CEOs Run Around the Enron Rule

Remember when the heads of CEOs were supposed to roll when things went sour at their companies?

A key part of the Sarbanes-Oxley law enacted to stop future scandals like Enron and WorldCom was that chief executives had to personally certify that all was kosher on their books. The law was designed to prevent a Sgt. Schultz "I know nothing" defense and make top execs personally responsible for the wrongdoing of everyone at their companies.

That should make folks like Jon Corzine and even, to a lesser degree, Jamie Dimon quake in their boots, right?

Not really.

Turns out there are so many loopholes that market regulators don't even bother trying to hold execs accountable under Sarbox anymore. Which is why the permanent DC rules factory now at full tilt will likely be ignored in the future, as executives continue to do an end run around the rules.

The U.S. government moved quickly after Enron, WorldCom and other companies blew up in accounting scandals where executives had inflated their earnings to pad their pay, scandals which cost investors billions of dollars and rocked public confidence in U.S. markets.

Congress passed and President George W. Bush signed into law the Sarbanes-Oxley Act in 2002, named after co-sponsors U.S. Senator Paul Sarbanes (D-MD) and U.S. Representative Michael G. Oxley (R-OH).

Countries like India, Italy, Japan, Germany, France, Australia, even South Africa, and Turkey passed their own Sarbox-type laws.

I covered these U.S. scandals, as well as the enactment of this new law. It was supposed to clean up U.S. markets and stop future scandals dead in their tracks (a year before WorldCom blew up, Bernie Ebbers blasted my criticisms of WorldCom’s accounting in columns at Forbes magazine).

In rather medieval fashion, section 302 of the new law forces chief executives and chief financial officers to literally sign their financial reports, stating in words to the effect that “they are responsible for the accuracy, integrity and fair representation of published financial statements,” and that their books follow U.S. accounting rules.

Section 404 also forces executives to sign off on the accuracy and adequacy of their company’s internal controls over their financial reporting.

If executives fail to comply with this law in any way, penalties range from the loss of exchange listings to loss of directors and officers insurance to multimillion dollar fines and even imprisonment.

But will executives ever have their feet held to the fire here? Not likely. Watch the loopholes at play at JPMorgan Chase (NYSE:JPM) as an example.

Set aside the lame argument that says the recent bad bets made by the bank were “economic hedges” or talk of the “hedginess” of the derivatives costing the bank more than $2 billion in losses, and counting.

“There are no accounting line items under U.S. generally accepted accounting rules for ‘economic hedges.’ They have no meaning whatsoever under U.S. GAAP,” a Big Six accounting executive says. “These items are booked as trading losses.”

Why else are these investments not “hedges”?

The bank’s Chief Investment Office, where these losses occurred, raked in over 25% of the bank’s profit last year. Under accounting rules, derivative positions taken by the CIO are booked as “available for sale” investments, meaning they can be dumped at any time. The very definition of a trade.

Moreover, the “economic hedges” JPMorgan made, credit default swaps, have to be marked to market each quarter as available for sale securities. The bank used these “investments” to provide liquidity protection for bank depositors.

Marked to market means the bank has to adjust the valuation of these securities to reflect current market values and take the earnings hit. If JPMorgan made loans here instead, they are booked as held to maturity. Meaning, the bank doesn’t have to value them each quarter and sluice them through their quarterly profit figures. They go to the balance sheet in shareholders equity.

The problem here: Banks argue that because they can profit off of swaps, they can then set aside lower amounts in reserves for their loans. That helps earnings, too.

A rose is a rose is a rose -- and a hedge is a hedge is a hedge. And a trading loss is a trading loss is a trading loss under U.S. accounting rules.

A JPMorgan spokeswoman declined comment.

All of this is a debate about the Volcker rule, named after former Federal Reserve chairman Paul Volcker, who had pushed the White House and Congress to stop any bank getting federal deposit insurance from engaging in speculative investing (proprietary trading), that does not benefit their customers.

Banks are already blowing wide open loopholes in this rule by dubbing any trading “hedging,” and blowing smoke in the media and D.C. about these “hedges.”

But more important to this debate is this: Jamie Dimon and his CFO signed off on books loaded with the bank’s own end runs -- the brilliant Sarbox expert Michael Crimmins has red flagged this.

JPMorgan’s filings with the Securities and Exchange Commission first says everything is kosher:“Based upon the assessment performed, management concluded that as of December 31, 2011, JPMorgan Chase’s internal control over financial reporting was effective based upon the COSO criteria. Additionally, based upon management’s assessment, the Firm determined that there were no material weaknesses in its internal control over financial reporting as of December 31, 2011." (COSO refers to the Committee of Sponsoring Organization of the Treadway Commission, and is essentially a framework for corporate governance.)

But dig deeper into JPM’s filing, and you’ll see this end run around the Sarbox rule -- all still within the letter of disclosure rules:

“Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate."

So why have the Sarbox law at all?