangerous in banking, and yet there it is, right under our noses!

Alexander Eichler provides a specific example in reporting that “the Fed agreed in 2008 to bring Goldman Sachs under its supervisory authority, thereby making it easier for Goldman to get billions in Federal Reserve loans. At the time, Stephen Friedman—then the chairman of the New York Fed—sat on Goldman's board of directors and owned stock in the company. Friedman received a waiver that allowed him to remain at the New York Fed, but the waiver was never made public, and Friedman continued to buy Goldman stock—unbeknown to his colleagues at the Fed, according to the report—until his resignation from the Fed several months later.” Even if Friedman had not been instrumental in Goldman Sachs being allowed to become a commercial bank, the combination of a chairman’s vested interests and consequence-free largess is a red flag. Indeed, the vastness alone of Goldman’s network of alums in government suggests that the bank may be open to far more conflicts of interest than Friedman.

In terms of the Federal Reserve, Eichler reports that, “All in all, the [GAO] found 18 current or former Federal Reserve board members who had ties to institutions that benefited from the Fed's emergency lending, including directors and executives from General Electric, JPMorgan Chase and Lehman Brothers.” Even if those members were not active in securing “consequence-free” loans for “their” institutions, even the appearance of impropriety or favoritism could hurt the Fed. According to Sen. Bernie Sanders, the GAO report indicates that “(t)he corporate affiliations of Fed directors from such banking and industry giants as [GE, Chase, and Lehman] pose ‘reputational risks’ to the Federal Reserve System . . . Giving the banking industry the power to both elect and serve as Fed directors creates ‘an appearance of a conflict of interest’.”  Even the appearance constitutes a wrong because it compromises or thwarts trust. The diminishing of trust constitutes a sort of harm to the otherwise-trusting parties, who do not deserve such harm. So even if the Fed could not obviate even the appearance, it still constitutes a wrong and the Fed is blameworthy. Accordingly, actual favoritism by any of those 18 board members is not necessary for us to reach this moral determination, though any such favors justifies even more moral condemnation for those parties who were involved as well as for the Fed and the banking industry overall because they permitted the relationships in which the corruption actualized. In other words, the Fed and the bankers should have known better than to permit the sort of conditions that are ripe for manipulation for one’s friends.

Sen. Sanders notes from the GAO report that “many directors own stock or work directly for banks that are supervised and regulated by the Federal Reserve. The rules, which the Fed has kept secret, let directors tied to banks participate in decisions involving how much interest to charge financial institutions and how much credit to provide healthy banks and institutions in ‘hazardous’ condition.” The rules make it so tempting for directors to enrich themselves or their favored banks that disclosure is not sufficient; the rules themselves should never have been promulgated and should not be allowed to remain in effect. Yet the GAO Report’s recommendations highlight disclosure, as if transparency were sufficient to obviate questionable policy or particular deals favoring specific banks.

GAO Recommendations:

1.       The Chairman of the Federal Reserve Board should encourage all Reserve Banks to consider ways to broaden their pools of potential candidates for directors.

2.       The Chairman of the Federal Reserve Board should direct all Reserve Banks to clearly document the roles and responsibilities of the directors, including restrictions on their involvement in supervision and regulation activities, in their bylaws.

3.       The Chairman of the Federal Reserve Board should direct the Reserve Banks to make key governance documents, such as such as board of director bylaws, committee charters and membership, and Federal Reserve Board director eligibility policy and ethics policy, available on their websites or otherwise easily accessible to the public.

Transparency can give the illusion of probity. For example, the pools of potential candidates for directors can be broadened while people for the same clique are disproportionately selected. Also, formally restricting a director’s involvement in regulation activities will not necessarily stop the said director from informally influencing those directors involved in the activities related to the particular bank tied to the director. What is needed is to forestall the hiring of that director in the first place, or to remove him or her forthwith once any ties are discovered. In other words, broadening the pool is not sufficient; the candidates themselves should not have any ties to the institutions being regulated.

It might be counter-argued that no bankers, or even business practitioners, could serve as directors if any substantive tie or relationship to a bank were sufficient to disqualify a potential candidate. The point that the Fed itself would be deprived of expertise in banking is specious, for there would still presumably be a bureaucracy of underlings at the central bank more than willing to apply their technical skills. At the upper echelons, the perspective needed is different—broader. So, for example, academic economists (and finance scholars) could be called on to serve at the Fed even though their only tie with a particular bank is in going in to their local bank for help on how to use their debit card. Perhaps other such “broadening but in the neighborhood” pools could be found as well. Besides the conflict-of-interest problem, Fed policy should not be arrived at through the prism of technical banking. Just as members of Congress need (and should) not all be lawyers, Fed directors need (and should) not all be former bankers. Having some is fine as long as they have moved to a regulatory mindset and no longer have ties, but the nepotistic practice of having former bankers regulate current bankers is not wise, given that even the appearance of a conflict of interest is immoral. 


Click to add a question or comment on the institutional conflicts of interest involving the Federal Reserve.

Sources:

Alexander Eichler, “Conflicts of Interest Abound at The Federal Reserve, Report Finds,” The Huffington Post, October 19, 2011. http://www.huffingtonpost.com/2011/10/19/federal-reserve-banks-links-finance-industry-conflict-interest_n_1019703.html

Bernie Sanders, “GAO Finds Serious Conflicts at the Fed,” Website of Sen. Bernie Sanders, October 19, 2011. http://sanders.senate.gov/newsroom/news/?id=70c40aba-736c-4716-97d1-45f1a1af10a0

GAO, “Federal Reserve Bank Governance: Opportunities Exist to Broaden Director Recruitment Efforts and Increase Transparency,” October 19, 2011. http://www.gao.gov/products/GAO-12-18

Thursday, October 20, 2011

E.U. Agenda: Taming Bloated Greek Patronage

As E.U. leaders wrestled in the fall of 2011 with how to bail out those state governments that had been amassing relatively large semi-sovereign debt loads, residents in relatively solvent states such as Germany were frustrated with what they perceived as profligate over-spending in Greece. It is possible that even the Germans did not realize how engrained the excessive politically-based Greek bureaucracy had become. I suspect that for many Greeks, news of their living beyond their means was met more with denial and utter disbelief than an attitude-adjustment. In other words, a vast disparity in perspective exists on the ground as the E.U. struggled to come to grips with the debt crisis. The “ever closer union” necessary for the E.U. to rise to the occasion has as its foremost obstacle the disparate perceptions existing within the union (and enforceable by state governments).

According to The New York Times, “Greece’s bureaucracy has been growing steadily since democracy was reinstated in 1974, with each new administration adding its supporters to the payroll — and wages rising steeply in the past decade, experts say. ‘There was really a party going on,’ said Yannis Stournaras, an economist and the director of the Foundation for Economic and Industrial Research in Athens. ‘The government kept adding bonuses and benefits and pensions. At election time there was a boom cycle as they handed out jobs.’”  In other words, at least part of the bloated state personnel costs has resulted from partisans seeking to maximize their political patronage.

The Times points out that the state “government is in many ways an army of patronage appointments built up over decades. When election time rolls around, state workers become campaign workers, and their reach is enormous. There are so many of them that almost every family has one.” The work force the state legislature “is so bloated, according to a local press investigation, that some employees do not even bother to come to work because there are not enough places for all of them to sit. . . . Some ministries still have employees whose sole job is to record the arrival of documents in a ledger,” even though many documents are submitted by email. It all sounds so much like Huey Long’s Louisiana. It should be no surprise that the Times reports that some “experts question whether the culture of bloat and favoritism will ever be conquered.”

                                                                                    Yannis Behrakis/Reuters

Listening to the Greeks protesting the austerity measures, one would think the state had been operating on a lean basis all along. On October 19, 2011, The New York Times reported on the massive two-day strike then going on in Greece. Anastasia Dotsi, a retired bank worker who said anger had driven her out to protest, said  that after two years of austerity measures, “we have been crushed as a people.” She went on to say that her two kids, both of whom work in the private sector, and not been paid in months. It would be unfortunate if hard-working people in the private sector were paying even as political patronage was alive and well in the state government’s bureaucracy. Dotsi’s reference to the entire people misses the possibility that the root cultural problem had not yet been nipped. To be sure, even as the strike was in progress, the state legislature was taking the first of two steps needed to pass a bill that “includes cuts in wages and pensions as well as thousands of layoffs in the public sector — once a political third rail in Greece’s welfare state,” according to the Times. However, it is far from clear that the Greeks were coming to grips with the underlying culture of excessive patronage. “The vote will boost our negotiating position; it will give us strength for the E.U. summit,” the prime minister, Mr. Papandreou, said before the first of two votes. The main goal for Greece, he added, is “to stay in the euro zone.” As beneficial as this goal is, it does not make explicit the need to focus on fundamentally changing the Greek bureaucracy. To the extent that the state’s residents were in denial, state leaders should have been using the pressure from the E.U. as leverage in pushing through substantive reforms that confront the denial and fundamental alter the balance of revenues and expenditures.

To be sure, Europe does not have to rely on the Greek prime minister to extricate the bloated corruption. Providing a check on corrupt state governments is a major plus of modern federalism. The federal head, which as in the case of the E.U. can include the intensive involvement of state officials, is capable of pressuring bloated state governments that are based on patronage to lose budgetary weight by shedding surfeit personnel. That is to say, excessive consumption from the public purse can be eventually brought into line to being within the norm in a federal system. As the crucial element of the federal design affording this check against corrupt state government, both the state governments and the federal head are semi-sovereign, which is the case in the E.U. As such, neither level can capture the other, even as each can pressure the other. This is particularly true in a federal system such as the E.U., given the extent of shared competencies. Were the E.U. a confederal alliance of sovereign states, the E.U. itself (or its states acting in concert) could not pressure the Greek government to get in shape by losing fiscal weight before it has a “heart attack.” Yet the misperception that the E.U.’s states are still sovereign detracts from the ability of the E.U. to use what leverage it has to pressure Greece to shift its culture of public patronage (and tax evasion).

In spite of the denial on what the E.U. is, any European miffed at the insufferable traction of the bloated public spending in Greece can be thankful that the European Union is a modern federal system rather than a mere alliance or confederation of sovereign states, for at least as of 2011, it wasn’t looking like the residents of Greece would shake their denial. Take, for example, Dimitrios Katsandris, a 67 year-old pharmacist “who attended the demonstration in an elegant tweed jacket.” That alone sends the wrong message. “Now the only thing the government has managed to do is get people against them,” he said. “You see people with different interests, but now they are united against the government.” His statement does not exactly reflect a people in any mood to recognize and confront the excesses at home. Fortunately, the E.U. was holding their representatives’ feet to the fire. This would be much more difficult were Athens still practicing its ancient direct democracy.

Click to add a question or comment on EU federalism and the corrupt Greek system of patronage.


Sources:

Suzanne Daley, “Bureaucracy in Greece Defies Efforts to Cut It,” The New York Times, October 18, 2011. http://www.nytimes.com/2011/10/18/world/europe/greeces-bloated-bureaucracy-defies-efforts-to-cut-it.html

Rachel Donadio, “Thousands in Greece Protest Austerity Bill,” The New York Times, October 19, 2011. http://www.nytimes.com/2011/10/20/world/europe/greek-workers-start-two-day-anti-austerity-strike.html?_r=1



Limited Tenure For CPA Firms?

Arthur Levitt, who headed the Securities and Exchange Commission from 1993 to 2001, “sought to root out conflicts of interest at audit firms in 2000, and urged Congress to adopt auditor term limits in 2002 after the Enron and WorldCom scandals.”  The Wall Street Journal also reports that Levitt did not buy the argument made by companies that it would cost them a lot of money to change audit firms. To be sure, he acknowledged that some added cost would be entailed in a system of mandatory auditor “term limits,” but a long auditor relationship “raises the perception,” he maintained, “that the auditor is very much beholden to the company and not totally independent. An environment of skepticism should trump the fraternal environment that tends to occur after a relationship has developed over a period of years.” Indeed, Arthur Andersen’s people were well ensconced at Enron by the time the energy giant went bust. In fact, the auditors even approved the questionable “partnership” accounting (used to hide debt).  Nor did the auditors communicate any misgivings to the audit committee of the company’s board of directors. The auditors were “in” with a rancid management.

Given that managements typically control their boards at large corporations, it is unlikely that the public accountants hired by the powerful managements would say much to a board’s audit committee that the management did not approve beforehand. The Wall Street Journal reports that from the start of 2005 until October 2011, only 120 cases of companies in the Russell 1000 stock index switched auditors, according to research by Audit Analytics. An average of just 2% or so a year of the companies hired a new auditing firm. It can be safely concluded that the managements of the overwhelming majority of publicly-traded companies must be pretty comfortable with their auditors.

Contrary to the company argument that the first or second years with an audit firm produce bad audits, Levitt has pointed out that not one of the audit failures in the big scandals involved a first- or second-year audit. “In each of those cases the auditor had a long relationship with the company, and yet the relationship did nothing to better-inform the audit committee about the company’s problems.” Typically, court documents “show that the auditor was aware of the problems and risks, and had even identified the audit as a high-risk audit, but never told investors about it.” This is no accident. Berle and Means pointed out back in the 1930s that control of the modern corporation in America had been already been separated from ownership. A management’s control could easily be extended over the auditors, particularly as management has the trump card of being able to fire them—even if that option is rarely exercised. I think it is the love of gain, or greed, that keeps the auditors so captive to even a slight possibility of being replaced with another firm. The fear-factor is exaggerated among the firms as their partners fret about losing a major client even though that rarely happens. It is not like the firms would go against their clients, unless the latter were on the verge of collapsing and therefore not likely to continue as clients anyway.

My point is that the client system in public accounting is broken. The question is: will limiting an audit firm’s tenure to ten years, and perhaps even making it impossible for a company to fire its auditors in the meantime, be sufficient to remedy the structural conflict of interest that has so compromised or eviscerated audit independence?  Let’s look at some alternatives.

A ten-year tenure without barring a firing in the meantime could simply mean that a company’s management controls one audit firm and then another. The mere possibility of being fired in the interim could be enough to keep the auditors in line, given the exaggerated fear-factor in greed that exaggerates the perception of an improbable downside being actualized. On the other hand, a cosy “long-term-itus” would be preempted without stifling the incentives that come from competition. Although an improvement on the status quo, the power that even this alternative gives to managements, given the separation of ownership and control, suggests that more reform would be needed.

Limiting an audit firm’s tenure and making it very difficult if not impossible for a company to fire its CPA firm in the meantime would reduce the management’s leverage over its auditors. To be sure, the latter would still depend on management for information, similar to how regulators depend on regulatees. However, the main problem with this scenario is that the motivation to do one’s best that comes from competition would be severely lessened for the auditors. To be sure, the prospect of being “re-elected” at the end of the ten year term would provide some incentive to produce high-quality audits while enabling the firm to “get over” any negative impact from a year’s qualified opinion. In other words, just as a six year term in the U.S. Senate enables senators to go against popular opinion of the day in the best interest of the people, this alternative could enable public accounting firms to “govern” in the sense of auditing for the public interest, which benefits in the long run from being able to trust financial statements. However, how many public accountants value their public service? Their “private enterprise” identity may trump their sense of obligation to the public that goes along with being a professional. In short, reducing the competitive pressure could strengthen the auditors’ ability to be independent if they value and desire it. Perhaps under this arrangement, CPA firms could be pressured by their regulators to look for different qualities in hiring—namely, more of a regulator-type than corporate personality.

As still another alternative, CPA firms could be paid by stockholders or one of the stock exchanges (which would charge companies listing an audit fee) and report directly to the chair of the audit committee of the board. The audit committee itself could authorize a change in audit firms at any time, thus aligning competitive pressure with protecting the investors. However, there is no guarantee that a board’s audit committee would act on behalf of creditors or the general public. For example, an audit committee could pressure its auditors to go along with an accounting practice that justifies an increase in dividends at the expense of paying off creditors. Also, given the power that CEOs typically have over boards, the audit committee could simply be rubberstamping management’s prerogatives. For this reason, and to extend auditors’ incentives to cover other interested parties and the general public itself, a stock exchange or a regulatory agency (e.g., SEC) might have to assign and pay the CPA firms. This variant is not without its own risks. A large audit firm could potentially use its market power and political connections to secure choice assignments by an exchange or regulatory agency. In general terms, the centralization of decision-making power in an exchange or agency could be an occasion for corruption rather than competition.

The tough nut to crack seems to be the apparently-intractable tradeoff between the benefits from a competitive market and a professional’s obligation to the general public by acting independently of even the professional’s own financial interests. It is difficult to structure a market mechanism of competition for CPA firms that is aligned with serving not only investors, but the public interest as well. In spite of this problem, obviating the structural conflict of interest should be a priority. Corporate managements are too powerful with respect to the boards, whose tasks include holding the respective management accountable. This makes it vital that reform be undertaken that reduces the leverage of managements over the audits. The systemic risk factor alone, given the sheer size of many banks and corporations, makes the extent of managerial power untenable and dangerous. The matter of auditor independence can thus be seen as a manifestation of wider cracks inherent in managerial capitalism.

Click to add a question or comment on how to align CPA firms’ incentives with the professionals’ obligatins to the public.

See related essay: "Deloitte: A Culture of Least Resistance"

Source:

Emily Chasan, “Keeping Auditors on Their Toes,” The Wall Street Journal, October 19, 2011. http://online.wsj.com/article/SB20001424052970204774604576629381572015722.html


The Franchise: A Flawed Arrangement

The franchise arrangement combines the reach (and efficiency) of central advertising with the ability to respond to local differences. I suspect that the benefit from local flexibility is typically overdrawn, such that the value of the franchise arrangement itself is overstated. Meanwhile, the downside in local autonomy is, I suspect, understated. That downside includes the propensity to engage unethically based in part on lack of character-virtues and on the accurate perception of weak accountability within the franchise arrangement. The downside also comes into greater play than perhaps is realized because management on the local level can be rather bad in quality (from a managerial standpoint). In other words, slim pickings with regard to managerial talent can be a factor at the local level. Without mechanisms of accountability from “higher up,” front-line managers can get away with an astonishing amount of bad (and unethical) managing.

For example, I stopped into a Papa John’s franchise on a weekday at 2:30p.m. to buy a slice of pizza. The employee told me that during mid-afternoons, he offers two for one slice at the regular price. So I bought two-for-one. The slices were terrible—the cheese almost non-existent. The next day, I happened to be passing the same establishment and thought I would see if the pizza was any better. I told the same employee that I wanted the same two-for-one. “I’m not doing that today,” he replied. “The pizza is fresher.” So apparently the two-for-one at the regular price is a matter of employee discretion, rather than being something a customer can count on. I was astonished because his manager was standing next to him as the employee spoke. As I was saying that I would pass on ordering anything, the manager suggested I order cheese-sticks instead. I just looked at him. He was utterly indifferent as to whether his employee had misled me, and yet that manager was in a position of authority sans accountability. There is probably nothing worse to a customer than an employee or manager going back on his or her word with the sense of impunity. I suspect that this is a common pattern in franchise businesses.

I have experienced local managers of Best Western, Motel 6, and Days Inns hotels/motels going back on their word, only for the corporations’ respective “customer service” employees to tell me that the managers at franchise properties can do whatever they want. In one such case, I later learned that the local police department had had so many complaints from customers about the local hotel’s manager that the chief had called the corporation only to be told that the buck stops with the local manager! The corporation could do nothing (apparently). At the very least, a conflict of interest exists in turning over a complaint against a manager to the manager himself, yet this ethical issue is apparently a casualty of the franchise arrangement; accountability regarding unethical local managers simply does not exist where the franchisee owner looks the other way. I suspect that the squalid managers know when they can get away with cheating customers for short-term financial gain. Such managers can thus easily exploit one of the downsides of the franchise arrangement itself, with the customers having little recourse.

We can perhaps generalize to say that the managerial skill (and ethical conduct) at the local-franchise level is insufficient to justify the looseness in the franchise-arrangement’s mechanism of accountability on managers and employees (and even franchise owners). That is to say, the franchise arrangement itself is flawed because it does not permit mechanisms that are sufficient to correct bad and unethical local managers—or at the very least to give those winners the sense that there could be such accountability exerted on them.

In fact, the franchise arrangement is flawed even apart from local managerial decadence and incompetence. For example, particular Subway franchises do not honor the specials advertised by Subway. In fact, next to the Papa John’s franchise location that I walked away from, a Subway franchise was selling subs, only without the month’s specials. Here, the problem is not managerial ineptitude or unethical conduct; rather, the fault lies in the franchise agreement itself, wherein individual franchisees can opt-out of particular advertised-specials. This loophole enables the possibility wherein a customer drives to a subway expecting to be able to purchase a special only to 1) be informed that there is no special there and 2) go home empty-handed. A potential customer in that situation would not be wrong in feeling misled even if it is not technically false-advertising (given the ads’ fine print). Franchisees should be required to honor and fulfill anything promised in the corporation’s advertisements. Otherwise, the arrangement itself is inherently unfair to customers. Again, the structure of the arrangement is found wanting and should be tightened, both for reasons of effectiveness and ethics.

The weakness inherent in the franchise arrangement can be grasped by situating it along a spectrum running from a confederal alliance to (modern) federal government. I contend that the franchise arrangement is too close to the confederal arrangement in the case of managerial and employee accountability. Whereas the polity members of a confederation hold all of the sovereignty in the confederal system, both the members and the government at the federal level are semi-sovereign in modern federalism. Also, whereas the confederal level can only reach its member polities, a federal government can reach the individuals inside the member polities. A federal government thus has more authority to hold citizens accountable even within their respective states (state governments do too). Where a state government looks the other way on racial violence, the FBI can step in and arrest the KKK individuals. In a confederation, this would not be possible; the state government alone reaches the citizens, and the authority at the confederal level is typically very limited and subject to support from all or a supermajority of the polities in the confederation.

The franchise arrangement evinces “dual-sovereignty” by analogy because the contract gives the franchisees autonomy to run their businesses as they see fit while subjecting them to specific requirements (e.g., products, signage, furnishings) that represent the “unity.” However, even though it is technically “modern federalism,” the arrangement resembles a confederation as regards managerial and employee accountability. That is, they requirements do not typically include managerial standards and accountability mechanisms; these are left to the “state governments.” As long as they adhere to the specific requirements, franchisee owners are largely autonomous in terms of how they have their businesses managed internally, or “domestically.” If there is a violation of one of the specific requirements in the franchise agreement, the corporation treats the franchisee business as a unit and holds the franchisee-owner to account. In this sense, the arrangement functions like a confederation. I submit that local management (and staffing) is typically not sufficiently capable (and forthright) to justify this. Therefore, to remedy the problem, an additional transfer of “sovereignty” to the corporation should be made such that a “check” or accountability mechanism can exist at the corporate level and reach directly to the franchisee’s managers and employees, even without respect to the franchisee-owner. By analogy, the FBI can arrest individuals at a KKK rally without checking with the governor of the particular state. Otherwise, inept or unethical franchisee owners will be able to cover for their hires. Indeed, “bad” employees may simply be doing an owner’s dirty work.

In conclusion, effective and ethical management does not extend as far locally as we, the general public, tend to assume (particularly in the food and hotel/motel industries). Corporations utilizing the franchise legal arrangement should strengthen their ability, in the legal documents, to hold local managers (and their employees) accountable. Customers would appreciate an employee in customer service actually going to bat for us, rather than giving us the quotidian “apology” only to say they can’t actually do anything about the problem because the buck stops with the local managers on X. We should not have to accept bad or dishonest business practitioners simply because they are numerous and the franchise arrangement itself is inadequate. Furthermore, just because certain customers can indeed be quite rude does not mean that holding managers and employees accountable for going back on their word is somehow excessive because serving the public is difficult. I suspect that American consumers in particular put up with much more crap at the retail level than necessary. In other words, the business of America could be done a lot better, yet for some reason we tend to assume that the status quo is unavoidable. We may even have convinced ourselves that efficiency justifies “a few bad apples.” Business itself would benefit were accountability mechanisms strengthened, and you and I would not suffer so many fools holding leverage over us on account of their positions. We need not be utterly frustrated with a dishonest, “my way or the highway” rigid and self-centered manager or employee. Life is too. So we do not have to accept the franchise arrangement in our business system and society simply because franchising is convenient to corporations. I contend that the arrangement only seems to be in their financial and strategic interests. The corporate executives are overstating the quality and honesty of their franchisee-owners and their hires. Sadly, uprooting even a putrid tree can be an exercise in futility if the sordid roots are deep and entrenched with vested interests.

Click to add a question or comment on managerial (and employee) accountability in the modern franchise arrangement.

Tuesday, October 18, 2011

Deloitte: A Culture of Least Resistance

On October 17, 2011, the Public Company Accounting Oversight Board issued a statement saying audits should protect investors. “The board therefore takes very seriously the importance of firms making sufficient progress on quality control issues identified in an inspection report in the 12 months following the report,” the statement said. Not having seen such progress at Deloitte, the board made its 2008 report on the firm public. The report “cited problems in 27 of the 61 Deloitte audits it reviewed, including three where the issuing company was forced to restate its financial statements.” This was “an unprecedented rebuke to a major accounting firm,” according to The New York Times. “In too many instances,” the report stated, inspectors from the board “observed that the engagements team’s support for significant areas of the audit consisted of management’s views or the results of inquiries of management.” In some cases, according to the Times, “Deloitte auditors did not bother to even consider whether accounting decisions made by companies were consistent with accounting rules. Instead, auditors accepted management assertions that the accounting was proper, the board’s report said.”

The inspections indicated “a firm culture that allows, or tolerates, audit approaches that do not consistently emphasize the need for an appropriate level of critical analysis and collection of objective evidence, and that rely largely on management representations.” Floyd Norris of The New York Times observes that the firm’s defensive, cult-like, reaction to the board’s “second guessing” actually belies Deloitte’s own defense. “By protesting that it was unfair to criticize Deloitte’s culture,” Norris points out, “the firm may have spoken volumes about that culture.” Would the culture that pulled together against the board “provide similar backing for a partner who angered a client’s management by forcing changes in financial statements that the company did not like?” Deloitte’s culture was not about to permit the sort of self-confrontation out of which self-correction and improvement can occur, so the board took the unusual step of making its report public. But rather than shame Deloitte, I suspect the publicity will operate only on the margins through the possible loss of a few clients.

By way of a thesis, I contend that Deloitte’s culture whisks away internal recognition of the reliance on the clients’ managements during the audits by burying it in the technical aspects of the audit process. An inherently unethical step stuck in the audit recipe as though simply one of several tasks in the process, who would think to pull out that tick-mark for special consideration? A culture wherein staff-auditors view themselves as business practitioners doing contracted work at companies, rather than professionals whose judgment was paramount and duty to the public salient, can reinforce the subterfuge of technique. This resonates with my own experience in working on audits at Deloitte, albeit many moons ago in what now seems like a distant galaxy populated by green technocrats.

When I started out as an auditor at the firm, I was trained to use the following tick-mark among others: as per comptroller, discrepancy resolved. I can even remember making a check with a line through its stem to indicate the tick-mark, adding the words at the bottom of the green-paper to explain the mark’s meaning. In training and during the audits, that tick-mark was treated no differently than any other. It never occurred to me to distinguish it as anything out of the ordinary. Even so, today I’m astonished that it never occurred to me that relying formally on a comptroller in an independent audit might not be kosher. Perhaps part of the explanation of why ethical lapses happen in business is that they are simply not seen by those making them.

Obviously, relying on an employee of the company being audited to resolve a discrepancy found in the audit sample is a complete and utter violation of independence. It is essentially to work as an employee for the financial department of the company being audited. This was very much the mentality that Deloitte staff auditors had during the audits while I was working there. The tick-marks and the audits themselves were treated as merely technical exercises. The nascent ethicist was asleep under the banality of business as mere technique.

Perhaps it is typical for businesses to hide or obfuscate ethical lapses by providing a veneer of machine-like technical points, which are (naturally) to be followed without much reflection. At Starbucks, for example, opening a store in the morning might be a list of to-do’s: first turn on the lights, then turn on the coffee makers, then put out the donuts, then turn on the cash registers and sign in. It would never occur to an employee to distinguish one of these as meriting special, even ethical, attention because they are all treated as ordinary (i.e., implied acceptable) and of the same type (e.g., instructions). Perception does not tend to break into such a list in search of the one item that does not belong. This is why it did not occur to me even to suspect that the ethically-problematic tick-mark was uniquely worthy of any special notice or suspicion.

Of course, training professionals to assume an employee identity through a technical approach to the work has its own downside in that boredom is apt to set in fairly soon. I did notice that the new-hires with “real lives” tended to slip out after a year or two, while those auditors without much personality were promoted and, oddly enough, displayed as though role models. It did not take me long to determine that public accounting was not for me, but I had absolutely no clue that Deloitte’s culture was so intrinsically compromised in terms of independence. The compromise, after all, was utterly blatant in one of the firm’s tick-marks and yet I did not even see it even as I was utilizing it!

It was only after Enron (and Andersen) that I looked back and realized that Deloitte’s audit had been intrinsically flawed under the guise of treating its tick-marks as homogenous technical markings. During the audits, I had felt like I was an employee working for the companies being audited. After Enron’s end implicated Andersen as tainted, my intuition made sense. I had been.

Looking back, I wonder if the emphasis on technique kept us, the staff-auditors, from even identifying ourselves as professionals. Being essentially “told” that we were employees, we were kept from asking questions of any real ethical significance, such as, should I really be taking the comptroller’s word on whether the trucks out back? I actually used the problematic tick-mark in exactly such an instance—going to the comptroller rather than verifying for myself that the trucks were out in back. In retrospect, it is astonishing how utterly blind I was. I simply did what the audit manager said I should do—having been trained by the culture to see myself as an employee than a professional. After all, when a boss says that the customer is always right, a low-level employee is not apt to turn on the professional judgment and say, wait just a minute.

Lest Deloitte become a kind of scapegoat for an industry that is mired in a structural conflict of interest, the board does not view the problem as not limited to one auditing firm. According to the board’s chair, James Doty, the board members “reviewed more than 2,800 engagements of such firms and discovered and analyzed hundreds of cases involving what they determined to be audit failures.” He said the firms had made efforts to improve, but that each year more failures were found. “I am left,” he said, “with the inescapable question whether the root of the problem is auditor skepticism, coming to ground in the bedrock of independence. The loss of independence destroys skepticism.” What Doty left out is that the loss of independence can be expected to continue until clients no longer the parties who pay their CPAs.

Unfortunately, Dodd-Frank did not bust open this nut and obviate the structural conflict of interest. Not having a viable alternative yet is no excuse for simply relying on reports from the board to “out” firms like Deloitte. Like Doty says, the firms who know who is buttering their bread will offer up only lip-service. It is not just a matter that such firms have a dysfunctional culture ethically; they are within the liar of the larger conflict of interest. So ultimately we have Congress and the U.S. president to blame for missing the boat on this larger point. As odious and duplicitous as firms like Deloitte are, we should not come down only on them, for they are simply floating down-stream on the route established by the system. Still, we can hold such firms as blameworthy, particularly if their cultures enable exploiting the institutional conflict of interest, while we fix that system such that no such conflict remains. More importantly, auditors at CPA firms should not be financially dependent on the managements of client companies.



Sources:

Floyd Norris, “Accounting Board Criticizes Deloitte’s Auditing System,” The New York Times, October 17, 2011. http://www.nytimes.com/2011/10/18/business/accounting-board-criticizes-deloittes-auditing-system.html

Floyd Norris, “Audit Flaws Revealed, At Long Last,” The New York Times, October 21, 2011. http://www.nytimes.com/2011/10/21/business/deloittes-failings-revealed-but-only-after-3-years.html?_r=1&ref=highandlowfinance




Sunday, October 16, 2011

Police Against Protesters: Sadism or Politics?


The day after several marches and rallies by the “Occupy Wall Street” movement in New York City, The New York Times reported that “two dozen people were arrested at a Citibank branch on LaGuardia Place on trespassing charges. Some witnesses said that the protesters had tried to leave but were locked inside by bank employees. ‘They were trying to leave, but they wouldn’t let them,’ said Meaghan Linick, 23, of Greenpoint, Brooklyn. She said one woman who had been inside and left was forced back inside by police officers. Citibank, in a statement, said the protesters ‘were very disruptive and refused to leave after being repeatedly asked, causing our staff to call 911.’ The statement continued, ‘The police asked the branch staff to close the branch until the protesters could be removed.’” The Times report does not mention whether the protesters were existing Citibank customers trying to close their accounts. The report does refer to this at a Chase bank. “Earlier, about a dozen protesters entered a Chase branch in Lower Manhattan and withdrew their money from the bank while 300 other people circled the block, some shouting chants and beating on drums. The former Chase customers, who declined to reveal how much they had in their accounts — though a few acknowledged it was not much — said they planned to put their money into smaller banks or credit unions.’ The more resources we give to small institutions, the more they’ll be able to provide conveniences like free A.T.M.’s and streamlined online banking so they can compete with the larger banks,’ said Hannah Appel, 33, a postdoctoral fellow at Columbia University.” The report does not indicate whether the former customers were arrested.

From the report, it does not appear that anyone was arrested for closing a bank account; the protesters at Chase closed their accounts but were not arrested, while the protesters at Citi did not close their accounts but were arrested (for trespassing). Of course, the newspaper’s information could be mistaken. Were any customers arrested simply for closing a bank account, both the bank branch’s manager and the police involved should be terminated from their respective employments and prosecuted. The report does indicate that Citi employees locked protesters inside the bank. This act constitutes false imprisonment, which is illegal. I would think that the subsequent arrests would be thrown out by a judge.

I suspect that psychologically abusive persons are a sizable presence on many police forces. From casual observation, I have been surprised at how quickly and easily a significant number of police employees cross the line simply because they can—meaning that they assume without reservation that they can get away with trespassing the rights of others with impunity. The pattern is no accident.

Beyond orchestrated political uses of police forces (e.g., to teach those kids a lesson), present police recruitment procedures across the United States are inadequate in ferretting out mentally disturbed, abusive personalities. Furthermore, mechanisms to impose accountability on individual employees of police departments are woefully impotent, given the lack of self-restraint or even apparent self-questioning by police employees who are going to do what they are going to do, period. So, besides investigating particular cases of how the political or business elite uses police departments against the rights of protesters, elected officials in towns and cities (at the urging of state- or federal-level officials if necessary) could do more in seeing to it that the citizens are not abused by individual police employees by 1) ordering police chiefs to expand the role of psychological tests and interviews in the recruitment process and 2) instituting an external, independent committee or board with the power to fire police employees for abusing (or threatening to abuse) their authority.

Concerning recruitment, it is important to keep in mind that no one has a right to be on a police force. It is especially the case that bad attitudes need not apply, yet it does appear that they are extant on police forces. The NYPD, for example, has a long history of police brutality and cover-ups, which suggests that the recruitment process is woefully inadequate in screening out psychologically troubled candidates.

                           Anthony Bologna of NYPD pepper-spraying protesters following his orders

Concerning accountability, enforcement of the law against police who go beyond their authority at the expense of other people should be strengthened and harsher sentences should be enacted. In some jurisdictions, even the laws by which police can make arrests should be tightened. In New York City, for example, police can arrest people for deemed “safety issues” even if no law had been broken. Outside an event run by the Huffington Post, the police lied to author Naomi Wolf when they stated that the Post’s permit barred protests on the sidewalk. Even though Wolf verified with the event organizer that the police claim was false, the police arrested her after she joined some protesters walking up and down the sidewalk (i.e., not obstructing foot traffic). At the police station, a sergeant told her she was arrested for a “safety issue.” According to the Huffington Post, “The cop didn’t dispute her claim that she wasn’t breaking the law. But she said he explained that whenever police deem it a safety issue, they can make an arrest.” Given the propensity of the police to arrest unlawfully, this loophole should be tightened or replaced with procedures triggered in the event of a disaster (not just safety) that can be independently documented (e.g., an explosion in a subway station).  

I suspect that the lack of accountability on police employees who take it on themselves to extend their force beyond the law stems from the fact that enforcement mechanisms are not typically sufficiently independent of the police and local governments. Even “internal affairs” is evidently not sufficient. Police on the beat not sensing any viable external restraint in abusing others is itself indicative of too little accountability on the books as well as in practice. In other words, the attitude itself bespeaks a lapse in the system, which the offending persons undoubtedly know exists and can be counted on as they impose themselves even on people they know to be innocent. A police employee who uses his or her position to intervene in a civil matter, for example, should be fired because it can be assumed that the encroachment was intentional. Also, a police employee who pushes or hits a non-violent citizen without the latter having resisted arrest should be fired. Additionally, the offending officer should be prosecuted. In fact, state legislatures should stiffen the penalties as a deterrent. The penalties for police employees should be stiffer than for other citizens because the right to legitimate force carries with it a special obligation. Breaking a special duty warrants a longer sentence.

Whereas some of the “Occupy Wall Street” protesters referred to “police terrorism,” such hyperbole should be replaced by sadism, the deriving of pleasure by inflicting pain on others. This diagnosis would doubtless apply to Anthony Bologna, who sprayed innocent people with pepper-spray. Beyond politics, the deeper problem is that of sickness. What would happen, je me demande, if the protesters simply chanted, “Sicko! Sicko! Sicko!” or “You’re sick!” at an offending officer as he violently lashes out without provocation?  I suspect that the truth would hurt. Moreover, the protesters could pressure elected officials to stiffen the enforcement mechanisms and sentences.


Sources:

Cara Buckley and Rachel Donadio, “Buoyed by Wall St. Protests, Rallies Sweep the Globe,” The New York Times, October 16, 2011. http://www.nytimes.com/2011/10/16/world/occupy-wall-street-protests-worldwide.html


Jason Cherkis, “Author Naomi Wolf Speaks Out About Her Arrest at Occupy Wall Street,” Huffington Post, October 19, 2011. http://www.huffingtonpost.com/2011/10/19/naomi-wolf-arrest-occupy-wall-street_n_1020986.html