Sunday, December 6, 2009

The Quality Rating Question

The credibility of credit rating agencies has taken a major hit during the financial turmoil of the past year. In most cases the credit rating agencies had before them audited financial statements to work with in making their judgments.

In some cases, the judgments themselves seem to have been faulty. In others, the data given the agencies has been faulty, even if audited.

PriceWaterhouseCoopers recently published its “Global Economic Crime Survey 2009”.

Quoting from their report: “…nearly one in three organisations around the world reported they were the victims of economic crime during the past 12 months. Of those, 43 percent said that the incidences of fraud in their organisations had increased during the period…Asset misappropriation or theft, cited by 67 per cent of those who reported crime, was the most pervasive, followed by financial statement fraud, cited by 38 percent…”

A representative of the accounting firm commented: “The global economic downturn has heightened the pressures and incentives to commit fraud…In these tough times, the temptation to inflate results or take part in other forms of financial statement fraud may overcome ethical values…”

If there is pervasive opportunity for misstatements among larger, more closely-scrutinized companies, how much greater is the opportunity among smaller, privately-owned businesses whose financial reports are not audited, or in many cases, even reviewed?

Add increased opportunity to increased incentive and the tests of “ethical values” are likely to be even more severe.

We’ve commented more than once in past posts about the fact that most TRE Sellers do not provide audited or reviewed financial statements. We’ve also made the point that it is the SELLER that makes the promise to re-purchase an unpaid invoice. The credit of the SELLER is actually more important in the TRE format than in many other factoring formats.

It is the nature of privately-owned businesses, many of which are in S-Corp or LLC formats for tax purposes, to allow tax considerations to influence financial reporting practices. It’s not unusual or even unexpected to be told that getting a picture of the “real” operations and profitability of such a company requires the books to be adjusted.

Some of the financial statements provided by TRE Sellers show obvious signs of such “adjustments” and some of those adjustments appear to be made clearly in order to present a more palatable view of their operations to TRE Buyers.

There’s not necessarily anything wrong with that!

The picture that a privately-owned business presents for tax purposes might actually be a seriously unfair view of it as an operating entity for any number of reasons.

But, to the extent that getting approved as a Seller on the Exchange provides incentive for erring on the side of optimism, the prospective Sellers have both opportunity and incentive to overstate their financial health. And that clearly increases the risk to the Buyer.

TRE has, on its staff, former FBI experts in detecting financial fraud. That’s a good thing.

A better thing, in my opinion, would be to also have a third-party rating entity on contract to examine all of the financial statements provided by Sellers and prospective Sellers and to attach quality ratings to all Sellers posting auctions for sale on the Exchange. Since Buyers are prohibited from contacting Sellers directly, there is little realistic opportunity for Buyers themselves to question financial statements provided by Sellers.

The Sellers have a conflict of interest that is clear.

The Exchange itself has conflicting incentives: a) it needs to bring in a substantial volume of new Sellers and so it needs to make the process as easy as possible for them, and b) it needs to protect against embarrassing defaults and losses.

A third party, without such conflicts, would provide the more credible solution.

Does the admittedly tarnished reputation of rating agencies, in general, damage the credibility of that suggestion?

I don’t think so.

There’s no Fannie Mae or AIG or Lehman Brothers, with the clout to bully a rating agency, among the smaller, privately-owned TRE Sellers. If anything, the balance of power between the rating agency and the Sellers would probably invert the opportunity for pressure in the process.

Any Buyer that has looked closely at the financial statements provided by TRE Sellers would, I wager, agree that a third-party assessment would be both welcome and valuable.

Maybe there's a Smyth Solution possible?

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