Who is right, the sleuth who exposed Bernie Madoff's gigantic Ponzi scheme, or GE's prestigious board and highly acclaimed CEO, a team hailed on Wall Street for making great strides in rescuing and reforming the abusive conglomerate?
In his flame-throwing report released August 16, entitled "General Electric, A Bigger Bedan Than Enron", Harry Markopolos – the forensic accountant who nailed Madoff – accuses GE of engaging in $ 38 billion in accounting fraud. He accuses the one-time industrial and economic colossus of deliberately failing to take sufficient reserves to cover gigantic current and future losses in its long-term insurance business, and broke US accounting rules by failing to post a major write-down on Baker Hughes GE energy unit. For Markopolos, GE is a dead end business. He cites that legendary scams Enron and WorldCom collapsed just four months after their misdeeds were exposed, saying that GE could implode just as quickly. "GE is a bankruptcy waiting to happen," he declared on CNBC.
Markopolos is not only aimed at the former regime of former CEO Jeffery Immelt. He claims that GE's current C-suite does not understand its opaque accounts ̵[ads1]1; and worse. In an interview at Yahoo Finance, he stated that "GE's accounts are almost unreadable," and that "I doubt" CEO Larry Culp can read them. When asked if the CEO and CFO are engaged in coverage, he replied: "I think so." Why didn't Markopolos GE allow him to review his findings before he went public? "Who wants to talk to the scammers so they can take part in coverage?" Markopolos told the Yahoo Finance interviews.
Markopolos & # 39; s attack on today's management is extraordinary, because GE has recently appointed a highly respected CEO and a largely new, extremely prestigious board. The directors, which include the former US headquarters, boast strong expertise in only those areas where the report finds fraud and abuse. Trading in GE shares indicates that while the report has raised new concerns among investors, Wall Street is nowhere near buying Markopolo's disaster scenario. After dropping 11.3% on the day of its release, the stock fell sharply on Friday, shaving its decline to a modest 2.7%.
The duel is one of the most fascinating and significant events in corporate America. The investigator claims that what appears to be a highly qualified team does not understand their own accounts, and fails to recognize that it is virtually insolvent – and perhaps even boils the books – – while GE claims the attacker has the numbers wrong, and is motivated by financial gain harvested by lowering the stock. The question is a crucial question that can apply to other troubled companies. Is it really possible that a new CEO and board, armed with all the right credentials, cannot understand a complex, opaque business to the point where what they believe is a resurgent business is really on the verge of failure?
According to my conversations with GE insiders, they believe Markopolos – – who acknowledges that he was working on an undisclosed hedge fund that gives him a share of their profits by shorting GE shares – who plan to use false, but transgressive beats. down the stocks and make a killing for themselves. The moment was successful: GE just announced that the CFO is leaving, raising questions among money managers about bad news to come. Insiders claim that Markopolos took advantage of the difficult nature of long-term care insurance, a hostile complex area based on complicated mortality assumptions and discount rates that makes headaches difficult to analyze. They suspect the secret fund cleaned up by dumping the shorts during the brief panic, which made it easy for themselves and for Markopolos.
The GE management will seem about as difficult to do as any team in US companies. Culp, appointed CEO on October 1, had achieved spectacular success at the helm of another industrial conglomerate, Danaher, and multiplied the share price five times from 2001 to 2014. In many rescue situations, a superstar chief executive at short notice, without the ability to assess the company's problems carefully from the inside, and are then overwhelmed by serial surprises. But Culp took the job after serving as a director for six months, so he could investigate all the business up close, so he clearly believed GE's worst problems were behind it.
GE's future also looked promising enough to attract a largely new board deep within its operating and financial talent. In early 2017, GE had 16 directors; thirteen have resigned, and among the thinned group of ten are six former or current CEOs, including Culp, Accor CEO Sebastien Bazin, and ex-CEOs of American Airlines and Cognizant, Tom Horton and Francisco D & # 39; Souza. The other two have long experience in insurance. James Tisch runs Loewes, owner of commercial carrier CNA, and Paula Rosput Reynolds, former director of Safeco. Horton and another director, Catherine Lesjak, also held major CFO positions: Horton at both US and AT&T, and Lesjak at Hewlett Packard. Ed Garden, a principal at Trian, a major GE investor, is known as a practical director in the fund's portfolio companies. It was Trian who threatened a power struggle that accelerated the transformation of the board.
The chair of the Audit Committee is Leslie Seidman, former head of the Financial Accounting Standards Board, the organization that creates US reporting standards. Seidman mixes a nice way with an approach to uncovering pitfalls so tough that as one person told me, "she eats nails for breakfast." The board chose Seidman to deliver a big draw, and she hit back hard. "The report is full of opinions," she told CNBC. "It's full of inflammatory and inaccurate claims. I'm not sure the author really understands accounting in this area. Is it because of incompetence or other motivation?" She took the allegations of fraud as a personal offense: "I have full access to the persons and books and records, and I am in charge of the financial reporting to this company. There is no basis for any allegation of fraud."
For Seidman, the game spreads high stories of malfeasance to get a fast windfall. "This report today set a very dangerous precedent," she concluded. "where someone can just say things and take advantage of the monetary downturn in the stock. That's wrong."
Nevertheless, Markopolos must be taken seriously because of its previous record revealing accounting fraud. His team took seven and a half months to produce the 168-page report, and it is extremely detailed and specific. Here are four areas that could raise major concerns for investors unless GE addresses them.
The alleged undisclosed losses are really, really big
The report charges that GE must immediately pump $ 18.5 billion in new cash into long-term care reserves to pay to nursing homes and the like that serve policyholders . That's because the report claims it has failed to set aside nearly enough in reserves to finance new claims, which massively exceed premiums. In addition, GE will be forced to take $ 10.5 billion, non-cash write-downs imposed by changes in accounting standards by the first quarter of 2021. This cost recognizes that future liabilities are much larger than the balance sheet figures. In addition to the $ 29 billion shortfall in long-term care, Markopolos maintains that GE exaggerates its investment in its majority-owned Baker Hughes $ 9.1 billion oil and gas unit. That brings the sum of what he calls "accounting fraud" to $ 38 billion.
It is a brobdingnagian number, equivalent to 40% of GE's market development before release. And Markopolos insists it's just "the tip of the iceberg."
The claims buzz premiums
In the mid-2000s, GE arranged to "reinsure" 280,000 long-term recipients for eight transporters who had sold the original coverage, and took full risk of these policies. The sector includes services such as housing in nursing homes and assisted living, and home nursing. It is one of the most unpredictable parts of insurance business, and it has proven to be a great loser for many carriers. Because people live far longer than the actuaries estimated decades ago when they signed up, and because medical costs have risen tremendously, the premiums collected and often do not come close to covering these lifetimes.
Markopolos, GE outperformed its competitors for two reasons. First, it did not put nearly enough money aside to fund future claims, instead used the premiums on share buybacks and dividends, and secondly, the policy was much riskier and more expensive than Prudential or Unum. In 2013, GE's largest insurance unit collected $ 192 million in premiums and paid out $ 160 million in claims, for a profit of $ 32 million. But premiums are dropping as claims soar, so GE last year brought in $ 113 million in premiums and paid out $ 594 million, for a $ 482 million deficit. Its "loss rate" of claims for premiums is thus 5.2 to 1, which means it spends $ 5 for every dollar it raises. Unlike both Pru and Unum, the premiums exceed the expenses .
Markopolos claims that GE has only paid around 13% of the total claims it will be required to cover in the future. The claims, he says, are increasing "exponentially" so that today's $ 28 billion deficit represents only a fraction of what GE will need to add to its future reserves.
GE wasted money needed for repurchase, dividend and c-suite pay reserves
From 2012 to 2018, GE generated $ 14.9 billion in net income, but still paid $ 106 billion in buybacks and dividends. Over the eight years, GE paid $ 637 million, a staggering 4.2% of net income, to the top five. Markopolos maintains that it simply treated premiums as "income" available to compensate shareholders or pay top brass when much of that money was needed for reserves.
Why Markopolos says GE is heading for bankruptcy
Markopolos claims that if and when GE takes the $ 28 billion in hidden losses, its equity will shrink to minus $ 6.2 billion. Since GE carries $ 106 billion in total debt, its debt and equity ratio will jump to 17 to 1. The tiny equity pledge can break GE's loan agreements with banks and bondholders, allowing them to bankrupt and recover part of their money by force the conglomerate to liquidate by selling assets.
Once again, this is the disaster movie that doesn't scare investors much – at least so far. GE's best defense is a very transparent, few-facts-out rejection. The star-studded board swears that it has facts on its side. This too secretive company in some ways invited the attack by revealing so little about a hereditary business where analysts need plenty of data to consider.
The duel has begun – and now it's up to investors to decide who they support.
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