Big Tech is Like a Long Firm Fraud

Another book that I really enjoyed last year was Davies’ Lying for Money. As its subtitle says, it’s about what legendary frauds reveal about the workings of the world, and while he doesn’t discuss big tech, the parallels are inescapable; understanding the patterns of fraud laid out in Davies’ book makes it possible to see them in Silicon Valley business plans.

Fraud is more common than prosecutions suggest, and its most dangerous forms are not easily recognized as fraud even by the people committing them. Many frauds begin as genuine optimism, turn into rationalization, and end in deliberate concealment. By the time the fraud is clear from the outside, its perpetrators may have so thoroughly internalized their own narrative that they are genuinely shocked by the prosecution. There is often no clear moment when they knew knew they were crossing a line.

The semi-technical definition of fraud is “a deliberate misrepresentation of material fact that causes someone to act to their detriment and the deceiver’s benefit”. It is easily confused with incompetence, negligence, and bad luck, but it is none of those things. A startup that believed its technology would work and turned out to be wrong is a business failure. A startup that knew its technology did not work and told investors and customers that it did is fraud. The difference is difficult to establish because (a) people can deceive themselves or mis-remember events and (b) they can also just lie.

Three kinds of fraud are particularly relevant to tech companies. A Ponzi scheme appears to generate returns by paying early investors with money from later investors, rather than from genuine investment gains. Each successful payment increases the scheme’s credibility and attracts additional investors. The schemer does not need to maintain a lie in the face of contradictory evidence: the evidence available to most participants is the evidence of payment, which is real. However, the scheme can only continue as long as new investment exceeds required payments. When new investment slows and required payments exceed available funds, the scheme collapses. The timing of the collapse is usually determined by market conditions outside the schemer’s control. This structure means that a Ponzi scheme operator may not know when the collapse will come, which provides an incentive for them to fool themselves as well as their investors. After all, the scheme worked yesterday—maybe it will work again tomorrow.

A long firm fraud operates on a longer timescale. The fraudster starts by building a legitimate-seeming business, establishing a track record of reliable transactions and prompt payments. Once they have a reputation for reliability, they use that to place large orders on credit, receive the goods, sell them quickly at a discount for cash, and disappears before the creditors can collect. The victim’s mistake is not in trusting the operator—the early trust is actually warranted. The mistake is failing to notice that the scale and urgency of later transactions is inconsistent with normal business patterns.

Control fraud operates inside a legitimate company rather than through a fictitious one. An executive who controls a company can use that control to route contracts to related parties, manipulate reported earnings to maximize personal compensation, extract value through structured transactions that are difficult for outside observers to interpret, and maintain an appearance of legitimacy for years. William Black’s The Best Way to Rob a Bank Is to Own One described the role control fraud played in the savings and loan crisis of the 1980s, and how it was made possible by Reagan-era deregulation that removed oversight mechanisms, and by accounting standards that gave executives wide latitude in reporting. The auditors who certified the books were paid by the companies they audited and had professional and commercial incentives to take management’s claims at face value.

Finally, accounting fraud works because accounting requires judgment at every stage where fraud can be inserted. Revenue can be recognized early or late; assets can be valued on optimistic or conservative assumptions, and liabilities can be disclosed prominently or buried in footnotes. Each of these choices meets professional standards and is individually defensible. Where the fraud comes in is consistently choosing the most aggressive position in every ambiguous case. Auditors frequently fail to catch accounting fraud because of the volume of material they need to review, and because their adversaries anticipate the specific tests that will be used to detect it. Most importantly, auditing fails because big accounting firms depend on their clients for their income, which gives them a powerful reason to not find any problems.

Davies2022

Dan Davies: Lying for Money: How Legendary Frauds Reveal the Workings of the World. Scribner, 2022, 978-1982114930.