Robert J. Kueppers on Trust and Regulation (Trust Quotes #14)

For most of you, Bob Kueppers is someone whose influence (high) is inversely related to the likelihood you’ve heard of him.

As Deputy CEO of Deloitte LLP, Bob Kueppers has responsibility for regulatory and public policy affairs. That means he rubs shoulders with government and industry leaders who determine regulatory and public policy matters in this country and the world. Bob Kueppers was recognized in 2009 by Directorship Magazine as one of the top 100 most influential professionals in corporate governance and the boardroom

Bob is refreshingly direct and candid in his interactions; combined with a mastery of a field both wide and deep, he’s a fascinating interview.

Bob has a number of other additional roles at Deloitte, but we’ll focus mainly on his perspective on trust and regulation.

CHG: Bob, I’m delighted to have you join this series. I hope you’ll forgive us delving into just two subsets of your expertise: trust and regulation. Let’s start with regulation. Regulators aren’t getting great press these days. Is it a necessary evil? Or does regulation play a more constructive role in our business and society?

RJK: Regulation in a free enterprise system is one of the essential checks and balances in three different scenarios:

1) When parties in the market may not be equals;

2) When the nature of the market activity is susceptible to fraud or abuse; and

3) When public health and safety are involved.

Even true believers in free markets must acknowledge that a certain amount of regulation actually helps to preserve the credibility of the markets, which helps the market to operate and thrive. 

The debate over regulation often has to do with striking the right balance—finding the right degree of regulation. Like with “Goldilocks and the Three Bears,” it’s hard to get it “just right.” The appropriate degree of regulation often varies depending on the times, current events, and lessons learned.

The formation of the Securities and Exchange Commission in the 1930s, following the crash and market abuses of the late 1920s, is often viewed as a regulatory success. The orderly functioning of the capital markets provided the financial fuel to fund the post World War II expansion that redefined America in the 1950s and 60s.

When things go wrong, the natural reaction is to call for more regulation. But how can you tell when you’ve gone too far? For instance, critics say the recently enacted financial regulatory reform legislation, informally known as the Dodd-Frank Act, goes too far. Others claim it doesn’t go far enough. The truth is that we still don’t know the answer and likely won’t for several years—until the hundreds of regulations needed to make the reforms operational are written and implemented.

 CHG: What should be the role of regulation in the mixed economies we have today in the US and Western Europe? 

 RJK: It depends on the priorities of the country in which that regulation operates.

For instance, the US is often viewed as having a more litigious environment than other countries; as a result, our regulatory environment can be quite different than that of other countries.

Leaving such differences aside, I see the role of regulation as twofold:

1) Help to protect the interests of stakeholders, or, said another way, help to build and maintain trust in the markets that make up the economy; and

 2) Help to improve or maximize the quality and efficiency of the product or service through the establishment of standards and the related enforcement of those standards, such as through consequences for certain instances of non-compliance.

Regarding regulation beyond our domestic borders: because there is no global government system, a truly global regulatory structure is unlikely in the foreseeable future. Differences among geographies in this increasingly global economy are inevitable. It’s natural for countries to want to reserve the right to do what they believe is in their best interest given the unique circumstances of their nation.

Nonetheless, it’s important to recognize the inter-connectedness of our global markets—reinforced by the recent financial crisis. It’s helpful for regulators around the world to collaborate and work together—through forums, organizations, or otherwise—to achieve consistency in approach. We see such coordination in my profession through IFIAR, the International Forum of Independent Audit Regulators.

Again, my own view is that regulation should serve to assist fair markets to operate because regulation helps foster trust in such markets by the market participants and the related stakeholders.

CHG: Are there several key types or roles of regulation, which vary perhaps by industry? Or is the role of regulation universal and essentially the same, whether it’s the SEC, the FDA, the EPA, or the NHTSA?

RJK:  In theory, while the consequences of failures in regulation and poor execution by the regulated vary (ranging from mere inconvenience to potential loss of money, physical suffering, and health and safety consequences), the role of regulators is similar: to help to protect consumers and stakeholders and maximize quality and efficiency.

In practice, there are differences. Think about regulation of an industry which produces goods or provides a goods-based service—like the airline or pharmaceutical industries, compared to the regulation of a profession, which generally covers standards of behavior or performance.

What these disparate forms of regulation have in common, however, is that stakeholders operate with a level of confidence that compliance with regulation—whether by an airline adhering to safety standards or a public company audit firm following professional standards—builds confidence in the markets.

CHG: Let’s hop over now to trust. What’s the relationship of trust to regulation? How does regulation help trust? Or is it a substitute for trust? Does the presence of one reduce, or enhance, the other?

RJK:   Regulation isn’t a substitute for trust, but the existence of regulation plays a key role in helping to build and maintain trust, particularly in times of crisis. Examples include the creation of the Public Company Accounting Oversight Board to directly regulate my profession following the Enron and Worldcom scandals, as well as what we are seeing now with financial services regulatory reform in response to the recent financial crisis.

This suggests we could view a regulatory failure as one that doesn’t garner trust from the intended beneficiaries of the regulation. Such an outcome may indicate that there is a cost to society, without the concomitant benefit.

Unfortunately, this seems to happen more often than we may realize. Our society goes through cycles of regulation and deregulation. But, regulation tends to be cumulative over time, and the result can be layers of regulation, not all of which may be effective. In some instances, conscious decisions are made to forgo regulation. Is that because a significant level of trust already exists or is it a perception about cost and benefit? Or, is it a combination of both?

Having said that, regulation is a large part of what makes our markets the best in the world. It helped our markets recover well from the loss of investor confidence that followed the scandals that gave rise to Sarbanes-Oxley and is aiding in the recovery from the most recent financial crisis, though we still have a long way to go.

Unfortunately, it’s really in times of crisis when the issues of regulation and trust are considered together the most. That’s when there’s pressure to act quickly, and hopefully strategically, to learn lessons and act on them. The answers under these circumstances may be different than what you’d get outside of a crisis environment.

CHG: What do you find are the biggest misconceptions that businesspeople hold about regulators? Conversely, what misconceptions do regulators typically have about business?

RJK:  Businesses may perceive that the regulator has different objectives than the regulated. They may lose sight of the fact that as a regulated entity, they generally have shared objectives with the regulator.

It is not implausible that regulated businesses may see compliance with regulation as an impediment to success in terms of competitive advantage or speed to market. Businesspeople are largely quite ethical and certainly want their products to be safe for consumers, for example. But at the same time, as a general matter, if you lose sight of the shared objectives and focus more on short-term success, rather than long-term sustainability of the business, you can become frustrated with regulations.

Regarding the regulators, it’s important that they understand the trends and developments affecting the markets or industries they regulate. It can be counterproductive to develop changes in regulation without staying in close touch with the regulated entities and other stakeholders.

This communication helps to inform issues like the cost of implementation, the need to modify proposed rules to make them more understandable, and unintended consequences of changes in the regulatory regime. There needs to be a level of trust between the regulator and the regulated to help prevent the regulator from implementing proposals that are unlikely to work in practice.

CHG: The regulation model for the public company auditing profession is interesting in that there is government oversight, but the PCAOB is a private sector body. Why does this model work?

RJK: The government, through the SEC, oversees the PCAOB, but in the Sarbanes-Oxley Act, Congress explicitly established the PCAOB as a private-sector body. The SEC’s oversight role was effectively reinforced by a recent Supreme Court decision in a case about the constitutionality of the PCAOB.

The SEC oversees the PCAOB through the appointment of PCAOB members and supervision of the Board’s activities.  This makes sense, given the public company auditing profession’s role in the capital marketsand the SEC’s overall mission to maintain fair, orderly, and efficient markets, as well as to facilitate capital formation while protecting the interests of the investing public. The main reason the model works is the alignment of the PCAOB’s mission with the regulatory mandate and statutory authority of the SEC. If there were substantive differences, it probably wouldn’t work as well as it does. 

This private-sector regulation working side by side with government regulation isn’t unique to the accounting profession. The Financial Industry Regulatory Authority is another example of a private-sector regulator that works closely with the SEC on issues important to the markets.

CHG:  Let’s forget about regulation for a moment and talk about another realm of trust—trust between professionals and their clients. It’s something you know a great deal about within your business. What’s the role of trust in client relationships?

RJK: In general, trust and mutual respect form the foundation of the most effective client relationships. Those clients who understand our role and respect it are the clients with the best relationships.

For example, clients who identify issues early in the audit, and auditors who are upfront with clients when they are not comfortable with an issue, tend to have the most effective relationships. A good client relationship doesn’t mean there are never any issues to resolve; to the contrary, it means that issues get resolved on a timely basis because they are identified early and there’s a mutual understanding of the need to work through a resolution process.

Over time, greater trust fosters a stronger and more successful business relationship. When you’re a trusted professional advisor, you can be more effective in your own responsibilities. Let me be clear, this doesn’t mean we always agree with the client. 

To the contrary, we draw the line when necessary.   Sophisticated clients—I don’t mean in terms of size and scale, but in terms of thinking and attitude—not only understand this, but appreciate it, even if it’s stressful at times. In the end, investors benefit from credible information.

Auditing is unique, though; to do our job and fulfill our professional responsibilities, we strive to thoroughly understand the client’s industry, business, and current circumstances. This requires management and the audit committee to trust us.

Yet we cannot take things at face value or trust without support; we must be professionally skeptical. Our independence and objectivity, coupled with our knowledge and experience, are key to the value that we bring as auditors and we don’t put those at jeopardy for any client relationship.

CHG: Are there a few key things that people in business can do to improve trust with their clients?  

RJK:  Here are some lessons that come from my audit background, but which I think hold true in many business relationships:

·      This one is obvious, but first and foremost, deliver high-quality services and bring the right resources to the assignment.

·      Facilitate open dialogue—the earlier, the better—if a problem looms.

·      Don’t be afraid to deliver the difficult news; in my experience, handling that candidly and proactively goes much further in building trust than delivering the good news or raising a problem at the last minute when deadlines loom.

·      Finally, stick to your guns when the going gets tough; clients respect the fact that we have to do that. They may not like it, but they will come to value it when you are clear as to the “why.”

 CHG: What about clients—not just in your service lines, but more broadly. What should they expect in terms of trust—and what should they be bringing to the party as well?

 RJK:  I think it’s the same on both sides of the equation. Both service providers and clients should bring integrity, forthrightness, and strong ethical values to the table. This is especially true when it comes to auditing, but it holds true more broadly in other instances as well. 

Finally, it comes down to people. You could have a company with a great brand and corporate reputation, but if the management team lacks integrity, you do not want them as a client.

I have worked in a partnership for over thirty years. One way I gauge people is to consider whether I would want them to be my partner. Would I trust them with our brand and our reputation? That’s the acid test for me.

CHG: Bob, thank you so much for the gift of your time. Yours is a valuable and unusual perspective, and we appreciate your sharing it with us so forthrightly.

Robert J. Kueppers on Trust and Regulation

is number 14 in the

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The SEC Chose Wisely in Goldman Case

The SEC earlier today announced a civil suit against Goldman Sachs.  This act was the talk of Wall Street—the DJIA dropped 125 points, Goldman’s stock lost 12.6%, and CNBC broadcast a special evening show called “Fraud on the Street.”

The suit charges Goldman with not disclosing information. I won’t bother with the detail, you can read that in the above links—the point is, the charge is non-disclosure.

Now, that’s an interesting charge. It amounts to some form of misrepresentation. In the non-legal world, that’s generally known as lying. In that same world, the teenager defense of “I didn’t actually tell a lie, I just let you think what you thought” is considered a distinction without a difference.

The point is, the SEC chose to charge Goldman with something that’s not only illegal, but resonates easily with Main Street as also being unethical. Since the gap between the illegal and the unethical is one of the main casualties of the recent financial debacle, this is a welcome sign—a charge that re-unites the legal and the ethical.

The Spin–Red Herring Issues

Goldman itself responded that the charges are “completely unfounded in law and fact.” Look for a splitting hairs defense a la “it depends on what the meaning of the word ‘is’ is.”

Goldman and others make several arguments that are pointedly red herrings. One is that they didn’t do this transaction to short the market (non-responsive). Another is that the buyers of the CDOs were big boys, and should know what they were getting into (ditto). Another (by Goldman) is that they themselves lost money on the deal (again…).

The pro-Wall Streeters are not alone. NBC News led with “if the government is right, people all across the country are still paying the price for schemes like this that we’re only learning about this now.” Their commentator presented the charge as betting against a carefully constructed product; not the SEC charge. Lisa Myers said, “essentially Goldman Sachs is accused of helping rig the game against investors.” And Robert Reich said the real crime is not what was done illegally, but what was done legally. Fair point, but not a commentary on the crime. CNBC’s Erin Burnett tried to get commentators to say it was suspicious timing, to buttress financial legislation in Congress or to deflect press attention from the SEC’s shortcomings in the Stanford case. Again—not on point.

What the SEC Did Right

I’m no lawyer, but I’m guessing the SEC could have pursued many other charges. It chose to pursue this one—the legal equivalent of what laymen call ‘lying.’ Lying is the most trust-corroding thing that can be done. It not only ruins credibility, it casts motives into doubt. Lying kills trust.

A charge of failure to disclose is exactly the kind of charge a responsible regulator should be pursuing. It reunites the legal and the ethical—a casualty of Wall Street’s actions—and aims at restoring trust.

Greed is not illegal, though it may be unethical; ditto for fleecing one’s customers. But misrepresentation—or the near-equivalent of selective disclosure—is both.

Good for the SEC for taking this route.

The Trust Week in Review


Introducing The Week in Trust: a weekly look at the world through trust-related eyes.

Part news-roundup, part mind-stretching and whimsical, part commentary that didn’t have enough zip to make it into the blog, but which needs saying.

Big Story Department.  

Regulation has got to be the story this week.   Regulation, at least to my schizophrenic view of things, represents the failure of capitalism to regulate itself.  I believe that business is a higher calling, and that it ought to be capable of long-term self-interested thinking.  But you couldn’t prove that by recent history.

According to the Wall Street Journal, Wednesday’s announcement represented “the most sweeping reorganization of financial-market supervision since the 1930s.”

Bruce Carton’s most excellent Securities Docket explains in not-that-complicated language why the WSJ is not being hyperbolic.  Credit cards, exotic derivatives, small banks, private equity, hedge funds, insurance—not to mention more energy behind enforcement.  It’s all coming down the pike.

And it’s not just the finance sector.  Let’s not forget (hey it was way back at the beginning of the week) that the US Food and Drug Administration (FDA to those who can read alphabet soup) will be regulating tobacco.  That was a long time in the making, and a milestone of sorts.

Why such a sudden glut of regulation?  On some level sure, it’s the Democrats. But Democrats can’t just regulate for the heck of it, and not all of them want to anyway.

I contend it is, as I stated above, a failure of self-regulation.  Whether it’s mortgage brokers or CFPs or regional airlines or credit card companies, what precedes regulation is a mountain of self-justifying rhetoric, aimed at short-term benefit of market players against consumers: ironically, thus harming the industry long term.

But enough about regulation, it’s Friday.  Let’s raise our sights.

Who Knew Department. 

What do you do if you’re a government with an endemic social dishonesty problem?  If you’re Indonesia, you open up 7500 ‘honesty cafes,’or food stores where the responsibility of paying the right amount is left to the customer.    I don’t know of any larger-scale attempt at testing the old saw that ‘the fastest way to make a man trust you is to trust him.’  Early returns are it’s working great in schools; in government offices, not quite so much.  

Hey, it’s the principle behind vaccines—expose them to a little bit of trusting, and they’re inoculated against being untrustworthy.  Nothing new to readers of this blog.  But way more fun.

Do guns kill people, or – does lack of trust kill them?  One of those academic studies that makes you scratch your head a bit; you know there’s some truth there even if it’s cleverly hidden behind the English language.

Trust Angles Department.

It’s one thing when a bucketshop broker or a used car dealer gets accused of being untrustworthy—right or wrong, that’s the price of being stigmatized as low-trust. Ho hum.

But what if you’re known for high trust and you get accused?  Ouch.  Big Ouch.  For example, the Canadian Conference Board. Ouch, I say.

What’s it mean to trust your babysitter?  Find out.

You may think trust is down, down, down.  After all, that’s the drumbeat du jour.  But how many of you are happily using cloud computing?  What an act of trust that is.  And sometimes, maybe it lets you down.  But–have you stopped using it?  And what does that say about your level of trust.

Your Opinion Department.

PGA pro Vijay Singh is still wearing his sponsor’s golf hat.  His sponsor, interestingly, is mini-Madoff  Stanford Financial.   Hate it when that happens. 

Is he being loyal?  Or stupid?  You be the judge.  

Please give me some feedback: should The Trust Week in Review be a regular Friday feature of TrustMatters?  Enquiring minds (ours) want to know.

The Ethical and Regulatory Morass of the Stanford Scandal

I didn’t start out looking for trouble.

But like the camera shots in a Sergio Leone western, every time the camera pulls back for perspective in the Stanford Investment Bank story, the plot changes.

But let’s begin at the beginning. You of course know Madoff–the man with the minus touch.

Now we have "Sir" Allen Stanford–let’s call him mini-Madoff. He’s head of the Stanford International Bank (SIB), now accused by the SEC of bilking about $1.8 billion through, what else, a Ponzi scheme. Based in Antigua, operated out of Mississippi and Texas, a very private management team.

SIB had an outside lawyer from the prestigious firm Proskauer, Rose. His name is Thomas Sjoblum. On February 10, in the SEC offices in Fort Worth, Texas, Mr. Sjoblum accompanied his client, SIB’s Chief Investment Officer Laura Pendergest-Holt, to a 4-hour deposition by her.

The next day, Mr. Sjoblum told the SIB folks he was resigning from the case.

Musta been one helluva testimony Ms. Pendergest-Holt gave, eh? So it would sound.

In a blackberry email to an SEC lawyer two days later, Sjoblum clarified:

"I disaffirm all prior oral and written representations made by me and my associates … to the SEC staff regarding Stanford Financial Group and its affiliates.”

For me, it all started with that funny word–“disaffirm.” In a blogpost on February 20 I said “disaffirm” was a tortured linguistic construct aimed at putting distance between telling the truth and technically not lying.

But then the real fun started. Pull the camera back a few feet.

I then separately heard from two lawyers for whom I have very high regard, suggesting I had been too hard on Sjoblom. They suggested Sjoblom was a whistle blower whose actions were principled, difficult and courageous.

They were not alone. The blog AmLaw Daily had written the day before:

…Sjoblom…sniffed out the fraud, withdrew his representation, and told federal investigators he essentially took back everything he had told to them in recent weeks…

Am Law Daily contacted a number of legal ethics experts to discuss Sjoblom’s decision to come clean about a client’s alleged frauds–especially given the possibility that in doing so, he disclosed confidential client information to the government…

Experts said Sjoblom did precisely the right thing–and, more importantly, that the federal Sarbanes-Oxley Act likely made his decision much easier than it otherwise might have been.

"He [Sjoblom] did the right thing here," says Stephen Gillers, a legal ethics expert at New York University School of Law.

I started looking for crow to eat. Until, that is, I read the Memphis Daily News account of what actually happened at that February 10 SEC deposition.

By the SEC’s own notes, Sjoblom came out swinging—asking if the SEC had yet referred the case to Justice, arguing that the SEC didn’t have geographic jurisdiction, arguing that the (allegedly) bogus CDs Stanford sold were not “securities” under the relevant legal definition.


Suddenly the aspiring Hollywood screenwriter in my head switched stereotypes: this was not the plot for the courageous whistle blower movie. This was the script for the B "mob lawyer" movie. Could he really have had a Saul on the road to Damascus conversion in one afternoon?

So–what happened in that room? Did Ms. Pendergest-Holt really drop a bombshell that blindsided Sjoblom? Or did Sjoblom do a Claude Raines (“I am shocked, shocked! to discover my client has lied to me for years about billions of dollars!”)? Incidentally, Ms. Pendergest-Holt was arrested by the FBI a few days later.

Let’s pull the camera way back.

Attorney Sjoblom is an ex-assistant chief litigation counsel in the SEC’s Division of Enforcement. On February 10 he aggressively explores defenses for SIB just before Pendergest-Holt comes on and says things that get her arrested. The next day he resigns.

The obvious question becomes, ‘What did Sjoblom know, and when did he know it?’ Of course I don’t know, but let’s consider what Sjoblom might have known:

  1. In 2003, a whistle blower case against Stanford was brought in front of the NASD (FINRA’s predecessor).
  2. In fact, according to Henry Blodget, "at least five former Stanford employees told the SEC they thought Stanford was running a Ponzi scheme, from 2003 on."
  3. A January 2008 lawsuit was filed against Stanford alleging endemic lack of compliance.
  4. A Venezuelan analyst wrote a report called Duck Tales in January 2009 which did for Stanford what Markopolis did for Madoff–blew the conceptual lid off.
  5. But the nail in the "shocked, shocked!" coffin is in the FBI arrest claim for Stanford’s Pendergest-Holt:

..the complaint alleges there were stormy preparation sessions for Pendergest-Holt in January and February “during which the bank’s shaky asset base became apparent to a wider circle of officials and to the lawyer — ‘Attorney A’ — who later quit.”

Um, who might ‘Attorney A’ be? Whoever it was, he knew something was up back in January.

So–just when did Sjoblom "sniff out the fraud?" The day after he heard testimony in Dallas? Or way before?

If he knew anything in advance–then why the aggressive denial-of-jurisdiction rant at the outset of the hearing? How much charade does a lawyer have to go through before he can speak some truth? I know legal ethics is much concerned with maintaining client confidences. But how much pretzel-twisting is required to serve that particular god?

The legal experts said Sjoblom did “exactly the right thing.” They also say that Sarbanes-Oxley made it far easier for lawyers to reveal confidences in certain situations. Let’s assume both statements are true. How horrible it must have been pre-Sarbanes–how many would-be whistle-blowing lawyers went to the grave mute?

How much in-your-face evidence of massive fraud does it take before a lawyer can say "my client is a crook and a liar" in a legally acceptable manner?

May I suggest the right answer should be–"less than this."

If this was a praiseworthy, ethical act consistent with the highest standards of the law, then something is very wrong–either with a lawyer, with legal ethics, or with the law itself. The law owes society more than citing last-minute tortured "disaffirmations" in the face of egregious criminal wrongdoing as examples of ethical behavior.

Note: It’s possible that Professor Gillers was not aware of all this background when he called Sjoblom’s actions "exactly the right thing." For all I know, given the background, he might even agree with me. I’d welcome his perspective here, and I’d welcome any correction from anyone about matters of law or fact.

Regulatory Policy 2.0 – The Alternative

[Second of a two-part Blog Post]

Yesterday I suggested that our existing 3-legged approach to regulation (separation, compliance, transparency) not only failed to prevent Madoff, but positively enabled him.

Today I’ll talk about an alternative.

Until last weekend, when the world discovered Madoff hadn’t bought stocks for 13 years (TrustMatters readers heard about it 5 weeks earlier here), the consensus was Madoff was so sophisticated no one could follow him.

Turns out sophistication itself was the ultimate scam. Madoff built a Potemkin village. He knew what a trading system and a hedge fund should look like, and gave us the appearance of one.

In fact, it was just another Nigerian Ministry scam.  Give me your bank account numbers. and I’ll make you rich. Trust me.

The SEC, like all regulators, relied largly on three mechanical approaches:

• structural separations
• compliance processes
• disclosure.

All were built around the modern sophisticated financial world. What they entirely missed was the human element of any great scam. Hide stuff in the most obvious of places. Utterly believe your own lies. Get the con to focus on your spiel while you swap the pea out of the walnut.

They missed the “man” in con man.

If past is prologue, as unfortunately it usually is, there will be a firestorm of protest and we will end up, through the best efforts of Congress, Fox News and the tabloids, with More of The Same. The same trio of regulations that Madoff manipulated. And it will cost billions and billions more in regulation and in stifled economic sub-optimization.

So what’s the answer?

Human-based regulation–beyond structure, processes, disclosure. Regulation 2.0.

Human-based regulation recognizes and embraces three human traits:

1. We live up (or down) to expectations
2. People are infinitely creative–regulators must be as well
3. Selective audits plus severe consequences both inform and deter people.

Set clear expectations. We cannot allow confusion between “ethics” and “compliance.” The phrase “but it was legal” cannot be permitted to be the end of conversation. Regulators have to continue dialogue with non-lawyer citizenry, stay in touch with norms and mores. Most important—they must have a visceral sense of the “rightness” that their agencies were built on in the first place, and unflinchingly convey that sense of mission and expectations to their industries.

Harness Creativity. Regulators can find role models in the audit profession, the IRS, and the GAO. They can look farther afield at successful police departments, e.g. New York City’s counter-terrorism operation. The ultimate objective can never be to just ensure compliance—it must be to fulfill mission.

Visiting RIA offices to review papers too easily becomes a bureaucrat’s exercise. We need regulators who think like cops, who are inherently suspicious, who demand proof, who creatively out-think the Madoff du jour. (Harry Markopolis’ testimony in Congress—the second part—gives excellent examples of this, epitomized by the simple, “is something funny going on around here? Here’s my card—call me if you see anything suspicious.”)

Selectively audit, severely penalize. Auditors and the IRS have excellent track records doing selective audits. You don’t need to examine every book—just let every bookkeeper know that their books might be the ones examined next.

Combined with the public announcement of severe consequences, this approach both tells the industry what behavior is expected, and says they are accountable to the public they serve. It’s like a police perp walk—it publicly shames and humiliates.

(From this point of view, the continued absence of a perp walk for Mr. Madoff, together with the absence of any consequences thus far, sends the wrong message. It says “old” regulation still holds sway: he can stay in his comfortable digs until the legal process grinds its way to some determination of whether or not he has committed a violation of a particular law).

Madoff’s scam was old-school, Nigerian-Ministry, thuggish. That doesn’t mean the SEC employs incompetent people. It does mean, however, that they are toiling under an inadequate philosophy of regulation.

We will not regain trust in our institutions until we remember that trust is, at its heart, a human thing—and begin to act that way.

Regulation 2.0 is a good start.

Regulatory Policy 2.0 : The Real Meaning of Madoff

[First of a two-part Blog Post]

Madoff has been a late-night TV comedy staple for some time now. While his victims surely don’t appreciate the humor, most of use have relegated him to cafeteria conversation, alongside Lindsay Lohan and the Oscars.

That would be a big mistake.

L’affaire Madoff will dramatically affect our approach to regulation. And in this case, our first instincts—can you say, ‘Sarbanes-Oxley 2.0’—would be the worst. We need Regulatory Philosophy 2.0. Here’s why, and how.

The Latest on Madoff. The headlines this past weekend screamed one thing: Madoff Bought No Stocks for 13 Years. ‘Look how brazen he was, how could the SEC miss that, no way his sons weren’t in on it all along, etc.’

It was no surprise to readers of this blog.

On January 17, I wrote, in a blogpost titled Madoff—Investment Fund or Virtual Reality Game

It’s beginning to look like Bernie Madoff’s business model had less in common with a hedge fund or investment management firm than it did with an online virtual reality game. Sort of a Sim City for investors. The money sent in was real: everything thereafter was from Oz…
…[It] was bupkus. Virtual reality money. Sim City money. Monopoly Money. In the real world, it didn’t exist except in Bernie’s bank account and a computer program.

This was not a case of sophisticated hedge fund managers in Greenwich or rogue currency traders in Hong Kong. The SEC was not out-gunned, outsmarted, or out-manned. This was not a Danny Ocean operation.

This was as simple as a Nigerian inheritance email spam scam. Gimme your bank account number and I’ll send you money. A garden variety mugging. Like a good magician, Madoff got us to look one way, while he swapped card decks.

Overnight, this recasts the regulatory task facing the SEC. We can no longer rely on traditional regulatory philosophy: we must get personal, human, and trust-based.

Regulatory Philosophy 1.0. Regulation (and not just in the financial industry) has become driven by three models—separation, compliance, and transparency. None of them stopped Madoff—in fact, they enabled him.

Separation. Think building walls—to legally and physically separate potential co-conspirators. Think traditional anti-trust laws. Think separating accountancies and consultancies. It is a heavy-handed, expensive, and sub-optimal way to regulate.

Madoff used this to his benefit—claiming his brokerage and investment management businesses were separate because, ‘after all, they had to be.’ Therefore FINRA could claim “it wasn’t my job.” Madoff knew FINRA would make that claim; in fact, he depended on it.

Compliance. This approach turns legislation into a blizzard of administrative processes, which must be complied with. Think check-boxes, filed copies, no-later-than dates, renewal requirements. All monitored and tracked in the latest systems. This approach is less heavy-handed, but equally oppressive—and mind-numbing to boot.

Madoff used this also to his benefit. You want forms? I’ve got forms. But the data was itself bogus.

Transparency. Lawyers, financiers, mortgage brokers and credit card operators love transparency-as-panacea. Coupled with a convenient belief in efficient market theory, this enables people to blame those who didn’t read the small print (Rick Santelli, are you listening?).

Madoff used this to his benefit too—blitzing investors with day-trader-like “records” of trades (bogus). We have come to measure “transparency” by the pounds of documents “disclosed,” rather than by their truth or import.

If we focus only on outrage at Madoff and at government bureaucrats, our politicians will do what they’ve always done: legislate more structural boundaries, design more and more checkbox procedures, and require publication of more minutiae. And thus we’ll enable Madoff 2.0–even faster this time.

Regulation 2.0.  There is a better way.

It is based on a simple fact–people are human. People are good and bad, trusting and non-trusting, sometimes all at the same time. Systems don’t commit fraud, people do. In this case, one Bernard Madoff.

Yet our existing regulatory processes are entirely non-human. Walls, processes and transparency are mechanical things. Devised by people, they can be broken by people. And being inhuman–we don’t trust them.

Our existing Philosophy of Regulation does not engender trust. To trust our institutions, we have to return to a simple principle: trust is inherently human. We have taken the human part of trust out of regulation, and we’re paying the price.

Tomorrow’s BlogPost: Why we need to build regulatory policy more around personal trust.

Mini-Madoff Scandal Scales New Linguistic Heights

R. Allen Stanford, head of Stanford International Bank, has been charged with fraud by the SEC.

Another day, another Ponzi scheme. Stanford’s take: $8 Billion. Not chump change, of course, but neither does it put him in Madoff’s league (up to $40 billion).

I think I shall call him mini-Madoff.

But the Stanford scandal has set a linguistic record—a record for creative disingenuousness. According to Securities Docket:

…one of Stanford’s own lawyers has emerged as a key figure in the matter. Bloomberg reports that last week, Thomas Sjoblom, a partner at law firm Proskauer Rose doing work for Stanford’s company’s Antigua affiliate, told authorities that he “disaffirmed” everything he had told them to date. According to his bio on his law firm’s website, Sjoblom spent nearly 20 years at the SEC, and served as an Assistant Chief Litigation Counsel in the SEC’s Division of Enforcement from 1987 to 1999.

“Disaffirmed” (italics mine). Doncha love it?

I hereby nominate “disaffirmed” as the new leader in the “Mistakes Were Made” category at the forthcoming Creative Language awards ceremony.

This is no trivial honor. It outpaces such classics as “the dog ate my homework,” “I have no recollection,” and “it depends on what the meaning of the word ‘is’ is.”

In my humble opinion, the only one that comes close was “modified, limited hangout” from the Watergate days.

It is a distant descendant of the old IBM (or was it GE?) culture that used “concur” and “dis-concur” as part of its decision-making process. But that was for standard business processes; this is for excusing $8 billion of malfeasance—clearly vaulting the term into another category altogether.

Sjoblom, a 20-year SEC employee, originally affirmed certain facts to his old employer. Enquiring minds want to know–where did he learn “disaffirm?” Was it at the feet of Stanford? Did he bring it with him from the SEC?  Was he–oh, this is juicy–speaking Ponzi-talk?  Or was he talking bureaucrat-speak?

And what’s to make of the syntax? Does it truly confound logic, as in "have you stopped beating your wife?" Or is it just a fancy "I lied?"

Never mind–let’s be practical. Where else can we put this word to use? After all, if you can undo a legal affirmation by using it—why, the sky’s the limit!

  • That affair I had back when I was married? I’d like to disaffair it, please.
  • Remember when I said I’d pick up the tab? Distab that, if you don’t mind.
  • The vows we made at our marriage? Disavow them, please (oops, that one’s a real word). Yes, I know I said "I do," I’m just saying "I dis-do."

You get the idea.

Language evolves marvelously to fit the circumstances requiring description. So it is here.  Double-talk is as double-talk does.

Mini-Madoff financially, perhaps. But in a league of its own in AOL—Abuse Of Language.

Wanted: Executives with Integrity, or At Least a Sense of Shame

I spoke a few days ago with a thoughtful, intelligent ex-management consultant who understands the financial big picture very well. What was his take on the crisis, I asked him?

“The whole thing comes down to a serious misalignment of incentives of all the major players,” he said. “Low interest rates and rising asset prices led banks, lenders, ratings agencies, credit insurance and other markets astray–everyone’s incentives got way out of whack.”

As a description, I buy it. But as a diagnosis, I don’t know whether to be disgusted or depressed. I think I’ll be angry.

“The incentives are out of whack” is the language of behaviorism—appropriate for a Skinnerian stimulus-and-response study of rats and cheese in a maze. Looking at the world through Skinnerian lenses has many virtues—not, however, including the concepts of responsibility or integrity.

In a time of financial faltering and blooming Ponzi schemes, this matters enormously. We have a once in a decade chance to alter the trustworthiness and ethics of the financial industry.

Will our new financial regulators view this as a chance to redraw the maze and manage the cheese distribution? Or will they also focus on restoring integrity?

How bad is it? Another friend told me about a conversation between an investment banker and a regulator—the banker said, with a sly wink, “You know, you folks shouldn’t be letting us get away with this.”

“Letting us get away with this?” Who put the gun in your hand? Who raised the drink to your lips? Who do these people think is responsible for their actions? The chief behavioral scientist at the SEC?

Just 7 years ago, post-Enron, Samuel diPiazza, tCEO of PricewaterhouseCoopers, and Robert G. Eccles, a former HBS professor, wrote, in Building Public Trust:

…even transparency and accountability are not enough to establish public trust. In the end, both depend on people of integrity. Rules, regulations, laws, concepts, structures, processes, best practices, and the most progressive use of technology cannot ensure transparency and accountability. This can only come about when individuals of integrity are trying to “do the right thing,” not what is expedient or even necessarily what is permissible. What matters in the end are the actions of people, not simply their words…without personal integrity as the foundation for reported information, there can be no public trust.”


Trust, integrity, and ethics are essentially about the link between individuals in society. Not between rats and cheese.

It must be tempting for Mary Schapiro, new SEC head, to respond to the political howling with a new Sarbanes-Oxley. Please don’t. As Jim Peterson says, “Any law that passes the US Senate 99 to 1 has got to be seriously flawed.”

What we don’t need more of is behavioralism–more paperwork, detailed regulations, disclosures, and Chinese walls. What we need more of is what diPiazza said—trustworthiness and integrity. On the regulatory side, that means better enforcement and sanctions.

But politics are critical too, and fulminating politicians can be as short-term focused as any banker. The public has a big role to play.

May I suggest shame, humiliation, and public shunning. Maureen Dowd has made a nice beginning  but everyone needs to pile it on.

Consider two contrasting headlines yesterday:

Ford Has Worst Year Ever But Won’t Ask For Aid


What Red Ink? Wall Street Paid Hefty Bonuses.

Which one is about mice, and which about men?

Get mad as hell about this.  Go shame a Wall Street banker today–we expect people to feel shame, not rats, so their response should tell us something.



How Not to Regulate Untrustworthy Industries

I haven’t done an analysis on this, but it feels like the financial sector has had more than its share of responsibility for scandal in the most recent economic “troubles.” Which makes it even more tempting to regulate by compartmentalizing and dictating specific behaviors.

In the broadest terms, that would be a mistake.

Say you have a 17-year old son who wants to take the family car out at night. You’re worried about alcohol abuse and aggressive driving—things occasionally associated with teenagers.

Do you say:

a. Absolutely not, and I don’t care what Louie’s parents are doing, you’re not going out at night with the car until you’re 18 / have your own car / etc. Period.

b. OK, but here are the ground rules, and if you violate them, here are the consequences; they will be severe and immediate, and I’ll check randomly.

I think most of us would prefer b. If not, just add a year to the age. Eventually you’re going to have to let the kid out at night.

More broadly, the question is: do you regulate by dictating behaviors, or combining audits with enforcement and sanctions?

You could answer this with ideology, or with a cost-benefit analysis. But there is one factor that I don’t think gets mentioned enough. And that is trust.

Let’s say an accounting firm is considered to have abused its relationship with its consulting branch. You could:

a. force accounting firms to sell their consulting businesses or build strong “Chinese walls (basically what Sarbanes Oxley did), or

b. increase the budget of the GAO, the Justice Departments’ enforcement branches, and the sanctions for violation of rules.

Others know more than I about the costs of Sarbanes; let’s just say it was high. But the real cost was that accountants won’t get to rub noses with consultants. Firms won’t have to develop their own policies. They have had to become compliance-driven, not outcome-driven.

The real trouble with structural regulation is that it removes the ability to evolve relationships, or trust, between business entities. Therefore it removes all possibilities for future economic improvement from trust.

Structural regulation is like putting up a concrete fence with your neighbor; it ain’t coming down anytime soon. The opportunity cost is bigger than the out of pocket cost.

In a really excellent NYTimes piece—The End of the Financial World as We Know It by Michael Lewis and David Einhorn (I find them the best source these days for understanding what just went down)–they nonetheless plop for structural approaches.

They are probably right in part; revolving doors from government to industry lobbying, for example, is a pretty sure source of corruption. But structural solutions ought to come as last options, not first.

There are tons of laws governing the financial industry that simply get buried in process, language, bureaucracy, small print. They simply do not get enforced, and if enforced, they are toothless, and even then do not get publicized.

Before we build concrete walls, invest some money in creative auditing, enforcement, and sanctions that really bite. It at least leaves the door open for good players to do something really good with relationships. To grow up and drive right.


Smoking Guns in the Rear View Mirror: Madoff and the SEC

Experienced bloggers tell me to lead with the headline, as in newspaper stories.

So here it is: read this link. It’s the document sent to the SEC in 2005 accusing Bernie Madoff of running a gigantic Ponzi scheme.

More specifically, it’s the Wall Street Journal’s copy of the letter, separately identified as coming from Harry Markopolos, the Deep Throat of the Madoff scandal. But that’s not the point.

The point is this: take 2 minutes to click on the link and give it a quick look.

Come on, you can afford 2 minutes, this is history we’re talking about. It’s only a 17-page .pdf file, and you don’t have to read all of it.

There, that wasn’t so bad, was it?

Now—what did you think? OK, let me help you out.

It wasn’t all that hard to read, was it? Some jargon, but largely around technical terms whose connotation was clear in context. Markopolos outlined it pretty well, right? You got the sense that something was most definitely fishy, and that this guy sounded like he pretty much knew what he was talking about—right? When he says "Madoff Securities is the world’s largest Ponzi scheme," did you get the sense he was telling the SEC that Madoff was running a Ponzi scheme? Yeah, me too.

Now—if you were a staff member at the SEC and received this letter—what would you do?

My own gut-level instinct—based on nothing more than having worked 6 months for the feds 30 years ago, knowing a whole 2 SEC employees, and having lived on this planet for a few years—is that at least a couple hundred human beings at the SEC are more than capable of of understanding it at least as well as you or I. And I’m sure several got the chance.

Which begs the obvious question: why, oh why, did nothing happen?

There are several really obvious answers, which I won’t belabor. Just now. (Though venality and incompetence generally head the list of usual suspects).

Now, at the risk of losing the bloggers, let’s get past the headline. When something in retrospect is shockingly obvious, it should at least raise the possibility that it might not have been so obvious looking forward. Consider the law of gravity, for example. Or Obama’s election. Not to mention this smoking gun of a document.

What kinds of things get in the way of clear forward perception? High on the list, I think, are beliefs. Not the opacity of data; not a lack of IQ; not a conspiracy of coincidence. Beliefs.

Beliefs: preconceptions, ideologies, inclinations, habits, norms, assumptions, conjectures, presumptions, presuppositions, expectations. A word for "stuff" in the mind that the neurobiologists haven’t yet "explained," but which laymen nonetheless manage to understand quite well.

Business doesn’t believe in beliefs these days. It believes in behavior, results, measurement—these it considers incontrovertible proof.

I have two suggestions. First, go see the movie “Doubt.” It raises questions about the effects of moral certitude.

Second, go back and read that Markopolos’ document again. It does exactly the same thing.

Why did the SEC look so pole-axed? Place your bets. Venality? Incompetence? Or blindness due to moral certitude? What’s your bet?

And by the way, who owns the movie rights?