The Board of Directors Club

I have been thinking about corporate governance and the role of the board of directors a great deal lately. My thoughts keep coming back to this post at the Harvard Law School Corporate Governance Blog. The post discusses a recent study on the appointment of CEOs as outside directors. Among other things, the study finds that, "The appointment of a CEO outside director helps certify the appointing company and its management, but it does not lead to measurable improvements in operating performance or corporate policies." Still, even though CEO directors add little (or nothing) to the corporate governance environment of the boards that they sit on, they are still highly sought after by firms.

We have recently posted on the need to get rid of moonlighters, and the shortage of truly independent directors. A host of other issues, such as executive compensation, would be reduced or perhaps solved by stronger governance from directors. So what needs to change in order to strengthen the governance of the board?

Perhaps one way we could improve upon our current situation is to increase the consequences of negligence. Ideally, stricter penalties for a failure in oversight would weed out directors who are not adding value to the corporation on behalf of the shareholders. Although firms may need to look outside of the 'club' for independent directors, the resulting increase in independence and oversight would go a long way toward reducing the occurrence of fraud.

Bride scams in China

While we are recovering from a real estate bubble that was at least partially fueled by government policies, China has a bubble of their own: an oversupply of unwed males leading to exorbitant prices for available brides. This WSJ article describes some of the scams that are resulting from this situation. I guess it shows that government intervention in life or markets can lead to all sorts of problems...

Fraud or tax planning?

The WSJ reported today that seven people have been charged criminally with fraud for selling tax "products" for over a decade starting in 1994. Denis Field, former BDO Seidman, LLP chairman, was among the seven charged with fraud. Mr. Field's lawyer expressed his disappointment in the charges and stated that Mr. Field "always believed that the transactions at issue in the indictment were legitimate tax planning." Now, I don't know if BDO's tax products were fraudulent or not but saying Field always believed they were legitimate is about like an embezzler saying he always planned to pay back the money! I think Mr. Field may want to get a new attorney!

Madoff Victims Want More

A group of Madoff victims have filed suit to change the way losses are being calculated in the fraud. Currently, losses are calculated as the difference between the total amount paid into the scheme and the total amount withdrawn. However, this group of victims believes that the current calculation is unfair. Via the NYT:

The customers say that, by law, they should be given credit for the full value of the securities shown on the last account statements they received before Mr. Madoff’s arrest in mid-December, even though they were bogus and none of the trades were ever made. According to court filings, those account balances add up to more than $64 billion.

The calculation of losses is especially relevant when considering eligibility requirements for SIPC compensation:

Customers who qualify are eligible for up to $500,000 in immediate compensation from SIPC. Those whose eligible losses exceed that amount would divide up the assets recovered by the trustee.

Thousands of long-term investors, including elderly people who lived for decades on withdrawals from their Madoff accounts, do not qualify for SIPC payments because they withdrew considerably more over time than they originally entrusted to Mr. Madoff, Barry Lax, a lawyer for the plaintiffs, said.

Aside from the fact that many of these individuals are undergoing serious hardships because of their losses, I don't see any possible justification for the calculation of losses based on fictitious gains. The bottom line: why should we give taxpayer dollars to individuals who profited from Madoff's Ponzi scheme?

Kozlowski's prophesy is realized...

The Wall Street Journal just reported that the U.S. Supreme Court ruled that a West Virginia judge had a conflict of interest in a case that involved a company that gave the justice over $3 million in campaign contributions. Given that the judge received these contributions, the court ruled that the judge's failure to recuse himself before overturning a lawsuit against the company needed to be rectified.

What is a bit shocking to me is that the ruling on the bench was 5-4. What were the other four justices thinking? My guess is that they never saw the classic movie "A Man for All Seasons" in which Sir Thomas Moore explains to Richard Rich that being a judge can involve incredible pressure in the form of bribes and that Rich should avoid those conflicts because he lacked the integrity that Moore exhibited when he gave his life on principle. In my opinion, Moore's life is an amazing story and "A Man for All Seasons" is one of the GREATEST movies ever filmed!

You may be asking: what does this have to do with fraud? Well it may only be indirectly applicable. More on point, however, is the news that the Supreme Court refused to hear appeals from Tyco's former executives, Dennis Kozlowski and Mark Swartz. It looks like Kozlowski's statement that "We have no perks, not even parking spaces" is now going to come true for several years as he lives out his life in jail. Maybe Kozlowski was prophesying...

The buck stops here: The Board of Directors

Corporate governance has long been a concern when massive corporate frauds come to light. Today, Boards of Directors are being criticized for their role in the subprime crisis. Ultimately, the Board is the highest level of control that can prevent or detect corporate malfeasance--whether it be fraud or other illegal business practices. An article in The New Yorker discusses the current state of corporate governance and suggests that Boards need to be much more than moonlighting opportunities for the CEO's friends. The article concludes by saying:

Right now, boards are made up of moonlighters. And, if the last few years have shown anything, it’s that protecting shareholder interests is a full-time job.

A private equity fund gets caught with its hand in the cookie jar...

The NY Times reports on a fraud at Archway and Mothers Cookie Company and, according to the article, private-equity firm, Catterton Partners, was taking out millions in management fees while doing very little to manage the company. Ultimately, the article suggests that the company was booking fraudulent sales and stuffing the distribution channels after its products deteriorated under Catterton's (mis)management.

The article describes one distributor's experience of receiving excess and damaged inventory during the period when the company was channel stuffing in order to boost its sales numbers to keep financing coming. This distributor summed up his view of Catterton's role in the failure of the Cookie Company by saying:

“What soured me on this experience is that these private equity firms that come in and buy companies don’t look at a company to grow it. Whether it sinks or swims doesn’t really matter to them ... They don’t think about the people whose livelihoods depend on that company. I hope I never have to go through that again.”

"Like bees to honey"

While much of the debate over our government's stimulus efforts has focused on the economic rationale for such programs and the resulting moral hazard, the discussion of the fraud opportunities created by the stimulus programs has been seemingly non-existent.

From the Boston Globe:

FBI director Robert Mueller says the government's stimulus package, including the Troubled Asset Relief Program, has "the potential to be the next wave" of cases the agency investigates.

"These funds are inherently vulnerable to bribery, fraud, conflicts of interest, and collusion," he said yesterday at the Economic Club of New York. "There is an old adage: Where there is money to be made, fraud is not far behind, like bees to honey." With trillions of dollars at stake, "even a small percentage of fraud would result in substantial, substantial taxpayer losses," he said.

Neil Barofsky, Special Inspector General for TARP has already launched over a dozen investigations into possible misuses of bailout funds. In addition, he said the following regarding the oversight of TARP (source):

Inadequate oversight and insufficient information about what companies are doing with the money leaves the program open to fraud, including "conflicts of interest facing fund managers, collusion between participants and vulnerabilities to money laundering,"

I almost wonder if some lawmaker, discussing oversight of the federal stimulus programs, said, "You know, I hear that Bernie Madoff has a great auditor," followed by, "I wonder if they are accepting new clients?"

As a footnote, anyone interested in getting a piece of the action should check out this EZ-CASH bailout application.

Making examples of Satyam's auditors

It looks like India's judicial system is a bit different than what we're used to here in the U.S. Two PricewaterhouseCoopers partners who worked on the Satyam audit have been in prison for four months while awaiting trial. The partners claim they had no idea of the fraud and that it was carefully concealed with fictitious documents. Apparently, the prison conditions are not exactly country club conditions either.

A New York Times article explains the partners' situation as follows:

The prison, opened in the 1800s, is surrounded by high watchtowers and a concrete wall. Behind its hulking, metal-studded front door live more than 900 men, held for crimes like pick-pocketing and murder. Then there are the two accountants....

The auditors, who are technically in “judicial custody,” are luckier than most prisoners here. Their wives can bring them food from outside during their twice-weekly visits. But they receive few other privileges. They sleep on the floor in a cell with other inmates, in temperatures that often exceed 100 degrees...

Accounting experts say that while authorities may be treating the PricewaterhouseCoopers partners particularly harshly, making an example of them may prevent more serious repercussions for the country’s economy and even the audit firm itself.

I wonder what they do when they catch terrorists in India...

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.