Odd Lots - Why Understanding Financial Fraud Is The Secret To Understanding Business

Episode Date: July 23, 2018

If you want to understand how the human body works, you can't just look at healthy humans. You need to examine the ill, so you can see how the body breaks down and where its weak spots are. And so if you want to understand how business works, it makes sense to look at financial fraud. After all, financial fraudsters work by getting to know a business really well, in order to take advantage of how it operates. That's the gist of our discussion this week with Dan Davies, the author of "Lying for Money: How Legendary Frauds Reveal the Workings of Our World." In our conversation, Davies shares with us his favorite fraud of all time, what all frauds have in common, and what people can do to avoid them. See omnystudio.com/listener for privacy information.

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I'm Joe Wisenthall. And I'm Tracy Allaway. Tracy, I think you're really going to like today's episode. Oh, okay. What is it? I mean, I guess I would hope that you like all of the episodes, but I feel like this is a topic that just from what I know about, you really animates you. But we are going to be talking about fraud and financial financial. fraud. Wait, should I take that as like a personal slight that you think I'm really interested in

financial fraud? No, it's not a slight. I just feel like that you have a mind that likes to figure out frauds. Leans towards fraud. Yeah, exactly. And figures them out and understands how they happen and the conditions that allow frauds to take place and how people missed everything. I feel like that's a you thing. Am I wrong? No, you're right. Right. You actually nailed it on the head in what you just said. It's the fact that people miss these things when they're happening. And then as they unfold, you kind of go back and you see all the warning signs and you think, how could people not have seen this coming? That's what fascinates me the most. It's people missing out on something that is quite clear in hindsight. Yeah, it's pretty incredible when we have these stories about big financial frauds, how egregious they seem. always in retrospect and how there just always seem to be numerous red flags that anyone with half a brain should have been able to pick up on. And yet somehow we have this sheer delusion

where nobody sees it or maybe people who saw it decided it wasn't worth pointing it out. And then we have to relearn human history and human behavior all over again for the next time. Yeah, exactly. And there's an example that springs immediately to mind, probably one of the most famous recent financial frauds, Bernie Madoff. And you remember after he got arrested, people started circulating charts that showed the historical performance of the fund that were coming from the Madoff Fund's marketing materials. And they were just a straight, smooth line pointing upwards. And of course, in hindsight, everyone thought that was deeply, deeply suspicious.

But at the time, people, some of them anyway, seemed more than happy to just accept that as fact. Yes, it's a perfect example because it's one of these things that in hindsight, as you say, it's like, oh, of course that could never have been realistic. Where was everyone at the time saying how impossible it was? It's a perfect example of how something happens and the exact same fact goes from being, oh, this is very impressive to, oh, this is obviously a scam. Yeah, how quickly things change. Yeah. So maybe we could avoid frauds in the future. or spot them quicker if we really studied the patterns and instituted some good practices about the weak spots in our behavior and in organizational behavior that fraudsters like to exploit.

I think that would make a lot of sense. So maybe we'll start on that road with our guest today. His name is Dan Davies, and he is the author of a new book called Lying for Money, how legendary frauds reveal the workings of our world. And it is a fascinating book, and it looks at lots of frauds and historical patterns and how they come about. And Dan joins us now.

Dan, thank you very much for joining us. Thanks very much for having me. Dan, before we get into the frauds and the patterns of fraudsters and why we miss them and all this stuff that we're talking about, let's just talk about your career. I kind of think of you as someone who just knows about everything, and you can talk about political referendums and you can talk about technical things. And tell us a little bit about your career

background and why you wanted to write a book on this topic. Well, I was basically equity analyst for 15 years. I started out at the Bank of England as a regulatory economist, and I used to be in the office next door to the guy who was the lead supervisor of Bairings Bank at the time of the Nick Leeson crisis, which was kind of an interesting set of office traffic to watch. Then I was lucky enough over the course of about 15 years in equity analysis to have a succession of bosses who allowed me to mess around looking at quirky things rather than doing something about the usually disgraceful quality of my earnings forecasts. And so, you know, you pick up a little bit of everything

because I was covering the financial sector and financials are relevant to more or less anything you want to get interested in, which was something that I took full advantage of. Then about four or five years ago, I kind of felt I'd had as much fun as it was possible to have out of equity analysis. So I quit and, well, started writing articles for newspapers and websites and eventually started writing this book. And, you know, frauds, it's just really interesting because it's like where the system breaks down. You know, you can study the economics all the time, but if you're only studying successful companies and economies, then it's like trying to learn about medicine by only studying healthy people.

where you really see how the structure works is in cases like bankruptcies and frauds and all these nasty things that people don't like to think about, where the whole system breaks down and where key assumptions turn out not to be true. I like that description. You're sort of probing the system for its weak spots. So I'm just going to jump right into it because, as Joe has already said, this is a topic that is dear to my heart. So what's your favorite example of fraud that you correctly?

chronicle in your book? Oh, it kind of changes every day because the thing is that obviously every day I come up with a new one that I wish I'd put in the book but didn't. Or someone asks whether they're favorites in there and I'm just like, dude, half of my favorites aren't in there. But I think the classic one is the great salad oil scam. It's just such a beauty. I mean, it's just basically oil floats on water. And because of this fact, it is surprisingly difficult to tell the difference between a tank full of valuable soybean oil and a tank that is basically full of seawater with a few gallons of soybean oil floating on top. And there was a guy called Tino de Angeles, who was the salad oil king and really knew more about soybean markets than

anyone else in the world at that time. But he was an absolute crook. And one of the ways that he managed to extract fraudulent cash from his company, American crude vegetable oils, was to borrow money collateralized against the soybean oil in his tanks, but to have vastly more warehouse receipts, as the kind of short-term ones, were called, outstanding, than there was soybean oil cartelized against them. He was a hell of a character, but what he used to do was let the lenders come out, take a dip sample into one of his tanks, and it either had oil floating on water, or there was a length of pipe welded into it full of soybean oil and the rest of the tank was empty, or they even had a plumbing system to pump it round so that the same soybean oil could appear in different tanks.

In the end, he was claiming to have more in his one tank form than the USAIP produced in an entire year. Now, obviously there's a scientific lesson here that, that, okay, oil floats on water, and just for various technical reasons, it's difficult to verify that a big tanker is actually filled with the soybean oil that the owner claims it is. What is the sort of human lesson, though? So what did he exploit with regards to human systems that allowed him to perpetrate this highly profitable scam? Well, yeah, that's it. It is all about the human systems, because at the end of the day, If it hadn't been that, he'd have thought of something else. That was just the kind of guy he was. At the time, American Express was an independent financial institution

rather than just a credit card brand. And it had a brand new corporate lending business. And it had a set of targets whereby every one of its divisions had to make at least a million dollars worth of profit every quarter, back in the days when that was a lot of money. And so there were people out there looking to gain market share rapid, and if you're looking to gain market share rapidly, you tend to not be choosy enough about the kind of customers that you take on.

So everyone wanted to believe him. He was a larger than life character. He actually used to allow rumours to circulate that Tino de Angeles was in the mafia because he felt like he wasn't, but he felt like if people believed that, then they would think that he had extra sources of cash flow to pay back his loans.

And so really, The thing that I keep on coming back to in these things is it's surprisingly difficult to challenge someone who's really determined to be a big time fraudster. If you've got someone who's really got into running a dishonest business, then actually they're going to design their scam around all the controls that you have and they're going to look like a really successful operator. And, you know, as we know from the dot-com era, from all sorts of examples from the very recent past, if something's a success story, it's very psychologically, sociologically and institutionally difficult to be the person who stands up to that guy. You know, it's the whole Emperor's New Clothes phenomenon. So I'm curious, from the fraudster's perspective, I mean, there's clearly a lot of intellectual ingenuity that goes into a scam like the one that you just described. Why do you think they sort of channel their creative energies towards fraud and scamming people, rather than actually working within the system to create a legitimate business?

It's very weird, actually, Tracy. I mean, I'm not sure I 100% understand why these people do this. I think the classic model is what they call the fraud triangle, like you have the murder triangle of means, motive, and opportunity for fraud. But what it seems to be is that you have an opportunity, which is a deficient control or a way around the existing control systems. You have a mead, which is just someone, you know, as I say in the book, bankers in the end steal for the same reason that heroin addicts do. They've been put in a position where they have to get hold of more money than they can get hold of immediately by honest means. And then you have what Cressy called a rationalisation.

because the interesting thing about these fraudsters is in general they don't regard themselves as deviant individuals in the way that other criminals basically do. I read about two dozen autobiographies of people who'd been convicted of famous frauds, and the absolute constant refrain through all of them is that it wasn't really my fault. They always find some way of distancing themselves and putting a psychological barrier between their self-image, as basically an honest and successful business person and the reality of what they're doing. So even Tino DeAngelis, who was clearly stealing money from his company, kept on rationalising it

that all he was doing was borrowing money in order to finance later transactions. There's usually some fantasy that there's going to be a big score at the end of it, which will allow them to pay everything back and make everything right as if the fraud had never happened. and then we only find out about them when they collapse. One thing that interests me is how many Nick Leesons there are out there

who actually did happen to have a good day on the markets and manage to make all of their hidden accounts balance. Dan, you said something that I thought was very funny when you said that this character, Tino de Angeles, like to have the rumor out there that he was linked to the mafia even though he wasn't because it put the idea and prospective business partners had that maybe Ed actually made him more credit worthy because he had other sources of income coming in.

It kind of reminded me of with Madoff, weren't there people who suspected something was amiss, but they thought it was something else. So they thought, oh, maybe he's doing some sort of insider trading or doing something else that sort of scammy with the market maker side of his company. and although you'd think that should be a red flag to anyone, that actually made them more confident that he would have the money to keep supporting his fund. Yeah, yeah, quite a lot of people thought exactly that. Also with Sam Israel at Bayou Capital,

and Sam Israel actually was an insider trader as well as a Ponzi scheme operator. But, yeah, people thought, well, he's a crook, but he's not necessarily going to scam me, which turns out usually to be quite a bad way to run your relationships. I'm June Grosso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators,

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podcast with me, June Grasso. Subscribe today wherever you get your podcast. So how can organizations, I mean, you've identified a couple of obvious weaknesses or blind spots that happen when organizations, they set out a specific target for making money or market share. That causes them to drop their guard. They think, well, I'm okay getting into business with a scammer because I'm not the one being scammed here. What are some practices that companies can't actually implement to sort of guard against these sort of obvious human failures? Well, I'm going to give two answers to that. I mean, directly answering a question, I think it comes back to the fraud triangle.

You want to avoid creating a need. So you don't want to create situations in which you're setting unrealistic targets for your staff. Because if you're setting unrealistic targets, then you're putting them in. in a position where they can't do things legitimately, and that's where you're getting what they call criminogenic incensives, so incentives structurally making people more likely to commit crimes. You can then look at the opportunity side of the triangle, and an opportunity to commit fraud is just a weakness in controls.

As we say in the book, every time you decide what you're going to check up on, you are also deciding what you're not going to check up on, and that's how the fraud gets into the system because you simply can't check up on everything. And so for catching the bulk of frauds, it's really like a risk return, except it's a fraud return trade-off where you start beefing up the controls

until you think that the marginal value of the frauds you're preventing is equal to the marginal cost of doing so. Having said that, that's a really difficult thing to investigate because the definition of a fraud is it's something that happens outside your normal manufacturing information systems. So you can really badly get that optimization calculation wrong. And the classic example of that is 1980s Medicare, where in the end, credible people, like non-politically, say that in the 1980s, between 20% and a third of all people. payments made under the Medicare system were fraudulent, which was probably hundreds of billions of dollars, probably the biggest fraud until the financial sector took the title back. And what was going on

there is that it was absolutely assumed that the main cost problem in Medicare was over-treatment and that the main driver of over-treatment was defensive medicine from doctors who were scared of getting sued. And so they had systems that were meant to catch. unusual treatments, but minimise otherwise the cost per claim processed. And so what they built was a system that couldn't detect 4,000 identical hip replacements coming in from a clinic in Florida that just simply didn't exist because it was a paper creation of some fraudsters. So you can think about things like that.

On the other hand, the second answer I'd give is almost to turn around the question and say, are you sure that minimizing your exposure to fraud risk is actually what you want to do? Because, you know, the question is, do you want to make yourself bulletproof against fraud, or do you want to get rich? And actually, it turns out, as far as I can tell, the optimum level of fraud is certainly not zero, and it could be very high. We could look in Silicon Valley and take a look at the Theranos case and Elizabeth Holmes, and say, well, this is pretty easy.

You avoid a Theranos by really checking out all your tech demos and then not doing any business at all with people who fake their demos, which is a great way of avoiding frauds. Unfortunately, it also means that you miss investing in Oracle because Larry Ellison totally fake demos at crucial early stages. It means you probably miss investing. in Apple around the time of the iPhone, because some of those demos, there were definite differences between what was happening on the big screen and what was being sent from the device. In general,

a system that's set up to eliminate fraud risk is going to eliminate so much legitimate business that I kind of find myself wondering if what you should be looking for is almost a rule of thumb to stop you trusting too little rather than trusting too much. I want to press you, on this point because it's a really interesting one. And, you know, if you read another very good book, Bad Blood, about the Theranos case, one thing that comes out is that Elizabeth Holmes was sort of pursuing strategies that she thought had been pursued by Apple and Microsoft before. So sort of a fake it till you make it approach. How many of the frauds that you look at actually start out as legitimate business activities, maybe even promising business activities, and then

encounter some trouble and then turn into actual frauds. I think it's about 50-50 between that sort of thing of being a legitimate business that drifts and something that was clearly set up as a fraud from day one. I mean, the interesting thing about the whole Theranos and the fake it till you make it model is that it's a history that comes from mining fraud. Gold miners always thought that there was a great big load. just a few feet away for digging rock, and that all they needed was a little bit more investors' cash in order to achieve it. And that's how gold miners started getting into the

habit of faking essay results, which is a tradition that goes way back to the first days of the Californian gold rush. And you get these things which start out as having an honest intention, but then when you realize that you can do that, there's some people who realize that actually faking it until you make it is one business model, but it's in many ways cheaper to just start straight out by faking it. Dan, what is the oldest type of fraud? The very earliest one I found is public procurement fraud. There is a public procurement fraud in the Bible.

and it's a case of skimming profits off a maintenance contract in the Book of Kings for anyone who's counting. And that's really because governments developed earlier in the history of civilization than corporations did. And what is actually quite interesting is that modern commercial fraud, as opposed to just generally stealing by lying, is surprisingly modern. you don't find that many of them before about 1800, and the reason for that is that you don't find that many recognizably capitalist enterprises before 1800. Actually, I tell a lie because I've got my ancient history wrong, the ancient Greeks had a lot of shipping fraud,

and that would presumably have predated the events of the Book of Kings. Getting a ship, pretending to load it with a valuable cargo, scuppering it or hiding it, and then telling your investors that they've lost their money, that's probably the oldest form of fraud. I have what might be a strange question, but I'm going to ask it anyway. Do you think as the world grows more complex and as we get more regulation, more supervisors, you know, big supervisory departments situated within companies, whether they're financial or something else, do you think that makes the potential to have frauds more likely or less likely?

So, for instance, the fact that we have insurers is what allows us to have insurance frauds, right? So do the opportunities expand as we have more regulation and more supervision, or do they shrink? I think it's an arms race, basically. So locally, they could be growing or shrinking. globally, I think they probably stay at a reasonably stable long-term proportion of the economy. I'm writing some more at the moments because there's a US edition of the book coming out. And looking back through the book, I realise that it's time after time that I'm talking about something that happened in the 80s or 90s and saying, of course, you couldn't get away

with this today because they changed the rules. and it makes me worry that I'm portraying this view of an almost Whig version of history of fraud that all these bad people did bad things in the past, but we got wise to them and we've shut that particular loophole and so that couldn't happen anymore. And then you get something coming along like subprime or LIBOR. So what you get is technology and algorithms, I think, are very good at detecting the general run of fraud, and you might actually even see genuine structural declines in just simple credit card skimming, check kiting, and fairly straightforward, small-time

stuff like that. But the nature of the really big frauds is that they're designed around the systems, they're designed around the guy who sets the algorithms in place, and you have the whole company controlled by a, either by a fraudster or by a system of incentives that's so bad that it might as well be a fraudster. And the thing is that the amount of loss and the amount of damage is just totally driven by the very big frauds. If we consider something like payment protection insurance in the UK or LIBOR or Forex, every single small time fraudster in the USA could work for five years and not get to be the tenth part of the ties of one of the really big financial scandals. Someone like Tino DeAngelis, the salad oil king, if he were in his prime

today, is he still alive? He is still alive. Yes, he was arrested for another fraud in the 1980s. It hasn't done anything since. Oh, that's good. If he were in his prime today coming up with the skills that enabled him to identify the selled oil opportunity, in your view, lend themselves to spotting opportunities for fraud today? Oh, yeah, absolutely, because it's just picking, it's a combination of a very deep understanding of one industry and the way that it goes about, because in general, if you're able to defraud something, then you have exactly the same knowledge as someone who's really good at managing it. If Tino was around today, though, he'd be doing initial coin offerings.

I mean, as far as I can see, with the amount of money that ICOs are capable of raising and the amount of direct oversight and regulation that goes into them, anyone who's doing any other kind of securities fraud today is just a damn fool. That brings me to this sort of obvious question. So you identify initial coin offerings as sort of a right. opportunity for fraud. Are the rules or rules of thumb that you can set up for looking at an economy, looking at a situation and saying, okay, this is the area, a generalizable rule is to be able to say this is the area where right now we're probably seeing a lot of fraud?

I think the big rule is exponential growth because the absolute signature of a fraud is that, Firstly, it has to grow at a compound rate because it's based on a business unit that's showing positive growth. And then on top of that, you've got a wedge reflecting the money removed by the fraudster, which also has to show compound growth. And because you've got those two things acting together, in general, a fraud has to grow unusually quickly, which is why they always look like great big success stories. So in the book, I think the golden rule that we suggest, is if something's growing unusually quickly, then it needs to be checked out. And then the second part of the test is it needs to be checked out in a way that it hasn't

been checked out before, because if it's a mega fraud, then it's been designed around all of the usual qualifications. And probably something I'd add to that is if you try to check something out and the person in charge won't give you. any of the information that you're looking for, then that ought to be really suspicious. Well, Dan, that was really fascinating. And I feel like I could keep asking you for more examples of famous financial frauds, but then we'll be here for about four hours. So we're going to leave it there. And we don't want to spoil the book. Yeah. And you have the U.S. edition coming out, right? Well, yes, that's going to be coming out in 2019. Basically, we realized with the U.S.

Shribner, that in the book I've got value-added tax, payment protection insurance, Ronnie and Reggie Kray, loads of kind of British things that, despite the best efforts of Guy Richie, Americans don't care about. So I'm rewriting that. Also, it turns out that Americans have slightly stronger forearms so they won't mind a book that's 20% longer. So I'm really excited about that working on that at the moment. All right, Dan Davies, thank you very much for joining us. Thanks very much. Well, Joe, you were absolutely correct in your assessment. I did very much enjoy that conversation.

And I think the thing that I found the most interesting is the concept of this idea that there's actually a really fine line between genius. You know, someone who sees an opening in the economy or in the system to make a bunch of money legitimately. And someone who pursues fraud and basically sees an opening in the economy. or in the system and pursues it illegitimately. So, you know, Dan gave that example of Apple and Steve Jobs and embellishing some of their reports early on in their history. And of course, Steve Jobs now is widely lauded as a genius, but it could have turned out so very differently. Yeah, I think that idea that to commit fraud within an industry requires a deep granular knowledge of the industry itself, is a really fascinating one.

And you know someone who just came to mind with regards to this is Martin Schrelli? And the pharma bro who's currently in prison. But the thing is, he really does know a lot about pharma. Like he is extremely knowledgeable about how the pharmaceutical industry works. And of course, he's argued that he was not a fraudster and so on. But regardless, he's someone with an unusually a high. level of just the actual mechanics of how the business works. Yeah, and there's plenty of dumb frauds out there for sure, but some of them are legitimately, ingeniously crafted, and you just

think, wow, this person is clearly smart, clearly knows the business, has clearly analyzed it, put the effort in to find the holes in the system. Why couldn't they have pursued, you know, a legitimate business? Absolutely. And this, uh, uh, this idea, too, that if you're going to catch a fraud, you better come up with some test that's never been devised before or never been applied to this company before. Because if the fraud had gotten to point X where you're thinking about it, it was almost certainly designed to fool the standard test. Yeah. And there's one other interesting thing, Dan said, which was, do you want to aim to have

no frauds ever in your system? And, you know, he, pointed out to the idea that a lot of frauds either end up as legitimate businesses or end up creating a lot of wealth for the people involved with them. And that kind of goes back to some of the bubble episodes that we've had, Joe. Like, clearly we all went insane when we thought Beanie Babies were worth thousands and thousands of dollars. But it did make a lot of people wealthy if they were able to pull out at exactly the right time. Well, and furthermore, this idea that if you were to construct a set of behaviors designed to ensure 100% that you never got caught up on a fraud, you would have to also guarantee that you miss a lot of things that don't turn out to be frauds,

that turned out to be wildly profitable. So you really sort of want to calibrate your fraud detection level, your approach at a level that maybe is not too onerous. Yeah. There's so much to unpack in this entire topic. It's such a good topic, which gets back to Dan's point in the beginning, that frauds are just a great entry point to understanding business or human systems. Yeah, and human nature. But for the avoidance of doubt, this is the PSA moment of odd lots. Don't do fraud, kids. Don't do it. This isn't an endorsement.

I have to say, so Nassim Telib blurbed Dan's book. and his blurb is, if you want to learn to fend fraud, read this. And if you want to commit fraud, don't. But if you absolutely must, first read this, which I thought was a pretty great blurb. Okay. All right. Well, this has been another edition of the All Thoughts podcast. I'm Tracy Alloway.

You can follow me on Twitter at Tracy Alloway. And I'm Joe Wisenthall. You can follow me on Twitter at The Stallworth. And you can follow our guest, Dan Davies, on Twitter. at D-Squared Digest. And you should follow our producer, Tofer Forges, on Twitter at Forges T, as well as the Bloomberg head of podcasts,

Francesca Levy, at Francesca Today. Thanks for listening. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Ruffini.

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