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Many wrongs do not make one right

An investigator of many years experience had been asked by his client to go undercover at an Asian location. The investigator had been requested to ascertain whether a major subcontractor of the client was manufacturing the goods produced under a special license with the client under its own account, thereby undercutting the client’s patent protected sales and affecting the return on extensive R & D which supported the patents.

After several weeks, the investigator had been able to make contact with an insider at the subcontracting company under investigation. To gain the insider’s cooperation and support and obtain specific inside evidence, the investigator had used public knowledge that the company was having financial troubles, on which basis he was holding himself out as a representative of a consortium interested in staging a buy-out and turn around exercise on the company. The insider, suitably impressed, provided extensive financial and business details and evidence to assist with a supposedly initial “due diligence” prior to a full offer being made by the “consortium”. The insider was extremely pleased to be able to “help” his company and ensure the long term viability and employment of the 1,000 or so employees at the company’s plant.

Evidence also included a full video of production lines, producing the same items as the client’s, albeit of a much lower quality, as well as shipping documents proving the shipment of such items to customers of the company, clearly in breach of the subcontract specifications and the patent protection.

Subsequently, after an extensive search of the internet, it was found that the company under investigation was in fact advertising its counterfeit products on several websites, stating specifically its capabilities which included the patented manufacturing process which it was not allowed to use; in addition, at a major international trade fair, the company CEO was touting its counterfeit products to visitors to its stand and even handed out several samples to the client company representatives. This in itself would have been sufficient evidence to prove breach of the subcontract conditions and an adequate basis on which to commence litigation for breach of patent.

The client of the investigator pressed charges and the subcontracting company was served notice of the impending litigation for breach of patent. In addition, the client terminated its supply contract, resulting in a loss of 40% of the company’s turnover with immediate effect.

Meanwhile, based on evidence uncovered, the investigator was able to confirm that the company investigated did indeed have major cash flow problems, caused to a large extent by poor management of the production lines and deficiencies in the logistics processes. Deliveries of orders therefore suffered such delays that many shipments needed to be shipped by air, resulting in losses on every cargo of products the company sent to its customers. Over the period of 4 years, the company, a subsidiary of a listed holding company, had run down its credit lines totaling many millions of dollars with several local and international banks, used up funds raised from a major multi million dollar bonds issue and was in the process of preparing another share issue. Its production process and logistics issues, its poor financial management, and its loss of a material customer had not been reported to its national stock exchange as per regulations, and investors were blissfully unaware that the subsidiary was likely to go into bankruptcy in the near future.

Instead of focusing on improving critical controls and systems at the company, management had been extremely creative in identifying two additional sources of revenues to prop up flagging finances. One means was the importation of clothing from a third country, re-labeling these to show the company’s country of origin, and exporting these to western markets, taking advantage of advantageous tariff structures in place under trade agreement between the company’s country of origin and the western markets; A second means was to try and become a money laundering agent for certain clandestine parties, an effort which was in the end unsuccessful. The company was able to mix finances and revenues from the illicit activities with its trading revenues, thereby presenting a much more positive financial picture than was actually the case.

Previously, the company auditors had been a reputable international firm, but in the past few years when trouble started, these were rotated out and a local firm of accountants was tasked to audit the subsidiary’s books. Needless to say, no issues had ever been noted by the auditors, and none were reported. The annual audit reports had been clean for the previous years.

When these matters were brought to the attention of a senior executive of the national stock exchange, his first reaction was to contact the head of one of the company’s major investors to assist them in reducing their exposure to what was potentially a multi million dollar default.

Conclusions

Although the conclusions of the investigation were extremely helpful to the client, the means by which they were obtained left a somewhat uncomfortable feeling. There is no doubt that the company under investigation and its management were acting illegally on a number of fronts, but the deceptive and subversive means by which the information and evidence was obtained raise a question whether such unethical methods are in fact appropriate. Initial research of public records and information available on the internet and through rating agencies would have been able to identify sufficient evidence for the client, without resorting to such methods.

Although many emerging markets have made great progress in establishing formal regulations on reporting to stock exchanges and regulators, a lot of these activities present form over substance. The reality is that much of the energies of emerging market companies management is still dedicated to creative schemes to defraud or deceive investors, while neglecting professional attention to everyday company systems and controls. If these best practice systems were improved or even in place, they would ensure the financial health of such companies without resorting to any “get rich quick schemes” as described.

Finally, regulatory bodies in emerging markets need to understand their role in providing the correct example in their commitment to enforcement of regulations and their basic understanding of their roles and potential conflicts of interest. It is not appropriate for executives of a stock exchange to privately pass information to certain investors to assist them in lowering their potential risks and exposure, while neglecting to follow up and discharge their responsibilities to investigate fully in the best interest of not only the full body of shareholders but any other stakeholders, which in this case included a sovereign government.