Despite more rigorous procedures in place, corporate fraud is still all too frequent, says Fidelity International’s Dhananjay Phadnis. But there are ways for active managers to spot a corporate fraud early.
Phadnis (pictured), manager of the four FE fundinfo Crown-rated £89m Fidelity Emerging Asia fund, highlighted recent examples of corporate fraud such as Luckin Coffee in China and Wirecard in Germany, which have thrust the issue into the spotlight. 
“There is an argument that the Covid-19 crisis, like a receding tide, will expose many more frauds that had been able to hide beneath the surface in good times, as happened in the wake of the global financial crisis in 2008-09,” said the manager.
“In fact, the well-known short-seller Jim Chanos has called this ‘the golden age of fraud’.”
As such, Phadnis highlighted the three key factors that have an important part to play in preventing corporate frauds.
Key Factor 1: Integrity
The first factor – integrity – is probably the most important trait required of management, according to Phadnis, but also one of the most challenging to validate.
“In the corporate context, management integrity means doing the right thing by stakeholders,” he said. “However, sometimes internal and external pressures can be so strong that they cause a failure of integrity that allows greed to take over.”
And it can be even harder to quantify in smaller companies and start-ups with little track record.
Nevertheless, there are seven red flags that are key predictors of integrity failures that have been identified by Marianne Jennings in her book ‘The Seven Signs of Ethical Collapse’, which Phadnis uses as the basis for his own observations.
The first is the pressure to maintain numbers, something that the Fidelity Emerging Asia manager sees in companies “trying to justify sky-high valuations” or under pressure from some groups of investors. This can take the form of excessive deal-making or “serial roll-up acquirers” (targeting companies in the same industry) as a way of driving up short-term profits at the cost of significant risk from more leverage.
‘Fear and silence’ can lead to a culture where people are too scared to speak up and allow “glaring misconduct” to occur and continue, such as at Enron, he said.
‘Young 'uns and a bigger-than-life CEO’ is where a charismatic chief executive leads people down a wrong path, according to Phadnis, an example of which is Silicon Valley blood-testing start-up Theranos that was later exposed as a fraud.
Another red flag for integrity is a weak board, according to the manager, which can also raise questions over genuine independence.
Conflicts of interest include webs of related-party transactions, or executives with substantial external interests, said Phadnis. But it also true of situations where there is little or no alignment between management and minority shareholders, “as is the case with many state-owned corporations”.
‘Innovation like no other’ concerns ethical boundaries in the pursuit of innovation, which has become increasingly important in the era of big data, he said. It could also have ramifications for sectors including technology, banking and healthcare.
The last red flag is ‘goodness in some areas atoning for evil in others’, which Phadnis said concerned companies or management teams that use philanthropic donations and activities to compensate for unethical behaviour elsewhere.
Key Factor 2: Independence
Another key factor in protecting against corporate fraud is independence, said Phadnis.
“Oversight is one of the biggest safeguards against failures of integrity,” he explained. “In the corporate context, one of the most important bodies that provide this oversight is the board of directors – but investors also depend on auditors and, ultimately, regulators to provide this.
“Maintaining the independence of the board and auditors is crucial to delivering effective management oversight; unfortunately, while many companies achieve this independence in form, they don’t achieve it in spirit.”
As such, there are several checks that Phadnis said can help evaluate whether independence has been compromised.
A long tenure can indicate compromised independence, as can ‘excessive boarding’ – where a director sites on more than one board – which limits true independent thinking.
Another check is compensation levels, as excessive remuneration may impair independence.
While state-owned corporations may have a number of independent directors, questions may arise over how much leeway they have to express their views, added the Fidelity manager. And in family-owned corporations some board members may be subject to a relationship that goes deeper than the corporate engagement.
Investors should also question the independence of auditors and deciding whether they are “too close for comfort”, he added.
Key Factor 3: Competence
The final factor revolves around competence and whether board members have the relevant professional experience to carry out their duties, said the Fidelity Emerging Asia manager.
“Too often, too few details are provided to the board with too little notice,” he said. “Without directors who are conversant with matters at hand, their responsibility of oversight will be compromised.
“For example, we expect the independent director heading the audit committee to have relevant experience in finance and accounting.”
Nevertheless, active fund managers have an important role to play as shareholders being able to look out for red flags when any of the above key factors are compromised, said Phadnis. They can also engage with boards to ensure that companies are meeting governance targets and expectations.
As shareholders, fund managers can also use their voting rights to express their views on board composition and other governance issues, he explained, and as a last result, divesting can have a powerful impact if other investors also take action and it leads to a decline in market value.
“The efforts to minimise corporate fraud still have a long way to go,” Phadnis concluded. “Attention to integrity, independence and competence can help minimise this risk. Shareholders have an important role to play via active ownership and engagement.”