Bob
Jensen's fraud updates are at
http://www.trinity.edu/rjensen/fraud.htm
Note that I’m not in favor of repealing the recent
legislation. But I am in favor of adding a public option so long as taxation and
insurance premiums are added to fully cover the annual costs of health
insurance. And let's stop the BS on the left and on the right side of this
debate.
Fuzzy CBO Accounting Tricks
"ObamaCare by the Numbers: Part 2," by John Cassidy, The New Yorker,
March 26, 2010 ---
http://www.newyorker.com/online/blogs/johncassidy/2010/03/obamacare-by-the-numbers-part-2.html
This is a long and somewhat involved followup to my
previous post on ObamaCare. . For those of you
with O.A.D.D. (online attention-deficit disorder), I’ve provided an express
and local version.
EXPRESS:
The official projections for health-care reform,
which show it greatly reducing the number of uninsured and also reducing the
budget deficit, are simply not credible. There are three basic issues.
The cost and revenue projections rely on
unrealistic assumptions and accounting tricks. If you make some adjustments
for these, the cost of the plan is much higher.
The so-called “individual mandate” isn’t really a
mandate at all. Under the new system, many young and healthy people will
still have a strong incentive to go uninsured.
Once the reforms are up and running, some employers
will have a big incentive to end their group coverage plans and dump their
employees onto the taxpayer-subsidized individual plans, greatly adding to
their cost.
LOCAL:
For future reference (or possibly to roll up and
beat myself over the head with in my dotage) I have filed away a copy the
latest analysis (pdf) of health-care reform from the Congressional Budget
Office. By 2019, it says, the bills passed by the House and Senate will have
cut the number of uninsured Americans by thirty-two million, raised the
percentage of people with some form of health-care coverage from
eighty-three per cent to ninety-four per cent, and reduced the federal
deficit by a cumulative $143 billion. If all of these predictions turn out
to be accurate, ObamaCare will go down as one of the most successful and
least costly government initiatives in history. At no net cost to the
taxpayer, it will have filled a gaping hole in the social safety net and
solved a problem that has frustrated policymakers for decades.
Does Santa Claus live after all? According to the
C.B.O., between now and 2019 the net cost of insuring new enrollees in
Medicaid and private insurance plans will be $788 billion, but other
provisions in the legislation will generate revenues and cost savings of
$933 billion. Subtract the first figure from the second and—voila!—you get
$143 billion in deficit reduction.
The first objection to these figures is that the
great bulk of the cost savings—more than $450 billion—comes from cuts in
Medicare payments to doctors and other health-care providers. If you are
vaguely familiar with Washington politics and the letters A.A.R.P. you might
suspect that at least some of these cuts will fail to materialize. Unlike
some hardened skeptics, I don’t think none of them will happen. One part of
the reform involves reducing excessive payments that the Bush Administration
agreed to when it set up the Medicare Advantage program in 2003. If Congress
remains under Democratic control—a big if, admittedly—it will probably enact
these changes. But that still leaves another $300 billion of Medicare
savings to be found.
The second problem is accounting gimmickry. Acting
in accordance with standard Washington practices, the C.B.O. counts as
revenues more than $50 million in Social Security taxes and $70 billion in
payments towards a new home-care program, which will eventually prove very
costly, and it doesn’t count some $50 billion in discretionary spending.
After excluding these pieces of trickery and the questionable Medicare cuts,
Douglas Holtz-Eakin, a former head of the C.B.O., has calculated that the
reform will actually raise the deficit by $562 billion in the first ten
years. “The budget office is required to take written legislation at face
value and not second-guess the plausibility of what it is handed,” he wrote
in the Times. “So fantasy in, fantasy out.”
Holtz-Eakin advised John McCain in 2008, and he has
a reputation as a straight shooter. I think the problems with the C.B.O.’s
projections go even further than he suggests. If Holtz-Eakin’s figures
turned out to be spot on, and over the next ten years health-care reform
reduced the number of uninsured by thirty million at an annual cost of $56
billion, I would still regard it as a great success. In a $15 trillion
economy—and, barring another recession, the U.S. economy should be that
large in 2014—fifty or sixty billion dollars is a relatively small sum—about
four tenths of one per cent of G.D.P., or about eight per cent of the 2011
Pentagon budget.
My two big worries about the reform are that it
won’t capture nearly as many uninsured people as the official projections
suggest, and that many businesses, once they realize the size of the
handouts being offered for individual coverage, will wind down their group
plans, shifting workers (and costs) onto the new government-subsidized
plans. The legislation includes features designed to prevent both these
things from happening, but I don’t think they will be effective.
Consider the so-called “individual mandate.” As a
strict matter of law, all non-elderly Americans who earn more than the
poverty line will be obliged to obtain some form of health coverage. If they
don’t, in 2016 and beyond, they could face a fine of about $700 or 2.5 per
cent of their income—whichever is the most. Two issues immediately arise.
Even if the fines are vigorously enforced, many
people may choose to pay them and stay uninsured. Consider a healthy single
man of thirty-five who earns $35,000 a year. Under the new system, he would
have a choice of enrolling in a subsidized plan at an annual cost of $2,700
or paying a fine of $875. It may well make sense for him to pay the fine,
take his chances, and report to the local emergency room if he gets really
sick. (E.R.s will still be legally obliged to treat all comers.) If this
sort of thing happens often, as well it could, the new insurance exchanges
will be deprived of exactly the sort of healthy young people they need in
order to bring down prices. (Healthy people improve the risk pool.)
If the rules aren’t properly enforced, the problem
will be even worse. And that is precisely what is likely to happen. The
I.R.S. will have the administrative responsibility of imposing penalties on
people who can’t demonstrate that they have coverage, but it won’t have the
legal authority to force people to pay the fines. “What happens if you don’t
buy insurance and you don’t pay the penalty?” Ezra Klein, the Washington
Post’s industrious and well-informed blogger, asks. “Well, not much. The law
specifically says that no criminal action or liens can be imposed on people
who don’t pay the fine.”
So, the individual mandate is a bit of a sham.
Generous subsidies will be available for sick people and families with
children who really need medical care to buy individual coverage, but
healthy single people between the ages of twenty-six and forty, say, will
still have a financial incentive to remain outside the system until they get
ill, at which point they can sign up for coverage. Consequently, the number
of uninsured won’t fall as much as expected, and neither will prices.
Without a proper individual mandate, the idea of universality goes out the
window, and so does much of the economic reasoning behind the bill.
The question of what impact the reforms will have
on existing insurance plans has received even less analysis. According to
President Obama, if you have coverage you like you can keep it, and that’s
that. For the majority of workers, this will undoubtedly be true, at least
in the short term, but in some parts of the economy, particularly industries
that pay low and moderate wages, the presence of such generous subsidies for
individual coverage is bound to affect behavior eventually. To suggest this
won’t happen is to say economic incentives don’t matter.
Take a medium-sized firm that employs a hundred
people earning $40,000 each—a private security firm based in Atlanta,
say—and currently offers them health-care insurance worth $10,000 a year, of
which the employees pay $2,500. This employer’s annual health-care costs are
$750,000 (a hundred times $7,500). In the reformed system, the firm’s
workers, if they didn’t have insurance, would be eligible for generous
subsidies to buy private insurance. For example, a married forty-year-old
security guard whose wife stayed home to raise two kids could enroll in a
non-group plan for less than $1,400 a year, according to the Kaiser Health
Reform Subsidy Calculator. (The subsidy from the government would be
$8,058.)
In a situation like this, the firm has a strong
financial incentive to junk its group coverage and dump its workers onto the
taxpayer-subsidized plan. Under the new law, firms with more than fifty
workers that don’t offer coverage would have to pay an annual fine of $2,000
for every worker they employ, excepting the first thirty. In this case, the
security firm would incur a fine of $140,000 (seventy times two), but it
would save $610,000 a year on health-care costs. If you owned this firm,
what would you do? Unless you are unusually public spirited, you would take
advantage of the free money that the government is giving out. Since your
employees would see their own health-care contributions fall by more than
$1,100 a year, or almost half, they would be unlikely to complain. And even
if they did, you would be saving so much money you afford to buy their
agreement with a pay raise of, say, $2,000 a year, and still come out well
ahead.
Even if the government tried to impose additional
sanctions on such firms, I doubt it would work. The dollar sums involved are
so large that firms would try to game the system, by, for example, shutting
down, reincorporating under a different name, and hiring back their
employees without coverage. They might not even need to go to such lengths.
Firms that pay modest wages have high rates of turnover. By simply refusing
to offer coverage to new employees, they could pretty quickly convert most
of their employees into non-covered workers.
The designers of health-care reform and the C.B.O.
are aware of this problem, but, in my view, they have greatly underestimated
it. According to the C.B.O., somewhere between eight and nine million
workers will lose their group coverage as a result of their employers
refusing to offer it. That isn’t a trifling number. But the C.B.O. says it
will be largely offset by an opposite effect in which employers that don’t
currently provide health insurance begin to offer it in response to higher
demand from their workers as a result of the individual mandate. In this
way, some six to seven million people will obtain new group coverage, the
C.B.O. says, so the overall impact of the changes will be minor.
The C.B.O.’s analysis can’t be dismissed out of
hand, but it is surely a best-case scenario. Again, I come back to where I
started: the scale of the subsidies on offer for low and moderately priced
workers. If economics has anything to say as a subject, it is that you can’t
offer people or firms large financial rewards for doing something—in this
case, dropping their group coverage—and not expect them to do it in large
numbers. On this issue, I find myself in agreement with Tyler Cowen and
other conservative economists. Over time, the “firewall” between the
existing system of employer-provided group insurance and taxpayer-subsidized
individual insurance is likely to break down, with more and more workers
being shunted over to the public teat.
At that point, if it comes, politicians of both
parties will be back close to where they began: searching for health-care
reform that provides adequate coverage for all at a cost the country can
afford. What would such a system look like? That is a topic for another
post, but I don’t think it would look much like Romney-ObamaCare.
Read more:
http://www.newyorker.com/online/blogs/johncassidy/2010/03/obamacare-by-the-numbers-part-2.html#ixzz0jrFSFK3j
Bob Jensen's threads on health care ---
http://www.newyorker.com/online/blogs/johncassidy/2010/03/obamacare-by-the-numbers-part-2.html
"SBA Warns Small Businesses of Scams to Help Obtain Government Loans,"
Journal of Accountancy, April 1, 2010 ---
http://www.journalofaccountancy.com/Web/20102758.htm
Bob Jensen's threads on fraud reporting are at
http://www.trinity.edu/rjensen/fraudReporting.htm
Bob Jensen's small business helpers are at
http://www.trinity.edu/rjensen/bookbob1.htm#SmallBusiness
Bonuses for What?
The only guy to make almost a $100 Million dollars at GE is the CEO who
destroyed shareholder value by nearly 50% in slightly less than a decade
"GE has been an investor disaster under Jeff Immelt," MarketWatch, March
8, 2010 ---
http://www.marketwatch.com/story/ge-has-been-an-investor-disaster-under-jeff-immelt-2010-03-08
When things go well, chief executives of major
companies rack up hundreds of millions of dollars, even billions, on their
stock allotments and options.
It's always justified on the grounds that they've
created lots of shareholder value. But what happens when things go badly?
For one example, take a look at General Electric
Co. /quotes/comstock/13*!ge/quotes/nls/ge (GE 16.27, +0.04, +0.22%) , one of
America's biggest and most important companies. It just revealed its latest
annual glimpse inside the executive swag bag.
By any measure of shareholder value, GE has been a
disaster under Jeffrey Immelt. Investors haven't made a nickel since he took
the helm as chairman and chief executive nine years ago. In fact, they've
lost tens of billions of dollars.
The stock, which was $40 and change when Immelt
took over, has collapsed to around $16. Even if you include dividends,
investors are still down about 40%. In real post-inflation terms,
stockholders have lost about half their money.
So it may come as a shock to discover that during
that same period, the 54-year old chief executive has racked up around $90
million in salary, cash and pension benefits.
GE is quick to point out that Immelt skipped his
$5.8 million cash bonus in 2009 for the second year in a row, because
business did so badly. And so he did.
Yet this apparent sacrifice has to viewed in
context. Immelt still took home a "base salary" of $3.3 million and a total
compensation of $9.9 million.
His compensation in the previous two years was
$14.3 million and $9.3 million. That included everything from salary to
stock awards, pension benefits and other perks.
Too often, the media just look at each year's pay
in isolation. I decided to go back and take the longer view.
Since succeeding Jack Welch in 2001, Immelt has
been paid a total of $28.2 million in salary and another $28.6 million in
cash bonuses, for total payments of $56.8 million. That's over nine years,
and in addition to all his stock- and option-grant entitlements.
It doesn't end there. Along with all his cash
payments, Immelt also has accumulated a remarkable pension fund worth $32
million. That would be enough to provide, say, a 60-year-old retiree with a
lifetime income of $192,000 a month.
Yes, Jeff Immelt has been at the company for 27
years, and some of this pension was accumulated in his early years rising up
the ladder. But this isn't just his regular company pension. Nearly all of
this is in the high-hat plan that's only available to senior GE executives.
Immelt's personal use of company jets -- I repeat,
his personal use for vacations, weekend getaways and so on -- cost GE
stockholders another $201,335 last year. (It's something shareholders can
think about when they stand in line to take off their shoes at JFK -- if
they're not lining up at the Port Authority for a bus.)
Bob Jensen's threads on
outrageous executive compensation are at
http://www.trinity.edu/rjensen/FraudConclusion.htm#OutrageousCompensation
Sarbanes-Oxley Act (Sarbox, SOX) ---
http://en.wikipedia.org/wiki/Sarbanes%E2%80%93Oxley_Act
Sarbanes–Oxley Section 404: Assessment of internal control ---
http://en.wikipedia.org/wiki/Sarbanes%E2%80%93Oxley_Act#Sarbanes.E2.80.93Oxley_Section_404:_Assessment_of_internal_control
The most contentious aspect of SOX is Section 404,
which requires management and the external auditor to report on the adequacy
of the company's internal control over financial reporting (ICFR). This is
the most costly aspect of the legislation for companies to implement, as
documenting and testing important financial manual and automated controls
requires enormous effort.
Under Section 404 of the Act, management is
required to produce an “internal control report” as part of each annual
Exchange Act report. See
15 U.S.C. § 7262.
The report must affirm “the responsibility of
management for establishing and maintaining an adequate internal control
structure and procedures for financial reporting.”
15 U.S.C. § 7262(a).
The report must also “contain an assessment, as of the
end of the most recent fiscal year of the
Company, of the
effectiveness of the internal control structure and procedures of the issuer
for financial reporting.” To do this, managers are generally adopting an
internal control framework such as that described in
COSO.
To help alleviate the high costs of compliance,
guidance and practice have continued to evolve. The
Public Company Accounting Oversight Board (PCAOB)
approved
Auditing Standard No. 5 for public accounting
firms on July 25, 2007.
This standard superseded Auditing Standard
No. 2, the initial guidance provided in 2004. The SEC also released its
interpretive guidance on June 27, 2007. It is
generally consistent with the PCAOB's guidance, but intended to provide
guidance for management. Both management and the external auditor are
responsible for performing their assessment in the context of a
top-down risk assessment, which requires
management to base both the scope of its assessment and evidence gathered on
risk. This gives management wider discretion in its assessment approach.
These two standards together require management to:
- Assess both the design and operating
effectiveness of selected internal controls related to significant
accounts and relevant assertions, in the context of material
misstatement risks;
- Understand the flow of transactions, including
IT aspects, sufficient enough to identify points at which a misstatement
could arise;
- Evaluate company-level (entity-level)
controls, which correspond to the components of the
COSO framework;
- Perform a fraud risk assessment;
- Evaluate controls designed to
prevent or detect fraud, including management
override of controls;
- Evaluate controls over the period-end
financial reporting process;
- Scale the assessment based on the size and
complexity of the company;
- Rely on management's work based on factors
such as competency, objectivity, and risk;
- Conclude on the adequacy of internal control
over financial reporting.
SOX 404 compliance costs represent a tax on
inefficiency, encouraging companies to centralize and automate their
financial reporting systems. This is apparent in the comparative costs of
companies with decentralized operations and systems, versus those with
centralized, more efficient systems. For example, the 2007 FEI survey
indicated average compliance costs for decentralized companies were $1.9
million, while centralized company costs were $1.3 million.[31]
Costs of evaluating manual control procedures are dramatically reduced
through automation.
Sarbanes–Oxley 404 and smaller public companies ---
Click Here
The cost of complying with SOX 404 impacts smaller
companies disproportionately, as there is a significant fixed cost involved
in completing the assessment. For example, during 2004 U.S. companies with
revenues exceeding $5 billion spent 0.06% of revenue on SOX compliance,
while companies with less than $100 million in revenue spent 2.55%.
This disparity is a focal point of 2007 SEC and
U.S. Senate action.[33] The PCAOB intends to issue further guidance to help
companies scale their assessment based on company size and complexity during
2007. The SEC issued their guidance to management in June, 2007.
After the SEC and PCAOB issued their guidance, the
SEC required smaller public companies (non-accelerated filers) with fiscal
years ending after December 15, 2007 to document a Management Assessment of
their Internal Controls over Financial Reporting (ICFR). Outside auditors of
non-accelerated filers however opine or test internal controls under PCAOB
(Public Company Accounting Oversight Board) Auditing Standards for years
ending after December 15, 2008. Another extension was granted by the SEC for
the outside auditor assessment until years ending after December 15, 2009.
The reason for the timing disparity was to address the House Committee on
Small Business concern that the cost of complying with Section 404 of the
Sarbanes–Oxley Act of 2002 was still unknown and could therefore be
disproportionately high for smaller publicly held companies. On October 2,
2009, the SEC granted another extension for the outside auditor assessment
until fiscal years ending after June 15, 2010. The SEC stated in their
release that the extension was granted so that the SEC’s Office of Economic
Analysis could complete a study of whether additional guidance provided to
company managers and auditors in 2007 was effective in reducing the costs of
compliance. They also stated that there will be no further extensions in the
future.
"Fraud Case Casts Doubt over Sarbox Exemption: An alleged $31
million fraud could quash claims that internal-controls checks don't matter,"
by Sarah Johnson - CFO Magazine, February 1, 2010 ---
http://www.cfo.com/article.cfm/14470842/c_14470994?f=magazine_alsoinside
If allegations that a finance executive pilfered as
much as $31 million over five years from Koss Corp. prove true, it won't
just be bad news for Koss: it may also deal a blow to those who hope that
smaller, publicly traded companies will be exempted from full compliance
with the Sarbanes-Oxley Act.
The well-known manufacturer of headphones reported
$38.3 million in sales last year, so a $31 million theft, even over five
years, suggests some serious problems with internal controls. Koss plans to
restate its financials for the past two years and may go back as far as 2005
to make corrections. Koss's stock spent 21 days in limbo after Nasdaq halted
its trading toward the end of December. At least one law firm has opened an
investigation for a possible shareholder lawsuit.
Koss fired its accounting firm, Grant Thornton, on
New Year's Eve. The auditor responded by pointing out that Koss is among
those companies not yet subject to Sarbox's Section 404(b), which requires
an auditor sign-off of internal controls. "The company did not engage Grant
Thornton to conduct an audit or evaluation of internal controls over
financial reporting," says a spokesperson for the accounting firm.
"Establishing and maintaining effective internal control is management's and
the board's responsibility."
Koss's management claims the company did have
effective internal controls, but the management report enclosed in its most
recent 10-K acknowledges in boilerplate language that "because of the
inherent limitations in all control systems, no evaluation of controls can
provide absolute assurance that all control issues and instances of fraud,
if any, within the company have been detected."
The criminal case against Sujata "Sue" Sachdeva,
Koss's former vice president of finance and secretary, alleges she used more
than $4.5 million of the company's money to buy clothing, furs, and jewelry
at various luxury stores in Milwaukee during the past two years. Following
those initial allegations, Koss has since disclosed that the extent of the
fraud may be worse; an internal investigation has uncovered additional
unauthorized transactions from as far back as five years ago that total more
than $31 million.
Gauging the Fallout While the Securities and
Exchange Commission has continually delayed the auditor-attestation portion
of Section 404 for nonaccelerated filers (companies with market caps below
$75 million), companies like Koss will finally have to get their auditors to
review their internal controls starting this summer (depending on their
fiscal year-end).
Or maybe not. The major regulatory-reform bill
passed by the House in mid-December would permanently exempt small
businesses from 404(b). Small-business proponents have pushed for the
exemption, saying audits of internal controls over financial reporting are
disproportionately costly and perhaps even unnecessary since, individually,
small companies represent only minuscule blips of total market
capitalization in the United States.
That exemption may disappear as the Senate works on
its version of the bill. Investor advocates certainly hope so. "Investors
believe that auditors' expertise can provide management with additional
perspective on the quality of its system of internal control, which can have
a positive impact on the quality of a company's financial reporting," wrote
four investor groups, including the CFA Centre for Financial Market
Integrity, in a recent letter to House members. The Koss case could bolster
such arguments.
Bob Jensen's Fraud Updates ---
http://www.trinity.edu/rjensen/fraudUpdates.htm
Bob Jensen's threads on professionalism in auditing ---
http://www.trinity.edu/rjensen/fraud001.htm
March 3, 2010 White Paper Announced in an email message from US Banker.
How Can Fraud
Models Combat New Tricks?
|
Download this White Paper
---
http://www.americanbanker.com/papers/FICO-1015350-1.html
|
What if your fraud detection solution could teach itself to identify new
fraud patterns? That’s adaptive modeling. Learn how adaptive modeling
can work with fraud detection systems that use past transactional and
case disposition data to significantly and measurably improve fraud
detection. Download the white paper, “How Can Fraud Models Combat New
Tricks?” |
University of Illinois at Chicago Report
on Massive Political Corruption in Chicago
"Chicago Is a 'Dark Pool Of Political Corruption'," Judicial Watch,
February 22, 2010 ---
http://www.judicialwatch.org/blog/2010/feb/dark-pool-political-corruption-chicago
A major U.S. city long known as a hotbed of
pay-to-play politics infested with clout and patronage has seen nearly 150
employees, politicians and contractors get convicted of corruption in the
last five decades.
Chicago has long been distinguished for its
pandemic of public corruption, but actual cumulative figures have never been
offered like this. The astounding information is featured in a
lengthy report published by one of Illinois’s
biggest public universities.
Cook County, the nation’s second largest, has been
a
“dark pool of political corruption” for more than
a century, according to the informative study conducted by the University of
Illinois at Chicago, the city’s largest public college. The report offers a
detailed history of corruption in the Windy City beginning in 1869 when
county commissioners were imprisoned for rigging a contract to paint City
Hall.
It’s downhill from there, with a plethora of
political scandals that include 31 Chicago alderman convicted of crimes in
the last 36 years and more than 140 convicted since 1970. The scams involve
bribes, payoffs, padded contracts, ghost employees and whole sale subversion
of the judicial system, according to the report.
Elected officials at the highest levels of city,
county and state government—including prominent judges—were the perpetrators
and they worked in various government locales, including the assessor’s
office, the county sheriff, treasurer and the President’s Office of
Employment and Training. The last to fall was renowned
political bully Isaac Carothers, who just a few
weeks ago pleaded guilty to federal bribery and tax charges.
In the last few years alone several dozen officials
have been convicted and more than 30 indicted for taking bribes, shaking
down companies for political contributions and rigging hiring. Among the
convictions were fraud, violating court orders against using politics as a
basis for hiring city workers and the disappearance of 840 truckloads of
asphalt earmarked for city jobs.
A few months ago the city’s largest newspaper
revealed that Chicago aldermen keep a
secret, taxpayer-funded pot of cash (about $1.3
million) to pay family members, campaign workers and political allies for a
variety of questionable jobs. The covert account has been utilized for
decades by Chicago lawmakers but has escaped public scrutiny because it’s
kept under wraps.
Judicial Watch has extensively investigated Chicago
corruption, most recently the
conflicted ties of top White House officials to
the city, including Barack and Michelle Obama as well as top administration
officials like Chief of Staff Rahm Emanual and Senior Advisor David Axelrod.
In November Judicial Watch
sued Chicago Mayor Richard Daley's office to
obtain records related to the president’s failed bid to bring the Olympics
to the city.
Bob Jensen's threads on the
sad state of governmental accounting are at
http://www.trinity.edu/rjensen/theory01.htm#GovernmentalAccounting
Bob Jensen's threads on political
corruption are at
http://www.trinity.edu/rjensen/FraudRotten.htm#Lawmakers
Bob Jensen's Fraud Updates are at
http://www.trinity.edu/rjensen/fraudUpdates.htm
The Financial Accounting Standards Board moved
last year to close the loophole that Lehman is accused of using, Bushee says. A
new rule, FAS 166, replaces the 98%-102% test with one designed to get at the
intent behind a repurchase agreement. The new rule, just taking effect now,
looks at whether a transaction truly involves a transfer of risk and reward. If
it does not, the agreement is deemed a loan and the assets stay on the
borrower's balance sheet.
"Lehman's Demise and Repo 105: No Accounting for Deception,"
Knowledge@Wharton, March 31, 2010 ---
http://knowledge.wharton.upenn.edu/article.cfm?articleid=2464
The collapse of Lehman Brothers in September 2008
is widely seen as the trigger for the financial crisis, spreading panic that
brought lending to a halt. Now a 2,200-page report says that prior to the
collapse -- the largest bankruptcy in U.S. history -- the investment bank's
executives went to extraordinary lengths to conceal the risks they had taken. A
new term describing how Lehman converted securities and other assets into cash
has entered the financial vocabulary: "Repo 105."
While Lehman's huge indebtedness and other
mistakes have been well documented, the $30 million study by Anton Valukas,
assigned by the bankruptcy court, contains a number of surprises and new
insights, several Wharton faculty members say.
Among the report's most disturbing revelations,
according to Wharton finance professor
Richard J. Herring, is the picture of Lehman's
accountants at Ernst & Young. "Their main role was to help the firm misrepresent
its actual position to the public," Herring says, noting that reforms after the
Enron collapse of 2001 have apparently failed to make accountants the watchdogs
they should be.
"It was clearly a dodge.... to circumvent the
rules, to try to move things off the balance sheet," says Wharton accounting
professor professor
Brian J. Bushee,
referring to Lehman's Repo 105 transactions. "Usually, in these kinds of
situations I try to find some silver lining for the company, to say that there
are some legitimate reasons to do this.... But it clearly was to get assets off
the balance sheet."
The use of outside entities to remove risks from a
company's books is common and can be perfectly legal. And, as Wharton finance
professor
Jeremy
J. Siegel points out, "window dressing" to make
the books look better for a quarterly or annual report is a widespread practice
that also can be perfectly legal. Companies, for example, often rush to lay off
workers or get rid of poor-performing units or investments, so they won't mar
the next financial report. "That's been going on for 50 years," Siegel says.
Bushee notes, however, that Lehman's maneuvers
were more extreme than any he has seen since the Enron collapse.
Wharton finance professor professor
Franklin Allen suggests that the other firms
participating in Lehman's Repo 105 transactions must have known the whole
purpose was to deceive. "I thought Repo 105 was absolutely remarkable – that
Ernst & Young signed off on that. All of this was simply an artifice, to deceive
people." According to Siegel, the report confirms earlier evidence that Lehman's
chief problem was excessive borrowing, or over-leverage. He argues that it
strengthens the case for tougher restrictions on borrowing.
A Twist on a Standard Financing Method
In his report, Valukas, chairman of the law firm
Jenner & Block, says that Lehman disregarded its own risk controls "on a regular
basis," even as troubles in the real estate and credit markets put the firm in
an increasingly perilous situation. The report slams Ernst & Young for failing
to alert the board of directors, despite a warning of accounting irregularities
from a Lehman vice president. The auditing firm has denied doing anything wrong,
blaming Lehman's problems on market conditions.
Much of Lehman's problem involved huge holdings of
securities based on subprime mortgages and other risky debt. As the market for
these securities deteriorated in 2008, Lehman began to suffer huge losses and a
plunging stock price. Ratings firms downgraded many of its holdings, and other
firms like JPMorgan Chase and Citigroup demanded more collateral on loans,
making it harder for Lehman to borrow. The firm filed for bankruptcy on
September 15, 2008.
Prior to the bankruptcy, Lehman worked hard to
make its financial condition look better than it was, the Valukas report says. A
key step was to move $50 billion of assets off its books to conceal its heavy
borrowing, or leverage. The Repo 105 maneuver used to accomplish that was a
twist on a standard financing method known as a repurchase agreement. Lehman
first used Repo 105 in 2001 and became dependent on it in the months before the
bankruptcy.
Repos, as they are called, are used to convert
securities and other assets into cash needed for a firm's various activities,
such as trading. "There are a number of different kinds, but the basic idea is
you sell the security to somebody and they give you cash, and then you agree to
repurchase it the next day at a fixed price," Allen says.
In a standard repo transaction, a firm like Lehman
sells assets to another firm, agreeing to buy them back at a slightly higher
price after a short period, sometimes just overnight. Essentially, this is a
short-term loan using the assets as collateral. Because the term is so brief,
there is little risk the collateral will lose value. The lender – the firm
purchasing the assets – therefore demands a very low interest rate. With a
sequence of repo transactions, a firm can borrow more cheaply than it could with
one long-term agreement that would put the lender at greater risk.
Under standard accounting rules, ordinary repo
transactions are considered loans, and the assets remain on the firm's books,
Bushee says. But Lehman found a way around the negotiations so it could count
the transaction as a sale that removed the assets from its books, often just
before the end of the quarterly financial reporting period, according to the
Valukas report. The move temporarily made the firm's debt levels appear lower
than they really were. About $39 billion was removed from the balance sheet at
the end of the fourth quarter of 2007, $49 billion at the end of the first
quarter of 2008 and $50 billion at the end of the next quarter, according to the
report.
Bushee says Repo 105 has its roots in a rule
called FAS 140, approved by the Financial Accounting Standards Board in 2000. It
modified earlier rules that allow companies to "securitize" debts such as
mortgages, bundling them into packages and selling bond-like shares to
investors. "This is the rule that basically created the securitization
industry," he notes.
FAS 140 allowed the pooled securities to be moved
off the issuing firm's balance sheet, protecting investors who bought the
securities in case the issuer ran into trouble later. The issuer's creditors,
for example, cannot go after these securities if the issuer goes bankrupt, he
says.
Because repurchase agreements were really loans,
not sales, they did not fit the rule's intent, Bushee states. So the rule
contained a provision saying the assets involved would remain on the firm's
books so long as the firm agreed to buy them back for a price between 98% and
102% of what it had received for them. If the repurchase price fell outside that
narrow band, the transaction would be counted as a sale, not a loan, and the
securities would not be reported on the firm's balance sheet until they were
bought back.
This provided the opening for Lehman. By agreeing
to buy the assets back for 105% of their sales price, the firm could book them
as a sale and remove them from the books. But the move was misleading, as Lehman
also entered into a forward contract giving it the right to buy the assets back,
Bushee says. The forward contract would be on Lehman's books, but at a value
near zero. "It's very similar to what Enron did with their transactions. It's
called 'round-tripping.'" Enron, the huge Houston energy company, went bankrupt
in 2001 in one of the best-known examples of accounting deception.
Lehman's use of Repo 105 was clearly intended to
deceive, the Vakulas report concludes. One executive email cited in the report
described the program as just "window dressing." But the company, which had
international operations, managed to get a legal opinion from a British law firm
saying the technique was legal.
Bamboozled
The Financial Accounting Standards Board moved
last year to close the loophole that Lehman is accused of using, Bushee says. A
new rule, FAS 166, replaces the 98%-102% test with one designed to get at the
intent behind a repurchase agreement. The new rule, just taking effect now,
looks at whether a transaction truly involves a transfer of risk and reward. If
it does not, the agreement is deemed a loan and the assets stay on the
borrower's balance sheet.
The Vakulas report has led some experts to renew
calls for reforms in accounting firms, a topic that has not been
front-and-center in recent debates over financial regulation. Herring argues
that as long as accounting firms are paid by the companies they audit, there
will be an incentive to dress up the client's appearance. "There is really a
structural problem in the attitude of accountants." He says it may be worthwhile
to consider a solution, proposed by some of the industry's critics, to tax firms
to pay for auditing and have the Securities and Exchange Commission assign the
work and pay for it.
The Valukas report also shows the need for better
risk-management assessments by firm's boards of directors, Herring says. "Every
time they reached a line, there should have been a risk-management committee on
the board that at least knew about it." Lehman's ability to get a favorable
legal opinion in England when it could not in the U.S. underscores the need for
a "consistent set" of international accounting rules, he adds.
Siegel argues that the report also confirms that
credit-rating agencies like Moody's and Standard & Poor's must bear a large
share of the blame for troubles at Lehman and other firms. By granting triple-A
ratings to risky securities backed by mortgages and other assets, the ratings
agencies made it easy for the firms to satisfy government capital requirements,
he says. In effect, the raters enabled the excessive leverage that proved a
disaster when those securities' prices fell to pennies on the dollar. Regulators
"were being bamboozled, counting as safe capital investments that were nowhere
near safe."
Some financial industry critics argue that big
firms like Lehman be broken up to eliminate the problem of companies being
deemed "too big to fail." But Siegel believes stricter capital requirements are
a better solution, because capping the size of U.S. firms would cripple their
ability to compete with mega-firms overseas.
While the report sheds light on Lehman's inner
workings as the crisis brewed, it has not settled the debate over whether the
government was right to let Lehman go under. Many experts believe bankruptcy is
the appropriate outcome for firms that take on too much risk. But in this case,
many feel Lehman was so big that its collapse threw markets into turmoil, making
the crisis worse than it would have been if the government had propped Lehman
up, as it did with a number of other firms.
Allen says regulators made the right call in
letting Lehman fail, given what they knew at the time. But with hindsight he's
not so sure it was the best decision. "I don't think anybody anticipated that it
would cause this tremendous stress in the financial system, which then caused
this tremendous recession in the world economy."
Allen, Siegel and Herring say regulators need a
better system for an orderly dismantling of big financial firms that run into
trouble, much as the Federal Deposit Insurance Corp. does with ordinary banks.
The financial reform bill introduced in the Senate by Democrat Christopher J.
Dodd provides for that. "I think the Dodd bill has a resolution mechanism that
would allow the firm to go bust without causing the kind of disruption that we
had," Allen says. "So, hopefully, next time it can be done better. But whether
anyone will have the courage to do that, I'm not sure."
Bob Jensen's
theeads on the Lehman/Ernst controversies are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst
"It’s Mine, Mine All Mine: Can Anyone Catch Lehman Stealing?" by
Francine McKenna, re: The Auditors, February 22, 2010 ---
http://retheauditors.com/2010/02/22/its-mine-mine-all-mine-can-anyone-catch-lehman-stealing/
Most of what’s been written about the financial
crisis and the firms that were forcibly acquired, failed, or bailed out
tends to focus on “fair value” as the feckless culprit.
Satyajit Das
wrote for the site,
Naked Capitalism:
“MtM [mark-to-market] accounting itself is
flawed… There are difficulties in establishing real values of many
instruments. It creates volatility in earnings attributable to
inefficiencies in markets rather than real changes in financial
position…Valuation for all but the simplest instruments today requires a
higher degree in a quantitative discipline, a super computer and a vivid
imagination. For complex structured securities and exotic derivatives,
the only available price is from the bank that originally sold the
security to the investor. Prices available from the purveyor of the
instrument (a concept known as mark-to-myself) strain reasonable
concepts of independence and objectivity…In the global financial crisis,
with the capital markets virtually frozen, the extent of losses on bank
inventories of hard-to-value products and commitments (structured debt
and leveraged loans) was difficult to establish.”
We know that the banks’ “independent” external
auditors had a hard time establishing both fair values and the “extent of
losses on bank inventories of hard-to-value products and commitments.” We
know this because their clients did not tell us about the extent of the
losses until it was too late. There were no
“going concern” warnings for any of the financial
institutions that went bankrupt, were taken over, or were nationalized via
bailout.
We also know that the auditors did a poor and
inconsistent job of
establishing fair values and forcing disclosure of the “extent of losses” on
banks’ investments because
their regulator, the PCAOB, told us so.
Inspection teams also observed instances
where firms’ procedures to test the fair values of financial
instruments, including derivative instruments, loans, and securities,
were inadequate. In these instances, deficiencies included (a) the
failure to gain an understanding of the methods and assumptions used to
develop the fair value measurements of financial instruments that were
illiquid or difficult to price, (b) the reliance on issuer-supplied
pricing information without obtaining corroboration of that information,
and (c) the reliance on confirmation responses from third parties or
counterparties that included disclaimers as to their accuracy and
appropriateness for use in the preparation of financial statements.
How do the auditors, one step removed and ten steps
behind, determine fair values of complex instruments especially in illiquid
markets if even the super-bankers couldn’t get it right? This question
supposes that it’s the auditors’ obligation to determine the values and that
the bankers didn’t get it right.
Neither is true.
What are the auditors’ obligations with regard to
clients’ fair value measurements and disclosures? Auditors do not establish
fair values. Instead, their role is to, “test management’s fair value
measurements and disclosures.” But that obligation is broader than just
taking the word of the
“masters of the universe.”
The auditor should consider using the work
of a specialist if the auditor does not have the necessary skill and
knowledge to plan and perform audit procedures related to fair value.[1]
Observable market prices may exist to assist in testing fair values.
Where they do not and other valuation methods are used, the auditor’s
substantive tests of fair value may involve (a) testing the significant
assumptions, the valuation model, and the underlying data, (b)
developing an independent estimate of fair value for corroborative
purposes or, where applicable, (c) reviewing events or transactions
occurring after the period covered by the financial statements and
before the date of the auditor’s report.
I say it’s outrageous to see
ongoing material “disputes” regarding the fair
value of complex derivatives between counterparties, especially if they are
clients of the same auditor. Critics have suggested that I condone breaches
of client confidentiality. Without betraying client confidentiality, they
ask, how can distinct audit teams compare the values assigned to either side
of same transaction?
One of my
commenters explained it:
Just how many PhD’s with CDS valuation
expertise do you think PwC has lying around in New York? The valuation
of these instruments and the testing of the assumptions would have been
sent to a centralized derivative valuation group to review and test.
Such a team would have had a fairly standard set of guidelines and
testing approach regardless of the team sending it. After validating the
inputs, they would have likely put it through their own sausage machine
/ valuation tool and compared the results. I think there would be a high
probability that the same analysts would have been reviewing the same
instrument for both GS and AIG. And when they notice that GS is using
market derived inputs for the referenced MBS while AIG is using the
historical average default rates and ignoring the market you would have
hoped they might speak up. And when the partner (finally) heard the
rumblings of a problem, even after it has been filtered through the
manager / senior manager “make-it-go-away” screen, he would have asked
“who else deals with this cr_p in the firm? GS… ah, [insert name of old
white guy here] is an old buddy of mine, I’ll just give him a call and
ask him what they do…”
When one excuses the auditors for not getting fair
value right, there’s a follow-on argument that claims no one got it right.
No one could possibly get it right. That’s why the crisis
occurred. That’s what the scoundrels that benefited most from the crisis
would like you to believe.
Reality is the opposite.
Much has been written about how well Goldman Sachs made out as a result
of the crisis. But there are others. Some are getting prosecuted like
Bank of America’s Ken Lewis for hiding losses to
further their interest in millions of bonus dollars. That’s why some are
starting to use the word “fraud” when speaking of Lehman’s collapse.
On February 11th,
Bloomberg’s Jonathan Weil asked why no one is prosecuting Lehman
Brothers executives for fraud:
It is so widely accepted that Lehman Brothers Holdings Inc.’s
balance sheet was bogus that even former Treasury Secretary Hank Paulson
can say it in his new memoir. And still, the government hasn’t found
anyone who did anything wrong at the failed investment bank…In his new
book, “On the Brink,” Paulson doesn’t
point fingers at specific Lehman executives for violating any rules. He
displays amazing candor, though, in describing how Lehman’s asset values
were a gross distortion of the truth. It doesn’t take much imagination
to figure out they didn’t get that way all by themselves.”
A reader, I’ll call him David the CFE,
repeats a story to me to illustrate this point:
“Casey Stengel probably said it best when
he said after the Mets 40-120 season, ‘Gentlemen, not one of you could
have done this on your own. This was a team effort.’ “
Losing $156 billion requires a team effort.
When former Lehman Managing Director
Arthur Doyle reviewed Larry McDonald’s book on Lehman,
he asked the same questions about fraud and Lehman
executives:
“The most important questions of all are
not even asked in “A Colossal Failure of Common Sense,” or in any other
account I have so far seen of the Lehman failure. Simply put, how did
Lehman’s published financial statements, as recently as its final 10-Q
published in July of 2008, show a positive net worth of $26 billion,
when the bankruptcy liquidators are saying that they are looking at a
negative net worth of $130 billion? Doesn’t any or all this constitute
securities fraud? And shouldn’t there be criminal liability for the
executives who signed the firm’s 10-K and 10-Q’s, who under
Sarbanes-Oxley are responsible for material misstatements made in those
documents?”
Bloomberg’s Weil has a theory about why these
crimes are not being prosecuted:
“There’s been much talk the past two years
about moral hazard, which is the risk that companies and their investors
will behave more recklessly when they believe the government will bail
them out. Less has been made of a similar hazard: The danger that
powerful companies won’t follow the law when their executives believe
the government won’t hold them to it…The latter risk threatens not only
our economy, but our democracy. There’s every reason to believe both
kinds are growing.”
David the CFE and I have
another theory:
Collusion.
The crimes are too numerous to prosecute without
indicting the whole system and most of the major players. And because they
were part of the problem before they were theoretically part of the
solution, culpability also attaches to Paulson and Tim Geithner.
David the CFE’s theory is
premised on some of the oldest tricks in the book for manipulating
revenue recognition and, therefore, reported
profits and incentive compensation payouts including stock options -
roundtrips, parking, and channel stuffing. In
another variation on the theme, global trading company Refco used
a round trip loan to
repeatedly hide a related-party transaction incurred to delay disclosure of
significant uncollectible accounts. It’s not like these techniques haven’t
been used before (by AIG, for example) to offload risk and smooth earnings
at quarter- and year-end.
“This
case shows that the Commission will
pursue insurance companies and other financial institutions that market
or sell so-called financial products that are, in reality, just vehicles
to commit financial fraud,” said Stephen M. Cutler, director of the
SEC’s Division of Enforcement.
With regard to
the financial crisis, these revenue recognition fraud techniques may have
been most useful in establishing
“observability” of market prices for otherwise
illiquid assets. Establishing “market prices” via fraudulent, sham
transactions amongst the market participants before quarter-end and year-end
reporting periods would have allowed assets to remain on the books longer at
inflated values and, therefore, to inflate profits and bonuses. “Market
prices” that appeared to support existing valuations sustained the myth. The
investments were not written down until long after the market for subprime
real estate securities started to wilt.
David the CFE explains
this theory in the case of Lehman Brothers:
Nassim Taleb
says about banks: “Banks hire dull people and
train them to be even duller. If they look conservative, it’s only
because their loans go bust on rare, very rare occasions. But bankers
are not conservative at all. They are just phenomenally skilled at
self-deception by burying the possibility of a large, devastating loss
under the rug.
Taleb further states: “Executives will
game the system by showing good performance so they can get their yearly
bonus.”
Lehman paid out $5.2 billion in bonuses in 2006
and $5.7 billion in bonuses in 2007. Did this result from the
executives at the bank gaming the system to increase their bonuses? An
example of burying a large loss under the rug can be found in this
excerpt from Lehman Brothers in its
2006 10-K:
We held
approximately $2.0 billion and $0.7 billion of non-investment grade
retained interests at November 30, 2006 and 2005, respectively. Because
these interests primarily represent the junior interests in
securitizations for which there are not active trading markets,
estimates generally are required in determining fair value. We value
these instruments using prudent estimates of expected cash flows and
consider the valuation of similar transactions in the market.
Junior interests in securitizations.
Lehman and other firms purchased
mortgages that would effectively be resold by them as collateralized
debt obligations. Each of Lehman’s securitizations was broken into
tranches in which senior interests received greater preference with
respect to collections of interest and principal than junior interests
that were entitled to greater profits, if such profits were realized. A
junior interest in a securitization is the lowest level of the tranches
for collateralized debt obligations. Generally, only the
bottom 3% of a
securitization was labeled as equity.
During 2006, housing prices dropped nationally
by at least 5% from the spring of 2006 to Lehman’s Nov. 30, 2006 and the
default rate was increasing as well. With prices of houses dropping and
the default rate increasing, there was a risk of large losses when the
buyer defaults. Thus, the junior interests in securitizations that
Lehman was purportedly investing in were probably already worthless at
the time that Lehman invested in them or at November 30, 2006.
An auditor would have to suspect a material
loss is being hidden and that collusion between several departments at
Lehman Brothers and management’s participation in the deception was
possible.
Ernst and Young, Lehman’s auditors, were
probably unwilling to consider such a possibility because auditors
accept as dogma that collusion between many employees and multiple
departments is unlikely no matter what the motive, i.e., $5.2 billion in
bonuses. Auditing standards also do not consider collusion likely.
Apparently, auditors did not consider the possibility that two different
groups at Lehman Brothers such as the underwriters who sold the
securitization IPOs and the trading departments would collude to hide a
$1.3 billion loss in a junior equity position that could not be sold.
Hiding losses on CDOs
and mortgages purchased for securitization. A reasonable
question to ask was: If Lehman Brothers started the fiscal year ending
Nov. 2007 with $57 billion of CDOs and held them for the year, what
would their estimated loss be? Also: What would the additional loss be
with $32 billion in CDOs and/or mortgages purchased?
Presumably, the losses would be in the range of
$10 billion to $30 billion. By Nov. 2007, everyone knew of the problems
with CDOs. Bear Stearns had already closed two hedge funds investing in
CDOs. Merrill Lynch had made huge write downs and forced out its CEO. My
guess is that Lehman Brothers engaged in schemes to fool the auditor in
order to avoid disclosing losses from their securitizations and
investments in CDOs.
Lehman probably pulled a variation of the old
“telecom swap.” In the “telecom swap” cases,
one telecom company would sell telecom capacity to another telecom and
then purchase the same amount of telecom capacity from the other party.
The firm selling the capacity would book the amount received as revenue
and the firm purchasing the capacity would book the amount received as a
fixed asset. It worked very well in creating fictitious profits for
those firms.
That same trick could be used by financial
institutions in the case of CDOs/CDSs. Let’s say Financial Institution A
sells collateralized debt obligations with a true fair market value of
90 million to Financial Institution B for 100 million dollars in cash.
Financial Institution B purchases collateralized debt obligations with a
true fair market value of 90 million dollars from Financial Institution
A for 100 million dollars in cash.
And then those phony trades are shown as the
“observable” similar transactions in the market.
Did the auditors check for this item? Probably
not. Why not? Because it’s an example of collusion between Lehman and
other companies. Auditors don’t check for collusion no matter how many
times they get fooled by it!
Continued in article
Bob Jensen's threads on the subprime mortgage scandal sleaze ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze
"Lessons from the Lehman Autopsy: The SEC can learn from Anton
Valukas, the lawyer who led a probe into Lehman—and uncovered accounting
chicanery that regulators largely ignored," by Paul M. Barrett, Business
Week via the Young CPA Network, March 24, 2010 ---
http://ow.ly/1qJvx
In 2008, Anton R. Valukas, a trial attorney in
Chicago, published a four-page stiletto thrust of an essay entitled
"Arrogance: My Favorite Sin." The piece, included in a lawyers' guide to
cross-examination, recounted Valukas' delight in using understated
questioning to tempt executives into making implausible statements of the
sort that reliably alienate jurors. "Frequently, the smartest witnesses—the
most sophisticated and the most arrogant—are most susceptible to this type
of examination," he wrote.
The piece reads today like a preamble to Valukas'
voluminous autopsy of Lehman Brothers, which he performed as the
court-approved bankruptcy examiner in the investment bank's formal
unwinding. The 2,200-page Lehman report, released on Mar. 11, constitutes
the single most penetrating document we have on the recent misbehavior on
Wall Street. Valukas' earlier primer suggests why he did such an exemplary
job: Although he heads a prestigious corporate law firm, Jenner & Block, the
former federal prosecutor just plain resents dissembling by big shots in
expensive suits. Not coincidentally, Jenner, a pillar of the Chicago
business elite, sues Wall Street institutions as often as it defends them.
In the interest of preventing future Lehman
disasters, we might ponder how to transplant Valukas' zeal into Washington's
financial beat cops. That could help preclude the need to call him back
again as corporate pathologist.
He'd be a hard man to clone. During a four-decade
career, Valukas, 66, has represented all manner of white-collar rogues. When
called to public service, he used his knowledge of the market's shadowy
corners to prosecute well-heeled miscreants. In the late 1980s, as U.S.
Attorney in Chicago, he sent agents disguised as commodity traders to clean
up the futures exchanges. The probe protected investors and led to a slew of
indictments. Some called him the Rudy Giuliani of the Midwest.
Unlike Giuliani, Valukas avoided elective politics
and returned to his law firm. He prospered at Jenner, not least in his
yearlong assignment as the Lehman examiner. Backed by colleagues from
Jenner, he went over millions of pages of documents, interviewed scores of
witnesses, and billed the Lehman estate $38.4 million. I'd say it was money
well spent. His findings will provide the script for what's likely to be a
theatrical airing in April, when Representative Barney Frank (D-Mass.)
convenes his House Financial Services Committee to interrogate Lehman's
former CEO, Richard S. Fuld Jr., and other participants in the debacle.
Dubious Behavior What Valukas brought to the
endeavor was a no-nonsense lack of deference toward Wall Street game
playing, says Francine McKenna, a former managing director at
PricewaterhouseCoopers. "That's a Chicago thing," adds McKenna, herself a
resident of the city. She now runs an investigative Web site called Re: The
Auditors. "The mindset is: I've been around the block, I know how the game
is played, and I'm not impressed by fancy names," she says.
As the Lehman examiner, Valukas doggedly unmasked
the dubious behavior of executives once lauded as among Wall Street's
conquering heroes. Fuld insisted to Valukas that he knew nothing about the
accounting trickery called Repo 105, which was used to hide the bank's
financial decline. Fuld's self-portrait—a veteran CEO blithely unfamiliar
with the workings of his company—was not just implausible; it could support
lucrative civil claims that he "was at least grossly negligent," as Valukas
wrote. The examiner noted that Fuld's denials were undercut by evidence that
he was thoroughly briefed on the chicanery.
Contacted by phone, Valukas declined to comment.
Fuld's attorney, Patricia Hynes, has said her client told the truth and did
nothing wrong.
Bob Jensen's threads on the Lehman/Ernst scandal are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst
Repo105 ---
http://en.wikipedia.org/wiki/Repo_105
Thanks XXXXX for the heads up!
Dear Bob,
Please don't forward this email with my name, but I thought
you may find the info below of interest, you may (or may not) want to
cut/paste info below to share with others; if you do share it, please
don't attribute the comments to me, it can just be someone
who prefers to be anonymous). Thank you!
www.repo105.com strikes me as possibly being a spam site, maybe even
authored by someone overseas, due to some misspellings on their site
including "Bernie Maddof" and "Dick Chaney."
Moreover, it looks like the site may have been set up to get attention of
people looking for info on "Repo 105" but drives them to their own business
which apparently is selling FX or gold trading, e.g. this para. on their
website:
"Financial markets may well roil in the throws of
this latest revelation, especially if the practice is shown to be widespread
From
XXXXX
Jensen Comment
An evolving site that might one day be quite good for Repo 105 information
might be
http://en.wikipedia.org/wiki/Repo_105
Currently I think my links below will be more useful on this accounting
controversy.
Bob Jensen’s threads on
the Lehman/Ernst Repo 105 mess will soon be available at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst
Also see
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms
Hi David,
“Accounting Pornography” (http://profalbrecht.wordpress.com/2010/03/16/what-is-accounting-pornography-revised/
)
breaks down in to three categories --- solos, couples, and groupies.
At the end of her blog post Francine suggests that Repos 105 OBSF ploys should
perhaps fall under the Groupie Category (her word is Fraternité).
“Liberté, Egalité,
Fraternité: Big Lehman Brothers Troubles For Ernst & Young,” By Francine
McKenna, re; The Auditors, March 15, 2010 ---
http://retheauditors.com/2010/03/15/liberte-egalite-fraternite-lehman-brothers-troubles-for-ernst-young-threaten-the-big-4-fraternity/
Begin Quote (about how top financial executives at
Lehman were former E=&Y auditors of Lehman)
That kind of comfort and
confidence in your client and their technical competence comes from a long,
lucrative relationship. But it must have been more than that. It could not have
possibly come from confidence in the CFO suite, given its revolving door and the
lack of accounting interest and aptitude in later years.
No.
Ernst and Young’s confidence in Lehman’s CFO leadership was rooted in
fraternity. Both Christopher O’Meara and
David Goldfarb,
his predecessor who was CFO from 2000 to 2004, are Ernst and Young alumni.
Prior to joining Lehman Brothers in 1994, Mr. O’Meara worked as a senior
manager in Ernst & Young’s Financial Services practice. Prior to joining Lehman
Brothers in 1993, Mr. Goldfarb served as the Senior Partner of the Ernst &
Young’s Financial Services practice, where he worked from 1979 to 1993.
Mr. Goldfarb, the former EY
Senior Partner, was the Lehman CFO who created the Repo 105 transactions.
End Quote
Jensen Comment
But the Lehman-E&Y Fraternity was merely a local chapter of the larger National
Fraternity. The National Fraternity appears to have been among the FASB, the
Credit Rating Agencies (read that Moody’s) and Big Four alumni working in all
the troubled Wall Street Banks. When drowning in the poison of AAA-rated CDO
Bond Investments that should’ve been rated as junk, the Repo 105 wash sale ploys
were invented to keep the poisoned bond investments off the balance sheet at
fair values along with the wash sale debt obligation to buy them back about a
week after a Wall Street bank’s books closed for the year.
Frank
Partnoy and Lynn Turner proclaim these fiction transactions are all part of the
“fiction” balance sheets of Wall Street banks ---
http://www.rooseveltinstitute.org/sites/all/files/Off-Balance Sheet
Transactions.pdf
The video is at
http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting
Fraternity brothers at the FASB apparently joined in this groupie by making FAS
140 mushy enough to make Repo 105 deceptive sales appear to be legitimate.
Lehman could sell a poisoned CDO bond the day before the books closed as long as
the Repo 105 sales contract had an iron-clad clause to buy the poisoned CDO bond
back at a higher price in about a week. This was a costly Hail Mary effort to
hide the poisoned CDO bonds from the balance sheet and “pretend” with an
orgiastic gasp that the poisoned bonds were sold at a phony price immensely
greater than true fair value of junk.
And yet the FASB continues to stand before the congregation and preach the
virtues of “Fair Value Accounting.”
The FASB makes a huge deal in FAS 133 and FAS 157 about booking financial
contracts at fair value, but in FAS 140 allows its fraternity brothers on Wall
Street (and their Big Four auditors) not to even have to disclose billions in
Repo 105 buy-back obligations. Even an Accounting 101 student can tell the FASB
that this wasn’t really a sale, and even if it was a sale the obligation to buy
it back should’ve been booked as debt.
Francine had the right idea about this being a groupie. But she only hints at a
local chapter of the groupie. I take that back. She does provide the slightest
hint of a National Chapter of that fraternity.
“Liberté, Egalité,
Fraternité: Big Lehman Brothers Troubles For Ernst & Young,” By Francine
McKenna, re; The Auditors, March 15, 2010 ---
http://retheauditors.com/2010/03/15/liberte-egalite-fraternite-lehman-brothers-troubles-for-ernst-young-threaten-the-big-4-fraternity/
Begin Quote (actually Francine’s quoting the
Examiner’s Report)
Lehman initiated its Repo 105 program sometime
in 2001, soon after SFAS 140 took effect in September 2000 Lehman’s outside
auditors and lawyers participated in the firm’s review of SFAS 140. Indeed,
Lehman vetted the concept of a SFAS 140 repo transaction with its outside
auditor, before the firm formalized a Repo 105 accounting policy and
approved Repo 105 transactions for use by firm personnel.
(Bankruptcy Examiner’s Report
V3, page 765)
End Quote
What’s ironic is that Lehman could not even find a shyster law firm in the U.S.
to bless its Repo 105 transactions. If you can’t get a U.S. law firm to lie for
you it must really be a rotten lie. Lehman and E&Y had to go all the way to
England to find a shyster law firm.
"Repos Played a Key Role in Lehman's Demise: Report Exposes Lack of
Information And Confusing Pacts With Lenders," by Suzanne Craig and Mike Spector,
The Wall Street Journal, March 13, 2010 ---
http://online.wsj.com/article/SB20001424052748703447104575118150651790066.html#mod=todays_us_money_and_investing
The rare look into the
repo market embedded in the report comes 18 months after Lehman Brothers
collapsed in the U.S.'s largest bankruptcy filing. While top Lehman executives
were quick to blame the real-estate market for their woes, the exhaustive report
singles out senior executives and auditor Ernst & Young for serious lapses.
The report exposed for
the first time what appears to be an accounting slight of hand known as a Repo
105 transaction, where Lehman was able to book what looked like an ordinary
asset for cash as an out-and-out sale, drastically reducing its leverage and
making its financial picture look better than it really was. The transactions
often were done in flurries in a financial quarter's waning days, before Lehman
reported earnings.
Four days prior to the
close of the 2007 fiscal year, Jerry Rizzieri, a member of Lehman's fixed-income
division, was searching for a way to meet his balance-sheet target, according to
the report. He wrote in an email: "Can you imagine what this would be like
without 105?"
A day before the close of
Lehman's first quarter in 2008, other employees scrambled to make balance-sheet
reductions, the report said. Kaushik Amin, then-head of Liquid Markets, wrote to
a colleague: "We have a desperate situation, and I need another 2 billion from
you, either through Repo 105 or outright sales. Cost is irrelevant, we need to
do it."
Marie Stewart, the former
global head of Lehman's accounting policy group, told the examiner the
transactions were "a lazy way of managing the balance sheet as opposed to
legitimately meeting balance-sheet targets at quarter end."
Lehman's use of this
accounting technique goes back to the start of the decade when Lehman business
units from New York and London met to discuss how the firm could manage its
balance sheet using accounting rules that had taken effect in September 2000.
Lehman soon created the "Repo 105" maneuver: Because assets the firm moved
amounted to 105% or more of the cash it received in return, Lehman could treat
the transactions as sales and remove securities inventory that otherwise would
have to be kept on its balance sheet.
Because no U.S. law firm
would bless the transaction, Lehman got an opinion letter from London-based law
firm Linklaters. That letter essentially blessed using the maneuver for Lehman's
European broker-dealer under English law. If one of Lehman's U.S. entities
needed to engage in a Repo 105 transaction, the firm moved the securities to its
European arm to conduct the deal on the U.S. entity's behalf, the report found.
That is likely why the counterparties on the repo transactions were largely a
group of seven non-U.S. banks. These included Germany's Deutsche Bank AG,
Barclays PLC of the U.K. and Japan's Mitsubishi UFJ Financial Group.
In a statement, a
Linklaters spokeswoman said the report "does not criticize" the legal opinions
it gave Lehman "or suggest or say they were wrong or improper." The law firm
said it was never contacted during the investigation.
Jensen Comment
Although Lehman could not find a shady U.S. law firm to "bless the transaction,"
Ken Lay at Enron managed to find a shady U.S. law firm to bless the Raptors'
transactions after Sherron Watkins (an Enron executive) sent her infamous
whistle blowing memo to both Ken Lay and to Andersen executives in Chicago.---
http://www.trinity.edu/rjensen/FraudEnron.htm
Yogi Berra says Lehman bankruptcy following Enron bankruptcy
is auditing “Déjà vu all over again.”
Ah, the innocence of youth.
What really happened in the poisonous CDO markets?
I previously mentioned three CBS Sixty Minutes videos that are must-views for
understanding what happened in the CDO scandals. Two of those videos centered on
muckraker Michael Lewis. My friend, the Unknown Professor, who runs the
Financial Rounds Blog, recommended that readers examine the Senior Thesis of a
Harvard student.
"Michael Lewis’s ‘The Big Short’? Read the Harvard Thesis Instead," by Peter
Lattman, The Wall Street Journal, March 20, 2010 ---
http://blogs.wsj.com/deals/2010/03/15/michael-lewiss-the-big-short-read-the-harvard-thesis-instead/tab/article/
Deal Journal has yet to
read “The Big Short,” Michael Lewis’s yarn on the financial crisis that hit
stores today. We did, however, read his acknowledgments, where Lewis praises
“A.K. Barnett-Hart, a Harvard undergraduate who had just written a thesis about
the market for subprime mortgage-backed CDOs that remains more interesting than
any single piece of Wall Street research on the subject.”
While unsure if we can
stomach yet another book on the crisis, a killer thesis on the topic? Now that
piqued our curiosity. We tracked down Barnett-Hart, a 24-year-old financial
analyst at a large New York investment bank. She met us for coffee last week to
discuss her thesis, “The Story of the CDO Market Meltdown: An Empirical
Analysis.” Handed in a year ago this week at the depths of the market collapse,
the paper was awarded summa cum laude and won virtually every thesis honor,
including the Harvard Hoopes Prize for outstanding scholarly work.
Last October,
Barnett-Hart, already pulling all-nighters at the bank (we agreed to not name
her employer), received a call from Lewis, who had heard about her thesis from a
Harvard doctoral student. Lewis was blown away.
“It was a classic example
of the innocent going to Wall Street and asking the right questions,” said Mr.
Lewis, who in his 20s wrote “Liar’s Poker,” considered a defining book on Wall
Street culture. “Her thesis shows there were ways to discover things that
everyone should have wanted to know. That it took a 22-year-old Harvard student
to find them out is just outrageous.”
Barnett-Hart says she
wasn’t the most obvious candidate to produce such scholarship. She grew up in
Boulder, Colo., the daughter of a physics professor and full-time homemaker. A
gifted violinist, Barnett-Hart deferred admission at Harvard to attend
Juilliard, where she was accepted into a program studying the violin under
Itzhak Perlman. After a year, she headed to Cambridge, Mass., for a broader
education. There, with vague designs on being pre-Med, she randomly took “Ec
10,” the legendary introductory economics course taught by Martin Feldstein.
“I thought maybe this
would help me, like, learn to manage my money or something,” said Barnett-Hart,
digging into a granola parfait at Le Pain Quotidien. She enjoyed how the subject
mixed current events with history, got an A (natch) and declared economics her
concentration.
Barnett-Hart’s interest
in CDOs stemmed from a summer job at an investment bank in the summer of 2008
between junior and senior years. During a rotation on the mortgage
securitization desk, she noticed everyone was in a complete panic. “These CDOs
had contaminated everything,” she said. “The stock market was collapsing and
these securities were affecting the broader economy. At that moment I became
obsessed and decided I wanted to write about the financial crisis.”
Back at Harvard, against
the backdrop of the financial system’s near-total collapse, Barnett-Hart
approached professors with an idea of writing a thesis about CDOs and their role
in the crisis. “Everyone discouraged me because they said I’d never be able to
find the data,” she said. “I was urged to do something more narrow, more
focused, more knowable. That made me more determined.”
She emailed scores of
Harvard alumni. One pointed her toward LehmanLive, a comprehensive database on
CDOs. She received scores of other data leads. She began putting together charts
and visuals, holding off on analysis until she began to see patterns–how Merrill
Lynch and Citigroup were the top originators, how collateral became heavily
concentrated in subprime mortgages and other CDOs, how the credit ratings
procedures were flawed, etc.
“If you just randomly
start regressing everything, you can end up doing an unlimited amount of
regressions,” she said, rolling her eyes. She says nearly all the work was in
the research; once completed, she jammed out the paper in a couple of weeks.
“It’s an incredibly
impressive piece of work,” said Jeremy Stein, a Harvard economics professor who
included the thesis on a reading list for a course he’s teaching this semester
on the financial crisis. “She pulled together an enormous amount of information
in a way that’s both intelligent and accessible.”
Barnett-Hart’s thesis is
highly critical of Wall Street and “their irresponsible underwriting practices.”
So how is it that she can work for the very institutions that helped create the
notorious CDOs she wrote about?
“After writing my thesis,
it became clear to me that the culture at these investment banks needed to
change and that incentives needed to be realigned to reward more than just
short-term profit seeking,” she wrote in an email. “And how would Wall Street
ever change, I thought, if the people that work there do not change? What these
banks needed is for outsiders to come in with a fresh perspective, question the
way business was done, and bring a new appreciation for the true purpose of an
investment bank - providing necessary financial services, not creating
unnecessary products to bolster their own profits.”
Ah, the innocence of
youth.
The Senior Thesis
"The Story of the CDO Market Meltdown: An Empirical Analysis," by Anna
Katherine Barnett-Hart, Harvard University, March 19, 2010 ---
http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf
A former colleague and finance professor at Trinity
University recommends following up this Harvard student’s senior thesis with the
following:
Rene M. Stulz. 2010. Credit default swaps and the
credit crisis. J of Economic Perspectives, 24(1): 73-92 (not free) ---
http://www.aeaweb.org/jep/index.php
Absolutely Must-See CBS Sixty Minutes Videos
You, your students, and the world in general really should repeatedly study the
following videos until they become perfectly clear!
Two of them are best watched after a bit of homework.
Video 1
CBS Sixty Minutes featured how bad things became when poison was added to loan
portfolios. This older Sixty Minutes Module is entitled "House of Cards" ---
http://www.cbsnews.com/video/watch/?id=3756665n&tag=contentMain;contentBody
This segment can be understood without much preparation except that it would
help for viewers to first read about Mervene and how the mortgage lenders
brokering the mortgages got their commissions for poisoned mortgages passed
along to the government (Freddie Mack and Fannie Mae) and Wall Street banks. On
some occasions the lenders like Washington Mutual also naively kept some of the
poison planted by some of their own greedy brokers.
The cause of this fraud was separating the compensation for brokering mortgages
from the responsibility for collecting the payments until the final payoff
dates.
First Read About Mervene ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze
Then Watch Video 1 at
http://www.cbsnews.com/video/watch/?id=3756665n&tag=contentMain;contentBody
Videos 2 and 3
Inside the Wall Street Collapse (Parts 1 and 2) first shown on March 14,
2010
Video 2 (Greatest Swindle in the History of the World) ---
http://www.cbsnews.com/video/watch/?id=6298154n&tag=contentMain;contentAux
Video 3 (Swindler's Compensation Scandals) ---
http://www.cbsnews.com/video/watch/?id=6298084n&tag=contentMain;contentAux
My wife and I watched Videos 2 and 3 on March 14. Both videos feature one of
my favorite authors of all time, Michael Lewis, who hhs been writing (humorously
with tongue in cheek) about Wall Street scandals since he was a bond salesman on
Wall Street in the 1980s. The other person featured on in these videos is a
one-eyed physician with Asperger Syndrome who made hundreds of millions of
dollars anticipating the collapse of the CDO markets while the shareholders of
companies like Merrill Lynch, AIG, Lehman Bros., and Bear Stearns got left
holding the empty bags.
The major lessons of videos 2 and 3 went over the head of my wife. I think
that viewers need to do a bit of homework in order to fully appreciate those
videos. Here's what I recommend before viewing Videos 2 and 3 if you've not been
following details of the 2008 Wall Street collapse closely:
This is not necessary to Videos 2
and 3, but to really appreciate what suckered the Wall Street Banks into
spreading the poison, you should read about how they all used the same risk
diversification mathematical function --- David Li's Gaussian Copula Function:
Can the
2008 investment banking failure
be traced to a math error?
Recipe for Disaster: The
Formula That Killed Wall Street ---
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
Link forwarded by Jim Mahar ---
http://financeprofessorblog.blogspot.com/2009/03/recipe-for-disaster-formula-that-killed.html
Some highlights:
"For five years, Li's
formula, known as a
Gaussian copula function, looked like an
unambiguously positive breakthrough, a piece of financial technology that
allowed hugely complex risks to be modeled with more ease and accuracy than ever
before. With his brilliant spark of mathematical legerdemain, Li made it
possible for traders to sell vast quantities of new securities, expanding
financial markets to unimaginable levels.
His method was adopted
by everybody from bond investors and Wall Street banks to ratings agencies and
regulators. And it became so deeply entrenched—and was making people so much
money—that warnings about its limitations were largely ignored.
Then the model fell apart." The
article goes on to show that correlations are at the heart of the problem.
"The reason that
ratings agencies and investors felt so safe with the triple-A tranches was that
they believed there was no way hundreds of homeowners would all default on their
loans at the same time. One person might lose his job, another might fall ill.
But those are individual calamities that don't affect the mortgage pool much as
a whole: Everybody else is still making their payments on time.
But not all calamities
are individual, and tranching still hadn't solved all the problems of
mortgage-pool risk. Some things, like falling house prices, affect a large
number of people at once. If home values in your neighborhood decline and you
lose some of your equity, there's a good chance your neighbors will lose theirs
as well. If, as a result, you default on your mortgage, there's a higher
probability they will default, too. That's called correlation—the degree to
which one variable moves in line with another—and measuring it is an important
part of determining how risky mortgage bonds are."
I would highly recommend reading the
entire thing that gets much more involved with the
actual formula etc.
The “math error” might truly be have
been an error or it might have simply been a gamble with what was perceived as
miniscule odds of total market failure. Something similar happened in the case
of the trillion-dollar disastrous 1993 collapse of Long Term Capital Management
formed by Nobel Prize winning economists and their doctoral students who took
similar gambles that ignored the “miniscule odds” of world market collapse -- -
http://www.trinity.edu/rjensen/FraudRotten.htm#LTCM
The rhetorical question is whether the failure is
ignorance in model building or risk taking using the model?
Bob Jensen’s threads on the CDO and CDS scandals ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze
Question
Were the Ernst & Young's auditors negligent or cleverly deceived or complicit in
the deception by the Lehman Brothers?
More from the examiner’s report:
Lehman never publicly disclosed its use of Repo 105
transactions, its accounting treatment for these transactions, the
considerable escalation of its total Repo 105 usage in late 2007 and into
2008, or the material impact these transactions had on the firm’s publicly
reported net leverage ratio. According to former Global Financial Controller
Martin Kelly, a careful review of Lehman’s Forms 10‐K and 10‐Q would not
reveal Lehman’s use of Repo 105 transactions. Lehman failed to disclose its
Repo 105 practice even though Kelly believed “that the only purpose or
motive for the transactions was reduction in balance sheet”; felt that
“there was no substance to the transactions”; and expressed concerns with
Lehman’s Repo 105 program to two consecutive Lehman Chief Financial Officers
– Erin Callan and Ian Lowitt – advising them that the lack of economic
substance to Repo 105 transactions meant “reputational risk” to Lehman if
the firm’s use of the transactions became known to the public. In addition
to its material omissions, Lehman affirmatively misrepresented in its
financial statements that the firm treated all repo transactions as
financing transactions – i.e., not sales – for financial reporting purposes.
Watch the Video
Its conclusions – that there is credible evidence
against Mr Fuld and others for breach of their fiduciary duties and against
E&Y for professional malpractice – are also a further blow to the battered
credibility of the entire banking industry
Francesco Guerrera, "Lehman file rocks Wall Street," Financial Times, March 12,
2010
Watch the Video ---
http://www.ft.com/cms/s/0/2e412d50-2d6e-11df-a262-00144feabdc0.html?ftcamp=rss
“A Lehman senior vice
president raised questions about the propriety of these transactions as early as
May 2008, but the report said that the accountants at Ernst & Young “took no
steps to question or challenge the non-disclosure of its use of $50bn of
temporary, off balance sheet transactions” ---
http://www.ft.com/cms/s/0/1be0aca2-2d79-11df-a262-00144feabdc0.html?nclick_check=1
Regarding FIN 41
Here’s a somewhat disturbing action by the FASB (caving in to Wall Street banks)
--
http://edmontonobservers.net/fasb-eases-up-on-repo-funding-source/
March 11, 2010 reply from
LynnETurne@aol.com
I’m forwarding this message from Lynn Turner without comment,
because I’m in a bit over my head on this without having studied the
nine-volume set of the Examiner’s report (2,200 pages). In fairness, I will
probably still be in over my head after reading the 2,200 pages.
Lynn Turner is a former Coopers partner who became SEC Chief
Accountant ---
http://www.s-ox.com/dsp_getSpotlightDetails.cfm?CID=2611
He’s one of my professional heroes, and I’ve enjoyed on occasion
sharing a speaking platform with him.
Robert E. (Bob) Jensen
Trinity University Accounting Professor (Emeritus)
190 Sunset Hill Road
Sugar Hill, NH 03586
Tel. 603-823-8482
www.trinity.edu/rjensen
From:
LynnETurne@aol.com [mailto:LynnETurne@aol.com]
Sent: Friday, March 12, 2010 2:07 PM
To: Jensen, Robert
Subject: Fwd: The Lehman Examiners Report on Auditorfs
From: eorenstein@financialexecutives.org
To: lynneturne@aol.com
Sent: 3/12/2010 11:56:58 A.M. Mountain Standard Time
Subj: RE: The Lehman Examiners Report on Auditorfs
Lynn, are you on Prof. Bob Jensen’s listserve (technically, it’s an
accounting listserve out of Loyola University, but Bob Jensen is the most
frequent poster/unofficial chairman of that listserve, so to speak). There
have been numerous posts on their listserve today on that topic (the AECM
listserve, and the CPAs-L listserve), they would probably be interested in
the info you have provided here, including your attachment, you may want to
forward this material to Bob at
rjensen@trinity.edu if you’d like him to share it. Thank you. Regards,
Edith
From:
LynnETurne@aol.com [mailto:LynnETurne@aol.com]
Sent: Friday, March 12, 2010 1:44 PM
To: lynneturne@aol.com
Subject: The Lehman Examiners Report on Auditorfs
Below is the discussion regarding the independent auditors from the
Examiner's report on Lehman. It provides and excellent case study for
students as it properly highlights how the courts and SEC have consistently
said auditors cannot merely hide behind "GAAP." This concept is also
engrained in the language of Sarbanes Oxley which requires executives to
sign off on the fair presentation of financial statements without mentioning
GAAP.
The report also states the auditor did not inform the audit committee of the
transactions in question. There have been other enforcement cases in which
it was found the auditor did not inform the audit committee of questionable
accounting practices. The PCAOB has done work in past years on the standard
for communications between the auditor and audit committee but has never
updated that standard.
From the Lehman Examiner Report - Volume 3, beginning page 945:
"(3) Lehman’s Board of Directors
Without exception, former Lehman directors were unaware of Lehman’s
Repo
105 program and transactions.3642
As discussed in greater detail below, Lehman’s own Corporate Audit group led
by Beth Rudofker, together with Ernst & Young, investigated allegations
about balance
sheet substantiation problems made in a May 16, 2008
“whistleblower” letter sent to
senior management by Matthew Lee.3643 On June 12, 2008, during the
investigation, Lee
informed Ernst & Young about Lehman’s use of $50 billion of Repo 105
transactions in
the second quarter of 2008.3644 At a June 13, 2008 meeting,
Ernst & Young failed to
disclose that allegation to the Board’s Audit Committee.3645
Former Lehman director Cruikshank recalled that he made very clear he wanted
a full and thorough investigation into each allegation made by Lee, whether
the allegation was contained in Lee’s May 16, 2008 letter or raised by Lee
in the course of
the investigation.3646 Another former Lehman director, Berlind, similarly
stated that the
Audit Committee explicitly instructed Lehman’s Corporate Audit Group and
Ernst &
Young to keep the Audit Committee informed of all of Lee’s allegations.3647
Berlind also
said that he would have wanted to know about Lehman’s Repo 105 program and
that if
he had known about Lehman’s Repo 105 transactions, he would have asked
Lehman’s
auditors to test the transactions to ensure they were appropriate.3648 Upon
learning from
the Examiner the volume of Repo 105 transactions at quarter‐end
in late 2007 and 2008,
Sir Christopher Gent said that he believed the volume mandated disclosure to
the Audit
Committee and further investigation.3649
Dr. Kaufman, on the other hand, stated that he would have wanted to know
about Repo 105 transactions only if they were “huge” and fraudulent, by
which he
meant in violation of specific accounting rules or in violation of the
law.3650 Dr.
Kaufman did not believe that $50 billion in Repo 105 transactions was
significant even if
that volume changed Lehman’s net leverage ratio by approximately two
points.3651 Dr.Kaufman considered a four or five point change in the net
leverage ratio to be
significant.3652
In late 2007 and 2008, management made numerous presentations to the Board
regarding balance sheet reduction and deleveraging; in no case was the use
of Repo 105
transactions disclosed in those presentations.3653
i) Ernst & Young’s Knowledge of Lehman’s Repo 105 Program
During several Rule 30(b)(6)‐type3654
interview sessions, the Examiner
interviewed members of Ernst & Young’s Lehman audit team regarding Ernst &
Young’s knowledge of and involvement in Lehman’s Repo 105 program.
(1) Ernst & Young’s Comfort with Lehman’s Repo 105 Accounting
Policy
The Examiner interviewed Ernst & Young’s lead partner on the Lehman audit
team, William Schlich, regarding Lehman’s Repo 105 program. According to
Schlich,
Ernst & Young had been aware of Lehman’s Repo 105 policy and
transactions for many
years.3655
Consistent with the statements of Lehman’s John Feraca (Secured Funding
Desk), Schlich stated that Lehman introduced its Repo 105 Accounting Policy
on the
heels of the FASB’s promulgation of SFAS 140.3656
During that time, Ernst & Young
“discussed” the Repo 105 Accounting Policy (including Lehman’s structure for
Repo
105 transactions) and Ernst & Young’s team had a number of additional
conversations
with Lehman about Repo 105 over the years.3657 However, according to Schlich,
Ernst &Young had no role in the drafting or preparation of Lehman’s Repo 105
Accounting
Policy.3658
Schlich stated definitively that Ernst & Young had no advisory role with
respect
to Lehman’s use of Repo 105 transactions and that Ernst & Young did not
“approve”
the Accounting Policy.3659 Rather, according to Schlich, Ernst & Young
“bec[a]me
comfortable with the Policy for purposes of auditing financial
statements.”3660
Following “consultation and dialogue” about the proper interpretation and
application of SFAS 140, Ernst & Young “clearly. . .concurred with Lehman’s approach”
to SFAS 140 and subsequent literature by FASB on the issue of “control” of
assets
involved in a repo transactions.3661 Ernst &
Young’s view, however, was not based upon
an analysis of whether actual Repo 105 transactions complied with SFAS
140.3662 Rather,
Ernst & Young’s review of Lehman’s Repo 105 Accounting Policy was purely
“theoretical.”3663 In other words, Ernst & Young solely assessed Lehman’s
understanding of the requirements of SFAS 140 in the abstract and as
reflected in its
Accounting Policy; Ernst & Young did not opine on the propriety of the
transactions as a balance sheet management tool.3664 Ernst & Young did not
review the Linklaters letter,
referenced in the Accounting Policy Manual.3665
According to Martin Kelly, it was not unusual for him to discuss various
issues,
including Repo 105, with Ernst & Young.3666 Indeed, Kelly recalled
specifically speaking
with Schlich about Repo 105 transactions soon after becoming Financial
Controller on
December 1, 2007, in an effort to learn more about the program and “to
understand
[Ernst & Young’s] approach before talking to Callan.”3667
Kelly “wanted to ensure that Ernst & Young analyzed the program in the same
way that [Marie] Stewart [Global Head of Accounting Policy] had analyzed
it.”3668
Kelly’s conversations with Ernst & Young focused on the accounting treatment
of Repo
105 transactions.3669 According to Kelly,
Ernst & Young “was comfortable with the
treatment under GAAP for the same reasons that Lehman was comfortable.”3670
Kelly also discussed with Ernst & Young Lehman’s inability to get a true
sale opinion under United States law for Repo 105 transactions.3671 Kelly
could not recall whether he
discussed with Ernst & Young his discomfort with Lehman’s Repo 105
program.3672
(2) The “Netting Grid”
Throughout 2007, Lehman maintained a document entitled “Accounting Policy
Review Balance Sheet Netting and Other Adjustments,” known colloquially
among
Lehman’s Accounting Policy and Balance Sheet Groups, as well at Ernst &
Young, as
the “Netting Grid.” The Netting Grid identified and described various
balance sheet
netting mechanisms employed by Lehman: one such balance sheet mechanisms was
Lehman’s use of Repo 105 transactions.3673
Lehman provided the Netting Grid to Ernst & Young at least in August 2007
(the
close of Lehman’s third quarter 2007) and in November 2007 (the close of
Lehman’s
fiscal year 2007).3674 Notably, the Netting Grid provided by Lehman to Ernst
& Young in
August 2007 and November 2007 only contained Repo 105 volumes from November
30, 2006 and February 28, 2007.3675 Schlich was unaware whether Ernst &
Young asked
Lehman to provide its second quarter 2007 and third quarter 2007 Repo 105
usage
figures or a forecast of Lehman’s fourth quarter 2007 Repo 105 numbers.3676
Ernst & Young reviewed the Netting Grid, analyzed the various balance sheet
netting mechanisms identified in the Netting Grid, and used the document in
connection with its 2007 year‐end audit of
Lehman.3677 According to Schlich,
Ernst &
Young, as part of its review of Lehman’s Netting Grid, approved of Lehman’s
internal Repo 105 Accounting Policy only, and did not pass upon the actual
practice.3678
The Netting Grid described the transactions and United States GAAP reference
as follows: “Under certain conditions that meet the criteria described in
paragraphs 9
and 218 of SFAS 140,
Lehman policy permits reverse repo and repo agreements to be
recharacterized as purchases and sales of inventory.”3679
With respect to Lehman’s use
of Repo 105 transactions to reduce its net balance sheet, the Netting Grid
sets forth the conclusion that Lehman’s “current practice [for Repo 105] is
correct.”3680 Schlich noted
that this conclusion about the Repo 105 practice was Lehman’s, not Ernst &
Young’s.3681
To test Lehman’s conclusion, however, Ernst & Young “reviewed how Lehman
applied
the control provisions of the accounting rules.”3682
Ernst & Young’s review, however, applied only to the accounting basis for
these
transactions, not to their volume or purpose. Specifically, Ernst & Young’s
review and
analysis of Lehman’s Repo 105 program did not account for the volumes of
Repo 105
transactions Lehman undertook at quarter‐end.3683
Indeed, Schlich was unable to
confirm or deny the volumes of Repo 105 transactions Lehman undertook at
Lehman’s
fiscal year‐end 2007, or in the first two quarter‐ends
of 2008.3684 Nor was Schlich able to
confirm or deny that Lehman’s use of Repo 105 transactions was increasing in
late 2007
and into mid 2008.3685
(a) Quarterly Review and Audit
Through Schlich, Ernst & Young maintained that its duties as Lehman’s
auditor
required it to ensure that transactions were accounted for correctly (i.e.,
that they
complied with accounting rules) and that Lehman’s financial disclosures were
not materially misstated.3686 According to Schlich, Ernst & Young’s audit
did not require
Ernst & Young to consider or review the volume or timing of Repo 105
transactions.3687
Accordingly, as part of its year‐end
2007 audit, Ernst & Young did not ask Lehman
about any directional trends, such as whether its Repo 105 activity was
increasing
during fiscal year 2007.3688 Notably, as part of its quarterly review
process, Ernst &
Young did not audit any of Lehman’s Repo 105 transactions.3689
(3) Ernst & Young Would Not Opine on the Materiality of
Lehman’s Repo 105 Usage
Ernst & Young, through Schlich,
was unwilling to
comment to the Examiner on
the materiality of the volume of Lehman’s quarter‐end
Repo 105 transactions.3690 Asked
whether, as part of its responsibility to ensure Lehman’s financial
statements were not
materially misstated,
Ernst & Young should
have considered the possibility that strict technical adherence to SFAS 140
or any other specific accounting rule could nonetheless lead to a material
misstatement in Lehman’s publicly‐reported
financial statements,
Schlich refrained from comment.3691
When pressed further, Schlich stated that the volume of any particular
transaction impacts neither the question of whether accounting rules are
applied correctly, nor the question of whether a financial statement is
materially misleading.3692
However, Schlich eventually acknowledged that “when you look at a balance
sheet
issue, volume is a factor.”3693
Notably,
the definition of “materiality” contained in a “walk‐through”
document
related to Ernst & Young’s 2007 fiscal year‐end
audit of Lehman was: “any transaction
that would move Lehman’s firm‐wide
net leverage by 0.1 or more.”3694 This
definition
reflected “Lehman’s determination of a materiality threshold” in connection
with
Lehman’s own criteria for when to consider reopening and adjusting its
balance
sheet.3695
When Schlich was asked what level of impact to Lehman’s firm‐wide
net assets
Ernst & Young would have considered “material,” Schlich replied that Ernst &
Young
did not have a hard and fast rule defining materiality in the balance sheet
context, and
that, with respect to balance sheet issues, “materiality” depends upon the
facts and
circumstances.3696 Schlich agreed that Lehman made no specific disclosures
about Repo 105 transactions in its Forms 10‐K and
Form 10‐Q,
including the MD&A section.3697
Schlich believed, however, that Lehman’s public filings would have included
general
language regarding secured borrowings and compliance with SFAS 140.3698
Schlich was
not aware whether Ernst & Young ever discussed Lehman’s disclosures vel non
of Repo
105 activity with senior Lehman management.3699
(4) Matthew Lee’s Statements Regarding Repo 105 to Ernst &
Young
On May 16, 2008,
Matthew Lee, then‐Senior
Vice President in the Finance
Division responsible for Lehman’s Global Balance Sheet and Legal Entity
Accounting,
sent a letter to certain members of Lehman’s senior management
identifying possible violations of Lehman’s Ethics Code related to
accounting/balance sheet issues.3700 Lehman involved Ernst & Young in its
investigation of the concerns raised in Lee’s May
16, 2008 letter.3701
Subsequently, less than a month later, on June 12, 2008, Ernst & Young –
Schlich
and Hillary Hansen – interviewed Lee.3702 Hansen’s notes of the interview
reveal that
Lee made certain statements to Ernst & Young about Lehman’s Repo
105 practice,
including, most notably, the volume of Repo 105 activity that Lehman engaged
in at
quarter‐end
(May 31, 2008).3703 Hansen’s notes specifically recount Lee’s allegation that
Lehman moved $50 billion of inventory off its balance sheet at quarter‐end
through
Repo 105 transactions and that
these assets returned to the balance sheet approximately
a
week later.3704
When interviewed by the Examiner, Schlich did not recall Lee saying anything
about Repo 105 transactions during that interview, although he did not
dispute the
authenticity of Hansen’s notes from the Lee interview.3705 In spite of
Hansen’s notes,
Schlich maintained that Ernst & Young did not know that Lehman engaged in
the
following Repo 105 activity during the listed time periods: $49.1 billion at
first quarter
2008 (Feb. 29, 2008); and $50.38 billion at second quarter 2008 (May 31,
2008).3706
During the Examiner’s interview of Hansen, Hansen recalled that while Ernst
&
Young questioned Lee about his May 16, 2008 letter, Lee “rattled off” a list
of additional
issues and concerns he held, one of which was Lehman’s use of Repo 105
transactions.3707 Ernst & Young had no further conversations with Lee about
Repo 105
transactions.3708 Prior to her interview of Lee in June 2008, Hansen had
heard the term
Repo 105 “thrown around” but she did not know its meaning; according to
Hansen,
Schlich described Repo 105 transactions to her shortly after they met with
Lee.3709
Following Ernst & Young’s June 12, 2008 interview of Lee, Schlich and Hansen
met with Lehman’s Gerard Reilly to discuss Lee’s assertions regarding
improper valuations.3710 During that meeting, Hansen informed Reilly of the
$50 billion Repo 105
figure Lee provided during Ernst & Young’s interview of Lee.3711 According
to Schlich,
Reilly (now deceased) told the auditors that he had no knowledge that Lehman
used
Repo 105 transactions to move $50 billion in assets off its balance
sheet.3712 “Hillary
[Hansen] took away from the meeting with Reilly that he did not know and it
was not
$50 billion.”3713
On June 13, 2008 – the day after Lee informed Ernst & Young of the $50
billion in
Repo 105 transactions that Lehman undertook at the end of the second quarter
2008 –
Ernst & Young spoke to Lehman’s Audit Committee
but did not inform the committee
of Lee’s
allegation, even though the Chairman of the Audit Committee had clearly
stated that he wanted every allegation made by Lee – whether in Lee’s May 16
letter or during the course of the investigation – to be investigated.3714
Ernst & Young met with
the Audit Committee on July 8, 2008, to review the second quarter financial
statements and again did not mention Lee’s allegations regarding Repo
105.3715 On July 22, 2008,
Ernst & Young was also present when Beth Rudofker, Head of Corporate Audit,
gave a
presentation to the Audit Committee on the results of the investigation into
Lee’s
allegations.3716
Ernst & Young did not disclose to the Audit Committee – either during the
meetings or in private executive sessions after – that Lee made an
allegation related to
Repo 105 transactions being used to move assets off Lehman’s balance sheet
at quarterend.
3717 Cruikshank told the Examiner that he would have expected to be told
about
Lee’s Repo 105 allegations.3718 Similarly, Sir Gent told the Examiner that
the alleged volume of Lehman’s Repo 105 transactions mandated disclosure to
the Audit
Committee as well as further investigation.3719
Ernst & Young did not follow‐up on
either Lee’s allegations regarding Lehman’s
Repo 105 activity or Reilly’s claim that he had no knowledge of Lehman’s
alleged $50
billion Repo 105 usage figure.3720 Ernst & Young signed a Report of
Independent
Registered Public Accounting Firm for Lehman’s second quarter 2008 Form 10‐Q
on
July 10, 2008, less than four weeks after Schlich and Hansen interviewed
Lee.3721
(5) Accounting‐Motivated
Transactions
Ernst & Young did not evaluate the possibility that Repo 105
transactions were accounting‐motivated
transactions that lacked a business purpose.3722
Schlich
characterized the off‐balance sheet treatment of Lehman’s assets in Repo 105
transactions as a consequence of the accounting rules, rather than a motive
for the
transactions.3723
j) The Examiner’s Conclusions
There is sufficient evidence to support a determination by a trier of fact
that
Lehman’s failure to disclose that it relied upon Repo 105 transactions to
temporarily
reduce the firm’s net balance sheet and net leverage ratio was materially
misleading. In
addition, a trier of fact could find that Lehman affirmatively
misrepresented its
accounting treatment for repos by stating that Lehman treated repo
transactions as
financing transactions rather than sales for financial reporting purposes,
despite the fact
that Lehman treated tens of billions of dollars in repo transactions –
namely, Repo 105
transactions – as true sale transactions.
The Examiner thus concludes that sufficient evidence exists from which a
trier of fact could find the existence of a colorable claim that certain
Lehman officers breached
their fiduciary duties to Lehman and its shareholders by causing the company
to file deficient and materially misleading financial statements, thereby
exposing the company
to potential liability.
Certain officers of Lehman not only failed to inform the public of
its reliance on Repo 105 transactions to reduce its balance sheet, they also
failed to
advise Lehman’s Board of Directors of the firm’s Repo 105 practice. Thus,
the Examiner
concludes that a trier of fact could find that certain Lehman officers
breached their
fiduciary duties to Lehman’s Board of Directors by failing to inform them
of: (1) the
firm’s reliance upon Repo 105 to reduce the balance sheet at quarter‐end,
(2) the rampup
in Repo 105 usage in mid‐to‐late 2007 and 2008, (3) the impact of these transactions
on Lehman’s publicly reported net leverage ratio, or (4) the fact that
Lehman did not
disclose its Repo 105 practice in its publicly reported financials
statements and MD&A.
(1) Materiality
The materiality of information is evaluated from the perspective of a
reasonable
investor.3724 Information is deemed material if there is “a substantial
likelihood that the
disclosure of the omitted fact would have been viewed by the reasonable
investor as having significantly altered the ‘total mix’ of information made
available.”3725
Materiality does not require, however, that the information be of a type
that would
cause an investor to change his investment decision.3726
(a) Whether Lehman’s Repo 105 Transactions Technically
Complied with SFAS 140 Does Not Impact Whether a
Colorable Claim Exists
This Report does not reach the question of whether Lehman’s Repo 105
transactions technically complied with the relevant financial accounting
standard, SFAS
140, because the answer to that question does not impact whether a colorable
claim
exists regarding Lehman’s failure to disclose its Repo 105 practice and
whether that
failure rendered the firm’s financial statements materially misleading.
Even if Lehman’s use of Repo 105 transactions technically
complied with SFAS 140, financial statements may be materially misleading
even when they do not violate GAAP.3727 The Second Circuit has explained
that “GAAP itself recognizes that technical compliance with particular GAAP
rules may lead to misleading financial statements, and
imposes an overall requirement that the statements as a whole accurately
reflect the financial status of the company.”3728
Similarly, as noted in In re Global Crossing Ltd. Securities Litigation,
even if a
defendant established that its accounting practices
“were in technical compliance with
certain individual GAAP provisions . . . this would not necessarily insulate
it from liability. This is because, unlike other regulatory systems, GAAP’s
ultimate goals of fairness and accuracy in reporting require more than mere
technical compliance.”3729
The court
explained that “when viewed as a whole,” GAAP has no “loopholes” because its
purpose, shared by the securities laws, is “to increase investor confidence
by ensuring
transparency and accuracy in financial reporting.”3730
Technical compliance with
specific accounting rules does not automatically lead to fairly presented
financial statements. “Fair presentation is the touchstone for determining
the adequacy of disclosure in financial statements. While adherence to
generally accepted accounting principles is a tool to help achieve that end,
it is not necessarily a guarantee of fairness.”3731 Moreover,
registrants are “required to provide whatever additional information would
be necessary to make the statements in their financial reports fair and
accurate, and not
misleading.”3732
This view is echoed in an SEC enforcement order, concluding that GAAP
compliance does not excuse a misleading or less than full disclosure
regarding a
transaction, especially if the transaction’s purpose is “the attainment of a
particular
financial reporting result.”3733 “[E]ven if the transactions comply with
GAAP, the issuer
is required to evaluate the material accuracy and completeness of the
presentation
made by its financial statements.”3734 Issuers must “ensure that the way
they publicly
portray themselves discloses, as required, the material elements of [their]
economic and
business realities and risks.”3735
3732 Id.
(citing 17 C.F.R. § 240.10b‐5(b)
and 17 C.F.R. § 230.408 (requiring that “in addition to the information
expressly required to be included in a registration statement, there shall
be added such further material information, if any, as may be necessary to
make the required statements, in the light of the circumstances under which
they are made, not misleading”) (emphasis added); see also SEC
v. Seghers, 298 Fed. App’x 319, 331 (5th Cir. 2008)
(“The Commission’s proof of
Segher’s misrepresentations and omissions does not depend on compliance with
GAAP, but instead depends on evidence that Segher’s statements and omissions
were false or misleading to investors.”); United
States v. Olis, Civil Action No. H‐07‐3295, Criminal No. H‐03‐217‐01,
2008 WL 5046342, at *20 (S.D. Tex. Nov. 21, 2008) (“The scheme to defraud
alleged and proved in this case did not turn on whether the treatment
accorded to Project Alpha in Dynegy’s financial statements technically
complied with GAAP or whether Olis and his coconspirators intended to
violate GAAP but, instead, on whether the defendants’ disclosures about
Project Alpha intentionally omitted material facts that caused Dynegy’s
financial statements to be materially false and misleading.”) (citing United
States v. Rigas, 490 F.3d 208, 221 (2d Cir. 2007), and United States v.
Ebbers, 458 F.3d 110, 125‐26
(2d Cir. 2006)).
Repo105 ---
http://en.wikipedia.org/wiki/Repo_105
"Colorable claims exist that Ernst & Young did not
meet professional standards, both in investigating Lee's allegations and in
connection with its audit and review of Lehman's financial statements."
For those of you who don't have time to read the entire 2,200-page
Examiners Report
that's so unkind to Ernst & Young and Lehman Executives
"Excerpts from the Lehman Report," The Wall Street Journal,
March 13, 2010 ---
http://online.wsj.com/article/SB10001424052748704131404575117682843690948.html?mod=todays-us-money-and-investing
Thursday, a U.S. bankruptcy-court examiner
investigating the collapse of Lehman Brothers Holdings Inc. released a
scathing 2,200-page report. Here are some highlights.
* * *
Criminal Case? -- "Colorable Claims"
The allegations lodged by a bankruptcy-court
examiner have raised questions about whether prosecutors could build a case
against former Lehman executives.
"Colorable claims exist against the senior officers
who were responsible for balance sheet management and financial disclosure,
who signed and certified Lehman's financial statements and who failed to
disclose Lehman's use and extent of Repo 105 transactions to manage its
balance sheet."
--From
the report, volume 1, executive summary,
page 20
"Colorable claims exist that Ernst & Young did
not meet professional standards, both in investigating Lee's allegations and
in connection with its audit and review of Lehman's financial statements."
--From
the report, executive summary, page 21
"The Examiner finds colorable claims against
JPMorgan Chase ("Chase") and CitiBank in connection with modifications of
guaranty agreements and demands for collateral in the final days of Lehman's
existence. The demands for collateral by Lehman's Lenders had direct impact
on Lehman's liquidity pool; Lehman's available liquidity is central to the
question of why Lehman failed."
--From
the report, executive summary, page 24
* * *
Whistleblower Letter -- "On Its Face Pretty Ugly"
Lehman employee Matthew Lee will gain fame as
one of whistleblowers who tried to prevent the company's demise. The report
says Lehman's auditors refer to Matthew Lee's letter to senior management as
a "whistleblower letter" and an "ugly" one at that. No wonder Lehman's
senior management and outside auditors, Ernst & Young, said they were
"stressed."
"[W]e are also dealing with a whistleblower
letter, that is on its face pretty ugly and will take us a significant
amount of time to get through. I am confident from what I have seen it
shouldn't result in any significant issues around financial reporting, but
again there is a lot of work to do yet. This combined with some very
difficult accounting issues around off balance sheet items is adding stress
to everyone." (From a June 8, 2008, email from William Schlich, a former
lead partner on Ernst & Young's Lehman team)
--From
the report: Volume 3, page 961
Repo 105 -- "Another drug we r on"
The examiner criticized Lehman for the "materially
misleading" approach it took to represent its financial condition. He
focused on the so-called "repo" market, in which firms sell assets in
exchange for cash to fund operations, often just overnight or for a few
days.
The examiner said that Lehman -- anxious to
maintain favorable credit ratings -- engaged in an accounting device known
within the firm as "Repo 105" to essentially park about $50 billion of
assets away from Lehman's balance sheet. The move helped Lehman look like it
had less debt on its books.
"In this way, unbeknownst to the investing public,
rating agencies, Government regulators, and Lehman's Board of Directors,
Lehman reverse engineered the firm's net leverage ratio for public
consumption."
--From
the report, volume 3, page 739
* * *
The Repo 105 strategy sparked debate inside Lehman,
according to the report. In an April 2008 email, Bart McDade called such
accounting maneuvers "another drug we r on." Mr. McDade, then Lehman's
equities chief, says he sought to limit such maneuvers, according to the
report (page 763..
Numerous internal Lehman e-mails referred to Repo
105 transactions in pejorative terms, such as "balance sheet
window-dressing."
An illustrative example is found in the following
July 2008 e-mail exchange:
"Vallecillo: "So what's up with repo 105? Why are
we doing less next quarter end?"
McGarvey: "It's basically window-dressing. We are
calling repos true sales based on legal technicalities. The exec committee
wanted the number cut in half."
Vallecillo: "I see . . . so it's legally do-able
but doesn't look good when we actually do it? Does the rest of the street do
it? Also is that why we have so much BS [balance sheet] to Rates Europe?
McGarvey: "Yes, No and yes. :)"
--From
the report, volume 3, pages 860-866:
* * *
Senior management exerted pressure, particularly at
or near quarter-end, to utilize the Repo 105 mechanism to meet the
firm-imposed balance sheet targets:
Four days before the close of Lehman's fiscal year
in November 2007, Mitch King wrote to Marc Silverberg: "Let me know if we
have room for any more repo 105. I have some more I can put in over month
end." Jerry Rizzieri, who reported directly to Kaushik Amin, replied to
King: "Can you imagine what this would be like without 105?"
--From
the report, volume 3, pages 860-866:
* * *
J.P. Morgan's Collateral Demands -- "Part Art,
Part Science, and Part Catch Up"
Several factors helped to tip Lehman over the brink
in its final days. Investment banks, including J.P. Morgan Chase & Co., made
demands for collateral and modified agreements with Lehman that hurt
Lehman's liquidity and pushed it into bankruptcy.
On September 11, J.P. Morgan executives met to
discuss significant valuation problems with securities that Lehman had
posted as collateral over the summer. J.P. Morgan concluded that the
collateral was not worth nearly what Lehman had claimed it was worth, and
decided to request an additional $5 billion in cash collateral from Lehman
that day. Discussions between Lehman and J.P. Morgan executives were tense.
According to J.P. Morgan witnesses, Steven Black, a senior J.P. Morgan
executive, communicated the $5 billion collateral request to Richard Fuld by
telephone on September 9. Black stated that he explained that the collateral
was intended to cover J.P. Morgan's exposure to Lehman in its entirety.
Lehman posted $5 billion in cash to JPMorgan by the afternoon of Friday,
Sept. 12.
Mr. Black described J.P. Morgan's formulation of
the $5 billion amount to the examiner as "part art, part science, and part
catch up."
"Black stated that he relayed to Fuld that JPMorgan
was not trying to solve JPMorgan's problem by creating new problems for
Lehman. He asserted that he told Fuld that, if Lehman was "near the edge,"
Fuld should say so. According to Black, Fuld asked whether JPMorgan was
interested in making a capital infusion, but JPMorgan was not. Black stated
that he advised Fuld that if Lehman were skating close to the edge, Lehman
should call the Federal Reserve so that the Federal Reserve could "herd the
cats" needed to assist Lehman. According to Black, Fuld said Lehman was not
anywhere close to the point of needing such assistance."
From the report, Volume 4, page 95
* * *
More on J.P. Morgan's Role -- Good Faith and Fair
Dealing?
"Notwithstanding J.P. Morgan's concerns with the
quantity and quality of collateral posted by Lehman, Lehman believed that
J.P. Morgan was overcollateralized. There is no evidence, however, that
Lehman requested in writing the return of the billions of dollars of
collateral it had posted in September. Lehman did informally request the
return of at least some of its collateral, and J.P. Morgan returned some
securities to Lehman on September 12. J.P. Morgan did not, however, release
any of the cash collateral that Lehman had posted in response to the
September 9 and September 11 requests.
"Finally, the examiner concludes that the evidence
may support the existence of a colorable claim – but not a strong claim –
that J.P. Morgan breached the implied covenant of good faith and fair
dealing by making excessive collateral requests to Lehman in September 2008.
A trier of fact would have to consider evidence that the collateral requests
were reasonable and that Lehman waived any claims by complying with the
requests."
--
From the report, volume 4, page 1071
* * *
'Hail Mary' to Warren Buffett:
New details in the report contain insights on why
Buffett passed on Lehman. They open a window on his methods for assessing
management and some of the red flags that waved him off.
"Fuld and Buffett spoke on Friday, March 28, 2008.
They discussed Buffett investing at least $2 billion in Lehman.2439 Two
items immediately concerned Buffet during his conversation with Fuld.2440
First, Buffett wanted Lehman executives to buy under the same terms as
Buffett.2441 Fuld explained to the Examiner that he was reluctant to require
a significant buy‐in from Lehman executives, because they already received
much of their compensation in stock.2442 However, Buffett took it as a
negative that Fuld suggested that Lehman executives were not willing to
participate in a significant way.2443 Second, Buffett did not like that Fuld
complained about short sellers.2444 Buffett thought that blaming short
sellers was indicative of a failure to admit one's own problems."
--From
the report, Volume 2, page 480
* * *
How Liquid was Lehman's Liquidity Pool?
"[T]he importance of liquidity to investment bank
holding companies cannot be overstated. Broker-dealers are dependent on
short-term financing to fund their daily operations, and a robust liquidity
pool is critical to a broker-dealer's access to such financing."
--From
the report, volume 4, page 1066
"By the second week of September 2008, Lehman found
itself in a liquidity crisis; it no longer had sufficient liquidity to fund
its survival. Thus, an understanding of Lehman's collateral transfers, and
Lehman's attendant loss of readily available liquidity, is essential to a
complete understanding of why Lehman ultimately failed."
--
From the report, volume 4, page 1084
"Lehman represented in regulatory filings and in
public disclosures that it maintained a liquidity pool that was intended to
cover expected cash outflows for 12 months in a stressed liquidity
environment and was available to mitigate the loss of secured funding
capacity. After the Bear Stearns crisis in March 2008, it became acutely
apparent to Lehman that any disruption in liquidity could be catastrophic;
Lehman thus paid careful attention to its liquidity pool and how it was
described to the market. Lehman reported the size of its liquidity pool as
$34 billion at the end of first quarter 2008, $45 billion at the end of
second quarter, and $42 billion at the end of the third quarter. Lehman
represented that its liquidity pool was unencumbered – that it was composed
of assets that could be "monetized at short notice in all market
environments."
"The Examiner's investigation of Lehman's transfer
of collateral to its lenders in the summer of 2008 revealed a critical
connection between the billions of dollars in cash and assets provided as
collateral and Lehman's reported liquidity. At first, Lehman carefully
structured certain of its collateral pledges so that the assets would
continue to appear to be readily available (i.e., the Overnight Account at
JPMorgan, the $2 billion comfort deposit to Citi, and the three-day notice
provision with BofA). Witness interviews and documents confirm that Lehman's
clearing banks required this collateral and without it would have ceased
providing clearing and settlement services to Lehman or, at the very least,
would have required Lehman to prefund its trades. The market impact of
either of those outcomes could have been catastrophic for Lehman. Lehman
also included formally encumbered collateral in its liquidity pool. Lehman
included the almost $1 billion posted to HSBC and secured by the U.K. Cash
Deeds in its liquidity pool; Lehman included the $500 million in collateral
formally pledged to BofA; Lehman included an additional $8 billion in
collateral posted to JPMorgan and secured by the September Agreements; and
Lehman continued to include the $2 billion at Citi, even after the Guaranty
and DCSA amendments."
--
From the report, volume 4, page 1082-1083
* * *
"This Section of the Report examines the
circumstances surrounding Lehman's provision of approximately $15 to $21
billion in collateral (both in cash and securities) to its clearing banks,
and Lehman's simultaneous inclusion of those funds in its reported liquidity
pool."
"Critically, the collateral posted by Lehman with
its various clearing banks was initially structured in a manner that enabled
Lehman to claim the collateral as nominally lien-free (at least overnight),
and continue to count it in its reported liquidity pool. However, by
September 2008, much of Lehman's reported liquidity was locked up with its
clearing banks, and yet this fact remained undisclosed to the market prior
to Lehman's bankruptcy."
--
From the report, volume 4, page 1067
\
From the Lehman Examiner Report - Volume 3, beginning page 945
as Forwarded (with highlights) to Bob Jensen by Lynn Turner
"(3) Lehman’s Board of Directors
Without exception, former Lehman directors were unaware of Lehman’s
Repo
105
program and transactions.3642
As discussed in greater detail below, Lehman’s own Corporate Audit group led
by Beth Rudofker, together with Ernst & Young, investigated allegations about
balance
sheet substantiation problems made in a May 16, 2008
“whistleblower” letter sent to
senior management by Matthew Lee.3643 On June 12, 2008, during the
investigation, Lee
informed Ernst & Young about Lehman’s use of $50 billion of Repo 105
transactions in
the second quarter of 2008.3644 At a June 13, 2008 meeting,
Ernst & Young failed to
disclose that allegation to the Board’s Audit Committee.3645
Former Lehman director Cruikshank recalled that he made very clear he wanted
a full and thorough investigation into each allegation made by Lee, whether the
allegation was contained in Lee’s May 16, 2008 letter or raised by Lee in the
course of
the investigation.3646 Another former Lehman director, Berlind, similarly stated
that the
Audit Committee explicitly instructed Lehman’s Corporate Audit Group and Ernst &
Young to keep the Audit Committee informed of all of Lee’s allegations.3647
Berlind also
said that he would have wanted to know about Lehman’s Repo 105 program and that
if
he had known about Lehman’s Repo 105 transactions, he would have asked Lehman’s
auditors to test the transactions to ensure they were appropriate.3648 Upon
learning from
the Examiner the volume of Repo 105 transactions at quarter‐end
in late 2007 and 2008,
Sir Christopher Gent said that he believed the volume mandated disclosure to the
Audit
Committee and further investigation.3649
Dr. Kaufman, on the other hand, stated that he would have wanted to know
about Repo 105 transactions only if they were “huge” and fraudulent, by which he
meant in violation of specific accounting rules or in violation of the law.3650
Dr.
Kaufman did not believe that $50 billion in Repo 105 transactions was
significant even if
that volume changed Lehman’s net leverage ratio by approximately two points.3651
Dr.Kaufman considered a four or five point change in the net leverage ratio to
be
significant.3652
In late 2007 and 2008, management made numerous presentations to the Board
regarding balance sheet reduction and deleveraging; in no case was the use of
Repo 105
transactions disclosed in those presentations.3653
i) Ernst & Young’s Knowledge of Lehman’s Repo 105 Program
During several Rule 30(b)(6)‐type3654
interview sessions, the Examiner
interviewed members of Ernst & Young’s Lehman audit team regarding Ernst &
Young’s knowledge of and involvement in Lehman’s Repo 105 program.
(1) Ernst & Young’s Comfort with Lehman’s Repo 105 Accounting
Policy
The Examiner interviewed Ernst & Young’s lead partner on the Lehman audit
team, William Schlich, regarding Lehman’s Repo 105 program. According to Schlich,
Ernst & Young had been aware of Lehman’s Repo 105 policy and
transactions for many
years.3655
Consistent with the statements of Lehman’s John Feraca (Secured Funding
Desk), Schlich stated that Lehman introduced its Repo 105 Accounting Policy
on the
heels
of the FASB’s promulgation of SFAS 140.3656
During that time, Ernst & Young
“discussed” the Repo 105 Accounting Policy (including Lehman’s structure for
Repo
105 transactions) and Ernst & Young’s team had a number of additional
conversations
with Lehman about Repo 105 over the years.3657 However, according to Schlich,
Ernst &Young had no role in the drafting or preparation of Lehman’s Repo 105
Accounting
Policy.3658
Schlich stated definitively that Ernst & Young had no advisory role with respect
to Lehman’s use of Repo 105 transactions and that Ernst & Young did not
“approve”
the Accounting Policy.3659 Rather, according to Schlich, Ernst & Young “bec[a]me
comfortable with the Policy for purposes of auditing financial statements.”3660
Following “consultation and dialogue” about the proper interpretation and
application of SFAS 140, Ernst & Young “clearly. . .concurred with Lehman’s approach”
to
SFAS 140 and subsequent literature by FASB on the issue of “control” of assets
involved in a repo transactions.3661 Ernst &
Young’s view, however, was not based upon
an analysis of whether actual Repo 105 transactions complied with SFAS 140.3662
Rather,
Ernst & Young’s review of Lehman’s Repo 105 Accounting Policy was purely
“theoretical.”3663 In other words, Ernst & Young solely assessed Lehman’s
understanding of the requirements of SFAS 140 in the abstract and as reflected
in its
Accounting Policy; Ernst & Young did not opine on the propriety of the
transactions as a balance sheet management tool.3664 Ernst & Young did not
review the Linklaters letter,
referenced in the Accounting Policy Manual.3665
According to Martin Kelly, it was not unusual for him to discuss various issues,
including Repo 105, with Ernst & Young.3666 Indeed, Kelly recalled specifically
speaking
with Schlich about Repo 105 transactions soon after becoming Financial
Controller on
December 1, 2007, in an effort to learn more about the program and “to
understand
[Ernst & Young’s] approach before talking to Callan.”3667
Kelly “wanted to ensure that Ernst & Young analyzed the program in the same
way that [Marie] Stewart [Global Head of Accounting Policy] had analyzed
it.”3668
Kelly’s conversations with Ernst & Young focused on the accounting treatment of
Repo
105 transactions.3669 According to Kelly,
Ernst & Young “was comfortable with the
treatment under GAAP for the same reasons that Lehman was comfortable.”3670
Kelly also discussed with Ernst & Young Lehman’s inability to get a true sale
opinion under United States law for Repo 105 transactions.3671 Kelly could not
recall whether he
discussed with Ernst & Young his discomfort with Lehman’s Repo 105 program.3672
(2) The “Netting Grid”
Throughout 2007, Lehman maintained a document entitled “Accounting Policy
Review Balance Sheet Netting and Other Adjustments,” known colloquially among
Lehman’s Accounting Policy and Balance Sheet Groups, as well at Ernst & Young,
as
the “Netting Grid.” The Netting Grid identified and described various balance
sheet
netting mechanisms employed by Lehman: one such balance sheet mechanisms was
Lehman’s use of Repo 105 transactions.3673
Lehman provided the Netting Grid to Ernst & Young at least in August 2007 (the
close of Lehman’s third quarter 2007) and in November 2007 (the close of
Lehman’s
fiscal year 2007).3674 Notably, the Netting Grid provided by Lehman to Ernst &
Young in
August 2007 and November 2007 only contained Repo 105 volumes from November 30,
2006 and February 28, 2007.3675 Schlich was unaware whether Ernst & Young asked
Lehman to provide its second quarter 2007 and third quarter 2007 Repo 105 usage
figures or a forecast of Lehman’s fourth quarter 2007 Repo 105 numbers.3676
Ernst & Young reviewed the Netting Grid, analyzed the various balance sheet
netting mechanisms identified in the Netting Grid, and used the document in
connection with its 2007 year‐end audit of
Lehman.3677 According to Schlich,
Ernst &
Young, as part of its review of Lehman’s Netting Grid, approved of Lehman’s
internal Repo 105 Accounting Policy only, and did not pass upon the actual
practice.3678
The Netting Grid described the transactions and United States GAAP reference
as follows: “Under certain conditions that meet the criteria described in
paragraphs 9
and
218 of SFAS 140,
Lehman policy permits reverse repo and repo agreements to be
recharacterized as purchases and sales of inventory.”3679
With respect to Lehman’s use
of Repo 105 transactions to reduce its net balance sheet, the Netting Grid sets
forth the conclusion that Lehman’s “current practice [for Repo 105] is
correct.”3680 Schlich noted
that this conclusion about the Repo 105 practice was Lehman’s, not Ernst &
Young’s.3681
To test Lehman’s conclusion, however, Ernst & Young “reviewed how Lehman applied
the control provisions of the accounting rules.”3682
Ernst & Young’s review, however, applied only to the accounting basis for these
transactions, not to their volume or purpose. Specifically, Ernst & Young’s
review and
analysis of Lehman’s Repo 105 program did not account for the volumes of Repo
105
transactions Lehman undertook at quarter‐end.3683
Indeed, Schlich was unable to
confirm or deny the volumes of Repo 105 transactions Lehman undertook at
Lehman’s
fiscal year‐end 2007, or in the first two quarter‐ends
of 2008.3684 Nor was Schlich able to
confirm or deny that Lehman’s use of Repo 105 transactions was increasing in
late 2007
and into mid 2008.3685
(a)
Quarterly Review and Audit
Through Schlich, Ernst & Young maintained that its duties as Lehman’s auditor
required it to ensure that transactions were accounted for correctly (i.e., that
they
complied with accounting rules) and that Lehman’s financial disclosures were not
materially misstated.3686 According to Schlich, Ernst & Young’s audit did not
require
Ernst & Young to consider or review the volume or timing of Repo 105
transactions.3687
Accordingly, as part of its year‐end
2007 audit, Ernst & Young did not ask Lehman
about any directional trends, such as whether its Repo 105 activity was
increasing
during fiscal year 2007.3688 Notably, as part of its quarterly review process,
Ernst &
Young did not audit any of Lehman’s Repo 105 transactions.3689
(3)
Ernst & Young Would Not Opine on the Materiality of
Lehman’s Repo 105 Usage
Ernst & Young, through Schlich,
was unwilling to
comment to the Examiner on
the materiality of the volume of Lehman’s quarter‐end
Repo 105 transactions.3690 Asked
whether, as part of its responsibility to ensure Lehman’s financial statements
were not
materially misstated,
Ernst & Young should
have considered the possibility that strict technical adherence to SFAS 140 or
any other specific accounting rule could nonetheless lead to a material
misstatement in Lehman’s publicly‐reported
financial statements,
Schlich refrained from comment.3691
When pressed further, Schlich stated that the volume of any particular
transaction impacts neither the question of whether accounting rules are applied
correctly, nor the question of whether a financial statement is materially
misleading.3692
However, Schlich eventually acknowledged that “when you look at a balance sheet
issue, volume is a factor.”3693
Notably,
the definition of “materiality” contained in a “walk‐through”
document
related to Ernst & Young’s 2007 fiscal year‐end
audit of Lehman was: “any transaction
that
would move Lehman’s firm‐wide
net leverage by 0.1 or more.”3694 This
definition
reflected “Lehman’s determination of a materiality threshold” in connection with
Lehman’s own criteria for when to consider reopening and adjusting its balance
sheet.3695
When Schlich was asked what level of impact to Lehman’s firm‐wide
net assets
Ernst & Young would have considered “material,” Schlich replied that Ernst &
Young
did not have a hard and fast rule defining materiality in the balance sheet
context, and
that, with respect to balance sheet issues, “materiality” depends upon the facts
and
circumstances.3696 Schlich agreed that Lehman made no specific disclosures about
Repo 105 transactions in its Forms 10‐K and
Form 10‐Q,
including the MD&A section.3697
Schlich believed, however, that Lehman’s public filings would have included
general
language regarding secured borrowings and compliance with SFAS 140.3698 Schlich
was
not aware whether Ernst & Young ever discussed Lehman’s disclosures vel non of
Repo
105 activity with senior Lehman management.3699
(4)
Matthew Lee’s Statements Regarding Repo 105 to Ernst &
Young
On May 16, 2008,
Matthew Lee, then‐Senior
Vice President in the Finance
Division responsible for Lehman’s Global Balance Sheet and Legal Entity
Accounting,
sent a letter to certain members of Lehman’s senior management
identifying possible violations of Lehman’s Ethics Code related to
accounting/balance sheet issues.3700 Lehman involved Ernst & Young in its
investigation of the concerns raised in Lee’s May
16, 2008 letter.3701
Subsequently, less than a month later, on June 12, 2008, Ernst & Young – Schlich
and Hillary Hansen – interviewed Lee.3702 Hansen’s notes of the interview reveal
that
Lee made certain statements to Ernst & Young about Lehman’s Repo
105 practice,
including, most notably, the volume of Repo 105 activity that Lehman engaged in
at
quarter‐end
(May 31, 2008).3703 Hansen’s notes specifically recount Lee’s allegation that
Lehman moved $50 billion of inventory off its balance sheet at quarter‐end
through
Repo 105 transactions and that
these assets returned to the balance sheet approximately
a
week later.3704
When interviewed by the Examiner, Schlich did not recall Lee saying anything
about Repo 105 transactions during that interview, although he did not dispute
the
authenticity of Hansen’s notes from the Lee interview.3705 In spite of Hansen’s
notes,
Schlich maintained that Ernst & Young did not know that Lehman engaged in the
following Repo 105 activity during the listed time periods: $49.1 billion at
first quarter
2008 (Feb. 29, 2008); and $50.38 billion at second quarter 2008 (May 31,
2008).3706
During the Examiner’s interview of Hansen, Hansen recalled that while Ernst &
Young questioned Lee about his May 16, 2008 letter, Lee “rattled off” a list of
additional
issues and concerns he held, one of which was Lehman’s use of Repo 105
transactions.3707 Ernst & Young had no further conversations with Lee about Repo
105
transactions.3708 Prior to her interview of Lee in June 2008, Hansen had heard
the term
Repo 105 “thrown around” but she did not know its meaning; according to Hansen,
Schlich described Repo 105 transactions to her shortly after they met with
Lee.3709
Following Ernst & Young’s June 12, 2008 interview of Lee, Schlich and Hansen
met with Lehman’s Gerard Reilly to discuss Lee’s assertions regarding improper
valuations.3710 During that meeting, Hansen informed Reilly of the $50 billion
Repo 105
figure Lee provided during Ernst & Young’s interview of Lee.3711 According to
Schlich,
Reilly (now deceased) told the auditors that he had no knowledge that Lehman
used
Repo 105 transactions to move $50 billion in assets off its balance sheet.3712
“Hillary
[Hansen] took away from the meeting with Reilly that he did not know and it was
not
$50 billion.”3713
On June 13, 2008 – the day after Lee informed Ernst & Young of the $50 billion
in
Repo 105 transactions that Lehman undertook at the end of the second quarter
2008 –
Ernst & Young spoke to Lehman’s Audit Committee
but did not inform the committee
of Lee’s
allegation, even though the Chairman of the Audit Committee had clearly stated
that he wanted every allegation made by Lee – whether in Lee’s May 16 letter or
during the course of the investigation – to be investigated.3714
Ernst & Young met with
the Audit Committee on July 8, 2008, to review the second quarter financial
statements and again did not mention Lee’s allegations regarding Repo 105.3715
On July 22, 2008,
Ernst & Young was also present when Beth Rudofker, Head of Corporate Audit, gave
a
presentation to the Audit Committee on the results of the investigation into
Lee’s
allegations.3716
Ernst & Young did not disclose to the Audit Committee – either during the
meetings or in private executive sessions after – that Lee made an allegation
related to
Repo 105 transactions being used to move assets off Lehman’s balance sheet at
quarterend.
3717 Cruikshank told the Examiner that he would have expected to be told about
Lee’s Repo 105 allegations.3718 Similarly, Sir Gent told the Examiner that the
alleged volume of Lehman’s Repo 105 transactions mandated disclosure to the
Audit
Committee as well as further investigation.3719
Ernst & Young did not follow‐up on
either Lee’s allegations regarding Lehman’s
Repo 105 activity or Reilly’s claim that he had no knowledge of Lehman’s alleged
$50
billion Repo 105 usage figure.3720 Ernst & Young signed a Report of Independent
Registered Public Accounting Firm for Lehman’s second quarter 2008 Form 10‐Q
on
July 10, 2008, less than four weeks after Schlich and Hansen interviewed
Lee.3721
(5) Accounting‐Motivated
Transactions
Ernst & Young did not evaluate the possibility that Repo 105
transactions were accounting‐motivated
transactions that lacked a business purpose.3722
Schlich
characterized the off‐balance sheet treatment of Lehman’s assets in Repo 105
transactions as a consequence of the accounting rules, rather than a motive for
the
transactions.3723
j)
The Examiner’s Conclusions
There is sufficient evidence to support a determination by a trier of fact that
Lehman’s failure to disclose that it relied upon Repo 105 transactions to
temporarily
reduce the firm’s net balance sheet and net leverage ratio was materially
misleading. In
addition, a trier of fact could find that Lehman affirmatively misrepresented
its
accounting treatment for repos by stating that Lehman treated repo transactions
as
financing transactions rather than sales for financial reporting purposes,
despite the fact
that Lehman treated tens of billions of dollars in repo transactions – namely,
Repo 105
transactions – as true sale transactions.
The Examiner thus concludes that sufficient evidence exists from which a trier
of fact could find the existence of a colorable claim that certain Lehman
officers breached
their
fiduciary duties to Lehman and its shareholders by causing the company to file
deficient and materially misleading financial statements, thereby exposing the
company
to
potential liability.
Certain officers of Lehman not only failed to inform the public of
its reliance on Repo 105 transactions to reduce its balance sheet, they also
failed to
advise Lehman’s Board of Directors of the firm’s Repo 105 practice. Thus, the
Examiner
concludes that a trier of fact could find that certain Lehman officers breached
their
fiduciary duties to Lehman’s Board of Directors by failing to inform them of:
(1) the
firm’s reliance upon Repo 105 to reduce the balance sheet at quarter‐end,
(2) the rampup
in Repo 105 usage in mid‐to‐late 2007 and 2008, (3) the impact of these transactions
on Lehman’s publicly reported net leverage ratio, or (4) the fact that Lehman
did not
disclose its Repo 105 practice in its publicly reported financials statements
and MD&A.
(1)
Materiality
The materiality of information is evaluated from the perspective of a reasonable
investor.3724 Information is deemed material if there is “a substantial
likelihood that the
disclosure of the omitted fact would have been viewed by the reasonable investor
as having significantly altered the ‘total mix’ of information made
available.”3725
Materiality does not require, however, that the information be of a type that
would
cause an investor to change his investment decision.3726
(a)
Whether Lehman’s Repo 105 Transactions Technically
Complied with SFAS 140 Does Not Impact Whether a
Colorable Claim Exists
This Report does not reach the question of whether Lehman’s Repo 105
transactions technically complied with the relevant financial accounting
standard, SFAS
140, because the answer to that question does not impact whether a colorable
claim
exists regarding Lehman’s failure to disclose its Repo 105 practice and whether
that
failure rendered the firm’s financial statements materially misleading.
Even if Lehman’s use of Repo 105 transactions technically
complied with SFAS 140, financial statements may be materially misleading even
when they do not violate GAAP.3727 The Second Circuit has explained that “GAAP
itself recognizes that technical compliance with particular GAAP rules may lead
to misleading financial statements, and
imposes an overall requirement that the statements as a whole accurately reflect
the financial status of the company.”3728
Similarly, as noted in In re Global Crossing Ltd. Securities Litigation, even if
a
defendant established that its accounting practices
“were in technical compliance with
certain individual GAAP provisions . . . this would not necessarily insulate it
from liability. This is because, unlike other regulatory systems, GAAP’s
ultimate goals of fairness and accuracy in reporting require more than mere
technical compliance.”3729
The court
explained that “when viewed as a whole,” GAAP has no “loopholes” because its
purpose, shared by the securities laws, is “to increase investor confidence by
ensuring
transparency and accuracy in financial reporting.”3730
Technical compliance with
specific accounting rules does not automatically lead to fairly presented
financial statements. “Fair presentation is the touchstone for determining the
adequacy of disclosure in financial statements. While adherence to generally
accepted accounting principles is a tool to help achieve that end, it is not
necessarily a guarantee of fairness.”3731 Moreover,
registrants are “required to provide whatever additional information would be
necessary to make the statements in their financial reports fair and accurate,
and not
misleading.”3732
This view is echoed in an SEC enforcement order, concluding that GAAP
compliance does not excuse a misleading or less than full disclosure regarding a
transaction, especially if the transaction’s purpose is “the attainment of a
particular
financial reporting result.”3733 “[E]ven if the transactions comply with GAAP,
the issuer
is required to evaluate the material accuracy and completeness of the
presentation
made by its financial statements.”3734 Issuers must “ensure that the way they
publicly
portray themselves discloses, as required, the material elements of [their]
economic and
business realities and risks.”3735
3732 Id.
(citing 17 C.F.R. § 240.10b‐5(b)
and 17 C.F.R. § 230.408 (requiring that “in addition to the information
expressly required to be included in a registration statement, there shall be
added such further material information, if any, as may be necessary to make the
required statements, in the light of the circumstances under which they are
made, not misleading”) (emphasis added); see also SEC v. Seghers,
298 Fed. App’x 319, 331 (5th Cir. 2008)
(“The Commission’s proof of Segher’s misrepresentations and omissions
does not depend on compliance with GAAP, but instead depends on evidence that
Segher’s statements and omissions were false or misleading to investors.”); United States v. Olis, Civil Action No. H‐07‐3295,
Criminal No. H‐03‐217‐01, 2008 WL 5046342, at *20 (S.D. Tex. Nov. 21, 2008) (“The scheme
to defraud alleged and proved in this case did not turn on whether the treatment
accorded to Project Alpha in Dynegy’s financial statements technically complied
with GAAP or whether Olis and his coconspirators intended to violate GAAP but,
instead, on whether the defendants’ disclosures about Project Alpha
intentionally omitted material facts that caused Dynegy’s financial statements
to be materially false and misleading.”) (citing United States v. Rigas, 490
F.3d 208, 221 (2d Cir. 2007), and United States v. Ebbers, 458 F.3d 110, 125‐26 (2d Cir. 2006)).
This is just a reminder that the survival of auditing firms other than
Ernst & Young are threatened by shareholder/creditor lawsuits resulting from
audits of failed banks and the virtual failure of all auditors to issue going
concern opinions of thousands of banks that failed in 2008 and 2009.
Where Were the Auditors ---
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms
Even the crooked credit rating agencies are suing the auditors.
Bob Jensen's threads on Ernst & Young ---
http://www.trinity.edu/rjensen/fraud001.htm
"Report
Details How Lehman Hid Its Woes as It Collapsed," by Michael de la Merced and
Andrew Ross Sorkin, The New York Times, March 11, 2010 ---
http://www.nytimes.com/2010/03/12/business/12lehman.html?src=me
It is the Wall Street
equivalent of a coroner’s report — a
2,200-page document
that lays out, in new
and startling detail, how
Lehman Brothers
used accounting sleight of hand to conceal
the bad investments that led to its undoing.
The report, compiled by an examiner for the bank,
now bankrupt, hit Wall Street with a thud late Thursday. The 158-year-old
company, it concluded, died from multiple causes. Among them were bad
mortgage holdings and, less directly, demands by rivals like JPMorgan Chase
and Citigroup, that the foundering bank post collateral against loans it
desperately needed.
But the examiner, Anton R. Valukas, also for the
first time, laid out what the report characterized as “materially
misleading” accounting gimmicks that Lehman used to mask the perilous state
of its finances. The bank’s bankruptcy, the largest in American history,
shook the financial world. Fears that other banks might topple in a cascade
of failures eventually led Washington to arrange a sweeping rescue for the
nation’s financial system.
According to the report, Lehman used what amounted
to financial engineering to temporarily shuffle $50 billion of troubled
assets off its books in the months before its collapse in September 2008 to
conceal its dependence on leverage, or borrowed money. Senior Lehman
executives, as well as the bank’s accountants at Ernst & Young, were aware
of the moves, according to Mr. Valukas, the chairman of the law firm Jenner
& Block and a former federal prosecutor, who filed the report in connection
with Lehman’s bankruptcy case.
Richard S. Fuld Jr., Lehman’s former chief
executive, certified the misleading accounts, the report said.
“Unbeknownst to the investing public, rating
agencies, government regulators, and Lehman’s board of directors, Lehman
reverse engineered the firm’s net leverage ratio for public consumption,”
Mr. Valukas wrote.
Mr. Fuld was “at least grossly negligent,” the
report states, adding that Henry M. Paulson Jr., who was then the Treasury
secretary, warned Mr. Fuld that Lehman might fail unless it stabilized its
finances or found a buyer.
Lehman executives engaged in what the report
characterized as “actionable balance sheet manipulation,” and “nonculpable
errors of business judgment.”
The report draws no conclusions as to whether
Lehman executives violated securities laws. But it does suggest that enough
evidence exists for potential civil claims. Lehman executives are already
defendants in civil suits, but have not been charged with any criminal
wrongdoing.
A large portion of the nine-volume report centers
on the accounting maneuvers, known inside Lehman as “Repo 105.”
First used in 2001, long before the crisis struck,
Repo 105 involved transactions that secretly moved billions of dollars off
Lehman’s books at a time when the bank was under heavy scrutiny.
According to Mr. Valukas, Mr. Fuld ordered Lehman
executives to reduce the bank’s debt levels, and senior officials sought
repeatedly to apply Repo 105 to dress up the firm’s results. Other
executives named in the examiner’s report in connection with the use of the
accounting tool include three former Lehman chief financial officers:
Christopher O’Meara, Erin Callan and Ian Lowitt.
Patricia Hynes, a lawyer for Mr. Fuld, said in an
e-mailed statement that Mr. Fuld “did not know what those transactions were
— he didn’t structure or negotiate them, nor was he aware of their
accounting treatment.”
Charles Perkins, a spokesman for Ernst & Young,
said in an e-mailed statement: “Our last audit of the company was for the
fiscal year ending Nov. 30, 2007. Our opinion indicated that Lehman’s
financial statements for that year were fairly presented in accordance with
Generally Accepted Accounting Principles (GAAP), and we remain of that
view.”
Bryan Marsal, Lehman’s current chief executive, who
is unwinding the firm, said in a statement that he was evaluating the report
to assess how it might help in efforts to advance creditor interests.
Repos, short for repurchase agreements, are a
standard practice on Wall Street, representing short-term loans that provide
sometimes crucial financing. In them, firms essentially lend assets to other
firms in exchange for money for short periods of time, sometimes overnight.
But Lehman used aggressive accounting in its Repo
105 transactions: it appears to have structured transactions such that they
sold securities at the end of the quarter, but planned to buy them back
again days later. These assets were mostly illiquid real estate holdings,
meaning that they were hard to sell in normal transactions.
Continued in article
Jensen Comment
The link to Volumes 1-9 of the Examiner's Report ---
http://dealbook.blogs.nytimes.com/2010/03/11/lehman-directors-did-not-breach-duties-examiner-finds/#reports
Question
It appears that Lehman is was trying to whitewash it's creative accounting with
a ruling from a shady law firm.
Because no U.S. law firm would bless the
transaction, Lehman got an opinion letter from London-based law firm
Linklaters. That letter essentially blessed using the maneuver for Lehman's
European broker-dealer under English law. If one of Lehman's U.S. entities
needed to engage in a Repo 105 transaction, the firm moved the securities to
its European arm to conduct the deal on the U.S. entity's behalf, the report
found. That is likely why the counterparties on the repo transactions were
largely a group of seven non-U.S. banks. These included Germany's Deutsche
Bank AG, Barclays PLC of the U.K. and Japan's Mitsubishi UFJ Financial
Group.
What other loser corporation and its auditing firm sought to hide behind a
shady law firm's blessing on deceptive accounting?
Hint: The law firm was contacted after a whistle blower notified both the
client's CEO and the its auditing firm.
Answer
If you don't recall the answer, scroll down past the following tidbit.
"Repos Played a Key Role in Lehman's Demise: Report Exposes Lack of
Information And Confusing Pacts With Lenders," by Suzanne Craig and Mike Spector,
The Wall Street Journal, March 13, 2010 ---
http://online.wsj.com/article/SB20001424052748703447104575118150651790066.html#mod=todays_us_money_and_investing
The rare look into the repo market embedded in the
report comes 18 months after Lehman Brothers collapsed in the U.S.'s largest
bankruptcy filing. While top Lehman executives were quick to blame the
real-estate market for their woes, the exhaustive report singles out senior
executives and auditor Ernst & Young for serious lapses.
The report exposed for the first time what appears
to be an accounting slight of hand known as a Repo 105 transaction, where
Lehman was able to book what looked like an ordinary asset for cash as an
out-and-out sale, drastically reducing its leverage and making its financial
picture look better than it really was. The transactions often were done in
flurries in a financial quarter's waning days, before Lehman reported
earnings.
Four days prior to the close of the 2007 fiscal
year, Jerry Rizzieri, a member of Lehman's fixed-income division, was
searching for a way to meet his balance-sheet target, according to the
report. He wrote in an email: "Can you imagine what this would be like
without 105?"
A day before the close of Lehman's first quarter in
2008, other employees scrambled to make balance-sheet reductions, the report
said. Kaushik Amin, then-head of Liquid Markets, wrote to a colleague: "We
have a desperate situation, and I need another 2 billion from you, either
through Repo 105 or outright sales. Cost is irrelevant, we need to do it."
Marie Stewart, the former global head of Lehman's
accounting policy group, told the examiner the transactions were "a lazy way
of managing the balance sheet as opposed to legitimately meeting
balance-sheet targets at quarter end."
Lehman's use of this accounting technique goes back
to the start of the decade when Lehman business units from New York and
London met to discuss how the firm could manage its balance sheet using
accounting rules that had taken effect in September 2000. Lehman soon
created the "Repo 105" maneuver: Because assets the firm moved amounted to
105% or more of the cash it received in return, Lehman could treat the
transactions as sales and remove securities inventory that otherwise would
have to be kept on its balance sheet.
Because no U.S. law firm would bless the
transaction, Lehman got an opinion letter from London-based law firm
Linklaters. That letter essentially blessed using the maneuver for Lehman's
European broker-dealer under English law. If one of Lehman's U.S. entities
needed to engage in a Repo 105 transaction, the firm moved the securities to
its European arm to conduct the deal on the U.S. entity's behalf, the report
found. That is likely why the counterparties on the repo transactions were
largely a group of seven non-U.S. banks. These included Germany's Deutsche
Bank AG, Barclays PLC of the U.K. and Japan's Mitsubishi UFJ Financial
Group.
In a statement, a Linklaters spokeswoman said the
report "does not criticize" the legal opinions it gave Lehman "or suggest or
say they were wrong or improper." The law firm said it was never contacted
during the investigation.
Jensen Comment
Although Lehman could not find a shady U.S. law firm to "bless the transaction,"
Ken Lay at Enron managed to find a shady law firm to bless the Raptors'
transactions after Sherron Watkins (an Enron executive) sent her infamous
whistle blowing memo to both Ken Lay and to Andersen executives in Chicago.
"Warning on Enron Recounted," by Alexei Barrionuevo, The New York
Times, March 16, 2006 ---
http://www.nytimes.com/2006/03/16/business/businessspecial3/16enron.html?_r=1&oref=slogin
Ms. Watkins, 46,
attracted national attention after testifying before Congress in February 2002
about Enron's collapse two months earlier. She was named one of Time magazine's
people of the year in 2002 for raising red flags about the company's accounting
while still working there. She has since written a book with a Houston
journalist about Enron's fall, and formed a consulting practice that advises
companies on governance issues.
Defense lawyers, during
combative cross-examination, tried to paint Ms. Watkins as an opinionated
fame-seeker who had profited from the Enron scandal on the lecture circuit. The
defense lawyers also suggested that Ms. Watkins was never charged with insider
trading for selling Enron shares because she was wrong in believing that the
Raptors were fraudulent.
Prosecutors contend that
the partnerships and hedges Ms. Watkins testified about were part of a broad
effort by Mr. Skilling and Mr. Lay to manipulate earnings and hide debt. The
former chief executives are accused of overseeing a conspiracy to deceive
investors about Enron's finances so they could profit by selling Enron shares at
inflated prices.
Defense lawyers contend
that prosecutors are seeking to criminalize normal business practices and that
the Enron executives were the victims of thieving subordinates like Andrew S.
Fastow, the former chief financial officer.
Ms. Watkins's appearance
on the stand came as the government neared the end of its case. Judge Simeon T.
Lake III said Wednesday that he estimated that the case could be wrapped up by
the end of April.
Ben F. Glisan Jr., a
former Enron treasurer, is scheduled to take the stand next week. Mr. Glisan
pleaded guilty to conspiracy and is currently serving a five-year prison term.
In often-colorful
testimony, Ms. Watkins recounted how she became concerned around June 2001 that
about a dozen Enron assets were being hedged, or guaranteed against loss, by the
Raptors vehicles, which she soon learned contained only Enron stock. The Raptors
were intertwined with partnerships run by Mr. Fastow, who became Ms. Watkins's
boss that summer. The value of the assets, she said, "had tanked," dragged down
by Enron's plummeting share price.
After doing some
investigation, she wrote an anonymous letter about her concerns, then on Aug.
22, 2001, she met with Mr. Lay to discuss them. The meeting came about a week
after Mr. Lay had stepped back into the role of chief executive after the
resignation of Mr. Skilling.
At the meeting, they
discussed a letter of hers in which she had said that she was "incredibly
nervous that Enron would implode in a wave of accounting scandals." She also
noted to Mr. Lay that employees were talking about a "handshake deal" that Mr.
Fastow had with Mr. Skilling that ensured that Mr. Fastow would not lose money
on transactions done with the LJM partnership, which Mr. Fastow was running.
Mr. Lay seemed to take
her seriously, Ms. Watkins testified.
Days after the meeting, she
learned that Vinson & Elkins, the law firm that had originally approved the
Raptors, was doing the internal investigation into the partnerships. The firm,
after consulting with Arthur Andersen, Enron's auditor, issued a report saying
that while the "optics" or appearances were bad, the accounting was appropriate.
Ms. Watkins said she
remained adamant that Andersen, which had received several high-profile
setbacks, should not be trusted.
"I thought this was
bogus," she said of the investigation.
Concerned that Enron was
manipulating its financial statements, Ms. Watkins stepped up efforts to leave
the company, which she had begun shortly after she concluded the Raptors could
be fraudulent. She did not leave until after the bankruptcy.
Ultimately, Mr. Lay
decided to unwind the Raptors and take a write-off in a single quarter rather
than restate the accounting of Enron's financial statements. Ms. Watkins, under
questioning from Chip B. Lewis, a lawyer for Mr. Lay, conceded that while that
was not her preference, "continuing the fraud would have been worse."
Defense lawyers sparred
with Ms. Watkins from the outset. Mr. Lewis placed a copy of Ms. Watkins's book,
"Power Failure," in front of her, calling it a "housewarming present."
Ms. Watkins acknowledged
that she could not explain why prosecutors did not charge her with insider
trading for selling Enron shares.
Continued in article
"Enron Employee Told Lay Last Summer Of Concerns About Accounting
Practices," by Michael Schroeder and John Emshwiller, The Wall Street
Journal, January 15, 2002 ---
http://interactive.wsj.com/articles/SB1011043581125393520.htm
A House committee asked
Enron Corp. for information related to a newly discovered letter written by an
Enron employee last summer warning the company's chairman about its accounting
practices, which prompted an internal investigation.
That inquiry,
conducted by Enron's outside law firm, Vinson & Elkins, "has the appearance of a
whitewash," said House Energy and Commerce Committee spokesman Ken Johnson.
A committee investigator
combing through 40 boxes of documents supplied by Enron found the letter over
the weekend. The author, Sherron Watkins, an Enron Global Finance executive who
wasn't identified further, questioned the propriety of accounting methods,
writing: "I am incredibly nervous that we will implode in a wave of accounting
scandals."
Enron, suffering from a
crisis of confidence by investors, filed for Chapter 11 bankruptcy-court
protection on Dec. 2, shielding it from creditors as it seeks to reorganize.
In concluding its review
of the matters raised in the letter, Vinson & Elkins told Enron that "further
widespread investigation by independent counsel and auditors" was unwarranted.
But the firm warned that "bad cosmetics" involving the transactions and the
decline of Enron's stock posed the "serious risk of adverse publicity and
litigation."
The internal review was
dated Oct. 15, 2001 -- one day before Enron announced its big third-quarter loss
and a $1.2 billion reduction in shareholder equity because of losses later
associated with various partnerships involving Enron officials.
Ms. Watkins's letter and
the lawyers' conclusion were quoted Monday in a request for additional documents
from the House committee to Enron Chairman Kenneth Lay; the firm's outside
auditor, Arthur Andersen LLP; and Vinson & Elkins. The panel is seeking
additional information about the letter and Enron's response to it.
Joe Householder, a
spokesman for Vinson & Elkins, said the firm had received the committee's
request for information, but that "we're not prepared to respond yet to the
specific questions in the letter."
An Enron spokesman didn't
return a call seeking comment. Ms. Watkins, who no longer works for Enron
Global, couldn't be reached for comment.
Her letter to Mr. Lay
questioned special-purpose entities that Enron used to help keep its debt off
its books, the adequacy of public disclosure and the financial impact of the
decline of Enron's stock.
The committee said the
existence of the internal investigation suggests that "senior officials at Enron
and Andersen were aware of the controversial financial transactions and
accounting practices that would ultimately contribute significantly to Enron's
demise."
Mr. Johnson said Vinson &
Elkins "had one hand tied behind its back" by Enron officials as it began its
review of Ms. Watkins's warnings. "As part of Vinson & Elkins's mandate for
investigating the letter, they were told [by Enron officials] not to second
guess Arthur Andersen and not to analyze specific transactions," he said.
Ms. Watkins wasn't the
first Enron insider to raise concerns about partnerships related to Chief
Financial Officer Andrew Fastow. Sometime before the end of 2000, then-Enron
Treasurer Jeffrey McMahon went to company President Jeffrey Skilling and
complained about potential conflicts of interest posed by partnerships operated
by Mr. Fastow, which began in 1999 and early 2000. Mr. Fastow quit the
partnerships last July.
Mr. Skilling didn't share
Mr. McMahon's concerns, say people familiar with the matter. Mr. McMahon
requested and received reassignment to another post. In October, Mr. McMahon was
named as successor to Mr. Fastow as Enron's chief financial officer in the face
of rising controversy over the partnerships.
Ms. Watkins's August 2001
letter came when what now appears to be the first major crack in Enron's facade
appeared. Mr. Skilling, who had been given the chief-executive post earlier in
the year, unexpectedly resigned on Aug. 14. He initially cited unspecified
personal reasons.
But in an interview the
next day, he said that his frustration over Enron's falling stock price played a
major role in his decision to quit after only six months as chief executive.
That remark has since raised questions about whether Mr. Skilling saw problems
ahead for Enron because some of its partnership arrangements relied heavily on
the use of Enron stock and their stability could be threatened by a falling
price.
Separately, Andersen
issued a statement providing more details about an e-mail sent by an in-house
attorney that resulted in the destruction by Andersen employees of numerous
Enron-related audit documents.
Mr. Odom forwarded the
e-mail to David Duncan, the partner in charge of the Enron audit as a reminder
of the firm's existing policy, Andersen said. The firm added that the e-mails
"are not a representation that there were no inappropriate actions" and said it
is continuing to investigate the matter.
Andersen's
records-retention policy goes into great detail about what documents should be
kept for what periods of time and when they should be disposed of. But the
policy does note, "In cases of threatened litigation, no related information
will be destroyed." At the time the e-mail was sent, no subpoenas had been
issued, but Enron's problems were mounting and drawing the attention of
attorneys representing shareholders.
"Liberté, Egalité, Fraternité: Big Lehman Brothers Troubles For Ernst &
Young," by Francine McKenna, re: The Auditors, March 15, 2010 ---
http://retheauditors.com/2010/03/15/liberte-egalite-fraternite-lehman-brothers-troubles-for-ernst-young-threaten-the-big-4-fraternity/
Ernst & Young, the audit firm, had a long and
lucrative relationship with Lehman Brothers. Lehman Brothers has paid EY
more than $160 million in audit and other fees since fiscal year 2001.
Although this isn’t nearly as much as
Goldman Sachs and AIG pay PwC – almost $230
million a year combined in 2008 – it was still a huge amount and represented
a significant client relationship for Ernst & Young.
It all started with Shearson Lehman American
Express back in 1975. Lehman Brothers inherited an audit relationship with
Ernst & Young when Lehman was
spun off from American Express in 1994. Current
Ernst & Young Global Chairman Jim Turley
cut his teeth on American Express.
“The decision to make Lehman Brothers an
independent company again, owned by American Express shareholders and
Lehman employees, completes American Express’s effort to rid itself of
the draining weight of its extraordinary, and ultimately unsuccessful,
expansion in the 1980s…the two companies will share no directors and
that Richard S. Fuld Jr. will continue as president and chief
executive of Lehman. Fuld, in a brief telephone press
conference, said Lehman was vigorously pursuing its plan to cut costs by
$200 million but could not say if that would result in further loss of
jobs. “It is much more important for us to talk in terms of
dollars and not in terms of people,” he said.”
Ernst and Young (EY) was fired by American Express
at the end of 2004. After a string of issues
with independence that threatened their
credibility and ability to accept new audit work, American Express
unceremoniously dumped them and hired PricewaterhouseCoopers.
“In 2003, Amex shelled out $23 million to
E&Y in audit fees, and $3.5 million for other services. The audit fee
was the largest paid by any U.S.-based E&Y client…an E&Y spokesman
declined to comment on the reasons the firm was dropped…E&Y has been in
the Securities and Exchange Commission’s (SEC) cross-hairs for about a
year, including one probe into whether the audit firm violated federal
auditor independence rules by entering a so-called profit-sharing
agreement in the 1990s with Amex’s travel-service unit…”
But EY’s relationship with Lehman continued until
the bitter end. So it comes as no surprise to me that
EY had a hard time acting independently with their
“sticky” client. Lehman Bankruptcy Examiner Anton Valukas, of local Chicago
Jenner & Block, sums it up nicely:
The Examiner concludes that sufficient
evidence exists to support colorable claims against Ernst & Young LLP
for professional malpractice arising from Ernst & Young’s failure to
follow professional standards of care with respect to
communications with Lehman’s Audit Committee, investigation of a
whistleblower claim, and audits and reviews of Lehman’s public filings.
(V3, Pg 1027)
For my first installment in this series, let’s take
each “colorable claim” individually and give them a
Red
(toast) ,Yellow
(may be vulnerable), or Green
(not likely to be too damaging) rating. I’m not going
to repeat the details from
Anton Valukas’ superb
Bankruptcy Examiner Report
in detail. I’ll offer my opinion and analysis on the “colorable claims,”
EY’s potential defenses, and any details or issues I believe may not have
been covered or any questions left unanswered.
(There’s a great summary of E&Y’s myriad sins and
probably soon-to-be ill-fated Financial Services Office over at
Zerohedge. I will be writing more about this
story, including looking more deeply into the
valuation issues, the impact on the other large
audit firms, the role of
Lehman’s internal audit function, the specific
accounting for the Repo 105 transactions, the relationship of this
bankruptcy to the
Lehman bankruptcy case in the UK, and
my prior theory about the fraud and additional
theories for litigation. )
Ernst & Young failed to
follow professional standards of care with respect to communications with
Lehman’s Audit Committee.
Ernst & Young failed to
follow professional standards of care with respect to an investigation of a
whistleblower claim
Lehman’s own Corporate Audit group
led by Beth Rudofker, together with Ernst & Young, investigated
allegations about balance sheet substantiation problems made in a May
16, 2008 “whistleblower” letter sent to senior management by Matthew
Lee. On June 12, 2008, during the investigation, Lee informed Ernst &
Young about Lehman’s use of $50 billion of Repo 105 transactions in the
second quarter of 2008. At a June 13, 2008 meeting, Ernst & Young failed
to disclose that allegation to the Board’s Audit Committee. (V3
page 945)
As the lawyers would say, the optics are
bad here. The Audit Committee asks EY to support Lehman’s internal auditor
in investigating a
“whistleblower’s” allegations of balance sheet
improprieties. The auditors interview the “whistleblower” and then don’t
say anything at any of the Audit Committee meetings. Turns out what Mr. Lee
the “whistleblower” was alleging is what the examiner believes is the
fundamental problem and grounds for “colorable claims” against top officers
and EY.
The word “whistleblower” is colored with tons of
emotion post-Enron. We now look at those called “whistleblowers” and see
heroes. But let’s look at what I think may have actually happened. Internal
Audit, not EY, was in charge of the investigation.
They “naturally” asked their trusted, all-things-to-all-people advisor, EY,
to help.
That was their first mistake. If I’ve said it
once, I’ve said it a thousand times: The external auditor should not be
conducting or assisting with internal investigations of potential fraud or
illegal acts by top executives. I wrote about it at
Siemens, subject of the largest ever FCPA
settlement in history. KPMG,
their auditor, got sued.
The external auditor should stay the hell away from
internal investigations because they may get caught up in something they
would rather not know. They may want to claim plausible deniability. And a
company should not engage the external auditor to support internal
investigations especially regarding fraud or illegal acts by top management.
Do they do it to be cheap or to keep dirty laundry inside? The external
auditor is too often part of the problem, an enabler, instead of part of the
solution.
If Lehman had hired another firm, a law firm or
anyone except their external auditor, to do the investigation, the
investigation would have been
covered end to end in privilege, the external
auditor may or
may not (in this case EY would have been better
not) have been included in the “circle of privilege,” and the investigation
would have been completed professionally.
However, by supporting this investigation, EY was
essentially doing internal audit work, a prohibited
service under Sarbanes-Oxley
for independence reasons. It’s shocking to me that
the EY audit partners did not at least turn over the investigation to EY’s
Forensic Accounting and Investigations Practice in order to provide some
semblance of independence and professionalism.
Even though EY may have been an unwilling party to
knowledge of an ugly situation right before an audit committee meeting, they
got stuck. They had an obligation under AU 380, as the external auditor -
not as an investigator – to inform the Audit Committee. They could have
been on the other side being informed – or not – instead of being the one
supposed to be doing the informing.
AU 380, the rules
for auditor communication with the Audit Committee, are very clear. But
they relate to the auditors role as an auditor not the role of an
auditor who is lent as muscle to an internal investigation. By playing the
“trusted advisor” they screwed themselves.
Stoplight? Yellow.
Looks bad, but EY may be able to talk their way out of
this one once it gets to court. They need to explain how they were still
looking into the issue, doing their “auditor” work and make sure their full
but limited role and responsibilities for the process are explained. If they
lose on this chalk it up to another case of audit partners wanting to be
supermen to their clients, the corporation’s executives, rather than looking
out for their own best interests. Unfortunately in this situation, the
shareholders were probably going to lose either way.
Ernst & Young failed to
follow professional standards of care with respect to audits and reviews of
Lehman’s public filings.
The Examiner finds that sufficient evidence
exists to support the finding of colorable claims against Richard Fuld,
Christopher O’Meara, Erin Callan, and Ian Lowitt in connection with
their actions in causing or allowing Lehman to file periodic reports
that did not disclose Lehman’s use of Repo 105 transactions and against
Ernst & Young for its failure to meet professional standards in
connection with that lack of disclosure…While there were credible facts
and arguments presented by each that may form the basis for a successful
defense, the Examiner concluded that these possible defenses do not
change the now final conclusion that there is sufficient evidence to
support a finding that claims of breach of fiduciary duty exist against
Fuld, O’Meara [CFO 2004-2007], Callan [CFO 12/07 to 6/2008], and Lowitt
[CFO 6/2008 to Chapter 11 9/08] and a colorable claim of professional
malpractice exists against Ernst & Young.” (V3, pages 990-991)
This one
is about mandated disclosure and unfortunately for EY – and these Lehman
executives – it looks like a prima facie case of securities laws
violation for the executives and malpractice for EY.
Color
this stoplight RED
for “EY is burnt toast.”
EY’s only
hope is perhaps an “in pari delicto” defense. The Lehman
executives will surely be subject to civil and criminal fraud charges. In
that case, given the challenges for a Bankruptcy Trustee who, strictly
speaking, stands in the shoes of felons whose actions may be imputed to
Lehman the corporation, EY may be able to try what PwC and Grant
Thornton/PwC/EY have tried in the
AIG and Refco cases coming before the New York Court of Appeals. But
if those questions are resolved in favor of the plaintiffs, EY will not be
able to count on Fuld, O’Meara, Callan and Lowitt to shield them from
accountability.
Why did
this happen? Well, any obfuscation, if intentional, was meant to fool
investors, ratings agencies,
short sellers, counterparties and anyone else
whose confidence the Lehman executives required. They wanted to appear
to be in better financial shape than they really were – for as long as
possible.
They may have been prolonging the inevitable, but
at some point they knew the inevitable would occur. Liquidity crises are
rarely sudden. But they are often suddenly acknowledged. In Lehman’s case,
the Bear Stearns failure was probably the bell that tolled hollow, loud and
clear.
So why did EY “fail to meet professional standards”
in connection with that lack of disclosure?
Brad
Hintz, Lehman’s CFO in the late 1990’s told Bloomberg
on March 12, “over ten years, a lot of venial sins add
up…” I’m assuming he means the mortal sin of accounting manipulation. I
think that over almost ten years EY may have ignored a lot of venial sins
until “the drug we’re on,” as Lehman’s McDade calls the now notorious
Repo 105 transactions,
added up to the mortal sin of accounting manipulation that was hidden form
investors by lack of disclosure.
Brad Hintz told me that the average CFO tenure
post-Lehman IPO 1994 was 540 days. The Examiners’s Report refers to three
CFOs during the period under examination alone. I’ve already told you what
was wrong with the last two,
Callan and Lowitt. You can sense their boredom and disdain for
accounting details when you read their testimony.
Continued in article
Bob Jensen's threads on Ernst & Young's troubles are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst
Bob Jensen's threads on the Enron/Andersen scandals are
at
http://www.trinity.edu/rjensen/FraudEnron.htm
Bob Jensen's threads on all large international auditing firms ---
http://www.trinity.edu/rjensen/fraud001.htm
March 13, 2010 message from David Albrecht
[albrecht@PROFALBRECHT.COM]
I know that most Big4 lawuits are settled out of
court. Is there anyplace on the web a listing of Big 4 lawsuits?
Although it might be argued
that settling is a business decision, I think a settlement is a symbolic
defeat by the CPA firm.
David Albrecht
March 14, 2010 reply from Bob Jensen
Hi
David,
Lawyers are going to use their very expensive legal research databases. A
list of sources in the U.S. is provided in
http://en.wikipedia.org/wiki/Legal_Research
I
know of no Web reference that records all criminal and civil actions where a
Big Four firm is a defendant.
Big Four lawsuits can arise in over 100 nations (recently one of the largest
actions in history was filed in Hong Kong, where the Ernst & Young partner
in charge was actually jailed) ---
http://www.trinity.edu/rjensen/fraud001.htm#Ernst
In
the U.S. there are both state and federal jurisdictions. And there can be
individual or class action lawsuits brought by plaintiffs. One of the better
sources for federal securities class action lawsuits is the Stanford
University Law School Federal Class Action Clearinghouse ---
http://securities.stanford.edu/
But this by no means covers most of the lawsuits against large auditing
firms. In fact, the database has surprisingly few hits for Big Four firms.
Many of the SEC lawsuits are not in this database.
Keep in mind that auditors are usually secondary in lawsuits with their
clients being the primary defendants. Most of the lawsuits are probably
filed in the state where a corporate client is licensed as a corporation,
which gives Delaware a lot of lawsuits.
For the past ten years I’ve tried to keep tidbits on the highly publicized
lawsuits involving large auditing firms ---
http://www.trinity.edu/rjensen/fraud001.htm
Interestingly, auditing firms sometimes win in courts, as recently happened
when Ernst & Young emerged as a winner.
For lawsuits dealing with derivative financial instruments I also have a
tidbit timeline at
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
Of
course the lawyers are going to use their very expensive legal research
databases. A list of sources in the U.S. is provided in
http://en.wikipedia.org/wiki/Legal_Research
I
don’t have time at the moment, but it would be interesting to see how much
PwC provides in the Comperio database. Since this database is heavily used
by clients, my guess is that Comperio is not a good source for searching
auditor lawsuits.
There are also instances where an auditing firm is a plaintiff, usually
where it is suing a former client.
There can also be criminal cases like the recent case where the managing
partner of PwC in England was charged with stealing money from PwC to pay
for the luxurious tastes of his mistress ---
http://www.trinity.edu/rjensen/fraud001.htm#PwC
Bob Jensen
"Calif
County Accuses Lehman Executives, Auditor Of Fraud In Suit," CNN, November
13, 2008 ---
Click Here
http://money.cnn.com/news/newsfeeds/articles/djf500/200811131743DOWJONESDJONLINE000915_FORTUNE5.htm
The San Mateo County (Calif.) Investment Pool sued
executives of bankrupt Lehman Brothers Holdings Inc. (LEHMQ)
and their accountants, accusing them of fraud, deceit
and misleading accounting practices that led to the loss
of more than $150 million in county funds.
The suit, filed in San Francisco Superior Court, said
executives of the former Wall Street investment bank
made repeated public statements about its financial
strength while privately scrambling to save it from
collapse.
The suit names former Lehman Chief Executive Richard S.
Fuld Jr., former Chief Financial Officers Christopher M.
O'Meara and Erin Callan, former President Joseph M.
Gregory, certain directors and Ernst & Young, Lehman's
auditor.
It accused Lehman of hiding its exposure to
mortgage-related losses while reporting record profits
for fiscal year 2007 and giving bonuses to its
executives.
"The defendants focused their efforts on trying to save
their company and their jobs with little or no regard to
how their egregious actions harmed those who in good
faith invested in Lehman Brothers," said San Mateo
County Counsel Michael Murphy. "In our view, their
actions were blatantly illegal."
The San Mateo County Investment Pool consists of the
county, school districts, special districts and other
public agencies in the county.
San Mateo County Supervisors Richard Gordon and Rose
Jacobs Gibson called for a federal investigation of the
allegations in the suit, and Supervisor Jerry Hill,
newly elected to the state Assembly, will request
hearings on how many California public entities face
similar losses.
Representatives of Lehman and of Ernst & Young were not
immediately available to comment.
This is but one of many lawsuits and criminal
investigations to be faced Ernst & Young and the other
large auditing firms. Survival of the Big Four will be
precarious ---
http://www.trinity.edu/rjensen/Fraud001.htm
|
|
A Rare Event: Convicted of Defrauding the Federal Government
Three individuals have pleaded guilty in a federal
court to scamming the Federal Communications Commission out of over $2.5 million
with organizations they owned that were designed to help people with hearing
impairments. The FCC has a program called Video Relay Service (VRS) for deaf
people and those with related hearing problems. It partners with local
organizations to provide interpreting services over the Internet to allow these
people to communicate with others through webcams and other video-to-video
channels. The local organizations pay their interpreters and are then reimbursed
by the FCC for providing the service, at a generous rate of $390 per hour ($6.50
per minute).
Mike Luttrell, "Three plead guilty to defrauding FCC of millions of dollars." TG
Daily, March 9, 2010 ---
http://www.tgdaily.com/business-and-law-brief/48767-three-plead-guilty-to-defrauding-fcc-of-millions-of-dollars
Bob Jensen's fraud updates are at
http://www.trinity.edu/rjensen/fraudUpdates.htm
Monkey Business
"Ex-Ohio man charged with bilking investors to finance movie 'Who's Your
Monkey'." by Peter Krouse, Cleveland.com, March 3, 2010 ---
http://blog.cleveland.com/metro/2010/03/former_ashtabula_county_man_ch.html
The 2007 dark comedy "Who's Your Monkey?" was
hardly a box office smash.
It played in maybe six cities before being
relegated to DVD.
But the movie has special meaning to a group of
Northeast Ohio investors who unwittingly financed the low-budget flick and
are now clamoring for blood.
Federal prosecutors this week indicted Thomas F.
Fink, 61, formerly of Ashtabula County, and his son Thomas C. Fink, 35. The
financial advisers are charged with looting client accounts, including those
of friends and family.
Instead of putting their clients' money into
conservative investments such as Microsoft stock and GE Capital bonds,
prosecutors said the father and son diverted $4.5 million for other
purposes, including the production of "Who's Your Monkey?"
The scheme began in 2005, according to prosecutors,
when Thomas K. Fink, a financial adviser with AXA Advisors, moved to Las
Vegas to go into business with his son.
The two men created investment funds, including one
called TTF Strategic Growth Partners LLC.
TTF was designed for conservative investments, but
about 25 clients who thought their money was going into blue chip stocks and
bonds later learned their money was spent on the younger Fink's personal
expenses and production of a movie, prosecutors said.
The Finks kept their clients at bay by sending them
bogus account statements, according to the indictment for multiple counts of
mail fraud.
Thomas F. Fink's lawyer said his client is ashamed
of what happened and will plead guilty. The younger Fink is another
question.
"As far as I know, the son has fled to Dubai and is
refusing to return to face this indictment," lawyer Jerry Emoff said.
Emoff said the elder Fink lost his own money in the
fraud and did not know his son used client funds to finance "Who's Your
Monkey?"
"The father really never knew what the son was
doing," Emoff said, but is admitting guilt because he should have kept a
closer watch on things.
It's not clear how Thomas C. Fink came to be
involved with "Who's Your Monkey?" or how the profits -- if there were any
-- were used. The movie cost $625,000 to make, according to the Internet
Movie Data Base.
The film is about four old friends come together
after one of them, an unemployed doctor, uses a martial arts throwing star
to kill (partly in self defense) one of his crystal meth customers who is
involved with animal porn.
The film features Scott Grimes, a former regular on
"ER," and Wayne Knight, who played Newman on "Seinfeld."
Warren Skeels, one of the film's producers, said
more star power would have helped promote the movie.
"A ton of people put a lot of hard work into
bringing that film to fruition," said Skeels, whose Tigerlily Media was
hired to produce the movie in Florida.
All that effort doesn't soothe the feelings of
people like Terry and Debby Fink of North Ridgeville. Terry Fink is Thomas
K. Fink's cousin.
Terry and Debby said they lost their life savings
in the scheme. A few other relatives of the elder Fink, including a cousin
in Middlefield, also lost out.
"Kind of tore the family apart," Debby Fink said.
Debby Fink said she thinks the younger Fink was the
mastermind of the fraud, but that the father should have been more diligent
in tracking the money.
Fink said she didn't know the son very well, but he
was smart, personable and made a lot of wealthy friends while attending
Washington & Lee University in Virginia. She also remembers him spending
time in Dubai and Europe.
"He just lived a very lavish lifestyle," she said.
And she has no interest in watching "Who's Your
Monkey?", the movie her money helped produce.
"It just kind of makes me ill," she said. "I
wouldn't want any part of it."
Bob Jensen's Fraud Updates are at
http://www.trinity.edu/rjensen/fraudUpdates.htm
"In Pari Delicto: Are Auditors Equally At Fault In The Big Fraud Cases?"
by Francine McKenna, Re: The Auditors, March 9, 2010 ---
http://retheauditors.com/2010/03/09/in-pari-delicto-are-auditors-equally-at-fault-in-the-big-fraud-cases/
The phrase in pari delicto
sounds like something dirty to me. Maybe I’m still preoccupied with the
accusation that I’m
producing accounting pornography.
“…the etymology of the term [pornography] is: “Etymology: Greek
pornographos, adjective, writing about prostitutes, from porn prostitute
+ graphein to write; akin to Greek pernanai to sell, porosjourney “
That implies accounting porn is writing about accounting
prostitutes. That being the case, then Francine McKenna, Sam Antar,
Tracy Coenen and Bob Jensen all engage in accounting porn. They write
about the corporate executives and audit firm partners that prostitute
their accounting reports in the search for fictitious profits and all
too real unearned bonuses. In other words, accounting fraud is
accounting prostitution…”
In pari delicto,
for those of you not lawyers or legal argument junkies like me, is “Latin
for “in equal fault”. It’s a legal
term used to indicate that two persons or entities are equally at fault,
whether we’re talking about a
crime or
tort. The phrase is most commonly used by
courts when relief is being denied to both parties
in a
civil action because of wrongdoing by both
parties. The phrase means, in essence, that since both parties are equally
at fault, the court will not involve itself in resolving one side’s claim
over the other, and whoever possesses whatever is in dispute may continue to
do so in the absence of a superior claim.”
There are two active cases where this doctrine and
defense is being employed by auditors trying to avoid liability for fraud.
In Teachers’ Retirement System of Louisiana
v. PricewaterhouseCoopers LLP, No. 454, 2009 (Del. March 4, 2010), one
of many AIG suits that PwC is involved in directly or indirectly, the
Delaware Supreme Court used a procedure provided for under the New
York Rules of Court to
certify a question of law to New York’s highest court, the New York Court of
Appeals.This matter involves an appeal from the
Delaware Court of Chancery regarding the oft-cited AIG case which
denied a motion to dismiss claims against the top officials of AIG for
breach of fiduciary duty based on Delaware law. However, the claims against
the auditor, PwC, were dismissed based on New York law. The Plaintiff’s are
appealing the Chancery Court’ decision regarding PwC. (Summary borrowed for
accuracy from Francis Pileggi at
Delaware Litigation.com who alerted me to this most
unusual move by the Chancery Court.)
The Court of Chancery held that the claims against PwC
were governed by New York law, and that based on the allegations of
the Complaint, AIG’s senior officers did not “totally abandon[]”
AIG’s interests—as would be required under New York law to establish
the “adverse interest” exception to imputation. Accordingly, the Court
of Chancery held that the wrongdoing of AIG’s senior officers is imputed
to AIG.3 The Court of Chancery concluded that, once the wrongdoing
was imputed to AIG, AIG’s claims against PwC were barred by New York’s
in pari delicto doctrine and by the related Wagoner line of
standing cases in the United States Court of Appeals for the Second
Circuit.
This Court hereby certifies the following question to the New
York Court of Appeals:
Would the doctrine of in pari delicto bar a derivative
claim under New York law where a corporation sues its outside auditor
for professional malpractice or negligence based on the auditor’s
failure to detect fraud committed by the corporation; and, the
outside auditor did not knowingly participate in the corporation’s
fraud, but instead, failed to satisfy professional
standards in its audits of
the corporation’s financial statements?
The other case where the in pari
delicto defense has tied the litigation into knots and
caused some stops and starts is in Kirschner v. KPMG LLP et al.,
case number 09-2020, in the U.S. Court of Appeals for the Second Circuit
which is about the
Refco fraud.
The
Second Circuit certified the questions about
an exception to the in pari delicto defense.
Now they have two high profile cases against auditors to consider. From
Law360.com:
Not one to go down easy, the bankruptcy trustee for
Refco Inc. brought his suit implicating
Mayer Brown LLP,
KPMG LLP and other corporate giants in the massive Refco fraud to a
federal appeals court…The U.S. Court of Appeals for the Second Circuit
found Monday that trustee Marc S. Kirschner’s fight to revive his claims
against the clutch of corporate insiders raised critical unresolved
questions concerning the bankruptcy trustee’s standing under New York
law to sue third parties for Refco’s fraud.
The trustee alleges outside counsel Mayer Brown, auditors
Ernst & Young LLP, [Grant Thornton]
PricewaterhouseCoopersLLP, Banc of America Securities LLC and
several other insiders are liable for defrauding Refco’s creditors,
namely by helping the defunct brokerage conceal hundreds of millions of
dollars in uncollectible debt.
Steve Jakubowski, a local Chicago lawyer who writes
the
Bankruptcy Litigation Blog, sponsored a guest
post in January by Catherine Vance, one of the
fiercest critics of the “expansive” use of the in pari delicto
defense. He introduces her post this way:
Whatever you may think about the fact that Refco’s outside corporate
counsel, Joe Collins, was convicted on 5 criminal counts and
sentenced today to 7 years in prison, one has to wonder how the
system got so turned upside down on the civil side that while the law
firm’s lead lawyer is torched in criminal court, his firm is summarily
dismissed from a civil case for precisely the same conduct on a simple
motion to dismiss (based on a theory that
the Refco trustee lacked standing to bring suit to recover for damages
arising from a fraudulent scheme devised and carried out by Refco’s own
senior management). One could argue that this result is unique to
the Second Circuit (and
the Seventh) because of the Wagoner decision and its progeny (which
are not followed in the First, Third, Fifth, Eighth, or Eleventh
Circuits). Even in those circuits, however, management’s wrongful
conduct has been imputed to the corporation under the in pari delicto
doctrine to just as effectively knock the props out from civil actions
involving some of the most spectacular commercial frauds of the century.
Ms. Vance wrote an article entitled, In
Pari Delicto, Reconsidered, in which she
posited–as none had before–that the in pari delicto
doctrine is being inappropriately used by federal courts to supplant
traditional tort law defenses that derive from state, not federal, law.
The way I see it, the in pari delicto
doctrine is being used like a pair of needle nosed pliers by
audit firm defense lawyers to diffuse a bomb – huge liability for some of
the biggest frauds in history. The in pari delicto
doctrine attempts to pull the auditors’ tails from the fire by excusing any
of their guilty acts due to the approval of those acts by potentially
equally guilty executives. The law allows these executives to continue to
“stand in the shoes” of the shareholder plaintiffs even after their guilt
has been determined. The theory is that the executives perpetrated the fraud
for the benefit of the corporation and never “totally abandoned” it, as
would be required for the “adverse interest” exception.
Auditors who should otherwise be tested on their
fulfillment of their public duty are instead getting reprieves because
courts have been unwilling to impose the
“adverse interest” exception as expansively as
they have the in pari delicto defense itself. How
can executives who are successfully sued, been subject to regulatory
sanctions or, in the case of the Refco executives, plead guilty to criminal
activities, still be considered representatives of the corporation’s
interests? They should forfeit the right to stand in the shoes of the
corporation’s shareholders in derivative suits and therefore to shield other
potentially guilty or negligent parties.
The situation gets complicated in a bankruptcy case
such as Refco since, traditionally according to
Section 541 of a decision called
In re PSA, Inc, “property of the bankruptcy
estate consists of all legal or equitable interests of the debtor, including
causes of action, as of the commencement of the bankruptcy case. A
bankruptcy estate’s causes of action, therefore, as well as the attendant
defenses thereto, transfer to the bankruptcy trustee frozen and fixed as
they existed at the commencement of the bankruptcy case. As a result, an
“innocent” bankruptcy trustee “stands in the shoes” of the pre-petition
debtor and may be unable to prevail on estate causes of action where the
pre-bankruptcy debtor participated or was complicit in the wrongful acts
upon which the estate attempts to sue.”
A trustee in bankruptcy must have
standing to sue anyone on behalf of the
creditors and other injured parties. Unfortunately, this habit of allowing
guilty parties to continue to drive the bankruptcy bus by having the
actions
of the guilty officers “imputed” to the corporation
and, therefore, in bankruptcy to the trustee
potentially threatens the trustee’s ability to sue “co-conspirators.”
It’s just nuts.
Akin Gump summarizes critics of this line of
reasoning this way:
The purpose of the in pari delicto defense,
they argue, is to prevent a party who is complicit in wrongdoing from
prevailing against their joint actors. In their view, the intercession
of an innocent trustee whose duty it is to maximize the value of the
estate for the debtor’s creditors purges the taint of the debtor’s
wrongdoing, and that to hold otherwise would simply elevate the legal
fiction of section 541 over the purpose of the in pari delicto defense.
Ms. Vance reminds us in her
treatise that in
pari delicto was ushered into modern
bankruptcy jurisprudence as a part of the
deepening insolvency
discussion. I’ve written about deepening insolvency many times as it relates
to the auditors who, by continuing to provide false and negligent clean
audit opinions, allow a company to go deeper and deeper into debt and ruin,
thereby significantly diminishing any remaining value for stakeholders once
the gig is up.
The deepening insolvency
arguments have been
shot down by no less than
Judge Posner whose pernicious pragmatism forces
him to engage in the self-delusion that helping companies remain “viable”
via fraud doesn’t hurt anyone. This fantasy presupposes the company to be a
person and not the embodiment of the goals and objectives, hopes and dreams,
faith and trust of the shareholders, employees, creditors, and community
that count on it to continue legally and honorably instead. I suppose a
Supreme Court that allows corporations to donate money to political
campaigns in an exercise of their inalienable
constitutional rights would not find this idea so strange.
Continued in article
Bob Jensen's threads on auditor fraud and negligence are at
http://www.trinity.edu/rjensen/fraud001.htm
February 5, 2010 message from Francine McKenna
[retheauditors@GMAIL.COM]
An interesting syllabus for a
course at U Central Florida by Steve Sutton.http://www.bus.ucf.edu/ssutton/
Ethics and Professionalism in Accounting and
Auditing (ACG 6835)
Spring 2010
Course Schedule
http://www.bus.ucf.edu/ssutton/A6835_syl_files/A6835_course_schedule.htm
If anyone else includes my
content in their syllabus, please let me know. I am making a list of
professors teaching using "non-traditional" sources.
[retheauditors@GMAIL.COM]
(I'd also love to visit!)
Thanks.
fm
February 6m 2010 reply from Bob Jensen
Hi Francine,
Thank you for the heads-up.
I think the (slow loading) Baylor University video should be
included in the curriculum of every accounting program and possibly the
curriculum of every high school in the U.S.
June 15, 2009 message from Dennis Beresford
[dberesfo@TERRY.UGA.EDU]
I apologize if this is
something that has already been mentioned but I just became aware of a very
interesting video of former WorldCom Controller David Meyers at Baylor
University last March -
http://www.baylortv.com/streaming/001496/300kbps_str.asx
The first 20 minutes is
his presentation, which is pretty good - but the last 45 minutes or so of Q&A is
the best part. It is something that would be very worthwhile to show to almost
any auditing or similar class as a warning to those about to enter the
accounting profession.
Denny Beresford
Jensen Comment on Some Things You Can Learn from the Video
David Meyers became a convicted felon largely because he did not say no when his
supervisor (Scott Sullivan, CFO) asked him to commit illegal and fraudulent
accounting entries that he, Meyers, knew were wrong. Interestingly, Andersen
actually lost the audit midstream to KPMG, but KPMG hired the same same audit
team that had been working on the audit while employed by Andersen. David Myers
still feels great guilt over how much he hurt investors. The implication is that
these auditors were careless in a very sloppy audit but were duped by Worldcom
executives rather than be an actual part of the fraud. In my opinion, however,
that the carelessness was beyond the pale --- this was really, really, really
bad auditing and accounting.
At the time he did wrong,
he rationalized that he was doing good by shielding Worldcom from bankruptcy and
protecting employees, shareholders, and creditors. However, what he and other
criminals at Worldcom did was eventually make matters worse. He did not
anticipate this, however, when he was covering up the accounting fraud. He
could've spent 65 years in prison, but eventually only served ten months in
prison because he cooperated in convicting his bosses. In fact, all he did after
the fact is tell the truth to prosecutors. His CEO, Bernard Ebbers, got 25 years
and is still in prison.
The audit team while with
Andersen and KPMG relied too much on analytical review and too little on
substantive testing and did not detect basic accounting errors from Auditing 101
(largely regarding capitalization of over $1 billion expenses that under any
reasonable test should have been expensed).
Meyers feels that if
Sarbanes-Oxley had been in place it may
have deterred the fraud. It also would've greatly increased the audit revenues
so that Andersen/KPMG could've done a better job.
To Meyers' credit, he did
not exercise his $17 million in stock options because he felt that he should not
personally benefit from the fraud that he was a part of while it was taking
place. However, he did participate in the fraud to keep his job (and salary). He
also felt compelled to follow orders the CFO that he knew was wrong.
The hero is detecting the
fraud was Worldcom's internal auditor Cynthia Cooper who subsequently wrote the
book:
Extraordinary Circumstances: The Journey of a Corporate Whistleblower
(Hoboken, New Jersey: John Wiley & Sons, Inc.. ISBN 978-0-470-12429)
http://www.amazon.com/gp/reader/0470124296/ref=sib_dp_pt#
Meyers does note that the
whistleblower, Cooper, is now a hero to the world, but when she blew the whistle
she was despised by virtually everybody at Worldcom. This is a price often paid
by whistleblowers ---
http://www.trinity.edu/rjensen/FraudConclusion.htm#WhistleBlowing
Bob Jensen's threads on
the Worldcom fraud are at
http://www.trinity.edu/rjensen/FraudEnron.htm#WorldcomFraud
Other possible source material for ethics, independence, and
professionalism courses is available at
http://www.trinity.edu/rjensen/fraud001.htm#Professionalism
The above site begins with one of my all time favorite quotations
(from Steve Samek) that indirectly suggests that no matter how much ethics and
professionalism is beat into the heads of students/employees in college and CPE
courses, it might help but probably is like trying to get obese people to lose
200 pounds by taking nutrition courses. Andersen had some of the best ethics and
professionalism courses ever developed, including a very expense set of CDs.
The day Arthur Andersen loses the public's
trust is the day we are out of business.
Steve Samek, Country Managing Partner, United States, on Andersen's
Independence and Ethical Standards CD-Rom, 1999
If a man's poor and not a bad fellow, he's
considered worthless; if he is rich and a very bad fellow, he's considered a
good client.
Attributed to Titus Maccius Plautus, 255 BC to 185 BC
In spite of all the warning signs, Enron was considered to be a juicy client.
Andersen billed Enron over $1 million per week.
Business Ethics ---
http://en.wikipedia.org/wiki/Business_ethics
Lots of Good Links
Business Ethics by Business Week ---
http://bx.businessweek.com/business-ethics/news/
Advancing Quality through Transparency Deloitte LLP Inaugural Report ---
http://www.cs.trinity.edu/~rjensen/temp/DeloitteTransparency Report.pdf
In my opinion the best preventative for ethics, independence, and
professionalism violations is a very intensive whistleblower program that is
much more than a sham ---
http://www.trinity.edu/rjensen/FraudConclusion.htm#WhistleBlowing
At Andersen it proved to be a sham!
"Auditor Received Warning on Enron Five Months Ago," by Richard A.
Oppel, Jr., The New York Times, January 17, 2002 ---
http://www.trinity.edu/rjensen/FraudEnron.htm#Hoax
According to
Congressional investigators, the Enron employee, Sherron S. Watkins, called a
former colleague at Andersen on Aug. 20 and told him of her concerns about the
energy company's accounting. About the same time, Ms. Watkins also laid out her
doubts in a letter to Enron's chairman, Kenneth L. Lay, disclosed earlier this
week by a Congressional committee, that warned that the company might be
revealed as an "elaborate accounting hoax."
Ms. Watkins's letter
pointed to new questions about Enron's web of partnerships and raised the
possibility that the company might have to reduce past earnings by $1.3 billion
more than it already has.
In an internal Andersen
memorandum obtained by the House Energy and Commerce Committee, Ms. Watkins's
former colleague at Andersen wrote that "based on our discussion I told her she
appeared to have some good questions."
On the next day, Aug. 21,
four Andersen officials met to discuss Ms. Watkins's concerns, investigators
said. They included David B. Duncan, the lead partner on the Enron account, whom
Andersen fired this week after saying he ordered the destruction of Enron
documents while the company's accounting was under investigation by the S.E.C.
The officials then
"agreed to consult with our firm's legal adviser about what actions to take in
response to Sherron's discussion of potential accounting and disclosure issues,"
according to the memo.
Investigators say
Andersen began the destruction of Enron documents in September and that an
e-mail message from an Andersen lawyer on Oct. 12 re-emphasized Andersen's
policy on destroying documents and encouraged the activity in the firm's Houston
office.
Mr. Duncan, who is
cooperating with authorities, spent hours in Washington today with government
officials who are investigating the failure of Enron, the Houston company that
pioneered energy deregulation and grew to be the nation's seventh-largest
company before seeking bankruptcy protection last fall.
He met for the second
time this week with officials from the Justice Department, which is conducting a
criminal investigation of Enron's collapse. On Monday — the day before Andersen
fired him — Mr. Duncan met with Justice Department officials as well as staff
members from the S.E.C. and agents from the F.B.I., according to people close to
the inquiries.
This afternoon, he spent
more than four hours answering questions from eight investigators for the House
Energy and Commerce Committee, one of several panels in Congress reviewing
Enron's demise. Flanked by his lawyers, Mr. Duncan was not sworn, but he was
warned not to give false statements to Congress. There was no discussion of
giving him immunity for his testimony, investigators said.
"He answered our
questions and provided us with some valuable information, which we are
pursuing," said Ken Johnson, a spokesman for Representative Billy Tauzin, a
Louisiana Republican and chairman of the committee. Mr. Johnson declined to
comment in detail about the interview but said that Andersen's shredding of
documents and handling of the Enron account were discussed.
Continued at
http://www.nytimes.com/2002/01/17/business/17ENRO.html
David's February 25, 2010 Book Review
"Shell Games by Sara McIntosh," by David Albrecht, The Summa,
February 25, 2010 ---
http://profalbrecht.wordpress.com/2010/02/25/shell-games-by-sara-mcintosh/
Sara McIntosh (a pseudonym) has published her first
novel, Shell Games, a financial action/thriller. It’s a good first
novel, and well worth the time invested for reading. [ordering
information]
Shell Games is a fun read for anyone.
Accountants, though, will receive an extra dose of enjoyment. The plot is
thrilling. In some tense scenes, I found myself cheating a look at the
final chapter to see how the story ends.
When considering the sub-genre of financial
action/thriller novels that showcase the role of fraud auditor (aka
financial sleuth or forensic accountant), there are few options. Well,
there has been only one serious option–The Devil’s Banker by
Christopher Reich. Shell Games is a pleasant contrast to the heavy
international espionage of Reich.
The Devil’s Banker
is a complicated story of international terrorist money transfer, with
bombs, assassinations and too many characters. It reads much like a Bond
film, with a super sleuth accountant as a Daniel Craig type of 007. The
male protagonist does all the heavy duty accounting, and a female spy does
most of the heavy action. Reich never convinces me, though, that the hero
is truly an accountant. Perhaps it’s because Reich has a finance, not an
accounting background. This is never more apparent than in Reich’s
Numbered Account, a story that would greatly have benefitted from some
nuts-and-bolts accounting, had Reich been able to supply it.
In McIntosh’s Shell Games, though, we
suffer no such handicap. The heroine–super sleuth and super sexy Marjorie
Stevens–is all accountant. She is convincing as a fraud auditor because
McIntosh was a fraud auditor. McIntosh’s bio reveals she was a, “fraud
auditor and financial executive for two of the largest consumer products
companies in the world, [and] uncovered numerous frauds, including one that
earned her … [an award for] ‘Finance Person of the Year’.” In addition, she
“founded her own finance and accounting consulting business, serving Fortune
100 companies” that could investigate fraud in global financial
operations.” Shell Games is convincing because McIntosh truly has
been there and done that, and she is a good enough writer to be able to show
us her former world. Obviously, there is a lot of Sara McIntosh (SM) in
Marjorie Stevens (MS).
McIntosh’s female perspective is a significant
influence. Instead of a male dominated action thriller with several shoot
‘em up scenes, the fast-paced action of Shell Games is moved along by
characterization and charming characters. Be prepared for women that are
effective and efficient in their roles (a woman is up for Chair of the
Securities and Exchange Commission) and men are not. Needless to say, the
women are uber attractive despite having passed their 39th birthdays.
Continued in article
Bob Jensen's Fraud Updates ---
http://www.trinity.edu/rjensen/fraudUpdates.htm
His lawyer, Murray Richman, told reporters in
the courthouse hallway that the councilman’s conduct did not constitute a crime.
That must've been one big bagel!
Excuse me. I was just distracted by the new
66-page federal indictment of Larry Seabrook, a New York City councilman who,
along with multitudinous other charges, is accused of altering a receipt from a
deli so he could get a $177 reimbursement for a bagel and diet soda.
Gail Collins,
The Biggest Losers, The New York Times, February 10. 2010 ---
http://www.nytimes.com/2010/02/11/opinion/11collins.html?hpw
But his attorney says that no crime was committed. This is acceptable behavior
of elected officials.
"Councilman Charged With Money Laundering," by Ray Rivera and William K.
Rashbaum, The New York Times, February 9, 2010 ---
http://www.nytimes.com/2010/02/10/nyregion/10seabrook.html
City Councilman Larry B.
Seabrook, a fixture in Bronx Democratic politics for more than two decades, was
charged on Tuesday with money laundering, extortion and fraud in a series of
schemes that included helping a close associate win a contract to install
boilers in the new Yankee Stadium and siphoning hundreds of thousands of dollars
in city money to himself, friends and family members.
Most of the charges in
the 13-count federal indictment revolve around Mr. Seabrook’s use of Council
discretionary funds, known as earmarks, to finance a string of nonprofit groups
that city and federal authorities say ultimately did little for the communities
they were supposed to aid.
Prosecutors say Mr.
Seabrook closely controlled the groups’ budgets and personnel decisions, helping
them to win city contracts and using the money to pay more than $500,000 in
salaries and consulting fees to his female companion, his brother, two sisters
and other family members.
Mr. Seabrook, 58, and
others were able to do this, prosecutors contend, in part by repeatedly
inflating expense claims to the city on the part of the nonprofit groups,
including rent costs. From 2002 to 2009, Mr. Seabrook directed more than $1
million to the groups while never disclosing his close affiliation with them.
The conduct alleged in
the indictment ranges from the ambitious to the nearly silly: from extorting
payments from a close associate to help win the boiler contract to altering a $7
receipt for a bagel sandwich and diet soda so that Mr. Seabrook was reimbursed
$177 for the purchase.
Mr. Seabrook, a former
assemblyman and state senator who in November won re-election for his third
Council term, pleaded not guilty. He is the second councilman charged in recent
months with stealing city money through the discretionary process. In July,
former Councilman Miguel Martinez, a Democrat who represented Upper Manhattan,
pleaded guilty to three felony counts involving the theft of $106,000, some of
which was intended for nonprofit organizations. He was sentenced in December to
five years in prison.
Mr. Seabrook, who over a
26-year political career has survived scares and scrapes with a variety of
investigations and audits, could face considerably more time if he is found
guilty on all or some of the charges in the indictment, most of which carry a
maximum sentence of 20 years.
In Federal District Court
in Manhattan on Tuesday, Mr. Seabrook, wearing gray suit pants, a matching vest
and a white shirt buttoned to the neck with no tie, pleaded “not guilty” in a
loud voice before United States Magistrate Judge Henry B. Pitman.
He was released on a
$500,000 personal recognizance bond. His
lawyer, Murray Richman, told reporters in the courthouse hallway that the
councilman’s conduct did not constitute a crime.
“We have no hesitation in
saying that we don’t perceive that a crime was committed,” Mr. Richman said,
adding, in reference to a check that was issued to reimburse the councilman for
what he said were legitimate expenses, “That’s laundering? I question that.”
At a news conference,
Preet Bharara, the United States attorney for the Southern District of New York,
said that through the use of discretionary funds, Mr. Seabrook “basically
operated his own corrupted City Council-funded friends and family plan.”
Rose Gill Hearn, the
city’s investigations commissioner, described the fraudulent schemes alleged in
the indictment as “breathtaking.” Even after one of the nonprofit groups was
flagged by city auditors for financial impropriety, she said, Mr. Seabrook
“found ways to dodge scrutiny and keep the money flowing.”
The allegations are
another blow to the embattled City Council, which over the course of a two-year
investigation by federal prosecutors and the city’s Department of Investigation
has been forced to take several steps to bring more transparency to the way it
distributes millions of dollars in discretionary funds each year.
Speaker Christine C.
Quinn said in a statement on Tuesday that all of the members of the Council
“take the deeply troubling allegations” against Mr. Seabrook “very seriously,”
adding that the matter was immediately referred to the body’s Standards and
Ethics Committee, which will convene as early as next week.
Mayor Michael R.
Bloomberg declined to comment on the specifics of the allegations on Tuesday,
saying he had not read them. At the same time he defended the Council and the
administration’s efforts to clean up its discretionary financing process.
Four of the 13 counts in
the indictment are based on what prosecutors allege was Mr. Seabrook’s
successful lobbying effort to help his close associate win the nearly $300,000
subcontract to install two boilers at the new Yankee Stadium and his direct
solicitation of $50,000 in payments from the man, much of which Mr. Seabrook
then funneled through his political committee.
Continued in article
Bob Jensen's threads on the sad state of governmental accounting are at
http://www.trinity.edu/rjensen/theory01.htm#GovernmentalAccounting
"SEC Discord Could Stymie Schapiro's Efforts," by Kara Scannell,
The Wall Street Journal, February 6, 2010 ---
http://online.wsj.com/article/SB20001424052748703894304575047623539208044.html#mod=todays_us_section_b
No one said it would be easy. But one big part of
Securities and Exchange Commission Chairman Mary Schapiro's job—winning the
support she needs from the agency's commissioners—is turning into a
headache.
Since taking over the embattled agency in January
2009, the 54-year-old Ms. Schapiro has brought in a new enforcement chief,
created a division to scout out market risks and laid out an ambitious
rule-making agenda to restore market confidence. The number of formal
investigations launched and temporary restraining orders sought more than
doubled last year from 2008. It takes about six months for the average SEC
rule to make it through the pipeline, down from 10 months.
Suddenly, though, Ms. Schapiro is hitting some
speed bumps inside the SEC. Usually, the five-person panel that must approve
new rules unanimously backs the agency's chairman. Under Ms. Schapiro, who
was sworn in a week after President Barack Obama, SEC commissioners have
splintered four times, with two Republicans suggesting that she is bending
to politics.
Last week, Commissioner Kathleen Casey, a
Republican appointed by President George W. Bush, accused the agency of
placing "the imprimatur of the commission on the agenda of the social and
environmental policy lobby" by issuing guidance encouraging companies to
disclose the effects of climate change on their businesses.
While the measure passed by a 3-2 vote, Ms.
Schapiro has been lambasted by Republican lawmakers. Rep. Spencer Bachus,
the House Financial Services Committee's top Republican, accused her of
pushing a "partisan political agenda."
The discord from within could complicate Ms.
Schapiro's efforts to push through more changes in the second year of her
cleanup. Friday, she said the agency will decide by the end of March on
proposed rules to put brakes on short selling, where investors borrow shares
and then sell them in hopes of making money from the stock's decline.
The ideas being reviewed include a circuit breaker
that would be triggered when a stock falls by a certain percentage. People
familiar with the matter say the agency is looking for steps that would be
the least intrusive to the market. Troy Paredes, a Republican who joined the
commission in 2008, voted for an earlier version of the short-selling
proposal but warned that the SEC needed "room" to "exercise [its] expert
judgment." Mr. Paredes didn't respond to requests for comment. Ms. Casey
also expressed skepticism.
In addition, the SEC is expected to take up soon
the long-controversial issue of whether to let shareholders nominate
director candidates using the ballots that companies mail to shareholders.
Shareholders now must fund their own proxy fights, which rarely happens.
Unions and some institutional investors support
giving shareholders more muscle, while some executives have warned that
frequent director battles could disrupt business and conflict with state
laws. The SEC voted 3-2 last year to issue the proposal for public comment,
with the two Republican commissioners dissenting.
Ms. Schapiro says more than 90% of enforcement
actions and more than 80% of open-meeting votes since she took over have
been approved unanimously. "We haven't shied away from difficult issues
because I think these are times that call for people to make hard choices,"
she said in an interview.
She denies accusations that she is bending over
backward to satisfy Democrats. "While we are interested in Congress's views,
it doesn't drive our agenda," Ms. Schapiro said.
The recent guidance on climate change, for example,
came after the SEC got petitions from investors who "had close to $1.4
trillion under management, and we didn't go anywhere near as far as they
asked us," she said.
Some outsiders say the split votes aren't a sign of
impending paralysis that would derail Ms. Schapiro's agenda as much as her
willingness to impose new regulations. Her predecessors also ran into
opposition from commissioners. But too much resistance could make it hard
for Ms. Schapiro to follow through on her strategy for revamping the SEC
following the financial crisis and Bernard Madoff fraud.
That includes persuading the sharply divided
Congress to give the SEC additional funding and wider authority.
"I would not like to see the commission devolve
into a steady stream of 3-2 votes," said Harvey Pitt, SEC chairman from 2001
to 2003. Ms. Schapiro has "really gotten off to a fabulous start" and is
"very tuned in to what needs to get done at the SEC," Mr. Pitt added.
Richard Roberts, an SEC commissioner from 1990 to
1995, said Ms. Schapiro might have miscalculated in her handling of the
climate-change vote. "When you wade into a polarized issue that's not
necessarily at the center of investor protection, there can be consequences
associated with that that are not always positive," he said.
James Cox, a securities-law professor at Duke
University, said critics of Ms. Schapiro are ignoring recent signs of her
political independence. For instance, she has said the Obama
administration's proposal to designate the Federal Reserve as the nation's
systemic-risk regulator needs to be tempered by a robust council of
regulators, compared with the administration's weaker council. "I give her
high marks of being independent of the administration's position," Mr. Cox
said.
Ms. Schapiro's split votes remind some securities
experts of William Donaldson, a Republican and longtime Wall Street
executive brought in as SEC chairman in 2003 to restore investor confidence
after the Enron and WorldCom scandals. He faced opposition from his own
party while pushing through a rule requiring hedge-fund advisers to register
with the agency. The rule was later tossed out by a federal appeals court.
Harvey Goldschmid, who often voted with Mr.
Donaldson as a Democratic commissioner, says commissioners who don't agree
with the chairman "should also be careful that they not jeopardize the
commission's reputation for independence and integrity by dissenting
unnecessarily."
Bob Jensen's threads on the shortcomings of the SEC are at
http://www.trinity.edu/rjensen/2008Bailout.htm#SEC
SEC Warns of Fraudulent Website Targeting Madoff's Victims
The U.S. Securities and Exchange Commission (SEC) on Wednesday warned investors
of a Web site that falsely claims to have recovered $1.3 billion in funds hidden
by convicted Ponzi schemer Bernard Madoff in Malaysia.
SmartPros, March 10, 2010 ---
http://accounting.smartpros.com/x68988.xml
Adjustable Rate Mortgage ---
http://en.wikipedia.org/wiki/Adjustable_Rate_Mortgage
Video: Strong ARM of Mortgage Bubble is Building to Burst:
"Second Financial Economic Crash Coming - Huge & Soon," CBS Sixty Minutes
---
http://www.youtube.com/watch?v=JKlBJavw_X4
"Dear Bank of America, I'd Like to Schedule a Default," by Austin
Hill, Townhall, January 3, 2009 ---
http://townhall.com/columnists/AustinHill/2010/01/03/dear_bank_of_america,_id_like_to_schedule_a_default
Dear Bank of America;
Hi, it’s me, your customer Austin. I’m writing to
schedule my mortgage default.
That’s right, I’m ready to schedule my mortgage
default. Does that sound strange?
Well, believe me, Bank of America, I had hoped that
our relationship wouldn’t come to this. But after months of trying to do
business with you, I’ve decided that it’s probably in my best interest to
just, you know - “walk away” from my mortgage.
How could it ever be in anyone’s best interest to
default on a mortgage? And why would anyone ever want to default on a
mortgage?
Well, here’s the deal: I have one of those
now-famous “Option ARM” loans on my residence – the interest rate is
adjustable, and the loan provides optional payment plans. And yes, Bank of
America, you inherited my loan when Countrywide Lending went down the tubes
in 2008, and you merged your company with theirs.
And here are some other details about me, Bank of
America: I am fortunate to have a great job with a solid income, and I work
under a long term employment contract. While my full time occupation is
being a daily talk show host, I am also a writer and a public speaker, so I
have multiple streams of income. I own real estate in multiple regions of
the U.S., and I’m a big believer in real estate as a long term investment.
And perhaps most interesting for you, Bank of America, I have a great credit
score, and I’m current on all my debt payments.
During the recent real estate “boom,” I took some
equity out of my home. Now, in the aftermath of the real estate “bust,” my
house is slightly “under water” – not by much, but a little. And the
interest rate on my loan won’t begin to move upward for another two years,
so I’m not in any crisis right now.
The value of my property has actually begun to move
upward a bit in the past few months, but it’s going to be a few years before
the value reaches parity with my debt. And that’s why I was thrilled to get
that little note you sent me in the mail last summer, Bank of America.
Remember? You sent me that nice letter asking if I’d like to have my loan
modified to a 30 year, fixed rate mortgage.
I responded quickly to that letter, Bank of
America. And I’ve called repeatedly for over half a year. But here’s the sad
truth that I’ve discovered about you: you’re not really interested in
working with me, because I’m not behind on my payments
With each and every call, Bank of America, I get
the same treatment. Once your customer service representative checks the
data base and realizes that I’m current on my payments, they “transfer my
call” to “another department” – and from there, I’m left on hold. If another
representative picks up, they want to transfer me again. And if I actually
have a conversation with anybody, I’m treated to a person reading through a
litany of “assessment questions” and surveys and evaluations. And then I’m
transferred again.
After repeatedly being told that there is immediate
help available to Bank of America customers who are delinquent, I finally
started asking, “so will you talk to me about a loan modification if I stop
making payments?” And to that question, I’ve repeatedly heard the same
answer: “I could never advise you to not make your payments Mr. Hill” the
representative will say, “I’m just telling you that if you become delinquent
we have help available…”
I’m not the only person who has this disturbing
kind of relationship with you, Bank of America. I discussed this on my talk
show in Boise, Idaho, and was inundated with calls and email detailing the
same sad story. I even addressed this over the holidays on a radio talk show
where I was guest hosting in Phoenix, Arizona – one of the most tumultuous
real estate markets in the country – and got the same response.
I’ve also talked with lots of personal friends
about this, Bank of America. People from Los Angeles to Chicago to
Washington, D.C., and from all walks of life. People with high school
diplomas and M.D.’s and MBA’s and Ph.D’s and J.D.’s. We’re current on our
payments, have great credit, and want to continue our relationships with
you. But you’re not taking our calls.
It’s sad to realize that as you focus on your
“troubled assets,” and ignore those of us with good credit, you’re likely
creating more troubled assets in the process. But that’s the system you’ve
put in place, Bank of America. It’s a system that rewards people’s bad
behavior, while punishing other people’s good behavior.
So after spending half a year trying to take
advantage of the offer you extended to me in the mail, I now understand what
your actual system entails. And I’ve calculated the risks of working within
the system you’ve put in place.
I’m ready to schedule my default. What would you
like to do next?
Bob Jensen's threads on sleaze in granting mortgages ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze
At the SEC: Madoff
Déjà vu on
Ignoring Whistleblowers
"At SEC, the system can be deaf to whistleblowing," by Zachary A.
Goldfarb, The Washington Post, January 21, 2010 ---
http://www.washingtonpost.com/wp-dyn/content/article/2010/01/20/AR2010012005125.html?wpisrc=nl_pmtech
Eric Kolchinsky was an executive at Moody's, the
credit rating company, when he called a top official at the Securities and
Exchange Commission in September to warn that his firm might be violating
securities law. He reported that Moody's was blessing mortgage-backed
investments that it knew were dangerous, according to a person familiar with
the conversation. The SEC official assured Kolchinsky that someone from the
agency would call him back shortly.
But the call never came, Kolchinsky later told
congressional investigators who were examining how the credit rating
industry's failures contributed to the financial crisis. He had gone to
Congress after losing patience with the SEC.
Kolchinsky is one in a series of whistleblowers who
in recent years tried to tip off the SEC to potential wrongdoing, only to be
ignored, misunderstood or left to wonder whether they were being listened
to. The SEC has no system in place to guide how officials should handle tips
and complaints from outsiders, making it difficult for investigators to take
advantage of an invaluable source of information.
This failure helped to continue two of the most
celebrated frauds of the last decade for several years, potentially costing
unwitting investors millions of dollars. Countless others may have been left
vulnerable to shysters because of warnings that went unheeded.
Since SEC Chairman Mary L. Schapiro took office
last year, she has said that fixing the holes in the process for handling
tips and complaints has been a top priority. But improving the way hundreds
of thousands of tips are analyzed and pursued has proven difficult.
The SEC's enforcement division got back in touch
with Kolchinsky about his allegations only after he told the story publicly
to a congressional committee last fall, according to a person familiar with
the matter.
The SEC said it responded to Kolchinsky's concerns
but declined to provide details or to say how fast it did so. Moody's said
it examined his allegations and found nothing improper.
The SEC has a haphazard, decentralized system for
analyzing outsider information. Tips arrive by phone, mail and e-mail to
officials throughout the agency -- investor education to enforcement
divisions. A study commissioned by the SEC last year and conducted by Mitre,
a nonprofit group that does research for the federal government, found that
the SEC lacks technology to analyze tips and complaints, as well as cohesive
policies for what officials should do when they get information.
Whistleblower complaints are one of the main ways
that investigators should be tipped to wrongdoing, SEC officials say, along
with inconsistencies in financial filings and alerts from financial
exchanges about suspicious trading patterns. But the SEC lags behind some
other federal agencies in handling tips. The Internal Revenue Service, for
instance, pays reward money to whistleblowers who provide credible
information about tax fraud. The Federal Trade Commission has set up a call
center for tips and complaints.
On top of structural problems at the SEC, agency
officials individually made mistakes in handling several recent cases,
sometimes violating agency rules.
Members of Schapiro's management team said they
recognized problems with the system for handling whistleblowers shortly
after taking over.
"There was no uniformity to it. Every division and
office had its own system of recording, tracking or handling tips and
complaints. That system was pretty rudimentary," said Steve Cohen, the
official tasked by Schapiro to overhaul the agency's tips, complaints and
whistleblower program. "We're already working to acquire and deploy
technology that centralizes all of the agency's tips and complaints so they
can be sorted, reviewed, analyzed and tracked."
Bob Jensen's threads on whistle blowing are at
http://www.trinity.edu/rjensen/FraudConclusion.htm#WhistleBlowing
"Study Linking Vaccine to Autism Broke Research Rules, U.K. Regulators Say
MMR/Autism Doctor Acted 'Dishonestly,' 'Irresponsibly'," by Nicky Broyd,
WebMD, January 29, 2010 ---
http://children.webmd.com/news/20100129/mmr-autism-doctor-acted-dishonestly-irresponsibly
The British doctor who
led a study suggesting a link between the
measles/
mumps/rubella (MMR) vaccine and
autism acted "dishonestly and irresponsibly," a
U.K. regulatory panel has ruled.
The panel represents the U.K. General Medical Council
(GMC), which regulates the medical profession. It ruled only on whether
Andrew Wakefield, MD, and two colleagues acted properly in carrying out
their research, and not on whether
MMR vaccine has anything to do with autism.
In the ruling, the GMC used strong language to
condemn the methods used by Wakefield in conducting the study.
In the study, published
12 years ago, Wakefield and colleagues suggested there was a
link between the MMR vaccine and autism. Their
study included only 12 children, but wide media coverage set off a panic
among parents. Vaccinations plummeted; there was a subsequent increase in
U.K. measles cases.
In 2004, 10 of the study's 13 authors disavowed the
findings. The Lancet, which originally published the paper, retracted
it after learning that Wakefield -- prior to designing the study -- had
accepted payment from lawyers suing vaccine manufacturers for causing
autism.
Fitness to Practice
The GMC's Fitness to Practise panel heard evidence
and submissions for 148 days over two and a half years, hearing from 36
witnesses. It then spent 45 days deciding the outcome of the hearing.
Besides Wakefield, two former colleagues went before the panel -John
Walker-Smith and Simon Murch. They were all found to have broken guidelines.
The disciplinary hearing found Wakefield showed a
"callous disregard" for the suffering of children and abused his position of
trust. He'd also "failed in his duties as a responsible consultant."
He'd taken blood samples from children attending
his son's birthday party in return for money, and was later filmed joking
about it at a conference.
He'd also failed to disclose he'd received money
for advising lawyers acting for parents who claimed their children had been
harmed by the triple vaccine
Continued in article
"U.S. Finds Scientific Misconduct by Former Nursing Professor,"
Inside Higher Ed, January 29, 2010 ---
http://www.insidehighered.com/news/2010/01/29/qt#218825
A former nursing professor at Tennessee State
University falsified data and results in federally sponsored research on
sexual risk behaviors among mentally ill homeless men, the Office of
Research Integrity at the U.S. Department of Health and Human Services
announced Thursday. The agency, in a statement in
the Federal Register, said that James Gary Linn, who was a professor
of nursing at Tennessee State, had provided falsified data to the university
and to a journal that published an article on his research in Cellular
and Molecular Biology. He will be barred from involvement in any federal
studies for three years.
Professors Who Cheat ---
http://www.trinity.edu/rjensen/plagiarism.htm#ProfessorsWhoPlagiarize
Bob Jensen's threads on the absence of replication and validity studies in
accountics research are at
http://www.trinity.edu/rjensen/TheoryTAR.htm
Epilogue
Jensen Question to Steve Kachelmeier, Senior Editor of The Accounting Review
(TAR)
Have you ever considered an AMR-type (“Dialogue”) invitation to comment?
These are commentaries that do not have to extend the research findings but may
question the research assumptions.
Steve's Reply
I have not considered openly soliciting comments on a particular article
any more than I have considered openly soliciting research on “X” (you pick the
X). I let the community decide, and I try to run a fair game. By the way, your
idea regarding an online journal of accounting replications may have merit – I
suggest that you direct that suggestion to the AAA Publications Committee.
My guess, however, is that such a journal would receive few submissions, and
that it would be difficult to find a willing editor.
Jensen Comment
In other words, the accounting research academy purportedly has little interest
in discussing and debating the external validity of the accountics research
papers published in TAR. Most likely it's too much of a bother for accountics
researchers to be forced to debate external validity of their findings.
The :"Shields Against Validity Challenges in Plato's Cave" will remain in
place long after Bob Jensen has departed from this earth.
That's truly sad!
Shielding Against Validity Challenges in Plato's Cave ---
http://www.trinity.edu/rjensen/TheoryTAR.htm
Wow: 97% of Elementary NYC Public Students Get A or B Grades --- There
must be higher IQ in the water!
"City Schools May Get Fewer A’s," by Jennifer Medina, The New York Times,
January 28, 2010 ---
http://www.nytimes.com/2010/01/30/education/30grades.html?hpw
Months after handing out
A’s and B’s to 97 percent of New York City elementary schools, education
officials plan to change their methods for grading the city’s public schools,
making it harder to receive high marks.
Under the proposed
changes, schools would be measured against one another, with those where
students show the most significant improvements getting the top grades. There
would be set grade-distribution guidelines, with 25 percent of schools receiving
A’s, 30 percent B’s, 30 percent C’s, 10 percent D’s, and the bottom 5 percent of
schools getting F’s.
Currently, the progress
reports measure improvements, but an unlimited number of schools can receive
high grades.
The Department of
Education plans to hold several sessions with principals on the proposed changes
to get their views. In a memo to principals, Shael Polakow-Suransky, the chief
accountability officer, acknowledged Friday that the department’s
“accountability tools aren’t perfect,” and said that it would continue to do
more to improve them.
“We want to be able to
really show how much value a school is actually adding,” he said in an
interview.
While the department is
responding to criticism that the report cards rely too heavily on year-to-year
changes on state tests, the new process could be more confusing to parents.
Rather than simply measuring how many students improved on state exams, the new
system would use what researchers call a “growth percentile model.”
Students would be
compared with others who scored at the same level on the previous year’s test,
and improvement would be measured on a percentile basis. So a student who scored
a 3 on the test in the third grade and 3.7 in the fourth grade could be in the
95th percentile, while a student who did not improve might be in the 35th
percentile.
Mr. Polakow-Suransky said
the department expected to have several meetings with parents to explain the
changes and would revise the progress reports given to parents to make them
easier to understand.
Michael Mulgrew, the
president of the United Federation of Teachers, criticized the decision to
reduce the number of schools that receive top grades.
Continued in article
Jensen Comment
Must be tough getting an A in the fourth grade and an F on the uniform
achievement examination.
This does not seem to embarrass the United Federation of Teachers.
This is a little like those universities (no names mentioned) that graduate
accounting majors almost never take and/or pass the CPA examination even though
they had all A or B grades in accounting.
Bob Jensen's threads on grade inflation are at
http://www.trinity.edu/rjensen/HigherEdControversies.htm#GradeInflation
Video: Fora.Tv on Institutional Corruption & The Economy Of Influence
---
http://www.simoleonsense.com/video-foratv-on-institutional-corruption-the-economy-of-influence/
Why single out capitalism for immorality and ethics misbehavior?
Making capitalism ethical is a tough task – and
possibly a hopeless one.
Prem Sikka (see below)
The
global code of conduct of Ernst & Young, another
global accountancy firm, claims that "no client or external relationship is
more important than the ethics, integrity and reputation of Ernst & Young".
Partners and former partners of the firm have also been found
guilty of promoting tax evasion.
Prem Sikka (see below)
Jensen Comment
Yeah right Prem, as if making the public sector and socialism ethical is an
easier task. The least ethical nations where bribery, crime, and immorality are
the worst are likely to be the more government (dictator) controlled and lower
on the capitalism scale. And in the so-called capitalist nations, the lowest
ethics are more apt to be found in the public sector that works hand in hand
with bribes from large and small businesses.
Rotten Fraud in General ---
http://www.trinity.edu/rjensen/FraudRotten.htm
Rotten Fraud in the Public Sector (The Most Criminal Class Writes the Laws) ---
http://www.trinity.edu/rjensen/FraudRotten.htm#Lawmakers
We hang the petty thieves and appoint the great ones to public office.
Aesop
Congress is our only native criminal class.
Mark Twain ---
http://en.wikipedia.org/wiki/Mark_Twain
Why should
members of Congress be allowed to profit from insider trading?
Amid broad congressional concern about ethics scandals, some lawmakers are
poised to expand the battle for reform: They want to enact legislation that
would prohibit members of Congress and their aides from trading stocks based on
nonpublic information gathered on Capitol Hill. Two Democrat lawmakers plan to
introduce today a bill that would block trading on such inside information.
Current securities law and congressional ethics rules don't prohibit lawmakers
or their staff members from buying and selling securities based on information
learned in the halls of Congress.
Brody Mullins, "Bill Seeks to Ban Insider Trading By Lawmakers and Their Aides,"
The Wall Street Journal, March 28, 2006; Page A1 ---
http://online.wsj.com/article/SB114351554851509761.html?mod=todays_us_page_one
The
Culture of Corruption Runs Deep and Wide in Both U.S. Political Parties: Few if
any are uncorrupted
Committee members have shown no appetite for
taking up all those cases and are considering an amnesty for reporting
violations, although not for serious matters such as accepting a trip from a
lobbyist, which House rules forbid. The data firm PoliticalMoneyLine calculates
that members of Congress have received more than $18 million in travel from
private organizations in the past five years, with Democrats taking 3,458 trips
and Republicans taking 2,666. . . But of course, there are those who deem the
American People dumb as stones and will approach this bi-partisan scandal
accordingly. Enter Democrat Leader Nancy Pelosi, complete with talking points
for her minion, that are sure to come back and bite her .... “House Minority
Leader Nancy Pelosi (D-Calif.) filed delinquent reports Friday for three trips
she accepted from outside sponsors that were worth $8,580 and occurred as long
as seven years ago, according to copies of the documents.
Bob Parks, "Will Nancy Pelosi's Words Come Back to Bite Her?" The National
Ledger, January 6, 2006 ---
http://www.nationalledger.com/artman/publish/article_27262498.shtml
And when
they aren't stealing directly, lawmakers are caving in to lobbying crooks
Drivers can send their thank-you notes to Capitol
Hill, which created the conditions for this mess last summer with its latest
energy bill. That legislation contained a sop to Midwest corn farmers in the
form of a huge new ethanol mandate that began this year and requires drivers to
consume 7.5 billion gallons a year by 2012. At the same time, Congress refused
to include liability protection for producers of MTBE, a rival oxygen
fuel-additive that has become a tort lawyer target. So MTBE makers are pulling
out, ethanol makers can't make up the difference quickly enough, and gas
supplies are getting squeezed.
"The Gasoline Follies," The Wall Street Journal, March 28, 2006; Page
A20 ---
Click Here
Once again, the power of pork to sustain incumbents gets its best demonstration
in the person of John Murtha (D-PA). The acknowledged king of earmarks in the
House gains the attention of the New York Times editorial board today, which
notes the cozy and lucrative relationship between more than two dozen
contractors in Murtha's district and the hundreds of millions of dollars in pork
he provided them. It also highlights what roughly amounts to a commission on the
sale of Murtha's power as an appropriator: Mr. Murtha led all House members this
year, securing $162 million in district favors, according to the watchdog group
Taxpayers for Common Sense. ... In 1991, Mr. Murtha used a $5 million earmark to
create the National Defense Center for Environmental Excellence in Johnstown to
develop anti-pollution technology for the military. Since then, it has garnered
more than $670 million in contracts and earmarks. Meanwhile it is managed by
another contractor Mr. Murtha helped create, Concurrent Technologies, a research
operation that somehow was allowed to be set up as a tax-exempt charity,
according to The Washington Post. Thanks to Mr. Murtha, Concurrent has boomed;
the annual salary for its top three executives averages $462,000.
Edward Morrissey, Captain's Quarters, January 14, 2008 ---
http://www.captainsquartersblog.com/mt/archives/016617.php
The motto
of Judicial Watch is "Because no one is above the law". To this end, Judicial
Watch uses the open records or freedom of information laws and other tools to
investigate and uncover misconduct by government officials and litigation to
hold to account politicians and public officials who engage in corrupt
activities.
Judicial Watch ---
http://www.judicialwatch.org/
Judicial Watch Announces List of
Washington's "Ten Most Wanted Corrupt Politicians" for 2009 ---
http://www.judicialwatch.org/news/2009/dec/judicial-watch-announces-list-washington-s-ten-most-wanted-corrupt-politicians-2009
"A Low, Dishonest Decade: The press and
politicians were asleep at the switch.," The Wall Street Journal,
December 22, 2009 ---
http://online.wsj.com/article/SB10001424052748703478704574612013922050326.html?mod=djemEditorialPage
Stock-market indices are not
much good as yardsticks of social progress, but as another low, dishonest
decade expires let us note that, on 2000s first day of trading, the Dow
Jones Industrial Average closed at 11357 while the Nasdaq Composite Index
stood at 4131, both substantially higher than where they are today. The
Nasdaq went on to hit 5000 before collapsing with the dot-com bubble, the
first great Wall Street disaster of this unhappy decade. The Dow got north
of 14000 before the real-estate bubble imploded.
And it was supposed to have
been such an awesome time, too! Back in the late '90s, in the crescendo of
the Internet boom, pundit and publicist alike assured us that the future was
to be a democratized, prosperous place. Hierarchies would collapse, they
told us; the individual was to be empowered; freed-up markets were to be the
common man's best buddy.
Such clever hopes they were.
As a reasonable anticipation of what was to come they meant nothing. But
they served to unify the decade's disasters, many of which came to us
festooned with the flags of this bogus idealism.
Before "Enron" became
synonymous with shattered 401(k)s and man-made electrical shortages, the
public knew it as a champion of electricity deregulation—a freedom fighter!
It was supposed to be that most exalted of corporate creatures, a "market
maker"; its "capacity for revolution" was hymned by management theorists;
and its TV commercials depicted its operations as an extension of humanity's
quest for emancipation.
Similarly, both Bank of
America and Citibank, before being recognized as "too big to fail," had
populist histories of which their admirers made much. Citibank's long
struggle against the Glass-Steagall Act was even supposed to be evidence of
its hostility to banking's aristocratic culture, an amusing image to
recollect when reading about the $100 million pay reportedly pocketed by one
Citi trader in 2008.
The Jack Abramoff lobbying
scandal showed us the same dynamics at work in Washington. Here was an
apparent believer in markets, working to keep garment factories in Saipan
humming without federal interference and saluted for it in an op-ed in the
Saipan Tribune as "Our freedom fighter in D.C."
But the preposterous
populism is only one part of the equation; just as important was our failure
to see through the ruse, to understand how our country was being disfigured.
Ensuring that the public
failed to get it was the common theme of at least three of the decade's
signature foul-ups: the hyping of various Internet stock issues by Wall
Street analysts, the accounting scandals of 2002, and the triple-A ratings
given to mortgage-backed securities.
The grand, overarching theme
of the Bush administration—the big idea that informed so many of its sordid
episodes—was the same anti-supervisory impulse applied to the public sector:
regulators sabotaged and their agencies turned over to the regulated.
The public was left to read
the headlines and ponder the unthinkable: Could our leaders really have
pushed us into an unnecessary war? Is the republic really dividing itself
into an immensely wealthy class of Wall Street bonus-winners and everybody
else? And surely nobody outside of the movies really has the political clout
to write themselves a $700 billion bailout.
What made the oughts so
awful, above all, was the failure of our critical faculties. The problem was
not so much that newspapers were dying, to mention one of the lesser
catastrophes of these awful times, but that newspapers failed to do their
job in the first place, to scrutinize the myths of the day in a way that
might have prevented catastrophes like the financial crisis or the Iraq war.
The folly went beyond the
media, though. Recently I came across a 2005 pamphlet written by historian
Rick Perlstein berating the big thinkers of the Democratic Party for their
poll-driven failure to stick to their party's historic theme of economic
populism. I was struck by the evidence Mr. Perlstein adduced in the course
of his argument. As he tells the story, leading Democratic pollsters found
plenty of evidence that the American public distrusts corporate power; and
yet they regularly advised Democrats to steer in the opposite direction, to
distance themselves from what one pollster called "outdated appeals to class
grievances and attacks upon corporate perfidy."
This was not a party that
was well-prepared for the job of iconoclasm that has befallen it. And as the
new bunch muddle onward—bailing out the large banks but (still) not
subjecting them to new regulatory oversight, passing a health-care reform
that seems (among other, better things) to guarantee private insurers
eternal profits—one fears they are merely presenting their own ample
backsides to an embittered electorate for kicking.
The sad state of governmental accounting and accountability ---
http://www.trinity.edu/rjensen/theory01.htm#GovernmentalAccounting
Before reading this module you may want to read about Governmental
Accounting at
http://en.wikipedia.org/wiki/Governmental_accounting
"Don't Like the Numbers? Change 'Em If a CEO issued the kind of distorted
figures put out by politicians and scientists, he'd wind up in prison," by
Stanford Economics Professor Michael J. Boskin, The Wall Street Journal,
January 14, 2010 ---
http://online.wsj.com/article/SB10001424052748704586504574654261655183416.html?mod=djemEditorialPage
Politicians and scientists who don't like what their data show lately have
simply taken to changing the numbers. They believe that their end—socialism,
global climate regulation, health-care legislation, repudiating debt
commitments, la gloire française—justifies throwing out even minimum standards
of accuracy. It appears that no numbers are immune: not GDP, not inflation, not
budget, not job or cost estimates, and certainly not temperature. A CEO or CFO
issuing such massaged numbers would land in jail.
The late
economist Paul Samuelson called the national income accounts that measure real
GDP and inflation "one of the greatest achievements of the twentieth century."
Yet politicians from Europe to South America are now clamoring for alternatives
that make them look better.
A
commission appointed by French President Nicolas Sarkozy suggests heavily
weighting "stability" indicators such as "security" and "equality" when
calculating GDP. And voilà!—France outperforms the U.S., despite the fact that
its per capita income is 30% lower. Nobel laureate Ed Prescott called this
disparity the difference between "prosperity and depression" in a 2002 paper—and
attributed it entirely to France's higher taxes.
With
Venezuela in recession by conventional GDP measures, President Hugo Chávez
declared the GDP to be a capitalist plot. He wants a new, socialist-friendly way
to measure the economy. Maybe East Germans were better off than their cousins in
the West when the Berlin Wall fell; starving North Koreans are really better off
than their relatives in South Korea; the 300 million Chinese lifted out of
abject poverty in the last three decades were better off under Mao; and all
those Cubans risking their lives fleeing to Florida on dinky boats are loco.
In
Argentina, President Néstor Kirchner didn't like the political and budget hits
from high inflation. After a politicized personnel purge in 2002, he changed the
inflation measures. Conveniently, the new numbers showed lower inflation and
therefore lower interest payments on the government's inflation-linked bonds.
Investor and public confidence in the objectivity of the inflation statistics
evaporated. His wife and successor Cristina Kirchner is now trying to grab the
central bank's reserves to pay for the country's debt.
America
has not been immune from this dangerous numbers game. Every president is guilty
of spinning unpleasant statistics. President Richard Nixon even thought there
was a conspiracy against him at the Bureau of Labor Statistics. But President
Barack Obama has taken it to a new level. His laudable attempt at transparency
in counting the number of jobs "created or saved" by the stimulus bill has
degenerated into farce and was just junked this week.
The
administration has introduced the new notion of "jobs saved" to take credit
where none was ever taken before. It seems continually to confuse gross and net
numbers. For example, it misses the jobs lost or diverted by the fiscal
stimulus. And along with the congressional leadership it hypes the number of
"green jobs" likely to be created from the explosion of spending, subsidies,
loans and mandates, while ignoring the job losses caused by its taxes, debt,
regulations and diktats.
The
president and his advisers—their credibility already reeling from exaggeration
(the stimulus bill will limit unemployment to 8%) and reneged campaign promises
(we'll go through the budget "line-by-line")—consistently imply that their new
proposed regulation is a free lunch. When the radical attempt to regulate energy
and the environment with the deeply flawed cap-and-trade bill is confronted with
economic reality, instead of honestly debating the trade-offs they confidently
pronounce that it boosts the economy. They refuse to admit that it simply boosts
favored sectors and firms at the expense of everyone else.
Rabid
environmentalists have descended into a separate reality where only green
counts. It's gotten so bad that the head of the California Air Resources Board,
Mary Nichols, announced this past fall that costly new carbon regulations would
boost the economy shortly after she was told by eight of the state's most
respected economists that they were certain these new rules would damage the
economy. The next day, her own economic consultant, Harvard's Robert Stavis,
denounced her statement as a blatant distortion.
Scientists are expected to make sure their findings are replicable, to make the
data available, and to encourage the search for new theories and data that may
overturn the current consensus. This is what Galileo, Darwin and Einstein—among
the most celebrated scientists of all time—did. But some climate researchers,
most notably at the University of East Anglia, attempted to hide or delete
temperature data when that data didn't show recent rapid warming. They quietly
suppressed and replaced the numbers, and then attempted to squelch publication
of studies coming to different conclusions.
The
Obama administration claims a dubious "Keynesian" multiplier of 1.5 to feed the
Democrats' thirst for big spending. The administration's idea is that virtually
all their spending creates jobs for unemployed people and that additional rounds
of spending create still more—raising income by $1.50 for each dollar of
government spending. Economists differ on such multipliers, with many leading
figures pegging them at well under 1.0 as the government spending in part
replaces private spending and jobs. But all agree that every dollar of spending
requires a present value of a dollar of future taxes, which distorts decisions
to work, save, and invest and raises the cost of the dollar of spending to well
over a dollar. Thus, only spending with large societal benefits is justified, a
criterion unlikely to be met by much current spending (perusing the projects on
recovery.gov doesn't inspire confidence).
Even
more blatant is the numbers game being used to justify health-insurance reform
legislation, which claims to greatly expand coverage, decrease health-insurance
costs, and reduce the deficit. That magic flows easily from counting 10 years of
dubious Medicare "savings" and tax hikes, but only six years of spending;
assuming large cuts in doctor reimbursements that later will be cancelled; and
making the states (other than Sen. Ben Nelson's Nebraska) pay a big share of the
cost by expanding Medicaid eligibility. The Medicare "savings" and payroll tax
hikes are counted twice—first to help pay for expanded coverage, and then to
claim to extend the life of Medicare.
One
piece of good news: The public isn't believing much of this out-of-control spin.
Large majorities believe the health-care legislation will raise their insurance
costs and increase the budget deficit. Most Americans are highly skeptical of
the claims of climate extremists. And they have a more realistic reaction to the
extraordinary deterioration in our public finances than do the president and
Congress.
As a
society and as individuals, we need to make difficult, even wrenching choices,
often with grave consequences. To base those decisions on highly misleading,
biased, and even manufactured numbers is not just wrong, but dangerous.
Squandering their credibility with these numbers games will only make it more
difficult for our elected leaders to enlist support for difficult decisions from
a public increasingly inclined to disbelieve them.
Mr. Boskin is a
professor of economics at Stanford University and a senior fellow at the Hoover
Institution. He chaired the Council of Economic Advisers under President George
H.W. Bush
Bob Jensen's threads on The Sad State of Governmental Accounting and
Accountability ---
http://www.trinity.edu/rjensen/theory01.htm#GovernmentalAccounting
"Taxpayers to Pay for Fannie, Freddie Aid: Treasury Removed Caps on
Assistance," SmartPros, January 13, 2010 ---
http://accounting.smartpros.com/x68543.xml
A recent move by the Treasury Department to remove
$200 billion caps on assistance to Fannie Mae and Freddie Mac eliminates any
doubt that taxpayers will pay for all their losses for the next three years
and appears to be a major step toward formally nationalizing the housing
enterprises, analysts say.
The government took control of the companies, and
effectively much of the U.S. mortgage market, in September 2008 and started
purchasing all their mortgage-backed securities. But the Treasury previously
used the $200 billion caps on aiding each company to try to limit taxpayer
exposure to their mounting losses.
Republicans charge that Treasury has given the
Depression-era companies a "blank check" to pay for burgeoning losses on
defaulting loans.
The two housing enterprises last year guaranteed
and secured nearly 70 percent of new mortgages, primarily made to "prime"
borrowers with the best credit ratings, while the Federal Housing
Administration insured most loans to subprime borrowers, leaving only a tiny
share of the mortgage market in private hands.
In its Christmas Eve statement announcing the
little-noticed changes, the Treasury insisted that it wants to preserve "an
environment where the private market is able to provide a larger source of
mortgage finance."
But analysts say Treasury's move may push off any
return to a normal mortgage market for years -- possibly forever. Treasury
removed the liability caps for three years and loosened restrictions on
Fannie's and Freddie's purchases of their own mortgage securities --
enabling them to maintain their dominant share of the mortgage market.
"These actions would preserve and strengthen the
governments involvement and control over the countrys housing finance system
and make it harder to reintroduce substantial private-sector involvement
later on," said Edward Pinto, a housing consultant and former chief credit
officer at Fannie Mae.
When combined with a separate move by regulators
not to provide common stock as part of executive compensation at Fannie and
Freddie, the administration's recent actions suggest that it is moving to
nationalize the companies, Mr. Pinto said.
Nationalization, or total government control and
ownership of the companies, would wipe out the value of Fannie and Freddie
stock, making it worthless as a way to pay executives. The value of the
stock has plummeted to between $1 and $2 a share in the wake of the
government's takeover.
Treasury spokesman Andrew Williams declined to
elaborate on the Treasury's actions, but denied that nationalization was the
goal.
The administration is preparing to present its
proposals for governing Fannie and Freddie in the future -- a major question
not addressed in financial reform legislation pending in Congress -- when it
presents its budget in February. Options range from fully nationalizing the
enterprises to reprivatizing them or turning them into public "utilities"
like the closely regulated gas and electric companies.
Sen. Bob Corker, Tennessee Republican, questioned
whether the administration was moving toward nationalization in a letter to
Treasury Secretary Timothy F. Geithner this week, urging the Treasury to
incorporate fully in its February budget the cost of any additional Fannie
and Freddie liabilities the government is acquiring.
"Due to the level of support that this
administration and the previous one have created for Fannie Mae and Freddie
Mac, would you not consider your latest move an effective nationalization?"
asked Mr. Corker, a member of the Senate Banking, Housing and Urban Affairs
Committee. "If so, then the liabilities of these two firms should absolutely
be reflected on the balance sheet of the U.S. Treasury."
Fully nationalizing the enterprises would
permanently increase costs for taxpayers and would bloat the government's
balance sheets. Fannie and Freddie currently guarantee about $5.5 trillion
of outstanding mortgages and debts -- nearly as much as the Treasury's own
public debt. If the companies were fully nationalized, the government's
books would have to reflect both the revenues and losses from those
obligations.
But even if the administration and Congress stop
short of formally incorporating the enterprises into the federal government,
the removal of the caps at least for now has eliminated any doubt that the
government stands behind all Fannie and Freddie obligations and will cover
their losses for the next three years.
Treasury reportedly told Mr. Corker that the move
was needed to calm markets.
Apparently, it deemed the certainty of government
backing to be critical at a time when the Federal Reserve has announced that
it will end its program of purchasing $1.25 trillion in Fannie and Freddie
mortgage bonds in March. The Fed's program -- another unprecedented federal
intervention in the mortgage market -- provided most of the funding to
finance prime mortgages in the past year.
Many housing analysts and economists worry that the
Fed's withdrawal from the mortgage market will cause a sharp rise in 30-year
mortgage rates of as much as one percentage point from 5 percent to 6
percent as private investors demand higher yields to compensate for the
increased likelihood of defaults on mortgages.
Nearly one in eight mortgages is in default, with
prime mortgages guaranteed by Fannie and Freddie having taken over subprime
last year as the principal source of delinquencies.
Rapidly rising delinquencies have prompted some
analysts to predict a collapse in the mortgage market once the Fed stops
buying most of Fannie and Freddie's debt. The Treasury's move appears
designed to reassure investors and prevent that from happening.
"When you have someone as big as the Fed was in
2009 walking away cold turkey, there have to be bumps along the road," said
Ajay Rahadyaksha, managing director at Barclays Capital. But he expects
investors to be enticed back into the mortgage market because they have
"massive amounts of cash" to invest.
While full nationalization of the enterprises would
be controversial, and likely provoke overwhelming Republican opposition,
most parties agree that after the massive efforts to prop up the mortgage
market in the past two years it would be difficult for the government to
entirely extricate itself in the future.
Former Treasury Secretary Henry M. Paulson Jr. said
he intended to keep the government's options open when he designed the plan
to take 79.9 percent control of Fannie and Freddie and put them under
government conservatorship.
But he said they should not be returned to their
previous ambiguous structure, where they were owned by private stockholders
even as they carried out a government mission. He said the best structure in
the future might be to turn them into public utilities that funnel the
government's guarantee on mortgage-backed securities for a fee.
The Mortgage Bankers Association and other private
groups have endorsed a permanent federal role in guaranteeing pools of prime
mortgages, perhaps through a revamped Fannie and Freddie.
One reason heavy government involvement is likely
to continue is that Fannie and Freddie -- unlike many banks that received
bailouts from the Treasury -- likely will never be able to fully repay the
nearly $100 billion in assistance they have received so far from taxpayers,
analysts say.
Their losses are growing by the day, and many of
them now are incurred as a result of new mandates from the Treasury and
Congress to spearhead the government's efforts to alleviate the home
foreclosure crisis and make credit available as widely as possible.
For example, Fannie recently said it may liberalize
its rules for mortgages used to buy condominiums in Florida -- an area that
has been plagued with high rates of default and foreclosure, while it is
giving preference to homeowners over investors when it sells foreclosed
properties, even if investors offer a better deal.
Many analysts expect the administration to soon
increase the subsidies the enterprises are providing to homeowners and banks
that renegotiate mortgages to try to avoid foreclosure, and some suspect it
already is using Fannie and Freddie to make loans available to riskier
borrowers.
Mr. Corker said the proliferation of government
mandates for the enterprises has essentially turned them into "a direct
extension of the Treasury Department."
How Fannie Mae creatively managed earnings and cooked the books to give
then CEO Franklin Raines millions and then had to fire Franklin and issued
restated financial statements ---
http://www.trinity.edu/rjensen/theory01.htm#Manipulation
"Defending Koss And Their Auditors: Just Loopy Distorted Feedback," by
Francine McKenna, re: TheAuditors, January 16, 2010 ---
http://retheauditors.com/2010/01/16/defending-koss-and-their-auditors-just-loopy-distorted-feedback/
My objective in writing this story was to handily
contradict Grant Thornton’s self-serving
defense to the Koss fraud.
The defense supported
by some commentators:
Audits are not designed to uncover fraud and
Koss did not pay for a separate opinion on internal controls because they
are exempt from that Sarbanes-Oxley requirement.
But punching holes in that Swiss-cheese defense is
like shooting fish in a barrel. Leading that horse to water is like feeding
him candy taken from a baby. The reasons why someone other than American
Express should have caught this sooner are as numerous as the
acorns you can steal from a blind pig…
Ok, you get the gist.
Listing standards for the NYSE require an internal
audit function. NASDAQ, where Koss was listed, does not. Back in 2003, the
Institute of Internal Auditors (IIA) made recommendations
post- Sarbanes-Oxley that were adopted for the most
part by NYSE, but not completely by NASDAQ. And both the NYSE and NASD left
a few key recommendations hanging.
In addition, the IIA has never mandated, under its
own standards for the internal audit profession, a
direct reporting of the internal audit function to
the independent Audit Committee. The
SEC did not adopt this requirement in their
final rules, either.
However, Generally Accepted Auditing Standards (GAAS),
the standards an external auditor such as Grant Thornton operates under when
preparing an opinion on a company’s financial statements – whether a public
company or not, listed on NYSE or NASDAQ, whether exempt or not from
Sarbanes-Oxley – do require the assessment of the internal audit function
when planning an audit.
Grant Thornton was required to adjust their
substantive testing given the number of
risk factors
presented by Koss, based on
SAS 109 (AU 314), Understanding the Entity and
Its Environment and Assessing the Risks of
Material Misstatement. If they had understood the entity and assessed the
risk of material misstatement fully, they would have been all over those
transactions like _______. (Fill in the blank)
If they had performed a proper
SAS 99 review (AU 316), Consideration of Fraud
in a Financial Statement Audit, it would have hit’em smack in the face
like a _______ . (Fill in the blank.) Management oversight of the financial
reporting process is severely limited by Mr. Koss Jr.’s lack of interest,
aptitude, and appreciation for accounting and finance. Koss Jr., the CEO and
son of the founder,
held the titles
of COO and CFO, also. Ms. Sachdeva, the Vice
President of Finance and Corporate Secretary who is accused of the fraud,
has been in the
same job since 1992
and during one ten year period
worked remotely from Houston!
When they finished their review according to
SAS 65 (AU 322), The Auditor’s Consideration
of the Internal Audit Function in an Audit of Financial Statements, it
should have dawned on them: There is no internal audit function and the
flunky-filled Audit Committee is a sham. I can see it now. The Grant
Thornton Milwaukee OMP smacks head with open palm in a “I could have had a
V-8,” moment but more like, “Holy cheesehead, we’re indigestible
gristle-laden, greasy bratwurst here! We’ll never be able issue an opinion
on these financial statements unless we take these journal entries apart,
one-by-one, and re-verify every stinkin’ last number.”
But I dug in and did some additional research – at
first I was just working the “no internal auditors” line – and I found a few
more interesting things. And now I have no sympathy for Koss management
and, therefore, its largest shareholder, the Koss family. Granted there is
plenty of basis, in my opinion, for any and all enforcement actions against
Grant Thornton and its audit partners. And depending on how far back the
acts of deliciously deceptive defalcation go, PricewaterhouseCoopers may
also be dragged through the mud.
Yes.
I can not make this stuff up and have it come out
more music to my ears. PricewaterhouseCoopers was Koss’s auditor prior to
Grant Thornton. In March of 2004, the
Milwaukee Business Journal reported, “Koss
Corp. has fired the certified
public accounting firm of PricewaterhouseCoopers L.L.P. as its independent
auditors March 15 and retained Grant Thornton L.L.P. in its place.”
The article was short with the standard disclaimer of no disputes about
accounting policies and practices. But it pointedly pointed out that PwC’s
fees for the audit had increased by almost 50% from 2001 to 2003, to $90,000
and the selection of the new auditor was made after a competitive bidding
process.
PwC had been Koss’s auditor since 1992!
The focus on audit fees by Koss’s CEO should have
been no surprise to PwC. Post-Sarbanes-Oxley, Michael J. Koss the son of
the founder, was quoted extensively as part of the very vocal cadre of CEOs
who complained vociferously about paying their auditors one more red cent.
Koss Jr. minced no words regarding PwC in the
Wall Street Journal in August 2002, a month after
the law was passed:
“…Sure, analysts had predicted a modest fee
increase from the smaller pool of accounting firms left after Arthur
Andersen LLP’s collapse following its June conviction on a
criminal-obstruction charge. But a range of other factors are helping to
drive auditing fees higher — to as much as 25% — with smaller companies
bearing the brunt of the rise.
“The auditors are making money hand
over fist,” says Koss Corp. Chief Executive Officer Michael Koss. “It’s
going to cost shareholders in the long run.”
He should know. Auditing fees are up nearly
10% in the past two years at his Milwaukee-based maker of headphones.
The increase has come primarily from auditors spending more time combing
over financial statements as part of compliance with new disclosure
requirements by the Securities and Exchange Commission. Koss’s
accounting firm, PricewaterhouseCoopers LLP, now shows up at corporate
offices for “mini audits” every quarter, rather than just once at
year-end.”
A year later, still irate, Mr. Koss Jr. was quoted
in
USA Today:
“Jeffrey Sonnenfeld, associate dean of the
Yale School of Management, said he recently spoke to six CEO conferences
over 10 days. When he asked for a show of hands, 80% said they thought
the law was bad for the U.S. economy.
When pressed individually, CEOs don’t
object to the law or its intentions, such as forcing executives to
refund ill-gotten gains. But confusion over what the law requires has
left companies vulnerable to experts and consultants, who “frighten
boards and managers” into spending unnecessarily, Sonnenfeld says.
Michael Koss, CEO of stereo
headphones maker Koss, says it’s all but impossible to know what the law
requires, so it has become a black hole where frightened companies throw
endless amounts of money.
Companies are spending way too much to
comply, but the cost is due to “bad advice,
not a bad law,” Sonnenfeld says.”
It’s interesting that Koss Jr. has such
minimal appreciation for the work of the external auditor or an internal
audit function. By virtue, I suppose, of his esteemed status as CEO, COO and
CFO of Koss and notwithstanding an undergraduate
degree in anthropology, according to
Business Week, Mr. Koss Jr. has twice served other
Boards as their “financial expert” and Chairman of their Audit Committees.
At
Genius Products,
founded by the Baby Genius DVDs creator, Mr. Koss served in this capacity
from 2004 to 2005. Mr. Koss Jr. has also been a Director, Chairman of Audit
Committee, Member of Compensation Committee and Member of Nominating &
Corporate Governance Committee at
Strattec Security Corp. since 1995.
If I were the SEC, I might take a look at those two
companies…Because
I warned you about the CEOs and CFOs who are
pushing back on Sarbanes-Oxley and every other regulation intended to shine
a light on them as public company executives.
No good will come of this.
I don’t want you to shed crocodile tears or pity
poor PwC for their long-term, close relationship with
another blockbuster Indian fraudster. Nor should
you pat them on the back for not being the auditor now. PwC never really
left Koss after they were “fired” as auditor in 2004. They continued until
today to be the trusted “Tax and All Other” advisor,
making good money filing Koss’s now totally bogus
tax returns.
Continued in article
Bob Jensen's threads on Grant Thornton litigation ---
http://www.trinity.edu/rjensen/fraud001.htm#GrantThornton
Bob Jensen's threads on PwC and other large auditing firms
http://www.trinity.edu/rjensen/fraud001.htm
Jensen Comment
You may want to compare Francine's above discussion of audit fees with the
following analytical research study:
In most instances the defense of underlying assumptions is based upon
assumptions passed down from previous analytical studies rather than empirical
or even case study evidence. An example is the following conclusion:
We find that audit quality and audit fees both
increase with the auditor’s expected litigation losses from audit failures.
However, when considering the auditor’s acceptance decision, we show that it
is important to carefully identify the component of the litigation
environment that is being investigated. We decompose the liability
environment into three components: (1) the strictness of the legal regime,
defined as the probability that the auditor is sued and found liable in case
of an audit failure, (2) potential damage payments from the auditor to
investors and (3) other litigation costs incurred by the auditor, labeled
litigation frictions, such as attorneys’ fees or loss of reputation. We show
that, in equilibrium, an increase in the potential damage payment actually
leads to a reduction in the client rejection rate. This effect arises
because the resulting higher audit quality increases the value of the
entrepreneur’s investment opportunity, which makes it optimal for the
entrepreneur to increase the audit fee by an amount that is larger than the
increase in the auditor’s expected damage payment. However, for this result
to hold, it is crucial that damage payments be fully recovered by the
investors. We show that an increase in litigation frictions leads to the
opposite result—client rejection rates increase. Finally, since a shift in
the strength of the legal regime affects both the expected damage payments
to investors as well as litigation frictions, the relationship between the
legal regime and rejection rates is nonmonotonic. Specifically, we show that
the relationship is U-shaped, which implies that for both weak and strong
legal liability regimes, rejection rates are higher than those
characterizing more moderate legal liability regimes.
Volker Laux and D. Paul Newman, "Auditor Liability and Client Acceptance
Decisions," The Accounting Review, Vol. 85, No. 1, 2010 pp. 261–285
http://www.trinity.edu/rjensen/TheoryTAR.htm#Analytics
"Taxpayers to Pay for Fannie, Freddie Aid: Treasury Removed Caps on
Assistance," SmartPros, January 13, 2010 ---
http://accounting.smartpros.com/x68543.xml
A recent move by the
Treasury Department to remove $200 billion caps on assistance to Fannie Mae and
Freddie Mac eliminates any doubt that taxpayers will pay for all their losses
for the next three years and appears to be a major step toward formally
nationalizing the housing enterprises, analysts say.
The government took
control of the companies, and effectively much of the U.S. mortgage market, in
September 2008 and started purchasing all their mortgage-backed securities. But
the Treasury previously used the $200 billion caps on aiding each company to try
to limit taxpayer exposure to their mounting losses.
Republicans charge that
Treasury has given the Depression-era companies a "blank check" to pay for
burgeoning losses on defaulting loans.
The two housing
enterprises last year guaranteed and secured nearly 70 percent of new mortgages,
primarily made to "prime" borrowers with the best credit ratings, while the
Federal Housing Administration insured most loans to subprime borrowers, leaving
only a tiny share of the mortgage market in private hands.
In its Christmas Eve
statement announcing the little-noticed changes, the Treasury insisted that it
wants to preserve "an environment where the private market is able to provide a
larger source of mortgage finance."
But analysts say
Treasury's move may push off any return to a normal mortgage market for years --
possibly forever. Treasury removed the liability caps for three years and
loosened restrictions on Fannie's and Freddie's purchases of their own mortgage
securities -- enabling them to maintain their dominant share of the mortgage
market.
"These actions would
preserve and strengthen the governments involvement and control over the
countrys housing finance system and make it harder to reintroduce substantial
private-sector involvement later on," said Edward Pinto, a housing consultant
and former chief credit officer at Fannie Mae.
When combined with a
separate move by regulators not to provide common stock as part of executive
compensation at Fannie and Freddie, the administration's recent actions suggest
that it is moving to nationalize the companies, Mr. Pinto said.
Nationalization, or total
government control and ownership of the companies, would wipe out the value of
Fannie and Freddie stock, making it worthless as a way to pay executives. The
value of the stock has plummeted to between $1 and $2 a share in the wake of the
government's takeover.
Treasury spokesman Andrew
Williams declined to elaborate on the Treasury's actions, but denied that
nationalization was the goal.
The administration is
preparing to present its proposals for governing Fannie and Freddie in the
future -- a major question not addressed in financial reform legislation pending
in Congress -- when it presents its budget in February. Options range from fully
nationalizing the enterprises to reprivatizing them or turning them into public
"utilities" like the closely regulated gas and electric companies.
Sen. Bob Corker,
Tennessee Republican, questioned whether the administration was moving toward
nationalization in a letter to Treasury Secretary Timothy F. Geithner this week,
urging the Treasury to incorporate fully in its February budget the cost of any
additional Fannie and Freddie liabilities the government is acquiring.
"Due to the level of
support that this administration and the previous one have created for Fannie
Mae and Freddie Mac, would you not consider your latest move an effective
nationalization?" asked Mr. Corker, a member of the Senate Banking, Housing and
Urban Affairs Committee. "If so, then the liabilities of these two firms should
absolutely be reflected on the balance sheet of the U.S. Treasury."
Fully nationalizing the
enterprises would permanently increase costs for taxpayers and would bloat the
government's balance sheets. Fannie and Freddie currently guarantee about $5.5
trillion of outstanding mortgages and debts -- nearly as much as the Treasury's
own public debt. If the companies were fully nationalized, the government's
books would have to reflect both the revenues and losses from those obligations.
But even if the
administration and Congress stop short of formally incorporating the enterprises
into the federal government, the removal of the caps at least for now has
eliminated any doubt that the government stands behind all Fannie and Freddie
obligations and will cover their losses for the next three years.
Treasury reportedly told
Mr. Corker that the move was needed to calm markets.
Apparently, it deemed the
certainty of government backing to be critical at a time when the Federal
Reserve has announced that it will end its program of purchasing $1.25 trillion
in Fannie and Freddie mortgage bonds in March. The Fed's program -- another
unprecedented federal intervention in the mortgage market -- provided most of
the funding to finance prime mortgages in the past year.
Many housing analysts and
economists worry that the Fed's withdrawal from the mortgage market will cause a
sharp rise in 30-year mortgage rates of as much as one percentage point from 5
percent to 6 percent as private investors demand higher yields to compensate for
the increased likelihood of defaults on mortgages.
Nearly one in eight
mortgages is in default, with prime mortgages guaranteed by Fannie and Freddie
having taken over subprime last year as the principal source of delinquencies.
Rapidly rising
delinquencies have prompted some analysts to predict a collapse in the mortgage
market once the Fed stops buying most of Fannie and Freddie's debt. The
Treasury's move appears designed to reassure investors and prevent that from
happening.
"When you have someone as
big as the Fed was in 2009 walking away cold turkey, there have to be bumps
along the road," said Ajay Rahadyaksha, managing director at Barclays Capital.
But he expects investors to be enticed back into the mortgage market because
they have "massive amounts of cash" to invest.
While full
nationalization of the enterprises would be controversial, and likely provoke
overwhelming Republican opposition, most parties agree that after the massive
efforts to prop up the mortgage market in the past two years it would be
difficult for the government to entirely extricate itself in the future.
Former Treasury Secretary
Henry M. Paulson Jr. said he intended to keep the government's options open when
he designed the plan to take 79.9 percent control of Fannie and Freddie and put
them under government conservatorship.
But he said they should
not be returned to their previous ambiguous structure, where they were owned by
private stockholders even as they carried out a government mission. He said the
best structure in the future might be to turn them into public utilities that
funnel the government's guarantee on mortgage-backed securities for a fee.
The Mortgage Bankers
Association and other private groups have endorsed a permanent federal role in
guaranteeing pools of prime mortgages, perhaps through a revamped Fannie and
Freddie.
One reason heavy
government involvement is likely to continue is that Fannie and Freddie --
unlike many banks that received bailouts from the Treasury -- likely will never
be able to fully repay the nearly $100 billion in assistance they have received
so far from taxpayers, analysts say.
Their losses are growing
by the day, and many of them now are incurred as a result of new mandates from
the Treasury and Congress to spearhead the government's efforts to alleviate the
home foreclosure crisis and make credit available as widely as possible.
For example, Fannie
recently said it may liberalize its rules for mortgages used to buy condominiums
in Florida -- an area that has been plagued with high rates of default and
foreclosure, while it is giving preference to homeowners over investors when it
sells foreclosed properties, even if investors offer a better deal.
Many analysts expect the
administration to soon increase the subsidies the enterprises are providing to
homeowners and banks that renegotiate mortgages to try to avoid foreclosure, and
some suspect it already is using Fannie and Freddie to make loans available to
riskier borrowers.
Mr. Corker said the
proliferation of government mandates for the enterprises has essentially turned
them into "a direct extension of the Treasury Department."
How Fannie Mae creatively managed earnings and cooked the books to give
then CEO Franklin Raines millions and then had to fire Franklin and issued
restated financial statements ---
http://www.trinity.edu/rjensen/theory01.htm#Manipulation
"How to Guard Against Stimulus Fraud:
Based on past experience, thieves may rip off the taxpayers for $100 billion,"
by Daniel J. Castleman, The Wall Street Journal, January 13, 2010 ---
http://online.wsj.com/article/SB10001424052748703948504574648331267709784.html#mod=djemEditorialPage
The Obama administration—and
state and local governments—should brace themselves for fraud on an Olympic
scale as hundreds of billions of taxpayer dollars continue to pour into job
creation efforts.
Where there are government
handouts, fraud, waste and abuse are rarely far behind. The sheer scale of
the first and expected second stimulus packages combined with the
multitiered distribution channel—from Washington to the states to community
agencies to contractors and finally to workers—are simply irresistible
catnip to con men and thieves.
There are already warning
signs. The Department of Energy's inspector general said in a report in
December that staffing shortages and other internal weaknesses all but
guarantee that at least some of the agency's $37 billion economic-stimulus
funds will be misused. A tenfold increase in funding for an obscure federal
program that installs insulation in homes has state attorneys general
quietly admitting there is little hope of keeping track of the money.
While I was in charge of
investigations at the Manhattan District Attorney's office, we brought case
after case where kickbacks, bid-rigging, false invoicing schemes and
outright theft routinely amounted to a tenth of the contract value. This was
true in industries as diverse as the maintenance of luxury co-ops and
condos, interior construction and renovation of office buildings, court
construction projects, dormitory construction projects, even the
distribution of copy paper. In one insurance fraud case, the schemers
actually referred to themselves as the "Ten Percenters."
Based on past experience,
the cost of fraud involving federal government stimulus outlays of more than
$850 billion and climbing could easily reach $100 billion. Who will prevent
this? Probably no one, particularly at the state and local level.
New York, for instance, has
an aggressive inspector general's office, with experienced and dedicated
professionals. But, it is already woefully understaffed—with a head count of
only 62 people—to police the state's already existing agencies and programs.
There is simply no way that office can effectively scrutinize the influx of
$31 billion in state stimulus money.
There is a solution however,
which is to set aside a small percentage of the money distributed to fund
fraud prevention and detection programs. This will ensure that states and
municipalities can protect projects from fraud without tapping already
thinly stretched resources.
Meaningful fraud prevention,
detection and investigation can be funded by setting aside no more than 2%
of the stimulus money received. For example, if a county is to receive $50
million for an infrastructure project, $1 million should be set aside to
fund antifraud efforts; if it costs less, the remainder can be returned to
the project's budget.
While the most obvious
option might be to simply pump the fraud prevention funds into pre-existing
law enforcement agencies, that would be a mistake. Government agencies take
too long to staff up and rarely staff down.
A better idea is to tap the
former government prosecutors, regulators and detectives with experience in
fraud investigations now working in the private sector. If these resources
can be harnessed, effective watchdog programs can be put in place in a
timely manner. Competition between private-sector bidders will also lower
the cost.
Some might object to
providing a "windfall" to private companies. Any such concern is misplaced.
One should not look at the 2% spent, but rather the 8% potentially saved.
Moreover, consider the alternative: law enforcement agencies swamped trying
to stem the tide of corruption on a shoestring and a prayer.
There will always be
individuals who will rip off money meant for public projects. In the
aftermath of the 9/11 attacks, and Hurricane Katrina hundreds of people were
prosecuted for trying to steal relief funds. But the stimulus funding
represents the kind of payday even the most ambitious fraudster could never
have imagined
To avoid a stimulus
fraud Olympics that will be impossible to clean up, it is better to spend a
little now to save a lot later. The savings could put honest people to work
and fraudsters out of business.
Mr. Castleman, a former chief assistant
Manhattan district attorney, is a managing director at FTI Consulting.
Bob Jensen's Fraud Updates ---
http://www.trinity.edu/rjensen/FraudUpdates.htm
Bob Jensen's
threads on The Sad State of Governmental Accounting and Accountability ---
http://www.trinity.edu/rjensen/theory01.htm#GovernmentalAccounting
The Most Criminal
Class is Writing the Laws ---
http://www.trinity.edu/rjensen/FraudRotten.htm#Lawmakers
"Massachusetts Ponzi Scheme Suspect Arrested in Mississippi,"
SmartPros, January 12, 2010 ---
http://accounting.smartpros.com/x68533.xml
A judge in Mississippi has ordered a Massachusetts
man returned to Boston where he will face federal charges alleging he ran a
$28 million Ponzi scheme.
Richard Elkinson had been arrested this past week
at a casino in Biloxi, Miss. On Monday, he waived his right to a hearing in
federal court in Gulfport.
U.S. Magistrate John M. Roper ordered the
76-year-old Elkinson given over to U.S. marshals for his return to Boston.
This past week, U.S. District Judge Joseph Tauro in
Boston froze Elkinson's assets at the request of the Securities and Exchange
Commission.
Federal prosecutors allege the 76-year-old Elkinson,
of Framington, Mass., stole $28 million from about 130 victims since 1997 by
selling unregistered securities in the form of promissory notes.
Elkinson allegedly claimed he had contracts to sell
uniforms. Federal authorities say he had no such contracts, repaid investors
with money obtained from new investors, and used the money for personal
purposes, including gambling.
Court documents showed the FBI tracked Elkinson to
Mississippi after the man left Las Vegas on Dec. 22.
"Feelings, Brain and Prevention of Corruption," Eduardo
Salcedo-Albarán, Isaac De León-Beltrán, and Mauricio Rubio,
International Journal of Psychology Research, Vol. 3, No. 3, 2008,
Via SSRN ---
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1391104
Abstract:
In this paper we propose an answer for the question: why, sometimes, people
don’t perceive corruption as a crime? To answer this question we use a
neurological and a psychological concept. As humans, we experience our emotions
and feelings in first person, but the neuropsychological mechanism known as
“mirror neurons” makes possible to simulate emotions and feelings of others. It
means that our emotions and feelings are linked with emotions and feelings of
others. When mirror areas in the brain are activated we can understand and
simulate in first person the actions, emotions and feelings of people. Because
of these areas, the observer’s brain acts “as if” it was experiencing the same
action or the same feeling that is perceived. Each organism establishes causal
relations to understand, manipulate and move in the world. Causal relations can
be classified as simple or complex. In a simple causal relation, cause and
effect are close in space and time. When cause and effect are not close in space
and time, the causal relation is complex. When perceiving or committing
homicide, a simple causal relation is enough for identifying a victim, but when
perceiving or committing a public corruption crime, a complex causal relation
must be established for identifying a victim. When seeing someone committing
bribe there is no an evident victim. If persons can’t identify victims of public
corruption crimes, then they will not generate empathy feelings. When a victim
is not identified and perceived, there is no reason for thinking that harm is
being inflicted and mirror areas in the brain are not activated.
Bob Jensen's threads on behavioral and cultural economics ---
http://www.trinity.edu/rjensen/theory01.htm#Behavioral