Re:Balance -- Jim Peterson

Teed Off at Bernard Madoff? His Character was Provable on the Golf Course

Bernard Madoff was observably crooked, and his long-running swindle could easily have been stopped, early on. Except that those in the know either didn’t care, or had their own interests to be served.

Calling a halt to his scheming did not require a wake-up call at the soporific SEC, so thoroughly outed after the fact by whistle-blower Harry Markopolis, or performance of the due diligence that the feeder funds promised their customers, for which they and their gatekeepers will now pay the litigation cost.

Instead, it was as simple as the questionable honesty of Madoff’s golf game – and the mutually corrupted readiness of his country-club set of investors to subvert the integrity of that ancient sport.

Deep in “Madoff’s World,” Mark Seal’s delicious piece in the April edition of Vanity Fair, Seal observes that in the catalog of Madoff’s obsessive-compulsive mannerisms, his golf game was as tightly managed as the rest of his life. He quotes Donald Trump: “Out of hundreds and hundreds of rounds, he never shot lower than 80 or more than 89.”

Although the Donald may not top everyone’s list of character witnesses, there’s an unmistakable clue to Madoff in his throwaway line, “Experts say he’s either the most consistent golfer in the world or he’s cheating.”

In golf as in most other endeavors, whether recreational or professional, there is simply no way to avoid the occasional bad day. A weekend duffer with no hope of approaching par will still have the rare round where the gods smile, drives are straight and every putt drops. Still, there are two tails to every bell curve. Symmetry teaches that there are days when the sand traps eat up approach shots and the cup seems to have a lid – and an honest scorecard shows it.

So the only way Madoff could have shown his reputed consistency would have been through all the available manipulative devices: improved lies, do-over shots and disregard of the whiffs and the penalties for landings in the water.

Golf being an activity where integrity relies crucially on self-reporting, that brings up the role of Madoff’s interested enablers -- the playing partners who would have seen his doubtful conduct in the bunkers and on the greens – but who if they called him, stood to lose their privileged access as early beneficiaries of his Ponzi scheme.   

Regular readers know that I have neither aptitude nor appetite for golf (here), choosing instead to keep the game safer for everyone by staying in the clubhouse. For its culture and protocols I rely on my friend Joe, who played scratch in college and still posts a handicap in the single digits.

He tells of a now-retired professional athlete of epic dimensions, who receives a guest's celebrity welcome on courses worldwide, but who will never be invited into serious club membership – because he is known to fiddle his scores, stiff his caddies and welsh on his bets.

That measure of the seriousness with which the game’s code is taken, and the apt phrase from the fractured Latin of the law schools – falsus in unum, falsus in omnibus – point the finger of accountability at Madoff’s companions. Facing the disrepute of Madoff’s violations, they evidently elected to accommodate their source, lest the promised stream of their investment returns be closed off.

Joe taught me that the dour Scots who invented the game called it “golf” because the more pungent four-letter words were already taken – “hell” or “damn” or the stronger alternatives, muttered or shouted in exasperation at the shanked drive or the malignly placed tree branch.

Would that Madoff’s blind-eyed followers had had the honesty to call “foul.”

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Survival of the Large Accounting Firms -- You Wanna Bet?

How confident are you in what you think you know? How certain that the facts underlying your belief are fixed and unchanging?

A renowned food writer was dining on the bouillabaisse in a storied Marseilles restaurant. In a dazzling flash of cutlery at tableside, the server expertly beheaded, skinned and de-boned the platter of cooked fish for addition to the classic soup.

In response to the writer’s extravagant praise for her display of elegance and precision, the server was understated. “Madam, I’ve been doing this for thirty years,” she said. “Every night, the bones are in the same place.”

Not so, elsewhere. I was recently challenged to a non-trivial wager, by a highly placed member of senior management of a Big Four accounting firm. He is prepared to take the other side of this proposition, that the Big Four’s days are numbered:

“Within five years -- by March of 2014 --  one (or more) of the Big Four will have incurred an event because of which its network will be unable to provide a single report on the consolidated financial statements of a significant number of its large global clients.

“This event could be a civil litigation impact, prosecution or other law enforcement action, professional regulatory sanction, voluntary or strategic withdrawal in one or more key countries, or some other event the identity of which cannot be known today.”

A lot is certain to happen in the next five years. Not least, we should both hope to be around for the reckoning. And my side of the bet should be seen as a modest hedge against my firm belief that – whatever its problems and shortcomings (see here and here) – a worthy profession and those relying on it deserve a better fate than its disintegration into ignominy or irrelevance.

Still, we are at a legitimate standoff. He views me as academic and naïve, detached from the “reality” of the capacity for change in the market for professional services. I in turn view him as operating under several types of bias, of the type I explore in my MBA students’ Risk Management course.

With access to both a classroom and this platform, I have the advocate’s advantage:

First, with his optimism about the stability of the Big Four’s audit franchise that I only wish I could share, my friend shows the “proximity” bias of a handsome compensation package and regular paychecks that are, for the moment, accepted at financial institutions worldwide.

Second, he has the common “induction” bias that over-values what he knows, minimizing the credible likelihood of a disruptive unknown. He reasons that because it hasn’t happened before – that large-company assurance has become unavailable – therefore it won’t happen in the foreseeable future.

Third and closely related, he rationalizes as proof of the Big Four’s stability that it has survived the last decade’s close calls and danger signals. His conclusions of strength -- despite the 5-to-4 shrinkage after Andersen’s collapse, KPMG’s avoiding a tax-shelter indictment, and PwC’s near-death experience in Japan -- resemble the tragically optimistic rationalizations of NASA management, that the Challenger and Columbia shuttles were safe to fly, despite the prior evidence of O-ring burn-through or insulation impact damage.

Fourth, a typical “hindsight” bias in any projection is to minimize conditions changed for the worse. In evaluating the Big Four’s ability to survive, past experience should in fairness be adjusted for the steady escalation in claim and settlement amounts, the collapse all around of major institutions once thought invincible (all involving Big Four clients, incidentally), and an atmosphere of public hostility to both corporate malefactors and their proximate watch-dogs.

I am in this dialog wrongly charged as being the pessimist whose dour predictions, over enough time, will be proved right.

Like the server in the restaurant, I demur – not saying that Big Four collapse must necessarily happen, but that the prospects that it may are likely enough that deliberate, explicit attention and consideration are required.    

To my MBA students, this will be a stimulating if academic exercise. Out in the profession itself, under managements’ real obligations of stewardship to safeguard four enterprises that together employ 600,000 people and have worldwide revenue exceeding $100 billion, wishful thinking is not an option.

Nor is “hope for the best” a strategy.

It is, instead, a bet I will be sad to collect.

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Another Blow to Limited Auditor Liability -- A Non-Surprise from the SEC

As reported in the on-line Financial Times for March 10 – here – the Securities and Exchange Commission has declared that financial statements are unacceptable for US purposes, where UK companies have followed that country’s recent rules permitting negotiated agreements for the proportionate liability of their auditors.

The only surprise about the SEC’s position – which effectively slams the door on the world’s only remotely influential action affecting the large auditors’ deadly litigation exposure – is that it took so long to arrive.

The British initiative was uncertain enough from the outset, but was bound to be dead on arrival. It is not just that Washington’s attitude toward British rule has been revolting since 1776. London had every reason to see the SEC’s hostility right out in broad daylight.

For as I wrote last July – here – the new UK rules were “hostage to the unremitting hostility of the SEC to any attempts to reduce unlimited auditor liability exposure, as well as the uncertain application by US judges of limits contracted under foreign laws.”

Since the 1860’s, when Mr. Deloitte himself led the Victorian-era pioneers of independent audit in fighting off potential government take-over of their newly defined function, the principle has been established that auditor engagement and payment directly by clients were acceptable.

Despite endless futile debates since, no intellectually certain or solid basis has emerged upon which to measure the elusive and ever-shifting “appearance” of impaired independence (see here). So the SEC’s passionate history of opposition to auditor liability limits is matched only by its irrationality.

Which should be a signal to the stiff upper lips in London, whose fallback proposal is to seek the same package via British legislation: Forget it. Fold the hand.

Because the SEC is not about to accept limitation agreements, even in the doubtful case that the UK profession might succeed in shepherding an enabling law through Parliament, it is an immovable opponent. So move on to something productive.

Trans-Atlantic struggles over conflicting regulatory schemes are the common stuff of impasse. Look only at the state of extra-territorial examinations by the Public Company Accounting Oversight Board, still close to immobilized, nearly seven years after the passage of Sarbanes/Oxley, by cross-border conflicts over secrecy laws and client confidentiality. Or listen to the inflamed rhetoric with which UBS is opposing the identity disclosure of 25,000 of its clients – banking secrecy being one of the few topics to arouse observable dudgeon among the phlegmatic Swiss, even with the early signs of reluctant easing.

More importantly, even a UK “success” would be hollow. Proportionate auditor liability – along with its companion, monetary liability caps – are both politically unachievable in the US and, in any event, are ineffectual to solve the fundamental problem, namely the crying fragility of the auditors’ financial capacity to answer litigation claims of death-blow magnitude.

The capital structure of the Big Four partners can be calculated to have upper limits on a worst big case of under $2 billion – here. Yet the size of the recent failures that embroil the auditors extend from the Lehman Brothers bankruptcy, where with $635 billion of assets there is an estimated quarter-trillion dollar recovery shortfall, to the ever-shifting $50 or $67 billion involving the feeder funds to now-jailed Bernard Madoff – and lists of other claims, complex to maintain but readily accessible (here). 

With those numbers over-hanging, no reasonable Big Four chief executive could with confidence send a team of trial lawyers into court, with the life of his firm in their hands, but depending for survival on achieving a jury’s fault allocation at a percentage in the low single digits.

So – taking note of the dictionary definition of a chimera as “an impossible or foolish fancy” – the SEC’s entrenched if churlish animosity should inspire the large audit firms to re-deploy the well intentioned but misdirected resources they have devoted to this futile exercise.

For the large firms, “liability caps” is a losing position – whether as skirmish, battle or campaign. Better to select a ground for change on which there is some non-zero possibility for success.  

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Where Else Does Size Matter? Audit Firms, and the Experience in India

Suppose a law that limited the height of professional basketball players to six feet. Or that forbade the performance of Beethoven’s symphonies by groups of musicians larger than a trio.

However able the players, the performance quality would be inferior. Discerning customers would flee in multitudes, for venues freely offering the unrestricted alternatives.

Independent audit has evolved a great deal since the winter of 1850, when sole practitioner William Welch Deloitte delivered his first opinion on the financial statements of the Great Western Railway.

Today the surviving Big Four – Mr. Deloitte’s namesake, along with Ernst & Young, KPMG and PricewaterhouseCoopers – collectively comprise some 593,000 personnel, and have worldwide annual turnover of $103 billion. The foursome together have a lock on engagements for global-scale companies in the developed economies – doing the audits, for example, of all but a handful of the S&P 500 in the United States, all of the FTSE 100 in the United Kingdom, and (with the involvement of some smaller firms as joint auditors) all of the CAC 40 in France.

Ample justifications are offered – scale, technical expertise, cross-border client demands, and uniformity of standardized practices being the usual rationales. On the other side, careful risk managers at the smaller networks are ready to concede this high-risk territory to their larger brethren, competing at levels where complexity and exposure are, optimistically, more manageable.

There being no cogent case that the smaller audit firms deliver better quality than the larger, an argument in favor of scale lies in the recent disasters: critics of the still-emerging schemes of Bernard Madoff and Allan Stanford are quick to point out that each employed tiny audit firms, lacking visible signs of personnel or qualifications, or indeed even appropriate licensing compliance.

Still, vestiges of the Victorian era of Mr. Deloitte’s start-up do survive in the profession’s structure and attitudes. The visible current example is in India, where the governing rhetoric is dominated by the small firms’ unexcepted hostility to the Big Four – even ahead of this winter’s demonization of PwC over the $1 billion debacle at Satyam Computer Services Ltd.

As a legacy of an earlier and simpler provincial time, audit firms in India have been capped at no more than 20 partners, each allowed to sign no more than 30 reports. All very well, for an economy comprising thousands of store-front enterprises – served in India by as many as 45,000 little accounting practices. But hardly does this suit the demands of global-scale enterprises, where even the members of the so-called “second tier” continue to lose market share to the largest networks.

Overseers of the profession, including the Institute of Chartered Accountants in India and the Ministry of Public Affairs – with the combination of bombast and naïveté that is characteristic of officials extended beyond their vision or their competence – have responded to Satyam with a variety of retrograde proposals, including mandatory rotation of audit firms and a blacklist for firms under investigation -- see here, here and here – also scrutinizing such superficialities as the firms’ policies on paid leave and Institute seminars.

The first of these is already discredited by the example in Italy – the only developed country with experience. There, mandatory rotation only increased the Big Four’s market concentration, and the consequent division of responsibility between Grants and Deloitte arguably contributed to the on-going misbehavior at Parmalat.

And if the punishment of a blacklist were applied ahead of the conclusion and final judgment of appropriate enforcement proceedings, it would only perpetuate the lack of due process manifest in the continued imprisonment of the still-uncharged and presumably innocent Satyam engagement partners from Price Waterhouse.

As well observed in the natural sciences, evolution is a force that will not be stopped. It can only be diverted or stalled temporarily – through artificial means, political resistance or subsidies and expediencies.

Still, the trend to large-company auditor concentration has been inexorable for decades elsewhere, and is already well on display in India: at last available count, of the 300 largest corporate enterprises not under Indian state control, 178 were audited by a Big Four firm (of which 24 included a smaller firm along for the ride as joint auditor).

The lessons of Madoff and Stanford speak loudly to the credibility of small-shop audits for large-scale situations. “Small is beautiful” cannot be established by the claim that sometimes “large may be ugly.” Those positioned to shape the future of the profession in India will eventually be obliged to take heed.

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Bernard Madoff -- Traitorous Villain or American Hero?

Last night I was with a friend just back from Boca Raton, Florida – essentially “ground zero” for the devastation wrought by Bernard Madoff.

Our subject was the uncertain reaction of an average citizen – suffering job uncertainty, equity erosion in the family home, and dissolving prospects of a comfortable retirement – at the plight of a late-arriving Madoff client, who in exchange for eager admission to his inner circle has seen a drop in net worth from, say, $10 million to $2 million. 

In this context another friend, the major options trader, intends to be taken seriously, I believe, in his position that Bernard Madoff should really be viewed as a modern hero.

In this view, instead of being vilified as the avatar of rapacity for his alleged $50 billion looting of endowment and retirement funds around the world, and hounded in his every ankle-braceleted step from “house arrest” in his luxury New York flat to the courthouse and back, Madoff should be recognized for his contributions to both the prosperity and the practices of the investment community.

This is according to Paul Bachow, who runs an options-volatility based hedge fund, and who has these four arguments:

First, since the inflows from Madoff’s overly-trusting clients to his apparently fictitious operation are estimated at about $17 billion, the forensic investigators are looking for some $33 billion of reported ordinary gains. Much of that will have accrued to the benefit of universities, museums and other tax-exempt organizations, but the rest will be ordinary taxable income, subject to the highest federal income tax rates.

The stream of payments by wealthy investors to the US Treasury and similar tax collectors elsewhere will have been considerable, conceivably well in excess of $10 billion. That’s assuming of course the appropriate compliance by those affected – which might, come to think of it and depending on the country and the culture, be something of a stretch. At a time when the government’s budget in America has plunged from surplus to record-breaking deficit, this support from citizens at the top of the pyramid of wealth and celebrity represents a real – if perhaps inadvertent – exercise in civic generosity.

Second, money managers using options strategies were challenged for years to achieve Madoff’s apparent results based on his “split strike conversion” strategy. PhD quants and Noble Prize winners for 30 years have focused their attention on options pricing and trading, but the best mathematical minds in the world were unable to replicate Madoff’s performance.  Madoff embarrassed and challenged them to improve their fancy models, re-setting the industry’s performance bar for improved options mathematics and trading systems.

Third, Madoff can be seen as a type of upper-end Robin Hood, taking large amounts of capital from the very rich and re-distributing it down to the merely well-to-do. These would include deserving retirees and charities in need of stable income streams -- insomniac over the level of their assumed investment risk, but enabled by Madoff to sleep at night as if invested in US Treasuries.

Although, for those bearing big-dollar investment responsibilities, the notion of “sleeping like a baby” in recent times had meant curling up in a fetal position, clutching a well-worn blanket and sucking a thumb while whimpering off to dreamland.

To be sure, those obtaining late-days admittance to Madoff’s peculiarly exclusive circle of the credulous had the shortest ride before the crash – an inevitability in the world of Ponzi schemes where only the early entrants prosper. But still, the re-distribution process is far from over: days of reckoning await for Madoff’s feeder funds and their auditors and advisors – witness the outstanding settlement offers to ameliorate the pain of customers on behalf of Bank Santander, the National Bank of Kuwait and French asset manager Meeschaert Gestion Privé.

The associated transaction costs will now go not to Madoff himself, but into the pockets of the plaintiffs’ lawyers driving the litigation process, it’s true – but job stimulus packages are now the order of the day – so herewith some more change to believe in.

Last and back where we started, it does ask a lot of most of the population – struggling from one paycheck to the next to pay the mortgage and the credit cards and the tuition and the health premiums – to drum up much sympathy for society’s elites – celebrities and foundations and high-income earners. Those who evidently checked their skepticism at the country club door, in violation of basic tenets ranging from asset diversification to fiduciary due diligence, stand as symbols for the salutary opportunity to learn from large-scale failure.

‘Twas ever thus: If it weren’t for an iceberg, maritime architects would have continued to build ocean liners with the fatal design flaws of the Titanic. Because of the tragedy of 9/11, the structural defects of the Twin Towers will never be replicated.

And maybe – just maybe – at least for the short period that collective investor memory will retain the impact of Madoff’s predations, some lessons will sink in, so to make a recurrence less likely.

At the very least, the academicians – whose after-the-fact scrutiny of the malign effects of herd-like behavior has done nothing to relieve its periodic outbreaks – have a large and flagrant example with which to fill their journals.

For all that, Madoff may deserve a hat-tip of gratitude – a sentiment that, if not popular in Boca Raton, would be shared by the options trader – to whom my thanks for his stimulating views.

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Resource alert: This will encourage those not yet moved over to Francine McKenna’s redesigned site at Re: The Auditors to do so – still in beta version and a bit of shaking down, but it’s a powerhouse upgrade and worthy of all the passion and attention that Francine brings to her patch of turf.