They say when the tide goes out, you find out who is swimming naked. And we have just seen a king tide that, if history is any guide, enabled an epidemic of skinny-dipping.
Frauds have been happening for years, with lies, concealments and half-truths having contributed to the ballooning value of stocks over the past decade. But throughout this up-only market, it was very hard to find victims — company owners weren’t mad that management was committing fraud, they were enriched by it.
The bust of crypto exchange FTX is a spectacular example of what I’m talking about. It looked like an ultra-profitable work of genius, but it was ultimately a house of cards run by imbeciles. They had billions in assets and lacked proper records? Amazing!
FTX founder and CEO Sam Bankman-Fried may be in handcuffs soon. But he won’t be the last CEO to trudge into court under guard. If history is any guide, the current market crash — and the recession arriving hot on its heels — should cause the Nasdaq-to-prison pipeline to really start humming.
In 2020 and 2021, asset values ran up enormously. As the next chart shows, the ASX 200 went up approximately 40% and the S&P 500 rose by more than 80% from the market bottom. But in 2022, those changes reversed. When central banks started lifting rates, asset values plunged.
It is only when the market turns down and fraud is revealed that investors are reminded why fraud is bad. So now we begin to find victims. If your superannuation fund buys stock in a company, it relies on that company accurately describing its finances. If a stock goes down and investors find out those finances were misrepresented, they sue.
All these investors need is evidence of a company telling lies. It can come out in several ways, such as from whistleblowers, journalists or short-sellers. This information might not even be new. The difference is that when any company in question was going well, there was no market for it.
Another way we can learn about a company’s misdeeds is if it finds itself unable to pay staff and/or service debt. In that case, they can enter administration (or file for bankruptcy under Chapter 11 in the US), and when administrators take hold of the company, they may discover things don’t add up. When the administrator arrived at FTX, he said he had never seen “such a complete absence of trustworthy financial information”. (This becomes extra impressive when you find out the guy handled the Enron insolvency!)
During this period of economic downturn, expect to discover that companies have been lying about their technology, customer numbers, costs, debts, profits and assets; that they have been trading while insolvent; that money has gone missing — plus no shortage of truly lurid extraneous details. The FTX senior management were into polyamory, for example.
Where to look for fraud
The lessons of the 2007-08 financial crash are too recent for the mainstream financial industry to be deep in fraud. It won’t be subprime loans this time — that’s not where the market got hot. Instead, look for fraud in places where things became crazy.
Think software firms: not Microsoft or Google, but young ones that weren’t around in the 2001 crash, such as fintech, app firms, everything backed by venture capital and anything with a crypto angle. Places where 30-year-old men in T-shirts make $500,000, floor space is devoted to ping pong, and customer growth is more important than profit. There’s some of this in Australia, but I expect the bulk will be from the US.
Electric vehicle company founder Trevor Milton is a perfect example of things to come. The 30-something CEO was arrested for falsely claiming that his company, Nikola (named after Nikola Tesla, get it?), had a working prototype of its electric truck. But in a 2018 promotional video released by the company, the vehicle moved only because… it was pushed down a hill. Milton, who spent $80 million on a private jet and tropical real estate in 2020, was convicted of fraud in October.
Hot markets
In recent times, investors were manic. They had enormous sums to invest in companies they thought would dominate the world. Ethics were an impediment to making those investors happy. A firm or founder with ethics puts limits on themselves. Firms with ethics did not grow at the same rate as firms that chose to put winning first.
If you invest only during rising markets, you would be smart to invest in firms led by greedy psychopaths because they will do better. If you invest during a range of market cycles, investing in rapacious criminals will eventually send your investments to zero. In the last decade, a lot of investors have learned only the first lesson.
The FTX CEO — in a spectacularly incriminating interview he apparently gave Vox reporter Kelsey Piper by accident after his firm went broke — describes this idea below. (Piper’s questions are in the blue bubble; Sam Bankman-Fried’s replies are in grey.)
He’s describing four quadrants. A matrix, if you like. You can be clean or dirty. And you can win or lose. He says winning is best, no matter how you do it. In short, he’s disavowing ethics. You don’t hear that anywhere — and certainly not in mainstream business!
But the best way to understand this is not that the man is an aberration. He is the product of circumstance. For a decade, crypto has bestowed rewards on those who took the biggest risks. The ones who aimed highest, borrowed most, lied most. He has been trained to be like this, repeatedly rewarded by the markets for trying to grow bigger and richer, at any cost. He won’t be the only one.
I’m excited for more of this to come out. The kind of drama that unfolds in a corporate fraud meltdown is so much less predictable and more interesting than in a regular, boring quarter of good earnings.
Jail time
This week, Elizabeth Holmes, the former CEO of the disgraced blood-testing company Theranos, was sentenced to 11 years in prison. She was unlucky to be busted for fraud when she did — her arrest doesn’t fit the boom-bust cycle.
Her misdeeds were pursued by Wall Street Journal investigative reporters in 2015, a book about her dodgy blood tests came out in 2018, and she went to trial in January. The WSJ described the sentence as “midrange”, especially when compared to the likes of Enron bosses (Jeff Skilling was sentenced to 14 years) and famous Ponzi scheme operator Bernie Madoff (sentenced to 150 years, died in jail).
Holmes’ sentence towers over the current landscape. That 11 years in the clink counts as midrange should terrify legions of corporate bosses. She lost merely hundreds of millions of dollars of investor money. Unrepentant crypto boss Sam Bankman-Fried lost billions. Will he go to jail? His parents are “prominent”, and he donated a lot to politicians, so it isn’t certain.
What about the next domino? Who will it be? Will they go to jail? If markets keep falling, we will find out soon.
