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Corporate frauds are in focus again. In the last few months, cases in China (Luckin Coffee and Kangmei Pharmaceutical) and Germany (Wirecard) have stolen headlines. Investors - especially those focused on environment, social and governance (ESG) factors - should be on high alert.

There is an argument that the Covid-19 crisis, like a receding tide, will expose many more frauds that had been able to hide beneath the surface in good times, as happened in the wake of the global financial crisis in 2008-09. In fact, the well-known short seller Jim Chanos has called this ‘the golden age of fraud’.

Why is it that corporate frauds still occur with such frequency and scale, despite all that has been done in the last few decades to tighten oversight, regulation and legislation? I believe the answer boils down to three key factors: integrity, independence and competence. The latter two apply to oversight functions of companies, while the former has to do with the character of management teams. As investors, we pay special attention to validating the strength of these factors. Much of investing, to put it crudely, is about avoiding the blow-ups.

Factor #1: Integrity

Integrity is probably the most important trait required of company managements, but also the most challenging one for investors to validate. Integrity is even more difficult to judge in companies with a short history of being listed, not to mention in start-ups or those firms with little overall track record. In the corporate context, management integrity means doing the right thing by stakeholders. However, sometimes internal and external pressures can be so strong that they cause a failure of integrity that allows greed to take over.

In her influential book “The Seven Signs of Ethical Collapse”, Professor Marianne Jennings studied the causes of corporate fraud and listed seven red flags that might be predictors of a failure of integrity. Here I share those seven signs according to Professor Jennings along with some of my own observations:

Pressure to maintain numbers. As a professional investor, I see this increasingly in companies that are trying to justify their sky-high valuations or are otherwise under pressure from certain groups of investors. Excessive deal-making or serial roll-up acquirers (those targeting companies in the same industry) are just two examples of symptoms of the pressure to drive up short-term profits at the cost of adding significant risk from more leverage.

Fear and silence. These can lead to a culture where people are too scared to speak up and will allow glaring misconduct to occur and continue. Fear and silence could also manifest via a culture of excessive secrecy, or one dominated by greed and win-at-all-costs thinking, like in the collapse of Enron. Another instance where fear and silence took hold was the 1998 implosion of Long-Term Capital Management, brilliantly described in the book ‘When Genius Failed’.

Young 'uns and a bigger-than-life CEO. A great example of a charismatic CEO leading people down a wrong path is the recent story of Theranos, the Silicon Valley blood-testing start-up that was later exposed as a fraud - a story told so well in the book ‘Bad Blood’ by John Carreyrou.

A weak board. This comes down to genuine independence. More on this below.

Conflicts (of interest). Typical red flags include webs of related-party transactions, or executives with substantial external interests, among others. However, this is also true of situations where there is little or no alignment between management and minority shareholders, as is the case with many state-owned corporations.

Innovation like no other. Overlooking ethical boundaries in the pursuit of innovation; this is increasingly important in the era of big data, with ramifications for sectors including technology, banking and healthcare.

Goodness in some areas atoning for evil in others. Companies or management teams that use philanthropic donations and activities to compensate for unethical behaviour elsewhere.

Factor #2: Independence

Oversight is one of the biggest safeguards against failures of integrity like those outlined above. In the corporate context, one of the most important bodies that provide this oversight is the board of directors - but investors also depend on auditors and, ultimately, regulators to provide this. Maintaining the independence of the board and auditors is crucial to delivering effective management oversight; unfortunately, while many companies achieve this independence in form, they don’t achieve it in spirit.

Let’s start with the board. While it is easy to analyse the proportion of board members tagged as ‘independent’, there are many additional checks that can help us evaluate if this independence has been potentially compromised:

Tenure. A very long tenure can indicate compromised independence.

Number of boards. Excessive ‘boarding’ on other corporates can imply limited bandwidth of a director to bring true independent thinking to the board.

Compensation. Excessive remuneration can impair independence. Remuneration or share awards need to be delinked from management key performance indicators.

Controlling shareholders. While a state-owned corporation may have a good number of independent directors, questions may arise over how much leeway they have to express their views given the influence of the sovereign on these directors.

Family-controlled corporations. In some cases, board members may also be subject to a social contract or a relationship that goes much deeper than the corporate engagement. But it’s not just directors where independence is crucial; investors also need to examine whether auditors are too close for comfort. While many countries now mandate a periodic rotation of auditors, these are some questions we can ask:

• Are the auditors getting disproportionate fees on other business relative to their audit fees? Is auditor compensation in line with peers?

• Are auditors merely refusing to comment on a matter when they should be highlighting a serious concern?

• What is the track record of the auditors and their local audit partners? Is the size and experience of the auditor commensurate to the size and complexity of the company?

Factor #3: Competence

While we often find companies where the board has a good level of independence, we still need to ask questions to ensure the various board committees are headed by independent directors with the relevant professional experience to carry out their duties.

Too often, too few details are provided to the board with too little notice. Without directors who are conversant with matters at hand, their responsibility of oversight will be compromised. For example, we expect the independent director heading the audit committee to have relevant experience in finance and accounting.

What should shareholders do?

Shareholders have a meaningful oversight role to play to help companies adhere to high standards of integrity, independence and competence.

• Red flag analysis. While passive investors don’t always have much choice, active managers like myself proactively look for red flags and warning signs to try to avoid potential frauds. These can emanate from things like aggressive accounting, or dependence on government contracts or relationships for business. We are also able to look for inconsistencies in company disclosures by researching alternative sources of information, including, for example, supply chain data or internet traffic. In addition, we pay a lot of attention to corporate culture and the steps a company is taking to engender a culture of integrity, adherence to rules and a high standard of ethics.

• Engagement. As part of our regular interactions with the management teams and boards of investee companies, we conduct specific ESG engagements where we endeavour to have a constructive dialogue to highlight our sustainability concerns and make suggestions for improvement. As long-term investors, we see a stronger alignment with management’s value creation objectives and can provide honest and independent feedback on their progress, initiatives and performance. In 2019, as a firm we had over 16,000 meetings with companies, voted on more than 4,300 corporate actions and had ESG-specific meetings with over 630 companies.

• Voting. Voting is one of the most important tools that shareholders can use to safeguard their own interests. Shareholders can use voting to express their views on board composition (independence, competency, tenure, number of boards, attendance) and a wide range of governance matters like capital allocation or executive remuneration.

• Divest. Probably the last resort, but when we sense that something is wrong and the management and board show no serious desire to initiate changes, we will sell out of an investment. Unlike passive investors who don’t have a choice here, active managers can exercise this choice and protect the interests of their fundholders. If more investors take the same view and sell out, it will lead to a significant decline in market value, which in turn can hurt employee and business-partner confidence. This provides an indirect check that encourages the company to pay attention to investor concerns.

Takeaways

The efforts to minimise corporate fraud still have a long way to go. Attention to integrity, independence and competence can help minimize this risk. Shareholders have an important role to play via active ownership and engagement. At Fidelity, we are using our strengths in fundamental analysis and ESG engagement to help mitigate the occurrence and the impact of corporate fraud on our funds.

More on ESG investing

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

Topics Covered

ESG investments; Investing ideas; Investing principle; Security and Fraud

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