Robert Benoit President Lord & Benoit

Just when it seems that the economic news can't get any worse, it does!  The sub-prime mortgage mess, commercial and investment bank failures and bailouts, insurance company failures, auto industry mismanagement, trillion dollar deficits etc. have all contributed to an economic tsunami which is threatening the very core of our national economic existence.  And new threats are lurking—for instance, the rising defaults in consumer (credit card) debt could trigger a collapse that could grind the economy to a halt. 

Amidst all of this, the occurrence of fraud is on the rise.  The Bernard Madoff scandal ($50 billion) and the Satyam Computer Systems fiasco (Satyam’s market value has dived to about $410 million from more than $7 billion six months ago) have both duped investors out of billions of dollars in investments.  In fact, according to a global fraud report by international security firm Kroll  a tough economy along with the credit crunch have led to a sharp increase in the amount of fraud and corporate crime suffered by companies around the globe.

Echoing these sentiments from an auditing perspective, at the recent American Institute of CPAs’ National Conference on Current SEC/PCAOB Developments, Public Company Accounting Oversight Board Chairman (PCAOB) Mark Olson said, “the risk of financial fraud tends to increase during tough economic times, and that if anything, auditors need to exert more “professional skepticism” when auditing corporate financial statements during the current economic downswing…With the spread of the crisis, auditors need to be alert to risks in other sectors and plan their audits accordingly.”

At the same conference, Chairman of the Securities and Exchange Commission (SEC) Christopher Cox said that with shifting economic currents, the “agency is in no mood to soften accounting rules in an effort to firm up financial reports .”
 
In referring to his company’s recent report on corporate fraud, Blake Coppotelli, senior managing director of Kroll's business intelligence and investigation division, pointed the finger clearly at lax managers as well as tougher market and economic conditions. "The findings show that fraud is not only widespread, but also growing and we expect to see this increase further as conditions become tougher for business and the full impact of the credit crunch unfolds," he said. "When you look into the causes of fraud, companies that cited high staff turnover or weak internal controls suffered much higher levels of fraud – in almost every case increasing their exposure by one-and-a-half times," he added. "Companies need to look carefully at how they can address these issues to reduce their risk to fraud and improve their business operations, " he continued. So then it appears that poor management and weak and poorly-audited internal controls is at the heart of the matter.

Certainly, most would agree that something needs to be done to prevent the increase of these “billion dollar” scandals.  And while each announcement of a major new scandal has a chilling effect on the investment community, there may be a more pronounced problem hiding in the shadows. 

While the press focuses on ills of larger public companies, smaller public companies garner little to no attention at all.  In fact, weak controls, poor management and occurrences of fraud are more likely in this segment than in larger public companies due to the fact that from both an audit and regulatory perspective, little consideration is given. 

For instance, while the Sarbanes-Oxley Act (SOX) Section 404 has been in full effect for larger public companies, smaller companies (with a public float of $75M or less) have been granted delays and have not as yet, fully complied with the provisions of SOX since its passage in 2002.

The following is an actual, detailed case study written by a financial official regarding their experience regarding weak controls and poor management at a smaller public company.  Both the name of the person and the company has been kept anonymous…

Case study of a Small Publicly Held Company
 “Our story is not unique:  a start-up company with great potential, CEO featured in local magazines and print media, stock price continues to climb, the shining house on the hill as everyone in town knew it.  Walk in the doors of our company, and you could see it: ultra modern furniture, the wall of flat screens, the office lounge.  If you looked around you could feel it…the energy...the vibe…the word on street…we were the future.” 

“Sure, our financials weren’t pretty:  little revenue, lots of debt, high operating costs.  But that’s the life of a start-up.  Without risk there is no reward.  Our projects take time; they take a lot of capital.  We’re still building our pipeline.  Look at the big names we are working with.  Would they work with a company that wasn’t going anywhere?”   

“Look at how much our stock has gone up.  Look at the magazine articles about us.  Look at our CEO and CFO making the list as top paid executives in our area because of share-based compensation.   We are a top notch organization.  We are the next big thing.  We are the future.  We will make you rich.”

Bankrupt
“Our story is not exclusive:  a start-up company filing for bankruptcy, CEO terminated or wrongfully forced out depending who is telling the story, stock price continues to plummet--the shining house on the hill is now known as the house of cards.”

“Our projects…well, our costs were out of control and we didn’t even know it.  Hey, we’re still building our pipeline…but we’re just now finding out that our other projects won’t be profitable either.  Look at us now with barely any deals.” 

“Imagine us once we hit it big!  Once it hits, we will be absolutely out of control.  Our overheads will be astounding.  If we can’t manage our business now, how can we be expected to manage it if we grow?  Can’t you see it?” 

“Look at how we run our operation.  Look at how we spend our money: 
•    Look at how we don’t have any idea where our costs are going 
•    Look at all the costs that have been authorized and approved
•    The advances made to employees
•    More advances on future commissions that aren’t even in the pipeline
•    Bonuses that are guaranteed not based on performance
•    “Loans” made to employees that will be forgiven over time
•    Expense reports without receipts
•    Expensive furniture
•    Apartments
•    Cars leased in the company’s name, or the rest of it” 

“What about our controls? What about the CFO?  What about the CEO?  What if they are the problem?”

Tipping point? 
“When I came to work with my company, I knew from the interview process that we had a lot of problems but I thought I could help fix them.” 

“I knew that many of our processes were in some ways out of control, but I also knew that we were going to be required by SOX to have our management assess our internal controls and attest as to their effectiveness.” 

“I knew that our financials didn’t look good, but they were audited.  I knew we had just been given $10 million dollars and that we had what seemed to be a great product, new projects in the works, and it was the right industry at the right time.”

“I viewed the company as being at a tipping point, that the decisions we would make and the processes we would implement over the next year would either propel us to success, or they will cause our fall.” 

“What I did not know was that the choices that were made before my arrival had brought us not to a tipping point, but instead, to a point of no return.  We had already crossed the tipping point and I was now going to be witness to the effects of those decisions.”

Where were the auditors?
“I understand the reason people bought into the dream that was us.  Our product appeared to be the right product at the right time.  We were doing work with big names and established companies.  We had momentum.  And then there was our CEO, making things happen.  He had presence, credentials, and had worked for a big Wall Street firm.  He had the image of a high roller in a small town and was a great salesman.”

“I hear some people asking about the auditors.  Why didn’t they catch all the things that were going on?  The auditors only attest to the material accuracy of the financial statements. Having some expense reports without receipts are not very material when you’re spending millions on projects.  Auditors don’t attest to whether it was appropriate to spend $5,700 for a chair, $30,000 for lounge furniture, or to give out Tiffany vases to the attendees at the Christmas party.  They attest that the money was spent, recorded in the proper period and depreciated appropriately.  They had their going concern disclosure.  They warned us.  And if we really looked at the financials the information was there, maybe not specifically stated with all the gory details, but there nonetheless:  a lot of expenses, a lot of debt, very few projects and no revenue.”

Where are we now?
“Now here we are today—a company that has filed chapter 11.  Several large investors had put millions upon millions into our company.” 

“Many in the town had personally invested in, and subsequently lost, their money in this company and the dream that was initially sold.  The word is that some have even mortgaged their homes to do so.  And there is also another group that in my mind gets forgotten all too often, but I am reminded of every day:  our vendors.  We hired them.  They provided the parts or services as we requested.  They spent their own money in overhead and equipment to help us.  We worked out deals with them, assuring them that we just got over $10 million dollars of financing and there is an agreement in place that much more will be coming.” 

“Any reasonable person would think that $10 million would last a long time.  We gave our word to them.  They believed in us and by working with us, invested in us too.  All of these investors will likely never get their money back.  The vendors will likely never get paid, and some even run the risk going out of business altogether because we aren’t paying for what we took from them.” 

“Then there are the employees.  Investing their time and their efforts, giving everything to try and make this dream a reality.  Employees have lost their jobs because of where we are at and decisions that have been made.”

How could SOX have helped?
“So what happened?  We did have controls, technically.  There were approvals and authorizations given.  There was segregation of duties.  There were auditors.” 

“What was missing?  From my assessment:  lack of integrity, moral courage and executive accountability.  Integrity is not just doing what’s right, or what can be argued as right.  Integrity is having full moral clarity to take a step back and do what appears to be right even when ‘technically’ or ‘justifiably’ it is not required.  Our traditional accounting system failed us.”

“This was the reason for Sarbanes-Oxley.  SOX focuses on the technical and justifiable, but more importantly focuses on the appearance of something as justifiable.  SOX is about integrity and moral courage.  The truth is that when you have integrity and moral courage instilled in a company’s management and throughout the organization, these values act as an umbrella covering all activities of an organization.  They will dictate the hearts and minds in the organization.  The hearts and minds in the organization will determine the actions of the organization.” 

“If the hearts and minds are under the umbrella of integrity and moral courage, the rest of the compliance with GAAP and traditional auditing standards will naturally be met because it would be in direct opposition to the integrity of the organization not to be in compliance. The moral courage of the company would require that compliance be achieved.  This is why SOX is the correct framework under which our businesses should be managed.”

“The [COSO] framework of SOX is like our Constitution.  The Constitution as a whole is in essence a set of the values and principles that guide our society.  It outlines our rights, which in turn, outline our actions.  SOX is similar in that it is the framework of a set of values and principles that guide our organizations.  It outlines management’s responsibilities, which in turn should outline their actions and the actions of the organization.”

SOX and the Balance of Power
“Our government has an executive, legislative and judicial branch, all designed to achieve a delicate balance of power.  Ideally, our organizations should also mirror this structure.  The CEO would represent the executive branch acting as the key decision maker and figurehead of the organization.  The CFO would be represented under the legislative branch, focusing on operational processes and financial budgets of the organization.  As with our legislative branch, the House and the Senate balance each other’s power.” 

“This is how it should be in an organization as well with Accounting/Finance acting as the Senate to balance out the actions of Operations acting as the House and vice versa. 

The Board of Directors and External Auditors combined would represent the judicial branch.  The Board of Directors is like the state courts which are responsible for reviewing the majority of activities to ensure they are in compliance with the laws.  For the Board of Directors, this would include the majority of the oversight of the organization, ensuring that its activities are in line with the framework of integrity and moral courage and GAAP as provided under SOX.  The External Auditors would in a sense be similar to the Supreme Court of our judicial branch, reviewing the key issues, preserving the overall integrity of the SOX framework and ensuring compliance with law.”

“In this example, GAAP is similar to state law.  State laws come out of the framework of values and principles of how our society should govern as outlined in the Constitution.  Such is the case with GAAP, its regulations would fall under the framework of values and principles of how our organizations should govern as outlined in the framework of SOX.”

Imbalance of Power
“So what was wrong with the structure our company?  Two key things: our CEO as the executive branch had too much power and our Accounting/Finance was not keeping the actions of our operations in check.  And perhaps, our judicial branch of the Board of Directors and External Auditors were not as judicious as they should have been.”

“First, our CEO had too much power because no one had the moral fortitude to tell him “no” or persuade him to make better financial decisions regarding company resources.  Some things, such as extravagant spending, while technically justified under “we need furniture” would not pass the integrity test of SOX.”

‘The CFO should be responsible here as well since it is his responsibility as the leader of the Accounting/Finance function to preserve the integrity of the company’s finances.  However, the Board of Directors should judicially review the actions of both to ensure that they are in compliance with the framework.” 

“If the CEO is able to exert too much authority, the balance of power fails.  This is not as much of a concern when that CEO has integrity, as they would continue to preserve the balance of power through their own actions.  However, a CEO that lacks integrity couple with unbridled power, is dangerous to the organization as they are essentially granted the authority to do all that they wish with no accountability.  I believe this is evidenced in our company.”

“The CFO should act as a balance to the CEO.  However, if the CFO is in lacking integrity or moral courage, or is fearful of losing their job or stock options, and is unwilling or unable to stand up to the CEO, the organization operates more like a dictatorship rather than a republic.  This is why both Board and Auditor oversight is so imperative.  The CEO, as the Chief Executive has no other true means of accountability other than the review of the Board (the Audit Committee in particular) and the auditor.”

“Second, the CEO and the CFO also have responsibility to ensure that the actions of the operations are in check.  At our company:
•    We could not get our hands around our costs on projects 
•    We were not doing timely financial closes 
•    We did not have a good accounting system to give us timely and accurate management reports that could be used by Operations to see where we were going wrong 
•    The CEO should have vetoed any actions that were not in the best interest of the organization 
•    Accounting/Finance, headed by the CFO, should have had the moral courage to require that such things as lack of budgets or cost review be resolved 
•    And perhaps, the Board of Directors and External Auditors should have focused on reviewing these systems to ensure that they were in place”

At what point do we start caring?
“How could this have been prevented?  Perhaps it couldn’t have.  If these were truly dishonest people out to swindle investors, then nothing could have stopped them.  I want to believe they weren’t dishonest.  I want to believe that they were good people that just made bad decisions and no one was there to hold them accountable until it was too late.  The thought I am left with is “what if?”

“When I started with the company, we were in a mad rush to do our SOX management self assessment because we had to internally assess and attest to our effectiveness of internal controls by our fiscal year end (four short months away at the time).” 

“We didn’t make it that far before things started unraveling.  We never got to officially finish our assessment.  If we had finished and material weaknesses existed (which I believe they did), if management was truly dishonest, they could just falsely attest to the effectiveness of controls.” 

“However, if there was to be a “judicial review” by the external auditors of our assessment, this would have been unlikely to happen.  Today, there is no auditor attestation for SOX compliance for us.”

What if SOX Deadlines Hadn’t Been Pushed Back?
“So then: What if?  What if the SOX requirements hadn’t gotten pushed out for small public companies?  What if we would have been required to do this assessment back when originally proposed?  What if we were being held accountable by the review of external auditors as to the effectiveness of our controls several years earlier?  They were proposed quite awhile before we got the $10 million.”

“Frankly, I believe it would have made a difference.  Prior to my arrival, we had already made changes in some respects to have better controls and we were moving in the right direction.  We knew we were going to have to be SOX compliant.”

“I believe those in our company that were operating without integrity and moral courage, could have been persuaded to act differently.  I believe that they sincerely wanted the company to succeed and would have been persuaded if it was required of them.” 

“So then: Why?  Why were we not required to implement SOX earlier?  I don’t know.  Too costly perhaps?” 

“What about the money that our investors lost? Should we ask them if it was worth delaying? What about our vendors who supplied services and equipment who will not get paid?” 

“What about the employees who have suffered layoffs?  Not implementing might have cost us our future.” 

“If SOX is the correct framework under which a public company should operate, we should not be held to a different standard because we are small.  We should all operate under the same framework of integrity and moral courage regardless of how large or small.  If we want to operate under a different framework, we have the option to be private where we can create our own framework.”

What If?
“So the same question remains:  What if?  What if we have been required to implement SOX earlier:
•    Well, we might have changed what we were doing back then. 
•    We might have gotten a handle on our costs because we would have had budgets and been reviewing them. 
•    We might not have spent so much that we shouldn’t have as we might have questioned more of our spending since
•    We might have been reviewing financials instead of figuring out where our to get our next cash infusion
•    Or how the next press release would impact our stock price 
•    We might still have people working for us today that aren’t.  We might have hired more people if we were profitable and growing a strong solid business 
•    We might be paying our vendors and helping them to grow with us 
•    We might have used that latest $10 million to grow this business into the promise that could have been 
•    We might not have needed the $10 million.  We might have done it with the millions that we previously received 
•    We might have made our investors money instead of losing it 
•    We might have revolutionized the world with our product.  We might have become a top-notch organization 
•    We might have been the next big thing.  We might have succeeded.  We might not, now”

Summary
Many are looking to the new administration to fix the system.  During his campaign, President Obama stated that “rapidly changing financial markets, coupled with increased government deregulation, have led to a cycle of economic bubbles and sudden declines that endanger Americans and threaten businesses.”

President Barack Obama said, “Our free market was never meant to be a free license to take whatever you can get, however you can get it. That is why we have put in place rules of the road to make competition fair and open and honest.  We have done this not to stifle, but rather to advance, prosperity and liberty ”

In an article entitled “Cost of corporate fraud far outweighs cost of legal compliance” published in the San Jose Mercury Times on February 15, 2007, Vice President (then Senator) Joe Biden commented:

“Sarbanes-Oxley helped restore confidence in American companies by holding corporate executives more accountable for their record-keeping and financial reporting, improving the quality of corporate auditing, and requiring greater transparency of companies' financial statements. And despite claims to the contrary, the evidence shows that Sarbanes-Oxley works.”

“There may be room to fine-tune and improve some of Sarbanes-Oxley's provisions. Congress should be open to that. But let's not turn back the clock to the uncertainty and dishonesty of the Enron era. Some may believe that the cost of financial integrity and corporate accountability is too high, but the cost of not demanding it would be catastrophic.”

“Critics have complained that the cost of compliance has caused some companies to go private, abandon plans to go public, or list overseas rather than on an American exchange. But the recent growth in private equity acquisitions has been driven largely by the availability of cheap debt financing and by the promise of high returns in the private equity market. In addition, many fund managers have been lured into this sector by generous compensation packages offered by private equity firms.”

“Those companies that have gone private to avoid regulation are mostly those with serious financial and corporate governance problems. They are precisely the kinds of companies that Sarbanes-Oxley seeks to discourage from trading publicly” (emphasis added).

Whether these statements give any indication as to what direction the new administration may choose with regards to Sarbanes-Oxley and financial regulations in general remains to be seen.  One thing is certain however, business investors in all sectors, regardless of size, should be protected from fraud and mismanagement.

Investors may be bewildered by the perception that smaller public companies with multi-million public floats are unable to afford the cost of compliance.  History and experience suggest that these smaller companies are particularly susceptible to fraud.  Individually, such conduct is unlikely to have the impact of an Enron-type fraud.  However, when considered collectively, the cumulative effect is immense—especially to the individual investor who can suffer a devastating loss.  While it is reasonable to conclude that investing in smaller companies is intrinsically more risky, it is quite another matter to assume that investors, who assume those risks, are willing to suffer the consequences of fraud, stock manipulation and related behavior.  In fact, these behaviors are not risks, but crimes.