Accounting Fraud

Maneuvering and Manipulation, Past and Present

This is the Story I Want to Tell in the Book

• Defining the various illicit financial and accounting acts over time, attempting to identify the major perpetrators and the reasons for their actions, determining what regulations were effective and why, and using the historical evidence to attempt to predict the future. No question, there will be more manipulation and fraud. The historical evidence, reinforced by psychology and economic, points to the critical importance of the incentives of key players whatever the existing institutional framework (p. xiii).

A boom without crooks is like a dog without fleas.

• Is it possible that scandal is somehow an essential ingredient in capitalism? That a healthy free-market economy must tempt a certain number of people to behave corruptly, and that a certain number of these will do so? That the crooks are not a sign that something is rotten but that something is working more or less as it was meant to work?

Michael Lewis

• The economy may be the most corrupt when it is most dynamic.

The Wisdom of Crowds (Surowiecki)

• Trust is central to economic systems because of cooperative behavior.•Corruption is very damaging to the system.•Current scandals: short-term gains from corruption

were immense.• Institutions designed to limit corruption were

ineffectual (or perhaps facilitated corruption).

What is Fraud?

• Fraud is the intentional deception for personal gain. (Personal view: if not illegal, it should be).• Accounting fraud is the deliberate misstatement of financial information

specifically for personal gain.• Corruption is the abuse of power or resources for personal gain ranging from

deception and bribery to complex fraud. Corrupt activities are improper and unethical, but do not necessarily involve illegal acts.• A scandal is a widely publicized incident that involves wrongdoing, disgrace,

or moral outrage.• Transparency International ranks to U.S. in an undistinguished 19th place for

perceived corruption.

The Complexity of Business Corruption

• Consider three categories of business corruption:1) Actions that are considered deceptive and outrageous, but still legal (e.g., high speed trading, preferred lists/spinning, bad bank loans repackaged as bonds).2) Complicated (e.g., front-running, insider trading, executive compensation).3) Blatant fraud (e.g., bribery, embezzlement, extortion).• Civil wrongs are torts (intentional misrepresentation or concealment);

criminal wrongs usually include deceitful conduct to manipulate and cheat others.

Capitalism in Action

• Crises—unsustainable booms followed by calamitous busts—have always been with us, and with us they will always remain. … The very things that give capitalism its vitality—its powers of innovation and its tolerance for risk—can also set the stage for asset and credit bubbles and eventually catastrophic meltdowns whose ill effects reverberate long afterward.

Nouriel Roubini and Stephen MihmThere has not been a decade in American history since 1789

without at least one recession.

Why do Companies Cheat?

• Crime pays: Wall Street, we suddenly understood, had never been a reward for ‘performance’ or a grateful recognition of what financial innovation did for the nation—it was strictly about what Wall Street could get away with.

Thomas Frank• (1) It pays to do it, (2) it’s easy to do, and (3) it’s unlikely that you’ll get

caught.Howard Schilit

• Basically, it is perverse incentives versus ethical standards and regulatory effectiveness. Upside benefits are greater than downside risks.

Behavior Follows Incentives

• Steve and the hardware store—the incentives to cheat.• Enron: executive pay encouraged growing accounting earnings (and

stock price), without much regard to ethics. Enron culture encouraged illicit activities, including pressuring auditors, attorneys, regulators, analysts, and banks to go along.• Illicit behavior might be contained if it is declared illegal, if the

penalties are severe enough for perpetrators to take pause, and if the regulators actively enforce the law. Consider the early SEC.• To what extent should government (especially regulators) take

responsibility for corporate fraud (e.g., Subprime Meltdown)?

Economics of Bad BehaviorNeoclassical economics: maximize profit.Enthusiastic business support: “The public be damned. I work for my stockholders,” William Vanderbilt.Libertarian perspective, Milton Friedman: “The Social Responsibility of Business is to Increase its Profits.”Duty of Loyalty: legal (fiduciary) responsibility of board (and others) can be interpreted to maximize profit: (1) Dodge brothers versus Ford (1919); (2) eBay versus Craig’s List (2010).Extremes: Ford Pinto; BP Deepwater Horizon.Social responsibility (necessary corporate governance or subversive doctrine?). Government role??

Why Regulation?

• The U.S. was based on a culture of rule of law, local democracy, property rights, and individualism.• The Constitution followed the complete failure of the Articles of Confederation.• Legislation/regulation (beginning at the local level) for public education, clean

water/waste disposal, public health, national parks, and determining business vs. individual rights.• Legislation followed scandals and public outrage: food safety, anti-trust,

securities laws, pollution control, and mortgage manipulation.• Problems of corruption, inept enforcement, underfunding, misguided rules,

compliance costs, “captured” agencies.; plus unintended consequences.• Current issues: internet, cyber-crime, bitcoin.

Scandals Before the SEC

• Early: Bribery, smuggling.• Railroad Booms: chartering, construction, stock manipulation,

insiders—Raiding the Erie, Credit Mobilier.• Corrupt government and political machines: Tammany Hall.• Manufacturing, oil and gas, distribution: Standard Oil—moving from

local markets to national and international markets (the concept of monopoly power); John D. Rockefeller becomes America’s most hated man.• Difficult to identify accounting fraud before accounting standards

existed.

The Roaring Twenties to the Great Depression

• Early 20th century a period of progressive legislation and reform.• !920s reverted to manipulation, speculation on borrowed money,

rampant corruption, and a stock bubble.• Market crash and Great Depression. Investigations (Pecora

Commission and others) uncovered manipulation and abuse.• Samuel Insull’s utility pyramiding (also manipulating dividends and

market values); Insull charged with fraud but not convicted (what laws, exactly, did he break?• Ivar Kreuger: The Match King and the Kreuger Crash.

Congress Takes Action

• The Securities Acts and the creation of the SEC.• SEC focused on (1) securities markets and (2) accounting and disclosure,

including disclosing top executive pay since the mid-1930s.• Accounting standards were “outsourced” to the private sector: Committee on

Accounting Procedure (1938-1959), Accounting Principles Board (1959-1973), and Financial Accounting Standards Board (1973- ).• After the abuse of Insull and others, IRS and accounting rules focused on

historical cost.• McKesson & Robbins fraud (falsified inventory and receivables) and auditing

reform (note comparison to Ultramares case of 1924).• Initially, the SEC was well-funded, activist and reasonably effective.

Post-World War II

• Substantial economic growth, low inflation, low interest rates, high taxes, rising middle class, and greater interest in the stock market. General Motors is the model of the American multinational.• Emerging opportunities/problems: foreign competition, rise of

conglomerates, bloated corporations, mergers, rising inflation.• Abe Brilof introduces cleverly rigged accounting ploys (CRAP), especially with

merger accounting.• The failure of Penn Central: liquidity and disclosure issues.• “Small fraud” at giant companies (GE, Westinghouse, military contractors).• Hostile takeovers, Michael Milken and junk bonds, insider trading.• Global bribery and the Foreign Corrupt Practices Act.

Small Companies, Big Fraud

• Investor Overseas Services: Bernie Cornfeld followed by Robert Vesco—tax avoidance fraud, embezzlement, looting the company.• ZZZZ Best: insurance restoration fraud, fake financial information.• Great Salad Oil Swindle: nonexistent inventory.• Continental Vending: false statements certified by auditor.• National Student Marketing: bogus data and stock fraud.• Equity Funding: life insurance cash values for mutual funds—bogus

policies and false financial reports.• Baptist Foundation of Arizona: illicit transactions and false statements.

Bigger Frauds in the 1990s

• Waste Management: garbage collection acquirer business boomed as garbage privatized, relying on political clout (contributions, lobbying, bribery) and manipulation (fixed asset manipulation, capitalizing operating expenses, sham transactions), regulation violations, but a clean opinion by Arthur Andersen. An SEC investigation, restatements, and lawsuits followed.

• Cendant: Hospitality Franchise Systems acquired fraudster CUC International; the fraud was discovered after the acquisition, resulting in restatements, indictments of former CUC executives, and lawsuits against Cendant and auditor Ernst & Young (settled for $3 billion).

• Sunbeam: outsider Albert (“Chainsaw Al”) Dunlap was hired as CEO after declining performance in 1996. Earnings and stock price improved because of cost cutting, plus earnings manipulation (“cookie jar reserves,” channel stuffing, bill-and-hold sales, capitalizing operating expenses) plus auditor Arthur Andersen gave an unqualified opinion. The fraud was discovered and Sunbeam went bankrupt—lawsuits followed.

• BCCI scandal: fraud, bribery, tax evasion, and money laundering: “largest bank fraud in world history,” ending with global liquidation.

Regulatory Response

• Fed Chairman William McChesney Martin (1951-70): “The job of the Federal Reserve is to take away the punch bowl just as the party gets going.”• “Great compression” (1940s-1970s), good for the middle class, not so

much for the top 1%.• 1970s: stimulative government policy, drop gold standard, inflation,

rising unemployment (“stagflation”).• Reagan Revolution: lower taxes, reduced regulation, Alan Greenspan

at Fed.• 1990s: booming economy, tech bubble, continued deregulation.

Manipulation Follows Executive Incentives

• Stock options explode in the 1990s (importance of regulations: lower taxes, “free options,” federal pay limitations).• Options in startups, especially high tech.• Incentives are clear: meeting earnings expectations results in pay

explosion—fraud expands.• Tech bubble is followed by stock collapse; fraud is exposed.• Tech companies crash, computer, internet and telecom companies

especially.• Giant frauds discovered.

Enron

• Enron had it all: giant company, long-term complex manipulation schemes (most of which are still around), interesting villains, unexpected bankruptcy (largest in U.S. history at the time), every facet studies by journalists, insiders, Congress, and other investigators. [Note Texas A&M connections.]• Mark-to-market accounting (as determined by Enron)• Gas trading and derivatives (expanded to electricity and other markets); gains

and losses manipulated; extreme corruption of California electric market.• Special purpose entities: Andy Fastow has a special knack for manipulation and

fraud.• Arthur Andersen requires restatements, bankruptcy follows.• Ken Lay: head fraudster or tolerant/hands-off CEO?

Other Major Scandals

• WorldCom, massive telecom specializing in acquisitions (and merger accounting). Under CEO Bernie Ebbers and CRO Scott Sullivan the company stayed afloat by capitalizing about $12 billion in operating expenses, discovered by internal auditor Cynthia Cooper. Arthur Andersen withdrew is audit opinion and WorldCom filed for bankruptcy in mid-2002—the new biggest bankruptcy in U.S. history.

• Tyco, a large conglomerate also relying on mergers for growth (and manipulation), under CEO Dennis (“Deal-a-Day Dennis”) Kowlowski. Kowlowski and CFO Mark Swartz convicted of fraud after an SEC investigation.

• Adelphia, a relatively small cable company with Regas-dominated board charged with committing fraud and pilfering the company—criminal acts by board of directors.

• Downfall of Arthur Anderson after indictment for destroying evidence.

Congressional Investigation and Action

• Congressional hearing start within days of Enron’s bankruptcy in December 2001, especially Paul Sarbanes’ Senate Banking Committee and Michael Oxley’s House Committee on Financial Services (Oxley not much interested in massive reform).• Sarbanes-Oxley Act of 2002 passed within a few days of WorldCom’s

bankruptcy. Focus on corporate governance, new audit requirements and a new audit regulator (Public Company Accounting Oversight Board), additional internal control oversight and reporting, and improved regulatory funding.

Manipulation Continues

• HealthSouth: Richard Scrushy started inpatient rehabilitation facilities and used mergers to propel growth. Medicare and other problems could be gamed and HealthSouth became a manipulation specialist. Company was charged with fraud by Medicare and forced to restate earnings. Executives charged with fraud. Scrushy charged with filing false reports under SOX 302, but was acquitted (using the “accountants did it” defense).• Stock Option Backdating: option grant date set to an earlier day with a lower

stock price; SEC investigated about 150 companies, most of which restated earnings while a few were charged with fraud. (Also spring loading and speed vesting).• Financial Scandals: before the subprime meltdown of 2008, a number of financial

companies investigated and charged with various illicit acts, including Fannie Mae and Freddie Mac (faulty derivative controls and fraudulent accounting); AIG (improper accounting for reinsurance, overstating equity, and internal control weaknesses); and mutual fund abuses (front-running and market timing after the close of trading).

Subprime Meltdown

• Mortgage Abuse and Fraud: Predatory lending practices, subprime and easy credit.• Securitization: creation of mortgage-backed securities, collateralized

debt obligations, and credit default swaps.• Relatively deregulated market by captured(?) bank regulators.• High leverage, dependence on overnight money.• Once housing prices declined (around 2006), the bubble was effectively

over. Bond rating downgrades of MBSs beginning in 2007.• Almost everyone, including many of the insiders, were clueless about

the consequences—until companies started failing.

Financial Collapse

• Early failures: Bear Stearns hedge funds for CDOs, collapsed in November 2007; January 2008: Countrywide acquired by Bank of America• March 2008 J.P. Morgan acquires Bear Stearns (liquidity crisis), after

Fed bailout• Conservatorship for Fannie & Freddie, summer 2008.• Failure of Lehman Brothers, October 2008; financial markets crash.• Bailout of AIG (holder of CDSs), October 2008.

Role of Accounting

• Accounting was a supporting player to financial scandal.• Major issues (obvious from Enron scandal): mark-to-market; OTC

derivatives unregulated; out-of-control executive compensation [note SFAS 123R (stock options) effective in 2006]; special purpose entities; risk measurement; leverage and liquidity issues. • SEC issues (allowed increased leverage of major investment banks,

Bernie Madoff).• Sarbanes-Oxley proved less effective than expected. • Lehman’s Repo105s scam exposed in 2010.

Government Action

• Fed funding facilities to provide liquidity.• Troubled Asset Relief Program funding, October 2008; major banks bailed out

with equity injections. (Not much help for underwater homeowners.)• Financial regulatory overhaul plan announced by President Obama in 2009;

creation of the Financial Crisis Oversight Committee.• Dodd-Frank Act of 2010: improving transparency; Financial Stability Oversight

Council, liquidation authority, “Volcker Rule,” limited OTC derivative regulation and clearinghouse requirements, Bureau of Consumer Financial Protection. • Basel III beefs up capital standards of banks.

Continuing Scandals

• Banks seemingly unrepentant and largely unpunished; scandals continue.• “Flash Crash,” stock market collapse, May 6, 2010.• Goldman Sachs settles SEC charges related to ABACUS 200078-ACI, a

CDO.• Rajat Gupta convicted of insider trading 2011; ditto Raj Rajarqtnam.• LIBOR scandal (fixing short-term interest rate), 2012.• J.P. Morgan’s “London Whale” scandal and big derivative losses, 2012.• Outsize compensation of bankers and various CEOs increase.

Future of Fraud

• Types of corruption and fraud change over time. [“History doesn’t repeat itself, but it rhymes” (Mark Twain).]• Accounting and auditing issues become increasingly complex as

business complexity increases.• Certain issues remain despite changing laws and regulations: market

value accounting, derivatives, pensions/OPEB, executive compensation (and other compensation issues).• Incentives structures usually beyond the scope of accounting (and

difficult to control through regulation). Follow the money.• In the 21st century, accounting will likely only be a contributing player.

Recommended Reading

Ahamed, Lords of Finance; Akerloff & Shiller, Animal Spirits; Andreas, Smuggler Nation; Bruner & Carr, The Panic of 1907; Cassidy, How Markets Fail; Chandler, Visible Hand; Eichenwald, Conspiracy of Fools; Freeland, Plutocrats; Giroux, Business Scandals, Corruption, and Reform, An Encyclopedia; Irvin, The Alchemists; Johnson & Kwak, 13 Bankers; Johnston, The Fine Print; Josephson, The Robber Barons; Koeppel, Banana; Lewis, The Big Short (note, new book—Flash Boys); Mitchell, The Speculation Economy; Partnoy, Infectious Greed; Patterson, The Quants; Reinhart & Rogoff, This Time is Different; Roubini & Mihn, Crisis Economics; Schultz, Retirement Heist; Sorkin, Too Big to Fail; Taleb, The Black Swan.