One of America’s Most Iconic Names Is Facing Fraud Allegations: Here’s What Investors Should Know

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Once the company that was famous for great management, Nobel prizes and manufacturing light bulbs, General Electric (NYSE:GE) is staring down a recent report by Harry Markopolos alleging that the company is hiding its financial issues for years and is about to collapse.               

Share price of GE tanked as much as 14% upon the release of the report, which Markopolos alleged that GE is committing fraud “bigger than Enron and Worldcom combined”.

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It’s hard to determine who to believe at this point and investors are still unclear what to do with the information. Hence, we are going to go through everything you need to know about these fraud claims and the implications for the market if the report is true after all.

Performing a detailed analysis of the short report is impractical both because of the depth and range of the report, so I shall attempt to sum it up to a few points in order for us to have a better understanding.

GE Fraud Allegations

2 weeks ago, famed fraud investigator Harry Markopolos, the man who had busted Bernie Madoff, came out with a report detailing the fraudulent activities within this industrial conglomerate. After going through the report, I found that the two main issues that Markopolos claimed are;

  1. Long Term Care Insurance Policies
  2. Accounting of the merger between GE and Baker Hughes

Long Term Care Insurance Policies (LTC)

What are LTCs?

Long Term Care Insurance is an insurance product that helps pay for personal or medical care needed when one becomes disabled due to age or has adverse health problems. In Singapore, we have a similar policy in Eldershield, which will be enhanced into the new “Careshield Life” scheme in 2020.  

What is the issue?

According to Markopolos’s report, GE’s LTC insurance arm do not have adequate reserves to be able to pay out their claims. He alleged that its liabilities have been understated for decades by underestimating its future payouts for LTC policies.

In total, he estimated that GE has to take a US$29 Bil impairment charge (non-cash) to balance out the disparity found in their books.

What will happen if the allegations are true?

If the report by Markopolos is true, the industrial conglomerate would be paying out billions of dollars more on its policies. Even if GE need not cough out the money immediately, it will likely come over a few years. With GE already informing that there will not be any positive cash flow until 2020, their financial situation seems bleak, and that is the scenario with no recession ahead.

Baker Hughes, A GE Company (NYSE:BHGE)

The Merger

In 2016, GE’s management decided to combine its Oil and Gas segment with Baker Hughes in an attempt to create a formidable player in the Oil and Gas industry. Upon completion of the transaction, GE shareholders acquired a 62.5% stake in the combined company, Baker Hughes, A GE Company (NYSE:BHGE) while Baker Hughes shareholders received a special dividend and walked away with 37.5% of BGHE’s equity.

What is the Issue?

The point of disagreement is based on the fact that GE consolidates BHGE into its own financials which Markopolos disagrees and claimed that BHGE should be the reporting entity. In GE’s books, BHGE should be classified as Marketable Securities Held for Sale and reported at fair value.

What will happen if the allegations are true?

The worse case that I can think of would be to take a loss of $9.1 Bil which have been clearly stated in their financial statements. However, I would not classify it as fraud. To be considered guilty of fraud, GE would have to withhold financial information from its shareholders, but in this case, it is more of an error in their financial reporting.

Other Allegations

Besides the two strongest claims that Markopolos makes, the rest of his allegations are as follows;

  • High margins reported by GE’s divisions are nowhere near GE’s corporate margins
  • GE only reports revenue and profit and did not include other details.
  • For joint ventures, their numbers do not match their partner’s more detailed reports
  • Reporting format in Annual Reports change frequently, making it very hard to make comparisons.

GE’s Response

General Electric’s management wasted no time vigorously denying Markopolos’ claims. In CEO Larry Culp’s words, “This is market manipulation — pure and simple.” 

These are the important points in their address.

1) Management Is Riding In the Same Boat As Investors: Sink or Swim Together

According to reports, Markopolos is working with a hedge fund that is currently shorting GE and if successful, he stands to gain a portion of the proceeds. This could be possible as it shows that it could just be  an elaborate short campaign just to make some money. Of course, I find it a little exaggerating when he even bought the www.gefraud.com domain just to make his point.

2) Rebuttals

A rebuttal in point form is released stating that they have plenty of cash to pay its LTC insurance claims and that raising more cash if necessary should not be an issue to GE. GE also queried on Markopolos’s accounting methods such as mixing up reinsurance contracts and insurance contracts in his investigation.

3) Share Buyback

If that was not enough to prove his innocence, Larry Culp, CEO of GE, bought back US$2 million worth of shares.

Editor’s note; I read this as sort of like a middle finger back at Markopolos’s claims. Thanks for making my shares cheap for buyback, I guess?

Investors, however, need to be aware that CEOs of big corporations tend to find millions of dollars small change unlike the average person on the street. $2 million is nothing compared to $20 million.

Note that share buyback when done right is good for investors. But buying shares at inflated prices using precious liquid cash is not a good thing for any company at all. Using this as a stop-gap measure to buoy share prices is not in the slightest bit a good thing.

Conclusion

It is still in the early days and I cannot say who is lying at this point. Markopolos had issued a very detailed report alleging fraud backed with evidence of financial irregularities. At the same time, I’m sure GE’s lawyers are crunching out the numbers right now to deny the claims and also to present proof of their financial strength.

Instead of playing the guessing game, it is more important for investors to think about the scenarios that would play out in each case. Of course, investors can also look forward to their next financial reporting as an update to GE’s business.

If you’re interested in taking a look at Markpolos’s report, here’s a link.

Cheers.

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