Bob Jensen's Enron Quiz (and answers) --- http://www.trinity.edu/rjensen/FraudEnronQuiz.htm

What Accountants Need to Know --- http://www.trinity.edu/rjensen/FraudReporting.htm#AccountantsNeedToKnow

Global Corruption (in legal systems) Report 2007 --- http://www.transparency.org/content/download/19093/263155

Tax Fraud Alerts from the IRS --- http://www.irs.gov/compliance/enforcement/article/0,,id=121259,00.html

White Collar Fraud Site --- http://www.whitecollarfraud.com/
Note the column of links on the left.

Bob Jensen's essay on the financial crisis bailout's aftermath and an alphabet soup of appendices can be found at
http://www.trinity.edu/rjensen/2008Bailout.htm

The Heroes of Financial Fraud, The Atlantic, April 2009 --- http://meganmcardle.theatlantic.com/archives/2009/04/the_heroes_of_financial_fraud.php

Rotten to the Core --- http://www.trinity.edu/rjensen/FraudRotten.htm

Bob Jensen's threads on fraud are at http://www.trinity.edu/rjensen/Fraud.htm

PBS Video on Multinational Illegal Payments
FRONTLINE: Black Money --- http://www.pbs.org/wgbh/pages/frontline/blackmoney/

"Keeping Fraud in the Cross Hairs." by Joseph T. Wells (Interviewed) , Journal of Accountancy, June 2010 ---
http://www.journalofaccountancy.com/Issues/2010/Jun/20102852.htm

Bob Jensen's threads on fraud are linked at http://www.trinity.edu/rjensen/Fraud.htm

AICPA Hotline Questions and Answers on Ethics for Your Accounting Students
"Test Your Knowledge of Professional Ethics," by Jason Evans,  Journal of Accountancy, June 2010 ---
http://www.journalofaccountancy.com/Issues/2010/Jun/20102778.htm 

Bob Jensen's threads on professionalism in accountancy ---
http://www.trinity.edu/rjensen/Fraud001.htm#Professionalism

I filed this under "Thinks That Rankle Tax Professor Amy Dunbar at the University of Connecticut"
"Supreme Court Declines to Hear Textron Work Product Privilege Case," Journal of Accountancy, June 2006 ---
http://www.journalofaccountancy.com/Web/20102952.htm

Another item filed under "Thinks That Rankle Tax Professor Amy Dunbar at the University of Connecticut" is the announced retirement of Brooks and Dunn ---
http://www.associatedcontent.com/article/2047767/boot_scootin_boogie_hitmakers_brooks.html?cat=33

Boot Scootin --- http://www.youtube.com/watch?v=d05tQrhNMkA

"Senators Get Donor $8 Million Earmark," Judicial Watch, June 8, 2010 ---
http://www.judicialwatch.org/blog/2010/jun/senators-get-donor-8-million-earmark

In yet another example of lawmakers unscrupulously funneling tax dollars to their political supporters, New Jersey’s two U.S. Senators steered a multi million-dollar earmark to enhance a campaign donor’s luxury condominium development.

Democrats Frank Lautenberg and Robert Menendez allocated $8 million for a public walkway and park space adjacent to upscale, waterfront condos built by a developer whose executives have donated generously to their political campaigns. The veteran legislators have received about $100,000 in contributions from the developer, according to federal election records cited in a news report this week.

Bob Jensen's Fraud Updates are at
http://www.trinity.edu/rjensen/FraudUpdates.htm

The Most Criminal Class Writes the Laws ---
http://www.trinity.edu/rjensen/FraudRotten.htm#Lawmakers

Why must we worry about the hiring-away pipeline?

Credit Rating Agencies ---- http://en.wikipedia.org/wiki/Credit_rating_agency

A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued. (In contrast to CRAs, a company that issues credit scores for individual credit-worthiness is generally called a credit bureau or consumer credit reporting agency.) The value of such ratings has been widely questioned after the 2008 financial crisis. In 2003 the Securities and Exchange Commission submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest.

Agencies that assign credit ratings for corporations include:

• A. M. Best (U.S.)
• Baycorp Advantage (Australia)
• Dominion Bond Rating Service (Canada)
• Dun & Bradstreet
• China Credit Information Service (China)
• Fitch Ratings (U.S.)
• Japan Credit Rating Agency (Japan)
• Moody's Investors Service (U.S.)
• Standard & Poor's (U.S.)
• Rating Agency Malaysia (Malaysia)
• Egan-Jones Rating Company (U.S.)
• Brickwork Rating (India)
• The Pakistan Credit Rating Agency Limited (Pakistan)

 

How to Get AAA Ratings on Junk Bonds

1. Pay cash under the table to credit rating agencies
2. Promise a particular credit rating agency future multi-million contracts for rating future issues of bonds
3. Hire away top-level credit rating agency employees with insider information and great networks inside the credit rating agencies

By now it is widely known that the big credit rating agencies (like Moody's, Standard & Poor's, and Fitch) that rate bonds as AAA to BBB to Junk were unethically selling AAA ratings to CDO mortgage-sliced bonds that should've been rated Junk. Up to now I thought the credit rating agencies were merely selling out for cash or to maintain "goodwill" with their best customers to giant Wall Street banks and investment banks like Lehman Bros., AIG., Merrill Lynch, Bear Stearns, Goldman Sachs, etc. ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze
But it turns out that the credit rating agencies were also in that "hiring-away" pipeline.

 Wall Street banks and nvestment banks were employing a questionable tactic used by large clients of auditing firms. It is common for large clients to hire away the lead auditors of their CPA auditing firms. This is a questionable practice, although the intent in most instances (we hope) is to obtain accounting experts rather than to influence the rigor of the audits themselves. The tactic is much more common and much more sinister when corporations hire away top-level government employees of regulating agencies like the FDA, FAA, FPC, EPA, etc. This is a tactic used by industry to gain more control and influence over its regulating agency. Current regulating government employees who get too tough on industry will, thereby, be cutting off their chances of getting future high compensation offers from the companies they now regulate.

The investigations of credit rating agencies by the New York Attorney General and current Senate hearings, however, are revealing that the hiring-away tactic was employed by Wall Street Banks for more sinister purposes in order to get AAA ratings on junk bonds. Top-level employees of the credit rating agencies were lured away with enormous salary offers if they could use their insider networks in the credit rating agencies so that higher credit ratings could be stamped on junk bonds.

"Rating Agency Data Aided Wall Street in Deals," The New York Times, April 24, 2010 ---
http://dealbook.blogs.nytimes.com/2010/04/24/rating-agency-data-aided-wall-street-in-deals/#more-214847

One of the mysteries of the financial crisis is how mortgage investments that turned out to be so bad earned credit ratings that made them look so good, The New York Times’s Gretchen Morgenson and Louise Story report. One answer is that Wall Street was given access to the formulas behind those magic ratings — and hired away some of the very people who had devised them.

In essence, banks started with the answers and worked backward, reverse-engineering top-flight ratings for investments that were, in some cases, riskier than ratings suggested, according to former agency employees. Read More »

"Credit rating agencies should not be dupes," Reuters, May 13, 2010 ---
http://www.reuters.com/article/idUSTRE64C4W320100513

THE PROFIT INCENTIVE

In fact, rating agencies sometimes discouraged analysts from asking too many questions, critics have said.

In testimony last month before a Senate subcommittee, Eric Kolchinsky, a former Moody's ratings analyst, claimed that he was fired by the rating agency for being too harsh on a series of deals and costing the company market share.

Rating agencies spent too much time looking for profit and market share, instead of monitoring credit quality, said David Reiss, a professor at Brooklyn Law School who has done extensive work on subprime mortgage lending.

"It was incestuous -- banks and rating agencies had a mutual profit motive, and if the agency didn't go along with a bank, it would be punished."

The Senate amendment passed on Thursday aims to prevent that dynamic in the future, by having a government clearinghouse that assigns issuers to rating agencies instead of allowing issuers to choose which agencies to work with.

For investigators to portray rating agencies as victims is "far fetched," and what needs to be fixed runs deeper than banks fooling ratings analysts, said Daniel Alpert, a banker at Westwood Capital.

"It's a structural problem," Alpert said.

Continued in article

Also see http://blogs.reuters.com/reuters-dealzone/

Jensen Comment
CPA auditing firms have much to worry about these investigations and pending new regulations of credit rating agencies.

Firstly, auditing firms are at the higher end of the tort lawyer food chain. If credit rating agencies lose class action lawsuits by investors, the credit rating agencies themselves will sue the bank auditors who certified highly misleading financial statements that greatly underestimated load losses. In fact, top level analysts are now claiming that certified Wall Street Bank financial statement were pure fiction:

"Calpers Sues Over Ratings of Securities," by Leslie Wayne, The New York Times, July 14, 2009 --- http://www.nytimes.com/2009/07/15/business/15calpers.html

Secondly, the CPA profession must begin to question the ethics of allowing lead CPA auditors to become high-level executives of clients such as when a lead Ernst & Young audit partner jumped ship to become the CFO of Lehman Bros. and as CFO devised the questionable Repo 105 contracts that were then audited/reviewed by Ernst & Yound auditors. Above you read that:  "In fact, rating agencies sometimes discouraged analysts from asking too many questions, critics have said." We must also worry that former auditors sometimes discourage current auditors from asking too many questions.
http://retheauditors.com/2010/03/15/liberte-egalite-fraternite-lehman-brothers-troubles-for-ernst-young-threaten-the-big-4-fraternity/

Credit rating of CDO mortgage-sliced bonds turned into fiction writing by hired away raters!
Frank Partnoy and Lynn Turner contend that Wall Street bank accounting is an exercise in writing fiction:
Watch the video! (a bit slow loading)
Lynn Turner is Partnoy's co-author of the white paper."Make Markets Be Markets"
"Bring Transparency to Off-Balance Sheet Accounting," by Frank Partnoy, Roosevelt Institute, March 2010 ---
http://www.rooseveltinstitute.org/policy-and-ideas/ideas-database/bring-transparency-balance-sheet-accounting
Watch the video!

At the height of the mortgage boom, companies like Goldman offered million-dollar pay packages to (credit agency) workers like Mr. Yukawa who had been working at much lower pay at the rating agencies, according to several former workers at the agencies.

In some cases, once these (former credit agency) workers were at the banks, they had dealings with their former colleagues at the agencies. In the fall of 2007, when banks were hard-pressed to get mortgage deals done, the Fitch analyst on a Goldman deal was a friend of Mr. Yukawa, according to two people with knowledge of the situation.

"Prosecutors Ask if 8 Banks Duped Rating Agencies," by Loise Story, The New York Times, May 12, 2010 ---
http://www.nytimes.com/2010/05/13/business/13street.html

The New York attorney general has started an investigation of eight banks to determine whether they provided misleading information to rating agencies in order to inflate the grades of certain mortgage securities, according to two people with knowledge of the investigation.

The investigation parallels federal inquiries into the business practices of a broad range of financial companies in the years before the collapse of the housing market.

Where those investigations have focused on interactions between the banks and their clients who bought mortgage securities, this one expands the scope of scrutiny to the interplay between banks and the agencies that rate their securities.

The agencies themselves have been widely criticized for overstating the quality of many mortgage securities that ended up losing money once the housing market collapsed. The inquiry by the attorney general of New York, Andrew M. Cuomo, suggests that he thinks the agencies may have been duped by one or more of the targets of his investigation.

Those targets are Goldman Sachs, Morgan Stanley, UBS, Citigroup, Credit Suisse, Deutsche Bank, Crédit Agricole and Merrill Lynch, which is now owned by Bank of America.

The companies that rated the mortgage deals are Standard & Poor’s, Fitch Ratings and Moody’s Investors Service. Investors used their ratings to decide whether to buy mortgage securities.

Mr. Cuomo’s investigation follows an article in The New York Times that described some of the techniques bankers used to get more positive evaluations from the rating agencies.

Mr. Cuomo is also interested in the revolving door of employees of the rating agencies who were hired by bank mortgage desks to help create mortgage deals that got better ratings than they deserved, said the people with knowledge of the investigation, who were not authorized to discuss it publicly.

Contacted after subpoenas were issued by Mr. Cuomo’s office notifying the banks of his investigation, representatives for Morgan Stanley, Credit Suisse, UBS and Deutsche Bank declined to comment. Other banks did not immediately respond to requests for comment.

In response to questions for the Times article in April, a Goldman Sachs spokesman, Samuel Robinson, said: “Any suggestion that Goldman Sachs improperly influenced rating agencies is without foundation. We relied on the independence of the ratings agencies’ processes and the ratings they assigned.”

Goldman, which is already under investigation by federal prosecutors, has been defending itself against civil fraud accusations made in a complaint last month by the Securities and Exchange Commission. The deal at the heart of that complaint — called Abacus 2007-AC1 — was devised in part by a former Fitch Ratings employee named Shin Yukawa, whom Goldman recruited in 2005.

At the height of the mortgage boom, companies like Goldman offered million-dollar pay packages to workers like Mr. Yukawa who had been working at much lower pay at the rating agencies, according to several former workers at the agencies.

Around the same time that Mr. Yukawa left Fitch, three other analysts in his unit also joined financial companies like Deutsche Bank.

In some cases, once these workers were at the banks, they had dealings with their former colleagues at the agencies. In the fall of 2007, when banks were hard-pressed to get mortgage deals done, the Fitch analyst on a Goldman deal was a friend of Mr. Yukawa, according to two people with knowledge of the situation.

Mr. Yukawa did not respond to requests for comment. A Fitch spokesman said Thursday that the firm would cooperate with Mr. Cuomo’s inquiry.

Wall Street played a crucial role in the mortgage market’s path to collapse. Investment banks bundled mortgage loans into securities and then often rebundled those securities one or two more times. Those securities were given high ratings and sold to investors, who have since lost billions of dollars on them.

 

. . .

At Goldman, there was even a phrase for the way bankers put together mortgage securities. The practice was known as “ratings arbitrage,” according to former workers. The idea was to find ways to put the very worst bonds into a deal for a given rating. The cheaper the bonds, the greater the profit to the bank.

The rating agencies may have facilitated the banks’ actions by publishing their rating models on their corporate Web sites. The agencies argued that being open about their models offered transparency to investors.

But several former agency workers said the practice put too much power in the bankers’ hands. “The models were posted for bankers who develop C.D.O.’s to be able to reverse engineer C.D.O.’s to a certain rating,” one former rating agency employee said in an interview, referring to collateralized debt obligations.

A central concern of investors in these securities was the diversification of the deals’ loans. If a C.D.O. was based on mostly similar bonds — like those holding mortgages from one region — investors would view it as riskier than an instrument made up of more diversified assets. Mr. Cuomo’s office plans to investigate whether the bankers accurately portrayed the diversification of the mortgage loans to the rating agencies.

Bob Jensen's Rotten to the Core threads on banks and investment banks ---
http://www.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking

Bob Jensen's Rotten to the Core threads on credit rating agencies ---
http://www.trinity.edu/rjensen/FraudRotten.htm#CreditRatingAgencies

“What A Tangled Web We Weave: AIG’s Cassano Says He Told PwC Everything,” by Francine McKenna, re:TheAuditors, June 30, 2010 ---
http://retheauditors.com/2010/06/30/going-concern-what-a-tangled-web-we-weave-aigs-cassano-says-he-told-pwc-everything/

My new column is up @Going Concern:

Joseph Cassano, the former head of AIG’s Financial Products Group, testifies today for the Financial Crisis Inquiry Commission, a bipartisan commission with a critical non-partisan mission — to examine the causes of the financial crisis.

[...]

The Department of Justice cleared Mr. Cassano in May. No criminal charges will be filed. U.K.’s Serious Fraud Office dropped probes last month, and the U.S. Securities and Exchange Commission also closed their investigations too…the investigations went south when, “prosecutors found evidence Mr. Cassano did make key disclosures. They obtained notes written by a PwC auditor suggesting Mr. Cassano informed the auditor and senior AIG executives about the adjustment…[and] told AIG shareholders in November 2007 that AIG would have “more mark downs,” meaning it would lower the value of its swaps.”

So who’s telling the truth? Was PwC duped by AIG? Who is looking out for AIG shareholders and the US taxpayer in this mess?

Based on my reading of the Audit Committee minutes, I believe that PwC was aware of weaknesses in internal controls over the AIGFP super senior credit default portfolio throughout 2007 and prior. Why were they pussy-footing around still on January 15, 2008 as to whether these control weaknesses were a significant deficiency (which would not have to have been disclosed) or a material weakness (which eventually was)?

Read the rest here.
http://goingconcern.com/2010/06/what-a-tangled-web-we-weave-aig’s-cassano-says-he-told-pwc-everything/

Bob Jensen's threads on PwC are at
http://www.trinity.edu/rjensen/Fraud001.htm

Where Were the Auditors?
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

Bob Jensen's Rotten to the Core threads on banks and brokerages ---
http://www.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking 

"PwC May Have Overlooked Billions in Illegal JP Morgan Transactions. Oopsie," by Adrenne Gonzalez, Going Concern, June 10, 2010 ---
http://goingconcern.com/2010/06/pwc-may-have-overlooked-billions-in-illegal-jp-morgan-transactions-oopsie/

Now £15.7 billion may not seem like much to you if you are, say, Bill Gates or Ben Bernanke but for PwC UK, it may be the magic number that gets them into a whole steaming shitpile of trouble.

UK regulators allege that from 2002 – 2009, PwC client JP Morgan shuffled client money from its futures and options business into its own accounts, which is obviously illegal. Whether or not JP Morgan played with client money illegally is not the issue here, the issue is: will PwC be liable for signing off on JPM’s activities and failing to catch such significant shenanigans in a timely manner?

PwC did not simply audit the firm, they were hired to provide annual client reports that certified client money was safe in the event of a problem with the bank. Obviously that wasn’t the case.

The Financial Reporting Council and the Institute of Chartered Accountants of England are investigating the matter, and the Financial Services Authority has already fined P-dubs £33.3 million for co-mingling client money and bank money. That’s $48.8 million in Dirty Fed Notes if you are playing along at home.

Good luck with that, PwC. We genuinely mean that.

Bob Jensen's threads on PwC are at
http://www.trinity.edu/rjensen/Fraud001.htm

Where Were the Auditors?
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

Bob Jensen's Rotten to the Core threads on banks and brokerages ---
http://www.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking

"Koss Sues Grant Thornton, Blames Firm’s Assignment of Newbie Auditors," by Caleb Newquist , Going Concern, June 25, 2010 ---
http://goingconcern.com/2010/06/koss-sues-grant-thornton-blames-firms-assignment-of-newbie-auditors/

Koss hired one of the best accounting firms in the world, Grant Thornton, and should have been able to rely on Thornton’s audits to uncover wrongdoing, Avenatti said. The suit against the auditing firm says auditors assigned to Koss were not properly trained.

The lawsuit lists hundreds of checks that Sachdeva ordered drawn on company accounts to pay for her personal expenses. She disguised the recipients — upscale retailers such as Neiman Marcus, Saks Fifth Avenue and Marshall Fields — by using just the initials. But the suit says Grant Thornton could have ascertained the true identity of the recipients by inspecting the reverse side of the checks, which showed the full name.

Continued in article

Bob Jensen's threads on Grant Thornton are at
http://www.trinity.edu/rjensen/Fraud001.htm

"Florida Appeals Court Turns Down Heat, For Now, On BDO Seidman," by Francine McKenna, re: theAuditors, June 24, 2010 ---
http://retheauditors.com/2010/06/24/florida-appeals-court-turns-down-heat-for-now-on-bdo-seidman/

I was surprised by the news that the record verdict against BDO Seidman in the Bankest fraud had been reversed. I was stunned not because the verdict had been reversed on appeal but by the reasons why.  Everyone has to prepare for a new trial because a judge erred in the setup of the proceedings.

That’s not supposed to happen.

It was a screwy sequence of events, for sure.  Every time I wrote about the case I had to carefully consider how to present all the twists and turns, ins and outs and complex machinations the court forced both sides to endure.

The 20-page opinion was written by Judge Vance E. Salter. Judges Gerald B. Cope and Linda Ann Wells concurred. Salter said Rodriguez’s trial-planning decision was based on good intentions for efficiency purposes.

“These objectives are much harder to achieve, however, in a complex case,” Salter said.

Rodriguez ordered the first phase of the trial to determine whether BDO Seidman had committed gross negligence, but Salter noted that was two months before the jury considered issues of causation, reliance and comparative fault.

One potential negative for the plaintiffs in the retrial is the likely judge. Miami-Dade Circuit Judge John Schlesinger, the judge who rendered the verdict for the defense in the BDO International phase of the case, has taken over Judge Jose Rodriguez’s civil division and will hear the retrial.  I was not impressed with Judge Schlesinger’s level of interest or aptitude during the BDO International trial for this “complex case brought by plaintiffs not in privity with the accounting firm/defendant.”

From Leagle’s posting of the opinion: The salutary objectives of judicial economy (no phase II damages trial is required if the jury returns a defense verdict in phase I), and the reduction of a longer case into more digestible “phases,” often support bifurcation and the exercise of that discretion. These objectives are much harder to achieve, however, in a complex case brought by plaintiffs not in privity with the accounting firm/defendant. In such a case, liability ultimately turns on specific demonstrations of knowledge, intent, and reliance. The evidence pertaining to those issues is inextricably intertwined with the claims and affirmative defenses on issues of comparative fault, causation, and gross negligence.

Bankest’s attorney Steven Thomas is optimistic about a retrial.  Me?  Not so much.   This isn’t because I doubt Mr. Thomas’ ability to kick tail as he did in the original trial.  This isn’t because the case doesn’t have sufficient merit.

From Michael Rapoport at DJ/Wall Street Journal: Steven Thomas, an attorney for Espirito Santo, said he was looking forward to a retrial. “The evidence of BDO Seidman’s failures of even the most basic auditing procedures is so overwhelming that we expect a new jury will reach the same conclusion as the original jury,” he said in a statement.

My doubts about the efficacy of a new trial are based on the disappointing, frustrating and completely unsatisfying way the court and the judges in this case have proceeded.  Some of the additional comments raised by the Appeals Court do not bode well for this plaintiff’s chances next time around. This is in spite of the fact they made a point of saying they would stop at the prejudice imposed by the trifurcation issue and say no more that would prejudice a new trial.

Because of the prejudice inherent in the premature, first-phase gross negligence finding, we do not address in detail other aspects of the trial. Our conclusion regarding the “trifurcation” issue renders moot or pretermits our consideration of most of the other parts of the jury’s verdicts and the remaining points on appeal and cross-appeal.

There are two other issues raised by the Appeals Court that may prove problematic to the plaintiffs in a retrial.

Continued in article

Bob Jensen's threads on BDO Seidman, are at
http://www.trinity.edu/rjensen/Fraud001.htm

Oil and Water Must Read:  Economists versus Criminologists
:"Why the ‘Experts’ Failed to See How Financial Fraud Collapsed the Economy," by "James K. Galbraith, Big Picture, June 2, 2010 ---
http://www.ritholtz.com/blog/2010/06/james-k-galbraith-why-the-experts-failed-to-see-how-financial-fraud-collapsed-the-economy/

The following is the text of a James K. Galbraith’s written statement to members of the Senate Judiciary Committee delivered this May. Original PDF text is here.

Chairman Specter, Ranking Member Graham, Members of the Subcommittee, as a former member of the congressional staff it is a pleasure to submit this statement for your record.

I write to you from a disgraced profession. Economic theory, as widely taught since the 1980s, failed miserably to understand the forces behind the financial crisis. Concepts including “rational expectations,” “market discipline,” and the “efficient markets hypothesis” led economists to argue that speculation would stabilize prices, that sellers would act to protect their reputations, that caveat emptor could be relied on, and that widespread fraud therefore could not occur. Not all economists believed this – but most did.

Thus the study of financial fraud received little attention. Practically no research institutes exist; collaboration between economists and criminologists is rare; in the leading departments there are few specialists and very few students. Economists have soft- pedaled the role of fraud in every crisis they examined, including the Savings & Loan debacle, the Russian transition, the Asian meltdown and the dot.com bubble. They continue to do so now. At a conference sponsored by the Levy Economics Institute in New York on April 17, the closest a former Under Secretary of the Treasury, Peter Fisher, got to this question was to use the word “naughtiness.” This was on the day that the SEC charged Goldman Sachs with fraud.

There are exceptions. A famous 1993 article entitled “Looting: Bankruptcy for Profit,” by George Akerlof and Paul Romer, drew exceptionally on the experience of regulators who understood fraud. The criminologist-economist William K. Black of the University of Missouri-Kansas City is our leading systematic analyst of the relationship between financial crime and financial crisis. Black points out that accounting fraud is a sure thing when you can control the institution engaging in it: “the best way to rob a bank is to own one.” The experience of the Savings and Loan crisis was of businesses taken over for the explicit purpose of stripping them, of bleeding them dry. This was established in court: there were over one thousand felony convictions in the wake of that debacle. Other useful chronicles of modern financial fraud include James Stewart’s Den of Thieves on the Boesky-Milken era and Kurt Eichenwald’s Conspiracy of Fools, on the Enron scandal. Yet a large gap between this history and formal analysis remains.

Formal analysis tells us that control frauds follow certain patterns. They grow rapidly, reporting high profitability, certified by top accounting firms. They pay exceedingly well. At the same time, they radically lower standards, building new businesses in markets previously considered too risky for honest business. In the financial sector, this takes the form of relaxed – no, gutted – underwriting, combined with the capacity to pass the bad penny to the greater fool. In California in the 1980s, Charles Keating realized that an S&L charter was a “license to steal.” In the 2000s, sub-prime mortgage origination was much the same thing. Given a license to steal, thieves get busy. And because their performance seems so good, they quickly come to dominate their markets; the bad players driving out the good.

The complexity of the mortgage finance sector before the crisis highlights another characteristic marker of fraud. In the system that developed, the original mortgage documents lay buried – where they remain – in the records of the loan originators, many of them since defunct or taken over. Those records, if examined, would reveal the extent of missing documentation, of abusive practices, and of fraud. So far, we have only very limited evidence on this, notably a 2007 Fitch Ratings study of a very small sample of highly-rated RMBS, which found “fraud, abuse or missing documentation in virtually every file.” An efforts a year ago by Representative Doggett to persuade Secretary Geithner to examine and report thoroughly on the extent of fraud in the underlying mortgage records received an epic run-around.

When sub-prime mortgages were bundled and securitized, the ratings agencies failed to examine the underlying loan quality. Instead they substituted statistical models, in order to generate ratings that would make the resulting RMBS acceptable to investors. When one assumes that prices will always rise, it follows that a loan secured by the asset can always be refinanced; therefore the actual condition of the borrower does not matter. That projection is, of course, only as good as the underlying assumption, but in this perversely-designed marketplace those who paid for ratings had no reason to care about the quality of assumptions. Meanwhile, mortgage originators now had a formula for extending loans to the worst borrowers they could find, secure that in this reverse Lake Wobegon no child would be deemed below average even though they all were. Credit quality collapsed because the system was designed for it to collapse.

A third element in the toxic brew was a simulacrum of “insurance,” provided by the market in credit default swaps. These are doomsday instruments in a precise sense: they generate cash-flow for the issuer until the credit event occurs. If the event is large enough, the issuer then fails, at which point the government faces blackmail: it must either step in or the system will collapse. CDS spread the consequences of a housing-price downturn through the entire financial sector, across the globe. They also provided the means to short the market in residential mortgage-backed securities, so that the largest players could turn tail and bet against the instruments they had previously been selling, just before the house of cards crashed.

Latter-day financial economics is blind to all of this. It necessarily treats stocks, bonds, options, derivatives and so forth as securities whose properties can be accepted largely at face value, and quantified in terms of return and risk. That quantification permits the calculation of price, using standard formulae. But everything in the formulae depends on the instruments being as they are represented to be. For if they are not, then what formula could possibly apply?

An older strand of institutional economics understood that a security is a contract in law. It can only be as good as the legal system that stands behind it. Some fraud is inevitable, but in a functioning system it must be rare. It must be considered – and rightly – a minor problem. If fraud – or even the perception of fraud – comes to dominate the system, then there is no foundation for a market in the securities. They become trash. And more deeply, so do the institutions responsible for creating, rating and selling them. Including, so long as it fails to respond with appropriate force, the legal system itself.

Control frauds always fail in the end. But the failure of the firm does not mean the fraud fails: the perpetrators often walk away rich. At some point, this requires subverting, suborning or defeating the law. This is where crime and politics intersect. At its heart, therefore, the financial crisis was a breakdown in the rule of law in America.

Ask yourselves: is it possible for mortgage originators, ratings agencies, underwriters, insurers and supervising agencies NOT to have known that the system of housing finance had become infested with fraud? Every statistical indicator of fraudulent practice – growth and profitability – suggests otherwise. Every examination of the record so far suggests otherwise. The very language in use: “liars’ loans,” “ninja loans,” “neutron loans,” and “toxic waste,” tells you that people knew. I have also heard the expression, “IBG,YBG;” the meaning of that bit of code was: “I’ll be gone, you’ll be gone.”

If doubt remains, investigation into the internal communications of the firms and agencies in question can clear it up. Emails are revealing. The government already possesses critical documentary trails — those of AIG, Fannie Mae and Freddie Mac, the Treasury Department and the Federal Reserve. Those documents should be investigated, in full, by competent authority and also released, as appropriate, to the public. For instance, did AIG knowingly issue CDS against instruments that Goldman had designed on behalf of Mr. John Paulson to fail? If so, why? Or again: Did Fannie Mae and Freddie Mac appreciate the poor quality of the RMBS they were acquiring? Did they do so under pressure from Mr. Henry Paulson? If so, did Secretary Paulson know? And if he did, why did he act as he did? In a recent paper, Thomas Ferguson and Robert Johnson argue that the “Paulson Put” was intended to delay an inevitable crisis past the election. Does the internal record support this view?

Let us suppose that the investigation that you are about to begin confirms the existence of pervasive fraud, involving millions of mortgages, thousands of appraisers, underwriters, analysts, and the executives of the companies in which they worked, as well as public officials who assisted by turning a Nelson’s Eye. What is the appropriate response?

Some appear to believe that “confidence in the banks” can be rebuilt by a new round of good economic news, by rising stock prices, by the reassurances of high officials – and by not looking too closely at the underlying evidence of fraud, abuse, deception and deceit. As you pursue your investigations, you will undermine, and I believe you may destroy, that illusion.

But you have to act. The true alternative is a failure extending over time from the economic to the political system. Just as too few predicted the financial crisis, it may be that too few are today speaking frankly about where a failure to deal with the aftermath may lead.

In this situation, let me suggest, the country faces an existential threat. Either the legal system must do its work. Or the market system cannot be restored. There must be a thorough, transparent, effective, radical cleaning of the financial sector and also of those public officials who failed the public trust. The financiers must be made to feel, in their bones, the power of the law. And the public, which lives by the law, must see very clearly and unambiguously that this is the case.

Thank you.

~~~

James K. Galbraith is the author of The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too, and of a new preface to The Great Crash, 1929, by John Kenneth Galbraith. He teaches at The University of Texas at Austin

Bob Jensen's threads on the subprime sleaze is at
http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze

"Guest Post – Fraud Girl: “Fraud by Hindsight”- How Wall Street Firms [Legally] Get Away With Fraudulent Behavior!," Fraud Girl, Simoleon Sense, June 6, 2010 --- Click Here
http://www.simoleonsense.com/guest-post-fraud-girl-%e2%80%9cfraud-by-hindsight%e2%80%9d-how-wall-street-firms-legally-get-away-with-fraudulent-behavior/

Last week we discussed the credit rating agencies and their roles the financial crisis. These agencies provided false ratings on credit they knew was faulty prior to the crisis. In defense, these agencies (as well as Warren Buffet) said that they did not foresee the crisis to be as severe as it was and therefore could not be blamed for making mistakes in their predictions. This week’s post focuses on foreseeability and the extent to which firms are liable for incorrect predictions.

Like credit agencies, Wall Street firms have been accused of knowing the dangers in the market prior to its collapse. I came across this post (Black Swans*, Fraud by hindsight, and Mortgage-Backed Securities) via the Wall Street Law Blog that discusses how firms could assert that they can’t be blamed for events they couldn’t foresee. It’s a doctrine known as Fraud by Hindsight (“FBH”) where defendants claim “that there is no fraud if the alleged deceit can only be discerned after the fact”. This claim has been used in numerous securities fraud lawsuits and surprisingly it has worked in the defendant’s favor on most occasions.

Many Wall Street firms say they “could not foresee the collapse of the housing market, and therefore any allegations of fraud are merely impermissible claims of fraud by hindsight”. Was Wall Street able to foresee the housing market crash prior to its collapse? According to the writers at WSL Blog, they did foresee it saying, “From 1895 through 1996 home price appreciation very closely corresponded to the rate of inflation (roughly 3% per year).  From 1995 through 2006 alone – even after adjusting for inflation – housing prices rose by more than 70%”. Wall Street must (or should) have foreseen a drastic change in the market when rises in housing costs were so abnormal. By claiming FBH, however, firms can inevitably “get away with murder”.

What exactly is FBH and how is it used in court? The case below from Northwestern University Law Review details the psychology and legalities behind FBH while attempting to show how the FBH doctrine is being used as a means to dismiss cases rather than to control the influence of Wall Street’s foreseeability claims.

Link Provided to Download "Fraud by Hindsight"  (Registration Required)
 

I’ve broken down the case into two parts. The first part provides two theories on hindsight in securities litigation: The Debiasing Hypothesis & The Case Management Hypothesis. The Debiasing Hypothesis provides that FBH is being used in court as a way to control the influence of ‘hindsight bias’. This bias says that people “overstate the predictability of outcomes” and “tend to view what has happened as having been inevitable but also view it as having appeared ‘relatively inevitable’ before it happened”.  The Debiasing Hypothesis tries to prove that FBH aids judges in “weeding out” the biases so that they can focus on the allegations at hand.

The Case Management Hypothesis states that FBH is a claim used by judges to easily dismiss cases that they deem too complicated or confusing. According to the analysis, “…academics have complained that these [securities fraud] suits settle without regard to merit and do little to deter real fraud, operating instead as a needless tax on capital raising. Federal judges, faced with overwhelming caseloads, must allocate their limited resources. Securities lawsuits that are often complex, lengthy, and perceived to be extortionate are unlikely to be a high priority. Judges might thus embrace any doctrine [i.e. FBH doctrine] that allows them to dispose of these cases quickly” (782-783). The case attempts to prove that FBH is primarily used for case management purposes rather than for controlling hindsight bias.

The psychological aspects behind hindsight bias are discussed thoroughly in this case. Here are a few excerpts from the case regarding this bias:

(1)“Studies show that judges are vulnerable to the bias, and that mere awareness of the phenomenon does not ameliorate its influence on judgment. The failure to develop a doctrine that addresses the underlying problem of judging in hindsight means that the adverse consequences of the hindsight bias remain a part of securities litigation. Judges are not accurately sorting fraud from mistake, thereby undermining the system, even as they seek to improve it” (777).

(2) “Judges assert that a company’s announcement of bad results, by itself, does not mean that a prior optimistic statement was fraudulent. This seems to be an effort to divert attention away from the bad outcome and toward the circumstances that gave rise to that outcome, which is exactly the problem that hindsight bias raises. That is, if people overweigh the fact of a bad outcome in hindsight, then the cure is to reconstruct the situation as people saw it beforehand. Thus, the development of the FBH doctrine suggests a judicial understanding of the biasing effect of judging in hindsight and of a means to address the problem” (781).

(3) “Once a bad event occurs, the evaluation of a warning that was given earlier will be biased. In terms of evaluating a decision-maker’s failure to heed a warning, knowledge that the warned-of outcome occurred will increase the salience of the warning in the evaluator’s mind and bias her in the direction of finding fault with the failure to heed the warning. In effect, the hindsight bias becomes an ‘I-told-you-so’ bias.” (793).

(4) “In foresight, managers might reasonably believe that the contingency as too unlikely to merit disclosure, whereas in hindsight it seems obvious a reasonable investor would have wanted to know it. Likewise, as to warning a company actually made, in foresight most investors might reasonably ignore them, whereas in hindsight they seem profoundly important. If defendants are allowed to defend themselves by arguing that a reasonable investor would have attended closely to these warnings, then the hindsight bias might benefit defendants” (794).

Next week we’ll explore the second part of the case and discuss the importance of utilizing FBH as a means of deterring the hindsight bias. We’ll see how the case proves that FBH is not being used for this purpose and is instead used as a mechanism to dismiss cases that simply do not want to be heard.

See you next week…
-Fraud Girl

Bob Jensen's Rotten to the Core threads on credit rating agencies ---
http://www.trinity.edu/rjensen/FraudRotten.htm#CreditRatingAgencies

Bob Jensen's Rotten to the Core threads on banks and brokerages ---
http://www.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking

Bob Jensen's Fraud updates ---
http://www.trinity.edu/rjensen/FraudUpdates.htm

"Guest Post – Fraud Girl: “Fraud by Hindsight”- How Wall Street Firms [Legally] Get Away With Fraudulent Behavior! Part 2," by Fraud Girl, Simoleon Post, June 13, 2010 --- Click Here
http://www.simoleonsense.com/guest-post-fraud-girl-%e2%80%9cfraud-by-hindsight%e2%80%9d-how-wall-street-firms-legally-get-away-with-fraudulent-behavior-part-2/

Last week we discussed the first part of the “Fraud by Hindsight” study. As we learned, the FBH doctrine is utilized in securities litigation cases. In learning about the FBH doctrine we reviewed the Debiasing Hypothesis and the Case Management Hypothesis. According to the Debiasing Hypothesis, FBH is used as a tool to “weed out” hindsight bias in order to focus on legal issues at hand. The Case Management Hypothesis, on the other hand declares that FBH is used to dismiss securities fraud cases in order to facilitate judicial control over them. This week we will strive to analyze how Fraud By Hindsight has evolved, meaning, how the courts apply the doctrine (in real life), which differs markedly from the doctrine’s theoretical meaning.

History

The first mention of FBH was in 1978 with Judge Friendly in the case Denny v. Barber. The plaintiff in this case claimed that the bank had “engaged in unsound lending practices, maintained insufficient loan loss reserves, delayed writing off bad loans, and undertook speculative investments” (796). Sound familiar? Anyway — the plaintiff plead that the bank failed to disclose these problems in earlier reports and instead issued reports with optimistic projections. Judge Friendly claimed FBH stating that there were a number of “intervening events” during that period (i.e. increasing prices in petroleum and the City of New York’s financial crisis) that were outside the control of managers and it was therefore insufficient to claim that the defendant should have known better when out-of-the-ordinary incidents have occurred. The end result of the case provided that “hindsight alone might not constitute a sufficient demonstration that the defendants made some predictive decision with knowledge of its falsity or something close to it” (797). Friendly established that FBH is possible, but that in this case the underlying circumstances did not justify a judgment against the bank.

The second relevant mention of FBH was in 1990 with Judge Easterbrook in the case DiLeo v. Ernst & Young. Like the prior case, DiLeo involved problems with loans where the plaintiff plead that the bank and E&Y had known but failed to disclose that a substantial portion of the bank’s loans were uncollectible. This case was different, in that there were no “intervening events” that could have blind sighted managers from issuing more accurate future projections. Still, Easterbrook claimed FBH and said, “the fact that the loans turned out badly does not mean that the defendant knew (or should have known) that this was going to happen” (799-800). Easterbrook believed that the plaintiff must be able to separate the true fraud from the underlying hindsight evidence in order to prove their case.

Easterbrook’s articulation of the FBH doctrine set the stage for all future securities class action cases. As the authors state, the phrase was cited only about twice per year before DiLeo but it increased to an average of twenty-seven times per year afterwards. Unfortunately, the courts found Easterbrook’s perception of the phrase to be more compelling. Instead of providing that the hindsight might play a role determining if fraud has occurred, Easterbrook claimed that there simply is no “fraud by hindsight”. This allows the courts to adjudicate cases solely on complaint, therefore supporting the Case Management Hypothesis.

The results of many tests provided in this case proved that courts were using the doctrine as a means to dismiss cases. Of all the tests, I found one to be most interesting: The Stage of the Proceedings. The results of the test shows that “over 90 percent of FBH applications involve judgments on the pleadings” (814) stage rather than at summary judgment. In the preliminary (pleading) stages, the knowledge of information is not provided, meaning that it is less likely that hindsight bias will affect their decisions. The more the judge delves into the case, the more they are susceptible to the hindsight bias. If the judge is utilizing the FBH doctrine mostly during the pleading stages where hindsight bias is “weak”, then the Debiasing Hypothesis is not valid.

The authors point out the problems with utilizing the FBH doctrine in this way:

“The problem, however, is that the remedy is applied at the pleadings stage, not the summary judgment stage. At the pleadings stage, a bad outcome truly is relevant to the likelihood of fraud. At this stage, the Federal Rules do not ask the courts to make a judgment on the merits, and hence the remedy of foreclosing further litigation is inappropriate. By foreclosing further proceedings, courts are not saying that they do not trust their own judgment, but that they do not trust the process of civil discovery to identity whether fraud occurred” (815).

Because cases are being dismissed so early in the litigation process, courts are not allowing for the discovery of fraud that may be apparent even though hindsight is a factor in the case.

By gathering this and other evidence, the case concludes that judges utilize FBH as a case management tool. They cited that the development of the FBH doctrine could be described as “naïve cynicism”. Though judges understand that hindsight bias must be taken into consideration, they express the belief that the problem does not affect their own judgment. The courts are relying on their own intuitions and gathering the necessary facts to prove fraud by hindsight. The authors note a paradox here saying, “Judges simultaneously claim that human judgment cannot be trusted, and yet they rely on their own judgment”.

The problem is that the naively cynical (FBH) approach has led to securities fraud cases to be governed by moods. The authors say that “In the 1980s and 1990s, as concern with frivolous securities litigation rose, courts and Congress simply made it more difficult for plaintiffs to file suit. In the post-Enron era, this skepticism about private enforcement of securities fraud might have abated somewhat, leading to lesser pleading requirements” (825).

Recap & Implications

Overall the case proves that the courts have not yet been able to establish a sensible mechanism for sorting fraud from mistake. It therefore allows cases that really involve fraud to potentially be dismissed. In cases since DiLeo, the win rate for defendants in FBH cases is 70 percent, as compared with 47 percent in those cases that did not mention it. The mere declaration of “Fraud by Hindsight” gives the defendant an automatic advantage over the plaintiff. Now, the defendant may in fact be innocent – but the current processes are not able to determine who is or isn’t guilty. Remember, judges spend much of their time in these cases separating the hindsight bias from the fraud. This task can become very complex and time consuming.

In sum, the increasing use of FBH has been beneficial for (1) judges because they don’t have to listen to these complicated cases and (2) defendant’s because they are likely to win the case by using the doctrine. The only ones who don’t benefit from doctrine are the plaintiff’s who may truly have been victims of fraud. It is crucial that the judiciary revise the way the FBH is interpreted in order to protect the innocent and convict the guilty.

Have any ideas on how to fix the FBH problem? Send me an email at fraudgirl @ simoleonsense.com.

See you next week.

- Fraud Girl

Click Here To Access The Original  Fraud by Hindsight Case – Part II ---
http://www.scribd.com/doc/32994403/Fraud-by-Hindsight-Part-II

Bob Jensen's threads on fraud are at
http://www.trinity.edu/rjensen/Fraud.htm

"Countrywide (now part of Bank of America) Pays $108 Million to Settle Fees Complaint." by Edward Wyatt, The New York Times, June 7, 2010 ---
http://www.nytimes.com/2010/06/08/business/08ftc.html?hp

The Federal Trade Commission announced Monday that two Countrywide mortgage servicing companies had agreed to pay $108 million to settle charges that they collected excessive fees from financially troubled homeowners.

The $108 million payment is one of the largest overall judgments in the commission’s history and resolves its largest mortgage servicing case. The money will go to more than 200,000 homeowners whose loans were serviced by Countrywide before July 2008, when it was acquired by Bank of America.

Jon Leibowitz, the chairman of the Federal Trade Commission, said that Countrywide’s loan servicing operation charged excessive fees to homeowners who were behind on their mortgage payments, in some cases asserting that customers were in default when they were not.

The fees, which were billed as the cost of services like property inspections and lawn mowing, were grossly inflated after Countrywide created subsidiaries to hire vendors to supply the services, increasing the cost several-fold in the process, the commission said.

In addition, the commission said that Countrywide at times imposed a new round of fees on homeowners who had recently emerged from bankruptcy protection, sometimes threatening the consumers with a new foreclosure.

“Countrywide profited from making risky loans to homeowners during the boom years, and then profited again when the loans failed,” Mr. Leibowitz said.

The $108 million settlement represents the agency’s estimate of consumer losses, but does not include a penalty, which the commission is not allowed to impose.

Clifford J. White III, the director of the executive office for the United States Trustees Program, which enforces bankruptcy laws for the Department of Justice, said that the commission’s settlement “will help prevent future harm to homeowners in dire financial straits who legitimately seek bankruptcy protection.”

The settlement bars Countrywide from making false representations about amounts owed by homeowners, from charging fees for services that are not authorized by loan agreements, and from charging unreasonable amounts for work.

In addition, the settlement requires Countrywide to establish internal procedures and an independent third party to verify that bills and claims filed in bankruptcy court are valid.

“Now more than ever, companies that service consumers’ mortgages need to do so in an honest and fair way,” Mr. Leibowitz said.

The F.T.C. has not yet established how much will be paid to each consumer, in part, Mr. Leibowitz said, because Countrywide’s record keeping was “abysmal.” About $35 million of the $108 million total was charged to homeowners already in bankruptcy proceedings, with the remainder charged to customers whom Countrywide said were in default on their mortgages.

Jensen Comment
I think Countrywide got off too easy. The evil Countrywide brokered mortgages to borrowers that had no hope of paying back the debt and then charged they excessive fees when they got behind in their payments.

Bob Jensen's threads on the sleaze of Countrywide are at
http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze

Bob Jensen's fraud updates are at
http://www.trinity.edu/rjensen/FraudUpdates.htm

"Guest Post: Fraud Girl – When The Financial Industry’s “Astrologers” Fail Us… Who’s Left To Analyze Credit Risk?" Fraud Girl, Simoleon Sense, May 30, 2010 --- Click Here
http://www.simoleonsense.com/guest-post-fraud-girl-when-the-financial-industry%e2%80%99s-%e2%80%9castrologers%e2%80%9d-fail-us%e2%80%a6-whos-left-to-analyze-credit-risk/

In light of Buffet testifying before the Financial Crisis Inquiry Commission, it’s only fitting to discuss the credit rating agencies and how Congress is considering fixing their “moral hazards”.

The Start of It All: “Doing it for the Money”

At the peak of the housing boom, credit rating agencies began reevaluating their AAA debt ratings. In 2006, agencies like S&P and Moody’s were forced to redo their models but nothing was significantly changed.  At the height of the crisis, it was apparent that these ratings were incorrect and as a result a “whopping 91% of AAA-rated mortgage securities were downgraded to junk status”. Because these credit agencies are so highly relied upon by Wall Street, a shock spread across the market. It wasn’t long before the entire financial system was in midst of a collapse.

The government began an inquiry on the credit agencies failure to properly assess credit risk. As noted in an article from CNN, emails began to surface that agencies knew that the crisis was forming but kept company’s ratings high anyway. In one email, and employee wrote:

“This is frightening. It wreaks of greed, unregulated brokers, and ‘not so prudent’ lenders”

Why weren’t the agencies doing their jobs? They had no incentive to. Agencies get paid from the company’s they rate. If an agency downgrades their reliability, the company will stop paying for the ratings.

Ideas on How to Fix the Problem

I found a post via The Baseline Scenario blog: Reforming Credit Rating Agencies. Former analyst and then managing director at Moody’s Investors Service, Gary Witt, discusses what Congress wants to implement to resolve the credit agency issues as well as his opinion on the matter.

The Financial Stability Act of 2010 addresses what Congress believes should be done…  including making the SEC responsible for examining the agencies at least once a year and making key findings public. It will also give the SEC the power to fine agencies for any wrongdoing they find.

Witt addresses the same concerns I do. He believes that having the SEC oversee the credit agencies is necessary but is uncertain as to whether they have the right qualifications to take that responsibility. We have seen what damage can occur when employees not experienced in Wall Street attempt to regulate the market (i.e. Bernie Madoff). We have learned that regulators aren’t asking the right questions and until they are educated enough as to how to ask those questions, they should not be asked to hold responsibility for our financial markets. If the SEC is going to take over, they are going to need well-experienced rating agents and must provide them with an incentive to work there.

Witt first suggests that we eliminate AAA ratings. How could anyone be sure that an instrument is 100% riskless? Witt instead believes there should be five simple categories to rate credit risk:

“A for securities expected to lose under 0.1%, B for expected losses between 0.1% and 1%, C for expected losses from 1% to 5%, D for expected losses from 5% to 10% and F for securities expected losses between 10% and 20%.”

If a credit agency performs poorly (i.e. rates credit an A that ended up in a loss), then the SEC can fine them. Though the agencies are still being paid by the companies themselves, they have more of an incentive to make accurate predictions.

Another option is to get rid of the agencies. I find this option more appealing.

The financial industry has placed too much trust in these agencies. Credit agencies are simply financial astrologists attempting to predict the future. An agency telling you an instrument is AAA rated does not mean that you should believe it.

Always ask the right questions: Where did this information come from? How did they make their decisions? What types of models do they use to come to these conclusions? If these types of questions were asked prior to the collapse, many investors would have realized that these ratings made no sense.

Individuals must perform the necessary research in order to determine their own judgments of risk. The problem we are having is that we have too much confidence in the regulators, auditors, agencies, etc. when most are falling short of their responsibilities.

Have any ideas on how to resolve the credit agency problems? Send me an email at fraudgirl [at] simoleonsense.com.

See you next week.

- Fraud Girl

Credit Rating Agencies ---- http://en.wikipedia.org/wiki/Credit_rating_agency

A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued. (In contrast to CRAs, a company that issues credit scores for individual credit-worthiness is generally called a credit bureau or consumer credit reporting agency.) The value of such ratings has been widely questioned after the 2008 financial crisis. In 2003 the Securities and Exchange Commission submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest.

Agencies that assign credit ratings for corporations include:

• A. M. Best (U.S.)
• Baycorp Advantage (Australia)
• Dominion Bond Rating Service (Canada)
• Dun & Bradstreet
• China Credit Information Service (China)
• Fitch Ratings (U.S.)
• Japan Credit Rating Agency (Japan)
• Moody's Investors Service (U.S.)
• Standard & Poor's (U.S.)
• Rating Agency Malaysia (Malaysia)
• Egan-Jones Rating Company (U.S.)
• Brickwork Rating (India)
• The Pakistan Credit Rating Agency Limited (Pakistan)

Actually the large CPA firms are looking into the possibility of becoming credit rating agencies
I consider this to be a bridge to far if they are both the auditors and the credit raters

KPMG and PwC eye rating move," by Richard Milne and Rachel Sanderson in London, Financial Times, May 16, 2010 ---
http://www.ft.com/cms/s/0/d88c971e-60fd-11df-9bf0-00144feab49a.html?ftcamp=rss

KPMG and PwC, two of the world’s largest accounting firms, have considered entering the credit rating business, in a move that would pitch them against the current top three – and heavily criticised – agencies Moody’s, Standard & Poor’s and Fitch.

John Griffith Jones, chairman of KPMG in the UK and co-chair in Europe, told the Financial Times it had discussed the move as – being one of the four biggest accounting firms in the world – it had the skills, knowledge and people to provide credit ratings.

Continued in article

The Scandals of Credit Rating Agencies ---
http://www.trinity.edu/rjensen/FraudRotten.htm#CreditRatingAgencies

Jensen Comment
If the auditing firms move into client credit rating business, I view this as an enormous conflict of interest.

My first objection is that auditors are supposed to have access to confidential data of clients. How is it possible to protect this confidential client-auditor relationship if auditors take on a credit rating service?

Bob Jensen's threads on the credit rating agency frauds are at
http://www.trinity.edu/rjensen/FraudRotten.htm#CreditRatingAgencies

Bob Jensen's Fraud Updates are at
http://www.trinity.edu/rjensen/FraudUpdates.htm

Bob Jensen's threads on the subprime sleaze --- http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze

Bob Jensen's threads on how whistle blowing is not rewarded --- http://www.trinity.edu/rjensen/FraudConclusion.htm#WhistleBlowing

1996 Case Loses after 14 Years:
"PwC loses ruling on big Pa. healthcare bankruptcy," by Jonathan Stempe, Reuters, May 28, 2010 ---
http://www.reuters.com/article/idUSN2821575820100528

PricewaterhouseCoopers LLP suffered a defeat on Friday when a federal appeals court ordered an inquiry into whether the auditor dealt in good faith with a large Pennsylvania hospital system that went bankrupt.

The Third Circuit Court of Appeals in Philadelphia threw out a January 2007 ruling dismissing claims against PwC by a committee of unsecured creditors of behalf of the now defunct Allegheny Health, Education and Research Foundation.

These creditors accused Coopers & Lybrand LLP, one of PwC's predecessor companies, of conspiring with AHERF officials in the 1996 and 1997 fiscal years to hide the increasingly dire financial health of the Pittsburgh-based system.

AHERF ultimately sought Chapter 11 protection in July 1998, with about $1.3 billion of debt, in the largest U.S. nonprofit healthcare collapse. The system once ran 14 hospitals and two medical schools and employed an estimated 31,000 people.

It is not clear whether Friday's ruling will result in more litigation or prompt the parties to pursue a settlement.

PwC spokesman Steven Silber said company officials could not be reached for comment. James Jones, a Pittsburgh-based lawyer for the creditors, declined immediate comment.

In his 2007 ruling, U.S. District Judge David Cercone said the creditors could not recover on AHERF's behalf under a legal doctrine governing cases of equal fault, concluding AHERF was at least as much at fault as PwC.

But the Third Circuit asked the Pennsylvania Supreme Court for guidance on that state's law, including whether an auditor such as PwC could be held liable for breach of contract, negligence or aiding and abetting a breach of fiduciary duty.

Writing for a unanimous three-judge panel of the Third Circuit, Judge Thomas Ambro adopted the Pennsylvania court's conclusion that an auditor could be held liable if it had "not dealt materially in good faith with the client-principal."

This effectively barred the equal fault defense in cases of "secretive collusion between officers and auditors to misstate corporate finances to the corporation's ultimate detriment."

Ambro also directed the district court to reconsider its finding that misstated financials could have been a short-term "benefit" to AHERF.

He said that, as a matter of law, "a knowing, secretive, fraudulent misstatement of corporate financial information" cannot benefit a company.

The AHERF bankruptcy generated much litigation and regulatory activity. In 2007, the bond insurer MBIA Inc (MBI.N) agreed to pay $75 million to settle regulatory fraud charges over a reinsurance transaction involving defaulted AHERF debt.

The case is Official Committee of Unsecured Creditors of Allegheny Health, Education and Research Foundation v. PricewaterhouseCoopers LLP, U.S. Third Circuit Court of Appeals, No. 07-1397. (Reporting by Jonathan Stempel; editing by Steve Orlofsky and Andre Grenon)

Bob Jensen's threads on PwC Litigation are at
http://www.trinity.edu/rjensen/Fraud001.htm

"Study Reflects High Financial Malfeasance Rates in Largest U.S. Corporations," SmartPros, June 3, 2010 ---
http://accounting.smartpros.com/x69720.xml

The need to "fix" or restate financial statements is an admission by corporate management that these reports (prior to their being corrected) to the government and the investing public misrepresented the corporations' financial positions, Texas A&M University sociology professor Harland Prechel reports in a research paper published in the June 2010 issue of the American Sociological Review (ASR).

Prechel and Theresa Morris of Trinity College in Hartford, Connecticut, examined the revised statements from hundreds of the largest U.S. companies between 1995 and 2004, then co-authored the paper, titled "The Effects of Organizational and Political Embeddedness on Financial Malfeasance in the Largest U.S. Corporations: Dependence, Incentives, and Opportunities."

The researchers' analysis examines restatements that occurred after Congress passed the 2001 Sarbanes-Oxley Act, which held chief financial officers (CFOs) and chief executive officers (CEOs) personally responsible for corporate violations of security and exchange laws. Soon after this legislation was passed, the number of financial restatements rapidly increased. After eliminating the legitimate reasons for financial restatements such as accounting rule changes, their analysis shows that over 21 percent of the corporations in their study group restated their finances at least once, and some as many as seven times, during the study period.

Their research centers on financial statements, corporate structure, and politics. And the findings have important implications for public policy, Prechel says. "The corporate and state structures enacted in the late 20th century were the outcome of a long-term, well-financed and systematic political strategy that provided managers with unprecedented power, autonomy, and opportunity to engage in financial malfeasance," the paper's summary states.

There are three main findings from their quantitative analysis. First, capital dependence on investors creates incentives to engage in financial malfeasance. Second, managerial strategies to increase shareholder value create incentives to engage in financial malfeasance. Third, the multilayer-subsidiary form and the political structure permitting corporate political action committees' (PAC) contributions create opportunities to engage in financial malfeasance.

A key point of the analysis, Prechel says, is that the multilayer-subsidiary business model, where parent companies own multiple legally independent subsidiary corporations, creates opportunities for managers to engage in financial malfeasance by overstating the value of the assets in these corporate entities. Prechel says that one case of improper reporting involved Enron, which overstated the value in one of its subsidiaries by $256 million.

He says he and Morris focus on the concept of "malfeasance"—an act that violates a law or a rule (or violates their intent) established by a government agency or a nongovernmental organization responsible for corporate financial oversight—rather than "crime," because behaviors that are legal may still mislead investors, especially small investors, due to information asymmetry (i.e., when one party (e.g., the company) has access to information that the other (e.g., investor) lacks).

Individual investors are vulnerable when they invest in corporations directly or via mutual funds, Prechel says. "There are opportunities for management to engage in financial malfeasance that investors aren't even aware of," he explains. "Management is aware of the true financial picture, while individual investors are not."

Companies that do not use the multilayer subsidiaries form file revisions less frequently, Prechel says.

"The more subsidiaries a parent company has, the higher the likelihood it will restate its finances," he says. "But, in the cases that were included in the analysis, there is no good reason for management to not understand their corporation's financial status."

He says Congress could fix the problem by reinstating the tax on capital transfers that it removed in 1986.

June 7, 2010 reply from Robert Bruce Walker [walkerrb@ACTRIX.CO.NZ]

Here is Accountancy’s report on the JP Morgan client accounting fiasco. You will see that PwC was actually engaged to provide some sort of specific certification in that respect. Whilst trust account auditing can be tricky, you don’t need to be an audit ‘expert’ to track GBP 16 billion. A few simple tracing tests ought to do it.

"PwC in potential inquiry over client money breach: FSA fines JP Morgan record £33m," by Pat Sweet

PricewaterhouseCoopers could face an inquiry by accounting regulators over its repeated certification that JP Morgan Securities Ltd (JPMSL) kept clients' funds separate from its own - a certification which is now in contention after the bank was discovered to have breached the rules.

The role of PwC - also the bank's auditors - in the certification of how the investment bank handled client funds is now under scrutiny, following a record £33.3m fine on the bank by the Financial Services Authority, which discovered that JPMSL had mixed its own funds with those of clients.

Under the FSA’s client money rules, firms are required to keep client money separate from the firm's money in segregated accounts with trust status. This helps to protect client money in the event of the firm's insolvency.

The FSA fined JPMSL after it found to have mixed client funds with its own cash over a seven year period. Up to £16bn of clients’ money went into the wrong bank accounts.

The FSA plans to pass on the details of its investigation to both the Financial Reporting Council and the ICAEW, which will then determine whether any further action is necessary, according to the Times.

In addition to serving as principal auditor, PwC was retained by JP Morgan Securities Limited to produce an annual client asset returns report, to confirm that customers’ funds were being effectively ring-fenced and therefore protected in the event of the bank’s collapse.

However, PwC signed off the client report even though JP Morgan was in breach of the rules.

The money at risk in this case consisted of funds held by customers of JPMSL's futures and options business — a sum that varied from £1.3bn to £15.7bn between 2002 and July 2009, when the breach came to light.

PwC has declined to comment.

Bob Jensen's Fraud Updates are at
http://www.trinity.edu/rjensen/FraudUpdates.htm

Bob Jensen's threads on PwC Litigation are at
http://www.trinity.edu/rjensen/Fraud001.htm

"Silencing the Whistleblowers:  Financial reform won’t prevent another bubble if banks bulldoze their internal warning systems," by Michael W. Hudson, The Big Money (Slate), May 9, 2010 --- http://www.thebigmoney.com/articles/judgments/2010/05/07/silencing-whistleblowers

In early 2006, Darcy Parmer began to worry about her job. She was a mortgage fraud investigator at Wells Fargo Bank. Her managers weren’t happy with her. It wasn’t that she wasn’t doing a good job of sniffing out questionable loans in the bank’s massive home-loan program. The problem, she said, was that she was doing too good a job.

The bank’s executives and mortgage salesmen didn’t like it, Parmer later claimed in a lawsuit, when she tried to block loans that she suspected were underpinned by paperwork that exaggerated borrowers’ incomes and inflated their home values. One manager, she said, accused her of launching “witch hunts” against the bank’s loan officers.

One of the skirmishes involved a borrower she later referred to in court papers as “Ms. A.” An IRS document showed Ms. A earned $5,030 a month. But Wells Fargo’s sales staff had won approval for Ms. A’s loan by claiming she made more than twice that—$11,830 a month. When Parmer questioned the deal, she said, a supervisor ordered her to close the investigation, complaining, “This is what you do every time.”

Amid the frenzy of the nation’s mortgage boom, the back-of-the-hand treatment that Parmer describes wasn’t out of the ordinary. Parmer was one of a small band of in-house gumshoes at various financial institutions who uncovered evidence of corruption in the mortgage business—including made-up addresses, pyramid schemes, and organized criminal rings—and tried to warn their employers that this wave of fraud threatened consumers as well as the stability of the financial system. Instead of heeding their warnings, they say, company officials ignored them, harassed them, demoted them, or fired them.

In interviews and in court records, 10 former fraud investigators at seven of the nation’s biggest banks and lenders—including Wells Fargo (WFC), IndyMac Bank, and Countrywide Financial—describe corporate cultures that allowed fraud to thrive in the pursuit of loan volume and market share. Mortgage salesmen stuck homeowners into loans they couldn’t afford by exaggerating borrowers’ assets and, in some cases, forging their signatures on disclosure documents. In other instances, banks opened their vaults to professional fraudsters who arranged millions of dollars in loans using “straw buyers,” bogus identities, or, in a few instances, dead people’s names and Social Security numbers.

Corporate managers looked the other way as these practices flourished, the investigators say, because they didn’t want to crimp loan sales. The investigators discovered that they’d been hired not so much to find fraud but rather to provide window dressing—the illusion that lenders were vetting borrowers before they booked loans and sold them to Wall Street investors. “You’re like a dog on a leash. You’re allowed to go as far as a company allows you to go,” recalled Kelly Dragna, who worked as a fraud investigator at Ameriquest Mortgage Co., the largest subprime lender during the home-loan boom. “At Ameriquest, we were on pretty short leash. We were there for show. We were there to show people that they had a lot of investigators on staff.”

Continued in article

Bob Jensen's threads on the subprime sleaze --- http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze

Bob Jensen's threads on how whistle blowing is not rewarded --- http://www.trinity.edu/rjensen/FraudConclusion.htm#WhistleBlowing

"5 Year Jail Sentence for Former Louisville Dean," Inside Higher Ed, May 18, 2010 ---
http://www.insidehighered.com/news/2010/05/18/qt#227682

Robert Felner, a former dean of education at the University of Louisville, was sentenced Monday to 63 months in prison for defrauding the university and the University of Rhode Island, where he had worked previously, of $2.3 million and for tax evasion, The Louisville Courier-Journal reported. In a plea agreement in January, Felner pleaded guilty to nine federal charges. Many professors complained that the university for years ignored complaints over Felner, who was highly successful at attracting grants and attention to the education school before the investigations of his conduct started.

COSO Releases Latest Fraud Study. May 21, 2010 ---
http://financialexecutives.blogspot.com/2010/05/sec-fasb-pcaob-testimony-posted-for.html

Yesterday, COSO announced the release of a new research study, Fraudulent Financial Reporting: 1998-2007, that examines 347 alleged accounting fraud cases identified by a review of U.S. Securities and Exchange Commission (SEC) Accounting and Auditing Enforcement Releases (AAER's) issued over a ten-year period ending December 31, 2007.

The COSO Fraud Study updates COSO's previous 10-year study of fraud and was led by the same core academic research team as COSO's previous Fraud Study.

COSO's Fraud Study provides an in-depth analysis of the nature, extent and characteristics of accounting frauds occurring throughout the ten years, and provides helpful insights regarding new and ongoing issues needing to be addressed.

COSO is more formally known as The Committee of Sponsoring Organizations of the Treadway Commission, and the five sponsoring organizations are the AAA, AICPA, FEI, IIA, and IMA. More COSO info is available on their website, www.coso.org.
 

Bob Jensen's fraud updates are at
http://www.trinity.edu/rjensen/FraudUpdates.htm

Bob Jensen's threads on fraud are at
http://www.trinity.edu/rjensen/Fraud.htm

More Headaches for Deloitte After Auditing the Biggest Bank to Ever Fail
"Investigation finds fraud in WaMu lending:  Senate report: Failed bank’s own action couldn’t stop deceptive practices," by Marcy Gordon, MSNBC, April 12, 2010 --- http://www.msnbc.msn.com/id/36440421/ns/business-mortgage_mess/?ocid=twitter

The mortgage lending operations of Washington Mutual Inc., the biggest U.S. bank ever to fail, were threaded through with fraud, Senate investigators have found.

And the bank's own probes failed to stem the deceptive practices, the investigators said in a report on the 2008 failure of WaMu.

The panel said the bank's pay system rewarded loan officers for the volume and speed of the subprime mortgage loans they closed. Extra bonuses even went to loan officers who overcharged borrowers on their loans or levied stiff penalties for prepayment, according to the report being released Tuesday by the investigative panel of the Senate Homeland Security and Governmental Affairs Committee.

Sen. Carl Levin, D-Mich., the chairman, said Monday the panel won't decide until after hearings this week whether to make a formal referral to the Justice Department for possible criminal prosecution. Justice, the FBI and the Securities and Exchange Commission opened investigations into Washington Mutual soon after its collapse in September 2008.

The report said the top WaMu producers, loan officers and sales executives who made high-risk loans or packaged them into securities for sale to Wall Street, were eligible for the bank's President's Club, with trips to swank resorts, such as to Maui in 2005.

Fueled by the housing boom, Seattle-based Washington Mutual's sales to investors of packaged subprime mortgage securities leapt from $2.5 billion in 2000 to $29 billion in 2006. The 119-year-old thrift, with $307 billion in assets, collapsed in September 2008. It was sold for $1.9 billion to JPMorgan Chase & Co. in a deal brokered by the Federal Deposit Insurance Corp.

Jennifer Zuccarelli, a spokeswoman for JPMorgan Chase, declined to comment on the subcommittee report.

WaMu was one of the biggest makers of so-called "option ARM" mortgages. These mortgages allowed borrowers to make payments so low that loan debt actually increased every month.

The Senate subcommittee investigated the Washington Mutual failure for a year and a half. It focused on the thrift as a case study for the financial crisis that brought the recession and the loss of jobs or homes for millions of Americans.

The panel is holding hearings Tuesday and Friday to take testimony from former senior executives of Washington Mutual, including ex-CEO Kerry Killinger, and former and current federal regulators.

Washington Mutual "was one of the worst," Levin told reporters Monday. "This was a Main Street bank that got taken in by these Wall Street profits that were offered to it."

The investors who bought the mortgage securities from Washington Mutual weren't informed of the fraudulent practices, the Senate investigators found. WaMu "dumped the polluted water" of toxic mortgage securities into the stream of the U.S. financial system, Levin said.

In some cases, sales associates in WaMu offices in California fabricated loan documents, cutting and pasting false names on borrowers' bank statements. The company's own probe in 2005, three years before the bank collapsed, found that two top producing offices — in Downey and Montebello, Calif. — had levels of fraud exceeding 58 percent and 83 percent of the loans. Employees violated the bank's policies on verifying borrowers' qualifications and reviewing loans.

Washington Mutual was repeatedly criticized over the years by its internal auditors and federal regulators for sloppy lending that resulted in high default rates by borrowers, according to the report. Violations were so serious that in 2007, Washington Mutual closed its big affiliate Long Beach Mortgage Co. as a separate entity and took over its subprime lending operations.

Senior executives of the bank were aware of the prevalence of fraud, the Senate investigators found.

In late 2006, Washington Mutual's primary regulator, the U.S. Office of Thrift Supervision, allowed the bank an additional year to comply with new, stricter guidelines for issuing subprime loans.

According to an internal bank e-mail cited in the report, Washington Mutual would have lost about a third of the volume of its subprime loans if it applied the stricter requirements.

Deloitte is Included in the Shareholder Lawsuit Against Washington Mutual (WaMu)

"Feds Investigating WaMu Collapse," SmartPros, October 16, 2008 --- http://accounting.smartpros.com/x63521.xml

Oct. 16, 2008 (The Seattle Times) — U.S. Attorney Jeffrey Sullivan's office [Wednesday] announced that it is conducting an investigation of Washington Mutual and the events leading up to its takeover by the FDIC and sale to JP Morgan Chase.

Said Sullivan in a statement: "Due to the intense public interest in the failure of Washington Mutual, I want to assure our community that federal law enforcement is examining activities at the bank to determine if any federal laws were violated."

Sullivan's task force includes investigators from the FBI, Federal Deposit Insurance Corp.'s Office of Inspector General, Securities and Exchange Commission and the Internal Revenue Service Criminal Investigations division.

Sullivan's office asks that anyone with information for the task force call 1-866-915-8299; or e-mail fbise@leo.gov.

"For more than 100 years Washington Mutual was a highly regarded financial institution headquartered in Seattle," Sullivan said. "Given the significant losses to investors, employees, and our community, it is fully appropriate that we scrutinize the activities of the bank, its leaders, and others to determine if any federal laws were violated."

WaMu was seized by the FDIC on Sept. 25, and its banking operations were sold to JPMorgan Chase, prompting a Chapter 11 bankruptcy filing by Washington Mutual Inc., the bank's holding company. The takeover was preceded by an effort to sell the entire company, but no firm bids emerged.

The Associated Press reported Sept. 23 that the FBI is investigating four other major U.S. financial institutions whose collapse helped trigger the $700 billion bailout plan by the Bush administration.

The AP report cited two unnamed law-enforcement officials who said that the FBI is looking at potential fraud by mortgage-finance giants Fannie Mae and Freddie Mac, and insurer American International Group (AIG). Additionally, a senior law-enforcement official said Lehman Brothers Holdings is under investigation. The inquiries will focus on the financial institutions and the individuals who ran them, the senior law-enforcement official said.

FBI Director Robert Mueller said in September that about two dozen large financial firms were under investigation. He did not name any of the companies but said the FBI also was looking at whether any of them have misrepresented their assets.

"Federal Official Confirms Probe Into Washington Mutual's Collapse," by Pierre Thomas and Lauren Pearle, ABC News, October 15, 2008 --- http://abcnews.go.com/TheLaw/story?id=6043588&page=1

 

The federal government is investigating whether the leadership of shuttered bank Washington Mutual broke federal laws in the run-up to its collapse, the largest in U.S. history.

. . .

Eighty-nine former WaMu employees are confidential witnesses in a shareholder class action lawsuit against the bank, and some former insiders spoke exclusively to ABC News, describing their claims that the bank ignored key advice from its own risk management team so they could maximize profits during the housing boom.

In court documents, the insiders said the company's risk managers, the "gatekeepers" who were supposed to protect the bank from taking undue risks, were ignored, marginalized and, in some cases, fired. At the same time, some of the bank's lenders and underwriters, who sold mortgages directly to home owners, said they felt pressure to sell as many loans as possible and push risky, but lucrative, loans onto all borrowers, according to insiders who spoke to ABC News.

Continued in article

 

Allegedly "Deloitte Failed to Audit WaMu in Accordance with GAAS" (see Page 351) --- Click Here
Deloitte issued unqualified opinions and is a defendant in this lawsuit (see Page 335)
In particular note Paragraphs 893-901 with respect to the alleged negligence of Deloitte.

Bob Jensen's threads on Deloitte's troubles are at
http://www.trinity.edu/rjensen/fraud001.htm#Deloitte

KPMG manager took HK$300,000 bribe: ICAC

“ICAC” is the Hong Kong Independent Commission Against Corruption. They have storefront offices all over Hong Kong at which any type of corruption of business or government can be reported.

Saturday, 8 May 2010
South China Morning Post
Reported by Enoch Yiu

KPMG manager took HK$300,000 bribe: ICAC

The ICAC yesterday slapped an additional charge on a senior manager of KPMG for accepting a bribe of HK$300,000 in connection with the Hontex International Holdings' initial public offering scandal.

Leung Sze-chit, 32, a senior manager of KPMG, allegedly received the bribe from an unidentified person as compensation for preparing the accountant's report in the prospectus for the global offering of Hontex, Independent Commission Against Corruption officer Caroline Yu said at the Eastern Court yesterday.

No plea was taken. Magistrate Bina Chainrai adjourned the case until May 28, pending transfer to the District Court.

Leung last month was charged by the ICAC with offering HK$100,000 to another employee of KPMG, whose identify has not been disclosed, "for preparing the accountant's report for the global offering" of Hontex, a Fujian sports clothing firm.

The Securities and Futures Commission in March won a court order freezing the HK$1 billion that Hontex raised in its initial public offering in December. The SFC alleged the firm had overstated its financial results and misled investors about its finances in the prospectus. The SFC ordered a suspension of trading of Hontex shares on March 30, two months after its listing.

KPMG was the auditor responsible for ensuring the accuracy of Hontex's prospectus in the share sale. Yesterday KPMG said it was the one that discovered the malpractices.

"KPMG wishes to emphasise again that the alleged payment was in fact reported through KPMG's internal hotline. After investigation, the member of staff in question was suspended by KPMG and a report was then made by KPMG to the relevant authority. KPMG has been, and continues, to co-operate fully with the authorities," the company said.

Hontex, controlled by Taiwanese businessman Shao Ten-po, said in its listing prospectus that it produces fabrics and makes garments for brands including Decathlon, Kappa and mainland sports chain Li Ning.

Bob Jensen's threads on KPMG are at
http://www.trinity.edu/rjensen/Fraud001.htm

Bob Jensen's fraud updates are at
http://www.trinity.edu/rjensen/FraudUpdates.htm

KPMG Caught Up in Diebold's Bill and Hold Fraud

"Diebold Restatement Calls Its Integrity Into Question," by: George Gutowski, Seeking Alpha, October 3, 2007 ---
http://seekingalpha.com/article/48871-diebold-restatement-calls-its-integrity-into-question

Diebold (DBD) will change the way revenue is reported after its accounting practices came under SEC scrutiny, the company said in a press release issued Oct 2. Diebold may now record sales only after its products are delivered or installed, said spokesman Mike Jacobsen.

A quick scan of their financial statements includes this note to financial statements that defines revenue recognition.

Revenue Recognition The company's revenue recognition policy is consistent with the requirements of Statement of Position [SOP] 97-2, Software Revenue Recognition and Staff Accounting Bulletin 104 (SAB 104). In general, the company records revenue when it is realized, or realizable and earned. The company considers revenue to be realized or realizable and earned when the following revenue recognition requirements are met: persuasive evidence of an arrangement exists, which is a customer contract; the products or services have been provided to the customer; the sales price is fixed or determinable within the contract; and collectibility is probable. The sales of the company's products do not require production, modification or customization of the hardware or software after it is shipped.

Kudos to the SEC for finally protecting the investor. The corporate press release makes mention that while they are still figuring it out, they will have to restate previous financial reports, but do not believe that the cash position will be affected. This is universal corporate baffle gab. Investors are supposed to be quiet if the cash position does not change, everything else is not so important.

Essentially Diebold was not following its publicly stated policies. Diebold was not following accounting standards that investors should be able to rely on. KPMG the auditors in this case certified the statements when they should not have. The Board OK'ed everything. Governance! Governance! Governance!

What consequences will Diebold executives have for this inadequacy? Many in the political arena contend that their voting machines cannot count correctly. The SEC has definitively determined that the corporate accounting was not counting correctly.

Does Diebold have a corporate culture problem?

"SEC CHARGES DIEBOLD AND FORMER EXECUTIVES WITH ACCOUNTING FRAUD," AccountingEducation.com, June 2, 2010 ---
http://accountingeducation.com/index.cfm?page=newsdetails&id=151150

The Securities and Exchange Commission today charged Diebold, Inc. and three former financial executives for engaging in a fraudulent accounting scheme to inflate the company's earnings. The SEC separately filed an enforcement action against Diebold's former CEO seeking reimbursement of certain financial benefits that he received while Diebold was committing accounting fraud.

The SEC alleges that Diebold's financial management received "flash reports" ­ sometimes on a daily basis ­ comparing the company's actual earnings to analyst earnings forecasts. Diebold's financial management prepared "opportunity lists" of ways to close the gap between the company's actual financial results and analyst forecasts. Many of the opportunities on these lists were fraudulent accounting transactions designed to improperly recognize revenue or otherwise inflate Diebold's financial performance.

Diebold ­ an Ohio-based company that manufactures and sells ATMs, bank security systems and electronic voting machines ­ agreed to pay a $25 million penalty to settle the SEC's charges. Diebold's former CEO Walden O'Dell agreed to reimburse cash bonuses, stock, and stock options under the "clawback" provision of the Sarbanes-Oxley Act.

The SEC's case against Diebold's former CFO Gregory Geswein, former Controller and later CFO Kevin Krakora, and former Director of Corporate Accounting Sandra Miller is ongoing.

"Diebold's financial executives borrowed from many different chapters of the deceptive accounting playbook to fraudulently boost the company's bottom line," said Robert Khuzami, Director of the SEC's Division of Enforcement. "When executives disregard their professional obligations to investors, both they and their companies face significant legal consequences."

Scott W. Friestad, Associate Director of the SEC's Division of Enforcement, added, "Section 304 of Sarbanes-Oxley is an important investor protection provision because it encourages senior management to proactively take steps to prevent fraudulent schemes from happening on their watch. We will continue to seek reimbursement of bonuses and other incentive compensation from CEOs and CFOs in appropriate cases."

Section 304 of the Sarbanes-Oxley Act deprives corporate executives of certain compensation received while their companies were misleading investors, even in cases where that executive is not alleged to have violated the securities laws personally. The SEC has not alleged that O'Dell engaged in the fraud. Under the settlement, O'Dell has agreed to reimburse the company $470,016 in cash bonuses, 30,000 shares of Diebold stock, and stock options for 85,000 shares of Diebold stock.

According to the SEC's complaint against Diebold, filed in U.S. District Court for the District of Columbia, the company manipulated its earnings from at least 2002 through 2007 to meet financial performance forecasts, and made material misstatements and omissions to investors in dozens of SEC filings and press releases. Diebold's improper accounting practices misstated the company's reported pre-tax earnings by at least $127 million. Among the fraudulent accounting practices used to inflate earnings and meet forecasts were: Improper use of "bill and hold" accounting.

Recognition of revenue on a lease agreement subject to a side buy-back agreement.

Manipulating reserves and accruals.

Improperly delaying and capitalizing expenses.

Writing up the value of used inventory.

Without admitting or denying the SEC's charges, Diebold consented to a final judgment ordering payment of the $25 million penalty and permanently enjoining the company from future violations of the antifraud, reporting, books and records, and internal control provisions of the federal securities laws.

The SEC charged Geswein, Krakora, and Miller, in a complaint filed in U.S. District Court for the Northern District of Ohio, with violating Section 17(a) of the Securities Act of 1933, Sections 10(b) and 13(b)(5) of the Securities Exchange Act of 1934, and Exchange Act Rules 10b 5 and 13b2-1; and aiding and abetting Diebold's violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Exchange Act Rules 12b-20, 13a-1, 13a-11, and 13a-13. In addition, the SEC charged Geswein and Krakora with violating Exchange Act Rules 13a-14 and 13b2-2 and Section 304 of the Sarbanes-Oxley Act. The Commission seeks permanent injunctive relief, disgorgement of ill-gotten gains with prejudgment interest, and financial penalties. The SEC also seeks officer-and-director bars against Geswein and Krakora as well as their reimbursement of bonuses and other incentive and equity compensation.

Scott Friestad, Robert Kaplan, Brian Quinn, Christopher Swart, Pierron Leef, and Kristen Dieter conducted the SEC's investigation in this matter. Litigation efforts in the ongoing case will be led by David Gottesman and Robyn Bender. The SEC acknowledges the assistance of the U.S. Attorney's Office for the Northern District of Ohio and the Federal Bureau of Investigation.

For more details see http://www.thehighroad.us/showthread.php?t=204185

Bob Jensen's threads on Bill and Hold Fraud are at
http://www.trinity.edu/rjensen/ecommerce/eitf01.htm#BillAndHold

Before reading this May 4, 2009 article you may want to read some introductory modules about Overstock.com at
http://en.wikipedia.org/wiki/Overstock.com

"Overstock.com and PricewaterhouseCoopers: Errors in Submissions to SEC Division of Corporation Finance," White Collar Fraud, May 19, 2008 --- http://whitecollarfraud.blogspot.com/2008/05/overstockcom-and-pricewaterhousecoopers.html

"To Grant Thornton, New Auditors for Overstock.com," White Collar Fraud, March 30, 2009 --- http://whitecollarfraud.blogspot.com/2009/03/to-grant-thornton-new-auditors-for.html

"Overstock.com's First Quarter Financial Performance Aided by GAAP Violations,"  White Collar Fraud, May 4, 2009 ---
http://whitecollarfraud.blogspot.com/2009/05/overstockcoms-first-quarter-financial.html

"Auditor Merry Go Round at Overstock.com," Big Four Blog, January 8, 2010 ---
http://www.bigfouralumni.blogspot.com/

"Overstock Back on Solid Footing With Help from KPMG ," The Big Four Blog, May 13. 2010 ---
http://www.bigfouralumni.blogspot.com/

We had blogged earlier about Overstock.com, which had changed three auditors in 2008-2009, from PricewaterhouseCoopers to Grant Thornton to KPMG, all in a space of about a year, and been in trouble with Nasdaq for filing unaudited financials.

See our earlier posts for all the drama with the company and its erstwhile auditors taking three disparate viewpoints on restatements, ownership and reporting.

However, over the last few months in 2010, things seem to have become much better for the company, and the online retailer seems to have put its heart back into retailing and put away the distraction of accounting from previous months.

Here’s a chronology of events:

Dec 29, 2009 Overstock.com Engages KPMG as the company's independent registered public accounting firm of record for the fiscal year ending December 31, 2009. KPMG will conduct an integrated audit of the company's 2009 financial statements, including review of the company's quarterly information for the periods ending March 31, 2009, June 30, 2009 and September 30, 2009.

KPMG is hired after a lot of back and forth with previous auditors, Grant Thornton.

March 31, 2010 Overstock.com Reports Restated FY 2009 Results with Revenue: $876.8M in FY 2009 vs. $829.9M in FY 2008 (6% increase); Gross margin: 18.8% vs. 17.4% (140 basis point improvement); Gross profit: $164.8M vs. $144.2M (14% increase); Contribution (non-GAAP measure): $109.2M vs. $86.6M (26% increase); Net income (loss) attributable to common shares: $7.7M vs. $(11.1M) ($18.8M increase in net income); and Diluted EPS: $0.33/share vs. $(0.48)/share ($0.81/share improvement)

Overstock.com ranked for the second year in a row, number 2 in the NRF/Amex survey of American consumers, behind only LL Bean and ahead of Amazon, Zappos, eBay, Nordstrom, and many other fine firms.

Patrick M. Byrne said, “As you may know, at the end of Q4 we engaged KPMG as our independent auditors, and announced that we were restating our FY 2008 and Q1, Q2 and Q3 2009 financial statements. I thank you for being patient with us as we worked through the questions raised by the SEC, the transition to the KPMG team, and the extra time it took to ensure that our financial statements are accurate.”

KPMG passed the actual audit of the company without adverse opinion, saying “In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Overstock.com, Inc. and subsidiaries as of December 31, 2009, and the results of their operations and their cash flows for the year ended December 31, 2009, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.”

But they did qualify that Overstock.com’s internal audit over financial reporting was not up to standards and provided an adverse opinion on internal controls. The company’s Audit Committee initiated strong steps to enhance internal audit by hiring competent professionals and instituting appropriate processes.

Overstock.com did restate its FY 2008 and Q1-2009 to Q3-2009 financial statements to account for a number of auditing issues and concerns.

A nice event, with all the accounting restatements done and good results to boot compared to FY 2008.

April 5, 2010 Overstock.com Regains Compliance with NASDAQ Listing Rules, receiving a notice from the NASDAQ Stock Market that the company is in compliance with the periodic filing requirement and this matter has been closed. Earlier, Overstock.com had received a letter on November 19, 2009 from the NASDAQ notifying the company that it had violated NASDAQ Listing Rule 5250(c)(1) when it filed its Quarterly Report on Form 10-Q for the period ended September 30, 2009 because the filing wasn't reviewed in accordance with Statement of Auditing Standards No. 100. In response to a compliance plan submitted by the company, NASDAQ granted an exception to enable the company to regain compliance by May 17, 2010.

Continued in article

"Can Investors Rely on Overstock.com's Reported Q1 2010 Numbers?" White Collar Fraud, May 5, 2010 ---
http://whitecollarfraud.blogspot.com/2010/05/can-investors-rely-overstockcoms.html
David Albrecht pointed this link out to me.

A close examination of Overstock.com's (NASDAQ: OSTK) Q1 2010 10-Q report financial disclosures reveals that the company still failed to remediate serious material weaknesses in internal controls that have resulted in three restatements of financial reports in four years to correct GAAP violations. In addition, a close examination of the company's financial disclosures reveals serious questions about the quality of its reported Q1 2010 earnings of $3.7 million and claimed improvement in financial performance when compared to Q1 2009.

Continuing Weaknesses in Internal Controls

Each and every initial financial report for every reporting period issued by Overstock.com from the company's inception in 1999 to Q3 2009 violated GAAP or some other SEC disclosure rules. Likewise, every single audit report from 1999 to 2008 was wrong and every single Sarbanes-Oxley internal control certification signed by management turned out to be false, too.

In its Q1 2010 10-Q report, Overstock.com disclosed that the company has not remediated serious weaknesses in internal controls:

...the Chief Executive Officer (principal executive officer) and Senior Vice President, Finance (principal financial officer) concluded that our disclosure controls and procedures were not effective as of the end of the period covered by this Quarterly Report on Form 10-Q due to the following material weaknesses:

We lacked a sufficient number of accounting professionals with the necessary knowledge, experience and training to adequately account for and perform adequate supervisory reviews of significant transactions that resulted in misapplications of GAAP. • Information technology program change and program development controls were inadequately designed to prevent changes in our accounting systems which led to the failure to appropriately capture and process data. [Snip]

As of March 31, 2010, we had not remediated the material weaknesses.

Based on Overstock.com's past history of accounting irregularities and financial reporting violations, we cannot be reasonably assured that Overstock.com's current Q1 2010 financial report is free of GAAP and SEC disclosure violations due to continuing reported material weaknesses in internal controls.

Quality of Earnings Issues for Q1 2010

In Q1 2010, Overstock.com reported a net profit of $3.72 million compared to a net loss of $3.96 million in Q1 2009 or a $7.68 million improvement in earnings. However, Overstock.com's reported Q1 2010 $3.72 million profit was helped in large part by a $3.1 million reduction in its estimated allowance for returns or sales returns reserves when compared to Q1 2009.

According to Overstock.com's Q1 2010 10-Q report:

The allowance for returns was $7.4 million and $11.9 million at March 31, 2010 and December 31, 2009, respectively. The decrease in the sales returns reserve at March 31, 2010 compared to December 31, 2009 is primarily due to decreased revenues due to seasonality.

It is normal for sales return reserves to drop from Q4 2009 to Q1 2010 "due to seasonality" issues such as decreased revenues from an earlier quarter (Q4 2009) compared to a later quarter (Q1 2010). However, in many cases such reserves drop due to changes from previous reserve estimates that artificially increase reported profits in later periods when such estimates are adjusted.

As the chart demonstrates, Overstock.com's reduction in allowances for returns may not be seasonal at all, but instead due to a change of estimate. As I detailed above, Overstock.com claimed that its reduction in sales return reserves was "primarily due to...seasonality" and the company did not claim any other factors such as operating improvements as a significant reason for the drop in reserves.

After Q4 2008, Overstock.com's allowance for returns steadily dropped in total dollars from $16.2 million to $7.4 million in Q1 2010, or a 54% reduction in reserves. On a relative basis, Overstock.com's allowance for returns steadily dropped from 6.38% of revenues in Q4 2008 to a mere 2.8% of revenues in Q1 2010, or a 56% drop in relative reserves.

If Overstock.com's return allowance had not dropped in dollar amounts from $10.5 million in Q1 2009 to $7.4 million in Q1 2010, the company would have reported a Q1 2010 profit of only $672k instead of $3.72 million.

In Q1 2010, Overstock.com's allowance for returns was 2.80% of revenues compared to 5.65% of revenues in Q1 2009. If we use that same percentage of revenues in Q1 2010 that Overstock.com used in Q1 2009 (5.65%), the company's allowance for reserves would have been $14.9 million, instead of $7.4 million as reported by the company. In such case, Overstock.com would have reported a Q1 2010 $3.78 million loss instead of a $3.72 profit.

Continued in article

Bob Jensen's threads on KPMG are at http://www.trinity.edu/rjensen/Fraud001.htm

Question
Note that a major part of financial auditing is external verification of accounts and notes receivables.
I wonder how many CPA audits are also test checking eligibility for benefits in business firms?

"Ensuring Insurance," by Doug Lederman, Inside Higher Ed, May 24, 2010 ---
http://www.insidehighered.com/news/2010/05/24/insurance

With their revenues declining and prospects for replacing them fading, colleges and universities around the country are embracing a series of tactics aimed at lowering their costs, such as redesigning entry-level courses and pruning unproductive research institutes. The measures aren't always popular, especially when they are perceived as taking cherished benefits away from employees.

That's the case in Georgia, where the state's public college system has undertaken an audit designed to ensure that health insurance coverage goes only to those who are qualified to receive it -- and to shave as much as $4.6 million off the $290 million that the University System of Georgia spends each year on employer-provided benefits. The so-called dependent eligibility audit, after an "amnesty period," requires all employees whose dependents are covered under the health insurance policy to submit documents (such as marriage licenses, birth certificates and tax returns) proving that their spouses and children warrant such coverage.

Similar audits are underway or planned at the University of Michigan, the University of Kentucky, and the University of Colorado System.

Employee groups in the Georgia system have not taken kindly to the audit. Viewed in isolation, said Hugh Hudson Jr., a Georgia State University historian who heads the state chapter of the American Association of University Professors, the idea of requiring faculty and staff members to prove that they're following the system's current policy may seem like no big deal.

But much else is happening in Georgia, Hudson said. State political leaders are imposing major budget cuts on public colleges, promising furloughs and threatening layoffs of tenured faculty members (a threat from which the university has since backed off), and legislators have taken aim at what they perceive to be the inappropriate research interests of some professors.

In that context, "we're told, 'Prove to me that you haven't been cheating.' This is the proverbial straw breaking the camel’s back." It's hard not to view the current review of benefits, Hudson said, as "part of a larger sense of growing hostility toward the value of higher education and the faculty."

Officials of the Georgia system insist that such a view seriously misreads their intent. While such audits typically find that between 5 and 10 percent of enrolled dependents should not be covered, the overwhelming majority are enrolled because of mistakes or incomplete understanding, not ill intent.

And it is just good fiduciary practice to limit health insurance to those who are actually qualified to receive it, they say -- a point of view shared by the increasing numbers of colleges and universities that are undertaking such audits.

“Many colleges and universities have recently conducted similar audits and are realizing significant annual cost savings -- some in the millions of dollars per year," Andy Brantley, president and chief executive officer of the College and University Professional Association for Human Resources, said via e-mail. "These kinds of audits are not meant to be an invasion of privacy and are only conducted to verify information previously submitted by the employee.... All institutions should regularly conduct these types of audits as a standard business practice.“

The university system's Board of Regents approved the audit in March, as one of a series of changes it had undertaken in the preceding months (at large part at the direction of its new chairman, Robert F. Hatcher) to shave costs from its health care programs.

"What we're trying to do is to preserve our health care plan for the people on the plan," said Wayne Guthrie, vice chancellor for human resources for the Georgia system. The dependent care audit is one way to do that, system officials said in documents explaining the plan, since "[covering individuals who are not eligible dependents raises our cost for health coverage which is reflected in the annual premiums."

The audit is being conducted by Chapman Kelly, an Indiana-based firm to which the regents agreed to pay about $300,000. (The expenditure of funds to an outside company given the state's tight budgets has also raised faculty hackles, said Hudson of the AAUP. "Is there no agency in the state that could do this work?") The review includes a weeks-long “amnesty period ... in which employees may voluntarily remove ineligible dependents with no penalties," the system told employees in its communications to them. (Employees were notified of the amnesty phase on March 29 and given until April 21.)

Continued in article

Bob Jensen's threads on higher education controversies are at
http://www.trinity.edu/rjensen/HigherEdControversies.htm

Bob Jensen's Fraud Updates are at
http://www.trinity.edu/rjensen/FraudUpdates.htm

The Dark Side:  Hiring Secrets of the Big 4
The suit claims Ernst & Young offers job contracts to graduating college seniors that “compel” them “to work for EY to the exclusion of all other employers,” but allow the company “to legally renege or cancel the offer of employment” if the senior does not maintain a vague “strong academic standing.”

"Taking a Louisville Slugger: Lawsuits Against E&Y, PwC Show Ugly Side of Big 4,″ written for Going Concern magazine by Francine McKenna, re: theAuditors, May 13, 2010 --- http://retheauditors.com/2010/05/13/going-concern-taking-a-louisville-slugger-lawsuits-against-ey-pwc-show-ugly-side-of-big-4/
With a video clip from The Untouchables

Robert DeNiro as Al Capone in The Untouchables:

“A man becomes preeminent, he’s expected to have enthusiasms. Enthusiasms, enthusiasms… What are mine? Baseball! A man stands alone at the plate. This is the time for what? For individual achievement. There he stands alone. But in the field, what? Part of a team. Teamwork…”

It must be heartbreaking to one day feel you’re part of a team, a big wonderful, eminent, respectable team and the next get cold-cocked.

Two new Big 4 lawsuits – one against Ernst & Young and the other against PwC – reminded me how many times professionals have written to say their firm had just knocked the stuffing out of them. They had been fired suddenly or a student’s offer was pulled at the last minute.

They were crushed. Humiliated. Confused. Betrayed.

It must be heartbreaking to one day feel you’re part of a team, a big wonderful, eminent, respectable team and the next get cold-cocked.

Two new Big 4 lawsuits – one against Ernst & Young and the other against PwC – reminded me how many times professionals have written to say their firm had just knocked the stuffing out of them. They had been fired suddenly or a student’s offer was pulled at the last minute. They were crushed. Humiliated. Confused. Betrayed.

Ms. Yunjung Gribben, 43, is the lead plaintiff in a class action lawsuit against EY in California. Ms. Gribben says Ernst & Young offered her a job with a starting annual salary of $50,000, then pulled the offer, after she graduated, because of “a couple of C grades she had received in accounting during her senior year at CSUF.” Ms. Gribben says she graduated from Cal State Fullerton with a 3.6 grade point average. The case seems to be more about age discrimination – she says younger candidates kept their jobs – than it is about contracts.

The suit claims Ernst & Young offers job contracts to graduating college seniors that “compel” them “to work for EY to the exclusion of all other employers,” but allow the company “to legally renege or cancel the offer of employment” if the senior does not maintain a vague “strong academic standing.”

I’ve written about the one-sided contracts and the high pressure recruiting tactics of the Big 4 audit firms at re: The Auditors. When the economy started to turn in 2007, the Big 4 began to slow the pipeline of recruits by offering fewer internships, offering fewer interns full time jobs, delaying start dates, and rescinding offers for vague, supposed breaches of their one sided agreements.

Candidates felt helpless since, like Ms. Gribben, once they had decided amongst all offers – many of the best students used to have a choice of all four of the largest firms and more – they were left with few choices if their selected firm reneged. Not only had the other firms moved on and given their slot to someone else, but the taint of having their offer fall through intimidates many students. Complaining might end up on their “permanent record” and “blacklist” them for the rest of their career. Many were locked in a stasis that sometimes only corrected itself after a call or email to me.

I have spoken to former Big 4 partners. They tell me getting fired after twenty years, their whole post-undergraduate degree career, is like getting whacked in the knees with a baseball bat. One day you’re leading engagements at prestigious Fortune 500 clients, smoking cigars and drinking single-malt scotch at parties, buying the McMansion in a “better” suburb and putting the BMW in the driveway and the next day you’re putting a profile together on “Linked In” and setting up an LLC in case you have to do independent consulting for an extended period.

Read the rest of the article at http://goingconcern.com/2010/05/taking-a-louisville-slugger-lawsuits-against-ey-pwc-show-an-ugly-side-of-the-big-4/

Recent Posts by Francine McKenna

• re: theAuditors
• Upcoming Speeches, Appearances and Conferences
• Volcanic Lemonade
• Forbes Interviews Francine McKenna
• @Going Concern “Treasury Votes To Reappoint KPMG As Auditor of Citi”

 

Bob Jensen's threads on lawsuits and settlements of CPA firms ---
http://www.trinity.edu/rjensen/Fraud001.htm

Question
Can any of you identify the mystery "Fraud Girl" who will be writing a weekly (Sunday) column for Simoleon Sense?

Hint
She seems to have a Chicago connection and seems very well informed about the blog posts of Francine McKenna.
http://retheauditors.com/
But I really do know know who is the mystery "Fraud Girl."

"Guest Post: Fraud Girl Says, “Regulators, Ignore the Masses — It’s Your Responsibility!!”
(A New SimoleonSense Series on Fraud, Forensic Accounting, and Ethics)
Simoleon Sense, April 25, 2010 --- Click Here
http://www.simoleonsense.com/guest-post-fraud-girl-says-regulators-ignore-the-masses-it%e2%80%99s-your-responsibility-must-follow-series-on-fraud-forensic-accounting-and-ethics/
 

I’m exceptionally proud to introduce you to Fraud Girl, our new Sunday columnist. She will write about all things corp governance, fraud, accounting, and business ethics. To give you some background (and although I can not reveal her identity). Fraud girl recently visited me in Chicago for the Harry Markopolos presentation to the local CFA. We were incredibly lucky to meet with Mr. Markopolos  and enjoyed 3 hours of drinks and accounting talk. Needless to say Fraud Girl was leading the conversation and I was trying to keep up. After a brainstorm session I persuaded her to write for us and teach us about wall street screw-ups.

So watch out, shes smart, witty, and passionate about making the world a better place. I think Sundays just got a lot better…

Miguel Barbosa
Founder of SimoleonSense

P.S. For Questions or Comments:  Reach fraud girl at:    FraudGirl@simoleonsense.com 

Regulators, Ignore the Masses — It’s Your Responsibility

Men in general judge more by the sense of sight than by the sense of touch, because everyone can see but only a few can test feeling. Everyone sees what you seem to be, few know what you really are; and those few do not dare take a stand against the general opinion, supported by the majesty of the government. In the actions of all men, and especially of princes who are not subject to a court of appeal, we must always look to the end. Let a prince, therefore, win victories and uphold his state; his methods will always be considered worthy, and everyone will praise them, because the masses are always impressed by the superficial appearance of things, and by the outcome of an enterprise. And the world consists of nothing but the masses; the few have no influence when the many feel secure.

-Niccolo Machiavelli, The Prince

Why are Machiavelli’s words so astonishingly prophetic? How does a 500 year old quote explain contagion, bubbles, and Ponzi schemes? Do financial decision makers consciously overlook reality or do they merely postpone due diligence? That is the purpose of this series — to analyze financial fraud(s) and question business ethics.

Recent accounting scandals i.e. Worldcom, Enron, Madoff, reveal a variety of methods for boosting short term performance at the expense of long run shareholder value. WorldCom recorded bogus revenue, Enron boosted their operating income through improper classifications, and Madoff ran the largest Ponzi scheme in history. Sure these scandals were unethical, deceived the public, and made a ton of money. But what is the most striking similarity? Each of these companies was seen as the golden goose egg; an indestructible force that could never fail. Of course, the key word is “seen”, regulators, attorneys, financial analysts, and auditors failed to see reality. But why?

Fiduciaries are entrusted with protecting the public and shareholders from crooks like Skilling, Pavlo, and Schrushy. An average shareholder lacks the knowledge and expertise of a prominent regulator, right? Shareholders don’t perform the company’s annual audit, review all legal documentation, or communicate with top executives. No, shareholders base their decisions off information that is “accurate” and “meticulously examined”.

Unfortunately in each of these instances regulators failed to take a stand against consensus and became another ignorant face in the crowd. “Everyone sees what you seem to be, few know what you really are; and those few do not dare take a stand against the general opinion”. Who are the few that really know who these companies are? The answer should be evident. What isn’t clear is why these cowardly few are in charge of overseeing our financial markets.

When Auditors Look The Other Way

A week ago, I came across this article: Ernst & Young defends its Lehman work in letter to clients. I chuckled as I was reading it, remembering Roxie Hart from the play Chicago shouting the words “Not Guilty” to anyone who would listen. Like Roxie, the audit team pleaded that the media was inaccurate. In recording Lehman’s Repo 105 transactions, they claimed compliance with GAAP and believed the financial statements were ‘fairly represented’. But, fair reporting is more than complying with GAAP. Often auditors are “compliant” while cooking the books (a mystery that still eludes me). In this case, the auditors blatantly covered their eyes and closed their ears to what they must have known was deliberate misrepresentation of Lehman Brother’s financial statements.

We will explore the Lehman Brothers fiasco in next week’s post…but here’s the condensed version. Days prior to quarter end, Lehman Brothers used “Repo 105” transactions, which allowed them to lend assets to others in exchange for short-term cash. They borrowed around $50 Billion; none of which appeared on their balance sheet. Lehman instead reported the debt as sales. They used the borrowed cash to pay down other debt. This reduced both their total liabilities and total assets, thereby lowering their leverage ratio.

This was allegedly in compliance with SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities that allowed Lehman to move the $50 Billion of assets from its balance sheet. As long as they followed the rules, auditors could stamp [the] financial statements with a “Fairly Represented” approval and issue an unqualified opinion.

Clearly in this case complying was unethical and probably illegal. Howard Schilit, the author of Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, once said, “You [the auditor] work for the investor, even though you are paid by someone else”. He insists that auditors should look beyond the checklists and guidelines and should instead question everything. Auditors are the first line of defense against fraud and the shareholders are dependent upon the quality of their services. So I ask again, with respect to Lehman Brothers, were the auditors working for the investors or where they in the pockets of senior management?

What can we do?

An admired value investor believes in a similar tactic for confirming the honesty of companies. It’s known as “killing the company”, where in his words, “we think of all the ways the company can die, whether it’s stupid management or overleveraged balance sheets. If we can’t figure out a way to kill the company, then you have the beginning of a good investment”. Auditors must think like this, they must kill the company, and question everything. If you can’t kill a company, then (and only then) are the financial statements truly a fair representation of the firms operations.

There was no “killing” going on when the lead auditing partner said that his team did not approve Lehman’s Accounting Policy regarding Repo 105s but was in some way comfortable enough with them to audit their financial statements. This engagement team failed in looking beyond SFAS 140 and should have realized what every law firm (aside from one firm in London) was stating; that the accounting methods Lehman Brothers used to record Repo 105s were a deliberate attempt to defraud the public.

So I repeat: Ignoring reality is not an option. Ignoring the crowd, however, is an obligation.

See you next week….

-Fraud Girl

Bob Jensen's threads on fraud are linked at
http://www.trinity.edu/rjensen/Fraud.htm

Bob Jensen's Fraud Updates are at
http://www.trinity.edu/rjensen/FraudUpdates.htm

Bob Jensen's threads on accounting news are at
http://www.trinity.edu/rjensen/AccountingNews.htm

"Viking Drama: Glitnir Bank Sues PwC for Malpractice and Negligence," The Big Four Blog, May 12, 2010 ---
http://bigfouralumni.blogspot.com/2010/05/viking-drama-glitnir-bank-sues-pwc-for.html 

It’s not just volcanic ash that comes out of Iceland.

We see today a large $2 billion lawsuit filed by one of Iceland’s largest banks, now defunct, naming PricewaterhouseCoopers as one of the defendants.

Glitnir Bank (we see in Wikipedia that Glitnir is the hall of Forseti, the Norse god of law and justice, and the seat of justice amongst gods and men), filed today a legal claim against Jon Asgeir Johannesson and also PwC for malpractice and negligence in the Supreme Court of the State of New York.

The suit against Jon Asgeir Johannesson, formerly its principal 39% shareholder, Larus Welding, previously Glitnir's Chief Executive, Thorsteinn Jonsson, its former Chairman, and other former directors, shareholders and third parties associated with Johannesson, alleges that these defendants fraudulently and unlawfully drained more than $2 billion out of the Bank.

Former auditors PricewaterhouseCoopers are also sued for “facilitating and helping to conceal the fraudulent transactions engineered by Johannesson and his associates, which ultimately led to the Bank's collapse in October 2008.”

The suits shows how a cabal of businessmen led by Johannesson conspired to systematically loot Glitnir Bank in order to prop up their own failing companies; how they seized control of Glitnir, removing or sidelining experienced Bank employees; and then facilitated and concealed their diversions from the Bank by overriding Glitner's financial risk controls, and finally how the transactions cost Glitnir more than $2billion and contributed significantly to the Bank's collapse.

There is in particular a sale of $1billion of Bonds to investors located in New York and elsewhere in the United States in September 2007, which is sure to get the attention of the very-aggressive US regulators.

According to Steinunn Guobjartsdottir, chair of the Glitnir Winding-Up Board, which conducted the investigation and is making the legal claim, "There is evidence supporting the allegation that Glitnir Bank was robbed from the inside."

In terms of PwC, the suit alleges, “Johannesson and the other individual Defendants could not have succeeded in their schemes without the complicity of PwC. PwC knew about Glitnir's irregular related party exposures, reviewed and signed off on Glitnir financial statements which grossly misrepresented these exposures, and facilitated Glitnir's fraudulent fundraising in New York.”

According to Reuters, “Neither PwC nor Mr Jóhannesson immediately responded to requests for comment.”

This is serious stuff, in that the bank’s own senior management is being accused of fraudulent intent to bankrupt the bank. Iceland’s banking system with its extraordinary regime of easy credit has negatively impacted thousands of investors and depositers all over Europe, but there are now government and non-governmental organizations investigating what happened and pursuing financial claims.

This Nordic Drama is just getting started, and likely other lawsuits will follow both in Europe and in the US. Auditors of Icelandic banks are sure to get named in these suits as defendants and parties to any misconduct.

"How Dangerous is the Two-Billion Dollar Suit Against PwC Over Iceland's Glitnir Bank? The Answer is Blowin' in the Wind," by James Peterson, re: Balance, May 12, 2010 --- Click Here

Bob Jensen's threads on large international auditing firm survival threats ---
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

Bob Jensen's threads on large auditing firm litigations and settlements ---
http://www.trinity.edu/rjensen/Fraud001.htm

"The Auditors And Financial Regulatory Reform: That Dog Don’t Hunt," by Francine McKenna, re: The Auditors, May 31, 2010 ---
http://retheauditors.com/2010/05/31/the-auditors-and-financial-regulatory-reform-that-dog-dont-hunt/

It’s not every day that a regular girl from Chicago has a chance to talk with a sitting US Senator about the subject most important to her.

No… I’m not talking about Rosie, my Rottweiler.

I’m talking about the auditors’ role in the financial crisis and their place in the regulatory reform bills now being considered. Through a series of wonderful and kind acts, namely the efforts of one particular journalist, I was invited to talk with Delaware Senator Ted Kaufman (D) and his staff about accounting industry reform.

The conversation was wide ranging and opinions expressed off-the-record.  The meeting happened on the same day as Representative Barney Frank’s speech to the Compliance Week conference and we talked about his remarks.  I expressed my disappointment with several things especially Rep. Frank’s capitulation on a Sarbanes-Oxley exception for smaller companies and his rambling response to the question about a Department of Justice implied “too few to fail” policy.

The Kaufman team is led with mucho gusto by the Senator. It was great to have a chance to meet them, but I realize it’s probably too late to get anything that addresses audit industry reform in this bill. There’s a lot of compromise going on with what’s already there.

Health care reform took some of the fight out of more than a few on both sides of the aisle and in both legislative bodies. Rep. Frank mentioned it a few times during his speech. He described advantages and disadvantages from a legislative perspective of the pure focus on financial regulatory reform now that health care is “a done deal.”  It makes it both easier for media to spotlight an individual politician’s positions without the clutter of other major legislation and harder for that politician to hide behind multiple major initiatives when it comes to supporting or voting for controversial or dramatic change.

I came to the meeting with a few points to make.  I think I did that but, as usual, a discussion of the issues facing the audit industry can get a little depressing, even for me.

However, this meeting, as well as the ones at the PCAOB, made me realize the time has come to make proposals and suggestions for industry change instead of just pointing out the issues, problems and need for change.

Most regulators and legislators avoid talking about wholesale change to the structure of the accounting/audit industry.  It seems too big a task and untenable.  The refrain I hear most often both when attending conferences and events and on this site is, “We can’t get rid of the audit opinion. It’s required.”  I’ve also written about the strong and steady political contributions the accounting industry makes, party-agnostic, dictated primarily by the politician’s position and influence over the audit firms’ interests.

Lack of vision and loads of cash. These are the fundamental obstacles to serving investors and other stakeholders with financial reporting that can be trusted.

But it’s also true that Big Oil has spent years deluding itself and others into thinking that this kind of spill was impossible and that preparing for one wasn’t necessary. Indeed, BP once called a blowout disaster “inconceivable.” Certainly, if you can’t conceive of a disaster, you’ll become more and more lax, more and more reckless, until one happens. You’ll cut corners on backup systems and testing. And you certainly won’t pre-build and pre-position any relevant equipment for staunching the flow. Since a disaster can’t happen, you and your allies in Congress will block all serious safeguards and demagogue all efforts to oversee the industry as “Big Government interference in the marketplace that will raise the price of gasoline for average Americans.”

This quote comes from Salon and refers to the oil spill disaster.  But it could have just as easily been said about the litigation threats against the largest global accounting firms and doubts about their viability and credibility post-financial crisis. If legislators and regulators can’t imagine a world without the audit firms and the audit report in their current form, then they can’t work towards something better for investors and the capitalist system.

The firms are broken and their basic product is worthless. The auditors were completely impotent to warn investors of over-leverage and risky business models, to prevent erroneous and potentially fraudulent financial reporting and to mitigate the impact on everyone of these errors, misstatements, obfuscations and subterfuge by executives of the failed, bailed out and nationalized financial institutions.

It wasn’t such an intellectual leap for media, regulators and legislators to see the inherent conflicts in the ratings agencies’ business model post-crisis and to essentially, with the stroke of a pen, destroy that business model.

New York Times, The Caucus Blog,
May 13, 2010: One amendment, sponsored by Senators George LeMieux, Republican of Florida and Maria Cantwell, Democrat of Washington, would remove references to the credit agencies in major financial services laws, including the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Federal Deposit Insurance Act. It was approved by a vote of 61 to 38.

Additional reform legislation sponsored by Senator Al Franken – I kid you not – puts the government in the middle between ratings agencies and the securities issuers. The ideas is to take the “pleaser” part out of how the credit raters make their living.

The Atlantic,
May 13, 2010: “The new legislation calls for every new ABS bond issue to have a rating by one agency assigned by a new board, instead of being chosen by the investment bank creating the security. The board will consist of mostly investors along with a few other industry participants. Although the underwriter can solicit additional ratings, it cannot escape the verdict of the assigned agency, so it cannot shop around for whichever agency has the most favorable view.”

Wouldn’t it be funny if the audit firms took advantage of the credit ratings agencies’ weakness and swooped in to do that business?  After all, the auditors have the trust and integrity thing down pat. But there’s no way the audit firms would have the nerve to even float that idea post-EY/Lehman…

Nobody disagrees when I remind them that audit firms have the same inherent conflict of interest as ratings agencies. The audit firms have a business relationship with Audit Committees who are selected by the corporations’ executives.  Audit partners are “pleasers.” The audit fees for the largest financial institutions are in the $100,000,000 annually range but it’s been a challenge to grow that business in the current economic environment. The Sarbanes-Oxley gravy train has pretty much derailed.

Is it such a stretch to think about taking the control over appointment and renewal of auditors away from the corporations – the corporate executives are the true corrupting influence on the poor, innocent auditors –  and give it to the SEC or PCAOB? Corporations could  be required to pay the auditor regardless of the audit opinion or how many exceptions are found or hard the auditor has to push back on aggressive accounting.  All this can happen under the watchful eye of their regulator who can put the firms on a “good list” and can effect limited or general “debarment” type actions if an audit firm or audit partner rolls over and plays dead too often.

Continued in article

Bob Jensen's threads on the survival threats of large auditing firms ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Auditors

Remember Crazy Eddie? --- http://en.wikipedia.org/wiki/Crazy_Eddie
"Guest Post: Fraud Girl Interviews Convicted Financial Felon Sam Antar," Simoleon Sense, May , 2010 ---
http://www.simoleonsense.com/guestpost-fraud-girl-interviews-convicted-financial-felon-sam-antar/

Hello Again –

On Monday, I had the pleasure of speaking with Sam E. Antar, the former CFO of Crazy Eddie who, in the 1980s, helped mastermind one of the largest securities frauds of its time. He eventually pleaded guilty to three felonies: conspiracy to commit securities fraud, conspiracy to commit mail and wire fraud, and obstruction of justice.

The following conversation involves a series of questions relating to fraud investigation and the misconceptions of white-collar criminals.

Do you have any additional questions for Sam Antar? Send me an email at fraudgirl@simoleonsense.com  .

See you next week…

-Fraud Girl

Copyright 2010 Fraud Girl @ SimoleonSense

You mention the quote “It takes one to know one” on your website and on your blog. Most people in the fraud catching industry are honest and good people. How can honest people shield themselves from believing the lies of these criminals?

It’s hard because you don’t know what a lie is until you’ve been exposed to it or until you’ve done it, and hopefully you don’t get exposed to it. Let me just say this. To discuss crime I have to be a little bit politically incorrect, so don’t get offended, alright?

Females for instance. Females are lied to more than men. It’s just a fact of the matter. Think of it this way, if you’ve gone out on dates with more than one guy, how many guys have told you anything, “You’re beautiful, you’re lovely, you’re smart, you’re intelligent. I want to spend the rest of my life with you”? No sex. Just to get to first base. I’m not saying you specifically; you can ask a lot of females that. Again, I’m not trying to be male chauvinist but that’s just the way it is.

Criminals themselves are charmers. We use deceit and charm to get what we want. In a lot a ways criminals are like some of the females I’ve had in my life too, they used deceit and charm.

Most of the forensic accountants I know are females. Generally speaking female forensic accountants, barring the fact they’re not criminals, are generally better than males. Women by nature are much more cynical and skeptical than men because women are taken advantage of in many ways in our society more than men.

I don’t know if you know Tracy Coenen, she writes on Fraud Files blog. She’s probably one of the best in the business. The only handicap she has is that she’s not a criminal, former criminal, ex-criminal, or retired criminal. I travel a lot and I meet a lot of people, and I find that generally females are just better forensic accountants because they’ve experienced being lied to more often than men.

If you lead a life where you live in a bubble, how can you expect to catch the crooks? At the next level up, who better then the people who commit the crimes?

Drug addicts, for example, are either in recovery or they are active, but they’re always drug addicts. And the best drug counselors are former addicts. If you take it one level further, the government does a lot of work with convicted felons. I do a lot of work for them. The government also uses criminals to help catch other criminals. It’s not very well publicized; the only movie that was ever done about it was “Catch Me If You Can”. But it’s kind of like a partnership between former evil and justice against current evil.

How can people go acquire the experience to really understand financial criminals? Do courses help? Is it just real life experience? What will help forensic accountants get through it?

It’s a combination of both. For example, The Going Concern blog recently did a thing about what is takes to become a forensic accountant. The problem is before you even get to the skill set necessary to be a good forensic accountant you need to get a double set of iron clad balls and triple thick skin because criminals fight back. We don’t play fair. We have no respect for you. We have no respect for your laws. We don’t have respect for your customs. In fact, your laws and customs make it easier for us to commit our crimes. It’s a paradox. The more humane the society is, the easier it is for criminals to commit their crimes. Humanity limits your behavior but it doesn’t limit our behavior because we’re immoral human beings.

You have to understand that to combat criminality, you have to have that set of iron balls. The rest of the stuff, double-check this, cross check that; that’s textbook stuff, anybody could learn it. What you’re asking me is, “Well how do we do it?” There are some people that are just wired in to do it. And again, I’m not trying to appear male chauvinist but if I am I don’t care anyway. But the point is that females are more, as a group, generally more wired to be forensic accountants, than men are. So if you know any females that are former criminals, or retired criminals they would make the best forensic accountants. And they would have the combination of on hand experience and genetics.

Why is our society built upon the “innocent until proven guilty”, “benefit of the doubt”, “trust and then verify” mentality?

I actually did worse than that. I was a fraudster, matchmaker, and a pimp. The point being is distraction. Magic doesn’t really exist. We all know that you can’t really do magic. But what is magic really based on? Magic is based on distraction. Distracting somebody’s attention from something that is really going on. Small talk is very, very important. It distracts people. You see how politicians change the subject? That distracts people. We see how they argue on TV more about personalities than policy. That’s distraction. There are many ways to distract people. The easiest way to distract somebody is really with a smile because with a smile people increase their comfort level because you appear friendly to them. You appear charming to them.

The three rules of criminality: white color criminals consider your humanity as a weakness to be exploited in the execution of their crimes, we measure our effectiveness by the comfort level of our victims, and in order to increase our victim’s comfort level we have to build walls of false integrity around ourselves.

When we look at humanity with the presumption of innocence until proven guilty, that’s a Judeo-Christian tradition. That is giving somebody a benefit of the doubt. When you give somebody the benefit of the doubt, the criminal has the freedom of action. Your ethics limit your actions. It might make you into a better person, but it also makes it easier for criminals that commit their crimes.

The second part is comfort level; criminals measure their effectiveness by the comfort level of their victims. What did Bernie Madoff do? He was the president of NASDAQ, he was involved in a lot of so-called reform and regulation. People were comfortable with Bernie Madoff.

The third thing is that criminals build walls of false integrity around them to increase the comfort level of their victims. You got Bernie Madoff again, being the president of NASDAQ. These combinations set the stage for most of the crimes.

Colleges don’t teach people how they’re going to get screwed. They teach people how to succeed. Society doesn’t teach people how they’re going to get screwed. We don’t teach people what happens when the shit hits the fan (excuse the language).

We teach people how to earn a living and how to become better in their careers. We teach people more on a positive end but we don’t teach people too much on the defensive end. That’s something you learn from the streets. That’s the unfortunate part that we have today. We don’t have enough studies on criminal psychology.

We learn about psychology in general. Pavlov the dog, throws the food in front of the dog, saliva comes out of his mouth. It’s like a reflective instinct, or whatever.

We don’t know enough about the criminal psychology and how criminals play on your humanity. An example of the way that we play with your humanity is found in the movie, “The Devil’s Advocate.” See the movie “The Devil’s Advocate” with Al Pacino. The devil’s favorite sin is vanity. We all have vanity. We criminals really make you feel good about your self-esteem in many cases. “You’re smart. You’re beautiful. You’re a great investor. You’re smart enough to make this decision”.

White collar crime is psychological warfare. Most of it’s really done on the personal level and the major problem I see is not so much the techniques. Anybody can learn them. The problem is applying those techniques and part of applying those techniques is to get into the psychology of criminals so you can become more skeptical and cynical.

For most people, including myself, the first instinct is to trust the person. But it seems that we cannot put trust in anyone.

Continued in article

Bob Jensen's Fraud Updates are at http://www.trinity.edu/rjensen/FraudUpdates.htm

On May 4, 2010, PBS Frontline broadcast an hour-long video called College Inc. --- a sobering analysis of for-profit onsite and online colleges and universities.
For a time you can watch the video free online --- Click Here
http://www.pbs.org/wgbh/pages/frontline/collegeinc/view/?utm_campaign=viewpage&utm_medium=toparea&utm_source=toparea

Even in lean times, the $400 billion business of higher education is booming. Nowhere is this more true than in one of the fastest-growing -- and most controversial -- sectors of the industry: for-profit colleges and universities that cater to non-traditional students, often confer degrees over the Internet, and, along the way, successfully capture billions of federal financial aid dollars.

In College, Inc., correspondent Martin Smith investigates the promise and explosive growth of the for-profit higher education industry. Through interviews with school executives, government officials, admissions counselors, former students and industry observers, this film explores the tension between the industry --which says it's helping an underserved student population obtain a quality education and marketable job skills -- and critics who charge the for-profits with churning out worthless degrees that leave students with a mountain of debt.

At the center of it all stands a vulnerable population of potential students, often working adults eager for a university degree to move up the career ladder. FRONTLINE talks to a former staffer at a California-based for-profit university who says she was under pressure to sign up growing numbers of new students. "I didn't realize just how many students we were expected to recruit," says the former enrollment counselor. "They used to tell us, you know, 'Dig deep. Get to their pain. Get to what's bothering them. So, that way, you can convince them that a college degree is going to solve all their problems.'"

Graduates of another for-profit school -- a college nursing program in California -- tell FRONTLINE that they received their diplomas without ever setting foot in a hospital. Graduates at other for-profit schools report being unable to find a job, or make their student loan payments, because their degree was perceived to be of little worth by prospective employers. One woman who enrolled in a for-profit doctorate program in Dallas later learned that the school never acquired the proper accreditation she would need to get the job she trained for. She is now sinking in over $200,000 in student debt.

The biggest player in the for-profit sector is the University of Phoenix -- now the largest college in the US with total enrollment approaching half a million students. Its revenues of almost $4 billion last year, up 25 percent from 2008, have made it a darling of Wall Street. Former top executive of the University of Phoenix Mark DeFusco told FRONTLINE how the company's business-approach to higher education has paid off: "If you think about any business in America, what business would give up two months of business -- just essentially close down?" he asks. "[At the University of Phoenix], people go to school all year round. We start classes every five weeks. We built campuses by a freeway because we figured that's where the people were."

"The education system that was created hundreds of years ago needs to change," says Michael Clifford, a major education entrepreneur who speaks with FRONTLINE. Clifford, a former musician who never attended college, purchases struggling traditional colleges and turns them into for-profit companies. "The big opportunity," he says, "is the inefficiencies of some of the state systems, and the ability to transform schools and academic programs to better meet the needs of the people that need jobs."

"From a business perspective, it's a great story," says Jeffrey Silber, a senior analyst at BMO Capital Markets, the investment banking arm of the Bank of Montreal. "You're serving a market that's been traditionally underserved. ... And it's a very profitable business -- it generates a lot of free cash flow."

And the cash cow of the for-profit education industry is the federal government. Though they enroll 10 percent of all post-secondary students, for-profit schools receive almost a quarter of federal financial aid. But Department of Education figures for 2009 show that 44 percent of the students who defaulted within three years of graduation were from for-profit schools, leading to serious questions about one of the key pillars of the profit degree college movement: that their degrees help students boost their earning power. This is a subject of increasing concern to the Obama administration, which, last month, remade the federal student loan program, and is now proposing changes that may make it harder for the for-profit colleges to qualify.

"One of the ideas the Department of Education has put out there is that in order for a college to be eligible to receive money from student loans, it actually has to show that the education it's providing has enough value in the job market so that students can pay their loans back," says Kevin Carey of the Washington think tank Education Sector. "Now, the for-profit colleges, I think this makes them very nervous," Carey says. "They're worried because they know that many of their members are charging a lot of money; that many of their members have students who are defaulting en masse after they graduate. They're afraid that this rule will cut them out of the program. But in many ways, that's the point."

FRONTLINE also finds that the regulators that oversee university accreditation are looking closer at the for-profits and, in some cases, threatening to withdraw the required accreditation that keeps them eligible for federal student loans. "We've elevated the scrutiny tremendously," says Dr. Sylvia Manning, president of the Higher Learning Commission, which accredits many post-secondary institutions. "It is really inappropriate for accreditation to be purchased the way a taxi license can be purchased. ...When we see any problematic institution being acquired and being changed we put it on a short leash."

Also note the comments that follow the above text.

But first I highly recommend that you watch the video at --- Click Here
http://www.pbs.org/wgbh/pages/frontline/collegeinc/view/?utm_campaign=viewpage&utm_medium=toparea&utm_source=toparea

May 5, 2010 reply from Paul Bjorklund [paulbjorklund@AOL.COM]

Interesting program. I saw the first half of it and was not surprised by anything, other than the volume of students. For example, enrollment at Univ of Phx is 500,000. Compare that to Arizona State's four campuses with maybe 60,000 to 70,000. The huge computer rooms dedicated to online learning were fascinating too. We've come a long way from the Oxford don sitting in his wood paneled office, quoting Aristotle, and dispensing wisdom to students one at a time. The evolution: From the pursuit of truth to technical training to cash on the barrelhead. One question about the traditional university though -- When they eliminate the cash flow from big time football, will they then be able to criticize the dash for cash by the educational entrepreneurs?

Paul Bjorklund, CPA
Bjorklund Consulting, Ltd.
Flagstaff, Arizona

Capella University is one of the better for-profit online universities in the world. ---
http://www.capella.edu/

A Bridge Too Far
I discovered that Capella University is now offering an online Accounting PhD Program --- 
http://www.capella.edu/schools_programs/business_technology/phd/accounting.aspx

• Students with no business studies background (other than a basic accounting course) can complete the program in 2.5 years part time or slightly less than 2 years full-time.
   
• The the Capella accounting PhD curriculum is more like an MBA curriculum and is totally unlike any other accounting PhD program in North America. There are relatively few accounting courses and much less focus on research skills.
   
• There are no comprehensive or oral examinations. The only requirements 120 credits, including credits to be paid for for a dissertation
   
• I'm still trying to learn whether there is access to any kind of research library or the expensive financial databases that are required for other North American accounting doctoral programs..

Although I have been recommending that accountancy doctoral programs break out of the accountics mold, I don't think that the Capella's curriculum meets my expectation ---
http://www.trinity.edu/rjensen/Theory01.htm#DoctoralPrograms

I really worry that students who hear about the dire shortage of new PhD graduates needed for North American colleges and universities will spend a lot of money earning an accounting PhD from Capella and then belatedly discover that Capella's PhD is just not fully accepted in the academy's tenure-track job market. Unless a tenure track applicant has exceptional credentials other than Capella's accounting PhD degree, I don't think that applicant will even get a foot inside the academy's doors. I'm not being snobby here! I just think that that, on paper, the Capella Accounting PhD Program is comparable to other doctoral programs in accountancy in North America.

On paper the curriculum is quite different from virtually all other North American accountancy doctoral programs that typically require much heavier prerequisites in accounting and have much more research foundation building curricula. For example, compare the Capella curriculum with that of the Fisher School of Accountancy at the University of Florida ---
http://warrington.ufl.edu/fsoa/programs/phd/
Or pick any other doctoral program listed in by Jim Hasselback ---
http://www.jrhasselback.com/AtgDoctInfo.html
Jim does not yet list Capella University, and maybe that's a good thing!

One thing that is quite confusing to me are the required courses in Capella's Accounting PhD Program. It seems to me that most of Capella's required doctoral program courses are really equivalents of undergraduate business and MBA courses (other than the dissertation credit courses). Most accountancy doctoral programs have required seminars and other courses that are beyond Capella's doctoral courses. Most also have more prerequisite accounting courses that are outside the doctoral-level curricula.

Capella's Accounting PhD program just does not require enough accounting. Virtually all other accounting programs require more accounting that students must have before matriculating into the doctoral program or take in addition to the doctoral-level courses. Capella apparently will admit accounting doctoral program students having little or nothing beyond two principles of accounting courses (I assume students cannot take the intermediate accounting course without having had basic accounting). If these students only take the accounting courses listed for Capella's doctoral program, they fall way short of having enough accounting in my judgment.

I would also like to know more about the credentials of the faculty teaching the doctoral program courses and supervising the dissertation research. Are they themselves PhD accountants with respectable track records in accounting research and publication?

Although I respect Capella University a great deal as a leading distance education pioneer, it would seem to me that the Capella Accounting PhD Program is a bridge too far.

I would like to hear from insiders who know a great deal about this program.

Capella has some doctoral programs that purportedly are successful, particularly this in the School of Education. At this point, however, I think the Capella PhD Program in Accounting may give Cappella a bad name in the academy.

I'm all in favor of distance education if it is as rigorous or more rigorous than its onsite competition. I think Capella has some undergraduate, masters, and maybe a few doctoral programs meeting this standard. But I'm very dubious about the admission standards, curriculum, and faculty credentials of the Capella University Accounting PhD Program. I would certainly like to learn more about this program.

Other Capella University Doctoral Programs --- http://www.capella.edu/schools_programs/degrees/phd.aspx

I still stand by my long-standing claim that there are no respectable online doctoral programs in accountancy even though there are some highly respected masters of accounting and masters of taxation online programs ---
http://www.trinity.edu/rjensen/Crossborder.htm

Added Jensen Comment
Another questionable feature of the Capella Accounting PhD Program is that the program now charges $4,485 per quarter on a plan that involves taking 12 credits per quarter for 120 credits for students having no transfer credits. This means that the program is intended to be completed in 10 quarters of part-time study  --- http://www.capella.edu/schools_programs/business_technology/phd/accounting.aspx
It takes even less time for students transferring in up to 48 credits allowed.
It also takes even less time for students carrying a full-time load of 16 credits per quarter at Capella.

A student transferring in the maximum of 48 credits can complete the doctorate in 1.5 years in theory, although Capella might not allow the dissertation credits to be earned simultaneously with other courses.

Taking the recommended 48 quarter credits per year, Capella Accounting PhD Program students can expect to graduate in 2.5 years or less depending upon transfer credits.

Traditional onsite accounting doctoral programs now take four or five years of full time study on campus irrespective of transfer credits. Hasselback reports that in reality "it often takes five or six years" --- "
http://www.jrhasselback.com/AtgDoct/FAQs.pdf

It hardly seems comparable for a Capella doctoral graduate to complete the PhD in 2.5 years part-time compared with onsite full time accounting doctoral students needing 4-6 years on campus. Either all the other accounting doctoral programs take too much time or Capella is offering a cheap shot accounting doctorate. I think both claims are supportable. But the point is that Capella's accounting doctorate is in no way comparable with other accounting doctoral programs in terms of study time.

Added Jensen Comment
One of the most time consuming aspects of a traditional onsite accounting doctoral program in North America, apart from earning course credits, is the need to study for a sequence of comprehensive examinations plus, in most instances, an oral examination. Capella frees up all this time by not having any comprehensive examinations or oral examinations. Bummer!

May 3, 2010 reply from Kate Mooney  [kkmooney@STCLOUDSTATE.EDU]

My concern with part-time/online PhD programs is the lack of academic behavior modeling. Without actually observing academics at work, how does the prospect figure out what they do? Most universities don’t really spell out the details of success. Without at least some time spent in-in residence watching the faculty in action, it is difficult to imagine ALL the pieces required for tenure.

Kate Mooney, PhD, CPA
Chairperson and Professor, Department of Accounting G. R. Herberger College of Business 367A St. Cloud State University St. Cloud MN 56301 USA 320.308.4987
kkmooney@stcloudstate.edu 
http://web.stcloudstate.edu/kkmooney/ 

May 3, 2010 reply from Barbara Scofield [barbarawscofield@GMAIL.COM]

Nova Southeastern has long had a nontraditional PhD program in business, but it now has a 4-course "specialization" in accounting in that program. My university has had several applicants with doctoral degrees "in accounting" from Nova Southeastern. What is the general evaluation of these degrees? Students also seem to complete these degrees very rapidly.

Barbara W. Scofield, PhD, CPA
Chair of Graduate Business Studies Professor of Accounting
The University of Texas of the Permian Basin 4901 E. University Dr. Odessa, TX 79762
432-552-2183 (Office) 817-988-5998 (Cell)
BarbaraWScofield@gmail.com

May 3, 2010 reply from Bob Jensen

HI Barbara,

Reputable doctoral programs are all money losers, which it is what makes it almost impossible, in my judgment, to attain highly respectable doctoral program in for-profit universities. Are there any respected accountancy doctoral programs in North America that do not rely upon undergraduate and masters program cash cows? To attain respect, a doctoral program has to provide access to a really costly library, expensive electronic databases, research support, and the highest paid faculty in the discipline who refuse to supervise more than a small handful of doctoral students. There’s no “volume” efficiency in a quality-program PhD CPV model.

Why would for-profit universities try to build new and reputable doctoral programs that probably will always be cash flow disasters? The answer is that they probably won’t become reputable among the competing doctoral programs in the academy. Rather they are more apt to develop cheap-shot doctoral programs with lower admission standards, inadequate assistantships and fellowships, poor libraries and electronic databases, no really challenging comprehensive examinations that students sweat blood over trying to pass, and hire unknown research faculty in the program. There is a need for distance education doctoral programs, but these should be developed by highly reputable universities that have the cash cows to develop creative, albeit cash losing, programs.

What’s the incentive for Capella University to lose an enormous amount of cash on a quality accounting doctoral program that knocks the socks off those of us in the accounting academy? There would be an incentive if governments or customers would pick up the tab. For example, a startup masters CASB program for chartered accountants developed a high quality distance education model in Western Canada, but chartered accountancy firms themselves picked up much of the tab either directly or indirectly. If CASB also started up a doctoral program, who would pick up the tab?

In my original message about Capella I mentioned that the Education Doctoral Program at Capella might be an exception. One reason is that education doctoral programs in even our top universities do not have the same respect as other doctoral programs to a point that the Carnegie Foundation is heavily funding studies and experiments to change both the PhD and EED programs in colleges of education:

All is Not Well in Programs for Doctoral Students in Departments/Colleges of Education
The education doctorate, attempting to serve dual purposes—to prepare researchers and to prepare practitioners—is not serving either purpose well. To address what they have termed this "crippling" problem, Carnegie and the Council of Academic Deans in Research Education Institutions (CADREI) have launched the Carnegie Project on the Education Doctorate (CPED), a three-year effort to reclaim the education doctorate and to transform it into the degree of choice for the next generation of school and college leaders. The project is coordinated by David Imig, professor of practice at the University of Maryland. "Today, the Ed.D. is perceived as 'Ph.D.-lite,'" said Carnegie President Lee S. Shulman. "More important than the public relations problem, however, is the real risk that schools of education are becoming impotent in carrying out their primary missions to prepare leading practitioners as well as leading scholars."
"Institutions Enlisted to Reclaim Education Doctorate," The Carnegie Foundation for Advancement in Teaching --- http://www.carnegiefoundation.org/news/sub.asp?key=51&subkey=2266

 Capella might do better focusing on doctoral programs for graduates headed into practice instead of the academy. I think this is why Capella’s doctoral program in education has a much better chance of success than in something like accounting or business in general where there is little incentive to get a doctorate outside of wanting a ticket to pass through the gates of our snooty academy.  The Capella Accounting PhD Program just is not going to cut it any better than Nova’s PhD program fails to provide keys to the kingdom.

I haven’t followed Nova recently Barbara, but Trinity University had a staff (not faculty) applicant who earned a Nova doctorate. This applicant was actually quite capable, but he was looked down upon by faculty and staff for putting a Nova PhD degree on his resume. That particular degree seems to have a negative stigma. The humor going around afterwards was that he might’ve been hired if he’d kept his PhD a secret. I think Nova makes a serious effort to have respected faculty teach classes and supervise dissertations. But it’s not really the same to rely on moonlighting faculty as opposed to resident faculty.

And there are so many factors going into educating a doctoral student and so many important learning interactions with other doctoral students and multiple faculty, such as those involved in creating and grading comprehensive examinations, that I really think that the researcher/teacher doctoral degree is a special kind of degree that benefits more from serendipity in residence than other types of degrees. Kate Mooney hinted at this in her reply. But I think it goes much further than that. Zane is correct about the importance of assisting other researchers face-to-face on campus. These researchers become mentors and role models --- usually positive but negative role models also serve a purpose.

How many of you benefitted from lifelong relationships and learning with your classmates onsite in a doctoral program? I would think virtually all of you had face-to-face experiences over several years of residency that are very hard to duplicate in distance education in spite of the intense communications that are now possible online. For example, one of the benefits of residency is to encounter bad role models whether or not you actually took classes from a bad teacher.

Another important factor in non-traditional programs is the quality of the applicants that are turned away. Perceptions of doctoral programs are often judged in the same manner as perceptions of research journals.

Capella would much more respected accounting doctoral program if it announced that applicants with less than 700 GMAT scores need not apply. But it must also be willing to lose a lot of money on the few that are admitted. Instead, Capella developed a cheap shot curriculum where applicants with no transfer credits can get a PhD in accounting in 2.5 years --- absurd by present standards of the accounting academy.

The worst thing that could happen for the accounting academy and Capella graduates would be for Capella to start cranking out more accounting graduates each year than any other accounting doctoral program in the Hasselback Directory --- http://www.jrhasselback.com/AtgDoctInfo.html

This would give a black eye to virtually all of the other degree programs in Capella University. Capella will then look more like a sausage factory than a university.

To earn greater respect, non-traditional doctoral program should have really tough admission standards, a really tough curriculum, and take as long or longer to meet all academic standards for completing a degree. Most importantly the program should employ faculty known by their track records for tough standards. Better yet the doctoral faculty should be so widely respected that the faculty themselves attract high-quality applicants. The academy is a snobby place, and starting out with a new program it’s important to recognize this from the start.

Snobby faculty set the faculty hiring standards as well as the graduation standards. This is not as bad as it seems in this era of disgraceful grade inflation.

The most sought after accounting PhD graduates will graduate from doctoral programs losing the most money per graduate.

Bob Jensen

May 4, 2010 reply from J. S. Gangolly [gangolly@CSC.ALBANY.EDU]

Bob,

Back around 1978 when I was starting my accounting career at Kansas, there was this myth that doctoral programs, as they then existed, are  a resource drain. I was on the doctoral committee, and the chair of the committee (a well-known Management Science faculty member) asked me, as a freshly minted  accounting PhD, to get an accounting of the net costs of the doctoral program. After impting the costs, we were shocked to learn that the program was actually subsidising the rest of the school.  The army of doctoral students manned most first courses under the very able mentorship of very outstanding senior faculty, and the marginal costs of PhD courses was non-existent since most courses were shared with MS students.

Even considering the assistantships that paid the students barely subsistence wages, with even more meagre faculty salaries those days (assistant professors started at $19,500 those days), the subsidy was not trivial.

Imagine what the situation today would be, with the astronomical faculty salaries in accounting. And these astronomical salaries are not of AAU's making. They are our equivalent of "Mark to Market".

It is true that as an AAU school, KU had to support a large library, a large computing center, and so on, but those costs were a given, unless KU wanted to drop out of AAU. I am sure the administrators would have rather dropped dead than dropped out of AAU.

I think teaching by the doctoral students, especially under faculty tutelage, is a valuable apprenticeship experience that perhaps many schools with accountics lack.

The way most accounting courses are taught, as I have seen at many schools, I am not sure if it matters that the PhDs are from within or without accounticitis indoctrination. I would rather have a CPA with sound business knowledge teach my kids than a PhD in numerical regression who has never seen the real world books of accounts. It is time we stopped pretending that accounting is rocket science. That the academic accounting emperors wear no clothes is perhaps a surprise to only a very few who wear the crowns.

Jagdish S. Gangolly,
Associate Professor (j.gangolly@albany.edu)
Director, PhD Program in Information Science, Department of Informatics,
College of Computing & Information 7A Harriman Campus Road, Suite 220
State University of New York at Albany, Albany, NY 12206.
Phone: (518) 956-8251, Fax: (518) 956-8247
URL: http://www.albany.edu/acc/gangolly

 May 4, 2010 reply from Bob Jensen

Amen to that Jagdish, especially the part about rather having experienced specialists teach courses than people who bought a fast-track, cheap-shot sausage link.

The really sad part about Capella’s Accounting PhD Program is that Capella just went a bridge too far when it created an accounting doctoral program that can be completed part-time in 2.5 years without much in the way of accounting courses and research skills courses. I also cannot respect a doctoral program that has no serious comprehensive examination hurdles even if the oral examination is waived.

By going this "bridge too far," Capella defeats the fine reputation that it established to date in most of its other online degree programs. Before it went a bridge too far, Capella was really one of my bright stars in the distance education galaxy --- http://www.trinity.edu/rjensen/Crossborder.htm

In 2008 the largest accountancy doctoral program in North America was the University of Texas at Austin. UT pours millions of dollars of resources into a doctoral program that raised its output of accounting graduates to seven in 2008 according to
http://www.jrhasselback.com/AtgDoct/XDocChrt.pdf

University of Texas
PhD Graduates in Accounting
2003 = 1
2004 = 4
2005 = 3
2006 = 2
2007 = 3
2008 = 7

Another large accounting doctoral program at the University of Washington graduated seven in 2007, but before and since it only graduated one or two year. Penn State similarly had an exceptional year in 2006 by graduating six, but the numbers are much smaller in other recent years. A historically large accounting doctoral program at Illinois is down to graduating one or two a year.

If Capella should try to make a profit on its new accounting doctoral program by cranking out more than one or two a year, it really will begin to look like a sausage factory.

The most an accounting PhD graduate will have invested in tuition at Capella over 120 required quarter credits is $44,850 = ($4,485)(10 part-time quarters). Without more data for a CPV analysis I can only guess that (even without an investment in an expensive research library, without investing in expensive electronic research databases, and without paying enormous fees to noted academic researchers in the accounting academy) Capella cannot possibly break even by graduating only one or two accounting doctoral students per year. The numbers of graduates will have to reach some sausage-cranking level of perhaps 20 or more a year.

Welcome to North America’s largest accounting doctoral program!

In my judgment the curriculum of this program is not at all comparable to any other accounting doctoral program in North America. It’s somewhat comparable to a few two-year, full-time MBA programs. And by going full time (16 credits per quarter) a student having only a bachelor’s degree can get an accounting PhD from Capella in less than two years. Bummer!

Is this the best way to solve our accounting PhD shortage problem in North America?
I'm with you Jagdish. I would rather have CPAs and other technical specialists teaching our courses than cheap-shot, fast-track sausage links.

Bob Jensen

"2009 Securities Litigation Study," by PricewaterhouseCoopers (PwC), May 6, 2010 ---
http://snipurl.com/pwc050610

Summary:
The financial crisis continued to dominate the litigation landscape in 2009 - although to a lesser degree than in 2008, according to the annual PwC Securities Litigation Study. Governments worldwide remained focused on regulatory overhaul, stimulus plans and investigations into the "who, what, when, where, why, and how" of alleged wrongdoings related to the crisis.

This is an annual PwC study.

Bob Jensen's threads on securities frauds ---
http://www.trinity.edu/rjensen/FraudRotten.htm

Bob Jensen's threads on auditing firm litigation ---
http://www.trinity.edu/rjensen/Fraud001.htm

Bob Jensen's Fraud Updates ---
http://www.trinity.edu/rjensen/FraudUpdates.htm

U.S. Government Accountability Office: High Risk --- http://www.gao.gov/highrisk/

This Web site brings together GAO's research on issues that are of great national concern and highlights GAO's High-Risk list, which calls attention to the agencies and program areas that are high risk due to their vulnerabilities to fraud, waste, abuse, and mismanagement or are most in need of broad reform. GAO has produced the list every two years since 1990. In addition to the most up-to-date information on the High-Risk list and other major challenges, this Web site also features: GAO's recommendations for addressing the issues Video messages from GAO issue-area experts Links to key reports for further research Contact information for GAO experts

Bob Jensen's threads on the sad state of government accounting and accountability ---
http://www.trinity.edu/rjensen/theory01.htm#GovernmentalAccounting

The Most Criminal Class Writes the Laws ---
http://www.trinity.edu/rjensen/FraudRotten.htm#Lawmakers

The Greatest Swindle in the History of the World ---
http://www.trinity.edu/rjensen/2008Bailout.htm#Bailout

"Lehman Channeled Risks Through ‘Alter Ego’ Firm," by Louise Story and Eric Dash, The New York Times, April 12, 2010 ---
http://www.nytimes.com/2010/04/13/business/13lehman.html?th&emc=th

It was like a hidden passage on Wall Street, a secret channel that enabled billions of dollars to flow through Lehman Brothers.

In the years before its collapse, Lehman used a small company — its “alter ego,” in the words of a former Lehman trader — to shift investments off its books.

The firm, called Hudson Castle, played a crucial, behind-the-scenes role at Lehman, according to an internal Lehman document and interviews with former employees. The relationship raises new questions about the extent to which Lehman obscured its financial condition before it plunged into bankruptcy.

While Hudson Castle appeared to be an independent business, it was deeply entwined with Lehman. For years, its board was controlled by Lehman, which owned a quarter of the firm. It was also stocked with former Lehman employees.

None of this was disclosed by Lehman, however.

Entities like Hudson Castle are part of a vast financial system that operates in the shadows of Wall Street, largely beyond the reach of banking regulators. These entities enable banks to exchange investments for cash to finance their operations and, at times, make their finances look stronger than they are.

Critics say that such deals helped Lehman and other banks temporarily transfer their exposure to the risky investments tied to subprime mortgages and commercial real estate. Even now, a year and a half after Lehman’s collapse, major banks still undertake such transactions with businesses whose names, like Hudson Castle’s, are rarely mentioned outside of footnotes in financial statements, if at all.

The Securities and Exchange Commission is examining various creative borrowing tactics used by some 20 financial companies. A Congressional panel investigating the financial crisis also plans to examine such deals at a hearing in May to focus on Lehman and Bear Stearns, according to two people knowledgeable about the panel’s plans.

Most of these deals are legal. But certain Lehman transactions crossed the line, according to the account of the bank’s demise prepared by an examiner of the bank. Hudson Castle was not mentioned in that report, released last month, which concluded that some of Lehman’s bookkeeping was “materially misleading.” The report did not say that Hudson was involved in the misleading accounting.

At several points, Lehman did transactions greater than $1 billion with Hudson vehicles, but it is unclear how much money was involved since 2001.

Still, accounting experts say the shadow financial system needs some sunlight.

“How can anyone — regulators, investors or anyone — understand what’s in these financial statements if they have to dig 15 layers deep to find these kinds of interlocking relationships and these kinds of transactions?” said Francine McKenna, an accounting consultant who has examined the financial crisis on her blog, re: The Auditors. “Everybody’s talking about preventing the next crisis, but they can’t prevent the next crisis if they don’t understand all these incestuous relationships.”

The story of Lehman and Hudson Castle begins in 2001, when the housing bubble was just starting to inflate. That year, Lehman spent $7 million to buy into a small financial company, IBEX Capital Markets, which later became Hudson Castle.

From the start, Hudson Castle lived in Lehman’s shadow. According to a 2001 memorandum given to The New York Times, as well as interviews with seven former employees at Lehman and Hudson Castle, Lehman exerted an unusual level of control over the firm. Lehman, the memorandum said, would serve “as the internal and external ‘gatekeeper’ for all business activities conducted by the firm.”

The deal was proposed by Kyle Miller, who worked at Lehman. In the memorandum, Mr. Miller wrote that Lehman’s investment in Hudson Castle would give the bank and its clients access to financing while preventing “headline risk” if any of its deals went south. It would also reduce Lehman’s “moral obligation” to support its off-balance sheet vehicles, he wrote. The arrangement would maximize Lehman’s control over Hudson Castle “without jeopardizing the off-balance sheet accounting treatment.”

Mr. Miller became president of Hudson Castle and brought several Lehman employees with him. Through a Hudson Castle spokesman, Mr. Miller declined a request for an interview.

The spokesman did not dispute the 2001 memorandum but said the relationship with Lehman had evolved. After 2004, “all funding decisions at Hudson Castle were solely made by the management team and neither the board of directors nor Lehman Brothers participated in or influenced those decisions in any way,” he said, adding that Lehman was only a tenth of Hudson’s revenue.

Still, Lehman never told its shareholders about the arrangement. Nor did Moody’s choose to mention it in its credit ratings reports on Hudson Castle’s vehicles. Former Lehman workers, who spoke on the condition that they not be named because of confidentiality agreements with the bank, offered conflicting accounts of the bank’s relationship with Hudson Castle.

One said Lehman bought into Hudson Castle to compete with the big commercial banks like Citigroup, which had a greater ability to lend to corporate clients. “There were no bad intentions around any of this stuff,” this person said.

But another former employee said he was leery of the arrangement from the start. “Lehman wanted to have a company it controlled, but to the outside world be able to act like it was arm’s length,” this person said.

Typically, companies are required to disclose only material investments or purchases of public companies. Hudson Castle was neither.

Nonetheless, Hudson Castle was central to some Lehman deals up until the bank collapsed.

“This should have been disclosed, given how critical this relationship was,” said Elizabeth Nowicki, a professor at Boston University and a former lawyer at the S.E.C. “Part of the problems with all these bank failures is there were a lot of secondary actors — there were lawyers, accountants, and here you have a secondary company that was helping conceal the true state of Lehman.”

Continued in article

"Demystify the Lehman Shell Game," by Floyd Norris, The New York Times, April 1, 2010 ---
http://www.nytimes.com/2010/04/02/business/02norris.html

Bob Jensen's Fraud Updates are at
http://www.trinity.edu/rjensen/FraudUpdates.htm

Bob Jensen's threads on the Lehman-Ernst scandal are at
http://www.trinity.edu/rjensen/fraud001.htm#Ernst

Bob Jensen's threads on the future of audit firms are at
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

Comparisons of Leading Plagiarism Detection Services

May 13, 2010 message from JustFit Studio [admin@justfitstudio.com] 

Hi Bob!

I have recently reviewed your threads on plagiarism here: http://www.trinity.edu/rjensen/plagiarism.htm and was impressed by how many sides of plagiarism it covers. It is very-very good material both as a source for any further research and  as a general knowledge.

So, I simply wanted to say thank you for a good job researching the topic and attract your attention to the article I recently posted on my website: "Top 10 Tools to Detect Plagiarism Online". I saw you posted the comparison of plagiarism detection services on your web page and wanted to advice you have a look at my article. It is fresh and has researched all the services available on the Internet and evaluated top 10 on a set of criteria. I mean maybe you will find any more information valuable for your further research in it.

I also would really appreciate if you put a reference (link) to my article from the web page of your threads.

Here is the link to it: http://www.justfitstudio.com/articles/plagiarism-detection.html

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Student Term Paper and/or Debate Idea
One idea for a student term paper or student debate would be to compare consumer product protection legislation and tort litigation with auditing firm legislation (e.g,, Sarbox) and malpractice insurance costs. This is relevant at the moment because of the pending 2010 Consumer Product Safety Improvement Act versus questions whether auditing firms will recover from pending lawsuits of thousands of bank failures ---
http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms

This is now especially  important debate for financial auditing firms who are possibly at risk of imploding like Andersen due to regulation and litigation risks.

One thing I would like to learn more about is the cost of auditing firm malpractice insurance compared between different nations such as the U.S. versus Canada versus Japan versus Germany.

Consumer Product Safety Commission --- http://www.cpsc.gov/
The pending 2010 Consumer Product Safety Improvement Act --- http://www.cpsc.gov/ABOUT/Cpsia/cpsia.HTML

Sarbox --- http://en.wikipedia.org/wiki/Sarbox

One issue of great concern is how regulation and tort liability can easily put small businesses and small auditing firms out of business even before lawsuits due to the mere cost of meeting regulation requirements and the exploding cost of malpractice insurance.
 

A second issue extends these question to large businesses and international auditing firms.

Students can also be assigned to debate the pros and cons of regulation and liability protection "relief."

One important point to consider is the 2006 Texas amendment to its constitution that limits punitive damages in medical malpractice lawsuits without limiting damages for loss of income in medical malpractice awards. Before this amendment may medical specialists dropped high risk services due to the high cost of malpractice insurance. For example, my wife's great female OB/GYN surgeon in San Antonio dropped OB services completely in 2003 because insurance coverage and Medicaid payments did not even cover the malpractice insurance cost for her OB services. After Texas amended its constitution, malpractice insurance costs dropped significantly. This great GYN surgeon once again added OB to her services after 2006.

Years ago while we were still living in San Antonio, Texas my wife had two of her 12 spine surgeries performed by a surgeon from the South Texas Spinal Clinic. When it came time for next surgery her surgeon turned her away saying that the Clinic no longer accepted any Medicare patients (she was then covered under Medicare Disability Insurance before retirement age). Purportedly the soaring costs, especially malpractice insurance, made complicated Medicare surgeries, on average, big money losers in for spinal surgeons in Texas. We subsequently moved to New Hampshire where Erika had two spine surgeries from Dr. Levi at the Concord Hospital. Erika later became so bent over that we afterwards sought out one of the very few specialists in the nation who can perform a "Pedicle Subtraction Osteotomity for Severe Fixed Sagittal Imbalance."

She went into a Boston hospital bent over like the Hunchback of Notre Dame and came out walking Marine-drill erect in 2007 (but with no relief from her chronic pain). She has hundreds of thousands of dollars worth of metal attached to her spine from neck to hips. But since it is jointed in three places, she can pick up a paper towel off the floor. --- http://www.trinity.edu/rjensen/Erika2007.htm

Out of curiosity in November 2009,  I phoned the  South Texas Spinal Clinic and discovered it once again is accepting Medicare patients even though Erika has no intention of returning to that Clinic. Ostensibly a major factor in deciding to once again take on Medicare patients is the decline in malpractice insurance costs due largely to a change in the Texas Constitution. Interestingly, decreases in malpractice insurance costs have been a major factor in increasing competition for physician specialists in Texas:

Four years after Texas voters approved a constitutional amendment limiting awards in medical malpractice lawsuits, doctors are responding as supporters predicted, arriving from all parts of the country to swell the ranks of specialists at Texas hospitals and bring professional health care to some long-underserved rural areas. “It was hard to believe at first; we thought it was a spike,” said Dr. Donald W. Patrick, executive director of the medical board and a neurosurgeon and lawyer. But Dr. Patrick said the trend — licenses up 18 percent since 2003, when the damage caps were enacted — has held, with an even sharper jump of 30 percent in the last fiscal year, compared with the year before.
Ralph Blumenthal, "More Doctors in Texas After Malpractice Caps," The New York Times, October 5, 2007 --- http://www.nytimes.com/2007/10/05/us/05doctors.html

Under financial stress hospitals in Massachusetts have had to take huge budget cuts. Rather than spread those cuts across the board to all departments, some hospitals have decided to concentrate on dropping the most money-losing departments. You probably can guess the leading candidate for being eliminated --- the obstetrics department.

My neighbor down the road has a second home up here in the White Mountains. However, he still practices cardiology in a Boston suburb. He says that Mass. hospital obstetrics departments are leading candidates for elimination, in large measure, because of the high cost of malpractice insurance covering obstetrics services relative to insurance payment caps in Mass.

Lawyers file cookie-cutter lawsuits against doctors, nurses, and hospitals for every defective baby irrespective of the facts in any given case. The reason is the tendency of sympathetic juries to make multimillion dollar awards to a mother of a defective baby irrespective of the facts in the case. Many juries feel that fat cat insurance companies owe it to the unlucky woman (and her lucky lawyers) who must nurture and raise a severely handicapped child. Juries make such awards even when the doctors, nurses, and hospitals performed perfectly under the circumstances. Paul Newman showed us how to love it when lawyers beat the medical system in favor of the "poor and powerless" in The Verdict --- http://www.youtube.com/watch?v=zVZFlBJftgg

But so-called "fat cat" insurance companies adjust rates based upon financial risks. The rates became so high for obstetrics that across most of the U.S. (less so in states like Texas that cap punitive damages) thousands of gynecologists dropped the obstetrics part of their services. And under then Governor Mitt Romney's Universal Healthcare in Massachusetts some strained hospitals dropped obstetrics services.

Canadian Malpractice Insurance Takes Profit Out Of Coverage," by Jane Akre, Injury Board, July 28, 2009 ---
Click Here

The St. Petersburg Times takes a look at the cost of insurance in Canada for health care providers.

A neurosurgeon in Miami pays about $237,000 for medical malpractice insurance. The same professional in Toronto pays about $29,200, reports Susan Taylor Martin.

These are just some factors to consider in the debate about the pros and cons of providing some relief from killer regulations and lawsuits for high risk product manufacturing and high risk services.

One thing I would like to learn more about is the cost of auditing firm malpractice insurance compared between different nations such as the U.S. versus Canada versus Japan versus Germany.

This is now an important debate for financial auditing firms who are possibly at risk of imploding like Andersen due to regulation and litigation risks.

Bob Jensen's threads on auditing firm litigation and professionalism are at
http://www.trinity.edu/rjensen/Fraud001.htm