A beginner’s guide to securities fraud

DISCLAIMER: No one at Stockopedia, including myself, is encouraging you to commit fraud of any kind. THIS IS SATIRE, NOT ADVICE. It is aiming to be humorous, but it should also be educational. By thinking through how and why securities fraud works, investors should be better able to spot when something seems off.

Nothing included here is based on real companies or scenarios. Any similarity to real events is purely coincidental.

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So, you want to get rich and have no moral compass? But, you don’t understand Cryptocurrencies? And the role of President of the United States is already taken? Plus, you don’t want to risk actual prison time? Well, securities fraud is for you.

Why securities fraud is a good option:

Hard to prove: Done well, it can be very hard to show that you had an intent to deceive. Arguing that you were unlucky with business conditions or were simply incompetent covers a lot of bases.

Long time until prosecution: If you are unlucky enough to face an investigation into your actions, the complexity of any case, plus an under-resourced police force, means that it will be years before you face any action. Precious years of freedom in your prime to spend your ill-got gains.

Low sentencing: If the authorities actually pin something on you, you can expect a low sentence in a minimum-security gaol.

Ability to repeat the fraud multiple times: It can be hard to repeat certain crimes. Steal from the safe of your employer, and you may have a hard time persuading your next employer to give you the keys to their safe. Not so with securities fraud. As Dan Davies notes in his book, Lying for Money:

It’s a sad fact, as my friends confirm, that if you want to find frauds, your best asset is a list of existing fraudsters. You might have noticed that comparatively few of the case studies we’ve looked at [in his book] were first offences. There’s something about commercial fraudsters that keeps coming back to the same pattern of behaviour.

I would argue that “something” is a lack of enforcement and the willingness for investors to overlook past failures when faced with a great story.

Kudos: While the average golf course will happily grant membership to the Bentley-driving drug kingpin, the other members may be a little wary of their reputation. Not a problem for a listed company CEO, such as yourself. You will be invited to all the right dinners, and there will always be a spot at the bar in the 19^th Hole for someone of your standing.

Setting up the company

With detection and conviction rates so low, you are off to a great start. However, having the proper structure at the start will enable your fraud to balloon into a truly profitable enterprise (for you):

The right advisors: If you are going to list on AIM, you will need a NOMAD. They will look over your announcements and check what you can and can’t say. Pick the least choosy NOMAD with the most to lose from your fees if you go elsewhere. Not sure? Just pick the NOMAD appointed by other questionable companies. If you really don’t want your homework marked, list it on the main market! The paperwork may be more onerous, but you’ll probably be left alone most of the time, with no one checking in.

The right Board: Having a well-regarded but compliant Board of Directors can be key to ensuring that you can keep things on the road. You want directors with strong reputations that lend credence to your operation, but as little actual business experience as possible. For this, I have two words of guidance for you: Generals and Lords. You may think that characters such as this wouldn’t risk their reputation for a monthly fee, but you’d be very wrong.

Don’t fight the fees: It may be tempting to negotiate hard on what you pay advisors and directors, so more money goes to you, but this is a mistake. It is other people’s money, so pay generously; you will make your path in the future far smoother if others have something to lose, too.

Raising the money

Someone is going to have to provide the money you will appropriate, so this is where you need investors:

Have a great story: there is no substitute for having a compelling narrative that sucks people in. It should have a couple of key features – the total addressable market should be huge, allowing shareholders to dream big, and it should be a new or complex area that makes it hard for investors to judge progress. If all else fails, just pick the sector that stockmarket investors are most excited about at the moment and hope you get your raise away before the wind changes direction (or you can shamelessly pivot the business model and narrative in time).

Develop a fanatical following: at some point, if you can generate enough hype, shareholders will start to promote the company itself, and you won’t need to risk putting out statements that could be later shown to be false and come back to bite you. Vague hints to the right people, but in a way that you can later deny the conclusion they came to, are more effective than a thousand corporate presentations.

The right shareholders: Try to attract individual investors who fall in love with a share and have a meltdown when anyone takes the contrary view to them. Their aggression will put more sensible critics off commenting.

When it comes to institutions, try to attract fund managers who have too many holdings to look into the details of each of them. Surprisingly, you’ll find the professionals are equally suckers for a good story; the structure of fund incentives means that fund manager bonuses depend on them finding the big winners, even if they are risky. Keep emphasising the upside of your venture.

Financial PR: If you can’t attract naïve investors organically, go the direct route. Get your “Investor Relations” to run a whole load of online ads, or do some soft interviews on the popular private investor platforms. You may think that no one would buy shares based on a random online advertisement, but it acts like a form of selection bias; by doing this, you're attracting the least experienced type of investor who won’t see through your ruse.

Free stuff: Reciprocity is a powerful effect. Give shareholders something for free, even if it is paid for from their own money, and they will feel forever favourably towards you. Buy a round of drinks at the investor event where you are promoting your company, or put on a lavish shareholder lunch. It will be many years before shareholders realise that the free shareholder golf day was the most expensive round of their lives!

Generating rapid growth

In order to convince everyone that the company has great prospects, you are going to have to show rapid growth. Simply making the numbers up is not likely to convince many investors for the length of time you need to get the cash out. At this point, there is usually no substitute for having some legitimate business that you can base this growth on. Some types of businesses are better than others:

Newsflow: If you want to keep the momentum behind your share price, you need to RNS everything. Product releases, minor contract wins, and awards where you sponsored the ceremony to guarantee a win are all noteworthy news. Nothing is too small, even if the NOMAD eventually makes you use an RNS-reach. However, it is surprising the number of Letters of Intent or Memoranda of Understanding you can convince your NOMAD are fully RNS-worthy.

If you are a resources company, then every operational milestone needs to be announced. A rig move, drilling commencing, a consultant appointed, a model updated, are all things that can give the impression that you have found something important and commercial, even if that decision is many years away.

Supporting a raise: Unfortunately, there is no substitute for putting some money back in when your company raises fresh equity. The key is to put in as little as you can get away with that still looks somewhat supportive. This is where having the right non-execs comes in, as these can be pressured into putting cash into any raise, making the overall support level of the board look good even though your own contribution is minimal.

Revenue recognition: Choose an industry where there is significant leeway in the judgment surrounding revenue recognition. If you can book revenue by signing a contract or buying something like an ongoing legal case, you have the ability to show revenue growth even if the cash will come in many years later, or not at all.

Adjacent expansion: Having a legitimate but largely unprofitable business enables you to start a similar but entirely fabricated business. Whereas a completely false enterprise may be discovered on a drive past your non-existent premises, the legitimate business acts as the perfect smokescreen. Your made-up business will be highly “profitable” since the costs are zero, and any “revenue” drops straight to the bottom line.

Skim and return: If you have a company where metrics such as like-for-like store sales matter a lot to investors, you can skim cash off in early years, or from a separate part of the business, and then return it at the right moment. It may require physically moving cash and some questionable banking arrangements, but the payback can be large; showing rapid growth in key metrics shortly before a big equity raise can be very important even if the net result over time is zero-sum.

Transfer pricing: Investors don’t tend to look at a whole enterprise but are often happy to do sum-of-parts valuations. If you can take a largely commodity product and layer on top a very exciting-sounding technology application, you are off to a flyer. What you can do is decide how much customers are paying for the commodity product and how much for your special application. As long as the total amount is less than the competition, the customer isn’t going to argue the details. Hey presto! You have a rapidly growing, high-margin business that investors will pay a high multiple for.

Getting the money out

Of course, all of your efforts come to nought if you can’t get the money out of your questionable enterprise. Here are some ways of doing this:

Pay yourself very well: A true entrepreneur will restrict their salary if they know that they have a good product and strong growth potential. The long-term returns are better if they own the equity and aren’t diluted. However, you know the underlying business is poor. So pay yourself as high a base salary as you can get past your carefully chosen remuneration committee.

Related party transactions: These require a willing accomplice and some planning, but are one of the best ways to appropriate the cash. The idea is that you get a confederate to set up a business in a related field. Your company then trades with that business on favourable terms, giving the impression that it is a valuable, growing enterprise. You can take an equity stake in the related business and account for some of the “profits” before eventually buying out the rest. The key is that any of your shares issued as part of the acquisition are without a lock-up and are immediately sold by your accomplice. You then share the spoils, as your share of the proceeds gets returned to you under the table.

Debt: Where possible, take on debt, even if you claim to have a large cash balance. While it doesn’t get cash out directly, it increases the amount you can appropriate by other means.

Engineer a takeover: This is the primo exit strategy, as you get all of your remaining equity purchased at a premium, and you get to sail off into the sunset on your yacht. It might seem like it would be difficult to convince a corporation, but if you can pull the wool over the eyes of the individual investor, you can do it to a CEO or fund manager. 

There are two key types of buyers to target. The first is an international trade buyer desperate for growth due to their own declining prospects. The secret here is that they can’t have enough local knowledge to suspect that something is off. The second type is an existing fund that is already stuck in your equity. They may suspect that something isn’t quite right, but that won’t stop them from buying the whole business to make the problem go away rather than risk negative headlines and scare off their own investors.

Dealing with short-sellers

While the authorities may not try to stop you, at least while you are extracting the money, short sellers can be a problem. Unless you are connected to the Security Services of a foreign power, you probably shouldn’t have your critics followed and threatened. However, there is plenty you can do if short sellers spot the things that are amiss:

Deny, deny, deny: In today’s post-truth world, a simple denial goes a long way. Make sure you rebut each of the allegations, but be careful to avoid giving away any further details that may actually reveal what you are up to.

Point out the conflict of interest: It is obvious that short sellers are writing a report in order to profit from a falling share price. Make sure to point this out and claim it to be a huge conflict of interest and suggest that they are manipulating the share price. Carefully avoid highlighting the equal conflict of interest that arises from brokers and anyone else you pay to write positive reports about your company.

Get regulators involved: Even the most diligently researched short report will have a few errors, as it is a lot harder to deduce something than know it. Jump on any minor mistakes and claim that these completely undermine the short thesis. If you are fortunate enough to be regulated in a high-trust but generally naïve European country, you can probably persuade its regulator to fine the short seller for some minor technical language error and completely ignore your crimes.

A carefully chosen audit scope: Being able to claim that the auditors have given you a clean bill of health can be an important step in determining your credibility versus short sellers. The problem is that your bill of health is anything but clean. One trick is to define materiality at such a high level that almost any of your multiple shenanigans get chalked up as immaterial.

An even better option is to have a lot of subsidiaries in far-off places. The key is to make sure only the PLC accounts are audited by a reputable firm. For everything below the PLC level, use local auditors who are easily fooled or can be co-opted into your scheme. Define the audit scope such that everything the local auditors say is trusted without question, and you’ve rolled the body up in a carpet and carried it out of the door without the main auditors noticing. If you want to fake your cash balance, claiming it is somewhere where local auditors are more easily fooled by fake paperwork is a good strategy.

Closing it down

Once things really start going wrong, and you haven’t managed to palm the problem onto someone else by engineering a takeover, then you may be in trouble. However, there are still a few things that you can do:

Resign early: There is no point in hanging around. Leave your non-execs to have those uncomfortable meetings with creditors. The big benefit of exiting the building is that you can sell the rest of your shares without declaring each sale. With some careful interpretation of the regulations, you can probably get shot of the lot before having to declare that you’ve done it. If you’ve pledged your shares against a loan, simply default. It’s their problem now.

Feign incompetence: While occasionally some directors just admit what they have been up to, unless you already have your money out of the country and a nice place in a land with a questionable extradition record, you should continue to deny, deny, deny. Blame the failure on your entrepreneurial nature not being valued in the UK or the general economic conditions. If these won’t fly, then incompetence is your best friend. Claim you were doing your best, but out of your depth. It may seem a risk to your future business endeavours, but your strategy now is to stay out of gaol. The competence bar for company directors is so low that you can still make a comeback after a few years.

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A final reminder: THIS IS SATIRE, NOT ADVICE. Hopefully, you found it entertaining but also educational about the type of things to look out for in order to avoid high-risk companies.

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