Re:Balance -- Jim Peterson

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.

 

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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.

Previewing 2010 -- And a Note of Thanks

As the old year winds down to the winter solstice and all those rituals by which we mark the holiday season, a brief look ahead.

Depending on reckoning, the New Year will either end an old decade or begin the next one. Whichever, here are a few events that will feature in 2010 among the on-going challenges to the global structure of large-company assurance:

• The Supreme Court in the US may well declare the PCAOB to have been illegally constituted (here or here). If so, predictable spasms of re-enactment and ratification by the SEC cannot successfully encompass such issues as the viability of pending investigations, the legitimacy of past inspection reports, or the need to re-register all the foreign accounting firms.

In the context of those issues of contention, the legislative mischief to be wrought by a Congress offered a blank page on which to re-debate the Sarbanes/Oxley law can scarcely be imagined.

• The fits and starts of accounting standards convergence will have no more traction than a pig on roller skates. The announced retirement of Sir David Tweedie as head of the IASB (here) will take one prickly personality off-stage, but will not solve the antagonisms among competing country and industry level interests. And as the scope of complexity and judgments within both GAAP and IFRS figure to be as significant as those between reporting systems, the achievability of comparability and comprehension will remain as elusive as ever. 

• Attempts to impose liability on the large accounting firms’ international structures will continue apace. The success of BDO International in confining the Bankest verdict in Miami to the Seidman firm alone (here) means that if that $521 million exposure becomes enforceable, BDO may need to find a new US member firm – a tactic painful enough for that organization but which none of the Big Four could achieve under like conditions.

Flashpoints for structural threats will include the Madoff-related feeder funds litigations, concentrated in the US but also spread around the world, and PwC’s exposure on Satyam.  And with PwC’s Indian partners on Satyam about to observe their first full year of local imprisonment, that network's attempts to extract itself from class action exposure in the American court system (here) raise the interesting question whether submission to Indian justice is really a preferred strategy.

• Tempting as it might be to be lured into the speculation about identifying which of the Big Four firm is most likely to disintegrate under the combined pressures of litigation and government threat, in 2010 or otherwise (here), I will decline – since the determining factor is the unpredictable timing of the cases themselves. Specify the judges’ scheduled trial dates for the 25 biggest cases hanging in Damoclean fashion over the large firms – and only then would I be able to offer a view.

• More broadly, strategic decision makers in the world of financial information will continue to confront the volatility of government conduct – an under-recognized factor in their overall risk assessment methodologies.
  

The reactive nature of public officials has been marked in recent years by an ad hoc cascade of unpredictable and unintended consequences – ranging in scope and scale from the back-of-envelope bank bail-out schemes to the bonus supertax in the United Kingdom to the first-ever invention in Dubai of a default-driven debt reorganization scheme of uncertain application or reliability.

So life in the forthcoming year will not be boring. 

Meanwhile, in this space, Re:Balance observes its second birthday. Launched in January 2008, this venture was the evolution from “Balance Sheet,” the column I had the six-year privilege and good fortune to write for the International Herald Tribune.

The challenges have been fascinating, starting with the anxiety-inducing migration from old-style print. No less than the accounting firms, the IHT itself -- like the other newspapers -- pursues its fading struggle in search of a sustainable niche business model. While in the world of rapidly mutating media platforms, the near-term impact of the likes of Twitter, Facebook and Kindle will continue at a dizzying pace to re-define the information landscape.  

It has been most gratifying over these two years, both to participate in community with an expanding group of smart and incisive commentators, and to experience steady growth in readership and especially in subscribers.

For these opportunities, I thank you all for your interest, your insights and your inputs.

Merry Christmas -- best holiday wishes -- and a healthy, peaceful and prosperous New Year to all. 

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Happy Times for the Big Four Accounting Firms? It's All in Whom You Read

The familiar formula for measuring forward-looking attitudes has an update:

The optimist sees a glass half full.

The pessimist sees a glass half empty.

Whereas -- the consultant sees a glass that’s twice as big as it needs to be.

Varying spins are given to the report just issued by the flagship firm of PricewaterhouseCoopers in the United Kingdom, for its year ended in June – 72 pages of sunshine about its £2.25 billion in revenue, profitability that works out to a 34 percent profit margin, and £770 thousand average profits per partner.

The Lex column of the Financial Times cheerily bought in – here. The pink color of the FT’s pages infuses the lenses through which it sees two themes:

“First, firms and their auditors have become more conservative since the Enron and WorldCom debacles. Second, Sarbanes-Oxley in the US and harmonized reporting standards elsewhere have forced greater disclosure requirements.”

The always-acerbic blogger Dennis Howlett begs to differ – here - with a link to the PwC report itself. His focus is on the structural impact of the decline in PwC’s audit and tax revenues, as offset by its rise in advisory practices, with notable emphasis on the £100 million derived from PwC’s work on the Lehman administration: 

“PwC UK may be doing very well at the moment but you can see where it is going. I anticipate that over time, it will continue to reduce its dependency on assurance services as the engine for growth but with it will come renewed criticism of its conflicted advisory position.”

The FT manages with a straight face to say that “the most important asset the accountants have maintained in this recession is their reputation” – a rosy view, not even shared by Floyd Norris of the New York Times (here), and suffering two-fold difficulties:

First, it is hard to see the recent years as a Goldilocks era for the accountants, post Enron and Sarbox, with the lengthy list of financial institutions that have fallen to collapse, shotgun mergers or government control – all of them flagging clean reports on their financial statements and their controls even as they plunged over the cliff to ruin.

It is more likely proved once again that the capacity for scandal-driven public outrage is both limited and finite, the only variable being the number of targets at which insults are sprayed.

That is, the energy and attention demands of the various stimulus and rescue efforts, and the related demonizing of the institutions and their high-bonus leaders – screeched by politicians, regulators and media alike – have in effect given the auditors at least a temporary pass from hostile scrutiny.

Second, there is the FT’s remarkable proposition that “the downturn has not notched up a big accounting scandal.” That’s as may be, but only if from its London base the vision stops at the shores of the sceptered isle.

Because the rest of the world will not disregard the inclusion of auditors in claims directly associated with the collapsed financial institutions (tracked and summarized by Kevin LaCroix at the D&O Diary), the massive claims involving the audits of the Madoff feeder funds (here) or the existential threat posed by the Satyam fraud in India to PwC’s practice in that country or the on-going criminal prosecution of its personnel there – the last flagged by Howlett although ignored by the FT and indeed by the PwC UK report itself.

Solutions to the multi-faceted antagonisms that ensnare the Big Four and put their survivability at risk will not be brought forward under the dewy pandering of the Financial Times. But it’s not that Howlett gets a complete pass either.

Howlett may be signaling that PwC is his entry in the commentators’ pool on the next of the Big Four to catch a fatal bullet – here. The near future will test the marker he puts down, to “watch for a potential breakup a la Arthur Andersen in years to come. Especially if they get nailed on Satyam.”

But he is experienced, skeptical and critical enough of the large firms’ exposed position to contribute above the unhelpful one-dimensional finger-pointing ordinarily delivered by the profession’s usual cast of critics. The sharp point of his pen could constructively jab at an issue much more challenging than the Big Four’s public relations exercises – such as this:

“If the large-company audit structure collapses, what takes its place?”

That’s a discussion yet to start.   

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The Indian Government's Reaction to Satyam -- Marching Backwards to the Future

In what is still the global-scale financial scandal of the year -- India’s Satyam Computer Services -- the search for villainy continues to diversify.

•    Blogger Francine McKenna leads the charge (Re:The Auditors) against what she sees as a corrupting business relationship of services provided alongside PricewaterhouseCoopers, whose Indian firm did Satyam’s audits.

•    Indian regulators are publicizing their cooperation with the US SEC (here), and suggesting the imminent end to their investigations (here).

•    And the amount of impartiality expected from the Indian system of criminal justice was signaled in the July 9 statement of Corporate Affairs Minister Salman Khurshid, that “All the concerned persons have been arrested except one and prosecution has begun against the guilty" (here, and the anxious emphasis is mine).

I was recently berated by a reader for saying back in February (here), that the Indian approach of incarcerating suspects even before charges were brought did not accord with basic notions of fairness and due process. The gist of his barb was that I was being “holier than thou,” because in his view the US government bail-out of its financial institutions was the “crime of the century,” whereby the “biggest crooks in our society” have stolen $ 700 billion of taxpayer money with no benefit to “the people who have landed on the streets due to foreclosure.”

My deeply insulted critic is entitled to his position. But he is trying to pick a fight on the wrong ground. I have lived and worked outside the US long enough to recognize the risk of presumptive cross-border judgments. And history, not he or I, will judge the leadership of President Obama, Treasury Secretary Geithner and Federal Reserve Chairman Bernanke. It’s not an “either/or” proposition.

Rather, it remains that, save for those like Alan Stanford who present flight risk, and where even the now-jailed Bernard Madoff enjoyed the liberty of his apartment until the day of his guilty plea, it offends mature notions of justice to imprison white-collar accused ahead of an adjudication of their guilt.

Pass this as a quibble. It is of more importance to the evolution of the Indian environment, that the degree of insight and perception shown by Minister Khurshid ominously suggests two reasons why the only impact of Satyam on that country’s governance and regulation will be from the “law of unintended consequences.”

The first issue is attitudinal. Satyam represents India’s “Black Swan” moment, in the phrase made popular by Nassim Nicholas Taleb’s best-seller (reviewed here). It was an unexpected and highly disruptive event – about which Khurshid commits the familiar error of misperception and flawed analysis, stating that “the Satyam scam is an aberration and the events are specific to the company in question. No other scam of this nature has come to notice since then” (here).

Now that Satyam has brought it forcefully home that large-scale corporate fraud is a reality in India (and in fact was completely predictable all along, despite official denial and evasion), it is equally certain that other similar situations are gestating even now, undiscovered but waiting their own moments to emerge.

So rationalizing Satyam as unique will be to miss the inevitable crises of the future. Yet, Khurshid’s remarks indicate a simple-minded determination to replicate the ineffective reactions of his counterparts in countries elsewhere.

That is, his view that a package of new legislation and an “elaborate regulatory framework” will address “all issues” involving forgery and computer manipulations, disclosures to stakeholders and discipline of public accountants and corporate secretaries (here) simply lacks the credibility of a track record of success.

Did Sarbanes/Oxley impede the credit market implosion? Or slow down Bernard Madoff? Measured against efforts at prevention, in jurisdictions suffering decades of corporate malfeasance and failing consistently to stop the periodic eruption of fresh cycles of wrongdoing, the Indian view that effective prevention can be learned and implemented from a one-off experience is dangerously naïve.

Secondly, even less likely to act as a deterrent is Khurshid’s proposal to include the concept of shareholder class actions in a new Companies Bill (here).

Events may well outrun the Indian legislators. As announced (here), the opportunistically-named Midas Touch Investment Association seeks to launch a class action in India on behalf of 300,000 shareholders, seeking over $ 1 billion from Satyam’s directors, auditors and promoters. At the very least, this promises a two-ring circus as veteran plaintiffs’ lawyers in the already-pending US actions will eagerly protect their access to an expected honeypot of legal fees.

Lest I attract further vitriol from those taking positions on either end of the advocacy spectrum – as to whether class actions are either a vital and essential weapon for defrauded investors, or a tool of extortion and destruction held over corporate management and a menace to the entire capitalist system -- a middle course:

Decades of American experience with securities class actions would suggest caution, before introducing such a jurisprudential tool into the kit of Indian governance and enforcement. At least, the empirical observation of developed economies and markets in Europe, which have thrived without the common resort to shareholder class actions, might at least indicate that steering the Indian system in the direction of the American would invite the re-invention of a set of less than desirable problems.

An available lesson from Taleb’s “Black Swan” is the all-too-human tendency to resist learning from failure. A special version – characteristic of the political classes and fully displayed by Minister Khurshid – is the hubris of the uninformed, who in their refusal to study the lessons of history are incapable of appreciating the boundaries of their ignorance.  

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The Indian Regulators Pronounce on Satyam -- And a False Dawn is Promised

Is corporate India now vaccinated against an outbreak of white-collar financial fraud?

The great and the good of the country’s regulators would think it – taking at face value their prideful descriptions of the investigative scrutiny of scandal-ridden Satyam Computer Services Ltd.

The former chairman of the Securities and Exchange Board of India, Meleveetil Damodaran, is quoted – here -- as calling the fraud at Satyam “unique,” and “an isolated case, not reflective of the state of affairs of India Inc.”

He would say so, of course, as a current board member of Tech Mahindra, the successful bidder now grasping the handle of the poisoned Satyam chalice. But the annoying question persists: on what basis could he possibly make such an over-reaching claim?

Not from the work of the Central Bureau of Investigation, which invokes its use of “cyberforensics” – here -- in order to “uncover how in-house computer systems (at Satyam) were exploited to generate false invoices.”

Please. Spare us another exaggerated claim on behalf of the “forensics” of post-exposure inquiry.

A sewer worker can unplug a cesspool, too, if given a shovel and told – pointing to the clogged hole – “Dig here.” Admirable are the muscles involved. But the worker is not thereby qualified to engineer the waste plant, nor to monitor the flow through its twisted pipes and drains.

The forensic program to illuminate a revenue statement inflated by bogus business would start – and typically would end – with a single sharp finger pointed to the designer of the information system:

“Will you please show me the back-door technique by which alternative invoices – authorized or not – can be entered into the system? And for good measure, would not such an entry be concealed from the mainstream reporting process?”

That’s it. Not the stuff of brilliance or epiphany.

It does remain to be revealed, probably in court, whether such simple and direct questions were ever asked in the normal course of Satyam’s risk management process – under audit or otherwise. But conceiving them after the fact is hardly the matter of revelation now being publicized by the Indian regulators.

As for the excessive enthusiasm of the good Mr. Damodaran. Nassim Nicholas Taleb’s “Black Swan” presents the two lessons essential to avoid the “induction trap” into which the SEBI veteran falls headlong:

•    First, no number of observations of white swans can disprove the existence of a black one. Likewise, however superficially successful may appear the historical performance of a financial reporting and assurance structure, the past can give no comfort that a catastrophic failure will not suddenly emerge.

•    Second, the single observation of a black swan not only destroys the baseless over-confidence that the species does not exist – it must also contemplate the prospect of other like specimens. More directly, Satyam as one mega-fraud not only establishes that it can happen in India, but supports the necessary expectation that others exist, only as yet undiscovered.  

Or in more folksy terms – the first appearance of a cockroach, in a kitchen thought to be pest-free, both disproves any assumption of health-code compliance, and also reasonably alerts the chef – since vermin are not known to be solitary – to the unpleasant presence of more.

The Institute of Chartered Accountants in India, meanwhile, is off on a wild-goose-chase of its own – here and still here -- chasing after the details of the international affiliations among the only accounting firms globally established enough to participate in the delivery of audit services in a true cross-border involvement.

As if agreements as to name-sharing, letterheads and business cards had anything to do with the defalcation at Satyam. Or, either, with the provincial stature of India’s locally-biased profession – flailing away in back-footed defensiveness as it confronts the reality that it is at least a generation behind the modernization required to participate in a globalized economy.

Rather than take comfort that a black pot of India Inc has been bleached to lily white, in other words, prudent investors and gate-keepers alike would do well to view the pronouncements of naïve regulators as a symptom that the country’s environment for financial chicanery remains fertile and inviting. 

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Once and Future Accounting Schemes -- What Will They Think Up Next?

       

"Everything old is new again ...."
                -- Peter Allen

To pull off the next large accounting scam – or, more virtuously, to try to prevent it – where would we look?

This always-pertinent question has global dimensions, with criminal charges now lodged against two Price Waterhouse partners in India – see here – for their alleged complicity in the fraud perpetrated at Satyam Computer Services Ltd. under the leadership of CEO Ramalinga Raju.

Those inclined to heed memory and history as guides for the future will find familiar the recited bad deeds by which the Satyam accused are now answerable to the Indian courts:

• Bogus invoices for customer work never performed lay at the heart of the mid-‘80’s house of cards known as ZZZZ Best.
• Inflated rolls of non-existent employees echo the ledgers of fictitious insureds a decade earlier at Los Angeles-based Equity Funding.
• Shadow businesses and opaque investments recall the undrillable pools of petroleum, said to lie deep under the Canadian Arctic, sold as snake oil in the 1960’s by Bernie Cornfeld in the original version of Fund of Funds.

In a world of borderless impacts, and with the certainty that details of the Satyam criminal file will now implicate the defensibility of the investor lawsuits lodged in the United States as well as in India, it’s well to ask what new risks lie over the next hill.

Especially since, as similarly structured schemes have kept recurring with dreary regularity, decade after decade, the learning capacity of the financial gate-keepers is slight enough in fighting the last war, let alone to anticipate or prevent the next.

A starting point will be the predictable re-emergence of another rogue trader – almost routinely expected if still highly impactful – the next generation’s reincarnation of Nick Leeson at Barings or Yasuo Hamanaka at Sumitomo or Jerôme Kerviel at Société Générale.

But it’s also back to basics, in a world said to be reverting to older styles of banking and finance. In the recent era of exotic financial derivatives and black-box valuation models, the pervasive separation of deal-doing incentives from underlying transaction risks prove illusory and ultimately disastrous. Looking ahead, it can be anticipated that the next generation of white-collar schemers will unsheathe the simpler tools that have served so effectively throughout the past to entice the investors and evade the auditors.

Old memories may still spark, for example, to recall the 1960’s tanks full of “vegetable oil” in the meadows of New Jersey: collateral for the negotiable warehouse receipts issued by American Express, but actually nothing but water – a scheme that succeeded because the auditors looked from the top of the tanks at the thin layer of oil on the surface, rather than taking taps from the bottom.

Or the herds of ghost cattle, sold in fractional interests to urban investors: the livestock numbers were inflated by repeatedly cycling the same calves through the counting chutes – under the noses of the city-based audit staff who failed to prevent double-counting by the simple control of a chalk-stick mark on the forehead of each animal as it passed by.

Or the heavy-duty oil-field trucks comprising salable equipment portfolios: sensibly counted as they were scheduled through their repair and maintenance depots -- except that each one slipped past the auditors multiple times by the simple expedient of driving behind the repair shed to swap the identifying bar code on its engine block.

Or – to tie off a list that could otherwise go on a while – the allocation to investors of interests in a giant hill of Latin American coffee beans: except that under a thin layer of the real thing, the mound consisted of sand and bales of hay – undetected by the auditors too fastidious or pressed for time to drill or dig deeply enough to the core to get a legitimate sample.

All real stories – none of them all that original. But any of them will likely show up again soon, as timeless devices used to inflate the performance of money-gathering institutions basing their business on asset-based transactions.

Let the gate-keepers be warned – and the future perpetrators too. But only if the lessons of the past are learnable.     

Drop me a note if you have a candidate for an industry or a practice having special exposure. As a teaser -- I will soon take a specific look at a particular sector where I would see this aspect of risk to be both newly emergent and especially acute.

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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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Prisoners of Satyam: Price Waterhouse Auditors Still Under Arrest

An eye for an eye and a tooth for a tooth.
The system seems fair
But is really quite ruthless.
For in time all involved
Become eyeless & toothless.  

The succinct wisdom of the late poet and trenchant social critic Jodie Hansen frames the dust-up started by my criticism of the extended jailing of the Indian audit partners of Price Waterhouse responsible for that firm’s work on Satyam Computers Services – here. That mis-treatment began with their arrest over the January 24-25 weekend and continues, bail applications having failed, apparently at least to late this month.

The PwC organization and its people have their hands amply full in defense, both in India and in the shareholder cases promptly filed in the US, and it is not my point, nor for anyone at this stage, to pre-judge the outcome.

Rather, it is right to scrutinize the means and quality of government response. One American reader, known to me as a wise counselor and teacher, wrote that:

“The Rule of Law has protected us (in America) from the get-go. Here we believe that not only must the result be in accord with law, we give equal importance to the process.”

The contrasting view of a reader in India was that my views were “totally objectionable,” on two grounds.

First, Mr. Ramakrishna asserts, “the Indian legal procedures and systems are far more stable and consistent than their counterparts in the US where far more fraudsters have gone scot-free.”

This is subject to test. Checking the recent roster of the post-Enron convicted and incarcerated – Messrs. Ebbers, Skilling, Fastow, Kozlowski, Black and Rigas come to mind, and adding Weiss and Lerach to boot – the wheels of justice seem to have ground along.

What would be fair grounds for criticism, though, to anyone evaluating the tax-payer impact of the world’s various bail-out packages or checking a retirement fund statement, is whether any of these machinations have wrought the least deterrent effect – either in the US or anywhere else in the world.

Mr. Ramakrishna goes on that “it is a good thing that the Government of India superseded the (Satyam) board and imprisoned the fraudsters – including the auditors.” His basis is evidently the long logical leap that audit quality is to be achieved by mandatory rotational appointment of auditors for a fixed term, and public posting to a website of all audit notes and working papers.

Global-level discussion has long since explored and declined to act on a roster of impractical and unachievable solutions to the persistent issues of audit quality – here. The only country to experiment with mandatory rotation is Italy, with conspicuous lack of success: There, required rotation led to an increase in concentration of large-company work by the large firms, while the 2003 exposure of a € 20 billion hole in the balance sheet of dairy products giant Parmalat exposed the gaping question of any positive impact on corporate reporting and governance.

This Indian reader also cited the critical observations about PwC of my estimable colleague Francine McKenna – Re:TheAuditors – whose characteristic umbrage at the behavior of the large firms was equally directed to me:

“I am a bit surprised you chose to spend so much precious space worrying about the poor PwC partners in custody…. It may be unusual by our standards. In fact it’s downright rare. But at this stage, I’m sure you’ll find lots of folks in the US wishing a few more CEOs, CFOs and auditors were sitting behind bars, examining their consciences.”

Sorry, but even appreciating the natural instinct for punishment and vindication, I will worry.

For what’s the rush? The careers of the PwC partners are in shreds, no matter what. They will never again put pen to a professional opinion, even if their firm does survive – which is far from sure.

The measure of a society’s civility is in how it treats its least – the poor, sick and hungry; the minorities and the disadvantaged. And, importantly, the accused. And those rights extend no less to a professional auditor than to a slumdog – else they dependably protect neither one.

Popular confidence essential for stable democratic institutions rests on trust in the agencies of government. Which requires that the exercise of power by those with the authority to use it be done not in a hasty rush to punitive judgment, but with the restraint and good process that engender credibility.

Robert Bolt’s 1966 play, “A Man for All Seasons,” made the case for the law’s restraint:

Sir Thomas More: What would you do? Cut a great road through the law to get to the Devil?
Roper: Yes. I’d cut down every law in England to do that!
More: Oh? And when the last law was down, and the Devil turned ‘round on you, where would you hide, Roper, the laws all being flat? …. Do you really think you could stand upright in the winds that would blow then? Yes, I’d give the Devil benefit of the law, for my own safety’s sake!

The alternatives are the tyranny of petty officialdom, red tape and corruption; pervasive short-term opportunism by those exploiting the cozy roles of insiders; and, not least, a citizenry both cynical and fearful.

Those choices are made at the local country level. It’s their resolution that determines whether a polity – Indian or otherwise -- deserves full and equal participation in a mature globalized economy.

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Satyam's Auditors from PwC Remain in Custody -- A Prisoners' Dilemma for "Indian Justice"

Even as I said last month that the Indian government’s reaction to the billion-dollar fraud confessed by Ramalinga Raju, the CEO of Satyam Computer Services, would be protracted, disruptive and expensive – here – one manifestation both expected and unpleasant was an excess of prosecutorial zeal.

The Satyam saga has a long and ugly ways to go. But for PricewaterhouseCoopers, auditors of Satyam from 2000 until recently sacked, it is unjust and offensive that its Indian engagement partners – S Gopalakrishnan and Talluri Srinivas -- should be in confinement for what is now almost two weeks and counting.

PwC and its people will eventually have a lot to answer for – the extent is presently unknown, and an impossible topic for uninformed speculation. In a best case, the two individuals are already professionally ruined; the firm’s Indian practice will take a serious reputational hit, even if it survives; and the eventual settlement cost of the flurry of shareholder suits will be painful.

That’s the best case. At worst, although the leadership of the profession could never be heard to admit it aloud, Satyam could be the fatal bullet in the global game of Russian roulette that the Big Four are playing with their survival.

No position is taken here on the defensibility of PwC’s work for Satyam – that’s entirely premature, until a credible legal process works its way. Nor, as regular readers know, am I an apologist for the large firms – neither for the persistence of their inability to learn from and surmount their recurring performance short-comings, nor for their mismanagement of the public dialogue in fruitless pursuit of impractical and politically unachievable “reforms.”

But – to be held without bail or lawyers, much less the consultation with their colleagues and their papers by which to answer charges and mount a defense, PwC’s personnel are suffering their fate in a country whose system of oversight and enforcement is immature, unpredictable and therefore extremely dangerous.

Due process of law should be expected in the official reaction to financial frauds, not the Alice-In-Wonderland policy of “sentence first – verdict afterwards.”  

Put otherwise, measured by comparison to systems evolved in their handling of corporate malfeasance, the operation of the “Indian justice system” is revealed to be as oxymoronic as the maligned Dark Ages version of the “Holy Roman Empire.”

Starkly showing the impotence of the large firms in the face of localized over-reaction, not even global PwC managing partner Sam DiPiazza’s short-cutting the World Economic Conference in Davos in favor of a hasty charm-offensive tour around the ministries of Mumbai has been able to spring the locks for his partners. 

When the dust settles and the prisoners from PwC are eventually released back to liberty, the global firms must re-assess their business model: They are over-exposed to the potential for employee hazard and business catastrophe, by the tri-fold interaction of their own uneven performance across international borders, clumsy enforcement agencies having dubious and disproportionate impacts, and porous leakage into the big-country legal systems where litigation exposures already threaten their ruin.

One potential solution, which would redound on the small-firm practitioners whose voices of hostility and criticism dominate the Indian accountancy regulator – and whose capacity to step in and carry out the challenges of a large multi-national audit engagement is precisely nil – would be to simply declare the Big Four’s services unavailable for use by local companies in the capital markets and securities exchanges of the more developed countries.

Under such a showing that “enough is enough,” the Big Four would -- both in India and other candidate countries coming readily to mind – continue with both their purely local clients and their inward referrals on local operations of global enterprises. What they would not do, however, is voluntarily expose their continued global existence to the vagaries of oversight by agencies lacking either competence or experience at that level.

The large accounting firms serve their clients, after all, as free-standing private enterprises. They are neither the nationalized minions of small-bore bureaucrats nor obliged to practice in a form of coerced servitude to hostile and chauvinistic government agencies.

They have the opportunity – as expected by their people who should deservedly be able to work without daily fear of being hauled off to indefinite imprisonment – to declare their entitlement to fair, measured and even-handed justice.

So far in India, that standard is not met.       

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Satyam's "Ghost Employees" -- An Innovative Approach to Job Creation?

On the record so far, it is safe to predict that the legal and political maneuverings around India’s Satyam Computer Services will be continue to be noisy, protracted and inefficient. But the answer will come quickly to one question:

Did or did not former chairman Ramalinga Raju loot the company by diverting the payroll of 13,000 fictitious employees, out of some 53,000, as alleged by prosecutors and, as of today, at least, denied – or at least not admitted – by both Raju himself and the company.

Whatever the answer -- with its broad implications for the company and its shareholders and gate-keepers, as well as for Indian governance and regulation of companies and their auditors – the process to get there should be rapid.

The investigative work program to unpack such a charge could be written by a second-year auditor – once again exposing that the roadmapped mopping-up of “forensic accounting” relates to the challenges of contemporaneous financial auditing as does the slog of post-battle casualty clearance to the smoky uncertainty of real-time warfare.

Legitimate employees demonstrate their presence far beyond their ID numbers and payroll entries, however susceptible to manipulation those high-level records may be. There are company accruals and payment obligations for taxes, social charges, pensions and benefits. They create hiring and departure dossiers. They occupy real office space, work stations, telephones and computers – all requiring the documentation and outlay of considerable real sums. And as alleged, a 25% padding of their rosters would affect everything in a company environment from cafeteria turn-over to usage of paper towels to the frequency of parties for maternity leaves.

What would have been in it for Raju to bear the cost side of over-stating his employee head-count? All the associated expenses, if fictitious, could have been exposed by a walk through a job site or an expense ledger. While if real, they would have been an impossible drain on the company’s margins – not to mention requiring a team of co-fraudsters to dummy up the records.

Volume padding is one of the oldest corporate scams. Barry Minkow created bogus job locations in the 1980’s to boost the turn-over of ZZZZ Best – but that Ponzi scheme was aimed at inflating the public company’s stock price. And a decade earlier, the perpetrators at Los Angeles-based Equity Funding used the unusual device of over-stating liabilities (to pay death benefits on non-existent insurance policy holders) – but they found a way to extract a pyramid of real cash through the use of reinsurance.

So there was the rub for Raju, and the challenge to the prosecutor’s assertion: ghost employees don’t generate revenue.

Or do they?

Padded jobs rosters, inflated client billings and systematic over-charges are also devices as old as time, as any manager knows who has ever pushed back against a service provider’s generous billing.

To realize revenue on the scale alleged in Satyam, however, would require a massive fabrication of client billings, at the very least – even if disconnected from legitimate employee numbers and expenses – plus the possibility of warehouses full of bogus time records and other job-related footprints. Again, all of this was subject to ready exposure through the most elementary form of inquiry and verification – whether by a client, internal auditors or outside monitoring and scrutiny.

Or is it the case, despite the world’s largest companies on Satyam’s client roster, presumably exercising some level of due diligence in bench-marking Satyam’s staffing and employee productivity against its peers, that the entire Indian out-sourcing industry is so lacking in basic control and oversight mechanisms that irregularities so allegedly pervasive – and, necessarily, collusive – could escape detection for so long.

The implications of that speculation will await exploration when the post-battle forensic hyenas have finished their scavenging. For now, expect that the porous nature of the Indian investigative process, which has already furnished so much to chew on, will continue to serve up a buffet of future morsels.    

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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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Fraud Outsourced to India: Satyam Computer Services -- Is it Enron, or Parmalat?

As this blog celebrates its first birthday, there are two related reasons why I am unconcerned about the supply of new material for its second year.

To start, the crystal ball seems fully functional – based on my calls of December 16 promptly coming good – here – “two predictions as the Bernard Madoff story brings a sorry year to its welcome close:”

    “The first is the safe but unfortunate bet …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 2009, 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.”

The first was sadly realized within the week – here – with the self-inflicted death in New York of French fund manager Rene-Thierry Magon de la Villehuchet.

As for the second, yesterday's resignation of Satyam Computer Service’s Ramalinga Raju, in a letter to his board confessing cash manipulation and a balance sheet inflated on the order of $ 1 billion, introduces large-scale public company scandal in a new region of the world, with consequences that will reverberate all around.

In addition, my belief in web-based communications and the developing capacity to inform and shape serious discussion of complex issues is reinforced by the emergence of new and innovative means – in particular, the launch by Bruce Carton, at his enormously informative Securities Docket, of the Securities Litigation and Enforcement Channel, with Tuesday’s webcast, “The 2008 Year in Review” – linked at his site and well worth a listen.

Bruce’s contributors were four experienced and insightful bloggers -- Kevin LaCroix (D&O Diary), Tom Gorman (SEC Actions), Francine McKenna (Re: The Auditors) and Walter Olson (Point of Law) -- all on my list of valued resources and worthy of attention.

As noted, the two events are related, in this way: During the webcast, the unsurprising outcome of a listeners’ poll on compelling issues for 2009 was that the risk of “Big Four auditors at the brink” was only a distant trailer. 

But that indifference is incorrect, as is about to be shown by the world of hurt quickly to fall on Satyam’s auditors, PricewaterhouseCoopers.

Comparisons with Enron and Arthur Andersen are being drawn, but are mis-placed unless PwC in India somehow manages a similarly self-inflicted indictment. For the post-scandal environment, the better comparison is with Parmalat, the family-controlled Italian dairy conglomerate whose € 20 billion “black hole” in 2003 has since swallowed up careers and treasure at both its audit firms.

The reason is that India, like Italy, is an immature venue for the handling of large-scale financial scandal – which makes the possible reactions of its regulators and politicians both unpredictable and extremely dangerous.

In Parmalat, Italian bankruptcy legislation was re-written after the fact, to enable a newly-empowered special administrator to pursue civil claims both at home and abroad – which he has done with enthusiasm to the tune of nine-figure settlements from Deloittes and proceedings still on-going against Grants.

Meanwhile that country’s antiquated and ponderous criminal justice system is unlikely to complete its prosecutions within the lifetimes of any of its targets – thus displaying an inability with credibility to render either punishment or deterrence.

Because even the scandal-scarred American experience has included the pell-mell excesses of the Sarbanes/Oxley law of 2002 and the Public Companies Accounting Oversight Board, can better be expected from public servants in India, never before exposed to corporate mischief on this scale?

In Satyam, the Ministry of Corporate Affairs, the Securities and Exchange Board and the accounting regulator, the ICAI, have all rushed to announce investigations – processes that, in a country lacking a base of experience with the scrutiny and exposure of serious financial manipulation, will make the posturings of America’s comical Henry Waxman look positively statesmanlike, and will more closely resemble a concoction of Gilbert & Sullivan.

While PwC’s practice in India will be put at risk for its personnel, its permission to practice and its very survival – along with whatever litigation risk may lurk in that country’s untested civil system -- there is the double-whammy of globalized shareholder litigation exposure for multi-national enterprise. Because Satyam’s securities included ADR’s traded on the New York Stock Exchange, the first of an anticipated parade of class actions was already filed on the very day of the company’s downfall.

Mumbai is so far from the American media centers, whose attention to financial scandal is short-lived and US-centric in any event, that Satyam will be a one-week story in the mainstream spotlight.

So although the company’s name may indeed be “truth” in Sanskrit, the amount extracted from the story will depend on those staying with it. Here, it’s the bet that the consequences of Satyam for PwC will be protracted, disruptive and expensive – with onward effects for the entire large-company assurance franchise.

And for those tempted to disagree – I have been two times right in the last month alone.

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