THE BLOG

Enron, CDOs and BP - Outsourcing Due Diligence

05/16/2010 06:40 pm ET | Updated May 25, 2011

I like process and explicit decision-making. While you can find many treatises on the academic subject of whether Congress has the authority to delegate its legislative power to regulatory agencies, there is little written about the pragmatic question: What is Congress's responsibility to the public for these agencies? The answer must be oversight.
Oversight cannot happen without a due diligence process. Due diligence is a process a buyer (or auditor) follows that a sophisticated observer (i.e., a knowledgeable practitioner in the field of interest) expects would disclose all material facts necessary for making an informed decision.

Congress, like a Board of Directors, must ensure there is a process that provides valid information upon which to make decisions. Unfortunately, Congress and we, as a Nation, keep getting it wrong. The old maxim, "Fool me once, shame on you; fool me twice, shame on me" would be an acceptable improvement over our present approach.

Let's look at three examples: Enron, Collateralized Debt Obligations (CDOs) (i.e., those pesky financial instruments that were at the heart of our latest financial collapse), and BP. From my perspective the common link is that Congress abdicated its responsibilities for oversight to organizations and agencies that were hopelessly riddled with conflicts of interest.

A major casualty of Enron's debacle was accounting firms. Accounting firms are the public's sole hope of independently certifying a company's financial status. But for years prior to Enron, industry drove down the price (and profits) for accounting services. To combat this loss of revenue, accounting firms started providing consulting services to their clients. Consulting services get a substantial premium in fees over accounting. By the time Enron occurred, consulting partners, NOT accounting partners, were controlling the profits of most big accounting firms. With that sleight of hand, independence died and with it any hope of impartiality.

We could place our latest financial disaster (e.g., CDOs) at the feet of a number of organizations: mortgage brokers, bankers, and/or Glass-Steagall. But not a single CDO would have been sold without Moody's or S&P giving the CDO a rating: No rating - no sale. The Nation (perhaps the World) had implicitly outsourced their fiduciary due diligence to the rating agencies. We can beat our chests over the stupidity of this. But clearly neither the buyers nor insurers of CDOs were conducting their own due diligence.

Rating Agencies are just like accounting firms. We rely upon rating agencies to evaluate and certify the financial strength of these monetary instruments. But these Agencies make their money from exactly the organizations they are rating: no independence. Worse, the income disparity between a Moody or S&P employee is so great as to approach the obscene. It's like a Duke stopping at a peasant's office to get a cup of water. Who is going to refuse the Duke?

BP is perhaps the most obvious and most obtuse of the three examples. BP is obvious in the sense that unlike Enron and CDOs, the risks of offshore drilling are well known. There have been 40 years of strong environmental opposition in Congress and from NGO-like organizations warning of the dangers of offshore drilling. The management of oil spills in not new. They have happened in Alaska, off the coast of France, and around the world. A rare event occurred with what can only be described as potential cataclysmic danger to the ecosystem, the economy, and the future of offshore drilling.

What is a bit obscured is the fact that the US Government and the States are financial benefactors of offshore drilling. The Department of Interior (DOI) negotiates leases and, unfortunately, DOI also oversees offshore drilling platforms. So the Agency that loves to show how much money it makes for the US is conflicted when push comes to shove on overseeing the Industry. This is an issue that President Obama has already identified and plans to correct, albeit too late for this event.

In each example the Nation allowed organizations with conflict of interests to be relied upon for independent oversight. This is the problem that Congress needs to solve. Say what you will about EPA and FDA, they at least are agencies that have demonstrated a strong adherence to the protection of the public (some might say over-protection). Congress needs to quit chest beating AFTER a problem occurs. Due diligence requires active oversight.