The ‘Spirit of Honesty’ haunts a corporate board room filled with Lobbyists, Speculating Trust Companies, Employed Perjurers, Watered Stock Certificates, and Fake Promoters.

Visualizing History 

From the Archives

Facts, Failures, and Frauds (1859)

A 19th century account of financial fraud that reads as relevant today as it did back then. Consider the first page of Chapter 1:

“Without any great violence, all the incentives to commercial crime may be brought under the one common rubric — the desire to make money easily and in a hurry.

The apprentice-boy, who robs the till of a few shillings in order that he may enjoy himself on a particular evening; the gigantic forger or swindler, who absorbs thousands that he may outshine the people who live and breathe around him, are so far in the same predicament that they cannot endure any delay to the gratification of this common passion.

Apart from these, but still actuated by the same desire, is the reckless speculator, who would risk everything in the hope of a sudden gain, rather than toil safely and laboriously for a distant reward. The speculator may, of course, be a perfectly honourable man, who would instinctively shrink from any deed that would invoke the interference of the criminal law; but if for time is adverse, he is on the high road to wrong-doing, and, moreover, there are many crimes not enumerated in the statute-book that are still heavy sins against the dictates of morality.”

Sunday Reads

I think it goes without saying that this week’s post has to be on the Wirecard scandal, the role of short sellers and journalists, and fraud. So let’s get going!

Wirecard & Fraud

“Battered German fintech company Wirecard AG has filed for insolvency proceedings, days after revealing that more than $2 billion in cash missing from its balance sheet probably didn’t exist.

The move is the latest in a startlingly swift unwind for a company that until recently was a shining star in Europe’s tech scene. Wirecard is the first insolvent company in the DAX 30, Germany’s premier stock-market index.

Shares in Wirecard crashed 70% after the announcement Thursday, meaning the company’s market value has all but evaporated to less than €500 million from almost €13 billion ($14.5 billion) a week ago. The collapse began on June 18, when Wirecard said its auditors couldn’t confirm the existence of €1.9 billion meant to be held in trust accounts. The company later said the money probably didn’t exist.” (WSJ)

For much of the company’s existence, German payments processor Wirecard was lauded as an exciting fin-tech company that had even replaced the prestigious Commerzbank in Germany’s DAX 30 Index. As the WSJ notes, however, the company’s presence in Germany’s premier stock index is now more notable for being ‘the first insolvent company in the DAX 30.’

So what happened? I could spend the entire Sunday Reads detailing what occurred, but as the Financial Times was at the heart of uncovering this fraud over the course of multiple years, who better to explain it than the journalist responsible for helping bring down Wirecard:

A simpler timeline of the company’s unraveling is provided below:

Yet, Wirecard is just one example in a recent slew of frauds that include Luckin Coffee and Hin Leong Trading. As I’ve discussed many times on this website, however, this uptick in frauds being revealed is largely in line with historical trends, particularly as outlined by the Kindleberger-Minsky model.

Said differently, frauds and bad businesses usually aren’t exposed until markets fall and investors became more skeptical and conservative. When the returns are good and money is being made, there is less incentive for investors to scrutinize their holdings. If returns go south, and investors lose money, however, investors begin investigating their positions more thoroughly. The infamous Worldcom fiasco after the Dot Com crash, and Bernie Madoff’s ponzi scheme blowing up amid the Great Financial Crisis are prime examples.

After COVID-19 produced a bear market that sent all three major US equity indices down more than 30% and caused an economic recession, we are now witnessing the unveiling of frauds and bad business models that were previously masked by bull markets and excess optimism.

Rather than focusing on the specifics of Wirecard’s accounting fraud, however, today’s post will offer historical context on the broader themes surrounding Wirecard’s demise. In particular, the role of short sellers and investigative journalists, Germany’s decision to ban short selling, the accuracy of ratings agencies, and how fraud is able to persist in an age of abundant information.

The Role of Short Sellers and Journalists

Financial history is riddled with examples of government’s and financial regulators banning short selling. In 2019, the German authorities announced that they were prohibiting new net short positions in Wirecard. The Economist reported on this development, stating:

‘”Those who profit from the misery of others are not often popular. Short-sellers, who try to make money by selling borrowed shares and buying them back later at a lower price, have long been viewed with suspicion. They are blamed for exacerbating price falls so that they can reap bigger returns. In times of market stress authorities often ban them. In 1610 regulators in Amsterdam forbade short-selling, blaming it for a fall in the value of the Dutch East India Company. Two centuries later Napoleon prohibited it as an act of treason.

On February 18th BaFin, Germany’s financial regulator, banned investors from taking new net short positions in Wirecard, a German digital-payments firm, after its share price fell by over 40% in under three weeks… The regulator cited Wirecard’s “importance for the economy” and the “serious threat to market confidence” following the collapse in its share price. Wirecard processes payments for 250,000 merchants, including Aldi and Lidl, two of Germany’s biggest retailers, and numerous airlines… The ban may have been a risky move. The regulator is meant to act in the public interest. This is the first time BaFin has used the measure to protect a single company.

Yet, the Wirecard affair offers the perfect example of what famed short-seller Jim Chanos has long argued:

“It is short sellers who are the real time financial detectives, whereas the regulators are often financial archaeologists.”

Instead of unearthing fraudulent accounting practices at Wirecard, the German financial regulator focused its efforts on battling the short-sellers and journalists that were calling attention to Wirecard’s wrongdoing. This week, however, the President of BaFin admitted their mistake and gave credit where credit was due:

I salute those, let it be journalists, analysts or yes, let it be short sellers, who have been digging out inconsistencies persistently and rigorously. We don’t know the facts today, nobody knows the right facts today, including those who asked the right questions.”

Without the short sellers and investigative journalists publicly questioning Wirecard’s accounting practices, who knows how long this fraud would have persisted?


Now let’s dive into this week’s reads!

A Short History of the Bear

Short-sellers and bears have been derided and chastised since the modern stock market was born in 1602 on the Amsterdam Exchange. However, their role in identifying fraud and excess in the market is crucial. Edward Chancellor writes:

“These two early pieces of legislation against short- selling reveal a common theme in the history of the bears. Bubbles occur when speculators drive asset prices far above their intrinsic value. The collapse of a bubble is frequently accompanied by an economic crisis. Who gets the blame for this crisis? Not the bulls, who were responsible for the bubble and the various frauds and manipulations perpetrated to keep shares high, while cashing in their profits.

No, it is invariably the bears who are blamed for the post-bubble crises and are the main objects of anti- speculative legislation. Yet during the bubble periods it is the bears who are generally the lone voice of reason, warning people of the folly of investing in overpriced markets. In the aftermath of a bubble, they continue their forensic work of exposing unsound securities and bringing prices back in line with intrinsic values, a point which must be reached before the recovery can start.

Ever since the trauma induced by the collapse of the Mississippi Bubble, the French have retained a more pronounced aversion to financial speculation than the English. Napoleon disliked bears and believed that shorting was unpatriotic. In 1802, he signed an edict subjecting short-sellers to up to one year in jail. The French prejudice against so-called Anglo-Saxon capitalism continues to the present day: after George Soros and other speculators drove sterling from the Exchange Rate Mechanism in September 1992, the French finance minister, Michel Sapin, commented that “during the Revolution such people were known as agioteurs, and they were beheaded.”

The No. 1  Ladies’ Defrauding Agency

This article makes the case for why we should be using the term ‘Howe Scheme’ instead of ‘Ponzi Scheme’ to describe scams representing a ‘pyramid-esque’ structure.

In the 19th century a female fortune-teller turned financier opened a bank offering guaranteed interest rates of 8%, and even offered to pay the first three months interest in advance for new depositors. Sweet deal! Suffice it to say that the accounting practices of this institution were, well, questionable…

I’ve provided an excerpt of the article below, but you should certainly read it in its entirety.

“Sarah Howe’s early life is mostly a mystery… but by 1877 she was single and working as a fortune-teller in Boston. It was a time of boom and invention in the United States. The country was rebuilding after the Civil War, industrial development was starting to take off, and immigration and urbanization were both increasing steadily. Money was flowing freely (to white people anyway), and men and women alike were putting that money into the nation’s burgeoning banks. In 1876, Alexander Graham Bell invented the telephone, and in 1879 Thomas Edison created the lightbulb. In between those innovations, Sarah Howe opened the Ladies’ Deposit Company, a bank run by women, for women.

The company’s mission was simple: help white women gain access to the booming world of banking. The bank only accepted deposits from so-called “unprotected females,” women who did not have a husband or guardian handling their money. These women were largely overlooked by banks who saw them — and their smaller pots of money — as a waste of time. In return for their investment, Howe promised incredible results: an 8 percent interest rate. Deposit $100 now, and she promised an additional $96 back by the end of the year. And to sweeten the deal, new depositors got their first three months interest in advance. When skeptics expressed doubts that Howe could really guarantee such high returns, she offered an explanation: The Ladies’ Deposit Company was no ordinary bank, but instead was a charity for women, bankrolled by Quaker philanthropists.

Word of the bank spread quickly among single women — housekeepers, schoolteachers, widows. Howe, often dressed in the finest clothes, enticed ladies to join, and encouraged them to spread the news among their friends and family. This word-of-mouth marketing strategy worked, Howe’s bank gathered investments from across the country in a time before easy long-distance communication. Money came in from Buffalo, Chicago, Baltimore, Pittsburgh, and Washington, all without Howe taking out a single newspaper advertisement. She opened a branch of the bank in New Bedford, Massachusetts, and had plans to add offices in Philadelphia and New York to keep up with the demand. Many of the women who deposited with the Ladies’ Deposit Company reinvested their profits back in the bank, putting their faith, and entire life savings, in Howe’s enterprise. All told, the Ladies Deposit would gather at least $250,000 from 800 women — although historians think far more women were involved. Some estimate that Howe collected more like $500,000, the equivalent of about $13 million today.”

From Insull to Enron: Corporate (Re)Regulation After the Rise and Fall of Two Energy Icons


This week the Wall Street Journal reported on a case of fraud in an energy-trading company:

“A distressed energy-trading company overstated its assets by more than $3 billion using “routine and pervasive” forgery, while its founder oversaw years of disastrous bets on oil derivatives, a report filed with a Singapore court said.”

In terms of where this leaves the company with it’s debtors…

“The study by interim judicial managers, or court-appointed independent administrators, offers the first detailed account of the implosion of Hin Leong Trading Pte. Ltd., a closely held Singapore company that owes $3.5 billion—mostly to banks, including HSBC Holdings PLC.”

I mention this high profile case of fraud in the energy trading industry because this article focuses on two other well-known instances of fraud / misleading investors related to energy: Samuel Insull and Enron. Since most people know the Enron story, I’ll focus on the Insull Empire of the 1920s and 30s.

My colleague Chris Meredith and I wrote about Insull as part of an article on Value investing last summer, and I’ve included our description of the Insull affair below:

“Although not well known, Samuel Insull might have had more effect on the utilities industry than anyone else in the country. Insull was originally hired as Thomas Edison’s personal secretary and had risen to become the number three person at General Electric by 1892. At the age of 32, he left to take over Chicago Edison which was about 2% of the size of GE. At Chicago Edison, he established several business paradigms for utilities that exist in today’s utility markets, including the use of AC/DC in distributing power.

As he built out the utility business, Insull aggressively purchased several other utilities, creating a gas and electric empire extending over thirty-two states. The basis for his ability to purchase so many companies was a pyramid holding company structure that heavily favored bonds and preferred stock with a guaranteed dividend. His aggressive acquisition spurred others to similar action, resulting in “eight holding companies controlling 73 percent of the investor-owned electric business.” As cash dried up, Insull also switched from cash dividends to stock dividends, using the inflated stock valuations in lieu of cash to keep the machine going. After a takeover attempt, Insull created two additional layers of holding companies to try and retain control. Stacking these structures created massive amounts of leverage, to the point where he controlled an empire of $500m in assets with only $27m in equity. This leverage was fine in the upmarket, but a market decline would cause significant problems. When asked in a Forbes interview about the leverage in his holding company, Insull responded that “a slump or calamity that would be disastrous [for electric utilities] is practically inconceivable”. 

During the decline of the Great Depression, Utility revenues did hold up better than manufacturing, but even a slight decline caused significant pressure on the company. Insull’s company had pledged its stock as collateral to New York banks, and eventually the company went under when England announced that it was leaving the gold standard. As the banks started uncovering the issues with leverage, the state initiated criminal proceedings, and Insull immediately fled the country, believing there was no way he could get a fair trial. He was eventually extradited and faced trial but was exonerated on all charges. One juror that had served as a sheriff commented he had “never heard of a band of crooks who thought up a scheme, wrote it all down, and kept an honest and careful record of everything they did.”

Now, back to the linked article. The authors had this to say about Insull:

“In late 1931 and early 1932, the country looked on in horror as Samuel Insull’s mighty and seemingly invulnerable electric utility holding company empire collapsed without warning, wiping out the holdings of over 1 million investors, most of whom believed that they had invested in a safe and secure electric utility enterprise… The newspapers of the day declared the event ‘the biggest business failure in the history of the world’.”

In fact, it was the collapse of Samuel Insull’s empire that spurred a wave of securities acts and regulations of the 1930s:

“President Franklin D. Roosevelt and the progressives in Congress subsequently used the Insull debacle as a rallying point from which to promote many of the most important laws of the New Deal, including the Securities Act of 1933, the Securities Exchange Act of 1934, the Public Utility Holding Company Act of 1935, the Federal Power Act of 1935, and the legislation creating the Tennessee Valley Authority and the Rural Electrification Administration.”

As you can imagine, things didn’t work out well for Insull.

However, the primary takeaway from this article concerns the role of regulators and preventing similar debacles from occurring in the future:

“The main lesson that emerges from our analysis is not so much that we need to strengthen laws against corporate wrongdoing. Rather, it is in recognizing that, during a financial bubble driven by rapid growth in network industries (e.g., electricity and the Internet), regulatory officials will almost inevitably buckle under political pressure and (a) fail to issue new rules that might interfere with the financial “hijinks“ and (b) fail to enforce vigorously laws already on the books. This Article suggests that the laws adopted in response to Enron are destined to be watered down and ignored during the next boom, just as the New Deal laws, passed in response to the Insull debacle, were watered down and ignored during the 1990s. The authors reluctantly conclude that history will likely repeat itself in another generation or two, and there is little that can be done beyond vain entreaties to our own grandchildren to become more devoted students of history.”

The End of Gatekeeping: Underwriters and the Quality of Sovereign Bond Markets, 1815-2007

Another interesting aspect of the Wirecard affair was the role (or lack thereof) that credit rating agencies played, and how they were equally duped by management.

Although this article focuses on sovereign debt, the same lessons hold true for corporate bonds.

The role of underwriters today is vastly different than it was in the past. This thought provoking article explores the evolving duties of underwriters and rating agencies over time. Perhaps the best overview is found on page 3:

In the past era (by which we mean the long-run period that began in the early 19th century and ended with the interwar crisis), underwriters provided valuable certification services. They tried to secure prestige by convincing investors that their name was associated with safer products. They did this not for the sake of honesty, altruism, or self-esteem but rather because doing so entailed benefits.

Today is different: underwriters have shed their role as certifiers and have outsourced it to rating agencies. The resulting reduction in liability risk also means that more competitive banks are prepared to issue riskier securities. We suggest that this new situation has given birth to a market for lemons, a market that did not exist in the past. We conclude that the next sovereign debt tsunami will crash on a foreign debt market that is by design more accident prone than its predecessors.”

This stark contrast in the roles of underwriters in each time period has led to what the authors call “the default puzzle”. This puzzle stems from the fact that underwriters used to have a vested interest in how the bonds they underwrote performed, as it could hurt or benefit their corporate brand. This meant that banks acting as underwriters were responsible for carrying out the roles of modern credit rating agencies. If a bank underwrote bonds that ended up defaulting, this would tarnish the bank’s reputation. Investors would ask “How could they fail to see the default risk before deciding to underwrite?”. 

The result was a bond market in which very few ‘junk bonds’ were issued, as underwriters were wary of putting their reputations at stake. The defaults that occurred were generally clustered around the few financial intermediaries that were willing to underwrite the ‘junkier’ bonds, and take on the reputation risk.

BUT! As we all know, credit ratings changed everything.

“The investment banks that became involved in the new market probably welcomed the transformation (they included reincarnations of interwar New York leaders such as JP Morgan or National City Bank).  Fees were now smaller, of course, but liability risk was also reduced. Rating agencies would be the new lightning rod for accusations of financial malpractice. The banks, although undoubtedly informed, would now be able to show to unhappy customers the grades given by (possibly less informed) rating agencies.”

In essence, there’s no longer a need to worry about reputation risk attached to underwriting, because if anything goes wrong, it is the rating agency that is blamed. Consequently, there is now a booming “market for lemons.”

Was Keely the Greatest Fraud of the Century?

I wrote about John Keely’s failed company here, and provide an excerpt below:

“In 1872, John W. Keely, founder of the Keely Motor Company (KMC), announced his newly invented ‘Perpetual Motion’ machine. According to Keely, the machine was capable of providing a new form of energy at an astonishingly low cost.

Not lacking bravado, the charismatic founder boldly claimed that his invention could fuel a round trip train journey from New York to San Francisco using just one quart of water. Furthermore, a single gallon of water could allegedly power a steamship’s voyage from New York to Liverpool, and back.

Unsurprisingly, Keely’s grandiose ambitions attracted investments from around the country. Within a year, Keely had garnered a substantial war chest from investors that were swept up by the inventor’s outlandish promises.

The only problem, however, was that the Keely Motor Company proved to be an elaborate fraud.

Far from successfully inventing a revolutionary machine that would disrupt industries far and wide, Keely had in fact devised a contraption just sophisticated enough to fool those who witnessed his presentations.

Although many scientists at the time publicly questioned his inventions, Keely successfully evaded being exposed during his lifetime. Upon his death, investigators finally learned of his nefarious trickery as they scoured his laboratory.

According to the Philadelphia Press investigation in 1899, the Keely Motor Company:

“Was composed of nearly all the fundamental tones of delusion that vibrate in ill-balanced mental systems: a revelation of nature’s mysteries, the stultifying of current science, a new mechanical contrivance to develop untold power…little more is needed to give Keelyism its proper place in a museum of pathological mental products.”

Most remarkably, over the 26-year period beginning with the founding of Keely’s company, until his death, John Keely never brought his product to market.

Despite the fact that he had first announced his invention in 1872, received investments from numerous wealthy individuals, and even publicly listed the company’s shares, the ‘Perpetual Motion’ machine never came to fruition.

John Keely

“Managers are again applying the thumb-screw…threatening a suit for obtaining money under false pretenses, unless Mr. Keely renounces his plan of progressive research, and gives his time to the construction of engines for the Keely Motor Company” — Bloomfield Moore (1893)

One of Keely’s many tactics for diverting scrutiny from his ‘Perpetual Motion’ machine was to ‘wow’ investors with new inventions, and even more ambitious goals.

However, shareholders of the Keely Motor Company eventually grew weary of the inventor constantly announcing new inventions, since he had not yet completed the ‘Perpetual Motion’ machine that had originally prompted their investments.

Understandably, investors were frustrated that Keely repeatedly turned his attention to new projects, or further research instead of focusing on bringing his original machine to market. Eventually, this discontent resulted in a lawsuit against the evasive founder.

The Keely Motor Company Board of Directors

Media Coverage and Stock Returns on the London Stock Exchange (1825-70)

Like short sellers, the media plays an important role in investigating companies and providing accurate information to investors.

“The main finding of this paper is that media coverage of stocks grows substantially after the emergence of arm’s-length and diffuse ownership in the UK from the mid-1840s onwards. We conjecture that the media were playing an important informational role for the new cadre of middle-class investors which emerged at this time. Consistent with this, we find that there was a discount on media stocks after the mid-1840s, which suggests that by increasing the information available to investors, the press reduced company-specific risk. In other words, as in modern developed country stock markets, there was a media discount in the nineteenth-century London market, but this only emerged after ownership became arm’s-length and diffuse. Therefore, our findings imply that arm’s-length and diffuse ownership may be a prerequisite for the media effect. Indeed, the absence of arm’s-length and diffuse ownership may explain why media appears to have little effect on developing country financial markets today.

Our findings suggest two avenues which could be explored by future scholars. First, our findings highlight the relationship between press reporting and advertisements. Future work should explore the nature of this relationship and whether it was insidious or benign. Second, newspaper reporting on financial markets in our period was factual, which means that an analysis of the tone or language used in newspaper reports is not possible. However, the development of the UK’s daily financial press in the 1880s and whether it influenced financial markets through its use of language is something that future work should explore.”