Red faces in the aftermath of Facebook fallacies

Financial Review

PUBLISHED: 26 May 2012 

Anna Bernasek 

Facebook’s 19 per cent share price decline in its first two days of trading as a public company came as a shocker. Disappointed investors issued recriminations, while rivals and analysts offered criticism aplenty. One regulator after another wants to examine the IPO, while the professionally aggrieved have predictably filed lawsuits against the company and its underwriters.

But since when is an IPO a guarantee of a stock price gain? Wasn’t the whole point of a public share listing to allow the market to set its price?

For Facebook, the market has spoken. At least for now the value of Facebook seems to be closer to $32 a share than the initial offer price of $38.

There’s an art to pricing an IPO, particularly for a speculative technology play lacking a steady track record of fundamentals. In Facebook’s case, it looks like the lead underwriter, Morgan Stanley, missed the mark.

Set too low a price and the company feels cheated. Reach too high and investors feel duped. The sweet spot would have been about 10 per cent below the first day’s close, affording a tidy but not outlandish initial gain.

There was little sign of weakness leading up to the IPO. The hype was exceptional, including blanket media coverage. n the US, only a person deeply uninterested in business could have been unaware of the historic nature of the offering.

The first inkling of concern came when final share allotments were announced. The way the game is played, underwriters try to drum up investor demand well in excess of supply. In return investors submit requests for more shares than they actually want, expecting to be cut back to something close to the right amount.

So when investors learnt that their allotments weren’t cut back, they instantly knew two things: they were holding more shares than they wanted and buyers would be few and far between.The result was a classic rush for the exit, driving down prices.

Morgan Stanley has to shoulder the lion’s share of responsibility. It took a very big fee for its service, reportedly in the $100 million range. With the IPO coming off so poorly, that fee looks more than a tad rich in hindsight.

Of course it didn’t help that the Nasdaq exchange had problems – still essentially unexplained – that resulted in potentially devastating delays in confirming early trades.

Funny that the Nasdaq system couldn’t handle what seems to be a routine, albeit large listing. It may have been a simple glitch but with such a prominent internet company, one has to wonder whether there was something akin to hacking going on.

Less obvious but potentially more important is the role Facebook itself played in the pricing. It had enjoyed remarkable growth and had confidence to match.

Facebook worked on its IPO for the last year, reportedly preparing the principal offer document even before selecting its bankers.

When the company conducted a beauty contest to select underwriters, it’s pretty clear who was in the driver’s seat. Although a fee in the $100 million range sounds like a nice payday for Morgan Stanley, that was actually a big cutback from the fee that a more ordinary company would have paid.

A typical IPO commission in the US is close to 7 per cent, which on a $16 billion deal would have meant over $1 billion to divide among Morgan Stanley and its peers. The message to the bankers was clear: they were lucky to be selected.

With Facebook in such a strong position, the company had a lot of influence over pricing. Even if Morgan Stanley had some concerns about the $38 price, it would have been extraordinarily hard to say, “Cut the price or the deal’s off,” and risk losing a $100 million fee.

Whether you blame Facebook for increasing the size of the stock offering at the last moment or Morgan Stanley for misreading demand or not standing up to its client, they both put their names behind a $38 price tag. That was the very top of the proposed range, showing just how confident they were right up to the last moment.

Unfortunately there’s no do-over for an IPO. No matter what’s going on in the business, a disappointing IPO story takes on a momentum of its own.

For the time being losing investor money is part of Facebook’s image. Regaining credibility may be even more difficult because the company has been relying on its potential, not its history. Facebook simply doesn’t have a track record to justify its valuation. Changing the market’s momentum will take time and sustained, incremental success. So the company faces more pressure than ever to hit its ambitious quarterly marks.

The most intriguing thing about Facebook’s debut is not what it says about Facebook but what it says about the sharemarket more broadly. Facebook traded down not on bad news but on lack of demand. The seemingly unlimited potential of internet technology to create wealth has its sceptics.

Waiting for the other shoe to drop

Financial Review

PUBLISHED: May 19, 2012

Anna Bernasek 

Judging by the reaction to JPMorgan Chase’s $US2 billion trading loss, you’d think America’s leading bank had just gone bust.

Prominent politicians, policymakers and commentators have piled in on Jamie Dimon, the bank’s chief executive, with lots of finger wagging and “I told you so”. Ina Drew, a top executive with a seemingly spotless 30-year trading history has abruptly resigned. And everybody is investigating the bank: the Securities and Exchange Commission, the Department of Justice, even the FBI.

Suddenly, the mighty bank that could do no wrong finds itself under the microscope as shareholders, officials and the public want answers.

Meanwhile Dimon, the erstwhile king of Wall Street, is taking it on the chin. “Anyone in business knows you always make mistakes,” he said on Meet the Press. “And so this is a terrible mistake, I’m not making excuses for that, but I know we’re going to make mistakes. When you’re in this kind of job, you hope they are small and few and far between. This one was far too big.”

It all seems a bit puzzling. Why would a $US2 billion markdown of a trading position – apparently a purely notional loss at this point – provoke so much hand-wringing for a bank with assets a thousand times greater, an incredible $2.3 trillion? That’s a 10th of a per cent for goodness sake.

The unit at the centre of the controversy, known as the Chief Investment Office, alone oversaw $356 billion of securities. A $2 billion loss on a portfolio that size amounts to a mere half a per cent.

So why is Dimon, not known as a shrinking violet, letting himself get pushed around?

The answer, it seems, is that this isn’t about the gross numbers. What’s going on both inside and outside the bank has a lot more to do with what the loss signals than the relative size of the loss.

While the $2 billion trading loss is tiny in comparison with the bank’s total assets, it’s more material in relation to its profits. Last year, JPMorgan earned $19 billion in net income so $2 billion is in the order of a 10 per cent hit.

And the position isn’t closed, so the loss could change in size. Depending on how the trade plays out, it’s thought that JPMorgan could lose as much as $4 billion.

Then there’s the fact that this department within the bank was never supposed to lose money. It was billed as a hedging unit created solely to manage the bank’s exposure to complicated transactions.

The whole philosophy behind the Chief Investment Office was to protect the bank against trades that were volatile or extremely risky. So there’s a sense of false advertising or deception that a unit that was supposed to protect the bank actually went out on a limb and hurt it.

Troublingly, the incident shows that the very people in charge of keeping the bank safe couldn’t resist the temptation to gamble.

It’s hard to tell whether the type of trade at issue was proper or flawed from the outset. But it looks certain that the size of the bet got out of hand. Years ago traders used to say: “Pigs get fat, but hogs get slaughtered.”

What happened to internal risk controls? Just as things started to look shaky, executives in the trading unit changed the rules internally on risk reporting. We’ll have to wait to find out if that was a coincidence, or something less innocent.

Perhaps the worst part of all this for Dimon is that it shows management had no handle on the situation. At first he called it a tempest in a teapot. By the time Dimon realised there was a real problem it was too late to do anything about it. One has to wonder what else he doesn’t know about the bank’s machinations.

The biggest problem for JPMorgan Chase may be yet to come. With regulators now scrutinising the bank, officials may find that rules were broken. In particular, investigators want to know whether the bank reported risk appropriately and disclosed that to the public. The issues aren’t always black and white, but that can cut both ways. Especially when public opinion is against you.

Dimon himself hasn’t ruled out bigger problems. Asked whether the bank broke any laws he said: “We had audit, legal, risk, compliance, some of our best people looked into all that. We know we were sloppy. We know we were stupid. We know that there was bad judgment. We don’t know if any of that is true yet. Of course, regulators should look at something like this. It’s their job. We are totally open kimono with regulators. And they will come to their own conclusion and we intend to fix it, learn from it and be a better company when it’s done.”

There may be another shoe to drop before this is all over.

Integrity comes before loyalty

Financial Review

PUBLISHED: 12 May 2012

Anna Bernasek 

America’s legendary cowboy humourist Will Rogers discerned three types of people.

For every one person who learns by reading, a few more learn by observation. The rest, a vast majority, have to pee on the electric fence to find out for themselves.

If Rogers were alive today he’d have some pert things to say about our latest wave of corporate scandals. There seems to be a never-ending supply of companies that engage in lawbreaking and then try to cover it up. Judging from past experience, that rarely ends well and someone always gets hurt.

Three otherwise impressive global companies are currently being investigated for wrongdoing and corporate cover-ups.

News Corporation hacked phones in Britain. Walmart bribed officials in Mexico, and Google purloined private data from millions of unsuspecting Americans.

In each case the companies involved were quick to blame rogue individuals or put it down to isolated cases. Further digging eventually indicated that wasn’t quite true; that the blame was more widespread. Yet rather than come clean, the companies have dragged their feet, hoping the stories will just go away.

The trouble is, any big company relies on the trust of lots of people to function. When that trust is undermined by a scandal, rebuilding trust should be the top priority, but again and again we see executives at a variety of levels avoiding the steps needed to put things right.

The ultimate responsibility for regaining widespread trust lies uniquely with the chief executive. When that doesn’t happen, it raises an issue of fundamental competence. Whether or not you believe that Rupert Murdoch, the head of News Corporation, is a fit person, it’s clear that he’s lost the trust of the British government.

In Google’s case the engineer at the centre of the personal data theft has pleaded the fifth amendment – his right to refuse to answer any questions. The fifth amendment applies, of course, only when there is a concern about a criminal conviction. According to official reports, others at Google were involved. So management’s initial hasty response isn’t looking too persuasive.

In News Corporation’s case, the board was quick – perhaps too quick – to express its confidence in Murdoch.

The Walmart and Google boards don’t seem overly concerned, either. That’s because the boards are pretty well insulated from responsibility. The worst that can happen to directors, generally, is to quietly retire from the board.

Not so for employees down the chain. There have already been arrests of News Corporation employees and there could be more. So some lessons to learn from corporate scandals apply to junior employees and mid-level executives; anyone, in fact, below the board of directors level.

Finding yourself looking at a nascent corporate scandal in the workplace can be pretty daunting. But bad things happen at companies, even really good ones, every day.

If you suspect illegal activity at your company or are asked to do something that feels wrong, how should you handle it?

The textbook response is to never do anything that you wouldn’t want to be publicised. But life is more complicated than that. It’s no simple thing to accuse your company of impropriety. Quitting or going to the authorities are not easy choices, either. In the current lousy job market one has to think twice before making waves on the job.

So in the spirit of making the best of a bad situation, here are a few ideas for junior executives to navigate their way around their next corporate crisis.

First and foremost, investigate the options. There’s usually a legal way to accomplish almost any legitimate goal. Breaking the law isn’t too bright when there are so many good alternatives. There’s never only one way to proceed.

Be sure to seek advice. Judgments about legal propriety can involve subtleties. Most companies have resources, in the legal department and elsewhere, that will be happy to assist in thinking through a smart course of action.

Ask questions. A really good one is: “Why are we doing this?” It’s not accusatory, but it’s not complicit either.

And never – never – get your own hands dirty. If something doesn’t smell right to you, either challenge it or work out how to gracefully step away.

Once you take part, even in a small way, there’s no saving you. As we’ve seen in previous scandals, the board of directors will simply wash its hands while employees, often after simply trying to please their bosses, take the fall.

In life there are some things money can’t buy. Your integrity is one of them. So manage your reputation like the valuable asset it is.

If the culture at your company is dishonest, eventually you’ll have to make a change. Sticking with it is a recipe for disaster.

Don’t pee on the electric fence!

Walmart case trashes US brand

Financial Review 

PUBLISHED: 05 May 2012

 Anna Bernasek

Every once in a while a business scandal takes your breath away. The discount retailer Walmart, the largest corporate employer in the world, is reported to have systematically paid bribes to Mexican officials to facilitate its rapid expansion.

By American standards that’s pretty shocking. Since 1977 it’s been illegal for US companies to bribe foreign government officials, and virtually every significant US company has a compliance program designed to stop that happening. For most, compliance with the Foreign Corrupt Practices Act (FCPA) is practically a given.

But apparently not at Walmart. If the reports are true, there was an organised approach to bribing Mexican officials in connection with Walmart’s dramatic expansion there. It seems that company records establish the amounts, times and other details. Which in itself is bad enough.

But it gets worse. Reports said the matter was referred to the highest levels of Walmart where a full investigation was shut down in favour of a quick whitewash.

The details of Walmart’s bribery scandal were revealed in The New York Times late last month and the company is now under federal investigation. Whether or not the government will prosecute Walmart remains to be seen, but the case turns a spotlight on the law and its significance.

There’s always been a temptation for aggressive companies to bribe governments in countries where the rule of law is not robust, because that approach is cheap and effective in the short term. While the ultimate benefits of cutting down on corruption are likely to be widespread, the near-term costs of doing the right thing tend to fall on specific companies and individuals. If not paying a bribe means losing a deal, that creates a lot of pressure.

Yet for years corruption has been one of the biggest obstacles to economic development in places like Africa, Asia and South America. That doesn’t just hurt the developing world. It also hurts companies and countries in the developed world that trade with corrupt regimes, in effect putting a drag on the global economy.

So when the FCPA was introduced during Jimmy Carter’s presidency it was a breakthrough.

The FCPA certainly wasn’t in the short-term interest of American companies back then and there was considerable opposition to the law from the corporate sector. Companies said they would not be able to compete with other nations such as Japan, Germany and France which didn’t face the same restrictions against bribery.

Legislators took a long view. They believed that American leadership on an important integrity issue would eventually become the global standard.

And they were right. When the OECD countries adopted the convention on combating bribery of foreign officials in 1997, they were finally coming up to the standard set by the US. Australia passed its own anti-corruption law modelled on the FCPA in 1999.

The FCPA was a down payment leading to investments in integrity around the world. At the time, the US was truly a global leader and had the confidence to take justified actions even if there was a short-term domestic cost. And after all, isn’t that what integrity is all about?

It’s hard to imagine that Congress would pass the FCPA today. With concerns about the economy, debt and taxation running high, taking a far-sighted approach to global leadership is not on the agenda.

Once the laws are in place, though, it all comes down to enforcement. In recent years, the US has stepped up its policing of the FCPA. In 2004, there were two cases of criminal enforcement. By 2010, there were 48. Currently, there are perhaps 100 cases open.

Which brings us back to Walmart, a huge, successful and influential company in the US. It occupies a position of prestige. As a company slogan says, its policy is to “get the right results, the right way”.
But befitting its famously hard-nosed style, Walmart has its share of detractors. In recent years, it has come under attack for its treatment of employees, fierce opposition to unions and impact on the environment.

So reports of systematic bribery in Mexico, apparently conceived by top management and condoned by the chief executive, look positively radioactive.

That’s because under US law an FCPA violation is a crime, plain and simple. That’s not to say that corruption never happens in other ways, but it generally isn’t so black and white. By the time your lawyers tell you that you have a problem, as they are reported to have done at Walmart, it’s too late to just close your eyes.

Walmart faces a pretty big challenge. Even if the government decides not to prosecute it under the FCPA, a Securities and Exchange Commission enforcement looks likely based on record-keeping and reporting violations. It seems as if Walmart won’t escape without significant consequences.