Most investors scrutinise the financial records of their potential investments, but despite doing so, all too often, it is those minor or inconsequential figures that do slip through the cracks. The issue really is, that there are no shortcuts to making great gains responsibly, and very often it is those dangerously small-line items that can end up destroying a company.
The irony is that, often, it takes just an innocuous query by a sharp-eyed person to ask for further details about an area of business that does not seem to gel with management’s view of its apparent rosy prospects.
This is what happened recently with a listed company whose business involved a new manufacturing technology. However, before this technology was accepted by the market, various economic powers would first ensure that it met all known safety requirements before the product with such technology was allowed to be sold.
Interestingly, it was the independent non-executive (INED) chairman of this listed company who asked the question that exposed some of the inner workings, which were at best, could be described as iffy. He did so after he was puzzled as to why the company was consistently paying a higher price for the raw materials compared with the industry.
So the chairman decided to do a thorough review of the prices at which the company purchased all of its raw materials. To start with, he asked the company’s in-house management to prepare a simple graphical chart of the prices at which they bought the raw materials, versus the market price at which their rivals bought the same materials.
From the prepared charts, it was evident that the higher prices that the company had paid were not a one-off aberration; in fact, the company had been over-paying for raw materials for more than 10 years.
The chairman pushed the needle further and asked for a summary of all the historical prices for the materials bought by the company. Again, it was clear from this summary that the company’s performance had been hurt by the higher prices it had been paying for a particular raw material. The higher raw material prices had clearly squeezed their profit margins.
Now, convinced that something was clearly amiss, the chairman then demanded that management start explaining itself for its counterproductive purchasing policy. He also commissioned a full forensic audit to pinpoint exactly where the company went so wrong.
The chairman is non-executive but, in his previous career, was in the criminal investigation unit. So, although he was now retired from the police force, he remained in close touch with his former colleagues, and reached out to them once he discovered such pricing discrepancies in the listed company.
With the help of the police, the chairman learnt that the company’s supplier and trader had been paying kickbacks to one of the company’s staff members since the Asian financial crisis in 1997. This kickback, or rebate, ranged from US$7 to US$40 per tonne.
In this scheme of things, US$7 per tonne, paid as a premium, as it were, for a deal would not really set off alarm bells since it works out to be a small percentage of the sale, and so is likely to go undetected during a normal audit.
But as the saying goes, the devil is in the details. So when the errant staff member got more greedy, over 17 years, this single supplier reportedly paid almost US$9mil in kickbacks to him. Another finding reported that a second supplier had been paying this staff member US$30 to US$40 per tonne for the past 11 years, which amounted to almost US$50mil in kickbacks.
The staff member in question soon got wind of the chairman’s probe into the purchasing mechanisms for the raw materials. The staff member also learnt from internal emails that a full-fledged investigation into the matter was under way; he even managed to read one particular email, which showed that he was being investigated.
In an attempt to cover his tracks, the staff member suddenly began to withdraw huge sums from his multiple bank accounts that had swelled from the kickbacks he received.
But it was too late. The investigators amassed enough proof for the company to sue the staff member. This enabled prosecutors to freeze the staff member’s bank accounts, and obtain a warrant to search the latter’s residence as well as office. Thanks to the chairman’s strong standing within the police force, this case progressed rapidly.
One search at the staff member’s residence uncovered piles of banknotes stuffed into old boxes, brown paper bags and old suitcases – all of which amounted to US$7mil in cash.
The investigators also later discovered his offshore banking accounts – the staff member had accumulated over US$70mil in these accounts.
Given the scale of his fraudulent act, the investigators have said that they are not ruling out the possibility that he was in cahoots with some of his colleagues. So the investigators are now looking to expand this investigation if necessary.
As this case progressed, the staff member claimed that his US$7mil cash hoard at home was from his sales of land. But when the investigators interviewed the company’s suppliers and traders, the latter disclosed that the staff member had required them to pay the rebates on the raw materials to an offshore company, with very clear banking instructions.
What makes this case so curious is that there has been no mention anywhere that the company’s auditors picked up any of the discrepancies noted by the chairman, especially the continuous squeeze in the company’s profit margins.
We have, however, heard that the circumstances discussed here happen in many ways and in different forms when procuring raw materials.
So, this manufacturing company case study highlights clearly the need for investors to pay close attention to details to ensure that operational compliance is robust, especially when there is raw material pricing, and procurement policies.
And, if you are lucky, you invest in a company that has a dynamo of a chairman who protects the best interest of the company.
© CORSTON-SMITH ASSET MANAGEMENT SDN BHD 2014