Sam Bankman-Fried, founder of FTX, began Monday a billionaire and ended Friday broke. FTX was a cryptocurrency exchange, and it collapsed within a week. It is another in a long list of corporate fraud and scandals that will continue to stretch on into the future. The wise investor can spot these disasters for what they are by, as the Economist magazine put it “searching within the ‘fraud triangle’ of financial pressure, opportunity and rationalization.”1
Think of the past scandals of Bernie Madoff, Enron, WorldCom, Archegos, and
Theranos, to name just a few. In each case there was something special about the company that set them apart. For Bernie it was a system that made money quarter after quarter with only one loss in years. Enron was the dominant player in short term energy trading, made possible by a national electrical grid. WorldCom was the second largest telecom company in the country, nearly giving them a monopoly. For Theranos, it was a technology reputed to be capable of performing hundreds of medical tests on a single drop of blood. FTX was a blockchain technology, and its application to cryptocurrency was tantalizing. (For an excellent presentation about FTX and how it grew and then imploded, I recommend “The FTX Disaster is Deeper Than you Think” by ColdFusion on YouTube. It is more than worth the 28-minute watch. I found it fascinating.)
When you are the CEO of a break-through technology company, in order to market your work, you become very exposed. There is pressure to perform financially. For companies listed on the stock exchanges, there is pressure from the analysts, the institutions, portfolio managers, and traders. 2022 has been a year when an “earnings or revenue miss” or even concerns for future revenues can tank the price of a stock. Many CEOs even have their salary tied to the stock price, which causes additional personal pressure to perform.
“That bosses feel pressure to deliver predictable profits is well documented. Almost all the 400 managers surveyed in the mid-2000s by John Graham, Campbell Harvey and Shiva Rajgopal, a trio of academics, confessed to a strong preference for smooth earnings. Most admitted they would delay big spending line items to meet a quarterly earnings target. More than a third said they would book revenues this quarter rather than the next, or incentivise customers to buy more earlier.
The rewards for smoothing earnings have since grown. Investors attach rich valuations to the shares of dependable earners. Such “quality stocks” have sagged already.
“Some bosses will resort to fraud to avoid plummeting further.”2
But as the Economist points out, financial pressure is not enough. There must also be “opportunity”.3 For small companies that operate on a cash basis, the revenues and expenses are entered on the books as cash in and cash out. What remains is the profit of the business. But large firms use an accrual basis of accounting where some expenses and even some revenues are booked even though the cash has not been received or paid out. Banks carry an accrual for “bad loans”. The loans have not defaulted, but banks see some probability that they will default and thus accrue the potential default as a bad loan and expense it.
As an aside, I am a balance-sheet guy when I examine the financials of a company. The income statement can be full of accruals that overstate income, understate or overstate expenses, and consequentially arrive at earnings which differ significantly from actual cash earnings. There is no question that some or maybe even most accruals are realistic. But over my many years in the business, I have seen too many income statements that have been less than accurate. In my opinion, balance sheets tend to be a more accurate representation of the business.
In any case, accruals in US businesses can be misleading and may potentially hide fraud. At least in the United States there are regulations and accounting standards. In emerging markets and even some very large markets, like China and India, there are fewer regulations and standards that offer greater opportunity for fraud. The Bahamas, for example, where FTX operated, has accounting standards, but companies are not required to follow them. At least that is my understanding.
But as the Economist continued, even the combination of financial pressure and opportunity are not enough. There must be rationalization. After all, the bosses reason, “Everyone is doing it.” (not true). Or they may rationalize it as a “short-term” problem. Or they may say “they are saving jobs”. There are any number of rationalizations the fraudsters use to justify their actions.
As Warren Buffett has said: “A rising tide raises all the boats, but when the tide goes out you get to see who is swimming naked.” We just want to be in the right stocks and bonds at the right time. Yes, that means sometimes when the tide goes out our stocks sink, but if chosen right – and we believe we have – those stocks will float and rise again.
1. “A Sleuth’s Guide to the Coming Wave of Corporate Fraud.” The Economist. The Economist Newspaper, November 7, 2022. https://www.economist.com/business/2022/11/07/a-sleuths-guide-to-the-coming-wave-of-corporate-fraud.
2. “A Sleuth’s Guide to the Coming Wave of Corporate Fraud.” 2022.