Re:Balance -- Jim Peterson

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

Summertime, And The Living Is Easy -- At Least For Now

      “If you’ve nothing nice to say…. come sit by me.”

 -- Dorothy Parker

With the change of seasons, I am just back from a two-week break in Russia, including a stretch so deep in the countryside as to be beyond all connectivity.

An annual break is probably no less important in the ink-spreading trades than elsewhere – although more for health and re-focus than for risk control (witness the “vacation rule” violations now part of the Paris trial of Société Générale’s rogue trader Jérôme Kerviel).

In any event it’s a good time for a pause:

• BP’s agonies in the Gulf and in Washington have pushed off the front pages the mis-adventures of Goldman Sachs and Lehman Brothers, showing once again that the capacity for public outrage is both finite and subject to “proximity bias.”

• The late-stage negotiations in the US Congress over financial institutions reform legislation include not one word of attention to the survivability plight of the global audit franchise of the Big Four firms – leaving that multi-dimensional problem to leap onto the public screen with the next (and inevitable) outbreak of financial scandal.
  

• Two significant court decisions still await the leisurely pace of the judiciary: the Florida appellate ruling in the Bankest matter, which could determine the fate of the Seidman accounting firm, and the United States Supreme Court’s now overdue ruling on the constitutionality of the Public Company Accounting Oversight Board (see here) – the latter having potential to unleash onto the world of financial information regulation all the mischief that Messrs. Frank, Waxman and Dodd can muster.

• And above all, outside the US at least, the season of the Coupe du Monde attracts far more interest and attention -- especially with the French team crashed out early in a spasm of mediocrity, petulance and politics -- than the soporific pronouncements from the accounting standards-setters about GAAP/IFRS convergence.

There being nothing worth tooting a vuvuzela about, in other words, let respect be paid to the quiet of summer.

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Goldman Sachs and the Fabulous Future of Fabrice Tourre

Is there a future at Goldman Sachs for Fabrice Tourre? The self-styled “fabulous Fab” was the only individual clipped as co-defendant in the suit by the Securities and Exchange Commission over Goldman’s late 2006 flogging of the exotic financial derivative Abacus, a credit default obligation based on a portfolio of toxic subprime mortgages.

Tourre is now safe-housed in London -- Goldman having evidently taken the strategic decision to keep their erstwhile wonder-boy clasped in close embrace for the duration of its legal exposures. 

For which, by contrast, compare the unpleasant consequential exposures for Société Générale, whose rogue ex-trader Jérôme Kerviel’s just published tell-all, “L’Engrenage, Mémoire d’un Trader”, re-ignites the early 2008 agony of his multi-billion euro infliction; or Arthur Andersen’s ready disavowal and jettison of Enron engagement partner David Duncan, before its own flame-out in 2002.

It would be inductively flawed for Tourre to assume continued enjoyment of his employer’s long-term hospitality. Thanksgiving turkeys, fattening in luxury through the autumn, learn to their dismay of the radical adjustment in their life-style when the farmer’s late-November strategy brings down the axe. Equally, Tourre’s useful life at Goldman is tied entirely to the resolution of its concerns with law enforcement.

So, being well-advised, he should expect to become chum for the sharks either as part of a settlement or directly thereafter.

Unless of course he can prove his present value by re-programming the energy with which he hawked the Abacus product to Goldman’s ready market of credulous believers. 

And how? The British bookmakers have already captured the odds-making on the survival prospects of the Tory/Lib Dem coalition. This year’s action on the NCAA basketball tournament is over. And the consequences of BP’s blown well in the Gulf of Mexico are priced into existing petroleum futures.

Other exotic alternatives? Given the volatility of emerging information about the organized church, arising from Chile to Germany, what about “clerical futures,” tied to the predicted tenure and turn-over of a portfolio of Catholic bishops, or the likelihood of Episcopal schism based on gay ordinations?

Or perhaps a wager on the total first-year sales volume of Apple’s iPad – directly tied to the roll-out of the device itself rather than the prosaic proxy of AAPL’s stock price?

Or here: our cultures now encourage wagers on the duration of life itself, through life insurance, viatical settlements and reverse mortgages -- and pre-nuptial agreements are increasingly used to manage the business side of romantic associations. Do the investment bankers’ innovators not see an unexploited niche market for financial products tied to the durability of marital contracts?

A full range of investment opportunities should be available. A customized wager on the likelihood of the neighbors’ break-up would require frequent re-pricing, depending on the level of loud arguments and broken crockery. By contrast, standardized trades could be tied to the five-year intervals celebrated in the etiquette books – call them “anniversary futures,” denominated wood, tin, pearl, silver, and golden, and priced accordingly.

The records of the domestic courts would also make historical data available to underpin trading opportunities in “marriage pools” -- say, by parish or profession or income level -- with divisions into tranches and risk ratings differentially assigned and priced. 

Consider the risk-disclosure language in the offering documents: triple-AAA ratings for the likely fidelity of a group of unadventurous stay-at-home actuaries – or junk-level assessment for the ten-year prospects of wander-lustful professional golfers or soccer players or elected officials.

These ideas might generate a certain reticence among portions of the investor community. Betting against the probity of the local clergy might infringe some sensitivities. Hard-core adherents to the sanctity of life-long vows might be uncomfortable taking bear positions. But no more so than the occasional unease with the role of short-sellers in the equities markets – recalling that nobody actually forced Goldman’s clients to buy those doubtful-looking CDO’s.

A host of small details would remain to be worked through – whether insider status would extend to clergy or divorce lawyers, for example.

But these are small concerns, and “the Fab” has time on his hands. 

Unless, being smarter than a turkey, he is already busy trading the over/under on his departure date.

 

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Société Générale’s 2007 Annual Report – Jérôme Kerviel Is So Last Year

The recurring claim of French exceptionalism got a big boost early this month – at a price. Société Générale asserted that the only fair way to report its loss of € 4.9 billion, inflicted in January by junior trader Jérôme Kerviel, was as an event occurring in 2007.

Deep down in footnote 40 of SocGen’s massive annual report – to get the English version -- here – ou bien la VO Française ici – the bank discloses that Kerviel was in a net positive position of € 1.471 billion as of the end of 2007. His blow-up came on January 18, and the unwinding losses in the following days came to an eventual € 6.382 billion.

Over-riding the compelling guidance of the International Accounting Standards Board, that would book the effects of Kerviel’s mischief as they fell, would be rare enough under the UK’s high-level “true and fair view” rubric, much less under the American guidance of “present fairly in accordance with generally accepted accounting principles.”

But that didn’t stop the French bank – supported by its national banking and securities market supervisors, as well as the two Big Four accounting firms -- Ernst & Young and Deloitte & Touche -- who share responsibility for its audit.

There is at least behavioral history on the French side: for years the European practice of booking the effect of deliberate errors in the year of discovery rather than in the year of perpetration has avoided the litigation hazard of the American requirement to re-state erroneous financial statements for prior years.

And on the recent and highly political side, the French have been vocal and steadfast in resisting the international standard for marking financial derivatives to market – the infamous IAS 39 – arguing the difficulty of valuation models other than historical cost but also conveniently retaining the flexibility of corporate management to time their recording of results to suit their discretion.

SocGen’s tone-deaf approach starts with its footnote description of Kerviel’s trading “plain vanilla” financial instruments – a colloquialism lacking both a usable French translation and a common understanding in the industry. Nor is there any positive spin to the term, since the more ordinary Kerviel’s scope and job description, presumably the more effective SocGen’s oversight and control of his desk should have been.

As I am told by the technical accountancy wonks, SocGen may – just barely – have a straight-faced justification, that its year-end balance sheet should reflect the € 4.9 billion body blow that struck only three weeks later.

Fair enough, on a casual first glance. But the argument for evading a well-known body of international standards, under an exception so obscure and elastic that prior examples are virtually unknown, fails on three grounds – technical, strategic and political.

First, on the technical side. Moving around Kerviel’s impact cannot lessen its prominence or significance. As a post-closing event it is comprehensively discussed for three pages in the SocGen report. A pro forma balance sheet presentation right there would do as much for disclosure as the roll-back could.   

Even if it can be done, in other words, doesn’t mean that it should be.

Strategically, then, what’s the point? The known facts are so notorious that no one will be diverted or misled. Whether CEO Daniel Bouton survives – whether the bank itself survives – or how much the bank will ultimately pay out to the shareholders who are now at the courthouses with claims that the bank was running a “culture of risk” – none of these will be affected by the choice of years. So if SocGen can achieve no good for itself, what constructive purpose could there be in adopting a lightning-rod position?

And politically, the bank has succeeded only in setting back the global arguments for international accounting convergence, harmonization and improvement. If a “fair reporting” excuse can be made for Kerviel, there is no intellectually defensible line-drawing guidance by which investors can anticipate where the next similar exception will be invoked.

The size of the event can’t be a factor. A knock of € 4.9 billion is big, to be sure, but consistency in the reporting of small things is of little use if it’s the really worrisome big problems that qualify for revision and exception.

And with a French tradition to favor management’s opportunity to manage the timing of bad news, agreed by the supporting players, predictability of reporting at the global level is out the window.

So vive la difference – but let it be kept to matters of local impact only. 

Societe Generale -- Of Internal Controls and Risk Management

Published in the IHT on February 1, 2008 (here)

SocGen: When Risk Management Fell Asleep at the Switch

Since the first story is seldom the whole story, it will take time and police work to get to the bottom of the €4.82 billion euros in financial trading losses racked up by the French bank Société Générale in unwinding unauthorized positions taken by a trader, Jérôme Kerviel.

Will Kerviel emerge as an evil genius disguised as a 30-something slacker? The ring leader of a clever gang of financial scamsters? Or, more likely, an average-to-dull employee who exploited the weaknesses of his employer's systems and the credulity of his overseers?

The answer to the question "How did he do it?" appears routine enough. Kerviel's exploits seem not very different from those of the wrong-way traders who have popped up like mushrooms in the back offices of trading institutions from Barings to Sumitomo to Allied Irish Bank to Penn Square.

The scenario is almost always the same: An early burst of irregular but winning trades, motivated by bonus envy or simple testosterone, later spirals the wrong way - briefly matched by a daisy chain of falsified counterdeals and an accelerating but ultimately futile concealment of old losses covered by new ones.

The more demanding question - "How did he get away with it?" - will become answerable only through SocGen's accountability to investigators; to President Nicolas Sarkozy of France, who is not amused; and to its shareholders.

Outside auditors have been summoned. But since there is no forensic process so banal as the after-the-fact sweeping of the dust off the wrong-doer's trail, the interesting question they will likely not address is this: "Where were the curious, persistent and demanding managers ahead of the wreck?"

It's too early to tell, but enough is knowable to suggest that a relative of Inspector Clouseau was seconded to the risk management and compliance function of the hapless bank.

My first and best mentor in the scrutiny of financial fraud made a point of extending his inquiry beyond the immediate problem. Called to investigate an irregularity in one corporate corner, he would search for other possible outbreaks. Instead of assuming a system to be foolproof, he would speculate about ways to stress-test it for vulnerabilities.

He had a first principle: Any system of recording and reporting transactions is suspect. As a product of human design and operation, it is vulnerable not only to simple error but also to deliberate subversion.
In the SocGen situation there are some basic risk management tools, implicated by Kerviel's apparent mode of operating.

First is the vacation rule: Everyone who processes transactions should be taken off his desk at intervals, so that a chain of successive falsifications, if one exists, can be discovered and broken. This has been an article of faith since long before it became the centerpiece of a landmark 1976 U.S. Supreme Court decision in the Hochfelder case. That case dealt with the right to sue under the securities laws, but it started as a dispute over the application of a simple tool in internal control: the realization that an employee who never takes a vacation may be hiding something.

A low-level French employee who declines to take his vacation entitlement is already an extraordinary anomaly, enough that Kerviel's superiors should have gone on immediate and full alert. As Kerviel himself acknowledged to French police investigators, "It's one of the elementary rules of internal control. A trader who doesn't take any days off is a trader who doesn't want to leave his book to another."

A second risk management premise is that you don't net positions before quantifying risk. The exposure in a portfolio with €50 billion euros of puts and €49 billion of calls is emphatically not limited to €1 billion. At least since the Continental Vending case in the 1960s, where criminality was charged over the improper offset of accounts receivable against payables before setting a reserve, "netting" has been recognized as a recipe for concealed disaster.

Especially in a trading environment, combining the ostensible effects of "buys" and "sells" subverts the very essence of safeguarding against the possibility that one leg or the other might somehow go wrong - or even, as here, be falsified altogether.

A third is that back-office compliance cannot be only a little bit broken. Whether Kerviel was known to take irregular trading positions as far back as 2005, as he says, or only starting in 2006, as the investigator suggests, either one indicates a tolerance at SocGen for a back-office error rate greater than zero. But as the effect of financial leverage in Kerviel's dealings makes clear, there is no such thing as small or controlled leakage in a commodities operation.

Back-office compliance does not work to the same margin of error as, say, audited financial statements, which need only be stated fairly within the broadly judgmental range of "materiality" - or, in laymen's terms, "close enough." For systems capable of going awry to the tune of billions of euros, that level of tolerance for error cannot pass a credibility test.

Finally, and indicative of the SocGen attitude of mind, is the report that Kerviel talked his way out of an external alert by producing falsified documents by way of excuse. Once the red flag is raised, going to the target himself for an explanation suggests a box-ticking mentality that is out of place in a compliance function.

"Rogue trader" is probably too colorful an epithet for Kerviel. For the functionaries in SocGen's risk management, "asleep at the switch" probably doesn't go far enough.