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Investors beware — the Great Fraud Reckoning is upon us


A hand knocking over a line of dominos leading to a house of cardsThe tough stock market will push some companies to paper over their weak performance by resorting to fraud.

Tyler Le/Insider

Sam Bankman-Fried was just the start

Get ready for what will feel like an inescapable wave of corporate fraud.

With financial conditions tightening, the market is primed to put pressure on corporate balance sheets, tempting executives to cheat to meet Wall Street’s expectations. 

This is what happens when cash is harder to find — say, after a sustained decline in the stock market or an enormous increase in the cost of borrowing money. First, there is what Bank of America called “corporate misery” as forward-looking numbers come in lower than projected. (That’s already happening.) Then that misery finds a company run by executives who think that by committing acts of fraud, they can obfuscate their dire financial situation.

The risk of running into companies that have moved from funk to fraud gets higher the longer financial conditions remain tight, Howard Scheck, a former chief accountant of the Securities and Exchange Commission’s Division of Enforcement, told me. Now he’s a partner at the advisory firm StoneTurn, where he leads accounting investigations for corporate clients facing allegations of fraud from regulators — like the people at his old job — or shareholders.

“I think we’re going to be very busy this year,” he said.

It’s getting dusty out there

After years of free-flowing money and pools of cash, the dollar drought is here. New cash and funding are getting harder to find, and we’re about to find out what happens when companies and other actors in financial markets get thirsty.

The Federal Reserve has raised interest rates to combat inflation, which, by definition, is supposed to limit the spigot of cash flowing into the economy. Higher interest rates mean taking out a new loan is more expensive, so companies have to think twice before adding debt to fund their operations. And as interest rates have risen, the stock market has fallen off — which makes it harder to get dollars by whipping up new investors or offering stock. Because inflation is raising prices, even when you do get a dollar, it doesn’t go as far. The rising cost of materials and workers is eating into revenues and squeezing the other side of companies’ ledgers.

When dollars become scarce for businesses, customers tend to get spooked and profits get squeezed. The companies that make up the S&P 500 are projected to report an earnings drop of 5% for the fourth quarter, according to FactSet, the first decline in corporate profits since earlier in the pandemic. And the number of companies posting earnings higher than Wall Street’s estimates — typically a bar that’s effortlessly cleared — is already 10 percentage points lower than the average of the past five years. There are plenty of other ugly warning signals that the well for dollars is going dry: Profit margins have declined for the sixth straight quarter, and revenue growth is projected to be the slowest since the end of 2020.

These desert conditions form what people in corporate finance call “the fraud triangle” — a moment in which a motive or pressure to commit fraud meets with the rationalization and the opportunity. When water is scarce, companies and executives try to conjure their own. Right now, the pressure is on for executives to deliver either for their own compensation, which is often linked to a company’s stock price, or for Wall Street.

They may rationalize that they’ll need to manipulate the figures for only a few quarters, until the economy turns up again, or that their company is being unfairly punished by the market. And if they have the power to manipulate financial metrics — the opportunity — they may do just that.

Tide goes in; tide goes out. You can explain that.

Executives have likely gotten used to stocks going up. The past decade, especially the pandemic years, helped the stock market hit “peak stupid,” as I wrote in February — a place where learning from past bubbles was frowned upon and a cascade of money chased dumb ideas. It included dopey dealmaking, profitless initial public offerings, and plenty of proclamations that “this time is different.” Interest rates aren’t the only reason we’re in drought season. We also made a bubble, and as it pops, money will disappear all over the market.

Despite Scheck’s assertion that the risk of a wave of corporate fraud has heightened, he didn’t want to speak in historical analogies. Accountants deal in dots and decimals, and for many of them, comparison lacks precision. But analogies abound.

The clearest is the dot-com bubble of the late 1990s and early 2000s. Back then, the initial colonization of the internet drove a full-on market frenzy. By 1999, companies with no customers and no revenue were going public. The lunacy was crowned by the $164 billion merger of AOL and Time Warner in 2000, now widely considered one of the dumbest mergers in Wall Street history. The tech-heavy Nasdaq index peaked in March 2000 and then spiraled down until it finally bottomed out in 2002.

The dot-com crash, like all crashes, was a money suck, and as cash dried up, some companies that were riding the exuberance crashed and burned early — the FTXes of their day. Firms with real businesses also got squeezed, and some eventually resorted to fraud to look healthy. Take the telecom company WorldCom, for example.

When the tech downturn prompted companies to slash their telecom budgets, WorldCom’s bottom line took a hit. To make it look like it was still growing at a healthy rate, executives started pulling accounting tricks — recording expenses as investments and manipulating cash reserves to the tune of $3.3 billion in fake profits from 1999 to 2001. Eventually, the company imploded, starved for cash and punished by the market and law enforcement. CEO Bernard Ebbers went to prison. Beware of companies that seem to be swimming in profits when others are splashing in puddles.

There be icebergs

Of course, there’s also fraud that goes undetected in times of easy money — companies where the very act of existing means stretching the truth. When the whole market dries up, fraud is harder to hide. This is when we’re going to see companies experience “sudden crises that really weren’t sudden at all,” Francine McKenna, an adjunct professor at the University of Pennsylvania’s Wharton School and the author of the accounting blog The Dig, told me. 

Recall that the disgraced investor Bernie Madoff, who ran a $65 billion Ponzi scheme, was discovered a full year after a bear market started in 2007. He was able to patch and plug holes for a while, but when enough of his clients — who were all hemorrhaging money in the market — called Madoff to get $7 billion in cash back, he didn’t have it. After cobbling enough cash together for months (including from his own checking account), Madoff hit a wall in December 2008 and was arrested a few weeks later.

You can go further back in history to see this dynamic, too. In 1932, American investors lost the equivalent of $4.3 billion betting on Swedish Match, a match company owned and operated by one of the richest men in the world, Ivar Kreuger. Kreuger had managed to hide that he had stretched the company’s finances beyond solvency by raising money on the US stock market while it was raging. When it crashed in 1929, though, it was impossible for Kreuger to keep up the charade. Like Madoff, his investors wanted cash, and while Kreuger was able to limp along for a bit after the crash, he was eventually exposed.

In a recent paper published in the Review of Accounting Studies, professors tried to figure out the amount of fraud that went undetected in the market at a given time — how many people were, in Warren Buffett’s analogy, swimming in the ocean without a bathing suit. The researchers did this by homing in on a strange liquidity event, the collapse of the accounting firm Arthur Andersen. The US government discovered in 2002 that Arthur Andersen had obstructed justice to help its client — Enron, with its infamous $74 billion fraud — cover up its own scheme. This caused a crisis of confidence in Arthur Andersen’s other clients: How many companies did the accounting firm help stay afloat? All of the firm’s clients had to assure investors that they were on the up-and-up. The result was kind of a forced low tide for these companies, a come-to-Jesus moment for any fraudulent firm that Arthur Andersen may have been aiding and abetting. WorldCom was one of them.

“What’s cool about Arthur Andersen’s bankruptcy is that there was a panic among its clients,” one of the study’s authors, the University of Chicago professor Luigi Zingales, told me. “They needed to do all sorts of cleanup.”

Analyzing the resulting exposures, Zingales and his peers found that in any given year, 10% of corporations committed securities fraud and — accidents aside — that 41% of companies “misrepresent” their financial reports. Like in Madoff’s scheme, they may appear to experience a sudden liquidity crisis that is not really so sudden. Down markets demand that companies have real cash flow, and well-hidden fraud generally does not.

Who’s afraid of the big, bad Feds?

If a tree falls in the forest and no one hears it, does it make a sound? If fraud occurs and there aren’t enough law-enforcement personnel to bust it, did anyone really get ripped off? That question may determine just how much fraud will get exposed in the coming months and years. The conditions are ripe for their exposure, but just how many companies are found to be fudging their numbers will be up to the SEC or, in some cases, the Commodity Futures Trading Commission.

“The notion that when things tighten in the economy more fraud gets revealed presumes that the enforcement agency has the slack to prosecute the fraud,” the University of Pennsylvania accounting professor Dan Taylor told me. “And that’s an assumption that’s dubious at best.”

Fraud enforcement has gone up in the past year, but that’s off record lows during the Trump administration. Without enough boots on the ground to conduct thorough investigations, it’s easy to confuse fraud with bad decision-making during a downturn. But Taylor said that increasing enforcement — and the penalties for wrongdoing — is critical to protect investors and ensure businesses are deterred from using deceptive practices.

“There have to be consequences for violating the law,” Taylor said. “If the only consequence for violating the law is a normal business decision, then people aren’t going to consider the legality of the act.”

Wharton’s McKenna similarly thinks legal considerations have been clouded by the fact that authorities have been hesitant to call a fraud a fraud, which could carry penalties such as heavy fines or jail time for individuals. Instead, the enforcement agencies have been explaining this scammy behavior away as “failure to disclose,” which only results in a fine for the corporation.

“If companies disclose the information of how they get to their numbers, it’s not fraud — but it would’ve been 15, 20 years ago,” she said.

That may have been enough when the stock market was on a heater and investors were winning, but it’s not enough when the stock market is falling, the economy is slowing, and everyone from regulators to lawmakers to kids on TikTok want answers. That’s when executives feel the pressure to pump to the max — and it’s when, suddenly, you look around and it seems there’s fraud everywhere.


Linette Lopez is a senior correspondent at Insider.

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