GE’s Alleged Fraud: Another Reason to Invest in Startups

General Electric shares dropped 11% yesterday to $7.80 after famed fraud investigator Harry Markopolos released a report calling GE a “bigger fraud than Enron.” You may remember Mr. Markopolos as the man who tried to alert the Securities and Exchange Commission (SEC) to Bernie Madoff’s billion-dollar ponzi scheme a decade before it collapsed.

To be fair, it’s worth noting that Markopolos is working with an unnamed hedge fund that has shorted GE stock and stands to make money if GE shares drop. So Markopolos is not exactly an unbiased witness. Despite this, I’m inclined to listen to what the man has to say.

In a 175-page report, Markopolos claims GE hid losses of at least $38 billion from its insurance business. Here are a few highlights I selected.

To prove GE’s fraud, we went out and located the 8 largest Long-Term Care (LTC) insurance deals that GE is a counterparty to, accounting for approximately 95% or more of GE’s exposure. Either these 8 insurance companies filed false statutory financial statements with their regulators or GE’s financial statements are false…

My team has spent the past 7 months analyzing GE’s accounting, and we believe the $38 billion in fraud we’ve come across is merely the tip of the iceberg. To put it into perspective, $38 billion in accounting fraud is over 40% of GE’s market capitalization, and we know we only found a portion of it. If you love analyzing accounting fraud as much as we do, we’re sure you’ll find our slide deck a gripping read…

GE has been running a decadeslong accounting fraud by only providing top-line revenue and bottom-line profits for its business units and getting away with leaving out cost of goods sold…

To make it impossible to compare GE’s numbers across multiyear time periods, GE changes its Financial Statement reporting formats every few years…

Our Whistleblower Report only details $38 billion in accounting fraud, but we know we didn’t catch everything. Only GE’s accounting department knows where the rest of the skeletons are buried…

The report is blunt, detailed and could be absolutely devastating to GE.

I have to believe Markopolos and his partner wouldn’t have made these claims unless they were certain. Primarily because if the allegations aren’t true, they will be sued into oblivion by an army of GE lawyers.

GE has issued a statement in response to the report, which begins by saying that “The claims made by Mr. Markopolos are meritless.” Meritless is an interesting choice of words.

Why not just say the allegations are false? I suspect that every word in that statement was chosen carefully.

Disturbing Implications If True

One question has been bouncing around in my head since these allegations broke. If the claims are true, how the heck did every analyst on Wall Street miss this?

For at least a decade, GE has been known to use murky accounting. Back in 2009, the SEC sued it for fraud, accusing the company of using “overly aggressive accounting.” The company paid a $50 million fine and admitted no guilt.

And in 2017, The Wall Street Journal wrote a series about GE’s accounting practices, stating that “No matter what happens with General Electric Co.’s dividend, investors will still have to grapple with the fact it is nearly impossible to tell how much of its earnings are backed by cash.”

With its history, you’d think GE would have been under more scrutiny from regulators and analysts. It’s disturbing to think it could have gotten away with such a massive scheme for so long (if the allegations prove true).

And if this is happening at one of the most iconic firms in America, and nobody spotted it, how much similar behavior is happening at other companies? At banks? Insurance companies? All are known to have “hard to decipher” financial statements.

Part of a Trend?

Too many U.S. companies today are thinking short term. Some “massage” their financial reports. Some commit fraud. And many others take on dangerous debt loads.

At GE, this alleged fraud may have started with a small deception to hit quarterly numbers and then snowballed from there.

Another big problem is that most companies today pay their CEOs far too much money. GE’s former CEO Jeffrey Immelt, for example, earned nearly $33 million in 2015, despite lackluster performance.

GE is not alone. Check out this chart, which shows how much more money American CEOs make than the average worker. In 1965, the CEO made 20 times the average employee. Today, it’s 312 times!

Note how the CEO pay ratio appears to have peaked in 2000 and 2008 during the height of the last bubbles. And it looks set to peak again soon. It’s yet another sign that we are in the late stages of this cycle.

The corporate culture in many “establishment” companies is failing. Eventually a lot of these dinosaurs will go extinct, leaving huge gaps across industries.

This is a big reason why I prefer to invest in young U.S. companies (startups) instead of the S&P 500 or the Dow.

Disruptive startups are already changing the landscape across all industries. The fact that many older, established companies are loaded with debt, use questionable accounting and are being raided from within by their own executives just makes the decision easier.

Good investing,

Adam Sharp

Co-Founder, Early Investing