Rigorous statistical research continues to demonstrate that corporate accounting fraud remains common and costly. Aside from tangibly harming the shareholders of fraudulent and even non-fraudulent firms, misleading accounting and disclosure practices weaken the integrity of capital markets; they further obscure issuer risks and undermine investors’ trust in the reliability of mandated corporate filings. In this report, James A. Kaplan shares his thoughts on how investors can use validated methods of fraud detection to improve portfolio performance.

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Dan Concannon, Chief Executive Officer of GMI Ratings, said: “Over the past few weeks, we saw another series of reports confirming that businesses often resort to aggressive and illegal accounting and disclosure practices to meet increasingly ambitious growth targets. The growing body of research on the incidence and economic costs of faulty accounting practices strongly suggests that institutional investors should integrate forensic analysis more fully into routine decisions about portfolio management and benchmarking, stock selection and rejection.”

Mr. Concannon added: “The white papers we published today provide a detailed analysis of QEM’s out-of-sample performance characteristics. We found that QEM scores effectively predict equity returns globally, across industries, large-cap and small-cap portfolios. In many areas, QEM not only improves returns, but also lowers portfolio volatility.”

Mr. Concannon concluded: “QEM is now available via data feeds to qualified institutional investors and asset owners. We welcome inquiries and back-test requests.”

About GMI Ratings GMI Ratings is an independent provider of research and ratings on environmental, social, governance (ESG) and accounting-related risks affecting the performance of public companies. A signatory to the Principles for Responsible Investment (PRI), GMI Ratings was formed in 2010 through the merger of GovernanceMetrics International, The Corporate Library and Audit Integrity. In the 2012 Independent Research in Responsible Investment (IRRI) Survey conducted by Thomson Reuters Extel and SRI-CONNECT.com, GMI Ratings was named “The Best Independent Corporate Governance Research Provider”. Clients of GMI Ratings include leading institutional investors, banks, insurers, auditors, regulators and corporations seeking to incorporate accounting and ESG factors into risk assessment and decision-making. Visit the GMI Ratings website at www.gmiratings.com.

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Contacts
Joe Kern
Email: jkern@gmiratings.com
Phone: +1 212 949 1313 ext. 335

Joshua Kendall
Email: jkendall@gmiratings.com
Phone: +44 (0)207 160 9861

The post GMI Ratings’ Quantitative Equity Model (QEM) Uses Forensic Measures of Issuer Risk to Predict Equity Returns Globally, Across Industries, Large-cap and Small-cap Portfolios appeared first on GMI Ratings.

Automotive battery maker Exide Technologies Inc. filed for Chapter 11 bankruptcy protection today. According to filings with the U.S. Bankruptcy Court in Delaware, the company plans to implement a restructuring de-lever balance sheet and create a sustainable capital structure.

Since June 2012, GMI Ratings’ Financial Distress Risk Model has rated Exide Technologies as “high risk” for financial distress. The most recent score for XIDE placed the company in the lowest 1 percentile of all companies in North America, indicating higher chance of financial distress than 99% of comparable companies rated by GMI.

The GMI Financial Distress Model is based on three primary components:

1. Accounting Factors are measures found to be predictive of financial distress, including liquidity (does the company have cash to fund operations?), leverage (does the company have too much debt?), and profitability (is the company making money?)

2. Merton Distance-to-Default represents the statistical distance between the market value of the firm’s assets and its relevant liabilities. The valuation approach is based on option theory, with critical inputs being the market value and volatility of the firm’s equity, and the face value of its liabilities. As the market value of the equity declines, the chances increase that the value of the firm will be less than its debt, and the probability of default increases.

3. The AGR Rating is represented by a percentile score of 1-100, with the riskiest companies having the lowest score. The AGR rating indicates the transparency and reliability of financial disclosure, based on statistical analysis of forensic accounting and corporate governance measures of risk. XIDE’s AGR score reflects the impact of the following red-flagged metrics:

With questions about GMI Ratings’ Financial Distress Litigation Risk models, please email us at sales@gmiratings.com.

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In prior blogs, my research premise and finds were described.  Essentially, my research shows that high and low governance-rated boards demonstrate a particular behavioral pattern in the board room.  There are distinct realms of the boardroom (front and back stage), each with their own unique social norms.  Directors falter when they don’t (or can’t) distinguish these norms and react appropriately in each realm.  In addition to understanding the distinct realms of the boardroom, my other notable finding was that there are two types of conflict present – cognitive and affective conflict.  Cognitive conflict is required to generate innovative ideas whereas affective conflict deters any constructive participation.  The question is why isn’t affective conflict addressed in low governance-rated boardrooms.

Perhaps the most surprising discovery of the research was why affective conflict is or is not addressed.  My interviews showed a consistent theme – there is a relationship between board governance quality and prior personal relationships of board directors. High governance boards cast a wide net when recruiting directors, and often recruit people with whom the other directors did not have a prior relationship.  My study showed that close to 70% of high governance-rated board directors were “strangers” when they joined their board, while only 25% of directors recruited to low governance-rated boards were unknown quantities.  The obvious conclusion is that when a director has a prior relationship with a newly-recruited director – one that spans beyond the boardroom – directors are driven by their desire to maintain a congenial relationship with one another.  There is a personal incentive to not “rock the boat” of their outside relationship by addressing affective conflict in the boardroom, even at the expense of the quality of board dynamic inside the boardroom.  This reminded me of Warren Buffets admission in his 2002 annual report: “[directors], decent and intelligent though they were, simply did not know enough about business and/or care enough about shareholders to question foolish acquisitions or egregious compensation. My own behavior, I must ruefully add, frequently fell short as well: Too often I was silent when management made proposals that I judged to be counter to the interests of shareholders. In those cases, collegiality trumped independence.”

Conversely, in high governance-rated boards, where directors only have the boardroom as the context of their relationship, it becomes even more important to address affective conflict to make sure that the work environment be productive.  Therefore, on the low governance-rated board, characterized by prior relationships, directors are loathe to point out and address affective conflict for fear that the confrontation will have a far-reaching impact in all spheres of their relationship.  On high governance-rated boards, directors are not willing to “sweep issues under the carpet” for the sake of keeping “peace” when the health of the company is at stake.  My research showed that high governance-rated boards more actively addressed affective conflict and eliminated it from the boardroom so that the impediments to a robust dialogue don’t exist and creative and innovative thinking can be fostered.

The moral of the story – recruit the best people you can to the boardroom – cast a wide net, get the most experienced, most connected people and screen director candidate for their behavioral characteristics.  Beware of recruiting your pal to the boardroom because even if you think you’re doing yourself and your qualified friend a favor, the outcome may be detrimental to your relationship, corporate governance quality and ultimately shareholder value creation.

Solange Charas
PhDc, Case Western Reserve University
President, Charas Consulting, Inc.
www.charasconsulting.com

The post Study Confirms the Buffet Rule on Boards: Collegiality Trumps Independence appeared first on GMI Ratings.

New York and Stockholm (June 10, 2013) – GMI Ratings and Ethix SRI Advisors have formed a partnership to integrate Ethix SRI data into GMI Ratings’ flagship research platform, GMI Analyst. The new data will allow subscribers to GMI Analyst to evaluate corporate issuers based, in part, on their involvement in activities such as adult entertainment, tobacco, gambling and firearms.

In addition to data integrated into GMI Analyst, this partnership will offer GMI Ratings clients access to data and consulting services focused on issuers’ involvement in:

The two firms expect to complete the first integration of Ethix data into GMI Analyst by end of June.  Once launched, this new feature of GMI Analyst will provide SRI data on more than 6,000 issuers for which GMI Ratings currently provides environmental, social and governance (ESG) research. Upon request from clients, GMI Ratings and Ethix will provide additional SRI screening coverage for international indices.

Dan Concannon, CEO of GMI Ratings, said: “GMI Ratings’ approach to product development has always been aligned with our clients’ needs. We see steadily growing demand for thorough and thoughtfully designed SRI screening, and we are delighted to partner with a pioneer in this area of research to offer our clients this essential set of analytical tools. The addition of Ethix data to GMI Analyst is a major step forward in helping our clients meet their evolving needs.”

Ulrika Hasselgren, CEO and founding partner of Ethix SRI Advisors, said: “Responsible investing is growing rapidly worldwide, and SRI screening remains an essential tool for investment managers and asset owners looking for new ways to improve portfolio performance, reduce risk and strengthen their competitive advantages. We feel very enthusiastic about our partnership with GMI Ratings. As we work to add our data to GMI Analyst, we will continue to explore more ways to help the clients of both firms benefit from the unique value of our combined intellectual capital.”

About Ethix SRI Advisors 

Established in 1999, Ethix SRI Advisors is a pioneer in Norm-Based Screening®, a leading expert of illegal weapons research, and a provider of a wide range of responsible investment-related services and products. As a trusted advisor to institutional investors and asset managers across Europe and in the US, Ethix helps clients with policy development and strategy, portfolio monitoring, company research, shareholder engagement programs, and communication support. Ethix is an international team with extensive experience in social, environmental and ethics research and analysis. The consultancy’s analyses encompass international humanitarian law, human rights, labour rights, the environment, anti-corruption, governance issues, as well as extensive social, environmental and ethical screens. Its clients manage SRI assets totaling in excess of €300 billion. More information is available at www.ethix.se.

About GMI Ratings

GMI Ratings is an independent provider of research and ratings on environmental, social, governance (ESG) and accounting-related risks affecting the performance of public companies. A signatory to the Principles for Responsible Investment (PRI), GMI Ratings was formed in 2010 through the merger of GovernanceMetrics International, The Corporate Library and Audit Integrity. In the 2012 Independent Research in Responsible Investment (IRRI) Survey conducted by Thomson Reuters Extel and SRI-CONNECT.com, GMI Ratings was named “The Best Independent Corporate Governance Research Provider”. Clients of GMI Ratings include leading institutional investors, banks, insurers, auditors, regulators and corporations seeking to incorporate accounting and ESG factors into risk assessment and decision-making. Visit the GMI Ratings website at www.gmiratings.com.

GMI Ratings Contacts

Joe Kern
Email: jkern@gmiratings.com
Phone: +1 212 949 1313 ext. 335

Joshua Kendall
Email: jkendall@gmiratings.com
Phone: +44 (0)207 160 9861

Ethix SRI Advisors Contacts

Ulrika Hasselgren
+46 8 407 00 11
ulrika.hasselgren@ethix.se

Reinhilde Weidacher
+46 8 407 00 15
reinhilde.weidacher@ethix.se

The post GMI Ratings and Ethix SRI Advisors Form Strategic Partnership appeared first on GMI Ratings.

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The post Director Tenure and Gender Diversity in the United States: A Scenario Analysis appeared first on GMI Ratings.

Download the full Event Summary.

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Last month, an eight-story garment factory building collapsed in Bangladesh, killing more than 1,100 people. The Rana Plaza factory collapse is not only the world’s worst garment-industry disaster, but also a resounding wake-up call to the hazardous conditions present in apparel industry factories all across the developing world. As a direct response to the collapse, the Bangladeshi government has agreed to allow garment workers to form trade unions without permission from factory owners and raised workers’ minimum wage. While it is hard to discern the ultimate effects of the factory collapse, it seems that the curtain has been thrown back on the so called “sausage factory”, as the disturbing imagery of this disaster correlates with growing unease over how and where a significant majority of the retail industry produces its goods.

Download the full report.

The post Adidas Missteps Go Beyond Its Supply Chain appeared first on GMI Ratings.

At the GMI Ratings seminar on May 14, NYU finance professor Dr. Baruch Lev spoke memorably about the decline of traditional accounting and our collective hope for a superior model. The relevance of this topic for investors today continues to become clearer, as evidence accumulates about the incidence and systemic repercussions of corporate fraud and misleading disclosure practices.

The latest research (summarized below) strongly suggests that, under the current regulatory regime, many material risks remain mispriced and inadequately disclosed. Accounting practices that distort underlying economic realities remain widespread. Regulators remain resource-constrained, notwithstanding the report in the Wall Street Journal today that the SEC plans to continue to increase its focus on quantitative forensic fraud detection.

This confluence of trends creates ideal conditions for the rise of forensic finance, a more skeptical version of its traditional predecessor. Recently published research reveals a clear need for stronger forensic sensibilities throughout the ecosystem of capital markets. Academic research and global surveys point to detection-resistant systemic anomalies that distort and destroy value. Below is a summary of recent reports on the incidence and economic cost of undetected risks.

ACFE 2012 Global Fraud Study

According to a 2012 estimate by the Association of Certified Fraud Examiners (ACFE), organizations lose 5% of their total revenue to fraud, which translates into a global annual loss of $US3.5 trillion. ACFE’s latest global fraud survey also found that:

Fraud Detection and Expected Returns

A team of researchers from Indiana University, Stanford University and Syracuse University, recently reported out-of-sample results of an accounting-based model in predicting both fraud and equity returns.

How Pervasive is Corporate Fraud?

Researchers at the University of Toronto and University of Chicago found that “The probability of a company engaging in a fraud in any given year is 14.5%,” and “on average, corporate fraud costs investors 22 percent of enterprise value in fraud-committing firms and 3 percent of enterprise value across all firms.”

Ernst & Young Fraud Survey

Ernst & Young’s latest Fraud Survey (May 7, 2013) confirmed again that businesses often resort to aggressive and illegal measures to meet increasingly ambitious growth targets. Key findings:

Survey of CFOs

A team of researchers from Duke and Emory recently made an important contribution to broader research on earnings quality. Their report — Earnings Quality: Evidence from the Field – is particularly helpful in that reflects the perspective of corporate finance chiefs: their views of earnings quality and the prevalence of earnings manipulation. The key finding of this research team is that “About 20% of firms manage earnings to misrepresent economic performance, and for such firms, 10% of EPS is typically managed.”

Auditor Deficiencies

An academic study sponsored by the Center for Audit Quality examined 87 investigations in which the SEC sanctioned external auditors in connection with alleged fraudulent financial reporting by publicly traded companies. The authors of the study classified six of these cases as “bogus audits” where the auditor did not perform any meaningful level of audit procedure. In the remaining 81 cases, the top five audit lapses cited by the SEC included the following:

In Conclusion

The evidence clearly suggests that, because of shortfalls across the spectrum capital market participants, the value of mandated corporate disclosures continues to diminish. Institutional investors today have few better practical choices than to methodically cultivate greater skepticism, which serves as the organizing principle of forensic analysis.

The post The Decline of Accounting and the Rise of Forensic Finance appeared first on GMI Ratings.

At its annual meeting of shareholders last week, the board of CommonWealth REIT (NYSE: CWH) sank to a new low, explicitly demonstrating that the company has little interest in the rights of their shareholders. For the past few months, the company has been involved in a tumultuous takeover fight with certain activist shareholders, namely Keith Meister’s Corvex Management LLC (Corvex) and Jeff Blau’s, Related Fund Management LLC (Related).

In April, CommonWealth blocked a proxy contest attempt by shareholders to remove the entire board of directors. While the initial action by shareholders looked promising, CommonWealth’s board unilaterally amended the company charter and bylaws to align with Maryland State statutes, resulting in stricter requirements for the removal of directors. In addition to the supermajority vote threshold that was already in place, shareholders must now show cause when attempting to remove any director. So, unless CommonWealth’s board can be shown to be criminally negligent, it looks like shareholders are stuck with the leadership they have.

To make matters worse, the CommonWealth’s poison pill contains a “dead hand” provision which states that the original directors who put the pill into place must approve the pill’s removal. As the document was initiated in 2004, early expiration of its terms is no longer possible as several of the directors have long since retired from the company. Shareholders must now wait until October of 2014 before attempting to acquire more than 10% of the company’s shares, making any further takeover through increased ownership impossible.

Meanwhile, Corvex and Related have been engaged in litigation with CommonWealth in the Maryland Courts, claiming that the company misled investors with regard to its future financial prospects. This legal battle, coupled with Corvex and Related’s failed proxy contest, indicate that certain shareholders at CommonWealth are extremely unhappy with the company’s leadership. While this season’s proxy battle may be over, the war for company control is likely to continue for many more months.

And most recently, at the company’s annual meeting on May 14, shareholders voted out CommonWealth director Joseph L. Morea. Despite Mr. Morea receiving only 21% of the vote—no other director received less support in 2012 or 2013—and his subsequent resignation, CommonWealth issued the following statement: “the Board of Trustees requested that Mr. Morea accept appointment to the vacancy created by his resignation.” In an act of corporate black art, CommonWealth immediately reanimated the defeated Morea and reappointed their fallen colleague back to the board of directors. Such flagrant indifference for clear shareholder intent has to make one wonder why the company bothered holding an election at all.

GMI Ratings currently ranks CommonWealth REIT a “D” in Ownership & Control. The combination and use of poison pills, director removal restrictions, business combinations, and controlling share thresholds has left the company’s shareholders with little means to enact change in the company. CommonWealth investors have seen steady decline in share value since 2010 and these recent events do not provide much hope for a leadership change or an increase in shareholder control anytime soon. In addition to adopting new takeover defenses, further entrenching its board, and utilizing the rarely used “dead hand” poison pill tactic, CommonWealth has now shown a complete disregard for shareholder rights.

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