Investors: It’s Never Enough to Depend on Regulators for Protection

As individual investors, is it always enough to depend on regulators or auditors for protection against fraudulent companies? I don’t think so – and neither should you.

Financial journalist Jason Zweig had recently interviewed investing maestro Charlie Munger and published some excerpts in The Wall Street Journal. As part of the interview, Munger commented on the role of accountants as a sort of policemen in the investing world (links and bracketed comments are Zweig’s):

“Accounting firms now [in the wake of regulatory requirements under the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010] have had to hire so many people that they have had to go way down in the bucket to get all these new employees. The government is asking accountants to be policemen, but the number of people smart enough to be qualified for policing is too low. We shouldn’t be expecting accountants to do the policing. Firms should have the ethical gumption to police themselves: Every company ought to have a long list of things that are beneath it even though they are perfectly legal. Every time you increase the antagonism of the audit by making the auditors the policemen, you increase the tension between the accountants and the clients. More things end up getting hidden, costs go up, everyone ends up worse off.”

Munger’s comments highlight how investors shouldn’t be overly reliant on “policemen” to do the job of ferreting out companies which might have significant ethical or legal issues in terms of their corporate actions. Although his words are specific with regard to the U.S., the broad strokes are still very applicable and important for us in Singapore.

Reading Munger’s words reminded me of an article titled “How Investors Can Protect Themselves Against Fraudulent S-Chips Such As Eratat Lifestyle Limited“ which my colleague Stanley Lim had written earlier this August. I’d come back to the connection between Munger’s interview and Stanley’s work, but first, let me go through a bit about the article. In it, Stanley discussed some of the lessons he had learnt about the fiasco that happened with Eratat Lifestyle Limited (SGX: FO8). Here’s a succinct recap:

1) In January this year, Eratat failed to service its loans when it supposedly had close to RMB600 million in cash on hand at that time; as a result, the China-based apparel company has been suspended from trading in Singapore’s share market since that month.

2) Then, Chinese banking authorities announced in August this year that Eratat had brazenly forged bank documents and grossly overstated the amount of cash it actually had – the company claimed it held RMB577 million in cash on hand as of 31 December 2013 when the actual amount was just RM73,000. Eratat has since sought a review of the Chinese banking authorities’ assessment of its cash balance.

In his article, Stanley also noted a few tell-tale signs that something was not quite right with the firm:

1) In July 2013, Eratat issued bonds with a two-year tenor which carries an effective annual interest rate of 16.7%. Those are very expensive borrowings for Eratat, especially when considering (a) that the company presumably had RMB545 million in cash just prior to the issuance of the bonds, and (b) the bonds’ short maturity.

2) The company had also chosen to borrow at such high interest rates even when cheap debt was (and still is) plentiful due to the prevailing low interest rate environment.

3) Eratat seemed to have earned an average interest rate of only 0.5% on its cash balance in 2012 even though RMB-denominated deposit rates in China were easily 3% at that time.

Circling back to Munger, the reason why the interview had reminded me of Stanley’s Eratat article was because a reader had commented on The Motley Fool Singapore’s Facebook Page about it, saying that “I’m sure SGX and [the] auditors would have done its due diligence on” the red-flags which Stanley pointed out. The thing is though, as investors, we would still have to depend on our own judgement – by a large degree – in order to protect our own investment capital from the likes of companies like Eratat. There’s only so much the regulators and “policemen” can do.

Investor and author Thornton O’Glove once wrote that when it comes to investing matters, “I would like to suggest that you can consult an expert whose advice can be trusted, someone who will be on hand whenever you need him or her, and who can be counted upon not to try to deceive… That expert is you [emphasis mine], or at least can be, if you make some effort.”

I couldn’t agree more with these wise words of his.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.