History of Fraud in America

Bob Jensen at Trinity University

I'm giving thanks for many things this Thanksgiving Day on November 22, 2012, including our good friends who invited us over to share in their family Thanksgiving dinner. Among the many things for which I'm grateful, I give thanks for accounting fraud. Otherwise there were be a whole lot less for me to study and write about at my Website ---

 

Colonial History

Earliest "business" fraud in America centered around phony heath cures.  Armstrong and Armstrong (1991) document many of the snake oil ploys that commenced soon after the Pilgrims landed on Plymouth Rock.  Medical frauds ranging from deceptive medicines to spiritual cures to bloodletting expanded over time to modern day cancer miracle cures and Internet charlatanism.

Since early America was largely agricultural, various land schemes accompanied the growing market for deceptive rural living and farming products.  As the original 13 colonies were established land was owned by men who had been granted land from the English King. They in turn sold land to individuals and established common areas.  Although many of the early dealings were legitimate, it did not take long for land swindles to commence.  Swindlers were either buyers or sellers of land. Victims were often new immigrants and Indians who lived on the land before Colonial times.  One of the best known frauds was the 1626 purchase of Manhattan Island for trinkets valued at 60 guilders (approximately $24).  In this case the Carnarsie Indians from Brooklyn perpetrated the fraud since their land was not even connected to Manhattan Island.  But in most cases it was the white men who cheated the Indians and each other.  Land swindling grew rampant as America expanded to the west and continues to be one of the major opportunities for fraud and deception. 

Accompanying fraud were various checks and balances.  Phony product hucksters were often fined and run out of town.  Disputes were sometimes settled with fists, knives, and guns.  Legal protections of deeds, claims, and land records came into existence to discourage, but certainly not eliminate, land and mineral swindles. 

Frontier History and the Saga of Corporate Fraud and Labor Abuses

Government acquisitions of land afforded expanding opportunities for legislators and government bureaucrats to accept bribes and otherwise collaborate with land swindlers.  The expansion west afforded more and more opportunity for collusive land dealings. 

The birth of business corporations expanded opportunities for government and business fraudulent exploitations.  The earliest corporations commenced in 17th-century Europe.  Nations in Europe and Russia chartered new corporations and gave them public missions in exchange for the legal right to exist, separation of ownership from management, and limited liability that protected shareholders from losses of the corporation. The United States was settled by one such corporation, the Massachusetts Bay Company, which King Charles I chartered in 1628 in order to colonize the New World.

Two features of corporations were size and political power that allowed them to become monopolies in restraint of trade.  The Boston Tea Party was a protest against the British East India Company's monopoly of imports.  However, corporations were relatively slow to expand in the frontier history of America.  In 1787, fewer than 40 corporations operated in the United States, and most of these were formed to contract with government to build roads, bridges, canals, dams, and other "public" projects.   Many of the projects were burdened with bribes, kickbacks, and inflated prices.  By 1800, there were slightly over 300 corporations but the number grew rapidly after 1807.  American venture capitalists seized opportunities to form corporations when importation from Europe was shut down by President Thomas Jefferson's embargo of France and Britain from 1807 to 1809 and by the War of 1812. 

The Marshall Court under Federalist John Marshall (1801-1835) created a national market by eliminating trade barriers between the states.  Marshall's Court resulted in the U.S. Constitution's "obligation of contracts" clause (Article 1, Section 10), which states that "no state shall ... pass any ... Law impairing the obligation of contracts." Subsequently Chief Justice Roger Taney tried to moderate the Marshall Court's iron-fisted rulings on the sanctity of contracts. In Charles River Bridge v. the Proprietors of the Warren Bridge (1837), Taney wrote for the majority:  "The continued existence of a government would be of no great value, if by implications and presumptions, it was disarmed of the powers necessary to accomplish the ends of its creation; and the functions it was designed to perform, transferred to the hands of privileged corporations."

Late in the 1800s, checks and balances began to rise up against rampant corporate fraud.  The most significant of these was the free press.  Newspaper reporting of scandals gave rise to the Populist movement that led to the passing of laws to regulate corporations and the robber barons who owned them. But the courts, using Marshall's interpretation of the inviolability of contracts, struck down repeated attempts to protect society from labor and monopoly abuses.

Jay Gould (1836-1892) was one of the most notorious "robber barons" of the 19th century. With Daniel Drew and James Fisk he waged the Erie Railroad war by issuing illegal stock and bribing state legislators.  Gould amassed a great fortune and became president of the Erie.  In 1869, Gould and Fisk almost cornered the gold market until the U.S. Treasury released some of its own gold stocks, leading to the Black Friday panic of Sept. 24, 1869. The resulting public indignation forced Gould to resign (1872) as director of the Erie.

Businesses were often victims of government frauds.  One of the most notorious was the Tweed Ring.  The end of the Civil War brought a dramatic upturn in the City of New York's need for new railroads, streets, docks, warehouses and offices. Alderman William Marcy Tweed placed several cronies-the so-called Tweed Ring-in key city posts. They included the former District Attorney, A. Oakey Hall who became Tweed's handpicked mayor. But just as important were the people he had placed on the Board of Supervisors.  Every business that contracted with city works had to have a "friend" in the Tweed Ring.   Tweed's New York began borrowing excessively and only a fraction of the money was making its way into the City's projects themselves. Banks refused to endorse new securities, and the city's credit rating plummeted. The press had a field day led by Harper's Weekly cartoonist Thomas Nast.  On October 26, 1871, Tweed was arrested.  He died in jail in 1878. 

The Tweed-style of operating public projects lives on in government at all levels and school systems.  Fraud arises at various levels of evil.  At a minimum, some business owners run for office in an effort to secure contracts for supply of materials and services.  For example, sellers of bonds are notorious for running for office mainly to get commissions for selling city and school bonds.  Bidding for such contracts and services is often neither competitive nor fair.  At a worse level, self serving contracts are also fraudulent in terms of pricing and/or quality.  Unfortunately such frauds are commonplace in nearly every locality in the U.S.

One of the nation's terrible frauds was perpetrated by General Motors Corporation.  Street cars were once and still would be one of the most efficient ways of moving people around urban centers.  In major U.S. cities the tracks were already in place and street cars were running efficiently up and down those tracks.  Then General Motors took it upon itself to capture the city bus sale and replacement market.  In an effort to persuade cities to abandon street cars in favor of buses, General Motors commenced a strategy to bribe or otherwise cajole cities to sell their streetcar systems to GM from the 1920s to the early  1940s.  You can read the following at http://www.stayfreemagazine.org/archives/19/generalmotors.html

When GM formed the holding company National City Lines (NCL) in 1936, Standard Oil and Firestone had already agreed privately to help fund its motorization campaign. Between 1936 and 1950, the three companies contributed $9 million to NCL, which covered the purchase, motorization, and resale of more than 100 streetcar systems in 45 cities, including New York, Los Angeles, and Philadelphia. The number of streetcars in operation over that period fell from 73,000 to 18,000, and the removal of public trolleys helped make way for the automobile and suburban explosion of the 1950s.

The strategy was an enormous success for GM and a fraudulent disaster for large cities.  Eliminating the trolleys not only helped GM make millions in sales of city busses, the public became more dependent upon buying GM cars for commuting into the cities.  This in turn enabled commuters to live further and further out in sprawling suburbia at the expense of urban decay and abandonment of central city living by the middle and upper classes.

There are many references on this.  For example, see http://snipurl.com/5yrt

 Also see http://www.erha.org/plot2.htm

History of Greed : Financial Fraud from Tulip Mania to Bernie Madoff ---
http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470601809.html

In his new book, History of Greed, noted financial fraud expert David E. Y. Sarna posits that the major scandals that came to light in 2008, like most of those in the last two hundred years are just the superficial manifestations of a system that, at its core, is based on fraud, greed and dishonesty. The root cause of the markets’ malaise, in one word, is “greed.” In two words, it is “easy money.” The quest for easy money took many forms, and each greedy person involved in the financial world found his or her own lucrative niche.

Through anecdotal examples, History of Greed provides an in-depth, behind-the-scenes look at the world of financial fraud, large and small. Millions of dollars are made every day (mostly by promoters and insiders) and lost every day (mostly by innocent but greedy investors) in the markets for these smaller stocks. The market for smaller stocks is a giant casino in which the dice are loaded and the cards are marked. Unlike some of the more exotic greed strategies, like hard-to-comprehend complex derivatives, this one is easy for everyone to understand. Sarna looks at smaller cases of fraud and major financial panics and fruads such as AIG, Goldman Sachs, Enron, and Twentieth Century Ponzi schemes.

Derivative Financial Instruments History of Fraud ---
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

American History of Fraud ---
See Belo

 

The Rise and Fall of the 14th Amendment Corporate "Person"
Immunized From Laws and Regulation

Corporate monopoly, abuse, and fraud were greatly exacerbated by misuse of the 14th Amendment, which states that "no state shall deprive any person of life, liberty or property, without due process of law." This Amendment was adopted during Reconstruction to protect emancipated slaves in a still-hostile South. But in the landmark case of Santa Clara County v. Southern Pacific Railroad (1886), the Court, invoking the 14th Amendment, defined corporations as "persons" and ruled that California could not tax corporations differently than individuals. It followed that, as legal "persons," corporations had First Amendment rights as well.

The 14th Amendment gave rise to ever increasing fraud ranging from stock swindles to land grabs to labor exploitation to consumer product/pricing fraud.  Among the most notorious of these were ploys to create monopolies with unregulated pricing exploitation.  For example John D. Rockefeller created the Standard Oil Corporation and nearly monopolized the supply side, Tarbell (1904).  Standard Oil also sought to monopolize the demand side by a simple ploy --- sell oil products below cost in every town and city until the competitors were forced out of business.  Then Standard Oil would jack up the price to as much as the public could possibly afford to pay for oil products that were becoming increasingly important in modern agriculture and commerce.  Eventually the monopoly was forced to be broken up into "baby" Standard Oil Companies much like the Bell System monopoly was later broken up into Baby Bells.

Prior to the Great Depression of the 1930s, laissez-faire economics had little or no public regulation of business corporations and restraints on monopoly abuses. The Great Depression may well have ended the future of corporate business without some form of public protection against stock and banking frauds.  Securities legislation that provided public treasury backing of the banking system also created shareholder protections and banking regulation.  These laws created the SEC and the FDIC.  In Santa Clara's West Coast Hotel Co. v. Parrish (1937), the U.S. Court redefined the due process clauses of the 14th Amendment. Chief Justice Charles Evans Hughes wrote, "The Constitution does not speak of freedom of contract. It speaks of liberty and prohibits the deprivation of liberty without due process of law."  Later  Justice William Douglas observed in Williamson v. Lee Optical of Oklahoma (1955):  "The day is gone when the Court uses the Due Process Clause of the 14th Amendment to strike down state laws, regulatory of business and industrial conditions because they may be ... out of harmony with a particular line of thought."

Although courts now permit state and federal regulation of business, corporations have managed to retain the First Amendment rights they were granted in Santa Clara. U.S. Corporations wield vast economic and political power.  They have grown into world powers with more resources than many of the countries in which they operate.  Monopoly powers have given way to world cartel powers that can be equally abusive.  Evils include labor exploitation, price gouging, disregard for environmental protection, stealing of minerals and oil, and aiding and abetting in political corruption around the world.  Of course, all multinational corporations are not evil all of or even most of the time.  They also provide a vast amount of good throughout the world in providing improved housing, food, education, health care, and economic opportunity in many impoverished parts of the world. 

 

World Cartels Can Be Politically Evil Beyond Financial Fraud

Americans were also subjected to frauds and other evils of world cartels.  German cartels created acute shortages in the medical field in the early 1900s.  Prior to World War I, more than eighty percent of surgical instruments were imported from Germany. Many medicines were under complete German control, particularly salvarsan, luminal and Novocain. Salvarsan was used at the time to treat syphilis, and luminal was used to prevent epileptic seizures. There were no replacements for these drugs and many patients went untreated.

The following is an excerpt from the State of the Union address by President Wilson on May 20, 1919:

Among the industries to which special consideration should be given is that of the manufacture of dyestuffs and related chemicals. Our complete dependence upon German supplies before the war made the interruption of trade a cause of exceptional economic disturbance. The close relation between the manufacture of dyestuff on the one hand and of explosives and poisonous gases on the other, moreover, has given the industry an exceptional significance and value.

The advantages and risks lie in the size and economic power of enormous corporations and cartels.  They have enormous capacities for good.  And they create enormous risks for abuse and exploitation.  Checks and balances reside more in the power of the free media than in the law.  The media has become much more than newspapers in the era of television, the Internet, and electronic mail.

But the media alone is not enough.  The media is reactive to damages that have already taken place.  On rare occasions whistleblowers contact the media before something bad is about to happen.  More often than not, however, the whistleblowers come forth only after investigations begin as to why something bad happened.  For example, when Enron was growing its way into the world's energy cartel, the company borrowed nearly $1 billion to build a fraudulent power plant in India.  It was fraudulent in the sense that a gas-fired plant in India made no economic sense since neither the surrounding public nor commercial enterprises in India could afford the cost of importing natural gas to run the plant.  The entire project was a ploy to force the Indian government (under a planned threat of withdrawing U.S. Aid money) to use general tax revenues in India to subsidize importing gas from Enron suppliers.  Nobody within the scheme blew the whistle until after the plant was built by Enron's Rebecca Mack.  Only afterwards when Enron lost its political clout of threatening to withdraw U.S. Aid to India (due in large part to the U.S. Government's need for India to become an ally in the Gulf War) did the scheme fail.  When Enron eventually collapsed, its Indian power plant fiasco along with other Enron frauds were belatedly discovered by the media.  By then it was too late to save the creditors and shareholders who financed the useless power plant.  Also by then, Rebecca Mack had taken her millions in salary and stock sales and departed from Enron before the scheme was uncovered.

 

Wall Street Rots to the Core --- http://www.trinity.edu/rjensen/fraudrotten.htm

Wall Street scandals in stock selling that led to the Crash of 1929 ended the laissez-faire policy of government toward unregulated buying and selling of corporate ownership shares.  Business even welcomed government regulation as a way of restoring investor faith in a failed system of corporate financing.  Among other things, new securities laws in the 1930s created the Securities and Exchange Commission with a charter to prevent securities frauds and to punish both companies and corporate insiders from exploitation of the investing public.  The SEC set its sights on corporate manager insider trading and for the most part has been successful in curbing major abuses.  The SEC also energized the auditing profession by requiring that companies listed on stock exchanges have annual audits by "independent" Certified Public Accounting firms.  Prior to the 1930s, corporations engaged CPA audits on a voluntary basis as a way of adding credibility to financial statements presented to the general public.  But auditing was not required.

The SEC also was granted regulatory power over stock exchanges and other securities market institutions and processes such as the selling of mutual funds.  Although the SEC gets high marks for many of its regulation efforts, it gets a solid failing grade in terms of its oversight of stock exchanges and related market institutions.  The SEC simply looked aside when it came to an ever increasing flood of Wall Street frauds of the 1980s and 1990s,  The high water mark of frauds came in the 1990s when the media finally got wind of "infectious greed" in investment banking, stock trading, bond rating, mutual fund, and other industries rooted on Wall Street.  Much credit is due to Frank Partnoy's FIASCO references noted at the end of this document. 

Especially note Frank Partnoy's, FIASCO: The Inside Story of a Wall Street Trader (Penguin, 1999, ISBN 0140278796, 283 pages).  This is a blistering indictment of the unregulated OTC market for derivative financial instruments and the million and billion dollar deals conceived in investment banking. Among other things, Partnoy describes Morgan Stanley’s annual drunken skeet-shooting competition organized by a “gun-toting strip-joint connoisseur” former combat officer (fanatic) who loved the motto: “When derivatives are outlawed only outlaws will have derivatives.” At that event, derivatives salesmen were forced to shoot entrapped bunnies between the eyes on the pretense that the bunnies were just like “defenseless animals” that were Morgan Stanley’s customers to be shot down even if they might eventually “lose a billion dollars on derivatives.”

This book has one of the best accounts of the “fiasco” caused almost entirely by the duping of Orange County ’s Treasurer (Robert Citron) by the unscrupulous Merrill Lynch derivatives salesman named Michael Stamenson. Orange County eventually lost over a billion dollars and was forced into bankruptcy. Much of this was later recovered in court from Merrill Lynch. Partnoy calls Citron and Stamenson “The Odd Couple,” which is also the title of Chapter 8 in the book.  Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, Incorporated, 2003, ISBN: 080507510-0, 477 pages) Frank Partnoy, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, Incorporated, 2003, ISBN: 080507510-0, 477 pages)

Partnoy shows how corporations gradually increased financial risk and lost control of an overly complex structured financing deals that obscured the losses and disguised frauds pushed corporate officers and their boards into successive and ingenious deceptions." Major corporations such as Enron, Global Crossing, and WorldCom entered into enormous illegal corporate finance and accounting. Partnoy documents the spread of this epidemic stage and provides some suggestions for restraining the disease.

You can read the following at http://www.trinity.edu/rjensen/fraudrotten.htm#DerivativesFrauds

Michael Lewis, Liar's Poker: Playing the Money Markets (Coronet, 1999, ISBN 0340767006)

Lewis writes in Partnoy’s earlier whistleblower style with somewhat more intense and comic portrayals of the major players in describing the double dealing and break down of integrity on the trading floor of Salomon Brothers.

John Rolfe and Peter Troob, Monkey Business: Swinging Through the Wall Street Jungle (Warner Books, Incorporated, 2002, ISBN: 0446676950, 288 Pages)

This is a hilarious tongue-in-cheek account by Wharton and Harvard MBAs who thought they were starting out as stock brokers for $200,000 a year until they realized that they were on the phones in a bucket shop selling sleazy IPOs to unsuspecting institutional investors who in turn passed them along to widows and orphans.  They write. "It took us another six months after that to realize that we were, in fact, selling crappy public offerings to investors."

There are other books along a similar vein that may be more revealing and entertaining than the early books of Frank Partnoy, but he was one of the first, if not the first, in the roaring 1990s to reveal the high crime taking place behind the concrete and glass of Wall Street.  He was the first to anticipate many of the scandals that soon followed.  And his testimony before the U.S. Senate is the best concise account of the crime that transpired at Enron.  He lays the blame clearly at the feet of government officials (read that Wendy Gramm) who sold the farm when they deregulated the energy markets and opened the doors to unregulated OTC derivatives trading in energy.  That is when Enron really began bilking the public.

Wall Street scandals were for the most part not orchestrated by common criminals or organized crime.  Sophisticated schemes for ripping off the public were devised by respected professionals with MBA degrees from Harvard, Yale, Stanford, Chicago, Wharton, and the like.  Honorable men and women started their Wall Street careers with very honorable intentions were subjected to temptations beyond belief.  Many eventually faltered and succumbed to the typical reasoning that "everybody's doing it."  And many in virtually every respected firm on Wall Street commenced to bilk the public out of billions of dollars.

And Corporate CEOs and CFOs invented sophisticated ways to get in on the Wall Street gravy train.  Corporate executives  often were afraid to make millions from inside trading of their own company's shares.  The SEC scared them in this regard.  But these executives had enormous spheres of influence on Wall Street by controlling with Wall Street firm would get their company's millions of dollars worth of financial business.  Elaborate kickback schemes emerged.  A common ploy was for the CEO of Company X to get in on the initial public offering (IPO) of Company Y shares at greatly discounted prices.  Former WorldCom President and Chief Executive Officer Bernie Ebbers made over $5 million on sweetheart stock deals offered by Salomon Smith Barney who granted Ebbers 869,000 shares in companies that were getting ready to launch their initial public offerings between 1996 and 2000. Other top executives were also given sweetheart deals in exchange for granting Worldcom business to Salomon Smith Barney.  This was by no means a rare type of kickback among virtually all leading Wall Street firms that became rotten to the highest levels of management.

The SEC did a lousy job regulating the investment banking industry whose frauds first came to light in the junk bond scandals.  In 1989 a federal grand jury indicted "Junk Bond King" Michael Milken for violations of federal securities and racketeering laws. He pled guilty to securities fraud and insider trading charges that earned him over a billion dollars. Scot Paltow wrote as follows in "The Dark Side of Wall Street: Why Scandals Continue to Erupt ," The Wall Street Journal, December 23, 2004 --- http://www.hermes-press.com/WS_dark_side.htm

Why do Wall Street scandals recur with the grim regularity of earthquakes and forest fires? The obvious answer, of course, is that Wall Street is where the money is. Beyond the inevitable appeal of billions of dollars changing hands daily, however, lie more peculiar reasons why knavery on a grand scale periodically racks the securities industry.

The $1.4 billion settlement of the Wall Street stock-research scandal marks the resolution of only the latest in a chain of scandals since the late 1980s. To mention just a salient few: the junk-bond scandals of Drexel Burnham Lambert; Salomon Bros.' fake bids for Treasury bonds; Prudential Securities' sales of worthless limited-partnership interests to tens of thousands of small investors; and the Nasdaq scandal, involving dozens of brokerage firms colluding to rig spreads at investors' expense.

While scandals are nothing new, the pain they cause is being felt more deeply. Ordinary Joes and Janes have flooded into the stock market, with an estimated 84 million individuals owning stock this year, double the number in 1983, according to the Securities Industry Association. The problem is that most lack the ability to easily detect flim-flam in balance sheets and earnings statements.

The analysts' scandal highlights one reason some Wall Street firms in modern times can't resist treating men and women of Main Street as chickens to be plucked. With the end of fixed commissions on stock trades in 1975, individual investors -- while remaining an important source of revenue -- became progressively less important for most firms than the huge fees to be earned from underwriting and investment banking for big corporations. Over time, taking advantage of the naiveté of individual investors became a convenient way to gain and keep big corporate clients. In the analysts' case, firms disseminated falsely rosey reports to induce unwitting investors into boosting the stock price of the firms' investment-banking clients.

Indeed, the language Wall Street traders and brokers use sometimes betrays disdain toward individual investors. Nasdaq market makers commonly refer to buy and sell orders from individuals as "dumb order flow," meaning their orders are almost certain to be profitable for the market makers because small investors typically trade without any hard information that could give them an advantage over these dealers.

Investment banking became rotten to the core in derivative financial instrument bucket shop schemes that ripped off pension and trust fund managers.  Various insider whistleblowers have written very revealing books about such schemes, notably whistleblower Frank Partnoy --- http://www.trinity.edu/rjensen/fraudrotten.htm#Partnoy
 

Partnoy's book Infectious Greed has chapters on other capital markets and corporate scandals. It is the best account that I've ever read about the Bankers Trust scandals, including how one Wall Street trader named Andy Krieger almost destroyed the entire money supply of New Zealand.  Chapter 10 is devoted to Enron and follows up on Frank Partnoy’s invited testimony before the United States Senate Committee on Governmental Affairs, January 24, 2002 --- http://www.senate.gov/~gov_affairs/012402partnoy.htm

The SEC did a lousy job regulating the mutual fund industry by allowing undisclosed fees and by allowing large investors to rip off small investors with after-hours trading --- http://www.trinity.edu/rjensen/fraudrotten.htm#MutualFunds
 

Mutual funds with poor investor return performances were commonly paying kickback schemes to large networks of investment advisors and stock brokers who, in turn, diverted customer accounts into those unscrupulous funds rather than better mutual funds who did not offer kickbacks.  Large brokerage chains such as the Edward D. Jones & Co chain succumbed to such kickbacks.  See "Why a Brokerage Giant Pushes Some Mediocre Mutual Funds," by Laura Johannes and John Hechinger, The Wall Street Journal, January 9, 2004, Page A1.

December 19, 2004 reply from Bob Jensen

Hello XXXXX,

What you must stress is that the history of capital markets and particularly fraud in capital markets is one of doing business in such a way as to circumventing regulations.  It's like a game where vendors sell unregulated securities until abuses become so widespread that there is a public outcry for regulations.  Then the bad guys rework what they sell so that they don't fall under the regulations.  The best example in recent decades is the explosion of derivative financial instruments and hedge funds.  In both cases there were virtually no regulations until billions were stolen.  Especially note the many books of Frank Partnoy --- http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds 

What I am saying is that in addition to deregulation in the 1990s, there was an even bigger problem of no regulation that is analogous to the laissez faire way of doing business prior to the Crash of 1929 and the ensuing securities acts (regulations) of the 1930s.

In terms of deregulation itself, much of it preceeded 1994.  We had the break up of AT&T as well as the global deregulation of the telecommunications industry --- http://www.peterkeen.com/virtual01.htm .  We had the deregulation of the airline industry which begain in 1979.  

In banking and securities markets, the big deregulation came with enactment of the Gramm-Leach-Bliley Act (GLBA) in 1999.  repealed the long-standing Glass-Steagall prohibitions on the mixing of banking with securities or insurance businesses and thus permits "broad banking."  But prior to this investment banks were largely unregulated which is why they got away with billions and billions of dollars worth of fraud, especially in derivatives markets. Of course the deregulation of energy markets in the 1990s that led to Enron's rise and fall is largely the doing of Senator Gramm (and his wife Wendy).  Certainly in the 1990s, the craze for deregulation commenced to burn out of control.  

I think what you should also stress is that having regulation does not do much good unless regulations are enforced.  One of the major factors leading up to the enormous securities, mutual fund, insurance, and other frauds of the 1990s was poor enforcement of Wall Street by the SEC.  Until recently Wall Street owned the SEC, NASD, NYSE, etc.  Regulations on the books were simply overlooked by Federal Regulators and state attorney generals (prior to Spitzer).  

What I am saying is that deregulation became a problem, but it was a lesser problem than lack of enforcement of existing regulation.  Of course this is a problem in nearly all Federal agencies once they become owned by the businesses they are supposed to regulate.  For example, agribusiness owns the Department of Agriculture, power companies own the FPC, industry cartels own the FDA, the airlines own the FAA, etc.  

And now we see Wall Street dealing behind closed doors to regain control of the SEC --- http://www.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking 

 

 

The Auditors Fiddled While Investors Burned

The majority of investor fraud is rooted in false and misleading financial performance reports of corporations.  Both shareholders and creditors have been burned over and over again even after the SEC in the 1930s granted monopoly auditing power to the profession of Certified Public Accountants (CPAs).  All companies listed on public stock exchanges are required to have annual audits by external "independent" CPAs.  Other companies, including private corporations, are often expected to do so by creditors.

When auditing was the primary bread winner for CPA firms in the decades from 1940 to 1980, the audits themselves were reasonably effective in preventing corporate-wide frauds that badly distorted the financial position and annual performance of most audited corporations.  That does not mean there were not major problems on the rise.  Increasingly, especially beginning in the 1970s, companies devised leasing and other ploys such as unconsolidated subsidiaries to keep debt off the balance sheet.  Also the CPA external auditors always insisted that their audits were not designed to detect fraud within a company such as employee looting of corporate resources.  CPA audits only certified with respect to "fairness" of the financial statement numbers and conformance of the accounting system with generally accepted accounting principles.  Supposedly the CPAs were only responsible to detect fraud that "materially" distorted the bottom line.  For example, if the CEO looted $10 million dollars from a multinational company that reported net earnings of $10 billion, the bottom line would not be materially distorted if the CPA auditor failed to detect the CEO's crime.

In the 1980s, corporations devised increasingly sophisticated financing contracts such as derivative financial instruments and revenue recognition schemes that commenced to badly distort some financial statements.  CPA firms increasingly became negligent in detecting significant distortions.  This in large measure arose because auditing was becoming a less profitable line of business for large international CPA firms.  Clients began to shop for auditors with determined intent to grant the audit to the lowest bidder.  Simultaneously, CPA firms got in on the ground floor of management and technology consulting and found that there were much higher margins in consulting.  Soon the largest international CPA firms were earning as much or more in consulting fees than they were auditing fees from the same clients.  In the year 2000, the CPA firm known as Andersen was earning over $25 million in consulting fees from Enron and $25 million in auditing fees from Enron.  And the consulting was much more profitable when factoring in costs of providing the services.  Worse yet, some clients were challenging the "independence" of the auditors by threatening to take away the consulting fees if the auditors made too much fuss about how certain items such as revenue and debt were reported in the audited financial statements.  Pressures to bend the rules became intense in many instances.

The scandals and bad audits of major CPA firms are documented at http://www.trinity.edu/rjensen/fraud.htm
Some of the schemes used by clients to fool auditors and the public are documented at http://www.trinity.edu/rjensen/ecommerce.htm

Frank Partnoy introduces Chapter 7 of Infectious Greed as follows:

Pages 187-188

The regulatory changes of 1994-95 sent three messages to corporate CEOs.  First, you are not likely to be punished for "massaging" your firm's accounting numbers.  Prosecutors rarely go after financial fraud and, even when they do, the typical punishment is a small fine; almost no one goes to prison.  Moreover, even a fraudulent scheme could be recast as mere earnings management--the practice of smoothing a company's earnings--which most executives did, and regarded as perfectly legal.

Second, you should use new financial instruments--including options, swaps, and other derivatives--to increase your own pay and to avoid costly regulation.  If complex derivatives are too much for you to handle--as they were for many CEOs during the years immediately following the 1994 losses--you should at least pay yourself in stock options, which don't need to be disclosed as an expense and have a greater upside than cash bonuses or stock.

Third, you don't need to worry about whether accountants or securities analysts will tell investors about any hidden losses or excessive options pay.  Now that Congress and the Supreme Court have insulated accounting firms and investment banks from liability--with the Central Bank decision and the Private Securities Litigation Reform Act--they will be much more willing to look the other way.  If you pay them enough in fees, they might even be willing to help.

Of course, not every corporate executive heeded these messages.  For example, Warren Buffett argued that managers should ensure that their companies' share prices were accurate, not try to inflate prices artificially, and he criticized the use of stock options as compensation.  Having been a major shareholder of Salomon Brothers, Buffett also criticized accounting and securities firms for conflicts of interest.

But for every Warren Buffett, there were many less scrupulous CEOs.  This chapter considers four of them: Walter Forbes of CUC International, Dean Buntrock of Waste Management, Al Dunlap of Sunbeam, and Martin Grass of Rite Aid.  They are not all well-known among investors, but their stories capture the changes in CEO behavior during the mid-1990s.  Unlike the "rocket scientists" at Bankers Trust, First Boston, and Salomon Brothers, these four had undistinguished backgrounds and little training in mathematics or finance.  Instead, they were hardworking, hard-driving men who ran companies that met basic consumer needs: they sold clothes, barbecue grills, and prescription medicine, and cleaned up garbage.  They certainly didn't buy swaps linked to LIBOR-squared.

 

Occupational Fraud

Typical occupational frauds include inflated expense claims and pilfered goods and money.  What is sad is that workers who might otherwise be honest seem to justify stealing from employers when they feel that they are underpaid or under appreciated.   In the year 2003, occupational fraud is estimated at $660 billion according to the 2004 Report to the Nation on Occupational Fraud and Abuse, The Association of Certified Fraud Examiners --- http://www.cfenet.com/resources/rttn.asp 

Question:
What has been one of the most massive, if not these most massive, fraud in the history of the U.S.?

Answer:
The attorney/physician rip off on phony asbestos health damage claims. 

"Diagnosing for Dollars A court battle over silicosis shines a harsh light on mass medical screeners—the same people whose diagnoses have cost asbestos defendants billions," by Roger Parloff, Fortune, June 13, 2005, pp. 96-110 --- http://www.fortune.com/fortune/articles/0,15114,1066756,00.html

How, then, to account for this: Of 8,629 people diagnosed with silicosis now suing in federal court in Corpus Christi, 5,174—or 60%—are "asbestos retreads," i.e., people who have previously filed claims for asbestos-related disease.

That anomaly turns out to be just one of many in the Corpus Christi case that sorely challenge medical explanation. At a hearing in February, U.S. District Judge Janis Graham Jack characterized the evidence before her as raising "great red flags of fraud," and a federal grand jury in Manhattan is now looking into the situation, according to two people who have been subpoenaed.

The real importance of those proceedings, however, is not what they reveal about possible fraud in silica litigation but what they suggest about a possible fraud of vastly greater dimensions. It's one that may have been afflicting asbestos litigation for almost 20 years, resulting in billions of dollars of payments to claimants who weren't sick and to the attorneys who represented them. Asbestos litigation—the original mass tort—has bankrupted more than 60 companies and is expected to eventually cost defendants and their insurers more than $200 billion, of which $70 billion has already been paid.

The odor around asbestosis diagnosis has been so foul for so long that by 1999, professor Lester Brickman of the Benjamin N. Cardozo School of Law was referring to asbestos litigation as a "massively fraudulent enterprise." At the request of his defamation lawyer, Brickman says, he toned that down to "massive, specious claiming"

Continued in the article

 

Fraud Explodes with Advances in Government Benefit Programs

Probably the biggest suckers in America are local, state, and federal government benefit programs.  Medicare and Medicaid frauds cost billions each year.  Social Security funds are heavily tapped into with phony claims of disability.  Farmers rip off government farm programs.  Able bodied workers claim phony unemployment and welfare needs.  Defense contractors and other contractors of government agencies rip the system off for untold billions. 

Fraud Explodes Exponentially With Advances in Technology

Opportunities to cheat companies and people out of money and other resources soared in the age of computers, networking, and off-site payments.  Corporate revenues and banking fees exploded when vendors commenced to accept credit cards over the phone and on the Internet.  But the downside was that criminals commenced to exploit this new opportunity using various schemes that entailed stealing of credit card numbers and in many instances stealing entire identities of honest people.

Phony investment, product, and charity frauds exploded exponentially with email.  Then the spammers began to clutter mail boxes hawking everything from pornography to lotteries to "free" travel.

Centralized databases have made it easier for insiders and hackers to crack into databases and either steal directly from a company or steal records that can be sold in secondary markets.  Electronic commerce between business and consumers (B to C) and business to business (B to B) have greatly improved the worldwide efficiency and effectiveness of world commerce.  But the price has been an immense rise in electronic frauds that accompany electronic commerce.  Information that used to be private is no longer private.  Computers connected to the Internet became two way streets in which evil people can get inside our computers and do very bad things without our knowledge.

Many of the schemes and ways of fighting back are documented at http://www.trinity.edu/rjensen/fraudreporting.htm

 

Major Underlying Causes of Fraud in the History of the United States

Obsession with Privacy
The major cause of fraud in the United States is that freedom is prized over the risk of being ripped off.  Most fraud will be eliminated if and when U.S. citizens become accountable for every dollar of value in their estates.  Such accountability would be greatly enhanced by the elimination of all cash money in society.  If all transaction payments were reported electronically in a way that audit trails on virtually every payment were reported to central authorities, then fraud opportunities would be reduced mainly to bartering opportunities.  Bartering opportunities could be reduced if items such as cars, guns, jewelry, furniture, works of art, etc.  had electronic identification numbers and ownership titles that could only be transferred by reporting transactions.  Fraud would be discouraged if citizens had to document the sources of funds used to purchase major items such as homes, travel, cars, and luxury items.  But in the United States, most citizens are not yet willing to sacrifice their privacies to such an extent in the interest of curbing frauds.

White Collar Crime Leniency
Fraud in the United States is especially high because the laws and courts are so lenient on non-violent white collar criminals.  White collar crime pays big even in the rare chance that the criminal is caught.  By the time the culprit is detected and indicted, he or she has already pirated away most of the loot in an offshore bank account or some other hiding place.  After spending a very small amount of time in relatively comfortable incarceration facilities, the culprit returns to a life of luxury.  Famous white collar criminals can become rich just by selling books they write about their crimes.  The problem of white collar crime leniency is discussed further in "White Collar Crime Pays Big Even if You Get Caught" at http://www.trinity.edu/rjensen/fraudconclusion.htm#CrimePays

Whistle Blowing is Discouraged
One of the best deterrents to crime is the risk that a whistle blower will report the crime.  Even though new laws such as the 2003 Sarbanes Oxley Act offer protections to whistle blowers, the fact of the matter is that whistle blowing is a high risk undertaking.  Whistle blowers may have some clues to a crime, but they seldom have all the facts.  If the criminal is not put away for the crime, the whistle blower faces possible risks of retaliation that can be physical or financial in the form of a lawsuit or extortion.  Even if the criminal is put away, whistle blowers may be ostracized by fellow employees.  America generally prides itself in team players, and whistle blowers are generally not respected as team players by fellow employees.  Americans just do not like tattle tales.

Declining Morality and Ethics
The main problem with the decline in morality stems from changing role models from stern parents to peers who often adopt the attitude that nearly "everybody is doing it."  There are of course other causes such as the rise in opportunities to cheat in large impersonal systems such as government programs, insurance companies, credit card systems, Internet sites, and large corporations in general.  And then there is the serious problem of drug addiction.  Much of the crime in the United States is perpetrated by people desperately addicted to drugs that they cannot afford.  And drug use is on the rise, especially among white collar workers.  Narcotic availability coupled with the decline of family stability and control contribute to a willingness to take criminal risks.  Another addiction in the United States is the obsession with wealth and all the trappings of greed.  Many young people feed they have failed if they are not millionaires before they reach thirty years of age.  They are motivated more by money than honor.  This became particularly infectious on Wall Street in the 1990s.  Newly minted MBAs from top universities came to Wall Street with one thing on their minds --- get rich quick and get out!  And even though their education courses did not encourage fraud, many of these courses provided the burglary tools.  The Wharton School at the University of Pennsylvania, for example, once had 22 courses in tools of finance without one course in financial ethics.  This has changed somewhat in business school curricula after the Wall Street scandals came to light.

Unaccountable Contracting
One of the problems faced by auditors is that some really complex financing arrangements have become so complicated that they virtually cannot be audited or explained.  Complicated instruments are issued that do not fit established concepts of liabilities or equity. Enron had over 3,000 special purpose entities offshore that accountants could not fathom even after the contracts came to light.  Clauses in these and other contracts create a maze of contingencies that often confuse sophisticated analysts. In many instances the main purpose of the confusion is to complicate the accounting.  See http://www.trinity.edu/rjensen/fraudconclusion.htm#UnaccountableContracting

Incompetent and Corrupt Audits are Routine
The auditing profession has just not kept up with the rapid pace of technology change in the systems being audited.  Far too often the audit trail ends in front of a maze of networked computers or some giant black box that cannot be fathomed.  Auditors, in turn, rely upon the opinions of employees who work with the systems.  But few, if any, employees really comprehend the complete network system and its vulnerability to computing viruses and insider fraud.  Even in cases where auditors could greatly improve the quality of the audits (say by moving to continuous auditing in place of visits four or fewer times a year), the requisite resources available to the audit firm from audit fees just do not exist.  The price of a really good audit is just too high for the system to bear.

CPA Audits Have a Flawed Design
The SEC mandates that corporations must have external audits by "independent" CPA firms.  The purpose of the audit is to protect shareholders, creditors, and potential investors in the corporation from misleading or fraudulent financial statements produced by the corporation's top management.  But the audit fee is paid to the CPA firm certifying to the correctness and fairness of management's financial report by corporate management. Corporate management both chooses the CPA audit firm and negotiates the audit fee.  The audit firm that does not issue a "clean" audit report is in jeopardy of losing the client.  For example, if the CPA firm called Andersen had balked at the way Enron was accounting for some suspicious transactions, the local Andersen office in Houston stood to lose $1 million per week in audit and consulting fees being paid by Enron.  Pressures are immense to maintain great relations with audit clients.

A Failed System of Campaign Financing
Legislators in state and local governments no longer can be elected to office without running enormously expensive campaigns, especially for offices in the U.S. House of Representatives and the U.S. Senate.  Even relatively honest candidates become somewhat beholden to large donors.  Large donors generally have highly oiled lobbying machines in any legislature, and these machines are highly successful in steering votes favorable to special interest groups.  Time and time again the bills protecting the public lose out to special interests.  This system time and time again encourages rather than discourages fraud.

In recent years, the failed campaign financing system is also corrupting the court systems of many states in the U.S.  Mike France and Lorraine Woellert write as follows in "The Battle Over the Courts," Business Week, September 27, 2004, Page 40:

To win hotly contested states, some judicial candidates are building multimillion dollar war chests---often from people who might well appear in their courtrooms.  Although precise figures are hard to tally, this year's races figure to be the most expensive ever.
 

Some of the Most Notorious White Collar Criminals

"WHITE-COLLAR CRIMINALS Schemers and Scams: A Brief History of Bad Business It takes some pretty spectacular behavior to get busted in this country for a white-collar crime. But the business world has had a lot of overachievers willing to give it a shot."
by Ellen Florian, Fortune magazine, March 18, 2002, pp. 62-68 --- http://www.fortune.com/indexw.jhtml?channel=artcol.jhtml&doc_id=206661 

1920: The Ponzi Scheme 
Charles Ponzi planned to arbitrage postal coupons--buying them from Spain and selling them to the U.S. Postal Service at a profit. To raise capital, he outlandishly promised investors a 50% return in 90 days. They naturally swarmed in, and he paid the first with cash collected from those coming later. He was imprisoned for defrauding 40,000 people of $15 million.

1929: Albert Wiggin 
In the summer of 1929, Wiggin, head of Chase National Bank, cashed in by shorting 42,000 shares of his company's stock. His trades, though legal, were counter to the interests of his shareholders and led to passage of a law prohibiting executives from shorting their own stock.

1930: Ivar Krueger, the Match King 
Heading companies that made two-thirds of the world's matches, Krueger ruled--until the Depression. To keep going, he employed 400 off-the-books vehicles that only he understood, scammed his bankers, and forged signatures. His empire collapsed when he had a stroke.

1938: Richard Whitney 
Ex-NYSE president Whitney propped up his liquor business by tapping a fund for widows and orphans of which he was trustee and stealing from the New York Yacht Club and a relative's estate. He did three years' time.

1961: The Electrical Cartel 
Executives of GE, Westinghouse, and other big-name companies conspired to serially win bids on federal projects. Seven served time--among the first imprisonments in the 70-year history of the Sherman Antitrust Act.

1962: Billie Sol Estes 
A wheeler-dealer out to corner the West Texas fertilizer market, Estes built up capital by mortgaging nonexistent farm gear. Jailed in 1965 and paroled in 1971, he did the mortgage bit again, this time with nonexistent oil equipment. He was re-jailed in 1979 for tax evasion and did five years.

1970: Cornfeld and Vesco Bernie 
Cornfeld's Investors Overseas Service, a fund-of-funds outfit, tanked in 1970, and Cornfeld was jailed in Switzerland. Robert Vesco "rescued" IOS with $5 million and then absconded with an estimated $250 million, fleeing the U.S. He's said to be in Cuba serving time for unrelated crimes.

1983: Marc Rich 
Fraudulent oil trades in 1980-81 netted Rich and his partner, Pincus Green, $105 million, which they moved to offshore subsidiaries. Expecting to be indicted by U.S. Attorney Rudy Giuliani for evading taxes, they fled to Switzerland, where tax evasion is not an extraditable crime.
Clinton pardoned Rich in 2001 (and he and Hillary received over $7,000 in furniture from the wife of Marc Rich to furnish the Clinton's new home in New York.)
Note from 

1986: Boesky and Milken and Drexel Burnham Lambert 
The Feds got Wall Streeter Ivan Boesky for insider trading, and then Boesky's testimony helped them convict Drexel's Michael Milken for market manipulation. Milken did two years in prison, Boesky 22 months. Drexel died.

1989: Charles Keating and the collapse of Lincoln S&L 
Keating was convicted of fraudulently marketing junk bonds and making sham deals to manufacture profits. Sentenced to 12 1/2 years, he served less than five. Cost to taxpayers: $3.4 billion, a sum making this the most expensive S&L failure.

1991: BCCI 
The Bank of Credit & Commerce International got tagged the "Bank for Crooks & Criminals International" after it came crashing down in a money-laundering scandal that disgraced, among others, Clark Clifford, advisor to four Presidents.

1991: Salomon Brothers 
Trader Paul Mozer violated rules barring one firm from bidding for more than 35% of the securities offered at a Treasury auction. He did four months' time. Salomon came close to bankruptcy. Chairman John Gutfreund resigned.

1995: Nick Leeson and Barings Bank 
A 28-year-old derivatives trader based in Singapore, Leeson brought down 233-year-old Barings by betting Japanese stocks would rise. He hid his losses--$1.4 billion--for a while but eventually served more than three years in jail.

1995: Bankers Trust 
Derivatives traders misled clients Gibson Greetings and Procter & Gamble about the risks of exotic contracts they entered into. P&G sustained about $200 million in losses but got most of it back from BT. The Federal Reserve sanctioned the bank.

1997: Walter Forbes 
Only months after Cendant was formed by the merger of CUC and HFS, cooked books that created more than $500 million in phony profits showed up at CUC. Walter Forbes, head of CUC, has been indicted on fraud charges and faces trial this year.

1997: Columbia/HCA 
This Nashville company became the target of the largest-ever federal investigation into health-care scams and agreed in 2000 to an $840 million Medicare-fraud settlement. Included was a criminal fine--rare in corporate America--of $95 million.

1998: Waste Management 
Fighting to keep its reputation as a fast grower, the company engaged in aggressive accounting for years and then tried straight-out books cooking. In 1998 it took a massive charge, restating years of earnings.

1998: Al Dunlap 
He became famous as "Chainsaw Al" by firing people. But he was then axed at Sunbeam for illicitly manufacturing earnings. He loved overstating revenues--booking sales, for example, on grills neither paid for nor shipped.

1999: Martin Frankel 
A financier who siphoned off at least $200 million from a series of insurance companies he controlled, Frankel was arrested in Germany four months after going on the lam. Now jailed in Rhode Island--no bail for this guy--he awaits trial on charges of fraud and conspiracy.

2000: Sotheby's and Al Taubman 
The world's elite were ripped off by years of price-fixing on the part of those supposed bitter competitors, auction houses Sotheby's and Christie's. Sotheby's chairman, Taubman, was found guilty of conspiracy last year. He is yet to be sentenced.

To this we add the more recent listings:

Enron's cast of characters and their stock sales can be found at http://www.trinity.edu/rjensen/FraudEnron.htm#StockSales 

"Post-Script on Corporate Scandal: Where are they now?" by Susan Funaro, LegalZoom.com, January 12, 2005 --- http://www.legalzoom.com/articles/article_content/article12954.html 

Adelphia Communications: The Rigas clan certainly knows how to have a good time and live well. John Rigas and his sons in fact were charged with multiple counts of fraud and conspiracy after using $2.3 billion in company “loans” to finance their lifestyle. Though the senior Rigas and his son Timothy were found guilty, Michael’s trial ended in a jury deadlock. Sentencing – John and Timothy face a maximum of 30 years - will not occur until the charges against Michael are resolved.

Enron:The fall-out is still reverberating three years later. Conspirators include not only Enron’s CEOs but also execs from Arthur Andersen and Merrill Lynch. The tangled charges of conspiracy, fraud, and obstruction of justice all stem from schemes to cook the books so that profits looked high. Why? So executives could line their pockets before the company tanked in 2001 when Enron lost $68 billion in market value. The real losers: employees and investors. Five thousand employees lost their jobs, and $800 million in pension investments went up in smoke. The sheer scale of the fraud led the Justice Department to set up an Enron Task Force. More than 30 people have been charged. Fourteen have pleaded guilty.

Arthur Andersen,auditor for Enron,was convicted of tampering and destroying evidence while the SEC was investigating their client Enron. Though Andersen’s lawyers argued that shredding documents was routine housekeeping, the company was eventually convicted of obstruction of justice in July 2004. The result: Andersen was sentenced to the maximum $500,000 fine and five years’ probation. The company has since dropped after leading the pack as one of the world’s big five accounting firms. A company that once employed 28,000 people has whittled its numbers down to 250 employees, mostly dedicated to litigation and to operating a training center.

Merrill Lynch & Co. Four Merrill Lynch executives were convicted of fraud on November 3, 2004 after the U.S. government discovered that Enron’s “sale” of energy generating barges to Merrill Lynch was a disguised loan “cooked up” to look like $12 million in profit. The real cost? Investors lost over $13 million. The four execs face up to 12 years in prison. Sentencing is scheduled for March 2005.

Enron executives:

Former Enron financial chief Andrew Fastow pled guilty to conspiracy, agreeing to serve 10 years and to testify against former Enron chief executives. Fastow’s wife Lea pled guilty to filing a false tax return and was sentenced to a year in prison after she agreed to help the prosecution and persuaded her husband to do the same. For her cooperation, the prosecution dropped six original felony charges against her.

Enron trials pending:

The date still isn’t set for the top 3 Enron executives: Kenneth Lay (Enron founder) faces charges of fraud and conspiracy, and taking over the conspiracy when Skilling quit three months before Enron’s collapse.Lay will have a separate trial for bank fraud, lying to banks, and using loans to buy Enron stock on margin. Jeffrey Skilling (former CEO) and Richard Causey (top accountant) face more than 30 counts. Among the charges are fraud, conspiracy, insider trading, lying to auditors, and knowing or participating in schemes to deceive investors.

RiteAid:Martin Grass,former CEO and the son of its founder, was sentenced to eight years in prison by a federal court in May 2004. Grass was convicted for conspiring to inflate the value of the company.

Martha Stewart, Inc: Our favorite home-maker Martha is cooking up crab apple jelly while serving her five month sentence at “CampCupcake” in Alderson, West Virginia. After being convicted of lying to investigators, Martha decided to begin her sentence while appealing, so that her company could begin its rebound. Martha’s broker, Peter Bacanovic, was given the same sentence but is awaiting his appeal before serving. Imclone founder, SamWaksal, was sentenced to seven years in prison for insider trading. He tipped investors that the FDA rejected the company’s application for Erbitux, which would cause stock to drop.

Tyco:The most serious criminal chargeagainst Dennis Kozlowski,enterprise corruption, was dropped by a judge in early November and the criminal case ended in a mistrial. Kozlowski and finance chief, Mark Swartz are accused of manipulating corporate loan programs and making improper stock sales, involving more than $600 million. Kozolowski also faces separate charges for not paying sales tax on $23 million of artwork he purchased. Other personal items purchased with corporate funds? A $6,000 shower curtain, $18 million in apartment décor, a $2.1 million trip to Sardinia, and a $19 million Boca Raton home.

WorldCom:Former CEO, Bernard Ebbers, is awaiting trial for conspiracy, securities fraud, filing a false document, and improper accounting to inflate profits. The defense requested a delay until January 2005.

Citicorp:A federal judge held that Citicorp is liable for a $2.575 billion settlement of a class-action lawsuit. The suit is being filed by WorldCom investors who claim they were defrauded by Citicorp when it hid WorldCom’s risks.

The moral of these stories? Policing corporations is an industry in itself, and it’s one that can’t be outsourced.

Executives on Trial

"The Latest Developments," The Wall Street Journal, January 14, 2004 --- http://online.wsj.com/documents/info-trials05.html 

 
BERNARD J. EBBERS
Former chairman and chief executive of WorldCom
 
L. DENNIS KOZLOWSKI
Former Tyco International chief executive officer
 
KENNETH LAY
Former Enron chairman and CEO
 
RICHARD M. SCRUSHY
Former HealthSouth Corp. chairman and CEO
THE CASE WorldCom went from being one of the biggest stock-market stars of the past decade to being the biggest case of accounting fraud in U.S. history after falsifying earnings reports to show continued profits. Investigators say Mr. Kozlowski, with former finance chief Mark Swartz, looted about $600 million from Tyco in unauthorized compensation and illicit stock sales, using questionable accounting practices to hide the misdeeds. Prosecutors and regulators say the former energy giant created off-the-books partnerships and used aggressive accounting methods to hide massive debt and inflate the firm's bottom line. Mr. Scrushy is accused of orchestrating a massive fraud that inflated the health-care company's earnings to meet Wall Street expectations.
UNCOVERED In early 2002, the SEC launched inquiries on the heels of a sharp cut in earnings forecasts from the company. WorldCom disclosed the accounting fraud on June 25, 2002. Mr. Ebbers was indicted in March 2004. Mr. Kozlowski was indicted in the Tyco case in September 2002. His first trial began in October 2003 and ended in April 2004. (Separate charges of tax evasion were handed down in June 2002.) The SEC launched an investigation in October 2001 after Enron booked a hefty charge related to sour investments (among them, a pair of limited partnerships run by the company's CFO). The company sought court protection from creditors in December 2001. In September 2002, the SEC requested a range of company documents for a fact-finding accounting inquiry. In March 2003, federal agents raided HealthSouth's headquarters and the SEC filed a civil case against HealthSouth and Mr. Scrushy.
IMPACT The collapse wiped out shares with a market capitalization of $115 billion at their peak in 1999. The fraud itself amounted to about $10.6 billion from moves that boosted earnings by understating expenses. The company admitted to overstating income from 1998 to 2001 by $1.15 billion. The tipping-point charge to earnings totaled $1.01 billion; CFO Andrew Fastow made an estimated $45 million from his partnerships' dealings with Enron. Earnings were inflated to the tune of $2.5 billion.
MAIN
CHARGES
Securities fraud, conspiracy and causing the company to make false filings with securities regulators. Mr. Kozlowski faced 24 counts, including several counts of grand larceny, securities fraud and falsifying business records, in his first trial. Earlier, the judge dismissed several other counts, including an enterprise corruption charge. Mr. Lay faces 11 criminal counts of securities fraud and wire fraud, in addition to charges of fraud and insider trading from the SEC. 58 federal criminal charges, including the first of providing false certifications to securities regulators under the Sarbanes-Oxley Act; conspiracy; making false statements and money laundering.
DEFENDANT'S
STATUS
Awaiting trial, with jury selection scheduled to start Jan. 18 and opening statements around Jan. 24. Awaiting retrial after the first trial, which came to symbolize the worst of corporate greed and excess, was declared a mistrial in April 2004. Jury selection begins Jan. 18, with testimony expected in February. He has been indicted; trial's timing and location to be determined this month. In November 2003, Mr. Scrushy pleaded not guilty to a list of 85 charges that later were consolidated into the 58 on which he is awaiting trial. Opening arguments are to begin on Jan. 25.
OTHER MAJOR
DEFENDANTS
Scott Sullivan
Former CFO
Pleaded guilty in March 2004 to orchestrating the fraud and is expected to testify against Mr. Ebbers

Jack Grubman
Former Salomon Smith Barney telecom analyst, one of WorldCom's most bullish supporters
Agreed to pay $15 million and be barred from the securities industry for life
Mark Swartz
Former CFO
Also awaiting a retrial

Mark Belnick
Former general counsel
Acquitted of grand larceny, securities fraud and falsifying business records
Andrew Fastow
Former finance chief
Pleaded guilty to fraud and admitted to conspiracy to inflate profits in return for a 10-year sentence

Jeffrey Skilling
Former CEO
Pleaded not guilty to 42 counts, from conpiracy to securities fraud; awaits trial; Mr. Fastow is expected to testify against him.
More than a dozen former HealthSouth executives have pleaded guilty in the case, including five former chief financial officers.
COMPANY'S
STATUS
In July 2002, WorldCom filed for Chapter 11 bankruptcy-law protection. It emerged last April and was renamed MCI. Tyco is under new management and thanks to a restructuring program has posted strong advances in profit for recent quarters. After three years under court protection, what remained of Enron was broken up into independent companies (CrossCountry Energy, Portland General Electric and Prisma Energy International) and sold in autumn 2004. HealthSouth, with a new raft of executives, recently settled an unrelated lawsuit over Medicare fraud dating back to the 1990s and has announced expansion plans.
FOR MORE
INFORMATION
Trial of WorldCom's Ebbers Will Focus on Uneasy Partnership
1/12/05
Lifting the Curtain: Tyco Retrial to Get Started
1/14/05
For Enron's Ex-Chief, Spotlight Shines on His Public Statements
1/5/05
Scrushy Indicted on Fraud Charges
11/5/03

 

 

Bob Jensen's threads on how white collar crime pays even if you get caught are at http://www.trinity.edu/rjensen/FraudConclusion.htm#CrimePays 

Bob Jensen's threads on the Enron and Worldcom frauds are at http://www.trinity.edu/rjensen/FraudEnron.htm 

Bob Jensen's threads on fraud, including derivative financial instruments fraud, are at http://www.trinity.edu/rjensen/fraud.htm 

Bob Jensen's threads on audit fraud and failures are at http://www.trinity.edu/rjensen/fraud.htm 

 

Is America Winning or Losing Its War on Fraud?

Fraud rolls across American history like waves move onto a beach.  Fraud rises and falls with new innovations and ultimate corrections.  For example, prior to the 1930s one innovative type of accounting fraud was to exaggerate the value of inventory on hand by reporting non-existent inventory.  External auditors were not required to verify the physical presence of inventory on hand.  The corrective measure came as a result of the famous McKesson Robbins scandal in which this company even reported inventory stocks in nonexistent warehouses.  As a result of the lawsuit and intense media reporting of the bad audit, the CPA profession instituted an auditing rule that required auditors to physically test for the existence of warehouses and inventory stocks within warehouses.

Each new corporate ploy to get around accounting and auditing rules eventually results in corrective accounting and auditing rules, which of course is why the exponentially growing set of such rules is becoming almost incomprehensible.  The same thing happens with consumer and investor protection laws.  When fraud finally gets so out of hand and has intense media exposure, U.S. democracy generally works.  Corrective laws are eventually passed, and criminals are forced to seek newer and more innovative frauds.

On at least two occasions fraud got so out of hand that there were immense tidal surges that threatened the entire financial system.  One of these was the Wall Street Crash of 1929 followed by the Great Depression that threatened the entire equity market and banking system in the United States.  Extreme corrective measures had to be taken that included greater regulation of capital markets and government backing of national banks.  Another tidal surge took place following the Enron debacle in the 1990s.  The resulting meltdown of Enron's auditing firm (Andersen) proved that bad auditing could destroy one of the largest and most successful international accounting firms in the world.  The resulting exposures of Wall Street's "infectious greed" coupled with Wall Street's smoking guns uncovered by NY Attorney General Elliot Spitzer might have toppled the major financial houses in America unless corrective measures were imposed.  And we have seen some of those corrective measures, but many more are needed to restore investor confidence in the ever-greedy market insiders.

The battle is still being lost over corporate governance.  None of the legislation to date has had a major impact on restraining excessive executive salaries and perks.  None of the legislation to date has substantially shifted corporate boards to seriously challenge management rewards for mediocre and lackluster performance.

The major deterrent to fraud, apart from freedom of the press, is worry over immense civil lawsuits.  This has led to really serious efforts to improve occupational safety, reduce sexual harassment, improve equal employment opportunities, improve accountability, improve internal controls, and increase professionalism.  But it has also threatened some companies with frivolous and greedy lawsuits such as the saga of asbestos lawsuits where monetary damages are far in excess of the harm actually caused by rare forms of asbestos.  Sometimes the lawsuits themselves are frauds that drag down good companies.  Investors and their attorneys should not believe that they can sue whenever a risky investment loses money.  Risky investments by definition have higher odds for failure, and investors taking on risk should not be able to turn risky investments into sure things with lawsuits.  Lawsuits should be reserved for gross negligence and fraud, not for inherent business risks.

Newer technology that creates opportunities for fraud also creates opportunities to deter fraud.  The rise in international fraud, especially on the Internet, has served to unite virtually all the industrial world to combat such fraud.

The future of some professions are in doubt.  The auditing profession in particular is at a very fragile juncture at this moment in time.  There is worry that the rise in multimillion dollar judgments against auditing firms might bring down these firms.  For more on the bright and dark sides of the future of auditing firms, to http://www.trinity.edu/rjensen/fraudconclusion.htm

The weakest front in the war on fraud is the political front where holders of political office, including judgeships, are increasingly dependent upon donations from interest groups that often oppose adoption of the most powerful laws and procedures for combating fraud.  For example, the extremely powerful corporate lobby resists many promising efforts to curtail corporate and government fraud.  Agribusiness resists efforts to curtail farm program fraud.  The medical industry resists efforts to protect Medicare, Medicaid, and medical insurance companies from fraud.

And so the waves of fraud continue to move across time in the life of the United States.


Financial WMDs (Credit Derivatives) on Sixty Minutes (CBS) on August 30, 2009 ---
http://www.cbsnews.com/video/watch/?id=5274961n&tag=contentBody;housing
I downloaded the video (5,631 Mbs) to http://www.cs.trinity.edu/~rjensen/temp/FinancialWMDs.rv 

Steve Kroft examines the complicated financial instruments known as credit default swaps and the central role they are playing in the unfolding economic crisis. The interview features my hero Frank Partnoy. I don't know of anybody who knows derivative securities contracts and frauds better than Frank Partnoy, who once sold these derivatives in bucket shops. You can find links to Partnoy's books and many, many quotations at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

For years I've used the term "bucket shop" in financial securities marketing without realizing that the first bucket shops in the early 20th Century were bought and sold only gambles on stock pricing moves, not the selling of any financial securities. The analogy of a bucket shop would be a room full of bookies selling bets on NFL playoff games.
See "Bucket Shop" at http://en.wikipedia.org/wiki/Bucket_shop_(stock_market)

I was not aware how fraudulent the credit derivatives markets had become. I always viewed credit derivatives as an unregulated insurance market for credit protection. But in 2007 and 2008 this market turned into a betting operation more like a rolling crap game on Wall Street.

Of all the corporate bailouts that have taken place over the past year, none has proved more costly or contentious than the rescue of American International Group (AIG). Its reckless bets on subprime mortgages threatened to bring down Wall Street and the world economy last fall until the U.S Treasury and the Federal Reserve stepped in to save it. So far, the huge insurance and financial services conglomerate has been given or promised $180 billion in loans, investments, financial injections and guarantees - a sum greater than the annual cost of the wars in Iraq and Afghanistan."
"Why AIG Stumbled, And Taxpayers Now Own It," CBS Sixty Minutes, May 17, 2009 ---
http://www.cbsnews.com/stories/2009/05/15/60minutes/main5016760.shtml?source=RSSattr=HOME_5016760


Simoleon Sense Reviews Janet Tavakoli’s Dear Mr. Buffett ---
http://www.simoleonsense.com/simoleon-sense-reviews-janet-tavakolis-dear-mr-buffett/

What’s The Book (Dear Mr. Buffett) About

Dear Mr. Buffett, chronicles the agency problems, poor regulations, and participants which led to the current financial crisis. Janet accomplishes this herculean task by capitalizing on her experiences with derivatives, Wall St, and her relationship with Warren Buffett. One wonders how she managed to pack so much material in such few pages!

Unlike many books which only analyze past events, Dear Mr. Buffett, offers proactive advice for improving financial markets. Janet is clearly very concerned about protecting individual rights, promoting honesty, and enhancing financial integrity. This is exactly the kind of character we should require of our financial leaders.

Business week once called Janet the Cassandra of Credit Derivatives. Without a doubt Janet should have been listened to. I’m confident that from now on she will be.

Closing thoughts

Rather than a complicated book on financial esoterica, Janet has created a simple guide to understanding the current crisis. This book is a must read for all students of finance, economics, and business. If you haven’t read this book, please do so.

Warning –This book is likely to infuriate you, and that’s a good thing! Janet provides indicting evidence and citizens may be tempted to initiate vigilante like witch trials. Please consult with your doctor before taking this financial medication.

Continued in article

September 1, 2009 reply from Rick Lillie [rlillie@CSUSB.EDU]

Hi Bob,

I am reading Dear Mr. Buffett, What an Investor Learns 1,269 Miles from Wall Street, by Janet Tavakoli. I am just about finished with the book. I am thinking about giving a copy of the book to students who perform well in my upper-level financial reporting classes.

I agree with the reviewer’s comments about Tavakoli’s book. Her explanations are clear and concise and do not require expertise in finance or financial derivatives in order to understand what she (or Warren Buffet) says. She explains the underlying problems of the financial meltdown with ease. Tavakoli does not blow you over with “finance BS.” She does in print what Steve Kroft does in the 60 Minutes story.

Tavakoli delivers a unique perspective throughout the book. She looks through the eyes of Warren Buffett and explains issues as Buffett sees them, while peppering the discussion with her experience and perspective.

The reviewer is correct. Tavakoli lets the finance world, along with accountants, attorneys, bankers, Congress, and regulators, have it with both barrels!

Tavakoli’s book is the highlight of my summer reading.

Best wishes,

Rick Lillie

Rick Lillie, MAS, Ed.D., CPA Assistant Professor of Accounting Coordinator - Master of Science in Accountancy (MSA) Program Department of Accounting and Finance College of Business and Public Administration CSU San Bernardino 5500 University Pkwy, JB-547 San Bernardino, CA. 92407-2397

Telephone Numbers: San Bernardino Campus: (909) 537-5726 Palm Desert Campus: (760) 341-2883, Ext. 78158

For technical details see the following book:
Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization (Wiley Finance) by Janet M. Tavakoli (2008)

Bob Jensen's Rotten to the Core threads are at http://www.trinity.edu/rjensen/FraudRotten.htm

Bob Jensen's threads on the current economic crisis are at http://www.trinity.edu/rjensen/2008Bailout.htm
For credit derivative problems see http://www.trinity.edu/rjensen/2008Bailout.htm#Bailout

Also see "Credit Derivatives" under the C-Terms at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms

Bob Jensen's free tutorials and videos on how to account for derivatives under FAS 133 and IAS 39 ---
http://www.trinity.edu/rjensen/caseans/000index.htm


The Greatest Swindle in the History of the World
Paulson and Geithner Lied Big Time

"The Ugly AIG Post-Mortem:  The TARP Inspector General's report has a lot more to say about the rating agencies than it does about Goldman Sachs," by Holman Jenkins, The Wall Street Journal, November 24m 2009 --- Click Here

A year later, the myrmidons of the media have gotten around to the question of why, after the government took over AIG, it paid 100 cents on the dollar to honor the collateral demands of AIG's subprime insurance counterparties.

By all means, read TARP Inspector General Neil Barofsky's report on the AIG bailout—but read it honestly.

It does not say AIG's bailout was a "backdoor bailout" of Goldman Sachs. It does not say the Fed was remiss in failing to require Goldman and other counterparties to settle AIG claims for pennies on the dollar.

It does not for a moment doubt the veracity of officials who say their concern was to stem a systemic panic that might have done lasting damage to the U.S. standard of living.

To be sure, Mr. Barofsky has some criticisms to offer, but the biggest floats inchoate between the lines of a widely overlooked section headed "lessons learned," which focuses on the credit rating agencies. The section notes not only the role of the rating agencies, with their "inherently conflicted business model," in authoring the subprime mess in the first place—but also the role of their credit downgrades in tipping AIG into a liquidity crisis, in undermining the Fed's first attempt at an AIG rescue, and in the decision of government officials "not to pursue a more aggressive negotiating policy to seek concessions from" AIG's counterparties.

Though not quite spelling it out, Mr. Barofsky here brushes close to the last great unanswered question about the AIG bailout. Namely: With the government now standing behind AIG, why not just tell Goldman et al. to waive their collateral demands since they now had the world's best IOU—Uncle Sam's?

Congress might not technically have put its full faith and credit behind AIG, but if banks agreed to accept this argument, and Treasury and Fed insisted on it, and the SEC upheld it, the rating agencies would likely have gone along. No cash would have had to change hands at all.

This didn't happen, let's guess, because the officials—Hank Paulson, Tim Geithner and Ben Bernanke—were reluctant to invent legal and policy authority out of whole cloth to overrule the ratings agencies—lo, the same considerations that also figured in their reluctance to dictate unilateral haircuts to holders of AIG subprime insurance.

Of course, the thinking now is that these officials, in bailing out AIG, woulda, shoulda, coulda used their political clout to force such haircuts, but quailed when the banks, evil Goldman most of all, insisted on 100 cents on the dollar.

This story, in its gross simplification, is certainly wrong. Goldman and others weren't in the business of voluntarily relinquishing valuable claims. But the reality is, in the heat of the crisis, they would have acceded to any terms the government dictated. Washington's game at the time, however, wasn't to nickel-and-dime the visible cash transfers to AIG. It was playing for bigger stakes—stopping a panic by asserting the government's bottomless resources to uphold the IOUs of financial institutions.

What's more, if successful, these efforts were certain to cause the AIG-guaranteed securities to rebound in value—as they have. Money has already flowed back to AIG and the Fed (which bought some of the subprime securities to dissolve the AIG insurance agreements) and is likely to continue to do so for the simple reason that the underlying payment streams are intact.

Never mind: The preoccupation with the Goldman payments amounts to a misguided kind of cash literalism. For the taxpayer has assumed much huger liabilities to keep homeowners in their homes, to keep mortgage payments flowing to investors, to fatten the earnings of financial firms, etc., etc. These liabilities dwarf the AIG collateral calls, inevitably benefit Goldman and other firms, and represent the real cost of our failure to create a financial system in which investors (a category that includes a lot more than just Goldman) live and die by the risks they voluntarily take without taxpayers standing behind them.

No, Moody's and S&P are not the cause of this policy failure—yet Mr. Barofsky's half-articulated choice to focus on them is profound. For the role the agencies have come to play in our financial system amounts to a direct, if feckless and weak, attempt to contain the incentives that flow from the government's guaranteeing of so many kinds of private liabilities, from the pension system and bank deposits to housing loans and student loans.

The rating agencies' role as gatekeepers to these guarantees is, and was, corrupting, but the solution surely is to pare back the guarantees themselves. Overreliance on rating agencies, with their "inherently conflicted business model," was ultimately a product of too much government interference in the allocation of credit in the first place.

The Mother of Future Lawsuits Directly Against Credit Rating Agencies and I, ndirectly Against Auditing Firms

It has been shown how Moody's and some other credit rating agencies sold AAA ratings for securities and tranches that did not deserve such ratings --- http://www.trinity.edu/rjensen/FraudRotten.htm#CreditRatingAgencies
Also see http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze

My friend Larry sent me the following link indicating that a lawsuit in Ohio may shake up the credit rating fraudsters.
Will 49 other states and thousands of pension funds follow suit?
Already facing a spate of private lawsuits, the legal troubles of the country’s largest credit rating agencies deepened on Friday when the attorney general of Ohio sued Moody’s Investors Service, Standard & Poor’s and Fitch, claiming that they had cost state retirement and pension funds some $457 million by approving high-risk Wall Street securities that went bust in the financial collapse.
http://www.nytimes.com/2009/11/21/business/21ratings.html?em

Jensen Comment
The credit raters will rely heavily on the claim that they relied on the external auditors who, in turn, are being sued for playing along with fraudulent banks that grossly underestimated loan loss reserves on poisoned subprime loan portfolios and poisoned tranches sold to investors --- http://www.trinity.edu/rjensen/2008Bailout.htm#AuditFirms
Bad things happen in court where three or more parties start blaming each other for billions of dollars of losses that in many cases led to total bank failures and the wiping out of all the shareholders in those banks, including the pension funds that invested in those banks. A real test is the massive lawsuit against Deloitte's auditors in the huge Washington Mutual (WaMu) shareholder lawsuit.

"Ohio Sues Rating Firms for Losses in Funds," by David Segal, The New York Times, November 20m 2009 --- Click Here

Already facing a spate of private lawsuits, the legal troubles of the country’s largest credit rating agencies deepened on Friday when the attorney general of Ohio sued Moody’s Investors Service, Standard & Poor’s and Fitch, claiming that they had cost state retirement and pension funds some $457 million by approving high-risk Wall Street securities that went bust in the financial collapse.

Already facing a spate of private lawsuits, the legal troubles of the country’s largest credit rating agencies deepened on Friday when the attorney general of Ohio sued Moody’s Investors Service, Standard & Poor’s and Fitch, claiming that they had cost state retirement and pension funds some $457 million by approving high-risk Wall Street securities that went bust in the financial collapse.

The case could test whether the agencies’ ratings are constitutionally protected as a form of free speech.

The lawsuit asserts that Moody’s, Standard & Poor’s and Fitch were in league with the banks and other issuers, helping to create an assortment of exotic financial instruments that led to a disastrous bubble in the housing market.

“We believe that the credit rating agencies, in exchange for fees, departed from their objective, neutral role as arbiters,” the attorney general, Richard Cordray, said at a news conference. “At minimum, they were aiding and abetting misconduct by issuers.”

He accused the companies of selling their integrity to the highest bidder.

Steven Weiss, a spokesman for McGraw-Hill, which owns S.& P., said that the lawsuit had no merit and that the company would vigorously defend itself.

“A recent Securities and Exchange Commission examination of our business practices found no evidence that decisions about rating methodologies or models were based on attracting market share,” he said.

Michael Adler, a spokesman for Moody’s, also disputed the claims. “It is unfortunate that the state attorney general, rather than engaging in an objective review and constructive dialogue regarding credit ratings, instead appears to be seeking new scapegoats for investment losses incurred during an unprecedented global market disruption,” he said.

A spokesman for Fitch said the company would not comment because it had not seen the lawsuit.

The litigation adds to a growing stack of lawsuits against the three largest credit rating agencies, which together command an 85 percent share of the market. Since the credit crisis began last year, dozens of investors have sought to recover billions of dollars from worthless or nearly worthless bonds on which the rating agencies had conferred their highest grades.

One of those groups is largest pension fund in the country, the California Public Employees Retirement System, which filed a lawsuit in state court in California in July, claiming that “wildly inaccurate ratings” had led to roughly $1 billion in losses.

And more litigation is likely. As part of a broader financial reform, Congress is considering provisions that make it easier for plaintiffs to sue rating agencies. And the Ohio attorney general’s action raises the possibility of similar filings from other states. California’s attorney general, Jerry Brown, said in September that his office was investigating the rating agencies, with an eye toward determining “how these agencies could get it so wrong and whether they violated California law in the process.”

As a group, the attorneys general have proved formidable opponents, most notably in the landmark litigation and multibillion-dollar settlement against tobacco makers in 1998.

To date, however, the rating agencies are undefeated in court, and aside from one modest settlement in a case 10 years ago, no one has forced them to hand over any money. Moody’s, S.& P. and Fitch have successfully argued that their ratings are essentially opinions about the future, and therefore subject to First Amendment protections identical to those of journalists.

But that was before billions of dollars in triple-A rated bonds went bad in the financial crisis that started last year, and before Congress extracted a number of internal e-mail messages from the companies, suggesting that employees were aware they were giving their blessing to bonds that were all but doomed. In one of those messages, an S.& P. analyst said that a deal “could be structured by cows and we’d rate it.”

Recent cases, like the suit filed Friday, are founded on the premise that the companies were aware that investments they said were sturdy were dangerously unsafe. And if analysts knew that they were overstating the quality of the products they rated, and did so because it was a path to profits, the ratings could forfeit First Amendment protections, legal experts say.

“If they hold themselves out to the marketplace as objective when in fact they are influenced by the fees they are receiving, then they are perpetrating a falsehood on the marketplace,” said Rodney A. Smolla, dean of the Washington and Lee University School of Law. “The First Amendment doesn’t extend to the deliberate manipulation of financial markets.”

The 73-page complaint, filed on behalf of Ohio Police and Fire Pension Fund, the Ohio Public Employees Retirement System and other groups, claims that in recent years the rating agencies abandoned their role as impartial referees as they began binging on fees from deals involving mortgage-backed securities.

At the root of the problem, according to the complaint, is the business model of rating agencies, which are paid by the issuers of the securities they are paid to appraise. The lawsuit, and many critics of the companies, have described that arrangement as a glaring conflict of interest.

“Given that the rating agencies did not receive their full fees for a deal unless the deal was completed and the requested rating was provided,” the attorney general’s suit maintains, “they had an acute financial incentive to relax their stated standards of ‘integrity’ and ‘objectivity’ to placate their clients.”

To complicate problems in the system of incentives, the lawsuit states, the methodologies used by the rating agencies were outdated and flawed. By the time those flaws were obvious, nearly half a billion dollars in pension and retirement funds had evaporated in Ohio, revealing the bonds to be “high-risk securities that both issuers and rating agencies knew to be little more than a house of cards,” the complaint states.

"Rating agencies lose free-speech claim," by Jonathon Stempel, Reuters, September 3, 2009 ---
http://www.reuters.com/article/GCA-CreditCrisis/idUSTRE5824KN20090903

There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by down grading your bonds. And believe me, it’s not clear sometimes who’s more powerful.  The most that we can safely assert about the evolutionary process underlying market equilibrium is that harmful heuristics, like harmful mutations in nature, will die out.
Martin Miller, Debt and Taxes as quoted by Frank Partnoy, "The Siskel and Ebert of Financial Matters:  Two Thumbs Down for Credit Reporting Agencies," Washington University Law Quarterly, Volume 77, No. 3, 1999 --- http://www.trinity.edu/rjensen/FraudCongressPartnoyWULawReview.htm 

Credit rating agencies gave AAA ratings to mortgage-backed securities that didn't deserve them. "These ratings not only gave false comfort to investors, but also skewed the computer risk models and regulatory capital computations," Cox said in written testimony.
SEC Chairman Christopher Cox as quoted on October 23, 2008 at http://www.nytimes.com/external/idg/2008/10/23/23idg-Greenspan-Bad.html

"How Moody's sold its ratings - and sold out investors," by Kevin G. Hall, McClatchy Newspapers, October 18, 2009 --- http://www.mcclatchydc.com/homepage/story/77244.html

Paulson and Geithner Lied Big Time:  The Greatest Swindle in the History of the World
What was their real motive in the greatest fraud conspiracy in the history of the world?

Bombshell:  In 2008 and early 2009, Treasury Secretary leaders Paulson and Geithner told the media and Congress that AIG needed a global bailout due to not having cash reserves to meet credit default swap (systematic risk) obligations and insurance policy payoffs. On November 19, 2009 in Congressional testimony Geithner now admits that all this was a pack of lies. However, he refuses to resign as requested by some Senators.

"AIG and Systemic Risk Geithner says credit-default swaps weren't the problem, after all," Editors of The Wall Street Journal, November 20, 2009 --- Click Here

TARP Inspector General Neil Barofsky keeps committing flagrant acts of political transparency, which if nothing else ought to inform the debate going forward over financial reform. In his latest bombshell, the IG discloses that the New York Federal Reserve did not believe that AIG's credit-default swap (CDS) counterparties posed a systemic financial risk.

Hello?

For the last year, the entire Beltway theory of the financial panic has been based on the claim that the "opaque," unregulated CDS market had forced the Fed to take over AIG and pay off its counterparties, lest the system collapse. Yet we now learn from Mr. Barofsky that saving the counterparties was not the reason for the bailout.

In the fall of 2008 the New York Fed drove a baby-soft bargain with AIG's credit-default-swap counterparties. The Fed's taxpayer-funded vehicle, Maiden Lane III, bought out the counterparties' mortgage-backed securities at 100 cents on the dollar, effectively canceling out the CDS contracts. This was miles above what those assets could have fetched in the market at that time, if they could have been sold at all.

The New York Fed president at the time was none other than Timothy Geithner, the current Treasury Secretary, and Mr. Geithner now tells Mr. Barofsky that in deciding to make the counterparties whole, "the financial condition of the counterparties was not a relevant factor."

This is startling. In April we noted in these columns that Goldman Sachs, a major AIG counterparty, would certainly have suffered from an AIG failure. And in his latest report, Mr. Barofsky comes to the same conclusion. But if Mr. Geithner now says the AIG bailout wasn't driven by a need to rescue CDS counterparties, then what was the point? Why pay Goldman and even foreign banks like Societe Generale billions of tax dollars to make them whole?

Both Treasury and the Fed say they think it would have been inappropriate for the government to muscle counterparties to accept haircuts, though the New York Fed tried to persuade them to accept less than par. Regulators say that having taxpayers buy out the counterparties improved AIG's liquidity position, but why was it important to keep AIG liquid if not to protect some class of creditors?

Yesterday, Mr. Geithner introduced a new explanation, which is that AIG might not have been able to pay claims to its insurance policy holders: "AIG was providing a range of insurance products to households across the country. And if AIG had defaulted, you would have seen a downgrade leading to the liquidation and failure of a set of insurance contracts that touched Americans across this country and, of course, savers around the world."

Yet, if there is one thing that all observers seemed to agree on last year, it was that AIG's money to pay policyholders was segregated and safe inside the regulated insurance subsidiaries. If the real systemic danger was the condition of these highly regulated subsidiaries—where there was no CDS trading—then the Beltway narrative implodes.

Interestingly, in Treasury's official response to the Barofsky report, Assistant Secretary Herbert Allison explains why the department acted to prevent an AIG bankruptcy. He mentions the "global scope of AIG, its importance to the American retirement system, and its presence in the commercial paper and other financial markets." He does not mention CDS.

All of this would seem to be relevant to the financial reform that Treasury wants to plow through Congress. For example, if AIG's CDS contracts were not the systemic risk, then what is the argument for restructuring the derivatives market? After Lehman's failure, CDS contracts were quickly settled according to the industry protocol. Despite fears of systemic risk, none of the large banks, either acting as a counterparty to Lehman or as a buyer of CDS on Lehman itself, turned out to have major exposure.

More broadly, lawmakers now have an opportunity to dig deeper into the nature of moral hazard and the restoration of a healthy financial system. Barney Frank and Chris Dodd are pushing to give regulators "resolution authority" for struggling firms. Under both of their bills, this would mean unlimited ability to spend unlimited taxpayer sums to prevent an unlimited universe of firms from failing.

Americans know that's not the answer, but what is the best solution to the too-big-to-fail problem? And how exactly does one measure systemic risk? To answer these questions, it's essential that we first learn the lessons of 2008. This is where reports like Mr. Barofsky's are valuable, telling us things that the government doesn't want us to know.

In remarks Tuesday that were interpreted as a veiled response to Mr. Barofsky's report, Mr. Geithner said, "It's a great strength of our country, that you're going to have the chance for a range of people to look back at every decision made in every stage in this crisis, and look at the quality of judgments made and evaluate them with the benefit of hindsight." He added, "Now, you're going to see a lot of conviction in this, a lot of strong views—a lot of it untainted by experience."

Mr. Geithner has a point about Monday-morning quarterbacking. He and others had to make difficult choices in the autumn of 2008 with incomplete information and often with little time to think, much less to reflect. But that was last year. The task now is to learn the lessons of that crisis and minimize the moral hazard so we can reduce the chances that the panic and bailout happen again.

This means a more complete explanation from Mr. Geithner of what really drove his decisions last year, how he now defines systemic risk, and why he wants unlimited power to bail out creditors—before Congress grants the executive branch unlimited resolution authority that could lead to bailouts ad infinitum.

Jensen Comment
One of the first teller of lies was the highly respected Gretchen Morgenson of The New York Times who was repeating the lies told to her and Congress by the Treasury and the Fed. This was when I first believed that the problem at AIG was failing to have capital reserves to meet CDS obligations. I really believed Morgenson's lies in 2008 ---
http://www.nytimes.com/2008/09/21/business/21gret.html
 

Here's what I wrote in 2008 --- http://www.trinity.edu/rjensen/2008Bailout.htm#Bailout
Credit Default Swap (CDS)
This is an insurance policy that essentially "guarantees" that if a CDO goes bad due to having turds mixed in with the chocolates, the "counterparty" who purchased the CDO will recover the value fraudulently invested in turds. On September 30, 2008 Gretchen Morgenson of The New York Times aptly explained that the huge CDO underwriter of CDOs was the insurance firm called AIG. She also explained that the first $85 billion given in bailout money by Hank Paulson to AIG was to pay the counterparties to CDS swaps. She also explained that, unlike its casualty insurance operations, AIG had no capital reserves for paying the counterparties for the the turds they purchased from Wall Street investment banks.

"Your Money at Work, Fixing Others’ Mistakes," by Gretchen Morgenson, The New York Times, September 20, 2008 --- http://www.nytimes.com/2008/09/21/business/21gret.html
Also see "A.I.G., Where Taxpayers’ Dollars Go to Die," The New York Times, March 7, 2009 --- http://www.nytimes.com/2009/03/08/business/08gret.html

What Ms. Morgenson failed to explain, when Paulson eventually gave over $100 billion for AIG's obligations to counterparties in CDS contracts, was who were the counterparties who received those bailout funds. It turns out that most of them were wealthy Arabs and some Asians who we were getting bailed out while Paulson was telling shareholders of WaMu, Lehman Brothers, and Merrill Lynch to eat their turds.

You tube had a lot of videos about a CDS. Go to YouTube and read in the phrase "credit default swap" --- http://www.youtube.com/results?search_query=Credit+Default+Swaps&search_type=&aq=f
In particular note this video by Paddy Hirsch --- http://www.youtube.com/watch?v=kaui9e_4vXU
Paddy has some other YouTube videos about the financial crisis.

Bob Jensen’s threads on accounting for credit default swaps are under the C-Terms at
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms

The Greatest Swindle in the History of the World
"The Greatest Swindle Ever Sold," by Andy Kroll, The Nation, May 26, 2009 ---
http://www.thenation.com/doc/20090608/kroll/print

 

Bob Jensen's threads on why the infamous "Bailout" won't work --- http://www.trinity.edu/rjensen/2008Bailout.htm#BailoutStupidity

Bob Jensen's "Rotten to the Core" threads --- http://www.trinity.edu/rjensen/FraudRotten.htm


Oil and Water Must Read:  Economists versus Criminologists
:"Why the ‘Experts’ Failed to See How Financial Fraud Collapsed the Economy," by "James K. Galbraith, Big Picture, June 2, 2010 ---
http://www.ritholtz.com/blog/2010/06/james-k-galbraith-why-the-experts-failed-to-see-how-financial-fraud-collapsed-the-economy/

The following is the text of a James K. Galbraith’s written statement to members of the Senate Judiciary Committee delivered this May. Original PDF text is here.

Chairman Specter, Ranking Member Graham, Members of the Subcommittee, as a former member of the congressional staff it is a pleasure to submit this statement for your record.

I write to you from a disgraced profession. Economic theory, as widely taught since the 1980s, failed miserably to understand the forces behind the financial crisis. Concepts including “rational expectations,” “market discipline,” and the “efficient markets hypothesis” led economists to argue that speculation would stabilize prices, that sellers would act to protect their reputations, that caveat emptor could be relied on, and that widespread fraud therefore could not occur. Not all economists believed this – but most did.

Thus the study of financial fraud received little attention. Practically no research institutes exist; collaboration between economists and criminologists is rare; in the leading departments there are few specialists and very few students. Economists have soft- pedaled the role of fraud in every crisis they examined, including the Savings & Loan debacle, the Russian transition, the Asian meltdown and the dot.com bubble. They continue to do so now. At a conference sponsored by the Levy Economics Institute in New York on April 17, the closest a former Under Secretary of the Treasury, Peter Fisher, got to this question was to use the word “naughtiness.” This was on the day that the SEC charged Goldman Sachs with fraud.

There are exceptions. A famous 1993 article entitled “Looting: Bankruptcy for Profit,” by George Akerlof and Paul Romer, drew exceptionally on the experience of regulators who understood fraud. The criminologist-economist William K. Black of the University of Missouri-Kansas City is our leading systematic analyst of the relationship between financial crime and financial crisis. Black points out that accounting fraud is a sure thing when you can control the institution engaging in it: “the best way to rob a bank is to own one.” The experience of the Savings and Loan crisis was of businesses taken over for the explicit purpose of stripping them, of bleeding them dry. This was established in court: there were over one thousand felony convictions in the wake of that debacle. Other useful chronicles of modern financial fraud include James Stewart’s Den of Thieves on the Boesky-Milken era and Kurt Eichenwald’s Conspiracy of Fools, on the Enron scandal. Yet a large gap between this history and formal analysis remains.

Formal analysis tells us that control frauds follow certain patterns. They grow rapidly, reporting high profitability, certified by top accounting firms. They pay exceedingly well. At the same time, they radically lower standards, building new businesses in markets previously considered too risky for honest business. In the financial sector, this takes the form of relaxed – no, gutted – underwriting, combined with the capacity to pass the bad penny to the greater fool. In California in the 1980s, Charles Keating realized that an S&L charter was a “license to steal.” In the 2000s, sub-prime mortgage origination was much the same thing. Given a license to steal, thieves get busy. And because their performance seems so good, they quickly come to dominate their markets; the bad players driving out the good.

The complexity of the mortgage finance sector before the crisis highlights another characteristic marker of fraud. In the system that developed, the original mortgage documents lay buried – where they remain – in the records of the loan originators, many of them since defunct or taken over. Those records, if examined, would reveal the extent of missing documentation, of abusive practices, and of fraud. So far, we have only very limited evidence on this, notably a 2007 Fitch Ratings study of a very small sample of highly-rated RMBS, which found “fraud, abuse or missing documentation in virtually every file.” An efforts a year ago by Representative Doggett to persuade Secretary Geithner to examine and report thoroughly on the extent of fraud in the underlying mortgage records received an epic run-around.

When sub-prime mortgages were bundled and securitized, the ratings agencies failed to examine the underlying loan quality. Instead they substituted statistical models, in order to generate ratings that would make the resulting RMBS acceptable to investors. When one assumes that prices will always rise, it follows that a loan secured by the asset can always be refinanced; therefore the actual condition of the borrower does not matter. That projection is, of course, only as good as the underlying assumption, but in this perversely-designed marketplace those who paid for ratings had no reason to care about the quality of assumptions. Meanwhile, mortgage originators now had a formula for extending loans to the worst borrowers they could find, secure that in this reverse Lake Wobegon no child would be deemed below average even though they all were. Credit quality collapsed because the system was designed for it to collapse.

A third element in the toxic brew was a simulacrum of “insurance,” provided by the market in credit default swaps. These are doomsday instruments in a precise sense: they generate cash-flow for the issuer until the credit event occurs. If the event is large enough, the issuer then fails, at which point the government faces blackmail: it must either step in or the system will collapse. CDS spread the consequences of a housing-price downturn through the entire financial sector, across the globe. They also provided the means to short the market in residential mortgage-backed securities, so that the largest players could turn tail and bet against the instruments they had previously been selling, just before the house of cards crashed.

Latter-day financial economics is blind to all of this. It necessarily treats stocks, bonds, options, derivatives and so forth as securities whose properties can be accepted largely at face value, and quantified in terms of return and risk. That quantification permits the calculation of price, using standard formulae. But everything in the formulae depends on the instruments being as they are represented to be. For if they are not, then what formula could possibly apply?

An older strand of institutional economics understood that a security is a contract in law. It can only be as good as the legal system that stands behind it. Some fraud is inevitable, but in a functioning system it must be rare. It must be considered – and rightly – a minor problem. If fraud – or even the perception of fraud – comes to dominate the system, then there is no foundation for a market in the securities. They become trash. And more deeply, so do the institutions responsible for creating, rating and selling them. Including, so long as it fails to respond with appropriate force, the legal system itself.

Control frauds always fail in the end. But the failure of the firm does not mean the fraud fails: the perpetrators often walk away rich. At some point, this requires subverting, suborning or defeating the law. This is where crime and politics intersect. At its heart, therefore, the financial crisis was a breakdown in the rule of law in America.

Ask yourselves: is it possible for mortgage originators, ratings agencies, underwriters, insurers and supervising agencies NOT to have known that the system of housing finance had become infested with fraud? Every statistical indicator of fraudulent practice – growth and profitability – suggests otherwise. Every examination of the record so far suggests otherwise. The very language in use: “liars’ loans,” “ninja loans,” “neutron loans,” and “toxic waste,” tells you that people knew. I have also heard the expression, “IBG,YBG;” the meaning of that bit of code was: “I’ll be gone, you’ll be gone.”

If doubt remains, investigation into the internal communications of the firms and agencies in question can clear it up. Emails are revealing. The government already possesses critical documentary trails — those of AIG, Fannie Mae and Freddie Mac, the Treasury Department and the Federal Reserve. Those documents should be investigated, in full, by competent authority and also released, as appropriate, to the public. For instance, did AIG knowingly issue CDS against instruments that Goldman had designed on behalf of Mr. John Paulson to fail? If so, why? Or again: Did Fannie Mae and Freddie Mac appreciate the poor quality of the RMBS they were acquiring? Did they do so under pressure from Mr. Henry Paulson? If so, did Secretary Paulson know? And if he did, why did he act as he did? In a recent paper, Thomas Ferguson and Robert Johnson argue that the “Paulson Put” was intended to delay an inevitable crisis past the election. Does the internal record support this view?

Let us suppose that the investigation that you are about to begin confirms the existence of pervasive fraud, involving millions of mortgages, thousands of appraisers, underwriters, analysts, and the executives of the companies in which they worked, as well as public officials who assisted by turning a Nelson’s Eye. What is the appropriate response?

Some appear to believe that “confidence in the banks” can be rebuilt by a new round of good economic news, by rising stock prices, by the reassurances of high officials – and by not looking too closely at the underlying evidence of fraud, abuse, deception and deceit. As you pursue your investigations, you will undermine, and I believe you may destroy, that illusion.

But you have to act. The true alternative is a failure extending over time from the economic to the political system. Just as too few predicted the financial crisis, it may be that too few are today speaking frankly about where a failure to deal with the aftermath may lead.

In this situation, let me suggest, the country faces an existential threat. Either the legal system must do its work. Or the market system cannot be restored. There must be a thorough, transparent, effective, radical cleaning of the financial sector and also of those public officials who failed the public trust. The financiers must be made to feel, in their bones, the power of the law. And the public, which lives by the law, must see very clearly and unambiguously that this is the case.

Thank you.

~~~

James K. Galbraith is the author of The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too, and of a new preface to The Great Crash, 1929, by John Kenneth Galbraith. He teaches at The University of Texas at Austin

Bob Jensen's threads on the subprime sleaze is at
http://www.trinity.edu/rjensen/2008Bailout.htm#Sleaze

History of Fraud in America ---  http://www.trinity.edu/rjensen/415wp/AmericanHistoryOfFraud.htm

Fraud Girl Posts

Question
Can any of you identify the mystery "Fraud Girl" who will be writing a weekly (Sunday) column for Simoleon Sense?

Hint
She seems to have a Chicago connection and seems very well informed about the blog posts of Francine McKenna.
http://retheauditors.com/
But I really do know know who is the mystery "Fraud Girl."

"Guest Post: Fraud Girl Says, “Regulators, Ignore the Masses — It’s Your Responsibility!!”
(A New SimoleonSense Series on Fraud, Forensic Accounting, and Ethics)

Simoleon Sense, April 25, 2010 --- Click Here
http://www.simoleonsense.com/guest-post-fraud-girl-says-regulators-ignore-the-masses-it%e2%80%99s-your-responsibility-must-follow-series-on-fraud-forensic-accounting-and-ethics/
 

I’m exceptionally proud to introduce you to Fraud Girl, our new Sunday columnist. She will write about all things corp governance, fraud, accounting, and business ethics. To give you some background (and although I can not reveal her identity). Fraud girl recently visited me in Chicago for the Harry Markopolos presentation to the local CFA. We were incredibly lucky to meet with Mr. Markopolos  and enjoyed 3 hours of drinks and accounting talk. Needless to say Fraud Girl was leading the conversation and I was trying to keep up. After a brainstorm session I persuaded her to write for us and teach us about wall street screw-ups.

So watch out, shes smart, witty, and passionate about making the world a better place. I think Sundays just got a lot better…

Miguel Barbosa
Founder of SimoleonSense

P.S. For Questions or Comments:  Reach fraud girl at:    FraudGirl@simoleonsense.com 

Regulators, Ignore the Masses — It’s Your Responsibility

Men in general judge more by the sense of sight than by the sense of touch, because everyone can see but only a few can test feeling. Everyone sees what you seem to be, few know what you really are; and those few do not dare take a stand against the general opinion, supported by the majesty of the government. In the actions of all men, and especially of princes who are not subject to a court of appeal, we must always look to the end. Let a prince, therefore, win victories and uphold his state; his methods will always be considered worthy, and everyone will praise them, because the masses are always impressed by the superficial appearance of things, and by the outcome of an enterprise. And the world consists of nothing but the masses; the few have no influence when the many feel secure.

-Niccolo Machiavelli, The Prince

Why are Machiavelli’s words so astonishingly prophetic? How does a 500 year old quote explain contagion, bubbles, and Ponzi schemes? Do financial decision makers consciously overlook reality or do they merely postpone due diligence? That is the purpose of this series — to analyze financial fraud(s) and question business ethics.

Recent accounting scandals i.e. Worldcom, Enron, Madoff, reveal a variety of methods for boosting short term performance at the expense of long run shareholder value. WorldCom recorded bogus revenue, Enron boosted their operating income through improper classifications, and Madoff ran the largest Ponzi scheme in history. Sure these scandals were unethical, deceived the public, and made a ton of money. But what is the most striking similarity? Each of these companies was seen as the golden goose egg; an indestructible force that could never fail. Of course, the key word is “seen”, regulators, attorneys, financial analysts, and auditors failed to see reality. But why?

Fiduciaries are entrusted with protecting the public and shareholders from crooks like Skilling, Pavlo, and Schrushy. An average shareholder lacks the knowledge and expertise of a prominent regulator, right? Shareholders don’t perform the company’s annual audit, review all legal documentation, or communicate with top executives. No, shareholders base their decisions off information that is “accurate” and “meticulously examined”.

Unfortunately in each of these instances regulators failed to take a stand against consensus and became another ignorant face in the crowd. “Everyone sees what you seem to be, few know what you really are; and those few do not dare take a stand against the general opinion”. Who are the few that really know who these companies are? The answer should be evident. What isn’t clear is why these cowardly few are in charge of overseeing our financial markets.

When Auditors Look The Other Way

A week ago, I came across this article: Ernst & Young defends its Lehman work in letter to clients. I chuckled as I was reading it, remembering Roxie Hart from the play Chicago shouting the words “Not Guilty” to anyone who would listen. Like Roxie, the audit team pleaded that the media was inaccurate. In recording Lehman’s Repo 105 transactions, they claimed compliance with GAAP and believed the financial statements were ‘fairly represented’. But, fair reporting is more than complying with GAAP. Often auditors are “compliant” while cooking the books (a mystery that still eludes me). In this case, the auditors blatantly covered their eyes and closed their ears to what they must have known was deliberate misrepresentation of Lehman Brother’s financial statements.

We will explore the Lehman Brothers fiasco in next week’s post…but here’s the condensed version. Days prior to quarter end, Lehman Brothers used “Repo 105” transactions, which allowed them to lend assets to others in exchange for short-term cash. They borrowed around $50 Billion; none of which appeared on their balance sheet. Lehman instead reported the debt as sales. They used the borrowed cash to pay down other debt. This reduced both their total liabilities and total assets, thereby lowering their leverage ratio.

This was allegedly in compliance with SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities that allowed Lehman to move the $50 Billion of assets from its balance sheet. As long as they followed the rules, auditors could stamp [the] financial statements with a “Fairly Represented” approval and issue an unqualified opinion.

Clearly in this case complying was unethical and probably illegal. Howard Schilit, the author of Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, once said, “You [the auditor] work for the investor, even though you are paid by someone else”. He insists that auditors should look beyond the checklists and guidelines and should instead question everything. Auditors are the first line of defense against fraud and the shareholders are dependent upon the quality of their services. So I ask again, with respect to Lehman Brothers, were the auditors working for the investors or where they in the pockets of senior management?

What can we do?

An admired value investor believes in a similar tactic for confirming the honesty of companies. It’s known as “killing the company”, where in his words, “we think of all the ways the company can die, whether it’s stupid management or overleveraged balance sheets. If we can’t figure out a way to kill the company, then you have the beginning of a good investment”. Auditors must think like this, they must kill the company, and question everything. If you can’t kill a company, then (and only then) are the financial statements truly a fair representation of the firms operations.

There was no “killing” going on when the lead auditing partner said that his team did not approve Lehman’s Accounting Policy regarding Repo 105s but was in some way comfortable enough with them to audit their financial statements. This engagement team failed in looking beyond SFAS 140 and should have realized what every law firm (aside from one firm in London) was stating; that the accounting methods Lehman Brothers used to record Repo 105s were a deliberate attempt to defraud the public.

So I repeat: Ignoring reality is not an option. Ignoring the crowd, however, is an obligation.

See you next week….

-Fraud Girl

Bob Jensen's threads on fraud are linked at
http://www.trinity.edu/rjensen/Fraud.htm

Bob Jensen's Fraud Updates are at
http://www.trinity.edu/rjensen/FraudUpdates.htm

Bob Jensen's threads on accounting news are at
http://www.trinity.edu/rjensen/AccountingNews.htm


"Guest Post – Fraud Girl: “Fraud by Hindsight”- How Wall Street Firms [Legally] Get Away With Fraudulent Behavior!," Fraud Girl, Simoleon Sense, June 6, 2010 --- Click Here
http://www.simoleonsense.com/guest-post-fraud-girl-%e2%80%9cfraud-by-hindsight%e2%80%9d-how-wall-street-firms-legally-get-away-with-fraudulent-behavior/

Last week we discussed the credit rating agencies and their roles the financial crisis. These agencies provided false ratings on credit they knew was faulty prior to the crisis. In defense, these agencies (as well as Warren Buffet) said that they did not foresee the crisis to be as severe as it was and therefore could not be blamed for making mistakes in their predictions. This week’s post focuses on foreseeability and the extent to which firms are liable for incorrect predictions.

Like credit agencies, Wall Street firms have been accused of knowing the dangers in the market prior to its collapse. I came across this post (Black Swans*, Fraud by hindsight, and Mortgage-Backed Securities) via the Wall Street Law Blog that discusses how firms could assert that they can’t be blamed for events they couldn’t foresee. It’s a doctrine known as Fraud by Hindsight (“FBH”) where defendants claim “that there is no fraud if the alleged deceit can only be discerned after the fact”. This claim has been used in numerous securities fraud lawsuits and surprisingly it has worked in the defendant’s favor on most occasions.

Many Wall Street firms say they “could not foresee the collapse of the housing market, and therefore any allegations of fraud are merely impermissible claims of fraud by hindsight”. Was Wall Street able to foresee the housing market crash prior to its collapse? According to the writers at WSL Blog, they did foresee it saying, “From 1895 through 1996 home price appreciation very closely corresponded to the rate of inflation (roughly 3% per year).  From 1995 through 2006 alone – even after adjusting for inflation – housing prices rose by more than 70%”. Wall Street must (or should) have foreseen a drastic change in the market when rises in housing costs were so abnormal. By claiming FBH, however, firms can inevitably “get away with murder”.

What exactly is FBH and how is it used in court? The case below from Northwestern University Law Review details the psychology and legalities behind FBH while attempting to show how the FBH doctrine is being used as a means to dismiss cases rather than to control the influence of Wall Street’s foreseeability claims.

Link Provided to Download "Fraud by Hindsight"  (Registration Required)
 

I’ve broken down the case into two parts. The first part provides two theories on hindsight in securities litigation: The Debiasing Hypothesis & The Case Management Hypothesis. The Debiasing Hypothesis provides that FBH is being used in court as a way to control the influence of ‘hindsight bias’. This bias says that people “overstate the predictability of outcomes” and “tend to view what has happened as having been inevitable but also view it as having appeared ‘relatively inevitable’ before it happened”.  The Debiasing Hypothesis tries to prove that FBH aids judges in “weeding out” the biases so that they can focus on the allegations at hand.

The Case Management Hypothesis states that FBH is a claim used by judges to easily dismiss cases that they deem too complicated or confusing. According to the analysis, “…academics have complained that these [securities fraud] suits settle without regard to merit and do little to deter real fraud, operating instead as a needless tax on capital raising. Federal judges, faced with overwhelming caseloads, must allocate their limited resources. Securities lawsuits that are often complex, lengthy, and perceived to be extortionate are unlikely to be a high priority. Judges might thus embrace any doctrine [i.e. FBH doctrine] that allows them to dispose of these cases quickly” (782-783). The case attempts to prove that FBH is primarily used for case management purposes rather than for controlling hindsight bias.

The psychological aspects behind hindsight bias are discussed thoroughly in this case. Here are a few excerpts from the case regarding this bias:

(1)“Studies show that judges are vulnerable to the bias, and that mere awareness of the phenomenon does not ameliorate its influence on judgment. The failure to develop a doctrine that addresses the underlying problem of judging in hindsight means that the adverse consequences of the hindsight bias remain a part of securities litigation. Judges are not accurately sorting fraud from mistake, thereby undermining the system, even as they seek to improve it” (777).

(2) “Judges assert that a company’s announcement of bad results, by itself, does not mean that a prior optimistic statement was fraudulent. This seems to be an effort to divert attention away from the bad outcome and toward the circumstances that gave rise to that outcome, which is exactly the problem that hindsight bias raises. That is, if people overweigh the fact of a bad outcome in hindsight, then the cure is to reconstruct the situation as people saw it beforehand. Thus, the development of the FBH doctrine suggests a judicial understanding of the biasing effect of judging in hindsight and of a means to address the problem” (781).

(3) “Once a bad event occurs, the evaluation of a warning that was given earlier will be biased. In terms of evaluating a decision-maker’s failure to heed a warning, knowledge that the warned-of outcome occurred will increase the salience of the warning in the evaluator’s mind and bias her in the direction of finding fault with the failure to heed the warning. In effect, the hindsight bias becomes an ‘I-told-you-so’ bias.” (793).

(4) “In foresight, managers might reasonably believe that the contingency as too unlikely to merit disclosure, whereas in hindsight it seems obvious a reasonable investor would have wanted to know it. Likewise, as to warning a company actually made, in foresight most investors might reasonably ignore them, whereas in hindsight they seem profoundly important. If defendants are allowed to defend themselves by arguing that a reasonable investor would have attended closely to these warnings, then the hindsight bias might benefit defendants” (794).

Next week we’ll explore the second part of the case and discuss the importance of utilizing FBH as a means of deterring the hindsight bias. We’ll see how the case proves that FBH is not being used for this purpose and is instead used as a mechanism to dismiss cases that simply do not want to be heard.

See you next week…
-Fraud Girl

Bob Jensen's Rotten to the Core threads on credit rating agencies ---
http://www.trinity.edu/rjensen/FraudRotten.htm#CreditRatingAgencies

Bob Jensen's Rotten to the Core threads on banks and brokerages ---
http://www.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking

Bob Jensen's Fraud updates ---
http://www.trinity.edu/rjensen/FraudUpdates.htm

June 8, 2010 reply from Robert Bruce Walker [walkerrb@ACTRIX.CO.NZ]

The link below is a book review of Michael Lewis’s latest book ‘The Big Short’. The book is clearly based on an article that Bob uncovered about 9 months ago. The mechanism underpinning the ‘short’ is better explained in the NYRB essay and, presumably, in the book itself. It seems that the ‘mezzanine’ tranches (BBB rated) of a series of MBS were packaged, rated AAA and then issued in another MBS. Dubious this might be, but fraud it will not be. It lacks the central element of mens rea. In the face of an accusation of fraud the accused will generally resort to the defence of incompetence or inadequacy – a dangerous thing when facing civil action as well – but better than being seen to have acted ‘knowingly’. No-one knew the property markets would collapse. Many people, including me*, thought that it was inevitable – but we did not know it.

http://www.nybooks.com/articles/archives/2010/jun/10/heart-crash/?pagination=false 

*When I was first told of the ‘low doc’ loan concept by an investment manager, I could hardly believe it. He, on the other hand, described the packager of such products as very clever. The investor in question failed badly due to an over-exposure to MBS. Funny that.

 


"Guest Post – Fraud Girl: “Fraud by Hindsight”- How Wall Street Firms [Legally] Get Away With Fraudulent Behavior! Part 2," by Fraud Girl, Simoleon Post, June 13, 2010 --- Click Here
http://www.simoleonsense.com/guest-post-fraud-girl-%e2%80%9cfraud-by-hindsight%e2%80%9d-how-wall-street-firms-legally-get-away-with-fraudulent-behavior-part-2/

Last week we discussed the first part of the “Fraud by Hindsight” study. As we learned, the FBH doctrine is utilized in securities litigation cases. In learning about the FBH doctrine we reviewed the Debiasing Hypothesis and the Case Management Hypothesis. According to the Debiasing Hypothesis, FBH is used as a tool to “weed out” hindsight bias in order to focus on legal issues at hand. The Case Management Hypothesis, on the other hand declares that FBH is used to dismiss securities fraud cases in order to facilitate judicial control over them. This week we will strive to analyze how Fraud By Hindsight has evolved, meaning, how the courts apply the doctrine (in real life), which differs markedly from the doctrine’s theoretical meaning.

History

The first mention of FBH was in 1978 with Judge Friendly in the case Denny v. Barber. The plaintiff in this case claimed that the bank had “engaged in unsound lending practices, maintained insufficient loan loss reserves, delayed writing off bad loans, and undertook speculative investments” (796). Sound familiar? Anyway — the plaintiff plead that the bank failed to disclose these problems in earlier reports and instead issued reports with optimistic projections. Judge Friendly claimed FBH stating that there were a number of “intervening events” during that period (i.e. increasing prices in petroleum and the City of New York’s financial crisis) that were outside the control of managers and it was therefore insufficient to claim that the defendant should have known better when out-of-the-ordinary incidents have occurred. The end result of the case provided that “hindsight alone might not constitute a sufficient demonstration that the defendants made some predictive decision with knowledge of its falsity or something close to it” (797). Friendly established that FBH is possible, but that in this case the underlying circumstances did not justify a judgment against the bank.

The second relevant mention of FBH was in 1990 with Judge Easterbrook in the case DiLeo v. Ernst & Young. Like the prior case, DiLeo involved problems with loans where the plaintiff plead that the bank and E&Y had known but failed to disclose that a substantial portion of the bank’s loans were uncollectible. This case was different, in that there were no “intervening events” that could have blind sighted managers from issuing more accurate future projections. Still, Easterbrook claimed FBH and said, “the fact that the loans turned out badly does not mean that the defendant knew (or should have known) that this was going to happen” (799-800). Easterbrook believed that the plaintiff must be able to separate the true fraud from the underlying hindsight evidence in order to prove their case.

Easterbrook’s articulation of the FBH doctrine set the stage for all future securities class action cases. As the authors state, the phrase was cited only about twice per year before DiLeo but it increased to an average of twenty-seven times per year afterwards. Unfortunately, the courts found Easterbrook’s perception of the phrase to be more compelling. Instead of providing that the hindsight might play a role determining if fraud has occurred, Easterbrook claimed that there simply is no “fraud by hindsight”. This allows the courts to adjudicate cases solely on complaint, therefore supporting the Case Management Hypothesis.

The results of many tests provided in this case proved that courts were using the doctrine as a means to dismiss cases. Of all the tests, I found one to be most interesting: The Stage of the Proceedings. The results of the test shows that “over 90 percent of FBH applications involve judgments on the pleadings” (814) stage rather than at summary judgment. In the preliminary (pleading) stages, the knowledge of information is not provided, meaning that it is less likely that hindsight bias will affect their decisions. The more the judge delves into the case, the more they are susceptible to the hindsight bias. If the judge is utilizing the FBH doctrine mostly during the pleading stages where hindsight bias is “weak”, then the Debiasing Hypothesis is not valid.

The authors point out the problems with utilizing the FBH doctrine in this way:

“The problem, however, is that the remedy is applied at the pleadings stage, not the summary judgment stage. At the pleadings stage, a bad outcome truly is relevant to the likelihood of fraud. At this stage, the Federal Rules do not ask the courts to make a judgment on the merits, and hence the remedy of foreclosing further litigation is inappropriate. By foreclosing further proceedings, courts are not saying that they do not trust their own judgment, but that they do not trust the process of civil discovery to identity whether fraud occurred” (815).

Because cases are being dismissed so early in the litigation process, courts are not allowing for the discovery of fraud that may be apparent even though hindsight is a factor in the case.

By gathering this and other evidence, the case concludes that judges utilize FBH as a case management tool. They cited that the development of the FBH doctrine could be described as “naïve cynicism”. Though judges understand that hindsight bias must be taken into consideration, they express the belief that the problem does not affect their own judgment. The courts are relying on their own intuitions and gathering the necessary facts to prove fraud by hindsight. The authors note a paradox here saying, “Judges simultaneously claim that human judgment cannot be trusted, and yet they rely on their own judgment”.

The problem is that the naively cynical (FBH) approach has led to securities fraud cases to be governed by moods. The authors say that “In the 1980s and 1990s, as concern with frivolous securities litigation rose, courts and Congress simply made it more difficult for plaintiffs to file suit. In the post-Enron era, this skepticism about private enforcement of securities fraud might have abated somewhat, leading to lesser pleading requirements” (825).

Recap & Implications

Overall the case proves that the courts have not yet been able to establish a sensible mechanism for sorting fraud from mistake. It therefore allows cases that really involve fraud to potentially be dismissed. In cases since DiLeo, the win rate for defendants in FBH cases is 70 percent, as compared with 47 percent in those cases that did not mention it. The mere declaration of “Fraud by Hindsight” gives the defendant an automatic advantage over the plaintiff. Now, the defendant may in fact be innocent – but the current processes are not able to determine who is or isn’t guilty. Remember, judges spend much of their time in these cases separating the hindsight bias from the fraud. This task can become very complex and time consuming.

In sum, the increasing use of FBH has been beneficial for (1) judges because they don’t have to listen to these complicated cases and (2) defendant’s because they are likely to win the case by using the doctrine. The only ones who don’t benefit from doctrine are the plaintiff’s who may truly have been victims of fraud. It is crucial that the judiciary revise the way the FBH is interpreted in order to protect the innocent and convict the guilty.

Have any ideas on how to fix the FBH problem? Send me an email at fraudgirl @ simoleonsense.com.

See you next week.

- Fraud Girl

Click Here To Access The Original  Fraud by Hindsight Case – Part II ---
http://www.scribd.com/doc/32994403/Fraud-by-Hindsight-Part-II

Bob Jensen's threads on fraud are at
http://www.trinity.edu/rjensen/Fraud.htm

 

 


 

 

References

Armstrong, David and Elizabeth Metzger Armstrong (1991), The Great American Medicine Show (Prentice-Hall, ISBN: 0133640272 )

Lewis,  Michael (1999), Liar's Poker: Playing the Money Markets (Coronet, ISBN 0340767006)

Rolfe, John and Peter Troob (2002), Monkey Business: Swinging Through the Wall Street Jungle (Warner Books, Incorporated, ISBN: 0446676950)

Tarbell, Ida (1904), The History of Standard Oil Company (McClure, Phillips, and Co.) --- http://www.history.rochester.edu/fuels/tarbell/MAIN.HTM

Special Mention:  The Works of Frank Partnoy
See http://www.trinity.edu/rjensen/fraudrotten.htm#DerivativesFrauds

Senate Testimony by Frank Partnoy --- http://www.trinity.edu/rjensen/FraudEnron.htm#FrankPartnoyTestimony 

Article by Frank Partnoy
"The Siskel and Ebert of Financial Matters: Two Thumbs Down for the Credit Reporting Agencies" (Washington University Law Quarterly, Volume 77, No. 3, 1999) --- http://ls.wustl.edu/WULQ/ 

Books by Frank Partnoy Published in Various Years

Report to the Nations on Occupational Fraud and Abuse, 2010 Global Fraud  --- http://www.acfe.com/rttn/rttn-2010.pdf
Thanks to Jim McKinney for the heads up.

Bob Jensen's Fraud Updates are at
http://www.trinity.edu/rjensen/FraudUpdates.htm

Fraud Reporting ---
http://www.trinity.edu/rjensen/FraudReporting.htm

WRESTLING WITH REFORM: FINANCIAL SCANDALS AND THE LEGISLATION THEY INSPIRED ---
http://www.sechistorical.org/
Thank you Jim McKinney for the heads up.

Bob Jensen's Fraud Updates ---
http://www.trinity.edu/rjensen/FraudUpdates.htm 

 

 

Background Links for This Document

Main Document on the accounting, finance, and business scandals --- http://www.trinity.edu/rjensen/Fraud.htm 

Bob Jensen's threads on professionalism and independence are at  file:///C:/Documents%20and%20Settings/dbowling/Local%20Settings/Temporary%20Internet%20Files/OLK36/FraudUpdates.htm#Professionalism 

Bob Jensen's threads on pro forma frauds are at http://www.trinity.edu/rjensen//theory/00overview/theory01.htm#ProForma 

Bob Jensen's threads on accounting theory are at http://www.trinity.edu/rjensen/theory.htm