Market View (April 2019) – Rules vs. Principles: A Talk by Andrew Fastow
by Daniel Yu, CFA®, AIF®, REDW Wealth
The CFA Society of New Mexico recently hosted a fireside chat by Andrew Fastow, the former CFO of Enron. Mr. Fastow began the time by acknowledging that what he did was wrong, unethical, and illegal. He also took full responsibility for his actions and apologized.
For the rest of his talk, however, Mr. Fastow did not focus on Enron, but rather the way we work to rationalize questionable behavior. Mr. Fastow led us through a few thought exercises that might appear to be unethical, but upon further examination and with a little more information were actually examples of routine business practices.
My personal favorite was how, with limited information, operating leases (a common and perfectly acceptable business practice) can look a great deal like off balance sheet entities (a practice frowned upon). Mr. Fastow’s point was Generally Accepted Accounting Principles (GAAP), like any complex set of rules, leaves a certain amount of gray area, and we can have a tendency to get creative inside the gray area. Additionally, we tend to rationalize and justify our so-called creativity as we work to achieve our goals.
Another example he gave was as follows: he met a group of students at a well-known university. He asked them what should be done if a scientist in the university’s health sciences department developed a new performance-enhancing drug that would guarantee their team would win a national title, but not harm the members of the football team and was not on any banned substance list.
A large majority of the students believed it would be fine for the team to use the new drug. The rationalizations went from “It is not on the list” to “If our team won a national title, it would bring a great deal of money into the school. Some of that money would probably find its way to the health sciences department, and they might find a cure for cancer. It would be a good thing for the team to use the new drug.”
That process of rationalization was at the heart of Mr. Fastow’s talk. We have to decide between if an action is allowed (there is no rule against it) vs. should it be done. We have to decide between the right to do and doing what is right. Given the gray areas of GAAP, we have to possess a set of ethics that will maintain the integrity of the entire system.
What does this discussion of ethics have to do with investing and the capital markets? In a sense, everything. Despite all the myriad rules, regulations and regulators, to a large degree the capital markets involve trust. We trust companies to report honestly. We trust the custodians of our assets to account for them properly. Of course, we have rules, regulations and regulators to safeguard and bolster trust; however, ethics are the first and best safeguard of trust. We must understand that following the letter of the law is not sufficient (Rules); we must follow the spirit of the law to be truly ethical (Principles).
In a follow-up conversation with Mr. Fastow, I asked if he had any advice to help business leaders navigate the gray areas of GAAP. His answer was, “Would you make this same decision if this were a private company that you owned, with your family’s name on the side of the building, and that you intended to leave to your grandchildren?” Sage advice.
All of us at REDW Wealth are committed to maintaining and even strengthening the trust you have placed in us. In future Market Views we will explore other ways ethics and investing intersect and dive deeper into how rationalization and confirmation bias affect our investing.
Quarter in Review
In the fourth quarter of 2018, fears of economic slowdown led to a general decline in equity prices, more than erasing the gains during the earlier part of the year. However, those fears subsided and equity markets staged a strong comeback in the first quarter of 2019.
While economic growth expectations for 2019 are generally lower than in 2018, we do not see a recession as imminent. Rates continue to be accommodative, and taxes and regulation are steady from last year. Global trade did slow in the first quarter, and it is an area of concern for us. However, we continue to believe the administration uses tariffs as negotiating tools. Housing is also an area that we watch for ongoing weakness.
Overall, the data points to a slowdown in 2019 and not a recession. We will continue to watch and send out updates as needed.
Copyright 2019 REDW Wealth, LLC. All Rights Reserved. This publication is intended for general informational purposes only and should not be construed as investment, financial, tax, or legal advice.