Chapter 22

Ten Financial Crises That Rocked the World

In This Chapter

Taking a look at foul play

Learning from the misfortunes of others

Finding fallout from faulty accounting

Sometimes, our financial system goes wrong. In these circumstances, it is very tempting to look around for somebody to blame. If we have suffered loss then we deserve to be compensated – or do we?

Some people think that accountancy is a form of advanced arithmetic. As such, the accounts should be an exact representation of the real world position of the company concerned. But accountancy is not an exact science. The records of the past (the bookkeeping) should be a true reflection of the facts, but there are many subjective judgements which need to be made in order to arrive at the financial statements.

In this chapter, we report on situations where things went wrong. Some arose because of the criminal behaviour of the individuals concerned. In other situations people suffered a loss that wasn’t caused by dishonesty – or even incompetence. What links these stories together is that they all provide us with an opportunity to avoid repeating the mistakes made in previous crises.

Enron: Be Cautious of Explosive Growth

Enron (once the world’s largest energy trader) has practically become synonymous with ‘corporate scandal’. Sure, some major scandals occurred before Enron, but the downfall of this company in 2001 rattled the markets with the massive scope of the misdealing that came to light. By how much Enron misstated its earnings is still an open question, but Enron definitely overstated its profits and hid debts totalling billions of dollars by improperly using off-the-books (not shown on their financial statements) partnerships to give investors a false impression about its financial position. Arguably the number could be as high as $20 billion.

Enron’s misdeeds didn’t stop with only misleading investors; company insiders also misled the Texas power market and the California energy market and bribed foreign governments to win contracts abroad. Enron’s lead in the energy-trading scandals exposed the manipulation of the energy market by other key energy companies, including CMS Energy, Duke Energy, Dynegy, and Reliant Energy.

The Enron scandal also took down one of the big five accounting firms, Arthur Andersen, although their convictions for fraud were reversed on appeal. Enron declared bankruptcy at the end of 2001 facing about $100 billion in claims and liabilities from shareholders, bondholders, and other creditors.

Some executives pleaded guilty to felony charges. A federal jury in Houston indicted two of Enron’s former chief executives, Kenneth L Lay and Jeffrey Skilling, on charges of fraud and insider trading in 2004. Lay was found guilty but died before sentence while Skilling received a jail sentence of 24 years. Former Enron finance chief, Andrew S Fastow, who allegedly pocketed $60 million in company money without the board’s knowledge, pleaded guilty and co-operated with the investigation. He was sentenced to six years in prison on one count of conspiracy to commit wire fraud and one count of conspiracy to commit securities fraud.

Today the company is much smaller and is operating under the supervision of a bankruptcy court. Its primary business focuses on the transportation of natural gas.

When you look at the explosive growth of a company – particularly one growing in an established industry by mergers and acquisitions – try to understand how they’re doing it. If the way they’re operating is really opaque, then maybe avoid them. But it’s hard to ignore spectacular growth, so invest – but remember such growth never goes on for ever so don’t forget to take some profits from time to time.

Adelphia and Hollinger: Be Wary of Lavish Lifestyles

Adelphia (a broadcasting and cable TV company) came to a crisis because of its greedy top executives: John Rigas, founder of the company, and his son, Timothy Rigas. The Rigases used the corporation as their personal piggy bank, stealing $100 million from the company that they used for luxurious personal residences, trips, and other items.

In 2004, John and Timothy Rigas were found guilty of concealing $2.3 billion in loans, which were hidden in small companies left off Adelphia’s books. The Securities and Exchange Commission (SEC) charged that in addition to hiding debt, Adelphia inflated earnings to meet Wall Street expectations between at least 1998 and March 2002; falsified statistics about the company’s operations; and concealed blatant self-dealing by the Rigas family, which founded and controlled Adelphia.

Two other executives from Adelphia were arrested in 2002 after the scandal broke. Michael Rigas, another son of John Rigas, and Michael Mulcahey, the company’s former director of internal reporting, were both found not guilty.

Conrad Black famously followed the Rigas example, robbing Hollinger International of millions of dollars to fund a lavish lifestyle. It was said that he used the company as though it were his own and did not belong to the company’s shareholders. His appeal against the jury’s verdict was rejected and he was sentenced to six-and-a-half years in prison on 10 December 2007.

Take care when thinking of buying the shares in a company whose senior managers’ lifestyles are lavish and highly publicised in newspapers and magazines.

WorldCom/MCI: If It Looks too Good to Be True . . .

WorldCom (a telephone company) overstated its cash flow by improperly booking $11 billion in company revenues. The company was first to announce that it needed to restate its financial reports in March 2002, but it wasn’t clear which financial statements the company needed to restate, or why.

Bernard Ebbers, WorldCom’s founder, was given $400 million in off-the-books loans by the company. Criminal fraud charges were filed against Ebbers and former Chief Financial Officer (CFO) Scott Sullivan. Sullivan pleaded guilty to three criminal charges related to the fraud as part of a deal to co-operate with prosecutors in their case against Ebbers. Ebbers was found guilty of fraud in 2005 and given a prison sentence of 25 years and Scott Sullivan five years.

Investor groups filed a class-action case against WorldCom’s former directors, former executives, 18 banks, and former outside auditor Arthur Andersen. A few of these plaintiffs settled out of court in 2004; the settlement included a $50 million payment by some former WorldCom directors and a $2.65 billion settlement by Citigroup, a bank that had promoted WorldCom’s stocks and bonds as good investments, even though it had concerns about WorldCom’s rocky financial position.

Other banks involved in the class action refused to settle at that time, insisting that the banks could not determine which financial statements were false and how the company misstated them. However, as time passed, all remaining investment banks have settled – and probably at higher figures than could have been achieved earlier. The class action is now believed to have raised over $6 billion.

WorldCom filed for bankruptcy protection in 2002. The company emerged from bankruptcy as MCI in 2004, which is the name of a company it bought along the way to building its kingdom. As part of the bankruptcy settlement among the company, the courts, and the creditors the company’s debt was reduced by 85 per cent to $5.8 billion, still leaving many creditors with little or nothing. Shareholders also were left with nothing, and their shares were worthless after the company emerged from bankruptcy. In turn, MCI was acquired in 2005 by Verizon Communications Inc, which thus became the biggest telecoms company in the US at the time.

If it looks too good to be true it probably is.

Parmalat: Keep It Simple

Parmalat is a good example of just how complicated these situations can be. Everybody knows that some sort of wrongdoing has occurred because 11 people were found guilty in June 2005 for their part in the collapse of the company. But these 11 are those who received reduced sentences (of up to two and a half years) in return for co-operating with the prosecution.

At the time of writing, Calisto Tanzi, the founder of the company, is on trial with others, including external auditors, for market rigging, providing false accounting information and misleading Italy’s stock-market regulator. Tanzi has also been indicted along with about 20 others for fraudulent bankruptcy and criminal association. In addition, five major international banks are due to stand trial for alleged market manipulation. So something big happened – but what?

This much is clear. Parmalat started as a small food company in northern Italy in the 1960s but had grown over the next 40 years to be a major international supplier of dairy products. Their problems came to public notice in 2003 when they had difficulty making a bond payment of 150 million euros. This made no sense since, according to the accounts, Parmalat had very healthy balances of cash on hand. The company then admitted that an amount of 3.9 billion euros, which it thought it had in the bank, did not in fact exist. It later emerged that the auditors had sought confirmation of this bank balance from the Bank of America, had received confirmation of the balance on the bank’s headed paper, but the bank said later that the letter was forged. People inside the company as well as outside had been taken in by this device.

As the problems escalated, it emerged that the group actually owed over 14 billion euros in debt – more than double the amounts booked on the balance sheet. Investigators allege that Parmalat borrowed money from banks, justifying the loans through fictitious sales. The loans were then moved to other companies which were not included in the consolidated accounts.

There are allegations of double-billing (charging for the same sale twice) and suggestions that the true position was that the company had been suffering substantial losses throughout the 1990s, but we will probably never know, let alone understand, what really happened.

Look for companies who keep their financial activities open and simply stated.

Independent Insurance: Unreliable Info, Higher Risk

At Southwark Crown Court three former directors of Independent Insurance were found guilty of conspiracy to defraud. The charge was that between 1 January 1997 and 17 June 2001, contrary to common law, they conspired together and with others to defraud directors, employees, auditors, actuaries, reinsurers, shareholders, policy holders, creditors and others who had a legitimate interest in knowing the financial condition of Independent Insurance Company Limited and the Independent Insurance Group Plc by misleading them about the true extent of the liabilities of the said companies.

The ‘indie trial’ which resulted in the handing down of sentences of seven, four, and three years on the three directors, is a useful case study for readers of this book. In simple terms, it has been reported that Independent Insurance received claims from its customers that were not entered into its accounting system. Consequently nobody, not even the company’s own directors, knew how large its liabilities were. It was this lack of information that led to the demise of the company. Faced with losses which could not be quantified, and unable to go ahead with a planned rights issue, the company ceased to trade in 2001. Whether there was indeed fraud does not change the important learning point from the indie trial. The directors cannot manage a company without reliable information. If the directors do not have reliable information, then potential investors have even less chance of making reasoned decisions. An investor must look at the reputations of the top people and make a judgement – although it is always easier to judge these things with the benefit of hindsight!

Some of the firm’s 500,000 private and corporate policyholders have been given a total of £357 million from the Financial Services Authority’s compensation scheme since the collapse; but this is a slow process and resulted in financial difficulties for many people who thought they were insured by a reputable company.

Versailles: Don’t Follow the Money-Go-Round

Versailles Trade Finance Ltd (VTFL) was set up in 1991 to provide bridging, or temporary finance for small businesses. The big banks often neglect this area and Carl Cushnie, the founder of the company, claimed to have come up with a new risk-free way to lend to small businesses. It was akin to factoring, selling your accounts receivable at a discount in order to get cash in now, but worked as follows: A client of VTFL wished to sell goods to a customer. Instead the goods were sold to VTFL at a discount (VTFL’s commission) and VTFL then sold them on to the final customer at full price. VTFL would pay the client 80 per cent of the value within 7 days of the sale. The balance, less interest and commission would be passed on when VTFL was paid by the customer.

Money was raised from banks and other backers to finance VTFL. Money was also raised from wealthy individuals (known as ‘Traders’) to finance another group company called Versailles Traders Ltd. The group grew rapidly. It was floated as Versailles Group plc in 1995 and, at its height, the company was valued by the market at £630 million.

However, most of the activity in the company involved transactions with other group companies as money was passed around the group. False documents and management accounts were given to the auditors to hide the fraud. The Serious Fraud Office (SFO) has given a restatement of turnover figures for the years from 1991 to 1999. Out of reported turnover in that period of over £680 million, less than £90 million was genuine.

The company collapsed following a DTI investigation in 1999 owing £70 million to the banks. The Traders had lost £23 million. Cushnie and his Finance Director, Frederick Clough, were both sent to jail for six years.

Barings Bank: Security, Accuracy, and Incompetence

Nick Leeson, a so-called rogue trader, worked for Barings Bank in Singapore as a trader in futures and options. He was regarded as a star because of the profits he was generating from arbitrage trading activities that were, on the face of it, reasonably risk free. He had in fact set up an internal account number 88888 in which to conceal the actual massive losses his activities were incurring. Between 1992 and 1995 the losses reached £830 million – enough to bring the bank down.

The Bank of England in its report concluded as follows:

The losses were incurred by reason of unauthorised and concealed trading activities.

The true position was not noticed earlier by reason of a serious failure of controls and managerial confusion within Barings.

The true position had not been detected prior to the collapse by the external auditors, supervisors, or regulators of Barings.

So there it is again: The crucial importance of secure systems offering managers and directors an accurate picture of the organisation’s financial affairs in time for them to realise what is going on in the physical world by studying the resulting numbers. The fascinating aspect of the case was to see how easily the guardians of the shareholders, the highly experienced external auditors, could be outwitted by a relatively junior trader. Okay, some incompetence existed, but remember that security and accuracy of information is not easy to achieve.

Equitable Life: Spread Your Pension Bets

The story of Equitable Life seems like a financial scandal at first but when looked at dispassionately the story is one of bad luck as much as anything – with a bit of bad judgement thrown in.

The impact of what went wrong was that many pensioners had a far smaller pension than they were expecting after saving in the long term with Equitable Life. (Equitable Life started business in 1762, so they were no spring chickens at the game when it all went wrong.)

In the 1950s Equitable Life started offering Guaranteed Annuity Rates (GARs) to its savers. This safeguarded its pensioners from some of the volatility of stock and money markets by offering a fixed rate of annuity when it came to cashing in their pensions. At the start pensioners probably got a little less than they would have got if they had taken normal market risk. However, high inflation in the seventies, when Equitable were still offering guaranteed annuities, was followed 20 years later by the low inflation and low interest rates of the nineties. This meant that Equitable Life could not possibly pay the guaranteed rates without damaging enormously its other pensioners. They tried to get out of the contracts but the courts would not let them.

So there was a compromise and everyone, those with and without GAR’s, got less pension than they were expecting. So bad luck or bad judgement, but no scandal surely. What we learn from this is not to put our pension savings in one pot: Spread it around a number of providers.

Robert Maxwell: Unfit to Lead

The sheer complexity of corporate and financial life does give those people who will stop at nothing the opportunity to damage other people by their unscrupulous and criminal dealings. Maxwell is a good example of this.

In 1969 a financial scandal cost Maxwell his political career and the control of his business. Despite the fact that a DTI report following these events had dubbed the man ‘unfit’ to run a public company, Maxwell, plainly it should be noted an extraordinary and charismatic man, bought back his company and clawed his way back into running a large media corporation using a huge amount of debt to finance his dealings. That finance became strained until it looked as though he would have problems meeting interest and repayment obligations. Simply put he then used his companies’ pension funds to buy shares in his own companies; this propped up the share price and he used these shares as collateral for further loans.

So this tale is different from the ones where tycoons put their company’s money into their own pockets – this time Maxwell was using the complex nature of cross-shareholdings and so on to prevent normal market forces from hindering what he aspired to achieve. In the end the result is the same, the companies went bust and the pension pot was empty.

They have of course, tightened up the rules on pensions but there are some observers who think that it could still happen again. Perhaps the message from this one is that if a man has been reported unfit to run a company and his empire looks too good to be true, we should use those clues to avoid those shares like the plague.

Northern Rock: Financial Problems Without Wrongdoing

Northern Rock provided the UK with its first bank run for more than a hundred years. Queues formed outside the branches of the Northern Rock as depositors sought to remove their savings. No doubt, when the dust settles, there will be demands for heads to roll. Probably the Northern Rock name will cease to exist having been gobbled up by a bigger rival. But has anyone actually done anything wrong? There is no suggestion that the financial statements do not reflect the true position of the company. The balance of trade receivables shown in the financial statement will already take account of the expected losses on bad debts. The problem is not with financial reporting but with the very nature of business itself.

Northern Rock depended for its cash liquidity on borrowing short-term money from other banks for short periods instead of the normal model of having a high level of depositors’ long-term savings. When the US had its own crisis caused by banks lending sums of money to people who were not very good credit risks this rolled out into a world wide credit crunch. Banks were simply loathe to lend money into the short term wholesale, that is other banks, market. This gave Northern Rock massive liquidity problems that were only solved when the Bank of England became a lender of last resort and lent the bank billions of pounds. The Bank of England also stopped the run by guaranteeing depositors savings.

Northern Rock’s business plan – previously seen as entrepreneurial – is now seen as too risky. Therefore, the market has reacted and shares are marked down. The company has the same assets and liabilities as before but now the market thinks it is worth a fraction of what it was at the start of the crisis. What the Northern Rock case illustrates is that it is difficult to run a big business when the decisions you make today can come back to haunt you in five, ten, or even twenty years time – if you doubt the truth of this, then ask Equitable Life. (See the section ‘Equitable Life: Spread Your Pension Bets’, earlier in this chapter.)

To move to a different issue, financial reporting itself is full of difficulties. For example, a few years ago, it was revealed that company pension funds were massively underfunded. This had been brought to light, we were told, by a new method of accounting for pension liabilities which had just been introduced by the UK Accounting Standards Board. The problem was that very few people (other than actuaries) understood what the figures actually meant. For example, a deficit of £10 billion sounds like a lot of money but the new rules had been introduced immediately after the dot.com crash and a large part of the deficit would disappear as the stock market recovered. What sounded like a financial scandal when the news broke turned out to have no evidence of wrongdoing.

Taking a broad look at potential investments

The stories we have told in this chapter have concentrated heavily, perhaps too heavily, on fraud. Fraud makes the headlines and the stories are always interesting, but through cases such as Equitable Life, Northern Rock and underfunded pensions, we have tried to demonstrate that financial crises can arise through a change in market conditions or even a change in the way that information is reported.

To return to the main themes of this book, when you invest in a company, you must obtain the financial statements. You would be very unfortunate indeed if the statements were tainted by deliberate fraud but remember that accountancy requires the directors to make a lot of subjective decisions so read the accounting policies very carefully.

But you must go beyond the financial statements and examine the business review (this may be called the Operating and Financial Review) and any other statements made by management. This is where you find the details of the business strategy. Try to decide what could go wrong with the strategy. Remember that, if the company is earning high returns then they may well be taking higher risks. If you invest in such a company, then it might give you good returns but, equally, there is no point in complaining if the downside occurs and you are the loser.