Re:Balance -- Jim Peterson

The Great Maple Syrup Caper -- A Sticky Mess in Quebec

While bidding farewell to the old year and welcoming the new, this Christmas Eve story out of Canada should not be lost in the holiday news cycle: 

“Over a one-year period during 2011 and ’12, some 6 million gallons of maple syrup – about $ 18 million worth – were stolen from the ‘strategic maple syrup reserve’ controlled by the Federation of Quebec Maple Syrup Producers (FPAQ)…. Last week, three men were arrested in connection with the heist.”

The Mounties have ridden to the rescue, the arrest total reportedly has reached 18, and weightier issues can now be on the table than a supply threat to the breakfast calorie count. Namely:

Producers around the world closely protect their strategic assets – whether Middle Eastern petroleum (OPEC), Japanese agricultural products (Nokyo), Colombian narcotics (Cali and Medellin) or American professional football and basketball players (NCAA). So it should not be surprising that the question is debated about Quebec, why our typically mild-mannered northern cousins maintain a government-run cartel to promote market stability in the supply and pricing of gourmet pancake toppings.

A better question, though, is just how fully one-quarter of the national stock – the equivalent of 16,000 barrels of syrup – could have been siphoned out of a warehouse described in the FPAQ’s own press release as “secured by a fence and locks, and visited regularly.”

The question must inevitably be asked, in short, “Where were the gate-keepers?”

Fortunately for the appetites of the world’s luxury crepe-and-candy consumers, the thieves were undone because they chose the hard way, working their felonious little scheme on the liquid commodity itself. Their sticky footprints left a trail, because to monetize their scheme required a disposition infrastructure – trucks and warehousing, a processing facility in neighboring New Brunswick and a sales pipeline through which to channel their slippery merchandise into the sweets-addicted US market. 

In this, they suffered the detection risks of scams like that of India’s Satyam in 2009 – where maintaining a roster of 13,000 phony employees would arouse the curious to wonder about the absence of ancillary evidence – the ghost workers’ non-existent desks, telephones and withholdings and remittances for health care and benefits.

Simpler, harder to detect and far less messy, would have been the time-honored creation of inventory that was fraudulent and fictitious from the outset. Consider these classics:

• The great Salad Oil Scandal of 1968, by which Tino DeAngelis floated only enough vegetable oil on bulk tanks of water to fool auditors who looked and tasted from the top rather than tapping the tanks at the bottom.

• Equity Funding in 1970’s Los Angeles, with over-stated death benefit liabilities under fictitious life insurance policies turned into cash through a Ponzi scheme of cessions to reinsurers.

• The South American coffee shipper, showing tons of stock on its balance sheet and available for collateralized borrowings, in reality comprising only camouflaged piles of sand under thin layers of beans.

• Over-stated Texas cattle herds, sold to unwary urban tax-shelter buyers – it being no great trick to run the same calves repeatedly through a maze of corrals, past the clip-boards of credulous city slickers unwilling to dirty their suits to exercise the control of chalk-marking the forehead of each passing animal.

• Or the related German scheme by which a fleet of trucks was over-counted in their repair sheds by auditors distracted from the back parking lots, where the vehicles were re-cycled by simply switching their license plates and dashboard bar codes.

The examples are as endless as the ingenuity of the criminal mind. Had the light-fingered Canadians only thought through the vulnerabilities of their targeted provincial cartel’s control system, they’d have kept their hands far cleaner while moving phony paper rather than hot syrup.

And they’d have made their illegal fortune while avoiding not just the brown sticky stuff, but what will now be extended stays in government custody, where the pancakes in the prison cafeteria will not be flavored with so much as a drop of down-market Aunt Jemima’s.

 

Happy New Year to all. Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription sign-up is easy and free, both at the Main page.     

 

 

Preserving and Re-Building Trust -- An Event Preview

On October 2, the Consortium for Trustworthy Organizations at Fordham University in New York sponsors “The Summit on Restoring Trust in Business,” on West 60^th Street in Manhattan. 

An A-list of participants from major companies and consultancies will be there. Those with professional or academic interest are invited – program details and enrolment information are here.

I have the pleasure of bringing my perspectives on risk management, litigation and disputes to a great panel, “Effective Trust Repair,” led by Charlie Green (for whom, see Trusted Advisor Associates and his blog, Trust Matters).

With the quality of gathered credentials and experience, the discussions will be seriously substantive – with more nuance and value than the sometime platitudinous slide-decks of the typical Trust-Building 101 curricula.  

Because a forum of this sophistication can dig far beyond the “easy stuff,” we expect to probe some of the conventional attitudes. Three such topics are sketched below -- in no more than the possible appetizer-sized portions.

“Trust Survival” May Be the Best There Is

Run-of-the-mill literature on trust in business strongly features its preservation and maintenance. But take note: when corporate times are rosy, the language of trust gets subsumed within the overall anodyne vocabulary of feel-good success. 

And after the fact of a disaster, it’s too late.

At the only time it truly matters – when an enterprise faces existential crisis –– continuity of trust is at best a problem of second-order importance. And the small circle making life-and-death decisions -- those directly reporting to the chairman or the CEO –- are the only people with real influence.

Examples:

• As Arthur Andersen spiraled into disintegration in 2002, it was the peeling away of partners, clients and its non-US firms – trust was implicated, to be sure, but at stake was the immediate impact on the firm’s very viability.

• At MF Global last fall, Jon Corzine would have cared less for the preservation of customer or counter-party trust, when what really mattered was a Hail Mary scramble for survival that turned into $ 1.6 billion in missing customer funds.

• And at Knight Capital over the weekend of last August 4-5, virtuous concerns for trustworthiness, following the $ 440 million loss inflicted by a trading software glitch the week before, would have been subordinated to the search for friendly rescuers – surrendering ownership to investors prepared to salvage the firm’s ability to open for business that Monday. 

Only if the enterprise survives, in other words, do the re-builders of trust have a chance at an invitation to the table.

And even then, trust-related advisors in a post-breakdown environment risk relegation to the same role as the medieval camp-followers after battle – executing the wounded and looting the corpses.     

“Trust Building” May Not Always Really Matter 

The constraints of a cartel or the impositions of regulation affect whether trust in business is relevant at all.

Nobody loves the indifferent service of the local cable company or the lock-step piracy of the neighborhood filling stations. But subscription and consumption continue.

As Michael Corleone was reminded by Frankie, the disaffected mob soldier in The Godfather II (1974), “Your father did business with Hyman Roth. Your father respected Hyman Roth. But your father never trusted Hyman Roth.”

Bond offerings require ratings, despite the agencies’ consistent behind-the-curve performance during times of crisis, from the savings-and-loans of the 1980’s to the subprime mortgage and sovereign debt calamities of this decade. Audit reports are required by law on the financial statements of public companies, despite manifest dissatisfaction with their content or their usefulness to readers.

The result in these contexts is narrowed relationships and skeptical doubts about value. Notions of “trust” are conspicuously absent from the dialog.    

“Trust Repair” May Be Non-Strategic 

Finally, when business trust is broken, and a supplicant comes around to plead for another chance, symmetry requires a response by those asked to re-affirm their faith. What conditions should apply? 

In other words, “fool me once…” – and then what?

Consider the frequency with which a large-scale fraudster gives early signals of his corruption – Bernie Madoff’s unbelievable golf scores evidenced his flim-flam. Or even confirms, like the recently re-jailed Barry Minkow of ZZZZ Best, the overwhelming rate of recidivism among white-collar criminals.

What combination of sentiment and compassion, or venality and credulity, blinds the risk processes of those charged as fiduciaries for their stakeholders, such that the victimizations continue?

Salience does enter in, of course. A single disappointing meal at a favorite restaurant should not kill its reputation, nor an explicable one-time lapse in service by a supplier or payment by a customer. Some tolerance is required, for the inevitable breakdowns that inhere in complex systems of human design.

But while repentance and forgiveness have their place in a caring society, prudent risk management counsels against re-admitting a known fox for a return visit to the henhouse.

These are among the complex issues, and they have no simple answers. Reactions here are invited and encouraged. And those able to extend the discussion in New York on October 2 are most welcome.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription sign-up is easy and free, both at the Main page. 

 

Sarbanes-Oxley, Ten Years After -- Are We Having Fun Yet?

It has not been difficult, through this summer of discontent and turmoil in the world’s financial markets, to ignore with enthusiasm the comprehensively vacuous observations of the tenth anniversary of the Sarbanes-Oxley law. 

Readers will recall my long-held skepticism about that knee-jerk post-Enron exercise, going back to my July 20, 2002 observation in the International Herald Tribune about the preliminary Senate vote, that “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.”

Nor has the decade horribilis given any reason to change.

Of the smug and fatuous self-congratulations of the bill’s eponymous sponsors (webcast on July 30, 2012), the less said the better. As the English essayist Charles Lamb wrote about a blame-worthy poetic effort:

“It would be an insult to my readers’ understandings to attempt anything like a criticism on this farrago of false thoughts and nonsense.”[1]

Rather, some unasked questions should be advanced.

Regarding the self-interested back-patting of those with careers to be served by the inflictions of Sarbox –- the PCAOB’s members and staff and the spokesmen for the accounting oligopoly dependent on its compliance revenue:

“Would the elves in Santa Claus’s toy shop be expected to vote against Christmas?”

As for those purporting to see some claim of benefit, yet propounding no solutions to the continued eruptions of financial chicanery (here, here and here), the challenge remains that the cyclical nature of market bubbles makes inevitable a post-scandal period of cleansing and temporary return to virtue – political dynamics notwithstanding.  

Put another way, the storm of both scandal and outrage after Enron and WorldCom was bound to clear, no matter what. So instead of the wrong question, whether post-Enron corporate behavior is now improved, under both the Sarbanes-Oxley law and the law of unintended consequences, the proper operative question should be:

“Would financial reporting and assurance not be better if Sarbanes-Oxley had not been passed at all?”

First, American law since 1934 has pronounced it illegal to make false statements in connection with the purchase or sale of securities. So – as confirmed by the absence of prosecutions under the redundant Sarbox requirements for executive certifications of financial results (summarized by Michael Rapaport and Francine McKenna) -- that exercise has from the outset never been more than optics and cosmetics.

Second, a decade of PCAOB intrusion into the relationships between auditors and clients has engulfed the corporate reporting process in cost, paperwork and degradation of the assurance function (here and here) – while, into the bargain, failing either to advance coordinated global-scale assurance regulation and oversight in most of the world’s major capital markets (here) or to prevent (among others) the wave of securities malfeasance of off-shore origin, notably from China.

Third, as to the law’s centerpiece obligations on internal controls reporting and assurance, it was always true, even pre-Sarbox, that most decently-controlled companies would do reasonably well on compliance, most of the time – while a parade of horribles since then has made it clear that, for reasons of scope limitation or plain enforcement dysfunction, the law has been ineffectual against the rare but all-too-frequent and truly consequential cases.

A brief post-Sarbox sampler illustrates that – as generally true of large-scale challenges to risk identification and management -- it is the “outlier” cases that really matter:

• The control failures that brought down Bear Stearns and Lehman Brothers

• The “buco nero” at Parmalat and the ghost employees at Satyam

• The in-house looting by the chief financial officers of Koss in Milwaukee and the city of Dixon Illinois

• The undetected Ponzi schemes of Bernie Madoff and Alan Stanford, unremarked by gate-keepers, regulators and out-of-control client advisors and abettors alike 

• The valuation fantasies behind the window-dressing at Fannie Mae and Freddie Mac

• The incentives-driven perversions in the mortgage businesses models of Washington Mutual, Countrywide and New Century

• The derivatives and trading fiascos at UBS, JP Morgan Chase, MF Global and now Knight Capital

What then is the purpose of law-making? Sarbanes-Oxley has manifestly not ameliorated the flaws persistent in the nation’s corporate reporting and assurance structures -- then of what use or benefit has it been? 

And, if only the mis-leading politically-motivated placebo that it appears, what more should be expected both of our elected representatives and of those aspiring to hold them to account?

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are always welcome, and subscription sign-up is easy and free, both at the Main page.  

 

 

---

[1] “On the Tragedies of Shakespeare,” 1811.

Dixon Illinois: Fifty Three Million Dollars Go Missing -- So Who Let the Horses Out?

 

    Trust – but verify.

            -- Ronald Reagan 

The revelation of a $ 53 million embezzlement by the treasurer and comptroller of the city of Dixon Illinois – home of the 40^th American president – once again brings this to the fore:

“Why are the accountants still so bewildered that there should be an ‘expectations gap’?”

According to her criminal indictment released on May 1, Rita Crundwell went undetected since 1990 in accumulating all the appurtenances of a life of rural luxury – not only the typical clothing and jewelry, but trucks and trailers, Liberty Coach motor home and Ford Thunderbird convertible -- all supporting her sideline prominence in the boots-and-bling world of quarterhorse breeders (here).

Extractions of that magnitude, from the coffers of a city with an annual budget of only $ 8 to $ 9 million, might have required her full-time devotion to shoveling the cash with both hands. But the self-efficient Ms. Crundwell did not scruple to observe four full weeks of paid vacation each year, and was evidently only caught out when she extended her absence to an additional twelve weeks.

Separation of employees’ duties? Back-up authority that someone else should glance at the city’s checkbook? Allowing her family members to pick up the city’s mail while she was on her holidays? Could the demands of minding the city’s affairs be so simple, naive and blasé, even in the exurban Midwest?

As for the expected queries (here and here) – what about the gatekeepers at the corral?

A large regional accounting firm is reported to have done compilation services for the city since 2006, having done audits in prior years.[1] But the distinction has so far not been explored.

Which, borrowing a metaphor from Ms. Crundwell’s expensive equestrian hobby, is to beat a sad and very dead horse. Because, as the professionals are in the process of learning to their sorrow, simple proximity and association are enough to attract whole worlds of grief.

The International Auditing and Assurance Standards Board – source of auditing standards on a global basis – on March 16 issued a new version of guidance on the performance of compilations:

"Since a compilation engagement is not an assurance engagement, a compilation engagement does not require the practitioner to verify the accuracy or completeness of the information provided by management for the compilation, or otherwise to gather evidence to express an audit opinion or a review conclusion on the preparation of the financial information."

The IAASB also speaks to the intended use of compiled financial statements, however, posing the question whether: 

"External parties other than the intended users of the compiled financial information are likely to associate the practitioner with the financial information, and there is a risk that the level of the practitioner’s involvement with the information may be misunderstood …"

What the IAASB does not offer – understandably, considering the many settings in which full-blown audits are not worth the cost or effort involved – is aide to either the profession or the user community on a necessary risk-based inquiry:

“Just because a service can be done, does it make any sense and should it be done?”

The accounting profession, mistakenly relying on disclosure of the limits on what a compilation report does or does not say, has traditionally looked on that work as low risk – which it mostly is. But consider the environment, and the typical level and quality of competence, governance and integrity in municipal government. What level of confidence should with safety be routinely reposed in those entrusted with management of a small city’s financial resources?

A typical compilation report – while offering no opinion – does recite that the accountant has performed with appropriate skill, ethics and the exercise of appropriate professional judgment. But that is all it takes to get burned.

I have tried to get across, both to my students in Risk Management and to my friends and clients in the profession, that for one caught holding an empty gasoline can, while standing next to a suspicious conflagration, it is not easy to avoid suspicion of arson. The explanation goes down hard, that the container was an innocent impulse purchase at the local hardware store.

As both an exercise for law and business students, and a message in the real world: there is no harm in not wearing a seatbelt, most of the time – or in not locking the barn door. Except for the rare time when it isn’t okay – and then it really matters. A long record of “being lucky” or a history of “getting by” counts for nothing when a bad event exposes the devastation wrought by casual habits.

How accountable the good townsfolk of Dixon will hold their city fathers for the quality of their stewardship – and whatever the exit cost may ultimately be, for a blinkered exercise in the assessment of risk and exposure to Crundwell’s plundering – it is once more made crystal clear that the accounting profession continues to market services that are under-comprehended and over-sold.

 

Thanks for joining this dialogue. Comments are welcome, and subscription is easy and free, both at the Main page.

---

[1] My requests to the firm’s media contact for an opportunity to converse have not been answered.

Lessons from Football: Strategic Risk, Reward and Uncertainty

If the essence of strategic decision-making lies in the assessment of potential rewards under uncertain conditions, whole seminars can be taken from the last minute of this year’s Super Bowl between the New York Giants and the Boston Patriots. 

For extra flavor and pedagogic potential, both coaches in this 46^th edition of America’s great sporting spectacle had to make choices that ran against their deepest, aggressive go-for-broke instincts.

Trailing by two points on the Boston six-yard line, Giants coach Tom Coughlin could come from behind and win with a chip-shot field goal – a high-odds likelihood but never a certainty. So to keep the ball out of the hands of dangerous Boston quarterback Tom Brady, his interest was not an attempted touchdown – but to stay out of the end zone and run the clock near zero before what would be the winning kick.

Whereas, having no chance to win without his offense on the field, Boston coach Bill Belichick’s defense had to allow the Giants a quick touchdown to have any last-minute hope.  

The play itself was surreal. Giants running back Ahmad Bradshaw, offered a clear path by the Boston defense, drove for the end zone with all the DNA of his entire playing history – realized his error and tried to stop short – but failed to halt his momentum, stumbling awkwardly for a bizarre and unintended score. 

At that point, the decision-theory exercise was complete. The game’s final outcome was then only interesting from the perspective of one of the largest-ever audiences of actual football fans.

As frequently the case, the ultimate outcome did not undercut the validity of either strategy – to which it was equally irrelevant that Boston was unable to score in their last remaining drive, or that the Giants snatched a victory despite Bradshaw’s gaffe.

In other words: Coughlin had the right idea, but his player failed to execute – and he still won the game. Belichick was no less canny, and got precisely his desired result – only to see Brady’s final drive fall short.

As my students in Risk Management come to grasp, it is not just the balance of success or failure of competing alternatives, but the magnitude of the consequences in either direction: a multi-dimensional decision calculus weighs both a huge potential benefit against a modest chance of loss, but also a likely but small upside against an unlikely but possible catastrophe.  

Examples run from the deeply personal, through all aspects of commercial and professional behavior, to the highest levels of governmental policy-setting: 

• To the feckless Francesco Schettino, captain of the stricken Costa Concordia, the frisson of a near-shore detour overcame his judgment as to the hazard that his ship would land on the rocks.

• To MF Global’s Jon Corzine, now-fallen former master of the universe, the desperate gamble to save his enterprise made it worth raiding the accounts of his customers.

• To central bankers confronting the potential collapse of, say, a General Motors or an AIG or the sovereign debt of a Greece or an Ireland, the ability to quantify and evaluate the “success” of a bailout must include complex and uncertain consequences, economy-wide, of both action and inaction.

The choice-making architecture in all of these – from the football field to the captain’s bridge to the bankers’ boardrooms – traces back to the proposition posed by the 17^th century French mathematician and philosopher Blaise Pascal, on how the rational man should wager on the existence of a benevolent god:

There is no downside to affirmative belief, which if ultimately correct gains an eternity of heavenly reward – whereas to doubt has no immediate benefit but if proved wrong carries the punishment of eternal damnation by an angry diety.

It’s getting the downsides properly evaluated that is often the hardest, as I have written elsewhere. Belichick was challenged, because to allow an opponent’s unimpeded score went against the competitive grain – unappealing, but less consequential than the likely prospect of a Giants winning field goal.

Fortunately for Coughlin, on the other hand, his choice had an inbuilt hedge – the undesirable touchdown gave him a four-point margin, putting back on Boston the higher burden of driving the field, within an NFL minute, to answer in kind.

As for Captain Schettino or Mr. Corzine or the world’s purported financial wizards – however sincere their various professions of hindsight regret might be – only the bright sunshine of prosecutions or public inquiry will shed light on the extent to which they were remotely conscious of the potentially catastrophic results of their choices.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy and free, both at the Main page.

 

 

 

 

The Airbus A380 as a Risk Assessment Case: Cracked Ribs Do Not Signal Good Health

Cause for concern are reports that European air safety officials have ordered inspections of cracks in the mounting brackets that attach the wings of the Airbus A380 – already a plane with a long history of delays, design issues and cost over-runs.

And if the bland assurances being spun by the manufacturer’s publicists – that “the cracking problem … is not a safety risk in the short- to medium-term” – reflect the company’s risk assessment attitude, then a suppressed but potential catastrophe is a matter of time – a mid-air disintegration with massive casualties and the subsequent grounding of an entire discredited fleet.

I am just winding up a month-long Risk Management teaching engagement, migrating an MBA-level curriculum to a class of undergraduates.[1]

Some recalibration has been involved. At the graduate level of business and law students, our focus is on the broken models and ineffective risk processes that have characterized the worlds of finance and banking, insurance, accountancy and professional services, over the years of the credit crisis. These run through the period -- from the collapse of Bear Stearns to that of MF Global; from rogue trader Jérôme Kerviel at Société Générale to his UBS counterpart, Kweku Adoboli; from the corruption of the American subprime mortgage market to that of Japanese corporate governance at Olympus.

Younger students stay with the basics – the human behaviors by which incentives are skewed, failures are rationalized away, and incipient disasters are hidden under the mistaken illogic that safety and soundness can be inferred, only because a breakdown “hasn’t happened yet.”

The discovery of cracks in the “rib feet” of the A380s presents a long-familiar challenge: what response is proper to the emergent symptoms of a potentially devastating event?

It is all too natural to put up an optimistic face – to admire success and to wish away the language of bad news. But the consequences can be dire:

• The late Steve Jobs may well have paid with his life for his denial-based postponement in treating his pancreatic cancer.

• The Italian liner Costa Concordia would most likely be cruising in comfort, rather than lying as a hulking wreck, had the supervisors tracking its earlier near-shore wanderings acted on the ready GPS data revealing the captain’s record of reckless behavior.

• And the signs of corruption in Bernie Madoff’s Ponzi operation were well within view, both to the SEC and to his investors, had they not chosen to turn blind eyes to the readily apparent.

Historical memory is hard to hold, especially where corporate budgets and profits and bonus payments depend on the wishful avoidance of delays, repairs and caution-based slow-downs.

But for learning directly applicable to the A380 and its cracks, my students have just scrutinized the 1986 case of the space shuttle Challenger – launched to its fatal explosion, before they were born, over the engineers’ objections that cold weather would threaten the flexibility of the eroded O-ring seals on its rocket booster.

The logical flaw in the shuttle case extends: The fact that prior launches had succeeded, despite O-ring erosion, did not provide comfort for future launches under other conditions. No more, that the A380s may have flown so far without incident despite wing bracket cracks – when such potential stresses as severe weather, hard landings or simple future wear-and-tear fatigue would change the failure calculations and render invalid the assumptions underlying margins of safety. 

In other words, paraphrasing with emphasis physicist Richard Feynman on the shuttle, “the A380 rib feet were not designed to crack. Cracking was a clue that something was wrong. Cracking was not something from which safety can be inferred.”  

In the Challenger case, seven astronauts and a space vehicle were lost to the deficiencies in NASA’s risk management. As for the A380, has any learning occurred?

As soon as my final grading is done, I will be uplifting for Paris and a spring-semester teaching gig with law students there.

But not on an A380. In its wounded state, I will be happy to book on the robust aircraft of an American airline.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy and free – both on the Main page.      

---

[1] My thanks and gratitude to the congenial community of Carthage College – faculty, administration, support and especially the students in my seminar – for a welcome and an experience as warm as this unseasonable winter in Kenosha, Wisconsin.

 

The Next Home for International Financial Scandal? If You Can Find It -- It's Malta

I recently made my first visit to the tiny island nation of Malta – once the Mediterranean crossroads of crusaders, smugglers, pirates and profiteers, now better known as a way-stop on the marine route of refugees fleeing coastal North Africa for near-by Sicily and mainland Italy.

My impressions -- of a country and people with much to be modest about -- leave me uneasy, with Malta now touted as headquarters to a rapidly-expanding roster of European-based hedge funds – e.g., here and here.

This is not good news. Because if true, the fuse is lit and sparking on the next explosive weapons of financial destruction.

For all its storied history, today’s Malta is a backwater. The country’s low-wage economy survives on limited tourism for history buffs, and second-language schools serving a heavy demand for English because the native tongue with its Arabic origin and Latin orthography is unlearnably complex, marginalized, and disappearing.

In by far the smallest country in the Euro zone, with a population of 400,000 mainly unprepossessing Catholics, the focus of governance is limited to the legality of divorce. While, as I was told by the under-employed college graduate who drove our taxi from the airport, ”You’ll probably never see a policeman during your visit. There’s so little crime, they go into the parks and sleep in their cars behind the trees.”

Transport on Malta until last summer’s upgrading was dominated by fleets of clapped-out orange and yellow buses, of a vintage more worthy of pre-Castro Cuba than a full-fledged member of the European Union.

The inevitable question asked by a tourist looking over the pervasively sand-colored Italianate architecture is, “Doesn’t a country with aspirations to be taken seriously care enough to wash its cars and clean the dirt off its windows?” To which the prompt and unashamedly self-deprecating answer, “who cares?” is that the prevailing winds off the African desert make a daily layer of dust as inevitable as the sunrise itself.

After centuries of outside dominance, latterly in the form of British colonial oppression until independence in 1964 and eventual troop withdrawal in 1979, a legacy of brain drain and talent flight assures a vacuum of local vision and mediocrity of leadership.

“Maltese” evokes several things – post-Crusade centuries of knightly influence, toy-sized white dogs in the laps of ladies who lunch, and the elusive avian statue that so bedeviled Humphrey Bogart’s Sam Spade in the eponymous 1941 re-make of Dashiell Hammett’s noir novel. 

What it does not call up is a legitimate industry of well-regulated financial institutions.

So what is nascent, with the explosive growth of a Maltese hedge fund sector, is dangerous regulatory arbitrage – the potential for a rush to the bottom not seen since “regulatory capture” in Antigua and Barbuda laid the foundations for Allen Stanford’s Ponzi scheming, through his purchase of a tin-plated knighthood along with the compliant gate-keepers’ keys to that country’s thatched-cottage banking industry.

The cases are legion that even big-country regulators have been asleep on the watch – from the SEC’s failure to finger Bernie Madoff, to OFHEO’s late-arriving blinking at the sub-prime mortgage trainwrecks of Fannie Mae and Freddie Mac, to the PCAOB’s belated discovery of something rotten in reverse-merger Chinese public companies coming to America to list on its exchanges.

So the chances that the Maltese have the competence to escape a worse fate, in response to the invading hordes of hedgies in their private jets and sharply tailored suits, are precisely nil.

I have been bold in this space to make an occasional prediction about the expected times and places for outbreaks of unpleasantness – in Islamic finance, a Madoff-related suicide, or the rates of white-collar recidivism exemplified by Barry Minkow’s return to prison – with a record that is almost distressingly robust. 

Readers prepared to files these views on the likelihood of serious mischief erupting on Malta into a time capsule with a three-to-five year seal are invited to check back with me then.

In the meantime, pending the passage of time sufficient to prove me right, prudence suggests that investors seek a home for their hot and mobile Euros other than Malta.   

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy and free, both at the Main page.      

Lessons in Risk Management: A Broken Clock is Never Right -- It's Just Broken

The national recalibration caused by this weekend's fall-back to standard time is a reminder of the cliché recently repeated by a friend, that: 

“Even a broken clock is right twice a day ….”

Or so it is supposed, for the proposition that some information is better than none at all.

I will spare my friend's identity, since this is not personal. But as studied by my students in Risk Management, it is vitally important to scrutinize both what you know and what you don’t – and not be misled into missing the difference by the invocation of familiar but unexamined verities.

I surveyed my students – who with their PC’s and iPads and smartphones are carrying around an average of 2.5 devices providing them with the hour – of which only a fraction are readable by way of little hands pointing at a circular array of twelve numbers on a dial.

It’s the same in today’s public life: the handsome golden landmark clock in Grand Central Station is an anachronism, superseded by the blinking digital screens of the airport flight announcements, the pulsing scoreboard lights of the sports arenas and the obnoxious talking panels of the typical office elevator.

Even in the classroom for my MBA course, a sleek modern rectangular digital time screen hangs above the door.

Here’s the point: when broken, the ubiquitous digital clocks simply go blank. There is no sense in which, when non-functioning, a dark and empty display can ever be “right.”

So the claim is incomprehensible to anyone raised in a world of digital time-pieces. Baby-boomers are likely the last at risk of being led astray, having grown up with (and still using) analog time-keeping machinery.

At no time in the diurnal cycle is any meaningful time guidance offered by a crashed computer or an uncharged cell phone – or, for that matter, a dead microwave or DVD player or any of the myriad of appliances now equipped with digital clocks on which generations younger than the fogies rely.

The “right twice a day” assertion also suffers a more subtle flaw: How do you know? The question of “right-ness” is only testable by reference to an outside source. Looking at the hands of a broken clocked stopped at the classic “ten-to-two,” you may suspect being late for lunch.  But you can’t know without a working alternative. Whatever its format, no informational value is added by viewing the face of a dysfunctional clock.

The inquiry really needs to go down another layer, though, to the reason for calling on the cliché in the first place.

Examples abound where a little information is actually worse than none, especially where users are lulled into a false sense of security and over-confidence.

Unmarked and narrow country roads suffer a lower rate of fatal vehicle accidents, for example, than high-speed expressways, even if the latter are fitted with lane markers and rumble strips and crash barriers, precisely because the rural lanes demand high degrees of focus and attention, prudence and speed discretion.

Equally, day traders seduced by computer-generated graphs and charts of stock price activities are lured into the misapprehension that the flood of data is a reliable measure for predictability, only to crash and fail at the rate of amateur punters in a casino.

And on a global scale since 2007, the road to financial ruin has been littered with the reputational corpses of those who mistakenly believed that the quants’ “value-at-risk” models and their off-spring sufficed to support their portfolios of exotic financial products – among them, Jimmy Cayne of Bear Stearns, Chuck Prince of Citi, Dick Fuld of Lehman Brothers and most lately, Jon Corzine at MF Global.

Which is not to say that there is nothing at all to learn from a clear-eyed acknowledgement of the limits on the knowable. But more likely than an unexamined repetition of a maxim that is both conventional and therefore probably wrong, let the inquiry seek wisdom from the more humble perspective of the counsels of caution. 

PS: An invitation: send me your suggestions for other clichés worthy of attention and deflation. Thanks.

Thanks also for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription sign-up is easy and free, both at the Main page.

 

 

UBS: Roguery at the Bank Provides a Teaching Moment

Kweku Adoboli has done me a great favor.

Many others could not say the same. They include Oswald Grüber, Carsten Kengeter and Maureen Miskovic – the chief executive, head of investment banking and senior risk officer of UBS – whose balance sheet the 31-year-old trader has blown up to the tune of $ 2.3 billion, through the unimaginative if devastating use of fictitious customer trades to mask his massive wrong-way bets on the S&P 500 and other major indices.

While Adolboli will stay another month in custody in London, and Grüber’s team of gnomes in Zurich begin the extended process of damage assessment and control of this latest outbreak at the troubled bank, I have the privilege of bringing to a seminar at the University of Chicago Law School the MBA-level course in Risk Management I have taught at business schools these last three years.

Arrested on the third anniversary of the collapse of Lehman Brothers, Adoboli not only lets me throw out the opening pages of my introductory lecture notes, on the inevitable eruption of large-scale unmanaged risks in complex systems. He also replaces Société Générale’s Jérôme Kerviel as a final exam topic on the test question, “Where’s the rogue?” 

In the law school environment, we will explore the proposition freshly demonstrated at UBS, that compliance-oriented risk systems – limited in concept, execution and assurance to the narrow and unsatisfactory conclusion that “most things are working, most of the time” – are both wasteful and ineffective to detect or deter an existential threat.

It’s as true for a rogue trader as for a suicide terrorist: doing pat-downs or box-ticks of an entire population, whether grandmothers on airplanes or bank clerks writing customer orders, will not stop the dangerous deviant capable of causing a blow-up – however much those intrusive and costly procedures may serve the political goal of lulling both leaders and constituents into a false if harassed sense of security.

In context of Adoboli’s shenanigans, said to date back to 2008 when UBS itself was bailed out of the consequences of its ill-fated venture into subprime mortgage-backed derivatives, on through its climb-down before the Justice Department over the business of sheltering US taxpayers, there is painful irony in reading the bank’s self-congratulation on the subject of its risk management. Take, for example, excerpts from its 2010 annual report:

“Operational risk is the risk resulting from inadequate or failed internal processes, human error and systems failure, or from external causes (deliberate, accidental or natural). Events may be manifested as direct financial losses or indirectly in the form of revenue forgone as a result of business suspension. They may also result in damage to our reputation and to our franchise causing longer term financial consequences.

“Managing risk is a core element of our business activities, and operational risk is an inevitable consequence of being in business. Our aim is not to eliminate every source of operational risk, but to provide a framework that supports the identification and assessment of all material operational risks and their potential concentrations in order to achieve an appropriate balance between risk and return.

“… Management, in all functions, is responsible for establishing an appropriate operational risk management environment, including the establishment and maintenance of robust internal controls and a strong risk culture.” (All emphasis added.)

With that, a question could be posed to Mr. Grüber concerning the bank’s reported 2010 payment of fees to Ernst & Young of 67.4 million Swiss francs ($ 59 million at today’s exchange), of which CHF 58.5 million were classified as audit, to obtain the latest annual version of a standard auditor’s report:

“With hindsight, how badly would you have wished to re-direct some portion of that audit fee to an engagement to conduct a precise and effectively directed, root-and-branch scrutiny of the condition of the controls at the sections of your bank having potential to inflict multi-billion dollar harm?”

Because herein lies the puzzle, about the unavailability of such valuable assurance to replace today’s outmoded commodity product:

In launching its concept release on the auditors’ report, Public Company Accounting Oversight Board chairman James Doty’s June 21, 2011 statement acknowledged “generalized investor dissatisfaction with the pass-fail model, and generalized frustration with auditors who had issued unqualified opinions on the financial statements of banks that later failed.”

And yet -- the entire community of financial statement issuers, users, regulators and auditors remain committed to what one comment letter notes as “the PCAOB’s intent to retain the current (‘pass/fail’) form of the auditor’s report.” As stated, there is “overwhelming support from all stakeholder groups for retaining this long-standing approach to auditor reporting.”

Why?

Kweku Adoboli now stands as poster boy for the unrecognized urgency of replacing that model.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription sign-up is easy and free, both at the Main page.     

Racing to Avoid a Crash: On the Track -- On the Street

There’s a stack of final papers in my Risk Management course – and an apero on the sunny terrace of the neighborhood café, to ease the grading process.

And a fond wish for one more class session, to dissect last weekend’s lesson in the disastrous consequences of bad risk assessment and choice-making under high-stress competitive conditions.

It happened at Sunday’s Indianapolis 500. Rookie driver JR Hildebrand had a comfortable lead going into the final lap. But instead of riding easily to victory, he attempted a high pass of a slower car on the very last corner, crashed into the wall, and slid his wreck to a second-place finish – passed by the doubtless astounded Dan Wheldon, on whom Hildebrand’s error of judgment and the fickle gods of fate bestowed a gift beyond imagination.

Aggressive, brave or foolish – the high cost of immature enthusiasm under “win or crash” analysis is not rare. Recall the Olympic gold medal that snowboarder Lindsey Jacobellis threw away on her final run at Turin in 2006, with her ill-advised showboating stunt attempt on the last bump.

My class of MBA and Finance students focuses on lessons from highly-consequential decisions, especially in failure situations – drawn from many fields into the worlds of commerce and professional services, where most will eventually work, and where senior leaders charged with risk responsibility have performed so poorly over the last four years.

From Hildebrand’s split-second choice – now part of racing lore and a life-long mark on his career record, they would take at least these two:

First, the skills and energy of the young are to be recognized and respected; a new hot-shot does command attention and can achieve greatness, whether in sport or government or a trading room. But as events at Indy showed, the converse is no less valid. Beginner’s luck is no substitute for seasoned strategy, and those surviving to accumulate the scars of experience bring wisdom that tempers rash choices.

Provided Hildebrand does learn his risk/reward lesson, in other words, he is not likely to repeat it.

Therein lies learning for business and financial disciplines, still struggling past the recent crisis. The tragically short time horizon of the designers of exotic derivatives, and the exclusion from the quants’ risk models of events beyond their recollection, created the conditions for the crushing impact of events erroneously thought to be unforeseeable.

The second lesson from Hildebrand’s choice-making looks at the structure of his decision matrix: a binary choice -- “try to pass” or “lay off” -- but with alternative and different benefits and detriments for each.

The consequences of playing safe and cautious were in his favor: there was no downside, as he was at no risk of being overtaken, and to cruise safely meant a checkered flag.

In choosing to charge the corner, on the other hand, he had negligible upside – he was already holding a dominant lead – while, as events proved, the downside of being unsuccessful was catastrophic.

(Take note, of course, that the calculation could alter dramatically – if, for one case, he was trailing and needed a last-minute pass to advance, or if he was tightly shadowed and at risk of losing his lead.)

The metaphor extends, readily enough:

Should an investment manager double down on a losing strategy, which unless reversed will bankrupt his fund? Or should the size of his positions be controlled along the way, so that no single exposure could threaten his entire firm’s survival?

Should an entrepreneur put all his capital at risk to start a new venture? To a retiree in reasonable comfort, the upside is limited, but the hazard of a failed and penurious old age is real; while to a new graduate with a long view, fortune favors seizing the greatest number of jackpot opportunities.

The under-appreciated risk-assessment obligation, all of this should suggest, lies in deliberate attention, usually overlooked, to the alternative choice: the action foregone, the rejected Plan B, the road not taken, the decision not to charge ahead.

To a rookie Indy driver with his hair on fire and his foot to the floor, this would all seem abstract, bloodless and pedantic. But it should feel otherwise to a risk officer whose strategic control over a floor of stoked-up traders is his bank’s best hope for survival through the next bubble.

Because my students are more likely, post-graduation, to steer companies and to run portfolios, than to drive turbocharged racing cars, the sorry case of JR Hildebrand’s impetuous mis-chance will keep a place in my curriculum.

Thanks for joining this dialog. Please share with friends and colleagues. Comments and suggestions are welcome, and subscription is easy and free – both at the Main page.        

 

The PCAOB Settlement in Satyam: PwC Agrees to Fall on its Pen-Knife

“Two aristocrats challenge each other to see which can come up with the larger number. The second agrees to the contest, concentrates for a few minutes, and proudly announces, “Three.” The proposer of the game is quiet for half an hour, then finally shrugs and concedes defeat.”

-- John Allen Paulos, “Innumeracy,” 1988

 

 The PCAOB’s April 5 settlement with the Indian firms of the PwC network, over the billion-dollar fraud at Satyam Computer Services Limited, adds a $1.5 million fine to the six million dollars the auditors also agreed to cough up to the SEC.

(Statements from the agencies are here and here; see Going Concern for the orders; and the NYT for statements from PwC.)

The amount compares to the aggregate salary of the five PCAOB members of $2,366,000. It would be a small fraction of either the annual compensation of PwC’s global chief Dennis Nally, or the firm’s legal fees on Satyam to date. And even measured by the $ 550 million ponied up by Goldman Sachs under its August 2010 SEC settlement of its one-issue dispute over the “Abacus” derivative peddled by its fabulous Fabrice Tourre (here), the amount is derisory. 

The Big Four giant is still facing on-going investor claims, to be sure. But the exposure is well-fenced; the Supreme Court’s June 2010 decision in Morrison closed the doors of the American courts to foreign securities claimants who bought their shares abroad, and the inexperienced Indian judicial system lacks the competence to be an attractive plaintiffs’ venue.

Consider the motives from the regulatory perspective. The settlement timing ahead of the April 6 hearing of the Senate Finance Committee on the role of the accounting profession in the financial crisis (here) gave senior officials a public forum. And the media coverage allowed the SEC’s enforcement head Bob Khuzami and FCPA unit chief Cheryl Scarboro, and the PCAOB’s chairman Jim Doty and his enforcement head Claudius Modesti, all to strut their achievement against foreign auditors – even while avoiding the obligation actually to try their case across international borders.

From the PwC perspective, meanwhile, the chance for a cheap exit from a major problem would have been a no-brainer. Consider:

First, an enforcement ding on the Satyam engagements had to be coming, sooner or later. From the PCAOB’s order – which PwC agreed not to contest – the Indian engagement teams on the audits from 2005 through 2008 basically did not:

• Adequately audit the company’s cash positions
• Control the confirmation process on bank balances or accounts receivable
• Pursue indications of inconsistent information or control weaknesses
• Follow PwC global directives on audit execution
• Inform or advise higher-level quality oversight personnel
• Document the work actually done (or not) in the work-papers, until subsequent back-dating while already under regulatory scrutiny

So a strategic decision not to defend the indefensible indicates early recognition of a step toward sustainable credibility. 

As for the sanctions – PwC’s undertakings on future practice quality, staffing, training and internal oversight are no more than necessary for an enterprise with aspirations to professionalism; the two-year presence of an outside monitor only adds one more stranger to the list of foreign intruders imposed on its Indian practice; and the six-month restraint on new SEC clients runs only to the settling Indian firms, so does not inhibit either the global network or its other Indian affiliates.

And, lastly, the financial impact of the fines on the massive PwC network is no more than a dime added to a roll of nickels.

For good measure, with the week’s news cycle dominated by military activities in Libya and a threatened government shut-down in Washington, and subsidiary attention to post-earthquake Japan’s nuclear hazards and Silvio Berlusconi’s “bunga bunga” trial, the entire story will drop off the media screen in less than no time.

Predictably, critics of the accounting profession who are unwilling to settle for less than the scalps of the Big Four leaders nailed to an enforcer’s door will make their outrage known.

But they will fail to acknowledge that both the regulators and PwC itself are only acting in full accordance with their respective DNA.

So once again, this settlement points up the challenge to the long-term achievability of a valuable, sustainable assurance function, to serve the issuers and users of the financial information of global-scale companies: the terms of the discourse are revealed as hopelessly inadequate.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is easy and free, both at the Main page.

 

Recidivism and Risk Management: Barry Minkow Goes Back to the Slammer

Son, always remember: some day, somewhere, a guy is going to come to you and show you a nice brand-new deck of cards, and this guy is going to offer to bet you that the jack of spades will jump out of this deck and squirt cider in your ears. But son, do not bet him, for as sure as you do, you are going to get an ear full of cider.

-- Damon Runyon, “The Idyll of Miss Sarah Brown” (1933)

 A question for those charged with risk management and fraud prevention:

 What’s your company policy on employing or doing business with ostensibly reformed white-collar criminals?

 And is a re-think indicated by the news that Barry Minkow, wunderkind among securities swindlers for the scam at ZZZZ Best in the 1980’s, for which he served seven years of a double-digit sentence on 57 counts, is negotiating a securities-fraud plea bargain under which he now faces fives fresh years of jail time (here).

My concern is a prosaic one – not Hollywood’s question whether his return to federal housing means that the pending Minkow bio-pic requires re-shooting of a new ending (here), or whether the February burglary of $50,000 at the Community Bible Church where he recently resigned as pastor (here) bears any of his felonious fingerprints (here).

It’s only this: Given the rate of relapse among those described by English essayist Charles Lamb as “so crooked that if they’d swallow a spike, they’d void out a corkscrew,” should a company concerned for its reputation and fiscal soundness ever yield to sentiment and invite such a fox back into its henhouse?

Experience over the years counsels against it. Examples in my own catalog include the large-company CEO convict, who finagled a reduced sentence via a convenient medical excuse, and was no sooner paroled to a halfway house than he took over its single pay-phone to peddle the rosy promises of new oil deals. Or the youthful CFO applicant who persuaded an employer of his time-served maturation, following bucket-shop charges; the naïve advice of the audit firm partner was to “keep the kid away from the cash” – unavailing to prevent a scandalous and catastrophic collapse and a portfolio of lengthy prison sentences for the entire executive team.

And it was surely foreseeable, following O.J.Simpson’s circus-trial acquittal, that his temporarily dampened symptoms of renewed personal violence would re-erupt – the only question being the period of his volcanic latency.

For a risk manager the decision-making process is a two-by-two matrix – evaluating the rewards and benefits of a yes/no choice whether to chance re-attachment to someone’s checkered past.

A successful result could yield good and honest performance – non-trivial, but likely not different from that available with many other candidates – whereas the negative – a relapse into criminality – would at minimum be seriously costly and disruptive.

On the other hand the cautious choice to forego the relationship would mean sacrificing the potential contribution of an ex-felon – again, a modest upside – although avoiding the destruction that a recidivist’s presence might cause.

The analytic process has its formulation in the 17^th-century French mathematician and philosopher Blaise Pascal’s wager on the existence of God:

Betting against the proposition, with no particular reward for being right, could – if proved wrong -- suffer the punishment of an eternally vengeful deity. Rather, the wager in favor of His existence carries no hazard if incorrect, but offers the upside of an eternity of bliss.

Minkow’s own now-former church is no doubt a repository of repentance, atonement, forgiveness and charity. Admirable qualities, all. But they should not overwhelm what is learnable from logic and experience.

Namely: the percentage of white-collar wrongdoers in the executive suites is small to begin with. But once the “contingent possibility” is established – that is, an already existing proclivity to misbehave – the risk calculus is fundamentally changed.

There is a cottage industry of ex-cons and their acolytes, working the book-and-lecture circuit and flogging scripts of penitence and redemption pitched to the credulous.

It is one thing to read their stories and even to consider the quondam relevance of their experiences. But the case is not made that they should be entrusted with access to the balance sheets of any enterprise involving other people’s money.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is free and simple, both at the Main page.   

Accounting Standards: Rules or Principles? Lessons From the UBS Dress Code

Goldman Sachs has snatched from its US clients the windfall chance to front-run Facebook's IPO, by limiting access to the potential of its $1.5 billion special-purpose fund to foreigners -- while professing no influence from the fuss-budgets at the SEC (here). So it seems a good time to ask:

Should regulatory compliance and accounting standards be expressed as detailed codes of precisely-drawn rules? Or as broadly-articulated principles?

There are lessons to be taken from the 43-page dress code issued by Swiss bank UBS in December (here).

The debate needs help: endless, pointless and fruitless, it feeds the conclusion that much-touted but never progressed “convergence” between international accounting standards and country-level codes in Europe, the UK and the US is as distant, elusive and unlikely as ever.

Popular reaction is that only a Swiss mentality could perpetrate the obsession at UBS, with its meticulous prescriptions on suit fabrics, cosmetic colors, collar points and hair care both facial and cranial.

Although, a dress code did appear late in my own corporate life – no less ridiculous but also raising non-trivial dissonant issues about the boundaries and effectiveness of guidance.

I was the senior member and titular head of a team based in Paris – an expatriate American amongst colleagues from the major European countries. To a man and woman, all were immensely talented and hard-working. They were also urbane, stylish and beautifully attired.

Global headquarters in the US published its requirements for the new “business casual.” It was only six single-spaced pages, compared to the fulsome 43 pages of UBS – but who’d have expected better from the sartorially challenged Americans?

It went into gruesome detail on necklines and sleeve styles and degrees of elasticity; it proscribed denim and gym gear and athletic branding; and it forbade flip-flops and open toes and footwear of any aerobic provenance.

On a given day, probably one-third of our Paris team would have been out of compliance. But, making their own individual decisions about skirt lengths, or pantyhose in July, or whether to match an Armani T-shirt with a differently-branded suit, my young charges were always impeccably turned out and appropriate for client premises and boardrooms anywhere.

For the purpose, they were capable of proper judgments under the lightest of guidance. At our annual group party our solicitor from Edinburgh was elegant in his formal tartan kilt, dirk and sporn – but for court he was always in proper dark grey suit. On warm spring days the length of limb on display among our lanky cadre of legal assistants was a substantial percentage of their average 1.8 meters – but they all donned decorous trouser suits when the visiting firemen arrived from America.

Which has what to do with the challenge of setting international accounting standards? The answer starts with the extent of mutual trust and confidence shared by a community seeking for mutually-acceptable guidance and limits.

Our Europeans rightly expressed derision and ridicule for the US code, just as most of the world feels for the pathetic efforts of UBS, because of our expectations for what was important: discipline, dedication and execution of first-quality work. Under broad principles of professionalism and good taste, their public face was virtually one of self-regulation.

Whereas if constrained by punctilious trivialities, they would have wasted both their morale and my goodwill, along with countless hours of productive time, on manipulation of the rules in rebellious search for boundaries and exceptions.

It’s no different with financial reporting standards and regulations. History teaches that bright-line limits are pushed to excess by the creative and the aggressive: the depreciation lives of mainframe computers in the 1970’s, the elastic retained ownership requirements for special-purpose entities exploited by Enron in the 1990’s, the investor limits skirted by Facebook under the counsel of Goldman Sachs.

It is the human condition that some deviance from codes of behavior is inevitable – society decides the amount, by voting its willingness to allocate resources to law enforcement and sanctions.

The range across cultures can be vast – from the de facto legalization of recreational drugs in urban America at one end, to the use of flogging in Singapore to punish the consumption of fast food on the public streets.

At the extreme, drunken driving among teen-agers could be eliminated: raise the driving age to 25 and impose capital punishment on first offenders. No less, accounting manipulations could be wiped out – by outlawing commercial transactions in more than one currency or that fail to settle for cash within 48 hours.

But the compromises required of society would never go so far. Instead, the certainty of occasional lapses and excesses is accepted. Limits are broadly defined, and enforcement mechanisms are calibrated -- for both better andworse -- in both the capital market’s use of financial information and the fashion decisions of a business office.

Judged by my experience in the latter, a global environment is far more seemly and operates with more success without the heavy hand of excess regulation.

That will soon be learned, I wager, in the halls of UBS. Whether the new leaders of the Financial Accounting Standards Board and the International Accounting Standards Board will agree is a matter of greater doubt.

 

Thanks for joining this dialog. Comments are welcome, and subscription is free and easy, both on the Main page.

 

 

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.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription is free and easy, both at the Main page.

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.

 

Thanks for joining this dialog. Please share with friends and colleagues. Comments are welcome, and subscription sign-up is easy, both at the Main page.