As the global economy hits the skids, we are likely to see more and more cases of fraud being exposed. Focussing on one particular story may make it seem obvious in hindsight, but the job of a short seller is incredibly difficult. It involves months, if not years, of painstaking research in many cases that often doesn’t go anywhere or show any type of results.

Even when they are right, short sellers have to have very strong convictions that their findings are accurate and correct. In a system built on trust and with the credibility of the establishment on the line, many short sellers have to endure burning criticism and in some cases, harassment, investigation and even the threat of jail time. Some of the biggest names in the business may come out against you, from renown experts in a particular field, to billionaires to even regulators themselves.

It’s no wonder then, that many short sellers prefer to remain anonymous or share their conclusions within a tight knit community of short sellers connected globally. I took the time to read up on a few of the recent fraud cases that have been exposed in the past few months and the similarities are both inspiring and depressing.

Inspiring because they show how diligent work and strong conviction can pay off through not just the satisfaction of being right but also profiting from it. Depressing because in some cases, outright fraud is well known for many months, years or even decades with most investors covering their head in the sand and ignoring the pesky short sellers.

What I found is that there are some similarities in the cases of fraud, to be exposed they required on the ground research and often international travel to remote locations. Budgets are tight and analysts don’t always have the money or time to dedicate to remote locations and granular on the ground research. Many companies know this and take advantage of this to their own benefit.

Wirecard

The biggest head shaker this year has been the German payment processor Wirecard. A few weeks ago, news outlets starting publishing stories about how Wirecard was unable to locate $2.1 billion that were supposed to be located in banks in the Philippines. Not only was the amount of cash not there but the banks and the Philippine regulator said accounts were never opened in the country at all.

This hid the fact that the revelation on the funds was the culmination of over a decade of accusations of accounting fraud and cooking the books at Wirecard, which had managed to escape big problems only until recently.

What was worse was the the regulator in Germany BaFin, seemed to be almost complicit in the fraud, banning short selling of the stock and investigating short sellers as well as The Financial Times (FT) which has been publishing stories for years now about the fraud within Wirecard. The Times didn’t even have a financial interest in the downfall of the company, they were simply selling the story to their readers for their benefit. How does fraud that has been publicized and exposed for so long go unpunished?

I don’t want to re-hash the entire Wirecard case but there are a few moments that seem to be key over the years, for when things were exposed and those trying to expose the fraud experienced major setbacks.

2002 – Markus Braun, a former KPMG consultant, takes over Wirecard in the wake of the dot com bust and merges the payment processor with a Munich rival.

2006 – Wirecard moves into banking with the purchase of XCOM. This puts it under the purview of the regulator BaFin, which regulates banks.

2008 – The head of a German shareholder association, publishes accusations that Wirecard is engaged in accounting fraud. Ernst and Young (EY) is a pointed special auditor and 2 people associated with the accusations are eventually jailed when they failed to disclose short positions in the company. This event was important because it enabled Wirecard to claim short sellers had actually been behind attacks on the company for many years to come.

2015 – After Wirecard raises $500 million and went on an international shopping spree, buying obscure payment processors, many in Asia and the Middle East, FT begins a series called The House of Wirecard, raising questions about their accounting. At that time, FT claimed there was a $250 million hole in their balance sheet. At this time also, smaller research firms also start to take notice and begin to publish their own findings of irregularities at Wirecard.

2016 – Some of these short sellers publish an anonymous dossier on Wirecard under the pseudonym Zatarra. Instead of investigating the claims, BaFin investigates Zatarra for market manipulation and a private investigation firm outlines plans to target FT and London financiers.

2018 – In March, the group’s own legal staff initiated an investigation of 3 members of the finance team in Singapore, the hub of its Asia operations after an internal whistleblower raised allegations. By October of that year, the whistleblowers then reached out to FT after they felt that the internal investigation had been suppressed.

2019 – The FT publishes its findings from the whistleblower and BaFin investigates the FT over market manipulation. One month later, officials raid the Wirecard Singapore office. BaFin then takes the step to ban short selling of the company for two months based on its importance to the German Economy. In October, the FT publishes a report that a Wirecard Unit in Dubai, which is responsible for a large share of the company’s gross profit, has fake clients. They manage to reach 29 of 34 clients and most are not even associated with Wirecard.

This puts huge pressure on the firm and investors push Wirecard to hire KPMG to investigate the allegations.

2020 – In April, KPMG says it cannot account for the profits, much of it from the Dubai unit mentioned above, that make up much of the profit of the firm. By this time it seems BaFin has realized its error and turned on Wirecard. Police searched their offices on June 5th and by June 19 announces that $2.1 billion is “missing”.

This whole scenario and is incredibly disheartening for someone in the know, like this blog post from a short seller that claims to be the inspiration or the original short sellers of Wirecard in 2008 who were imprisoned. The author explains how he had seen Wirecard get away with it for so long, he thought the company may never be caught.

Another short seller, Crispin Odey, is reportes to have made over 40 reports detailing the fraud at Wirecard over the years. I can’t imagine the grit and determination it must take to keep pressing on these points despite all the naysayers around them, not the deep satisfaction these researchers must have now that they are finally validated.

Not So Lucky

Luckin Coffee is another case which had its own detractors but seems to have played out both in a unique and much faster way than Wirecard.

A Wall Street Journal article detailed how a Chinese hedge fund based in Beijing and Hong Kong exposed the fact that Luckin Coffee was inflating it’s sales numbers by as much as $350 million in early 2020. Multiple on the ground attempts had been made by various hedge funds and investment managers to verify the growing sales numbers of Luckin, which touted itself as the rival to Starbucks in China.

However, the anonymous report that ended up taking down the fraud involved a massive and painstaking effort. It took 1500 people fanning out across 4,000 of Luckin’s stores across China, 11,000 hours of video and the counting of receipts to come to the conclusion that the company was inflating its sales numbers. The report was published by Carson Block of Muddy Waters LLC bis Twitter in January 31, which opened the flood gates and the shares started falling.

Credit Suisse, who led Luckin’s 2019 IPO in 2019 as well as their convertible notes in January 2019 tried to stem the tide by issuing a research report defending the company. By the time the fraud was confirmed by the company, both Credit Suisse and Morgan Stanley suspended coverage, saying their “hold” ratings at the time were based on the most up to date audited financials.

That seems great, but think of the outcome were none of the on the ground research to have worked and the findings came back that there was no fraud and they found nothing. There would have been a massive waste in both time and effort to get to the conclusion that many others had already arrived at. The author behind the paper and the idea must have had a very strong inclination that something was amiss to dedicate and convince others to dedicate their time and money to expose the fraud.

The fact that the company admitted it and was exposed so quickly was also unique. The same WSJ report mentioned that between 2017 and 2019, 32 US companies were accused of accounting irregularities but 25 of those companies saw their stock price rise after the accusations.

National Pride

It seems one thing these two recent cases had in common though was national pride, especially in the case of Wirecard. China has some answers in tech but wants to compete with US brands in everything, especially in their home market. Luckin Coffee was supposed to be China’s homegrown answer to Starbucks. Wirecard was the one shining European example of a tech unicorn as an answer to Silicon Valley.

The other interesting point to note in these cases is that investing is continuing to go international and now involves more listings overseas and global reach for those with the scale. This increases the opportunities for companies to take advantage of opaque accounting rules in particular countries, claim physical presence in remote locations that are expensive to verify and “state capture” of regulators, exploiting national pride and lack of sophistication for global operations from regulators.

Despite this, short sellers provide a valuable service to the wider investment community. They are incentivized to expose fraud and when they are right, make sure share prices reflect the rot underlying corrupt companies and management. They are not the most lived by bulls and managers but their hard work is appreciated by this market watcher.

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