Michael Woodford lost his job on October 14. He had been CEO of Olympus, the Japanese maker of medical systems and cameras, only since last July; and as recently as September, the company’s Chairman had said he was “extremely pleased” with Mr. Woodford’s performance. But then the board fired him for “causing problems for decision making.”
He definitely was causing problems. He kept asking embarrassing questions about the Olympus’ 2008 acquisition of Gyrus, another medical equipment company. Olympus paid $2.2 billion for Gyrus, including $687 million in advisory fees to AXAM, an obscure Cayman Island firm that vanished from the trade register a few months after the deal. See this interview of Mr. Woodward in the Financial Times for more information.
The Olympus case reveals big weaknesses in Japanese corporate governance: unaccountable senior executives, weak disclosure standards, and dangerously passive shareholders. At the heart of these is an issue behind many failed companies and damaged lenders — poor governance.
Board Strength
Many things contribute to good governance, but the key factor is a strong board of directors. We think there are three dimensions to board strength.
Independence. The majority of directors on any board need to be independent of management. There are different standards of independence in use around the world, if not in Japan. Among the most rigorous is one from the Council of Institutional Investors, which defines independence this way: “An independent director is a person whose directorship constitutes his or her only connection to the corporation.”
Expertise. Directors of an effective board have relevant industry and management experience. They are well equipped to evaluate the company’s strategy, operating results, and finances, as well as the complexity, opportunities, and challenges management must deal with.
Effort. Being a director is hard work. Good directors spend a great deal of time and energy preparing for meetings, working on committees, and contributing to the decisions the board must make.
Board Strength at Olympus
How does the board at Olympus measure up to these standards?
Independence. Of fifteen directors on the board at Olympus, only three were outsiders. All the rest were executives of the company. It’s not clear that any of the outsiders were truly independent. In Japan, outside directors often come from subsidiaries or the company’s lead bank.
Expertise. Japanese disclosure about directors can be quite limited. But none of Olympus’ directors appear to have any top-level management experience or be seasoned deal makers.
Effort. Judging by Mr. Woodford’s account of the special board meeting at which he was fired, Olympus’ directors aren’t a very engaged or energetic bunch. Mr. Woodford was not allowed to speak, and there was no discussion. The board simply voted to approve every resolution Tsuyoshi Kikukawa, the Chairman, put before them.
It’s Not Over
The Olympus story is still unfolding. For more information on Mr. Woodford’s sudden departure, try this report in Reuters and this article in Fortune. Troubling new information about other deals with shadowy investment firms is emerging; see this article in the New York Times. And, as Japan Today reports, Mr. Kikukawa has resigned as chairman and president but remains on the board.
Whatever else develops, it’s clear that when it comes to Mr. Woodford’s dismissal, the rapid cycle of promote, praise, and pitch overboard doesn’t speak well for Olympus’ board. The company’s fumbling, contradictory explanations of the Gyrus acquisition only make management and the board look stupid or deceitful. So far, Olympus seems to be a poor example of how to govern a company. Who knows? As the story unfolds, it may prove to be an even worse one.
Jean Marie Messier became Chairman of Compagnie General des Eaux in 1996 at the age of 38. He was a graduate of elite French universities. At age 29, he held a senior post in the French Ministry of Economy and Finance. At age 32, he joined Lazard Frères, where he became the French investment bank’s youngest general partner.
He renamed the company Vivendi in 1999. And under Messier, Vivendi’s deal flow was staggering: the company sold 39 businesses and bought control of or stakes in 65 others. The capstone deal was a merger with Seagram-Universal and Canal Plus in 2000.
The share price climbed to a record high, and Messier became a darling of the financial press. Time magazine named Messier the 12th most influential businessperson in the world, and the French Government awarded him the Legion of Honor. Articles in Business Week and Fortune compared him to Jack Welch, the legendary CEO of General Electric.
The French press called him Jean “Magic” Messier. But Messier preferred J6M, which stood for Jean Marie Messier, moi-meme maitre du monde (“Jean Marie Messier, myself, master of the world”).
Massive impairment charges hurt the company’s credit ratings in 2001, which led to problems rolling over short-term debt, which put pressure on liquidity, which hurt the share price. Messier fought back in 2002 with a massive increase in share buybacks, a special dividend, and a request for a big increase in his compensation. Directors began resigning in packs, and Messier lost his job that July.
He paid over $2 million in civil fines for misleading investors in France and the United States. Now he’s been convicted on criminal charges for the same offense. In these difficult times, it may be gratifying to see a member of the global business elite in trouble. But what’s the lesson in the Messier mess for risk analysts? How could a manager so brilliant, so accomplished, so successful get himself and his company into so much trouble?
We think the answer is at the intersection of management and character. Messier displayed many of the traits of spectacularly unsuccessful people Sidney Finkelstein describes in his excellent book Why Smart Executives Fail.
1. They see themselves and their companies as dominant. Messier overestimated his ability to control events, especially when Vivendi got into trouble in 2001 and 2002. Instead of shoring up the company’s finances, he threw money at the share price and kept insisting Vivendi had more liquidity than it really had, as if his assurances alone were enough to save the company.
2. They identify completely with the company. But the relationship is inverted: the company’s good doesn’t come first, the manager’s does. Messier believed what was good for him must be good for the company. That’s how he could ask for a raise when Vivendi was in the middle of a liquidity crisis.
3. They think they have all the answers. Messier’s self-confidence and vanity were legendary. No one could persuade him to see the mistakes in business and financial strategy that led to Vivendi’s liquidity problems.
4. They eliminate anyone who isn’t 100% behind them. Messier fired the only other widely admired manager at Vivendi, Pierre Lescure, the highly popular CEO of Canal Plus. He stuffed the board with friends and supporters.
5. They are the company’s spokesperson. Messier loved the limelight and cultivated it. He became obsessed with the appearance of success, insisting that there were no real problems at Vivendi, even when losses were growing and financing shriveling away.
6. They underestimate obstacles. Messier refused to admit the extent of Vivendi’s funding problems. His CFO tried to warn him, saying, “I’ve got the unpleasant feeling of being in a car whose driver is speeding up into the bends and that I’m in the death seat.” But Messier ignored him.
7. They rely on what worked for them in the past. When things began to go wrong for Vivendi, Messier just did more of what he’d always done. He increased the pace of acquisitions and divestitures, raised share buybacks and dividends, and made more public appearances.
Messier, for all his ability, was a catastrophe masquerading as a hero. Fortunately, he did not destroy Vivendi, the way Bernie Ebbers did at WorldCom or Jeff Skilling did at Enron. But he came close. Analysts and investors who want to avoid the next management disaster should pay attention to character, and these seven traits are a great help for that.
Here’s our list of the top 10 topics on the minds of credit professionals in 2010:
10) Risk Management – We’ve written many times this year about risk management, both good and bad. Whether it was BP and operational risk, suppliers dealing with customer concentration risk (or “Wal-Mart Risk”), or Lehman just not managing risk. This topic was on our radar in 2010 (and needs to stay there into 2011 and beyond).
9) Games CFOs Play – Aggressive financial reporting (and outright fraud) can happen at any time, but management’s motivation to do it is heightened during an economic downturn when there is pressure to “hit the numbers” (and not breach covenants, etc.).
8 ) Managing High Risk Clients – Sure the recession is over, but many companies are still struggling with high leverage, high competition, low sales growth, and high costs. Lenders and bondholders will be working with many “high risk” clients well into 2011.
7) Intercreditor Priority – When times are good (think the 2003-07 credit bubble), no one pays much attention to collateral and subordination (or covenants, or any other part of credit documentation for that matter). The restructurings and bankruptcies of the great recession reminded us how important these issues are. We fear that the market is already starting to forget these lessons (think covenant lite and second lien!).
6) Cash Flow Analysis – Cash is king. Real cash, not EBITDA. Enough said.
5) Liquidity – Many CFOs (and lenders) have learned the hard way that liquidity can be the most important element of financial strategy. Our favorite analytical tool for looking at liquidity is the liquidity position.
4) Financial Strategy- Leverage matters too. A company’s debt strategy should depend on its business needs and business risk, not just the condition of the capital markets. The levering up we saw in the boom is evidence that some companies forgot this rule – many have been working to delever since 2008.
3) The Credit Cycle - The debt markets have returned (although not to the levels of 2006-07, yet). The return hasn’t been smooth, however. Issuers and investors have been looking closely at the relationships between the loan and bond markets, perhaps venturing where they haven’t been before.
1) New Opportunities – With the economy (slowly) improving (think increasing loan demand), and bank capital on the mend (think increasing loan supply), we think the increasing bond and loan volumes we saw in the second half of 2010 will continue into 2011. Here’s hoping that 2011 brings you many new opportunities.
What “hot topics” do you see looking forward – leave a comment…
Last post, we argued that Lehman’s Repo 105 balance-sheet-management tactic was not the worst thing Lehman Brothers did on its way to extinction. Volume 8 of Anton Vakulas’s Bankruptcy Examiner’s report details a bunch of blunders with far more serious consequences.
Here are a few of our favorites:
Although management was aware of the growing problems in the mortgage markets as early as 2006, Lehman decided to take on more risk “to pick up ground and improve its competitive position.”
It chose to do that by “making ‘principal’ investments – committing its own capital in commercial real estate, leveraged lending, and private equity investments.”
And it sacrificed liquidity along the way, so that “less liquid assets more than doubled during the same time from $86.9 billion at the end of the fourth quarter of 2006 to $174.6 billion at the end of the first quarter of 2008.”
But in our view, Lehman’s biggest missteps were in risk management. Lehman’s opportunistic push for growth changed into an aggressive push to offset declines in its commercial mortgage business late in 2007 and early in 2008, and that led the company to ignore its own risk controls.
This chart from the Examiner’s Report shows how Lehman’s risk appetite grew through 2007 and into 2008. Risk appetite was Lehman’s estimate of the amount it could lose without jeopardizing employee compensation or shareholder returns.
The chart also shows how in the last two quarters of 2007 the firm exceeded its own risk appetite limit with hardly any restraint, and then in the first quarter of 2008 solved the problem not by reducing risk but by raising the limit.
There are plenty of other instances of management’s undisciplined approach to risk management:
Management played games with key risk measures and “omitted some of the largest risks from its risk usage calculation” until June 2008 and “did not revise its stress testing to address its evolving business strategy.”
“Lehman rewarded its employees based upon revenue with minimal attention to risk factors in setting compensation,” in spite of the fact that managers were supposed to “use risk-weighted metrics such as return on risk equity…to determine compensation.”
After she resisted an increase in the firm’s risk appetite in 2007, Lehman replaced its highly regarded Chief Risk Officer, Madelyn Antoncic, in the third quarter of 2007 with the Chief Financial Officer, Rick O’Meara, who had no risk management experience.
Lehman did not see risk management as a crucial discipline or as a vital safeguard for a company operating with little capital and limited liquidity in troubled markets. For Lehman, risk management was a public relations tool.
It was a show put on to reassure clients, regulators, lenders, and the rating agencies but with no substance or bite. And that misuse of risk management was far more misleading and much more damaging than Repo 105.
A few weeks ago, the world was shocked to learn that Lehman Brothers was guilty of “window dressing” its balance sheet throughout 2007 and 2008. As the New York Times’ Dealbook put it, ”In Lehman’s Demise, Some Shades of Enron.”
The outrage is based on information in the examiner’s report on Lehman’s bankruptcy. We’ve read the report, and we think there is less to be upset about than the press coverage suggests.
The charge against Lehman is that they used accounting tricks to move assets of its books, making leverage ratios seem lower than they really were. The amounts were $38.6 billion in the fourth quarter of 2007, $49.1 billion in the first quarter of 2008, and $50.4 billion in the second quarter of 2008.
These seem like big numbers. They certainly meet the test for materiality set by Lehman’s auditors, Ernst and Young, which was “any item that moves net leverage by 0.1 or more (typically $1.8 billion).”
But let’s look at their impact not from a reporter’s point of view, or even a lawyer’s. Let’s look at this the way a credit risk analyst would.
This chart shows Lehman’s net leverage ratio as reported (without the Repo 105 assets) and as adjusted (with the Repo 105 assets). It was a measure the company emphasized in its public reporting and in its presentations to the rating agencies.
Net leverage is total assets less restricted cash, securities held as collateral, securities held to resell, borrowed securities, and intangible assets divided by stockholders’ equity less intangible assets.
When we analyze financial ratios we like to look at two dimensions of the data: level and trend. Let’s take a look at both for Lehman’s net leverage ratio.
Repo 105 does not make a big difference in the level of Lehman’s leverage. It changes from 12.1x to 13.9x in May 2008, for instance, but that’s not a decisive difference. When the examiner told the rating agencies about Repo 105, none of them said it would have made them change their ratings.
And Repo 105 does not change the trend in the company’s leverage. From November 2007 to May 2008, it fell by 25% with Repo 105 and by 22% without it. Either way, Lehman was cutting its leverage significantly.
Repo 105 makes for exciting headlines and promising legal claims, but it’s just not that big a deal. The public dismay over Lehman’s window dressing is disingenuous: banks and investment banks having been doing it for years.
The fuss reminds us of the police captain in Casablanca who is “ Shocked to find there’s gambling going on in here!” just as he gets his winnings from the croupier. Lehman did plenty wrong, but Repo 105 was not the worst by any means.
What do Calisto Tanzi, Bernie Ebbers, and Edward Groves have in common? Several things, actually.
For one, they all ran major companies. Tanzi was CEO of Parmalat, an Italian food company; Ebbers was CEO of WorldCom, an American telecommunications firm; and Groves was CEO of ABC Learning Centres, an Australian day care provider.
For another, each was a hard-driver who started small and made it very big. Tanzi built a global company from one pasteurization plant. Ebbers turned a rural telephone exchange into the third largest telecommunications company in the United States. Groves began with a single childcare center and grew it into the largest day care company in the world.
Another thing was they all owned professional sports teams. Tanzi had a Serie A football team, Parma F.C.; Ebbers had a minor league hockey team, the Jackson Bandits; and Groves had a basketball team, the Brisbane Bullets.
Yet another common point is that all of them were involved in massive misstatements of their companies’ finances. Tanzi kept enormous amounts of debt off Parmalat’s balance sheet, while Ebbers and Groves kept tremendous amounts of costs off their companies’ income statements.
The final thing they have in common is prison. Tanzi has been sentenced to ten years, and Ebbers is serving a 25-year sentence. Groves has yet to face criminal charges, but he may end up in jail yet.
So what does all this mean? Is owning a professional sports team an early warning sign of financial fraud? Not really. But it does mean Tanzi, Ebbers, and Groves shared traits that led to their misdeeds, and those traits may be useful signals of misconduct in others.
What these three malefactors had in common is some combination of these behaviors, which are based on Sydney Finkelstein’s “Seven Habits of Spectacularly Unsuccessful People” from his book Why Smart Executives Fail.
They were domineering. They resisted any outside control, including accounting rules.
They had no sense of a boundary between their interests and the company’s. What was good for them must be good for the company.
They thought they had all the answers. Since they were always right, they made their own rules.
They eliminated resistance. They quashed dissent and had no one to warn them about the risks they took.
They were the public face of their companies. They reveled in public attention and professional rewards, and they saw financial statements mainly as public relations tools.
They underestimated difficulties. It never occurred to them they eventually would be caught.
They relied on what worked in the past. They were sure that if a little bit of deception worked before more would work even better now.
It’s a truism of credit analysis that character matters, but it doesn’t just matter in small and medium-sized businesses. It’s crucial in big companies too.
Tanzi, Ebbers, and Groves did not set out to create criminal enterprises. But their own flaws pushed them and their companies across the boundary between aggressive reporting and fraud, with grim consequences for shareholders, bondholders, and lenders. And disastrous consequences for at least two of them.
We mentioned the absence of early warning signs in our earlier post on Satyam – especially the lack of a gap between earnings and cash flow. It turns out there were a few. We can classify them either as behavioral or financial.
Behavioral Warning Signs Behavioral early warning signs are actions, things key insiders and important outsiders do that signal trouble. In Satyam’s case, the first occurred last December 16, when Satyam agreed to acquire – without proper shareholder approval and at an inflated price – two struggling companies controlled by Chairman Ramalinga Raju’s family.
Then on December 23, the World Bank‘s barred Satyam from doing business with it for eight years for providing “improper benefits to bank staff” in exchange for contracts and providing a “lack of documentation” on invoices. Right after that, four of the company’s six independent directors resigned, another bad sign.
On December 26, Merrill Lynch signed on as advisor, began its “due diligence” research on Satyam, and quit the project after just ten days. Their reason was that, “In the course of our engagement, we came to understand that there were material accounting irregularities.”
This barrage of bad news was a powerful sign that something was very wrong at Satyam. Unfortunately, it came too quickly to be of much use. Raju sent his confession to the board on January 7, 2009, the day after Merrill Lynch mentioned problems with Satyam’s accounting.
Financial Warning Signs
Financial early warning signs are problem indicators based on financial statement analysis. Analysts look for inconsistent trends in related accounts. For instance, a gap between the trend in earnings and the trend in cash flow suggests overstated revenues or understated expenses.
In Satyam’s case, there is a puzzling difference between the trend in the reserve for uncollectable accounts receivable and the trend in the amount of time it takes the company to collect its accounts. In 2006 the provision for doubtful accounts was 8.5% of accounts receivable, in 2007 it fell to 6.6%, and in 2008 in was only 6.0%. Yet over that same span of time, the payments on those accounts began to slow down, as days receivables grew from 89 in 2006 to 101 in 2007 and 103 in 2008.
If the quality of receivables was declining, why was Satyam taking lower provisions? Perhaps to understate expenses. If the quality of receivables was improving, why were they taking so much longer to collect? Perhaps because Satyam was overstating revenues.
The Limits of Early Warnings
Early warning signs are far from perfect. They’re not definite. They can only suggest something’s wrong; they can’t prove it. They’re not precise. They can’t tell you how big the misstatement is.
But taken together, the behavioral and financial warning signs can alert you to an increase in reporting risk. Then you can begin to watch the company more closely, review your exposures, and check your legal agreements. You can be prepared to reduce your risk in case the worst happens and, like Satyam, the company ends up actually committing financial fraud.
It’s the biggest corporate fraud in Indian history, and the press labeled it “India’s Enron” as soon as the news broke. But Satyam looks to be worse than Enron in scope, if not in scale. How can we say that before the authorities have completed their investigation? We can tell by the absence of early warning signs.
Satyam Computer Services is one of India’s leading information technology companies and ranks 185 of the Fortune 500 companies among its clients. Early last December, the company’s Chairman, Ramalinga Raju, confessed to using fake revenues to inflate profits over a number of years. That led to a build up of what Raju called “artificial cash” of over $1.0 billion (Rs 50 billion) by the end of September 2008.
Through long, bitter experience, investors have developed a set of early warning signs of financial reporting fraud. One of the strongest is the difference between income and cash flow. Because overstated revenues cannot be collected and understated expenses still must be paid, companies that misreport income often show a much stronger trend in earnings than they do in cash flow from operations.
But you can see there is no real difference in the trends in Satyam’s net income and its cash flow from operations over the last five years. That’s not because the earnings were genuine; it’s because the cash flows were manipulated too. To do that, Raju had to forge accounts receivable and falsify collections.
The fake cash flows led to the bogus bank balances. To keep from tripping the income-cash flow alarms, Raju had to manipulate nearly every account related to operations. It was a stunningly comprehensive fraud, likely to be far more extensive than what Skilling, Lay, and Fastow did at Enron.
Michael Woodford lost his job on October 14. He had been CEO of Olympus, the Japanese maker of medical systems and cameras, only since last July; and as recently as September, the company’s Chairman had said he was “extremely pleased” with Mr. Woodford’s performance. But then the board fired him for “causing problems for decision making.”
Jean Marie Messier became Chairman of Compagnie General des Eaux in 1996 at the age of 38. He was a graduate of elite French universities. At age 29, he held a senior post in the French Ministry of Economy and Finance. At age 32, he joined Lazard Frères, where he became the French investment bank’s youngest general partner.
What do Calisto Tanzi, Bernie Ebbers, and Edward Groves have in common? Several things, actually.
Another thing was they all owned professional sports teams. Tanzi had a Serie A football team, Parma F.C.; Ebbers had a minor league hockey team, the Jackson Bandits; and Groves had a basketball team, the Brisbane Bullets.
The final thing they have in common is prison. Tanzi has been sentenced to ten years, and Ebbers is serving a 25-year sentence. Groves has yet to face criminal charges, but he may end up in jail yet.