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Systemic Risks

Summary: 

Systemic risks are those that can bankrupt the funding agency+. Their causes are often perfectly unpredictable (i.e., perfect storms). We can't foresee all these risks, so we set up the agency so it can better weather the storm when they arrive.

Illustrative Corporate Systemic Failures

WorldCom Fraud Centered on Connection Costs

The accounting fraud at WorldCom resulted from a decision by its chief financial officer to categorize as long-term investments money paid to local phone companies to complete calls. At the beginning of 2001 the $3.8 billion scandal came to light. WorldCom shook financial markets by announcing it would restate five quarters of past earnings to reclassify these monies instead as routine costs.

Yet another corporate scandal – employee stock option backdating

Since the start of the year (2006), more than 100 companies have undergone federal investigations into stock option backdating, a way of boosting the value of options grants used as compensation by issuing them retroactively on days when company stocks were trading low, the Securities and Exchange Commission says.

Jenkens & Gilchrist Attorneys, Former BDO Seidman CEO and Deutsche Bank Broker Found Guilty in New York of Multi-Billion Dollar Criminal Tax Fraud Scheme

The case involved making up hundreds of millions of dollars in losses for clients to avoid paying taxes.

Prosecutors: Sentence Ghilarducci to 41 months in prison

Ghilarducci admitted to having inflated the value of Humboldt creamery's accounts receivable and inventory in financial statements prepared for creamery's lender, CoBank, between 2005 and 2008. The creamery had a line of credit from CoBank of about $50 million tied to accounts receivables and inventories. ”The greater these numbers, the greater the line of credit,” When the deceit was uncovered, the 80-year-old, cooperatively-owned creamery went bankrupt.

A fraudulent scheme led by managers of Nortel to manipulate Nortel’s accounting

…Nortel Networks’ reversals of its excess accruals provide a vivid example. Management booked excessive non-recurring and extraordinary charges, to put future earnings in the bank (i.e., putting profits away for a rainy day). Furthermore, these future earnings were buried in operations, making it difficult for investors to diagnose the reasons for subsequent earnings increases.

The Parmalat Scandal

Parmalat SpA, an Italian dairy and food company, declared bankruptcy in late 2003 primarily due to an accounting scandal worth 8 billion euro. Among the questionable accounting practices used by Parmalat: it sold itself credit-linked notes, in effect placing a bet on its own credit worthiness in order to conjure up assets out of thin air.

Introduction

Systemic risks can bankrupt a company despite the robustness of its underlying operations. No one or two safeguards fail in isolation, rather a series of safeguards fail in sequence, leading to a collapse that would have been near impossible to predict (at least without the benefit of the retrospectoscope+). Systemic failures are often beyond the ken of any one or few individuals. Afterward, many are left wondering and debating how they could have happened.

These risks come from mismanagement, fraud, misrepresentation, negligence or breach of fiduciary duties. They can be sins of omission or commission, for example management not exercising sufficient oversight of individuals within their organization. They often involve disputes with host country regulatory authorities or contract breaches with third parties.

We do not prohibit the use of sophisticated financial or contractual instruments in our funding agency+. We use Derivative Investment Vehicles+; the very type of investment security at the center of the 2008 global financial collapse. Securitized mortgages derived their value from underlying mortgages. Our perpetual fund+ ‘derives’ its value from underlying assets+. Investors have no ownership in the assets whose valuations roll up into the perpetual fund share price. We also frequently ‘bring forward’ future (uncertain) cash to fund today’s investment operations, and this ‘act’ employs many sophisticated financial innovations. Sophisticated financial instruments and risk management lie at the heart of our finances.

We don’t settle for quantitative measures of safety when assessing systemic risks. For example, we don’t rely on arbitrary percentages or statistical measures of safety. Instead we rely on expert analysis and review of structural protections+ for these risks. For example, we routinely stress test the robustness of our credit lines – especially in times of economic distress. Can we thrive despite the collapse of a credit partner(s)? We may deliberately attempt a subversion of systemic protections via the ballot box, to stress-test investor levels of attention to our protections. Ours are qualitative measures, real time tests of the robustness of our protections.

Auditors and regulators at times catch systemic risks only after it’s too late. As seen in the above summary of corporate bankruptcies, most of which were covered by the best-of-the-best in the audit professions, sophisticated financial instruments (e.g., credit-linked notes) often are poorly understood. Their risks go unchallenged by members of these professions. Our funding agency is unique, and only those intimately familiar with its operations can truly evaluate its overall credit-worthiness. Auditors and regulators, at least off-the-shelf, will never gain an appreciation for our approach, and will default to restrictive one-size-fits-all+ practices from their often limited repertoire.

Generally Accepted Accounting Principles (GAAP) and the Financial Accounting Standards Board (FASB+) pronouncements provide no protections. Entrepreneurs (including our agency managers under the advice of legal and CPA experts) scour these pronouncements to uncover loopholes allowing them to do what they want to do anyway. GAAP and FASB are put in place to keep out the other guy. We alone will find ways to manipulate these rules so as to achieve our desired results. We fund Phase 1 industries+, those who make their own rules. By extension, our funding agency too will make its own financial rules, leveraging the creativity and entrepreneurial talent of its leaders.

Structural Protections

We recognize perception is reality, and conspicuous consumption by agency or Investible Unit managers undermines faith placed in us by investors. After all, for the most part we are spending their money. Funding of unpredictable R&D+ is highly dependent on the trust of our investors. Lose their trust and they’ll rush for the exits, collapsing the entire enterprise. As a consequence we are justified instituting highly invasive monitoring of managers who potentially can damage these perceptions. We care, as a funding agency, when a manager takes a trophy bride.

We put in place many structural protections to control systemic risks, some of which are listed here:

  • We mandate reinvestment of winnings by agency and Investible Unit managers until it can be shown they did not mortgage the future+ of the agency in the creation of these winnings. Reinvested winnings are at risk.
  • We have an independent judiciary, charged with protecting the long-term financial health and wealth of the funding agency. Every major decision of the judiciary is stress-tested against keeping protections against systemic risks intact.
  • We practice one person, one vote+, no proxies. No one or few individuals can always have their way. Our investors are educated and participatory. They can and will cast informed votes on matters of systemic risk.
  • We leverage competing interest groups, and ensure these groups have at their disposal the information and means needed to protect their own self-interest. To the extent possible we leverage interest groups as our watch guards for systemic risks.
  • We build financial firewalls between different series of the perpetual fund. Catastrophic failure in one fund does not spread into another.
  • We employ a third party hazard insurance company, focused on prevention of systemic risks. The insurance agent would be expected to design and execute many of the structural stress tests on our protections, as illustrated above.

We are a private fund. We make up our own rules (to the extent allowed by host governments). We also make up our own protections and are not overly beholden to one-size-fits-all protections often proffered by elites in host governments and professional societies.

The design of the funding agency (as of 09/11) was heavily influenced by the lessons of 2008. Management can screw up. We put in place measures to minimize these failures, but we always seek to preserve management’s freedom of action in the operations of the funding agency (or Investible Units+). We acknowledge the temptations generated by the enormous amounts of cash flowing through our funding agency. We also acknowledge rules often ensure we will be less effective at work – they limit thinking and provide excuses for stale thinking. We rely on structural protections such as those listed above, ones built into the fabric of our organizational model. We minimize rules and regulations as a remedy for these failures to the extent possible.


Editor's Picks for September, 2011

Further Reading
Reba Tull
Offline
Joined: 03/30/2011
Too expensive

Sounds quite expensive. Are you sure there will be money left over for profit distribution after you’ve paid all this protection money?