In the Wake of Wirecard What is to be Done about Corporate Fraud? Part 1

Corporate fraud is a twin of corporate misgovernance. 

The two are frequently companions.

 “طيزين في سروال واحد “. 

Or, if you are a film buff like A, “طيزين بلباس “. 

I’ve written before on this topic but in relation to “corporate governance”. Here and here.

To launch this discussion intended to consist of three posts, let’s begin by looking at a proposal Edward Hadas made in an article at Reuters. 

When a sharp incisive journalist like Ed writes a piece, it’s always a good idea to take a close look.

In his article, he proposes the use of private sector forensic accountants to conduct investigations to uncover fraud.  

They would be funded by a portion of the fees that companies pay their "regular auditors" so that the "fraud busters" could be independent of the economic considerations that are often considered impediments to financial auditors' full performance of their duties.

The “fraud busters” would not check all companies but only those where they “sniff out suspicious activity”.

How?

Either from tips from stock analysts, whistleblowers, worried bankers, and/or investigative journalists. Or from their own ratio analysis, etc.

The “fraud busters” might also choose to focus on industries that “attract miscreants”.

They would be given “a government license to pry”, presumably at a minimum to conduct investigations and compel the company to provide access to confidential information. 

They would also have “the authority to prevent regular auditors from signing off on accounts.”

An interesting proposal.

However, I think this system would be difficult to institute and would pose several significant challenges.

First, the “government license to pry” and the authority “to prevent auditors certifying financial statements” imply that the “fraud busters” would be granted legal powers akin those to enjoyed by governmental agencies.

If so, this is likely to result in potential conflicts between the “fraud busters” and the governmental agencies.

Why?  

Because unlike investigative journalists, security analysts, etc. they would be able to compel testimony and the provision of records as well as issue binding judgements, e.g., on financial auditors.

Would the “fraud busters” or a government agency have the final say about inception, the determinative process, and disposition of a potential case?

As well, in order to the prevent the “fraud busters” from interfering with ongoing or contemplated non-public official investigations, they would need to be informed about them.

Official agencies would naturally be reluctant to provide this information for fear that it would be “leaked” in one way or another, thus alerting the “target”. 

Or potentially causing harm to the "target" before the process was complete. 

Or that such “inside information” would be misused for “insider trading”.

Second, and more importantly, giving private sector companies rights typically the monopoly of government agencies would raise significant constitutional and legal issues regarding due process and the rights of a defendant. And probably not only  in the USA. 

What would be the “probable cause” standard for a “fraud busters” investigation?

It would seem that at least it would have to be equivalent to the standards that governmental agencies must meet before formally commencing an investigation, including the legal right to compel testimony and provision of records. 

Think of the steps required for an SEC Formal Order of Investigation or the judicial processes associated with US DOJ actions. Or of “discovery” in civil cases.

There are operational issues on exactly how this would be arranged (structure) and managed (process) for "fraud buster" investigations to ensure the rights of “targets” are protected. And confidentiality were maintained.

I think these legal issues are particularly important because as I read Edward’s article—and apologies to him if I have misread it—the “fraud busters” seem to have fairly wide latitude to begin an investigation.

They seem to be “financial bounty hunters” or a version of the Met “Flying Squad” set free to range far and wide to uncover frauds.

For example, as per his article, they might “focus” on companies in an industry they judge “attracts miscreants”. This might be characterized as “guilt by association” by targets.  And even harder to justify on a “probable cause” basis if legal objections were raised by the target.

Other justifications would be “tips” as mentioned above from third parties and financial ratio analyses the “fraud busters” conducted themselves.

How would the credibility and “weight” of the “tips” be assessed? Particularly, when many of the tips are likely to originate from sources that do not have first hand access to inside information of wrongdoing.  

Or where the “tipper” has an economic interest in lowering the price of the target’s stock? Think Herbalife. 

All these raise issues about probable cause in a USA context. 

Should their investigations be limited to the subject of the tip? Or might they like Kenneth Starr range far and wide beyond their initial scope to find wrongdoing once they commenced an investigation?

Initial suspicions on NMC concerned overvaluation of acquisitions. What turned out to be the “real” problem was unrecorded liabilities. There were no tips that I am aware of on that problem until information came out at the final stages of the company’s unraveling.

What should be the impact of ostensible independent third party’s report that it found no evidence of fraud?

As per “Management” Note 2.5 on page 97 of Wirecard’s 2018 audited annual report a Singapore law firm, Rajah and Tann, conducted an investigation which cleared Wirecard at least preliminarily. A Government of Singapore investigation was still ongoing at the time.  

This may seem like pettifogging. 

But if we hope to see criminal or civil penalties imposed on fraudsters, we need to make sure that they have no defense from shortcomings in due process or violations of defendants' rights.

Third, if, as asserted, economic considerations motivate auditors to not properly execute their responsibilities, wouldn’t “fraud busters” be subject to the same temptations?

In their case the issue would not be doing too little but doing too much.

Investigation for the sake of investigation because presumably, they will be paid for the number of investigations they conduct. 

With the lure of a sizable “bounty” for uncovering a fraud perhaps providing  additional incentive to “keep digging” or to overstate wrongdoing.

There are other difficulties.

For example, because they receive their authorities from national governments, cross border investigations would likely be more limited that those by governmental agencies. That is not to assert that national governmental agencies have an easy time with cross border cases.

Similarly, granting the “fraud busters” powers similar to governmental agencies probably would require as well the provision of legal immunity regarding their investigative actions in order for them to discharge their duties.  

In the next post I’ll outline an alternative proposal—admittedly imperfect—that seeks to leverage existing structures to increase the detection of fraud.  

Wirecard - Why Income Statement Manipulation Results in Balance Sheet Manipulation

R^2 -Not Affiliated with Wirecard or Hin Leong

As you will recall, Financial Times articles reporting that Wirecard’s (WC) revenues and thus net income had been deliberately overstated triggered the unraveling of the company. Here is an article from early 2019.

If these allegations are true, then it should be no surprise that a significant amount of WC’s assets (most likely cash) does not exist.

And like AA’s “missing” Maybach S 850 Luxury Edition never did.

What that means is that Wirecard’s “billions” have not be misappropriated.

Nor have they been misplaced. Not left, perhaps, in the German equivalent of the Victoria Station Brighton Line cloakroom in a handbag or handbags.

Furthermore, we should have expected to learn that assets were inflated when we first read that income had been.

Since it seems that there is some confusion on this matter, (example here) I’m writing this post to explain why income statement manipulation necessarily requires manipulation of the statement of condition (balance sheet) by the same amount.

Similarly if there is misstatement of a company’s balance sheet, then it’s a very good “bet” that company’s income statement has been misstated as well as discussed further below. 

Why is this?

The answer comes the fundamental accounting identity: Equity = Assets – Liabilities.

If net income is overstated, then equity must be similarly overstated because the results of operations – net income or net loss – are added to equity.

As the balance sheet identity above demonstrates, if equity is overstated, then so must A-L.

Inflating net income then requires that one:

1. overstate assets or 
2. understate liabilities. 
3. Or some combination of 1 and 2.

But there’s more.

There is a very close relationship between the income statement and balance sheet.

In general every entry on the income statement is mirrored in an equal but opposite entry or entries on the balance sheet.

If one reports USD 100 in revenues (a credit), then a debit or debits for the same amount must appear on the balance sheet, e.g., in cash and/or accounts receivable.

If one reports USD 100 in expenses (a debit), then an equal amount credit or credits appears in the balance sheet, e.g., in cash and/or in accounts payable (a liability).

Non-cash revenues (e.g., revaluation of assets, reversal of provisions) must be accompanied by debits to the assets concerned or to existing provisions (contra accounts or liabilities).

Non-cash charges (e.g. depreciation, amortization, provisions) must be accompanied by credits most often to contra accounts to assets or in some cases creation of liabilities, e.g., reserve for litigation.

There’s no escaping this – if one’s balance sheet is to balance.

A dollar’s worth of “fiddling” the income statement, requires a dollar’s worth of “fiddling” the balance sheet.

As noted above, when one hears that a company's assets have been manipulated - usually to make them larger, then one should know that so has income.

By way of example is the case of Hin Leong Trading Singapore.

At this time, reports are preliminary not final.

Details remain “sketchy”--in both senses of the word.

Based on these three articles, CNBC, The Independent (Singapore), and AsiaOne, it appears that HLT hid some USD800 million in derivatives losses (oil futures), and fabricated some USD 2.2 billion of accounts receivable.

As well, the company's inventory is "short" USD800 million.

What that means in layman speak is that HLT’s inventory is overvalued. In this case the value of the actual (physical) inventory is USD800 million less than the value shown on HLT’s balance sheet.

HLT seems to have had two goals with the manipulation of its financials.

Creating fictitious income to cover losses.

Because the amount of the “inflated” receivables is much greater than the USD800 million derivatives losses it’s clear that HLT has been unprofitable for some time as well as cashflow negative.

HLT’s unrecorded sale of USD800 million in pledged inventory to obtain cash for its general operations not only supports the latter conclusion (negative cashflow) but shows just how serious it was.

Maintaining/expanding its “borrowing base”

Most banks lend to commodity traders on a secured basis, with the maximum loan expressed as a percentage (borrowing base) of receivables and inventory.

The “base” is always less than 100% to provide a margin of additional protection because typically one doesn't realize the face value of collateral.

When the outstanding loan is equal to the allowed borrowing under the “base”, the bank will make no further loans.

If outstandings are greater than the amount allowed under the "base", the bank will demand a repayment in the outstanding loan to bring it within the base.

Account Receivables

Banks generally tier the lending percentage according to the days outstanding of receivables, the credit standing of the obligor, etc. The quicker a receivable is collected the better credit quality it is. The longer a receivable is outstanding the lower the quality and therefore the "base".

The nature of the goods being sold is also a factor.

HLT fabricated multiple transactions to replace “aging” bogus receivables with new ones to maintain the borrowing base.

And critically as well to create additional amounts of receivables to expand its “base” and fund its cash “burn”.

Banks also monitor the turnover (inflows and outflows) in borrowers’ balance sheet accounts as well as the borrower's cash account with the bank, particularly those borrowers involved in trading.

If a borrower’s account is “stagnant”, it is a sign of distress in its business. If receivables are turning over (being collected) at a glacial pace, another red flag.

HLT round tripped cash through its accounts to give the appearance of robust cash flow, e.g. collection of receivables.

Inventory

Banks perform a similar borrowing base calculation with inventory, factoring in price volatility, nature of the commodity/goods, costs of sale, etc. 

For example, in general crude oil inventory would be considered “better” than specialty manufactured goods that could be used by only a limited set of potential buyers.

HLT needed cash and didn’t want to reduce its borrowing base which would prompt a demand for reduction in its loans. So it sold pledged inventory without recording it in the income statement or its balance sheet.

R.I.P. Dame Lynn

18 juin 1940

"Le Gouvernement français a demandé à l’ennemi à quelles conditions honorables un cessez-le-feu était possible. Il a déclaré que, si ces conditions étaient contraires à l’honneur, la dignité et l’indépendance de la France, la lutte devait continuer."

Bahrain Middle East Bank - Successful AGM, No EGM = Future Remains Bleak

At the Third AGM, a Quorum Can Be Rather Small

BMB “successfully” held its FY 2019 AGM on 9 April after two previous unsuccessful tries. Minutes here.

But just barely.

Only one shareholder holding one share was in attendance.

That’s 0.00000025% of outstanding shares according to the AGM Minutes.

As per Bahrain’s Commercial Companies Law, there is no required minimum quorum for a third meeting.

All AGM agenda items were approved.

The EGM – which is needed to address the critical issue of continuity of BMB – failed for lack of a quorum. 

See below for the main focus of the AGM:  a discussion of the implications of failure to hold an EGM on BMB's ability to legally continue as a "going concern".

As noted in an earlier post, because AN Investments was excluded from voting in the EGM, if their shares are excluded from the total number of BMB shares, only 4.81% of shares would constitute a quorum for the EGM.

As also noted in that post, that would require AlFawares (ALF) to be present to vote its shares because in the event that AN Investments' shares are excluded a minimum of 4.81% of total outstanding BMB shares would have to be present and all other shareholders own only 4.51% of BMB. 

ALF was not in attendance for the EGM.

It’s unclear what the reason is for their failure to participate.

Earlier the Board noted that certain members of senior management and the Vice Chairman were under investigation for an alleged fraud. None of these individuals were directly associated with ALF.

Also, ALF’s two directors on the Board resigned "just before" the CBB ordered that the Board resign.

I have interpreted the timing of these events as an early warning from the CBB to the ALF directors to exit before being forced to resign.

In which case ALF should have nothing to fear from attending the EGM unless it fears (a) other legal exposure of some sort, (b) being forced to participate with new equity, or (c) the "sting" of unpleasant comments from other shareholders.

Re the first point, it would seem that the CBB’s actions—if my assessment is correct—indicate that ALF’s hands are “clean”, though see the potentially troubling reference to the difficult situation with “majority shareholders” below.

What might be the "sticking point" is ALF's own obligation to the Bank for the Installment Sale Receivable (ISR) loan which BMB has provisioned in full.

Re the second point, I don’t think Bahraini law gives the CBB or another Bahraini authority the power to compel a shareholder to invest additional equity. Participation in rights issues is voluntary and rights entitlements may be waived and in some cases traded.

And if the good sheikhs at ALF are sensitive to criticism, they can always give a party with thicker skin their proxy. The proxy holder can turn away questions regarding new capital or any other matter, including the ISR, with a simple “I don’t know”.

Given ALF’s own financial “difficulties”, their absence seems strange as restoring value to BMB increases the assets they need to meet their own obligations.

Given that the CBB appears to have given ALF's directors advance warning so they could keep their "thoubs" clean, it seems downright ungrateful of ALF not to cooperate.

Beyond that, Kuwaiti investors often use OPM to fund their investments as a tried and true method of limiting their downside risk.

If the investment goes bad, they hand the "keys" to the investment to the lender with a smile.

One might therefore expect there could well be a lender holding the BMB shares as collateral. 

An institution one would hope would be motivated to see the value of those shares preserved, or, in this case, increased from zero.

In such a case it would seem that at a minimum that lender would demand that ALF give it a proxy,  assuming it does not already “own” the shares through realization of its collateral.

The main focus of the meeting was a discussion of the implications of the failure to hold the EGM this year, following a similar failure earlier.

Mr. Yusuf Taqi a member of the Board asked the “regulators to provide directive on this issue {continuity of the bank} given that it may not be possible to hold at EGM in the future”.

BMB’s counsel opined that failure to convene an EGM and take the legal steps to maintain continuity of the Bank could lead to the bank being wound up or placed under administration.

Mr. Isa al-Motawaj, Director of Wholesale Banking at the CBB, noted that the CBB understands that BMB is in an “abnormal situation’ vis-a-vis its majority shareholders. (Note the plural in the minutes).

Is ALF included in the phrase “majority shareholders”? 

And, if so, is their inclusion a reference to their own significant financial difficulties? 

Or is there something more here?

Or is it an inadvertent slip? A reference to the fact that AN Investments is owned by the three Turkish “amigos”?

Mr. al-Motawaj stated that the CBB had evaluated that directing the bank to liquidate or be put under administration “would not be in the best interest of the stakeholders” particularly as there are other financial institutions exposed to the same defaulted parties as BMB is trying to recover funds from.

He also went on to assure the Board that they were duly constituted and operating in line with legal requirements, noting the importance of the asset recovery efforts underway.

He also responded to a board question about the legality of the AGM, noting that the representative of the MOIC&T had vouched for compliance wiht Bahrain's Commercial Companies Law, even though only one share was in attendance.

The CBB has gone on the record that it is willing to give BMB some leeway given its unique situation.

That being said, even with a successful EGM, BMB’s future is bleak.  

Recovery is highly unlikely to be in full.  

Additional capital will be required.  

Hard to see investors rushing to commit equity.

As a wholesale bank, BMB is unlikely to benefit from rescues afforded retail banks in the Kingdom.

Finally, kudos to the one shareholder who apparently believes in exercising his or her corporate governance responsibilities.

All markets, not just those in the GCC, need more shareholders like this individual.