In 2000 I was working on a transaction in South Korea when I was charged with analyzing the target company's income statement and balance sheet. I was concerned about the differences in their accounting methodology versus U.S. GAAP and whether its balance sheet had been marked-to-market. My counterparties at the target company laughed out loud at how even U.S. accounting standards were by no means "best in class." U.S. investors were reeling from losses incurred in the stocks of Enron and WorldCom who had misrepresented their financial statements. Enron had taken liberties with accounting statutes to put billions of expenses and liabilities into offshore entities and exclude them from its financial statements. WorldCom was accused of inflating revenues and understating expenses in order to keep its stock price afloat. Auditors determined that WorldCom had defrauded investors by nearly $4 billion.
As a result of accounting fraud at several public-traded companies, congress passed the Sarbanes-Oxley Act of 2002 ("SOX"), requiring management to personally certify to the accuracy of a company's financial statements. According to a new book, "Shock Exchange: How Inner-City Kids From Brooklyn Predicted the Great Recession and the Pain Ahead":
The Sarbanes Oxley Act of 2002 was enacted after corporate scandals surfaced at Enron, WorldCom, Tyco and Adelphia Cable in the early 2000s. Sarbanes requires corporate officers to attest to the accuracy of their companies' financial statements. However, there is evidence that executives hid their companies' true financial conditions during the crisis. Lehman filed for bankruptcy on September 15, 2008, mere weeks after issuing its quarterly financial statements. Those statements never mentioned that Lehman's inability to operate as a going concern risk was an imminent risk. In fact, it issued rose financial statements in order to assuage investors ... Not coincidentally, corporate America has tried to do away with Sarbanes, arguing that its costs far outweigh its benefits.
It is interesting how Sarbanes was spawned from the corporate crimes during the early 2000s, yet it was not applied during the financial crisis of 2008. That said, lawmakers may finally get their chance to apply Sarbanes with the recent Whale loss sustained by JPMorgan Chase (JPM) and the company's actions to conceal them. The trades were pursuant to the $6.2 billion loss orchestrated by the famed "London Whale." The article, "J.P. Morgan: From Predator To Wall Street Prey" explained how the Whale loss occurred:
In early May JPMorgan Chase reported $2 billion in trading losses on bets gone awry in the bank's Chief Investment Office. The losses were odd given that [i] the Wall Street Journal had reported a month earlier that a JP Morgan trader nicknamed the "London Whale" had made large bets in the debt markets and [ii] during the financial crisis, JP Morgan avoided the missteps of Goldman Sachs ("Goldman (GS)"), Morgan Stanley (MS), and AIG (AIG) from bets on real estate, mortgage-backed securities and credit default swaps. The Whale made bets on a continued economic recovery with complex trades that moved in relation to the value of corporate bonds ... Other casualties of the trading loss were Ina Drew, JP Morgan's Chief Investment Officer, who retired less than a week after the loss was revealed and Irvin Goldman, who was stripped of his duties as oversight of risk in the Chief Investment Office.
A few weeks ago, Douglas Braunstein, JPMorgan's former CFO and Ina Drew, the company's former CIO, testified before the Senate Permanent Subcommittee on Investigations Hearing on JPMorgan Chase Whale Trades. Drew blamed the losses on undue risk-taking by traders in the firm's London office, while the government pointed to a general culture of wild risk taking at the company. However, in attempting to conceal the losses from regulators and shareholders, JPMorgan may have breached Sarbanes in the following ways:
Ina Drew's Office Overstated The Value of The Synthetic Swaps
According to the Subcommittee, Ina Drew oversaw a separate unit of the bank to invest its excess deposits. From 2008 to 2011 the group amassed a portfolio of synthetic credit derivatives whose notional size grew from $4 billion to $51 billion. In the first quarter of 2012, JPMorgan grew the net notional amount threefold from $51 billion to $157 billion; furthermore, Drew grew the portfolio with little or no regulatory oversight. Once pending losses from the trades began to materialize and the media exposed them, JPMorgan represented to regulators and shareholders that the portfolio was designed to hedge credit risk. However, management was unable to identify the assets being hedged or the effectiveness of the hedges. Ina Drew's office then concealed the whale losses in 2012 by overstating the value of the credit default swaps. Those values were disputed by both internal bank reviews and counterparties. In fact, one JPMorgan own trader was overheard on recorded phone conversations calling the valuation of the swaps "idiotic."
JPMorgan Changed The Metric For Valuing The Swaps Portfolio
JPMorgan's valuation metric for the credit default swaps had been the midpoint of the daily average "bids" and "asks" in the marketplace. By late January 2012, the company changed its valuation methodology; it started using "prices at the extreme edges of the daily price range" to hide escalating losses. By using the daily price range, the CIO was able to report smaller losses on its internal profit and loss reports filed internally at the bank.
JPMorgan Kept Two Sets of Books
The company began maintaining two sets of books and records for the swaps - one set which valued the swaps based on the midpoint of daily average bids and asks (original method), and another based on extreme edges of the daily price range (new method). At one point, the difference in the hidden losses under the two methods exceeded $600 million. According to the Subcommittee, On March 23, JPMorgan traders estimated in an email that the swaps portfolio had lost about $600 million using midpoint prices and $300 million using the new method. Furthermore, the CIO's Valuation Control Group ("VCG") noted that, by March 31, 2012, the difference in the CIO's P&L figures between using midpoint prices versus the more favorable prices totaled $512 million.
JPMorgan Re-stated Earnings
When JPMorgan announced $2 billion in losses on the Whale trade, counterparties were disputing the valuation of its swaps. In July, the company re-stated its first quarter earnings after an internal investigation revealed that even its own traders thought the valuation of its credit default swap portfolio was mismarked. Management told the public that it re-stated earnings because it was no longer confident that traders had fairly valued the positions in the swaps portfolio. Actually, the mismarked values were due to management's decision to change the valuation of the portfolio from the original method to the new method. Not only was management complicit in mismarking the values, management orchestrated it. That said, Ina Drew told the Subcommittee that she did not become aware of a separate set of books until July 2012, until after she had left JPMorgan. She also represented that she had never seen that type of "shadow P&L document."
According to New York Times Dealbook, there is a high bar for any criminal case and it will be difficult to prosecute any individuals in the Whale saga. In attempting to conceal the Whale losses, JPMorgan's actions could be deemed to be similar to those of Enron or WorldCom. At a minimum, when they attested to the accuracy of the company's first quarter financial statements, corporate officers may have fun afoul of Sarbanes.
JPMorgan generated net revenue of $102.7 billion, $97.2 billion, and $97.0 billion for 2010, 2011, and 2012, respectively. Meanwhile, its income before taxes before taxes increased from $24.9 billion in 2010 to $26.7 billion and $28.9 billion in 2011 and 2012, respectively. There is no certainty that the Subcommittee hearings will have a financial impact on the company, yet I would avoid the stock simply due to the headline/reputational risk in the near term.