Bean counters: Lost in Paradise

How to run a control fraud

The best way to run a control fraud is to turn the independent professionals that provide internal and external controls – auditors, appraisers, and credit ratings agencies – into allies, and use their reputation, alleged professionalism and independence to assist you in convincing the victims of your fraud, to trust you.

“While Margaret Hodge was attacking PwC for aggressively marketing and enabling tax avoidance schemes through Luxembourg as Chair of the Public Accounts Committee in 2013, Ed Balls (Shadow Chancellor), Chuka Umunna (Shadow Minister for Small Biz) and Chris Leslie all had PwC staff researchers seconded to their offices to assist with drafting new Labour party policy regulation,” says Joel Benjamin, campaigner for Debt Resist UK.

Professor Atul K. Shah, a Chartered Accountant and member of the Institute of Chartered Accountants in England and Wales told Renegade Inc that little is known exactly about how The Big Four accounting firms practice regulatory arbitrage and the extent to which it is structural and systemic, and how they continue to get away scot free from major financial crises and corporate failures. His detailed study of the failure of one of Britain’s largest Banks, Halifax Bank of Scotland (HBOS), has just been published as a major book by Routledge.

“In the case of the audit failure at HBOS, KPMG have still not been independently investigated eight years after the loss of billions of pounds, thousands of jobs and huge losses for investors, pensioners and retirees,” he said.

Analysis by the Parliamentary Committee for Banking Standards shows by contrast that the real problem was solvency, the masking of which was demonstrably an accounting failure.

Emile Woolf, former Chairman of the Auditing Practices Committee (APC) for the Institute of Chartered Accountants told Renegade Inc that the December 2007 accounts declared a profit of £5.5 billion, supported, incredibly, by a solvent balance sheet. Yet only eight months later, HBOS went bust, with the loss of 50,000 jobs, and over the next four years, £52.6 billion of its loans and investments proved to be worthless, at a cost to taxpayers of £21 billion.

“This is a case that highlights the ease with which accounting, as now practiced and supervised by the FRC, is capable of churning out utter tripe as plausible information, and then lending it bogus credibility in a formal audit report,” he said.

“The advent of the LLP was the beginning of the end.”

Enron ‘reforms’ the beginning of the end

The Limited Liability Partnership was born out of the Enron scandal and the death of one of the (then) big eight accounting firms, Arthur Andersen. The financial world had to protect itself from going the same way.

“Auditors failed abysmally over Enron,” Woolf told Renegade Inc.

“It actually wasn’t the springboard for a period of great integrity, rather it was a springboard for the blindness that happened before the Great Financial Crisis in 2008. The feds stopped doing auditing properly.”

The advent of new LLP structures meant when firms under audit went bust, if the auditor was sued, losses would be incurred by shareholders, not partners as under the old system.

Using the model of incurred losses (rather than expected losses), banking and financial institutions had no obligation to declare their bad debts until such time as management decided they were irrecoverable.

“All these bad debts were stuck on the banks’ balance sheets until the big financial crash occurred in 2008, when all of a sudden everybody recognised that these were the things that brought down Fannie Mae and Freddie Mac, the two biggest lending institutions in the world that were rendered bankrupt by their own subprime derivatives trading,” says Woolf.

Woolf was actually in the meeting in the UK in 1989 where it was decided that asset valuations should shift from expected to incurred losses.

As chairman of the APC of the Institute of Chartered Accountants, Woolf’s job was to attend meetings as an observer, simply to understand how accounting standards were developing.

“I remember the meeting was chaired by Michael Renshaw,” he said. “At that meeting the Professor of Accounting at Exeter University stood up and proposed a change in accounting standards from lower cost of market value, to marking to market which he claimed was much more reliable and up-to-date.

“They fell for it hook, line and sinker,” he said. “Everybody loved it.”

The change meant auditors could look at their client’s paper assets in the form of loans and other financial instruments and decide that a transaction between two banks is ample evidence of the existence of a market.

“It was the open sesame for subjective valuation,” said Woolf.

Meanwhile, in America more than 11,000 US appraisers signed a petition in 1998 which warned the key authorities, bluntly, that they were being extorted by lenders to inflate appraisals and those who refused to do so were threatened with blacklisting.

“No action was taken, in response to this warning,” says Professor Bill Black, a key prosecutor in the Savings and Loans scandal, which resulted in the bankruptcy of half of the Savings and Loan banks in the United States.

The Hogan’s Heroes excuse: “I know nothing”

Professor Black says during the 1980s and ’90s, CEOs, regulators and the Federal Government were all doing their very best impression of Sergeant Schultz of Hogan’s Heros fame.

“The Savings and Loan debacle was not a random anomaly,” he said. “That was an act of specialised deregulation in 1982 that set up a competitive wave – in this case a race to the bottom – between the federal government and the states.”

In the case of Enron, its accounting and securities fraud was aided and abetted by the world’s largest banks, (including Natwest as described in detail in Ian Fraser’s Shredded),  via its Special Purpose Vehicle – a subsidiary company whose asset/liability structure and legal status allows it to essentially hide liabilities from its balance sheet.

Black described how the board of the US Federal Reserve was “enraged” at its long-serving head of supervision, Richard Spillenkothen for describing in a lengthy document the role the banks played in aiding and abetting Enron’s accounting frauds.

“He noted that the extreme reaction of the economists caused reluctance amongst auditors to bring bank abuses to their attention,” he said.

“The Justice Department didn’t prosecute the banks, even though they had them absolutely dead to rights and had pages of internal memos documenting evidence of their complicity in Enron’s control fraud.

“It really is a great episode that captures the insanity,” says Professor Black. “The banking agencies saw this disaster coming, they realised it is going to be repeated, but they won’t do anything.”

Eventually Congress passed some unenforceable guidelines. “It basically said ‘well maybe if you do something for which you are prosecuted, we might consider doing something’,” he said.

When banks became the government’s customer

One of the big components that led to the race to the bottom between banking regulatory agencies in the US and the City of London in particular, was the research of Australian economist, Professor John Braithwait of The Australian National University. The professor’s theory of responsive regulation and enforcement argued that the real problem was that regulators had created a culture of resistance that was too quick to prosecute and punish banking institutions for financial impropriety.

“John is someone I consider a personal friend,” says Professor Black. “But I think he was horribly wrong on this, and in particular his ideas were ideal to exploit if you were a control fraud.”

Braithwait’s work had enormous effect in the US, the UK, Australia and the EU. His work was picked up by the OECD which threatened to punish governments that didn’t dismantle their regulatory systems.

“They called it reform. I call it eviscerating,” said Professor Black.

This mantra was adopted by both the New Democrats under Bill Clinton and New Labour under Tony Blair and Gordon Brown.

The doctrine of rent-seeking in the United States was called “Reinventing Government”. The New Democrats in their key early years took funding from the Koch brothers and the Bradley Foundation, the leading union busting group in the United States.

Black says he got out of government after he was instructed by the National Office under Reinventing Government “to refer to, think of and treat the financial industry as ‘our customer’”.

“I stood up and said ‘surely you mean the American people’,” said Black. “They replied ‘no, we thought about that and we rejected it’”.

Braithwait’s work led to the evisceration of the Security Exchange Commission (SEC). Neither it or the Commodity Futures Trading Commission (CFTC) even had sufficient computer capacity to even investigate the Flash Crash. And the Republicans in Congress deliberately refused to fund them to even have the capacity to know what the industry is doing with hyper velocity trading.

The UK offensive

Meanwhile, the UK’s ‘light touch’ Financial Services Authority went on the US offensive. Congress had recently passed the Sarbanes Oxley act which forbid audit firms – at least temporarily – from conducting core audit work while acting in consulting capacities for their clients.

“Because of this crackdown, the FCA went to US firms and said ‘Bring your business to London, we’re light touch, we won’t look too closely at what you’re doing,” says Joel Benjamin, campaigner for Debt Resist UK.

“It basically lowered UK accounting standards to attract all of that business from the US constrained by Sarbanes Oxley,” he said.

“You have the regulator in Britain engaging in a race to the bottom with an objective to grow the financial services sector at cost of audit probity.”

Benjamin told Renegade Inc that UK auditors based in Jersey and The Isle of Man and other offshore centres lobbied the British government for limited liability partnerships whereby shareholders – and by extension, the public – assumed responsibility for audit failure.

“They said ‘give us these LLPs or else we’ll take our business elsewhere and the UK won’t be a major financial centre’,” he said.

“Much like the banks, their auditors have now been deemed too big to fail.

Having socialised their risks, audit firms are in a far stronger position to basically act as shadow directors, writing financial policy and enabling financialisation, inserting themselves into governments, ministers of Parliament offices and government agencies, assuming financial and tax policy, assessing roles for themselves.”

It also means the major firms have significant conflicts of interest acting both as auditor and consultant.

“They have basically concocted schemes to avoid tax on an industrial scale and to large extent have avoided any responsibility for that,” says Benjamin. “The focus of the Panama Papers was on the smaller boutique firms like the Von Seckers but there was basically no focus on role of PWC and KPMG and Ernst and Young, the big accounting firms that allowed foreign players to access the shadowy firms in offshore tax havens.”

Consultant advisory work, as a proportion of income, takes up a bigger slice of the pie than the actual core audit.

The result is a reduction both in the quality of the audit and the proportion of overall income, as well as significant conflicts of interest.

“Let’s say for instance Ernst and Young is auditing Barclays and 60% of their income comes from advisory work and 40% from a core audit,” says Benjamin. “If they find a major problem in the core audit, the incentive is to cover it up and not jeopardise the 60% of revenue they’re getting from consultancy work which the bank might withdraw from them if they start raising problems.”

Benjamin says you can draw a direct line from those interventions to what happened a few years later in 2008 collapse of RBS and Halifax Bank of Scotland, (HBOS).

“The fact is that 10 years later, we are only starting to investigate the role of audit failures in those particular bank collapses.”

James Crosby, the CEO of HBOS was concurrently Deputy Chairman of the Financial Services Authority from 2004 – 2009.

We still have the ridiculous situation where John Griffith Jones, Chairman of KPMG during its disastrous audit of HBOS is Chairman of City Regulator – the Financial Conduct Authority.

The release of the Paradise Papers brings up even more questions about the role of the accountants in one of the greatest industrial acts of offshoring and tax avoidance in history.

Prosecution: the only solution

“The phrase ‘Set a thief to catch a thief’ is common parlance,” says Professor Atul K. Shah. “‘Set a global brand of professional accountants to rob society and pilfer its taxes, bleeding governments’, is not, but it should be.’

Professor Bill Black says internal controls are absolutely critical in reducing fraud by insiders in particular, but not just insiders, as the Paradise Papers have repeatedly demonstrated.

Emile Woolf says there is no way to remove control fraud and dodgy accounting practices from the economy without first prosecuting the culprits.

“The devils that committed this criminal negligence – with the exception of the Royal Bank of Scotland (RBS) – have never been fined or prosecuted” he said. “What you can then do is create a ring fenced fund inside those institutions, earmarked to save them from going under. But the company has to recognise it has to be paid back.

“RBS is incapable of paying back the billions of fines it still owes for misconduct,” he says. “Where does that money come from and where does it go? Without the fines RBS would have made £100 million profit this year, but because of the reserve for fines in the USA and UK, all those fines are far too great to allow for payment of a dividend.”

Of course calculating a true profit figure is difficult when a significant portion of that profit is fraudulent, because it doesn’t take into account the result of the inequities of ten years ago.

“The worrying thing for all of us is if it happens again,” he says. “My hope is that three years from now, banks will be forced to recognise their loans that will never be repaid. But my worry is that this is going to be after the next financial crisis, because it’s happening again. There is no redeeming features in the present. The only difference is the next crisis is going to be bigger.”

Joel Benjamin told Renegade Inc that accounting is as much about *what* you count or don’t count as it is *how* you count it.

“This is evidenced through the practice of ‘base erosion and profit shifting’ – shifting profits to offshore low or no tax jurisdictions, ” he said.

In the space of 50 years, Britain’s economy has transformed from an industrial power house, to that of a finance-led extractive parasite, where the cash starved productive economy receives less than 10% of bank credit.

“Until the Big Four accountancy firms are accurately viewed as enablers of corporate offshore dealing, regulatory arbitrage and ardent defenders of the neoliberal order, not the ‘reputable’ objective independent arbiters of the public interest as they claim, society will continue to be taken for a ride, and public services and social cohesion will continue their long decline,” he said.