Reuters has reported that Luckin Coffee—sort of the Starbucks of China—is under investigation by the SEC for cooking their books. Luckin is being accused of overstating sales last year. Luckin stocks have been frozen, so no buying or selling, meaning investors are going to take a hit. While Luckin’s alleged impropriety happened last year, their story is a reminder about the danger of corporate fraud during a downturn like the one we’re experiencing now.
Now is the time for investors to be even more vigilant when it comes to investment sales pitches. CNBC reported that the S&P 500’s first quarter this year was its worst since 2008. The pandemic has taken a serious toll. When revenues go down, corporate managers can be tempted to conceal losses with accounting fraud. Shareholders are often left holding the bill.
Everyone around here remembers WorldCom as a primary example of this. In the early 2000s, the telecom industry tanked, as markets spooked on the idea that the industry had overbuilt and could not promise revenues to recoup the expenditures. As the market went down, managers at WorldCom fraudulently classified some of their operating expenses as capital expenditures. They reported some expenses like leases were actually capital assets, not losses.
The scheme was uncovered by an internal auditor and certified fraud examiner, Cynthia Cooper. By the time the world realized WorldCom was taking big losses, it was too late. The company crashed, people lost their jobs, and investors lost a fortune.
Downturns create the potential for fraud because of the way some people think and the pressure they are under. Fraud investigators often use a framework called the Fraud Triangle to try to predict when white collar crime will happen. The Triangle was invented by Dr. Donald Cressey from the University of California, Santa Barbara. It states that, when three elements are present, there is a high potential for fraud. The three elements are pressure, opportunity, and rationalization.
First, pressure. When there is financial pressure on someone—for example, when a CEO believes she must deliver big returns or lose her job—that may push someone to commit fraud. Sometimes the pressure is imposed by a failing marketplace, as in the case of WorldCom, or sometimes it’s self-imposed. For the latter, I always think of Enron CFO Andy Fastow, who lived a large lifestyle and put pressure on himself to turn a simple gas pipeline company into a much more profitable energy finance company. Unfortunately, he did that through accounting fraud.
Next, opportunity. If a corporate manager has a great deal of control over the books of their company, with no one checking their actions, that can open the door to fraudulent behavior. Of course, even when there are auditors and oversight, fraud can still happen. Arthur Andersen watched as both Enron and WorldCom committed fraud.
Finally, rationalization. Fraudsters often convince themselves there’s nothing wrong with what they’re doing. In the corporate world, managers might say, “The market is down, and everyone is minimizing (i.e., concealing) losses just like we are.” They justify their actions to themselves.
When those three elements are present—and they are more likely to be present during a recession—the potential for fraud is high. And you don’t want to be holding a lot of that company’s stock when it goes down.
The SEC is already seeing this pattern. Last month they warned that some companies were claiming to investors they had developed a key COVID-19 treatment. When investors bought into the company, the share price was bid up, and the original owners dumped their shares and made a nice profit off a false promise. The SEC calls it a pump-and-dump scheme, as in “pump” the share price up and then “dump” it. If someone comes to you claiming they know of a COVID-19 treatment or test, you should check with an official source, like CDC.gov, to see if this treatment or test is legitimate.
In short, now is the time to be careful, not just with our physical health, but also with our financial health.
Shad White is the 42nd State Auditor of Mississippi and a Certified Fraud Examiner.