Fraud and Corruption Go Together

by admin

Fraud is corruption’s first cousin.


The above is the author’s opinion, based on my own experience.  While “corruption” generally represents stealing on the part of government officials, “fraud” is roughly the same but as applied to non-government personnel (keeping in mind that that two can become intertwined).  While measures of the frequency of fraud, along the lines of the Corruption Perception Index, are difficult to find, my direct experience in China demonstrated to me that business and commercial fraud are as common as corruption.  Below are a few examples from my personal experience.


Commercial shenanigans: Who owns that factory?

I once visited a supplier with a factory, owner, company sign, and employee uniforms.  The next day I visited another supplier that had a different owner, company sign, and employee uniforms.  The problem was, it was the same factory.  Two different agents tried to show me the same factory and say it was theirs.  They changed the people, uniforms and signs, but it was the same factory.  I had to laugh at such an elaborate scam.  Keep in mind, this occurred in the country in which, famously, someone erected a fake Apple store.


Working off the books

We took bids on a fairly sophisticated piece of metal fabrication we had to source in order to supply components for a large manufacturer of heavy equipment.  We received an extremely competitive bid from a well-known Chinese state-owned enterprise (SOE) in heavy industry.  Because the price was at a “too good to be true” level, my Chinese colleagues were particularly suspicious.  So we put great focus on asking the right questions, probing around the right issues relative to invoicing, payments, documentation, etc.   In the end we declined to buy from that supplier as we concluded the price was so good because the managers at this factory were going to sell these parts to us “off the books.”  In other words, they would use the SOE’s equipment, labor, and materials, we would pay for the parts, but into a special account they controlled.  They would likely pass some of the funds to the SOE, perhaps enough to cover the cost of the materials.  The rest they would keep for themselves.  This clever form of embezzlement is actually fairly common in SOE’s in China, which is why my Chinese colleagues were skeptical in the first place.



China Stocks Collapse (and Americans get “played,” like Afghanistan)

An American who worked in the Private Equity field in China once told me that 80% of the financial statements they saw from companies in which they considered investing were largely bogus and required significant restatement.  This matches the general sense one gets from the investment field in China in general.


The best example of this would be “China Stocks” listed in the US.  Beginning in the early to mid 2000’s, hundreds of Chinese companies listed on US stock exchanges.  There were a number of reasons for this, including that China had strict rules as to who could list on China’s exchanges and the rules tended to favor large, state-owned enterprises (SOE).  So many entrepreneurial Chinese companies listed in the US (and other foreign exchanges including London and Toronto).


In the late 2000’s I worked for a company that provided services in the capital markets so my job was to work with Chinese companies issuing stock in the US and investors interested in those companies.    From my point of view, it was a disaster in the making, unfolding in slow motion over several years.  My experience told me that there was a good chance many of the Chinese companies were not necessarily playing by the rules.  The foreign investment firms did not have enough awareness of this.  Relatively few of the American investment managers spent much time in China.  Usually they hired young Chinese people who spoke English but had little experience.


China Stocks Crater; American Investors Lose

A few years later, after I had moved back to the US for personal reasons, I wasn’t surprised when America’s “China stocks” cratered.  It all started with one accusation of financial impropriety against one Chinese company.  Then came an accusation against another Chinese company and then another and another. Irregular accounting practices, questionable transactions, lack of disclosure, etc.  Pretty soon confidence in the China stocks had evaporated and prices plummeted.


One US hedge fund explained a huge loss it incurred by saying, “We rely on the financial statements of the companies in which we invest.”  My response would be, “Then why are you investing in China?!”  In a sense, the “China stocks” were like another mini-Afghanistan.  The lack of appreciation of the challenge relative to the rule of law led to failure.  In the end the Americans were “played.”


Counterfeit Booze and Stealing from the Chinese Government

Counterfeit goods often represent both Intellectual Property theft (against the owner of the IP) and fraud (against the buyer of the product).  The US Customs Bureau has cited China as the leading source of counterfeit goods entering the US for many years.  But it isn’t just the US that suffers from this problem.  It is well known and documented that counterfeit cigarettes and booze are a huge business in China.  This is particularly interesting because the major tobacco and alcohol companies in China are all state-owned enterprises.  So the counterfeiters are stealing from the government.  Furthermore, I think it would be impossible for anyone to run a large counterfeit operation without paying off local government officials.  In all likelihood, one part of the government is making money by committing fraud against another part of the government.  This just shows how deeply engrained the behavior is in China.


Deadly counterfeits hurt kids (and threaten my own son)

I couldn’t write this section without including the time I had to cancel my afternoon to buy milk.  Our one-year-old son drank milk daily.  In order to deceitfully exaggerate the protein content of milk, some farmers in China had added a nitrogen-rich chemical, melamine, to their milk, eventually poisoning 300,000 babies of which 6 died and tens of thousands were hospitalized.  For this reason, no one would drink milk made in China for a while, including my family.  So we were on the waiting list at a local grocer in Shanghai for milk from Australia.  We were down to our last few servings when my wife received a call saying the milk had arrived.  When my wife told the grocery store person that her husband would get the milk after work, the person replied that she wasn’t sure any milk would be there by the end of the day.  She recommended we come immediately.  My wife called me and told me to drop everything and get the milk, which I did.


Rule of Law was weak in the US early in the Industrial Revolution

I think it is safe to say that this type of behavior is common among all countries who have a corruption problem.  Perhaps the best evidence of this is the US itself.


I’m tipped off that they’re going to lay out a new park at a certain place. … I see my opportunity and take it. I go to that place and I buy up all the land I can. … Ain’t it perfectly honest to charge a good price and make a profit on the investment and foresight? Of course it is. Well, that’s honest graft.  


George Plunkitt, member of the NY State Assembly, 1880’s and 90’s


Above is a quote from a former assemblyman from New York’s infamous Tammany Hall.  Plunkitt was actually trying to explain why “honest graft” is good for society.  The mere attempt to do so is an indication as to how perspectives (and values) have changed since then. The fact is, corruption was much more common in the US in the early stages of the Industrial Revolution than it is now.  The same is true for all aspects of the rule of law including corruption, fraud, embezzlement, etc.  While there aren’t necessarily any measures or statistical indices from back then, the examples below provide a good description of the general environment.


The Erie War: was a takeover battle for Erie Railroad in the late 1860’s.  Two financiers issued fake shares in the company, “watering down” the stock.  Millions were lost by those buying the spurious shares.  It was a primitive act of fraud and yet not illegal. The financiers bribed Tammany Hall to make their act legal, ultimately gaining the support of Boss Tweed who would eventually be jailed for corruption.


The Credit Mobilier Scandal: This was a fraudulent financial scheme involving many U.S. politicians and the Union Pacific Railroad in the 1860s. Money intended to fund the construction of the railroad was used to line the pockets of politicians and benefit some crooked businesspeople.


Insider Trading: During the stock market crash of the Great Depression, CEO’s were selling their company’s shares short, in essence profiting from the demise of their own company.


Fraudulent Ingredients: Some food producers used unsafe additives to make food more cheaply or quickly or to make it appear to be fresh.  Many died or became ill from such food. This led to landmark legislation such as the Bottled-in-Bond Act of 1897 and the 1906 Pure Food and Drug Act which were supported both by government reformers and legitimate food and liquor producers of that time.


All countries face the same challenges

The above examples resonate with me as they are comparable to what China has experienced over the past few decades.  This helps illustrate a critical point which is worthwhile to reiterate here.  The idea is not that today’s LDC’s are somehow unusually or particularly deficient of good values or behavior.  Rather, the idea is that all societies face these challenges prior to economic development.  Weakness in the rule of law, i.e., relatively low levels of rule following, appears to be a fundamental part of human nature, evident in all societies, until conditions change in a way that produces progress and economic development.  To get more democracy, a society must change conditions, introducing economic empowerment and the free market.

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