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Sarbanes-Oxley

April 3, 2010

I have written about control fraud here and here, so I won’t bother going into the details of it again.

This morning I read this article from Salon regarding financial reform. It provides a perfect example of a Gresham’s dynamic.

“In order to look like it could borrow $30 for every dollar of its own money, Lehman shifted liabilities off its books at the end of each quarter. Its CPA, Ernst and Young, approved of this fraud against the advice of a whistle-blower, who was fired by Lehman after alerting Ernst and Young.”

First, Lehman fired its employee not because he tipped off Ernst and Young, but because his actions showed that he was not willing to participate in the control fraud. Lehman has set up an environment in which it will only employ workers willing to go along with the control fraud.

Second, Ersnt and Young continued to engage in the control fraud even after they were tipped off by the Lehman employee because Lehman would have fired Ernst and Young as its CPA and hire one that would be willing to overlook these accounting “mistakes.”

The author of the article writes that the Securities and Exchange Committee (SEC) needs to enforce the Sarbanes-Oxley Act that “requires CEOs and other senior executives to take personal responsibility for the accuracy and completeness of their companies’ financial reports and to set up internal controls to assure the accuracy and completeness of the reports.”

The reason why Sarbanes-Oxley is important is because often times it is the CEO of a company that engages in the control fraud.

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