Bad Corporate Governance And Cost Cutting

Some of the dumbest things I have seen in my life inside corporations revolve around incompetent managers, who don’t have the foggiest idea how to grow value organically, and use a variety of shortcuts or cheats to give an illusion of creating value by doing nothing.  I have given a few examples in these two articles:

Here are some more examples:

Some acquirers tend to despise the employees of firms that they acquire, and assume there is a lot of fat to be cut.  So it was that a client that I managed assets for that was acquired by a British company.  A few months after the acquisition the client firm announced that they were firing half of the accountants, and all of the accountants dealing with investing.  I went to the management of the firm that was a new client of ours and expressed my concerns, saying that they would lose all customization and control of results by outsourcing investment accounting — it could never be as responsive as retaining “in-house” staff.  Also, firing half of the remaining accountants would lose a lot of local knowledge where systems are deficient and need “hand holding’ with regular adjusting entries to make sure the accounting was correct.

In this example, the investment accountants were actually quite good, though their leader did not present well.  I had a good relationship with him and his staff, and helped them find new jobs, much as I hated to see them go.  I did the same for some of the other accountants that were let go, since I interacted with some of them as well.  It almost seemed like the new client wanted to eliminate all of the accountants with special long-term knowledge of the business, and retain the cheaper ones with less institutional knowledge/tenure.

As it was, my dealings with the new heads of financial reporting left me scratching my head, wondering why the new guys were a “trade up.”  They seemed to understand the issues less well than those they replaced, but were advertised to be really bright.  Okay, lost on me.

I relayed my concerns to my bosses, and they said, “Not much we can do.  We have the same ultimate parent company, but they’re not geared toward taking feedback at what would be such a micro level for them.  Let’s just watch and see what happens — if it is as bad as you think, it should materialize in six months or so.”

As it was, my bosses were right, and so was I.  For the first six months after the accounting change, profits were astounding.  The new management team was patting itself on the back, certain that their decisions were leading to greatly improved profitability.  (As an aside, I remember sitting through interminable meetings where new accounting software was being introduced. The old stuff was not good enough.)

Then came the year end audit, and new internal auditor plus new external auditors questioned accruals produced by the new outsourced investment accountants.  I was asked what the right approach was for accruing income on some obscure fixed income security.  Belying their cheap cost, the new investment accountants did not make the correcting entries into the system that the old accountants had, leading to a massive over-reporting of income.  Far from being more profitable than the past, it was far less profitable, despite all of the firings in accounting.

This was the first comeuppance of many for an untalented management team that eventually all got fired, as well as the ultimate CEO of the firm that trusted them, and invested a lot of money into that subsidiary.

Warnings to the wise: always analyze your profit margins in a competitive industry, and if results seem too good to be true, don’t accept them, push back and look at all of the squishier accrual items to see if there is an error.  Bad management teams accept good results without question, and criticize bad results always.  Good management teams criticize unusual results, whether good or bad, but bias income to the low side of fair, allowing small positive surprises to emerge.

Then there was the time where an insurance company that I worked for bought out a smaller company, and the hidden price of the deal was that the new CEO would be the CEO of the acquired company in a year.  Bad move.  The guy was an accountant, and his only means of “adding value” were cutting employees, and skimping on squishy accrual items.  While he was CEO, I kept track of how mach GAAP income outpaced my adjusted Statutory income, which should have been close to GAAP.

The CEO had a fragile personality as he did this, emphasizing that the team he had assembled (loyal, but less competent) was highly ethical.  As it was, the CFO tried to find ways to convert capital gains into regular income for GAAP but not tax purposes, which maximized ROE, which was the largest contributor to management bonuses.  They were even the first ones to try an unusual derivative marketed by Morgan Stanley (NYSE:MS) — bull/bear notes, as they were called. It was a bond that would split in two after a certain trigger, leading to two bonds — one with a premium income that would be held, and one with a discount income that would be sold for a capital loss.

Sadly, the company had a hard time evaluating the offer, until they approached me.  (Here is where ability conflicts with ethics.)  The chief actuary (via the Peter Principle, but true of all of that management team) showed me the derivative, and I said, “Oh, that’s easy.”  I told him I would have results by the next morning, and it was 4PM already.  I took it home, worked on it through the evening, and the next day presented the result.

I told him that the math worked mostly, but that if the US Treasury applied anti-abuse rules, it would be invalidated.  I also told him that I didn’t think the transaction was ethical, because restructuring merely to avoid tax, and change the GAAP statement impact had no economic substance.

He ignored my warnings, and so I found myself a week later presenting before all of the leading managers of the company the details of the transaction to be.  (Before that, I talked to the instigator of the idea at Morgan Stanley (NYSE:MS), and showed him errors in his spreadsheet.  Do not assume that investment banks are infallible. Also, don’t assume that actuaries or any quants are infallible.  They are human too, and subject to their own biases.  People often shout the word “science” when they are the most weak.)

I told them that I thought the idea was not ethical, but that it would do what was promised.  They were happy with that. 

1, 2  - View Full Page