When Fraud Bites Business: Lost Fortunes, Reputations and Lives

Credit card breaches, swindlers and even baby formula form a web of fraud that spans the globe

By Dan Burrows, InvestorPlace Feature Writer

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In the late 1800s, swindlers like Reed C. Waddell and Charles and Fred Gondorf sold the Brooklyn Bridge — over and over again — to newly arrived immigrants for anywhere from $200 to $1,000. That’s as much as $28,000 in today’s money. So convincing was the con that police would have to eject the new “owners” for trying to erect toll barriers.

Cheated business fraud corporate fraudFraud has always been with us. It wouldn’t be surprising if archeologists one day discovered a scam to sell the pyramids.

But the scope of fraud is much larger today and the sums involved are certainly greater than 28 grand.

Fraud’s Financial Costs Pile Up in a Hurry

Counterfeit goods, which can range from jewelry to workout videos to guitars, account for 10% of global trade worth $500 billion a year, according to the World Customs Organization. The Department of Homeland Security alone seized products infringing on patents, trademarks and copyrights last year worth more than $1.7 billion at the manufacturer’s suggest retail price.

And the pain of fraud to the little guy can be intolerable. One accounting study puts the median loss from fraud at $105,000 for U.S. organizations. True, that won’t bankrupt Walmart (WMT) or Apple (AAPL), but it could easily sink a small-business owner.

For the most part, investors in listed securities don’t have to worry about fraud. There’s no need to discount the price-to-earnings ratio of a stock to account for the possibility that it’s all smoke and mirrors. The Securities Exchange Act of 1934 made it much harder for con artists to swindle investors — at least those investors who aren’t playing around with penny stocks.

True, the recent data breach at Target (TGT) cost the retailer tens of millions of dollars and hurt its share price, but investors didn’t lose everything. The same goes for Citigroup (C), which had to slash its outlook after discovering $400 million in fraudulent loans made by its Mexico subsidiary.

But fraud does extract a huge toll on industries and private citizens.

Take the insurance industry, for example. Excluding health insurance, the FBI estimated back in 2010 that insurance fraud comes to more than $40 billion a year.

Naturally, insurers pass the costs of fraud onto their policyholders — and the hit to their bank accounts is substantial. The FBI also said insurance fraud raises the premium payments for the average U.S. family from $400 to $700 a year.

White-collar fraud and corporate fraud probably get the most attention, if only because they often turn out to be massive scams involving well-known companies. Enron had a market cap in excess of $60 billion at one point. WorldCom’s market value peaked at three times that amount.

More recently, Bernie Madoff won the dubious award for perpetuating the greatest financial fraud in U.S. history, swindling his marks out of $17 billion.

When Losses to Fraud Go Beyond Dollars

However, the damage from an Enron imploding or a Ponzi scheme like Madoff’s tends to be limited to bondholders, shareholders, employees or investors. Moreover, it’s mostly monetary damage, much less physical.

That’s not the case with counterfeit goods, which can spread disease and even cause death.

The majority of counterfeit goods come out of China, but the Chinese often pay the steepest price. For instance, a decade ago, dozens of babies died as a direct result of fake baby formula sold in eastern China.

Counterfeit condoms are likewise a dangerous problem. In May 2013, authorities in China uncovered one of the largest counterfeit condom operations ever seen. Police seized more than 4.5 million condoms, branded with major names such as Durex, Contex and Jissbon. They confiscated another 1,100 pounds of unpackaged condoms, shutting down a scam that could fabricate 20,000 fake prophylactics a day.

Even more troubling is the global trade in counterfeit pharmaceuticals.

Never mind that big pharma companies like Merck (MRK) and Pfizer (PFE) need all the revenue they can get now that so many blockbuster drugs have gone off-patent. Fake drugs can kill, and they’re one of the largest, most wide-spread scams in the world.

Just last month French customs officials intercepted more than 2.4 million counterfeit drugs. Some of the medications were nothing more than sugar pills.

Online pharmacies pose another danger — and outlet — for counterfeit meds.

Last week, in an operation coordinated by Interpol — and supported by Microsoft (MSFT), MasterCard (MA) and Visa (V), among others — law enforcement agencies in 111 countries shut down 10,600 online pharmacy websites and seized $36 million in potentially dangerous fake drugs.

When Industries Cry Wolf

Other recent seizures of counterfeit goods include jewelry, watches, cigarettes, airbags, apparel, NFL and NHL merchandise and even baby oil and lip balm. Indeed, in 2012, federal agents shut down a Baltimore flea market, confiscating more than 200,000 fake items ranging from shoes to cosmetics. Based on the manufacturer’s suggested retail price, the value of the fraudulent goods exceeded $47 million.

Interestingly, though, when it comes to high-end items like Rolex watches, or digital piracy like illegal downloads of music and movies, the losses aren’t as great as the industries would have you believe.

Movie studios and record companies claim losses of between $200 billion and $250 billion from digital piracy, a figure that has been debunked. Another spurious analysis put the losses at $58 billion.

No one knows what the real costs are. The problem with accounting for losses in luxury items, movies or music is that a large but unknown portion of the goods are stolen by people who don’t have the ability or inclination to buy the item legitimately. Such thefts can’t be marked against revenue since those purchases would never have been made anyway.

That’s partly why the losses to digital piracy probably don’t hurt the affected industries as much as they would have you believe either.

One academic paper studying the matter found that illegal music downloads don’t have a “significant or lasting effect on the sales revenue, margin, SGA expenses or operating income of any of the three largest individual record companies.”

Lost Money and Blown Reputations

Payment-card fraud is another story entirely. Having their credit or debit card data stolen is probably the scariest form of fraud facing most American consumers. A study by Aite Group and ACI Worldwide reported in The Economist found that 42% of Americans had experienced some form of payment-card fraud in the last five years. Not only is it far too common, but the costs to banks and businesses can be staggering.

The data breach at Target over the 2013 holiday selling season cost the company $26 million in its most recent quarter. Lawyers, investigators and security experts will cost millions more in upcoming quarters, forcing Target to cut its annual earnings estimate by about 6%.

But the Target attack was small beer compared to a multiyear hacking effort at companies including Nasdaq OMX (NDAQ), JCPenney (JCP) and 7-Eleven. Between 2005 and 2012, Russian hackers stole 160 million debit and credit card numbers and targeted 800,00 bank accounts. Losses stemming from the attack came to at least $300 million.

Add it all up and card issuers lost $3.4 billion to payment-card fraud in 2012, according to the Nilson Report. Merchants lost another $1.9 billion.

And yet enterprise soldiers on despite the losses. That’s largely because the losses are small enough relative to revenue that they’re just a cost of doing business. Target spent $26 million last quarter to clean up its data breach, but that was less than 1% of its $17 billion in quarterly revenue. Mismanagement of its Canadian stores cost Target almost 10 times that amount in the same period.

Perhaps the worst aspect of fraud for big business is the psychological damage it can do. Target will be trying to convince consumers its a safe place to shop for a long time — and that’s no good for sales.

The data breach may have cost Target $26 million and counting, but chances are the retailer would happily spend many times that amount to get its reputation back.

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As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2014/05/business-fraud-corporate-fraud/.

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