Best summary of coverage is from my editor at American Banker, Marc “The Rock” Hochstein in the Morning Scan. If you’re not subscribing you should. Marc recaps the prior day’s news highlights with a bit of wit and a touch of sarcasm.

Just the way I like it.

Here’s a link to yesterday’s Morning Scan.

My column on the subject this morning at American Banker is getting quite a bit of play. Dimon’s mea culpa on the loss was timed to avoid lying, again, to a room full of people  - JP Morgan’s Annual Meeting is tomorrow May 15 - about how bad 2nd quarter results will end up. Listen to the conference call, scheduled hastily at 5pm EST last Thursday to hear Dimon apologize to several analysts he met with earlier that week for not telling them about the trading losses.

I ask, “Will ‘Egregious’ Error Sway the Say-on-Pay Vote at JPMorgan?”

It’s not too late for JPMorgan shareholders to change their votes on Dimon’s pay package. The proxy instructions say that votes can be changed at the meeting if you attend in person or revoke or amend your prior instructions by contacting the Corporate Secretary in the same way they were initially given – by telephone, email or in writing.

JP Morgan’s auditor? PricewaterhouseCoopers since 1965.

We are looking forward to your thoughts. My timeline for feedback is asap, but we have a bit of time as we are still searching for more mortgages.

As we discussed, we are researching some $1.1 billion in mortgages identified to date, which were taken out by the CEO of Chesapeake Energy Corp, Mr. Aubrey McClendon. He pledges his share of the company’s oil and gas wells and related equipment, intellectual property and hedging contracts as collateral.

The transactions are done through three separate firms he controls called Jamestown Resources LLC, Larchmont Resources LLC and Chesapeake Investments LP.

The result of Brian’s work, with co-author Anna Driver, is a special investigative report, that came out this past week. The publication of the report last Wednesday moved the Chesapeake stock price to its 52-week low. There have also been calls for CEO McClendon’s ouster and lawsuits filed.

Chesapeake Energy has now agreed to provide additional disclosures to investors.

Talk about impact journalism!

I posted a column on Forbes.com to highlight the report and my quote in it.

You have to wonder whether Chesapeake Energy‘s Board of Directors and General Counsel Henry Hood have been overcome by fumes. The company’s response to inquiries from Thomson Reuters’ special investigation by Brian Grow and Anna Driver is not only disingenuous it’s borderline delusional.

McClendon has borrowed as much as $1.1 billion in the last three years by pledging his stake in the company’s oil and natural gas wells as collateral, documents reviewed by Reuters show.

The loans were made through three companies controlled by McClendon that list Chesapeake’s headquarters as their address. The money is being used to help finance what could be a lucrative perk of his job – the opportunity to buy into the very same well stakes that he is using as collateral for the borrowings.

The size and nature of the loans raise concerns about whether McClendon’s personal financial deals could compromise his fiduciary duty to Chesapeake investors, according to more than a dozen academics, analysts and attorneys who reviewed the loan agreements for Reuters…

Chesapeake said McClendon’s loans are “well disclosed” to company shareholders. General Counsel Hood cited two references in the company’s 2011 proxy. In them, the firm refers to McClendon’s personal “financing transactions,” including one in a section entitled “Engineering Support” that discusses McClendon’s use of Chesapeake engineers to assess well reserves.

Nowhere in Chesapeake proxy statements or SEC filings does the company disclose the number, amounts, or terms of McClendon’s loans. Veteran analysts of the company said they were never aware of the loans until contacted for this article.

“We believe the disclosures made by the company have been appropriate under the circumstances, particularly since the disclosure of the loans is not required in any event,” Hood said in a statement.

You may wonder where the SEC is in all this. Don’t the rules require disclosure of related party transactions regardless of “materiality”?

McClendon’s loans – backed not by stock but by stakes in company wells – aren’t covered by the SEC rule. “Because they have decided to compensate him with a business interest, it kind of falls through the cracks,” says Francine McKenna, an accounting expert and author of the accounting-related blog re: The Auditors.

As a result, no SEC regulation precludes McClendon from using his well plan stake as loan collateral. The SEC declined to comment on the McClendon loans.

The SEC may not be specifically requiring disclosure of the complicated relationship between McClendon and EIG, between EIG and Chesapeake, and between Chesapeake and all the investors in EIG hedge funds that count on McClendon staying alive and in charge of Chesapeake. However, the audit industry regulator, the PCAOB, has proposed a new auditing standard that will require auditors to take a closer look:

Several news reports confused the source of the loans, the source of the collateral, and how the  loans were used. The loans were made by a banks and private equity firms not Chesapeake. They were made using McClendon’s interests in the wells as collateral. The most recent ones were used by McClendon to purchase the participations in the wells via a special purpose vehicle  - a legal entity set up in partnership with the private equity firm EIG so that the well participations could be converted to an asset held an EIG hedge fund.

Since he co-founded Chesapeake in 1989, McClendon has frequently borrowed money on a smaller scale by pledging his share of company wells as collateral. Records filed in Oklahoma in 1992 show a $2.9 million loan taken out by Chesapeake Investments, a company that McClendon runs. And in a statement, Chesapeake said McClendon’s securing of such loans has been “commonplace” during the past 20 years.

But in the last three years, the terms and size of the loans have changed substantially. During that period, he has borrowed as much as $1.1 billion – an amount that coincidentally matches Forbes magazine’s estimate of McClendon’s net worth.

The $1.1 billion in loans during the past three years breaks down this way:

In June 2009, McClendon agreed to borrow up to $225 million from Union Bank, a California lender, pledging his share of wells as collateral.

In December 2010, he borrowed $375 million from TCW Asset Management, a private equity firm.

And in January 2012, McClendon borrowed $500 million from a unit of EIG Global Energy Partners, a private equity firm formed by former TCW executives.

In one document provided to me by Reuters for my review, EIG Chief Operating Officer Randy Wade makes a pitch to the New Mexico State Investment Council for an investment in a new hedge fund his firm has created.

Mr. Wade responded that they have known Chesapeake Energy for 25+ years and provided pre-IPO financing for them in the late 1980s. He explained that Chesapeake’s chairman Aubrey McClendon has the personal right to invest, for a 2.5% interest, in every well that Chesapeake drills during a calendar year. In fall 2008, Mr. McClendon didn’t have liquidity to participate in the program in 2009, at which point EIG entered into discussions with him and ultimately came up with an SPV called Larchmont, which is in Fund XIV and is the analogy to Fund XV’s first investment. He said EIG set up a new entity and made a senior secured loan to the entity, and McClendon contributed his rights to participate in the 2009 drilling program at Chesapeake with an option on 2010, which EIG ultimately exercised.

He said EIG sweeps 100% of the cash flow generated by those projects until EIG has gotten all of its money back plus a 13% realized return; and in perpetuity EIG has a 42% net profit interest in all of the leases for which a well was drilled with EIG’s capital. To put it into context, 2,500 wells were drilled in this program, which ended in 2010, and this is the largest most diversified drilling program EIG has ever participated in. Fortunately, EIG had taken a fairly conservative underwriting approach on reserves and production; and while it is still early in the program, generally they are 25%-40% outperforming their base case.

Reuters reports that several state pension plans are counting on McClendon staying healthy, and on the job, at Chesapeake. That’s the only way these investments pan out for them.

An investment management firm that has loaned hundreds of millions of dollars to Chesapeake Energy Corp.(CHK.N) Chief Executive Aubrey McClendon raised money for its most recent investment fund from 19 institutional investors, including some of the largest U.S. public pension funds, according to a private equity research firm.

The list of state pensions that put money into the $4.1 billion EIG Global Energy Partners fund include ones from Alaska, Connecticut, Louisiana, Maryland, Minnesota, Missouri and Texas, according to research firm Preqin. Other large investors in the EIG Energy Fund XV were insurance giant MetLife and a Teamsters pension plan.

Chesapeake Energy’s auditor is PricewaterhouseCoopers. The auditor is paid less than $3 million to prepare an opinion on this challenging company. Sometimes you can be paid too little to be sufficiently skeptical…

Aubrey McClendon was also named an Ernst & Young Entepreneur of the Year last year.

The good news: regulators are pulling back the curtain on the consultants that the big mortgage servicers hired, under orders from the agencies, to review their foreclosure processes.
The bad news: what’s been revealed isn’t pretty.

Why, you might ask, did Congressman Brad Miller of North Carolina ask PCAOB Chairman Jim Doty and SEC Chief Accountant Jim Kroeker about my column? Those thought I had left town after the PCAOB two-day hearings on auditor independence and auditor rotation.

Not so fast! Congressman Miller wanted to know if they knew about Deloitte’s assignment to review their own work at JP Morgan Chase.

The Deloitte partner in charge of the JPMorgan engagement, Ann Kenyon, was a partner on Deloitte’s audit of Washington Mutual. So it would not be in her interest for Deloitte’s consultants to turn up any auditing errors the firm made with that mortgage originator, particularly since Deloitte is a defendant in shareholder litigation related to Washington Mutual’s collapse. In addition, Deloitte audited Bear Stearns, and is going to trial as a defendant in Bear Stearns investor litigation related, in large part, to EMC. So the consultants wouldn’t have a strong incentive to find any auditing goofs there, either.

If that’s not enough conflict to disqualify a firm, I don’t know what is.

Doty seemed a little surprised to hear my name and Kroeker said that it’s not his job. Not good answers. (I’ve whispered in both sets of ears since to try to help them recover from what I think is a big problem – the perception they left that the consulting side of the audit firms is unregulated.)

You can listen for yourself here. My name and my work is mentioned starting at the 1:14:00 mark.

It’s a curious thing that I have never been quoted in the Sun Times or Crain’s Chicago Business, and only once in the Chicago Tribune.  The accounting industry is immensely important to the Chicago metropolitan area – jobs, charitable support, civic pride, and tax revenue. Maybe that’s why local media goes out of its way to tell the public relations version of what the audit firms are up to and don’t report on the underbelly – litigation, client failures, layoffs,  and potential complicity on public corruption.

So it is with great pride that I thank Chicago Magazine – now owned by the Chicago Tribune – and Whet Moser Associate Digital Editor and a contributor to the magazine’s staff blog, The 312, for a recent mention.

Whet, like a lot of other intelligent folks, was baffled by the use of the word “vaporized” by the Wall Street Journal to try and explain what happened to the missing MF Global customer $1.6 billion – give or take a few hundred million.

Please go and read the rest of the story there.

Whet has also mentioned me here, here, here, and here in the past.

One of the weirder headlines of our postmodern financial era came in the wake of MF Global’s collapse: the money “vaporized.” What, exactly, happens when money vaporizes? Does it dry up, like a raisin in the sun? Or does it explode? Water is often used as a metaphor for money—it flows, pools, and dams up. Maybe it can turn into vapor, too!

Local financial journalist Francine McKenna, who runs the invaluable Re: The Auditors and who also writes for Forbes and American Banker, recently discussed this question on the Kaiser Report. She’s a former accountant, so some of the things she’s talking about are fairly arcane, at least for a layman. But I was comforted by the fact that her interviewer, a Wall Street vet, seemed just as perplexed as me, not to mention the rest of the world.

It’s difficult for me to imagine a new generation of systemically important financial services company CEOs without strong risk management experience. Independent board members with risk management experience will also be in demand. The current generation of CROs is gaining the experience to lead as CEOs and board members in today’s challenging market and regulatory environment.

Stewart Goldman, a senior client partner at executive search firm Korn/Ferry International, tells me there’s a ‘’scarcity” of candidates with the ”ideal skill set” to be chief risk officers, so institutions are considering people with a broader range of backgrounds to fill the post.

A Chief Risk Officer who does a good job mitigating risk while optimizing opportunities can now have significant stature and sway. But, conversely, that new prominence gives shareholders, regulators, and the media an easy target for ridicule after a corporate stumble or failure.

I’ve written quite a bit about some additional cases of Chief Risk Officers getting the heave-ho when something goes wrong. These additional examples – all outside of the US – didn’t make it to the American Banker column. It was a case of space as well as an “American” banker focus. But, I wonder out loud if there’s something different going on in Europe – something that forces accountability – or if the executives given the shove-off in Europe were just easy scapegoats.

Société Générale had its own “rogue trader” scandal in January 2008. Société Générale  lost $7 billion in spite of service from dual auditors under French law, Ernst and Young and Deloitte, and myriad policies, procedures, organizations and systems they, theoretically, had in place to manage risk.

However, words alone do not insure sufficient risk management. In 2009 Benoît Ottenwaelter replaced Group Chief Risk Officer Didier Hauguel. Hauguel had served as Group CRO and a member of the Executive Committee and Group Management Committee of Société Générale since 2000.

Paul Moore, HBOS’ former head of regulatory risk and a former KPMG partner told the Treasury Committee of the UK’s Parliament that Sir James Crosby, HBOS former chief executive, fired him after he warned the HBOS board in 2004 about its potentially dangerous “sales culture”. KPMG, external auditors for HBOS, ended up front and center in the 2004 controversy because the audit firm “independently” investigated Moore’s firing at the request of the Board after Moore blew the whistle. KPMG got the job in spite of its long and very lucrative relationship with HBOS management including significant fees for work done for the bank’s bid for Abbey National that same year.

The role of chief risk officer at Anglo Irish Bank, a tough job, has not been filled on a permanent basis since May of 2009. AIB was nationalized by the Irish Government in January 2009. In December AIB lost its second acting chief risk officer in less than a year when Stephen Bell, a PricewaterhouseCoopers Director, announced he was leaving to become Chief Risk Officer at Ulster Bank. AIB had hired PwC to help run the bank. Bell took over from Mary Phibbs, an associate at restructuring firm Alvarez and Marsal, who had been on the job since the previous October.

One interesting additional US example can be found at Countrywide, now ignominiously owned by Bank of America. I wrote about it in January of 2008.

At the end of 2004, Sherry Whitley, then the Executive Vice President of the Enterprise Risk Assessment Group for Countrywide, wrote this article for the Institute of Internal Auditors FSA Times Publication.

Countrywide’s strategic-planning process includes a companywide focus on managing risks.

In the wake of headline-grabbing corporate financial scandals, management and boards of directors of public companies are under intense pressure to increase their involvement in the strategic and operational activities of the companies they oversee. Executives at Countrywide Financial Corporation, a diversified financial services provider, reviewed various ways to provide a more focused, comprehensive approach to help their leadership teams identify and better manage business risk across the organization.Approaching risk with the goal of increasing shareholder value, in mid-2002 Countrywide incorporated comprehensive enterprise risk-management techniques into its leadership strategy, focusing board participation on a more global, disciplined decision-making process than has historically been used in the past.

In 2007, the Institute of Internal Auditors and their Research Foundation, lauded Countrywide’s Risk management initiative.

Countrywide Financial Corporation, the subject of our first case study, has the most comprehensive ERM program we have seen. Readers who want to know how a state-of-the art ERM program operates will see it illustrated through Countrywide’s example.

A writer for Internal Auditor magazine, an IIA publication, wrote in April of 2007 about this model initiative.

The largest independent originator and servicer of mortgage loans in the United States, Countrywide has the most comprehensive ERM program of the organizations in the study. Under the leadership of Senior Managing Director Walter Smiechewicz, Countrywide is currently building Sarbanes-Oxley functionality into an internally developed enterprise risk assessment software application…Countrywide’s Enterprise Risk Assessment division has 45 professionals with risk assessment responsibilities. They are supplemented by 112 internal auditors within the Enterprise Risk Assessment division and the risk management specialists in another division who manage credit and market risk for Countrywide…Enterprise risk assessment at Countrywide has both a bottom-up and top-down governance structure. It has led to a major restructuring of committees from the board level down through operating units. This restructuring has improved the flow of risk information throughout the organization…Countrywide’s program is truly “best practice…”

Things didn’t get any better when Bank of America tried to close the deal on Countrywide. In March of 2008, I reported that Bank of America was staring down a very dark tunnel on Countrywide exposure:

Just who is doing the due diligence for Bank of America on the acquisition?

Countrywide’s Mortgage Woes Deepen
Countrywide Financial Corp.’s mortgage portfolio continues to deteriorate rapidly as defaults increase and home prices fall, a securities filing shows…But if losses on the loans exceed certain levels, Countrywide isn’t reimbursed immediately and may never be reimbursed unless income from the loans outstanding is sufficient to meet obligations to investors in the securities.

Countrywide said the likelihood of such a situation was “deemed remote” until late 2007. It blamed a “sudden deterioration” in the housing market. As a result, it recorded a $704 million loss to cover the estimated costs of its obligations on the lines of credit…A Countrywide computer model used to gauge risks on these securities didn’t take into account the possible effects of exceeding the loss levels that cut off reimbursements, according to a Dec. 28, 2006 internal report reviewed by The Wall Street Journal.

I can’t find any mention of Sherry Whitley, former Executive Vice President of the Enterprise Risk Assessment Group for Countrywide, working at Bank of America or anywhere. Walter Smiechewicz, who implemented Countrywide’s ERM program, moved to Audit Analytics in 2008 and is now Chief Risk Officer at First Niagara Bank in California.

My latest column is up at American Banker, “Are Cozy Ties Muzzling S&P on MF Global Downgrade?”

You may recall the last time I wrote about MF Global. That story was about the “rogue” trader that cost them $141 million. In the meantime we’ve seen another “rogue” trader scandal and PwC has given MF Global clean opinions on their financial statements and internal controls over financial reporting since the firm went public in mid-2007.

I’m sure PwC thought everything was peachy as recently as this past May when the annual report came out for their year end March 30. Instead we’re seeing another sudden, unexpected, calamitous, black-swan event that no one could have predicted let alone warn investors about.

Right….

This video is NSFW. Many will find it offensive. I find it offensive – the dogfighting scene is antithetical to my love for my Rottweiler – but the phrase “99 problems” has entered the popular lexicon as a result of this video. You can’t pick your inspirations…

Most media enable him.

His latest stunt, ostensibly meant to save Bank of America while closing a savvy deal for Berkshire Hathaway, garnered laudatory headlines. Bank of America spun Buffett’s $5 billion investment for maximum effect.

Buffett supposedly came up with the idea in the bath. Several journalists added to his repertoire of folkways by reporting it.

Unfortunately, Bank of America is going to need more than $5 billion and temporary use of Warren Buffett’s aura to solve their problems.

The Wall Street Journal, September 2, 2011: U.S. regulators have pushed Bank of America Corp. to show what measures it could take if conditions worsen for the Charlotte, N.C., lender, according to people familiar with the situation.

Executives of the bank recently responded to the unusual request from the Federal Reserve with a list of options that includes the issuance of a separate class of shares tied to the performance of its Merrill Lynch securities unit, these people said. Bank of America purchased Merrill Lynch in 2009, and it has become the bank’s most profitable division.

It’s easy to forget that Buffett is the CEO and Chairman of a publicly held company when he’s seen scurrying around like Mighty Mouse, nibbling at failing banks and pulling billions from his fanny pack. Berkshire is a big company with some shareholders that aren’t him, his family, or his ego-stroking entourage otherwise known as the Board of Directors.

Buffett’s Bank of America move is not the kind you see most fiduciaries, bound by duty and good faith, make. It’s a public relations coup as performance, designed to leave a refreshing aftertaste.

Instead, investors are often stuck with a bitter one.

The next time something goes terribly wrong at a Berkshire Hathaway company, there’s a strong possibility no one will hear about it. Warren Buffett and Charlie Munger won’t be held directly responsible either. That’s the beauty of Buffett’s version of a conglomerate corporate structure, decentralized to such an obscene level such that its minimalism is brandished as a feature not a bug.

As our first owner-related principle tells you, Charlie and I are the managing partners of Berkshire. But we subcontract all of the heavy lifting in this business to the managers of our subsidiaries. In fact, we delegate almost to the point of abdication: Though Berkshire has about 260,000 employees, only 21 of these are at headquarters.

Buffett judges the investments he makes ruthlessly, but allows his operating companies to run on autopilot. It’s a wonder such financial, legal, and regulatory issues as the Salomon Brothers slip-up, Berkshire’s non-prosecution agreement with the Department of Justice over its dealings with AIG from 2000-2004, the James River lawsuit, and Sokol’s usurpation ever saw the light of day. It’s a testament to a few diligent folks who pushed those rocks, like Sisyphus, up transparency hill.

None of the issues mentioned above has tarnished Buffett’s halo for long, but the list of missteps grows longer. The Berkshire chairman claims plausible deniability. That’s made possible by the insatiable appetite of investors for gurus and sages rather than sirens.

The most frequent rebuttal to any attempt to burst Buffett’s bubble of infallibility is that “proof is in the performance”. Lots of long-term investors swear by Berkshire Hathaway stock and hang on every word from Buffett and Charlie Munger for investment insight.

But, as Aaron Task at Yahoo’s Daily Ticker recently reminded us, all that glitters is not gold:

“…investors who’ve followed Buffett into investments like Goldman Sachs and GE got burned, assuming they adhered to Buffett’s dictum about “forever” being the best holding period. The rest of us didn’t get the big dividends Buffett earned and both stocks are currently trading below the levels when Buffett made his “confidence-boosting” investments in 2008, Goldman by 12% and GE by 37%.

Finally, shares of Buffett’s own company, Berkshire Hathaway, have underperformed the S&P 500 in the past year and the company recently split its B-shares, violating yet another of Buffett’s not-so-sacred tenants.”

Buffett himself has admitted that being too big now affects his ability to capture outsize returns for the primary business of producing cash from other companies.

From the Berkshire Hathaway 2010 Annual Report:

The past growth rate in Berkshire’s book value per share is not an indication of future results.

In the years since our present management acquired control of Berkshire, our book value per share has grown at a highly satisfactory rate. Because of the large size of our capital base (shareholders’ equity of approximately $157.3 billion as of December 31, 2010), our book value per share will very likely not increase in the future at a rate even close to its past rate.

Buffett’s reluctance to sell loser portfolio operating companies or fire under performing managers means he has to make repetitive $5 billion Bank of America and Goldman Sachs preferred stock plays to compensate for tragic flaws like misplaced loyalty and day-to-day conflict avoidance.

And then there’s the numbers.

Berkshire Hathaway is a publicly traded company, listed on the New York Stock Exchange and regulated by the Securities and Exchange Commission. The integrity of Berkshire Hathaway’s external financial reporting should be ensured by the strictures of the Sarbanes-Oxley Act of 2002. Berkshire Hathaway and Warren Buffett, however, pay no more than lip service to the requirements and reject many other recommended corporate governance practices.

What’s left – of the financial reporting process, the internal audit organization, and the external audit relationship – is not enough, in my opinion, to prevent someone from spinning straw into gold.

Questionable corporate political campaign finance practices and foreign corrupt practices in the mid -1970s prompted the U.S. Securities and Exchange Commission and the U.S. Congress to enact campaign finance law reforms and the 1977 Foreign Corrupt Practices Act (FCPA) which criminalized transnational bribery and required companies to implement internal control programs. The Treadway Commission, a private-sector initiative, was formed in 1985 to inspect, analyze, and make recommendations on fraudulent corporate financial reporting. The original chairman of the Treadway Commission was James C. Treadway, Jr., Executive Vice President and General Counsel, Paine Webber and a former Commissioner of the U.S. Securities and Exchange Commission.

The accounting industry regulator, the PCAOB, tells us that existing auditing standards are neutral regarding the internal control framework that auditors use for obtaining an understanding of internal controls over financial reporting (ICFR), testing and evaluating controls, and, in integrated audits, reporting on ICFR. For integrated audits, PCAOB standards state that auditors should use the same internal control framework that management uses.

Since the Committee Of Sponsoring Organizations of the Treadway Commission’s (COSO) Internal Control-Integrated Framework (IC-IF) was published in 1992, many companies and auditors have used IC-IF as their framework in considering internal control over financial reporting. Also, since companies and auditors began reporting on the effectiveness of ICFR pursuant to §404 of Sarbanes-Oxley Act of 2002, many of those companies and auditors have used IC-IF as the framework for evaluating and reporting on ICFR.

Before leading the Treadway Commission, before the savings and loan scandals of the 1980’s, before Enron and the rest of the scandals of the 90’s such as WorldCom, Tyco, Adelphia, HealthSouth, and many others, James Treadway, SEC Commissioner, made a speech about financial fraud. His remarks specifically mentioned corporate structure, in particular a decentralized organizational structure, as a common characteristic of companies involved in financial fraud.

An excerpt of remarks by James Treadway to the Third Annual Southern Securities Institute, Miami Beach, Florida, April 8,1983

I refer to a decentralized corporate structure, with autonomous divisional management. Such a structure is intended to encourage responsibility, productivity, and therefore profits—all entirely laudable objectives. But the unfortunate corollary has been a lack of accountability.

The situation has been exacerbated when central headquarters has unilaterally set profit goals for a division or, without expressly stating goals, applied steady pressure for increased profits. Either way, the pressure has created an atmosphere in which falsification of books and records at middle and lower levels became possible, even predictable. This atmosphere has caused middle and lower level management and entire divisions to adopt the attitude that the outright falsification of book and records on a regular, on going, pervasive basis is an entirely appropriate way to achieve unrealistic profit objectives, as long as the falsifications get by the independent auditors, who are viewed as fair game to be deceived.

Treadway goes on to describe a company that’s almost an exact replica of Berkshire Hathaway. What’s most troubling is that nearly thirty years later there’s no excuse – lack of technology, real time communications, or specific regulatory requirements – for these conditions to still exist in a company of the size and systemic importance of Berkshire Hathaway. The weaknesses remain by design, not by default, which begs the question of whether they could serve an illegal or unethical purpose at any time.

Treadway’s speech goes on to describe eight characteristics of decentralized companies that promote lack of accountability and, potentially, the existence of financial fraud. I repeat them here, in italics, with a few comments after each related to Berkshire Hathaway.

1.The divisions and subsidiaries were autonomous, with little or no oversight by headquarters, particularly in the areas of auditing, accounting, and internal controls.

Berkshire Hathaway’s divisions and subsidiaries are, by Buffett’s admission, run with little or no oversight by Omaha headquarters. Each year he sends the CEOs a general letter outlining high-level goals and requires very few reports or status updates. One-way communication of monthly and quarterly financial results is the primary method used by most of the business units to report to headquarters.

From Warren Buffett’s annual letter to shareholders this past February, 2011:

At Berkshire, managers can focus on running their businesses: They are not subjected to meetings at headquarters nor financing worries nor Wall Street harassment. They simply get a letter from me every two years and call me when they wish. And their wishes do differ: There are managers to whom I have not talked in the last year, while there is one with whom I talk almost daily. Our trust is in people rather than process. A “hire well, manage little” code suits both them and me.

Berkshire’s CEOs come in many forms. Some have MBAs; others never finished college. Some use budgets and are by-the-book types; others operate by the seat of their pants. Our team resembles a baseball squad composed of all-stars having vastly different batting styles. Changes in our line-up are seldom required.

2. Constant pressure was strongly exerted by distant top management on subsidiaries and divisions to achieve profit goals set unilaterally and arbitrarily by corporate headquarters.

I don’t know to what extent pressure is brought to bear on subsidiaries by headquarters to meet specific numeric goals. What we have seen, in the Sokol scandal most recently, is that joining the Berkshire family may give some CEOs the impression they can break rules as long as they deliver expected results. In fact, they may even be touted as a possible Buffett successor.

Sokol’s Ways Questioned in Past Suits, The New York Times, April 4, 2011: Lawsuits involving David L. Sokol after he joined Berkshire Hathaway suggest that management had some warnings about his rules-pushing nature long before his resignation last week for buying stock in a company shortly before Berkshire acquired it. The most serious lawsuit centered on the accounting of an irrigation project by MidAmerican Energy, where Mr. Sokol was chief executive when Berkshire bought it in 1999.

In a rebuke last year, the judge ruled in that case that MidAmerican had improperly changed its accounting on the project and criticized Mr. Sokol directly. The change in accounting was “intended to eliminate the minority shareholders’ interests,” the judge wrote, awarding more than $32 million to the minority shareholders. The case had taken more than five years to work its way through the courts. During that time, Warren E. Buffett, the chief executive of Berkshire, expressed confidence in Mr. Sokol by broadening his portfolio beyond MidAmerican to include Netjets, a company that sells fractional use of private aircraft.

After Mr. Sokol took over Netjets in July 2009, some critics complained about his management style and his strategy for shrinking the company, which had been ailing even before the financial crisis did more severe damage.

3.  Communications between divisions and headquarters about the practicability of reaching established profit goals ranged from limited to non-existent.

From the 2010 Berkshire Hathaway Annual Report:

Berkshire’s operating businesses are managed on an unusually decentralized basis. There are essentially no centralized or integrated business functions (such as sales, marketing, purchasing, legal or human resources) and there is minimal involvement by Berkshire’s corporate headquarters in the day-to-day business activities of the operating businesses.

4. Headquarters and top management created an atmosphere in which sales and marketing functions in the divisions we reviewed as more important than accounting and auditing.

To say that there’s a strong focus on sales and marketing at Berkshire Hathaway would be a significant understatement. Buffett himself calls the company’s annual meeting “Woodstock for Capitalists”. Reports of the proceedings describe a carnival like atmosphere. Some of the highlights of the weekend are a showcase for the portfolio companies highlighting their products and services, a Q&A for international journalists held in the dazzling Borsheim’s jewelry showroom, and a BBQ at their Nebraska Furniture Mart.

But for a taste of the performance art purveyed in service to the Buffett cult, take a look at this excerpt from Michael de la Merced’s live blog for The New York Times Deal Book:

9:41 A.M. A brief commercial break

Because this is a haven for capitalism, there’s a brief commercial break. There’s Coca-Cola, one of Mr. Buffett’s most famous investments, and there’s Geico’s commercial about woodchucks chucking wood.

9:38 A.M. The Gekko arrives, and the day is saved

The Geico Gekko is one of several Berkshire employees to appear — along with Charlie Munger and Mr. Buffett’s assistant Debbie Bosanek — offering the MBA cyborg insurance. The MBA responds: “I’m self-insured.”

Of course, Ah-nuld and Mr. Buffett show up to save the day.

9:35 A.M. Buffett, action movie star

The movie begins with an animated segment about the “MBAs,” ruthless trading machines who plan to destroy the world.

The only hope is Warren Buffett.

We’ve already got a couple of celebrity cameos. Arnold Schwarzenegger is suiting up as “The Governator,” shortly after having stepped down as governor of California. (And there’s Larry King asking him a question!)

9:30 A.M. The lights have dimmed

After a brief introduction from Mr. Buffett, explaining the movie and asking shareholders not to record it (in part to assuage the famous people — who, “surprise, surprise” work for Berkshire for free), the movie begins.

It’s a time-lapse video of the prepping of the Qwest Center for the Berkshire annual meeting, set to U2’s “Beautiful Day.” It’s really amazing to see just how people flow into the arena and fill it to the brim.

It’s also amazing how the crowd, so noisy just minutes ago, has turned silent in the dimness.

9:26 A.M. Ladies and gents, take your seats

It’s almost showtime. A gravelly announcer — who sounds awfully similar to that guy from all the movie trailers — tells of those who have gathered for “one gloriously capitalistic weekend.” He further intones, “All roads led them to Omaha” before the big finish: “You’ve arrived at the Berkshire Hathaway shareholders meeting. The movie will begin in 10 minutes.”

5. That atmosphere caused divisional managers and personnel to believe that falsifying or “cooking the books” was the only way to achieve the profit demands, and that this was acceptable to headquarters. The divisional personnel engaged in the improper activities as part of an admitted” team effort.” In some instances, divisional employees stated that they believed it a “mortal sin not to meet the profit goals.

Here’s an excerpt from Buffett’s letter to his CEOs (“The All-Stars”) in July of 2010:

Somebody is doing something today at Berkshire that you and I would be unhappy about if we knew of it. That’s inevitable: We now employ more than 250,000 people and the chances of that number getting through the day without any bad behavior occurring is nil. But we can have a huge effect in minimizing such activities by jumping on anything immediately when there is the slightest odor of impropriety. Your attitude on such matters, expressed by behavior as well as words, will be the most important factor in how the culture of your business develops. Culture, more than rule books, determines how an organization behaves.

In other respects, talk to me about what is going on as little or as much as you wish. Each of you does a first-class job of running your operation with your own individual style and you don’t need me to help. The only items you need to clear with me are any changes in post-retirement benefits and any unusually large capital expenditures or acquisitions.

6. No employee involved received any direct personal benefit from theft, bribes, kickbacks, or diversion of assets.

What was so disturbing to so many about the Sokol scandal at Berkshire Hathaway last spring was the sheer audacity of David Sokol putting himself first, not the company. That was surprising to observers and seemed to take Warren Buffett by surprise, also. But it’s not so clear that Buffett had made Sokol, and by implication perhaps his other CEOs, understand where he truly draws the line and when, and if, failure and bad behavior would be subject to punishment or banishment.

Warren Buffett, Unplugged, The Wall Street Journal, November 12, 2005: Mr. Buffett tends to stick to investments for the long haul, even when the going gets bumpy. Mr. Sokol recalls bracing for an August 2004 meeting at which he planned to break the news to Mr. Buffett that the Iowa utility needed to write off about $360 million for a soured zinc project. Mr. Sokol says he was stunned by Mr. Buffett’s response: “David, we all make mistakes.” Their meeting lasted only 10 minutes. “I would have fired me if I was him,” Mr. Sokol says. “If you don’t make mistakes, you can’t make decisions,” Mr. Buffett says. “You can’t dwell on them.” Mr. Buffett notes that he has made “a lot bigger mistakes” himself than Mr. Sokol did.

7. The falsifications were large, simple, and direct. Expenses were improperly shifted from one accounting period to another. Goods ready for shipment, sometimes not even manufactured, were accounted for as sales in the current period, even though not actually shipped or manufactured until a succeeding period. False statements were made to auditors. Multiple sets of expense records were kept. Shipping invoices and bills were altered, with third parties sometimes enlisted to assist.

Buffett once criticized derivatives, for which there are particularly complicated rules and often difficult to determine values, as “financial weapons of mass destruction”.  Now he likens them to insurance and counts on the contracts to juice his earnings.

From Warren Buffett’s annual letter to shareholders this past February, 2011:

Two years ago, in the 2008 Annual Report, I told you that Berkshire was a party to 251 derivatives contracts (other than those used for operations at our subsidiaries, such as MidAmerican, and the few left over at Gen Re). Today, the comparable number is 203, a figure reflecting both a few additions to our portfolio and the unwinding or expiration of some contracts.

Our continuing positions, all of which I am personally responsible for, fall largely into two categories.

We view both categories as engaging us in insurance-like activities in which we receive premiums for assuming risks that others wish to shed. Indeed, the thought processes we employ in these derivatives transactions are identical to those we use in our insurance business. You should also understand that we get paid up-front when we enter into the contracts and therefore run no counterparty risk. That’s important.

But for the benefit of you, the investor, he tries to “keep it simple, stupid.”

On Reporting and Misreporting: The Numbers That Count and Those That Don’t

Earlier in this letter, I pointed out some numbers that Charlie and I find useful in valuing Berkshire and measuring its progress.

Let’s focus here on a number we omitted, but which many in the media feature above all others: net income. Important though that number may be at most companies, it is almost always meaningless at Berkshire.

Regardless of how our businesses might be doing, Charlie and I could – quite legally – cause net income in any given period to be almost any number we would like… If we really thought net income important, we could regularly feed realized gains into it simply because we have a huge amount of unrealized gains upon which to draw. Rest assured, though, that Charlie and I have never sold a security because of the effect a sale would have on the net income we were soon to report. We both have a deep disgust for “game playing” with numbers, a practice that was rampant throughout corporate America

in the 1990s and still persists, though it occurs less frequently and less blatantly than it used to.

Operating earnings, despite having some shortcomings, are in general a reasonable guide as to how our businesses are doing. Ignore our net income figure, however. Regulations require that we report it to you. But if you find reporters focusing on it, that will speak more to their performance than ours.

Contrast that tough talk with their actions when questioned by the S.E.C. about the declining values of some of their equity investments. Warren Buffett and Berkshire Hathaway had to be dragged kicking and complaining to recognize those significant unrealized losses. They resisted taking others.

They hate to admit a loser.

Berkshire Wrote Down Stocks After SEC Query, The Wall Street Journal, March 29, 2011: Warren Buffett’s Berkshire Hathaway Inc. took an accounting charge to reflect the declines of three stocks in its portfolio after regulators asked about the company’s policy for writing down investment losses.

But Berkshire pushed back when securities regulators asked about two of its largest holdings, including its $11.1 billion stake in Wells Fargo & Co., saying it didn’t plan to write down losses on those investments… Chief Financial Officer Marc Hamburg complained…Despite Mr. Hamburg’s objection, the company recorded $938 million in impairment charges in the fourth quarter to reflect declines in shares of Swiss Reinsurance Co., U.S. Bancorp and pharmaceutical firm Sanofi-Aventis SA….

“Berkshire management,” Mr. Hamburg wrote, “does not believe that the validity of the efficient market hypothesis as suggested by the Commission can either be proven or disproven. Information made available by the issuer of a security including current results and expectations regarding the future will likely be interpreted differently by individual investors.”

Berkshire also told the SEC it wouldn’t write down its $413 million in unrealized losses in Wells Fargo or a smaller loss on its investment in Kraft Foods Inc. The two companies are among the largest holdings in Berkshire’s stock portfolio.

8. The falsifications were undetected by top management, not for brief periods of time, but for years and years. In short, the break-down was systemic.

If systemic breakdowns in accounting and financial reporting in Berkshire Hathaway companies, or via “top-side” journal entries made at headquarters, ever surface, they will have gone undetected for years. The revelations may not come until Warren Buffett no longer sets the high water mark.

After Enron, Buffett criticized “toadie” auditors and lackadaisical audit committees.

But perhaps the best place to focus attention is on the audit committee of boards of directors. Warren Buffett proposes that the audit committee have a Q&A session with auditors.

“You can’t meet on an audit committee for two hours twice a year and really know what’s going on,” says Buffett. “Auditors most of the time will know–put them on the spot.” And Buffett wants these questions and answers to go into the minutes unfailingly.

However, Berkshire’s own audit committee was seriously understaffed last year when the Sokol debacle played out and met only five times in 2010, mostly without its third member. When the audit committee launched an investigation of the Sokol scandal, they used the house law firm, Munger, Tolles rather than an independent one, even though a Munger, Tolles partner is the company’s ad-hoc General Counsel and was already being sued, along with the rest of the directors including audit committee members, over their handling of the issue.

James Treadway goes on to discuss, in his 1983 speech, the role of the auditor in finding fraud. What’s sad is that the examples he cites – auditors abdicating their duty to shareholders -are eerily similar to the ones cited recently by PCAOB Chairman Jim Doty. Doty has been emphasizing the need for more auditor skepticism. PCAOB inspectors see an appalling lack of it and the deficiencies cited in their reports are increasing rather than decreasing.

Preventing “cooked books” requires careful attention to sound accounting controls and procedures, and a corporate atmosphere and structure that emphasizes the significance of such controls and procedures — at all levels. But that lesson of attention to detail and the need for verification and sometimes tough-minded questioning seems difficult to learn.

To draw a parallel, let me quote from a few Accounting Series Releases over the last four decades.

“The time has long passed, if it ever existed, when the basis of an audit was restricted to the material appearing in the books and records …. [T]he partner in charge.., was not sufficiently concerned with the basic problems of internal check and control to make the searching review which an engagement requires.”

ASR-19, 1940. In the Matter of McKesson & Robbins, Inc.

“We have also found that in certifying such financial statements the respondents failed to comply with generally accepted auditing standards … by their reliance upon the unsupported and questionable representations of the Seaboard Management …. ”

ASR-78, 1957. In the Matter of Touche, Niven, Bailey & Smart, et al. (Seaboard Commercial Corporation.)

“A major deficiency of the Stirling Homex audit was Peat, Marwick, Mitchell & Co.’s reliance on the unsupported, undocumented representations of management.”

ASR-173, 1975. Mitchell & Co.

In the Matter of Peat, Marwick, (Stirling Homex.)

“Throughout the years, it appears that no auditor ever asked for supporting documentation for this asset account, nor did the auditors ever confirm with outside sources the existence of the balances.”

ASR-196, 1976. In the Matter of Seidman & Seidman. (Equity Funding.)

I’ll write next about Berkshire Hathaway’s relatively small spend for internal audit, external audit, and internal controls over financial reporting. (Berkshire Hathaway’s external auditor is Deloitte.) If something goes sideways at Berkshire Hathaway,there’s very little besides “culture, not rule books” to regulate behavior and insure financial reporting integrity.

Here’s an Andy Kaufman performance treat. The late comedian was famous for his put-ons. Or were they?

True, it was a hot story yesterday. Anything with Buffett is an automatic traffic attractor, since people will read it whether it’s “for him” or “against him”. It was a no-brainer to write yesterday about the news of his investment in Bank of America.  I saw the Google Alert from the Wall Street Journal when I woke up, knew it was “the” news after the Steve Jobs resignation news of the night before, and emailed my editor at Forbes that I would put my two cents in.  That was 8:30 am Chicago time.

I thought I’d finish it sooner.  It’s always good to get my posts up for Forbes before 11 am CST or else they wallow in the east coast afternoon oblivion. But I wanted to get in something about John Hempton’s post.  Since we have now spoken on the phone, shared a radio program, and shared thoughts about Chinese reverse mergers and the auditors, I saw his thoughts as a good counterpoint to what I wanted to write.  His sin was to be on Australia time, so far ahead of the crowd he wrote about Bank of America’s stock slide from earlier in the week  - and the bloggers who are blamed for precipitating it – before the news of Buffett’s investment.

I published the post slightly after 2:oopm Chicago time, which is really late for the East Coast.  And they are totally preoccupied with Hurricane Irene. But within a minute it was on the front page.

No worries.  My points on what Hempton said were still valid and he had added an update later which, by then, was very late in the day for him. Or maybe it was already Wednesday there?  I get confused with the international date line…

The story of Bank of America is now one that I have a whole series of posts about – another Kindle e-book, maybe – all the way back to their purchase of Countrywide and their initial pain in realizing that mistake.  It’s obviously still haunting them.

Here’s a small look at “Bank of America Buys Time Via Buffett Effect.”

What Hempton ignores is the accounting. There are rules about when banks are supposed to be taking losses – they are not as flexible as some would have you believe – and how much they should reserve for those losses, whether due to bad loans, wrong trades,litigation contingencies, or falling asset valuations.

To suggest otherwise is to suggest banks are fraught with earnings manipulation.

Hempton, and others like him, bet on two things when continuing to place their confidence, and their money, in the big banks:

1. That the U.S. government will never let a big bank fail.

2. That the U.S. government and the banks’ regulators and auditors will be lenient in enforcing accounting standards that force earlier and more honest recognition of the true status of the banks’ balance sheets.

There is a way to measure working capital and regulatory capital. The banks do it every day and report it to regulators. As we have seen, this daily measurement is both possible and taken seriously. The decisions regarding Lehman, Merrill Lynch, and the other banks were taken over that fateful weekend in September of 2008 because some of them reported less than a few days of capital available to meet obligations. They know what they have to pay out each day and they know, and should know, how much capital they have of various types available to meet those obligations.

It’s a moving target but you still have to hit it at least once a day…

Please go read the rest at Forbes.com.  Leave a nice comment. If I do really well, maybe they will ask me to write someday for the magazine.  ;)

It was repeated in Australia at 7pm Tuesday and is available as a podcast. There is also a transcript available.

Where does the buck stop when big banks and corporations, even nations collapse. Who signs off on the books? The auditors or the directors of the board? And who should tell investors when there’s something shifty going on? Who are the auditors answerable to? Reporter, Stan Correy.

Stan told me that I speak directly about a subject where so often other people try to obfuscate. One of the problems he had, I’m sure, and that I have every day is making news of auditing, accounting, and the business of the Big Four audit firms accessible to an audience that may think it’s boring or that nothing much happens.

Even general business professionals are sometimes confused or completely unaware of the role that Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers play in the capital markets and global financial system regulatory scheme.

Given the serious economic issues we are all dealing with, all over the world, I’m glad to see journalists like Stan Correy push the story of the audit firms and the accounting industry off the business pages and onto the front page.

Updated: I listened to the show live and had goosebumps. It’s a great summary of the state of the audit industry and, therefore, the accounting profession.

I was quoted generously based on Stan’s extensive interview with me. I was also pleased to hear so many other distinguished commenters including several university professors, John Carney from CNBC, and Richard Murphy in the UK.

Stan gives me the last word, in response to investor John Hempton who recently defended the audit firms, in particular Deloitte, for the Chinese reverse merger frauds.

John Hempton: What auditors do and what they’re expected to do is follow process. And there’s a perfectly good reason why you follow process; if you follow process in a world where most things are honest, the process works, and auditors get into trouble when they don’t follow process. The problem is that the process doesn’t work in China, ‘cos this is so pervasive that there’s no fixed point of reference.

Stan Correy: John Hempton from Bronte Capital.

Columnist for Forbes Magazine and herself an auditor, Francine McKenna, doesn’t buy the partial defence argument. She says auditors who take on these jobs should be looking at these clients as extremely high risk. After all, it hasn’t been a secret, even in China, that fraud is a problem in government and the private sector.

Francine McKenna: The audit firms are so… it’s so embarrassing to the profession for me, their most common response when they get hit with a fraud-I mean, I could show you several examples, quotes-they’ll say, ‘We were victims too. We were fooled; we were duped.’ What other profession is willing to say that they’re idiots and incompetent and can be fooled over and over and over again by their own clients, just for the sake of evading liability? It’s embarrassing! It’s embarrassing.