We spend a significant amount of our time in Marcellus probing our investee companies’ accounts for fraud & theft. It is exhausting work and given the ingenuity of Indian promoters and the Chartered Accountants they hire, it is never ending work. We often lie in bed thinking about the various ways a promoter could be tricking us and his other shareholders. In that context it comes as a relief to know that investors far mightier than us can be humbled by good old fashioned corporate fraud in….Germany. This NYT article describes how Berkshire Hathaway was tricked into investing in a German company which was padding revenues: “The whistle-blower’s tip eventually led to the exposure of an elaborate conspiracy involving fake sales invoices, phantom customers and hacked computer systems, according to testimony in a legal dispute. The case showed that even Mr. Buffett, one of the shrewdest investors in the world, can be hoodwinked.
What looked like a profitable German manufacturer of specialized pipes for the oil and gas industry was, in fact, nearly bankrupt, according to testimony.
As a result, according to the findings of an American arbitration panel, Precision Castparts, a Berkshire Hathaway subsidiary, paid 800 million euros, or $870 million, for a company that was worth only about one-fifth that price. The acquisition of the company, Wilhelm Schulz, was an expensive misstep for Mr. Buffett’s holding company… German prosecutors have opened a criminal investigation focusing on eight suspects at Wilhelm Schulz, all of them former high-ranking executives, finance officials or information technology specialists. None have been charged.”
On the face of it, Wilhelm Schulz looked a classic mid-sized German engineering operating in a nice little profitable niche: “On the surface, Wilhelm Schulz seemed like the kind of solid industrial company that has made Germany an export powerhouse. Based in Krefeld, north of Düsseldorf in Germany’s industrial heartland, Schulz appeared to have a strong position in its market niche: specialized pipes for the oil and gas industry.
The chief executive, Wolfgang Schulz, was the son of Wilhelm Schulz, who put his name on the company when he founded it only months after the end of World War II. Wolfgang Schulz was well known locally as the owner of a pro ice hockey team, the Krefeld Penguins.”
But underneath this respectable exterior, Wilhelm Schulz seems to have been doing what is known as ‘evergreening’ in India: “…Schulz had narrowly avoided bankruptcy only weeks before. The company had been unable to make payments on a €325 million credit line from Commerzbank, according to the arbitrators’ report. A lawyer hired by Schulz had advised the company that it was obligated under German law to file for insolvency.
Schulz avoided that fate only because it persuaded Commerzbank to front it €8 million more, saying it was waiting for payment from a big customer. The bridge loan came with a proviso. If Schulz couldn’t pay, Commerzbank would effectively take control of the company.”
However, Schulz was also raising money by discounting its receivables and it is here that the fraud seems to have begun: “Schulz was also raising cash by borrowing against accounts receivable — money that customers owe but have not yet paid — a common practice known as factoring. But some of the documentation that Schulz presented to the lender (and later reviewed by Precision Castparts before the purchase) was fabricated by using Photoshop software to create fake invoices and delivery receipts, the arbitrators found.”
Even as the Berkshire subsidiary, Precision Castparts, conducted due diligence on Schulz, employees of Schulz’s IT department swung into ingenious action: “…a Schulz information technology employee engineered a five-day outage of the computer system used to track sales and orders. A team at Schulz exploited the downtime to fabricate nearly 50 orders, worth tens of millions of euros, that were backdated to make it look as if they had been placed in 2014 and 2015, according to the arbitrators’ report… a tribunal in New York found that Wolfgang Schulz and his employees had “engaged in a pervasive effort to present a fundamentally misleading picture of the financial condition” of the company. An expert who testified concluded that fake transactions inflated Wilhelm Schulz’s profits by €160 million.”
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Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services. Marcellus Investment Managers is also regulated in the United States as an Investment Advisor.
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