Gowex Shows Why Lending is the Best Venue for Accounting Control Fraud

By William K. Black
(Cross posted on Benzinga.com)

A classic accounting control fraud, Gowex, has collapsed in Spain.  Gowex was a wi-fi firm.  It was able to run its scam for at least four years.  It was a crude scam that involved simply making up contracts and borrowing to grow rapidly.

“The US firm Gotham City Research had described Gowex as a ‘charade’ and said that its revenues were ‘at most’ 10% of those reported.”

As soon as Gotham City Research blew the whistle on Gowex it made it impossible for Gowex to borrow additional funds and avoid collapse.

Accounting control fraud at Gowex, of course, led to the “sure thing” of enormous reported success and fame and wealth for its leader.  “Gowex … was widely touted as one of Spain’s entrepreneurial success stories.”

“In recent years, Spanish government officials often pointed to Mr. García and Gowex to highlight how innovative Spanish companies could grow by competing outside the country. Early this year, Spain’s government export agency granted Gowex its ‘Start-ex’ award for the company’s internationalization strategy.

Prior to the collapse, Gowex’s stock price rose from €2 to €26, so it was able to deceive both its creditors and investors for years despite relying on an unsophisticated fraud scheme.

For a wondrous ode to Gowex one needs to go back in time only a year to read the financial experts at Bloomberg.  The entire article is so hysterically hagiographic that I will simply provide the link and urge the reader to enjoy it in its entirety as a warning about how even unsophisticated accounting control frauds can easily con the world’s allegedly most financially sophisticated experts.

Ernst and Young named Gowex’s CEO Spain’s entrepreneur of the year in 2011.

A Spanish professor has written a column about Gowex’s collapse that says we should celebrate Gotham’s role.  In one way, his column supports my thesis.  It is, however, a strangely revealing column because of it takes such a blasé view to fraud.

“The collapse of Spanish WiFi connections provider Gowex, valued at around 1.4 billion euros less than a week ago, should prompt serious concern… but I’m not seeing much sign of it on the web. The first, and most important thing to establish as far as I am concerned, is that Gowex’s failure is no reflection on the sector it operates in.”

The professor’s view that the “most important thing to establish” is that Gowex is “no reflection” on the web is symptomatic of why massive accounting control frauds crimes are allowed to persist.  There have been enormous, disproportionate frauds in web products and the web is awash with fraud effort – all of which the professor ignores in his apologia for the web.  My point is that since he views Gowex as a success story for the web – it was only a roughly $1.5 billion fraud that lasted at least four years.  In the Spanish context, particularly at this time of crisis, Gowex is a catastrophe for the Nation.

Why Finance Produces the Worst Accounting Control Frauds

The CEOs of financial lenders and investors can easily produce dramatically more sophisticated accounting control frauds than were available to Gowex’s CEO.  The fraud “recipe” for a lender (which I have explained in numerous columns) has great advantages that typically cannot be replicated in other fields.  The proceeds of financial fraud are often cash or cash equivalents so no “fence” is required.  The assets frequently lack readily verifiable market values.  Leverage is typically extraordinary.  It is simple for CEOs of larger firms to suborn “independent” “controls” (auditors, appraisers, economists, credit rating agencies and attorneys) by deliberately creating a Gresham’s dynamic, but the process is much more successful in the finance sphere because it is far better to inflate than invent.  Making up customers is indefensible once it is discovered.  Understanding accounting control fraud schemes that involve making a property loan for 130% of the true value of the collateral, when backed by an inflated appraisal, is beyond the ken of modern (non) prosecutors.

Benjamin Wagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases in Sacramento, Calif., points out that banks lose money when a loan turns out to be fraudulent. “It doesn’t make any sense to me that they would be deliberately defrauding themselves,” Wagner said.

Wagner has jurisdiction over several of the leading “vectors” of the epidemics of control fraud that drove this crisis so his inability to keep his pronouns straight (“they” are the officers; the entity they are defrauding is the bank, not “themselves”) made it certain that the senior officers made wealthy by running the control frauds in his jurisdiction had practical immunity from prosecution.  Finance offers an ideal combination of seeming transparency that masks extreme opaqueness.

Publicly insured lenders find it even easier to grow dramatically to bring in new cash.  Systemically dangerous institutions (SDIs) (aka “too big to fail”) can also borrow much more cheaply because of the implicit governmental subsidy.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @williamkblack

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