Why do experts fail to predict company failures such as Parmalat, Enron and WorldCom? To find out, The Banker invited credit and rating analysts and auditors to a roundtable discussion to explore the issues. The discussion got quite heated as the finger was pointed at the various parties and a proposal to change the way underwriters get paid was put up for debate

The participants were:

Sam Theodore, head of European bank ratings at Moody’s

Claire McGuckin, senior credit analyst at ABN Amro

Chris Lucas, an auditor who is partner and head of the London banking, capital markets practice at PricewaterhouseCoopers

Stephen Kingsley, a partner with consultant Diamond Cluster, a former head of Arthur Andersen’s global financial services practice and a former auditor

Stephen Timewell, Editor in Chief, The Banker

Brian Caplen, Editor, The Banker

 

Theodore: We are never going to prevent disasters, that’s not the nature of the financial world. Financial investments and banking all involve taking risks, and people who delude themselves about being able to eliminate risk altogether are obviously making a big mistake. It’s impossible. If you don’t take any risks you’re not going to make any money, you’re not going to have happy shareholders and you’re not going to be able to exist.

The question now is: are we getting any better at preventing these disasters, or at least mitigating the negative effects of these disasters, than before? I have to take the optimistic view, I have to say yes. As much as we have faced in recent years Enron, WorldCom and now Parmalat, the banking industry today is in much better shape in terms of risk coverage than it was during the last banking crises of the late 1980s or early 1990s.

 

Sam Theodore ‘In this context, it’s difficult for a rating agency to detect fraud. We are outsiders to these developments’

McGuckin: All banks – and certainly the big ones – have improved markedly [in risk management] because they’ve had to and because the sophistication of the financial market has grown exponentially. The problem is the complexity of companies with subsidiaries in 30 to 40 different countries, and that we can only go on the information we’re given. Analysts sitting outside of Parmalat with no non-public information cannot confirm whether there is $4bn of cash or not. They have to rely on the audited accounts.

Now that’s not saying there weren’t [warning] flags. There were many. And there were many analysts in both the equity and the debt markets who were very uncomfortable with the financial structure of Parmalat, including the rating agencies themselves. But because the company had pieces of paper from auditors saying they had $4bn in cash, who could have thought that the money didn’t exist? The natural assumption is that somebody checked it was there.

 Claire McGuckin ‘For the credit analyst there must be an instinct to ask the questions and be sure the responses are 

Lucas: [From an auditor’s viewpoint] fundamentally the most important question we have to answer is whether we want to do business with a company or with the individuals involved; that is probably the lesson we have learnt as a firm over the past few years. And I wouldn’t like to say that we get it right in every case. But that is the most important question that we ask, particularly when we take on a client and then ask every year, as we decide whether we wish to keep a client or not.

 

Chris Lucas ‘External audit will not provide absolute assurance about the absence of fraud in an organisation’ in-depth enough’ 

Kingsley: I perhaps take a somewhat more hawkish view than you guys. I start from the point of view that the financial markets have globalised pretty radically in the last 10 or 15 years.

What that means in practical terms is that issuers like Parmalat, good or bad, can get connected to the man in the street. The man in the street doesn’t know Parmalat from a hole in the ground and may never have been to Italy but nevertheless he becomes an investor in Italy.

So it’s all very well saying the banks are safe but, at the end of the day, somebody has to pay. I suspect it’s the man in the street who’s doing quite a lot of the paying. And that’s not good because it brings the industry into disrepute. There have even been commentaries about politicians wanting to nationalise financial services if things don’t improve.

The intermediaries, whether they’re investment banks, rating agencies, investment managers or auditors, should represent safeguards, it seems to me – at least as far as the ultimate investor is concerned.

And, if you go backwards down the chain, you’ve got managers who collect the money from the individual investors and place it. They rely on representations that are coming from investment banks, rating agencies and auditors, as well as the management. And so it goes on. There’s a shift of responsibility. The investment bankers do the same thing, the rating agencies are doing the same thing, the auditors are listening to management and then making representations to the outside world.

I don’t think these safeguards are anything like as effective as we collectively, represented by the media, think they are. The trouble is that people are lulled into a false sense of security. Claire [McGuckin] was very eloquent about it. She said:‘Well, you know, the man just looked at the financial statement that came from Parmalat, looked at the ratings, ticked a couple of boxes, woompf, we can invest in this, it’s investment grade, it’s producing profit, looks solvent, tick’.

 

Stephen Kingsley ‘One of the problems in today’s globalised financial market is there isn’t enough emphasis put on enquiry’

McGuckin: That’s not what I said.

Kingsley: I know, I’m paraphrasing. But, for some people, that could be an investment process. I don’t think it’s too bizarre or way out of line. And the trouble is, it doesn’t put people under enquiry.

One of the problems in today’s highly globalised financial market is there isn’t enough emphasis put on enquiry, there isn’t enough market discipline around some of these processes. The second thing is that, because there isn’t enough enquiry, perversely, it is easier to do a Parmalat now than it was before. Because if you want to do a Parmalat your scope of action is not just the Italian capital markets, it’s the global capital markets you can access and therefore, the size of what you can do – if you really want to do something like that – is limited only by the appetite of the market to take your paper. And your ability to finance the implications. The answer is to introduce more discipline and more enquiry into the market.

Timewell: What would that mean in practical terms?

Kingsley: It means aligning the activities of some of these intermediaries more closely with the performance of the instruments they’re distributing. Example: investment banks. They are primary underwriters of the paper.

At the moment, they are being paid in relation to the transaction. In a sense, as long as the transaction is investment grade, they get it away. They’re happy. But if they were being paid according to the duration performance of the bonds, they might behave differently.

McGuckin: The man in the street has no responsibility because he’s not an investment professional. But it’s not good enough to say it’s the banks’ fault because they sold them or it’s the rating agencies’ fault because they…

Kingsley: That’s not what I’m saying. It’s the system.

McGuckin: There is another level of risk assessment that happens in every financial company that buys these bonds for its different portfolios. And they look at all the knowledge that is out there, including all the rumours, including all the [warning] flags, and decide whether they feel the risk-reward values are acceptable.

Kingsley: So they’re driven by a pool of unallocated cash.

McGuckin: That doesn’t transfer the responsibility to the banks. It’s a balance. Everybody has to take responsibility for their own professional financial judgments.

Kingsley: Absolutely, but I think my point is that things ought to be made more transparent because it’s not clear what’s happening. The final safeguard that I really don’t think works is the audit.

My personal professional experience tells me that an external audit is not a safeguard against any of these problems happening. When you read the auditors’ own reports they say: ‘If people have been lying to us then we don’t take any responsibility’.

That’s fine, but the trouble is the man in the street and everybody who represents him, including the media, thinks that that is exactly the type [of company] that needs auditing. We need [auditors] to stop the Parmalats of this world happening.

It’s true that it’s very difficult. If a management is absolutely intent on lying and misrepresenting the truth, outsiders coming in, listening to what the management has to say and trying to verify it will find it very difficult to counteract the effect of management.

But then you have to ask yourself: is the whole concept of external auditing flawed? I don’t think the reaction is to say: how do we make external auditing more effective? Because I think that’s very hard to do. We’ll never get to the stage of being able to avoid things like Parmalat and Enron and all the rest of it through auditing. I don’t think it works that way.

Lucas: External audit will not provide absolute assurance about the absence of fraud in an organisation. All the evidence will show that complex fraud is very difficult to spot and even where it’s been spotted it’s usually been discovered over a period of about three to four years. So that is a very long time, even if the audit is ultimately identifying fraud. And the basis on which audits are done is the assumption that there is no fraud.

The second thing is the responsibility of management for the preparation of information. And that’s not to remove the auditor’s responsibility, that’s to look at the relative responsibilities. I think some of the legislation has gone a considerable way to reminding management of their responsibility for the presentation of the information.

McGuckin: Professionals must listen to their instincts because the search for return can frequently blur your own gut instinct. In all these cases, there were big returns to be made, whether that be fees for accountants, origination fees for banks, trading fees or a greater yield for the funds themselves.

There was money to be made the whole way along the chain. For the credit analyst, there must be an instinct to ask the questions and be sure the responses are in-depth enough and honest enough. There is a responsibility and these things can be spotted. But if a management team wants to set out to defraud and they are of reasonable intelligence then [they can succeed].

More responsibility needs to be placed on the management running the company in terms of them being financially responsible for their actions if they set out to defraud investors or take risks deliberately. Because they’re effectively taking risks with other people’s money and they need to be held accountable for that in the same way that everybody else is.

Theodore: In this context it’s difficult to expect a rating agency to detect fraud. We are outsiders to these developments. Again, as you say, the auditors are closer to the accounts than the rating agencies. Nevertheless, if a management team is hell-bent on cheating and lying, if they don’t want to answer questions and if they try to change the topic and manage the information, it’s very, very difficult to see through this. OK, you have suspicions here and there but you cannot really see fraud, it’s very difficult to do it. So we are in the same situation as everybody else.

McGuckin: The warning signs weren’t missed [in most of these cases]. They were there and they were commented on time and time again.

It goes back to people simply thinking that the risk-reward scenario was worth it. If you look at Ahold, people knew that it was quite aggressive with its accounting and it had been commented on for at least 12 months before the announcement came out: little things, such as questions about the way it was reporting organic growth and about how it could grow so quickly.

At the end of the day, remember, it was the audit that picked up what was happening at Ahold. And, probably, there are many incidences of that on a daily basis with much less high-profile companies that maybe don’t hit the front of the FT or of every newspaper because they’re tiny. So I think the audit process is very valuable.

Lucas: If the expectation of an audit is that it’s a guarantee of the accuracy of the numbers, then people are going to feel disappointed. I don’t think it ever set out to do that. So part of the problem may well be that the audit profession has lost its ability to describe what it does.

Conversely, in instances where I have seen frauds discovered – and I have seen a few that were discovered in a relatively short space of time – it was because of imperfections in third-party evidence. That is the most important piece of evidence and, therefore, should the audit profession maximise its use of that sort of thing? Absolutely, it should. But it’s still never going to give you that absolute assurance that some people would like.

Timewell: We haven’t mentioned disclosure. We’ve mentioned it broadly but I’d like to draw some conclusions about how it can be improved? Is it just that we have to expect disaster every so often?

Theodore: It’s nice to get more financial disclosure and the more you have disclosure from a company, the less room you have for fraud. But, nevertheless, there is always enough room left for fraud, for people who are willingly trying to defraud the markets or investors.

As a rating agency, we work a lot with confidential information so we go far beyond what’s publicly disclosed. And, even there, there’s a lot of room [for fraud] unless you say: ‘You have a bank account, I want to see the statement from your bank’. And, you know, a company would have hundreds… You can’t do these things. The economics of doing this exhaustive detective work are simply not worth it for the 1% of companies that are fraudulent. So I’m not sure that more disclosure is the answer.

McGuckin: [With the role of the underwriting banks] why shouldn’t they help a company to raise finance in the market? From everything we’ve seen so far, there’s very little indication that banks assisted Parmalat [in fraud]. The banks had access to information provided by auditors and management, and they made a financial risk assessment and it looked like Parmalat was fine. It so happened that there was a fraud in the background that nobody knew about.

And that goes back to how you detect these things, how you stop them. Why shouldn’t the banks play this role?

Kingsley: Well, they should. They absolutely should. But there is something of a disconnection between a transaction-oriented compensation structure on the selling side and a long-term performance set of criteria on the buy side that needs to be looked at again.

And, when you look at all of the mis-selling issues that have happened in Britain over the last 15 years – whether it’s mortgages, precipice bonds, you name it – the interests of the buyers and the sellers have not been aligned because the seller is getting his up-front commission and the buyer is left with a long-term risk.

That is where, if you’re going to try [to improve things], you begin to look for the answer. You may not find it – but that’s where you begin. Plus, giving the alleged safeguards a good kicking to see whether they’re working properly or not.

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