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The Wirecard scandal: what went wrong?

The collapse of the German payment processor carries several important lessons for investors
The Wirecard scandal: what went wrong?

In less than a fortnight, Wirecard (Ger:WDI) has gone from one of Europe’s most hyped financial technology firms to insolvency, all-but extinguishing the value of a company that was worth almost €20bn (£18bn) as recently as April.

After years of rising suspicion, dogged investigative reporting and growing short interest, it was the company’s own admission on 18 June that auditors could not locate €1.9bn of cash which sounded the death knell. Already, comparisons have been drawn with Enron, the energy group and one-time stock market darling whose systematic fraud and corruption rocked the US business establishment when it was uncovered in 2001.

For investors in 2020, the Wirecard scandal opens a vault of questions, chief among them concerning the integrity of market regulation and corporate audit process.

 

House of cards

First, it is worth retracing the history of a company that until recently was relatively unknown in the business world. Founded at the tail-end of the dotcom boom in 1999, Wirecard initially specialised in managing payments for gambling and pornography websites, but later pivoted into banking and rebranded as a payments processor after it joined the Frankfurt stock market in 2005. A key part of everyday digital transactions, payments processors act as intermediaries between customers and merchants, using technology to manage transactions on behalf of issuing banks.

Before it failed to locate its own cash this month, Wirecard was a champion of the transition to a cashless economy, and projected stratospheric growth in the demand for its services as consumers increasingly switch to smart payments devices and online shopping.

The story was warmly received by investors. In the decade to September 2018, Wirecard’s share price rose more than 30-fold as its sailed into Germany’s DAX 30 blue-chip index. Headed by a charismatic and black turtleneck-clad chief executive Markus Braun, the company was held up as a rare example of a corporate tech success story in a country better known for heavy industry and manufacturing. Prominent investors including Alexander Darwall, the former Jupiter Fund Management stock-picker who set up on his own last year, gave credence to the quality of the firm’s growth.

However, the house of cards began to teeter at the beginning of 2019, when an investigation by the Financial Times found that an executive in Wirecard’s Asia-Pacific division had been suspected of using forged contracts. So began the newspaper’s gradual unmasking of an apparent large-scale fraud, during which time a team of journalists led by former Investors Chronicle writer Dan McCrum found evidence of inflated profits and dubious outsourcing arrangements – all the while facing legal threats from the company and a criminal probe from BaFin, Germany’s financial regulator.

With a couple of notable exceptions, the investigations were either overlooked or dismissed by company analysts (see chart). In one particularly egregious instance, Commerzbank’s Heike Pauls accused the Financial Times of “fake news” in a 2019 report to clients. Though the note was subsequently retracted, the reproach echoed the idea that the reports were part of a conspiracy with hedge funds to profit from a fall in Wirecard’s share price.

It is now clear that bearish hedge funds were right, and that allegations of collusion served as a smokescreen by the company to distract from critical media reports.

“Once again short sellers have played the unpopular role of market vigilante in unmasking a deceit,” argues Barry Norris, whose firm Argonaut Capital was one of those betting that Wirecard’s stock would fall. “It is time to recognise that without short sellers we would inevitably have a more dishonest stock market and that would lead to a higher cost of capital and lower long-term economic growth.”

 

The blame game

If short-sellers have again been vindicated, what does this mean for those who backed the company, or provided the veneer of legitimacy?

“I don’t think it represents a bigger malaise in the fund industry,” says Peter Toogood, the chief investment officer of retirement solutions business Embark Group. “Managers simply don’t look for fraud per se. But fraud is fraud. The audit process is a 'checking for 1-in-a-100 or 1-in-a-1000' game, and – hey, things get missed – and here, someone was fraudulent.”

However, reports that accountants Ernst & Young failed to properly verify Wirecard’s bank statements for three years have again thrown into doubt the reliance investors can place in the audit process, regardless of the sophistication of a fraud.

To Carson Block, founder of short-seller Muddy Waters Research, the nature of global audit firms’ international networks creates “no real disincentive for auditors to issue unqualified opinions on problematic companies”.

“Audit standards exculpate them from liability in most of these situations, because they’re supposed to assume that management’s telling the truth, that the accounts are genuine, and that the documents they’re given are genuine,” says Mr Block. “An auditor has to be really, really negligent in order to be professionally liable.”

Auditors aren’t the only financial market supervisors thrust into the dock. For some, Wirecard’s collapse is especially unnerving because it happened in Germany, a country with a reputation for strong safeguards against corporate malpractice and fraud.

“Generally, stakeholder capitalism is considered to go alongside a very strong regulatory framework and a long-term approach to business,” says Professor Kenneth Amaeshi, chair in business and sustainable development at University of Edinburgh. “Of the methods of organising the economy and policing corporate ethics it is the system thought least likely to fail in preventing the kind of activities Wirecard was engaging in.”

Critics of Germany’s regulatory regime argue that a consensual model of market oversight means it is not fit for purpose. That view has been given extra weight by a request from the EU’s head of financial services policy to investigate BaFin’s handling of the Wirecard scandal.

“BaFin has just been atrocious, and not just on Wirecard,” says Mr Block. “Every single public critic of a public company in recent years has been put under criminal investigation in Germany. I look at BaFin as Wirecard’s most powerful accomplice imaginable.”

 

Blinded by the lights

Finally, there is the matter of corporate governance, and how high-flying, fast-growth stocks seem to perpetually breed an apathy within financial markets. In retrospect, the adage “if it looks too good to be true, it probably is” looks appropriate in the case of Wirecard.

“What Wirecard shows is that transparency and governance process have to scale in tandem with rapid business growth,” says Martin Davis, chief executive of Draper Esprit (GROW), a tech-focused listed venture capital firm. “It’s a warning signal that we should pay attention to.”

The saga will also raise scrutiny of the methodologies many funds and investors use to determine a company’s governance ‘score’. The Swiss ESG research provider RepRisk initially flagged the company as a medium risk in 2016 before upgrading it to a high risk in March 2019, though Wirecard had median ESG ratings from data providers including MSCI and Sustainalytics prior its collapse. This appeared enough to land the shares a spot on ESG-themed exchanged traded funds run by BlackRock and Vanguard.

Additional reporting by Megan Boxall.

This article was amended to clarify RepRisk's re-categorisation of Wirecard's ESG score in 2019.