MARK BAUM: But that’s not stupidity. That’s fraud!
JARED VENNETT: Tell me the difference between stupid and illegal and I’ll have my wife’s brother arrested.
—THE BIG SHORT (MOVIE, 2015)
IN CLASSIC WESTERN MOVIES, you can always tell who the bad guys are because they wear black hats. Darth Vader’s black helmet warns that he is evil. But in the Harry Potter stories, black work hats identify sorcerers both good and evil. Magicians and financial shysters both create illusions that depend on their audience’s suspension of disbelief in their supernatural abilities. On closer inspection, magic tricks and fraud turn out to consist not of miraculous events but of misdirecting the eye away from one action and toward another. That said, fraud is a detective story in which, despite examining the evidence carefully, innocent bystanders are often suspects.
Bad guys do share some common identifying markers, but, inconveniently, blameless people display them as well. Statistically, when the error rate on a test is greater than the frequency in a population, noise overwhelms the signal. The tests for fraud are quite noisy. For example, if there’s one rogue in five hundred and the test has a 2 percent error rate, 9.98 (499 × .02) false positives show up along with (usually) the one bad guy. Because the tests are somewhat unreliable, I eliminate only the prospects that I think would be disappointing investments for other reasons. For example, companies that constantly require outside financing might be at greater risk for fraud, but I avoid them because of the dilution from financing.
Unless you’ve never fibbed out of kindness or guilt, you also know that there are shades of dishonesty. In my years of investing, I’ve seen a couple of blowups, which led me to think further about character. Means, motive, and opportunity are the traditional clues used to detect criminals, but in financial cases, the fraud triangle applies: pressure, opportunity, and rationalization.
Highly Overconfident
Of the sample set of hundreds of analysts and portfolio managers I have worked with at Fidelity, just one went on to become a newsworthy financial scoundrel (after he left the firm): Florian Homm. Homm left Fidelity Boston more than a quarter-century ago, and his alleged misdeeds occurred nearly two decades later. Homm’s office was next to mine, so we became well acquainted. At the time, I pegged Homm as a brilliant, erratic, European playboy, not a swindler. Everything that follows is a matter of public record, mostly in Homm’s autobiography, Rogue Financier. Homm was larger than life, nearly superhuman: 6'7", well built, graduate of Harvard and Harvard Business School, uber-wealthy family, played in the German national basketball league, brash, and personable. On his very first day, he was assigned to manage a fund. (I waited three years to manage money.) I don’t think any of those characteristics should be used to spot trouble.
Still, I wasn’t totally shocked that Homm got into mischief later. Cocky, talented characters like him are given more leeway to behave badly. Florian was hyperactive and craved thrills, which might have made him more likely to take those chances. Moreover, the rules aren’t always applied to charismatic rogues. More generally, the appeal and the peril of charismatic leaders is that they get people to do things that they otherwise wouldn’t.
Greed was the obvious motive for Homm’s alleged crime, but there’s more to it than that. Badly designed incentives—including too much of a good thing—create pressure that leads to bad behavior. When he worked at Fidelity, Homm managed a smallish fund that might have carried a fee of 0.55 percent of assets. His pay was likely a fraction of the fee, and not directly based on the fee. Financial incentives to misbehave came years later in 2004 when he cofounded Absolute Capital Management, a hedge fund management firm, which at its peak handled more than $3 billion in assets. Hedge funds customarily charge 2 percent of assets, which would equate to $60 million a year. On top of that, they collect 20 percent of the profits, which, in a bullish year, would be an even grander sum. Absolute Capital’s fund performance was at the top of the charts in the European financial press. The management company was initially offered to the public in London, and Homm remained a key shareholder. By 2007, Homm was listed as one of the 300 richest individuals in Germany, worth 400 million euros.
Usually, when founders and senior executives are major shareholders of their companies, as in Homm’s case, interests are aligned. I worry more about executives who collect massive option grants but don’t hold as many shares. At Enron, CEO Ken Lay and other officers had many more option shares than directly owned shares. Stocks can go up or down, but options have only upside. When executives don’t share in the downside, they take bets with huge upside and downside, and hope. However, Homm’s interests lined up with those of his management company, not his fund holders. For fiduciaries, they should be related, with fund holders first.
Pride in an exceptional track record sounds like a fluffy motivation compared with greed, but in Homm’s case I suspect that the pressure to keep it up was powerful. Homm was a phenomenon, not just some top-performing hedge fund manager. He was labeled the “Antichrist of finance” because his bear raid on Bremer Vulkan triggered the shipbuilder’s collapse. He co-owned Artemis, Germany’s largest “wellness bordello.” He was a local hero for rescuing the popular (but insolvent) Borussia Dortmund soccer team.
Rackets can run for years, even decades, before they are recognized as such; then they often unwind quickly and dramatically, as Homm’s did in 2007. The U.S. Securities and Exchange Commission alleged that funds managed by Homm at Absolute Capital had been running a pump-and-dump scheme. His funds would buy huge blocks of lightly traded penny stocks, sometimes as private placements, often executed by Hunter World Markets, a brokerage half-owned by Homm. Then Homm would ramp the share price with semi-fictional trades, or simply mark the price up. In an exuberant bull market like that of 2006 and 2007, the pump part was easy. As long as a fund is receiving inflows, the dump part doesn’t seem urgent. Managers can use the new cash to further pump up the stock price. Or they can let the inflows reduce the portion of the fund held in the inflated stocks.
Stock markets turned wobbly in September 2007, and Homm’s funds had several brutal weeks. Florian donated personal shares of Absolute Capital Management worth 33 million euros to his funds to prop up their value. Then, abruptly, Homm quit, and it was revealed that his funds held $530 million in penny stocks where Absolute accounted for almost all of the trading activity. Absolute Capital immediately halted redemptions of Homm’s funds. After absconding to Bogotá, getting shot in Venezuela, and playing cat and mouse for years, Homm was arrested at the Uffizi Gallery in Florence, Italy. Perhaps it was karma, but some of Homm’s alleged loot ended up invested in the Madoff funds.
Madoff with the Money
Around 2000, I met with Harry Markopolos, a Boston money manager, who had tried to reverse engineer the returns of a much-touted strategy run by Bernard Madoff. Even in sloppy markets, the Madoff funds were rumored to be perennially profitable, and I was interested in copying his investment strategy (which I assumed to be legitimate) to improve my fund’s performance. Markopolos wanted to show me that Madoff was a hoaxer. I gleaned no investment insights because nothing in Madoff’s ostensible strategy made sense; Markopolos was right. He had tried and failed to correlate Madoff’s returns with all manner of strategies and specific stocks.
Everything about Madoff’s funds, including the exact numbers, was shrouded in secrecy. Investors had to be invited to gain admission to the Madoff club and then invested only indirectly, through a “feeder fund” or fund-of-funds. This distance from his clients meant that clients didn’t know what they owned; it also may have allowed Madoff to keep his emotional distance from them. Most clients had no access to reports about their accounts. Madoff cleared his own trades and effectively had no external custodian.
Eventually, Madoff’s operation proved to be the world’s largest Ponzi scheme, costing investors billions. Madoff was well-known in the industry—chairman of the board of the National Association of Securities Dealers (NASD), a self-regulatory body that has since been succeeded by the Financial Industry Regulatory Authority. He had helped transform the “pink sheets” market makers into the NASDAQ electronic market. A cynic might wonder whether Madoff—now serving life in prison—felt he was above the rules. In November 2007, a year before the scandal broke, Madoff said, “In today’s environment, it is virtually impossible to violate rules.”
It is unclear whether Madoff’s fraud began around 1990 or earlier. Madoff’s testimony suggested that it stemmed from pressure to meet unattainable expectations and as a way to deny failure. One story is that he had set up complex long/short trades and was faced with a large fund withdrawal. Madoff sold the stocks on the long side, but the investment bank refused to let him out of the short side of the trades. Supposedly, the short leg produced heavy losses. Clients had become used to consistent large gains, and he felt he had to cover the losses. In this version, it all happened because Madoff wanted to keep his clients happy. Incredibly, some investors had suspicions about Madoff, but thought they could get out in time.
Enron’s Pipeline Dreams
A memory of being once burned kept me from ever being enthusiastic about Enron stock. I have often flashed back to 1987, when I was a rookie in the arena of natural gas who had just flown in to meet Enron. At the hotel in Houston, I received a call from Beth Terrana, the manager of Fidelity Growth & Income Fund. She was livid that Enron had announced a $140 million trading loss, but I was clueless about the situation. Analysts didn’t have the Internet or even cell phones then. I called Enron but didn’t get a call back.
At the meeting, I recall being alarmed by the patchy details of the trading loss. Enron’s CFO admitted that its traders had made a catastrophic bet on oil prices and had also diverted some money. He said that the damage had occurred nine months earlier, had been as bad as $1 billion, but had been nimbly reduced. If Enron had disclosed the misappropriation earlier, the trades would have cost far more to unwind and might have tripped debt covenants. While Enron was working out of the losing trades, and shutting down the oil trading desk, it was an open question whether the losses should be immediately reflected (“market”) or deferred until the final amount was known (“cost”). Just maybe, the billion-dollar loss was never reversed and led to much bigger abuses. More likely, it opened management’s eyes to the accounting possibilities.
I met with several other officers of Enron that day. Kenneth Lay, the CEO, was a PhD, which was unique in the energy business. Rich Kinder, the chief operating officer, was nicknamed “Doctor Discipline” and seemed exceptionally capable. At the gas trading desk, I inquired about controls and position limits; they claimed risks were well balanced. The deregulation of natural gas pricing had created exciting trading and arbitrage opportunities. I wondered whether these included opportunities to shuffle costs between Enron’s regulated and unregulated activities. But really, gas trading seemed like any dealing desk, with telephones, computer screens, and confident, aggressive men. I still saw a company with tons of debt, frequent extraordinary items, a drab return on equity, and now a big trading loss. Enron stock dropped 30 percent in October 1987, but since the stock market crashed that month, the scandal was forgotten until 2001.
The origin of the fraud that ultimately bankrupted Enron remains obscure, but it may have been in a change in accounting standards in 1992 that allowed energy traders to value positions at market rather than cost. Enron and Arthur Andersen had lobbied for this treatment, so you might surmise the scheme was already afoot. At the least, the new accounting enabled the subsequent chicanery. An alternative theory is that when Rich Kinder left Enron in 1996, and Jeff Skilling, a Harvard Business School grad and former chairman of Enron Finance and then of Enron Gas Services, took the reins, Enron’s financial and trading businesses ballooned. Enron’s operating cash flow turned negative. It also became much more promotional. Analysts and reporters started producing worshipful stories. Fortune magazine called Enron “America’s Most Innovative Company” and ranked it number 1 in Quality of Management.
Promotional companies are bad news, and not just because they are more likely to be frauds. A hard sell usually indicates that some form of financing is impending. As a value investor, what really scares me away is that if investors believe the hype, a stock will be overpriced. Nearly all of the companies on lists of major accounting debacles had stocks trading at demanding multiples. Enron’s price/earnings ratio (P/E) was twenty or higher for much of the 1990s and peaked at seventy times earnings. Without the trading businesses, Enron’s goal of 15 percent earnings growth would have seemed laughable. Energy prices were stagnant. In the 1990s, American natural gas production grew but never returned to the peak levels reached two decades earlier. Enron’s trading businesses had such tiny margins that between 1996 and 2000 its sales octupled from $13 billion to $101 billion, but reported earnings per share rose only 4 percent.
In retrospect, the suppression of contrary opinions at Enron was a clear sign of impending disaster. At the start of 1998, I got a tearful call from “Scarlett,” an analyst at a competing firm. Enron had called her Director of Research, pressuring him to take her off of covering Enron and fire her. She did land another job but complained that her phones were tapped and she was being followed. Similarly, John Olson, a thoughtful natural gas analyst at Merrill Lynch, had not been an enthusiastic cheerleader for Enron. In 1998, Enron retaliated by cutting Merrill out of an investment banking deal. Olson “agreed to retire early” from Merrill. Other analysts were excluded from conference calls or barred from asking questions. Jeff Skilling famously called analyst Richard Grubman an “asshole” during one such call.
Those events cast a different light on Enron’s policy of forced-ranking employees and eliminating the worst-performing 15 percent each year. If that many people had to be canned, Enron must have been abysmal at hiring the right ones. Teams do have to work together, so personnel decisions are unavoidably subjective and political, but forced-ranking would ramp it to a scary level. For the winners, Enron offered rewards previously unimaginable at a public utility, including shares of special-purpose entities, stock options, and more.
As Enron collapsed, lots of tawdry behavior was revealed. Top Enron executives, including vice chairman Cliff Baxter, dumped large amounts of shares while the retirement plans of lower-level employees were locked in and other paper fortunes vanished. Just before he was due to testify to Congress, Baxter committed suicide.
Arthur Andersen & Co. played a supporting role in Enron’s misstatements and is itself a tale of incentives and opportunity for bad behavior. When I was in business school, Arthur Andersen & Co. was considered a forward-looking, principled employer that paid well, especially on the consulting side. In the early 1950s, the firm had developed a payroll processing system for General Electric and recommended a Univac computer to do the job. Thus was born the computer systems integration industry. In the following decades, Arthur Andersen’s financial systems integration business was even more successful than its auditing practice.
The success of the consulting division provided both motive and opportunity for Arthur Andersen. As both auditor and consultant for Enron, Andersen was in the dubious position of evaluating its own work, with one arm affirming the value of the other. To top it off, Enron outsourced parts of its internal audit function to Andersen. Usually companies prepare financial statements, audit them internally, and then the outside auditor reviews them. On self-graded exams, there are lots of perfect scores.
Consulting billed out at higher hourly rates and was a much bigger market than audit. For example, between 1991 and 1997, Waste Management paid Andersen more than twice as much for consulting as it did for auditing. A director called one $3 million consulting project a “boondoggle”; it was never used. When Andersen discovered Waste Management’s fabrications, the public accountants did not inform Waste Management’s board of directors; instead, the auditors helped to conceal the improprieties.
Enron paid Andersen $27 million of consulting fees and $25 million in auditing fees in 2001, so the balance wasn’t as skewed as it was with Waste Management. But Andersen believed that Enron could become a $100 million client. Those audit fees were also unusually large, probably exceeding ExxonMobil’s, a company many times larger by any measure. I would guess that Enron’s complex organizational structure and use of special-purpose entities made it a time-consuming auditing job. Or was it hush money?
Auditors and systems integrators work under different ethical principles. I suspect that as Andersen’s consulting business became the larger profit center, the standards of consulting prevailed rather than those of auditing. Auditors and investment managers occupy a position of public trust, but they are also in business. Duty is meant to come before profits, and obligations to the public can come before those to the client. As with any enterprise, marketing is required but is asked to be low-key, because there are certain things that clients want that professionals should never promise. Andersen’s CEO urged the firm’s partners to market heavily and increase cross-sales, which was the right approach for the consulting side. Over time, the consulting business increasingly separated from the auditing practice, with the consulting side rebranded as Accenture.
Six Things That Make Me Nervous
1. Companies That Must Lie to Stay in Business
Distressed and highly indebted companies often don’t want the truth to come out. If the extent of their troubles were revealed, the bankers might seize control. Any capital-raising would bring in less money. The company could become vulnerable to a takeover. Staff might become demoralized and start to circulate résumés. Suppliers might stop shipping goods, which could deepen the distress.
Corporate deceit can be rationalized in any number of ways: if the company had to be sold, bankers and shareholders might recover less in a distress auction—so it would be better not to tell them. It would be harder to attract talented executives who might solve the company’s problems. A white lie is sometimes better for everyone.
2. Tiny Audit Firms
In financial crimes, opportunity arises from a lapse in the usual regulations, cross-checks, audits, and separation of functions. External auditors are meant to protect outside investors and lenders, but they don’t have a foolproof test for fraud either. Auditors are paid by the company they are evaluating. The financials are prepared by the company, and auditors depend on its cooperation and internal controls. Nor does use of a big-name accounting firm guarantee against corporate chicanery. Ernst & Young audited Absolute Capital Management and never qualified its opinion. Enron engaged Arthur Andersen & Co., which was one of the Big Five auditors until it went under. Enron was the deathblow for Arthur Andersen, whose audits of Waste Management and WorldCom had also been severely criticized. However, it was a red flag that Madoff hired Friehling & Horowitz, an accounting firm with just one working accountant; the firm by its own admission had not conducted audits in fifteen years.
3. Inside Boards
Responsibility for poor or missing controls belongs to a company’s board of directors. In principle, a good board of directors would be knowledgeable, think independently, and act in shareholders’ interests because they own a lot of stock. Directors’ shareholdings are listed in the company’s proxy statement, but their expertise and independence can be inferred only from their résumés. When most of the directors are officers of the corporation and their cronies, you have an “inside board.” And that means oversight isn’t separated from management.
For shareholders, the worst combination for shareholders is an inside board that owns little stock. One way to gauge independence is to compare the CEO’s pay package with those of CEOs at like-sized, similarly situated companies. If the CEO is taking home a great deal more than comparable CEOs, the board of directors is probably an inside board. A board that isn’t watching over executive compensation may not be on top of financial controls either.
4. Glamorous Rollups
Glamorous, fast-growing industries suck in capital, which opens up possibilities for impropriety. When business is changing rapidly, it’s impossible to prove that an expansion project will never pay off. Mergers and acquisitions not only allow companies to bulk up quickly; they also confuse the numbers. Think of all of the largest accounting scams at nonfinancial companies—Enron, HealthSouth, Qwest, Waste Management, Tyco, Sunbeam, and WorldCom. Every single one of them rolled up scores of companies. As we’ll see in the next chapter, some of their misstatements were in plain sight. In these cases, the financial statements shown in the company’s 10-K annual report were more accurate indicators than the more flattering “adjusted” figures. With fast-changing rollups like these, it’s tough to keep abreast of everything that’s going on.
5. Financial Firms
Financial companies are the jackpot for scam artists who want to get their hands on other people’s money. Clients routinely trust banks and brokers with their assets. For each $1 billion of equity, most banks hold deposits and borrowings in excess of $10 billion. An electronic record of a loan or security corresponds to another electronic or paper document, not a physical property. Even if accountants view the physical collateral supporting a loan, they also need to know the other liens and contractual wording. Often these documents are confidential. The combination of opaqueness and other people’s money may explain why many of the largest fraud cases involve financial firms.
6. Sunny Havens
Warm, sunny places like Florida attract more than their fair share of dubious promotional schemes. Wealthy retirees bring plenty of capital to invest and, being past their working years, may be less inclined to do due diligence. They are ripe targets, especially for affinity scams, which zero in on victims belonging to social or demographic groups. Madoff’s use of affinity groups allowed him to maintain a low profile, reduced disclosure needs, and enhanced his mystique.
Along with its beautiful beaches and low taxes, Florida has a Homestead Act that protects even mansions worth tens of millions of dollars from seizure by creditors. The Homestead Act has a long history of sheltering assets of people with unstable finances. Florida homesteaders can even sell their property and protect the cash, as long as they intend to buy another home in Florida.
Places like the Cayman Islands, the Bahamas, Bermuda, and Cyprus are sunny isles for shady people. Like Florida, these jurisdictions have magnificent beaches, but are even more appealing for avoiding taxes and the law. They attract what I call homeless companies, or nomads. For example, a nomad might have most of its assets in China, most of its officers in Hong Kong, incorporated in the British Virgin Islands, with a foundation in the Dutch Antilles and its stock listed only in the United States.
Many companies incorporate in tax havens but are not otherwise outside of the law. Systems integrator Accenture, for example, is incorporated in Ireland, although operations are coordinated from Switzerland and a large part of its revenue comes from the United States. A homeless company will be “forum shopping,” seeking the most lenient securities and accounting rules. In case of fraud, there’s no legal recourse, particularly if managers had the foresight to relocate their personal domicile to a tax haven without extradition treaties.
Even if means, motive, and opportunity can be shown, the prosecution must still prove that securities fraud was willfully committed. For those of us who are not mind readers, mental states can’t be proved definitively; even “beyond a reasonable doubt” is tough. Business misadventures are often intertwined with fraud and are common enough that stupidity, ignorance, or bad luck work as defenses. Because Enron’s executives were tagged as “the smartest guys in the room,” the jury wouldn’t buy stupidity. CEO Lay argued for ignorance, implying that his subordinates did all the bad deeds. Bad luck can be a bona fide defense. Several energy trading companies blew up around that time, and fraud wasn’t seen as the culprit in all of them. Dynegy, Mirant, Aquila, and several others had such disastrous results from energy trading that they exited the business. Enron could truthfully argue that it was a dicey operation and blowups were bound to happen.
Making aggressive deals isn’t always illegal. Still, I exercise caution before investing with someone like Ron Perelman. In 2011, Perelman offered $25 a share to buy out the shares of M&F Worldwide that he didn’t own. That equated to a P/E of four for the maker of licorice flavorings and bank check printer. The company had repurchased shares at $45, and the stock had been as high as $67. Don’t ask me why the independent directors and a majority of noncontrolling shareholders signed off on $25 as a fair price. Billionaire Carl Icahn said of Perelman, “He was like a plumber you loan money to get him started in business; then he comes in, wrecks your house, then tells you he wants the house for nothing” (New York Times, 1998).
Disaster Can Be Avoided
If you try to avoid being hoodwinked, you will miss some perfectly good opportunities. Enron stock skyrocketed before it collapsed. The choice boils down to temperament. Some people can’t stand to miss a moonshot, no matter how sketchy. I prefer to avoid a small chance of quick, devastating losses. When a manager has a criminal record or a history of cheating investors or even just feels above the law, I stop right there. Crooks don’t suddenly sprout a sense of fiduciary duty. When a piece of evidence might or might not tag a bad guy, I use it only if it hints at other investment defects. Glamorous hype stocks are more likely to be scams, but I avoid them because they are usually overpriced and prone to raising capital constantly. Intricate corporate structures make analysis difficult, even if nothing bad is going on.
To spot bad guys, look for the fraud triangle: pressure, opportunity, and rationalization. Philosopher Hannah Arendt had it right that “most evil is done by people who never make up their minds to be good or evil.” Watch for when massive option grants or hefty fees compel people to try too hard. Pride can be a dominant motive when an audience believes in someone’s magical powers. Charismatic promoters often suppress the boards of directors, auditors, and other naysayers that might prevent them from doing what they want. They cluster in industries and geographies where capital is abundantly available with little scrutiny or accountability. Lax accounting standards are also a draw. Don’t buy anything someone is pushing hard. By avoiding the bad-guy stocks—and it’s a short list—I slash the possibility of a disastrous outcome but scarcely reduce my opportunity set.