To quote Warren Buffet: “It’s only when the tide goes out that you realise who has been swimming naked”.
To put his quote into context, one needs to recall the severe financial turmoil that gripped the Western world from 2008. Whereas before the sub-prime crisis everything seemed so rosy in the Wall Street garden, it had to be the sudden demise of Lehman Brothers (among other omens) that uncovered who was swimming naked and thus over-exposed. As stock markets around the world collapsed during 2008, the enormous losses caused investors to withdraw large amounts of cash from their investments. These cash withdrawals in turn triggered the discovery of several cases of financial fraud as perpetrators could no longer hide the results.
The discovery of high-profile financial scandals increased scrutiny on governance practices and companies’ financial statements. In Malta, this hubris on financial crisis may appear to be stuff fit for Hollywood films such as Wall Street – Money never sleeps, but on closer scrutiny we may notice how the wide-reaching tentacles of the US menace has reached our shores.
It is true that 2009 was a disastrous year for us, both in terms of exports and tourism (even the local banks, which are usually Teflon-coated, appeared to have reported lower earnings, in fact it was unofficially reported that many had burned their fingers investing in Lehman shares and other so-called “toxic instruments”). But the revelation that a hedge fund run by Valletta Fund Managers ( a wholly-owned subsidiary of Bank of Valletta ) has failed rams home the realisation that we are not immune to the virus that has gripped the world. A lot has been written in the local press about retired investors who were allegedly lured to divest themselves of their life savings to buy units in La Vallette Multi–Manager Property Fund (a joint venture between BOV and Insight Investment of London.) A retired small-timer is protesting that Bank of Valletta advised him to move risk-free Malta Government Bond holdings into the fund. In a shocking revelation, the claimants are alleging that La Valette Sicav had invested in funds that had liabilities in excess of the funds’ total assets, which is in breach of the rules.
It is true that the directors of a sub-management company appointed in Guernsey were being sued for criminal activity and the fund was thereby suspended pending investigations, but this grave situation was not immediately and clearly stated. Another serious allegation is that it appears that insiders at the bank redeemed their units ahead of the fund’s suspension, although this still needs to be proved in court. The bank is defending itself on the grounds that there was no wrongdoing on its part and that the fund had simply fallen victim to the international financial crisis.
BOV’s chairman avoided commenting at the press conference last week at which the bank announced a bumper profit of just under €100 million. He wisely steered away from commenting on any potential liability to compensate for alleged infringements. Still, one swallow does not make a summer and one has to be cautious not to over-react if one apple in the barrel goes rotten. Regrettably, it was such a big apple that went so rotten that we read about a number of investors protesting that the bank’s officers were over-zealous in their drive to promote the fund among ordinary people. (who signed they were qualifying investors). The accusation was made in a judicial protest filed against the bank by 32 investors who join a group of 227, all claiming that their money was mismanaged. It comes as no surprise that, in a small island, investors are not so sophisticated in high finance and consequently a loss of €50 million creates a storm
However, some experienced investors, such as Finco Treasury Management, are also protesting that the fund administrators may not have been so forthcoming. Investors gave details taken from documents of nine underlying funds that they claim breach the investment and borrowing restrictions of the fund’s supplementary prospectus. In simple words, investors are alleging that the rules of the fund which allowed only limited leverage were exceeded without their permission. In their opinion the administrator did not tell them it was continuing to invest in the nine still-risky funds.
This sad story has starkly revealed that the recession in property and the sub-prime mortgage crisis has not spared our shores. Much as we may think that such a small island is cocooned as a well-protected and highly regulated investment centre, yet the fly in that ointment is the failed fund that was so loved by local investors (both experienced and not so experienced). That this sad story should unfold now, almost three years after the fund was established, is what Warren Buffet was emphasising when he said that it’s only when the tide goes out that you realise who has been swimming naked. The fact that the cancer was detected late in the day is what surprises many in the post sub-prime era, but then while we are licking our wounds these pail by comparison with the fraud that was concealed in the software giant Satyam in India. When the firm’s founder and former chairman B. Ramalinga Raju appeared at a preliminary hearing in the southern city of Hyderabad, he claimed that neither he nor the managing director had benefited financially from the inflated revenues. He also claimed that none of the board members had any knowledge of the situation in which the company was placed due to the falsified accounts. Notwithstanding the eight-year-old scam, Satyam continued issuing clean audit reports to show positive results up to 2008 and claimed success in navigating the economic crisis.
Raju appeared in court this month in a billion-dollar corporate fraud case dubbed “India’s Enron”. When the game was up, he confessed that Satyam’s balance sheet of 30 September 2008 contained inflated figures for cash and bank balances of $1.14 billion. Other dubious entries in the books that went undetected for years included accrued interest of $85 million, undisclosed debts of $279 million and overstated debtors. In October 2008, Satyam falsely reported a net income of $132.3 million, an increase of 28 per cent over the same quarter the previous year. The company asserted that, despite the challenging environment, it had continued to find opportunities for growth. But the cracks could not be papered over for ever, and the first crack in the company’s reputation occurred when the World Bank sacked Satyam as a supplier and issued an eight-year ban against the company.
The World Bank accused Satyam of installing spy systems on its computers and stealing assets from the World Bank. An analyst expressed serious concern about the large balances and reservations about the accuracy of the figures. But markets behave in a quirky way, and most of them ignored the analyst’s comments, so the share price rose with reports of positive earnings and revenue growth. A Big Four auditing firm audited Satyam’s books from June 2000 until the discovery of the fraud. Several commentators have severely criticised the auditors for failing to detect the fraud, adding that one troubling item concerned the fictitious $1.04 billion that Satyam claimed to have on its balance sheet in non-interest-bearing deposits. According to accounting professionals, a reasonable company would have either invested the money in an interest-bearing account or returned the excess cash to the shareholders.
Such a large amount of cash should have been a red flag for the auditors that further verification and testing was necessary, but professional leaders still rallied behind the beleaguered audit profession in India following the revelation of one of India’s largest white-collar crimes.
To conclude, all cases of falsification usually start as a marginal gap between the actual operating profit and the false one reflected in the account books. This snowballed over the years and the deception had to be maintained while the deficiency ballooned. Commentators expressed the view that perpetrating the fraud and fearing its ultimate detection was like riding a tiger – not knowing how to get off without being eaten. It is to be hoped that investors will remain cautious in how they navigate the waters in turbulent times and always heed Warren Buffet’s golden words.
by George M. Mangion
The writer is a partner in PKF Malta, an Audit and Business Advisory firm.