Category: Ethics

Ethics and the 75 percent

roger clemens

The 75 percent  number represents the votes needed by the Baseball Writers’ Association of America for a candidate to granted entry to baseball’s Hall of Fame. There were 569 ballots cast. On Wednesday, the BWAA announced that one of the greatest hitters and one of the greatest hitters in the history of baseball were denied entry.

Barry Bonds is the all-time home run leader. Roger Clemens is a seven-time Cy Young Award winner. Each received less than 40% of the votes cast. The BWAA has unequivocally decided that the use of performance enhancing drugs is a disqualifier for induction to baseball’s Hall of Fame.

Last year was the first test when Mark McGwire and Rafael Palmeiro fell short in the vote count.  You could make some argument that they would not have made it into the Hall of Fame even if they didn’t have the stain of performance enhancing drugs.

But Bonds and Clemens would have been first sure bets to be in the Hall of Fame, if it were not for the stain of performance enhancing drugs.  Their exclusion has to be because a large portion of the voting writers believes that taking steroids means you don’t have a bust in Cooperstown.

As early as 1991, Major League Baseball took the position that steroid use was against the rules. But it was not until 2005 that MLB adopted a formal policy, began testing, and issuing penalties.

I have to admit that I’m not a big baseball fan, but I am a Red Sox fan. You have to be if you grow up in Boston. That means my heart was broken in ’86 when the Mets beat the Sox. Roger Clemens was part of that Red Sox team. Ten year later Clemens left the team in what seemed like the twilight of his career.

But then came two incredible years in Toronto. His lights out pitching earned him two more Cy Young awards in Toronto. I look back and wonder this is where Clemens went down the dark path of performance enhancing drugs. When I look at fraud cases I always try find the triggering event for when the perpetrator stepped over the line and what caused him to do so.

Clemens was acquitted of lying about his steroid use. His legal prosecution is likely over. The court of public opinion, or at least the opinions of BWAA voters, stil consider him guilty.

Marathon Times, Lies, and Paul Ryan

I generally stay away from politics when it comes to any stories about compliance and ethics. Politicians spend too much time spinning the facts and bending the truth. When it comes to policy, the facts rarely tell a black and white story about whether the policy worked, so I can forgive most of the spin. But sometimes the facts are clear and you have to wonder what is going through a person’s mind when they tell a blatant lie.

In an interview with Hugh Hewitt, vice presidential candidate Paul Ryan claimed that he had run a marathon in under three hours.  An impressive time. Unfortunately, that claim was revealed to be untrue. It actually took him more than four hours to finish Duluth’s Grandma’s Marathon.

I ran one marathon. It was ten years ago, but I still remember what my finishing time was. My wife remembers what my finishing time was, because my months of training were so arduous and time-consuming.  Anyone who has run a marathon knows there is a huge difference between running a 3 hour marathon and a 4 hour marathon. A sub-three hour marathon means that you are an elite runner. A four hour marathon means that you are a fit, but still recreational, runner. You spill a great deal of blood, sweat, and tears training for a marathon. Your mileage splits and likely finishing times are burned into your mind during the months of training that lead up to the race itself.

Here’s the transcript of what Ryan said to Hewitt:

H. H.: Are you still running?
P. R.: Yeah, I hurt a disc in my back, so I don’t run marathons anymore. I just run ten miles or [less].
H. H.: But you did run marathons at some point?
P. R.: Yeah, but I can’t do it anymore, because my back is just not that great.
H. H.: I’ve just gotta ask, what’s your personal best?
P. R.: Under three, high twos. I had a two hour and fifty-something.
H. H.: Holy smokes. All right, now you go down to Miami University…
P. R.: I was fast when I was younger, yeah.

Unlike policy outcomes, a race finishing time is a very straight-forward fact. One that cannot be subject to spin, just subject to excuses about why you ended up slower than expected or faster than expected. (I developed an injury while training for the marathon. Competing in a 24 hour adventure race during the marathon training re-injured my legs. Excuses, excuses…. but my finishing time is still my finishing time.)

I ask any of you who have run a marathon whether you remember your finishing time? Of course you do. Could Ryan have misspoken? Perhaps. Here’s what Ryan had to say in response:

“The race was more than 20 years ago, but my brother Tobin—who ran Boston last year—reminds me that he is the owner of the fastest marathon in the family and has never himself ran a sub-three. If I were to do any rounding, it would certainly be to four hours, not three. He gave me a good ribbing over this at dinner tonight.”

It was not a conventional news outlet but, rather, Runner’s World who looked into his claim and found it lacking. Maybe Ryan was looking to win the marathon runner demographic by throwing out an impressive finishing time. I suspect that he has lost the votes of most marathon runners. You can make excuses, but you can’t lie about your finishing time.

Any marathon runner will tell you the difference between a four-hour marathon and a sub-three hour marathon is enormous. For a non-runner it may seem easy to confuse or inconsequential. (I suspect political affiliation will also affect one’s view of this story.) Ryan is a self-proclaimed fitness nut. It should be nearly heartbreaking to be a minute over four hours rather than a minute under four hours. It’s only two minutes, but it’s the difference between having your time start with a “3” instead of a “4”. Starting with a “2” is only a distant dream at that point.

That two minute difference pits him against the last Republican vice presidential candidate.  Sarah Palin has run a marathon in 3:59.

That difference between a 3 and 4  has to be even more troubling when your brother runs marathons and has a better time than you. As his response pointed out, Ryan’s brother will not let him forget that he has the best marathon time in the family and it starts with a “3”, not a “2”.

One of my ongoing areas of interest is what makes an otherwise respectable business person turn into a white collar criminal. During my recent trip to FBI Headquarters,  Supervisory Special Agent Susan Kossler pointed out that two of the traits that distinguish a regular person from a white collar criminal is pathological dishonesty and little regret for misstatements. You look back at a Madoff or Stanford and wonder what led them from being legitimate, successful businessmen to start believing in their own lies and deception and become fraudsters. Even today neither expresses much remorse for their fraud.

People ask marathon runners about their finishing times. Look back at how easily Ryan responded to Hewitt’s question about his finishing time. Ryan, the fitness nut, must have been asked that question many times and responded many times  (dozens? hundreds? of times). When did he stop responding with “four hours” and start  saying “almost four hours”? Or “three and a half hours”? And then “a two hour and fifty-something”? When did one marathon turn into the plural “marathons”?

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How Wall Street Killed Financial Reform

I’m sure you heard in the news that JP Morgan lost $2 billion in a trades using complex derivatives tied to corporate bond defaults. But didn’t we fix this two years ago when Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act? It seems like JP Morgan’s mistakes should be the first test of Dodd-Frank. The law fails. It’s just lucky that JP Morgan’s trade was stopped before it destroyed the bank.

By coincidence, Matt Taibbi wrote a piece in Rolling Stone about the failings of Dodd-Frank: How Wall Street Killed Financial Reform. I generally find Mr. Taibbi’s take on finance to be a bit over the top, with more hyperbole in a world that lacks the subtle shades of compromise. This article is no different. But he also gets lots of the right points. Dodd-Frank will not result in financial reform.

Taibbi makes five key points.

1. Strangle it in the Womb

Financial reform started off with some great ideas. But they were watered down as the law progressed through the legislative process. For example, Mr. Volker’s simple concept of banning proprietary trading got twisted and poked, allowing broad exemptions. The Consumer Financial Protection Bureau went from being an independent watchdog to an office under the budgetary constraints of the Federal Reserve System.

2. Litigation

The federal regulators will need to contend with courtroom challenges to their regulations, with industry arguing that they go beyond the scope of the legislation or failed to adequately run a cost-benefit analysis of the regulation.

3. If You Can’t Win, Stall

Many sections of the law are experiencing “unforeseen delays.” Taibbi blames Wall Street lobbyists. I blame the law itself. Dodd-Frank deferred much of the implementation to the regulators, meaning they would need to craft new complex regulations and definitions of key terms that are mere sketched out in the law itself. This overloaded the ability of the regulators to produce new regulations. They are tasked with a ten-fold increase in the rule-making agenda. That means the regulators need more staff and the time to get them up to speed. But Congress largely failed to provide the financial support.

4. Bully the Regulators

When Congress is frustrated with a regulator, they just cut funding. Rather than increase the SEC’s budget to allow for the resources to create and implement the new regulations, Republican congressmen tried to cut the Commission’s budget.

5. Pass a Gazillion Loopholes

Congress is moving bills forward to further undercut Dodd-Frank. We saw that with the Rapid passage of the Jumpstart Our Business Startups Act. (I would argue that it undercuts Sarbanes-Oxley, not Dodd-Frank.) As the balance of power in Congress shifts, parts of financial reform become less viable. I think the true test will come a year from now, after the Presidential election. A Romney win and some Republican congressional wins will likely lead to a rapid erosion of Dodd-Frank.

The one point that Taibbi only alludes to is that Congress does not understand the financial markets or the securities laws. I watched some of the Congressional testimony on the JOBS Act. Only a handful of the member of Congress had any idea what was really in the law. Dodd-Frank is even worse. It was a massive law. I would place a wager that no more than 10 members of Congress actually read the whole law before voting on it. Even fewer understood the implications.

 

Mishandling Fund Conflicts

Success or Failure Which?

The key aspect of registration under the Investment Advisers Act is managing conflicts of interest. The financial services industry is full of conflicts. Investment advisers owe a higher level of duty to their clients than broker-dealers. In the case of fund managers, they owe the duty to their funds. One particular concern is a transaction between an investment adviser’s funds.

The SEC recently issued a cease-and-desist order that highlights a fund manager that handled the conflict poorly. I’m assuming the facts in the SEC’s order is true, although Martin Currie neither admits nor denies the allegations in the complaint.

The main focus of SEC’s complaint is that Martin Currie used one fund to rescue another fund. That’s good for investors in one fund and bad for investors in the other fund.

Hedge Fund Investment

The problems began in June 2007 when Martin Currie caused its Hedge Fund to purchase a large quantity of illiquid bonds in a Chinese company: Jackin International Holding. That deviated from the Hedge Fund’s normal equities-trading strategy. Martin Currie realized the investment would cause the Hedge Fund to breach its self-imposed 5% limit on investments in unlisted securities. To cure that problem, Martin Currie obtained approval from the Hedge Fund’s board of directors to modify the 5% limit. However, Martin Currie may have failed to present all material issues and risks for the board’s consideration. After the deal closed, the high-yield Jackin bonds were improperly characterized as cash in the firm’s risk management system. Because of this misclassification, the liquidity and credit risks from the Hedge Fund’s exposure to Jackin were not appreciated at Martin Currie headquarters until after the Hedge Fund had purchased even more Jackin bonds. It’s not clear from the order whether the misclassification was intentional or accidental.

2008 Financial Crisis

Then the 2008 financial crisis rears up and causes a liquidity crunch in the Hedge Fund as investors redeem their interests.  As more liquid assets were sold off to generate cash for redemption, those illiquid Jackin bonds became an increasingly larger part of the portfolio.

Martin Currie also acted as the adviser to a closed end fund: the China Fund. It just so happened that the China Fund was working with a group investors to buy one of Jackin’s subsidiaries: Ugent Holdings. Coincidentally, the sale of Ugent would allow Jackin to repay the bonds held by the Hedge Fund.

Board Approval of the Transaction

The group at the China Fund decided they needed approval of the fund’s board to proceed with transaction. However, the SEC accuses Martin Currie of failing to properly disclose the conflict of interest when it sought the board approval. Board approval does not clear the conflict if the board did not know about the conflict. It’s even worse if the board approval is based on “incomplete and misleading representations.”

On top of the faulty approval, Martin Currie used some dubious pricing and rationale for the China Fund’s investment. Ugent and Jackin’s financial situation had detoriated as a result of the 2008 financial crisis and its earnings and profits had fallen sharply. But Martin Currie used eight month old financial data and due diligence. They pushed ahead without assessing whether the Ugent investment was good for the China Fund. (It certainly was good for the Hedge Fund.)

Second Approval

At the next regular meeting of the China Fund’s board, the Ugent investment was once again presented. Once again the description of the transaction failed to mention that the sales proceeds would ultimately end up in the hands of the Hedge Fund. The Hedge Fund’s bond investment was cashed out at par, solving its liquidity crisis. Now the China Fund was holding $22 million of illiquid convertible bonds of dubious value.

Board approval could have cured the conflict. Without disclosing the conflict, the board approval fails. I would have to assume the board would not have approved the transaction if it knew about the conflict.

Valuation Failure

To compound the problem, Martin Currie failed to follow its procedures for valuation of the shiny, new bonds. The China Fund had adopted FAS 157 and was supposed to value its holding at “fair value.” For non-traded, direct investments like these bonds, the China Fund’s policies called for a valuation at cost, unless there was a material change in value.

Martin Currie failed to point out to the valuation group that Jackin/Ugent was having serious financial problems. Jackin’s auditor issued a going concern warning and Martin Currie failed to inform the valuation group. On top of that the Hedge Fund was selling its remaining interests in Jackin.

Within 19 months of the investment, the China Fund wrote down the investment by 50%. A month later, it wrote it all the way down to $0.

Pointing the Finger of Blame

Although I used the name Martin Currie liberally above, the investment advice was coming from different units of the company and separate individuals in the organization.  Martin Currie cooperated with the SEC, including refunding losses incurred by the China Fund and refunding management fees. The firm also terminated an unidentified project manager who directed the misrepresentations to the board. I assume that project manager is subject to further investigation, perhaps by the investigators who can subject the project manager to jail time.

Even with the cooperation, Martin Currie was subject to a fine in excess of $8 million. From the press release, it sounds like the problem was discovered as part of an SEC examination and gives credit to an SEC examination conducted by Jason Rosenberg and Lucas Tepper under the supervision of Mavis Kelly.

To some extent, this case in another in a long string of cases where fund managers took in appropriate steps to stay alive during the 2008 financial crisis. There were no safe places to put money. The robust underwriting standards of the 2007 boom collapsed under the weight of a global financial crisis and a stark new reality. Some managers stepped up and did the right thing by investors, hoping they would appreciate the honesty. Others locked down the funds keeping investors from jumping into lifeboats, claiming the boat is just in rough waters and not sinking. Others took dubious actions trying to cover up their failings.

Remember that it was the redemptions from the 2008 financial crisis that finally brought down the Madoff ponzi scheme after years (decades?) of deceit. Even this master swindler could not hide from a global financial crisis.

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Image of Success or Failure is from Todd Ehlers

World’s Most Ethical Companies – 2012 Edition

The Ethisphere Institute announced its sixth annual selection of the World’s Most Ethical Companies. One hundred forty-five organizations made the list in 2012 from more than three dozen industries, including 43 headquartered outside the United States.

Twenty-three companies that have been honored each of the six years the WME has been awarded, including Aflac, American Express, Fluor, General Electric, Milliken & Company, Patagonia, Rabobank. and Starbucks.

In the past, I’ve analyzed the list and found that investing in the companies on the list was a good choice. Last year, I looked at the 2007 list and projected forward and found that an investment in those companies would have out-performed the S&P 500 and Dow Jones Industrials.

Last year, Ethisphere highlighted the fact that this list of companies outperformed the S&P 500. That’s missing this year.  I went back to the 2007 list to see what happened .

I still see an outperformance: 13.12% versus -3.48% for the S&P and 3.02% for the Dow Jones Industrials.

You can see my calculations in this spreadsheet (in Google Docs):
https://spreadsheets.google.com/ccc?key=0AuuCq02eKVqldDhydERtRmVsdVo2X0NfOUdXbkZTcmc&hl=en

That seems to show that being ethical is generally good for a company’s shareholders.

Ethisphere’s 100 Most Influential People in Business Ethics


The Ethisphere Institute unveiled its “100 Most Influential People in Business Ethics,” an annual list of individuals who have made a significant impact in the realm of corporate citizenship over the course of the previous year.

Some are world famous and some are little unknown. Here are some that caught my attention:

#48 Stephen Colbert – Satirist, The Colbert Report
Category: Media and Whistleblowers

#64 Jack Dorsey – Founder and Executive Chairman, Twitter
Category: Business Leadership

#77 Chris MacDonald – Author, Business Ethics Blog
Category: Media and Whistleblowers

#85 Dick Cassin – Author, FCPA Blog
Category: Media and Whistleblowers

#91 Matt Kelly – Editor-in-Chief, ComplianceWeek
Category: Media and Whistleblowers

Ethisphere and the New York Stock Exchange

This morning, the Ethisphere Institute is ringing The Opening Bell at the New York Stock Exchange with some of the NYSE-listed 2011 World’s Most Ethical Companies. I guess the NASDAQ companies are not invited.) The purpose is to recognize the connection between ethical business practice and increased business performance.

NYSE-listed 2011 World’s Most Ethical Companies that will ring the bell with Ethisphere include

  • AECOM
  • Ford
  • General Electric
  • International Paper
  • Jones Lang LaSalle
  • Marriott
  • PepsiCo
  • Salesforce.com

The Bell ringing is followed by Ethisphere’s NYSE Bell Ringing & Ethics Drives Performance™ Conference.

The World’s Most Ethical Companies, if indexed together, have significantly outpaced the S&P 500. I found it interesting that the companies outperform going forward once they are recognized, not just leading up to the recognition.

Ethisphere numbers seem to take the current list of companies and look at their performance. I expect that companies getting onto the list are well run and should perform well. But would it last going forward? I took the companies from the original 2007 and tracked them forward.

The companies on the 2007 list, as a group outperformed the broader S&P 500 and Dow Jones Industrial Average.  They were not all winners.

Ethisphere is now accepting nominations for the 2012 World’s Most Ethical Companies. To learn more about the World’s Most Ethical Companies recognition and selection process and to nominate your organization for consideration visit:http://ethisphere.com/nominations/.

The Echoes of Madoff at the SEC

The Madoff scandal is one of the low points in the history of the Securities and Exchange Commission. Every Congressional hearing or SEC-basher inevitably uses the failure to catch Madoff as evidence of the ineffectiveness of the SEC.

In a continuing journey down the rabbit hole, the SEC’s Inspector General David Kotz released his 123-page report (.pdf) on former SEC General Counsel David Becker and his involvement with Madoff. Kotz has made a referral to the Department of Justice under a criminal conflict of interest provision.

Mr. Becker’s late mother had an account with Madoff. If Mr. Becker were to be involved in mopping up the Madoff matter, there would be potential conflict of interest.

David Becker seems to have done the correct thing. He sought an answer from the SEC Ethics Counsel as to whether he should work on Madoff matters.

“I did precisely what I was supposed to do. I identified a matter that required legal advice from the SEC’s Ethics Office. I sought that advice, received it, and followed it.” Testimony of David Becker September 22, 2011

He fully disclosed the fact that he had been a beneficiary of his mother’s estate which had invested in Madoff funds. The Ethics Counsel told him he did not need to recuse himself. His boss, SEC Chair Mary Shapiro, knew of the investment.

Nonetheless, the SEC’s Inspector General is referring its results to the Department of Justice for criminal investigation.

Personally, I don’t think Mr. Becker actually did anything wrong. I believe he joined the SEC as a white hat, wanting to resume his role in public service.

The problem is that it looks like he did something wrong. That’s the problem with conflicts of interest. Even if you do the right thing, it will look like you were improperly influenced or tainted.

Becker did seek guidance from the SEC’s Ethics Counsel. Unfortunately, the Ethics Counsel is part of the Office of the General Counsel. As General Counsel, Becker was the advice-giver’s boss. Another conflict.  I’m not saying that Becker actually unduly influenced the Ethics Counsel. It’s just looks bad and layers another conflict of interest onto the existing conflict of interest.

The SEC knew that Madoff was toxic and high-profile. They should have been more vigilant and not allowed Becker to participate. I would guess that Becker was so good at his job and so enthusiastic to help that he and the SEC failed to see his weaknesses. It would be hard to make him sit on the sidelines while the Commission was trying to clean-up after one of its biggest failure. But that is what they should have done.

They let the conflict of interest stay in place. That should have known that it would subject them to a later review and attack on their decision to keep Becker involved. They should have known that it would have led to something like the Inspector General’s report.

I don’t think Becker should be subject to criminal charges and hopefully the Department of Justice will drop the matter after a brief investigation.

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