Crime Never Pays

(Copyright Parker Brothers. Download source.)

(This post was partially written about two months back so some additional details confirming the story have emerged in the last few weeks. The main story remains the same.)

Crime never really pays. Sooner or later, criminals get caught — not all the time, of course, but most of the time (in countries with adequate policing, with "decent" culture and legal system). One big reason criminals don't get away is because it's hard to cover the tracks. There are just too many things that can go wrong when trying to mask a crime's evidence.

Such is the case with the Japanese electronics company, Olympus.

Readers may recall a post from a while back, pointing out how the CEO of Olympus was fired within 2 weeks of being hired. Things looked puzzling at that time and the story kept getting interesting by the minute — assuming you are not a shareholder of Olympus, of course.

Over the last month, the fired CEO revealed that Olympus had carried out questionable financial transactions. It appears that Olympus engaged in questionable deals totalling $1.4 billion, including $687 million paid as advisory fees in a takeover (the fees were exorbitant and make no sense for that deal).

Well, it has become evident that those transactions were to mask investment losses in the 1990's. As Bloomberg reports,

Olympus Corp. (7733), reeling from a scandal about payments made for a 2008 acquisition, said it used fees paid to advisers on the takeover of Gyrus Group Plc and others to hide losses from investments in the 1990s.

Olympus funneled the advisory fees to several investment funds to cancel unrealized losses that the company had kept off its financial statements, according to a statement from the Japanese camera maker to the Tokyo Stock Exchange today. The company apologized to shareholders and stakeholders.

So, the transactions that looked dubious weren't at the root of the problem. Instead, it seems that those transactions were used to fake financial losses years earlier.

This situation is a good example of how criminals have a hard time getting away. They hid the original losses but they left some fingerprints.

Olympus is a giant company and the losses seem somewhat small so it probably isn't going to collapse (in fact, it might be an attractive investment for those that can tolerate high risk). But the point is that masking criminal activities is much harder than it seems.

Small Moral Compromises

In an article for The New Yorker in 2009, Ron Chernow suggests some reasons Ponzi schemes and frauds may come about (bolds by me):

Few financiers become embroiled in Ponzi schemes voluntarily, for the simple reason that such schemes are mathematically certain to fail. At some point, the incoming money cannot keep pace with the outgoing claims, and the fraud must unravel. And so the saga of Ivar Kreuger [a matchstick tycoon from the early 1900's] presents a credible explanation of how giant Ponzi enterprises come about: not as sudden inspirations of criminal masterminds but as the gradual culmination of small moral compromises made by financiers who aren’t quite as ingenious as they think. As Charles Baudelaire once said, we descend into hell by tiny steps. Indeed, in pleading guilty last Thursday, Madoff explained that he had initially thought his fraud would be short-lived. He may well have fancied himself a brilliant money manager. Perhaps, early on, he even had a few good, legitimate years. When his lucky streak suddenly ended, he might have thought that he would temporarily make whole the losses of old investors by giving them money from new ones. And then he was off and running.

I share Chernow's view that many white-collar crimes, such as Ponzi schemes, start off as "small moral compromises." I'm talking about white-collar crimes here; other crimes are more driven by social factors in my opinion (although some conservatives will probably disagree).

Most criminals, like Bernie Madoff or Kenneth Lay, appear to get caught in a trap with a small lie, that snowballs into a big one. One fake earnings report—we'll fake only one!—leads to additional ones down the road. Often, large crimes seem like a farce in hindsight, precisely because the criminals started with small steps and have to engage in all sorts of crazy contraptions to cover numerous steps along the way.

Since the criminals end up trying to fix numerous small mistakes, they also end up leaving lots of fingerprint at the crime scene. Even if they cover up the fingerprints, they leave tire tracks. Or even if they cover up their fingerprints and erase their tire tracks, they forget about the delivery driver that drives by everyday at that time.

Ivar Kreuger & His Empire of Shell Companies

One of Ivar Kreuger's Companies

(source: The Share Gallery)

Ivar Kreuger is an interesting figure. I never heard of him until I read Ron Chernow's article a while back. People often think that current crimes are somehow more sophisticated than in the past — how many have suggested that the Enron shell companies were something new and advanced? Yes, that's true to some degree. However, we have had sophisticated crimes in the distant past as well.

Who was Ivar Kreuger? Ron Chernow describes him as:

Kreuger didn’t merely fabricate returns. He was a genuine businessman, backed by factories, mines, and other tangible assets. Like other industrialists, Kreuger planned to amass a huge fortune by manufacturing something ubiquitous and banal, much as John D. Rockefeller had done with kerosene. Kreuger wanted to monopolize the sale of the tiny boxes of safety matches that people used to light stoves or tobacco; cigarette smoking had become faddish among women as well as men in the nineteen-twenties, stoking demand for the product. By the 1929 crash, Kreuger’s Swedish Match Company, a subsidiary of his holding company, Kreuger & Toll, had cornered the market on two-thirds of the forty billion matchboxes sold worldwide each year. Kreuger & Toll also earned a reputation as a proficient builder that completed construction projects reliably and on time. John Maynard Keynes extolled Kreuger as “perhaps the greatest constructive business intelligence of his age.”

This wasn't just some ordinary man; he wasn't an ordinary businessperson either. If John Keynes talks about him in such high regard, Kreuger was clearly near the top. In fact, Ron Chernow describes how "his stocks and bonds ranked as the most widely held securities on Wall Street."

Like [Charles] Ponzi, Kreuger didn’t set out to create a fraudulent enterprise. Nor was he booking only phantom profits. Rather, he aroused exaggerated expectations that he couldn’t live up to. Annual returns in the match industry fluctuated wildly, denying Kreuger the steady high earnings he needed. So he turned to the venerable robbing-Peter-to-pay-Paul racket. To pay his dividends, he took out secret loans, imagining that they were temporary, only to have the deception take on a permanent life of its own. Financial engineering had, instead of acting as the servant of his business, evolved into its very essence.

Didn't set out to create a fraudulent enterprise! If there's a common element in many Ponzi schemes and other frauds, that's it. Very few ever set out to create a fake business. Yet they all end up as one.

Eventually his empire collapsed. How so? Like all ponzi schemes.

Kreuger was a virtuoso at financial shell games, shuffling assets from one subsidiary to another to produce the desired results. He converted corporate balance sheets from transparent tools to instruments of deceit. His maze of companies was so baffling that secret subsidiaries spawned other secret subsidiaries in a never-ending chain of concealment. Anticipating the murky world of Enron and A.I.G., Kreuger pioneered off-balance-sheet entities, shunting debt to invisible firms and dummy companies. At times, it seemed as if Ivar Kreuger alone understood the corporate behemoth he had created, and he showed how easily legitimate companies, with a little creative accounting, can turn into outlaw enterprises.

History rhymes. As usual, there is always some incompetent, at times possibly greedy or corrupt, accountant in the mix:

Those who wonder how Madoff duped his auditors will find an instructive case study in Partnoy’s account of Kreuger’s relationship with A. D. Berning, a junior auditor with Ernst & Ernst, the accounting firm that earned lucrative fees from representing Kreuger’s business interests. The young functionary prided himself on handling the mogul’s account, and was pathetically eager to please him. Berning wasn’t disposed to question shocking discrepancies that surfaced in the ledgers, especially after the Kreuger account led to his making partner. The Match King softened him up with perks and presents, inviting him along on fancy trips that stroked the auditor’s ego. Berning gradually became complicit in the fraud without ever quite realizing that he had strayed across the line. Later, he achieved heroic stature by his part in exposing the fraud that he had helped to perpetuate. Kreuger’s American bankers, the Boston Brahmin house of Lee, Higginson & Company, were no less credulous toward their foremost underwriting client. Every time the firm got too nosy, Kreuger boosted the fees he paid it.

Some of you reading this blog work as auditors, accountants, or regulators. Hopefully none of you fall for the temptation of wealth. If management pressures you to fabricate numbers, just don't do it. Not even, just this time!

Not the Home of Any God

Olympus was the home of the Olympian Gods — at least to the followers of Greek mythology. The Olympus that is embroiled in the fraud is not so virtuous. The stock (TSE: 7733) is off around 60% in one year.

One of the toughest thing for investors is to detect accounting frauds. Even skilled fundamental analysts don't detect problems ahead of time. It's 100x worse when, as William Pesek of Bloomberg says, involves "clueless executives, hapless regulators, compliant bankers, billions of missing dollars, gangsters, [and] exotic-sounding book-cooking techniques like 'tobashi.'"

The Olympus case is very illustrative of investments in Japan. Anyone investing in Japan should certainly realize how the shareholder rights, or lack there of, differs in Japan. As Pesek continues,

Somehow, Olympus executives, led by new President Shuichi Takayama, are clinging to their jobs. No argument can be made that the board shouldn’t be axed, and yet it remains employed. Shareholders should speak out and demand answers -- and change -- at Olympus. Sadly, they’re not. And, frankly, they deserve what they get as Olympus’s share price dwindles.

On Thursday alone, shares plunged as much as 20 percent after Olympus restated earnings and took a $1.3 billion reduction in net assets. Few believe this will be the last restatement as this surreal plot thickens and darkens.

Regulators, meanwhile, are doing Japan no favors by going easy on Olympus. In 2007, Livedoor Co. President Takafumi Horie was jailed for fraud in a hostile takeover battle. Very small beer compared to Olympus, that episode involved Livedoor’s offices being raided and the Internet start-up being delisted. Why has none of this happened at Olympus? No raids, no high-profile arrests, no delisting of shares. Why the double standard?

Here you have one of the biggest corporate frauds in Japanese history! We are talking more than a billion dollars being misappropriated from a high profile, successful, 92-year-old company. Yet the board of directors who permitted, and possibly abetted (we don't know for sure), are still there. Senior management responsible for almost bankrupting the company are still in power and overseeing the "investigation" into the problems.

Will the story of Tsuyoshi Kikukawa, the CEO of Olympus, and other involved culprits, resemble that of Kreuger, Ponzi and Madoff?

The Olympus saga is beyond farce; It's surreal. I think the Gods want their name back.