The Wirecard Scandals
The big financial story dominating headlines in Germany over the last months, apart from Covid-19 of course, is the collapse of Wirecard, a payments processor and onetime proof point that Europe too can nurture Internet giants to rival those in the US and China. Ouch. The fraud perpetrated by its managers is just one aspect of the scandal and by no means the most troubling one.
Please FORWARD this to your friends and colleagues - it's a FREE article.
Feel free to share this with others and on social media.
Or tell your colleagues and friends to sign up for free
Scandal #1
The first and most obvious scandal is that a company was able to become so large by deceiving both customers and investors (I will get to regulators shortly). However, as scandals go, I do not find this to be a particularly big one in this respect. Over its surprisingly long life, Wirecard raised several billion Euro, which are now lost. However, this is small change compared to the benefits conferred on society by a market-based economy, where there will inevitably be a few bad actors. Yes, Wirecard had at its peak a market capitalisation of over EUR 20 bn, which has now largely evaporated. However, if you bought shares at the peak, your money is not gone, as the saying goes, it just belongs to somebody else.
Scandal #2
The second and far bigger scandal, in my view, is that the Wirecard fraud was outside the remit of Germany’s main financial regulator, the BaFin. The debacle was not so much due to a failure of regulation as an absence of regulation. Given the enormous cost to financial institutions of complying with myriad regulations, it is a truly terrifying thought that there is potentially little benefit to society from it. It is like paying for a bridge across the Atlantic only to find the two ends do not meet in the middle.
The cost of regulation is not just the direct expense in the form of the tens if not hundreds of billions of Euros spent annually on compliance (cost that is ultimately borne by customers in the form of higher fees). It is also the hidden cost of the start-ups that never get started as the burden of compliance is too high an entry barrier to negotiate. This has meant that financial services have remained largely in the dark ages whilst other sectors of the economy accelerated into the future.
Scandal #3
The third scandal, perhaps somewhat related to the prior one, is how financial regulation focuses almost exclusively on compliance with its own internal rules, many of which have little to do with the actual substance of how a financial institution behaves. According to this logic, the timely and complete filing of reports, is more important than the actual accuracy of said reports.
In some respects, strong compliance could be a contrarian indicator of bad behaviour as presumably a company that is perpetuating a massive fraud is unlikely to want to draw unwanted attention by getting a speeding fine. By contrast, a company doing its best to do right by its clients may pay less attention to the minutiae of regulation in the belief that the substance of its actions will trump appearances. It would not surprise me if one finding in the aftermath of the Wirecard fraud was that its regulatory compliance was exemplary.
Scandal #4
The fourth and final scandal was that whilst there was nobody policing Wirecard, law enforcement was policing anyone who dared to flag its dubious practices. Blogger memyselfandi007 posted as far back as May 2008 about inconsistencies in Wirecard’s balance sheet. For his troubles, he received a visit from two police officers. He describes the ordeal in a blogpost here. Amazingly, neither those two police officers, nor any other police officers, sought to establish whether there might be any truth to his assertions. Like the BaFin, they apparently did not see it as part of their remit.
To be clear, I do not think that markets do a good job of regulating themselves, and I am in favour of a robust role for regulators, but to the extent regulators abdicate their responsibility, they should at least give everyone else a shot at getting to the truth.
Role of Short Sellers
Without wishing to contradict my point above, I do not see an expanded role for short sellers as a potential solution to prevent future Wirecards. I disagree with the restrictions placed on short sellers by regulators in the case of Wirecard and more generally as well. They throw an even worse light on regulators to the extent that is possible. However, it was ultimately a journalist at the FT who exposed the scandal, not short sellers.
The short selling business model does not dovetail with slow burn frauds such as Wirecard. There were already robust indicators that Wirecard was a fraud in the mid-2000s. By the time the scandal broke in 2020, the share price had gone up 100-fold. An early short seller would have been bankrupt many times over. The best opportunity for short sellers was after the scandal broke, and the stock had been cut in half in a single trading session. By then, it was basically an accepted fact that the company was a fraud, and yet astonishingly the market capitalisation was still almost EUR 10 bn! However, this does not solve the problem of how to expose the fraud in the first place.
I disagree with the characterisation of short sellers as noble warriors fighting for the truth in an otherwise flawed and dangerous world. Although some short sellers do first-class work, they are the exception rather than the rule. Most short sellers that I come across cobble together superficial reports with a sensationalist and blatantly false headline. These reports are designed to panic retail investors and catalyse a drop in the share price. By the time it becomes clear that the accusations were baseless, the short seller has moved on to the next target.
In our portfolio alone, which consists of just ten out of tens of thousands of listed companies worldwide, many have been subject to, in my view, unfounded attacks by short sellers. I do not have a problem with this from a financial perspective. If one of our stocks is down 15% based on an assertion that I know to be false, I will most likely buy more of it. I suspect my fund’s performance would not be as good as it is without short sellers in our companies. It does pain me though to see the life’s work of our managers dragged through the gutter.
A Lesson from the Wirecard Scandal
The lesson from the Wirecard scandal is that we need regulation. However, we need regulation that pays a little more attention to the spirit of the law and a little less attention to the letter of the law. It is not something I am holding my breath for.
Help us grow 🌱
If you enjoy Breezy Briefings, there are three things you can do to help us grow and reach more people. Which would be lovely!
Share it with someone else. Forward the email. Post on social.
Click/tap the little ❤️ icon at the top or bottom. It actually helps.
A further Lesson from the Wirecard Scandal
I recently listened to a podcast with author Matt Ridley in which he discusses the ideas behind his new book “How Innovation Works”. He argues that the missing link between freedom and prosperity is innovation. I do not agree with everything he said. For example, a nomad in the savannah is free but unlikely to be able to innovate, suggesting there are many other factors including the agglomeration of people and the rule of law (regulation, if you will). Nevertheless, I certainly agree that innovation is the secret sauce.
In one fascinating section of the podcast, he responds to the question why China, with a supposedly repressed population, has managed to nurture so many more Internet giants than Europe, where we live in a blissful state of freedom (unless you want to write unkind things about fraudulent companies). His response is eye-opening. Provided they do not say anything mean about the ruling communist party, entrepreneurs in China are given a surprisingly long leash.
In Europe, by contrast, there are enormous restrictions placed on entrepreneurship in the form of regulation. He specifically mentions the example of James Dyson, a British entrepreneur who was hindered for five years from launching his revolutionary bagless vacuum cleaner due to absurd regulation that the power consumption of vacuum cleaners should be measured without dust (regulation driven by the incumbent manufacturers). There are countless other examples he could have given such as financial regulation (the topic of this memo) or GDPR, which is hindering the formation of new Internet businesses in Europe. Beyond the political sphere, we are far less free than we think.
Overbearing regulation leaves me pessimistic about the future of Europe. It is no coincidence that most of the companies in my fund are based outside of Europe. I do not, however, share Matt Ridley’s view that disengagement in general and Brexit in particular is the antidote. Brexit would not have solved Dyson’s problem of how to sell into the European market. Yes, it would have perhaps allowed him to sell earlier outside of Europe, but if the lesson from Dyson’s experience is that regulation is rigged to support incumbents, the implication is surely that the further companies venture from home, the greater the problem is likely to become (in aggregate, if not in every individual case). The correct response in my view is that the UK should be at the centre of Europe, making the argument that there is a trade-off between regulation and growth, and that the pendulum has swung too far in one direction. Sadly though, that ship has sailed.
Footnote
In case you are wondering why my fund never invested in Wirecard, it is not because I had an epiphany after a close reading of its annual report. For that, I would have had to have read its annual report, which I never did. I did not read it because a fellow fund manager warned me back in the mid-2000s that the company had sent a couple of heavies to visit him after he had made a few critical comments about it in public. At the latest, when mafia types enter the scene, it is time for me to get off the bus.
The fund manager in question was a garrulous chap, so I am sure I was by no means the only person privy to his story. It suggests that it was not so much that Wirecard investors did not know about the reputations of its managers, but that they did not care. I do not wish to imply they are bad people. They most likely placed greater weight on other factors, perhaps the stellar growth (whilst it lasted) or its weight in an index. It is a further proof point that the reason investors struggle to evaluate the character of the managers they invest in is not because it is difficult, but because they choose not to.
Robert Vinall is the founder and managing director of RV Capital GmbH based in Switzerland.