Is the CEO or CFO lying during the quarterly earnings call? How can you tell?
David F. Larcker and Anastasia A. Zakolyukina of the Stanford Graduate School of Business turned to the rich data set of quarterly calls and subsequent financial restatements. After studying Q&A sections of transcripts of hundreds of calls with CEOs and CFOs, the researchers then looked to see whether financial statements being discussed were substantially restated at some point after the call. If they were restated, Professor Larcker and Zakolyukina (a PhD student at the school) reasoned that the executive had been “less than candid.”
They found that answers from deceptive executives:
have more references to general knowledge
fewer non-extreme positive emotions
fewer references to shareholders value and value creation
use signi significantly fewer self-references, more third person plural and impersonal pronouns
more extreme positive emotions
fewer extreme negative emotions
fewer certainty and hesitation words
Their performance is only 4% to 6% better than a random guess. So it’s statistically significant, but not determinative.
“Power corrupts, as Lord Acton famously said, but so does powerlessness. Though powerlessness might not result in the egregious violations associated with arrogant officials who feel they are above the law, it is corrosive.”
Managers spread powerlessness by limiting information.
They compound the insult by sneaking unpopular decisions through when they think no one’s looking.
Powerlessness burgeons in blame cultures.
The powerless retaliate through subtle sabotage. They slow things down by failing to take action
Negativity and low aspirations show up in behaviors psychologists call defensive pessimism, learned helplessness, and passive aggression.
Those are a lot of points for targeting the tone at the middle and the tone at the bottom.
Dilbert, being the epitome of powerlessness, captures some of this in today’s strip.
Driving ethical growth – new markets, new challenges, the title of Ernst & Young’s 11th Global Fraud Survey, shows fraud is up; audit and legal are stretched to deal with these challenges; compliance is patchy; and Boards need more and better information to manage the risks.
They interviewed more than 1,400 chief financial officers, and heads of legal, compliance and internal audit in 36 countries to get their views on how companies are managing the risks associated with fraud, bribery and corruption.
Consistent with the experience of past recessions, companies have been struggling with an upsurge in fraud and corruption. Almost one in six of our respondents have experienced a significant fraud in the past two years.
Compliance is New
Compliance is still a developing area outside of the highly regulated industries, such as life sciences and financial services.
About half of the compliance professionals surveyed have been in a compliance role for less than five years.
As a relative newcomer, the compliance function faces the extra hurdle of demonstrating its value. Of course, you need to demonstrate value if you want to get more resources. This was the greatest challenge identified by compliance professionals in their survey.
The competition for resources also reduces compliance’s ability to gather the current management information required to do its job, making it harder still to demonstrate value to the rest of the business.
Board Concerns
Seventy-six percent of respondents feel their boards are increasingly concerned about their personal liability from fraud, bribery and corruption. The survey indicates that the Board’s level of concern with fraud has risen with the overall rise in fraud and corruption risks in the current economic climate. All the survey participants think that board members are taking their own personal exposure seriously.
There has been lots of criticism aimed at Goldman Sachs over the Abacus 2007-AC1 deal. They help set up a CDO so their client, Paulson & Company, could make a bet on a downturn in the residential real estate market. To make that bet, they allowed Paulson to influence the securities that went into the CDO. Most of them turned out to be dreck and the CDO ended up tanking. Paulson made money from his short position and the investors in the CDO lost more than $1 billion.
Who Was the Client?
Paulson & Company hired Goldman Sachs and paid them $15 million for the structuring of the Ababcus 2001-AC1 CDO. So they were clearly a client.
The purchasers of the CDO were clients of Goldman Sachs. Since they were purchasing securities from Goldman Sachs as a broker-dealer, they were not owed a fiduciary duty by Goldman Sachs. That is one of the current differences between the law governing investment advisers and broker-dealers. Goldman made a statement in the materials that they do not have a fiduciary obligation to the investors.
Goldman Sachs had a split loyalty that is common with Wall Street transactions.
Disclosure
In selling securities you are required to disclose all material information and risks in a prospectus for the security and deliver that prospectus to purchasers.
Goldman claims that its Abacus investors had all the information needed to evaluate risks for themselves in the prospectus.
The SEC is claiming that Goldman should have disclosed that Paulson influenced the selection of securities placed in the CDO and that they were engaged by Paulson to build the CDO so Paulson could take a short position against it.
Illegal or Unethical?
Obviously, the SEC is taking the position that Goldman acted illegally. Personally, I’m not sure it was illegal. If it turns out that they said Paulson was long on the CDO, when he was actually short, then they are in trouble.
Lots of people are arguing that they acted unethically. That is a stronger argument. Goldman may not have been required to disclose Paulson’s role in the transaction, but they probable should have disclosed it.
I prefer to use the very technical term “yechy.” Goldman looks very bad. As a company, they seek to have a better reputation than this.
They should not have structured the transaction this way. They should settle this case, chalk it up as a mistake and act better. (I own some stock in Goldman Sachs that I bought when the price dropped because of these accusations.)
What about the Rating Agencies?
Even with all the dreck in this CDO, the rating agencies still gave a AAA rating to the $480 million Class A, AA to the $60 million Class B, AA- to the $100 million Class C, and A to the $60 million Class D.
Clearly one of the factors in the sub-prime market was the failure of the rating agencies. They were giving AAA ratings to collections of dreck.
S&P defines the AAA rating for structured finance as “judged to be of the highest quality, with minimal credit risk.”
Maybe this chart is better explanation of the ratings:
Yesterday, evidence came out that Washington Mutual knew about fraud in its residential mortgage originations. No surprise. There was lots of fraud in the heyday of the residential mortgage boom.
What was surprising was that WaMu allowed these loans to be sold to investors and packaged into residential mortgage backed securities.
Since Senator Levin is from Michigan it reminded me of a similar story from a GM plant. They never stopped line in the GM plant. Even if someone had put a Regal front end on the a Monte Carlo, nobody would push the button to stop the production line and fix the problem.
The GM plant managers were paid to get cars off the end of the production line, regardless of what condition they were in or even if they were driveable.
The Washington Mutual loan officers were paid to get loans to the end of the production line, regardless of whether there was fraud or if the loan could be repaid by the borrower.
Both WaMu and GM ended up insolvent. The workers and the managers were paid on quantity, not quality.
I occasionally like to look at consumer fraud complaints to see if I can learn any lessons for corporate compliance.On the consumer side there is tremendous volume of complaints and many parties trying to help.
It caught my eye when four different organizations got together to identify the top consumer complaints for 2009. Here are their lists:
Massachusetts Office of Consumer Affairs
1. Home Improvement Contractors
2. Auto Insurance
3. Health Insurance
4. Lemon Law
5. Foreclosure assistance
1. New Car Dealers
2. Retail Furniture Dealers
3. Collection Agencies
4. Used Car Dealers
5. Movers
Federal Trade Commission
1. Identity Theft
2. Third Party/Creditor Debt Collection
3. Foreign Money Orders/Check Scams
4. Internet Services
5. Shop-at-Home and Catalogue Sales
Differences in the Lists of Complaints
I’m sure each agency has a different taxonomy for categorizing complaints so it’s not fair to compare across agencies. I will anyhow.
It seems really strange that the lists are so different. You would think that there would be some common themes.
I see “Lemon Law” on the Office of Consumer Affairs, with “New Car Dealers” and “Used Car Dealers” on the Better Business Bureau list. So they both have cars, but no sense of the consumer complaint from the BBB list.
The Office of Consumer Affairs has “foreclosure assistance” and the Attorney General has “Loan Modification Fee Schemes” on its list. I sense those entries are a sign of the times and each agency is trying to focus on those related issues.
How you intake complaints will affect how you classify complaints and how you report on complaints. So I thought it would be a useful exercise to see how these agencies intake complaints to see if you can see a relationship to their top complaints.
Federal Trade Commission
Why does the FTC have a category for “Internet Services”? That seems way too broad. I guess it is just the “internet is scary” category. So I tried out the FTC Complaint Assistant.
Its no surprise that “Identify theft” is the top category. That the first question asked. So with the FTC complaint everything is either an identify theft complaint or something else.
The something else is then divided into “Debt collectors or debt collection practices”, “Credit Reports” or something else. So its no surprise what the second item is on the FTC list. It does leave me surprised that “Credit Reports” did not make their top five. The “internet” is one of the categories in other, but the other two on the top five are no obvious from the input taxonomy.
a product or service (other than a vehicle or a cell phone)
a charity
children’s advertising
So its no surprise that New Car Dealers and Used Car Dealers are in their top five list.
Massachusetts Office of Consumer Affairs
I thought it was strange to see this agency in the mix because it has a limited mandate when it comes to consumer complaints. If you go to their How to Resolve a Consumer Problem webpage they make it hard to even find how to file a complaint with this agency.
They really just have jursdiction on Lemon Law disputes and home improvement arbitration. So what’s odd is that lemon law was only in the number four position in their top five.
(In the interest of disclosure, I worked as a intern at this agency working on consumer complaints.)
Massachusetts Attorney General
This consumer complaint form has the broadest taxonomy, with two dozen categories to choose among. I would put the most faith its listing of the top consumer complaints because you are not forcing them into a box.
But that leaves me wondering how “time share resellers” are above “loan modification fee schemes”? Maybe there are just lots of people trying to unload their time shares in this bad economy so they can avoid having to modify their loan.
Sources:
Press Release: Top 5 Consumer Issues and Complaints Outlined by Patrick-Murray Administration’s Office of Consumer Affairs and Business Regulation, Attorney General’s Office, Better Business Bureau, and Federal Trade Commission
Take advantage of the FTC’s free resources, which can help you protect your privacy, manage money and debt, avoid identity theft, understand credit and mortgages, and steer clear of frauds and scams.
This year’s theme is Dollars & Sense: Rated “A” for All Ages. The idea is to highlight the importance of using good consumer sense at every age, from grade school to retirement.
In the meantime, Congress still seems to be thinking about whether there should be a federal consumer protection agency and who should be in charge of it. Senator Dodd appears to want it under the umbrella of the Federal Reserve. US Representative Barney Frank wants a Consumer Financial Protection Agency to be an independent watchdog on financial issues.
When the Madoff ponzi scheme collapsed the claim was that there was $65 billion in losses. That was the total dollar value on the account statements given to investors. Of course, that number was fictional because there were not real assets behind those numbers.
The trustee overseeing the liquidation of the assets looked at the cash that came into Madoff and the cash that came out. The bankruptcy judge agreed. In a decision filed on Monday, Federal Bankruptcy Judge Burton R. Lifland ruled that losses should be defined as the difference between the cash paid into a Madoff account and the amount withdrawn before the fraud collapsed in mid-December 2008.
The Madoff trustee, Irving H. Picard, took the position that “the only verifiable amounts” reflected in the Madoff records are the differences between how much investors put into their accounts and how much they took out.
The result is that those investors who didn’t pull out their initial capital will get a greater percentage of their money out than those who took withdrawals from their accounts.
To put it another way, the people are getting the greatest percentage of money back are:
Those who least need the money. Since they took less money out they presumably have other income or capital to support their needs.
Those most trusting of Madoff. Since they trusted Madoff, they did not pull money out of their investment accounts. They rode those returns and let their fictional returns keep accumulating.
Those who took out more cash from Madoff than they put in were labeled the “net winners” and get nothing. Even worse, it looks like the “net winners” may have to give back some of their “winnings” to the bankruptcy estate to pay off the net losers.
Of course, the opposite ruling is just as bad since the early investors would be paid by later investors, effectively extending the Ponzi scheme.
The judge is taking the position that people should be put back to their position as if they had not invested with Madoff. In the end its going to bad for all the investors. It’s just a question of who feels the most pain.
New York Attorney General Andrew Cuomo filed securities fraud charges against former Bank of America CEO Kenneth Lewis and former Chief Financial Officer Joseph Price. The Attorney General claims that the two decided not to disclose the enormous losses at Merrill Lynch & Co. before getting shareholder approval to acquire the Wall Street firm.
The Complaint is full of newsbites:
“Ultimately, this was an enormous fraud on taxpayers who ended up paying billions for Bank of America’s misdeeds. Throughout this episode, the conduct of Bank of America, through its top management, was motivated by self-interest, greed, hubris, and a palpable sense that the normal rules of fair play did not apply to them. Bank of America’s management thought of itself as too big to play by the rules and, just as disturbingly, too big to tell the truth.” (#1)
From the Frontline Report, Breaking the Bank, it sounded like Bank of America was strong-armed into completing the merger with Merrill Lynch. Ken Lewis had the choice of going ahead with the merger or losing the bank. The complaint addresses this point
“The evidence further demonstrates that almost immediately upon reviewing the December 12 loss analysis, the Bank planned to seek taxpayer aid to save the merger, and to use the empty threat of a MAC claim as leverage with the government in negotiations.” (#21.)
Politicians have been looking for heads to roll. That bloodlust has gotten even frothier with year-end bankers’ bonuses getting readied for distribution. Lewis and Price have their heads in the civil lawsuit guillotine.
The Securities and Exchange Commission charged three former top officers of New Century Financial Corporation with securities fraud for misleading investors as New Century’s subprime mortgage business was collapsing in 2006. At the time of the fraud, New Century was one of the largest subprime lenders in the nation.
In its complaint, the SEC alleges that New Century disclosures generally sought to assure investors that its business was not at risk and was performing better than its peers. However, New Century failed to disclose important negative information, including dramatic increases in early loan defaults, loan repurchases, and pending loan repurchase requests. The complaint also alleges that Dodge and Kenneally fraudulently accounted for expenses related to bad loans that it had to repurchase.
The SEC’s complaint names as defendants:
Former CEO and co-founder Brad A. Morrice
Former CFO Patti M. Dodge
Former Controller David N. Kenneally
It was interesting to see the SEC bring this case after the Department of Justice lost a similar case against two former Bear Stearns hedge fund managers. In both cases, there were some public statements about how they would weather the subprime crisis. In the Bear Stearns case, it was a private fund. In this New Century it was a public company. The argument is both cases is that the principals were hiding their knowledge of the underlying losses.
The SEC is charging the New Century trio with accounting fraud as part of their scheme to hide the losses from the subprime loans going bad. Part of the downfall may have been its conversion in 2004 to become a mortgage REIT. While this structure reduces the amount of taxes it needs to pay, it also requires the company to distribute at least 90% of its annual taxable income. That means New Century would have trouble accumulating capital for operations and keeping reserves for future losses.
The complaint is a fun read because it takes you through the greed of the subprime marketplace as New Century introduces new products that, in hindsight, are increasingly riskier. As the losses accumulated, the disclosure got murkier and murkier. The SEC sees the disclosure as “false and misleading.”
New Century’s trademarked byline was “A new shade of blue chip.” It seems like red (as in the ink) would have been a better color choice.
New York v. Bank of America Corporation, Kenneth D. Lewis and Joseph L. Price
