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Should gatekeepers be shown the door?

D. Murali

BIRD flu is not the only infectious disease around. Scandals are infectious too — such as deceit and risk that corrupted the financial markets. And in Infectious Greed, Frank Partnoy discusses how big corporates imploded, "prey to a greed-driven culture and dubious or illegal corporate finance and accounting." The book, from Owl Books (www.henryholt.com), is a narrative of how "each new level of financial risk and complexity obscured corporate sickness," laid out in three stages, appropriately named, "infection, incubation and epidemic".

The author defines his aim in the intro: "The book is a financial history, a story of the dramatic changes in markets during the past fifteen years." Something necessary, because: "investors periodically become outraged, and the media seize on a few indignities, but over time everyone seems to lose the ability to relate back — especially as markets begin going up again."

Three major changes that Partnoy traces are: "First, financial instruments became increasingly complex and were pushed underground, as more parties used financial engineering to manipulate earnings and to avoid regulation. Second, control and ownership of companies moved greater distances apart, as even sophisticated investors could not monitor senior managers, and even diligent senior managers could not monitor increasingly aggressive employees. Third, markets were deregulated, and prosecutors rarely punished financial malfeasance."

In the first chapter, titled `Patient Zero', the author explains the `dramatic' difference between exchanges and over-the-counter markets: "An exchange is like a Las Vegas-casino sports-book, where a gambler can place a limited set of bets." While casinos, like exchanges, aren't in the business of taking risk OTC markets allow gamblers and traders to "design any trade they wanted... limited only by their imagination."

The subsequent chapter, "Monkeys on their Backs" discusses, among other things, RAY-rock (RAROC — risk-adjusted return on capital) for measuring profitability of a particular business. "The idea behind RAROC was that a company should reward employees based not only on how much money they made, but also on how risky their business was."

For many it may come as a surprise that, after Enron's bankruptcy, "the firm's own officials were unable to grasp enough detail to issue an annual report; even with the help of a new team of accountants from PricewaterhouseCoopers, they simply could not add up the firm's assets and liabilities."

The epilogue portrays the current widening gap in information and sophistication between average investors and companies, arising due to changes in markets, law and culture.

"Accountants, bankers and lawyers continue to use derivatives to avoid regulation. Corporate executives, securities analysts, and investors continue to focus more on meeting quarterly estimates of accounting earnings than on the economic reality of their businesses."

A suggestion that could be deadly for gatekeepers such as accountants, lawyers, bankers and credit-rating agencies is this: "Eliminate the oligopoly lock of gatekeepers." Why? Because they have performed "unimaginably disreputable acts." While their reputations have suffered only a little, their profits have not suffered at all, points out Partnoy. "Gatekeepers will continue to earn substantial profits as long as rules supporting them persist."

Here is a solution that the author proposes: "Eliminate the legal rules that effectively require that companies use particular gatekeepers, while expanding the scope of securities-fraud liability and enforcement to make it clear that all gatekeepers will be liable for assisting companies in transactions designed to distort the economic reality of financial statements."

This would "encourage new intermediaries to attempt to fill the shoes of the accountants, bankers, lawyers, and credit-raters who have failed during the past decade." Are CAs going to go jobless?

Is there hope for investors? Vigilance is the answer. Watch out for the many warning signs — on "related party transactions, options compensation, and off-balance-sheet derivatives" — that are lurking in the footnotes of corporate annual reports, advises the author, to counter the greed virus.

BooksOfAccount@thehindu.co.in

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