Introducing Inquisitorial by Indianaut, a long-form newsletter where we explain and analyze important stories stemming out of the Indian entrepreneurial ecosystem & economy. New articles every Saturday & Sunday.
Corporate frauds happen in many ways, from manipulating account statements, misappropriation of company funds and resources, to corruption, money laundering, etc. These frauds have continued to fascinate the masses as they are often carried out by employees and management entrusted to run the company and continue to happen despite increasing regulatory oversight, self-governance rules, ethics guidelines, and rigorous punishments.
In this piece, we explore what exactly happened at Wirecard, the events that followed, and how a fraud of this magnitude could have been avoided.
Founded in 1999, Wirecard offered electronic payment transaction services on all continents. At its peak, the company was valued at $28 billion and was among the 30 listed companies on Germany’s prestigious DAX stock index. Wirecard, which offered electronic payment transaction services, risk management as well as physical and virtual cards, collapsed on June 25, owing creditors more than €3.5 billion (almost $4 billion) after disclosing a gaping hole in its books that its auditor EY said was the result of a sophisticated global fraud. The company’s new management had been in crisis talks with creditors but pulled out “due to impending insolvency and over-indebtedness”.
(Credits: Reuters)
What exactly happened at Wirecard?
What is now being called “Germany’s Enron” is arguably Germany’s biggest since Volkswagen’s Dieselgate crisis of 2015 and the Siemens corruption scandal of the late 2000s. The Wirecard scandal began just like another accounting fraud where the company was trying to inflate its revenue and profits. For many years, there had been successive complaints regarding accounting irregularities. Financial Times’ investigation into the company’s transactions and business processes and detailed accounts provided by the whistle-blowers alleged that the company had forged its sales transactions and the numbers that it was reporting were, simply, not true. One important aspect of how Wirecard responded to these accusations is to notice the level of unusually aggressive tactics deployed by the firm towards those who raise questions about the company's business operations or accounting. In 2019, the company hired the former head of Libyan foreign intelligence Rami El Obeidi to conduct sting operations against journalists and public short sellers. Mr. El Obeidi presented evidence as proof that Financial Times colluded with short sellers, which the newspaper rejected after an investigation by an external law firm. Later in 2019, the accounting firm KPMG was called in as an outside auditor to run an independent probe.
What we need to understand here is how Wirecard operates and what its revenue model is. The firm operates through third party firms in places like Dubai, Philippines, and Singapore. These third-party firms pay commissions to Wirecard for the contracts they get. Despite owning a bank, Wirecard said that money received from the third-party firms was deposited into an Escrow Account, which on paper was supposed to be held by two banks in the Philippines. These third-party payments turned out to be inflated and made up, as revealed by the KPMG’s Special Audit. The Special Audit mentioned that the forensic investigators could not verify cash balances of €1 billion and were unable to trace vast sums of advances to merchants. The findings led to calls for the removal of Wirecard’s CEO Markus Braun. Subsequent Annual audits by EY failed to verify the existence of €1.9 Billion in these Escrow accounts. The Banking Regulators of the Philippines informed the investigators that the said money never entered the Philippines’ financial system.
On June 25, Wirecard filed for insolvency after talks with creditors failed.
Repercussions of the Scandal
Wirecard now holds the dubious distinction of being the first DAX listed company to go bust, barely two years after it was first included. It owes its creditors around €3.5 billion, out of which €1.75 billion come from 15 banks plus a €500 million issued in bonds, which now seems an irrecoverable amount. Softbank had also invested a sum of $1 Billion as a cash injunction in 2019, for the unavoidable loss of which it holds the auditors responsible and is planning to sue them for damages. With the top management being arrested and now out on bail, Wirecard is being investigated by the German authorities as well the US Justice Department. The auditors i.e. EY is also facing the backlash. German shareholders’ association SDK has filed a criminal complaint against Wirecard’s auditors. The complaint targets two current employees and one former staff member at EY. It comes after law firm Schirp & Partner brought a class-action lawsuit against the accountancy on behalf of Wirecard investors, alleging it failed to flag improperly booked payments on Wirecard’s 2018 accounts.
Could all of this have been avoided?
While companies operate in an environment of trust, it must be acknowledged that major frauds are perpetrated from inside the organization for personal gain by individuals occupying positions of trust and influence in management. A moral hazard exists since the incentive of committing fraud for the individual or the company is often greater than the disincentive of being caught.
Fraud detection systems based on Machine Learning sift through hundreds of transactions and identify questionable transactions. Block-chain can also enhance the fraud detection capacities of companies.
While these systems are effective in identifying errors and mistakes, an employee or a group of employees acting in concert can easily circumvent these systems.
Corporations must foster a culture of honesty and promote ethical behavior. The business environment is becoming increasingly complex where employees find themselves making decisions that have wide ramifications not only for the company but also their own careers. Thus, an easy to understand Code of Ethics and regular workshops on the same can train and educate employees about the Company’s standards and how they can identify and report questionable behavior. Ethics Training should not be conducted in the manner Michael Scott conducted his at Dunder Mifflin Paper Company.
An Internal Audit Committee can maintain effective oversight over employees and Management. Good Corporate Governance must flow from the top. Systems must be built to identify and investigate financial and non-financial frauds. A whistle-blower system must be created that protects the identity of the complainant and meaningfully responds to all complaints in a timely manner.
A bigger and more effective role also has to be played by independent auditors. Recent incidents at ILFS, 1MDB has eroded public confidence in these institutions. An investor survey has found that 57 per cent large investors and sell-side analysts do not have any faith in the Big-4 audit firms as they have lost credibility. Even in the Wirecard scandal, questions have been raised about EY failing to identify and report “unorthodox financial arrangements” as far back as 2016. Had EY, Wirecard’s auditor been more diligent in the audit, they could have asked the Philippines counter-party for proof of cash balance in the escrow account and could have easily verified that the cash never existed in the first place, something which is the auditing norm under normal circumstances. Better accountability and liability for any wrongdoing for the Auditors would have made them more stringent in their verification and auditing process, the only two steps required for identifying and avoiding such frauds.
Regulators need to maintain a more proactive oversight and enhance its capacity to administer speedy prosecution and justice in such situations. BaFin, Germany’s financial Regulator reportedly took more than a year to report Wirecard for suspected market manipulation following a tip-off from a whistle-blower about irregularities at the payments company. Systems need to be overhauled to ensure the erring companies and auditors do not get away with a slap on the wrist but are appropriately penalized.
Dilip Mishra is a B.Com (Hons.) graduate from the University of Delhi and has previously worked with S&P Global Market Intelligence as a Data Researcher.