Frauds are fascinating, almost like work of art. Why?
Every time they happen ( and do they happen often) you think that how the hell was this missed.
But therein lies the beauty or art of the fraud. The promoters or companies use the same playbook but make it look very different than older ones. A combination of financial engineering and money management are tools used to execute this art.
The root of every fraud stems from either greed for money or desire for power or a combination of both.
And interestingly, they both arise from success. We don’t know of any company which was unsuccessful from the start and was also a fraud.
Ergo, as a CEO, Promoter, Founder any moderate success ensures that both greed and power are available to you in reasonable doses.
This is the trickiest part, top management needs both these to keep the company forging ahead but over-indexing on any of them means they have set the company on a slippery path.
Let us take a few cases from the previous decade. We choose older cases so that you can see that patterns remain the same for newer frauds also.
Take the case of Satyam.
When Ramalingam Raju started everything initially was going great. But then the greed of market cap came in and the power of owning an empire came in. To hit them Satyam starts to give far more aggressive guidance to investors, who lapped them up to push the stock prices up and they flywheel continued to move. To satisfy the urge of power Maytas, an infra company was created ( infra was super hot at that time). A fair bit of Financial Engineering and funds from Satyam started to move into Maytas and that engine also got its fuel.
Eventually, we know what happened. The lies of higher guidances led to fake revenues to fake cash and so on
Take the case of Moser Baer.
Moser Baer started very well. They were trying to make a brand play in a commodity business of CD’s. After initial success instead of realizing that Chinese competition was going to make this really hard, they started getting greed. The numbers would show Moser Baer a fast-growing, high-tech, export-oriented company having huge margins and 10% of the global market of its products in early 2000.
Moser Baer claimed to have a 10% share of the global market. Its two key competitors Ritek and CMC Magnetics (both of Taiwan) at that time supplied nearly 50% of the world’s recordable, compact discs (CD-Rs). Their gross margins were under 20% in 2001.
However, they realized after some time that this was not working but instead of cutting out their greed they moved to start a new business.
As oil prices have been high since 2007, Moser cooked up the idea of getting into solar power. The lure of power and money combined here eventually leading to the bankruptcy of both the companies.
Translating this greed and power to more palatable motives leads to cited motives like: meet earnings expectations; conceal the company’s deteriorating financial condition; bolster performance for pending equity or debt financing, or to increase management compensation.
From this lens what are the few things which you can look for to get your fraud signal alerted
- When a company tells a story which usually is too good to be true, it usually is too good to be true. Greed and Power often combine to drive this narrative.
- A sudden increase in PR/ Media Appearances— > While the PR appearances do tend to make the brand more recognizable, but usually they are part of a bigger narrative. Great companies typically don’t need PR for CEO’s as the consumers do that work for them.
- A great business suddenly diversifies into a very hot area. The story usually told is that we are great executors of X and therefore will be able to execute the Y
- A company is showing great results when the whole sector is screwed. This is often much harder to execute than its shown. Divergence from the performance of other companies may not necessarily be due to the ability of the company.
- Then there are a lot of smaller indicators like low delivery to volume ratio, consistent price rise with huge volumes which the share has never seen.
Even with tools like above Detecting fraud is fascinating as you need to use the data and news to figure out if the company is on the path of greed and power. That is much lesser science but much more art.