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“Things gained through fraud are never secure”*…

… Still, the damage done to the defrauded is too often too real. A unsettling report from the front lines of financial accounting…

The level of corporate earnings manipulation is similar to that of past pre-recessionary periods, according to research by professors at the University of Missouri and Indiana University.

Their finding is based on the M-Score, a screening model that catches fraud in corporate earnings reports. Messod Daniel Beneish, a professor at the Indiana University Kelley School of Business, created the M-Score in the 1990s. The “M” stands for manipulation, and the measure is also sometimes referred to as the Beneish M-Score.

Based on known examples of past financial misreporting, the M-Score combines eight ratios on a company’s balance sheet to assess its fraud risk. A higher M-Score means a company is more likely to be manipulating its earnings.

“It allows us to assess fraud risk in real time,” said Matt Glendening, an accounting professor at the University of Missouri. “The advantage of using a measure such as the M-Score is that if you use actual instances of accounting fraud, not all cases are caught, especially the less severe cases. And also, there is a delay between the misreporting period and the time at which the fraud is actually revealed.”

One notable M-Score success came in 1998, when a group of Cornell students used the M-Score to flag Enron as having an elevated fraud risk. This was three years before the public learned that the company was inflating its profits, resulting in what was then the largest corporate bankruptcy in history and several executives going to jail.

Corporate earnings are traditionally manipulated either by overstating revenues or understating expenses. How companies do this varies, but it could include recognizing sales revenues early or understating inventory.

“There are all sorts of capital market pressures on firms to maintain stock price, maintain earnings growth,” Glendening said. “There could also be some compensation incentives at play.”

In 2019, Beneish expanded the M-Score, creating a new measure that goes beyond individual companies to the economy as a whole. With the help of Glendening and two other co-authors, Beneish created the aggregate M-Score, which now compiles the M-Scores of 2,004 companies to measure the likelihood of earnings manipulation across the economy. Earlier in 2023, the aggregate M-Score was at its highest level in 40 years.

“Accounting manipulation matters for the economy at large,” Glendening said. Companies use other business’ earnings data to inform hiring, purchasing, and production decisions. “What we are finding is that the level of aggregate misreporting is very similar to what we’ve observed in pre-recessionary periods.”

Ask not for whom the bell tolls: “This little-known accounting measure is ringing an economic warning bell,” from Kai Ryssdal (@kairyssdal) and Andie Corban on @Marketplace.

See also: “Corporate Fraud” (source of the image above)

* Sophocles


As we look more closely, we might recall that it was on this date in 1974 that the House Judiciary Committee voted to recommend that America’s 37th president, Richard M. Nixon, be impeached and removed from office for a variety of offenses that arose from the Watergate Affair. Several days later (August 5), as the full house discussed the trial, the “Smoking Gun” tape was released, demonstrating that Nixon was in fact involved in the cover-up. His political capital destroyed, Nixon resigned– in a nationwide television address– on August 8, effective the next day.


“If you don’t allow for self-serving bias in the conduct of others, you are, again, a fool”*…

Private equity firms are in the spotlight for their negative impact on health care, journalism— indeed, essentially every sector they touch in the interest of generating big returns for themsleves and their investors (some of which are sovereign wealth funds; some, very wealthy individuals/families; but largely, insurance companies and public pension firms). Now, as the inimitable Matt Levine points out, even those investors (who were already paying massive fees) are in the private equity firms’ crosshairs…

Two basic features of private equity economics are that if you raise a fund and you spend $1 billion to buy a company, and you do a good job running the company and it becomes worth $5 billion, then:

  1. You charge a management fee — say, 2% per year — on the $1 billion you paid for the company, not the $5 billion it’s currently worth.
  2. If you sell the company — to a strategic buyer or another private equity firm or in an initial public offering — you collect $800 million of carry (20% of the value that you added to the company), but you can’t charge the management fees anymore.

It would be good, for you, to mark the company to market. Raise your own new private equity fund, and sell the company from your old fund to the new one at its current market value. Then:

  1. You can keep charging 2% per year, but now on $5 billion rather than $1 billion.
  2. You can collect your $800 million of carry now, and then if you add more value you can collect more carry when you sell it.

This is called a “continuation fund.” The Financial Times reports on “a new and controversial type of transaction that is fast becoming the private equity industry’s hottest trend in the US, UK and several other markets — deals in which a buyout group in effect sells a company to itself”:

Such deals have partly been a consequence of the tidal wave of cash that has flooded private markets during the long era of low interest rates. As that era comes to an end and a downturn looms, these deals are set to become more attractive than ever for private equity groups with companies to sell.

The deals — a way for buyout groups to return cash to their original investors within a pre-agreed 10-year time period, without the need to list companies or find outside buyers — have been growing in popularity since the early days of the Covid-19 pandemic, when a market freeze prompted a search for new options…

Equity market investors are becoming increasingly vocal about how private markets value companies. Vincent Mortier, Amundi Asset Management’s chief investment officer, said this month that parts of the buyout business “look like a pyramid scheme” because of “circular” deals in which companies are sold between private owners at high valuations.

Speaking privately, some pension funds are frustrated. “This is wonderful for the [buyout groups]; it’s one of the best things they ever discovered,” says one pension fund’s head of private equity, who asked not to be named.

But “it’s one of the worst things” for their investors, he adds. “The pie is getting bigger” as private equity balloons in size, he says, but “more of the pie is going to the [private equity firm] and less is going to [its investors].”

More on these Machiavellian machinations: “Buyout Firms Buy From Themselves,” from @matt_levine in @business.

[Image above: source]

Charlie Munger


As we ruminate on rapaciousness, we might recall that it was on this date in 1873 that Jesse James and his gang staged the first train robbery (the world’s first robbery of a moving train), a mile and a half west of Adair, Iowa… the site of which is now commemorated as a county park.



“Long life is welcome, agreeable, pleasant, and hard to obtain in the world”*…

… maybe, as recent research from Saul Justin Newman explains, even harder than we thought…

The observation of individuals attaining remarkable ages, and their concentration into geographic sub-regions or ‘blue zones’, has generated considerable scientific interest. Proposed drivers of remarkable longevity include high vegetable intake, strong social connections, and genetic markers. Here, we reveal new predictors of remarkable longevity and ‘supercentenarian’ status. In the United States supercentenarian status is predicted by the absence of vital registration. In the UK, Italy, Japan, and France remarkable longevity is instead predicted by regional poverty, old-age poverty, material deprivation, low incomes, high crime rates, a remote region of birth, worse health, and fewer 90+ year old people. In addition, supercentenarian birthdates are concentrated on the first of the month and days divisible by five: patterns indicative of widespread fraud and error. As such, relative poverty and missing vital documents constitute unexpected predictors of centenarian and supercentenarian status, and support a primary role of fraud and error in generating remarkable human age records…

The paper in full: “Supercentenarian and remarkable age records exhibit patterns indicative of clerical errors and pension fraud,” at @biorxivpreprint.

(Image above: source)

* Buddha


As we long for longevity, we might send healthy birthday greetings to William H. Welch; he was born on this date in 1850. A physician, pathologist, bacteriologist, and medical educator, He was one of the “Big Four” founding professors at the Johns Hopkins Hospital, the first dean of the Johns Hopkins School of Medicine, and the founder of the Johns Hopkins School of Hygiene and Public Health, the first school of public health in the country.

Welch revolutionized American medicine by demanding of its students a rigorous study of physical sciences and an active involvement in clinical duties and laboratory work. His students included Walter Reed, James Carroll and Simon Flexner.


“The opposite of knowledge is not ignorance, but deceit and fraud”*…

In follow-on to our last look at corporate fraud, a provocative piece by Byrne Hobart

This paper has been getting some attention lately for its eye-catching estimates: 11% of publicly traded companies are committing securities fraud every year, with an annual cost of over $700bn…

[There follows an illuminating discussion of lessons that can be drawn for the follow-on to Arthur Andersen’s collapse after the implosion of Enron, the rules/regulations developed then to prevent similar public company frauds, and a consideration of whether corporate fraud has waned– at least among publicly-traded companies– and is perhaps a little less wide-spread than the paper argues…]

But since fraud is a human problem, and not purely a matter of better accounting standards, it’s not likely to have just gone away. But if the rate of accounting problems among big publicly-traded companies is lower than the 11% number cited in the paper, the question isn’t “why did it disappear?” but rather “where did it go?” And we can take our list of trends against fraud and invert them:

• Sarbanes-Oxley does apply to private companies, but only on the penalty side, not the disclosure side. But accounting frauds in private companies are often less visible; many investments go to zero, anyway, and it’s less embarrassing for everyone involved not to say why.

• There are no short-sellers in private markets. There have been efforts here, but they don’t work out because the market doesn’t clear (“everyone wanted to short Theranos, Dropbox and WeWork”). The closest you can get to shorting is to pass on a round and then brag about it later. Big deal: I didn’t invest in FTX, either.

• There’s less data available on private companies, though the rise of alternative data tools means it’s easier to get decent proxies.

• Startups are not expected to return capital. It’s a bad sign if they do. They’re often valued either based on strategic considerations or starting with a multiple of sales—a dollar of sales is much easier to fake than a dollar of earnings or cash flow, so the incentive to do so is strong.

• The idea market in startups is liquid when it comes to successes, but it would be pretty tacky for a VC to write a long blog post explaining why they passed on a live deal. (That memo may exist internally, but to the extent that it’s shared it’s in the form of a quick summary over Twitter DM or Signal.)

JPMorgan Chase’s writedown of their fintech acquisition Frank is a great case study in all of these forces. The NYT has a good story digging into the details: Frank’s founder is a serial exaggerator whose self-promotion veered into fraud (once again, if the rate of continuous improvement in public perception to be maintained exceeds what the fundamentals can deliver, compound interest works its ruthless magic). The company was valued at a high multiple of what turned out to be a flexible metric, total email addresses captured. And there were alternative datasets that could have pointed to problems: given the likely number of student aid applicants in the US, Frank’s numbers implied that it had reached near-dominant market share in the category with little marketing. Meanwhile, its monthly site traffic was not enough to have acquired that sizable a customer list over Frank’s entire existence. So it could have been caught, if the buyer had been looking for fraud. But one paradox of frauds and cheats in general is that lying is less than half the work—most of the effort is in appearing not to need to lie. The more impressive a company looks, the more embarrassing the basic due diligence questions are.

A down market and a series of high-profile failures might give private markets the same kind of natural experiment that Arthur Andersen’s failure did for public markets. Due diligence checklists will get longer and more thorough, and new funding rounds will feel more like a cross-examination and less like a party. One reason for a high base rate of fraud is that at least some of it stems from inattention rather than malice—the Arthur Andersen study finds that most of the frauds were fairly minor, and could be more the result of poor internal metrics than of intent to mislead. But either way, standards will get higher, and private companies will need to step up their efforts accordingly…

Has the primary locus of corporate fraud moved from public to private companies? “Where Fraud Lives and Why,” from @ByrneHobart.

[Image above: source]

* Jean Baudrillard


As we do due diligence, we might recall that it was on this date in 2016 that the Centers for Medicare and Medicaid Services (CMS) sent a letter to Theranos after an inspection of its Newark, California, lab. The investigation, which took place in the fall of 2015, had found that the facility did not “comply with certificate requirements and performance standards” and caused “immediate jeopardy to patient health and safety.” This followed on three exposes on Theranos in the Wall Street Journal (in October [here and here] and December of 2015) and a critical FDA report. Things unraveled from there: in March, 2018, Thearnos, CEO Elizabeth Holmes, and President Sunny Balwani were charged by the FCC with fraud. Three month later, a federal grand jury indicted both Holmes and Balwani on two counts of conspiracy and nine counts of wire fraud, finding that the pair had “engaged in a multi-million dollar scheme to defraud investors, and a separate scheme to defraud doctors and patients.” Theranos closed in 2018. Holmes was convicted and sentenced to 11 years in prison for her crimes (a sentence she is appealing); Balwani, to 13 years.

Theranos was a private company, funded by investors including Henry Kissinger, Betsy DeVos, Carlos Slim, and Rupert Murdoch.

Elizabeth Holmes found guilty (source)

“There are only two different types of companies in the world: those that have been breached and know it and those that have been breached and don’t know it.”*…

Enrique Mendoza Tincopa (and here) with a visualization of what’s on offer on the dark web and what it costs…

Did you know that the internet you’re familiar with is only 10% of the total data that makes up the World Wide Web?

The rest of the web is hidden from plain sight, and requires special access to view. It’s known as the Deep Web, and nestled far down in the depths of it is a dark, sometimes dangerous place, known as the darknet, or Dark Web

Visual Capitalist

For a larger version, click here

And for a look at the research that underlies the graphic, click here.

What’s your personal information worth? “The Dark Web Price Index 2022,” from @DatavizAdventuR via @VisualCap.

(Image at top: source)

Ted Schlein


As we harden our defenses, we might recall that it was on this date in 1994 that arguments began in the case of United States vs. David LaMacchia, in which David LaMacchia stood accused of Conspiracy to Commit Wire Fraud. He had allegedly operated the “Cynosure” bulletin board system (BBS) for six weeks, to hosting pirated software on Massachusetts Institute of Technology (MIT) servers. Federal prosecutors didn’t directly charge LaMacchia with violating copyright statutes; rather they chose to charge him under a federal wire fraud statute that had been enacted in 1952 to prevent the use of telephone systems for interstate fraud. But the court ruled that as he had no commercial motive (he was not charging for the shared software), copyright violation could not be prosecuted under the wire fraud statute; LaMacchia was found not guilty– giving rise to what became known as “the LaMacchia loophole”… and spurring legislative action to try to close that gap.

Background documents from the case are here.

The MIT student paper, covering the case (source)

Written by (Roughly) Daily

November 18, 2022 at 1:00 am

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