Creative Accounting

Many of the recent memorial tributes to the comic actor Gene Wilder emphasized his portrayal of the title character in the initial film version of Willie Wonka and the Chocolate Factory. Indeed, though that movie was never a major hit, Wilder’s “whimsical yet obscurely menacing” portrayal perfectly captured his unique brand of humor.

But did you know that Wilder was also the originator of the business world’s phrase creative accounting? He played the psychotically repressed Max Bloom in the 1967-68 cult comedy classic The Producers, portraying an accountant who conspires with the producer of a Broadway show to swindle his investors.

The phrase creative accounting was a sarcastic reference to the manipulation of financial bookkeeping practices to enable the swindle. More specifically, it involved a scheme involving accounting principles for equity capital.

So how did the swindle work? The producer, a character named Max Bialystock, raised capital by promising investors that he would launch an extremely successful Broadway show. But he intentionally created an atrocious show that was designed to be severely criticized — and then closed down — after a single Opening Night performance.

Bialystock knew that traditional accounting debits and credits are recorded in dollars and not in ownership percentages. So he sold and resold the same shares of ownership over and over, and kept recording the cash inflows as new investment capital.

Once the show closed, Max assumed that the investors would be too embarrassed about investing in such an awful flop to demand their money back. And so he assumed that he and his conspirator Max Bloom could pocket the unspent funds.

Did they get away with it? You’re welcome to watch the film and learn the answer to that question. But here’s a hint: the outcome of the movie pivoted on the hilarious reactions of the Opening Night audience.

Incidentally, if you believe that such schemes could never be perpetrated in the real world, please think again. Until a few years ago, for instance, American politicians often raised millions of dollars through Political Action Committees. Then they announced their retirements and routinely kept the funds for their personal use.

Indeed, if The Producers were to be re-made for today’s movie audiences, there’s a good chance that it wouldn’t be situated in the world of Broadway theater. Nowadays, the most audacious producers of creative accounting techniques — and many other examples of financial chicanery, for that matter — practice in the world of politics.

But that’s another story!

Libor Scandal: A Win For The Banks!

It has been a rough year for the global banking industry, hasn’t it? From the revelation that HSBC provided money laundering services to drug kingpins and terrorist organizations, to JP Morgan Chase’s multi-billion dollar losses over a series of trades by the infamous London Whale, the institutions have struggled to win back the trust and good will of the global public.

The biggest scandal of them all, of course, has been the Libor manipulation brouhaha that was first reported in the business press nine months ago. First, the U.S. Commodity Futures Trading Commission successfully fined Barclay’s $200 million for interest rate manipulation in a debt market that is estimated at $300 trillion.

Subsequently, American and British government regulators won settlements from the Union Bank of Switzerland and the Royal Bank of Scotland as well. And many additional investigations are now reportedly proceeding on their paths through the regulatory system.

Last week, however, the banks won a temporary reprieve of sorts, when a New York based Federal District Court judge tossed out a set of multi-billion dollar lawsuits from investors and other parties who claimed to have been damaged by the interest rate manipulations. Does this mean that the banks have been vindicated in the court of law, if not in the court of public opinion?

Legal Technicalities

The plaintiffs of last week’s lawsuits had based their cases on the provisions of antitrust law, a set of regulations that prohibit banks and other parties from colluding with each other when they should be competing for new business and profits. These plaintiffs asserted that the banks engaged in collusive activities, and thus they claimed to have incurred losses as a result of the illegal actions.

The judge, however, decided that the banks had simply taken advantage of a system that permitted them to manipulate the Libor interest rate through the independent submission of rate quotations. In other words, although the judge acknowledged that the banks’ activities may have constituted illegal misrepresentations of interest rates, she asserted that their independent actions failed to meet the legal definition of collusion under antitrust law.

So why did the plaintiffs frame their cases as antitrust actions instead of as fraud actions? After all, it may have been possible for them to win fraud causes more easily than antitrust cases. It is quite likely, though, that the plaintiffs were enticed to do so by the prospect of receiving punitive awards with treble damages. Such awards are available under antitrust statutes, but not under fraud and other statutes.

Many other cases are still progressing through the legal system; furthermore, last week’s settlement may be appealed in a higher court. Thus, last week’s win may prove to be a fleeting one; nevertheless, it is a victory for which the global banks are undoubtedly grateful.

Explicit vs. Implicit Collusion

It’s important to keep in mind, though, that the Federal District Court judge was referring to the absence of explicit collusion. Such collusion often requires competitors to directly communicate with each other for purposes of fixing retail sales prices.

The classic Hollywood film version of such activities, featuring smoke-filled back rooms and dark alleys, is rarely ever replicated in the real world. Nevertheless, explicitly collusive conduct may occur during interactions as brief as limited telephone conversations. One such infamous conversation occurred between the Chairman of American Airlines and the President of Braniff Airways in 1983.

As noted in a Bloomberg Businessweek article last year, flaws in the Libor methodology allowed global banks to “rig” interest rates without explicitly conspiring to do so. Nevertheless, the institutions did indeed collaborate in an implicitly collusive scheme, as described by Michael Kraten in the Businessweek article:

“You have 16 banks employing people who are eating at the same restaurants, drinking at the same pubs. They look at each other as competitors, but also as friends. It’s easy to believe that whether or not they’re explicitly talking to each other, they understand each other well and they’re implicitly colluding.”

Implicit collusion. According to the Federal District Court judge, it isn’t an illegal activity, regardless of the level of damage that it inflicts on the public.

Fraud vs. Antitrust

But what of the other cases that are progressing through the legal system? Will they be dismissed on the basis of such legal technicalities as well?

Probably not, for many of these cases rely on legal claims that are unrelated to antitrust law. The federal government, for instance, is pursuing a case through the quasi-public mortgage finance giant Freddie Mac. This particular case relies on multiple charges of fraud and breach of contract, in addition to charges of collusion. Thus, even if the third charge is dismissed by the courts, the first two charges may indeed proceed to trial.

Considering these events, are you feeling impatient that the global banks have not yet incurred some type of significant punishment for their transgressions? Although they appear to have dodged one such punitive measure last week, they will likely face many more such challenges for years to come.