When the elite few put entire societies at risk
South Africans need to take note of the role private sector institutional decay can play in our long-term prosperity in the lead-up to elections
Over the past few months, I have been obsessed with the story of Wirecard, the nowinsolvent German payment processor and financial services provider.
For those who are not familiar with the story, Wirecard was founded in 1999 as a payment processor for internet transactions. In the early years of internet commerce, gambling and pornography were the two main industries that required safe and discreet payment support and so, by the mid-2000s, they were the company’s main income stream.
Using what might have been questionable financial statements, the company was able to raise over €500-million by 2015, and this is around about the time when the Financial Times’s Dan Mccrum started reporting on inconsistencies in the company’s financial statements, including a “black hole” of approximately €250-million in its balance sheet.
What is most interesting for me about the Wirecard story is the reaction of both the market and the German financial regulators. Despite unrelenting reports from the Financial Times and short sellers about its dubious finances, the company’s share price rose astronomically, moving from just under $50 in January 2016 to a record $223 in late August 2018. This was helped by a clean audit provided by accounting firm EY.
Stock traders who pride themselves on their rationality refused to engage with new information about the company, even as the company rallied its way into the Dax 30 index. Instead, many of them took to social media to attack FT journalist Mccrum, accusing him and the publication of being in bed with short sellers. Moreover, German financial regulator Bafin chose to investigate the FT and its journalists for market manipulation, rather than investigate the veracity of the accusations.
The entire scheme would be revealed after another FT expose showed how the company was inflating profits, forcing the shareholders to appoint KPMG to conduct a special audit. With KPMG unable to verify at least €1-billion of cash, and EY stating it could not accept the documents provided by the company to verify €1.9-billion in assets and sign the audited financial statements, the company finally acknowledged the “black hole” and promptly declared insolvency.
There are several lessons one can take away from the Wirecard saga, all of them pointing to the importance, and the deterioration, of key institutions in capitalist markets. First, many have highlighted the oversized role of the Big Four auditing companies — that is KPMG, Pricewaterhousecoopers (PWC), Deloitte and Ernst & Young (EY) — in some of the biggest corporate fraud cases in the world, from Enron in the early 2000s to Wirecard recently.
The role of auditing companies is to provide a level of assurance that the financial statements of a company have been produced in accordance with an accounting framework and do not include any substantial misstatements. This level of assurance is particularly important for listed companies because it forms part of the basis for institutions such as pension funds to trade a stock.
In Wirecard’s case, the assurance from EY gave its stock momentum to enter into the Dax 30, spreading the risk into investor groups which trade more prudently.
How can large, high-profile, listed firms be dissolved overnight because management has fooled auditors with false assets and off-the-books bookkeeping?
There is a cynical view that auditing companies have been increasingly operating right at the edge of ethics, often crossing the line. EY, PWC and KPMG were recently fined for test cheating by US, Canadian and Australian employees. Staff shared answers on internal tests and tampered with testing systems to minimise the number of right answers required to pass.
Ironically, EY was fined more than $100-million by the US Securities and Exchange Commission because its employees were cheating on ethics exams.
In many instances, partners in auditing firms are part of the fraud, such as was the case with VBS Mutual Bank in South Africa.
The other institutional failure in the Wirecard saga was that of Bafin, the German financial regulator. In his book Money Men, Mccrum goes into extensive detail on how Bafin officials protected the company, despite evidence that should have prompted the contrary.
In 2019, local police raided the company’s Singapore offices as part of their investigation into alleged fraud. In response, Bafin restricted investors from betting against
Wirecard shares to protect its value and attempted to criminally charge the two FT reporters who covered the Wirecard story.
Throughout the period in question, the regulator chose a nationalistic point of view, ignoring the importance of objective supervision and oversight for systematically significant institutions, which Wirecard had become. The regulator conflated the protection of Germany’s reputation with the protection of the German financial system.
The company’s governance bodies also failed. Shareholders were not adequately represented on the Wirecard board and governance committees. Instead, people were picked based on their personal relationships with chief executive Markus Braun and his close lieutenant and chief operations officer Jan Marsalek. Therefore, without any real independence, the board could not do an effective job.
Whether it’s Wirecard, Wework, Theranos or Steinhoff, increasingly we are seeing what should be independent institutions fall under the charm of charismatic private sector leaders and fail in their duties of oversight. Capitalism is creating outsized institutions with the power to ignore rules, while small players and individuals have to follow under the risk of consequences.
In the case of Wirecard, Braun and Marsalek only faced risk of prosecution once the company was declared insolvent, and not a moment before, and this gave Marsalek the opportunity to flee to Russia.
Certain institutions are meant to be guardrails to keep the system fair and in check. But the increasing ease with which they can be captured by a few wealthy men puts entire societies at risk.
Many of us believe these are the problems of rich people, forgetting that our retirement funds are used to buy these stocks, thus tying our future comfort and independence to their success.
When certain institutions fail in their assurance and oversight roles in the economy, the result is the money we think we are putting away for the future might very well disappear.
PWC, for example, revealed that Steinhoff had reported fraudulent or irregular transactions worth $7.4-billion between 2009 and 2017, destroying stock value that affected many pension funds.
This is as true of auditors and financial regulators as it is of the police services, Transnet or Eskom. This is why we need to pay attention.
My choice to use a private sector and European example was very deliberate.
As South Africans, we know institutional decay when it comes dressed in public-sector clothing, but many of us ignore the damage that private-sector institutional decay can play in our long-term prosperity. Many of us are oblivious to the symbiotic relationship between private and public institutional decay.
Public institutions derive much of their power from the political economy. It is now commonly understood in economics literature that strong institutions are a strong indicator of economic growth and development. The extent to which public institutions can be effective is, however, closely tied to the perspective that the governing party takes on the role and function of those institutions which is not only reflected in legislative mandates, but also in the political support institutions receive as they conduct their duties.
Public institutions are also where citizens, through their electoral power, have the most agency to intervene. As we move towards the national elections in 2024, we should pay closer attention to each party’s position on critical public institutions, very selfishly so.
We should pay close attention to their proposed strategy on building objective, independent and effective institutions that can safeguard us against more Eskoms and Steinhoffs.
When institutions fail in their oversight roles in the economy, the money we think we are putting away for the future might disappear