Snouts in The Trough

MPs often bemoan the fact that the public don't take them seriously anymore, don't trust them and are apathetic about voting.

However, before lecturing us about our shortcomings, they should look closer to home and address their own shortcomings.

The current scandal involving Derek Conway, who claimed £50K allowances for his son (the self proclaimed "Queen of Sloane") to do bugger all, is a fine example of why people have little time or respect for politicians.

MPs need to get their noses out of the trough, then people may show them a little more respect.

The Rotten Core at The Heart of Britain’s Financial System

It is often assumed by both the public and the politicians that, aside from the occasional scandal such as the Maxwell fraud, Britain’s financial system is well run and relatively honest.

After all, the UK has a plethora of rules, regulations and watchdogs (such as the FSA) governing; the stock market, financial advisers, pensions, auditors and all the other components that go to make up the UK’s financial system.

However, I am firmly of the opinion that this “confidence” is based on nothing more than hubris; and that, in fact, we live in country that has a fundamentally rotten financial system.

I would like to cite a number of examples that support my view:

The Endowment Mis-selling Scandal

The endowment mis-selling scandal, of the late eighties and nineties, readily springs to mind as one of the major failings of our financial system. As has been well documented, the life assurance companies used the bull market to create a totally unsuitable, and useless product, that they aggressively sold in the manner of TV sets and washing machines to over 8 million unsuspecting home owners.

The theory being that the bull market would create high yield returns on this product; that would not just pay off the mortgages of the hapless holders, but would also give rise to a modest surplus. Needless to say, what the life assurance companies did not bother to clearly tell people was that their commission charges would rob the product of much of its initial value, and that their projections for growth were totally unrealistic.

It now turns out that the 8 million holders, of these white elephants, are facing shortfalls of over £40BN. Although, in theory the policyholders can try to claim compensation, the life assurance companies are using every excuse in the book to slow the process down in order to avoid paying compensation. To date a paltry £1BN has been paid to those seeking redress.

The FSA, although they offer some fall back position for those refused compensation by the life assurance companies, do not have any intention of “rocking the boat” too hard. The FSA refuse to acknowledge the fact that the life assurance companies perpetrated the greatest financial scandal in the UK in living memory.

Pensions

Needless to say the results of the endowment policy mis-selling scandal have, coupled with the ill thought out tax raid by Gordon Brown on the pension’s industry, destroyed peoples’ confidence and willingness to invest in life assurance/pensions policies. The British people are facing a pension black hole that will leave the majority of pensioners, over the next few decades, living in penury. The politicians have failed the electorate, by allowing the electorate the self-delusion that they will forever have increasing standards of living without having to work harder. Instead of telling it straight, that people are going to have to work beyond what is considered to be the normal retirement age of 60-65, the government fiddles while “Rome burns”.

Corporate Governance

Corporate governance, so long thought of as being well established and effective in Britain, is failing lamentably. The boards of many companies are made up of directors and non-executive directors from a small clique of friends, and contacts in the City, who sit on each other’s boards. These people, instead of seeking to ensure effective and robust management in the interest of the shareholders, in fact more often than not sit passively; nodding through a host of half baked business plans, and the most greedy of executive remuneration packages.

I can certify that, more often than not, the primary qualification for being selected to serve as a non executive director (a position that in theory is meant to oversee the actions of the main board, so as to safeguard the interests of the shareholders) is that they have probably served in the same company before, or have certainly got “the right” connections. The concept of robust, proactive, independence doesn’t apply.

Directors of companies are routinely lambasted for awarding themselves, like pigs with their heads in the trough, inflation busting pay and pension packages. Politicians wring their hands, and shed crocodile tears, lamenting at this practice. However, once they have left ministerial office, each one of these “champions of the people” soon finds their way on to the boards of the companies that they were criticising.

Post Enron and Sarbanes Oxley the UK has, in its normal slow unhurried way, put together via the Higgs/Smith reports and the Combined Code a set of guidelines for companies and executives to follow with regard to corporate governance. However, it is not compulsory; all the company has to do, if it wishes to ignore these guidelines, is to write a few notes in the accounts.

Companies that are increasing their internal control and review procedures, not I may say because they want to, but because Sarb-Ox has forced them to; are complaining loudly about the increase in audit fees. It seems to me that it is not unreasonable that, because a greater amount of work is required to be done by the audit firms, they will have to charge more.

Audit Firms

Audit firms are not entirely immune from the rotten stench that emanates from the UK financial system. I well remember as a trainee auditor witnessing the booking of extra hours, that were not in fact worked, to the timesheet of a well known FTSE company; so that the audit fee could be justified to the FD of the client who, not unreasonably, had asked to see a breakdown of the hours worked.

A few years ago, audit firms, having felt the pressure of the market were forced to find ways to cut costs. Their brilliant and inspired solution was to create the concept of “risk management”, and audit only those areas that were deemed to be high risk; system compliance tests, which took up a lot of time, were thrown out of the window. The audit became a cheap and cheerful “risk management” exercise; whereby the real money was made by selling on added value services, such as consultancy.

In 2000 I attended, as an observer, an Arthur Andersen training course in Chicago; the mantra “forget about the audit, hard sell the high margin add ons” was pumped into the participants at every opportunity.

The consultancy advice usually given to the hapless client was to outsource mainstream functions such as; internal audit, tax and treasury to yes, you’ve guessed it the audit firms. I would say this, if Arthur Andersen had not been the first to “cop a fall” over lack of segregation of practices and excessive greed with its Enron and WorldCom debacle, then one of the other big firms probably would have done so.

Now they are forced to segregate services, and as such are reverting to the old “tick bash” routine in order to keep fee incomes high.

There is one other fly in their ointment. With the Enrons of this world came mega sized law suits, something that the accountancy firms and their insurance firms do not wish to pay for. This has caused something of a stand off with the government; Gordon Brown wishes for uncapped liability of audit firms, the audit firms are arguing for a cap. Their secret weapon is that if they don’t get a cap, they will dump certain “high risk” clients; this would leave the government with the responsibility for reviewing these companies’ books of account. In other words, the audit firms are holding the government to ransom; and trying to pass the risk of errors and omission in their working practices on to the shareholder and tax payer. Nice trick isn’t it?

The Stock Market

Those of you who are still not convinced that the financial system in the UK is rotten, should take a look at the stock market; and ask yourselves whether the ordinary investor, with a modest portfolio, can make money to the same degree as the big market players.

Monitor the swings and movements in the share price of any share, that you care to pick, over a few months; and watch the buys and sells preceding the announcement of any news that affects the share price, such as a take-over bid. In the majority of cases you will see that there are significant buys/sells (depending on the nature of the announcement), prior to the news being made public. That is not coincidence, but the result of the news being leaked to a few well connected “players” in the market.

When there is little news coming out about a company, more often than not the market makers will adjust the prices to shake out sellers or buyers; there is no reason for these price movements, other than to panic smaller holders into adjusting their portfolio which in turn generates commission for the market makers.

Consumer Debt

I will take as my final example the house price bubble that has grown over the last few years. As I write this, the effect of the recent interest rate rises by the Bank of England seem to be slowing the price rises down or indeed may even have pricked the bubble. The fact that this unsustainable rise could be allowed to continue for so long is damming in itself. However, the real issue is what has been sold on to the unsuspecting, and financially illiterate, consumers on the back of the bubble.

In the eighties, as already noted, we had endowment polices; now we have equity release schemes designed to consolidate credit card debt to encourage borrowers to borrow more, and spend on short term consumption. Borrowing long to spend short is recipe for disaster, as Weimar Germany and the world discovered to its cost in the 1920’s.

Loan companies have been allowed to aggressively target their advertisements at the most vulnerable, financially illiterate, people in society; without any regulatory interference. The interest rates on many of these debts bear no correlation to the risk profile of the loan. Instead they reflect the lending company’s “greed pricing grid”; which is the in house pricing model utilised by the lender to identify the maximum rate of interest that it can charge without losing customers to other lenders.

The result is that consumer debt in the UK now stands at over £1 trillion, which in my view is unsustainable. As house prices start to deflate many people will find themselves in a situation with negative equity; unable to move house, or restructure their finances. They will be saddled with an unsupportable level of debt for the rest of their lives.

Now, taking all of the above into consideration, do you feel that the financial system in the UK is well regulated and honest?

The Illusion of Increasing Property Values

The UK has, over the last decade, experienced an unparalleled growth in the value of domestic property; fuelled by low interest rates and demand exceeding supply. Some areas of the country have experienced annual increases of over 20%.

This growth has led to a feeling of smug self satisfaction among those who own property, and has underpinned a consumer boom; as people release the perceived excess equity in their homes, and use it to satisfy short term desires and whims.

However, the perceived increase in personal wealth has a number of drawbacks:

 The growth in prices is slowing down, and in some parts of the country gone into reverse. This has placed some of those who have borrowed heavily in the uncomfortable position of having negative equity; they have become financial prisoners within their own homes.

 The increase in prices has made it more difficult for first time buyers to fund the purchase of their first home; without borrowing excessive multiples of income, sometimes up to five times their annual salary.

 A house is a lifetime commitment, the debt that goes with it usually takes twenty five years to pay off. I know of no one who can, with certainty, look twenty five years into the future; and guarantee that income, taxes and other issues will not conspire against them to impede their ability to pay off the debt.

 The feeling of greater wealth, that increases in property values brings about, is illusory. You have to live somewhere, if your home has risen by 20% then others have done so as well. Should you wish to move to a larger property, in a few years time, the ongoing increases in prices make that more difficult.

Take the following example:

Property A is worth £100K

Property B is worth £200K

The net difference is £100K

After one year prices have risen by 20%.

A is now worth £120K and B £240K, the net difference is now £120K.

In one year it is now £20K more expensive for the owner of A to sell and buy B.

The only way to benefit from a rising market is to downgrade, and buy a smaller property or live in a cheaper area.

 Finally I would caution all to be very wary of the current Administration’s greed for tax revenue. It is eyeing the rise in property values with great avarice. It will most definitely find a way to grasp an undeserved slice of these gains for itself.

In short, don’t be seduced by the rises; you are probably worse off.

What Use Is Religion?

Mankind throughout the millennia has believed in one, or many, omnipotent beings; who have the power to influence events on earth, and create a spiritual paradise or hell in the supposed afterlife.

These omnipotent beings have been given many names including; Allah, Apollo, God, Osiris and Zeus to name but a few.

The one strand of commonality that links them is that they all, according to those who believe in them, require to be acknowledged and worshipped; thereby necessitating the creation of religions, designed and instigated by mankind.

These religions, by the very fact that they are human creations, contain all the faults and weaknesses of the human character including; vanity, aggression, pride, greed, lust and envy.

Many religions claim to be tolerant; yet their actions, in asserting their own dominance, belie this assertion. Taking three “mainstream” religions as an example; Christianity has throughout the centuries sought to convert the heathen, extreme Islam seeks to eliminate the infidel and fanatical Judaism seeks sole occupancy for those of the Jewish faith of the land in and around Israel.

Throughout mankind’s history, wars have been fought in the name of whatever omnipotent being of the day was believed to be in charge.

In short organised religion, because it is organised by humans, is used as a means to extend the baser instincts and desires of human nature.

There are individuals, such as rabbis, priests and mullahs who seek to do good and to comfort those in distress. However, they do this out of their own inherent sense of decency and affection for their fellow man; not because of the decency of their particular organised religion.

Even those who claim to believe in the same omnipotent being, such as Christians, manage to find ways to use religion against each other. A fine example of this is the animosity between catholics and protestants in Northern Ireland; they so loath each other that they choose to live apart in segregated areas of their cities.

Mankind will always look for ways to factionalise itself, and fight one another; religion has given it another means to do this.

Should an omnipotent being exist, I doubt very much that he/she would wish to be associated with this.

Therefore I ask, “What use is religion?”

Ten Reasons Frauds Occur

In my roles as Head of Internal Audit and International Forensic Co-ordinator, in both Philips and De Beers, I have had many years of experience investigating frauds. Based on this experience I have put together my personal “top ten” list of reasons why frauds occur.

1. Greed - good old fashioned human nature intervenes when an individual, or group of individuals, sees a chance to make “a fast buck”. A good example being those cases where people “adjust” their expense claims upwards.

2. Lack of transparency - complex financial transactions that are difficult to understand are an ideal method to hide a fraud. The Barings fraud was perpetrated by use of an accounting “dump account” that no one understood.

3. Poor management information – where a company’s management information system does not produce results that are timely, accurate, sufficiently detailed and relevant; the warning signals of a fraud, such as ongoing theft from the bank account, can be obscured.

4. Excessively generous performance bonus payments – the more generous the bonus, when coupled to a demanding target; the more temptation there is to manipulate results, such as year end sales figures, to reach that target.

5. Non independent internal audit department – where an organisation’s internal audit department is not independent, eg the where it does not report to a truly independent audit committee but to the Finance Director, the more likely that when there are signals that a fraud is occurring the more likely they will be ignored. It is indeed interesting to note that Cynthia Cooper (Head of Internal Audit at WorldCom) had to bypass her boss (the CFO) and go directly to the audit committee to report the discovery of the capital expenditure fraud.

6. Lack of clear moral direction from senior management – leadership comes from the top. Where the senior management indulge themselves in “semi corrupt” behaviour, eg adjusting their expense claims upwards, others will follow adopting the well worn mantra “everyone’s at it”.

7. Excessively complex organisational structure - designed to obfuscate the revenue streams; and so hide reality from third parties, such as the Internal Revenue Service. Enron, with its complex off balance sheet structure and transactions, is a textbook example of this.

8. Poor accounting controls– where the accounting controls, such as a monthly reconciliation of the bank account, are lapse the signals that a fraud has occurred will be missed.

9. Arrogance – some people believe that they are better than “the system”, and that they can get away anything. The late Robert Maxwell (of the Mirror Group) plundered his company pension scheme, arrogantly assuming that since he was chairman of the company he could get away with it; he almost did!

10. Complacency – I have met many a manager who has an almost childlike faith, based in part on the “old boy” network, in the probity of their colleagues; believing that fraud “is not the sort of thing that could happen here”. Others will, and do, take advantage of that trust.

My simple advice is, if you think that a fraud may be happening then fear the worst; because it probably is.

In Place of Strife

Over the last year to eighteen months the world’s stock markets have been tumbling and investor confidence is at a low point. Scandals, frauds and mismanagement are occurring in organisations as diverse as Enron, AIB, WorldCom, Marconi and Arthur Andersen have severely tested the credibility of companies reported figures and profit forecasts.

I would like to place in the public domain my views on how we found ourselves in this situation, and how companies may win back confidence. These opinions are derived from my experiences and observations whilst working for “blue chip” organisations, in the UK and internationally, both as an external auditor and internal auditor (holding positions ranging from junior trainee to Head of Internal Audit).

The meltdown in confidence arose for a number of reasons, I highlight the following as my personal top ten “chart busting” favourites:

 The Gordon Gekko mentality of “greed is good”, all credit to that most insightful film “Wall Street”; which has beguiled senior executives, investors and external auditors. Whilst the Western economies were growing and shares in both the US and London were enjoying an unparalleled bull market investors and others, such as non executive directors (who should have known better), did not question too publicly, if at all:

- the remuneration packages of senior executives

- the growth and investment strategies, most notably within the “tech sector” (Marconi’s cash burn and level of gearing being a prime example of senior executives’ egos overriding common sense and good business practice)

- the corporate governance arrangements (such as the composition and “independent pro activity” of the audit committee)

of the companies they were involved with. To me this Gekko beguilement is best summed up by a quote from Bernie Ebbers (ex CEO of WorldCom) when asked about low investor returns on capital. He replied “investors do not care if a company’s return is 6 or 60 percent. They only care if the share price goes up”.

His comment insightfully highlights the short term vision of investors, and unwittingly highlights many a senior executive’s contempt for them.

 Much like the emperor who was sold the invisible suit, once the magic spell is shown to be a sham the illusion cannot be recreated. Specifically, the emperor needs some real clothes! These will take time and genuine effort, measured by hard work not “sophisticated financial solutions” (such as complex off balance sheet arrangements whereby, for example, assets are held in the Cayman Islands and liabilities in Bermuda), to weave.

 Companies need to re-evaluate their method of remunerating senior executives. The practice of offering large levels of share options is all very well, in theory. However, it places a significant pressure on the executive to always talk the stock up, and in the case of the less honest to arrange for transactions and off balance sheet schemes that give a misleading picture as to the earnings and gearing of the company (Maxwell, Enron and WorldCom all being text book examples of this).

 Even the very act of awarding share options is suspect; as the remuneration committee, whose job it is to review the level of senior executive remuneration and determine if it is fair and reasonable, are not in a position of complete impartiality. After all, they are hired by the same executives (even if the appointments of the non executives, who make up the remuneration committees, are asked to be approved or rather “nodded through” by the shareholders) for whom they are reviewing the pay awards.

Sometimes investors start to “rattle the cage” and complain about the level of remuneration. However, even if they are successful in delaying or preventing a change, such as in the case of Marconi (in early 2001), by then it may be too late. Marconi is now consigned to penny share status.

 The external auditors do not escape unscathed from the stench of cronyism and greed that contaminates many board rooms. Following the mega mergers of the eighties, there are effectively four main players in the market (allowing for the implosion of Andersens). These firms audit the majority of the quoted companies in the US and UK. The freedom of choice is therefore limited, even if companies wished to shop around.

That is in itself wishful thinking on my part, many of the audit firms have held the same client for years, some for fifty years or more. The “comfort blanket” of familiarity, complacency and dislike of change has in effect lead to a stagnant audit market. The only area seen as offering growth potential by the big four is in the area of consultancy and “added value services”; sold by the big four with an almost evangelical fervour.

I spent a few weeks in Andersens’ spiritual home in St Charles (near Chicago) at the beginning of 2000 observing one of their audit courses. I even have a certificate to prove it! This was indeed an eye opening experience. The key objective of a client review, it would seem, was not to do a good audit but to sell in extra services. Now the spiritual centre acts as an outplacement centre for all those Andersens’ employees looking to sell themselves to a new employer.

In my view, a stagnant audit market is not good for the companies, investors or auditors.

 The relationship between the external auditor and client could, in my opinion, even be termed incestuous; many quoted companies hire staff and senior executives that were trained by their audit firms. This, to my view, creates the following risks:

- The arms length relationship between auditor and client is tarnished.

- Both auditor and client develop a blinkered approach to the operation of the business, and their attitude to the audit process itself. Namely, the auditor takes the point of view “this is the way the audit was done by the previous auditor who is now CFO, and so this is the way we do it now”. Whilst the business, having hired past auditors, have in effect taken in a pool of people who have not necessarily the optimum range of experience gained by working in other industries or companies required to stimulate new ideas.

- The “old boys’ club” exerts a powerful influence over both client and auditor not to rock the boat. Namely, the client will be reluctant to change auditor and the auditor may be reluctant to address concerns with respect to the business that he comes across during its review.

 Companies, in addition to using the services of external audit, more often than not have an internal audit department (even if this is just to pay lip service to Turnbull). The mission of which should be to provide the Board with independent assurance as to the quality of the business controls, and the adequacy of the risk management process. To enable the internal audit department to function independently its reporting line should be to an audit committee which should comprise a majority of non executive directors. Herein lies two problems:

- Internal audit departments often do not report only to the audit committee, but have a dual line to a senior executive (usually the CFO). This severely limits the independence of the department. It is indeed interesting to note that Cynthia Cooper (Head of Internal Audit at WorldCom) had to bypass her boss (the CFO) and go directly to the audit committee to report the discovery of the capital expenditure fraud.

- How independent, and competent, are the non executive directors? The shareholders in Marconi may be forgiven for thinking that there were no non executives working at Marconi during the period of the cash burn.

The effectiveness, and indeed raison d’être, of the internal audit department is effectively nullified by a dual reporting line and a non independent audit committee which does not proactively question the status quo and actions of the senior executives.

 A non executive, in my view, cannot exercise his or her fiduciary duty adequately if he or she has a string of executive positions (many hold half a dozen or more). How can an individual devote sufficient time to each company with such a spread of responsibilities?

 Even more disturbing, in my opinion, are those cases where non executives hold positions on the boards of companies for which they worked for many years in an operational capacity. Companies offer these positions as a sinecure for years of loyal service. The thin veil of independence is exposed to be a sham. Whilst the non executive may well understand the companies operations, he or she is in no position to think or act independently.

 At an even more basic level there are those non executives who, because of their age, are simply not up to the job; they have become inflexible, they do not understand the changing environment.

The solution to these ills, in my opinion, is as follows (note that none of these points is earth shattering, they are simple common sense):

 Open up the auditing profession to more competition by enforced rotation of external auditors every five years or so.

 Place an enforced period of suspension, of at least one year, between a senior manager or partner in an audit firm relinquishing a particular client and joining that self same client.

 Companies should limit share option schemes to only account for a maximum percentage (say ten percent) of an individual’s total remuneration. This proposal invariably receives the curt riposte from companies (or rather their senior executives) that in order to attract the best you must pay “top dollar”. Well my riposte to this goes as follows:

- It has been my experience to observe the careers of quite a number of senior executives at close quarters. Their careers tend to follow similar paths. They arrive at the organisation and in keeping with their egos, and position, they identify a number of areas that need to be improved; otherwise the organisation may well as they put it “cease to exist”. With much fanfare of corporate videos and “managed” change programmes the new mantra is disseminated to the employees. These change programmes/projects tend to be given a five year time span. However, one small problem; the executive tends only to stay in that position for two years (their ego and supercharged need to move on “to face new challenges” prevents them seeing the project through to completion). This scenario I call “two year managers for five year projects”. The long suffering employees and organisation then endure the whole process over again with another executive who decides to change the change programme. The result, an organisation constantly changing but going nowhere.

- The concept that if you pay “top dollar” you will get the best always amuses me. To my view all that a super charged salary and benefit package does is attract those with the largest egos and greediest personalities. They move on after a short period of time to the next role which offers even more money; having no thought, or loyalty, for the people or organisation they leave behind.

- Regarding the quality of management attracted by these packages; ask the shareholders of Marconi or Enron if they feel they were well served by the senior executives they were told were the best money could buy!

In short, if a senior executive starts to complain about his level of remuneration; then show him the door and help him on with his coat.

 The cost of the share option schemes should be taken immediately to the profit and loss account. “An expense is an expense, is an expense!”, no prevarication. This way it is clear to all the world exactly how expensive the senior executives are.

 Non executive directors should only be recruited from outside of the organisation.

 The remuneration of non executive directors should be increased, and the number of posts which they hold reduced (maximum three); to allow them to devote a more appropriate amount of their time to the company.

 Internal audit should report directly to the audit committee. The committee should consist of a majority of non executive directors who should be appointed in terms of the above. There should be no dotted line to other directors. Dual reporting lines, in my experience, weaken the independence and effectiveness of the internal audit function.

 The chairman of the audit committee should, like the senior partner from the external auditors, attend the AGM and be prepared to answer questions from the investors.

 The chairman of the audit committee should be given the formal right to address the AGM without hindrance from the Board.

 The annual report should contain a statement from the audit committee signed by the chairman of the audit committee.

 External auditors should not provide add on consultancy services to their audit clients.

 Companies should adopt a code of conduct outlining their attitude to ethical principles, covering core values such as:

- Honesty

- Trust

- Respect

- Fairness

The code should state the company’s commitment to:

- Society (eg environmental issues, quality of service and products etc.)

- Shareholders (eg providing a decent return on equity)

- Employees (eg covering issues such as harassment, discrimination and quality of work)

The code should give clear guidelines as to the company’s attitude to, eg:

- Integrity of records.

- Bribes and commission payments.

- Interests outside the company leading to potential conflicts of interest.

- Respecting national and international law (eg obeying tax laws; viz complex off balance sheet schemes to evade tax should be disassembled immediately).

The code should be distributed to all employees, shareholders and be freely available to other interested parties. Compliance with the code should be audited annually, and a report to this effect placed within the annual report (what gets measured gets done!).

Mark my words these changes will come eventually, so why not stop delaying and just let’s get on and implement them now!