Today there is so much in the news regarding public versus private business benefits, regulatory landscape, and crypto. When I read or listen to each individual perspective, I can’t help but consider the risk to an investor whether it’s an individual investor, private equity firm, Initial Public Offering (IPO), or current Shareholder value, which is:
How easy is it for an investor to understand the complexities of a company and/or related transaction activity when transparency into the structure, financials and/or beneficial ownership is not available, misleading, or unable to be validated through a truly independent and authentic validation process?
As a result of the questions above and due to the ability of individuals to create legal structures to exempt them from reporting and/or purposefully create complexity to cause confusion, my approach with any client project, is to understand and assess the organizational structure, beneficial ownership and affiliates of each company and activities being performed inclusive of intracompany transactions to identify where vulnerabilities or inappropriate activities could exist thereby enhancing overall risk management and ultimately protect against credit and liquidity risk. To be honest, this can be quite difficult at times due to available information and related complexities.
A few events which jumped out at me over this past week:
- Rocket merger with Mr. Cooper Group and Maverick: since these companies are publicly held, including the newly formed Delaware company, Maverick, investors may review the required forms surrounding the deal, beneficial ownership, and financials which can be utilized by multiple parties and for multiple purposes. While the deal is not closed and associated transactions reported via financials, questions arising include:
- What is the purpose of the newly formed company, Maverick?
- How will transactions flow?
- What are the contractual obligations?
- What sort of due diligence was performed over the loan portfolio?
- X merger with xAI: since both are privately held, there is not much for me to review to gain an understanding about the transaction, beneficial ownership, or related accounting transactions. What I assume is one individual is likely the majority stakeholder; however, unsure if there are others involved; however, I do see where cash flow can be immediately increased while reducing tax liability (from a high-level perspective). Therefore, if I were a private investor, questions which arise:
- Who were the beneficial owners of each company (i.e., individuals owning 5%+ of each company’s equity)?
- How was the $45 Billon valuation determined and supported by independent sources free of influence or pressure?
- What were the related accounting transactions recorded, at what value, and amortization schedule (e.g., goodwill, stock compensation, etc.) within the financials?
- What other Critical Audit Matters exist related to the merger and the way the deal was structured via contractual obligations?
- What level of due diligence was performed around performance and financial metrics with tie-out to valid and authentic supporting details and transactions (which somewhat goes to 1b above).
- Crypto: as stated in previous blog posts, when evaluating the crypto activities and parties, conceptually this is the same as other security trading and/or pre-IPO – the difference includes the platform in which its done and the underlying asset and how value is derived. Specifically, when assessing the “crypto” activities being performed, all the applicable trading activities (e.g., buying, selling, swaps, futures, etc.) occur inclusive of investment schemes, financial crimes, and fraud. The question which arise:
- How is security over the platform, signatures, transactions, etc. monitored?
- How is the value derived over the asset (e.g., token)?
- How are activities monitored to prevent investment schemes, financial crimes, and fraud?
In the scenarios above, the current regulator landscape does not monitor the last two transactions, unless there is violation of trade, financial crime, or fraud being committed, increasing the risk to the investor due to credit and liquidity concerns and ability to receive equity from these investments.
Let’s utilize a few historical events realizing credit and liquidity risk:
- Enron: while a public company, two companies merged and later defrauded investors through complex company structures, transactions, and creative accounting treatment. The root cause: lack of independence and understanding inclusive of the external audit firm as well as insufficient due diligence and analysis around the purchase/sale transaction activities, rates charged, value recorded, etc.
- Mortgage Crisis: new and creative financial instruments were created, securitized, marketed, and sold to investors with the benefit of receiving higher return on investment – who wouldn’t have bought into it. The issue was the credit quality of the loans packaged, marketed, and sold were of poor quality due to the individuals originating and underwriting the loans yet the credit agency ratings were not reflecting the actual quality – ultimately a result of insufficient due diligence of the loans packaged to adequately rate the securitized pool due to the complexity of the financial instrument. There are a few entertaining and informative movies made around this – The Big Short, Margin Call, Wolf of Wallstreet – if you haven’t watched them, I highly recommend you do as they do a good job of explaining while entertaining the audience.
In the above historical scenarios, unfortunately, consumers and investors were negatively impacted based on the decisions made by the employees and companies. These individuals were not able to recover investments made whether it be in equity owed, retirement savings, etc.
In summary, due to the ambition of individual(s), if we as risk professionals do not timely identify red flags and provide adequate monitoring and oversight, we will have history repeat itself via emerging and evolving products, services, platforms, activities, etc. by those involved in the lifecycle of the transaction regardless of whether you are a public or private company. The red flags to me can be summed up as follows:
- Complexity and Creativity with:
- Organizational structure
- Beneficial ownership inclusive of traceability
- Transactional activity inclusive of traceability
- Accounting treatment
- Lack of Independence and Oversight
- Insufficient Due Diligence and Ongoing Monitoring,
Historical Event Articles:
- District of Massachusetts | Eighteen Individuals and Entities Charged in International Operation Targeting Widespread Fraud and Manipulation in the Cryptocurrency Markets | United States Department of Justice
- Enron — FBI
- Crisis and Response: An FDIC History, 2008–2013
Regulatory Guidance, Bulletins, Press Releases, Tools
Sen. Rick Scott Introduces Bill to Track Treasury Payments After DOGE Finds $4.7…
SEC.gov | EDGAR Full Text Search
FDIC Clarifies Process for Banks to Engage in Crypto-Related Activities | FDIC.gov
PCAOB | Driving improvement in audit quality to protect investors
IRS-CI releases FY24 BSA metrics, announces CI-FIRST initiative | Internal Revenue Service