Financial Scandals – 8 of the biggest financial frauds, scandals and ponzi schemes of all time

Business scandals involve accounting and financial market manipulation or multiple types of fraud

Unfortunately, one of the realities of business and investing is the occasional financial scandals and frauds that emerge. Investors should always be aware that there are unethical companies and people around and that financial scandals can result in investments becoming worthless very quickly.

Financial Scandals
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The following financial scandals are amongst the biggest in history and illustrate some of the ways unscrupulous people can defraud investors to enrich themselves.

Enron

Enron / Accounting Fraud
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The Enron scandal is probably the most famous of Wall Street’s financial scandals. Enron was a high-flying energy services company and a darling of the stock market in the last 1990s. When it eventually collapsed shareholders lost as much as $74 billion. The CEO, Jeff Skilling and the CFO, Andrew Fastow, used an array of dubious accounting practices to inflate revenue and hide debts. The result was that the company appeared to be the most profitable company in history, when in fact it was saddled with debt. The appearance of a healthy balance sheet and large revenues allowed Enron to easily raise more capital to keep the charade going.

Most of the fraud was committed between 1998 and 2001 resulting in the stock price trading as high as $90.56. During this period CEO Ken Lay gave Skilling more and more authority, which Skilling used to manipulate the company’s accounts. The company was able to exaggerate asset values and revenue by changing an accounting policy to use market-to-market prices. These prices were then manipulated. Billions of dollars in debt were also moved from the balance sheet and hidden in shell companies in the Cayman Islands. The fraud accelerated when Skilling took over the CEO position from Lay.

In 2001 the fraud became unsustainable and the company collapsed. Ken Lay, Jeff Skilling, Andrew Fastow, and others were arrested. Fastow and Skilling served six and 12 years in prison, respectively. Ken Lay died before he was sentenced. The scandal didn’t only lead to the collapse of Enron, but to the demise of the Arthur Andersen, Enron’s auditor. The auditor overlooked the financial fraud and helped with the cover up. Arthur Andersen’s role in the fraud remains one of the biggest accounting scandals in the United States to date.

WorldCom

WorldCom / Telecommunications Company
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During the 1990s WorldCom was the second largest telecommunications company in the US. However, in 2002 the company collapsed after wide ranging accounting fraud was uncovered. Telecom companies performed very well during the 1990s as the use of mobile phones grew. When the industry later came under pressure, WorldCom executives turned to cooking the books. They inflated revenue, and listed expenses as investments to create the impression that the company was still profitable and growing.

Investors believed the stock was still a good investment, and so at its peak the company was valued at $180 billion. At the time this meant it was one of the most valuable companies in the world. When auditors discovered that revenues and profits had been overstated by as much as $7 billion, the stock price quickly collapsed from $60 to $1, and thousands of employees lost their jobs. The company filed for bankruptcy protection and later emerged as MCI, a much smaller restructured company. MCI was later bought by Verizon Communications.

In 2006, WorldCom’s CEO, Bernhard Ebbers, was sentenced to 25 years in prison. He was released earlier this year after serving 15 years and died shortly thereafter. The WorldCom scandal remains one of the world’s largest corporate scandals and resulted in nearly $180 billion in losses for investors, and thousands of lost jobs.

Mississippi Bubble

Mississippi Bubble
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One of the first documented financial scandals, was the Mississippi Bubble. It was also one of the strangest stories in the history of finance, involving an eccentric Scottish economist, the French economy and one of the first banks to issue paper currency. For some reason, the Duke of Orleans who was acting as Regent in France, appointed John Law, a fugitive from England, as defacto Minister of Finance.

France’s economy was crippled by debt, and Law was given the authority to try to fix it. One of the solutions he pursued was setting up government-controlled monopolies to generate revenue for the state. Another was setting up a new bank that issued paper currency, still a novelty at the time. One of the monopolies that Law established was the Mississippi Company which would consolidate the trading companies in Louisiana into one entity.

Law was allowed to issue 50,000 shares, but investors only needed to put down a deposit equal to 15% of the share price. Investors flocked to buy shares, and Law was able to issue another 300,000 shares. Within months the share price rose from 500 to 10,000 livres. Law raised so much money that he was able to lend the French government enough money to pay off the national debt.

The problem was that so much cash was required for investors to buy the shares that Law’s bank had to print more money. When Law realized that both the currency and the share price were inflated, he tried to devalue both in a controlled manner. Unfortunately, this resulted in a selling frenzy, with investors trying to sell their shares and then exchange the currency for gold. In the end the company collapsed, and both the shares and France’s currency became worthless. Widespread unrest followed and Law, who had already been sacked, had to flee Paris, and go into hiding.

Charles Ponzi’s Ponzi Scheme

Ponzi Scheme
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Charles Ponzi’s scheme was by no means the biggest of financial scandals, and it wasn’t even the first. In fact, Ponzi had reputation as a con artist long before the scheme that made him famous. But it’s worth mentioning because it was such a big story at the time that certain types of pyramid schemes are now known as Ponzi schemes. In 1919, Ponzi came up with a plan to trade international reply coupons (IRCs). These are coupons that can be exchanged for postage stamps. He believed there was an opportunity to buy discounted IRCs in Europe and then exchange them at face value in the United States. He raised money from investors, promising a 100% return within 90 days.

The scheme quickly gained traction and he was easily able to raise more capital. At one point he was attracting as much as a million dollars a day. In reality though, the scheme very quickly became too big to be feasible. But Ponzi found that he could easily pay the promised returns to investors from new investors, and that most re-invested the money in the scheme anyway. In fact, he had so much money flowing into the scheme that he could live an extravagant lifestyle. But the scheme collapsed within a year when a series of articles in the Boston Post caused investors to demand their money back.

Ponzi ended up serving time in Prison, but amazingly launched another scam as soon as he was released. Ponzi schemes and pyramid schemes are illegal in most countries. They are similar in that both pay returns to investors using capital from new investors, and both are unsustainable. The difference is that a Ponzi scheme has one central operator recruiting investors, while a pyramid scheme encourages each investor to recruit new investors.

Bernie Madoff

Bernie Madoff / Financial Scandals
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In 2008, Bernie Madoff’s hedge fund empire was exposed to be another Wall Street fraud and the largest Ponzi scheme in history. This story is also unique in that it wasn’t ordinary people but wealthy investors and fund managers that were fooled and suffered losses. Madoff posted impressive, but fictious returns for his hedge funds. Supposedly he was investing in blue-chip shares, and then engaging in portfolio hedging by buying options on the S&P 500.

The fact that his funds appeared to generate steady returns with low volatility meant he had a steady flow of new capital flowing into them. Very few investors ever withdraw their money, so he was able to maintain the illusion for a very long time. Eventually in the wake of the 2008 global financial crisis it became clear that the charade was about to collapse. Madoff’s own sons reported him to the SEC. In total, investors lost $64 billion, though the money never really existed in the first place. Madoff was ultimately sentenced to 150 years in prison.

Madoff started out with a legitimate business, and it’s not quite clear when it actually became a Ponzi scheme. Some believe the fraud began in the 1980s, which would mean he kept the scheme going for as much as 20 years. Red flags were also raised by investment advisors and traders long before the fund collapsed, but the SEC ignored their warnings. It also appears that some investors knew the returns were too good to be true but allowed greed to cloud their judgement.

2008 Global Financial Crisis

Global Financial Crisis
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The GFC of 2008 is typically regarded as an economic crisis and not counted amongst financial scandals. However, amongst the many causes of the crisis is a long list of unethical behavior, conflicts of interest and corporate fraud. For a start, rating agencies were paid by issuers to give very risky securities investment grade credit ratings. This presented a conflict of interest as rating agencies had a financial incentive to overlook the true risk a security carried. 

Next, mortgage originators encouraged home buyers to exaggerate their assets and income to ensure mortgage applications were approved. They also used aggressive sales tactics to sell mortgages. Later, banks were found to be illegally foreclosing on properties. Banks sold securities to investors that they knew to be incredibly risky. In some cases, banks were short selling the same securities they were promoting to fund managers. Banks also created synthetic products to help hedge funds bet against the mortgage market.

One of the big catalysts for the crisis was Lehman Brothers, which filed for bankruptcy when it could not be bailed out. One of the factors that contributed to the demise of the bank was a very dubious method of valuing repurchase agreements on its balance sheet. A loophole in the accounting standard allowed them to use repurchase agreements to hide the true extent of their leverage and debt.

All of these companies with ethical issues contributed to the crisis, which as we know resulted in a major stock market crash and recession. Most people regard the GFC as a black swan event. But for those who were watching closely there were plenty of investment warning signs and red flags.

Wirecard

Wirecard / Financial Scandals
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The recently uncovered fraud at Wirecard has turned out to be one of Europe’s biggest financial scandals. Wirecard which was a member of Germany’s leading stock index, and one of the biggest fintech success stories in the world, collapsed in June this year. The fraud at Wirecard was actually remarkably simple. Wirecard was a company that processed payments on behalf of merchants. In certain countries, Wirecard used subsidiary companies to process these payments on its behalf. At some point, the company began reporting fictious revenue from these subsidiaries which eventually accounted for the bulk of Wirecard’s profits.

When analysts, investors, and journalists questioned the lack of cash flow from the subsidiaries, Wirecard stated that the cash was all held in the subsidiary escrow accounts. This would mean the cash was in the same account that payments were processed through, and therefore difficult to dispute. When the media and several whistleblowers alleged the revenue did not exist, Wirecard accused them of trying to manipulate the share price for short sellers. They even sued the Financial Times, which resulted in German regulators investigating the journalists rather than the company. This is an increasingly familiar pattern when financial scandals involve listed companies.

Company management will often accuse short sellers and hedge funds of trying to manipulate the share price. In many cases regulators end up siding with the company, fearing the effects financial scandals might have on investor confidence. Eventually KPMG was asked to investigate and confirmed there was a hole in the balance sheet. It ultimately transpired that around $2 billion in liquid assets simply didn’t exist. Within days the share price collapsed from €100 to zero. Wirecard, which was worth $28 billion at one point, is now insolvent. This makes it one of Germany’s and Europe’s biggest financial fraud cases.

1MDB

Kuala Lumpur / Malaysia
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One of the biggest financial scandals in Asia began in 2009 and is still being unraveled. The story of 1Malaysia Development Berhad (1MDB) involves Malaysia’s prime minister at the time, Goldman Sachs, and a blockbuster movie starring Leonardo DiCaprio. Jho Low, a young financier who masterminded the fraud is now an international fugitive. In 2009 Malaysia’s prime minister Najib Razak launched 1MDB as a strategic development company, which was owned by the Malaysian government.

Amongst the fund’s objectives were ESG investing and funding projects to drive growth for Malaysia’s economy. The fund then went about setting up companies and joint ventures with specific objectives. Amongst the investments was the company that produced the hit movie “Wolf of Wall Street”. In 2012 and 2013 Goldman Sachs helped 1MDB raise $6.5 billion by selling bonds. However, within two years the company missed a loan payment, and it emerged that $700 million belonging to the company had found its way into Razak’s bank account. In the wake of the unfolding scandal, Razak’s party lost power for the first time in decades, and he and his wide attempted to flee the country.

It has since emerged that as much as $4.5 billion were embezzled by key officials. The perpetrators covered their tracks by transferring money back and forth between a complex web of shell companies. Investigations are still ongoing, but it is clear that billions have disappeared and were used to buy jewelry and a super yacht, and to fund the lavish lifestyle of Jho Low. The key players in the saga have all claimed they are innocent and continue to blame one another. However, Goldman Sachs agreed to a $3.9 billion settlement with the Malaysian Government for its role in the fraud.

Conclusion – Biggest financial scandals in history

Sometimes, regardless of the amount of fundamental analysis you do to aid your stock picking, you may still find yourself invested in a company at the center of a financial scandal. Sometimes there are red flags, but business scandals can still come out of the blue. Besides keeping a lookout for warning signs, the best thing you can do is to manage portfolio risk properly. This is best done with diversified asset allocation across a wide range of investments and asset classes.

About Richard Bowman
Richard Bowman is a writer at Catana Capital, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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