Smart fraud

Smart fraudsters do not commit fraud.  There are many ways in which scumbags can legally deceive (or lie to) investors.  Given all the legal methods available, I’m surprised that some people choose to do illegal things.

Resource estimation

Estimating a resource (e.g. oil, gas, minerals, etc.) is inherently subjective.  Because of this, there is room to be overly optimistic.  Many management teams in the resource sector have figured out that they can pressure their reserve estimators into delivering inflated estimates.  The interesting thing about this is that management can blame the engineer if there are problems with the estimate.  Management can basically get these engineers to lie for them without having to take any responsibility for those lies.

Science projects

There are some areas of bleeding-edge technology which have not been thoroughly tested (e.g. underwater mining, in-situ oil shale extraction, etc.).  There is a high degree of uncertainty as to whether or not this new technology is economic.  Fraudsters can make ‘overly optimistic’ forecasts about their science project.  Fortunately for fraudsters, very few people understand the technology while there is a large pool of investors willing to invest in things they do not understand.

Accounting shenanigans

For whatever reason, the people who create accounting standards often create areas that are ripe for abuse.  These rules are poorly thought out, do not help investors understand a business, and create opportunities for accounting shenanigans.  For example, mining companies are allowed to capitalize some of the cost of removing waste ore as “mine development” costs.  (Capitalizing overburden removal is fine.  However, removing waste ore should definitely be expensed.)

Aside from industry-specific accounting quirks, a skilled CFO will be able to identify general areas such as options accounting that can be abused.

Skimming money from the company

Some management teams openly skim from investors.  Their shenanigans appear in the related party disclosures in regulatory filings.

Management teams can also skim money from investors without having to disclose their activities.  For example, they can live a lavish lifestyle and bill the “travel and entertainment” expenses to the company.  For this reason, it is important to analyze the G&A spending at a company.

Hybrid frauds

It is generally a good idea for fraudsters to combine the fraud with a real business.  This makes the fraud more difficult to detect and makes it more believable.  Those who perform cursory due diligence on the company will see a real business.  Management can also gain credibility by taking investors on a (staged) investor tour of the actual business.

Making money shorting frauds

In my opinion, it makes more sense to go after the dumb fraudsters.  I want to short the companies run by people who are doing illegal acts.  People who are willing to commit illegal forms of fraud are more likely to ruthlessly steal from the company.  The two behaviours tend to come as a package.  They are also more likely to be running the fraud for pump and dump purposes.  Any selling of stock is from insiders rather than the company.  The proceeds of the stock sold does not increase the intrinsic value of a company.