Cleaning up after Madoff

Tough job. From the article:

“I told my staff at the fund: with this kind of pain, don’t expect a ‘thank you,’ don’t expect a ‘well done,’ ” he said. “The idea that they’re going to be grateful, to be satisfied? Not in this life.”

Directors and Corporate Governance

I wonder how many frauds could have been prevented if board members had been more active in protecting the interests of shareholders. While most, if not all, recognize the need for a strong, independent board, I don't know that our current system encourages board members to actively pursue shareholder interests.

My personal (anecdotal) experience with directors is that most boards seems to be comprised in a manner similar to the following example:

• Chairman of the Board (usually either the current or former CEO of A Corp.)
• Several other C-level executives and a few VPs from A Corp.
  
• "Independent" directors who are executives at B, C, and D Corps., where the CEO of A Corp. is also an "independent" director
• Enough additional independent directors to meet independence and expertise requirements
  

Most of these individuals seem to be inclined toward favoring management over the shareholders. In such a situation, I doubt that the remaining independent directors have enough influence over the board to adequately represent the shareholders. We can continue to stress the importance of corporate governance, but until we see more independence among board members, said governance will be flawed and will continue to be a weak deterrent to fraud.

Is the Government Guilty of Round Tripping?

Round tripping is a method some financial statement fraud perpetrators have used to boost their revenues. Essentially, they transact with another party to sell goods or services and then buy from that party some goods or services. This was a common scheme used in the "new economy" boom era that internet businesses used to create sales volume.

As it turns out, Citibank is currently under negotiations with the SEC as an investigation is under way regarding Citibank's disclosure of troubled mortgage assets. However, if the SEC imposes a fine, the concern is that since the government has used TARP funds to prop Citibank up, then they will be taking their own funds back in the form of a fine.

The WSJ reported:

Among issues being debated inside the SEC is whether, as a recipient of government-rescue funds, Citigroup should pay a large penalty in the case. There is concern at the SEC about the notion of financial firms in effect using taxpayer money to pay penalties, people close to the situation say. Citigroup received $45 billion from the government's Troubled Asset Relief Program ... "The question is: Is the money being round-tripped, going from one part of the government to another part?" said Oliver Ireland, a partner in the financial-services practice at the law firm Morrison & Foerster LLP. If the government is "trying to shore up the capital of an institution so it can function in the marketplace, you've got to take that into consideration" in determining the size of any fine or penalty, Mr. Ireland said.

Want job security? Fight fraud for a living...

The WSJ reported that the U.S. Justice Department is hot on the trail of U.S. companies that are bribing foreign officials in violation of the Foreign Corrupt Practices Act. According to the journal, the law

is worded broadly enough that it's spawning an army of consultants, some of whom once prosecuted bribery cases for the Justice Department, who offer to interpret the gray areas.

"When you have a law that can result in criminal sanctions and jail time and that you can violate without actually realizing you're violating it, that's terrifying," said Alexandra Wrage, president of Trace International Inc., a Washington-based nonprofit specializing in antibribery compliance.

The FCPA consulting business is a huge growth area for the Big Four accounting firms and other forensic accounting practices and is an example of two forces that are leading to a need for more people who know how to detect corruption in business. One force is the trend in society and business of lower standards of ethical behavior. The other trend is the effort to counteract the first trend by increasing government regulation.

I personally don't see either trend reversing any time soon. As such, if you're looking for a promising career, this is an area to consider.

Pinstripes

A few weeks ago, my wife and I watched Catch Me if You Can, which is based the life of the famous con artist, Frank Abagnale Jr. Since watching the movie, I keep thinking of a line from the movie, attributed to Mr. Abagnale:

Why do the Yankees always win? The other team can't stop looking at the pinstripes.

Even today, it seems that we can't stop staring at the pinstripes. For example, a great deal of Bernie Madoff's ability to perpetuate his Ponzi scheme came from the reputation he had developed and the respect he was given. In another example, the SEC recently filed suit against Global One, an investment firm run by a Texas A&M finance professor and another man who was both an attorney and a CPA. From the SEC Actions Blog:

Fake records coupled with the identity of the defendants — a professor from a well known university and an attorney/CPA — certainly helped induce investors to purchase shares. Fake bank records and the phony account statements sent to investors periodically also facilitated the fraud.

While trust plays a vital role in helping society to function properly, we can't forget to exercise a healthy dose of skepticism in making investment decisions. "Pinstripes" have many shapes and forms, including titles, such as successful businessman, professor, CPA, attorney, respected civil servant, church leader, etc. Pinstripes can also be relationships such as friend, colleage, or even family member. No matter who is pitching an investment to us, we have to remember to subject that investment to close scrutiny or we run the risk of being conned. Let's quit staring at the pinstripes and see potential investments for what they really are.

Changing trends in executive compensation

In Europe, shareholders have started rejecting the large executive compensation plans that have become so commonplace in the last decade or two. The Wall Street Journal reports:

Shell is the largest among a growing group of British companies whose shareholders have voted down compensation plans in advisory votes, including Royal Bank of Scotland Group, Bellway PLC and Provident Financial PLC.

In the U.S. however, shareholders are still very generous to executives. In comparing Europe to the U.S., the article states:

European investors are angry over bonuses that are relatively modest by U.S. standards. At Exxon Mobil Corp., the largest U.S. oil company, Chief Executive Rex Tillerson received a 2008 compensation package valued at $23.9 million, including $1.87 million in salary, a $4 million bonus and stock grants initially valued at $17.6 million, according to the company's latest proxy.

Shell Chief Executive Jeroen van der Veer was awarded 78,889 shares, worth about €1.3 million ($1.76 million at current prices), in addition to his salary, bonus and benefits of €5.7 million.

The enormous stock grants that executives have received have been blamed for creating the pressure and incentive behind many of the financial statement frauds. In many cases, executives can make millions if they can get their stock to move a few dollars. Beating analysts' expectations by reporting fraudulent financial performance is the means that some executives have used to drive their stock price up.

Warren Buffet has been outspoken about his view that executive compensation is broken. I've heard that Buffet actively works to eliminate incentive for fraud at his companies. In any case, he has long been a critic of current compensation arrangements.

Some proposals floating around should lessen the incentive to commit fraud. For example, a recent MarketWatch article lists proposals to eliminate annual equity awards and make executives wait until two years after retiring to cash in their stock options. It will be interesting to see how executive compensation packages change in the near future and whether the changes will reduce incentives to commit fraud.

Santander Settles

At least one of the Madoff feeders appears to be taking some responsibility for its actions (via WSJ):

Banco Santander SA, one of the largest conduits of investor money to Bernard Madoff, agreed on Tuesday to pay $235 million to settle potential legal claims by the trustee of the defunct Madoff firm.

Santander is one of several banks to have offered its clients compensation for losses from the fraud. In its results in April, Santander said that 93% of clients affected by the Madoff fraud had taken up its offer, which it originally valued at €1.38 billion.

While I am glad that Santander and others have attempted to provide some restitution to their clients, I am still concerned by the apparent lack of due diligence that fueled the fire of this Ponzi scheme. Wall Street seems to thrive by creating obscure financial products that are only truly understood by their creators, and then layering those products until investors have very little understanding of the economic reality underlying their investment decisions. The resulting lack of clarity is a perfect breeding ground for fraud.

Did Madoff's feeder funds commit fraud?

Over the past month or so, many of the hedge funds that fed billions into Bernie Madoff's Ponzi scheme (i.e. his feeder funds) have been sued or charged with fraud. For example, former GMAC Chairman, Ezra Merkin, was sued by the trustee who is collecting assets for Madoff's victims. Merkin's hedge funds apparently fed $2.4 billion from universities and nonprofit ogranzations into Madoff's scheme. Madoff's biggest feeder fund, Fairfield Greenwich Group, channeled $3.5 billion into the scheme and was also sued this month. In both cases, the trustee claims the funds "should have known" Madoff was engaged in fraud.

As for criminal charges against the feeder funds, Massachusetts regulators are prosecuting Fairfield on fraud charges and New York's Andrew Cuomo has charged Merkin with fraud. The challenge will be to show that these hedge fund managers committed fraud.

On page 7 of my favorite fraud text it explains that fraud must involve an intentional representation about a material point which is false. It also must be believed and acted upon by a victim to his or her damage. As for victims' damages, these fund managers took investors' funds and gave them to Madoff and collected hundreds of millions of dollars. Cuomo's complaint says that Merkin collected $470 million in fees for his work managing the $2.4 billion that he turned over to Madoff.

I believe that the key point to whether the funds will be shown to have committed fraud is whether the funds made false and material representations. Cuomo's complaint says that Merkin's three funds promised that he "actively managed" the money in the funds. As evidence Merkin was not actively involved in managing the funds, Cuomo claims that Merkin ignored many warning signs including one of Merkin's money managers who warned him not to invest with Madoff because achieving Madoff's returns was impossible. In addition, Cuomo's complaint says that Merkin kept two 2001 news articles written about Madoff's funds that questioned Madoff's ability to produce such steady returns.

So, back to the question of whether Madoff's feeder funds committed fraud, I suppose that will have to be resolved in the courts. In deciding how active Merkin was in his management, I'm pretty sure he will have to answer questions such as whether he looked at the audit report on Madoff's fund. As a follow up, I would ask if it occurred to him that it was odd that a fund the size of Madoff was audited by a three-person auditing firm?

I'm pretty sure these questions will show that these fund managers were actively managing their handicap on the golf course much more than they were actively managing the billions of dollars that they collected and gave to Madoff.

As for me, whether the courts decide that Merkin and company committed fraud or not, I do believe these hedge fund managers were extremely greedy. Imagine taking roughly one-half billion dollars of investors' money and then turning the rest over to a person to invest. All I can see that these hedge funds did was act as a sales conduit for Madoff and then they took their cut before putting billions into the largest Ponzi scheme ever! If this isn't fraud then there ought to be some law against it!

Reasons why fraud spikes in a recession

A recent Time Magazine article explains: "As sure as growth slides and employment numbers tumble, so cases of fraud rise during recessions. This time is no different."

This article is interesting but I think it would be more complete if it analyzed different forms of fraud. Some may actually go down during hard times. For example, I'm of the opinion that financial statement fraud probably spikes in boom times but comes to light in a recession. On the other hand, embezzlement and scams probably spike in hard times as people are more desperate.

Finally, I disagree with the article when it says: "The slump may also prompt fraudsters to rationalize their behavior." I think a slump causes increased pressure and not necessarily a change in rationalizing behavior. The increased pressure of hard economic times is simply a harder test of a person's ability to not rationalize committing fraud that is failed by more people.

Another bubble candidate

In addition to the green energy industry, I believe that the health care industry has potential to develop into our next bubble. The attitude toward the health care industry is similar in many ways to the pre-bubble attitude toward the housing industry. Similar to housing (and green energy), health care is being subjected to a great deal of government tinkering, with the objective of making health care affordable for all (note: I will save my political views on health care reform for another post--in this post I simply wish to point out the similarities between the pre-bubble housing industry and the current health care industry). In addition, many individuals believe that the demand for health care will continue to either increase or remain constant, similar to the "house prices will always increase" belief. Although differences between the two industries (e.g. a lower degree of leverage in health care) may limit the severity of a health care bubble in comparison to the housing bubble, I still believe that health care is a viable candidate for our next bubble.

The next bubble...

After two major bubbles popping in our economy in the last decade (the internet and real estate bubbles), I've wondered where the next bubble will form and if the pop will be as dramatic as the first two. Each bubble grows as investors jump on board in the boom times but, eventually, the market has a reality check and the bubble pops. In the boom times, fraud perpetrators have abundant opportunities to create a facade that investors are happy to finance. Then, when the reality check comes, the facade is revealed and rampant fraud is revealed.

I was reading about the proposed legislation for green energy and I'm going to be watching for a bubble in this area of the economy. Along with the bubble, I'm curious to see how much fraud forms among the companies that are jumping on board to make their millions while the government is blowing hot air into that part of the economy. Don't get me wrong, I would love to see us get away from foreign oil and put the middle east out of business but I'm also pretty sure that whenever the government is blowing hot air that a bubble will form and fraud perpetrators will come running to get their share.

Why so much fraud?

With the many Ponzi schemes, financial statement frauds and various schemes that keep coming to light, I've been asking myself why our society has so much fraud. I've come to the conclusion that it probably has something to do with the claim I've heard before that you can sell anything to 3% of the population. I don't know if it's 3% or some other percent but it seems like some people will buy anything. Like take the Pontiac Aztek. Who bought those cars anyway?! Perhaps a better question is who hired those designers and engineers to begin with?!

I believe that in certain segments of business the percentage of people who will buy anything is much higher than 3%. For example, fad diets and get rich quick schemes are sold to about 30% of the people I know. It seems that any product that claims to circumvent established laws of health and economics can be sold to a much higher percentage of the population than 3%. Why is that? Do these people think to themselves: "Never mind that science says that a balanced diet and exercise is the key to health, this diet says if I eat nothing but meat then I can play video games all day and still have washboard abs!" Or maybe they think to themselves: "I don't think economists know what their talking about since a friend of mine is able to make 12% per day by clicking on 7 websites!" Don't they ask themselves: "Why don't these people just employ all the population of India to click day and night and keep the profit themselves?!"

I'm convinced that when it comes to fad diets and get rich quick schemes, much more than 3% of the population will buy anything. The perfect recipe for a fraud seems to be to couple a fictitious health or diet claim with a get-rich-quick scheme. Many successful "entrepreneurs" do this with business models that aren't "technically" fraudulent. For example, how many multi-level-marketers are there who sell an unproven nutritional supplement at a price that is at least one order of magnitude higher than what you would pay for an equivalent product at Walmart?

Actually, many of these companies don't sell their products to end users; instead, they sell their products to other "distributors" who want to be a distributor so they can make their friends and family their downline. Yes, for many, the promise of getting rich quick is just too hard to resist.

Detecting Fraud: Lessons from Satyam

BusinessWeek has an interesting article on the Satyam fraud. One of the most amazing thing about this fraud is that the fraud appears to have been primarily a cash fraud (i.e. the company claimed to have cash that didn't really exist). The authors of the article discuss two possible scenarios that could have resulted in the fictitious cash balance: (1) fake sales and (2) theft of real cash. Because of the inherent difficulty in creating fictitious sales and sustaining such a fraud over an extended period of time (the problems at Satyam allegedly took place over seven years), the latter possibility appears to be the most likely. In the words of the article:

Consider, again, the $825 million Satyam reported as investments in bank deposits in its consolidated balance sheet as of Mar. 31, 2008. If one were to substitute the line item "investments in bank deposits" with "Chairman Raju's personal account," this scenario assumes significance. As such, the hypothesis we raise is that Satyam was a legitimate cash-generating business over time; that Raju misappropriated Satyam's cash; and, that most of the misappropriation was probably not reflected on the company's books.

If this is true, it implies a major failure in corporate governance, including a significant audit failure by Satyam's external auditors. Ironicly, cash is generally considered one of the easiest accounts to audit and junior auditors often complain when assigned to audit of a company's cash balance because the task is perceived to be very basic.

While the authors conclude that, "Only a detailed analysis of the cash flow statements could have caught [the fraud]," I am not completely convinced. While closer scrutiny of the cash flow statements may have helped raise some red flags, I am not sure that it would have been sufficient to uncover this fraud. Instead, I believe that Satyam's auditors would have been more likely to catch the fraud by engaging in additional strategic reasoning.

In other words, Satyam's management was most likely able to fool the auditors by considering the auditor's standard procedures for auditing cash and developing some method of fooling those audit procedures. If the auditors had considered how Satyam's behavior might change in response to their basic procedures, the auditors may have been able to develop better procedures that may have caught the fictitious balance.

Shrink the SEC?

Bloomberg reports that the Obama administration may attempt to reduce the regulatory power of the SEC, although the article acknowledges that the administration may have difficult time gaining the required support in congress. I am interested to see whether the proposed changes would affect either financial accounting standard setting or public company audit standard setting (both fall under SEC jurisdiction via the FASB and PCAOB). I would also like to know why the administration believes that we have a need for such a regulatory overhaul. While the SEC has had some rather public blunders lately, I believe that the agency plays an important and valuable role in helping to ensure a safe and fair marketplace. I have a hard time believing that diminishing or dissolving the agency is in the best interests of the country as a whole.

Audit Quality and the PCAOB

The PCAOB, charged with oversight of public company audits, has received a great deal of criticism as of late. Clive Lennox and Jeffrey Pittman add to the debate with their paper, Auditing the auditors: Evidence on the recent reforms to the external monitoring of audit firms, which was recently accepted for publication in the Journal of Accounting and Economics (HT Harvard Law School Corporate Governance Blog).

The paper focuses on the value of PCAOB inspection reports, which have replaced peer review reports as the primary source of information about audit firm quality. The authors find that:

• PCAOB inspection reports are not a meaningful signal of audit quality to audit clients
• Peer review reports are less informative than they were prior to the initation of PCAOB inspections

These findings imply that we know less about audit quality under the current regulatory structure. This reduction in knowledge causes concern, as a strong, independent audit is a significant deterrant to fraud.

The full text of the paper can be found here.

Fairfield (Madoff Feeder) Sued

Madoff's largest feeder sued (via WSJ). Per the article:

The lawsuit, in federal bankruptcy court in Manhattan, alleges the funds, which placed client money with Mr. Madoff, "should have known" he was engaged in fraud. The suit doesn't provide evidence Fairfield or its officers had knowledge of the Madoff fraud but says the firm didn't perform the adequate due diligence it promised its clients.

The suit says Fairfield reaped hundreds of millions of dollars in fees from its clients. The suit alleges Fairfield missed numerous warning signs, including trades listed in its accounts that could never have occurred, and seeks the return of money it withdrew on behalf of its clients since 1995.

I am interested to see how this suit and other similar lawsuits will pan out. In my opinion, many of these feeders must have been either complicit in the fraud or completely negligent in their due diligence.

Madoff Victims Facing Criminal Investigation

The WSJ reports that some of Madoff's high-profile investors are now facing criminal investigation. Should anyone be surprised that a $50 billion fraud has so many layers?