Motley Fool Hidden Gems Investing - Part 1: How to Spot a Corporate Fraud Before It Makes the Headlines

Starting point is 00:00:00 you think that people like auditors and law firms and a board of directors is there to protect you the individual investor but the more you learn the more you realize that their main incentive is keeping the company happy and that's still true today it. That was Bethany McLean, the investigative journalist who exposed Enron before Wall Street did, and one of the sharpest financial minds in the business. I'm Motley Fool analyst Rachel Warren. Bethany has spent decades following the money through every major boom and bust in modern financial history, and she has a lot to say about where we are right now. In part one of our conversation, we dig into the psychology behind corporate fraud, how to spot a red flag before

Starting point is 00:00:53 it becomes a headline, and why the line between a visionary CEO and a fraudster may be thinner than you think. We hope you enjoy. Welcome back to Motley Fool Conversations. I'm Motley Fool analyst Rachel Warren. Today I'm joined by veteran investigative journalist and Vanity Fair contributing editor Bethany McLean. Bethany is famously the co-author of the definitive Enron Chronicle, the smartest guys in the room, and has spent decades exposing hidden financial risks from the 08 financial crisis and all the devils are here to the pandemic corporate bailouts in her book, The Big Fail. Today, we're using her legendary investigative toolkit to give you a masterclass on spotting corporate red flags, evaluating charismatic CEOs, and finding the

Starting point is 00:01:35 next hidden market risks. Bethany, welcome to the show. Thanks for having me on. You have a remarkable record of being early on massive stories that later blew up. And, you know, we have to talk a bit about Enron. I mean, when you look back at Enron now, 25 years ago or so, how much of that collapse was a failure of the raw numbers versus a failure of, you know, the gatekeepers who were simply afraid to ask the hard questions? Well, I think it's both. The raw numbers were a failure because the gatekeepers failed in their job. And that, to me, is still the most instructive lesson from Enron's collapse, which is that you think that people like auditors and law firms and a board of directors is there to protect you, the individual investor. But the more you learn, the more you realize that their main incentive is keeping the company happy.

Starting point is 00:02:32 And that's still true today. And it's not even so much a question just of peer greed and who pays them. It's also just human nature. When your approval rests on somebody else saying good job, you start to want them to say good job. And that happens time and time again. We see that the auditors have failed investors many times since Enron. And so it's just a really important lesson to know that just because the auditors and the lawyers and the board of directors say it's okay, and just because the bankers have a buy rating on the stock, that doesn't mean it's okay. You know, for members of our audience who might only know Enron as a historical buzzword, maybe you can go through a bit. How did management use complex financial structures, mark-to-market accounting to turn, you know, future projections into fake current profits? Maybe you can walk us through that story a little bit. It's funny. So I joked when I wrote about Enron way back when Fortune magazine, where I worked at the time, had labeled Enron its most innovative company for the previous seven years. And I still think that Enron was the most innovative company in corporate America, even 25 years later, because they used all of those tools in order to make their reported earnings look much better than they were. And one of the fascinating things about Enron is that people think of it as this giant fraud. It actually wasn't. There was a lot of reality to their business. The fraud lay in just pushing the boundaries of generally accepted accounting principles past the breaking point in a few key ways. But most of what they did was legal. And what they did was figure out how to create reported earnings, even when the economic substance wasn't there. And they used a whole variety of toolkits from mark-to-market accounting, which is, and the reality is accounting is language. Mark-to-market isn't necessarily any better or any worse than using historical prices, which is the other way of doing things. Both can be manipulated.

Starting point is 00:04:33 But what Enron did is they used smart to market to increase their reported earnings they could produce. They used special vehicles that their CFO had set up in order to sell at investments to that vehicle and be able to record of the gain on the investment they had sold what was effectively a captive vehicle. And they used a whole host of other techniques. And so what it really shows is the way in which accounting laws can be manipulated without breaking the law in order to increase the metric that a company wants to increase. Well, and, you know, obviously, the regulatory environment, you know, the industry, there were a lot of lessons learned from Enron, to be sure. But I think that there has been and continue to be since that time concerns about how those dynamics can repeat in the future. you know, in your career covering scandals since? Have you found that corporate fraud is planned from day one or is it more of a slippery slope where there's sort of, you know, executives are trying to cover up one back quarter and then it just kind of completely spirals out of control? It's almost always the latter. When I first started working on my book about Enron, I was young and I was a math major. So I had this very simplistic view of the world. And I thought if

Starting point is 00:05:47 bad people are doing bad things, then they know they're doing bad things. And that's just not the case. Hank Paulson, the former Goldman CEO and turned Treasury Secretary, said at one point, it's not that interesting why good people do good things, and it's not that interesting why bad people do bad things. But what's interesting is when good people do bad things. And the system of corporate incentives combined with human nature can lead people down this path because they rationalize that, oh, I'm doing the right thing by my investors by not quite telling the truth about this because if I did, my stock price would crash. And if I stock price crashed, it would hurt investors or it would make it so that I couldn't raise any more money,

Starting point is 00:06:28 in which case the bad outcome would be guaranteed. So I'm just going to fudge this a little bit. And they don't even really mean to do it that way. It's this combination of rationalization and self-delusion. And almost every story of business gone wrong has that in common, with a possible exception of Bernie Madoff. You know, there's still a raging debate about how much he deluded himself and whether he planned the whole thing from the beginning or slowly fell into the trap after losses made him not want to confess the truth to investors and believe that he could dig himself out of it. Yeah. I mean, that's the question, right? I mean, when a corporate disaster happens, I think we often debate whether the executives were malicious

Starting point is 00:07:07 fraudsters, which is sort of easy to paint them as such, right? Or just incredibly incompetent and delusional. You know, in your decades of reporting, which have you seen be more common, an active malice or just mass corporate delusion that overtakes the reality? Really mass corporate delusion. Almost no one thinks it through and thinks, huh, I'm going to set out to deliberately defraud investors. And if this goes badly, I could find myself in the headlines and possibly being prosecuted. That's just not the chain of logic that people use. If they did, then this would never happen. So it's almost always the latter.

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Starting point is 00:08:12 So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. You've obviously seen public corporate fraud up close, but you've also looked at private scandals like Theranos. I'm wondering, is it actually easier for a charismatic founder to hide systemic rot in a venture capital-backed private company than it is in a heavy regulated public market? What are your thoughts on that? Yeah, I think it is much easier with a caveat. It's much easier in a technical way because the financial statements aren't public and there are no there can't be short sellers. And so those two things, publicly filed financial statements and short sellers are are helpful signs. They're helpful red flags. You may not be able to find anything in the publicly filed financial statements, and the

Starting point is 00:09:01 shorts may not be right. But if there is a heavy short interest in a stock, chances are there is a reason and you should at least understand the reason and then feel free to dismiss it and say they're wrong, but you should understand it. And so you can see that, whereas with a private company, you can't see any of that. The only caveat I'll offer is that in times like this, where we're in this raging, crazy bull market that almost feels more like gambling than it does like investing. The preeminence of belief or the preponderance of belief in things that seem to be crazy can make you overlook red

Starting point is 00:09:36 flags because you see the red flag and you think, oh, this must be a bad sign. But then year after year, the red flag doesn't materialize and the stock keeps going up. And so you start to think, well, I must be crazy. And so you start to dismiss these red flags in a raging bull market because they don't matter until they do. You know, you probably have many examples to pull from, but when you have suspected a company's corporate narrative doesn't match its financial reality, what are some of the key signals, whether it's corporate behavior or otherwise, that tip you off first? I think that's something important that investors would want to explore. Yeah. So it's everything from odd disconnects in the financial statements. I mean, in Enron's case, looking back, it was just laughably simple because no one actually understood how they made money. And if you asked people who were raging bulls on the stock, how does this company make its money? One person actually laughed and said to me, I don't know. If you figure it out, let me know. We don't have to worry about it. These are just the best, smartest guys in the room. And you always know that the bottom line is going to be what they say it's going to be. So who really cares about the details?

Starting point is 00:10:42 So I think that's one thing is when people don't really understand the company's business. Another is just grungy clues in the financial statements. You know, if you have a big, you can't do it if you own an index fund. You can't do it if you have a gigantic investment portfolio. But if you have a concentrated bet in a certain company, you should be familiar with every aspect of their financial statements. You should have seen the risk factors. You should have seen the related party discussions.

Starting point is 00:11:09 You should make sure that you understand, for example, in Enron's case, the cash flow statement didn't make sense relative to the income statement, because the income statement showed earnings going straight up, marching upwards on this beautifully predictable line. And the cash flow statement was all over the place, and you couldn't really reconcile the two statements. And so that's all important if you have a big portion of your portfolio exposed to a certain name. I'd also watch for signs of hype. Whenever you see a management team start to disconnect from the reality of the business, and this one is a little bit tricky today too, and I'll explain what I mean. But, you know, in Enron's case, Jeff Skilling went from saying this is the world's leading energy company to world's leading company. And when you see a CEO start to talk too much in terms of market value rather than in terms of value provided, I always see that as a red flag. The difference today, and I wrote a piece for the Washington Post last fall about when CEOs turn hype into capital. And the difference today is that the more hype you can generate around your

Starting point is 00:12:15 stock, the more access you have to the markets, the more ability you have to raise money. And if you are losing money today, then potentially the more opportunity you have to succeed. And so the rules are a little trickier today than they used to be. Well, and I want to dig into that a bit more. This, you know, we are in an age of hype. Obviously, there are a lot of very exciting companies and businesses amidst the AI revolution and beyond. But there are many others that might seem uncertain in terms of their growth story. And I'd love to hear your thoughts on how, as individual investors, we can be analyzing these company fundamentals to see, you know, is management running what is a really great business?

Starting point is 00:12:53 or just managing the stock price. Right. Well, I think one really important thing, and it's such an old school thing, but really understand the company's debt, how much there is and how much access it needs to the capital markets. Because companies that are dependent on the capital markets, should that access go away, either because investors lose confidence in that particular narrative or because there is a capital markets cataclysm, it's a risk factor. And you should understand that. So I just recently wrote about SpaceX for The New York Times, and that's kind of the epitome of this debate, right? But SpaceX, one analyst predicted, needs to raise some $80 billion of capital each year to continue to fund its aspirations. That's a lot of money, and that's a lot of risk. So you have to understand that and take that into account. And if you're believing the narrative and the hype and the huge story, you also have to understand the mechanism about how the company is going to get there. And then just watch, do things that the CEO says happen, happen. Does reality follow the grand pronouncements in some sort of measurable way? And I think that's really important, too.

Starting point is 00:14:06 Well, and I think another thing as well that we often think about is, you know, not just listening to what company executives are saying, but what they might avoid saying, you know, and I'm curious if there's, you know, whether it's linguistic pivots or, you know, dodges or could be patterns of executive turnover. What are some of these elements that make your antenna go up and want to probe a bit further? So for sure, executive departures are a big one. If you see a company where nobody seems to want to stay and where there's constant turnover in the management ranks, that's a sign of, it's a sign of a lack of stability for sure, and possibly a sign that people are seeing things they don't like. So I think that is a big one to understand. I think it's also really important to listen to how a CEO talks. And I always think about that wonderful line from Alice in Wonderland, and it's Humpty Dumpty. And he says, just because a word means this doesn't mean anything. I can make a word mean whatever I want it to mean. And I'm paraphrasing, but there are CEOs who talk like that. And so, and you can fall victim to it because you think, oh my goodness, this person just gave me this enormous amount of information buried in there somewhere. It must be my answer, so I'm not going to ask again. Or I just, you know, I'm overwhelmed, but it must be in there somewhere because somebody so smart just shuffled a lot of words at this answer. And you have to really be able to decipher the language and say, is there an answer here? Did this person actually answer the question or did they actually dodge the question? As you alluded to, you've done a lot of work reporting on Elon Musk as finances and corporate structures, obviously, some of which raise questions that retail investors, even those who are the most bullish on his ideas and growth stories. These are questions that I think a lot of investors contend with constantly. So I think that raises the point. When does a charismatic CEO represent massive upside for a business or when does the, you know, whatever you want to call it, cult of personality otherwise, when can that become a risk for a founder-led company? It is a huge unknown. And what I mean by that, I have this way of thinking that I used to think that a fraud and a visionary were two different things, that the fraudster sat on this end of the spectrum and the visionary sat on the other end of the spectrum and they were not the same person. And I started to realize over my career that they are actually where the ends of the circle meet. The fraudster could be the visionary and the visionary could be the fraudster. But for a few quirks that make all the difference, I mean, if you think about them, they have some of the same characteristics. Hype, a massive ability to get people to believe in whatever they're saying, an ability to believe in themselves, to persevere through the doubters and the people who say it can never be so to say, but it will be so.

Starting point is 00:16:47 But those are the very same characteristics that can get the visionary into trouble. And I've joked that sometimes I think the only thing that separates them is that the visionary gets lucky through that period of time when he or she still needs access to capital and is able to keep raising money to sort of paper over the mistakes and overstatements and grand promises and to get to the other side. Whereas the fraudster is one who gets caught in the middle and can't raise capital right when he or she most needs it. And then the lies are exposed and it becomes known as this gigantic fraud because the lies were exposed. I'm not sure Elizabeth Holmes is totally an accurate figure through which to see this because there's a debate about whether her technology ever would have worked. But for sure, I think she believed it would. And so if she had gotten to the other side, then would it matter that there had been lies in the run-up to it, projections to investors that weren't entirely true, lies about how well the technology worked? No, everyone would remember her as a visionary because she made it to the other side. So I think it's really, really difficult to tell the difference between the two figures until the old saying hindsight is 20-20. But again, back to that key question, just pay attention to the capital needs. If the company needs people to continue to believe because the company is dependent on the markets in order to or on continued fundraising from investors, that's a risk factor. So you would say there's not necessarily a huge delineation sometimes between a visionary founder and a corporate illusionist? I don't think so. I think Elon Musk is a perfect example of how difficult it is to tell the difference. There have been skeptics about Musk, obviously, since the get-go, and they have, by the way, been right about a lot of things. They've also been wrong about a lot of things.

Starting point is 00:18:37 And the confidence of the markets and Musk, his ability to raise money, has not cracked. So that's the most important thing. Right. And unless that cracks, he will continue to be to be a visionary. I want to talk a little bit about your book on the 2008 crisis, All the Devils Are Here. It's a masterclass on how risk gets hidden and repackaged and sold to people who don't understand it. I think that also brings up the current era of private credit that's currently flooding the market in the age of AI. So I would love if you could talk a bit about some of that. I mean, do you see it carrying some of the same risk as what mortgage-backed securities did back in 08? I'd love to hear your thoughts on that. So I do. I wrote a piece for Inc. actually

Starting point is 00:19:29 about private credit and why I was worried about it. And I do think it carries some of the same risks because the whole premise of private credit is that we built a better mousetrap because now lending is match-funded, meaning that the investors who are putting money into private credit are asking for their money back on the same schedule that the companies are repaying it so you don't have the risk of a run on the bank. But of course, Wall Street being what it is, they've come up with ways to not necessarily kill their own golden goose, but potentially name their own golden goose. So by doing these evergreen funds that promised semi-liquidity to investors where you could supposedly get some of your money out on this specific schedule,

Starting point is 00:20:10 They undermined that whole premise of match funding. And I think that's where Wall Street's greed is similar this time around to what it was in the financial crisis, which was Wall Street saying, oh, my goodness, mortgages made to people who can't pay them back can be packaged up into these really high yielding securities and sold to investors around the globe who just look at the AAA rating and don't really understand what it is, what it is they're buying. And they just cranked the machine and cranked the machine until it broke. And so in this case, these loans, these private credit loans are also being sliced and diced into different types of securities, a great portion of which are being sold to insurance companies and to buyers that in some cases are captive of the private credit firms that are making the loans. There's just a lot of potential in there for bad things to happen. There's also been a change on Wall Street in that some of these private credit firms and the private equity firms that have gone into private credit are now themselves publicly traded. And because they're publicly traded, their incentive is to put as much money to work as possible because their stock is valued based on fees on the assets they have under management. So growing the assets under management is more important than earning an incentive fee on the products they've created. So it's changed the whole incentive structure. And these things taken together make me worried. You know, there still is an argument that it will all be OK in the end. And just because so many people, including me, are looking at it, it might be OK in the end because the crises tend to erupt where nobody's looking. Right. But there are enough risk factors here that that I think it's concerning. Well, it's interesting as well. I mean, private credit and private equity markets are pretty opaque. And I'm curious your thoughts on how a potential stressor in those sectors could expand to the very liquid publicly traded equities that a lot of retail investors own. Yeah, well, it could because private equity is so big now, it makes up so much of the market that if there is a decline in private equity, the private equity market and the publicly traded market are now, they're not an offset to each other. they're actually quite related. Because right now, for instance, private equity firms are

Starting point is 00:22:30 sitting on this giant backlog of investments that they can't sell because they have them marked at levels that are too high, and they can't be sold into the public market. But if the public markets are to crack, that backlog gets worse and worse and worse. And so private equity firms are dependent on the performance of the public market. So there's this interplay between the two that is just not great. My view is that we should end the distinction between private markets and public markets because the underlying investors in each are actually the same. The big investors in the private equity firms are pension plans who hold all of our retirements or many of our retirements in their grasp. So if the underlying investors are the same, why are their public markets and

Starting point is 00:23:14 private markets? Why not just regulate it all the same thing, all the same way? One more question on private equity. A little unrelated to what we were talking about, but it's worth touching on. You've written extensively on private equity's expansion to everyday life, you know, vet clinics, nursing homes, housing. Obviously, this impacts a lot of, you know, privately held entities, but publicly traded ones as well. Is this consolidation? Obviously, there's the argument that, okay, well, this creates operational efficiency. Or is this really just, you know, predatory financial engineering and something that, you know, consumers, individuals, and of course, investors should be aware of? I think it depends on each situation, and you have to look at it. I think there are really good private equity firms out there that really are adding value to the businesses they acquire and are creating something better and are bringing capital to areas that are underserved and need it. And then I think there are purely predatory operations. And I don't even think it's as simple as each looking firm by firm. I think you almost have to look at each deal. I do think that these two incentives have combined in a really dangerous way, one being the one I just mentioned about private equity firms being publicly traded. They have an incentive to put as much money to work as possible, which means doing deals where they may not be adding that much value. The other thing that happened was that the decades of very, very low interest rates made it very efficient for private equity firms to add debt to deals that they were doing. More debt then was really sustainable. But it also separated private equities outcome from that of the underlying investment. So the private equity firms, like in the case of this hospital company called Steward, that ended up bankrupt a couple of years ago, they can actually make a great deal of money, hundreds of millions of dollars in the case of Steward, while the underlying company, in this case, a hospital chain that many people depended on, goes bankrupt. And so that split is not what private equity was supposed to be. Old school private equity was we do well because the company does well.

Starting point is 00:25:17 and that's that that makes a kind of sense it can be a brutal form of capitalism but at least it's uh at least it's a win-win form of capitalism what i really dislike about modern private equity is that it can be a win-lose that was part one of our discussion tune in next week for part two as always people in the program may have interests in the stocks they talk about and the motley fool may have formal recommendations for or against so don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley Fool editorial standards and is not approved by advertisers. Advertisements are sponsored content and provided for informational purposes only. To see our full advertising disclosure, please check out our show notes.

Starting point is 00:25:58 For the Motley Fool Hidden Gems investing team, I'm Rachel Warren. Thanks for listening. We'll see you next time.

Motley Fool Hidden Gems Investing - Part 1: How to Spot a Corporate Fraud Before It Makes the Headlines

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