JENARO GARCÍA was an eloquent cheerleader for Gowex, helping to propel the Spanish Wi-Fi firm to European startup stardom. When investors asked detailed financial questions of its founder and boss, however, he would clam up. Short-sellers, who bet against companies by selling borrowed shares, in the hope of buying them back more cheaply later, began to act on this reticence early this year. But the killer blow was a report by an opaque outfit called Gotham City Research, alleging that Gowex had far fewer wireless hotspots than it claimed and that 90% of its sales were bogus. On July 6th, five days after the report’s publication, the firm said it would file for bankruptcy and that Mr García (pictured) had resigned after admitting to fiddling the accounts for at least four years.
Gowex’s dramatic collapse marks one of the biggest victories for a relatively new breed of company-accounts “detectives”: small, independent research-and-investment outfits that revel in unearthing alleged book-cooking. Having focused largely on China’s fraud-filled market until now, they are branching out. Gotham is a secretive group linked to Daniel Yu, a trader whose motto is, “It is not who we are underneath, but what we do that defines us.” Other firms with which it has locked horns include Quindell and Ebix, two software providers. Both deny wrongdoing.
Gotham’s approach is to short and shout: it takes a negative investment position, then noisily publicises its findings. It is cut from the same cloth as Muddy Waters, which is run by Carson Block, a former self-storage entrepreneur. His biggest scalp to date is Sino-Forest, which went bust in 2012 after Muddy Waters accused it of overstating its forest holdings in China.
Another such outfit is Citron Research, whose leader, Andrew Left, prides himself on never having been successfully sued for defamation. A few hedge funds like to kick up a similar stink—most notably Bill Ackman’s Pershing Square, which is out to prove that Herbalife, a nutritional-supplements firm, is a pyramid scheme. (The market is unconvinced; the company rejects his accusation.) Their lineage can be traced back to the successful shorting of Enron in 2001 by James Chanos, another hedge-fund manager.
Gotham spent eight months studying Gowex, amassing far better information than investment-bank analysts, most of whom were still recommending the shares when it buckled. Gotham spotted that Gowex used a little-known auditor (a classic red flag: see the Bernard Madoff case), whose fees were unusually low, as if they were based on revenue far smaller than Gowex’s books stated. Often, the sleuths comb the books for ratios that are hard to manipulate. Gotham also noted, for instance, that Gowex’s revenue per employee was implausible compared with rivals’—while the revenue could be inflated, it was harder to fake the headcount.
Legwork also helps. Muddy Waters’ analysts visit target companies, their suppliers and clients to verify claims about production, staff levels and so on, sometimes posing as prospective business partners. Chinese firms with advance warning of visits by analysts have been known to rent workers and stock to deceive them.
Gotham’s declaration after Gowex’s downfall—“May truth, justice (and not vengeance), restoration and redemption prevail”—was somewhat bombastic. But a bit of bravado is justified: taking a big short position requires courage, especially in a rising stockmarket. Since shares have a floor but no ceiling, the upside for short-sellers is more limited than the downside.
There have been cases of short-sellers seeking to profit by spreading false alarms, but they probably detect real fraud more often than auditors, regulators and bankers combined. In catching fiddlers while they are still tiddlers, Gotham and its kind are sparing investors Enron-sized nightmares. Nevertheless, market regulators often eye them with suspicion: Spain’s at first reacted to Gotham’s report by investigating its publisher, not Gowex. China has cracked down on shorts, even imprisoning the writer of one negative report.
Even so, China will remain fertile territory. Muddy Waters’ latest quarry there is NQ Mobile, the head of whose audit committee resigned abruptly on July 4th. Mr Block is also said to be sniffing around in Africa, where investors are chucking money at little-known firms. Citron’s Mr Left reckons corporate fraudsters “can’t bullshit [investors] the way they used to,” because “there’s so much more accessible information online, in public records, and so on,” with which to disprove their claims. True, but the temptation to give it a try, faced with so many naive punters hungry for fat returns, seems undiminished.
Gerard Zack, the author of “Financial Statement Fraud”, a textbook, reckons that perhaps two-thirds of cases involve improper revenue recognition. New global accounting rules announced in May seek to curb one common ruse, booking sales prematurely, for instance on long-term contracts. But sometimes the revenues are simply invented, often by getting a related party to pose as a customer. Sometimes very closely related: Gotham said in its report on Gowex that it had evidence the firm’s biggest customer “was really itself.”
Such tricks can be used in any industry: think of the massive fake sales at Parmalat, an Italian dairy firm. But verifying that accounts match reality is often harder in technology businesses, making them “easier candidates for fraud”, says Michael Jones, editor of another book on “creative accounting”. In fast-growing tech industries there is a temptation to exaggerate revenues, to persuade the world that you are the “next big thing” and create enough momentum for truth to catch up with the hype. If this turned out to be the motive with Gowex, it would be no surprise.
From the print edition: Business