The world’s most powerful securities regulator has long called itself the investor’s advocate. Given its stunning failure over the Madoff scam and the latest scandal, involving R. Allen Stanford, it may be on its way to becoming known as the investor’s nightmare.
For years, the Securities and Exchange Commission was regarded as one of the toughest securities cops in the world. The Ontario Securities Commission, North America’s second largest capital markets regulator, on the other hand, has been viewed more like the Keystone Kops –missing the red flags in the Bre-X fraud, dropping the ball on Livent, dodging the tough calls with Hollinger, and losing a number of high profile cases before the courts. In many quarters, the OSC has been dismissed as something of a joke inside Canada and an embarrassment outside.
But recently, it is the SEC that has taken quite a hit. (more…)
As the fraud at Satyam is dissected, it will reveal red flags that should have been obvious to attentive bodies and a level of complacency on the part of directors, auditors and regulators that should never have occurred.
Once again, we are invited to believe that one man has outwitted a huge group of purportedly intelligent and conscientious directors (two were on the faculty of Harvard University) and PricewaterhouseCoopers, one of the largest accounting firms in the world, along with a host of securities regulators in India and the United States. The latest scandal installment comes with the resignation of B. Ramalinga Raju, founder and chairman of India-based (and NYSE traded) Satyam Computer Services Ltd., who admitted today in a letter to directors and securities regulators that he had committed accounting fraud to falsify profits.
We’ve been down this road before with Barings, Société Générale, Enron, WorldCom, Tyco, Computer Associates and Hollinger, to name a few. A similar drama on a particularly spectacular scale appears to be unfolding in connection with the alleged multi billion Ponzi scheme of Wall Street’s fabled Bernard Madoff. He, it is said, managed to fool the most sophisticated investors and regulators at the highest levels for a number of years.
Usually, it is the act of the individual culprit that most regard as the scandal. In truth, there is much that is scandalous in the actions, or very often inactions, of those entrusted with overseeing and regulating entities that operate with other people’s money.
As the fraud is dissected, it will reveal red flags that should have been obvious to attentive bodies and a level of complacency on the part of directors, auditors and regulators that should never have occurred. A good starting point would for the auditors, and the board audit committee, to explain how they could certify the books of a company where there was supposed to be a billion dollars in cash but in fact there was less than $100 million.
Good luck on that one.
Even Canada’s corporate crime cops are suddenly busy busting businessmen
It was a day for the record books. Never have so many high profile former insiders in so many companies been charged with fraud on both sides of the border. The RCMP, a frequent object of criticism for its slow pace in bringing white-collar criminals to justice, suddenly broke into a sprint and charged a whole slew of former executives in Nortel and Royal Group Technologies, including past CEOs of both firms. In the United States, justice department officials brought indictments against two former hedge fund managers at defunct Bear Stearns.
As an aside, you may have noticed the former Bear Stearns managers being taken away in handcuffs, escorted by armed federal agents. You will not see that picture in Canada. It’s just not considered the Canadian way -at least not when it comes to dealing with corporate fraud at this level. Some observers believe the contrast says a lot about the differences in how seriously the two jurisdictions treat white-collar crime.
Now that one-time executives at Nortel and Royal Group Technologies have been charged, the question is when will they be tried? Canada has a notoriously slow record in getting high profile white-collar cases into the courtroom. Garth Drabinsky and Myron Gottlieb, founders of the once highflying Livent, where charged with accounting fraud in 2002. Their trial got underway in Toronto just last month. We have been attending some of the proceedings and will be following up with a posting shortly. The charges involving Nortel’s former executives arise from events in 2002 and 2003, nearly six years ago. The fraud at Royal Technologies is alleged to have taken place some 10 years ago. By contrast, the U.S. justice system typically works much faster, as Conrad Black discovered to his dismay. The Bear Stearns fraud is said to have taken place in early 2007. The legal future of the pair charged there will likely long have been decided before even the first word is spoken in the Canadian corporate trials of the former stars of Nortel and Royal Technologies.
One more fact in common among these three companies is worth noting. They were a model of corporate governance failure. We broke news on Bear Stearns’s stunning board shortcomings even before its unceremonious end. Royal Technologies’ governance, and it’s being generous to call it that, was so bad it is hard to imagine that the lights were ever turned on in the boardroom. Did the CEO hide the switch from the directors? We shall see. Nortel, like Enron, was one of the boards that looked good on paper but in reality was giving management a blank check. It’s not surprising that some of the company’s former management may actually have taken that role a bit too seriously. To have had to restate its financial figures as often as Nortel has (four times in all and a record for a publicly traded company in such a period of time), and to admit the extent to which its internal financial controls had failed, are a testimony to how far and how long its big-name board slumbered.
Don’t be surprised if the issue of corporate governance, and what directors did and did not do, features prominently in some of these trials.
Investigations by Congress in 1912, 1932 and 2002 revealed weaknesses and abuses in both the regulatory regime and in the governance of corporations that yielded major reforms. A comparable effort is needed now in the face of the worst credit crisis since the Great Depression.
A trio of former SEC chairmen and a solo performance on the part of a former high-ranking Fed official are making for some interesting music and a much-needed counterpoint to the current chorus of conventional thinking. In a recent Op-Ed piece in The New York Times, William Donaldson, Arthur Levitt, Jr. and David Ruder write: “In 1987, a presidential task force was established to investigate the Black Monday crash. Today, we need a similar exhaustive, bipartisan and impartial examination to explore a series of possible business and regulatory failures”. The former securities regulators invite an examination of:
…apparent conflicts of interest on the part of the credit ratings agencies; the failure of banks and other lenders to adopt sound lending practices; the failure of investment banks to disclose that they had significant portfolios of securities backed by subprime mortgages; the sale of high-risk securities to investors for whom they were unsuited; the breakdown (or absence) of adequate risk management systems among the top financial services firms; and the failure of regulators to recognize and take early action to deal with the problems that have grown to today’s magnitude.
We would add to that list for investigation the alarming failure of too many boards to effectively oversee risk and the role that excessive compensation played in rewarding CEOs for taking on levels of risk that would run up the price of shares and boost their pay in the short term but which ultimately proved to be unmanageable over the longer run. As we predicted some years ago, Titanic-sized CEO compensation has proven to be the most corrosive force in the modern American boardroom. It will continue to be associated with mishaps, scandals and failures in the future, as it has been in the past, unless it is checked by a healthy injection of common sense and sound judgment around the director’s table.
Valuable as a review of the SEC’s role would be, we have expressed the view that a more comprehensive inquiry regarding the actions of all the players in the subprime ordeal, and what changes are necessary both in the regulatory system and in corporate governance practices, is more appropriate. Back in January, in Time for Tough Questions About Subprime Solutions -and Their Potential Dangers, we suggested that Congress needed to get to the bottom of what was happening and why. We concluded by noting:
The issues of subprime bailouts, foreign investment and the failures that brought American capitalism to this troubling state are far too important to be permitted to escape scrutiny or unfold by stealth or default, which is the current mode of operation. Those actors have too often entered the room when no one was paying attention and waltzed out with most of the silverware in their pockets.
Vincent Reinhart, who was director of monetary affairs at the Fed until last year, has called the Bear Stearns bailout “the worst policy mistake in a generation.” We, too, have had our reservations about that rescue and the lack of transparency associated with it. As we said shortly after the deal was announced:
Americans cannot permit free enterprise to reign just when CEOs and companies are making piles of money only to have it replaced by socialism when they are teetering on disaster.
In a later posting we noted:
More and more, the picture is emerging that this was a bailout of Wall Street, prompted by Wall Street, over problems caused by Wall Street, with terms dictated by Wall Street. The Fed’s agreement constitutes the single most significant market intervention in generations. Such a decision…places substantial taxpayer dollars on the line and the concept of moral hazard in jeopardy.
The causes of the worst crisis in America’s capital markets since the Great Depression, and the unprecedented decisions of the Fed in dealing with it, along with the role other public and corporate actors have played in this saga, call out for serious analysis and national discussion. Congress has acted before in the face of momentous challenges to the stability of the market and public confidence in its functioning. A special subcommittee of the United States House of Representatives was formed in 1912 under the legendary chairmanship of Louisiana Congressman Arsène Pujo to examine the influence of the “money trust” and the growing power of Wall Street titans like J.P. Morgan.
In 1932, in the wake of the Crash of 1929 and the ensuing economic depression, the United States Senate Committee on Banking and Currency (as it was called then) began to consider the need for reforms. Its landmark work, spearheaded by committee counsel Ferdinand Pecora, produced the first securities laws of 1933 and 1934 and created the SEC.
More recently, as a result of a series of accounting scandals and widespread failures in corporate governance, efforts by Congress under Senator Paul Sarbanes and Representative Mike Oxley led to the creation of omnibus boardroom reforms known as the Sarbanes-Oxley Act of 2002.
A wide-ranging inquiry into the causes and lessons of the subprime credit implosion, similar in scope and heft to the Pujo, Pecora and Sarbanes-Oxley hearings, needs to be conducted, and soon. We also think it is important to include in that review the governance of the Federal Reserve System and the reforms that are needed to bring it into line with 21st century levels of public confidence, independence and accountability. We pointed out earlier, for instance, that at the New York Federal Reserve, which played the leading role in the Bear Stearns bailout, Jamie Dimon of JPMorgan Chase, the Fed-assisted purchaser of Bear Stearns, was a director. Richard Fuld and Jeffrey Immelt, CEOs of Lehman Brothers and GE, both big players in the capital markets, were elected by the New York Fed directors to represent “the public.” That, we find to be a bit of a stretch. It’s a throw back to the cronyism of the New York Stock Exchange before it was faced with a wave of demands for reform after the pay scandal involving former CEO Richard Grasso. It is simply not possible for any player in the Fed system to maintain credibility regarding its important public mandate while at the same time maintaining what is an essentially privately structured, club-like governance system. It is time for a serious rethinking about to whom and for what the Federal Reserve System is accountable, and how its governance practices need to be more aligned with its public mission.
Comprehensive investigations by Congress in 1912, 1932 and 2002 (and these were not one- or two-day affairs, as recent hearings on some aspects of the subprime debacle have been) revealed weaknesses and abuses in both the regulatory regime and in the governance of corporations that yielded major reforms. Their enactment paved the way for a restoration of public confidence and enabled significant periods of growth and expansion.
It is important that the opportunity to understand more completely the causes of the subprime crisis, and the vulnerabilities that led to it, not be lost. Only then will the full spectrum of necessary reforms both in the boardroom and in the regulatory arena become clear. In that respect, basic logic if not sound public policy principles counsel that the package of regulatory changes proposed recently by the Bush Administration was premature. More needs to be known about the specifics of the failures at all levels that created the current problem before the correct solution can be adopted. Uppermost in any such legislative review is the question: How exactly was one company, Bear Stearns, allowed to become so critical to the functioning of the market that only by preventing its failure through a massive intervention of the federal government could the collapse of the entire financial system be narrowly averted, as U.S. officials have asserted in testimony before Congress.
Not even in the unfettered era of J.P. Morgan’s trusts, or at the height of the rail-riding Great Depression, was the American public presented with the frightfulness of that prospect.
Last week, we received inquiries from the press asking for a comment on Eugene Melnyk’s plans to change the board of Biovail. The published versions omitted our most important point: the SEC’s probe into Mr. Melnyk and Biovail may be the biggest factor in determining any influence he has in the future of the company. The second shoe in the investigation dropped today with the SEC bringing civil charges of accounting fraud against Mr. Melnyk and several other parties. Similar proceedings were also brought in Toronto by the Ontario Securities Commission.
We expect Mr. Melnyk will be putting his plans for the company he founded on hold for a while. He was at the helm of Biovail when the alleged improprieties occurred and his griping about the state of the company now is a little like Conrad Black lambasting the board and management of Hollinger Inc., and its Sun-Times Media Group subsidiary, from his baronial power base at the Coleman federal prison complex in Florida.
The complaints also included proceedings against Biovail’s most senior financial officials: current Controller John Miszuk and current CFO Kenneth Howling. The company has announced that they have been reassigned to other positions in the organization. Biovail needs to be more specific about how close those roles are to financial functions in the company as the market does not generally respond well when so many past and current officials are the subject of regulatory proceedings, especially those involving fraud. (See Hollinger).
The company itself paid a $10 million penalty to the SEC for its role in the alleged accounting scheme.
Less than a year ago, Treasury Secretary Henry M. Paulson, Jr. was giving a lot of support to efforts that were designed to loosen business regulation and Sarbanes-Oxley reforms. We had some thoughts on the subject at the time. Fresh from the top post at Goldman Sachs and on the job for only a few months, the Secretary noted:
A consequence of our regulatory structure is an ever-expanding rulebook in which multiple regulators impose rule upon rule upon rule. Unless we carefully consider the cost/benefit tradeoff implicit in these rules, there is a danger of creating a thicket of regulation that impedes competitiveness.
Today, Secretary Paulson called for a tightening of rules in a whole range of market areas and indicated that new regulations are on the way. Meltdowns in the housing market and downturns in the economy that get people thinking about the 1930s, and where weak oversight and unfettered risk creation were major contributors to the turmoil, have a tendency to do that. In his speech, Mr. Paulson observed:
We must have better policies, processes and mechanisms to understand and manage complexity, to discourage its excess, and to better understand and manage risk.
It’s amazing how different the world looks when the perspective shifts from what’s good for Wall Street to what’s needed on Main Street.
