Disclosure is an Attitude

I recently had lunch with a senior executive from a big accounting firm who complained about the criticism his firm was facing over audits it conducted at big companies that later were found to have big problems.

In all these cases, the executive said, there was a “well established body of accounting practice” that permitted the company to forestall disclosure or keep certain items off the balance sheet or bury an important fact in a fine-print footnote.

As it turned out, the things these companies obscured were pretty important to investors.  Once the off-balance-sheet liabilities were known, the company’s valuation tumbled, executives were fired and lawsuits and recriminations ensued – for the board and its auditor.

The accountants’ defense that “we were just following the rules” just doesn’t fly.  For one thing, the so-called “rules” on disclosure don’t exist.  The SEC does not provide a strict threshold for disclosure, choosing instead to let companies determine what should be released.  The burden is, appropriately, on the company’s board to make the right judgment, consistent with its fiduciary obligation to shareholders.

More than that, auditors ought to stand up as professionals and insist on disclosure when important issues are involved.  Sadly, there are few examples when they’ve done so.

It’s not all the fault of the auditors.  Ultimately, it’s up to the board.  Disclosure isn’t a matter of meeting a test or ticking a box.  Disclosure is an attitude.  A company decides it is going to keep investors informed or not.

Disclosure failures have been at the heart of spectacular corporate failures, from Enron nearly a decade ago, to Lehman Brothers in 2008, and it’s again in focus in the aftermath of Facebook’s bungled IPO.  There, Facebook filed a revised prospectus with a vague statement about user growth was outpacing advertising – an oblique way of saying its revenue growth was slowing.

Did the SEC filing by Facebook meet the legal requirement to disclose a material fact? Probably. (Although that question seems headed for the courts.) Was the statement sufficient to inform investors about the true state of Facebook’s profit outlook?  No, it wasn’t.

The adequacy of J.P. Morgan’s disclosures has also been questioned following its $2 billion trading loss from a complex hedging strategy.

Ultimately, the decision to make a disclosure comes down to management and the board and whether they want to state the facts openly or hide behind obscure accounting practices.

I know in which company I’d want to invest.


Communicating European debt risk

As reported today, the US Securities and Exchange Commission has introduced guidance for financial firms related to reporting of their European debt exposure.  The SEC issued its recommendations to address the inconsistent approach firms have used to disclose their risk to sovereign and private borrowers:

“In response to our comments on their disclosure documents, registrants have provided incremental improvements in disclosures of exposures to sovereign debt in several countries during the year. However, we find that expanded and enhanced disclosures are not consistent from registrant to registrant. Therefore, we determined that investors would benefit from our providing additional guidance to assist registrants in their assessment of what information about exposures to European countries they should consider disclosing and how they should disclose this information with the goal of greater clarity and comparability.”

The SEC gives very clear instructions as to the type of information it believes firms should disclose and the form it which it should be presented:

“We believe that disclosures should be provided separately by country, segregated between sovereign and non-sovereign exposures, and by financial statement category, to arrive at gross funded exposure, as appropriate. Registrants should also consider separately providing disclosure of the gross unfunded commitments made. Lastly, we suggest that registrants provide information regarding hedges in order to present an amount of net funded exposure.”

The SEC’s action will likely result in additional disclosures by financial firms in their 2011 annual report (10-K) filings.  It could also produce some surprises for investors and fresh volatility in stock prices for firms whose risks are seen as greater than previously thought.  These firms wiould be well advised to prepare a thorough communication plan for reporting their risk exposure – and not simply leave it to be discovered in the fine print of a regulatory filing.


More on Refco and MF Glboal

Years after its collapse, Refco continues to make news.  Yesterday, an appeals court overturned the conviction of an attorney, Joseph P. Collins, who had been the chief outside counsel for the futures brokerage and was found guilty of aiding the company’s scheme to hide millions in debt and mask its true financial condition.  When the fraud was discovered, Refco filed for bankruptcy, and its assets later were sold to Man group, which later spun them off as MF Global.

Collins was convicted largely on the basis of testimony from a former Refco executive who cooperated with federal prosecutors.  Similarly, in the MF Global investigation, high-profile prosecutions seem likely if the government finds a cooperating witness.

News reports today say the investigation of MF Global’s collapse and the disappearance of customer funds is gathering pace but has been hampered by the firm’s chaotic back-office records.  As a New York Times article today notes:

Federal authorities have reviewed internal MF Global e-mails that instructed Ms. O’Brien to transfer roughly $200 million to JPMorgan Chase to satisfy an overdrawn account, though there is no indication that she knowingly transferred customer money. MF Global’s sloppy records may have obscured the fact that staff was dipping into customer cash to cover the firm’s own needs.

Poor record-keeping at MF Global likely reflects the broader weaknesses in risk management and reporting that carried over from Refco, an issue I addressed in an earlier post a few weeks ago.  These issues are likely to put the company’s former auditors, Pricewaterhouse Coopers, in an uncomfortable spot in the weeks to come.  (See this Forbes piece for more on the issues facing PwC.)




The Irony of MF Global: The System Worked

Were it not for the missing customer funds, the collapse of MF Global would be hailed as an example of how well the financial system worked.

That’s a very big “if,” of course, and the loss of customer funds is a scandal all its own.  But the market worked – and that’s an important lesson.

The accountants, the regulators and the board of directors did their part – not perfectly and perhaps not quickly – but they asked the right questions, demanded disclosure of the firm’s trades and forced management to defend its strategy.  Customers, shareholders and counterparties then concluded MF Global had too much risk and abandoned the firm – exactly the sort of rough justice that’s at the core capitalism.

Let;s start with the MF Global board, which, unlike Bear Stearns and Lehman Brothers, had directors who were financially sophisticated.  The board questioned the risk of MF Global’s European debt trades in what sounds like a heated exchange with CEO Jon Corzine.  The board may have erred in its judgment that Corzine’s trades were prudent, but it did its job by asking tough questions about risk.

The regulators, too, did their part.  Led by FINRA, they raised the alarm, and stood firm as Corzine fought to convince them MF Global needed less added capital than the regulators were demanding.  Even the firm’s auditors forced a disclosure of the trades, albeit belatedly.  Here’s how the New York Times described the events:

Eventually, MF Global’s auditor, PricewaterhouseCoopers, asked Mr. Corzine to report the European debt exposure to his investors. He personally met with the accounting firm in December 2010, two people said, and it was agreed that the transactions would be mentioned in a footnote in the firm’s annual report, which was filed on May 20, 2011.

Earlier, one of MF Global’s many regulators noticed something curious. The Financial Industry Regulatory Authority, which helped watch over MF Global’s securities business, noticed a sharp swing in profits in a monthly report the firm filed to regulators. Finra asked MF Global executives about the volatile accounting line but did not get a satisfactory answer, say people familiar with the matter, until the annual report came out weeks later.

When Finra realized what MF Global was doing, it grew concerned. The Wall Street self-regulator told MF Global to set aside enough money in case the trades went bad. But Finra didn’t have the authority to force the firm to do so — that power was in the hands of the Securities and Exchange Commission, whose rule Finra was citing.

Mr. Corzine then personally took the firm’s case to the S.E.C. in mid-August, taking the Delta Shuttle to Washington for a meeting with a top agency official.

The S.E.C. indicated it would side with Finra, but needed a few weeks to make a final determination. In the meantime, MF Global and Finra haggled over the size of the capital cushion: the regulator wanted $200 million set aside, while the firm pushed for a figure closer to $50 million. In late August, Finra won out.

It would be the beginning of the end for MF Global.

As the facts come to light, we’ll see major mistakes in the way MF Global handled its risk reporting and client accounts.  But for exerting discipline where risk-taking is concerned, the system worked.

Refco’s ghost haunts MF Global

It’s impossible to read about the demise of MF Global and not think about Refco, the futures brokerage that collapsed in scandal in 2005 and whose remains were later bought by MF Global.   Like Marley’s ghost, the weaknesses that played a part in Refco’s downfall returned to haunt MF Global.

Refco’s problems came to light just a few months after it completed an initial public offering in August 2005 that valued the company at $3.5 billion.   A short time later, the firm discovered that CEO Phillip Bennett had maintained control of a separate entity that wasn’t consolidated with Refco’s books and held $430 million in Refco debt.  When Refco disclosed the debt in October 2005, just eight weeks after the IPO, Refco’s liquidity evaporated, customers rushed to withdraw funds and the firm filed for bankruptcy within a week.

That scenario sounds a lot like MF Global, where a big and poorly disclosed bet on European debt led to a credit downgrade and a spiral into bankruptcy.

Refco CEO Philip Bennett masterminded the fraud, personally directing a series of transactions to mask Refco’s true financial condition.  But the scheme could not have succeeded without a weak risk-monitoring system.  And it seems likely that these weaknesses remained when Refco’s business was bought in a bankruptcy-court auction by MAN Financial, the predecessor to MF Global.

The New York Times recently reported that MF Global CEO Jon Corzine scuttled plans to upgrade the firm’s risk systems.  So it’s quite likely that MF Global did not have the means to properly segregate client funds, track margin balances and, importantly, monitor the use of customer collateral by MF Global to finance its positions, a practice that, however surprising, appears to be lawful.  (Seeking Alpha has a lengthy description here.)

The facts aren’t yet known, but if MF Global was tapping customer collateral to finance its trading, the parallels to Refco become even more striking.   For the main technique used by Bennett in the Refco fraud was a series of short-term loans with third parties.  The report of the Court-appointed Examiner in the Refco bankruptcy case describes it below:

To hide the RGHI Receivable, as each reporting period came to a close, Bennett and others caused the consolidated reporting Refco companies to manipulate their books through a series of transactions commonly referred to as “Round Trip Loans.” The loans made it appear that the RGHI Receivable was due from unrelated third parties rather than from RGHI.  This concealment of the true nature of the RGHI Receivable also provided comfort to outsiders that the receivable was collectible. The mechanics of the typical Round Trip Loans is described below:

The Round Trip Loans were two short term loans of several weeks duration that spanned the end of Refco’s fiscal year-end or quarterly financial reporting periods. The first loan was made by a Refco entity to a third party at a certain interest rate for a certain period of time. The second one was made by that same third party to RGHI for the same period of time, but at a higher interest rate. The repayment of the loan by RGHI to the third party was guaranteed by RGL and the third party was also indemnified by RGL against any loss or expense for entering into the Round Trip Loan.

The funds or credit advanced for the loan to the third party were deposited into the third party’s account with RCM. Those funds were then transferred at the third party’s request from the third party’s account at RCM to RGHI’s account at RCM. The effect of these transactions was to reduce RGHI’s receivable balance owed to RCM by the amount of the Round Trip Loan, and to substitute a receivable in that amount from the third party. In most cases, these were bookkeeping entries and no cash actually “moved.” After the end of the applicable reporting period, the process was reversed and unwound.

These Round Trip Loans were sham transactions with no economic substance which were entered into solely to “dress up” Refco’s consolidated financial statements. The loans involved no risk to the third party because they included secret guarantees by Refco that were not reflected on Refco’s books.

(Refco’s use of Round Trip Loans sounds a lot like the “Repo 105” transactions used by Lehman Brothers to dress up its financial statements at quarter-end.)

The full report of the Examiner is a worthwhile read, if long.  It provided the factual basis for prosecutions of Refco’s former executives and advisers.  Former Refco CEO Phillip Bennet is now serving a 16-year prison sentence.  Joseph Collins, a former partner at law firm Mayer Brown who served as outside counsel to Refco was convicted of fraud and conspiracy and sentenced to seven years in prison.

The Examiner’s report also had harsh words for Refco’s auditors and tax advisers, among them Ernst & Young, for which the Examiner found sufficient evidence to support a claim against the firm for professional malpractice and aiding and abetting fraud.  Indeed, the Refco estate later sued E&Y and other advisors for $2 billion.

You can be sure that part of the report is getting careful attention at PricewaterhouseCoopers, which audited MF Global.  And to complete the irony, PwC also worked for Refco.

Crisis continues for Olympus

The crisis at Olympus shows no sign of easing after the resignation of Chairman Tsuyoshi Kikukawa.  Japanese regulators have joined investors in calling for a full explanation of payments Olympus made in connection with acquisitions it made in recent years.

His resignation will not remove Kikukawa from the company, however.  He remains a director on the board, a situation that critics say could allow him to continue to influence a board he’s managed very closely for years.

From a communication standpoint, Olympus still has failed to offer a persuasive justification for these payments or to fully disclose who received them.  Its news conference yesterday backfired badly when it became clear that company officials were not providing any new information.

None of the events of the past two weeks – Kikukawa’s resignation, the pressure from Japanese institutional investors and the awakening of Japan’s governance activitsts – would have occurred if not for the aggressive media campaign waged by Michael Woodford, who was ousted as CEO by the Olympus board. He’s been quoted extensively in print and interviewed frequently on television, helping to keep the story alive and subtly refuting the Olympus portrayal of him.

Armed with the report he commissioned from PriceWaterhouseCoopers that provided stinging details on the disputed M&A fees, Woodford was able to bring enormous attention to the issue.  Against those facts, the Olympus position that Woodford was fired for being a poor cultural “fit” quickly fell apart.

It’s interesting to speculate on whether Olympus would be in this spot had it reached a separation agreement with Woodford barring him from speaking publicly.  That’s a common part of CEO exit packages, but perhaps there was too much acrimony between Woodford and Kikukawa to negotiate anything.   And scathing investigative reports usually find their way into the media once they’re written.




Olympus: Where were the auditors?

The hole is getting deeper for Olympus and its chairman, Tsuyoshi Kikukawa. And his outside auditor, Ernst & Young, might find itself alongside him.

A day after denying allegations by its former CEO, Michael Woodford, that it paid advisory fees of $687 million on a $2 billion acquisition, the company reversed itself and acknowledged that Woodward’s figures were correct.

Analysts have downgraded the shares, and Goldman Sachs suspended its rating over doubts about the company’s accounting, calling into question the accuracy of Olympus’s books over the past several years.

It hasn’t helped that three different company officials are speaking on the matter – Chairman Kikukawa, Executive Vice President Hisashi Mori and press spokesman Yoshiaki Yamada.  All have made contradictory statements, further undercutting Olympus’s credibility.

There has not yet been much focus on the Japan affiliate of Ernst & Young, the independent auditor for Olympus.  Presumably, it would have reviewed the accounts for the acquisitions in question at the time it prepared the company’s financial reports.  E&Y could face scrutiny for its role, especially if Olympus must restate its accounts.

The story shows also no sign of falling from the headlines, with the Financial Times and other business publications giving it intensive coverage.   Attention seems certain to shift to learning the identity of the firms that received the advisory fees and whether other acquisitions were done properly.  A Bloomberg report said:

“One of the advisers receiving the fees, Cayman Islands- incorporated AXAM Investments Ltd., was removed from the local registry in 2010, according to an official filing. PwC said they were unable to identify the owners of AXAM Investments.”

It also will be interesting to watch the actions of Olympus shareholders in Japan.  With the stock off some 40%, there will be growing pressure on Kikukawa to resign.  Even in Japan’s insular corporate world, this crisis is too big for shareholders to ignore.