But Wait! Shocking Deficiencies In Internal Controls Are Set To Fuel Even More, We Guarantee
Over the past three months your editor-in-chief has had three assignments as an expert witness/expert consultant - all involving big stock market losses - and all with the same M-O: A shocking number of the “agents” - and two big and famous fiduciaries hired by the client diddled and delayed, went down blind alleys and in two cases, key people took vacations and “attended meetings” while failing to attend to the pressing business at hand. Meanwhile, the prices of the three stocks in question were sinking fast. Two of the three cases involved losses in the $50 million dollar range.
If there’s one big lesson we’ve learned as business managers, expert witnesses and as journalists over many years it’s this: When you see the same sort of thing happen three times in three months or less, you’re looking at a major trend. And this is a very scary one indeed.
Among the major players here were the ‘big client division’ of one of the country’s biggest brokerage firms, acting as custodian for the portfolio of a large private investor, the Trust Division of a top-tier firm, acting for a Fortune-100 company Trust, and two of the top-four transfer agents, which, while not largely responsible for the losses, could and should have been a lot more help than they were, but where there was confusion, and lack of coordination on every front. The transaction that resulted in the largest loss took 45 days to conclude something that could and should have been done in five business days!
While the specific circumstances varied from case to case, the root causes of the big losses appeared to be precisely the same: What we initially ascribed to “Covid-era dislocations.”
In every case, we knew that there were “experts” around - somewhere - who could have set misguided workers straight in a flash. But they were not only not “around” - in every case the names and phone numbers of the “real experts” were not even known to the hapless clerks that were supposedly “on the case.”
And in every case, the hapless clerks - and the few colleagues they knew well enough to reach out to – which in one case included the officer who was officially in charge of the business unit - lacked what any expert would consider to be “basic knowledge” about what to do - and how to do it - and when it needed to be done in order to be compliant with industry standards.
But as we wrote this article, we suddenly realized that there are much bigger and much more serious issues afoot than mere ‘Covid-dislocations’ – and they were being illustrated almost every day in the newspapers:
For starters, who could ever imagine that the Trust Division of Citigroup would ever pay out the entire $900 million dollars of principal on a bond issue where they served as Trustee and Paying Agent - instead of the semi-annual interest?
To make it worse, the issuer of the bonds - a “household name” - was, as widely reported in the newspapers, teetering on the edge of bankruptcy. Normally, this news alone would trigger a higher-than-usual increase in attention – and in due diligence – within any Trust Division- especially when it came to paying out $900 million in cash.
Most shocking of all to your editors – both Trust Division veterans – Citi had no money in hand from the issuer. They ‘accidentally’ paid out $900 million of Citi’s own money!
The story gets even worse: Citi got back most of the money from bondholders who were ‘unjustly enriched’ by the mistake. But, under an unusual provision in NY law that allows actual creditors to retain any money remitted in error, $250 million has not been - and may never be returned.
Then – and perhaps the most horrifying development of all where Citi’s stock price is concerned – a 9/15 WSJ article reported that “Federal Reserve officials have repeatedly grilled Chief Executive Jane Fraser about the bank’s plans to fix its risk management system, demanding to see more progress,” adding that “In a meeting this summer, officials from the Office of the Comptroller of the Currency warned the bank’s board that there could be consequences for not getting a handle on the situation.”We are big fans of Jane Fraser, having written up her “star turn” in her first annual meeting as CEO and for her determination to ‘right the bank’ in our 2nd quarter 2021 issue. Over the past two years the bank has added 30,000 new employees to work on the internal control environment – but Fraser warned it would take several years and cost billions of dollars. We are rooting hard for her.
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Then came yet another mega-blooper – at Barclays: On Sept. 30, the SEC announced a $361 million settlement with them for an “unprecedented over-issuance of securities” – something that Corp Counsel bloggers Liz Dunshee and John Jenkins described as “every security lawyer’s nightmare” but which we would describe as revealing essentially the very same problems we saw at Citi - an unprecedented and staggeringly costly series of failures in the bank’s system of internal controls.
The SEC order states that, “following a settled Commission action against a BBPLC affiliate in May 2017, BBPLC lost its status as a well-known seasoned issuer (WKSI).
As a result, BBP had to quantify the total number of securities that it anticipated offering and selling and pay registration fees for those offerings upon the filing of a new registration statement.”
The SEC’s order notes that, “given this requirement, BBPLC personnel understood that the firm needed to track actual offers and sales of securities against the amount of registered offers and sales on a real-time basis; yet, no internal control was established for this purpose.
According to the SEC’s order, “as a result of this failure, BBPLC offered and sold approximately $17.7 billion of securities in unregistered transactions.” The order notes that Barclays established a multi-person working group when it lost WKSI status that “talked about calculating the total amount of securities that the business expected to offer and sell, in order to pay registration fees in advance. They also talked about the need to track actual offers and sales. But they didn’t create any process or assign responsibility for that task.”
The bottom line for Barclays? They had to buy back the securities they’d issued under the non-, existing shelf – at what they estimated to be a $600 million loss. Then, Barclays paid out another $200 million in civil penalties, plus disgorgement and prejudgment interest.
The biggest shockers here? First, there are literally dozens of inexpensive, off-the-shelf systems and programs to let companies manage their “cap tables” that Barclay’s staffers could and should have used to prevent the big snafus. But also – where were the bond Trustees? Did they use any? Were there reviews by outside lawyers - with official “closings” – and with the customary opinions of counsel that the bonds were duly authorized for issuance? A total breakdown, we’d say, of normal Trust Division systems of internal controls.
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Also in September, the SEC – and the Commodities Futures Trading Commission - imposed a whopping $1.8 billion in fines and penalties on 16 major financial institutions – like Bank of America, Barclays, Citigroup, Morgan Stanley and others for allowing key employees to communicate on unsecure devices – using text messages and apps like WhatsApp – and for failing to maintain and preserve appropriate records of such dealings.
The big WSJ article on the fines noted that JP Morgan Chase had been fined $200 million for similar violations this summer, when the SEC warned hat similar violations could have a serious impact on investigations going forward. The article also noted that before the JPMC case, the highest fine for failing to produce emails during investigations of IPOs was “just $15 million against Morgan Stanley, in 2006.”
Our advice to all our readers: Prepare to see more lawsuits – and for more big enforcement actions like these – with bigger-than-ever fines and penalties than ever before to come out of the woodwork over the next year or two.
To our valued friends in the service-supplier community: Please, we say…urgently review, rethink, revise and update your employee recruitment, orientation, training, mentoring and supervision programs. While it is easy to blame day to day snafus on work-from-home programs - and lately on undetected ‘slackers’ – employers have to do a lot more homework of their own in this post-Covid era: Many employees have never been on-premises at all - much less have had the benefit of a tour of the workplace, an overview of the business as a whole, the various ‘departments’ and how they relate to one another, the chain-of-command - or even a proper introduction to co-workers and their places on the team.
Employees at every level seem to need a thorough review of corporate and industry-wide performance standards, and the serious consequences of failure to adhere to them.
Most important of all: It seems crystal clear that financial industry firms sorely need a top-to-bottom review, rethinking and re-writing of their internal control systems – and to do it ASAP.
Back in 1970, when “RICO” - the Racketeer Influenced and Corrupt Organizations Act was passed – aiming not just at organized crime but at white-collar crime in general - your editor-in-chief was charged with reviewing, revising, editing - and sometimes writing from scratch – all of the written descriptions of every area of the Corporate Trust and Agency Division of the old Manny Hanny, where detailed descriptions of all the Internal Controls over Systems and Procedures that were in effect were required by the new law for ALL financial institutions. We say that every one of them should be undertaking a similar program of action TODAY.
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