Investors, beware! The Great Fraud Reckoning has arrived

Be prepared for an inexorable wave of corporate fraud.

The market is preparing to increase financial pressure on corporate balance sheets. This could lead to executives cheating to meet Wall Street’s expectations. This happens after cash becomes scarce, such as after a steep decline in stock markets or a significant increase in borrowing costs. The first is ” corporate misery”, which Bank of America calls when forward-looking numbers are lower than expected. This is already happening. That misery can then be found in a company that is run by executives who believe that they can hide their financial woes by engaging in fraud. Howard Scheck, an ex-chief accountant of the Securities and Exchange Commission Division of Enforcement told me. He is now a partner in the advisory firm StoneTurn where he conducts accounting investigations for corporate clients that are facing fraud allegations from regulators, such as his former employees or shareholders. He said, “I think that we’re going be very busy this year.” After years of money flowing freely and cash pools being available for purchase, the dollar crisis is upon us. The dollar drought is here after years of free-flowing money and cash pools. Companies should think twice about adding debt to finance their operations because higher interest rates make it more difficult to obtain a loan. The stock market has declined as a result of rising interest rates. This makes it more difficult to raise new investors and offer stock. Inflation is driving up prices so even if you get a dollar it doesn’t go nearly as far. Rising costs of labor and materials are reducing revenues and making it harder for companies to make a profit. According to FactSet the S&P 500 companies will report an earnings decline of 5% in the fourth quarter. This is the first drop in corporate profits since the pandemic. The number of companies reporting earnings that exceed Wall Street’s estimates is already 10 percentage point lower than the average for the past five years. There are other signs that the dollar well is drying up: Profit margins are dropping for the sixth consecutive quarter and revenue growth is expected to slow down for the first time since 2020. This is known as the “fraud triangle”, which corporate finance refers to as a situation in which fraud motives or pressures meet rationalization and opportunity. Companies and executives attempt to create their own water when there is no water. Executives are under pressure right now to deliver on their compensation. This is often tied to the stock price of the company or Wall Street. If they have the ability to manipulate financial metrics, they might do so. The stock market reached “peak stupid” in the past decade, particularly during the pandemic years. This was a place where learning from past bubbles wasn’t encouraged and where money chased stupid ideas. This included dopey dealmaking and profitless initial public offerings. There were also many proclamations that “this is different.” We are in drought season not only because of interest rates. We also created a bubble and money will disappear from the market as soon as it bursts.

Scheck stated that there is a greater risk of corporate fraud, but he was reluctant to use historical analogies. Accounting professionals deal in decimals and dots, so comparisons are difficult for many. However, analogies are abundant.

The dot-com bubble in the late 1990s/early 2000s is the most obvious. The internet’s initial colonization drove a market frenzy. In 1999, companies without customers or revenue were publicly traded. The $164 billion merger between Time Warner and AOL in 2000 was the crown. It is widely considered to be one of the most stupid mergers in Wall Street History. The tech-heavy Nasdaq index reached its peak in March 2000, and it continued to decline until it reached its lowest point in 2002.

Like all other crashes, the dot-com crash was a money suck. As cash ran out, some companies riding the exuberance of the era crashed and burned. These were the FTXes. Real businesses were also affected, and some resort to fraud to appear healthy. For example, take WorldCom, a telecom company.

WorldCom’s bottom line suffered when companies cut their telecom budgets. Executives began to use accounting tricks to make it appear that the company was still growing at an acceptable rate. They recorded expenses as investments and manipulated cash reserves to the tune $3.3 billion in false profits between 1999 and 2001. The company collapsed and was eventually punished by law enforcement and the market. Bernard Ebbers, the CEO, was sentenced to prison. Companies that appear to be making huge profits while others are struggling for cash should be avoided. Fraud becomes harder to conceal when the market is dry. When the market is dry, fraud becomes more difficult to hide. Francine McKenna, an adjunct professor at Penn’s Wharton School, explained this to me. She is also the author of The Dig accounting blog. Remember that Bernie Madoff was a disgraced investor who ran a Ponzi scheme worth $65 billion. This happened a full one year after the bear market began in 2007. After he was able to plug the holes for a while, Madoff couldn’t get $7 billion back from his clients, who had all been losing money on the market, and he wasn’t able to do so again. Madoff was able to gather enough cash for several months, including from his personal checking account. He was finally arrested in December 2008. American investors lost $4.3 billion on Swedish Match in 1932. This match company was owned and operated by Ivar Kreuger, one of the wealthiest men in the world. Kreuger managed to conceal the fact that he had inflated the company’s financial situation by borrowing money from the US stock exchange while the market was raging. Kreuger was unable to continue the deceit after the 1929 crash. As Madoff, Kreuger’s investors wanted cash. Kreuger could not keep up the charade after the 1929 crash. This was done by the researchers by pinpointing a peculiar liquidity event, Arthur Andersen’s collapse. In 2002, the US government discovered that Arthur Andersen had attempted to obstruct justice in order to assist Enron with its $74 billion fraud. Arthur Andersen’s other clients were also affected by this crisis. How many companies helped the accounting firm to stay afloat? All clients of the accounting firm had to assure investors they were doing well. These companies were forced to go under the water, which was a kind of a low-water mark for them. It was a moment of salvation for any fraud firm Arthur Andersen might have assisted or aided. WorldCom was one.

Luigi Zingales from the University of Chicago, one of the study’s authors, said that Arthur Andersen’s bankruptcy was “cool” because there was panic among its clients. They needed to do all kinds of cleanup.

Zingales and his colleagues analyzed the exposures and found that 10% of corporations had committed securities fraud in any given year and that 41% of companies had “misrepresented” their financial statements. They may seem to be experiencing a sudden liquidity crisis, but it isn’t really that sudden. Companies must have cash flow. Well-hidden fraud is not. Down markets expect that.

Does a tree that falls into a forest make any sound if no one hears? Did anyone get ripped off if fraud is committed and there aren’t enough law enforcement personnel to stop it? This question could determine how much fraud is exposed over the next months and years. They are in a perfect position to expose themselves, but the SEC and, in certain cases, the Commodity Futures Trading Commission will have to determine how many companies are falsifying their numbers.

Dan Taylor, University of Pennsylvania accounting professor, told me that “the notion that more fraud is revealed when the economy tightens” assumes that the enforcement agency has the resources to prosecute fraud. “And that assumption is at best dubious.”

While fraud enforcement has increased over the past year, it’s still at record lows under the Trump administration. It’s easy for fraud to be confused with poor decision-making in a downturn if there aren’t enough investigators on the ground. Taylor stated that it is crucial to increase enforcement and penalities for wrongdoing in order to protect investors as well as deter deceptive practices.

Taylor stated that there must be consequences for violating the law. Taylor stated that if the only consequence of violating the law is a business decision, people won’t be willing to think about the legality.

Wharton’s McKenna believes that legal considerations are clouded by the inability of authorities to label frauds frauds. This could result in heavy fines and jail time for individuals. The enforcement agencies have been describing this fraudmy behavior as “failure of disclosure,” which only results into a fine for corporations. She said that if companies reveal how they got to their numbers it is not fraud, but it would’ve had been 15, 20 years ago. This is when executives feel the need to push the envelope and when suddenly you see fraud everywhere.