Re:Balance -- Jim Peterson

Whence The Next Fresh Accounting Scandal? The Ominous Threat of A Shoe That's Yet to Drop

There’s a folk tale’s moral about the aggressive bird, who filches a whole length of sausage from the butcher’s market stall, eats his larcenous fill, and celebrates by singing from the treetops at full voice – only to be spotted and shot for a hunter’s dinner:

    When you’re full of bologna, keep your mouth shut!

Or as attributed to Voltaire, with rather more gentility – “better to keep silent and be thought a fool, than speak up and remove all doubt.”

As calendar-year American public companies face their deadlines for annual filings with the Securities and Exchange Commission, there are benefits to a blogger’s ability to keep quiet – a comfort compared with my prior writing life under the regularity of a newspaper deadline – especially in resisting the siren call to publish for the sole sake of reader traffic above all else.

But even for want of a compelling subject, fingers get itchy at the keyboard. Something feels ominous in the world of financial scandal and accountancy distress. It’s just been too quiet out there.

It could simply be impatience with officialdom’s combination of lassitude, inattention and inertia:

• Michel Barnier’s EU-level initiative of a green paper consultation on the fragile state of the global audit franchise has come out as the predictably damp non-event (here).

• America’s Dodd-Frank legislation addressed not a word to the obsolescence of the entire financial reporting and assurance model.

• Regulators have walked on tip-toes around the implications of issues from the degraded state of Citibank’s internal controls (here) to the Bank of England’s body language that enabled clean audit reports on the UK banks (here).[1]

• And the re-cycled trio of new members at the PCAOB, with old SEC hand Jim Doty in the chair, has offered only more of the same likely inaction that has characterized the torpor of its first nine years (here).

Not for nothing do major financial scandals emerge around the time of full-year information release. Investors’ expectations are whetted. Ponzi schemes escalate toward their inevitable explosion. And those pesky auditors are poking and prodding in dark and unwelcome corners.

Think back: Parmalat broke in December 2004; the rogue trading at Société Générale came out in January 2008; Bernie Madoff was exposed in December 2008; the CEO’s letter of confession in Satyam was delivered in January 2009; and January 2010 unveiled the looting via Amex card at Koss.

There are ample examples validating the risks concealed in the calm before the storm: the crime-solving deduction by Sherlock Holmes from the dog that didn’t bark, the siege guns’ silence just before the invasion, the receding waters before the tsunami, the movie cliché when the hero’s B-list sidekick whispers in terror that the native drums have suddenly stopped.  

The looming sound of silence is not always a signal. Sometimes the other shoe never does fall. An extended period of quiet does not mean that an outbreak must occur. But that is not ground for comfort or complacency either – it’s a flawed and mistaken inference that because the scandal level has been muted, it won’t erupt.

Somewhere out there, instinct cries, fresh new trouble is brewing.

 

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[1] Those with an appetite for satiric musical comedy are invited to imagine the UK’s House of Lords committee or the commissioners of the SEC as part of this chorus of hapless and ill-equipped pirates in Gilbert & Sullivan’s classic.

Holiday Gifts in Bernie Madoff's Bankruptcy: A Widow Does Her Bit -- and the Banks Will Too

 Holiday gifts arrived early in December for the circle of players around the wreckage that was Bernie Madoff. There are several lessons.

First, the widow of Madoff’s ur-client Jeffrey Picower redefined the landscape of civil forfeitures by agreeing with Madoff trustee Irving Picard to turn over an astonishing $7.2 billion – said to be her late husband’s entire take from a 35-year relationship (here).

Second, Picard himself dumped sacks of coal and lawsuits into the stockings of the Madoff enablers – notably including Unicredit, JPMorgan Chase, UBS and HSBC – charging them with notice of Madoff’s irregularities even while profiting from their proximity as custodians, administrators and managers of the monies fed to him by investors (the FT’s December series is well summarized here).

The former is of interest at least as a matter of social behavior and norm-setting. The latter will have reverberations with effect on the relationships between banks and other intermediaries and their own gate-keepers, including their auditors.

Barbara Picower faced this dilemma: She could have spent the rest of her own life defending against Picard’s suit, fighting uphill to protest the conduct and virtue of her spouse – who, charitably accepting her own claim of innocent ignorance of Madoff’s scheming, confronted the plainly demonstrable character evidence of his propensity to cheat at golf (a favorite post with readers from March 2009 is here).

Or – presumably able to live in adequate comfort on her bequest from Jeffrey of $ 200 million, and thus dramatically re-calculating the magnitude of a “widow’s mite” – she could launder her own status with a dramatic gesture of civility and largesse.

Secular sainthood is seldom so available – and with nary a hungry day either.

The noblesse of the widow Picower has made life less pleasant for Madoff’s other A-list clients. Those like Picower, close enough to finger the tattered edges of his moral fabric, are now forced to choose. They can oppose Picard’s claims to claw back their ill-gotten returns, under the shadow of the widow’s precedential capitulation. Or they can join the settlement queue – although not cushioned by the generous inheritance she enjoys, and to be seen only as belated converts, never to enjoy the halo effect she obtained as first-mover.

Depending on his trawl through Madoff’s client list, Picard is now working on a shortfall of some $10 billion. Of that, it says here that he will extract on the order of $ 1 billion from HSBC alone – precisely on account of the roadmap to its liability provided by the due-diligence engagements performed for the bank by KPMG in 2005 and 2007 and roundly ignored. It’s a plaintiff’s dream and an evidentiary nightmare for the bank that, prediction suggests, HSBC will pay handsomely to keep far away from a trial.

There’s more here, though: The KPMG engagements are a roadmap not only to what was done for its client, but to what could have been done for the other enablers targeted by Picard. Therein will lie a tale for the courts – and another set of eight or nine-figure contributions eventually to reach Picard’s collection basket.

But now for the broader questions: What if HSBC had taken KPMG’s work to heart. Or the other banks and feeder funds had engaged credible due diligence by their advisers on accounting, auditing and controls? Madoff’s pyramid would have been toppled before it reached pedestrian levels.

Suppose by extension, while we are at it, that Lehman Brothers had asked E&Y for a critical study of the exposures lurking in its use of repo derivatives to window-dress its balance sheet? And actually acted on it?

Or that Daniel Bouton at Société Générale had re-deployed a portion of his bank’s costs of external audit to give actionable scrutiny to the corrupted back-office operation that was so expensively exploited by rogue trader Jérôme Kerviel?

Or that AIG had given credence to a state-of-thinking study of the non-correlated nature of the inter-connected structure of the global CDO market?

Instead of the risk management possibilities of available but unavailed sources of wisdom, these institutions continued to subscribe to the one-page, bog-standard commoditized reports that regulators require from auditors – to be ignored in good times, because they convey no value regarding non-problematic operations, and useless for the detection and prevention of catastrophic events in bad. 

It’s a closed and obsolete system as bankrupt as Bernie Madoff himself. In the entire cast of characters, Barbara Picower emerges so far as the best of the whole sorry lot.

 

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Dodd-Frank Lets Small-Company Auditors Off the Internal Controls Hook: Putting a Partial Lid on the Sarbox

At least one piece of the Dodd-Frank legislation now has a ribbon neatly tied around it: the Securities and Exchange Commission has issued its rules to exempt small companies – generally those with less than $75 million of common equity – from having a separate independent auditor’s report on their internal control assurance under Section 404 of the Sarbanes-Oxley law.

(For her customarily concise and lucid summary, see Edith Orenstein’s FEI Blog.)

I’ve been quiet on Dodd-Frank. Why not? Unmanageable in its creation, incomprehensible in its enactment, unpredictable in its consequences, as it was. Who could work up an appetite to ingest such a pigs’-breakfast of law-making?

Small companies may say, with the night watch in Hamlet’s Elsinore, “For this relief much thanks.” But marginal tinkering with the mis-begotten obligations of Sarbox 404 will matter less, and for different reasons, than are usually put on view.

To start, the toxic post-Enron environment in which Sarbanes-Oxley was enacted in 2002 has effectively immunized its impositions from critical cost-benefit evaluation. Persistently asking the wrong question – “Has the quality of corporate reporting actually improved since the days of WorldCom and HealthSouth?” – not only ignores the built-in cyclicality by which outbursts of scandal are purged by self-cleansing returns to virtue. It also leaves unasked the proper question: “Is that reporting better than if Washington had done something else – including doing nothing at all?”

More importantly, can any scarred survivor of the last three years of Bear-Lehman-Fannie-Freddie-AIG-Merrill – the most disruptive economic period since the Great Depression – argue seriously that auditors’ reports on the “out-of-controls” of those fallen industry giants actually made any positive contribution to systemic safety, stability or credibility?

In that dreary context, of course, it makes perfect rational sense to give small companies a “Get Out Free” card.

That’s because, as I was advised about parenting strategy when our daughter was born: “Little kids, little problems; big kids, big problems.” A new father’s worries escalate, from the essentially trivial inconvenience of an infant’s colic or spilled oatmeal, on to little league injuries and a teenager’s driving safety, up to college admission and the launch to the challenges of adulthood.

In the same way, the fewer zeroes on a balance sheet, the lessened likelihood of systemic impact of mis-behavior that makes a difference. “Out-of-control” at a Koss or an American Apparel may be inconvenient for a limited constituency, and provide grist for the mill of the plaintiffs’ securities class action lawyers – but otherwise doesn’t matter in the great scheme of things. It’s altogether different when the entire global financial system can seize up under the effects of a threatened, undetected and undeterred collapse at an AIG or a Lehman.

History and experience teach that regulatory systems designed and applied under motives of political correctness over the fat part of the compliance curve are wasteful and ineffective – whether aimed at school truancy, auto emissions or corporate disclosures. Instead they will fail to identify and address the “outliers” that actually prove disruptive – the SEC’s sorry performance in regard to Bernie Madoff and Allen Stanford make the case. 

Section 404 reports on small companies were never any more likely to be effective by way of detection or deterrence for small companies than they have proved for the large. So it was an inevitability that inflicting Sarbox 404 auditor reports on small companies would have been largely an exercise in even further futility. If regulation has not worked for the big and dangerous, in other words, how can it be good or useful for the small and irrelevant?

Drab as it may seem, finding negative comfort that at least our legislators have stumbled into a way to avoid making a weak situation even worse, there is both logic and benefit in leaving bad enough alone.

 

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The SEC Strikes Goldman Sachs -- Now Will Goldman Strike Out?

As the great baseball umpire Bill Klem said, about whether a pitch was a ball or a strike:

“It ain’t nothin’ ‘til I call it.”

Which, as a lesson in political science, is being taken to heart by only some of those holding forth on the April 16 charges of fraud lodged by the Securities and Exchange Commission against Goldman Sachs and one of its employees (here), alleging misstatements and omissions in the structure and marketing of a synthetic collateralized debt obligation tied to residential mortgage-backed securities.

The SEC’s enforcement director, Robert Khuzami, dealt a high fastball -- avoiding complexity in packaging his advocacy for public soundbite-scaled consumption (here):

“The product was new and complex but the deception and conflicts are old and simple.”

Goldman itself played its defensive position the same way, but to different effect (here). Its terse one-liner fouled off the pitch: “We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact.”

Give Goldman points for a sense of reality, recognizing both that the judicial process will be unaffected by public posturing, and that the court of public opinion itself will not be in a mood for hand-wringing.

For it remains a mystery what inspires any claim to credibility by the typical spinners of over-played corporate protestations, when initial impassioned pleas of innocence give their inevitable way to plea bargains and outsized settlements to “put it all behind.” 

Meanwhile, the purple clouds of “I told you so” commentary from the bloggerati are as noxious as the volcanic spews from Iceland, and should only be dispersed as rapidly into inconsequence. 

Not least, the self-righteous are – as customary – conflating an initial law enforcement complaint with an adjudicated conclusion. Consider:

• ·      Much as public opinion had convicted O.J. Simpson of his wife’s murder, before his trial, the jury found otherwise – and he remained at large until the outbreak of his predictable recidivism.
• ·      It was financial and structural weakness that felled Arthur Andersen, not its indictment – remembering that procedural flaws in its conviction led to the Supreme Court’s reversal, but with no element of vindication or rehabilitation.
• ·      Even the now-jailed Bernie Madoff was presumed innocent (although charged) until the entry of his guilty plea, and entitled to bail and at least a measure of his liberty.

Respect for due process requires a measured recognition that the SEC case is at the top of the first inning – though there may well be further cases, additional claimants and private claims as well (see Kevin LaCroix’s always helpful D&O Diary). 

But Charlie Green also has it right, at Trust Matters. That is, if as Charlie suggests, the SEC’s case “resonates easily with Main Street as also being unethical,” and as corrosive to credibility, motives and trust, then the capital markets community will hold Goldman accountable for the state of its franchise in ways that the judicial process can never address.

A final constituency is yet to be heard from, about we should worry. Eight years ago, when the collapse of Enron was trailed by WorldCom, a stampeded Congress inflicted Sarbanes/Oxley and its massive demonstration of the law of unintended consequences.

Given its head, a legislature bent on retribution against the financial services sector is capable of twinning up the bankruptcy examiner’s report on Lehman Brothers (see here) with the SEC’s complaint against Goldman.

In which case, anxiety should run very high.

Because the result, in Bill Klem’s terms, will most likely be a wild pitch.

 

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How Valuable is Today's Audit Report? Military History's Metaphor for "Expensive, Obsolete and Irrelevant"

The dog days of summer. I’d rather be under a beach umbrella, doing teaching outlines for the fall semester with the facilitating aid of something cold and rum-based. Instead I am in deep dialog on tough issues with one of the world’s thoughtful accountancy regulators.

A very small group, that. “Thoughtful accountancy regulator” being as oxymoronic as “Italian justice system” or “effective Belgian government,” their entire convocation could be booked in a telephone booth with room to spare.

On our table was one of my persistent themes, under the rubric of the threatened survivability of the Big Four and their nearly exclusive franchise to audit large global companies – only one major shock away from disintegration, which once started will be unstoppable not least because of the limited vision and authority of the political and regulatory classes.

Namely, there is no real chance to get ahead of this destructive tidal wave without explicit confrontation of the obsolete and anachronistic nature of the audit report in its current form.

To this proposition, my correspondent suggests there is at least some chance of traction under cover of the legislative debates on the question why auditors did not do more in relation to the credit and banking crisis of the last two years.

Possibly. But because the lawmakers’ limited attention span is focused elsewhere – on executive pay schemes and bank survival subsidies and constraints on short sales and flash trading -- I doubt it.

Our exchange calls to mind a recent holiday, and the moving experience of touring one of the surviving fortresses of the Maginot Line – the defensive installations named for France’s Minister of Defense, built in the 1930’s and left largely unscathed when the invading Germans simply and speedily flew their planes and drove their tanks over and around.

Dug deep into the Alsatian hills, these brutal piles of 1920’s military technology – built for 3 billion francs and among the largest public projects in France since the construction of the Gothic cathedrals – are derided by history as a strategic failure, because they were rendered irrelevant by the German circumvention.

Yet consider the success -- in terms, the Line did its job. It was evaded, rather than destroyed by direct attack; surrendered largely whole, rather than bombarded; and only thereafter abandoned by government to the effects of rust, decay and amateur tourism.

It’s much the same for the modern-era audit report: Conceived in an earlier and simpler time, oriented to the avoidance of problems no longer meaningful, and now ignored by aggressors with superior tools in their armory. Consuming vast sums of defensive budgets, engaging battalions of trained and expensive manpower in an endeavor of questionable value, and achieving no obvious deterrence against threats on a scale of systemic corporate collapse.

Life for the French garrisons would have been misery: cramped underground in caves of steel and concrete; enclosed by machinery, ducts and wiring; ventilators struggling with the confluent mixture of petrol, dangerous explosives and close human quarters. Happily, except for times of drills and alerts, they were often able to emerge into the French forests, to hunt the birds and rabbits that relieved their military rations. 

Contrast the modern audit engagement team – inflicting vast costs on their clients for a marginal purpose, toiling away to tick the boxes required by Sarbanes/Oxley and its equivalents, facing a hostile world through the narrow visor of inflexible reporting requirements and a crude and outmoded arsenal of opinion language, and exposed to being out-flanked or over-run without warning by antagonists of superior mobility and strategic imagination.

Just as the Maginot Line proved its worth as a sublimely ironic success against invasion that never came, the current audit report stands as a bulwark effective only against the kind of assaults about which no one cares.

Instead, just as the hapless French troops were obliged to surrender without a struggle when overtaken from the rear, the modern system of assurance has been revealed as dug in and powerless against such invasive forces as the exotic financial derivatives of the credit crisis or the guerrilla tactics of a Bernie Madoff or an Alan Stanford.

And to what end? The metaphor can be pressed one step further. By surrendering the Maginot Line’s indefensible position, the French cut losses that would otherwise have been catastrophic, and survived to be joined by their allies in a strategic re-grouping.

As with supplanting the dimly mis-guided André Maginot, can the regulators find in their weary ranks the likes of a Churchill or Roosevelt or DeGaulle?

Cometh the hour, cometh the man? The future of the profession can only hope.  

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A Scandal Erupts in Islamic Finance: The Algosaibi / Saad Dispute -- And is Anyone Surprised?

An exchange of lawsuits escalated late last month between Saudi Arabia’s Algosaibi family companies and the Saad group’s Maan al-Sanea.

Misappropriations rising to $10 billion are claimed, based on an alleged series of foreign exchange transactions in a workers’ remittance unit, by which riyal-for-dollars deals were rolled over and diverted through the use of forged documents and phony confirmations (here).

At the end of last week, a court in the Cayman Islands even presumed to order a worldwide asset freeze against al-Sanea (here) – an exercise of jurisprudential hubris worthy of the Grand Duchy of Fenwick in Peter Seller’s 1959 “Mouse That Roared.”

So another prediction promptly comes good: my call on June 8 – here – that “accounting scams pose risks to Sharia finance.”

From allegations in a New York court filing, the basics of my predictions are confirmed:

•    With lawsuits proliferating in the US and the UK, by bankers exposed on the debt securities of both sides of the Saudi feud, another multi-national financial scandal spreads across a borderless world of disputes.

•    The securities of both the Saad group and the Algosaibis – “sukuk” in the Sharia-compliant terminology – are trading at default levels, despite the demand for compliance with Islamic law, that repayment be assured by way of especially-designated collateral.

•    And so, as the spiritual basis for Islamic finance is overcome by the victims’ drive for secular accountability, the illusory pretense that “we’re different” and “it’s not done that way here” give way again, in the Gulf as it has elsewhere throughout history, when the veils of naïveté and denial are torn away.

One aspect yet to emerge from the Islamic dust-up is the finger-pointing at the gatekeepers. With aggressive advocates now driving claims that the string of unfulfilled financial commitments extended over four years, it is to be expected that the questions will be pursued: “Where were the lawyers?” and “Where were the auditors?”

Which will make for ominous times among the professionals.

The July 11 criminal conviction of Chicago lawyer Joseph Collins, for his role in the transactions by which now-jailed Refco chief Philip Bennett fleeced his shareholders and investors, puts a darkened color to the on-going civil litigation exposure of both lawyers Mayer Brown and accountants Grant Thornton.

And it appears that David Friehling, held out as Bernie Madoff’s long-time auditor, is in negotiations for a criminal plea deal – although in context of the 150-year sentence dealt out to Madoff himself, a deal would seem unlikely unless it spares Friehling the greater part of the maximum 105 years he faces.

For an informative if unsurprisingly defensive apologia for Mr. Collins, from a fellow lawyer, see here.

The Collins conviction may signal a new era of exposure for the bar, considering that their brethren among the accountants have been unsuccessful for years in selling the “pure heart – empty head” defense. The lawyers have long relied on their client privilege and a jealousy-guarded “duty of advocacy” behind which to manufacture and supply the tools of felonious monkey business. But if the duties and accountability of the two professions are seeming to converge, as the Friehling negotiations and the Collins verdict would suggest, the lawyers’ pain will be palpable.

Meanwhile -- from Refco to Madoff to Saad/Algosaibi, commodities options to Ponzi-style fictions to Sharia-based forex -- the repetitive pattern of window-dressed accounts that serve to conceal the predations of the principals -- facilitated or over-looked by those chargeable with detection and prevention oversight – continues to roll around the globe.

And only one thing is knowable for certain: the latest Saudi mis-adventure – immediate proof that Islamic finance is no more virtuous or scandal-proof than its Western equivalents – will not be the last.

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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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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.

Madoff and Satyam, Dead in the Water -- Scuba Diving as a Risk Metaphor

With a winter blizzard swirling outside, it’s a good day to adopt a lesson from my last Caribbean resort experience into the curriculum of the MBA course on Risk Management that I will teach later this month.

The context is certainly rich: between the collapse of Bernard Madoff’s investor scheme and the revelation that Satyam Computer Service’s balance sheet was a work of fiction, effective risk management is once again found wanting on a broad scale.

So there is relevance both for students and to the theme of my usual writing -- the challenge for investors and other users of financial information to find reliable guidance for their decisions, especially in the current troubled state of the worlds’ capital markets.

In a blue-water lagoon during a recent school holiday, I had a near-disaster in my quest to obtain my scuba diving certificate. I had a surprise equipment failure on my very first dive. A calm and beautiful undersea experience was turned in an instant into scary and airless gasping.

Back on the boat, having survived a breakdown that had not ever occurred in the experience of our captain, the dive master or any of her students, I was in a state of high-adrenalin calm. I hope never to repeat those intense and time-frozen moments. But I was ready to go back down again.

Why?

First, life is full of contingencies. If I had ignored or disrespected the pre-dive training that provided me with the hand signals to communicate my distress – if I had been too deep to be able to surface on my own depleted lung capacity – if I had yielded to the urge to panic – the result could have been dire and I might not be writing this at all.

I have written – here – on the importance of comprehending the importance of those unpredictable but highly consequential events that occur much more frequently than we perceive: October 1987 -- September 11, 2001 -- Long Term Capital Management -- Virginia Tech. In his eponymous best seller, Nassim Nicholas Taleb calls these the “Black Swan” events -- the very ones that cannot be anticipated, but that have disproportionate influence in our lives.

Users of any system designed and operated by human beings – whether a diving apparatus or a subprime mortgage derivative valuation model or a corporate audit – have the responsibility to know of the non-zero risk of failure.

Although it is the essence of random events that they cannot be predicted, their possibility does give the chance to think ahead. Pay attention to your dive master, the better to cope with an accident. Wear your seatbelt, to avoid becoming a traffic statistic. To reduce the chance of lung cancer, stop smoking.

And to avoid a collapsed portfolio, don’t put all your investment eggs in a basket woven out of improbable stories, untestable strategies and irrational enthusiasm (Mr. Madoff, q.v.).

The liability release form that I had signed, back on the dock, was miles away from my thoughts or any possible influence on my reactions, fighting off panic at a depth of twenty feet just above a reef. The reality of high-stress experience is disconnected from the compliance requirements of licensing authorities, regulators or politicians.

Instead, an effective approach to unpredictable hazard is to mitigate the risk directly through research and preparation. Rehearse the divers’ emergency procedures. Pay attention to the flight attendants’ safety speech. Get a second opinion to validate an initial cancer diagnosis. And get better investment advice than available in the country club’s locker room.

Another is to measure and manage the downside consequences. Don’t dive deeper than experience supports. Allocate investments under a managed plan; the long-term requirements to manage a retirement or a charity’s endowment make them a poor place for excess concentration or exotic long-shots.

As a beginner, I’ve got no more competence to do deep-water salvage diving than I do to trade foreign currency derivatives. If I tanked in either one, I would deserve the consequences.    

The lessons from my underwater accident should not be pushed too far. Life has risks, and they can’t all be eliminated. Who can tell how any of us would react under other kinds of sudden deadly threat – an icy night road or a gunpoint robbery or exposure of a giant corporate fraud scheme?

But as I learned under the sea, about the combination of advance preparation, calm at the crisis point and plain uncontrollable luck, the first two are subject to our individual influence and responsibility. And they will affect the outcome, whether involving a blown air tank or a blown portfolio.

I intend to keep diving, just as I intend to keep investing. In either case there is a non-trivial chance that I might end up dead in the water. But if so, it won’t be for reasons within my own control or responsibility.

Over the months I have shared experiences supporting my course’s core proposition – that improved choice-making is possible, even under turbulent and threatening conditions, through awareness of the avoidable traps, biases and errors – examples here, here and here.

This being a large and open topic, I invite your suggestions for my students' benefit of other “teachable moments.”

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Sadly Predicted -- A Madoff Investor is an Apparent Suicide

Last Tuesday, December 16, I wrote that one of the "safe predictions as the Madoff story brings a sorry year to its welcome close" was this:

"(T)he safe but unfortunate bet, at this still-early writing, that at least one remorse-driven suicide will further color an already tawdry tale" -- here.

Today's news announced in New York -- here quoting the Associated Press -- is that Rene-Thierry Magon de la Villehuchet, "the founder of an investment fund that lost millions with Bernard Madoff was found dead at his Madison Avenue office of a possible suicide...."

There are aspects of this work that bring no satisfaction. Being right in this prediction is one of them.

With much more to come, it is enough today to say that my condolences go out to M. de la Villehuchet's family and his colleagues. 

Sheep on the Prowl -- Madoff's Victims Go After the Auditors

There’s an ominous if predictable new chapter this week in the saga of Bernard Madoff’s alleged $50 billion escapade: the inclusion of the auditors as recovery targets. As the front page of the normally sensible Financial Times put it on Wednesday, “lawyers say the asset-rich firms are likely to be targeted for legal action.”

The Seidman firm has been sued along with its client Ascot Partners, and threats are percolating against three of the Big Four who audit funds that had fed some $20 billion into the Madoff operation.

The large firms were already on the bubble of survival, awaiting only the return of critical political and regulatory scrutiny later this winter – here. Now, for two reasons, what might once just have been Madoff’s epic re-scaling of the familiar story of a glib and well-connected scamster and his credulous circle of ready victims takes on the potential to rock the already shaky foundations of global financial statement assurance.

The first is that, much as Madoff’s victims might hope for deep pockets to pick, characterization of the large accounting firms as “asset-rich” is thoroughly wrong.

The principal “assets” of the firms appear nowhere on their balance sheets – comprising only their fragile measure of gate-keeper trust, and the professional skills of the partners and their staff that deploy by the tens of thousands. But these structures are highly brittle under stress and threat, as proved by the speed of Arthur Andersen’s post-indictment disintegration in 2002, and they have no monetizable value – to pay lawsuits or otherwise – as shown by their lack of appeal to the world’s investment bankers – here.

On the contrary, under a model developed two years ago in London for the European Commission, the limited capacity of the thinly-capitalized Big Four to withstand a litigation death-blow can be calculated as ranging between $500 million and $2 billion – here -- small fractions of the amounts Madoff apparently sluiced away.

Impelled by fee-motivated lawyers, the blame-seeking Madoff investors are unlikely to be deterred by the absence of a pay-off, of course, which exposes the other reason the auditors should be very worried:

Namely, “failure to detect” cases are easily started, but they are hell’s difficult for the auditors to defend, much less to win.

On the jurisprudence, cases are brought by audit clients in the often accommodating state courts, under garden-variety common law theories of malpractice, negligence and breach of contract, rather than under the stricter standards of fraud required by the federal securities laws.

In addition, defendant auditors face three huge hurdles in the courtroom:

First, human nature cannot resist applying the crystal clarity of hindsight, so juries presented with the inescapable reality of a catastrophe are inexorably drawn to the allocation of blame, rather than a reasoned consideration of ex ante discoverability or prevention.

Second, the very nature of audit execution involves judgment and choice about sampling and the depth and extent of work to be done. After the fact, even for a job perfectly executed, plaintiffs are well armed to second-guess any audit procedures omitted or disregarded – and are abetted in their advocacy by forensic experts hired to focus the jurors’ attention on the hostile arguments of fault.

And third, if the past is future, the nightmarish likelihood is that down deep in the audit papers on the feeder funds, waiting to be unearthed by the plaintiffs’ subpoenas, lurk the worrisome memoranda of alert staff personnel, questioning the legitimacy of Madoff’s operations or fingering its weaknesses – the very smoking guns with which the firms will have to play survival roulette.

Despite the large firms’ formulaic protests that they conformed to applicable standards, and their professed readiness to defend themselves, the future of the Madoff cases can be foretold.

That is, the record already presented by the firms themselves to the US Treasury Department’s Advisory Committee on the Audit Profession – here – is that the large firms cannot afford to go to trial in life-threatening cases – as reinforced by the Seidman firm’s survival on life support as it appeals its $521 million Bankest verdict in Miami -- here.

So, facing a deeply insulted and well-heeled set of investor adversaries, the large firms would be brought to the brink of survival if obliged to take up any share of Madoff’s predations of $50 billion that even approached ten percent.

That thought alone -- passing the gruesome ignominy that a noble profession delivering highly complex and technical service to the world’s capital markets could be brought down by the prosaic activities of a single if grandiose con artist – is enough to mute the level of cheer and festivity at the large firms’ annual holiday parties.

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Bernard Madoff -- Voyeurs Around the Investor Pool

There’s a rich new context for the aphorism forever linked to Warren Buffett, that “when the tide goes out, you learn who’s been swimming naked.” And it’s not a pretty sight.

In the social cliques of the Hamptons and around the pools of Palm Beach, there’s agony aplenty among those pink-cheeked with embarrassment at being fleeced by Bernard Madoff. It’s not just that he was one of their own, but that the credulous actually paid for the chance to be invited into the privileged circle of his victims.

As with so many of this decade’s scandals, the Madoff scheme differs only in scale from predecessors dating to time immemorial. The accounting shenanigans at Enron and Parmalat hark back decades to those of Penn Square and Equity Funding, and the subprime mortgage meltdown echoes the savings and loan debacle of the 1980’s. The methods of the schemers don’t change – only the number of zeroes.

Scam artists have forever used the same four techniques to skin their constituents, starting with the suppression of intelligence that goes with membership in a shared and exclusive community. The investment advisers who work over a church roster or an Elks lodge or a society of county dentists are no different from Madoff – and more’s fool the over-eager who suspend belief in favor of the comfortable but dangerously irrelevant rituals of insider familiarity.

The second tool is the “admission threshold” – the bogus entry ticket by which the victim is lulled into feeling special. As proved lately by the hedge fund stampede of the medium-rich, the enticement of “I’ll take your $5 million, although my usual minimum is $10” can be remarkably seductive.

Third, recall the 1989 tax evasion trial of the late Leona Helmsley, hotel queen and über-bitch that she was – an event defined by her pronouncement that “Only the little people pay taxes” – her cluelessly insulated attitude now revealed as extending to disregard and disrespect for the basics of skepticism and due diligence as well.   

Fourth and most pernicious, accountability and transparency are quashed by the enticement of secrecy: Returns may seem inexplicable, and strategies opaque –- but ask too many questions, or break the code of silence, and risk expulsion from the circle of initiates.

That model has ugly antecedents – the same coercive rules have enabled pedophile clergy, corrupt police rings and gangster clans.

If this late-arriving exposé of another “story too good to be true” does not exactly elicit outcries of sympathy for the lambs willingly prepared to be sheared by Madoff, some hostile reaction might well be directed at the banks and hedge funds who ran “feeder” funds, taking a fee rake-off with a compliant lack of curiosity at Madoff’s apparent lack of technology infrastructure, oversight or a comprehensible investment strategy.

The very concept of “funds of funds” has always suggested a structure designed primarily for the enrichment of the fee-collectors, especially for those with memories extending to the Geneva-based wheeler-dealer Bernard Cornfeld, whose 1960’s Fund of Funds had a Ponzi-like flame-out that differed from Madoff’s only in the size of his elaborate sales force.

Lastly, as for the notion of regulatory alertness or prevention of Madoff’s eye-popping piracy, it’s been clear for two years now that Washington’s bureaucrats would not recognize a crisis unless a Black Swan flew up and kissed SEC Chairman Christopher Cox on the ear. And in any event, with the Congress on the eve of adjournment and the Bush administration in its final exhausted weeks, its place-holders will be able to slink out of town before the forces of blame can assemble.

If past is prelude, there are two safe predictions as the Madoff story brings a sorry year to its welcome close.

The first is the safe but unfortunate bet, at this still-early writing, that at least one remorse-driven suicide will further color an already tawdry tale.

The second is that before the books are closed on the reporting of dismal corporate results for 2008, an entirely new multi-billion dollar operational and accounting scandal will erupt somewhere in the world – outside the investment scams and the already battered financial services sector.

That’s because with the tide already fallen so far, and still receding, the exposure means that the gauzy swimsuits peddled by the Emperor’s clothier are still in the process of dissolving.