Peeling away financial reporting issues one layer at a time

High “Power Distance” at the SEC: Why Madoff Was Allowed to Take Investors Down with Him

Ever since I read Malcom Gladwell's acclaimed new book, Outliers: The Story of Success, I have been thinking about its many policy implications. The main message of the book is that highly successful people owe much more than one would expect to happenstance: e.g., where you are from, and even the month of the year in which you were born.

A lesser, but significant, component of Gladwell's book is explaining why people fail. Human errors that caused plane crashes supply the most compelling examples. The most prominent cases were the high frequency of crashes by Korean Airlines, and the crash of an Avianca (of Colombia) flight short of the runway at Kennedy Airport after it ran out of fuel. In both cases, Gladwell reports that researchers pinpointed cockpit communications as the critical and systemic problem; and its roots were a cultural trait known as "power distance." In the Korean Air crashes, it became evident that copilots were overly deferential to captains, even when they were clearly fatigued and their judgment was impaired. In the Avianca case, the co-pilot failed to adequately communicate the urgency of the problem to New York-based air traffic controllers, and could not bring himself to reveal all of the negative information to the pilot that he needed to know.

Power distance is one of the cultural dimensions identified by the Dutch psychologist Geert Hofstede while working for IBM in the 1960s and 1970s. He defined it as the degree to which people are willing to live with unequally distributed power. Hofstede found that Scandinavian countries and others with steeply progressive tax rates and generous government-provided social services tend to be low power distance countries, while countries with extremely uneven wealth distribution—like Colombia and to a lesser extent, South Korea—tend to be on the high end of the scale (rankings available at http://spectrum.troy.edu/~vorism/hofstede.htm).

As it happens, I co-authored a book on international financial statement analysis* prior to the ascendency of IFRS, and in the introductory part of the book we** focused on explaining differences in accounting standards among countries in terms of cultural dimensions. Power distance was, in my view, the dimension that did the best job in explaining differences in financial reporting regimes. In today's terms, we would say that high (low) power distance countries tended toward rules-based (principles-based) financial reporting systems. Although we in the U.S. may see ourselves as residing in the world's capital of egalitarianism, our power distance score is not among the lowest, ranking 16th out of 52 countries. Of the eight countries we covered in detail in our book, the U.S. was squarely in the middle in power distance ranking. We felt that the middle ranking on power distance was one good explanation as to why the U.S. may have a well-enunciated system of accounting principles, yet rules effectively predominate.

What Does This Have to Do with Bernie Madoff?

You can't read the newspapers without feeling the heat that Congress has put on the SEC staff for failing to detect Madoff's $50 billion Ponzi scheme. I discussed this question with Jim Noel, my good friend and former colleague who can challenge my viewpoints with the skill of a brain surgeon; and about a day later it occurred to me that the SEC's failure to act had a lot of similarities to the plane crash studies reviewed in Outliers.

I don't think we in the U.S. are as low a power distance society as we fashion ourselves, and the redistribution of wealth that has been occurring since the 1980s may be pushing us inexorably towards Colombia. That may be why it wasn't difficult for me to think of a few examples of where the SEC in particular has been exhibiting symptoms characteristic of a high power distance country:

  • When asked why he robbed banks, Willie Sutton simply replied, "Because that's where the money is." Lately, it seems that the SEC staff (i.e., the "co-pilots,") has shied away from the big money, out of a mirror-image version of the self-interest (survival, in case of a staff member) that motivated Mr. Sutton. And that fear is not merely paranoia, as tangibly illustrated recently when a former SEC investigator was fired after pursuing evidence that John Mack, Morgan Stanley's CEO, allegedly had committed securities fraud by tipping off another investment company about a pending merger.

  • The Christopher Cox administration instituted an unprecedented policy that required the Enforcement staff to obtain a special set of approvals from the Commission in order to assess monetary penalties as punishment for securities fraud. Mary Schapiro, the new SEC chair, claims that the policy, among other deleterious effects, "discouraged staff from arguing for a penalty in a case that might deserve a penalty…" In other words, the co-pilots were "encouraged" to keep a lid on embarrassing news that reflected badly on members of the pilot class.

  • And, lest you should not labor under any illusion that enforcement of accounting rules is a level playing field, consider the case in 1992 (I think–during the reign of George I) when the SEC effectively handed out special permission to AT&T to account for its acquisition of NCR as a "pooling of interests." Quite evidently, the SEC staff could not bring themselves to deliver the bad news to the "pilots" that the merger with NCR would not happen, just because AT&T did not technically qualify for the accounting it so sorely "needed." To put it in the stark terms of today, the merger was simply "too big to fail." (And perhaps not coincidentally, acquiring NCR proved to be one of the biggest wastes of shareholder wealth in the history of AT&T.)

So, is it any wonder why the SEC staff refused to poke Madoff, a Wall Street icon, too hard? I hope that Mary Schapiro will realize that making policy corrections to give the staff more autonomy is only the start. She must also adopt a strong leadership style that reduces the power distance between the Commission, its staff and the "pilots" of industry.

As an important first step, the SEC should change the formal and informal ways in which service accomplishments are measured, and staff members are evaluated. If you read any of the recent SEC annual reports, you cannot help but notice that any case that results in a sanction, however mild, counts for one scalp, so to speak. A basic problem blocking substantive enforcement is that the scalp of a Lilliputian counts about the same as the scalp of a Goliath, like Madoff. Too make matters worse, virtually every scalp comes from a defendant who is given the opportunity to settle with the SEC, without ever admitting or denying guilt, just so long as it consents to some sort of sanction. Sometimes, the sanction is nothing more than to agree to cease and desist from engaging in the offending behavior. 

The bottom line is that getting a Lilliput to agree to a slap on the wrist counts the same as winning a verdict against a Goliath; but in terms of real service accomplishment, the ratio should be more like 100 to 1.  Would the staff members who were handed the Madoff case on a silver platter, and turned it down, have acted differently if they knew that a conviction would win them 100 scalps?

If not, they should have, and that's where Mary Schapiro has her work cut out for her.

 

*International Financial Reporting and Analysis: a Contextual Emphasis, with Mark Haskins and Kenneth Ferris, Irwin Publishing Co., 1996 (2nd edition, 2000).

**Actually, my co-author, Mark Haskins, deserves the lion's share of the credit for this.

***Sweden, Germany, Great Britian, Italy, Japan, South Korea and Brazil were the others.

1 Comment

  1. Reply Independent Accountant February 11, 2009

    My experience with the SEC is that it is corrupt. Staffers there look for other jobs so are always “resume polishing” in deciding which entities to enforce the rules against. I do not expect that Schapiro will be better than Cox. Seeing who Schapiro selected for Enforcement Director and Chief Counsel, it seems nothing has changed.
    Cox was the worst SEC chairman I ever saw. He was worse than Pitt!

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