DISORGANIZED CRIMES goes international…

Accounting fraud at WIRECARD.

Every so often a seemingly deliberate accounting fraud deceives investors and accountants and winds up stimulating regulatory zeal.   The financials debacles of 2001-2 and 2008-9 led to Sarbanes-Oxley and Gramm-Dodd. We should expect that if the Corona-virus causes immense financial dislocations, we will see financial fraud and regulatory actions grow apace. Before the curtain on new episodes of Congressional Propriety goes up, we should begin to ask whether regulators have succeeded in the past and what costs are imposed? The recent disclosure of a large financial fraud in a large German public company (Wirecard) is a signal for the fraud parade is beginning. We don’t really have the essential facts to analyze this case but the similarity to our previous work elicits a few comments

1) Most accounting frauds of major public companies are detected by some market participants long before regulators are ever alerted.   Regulators don’t like short sellers so they are often late to the crime and by then the major damage to the “longs” has been done.  Next come the lawyers, but that is a story about insurance law and rewards to successful class action litigators.  There are several lessons here worth remembering. One might be if E&Y, Wirecard’s auditor noticed anything from Wirecard’s price volatility much earlier? If so, why didn’t they act much earlier. The usual answer is that they don’t wish to lose a client. More on this below

  1. such frauds usually begin with companies already on a losing path.  The resulting frauds are designed to conceal true operating losses.  Enron and WorldCom are class one exhibits

  2. frauds of this kind usually involve auditors who have long standing ties to the fraud company. (ah, yes… should we be asking for term limits for auditors once again?). We can count on the advocacy of those most affected (accounting firms) and political friends to be assured that meaningful term limits are not likely

  3. another question to ask is “Where were the Directors?” But even without the facts in this case, we know that Directors are more often there to bless and shield their managements. They are not likely to probe too deeply in searching potential corporate financial behavior for mismanagement or fraud cases. Company managements get very uncomfortable with a overly-zealous Director

2) Is regulation imperfect as an answer to deter financial fraud?  Again, case details are important, but generic punishments without individual liabilities for Directors, Auditors and Corporate General Counsels make ongoing investigation difficult and unrewarding to outside agencies tasked to protect investors.  Conclusion:  the corporate establishment that includes auditors, directors, general counsels, credit raters, underwriters, and even some bankers is all to willing to sacrifice by investing in more errors and omissions insurance and reliance on the long lag between crime and punishment in exchange for avoiding personal liability. (“You can’t blame me for dishonest clients!”)

It is another example of the famous line in the movie A Few Good Men, when Defense Counsel (Cruise) demands the truth, Colonel Jessup (Nicholson) answers, “YOU CAN’T HANDLE THE TRUTH.” We call this Jessup’s Law. It needs to be a part of every class in Corporate Governance!

In short, Frauds like Crime are inevitable because for some individuals, the probable rewards of fraud exceed the expected value of their personal losses.

Of course, we could do better, but the costs of fraud protection via regulations rise as well.   We could do better, perhaps, but we infer that Society believes the optimal quantity of financial fraud is not zero. The costs of prevention are not zero, while the praise for corporate honesty from Philosophers, Pastors and Op-ed Writers is insufficient to enforce a more rigorous anti-fraud environment.

Bloomberg’s report on Wirecard can be found at https://www.bloomberg.com/news/articles/2020-06-26/wirecard-auditors-say-elaborate-fraud-led-to-missing-billions