Re:Balance -- Jim Peterson

Michael Jackson: Please Get Off the Stage

A diversion from the usual topics -- because Saturday we had the privilege again to hear the exquisite Diana Krall in live performance – maturing and better with each tour.

Unannounced, in the middle of the set, came a sonorous and dirge-like instrumental of “I’ll Be There” – a touching tribute to the late Michael Jackson, and a rare example of taste and restraint in this post-death period of media-driven frenzy.  

It may be churlish to suggest – in a time when the world’s adult challenges include on-going violence and epochal turmoil in the Middle East, financial dislocation around the globe, and political opportunities not seen for a generation in America – that the editors and producers of the channels of news should get over and beyond their voyeuristic fixation with Jackson, and get back to serious business.

All this is for what? The Neverland comparison does a disservice to Peter Pan – who exercised leadership and earned loyalty from his band of boys without drugs, inducements or molestation charges – and who faced pirates as adversaries rather than hiring them as a squad of goons and hangers-on.

The better comparison is with Benjamin Button, the eponymous, reverse-aging hero in Scott Fitzgerald’s story: Brad Pitt in the movie – manifest by Jackson in life, first as the boychild performing grown-up choreography and adult lyrics, who then did not mature but aged instead into adolescent behavior and infantile judgments.

And if there were virtue or ennobling in the pitiable story's end, wrought by physical and emotional family violence and indulgently enabled substance abuse, it would be no more for a talented escapee from the underclass shacks of Gary, Indiana, than for the less fortunate multitudes who suffer and die of the same causes without escaping those oppressive venues.

As for the career. Somewhere at least, there was surely business genius in securing control over the Beatles’ songbook. Less clear is the weight of all that against decades of profligacy and waste.

I plead a generational gap that impedes my “getting it” on Jackson’s music. Under the blazing arc at the end of the ‘60’s that extended from the Beatles and the Rolling Stones across the Atlantic to the post-Woodstock generation, the Jackson Five looked to be a bubble-gum machine, engineered to prop up Berry Gordy’s Motown after the best years of Smokey Robinson, Diana Ross, Stevie Wonder and Marvin Gaye.

In that context, even “Thriller” had its weirder side, foreshadowing – but who knew – the Wacko Jacko to come.

Members of a news-deprived minority who would plead “enough” will have their own candidates for the moments of gag-me excess in this week’s saturation coverage. My own -- so far -- is the self-promoting sycophancy of Larry King’s photo op with Jackson – reminiscent of Richard Nixon’s nausea-inducing drape over the slight but accommodating shoulders of Sammy Davis, Jr.

Relief, for God’s sake! There are serious and real subjects to address. This is, not least, the week we are to learn the sentence to be given to Bernie Madoff. Let’s keep things in perspective.

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BDO's Liability for the Bankest Verdict Against Seidman: Whose Side to Take?

Ham-and-eggs for breakfast? To the hen, the choice is a matter of interest. To the pig, it’s life or death.

On the complexities of auditor liability and accounting firm survival, a reader last week had a subtle question. It concerned the Miami state court outcome in the Bankest litigation – where the BDO international firm was held not liable for any part of the $521 million jury verdict imposed in June 2007 against its US component, the Seidman accounting firm.

For the American partners of Seidman, the dispute now moves to its penultimate phases of appeal and possible enforcement of ruinous damages -- $170 million plus an additional punitive assessment of $351 million -- with this question:

As interested spectators of the trial just ended, which sought to hold BDO liable along with the Seidman firm, which side would they have been rooting for?

That is, facing financial devastation (for the calculations, see the Note below) – would they have preferred that their international brethren be put under judicial fiat to share their pain? Or are they better off standing alone – facing ruin, and hoping to rely on the strength of their network and the readiness of their colleagues to provide succor on the basis only of network agreements and business solidarity?

And in the end, will it matter? 

Those whose work is with the assessment and management of disputes look with envy on their counterparts who deal with allocating good and positive economic outcomes. Business lawyers, for example, thrive on the deals and contracts that include mutually shared profits, repeat business with counter-parties and the nurturing of on-going relationships.

The supporting literature of game theory and decision strategy offers exquisite exercises in dividing the results of negotiations -- heavily biased toward optimistic scenarios. Case studies on shared outcomes focus on happy conditions: the division between two strangers who find a wallet full of money, or how and whether to share the pay-off of a winning lottery ticket received as a gift.

The outcomes under dispute scenarios go the other way: typically they are zero-sum between one-time antagonists; lawsuits involve wasting assets and the steady bleeding of costs, legal fees and business pressures.

And the impositions of shared punishments or detriments are not the subject of useful scrutiny: litigation lawyers suffer the scholars who default to the platitudes of “re-framing for a ‘win-win’,” or “finding a way to ‘yes’.”

The real world doesn’t work that way. In the Bankest case, the impending next steps include the plaintiff’s pursuit of finality and collection of a half-billion dollars, the challenged viability of BDO as an international enterprise and the careers of its several thousand professionals, and – considering that Bankest is only a smaller version of the much bigger cases hanging over the Big Four – a clarion warning on the survivability of privately provided, large-company audit services.

Either way – whether BDO was formally held liable or not -- the final chapter for Seidman and BDO is ominous. The collapse of the Andersen network in 2002, within weeks of the indictment of its US firm – through the flight of clients, partners, personnel and the international entities – showed the fragility of the wealthiest and most cohesive of the large accounting structures.

Just as Andersen’s ex-US practices voted their local interests with their feet, it remains to be seen how the business and integrity of the BDO network could withstand the drain needed to sustain its vital US member firm.

And whether a Miami court judgment might affect BDO’s strategic choice between its own disintegration and collapse, and massive sacrifice for the sake of its US member firm, will be a matter not of legal enforceability but of corporate behavioral psychology at the highest level.

The graduate students in my MBA class on risk management and decision-making are always in need of good assignments. As the Seidman/BDO dynamic plays along, it will provide a rich if depressing study.

Please let me know – for whom would you have cheered, and why?  

Note: A model to calculate how big a “litigation hit” would disintegrate a large accounting firm was done by a UK consultancy for EU Markets Commissioner Charlie McCreevy – here. I have applied it to the Big Four’s American and global practices – here and here. The topic is anathema to the large firms, but they have not voiced public disagreement with either the approach or the frighteningly small numbers.

Based on Seidman’s reported 2008 revenue of $ 659 million and the BDO networks’ global figure of $ 5,145 million, the model indicates breakup thresholds of around $ 100 million for the US firm of Seidman on its own, and perhaps $ 750 million for the BDO network as a whole. Look on the Bankest verdict at $521 million – and despair.

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Future Directions for Accounting and Audit: Can Anyone Get There From Here?

   

Recall the frustrated Irish villager, trying to direct a befuddled tourist toward Dublin:

        “If I was to be going there, I wouldn’t be starting from here at all.”

Last week came the news that Mark Olson is resigning as chairman of the American audit regulator, the Public Company Accounting Review Board.

Timely of Olson. He paddles away from a leaking ship, likely to be scuttled next year by a predictable Supreme Court ruling that the agency’s basic authorization under Sarbanes/Oxley back in 2002 was constitutionally flawed.

Also: Paul Boyle is departing as chief executive of the Financial Reporting Council, the United Kingdom’s audit regulator. Charlie McCreevy’s time is shortening as EU Markets Commissioner, whence comes what passes in Brussels for guidance on the topic. And Mary Schapiro and her crew of SEC newbies are fully pre-occupied with agency rehabilitation.

Along with the turn-over in all these seats, Treasury Secretary Tim Geithner this week may propose a “council of regulators” whose inevitable internecine squabbling will dilute even further the alphabet soup of American financial oversight.

So this long-pending question takes on renewed freshness:

Where is the leadership with the focus, vision and stature to bring about the fundamental and necessary re-structuring of both financial reporting and the related assurance – existing models having proved so ineffectual in the global financial crisis?

For dismal context, all this shuffling comes while a death-watch gathers around the continuing Bankest trial in Miami. There, a looming $ 522 million liability threatens to drop the final curtain on both the Seidman firm and BDO, its global network – here – proof to come that the mantra of “too big to fail” has no application to the large private accounting networks.

The likely legislative reconstruction in 2010 of a freshly-authorized PCAOB will present a one-time opportunity to write on a blank page, especially if Seidman has by then been hauled off to the knackers' yard. But the prospects are grim for grown-up guidance or perspective.

Certainly not from government. William McDonough, Olson’s predecessor at the PCAOB, left office in 2005 with the candid if pessimistic concession that “None of us (regulators) has a clue what to do if one of the Big Four failed”-- here. Four years on, and no clues have been revealed -- nothing has changed.

And as discussed almost a year ago – see here and here -- the gathering of talent known as the Treasury Department’s Advisory Committee on the Auditing Profession, convened by then-secretary Henry Paulson, limped into oblivion -- without managing even to agree that privately-provided large-company audits faced a serious threat to survivability, much less offering any hint of a blueprint for an achievable future.

Nor are there signs of life in the Big Four executive suites, where a managing partner would be deposed by immediate revolt for daring to propose serious change to the current model, creaky and obsolete as it is.

And the lobbying muscles flexed by issuing companies, over such contentions as mark-to-market and GAAP/IFRS convergence, have shown their allegiance to the status quo – preferring diminished transparency and reduced user value as the trade-off for their own control and dominance over the reporting and standard-setting process. 

The essential elements of a functional financial information regulatory structure are in principle not so complex:

•    Sufficiency of input to the setting of accounting and reporting standards.

•    Licensing and oversight of the audit function by which assurance is delivered.

•    Investigative and enforcement resources for the level of detection, prevention and deterrence of irregularity that society is prepared to pay for.

•    Finally, a last-resort structure for investor protection to supplant a liability regime that has run beyond the limits of sustainability.

Unhappily, the incremental nature of government evolution – including the certainty that the first priority for any agency is its own self-renewal and perpetuation – means there is only one true blank page: if the slate were wiped clean by the collapse of the Big Four networks and their consequential elimination as the only available source for large-company audit delivery.

That highly disruptive scenario is not one that any reasonable participant in the dialog could want or wish for.

But how else, the ominous question remains hanging, is a guiding force to come forth – one to map a future reachable by intelligent public exploration, discourse, negotiation and agreement?

As in the Irish village, there is no choice but to start from here. 

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The Old Is New Again, Part II -- Accounting Scams Pose Risks to Sharia Finance

When a felon's not engaged in his employment
Or maturing his felonious little plans
His capacity for innocent enjoyment
Is just as great as any honest man's.

 -- Gilbert & Sullivan, “Pirates of Penzance”

When I wrote recently of the likely recurrence of old-fashioned accounting scams – here – based on non-existent assets and fictitious transactions, I promised to put up my own candidate as the sector ripe for eruption.

It’s this: the already huge and rapidly growing market for financial products and services based on Islamic law – Sharia – which is closing in on $1 trillion in size, targeted at Muslim customers comprising one-fifth of the world’s population, and predicted to expand at ten to twenty percent a year (here, here).

It can be safely predicted that market pressures, competitive greed and misaligned incentives will breed scandals in Sharia-based finance – going well beyond the large if simple issues of non-performance already seen in the suspension of debt payments by Kuwait’s Investment Dar as majority holder in carmaker Aston Martin, and the missed debt payments and cross-defaults of Global Investment House (here and here).

Why? And how, if they can be predicted, can they be prevented?

There are two drivers: the prospect that the bursting of the “shadow banking” bubble will bring a general global return to more traditional asset-based financing structures, and the certain cycles of re-emergent white-collar rascality.  

Koranic principles prevent the charging of interest or the assumption of undue risk. Sharia-based financiers are therefore inhibited in using derivatives or other hedging contracts, short selling, insurance in the Western sense or other risk-mitigating techniques.

Instead their financings involve the sharing of risks and rewards – exemplified by “sukuks” -- structured offerings of asset-based securities, with the “buyer” entitled to a “rent” based on a participation in underlying tangible property, and “murabahas” – financing commitments involving a “profit rate” rather than an interest payment.

Well enough, so far: boards of Islamic scholars vet and approve each transaction for compliance with Sharia principles as applicable, country-by-county. But what the resulting imprimatur – the “fatwa” -- does not do is extend to either up-front due diligence or on-going audit work to assure the fundamental bona fides of the transaction.

And right there lies the hazard. Islamic finance is a fermenting laboratory experiment for the cultivation of schemes and irregularities: a sector big enough to attract new and eager players, out-sized growth potential, modest size and limited talent and experience among the current participants, and cultural incentives to grow in competition against foreign non-believers.

History should teach that the incentives to gain or hold market share, or to stretch the level of transaction risk for the sake of enhanced volume and returns, open the door to irregular behavior on the part of individuals acting under stress -- no less for a Sharia-based sukuk than for a real estate investment trust or a field of oil wells.

One certainty is that the recurrence of financial frauds is no respecter of either piety or theology. The ecumenical scope of exploitive scandals ranges from the 1982 discovery of Roberto Calvi – “God’s Banker” – hanging dead under Blackfriars Bridge in London even as his Banco Ambrosiano suffered multi-billion lire holes in its balance sheet – to the disgraced fall of Christian evangelists Jim and Tammy Bakker – to Bernard Madoff’s looting the community of his Jewish friends and golf partners. 

And the pressures are only amplified where a sector is going through dramatic and rapid growth, with a stretching of experience and resources, increased transaction costs in lieu of interest-based revenue, and the ever-present temptation to minimize the red flags of risk in favor of the satisfaction of aggressive targets.

And so – Sharia transactions involving profit participations based on shared interests in presumably real assets raise exposures of the old-fashioned variety, namely the “sales” of assets that are inflated or fictitious – with variations on the shell-game devices used throughout history to evade due diligence and to fool the auditors.

Among the incisive comments on my last piece on likely audit threats were these:

•    One reader had the anxiety-raising concern that a gremlin may yet emerge in the securitized residential mortgage market, beyond the issues of bad credit and poor collateral – a portfolio of entirely fictitious houses or borrowers. The accuracy of his concern was promptly confirmed not only by the SEC’s broad charges of mortgage-related fraud against the Countrywide team led by CEO Angelo Mozilo (here), but by criminal charges over a New York scheme based on unbuilt buildings, fictional addresses and bogus appraisals (here).

•    And another, a regulator, had the reminder that beyond all the weaknesses in audit sampling, lies the ever-present threat of “shadow” control structures, designed and run for the pure purpose of evasion and manipulation.

Regulators, gate-keepers and systems of justice in Western traditions have been caught unprepared and flat-footed, all too often. Whether their counterparts in the emerging Sharia environment can somehow do better – despite an absence of history, tradition or experience – remains to be proved.

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