(Roughly) Daily

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

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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)