I just posted an article about the ludicrous excuse that Mary Barra, GM’s CEO, offered in her congressional testimony for GM’s lengthy refusal to correct a design defect it knew was killing and maiming people.
The defective design caused GM cars, without warning, to suddenly lose electrical power essential to the driver’s ability to control the car and for the air bags to function. The car became an unguided missile and simultaneously lost the protective device that was most critical to safety in such circumstances. The design defect, therefore, endangered not only GM customers but also anyone in the vicinity when the GM car lost electrical power.
Barra’s story is that a large number of GM employees, over half of them “executives,” knew about the defect but did not fix it or alert GM’s leaders about the problem because they were all “incompetent.” Barra tried to buttress this tale with an “independent” report from Anton Valukas of Jenner & Block and another law firm – both of which have disabling conflicts of interest.
As I pointed out in my earlier article, these “independent” reports have a long history of failing to identify even massive frauds as “frauds.” The Powers report couldn’t find fraud at Enron and Valukas’ report on Lehman missed its massive fraud via “liar’s” loans. Valukas and Powers missed the entire concept of accounting control fraud. Barra, hilariously, described the Valukas report as “brutally tough.”
Yes, and Barra probably thinks a $50 traffic fine is “brutal.”
Neither Powers nor Valukas ever studied accounting control fraud or had guidance from anyone with expertise in such frauds. Even very bright people with superb quantitative skills need to be introduced to the concept and mechanisms of control fraud in order to understand such schemes. This was demonstrated recently in a remarkable op ed by Vincent Kaminski, Enron’s (honest) risk manager.
“There is one particular book I wish I had read in the early days of my business career, which would have saved me and the firms I worked for a lot of money.
Many companies that have eventually gone bankrupt have been very successful at projecting the image of unstoppable success for a long time
The book, entitled The best way to rob a bank is to own one: how corporate executives and politicians looted the S&L industry, was written by William Black, associate professor of economics and law at the University of Missouri-Kansas City. It is based on his experience as a regulator of savings and loans (S&L) institutions during the S&L crisis of the 1980s and early 1990s. Within its pages, Black introduces the concept of ‘control fraud’ – effectively, a very simple recipe for great riches and limited civil and criminal liability. It can be summarised as follows:
Take advantage of the chief executive’s ability to suborn internal and external controls through hiring decisions.
Steer the company into risky business by engaging in high-profile or high-exposure ventures.
Mask potential problems through transactions with related parties, inflated asset values and deflated assessments of liabilities.
Transfer company assets to private use through potentially risky transactions.
Base your compensation, and the compensation of key employees, on stock and option grants.
Engage in the manipulation of the external business and regulatory environment through the political system and shameless self-promotion.”
Sadly, Valukas has obviously never read my book.
Valukas’ Failure to Even Try to Understand the Criminogenic Role of GM’s Bonus System
I noted in my initial blog that Barra and Valukas conveniently ask the wrong questions, ensuring the wrong answer. He looked for memoranda or emails ordering a cover up and, of course, found none. He didn’t look at how control frauds actually suborn unlawful conduct – through their executive and professional compensation systems. The Valukas report on GM contains the words “bonus” and “compensation” only three times each in this passage.
“3. Other Board Activities
One way in which the Board expressed its commitment to improving the quality of GM’s vehicles was through the design of the short-term incentive compensation – bonus – plans that applied not only to corporate officers but also to employees at the executive, director, manager, and supervisor levels. With a single exception in the past decade, the annual targets GM had to achieve before any bonus would be payable included improvement of the quality of GM’s vehicles. The quality component in the annual target constituted 10% of the overall calculation, and three financial and sales components accounted for the balance for each year in the past decade except 2010, when the target’s components were limited to the three financial and sales metrics. In about mid-2013, Alicia Boler-Davis, the head of Global Quality, became a direct report to then-CEO Dan Akerson (having previously reported to Mary Barra as EVP of Global Product Development, Purchasing & Supply Chain) and proposed an increase in the relative weighting of the “quality” factor in the incentive plan to 25%. The Board’s Executive Compensation Committee approved the increased importance of quality improvement in determining the extent of bonuses, effective this year.
Similarly, the annual performance objectives for the CEO set by the Board’s Executive Compensation Committee included quality improvement as among the many factors by which the CEO’s performance would be assessed by the Board” (Valukas 2014: 247-248).
The context is that Valukas is trying to make the case that GM’s “tone at the top” was excellent. The passage I have just quoted is crafted to create the impression that GM’s leadership sought to shape a compensation system that would ensure that GM employees strove constantly to increase the quality of GM cars. Instead, Valukas demonstrates its failure to accurately describe the effect of GM’s perverse compensation system. Valukas’ description of GM’s compensation system is so vague that it reveals either Jenner & Block’s lack of understanding of compensation or its effort to spin GM’s system as reflecting well on its leaders (or both).
The compensation system Valukas describes is a critical component of the criminogenic environment that prompted GM’s murderous delay in correcting the defective ignition switch. The GM bonus system he portrays as an exemplary means of ensuring high quality is actually the problem.
First, the system is, as Valukas admits, “short-term.” That guarantees intensely perverse incentives. Short-term reported results are far easier to falsify in order to maximize one’s bonus. By providing a short-term bonus system that extends to thousands of employees GM’s controlling officers have created a vast cadre of employees with perverse incentives to inflate GM’s short-term reported profits and car quality. GM’s perverse compensation system is also designed to create plausible deniability for the CEO. The CEO can prate on about the corporate commitment to quality and safety while using a short-term compensation system that will produce the opposite.
Second, GM’s short-term compensation system creates a powerful incentive for employees to cover up quality problems. No one has to “order” the cover up. The short-term compensation system explains why at least 20 GM employees (over half of them executives) – in several different units – all decided to cover up the defect rather that report it. The claim that well over a dozen employees, over half of them “executives,” all decided randomly not to fix a defect they knew to be lethal because they were “incompetent.” Amazingly, the minimum of 20 employees were all competent enough to understand the design defect, but then became so incompetent that a lethal defect needs to be fixed. Even more amazingly, not a single highly competent GM employee or executive spotted the defect for many years. (We “know” this because Barra and Valukas assure us that only incompetent employees and executives fail to report and fix lethal design defects.) Barra, through direct appointments and indirectly through her direct reports managed to assemble this team of incompetents.
Our amazement can only grow when we “realize” (through a credulous reading of Valukas’ report) that GM’s controlling officers and board members are dedicated to quality and safety regardless of cost, that they set a superb “tone at the top” that made that dedication clear, and that they created a short-term bonus system to constantly reinforce their desire to ensure their employees’ total commitment to quality and safety. That’s the trifecta of superb leadership (just ask Valukas or Barra).
How unfair it was that at least 20 employees (over half of them executives) responded so churlishly to the trifecta created by their wondrous controlling officers and directors. Of course, it is a bit surprising that despite the trifecta of wondrousness from the top – every single GM employee (over half of them executives) failed to do the right thing when they learned of the lethal design defect. Apparently, they all, spontaneously, became suddenly incompetent when they learned of the lethal defect. That certainly is the only logical explanation for their allowing a lethal defect to kill and maim more victims. It couldn’t have been the perverse incentives of GM’s short-term compensation system. That would be an illogical explanation for why we would see the same behavior in so many people in so many different units – all subject to the same compensation system. .
Third, Valukas, implicitly assumes that GM “quality” is an objective fact that is not subject to manipulation by the employees and executives interested in maximizing their short-term bonuses. Given that the context of the Valukas report is the admitted refusal of GM employees and executives to make public and fix a lethal defect that is an absurd assumption. The combined result of the perverse quality incentives and the incentive to cover up the defects was a massive overstatement of GM vehicle quality. GM has recalled 13.8 million vehicles in the first five months of 2014 – more vehicles than it sold in the last five year cumulatively. That means that the quality of its cars was overstated enormously – for many years.
If Valukas’ description of GM’s short-term bonus plans is accurate, that means that but for the massive cover ups of the quality defects virtually no one at GM would have received a bonus for the last five years. Valukas claims that quality improvement was a requirement to receive any bonus: “the annual targets GM had to achieve before any bonus would be payable included improvement of the quality of GM’s vehicles.”
It is certain that Valukas’ description is inaccurate in at least one critical manner. It is the same error that he made about compensation in his report about Lehman. It was not necessary for “the quality of GM’s vehicles” to “improve” to receive a bonus. All that was necessary was for the reported quality of GM’s vehicles to improve. Similarly, at both Lehman and GM it was not necessary for the firm’s profitability to rise to receive a bonus – it was only necessary to for the firm’s reported profitability to rise. It is simple to make reported quality and profitability increase for years. That is why George Akerlof and Paul Romer famously warned in their 1993 article (“Looting: The Economic Underworld of Bankruptcy for Profit”) that fraud is a “sure thing.” Valukas failure to understand this point and his lack of knowledge of the fraud “recipe” for a bank led him to miss Lehman’s massive liar’s loan frauds.
The Valukas report documents that GM’s leadership’s compensation systems, orders for massive cost cutting, and orders not to be frank about safety in written reports combined to create a criminogenic environment that led to the production of well over 13.8 million defective vehicles in recent years. GM leaders crafted the perverse incentives Barra and Valukas observed – but blame on the supposedly “incompetent” employees and executives who are far lower in GM’s food chain. GM leaders designed and implemented the criminogenic incentives that made the sale of dangerous vehicles common and covering up the defects the norm when those defects were difficult for consumers to observe. The cover ups of the ignition switch defects were conducted in a manner designed to make it far more difficult for consumers and mechanics to spot the defects. The assignment of the old part number to the improved ignition switch was a particularly nasty tactic designed to prevent consumers from becoming aware of the defective ignition switch.