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.

The Godfather–The Pursuit of the American Dream by an Immigrant Family

Michael Corleone

Statue of Liberty

.                                                    

Kicking with my big brother, watching the Godfather II and blazing a cohiba while at it. It was a perfect way to decompress on a rainy weekend in the Pacific Northwest. I make it a point to watch the Godfather trilogy at least once a year as it was pivotal in shaping my passage to adulthood. I haven’t seen the movie in the last two years as the pressures of life have prevented me from doing the things I enjoy. Watching it again this weekend gave me an opportunity to reflect and contextualize the movie to contemporary challenges.

The Godfather II is my favorite among the three. Michael Corleone was ruthless, cunning and nefarious. He called everything right except for killing his own brother Fredo. After finding out Fredo had betrayed him to Hyman Roth, I would have shipped him (Fredo) some place faraway to keep him out of the loop but not kill him. I understand why he did but that wouldn’t be my choice – I’d never kill a brother under any circumstances. Nonetheless, Al Pacino played the role masterfully. Tom Hagen was ever so smart, eloquent and witty as Consiglieri of the Corleone family. How he got Frank Pentangeli not to testify at the Senate hearing is still a mystery to me. It’s a testament to his resourcefulness - Robert Duvall gracefully played this key character. And last but not least, my personal favorite; Robert De Niro as Vito Corleone. It was just a delight to watch De Niro speak Italian. Vito’s meteoric rise to become the boss of all paisans in the Bronx was catalyzed by a single action – his assassination of Don Fanucci. He knew how to pick his battles and he hit it hardest when it counted the most. He cleverly outmaneuvered Pete Clemenza and Sal Tessio (who both introduced him to crime) to become their Don. Brilliant!

Vito Corleone arrived on Ellis Island in 1901 when he was 9 years old from Corleone, Sicily. His whole family had been murdered by Don Ciccio, a rival mafia chieftain who was locked in a turf war with Vito’s late father, Antonio Andolini. He came to America at a time when the US had opened its doors to immigrants from Europe. It is widely believed that the derogatory term “wop” (meaning without papers) referred to Italians because unlike the other Europeans, they were required to carry their immigration papers. I’m not sure how true this is but this didn’t deter young Vito from getting on a ship to America at age 9. It is a testament to the bravery, courage, determination, hard work and resourcefulness of many immigrants in pursuit of the American dream.

Let’s contextualize the Corleone family’s story to the struggles of modern day immigrants in particular international students looking for work in the US. From time immemorial, the US has attracted the best and brightest from around the world because it has always opened its doors to talent. According to Simon School – University of Rochester Dean Mark Zupan, the US has always benefited from this open door policy and tends to lose in the long run when its policies become inward looking and protectionist.

Dean Zupan’s comments come at an important time for this country especially as the economy starts to recover from the deepest recession since the Great Depression. Typically the international students that come to the United States are people that are very smart, highly motivated, hardworking, entrepreneurial and willing to take calculated risks. These are traits that are overwhelmingly synonymous with American values. It was these same traits that drove the pilgrims, the Irish, the Jewish, the Italians, etc to come here. The biggest innovations of the past two decades have come from foreigners working in PhD labs in American universities. Protectionism especially of high caliber talent stifles these traits, kills innovation and in the long run America loses. I have never seen the Godfather through these lenses before but there’s no limit to the kind of things this movie opens your eyes to. That’s what makes it an all time classic.

Unless an international student gets extremely lucky, the challenges he has to face to navigate these issues are unimaginable. Under the shadow of student loans from American banks that are almost impossible to defer, the odds are dire. Yet, I’m sure many international students wouldn’t do anything differently in hindsight. After all, it is the ultimate pursuit - the pursuit of the American dream.

Repo 105 - What happened to Materiality and Substance over form?

Out-going New York Attorney General (AG) Andrew Cuomo recently brought civil charges against Lehman Brothers’ external auditors Ernst & Young (EY) for complicity in fraudulently misleading investors. The AG alleges that Lehman’s then-auditor (EY) assisted the bank to perpetrate financial fraud. In particular, Cuomo has charged the accounting giant with three counts of securities fraud under the Martin Act and a charge of persistent fraud and illegality brought under the Executive Law § 63(12) of New York. The AG claims that EY, by signing off on the controversial Repo 105 transactions worth about $US 50 billion on Lehman’s balance sheet just before it went bankrupt, aided the bank to mislead investors.

Repo 105 (Repo is short for repurchase agreements) involved what amounted to a short-term loan, exchanging collateral for cash up front, and then unwinding the trade as soon as overnight. It involved selling securities for 105% of their value to counterparties with the agreement to repurchase the securities later. Repo 105s have been around since 2001 but they proved particularly useful to Lehman during the subprime crisis in 2008. The underlying collateral that Lehman typically used for its Repo 105 transactions included A- to AAA-rated securities, Treasuries and Agency debt since many of Lehman’s counterparties to the Repo transactions preferred liquid investment grade assets. However during the 2008 crisis Lehman shifted some of its Commercial Mortgage Backed Securities (CMBS) and subprime mortgages — which were falling in value in a very illiquid market off its balance sheet through Repo 105. Merely selling off those assets to decrease leverage would have resulted in significant losses for the bank, therefore Repo 105 came in especially handy. The beauty of Repo 105, according to Lehman adviser Linklaters, was that the firm could book the transactions as a sale rather than a loan. That meant that for a few days Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was; in time for quarterly reports.

When Lehman first designed Repo 105 in 2001, however, there was one catch. The firm couldn’t get any American law firms to sign off on the aggressive accounting. American law firms thought the transactions were loans in reality veiled behind the legal appearance of a sale. Therefore they (Lehman) hired British law firm Linklaters who provided a sale opinion on the Repo transactions under British law. Incidentally, Lehman’s Repo 105 transactions were executed through its European arm Lehman Brothers International (Europe) or LBIE. This “opinion-shopping” provided Lehman with exactly what it needed to book its Repo 105 transactions as sales and is a key argument in Cuomo’s suit.

In response to the AG’s allegations Ernst & Young said:

“There is no factual or legal basis for a claim to be brought against an auditor in this context where the accounting for the underlying transaction is in accordance with the US Generally Accepted Accounting Principles (US GAAP). Lehman’s bankruptcy occurred in the midst of a global financial crisis triggered by dramatic increases in mortgage defaults, associated losses in mortgage and real estate portfolios, and a severe tightening of liquidity. Lehman’s bankruptcy was preceded and followed by other bankruptcies, distressed mergers, restructurings, and government bailouts of all of the other major investment banks, as well as other major financial institutions. In short, Lehman’s bankruptcy was not caused by any accounting issues.”

EY’s response is all true. The provision applicable to the Repo 105 transactions, called SFAS 140, is subject to interpretation, like most accounting rules. Taking a liberal view of its requirements would support the conclusion that Lehman complied with reporting standards and therefore would be difficult for the attorney general to establish that the accounting treatment violated GAAP. Secondly, I remember September 2008 all too well. It was two months after IndyMac Bank had suffered a bank run leading to its bankruptcy following Sen. Charles Schumer’s unrelenting public comments on the banks poor health. It was an era marked with fire sales of undervalued assets, panic, speculation arising from nervous markets and credit contagion.

But the fact of the matter is the AG is not charging E&Y for being responsible for Lehman’s bankruptcy, neither is he saying Repo 105’s violated GAAP or that they caused Lehman’s bankruptcy. At the core of Cuomo’s complaint is whether investors failed to comprehend the risks on Lehman’s balance sheet because the Repo 105 transactions (or their lack of disclosure) concealed the firm’s precarious position.

This brings me to the core accounting convention of Materiality and to a lesser extent full disclosure. Materiality means that accountants only record events that are significant enough to justify the usefulness of the information. Only items that are deemed significant for a given size of operation should be recorded. In other words information is deemed material if it’s inclusion or lack thereof can be significant enough to alter users' decisions or otherwise mislead users. On Lehman’s last balance sheet before it went bankrupt, there were US$ 50 billion worth of Repo 105 transactions. Is this material enough to be fully disclosed in the footnotes to the account? Let’s find out. Based on my audit experience, I would deem a transaction or account to be material if it was either 5 – 10% of pretax income (default for public companies), 0.5 –1% of revenue, 1 – 2% of Gross margin or 1 –5% of Equity. Lehman’s pretax income for the period ended November 30, 2007 (it’s last before it filed for bankruptcy was) was US$ 6 billion. So assuming Lehman was thought to be lower risk by its auditors they (E&Y) would set materiality at say 10% of 6 billion. Meaning any account with a value of at least US$600 million would be considered material. Clearly the volume and dollar value of the Repo 105 transactions for that period alone exceeded reasonable materiality thresholds. The question is was it material enough to require separate and full disclosure on the financial statements? These are difficult questions that have no easy answers.

The other issue is the accounting principle of substance over form. In accounting, real substance takes precedence over legal form. Meaning accountants must look beyond the legal form and consider the economic reality or financial substance of transactions. Repo 105s in all reality would appear to be a short term financing deal; rather than a sale. This would make it some type of collateralized short term loan. Of course recording the transaction as a loan would do nothing to improve the snapshot view of Lehman's deteriorating leverage position on its balance sheet at the cutoff date, which would appear to be the reason Lehman sought legal grounds in the UK to book the transactions as a sale. I mean who sells assets and buys them back after a few days, every quarter at the cutoff date for reporting? Obviously Lehman performed its actions with decent legal grounds but the financial substance was sketchy. Should Ernst & Young have insisted that Lehman separately disclose the volume of its Repo 105 transactions because of the extent of their materiality? Should they have invoked substance over form to restate the financial statements to reflect the Repos as a loan rather than a sale? I don’t know. I do know that the world of finance can be very complicated.

Ernst & Young is a solid reputable firm and this suit is not doing a lot of good to its image. Rather than risk the reputational cost of a prolonged legal battle if this case goes on trial, I would hope Ernst & Young will settle the case out of court. I worked at Ernst & Young prior to b-school and it is solid beacon among the world’s top four accounting firms. Needless to say, it will be interesting to see how this case unfolds.

KALEVOR: Global vertical integration personified – The China Model

China maybe ruled by the Communist party but there’s hardly anything communist about the way the country is run. China has become a global behemoth over the last few decades since Deng Xiaoping begun economic reforms in 1978. Their government is a well oiled machine that runs with blistering efficiency. Decisions are taken quickly and executed with just as much dispatch. The communist party runs the country like a corporation.

In the second quarter of 2010 China surpassed Japan to become the world’s second largest economy after posting a second quarter GDP of $1.337 trillion. Undoubtedly this caps China’s meteoric rise from rural communism to being a global economic force. But the story of China is just beginning. The reasons are simple. Over the past decade, China has been on a relentless mission to control the critical resources that drive its growth – steel, iron ore, oil, agriculture, technology and rare earth elements. At the same time, the artificially devalued renminbi (the Chinese currency) effectively ensures that China controls its export prices, making its export led growth a smooth sail - for now at least. A vertically integrated model that worked successfully for western business moguls such as John D. Rockefeller, Andrew Carnegie, US Steel, BP, Exxon Mobil, etc. Simple strategy, effective results.

BHP Billiton’s (the world’s largest mining conglomerate) $39 billion bid for Potash Corp in August 2010 was not the only time the Australian mining giant attracted China’s unwelcome attention. In November 2007, BHP’s bid for iron-ore giant Rio Tinto crumbled under China’s “dawn raid” on Rio Tinto. BHP had proposed a 3 for 1 share swap for the deal which Rio unequivocally rejected as undervaluing it. At the same time, China’s steel industry, the largest in the world was worried that a BHP-Rio merger would cause a monopoly in global iron-ore production. The combined enterprise would control at least 60% of global iron ore production. Such a monopoly could cause the price of steel to rise and effectively stifle China’s export led growth. China, eager to have control of a crucial ingredient to its expansion would stop at nothing to keep Rio Tinto out of BHP’s hands. BHP raised the bid for Rio to $147 billion on February 6, 2008 but it was too little too late. Just 5 days earlier, China Aluminum Company (Chalco), China’s state owned aluminum producer had launched a dawn raid and bought a 9.3% stake in Rio Tinto. Making it the biggest shareholder, China gained two advantages – they could acquire Rio at a depressed stock price or they could gain enough clout to outvote BHP’s bid. So with a simple strategic move, China now controls an essential ingredient to its growth. They played it beautifully!

It looks like BHP is going to get burned by China yet again. Sinochem Corp, China’s state owned chemicals company has been keenly following BHP’s bid for Potash Corp. (a Canadian mining giant and the world’s largest producer of fertilizer) Why is China so interested in Potash? Simple - agriculture! Potash is a key ingredient in fertilizer and as the world’s population expands and food security becomes important, whoever controls potash production is likely to be laughing to the bank. BHP knows this, but unfortunately for them, so does China. Secondly, as a top consumer of potash, China wants to keep prices for the vital crop nutrient low and does not want Potash in BHP's hands. That situation is still unraveling and it will be interesting to see how it plays out.

Needless to say, this strategy has been very successful for China. Buying foreign companies with the technology they need, moving production to China and eventually owning the technology. A few decades ago the best PC brands were made exclusively in the US. Today, superior brands such as Lenovo and Asus are manufactured in China. Lenovo bought IBM’s PC division a few years back, took production home and now Lenovo is a widely used brand in US markets.

China is getting its hands on everything. Last week state-owned oil refiner Sinopec paid $7.1 billion to the Spanish oil company Repsol for a 40% stake in its Brazilian unit. The new funds will allow Repsol to develop its discoveries in the Guara y Carioca blocks, both located in the Santos Basin off the Atlantic coast, where Petrobras is also actively exploiting one of the largest oil finds in recent history. Petrobras (Brazil’s state owned oil giant) raised $67 billion in a secondary stock offering – the largest such offering in history on September 24 2010. And China will be there, getting a piece of that wealth. It’s remarkable to say the least. But the most impressive story of China’s quest to “vertically integrate” is how it managed to control 97% of the world’s production of rare earth elements (REEs) – a key input needed for its military and technological expansion.

Rare earth elements are a group of 17 naturally occurring chemical elements on the periodic table. They represent a family of minerals found in commercial products ranging from TV displays, cell phones, superconductors to green technologies such as hybrid electric motors and wind turbines. For instance, the rare earth element neodymium is very magnetic and is used in everything from computer hard drives to Toyota's Prius hybrid car. Military technologies such as guided bombs and night vision goggles rely heavily upon rare earth elements. Promethium is a highly radioactive rare earth element and is used in making nuclear batteries.

Since the 1990s, China has been buying up mining companies that own rights to rare earth mines around the world. They gained global market share at an exponential rate by reducing the price of REEs and effectively controlling the market after a few years. Through learning effects and scale economies, China acquired the technology to mine REEs efficiently and the bulk of the 97% of global output comes from the Inner Mongolia region of China. The United States was once the main source of REEs. The Mountain Pass, CA rare earth mine is perhaps the largest non-Chinese source of REEs. In 2005, the China National Offshore Oil Corporation (CNOOC) made a bid to acquire Unocal Corp, the US oil company that owns the Mountain Pass, CA mine. Had the US Congress not blocked the deal, the mine would have slipped quietly into Chinese hands and they would be controlling a near 100% of global REE production.

An April 2010 report by the US Government Accountability Office (GAO) states that this situation poses a serious national security risk. "Defense systems will likely continue to depend on rare earth materials, based on their life cycles and lack of effective substitutes," the GAO reported. The report further stated that it could take at least 15 years for the US to wean itself of its dependence on REEs from China.

The Department of Defense (DOD) and military officials have stressed how rare earth elements form a currently irreplaceable part of devices such as lasers, radar, missile-guidance systems, satellites and aircraft electronics. And many military systems rely on commercial computer hard drives that use rare earth magnets. Even more specific examples of rare earth-driven technologies include the navigation system for the M1A2 Abrams battle tank, and a new hybrid electric drive in the works for the Navy's DDG-51 destroyers. According to the GAO report, rare earth elements might eventually become part of the US National Defense Stockpile. Again, China was one step ahead as they seem to be in recent decades. The rare earth unit of China's Baotou Iron & Steel Group gained official approval in February 2010 to begin building a strategic reserve of rare earth elements, China's official newspaper, People's Daily, recently reported.

Clearly with the amount of control China now holds on these key resources it will become a global superpower without much doubt. China is clearly attempting to backward-vertically integrate the inputs needed for its expansion. In some cases it has set quotas on REE exports to satisfy its own demand for the resource. They set quotas or outright bans for other reasons as well. And they do it because they can.

In September 2010, China imposed a ban on exports of REEs to force the release of a detained captain of a Chinese fishing trawler whose boat collided with two Japanese coast guard ships off the East China sea. Within days of the ban, Japan which was initially adamant, released the boat captain. Now this may seem like a minor diplomatic row, but if China can exercise such leverage, then what it can do with this power remains to be seen.

KALEVOR: The Role of Free Market Economics in the Future

With the U.S. economy spinning dangerously out of control and with G-20 leaders scrambling for options at their recent summit, several questions have been raised about the potency and viability of free market capitalism as a sustainable means of efficiently allocating resources and creating wealth.

Former Federal Reserve Chairman, Alan Greenspan, one of the most authoritative economists of the post WW II period, admitted that he was shocked at the scale and magnitude of this recession which was sparked off by frozen credit markets. At a speech prepared for delivery before a congressional committee in 2008, he said “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity—myself especially—are in a state of shocked-disbelief.”

This raises some pertinent questions, a few of which are: Are we going back to an era of nationalization of private enterprise—given the unprecedented scale of government intervention in the capital markets? Should it be so or should the market be allowed to perform its duty of “efficiently” allocating resources? Is the market really efficient? Or, the market is sometimes irrational? Was Citigroup Inc. really worth ninety-something cents a share when it broke the buck in March 2009? Is this the end of free market economics as we know it?

In the light of all this, I present below compelling anecdotal (the experience of my home country Ghana) and empirical evidence from Adam Smith’s book, Wealth of Nations, that point to all indications that free markets is still the most potent social system for creating wealth.

On December 31 1981, Lt. Jerry Rawlings and his team of air force officers overthrew the democratically elected government of Dr. Hilla Limann. This was the second time that Rawlings had staged a military coup in two years—the first was in 1979 when he led a group of renegade military officers to oust the Supreme Military Council. This marked the beginning of Ghana’s tumultuous slide towards centralized economic planning. Rawlings and his band of idealists were angry about, what they termed, the “greed and corruption” of wealthy politicians and businessmen; thus he promised a “revolution” with his 1981 comeback.

In hindsight, Rawlings genuinely sought to bring progressive change but was in need of proper direction as he led Ghana to find its identity. He seized money, property, and businesses of wealthy businessmen and promised to equitably distribute the nation’s resources to all citizens. His regime centralized all the major sectors of the economy, including agriculture which was its backbone. My mother tells me that she had to queue for hours to buy food from government warehouses in those days. By 1984, the drought that had hit most parts of sub-Saharan Africa had taken its toll on Ghana and millions of people were starving across the country. Rawlings had to turn to the same western liberalized economies that he so despised because of his leftist inclination, for food aid. The fact that Ghana couldn’t survive the drought without food aid leads me to conclude that while centralized economies may satisfy short term goals, over the long haul, they are not sustainable for economic prosperity.

Today, it’s a new Ghana, booming with the fastest growing financial markets in Africa, attracting foreign direct investment, and recording one of the highest GDP growth rates on the continent. By 1990, it was clear that the future of the country lay in free market economics. The state-owned telecommunications, postal, electricity, and agricultural sectors were divested to private entrepreneurs. Under the Financial Sector Adjustment Program (FINSAP), the banking sector was deregulated and a stock exchange was established in 1990.

Free market economics provides the incentives necessary to drive innovation, growth and economic prosperity. It removes the “tragedy of commons” that bedevils centrally planned economies. In his book, Wealth of Nations, Adam Smith (1776), noted that a group is collectively better off, if each individual in the group strives to achieve self interest. The incentives, derived from individual success, motivate everybody to innovate and create value leading to positive externalities that benefit all. This explains why companies especially in biotechnology, pharmaceuticals, aerospace/defense, and robotics deploy billions of dollars in research and development.

But for patent laws that protect their proprietary knowledge and processes, they would not profit from their research and we would gravitate to a Nash equilibrium where no one conducts research at all. With patent laws, these firms benefit the most (for instance, the huge rallies in their stock prices/windfall corporate profits when their patents are approved) from their research, but the community also benefits (positive externality) because of cutting edge cancer drugs, anti-retroviral drugs, etc that their research produces and which save lives. This incentive to innovate, that Adam Smith referred to 300 years ago, probably explains why some small biotech firms tend to be less innovative when they’re acquired by larger pharmaceutical firms. The potency of free market economics is as true today as it was 300 years ago, from this example.

William E. Simon (1978) (63rd United States Treasury Secretary and namesake of the William E. Simon Graduate School of Business – University of Rochester) in his book, A Time for Truth, recounts his experiences as the Chairman of the Oil Planning Committee in the 1970s. He notes how the Energy Planning Office centralized the distribution and allocation of oil resources. The lack of innovation in energy exploration that resulted from government regulation of the sector resulted in a heavy reliance on imported oil. By 1973, the U.S. was importing one-third of its oil, half of which came from the Middle East.

The 1973 oil embargo from Arab countries created a gaping hole in the U.S. oil supply chain. Again, central planning proved not to be sustainable in the face of this crisis. These experiences cemented William E. Simon’s beliefs in laissez-faire capitalism. He wrote that, “there is only one social system that reflects the sovereignty of the individual: the free market.”

These examples overwhelmingly demonstrate that free market economics is the best social system in the sense that it guarantees the primacy of the individual and it creates value as a consequence. The viability and applicability of free markets have no geographic boundaries as demonstrated by the Ghana and United States examples. Finally, the concept has stood the test of time; thus, history is the best argument in favor of free markets.

In the face of the 2007-2009 global recession and the unprecedented government intervention that we’re seeing, the efficacy of this argument remains to be seen going into the future. But that is a story for another day.

Delaena Kalevor is an MBA Graduate from the Simon Graduate School of Business, University of Rochester. Excerpts from this article were part of an award-winning essay he presented to the Simon School for which he was awarded The Prince Family Scholarship for his philosophical insights into free market capitalism.