The Abuse of Trust

Cyprus Risk Watch Column

The Abuse of Trust

BY DR ALAN WARING
Cyprus Risk Watch Column

Once upon a time, ‘my word is my bond’ was thought to be good enough to ensure that business dealings were above board and would be completed with integrity. Such was the implicit level of trust between parties that anything more formal as proof of honesty and integrity would have been frowned upon. Not so today!
We now have two decades’ worth of multiple corporate scandals and collapses to reflect upon – from BCCI, Mirror Group Newspapers and Polly Peck through WorldCom, Enron and Sanlu/Fonterra to more recently Stanford International, Madoff and many of the major banks.
When fraud meets incompetence it creates a particularly toxic brew. Shareholders, investors, employees and customers suffer major losses. Brands as well as individual, corporate and sometimes national reputations lie in tatters. In extreme cases, members of the public have died, e.g. melamine in milk products, for which some convicted Sanlu directors in China were executed while others received long prison sentences.

BLIND TRUST VERSUS PRUDENCE

Only recently, as reported in the Financial Times, Klaus Hilligardt the creator of Business Media China discovered too late and to his cost that highly trusted senior Chinese employees had been systematically defrauding the company. Mr Hilligardt placed a lot of trust and confidence in two individuals, one his personal secretary and the other a young senior executive whom he had appointed. Before long, his secretary and the executive became romantically involved.
BMC did well. By early 2008 and the approach of the Beijing Olympics, share values were over €20. Immediately after the Olympics, however, advertisement revenues fell sharply and far more than might have been expected. The revenue downturn continued throughout 2008 and income had virtually ceased by year end. By mid-2009 the share value was about €0.40.
The main board in Germany lost confidence in the China operations and Mr Hilligardt and the Chinese senior executive were removed from the board. A new Swiss CEO was appointed who discovered that, despite the books showing no orders, in fact the BMC display boards at prime sites were full of advertisements from BMC clients. A separate company called BMC Heli using the same logo as BMC had been set up by the trusted senior executive and a number of current and former employees, including the trusted personal secretary. They were diverting all the advertisement business to the parallel company. BMC Heli was also invoicing BMC for all its operating costs.
Arrests have been made and the police investigation continues. The case is a salutary tale of allowing trust to take precedence over prudence. Trust is always an important ingredient in any business relationship but it cannot be extended to blind trust.

COMPETENT ADVISERS

What about when investors consult independent advisers about the probity and trustworthiness of an investment opportunity? A number of companies that provided risk advice to investors in Stanford International Bank, whose controlling owner Sir Allen Stanford is under arrest in the U.S. accused of operating a US$ 7 bln ‘Ponzi’ fraud scheme with investors’ money, have been sued by investors. These investors say that they only entrusted Stanford International with their investments after seeking the advice of trusted brokers and being assured that all was OK.
In one instance, an investor alleged that Kroll Inc, part of the Marsh insurance broker group, carried out a ‘due diligence’ check on the bank’s soundness and presented a favourable risk report which the investor relied upon. We cannot know the truth of the matter but one clue that something was not right was the statement by Kroll that they had only ever been commissioned to carry out limited ‘due diligence’ checks for a US$15,000 fee. If correct, it would indicate that the client was being very unrealistic in expecting a comprehensive ‘due diligence’ risk evaluation for a paltry US$15,000! When $millions are being invested or are at stake, the scale of any independent due diligence work (and therefore the cost) has to be in proportion to the financial – and reputation – risk. Corner-cutting is asking for trouble.
In the same case, in July 2009, a group of investors filed suit in the Federal Court in Dallas against another global insurance broker, Willis, alleging that they suffered large losses after relying on assurances from Willis that Stanford International was safe and secure. This was followed quickly by another Federal law suit as a class action in Miami by a Venezuelan investor, who alleged that Willis were ‘instrumental’ in enabling Stanford and his companies to carry out a $multi-billion fraud against investors. He alleged that Willis provided Stanford agents with letters falsely certifying that SIB’s staff were first class business people and that SIB had undergone a stringent Risk Management Review by an independent audit firm.

PROPERTY INVESTMENT IN CYPRUS

While thankfully Cyprus has not been tainted by mega-cases of international corporate scandals, nevertheless it continues to suffer on the world stage from the collective sins of its property sector. Many buyers have been hit by fraud and thousands still cannot obtain their Title Deeds. Despite much vaunted government plans to rectify the property mess, even if they work it could take up to two generations for the global stigma and its marketplace consequences to fade. As a leading estate agent confided to me recently: “The arrogance still being shown by developers towards foreign buyers on the Title Deeds issue is scandalous. They don’t seem to be aware just how much lasting damage they have done to the market and to Cyprus”.
The risk of Cyprus developers going bust is exemplified by the A&G Froiber collapse last September. A large number of buyers who had already paid for their property but had not received their Title Deeds have found themselves in conflict with the bank who issued mortgages to A&G on the same properties. The outcome is unclear but at one stage a bank spokesman was making it clear that liquidation could well result in buyers losing their property and, at best, receiving only a percentage of the liquidation money.
Other developers are desperately struggling to survive in a flat market and rumours of particular developers being in serious financial trouble abound. Such rumours harden when one reads press advertisements by agents inviting offers on significant numbers of distressed properties. The ‘high prices, no buyers’ problem is exacerbated by the banks continuing to extend developer loans rather than instituting 90-day recovery procedures. This encourages developers to think they can sit out the recession with artificially high prices and await the return of mass foreign buyers. As this may take another 5-10 years or more, much of the current new stock will be distinctly old by then and sellable only at knock-down prices.
In a number of recent cases reported to Risk Watch, it has been alleged that developers have sold the same property several times over and inexplicably all the contracts of sale appear to have been lodged with the Land Registry. While the majority of the victims are foreigners, some are also Cypriot citizens. Since the government through the Attorney General has determined that cases of this kind are civil wrongs and not criminal offences, the police will not accept information laid before it and will not proceed with a criminal investigation. Perhaps it is felt that there are so many potential property fraud cases that to accept one as warranting criminal investigation would open the floodgates to hundreds if not thousands of others that would both swamp the police and add to international embarrassment. However, an official blanket denial that property fraud is a crime may not be effective in quelling angry buyers, investment boycotts or international reaction. It may simply throw fuel on the fire.

SUMMARY

Trust is always an important ingredient in any business relationship but it should not take precedence over prudence or, worse, be extended to blind trust.
Fraud plus incompetence creates a particularly toxic brew from which shareholders, investors, employees and customers require protection. Brands as well as individual, corporate and sometimes national reputations are also at stake. The Cyprus property sector is particularly vulnerable.
Corporate investors owe a duty of care to their own shareholders to ensure that investment risks are properly evaluated. The scope and depth must be appropriate and not just a quick skim. Corporate investors not only have to show prudence in how much trust they place in investment companies but also in their own risk advisers. Proper corporate due diligence cannot be done adequately for a nickel or a dime.

Dr Alan Waring is an international risk management consultant with extensive experience in Europe, Asia and the Middle East with industrial, commercial and governmental clients. Contact [email protected] .