What Lynch Left Out

When Gary G. Lynch produced his 85-page report on the Kidder, Peabody & Co. trading scandal, it seemed to slam the final nails into the coffin of that widely tarred villain--former government bond chief Joseph Jett. In excruciating detail, Lynch piled fact upon fact in buttressing his view that Jett, by dint of "lax" supervision, was responsible for $350 million in phony trading profits from 1991 to 1994. Jett has protested his innocence, but after the Lynch report, his protests seemed to ring hollow. It was, after all, Jett's word against a dispassionate investigation by a former chief of enforcement at the Securities & Exchange Commission. Whom would you believe?

Jett? Hardly. But a critical reading of the Lynch report casts grave doubt on its credibility, too.

Copies of the report have been circulating for a week now on Wall Street, and unanswered questions have become jarringly apparent. Those omissions call into question the fairness of the report, and so does the soft-pedaling of a crucial fact favorable to Jett--a managing director's assertion that he was told fixed-income chief Edward A. Cerullo was "aware of Jett's trading activities." That contradicts Lynch's conclusion that Cerullo was unaware of Jett's trading strategies--and even calls into question Lynch's assertion that Jett acted alone.

The upshot is that the truth of the Kidder affair may very well lie between Jett's version and Lynch's. Jett claims that his trading was known to his bosses, Cerullo and his predecessor, Melvin Mullin. Cerullo and Mullin, both of whom left Kidder after the scandal erupted, have vigorously denied that they were aware of Jett's trading. To the extent that Jett can show culpability up the chain of command, the consequences would be ever more serious for Kidder.

Here are the questions that are being raised about the Lynch report:

-- Where were the auditors? Kidder has maintained, and the Lynch report confirms, that Jett realized phantom profits by a series of phony transactions that involved stripping and reconstituting Treasury bonds. That involves turning bonds into separate interest and principal components and vice versa. The report says Jett obtained profits out of those transactions by manipulating the firm's trading and accounting systems. The volume of phony trading was mind-boggling--$1.7 trillion in 1993 alone--and resulted in profits of Jett's zero-coupon trading desk skyrocketing during 1992 and 1993. But the report provides meager information on the extent to which auditors at Kidder or its parent, General Electric Co., checked to see if the trades were real.

The report says that internal auditors at Kidder conducted two reviews of Jett's trading desk in 1993 but never caught on because they were inexperienced and were given "misrepresentations" by Jett. But what about 1991 and 1992? What about other audits by Kidder and GE auditors? Were there any? The report doesn't say--even though $350 million in phony profits were piling up in Kidder and GE ledgers. In 1993, Jett's phony profits totaled 27% of the profits of the entire fixed-income unit--all of which were accumulating on assets sitting in the Kidder coffers. Indeed, they also boosted the balance sheet of GE--which is conspicuous by its absence from the report. "I can't believe that Kidder and GE auditors didn't look at the quality of those assets," asserts John Shank, a professor of accounting at the Amos Tuck School of Business at Dartmouth University. In fact, GE never did--at least while Jett was doing his trading. A GE spokesman says GE audits Kidder every 18 months, most recently at yearend 1992. Then, the audit concentrated on "hedging effectiveness," mainly mortgage derivatives and government options, and "the government Treasuries desk was not involved."

-- Where was the cash? One gaping hole in the report is the omission of a single word--cash. According to Kidder, the Jett trades--to the extent any were completed--were not really trades at all but conversions of securities, akin to going to the bank and changing a $10 bill into two fives. Not a penny entered Kidder's coffers. Once again, where were the folks in the green eyeshades? Where was Kidder Chief Financial Officer Richard W. O'Donnell? "The disparity between the volume of profits and absence of cash should have tipped off the internal auditors," says a top executive at another brokerage. A Kidder spokesman said that O'Donnell and other employees were not commenting on the report.

The lack of cash also should have been a red flag for Cerullo and Mullin. According to the report, they relied on internal statements that didn't distinguish between profits from sales of securities, or "realized" profits, and "unrealized" profits from increases in the value of the securities. "An analysis of realized vs. unrealized gains would have brought the Jett scheme to light earlier," says the Lynch report. Indeed, the report goes beyond that--by noting that Jett's supervisors simply didn't know how he made money.

Executives of other firms, who would comment only on condition of anonymity, find the professions of ignorance all but impossible to believe. At the very least, managers know if their subordinates' profits are realized or unrealized. Maybe not on a minute-by-minute basis, but month after month, year after year, of ignorance? Impossible. After all, realized profits are cold cash, while unrealized profits can vanish overnight. Securities lawyers say that managers also have a legal duty to keep an eye on their traders. "If, on the face of it, your systems are inadequate, then you are supposed to fall back on personal contacts with the trader," says John C. Coffee, a professor of securities law at Columbia University.

-- Why did "outside counsel" conduct a "review" of the government trading desk in October, 1992? According to the Lynch report, the review was "undertaken at Cerullo's direction." But the Lynch report is silent on the reasons for the review or any of its findings, other than the recommendation, which was ignored, that supervisory personnel review order tickets on a daily basis. The report neither discusses the magnitude of the review nor identifies the "outside counsel."

-- Did Cerullo's assistant say that Cerullo really knew about Jett's activities? If so, that undercuts one of the central tenets of the report. Yet buried on page 67 is the revelation that Brian Finkelstein, the managing director in charge of the repo desk, voiced concerns about Jett's "remarkable profitability" toward the end of 1993. Finkelstein discussed his concerns with Cerullo's assistant, David Bernstein. "According to Finkelstein," the report says, "Bernstein also stated that Cerullo was aware of Jett's trading activities." So what does Bernstein have to say? "Bernstein recalls," the report goes on, "that he suggested that Finkelstein approach Cerullo if he knew of any impropriety." Did Bernstein deny that? The report doesn't say.

-- Where was Carpenter? If Cerullo knew, what about his boss, former Kidder Chairman and CEO Michael A. Carpenter? Did Carpenter ever inquire about how his hotshot trader was making money--at least before Jett was awarded the "Chairman's Award" for his contributions to profitability in 1993? The report is completely silent on possible managerial oversights by Carpenter, a friend of GE Chairman John F. Welch Jr. This omission buttresses the view that the Lynch report was aimed at defending Kidder and GE in the ongoing government probes. Kidder maintains that the report was a well-financed, no-holds-barred probe of the Jett affair. Nevertheless, Kidder faces investigations by the SEC and the U.S. Attorney's office. Depending on their seriousness, failure-to-supervise charges could result in big fines being imposed on Kidder as well as government-ordered managerial changes, Coffee notes.

-- What does the report indicate about the rest of Kidder? Perhaps the most crucial omission from the report is a subject that it was never supposed to cover: What about the rest of Kidder? If the managerial and auditing shortcomings in the government bond department were duplicated elsewhere at the firm, the implications are staggering--particularly for its huge mortgage-securities area, which was severely hurt by the collapse of Askin Capital Management. As portrayed in the report, "the risk management at Kidder is equivalent to the lookout on the Titanic," sneers one veteran fixed-income trading executive. "If Kidder can get hoodwinked on something as simple as government bonds--that's just interest-rate risk and mathematics--you can imagine what's going on in its mortgage desk."

For the moment, though, Kidder is preoccupied with controlling the damage caused by the Jett mess. So far, Lynch has been winning the public-relations war. Can his analysis be believed? Perhaps. But until those gaping holes are filled, the best approach to the Lynch report is to see it for what it is--a brief for the defense of a brokerage firm that may be in serious trouble.

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