As an investor, I don’t want to be on the wrong end of fraud. But I thought it would be interesting to look at things from a different perspective: what is the best way to commit fraud? What is the best way to fleece investors?
Finding that gold
To actually find an economic deposit would take a lot of luck. It may be easier to buy a deposit with high grades and some type of fatal flaw:
- Veins are too narrow to be economic.
- Infrastructure costs to build a mine would be too high.
- The ore is refractory.
- Political risk.
- The mine is close to the end of its life.
Inflating the assay results
Gold often isn’t evenly distributed within a drillcore. How you cut the drillcore in half matters. The right way of doing it is to look at the visible gold and try to have equal amounts of visible gold (or gold-bearing mineralization) in both halves. A really smart and devious person would intentionally cut the core so that the split is as uneven as possible. The half with more gold would be sent off to the assay lab.
To avoid detection, a sociopath geologist could send the gold-poor core 10% of the time for high-grade intervals and 30-50% of the time for mid and low grade intervals. If another party were to come in and perform QC checks, the error would not always be in one direction. This makes it look less like fraud and more like other legitimate causes of error (e.g. legitimate sample error).
It is highly unlikely that this type of fraud would be detected (unless the difference was greater than say 20%), especially when half of the evidence is turned into pulp. To detect this form of fraud would require an extensive QC program with a large sample size. And even then, the evidence likely would not hold up in court as there are legitimate explanations for the discrepancies.
(The defense against this is to take pictures of both sides of the drillcore before or after splitting.)
Don’t end up in jail
There is no reason to engage in behaviour that would land you in jail. Many forms of deception and unethical behaviour are perfectly legal. There is no reason to engage in a blatantly illegal salting fraud (adding gold to the drillcore pulps). A major inflation of the assay results will eventually be detected. There are legal methods for inflating a deposit’s economics without resulting in jail time or other repercussions for the perpetrators.
Inflating the resource estimate
This is the best way of widly inflating a deposit’s economics without ending up in jail. There are various ways to do this. A sociopath would likely try to avoid the obvious means of inflating the resource estimate (e.g. using unrealistic assumptions about commodity prices).
Go shopping for engineers that (A) lack integrity and (B) are very good at not making the aggressive assumptions obvious. Behre Dolbear meets the first requirement but not the second (aggressive commodity price assumptions are too obvious). A firm like BBA meets both requirements (go read their technical report on Bloom Lake, filed on SEDAR by Consolidated Thompson). Such feasibility studies can wildly inflate the economics of a project (e.g. BBA claimed that Bloom Lake’s production costs would be$35/ton; actual costs are in the range of $80-90/ton). Sadly enough, this is legal and nobody has ever gone to jail for this. I’m not aware of any mine engineer or geologist being punished for engaging in this activity.
Play the stock promotion game
One of the best forms of advertising is when other “credible” sources say good things about you. Online affiliate marketers have figured out that this is the most powerful form of advertising. What other people say about you can be more important than what you say about yourself. It can be worth paying underwriting fees on private placements as the brokers will have an incentive to shill for you via their “independent” research from their analysts.
It could be worth giving sweetheart private placement deals to big-name investors with stellar track records (they do not have to be skilled). There are some investors who simply follow the hot money. They seek comfort in copying other successful investors.
On the Internet, anyone can create fake personas to pump a stock. Here are some tactics that could be used:
- Is X a fraud? One user starts a new thread on a forum asking if a particular company is a fraud. They give a very weak argument as to why that company is a fraud, perhaps something along the lines of: “ive heard that mining stocks r really risky and ive no clue if this one is a fraud or not. dis looks 2 good 2 b true… help plz?”. Then another experienced forum user comes in and explains how frauds work and how you can defend yourself against them. This kind of thread subject would grab attention and possibly gather a large number of views. The second poster would likely gain a lot of credibility for “exposing” other frauds that exist. The shill might also have third and fourth posters jump in and “thank” the second poster without being too obvious about it (e.g. “very interesting stuff!”). Ultimately the second poster would conclude that X isn’t a fraud (even though it is). For whatever reason, human beings unfairly attach credibility to those who “expose” frauds. If you Google something like “is rich jerk a scam?” (Rich Jerk is an information product that describes how you can make money by running a pyramid scheme scam; you’d be an idiot to buy it), you will see this format in action.
- X is a scam, but Y is not. This is a variation on the “Is X a fraud?” format. Affiliate marketers have figured out that you can get people to buy Y by exposing X as a fraud and claiming that Y isn’t. What a shill could do is to find news stories on similar competing companies, accuse them of being frauds (or overvalued, etc. etc.), and then recommend others to take a look at Y.
- The “independent” review. In this format, the shill provides an independent, unbiased review of several different things. You can find example fake review sites by searching “web hosting reviews” and clicking on the paid ads. There are subtleties as to what these fake sites do. They often make the information easier to analyze by boiling everything down into one simple number (e.g. a star system or percentage system). People like simplicity as it makes complicated purchasing decisions easier. The fake review sites don’t give out perfect scores as that would seem too fishy.
Misleading insider buying
Take some extra salary in cash and use that money to buy shares on the open market. There are people who rely on insider trading as a signal.
Do charity work
Reputation management helps. Bernie Madoff understood this. He was well respected even though his market making business was pretty shady (but nobody understands market making so most people didn’t figure out that he was a sleazeball). Unfortunately his ego got the better of him and he decided to run a Ponzi scheme instead of admitting that one of his hedge funds didn’t do so well.
Barry Minkow and Sam Antar also understand the value of doing good deeds to improve their images. These former conmen portray(ed) themselves as reformed fraud fighters. Minkow became a pastor… and then bilked his congregation into investing in his fictitious movie. Antar hasn’t blown up in a spectacular fashion, though I have my suspicions about him. Considering how much fraud is out there, how can it be that he has found so little?
A graceful exit
A sociopath would try to have a senior mining company buy out their company. Some seniors may do this if they can pay for the purchase in overpriced shares (or they may simply do this because the CEO was duped into making a dumb purchase and surrounds himself with yes men). The wonderful thing about this is that the senior miner has a vested interest in perpetuating the lies. If any feasibility studies were overly optimistic, the senior miner is unlikely to correct that. For example, Cliffs continued to repeat the lies about how Bloom Lake’s cash costs would be $35/ton after buying the deposit. Any fallout from the fraud will be delayed and likely will not stick to the perpetrators. By the time the lies are uncovered, most people will have forgotten about those responsible and won’t connect the dots.
Accounting trickery can be used to understate excessive insider compensation. TransGlobe Energy has the best example of this that I’ve seen (for an explanation, see my post on TGA). Their options accounting is extremely aggressive. I doubt that many people will pick up on what they’re doing because most people find options difficult to understand and because the methods they used are obscure.
Another way of understating insider compensation would be to issue mineral royalties valued at $0 as a form of compensation.
A winning strategy in the past several years has been to promote stock and to use that overpriced stock as currency to acquire real assets. The model is part Ponzi scheme and part real business. As long as the asset base is quickly growing, it is difficult for investors to determine the cash flows and economics of existing mines. In other words, it is hard for investors to figure out how much money the real business earns or loses.
Accounting profits can be increased by:
- Capitalizing as many expenses as possible: interest, internal costs / G&A, etc. etc.
- Capitalizing stripping and mine development activities. (I can’t believe that somebody created the accounting rules that allow this. It is complicated, unnecessary and creates opportunity for abuse.)
- Projecting a very long mine life. This will spread out depreciation and amortization costs further into the future, increasing accounting profits in the short term. Assumptions about a long mine life will also allow more stripping and mine development activities to be capitalized.
What this means for investors
In general, there is fraud everywhere. The former CEO of BRT Realty Trust (NYSE:BRT) was a gambling addict and engaged in kickback schemes. Warren Buffett was burned when he bought GenRe as he did not realize that the reinsurer had many hidden problems (e.g. in its derivatives unit). I don’t think that it’s possible to avoid all forms of fraud and deception. Some forms of fraud and deception are simply very difficult to detect. It’s just something that you can’t completely avoid.
When it comes to investing, your odds are a lot better when you work with people of integrity. Interestingly enough, Buffett mostly relies on his judge of the seller’s character. He does not supplement that with a team of lawyers or accountants before signing a deal to buy a private business. Buffett has made very few investing mistakes over his career despite the lack of conventional due diligence.
Secondly, it pays off to do your own due diligence. A lot of deceptive behaviour is publicly disclosed in regulatory filings. Disclosure protects the perpetrators from legal action. There is little incentive for them to hide any shady accounting or excessive pay because most investors don’t bother to go through regulatory filings. On top of that, some people are so greedy/flawed that they will invest in companies even knowing that the company is shady. (I know that I’ve done this and have been burned for doing so.)
In mining specifically, stay away from companies that are constantly raising capital (e.g. selling shares or convertible debt). Don’t believe any technical report as almost all of them are inflated; you need to do your own work. Most (or almost all) of the sector should be avoided as most CEOs in the mining industry lack integrity.
Currin Trading (part 1) (part 2) (part 3) – The perpetrator of a Ponzi scheme in an online computer game explains how he pulled off his scheme. What I find interesting is that many of the human dynamics are the same with real world investments.
Morty then asked a question that gave me no end of amusement. “Wait, how can I trust you?” […] It was a question that I was sure to be asked again and again. I replied, “there’s really no way to verify this. That’s why I always recommend that people only invest what they feel comfortable with, and that varies from person to person.” Morty seemed satisfied by my answer, and after an interminable series of pleasantries, he finally closed the convo. I had just stolen a billion isk [game currency].