GE vs. accountant who exposed Madoff: the most fascinating clash of American companies

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Who's right, the detective who exposed Bernie Madoff's gigantic ponzi scheme, or the prestigious GE board and CEO, hailed on Wall Street the efforts made to save and reform the conglomerate. ruined?

In his report on the launch of the torch released Aug. 16, titled "General Electric, Greater Fraud than Enron", Harry Markopolos – the forensic accountant who nailed Madoff – accuses GE of committing fraud accounting of $ 38 billion. He claims that the former industrial and financial colossus deliberately failed to build enough reserves to cover the current and future huge losses in his long term care insurance sector. He also violated US accounting rules by not effecting a significant write-down on his Baker Hughes portfolio. GE Energy Unit. For Markopolos, GE is a dead company that works. He cites legendary frauds, Enron and WorldCom, collapsing just four months after the revelation of their misdeeds, and that GE could implode so quickly. "GE is about to go bankrupt," he told CNBC.

Markopolos is not just targeting the former regime of former CEO Jeffery Immelt. He claims that GE's current C-suite does not understand its opaque financials – and worse. In an interview on Yahoo Finance, he said that "GE's financial statements are almost unreadable" and that "I doubt" that CEO Larry Culp can read them. When asked if the CEO and CFO are involved in a camouflage operation, he replied, "I believe so." Why did Markopolos not allow GE to review its findings before becoming public? "Who wants to talk to fraudsters so that they can cover themselves?" Markopolos told Yahoo Finance's investigators.

Markopolos' assault on today's leadership is extraordinary, as GE recently appointed a highly respected CEO, along with an essentially new and extremely prestigious board of directors. Directors, including the former chief accountant of the United States, have extensive expertise in areas where the report reveals cases of fraud and abuse. GE's stock trades indicate that if the report raises new concerns among investors, Wall Street is not close to buying the Markopolos disaster scenario. After falling 11.3% on the day of publication, equities rebounded sharply Friday, bringing the decline to a modest 2.7%.

The duel is one of the most fascinating and important events of American companies. The investigator alleges that what appears to be a highly skilled team does not include its own accounting and does not recognize that it is practically insolvent – and perhaps even cooking the books – while GE says that his aggressor has miscalculated the numbers, and is motivated by the financial gain from the decrease in his stock. The question is crucial and could apply to other companies in difficulty. Is it really possible that a new CEO and a new board of directors, endowed with all the appropriate skills, fail to understand a complex and opaque enterprise to the point where what they think to be a booming business is on the verge of failure?

Inside GE

According to my conversations with GE insiders, they believe that Markopolos – who recognizes working with an undisclosed hedge fund that gives him a share of the gains from the GE short sale – plotted to use fictitious but titling charges, makes the headline. a murder for himself. The timing was right: GE has just announced the departure of its chief financial officer, which raises questions among fund managers about the bad news ahead. Insiders maintain that Markopolos took advantage of the difficult-to-understand nature of long-term care insurance accounting, an extremely complicated field built on the basis of complicated mortality assumptions and difficult discount rates. to analyze. They suspect that the secret fund cleaned up by the dumping of his shorts during the brief panic allowed him to easily earn money for Markopolos.

The management of GE seems about as difficult to convince as any other US company team. Culp, named CEO on Oct. 1, had a spectacular success at the helm of another industrial conglomerate, Danaher, tripling its share price from 2001 to 2014. In many rescue situations, a CEO of Superstar parachute without notice have the opportunity to carefully evaluate the problems of the company from the inside, and then be overwhelmed by serious surprises. But Culp accepted the job after being a director for six months. He was able to examine all his operations closely, so that he clearly thought that GE's worst problems were behind all that.

The future of GE also seemed promising enough to attract a new board mainly composed of operational and financial talents. At the beginning of 2017, GE had 16 directors. thirteen have left and, among the small group of ten, are six former or current CEOs, including Culp, Sebastien Bazin, head of Accor, and the former CEOs of American Airlines and Cognizant, Tom Horton and Francisco D & # 39; Souza. The other two have extensive insurance experience. James Tisch heads Loewes, owner of the CNA commercial carrier, and Paula Rosput Reynolds, former director of Safeco. Horton and another director, Catherine Lesjak, also held senior CFO positions: Horton at American and AT & T, and Lesjak at Hewlett Packard. Ed Garden, director at Trian, a major GE investor, is recognized as an active director of the fund's portfolio companies. It's Trian who has threatened a proxy battle speeding up the transformation of the board of directors.

The Audit Committee is chaired by Leslie Seidman, former Chief of the Financial Accounting Standards Board, which sets the US reporting standards. Seidman combines a nice way with an approach to find the traps so difficult that a person told me: "she eats nails for breakfast". The jury chose Seidman to hit hard and she fought back. "The report is full of opinions," she told CNBC. "It's full of inflammatory and inaccurate statements." "I'm not sure the author really understands the accounting in this area. Is it due to incompetence or some other motivation?" She took the allegations of fraud as a personal affront: "I have full access to people, books and records and I subscribe to the financial reports of that company." No allegations of fraud can be invoked. "

For Seidman, the game scatters great stories of malfeasance to capture a quick windfall. "This report creates a very dangerous precedent today," she concluded. "Where someone can just say things and benefit financially from the downside of the stock.It is wrong."

Nevertheless, Markopolos must be taken seriously because of its antecedents revealing an accounting fraud. His team took seven and a half months to produce the 168-page report, extremely detailed and specific. Here are four areas that could be of great concern to investors unless GE corrects them.

The alleged undisclosed losses are really big

According to the report, GE must immediately inject $ 18.5 billion of additional cash into its long-term care reserves to make payments to retirement homes and other service facilities that serve its insureds. Indeed, the report states that it has not set enough aside in its reserves to finance new demands, which far exceed premiums. In addition, GE will be forced to accept a non-financial write-down of $ 10.5 billion imposed by a change in accounting standards by the first quarter of 2021. This charge actually recognizes that its future obligations are much higher than the figures on its balance. sheet. In addition to the $ 29 billion long-term care deficit, Markopolos says GE overestimates its investment in its oil and gas unit Baker Hughes by $ 9.1 billion. This brings the total of what he calls "accounting fraud" to $ 38 billion.

This is an approximate figure, equivalent to 40% of the market capitalization prior to the release of GE. And Markopolos insists that it is only "the tip of the iceberg".

Claims are submerged premiums

In the mid-2000s, GE made arrangements to "reinsure" 280,000 long-term care recipients for eight carriers that had sold the initial coverage, assuming all the risks associated with these policies. The sector includes services such as retirement home residence, assisted living centers and home care. This is one of the most unpredictable aspects of the insurance industry, and it has turned out to be a big loser for many carriers. Because people live much longer than the actuaries estimated decades ago when they enrolled, and medical costs have increased significantly, premiums collected and invested frequently do not cover these services in the end. of life.

According to Markopolos, GE's performance was well below that of its competitors for two reasons. First, she did not put enough money aside to finance future receivables remotely, but instead spent share and dividend redemption premiums, and second, her policies were much riskier and more expensive than those a Prudential or Unum. In 2013, GE's largest insurance unit collected $ 192 million in premiums and settled $ 160 million in claims, for a surplus of $ 32 million. But premiums are falling with the number of claims, so GE has cashed $ 113 million in premiums and paid $ 594 million, a deficit of $ 482 million. His "loss ratio" of claims to premiums is 5.2 to 1, which means he spends $ 5 for every dollar he collects. On the other hand, at Pru and Unum, the premiums exceed expenses.

Markopolos claims that GE has settled only about 13% of the total claims that it will be forced to cover in the future. The claims, he says, are increasing "exponentially", so the immediate $ 28 billion deficit today is only a fraction of what GE would need to add to the future reserves.

GE has squandered necessary cash on reserves for redemptions, dividends, and C-suite pay

From 2012 to 2018, GE generated $ 14.9 billion in net income, but paid $ 106 billion in redemptions and dividends. During these eight years, GE paid $ 637 million, or 4.2% of net income, to its top five executives. Markopolos argues that he simply considers premiums as an "income" available to offset shareholder ownership or as an optimal source of compensation, while much of that money was needed for reserves .

Why Markopolos says GE is about to go bankrupt

Markopolos says that if GE recovers the $ 28 billion in hidden losses, shareholders' equity will be reduced to $ 6.2 billion. With GE's total debt of $ 106 billion, its debt-to-equity ratio will rise to 17: 1. This tiny capital buffer could violate the loan agreements between GE and the banks and bondholders, allowing them to drive GE to bankruptcy and recover some of their debts. by forcing the conglomerate to liquidate by selling assets.

Again, it's the disaster movie that does not scare investors – at least until now. GE's best defense is a highly transparent and evidence-based rebuttal. His starred board of directors swears that he has the facts on his side. This overly secretive society has somehow triggered the attack by revealing so little information about a mysterious enterprise in which analysts need a lot of data to evaluate.

The duel has begun – and it is now up to investors to decide who they support.

Inside GE

The alleged undisclosed losses are really big

Claims are submerged premiums

GE has squandered necessary cash on reserves for redemptions, dividends, and C-suite pay

Why Markopolos says GE is about to go bankrupt

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