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.


The Facebook IPO Trainwreck

No one is covering themselves in glory in the aftermath of the Facebook IPO.

Lead underwriter Morgan Stanley is battling allegations that it priced the deal too richly.

Facebook insiders are being called greedy for the last-minute increase in the number of shares they sold in the offering.

Facebook’s management is being criticized for signaling analysts to lower their revenue estimates just days before the deal priced – a move that could be a violation of securities laws.  It also appears some institutional investors were informed of the analysts’ downgrade but retail investors were not.

If all that wasn’t enough, Nasdaq has endured a barrage of complaints for breakdowns in its system on the first day of trading that left investors in the dark about the status of their orders.

Predictably, regulators are launching investigations, legislators are scheduling hearings and plaintiff attorneys are filing lawsuits.

This is hardly the place Facebook wanted to be after completing its IPO.  Nor is it encouraging to other firms that are thinking about going public.

Morgan Stanley is clearly in the hot seat. The firm issued a statement late Tuesday defending its actions, but it is standing on narrow ground, asserting that its procedures were “in compliance with all applicable regulations” and that it handled Facebook in the same manner as every IPO.   That’s not enormously reassuring but it may be all it can say right now as it gathers the facts.

Nasdaq also has a lot to answer for.  Its systems are meant to handle high transaction volumes, and its people are expected to test and monitor the infrastructure to prevent these kinds of problems.  It’s not reassuring to hear Nasdaq executives admit they underestimated the scale of the technical problems.  Nasdaq needs to give guidance quickly on how it will address investor losses and repair the weaknesses in its systems.

Even if Facebook shares recover, the events of the past few days will linger in the minds of investors.  It’s too early to know if it will lead to changes in the IPO book-building process, which hasn’t changed much in the past half-century.  If it does, Facebook in its own way will disrupt Wall Street, just as it upended the media and technology sector.

What to Do When David Einhorn Strikes

Herbalife shares are rebounding a little after a 22% drop yesterday, when questions from investor David Einhorn during the company’s earnings call sent investors fleeing.  Einhorn is known for spotting accounting problems at companies and backing up his skepticism by taking big short positions. His sharp questioning of Lehman Brothers highlighted issues that ultimately brought about the firm’s bankruptcy.

Herbalife did a reasonably good job of responding to the issues Einhorn raised.  First, it addressed them directly on the earnings call where Einhorn spoke.  Later, the company put out a short statement reiterating its views.  It was a little defensive but conveyed the message that the company regarded the issues as unimportant, and that it had a share buyback plan to shore up its shares. Last, it enlisted support from several analysts who follow the company.  Their comments, which were included in many press reports, expressed confidence in Herbalife’s accounting and its management.

Herbalife isn’t out of the woods, though.  Its statement said it would provide additional detail on its response to Einhorn’s questions, but it has not yet done so.  Company insiders also have been selling a lot of shares in recent weeks, a sign perhaps that management believes the shares have peaked, at least for now, or that unpleasant disclosures might be in the offing.  The latter would be very bad news, both for shareholders and for management’s credibility.


Chesapeake Shows Why Lawyers Shouldn’t be Communicators

The board of Chesapeake Energy (NYSE: CHK) just released a statement in which it denied knowing of CEO Aubrey McClendon’s borrowings related to his stakes in the company’s wells, contradicting a statement made by the company’s general counsel earlier in the week:

“Chesapeake also wishes to clarify a statement appearing in its April 18, 2012 press release captioned “Chesapeake Energy Corporation General Counsel Henry J. Hood Issues Statement.” The statement that “the Board of Directors is fully aware of the existence of Mr. McClendon’s financing transactions” was intended to convey the fact that the Board of Directors is generally aware that Mr. McClendon used interests acquired through his participation in the FWPP as security in personal financing transactions. The Board of Directors did not review, approve or have knowledge of the specific transactions engaged in by Mr. McClendon or the terms of those transactions.”

Details of McClendon’s borrowings first came to light in a Reuters article on April 18.  Chesapeake quickly mounted a stern rebuttal, creating a webpage with a statement, links to regulatory disclosures and a lengthy Q&A with Reuters as the story was being developed.

Unfortunately, while the strategy to use a purpose-built website and shine light on the reporting process was good, the company’s responses were lawyerly, defensive and at times needlessly combative. Here’s an example:

Question [from Reuters]: More than a dozen academics, attorneys, Wall Street analysts and corporate governance experts who have reviewed the loan agreements say that the mere existence of as much as $1.1 billion in loans taken out by Mr McClendon against his share of the company’s wells raises the potential for conflict of interest in multiple ways. As a result, they say the loans should be disclosed in more detail than is currently provided by the references to “financing transactions” in the annual proxy. What is Chesapeake’s response to this view?

Answer: The question is improper on a number of levels. First, it does not specify the supposed conflict of interests nor does it include any analysis that reflects the information reviewed by the speaker, the information the speaker considered important, the speaker’s experience in the oil and gas industry or what assumptions were made by the speaker. Thus, one cannot tell if the conclusion was based on a short email with a leading narrative (as we have seen from your emails that have been provided to us), incomplete information or a thorough review of the pertinent information. Second, the concept of an “expert” is that the individual’s reputation and training supports a conclusion that the person’s opinion on a given topic is worthy of respect. That is inconsistent with hiding one’s identity, analysis or bias. Third, disclosure is an intricate regulatory scheme of multiple laws and rules that can be made unworkable by adding multiple disclosures of transaction details just because a small group of shareholders might think it is helpful. This is exacerbated where there are multiple small groups, each with their own special data request to fit their own special agendas.

Ugh.  There’s more where that came from, and it’s just as unhelpful.  As a result, Chesapeake reinforced the impression that the CEO had a lucrative deal that was obscured from shareholders.  And with today’s disclosure, we now know the response wasn’t truthful, either.


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.


SEC suit a challenge for life settlements industry

The U.S. Securities and Exchange Commission on Tuesday sued Life Partners (NASDAQ: LPHI), a major dealer in the secondary market for life insurance policies.  Life Partners and other financial firms have been at the forefront of the “life settlements” industry, which purchases life insurance policies from individuals, usually seniors, for a lump-sum and collects the face amount when they die. (Disclosure: Some years ago, I was an investor-relations advisor to National Financial Partners, an insurance and financial services firm that is active in this market.)

The industry has seen its share of controversy but in recent years has made an effort to develop business-practice standards under the authority of a trade group, the Life Insurance Settlement Association, fondly known as LISA.  As of this morning LISA had no comment on the SEC’s action, and it is not clear if Life Partners is a member of the group.

Importantly, the agency has not accused Life Partners of misconduct in the purchase of life insurance policies from clients, but of misleading investors over its valuation of the policies.   (It’s unclear whether the SEC would have jurisdiction over insurance contracts, which are usually regulated by the states.)  The SEC also accused two of the company’s executives of insider trading.

The case seems likely to draw renewed attention to the sector, from both the media and from state attorneys general, several of whom have investigated life settlements firms in the past.  It’s a good chance for the industry to take a stand, articulate the benefits it brings to people and how its market operates.  We’ll have to wait and see.


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.