In narrative terms, "fraud" is a binary concept. One day, Enron is a company that's been #1 on Fortune's list of America's most innovative companies, the next day, it was all a sham. At one moment, Elizabeth Holmes is getting exactly the media coverage she was angling for&mash;the next Steve Jobs!—the next, she's a criminal mastermind who didn't just rip off investors but gave sick people false diagnoses.

This arc of public perception precisely mimics the returns of a martingale betting strategy (i.e. if you lose, double your bet until you're back to even). And that's not a coincidence. Most of the big frauds aren't born as frauds, but as legitimate companies that can't quite keep up with ever increasing expectations.¹ Which means that they're often in the same category as addictive behaviors—the point at which it's obvious that there's a serious problem is also the point at which it's pretty embarrassing to admit to one, and pursuing that behavior a little bit longer is the easiest way to delay the inevitable.

GE and Enron were both instances of this. Both companies were sprawling global businesses with lots of complicated projects running in parallel, many of which had a natural mismatch between when they accrued economic value and when they showed accounting profits. Both companies also had large financial arms that gave them access to liquidity, and to a potential "cookie jar" of unrealized gains. They were both operating at a time when investors fixated on earnings per share, and got in the habit of bidding up companies that hit mid-teens EPS growth. In the early 2000s, for example, Coca-Cola set a 15% EPS growth target for their CEO's compensation. Given that volume growth over the previous five years was about 6% annualized, that meant nine points of annual growth from pricing (and attendant margin expansion), cost cuts, accretive acquisitions, buybacks (at 50x earnings, deploying 100% of them to buybacks gives you just 2 points of EPS growth), or finding something to sell for a gain. But by the end of the reference period for that incentive plan, shareholders and regulators frowned on hitting the number in a way that led to lots of confusing 10-Q footnotes. The preference is almost always for organic growth and durable increases in incremental margins via volume, pricing power, operating leverage, etc. not via financial engineering.

The most dangerous situation a manager can get into, unless they're incredibly upstanding, is to have a goal like 15% earnings growth and to realize, late in the year, that they’re on track for 14.7%. There are just so many ways to get those last thirty basis points! Maybe some cost gets pushed to the next quarter, or they lean on customers to over-order just a tiny bit. Maybe they think about all the things they're depreciating right now, and how many fully-depreciated assets still have economic value and what that implies about how aggressively they need to depreciate. If that manager is running a lending business, or a trading business that transacts in exotic derivatives that don't have a market price and need to be modeled, there's even more room for just-this-once-ing it: maybe an impaired loan doesn't need to be recognized as such just yet, and perhaps it can be restructured to pay lower interest for a bit and more later on, preserving its net present value. Maybe there's some elaborate trade where the market price and the value a model spits out are divergent enough that making it can lead to an immediate gain.²

Whatever the method, this manager is now running a bigger business, which is harder to scale, and in order to hit their 15% bogey, they now need to produce 15.3% actual growth. That gap compounds naturally, but it also warps their decisions, because over time their target shifts from doing whatever leads to 15% growth to some combination of:

1. Making riskier bets in order to make up the gap, without explicitly talking about this, and

2. Structuring more of their business around creating opportunities/more optionality for another end-of-quarter tweak—maybe they try to do more business with their most flexible and accommodating customers, giving those customers a break on price in order to collect favors. Or they buy more assets they would otherwise lease, because over time there will be dispersion between the market value and book value of the assets, and they can do a sale-leaseback on whatever has appreciated while holding on to whatever hasn't. Or, at the top level, they can allocate more money to a financial division whose reported profits are more discretionary. Maybe they do something really sneaky, like moving some of their borrowing from bank loans to receivables factoring, a more opaque market where they might, in a moment of desperation, factor the same set of receivables two or three times over.

Both of these options erode the value of the company, and the second option also slowly elevates the company's leverage. The way some 90s frauds got caught was that they kept piling up great GAAP numbers, but had to turn to outside sources for cash. More recent ones have been okay on the cash side, either because they had bigger liabilities than they admitted (First Brands) or because one or more bank accounts were fake (Wirecard). That is the basic way that they die: if they overstate GAAP earnings, eventually the cash-to-GAAP gap gets unsustainably big, and at some point they have an obligation that they could trivially meet if their books were honest but that's existential if it's not.

And at that point, people ask: where did the money go? A company that was worth billions of dollars suddenly disappeared—where are the billions? The answer is that they disappeared one small decision at a time, in the form of delivering returns to lenders that didn't match the underlying money they were making, and by making business decisions that destroyed value on a risk-adjusted returns basis because they were just reaching for risk.

The people who turn to fraud in order to get rich typically flame out fast. The really big frauds are from people who were trying to stay rich, and more in a socio- than economic sense—the higher you go in the class structure, the more precarious you are, at least in places where class isn't mostly determined by pedigree.³ If you can get comfortable with the fact that not every year has to be a record-breaking year, and that sometimes people will think you're washed up—and that you might in fact be washed-up at some point!—then you're safer from the temptations of fraud. And that's one reason to think that fraud risk is growing, and the next financial crisis, as with the last few, will reveal a lot of it: the more tracked careers there are, where every year is a relentless progression, the more people there are who view even a tiny shortfall from expectations as a critical problem. (And as one that they, with their long track record of getting into the right schools and jobs, and getting the right promotions, can of course make up for next quarter.)

In The Diff, we’ve looked at lots of frauds, and how they function, including:

• We reviewed the FTX bankruptcy examiner's report ($).

• Whistleblower rewards sound like a great idea, but savvy traders know not to exercise an option early ($), so they can actually lead to more fraud.

• Drawdowns, in market value or cash on hand, tend to kill frauds. So it's good to have a taxonomy of drawdowns.

• And we've also shared an appreciation for the Nikola short report, an all-time masterpiece ($).

• We reviewed what happened to the JPMorgan acquisition of Frank.

• And, back in 2020, we noted that it's surprisingly hard to make money shorting worthless stocks ($), which introduced the idea of willingness and ability to commit fraud as an invisible line of credit.

• We briefly reviewed a book about the collapse of Tyoc, whose problem was less that shareholder money was misused and more that it was put to such tacky uses.

Join the discussion!

1  Madoff seems to be an exception, but even he had a legitimate business adjacent to the criminal one.

2  This actually gets into some fun and tricky accounting territory. Suppose you strike some ten-year deal, which, once it's fully hedged, will produce $1m in present-value cash flows each year for the next ten years. You can think of this as a $1m/year stream of returns—but if you bought a ten-year bond at 100 cents on the dollar, and it immediately dropped to 50 cents, you wouldn't book a 5 cent on the dollar loss each year for the next ten years. The price already changed! Enron's accounting was actually blessed by the SEC, though Enron promptly applied that permission retroactively and waited for the SEC to complain (they didn't).

3  This might imply that former athletes and politicians are uniquely disinclined to commit fraud. If you're earning a nice upper-middle-class lifestyle with whatever normal job you landed after that other career ended, you'll always be the guy who played for the NFL or served in the House or whatever. So you can still have money anxiety, but you have a lot less class anxiety. And you probably also know that cheating, even a little bit, becomes a bigger story because you're famous. So the incentive basically flips: if your status comes from the job you're doing now, fraud is one way you maintain it; if your status comes from what you accomplished before, fraud is the main way you can risk it.