Uncritical belief can be dangerous…

The recent announcement of the actions of the SEC against various executives of Theranos (as well as the company) for alleged fraudulent behaviour towards investors had the Awbury team reminiscing about the various examples of corporate malfeasance that we have seen over the decades, and whether there are any common themes.

Of course, hindsight is a wonderful mental faculty; but, over the years, the Team’s members have learnt that, while some events come out of nowhere (Barings’ collapse in 1995 being a good example), others offer markers or warnings signs.

So, here are a few of our ”favourites”.

The smartest guys in the room were supposed to be from Enron, as they went about creating new business models and developing new financing structures. Unfortunately, it turned out that what was reported publicly was far from representing the true state of the company’s finances. Having essentially lost the trust of regulators and capital markets, the company was forced to file for bankruptcy in December 2001, and was subsequently broken up, while its auditor, Arthur Andersen, also did not survive the debacle.

A year later, Worldcom, a major US communications provider, imploded when its internal audit department uncovered massive fraud based on accounting manipulation of expenses (leading to underreporting) and inflation of revenues. Its CEO, Bernie Ebbers ended up in jail, and we have this scandal to thank for the Sarbanes-Oxley Act (SarbOx), beloved by all corporate executives.

For a little more exoticism, in 2003, it turned out that EUR 4BN of funds supposedly held in an account with Bank of America on behalf of an Italian dairy company, Parmalat, did not exist, which then led to the discovery that, at EUR 14.3BN, Parmalat’s debts were some 8 times what it had disclosed. A long investigation determined that there had been an elaborate scheme created by Parmalat’s senior executives to deceive investors about the true state of Parmalat’s finances. The irony here is that Parmalat was a decent business, which managed to survive and was eventually re-listed as a public company.

And naturally, we cannot resist mentioning that, also in 2003, Freddie Mac, one of the 2 entities that underpin the US residential mortgage market, was found by the SEC to have mis-stated earnings to the extent of USD 5BN, leading to the firing of much of its then senior management.

Perhaps the “poster child” for recent corporate fraud is the Madoff case- a scheme that would have made Ponzi proud- in which a long-respected and influential money manager managed to conceal that his investment management business had simply been paying investors returns out of their own capital or money from new investors. Disturbingly, he was only caught because he admitted what he had been doing to his sons, who turned him in to the SEC. With hindsight, the reason for his ability to generate smooth returns year-in-year out became blindingly obvious- they were fictitious.

In the case of Theranos, questions had been raised by investigative journalists about the true efficacy of its blood analysis systems, and the company also fell afoul of the FDA, so perhaps the writing was on the wall before the most recent disclosures, but it is telling that the company had still managed to retain the support of a roster of influential directors and advisers, yet had few medical professionals on its Board.

While each situation is different, there are some factors which seem to recur over time: one or more “charismatic” leaders; a lack of normal checks and balances; over-concentrated control; the use of or attempt to influence political actors and regulators; suspension of disbelief by those who should know better; over-complexity or a “story” that is a little too pat; greed and the misalignment of interests. Paradoxically, discovery often appears to be a relief for those involved, as the burden of pretense no longer has to be sustained.

The type of events described above are the stuff of nightmares for risks managers and underwriters, because they contravene the fundamental tenet upon which business is founded, which is trust. At Awbury, we are sufficiently skeptical and experienced to understand that, while one can never achieve certainty (and pretending such things is hubristic folly), one can try to minimize the risk of being caught by such events by focusing on alignment of interests, the validity and verification of track records, and the fact that if something looks too good to be true it probably is.

However, that still does not mean that we sleep soundly at night!

The Awbury Team


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