by Joe Pimbley, who consults for PF2, and director Gene Phillips
The sudden crash of Wirecard dominates
headlines. Though pernicious, the fraudulent activity of this
eminent European company is quite common. Fraud is everywhere and we
must guard against it just as our bodies resist harmful disease.
Fraud at Wirecard
Wirecard, the large
German payment processor and DAX 30 constituent, filed insolvency proceedings
in late June 2020.[i] The firm
had long faced contested allegations of false or questionable bookings of
revenue and profits with pressure increasing in January 2019.[ii] In a final
blow, Wirecard’s audit firm could not verify the existence
of stated balance sheet cash of EUR 1.9 billion.[iii] An apt
description of Wirecard’s subsequent corporate
fate is Lemony Snicket’s “death swooped down like a bat.”[iv]
Fraud is everywhere
Fraudulent statements and
behavior of human beings are as old as humanity itself and will continue until
the death of our species. This sentiment is not a denunciation of
people; it is merely a characterization of human society. As the
joke of our current era goes: human guile is not a bug; it’s a
feature.
Our definition of “fraud”
casts a wide net to include one extreme of telling blatant lies, for example,
to sell the Brooklyn Bridge to tourists, while also capturing the other extreme
of deliberately failing to correct a false impression that others may have of
you. (We know of a Physics Nobel laureate who, in answer to a direct
question, told the U.S.-based interviewer for his first professional job that
his college grade-point-average was 4.0. The interviewer was visibly
impressed. Surprised by this reaction and realizing the
interviewer’s likely error, the future laureate did not qualify the information
by stating that 4.0 was a terrible GPA in his home country of Norway.)
The Brooklyn Bridge story is
the classic fraud example. Most of us would consider the interviewer’s
ignorance of the Norwegian GPA scale not to be an act of fraud on the part of
the young job applicant. Of course, there is a vast middle ground
between these extremes. We see all sections of this middle ground in
our personal and professional lives. Here are a few “middle ground”
examples of varying import one of the authors witnessed directly with past
employers or learned confidentially from colleagues:
- On a derivative trading floor, managers assigned trade identification numbers in a manner that would give counterparties the impression that the trading floor executed ten times more trades than the actual number.
- A risk manager discovered an error in a capital adequacy calculation agreed a decade earlier with the firm’s dominant regulator; the General Counsel chose not to inform the regulator because "it would be confusing.”
- A senior executive of a credit rating agency told a rating analyst what the final rating should be for the debt of a new client (i.e., “just prepare an analysis that reaches the rating we want”).
- Following the ouster of a CEO during a year of painful losses, the new CEO entered and asked the internal accountants to find and take as many additional losses as possible for that current year.
So fraud, in the sense of
giving deceptive information or withholding information for the purpose of
helping an individual, group, or company, is everywhere. These four
examples are somewhat trivial and one might consider only one or two, or perhaps
none, of them to be “true fraud.”
The Ponzi scheme template for
fraud
Broadly, the fraud allegations
against Wirecard are for
misstatements of financial condition and activity. Instead of
delving into the Wirecard details, we discuss
a simpler, generic variant of such fraud that the financial industry calls “the
Ponzi scheme.”[v]
In a Ponzi scheme, an
investment manager solicits funds from investors to make specified purchases of
assets (for example, real estate, stocks, bonds, small businesses, et
cetera). Either through losses on these assets or
embezzlement of the manager or both, the value of total assets
falls. This situation becomes a Ponzi scheme when the investment
manager deliberately misstates the current asset value in reports to the fund
investors. Believing the fund to be healthy and relying on the
(false) manager statements, current investors will tend to keep their principal
invested and new investors will add money to the fund. The Ponzi
fraud may remain undetected as long as investor redemption requests do not
exceed the sum of (diminished) assets and inflows of new investor money.
In its mildest form, the
perpetrator of a Ponzi fraud does not begin the enterprise with criminal
intent. Rather, the manager’s investments perform poorly and,
fearing investor withdrawals and business failure as consequences of honest
disclosure of this performance, the manager chooses to make false statements. This
is the paradigm for Wirecard-like
frauds. Management makes false statements and obfuscations to cover
poor performance or to gain some undeserved short-term benefit.
Fraud is a pathogen of human
society
A pathogen is a virus,
bacterium or other agent that produces disease. Pathogens are
ubiquitous, both internal and external to our bodies. We have
developed practices as well as natural and man-made defenses to counter most
pathogens. Humanity would not exist otherwise. Pathogens
vary widely in their infection frequency and lethality and generally do not
kill their hosts (not immediately, at least).
Fraud is very much a pathogen
of society. Its goal is not to kill the host since, without a mostly
healthy society, fraud would not be fruitful. Like pathogens, fraud
is everywhere and there is no prospect or possibility of eliminating all fraud.
But society has an immune
system deriving from learned and innate caution and skepticism. We
also have experiences and stories of the personal and business worlds that
become lessons for best practices.
Combat fraud as we would a
pathogen
There are many strategies for
investors to avoid fraud just as there are strategies for people to avoid
disease. Our list below blends some time-tested ideas with those
that are most relevant to the Wirecard debacle.
- Be consciously aware that fraud is possible in any investment. It may seem that significant fraudulent activity is less likely in a widely studied investment such as a Microsoft or Wirecard, but fraud at some level is everywhere.
- Think for yourself, ask your own questions. The apparent confidence of many other investors can provide a false sense of comfort.
- Realize that many people are inherently dishonest, and certainly “less than honest.” People do lie.
- Think critically about “the story” of the investment you’re considering. If it does not make sense to you, don’t invest. Trust yourself more than you trust anyone who tells a story you do not understand or believe.
- Three elements of the financial world’s “immune system” to fight fraud are auditors, regulators and credit rating agencies. For any potential investment, determine whether there are relevant auditors, regulators and rating agencies and consult their findings. Illness sometimes prevails because an immune system component fails to fulfil its role.
- Auditors make mistakes. Audit firms investigate the financial statements of their clients to certify absence of material misstatements and adherence to accepted accounting policies. Since the client pays the auditors for the service, the auditors have a “moral hazard motive” not to press fraud investigations vigorously. While most audit firms DO have strong motives to protect their brands and reputations by maintaining high standards for their investigations, that is no guarantee that individual audit groups will do their jobs honestly or competently. Hence, do not base a positive investment decision on satisfied auditors.
- Regulators are government employees. They and the regulations they supervise and enforce are generally well intended. But corporate entities that are willing to deceive investors will also deceive the regulators. Ironically, regulators will often defend their regulated firms from external accusations because it “looks bad” for the regulators if such accusations are valid. Further, the mission of regulators favors protection of the banking system and government interests over those of investors in individual firms. Hence, do not base a positive investment decision on satisfied regulators.
- Credit rating agencies are non-government companies that claim to advocate for investors. They would like you to think of them as “expert investors” that provide unbiased opinions of investment risk. But this profile is inaccurate. The rating agencies do not invest and, therefore, do not take the risk you will take as an investor. Further, their paying clients are the corporate firms themselves, which means that the rating agencies have the same “moral hazard motive” as the auditors. Though the meanings of the credit ratings themselves are poorly defined, we do consider it valuable to have one or more ratings for corporate debt securities you may purchase. For “investment-grade” credit ratings, ~80% of such securities will have reasonably low risk (allowing for the errors that these rating agencies do make). Do not rely only on a credit rating for a positive investment decision on a debt security.
- Pay attention to the statements of vocal critics of entities in which you have invested or may invest. Financial journalists, investment advisors and other investors will sometimes publish negative results from their own investigations. Read such opinions skeptically since the reports may be mistaken or deliberately false or exaggerated. Even when wrong or mostly wrong, such third-party views and rebuttals from the investment entity, if any, stimulate your own productive analysis.
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[i] See “Wirecard files for insolvency owing $4 billion,” New York Post
[ii] See B. Jennen and N. Comfort, “Wirecard Whistle-Blower Tipped German Watchdog in Early 2019,” Bloomberg
[iii] See R. Browne, “It was once Germany’s fintech star. Now, a missing $2 billion puts Wirecard’s future in doubt”
[iv] See L. Snicket, The Miserable Mill, Scholastic, Inc., 2000. The excerpted quote is available at https://snicket.fandom.com/wiki/The_Dismal_Dedications.
[v] See the U.S. Securities and Exchange Commission discussion of Ponzi schemes
