Madoff shows why managers shouldn't write their own report cards

I often feel pretty stupid. One reason is that ideas that seem obvious to me make no sense to just about everyone else. This comes to mind today in reading about a well-known thief -- Bernie Madoff. It now appears that he defrauded his customers of $64.8 billion. How did he do it? He created fake financial statements for his customers -- in effect, he was grading himself.

Here's where I feel stupid -- in my 2003 book Value Leadership, which came out in the wake of Enron, I argued that companies should not write their own report cards. (I've posted about this here and here.) Instead, we should create an independent auditing group which is part of the government. These auditors would produce financial statements for companies and money managers and would be funded by taxes. As long as managers write their own report cards, fraud is inevitable. And as long as so-called independent auditors are paid by the companies they audit, there is too much of a financial incentive for them to go along with management.

How does this apply to Madoff? According to prosecutors cited by the New York Times, Madoff put together a subservient and largely untrained staff to "generate false and fraudulent documents," and Madoff "told lies and supplied false records to regulators, and shuffled hundreds of millions of dollars from bank to bank to create the illusion of active trading." In other words, he wrote his own report card every day. But of course this report card was completely false, and it helped him fool investors into giving him money.

There will always be people willing to steal money from investors. But we don't have to make it so easy for them to foment the deception that allows these criminals to steal. If the law had not allowed Madoff to operate an investment firm in which he produced customers' financial statements, he would never have gotten $64.8 billion under management.

I am too stupid to figure out why our legal system continues to allow managers to write their own report cards. Surely it would cost less than the $64.8 billion Madoff took from investors to create an independent group to produce financial statements. And many companies and money managers would probably end up paying less for generating financial reports if all that activity -- which should not be the core business of any company but was in Madoff's case -- was performed by an independent government group.

Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College and is the author of You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing.

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