01 Mar Forward-Looking Fact-Based Fraud Detection System (3/3)
In recent years, Asian markets have witnessed many cases of dramatic share declines in companies where controlling shareholders and directors pledged their shares to banks to secure debts, margin loans or guarantees of issuers. These parties often utilise these loans for personal investments unrelated to the company’s business.
The disclosure of shares pledged and margin loans by directors, controlling shareholders and buy the parties providing the loans is one area where disclosure requirements vary across the different jurisdictions in Asia.
For instance, India (disclosure of shares pledged within 7 working days) and Hong Kong have mandatory disclosure requirements but there are no specific rules in Singapore under SGX Listing Rules or Securities and Futures Act.
Manipulative insiders could use loans secured from pledged shares to do an insider buying of shares say a few million to prop up the share price of the listco which has a market value of a few hundred million. This would create a false signal of confidence in the firm’s prospects and artificially pump up sentiments and share price to reduce the cost of financing of the loans.
These market-based debt covenants secured from the pledged shares are then utilised in other projects in the wider business group or to carry out capital market events, such as fund raising via secondary equity offerings (SEO) or/and debt or prior to the expiry of the moratorium period of shares.
We would like to suggest a couple of critical regulatory and corporate reform to protect the interests of minority shareholders to avoid a repeat of the Davomas saga (See Part 2):
(a) Mandatory disclosure on whether shares of listed companies are pledged, to whom and the details/terms;
(b) Reforms to the opaque and complex shareholding structure to pierce the corporate veil, revealing the identities of the ultimate controlling shareholders. This is done by dismantling the nominee and trust accounts disclosure regime to expose the dalang puppet master and hold them accountable for their actions;
(c) Mandatory disclosures on the other business interests of the controlling shareholders and how the listco is positioned in the wider business group structure;
(d) Mandatory audit of dormant and inactive subsidiaries of listed companies;
(e) Disclosure of the list of companies on the exchange website under the four categories of commonly-used tunneling methods used by actual insiders, manipulators and syndicates to expropriate corporate assets in broad categories: (1) “Intercorporate Loans and Other Receivables” (2) “Capex” (3) “Deals” (4) “Consolidation”;
(f) Redesign the market microstructure by including:
(i) The empirically-tested PRIN measure right next to the share price in the exchange website to inform the investing public about potential price manipulation. The PRIN score is calculated from broker-stock exchange data and can be sorted in deciles from 0 to 1 with a higher score indicating a bigger probability of price manipulation.
The PRIN captures the “principalness” of trades, including wash trades amongst the same small group of collusive parties, and “pump-and-dump” price manipulation scheme; when prices are low, colluding brokers and insiders trade amongst themselves to artificially raise prices and attract positive-feedback traders and once prices have risen, the former exit leaving the latter to suffer the ensuing price fall.
(ii) Order-based cancellation / manipulation score right next to the volume data in the exchange website. Manipulators generate profits by placing and withdrawing limit orders strategically, involving only submission of buy or sell order limit, followed by cancellation of the order before it is executed.
The purpose of the behaviour is to affect the view of other participants. For example, if there are lots of limit buy orders placed at a price lower than the current price, there seems to be strong demand of the stock and a “so-called support” is created.
The Australia Stock Exchange imposes a fee on these unusual unfilled order volume, excessive quoting, phantom quotes and quote stuffing. This practice can be emulated by the Singapore Exchange.
Otherwise, after the dalang has finished chewing the sweetness of the capital lured into the shares, he or she can easily spit out the pulp. As the sagely Warren Buffett puts it aptly:
“But in the end, the only wealth creation comes about through what the business creates. If a company that’s not worth anything sells for $20 billion and 5% of it changes hands, somebody takes $1 billion from somebody else, but investors as a whole gain nothing. They are all fee richer. It’s a very interesting phenomenon. But they can’t be richer as a group unless the company makes them richer.”
Interestingly, the examination of the underlying substance and structure of unusual related-party transactions is neither a feature in audit or financial analysis-related subjects in the university. This is also not tested in the professional CPA and SQP qualification examinations and especially uncommon in the investment industry in Asia. We like to suggest further educational efforts in this area.
We have been asked why do we not invest in this or that company in Singapore that appears cheap in valuation or a potential turnaround story. Of course, we do understand that the best investments are contrarian in nature and could be companies in a turnaround situation. However, there is a critical difference when there are clear accounting irregularities detected in the company.
Our good friend, Mr Hemant Amin, who is a highly accomplished and astute Indian value investor who runs his own multi-million family office Asiamin Capital, would ask a simple yet profound question:
“How much money can you invest in this idea? $100,000? $1 million? $10 million? If there is an iota of doubt about the integrity of the accounts and management, why take a chance when you cannot possibly size up the investment and your time would be better invested in analysing a high-quality business at reasonable valuations.”
An individual may make good money for himself in the short-term by opportunistically betting on companies with creative accounting issues, seemingly a skilful genius, while his investment size remains small.
However, this is akin to pushing a snowball up a snowy mountain which seems easy at the beginning, but gets tougher as the snowball grows bigger, until at one point the investor finds himself in a precarious position when the gravity of the situation turns the snowball onto him and send him tumbling down the slope.
One could make a lot of money nine times out of ten opportunistic bets, increasing his bet size as the profits roll bigger, but it only takes one mis-step to wipe out his capital – and his family’s and relative’s money.
We view such opportunistic behaviour and action unfavourably and believe it is not a sustainable way of investing nor is it an encouraged way of Life. We could know a character by observing the type of companies a fund manager involves himself with, by observing his way of life and by the congruence of his actions & behaviour against his words or proclaimed values.
This is pretty much the same way we would know the character of the management of listed companies. The difference between a businessman and an entrepreneur is that a businessman can always make money for himself but an entrepreneur builds an idea larger than himself to serve others and carry more people on board the bus.
This is what I wrote in a comment to Robert Hagstrom’s article on CFA about “What is the Difference between Investing and Speculation”:
“Investing is the relentless process of translating and refining tacit knowledge into a distinctive and unique investment framework or mental model that is scalable beyond one single person and adaptable in different relevant contextual situations, particularly in dealing with what we do not know.
Investors care deeply about ideas and research. Speculators care solely about “making money”. Writing, research, ideas, knowledge – these are frivolous/useless pursuits with no immediate or short-term profits to Speculators.
Investors have an instinctive longing, to weave outside our own skin, some reflection of our mind. Investors uphold the notion of responsibility, which emphasizes the active nature of the agent/knower, as well as the element of choice involved in the activity of the agent/knower, who can be assessed to be responsible or irresponsible as having fulfilled his obligations to fellow enquirers as part of membership in a community.
Getting closer to the truth as a result of one’s virtues is more valuable for Investors than getting it on the cheap for Speculators.”
We believe the sustainable way of fund management is to build our investment DNA and processes right from the start, deepening the foundation to build a lasting idea and structure larger than oneself. This is met with permanence in generating process-based outcome to serve others and be entrusted to handle greater responsibilities in managing more assets, especially the stewardship and care of the assets of other people.
An asset manager’s single best investment will be the one he makes in his team and I wish to create a productive culture able to stand the test of time; one where the organisation will evolve, but the culture endures.
By building a team with every member aligned with the mission and reinforcing key principles and values, we can best prepare to execute. I will not hesitate to make the team changes we need to thrive and to make the hard decisions to do the right thing for the firm irrespective of external perception.
We will create value with values.