Beware the false reassurance of corporate probes; Directors do not like to embarrass themselves by exposing serious problems, writes Carson Block

March 6, 2014 6:20 pm

Beware the false reassurance of corporate probes

By Carson Block

Directors do not like to embarrass themselves by exposing serious problems, writes Carson Block

When it comes to defending themselves against accusations of wrongdoing, management teams and their complacent boards follow a well-worn routine. Their immediate reaction is to issue a blanket denial and announce that an independent committee of directors will investigate the accusations. The committee duly appoints an independent law firm to oversee the investigation, and the consulting arm of a Big Four accountancy to pore over the books.

Too often, such investigations are worthless endeavours that lead to more pain for investors. Frequently, companies are exonerated by their boards but subsequently tumble into bankruptcy or announce earnings restatements or evidence of other serious problems.

There are no better examples than the numerous companies – based in China and listed in the west – accused of fraud by short sellers, including Muddy Waters Research.

In 2011, Sino-Forest Corporation, a China-based company listed on the Toronto Stock Exchange that Muddy Waters had accused of falsifying its revenue, spent approximately $50m on such an investigation, hiring PwC as a consultant. The result was a clean bill of health. In a press release announcing the completion of the investigation, the independent committee said the company was unequivocally “not the ‘near total fraud’ and ‘Ponzi scheme’ as alleged by Muddy Waters . . . Sino-Forest is a real company.”

Unfortunately, investors who bought Sino-Forest bonds following the committee report saw their prospects for recovery plunge when the company declared bankruptcy four months later.

Directors are not inclined to embarrass themselves by exposing serious problems that had long been under their noses. That would invite shareholder lawsuits, regulatory scrutiny and professional embarrassment.

Nor are they likely to relish the prospect of clashing with management when the chief executive is often the one who put them on the board in the first place. Board members may even be conspirators in the fraud. If they are based in China and have little connection to the US, they are unlikely to face prosecution.

Time and again, investigators report that they have found no evidence to support claims of wrongdoing. The question that investors need to ask themselves is: how hard did these investigators look for clues that might have revealed something was amiss?

The firms hired to support the probe are often given a deliberately narrow brief. For example, there might be tight restrictions on the investigators’ ability to investigate the sources of the company’s cash balances.

Fraudsters have repeatedly duped independent committees and their advisers by showing that they control large cash balances. Often, they do this by borrowing the funds. If directors make it impossible to detect such ruses by limiting investigators’ access to evidence, nobody knows; the entire process is shrouded by the cloak of attorney-client privilege.

Accounting firms are also rife with conflicts of interest. Their main line of work is auditing public companies. This makes them unwilling to heap embarrassment on management teams and boards. To do so would be bad for business.

Professional advisers are least likely to speak up when they detect a fraud that is an instance of systematic wrongdoing. An auditor confronted with evidence of wrongdoing in a China-based company has a strong incentive to keep it under wraps, lest the discovery of the fraud attract scrutiny to other clients in China.

The refusal of Chinese affiliates of the Big Four accountancies to turn over documents relating to their Chinese audit clients to the Securities and Exchange Commission in January prompted a US judge to prevent them from auditing companies listed in the US. This is a sign of how little faith we should put in the notion that auditors act in investors’ interests.

The problem is not confined to emerging markets. In the US, numerous independent board investigations have issued clean bills of health, only to be proved wrong later on.

A report into wrongdoing at Enron, carried out by a law firm hired by the company, was later described as “a whitewash” by an Arthur Andersen investigator. When Global Crossing ordered an investigation into allegations levelled by a former employee, the report came back clean. Yet the company fell into bankruptcy and settled with the SEC over an accounting scandal.

Investors in companies that are suspected of wrongdoing need to mistrust investigations by purportedly independent directors that strongly favour the alleged wrongdoers. Boards that truly want transparency should stop hiring law firms to conduct these investigations in private and under legal privilege, and open their work to genuine scrutiny.
The writer is a short seller and founder of Muddy Waters Research


About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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