Ever since 2003 when I wrote about this in Value Leadership, I have believed strongly that when you let an investment manager or business executive oversee the production of financial statements, you are creating a conflict of interest that will inevitably be resolve in favor of the manager -- not the investor. I posted about this topic here.
Now the Securities Investor Protection Corp. (SIPC) is reporting that Bernie Madoff took advantage of this conflict of interest to create two separate sets of books for his firm. One set of books told a comforting story of steady 1% per month gains for investors. The other set of books described reality. Investigators are trying to determine whether the "real" books are accurate and how big the divergence was between the real and fake books. (By the way, if the SIPC can prove that securities held by Madoff were stolen, then account holders may be insured up to $500,000. Unfortunately the SIPC only has $1.5 billion in its insurance fund.)
If you look at the failure of Enron and WorldCom and doubtless many other investment frauds, you will notice that their ability to create fake financial statements kept the companies afloat for longer than they should have been. If a fraudster borrows money, eventually their inability to pay it back exposes their deception. In Madoff's case, he had borrowed from investors (and possibly $33 billion from banks as well) -- so when investors demanded $7 billion back in the last few weeks, the jig was up.
So eventually these criminals get found out -- but at a very high cost to society. But the goal of public policy should be to keep these fraudsters from getting off the ground in the first place. If their thievery can be nipped in the bud, its costs will be much lower. And the way to do that is to take away their ability to write their own report cards by creating an independent group that creates financial statements.
Then we can shrink financial fraud to the point where, to paraphrase Grover Norquist, we can drown it in the bathtub.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College and edits and edits The Cohan Letter.
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Reader Comments (Page 1 of 1)
12-17-2008 @ 3:41PM
BHarrison said...
Quote from article: "If you look at the failure of Enron and WorldCom and doubtless many other investment frauds, you will notice that their ability to create fake financial statements kept the companies afloat for longer than they should have been."
doesn't this provide the unequivocal PROOF of the need for a requirement for TOTALLY INDEPENDENET FINANCIAL AUDITING OF MAJOR CORPORATIONS, with requirements for the Auditors to be changed n an annual basis?
Sucha requirement would have prevented ALL of these FRAUDS in the early stages . . . cosider the costs of that versus the "costs that have been incurred by our nation as a whole". Can there be any questions about any of this.