Oh My Fraud

Attention: This is a machine-generated transcript. As such, there may be spelling, grammar, and accuracy errors throughout. Thank you for your understanding!

Caleb Newquist: [00:00:00] I recently came across a quote about fraud that I really like. It comes from Weiss v United States, a 1941 case heard before the fifth Circuit Court of Appeals, and it was written by Edwin R. Holmes. It reads, The law does not define fraud. It needs no definition. It is as old as falsehood and as versatile as human ingenuity. Now, I don't know if the first part is technically true. Maybe the law didn't define fraud in 1941, and I don't know if I agree that fraud doesn't need a definition. At the very least, a definition is helpful. I do agree. And like the bit about how fraud is as old as falsehood and as versatile as human ingenuity. Fraud is everywhere happening all the time. It's probably been around since our ancestors were hunting and gathering. Nowadays it comes in many forms and its only limits seem to be how creative and brazen someone is willing to be. So it's tough to get your head around just how much fraud is happening out there at any given time. Fortunately, there are some people out there trying to get their heads around it, and a recent paper they wrote tried to pin it down. And spoiler alert, it's a lot.

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Caleb Newquist: [00:01:37] This is On My Fraud, a true crime podcast where the devil is in the details instead of someone's heart and soul. I'm Caleb Newquist, And.

Greg Kyte: [00:01:45] I'm Greg Kite. And I. The devil is in both my heart and my soul.

Caleb Newquist: [00:01:50] Taking up permanent residence.

Greg Kyte: [00:01:52] It's a yeah, it's not a it's not a vacation rental. It's more of a long term situation.

Caleb Newquist: [00:01:57] Long term rental.

Greg Kyte: [00:01:58] Yeah.

Caleb Newquist: [00:01:59] Oh, Greg, you've done such a.

Greg Kyte: [00:02:01] And that motherfucker's not getting his deposit back.

Caleb Newquist: [00:02:05] Good, good. Greg, have you ever been a victim of fraud? Like, did you ever try to help a Nigerian prince or over email or or lose a bunch of money at a three card monte table or something like that?

Greg Kyte: [00:02:18] I I've never been defrauded per se. I'd say at the worst, I've been bamboozled, like, oh, yeah, like I was in the Philippines last December and I paid about ten times the going rate for what was supposed to be a taxi, but ended up just being a really shitty Uber. So, so stuff like that's happened to me. But again, I don't know if I, if I would define it as fraud. I think it was just people taking advantage and naivete. But, but who knows, maybe that does creep into the area of fraud. I will say this the company I work for has been the victim of fraud. And you and I together have decided that we're too scared to talk about the $600,000 that somebody took from my employer in a not so sneaky way. But. So, yeah. Are we too scared? I thought you were too scared. You were like, am I? I'm not. I'll talk about it.

Caleb Newquist: [00:03:16] Well, not on this episode.

Greg Kyte: [00:03:17] And enough. Allegedly. We'll just say. Allegedly. Enough. Think. Get away with it.

Caleb Newquist: [00:03:20] Allegations. Yeah.

Greg Kyte: [00:03:22] We'll have the oh, my fraud lawyers look at it and make sure that it doesn't you know get into the the the libel or slander slander area.

Caleb Newquist: [00:03:34] Yeah. All right. Anyway, sorry to throw you off track there. So you never so like, for example, like nobody like you never had any unapproved transactions hit your bank account or a credit card or anything like that.

Greg Kyte: [00:03:50] I mean, I think I did along. I kind of vaguely remember something a long time ago where somebody bought like some kitchen equipment and like a wedding dress on one of my cards. But. Oh, yeah, but but it didn't it didn't take because, like, the credit card company was like, yeah, those were fraudulent charges and they reversed it. So I, you know, a victimless crime, I guess.

Caleb Newquist: [00:04:12] Yeah. Yeah. Somebody got a wedding dress.

Greg Kyte: [00:04:15] I guess so. And some kitchen equipment. Hopefully they're cooking themselves a nice a nice buffet for their wedding.

Caleb Newquist: [00:04:23] Yeah. I mean, maybe I'm overstating this, but again, maybe I'm not. But I think virtually everyone has been a victim of fraud at some point or another, even if it's just something small, like, again, somebody buying, you know, somebody got your credit card number and they went to, you know, they they withdrew 500 from the ATM and before it got shut off or something like that.

Greg Kyte: [00:04:47] Bought some gas. And and I'm not saying there wasn't hassle when that stuff happened. Sure. There wasn't a like a financial consequence to me of that happening, which was fortunate. I feel fortunate for that.

Caleb Newquist: [00:04:59] Right. Right. That's that's a fair way to put it. Like, like when your bank kind of makes you whole and banks almost always make you whole. Yeah, it's like, yeah, that was fine. Like, maybe I'm not a victim of fraud, but we're kind of victim. I guess maybe the bank is a victim of fraud.

Greg Kyte: [00:05:15] Yeah. Yeah.

Caleb Newquist: [00:05:16] It wasn't ultimately who bears that cost. I mean.

Greg Kyte: [00:05:19] Listen, I don't. I don't have a LifeLock subscription, so that's. That's the true measure of how bad someone's been a victim of fraud. Is it to the point where you got a LifeLock subscription, then you got screwed? For me, it's just been just been a little, you know, just like some fraud confetti thrown at me. But it didn't really get my hair right.

Caleb Newquist: [00:05:44] Yeah, but I think when you think about cybercrime and like, bank hacks and whatnot, it just feels like everybody's been touched by it in some way. Yep.

Greg Kyte: [00:05:52] Yeah. There are so many fraud stories out there. We'll definitely never run out of new stories for episodes of this podcast. I'm more worried about me not wanting to work anymore than I am about fraud. Not happening.

Caleb Newquist: [00:06:07] Anymore. Yeah, I kind of feel the same way. Man's desire to rip off widows and orphans is going to long outlive my work ethic.

Greg Kyte: [00:06:16] Yeah, well put.

Caleb Newquist: [00:06:18] Well put. But on this podcast, we've joked we've joked a few times that we'll never know who the smart fraudsters are because the smart ones never get caught. Right. Yeah. And I and I think the fraudsters that don't get caught, I don't know if we've said this exactly, but they're also incredibly lucky, too. And I guess I got to thinking about Bernie Madoff and his Ponzi scheme, and he carried that fraud. He carried that on for like 20 years. Right? Over 20 years with virtually no one knowing about it. Yeah. And I mean, obviously, people knew about it in his inner circle, but the outside world, nobody knew about it. And he got lucky in a couple of ways. The Securities and Exchange Commission ignored Harry Markopolos. He was the financial investigator who first blew the whistle on Madoff. They totally ignored his, you know, his warnings about this and, hey, go look into this. And I would.

Greg Kyte: [00:07:09] Say that's lucky because.

Caleb Newquist: [00:07:11] That's super lucky.

Greg Kyte: [00:07:11] Yeah.

Caleb Newquist: [00:07:12] Yeah. And what ultimately took down his Ponzi scheme was the largest economic collapse since the Great Depression.

Greg Kyte: [00:07:20] Right.

Caleb Newquist: [00:07:22] Right.

Greg Kyte: [00:07:23] It took it took an incredible, like global amount of bad luck for everyone for it to to wipe out his good luck that he'd had over the last 20 years.

Caleb Newquist: [00:07:34] Right. And guess what? The point I'm trying to make is that there is fraud going on all the time that people just don't know about it. Absolutely. Like like frauds going on now. Yeah. Like why we're talking like, right now. Yeah. And because we don't know about it, we don't really have a good sense of just, like, how widespread its effects are.

Greg Kyte: [00:07:57] Yeah. And I remember, I mean, if we're talking about fraud quotes, I can't remember where I saw it or who said it, but it was something along the lines of if these people weren't, if these people committing fraud, weren't so greedy, they wouldn't get caught, which I think is hilarious because. Because what else are they being if they're committing fraud but being. But but I get what the point is. It's like if they if they just didn't go harder and harder into their fraud, then they could have kept it going indefinitely. Indefinitely. And that's the thing we see. I mean, even, you know, we've talked about this. It's the it's one way to look at your financial statements and look at any vendor and make sure that they're not growing like in in huge leaps and bounds year to year, just vendor to vendor, because that's a that's a reasonable that's something you need to look into more closely. That might be a something that indicates that fraud is happening. And that's because you can see in these cases that people will start stealing at a literally exponential rate once they once they're going, oh, I didn't get caught stealing, you know, 100,000. So next year I'm going to do 200,000. Next year I'm going to do 400,000. And and that's how that's how it goes. Yep.

Caleb Newquist: [00:09:14] So there's this new paper. By Alexander Dyck of University of Toronto. Adair Morse of the University of California at Berkeley. And Luigi Zingales think I'm saying that, right? Of the University of Chicago. And they attempted to quantify how pervasive corporate fraud is. And Greg, do you have any guesses as to what the name of their paper is?

Greg Kyte: [00:09:41] Uh, let's see a paper that it's attempting to quantify how pervasive fraud is. My guess is it's called we bought a lot of beer with the grant money we were supposed to use studying fraud, which demonstrates the ubiquity of fraud. Is that. Is that it? Did I get it?

Caleb Newquist: [00:10:00] Yeah.

Greg Kyte: [00:10:01] Nice.

Caleb Newquist: [00:10:01] I wish. I wish that was the name of the paper. That's academia. Could use a little bit of. Yeah. Levity.

Greg Kyte: [00:10:08] We we defrauded the Illinois Board of academics who was handing out grants and.

Caleb Newquist: [00:10:14] Well, this would be. This would be an international.

Greg Kyte: [00:10:16] Oh, academic.

Caleb Newquist: [00:10:17] Scandal. This would be because of the University of Toronto.

Greg Kyte: [00:10:19] Oh, right. That'd be a big. Anyway, that really that really proved their point.

Caleb Newquist: [00:10:23] It would, Yeah. No, no, Sadly, the the name of the paper is How pervasive is corporate Fraud?

Greg Kyte: [00:10:30] Oh.

Caleb Newquist: [00:10:31] Well.

Greg Kyte: [00:10:33] Mine's better.

Caleb Newquist: [00:10:34] It is. I agree. Anyway, so the way these guys explain it is they use the old tip of the iceberg adage. You know, the idea that the tip of an iceberg is the part that's above the surface of the ocean, that we, the doomed passengers of the Titanic, can see. It's small, it's relatively harmless looking. And we figure if we keep a safe distance away from it, we'll be fine. Right. Right. But what we should all really be worried about is what lurks beneath. Yeah.

Greg Kyte: [00:11:08] Well, I think that's. That totally makes sense, because the. Because you should be more afraid of the fraud that goes undetected and.

Caleb Newquist: [00:11:19] Yes. And why is that, Greg?

Greg Kyte: [00:11:21] Because. Because if it goes undetected, it's the stuff that's detected means that it's also stopped.

Caleb Newquist: [00:11:27] Stopped?

Greg Kyte: [00:11:28] Yep. And the stuff that's undetected, you continue to get. It's. Yeah, it's like a it's like the, the fruitcake fraud where they, they kept going, We're doing our best and we're still just not getting out of these mediocre results. What is happening here. And, and it was like oh oh we've been this guy's been stealing but tons of money from us all the time. So yeah, you want to you don't you don't want it to go. I mean, that's the whole thing. If it's underneath, it's undetected. An undetected fraud is what's going to continue to, to, uh, it's the cancer on your business that you need to root out, right?

Caleb Newquist: [00:12:02] So, in other words, the iceberg that's below the surface, we don't know anything about it until it strikes when we're least expecting and it sends us to an icy, watery, but very romantic death. Right. And as we kind of just established, that's how fraud is. Yeah.

Greg Kyte: [00:12:21] You probably won't even get the opportunity to be painted like one of Jack's French girls.

Caleb Newquist: [00:12:28] Right? Yeah. But I think you mentioned the fruit story. Uh, I've. I don't know what episode it is.

Greg Kyte: [00:12:34] Episode episode Christmas time.

Caleb Newquist: [00:12:37] Yes. There you go. Christmas special episode, that one. That's a good example of where the fraud undetected there. It was having an impact on that business. And people were making decisions. Yeah. Based on circumstances that they thought were real but were actually a circumstance of circumstances of fraud. Right.

Greg Kyte: [00:12:56] Well, and, and also it brings to mind, uh, Dixon, Illinois with Rita Crundwell. Yeah. Where is that? Because didn't that one go on over 20 years.

Caleb Newquist: [00:13:05] Which was over 20 years. Yeah.

Greg Kyte: [00:13:07] And, and do you remember where there was the. There was a city of comparable size not too far from Dixon. We're going, we're doing great. What's why does Dixon have to borrow Dixon's problem? Right, exactly. And it was like, well, I mean, same kind of thing. And they're like, oh, we don't know. I guess government's complicated. And it was like, oh, no. The lady who who is running this quarter horse empire that doesn't that shouldn't need a $50,000 a year job is still at your $50,000 a year job every day because that's how she's feeding her quarter horse empire.

Caleb Newquist: [00:13:39] That's right. So in their paper, Dick Morris and Zingales mentioned that studies have tried to do this before with various methods, but these guys came up with a clever new way to estimate it. They used one of the most infamous events in the history of American business, the failure of Arthur Andersen.

Greg Kyte: [00:14:01] Now, before you finish yawning and decide to listen to another podcast because stop this podcast. Arthur Andersen Right. Over the last 20 years. Just just stay with us. So these eggheads, they use the failure of Arthur Andersen to figure how much fraud is going out there and the big bad fraud world. But before before we get into their methodology and their conclusions, may maybe you listener are new to the fraud space or maybe you are a member of Gen Z and weren't alive 20 years ago when Arthur Andersen and Enron happened. And you're like, Tell me more about this Arthur Andersen person. Who was he and what did he do? So real quick, Arthur Andersen was a multinational accounting firm based in Chicago. Everyone knows about the big four accounting firms. Well, it used to be the big five because Arthur Andersen was still around. So why isn't Andersen around now? I'll tell you why. In the late 1990s and early 2000, a lot of Andersen audit clients were doing some pretty dodgy stuff with their accounting, but Andersen signed off on the numbers anyways, at least in part because they didn't want to jeopardize the lucrative consulting contracts that they had with these clients.

Greg Kyte: [00:15:17] Wait, you might be asking. Auditors can have consulting contracts with their audit clients who they're supposed to be independent of in both fact and appearance. Well, they used to, but we don't have time to get into that now. And some of these clients, most notably Enron, went bankrupt because people were like, Yo, Andersen, what's going on? And Andersen was like, uh, we're sorry. So in June 2002, Andersen was convicted of obstruction of justice for shredding documents related to its audit of Enron because the Securities and Exchange Commission cannot accept audits from convicted felons, the firm agreed to surrender its license and its right to practice before the SEC. This, along with a bevy of scandals surrounding it, put the firm out of business, even though the conviction of obstruction was later overturned by the Supreme Court of the United States. And unfortunately, we don't have time to get into that now either. Okay. So now back to the original question. How could these guys use the failure of Anderson to figure out how much corporate fraud is going on that we don't know about? Great question.

Caleb Newquist: [00:16:22] Great question.

Greg Kyte: [00:16:24] Well, we're going to summarize this. And and it's because it's actually surprisingly simple. But if you want the more complicated explanation, we've got a link to the paper in the show notes. And if you've got an extra two hours and an extra 20,000 brain cells that you'd like to forfeit for, reading through this incredibly boring paper, feel free to click on that link. But here's here's here's the Greg and Caleb summary. Arthur Anderson fell to shit and they didn't exist anymore. So all the old Arthur Anderson clients had to go find new auditors. And because of Arthur Anderson's failure and because of all the shenanigans of Arthur Anderson's former clients, all these people who used to be Anderson, clients were like subject to this incredibly detailed scrutiny, not just by their auditors, but also by investment intermediaries, short sellers and other internal gatekeepers. And because there was so much suspicion about these clients, the new auditors had even stronger incentives than they would otherwise to uncover any kind of fraud committed by these former Arthur Anderson clients. So what the researchers are basing on is like if ever there was a time that auditors were going to find fraud, it would be with these former Arthur Anderson clients. And then they use this thing called the Kolmogorov axiom of conditional probability, which is some real.

Caleb Newquist: [00:18:06] Math nerd shit.

Greg Kyte: [00:18:07] Real math nerd shit, which they said gave them a very conservative estimates of of not like conservatively low estimates of detection likelihood and then a conservative view of just the pervasiveness of corporate fraud that goes undetected. Yeah.

Caleb Newquist: [00:18:26] Does it make sense to you, Greg? Like, I mean, I read this thing, believe it or not. I mean, how do you like do you feel like like at a high level, it makes sense. Like, I don't understand the fucking axiom of conditional probability, to be honest.

Greg Kyte: [00:18:42] I'll be honest. I have a math degree and I took multiple probability classes and I'm sure I studied this axiom at some point, but it's long since been forgotten.

Caleb Newquist: [00:18:51] But I mean, I think but the overarching premise is that you have this unique event happen, right? The failure of. Anderson Yeah. You had scores, maybe hundreds, probably hundreds of businesses that had to go out and find a new auditor. Yeah. And that that just doesn't happen every day. Right. And the circumstances around that failure would would would cause people to be suspicious because of the nature of the circumstances. Yeah. And so therefore, detecting fraud, it's more likely that fraud would be detected in the aftermath of that failure. That's what they're saying.

Greg Kyte: [00:19:33] Yeah. And I would say, well, because there's two things that are true and we know this fresh eye is catch more bullshit. So that that's.

Caleb Newquist: [00:19:42] Is that the expression?

Greg Kyte: [00:19:43] Yeah. That expression that was, that's, that's actually in the auditing standards, uh, the codified auditing. So you can look it up. But the so, so you've got not just fresh eyes, but you've got people. The whole idea is if ever there was a time when frauds would get caught, it's in that unique circum set of circumstances after the failure of Arthur Andersen. And if nothing else, and I think this is really where these researchers were going is in no way would there be fewer frauds detected in that in that sample that they're looking at specifically.

Caleb Newquist: [00:20:22] Right.

Greg Kyte: [00:20:23] So the authors used four ways to identify detected frauds. So one of the ways was auditor detected frauds, just plain and simple. The external auditor found cases of fraud with these Arthur Andersen, their former clients. The second one was the SEC accounting and auditing enforcement releases, where the SEC was like, Hey, here's some shit that went down. The third way was financial misreporting, not due to simple clerical errors. In other words, that's when one of these companies would would go through the process of restating their own financial statements. And then the fourth one is all securities fraud under. Sec. Section ten B-5.

Caleb Newquist: [00:21:14] So, Greg, correct me if I'm wrong here, but it seems to be that they are casting a wide net in terms of what constitutes fraud.

Greg Kyte: [00:21:24] Yeah. There and even arguably, they were looking at all of these different ways. This is how I read the paper. They're looking at all these different ways to identify detected frauds. And again, they're going for a conservative approach. So they're trying to find the one or the combination of factors that really they can they can feel like they've got a very solid case for making the conclusions that they're coming to in the paper. Right. The authors wrote that, quote, Our estimates represent an upper bound for the detection likelihood, which implies that our estimates of unobserved fraud are conservatively low. So whatever they're saying, they're like going, this is like at minimum, what we're not seeing, that's what they're trying to go for, is it's like everything was so conservative. There's no way you can shoot down our conclusions because it's at least this much. Then they conclude fraud is indeed like an iceberg with significant undetected fraud beneath the surface, near far. Wherever you are, the fraud will go on.

Caleb Newquist: [00:22:42] Okay, so how much fraud is below the surface? Keeping in mind that they were observing data in the aftermath of Andersen's demise. The authors estimate that in an average year, 10% of all large public corporations are committing a misrepresentation in information, omission or another misconduct that can lead to an alleged securities fraud claim settled for at least $3 million. And they have a 95% confidence interval between 7 and 14%.

Greg Kyte: [00:23:12] Which and blah, blah, blah. They're just saying their whole thing is 10%. I think the big takeaway, 10% of large public companies. Yeah. Are committing some fraud.

Caleb Newquist: [00:23:23] And their 95% confident, about.

Greg Kyte: [00:23:25] 95% confident if you if you expand the interval if you remember your if if you go a little bit above and a little bit below 10%, they're like, oh, we're super confident in this range.

Caleb Newquist: [00:23:34] Okay. They also estimate that 41% of companies misrepresent their financial reports even when ignoring simple clerical errors. Now, the authors do say, quote, We do not want to conclude from this estimate that each year 41% of large corporations commit a severe misreporting. To reach this conclusion, we would need to we would need some more substantive filters to eliminate inconsequential misreporting. Nevertheless, the estimate does not bode well for the US auditing system. In spite of all the regulation, roughly half of the US financial statements suffer from misreporting more serious than pure clerical errors.

Greg Kyte: [00:24:12] That's a big damn deal. And again, seems like definitely even if it's not fraud, that's that's unquestionably audit failure. If two out of five financial statements are just wrong, that's whether it's fraud or whatever, that's they're at least pointing out a massive audit failure.

Caleb Newquist: [00:24:33] Yeah. The authors then compared their main finding that 10% of large public companies committing some kind of fraud with the academic literature. And they found that, quote, Our estimate is at the low end of the pervasiveness of corporate fraud found in the literature. So. There. Like you said, at a minimum, this is probably what's happening or this is their estimate. At a minimum, 10% of these large the large businesses. And there's a technical definition that I'm not going to get into, but like don't. But 10% of those businesses are committing some kind of misrepresentation.

Greg Kyte: [00:25:12] And that's and that in and of itself, that's huge. That's that seems.

Caleb Newquist: [00:25:16] Like a lot.

Greg Kyte: [00:25:17] That's ridiculous.

Caleb Newquist: [00:25:18] Yeah. Okay. And so to take the numbers a bit further here, they figured that the detected frauds account for one third of all the cases and cost 25% of the company's market value. Okay. Gotcha.

Greg Kyte: [00:25:35] So, so to, to restate that, for every fraud detected, there was two frauds that went undetected.

Caleb Newquist: [00:25:43] Right? So next point, undetected represent two thirds of the cases and the cost is 10.9% of the market value. Okay.

Greg Kyte: [00:25:51] Which kind of makes sense also, because if it's undetected, again, it was probably people not getting greedy with their greed and keeping stuff on the down low. So it's not hurting the business as much. Right.

Caleb Newquist: [00:26:03] But the stock may still underperform, hence the cost of 10.9%. It may still underperform because there's a short seller out there who's kind of like, Yeah, I know what they're doing. Yeah. And like, right. But it isn't wide. It isn't widely known. Right, Right. Virtually undetected. Yeah, right. That makes sense. There might be.

Greg Kyte: [00:26:25] A hint, a whiff of it going around, but nobody's nobody's nailed them.

Caleb Newquist: [00:26:29] Right. Okay. The average cost of the fraud is 15.6% of the company's market capitalization.

Greg Kyte: [00:26:38] Right. And that's like the weighted average between their detected frauds and their assumed undetected frauds. Yep.

Caleb Newquist: [00:26:44] And you can double check their math in their paper if you did. You did.

Greg Kyte: [00:26:47] I knew it. I don't know. Kolmogorov's conditional axiom of probability, but I can do some bad ass weighted average goddamn arithmetic. If it's eighth grade math or less, I kick ass at it.

Caleb Newquist: [00:27:03] All right. Awesome. So if 10% of the companies are committing fraud, remember, that's the big finding. Yep. That means that the cost of fraud is 1.6% of equity value per year.

Greg Kyte: [00:27:16] Gotcha. That makes sense. Because if they're saying fraud 15.

Caleb Newquist: [00:27:21] 15.6%.

Greg Kyte: [00:27:22] We'll round it to 16%.

Caleb Newquist: [00:27:24] Right?

Greg Kyte: [00:27:25] That's the loss.

Caleb Newquist: [00:27:26] And 10% of the companies are committing fraud every year.

Greg Kyte: [00:27:29] So you take one tenth of 16% and you get 1.6%.

Caleb Newquist: [00:27:33] Bingo of the equity value.

Greg Kyte: [00:27:35] That's seventh grade math. I'm so on top of this.

Caleb Newquist: [00:27:37] It is decimals or as they said in The Incredibles, domiciles.

Greg Kyte: [00:27:42] Math is. Math is math.

Caleb Newquist: [00:27:46] So in 2004, the total market cap of the US equity market was $16 trillion. And so that puts the annual cost of corporate fraud somewhere around $254 billion in 2004.

Greg Kyte: [00:28:04] Back in 2004.

Caleb Newquist: [00:28:05] Back in 2004. Yeah. And here from the paper, quote, Combining fraud pervasiveness with existing estimates of the costs of detected and undetected fraud, we estimate that corporate fraud destroys 1.6% of equity value each year, equal to $830 billion in 2021.

Greg Kyte: [00:28:26] Right. So the big takeaway is 10% of businesses are committing fraud. And the loss for shale for really for shareholders is $830 billion in 2021. Now, Caleb, one thing I can appreciate about all this complicated academic research crap is that the authors attempted a cost benefit analysis. Ooh. Yeah. So, in other words, they tried to put these massive numbers into a context that maybe a CFO or some corporate executive might be able to use in some practical way. And how exactly did they do that? Great question. They used the often maligned legislation known as Sarbanes-Oxley. And if you're not familiar with that, it's also known as SaaS Box and Sox. If you're lazy and it was passed into law in 2002, in response to the flurry of corporate and accounting scandals, including Enron and Arthur Andersen and Worldcom and others, all those preceded this legislation. And like many other things in this episode, we can't get into the nitty gritty details of Sarbanes-Oxley right now. However, with the passage of Sarbanes-Oxley came a wave of new regulations with which public companies had to comply, which naturally, of course, led to higher compliance costs. And these new costs to comply were considered by so many people to be overly, how shall we say it, costly and burdensome. And yes, and and this is a direct, quote, giant pain in my ass. And you may you may even remember if you're a studious listener of oh, my fraud, that back in episode 24, Michael Koss, the chief executive of the Koss Corporation, expressed his doubts about complying with all the additional rules that were required by Sarbanes-Oxley. Conversely, there have been many fervent defenders of Sarbanes-Oxley since its passage over 20 years ago, the feeling being that requiring companies to regularly assess the quality of their internal controls for auditors of public companies to have their work closely inspected, among many other new regulations, has greatly benefited investors. So maybe reasonable people can disagree. But I think it's fair to say that using the cost of Sarbanes-Oxley is a perfectly fine way to do a cost benefit analysis. Do you do you agree, Caleb?

Caleb Newquist: [00:31:12] Do you I'm asking you, Greg, do you really feel that way? I wrote those words. I put the words in your mouth.

Greg Kyte: [00:31:19] I, I will speak more of this in the lessons learned. Okay.

Caleb Newquist: [00:31:24] Very well. I would say here's what I would say. Yeah, if I may.

Greg Kyte: [00:31:28] Please.

Caleb Newquist: [00:31:28] The the cost of implementing Sarbanes-Oxley was costly.

Greg Kyte: [00:31:36] Exorbitant.

Caleb Newquist: [00:31:37] Yeah. Yeah. It cost people a lot of money and people were plenty upset about it. Yep. And so it seems, it seems appropriate that this would be the focus of the cost benefit analysis. Yeah. I mean, you could certainly do worse.

Greg Kyte: [00:31:53] You in terms of. Yeah, no, I think it's a great way to look at it, especially once you quantify what you think the loss due to fraud is among public companies. Yeah, it's a great it's a great little math problem to do at the end of your very rigorous and nerdy research and calculations.

Caleb Newquist: [00:32:14] Right.

Greg Kyte: [00:32:15] And as a matter of fact, Caleb, if I may, the authors themselves even say this as an illustration of the wide applicability of our estimates, we sketch how it can be used for a cost benefit analysis of Sox. Note that reducing agency costs is only one of the benefits of Sox. So after reading that quote, it's probably worth noting here exactly what agency costs are.

Caleb Newquist: [00:32:47] Confession. I was not familiar with this idea of agency costs before.

Greg Kyte: [00:32:52] It's yeah, it's not. It's not the extra amount that you have to pay a travel agent to put together your dream vacation. Southern Italy Dream vacation.

Caleb Newquist: [00:33:06] Okay. It's good. Oh.

Greg Kyte: [00:33:08] The easiest way to think about agency costs as we're talking about it is that agency costs is when someone who's not an owner of a company, for instance, let's say a manager, maybe they own just a little tiny chunk, but for the most part, they're not a major investor in the company. Just think of them as a manager. So that person has both the opportunity and the authority to make decisions or take actions for the company. And these decisions are shit. And because of their shit decisions, they cost the owners and shareholders money. That's agency costs. For example, if management conducts an elaborate fraud to pump up the company's share price and then sells a bunch of shares for millions of dollars only to have the fraud be found out, which in turn costs the shareholders millions of dollars when the share price tanks. That is very much exactly an agency cost. Makes sense.

Caleb Newquist: [00:34:05] Makes sense.

Greg Kyte: [00:34:07] Awesome. So back to the paper. The authors cite a survey from 2009 that, quote, used survey data collected by Finance Executives International to arrive at an estimate of $3.8 million of compliance with Sarbanes-Oxley costs per firm with costs increasing in the issuer's size. So they multiplied that $3.8 million in average compliance costs by the number of publicly traded firms in 2004, which was if you're playing along at home, 5226 companies. And that multiplication problem obtained an annual compliance cost for Sarbanes-Oxley of $19.9 billion in 2004. Makes sense.

Caleb Newquist: [00:35:04] Perfect sense.

Greg Kyte: [00:35:05] Nice. So here's what these eggheads say as a conclusion.

Caleb Newquist: [00:35:11] You like you like the eggheads?

Greg Kyte: [00:35:12] I do, because that's really feels right to me. So these.

Caleb Newquist: [00:35:17] Big brains.

Greg Kyte: [00:35:18] These damn eggheads are saying this because you remember that their estimate was that their conservative estimate was that 10% of firms engaged in fraud. Do you remember that?

Caleb Newquist: [00:35:31] I do, yes.

Greg Kyte: [00:35:32] So what they say is that if Sarbanes-Oxley resulted in only 9% of firms engaging in fraud, instead of the 10%, that 1% reduction would drop the total cost of fraud by $25 billion. Now, if you also remember, they just estimated that compliance costs with Sarbanes-Oxley was right around $20 billion. Right. So if Sarbanes-Oxley reduces the cost due to fraud by 25 billion and it only costs you 20 billion to do it, you just came out in the black by $5 billion.

Caleb Newquist: [00:36:12] 5 billion.

Greg Kyte: [00:36:13] Exactly. Yeah. So that's the cost benefit calculation that they made.

Caleb Newquist: [00:36:17] Right. And the authors, they write with this estimate, we can easily assess what is the minimum level of of effectiveness in terms of reduction in the probability of starting a fraud that any system of controls needs to achieve to justify its cost. All right. So let's recap, shall we? Yes. All right. The authors estimate that for the period they examined in the wake of Arthur Anderson's failure, two out of three corporate frauds went undetected. Check. 41% of large public companies misreported their financials in a material way. Check. 10% of firms were committing securities fraud.

Greg Kyte: [00:37:05] Crazy, but okay.

Caleb Newquist: [00:37:08] Yep. And this resulted in an annual cost of $254 billion to investors.

Greg Kyte: [00:37:15] Yep, they said that.

Caleb Newquist: [00:37:17] Okay. And if you extrapolate this out to 2021, they estimate the annual cost of corporate fraud to be $830 billion in $2,021. Right. The authors conclude, quote, These figures project a dismal picture of the effectiveness of financial Auditing Prix Sox. Now, now they do confess that whether Sox reduced or eliminated the problem, our paper is unable to answer. Yet the magnitude of the problem suggests that some action was warranted. Greg, what do you think of that?

Greg Kyte: [00:37:55] I do agree that some action was warranted, but I am jaded about government and legislation and that that the it's more we have to do something because we have a lot of people who are really upset right now. And if we do nothing, then we can't justify our existence as legislators. So I, I think it was warranted. I don't think Congress could not have done anything, but I definitely resounds with me with what they say, whether Sarbanes Oxley did anything at all. Their paper is actually that's outside the scope of their paper.

Caleb Newquist: [00:38:36] Yeah, but remember when they did the cost benefit analysis, they found that if a new regulation, i.e. Sarbanes-Oxley, could reduce the probability that a fraud would be started by just 10%. Its cost would be fully justified. So, Greg, did we learn anything?

Greg Kyte: [00:39:01] I would say that it if I didn't learn anything, it made me think about a couple of things. Okay. Pretty deep. Which. Okay. That's learning, isn't it? It is. Yeah.

Caleb Newquist: [00:39:12] Definitely.

Greg Kyte: [00:39:13] Definitely. So one of the one of the things that that really stuck in my brain was that these researchers estimated that the corporate fraud eliminated $830 billion of shareholder value in 2021. Now, Caleb, you also know that I am locked in to the ACF and their biannual report to the nations. Yes. And and what's interesting is the ACF estimated not $830 billion, they estimated $4.7 trillion was lost to fraud globally in 2021, which is the same year that they, you know, extrapolated their data to, to get it in $2,021 as well. So we've got one set of research that says 830 billion. And not only that, those guys are saying that that's a very conservative number, but we've got this other respected group that says 4.7 trillion. Okay. So with that, my accountant brain kicks in and I go, how can we reconcile these two very divergent numbers with one another? And what's weird is I think you can kind of do it because if you just look at it, the ACF's number is about eight times larger than what these researchers estimated. So we've got an eight fold difference between the numbers. But the authors of the paper explicitly and repeatedly state that their estimates are conservative, which which brings me to think of whether like to make a judgment as to whether or not I think that the ACF is being conservative or liberal with their estimation and again being jaded, I go, Oh well, the ACF kind of has a dog in this fight and they want it to look like, you know, their whole thing is to help support the forensic auditing profession. So they want to go, Oh my gosh, the, the problem.

Caleb Newquist: [00:41:17] With so much fraud.

Greg Kyte: [00:41:19] It's huge.

Caleb Newquist: [00:41:20] So much fraud, you.

Greg Kyte: [00:41:22] Really need our services where the researchers were just trying to come to a conclusion. So I would say so, which is also very interesting when you look at this, because a reportedly conservative number versus a number that feels like it's probably not so conservative. It's a.

Caleb Newquist: [00:41:41] Marketing data.

Greg Kyte: [00:41:41] Point. It's a it is. And it really is kind of comes out of their ass because if you even look at the ACF's methodology, they really go to certified fraud examiners and go, hey, about how much revenue do you think is lost to fraud every year? And they're like they scratch their head for a minute and go, Your best.

Caleb Newquist: [00:41:58] Guess is.

Greg Kyte: [00:41:58] Fine. 5%. I say 5%. It's five. It's about 5%. And, you know, and I think they do some, you know, some statistical gymnastics to to, you know, to verify that that number is at least in the realm of reasonableness or at least that they feel like they can justify it as such. So so with that, you still have to go, okay, so who's right? But what's interesting is if you look at the paper, they're only looking at shareholder wealth for us publicly traded companies. Right. But what the ACF is looking at is it's looking at global what was lost globally, not just for public companies but for private companies as well. And and the, the, the paper, they did a real shitty job of defining fraud. Uh, but I think and tell me if you think I'm wrong, but I think digging through the numbers like we did their primary early looking at financial statement fraud. Yeah I think that's but but the ACF is not just looking at financial statement fraud. They're looking at embezzlement like asset misappropriation, which most people relate that to embezzlement, but it can also be people stealing inventory or whiskey. Exactly. Or even like, you know, using a company truck and that burns gas.

Greg Kyte: [00:43:24] That kind of stuff can be asset misappropriation. Also corruption, aka See the Fat Leonard podcast. So the ACF looks at all of those. So if you if you start to look at okay the if you look at just the US and just the public companies and just financial statement fraud that yeah, that seems reasonable that that would be one eighth of global fraud for not just financial statement fraud but also embezzlement and corruption. And if anything I. I think that that that very much I mean, just again, I tried to do some math to verify that. And I think it's very justifiable that if you take the the the researchers conclusions about lost due to fraud and you try to try to take that to a global level for all sorts of fraud, it really I think the numbers line up pretty good. And I think that that's kind of a gold star in my mind to these researchers and what they're doing and maybe even more so, Gold Star to the ACF for not just having a marketing number, but having something that I think is actually probably is backed up by this, by this paper.

Caleb Newquist: [00:44:35] Yeah. All right. That was a good one.

Greg Kyte: [00:44:37] That's a good one.

Caleb Newquist: [00:44:39] What else What else got you thinking?

Greg Kyte: [00:44:42] The other thing that got me thinking is that because the whole cost benefit analysis thing, I. I don't. For as much as they tried to frame it as here's, here's something that, that C-suite officers can use to make decisions bullshit C-suite that you don't have a decision as to whether or not you're going to pay the money to comply with Sarbanes-Oxley or not. All that it was is it was it was a big picture, again, kind of ivory tower thing of going, hey, let's see if Sarbanes-Oxley is was worth it after all. 20 years later, can we justify the cost that was imposed on corporations with compliance with Sarbanes-Oxley? And their whole thing was that Sarbanes-Oxley reduced fraud so that it was less than 10% of companies that were committing fraud. And I say, no fucking way. That's my, my, my un unabashed opinion is there's no fucking way that Sarbanes-Oxley reduces fraud by by 10%. Because again, to just back into those numbers, they said fraud had to go from from 10% of all companies down to 9% of all companies which you go, oh, wait, Greg, that's only a 1% reduction. It's like, no, no, no. That's going from 10% down to 9%. That's 10% of the 10%, right? Yep. So so there's no in my mind, there's no way that Sarbanes-Oxley reduced fraud by 10% because here's and here's here's how I'm going to back that up and tell me if you agree with me or not. But the first off is that is that firms who audit public companies are constantly being fined and censured by the PCAOB for not doing their fucking job at auditing these companies. So they're doing the the auditors who are supposed to be enforcing who are who are they're they're not they're not doing what Sarbanes-Oxley is telling them to do, which is why the PCAOB is pissed off at them. Right.

Caleb Newquist: [00:47:06] What?

Greg Kyte: [00:47:07] Shut up. Plus, audit firms are incentivized to give unqualified opinions, which is basically an unqualified opinion, is basically a clean bill of health for financial statements. And if you're an audit company, you want to give a clean bill of financial health to your clients. We we might want auditors. We might want their job to be keeping public companies from committing fraud. But in my opinion, what they actually do, boots on the ground, is they do the bare minimum to comply with auditing standards, to support a positive report for their clients. And that's it. Prove me wrong. And I'm not and I'm not saying the Sarbanes-Oxley does nothing. I'm saying that I'm absolutely convinced that there's no way Sarbanes-Oxley reduces fraud by 10%.

Caleb Newquist: [00:48:06] Yeah, I mean, that's that's that's that would be a big that would be really big. A 10%, 10% reduction is large. Yeah. And so and now.

Greg Kyte: [00:48:17] Again, so to give these researchers their due, they did say that whether or not it actually reduced it to that extent was not was outside the scope of their paper. Yeah. And really they're saying that that's what.

Caleb Newquist: [00:48:32] Threshold but I think but I think honestly the takeaway I think the biggest takeaway though is the bit where they say there's 41% of businesses who are in a given basically in a given year. But like, you know, they they based it on the sample. The sample years Post-It Anderson failure there's a 41% are misrepresenting their numbers like that right there That's the indictment of auditing where you're just like, yeah, what is going on? Like how is how like you said, 2 in 5 are misrepresenting their numbers and they're just getting clean audit opinions. Yeah, that's the thing where they're like, they clearly say this does not speak well of auditing in the United States.

Greg Kyte: [00:49:16] Absolutely. But again but that's the thing is their paper wasn't about the the effectiveness of auditing. It was about detecting.

Caleb Newquist: [00:49:25] The pervasive it's about the pervasiveness of fraud.

Greg Kyte: [00:49:27] Right. But but.

Caleb Newquist: [00:49:29] Trying to figure it.

Greg Kyte: [00:49:29] Out that at least for you and I, one of the big takeaways is also, yeah, auditors suck at doing their jobs.

Caleb Newquist: [00:49:36] Well, yeah. And I think I think it's I we maybe we're being are we being are we is this a quibble do you feel like the the Sarbanes-Oxley bit like the cost benefit like I don't know I don't think the paper said this is for CFOs like they really just wanted to like illustrate how one could take this number and try to use it in a practical fashion. Right. I mean. Right.

Greg Kyte: [00:50:00] Well, it's.

Caleb Newquist: [00:50:01] Almost as though, yep, we we crunched all these numbers and this is what we came up with. But can you apply it to real life? That was that was.

Greg Kyte: [00:50:10] Sure as hell.

Caleb Newquist: [00:50:11] They tried. They tried. Yeah. Yeah, right. But you're Greg Kite's not buying it.

Greg Kyte: [00:50:16] Nope, I'm not buying it. All right. And if anything, I would say, yeah, I'd say that it's that maybe the conclusion of their paper is Sarbanes-Oxley wasn't worth it.

Caleb Newquist: [00:50:28] Maybe. I mean, as, as I recall, that's outside of the scope of this paper.

Greg Kyte: [00:50:32] Yep, exactly. So, Caleb, what were some things that got you thinking based on this paper?

Caleb Newquist: [00:50:37] So the one thing that I kind of learned reading this study and then also people's reactions to this study was you mentioned a little bit is just how they define fraud, right? Like because that's that's the big question is like, well, if you're going to if you're going to try to quantify the pervasiveness of fraud, then you have to kind of start with the question, well, what is fraud? Right. Okay. And how they chose to do that was a little weird and slightly controversial. Yeah. And I mean, by their own admission, they put it right in the paper. They said we were being overly broad and because they want because they wanted to be conservative. Right. They wanted to they wanted to be conservative in order to account for virtually every instance that could possibly occur. Okay. Right. Yeah, Right. Okay. So for example, I just want to find the this actually, this actually didn't get that much press when I was doing the research. Okay? There wasn't that many media that picked it up, but The New York Times picked it up and they got this great quote from a Stanford professor who's also a former SEC commissioner. His name is Joseph Grundfest. Oh, yeah. Like I, I feel like I've said his name before. Anyway. Grundfest He he told the Times, quote, The use of the term fraud in the article's title is highly problematic. The authors themselves concede that they used the fraud, the word fraud, loosely and for simplicity. But events they call fraudulent include alleged frauds that weren't frauds, honest mistakes and differences of opinion about accounting treatment. Calling all these events frauds is like loosely calling a mouse an elephant for the sake of simplicity and then rationalizing the overbroad categorization on grounds that both are mammals, just as mice are not elephants, alleged frauds are not frauds, and differences of opinion are also not frauds. So like, this guy really isn't impressed by. All right. Right.

Greg Kyte: [00:52:32] Take that. Researchers.

Caleb Newquist: [00:52:34] Yeah. And so I think we've talked about this in other episodes. Well, not other episodes. Maybe one other episode where like I think there's certain academics who get a pretty profound sense of joy when they poke holes in their colleagues or their peers in their peer studies. Yeah. And this guy Grundfest seems to be one of those guys because he's just like, Yeah, not impressed at all. Right?

Greg Kyte: [00:53:01] I feel like it's that's the same sort of joy that we feel poking holes in these people's research as well. You maybe look at this, look at this wonderful cake that you made here. The icing is wrong. Do it again. We're like, we're we're Gordon Ramsay for these guys. These guys research paper.

Caleb Newquist: [00:53:20] So maybe it's not ironclad, but this study is is interesting. And I mean, we did a whole podcast episode about it. So that's is that that's something Is that something.

Greg Kyte: [00:53:32] Sure, that's something. Caleb And one way or another that's it for this episode. So remember, the only limits to fraud are your imagination.

Caleb Newquist: [00:53:44] And also remember, if you see an iceberg, get the hell away from it. I'm with you.

Greg Kyte: [00:53:49] Yeah, exactly. Hey, if you want to drop us a line, send us an email at. Oh, my fraud at earmark Cpcomm. And, Caleb, if people want to get a hold of you, where can they find you?

Caleb Newquist: [00:54:02] On Twitter at C Newquist and LinkedIn Backslash. Caleb Newquist. Greg, where are you?

Greg Kyte: [00:54:09] Same thing. Twitter at Greg Kite and LinkedIn Backslash. Greg Kite. Pretty straightforward.

Caleb Newquist: [00:54:14] Oh my Fraud is written by Greg Kite and myself. Our producer is Zach Franc. If you like the show, leave us a review or share it with a friend. Rating the show and leaving reviews helps people find the podcast. Be sure to subscribe on Apple Podcasts, Stitcher, Spotify or wherever you listen. And for the accountants out there, if you listen to the podcast on earmark, you can get free CPE.

Greg Kyte: [00:54:35] I earn so much CPE on earmark. It's unbelievable. If you're not getting CPE on earmark, then you're getting CPE wrong.

Caleb Newquist: [00:54:45] That should be on their website. It should be.

Greg Kyte: [00:54:48] At least on their business cards.

Caleb Newquist: [00:54:50] Yeah. Join us next time for more average swindlers and scams from stories that will make you say, Oh my.

Greg Kyte: [00:54:55] Oh my fraud.