WEBVTT 00:00:00.000 --> 00:00:02.439 Welcome back to the Deep Dive. I have to say, 00:00:02.580 --> 00:00:05.160 looking at the stack of research we have on the 00:00:05.160 --> 00:00:07.040 desk today, I feel like we need to put on some 00:00:07.040 --> 00:00:10.480 latex gloves. Ha! Yeah, this is not a clean subject. 00:00:10.660 --> 00:00:13.259 Not at all. We are digging into something that, 00:00:13.279 --> 00:00:16.920 on the surface, seems incredibly dry. You know, 00:00:16.960 --> 00:00:20.239 ledgers, balance sheets, audit reports. But when 00:00:20.239 --> 00:00:22.879 you actually peel back the cover, it's a crime 00:00:22.879 --> 00:00:25.660 scene. It really is. We are entering the world 00:00:25.660 --> 00:00:28.019 of forensic accounting today. And you're right. 00:00:28.100 --> 00:00:30.100 Usually when people hear accounting, they think 00:00:30.100 --> 00:00:34.659 of a beige office, a calculator and a very risk 00:00:34.659 --> 00:00:37.000 averse person worrying about tax compliance. 00:00:37.119 --> 00:00:39.560 Totally. It's viewed as the most rigid black 00:00:39.560 --> 00:00:41.759 and white profession on Earth. Most boring, some 00:00:41.759 --> 00:00:44.289 would say. Exactly. Math is math. Two plus two 00:00:44.289 --> 00:00:45.750 equals four. There's no room for interpretation, 00:00:45.950 --> 00:00:48.229 right? That is the perception. But the reality 00:00:48.229 --> 00:00:49.990 we are going to explore today is that accounting 00:00:49.990 --> 00:00:53.030 can be incredibly creative. And you don't mean 00:00:53.030 --> 00:00:55.689 creative in a good way. No, not at all. Not like 00:00:55.689 --> 00:00:58.810 a beautifully designed building. I mean, creative 00:00:58.810 --> 00:01:01.950 in the way a fiction writer creates a dragon. 00:01:02.549 --> 00:01:05.629 We are talking about the moment where numbers 00:01:05.629 --> 00:01:08.569 stop representing reality and start representing 00:01:08.569 --> 00:01:11.390 a fantasy. We are talking about accounting scandals. 00:01:11.719 --> 00:01:13.920 the cooked books. And the scope of what we're 00:01:13.920 --> 00:01:17.969 covering today is massive. I mean, we aren't 00:01:17.969 --> 00:01:19.950 just looking at petty theft from the cash register. 00:01:20.090 --> 00:01:22.909 No, no. We are looking at the heavy hitters from 00:01:22.909 --> 00:01:27.030 the Enron era that really defined the early 2000s 00:01:27.030 --> 00:01:29.909 to the massive modern collapses like Evergrande 00:01:29.909 --> 00:01:31.989 that are shaking up the global economy right 00:01:31.989 --> 00:01:33.969 now. And we aren't just going to list the crimes. 00:01:34.189 --> 00:01:35.950 Anyone can read a headline about this stuff. 00:01:36.150 --> 00:01:38.230 Our mission today is to understand the mechanics. 00:01:38.469 --> 00:01:40.629 How do you hide a billion dollars? How do you 00:01:40.629 --> 00:01:42.510 make a company that is bleeding money look like 00:01:42.510 --> 00:01:44.189 it's the most profitable business in the world? 00:01:44.290 --> 00:01:46.030 And perhaps most importantly, why do they do 00:01:46.030 --> 00:01:48.170 it? The psychology of the con, I think that's 00:01:48.170 --> 00:01:50.549 the part that fascinates me the most. We tend 00:01:50.549 --> 00:01:52.489 to think of these fraudsters as these, like, 00:01:52.510 --> 00:01:55.609 evil masterminds, but often they're just desperate 00:01:55.609 --> 00:01:57.310 people who painted themselves into a corner. 00:01:57.650 --> 00:01:59.890 Or, on the other hand, they're narcissists who 00:01:59.890 --> 00:02:02.069 genuinely believe they are smarter than the market, 00:02:02.069 --> 00:02:04.109 smarter than the auditors, smarter than everybody. 00:02:04.409 --> 00:02:07.750 It's a real mix. So let's set the stage. We have 00:02:07.750 --> 00:02:09.710 a lot of ground to cover everything from what 00:02:09.710 --> 00:02:12.069 we're calling the fraud triangle to the hall 00:02:12.069 --> 00:02:14.469 of shame. But I think we need to start with a 00:02:14.469 --> 00:02:17.330 definition. What is the line between a mistake 00:02:17.330 --> 00:02:20.430 and a crime? Because I definitely messed up my 00:02:20.430 --> 00:02:22.370 own budget before, but I don't think the FBI 00:02:22.370 --> 00:02:24.669 is coming for me. Well, let's hope not. But you've 00:02:24.669 --> 00:02:27.289 hit on the key word, the legal pivot point. It's 00:02:27.289 --> 00:02:30.110 intent. Intent. An accounting error is just that, 00:02:30.210 --> 00:02:33.530 an error. You forgot to carry a one or you categorized 00:02:33.530 --> 00:02:35.930 a lunch receipt as office supplies by accident. 00:02:36.169 --> 00:02:39.680 It's a mistake. a scandal a fraud that arises 00:02:39.680 --> 00:02:41.939 from the intentional manipulation of financial 00:02:41.939 --> 00:02:44.639 statements so it's a deliberate act it's a deliberate 00:02:44.639 --> 00:02:47.960 act by trusted executives or employees to misuse 00:02:47.960 --> 00:02:50.740 funds or more often to just misrepresent the 00:02:50.740 --> 00:02:52.659 truth okay so the difference between tripping 00:02:52.659 --> 00:02:56.560 over a rug and deliberately pushing someone down 00:02:56.560 --> 00:02:59.699 the stairs. Precisely. And in the world of corporate 00:02:59.699 --> 00:03:02.919 fraud, we generally categorize these pushes into 00:03:02.919 --> 00:03:05.460 two main buckets. Okay. The first one is the 00:03:05.460 --> 00:03:08.539 most intuitive. It's called misappropriation 00:03:08.539 --> 00:03:10.860 of assets. Which is just a fancy suit and tie 00:03:10.860 --> 00:03:14.379 way of saying theft. It is. Exactly. The industry 00:03:14.379 --> 00:03:17.620 term is often defalcation, but yeah, it's theft. 00:03:17.819 --> 00:03:20.400 This is when an employee steals the company's 00:03:20.400 --> 00:03:23.560 assets. Now, historically, this meant... stealing 00:03:23.560 --> 00:03:26.400 cash. You're working the register, you pocket 00:03:26.400 --> 00:03:29.340 a 20. Right. Or you're in the warehouse and a 00:03:29.340 --> 00:03:31.939 box of inventory falls off the truck. You know, 00:03:31.979 --> 00:03:34.400 the classics. The classic shrinkage that companies 00:03:34.400 --> 00:03:37.740 used to budget for. Exactly. But as the economy 00:03:37.740 --> 00:03:40.300 has evolved from physical goods to information, 00:03:40.639 --> 00:03:43.939 so has the theft. Now we see the theft of intellectual 00:03:43.939 --> 00:03:47.000 property becoming a huge problem. So not stealing 00:03:47.000 --> 00:03:49.020 the computers, but stealing what's on the computers. 00:03:49.060 --> 00:03:51.639 Right. Stealing the customer list, stealing the 00:03:51.639 --> 00:03:54.500 source code for the new software, stealing proprietary 00:03:54.500 --> 00:03:57.620 data. Things that are intangible, but incredibly 00:03:57.620 --> 00:04:00.340 valuable. That seems infinitely more damaging. 00:04:00.960 --> 00:04:03.379 If I steal a laptop, the company's out, what, 00:04:03.419 --> 00:04:07.199 $2 ,000? If I seal the design for the new prototype 00:04:07.199 --> 00:04:09.800 that's on that laptop, the company could be out 00:04:09.800 --> 00:04:13.680 millions or even its entire future. It can be 00:04:13.680 --> 00:04:16.079 an extinction -level event for a small to mid 00:04:16.079 --> 00:04:18.899 -sized business. It's terrifying. There was a 00:04:18.899 --> 00:04:20.860 striking statistic in our research notes from 00:04:20.860 --> 00:04:24.920 2015. It found that 33 % of all business bankruptcies 00:04:24.920 --> 00:04:27.620 that year were caused, at least in part, by employee 00:04:27.620 --> 00:04:30.629 theft. Wait, a third? A third of businesses that 00:04:30.629 --> 00:04:32.769 failed were essentially eaten from the inside 00:04:32.769 --> 00:04:35.910 out. Yes. It really highlights the internal controls, 00:04:36.129 --> 00:04:37.850 you know, making sure you know who has the keys 00:04:37.850 --> 00:04:40.129 to the kingdom, aren't just bureaucratic red 00:04:40.129 --> 00:04:43.069 tape. They are survival mechanisms. Wow. But 00:04:43.069 --> 00:04:45.910 while asset misappropriation is common and devastating, 00:04:46.310 --> 00:04:48.670 it's usually the second bucket of fraud that 00:04:48.670 --> 00:04:50.149 ends up on the front page of the Wall Street 00:04:50.149 --> 00:04:51.829 Journal. This would be the big lie. Correct. 00:04:52.470 --> 00:04:55.209 Bucket number two is fraudulent financial reporting, 00:04:55.350 --> 00:04:57.589 or as it is sometimes euphemistically called 00:04:57.589 --> 00:05:00.610 in the business world. Earnings management. Okay. 00:05:00.649 --> 00:05:02.649 Earnings management sounds so much nicer than 00:05:02.649 --> 00:05:05.149 fraud. It does, doesn't it? That's the point. 00:05:05.250 --> 00:05:07.170 And this is the one that always confuses people 00:05:07.170 --> 00:05:10.310 because money isn't necessarily being stolen 00:05:10.310 --> 00:05:14.129 in the traditional sense, right? The CEO isn't 00:05:14.129 --> 00:05:16.310 walking out the door with a duffel bag full of 00:05:16.310 --> 00:05:19.420 cash. Not directly, no. Not usually. In this 00:05:19.420 --> 00:05:21.879 scenario, the goal is to manipulate the financial 00:05:21.879 --> 00:05:24.279 statements, which are basically the report card 00:05:24.279 --> 00:05:26.800 of the company, to make it look better than it 00:05:26.800 --> 00:05:28.899 actually is. So they're lying on the report card. 00:05:29.060 --> 00:05:31.639 They are. They are overstating revenue, they're 00:05:31.639 --> 00:05:34.279 understating expenses, or they're inflating the 00:05:34.279 --> 00:05:37.420 value of their assets, all to create a false 00:05:37.420 --> 00:05:41.160 picture of health. So if asset misappropriation 00:05:41.160 --> 00:05:44.139 is stealing a slice of the pie, fraudulent financial 00:05:44.139 --> 00:05:46.379 reporting is lying about the size of the pie. 00:05:46.540 --> 00:05:48.819 That is a perfect analogy. And the motivation 00:05:48.819 --> 00:05:51.759 is usually about external perception. They need 00:05:51.759 --> 00:05:54.560 to secure investor interest, you know, keep the 00:05:54.560 --> 00:05:56.839 stock price high to please Wall Street analysts, 00:05:57.120 --> 00:05:59.500 or they need to convince a bank to give them 00:05:59.500 --> 00:06:02.079 a loan. Or, and let's be cynical for a second, 00:06:02.199 --> 00:06:04.279 they need to hit a specific number on a spreadsheet 00:06:04.279 --> 00:06:07.470 to trigger their multimillion dollar bonus. That 00:06:07.470 --> 00:06:09.970 is unfortunately a very, very common motive. 00:06:10.129 --> 00:06:13.329 We call it gaming the metrics. If your contract 00:06:13.329 --> 00:06:15.889 says you get a million dollars, if the company 00:06:15.889 --> 00:06:18.810 earns $100 million and the company only earns 00:06:18.810 --> 00:06:22.930 $98 million, well, the temptation to find that 00:06:22.930 --> 00:06:25.449 extra $2 million in the cushions is immense. 00:06:25.810 --> 00:06:28.209 Just find it somewhere, anywhere. It's amazing 00:06:28.209 --> 00:06:30.750 how creative people can get when a bonus is on 00:06:30.750 --> 00:06:33.269 the line. And the SEC has a whole list of tricks 00:06:33.269 --> 00:06:36.529 they use to do this. Period end stuffing was 00:06:36.529 --> 00:06:38.790 one that jumped out at me from our notes. It 00:06:38.790 --> 00:06:40.910 sounds like a Thanksgiving activity, but I assume 00:06:40.910 --> 00:06:44.310 it's less delicious. Much less. Period end stuffing, 00:06:44.470 --> 00:06:46.290 or it's sometimes called channel stuffing, is 00:06:46.290 --> 00:06:48.310 when a company forces sales into the current 00:06:48.310 --> 00:06:50.209 quarter that really shouldn't happen yet. How 00:06:50.209 --> 00:06:52.689 do they do that? Let's say it's March 30th, the 00:06:52.689 --> 00:06:54.269 quarter is about to end, and you're short on 00:06:54.269 --> 00:06:56.829 your sales numbers. You might call up a customer, 00:06:57.009 --> 00:06:59.129 a distributor, and pressure them to take a huge 00:06:59.129 --> 00:07:01.300 delivery they don't need yet. You promise them 00:07:01.300 --> 00:07:03.180 deep discounts or you tell them they don't have 00:07:03.180 --> 00:07:05.699 to pay for 180 days just so you can record the 00:07:05.699 --> 00:07:08.220 revenue now. Ah, so you're borrowing from the 00:07:08.220 --> 00:07:11.519 future to survive the present. Exactly. But the 00:07:11.519 --> 00:07:14.079 problem is when the next quarter starts on April 00:07:14.079 --> 00:07:16.639 1st, you're already in a hole because you've 00:07:16.639 --> 00:07:19.339 cannibalized your own future sales. So you have 00:07:19.339 --> 00:07:21.839 to cheat even more just to stay flat. It's a 00:07:21.839 --> 00:07:23.699 treadmill that just keeps speeding up until you 00:07:23.699 --> 00:07:26.279 fly off the back. It becomes a cycle that's almost 00:07:26.279 --> 00:07:29.180 impossible to escape. It sounds exhausting. And 00:07:29.180 --> 00:07:31.980 this brings us to the core question of why. Why 00:07:31.980 --> 00:07:35.139 do people who are often already wealthy, successful 00:07:35.139 --> 00:07:38.560 and respected risk everything? Their reputation, 00:07:38.939 --> 00:07:41.819 their freedom to fudge a spreadsheet. Criminologists 00:07:41.819 --> 00:07:45.300 have spent decades studying this. The gold standard 00:07:45.300 --> 00:07:47.220 model for explaining it, the one that comes up 00:07:47.220 --> 00:07:49.779 again and again, is called the fraud triangle. 00:07:50.019 --> 00:07:51.800 I love a good geometric model. Let's walk through 00:07:51.800 --> 00:07:53.379 the corners of this triangle. What's the first 00:07:53.379 --> 00:07:55.720 one? The first corner is incentive or pressure. 00:07:55.879 --> 00:07:58.300 This is the motive, the why. We just talked about 00:07:58.300 --> 00:08:01.180 bonuses. It's a powerful incentive, but often 00:08:01.180 --> 00:08:04.680 it's pressure. Yes. A lot of the time it boils 00:08:04.680 --> 00:08:08.230 down to fear. Fear of failure. At the corporate 00:08:08.230 --> 00:08:11.050 level, there is just immense pressure to meet 00:08:11.050 --> 00:08:13.850 analysts' forecasts. If Wall Street expects you 00:08:13.850 --> 00:08:16.110 to make a $1 per share and you come in at 99, 00:08:16.290 --> 00:08:19.750 just one penny short, the stock might tank 10%. 00:08:19.750 --> 00:08:23.290 The market punishes misses severely. It's completely 00:08:23.290 --> 00:08:25.310 unforgiving. And there are debt covenants, right? 00:08:25.389 --> 00:08:27.209 That sounds like something from an Indiana Jones 00:08:27.209 --> 00:08:29.269 movie, but it's a banking term. It is. It's a 00:08:29.269 --> 00:08:31.790 very serious one. When a bank lends a company 00:08:31.790 --> 00:08:34.350 money, they often include covenants, which are 00:08:34.350 --> 00:08:36.990 basically rules. For example, a rule might... 00:08:37.000 --> 00:08:40.259 be your total debt cannot exceed 50 % of your 00:08:40.259 --> 00:08:43.100 total equity. If you cross that line, if you 00:08:43.100 --> 00:08:45.399 violate the covenant, the bank can call in the 00:08:45.399 --> 00:08:48.139 loan immediately, demand repayment in full. And 00:08:48.139 --> 00:08:50.419 that would bankrupt the company overnight. Absolutely. 00:08:50.500 --> 00:08:53.059 So if you're getting close to that line, the 00:08:53.059 --> 00:08:55.480 pressure to fix the numbers, to inflate your 00:08:55.480 --> 00:08:57.519 equity or hide some debt just to stay compliant 00:08:57.519 --> 00:09:00.240 is existential. It's life or death for the business. 00:09:00.440 --> 00:09:02.220 Yeah. And then there is the personal pressure, 00:09:02.299 --> 00:09:04.740 which can be just as strong. For sure. Things 00:09:04.740 --> 00:09:07.809 like gambling debts. substance abuse issues, 00:09:07.929 --> 00:09:10.870 a messy and expensive divorce, or something a 00:09:10.870 --> 00:09:13.490 little more sinister like the golden handshake. 00:09:13.649 --> 00:09:16.590 I wanted to ask about this. This is the idea 00:09:16.590 --> 00:09:19.970 that an executive might actually want the company 00:09:19.970 --> 00:09:23.080 to struggle. That seems counterintuitive. It 00:09:23.080 --> 00:09:25.899 does, but it happens. A golden handshake often 00:09:25.899 --> 00:09:28.460 refers to a massive payout an executive gets 00:09:28.460 --> 00:09:31.440 if the company is sold or merges. So sometimes 00:09:31.440 --> 00:09:34.000 you see executives manipulate the books to make 00:09:34.000 --> 00:09:36.419 the company look like a juicy acquisition target 00:09:36.419 --> 00:09:39.419 or even distress it slightly to force a sale 00:09:39.419 --> 00:09:41.379 just so they can cash out their stock options 00:09:41.379 --> 00:09:44.039 and walk away with a huge check. That is incredibly 00:09:44.039 --> 00:09:45.840 dark. You're essentially tanking the ship so 00:09:45.840 --> 00:09:47.440 you can sell the records you get paid for it. 00:09:47.500 --> 00:09:50.639 It happens. So that's pressure. The first corner. 00:09:50.860 --> 00:09:52.940 The second corner of the triangle is opportunity. 00:09:53.179 --> 00:09:56.059 The open door. Exactly. You can be as desperate 00:09:56.059 --> 00:09:57.940 as you want, but if the vault is locked and you 00:09:57.940 --> 00:10:00.919 don't have the key, you can't steal. Opportunity 00:10:00.919 --> 00:10:03.620 arises when internal controls are weak or when 00:10:03.620 --> 00:10:05.679 the accounting is so complex and opaque that 00:10:05.679 --> 00:10:07.500 no one can really figure out what's real and 00:10:07.500 --> 00:10:09.419 what's not. Our notes mention that industries 00:10:09.419 --> 00:10:12.820 relying on significant judgments are more vulnerable. 00:10:13.840 --> 00:10:15.919 Can we unpack that? What does that mean? Sure. 00:10:16.000 --> 00:10:18.259 Think about it this way. If you run a trucking 00:10:18.259 --> 00:10:20.590 company. It's pretty easy to verify your assets. 00:10:20.809 --> 00:10:23.029 I can go to the parking lot and count the trucks. 00:10:23.129 --> 00:10:25.009 One, two, three. It's hard to fake that. They're 00:10:25.009 --> 00:10:29.070 tangible. Right. But what if you are a bank holding 00:10:29.070 --> 00:10:32.590 complex derivatives or a software company trying 00:10:32.590 --> 00:10:34.950 to place a value on goodwill from an acquisition 00:10:34.950 --> 00:10:37.350 you made five years ago? The value is an estimate. 00:10:37.450 --> 00:10:40.529 It's an opinion, not a hard fact. Exactly. If 00:10:40.529 --> 00:10:42.970 I say this patent is worth $100 million and you 00:10:42.970 --> 00:10:46.159 say it's worth $50 million, who is right? It's 00:10:46.159 --> 00:10:48.779 objective. It's a judgment call. And that ambiguity, 00:10:48.919 --> 00:10:52.139 that gray area, creates the opportunity to nudge 00:10:52.139 --> 00:10:53.980 the numbers in your favor without it looking 00:10:53.980 --> 00:10:56.620 like an outright lie. It's not a lie. It's just 00:10:56.620 --> 00:10:58.980 an optimistic valuation. That is the defense 00:10:58.980 --> 00:11:01.620 lawyer's favorite phrase. And that leads perfectly 00:11:01.620 --> 00:11:04.159 to the third corner of the triangle, attitudes 00:11:04.159 --> 00:11:07.340 and rationalization. The mental gymnastics. Yeah. 00:11:07.419 --> 00:11:09.480 This is how they sleep at night. This is how 00:11:09.480 --> 00:11:12.149 they look in the mirror. The fraudster rarely 00:11:12.149 --> 00:11:15.090 sees a criminal staring back. They tell themselves 00:11:15.090 --> 00:11:17.690 stories to justify their actions. What kind of 00:11:17.690 --> 00:11:20.690 stories? Things like, I'm underpaid, the company 00:11:20.690 --> 00:11:23.769 owes me this so I deserve it. Or, everyone else 00:11:23.769 --> 00:11:25.629 is doing it, it's just how the game is played. 00:11:26.029 --> 00:11:29.090 Or, the most dangerous one of all, I'm just borrowing 00:11:29.090 --> 00:11:31.129 it, I'll pay it back next quarter when things 00:11:31.129 --> 00:11:33.149 turn around. And of course they never do. They 00:11:33.149 --> 00:11:35.490 never do. Another big one is the noble cause, 00:11:35.730 --> 00:11:38.440 corruption. Right, the idea that... I'm doing 00:11:38.440 --> 00:11:41.279 this for the good of the company. Exactly. I'm 00:11:41.279 --> 00:11:43.840 cooking the books to save jobs. If I tell the 00:11:43.840 --> 00:11:45.960 truth, we go under and everyone gets fired. So 00:11:45.960 --> 00:11:48.820 I'm actually the hero here. They reframe the 00:11:48.820 --> 00:11:52.240 fraud as a heroic act. That's a powerful rationalization. 00:11:52.440 --> 00:11:54.879 And this is all heavily, heavily influenced by 00:11:54.879 --> 00:11:57.799 the tone at the top. If the CEO cuts corners, 00:11:58.059 --> 00:12:00.200 cheats suppliers or laughs about regulations, 00:12:00.559 --> 00:12:03.600 that sends a message. The mid -level managers 00:12:03.600 --> 00:12:06.299 feel authorized to do the same. It creates a 00:12:06.299 --> 00:12:08.539 culture where fraud becomes normalized, just 00:12:08.539 --> 00:12:11.659 business as usual. So pressure, opportunity, 00:12:11.919 --> 00:12:15.779 rationalization. That's the triangle. But I noticed 00:12:15.779 --> 00:12:18.000 in our research that the triangle wasn't enough 00:12:18.000 --> 00:12:20.299 for some modern theorists. They've added more 00:12:20.299 --> 00:12:22.539 shapes. We have a diamond and a pentagon now. 00:12:22.600 --> 00:12:25.320 We do. We are getting into advanced fraud geometry 00:12:25.320 --> 00:12:28.480 here. The fraud diamond was proposed later, adding 00:12:28.480 --> 00:12:31.549 a fourth critical element. Which makes total 00:12:31.549 --> 00:12:33.789 sense. I might have the pressure and the opportunity, 00:12:34.009 --> 00:12:35.690 but if I don't know how to hack the accounting 00:12:35.690 --> 00:12:38.649 software or structure a complex deal, I can't 00:12:38.649 --> 00:12:40.629 actually. Right. You need the technical skill 00:12:40.629 --> 00:12:44.090 and crucially, the position of power. A janitor 00:12:44.090 --> 00:12:46.370 cannot commit financial statement fraud. You 00:12:46.370 --> 00:12:50.230 need the CFO or the controller, someone who understands 00:12:50.230 --> 00:12:52.289 the plumbing of the financial system and has 00:12:52.289 --> 00:12:54.830 the access to change it. OK, so that's the diamond. 00:12:54.950 --> 00:12:56.529 What about the Pentagon? What's the fifth side? 00:12:56.840 --> 00:12:59.799 The Pentagon adds arrogance or ego. The master 00:12:59.799 --> 00:13:02.539 of the universe complex? It's that specific brand 00:13:02.539 --> 00:13:05.120 of narcissism where the individual believes the 00:13:05.120 --> 00:13:07.419 rules simply do not apply to them. They think 00:13:07.419 --> 00:13:09.340 they're smarter than the auditors, smarter than 00:13:09.340 --> 00:13:11.480 the regulators, and smarter than the market. 00:13:11.980 --> 00:13:14.059 When you looked at the major scandals we are 00:13:14.059 --> 00:13:16.879 about to discuss, that arrogance is the common 00:13:16.879 --> 00:13:19.100 thread that runs through almost all of them. 00:13:19.519 --> 00:13:22.039 Well, speaking of major scandals, I think it's 00:13:22.039 --> 00:13:24.019 time to open the doors to the Hall of Shame. 00:13:24.590 --> 00:13:26.590 We have quite the lineup today. We certainly 00:13:26.590 --> 00:13:28.809 do. Where should we begin? We have to start with 00:13:28.809 --> 00:13:31.750 the big one, the patient zero of modern corporate 00:13:31.750 --> 00:13:35.950 fraud, Enron. Enron. It's almost a cliche at 00:13:35.950 --> 00:13:38.370 this point, but you really cannot overstate how 00:13:38.370 --> 00:13:41.210 shocking this was back in 2001. Enron wasn't 00:13:41.210 --> 00:13:43.769 some shady back alley operation. It was voted 00:13:43.769 --> 00:13:46.450 America's most innovative company by Fortune 00:13:46.450 --> 00:13:48.750 magazine for six years in a row. They were the 00:13:48.750 --> 00:13:51.549 golden child of the new economy, trading energy, 00:13:51.789 --> 00:13:54.009 bandwidth, even things like weather derivatives. 00:13:54.509 --> 00:13:57.389 They were seen as the future. They were. But 00:13:57.389 --> 00:13:59.789 underneath all that innovation, it was a house 00:13:59.789 --> 00:14:02.370 of cards. And it was built on two main mechanisms 00:14:02.370 --> 00:14:05.049 that are pretty complicated but worth understanding. 00:14:05.350 --> 00:14:07.370 Mark -to -market accounting and special purpose 00:14:07.370 --> 00:14:09.450 entities. Okay, let's get technical for a second 00:14:09.450 --> 00:14:11.669 because this is fascinating. Explain mark -to 00:14:11.669 --> 00:14:14.730 -market to us. What is that? So traditional accounting 00:14:14.730 --> 00:14:17.289 is usually based on history. You sell a widget 00:14:17.289 --> 00:14:20.929 for $10. You record $10 in revenue. Simple. Mark 00:14:20.929 --> 00:14:23.350 -to -market accounting is based on future value. 00:14:23.899 --> 00:14:26.279 The future value of something. Yes. Enron was 00:14:26.279 --> 00:14:29.360 signing these massive 20 -year contracts to supply 00:14:29.360 --> 00:14:32.480 energy. Instead of booking the profit year by 00:14:32.480 --> 00:14:34.860 year as they actually earned it, they would estimate 00:14:34.860 --> 00:14:36.960 the total profit they thought they'd make over 00:14:36.960 --> 00:14:39.820 the next 20 years and book all of it today. So 00:14:39.820 --> 00:14:41.879 if I sign a deal that might make me $20 million 00:14:41.879 --> 00:14:44.559 over two decades, I can tell my shareholders, 00:14:44.740 --> 00:14:47.860 hey, we just made $20 million today. Essentially, 00:14:47.860 --> 00:14:50.960 yes. You book the net present value of Alder's 00:14:50.960 --> 00:14:54.580 future profits. But here is the catch. Predicting 00:14:54.580 --> 00:14:57.740 energy prices 20 years out is basically impossible. 00:14:58.559 --> 00:15:00.960 So Enron was just making up the assumptions. 00:15:01.139 --> 00:15:03.740 They were booking massive hypothetical profits 00:15:03.740 --> 00:15:06.720 based on their own optimistic models. So they 00:15:06.720 --> 00:15:09.379 had huge profits on paper. But they didn't have 00:15:09.379 --> 00:15:12.019 the cash to back it up. It's the ultimate paper 00:15:12.019 --> 00:15:15.379 rich, cash poor situation, but on a massive scale. 00:15:15.460 --> 00:15:18.340 Yeah. And when the deals actually went bad, which 00:15:18.340 --> 00:15:20.960 they often did, Enron didn't want to admit it, 00:15:21.000 --> 00:15:22.779 that would hurt the stock price. So what do they 00:15:22.779 --> 00:15:25.139 do with the losses? This is where mechanism number 00:15:25.139 --> 00:15:28.850 two comes in. Special Purpose Entities, or SPEs. 00:15:28.850 --> 00:15:30.809 These were the infamous shell companies, right? 00:15:30.870 --> 00:15:32.789 The ones with the crazy Jurassic Park names like 00:15:32.789 --> 00:15:35.929 Raptor. Raptor, Chuco, LJM. These were partnerships 00:15:35.929 --> 00:15:38.830 created and controlled by Enron's own CFO, Andrew 00:15:38.830 --> 00:15:41.830 Fastow. When Enron had a bad asset, a losing 00:15:41.830 --> 00:15:44.149 investment, or a massive debt, they would sell 00:15:44.149 --> 00:15:46.149 it to one of these shell companies. So they just 00:15:46.149 --> 00:15:48.149 moved the toxic waste off their own balance sheet 00:15:48.149 --> 00:15:49.929 and onto the balance sheet of this other company 00:15:49.929 --> 00:15:52.149 that nobody's looking at. Correct. But here's 00:15:52.149 --> 00:15:54.919 the fraud. The shell companies were backed by 00:15:54.919 --> 00:15:58.419 Enron stock. It was completely circular. It was 00:15:58.419 --> 00:16:01.379 like taking debt off your Visa card and moving 00:16:01.379 --> 00:16:04.100 it to a MasterCard that is guaranteed by your 00:16:04.100 --> 00:16:06.539 Visa card. So if the Visa card fails... The whole 00:16:06.539 --> 00:16:09.120 thing collapses. And that's what happened. When 00:16:09.120 --> 00:16:12.120 Enron's stock price started to fall, the SPEs 00:16:12.120 --> 00:16:15.059 became worthless, and all that hidden debt came 00:16:15.059 --> 00:16:17.759 rushing back onto Enron's books. And the craziest 00:16:17.759 --> 00:16:20.440 part of this whole saga is the auditor's role. 00:16:20.779 --> 00:16:23.870 Arthur Anderson. They were one of the big five 00:16:23.870 --> 00:16:25.509 accounting firms. They were supposed to be the 00:16:25.509 --> 00:16:27.429 referees, the independent watchdogs. They were, 00:16:27.610 --> 00:16:30.389 but they were making so much money from consulting 00:16:30.389 --> 00:16:32.269 fees with Enron. At one point, it was roughly 00:16:32.269 --> 00:16:34.549 a million dollars a week that they lost their 00:16:34.549 --> 00:16:36.850 independence. They became enablers. And when 00:16:36.850 --> 00:16:38.950 the SEC started investigating, Arthur Anderson 00:16:38.950 --> 00:16:40.809 didn't say, here are the files, let's get to 00:16:40.809 --> 00:16:43.250 the truth. They started shredding. The image 00:16:43.250 --> 00:16:46.210 of auditors frantically shredding documents by 00:16:46.210 --> 00:16:49.230 the ton while the feds are closing in is just 00:16:49.230 --> 00:16:52.940 cinematic. It cost them everything. Arthur Anderson 00:16:52.940 --> 00:16:55.600 was convicted of obstruction of justice. They 00:16:55.600 --> 00:16:57.419 were forced to surrender their CPA licenses. 00:16:57.759 --> 00:17:01.139 The firm collapsed. 85 ,000 employees lost their 00:17:01.139 --> 00:17:03.700 jobs essentially overnight, most of whom were 00:17:03.700 --> 00:17:06.220 completely innocent. And the big five became 00:17:06.220 --> 00:17:08.980 the big four, which it still is today. A stark 00:17:08.980 --> 00:17:11.779 reminder that trust takes decades to build and 00:17:11.779 --> 00:17:14.200 just seconds to destroy. Okay, let's move down 00:17:14.200 --> 00:17:17.519 the timeline just a year later, 2002. Enron is 00:17:17.519 --> 00:17:19.480 still fresh in everyone's mind, and then bam. 00:17:20.180 --> 00:17:22.579 WorldCom. The too -big -to -fail era, as you 00:17:22.579 --> 00:17:24.880 said. It was one body blow after another to the 00:17:24.880 --> 00:17:27.119 market's confidence. And if Enron was this complex 00:17:27.119 --> 00:17:29.660 magic trick involving derivatives and shell companies, 00:17:30.160 --> 00:17:33.660 WorldCom feels almost dumber, like brilliantly 00:17:33.660 --> 00:17:36.119 stupid in its simplicity. It was certainly less 00:17:36.119 --> 00:17:38.640 sophisticated, but no less devastating. WorldCom 00:17:38.640 --> 00:17:40.940 was a massive telecom company, the second largest 00:17:40.940 --> 00:17:43.599 in the U .S. They grew by buying up dozens of 00:17:43.599 --> 00:17:45.339 other companies, but when the dot -com bubble 00:17:45.339 --> 00:17:47.799 burst, their revenue stalled. The growth story 00:17:47.799 --> 00:17:50.710 was over. And the shroud they use to hide this 00:17:50.710 --> 00:17:53.509 involves something called capitalization of expenses. 00:17:54.329 --> 00:17:56.369 We probably need to explain the difference between 00:17:56.369 --> 00:17:58.730 an expense and a capital asset for the listeners. 00:17:58.950 --> 00:18:01.309 Right. It's a fundamental accounting concept. 00:18:01.730 --> 00:18:04.250 Think of it this way. If you buy a sandwich for 00:18:04.250 --> 00:18:07.029 lunch, that is an expense. You eat it. It's gone. 00:18:07.390 --> 00:18:09.529 It reduces your profit for the day immediately. 00:18:10.289 --> 00:18:12.769 If you buy a house, that is a capital asset. 00:18:12.910 --> 00:18:15.089 You exchange cash for a house. Your net worth 00:18:15.089 --> 00:18:16.789 doesn't go down. You just have a house instead 00:18:16.789 --> 00:18:19.269 of cash. You get to use that house for years. 00:18:19.670 --> 00:18:23.430 Okay. So expenses hurt profits now. Assets don't. 00:18:23.430 --> 00:18:26.170 Correct. You depreciate assets over time, but 00:18:26.170 --> 00:18:28.329 the immediate hit to your profit is minimal. 00:18:28.970 --> 00:18:31.509 Now, WorldCom paid billions of dollars in line 00:18:31.509 --> 00:18:35.299 costs. These are fees to other phone companies 00:18:35.299 --> 00:18:37.539 to use their networks to complete calls. So it's 00:18:37.539 --> 00:18:40.140 a regular recurring cost of doing business, like 00:18:40.140 --> 00:18:42.920 the electric bill. Exactly. It's clearly an operating 00:18:42.920 --> 00:18:45.519 expense. You pay it every month. But WorldCom 00:18:45.519 --> 00:18:49.140 CFO Scott Sullivan told his team to start recording 00:18:49.140 --> 00:18:51.720 these bills as if they were assets. Wait, they 00:18:51.720 --> 00:18:53.759 took their monthly phone bill and called it an 00:18:53.759 --> 00:18:57.009 investment? Essentially, yes. They took $3 .8 00:18:57.009 --> 00:18:59.869 billion of these daily operating costs and just 00:18:59.869 --> 00:19:02.269 wrote them down on the balance sheet as investments 00:19:02.269 --> 00:19:04.990 in infrastructure. So instead of telling investors, 00:19:05.109 --> 00:19:07.730 we spent $3 .8 billion this quarter, they said, 00:19:07.730 --> 00:19:11.109 we bought $3 .8 billion worth of new assets. 00:19:11.410 --> 00:19:13.529 Which meant their profit looked $3 .8 billion 00:19:13.529 --> 00:19:16.150 higher than it actually was. It was a simple 00:19:16.150 --> 00:19:19.170 journal entry in the ledger. Debit asset, credit 00:19:19.170 --> 00:19:22.130 cash, no complex shell companies required. Just 00:19:22.130 --> 00:19:25.039 a lie. And the scale, it was ultimately revealed 00:19:25.039 --> 00:19:28.779 to be an $11 billion fraud, is staggering. At 00:19:28.779 --> 00:19:31.299 the time, it dwarfed Enron. It was the largest 00:19:31.299 --> 00:19:33.599 corporate insolvency ever. And it wasn't uncovered 00:19:33.599 --> 00:19:36.200 by the SEC or a Wall Street analyst. It was caught 00:19:36.200 --> 00:19:38.759 by a small team of internal auditors led by Cynthia 00:19:38.759 --> 00:19:41.480 Cooper. They worked in secret, often at night, 00:19:41.519 --> 00:19:43.539 digging through the company's own systems because 00:19:43.539 --> 00:19:45.740 they knew something was wrong. They are the real 00:19:45.740 --> 00:19:48.329 heroes of that story. Truly. Okay, let's jump 00:19:48.329 --> 00:19:50.950 forward a few years to 2008. The great financial 00:19:50.950 --> 00:19:53.809 crisis is unfolding. And the name that dominates 00:19:53.809 --> 00:19:56.329 that era of fraud is, of course, Bernie Madoff. 00:19:56.450 --> 00:19:59.009 The $64 billion question, as you called it earlier. 00:19:59.230 --> 00:20:01.789 Now, everyone knows it was a Ponzi scheme. He 00:20:01.789 --> 00:20:03.970 took money from new investors to pay off old 00:20:03.970 --> 00:20:07.269 investors. The basic mechanism is well understood. 00:20:07.750 --> 00:20:10.269 But what I want to focus on is the single biggest 00:20:10.269 --> 00:20:14.390 red flag that everyone, including the SEC, missed 00:20:14.390 --> 00:20:17.960 for decades. The auditor. This is the detail 00:20:17.960 --> 00:20:20.900 that still keeps regulators up at night. Madoff 00:20:20.900 --> 00:20:22.940 Investment Securities claimed to be managing 00:20:22.940 --> 00:20:25.440 tens of billions of dollars for thousands of 00:20:25.440 --> 00:20:28.119 clients globally. You'd expect a firm of that 00:20:28.119 --> 00:20:31.920 size to be audited by a global powerhouse. PwC, 00:20:32.079 --> 00:20:35.660 Deloitte, EY, KPMG, one of the big four. Right. 00:20:35.720 --> 00:20:38.200 You'd want an army of forensic accountants combing 00:20:38.200 --> 00:20:40.420 through every trade. Instead, the auditor of 00:20:40.420 --> 00:20:42.839 record was a firm called Freeling & Horowitz. 00:20:43.440 --> 00:20:45.680 Which sounds respectable enough, right? Maybe 00:20:45.680 --> 00:20:48.900 a boutique, high -end firm. But in reality, what 00:20:48.900 --> 00:20:51.240 was it? It was a tiny office in a strip mall 00:20:51.240 --> 00:20:53.660 in New City, New York. It was basically one room, 00:20:53.740 --> 00:20:57.180 a storefront. One room to audit a $60 billion 00:20:57.180 --> 00:21:00.200 operation. And the firm consisted of one active 00:21:00.200 --> 00:21:02.490 accountant, David G. Freeling. He was in his 00:21:02.490 --> 00:21:04.730 late 70s working from this tiny office. He didn't 00:21:04.730 --> 00:21:07.289 have a team of forensic analysts. He barely had 00:21:07.289 --> 00:21:09.990 a secretary. So how does one guy audit a global 00:21:09.990 --> 00:21:12.690 hedge fund of that size? He doesn't. He couldn't. 00:21:12.690 --> 00:21:15.529 He simply rubber stamped the documents Madoff 00:21:15.529 --> 00:21:18.890 gave him for 18 years. He admitted he didn't 00:21:18.890 --> 00:21:21.529 perform any actual audit procedures. He didn't 00:21:21.529 --> 00:21:23.950 independently verify the trades. He didn't even 00:21:23.950 --> 00:21:26.210 check to see if the bank accounts with the supposed 00:21:26.210 --> 00:21:29.549 billions actually existed. And why? Was he just 00:21:29.549 --> 00:21:33.130 lazy? Incompetent? He was hopelessly compromised. 00:21:33.150 --> 00:21:35.430 He and his family had millions of dollars of 00:21:35.430 --> 00:21:38.210 their own money invested in Madoff's fund. No. 00:21:38.369 --> 00:21:40.710 That is the single biggest conflict of interest 00:21:40.710 --> 00:21:44.009 imaginable. Audit rule number one. You must be 00:21:44.009 --> 00:21:46.450 independent in fact and appearance. Exactly. 00:21:46.920 --> 00:21:48.900 If he found the fraud, he would not only lose 00:21:48.900 --> 00:21:51.259 a major client, he would lose his own life savings 00:21:51.259 --> 00:21:54.640 and his family savings. He was financially incentivized 00:21:54.640 --> 00:21:57.819 to be blind. It's a perfect, tragic example of 00:21:57.819 --> 00:22:00.519 why auditor independence is the absolute cornerstone 00:22:00.519 --> 00:22:02.779 of the whole financial system. It's just incredible. 00:22:02.920 --> 00:22:04.900 The biggest financial crime in history was hidden 00:22:04.900 --> 00:22:07.359 behind a strip mall storefront. Now, we've been 00:22:07.359 --> 00:22:10.119 very U .S.-centric so far, but creative accounting 00:22:10.119 --> 00:22:13.380 is a global language. Let's take a quick trip 00:22:13.380 --> 00:22:15.019 around the world. Let's do it. We're two first. 00:22:15.259 --> 00:22:19.750 Let's go to Europe. Italy, 2003. Parmalat. Ah, 00:22:19.869 --> 00:22:23.829 Parmalat. The European Enron. Parmalat was a 00:22:23.829 --> 00:22:26.609 massive company, a dairy giant. They made milk, 00:22:26.650 --> 00:22:29.430 yogurt, cookies. They were a huge family -owned 00:22:29.430 --> 00:22:32.170 conglomerate, a point of national pride in Italy. 00:22:32.569 --> 00:22:35.990 But it turned out they had a 14 billion hole 00:22:35.990 --> 00:22:39.930 in their books. 14 billion euros. And the way 00:22:39.930 --> 00:22:42.569 they hit it... Honestly, it sounds like a prank 00:22:42.569 --> 00:22:44.890 from a bad sitcom. It does. It's almost comical 00:22:44.890 --> 00:22:47.490 in its audacity. They claim to have a bank account 00:22:47.490 --> 00:22:49.650 with Bank of America in the Cayman Islands. And 00:22:49.650 --> 00:22:52.069 this account supposedly contained nearly $4 billion 00:22:52.069 --> 00:22:55.430 in cash. Nice little rainy day fund. The auditors, 00:22:55.470 --> 00:22:57.549 for years, would ask for proof of this cash. 00:22:57.829 --> 00:23:00.670 So Parmalat executives simply forged a letter 00:23:00.670 --> 00:23:02.369 on Bank of America letterhead confirming the 00:23:02.369 --> 00:23:03.990 balance. Like they just made it up in Microsoft 00:23:03.990 --> 00:23:06.170 Word and put a fake signature on it. Even cruder. 00:23:06.559 --> 00:23:08.859 It was essentially cut and paste, scanned and 00:23:08.859 --> 00:23:11.319 faxed. The prosecutors later said it was a clumsy, 00:23:11.460 --> 00:23:13.759 obvious forgery. But for years, the auditors 00:23:13.759 --> 00:23:16.240 just accepted the facts as proof. They never 00:23:16.240 --> 00:23:17.980 once picked up the phone to call the bank and 00:23:17.980 --> 00:23:20.180 verify it. The old mantra of trust but verify 00:23:20.180 --> 00:23:23.279 minus the crucial verify part. Exactly. When 00:23:23.279 --> 00:23:25.980 a new auditor finally took over and said, hey, 00:23:26.059 --> 00:23:27.940 out of an abundance of caution, let me just double 00:23:27.940 --> 00:23:30.079 check this with the bank. Bank of America's response 00:23:30.079 --> 00:23:32.480 was, we don't have an account for this company. 00:23:32.559 --> 00:23:34.680 We've never heard of it. The whole thing collapsed 00:23:34.680 --> 00:23:37.900 instantly. Unbelievable. Okay, let's move over 00:23:37.900 --> 00:23:43.700 to Asia. Japan, 2011. Olympus, the camera company. 00:23:43.880 --> 00:23:46.779 Yes, Olympus. This one is fascinating because 00:23:46.779 --> 00:23:49.700 of the cultural element involved, a practice 00:23:49.700 --> 00:23:53.019 known as Tobashi. Tobashi. What does that translate 00:23:53.019 --> 00:23:56.200 to? It roughly means to make fly away. And it 00:23:56.200 --> 00:23:58.619 refers to a financial maneuver where you shift 00:23:58.619 --> 00:24:00.880 your losses off your company's books to hide 00:24:00.880 --> 00:24:03.380 them from investors, often by moving them to 00:24:03.380 --> 00:24:06.500 obscure shell companies. So similar to Enron's 00:24:06.500 --> 00:24:09.519 SBEs. Very similar in concept. Olympus had made 00:24:09.519 --> 00:24:11.640 some terrible speculative investments back in 00:24:11.640 --> 00:24:14.460 the 1980s during the Japanese asset bubble. When 00:24:14.460 --> 00:24:16.539 the bubble burst, they were sitting on huge, 00:24:16.619 --> 00:24:19.079 embarrassing losses. So instead of admitting 00:24:19.079 --> 00:24:21.339 it and taking the hit to their stock price. They 00:24:21.339 --> 00:24:24.039 spent the next 20 years hiding it. Their method 00:24:24.039 --> 00:24:26.660 was to overpay for acquisitions. They would buy 00:24:26.660 --> 00:24:28.799 other companies at massively inflated prices. 00:24:29.220 --> 00:24:31.720 The extra money they paid for these acquisitions 00:24:31.720 --> 00:24:33.980 wasn't for the company itself. It was secretly 00:24:33.980 --> 00:24:36.140 being funneled into show companies to pay off 00:24:36.140 --> 00:24:39.099 those old investment losses from the 80s. So 00:24:39.099 --> 00:24:40.660 they were buying companies not because they wanted 00:24:40.660 --> 00:24:43.839 the technology or the business, but because they 00:24:43.839 --> 00:24:45.660 needed a laundry machine for their old debt. 00:24:45.900 --> 00:24:48.460 It was a very expensive and elaborate way to 00:24:48.460 --> 00:24:50.690 hide the truth. And this went on for two decades 00:24:50.690 --> 00:24:53.769 until a new CEO, Michael Woodford, who was British 00:24:53.769 --> 00:24:56.230 and the first non -Japanese CEO in the company's 00:24:56.230 --> 00:24:59.349 history, started asking questions. Simple questions 00:24:59.349 --> 00:25:02.710 like, why did we pay $2 billion for a small recycling 00:25:02.710 --> 00:25:05.190 company that makes no money? And because he was 00:25:05.190 --> 00:25:06.930 an outsider, he didn't understand the cultural 00:25:06.930 --> 00:25:09.430 rule of silence and not rocking the boat. He 00:25:09.430 --> 00:25:12.970 broke the Japanese concept of harmony. The board 00:25:12.970 --> 00:25:14.970 fired him for asking too many questions, but 00:25:14.970 --> 00:25:16.950 he went to the press and the police, and the 00:25:16.950 --> 00:25:19.589 entire 20 -year -old scheme came crashing down. 00:25:19.970 --> 00:25:22.730 Incredible persistence. Okay, let's hit our neighbor 00:25:22.730 --> 00:25:26.130 to the north, Canada. Nortel Networks, 2003. 00:25:26.829 --> 00:25:29.289 This is a classic example of earnings management, 00:25:29.450 --> 00:25:32.990 driven by pure... unadulterated greed. This was 00:25:32.990 --> 00:25:35.849 the return to profit scheme. That's right. Nortel, 00:25:36.009 --> 00:25:38.509 the telecom giant, was struggling after the dotcom 00:25:38.509 --> 00:25:42.309 bust. In 2002, the top executives realized they 00:25:42.309 --> 00:25:44.210 weren't going to hit their profit targets for 00:25:44.210 --> 00:25:47.029 the year. So they decided to take what's known 00:25:47.029 --> 00:25:50.329 as a big bath. A big bath. What does that mean? 00:25:50.490 --> 00:25:52.670 It means you make the current year look as bad 00:25:52.670 --> 00:25:55.450 as humanly possible. You write off every bad 00:25:55.450 --> 00:25:58.210 asset you can find. You prepay future expenses. 00:25:58.390 --> 00:26:01.220 You accrue massive liabilities. You basically 00:26:01.220 --> 00:26:03.539 flush all the bad news through the system at 00:26:03.539 --> 00:26:05.980 once. Why on earth would you want to make your 00:26:05.980 --> 00:26:07.920 company look terrible? Because it dramatically 00:26:07.920 --> 00:26:10.519 lowers the bar for the following year. If you 00:26:10.519 --> 00:26:13.119 make 2002 look like an absolute disaster, it 00:26:13.119 --> 00:26:15.740 becomes very easy to make 2003 look like a miraculous 00:26:15.740 --> 00:26:18.000 recovery. And why did they specifically need 00:26:18.000 --> 00:26:20.799 2003 to be a recovery year? Because their executive 00:26:20.799 --> 00:26:23.240 bonus plan had a special return to profitability 00:26:23.240 --> 00:26:25.619 trigger. If they could just show a profit, any 00:26:25.619 --> 00:26:29.119 profit in 2003 after the disaster of 2002, the 00:26:29.119 --> 00:26:31.160 topic... executives would share a bonus pool 00:26:31.160 --> 00:26:34.880 of $70 million. So they deliberately engineered 00:26:34.880 --> 00:26:37.599 a loss in one year so they could engineer a profit 00:26:37.599 --> 00:26:41.119 the next, solely to unlock a wire transfer to 00:26:41.119 --> 00:26:43.759 their personal bank accounts. It is arguably 00:26:43.759 --> 00:26:46.400 the most cynical form of fraud. It wasn't about 00:26:46.400 --> 00:26:48.759 saving the company or protecting jobs. It was 00:26:48.759 --> 00:26:51.539 purely about the payout. And finally, let's bring 00:26:51.539 --> 00:26:53.480 it to the present day for the biggest one of 00:26:53.480 --> 00:26:57.140 all, China. Evergrande. The scale of this one 00:26:57.140 --> 00:26:59.240 just makes the others look small. Evergrande 00:26:59.240 --> 00:27:02.339 is or was one of China's largest property developers. 00:27:02.640 --> 00:27:05.880 In 2023, Chinese regulators accused the company 00:27:05.880 --> 00:27:09.859 of overstating its revenue by $78 billion over 00:27:09.859 --> 00:27:14.440 two years. $78 billion. That is the entire GDP 00:27:14.440 --> 00:27:17.380 of a decent -sized nation. How is that even possible? 00:27:17.759 --> 00:27:20.089 It stems from how they recognize revenue. In 00:27:20.089 --> 00:27:22.910 China, real estate is often sold presale. You 00:27:22.910 --> 00:27:24.990 pay for the apartment years before it is actually 00:27:24.990 --> 00:27:27.589 built. OK, that's common here, too. Right. But 00:27:27.589 --> 00:27:29.529 proper accounting says that money you receive 00:27:29.529 --> 00:27:32.160 is a liability. a customer deposit until you 00:27:32.160 --> 00:27:34.019 actually finish the building and hand over the 00:27:34.019 --> 00:27:36.359 keys. You haven't earned it yet. Evergrande was 00:27:36.359 --> 00:27:38.680 allegedly booking all that cash as revenue the 00:27:38.680 --> 00:27:40.579 moment they received it. So they were counting 00:27:40.579 --> 00:27:43.200 the chickens not just before they hatched, but 00:27:43.200 --> 00:27:45.039 before the eggs were even laid. And then they 00:27:45.039 --> 00:27:47.880 were using that fake revenue on their books to 00:27:47.880 --> 00:27:50.039 go out and borrow more money to buy more land 00:27:50.039 --> 00:27:52.920 to sell more unbuilt apartments. It was a classic 00:27:52.920 --> 00:27:55.440 Ponzi scheme, but fueled by real estate debt 00:27:55.440 --> 00:27:57.619 instead of investor cash. And when the Chinese 00:27:57.619 --> 00:28:00.210 government tightened lending rules to cool the 00:28:00.210 --> 00:28:02.569 property market. The liquidity dried up and the 00:28:02.569 --> 00:28:05.269 music stopped. The whole thing imploded. And 00:28:05.269 --> 00:28:08.150 because real estate is such a huge part of China's 00:28:08.150 --> 00:28:11.160 economy, this sent shockwaves globally. It did. 00:28:11.420 --> 00:28:13.740 It's a powerful reminder that these aren't just 00:28:13.740 --> 00:28:16.299 numbers on a page. When these giant companies 00:28:16.299 --> 00:28:19.019 collapse, construction stocks, people who paid 00:28:19.019 --> 00:28:21.200 for homes lose their life savings, suppliers 00:28:21.200 --> 00:28:24.059 don't get paid, banks are left with bad loans. 00:28:24.299 --> 00:28:27.700 The ripple effects are very, very real. So we've 00:28:27.700 --> 00:28:29.220 seen the anatomy of the crime. We've been through 00:28:29.220 --> 00:28:31.160 the hall of shame. Let's talk about part three, 00:28:31.279 --> 00:28:34.539 the fallout. What happens after the dust settles 00:28:34.539 --> 00:28:37.599 from one of these massive scandals? Usually the 00:28:37.599 --> 00:28:39.799 government steps in with a big regulatory stick. 00:28:40.220 --> 00:28:43.119 The biggest and most famous response to the Enron 00:28:43.119 --> 00:28:46.079 and WorldCom era was the Sarbanes -Oxley Act 00:28:46.079 --> 00:28:50.759 of 2002, known universally as SOX. I have friends 00:28:50.759 --> 00:28:52.599 in finance who still shudder when they hear the 00:28:52.599 --> 00:28:56.019 word SOX. It's famous for being a paperwork nightmare. 00:28:56.400 --> 00:28:58.819 But what did it actually change in a meaningful 00:28:58.819 --> 00:29:01.900 way? I think the most critical change was establishing 00:29:01.900 --> 00:29:05.660 personal liability for executives. Before SOX, 00:29:05.720 --> 00:29:08.759 a CEO could plausibly say, hey, I'm the big picture 00:29:08.759 --> 00:29:11.119 guy. I focus on strategy. I didn't know what 00:29:11.119 --> 00:29:13.160 the accountants in the basement were doing. The 00:29:13.160 --> 00:29:15.079 old sheet and Schultz defense. I know nothing. 00:29:15.220 --> 00:29:17.500 Plausible deniability. SOX killed that defense. 00:29:17.759 --> 00:29:20.940 Section 302 of the act requires the CEO and CFO 00:29:20.940 --> 00:29:23.700 to personally certify to sign their names on 00:29:23.700 --> 00:29:25.539 the dotted line that the financial statements 00:29:25.539 --> 00:29:27.920 are accurate and not misleading. So they can't 00:29:27.920 --> 00:29:29.859 hide anymore. If the statements turn out to be 00:29:29.859 --> 00:29:32.420 fraudulent, the executives can face massive fines 00:29:32.420 --> 00:29:34.640 and prison time, regardless of whether they knew 00:29:34.640 --> 00:29:36.779 the specific details of the fraud. It forces 00:29:36.779 --> 00:29:38.880 them to take responsibility. It forces them to 00:29:38.880 --> 00:29:40.980 know. I remember President Bush, when he was 00:29:40.980 --> 00:29:43.339 signing it, said something to the effect of the 00:29:43.339 --> 00:29:46.019 buck stops here and the buck is fake. You're 00:29:46.019 --> 00:29:48.039 going to jail. That's essentially the spirit 00:29:48.039 --> 00:29:51.049 of it. But this whole episode sparked a massive 00:29:51.049 --> 00:29:53.250 philosophical debate in the accounting world 00:29:53.250 --> 00:29:56.329 that is still raging today. The debate between 00:29:56.329 --> 00:30:00.029 rules versus principles. This sounds a bit academic, 00:30:00.029 --> 00:30:01.970 but bear with us, listener, because it really 00:30:01.970 --> 00:30:04.329 gets to the heart of why fraud. keeps happening. 00:30:04.609 --> 00:30:06.730 What is the difference between these two approaches? 00:30:07.029 --> 00:30:10.089 The U .S. system called generally accepted accounting 00:30:10.089 --> 00:30:12.769 principles is a rules based system. It's like 00:30:12.769 --> 00:30:15.349 a massive, incredibly detailed instruction manual. 00:30:15.569 --> 00:30:18.549 It says if you have a lease that covers 75 percent 00:30:18.549 --> 00:30:20.869 of the assets useful life, you must treat it 00:30:20.869 --> 00:30:23.890 as a capital lease. If it's 74 percent, you treat 00:30:23.890 --> 00:30:26.049 it as an operating lease. It's very specific 00:30:26.049 --> 00:30:29.109 checklist, black and white. Exactly. But that 00:30:29.109 --> 00:30:33.609 very specificity creates loopholes. Smart fraudsters 00:30:33.609 --> 00:30:35.990 like the guys at Enron, they don't break the 00:30:35.990 --> 00:30:38.869 rules. They read the rule book and design transactions 00:30:38.869 --> 00:30:41.490 that are technically compliant but ethically 00:30:41.490 --> 00:30:44.349 bankrupt. They might structure a deal to be 2 00:30:44.349 --> 00:30:47.069 .9 % owned by an outsider because the rule says 00:30:47.069 --> 00:30:49.349 3 % ownership triggers a certain disclosure. 00:30:49.690 --> 00:30:51.890 So they follow the letter of the law precisely 00:30:51.890 --> 00:30:54.450 to violate the spirit of the law. Perfectly put. 00:30:54.970 --> 00:30:57.349 Now, contrast that with principles based systems 00:30:57.349 --> 00:31:00.089 like the IFRS international financial reporting 00:31:00.089 --> 00:31:02.369 standards used in Europe and most of the rest 00:31:02.369 --> 00:31:05.250 of the world. That system is much broader. It 00:31:05.250 --> 00:31:07.210 says something like the financial statements 00:31:07.210 --> 00:31:09.950 must present a true and fair view of the company's 00:31:09.950 --> 00:31:11.849 financial position. It's more like a guiding 00:31:11.849 --> 00:31:14.390 principle. Don't be evil. Right. It relies on 00:31:14.390 --> 00:31:16.289 the professional judgment of the accountants 00:31:16.289 --> 00:31:18.910 and auditors. Does this look right? Does this 00:31:18.910 --> 00:31:20.869 reflect the economic reality of the transaction? 00:31:21.089 --> 00:31:23.470 But the problem there is that judgment is subjective. 00:31:24.329 --> 00:31:26.549 harder to enforce in a courtroom. And the great 00:31:26.549 --> 00:31:30.549 paradox here is that we see massive fraud happening 00:31:30.549 --> 00:31:33.490 in both systems. Enron happened under the strict 00:31:33.490 --> 00:31:37.509 U .S. rules. Parmalat and more recently Wirecard 00:31:37.509 --> 00:31:40.210 happened under the European principles. It really 00:31:40.210 --> 00:31:41.849 suggests that if someone is truly determined 00:31:41.849 --> 00:31:44.410 to lie, the specific rulebook doesn't ultimately 00:31:44.410 --> 00:31:47.269 matter that much. Speaking of Wirecard. That 00:31:47.269 --> 00:31:49.609 was a huge scandal in 2020. SOX had been around 00:31:49.609 --> 00:31:52.150 for 18 years by then. We had all these new regulations. 00:31:52.430 --> 00:31:55.150 Did the system fail? Regulation is a deterrent, 00:31:55.150 --> 00:31:58.730 not a cure. It can't eliminate bad actors. Wirecard 00:31:58.730 --> 00:32:01.269 was a German payment processing company, a tech 00:32:01.269 --> 00:32:04.569 darling. They claim to have $1 .9 billion in 00:32:04.569 --> 00:32:06.809 cash sitting in trust accounts in the Philippines. 00:32:07.170 --> 00:32:09.970 And let me guess. Just like Parmalat. The money 00:32:09.970 --> 00:32:12.849 didn't exist. The accounts were fake. The auditors, 00:32:12.930 --> 00:32:15.029 Ernst & Young in this case, had failed to verify 00:32:15.029 --> 00:32:17.809 the cash directly with the banks for years. They 00:32:17.809 --> 00:32:20.089 relied on documents and confirmations provided 00:32:20.089 --> 00:32:22.549 by a third party trustee who was in on the scheme. 00:32:22.769 --> 00:32:25.230 It just seems like call the bank directly is 00:32:25.230 --> 00:32:27.490 the one simple step that auditors keep skipping 00:32:27.490 --> 00:32:29.930 over and over again. It seems to be the Achilles 00:32:29.930 --> 00:32:33.130 heel of the audit profession. And then just this 00:32:33.130 --> 00:32:37.019 year, 2024. We have the case of BF Borgers. This 00:32:37.019 --> 00:32:38.759 is the most recent one on our list, and it feels 00:32:38.759 --> 00:32:41.900 different. It's different because the fraud wasn't 00:32:41.900 --> 00:32:44.500 at the company being audited. It was the audit 00:32:44.500 --> 00:32:47.380 firm itself that was the fraud. BF Borgers was 00:32:47.380 --> 00:32:49.819 an audit firm in Colorado. They filed reports 00:32:49.819 --> 00:32:53.400 for over 1 ,500 SEC filings for various small 00:32:53.400 --> 00:32:57.500 companies. The SEC found that in 75 % of those 00:32:57.500 --> 00:33:00.019 filings, they hadn't even done the work. What 00:33:00.019 --> 00:33:01.660 do you mean they hadn't done the work? They just 00:33:01.660 --> 00:33:04.220 fabricated the audit documentation. They would 00:33:04.220 --> 00:33:06.700 copy and paste work papers from previous years, 00:33:06.900 --> 00:33:09.019 change the dates, and sign off on the audit. 00:33:09.180 --> 00:33:11.099 They were selling the appearance of an audit 00:33:11.099 --> 00:33:13.359 to companies that needed one to be publicly listed. 00:33:13.930 --> 00:33:16.069 So it's like buying a car inspection sticker 00:33:16.069 --> 00:33:18.849 from a guy in an alley who never even looks at 00:33:18.849 --> 00:33:21.029 your brakes. That is exactly what it was, a fake 00:33:21.029 --> 00:33:23.109 audit factory. It just goes to show that no matter 00:33:23.109 --> 00:33:25.809 how many rules and regulations you have, you 00:33:25.809 --> 00:33:28.650 can't regulate away fundamental dishonesty. So 00:33:28.650 --> 00:33:31.910 if humans keep failing, if auditors are lazy 00:33:31.910 --> 00:33:35.269 or compromised or just plain tricked, is technology 00:33:35.269 --> 00:33:38.329 the answer? We hear about AI revolutionizing 00:33:38.329 --> 00:33:41.950 every other industry. Can AI catch a Bernie Madoff? 00:33:42.299 --> 00:33:44.279 It is the new frontier, and there's a lot of 00:33:44.279 --> 00:33:46.500 hope there. We are seeing the rise of things 00:33:46.500 --> 00:33:49.160 like continuous auditing using deep learning 00:33:49.160 --> 00:33:51.460 and AI. How does that actually work? Well, a 00:33:51.460 --> 00:33:54.619 human auditor can only ever spot check. They 00:33:54.619 --> 00:33:56.799 might look at 50 transactions out of 50 ,000. 00:33:56.920 --> 00:34:00.059 It's a sample. An AI can look at 100 % of the 00:34:00.059 --> 00:34:03.000 transactions instantly, and it can spot anomalies 00:34:03.000 --> 00:34:05.700 and patterns that humans would never, ever miss. 00:34:05.880 --> 00:34:07.519 Like that thing called Benford's Law. I read 00:34:07.519 --> 00:34:09.679 about that. Yes. Benford's law is fascinating. 00:34:10.099 --> 00:34:12.320 It's a mathematical observation that in naturally 00:34:12.320 --> 00:34:14.380 occurring sets of numbers like utility bills 00:34:14.380 --> 00:34:16.659 or stock prices or street addresses, the leading 00:34:16.659 --> 00:34:19.179 digit is most likely to be a 1. In fact, about 00:34:19.179 --> 00:34:21.460 30 % of numbers in the real world start with 00:34:21.460 --> 00:34:24.019 a 1. Only about 5 % start with a 9. That seems 00:34:24.019 --> 00:34:25.860 so counterintuitive. You'd think all the digits 00:34:25.860 --> 00:34:28.000 would have an equal chance. You'd think so, but 00:34:28.000 --> 00:34:31.119 they don't. But here is the catch. When humans 00:34:31.119 --> 00:34:33.360 try to make up random numbers to fake a ledger, 00:34:33.480 --> 00:34:35.960 we tend to distribute the leading digits pretty 00:34:35.960 --> 00:34:38.820 equally. We put in too many eights and nines 00:34:38.820 --> 00:34:41.619 and not enough ones and twos. Our fakes don't 00:34:41.619 --> 00:34:44.880 look natural. So the AI scans the entire general 00:34:44.880 --> 00:34:47.699 ledger, sees that the distribution of first digits 00:34:47.699 --> 00:34:51.280 is unnatural, and flags it for review. Exactly. 00:34:51.320 --> 00:34:53.960 It says these numbers look cooked. It's an incredibly 00:34:53.960 --> 00:34:56.820 powerful tool for fraud detection. But of course, 00:34:56.840 --> 00:34:59.599 as the detection gets better with AI, the fraudsters 00:34:59.599 --> 00:35:02.400 will likely start using AI to generate more natural 00:35:02.400 --> 00:35:05.239 -looking fake numbers. So it's a perpetual arms 00:35:05.239 --> 00:35:08.019 race. Robo Auditor versus Robo Fraudster. It 00:35:08.019 --> 00:35:10.480 is and always will be the nature of the game. 00:35:10.619 --> 00:35:13.119 Well, on that slightly dystopian note, let's 00:35:13.119 --> 00:35:16.260 wrap this up. But before we go, you found a detail 00:35:16.260 --> 00:35:18.679 about an award that I think sums this entire 00:35:18.679 --> 00:35:21.099 deep dive up perfectly. The Imaginary Numbers 00:35:21.099 --> 00:35:23.460 Award. I love this. This was from the Ig Nobel 00:35:23.460 --> 00:35:26.570 Prizes. the parody Nobel Awards that honor achievements 00:35:26.570 --> 00:35:29.130 that make you laugh, make you think. And this 00:35:29.130 --> 00:35:31.469 is in 2002, right in the thick of the Enron and 00:35:31.469 --> 00:35:33.789 WorldCom scandals. The recipients of the Ig Nobel 00:35:33.789 --> 00:35:36.769 Prize in economics were the CEOs and executives 00:35:36.769 --> 00:35:41.070 of Enron, WorldCom, Arthur Anderson, and a dozen 00:35:41.070 --> 00:35:43.269 other companies that imploded that year. And 00:35:43.269 --> 00:35:44.889 the citation for the award, what did it say? 00:35:45.090 --> 00:35:47.789 It said they won the prize for adapting the mathematical 00:35:47.789 --> 00:35:50.590 concept of imaginary numbers for use in the business 00:35:50.590 --> 00:35:53.090 world. It's funny, but it stings, doesn't it? 00:35:53.289 --> 00:35:55.909 It really cuts to the core. These people treated 00:35:55.909 --> 00:35:58.349 business not as a mechanism to provide value 00:35:58.349 --> 00:36:00.889 to build cars or supply energy or connect phone 00:36:00.889 --> 00:36:03.570 calls, but as a theoretical math problem where 00:36:03.570 --> 00:36:05.670 the variables could be adjusted to fit whatever 00:36:05.670 --> 00:36:07.550 answer they wanted. And that brings us right 00:36:07.550 --> 00:36:09.949 back to the fraud pentagon, that fifth element, 00:36:10.130 --> 00:36:13.329 the arrogance. Absolutely. The systems we all 00:36:13.329 --> 00:36:16.710 rely on, global trade, the stock market, your 00:36:16.710 --> 00:36:19.070 retirement fund, they all function on a baseline 00:36:19.070 --> 00:36:21.920 assumption of truth. We assume a dollar is a 00:36:21.920 --> 00:36:23.980 dollar and a sale is a sale. When the people 00:36:23.980 --> 00:36:26.739 at the top decide that reality is optional, that 00:36:26.739 --> 00:36:28.420 the map is more important than the territory, 00:36:28.699 --> 00:36:31.900 the damage is truly limitless. So here is our 00:36:31.900 --> 00:36:34.059 final provocative thought for you, the listener. 00:36:34.420 --> 00:36:36.960 The next time you see a company that is constantly, 00:36:37.079 --> 00:36:39.559 quarter after quarter, beating Wall Street's 00:36:39.559 --> 00:36:43.119 expectations by exactly one penny, or you see 00:36:43.119 --> 00:36:46.199 a company that reports perfectly smooth, steadily 00:36:46.199 --> 00:36:48.780 climbing profits in a market that is chaotic 00:36:48.780 --> 00:36:53.210 and volatile. Ask yourself, is this unparalleled 00:36:53.210 --> 00:36:55.690 operational excellence? Is this management genius 00:36:55.690 --> 00:36:58.349 at work? Or is it creative writing? It is a question 00:36:58.349 --> 00:37:00.050 worth asking. Thanks for diving deep with us. 00:37:00.090 --> 00:37:01.630 Keep your eyes on the numbers and we'll see you 00:37:01.630 --> 00:37:01.969 next time.