The Grim Reality of the Crisis in Iraq

Apparently Abu Bakr al-Baghdadi, leader of ISIS (the group that swept across Northern Iraq and quickly took over several key towns last month) made it to Time Magazine's 100 Most Influential List. I admire Lt. Gen. Frank Kearney for recognizing a clever, elusive guerrilla commander like Baghdadi. A good solider knows his enemy well, says Sun Tzu. Now, with the nearly $500MM in cash that ISIS fighters stole from Mosul, they’re probably the richest "terrorist" organization in the world.

Many disaffected Sunnis, former Saddam loyalists and Baath party sympathizers are already joining the ranks of ISIS. They're not fundamentalists like ISIS but they're all Sunnis and now Baghdadi has the dough (and the clout) to recruit. ISIS – stands for Islamic State in Iraq and the Levant. Their goal is to turn the Levant (Iraq/Syria/Lebanon) into an Islamic Caliphate. They’re devoutly committed to global Jihad and so I’m not sure anything could have prevented this. It was bound to happen but perhaps Prime Minister Nouri al-Maliki’s policy of politically purging Sunnis has accelerated the process of radicalizing them. Battle-hardened from fighting Bashar al Assad’s troops in the rebel strong-hold of Aleppo, ISIS fighters are pouring into Iraq in their numbers to join the fray.

But then, can who can blame Maliki for his anti-Sunni stance? After all the Shias suffered decades of repression under Saddam, who is from Tikrit, in the Sunni North (one of the first towns to fall to ISIS last month). This whole problem began with the 2003 Iraqi invasion. But then maybe NOT. Maybe it began way before that. Maybe in 1918? – after the allied victory in World War I ended the Ottoman Empire and resulted in its partition into the Republic of Turkey and several “new” Arab states in the Middle East.

You see, much of what is today’s Arab world was part of the Ottoman Empire for centuries. During World War I, a lesser know theater of the war began with the so-called “Arab Revolt”. The continuing ruthlessness of the Ottoman Turks led to simmering Arab Nationalism within the Empire. It eventually culminated in the Arab Revolt which drew support from Britain (via Lawrence of Arabia). By the end of the war, the Germans and the Ottoman Turks were all but defeated and the world powers were faced with the task of creating new sovereign states from the remnants of the Ottoman Empire. While this was no easy task, Britain and France botched this effort in disastrous fashion. Instead of granting freedom to the Arabs (as promised) after their revolt helped defeat Germany and its Ottoman allies, Britain and France secretly drew up plans to divide up the Arab remnants of the empire and share them between each other.

The Sykes-Picot Agreement was one of the worst examples of imperial greed and folly. These guys carved up the land with no regard for the sectarian differences on the ground. The French took Syria and Lebanon, the British took Iraq and Palestine (which later became present-day, Jordan, Israel and the Palestinian territories of the West Bank and Gaza). The Ottoman possessions in the Arabian peninsula became the Kingdom of Saudi Arabia and Yemen; and those in the Persian Gulf became several small kingdoms (UAE, Bahrain, Qatar, Oman and Kuwait) that are ran by western puppets. To show the unconscionable nature of Sykes/Picot’s actions, let me give you a few examples of the sectarian fault lines that have haunted these nations from the the day they were formed.

Iraq for example is about 65% Shia, 20% Sunni and 17% Kurdish. Syria is the exact opposite –it’s about 15% Shia/Alawite, 70% Sunni and 10% Kurdish. Lebanon is about a third Sunni, a third Shia and a third other sects (Maronite Christians, Druze, Catholics). Bahrain is similar to Iraq (more than 70% Shia, and about 10% Sunni) but it’s different in one fundamental way - it’s a Gulf kingdom ruled by the Sunni al-Khalifa dynasty. There are Maronites, Catholics and Druze in varying numbers in most of the region but they’re mostly a minority. Adding another layer of complexity to the region is the Palestinian/Israeli conflict. But that is a subject worth a separate discussion.

As the Sunnis and Shias battle each other in Iraq (and Syria), the Kurds (the indigenous people of the region) are carving up more land. The chaos in the region has actually been good for the Kurds as they are gaining more autonomy in both countries. Assad's troops and the Syrian rebels alike, both stay away from Kurdish-controlled areas inside Syria. ISIS does the same in Iraq. I guess I am “happy” for the Kurds, as they've endured the most suffering and displacement in the region for centuries due to Ottoman rule and European interference. As an African, whose people have endured centuries of slavery and European colonization, I am very sympathetic to the Kurdish cause. Long before the so-called Arab spring of 2011, which resulted in Syria's civil war, the Kurds were fighting the injustice of Bashar al Assad's regime. Long before ISIL took over northern Iraq, they were fighting Saddam Hussein in Iraq. And they've been fighting for autonomy in Turkey for decades. They are brave and battle hardened. And I believe they will be the only credible force that can defeat the scourge of ISIL.

What does all this mean for the region? Well, for starters if the violence continues, the whole region could dis-integrate along the sectarian fault lines that have existed for centuries. We’re already seeing signs of the Kurdish minority in Iraq and Syria getting close to their dream of an autonomous Kurdish homeland (referred to as Kurdistan) as they continue to defend their territory and even capture more land. In addition, as the beleaguered Maliki government continues to lose control of Iraq, more radical Shia elements will step in, garner populist Shia support and that will ultimately lead to more bloodshed. The last thing you need is a war between fundamentalists on both sides of it.

However, everything seems to be headed in that direction – the radical Shia  cleric, Muqtada al-Sadr and his Mahdi army (famed for their long battle with coalition troops during the 2003-2011 Iraq war) is already rallying his troops to make a stand, should ISIS decide to march on Baghdad. Ayatollah Ali Sistani, the highest ranking Shia spiritual leader in Iraq, has also called on all Shia to defend their homes against ISIS. It won’t be long before al-Sadr and Sistani call on their Shia brothers in Iran, Hezbollah and the Assad regime to come to their aid. There have already been reports of Iranian fighter jets being deployed within Iraq’s armed forces to bomb ISIS held areas in Mosul, Fallujah and Kirkuk. If the fighting intensifies, Saudi Arabia, Turkey and the Sunni kingdoms in the Gulf will continue sending piles of cash to aid the cause of ISIS and their Sunni brothers.

The outlook for the region is very grim – perhaps the best prospect for lasting peace is for Sunni, Shia, Kurdish, Druze, Christians and all the peoples of the region to come together and live in harmony. But that hasn’t happened for centuries. Will it ever happen?

Rest in peace Tata Mandela

Below is a tribute to the late South African leader, Nelson Mandela by a South African colleague:

“Thank you Tata Madiba

If Mandela (and many more like him)  had not stood up and fought against apartheid I would not be writing this post.

I would not have been employed by one of the big 4 International Accounting Firms in their Cape Town office as a junior tax consultant in 1998.  It seems inconceivable today that  at the time I was the second black African employed by the tax department. 

He taught us "Ubuntu" ...to be human.  To forgive even your prison warden and people who treat you badly ........for your own freedom.... to allow you to move forward.
Lala kahle Tata Madiba siya kubonga
(rest in peace Tata Madiba thank you)”

She couldn't have put it any better. This goes to show how much Mr. Mandela and his compatriots, who fought against apartheid have achieved. Right up until 1994, South Africa was still under the grips of apartheid.

Next year will be 20 years since the apartheid regime was dismantled after nearly half a century in power. Thank you, Mr. Mandela for your fight. May the ancestors who went before you guide you home to a better place.

It's funny though that whatever top 4 accounting firm she was working for was operating in South Africa during the apartheid years. That was actually the case for several western companies. I don't blame them though...there was plenty of money to be made - the apartheid regime's economic policies were very neo-classical. Many companies that put profit above all else found this attractive and flocked into apartheid era South Africa to do business. Obviously this was made possible because several western countries, did not impose sanctions on South Africa during those dark years.

The right thing should have been for the US and other western countries to impose crippling sanctions on the apartheid regime, as enthusiastically as they did on Iran, for which we're seeing an about-face in Iranian policy. I will always have an issue with Ronald Reagan & Margaret Thatcher for their cozy ties with the apartheid regime. They never publicly endorsed apartheid, but their so-called “constructive engagement” policies, created conditions that benefited the regime and enabled it to survive. Margaret Thatcher actually considered Mandela a terrorist for a long time. It totally makes sense why many people in Africa, celebrated when Thatcher died. 

To make matters worse, while most countries had imposed diplomatic and economic embargos on South Africa, the US, Britain, Israel, France and a handful of western nations, continued to have normal trade and political relations with the apartheid regime. As an African, the suffering of my fellow Africans at the hands of white Afrikaner settlers, coupled with the close economic ties these countries shared with the perpetrators of these heinous crimes, left a sour taste in my mouth. In the end, the forces of good prevailed and many of these countries, including the US, were left on the wrong side of history.

I will tell you who was on the right side of history though – Fidel Castro. Castro’s contribution to the fight against apartheid was pivotal. I consider him a great man, simply because of that. The presence of thousands of Cuban freedom fighters in Angola and Namibia, made all the difference, in the decisive phases of the Angolan and Namibian Bush wars. South Africa’s defeat at the hands of Angolan forces (with the help of Cuba) and their eventual retreat from Angola in 1988, was the last nail in the coffin of apartheid. Why? Because strategically, Angola played a key role in the fight against apartheid. The anti-apartheid movement smuggled weapons through Angola to help the armed struggle. Therefore, de-stabilizing Angola was a key national security priority of the apartheid regime.

However, after the apartheid regime lost the Angolan Bush war, it became clear that their position was untenable. This explains why these 3 events – the Angolan Bush War, the Namibian War of Independence and the fight against apartheid were closely related. South Africa retreated from Angola in 1988, Nelson Madela was released from prison in February 1990 and Namibia declared independence from South Africa, a month later, in March 1990.

Thankful to Mandela and all the others who rose up and fought against such an unjust system. Rest in peace Madiba Mandela. You'll be sorely missed.

Gen. David Petraeus – A Thought leader in the making

By Delaena Kalevor

On Friday November 9 2012, Gen. David Petraeus resigned as CIA director amid a sex scandal with his biographer. The retired 4-star general and husband of 37 years expressed his remorse and poor judgment in indulging in this extra-marital affair. Even though I greatly admire Gen. Petraeus, I agree he did not conduct himself properly.

However, I am not here to pass moral judgment on his character - after all no one is perfect. Rather, I would like to address his intelligence, candor and leadership; and highlight some of the management lessons that myself and other aspiring thought leaders can draw from his life. In my eyes, Petraeus is still a great soldier and I don’t care what conversation you’re having; but when you mention the likes of Dwight Eisenhower, Vo Nguyen Giap, Colin Powell and Norman Schwarzkopf, you should mention Petraeus. I’d hate for his otherwise stellar career to be defined by this single act of indiscretion and weakness.

Gen. Petraeus pretty much wrote the script on the US army’s counter-insurgency strategy during the Afghan and Iraqi wars. While, Donald Rumsfeld was blindly carrying on a bloody war of attrition against the Taliban/Iraqi insurgents, Petraeus was quietly but resolutely advocating his counter-insurgency strategy. Rumsfeld’s strategy was apparently to kill as many Taliban as possible to rid Afghanistan of their influence. That strategy of using overwhelming military might to break the enemy’s will is hardly effective. If it was, the U.S. would have defeated North Vietnamese general Vo Nguyen Giap during the Vietnam War. The U.S. dropped more than 7 million tons of bombs on Vietnam and Cambodia during the war (more the twice the tonnage deployed during World War II) yet Saigon fell to General Giap and communist North Vietnam; eventually marking their victory over the United States.

By the same token, America’s overwhelming military might, even though it killed hundreds of thousands of people, was doing little to break the Taliban and the die-hard Iraqi insurgents. At the risk of being isolated from the Pentagon and appearing as a renegade general, Petraeus continued to advocate his counter-insurgency strategy. At a point, he was even assigned to train the Iraqi army – a move apparently intended to punish him for his independent thinking. I say this because, in a war this important to US Foreign policy, being assigned to a training position (instead of a combat position) could be interpreted as a punitive measure. A training position such as this definitely seemed like a dead-end job.

Still, Petraeus continued to push for his ideas. He had the moral courage to fight for his ideas and he used a rare combination of persistence, tact, ambition, intelligence and humility to forcefully drive them home. Because he was an intellectual, he had thought things through for himself, come to the conclusion that the Pentagon approach was wrong and he had the confidence to push for the right ideas. This is Thought leadership!

His big break came when President Obama appointed him Commander of the International Security Assistance Force (ISAF) in Afghanistan to replace General Stanley McChrystal. As commander of NATO forces, Petraeus now had the leeway to implement his counter-insurgency strategy. Instead of carrying on a war of attrition, he started to build relationships with Afghan tribal leaders in the hostile countryside.

NATO patrols, which hitherto involved raiding Afghan villages to interrogate suspected insurgents, had a complete overhaul. Petraeus recognized that the insurgents had infiltrated the civilian population and had embedded themselves among them. So instead of raids, NATO patrols involved visiting tribal leaders to ask about how "things were going", "what they needed", "whether they needed a well drilled for drinking water", etc. Petraeus gained the trust of the communities as a result and the insurgency started to decline. The strategy simply involved three steps: clear, hold and build - isolating the insurgents by gaining the trust of civilians; consolidating the trust and securing the area; and building infrastructure and institutions to help the people.

His counter-insurgency strategy was the turning point in the coalition’s success in Afghanistan and Iraq. He literally won the war for NATO without as many casualties. Sun Tzu, would have applauded Gen. Petraeus. To paraphrase the great Sun Tzu, sheer military might alone does not necessarily convey an advantage in warfare.

The great Gandhi, decimated the mighty British empire without a single violent act. And I say Gandhi decimated the empire because that is my interpretation - India was the British crown's most prized possession. It was vast, densely populated and it had a great civilization. As soon as they (the Brits) lost India in 1947, they lost most of their other colonies (including my home country, Ghana) in rapid succession. So Gandhi did destroy the once mighty British empire. Again, Sun Tzu would've applauded Gandhi. Winning a war is not about killing people. It's about winning them over - breaking their will, mentally. And this is exactly what Petraeus tried to do with his counter-insurgency strategy.

In conclusion, despite his moral weaknesses, Petraeus is still a great leader. The greatest of his generation. He should be remembered for his great deeds not his indiscretion.

What do Lionel Messi and Charles Simonyi have in common?

Have you ever used Microsoft Word, Excel or any of Microsoft’s office applications? If so, then you have Charles Simonyi to thank – he’s the geek that developed them.

Simonyi was born and raised in Hungary during one of the most difficult times in the country’s history. After earning his PhD in Computer Science from Stanford in 1977, he worked at Xerox where he was part of a team that developed one of the earliest PCs before he joined Microsoft in 1981. As an international student Simonyi struggled with work visa issues for a few years till he applied directly to Bill Gates for a job at Microsoft. Gates, seeing the potential in Simonyi paid for all the paper work required for Simonyi to have the unrestricted right to work in the U.S. Little did he know that Simonyi would eventually develop the most profitable of Microsoft’s products – Microsoft office. He went on to develop other pioneering algorithms and computer programming conventions that form the cornerstone of many Microsoft applications. After interviewing Simonyi, Bill Gates realized that the guy was special. He was gifted. So he went above and beyond the call of duty to make sure he could exploit his talent. And boy, did he exploit that talent. Where would Microsoft be without Microsoft office?

Ultimately, spotting exceptional talent and creating an enabling environment that maximizes that talent is what distinguishes great CEOs from good CEOs. Gates gave Simonyi the room to bring the full complement of his creativity to bear in developing office and in the end, a game-changing application was created.

So what does all of this have to do with football or Lionel Messi? Simonyi’s experience is similar to that of Messi in a few ways. Messi was born in the small town of Rosario, Argentina in 1987. Football scouts from FC Barcelona saw him play and immediately realized that he was gifted. In 2000 at the tender age of 13, the club paid for all expenses to relocate Messi and his family from Rosario to Barcelona. Messi needed his family with him because he had some health issues – he had to undergo treatment for growth hormone deficiency which Barcelona fully paid for. So just like Simonyi’s case, some C-level executive with decision making power saw the potential in Messi and decided to do whatever it took to exploit his talent. Messi didn’t debut for Barcelona until 2004. He spent four years in training at Barcelona’s football academy after his treatment. For someone to invest that much time and money in untested talent shows the strong conviction of FC Barcelona’s bet on Messi.

But it didn’t stop there. Just as Gates gave Simonyi the room to maximize his creativity; Barcelona’s coach Pepe Guardiola allows Messi room for creativity by setting up the attack formation around him. Messi is at his best when Barcelona plays the 4-3-3 or the 4-3-2-1 formation. Football may seem simple on TV but it’s a highly technical game. Realizing how gifted Messi is; Guardiola always tries to use this formation or variants of it (such as their deadly 3-4-3 formation) to ensure that Messi is at his peak performance. The results speak for themselves. Messi has won multiple UEFA Champions League titles with Barcelona in addition to winning the Spanish La Liga multiple times. He is the first footballer to win the FIFA Ballon d’Or for three years in a row.

So why does Argentina have the world’s best player yet hasn’t won a major tournament since winning the world cup in 1986?  Clue – it’s not because Messi doesn’t play his heart out for his country. Messi loves Argentina dearly – Spain offered him citizenship to convince him to play for the Spanish national team but he chose to play for his country of birth even though he and his family have lived in Spain since he was 13. So if he loves Argentina so much why isn’t he at his peak when he plays for his country? The answer lies in leadership (or a lack thereof). Part of the reason for Argentina’s lackluster performance on the international stage is because they lack a tactical coach who will exploit Messi’s talent.

Former Dutch international Johan Cruyff noted that Argentina’s technical bench needs to study Messi – figure out what makes him tick so they can exploit his talent.

Exceptional talent is rare and so when a team is lucky to have such people; they should be treated as such. Obviously football is a team sport but the likes of Messi and Pele belong to a class of their own – and should be treated accordingly. Finding that sweet spot – the optimal situation in which super-stars coexist effectively and efficiently with the rest of us, is often illusive. CEOs and coaches that find that sweet spot turn out to be the greatest.

Argentina’s new coach Alejandro Sabello named Messi captain of their national team in August 2011. It’s taken them this long to realize that the kid is gifted – let’s hope they’re able to exploit his talent to the fullest. It would be nice to see Argentina square off against arch rivals Brazil in the 2014 world cup finals which will be hosted…where else?… in Brazil.

I came, I saw, I botched – How MySpace was given away for a song

On Wednesday June 29 2011 Reuters reported that News Corporation had sold MySpace for $35 million to Justin Timberlake and Specific Media Inc. - an Irvine, CA based advertising company. Justin Timberlake?! I’ll get to that in a minute. This sale represents a return on investment to News Corp of –94%. 

This deal comes on the heels of a long auction process originally expected to raise hundreds of millions of dollars for News Corp’s exit strategy. In the end, Justin Timberlake emerged as the only white knight. Well, him and Specific Media. In an era where internet companies are commanding ridiculously high valuations in the billions of dollars, it’s hard to imagine the lackluster appetite investors have shown in MySpace's bidding process. Not to downplay Timberlake, but in 2011 where we’ve seen Groupon and Zynga file to go public; and LinkedIn, Pandora and Yandex already go public (all of which are expected to have valuations in the billions) if Timberlake was the best MySpace could do then something must have seriously gone wrong.

News Corporation acquired MySpace for $580 million by outbidding Viacom Inc. in 2005 at a time when MySpace had tremendous potential and was poised for triple digit returns. Or so they thought. However, what actually happened has been a totally different story. News Corp’s management of MySpace has been characterized by one execution flaw after another. I’d like to address one of those – how MySpace handled (or mishandled) its 2009 acquisition of San Francisco, CA based social media company Imeem.

Imeem started in 2003 as a social media website where users could legally share, upload  and stream music and music videos. Imeem was a pioneer of a revolutionary business model – free, advertising supported online music. Imeem generated revenue through online advertising, MP3 downloads, sale of tickets and ring tones, and subscription fees from premium account users. Unlike Pandora where free accounts get only 40 hours of internet radio and are also unable to create their own playlists; Imeem users had unlimited access to stream content online and customize  playlists from different users. It was a daring model and Imeem would have been an explosive success if they had achieved their break-even number of users before the credit crunch hit. They hoped to generate enough critical mass from the free online model in order to raise advertising revenue to pay for music royalties. In 2007, Imeem became the first online music site to acquire licenses from all four major US record labels - Universal Music Group, Sony Music Entertainment, Warner Music Group and EMI Group. However by December 2009, the credit crunch had forced Imeem into solvency problems as it was hard to generate sufficient ad revenue to pay for royalties. MySpace acquired it in a fire-sale for an undisclosed amount.

MySpace's integration of the newly acquired firm was executed horrendously. They botched the migration of Imeem’s data onto their servers in a monumental manner. Within days of the acquisition, MySpace decided to import everything from Imeem onto MySpace servers and shutdown the Imeem website. As an Imeem user, I remember receiving an email from MySpace telling me to create a MySpace account and import my playlists within seven days. With MySpace's convoluted website architecture and its own restrictions on music offerings, many users either ignored the email and lost their playlists as a result; or those that created MySpace profiles, couldn’t find their playlists.

Within a few weeks, MySpace had managed to single handedly alienate millions of Imeem users; effectively making the acquisition worthless. The strategic rationale for the acquisition was to attract more users onto the MySpace site in order to increase web traffic, bolster ad revenue and rival Facebook. MySpace had failed to achieve all three.

Instead of trying to migrate Imeem “overnight”, MySpace should have proceeded with the integration on a phased time table. Just like Google did with YouTube when they acquired it in 2006, MySpace should have maintained Imeem as a subsidiary (while maintaining the Imeem site) and then figure out a way to address royalty payments -  perhaps by making the subscription service more attractive and limiting free users to say X hours of streaming, like Pandora does.

They could have figured out creative ways of generating additional revenue such as bundling the free streaming with other services to attract more traffic to the site. The free streaming would serve as a “loss leader” to attract more profitable complementary services. The idea is once you bundle the free service with other attractive services, you tie your users and increase their switching costs. Over time you limit the complementary services to only premium accounts by which time users’ switching costs would be so high it would make sense for them to buy a premium subscription. It’s been proven empirically that products with high switching costs tend to be inelastic (i.e. less price sensitive). At this point the premium accounts could be tied with “free” file conversion software, online games, messaging service and so on and so forth. These would make premium very attractive, thereby having a consistent fee service plus ad revenue to pay for royalties.

They could also have opened up the Imeem platform to open-source developers to design additional services to complement Imeem’s core offerings. Such a penetration pricing strategy would probably have succeeded in making Imeem a dominant platform. In the technology space, free and open source platforms tend to dominate through network effects. Think of how Google’s Android OS is rapidly gaining market share from Apple’s iPhone iOS.

Once Imeem became the dominant platform thereby increasing the switching costs of users, MySpace could then gradually migrate users on a pilot basis until all Imeem users had MySpace accounts. Once their playlists remained intact, it would almost be guaranteed that Imeem users would visit MySpace in a phased migration. However MySpace lacked the vision, strategy, creativity and execution to stay committed to a working plan that would probably have taken many months (perhaps a few years) but could have been successful.

One can point anecdotally to Former IBM CEO Lou Gerstner who noted that a corporate strategy is only as good as its execution. Think of how GE integrates its subsidiaries – on a gradual basis. Or how Oracle integrated Sun Micro Systems after its acquisition. Or how Google allowed Google voice users to send free international text messages for months before introducing a billing service. It’s all about tying and bundling packages for users.

Instead, MySpace destroyed any potential of accreting value from the Imeem deal and eventually had to cut its losses and exit. Such is the difference between success and failure – having the vision and commitment to work out a gradual plan. In the end MySpace has become a poster child of how NOT to integrate an acquired company.

Remembering Chernobyl and what it means for the energy challenges of the future.

On April 26 1986, a series of explosions at a nuclear power plant in Chernobyl, Ukraine led to the emission of huge amounts of radioactive contaminants over a wide geographical area. Much of Europe was contaminated with catastrophic levels of ionizing gamma radiation and nuclear fission particles including radioactive iodine, cesium and strontium.  As of 2008, the WHO estimates the deaths resulting from the long term effects of the radioactive fallout from the accident at 4,000. Other estimates range from 200,000 to 985,000. On the 25th anniversary of what has become the worst nuclear accident in history, it’s important to reflect on the role of nuclear energy and engage in a broader discussion on global energy consumption patterns.

The US Department of Energy estimates that nuclear energy currently accounts for 20% of US electricity and 70% of its “carbon free” electricity. Fossil fuels account for close to 70%  of US electricity generation with coal accounting for 46%, natural gas 23% and petroleum 1%. Coal accounts for the bulk because it is a relatively cheap source and it occurs naturally in abundant proportions in the United States.

Unfortunately, burning fossil fuels to generate electricity leads to significant environmental pollution. Combustion of coal for instance produces unfathomable amounts of green-house gases such as carbon dioxide, carbon monoxide, sulfur dioxide and heavy metals like mercury, uranium, thorium and arsenic. Plumes of thick poisonous smoke billowing from coal-fired plants produce significant amounts of fly and bottom ash that permanently stay in the earth’s atmosphere and become smog. Aside from the green-house gases and their well known effects on global warming and climate change, the ash predisposes residents in close proximity to fossil-fuel combustion plants to lung cancer. Coal mining can also affect the water table and contaminate underground water. Arsenic and mercury poisoning of underground water resources has led to many deaths in Bangladesh and neighboring countries. In addition to the green-house effects of sulfur dioxide, it also contributes significantly to acid rain.

With such a devastating environmental impact, it’s important to focus attention on carbon free sources of energy. The Obama administration has been making a strong push for clean energy with emphasis on renewable sources such as wind, solar and hydroelectric power. In December 2010, however, Energy Secretary Steven Chu said that the administration’s push for a clean energy standard could include non-renewable sources such as nuclear energy and clean coal. While nuclear energy is carbon free it comes with a separate set of costs. In the wake of the Fukushima I nuclear crisis following the March 11 tsunami in Japan, nuclear energy as a source of generating electricity has come under serious scrutiny.

Nuclear power is produced by the splitting of the nucleus of dense fissile material (such as uranium or plutonium) which generates an incredible amount of energy. This reaction is referred to as nuclear fission. Nuclear fission is exothermic (meaning heat is released) and it is that heat energy that powers a nuclear reactor to generate electricity. The problem with nuclear fission however is that the nuclear chain reaction produces particles that are different from the original element, a process called nuclear transmutation. Therefore the fission products – iodine, cesium, krypton, cadmium, strontium, xenon, lanthanides, etc tend to be highly radioactive. They have unstable nuclei and decay spontaneously by emitting ionizing radiation. They become even more dangerous when radioisotopes of iodine and cesium get absorbed in the human food chain. These ultimately become silent killers because they are absorbed into the leucocytes predisposing people with prolonged exposure to leukemia and other forms of cancer. Cesium-137 is even more dangerous this way because it has a half life of 30 years. This poses a serious problem for nuclear waste disposal and storage.

Normal waste can be easily disposed – hydrocarbons can be recycled, organic waste decays naturally because it’s biodegradable and the rest can be incinerated. The problem with nuclear waste is infinitely more complicated. Uranium 235, the uranium isotope used as a fuel rod in nuclear plants has a half-life of 700 million years. Half-life is the time it takes for an element undergoing radioactive decay to decrease by half. With a half life that long it becomes a major headache to safely dispose of spent nuclear fuel. It’s also worth noting that while spent uranium undergoes its natural decay in storage it emits particles/fission products that are also radioactive.

The largest environmental cleanup exercise in the world is currently underway at the Hanford nuclear site in Hanford, WA.  Hanford was the first full scale plutonium production reactor in the world. The plutonium bomb dropped on the city of Nagasaki during Word War II was manufactured at Hanford. The facility was decommissioned in the 1970s but disposal of the radioactive waste has been a problem since then. Much of the spent nuclear waste on the site is stored underground in double shell tanks. These tanks have corroded from rain over the decades and it is feared that liquid radioactive waste could seep into the ground and contaminate the area’s underground water and possibly the Columbia River further downstream. A major groundwater remediation project costing the government billions of dollars is currently underway there. Furthermore, the Hanford Waste Vitrification Plant (after construction is complete) will process nuclear waste into canistered glass logs for long term disposal at an underground national repository yet to be determined. The purpose of vitrification is to make radioactive waste stable (neither decay nor react with other elements) by heating the radioactive waste in a furnace with fragmented glass. The resulting glass is a new substance in which the waste is bonded into the glass matrix when it solidifies. This new glass is very stable and suited for long term underground storage for up to thousands of years. This project has been ongoing for close to a decade and it’s expected to cost the federal government up to $200 billion in 50 years.

Obviously, nuclear energy is not necessarily “better” than fossil fuels as the costs of disposing spent nuclear fuel is enormous. In addition, nuclear reprocessing technology can be used to sequester and harvest fissionable (weapons grade) plutonium from spent nuclear fuel to manufacture nuclear weapons. Over 90% of spent nuclear fuel is made up of several isotopes of uranium. Reprocessed uranium can also be re-enriched to recover Uranium-235 which is weapons grade. The by product of uranium enrichment, depleted uranium is commonly used in mortar shells of army tanks. Given it’s potential to lead to the proliferation of nuclear weapons, spent nuclear fuel (or their lack of proper disposal) poses significant challenges. Despite this grim picture, there is some hope. There are significant technologies out there that can considerably facilitate the disposal of heavy metal and nuclear waste.

Two such technologies were developed by ChemNano Materials Limited, a startup based in Akron, OH. The company owns patents to two technologies that remove heavy metals and radionuclides (including uranium and plutonium) from liquid or gas. NanoDM is the sequestering agent for heavy metals and NanoUREX for radionuclides. NanoDM can remove heavy metals such as lead, mercury, zinc, arsenic, copper, chrome, and cadmium from liquid or gaseous industrial waste in two simple steps. Waste streams from coal fired plants, ore refineries or chemical processing plants that contain such heavy metals pass through NanoDM which then captures the target metals after a few hours of contact. NanoDM sequesters the metal waste onto solid NanoDM polymer matrix. The efficiency of this technology can significantly save millions of dollars by eliminating several stages in the current treatment of the waste. This technology can significantly complement current clean coal technology to make coal more appealing as a source of energy.

NanoUREX sequesters liquid radioactive waste nuclides onto a solid nanotube matrix. By passing the liquid radioactive waste over the matrix, NanoUREX concentrates the liquid waste which makes it coalesce into solid around the nanotube matrix. This can considerably reduce the volume of radioactive waste for storage. A 2005 Congressional report states that as of the end of 2004, total inventory of discharged spent fuel from nuclear power plants across the country was 54,000 metric tons. NanoUREX can help reduce the volume of this radioactive waste considerably. The technology can also complement the vitrification plant at Hanford, WA by reducing the volume of nuclear waste that has to be vitrified for storage.

Furthermore, significant investment should be made into Carbon Dioxide Capture and Storage (CCS) technologies. CCS is a broad term that encompasses a number of technologies that can be used to capture CO2 from point sources, such as power plants and other industrial facilities; compress it; transport it mainly by pipeline to suitable locations; and inject it into deep subsurface geological formations for indefinite isolation from the atmosphere. As world energy demand increases, propelled by China’s exponential growth, much of the supply has come from fossil fuels. This has had adverse effects on climate change and global warming. Therefore clean coal will remain a critical tool for the future management of energy policy.

Finally and most important, renewable sources of energy should become an integral part of global energy needs. Wind energy, hydroelectric power, geothermal energy, tidal energy, biofuel, ethanol, and solar energy must be encouraged to help reduce the carbon footprint from fossil fuels. An August 2010 BusinessWeek article titled “Obama: Clean Energy's Venture Capitalist-in-Chief” commented on the administration’s aggressive policies towards promoting renewable energy. I think the President is making the right bets by promoting sustainable energy. The costs of inaction could be much worse.

KALEVOR: Accounting treatment of Convertible Debt and Bonds with detachable stock warrants – a conceptual evaluation

                                           Source of image: Investopedia.com

Behavior of the Price of the conversion option of a Convertible Bond

When I was at Simon, my Corporate finance professor, Cliff Smith had a fascinating way of using humor to engage us in an otherwise technical, often boring subject. During one of his classes on capital structure, he once joked that “on Wall Street, when debt is not straight, we don’t call it gay - we call it convertible.” I was like, what? I couldn’t stop laughing but neither could I stop paying attention. With that said, let’s get a little technical.

The accounting treatment for convertible debt has always attracted a great deal of controversy. The bearer of a convertible bond has the option to convert the bond to equity within some specified time after issuance. The hybrid nature of convertible debt affords the investor the security of holding a bond (guaranteed interest income plus principal at maturity) as well as the flexibility of the added option of conversion if the value of the issuer’s stock appreciates considerably. For the issuer it offers two main advantages – to raise quasi-equity (or mezzanine capital) without necessarily diluting EPS and secondly to raise debt at a cheaper rate. If Google needed to raise $2 billion for instance and the current stock price was $500, it would have to issue 4 million new shares which would have a major dilutive effect. On the other hand it could issue 2 million convertible bonds at $1,000 par each convertible into 1 share of common stock. This way Google is able to raise the $2 billion it needs but only commits 2 million shares instead of 4 million. In addition, issuers are able to raise convertible debt at rates much lower than current market yield to maturity on similar rated straight debt. For instance, Google could issue its convertible debt at a yield to maturity of say 4.5% when the effective yield on similar rated straight debt would be say 6.5%. By foregoing this 2% spread, investors acquire the right to convert their bonds to common stock at a specified time period after issuance.

The conceptual dilemma lies in the accounting treatment of convertible debt at the time of issuance. At the date of issue the method for recording convertible debt follows that of straight debt – all proceeds are recorded as debt, none as equity. The reasons are that at the time of issuance, it is difficult to predict when, if at all, conversion will kick in. At the time of conversion, the debt ceases to exist and is converted to equity. So for instance in the Google example, at issuance the following journal entries would occur:

Cash	$2 billion
Bonds payable		$2 billion

If all the investors converted their debt into equity and Google common stock had a par value of $10:

Bonds payable	$2 billion
Common Stock (2 million * $10)		$0.02 billion
Paid in Capital in excess of Par		$1.98 billion

While this current treatment is logical as the debt ceases to exist after conversion, merely ignoring the equity component of a hybrid security misrepresents its economic reality. The reason is that at issuance investors receive a lower yield on convertible debt compared to similar straight debt. This lower yield represents the opportunity cost of acquiring the conversion option. Secondly, by converting to equity, investors actually lose future interest income till maturity and the principal itself. So why then are we not separately accounting for the equity component at issuance, if the opportunity costs (which are real and quantifiable economic costs) of the conversion option and the equity itself are so significant?

To better understand this argument, let’s compare convertible bonds to a straight bond issued with a detachable stock warrant. As the name suggests a detachable stock warrant can be separated and traded as a separate security from the underlying security (in our example a plain vanilla bond). The warrant is essentially a long term option to buy common stock at a fixed price. The FASB treatment for such securities is to separately account for the debt and the equity component.

For instance, let’s assume that Amazon issues 10,000 bonds with 5-year detachable warrants to buy one share of common stock (par value $10) at $28. These warrants would enable Amazon to price its bond offering below market yield of similar debt that didn’t have such warrants. So for example Amazon’s bonds would normally sell for say 95 cents on the dollar without the warrants based on Amazon’s bond rating. However, because the bonds were issued with detachable warrants they would sell for say par (100 cents on the dollar). Assume further that Amazon’s investment bank estimates the market value of each of the 10,000 warrants to be $30 and that the price for the 10,000, $1,000 par value bonds (with the warrants) was $10,000,000. With these facts, the allocation between debt and equity would be as follows:

Fair market value of bonds without warrants ($10,000,000*0.95)	$9,500,000
Fair market value of warrants ($30*10,000)	300,000
Aggregate fair market value	$9,800,000

So the allocation would be as follows:

Allocated to bonds: (9,500,000/9,800,000)*10,000,000

$9,693,878

Allocated to stock warrants: (300,000/9,800,000)*10,000,000
       306,122

$10,000,000

So here, the investor is buying both a bond and a possible future claim on equity (detachable stock warrant) for which he pays $306,122. The bonds (without the warrants) would have cost $9,693,878 but investors pay $10,000,000. The difference of $306,122 is the price of the stock warrant.

If all 10,000 warrants were exercised the following journal entries would be recorded:

Cash (10,000*$28)	$280,000
Paid-in-Capital – Stock warrants	$306,122
Common Stock (10,000*$10)		$100,000
Paid-in-capital in excess of par		$486,122

So the difference between this and a convertible bond is that the underlying bond continues to exist after the warrants are exercised but a convertible bond no longer exists after conversion. Arguably, the conversion feature of a convertible bond is not significantly different in nature from the call represented by a warrant. The litmus test is whether sufficient similarities exist to require the same accounting treatment regardless of the different legal forms.

In its current exposure draft on this issue, the Financial Accounting Standards Board (FASB) suggests that companies should separate the debt and equity components of securities such as convertible bonds. This seems like a reasonable assertion and I’m personally leaning towards it. The fact of the matter is, in either case (a convertible bond and a bond with a detachable stock warrant) the investor makes a payment to the issuer for an equity feature – the option to acquire common stock at some future date. In both cases the payment for the equity option is in the form of a lower yield to maturity compared to the market yield on similar traded straight debt.

The only real distinction between them is the additional payment made when the equity is actually acquired – for a stock warrant, the holder pays additional cash to the company ($28 * 10,000 = $280,000 in the Amazon example); and for a convertible bond, the holder forfeits the present value of future interest income till maturity plus the principal. Clearly, the only real difference between these two hybrid securities lies in the method of paying for the equity component if/when it is exercised; but the economic substance remains the same, regardless of legal form. Based on this, I think it’s fair to expect these two to receive the same accounting treatment at issuance. However, until the accounting rules are amended to reflect this similarity, convertible bonds will continue to remain a controversial issue.