Secret Pension Fund Manager: How to Spot Fraud

When I learned that Elizabeth Holmes, the founder of the blood testing company Theranos, had been convicted of conspiracy to defraud its investors, my thoughts returned to other corporate scams I have observed at over the past 30 years.

In my experience, most frauds are unplanned in the first place. They start with overly optimistic forecasts that don’t come true, then move on to creating fictitious profits to fill those temporary holes.

Only, the holes are not temporary and the overstated cumulative profits increase until the deception is discovered.

How are these fake profits created?

It’s simple: either overestimate revenues or underestimate operating costs. I invested in a small agrochemical company that delivered excess inventory to one of its third-party distributors.

The distributor did not pay for the inventory it did not need, but the company recognized the transfer as a sale and thus inflated its profits. When the maneuver was exposed, the president fired the CEO.

MTM, a British chemicals company, collapsed in 1992 after its auditor refused to sign the 1991 accounts. The company had inflated sales and capitalized operating costs as capital expenditure.

Its chairman, Richard Lines, was then jailed for two years, but his ruse of counting opex (operating expenditure) as capex (capital expenditure) seemed to me at the time a chilling way to inflate profits.

A warning sign that reported earnings are overstated is that they are not generating cash. To match false profits, net assets on the balance sheet must increase, which is often done by increasing accounts receivable rather than cash.

When Wirecard’s profitability was questioned, its chairman Thomas Eichelmann thought there was no problem since it was generating cash. The problem was that this money was fictitious, with 1.9 billion euros, supposedly deposited in two Philippine banks, missing in 2020.

The “most optimistic version” given to me is that of British Biotech (BB). At one point in the 1990s, I was covering the pharmaceutical industry while my boss was on maternity leave.

When BB management came to see me, I asked them how the clinical trials of their pancreatic cancer drug, Marimastat, were going. I got the answer that he was about to adopt them, and the science meant that if the drug cures pancreatic cancer, then it will cure all cancers.

This revelation threw me into a spin. I quickly tried to figure out what the company would be worth with a drug that cured cancer and guessed that I would have to add two or three zeros to the stock.

Then alarm bells started ringing in my head. Why had the management, whom I was meeting for the first time, given me what seemed to be enormous inside information? If they were indeed about to land pharma gold, why risk their careers on me?

I staggered out of the meeting, returned sector coverage to my former boss, and dodged a bullet by not buying any BB shares. Marimastat was failing clinical trials and the United States Securities and Exchange Commission was investigating. BB CEO Keith McCullagh resigned in 1998 after Andrew Millar, the director of clinical trials, spoke out.

Most corporate frauds evolve haphazardly with new lies needed to cover old ones, but some are planned from the start. The model is to create a front company, cook the books, raise capital from investors, then talk the stock price or private valuation to buy time and steal capital.

This is called “backing and tunneling”, where the valuation is backed up by deception and lies while the money is expelled. Selling stocks to investors is the most direct route to stealing their money, but related party transactions are also an option.

Crooked managers overpay for another asset or business that they or their associates own, thereby siphoning off more of their investors’ capital for themselves.

The problem for white-collar criminals is getting away with it. Once they prop up the stock price and collect some of the money, how do they escape with the loot? Either they can flee like Jan Marsalek, the former COO of Wirecard, or they must continually try to buy more time. Maybe in the world of private venture capital, they can “fake it until they get it.”

Redemption caution

With listed companies, I’ve noticed that attempting a management buyout (MBO) is often the last roll of the dice. Make the company private, away from public scrutiny and nosy shareholders, then worry about how to pull the wool over the eyes of new creditors later.

Consider ISC, which was an American defense company that supplied weapons to countries in the Middle East. His contracts were so sensitive that he didn’t tell his board exactly who he was supplying.

His listeners only saw cash going out to pay sub-contractors, then back in secret clients. However, it was only shareholders’ money that was going around in circles. The majority of the contracts were fictitious.

ISC first floated in London in 1982. Then more time was bought and investors’ money stolen by selling to Ferranti in 1987. Just before the house of cards collapsed in 1991, the founder James Guerin, who was now Vice President of Ferranti, attempted an ISC MBO of Ferranti.

The MBO was not completed, Ferranti went bankrupt and was taken over by GEC. Guerin was sentenced to 15 years in prison despite his claim that he worked for the CIA.

Similarly, in 1990, Asil Nadir announced that he was going to privatize Polly Peck. Again the MBO failed to materialize and within a month Polly Peck collapsed. Nadir then served four years in prison after his first flight to Cyprus.

An alternative to this latest MBO ploy is to make a big acquisition. I call this the “invade Afghanistan” strategy. It will end in tears but will muddy the waters for a few years. Just months before Wirecard’s collapse, its CEO Markus Braun hired management consultancy McKinsey to help plan the acquisition of Deutsche Bank.

By merging Wirecard’s fraudulent operations with Deutsche Bank’s sizable balance sheet, its missing cash could initially be hidden and then covered by a post-acquisition impairment charge. The case did not come off the drawing board and Braun was arrested. Corporate fraud usually doesn’t pay.

The Secret Pension Fund Manager is a former institutional equity investor with over 30 years of experience. To learn more about the manager of the secret pension fund, click here.

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Dolores W. Simon