By Steven Pearlstein
Friday, December 15, 2006

Wonderful news!

The tough new federal regulators who were deputized to clean up the accounting industry after Enron, WorldCom and the other scandals have been busy reviewing the work and procedures of the Big Four accounting firms.

And guess what?

Everything is now hunky-dory. There's no need to worry any longer about channel stuffing, accounting for derivatives or backdating of stock options. The auditors have it covered.

We know this because not a single member of any Big Four accounting firm has been sanctioned or censured since the Public Company Accounting Oversight Board opened its doors in 2003. In fact, from what has been made public -- not much -- one might surmise that shoddy auditing has been found exclusively at a handful of small accounting firms.

Just as encouraging, the PCAOB -- "Peekaboo" to its friends in the industry -- has declared that the Big Four accounting firms have made "substantial, good-faith progress" toward fixing the systematic problems board investigators found with their internal quality controls. In fact, there's been so much progress that, under the agency's authorizing statute, no investor or corporate audit committee will know those deficiencies ever existed.

What we have here is yet another success for what is called "supervisory" or "prudential" regulation -- a concept that is all the rage these days. Rather than an antagonistic, enforcement-oriented regulatory regime that makes examples of wrongdoers and requires detailed rules, prudential regulation rests on behind-the-scenes collaboration between regulator and regulated.

Everyone's favorite model is Britain's Financial Services Authority, whose "light touch" approach to regulation is alleged to be one reason London has pulled ahead of New York as the place to list and trade stocks. In the United States, prudentialists want to bring the industry-friendly approach used by regulators at the Federal Reserve, the Commodity Futures Trading Commission and the PCAOB to the heavy-handed lawmen of the Securities and Exchange Commission.

There's only one thing wrong. It's a terrible idea.

First, as former SEC chairman Arthur Levitt and others wisely point out, there's a big difference between bank regulators, who care only about maintaining the "safety and soundness" of the financial system, and securities regulators, whose aim is to provide full disclosure, fairness and a level playing field for investors. If regulators like those at the Fed had been in charge of securities regulation, they would have lent Enron whatever it needed to avoid collapse, hushed up the investigation into financial chicanery and sent Ken Lay into a luxurious retirement.

Second, as current SEC Chairman Chris Cox explains, principles-based regulation doesn't work so well in the context of the U.S. legal system.

The theory is that regulators would set down general principles and leave it to each company to decide how to implement them, without all the thou-shalt-nots. The regulator, however, reserves the last word in deciding whether a company's actions or policies pass muster. That's the way it works in Britain, where nobody dares defy the FSA.

But in this country, as soon as some company disagreed with the regulator, it would head straight to federal court to complain about "arbitrary" and "capricious" government oversight. In truth, the business community doesn't want to get lawyers out of the regulatory process -- just the government's lawyers.

Perhaps the biggest problem with "prudential" regulation is that, by its nature, it overlooks the worst kind of abuses -- those that become so commonplace that everyone thinks they're acceptable. Recent examples range from "managing" quarterly earnings to doling out hot stock offerings to favored customers. At some level, the lawyers, the auditors and the regulators understood that they violated basic principles of fair dealing. And yet few thought to question these practices.

In the end, it took whistle-blowers and outsiders like journalists and state attorneys general to expose these abuses and force new rules. But in the closed loop of a prudential regulator system, none of that would have happened. The whole idea is to keep the heathens out and work things out behind the scenes, without lawsuits, public sanctions or disclosure of embarrassing details.

And that brings us back to the good folks at Peekaboo.

Pardon my skepticism, but I have trouble believing that, as the PCAOB asks us to believe, the Big Four have miraculously transformed their corporate cultures, pushed out the bad apples and fixed all their quality-control problems.

Could it be true? Perhaps. But as long as the PCAOB shrouds its every action involving the Big Four under a cloak of prudential secrecy, we'll never know, will we?

Steven Pearlstein can be reached atpearlsteins@washpost.com.