Market manipulation by a whistleblower or endemic malpractice by GE?
General Electric of the USA has recently been shaken by an in-depth forensic report by Certified Fraud Examiner, Harry Markopolos. This report, titled General Electric, a Bigger Fraud than Enron, and sub-titled GE’s £38 Billion in Accounting Fraud, accuses GE of hiding huge actual and potential liabilities. It suggests that bankruptcy looms.
GE denies the charges, in turn accusing Mr Markopolos of market manipulation, since he has partnered with an unnamed hedge fund to share in any profits resulting from shorting the GE shares.
Since he is famous for predicting the exposure of Bernie Madoff’s notorious Ponzi scheme, GE’s shares immediately dropped on release of the report.
So is he right, and has GE systematically misrepresented its financial performance over the last couple of decades, or has he concocted his challenge to make money out of a big short? And what lessons for corporate governance should we draw from all this?
General Electric: the background
For our purposes, we start with the arrival of Jack Welch as CEO of General Electric in 1981. Neutron Jack, as he later became known, was a hard-driving manager who set hugely demanding standards. These included:
- consistently meeting forecasts for Wall Street of steady growth, and corresponding expectations from the heads of business in the sprawling conglomerate that he inherited
- setting the requirement that each of his businesses should be number one or two in their market sector, failing which they would be sold or closed.
Under his leadership, GE rode an eighteen year bull market from 1983 to 2000, and shareholders received a total return of 5400%, compared with a 2400% gain of the S & P 500 index. Revenues rose from $25bn to $120bn and profits from $1.5bn to $15bn, an outstanding performance which confirmed his status as the most admired CEO in the US, if not the world.
He retired in 2001 and handed over to his chosen successor, Jeff Immelt, who, however, inherited some significant problems:
- the recent collapse of the eighteen year bull market
- severe under-capitalisation of the financial arm, GE Capital, coupled with significant bad loans
- a culture of obsession with the stock price and undeviating improvement in results.
In his turn, a number of new problems happened on his watch, over the next sixteen years:
- the great recession of 2008
- partly as a result, with the collapse of interest rates, the transformation of a pension surplus into a huge deficit
- a financially disastrous acquisition of Alstom’s power and transmission divisions in 2015
- a similarly financially disastrous acquisition of oilfield services company Baker Hughes in 2017
- finally, and possibly most serious, the emerging actual and potential liabilities in the Long Term Care part of GE’s insurance business.
The combination of the culture and ill-judged strategic decisions gave rise to some significant pressures. These included:
- the demands to deliver a smooth progression of improving results to Wall Street, notwithstanding periodic major upsets
- the consequent intense pressure on managers to produce trading figures to consistently match Wall Street expectations, or face lost bonuses or even their jobs
- the incentive to achieve revenue targets by stretching revenue recognition
- the incentive to protect profit figures by managing mark to model for asset valuations
- consequent pressures on cash flow, and the incentive to hide these
- finally, the difficulty for independent directors on boards to really understand the underlying corporate position from carefully managed presentations of complex results which might embrace deliberate obfuscation.
Interestingly, these were the self-same pressures which brought down Enron, which, while posting steadily growing trading figures and profits, progressively ran out of cash, and where a whistle-blower set in train a process which eventually caused the whole business to collapse spectacularly.
Similar extreme performance demands on management at UK supermarket group Tesco led to revenue recognition misbehaviour, a major back-dated write-off and the departure of the CEO and chairman, coupled with a collapse in the share price and the departure of Warren Buffett as a shareholder. Fortunately, the size of the misdemeanours wasn’t big enough to bring down the company, but, again, the exposure was precipitated by a whistle-blower.
For GE, the charge sheet, as presented by Harry Markopolos in his 175 page presentation, is that:
- GE has a history of transgressions in the past twenty five years or so, in terms of lack of transparency and accountability to shareholders, which have been punished by the regulatory authorities
- it is currently sitting on major liabilities in various parts of its business which it has been tardy in acknowledging, and some of which are increasing exponentially
- the trends of trading and declining profitability in various parts of its business are such that it has minimal chance of settling its liabilities in the required time frame
- hence, notwithstanding its positive current disclosures to Wall Street and financial analysts, it is deliberately hiding its true position, which is potentially catastrophic.
GE’s response, at the time of writing, has been limited to brushing off the criticisms as ill-informed and biased by Mr Markopolos’s plan to benefit from shorting GE’s shares following publication of a report calculated to damage the share price.
For me, the figures presented, peer comparisons drawn, and trends revealed, require a much more detailed response to justify the company’s blanket rebuttal and dismissal. And whatever the views of the board, the stock market’s view of GE’s long-term performance is indicated by the progressive collapse in its share price since Jack Welch’s departure, from nearly $60 in 1999 to just over $8 currently.
How do we assess all this from a Corporate Governance perspective?
There have been strategic errors, but surely the key aspect on which to focus is the culture of General Electric, which was set during the term of Jack Welch and perpetuated after he retired. Again, there are parallels with the strong culture established at Enron by Ken Lay and Jeff Skilling.
The first of our five golden rules of good corporate governance is Ethics, which embraces the culture of an organisation. Let us remind ourselves that culture comprises both ethics, from the Greek origin meaning the sort of person, or their character, and morality, from the Latin, meaning customs, in terms of interpretation of duties, obligations, and consequential actions.
We are looking here, then, at the ethical character of the company and its managers, and its morality – the way it behaves.
The culture embedded by Jack Welch created the ethical character and mindset which favoured delivering targeted results as a priority over all other considerations. This was put under extra pressure by the impact from strategic missteps such as the problems arising from the capital shortage in GE Capital, the write-offs required re Alstom and Baker Hughes and the emerging liabilities from the Long Term Care insurance. So the corporate morality was to act according to the culture and stretch standards to the limit and beyond.
Lessons for the board
There have been several very high profile cases in recent years where the boards were apparently caught blind-sided by bad corporate behaviour. We have mentioned Enron (where it proved fatal) and Tesco (costly but not fatal). We can add Wells Fargo (embarrassing and very costly), Steinhoff (very nearly fatal), Carillion (fatal).
These examples show the need for the board to take a broad view of the company’s governance, well beyond “compliance” with laws and regulations, to embrace a holistic view, addressing its ethics and corporate behaviour.
Directors need to check on all aspects of the company’s performance, not accept too readily the results as presented by management, and try to avoid being blind-sided and misled. Above all, they need to set in place a permanent, on-going, independent review of the company’s performance, including non-financial assessments.
Hence our recommendation to establish a system of external surveys of the key stakeholder groups, using appropriate metrics, whose results are delivered directly to the office of the chairman and made available transparently to the board.