Victus Spiritus

As a regular on AVC.com, a few weeks ago I tuned into Fred's post and informed community comments on an act that would lower regulations on IPOs under $1 billion dollars.

While diving in to the post and comments I was reminded of a recent dinner conversation I shared with a financial wizard. When asked by yours truly about the rationale for complex rules on (mid sized) businesses he was kind enough to explain the exploitation of bad asset swaps by shell companies, and why careful regulations are needed to prevent repeats of stories like Enron.

Here Dan breaks it down in laymen's terms:

The shenanigans come from Section 404 of SOX, and the SEC rule 33-9142.

Section 404 is basically that the dudes at the top cannot claim negligence to financial shenanigans (as in "I'm not crooked, i'm just dumb"). Thats how they pulled the Enron stuff, and how just about everyone walked away without jail time.
http://www.sarbanes-oxley-101.com/SOX-404.htm

SEC rule 33-9142 exempts loads of businesses from Section 404.
http://taft.law.uc.edu/CCL/34ActRls/rule12b-2.html

The problem is that giving companies 5 years to be SOX compliant sounds very nice on paper, you are also giving some dirty mo-fos a 5 year head start. And give the SEC adjustment (passed Sep 2010, right before the election...) you can setup tiered shell companies that all fall under the exempt heading. You have to make sure to keep them in business for over a year, and keep them in line with certain incomes, but as long as you cascade them, you can shuffle forever.

2012 - start companies A, B, C, D, E. A-E reports a minimal loss.
2013 - start companies F, G, H, I , J. A-E buys all of F-J bad assets, F-J reports a minimal loss, A-E shows massive "investments"
2014 - start companies K, L, M, N, O. A-E buys all of K-O bad asssets, F-J buys all of A-E bad assets, K-O reports a minimal loss, A-J show massive "investments"
2015 - same shenanigans, just add 5 more
2016 - same shenanigans, just add 5 more

Now your reporting shows that A-E made significant investments over the past 5 years. You hold an IPO, at a moderate price, given your "investments". The sale happens, the bubble bursts, the price plummets, and everyone but you get screwed. The SEC comes calling, but since you have numerous small shells that all fall under the SEC exemption, you are not responsible to be SOX compliant. If they press the issue, you claim "I'm an idiot" and they can't pursue you, as per the SEC exemption. You walk away clean.

The above example is identical to what those guys did in 2002 that caused a need to create SOX in the first place. Problem is, everyone forgot about that, and now shenanigans are about to happen again. We just need a few years.

Granted, the intention of the laws and regulations are there. And I 100% understand the thought process. The problem is, when you allow for this kind of crap to happen, it's going to. Much like people taking advantage of welfare, unemployment, etc. The theory is good in a vacuum, but in reality it needs fixing really badly.