Wirecard: No End to Stock Frauds In China and Europe?

With €1.9 billion ($2.1bn) in cash missing, it appears that Wirecard may join an illustrious lineup of large cap stock frauds in Europe and China. It is notable that the U.S. market has not experienced, as far as we all know, any large cap frauds in nearly 20 years since the failure of Enron and Worldcom.

China and Europe remain the hotbeds of stock frauds in large companies. China is a special case. Its legal system can effectively give fraudsters immunity from prosecution because it does make stock fraud against foreigners a crime. Moreover, defrauded investors who obtain judgments in Western courts against the perpetrators have arguably little chance of collecting from Chinese residents. When one can cheat with impunity, it is no surprise that some people take advantage of this massive loophole.

While the incentives for Chinese stock frauds are obvious, they are less evident for those in Europe. Large scale problems at several big corporations indicate that we are not dealing with outliers but with fundamental weaknesses in prevention. Spanish internet service provider Let’s Gowex was an award-winning tech startup until it collapsed under allegations of having made up fictitious clients, leading to €1.9 billion in investor losses. Steinhoff is a dually-listed South African/German retail conglomerate that experienced a $7.4 billion accounting fraud and only narrowly avoided bankruptcy. Fake customer shipments at Belgian speech recognition software firm Lernout & Hauspie led to $10 billion in losses. Even governments are in on scams: in the 1999 privatization of Deutsche Telekom, the company’s real estate portfolio was overvalued by €2 billion, which netted the government extra cash from the sale of its shares to the unsuspecting public. Shares later dropped 92%.

Warning signs abound at Wirecard

Starting on April 24, 2019 a series of articles by the Financial Times reporter Dan McCrum, based on information provided by a whistleblower, began to shed doubt on the reported revenues from Wirecard’s Asian operations, which represented nearly half of revenues and 95% of EBITDA [i]. A whistleblower claimed that no cash was ever received for the revenues or earnings.

Wirecard commissioned KPMG to conduct an investigation into the allegations. The report was released on April 28 of this year. However, the contents of the report and Wirecard’s press release don’t quite match up. Wirecard boasts that the report found no evidence of criminal wrongdoing. That is absolutely correct.

But even factually correct statements can be a smokescreen. In fact, the report says nothing about criminal wrongdoing. Instead, it points out several troubling inconsistencies that should have set off alarm bells at the company [i]:

• Section 1.3.1.1.2: “KPMG can […] neither make a statement that the revenues exist and are correct in terms of their amount, nor make a statement that the revenues do not exist”

“… unwillingness of the Third Party Acquirers to participate in this special investigation in a comprehensive and transparent manner …”
“… In view of the spread of the coronavirus, it has not yet been possible to provide KPMG with corresponding direct bank confirmations in a timely manner …”

• Section 1.3.1.1.3: “Bank confirmations and account statements from the bank managing the trust accounts were not submitted to us, as Trustee 1, according to the information provided, has terminated the contractual relationship with the Wirecard companies and no longer responds to inquiries from Wirecard.” 

Hold on – a trustee who no longer responds to inquiries? That does not seem plausible. The proper setup for an escrow managed by a trustee would have been to retain a corporate trustee, a service provided by most major banks and numerous independent firms. These firms do not just simply stop responding. After all, their professional reputation is at stake. This defies logic. Unfortunately, it doesn’t get better:

• Section 1.3.1.1.5 : “KPMG believes that the internal controls in place are not fully sufficient to fully ascertain the amount and existence of the revenues in the investigation period. As a result, we were unable to derive in a sufficient manner the amount and existence of the revenues from control documentation, particularly for the purposes of our forensic special investigation.”
  “In order to verify the existence of the transactions and the customer relationships underlying the transactions, we had also requested contracts between the TPA partners and their contract partners, who were allocated to the "account name" designations as shown on the respective settlements. The relevant contracts were not submitted to KPMG”
  
  
• Section 1.3.1.4.3: “KPMG comes to the conclusion that there are arguments against Wirecard's accounting of escrow accounts as cash or cash equivalents in the investigation period 2016-2018. In KPMG's view, there are arguments that the funds in the escrow accounts could be other financial assets. However, there is room for interpretation and discretion …”

In other words, KPMG suggests that what was labeled “cash” may have been more akin to a receivable.

These concerns raised by KPMG clearly call Wirecard’s financials into question. The fact that the company makes an irrelevant press release about non-existing criminal wrongdoing while ignoring the actual contents of the report could be a tell-tale sign that it is not acting in good faith. The question for investors in such a situation is: do you want to give the company the benefit of the doubt, or do you run away with your money? The stable stock price in late April suggests that few investors ran.

Remember Parmalat?

Cash gone missing seems to be a recurring pattern in European stock frauds. Verifying cash balances is the easiest part of an auditor’s job. Somehow, European auditors have been getting this wrong to the tune of billions. In 2004, Italian milk distributor Parmalat collapsed with €3.95 billion cash allegedly invested in an account at Bank of America through a subsidiary. It was later discovered that confirmations had been doctored by executives with a scanner [iii]. Of course, best practice would have been for the auditor to get bank confirmations directly from the bank. We believe that this is even an audit requirement in the U.S. How an auditor can take a shortcut on such a material item and accept confirmations from the company rather than from the source remains a mystery.

Shortcomings of the BaFin regulator

To understand why the BaFin regulator ignored red flags uncovered by the Financial Times and went after Dan McCrum, the investigative journalist, we have to go back in history to 1993. In that year, Franz Steinkühler, a union leader who sat on the board of Daimler as a worker representative, was caught using inside information to trade Daimler stock in his personal account for a profit of $39,000 [ii]. At the time, that was not illegal in Germany. Nevertheless, the Financial Times published his incriminating account records which caused a major scandal forcing the government to introduce insider trading legislation. So, regulators who had let insider trading slip for years were caught off guard by the FT revelations.

As a result, BaFin and prosecutors have been laser focused on insider trading and market manipulation at the expense of prosecuting other wrongdoing. For example, BaFin regularly misses Ponzi schemes, which are costing small retail investors billions. However, when it suspects stock manipulation, no approach seems to be too heavy handed. Sources tell us that BaFin had police execute a search warrant on the parents of a PhD student whose professor had been critical of a publicly traded company and thus come into the crosshairs of the regulator. The investigation was closed without charges being filed.

Before the Wirecard scandal, we had thought that BaFin’s obsession with market manipulation by investors rather than issuers had peaked during the Greek debt crisis. As we pointed out elsewhere [iv], the then-head of BaFin, Jochen Sanio, claimed in a parliamentary committee that investors in credit default spreads might spread false rumors about Greece. In doing so, he completely bungled percentage math, which we might forgive someone trained as a lawyer, but also exhibited complete ignorance about how credit default swaps are valued, even though that was the topic of his deposition. Sanio talked about market manipulation as the source of Greece’s problems while ignoring the fundamentals.

BaFin’s focus on market manipulation by investors needs to be seen in a broader intellectual climate that despises investors, and shareholders in public companies in particular, as ruthless speculators, while corporate managers, academics, bureaucrats and politicians are deemed responsible disinterested decision takers working for a good cause. This climate is also reflected in domestic press coverage which parrots BaFin press releases without independent investigative reporting, which in turn further reinforces the prevailing intellectual climate.

Therefore, it is not a surprise that BaFin got Wirecard wrong when it banned short selling in its stock. It sees only trees of market manipulation but misses the forest of corporate wrongdoing.

Wirecard is just one case

Wirecard is concerning on several levels:

Cash is the easiest item to confirm in an audit. With the company having free cash flow of approximately €800 million (if true) last year, €1.9 billion would have taken several years to accumulate and hence may have been missing in multiple prior audits. Cash was also an audit miss at Parmalat. It is troublesome that auditors still cannot figure out cash.

Regulators were so focused on conspiracy theories about evil short sellers conspiring with journalists to destroy a good company through an alleged bear raid, that they missed obvious red flags that had been highlighted.

The whistleblower had no channel to go to other than the financial press. In the U.S. the SEC now runs a reward program for whistleblowers, who have in some cases collected millions of dollars in rewards for exposing fraud. Elsewhere, the lives of whistleblowers are more perilous, as Xavier Andre Justo’s experience shows. He spent 18 months in a Bangkok jail under fabricated charges after revealing the multi-billion dollar fraud at Malaysia’s 1MDB. [v]

Investment implications

The issue of fraud in Chinese stocks remains intractable. A bill made its way through the Senate that would bar U.S. listings by Chinese companies that are state-owned or that have not been audited by firms overseen by the Public Company Accounting Oversight Board for three years. It is not quite clear whether this bill will actually apply to the Chinese operations of the listed companies. After all, many of the listed firms are simply shells that have the economic interest of their Chinese businesses assigned to them. Therefore, it would take a broad reading of the bill for it to have major consequences, which we believe to be unlikely and also unintended politically. In other words: Chinese frauds are likely to continue to hurt investors, who should take Chinese firms with a grain of salt.

As to European firms, while frauds are much less pervasive, they still occur more frequently than in the U.S., where Sarbanes-Oxley, while imposing substantial burdens on listed companies, appears to have been effective in routing out major frauds. It is not clear to us whether Europe needs new laws like Sarbanes-Oxley.

We believe that it would be sufficient for regulators to become more responsive to concerns raised by investors. After all, concerns about bear raids may be mostly folklore. Short sellers have been some of the most effective detectives in uncovering frauds.