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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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.

 

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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.

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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Drilling Down Into BP's Risk Management: A Process As Blown As The Well

“I never went to bed with an ugly woman. But I’ve sure woke up with a few.”

-- Country songwriter Bobby Bare

The failure of BP to “top kill” the Deepwater Horizon well brings to mind Blaise Pascal’s difficult question, how to strategize the unanswerable question whether God exists.

As he came out, to assume the positive and be right is marvelous, and to be wrong is of little effect; to assume the negative and be right is no worse than neutral – but to be wrong is damning.

Looked on as a matter of risk management – rather than as a much-debated philosophical or spiritual conundrum – Pascal’s challenge sits on top of the list of lessons from the events just ahead of the catastrophic blow-out in the Gulf of Mexico.

That is, if it were a final examination question in my MBA class – where we search for the lessons from failures in decision-making across a broad range of business and personal activity -- it would be hard to improve on the Deepwater Horizon disaster. The catalog of avoidable errors in analysis and performance is long and troubling – for example:

• Increased safety measures can mask heightened risk, especially where early signs of trouble are ignored as “close calls.”
• Increased complexity of technology alters the risk profile at the frontier of safety margins. 
• Management over-ride of on-the-spot warnings discourages honest communication and conceals bad news under the pressure to deliver success.
• Group-think and herd behavior are exacerbated by the over-confidence that mistakes past achievement for future safety.
  

Briefly put, the central theme in BP’s failed process was the consistent mis-measure, in its concededly risky choices, of Pascal’s potential up and downside gains and losses – related to what the statisticians confuse us all by referring to as Type 1 and Type 2 errors.

Examples abound, from the modestly consequential to the highly destructive. Consider:

A driver is low on gas. If he chooses to stop immediately, he gains the certain security of a full tank, foregoing the possibility of a modest savings. Whereas, if he carries on in search of a station with a lower price, his maximum upside is a few dollars gained, but his downside is to be marooned awaiting rescue by the roadside, or worse.

Or this: The space agency NASA must decide whether a shuttle launch can safely proceed in cold weather. Postponement to a warmer day means a modest loss of time, for the sake of mission safety – whereas pushing for a “go” decision can at best achieve budget and reputational success, but only with the risk that the frigid conditions will cause an explosive failure of the rocket’s booster (q.v., the 1986 loss of the shuttle Challenger and the lives of its seven astronauts).   

How extensible are the lessons of BP’s questionable decisions – the use of a riskier well casing, under pressures of time and budget, or the premature substitution of lightweight seawater for heavier drilling fluid, under delays costing $500,000 per day (here)?

At the level of individual risk tolerance, consider two insurance scenarios: Taking a pass on auto collision insurance saves the premiums, and puts at risk only the replacement cost of a total wreck. But choosing not to buy long-term health care insurance runs the uninsured risk of a debilitating and devastatingly expensive illness.

Or for investors: excess portfolio concentration in pursuit of incremental performance ignores the question, “How bad could this possibly get?” – as learned to their sorrow by Bernie Madoff’s clients and employees with their savings in Enron’s retirement program.

Consequences vary. Pick a bad restaurant, and the only loss is an evening’s sub-standard dining. But fail to hedge a naked short, and the losses could be ruinous. 

Corporate risk management depends for success on similar decision-making dynamics: Is a bet-the-company strategy acceptable? Is it even recognized?

Whatever the assessments made by Bear’s Jimmy Cayne or Lehman’s Dick Fuld or Countrywide’s Angelo Mozilo, they mis-evaluated their exposures to disastrous downsides – no less than the bureaucrats of NASA or the over-seers at BP.

On the other hand, betting Pascal’s wager the wrong way risks the wrath of an angry deity – which in the long run may be worse.

 

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The Valukas Report on Lehman Brothers: Sarbanes/Oxley's Credibility Takes a Dive

A host of hard questions lurk within all nine volumes and 2200 pages of the report by Lehman Brothers examiner Anton Valukas, released on March 11 (here) – which finds in its executive summary (here) that the company “painted a misleading picture of its financial condition.”

One of them, directed at anyone still harboring the belief that the Sarbanes/Oxley law of 2002 has had a beneficial effect on corporate governance and financial reporting: “Ready to change your mind?”

A lengthy list of potential defendants are teed up as targets for “colorable claims,” for actionable balance sheet manipulations using accounting techniques described in internal e-mails as having no substance, but serving only the purpose of reductions in Lehman’s balance sheet. 

Along with the apologists among the advocates of Sarbox’s efficacy, they will be heard to argue that its aspirations did not extend to the likes of Lehman’s financial machinations – a perspective begging this further question:

How can a regulatory program of the scope of Sarbox be justified, for the cost and complexity it inflicted on public companies and their gatekeepers -- most of whom would have been legitimately law-abiding even if left entirely alone -- while failing to identify, deter and capture the truly outstanding global-scale malefactors?

More simply put, if Sarbox didn’t have an impact on Dick Fuld and Lehman, what possible good has it wrought?

I’ve been in retreat this last week, reading the final papers of my MBA students in Risk Management – a bright and engaged group writing on recent case studies in the failures of risk modeling, assessment, comprehension and regulation.

Their examples cover the three years from the collapse of the Bear Stearns real estate funds, down to Toyota’s recent spiraling loss of both quality control and reputational stature. Even ahead of the Valukas report, it’s a target-rich environment, constantly replenished by the steady supply of newly-displayed examples of human venality, folly and frailty.

Among our course goals is the search for effective regulatory tools by which to shape improved policy-making and enforcement – a particularly challenging proposition, given the manifest inability of bureaucrats and elected officials to escape their inbred limitations of vision and effectiveness.

Depending on the importance of the issues at hand, how much enforcement should be imposed, and at what cost? 

Choices can be as coercive and heavy-handed as a polity will support and enforce. Taken to extremes, for example, teenage drunken driving could be eliminated: all that would be required is to raise the age of licensing to 25, and to impose automatic, non-negotiable twenty-year prison sentences on first-time violators.

Unthinkable, of course. Society is no more prepared for such draconian steps than it is to impose capital punishment on balance sheet manipulators or insider traders or even Ponzi schemers.

At the looser end of the enforcement spectrum, behavioral norms can be largely left to society’s level of tolerance for its own inconvenience. New Yorkers collectively agreed years ago, for example, that recreational marijuana was deemed to be de facto legitimate, thereby literally changing the atmosphere of Central Park. Likewise, no amount of patrolling will affect the dog-minding habits of Parisians, until they decide to alter the customs of a lifetime.

In the same way, the hindsight revelation of the Valukas report is that the inability of Sarbox to reach global-scale problems shows the futility of legislation so politically anodyne that it passed the US Senate by a vote of 96-0. 

The problem is one of closing the gap, between the level of deviance that society will stand and the amount of burden that it will pay for.

That is, a program of airport security will lack credibility, if so broadly applied as to deprive ordinary citizens of their ability to carry a bottle of wine or a tube of toothpaste, but that fails to identify terrorists whose deadly threat is limited only by their inept inability to detonate their shoes or their underwear.

Sarbanes/Oxley suffers the same defect: if it could not detect and deter an “outlier” on the scale of Lehman, then what beneficial effect can its proponents claim it has accomplished, by imposing an intrusive system of box-ticking on the vast bulk of corporate registrants?

As laid out in Richard Thaler and Cass Sunstein’s 2008 book, “Nudge,” which outlines such minimally-intrusive approaches as automatic enrolment options in voter registration, organ donation and retirement savings plans, the challenge to long-term incentives – whether in personal diets or corporate financial disclosure – is the compelling immediacy of short-term rewards. 

Which means it should be no surprise either that the rewards for the purveyors of subprime mortgages and exotic securities were dissociated from the risks of later implosion, or that compensation for executive leadership should be tied to measures based on the latest quarterly results.

Or, depressingly, that the time frame for political reaction to pressing public issues is no longer than the calendar for the next election.    

 

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The Risk of Crashing on a Slippery Slope: Bankers and Lugers on Parallel Tracks

A Risk Management class of bright, perceptive MBA students devoted their meeting this weekend to Olympic sports – scrutinizing the death on February 12 of Georgian luger Nodar Kumaritashvili, who lost control on the last curve of the world’s fastest track at the Whistler Sliding Centre and crashed into a steel pillar.

The students’ usual focus is on the manifold failures in risk identification, appreciation and evaluation over the last three years. They look to specify and learn from such displays of bias, error and miscomprehension as Jimmy Cayne’s loss of control of the real estate funds of Bear Stearns, the confession by Ramalinga Raju of a multi-billion dollar fiction in the accounts of Satyam Computer Services, and Akio Toyoda’s tone-deaf bungling of the world’s largest vehicle recalls.

What they found was a set of questions with compelling resonance for the financial crisis:

• ·      Was a fatal crash the result of an overly aggressive and under-trained youngster, turned loose in a competitive environment beyond his skills and capabilities?
•  ·      Was there a simple but overlooked design flaw in the structure – in Vancouver, an unpadded steel pillar squarely in the path where a loss of control would eject the 90 mph victim of a small but highly consequential mistake?
• ·      Or did the designers who pushed the limits of knowledge and technology compromise the need for safety to the desire for high-speed achievement, failing to recognize that traditional measures of safety were outmoded and insufficient?

Just like the world’s tightly-linked capital markets, the Whistler track is wonderfully designed for success. Its users describe it as challenging but thrilling – the demands are huge, as are the rewards.

But like any other advanced and sophisticated device designed and operated by humans – whether a space shuttle or a nuclear reactor or this decade’s leading-edge array of exotic financial instruments -- a luge track is subject to the non-zero possibility of catastrophic error.

Even the engineers of the most prosaic highways, who strive to improve both safety and overall speed, are mindful of speeders who will test their design limits. Where pressing the outside limits of speed and safety is the very goal of the participants – recall the Olympic motto: “Citius, Altius, Fortius” – it is hollow and unresponsive to the point of irresponsibility to claim that the track is "relatively safe" (here).

As elsewhere, average performers disappear into the obscurity of the crowd. Outliers achieve prominence in two ways, both beyond the boundaries of ordinary expectations:

At the Games, one athlete wears a gold medal and salutes his national anthem from the victor’s podium. But at the opposite tail of the performance curve, the one who crashes earns only a memorial wreath and a home-town funeral.

In the marketplace, where the gold-medal outlier may be Warren Buffett, the opposite tail is populated by the likes of Dick Fuld of Lehman, Fannie Mae’s Franklin Raines and Countrywide’s Angelo Mozillo.

There is one huge difference between the “failure study” of the Whistler designers – who promptly lowered the luge start, re-shaped the fatal curve and padded the unfortunately-located steel pole – and the finger-pointing scapegoaters of Washington and London and Brussels.

Namely, every failure in the engineering field is an opportunity for learning – even if belated. Thanks to the iceberg, the Titanic’s design was no long the model for generations of at-risk ocean liners. Nor, after 9/11, would high-rise towers ever copy the World Trade Center.

But in the politically-motivated bickering over the allocation of blame for the financial markets’ debacle, by contrast, there is not even a civil forum in which to ask the pertinent questions – much less make progress on a search for answers. 

Which, as I remind my Risk Management students, invokes the observation on learning of the 5^th century BC playwright Aristophanes:

Youth matures

Immaturity is outgrown

Ignorance is curable by education

Only stupidity is forever

 

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The SEC Whacks Ernst & Young Over Bally Total Fitness -- Now for the Spoils of Victory

The SEC’s proceedings last month against Ernst & Young and six of its partners, relating to the financial statements of Bally Total Fitness, for the long-ago years 2001 – 2003 (here), threaten a double hazard under the axiom attributed to Winston Churchill, that “history is written by the victors.”

It’s not just tough enough for the accounting profession’s risk and quality managers, seeking to understand what really happened in Bally -- not only because the entire narrative is drafted by the enforcers, but also because without recourse to a public forum, the “consent decree” process acts as a muzzle on the targets. 

Worse – conceding that the only script available is written by the SEC itself – the array of sanctions and undertakings inflicted on E&Y signals that the environment for application of quality-oriented judgments has just become a lot more volatile, unpredictable and challenging.

This cannot be the place to debate either the facts or the justice of Bally; offered an exit from the SEC’s eternal grip, a target’s only strategy is to grit the teeth and roll over in silence.

Questions for the profession worth attention post-Bally, rather, are what to expect in the future, and how will behaviors be changed.

To start, with all other government agencies coming off the back foot in the financial crisis aftermath, the SEC carries three extra pieces of baggage: defensive reaction to its blinkered short-comings in failing to unmask Bernie Madoff, the passage of a half-decade in bringing the ancient Bally proceedings, and the lurking reality that pursuing a death-threat outcome against a Big Four firm itself would risk disintegration of the entire large-company assurance franchise.  

From these, it can be predicted – and the accounting profession should expect – that going forward, the SEC will aggressively aim its macho enforcement testosterone at the big firms’ individual personnel. Nuances and subtleties of professional judgment be damned, the agency will seek to show that its gun-slingers clank when they walk.

Which means, as Bally itself shows, that professional decisions will be second-guessed to the last degree. Where credit might be earned for careful risk considerations, E&Y had identified Bally as one of its highest risk clients – a sorting-out effort reflective of a profession-wide aspiration to differentiate levels of client complexity and reduce the commodity nature of the audit itself.

And E&Y also brought into consultations an entire circle of senior help, beyond the engagement and review partners – the geographic area manager, national practice quality assistance and even the firmwide head of practice and risk.

These actions should be encouraged. Picture the counter-factual: if Bally’s problems had gone as wrong as they did, and E&Y had not done so. The enforcement hounds at the SEC would have bayed to the skies. Instead, now, the firm’s personnel suffer individual censures and bar orders of up to three years, for conduct worthy of respect – albeit for results now deemed unsatisfactory.

What messages are sent to the profession’s quality and risk functions? Ought they to reduce the exposure of their senior personnel, by hanging out the line operators to struggle on their own? And by the way, who would aspire to the headaches of a consultative role, if only to finish a long career by dangling from the SEC’s noose?

One of E&Y’s undertakings in Bally is to re-visit, under the scrutiny of an outside examiner, its documentation of higher-level issue consultations.

So, under a sanction that only a bureaucrat could love, Bally will impel the Big Four’s national office boffins to “re-audit” information they receive from the field, and to build a fortress of memoranda to defend against the assaults of later second-guessing.

With the secondary effect that the time and energy available for real problem assessment must now be side-tracked to the same kind of self-protective file stuffing that is strangling American enterprise ranging from product safety to medical treatment to airport security. 

The SEC’s goal in the Bally settlements may not have been deliberately to degrade the large firms’ risk management capabilities. But the direction and effect will all go that way.

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Hand Washing and Swine Flu -- A Hospital That Could Avoid Failing Risk Management

Risk management is, for better or worse, a constant business challenge. As examples, I’ve given recent attention to the timing mis-alignment between senior-level compensation and litigation exposure – here – and the perils of failing to assure a long-term plan for business sustainability – here.

How about a major unmanaged public health risk – the threat of wider-spreading swine flu – that exists right now at the heart of the health system. A large regional hospital is ignoring our mothers’ most basic admonition: “Hey, wash your hands!”

I spent last weekend visiting a loved one, who is recovering remarkably from complex, life-threatening and brilliantly executed surgery. That much, the hospital had right.

Outside his room, and all along the wards, there were dispensers of hand-sanitizing gel – which the staff all used in diligent compliance with the posted signs.

Frequent use of soap-and-water or alcohol-based sanitizers is a low-cost, front-line tool in the fight against contagion (see here and here). So what was missing?

It was the complete lack of attention to the hundreds of daily visitors – a steady stream of arrivals from who knows what cesspits of contamination, spreading out through the hospital to hug and pat the patients, fluff the pillows, handle all the medical playthings, and shake hands with the doctors and nurses.

There was not one word of direction or support to disinfect this parade of the unwashed, before they acted as a delivery service for infectious pathogens from the ugly and germ-ridden outside world.

In my business school course on Risk Analysis and Management, we spend time on the problems of incentives – how to recognize and adjust the influences that lead to good or bad choices.

Personal issues include the difficulty of balancing immediate consumer spending against saving for future retirement, and succeeding with the well-intended plans for diet and exercise that fall victim to daily distractions and temptations. On the business side, as recent history has shown, mortgage brokers paid for volume will push subprime loans on unqualified buyers, and banks that off-load dodgy financial products pay out huge bonuses despite the inevitability of catastrophic future reckonings.

My class looks at the kind of cost-effective and minimally intrusive techniques laid out in the book “Nudge,” by the University of Chicago’s Cass Sunstein and Richard Thaler – here -- who explore situations ranging in complexity from the location of sweet desserts in a cafeteria line to retirement plan investment options to carbon mitigation techniques affecting climate change.

Which has what to do with promoting germ-reduction in a hospital? My students would zero in on the hospital’s unanswered question:

Why was there not a hand sanitizer conspicuously located at the reception desk – a control point where visitors must pass? What would it take?

There would be no cost to the hospital, since the devices are already stocked for staff use. No visitors would resist, since no fee or other imposition is involved, and in any event their wish for admittance creates ample motivation to cooperate.

In terms of Thaler and Sunstein’s search for the gentlest possible nudges toward hand-hygiene compliance, a research opportunity could test and evaluate for the most effective among the various levels of encouragement:

•       No sign at all might be needed, besides the clear and present reminder of the dispenser itself.
  
•     There could be a simple sign: “Please help prevent the spread of flu.”
  
•     Or the more aggressive: “It’s state law – visitors must use sanitizers.” 
  
•     Or the truly coercive – ultimately effective if perhaps a bit harsh: “Failure to use hand sanitizers is liable to punishment, including amputation.”

Broader lessons may lurk in the “teaching moment” of this hospital’s readily achievable illness-reduction opportunity, for the identification of “clean hands” incentives to promote fiscal or economic or corporate health and safety. 

For now, I concede my ambiguous emotions about going into hospitals -- because they’re always full of sick people. I would feel better, though, only knowing at least that by nudging everyone on their premises to use proper hand-cleaning techniques, they would be lowering my risk of leaving with my own case of swine flu. 

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Why the Bankers' Models Failed in Crisis: A GPS Program is Not the Same as Real Traffic

Lost, trapped and at risk of a serious crash.

That could very well describe the participants in the financial markets turmoil of the last two years. Instead it was my experience last Saturday afternoon – as an anxious and helpless rear-seat passenger during a frustrating hour fighting the exit traffic after a major college football game.

Autumn weekends in America are given over to exotic rituals. Cult-like herd behavior, irrational devotion to long-odds causes, microscopic analysis of esoteric game plans, prayerful invocations of last-minute rescues, and the frequently-literal intoxication of victory and defeat -- all the ways that bankers and investors behave during the routine work-week are migrated on Saturdays to tail-gate barbeques and stadium hoopla.  

Among a hundred thousand fans choking the bottle-necks of the parking lot, our driver was hopelessly conflicted. We were trying in futility to drive against the overwhelming flow toward the tollway. Normal daily street patterns were closed against us, and stern patrol officers blocked our turnings and waved off our intentions.

Trying at the same time to cope with the double distractions of his co-pilot working a cell phone and the urgently artificial voice of the dashboard GPS that insisted we should be taking forbidden routings, he also faced the threatening reality of aggressive crossing traffic at each frustrating intersection.

The recent banking and credit markets crisis was perfectly reflected in our dilemma: ordinary daily transaction flow was overwhelmed by an exceptional one-time event – an unruly horde in single-minded escape mode had nowhere to go – and an on-board warning system could not comprehend the disruptive effects of events beyond its programming.

The disconnection for the driver between the seductive directions of the GPS, to plunge into the systemic dysfunctionality of the streets, would perhaps have resembled the state of market unreality, going back to Jimmy Cayne’s dislocation as the presumptively risk-managed real estate funds of Bears Stearns spun into collapse.

Think of a traffic-guidance system as a risk management tool, in other words: it can start as an aide – but becomes a dependence -- and then an addiction. However luxurious the vehicle, it is a dangerous instrumentality when the driver’s ability to reckon direction has atrophied under commitment to a model that seizes up under stress.  

In short – as the data loaded in a GPS cannot imagine or replicate a post-game traffic jam, neither can a triple-A rating or a quantitative calculation of daily ValueAtRisk hope to capture the no-exit entrapment of an interlinked portfolio of subprime mortgage-based securities.

There are three further comparisons – one being the common and universal nature of the predicament. Equally pinned in the single-lane mess were the limousines of the VIP alumni, the high-end sports vans of the tail-gaters, and the boisterous bus-loads of drunken end-zone fans – all were as captive as Citi’s Chuck Prince and the feckless vision he imposed on the entire industry in July 2007, to keep dancing “as long the music is playing.”

Also, with every state trooper and traffic monitor devoted to prodding the crowd on its way out of town, the overload on law enforcement was evident. Marauding gangs could have been looting the Food King or emptying the town’s ATM’s – while the over-stressed constables echoed the SEC’s paralysis during the banks’ disintegrations or its curbside blinking at the predations of Bernie Madoff.

And finally: dispersion of the congestion was inevitable, and we eventually broke free. Accelerator down at last, our driver was excited: “Full speed at last,” he crowed.

“Yes,” said the still-befuddled navigator from behind his map. “Unfortunately, we have no idea which way we’re going.”

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The Nirvana Fallacy: The Best is the Enemy of Good Thinking

I was struck last weekend by the frequency of coincidence. I was working on the curriculum for my course in Risk Analysis – trying as always to stay a jump ahead of a class of smart, inquisitive MBA students.

This time it was the recurring observation of a common defect in logic and reasoning, named the “Nirvana Fallacy”: the lapse into error of comparing a defective or sub-optimal situation against an idealized or perfect state – failing to recognize that the assumed achievement of perfection is impossible in a world of flaws, limits and constraints.

Thanks to my colleague who identified a relevant example of this common behavioral trait: United States Senator Charles Schumer (D-NY), arguing for a legislative program to address the shortcomings in the regulation of the financial institutions by whom the capital markets have lately been served so poorly.

Falling into the fallacy, the good Senator advanced an argument that assumed an ideal state of affairs: “You need a tough, strong regulator – unified – no holes in the system ---…who sees the problem ahead of time, so they have complete transparency, they know exactly what’s going on….”[i]

The problem is, Senator Schumer was assuming two impossible aspects of his end state – the availability of an inaccessibly complex body of information on a timely basis, and omniscient regulators free of their manifestly inherent limitations in talent, vision and authority.

Suddenly, I was seeing examples of the Nirvana Fallacy everywhere.

There was the football coach, asked in a pre-game interview about his losing streak, who claimed that, “all we need to turn ourselves around is to sharpen our execution and carry out our game plan.” As the Saturday afternoon results shortly proved, his sunny recipe for redemption of a rapidly fading season failed to acknowledge that his team was fundamentally smaller, slower and less well coached than his opponent.

The Sunday morning television pundits were equally circular in arguing perfected solutions to complex diplomatic challenges. “We accomplish our mission in Afghanistan by disabling the capacity of the Taliban” – a proposition that mistakenly assumes its own conclusion, in the face of centuries of history in which no foreign influence has prevailed in that region.

Or the debaters on the challenging issue of American health care reform, who mouth their competing platitudes of “no government takeover” and “low cost coverage for every single citizen,” while resisting the hard work of reconciling deep and intractable opposing forces and ideological differences.

Or the bureaucrats in India, proposing that the government’s Serious Fraud Investigation Office could effectively probe corporate frauds, if only given power to seize documents and conduct interrogations (here) – while walking right past the plain fact, made stark by the blind-side emergence last winter of the Satyam scandal, that mature, sophisticated securities oversight in India is today no more than a figment of regulatory imagination.

As I try to help my students and my clients alike to become better at identifying and avoiding the traps and sources of bias and error in their decision-making, the Nirvana Fallacy deserves a place of prominent scrutiny and recognition – although it does suffer the dual handicaps of a miserable launching pad and the need for a comprehensible introduction into the area of public discourse.

Completeness obliges identification of the original source – footnoted below.[ii] In good conscience, however, I do not recommend anyone’s diversion of energy into looking there for help. Time spent in academic and scholarly journals can be hazardous to one’s health; as the quoted excerpt shows, those periodicals are the place where simple, lucid writing goes to die.

My students can expect a homework assignment on the Nirvana Fallacy: identify and discuss an illustrative scenario, from work or personal experience or the worlds of political or economic activity. I will expect examples ranging from fancifully assumed cost savings in proposed corporate mergers, to campaign pledges of government largesse free of any of tax increases – or from rejection of a weight-loss plan as too little to be effective, to over-confidence in Sarbanes/Oxley as the cure for all executive venality and excess.

Similar examination of the flaws in the promises and arguments of public debate would benefit us all.

[i] See Sheldon Richman's April 2009 article at the Foundation for Economic Education.

[ii] * Economist Harold Demsetz, Journal of Law and Economics 12 (April 1969) 1:

“The view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing ‘imperfect’ institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements.”

Compare this with Voltaire, who needed only the six words borrowed for the title of this piece: “Le mieux est l’ennemi du bien.”

 

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What To Read: Catch 22 -- The Ultimate Management Manual

Always stimulating, Francine McKenna last week posted at Re:The Auditors her advice to young professionals, "Recommendations: Great Books to Read at Any Stage of Your Career."
Her list being of recent vintage, my own preferences tend to sources that have withstood tests of time -- Niccolo Macchiavelli's "The Prince," published in 1532, for example, or perhaps Sun Tzu's "The Art of War" (c.400 BCE) -- and for pedagogic purposes, I also favor the wisdom available from sources outside the field under scrutiny.
So -- slightly updated from the original as it ran in the International Herald Tribune for January 24, 2004 -- if you had only one guide on corporate behavior and management strategy:

“It's a Catch-22 situation.” Those words, spoken by a French banker at a conference for European business leaders and received with understanding all around, reminded me how deeply Joseph Heller's 1961 novel has penetrated the global business environment.

I have long relied on Heller, and his vision of a military comprising equal parts corrupt self-interest and naïve idealism, as an extended guide to life in any complex system, including business. Periodic re-readings have had more value for me than any of the so-called team-building exercises and mission statements that pass for motivational management these days.

For those unfamiliar with the story of Yossarian the bombardier and his World War II comrades on the Italian island of Pianosa, Catch-22 goes like this: Only a crazy man would fly the murderous late-war missions demanded of the pilots, and flight surgeons had to ground anyone who was crazy. But asking to be grounded showed proof of sanity, which required denial of the request and continued flying.

Caught in an endless loop of twisted logic and bloated bureaucracy, Heller's characters cope as best they can. A testimony to the universality of their experience is that to this day, the same characters can be found at business enterprises, university faculties and professional partnerships the world over:

•    Major Major, the persistent but hopelessly mediocre administrator, promoted by those eager to be rid of him. Once made squadron commander, he loses access to his mess hall and basketball buddies, and then makes his isolation complete by ruling that visitors wait outside his office while he is in and be allowed in only when he is out.

•    Doc Daneeka, the flight surgeon who refuses to ground anyone who is sane enough to ask for it and who keeps up his combat pay by forging entries in flight logs. After being listed erroneously as a casualty of a plane crash, he lurks unacknowledged outside his own medical tent, losing his pay, his PX privileges and his wife, whose grief at his untimely loss is tempered by full collection of his GI death benefits.

•    Colonel Cathcart, pumped with aggressive insecurity and conceited ambition. He indulges his taste for power by continually raising the number of missions that must be flown - often just before a pilot has attained them.

•    General Peckem, the noncombatant expert at turf expansion, whose successful ambition to bring bombing operations within his purview at Special Services turns to ashes when command changes to the sycophantic General Scheisskopf, who was promoted from lieutenant on the sole strength of his meaningless memos announcing the postponement of Sunday parades.

Even more than Heller's personalities, the bizarre interactions replay endlessly in corporate corridors and boardrooms - and find eerie echoes in recent events:

The questionable Cayman bank balances of Parmalat or the non-existent securities of a Madoff or the kerfuffle of "mark-to-market" would have been child's play to Milo Minderbinder, the entrepreneurial mess officer who could make a profit on fresh eggs bought in Malta for 7 cents each and sold to the mess halls for 5 cents. (Message to Bob Herz at the Financial Accounting Standards Board: the lowdown on how he did it can be found in Chapter 22.)

The debacles at AIG or Bear Stearns or Long-Term Credit Management could easily have been Milo's operations. The demise of the latter was a hedge fund set up by its Nobel Prize-winning managers, running their highly touted models into the ground with a wrong-way bet on Russian debt. That tracks the universal acclaim the military heaps on Milo's business acumen - until he corners the market in Egyptian cotton that nobody wants, bringing his black-market syndicate to the brink of ruin.

The antics of the equities analysts through the bubble years of the 1990's or the sub-prime mortgage originators of this decade are echoed in the treatment of Chief White Halfoat and his Oklahoma tribe, who have such an affinity for petroleum products that everywhere they seek to settle, the oil companies hit oil, requiring the forced relocation of the tribe. At some point geologists and engineers begin to guess where they will settle next and drill before they arrive, kicking them off the land before they can unroll their blankets.

Heller's characters, at least some of them, survive the insanity by finding ways to stay alive until the end of the war. Corporate managers seeking to cope with a dysfunctional organization may not be so fortunate. But they can at least save the huge fees inflicted by outside gurus and facilitators just by going away for a weekend, each having read "Catch-22" as a homework assignment, and recasting the novel's plot and characters out of the people and events well known to all.

I've done it. It works. As a way of placing the absurdity of the workplace in perspective - and as a starting point for finding solutions - "Catch-22" is an indispensable tool. Or, in the words of Doc Daneeka, "It's the best there is."

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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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