Ethics Sage

Threats to Independence Raise Ethical Questions for the Big-Four CPA Firms

KPMG Faces Conflict of Interest Charges in Audit of JobsOhio

KPMG is at it again. In the most recent allegation of violating independence standards of the accounting profession, KPMG’s Columbus, Ohio office was auditing JobsOhio’s books while, at the same time, an out-of-state office of the firm was seeking $1 million in taxpayer money from JobsOhio for an unnamed client. As the state’s lead economic-development agency, JobsOhio is charged with recommending financial incentives for companies seeking to relocate in the state. On November 5, 2012, about the time that the audit was being conducted, KPMG was also listed on a sheet of eight pending grant commitments from the state for fiscal year 2013, one of which was for the unnamed client.

I will return to this case later on, but first a review of the recent insider trading charges against the firm. I have previously written about about insider trading at KPMG. In that case, KPMG resigned two audit accounts and withdrew its blessing on the financial statements of Herbalife for the past three years and of Skechers for the past two. KPMG withdrew its audit opinions, a serious step for any auditor, after concluding it was not independent because of alleged insider trading.

The KPMG insider trading case is a particularly egregious one because it involves an auditor tipping off a friend about stock of audit clients. Scott London, the KPMG auditor, did not trade in the stock himself but he did gain personal wealth (“unjust enrichment”) when his friend, Brian Shaw, used the inside information to trade in stock of Herbalife Ltd. and Skechers USA Inc. Shaw benefitted by $1.27 million on the trades. Shaw paid London $50,000 cash and gave him a Rolex watch.

Looking at the JobsOhio case, as KPMG was auditing JobsOhio's books in the fall of 2012 the firm also was seeking $1 million in taxpayer money from JobsOhio for an unnamed client. JobsOhio, the state's privatized development agency, said that the grant request was handled separately from and without the knowledge of the firm's auditing division.

The ethical problem for KPMG in the JobsOhio case is independence in appearance. This is an important requirement of an independent audit because factual independence is sometimes difficult to determine. Factual independence goes to the mindset of the auditor in approaching an audit with objectivity and professional skepticism. It is difficult to assess so appearances serve as a proxy in that regard.

JobsOhio denies any conflict of interest. Laura Jones, a spokeswoman for JobsOhio, said KPMG LLP's Columbus office conducted the audit, but the grant was sought by an out-of-state office. "The fact that KPMG serves JobsOhio and countless other businesses ... from the same office here in Columbus is not a conflict in our minds," she said, adding that “the state also monitors and ultimately approves taxpayer-funded incentives to companies.”

Most observers would probably conclude that the two offices of KPMG would never collude on their own to achieve some benefit for the firm. However, the more troubling issue is whether JobsOhio might perceive some pressure on them to provide financial incentives to the KPMG audit client perhaps to make it less likely that KPMG would point out problems with the JobsOhio audit, assuming any occur.

The accounting profession has strict independence standards to protect the public interest. Shareholders, creditors, and the beneficiaries of public funds rely on the honesty, trustworthiness, and responsibility of auditors to go the extra mile to ensure that the financial statements of entities that operate in the public interest are based on an independent audit – both in fact and in appearance.

KPMG is not alone in violating the most basic and cherished independence standards. As I have previously blogged, in 2010 Deloitte and Touche was investigated by the SEC for repeated insider trading by Thomas P. Flanagan, a former management advisory partner and a Vice Chairman at Deloitte. Flanagan traded in the securities of multiple Deloitte clients on the basis of inside information that he learned through his duties at the firm. The inside information concerned market moving events such as earnings results, revisions to earnings guidance, sales figures and cost cutting, and an acquisition. Flanagan’s illegal trading resulted in profits of more than $430,000. In the SEC action, Flanagan was sentenced to 21 months in prison after he pleaded guilty to securities fraud.

On January 7, 2013, the SEC announced it is investigating whether Ernst & Young violated independence rules by letting its lobbying unit perform work for several major audit clients. The SEC inquiry began shortly after Reuters reported in March 2012 that Washington Council Ernst & Young, the E&Y unit, was registered as a lobbyist for several corporate audit clients including Amgen, CVS Caremark, and Verizon Communications.

The problem for EY is that U.S. independence rules bar auditors from serving in an "advocacy role" for audit clients. The goal is to allow auditors to maintain some degree of objectivity regarding the companies they audit, based on the idea that auditors are watchdogs for investors and should not be promoting management's interests.

Finally, in December 2012, Thomson Reuters announced it signed a three-year contract with PwC, the company’s auditor, to provide use of the Thomson Reuters ONESOURCE Corporate Tax solution for China. PwC U.K. also uses this Thomson Reuters software for its tax clients. Business alliances between a company and its auditor are prohibited under U.S. and U.K. auditor regulations. Once again an independence violation exists because such arrangements create a “mutuality of interests” as a result of the business relationship between the auditor and audit client.

I am very concerned about the actions of KPMG in the JobsOhio case, Deloitte & Touche and KPMG insider trading scandals, EY serving as an advocate for an audit client, and PwC in becoming involved in a joint business relationship with an audit client. These relationships create threats to independence and taint the audit because of conflicts of interest.

The SEC needs to look into these matters, not just individually but collectively, and determine whether the Big-4 CPA firms have built adequate safeguards to protect audit independence and whether more stringent independence and ethics standards are needed to protect the public trust in the independent audit.

Blog posted by Steven Mintz, aka Ethics Sage, on May 7, 2013

Should the SEC Permit Social Media Postings of Financial Information?

Financial Disclosures on Social Media Sites Raise Questions of Fairness and Security

On April 2, the Securities and Exchange Commission outlined new disclosure rules that clarify how companies can use Facebook, Twitter and other social networks to disseminate information provided they meet certain requirements. The SEC said that companies must inform investors in advance that those will be the outlets used to disseminate financial reports. Some have heralded the move as bringing the SEC into the 21^st century and catching up with the new era of social media. Others have criticized it including Warren Buffett’s Berkshire Hathaway-owned Business Wire.  

Business Wire said that the SEC's rule "poses a disservice to the investment community” explaining that it threatens increased fragmentation of price-sensitive information, privacy concerns as users are required to register to gain access to material news, security risks that may adversely affect market stability, and the loss of simultaneity -- and the "level playing field" -- that is at the core of Regulation Fair Disclosure, commonly known as Reg FD.

Business Wire supports the use of social media tools, web posting on company web sites and blogging as supplemental platforms to communicate material information, but it believes that a broadly disseminated news release -- distributed simultaneously and in real-time via a legitimate news wire service -- is still the most effective way to maximize investor outreach, and to inclusively serve the needs of all market participants.

The use of social media to post financial information first came on the SEC’s radar last December when the regulator warned Netflix that it could take action against the company for a 43-word message that the company’s chief executive, Reed Hastings, posted in his personal Facebook feed. In the note, Mr. Hastings congratulated his team for exceeding one billion hours of video watched in a single month.

But the SEC raised concerns that the post violated Reg FD, which requires a company to publish material information to all investors at the same time. While Mr. Hastings’s announcement was made on his publicly available Facebook page, which had over 200,000 followers, the information was not subsequently disclosed in a securities filing or news release.

At the time, Hastings and Netflix said that his message was both immaterial and readily available to investors, having been picked up by a number of blogs and news media outlets. “We use blogging and social media, including Facebook, to communicate effectively with the public and our members,” Mr. Hastings wrote — on his Facebook page, naturally — after disclosing the investigation last year.

It seems the SEC is willing to allow “the tail to wag the dog” on this matter. From an ethical perspective, one obvious problem is reliance on social media alone will likely negatively impact market fairness and investor awareness. Potential also exists for the misuse of sensitive information and, I believe, hacking into the social media sites to change the reported information. Finally, I fail to see how the new rule protects investors’ interests and need for full and fair disclosure, the mandate for the SEC in its role as market regulator.

Blog posted by Steven Mintz, aka Ethics Sage, on April 15, 2013

Related articles

SEC Approves Social Media Use for Companies' Material Disclosure

KPMG Insider Trading Scandal Damaging to the Reputation of the Accounting Profession

What Possesses an Audit Partner to Trade on Insider Information?

KPMG is embroiled in an insider trading scandal that concerns me because a pattern of such improprieties may be developing. In 2010, Deloitte and Touche was investigated by the SEC for repeated insider trading by Thomas P. Flanagan, a former management advisory partner and a Vice Chairman at Deloitte. Flanagan traded in the securities of multiple Deloitte clients on the basis of inside information that he learned through his duties at the firm. The inside information concerned market moving events such as earnings results, revisions to earnings guidance, sales figures and cost cutting, and an acquisition. Flanagan’s illegal trading resulted in profits of more than $430,000. In the SEC action, Flanagan was sentenced to 21 months in prison after he pleaded guilty to securities fraud. Flanagan also tipped his son, Patrick, to certain of this material non-public information. Patrick then traded based on that information. His illegal trading resulted in profits of more than $57,000.

The KPMG case is a particularly egregious one because it involves insider trading by an auditor of client stock. Scott London, the partner in charge of audits of Herbalife Ltd. and Skechers USA Inc., traded on inside information for personal gain.  KPMG resigned as the auditor of both companies after learning that London provided non-public information about the companies to a third party, who then used the information in stock trades. The firm fired London.  

In resigning the two audit accounts, KPMG said it was withdrawing its blessing on the financial statements of Herbalife for the past three years and of Skechers for the past two. KPMG stressed, however, that it had no reason to believe there were any errors in the companies' books. Both companies said they are moving to find new auditors.

In a statement that should raise red flags for all CPA firms that audit public companies, KPMG stated it had concluded it was not independent because of alleged insider trading. Independence is the foundation of the accounting profession and the cornerstone of an audit conducted in accordance with generally accepted auditing standards. The public (i.e., shareholders and creditors) relies on auditors’ independence, objectivity, and integrity to ensure that the audit has been conducted in accordance with such standards and that the financial statements are free of material misstatements.

I’m having a hard time understanding the stupidity and moral blindness of London in this case. Surely he knew of his ethical obligations. All audit firms supposedly have been carefully assessing independence in the aftermath of financial frauds in the late 1990s and early 2000s (i.e., Enron and WorldCom). Firms generally have quality controls in place to prevent compromises to audit independence.

Trading on insider information for cash and gifts is bad enough, and when done by an audit partner it is unforgiveable. Even more baffling to me is that the quid pro quo for passing along stock tips about clients to a friend for London was to receive cash and gifts in return. According to London, he received a discount on a watch, and the friend bought him dinners from time to time and on a couple of occasions gave him $1,000 to $2,000 in cash. A cynic might say he sold himself cheap.

So, what happens next? Both Herbalife and Skechers will need to have their financial statements re-audited, not an inexpensive proposition. Even though the companies were not at fault, the public may misunderstand and think the companies were complicit in the matter.

For KPMG, the insider trading investigation is a setback. The accounting firm has worked hard to rehabilitate its reputation after coming under scrutiny last decade in a wave of corporate accounting scandals and the firm’s role in the marketing of fraudulent tax shelters. KPMG paid large nine-figure settlements to resolve lawsuits related to accounting scandals at the drugstore chain Rite-Aid and Oxford Health Plans. In 2005, the firm paid a $456 million penalty to the government related to tax fraud.

I have to wonder whether insider trading by partners at Deloitte and KPMG portends a larger scandal on the horizon. It seems every ten years or so the accounting profession finds itself in a “pickle” and hauled before Congress to explain its actions. It is about that time following financial frauds at Enron, WorldCom and a host of other companies. I don’t know how to get the message across to those in the profession that every time such incidents occur, and now insider trading, the public loses patience with the profession and doubts begin to surface about whether the profession truly acts to protect the public interest.

Blog Posted by Steven Mintz, aka Ethics Sage, on April 12, 2013

The Ethics of Profit Repatriation by U.S. Multinationals

U.S. Companies Using Short-Term Loans to Avoid Taxes on Repatriated Cash

I have previously blogged about the use of transfer pricing techniques by U.S. companies to shift profits away from the U.S., which has the highest corporate tax rate (about 40%), to countries with lower tax rates such as Ireland (12.5%). As long as profits made overseas are not repatriated back to the U.S., those overseas profits remain untaxed by the IRS. Critics claim that a much lower tax rate (say, 15-20%) would encourage U.S. companies to bring the profits home in the form of investments and spur economic development and job growth.

Other countries have come to realize their corporate tax rates are too high. For example, Germany has reduced its rate from a high of 45% in 2008 to 15% today. The UK has gradually lowered its rate from 52% in 1981 to a projected 20% in 2015.

Repatriation is more than an economic issue; it has ethical overtones. It also highlights a practice used by some U.S. companies to skirt the repatriation law by taking the “trapped” overseas cash and providing loans to their U.S. parent companies. Under U.S. tax rules, a foreign subsidiary can lend funds to its parent without jeopardizing its untaxed status. Here is how it works:

• The loans have to be short term and can remain outstanding throughout a fiscal quarter as long as they don't cross beyond its end. If they do cross a quarter, they can remain outstanding for a total of 30 days. And that can be done for 60 days a year by any one foreign unit.
• If the borrowing is carefully set up to comply with IRS rules and U.S. auditing standards, the funds can be used over and over without incurring taxes.
• Companies are not required to disclose these moves, which makes it difficult to assess how many use them.

According to the Wall Street Journal, Hewlett-Packard (H-P) entities lent the parent about $6 billion in the year that ended in October 2010. For the 2011 fiscal year and through July 2012, the average outstanding balance of the alternating loans was $1.6 billion.

The sums rivaled H-P's borrowings in the commercial-paper market—the traditional source of big firms' day-to-day funds. Those averaged $1.9 billion over the 2011-2012 period.

More details of H-P's transactions have emerged since a 2012 hearing conducted by the U.S. Senate. The company said it told the Senate panel it used the alternating loans for all but 85 days of the 2011 and 2012 fiscal years. In a 2008 internal presentation, H-P called the loans "the most important source of U.S. liquidity for repurchases and acquisitions."

H-P spokesman Michael Thacker says H-P has "complied fully with all applicable provisions of the U.S. Internal Revenue Code, and auditor Ernst & Young has consistently reviewed and approved the accuracy of H-P's financials." The IRS has never raised concerns about the loan programs, he adds.

American concerns have long argued they should be allowed to bring back some of the estimated $1.7 trillion in profits they hold at their foreign subsidiaries, saying the money could be put to use in the U.S. The firms claim to be deterred by the huge tax liabilities they would incur under current IRS tax rates.

The U.S. is the only major economy that taxes its companies' overseas earnings. Those taxes aren't actually incurred until the money is considered to have been transferred to the U.S. parent, giving companies an incentive to maximize their earnings at foreign subsidiaries and keep them there indefinitely.

People on both sides of the debate argue the system doesn't work, creating perverse incentives that distort companies' balance sheets and deprive the U.S. Treasury of tax revenue. The short-term loans to avoid repatriation and taxes is the main example of the practice.

During the last Presidential election, business interests called for a “tax holiday,” in which American corporations would be allowed to transfer their foreign profits to their American bank accounts at a tax rate under 6 percent for one year. Such a holiday would raise revenues and create jobs in the U.S., according to the WinAmerica Campaign, a coalition of companies including Apple, Google and Pfizer.  

But the last time such a holiday was tried, in 2004, it raised less than $19 billion and did not substantially increase jobs. Most of the repatriated profits went to corporate shareholders, through dividends or stock repurchases.

Instead of a one-off holiday, some corporations — Caterpillar and Kimberly Clark, for example — have called for a permanent fix: a territorial system for taxing foreign corporate profits, as most industrialized countries use. In a pure territorial system, the profits of multinational companies based in the U.S. would be taxed only by the country in which the profit is earned.

But none of our major trading partners takes a pure territorial approach, for two good reasons. First, almost all countries impose domestic taxes on “mobile” corporate income — for example, investment interest or royalties that can easily be shifted from one country to another. Second, many countries still collect taxes on foreign profits of domestic corporations if those profits are earned in tax havens that collect little or no taxes, like Bermuda and the Cayman Islands. These havens violate the premise of the territorial system, which is that corporate profits are taxed somewhere in the world at a reasonable rate.

The ethical issue I raise is: Does a U.S. corporation have an ethical obligation to repatriate profits to the U.S. to pay their “fair share” of taxes and help to stimulate the economy in an increasingly competitive global economic marketplace?  The answer is not a simple one because we could argue about the ethics of having the highest tax rate in the world. We could also argue and debate whether the government uses its tax revenue in an ethical or socially-desirable manner to employee the unemployed, give opportunity to those wanting to improve their economic lot, and help stimulate our economy.

For me, it is time to lower the corporate tax rate to be more competitive with other countries and challenge U.S. companies on their claim to repatriate profits with a lower rate. Without debating how low is low enough to achieve the desired goal, we need to try harder to improve the economic status and wealth of the middle and lower-classes and repatriation with taxation is one way the goal might be accomplished. At least it is worth a try. If corporations do not repatriate with lower taxes but still find ways around their obligation, then they will be exposed for all to see the hypocrisy of their position.

Blog Posted by Steven Mintz, aka Ethics Sage, on April 1, 2013

IRS "Dirty Dozen" Tax Scams

Tax Scams and Scammers Cheat All of Us

The IRS issued it “Dirty Dozen list of tax scams" Tuesday, highlighting fraudulent schemes commonly committed by and upon taxpayers. The annual warning, released to coincide with tax filing season, emphasizes the most egregious schemes involving filing false returns or return items, but it also advises the unsuspecting about practices that prey upon the unwary and uninformed.

As you read thought the 2013 list, think about all the scams and scammers and how they cheat all of us who pay the correct amount of our taxes due and, while we may not agree with the way the government uses our tax dollars, we do see paying taxes as a civic responsibility.

1. Identity theft: The IRS spotlighted its measures, including its new Identity Protection we portal, to prevent and combat the growing problem of tax fraud involving stolen identities, which it called one of its top priorities. During 2012, the IRS prevented issuance of $20 billion in fraudulent refunds including those related to identity theft, up from $14 billion in 2011, it said. The IRS also noted that its identity theft enforcement sweep in January led to nearly 300 indictments, complaints, and arrests, on top of thousands of enforcement actions against identity theft tax fraud in 2012.

2. Phishing: The IRS again this year warned against fake electronic communications designed to obtain recipients’ information, reminding that the IRS does not initiate contact with taxpayers by email, text messages, or social media to request personal or financial information.

3. Return preparer fraud: In addition to suggesting taxpayers make sure paid preparers sign returns and enter their preparer tax identification number (PTIN), the IRS this year included information about using Form 14157, Complaint: Tax Return Preparer, to report abusive tax preparers.

4. Hiding income offshore: This warning also updated the number of participants in the IRS’s Offshore Voluntary Disclosure Program to 38,000 and its collections to $3.4 billion from the 2009 program alone (March 23, 2009, through Oct. 15, 2009) and $1 billion so far in “up-front” payments from the 2011 program (Oct. 16, 2009, through Sept. 9, 2011). In 2012, the program was extended indefinitely.

5. “Free money” from the IRS and tax scams involving Social Security: With fliers and advertisements “appearing in community churches around the country,” promoters of schemes promising refunds for returns with little or no documentation have enticed “unsuspecting and well-intentioned” victims, some of whom have spread the word to friends and relatives, the IRS said. One scheme falsely advises taxpayers to claim the American opportunity tax credit even if they have no current qualifying educational expenses.

6. Impersonation of charitable organizations: Some fraudsters have doubly victimized people hit by a natural disaster by claiming to be working on behalf of the IRS to help them claim a tax casualty loss but instead steal their financial and personal information. This replaced “abuse of charitable organizations and deductions” from the 2012 list.

7. False/inflated income and expenses: Exaggerating wage or self-employment income is a common ploy by some unscrupulous preparers to inflate refundable credits, including the earned income tax credit, by more than any additional tax.

8. False Form 1099 refund claims: One scheme involves issuing a bogus information return, often Form 1099-OID, Original Issue Discount, to the IRS. A refund is then claimed on a corresponding tax return. The IRS says this is based on the theory that “the federal government maintains secret accounts for U.S. citizens and that taxpayers can gain access to the accounts by issuing 1099-OID forms to the IRS.”

9. Frivolous arguments: The IRS maintains a webpage describing some of the more common and legally fanciful of these theories.

10. Falsely claiming zero wages: A Form 4852, Substitute Form W-2, or “corrected” Form 1099-MISC, Miscellaneous Income, is fraudulently filed to reduce or eliminate income on a legitimate information return. Sometimes it is accompanied by a frivolous argument regarding the income.

11. Disguised corporate ownership: The IRS said it works with state authorities to identify entities by which taxpayers underreport income, claim bogus deductions, and engage in other misconduct.

12. Misuse of trusts: The IRS said it has seen an increase in improper use of private annuity trusts and foreign trusts to shift income and deduct personal expenses.

As frequent readers of my blog know, I like to use famous quotes to make a point.

James Madison, the "Father of the Constitution," "Father of the Bill of Rights," 4th President of the U.S. stated the purpose of income taxation:

"The power of taxing people and their property is essential to the very existence of government.''   

A poignant statement that expresses a philosophy held by some today (whether you agree with it or not) dates back to 400 B.C. and was expressed by Plato, the Greek philosopher:

“Where there is an income tax, the just man will pay more and the unjust less on the same amount of income.” 

I leave you with a quote from Ben Franklin: “…but in the world nothing can be said to be certain except death and taxes."

Blog posted by Steven Mintz, aka Ethics Sage, on March 29, 2013

Accounting for Nuts

Diamond Foods Fraud Illustrates the Danger of overly-optimistic Earnings Projections

Management does it all the time – set overly optimistic earnings and earnings per share projections to motivate financial analysts to give positive recommendations to current and potential investors with respect to stock holdings. It was the fuel that engineered the accounting frauds at Enron, WorldCom, et al. A recent example is Diamond Foods.

On November 14, 2012, Diamond Foods Inc. disclosed restated financial statements tied to an accounting scandal that reduced its earnings during the first three quarters of 2012 as it took significant charges related to improper accounting for payments to walnut growers. The restatements cut Diamond’s earnings by 57 percent for fiscal 2011 to $29.7 million and by 46 percent for fiscal 2010 to $23.2 million. By December 7, 2012, Diamond’s share price had declined 54 percent during 2012.

Diamond Foods, long-time maker of Emerald nuts, and subsequent purchaser of Pop Secret popcorn (2008) and Kettle potato chips (2010), became the focus of a SEC investigation after The Wall Street Journal raised questions about the timing and accounting of Diamond’s payments to walnut growers. The case focuses on the matching of costs and revenues. At the heart of the investigation was the question of whether Diamond senior management adjusted the accounting for the grower payments on purpose to increase profits for a given period.

The case arose in September 2011, when Douglas Barnhill, an accountant who is also a farmer of 75 acres of California walnut groves, got a mysterious check for nearly $46,000 from Diamond. Barnhill contacted Eric Heidman, the company’s director of field operations, on whether the check was a final payment for his 2010 crop or pre-payment for the 2011 harvest. Diamond growers are paid in installments, with the final payment for the prior fall’s crops coming late the following year. Though it was September 2011, Barnhill was still waiting for full payment for the walnuts he had sent Diamond in 2010. Heidman told Barnhill that the payment was for the 2010 crop, part of fiscal 2011, but that it would be “budgeted into the next year.” The problem is under accounting rules you cannot legitimately record in a future fiscal year an amount for a prior year’s crop. That amount should have been estimated during 2010 and recorded as an expense against revenue from sale of walnuts.

An investigation by the audit committee in February 2012, found payments of $20 million to walnut growers in August 2010 and $60 million in September 2011 that were not recorded in the correct periods. The $20 million payments to growers in 2010 caught the eye of Diamond’s auditors, Deloitte & Touche. However, it does not seem that the auditors lived up to their professional responsibilities in detecting and/or reporting the fraud.

The disclosure of financial restatements in November 2012 and audit committee investigation led to the resignation of former CEO Michael Mendes who agreed to pay a $2.74 million cash clawback and return 6,665 shares to the company. Mendes’ cash clawback was deducted from his retirement payout of $5.4 million. Former chief financial officer Steven Neil was fired on November 19, 2012 and did not receive any severance.

An interesting aspect of the case is the red flags including unusual timing of payments to growers, a leap in profit margins, and volatile inventories and cash flows. Moreover, the company seemed to push hard on every lever to meet increasingly ambitious earnings targets and allowed top executives to pull in big bonuses, according to interviews with former Diamond employees and board members, rivals, suppliers and consultants, in addition to reviews of public and nonpublic Diamond records.

Nick Feakins, a forensic accountant, noted the relentless climb in Diamond’s profit margins including an increase in net income as a percent of sales from 1.5 percent in fiscal 2006 to more than 5 percent in fiscal 2011. According to Feakins, “no competitors were improving like that; even with rising Asian demand…it just doesn’t make sense.” Reuters did a review of 11 companies listed as comparable organizations in Diamond’s regulatory filings and found that only one, B&G Foods, which made multiple acquisitions, added earnings during the period.

Another red flag was that while net income growth is generally reflected in operating cash flow increases, at Diamond the cash generation was sluggish in fiscal 2010 when earnings were strong. This raises questions about the quality of earnings. Also, in September 2010 Mendes had promised earnings per share growth of 15 percent to 20 percent per year for the next five years. In fiscal 2009, 2010, and 2011, $2.6 million of Mendes’ $4.1 million in annual bonus was paid because Diamond beat its EPS goal, according to regulatory filings.

The ethical issues in this case are fairly obvious: misleading financial results; improper accounting; and a corporate governance system that did not work. The earnings projections raise questions whether auditors should include these projections in their audit work. In accounting, they are referred to as “forward-looking” statements and cautionary language is assigned to the amounts. However, this is insufficient to protect the public in an environment of capitalism run amok.

Blog posted by Steven Mintz, aka Ethics Sage, on February 18, 2013

Groupon Reports Troubling Financial Results

Problems for the Company and Stock Price Declines Continue

Groupon just released its 3^rd quarter 2012 earnings report, marking its first full-year cycle of earnings reports since its initial public offering (IPO) in November 2011. While the net operating results show improvement year-to-year, the company still shows a net loss for the quarter. Moreover, while its revenue has been increasing in fiscal 2012, its operating profit has declined over sixty percent. This means its operating expenses are growing faster than its revenues, a sign of impending disaster. The company’s stock price on Nasdaq has gone from $26.11 per share on November 5, 2011, the end of the IPO day, to $4.14 a share on November 30, 2012, a decline of more than 80 percent in one year. The company did not meet financial analysts’ expectations for the 3^rd quarter of 2012.

Groupon blamed the disappointing results on its European operations. Some analysts took solace in the fact that Groupon reported it has 39.5 million active customers, an increase of 37 percent from the previous year. But, what good does it do to have a larger customer base if it also leads to larger-than-expected operating costs? This is the question Groupon needs to answer.

I want to go back awhile to the day of the IPO to show how Groupon’s problems first started. On November 5, 2011, Groupon took its company public with a buy-in price set at $20 per share.  Groupon shares rose from their IPO price of $20 by 40% in early trading on Nasdaq, and ended at the 4 p.m. market close at $26.11, up 31%. The closing price valued Groupon at $16.6 billion, making it more valuable than companies such as Adobe Systems and nearly the size of Yahoo.

At a size of up to $805 million, Groupon ranked as the third-largest Internet IPO sold in the U.S.in 2011, after a $1.4 billion issue by Russian search-engine operator Yandex NV in May and a $855 million issue by China social networking platform Renren, according to Dealogic. It was the ninth-largest ever on a list topped by the $1.9 billion sale by Google in 2004.

Less than five months later on March 30, 2012, Groupon announced that it had revised its financial results, an unexpected restatement that deepened losses and raised questions about its accounting practices. As part of the revision, Groupon disclosed a “material weakness” in its internal controls (accounting speak for we blew it, were caught, and now admit it), saying that it had failed to set aside enough money to cover customer refunds. The accounting issue increased the company’s losses in the fourth quarter to $64.9 million from $42.3 million. The news that day sent shares of Groupon tumbling 6% to $17.29. Shares of Groupon had fallen by 30 percent since it went public and the downward trend continues.

In its announcement of the restatement, Groupon explained that it had encountered problems related to certain assumptions and forecasts the company used to calculate its results. In particular, the company said it underestimated customer refunds for higher-priced offers such as laser eye surgery.

Groupon collects more revenue on such deals, but also carry a higher rate of refunds. The company honors customer refunds for the life of its coupons, so these payments can affect its financials at various times. Groupon deducts refunds within 60 days from revenue; after that, the company has to take an additional accounting charge related to the payments.

As Groupon prepared its financial statements for 2011, its independent auditor, Ernst & Young, determined that the company did not accurately account for the possibility of higher refunds. By the firm’s assessment, that constituted a “material weakness.” We did not maintain effective controls to provide reasonable assurance that accounts were complete and accurate,” Groupon said in its annual report.

In an interesting twist, in response to the conclusion that the company’s internal controls contained a material weakness, Groupon said it’s been working for several months with an accounting firm, not Ernst & Young, and will report on the effectiveness of those controls by the end of 2012. This could be because the company blames Ernst & Young for not finding the problem earlier. In fact, it was management’s own report on internal controls over financial reporting that first disclosed at the problem.  

In a related issue, on April 3, 2012, a shareholder lawsuit was brought against Groupon accusing the company of misleading investors about its financial prospects in its IPO and concealing weak internal controls. According to the complaint, the company overstated revenue, issued materially false and misleading financial results, and concealed how its business was not growing as fast and was not nearly as resistant to competition as it had suggested.

These claims bring up a gap in the sections of the Sarbanes-Oxley Act that deal with companies’ internal controls. There is no requirement to disclose a control weakness in a company’s IPO prospectus. Groupon would have no obligation to disclose the problem until it filed its first quarterly or annual report as a public company – which is what it did.

What should we make of the financial results at Groupon? I see a company that hasn’t reigned in its operating costs while it expands into new markets. This may be a disaster ready to happen if Groupon doesn’t get a handle on these costs and soon. One area to look at is executive compensation. Groupon wouldn’t be the first company to overpay its top executives while it struggles to develop a sustainable market. I can just see LivingSocial and Amazon chomping at the bit as it reads about the continuing problems at Groupon.

Blog posted by Steven Mintz, aka Ethics Sage, on December 3, 2012

SEC Receives 3,000 tips from Whistle-blower Program

Is the Dodd-Frank Whistle-blower Program Successful?

As someone who follows whistle-blowing in business and accounting carefully, because of the obvious implications for ethical behavior, I was drawn to the Securities and Exchange Commission’s Annual Report on the Dodd-Frank Whistleblower Program for Fiscal Year 2012.

The “Report” was released on November 15 and reveals a number of interesting data.  The SEC has received a lot of tips, complaints, and referrals:  A total of 3,001 in fiscal year 2012 with the lowest number (166) in November 2011 and the highest number (313) in May 2012.  Those tips, complaints, and referrals came from all 50 states, the District of Columbia, Puerto Rico and 49 countries, primarily from tipsters located in states with proximity to major markets.

Just over 10% of the tips were received from individuals outside of the U.S.  And, the 3,001 tips primarily were concentrated in three areas:  Corporate Disclosure and Financials (18.20%); Offering (IPO) Fraud (15.50%); and Manipulation (15.20%). 

What the Report does not tell us, except in the most general terms, is what the SEC is doing with the tips. I mean, isn’t that the more important piece of information? I can just imagine how many employees send in tips to get back at the company for some perceived bad treatment or “discriminatory” behavior.  For example, how many of the 3,001 tips actually identified fraud or wrongdoing?  How many were duplicative?  How many were referred to the Division of Enforcement?  How many resulted in the initiation of investigations by the Division of Enforcement?  How many related to investigations that already were ongoing? 

The Report does describe the first, and only, award under the program made in August 2012 to a whistleblower that reportedly helped the SEC stop an ongoing multi-million dollar fraud.  The whistleblower will receive nearly $50,000 for evidence of securities fraud. I have previously blogged about this incident.

According to the SEC, judgments and orders issued during fiscal year 2012 have exceeded the statutory threshold of $1 million in 143 cases, for which Notices of Covered Action have been posted so that individuals may apply for whistleblower awards.  The Report notes, however, that the posting of such notices does not indicate that a whistleblower tip, complaint, or referral led to the SEC initiating an investigation or filing an action or that an award to a whistleblower will be paid in connection with the case.  Thus, the Report does not reveal whether the SEC utilized a whistleblower’s assistance in any of the 143 cases; nor, does it disclose whether whistleblowers have brought compelling cases to the SEC that have resulted in judgments and orders below the statutory threshold.

One startling bit of information revealed in the Annual Report is that there are only 14 total employees working for the Office of the Whistleblower.  Although the Report suggests that these employees are receiving assistance from the Division of Enforcement’s Office of Market Intelligence, it is unclear how the Whistleblower Office or the SEC as a whole can effectively administer a program that generated 3,001 tips and, according to the Report, required the staff to return over 3,050 phone calls from members of the public in its first full year.  The Annual Report does not answer this question, nor reveal the average length of time between the filing of a tip and review of the information of purported wrongdoing.  Congress included an enhanced whistleblower program in Dodd-Frank not only to help the government root out fraud but also to encourage corporations to better police themselves and address illegal conduct head on.

The most controversial provision of Dodd-Frank is the whistle-blowing award that some believe is akin to a “bounty hunter” fee. I believe the potential is there for unsubstantiated claims as a result of the award. My fear is that a disgruntled employee will report alleged fraud and hope the SEC will uncover enough details in its investigation to justify receiving the award. On the other hand, if it helps to stem the tide of financial fraud, then the program will serve as a valuable deterrent to crime in business and financial operations. Somehow I doubt that will be the case given the long history of financial fraud in the U.S.

My favorite fraud, and on that set the tone for many years to come, occurred in 1963. Anthony “Tino” De Angelis was a commodities broker who had run into trouble with the law for supplying improperly prepared meat to the federal school-lunch program. In the early sixties, he finagled an initial ­contract with the U.S. government’s Food for Peace program, which sold excess foodstuffs to poor countries. And on the basis of his stunningly large, almost totally fake inventory—De Angelis claimed 1.8 ­billion pounds of soybean oil, but had only 110 ­million—the swindle raised at least $180 million from investors.

De Angelis filled some of his tanks with water, leaving only a thin film of oil on top in case of inspection—­perhaps the most literal Wall Street slickster of them all, at least in the day. The problem was the soybean prices tumbled when the Soviet market didn’t open up as De Angelis had expected, and when panicked investors came knocking to collect on their investments.

Sometimes I’m amazed the lengths to which some people will go to pull the wool over the eyes of others and commit financial fraud. Bernie Madoff comes to mind as the biggest fraudster so far in  the 21^st century.

Blog posted by Steven Mintz, aka Ethics Sage, on November 30, 2012

Accounting Fraud at Autonomy Perplexing to H-P and Me

Where were the auditors?

Lily Tomlin once famously said: No matter how cynical I get, I can’t keep up. I was reminded of how true this is on November 20 when I read about Hewlett-Packards’ disclosure that it had discovered an accounting fraud and has written down $8.8 billion of the value of Autonomy, the British software company it bought last year, after discovering that Autonomy misrepresented its finances. H-P said it has asked U.S. and U.K. regulators to launch criminal and civil investigations into the alleged fraud. The developments drove H-P’s already beaten-down stock because of disappointing earnings reports down another 12% to 10-year lows.

What I find amazing is no one seemed to know about the fraud – not H-P, not the external auditors, and certainly not the regulators. How is it that a major accounting fraud could occur and the auditors were kept in the dark? Didn’t audit firms learn their lesson after the frauds at Enron, WorldCom, Tyco and a multitude of other financial frauds? Apparently not. One again the refrain should be: Where were the auditors?

Now for the unbelievable details. H-P said its internal probe and forensic review had uncovered “accounting improprieties, misrepresentations and disclosure failures” in the financial statements of Autonomy, the U.K. and San Francisco-based enterprise software company H-P acquired in August 2011 for a final price of $11.1 billion.

HP’s earnings for the quarter ending on October 3, 2012, showed troubling results. Revenue is down 7 percent to $30 billion compared to the same quarter in 2011. But the real problem comes from so-called GAAP net income [Income based on Generally Accepted Accounting Principles], with a net loss of $6.9 billion, or $3.49 per share, compared to a slim net profit of $0.2 billion for the fourth quarter of 2011. Non-GAAP diluted earnings per share is at $1.16 compared to $1.17 year-over-year. Most of the bad news comes from a huge $8.8 billion write-down related to the Autonomy accounting fraud.

The Autonomy disclosures are the latest efforts by CEO Meg Whitman to clean up the mess she inherited from former CEO Leo Apotheker, who H-P reminded shareholders presided over the disastrous Autonomy deal.

In a statement, Apotheker said he is both "stunned and disappointed to learn" of the alleged accounting improprieties and the developments "are a shock to the many who believed in the company, myself included." 

Apotheker said the due diligence process was "meticulous and thorough" and "it's apparent that Autonomy's alleged accounting misrepresentations misled a number of people over time -- not just HP's leadership team, auditors and directors."

Once again, how can this happen and top management was unawares? Where was the controller and CFO while the fraud was occurring? I can’t believe lower level accountants cooked up the fraud without the knowledge of higher-ups in H-P.

The Autonomy investigation began after an unnamed “senior member” of Autonomy’s leadership alleged there had been a “series of questionable accounting and business practices” prior to the acquisition. H-P said the whistleblower gave “numerous details” that H-P previously had no “knowledge or visibility” of.

In response, H-P tapped PricewaterhouseCoopers to do a forensic review of Autonomy’s historical financial results and put John Schultz, the company’s general counsel, in charge of the investigation.

The probe determined that Autonomy was “substantially overvalued at the time of its acquisition” due to misstatements of financial performance, including revenue, core growth rate and gross margins.

A spokeswoman for Mike Lynch, the former CEO and co-founder of Autonomy, told Reuters that the H-P allegations are "false" and Autonomy's management was "shocked to see" the fraud charges. Lynch said H-P's due diligence was intensive and the larger company's senior management was "closely involved with running Autonomy for the past year," Reuters reported. 

Lynch further commented that:

• HP is using this as a ruse to distract investors from its bigger problems: "People certainly realize I'm not going to be used as Hewlett-Packard's scapegoat when it's got itself in a mess."

• HP's numbers don't add up. It's questioning about $100 million in revenues, yet blaming $5 billion of the write-off on fishy accounting.

• He wants HP to explain in detail how it came up with the $5 billion in write-offs from alleged fraud.

• He not only denies all wrongdoing but says he has backup because Autonomy was audited quarterly and every invoice over 100,000 euros ($129,000) was approved by auditors.

He says some of the accusations are misleading because Autonomy was following International Financial Reporting Standards, as British companies do, not the GAAP standard used by HP, which means it recognizes revenue differently in certain situations from U.S. practices. I doubt that claim because IFRS is not that different from U.S.-GAAP although the devil may be in the details.

H-P said it has alerted the Securities and Exchange Commission’s Enforcement Division in the U.S. and the U.K.’s Serious Fraud Office. Further, H-P said it is preparing to aggressively “seek redress against various parties” in civil courts to recoup what it can for shareholders.

On a conference call, Whitman said the board, which approved the Autonomy transaction, relied on audited information from Deloitte & Touche and additional auditing from KPMG, though she said she’s not blaming the accountants.

"Neither of them saw what we now see after someone came forward to point us in the right direction," Whitman said. 

Deloitte, which was the auditor for Autonomy in the U.K., said in a statement that it "notes the allegations" made by H-P and that the charges have been referred to regulators. We cannot comment further on this matter due to client confidentiality. We will cooperate with the relevant authorities with any investigations into these allegations.”

In my experience as an accounting professor and ethicist I have found all too many audit firms cut corners in the audit and even send out less-than-qualified auditors in order to keep audit costs at a minimum and match the sometimes “low-ball” bid to gain the client. Independence problems abound and it appears the audit firms were guilty of it in their examination of the financial results of Autonomy. When will the accounting profession learn the public expects them to find fraud?

Blog posted by Steven Mintz, aka Ethics Sage, on November 26, 2012

Moral Blindness

Why Good People Sometimes Do Bad Things

The noted moral psychologist James Rest developed a Four-Component Model of Moral Development that identifies four essential characteristics of moral behavior. If we examine the model, we can see why good people sometimes do bad things. I'm talking about people who would otherwise act ethically but for pressures either self-imposed (i.e., desire to be a "team player" even though you are asked to do something you know is wrong) or imposed by an outsider (i.e., a superior who threatens your job if you don't go along with something you know is wrong).

In order to make an ethical decision and act ethically, the first step is to identify that an ethical issue exists for you, or what Rest called ethical sensitivity. This is not so easy since many people who want to do the right thing -- try to do the right thing -- do not realize they are involved in an ethical situation. I tell my students a good perspective is that you are faced with an ethical issue whenever your actions affect others. These are the stakeholders potentially affected by what you do or do not do. It is a matter of ethics how you treat them (remember "The Golden Rule"). If you treat others with respect, caring and empathy, fairness, and with honesty and trustworthiness, then you are sensitive to the ethical issues. Since Accounting is my field a good analogy is to recognize that the financial statements must be accurate and reliable to protect the position of shareholders and creditors.

Once the ethical issues have been identified, the next step is to apply moral judgment to reason out what is the most ethical action to take. We should consider how our actions affect others using ethical reasoning methods such as harms and benefits (Utilitarianism) and not violate the rights (Rights Theory) of others. It would be wrong for an accountant or auditor to go along with materially misleading financial statements because it violates the rights of shareholders and creditors to receive accurate and reliable financial information. These stakeholders make decisions based on the information so it must be in accordance with generally accepted accounting principles and be transparent.

It is not enough to have the skills to reason out what is the most ethical action. Rest points out that ethical intention must follow ethical reasoning to turn decisions into action. In other words, do you want to be an ethical person? Do you want to do the right thing? Let's be honest, not everyone is concerned about whether they make an ethical choice/decision. Some people don't care -- John Edwards is a good example. Others believe they won't get caught so they ignore ethics. I believe Tiger Woods works well here.  Also, you can pick any one of a number of corporate executives involved in financial fraud at Enron, WorldCom, and so on.

Even the desire to do the right thing and act ethically is not enough because of the pressures previously mentioned. Young people get caught up in giving in to peer pressure and they go along with something they know is wrong. In accounting, a supervisor (i.e., Chief Financial Officer) might pressure an accountant (i.e., Controller) to go along with materially misstated financial statements. The accountant knows his or her job may be on the line. An expected promotion may be withdrawn or a demotion forthcoming unless that person agrees to manipulate the statements or at least be silent about it.

So how can an otherwise ethical person combat these pressures and follow through with ethical judgment and action? The key is integrity. Integrity is an ethical value that summons up the courage to take an ethical action despite pressures to do otherwise. It means we have the courage to act in accordance with our principles which should be to:

Treat Others the Way We Want to Be Treated.

Respect the Rights of Others.

Never take an Action that Does More Harm than Good.

I could go on but you get the point. Ethics is not easy. Being committed to your values takes moral strength. The key is not to take the first step down the proverbial ethical slippery slope. Once we agree to be silent; to go along with wrongdoing; and go along to get along; then we have begun the slide and it becomes very difficult, should we gain a conscience, to turn around to reclaim the high road.

I leave you with something said by W. Clement Stone, a businessman, philanthropist, and self-help book author: "Have the courage to say no. Have the courage to face the truth. Do the right thing because it is right. These are the magic keys to living your life with integrity."

Blog posted by Steven Mintz, aka Ethics Sage, on May 3, 2012

Financial Reporting Practices of Chinese Companies Investigated by SEC

Can We Trust Financial Reports of Chinese Companies?

It's déjà vu all over again as the famous philosopher Yogi Berra once said. The Securities and Exchange Commission in the U.S. has sued yet another China-based company and two of its executives, charging them with lying to investors about the value of the company's assets and how it used $120 million in proceeds from its initial public offering on the Nasdaq. In a complaint filed on April 23, the S.E.C. also charged that the chairman of the company, SinoTech Energy, secretly siphoned $40 million from the company's account at the Agricultural Bank of China last summer.

I have previously blogged about accounting and ethics problems at Chinese companies such as Longtop Financial. The legal action against SinoTech, an oil field services company de-listed by the Nasdaq in January, is the latest example of a continuing crackdown on accounting fraud and other financial crimes at Chinese companies listed in the United States. The S.E.C. also charged 11 investors in AutoChina International, including a senior executive and director, with market manipulation. The Commission also secured a court order freezing the assets of six Chinese citizens and an offshore holding company after accusing them of insider trading in the shares of Zhongin Inc, a pork processor based in China.

In its complaint against SinoTech, the S.E.C. charges that the company “grossly overstated the value of its primary operating assets,” including hydraulic drilling equipment. The company claimed in its listing document it would spend $120 million on such equipment, but the Commission found that it bought less equipment than it said it would, lied about the equipment it did buy and overstated the value of its purchases by nearly fivefold in its financial statements.

The S.E.C. alleged that the chief executive, Guoqiang Xin, 47, and the former chief financial officer, Boxun Zhang, 35, were behind the equipment purchasing fraud. In addition, the Commission accused the company’s chairman and controlling shareholder, Qingzeng Liu, 50, of stealing $40 million from a company bank account and lying about it to investors.

SinoTech Energy raised $167.8 million in an initial offering on the Nasdaq in November 2010. The company caught the attention of regulators after it was criticized last August in a negative report. The company’s auditor, Ernst & Young Hua Ming, resigned in September.

Many questions exist about Chinese accounting principles and the reliability of the financial statements produced by state-owned and private enterprises.  Questions continue to be raised about the value of those statements to investors looking to obtain a piece of the growing Chinese economic pie. For the most part, accounting rules are ignored; financial disclosures lacking; and transparency seems to be a word not in the disctionary of Chinese companies.

An important point is that China must play by SEC rules if it is to audit affiliates of US companies that are subject to inspection by the Public Company Accounting Oversight Board and if Chinese companies are to list their stock on U.S. exchanges. All foreign c companies that list stock in the US are subject to such inspections. China should not be treated any differently. If China wants to be a key player and become a force in the international financial markets, then it must learn to play by the rules of regulators outside their own country even if it seems to run counter to cultural norms whereby such regulations and inspections might be interpreted as demonstrating a lack of trust in Chinese management.

Blog posted by Steven Mintz, aka Ethics Sage, on April 27, 2012

 

Skilling’s “Honest Services” Argument Fails in the US Supreme Court

Enron Redux

You remember the Enron failure. It ushered in a sustained period of financial statement fraud where earnings restatements totaled in the billions. It has been estimated that financial statement fraud caused a decrease in market value of stock of approximately 500 to 1,000 times the amount of the fraud so that, for example, a $10 million fraud might cause a $5 billion loss in market value.

The perpetrator of the Enron fraud was Jeff Skilling, the former CEO of Enron. Skilling blessed the off-balance sheet, special-purpose entities (SPEs) set up by its financial wizard, Andy Fastow. This maneuver enabled Enron to keep billions of debt off its Balance Sheet and shift it to the entity. Many of these entities were shells set up to hide debt. In return for cash received by Enron from bank loans made to the SPEs, these entities agreed to accept unwanted assets on Enron’s books.  In some cases Enron even recorded a gain on the exchange thereby boosting income because the cash received from the SPE was greater than the book value of Enron’s asset transferred to it.

On October 23, 2006, Skilling was sentenced to 24 years and 4 months in prison and fined $45 million. That means he wouldn’t get out until 2030. By then he’d be 74 years old.

Skilling has filed a serious of appeals of his sentence. On April 3, 2008, Skilling’s defense attorney argued with government prosecutors that Skilling’s trial and the conviction itself was based on “honest services fraud” that he said did not apply to Skilling.

Honest services fraud refers to a 28-word sentence of 18 U.S.C. Section 1346 (the federal mail and wire fraud statute), added by the US Congress in 1988, which states: "For the purposes of this chapter, the term, scheme or artifice to defraud includes a scheme or artifice to deprive another of the intangible right of honest services."

The statute has been applied by federal prosecutors in cases of public corruption as well as in cases in which private individuals breached a fiduciary duty to another. In the former, the courts notably have been divided on the question of whether a state law violation is necessary for honest services fraud to have occurred. In the latter, the courts notably have taken differing approaches to determining whether a private individual has committed honest services fraud – a test based on reasonably foreseeable economic harm and a test based on materiality.

The statute, which has been a target of criticism, was given a narrow construction in the case of Skilling v. United States. In order to avoid finding the statute to be unconstitutionally vague, the Court interpreted the statute to only cover "fraudulent schemes to deprive another of honest services through bribes or kickbacks supplied by a third party who ha[s] not been deceived."

Skilling’s basic argument was that even though he committed illegal financial maneuvers, he did so in order to save the company and did not profit from it. This sounds to me like a “delusional” defense approach.

On January 6, 2009, the US Court of Appeals for the Fifth Circuit affirmed Skilling’s conviction, but vacated the sentence and remanded for resentencing. I believe there were procedural errors in the original trial that led to the decision.

On October 13, 2009, the Supreme Court agreed to hear the appeal. A key question was whether the federal “honest service” fraud statute required the government to prove that Skilling’s conduct was intended to achieve “private gain” rather than to advance the interest of his employer, and, if not, is the statute unconstitutionally vague.

Let’s not forget our Enron history. On May 25, 2006, Skilling was found guilty of conspiracy, insider trading, making false statements to auditors, and securities fraud. It seems to me Skilling’s motivation for the fraud was both to advance the company’s interests and increase his own individual wealth. It’s a common theme that ran throughout the many frauds at the time including Enron, WorldCom, Tyco, and Global Crossing.

On April 16, 2012, the Supreme Court left intact Jeffrey Skilling’s conviction for leading the Enron Corp. accounting fraud, refusing to grant a second hearing to the imprisoned former chief executive officer. Let’s hope it stops right here and right now. Skilling should accept responsibility for his actions and not look for loopholes in the law to escape serving his sentence. He was a main contributor to the fall of the 7^th largest company in the US back in 2001.

A long time ago Sophocles, one of three ancient Greek writers of tragedy said: “It is a painful thing to look at your own trouble and know that you yourself and no one else has made it.”

Blog posted by Steven Mintz, aka Ethics Sage, on April 20, 2012

 

Groupon Restatement of Earnings a Cause for Concern

The Signs are there: Market Stability at Risk

You may have heard that Groupon restated its “earnings” to reflect a larger fourth-quarter loss after failing to set aside enough money to account for customer refunds. Groupon’s stock has been falling since it revealed last Friday that it was revising its first quarter earnings to reflect a larger than expected loss. With its past accounting problems, some of which I have previously blogged about, Groupon is now a prime target for shareholder lawyers who believe the company may be liable for the losses investors have suffered since Friday. The stock is currently down about 12% and falling.

Groupon’s restatement increased the company’s fourth-quarter losses from $42.7 million to $64.9 million, more than a 50% increase in the reported loss. Moreover, the company had $500 million revenue last year so the amount of restatement is significant, or material as accountants would say.

According to Groupon’s accountant, Ernst & Young, the accounting error came from a “material weakness in its internal controls”. This means other transactions may be at risk since poor controls in one area tend to cause problems elsewhere. More important, the internal control problems raise questions about the management of the company and its corporate governance.

The red flags have been waving even before the company went public last year. In preparing its IPO, the company used a financial metric it called “Adjusted Consolidated Segment Operating Income”. The problem was that figure excluded marketing costs, which make up the bulk of the company’s expenses. The net result was to make Groupon’s financial results appear better than they actually were. After the SEC raised questions about the metric — which The Wall Street Journal called “financial voodoo” — Groupon downplayed the formulation in its IPO documents.

Groupon’s latest restatement is partially a consequence of the “Groupon Promise” feature of its business model. The company pledges to refund deals if customers aren’t satisfied. Because it has been selling those deals at higher prices lately — which leads to a higher rate of returns — it needs to set aside larger amounts to account for refunds — something it hasn’t been doing. It’s another example of Groupon failing to accurately account for a part of its business that reduces its financial performance. That shouldn’t inspire investor confidence.

In an updated filing with the SEC, Groupon said it is working to “remediate the material weakness,” in its internal financial reporting controls, and will hire “additional finance personnel.” But it warned: “If our remedial measures are insufficient to address the material weakness, or if additional material weaknesses or significant deficiencies in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results.”

In a statement, Groupon tried to put a positive spin on the whole matter. “We remain confident in the fundamentals of our business, as our performance continues to highlight the value that we provide to customers and merchants,” said Groupon Chief Financial Officer Jason Child.

This is right out of the Enron playbook when former CEO and chair of the board of directors, Ken Lay, stood in front of a meeting of employees, many of whom bought Enron stock for their 401-Ks, and touted the viability of the company’s unusual business model that had served Enron so well for so long albeit because of falsified financial statements.

Groupon's latest missteps, combined with its previous accounting issues, call into question whether the start-up was ready to be a public company that has to produce reliable financial reports, said Sandra Peters, head of financial reporting policy for the CFA Institute, which represents chartered financial analysts who work with individual investors.

"It really demonstrates, for an IPO, were they really ready to go?" she said. "Did they have the financial systems, did they have the processes and procedures in place?"

Similar concerns were echoed by people who track the company on Wall Street. "It's going to definitely unsettle a lot of investors," said Ken Sena, an analyst covering Groupon for Evercore Partners.

What is the lesson to be learned from Groupon’s experience? It is that we are vulnerable once again to a market meltdown because there are many companies like Groupon that want to cash in on Google’s phenomenal stock growth since its IPO. A better economic outlook and rising stock market are heating up the market just weeks before Facebook's highly anticipated IPO.

Congress, meanwhile, is lessening restrictions on IPOs in an attempt to make it easier for younger companies to raise money. Where have we heard this before? Was it when the Congress repealed the Glass-Steagall Act that had served the market so well by preventing commercial and investment banks from combining? Let’s not forget that the repeal in the law ushered in a period of over-selling in the market and, ultimately, the financial meltdown of 2008.

Let’s also not forget that famous line from Albert Einstein about insanity. Einstein defined insanity as “doing the same thing over and over again and expecting different results.”

Blog posted by Steven Mintz, aka Ethics Sage, on April 5, 2012

Regulators are Considering Forcing Companies to Change their Auditors

Is Mandatory Auditor Rotation a Good Thing?

Auditor rotation has been recommended by many years as a way to cut down on the cozy relationship that develops between an auditor and the client. Given that independence, objectivity, and integrity are cornerstone ethical values in accounting, it does make sense to change auditors every so often. In the past a five-year rotation has been suggested.

This is too short a period of time because it takes a few years to become familiar with the client’s systems. Audit firms invest much time and effort in the learning process. They should be able to benefit from their time and expertise with respect to servicing a client and earning audit fees. It seems to me ten years might work better. After all, it can be a good thing if new auditors take a fresh look at a client’s financial results every ten years.   

Let’s look at the recent past. Companies that ran into trouble in the financial crisis—Lehman Brothers, AIG and GM, for example—were with their auditors for decades without obvious benefit to investors. And regulators are increasingly worried that being overly-friendly with clients erodes auditors’ independence. In August James Doty, the head of the Public Company Accounting Oversight Board, (PCAOB) suggested forcing companies to rotate audit firms after a set (and as yet undefined) period.

According to Audit Analytics, a research firm in Sutton, Mass., 30% of the 1,000 leading U.S. companies have used the same firm to audit their books for at least a quarter-century. Fully 11% have used the same audit firm continuously for 50 years or more. Eight companies haven't changed auditors in at least a century; the last time any of them hired a new accounting firm, William Howard Taft was in the White House.

The PCAOB has asked whether long tenure might lead to complacency. Late last year, the board sought opinions on whether it should require listed companies to rotate their accounting firms every few years. The last of those 611 public comments came in to the PCAOB last month. An overwhelming 94% were opposed to term limits.

Auditors say it helps to know their clients’ business intimately. The Big Four accounting firms—PwC, Deloitte, Ernst & Young and KPMG— agree that forced rotation will impair audit quality. PricewaterhouseCoopers and Deloitte pointed to studies casting doubt on whether changing auditors improve financial reporting. Ernst & Young said that some clients have threatened to hire a different firm if E&Y didn't bless a dubious decision—which E&Y refused to do. KPMG said it evaluates the judgment and ethics of each partner at least once every three years.

As for the PCAOB, James Doty, chair of the Board, recently said: "We know from our own inspection reports that there is a problem." Without independence, it's unlikely you're going to get skepticism or a healthy look for disconfirming evidence."

This certainly was the case before Sarbanes-Oxley because not one of the accounting frauds in the late 1990s and early 2000s that led up to the Act were reported by the external auditors. In fact, peer review reports indicated the firms were doing just fine.

The problem, says Howard Schilit, an accounting expert at Financial Shenanigans Detection Group in Key Biscayne, Fla., is simple: "When you're an auditor who's trying to protect a long-term relationship, you have to suck up to the client, and the client knows it."

Since floating the idea last August about mandatory rotation, the PCAOB has received 620 letters, about 20 times the normal amount, with most warning of unintended consequences if rotation is passed.

Chief among the critics are auditors, who warned rotation would raise audit costs and hurt the quality of audits as new audit firms got up to speed. Board audit committees also complained about rotation, saying it would usurp their choice over auditors, a responsibility given them by the Sarbanes-Oxley Act. And financial officers at some large companies said they might have trouble finding a new auditor at all because of the shortage of firms with necessary industry expertise.

John Biggs, former chair and CEO of the mega-retirement fund TIAA-CREF, testified in favor of rotation during hearings on audit reforms that became part of the 2002 Sarbanes Oxley Act. Rotation was left out of Sarbanes-Oxley Act in lieu of other measures to shore up auditors’ independence, such as making board audit committees rather than company managers responsible for hiring audit firms.

In Biggs’ view, the recent financial crisis shows those reforms may not be doing the job. He wrote:

“The financial collapse of 2008-2009 certainly suggests that public confidence still needs to be restored in the financial management of our banking institutions. In particular, investors have to wonder about the independence and professional skepticism of the auditing profession.”

While many have criticized sloppy underwriting by banks and securities firms and rating agencies’ lack of skepticism, they were not alone, Biggs wrote.

“Shouldn’t there have been some skeptical auditors, of say, triple-A valuations of CDO’s (collateralized debt obligations) based on sub-prime mortgages?”

Many audit committees have become more diligent about assuring the independence of their auditors since Sarbanes-Oxley was passed, Biggs said.

If rotation is not found acceptable, regulators should at least require that companies disclose how long they have had the same auditor in annual proxy statements sent to investors, he said.

This makes a great deal of sense to me. Transparency is always a good thing. I would think the accounting profession would embrace this proposal if for no other reason than to rebuild trust in the public arena.

Blog posted by Steven Mintz, aka Ethics Sage, on March 8, 2012

Fraud at Chinese Companies Raise Questions of Transparency and Oversight

SEC Brings Charges against Ming Zhao, chairman of Puda Coal Inc., and its former CEO, Liping Zhu

I have previously blogged about ethical problems in Chinese Businesses and financial reporting practices that bring into question the trustworthiness of accounting and financial reporting practices by Chinese companies. In particular, a massive fraud at Longtop Financial, a popular Chinese software company raises doubts about whether and when China will be accepted as playing by the free market rules that depend on financial accuracy and transparency.

Additional problems have been identified by federal regulators after filing civil fraud charges on February 22 against the chairman and the former CEO of a Chinese company, accusing them of duping people to invest in a coal company that was an empty shell.

According to the Associated Press, The Securities and Exchange Commission announced the charges against Ming Zhao, chairman of Puda Coal Inc., and its former CEO, Liping Zhu. The SEC said they conspired to “loot” and sell the company’s main asset, a coal mining firm.

Puda Coal’s stock traded on the New York Stock Exchange from September 2009 to August 2011. The SEC said Zhao and Zhu raised money from U.S. investors in two public stock offerings during which time they stole and sold the company’s assets before they raised more than $100 million from public investors in the United States.

Because Zhao and Zhu failed to disclose their moves in regulatory filings, the investors were unaware that Puda Coal no longer owned the coal mining firm and was a shell company with no business operations, the SEC said in a lawsuit filed in federal court in Manhattan.

Their “massive fraud ... wiped out hundreds of millions of dollars in shareholder value,” George Canellos, director of the SEC’s New York regional office, said in a statement.

The agency also alleged that Zhao and Zhu obstructed its investigation of Puda Coal, forging a letter from a large Chinese state-owned financial firm attesting that the coal company’s investors weren’t harmed by the sale of the mining firm.

The SEC is seeking unspecified fines and restitution from Zhao and Zhu, and a ban against them serving as officers or directors of any public company.

There have been troubles at several other Chinese companies, most of which went public in the U.S. through a back-door procedure known as a reverse merger that doesn’t require an initial public offering. A private company can access the public markets by buying a shell company that is already listed.

The most interesting aspect of the Puda Coal case is how easy it turned out to be to discover the fraud. It was basically spelled out in documents that were publicly available in China months before American and Canadian investment banks, advised by major law firms, raised the money from investors. But it appears no one bothered to look — not the underwriters and not the auditors.

“They charge a lot for due diligence,” says the man who uncovered the fraud, Dan David, a 43-year-old money manager from Skippack, Pa. “But they don’t do it.”

What the documents showed was laid out last week by the S.E.C. Puda’s principal asset was a coal mining company, Shanxi Puda Coal. But in 2009, chairman Zhao transferred that interest from Puda to himself. The next year, he sold a controlling interest in it to Citic.

Puda, which had gone public in the US through a merger with a shell company in 2005, did not disclose those crucial facts when, in February 2010, it raised $12.8 million selling stock to American investors, in an offering underwritten by Brean Murray, Carret & Company of New York and Newbridge Securities of Fort Lauderdale, Fla. In December 2010, a $100 million share sale was underwritten by Macquarie Capital, a Canadian firm, and Brean Murray. Investors in that offering paid $12 a share for stock that now trades for about 25 cents.

The fraud blew up last spring. On Friday, April 8, Mr. David posted his analysis on his Web site, GeoInvesting, and a similar analysis was posted on the Web site of Alfred Little, a firm that had a reputation for spotting Chinese frauds. That analysis was unsigned, but it was written by Andrew Wong, the head of the IFRA Group, a Hong Kong research firm.

“In contrast to most of the other Chinese frauds, where the business was not real, this was a profitable company that the chairman just stole,” Wong said in an interview last week. He said he had looked into the company after David asked him to review his own research.

“Incredibly,” Wong wrote in his report, “Puda’s auditor, Moore Stephens, failed to catch this theft of an entire company that is clearly documented in government ownership filings that any lawyer can obtain directly from the source.” In July, Stephens quit as the company’s auditor and said its previous audits could not be relied on.

The company’s audit committee investigated the allegations, and eventually concluded they were accurate. But there was contradictory statement by Zhao who in April produced a letter, ostensibly from Citic, saying that it had not purchased the company, and sought to reassure investors by saying he was considering taking the company private at $12 a share. Eventually, Citic said the letter was false, and the company said Mr. Zhao had admitted forging it.

The readily available documents were filed with China’s State Administration for Industry and Commerce, known as S.A.I.C., showing transactions affecting the filing companies. Chinese companies must publish lists of all their subsidiaries, and it is necessary to check filings by all the subsidiaries.

The Chinese authorities appear thus far to have shown no interest in bringing charges against the men named by the S.E.C. and, according to David, the Chinese government was restricting access to some S.A.I.C. filings and asking why people they were interested in a certain company, a fact that has scared some investigators who fear reprisals.

A basic requirement of investment markets is for investors to have a reasonable confidence that they are not being defrauded, and — if it turns out they are — that the government will seek to punish those responsible. It is quite clear to me that businesses in China have failed to establish a corporate governance system that prevents fraud from occurring and fully discloses it when it does occur. For those of you who are considering investing in Chinese companies to take advantage of their economic boom I can only offer two words of advice – caveat emptor.

Blog posted by Steven Mintz, aka Ethics Sage, on February 27, 2012

KPMG Disclaims an Audit Opinion on Chinese Company

Ethical Culture of Chinese Businesses Raise Doubts about Financial Reports

Chinese-style western capitalism has been spreading to virtually every continent as China seeks to form joint ventures in Africa, South America, and elsewhere to ensure reliable access to needed natural resources to feed China’s hunger for economic growth and development. In recent years it has spread its “currency reserve wings” into the US through Chinese state-owned and private enterprises. The question for the investing public is whether Chinese financial statements can be relied on and, correspondingly, whether Chinese businesses can be trusted as they flex their economic muscle. A good example of the perils of outright trust is Sino-Forest Corp., a Chinese company that was charged with allegations of accounting abuses and fraud, burning investors including John Paulson, the billionaire whose hedge fund said in June it lost $468 million on Sino-Forest.

I have previously addressed the growing questions about Chinese accounting principles and the reliability of the financial statements produced by state-owned and private enterprises. I called it "The Dark Side of Chinese Capitalism". I've also looked at regulation of Chinese companies doing business in the US. In this blog I look at a recent event where the Big-4 international accounting firm, KPMG, withdrew from the audit of a Chinese company because it couldn't trust the information provided for those reports.

Just last week it was announced that after issuing a “disclaimer of opinion” with respect to China Forestry Holdings’ financial statements for the year ended December 31, 2010, KPMG has opted not to stand for reappointment as the company’s auditor. KPMG resigned as auditors of the Company as of January 5, China Forestry disclosed to the Hong Kong Stock Exchange.

First, let me dispense with a disclaimer of opinion. According to generally accepted auditing standards, an auditor should not issue such an opinion unless the firm has been unable to gather a sufficient amount of credible evidence to support the numbers in the financial statements prepared by company management. KPMG’s disclaimer “was due to the irregularities we identified during our audit and limitation in the scope of our work,” KPMG told the company in a letter.

Scope restrictions are a valid reason for a disclaimer. I’m more concerned about the former – irregularities found during an audit. My concern is not so much from an audit opinion perspective but whether the ethical culture of Chinese companies is such that American investors should follow the old adage when contemplating investment in Chinese companies – “buyer beware”.

Returning to China Forestry, the company describes itself as “one of the three largest, privately-held, naturally regenerated and plantation forest operators in China”. On its website, it claims to own and operate more than 171,000 hectares of forest land in Yunan and Sichuan provinces. It reported a loss of RMB2.7 billion (US$429 million) in 2010, in the report that KPMG issued a disclaimer of opinion.

The company admitted that for the 2011 financial year, KPMG asked that “a number of other matters will need to be resolved”. These are verification of the ownership and valuation of plantation assets, valuation of lease prepayments, valuation and ownership of inventories of logs and related sales and purchase transactions, and estimation of payables for plantation assets and taxation matters. In other words, the accuracy and reliability of all company financial statements are in doubt. China Forestry had apparently not come through on these demands, resulting in KPMG’s decision to resign.

When I look at the way Chinese companies are run I am not surprised by the increasing level of disclosure of financial wrongdoing. I find that Chinese companies have not built a strong ethical base in their state-owned and private companies. Chinese companies are not used to being questioned about what they do and why they do it because they existed so long under the Chinese communist system where the government ran the businesses. Moreover, secrecy is an important value in Chinese society so their perspective is to disclose as little as possible about a company’s financial status. Contrast that with the full disclosure notion for US companies and you can see why there is what I call a “believability GAP” in Chinese financial reports.

In the US and all western-style capitalist nations, internal controls are the bedrock of accurate and reliable financial reports. In China, the notion of internal controls has yet to take hold as questions of management about their controls can meet with stares of mistrust about the motives of an auditor who questions the believability of the financial statements.

The next great financial scandal may be waiting in the wings with respect to financial statements by Chinese businesses. In a sense the expansion of capitalism and potential for greed is one step ahead of developing and enforcing rules to prevent such occurrences and creating the kind of ethical culture that helps to prevent fraudulent financial reporting.

Blog posted by Steve Mintz, aka Ethics Sage, on January 9, 2012

Financial Statement Fraud at Olympus

Japanese Cultural Values May Have Enabled the Cover-up of Fraud

Most financial statement frauds extend for about 3-5 years before someone blows the whistle, the company makes a mistake, or it all catches up with them as the house of cards that built the fraud collapses. Not at Olympus Corporation, the Japanese maker of cameras and medical imaging equipment, where the fraud lasted more than two decades.

The Olympus fraud has a real life whistle-blower – Michael C. Woodford – the newly appointed president and CEO at the time of the fraud. It is quite unusual for the top manager to blow the whistle on his company’s fraud; kudos to Woodford for doing the right thing.

It turns out the motivating factor for the fraud was an effort to make the company’s books accurate — at least in terms of its balance sheet — that led to the suspicious transactions noticed by Woodford. He thought they showed theft from the company by its chairman, and he confronted him. Instead, the chairman had only tried to clean up an accounting mess without damaging the reputation of Olympus. The chairman felt there was no need to tell Woodford about what had happened because the fraud was finally behind the company when Woodford took the job.

New York Times reporter Floyd Norris points out that a report by an investigating committee shows that two changes in accounting rules, one caused by the Enron scandal, eventually led to the collapse of the scheme. It shows that KPMG AZSA, the Japanese affiliate of the international accounting group, failed to notice what was going on for years but finally did complain about the somewhat clumsy transactions intended to put the losses on Olympus’s books. Ernst & Young Sjin Nihon, a Japanese affiliate of that network, was brought in and did sign off.

The scandal also highlights the controversy over mark-to-market accounting. The Financial Accounting Standards Board (FASB), the U.S. accounting standard-setter, started to require it for some financial instruments in 1997. However, the fraud had begun seven years earlier so covering up the losses was easy. One reason is took so long to uncover the fraud was  at the time accounting rules in Japan, as well as in other countries, allowed investments to be carried at cost. Theoretically, there should eventually have been a write-down to a lower market value, but there never was.

At Olympus, it appears the company held at hope that with additional risky investments, the losses could somehow be made up. They were not. Over time, the company tried securities speculation and private equity investing in promising start-up companies. It didn’t work and eventually the losses grew to more than $1 billion.

Olympus seems to have been content to sit on the losses until 1997, when accounting rules required some investments had to be marked to market. To hide the fraud, the company developed a plan to “sell” the losing investments, at original cost, to shell companies (off-balance-sheet-entities) set up by Olympus for that purpose. The sales were financed with loans from banks, which received cash from Olympus to secure the loans. Under lenient accounting rules at the time, those shell companies did not have to be consolidated with Olympus, so the losses could remain hidden. These rules were tightened after the Enron fiasco.

The plan was to phase out the losses, either by more investments or through overpriced acquisitions, with the extra cost of the acquisitions going to the off-balance-sheet-entities to make them whole. That was done through a variety of means, one of which was retaining the shell companies as high-priced investment advisers. The “cost” would appear on the company’s balance sheet as good will, and eventually written off. When that was done, the balance sheet would show an accurate value for Olympus.

From 1999 to 2003, Olympus managed to get out of some losses, or at least to convert them to good will. No one outside the company was the wiser. KPMG, the auditor, did not notice, the committee report says, in part because some of the information it received was false.

However, in 2003 the FASB changed the rules for off-balance-sheet entities controlled by sponsoring entities (i.e., Olympus) so that these entities would have to be consolidated on the sponsor’s books and losses could no longer be hidden. One of Olympus’ ways to manufacture phony profits was to “sell” assets to the off-balance-sheet entities it controlled, and to book profits on those sales. That technique was negated by the new rules.

In Japan, the rules changed in 2007 and the fraud started to unravel. The off-balance-sheet-entities would have to be consolidated. Olympus had until March 31, 2008, the end of its fiscal year, to clean up its books. Efforts to continue to hide the fraud fell apart when in April of that year Woodford became president and chief executive in September. He was told to not worry about such history, but he did. With the assistance of PricewaterhouseCoopers, he unraveled the transactions but not their purpose, and concluded that company money was being stolen. He confronted the chairman and was fired. He forced an investigation, which resulted in the December 2011 report.

The report says the top officers of Olympus knew what was going on throughout and that new presidents always accepted the decisions made by their predecessors. It does not say why Woodford evidently was not told, but some have speculated that it was some combination of not trusting a foreigner who had not worked in Japan and a belief that, with the balance sheet now reflecting reality, there was no need to involve him.

On December 20, 2011 -- nearly two months after Woodford blew the whistle -- Japanese authorities raided the company’s headquarters in Tokyo, emerging several hours later with boxes of documents. The company’s stock market value had already dropped by 50 percent. Foreign investors had started to question the culture of old-style Japanese companies that attempt to thwart disclosures of negative information.

The eventual Olympus salvage plan could be a Japan-wide effort. Last week, the Nikkei business daily reported that Olympus might issue about 100 billion yen (about $1.3 billion) in new preferred shares, and that Japanese technology companies like Fujifilm or Sony might be possible buyers. Those two companies, though, denied that any such investment was in the works.

Top Olympus executives acknowledged in November 2011 that the company had conducted a decades-long effort to cover up $1.7 billion in investment losses in a global scheme that sparked public investigations on three continents. Last month, Olympus acknowledged some of the losses in five years’ worth of revised statements. Three executives implicated in the scheme have left the company. But the rest of the Olympus board has been scrambling to retain control. Backing them are the country’s biggest banks, which have significant influence over top Japanese corporations, serving as major lenders and as major shareholders.

The ethics lesson to be learned from the Olympus affair is that a lack of underlying ethical values trumps full disclosure even in the post-Enron era of transparency. In fact, underlying cultural values such as secrecy may continue to rule the day in countries like Japan that seem to place not “losing face” ahead of ethical values such as full disclosure and the rights of investors and creditors to be fully informed about both good and bad financial dealings.

Blog posted by Steven Mintz, aka Ethics Sage, on January 6, 2012  

Is Corzine a Fraudster or just Incompetent?

Corzine Feigns Ignorance in Questioning about MF Global

Is Jon S. Corzine, the former U.S. Senator, New Jersey governor, and Goldman Sachs CEO, a fraudster who is trying to absolve himself of any responsibility for the meltdown at MF Global by feigning ignorance, OR is he the most incompetent CEO ever to come out of the C-Suite? You make the call.

MF Global filed for bankruptcy protection on October 31 after a disastrous bet on European government debt. In just a week, stock investors lost about $585 million. More than $600 million in clients' money is still missing. Regulators say MF Global moved the money out of client accounts within days as the firm's cash dried up.

MF Global didn't list the European debt on its balance sheet for all to see. Instead, those holdings were shifted to the company's "off-balance sheet," deep in its financial statements. Some separate filings with regulators excluded the European debt entirely.

Under a 2002 anti-corporate fraud law (Sarbanes-Oxley Act) — which Corzine co-wrote as a U.S. senator — CEOs of public companies must personally certify the accuracy of their company's financial statements. If client money was used by the firm for its own purposes, Corzine could be held responsible, according to Thomas Ajamie, an attorney who specializes in financial fraud cases. "That would be the house gambling with customers' money," Ajamie said.

The direct costs of the failure include $1.2 billion in supposedly segregated retail investor accounts that have not been identified and 2,900 people lost their jobs. The real costs go way beyond and include a further rupturing of the trust in the securities industry on the part of the American public and concerns about whether our regulatory systems are capable of monitoring banks and securities firms to identify problem firms while the fraud is occurring and take action against such firms after the fact.

Corzine appeared before Congress last Thursday having been subpoenaed to testify about his role as the former CEO of MF Global. Here are some of Corzine’s explanations and responses to questions from the Congressional panel. It’s worth noting that Lawmakers had previously heard from farmers, ranchers and small-business owners who are missing money deposited with the firm. Agricultural businesses use brokerage firms to help reduce their risks in an industry vulnerable to swings in oil, corn and other commodity prices.

• In his prepared testimony submitted before the hearing, Corzine said he could not explain what happened to “many hundreds of millions of dollars” that the firm was holding for customers. "I simply do not know where the money is, or why the accounts have not been reconciled to date," he told the House Agriculture Committee, adding that he was "stunned" when he heard of the missing funds.
• Under pointed questioning by members of the House Committee, Corzine said he “would not rule out the possibility that someone at the firm misinterpreted him as suggesting that the struggling firm tap into investors’ funds.”
• Asked why there was a shortfall in customer funds, Corzine said that “many transactions… occurred in those last chaotic days.” He said he was not aware of all of those transactions and that “as a consequence it would be very hard for me to speculate why or where that shortfall took place.”
• Asked if he authorized a transfer of customer funds, Corzine responded, “I never intended to break any rules, whether it dealt with the segregation rules or any of the other rules that are applicable.”
• When asked if he was aware of any transfers, authorized or unauthorized, out of customer accounts, Corzine said, “I’m not in a position, given the number of transactions, to know anything specifically about the movement of any specific funds.”

Janet Tavakoli, an expert on the transactions MF Global specialized in, said Corzine's remarks seemed to divert attention from the firm's fundamental flaw under his leadership: It lacked the cash to cover its bets after investors started to fear that a major European nation would default.

Rep. David Scott, D-Ga., said it was the "height of disbelief" to think that Corzine knew nothing about the $1.2 billion. "We've got to get better answers from you because you [were] the CEO," he said. Rep. Tim Johnson, R-Ill., said that "people who live in the real world" have "suffered dramatically" from MF Global's downfall, and he asked Corzine whether he'd be willing to pay back those people with his own personal fortune. Corzine dodged the question, saying he was confident the money would be found. Seriously?

In his testimony to the House Agriculture Committee, Corzine sought to deflect blame for the company's collapse, arguing that he inherited a firm already doomed by his predecessors' bad financial decisions. Let me get this straight. Here is a former Senator, Governor, and CEO of Goldman Sachs taking a position as CEO of a failing company. Why would he do that? It doesn’t pass the smell test unless he saw it as a vehicle to stoke the burning fire that is his ego. Perhaps Corzine saw it as a way to personally enrich himself and he didn’t consider the possible consequences of his actions. That seems to be a recurring theme in the business frauds and financial meltdown that has plagued our country since the late 1990s.

Blog posted by Steven Mintz, aka Ethics Sage, on December 12, 2011

What should be the Next Step for the OWS Movement?

Citizen Watchdog Groups Have an Important Role to Play in the OWS Movement

It’s been one month since the Occupy Wall Street (OWS) movement set off a chain of events that have literally spread throughout the world. I believe the motivation for the movement comes from two sources: (1) the efforts of those involved in the “Arab Spring” to bring about meaningful and lasting change in the way their government operates and how they treat citizenry and (2) the ongoing economic crisis in the U.S. that has affected many in the ‘99%’. Just consider the effects of the financial crisis that ushered in a recession in 2008 and motivated the ‘99%’ to protest nationwide.

• Millions have lost their jobs or been forced to work beneath their skill level, accept less hours on the job, no pay raises, and increases in their share of health plan costs
• Millions have been unable to prevent their houses from going into foreclosure because of the downward spiral of home prices, underwater mortgages, and stagnant or a decline in in their personal wealth over a number of years
• Millions have seen their retirement accounts (i.e. IRAs, 401-Ks) go down in value or increase only marginally due to declines in stock prices over a number of years

I haved previously blogged about the growing gap in income in America. Studies show that the 400 richest families in America, who saw their wealth increase by some $400 billion during the Bush years, have now accumulated $1.27 trillion in wealth. At the same time, working families have watched as median family incomes dropped nearly $2,200, the third year in a row we have witnessed such a decline. In a recent report issued by the U.S. Census Bureau on poverty in America, 46.2 million Americans are now living in poverty.  The number of those living in poverty in America has grown by 2.6 million in just the last 12 months, and that is thelargest increase that we have ever seen since the U.S. government began calculating poverty figures back in 1959. Back in the year 2000, 11.3% of all Americans were living in poverty.  Today, 15.1%  of all Americans are living in poverty.  The last time the poverty level was this high was back in 1993.

Participants in the OWS movement point to the gap between rich and poor, use of public funds to bail out failing companies (i.e., the GM, Chrysler, and AIG), and greed on Wall Street and in corporate America as evidenced by a survey by salary.com that shows the average salary and benefits paid to the CEOs of the Standard & Poor’s top 500 companies in 2010 was $11.4 million. We are rapidly becoming a country of haves and have-nots and that is a recipe for civil disobedience, or worse. Add to the mix the public distrust of government and politicians who place partisan interests ahead of acting for the public good, and you can understand why our individual angst has now spread throughout the country.

Critics of the OWS movement believe it has been hijacked by groups that have self-serving interests such as the Services Employees International Union (SEIU), labor unions, and those just looking for a warm place to sleep. No doubt, there is some truth in these charges and other (fringe) groups and individuals have given the movement a bad name. But this is to be expected in a Vietnam-type environment where disenchantment among the populace has motivated a movement for change in the way “the powers that be” drive the political and economic agenda in America.

The OWS movement needs to identify where they want to go with their legitimate complaints. The Tea Party organized into a powerful representative group with a common point of view – no new taxes, reductions in entitlement payments, and cleaning up America’s economic mess that, as of November 18, created an outstanding public debt of more than $15 trillion and climbing --  which is over $48,000 for each citizen of the U.S. based on a population of about 312 million.  

I recommend that government watchdog groups take the lead in identifying a unifying message for the OWS movement. Most of these groups have missions that are complimentary to that of OWS. Here are some groups I think could lead the way:

Citizens for Responsibility and Ethics in Washington: an organization dedicated to promoting ethics and accountability in government and public life by targeting government officials who sacrifice the common good to special interests.

Common Cause: an advocacy organization that serves as a vehicle for citizens to make their voices heard in the political process and to hold their elected leaders accountable to the public interest. 

Corporate Accountability International: a group that challenges corporate abuse and demands direct corporate accountability to public interests.

The Project On Government Oversight: a watchdog group that champions good government reforms and  investigates corruption, misconduct, and conflicts of interest to achieve a more effective, accountable, open, and ethical federal government.

These are four groups that can best lead the charge to promote ethics in government, accountability from our elected officials, public interest decision-making, and corporate responsibility. Many other groups are equally worthy to lead the way, but the effort must be limited and focused on common goals to have a meaningful impact on the OWS movement, create true and lasting change, and to advance the endeavor to the next level of true reform in government and corporate America.

Blog posted by Steven Mintz, aka Ethics Sage, on November 19, 2011

Madoff, Mets, and Clawbacks

Trustee Picard on the Losing End of Clawback Lawsuits

Unless you’ve been living on a remote island since December, 2008 where communication with the outside world is difficult, and if so please pass along the details, Bernie Madoff was arrested on December 11, 2008 in the largest Ponzi scheme ever devised. In March 2009, Madoff pleaded guilty to 11 federal felonies and admitted to turning his wealth management  business into a massive Ponzi scheme that defrauded thousands of investors of about $65 billion. The irony is, if Madoff  hadn’t faced $7 billion in redemptions, the Ponzi scheme might not have been discovered. On June 29, 2009, he was sentenced to 150 years in prison, the maximum allowed.

Perhaps you saw Madoff’s wife and son on 60 Minutes a week ago. Talk about a woman in denial. She looked like she had just taken a dose of Propofol. It’s hard to feel sorry for members of the family who deny any knowledge of the fraud. “Burying your head in the sand" is not a defense to standing by as thousands of investors lose billions of dollars, many their life savings.

Irving Picard was appointed the trustee to unravel Madoff’s finances. The trustee has filed about 1,000 lawsuits worth some $100 billion against individuals and companies accused of profiting from Madoff's scheme including multibillion-dollar lawsuits against  mega financial firms JP Morgan, UBS nad HSBC. That's five times the $20 billion that Madoff is believed to have cheated from his clients while masquerading as an investment firm. Ironically among those sued was Madoff’s son Mark, who hung himself in his Manhattan apartment on the same day, the two-year anniversary of his father’s arrest. "Mark Madoff  had made it clear that he felt his family ... would be better off without 'this' hanging over them all, forever," a source told the NY Daily News.

The basis for the “clawback” lawsuit is that some investors profited handsomely from Madoff’s scheme gaining large returns while others lost everything. The suits aim to force those who profited by the “ill-gotten gains” to return these amounts for distribution to the losers.

For those of you sports fans out there, Picard also sued the owners of the New York Mets baseball team for the return of profits earned from their Madoff investments. Mets owners Fred Wilpon and Saul Katz and associated individuals and firms, received $300 million from the scheme according to the lawsuit. Wilpon and Katz have "categorically rejected" the charges.

Helen Chaitman of Becker & Poliakoff represents more than 300 investors who had accounts with Bernard Madoff. For more than two years she’s hammered away at one particular argument in federal bankruptcy court, in Congress, even on YouTube: Madoff bankruptcy trustee Irving Picard of Baker & Hostetler shouldn’t be allowed to demand the return of profits that Madoff investors pulled out of their accounts as long ago as 2002, six years before the Ponzi scheme imploded in December 2008. Two weeks ago, Chaitman finally found vindication, even though it wasn’t in any of her cases. Manhattan federal judge Jed Rakoff, ruling in Picard’s fraud case against the owners of the New York Mets, concluded that a section of the federal bankruptcy code precludes Picard from attempting to claw back money Madoff investors pulled out of the Ponzi scheme before 2006.

The decision is a boon to the Mets owners. The judge left standing only one of Picard’s fraud counts against the Mets, limiting the Madoff trustee’s potential recovery to no more than $386 million, rather than the nearly $1 billion in principal and profits Picard wanted. Moreover, for Picard to get his hands on any of the Mets owners’ principal, he will have to prove they were “willfully blind,” a prospect Judge Rakoff doesn’t seem to consider very likely. “This is something I’ve been saying from the beginning,” Chaitman said. “Anyone who didn’t withdraw their money in the last two years…is out completely.”

On November 2, a federal judge threw out most of a $19.9 billion lawsuit against JPMorgan Chase & Co and a $2 billion case against UBS AG. According to the ruling, Picard lost the right to demand $19 billion in damages from JPMorgan, for victims of Madoff's fraud. The decision by U.S. District Court Judge Colleen McMahon in Manhattan is one of the largest setbacks for the trustee, Irving Picard, who has spent nearly three years liquidating Bernard L Madoff Investment Securities LLC. On November 10, Picard asked for an expedited appeal of her ruling to finally determine his claims were viable. “Permitting an immediate appeal would provide much-needed finality for the trustee and the BLMIS estate as to the viability of these claims,” he said, asking her to enter a final judgment in the case, which will make it easier for him to appeal her ruling. BLMIS refers to Madoff’s firm.

Perhaps in the most unfair ruling on October 27, Madoff’s family would keep about $82 million of “other investors’ money” under a ruling that limited a bankruptcy trustee to claiming from the owners of the Mets only two years of withdrawals from the Ponzi scheme, according to a court filing.

Madoff’s family took out $141 million in the six years before Madoff’s firm went bankrupt in 2008, of which less than $59 million was taken in the two years before the bankruptcy, trustee Picard said in a filing. Many other investors are trying to hang onto “stolen” money that belongs to customers who took losses in the fraud, he said.

In a previous blog I pointed out that while it may seem clear that clawback suits are the right thing to do, there are ethical issues that should be considered. If the investors did not know the returns were based on fraudulent activities, should they be penalized? What if the investors used their returns to invest in the stock market and lost everything in the meltdown, should this be taken into consideration in deciding whether to file clawback suits against them and how much should be redistributed? What is the key ethical principle that should guide trustee Picard’s actions? It would seem to be fairness. That is, the losses should be spread proportionately to investors who lost all their money and those who received some returns. Fairness provides that equals should be treated equally; unequals, unequally. Of course, the devil is in the details.

Blog posted by Steven Mintz, aka Ethics Sage, on November 16, 2011

The Role of Business Schools and MBAs in the Occupy Wall Street Movement

Reform of Capitalism Should be the Underlying Message of OWS

We’ve heard it all before. Corporations have no soul. Critics complain that those with a Master of Business Administration (MBA) degree act out of self-interest and not those of employees who work for them, the community affected by its actions, and society as a whole. The bottom line is that corporate social responsibility has been relegated to a secondary role far behind maximize corporate profits and shareholder wealth as the guiding principles of corporate behavior. The problem is these goals are achieved at the same time the wealthy become wealthier, the middle class, poorer, and more and more low income Americans fall into poverty. Does it sound right to you that top corporate officials earn as much as $16,000 per hour, while workers earn well below $16 per hour. Is it right that the average corporate executive earns 350 times the average worker? When is enough, enough?

So I ask in this blog: What role should business schools and MBA students play in the OWS movement? We can draw parallel to the anti-Vietnam War experience when peace movements consisted largely of college and graduate students, and mothers, as well as anti-establishment "hippies".  The first major student demonstration against the Vietnam War took place on May 2, 1964 when hundreds of students marched through Times Square in New York City, while another 700 marched in San Francisco. Smaller numbers also protested in New York; Seattle; and Madison, Wisconsin. Sound familiar?

On October 21 the invasion of The Wharton School’s Huntsman Hall at the prestigious University of Pennsylvania by Occupy Wall Street protestors opened the door to MBA bashers who chided the students for trying to shout down the protesters who were airing their grievances against corporate America and Wall Street investment firms. Wharton students taunted protesters with chants of "Get A Job!" and a banner which read "Get Into Our Bracket" a take-off from the slogan of the protesters that they are in the 99 percent majority.

A posting on "Think Progress" about the 99% movement  includes the following evaluation of what happened at Wharton: “While the students who jeered the protesters certainly do not necessarily represent all Wharton students, it’s important to understand the context of the elite status they likely either come from or graduate into,” the writer of the article noted. “Wharton graduates much of the nation’s corporate elite, with the median starting salary for an MBA graduate being $145,000 — six times the poverty level for a family of four. The school’s Board of Overseers is staffed with multiple Goldman Sachs executives and high-ranking employees of a wide variety of financial firms. Meanwhile, its Graduate Executive Board is staffed with senior employees of Bank of America, Blackstone Financial Management, and PMC Bank. Wharton’s endowment is $888 million, greater than that of many large public universities. Essentially, the students jeering the protesters represented the future financial elite.”

The Occupy Wall Street protests have grown into one of the most powerful grassroots social movements since the Great Depression and has gone international fueled by the power of social media. It seems the movement is picking up steam as Democrats use it for political gain and Republicans brandish the protesters as those who “hate America”. I believe the message of the movement must remain loud and clear that our free market capitalistic system is failing us and must be reformed before it is too late.

Corporate greed, fraudulent financial statements, and Ponzi schemers have wiped out vast amounts of wealth for the average American through job layoffs, massive losses in stock and retirement accounts, and plunging home values fueled by greed driven home mortgage lending practices that shift the risk of homeowner default to outside investors through the packaging and sale of collateralized debt obligations.  

There is no doubt that some individuals and groups have tagged along with the OWS movement to get their message across. The theme of their protest seems to be to rant against income inequality in America. However, this is a symptom and not the crime and it fails to get to the root cause of the problems facing America. We need to reform our capitalist system. It is important to remember that Adam Smith connected ethics to economics. Smith came to his philosophy of economic behavior described in The Wealth of Nations through his view of moral behavior espoused in his first book, The Theory of Moral Sentiments. Smith, who is generally regarded to be the founder of free market economics, posited that rational self-interest informed by moral judgments based on fairness and justice would lead to promoting the best interests of society guided by the invisible hand of the marketplace. What is missing from the calculation of recent economic decision making is ethical decision making. We must ask: What are the rights of shareholders and other stakeholders and what are the obligations of CEOs and boards of directors to those parties? How is it in the best interest of shareholders for CEOs to walk away with multi-million severance packages even after leaving a failed firm?

The bottom line is ethical behavior cannot be legislated. It comes from within and a desire to do what is right for society and not to act solely in one’s own self-interests. This is where graduate business schools that train tomorrow’s corporate leaders have an important role to play. The curriculum of every business school should include courses in ethics, leadership, and corporate social responsibility. Even today some of the best schools follow the historical model of teaching the technical skills while shying away from the “touchy-feely” material. Yet it is the latter that plays an integral role in returning America to its core role of promoting economic welfare for all.

The nature of the present economic crisis and Wall Street protests illustrates the need for departures from uncontrolled self-dealing that has infected corporate America and Wall Street. As they say in Texas, “That Dog Won’t Hunt.”

Blog posted by Steven Mintz, aka Ethics Sage, on November 4, 2011

Chinese Companies Financial Reporting Practices Escape US Regulators

Can We Trust the Financial Statements of Chinese Companies?

I have previously addressed the growing questions about Chinese accounting principles and the reliability of the financial statements produced by state-owned and private enterprises. I called it “The Dark Side of Chinese Capitalism.” Questions continue to be raised about the value of those statements to investors looking to obtain a piece of the growing Chinese economic pie. In this blog I look at how Chinese companies look for ways to avoid U.S. regulators including the SEC.

China is dealing with charges of fraud in financial statements. I blogged about how U.S.-style capitalism may be infecting Chinese companies with the “fraud bug.” A good example is Sino-Forest Corp. that has been charged with allegations of accounting abuses and fraud, burning investors including John Paulson, the billionaire whose hedge fund said in June it lost $468 million on Sino-Forest.

Two reporters for Bloomberg on line, Dune Lawrence and Gary Putka, identify a common corporate structure that has allowed dozens of Chinese companies to get listed on U.S. exchanges but may run afoul of U.S. regulations. Chinese Internet companies such as Sina Corp. and Baidu Inc. have used so-called variable interest entities, or VIEs, to work around Chinese restrictions and seek foreign investors since 2000. In case you have forgotten, these are the same self-created off-balance sheet entities used by companies such as Enron to keep debt of the balance sheet and make a company look more liquid than it really is thereby misleading investors and other users of the financial statements.

The VIE structure, which allows firms to set up contractual relationships that mimic equity ownership, may carry its own risks, according to Joseph St. Denis, director of research and analysis at the Public Company Accounting Oversight Board. The PCAOB, which oversees auditors of U.S. public companies, has begun to look at VIEs’ audit implications.

“China has blocked our inspections of firms in their region, but we think VIEs are a risk area,” St. Denis said. “We can’t know, without going to inspect, how much risk they represent.” Last month, the Chinese government signaled it may create new rules for VIEs, which have helped enable the boom in overseas listings of Chinese stocks.

Reporter Tom Schoenberg points out that financial software maker Longtop Financial Technologies Ltd., disclosed that it may face SEC civil claims related to accounting abuses and whose U.S. shares have lost more than 99 percent of their value this year, used a VIE structure. The company is conducting an independent investigation into allegations made by its auditor, Deloitte Touche Tohmatsu CPA Ltd. The auditor resigned in May, saying Longtop’s chairman had admitted there was fake revenue and cash on the company’s books.

Deloitte has its own problems. Mark Lanpher, an SEC lawyer, believes the company should be ordered to appear in a U.S. Court for rejecting a SEC demand for documents related to an investigation of its former client Longtop Financial Technologies Ltd. Lanpher claims Longtop has refused to respond to a court filing seeking documents that the regulator claims are “critical” to its probe of possible fraud at the company.

The key take-away is that China must play by SEC rules if it is to audit affiliates of US companies that are subject to inspection by the Public Company Accounting Oversight Board and if Chinese companies are to list their stock on U.S. exchanges. All foreign c companies that list stock in the US are subject to such inspections. China should not be treated any differently. If China wants to be a key player and become a force in the international financial markets, then it must learn to play by the rules of regulators outside their own country even if it seems to run counter to cultural norms whereby such regulations and inspections might be interpreted as demonstrating a lack of trust in Chinese management.

Blog posted by Steven Mintz, aka Ethics Sage, on October 26, 2011       

Social Media Governance

Framework to Deal with the Use of Social Media

Nothing short of a revolution in online communication and social media has been occurring over the last few years. The movement has gone beyond being an information security challenge and become a genuine governance issue. Boards of directors must take notice of these new challenges, identify oversight responsibilities, and develop the appropriate policies and procedures to protect the integrity of company data and make sure the use of social media is consistent with the company’s values. In this blog I look at what can be done to get ahead of the situation.

Social media are no longer just social— these tools are commercial, and they are becoming a key element of business strategy. From engaging customers in real time, to adding sales channels, to enhancing market research, companies are discovering many ways to take advantage of social media.

Social media brings many advantages including getting one’s message out to potential customers, promoting brand, and communicating with stakeholders. But for all their advantages, social media also bring inherent risk, even to those companies not actively using them—e.g., threats to confidential information or intellectual property, reputational risk and the potential for regulatory infractions, to name a few. As a result, it is critical that management develop and maintain a clear-cut governance framework as a central part of its social media development initiatives.

The work time use – and/or misuse – of Facebook, MySpace, LinkedIn, Twitter and YouTube is a management and human resources issue; data leakage through these channels is a compliance and, potentially, a competitiveness issue; and the risks to confidentiality, availability and integrity of information is an information security issue. But social media may also have a significant role to play in how the organization communicates with customers, partners, suppliers, potential employees and stakeholders. Social media have an increasingly important part to play in corporate marketing strategies, whether in brand development or product positioning.

Organizations that embrace social media increasingly recognize that they need a coherent, comprehensive approach, an approach that ensures clarity about corporate policy, identifies roles and responsibilities, and provides appropriate training to individuals supported by guidance and practical tips for effective use of these media. They need, in other words, a governance framework that contains board-level guidance about the role of social media in the business strategy, which ensures that roles, responsibilities and resources are allocated, that risks are identified and controlled, and that appropriate business objectives are achieved.

The international accounting firm of KPMG examined the role of audit committees in ensuring that management (often spearheaded by marketing and closely supported by legal/compliance and information technology) has in place a social media governance framework that effectively addresses the range of internal and external risks, and that it is designed to keep pace with the rapid speed at which this area is evolving.

To address this challenge the firm identifies five areas of focus for audit committees:

• Can management demonstrate an understanding of how the use of social media is evolving and impacting the business—and the associated risks? This would include how social media impacts marketing strategy; advertising and communications strategies; workforce effectiveness; information protection; reputation risk; and legal/regulatory risk; and how effective are social media monitoring controls?
• Is someone actively monitoring the major social media networks to identify potential problems and opportunities? How does the company monitor the use of social media tools and its role in the enterprise risk management process? How does the company decide when to react to potential reputational issues being discussed in various social media—and, when needed, how does the company respond?
• Do we have a single, clearly defined policy regarding employee use of social media both on the company’s enterprise technology and employees’ personal devices? Employee use of social media raises a variety of issues unique to the company, including employee commentary on company matters and workplace conduct, the protection of the company’s intellectual property rights (logos, registered phrases, developing products, business plans), information privacy, proper use of company devices to access external social media sites, and the company’s right to monitor employee postings on those sites. What training on the use of social media is provided employees?
• Does the company’s social media governance framework define how the company’s message will be managed through use of social media for marketing and communications? Protections should be in place to prevent employees from becoming unsupervised spokespeople for the company. Investor relations and marketing/ communications should play a central role to monitor the use of social media and by whom. Questions to ask: Do we have formal guidelines for all market-facing organizations? Do we have procedures for message approval so that key constituents (e.g., legal/regulatory, and marketing/communications) can have timely input?
• How do we monitor compliance with the company’s social media policy? Who is responsible for enforcement of the policy? Internal audit may have a central role to play, focusing particularly on the adequacy of controls around the key risks posed by the use of social media, and auditing the adequacy of the company’s social media governance framework, including employee adherence to the policy—and the effectiveness of employee training.

Social media governance was at one time dismissed as an idea that something as individually-based as social media might be governed.  Now, it’s an essential step for forward-looking organizations. Boards should no longer be asking if social media will be used by the company; instead they should be asking for transparency in how social media are being used and managed across the enterprise. An effective social media governance policy should become part of the ethical culture of an organization.

Blog posted by Steven Mintz, aka Ethics Sage, on October 12, 2011

 

 

 

 

 

 

Deloitte Sued for $7.6 Billion, Accused of Missing Fraud

Are CPA Firms Finally Being Held to Account for the Financial Meltdown?

Deloitte Touche Tohmatsu Ltd, the world's largest accounting and consulting firm, was accused on September 26 of failing to detect fraud during its audits of one of the biggest private mortgage firms to collapse during the U.S. housing crash. This was the latest lawsuit to hit one of the major accounting firms over their role in the credit crisis. Pricewaterhouse Coopers, KPMG and Ernst & Young are also facing accusations about their auditing standards by investors who collectively seek to recoup billions of dollars lost in the financial meltdown.

A trust overseeing the bankruptcy of Taylor, Bean & Whitaker Mortgage Corp, or TBW, and one of the company's subsidiaries filed complaints in a Miami Circuit Court claiming a combined $7.6 billion in losses. Deloitte spokesman Jonathan Gandal said the "claims are utterly without merit."

Lee Farkas, the former chairman of Taylor, Bean and Whitaker, was sentenced to 30 years in prison in April for masterminding what U.S. officials described as one of the biggest bank frauds ever. U.S. Justice Department officials said Farkas ran a $2.9 billion fraud scheme that led to TBW's downfall and the collapse of one of the largest U.S. regional banks, Colonial Bank. Farkas was accused of running a wide-ranging scheme to cover up large losses at Taylor, Bean, which was based in Ocala, Florida, by moving funds between accounts at Colonial Bank and also by selling mortgage loans that did not exist, were worthless or had already been sold.

The complaint filed by Neil F. Luria, a plan trustee of Taylor, Bean & Whitaker Trust, claims losses of approximately $6 billion. A second complaint by Ocala Funding, a wholly owned TBW subsidiary which served as a lending facility, claims losses of $1.6 billion.

"Deloitte missed this fraud because it simply accepted management's conflicting, incomplete and often last-minute explanations of highly-questionable transactions, even though those explanations made no sense and were flatly contradicted by the documents in Deloitte's possession," according to the complaint by Ocala Funding. Furthermore, “Ocala relied on Deloitte to detect material misstatements in the financial statements due to error or fraud.

According to Generally Accepted Auditing Standards (Statement on Auditing Standards No. 99), "The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.” The key always has been the interpretation of “reasonable assurance” and auditor responsibilities to examine evidence. Generally, evidence provided by the client is less reliable than that gained by auditor communications with third parties and by applying accepted audit procedures. Deloitte apparently relied too much on management’s explanations and did not do its due diligence in collecting and analyzing data. Plaintiffs' lawyers argued that as gatekeepers, auditors have a duty to be vigilant at rooting out fraud.

One question that arises is whether Deloitte missed the red flags that fraud may be present. According to Jacob Zamansky, founder of Zamansky & Associates, a law firm specializing in securities fraud, “If [auditors] see something they need to report it. If they consciously ignore red flags, they could be held responsible as an aider or abettor to the fraud."

 

Auditors are expected to exercise professional skepticism in making professional judgments on the extent and scope of evidence to be gathered and in evaluating its usefulness in rendering an opinion on the fairness of presentations in the client’s financial statements.

From the auditor’s point of view they can take solace in a newly emerging legal defense called "in pari delicto," or equal fault principle, used when a company being audited was equally to blame for wrongdoing. It is very fast becoming a law of this nation, which is a tremendous protection for the Big Four." However, Steven Thomas, an attorney for the plaintiffs, said his case rests on solid legal ground. He said that a key bankruptcy decision holds that under Florida law, the in pari delicto defense does not apply in cases in which the auditor has a duty to detect fraud and in which there were innocent board members who could have been alerted about the fraud. "They (Deloitte) had a public duty to detect the fraud," Thomas said. "They didn't do their job, and that's what we're going to prove."

Deloitte has also been named in other big lawsuits stemming from the credit crisis, including one involving its audits of Bear Stearns, which collapsed after suffering enormous mortgage losses, and another involving Washington Mutual, the biggest bank to fail during the credit crisis. Critics have argued that the independent auditors should have predicted the dramatic and unprecedented decline in the housing market that shocked the entire industry.

Are auditors finally going to be held accountable for their role in the financial meltdown? Time will tell but there can be no doubt some must have missed the red flags and, more important, ignored the changing business model and risks inherent in dealing with financial instruments such as sub-prime mortgages and credit default swaps. Auditors are supposed to understand the environment in which their clients operate and use that knowledge and related risk assessment to determine proper audit procedures. It appears that Deloitte failed to do so and there may be other cases waiting in the wings.

Blog posted by Steven Mintz, aka Ethics Sage, on September 30, 2011

ETHICS at the SEC: An Oxymoron

SEC Has Lost its Moral Authority to Regulate Securities Markets

Perhaps you heard that a not-for-profit group co-founded by a Securities and Exchange Commission lawyer used his name to raise thousands of dollars from law firms that represent clients before the agency. According to an article by Jessica Holzer posted online at the Wall Street Journal, four law firms, including Winston & Strawn LLP and WilmerHale LLP, paid the Electronic Discovery Institute $4,500 each to sponsor a conference the group hosted last week at the Ritz Carlton resort in Amelia Island, Florida. The conference was attended by officials from dozens of large corporations.

Patrick Oot, the SEC's special counsel for electronic discovery, co-founded the Electronic Discovery Institute in 2006 before coming to the SEC in the fall of 2010 to develop the agency's procedures for handling outside requests for its emails and other electronic documents in lawsuits and investigations. Oot, who also is a top official at EDI, is quoted promoting the Amelia Island event in a document that details what law firms get in return for the $4,500 sponsorship fee, including having their logo placed on all event marketing materials and the chance to speak on a panel or moderate a lunchtime discussion. EDI said the firms could count $3,700 of their $4,500 sponsorship payment as a charitable contribution to EDI.

Federal regulations bar government employees from knowingly soliciting funds from certain "prohibited sources," which include "someone who conducts activities regulated by the employee's agency." For the SEC, such sources would include securities firms or publicly traded companies, the very entities they are sworn to regulate. Asked whether a law firm representing clients before the SEC is a prohibited source, a spokesman for the Office of Government Ethics, an agency charged with writing federal ethics regulations, said, "A company that does business with an agency is a prohibited source for the employee of that agency."

This isn’t the first time the SEC got caught with its (ethical) pants down. Last March SEC chair, Mary Schapiro, came under Congressional fire for hiring as the SEC’s general counsel someone with a Madoff financial interest — David M. Becker, who participated in matters involving how the scheme’s victims would be compensated.

The revelations about Mr. Becker’s role have raised fresh questions about ethical standards and practices at the agency, where Schapiro was brought in with a mandate to strengthen its enforcement unit. Louise Story and Gretchen Morgenson point out in a NY Times story that questions about Becker arose after Irving H. Picard, the trustee overseeing the Madoff case, sued him and two of his brothers to recover $1.5 million of the $2 million they had inherited in 2004 from a Madoff investment by their late mother. Becker’s financial ties to Madoff had not been publicly disclosed until that suit.

 “One of the things the S.E.C. does is hold companies to a very high standard with regards to transparency and disclosure,” said Representative Randy Neugebauer, Republican of Texas. “We think it’s important that the same integrity exists within the SEC, ensuring that people working there do not have conflicts of interest and that here is a process to vet those issues and make sure they are taken care of in a way that gives confidence.”

Perhaps the most significant Madoff matter involving Becker is a proposed reversal of the agency’s recommendation on how to compensate victims of the scheme. While the SEC had agreed on a deal that would return to investors only the money they had put into their Madoff accounts, Becker argued that the commission should change its stance to allow victims to keep some of the gains their investments had generated, since the investment would have grown somewhat over time even in a low-interest account. The Becker family would benefit from this approach.

In correspondence with lawmakers late last month, Becker said that he alerted the ethics office about his family’s Madoff investment again that May after he received a letter from a number of law firms representing Madoff victims asking that the commission change its proposed compensation formula. Among the issues are whether Madoff investors who withdrew money before the fraud was exposed must return some of their proceeds — and if so, how much — to other investors. “I recognized that it was conceivable that this issue could affect my financial interests because the issue could affect the trustee’s decision to bring clawback actions against persons like me,” Becker wrote in response to lawmakers. The ethics officer approved his participation, he said.

The mission of the SEC Securities is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. It’s difficult to do that when questions arise about the credibility of the SEC’s own actions. The Commission has compromised its integrity and has a black eye from the Madoff affair. It has lost its moral authority to ensure that public companies act in accordance with ethical standards. Congressional investigations will do no good other than to impose an additional layer of requirements on the SEC. Like most regulatory efforts where ethics is the underlying issue, the effort is doomed to fail because you can’t legislate ethics.

Blog posted by Steven Mintz, aka Ethics Sage, on September 16, 2011   

Google: All that is wrong about American Business

Google pays out $500 Million to Settle Criminal Investigation

Google draws over 1 billion visits to its websites each month, making it the world's largest Web property. You may have heard that search giant Google Inc. has agreed to pay $500 million to settle a Justice Department investigation into allegations that it improperly accepted ads from online Canadian pharmacies that import prescription drugs into the US.  Google agreed to forfeit $500 million, which represents revenue it earned in ads from Canadian pharmacies plus revenue earned by the pharmacies, the Justice Department announced in a statement, calling it one of the largest ever forfeitures. The DOJ said that it is almost always illegal to import prescription drugs into the U.S., because the FDA cannot ensure the safety and effectiveness of the foreign drugs.

Google can now be added to the long and ever-growing list of unethical companies that put profits and self-interests ahead of doing the right thing. I’ve previously blogged about the lack of corporate social responsibility. Corporations lack a collective conscience because they fail to reflect on their actions prior to taking them; cover-up when caught; and repeat the offensive behavior. They seem to act as if they are above the law. Their ethical blindness has cost society trillions in lost wealth and the cost to government to create regulations they themselves criticize, but fail to realize it’s because of their bad behavior. If only corporation would self-regulate, then perhaps those moneys could be used to truly stimulate the economy and help fund start-ups.

Here are a group of standards I suggest corporations follow to be ethical:

Honesty and Transparency

• Be honest and open about transactions and activities. Don’t withhold relevant information. Be transparent.

Trustworthiness

• Act in a trustworthy manner. The public must rely on the diligence and good faith of companies in carrying out company operations.

Integrity

• Be principled and consistent in action and deed. Avoid giving in to pressures within the organization to engage in or condone improper behavior.

Responsibility and Accountability

• Be responsible and accountable for actions and decisions. Admit mistakes right away; be contrite about the mistake; promise to never do it again…and DON’T!

Reasoned Judgment

• When faced with a conflict consider the consequences of proposed actions on affected parties. Strive to follow the basic principle: “First, do no Harm.”

Reflection

• Reflect on proposed actions before making a final decision. Ask: Would I want my actions to be examined on the front pages of the newspaper.

Google admitted that the company had banned the advertising of prescription drugs in the U.S. by Canadian pharmacies some time ago. Google acted with reckless disregard (my characterization) by putting profits over the possible effects of their actions on the consuming public.

That’s not all. Recently the FTC concluded an antitrust investigation into whether Google had been profiting from illegal activity. In 2007 the three largest Internet companies, Google, Microsoft, and Yahoo agreed to pay a combined $31.5 million fine to settle civil allegations by DOJ that they had accepted ads from illegal gambling sites.

The FTC is also investigating whether Google is taking information like local business reviews that is collected by competitive sites for use on its own sites. The agency also wants to know if Google is giving its own sites, such as Places pages and Google Finance, higher placement in search results than competitive sites.

Google is also facing a separate antitrust investigation launched last year by the European Commission. That investigation is focused on a similar issue -- whether Google abused its dominant position in search to promote its own services.

It will be a difficult case to make: Google says the site is free to users, and “if you don't like its results, you can go elsewhere for information.” And despite its dominant market share, Google argues it doesn't have a monopoly, pointing out there are other search engines like Bing. But more important, it says the FTC's notion of search is antiquated.

What an unethical, irresponsible, insensitive approach to business that is especially offensive given the size and scope of Google’s actions. It’s clueless when it comes to acting with integrity and as a good corporate citizen. Perhaps it’s time for the FTC to open up a separate division just to investigate Google. The company acts like a bully. Perhaps the company motto should be the spins starts here. Google has created a culture of wrongdoing and rationalization for unethical actions that infect other areas of its operations.

The NY Times recently reported that some of the largest US corporations are pressing the Obama administration for tax breaks to encourage the repatriation of profits and use to stimulate the US economy. Google has $17 billion offshore. Under the proposal, known as a repatriation holiday, the federal income tax owed on such profits returned to the United States would fall to 5.25 percent for one year, from 35 percent. In the short term, the measure could generate tens of billions in tax revenues as companies transfer money that would otherwise remain abroad, and it could help ease the huge budget deficit.

Corporations and their lobbyists say the tax break could resuscitate the gasping recovery by inducing multinational corporations to inject $1 trillion or more into the economy, and they promoted the proposal as “the next stimulus.” For every billion dollars that we invest, that creates 15,000 to 20,000 jobs either directly or indirectly,” Jim Rogers, the chief of Duke Energy, said at the conference. Duke has $1.3 billion in profits overseas.

But that’s not how it worked last time. Congress and the Bush administration offered companies a similar tax incentive, in 2005, in hopes of spurring domestic hiring and investment; 800 companies took advantage. Though the tax break lured them into bringing $312 billion back to the US, 92 percent of that money was returned to shareholders in the form of dividends and stock buybacks, according to a study by the nopartisan National Bureau of Economic Research.

This money comes from overseas operations and in some cases accounting maneuvers that shift domestic profits to low-tax countries. The study concluded that the program “did not increase domestic investment, employment or research and development.” Indeed, 60 percent of the benefits went to just 15 of the largest US  multinational companies — many of which laid off domestic workers, closed plants and shifted even more of their profits and resources abroad in hopes of cashing in on the next repatriation holiday.

That’s the moral rub. A “one-time” reduction of the repatriation rate creates a moral hazard. Other companies may come to believe if they just park their profits overseas sooner or later the government will institute a partial tax holiday. Moreover, it is highly unfair to US companies that have been paying their fair share all along. What message does it send to society: Do the wrong thing and you eventually you will be rewarded!

Blog posted by Steven Mintz, aka Ethics Sage, on August 31, 2011

Whistle-blowing and Accountants' Obligations

Accountants as Whistle-Blowers: Confidentiality Issues

Accountants are increasingly being asked to blow the whistle on corporate wrongdoing to help stem the tide of recent massive financial frauds such as Bernie Madoff’s Ponzi scheme. I have blogged about whistle-blowing considerations before, but not on specific expectations in the law for accountants to blow the whistle. The laws that encourage whistle-blowing by accountants may be well-meaning but they fail to consider the fact that professional accountants and auditors who are Certified Public Accountants or who hold a Certificate in Management Accounting and Certificate in Internal Auditing, all have to abide by a strict code of conduct that generally precludes whistle-blowing. Corporate accountants might be seen as disloyal if they blew the whistle on wrongdoing by their employer. However, this is where ethics and the law part ways. Ethical people use the law as a minimum standard of behavior. They always try to adhere to the law and, in this case, rules of professional accounting and auditing. Under the profession’s rules of conduct, if you know your employer is committing fraud the first step is to take your concerns up the chain of command all the way to the audit committee of the board of directors, if necessary. If you are shut out at every step then, based on your conscience and ethical beliefs about right and wrong, it may be that you choose to take your concerns outside the organization even though it violates your confidentiality obligation and the rules of professional conduct. This is whistle-blowing.   

Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. One of the goals of Dodd-Frank was to extend whistleblower protection beyond the Sarbanes-Oxley Act of 2002 to further incentivize whistleblowers to expose securities fraud. On May 25, 2011, the U.S. Securities and Exchange Commission (SEC) approved final rules to implement a program to pay individual whistleblowers that provide information relating to possible securities law violations that lead to successful SEC enforcement actions.

While CPAs are not permitted to receive a reward under Dodd-Frank by reporting possible violations of a client, they are permitted to receive a reward by reporting possible violations of their accounting firms in the performance of audit services for a client. In a sense Dodd-Frank contains what some have called a “bounty hunter” provision. To be eligible for a reward under the whistleblower provisions, a whistleblower must voluntarily provide the SEC with original information that leads to a successful enforcement action by the SEC and that results in monetary sanctions of more than $1 million.

Where the SEC recovers at least $1 million, the whistleblower must be awarded anywhere from 10 percent to 30 percent of amounts recovered, although the SEC has broad discretion in determining the exact amount of the award. If the SEC does not ultimately recover at least $1 million, the whistleblower receives nothing.

To receive the award, the whistleblower must agree to provide sworn testimony if needed and other assistance and cooperation with the SEC’s investigation. As a result, whistleblowers may be faced with years of ongoing cooperative obligations before receiving any payment. Although initial whistleblower reports can be made anonymously via an attorney, a whistleblower must identify himself or herself to the SEC before collecting any reward.

The whistleblower provisions exclude two categories of accountants from award eligibility because of their pre-existing legal duty to report securities violations:

1. Individuals with internal compliance or audit responsibilities at an entity, including CPAs, who receive information about potential violations, cannot receive whistleblower awards since it is part of their job responsibilities to report suspicion of illegal acts to management. However, these individuals will not be excluded from receiving a whistleblower award where:
   1. Disclosure to the SEC is needed to prevent “substantial injury” to the financial interest of an entity or its investors,
   2. The whistleblower reasonably believes the entity is impeding investigation of the misconduct or
   3. The whistleblower has first reported the violation internally and at least 120 days have passed.
2. CPAs who receive information about potential violations of a client or its directors or officers through an audit or other engagement required under the federal securities laws are not eligible to receive whistleblower awards. The SEC included this exclusion so as not to undermine the legal duty that auditors have under Section 10A of the Securities and Exchange Act of 1934 to report illegal acts by officers, directors, and other client personnel up the chain of command. If the issues are not addressed adequately by management, the auditor must then resign from the engagement and file a report with the SEC.

Notably, the whistleblower exclusions do not apply to CPAs who report information about potential violations regarding their own firms’ performance of audit services for a client. This is true even where the CPA’s information about his or her firm leads to a successful enforcement action against one of the firm’s clients.

Several members of the public accounting industry, including KPMG, Ernst & Young, PricewaterhouseCoopers and the Center for Audit Quality, have expressed concerns to the SEC that the accountant exclusion in the whistleblower provisions is too narrow. Those entities believe that permitting CPAs to obtain monetary rewards by blowing the whistle on their own firms’ performance of services for clients could create several significant problems with respect to maintaining the confidentiality of client information.

Blog posted by Steven Mintz, aka Ethics Sage, on August 10, 2011

Throw the Republicans and Democrats Out of Office

Politicians Have Violated the Public Trust

Politicians have lost sight of their main responsibilities -- to serve the public interest, honor the public trust, and be faithful to their constituency. It's the latter that can get them into trouble as is the case with the current budget deliberations. The republicans are driven by conservative views and the Tea Party principles based on balancing the budget, cuts in spending especially from entitlement programs and no new revenues. If this is the Tea Party manifesto then it should start to drink caffeinated coffee. This is not the time to pursue a balanced budget amendment given the government has failed to deliver one for at least the last 14 years and we are still fighting two unwinnable wars. 

The Democrats want no balanced budget amendment, limited cuts in spending programs and new revenues by raising the tax on taxpayers making over $250,000 in income. There needs to be changes in social security such as expanding the retirement date to a minimum of 65 years and a maximum 70 years. I would also recommend a slight increase in the 2.5% tax on Medicare which is low in comparison to the 6.25% rate for social security. We have an aging population that now lives longer than in the past and a slight increase in the Medicare rate is justified given the higher Medicare costs to the government.

'Cut, cap and balance' is predicated on the balanced budget amendment. These are laudable principles and ones that should be included in a national debate during the next 15 month election cycle. However, Rome was not built in a day. Let the voters decide in the ballot box. Politicians should make decisions based on principled behavior and serving the public trust and not motivated by satisfying lobbyist groups.

There should be a comprehensive audit of government programs to eliminate the fraud and abuse. For years we have heard about $500 million in Medicare fraud yet no one seems to have the political will to eliminate it. The Government Accountability Office seems unwilling or incapable of identifying abuse areas and eliminating it. I suggest calling in one of the Big-Four CPA firms to conduct an independent audit. They know how to examine documentation and ask the right questions. CPA firms must abide by strict ethical standards including serving the public interest.

There undoubtedly are other areas of fraud and abuse including in the procurement program, community-based funding, and the misuse of government resources by some in Congress including unsupportable reimbursement of trip expenses and payoffs to lobbyists. 

Our country is at a crossroads. We are headed down a path that will make us the second largest economy after China. Our work ethic is declining perhaps due to not having the skills necessary to compete in the global environment and/or pure laziness. A malaise has taken over our society. If we put the same time and effort into our schoolwork and job performance that we do to social networking time, then much of the declining work ethic would vanish. Americans have gotten lazy and believe they are entitled to a certain standard of living provided by the government. I call it the "Greece-ization oif America."

Congress should be given sufficient time to get the job done right and not based on some arbitrarily imposed deadline. Going forward, we all must make a shared sacrifice and Congress should lead the way by setting a good example and insist on reductions in fraud and waste and reduce their own profligate spending to regain the public trust.

Blog posted by Steven Mintz aka Ethics Sage on July 30, 2001

 

 

 

SEC Adoption of IFRS: An Inconvenient Truth

SEC Ignores Concerns in Roundtable Discussion

The much anticipated SEC Roundtable discussion about IFRS adoption in the U.S. has come and gone and the world is still standing. I estimate that there was a 1,000,000:1 ratio of Americans interested in the verdict in the Casey Anthony trial when compared to the results of the roundtable discussion that took place in Washington, D.C. on July 7, 2011. From what I have read, the panelists largely ignored important concerns about IFRS adoption raised by small businesses, public investors, and those claiming the costs of implementation outweigh any benefits to be derived from adopting an IFRS regime in the U.S. Even the idea of "condorsement." that I have blogged about before, is not universally supported.

One consistent outspoken critic of the IFRS regime is Tom Selling. He has served a year as Academic Accounting Fellow in the Office of the Chief Accountant at the U.S. Securities and Exchange Commission and has a distinguished career in academe. Dr. Selling, a retired accounting professor, writes a popular blog on financial accounting -- "The Accounting Onion." Tom attended the roundtable and writes about his perceptions of its accomplishments in his blog, I highly recommend reading it for an insightful view of the shortcomings of the discussion and the process followed. Selling astutely questions the motives of supporters and one-sided perspective of support for IFRS adoption in the U.S. He labels followers of the SEC as “zombies” because they fail to think independently about the problems of IFRS adoption and seem to have drunk the adoption/condorsement cool-aid. He points to the Certified Financial Analysts (CFA), a group with 70-percent non-US. membership, as a strong endorser of IFRS but without details of membership support to back it up . The CFA’s blind endorsement of condorsement (sorry, I couldn’t resist) seems motivated by the largely international membership that practice in countries that have adopted IFRS as their global reporting standards.

Selling praises Gaylen Hansen, the NASBA representative, who “shot down every stated reason and unsupported assertion for incorporating IFRS into GAAP into oblivion.” Here is a summary of Hansen’s concerns:

• The SEC hasn’t established that IFRS itself is at least better than U.S. GAAP, if not far superior, to justify such a radical change with so many unknown (and uninvestigated) variables.
• The notion that one version of IFRS (i.e., the Holy Grail) has been gaining currency in the rest of the world is a myth. The claim that over 120 countries worldwide have adopted IFRS issued by the International Accounting Standards Board is simply not true. He points to Canada where some of the companies are not doing anything other than wrapping the IFRS name around Canadian GAAP, and conversion to IFRS was extremely costly, and without benefit.
• Adoption of IFRS in the U.S. has become a political issue as IFRS-supporters, especially in the European Community, pressure U.S. regulators to climb aboard the IFRS bandwagon. 
• Finally, Hansen contends that: "I have never had a lender or investor request international standards. I have never even heard of such pleas. On the contrary, the call for IFRS always seems to be from the suppliers [of financial statements], primarily large multinationals and international accounting firms."

What is the future of  IFRS adoption/conversion/condorsement in the U.S.? I’m not sure but one thing I can tell you is the uncertainty does not help the goal of integrating IFRS into the accounting curriculum at hundreds of colleges and universities. The SEC seems to be following the time-honored practice in the U.S. of kicking the can down the road. The problem is too many universities are happy to put off the decision about when to incorporate IFRS into the curriculum and the efficacy of developing a stand-alone course in international accounting. Even if you are against IFRS adoption in the U.S. or even the idea of condorsement, the SEC needs to act as quickly as possible to make a final decision to bring certainty to the issue. If sanctioning IFRS in some form or another is to be the final decision, then make it now and establish a reasonable time table so that accounting faculty have the ammunition they need to approach college and university administrators to gain their support for any resources that may be needed to implement IFRS coverage into the curricdulum.

Blog posted by Steven Mintz, aka Ethics Sage, on July 14, 2011

Is J.P. Morgan A Criminal Enterprise?

Persistent Business Fraud Endemic to J.P. Morgan

JP Morgan’s actions with respect to rigging bids on Municipal Bond sales, the packaging of mortgage loans as collateralized debt obligations, its relationship with Bernie Madoff Securities, and the facilitation of Enron’s special-purpose entities, together raise questions about whether the Company is working in furtherance of a continuing criminal enterprise I am not saying JP Morgan is a criminal enterprise but its actions make it appear to be so. The legal definition assumes a person is acting through an enterprise in the furtherance of criminal activity. A person is engaged in a continuing criminal enterprise if—

(1) He violates any provision of the Racketeer Influenced and Corrupt Organizations (RICO) law, the punishment for which is a felony, and

(2) Such violation is a part of a continuing series of violations of the Law

(A) which are undertaken by such person in concert with five or more other persons with respect to whom such person occupies a position of organizer, a supervisory position, or any other position of management, and

(B) from which such person obtains substantial income or resources.

Here are the facts to back up my claim. If you are not interested in the technicalities and prefer to skip to the ethical analysis, go to the last paragraph.

1.                  Criminal fraud charges were brought in July 2011, by the US Department of Justice against 18 former employees of JP Morgan Chase -- of whom nine have pleaded guilty. JP Morgan was accused of paying to have a sneak preview of rival bids to win contracts to invest cash on behalf of local and state governments, including those of California, Texas and New Jersey. The Securities and Exchange Commission alleged that from 1997 through 2005, the bank manipulated the municipal bond market using information obtained from bidding agents about competing bids, in a practice known as "last looks." The bank was accused of using "secret arrangements" to set up certain providers to win, either through deliberately submitting losing bids or by having bidding agents obtain losing bids from competitors. The company agreed last week to pay $228m to settle claims it rigged auctions. Here's how the money from the settlement will be divided:

-- The SEC will receive $51 million to settle civil fraud charges.

-- JPMorgan will pay the IRS $50 million because its actions violated rules governing municipal bonds, which are tax-exempt.

-- The bank's main regulator, the Office of the Comptroller of the Currency (OCC), will receive $35 million.

-- The settlement with the states is worth $92 million. That includes half of the $35 million JPMorgan agreed to pay the OCC. The settlements have a face value of $228 million because $17 million is counted twice.

2.                  The municipal bond settlement comes on the heels of an agreement to a $154m payout to settle charges of misleading buyers of its mortgage investments. Leading up to the financial meltdown, JP Morgan allegedly sold complex mortgage investments just as the housing market was collapsing. These collateralized debt obligations (CDO) were sold to investors without admitting that the bonds in the deal were selected by a hedge fund, Magnetar Capital, that was positioned to profit if the deal were to fail. That meant Magnetar had every incentive to pick the worst bonds it could find. And apparently it did. JPMorgan sold $150 million worth of bonds based on the Squared CDO in the first quarter of 2007. Magnetar reportedly made as much as $600 million on the deal. Among the investment firms and their clients or investors who were wiped out are Thrivent Financial and GM's pension fund.

3.                 Even though an appellate court dismissed a Bernie Madoff investor's racketeering claim against JPMorgan Chase, the company is facing a very similar $19 billion racketeering suit brought by Irving Picard, the bankruptcy trustee for Bernard L. Madoff Investment Securities. However, the ruling in the racketeering claim appears to foreclose the only possible route to recovery through federal court for securities investors suing defendants who aid and abet a company engaged in securities fraud. The logic is that The Private Securities Litigation Reform Act (PSLRA), enacted in 1995, includes an amendment to RICO. The PSLRA's so-called RICO amendment bars investors from bringing racketeering claims against securities fraud defendants. Congress' intent was to prevent wily plaintiffs’ lawyers from suing securities defendants under RICO -- which carries the potential for triple damages -- rather than under the securities laws. Plaintiffs’ lawyers are fighting back by putting a creative spin on the strict language of the PSLRA's RICO amendment. The provision holds that "no person may rely upon any conduct that would have been actionable as fraud in the purchase or sale of securities to establish a violation of [the RICO statute]." Securities class action lawyers seized on the word "actionable" and argued that they could still pursue RICO claims against securities fraud aiders and abettors -- because the conduct of aiders and abettors is not actionable under the securities laws. In other words, a law that was supposed to preclude RICO as an avenue to recovery against securities defendants was repurposed by investors to permit claims against defendants they otherwise couldn't go after.

It appears plaintiffs’ lawyers claims might have some legs. At least two well-regarded Manhattan federal court judges green-lighted racketeering claims against alleged aiders and abettors. Judges Shira Scheindlin and Lewis Kaplan accepted the proposition that investors can sue alleged aiders and abettors for RICO because they can't otherwise sue them for securities law violations.

4.                 Back in February 2011, JPMorgan Chase was sued by Allstate insurance company for fraud, claiming the bank knowingly sold a poor-quality product. In the lawsuit, the insurance company accuses the bank of knowing that the bundles of loans it was selling that kicked off the financial meltdown of 2008 were very likely to go bad. The suit joins a host of similar accusations from insurance companies and investors, who suffered losses when securities that were sold as high-quality instead turned sour. Allstate is claiming that JPMorgan and the banks it now owns fraudulently sold it more than $750 million of such mortgage-backed securities. In another lawsuit, recently unsealed, Ambac insurance company has accused Bear Stearns (now owned by JPMorgan) not only of knowing the loans it was selling were toxic, but also of accepting payments from mortgage companies to compensate for those loans.

5.                 J.P. Morgan also was implicated in the Enron fraud uncovered in early 2000. The SEC charged that the company aided and abetted Enron’s manipulation of its reported financial results through a series of complex structured-finance transactions, called "prepays," over a period of several years preceding Enron's bankruptcy. According to the Complaint, in December 1992, JP Morgan created and controlled an energy trading business set up as a special-purpose-entity, Mahonia Ltd. Mahonia operated out of the Channel Islands in the UK. Sixty percent of its transactions were made with Enron. These transactions were originally made by Enron in an attempt to defer taxes, but as the company's debt increased, and the energy industry continued to experience losses, the transactions became a means to finance its operations. Enron would sell Mahonia Ltd. a specified amount of gas and oil to be delivered incrementally, over a specified period of time. Enron would record the "pre-paid" purchases by customers as sales on its current ledger, although it hadn't actually delivered any product. This allowed Enron to record the sales on the company's current earning statement, and move its liability (delivering the pre-paid gas) to the following year's ledger. The company deferred taxes by acknowledging the pre-paid sales as debt, when necessary, in its tax statements.

Ethical behavior in accounting means to report financial information in an accurate and reliable manner. It requires the highest standards of integrity on the part of both the information content and, more important, the accountants and auditors who are charged with protecting the public interest. Transparency requires to record all the information an intended user (i.e., investors and creditors) has a right to know to assist their decision-making needs. The public relies on the ethics of accountants and auditors to achieve these goals. Top management, for its part, has a fiduciary responsibility to safeguard company assets for the benefit of shareholders in line with its obligation to act in good faith and with due diligence. To say that the ethical systems failed in the JP Morgan case is an understatement.

Blog by Steven Mintz, aka Ethics Sage, July 12, 2011

SEC IFRS Condorsement Approach Misguided

Conforming IFRS to GAAP Via Condorsement Process

It's not a word in the English language, yet the SEC chose "condorsement" to describe the proposed process going forward to implement International Financial Reporting Standards (IFRS) in the U.S.  SEC Deputy Chief Accountant Paul Beswick explains condorsement as an approach that permits  U.S. Generally Accepted Accounting Principles (U.S. GAAP) to continue to exist.  The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) would work to finish their joint convergence projects.  After completion of their joint projects, FASB would work to converge U.S. GAAP to IFRS over a period of time for standards that are not on the IASB’s work plan. 

At the same time, FASB would have a process to consider new standards issued by the IASB for incorporation into U.S. GAAP.  The new standards could be incorporated into U.S. GAAP with or without U.S. modifications. The condorsement approach would allow FASB to retain control over U.S. GAAP.  It would also mitigate the effort associated with a full scale, mandated switch to IFRS. The condorsement approach moves the SEC away from its originally stated goal of convergence of GAAP and IFRS.

For almost 40 years a movement has been underway to establish one set of international accounting standards for all countries around the world in order to facilitate international trade and investment. Since it is no longer unusual to have foreign companies list their stock on the New York Stock Exchange, one common set of accounting standards should go a long way towards increasing the understandability of international financial reports. Until recently, listing rules required that non-U.S. companies must reconcile their financial statements prepared under home country standards to U.S. GAAP.

I have previously blogged about the SEC proposed roadmap for the adoption of IFRS in the U.S. that was a reaction to the pressure to adopt IFRS because members of the European Union did so in 2005 and many other countries have or will be adopting IFRS within the next few years. To date about 120 nations have adopted IFRS as their home country standards. The final decision of the SEC to mandate IFRS will be based on whether those accounting standards are of high quality and sufficiently comprehensive. The SEC’s existing convergence approach is based on the notion of “improve and adopt” IFRS before giving its stamp of approval. The Commission has been assessing whether IFRS develops a high quality of financial reporting relative to the standards which may be replaced.

The condorsement approach is in essence an Endorsement Approach that would share characteristics of the incorporation approaches with other jurisdictions that have incorporated or are incorporating IFRS into their financial reporting systems. However, during the transitional period, the framework would employ aspects of the Convergence Approach to address existing differences between IFRS and U.S. GAAP. Importantly, the framework would retain a U.S. standard setter and would facilitate the transition process by incorporating IFRSs into U.S. GAAP over some defined period of time (e.g., five to seven years). According to the recently issued SEC work plan, at the end of this period, the objective would be that a U.S. issuer compliant with U.S. GAAP should also be able to represent that it is compliant with IFRS as issued by the IASB. Incorporation of IFRS through the framework would have the objective of achieving the goal of having a single set of high-quality, globally accepted accounting standards, while doing so in a practical manner that could minimize both the cost and effort needed to incorporate IFRS into the financial reporting system for U.S. issuers. It also would align the United States with other jurisdictions by retaining the national standard setter’s authority to establish accounting standards in the United States.

The irony of condorsement is that IFRS have snuck in through the back door and are already spreading across the United States. For example, when a foreign entity using IFRS obtains control over a U.S. entity, the former would then prepare its financial statements in accordance with IFRS, not U.S. GAAP. International Accounting Standard (IAS) 27, “Consolidations and Separate Financial Statements,” states that, “a group must use uniform accounting policies for reporting like transactions and other events in similar circumstances. Assume a German entity purchases 75 percent interest in a U.S. entity on Jan. 1, 2011. The German entity has a calendar year end and it prepares its financial statements using IFRS. Because of IAS 27, the U.S. subsidiary will have to adopt the same accounting policies (IFRS) as the parent in 2011.

Peter Margaritis writing for the Maryland CPA Association points out another instance in which an IFRS sighting can occur is when a foreign company begins operations in the United States. Viewed another way, Canada and India are adopting IFRS in 2011. Mexico is adopting IFRS in 2012 and Japan is adopting IFRS in 2016. The European Union and Australia adopted IFRS in 2005. In this global economy, IFRS is all around us. CPAs will increasingly come in contact with companies using IFRS. Industry accountants and auditors of multinationals must understand IFRS and how they comply with GAAP. An  organization could suddenly need to switch to IFRS because of underlying structural changes.

As a university accounting professor I am afraid the condorsement approach may have the unintended consequence of providing an excuse to delay teaching IFRS, and that would be unfortunate. Moreover, many of our accounting graduates go to work for large CPA firms with clients having overseas subsidiaries that are required to report in IFRS so these students will need to be conversant in IFRS. We do them a disservice to delay incorporating IFRS instruction into the accounting curriculum.

Blog by Steven Mintz, aka Ethics Sage, July 1, 2011

KPMG Study Shows Company Bosses Increasingly Commit Fraud

Senior Management/Board Increasingly Commit Fraud in Companies

A new KPMG survey reveals that business fraud is on the increase, with a significant proportion committed by those with board-level positions. Company bosses are responsible for an increase in fraud across the globe. The KPMG study found that board members at divisional, subsidiary and corporate level, commit nearly one fifth of fraud — an increase from 11 per cent in 2007 — to 18 percent in 2011. Of the various board roles, CEOs account for an increase in committed fraud from just 11 percent in 2007 to 26 percent across the four-year period.

Often long-serving and more senior employees will be better able to override controls and have accumulated a good deal of personal trust, so will be less suspected, and they are most prone to committing embezzlement and/or procurement fraud (these account in aggregate for just over 50 percent of the 348 cases). Examples include false billings by a supplier to fund kick backs to a senior employee; employees accepting bribes from a contractor in exchange for signing off inflated project costs; and supplier collusion with victim company employees leading to overbilling.

Richard Powell, KPMG’s EMA forensic investigations network lead, concludes from the study: "Given the findings from our survey of red flags not being followed up, coupled with increased recessionary pressures, and the impact of the credit crunch, it seems probable there will be a marked increase in the number of as yet undetected fraud cases which will surface over the next couple of years."

On May 23, I blogged about The Network, Inc., a leading provider of governance, risk and compliance  solutions, and BDO Consulting, a division of BDO USA, LLP, that had announced the first quarter 2011 findings of its Quarterly Corporate Fraud Index, a comprehensive examination of fraud incident report activity from almost 15 million employees worldwide.

For the first quarter of 2011, the Fraud Reporting Percentage (FRP), a statistic measuring fraud reporting in comparison to all compliance reporting activity from more than 1,000 organizations worldwide, was reported at 20.3 percent. The FRP statistic rose by more than 60 basis points since last quarter. FRP has increased in each of the last three quarters and stands at its highest mark since the second quarter of 2009.

According to Luis Ramos, chief executive officer of The Network, the 2011 Q1 fraud index is at a near-record high. Ramos said: “This quarter’s FRP is only 10 basis points lower than it was in 2009, one of the worst years for business on record. The increase is in line with what we are hearing from financial analysts and reinforces the trend that even in a recovering economy, fraud reporting is still on the rise.”

I find it astonishing that corporate fraud continues to increase and top management is leading the way. The increase in the FRP statistic seems to bear out the spread of the cancer that has been attacking the capitalistic system during the past 20 years or so. Remember the "Greed is Good" mantra in Wall Street? Well it's instructive to look at the entire quote by Gordon Gekko: “The new law of evolution in corporate America seems to be survival of the unfittest. Well, in my book you either do it right or you get eliminated…The  point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the            essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the uoward surge of mankind."

I believe the greed is good culture has infected society in the U.S. and contributed to our economic decline. The U.S. can stand above all others -- economically, socially and politically -- for only so long but we will eventually crumble under the weight of narcissistic behavior by our leaders as has been occurring in every field of endeavor. 

I love to read about Greek mythology because of my high regard for the ancient Greeks, Plato and Aristotle, who developed the concept of virtue. Although concern for virtue appears in several philosophical traditions, in the West the roots of the tradition lie in the work of Plato and Aristotle, and even today the tradition’s key concepts derive from ancient Greek philosophy.   

This brings me to my final point linking our economic situation today to dysfunctional, narcissistic behavior. Narcissus or Narkissos (Greek: Νάρκισσος),  possibly derived from ναρκη (narke) meaning "sleep, numbness," in Greek Mythology was a hunter who was renowned for his beauty. He was exceptionally proud, in that he disdained those who loved him. One day Narcissus saw his own reflection in the waters and fell in love with it, not realizing it was merely an image. Unable to leave the beauty of his reflection, Narcissus died. Like all mythology you need to accept the story by taking a leap of faith but it is not that far a cry from today's business and political leaders who exhibit traits of narcissistic personality disorder including egotism, vanity, conceit, or simple selfishness. Applied to a social group such as investment bankers, it is sometimes used to denote elitism or an indifference to the plight of others. Sound familiar?

 

 

Narcissus by Caravaggio
Narcissus gazing at his own reflection.

Blog by Steven Mintz, aka Ethics Sage, June 27, 2011

Dark Side of Chinese Capitalism

Reverse Mergers, Improper Accounting, a Lack of Transparency and Poor Governance Threaten the Recent Success of Capitalism Chinese Style

Is the Chinese capitalistic bubble about to burst under the weight of fraud investigations and back-door stock listings? The dark side of Chinese capitalism has become very apparent the past few months. I have previously blogged about the Chinese brand of capitalism using state-owned entities to control business operations. Most people expected these entities to present challenges to the success of capitalism. In fact, it is the privately and publicy-owned companies creating the regulatory stir.

Let's start with the "reverse merger." In a reverse merger, a Chinese (or any foreign company) is "bought" by a publicly traded U.S. shell company. The Chinese company assumes control and gets the shell's U.S. stock listing without the SEC's usual level of scrutiny of an IPO. It's a backdoor way of getting listed on  U.S. stock exchanges. The Public Company Accounting Oversight Board (PCAOB) recently reported that nearly three-quarters of the 215 Chinese companies listing in the U.S. from 2007 to early 2010 did so using the reverse merger.

The SEC has turned its attention to some accounting firms over their audits of Chinese companies with U.S. listings in order to follow through on the Commission's mandate to protect the U.S. investing public. Concerns exist over accounting practices, disclosure and transparency issues. Questions have been raised about the truthfulness of financing Chinese operations. Also, the audit profession is at risk over allegations of improper professional conduct that could lead to the filing of administrative proceedings against firms. The problem seems to be that some U.S. audit firms outsource accounting work to inadequately trained Chinese accounting firms, and China has blocked the PCAOB from inspecting audits onsite. What's worse is the alleged failure of U.S. auditors to verify that work by Chinese auditors conforms with U.S. auditing standards.

It was somewhat surprising to me to learn that it is mostly the publicly-owned Chinese companies that have come under scrutiny. Moreover, mostly small audit firms issue audit reports on the companies in question. From 2008 to early 2010, at least 40 U.S. firms with fewer than five partners and ten professional staff issued these reports. One explanation for alleged deficient audits might be the less sophisticated quality control systems in small firms including a lack of reviewing partner oversight of audits and vigorous staff training of audit staff.

The problem starts even before audits are performed. There is little or no vetting from underwriters and investors that companies typically undergo when they perform a traditional IPO. Here are some recent examples of the problem:

(1) Sino-Forest Corp., a Toronto-listed timber company, saw its stock tumble by 72 percent during June on accusations of inflated assets and sales, and

(2) China MediaExpress, an advertising entity, saw its audit firm resign in mid-March, saying it could no longer "rely on the representations of management." Its shares are no longer traded on Nasdaq following months of investor concerns over the size of its business and questions over its accounting.

The SEC reported that in March and April alone more than two dozen Chinese firms listed in the U.S. announced auditor resignations or other conflicts.

MediaExpress is larger than the other troubled Chinese companies and its international audit firm of Deloitte Touche Tohmatsu resigned in March, saying that it had raised concerns over "possible undisclosed bank accounts and bank loans," and "issues concerning the validity of certain advertising agents/customers and bus operators," among other issues, according to a MediaExpress regulatory filing verified by Deloitte. The firm also said it had lost confidence in the MediaExpress board of directors' commitment to "reliable financial reporting."

As if things couldn't get worse for Chinese companies listing shares outside mainland China, a regulator at the Hong Kong stock exchange, where many Chinese companies list their stock, warned investors in early June against rushing headlong to buy shares in Chinese companies, calling China "the new dot.com" of the investment world. Martin Wheatley emphasized the failure of investors to properly analyze the fundamentals and likened it to the run-up to the Internet stock boom of the late-1990s in the U.S. Wheatley is concerned about lax corporate governance procedures and its possible effect on the level of trust that has been grudgingly gained by Chinese listed companies in a country with deep-rooted ethical problems and notorious for product-safety scandals and fake goods.

I believe we are witnessing growing pains and the maturation process of Chinese state-owned companies that have been morphing into public companies with limited state ownership and are transitioning from a controlled environment to a more open culture where risks are taken, global competition exists, and the destructive temptations of the capitalistic ethic to pursue self-interest above all else has reared its ugly head. We need to give China time to work it out -- the Chinese way -- and be patient while strengthening oversight and approaching future IPOs of Chinese companies with a healthy dose of skepticism.

 Blog by Steven Mintz, aka Ethics Sage, June 22, 2011

LinkedIn and Now Groupon IPO: Caveat Emptor

Groupon Model Not Sustainable

Groupon filed its S-1 registration  statement last week with the SEC for the company's $750 million initial public offering. According to co-founder Andrew Mason, “After selling out on our original mission of saving the world to start hawking coupons, in order to live with ourselves, we vowed to make Groupon a service that people love using.” I'm not sure I know what this means but what I am sure of is these are not pearls of wisdom that would make me gravitate to a Groupon IPO, unless, of course I get in at the asking price (let's say $40 per share) and cash out in the first few days, at let's say $80.

The owners of Groupon saw what happened at LinkedIn two weeks ago and they want a piece of the action. After the LinkedIn IPO, I questioned whether we were headed for another market meltdown as social media companies look to go IPO, wait for a brief period of time, and then cash in while the getting is good. Let's look at what happened at LinkedIn in the two weeks since its IPO. LinkedIn shares were priced at $45 at the opening and the company raised $353 million. For the chosen few who got in at the ground floor (i.e., LinkedIn founders, investment banks, the well-heeled and well-connected), the gain was substantial as the IPO priced at $94.25 the end of the first day of trading, a 109 percent increase in wealth. Not a bad return on investment for one days' "work."  The results weren't so rosy for retail investors that were allowed in at an opening price of $83, up 84 percent from its issue price, but LinkedIn closed at $79.70 on June 3. My conclusion is that LinkedIn appears to have been an overvalued IPO, and that is bad news for long-term investors who are desperately needed to create a sustainable stock market.

Back to Groupon. If you look at sales, the company's prospects are bright. Sales increased from $3.3 million in the second quarter of 2009 to $644.7 million in the first quarter of 2011, according to the S-1 filing, as compared to $713,4 million for all of 2010 and $30.47 for 2009. However, given the company is currently losing a staggering $117 million per quarter, despite revenues of $644 million, Groupon will be burning through its cash almost as soon as it hits the company's account.

Groupon has been emphasizing growth and the consolidation of its market position around the world. However, the company seems to have ignored the cost equation and created a model that is not sustainable in the long run. The company said it expects its “operating expenses will increase substantially in the foreseeable future as we continue to invest to increase our subscriber base, increase the number and variety of deals we offer each day, expand our marketing channels, expand our operations, hire additional employees and develop our technology platform.”

CEO Mason set the tone in his letter that kicks off the IPO filing where he indicates that Groupon is focused on growth, and measures its success by metrics such as free cash flow, gross profit (Groupon’s actual take from its customer transactions, which was $280 million in 2010) and a third yardstick that is quite a mouthful: Adjusted Consolidated Segment Operating Income (CSOI). Those kinds of non-standard financial metrics were all the rage in the late 1990s tech bubble. Groupon discloses in its S-1  that the CSOI measurement reports the company’s operating income excluding several major expenses, including marketing and acquisition-related costs. Going by the nonstandard metric, Groupon pulled in nearly $60.6 million last year, much higher than the $3.5 million it reported in 2009. And in the first quarter this year alone, the company reported $81.6 million in adjusted CSOI. Groupon writes in its filing that it believes that the metric measures its financial health, excluding future operating expenses and noncash charges.

Accounting according to Groupon is strange indeed. Michael J. De La Merced, writing in DealB%K, an online publication of the NY Times, points out that those operating expenditures are very real costs, notably its huge marketing budget. "The company spent $263.2 million in marketing last year, an astronomical leap over the $4.5 million it reported for 2009."

Groupon's future is tenuous at  best. In the short term, Groupon will probably do well and may mimic Amazon's success. Amazon IPOed in 1997 when the company lost $27.6 million that year on net sales of $147.8 million. That's an 18% loss for Amazon compared to Groupon's, 18% loss. Coincidental? Amazon didn't report their first profit until Q4 2001. But, Amazon had the market all to itself at the beginning as it took Barnes & Noble quite a while to make its mark as an online book sales competitor. Groupon, on the other hand, already is facing competition from the likes of  LivingSocial.

Some have said that we have a new paradigm for commercial and service organizations. They work for money that works, not for profit and loss where losses and debt burdens can do damage for no good reason at all. In other words if you buy Groupon stock after it goes IPO, let the buyer beware. While the company is now experiencing rapid revenue growth, its operating margins are declining as a result of: decreasing per customer revenue; increasing costs to acquire customers; and increasing sales costs to run deals with smaller merchants to personalize the experience.

Are LinkedIn and Groupon harbingers of things to come for Facebook and Twitter? Are we heading for a social media stock bubble that will make the rich, richer while the poor do not share in the wealth and the middle class continue to get squeezed. I believe we will continue the recent pattern in the U.S. where the chosen few cash out before the bubble burst and the rest of us are stuck holding the collapsed balloon.

  Blog by Steven Mintz, aka Ethics Sage, June 7, 2011

Corporate Fraud in Chinese Company: Welcome to Capitalism

Fraud at Longtop Financial Affects Investor Confidence  in Stocks of Chinese Companies                 

This is the first of a two-part blog dealing with ethical issues that must be raised with respect to business practices in China and its growing role as a world economic powerhouse. Today I deal with the growing problem of fraudulent business practices by Chinese companies. Tomorrow's blog addresses the politically sensitive issue of software privacy.

A massive fraud at Longtop Financial, a popular Chinese software company, brings into question whether Chinese corporations are starting to show the stresses of competing in a more western-style model of business -- the publicly-owned corporation. The "cash balance" on Longtop's balance sheet, it turns out, was fake--a fiction created by the company's managers with bank complicity.

According to an extraordinary letter that Longtop's auditor, Deloitte, sent the company when it quit a few weeks ago and that was reported by Business Insider (see below), Longtop's banks sent out fake statements attesting to the company's fake cash balances. It wasn't until Deloitte's examiners actually physically visited the banks, and talked to other employees at the banks, that the fraud was discovered.

Floyd Norris at the New York Times reported on May 26 that the Longtop fraud fooled some of smartest hedge funds, mutual fund investors, and the New York Stock Exchange. It fooled the investments banks that underwrote Longtop's stock--and defended it until its demise under the guise of having conducted "due diligence" designed to set investors' fears to rest. And, for a long while, it fooled the very audit firm that is expected to protect the public interest -- Deloitte. In its audit report dated March 31, 2011, Deloitte points out that the firm had determined based on bank confirmations that it was appropriate to perform follow up visits to certain banks." According to the audit report,

            "The audit steps were recently performed and identified a number of very                     serious defects... [that led to] a second round of bank confirmations...                                Within hours however, as a result of intervention by the Company’s officials             including the Chief Operating Officer, the confirmation process was stopped                      amid serious and troubling new developments including: calls to banks by                             the Company asserting that Deloitte was not their auditor; seizure by the                 Company’s staff of second round bank confirmation documentation on bank             premises; threats to stop our staff leaving the Company premises unless they             allowed the Company to retain our audit files then on the premises; and then                seizure by the Company of certain of our working papers. In that connection,                       we must insist that you promptly return our documents."

According to Blodgett, on May 20 the Chairman of the Company, Jia Xiao Gong, called Deloitte's Eastern Region Managing Partner, Paul Sin, and informed him in the course of their conversation that “there were fake revenue in the past so there were fake cash recorded on the books. ” Jia did not answer when questioned as to the extent and duration of the discrepancies. When asked who was involved, Jia answered: “senior
management.”

Auditing standards in the U.S. (Statement on Auditing Standards No. 99) require that the auditor look for instances of fraud that were, in fact, identifed and which led to the resignation of Deloitte. Here are the reasons provided by Deloitte for its resignation from the audit of Longtop Financial: (1) the recently identified falsity of the Group’s financial records in relation to cash at bank and loan balances (and also now seemingly in the sales revenue); (2) the deliberate interference by the management in our audit process; and (3) the unlawful detention of our audit files. "These recent developments undermine our ability to rely on the representations of the management which is an essential element of the audit process; hence our resignation." Deloitte added that "we are no longer able to place reliance on management representations in relation to prior period financial reports. Accordingly, we request that the Company take immediate steps to make the necessary 8-K filing to state that continuing reliance should no longer be placed on our audit reports on the previous financial statements and moreover that we decline to be associated with any of the Company’s financial communications during 2010 and 2011."

The Longtop Financial fraud has broader implications for the U.S. and global stock markets than just one Chinese company committing fraud. There have been other stock fraud so that we should question whether this is just the tip of the iceberg with respect to the growing number of Chinese companies that list their stock on foreign exchanges. Given the rapid movement to a Chinese-style of western capitalism, the following question must be asked: Do managers of Chinese companies have the requisite discipline and core values to ward off the temptation to manipulate financial results that tend to make the company look healthier than it really is? We know little of the culture of Chinese companies from an ethical perspective. However, it is a critical assessment to make going forward so that the financial markets can develop the long-term confidence needed in corporate China to sustain international investment.

 Blog by Steven Mintz, aka Ethics Sage, June 1, 2011

 

Whistle-Blower Rewards Under Dodd-Frank Under Attack

Corporate America and Whistle-Blowing

A new bill in the House of Representatives proposed by freshman congressman Michael Grimm (R-N.Y.), would make "any whistleblower who has legal, compliance, or similar responsibilities for . . . an entity and has a fiduciary or contractual obligation to investigate or respond to internal reports of misconduct" ineligible for the whistleblower awards incorporated into the Dodd-Frank Financial Reform Act. This  would include chief financial officers. The Dodd-Frank law passed last year aims to give witnesses to securities fraud a monetary incentive -- starting at $100,000 -- to report wrongdoing to the Securities and Exchange Commission. Under an SEC proposal made in December, informants would collect 10% to 30% of wrongdoers' payout to the commission for enforcement cases that involve penalties worth more than $1 million.

National Association of Corporate Directors (NACD) President and CEO Ken Daly testified before the House Financial Services' Capital Markets and Government Sponsored Enterprises Subcommittee on the impact of whistleblower reward provisions in the Dodd-Frank Act and supported the proposed Grimm bill. He enumerated the unintended consequences that may result from the proposed SEC whistleblower regulations to implement Dodd-Frank. Under previous rules, the SEC could choose to reward whistleblowers, but was not required to provide monetary compensation. The main focus of  Daly's testimony was to recommend deferral of the proposed regulations until further study can determine the effectiveness of the provisions that already exist in the Sarbanes-Oxley Act.    

The first person to win protection under the Sarbanes-Oxley Act's whistle-blower provision was a CFO, David Welch, a former finance chief of Cardinal Bancshares. Welch had claimed he was fired after raising questions about the bank's accounting policies and internal controls. A government review board later rejected the Department of Labor's initial decision that Welch should get his job reinstated and collect back pay. Dodd-Frank's whistle-blower rules were designed to make the process more favorable to informants.

 This is not an easy issue from an ethical perspective. On the one hand I believe whistle-blowing should be encouraged if it helps to uncover corporate fraud and save the investing public from untoled losses. On the other hand, a top company official like a CFO should go through the chain of command including reporting to the CEO and board of directors when he or she suspects corporate wrongdoing. I think it's reasonable to amend Dodd-Frank to require those steps be taken first before blowing the whistle externally. One would hope the proper corrective action would be taken internally before it comes to that point --  assuming the allegations are correct.

I have previously blogged about what it takes to have an ethical corporate culture -- one that promotes financial responsibility and fosters ethical behavior. However, I do take exception to Ken Daly's cynical characterization of Dodd-Frank that, he claims, " has created 'a perverse incentive' for whistle-blowers to let a problem fester in order to collect a higher reward." Daly is guilty of the same kind of rhetoric we hear all too often from corporate America today that they are over-regulated. Well, look in the mirror! Who do you think is to blame? Might it be these very same corporations that gave us Fannie Mae and Freddie Mac, Countrywide and all the risky derivatives trading, the Enrons and WorldComs of our world -- OR, should we blame Congress that, for all its other faults, is trying to protect the very public it was sworn to serve?

  Blog by Steven Mintz, aka Ethics Sage, May 27, 2011

SEC Playing Around With its Mandate to Protect the Investing Public

Should the SEC Take Action to Expand Private Share Offerings?

Republicans in Congress want the SEC to raise the 500-shareholder threshold that separates a private from public-offering of stock, or else change the rule so that more sophisticated investors who understand the markets will not count toward the total. The SEC is considering whether to ease the decades-old requirement that private companies with 500 or more shareholders make lengthy financial disclosures and a rule prohibiting closely held companies from advertising their shares, known as the "general solicitation" ban. The 499-owner limit, which applies to firms with more than $10 million in assets, was created to ensure that shareholders get sufficient information about their investments. House Republicans argue that restrictions on private-stock sales and the costs of complying with SEC rules for public stock offerings are negatively affecting companies' ability to raise capital.

In my previous blog on the LinkedIn IPO, I warned that inflated post-IPO stock prices following the LinkedIn IPO, and the prospect of the same happening with similar public offerings that are expected such as at Facebook, might create the same kind of pressure to manipulate reported earnings that we saw during the dark days of Enron and WorldCom. Past history tells us that too many top executive never seem satisfied with merely meeting financial analysts' earnings expectations. Revenue manipulations occur all too often to enhance reported earnings, drive up the stock price, and enable the top executives to cash in on lucrative stock options. I fear that any loosening of the 500-shareholder limit on private placements will add fuel to the fire that lays dormant right now but just needs a spark to set it off ablaze once again.

Am I an alarmist? Wouldn't it be a good thing for the SEC to loosen the rules and facilitate growing companies' access to America's investment capital? At a recent congressional hearing, SEC Chairman Mary Schapiro was pressed to make regulatory changes to help small and medium-sized companies more easily raise capital without going public. Rep. Darrell Issa (R-Calif.), chairman of the House Committee on Oversight and Government Reform, pressed the cause of businesses that want to tap investors for money but are far from eager to make the many financial disclosures demanded of companies traded on the stock market. Now, when companies amass 500 or more shareholders of record they are required to register with the SEC and make an array of disclosures, including how much money they are making or losing and how much they pay their top executives.

What's wrong with this picture? Why should honest companies that act with integrity be concerned about making financial disclosures including those about executive compensation? What ever happened to financial transparency as the goal of financial reporting? Moreover, why should the SEC even entertain this argument in deciding whether to relax the current rules? After all, its regulatory mission is to protect investor interests above all else. Schapiro hit the nail on the head at the hearing when she said: "Too often, investors are the target of fraudulent schemes disguised as investment opportunities...and that such frauds accounted for 22% of the commission's enforcement cases in fiscal year 2010."

You may recall that Goldman Sachs pulled the Facebook private offering on January 17 because of concern that '''immense media attention''' could violate SEC rules limiting marketing of private securities. Issa contends the decision showed that private capital formation in the U.S. is increasingly difficult. He believes that reversing this trend and efficiently attracting capital to the best investment opportunities in the  U.S.  is a critical step that would facilitate a widespread economic recovery and the long-term viability of our global market position. The SEC sharpened its focus on how unlisted companies raise money after Goldman halted a planned offering of as much as $1.5 billion in Facebook Inc. shares to U.S. investors. The foreign placement that followed was hugely successful and many investment bankers lament the lost opportunity for Facebook to tap into domestic capital markets.

The SEC's job is not to facilitate the process of raising investment capital in the U.S. The fact is some private companies are deliberately trying to avoid the disclosure and other laws enacted over time to protect the interests of the investing public, and Facebook is a prime example. Even if we concede that it may be a better economic policy for America to not  limit the opportunity for private companies to remain private and raise capital without full disclosure, I believe companies like Facebook and Twitter, and all other private companies that choose to raise more funds privately rather than go public, have forfeited the right to set the rules of the game. They are part of a pursuit of self-interests system that encouraged their brethren to make risky investments with the public's money and that directly led to the financial meltdown of 2008. These technology and predecessor telecommunications companies and their investment bankers gamed the system and took actions that caused so much economic pain and personal misery for so many in the investing public -- that very same public the SEC is sworn to protect.

  Blog by Steven Mintz, aka Ethics Sage, May 25, 2011

Ethics Resources

Ethics Resources for Academics and Business Professionals

Business ethics researchers may want to check out the Ethics Resource Link on my blog site (http://www.ethicssage.com/) that identifies over thirty websites where you can obtain free information about ethics research, business ethics programs, codes of conduct, on-line ethics magazines, newsletters and other valuable resources for academic and business professionals. Also, some of my favorite blogs that deal with ethics, leadership, values-based decision making and accounting and auditing topics are referenced. Thanks to all my loyal supporters who read my blogs. I hope you find them stimulating, informative and enjoyable.

Individuals and organizations that want to learn more about what I do, expert areas for commentary, availability for speaking engagements, ethics consulting, or just to dialogue directly can e-mail me at steve@ethicssage.com.

Posted on May 15, 2011

Nothing Normal About AIG's "Normalized" Earnings

AIG's March 31 Quarterly Earnings Misleading Investors

AIG's reported "normalized earnings" for the quarter ending March 31, 2011 is anything but normal. Don't get me wrong. The company takes the same liberties as most others and defines normal however it wants. There are no specific accounting rules on how to determine that amount. In fact, the results can, and do in AIG's case, deviate significantly from what would have been reported under conventional generally accepted accounting principles (GAAP).  The differences are astounding. The reported net income attributable to AIG is $269 million (GAAP) whereas the after-tax operating income (normalized) is $2.030 billion. That is a 647 percent differential. How can that be?

		Three Months Ended March 31,
											% Inc.
			2011				2010				(Dec.)
Net Income Attributable to AIG		$	269			$	1,783				(84.9) %
Income from Discontinued Operations Attributable to AIG, net of tax			1,646				333				394.3
Net Loss on Sale of Divested Businesses, net of tax			(47	)			(76	)			(38.2)
Net Income from Divested Businesses, net of tax			6				484				(98.8)
Deferred Income Tax Valuation allowance (charge) / release			(563	)			821				-
Amortization of FRBNY prepaid commitment fee asset, net of tax			(2,358	)			(415	)			(468.2)
Net Realized Capital Gains (Losses)			(387	)			(229	)			(69.0)
SunAmerica DAC offset related to Net Realized Capital Gains(Losses)			11				3				266.7
Non-qualifying Derivative Hedging Losses , net of tax			(69	)			(107	)			35.5
Bargain Purchase Gain			-				332				-
After-Tax Operating Income Attributable to AIG		$	2,030			$	637				218.7

The numbers above were reported by AIG in its March 31, 2011 Financial Supplement that alerts the reader to read the report in conjunction with AIG's Quarterly Report on Form 10-Q filed with the SEC. The reason is the 10-Q reports the GAAP numbers only. AIG's Financial Supplement shows the reconciliation between GAAP net income and normalized earnings as required by Regulation G.  The numbers were included in a press release sent to analysts in advance of a conference call. The following explains AIG's reasons for normalizing its earnings: "Throughout this press release, AIG presents its operations in the way it believes will be most meaningful and useful… as well as most transparent… to the investing public and others who use AIG’s financial information in evaluating the performance of AIG. That presentation includes the use of certain non-GAAP measures."

Are investors supposed to have faith in the numbers provided by a company that needed a $182 billion bailout from the U.S. government? If that doesn't make you skeptical, read the following additional explanation:

"In light of the company’s significant divestiture and restructuring-related activities, AIG revised its definition of after-tax operating income (loss) (formerly adjusted net income) in the fourth quarter of 2010. AIG revised the definition in order to present and discuss its financial information in a manner most meaningful to financial statement users. AIG’s definition of aftertax operating income (loss) was revised to exclude income (loss) from divested businesses that did not qualify for discontinued operations accounting treatment, amortization of the FRBNYprepaid commitment fee asset, goodwill impairment charges arising from divestiture-related activities, the DAC offset associated with net realized capital gains (losses) for SunAmerica, and deferred income tax valuation allowance charges and releases. AIG believes that this revised measure of after-tax operating income (loss) permits a better assessment and enhanced understanding of the operating performance of its businesses by highlighting the results from ongoing operations and the underlying profitability of its businesses, without the distortive effects of the highly unusual events that have affected AIG since 2008."

So, AIG not only uses a non-GAAP measure to explain its results on a quarterly basis in reports to financial analysts that purportedly are most useful to investors, but the company even changed the way it defines the measurement of after-tax operating income in the fourth quarter of 2010. It even changed the name of the reported statistic from adjusted net income. Not surprisingly, most of the excluded items increased GAAP earnings to higher normalized amount. In fact, the increase from $269 million to $2.0 billion is 647 percent! To make matters worse, it's GAAP income went down 84.9% on a March 31 year-to-year basis.

The concept of transparent financial results implies a level of ethics not present in AIG's reporting. These are not statements of high quality that are clear, easily understood, candid and frank. They mislead investors into thinking AIG has made a remarkable recovery from its financial doldrums. I looked at its Statement of Cash Flows in the 10-Q and the all-important cash flows from continuing operations went from a positive $1.52 billion at 3/31/10 to a negative $6.54 billion at 3/31/11, or a 535 percent decline! 

On a broader scale, AIG's use of normalized earnings highlights a larger problem with accounting standards. We've been down this road too many times and the profession's still fails to clean up its act. Companies like Enron and WorldCom manipulated reported earnings to make it look like the company was doing better than it really was. Other companies routinely put their own spin on the numbers reported to analysts and investors on a quarterly basis. The profession has failed to address this issue; therefore, it is complicit with those companies that use normalized earnings to imply future results. As such, it has failed to live up to its responsibilities to protect the public interest.

  Blog by Steven Mintz, aka Ethics Sage, May 9, 2011

City of Montebello Accused of Misusing HUD Funds

Responsibilities of City Government and Auditor Shortcomings

Is Montebello the second coming of the City of Bell? Last year we learned about former City of Bell administrator, Robert Rizzo, who was accused of stealing from the treasury while paying himself a salary well in excess of $800,000. Los Angeles County District Attorney Steve Cooley filed charges against eight current and former Bell officials last September alleging that they misappropriated $5.5 million in public funds. Rizzo is charged with 50 counts of fraud, including 44 counts of misappropriation of public funds, six counts of falsification of records by an official custodian, three counts of conflict of interest and one count of public officer crime.

Now we have the City of Montebello where the U.S. Department of Housing and Urban Development (HUD) is looking for possible criminal activity regarding the city's use of federal grant money in its HUD HOME program. In 2010, HUD demanded that Montebello repay $1.3 million because the city gave a developer HOME money to help build a housing project with affordable units and reported to the federal agency the project was complete, but construction had not started. The city is currently dealing with the suspension of funding by federal housing officials and the demand for repayment of a total of $5 million in grants.

According to a story written by two L.A. Times reporters on April 28, Abby Sewell and Jessica Garrison, departing city administrator Peter Cosentini said in a memo to City Council members that some of the city's past handling of HUD funds "may border on criminal." Whittier Daily News staff writer Bethania Palma Markus quoted James Todak, special agent in charge of HUD's Office of Inspector General, as saying,  "We're looking at it, and if there's criminal activity we'll work with the U.S. Attorney's Office and prosecute." HUD officials declined to describe Montebello's 31 violations but said they will outline them in a report that will be released later in the month.

The city is also facing several other probes by outside investigators. State Controller John Chiang last week announced his office will audit Montebello's books, citing concerns over delinquent financial reporting, use of restricted funds to cover operating costs and the discovery of two off-the-books bank accounts. It’s the first such audit since Chiang investigated the city of Bell last year and found massive misconduct.

The ethical issue in the Montebello situation is one of accountability. The City Finance Department prepares a Comprehensive Annual Financial Report (CAFR) that includes an independent auditor's report. The CAFR for the fiscal year ended June 30, 2010, includes a letter to the Mayor and City Council signed by Interim City Administrator Peter Cosentini that identifies the city's responsibility for the accuracy, completeness and fairness of the financial statement presentations. The letter clearly states the information is accurate and all disclosures are adequate "to the best of our knowledge." The audit report prepared by the independent firm of Eadie & Payne provides a clean opinion with respect to the City's financial statements.

It is interesting to note that the audit report is dated April 7, 2011, more than nine months after the fiscal year end of June 30, 2010. This time lapse between the date of the statements and issuance of the report is much longer than usual but probably can be explained by the ongoing HUD investigation. The financial statements include a footnote to the statements (# 17: Subsequent Events) that point to a December 22, 2010 notification by HUD that during its review of the City's books and records it discovered that:

"[T]the City could not provide sufficient documentation with respect to a $1,300,000 HOME expenditure. The City was ordered to repay HUD $1,300,000. The City has demanded payment from the developer who failed to provide the City the proper documentation to support the expenditure and has recorded a $1,300,000 receivable in its Capital Projects Fund. On February 18, 2011, the City was notified by HUD during its review of acquisition and related costs of property located at 124 South Sixth Street, Montebello, CA, that the City could not provide documentation and support regarding the City's acquisition of the property. The City was ordered to repay HUD $889,106. The City is currently negotiating a payment plan with respect to the above amounts due. The City has reflected these amounts due as notes payable - due within one year in the Statement of Net Assets - governmental activities."

Eadie & Payne's audit report does not mention the HUD investigation or payments already ordered with negotiated payments in the works. It also does not mention the city's failure to provide documentary support for the $1.3 million expenditure under the HOME program and its demand to be repaid that amount by the developer. Eadie & Payne may not have, in fact, violated generally accepted auditing standards because the financial statements include the appropriate footnote disclosure. However, I believe the firm failed in its ethical obligation to protect the public interest by not inserting a separate paragraph in its audit report about the HUD matter. The city already is reeling from a $1.6-million deficit this year, on top of $16.8 million that the general fund owes the city redevelopment agency as part of a highly unusual loan the council authorized last fall. How much longer can it be before the city of Montebello goes bankrupt as did the city Bell? The fact is Montebello's problems jeopardize its ability to continue to operate without outside intervention by the state and that should have been addressed by the auditors.

 Blog by Steven Mintz, aka Ethics Sage, May 4, 2011

Are Businesses Over-Regulated or Is It Necessary to Protect the Public Good?

The Conundrum of Promoting Free Markets and Unethical Behavior

One of the core values in the mission statement of the Tea Party is to promote a free markest by reigning in government interference in the form of excessive regulation that limits individual and economic liberty. On February 9, 2001, the U.S. House of Representatives Committee on Oversight and Government Reform issued a preliminary report, Assessing Regulator Impediments to Job Creation. The report is based on almost 2,000 pages of letters from business groups that say government red tape is deeply harming the competitiveness of American industry and contributing to unemployment, especially in the manufacturing sector. The full report can be found at: http://www.scribd.com/doc/48523377/Assessing-Regulatory-Impediments-to-Job-Creation-Issa-Report-February-2011. The report comes as President Obama has vowed to eliminate unnecessary regulations, ordering a broad review of current government rules “to remove outdated regulations that stifle job creation and make our economy less competitive.”

Issa’s report cites an estimate from the National Association of Manufacturers that “structural costs imposed on U.S. manufacturers including regulation create a 17.6 percent cost disadvantage when compared with nine major industrialized countries.” The issue of cost disadvantage is important because Obama has made “winning the future” by making American business more competitive with foreign industries a top priority.

The issue of whether U.S. business are overly-regulated begs the question of why such regulation is needed in the first place. Our free market economic system depends on the exercise of ethical behavior by corporate officials to provide for the public good. Absent decision making based on ethical values such as honesty, integrity, and transparency, the system cannot be trusted to allocate resources in the best interests of society. The root cause of such problems is the pursuit of self-interests to the exclusion of all others. The financial crisis of 2008 was triggered by predatory lending practices and risk-shifting behavior that all but tossed aside the notion that banks and financial instituions have an ethical obligation to those who borrow money. Banks have an ethical obligation to be honest and candid about the inherent risks to borrowers of certain mortgage (subprime) loans and to fully disclose hedges against future nonpayment made by the holder of the mortgage through the purchase of credit default swaps.

It is important to remember that Adam Smith connected ethics to economics. Smith came to his philosophy of economic behavior described in The Wealth of Nations through his view of moral behavior espoused in his first book, The Theory of Moral Sentiments. Smith, who is generally regarded to be the founder of free market economics, posited that rational self-interest informed by moral judgments based on fairness and justice would lead to promoting the best interests of society guided by the invisible hand of the marketplace.

The self-serving and unethical conduct by commercial and investments banks led to passage of the Dodd-Frank Financial Reform Act by Congress that extends the regulatory arm of the government to areas including consumer protection, systemic risk oversight, executive compensation, and capital requirements. It is estimated that the act mandates nearly 250 regulations and 70 studies.

The Sarbanes-Oxley Act of 2002 was passed by Congress in response to a large number of business and accounting frauds at companies such as Enron and WorldCom that cost taxpayers billions and shredded 401-K and other retirement investment accounts. The Act added another layer of oversight of the accounting profession -- the Public Company Accounting Overight Board -- and imposed onerous internal control assessment costs that many credit with the flight of foreign companies from the U.S. stock market.

The Foreign Corrupt Practices Act of 1977 was passed after the disclosure of widescale bribery of foreign government officials by U.S. multinationals to gain business abroad. The antibribery act imposes disclsoure and internal recordkeeping requirements on U.S. businesses doing business outside the U.S.

Businesses claim these and other regulations impose excessive compliance costs that mitigate against job creation and economic growth. That may be true and it is unfortunate but corporate America has no one to blame other than themselves for decades-long self-serving behavior born out of greed with no accountability to shareholders who are ultimtaely harmed by such behaior and the public that has helplessly stood by and watched the enormous loss of wealth in our society. 

 Blog by Steven Mintz, aka Ethics Sage, May 2, 2011

Demand for Accounting Graduates on the Rise

Ethical Expectations for Accounting Professionals

According to the Occupational Handbook 2010-2011 published by the U.S. Bureau of Labor Statistics (BLS), accountants and auditors are expected to experience much faster than average employment growth through 2018. Job opportunities should be most favorable for those with a professional certification such as Certified Public Accountant (CPA). According to the BLS study, about 279,400 new jobs will be created during the next ten years as the economy rebounds, the increase in new businesses, changing financial laws (Dodd-Frank Financial Reform Act) and corporate governance regulations (Sarbanes-Oxley Act), and increased accountability imposed on accountants to protect an organization's stakeholders. Another factor is the continued globalization of business that will lead to more demand for accounting expertise and services related to international trade and accounting rules and international mergers and acquisitions. Additionally, there is a growing movement towards International Financial Reporting Standards (IFRS), which uses a judgment-based system to determine the fair-market value of assets and liabilities, which should increase demand for accountants and auditors because of their specialized expertise. To access the full report go to the following link: http://www.bls.gov/oco/ocos001.htm#outlook. 

I have previously blogged about the transition from U.S. GAAP to IFRS in the United States (see: http://www.ethicssage.com/2010/12/international-accounting-standards-for-almost-40-years-a-movement-has-been-underway-to-establish-one-set-of-international-ac.html). The ongoing effort to converge the two sets of standards is supposed to lead to full IFRS adoption in the U.S. about 2015. CPA firms need to gear up in the next few years to meet the need for accountants and auditors who are educated in IFRS compliance. I teach an International Accounting course in the Masters of Accountancy program at the California Polytechnic State University at San Luis Obispo. I am mindful of the need for our graduates to be well-versed not only in how IFRS standards differ from U.S. GAAP but also how cultural dimensions influence business and accounting practices, and ethics standards around the world.

The accounting profession has a high set of ethical standards. Those standards are best illustrated by the following statement from the landmark ruling in United States v. Arthur Young & Co., 465 U.S. 805 (1984):   "By certifying the public reports that collectively depict a corporations financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant [465 U.S. 805, 818] performing this special function owes  ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This "public watchdog" function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust."

In order to meet the ethical expectations embodied in the Supreme Court decision, auditors must put the interests of the public ahead of those of the client, an employer, and one's self-interests. The accounting profession is the only profession where the public interest trumps all others. Lawyers owe their ultimate allegiance to the client and doctors to their patients. Therefore, information about these groups is confidential and must not be disclosed although reporting obligations do exist for doctors and lawyers when the public health and safety is at risk.

Accounting graduates need to be sensitized to their ethical obligations as professionals. These include acting with integrity and not allowing the client or one's employer to make the final call about what should and should not be included in the financial statements and how it should be reported. Courage is the ethical value that enables accountants and auditors to withstand client pressures to manipulate financial statement numbers.

The public places its trust in accountants and auditors to act with honesty and integrity. Most investors do not understand the complexities inherent in GAAP. They expect accounting professionals to ensure that the financial statements accurately portray financial position, results of operations, and changes in cash flows.

Increasingly, accounting students are expected to be educated in ethics at the university level to meet state board of accountancy educational requirements to sit for the CPA Exam. Several states, including Colorado, Maryland, Nebraska, New York and Texas, have laws on the books requiring three units of ethics education. California has gone beyond those states in SB 819 that calls for ten units of ethics education starting in 2014. I am a member of the state board committee to define the scope and content of those units. It's a daunting task to say the least, but we recognize that the public must be protected from future ethics meltdowns that existed in the financial crisis of 2008 and the failure of companies such as Enron and WorldCom.

Here's my advice to accounting students who aspire to become accounting professionals. Understand your ethical responsibilities and the virtues needed to meet those obligations. You should incorporate them into everything you do beginning with developing sound work habits in college. The ancient Greeks identified virtues as positive traits of character that inform decision making. We develop these virtues through practice and reflection. It should become a habit and influence all actions and decisions both in your personal and professional lives.

Blog by Steven Mintz, aka Ethics Sage, April 30, 2011

Outsourcing Jobs and Taxes

How US Corporations Avoid Paying US Income Taxes

We're all aware that US corporations outsource jobs to countries such as India and the Philippines to lower costs and increase profits. A major concern is another practice sanctioned in the U.S. Tax Code that allows companies to avoid paying US income taxes on profits earned by foreign subsidiaries until and unless such amounts are repatriated to the US parent. The technique used to defer taxes payable to the US government on profits earned abroad is known as transfer pricing. It has been estimated that the deferral of tax payments may be costing the US Treasury $100 billion or more each year. This has become a politically hot topic as we begin the 2012 election year cycle.

Here's how it works. Say you have a US company and it sets up a subsidiary in Ireland. Let's assume the US company ships raw materials or semi-finished (even finished) goods to Ireland. The subsidiary operates as a separate entity so a price has to be established for the shipment. Ireland has one of the lowest income tax rates on corporations in the world (12.5%) whereas the maximum rate is 35.0% in the US. The goal of the US parent company is to minimize worldwide taxes thereby maximizing global profits. Let's assume the raw materials cost $1 million. The US company charges the Irish subsidiary $1.1 million even though it could sell the materials for as much as $2 million in the US had the raw materials or semi-finished product been kept at home. The US company earns $100,000 in profit, pays the US government $35,000 in taxes ($100,000 x .35), and nets $65,000.  Now, the Irish subsidiary sells the product it received from the US company at a cost of $1.1 million, to customers in Ireland and elsewhere for what the product is really worth -- $2 million. The subsidiary earns $900,000 in profit, pays the Irish government $112,500 in taxes ($900,000 x.125), and nets $787,500. The total worldwide profits are $852,500 ($65,000 + $787,500).

However, had the US company not set up the Irish subsidiary and simply made and sold the product in the US, its profits would have been $1 million ($2m-$1m) and paid $350,000 taxes to the US government ($1 million x .35) thereby netting $650,000 or $202,500 less than in the transfer situation ($852,500-$650,000). The US government is "cheated" out of $315,000 in taxes: $350,000 it should have received less the $35,000 it did receive. If we add some zeroes to the total value of such transferred goods in our hypothetical company and add to it the same effect that is occurring in hundreds of US companies, then we have our estimated $100 billion in tax revenue lost by the US Treasury. Let me summarize the data.

                    US Profit w/o Transfer     US Profit w/Transfer  &   Irish Sub Profit    

Sales                     $2,000,000                      $1,100,000                        $2,000,000               

Cost                       (1,000,000)                      (1,000,000)                       (1,100,000)   

Profit                    $1,000,000                     $    100,000                        $   900,000

Taxes            (.35)  $350,000          (.35)  $       35,000             (.125)   $  112,500

                                                                                                                  (paid to Irish gov't)

  Lost Tax Revenue to US Treasury $315,000

I previously blogged about the fact that G.E. reported worldwide profits for 2010 of $14.2 billion of which only $5.1 billion came from US operations. The company not only paid no US tax but it claimed a tax benefit of $3.2 (http://www.ethicssage.com/2011/04/ge-pays-no-us-taxes.html).  About 30% of GE's business and 46% of its employees were overseas in 2000. Today it is 60% and 54%, respectively.

A similar income-shifting result occurs in a different transaction when a pharmaceutical or technology company -- Google for example -- sells or licenses the foreign rights to intellectual property developed in the US to a subsidiary in a low-tax country. The result is foreign profits based on the technology get attributed to the offshore unit, not the US parent.

In the US, Section 482 of the Internal Revenue Code governs transfer-pricing rules. The Code permits the IRS to redistribute the profits between the US company and its foreign subsidiary if it believes tax evasion is occurring. The IRS prefers that all transfers among related entities take place at "arm's-length" prices, which are defined as prices that would be obtained between unrelated entities.  The problem, of course, is how to determine what an arm's-length price is. Disputes between the IRS and a company can take years to resolve. In fact, on September 11, 2006 , the IRS announced it had successfully resolved a transfer pricing dispute with GlaxoSmithKline. The case represents the largest tax dispute in the history of the IRS. Under the settlement agreement, GSK paid $3.4 billion to resolve the parties' long-running transfer pricing dispute for the tax years 1989 through 2005.

Transfer pricing is at the core of the current debate about whether US corporations pay their fair share of taxes to the US  Treasury. There are arguments on both sides of the issue. Those who defend the deferral practices believe:

• US corporate tax rates are among the highest in the world and promote offshore activities and discourage the repatriation of profits
• US companies locate overseas to better serve growing markets such as in Brazil, China and India and to remain globally competitive not for tax advantages
• US companies need to be competitive with foreign multinationals many of which operate in countries with a "territorial" tax treatment of foreign earnings that largely exempt these active earnings from home country taxation

Those who criticize US multinationals for using transfer pricing practices point out they shift income and tax payments outside the country thereby denying the Treasury of needed tax revenues and those practices negatively affect the economic recovery and future growth. Also, income-shifting techniques promote outsourcing of jobs, capital, and even know-how.

What is the answer to the dilemma? One suggestion is to lower the tax rate to 25% or less. Bear in mind corporate tax rates in the US range from 15-35% so the 25% would be the upper limit. Supporters point to low tax corporate federal tax rates in countries such as Canada (11-16.5%), Germany (15%) and the UK (20-26%) . China's corporate tax rate is 25% however in some cases it can be lowered to 15%, if the enterprise is in an industry promoted by the Chinese government (High technology/New technology companies, for example). China's policies raise questions whether the US can remain competitive when the governments in some countries subsidize business practices? That's a subject for another blog.

One implication of lowering the US corporate income tax rate to 25% or less is the earlier repatriation of profits and encouraging companies to set up operations and hire workers in the US. The result could be to increase net tax revenues to the Treasury even though the rates go down. I believe this matter should be given the highest priority by Congress because doing nothing, our usual approach to complicated, politically controversial issues, will lead us down the road of falling further behind countries like China. We need to find a way to: create new jobs in the US and not overseas; create an environment for sustaininable economic growth; and get to the point where we can start to pay down our enormous debt.

Blog by Steven Mintz, aka Ethics Sage, April 21, 2011

G.E. Pays No US Taxes

G.E. Earns $14.2 billion BUT Pays No US Taxes

NY Times reporter David Kocieniewski reported on March 24 that G.E. reported worldwide profits for 2010 of $14.2 billion of which only $5.1 billion came from US operations. The company not only paid no US tax but it claimed a tax benefit of $3.2 billion (see: http://www.nytimes.com/2011/03/25/business/economy/25tax.html?_r=1). According to the Times story, while the top corporate tax rate in the United States is 35 percent, companies have been increasingly using a maze of shelters, tax credits and subsidies to pay far less. Moreover, even though the financial crisis led G.E. to post a loss in the US in 2009, regulatory filings show that in the last five years it has accumulated $26 billion in American profits, and received a net tax benefit from the I.R.S. of $4.1 billion. How can this be? First, contrary to some reports all foreign tax rates abroad are not greater than the rates in the US. Second, tax law permits American companies to pay no taxes as long as the money remains overseas. So, GE makes their money overseas and, by the way, hires a lot of foreign labor, and then keeps the money in those foreign countries to avoid paying taxes in the US. It’s not a very good deal for the American taxpayer.

I considered the ethics of GE’s policy to avoid paying US taxes. On the one hand what the company is doing is legal and it is done by many other US companies. But, does that make it right? Milton Friedman posited a long time ago that the only responsibility of a corporation is to maximize shareholder wealth. GE’s tax approach certainly meets that standard. In fact, it is totally consistent with GE's mottos: "We bring good things to life" and "Imagination at Work." Yes, good things for G.E. and its top executives, and its failure to pay US taxes does depend on accounting creativity.

The ethical problem is it creates an un-level playing field since it’s difficult, to say the least, for individual taxpayers to do the same thing. It’s a fairness issue. Why should a US company be able to avoid paying taxes by keeping their money overseas while individual taxpayers cannot? If a US taxpayer invests in a foreign mutual fund, for example, the reported dividend income and capital gains gets taxed. There may be a foreign tax credit if any taxes are paid to the foreign government on earned income.

The ironic part of the story is that President Obama designated G.E.’s chief executive, Jeffrey Immelt, as his liaison to the business community and as the chairman of the President’s Council on Jobs and Competitiveness. In announcing Immelt’s appointment in January Obama said: “He understands what it takes for America to compete in the global economy.” True, if competing in the global economy means outsourcing US jobs overseas and avoiding paying US taxes.

 Blog by Steven Mintz, aka Ethics Sage, April 2, 2011

Ernst & Young and Social Network Recruiting

EY Using Facebook to Attract Students

As an accounting/ethics professor in college, I was interested to learn that Ernst & Young, one of the four largest public accounting firms in the world, has discovered facebook as a way to attract student interest in a career with the firm. The firm is meeting the students where they "live," online. Based on market research and analysis, Ernst & Young has determined that more than fifty percent of its target recruitment audience said that they would be interested in receiving more information about potential employers on their mobile devices. A mobile version of Ernst & Young’s Careers site also launched last fall at http://www.ey.mobi/US/en/Careers/Mobile-Careers---Home.

EY’s facebook page (59,993 likes as of February 23) features a short six-question quiz which students can receive on their mobile phone. Anyone can take the quiz, but to win a prize, you have to meet the eligibility requirements (see http://www.facebook.com/ernstandyoungcareers) Every Monday, from February 7 to April 4, the questions change. Participants are invited to take all the quizzes and can retry any quiz as many times as they want, with only their best ranking from each week recorded. According to America's Leader for Branding and Communication for Recruiting at E&Y, Deborah Compagner, when the quiz is all over, the top three scorers will each win an iPad. The top scores are determined by the highest number of correct answers combined with the best times.

According to the online publication accounting web (http://www.accountingweb.com/topic/education-careers/new-way-attract-accounting-talent-ey-might-be-something-big), the firm wants a meaningful outreach to the next generation of accountants, using a tool with which students are comfortable. The quiz is part of a social media connection to those seeking careers in accounting in the near future as well as to those who are looking for career direction. E&Y wants to drive home its brand as a place where talented individuals want to work. Dan Black, America's director of campus recruiting for E&Y, said "We want to find the best and brightest, for internships and for full time jobs." Black said his firm has been on facebook for nearly five years, so this campaign is more than just a mobile app. "It adds to our accessibility and draws attention to our site."

Now in its third week of this campaign, Compagner said the response to the quiz has been promising. "We've gone through recruiting offices on campus to promote this and the results have been great." As noted above, when the contest is over, three winners will be given iPads.

I have looked at the EY career page on facebook and it is quite informative. Students can e-mail questions about internships, full-time positions, the CPA exam, the accounting profession and so on.  The responses are quite helpful in providing direction for students and suggestions on where to go for more information on recruiting and career issues.

I have thought long and hard about EY’s use of facebook. I know some of my students will read this blog and consider what I have said. I want to be fair to the firm and what it is trying to accomplish. I believe the use of social media to attract students while at the same time providing valuable information is a great idea. Whoever thought of it should be rewarded. However, in the interest of creating a dialogue I ask the question of whether using the quiz as a way to attract talent to EY and dangling an iPad as the reward is an ethical action? It's not only the iPad that concerns me but the blatant commercialism of the effort. What message does it send to impressionable students that firms have giveaways to get what they want? Could that translate into the attitude that we should giveaway unqualified audit opinions to keep a client happy? Then again, maybe I'm reading too much in it. If you believe that is the case, please respond so we can get a dialogue going on this important issue that may revolutionize student recruiting in the public accounting profession.

US Accounting Standard Setting

FASB and FASB-Lite

Do we really need more bureaucracy in accounting standard setting? On January 26 a blue-ribbon panel submitted a report to FASB’s parent organization—the Financial Accounting Foundation (FAF)—recommending significant changes to the future of accounting standard setting for private companies, including a separate standard-setting board. The panel concluded that “there are urgent and growing systemic issues that need to be addressed in the current system of U.S. accounting standard setting,” the report states. FAF is expected to discuss this report at its Feb. 15 meeting. The panel believes that “the system should focus on making exceptions and modifications to U.S. GAAP for private companies that better respond to the needs of the private company sector rather than move toward a separate, self-contained GAAP for private companies or a wholesale reorganization of GAAP,” at least in the near term, according to the report. The report recommends establishing, under FAF’s oversight, a separate private company standards board to help ensure that appropriate and sufficient exceptions and modifications are made, both for new and existing standards. The new board would work closely with FASB to create a coordinated and efficient standard-setting process but would have final authority over such exceptions and modifications. I call the proposed new board “FASB- Lite.”

This makes no sense at all – at least not now. The SEC has indicated that effective 2015, US accounting standard setting would change for public companies because we would adopt International Financial Reporting Standards (IFRS) in lieu of US GAAP established by FASB. While a final decision has not been made, there is great pressure on the SEC to transition to IFRS because those standards have already been adopted in the European Union and over 100 countries use IFRS. Why not wait until the SEC makes a final decision that may come as early as 2012, before creating another bureaucracy? If we adopt IFRS, as we should do, then FASB can become the standard setter for private companies.

On a personal note, some claim that we have the best accounting standards in the world and shouldn’t move to IFRS. Our standards are rules-based and allow for lots of wiggle room around the rules. IFRS is principles-based and seem to create stronger ethical reporting standards. Now, that doesn’t mean IFRS are better. However, we have to look at the evidence and concede that the number of accounting frauds over the years by companies that applied US GAAP seems to contradict the assertion that we have the best standards in the world. Unless you want to say we have the least ethical business and accounting practitioners in the world.

 

IRS Whistleblower-Informant Award

 You Can Whistleblow for the IRS

Last week I blogged about whistleblowing provisions in the recently passed Dodd-Frank Financial Reform Act. Today, I turn my attention to our friends at the IRS.

Did you know the IRS has just made it easier for whistle-blowers to collect rewards for turning in big-time tax cheats? The agency new rules are designed to recover the estimated $2 million (a figure that is probably too low) of taxes. Under the old rules, whistle-blowers could get rewards only if their tips resulted in businesses or individuals paying additional taxes. The new rules qualify whistle-blowers for rewards if their tips prevented businesses from claiming fraudulent refunds.

I don't get it. You mean a tipster can contact the IRS and inform them a company or individual is about to file a false tax return? Then, the IRS will contact the company and check it out before the return is filed? The company or individual will, of course, admit to the potential wrongdoing and then the IRS will pay the reward. Huh? Maybe I am missing something here but this makes no sense. Putting aside the ethical issue of loyalty and whether a tipster is acting in his or her own interests as a motivating factor rather than the good of society, is this the kind of behavior we want to encourage?

Actually, I can see one benefit of extending the whistleblowing program and encouraging more tipsters to come forward and claim their awards. We can significantly reduce the unemployment rate if this becomes a national phenomenon. Thousands can be put back to work. Colleges can offer new programs on how to develop a credible tip. I can envision the course now -- Whistleblowing 101. Former tipsters can come into the class and share their experiences. An IRS agent can present on why it's important to come forward. You know, it's your civic duty. The final exam can be to investigate some company or person and send a tip to the IRS. The higher the award, the higher the final course grade.

For those of you who are interested in pursuing this new career, go to the IRS website for specific details (http://www.irs.gov/compliance/article/0,,id=180171,00.html).

 

Foreign Corrupt Practices Act

The UK Bribery Act

I previously blogged about the U.S. Foreign Corrupt Practices Act (FCPA) and the Justice Department and SEC's expanded investigations of possible bribe payments in connection with contracts Hewlett Packard obtained in Russia. The payments may have violated the Act that prohibits persons, entities, and certain foreign entities (mainly issuers of securities on a US exchange) from making bribes or offering any inducement for the purpose of obtaining or retaining business with a US firm. The Act extends to anyone transacting business while in the US. Basically, if the payments are designed to induce a foreign party to make a decision that might not normally be made, for example, awarding a contract to the payer of the bribe, then it violates the FCPA. Payments that are made to induce foreign parties to do what they should be doing anyway (i.e., payments to custom officials to let exported goods into the foreign country), do not violate the FCPA and are considered a facilitating or "grease" payment.

Now, the UK has passed its version of the FCPA known as the Bribery Act. It is more sweeping than the FCPA because, in addition to prohibiting illicit payments to foreign officials, the Act bans bribes between private business people. It applies even if the person making the payment doesn't realize the transaction is a bribe. In other words, ignoarnce of the law is no defense. The Bribery Law prohibits grease payments, small bribes common in some countries to get mail serviced, phone hook-ups or other services that otherwise would be delayed.

US companies are concerned because they fear treating business contacts to an expensive dinner or sporting event could be considered bribery under the UK Bribery Act that covers any company doing business in Britain, regardless of where the company is based. US companies see this as a double whammy since it comes on top of the recently passed Dodd-Frank financial-reform bill. A provision of that Law entitles whistleblowers to share in money collected by the SEC in fraud and corruption cases. Some companies fear employees will have little incentive to report suspected bribery internally when they could ultimately gain a windfall by taking their companies directly to the SEC.

In reflecting on concerns about the FCPA, UK Bribery Act and Dodd-Frank law I was struck by how much time US companies give to worrying about the provisions of these laws that may subject them to fines, penalties and, in some cases for some people, jail time. Wouldn't it be a lot easier and ultimately much more beneficial to our economy and society if top company officials simply created an ethical environment that promotes following all laws and acting ethically at all times? I recall a statement by Benjamin Disraeli, the noted English novelist, debater, and former prime minister: "When men are pure, laws are useless; when men are corrupt, laws are broken."

Audit Committees

Audit Committees and Corporate Governance

In the aftermath of accounting scandals at companies such as Enron and WorldCom, Congress passed the Sarbanes-Oxley Act that strengthens corporate governance mechanisms. One important requirement is for the audit committee of the board of directors  to be completely independent of  management. In the accounting scandals, the audit committee either didn't know about the fraud or chose to look the other way. A conscientious and diligent committee is an essential ingredient of an effective corporate governance system -- one that takes its role in financial statement oversight to heart and follows basic principles of responsibility, accountability, and transparency.

The Audit Committee Institute at the international accounting firm KPMG, recently issued "Ten To-Do's for Audit Committees in 2011." The msot important are: (1) Focus on financial reporting and strong internal controls; (2) Review the company's whsitleblower processes and compliance program; (3) Understand the significance of risks to  the company's operations and financial reporting; (4) Consider whether the company's disclosures provide investors with the information needed to understand the state of the business; (5) Set clear expectations for the internal audit function and communication with the external auditors; and (6) Understand the audit committee's role in information technology.

There can be no doubt that a company would act more responsibly if  its top officers -- the chief executive officer and chief financial officer -- embrace these goals and make them part of the corporate culture.

 

Government's Stepped-up Efforts to Curb Fraud

Looking at Criminal Fraud

On Monday, December 6, 2010, the Justice Department charged hundreds of people in criminal and civil financial fraud cases in an effort to cut down on investment scams such as Ponzi schemes.  The Bernie Madoff affair is the "mother of all Ponzi schemes" as I previously blogged. However, it doesn't stop with Madoff. Government officials claim that these and other schemes harmed more than 120,000 people and that criminals stole thousands and sometimes millions of dollars from victims.  There appears to be three groups of scammed investors. One group are those that trust the scam artist and may even have a personal relationship with that party just as did those harmed by Madoff's scams. Another group appears to be well-heeled individuals such as those in the sports and entertainment fields. These folks may be ready targets because they have a lot of money to invest, typically know little or nothing about how to invest it, and some may also rely on outside parties to advise them on investments only to find that they, too, have been scammed. Then there are the least among us able to provide for our own future retirement such as the elderly who believe the promises of huge returns only to lose their life savings.

What leads someone to take advantage of others in the worst kind of way? Are they good people who just got greedy? If that's the case they are not good people. They pursue their own self-interests to the detriment of others. They rarely consider the consequences of their actions on others. They look for any advantage -- an opening -- to build the level of trust needed to scam another party in the grossest way.

What can we do about it as a society? Ponzi schemes and the like are indicators of a greater malaise in our society where too many people look for ways to get money without working hard to get it. In other words, they earn their money the new way -- scamming -- not the old fashioned way as the veritable, old brokerage house of Smith Barney used to say. You remember -- we eeaarn it!

Every day we seem to hear about some kind of financial fraud whether it is investment scams, financial statement fraud, Medicare fraud, city officials like those at Bell city in California stealing the public's money by pulling in outrageous salaries and other benefits. Then there are those who use their position and influence to enhance personal wealth such as government officials. Let’s not leave out the corporate-types who walk away from their jobs with multi-million dollar severance packages even in the face of a financial meltdown.  This is just the tip of the iceberg. We have a real problem in the U.S. and it's getting worse.