How Institutional Defects Get Ignored: The GM – and Lehman Reports by Valukas

By William K. Black

The beleaguered profession of law has one lucrative growth area – preparing reports for a corporation on the misdeeds of the corporation. One of the leaders in this burgeoning field is one of the Nation’s top white-collar defense firms – Jenner & Black. Its head, Anton Valukas, is now famous for the “Valukas” reports for Lehman and GM. I testified at the same House hearing on Lehman’s failure with Valukas. Valukas famously suggested there could be grounds for criminal prosecutions of Lehman’s use of an accounting device designed to deceive investors and creditors about the (crippling) extent of its debt. Attorney General Holder and a senior SEC (anti) enforcement leader combined to allow Lehman’s officers commit this variant of accounting control fraud with impunity. (This is one the events that sparked the recent long-time SEC enforcement attorney’s evisceration of the SEC at his retirement dinner.)

Valukas was blind, however, to the vastly larger and more damaging accounting control fraud that constituted Lehman’s core. His report showed no understanding of how controlling officers use executive and professional compensation to induce widespread fraud by more junior officials. Jenner & Block’s expertise and revenue, as I explained, is derived from defending senior executives charged with committing white-collar crimes.

Valukas’ newest report is about GM’s lethal ignition system failures. The New York Times has reported on its contents in an article entitled: “G.M. Says Inquiry Found ‘Pattern of Incompetence.’” I was born in Detroit and grew up in Dearborn so cars are a big deal to me.

The context is the effort by Mary Barra, GM’s CEO, to save her job and reduce the hit to GM’s reputation. CEOs who lead control frauds use outside professionals’ reputations to aid and abet their crimes and make it far harder to hold them accountable even when their wrongs are (partially) revealed.

Hiring Jenner & Block Doesn’t Pass the Laugh Test of “Independence”

Valukas is a very fine lawyer and he is in no way evil, but GM’s retention of Jenner & Block (aided by King & Spalding) to conduct a purportedly “independent” review is farcical.

“But Professor Tobias said that Mr. Valukas was a good choice for the delicate task of investigating G.M. ‘His reputation is on the line with this report, so he is not likely to sacrifice that for G.M.,’ he said.

Jenner & Block has long had ties with the automaker. In addition to performing securities work for the company, one of Jenner & Block’s lawyers, Robert S. Osborne, was G.M.’s general counsel from 2006 to 2009, years that the ignition switch problem festered within G.M. And before that, Mr. Osborne was a senior partner at Jenner & Block.

The other firm involved in the internal investigation, King & Spalding, defended G.M. in a wrongful-death lawsuit filed by the family of Brooke Melton, a case that brought the ignition switch defect to light last year.”

Today’s NYT article would have only had to go back to the paper’s coverage of the GM scandal in a story that first ran on May 17, 2014 story to explain to its readers just how disabling the law firms’ conflicts of interest were. The title of the May 17 article was a pretty good hint: “Inquiry by General Motors Is Said to Focus on Its Lawyers.”

“As General Motors faces a number of continuing investigations into its handling of a vehicle safety defect linked to 13 deaths, its legal department has become a focus of a broad internal inquiry into how the company handled the issue, according to two people with knowledge of the inquiry.”

Handily enough, the same NYT reporter wrote both articles. Jenner & Block and King & Spalding were both in obvious conflict situations. GM should not have asked them to prepare an “independent” report and they should have rejected GM’s request. Tobias is wrong on multiple levels that Valukas’ “reputation is on the line with this report, so he is not likely to sacrifice that for G.M.” First, we know from research that conflicts matter – enormously – which is precisely why Barra selected two firms with glaring conflicts. Conflicts of interest matter in ways that are insidious – as anyone who studies criminology or behavioral finance would understand immediately. Conflicts of interest blind us to the existence and impact of those conflicts on our decision making.

Second, Valukas will not suffer any loss of “reputation” from failing to spot a “control fraud.” It is not like control fraud is something is well aware of and can spot without investigation. Valukas demonstrated that failing to spot Lehman’s control fraud caused no damage to his reputation. Indeed, his Lehman report greatly enhanced his reputation. It is important to recall that Lehman was one of the world’s leading sellers of “liar’s” loans. That lacks subtlety, but Valukas failed to identify even such a blatant, massive series of frauds. The fraud incidence in liar’s loans was 90%, so we know that Valukas made no meaningful investigation of the vastly larger crimes that Lehman’s officers committed.

Review the incredibly positive news coverage that William Powers received for “his” report on Enron. First, it isn’t his report. Second, the report is exceptionally weak – even though it was supposed to document one of the most blatant accounting control frauds in history. Powers went from a typically ineffective member of Enron’s board of directors to a much sought after sage as a result of “his” report. He parlayed it into becoming the head of the University of Texas. Even pathetic corporate reports can greatly enhance the reputation of the person after whom the report is named. (The perceptive reader will have noted that Valukas does not brand “his” reports as “the Jenner & Block report”.)

How many times, collectively, did the Powers report mention the words “fraud,” “crime,” “criminal,” and “deceit?” How about when we broaden the search to include “breach” (short for “breach of fiduciary duties”)? If you guessed “zero” as the answer to both questions you are a winner – and you understand the art of writing an “independent” report that will transform you from the grave embarrassment of being a failed member of Enron’s board of directors into a leader of American higher education.

Third, Tobias’ belief in Alan Greenspan’s “reputational trump” has been falsified at every step of the recent financial crisis (and all our modern financial crises). The most prestigious attorneys, auditors, appraisers, credit rating agencies, and loan brokers consistently aided and abetted the CEOs leading the epidemics of accounting control fraud that drove the crisis. Indeed, the fact that Tobias would play Alan Greenspan’s falsified “reputational trump” card to try to enhance Valukas’ reputation – after the financial crisis – is a compelling demonstration of the falsity of the claim that concern for reputation trumps self-interest.

Fourth, context matters. In the Lehman report, Valukas was describing a dead firm in which all the senior managers were gone. Lehman and its managers were not likely to send Jenner & Block future business regardless of what Valukas reported. In the context of GM each of the law firms conducting the faux “independent” “investigation” has substantial reasons to hope for lucrative future assignments from GM.

Fifth, the art in one of these reports in which the company remains is business is not to find nothing, but to find nothing that will cause the CEO to lose her job. One burnishes one’s credibility (at least for the credulous) in Valukas’ position by finding problems with the actions of lower ranking employees and officers who can serve as scape goats. The CEO then sacrifices the scapegoats as a burnt offering to expiate any or personal corporate guilt.

In the case of Lehman, Valukas was able to ignore Lehman’s overall fraud scheme and, with the aid of a whistleblower, identify a relatively tiny fraud that would be difficult to tie to senior executives. There is no indication in the Lehman report that Valukas’ team even interviewed the whistleblowers about Lehman’s vastly larger and more damaging frauds through liar’s loans.

It’s Executive Compensation, Stupid!

I’m simply doing a riff off the campaign slogan: “It’s the economy, stupid!” I do not intend to label people as “stupid.” The obvious link between the scandals at Enron, Lehman, and GM is modern executive and professional compensation. The definitive explanation was provided by the CEO that the Business Roundtable chose as its spokesperson to respond to the Enron-era epidemic of accounting control fraud. Businessweek asked the CEO to explain what caused the epidemic. Franklin Raines responded:

“Don’t just say: ‘If you hit this revenue number, your bonus is going to be this.’ It sets up an incentive that’s overwhelming. You wave enough money in front of people, and good people will do bad things.”

I have written about this several times and recently wrote a column quoting House Financial Services Chairman Jeb Hensarling (R, TX), who explained that Raines ran an accounting control fraud at Fannie Mae.

The CEO of Enron, Lehman, or GM cannot send a memorandum to thousands of employees and officers encouraging them to aid his or her control fraud. The CEO can, however, send that same substantive message through the firm’s compensation system for executives and outside professionals. “You wave enough money in front of people, and good people will do bad things.” They don’t all have to do bad things for bad things to become the norm.

The great irony of the article by the NYT about Valukas’s work for GM’s controlling officers is missed by the reporter. He notes only that Barra announced that GM:

“[W]ould put in place a long-awaited compensation program for victims, to begin on Aug. 1, administered by Kenneth Feinberg, a lawyer who specializes in compensation programs.”

The article, and if it is accurate, the Valukas report on GM, ignores the use of perverse compensation incentives designed and implemented under Barra. It speaks only of a “compensation program” for the victims to be run by Feinberg. It turns out that I have also testified at the same congressional hearing on executive and professional compensation with Feinberg. He was TARP’s “pay czar” and the thrust of his testimony was that the Nation’s largest banks that were TARP recipients had learned nothing from the financial crisis and were continuing to design executive compensation programs that created perverse incentives. He rejected most of the largest TARP banks’ proposed pay plans. It wasn’t that Feinberg was tough – SIGTARP regularly detailed his excessive laxity on pay – it was that the misconduct of the banks controlling officers’ even after the crisis remained so outrageous that even Feinberg criticized their actions. (Feinberg is another proof of the readily observable fact that weakness in ferreting out fraud and excessive and perverse compensation typically aids ones reputation among the CEOs that determine who is hired.)

By Ignoring the Perverse Compensation Incentives Valukas can Give Barra a Pass

Barra’s story is facially fanciful.

“Repeatedly, individuals failed to disclose critical pieces of information that could have fundamentally changed the lives of those impacted by a faulty ignition switch,” she said. “If this information had been disclosed, I believe in my heart the company would have dealt with this matter appropriately.”

The Barra/Valukas theory is that GM’s engineers are pervasively “incompetent.” Roughly 18 of them “failed to disclose” to their superiors the ignition switch design defect that they knew was proving murderous. That story makes no sense.

Why would so many engineers refuse to disclose that a GM safety defect was killing and maiming its customers? Why would they, eventually, fix the defect and deliberately give the new, safe switch the same product ID number as the defective version of the switch – knowing (and intending) that this would deceive the customers. There’s only one credible answer to that question – GM’s perverse compensation incentives that threatened their bonuses if they disclosed the defect.

Barra continues to refuse to ask – “why?”

“Numerous individuals did not accept any responsibility to drive our organization to understand what was truly happening,” she said. “The report highlights a company that operated in silos, with a number of individuals seemingly looking for reasons not to act, instead of finding ways to protect our customers.”

No, not “seemingly” – “actually” is the word. GM employees and officers knew of the defect, knew how to fix it (very cheaply), knew that it was killing and maiming people (and would continue to do so) and responded to this knowledge by “looking for reasons not to act, instead of finding ways to protect our customers.” Why? There’s only one logical answer – because Barra administered a compensation system at GM that gave them perverse incentives “not to act” and not “to protect.” A failure to act by an individual is one thing – a failure of roughly 18 people to act establishes a systemic problem. (And we should be skeptical that “only” roughly 18 GM employees/officers failed to warn.)

The article then discusses the even more disingenuous aspects of Barra’s testimony and Valukas’ report.

“But despite the failures, she said the report found no institutional effort to cover up the problems, an allegation she faced in pointed questioning before congressional lawmakers.

‘Mr. Valukas’s report revealed no conspiracy by the corporation to cover up the facts,’ she said. ‘In addition, the investigators found no evidence that any employee made a trade-off between safety and cost.’

She repeated that G.M. had undertaken a series of initiatives to improve is safety practices and quality control, including the appointment of a new vice president for safety, Jeff Boyer.”

Each of these paragraphs is based on a torturous framing the real questions. “No institutional effort to cover up the problems.” Barra’s own testimony demonstrates that there was a successful institutional effort to cover up the problems – for many years. Barra admitted the cover up in the portions I discussed above by many GM officials in multiple units. Those multiple acts of covering up the safety defect occurred because of a critical “institutional effort” called executive compensation. No one has to order a specific cover up when the compensation system creates powerful, automatic incentives across the entire organization to cover up defects that are difficult for the consumer to identify. Barra’s and Valukas’ efforts to treat executive compensation as non-“institutional” are unsupportable – but deeply purposeful. “Watch my right hand” – when you here that phrase you can be sure the action happening in the illusionist’s other hand.

Similarly, by “no conspiracy” Valukas means simply that there is no need to issue instructions to cover up a safety defect that it is difficult for the consumer to detect where the cost of the recall could reduce employees’ and officers’ compensation. Modern executive compensation means never having to say “I love you (and I‘d like you not to flag safety violations we can get away with).”

The most absurd “finding” is this one: “investigators found no evidence that any employee made a trade-off between safety and cost.” First, employees are supposed to measure and make intelligent “trade-off[s] between safety and cost.” Doing so is inherent in doing their jobs properly. Second, the claim that no one at GM considered such a trade-off proves no one told Valukas’ people the truth all of the time. Third, the key thing they were trading off was concern for their compensation against concern for drivers and passengers (not merely “customers”). In every case the roughly 18 GM officials decided to make that trade-off in favor of maximizing their own compensation by placing drivers and passengers at risk of death. Again, that demonstrates an institutional crisis. The odds of 18 engineers independently deciding to maintain, and keep secret, a safety defect that put the lives of everyone on the roads at risk (not merely GM “customers”) is so vanishingly small as to be equivalent to zero. Some systematic – institutional – factor has to be added to the equation to explain why GM’s engineers went zero for 18 (and the latter number will likely grow if there is a real investigation). The added factor is modern executive compensation – not the absurd claim that each of the 18 engineers (spread out in purported “silos” across GM’s huge organization) who recognized the safety defect (which would imply competence) randomly turned out to be so “incompetent” (not immoral or greedy) that they believed that if you spot a GM design defect your response should be to “look for reasons not to act” or affirmatively act to cover up the defect. The article says that more than half of the people who refused to disclose the safety defect were “executives.” What are the odds that roughly 10 GM executives – each competent enough to recognize the safety defect – were all so “incompetent” that they could not recognize that safety defects should be fixed? What are the odds that GM, for nearly a decade, employed zero engineers and executives who were sufficiently competent to (1) recognize the safety defect and (2) recognize that they should get the defect fixed?

And if GM is so bereft of “competent” “executives” that a random selection of their executives went zero for 10 in being even sufficiently competent to realize that safety defects that could kill should be fixed – then why is the CEO who choseand trained these pervasively incompetent executives still in charge?

But, surely, Valukas’ and Barra’s first or second proposed reform is to remove the perverse incentives from GM compensation system that made the organization such a criminogenic environment that the number of recalls they have been forced to order threatens to push the company back into bankruptcy. No, at least as described in the article, Barra offers nothing on executive compensation – she’s simply creating another executive with the same old perverse incentives. .

Many Control Frauds Maim and Kill

The amount of financial losses caused by the three epidemics of accounting control fraud that drove our financial crisis is staggering. Lost U.S. production is now projected to hit $21 trillion. Over 10 million Americans also lost their jobs as a result of the crisis. The production and job losses are far larger in the EU due to their “winning” the regulatory “race to the bottom” and committing the massive “own goal” of austerity. In a number of articles I have explained that while I focus on financial control frauds there are many forms of control fraud that maim and kill.

GM is an example of an anti-purchaser control fraud that can maim and kill not only the purchaser, but whoever is in the car and whoever is on the road at the same time that the ignition switch defect could suddenly convert the car you gave your daughter as a graduation present into an unguided 1+ ton missile without steering or power braking hurtling down, across, or off the road at 70 mph – with the air bags rendered useless. F = MA, and that equation applies to your daughter’s and her passengers’ bodies when the car decelerates suddenly because of an impact with a car, truck, or tree.

My Regret about George Akerlof’s Article about Markets for “Lemons”

I often wonder whether what the economic profession learned from reading George Akerlof’s famous 1970 article about a market for “lemons” would have been vastly greater had he described deceptions about quality that could maim and kill the consumer. The article remains Akerlof’s most famous piece and it was the one cited principally in the award of the Nobel Prize to him in 2001.

My fear is that economists’ dogmas about the supposedly mystical properties of “free” markets are so all-consuming that nothing would have changed even if Akerlof had chosen examples of product quality fraud that could maim and kill the customer. Worse, given the field’s dogmas, it might have made an article that Akerlof had to struggle mightily to get published into an article seen as so “radical” that it would not have been published. It is well to remember, in this the 75th anniversary of Edwin Sutherland’s famous presidential address announcing the concept of “white-collar crime” that he – the president of the association of sociologists – could not get published his research findings on elite corporate crimes. His research findings were based on publicly reported information, but no publisher would publish his book with the tables listing the corporations’ names.

Economists promptly marginalized Akerlof’s work on fraudulent markets. Read a hundred descriptions by economists of his article on “lemons” and one will find the phrase “asymmetrical information” 100 times – and the words “dishonesty” and “misrepresented” zero times (unless the article is written by me or my colleagues). But those were the words Akerlof used to describe the anti-purchaser control frauds that are the focus of his article.

“C. The Costs of Dishonesty

The Lemons model can be used to make some comments on the costs of dishonesty. Consider a market in which goods are sold honestly or dishonestly; quality may be represented, or it may be misrepresented.”

Economists likely would have reacted to an article in which Akerlof explained how the heads of firms defrauded their customers about quality in a manner that endangered the customers’ health and lives as a ludicrously uncommon condition that the “markets” or laws would promptly remove. Akerlof’s focus on what economists would have (wrongly) assumed was “an extreme outlier” would have led to charges that he was deliberately choosing gory examples to try to smear capitalism and capitalists as heartless monsters.

Of course, the signature example of such control frauds that Akerlof used, and shaped his article’s title, was car dealers selling horribly defective cars (“lemons”) to customers as if they were far higher quality. That process of “dishonest[ly] misrepresent[ing]” the quality of a defective car can endanger the customers’ lives and health (and their passengers and other people on the roads when the defects manifest themselves).

4 responses to “How Institutional Defects Get Ignored: The GM – and Lehman Reports by Valukas

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