Sometimes it helps to look at a situation, such as a fraud scheme, in a different way. When the scheme is explained this way it seems ridiculous that investors, or auditors, or regulators didn’t see what was happening.
Paul Krugman is an economist who won the Nobel Prize for Economics in 2008 and has been a professor at Princeton and MIT. He has written dozens of books and countless columns for the New York Times and for business magazines. In 2002 one of his New York Times columns caught my eye and I have kept a copy ever since. Called Flavors of Fraud, Krugman used a fictitious ice cream shop to describe several well-known frauds at the time in a way that was amusing. Also made me wonder why it took so long to discover them.
The following cases all occurred in the early 2000’s. In the prior decade the internet became much more well-known to the general public and any start-up claiming a business associated with its technology could easily find investors and borrow money to grow. Then the “tech bubble” popped….
See my previous blog which provides more insight into the company than I will here. Essentially it went from a utility to a company that made more money trading electricity contracts. It seemed invincible until it went bankrupt in 2001. Krugman explains what it did:
So you’re the manager of an ice cream parlor……. You sign contracts to provide customers with an ice cream cone a day for the next 30 years. You deliberately underestimate the cost of providing each cone; then you book all the projected profits on those future ice cream sales as part of this year’s bottom line. Suddenly you appear to have a highly profitable business, and you can sell shares in your store at inflated prices.
Another utility company which even tried to buy Enron at one point. It also got into energy trading, lost a lot of money and its senior executives tried to cover up the losses. It eventually went bankrupt as well. Again, here’s Krugman:
Ice cream sales aren’t profitable, but you convince investors that they will be profitable in the future. Then you enter into a quiet agreement with another ice cream parlor down the street: each of you will buy hundreds of cones from the other every day. Or rather, pretend to buy — no need to go to the trouble of actually moving all those cones back and forth. The result is that you appear to be a big player in a coming business, and can sell shares at inflated prices.
A Pennsylvania based company offering TV cable and long distance telephone services (this was prior to cell phones when long distance phone calls were expensive). The owners stole over $100 million from the company for use in their personal ventures eventually forcing Adelphia into bankruptcy. Krugman’s tale:
You sign contracts with customers, and get investors to focus on the volume of contracts rather than their profitability. This time you don’t engage in imaginary trades, you simply invent lots of imaginary customers. With your subscriber base growing so rapidly, analysts give you high marks, and you can sell shares at inflated prices.
Originally LDDS (Long Distance Discount Services) it also offered long distance telephone services. It grew rapidly and acquired many other companies. The growth caused the stock price to soar and the CEO margined the stock to finance other personal businesses. By 2000 the business began to decline but its problems were hidden by some accounting dodges conducted by the senior managers. Here is Krugman’s explanation:
Finally, there’s the WorldCom strategy. Here you don’t create imaginary sales; you make real costs disappear, by pretending that operating expenses — cream, sugar, chocolate syrup — are part of the purchase price of a new refrigerator. So your unprofitable business seems, on paper, to be a highly profitable business that borrows money only to finance its purchases of new equipment. And you can sell shares at inflated prices.
In each case the CEO benefitted personally from the stock at high prices and had an incentive to keep the price high. Krugman even discusses that:
I almost forgot: How do you enrich yourself personally? The easiest way is to give yourself lots of stock options, so that you benefit from those inflated prices. But you can also use Enron-style special-purpose entities, Adelphia-style personal loans and so on to add to the windfall. It’s good to be C.E.O.
No big lessons here although I hope you recognize the Fraud Triangle….Pressure, Opportunity and Rationalization. These factors were present in each case.
If your company has been a victim of fraud let me know if you are willing to discuss it with me. It would be helpful to other entrepreneurs to hear about real life examples of fraud, loss and recovery.
Let me know what you think………