I can see what you see
not
Vision milky, then eyes
rot.
When you turn, they
will be gone,
Whispering their hidden
song.
Then you see what
cannot be
Shadows move where
light should be.
Out of darkness, out of
mind,
Cast down into the
Halls of the Blind. - Diablo
I usually avoid referring to stuff from the 90s as the opening
act. It risks giving away my vintage…
But the above words from one of the most successful role-playing
games from the 90s – Diablo – (who remembers it?) is apt for this edition.
Auditor Problems.
It’s an opportune moment to dive into the Corporate Halls of the
Blind.
*****
Indian markets have been beset by a sudden wave of auditor
resignations from listed companies in recent times. Stock prices of the
affected companies have taken a beating. Runaway auditors have caused market
participants to speculate over the next defection, as alpha monkeys smell quick
gains. Auditor issues have surfaced after a period of widespread price
correction. Wounded consciences that were assuaged by the Band-Aid of rising
stock prices have been violently peeled off as prices have turned down.
Rule of thumb: identification of ‘n’ frauds (real or otherwise)
leads to 2^n fraud suspects, as sleuths scour the market for impending pockets
of doom.
The problem highlights several aspects of investor behaviour that
is worth noting. As always, history is the best place to look.
A throwback to the internet bubble era, with a special focus on a
then market darling – Enron Corporation.
An excerpt from its then Annual Report, reprinted word-for-word.
Friendly English commentary follows soon after.
Enron entered into a series of
transactions involving a third party and the Related Party. The effect of the
transactions was (i) Enron and the third party amended certain forward
contracts to purchase shares of Enron common stock, resulting in Enron having forward
contracts to purchase Enron common shares at the market price on that day, (ii)
the Related Party received 6.8 million shares of Enron common stock subject to
certain restrictions and (iii) Enron received a note receivable, which was
repaid in December 1999, and certain financial instruments hedging an
investment held by Enron. Enron recorded the assets received and equity issued
at estimated fair value. In connection with the transactions, the Related
Party agreed that the senior officer of Enron would have no pecuniary interest
in such Enron common shares and would be restricted from voting on matters
related to such shares. In 2000, Enron and the Related Party entered into
an agreement to terminate certain financial instruments that had been entered
into during 1999. In connection with this agreement, Enron received
approximately 3.1 million shares of Enron common stock held by the Related
Party. A put option, which was originally entered into in the first quarter of
2000 and gave the Related Party the right to sell shares of Enron common stock
to Enron at a strike price of $71.31 per share, was terminated under this
agreement. In return, Enron paid approximately $26.8 million to the Related
Party.
English translation:
Enron transferred 6.8 MM stock to the related party; gets back
only 3.1 MM shares. Net-net: Enron transferred 3.7 MM shares valued at $260 MM
at that time + $27 MM for a total cash transfer of $300 MM to cancel a contract
with the Entity controlled by a very interested party. A fictitious contract is
created from thin air, then nullified, with a very real movement of hard cash.
This ‘gifting’ accounted for a quarter of Enron’s operating cash
flow in 1999.
These should've been noticed by discerning investors. But not many did. Until it was too late.
In the internet boom as Enron’s stock price levitated, few took
notice or reacted to such wondrous nonsense. A precipitous fall in the stock
price triggered ‘auditor concerns’, then ‘scandal’.
Rest (in peace) is history.
*****
In bullish times, when a growing mass of believers coalesce around
rapidly levitating stock prices, numbers and other such mundanities seldom
matter. Until they do.
The recent auditor issues in India has dusted off questions that
lurked in the shadows during normal (‘bullish’) times.
How can one be confident that the numbers that really count are
being counted correctly?
Of what use is identifying a ‘fraud’ if nothing can be done about
it (read: profitable exploitation)?
Faced with such difficulties, the market’s muscle memory kicks in
for a rational Pascal’s Wager. ‘It wouldn’t hurt much if I believed in God and
God didn’t exist. But I could benefit greatly if God existed. So let me believe
in the numbers…until…’
Markets scrub their conscience on dodgy companies and selectively
outrage against some when the tide turns.
Yet, many questions continue to be lost in the Halls of the Blind:
What about the Outsourced Diligence Model of investing? ‘A’ relies
on an auditor, who relies on other auditors/managements, who rely on fuzzy
estimates of unquantifiable aspects of businesses.
Markets do not exist as a torchbearer of collective morality. To
the extent that the collective belief that markets discount future earnings
potential is true, corporate governance issues shall be relegated to the
shadows in the next cycle.
*****
Often get asked as to how investors can keep up with all this. It
seems scary to many that such dangers lurk in the shadows.
It helps to remember that in the long timeline of history, failure
is the norm, success the exception. A sceptical mind-set that assumes most
things are likely to fail is a good place to begin. Since the pool of failures
vastly outnumbers successes, a philosophy that rests on elimination is a strong
weapon in an investor’s arsenal.
*****
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