I recently listened to the Great Courses series of lectures, entitled Crashes and Crisis: Lessons form a History of Financial Disasters, hosted by Professor Connel Fullenkamp. It was so entertaining that this week I am considering some great economic disasters from history to see what lessons they might impart for the compliance professional. So far, I have considered the Dutch Tulip Bubble from the 1630s and the South Sea Bubble of 1720. Today I review the Mississippi Bubble of 1720 and John Law.
The Mississippi Bubble has nothing to do with the state of Mississippi or the great river but rather a French trading company which had been granted an exclusive charter by the King of France to develop France’s territory in the Mississippi territory in the New World.
Fullenkamp said of the scandal, “In 1720, a Scotsman named John Law was put in charge of the entire French economy and given free rein to put his ideas about money, banking, and finance into effect. Law did get the French economy moving, but along the way, he also helped create one of history’s most famous, and least understood, financial bubbles: the Mississippi bubble.” It is a prime example of what can happen when governments put radical economic theories into practice on a large scale.
One cannot understand the Mississippi Company Bubble without understanding John Law. Whoever said that economists are universally dull, drab and dreary never met John Law. A genius with numbers and a profligate gambler because of the card counting he could do; Law fled from England to the Continent after killing a rival in a duel. He studied finance in Amsterdam, Venice and Paris. He was one of the first proponents of removing the gold backing of specie, claiming that, according to Jesse Colombo, “the use of fiat currency would stimulate commerce. Due to these distinct views, Law is often considered to be an early Keynesian-style economist.”
Through royal connections and maneuvering, in 1717 Law acquired the Mississippi Company and the exclusive royal charter. In July 1719 he purchased the right to mint new coinage for the country. In August 1719 the company obtained the right to collect all French indirect taxes and in October 1719 the Compagnie took over the collection of direct taxes. The final step was a plan “launched to restructure most of the national debt, whereby the remainder of existing government debt would be exchanged for Compagnie shares. By this time, John Law had amassed an incredible amount of power as his companies now controlled both France’s foreign trade and its finances.”
To pay for these monopoly rights, the Mississippi Company was allowed to issue stock. First, in June 1719, the company was allowed to issue new shares offered at a price of 550 francs, but a person had to pay only 75 francs up front and the rest in monthly installments. Law repeated this tactic twice, driving up the share price to as high as 5,000 francs. Law used these proceeds to virtually wipe out the French national debt. Law then made one final offering of shares at 5,000 francs and for which buyers only had to put 10% down. It sold out almost immediately and it pushed the Mississippi Company stock price up to 9,000 francs.
But the end was nigh as the bust came when two independent, yet inter-related events occurred. The first was that speculators who had bought in at the original 500-franc subscription amount and now held paper worth 10X that wanted to cash in by redeeming that Mississippi Company stock. Fullenkamp said, “People who had bought shares on credit when the price was 550 were sitting on huge paper profits that they wanted to realize. So, they began to sell the shares, and this started to push the share price down in the market.” This led to Law (in his defacto position as French national Treasurer) to issue enough paper money to meet the redemption calls, swamping the French monetary system with enough money to double the money supply and cause inflation, which was already running high to double in six months. This led eventually to stock price devaluation was the French money was devalued.
What does it all mean? Fullenkamp opined, “The legacy of the Mississippi Bubble is a cautionary tale about what happens when economic theories meet reality. John Law had some good ideas about monetary policy . His proposal to increase the money supply when the economy was in recession eventually became a standard policy prescription, especially among Keynesian economists. But not all of his ideas about money were sound, especially his claim that stocks are exactly equal to money. Worse still, to put his ideas into practice, he had unleashed powerful financial forces that he didn’t truly understand. He needed to solve the French government’s debt problem before he could get the economy going . But to solve the debt problem, he had to start the Mississippi Company and provoke speculation in its shares to raise enough money to buy off the king’s debts.”
I thought about the Mississippi Company in the context of the Johnson Controls, Inc. (JCI) Foreign Corrupt Practices Act (FCPA) enforcement action. The bribery scheme involved was quite sophisticated with “a multi-stepped arrangement that required the complicity of nearly the entire China Marine office from the managing director, to the sales managers, the procurement managers and finally to the finance manager. The managing director aided or at times approved requests for the addition of certain vendors to the vendor master file without disclosing that certain sales managers had ownership or beneficial interest in the vendors. After the managing director’s approval, sales managers added bogus costs for parts and services to sales reports, which inflated the overall cost of the project, and generated purchase orders for the bogus parts and services. The procurement manager knowingly approved the purchase orders.” The scheme even included the vendors themselves who “created fake order confirmations for the unnecessary parts and services and submitted invoices for payments.” To complete the circle, the business unit finance manager would authorize the fraudulent payments.
In what can only be called a complete, total and utter failure of JCI’s internal controls, company auditors could not understand the transactions. Further, and with even more evidence of the lack of effective internal controls, many of the transactions were deemed non-material so they were at a level below that which would trigger a review of corporate oversight from JCI’s Denmark office, which oversaw the business unit where the corruption occurred.
For the Chief Compliance Officer (CCO) or compliance practitioner there are several important lessons to be garnered from this enforcement action. First is the absolute requirements for effective internal controls to be put in place. If your company does not understand the transactions that any subsidiary engages in, you have put your company at serious risk. For if a company’s internal auditors cannot understand a series of transactions, then you certainly cannot explain them to an auditor. Further, under Sarbanes-Oxley (SOX) §404 a company must not only acknowledge its responsibility for establishing and maintaining a system of internal controls and procedures for financial reporting and an assessment, but also report on the effectiveness of the company’s internal controls.
This lack of seeming awareness of enhanced risks, is a confounding aspect of this case. The business unit where the corruption occurred was clearly identified as a high-risk business unit of both JCI. If your own company policies, procedures, controls and personnel cannot determine how business is transacted in your organization, you run the risk of a legal violation such as the FCPA or something similar to the fall of the Mississippi Company and John Law, who was forced to flee France disguised as a woman.