For all those who were unable to attend the sold-out ACFE Europe conference in Frankfurt a.M., see my earlier post , a number of posts by ACFE staff covering the sessions and keynote speakers as well as a summarizing video with comments and impressions are now available.
Recent headlines covered Brexit and Britain’s subsequent repeal of laws, Germany’s private bank Hauck & Aufhäuser, dissolved Welling & Partners in the British Virgin Islands (IcelandReview, ruv.is), and Fashion brand founder Karen Millen’s bankruptcy. Unrelated, at first glance, they also entailed various fraud-related issues and bring a pressing need for effective due diligence back into the focus of public attention.
National and international aspects:
The headlines and underlying cases are indicative of the complexity of cross-border transactions in a globalized world where legislation, regulation, and enforcement still remain largely a national matter. Further significance has been added by the recent conflict of interest breach at the Bank of England, resulting in the Deputy Governor’s resignation. The ongoing prolific debate around conflicts of interest in the current US White House (visualized web ) has additionally furthered public appetite for scrutiny and clarity byeond national confines and territories.
Spanning Britain, Germany, Iceland, the European Union (EU) and EEA (European Economic Area), as well as off-shore tax havens in the British overseas territories, taking a birdseye view helps to understand and illustrate the challenges resulting from a broad network of anti-money laundering regulatory provisions and policies.
“EU legislation requires that institutions adequately manage and mitigate operational risk, which is defined as the risk of losses stemming from inadequate or failed internal processes, people and systems or from external events.
Operational risk includes legal risks but excludes reputational risk and is embedded in all banking products and activities. It has always existed in banking, and non-banking organizations but it has acquired a greater relevance given the increased complexity and globalization of the financial system and the recent materialization of unprecedented extremely large losses.”
Source: European Banking Authority (EBA)
Conducting required checks and ongoing monitoring and registry maintenance sufficiently, requires both, the buyer’s and seller’s concerted efforts in order to mitigate and manage risk emanating from improper or inadequate due diligence.
The complex landscape of regulations and guidelines:
- Britain‘s exit from the EU will leave its leading role in anti-money laundering (AML), anti-corruption (and anti-bribery and sanctions compliance) mostly intact thanks to the UK Bribery Act which is independent of EU regulations. Of greater concern is the stricter control of offshore territories, mainly in former colonies, as well as compliance regulation, applicable to financial firms, which is predominantly derived from EU legislation (OECD concern).
- Iceland, as a member of the European Economic Area (EEA), has to comply with the EU regulations and its interpretations of the Financial Action Task Force (FATF) standards (Iceland in FATF). This scenario could also apply to Britain, depending on the outcome of future negotiations, for now, Britain remains a member of the FATF.
- The European Union’s 4th Anti-Money Laundering Directive (4AMLD – summary) was adopted in May-2015, became effective in Jun-2015, and its national transposition is required by 26-Jun-2017.This will entail central registers of beneficial ownership as already set up in Ireland but currently not yet in place in Germany (see the Beneficial Ownership Transparency – Country report, 2015 – for in-depth analysis).
Knowing which rule, regulation, and watchlist apply:
Conducting checks is time-consuming, resource-intense and it may be costly. However, failing to thoroughly substantiate the identity of a customer or UBO (buyer, seller, business or other transaction-partner alike) may be significantly more costly and damaging to the reputation and funds.
- Enhanced due diligence ( FFIEC, US – CDD rules, BSA/AML),
- Know Your Customer (KYC) requirements (PwC KYC guide)including frequently updated watchlists
- Registries of Conflicts of Interest: e.g. Canada’s House of Commons, US Senate Ethics/COI – (mostly not centralized and non-public),
- and Ultimate Beneficial Owners (UBO), see also GlobalWitness article discussing on UK UBO database.
“Risk, I had learned, was a commodity itself. It could be canned and sold like tomatoes. Different investors place different prices on risk. ”
(Michael Lewis, Liar’s Poker, 1989)
Outsourcing the checks may be one option but ultimate responsibility may remain with the outsourcing party – as the case of Karen Millen’s tax evasion scheme around-the-world (see EU Parliament Library note on corporate tax avoidance) demonstrated. A list of significant failures of duty of care in this regard is available on the UK’s Financial Conduct Authority site (FCA).
Knowing when to conduct checks:
Certain types of risk cannot be insulated, transferred, or legally sold. Due Diligence (and Enhanced DD: EDD), Know Your Customer (KYC), Conflict of Interest (COI), and Ultimate Beneficial Ownership (UBO) regulations and rules are neither effective nor meaningful past the event, which does not render them obsolete but makes their use all the more valuable as a set of preventive instruments throughout the interaction. Compliance programs and efforts have become increasingly sophisticated, however, human factors such as misplaced bias, trust, unquestioned routines, and practices may enhance the operational risk.
“Let me put it this way: I’m standing in front of a burning house, and I’m offering you fire insurance on it.”
(Jared Vennett explains Credit Default Swaps (CDS) in M. Lewis’ The Big Short: Inside the Doomsday Machine, 2010/2015)
Latent reputation risk and litigation risk may arise instantly, at a very early stage during negotiations. This may apply irrespective of the nature of a transaction, whether an acquisition, a merger or a sale of a specific stake.
It requires due consideration and pro-active mitigation at a time when there is neither smoke nor fire, a long-term approach that may be deemed a challenge in environments where accounting for long-terms risk conflicts with short-term objectives. Adhering to ethics codes voluntarily may be one way to address the issue, voluntarily applying EDD can be yet another.
Overall, it can be argued that transparency of data, consolidation of watchlists, regulations, and enforcement efforts are increasing and increasingly streamlined, consolidated, and subject to public awareness and debate.
Snap Inc.’s IPO has turned from hyped to sour in less than a week – NYSE: SNAP. I had already flagged some concerns with the company’s valuation and potential issues as to underlying metrics which were, according to the lawsuit linked in my previous post, alleged to be fraudulently inflated.
There has been much debate across various media channels as to the underlying metrics which informed the calculation of the valuation. However, goodwill remained unmentioned. While notoriously hard to value, it deserves more public debate. In particular so, as in the case of Snap Inc.’s going public the goodwill valuation shows a significant increase from 2015 (USD 133.9 mn) to 2016 (USD 395.1 mn), see p 35 in SEC Statement under The Securities Act 1933 where Snap Inc. states:
If our goodwill or intangible assets become impaired, we may be required to record a significant charge to earnings, which could seriously harm our business.
Under U.S. generally accepted accounting principles, or GAAP, we review our intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is required to be tested for impairment at least annually. As of December 31, 2016, we had recorded a total of $395.1 million of goodwill and intangible assets, net related to our acquisitions. An adverse change in market conditions, particularly if such change has the effect of changing one of our critical assumptions or estimates, could result in a change to the estimation of fair value that could result in an impairment charge to our goodwill or intangible assets. Any such material charges may seriously harm our business. [emphasis added]
The quick return down to earth may not come as a surprise to those who refrained from investing and held a critical view on the corporate governance issues and Snap Inc.’s business model. But those among the public investors who hoped for sustainable profit may have had a rude awakening.
Some argue that a segment of the investors confused popularity with profitability. Looking beyond the hype and one’s personal preferences should be part of due diligence every potential investor invests in – as a tool of damage control and sound risk management practice, before the actual investment. Conducting this due diligence with respect to goodwill valuations and the choice of metrics underpinning the overall valuation is a challenge, though.
It helps, especially when it comes to tech stock or unicorns to keep a set of questions in mind, coupled with a few considerations that should guide the investor’s evaluation. Goodwill valuation, its challenges and the particular risks embedded in the metric that is prone to bias and often deemed an art rather than fact-based science, is equally important and difficult to assess in terms of accuracy.
For the purpose of understanding a whole range of motives, pressure and influencing circumstances that may inflate a valuation underpinning the going-public of a tech company, the following questions and aspects should be kept in mind:
- Generally speaking, the industry’s standard needs to be taken into account – keeping in mind the dot-com bubble during the late 1990s and the related history of very short track records coupled with thin profits.
- A key concern is and remains the fact that underwriters, such as large investment banks, charge considerable fees. Up to 6-10% of the capital raised in the IPO are due and represent a considerable lucrative incentive, making this a non-deferred reward system prone to fraud.
How do underwriters make their money? A bank or group of banks put up the money to fund the IPO and ‘buys’ the shares of the company before they are actually listed on a stock exchange. The banks make their profit on the difference in price between what they paid before the IPO and when the shares are officially offered to the public. Competition among investment banks for handling an IPO can be fierce, depending on the company that’s going public and the money the bank thinks it will make on the deal. (CNBC explains:IPO)
- CEOs and CFOs are disproportionately frequently involved in financial statement fraud (underpinning the valuation), this is largely enabled due to their position of power, status and related access to systems and coupled with particular pressures and expectations that these roles entail.
- The pressure and common reasons senior management cite when caught overstating their financial statements include (a) compliance with loan covenants, (b) meeting and exceeding earnings or growth expectations of stock market analysts, (c) showing a pattern of growth to support a planned securities offering or sale of the business, (d) meet personal or corporate performance criteria – to name only the most prevalent ones in this context (see Forensic Accounting and Fraud Examination, 2010, Wiley, by John Wells, Mary-Jo Kranacher, and Richard Riley).
- Taking the figures at face value is not advisable, frequently footnotes and disclosure notes might indicate deviations from generally accepted accounting principles (GAAP). Despite standards, guidelines, and rules, it is vital to keep in mind the subjective nature of book- and record-keeping. Differences in judgment can result in significantly differing valuations. To illustrate:
.5 Fair value measurements for which observable market prices are not available are inherently imprecise. That is because, among other things, those fair value measurements may be based on assumptions about future conditions, transactions, or events whose outcome is uncertain and will therefore be subject to change over time. The auditor’s consideration of such assumptions is based on information available to the auditor at the time of the audit. The auditor is not responsible for predicting future conditions, transactions, or events that, had they been known at the time of the audit, may have had a significant effect on management’s actions or management’s assumptions underlying the fair value measurements and disclosures.
source: AICPA (American Institute of Certified Public Accountants) Standard Audit Test AU00328 and VS Section 100: Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset
The issue with valuing young companies is not a new one. In recent times we witnessed the case of Theranos (Fortune, 2016, Wired, 2016, Gawker) which turned from a USD 9 billion valuation into a serious fraud disaster. Then there is The Honest Company which has been under persistent criticism for product fraud but more importantly in this context is its seemingly inflated and unjustified valuation, given these issues. Of course, there is also the valuation controversy around Uber, to name only a few examples.
Some argue that the current tech valuations are entirely made-up (see Zero Hedge, 2015). We know for certain that the dot com bubble was a culprit in this regard (Business Insider, SEC action against Henry McKelvey Blodget, Merrill Lynch, internet sector stock fraud). As mentioned above, the not so distant past might be an indicator as to where valuation practices remain problematic and require further regulation or more meaningful methodologies.
The key nagging questions that remain:
- If investors who provide large amounts of funds aren’t doing their proper due diligence, does this mean the data they rely on is insufficient and not sufficiently transparent?
- If availability, accessibility, and transparency of data are not the issue or main driver of lack of rigorous due diligence, what irrational drivers make such investors ignore all (or any) red flags?
- Is it the simple but persistent Gecko’s “greed is good” which appears to work again and again, even if in the very short-term only?
Further reading on valuation, in particular also goodwill valuation, in the context of IPOs:
Fraud has many faces and is not confined to the most commonly occurring schemes such as
- bribery and corruption
- asset misappropriation including larcency and and embezzlement.
Financial statement fraud and all forms of forgery which result in fraudulent documents, statistics, reports and statements are just other variations. This has put corporations such as Enron and WorldCom and more recently Volkswagen (see my previous article) on everyone’s radar. However, financial statement fraud is not a privilege of U.S. corporations but can be found in such seemingly opposing areas such as care homes and Germany’s health care providers.
In terms of sectors, fraud is not discriminating, it is found in every sector and industry, with some perceived by the public as less prone though:
- Health care fraud, medical fraud and insurance fraud which are often interconnected and link to the wider sector, include care home fraud. Read more about Nursing Home Fraud in Germany; and see also publications by the European Healthcare Fraud & Corruption Network.
- In the broader sense, medical fraud may be interconnected with scientific and pharmaceutical fraud, see also Fraud and deceit in medical research (2012).
- Academic fraud may be related to grant and funding fraud, or fraudulent studies and misleading research findings.
Plagiarism is a type of fraud found among students, researchers and senior academics. See also Der Spiegel on Academic bribery in Germany (English), a type of fraud which applies across academic disciplines and may involve scientific misconduct, education fraud and breach of the relevant Ethics Code, see also the Guardian: UK watchdog closes 30 fake universities.
Government fraud and corruption come in many shades and are deeply damaging as they also erode public trust in governmental bodies and public services. This ranges from government officials, customs officers or other staff
- taking bribes,
- manipulating bids,
- favoring someone’s family member for a position to
- promoting a lobbyist’s agenda in exchange for gifts, favors or non-repayable personal loans etc.
In charities, sport clubs, religious congregations, churches, and other non-profit and non-governmental organizations which may be handling more cash due to donations or lack of automated payment systems, the risk of fraud still tends to be even higher. Frequently, charity fraud is found in organizations which also enjoy a high amount of public trust per se due to the nature of their cause. Fraud risk then is amplified by the lack of internal controls and independent external scrutiny, see also US charity fraud, UK Charity Fraud Line .
Essentially, fraud can happen in every industry – wherever internal and external controls are weak and poorly enforced. To illustrate this with one basic yet dominant example of fraud that prevails across the industries: fraudulent expense claims frequently concern travel costs or business gadgets. Disbursements of such fraudulent travel expenses or presumably lost or stolen mobile phones, laptops etc. will be found to have been inflated, mis-characterized, multiplied or are even fictitious.
Whether you are affected as parent, citizen or employee, business owner or somewhere in middle management, whether you lead at the top or stand in the front rows of the organization – fraud concerns everyone, also as bystander and taxpayer.
Every time, fraud goes undiscovered, or is passively tolerated by looking the other way, the entire society suffers. That means you, your family, your wider circle of loved and trusted ones, and ultimately the society you live in. Tolerating fraud is rolemodeling irresponsible tacit consent to our children and others.
Further sources which can be shared, embedded and harnessed to kicking off discussions and raising awareness – in every area of your life – are available at Fraudweek.com and via #fraudweek on Twitter