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August 16, 2012

Play Defense Against Corporate Criminals

By Mathew Weinschenk of Wall Street Daily

Corporate crime has gotten ugly.

We’ve come to expect an occasional fraudulent earnings meltdown (like Enron). And it’s no surprise to find out that a CEO has abused his access to the corporate jet… or that a rogue trader or an executive has been pocketing a few extra bucks on the side.

Lately, though, it seems like there’s been a significant rise in outright criminal activity among public companies. I’m talking about a new level of audacious decisions that go public and blindside investors.

Standard Chartered (London: STAN) is the latest culprit. While the bank still denies the specifics, it’s been accused of earning hundreds of millions of dollars through transactions with Iran that were barred by U.S. sanctions. We’ll find out eventually if the transactions actually were illegal, but shares are already down 6%.

While the true extent of Standard Chartered’s illegal activity still needs to be determined, there’s less in question when it comes to MF Global (OTC: MFGLQ). In his quest to turn the firm into a full-service investment bank, CEO, Jon Corzine, placed billions of dollars in risky bets on European bonds. Only the money wasn’t his to gamble, since it came from customer accounts. The firm is currently in bankruptcy and shares are down 99%.

Meanwhile, the LIBOR scandal centers around Barclays (London: BARC), but it appears that nearly every UK bank lied about its LIBOR numbers. HSBC (NYSE: HBC) is also under investigation for laundering billions of dollars for Mexican criminal organizations.

Even Wal-Mart (NSYE: WMT) got busted for paying bribes to local Mexican officials, which is a crime under the Foreign Corrupt Practices Act.

These aren’t just cases of shady accounting practices – but outright, deliberate criminal acts.

The problem with these corporate criminal cases is that there’s no deterrent. The conviction rates and sentences pale in comparison to the profits that can be gained.

Even worse, there appears to be no stigma attached to corporate criminals.

Major healthcare company, Columbia/HCA, was charged with defrauding the U.S. government by overbilling. It pled guilty to 14 felonies and paid $1.7 billion in fines. Its CEO at the time? Rick Scott, current Governor of Florida.

Then there’s Steven Rattner. President Obama appointed him to lead the bailout for automakers, despite the fact that Rattner was under investigation for paying bribes to U.S. officials.

Bottom line: So long as convictions and penalties for corporate crime remain weak, it’s up to investors to avoid stocks that could potentially experience a catastrophic criminal case.

Don’t bother using official data on corporate crime, though. Although FBI statistics indicate that criminal activity is on the rise, the data doesn’t pinpoint the companies to keep out of your portfolio.

Luckily, the key to avoiding these risky stocks is easy: Focus on smaller companies with basic businesses and high levels of insider ownership.

The logic is simple.

A small, easy-to-understand business is much easier to monitor than an international bank with complex financial transactions.

And so long as insider ownership is high, the executive has an incentive to prevent profit seeking through criminal means. To a true business owner, short-term stock gains don’t outweigh long-term stability.

For proof, consider that right before the scandals I mentioned above came to light, insider ownership was abysmally low: Standard Chartered, 0.06%…  Barclays, 0.13%… HBSC, 0.11%… Wal-Mart, 0.81%…  and MF Global, 1.14%.

On the opposite end of that spectrum, there’s a company like Revlon (NYSE: REV). It boasts a dead simple business selling consumer staples. More importantly, insiders own 76.9% of the stock, led by Chairman, Ronald Perelman, who holds 76.2% himself.

Or look at Dole Foods (NYSE: DOLE), the billion-dollar producer of fruits and vegetables. Its business is simple and profitable enough to encourage insiders to own 48.2% of outstanding shares.

You should also check out Heartland Express (Nasdaq: HTLD), the trucking company with insider ownership at 44%.

Granted, you can’t build your entire portfolio out of this small subset of stocks. But you should give them some extra attention to reduce your risk of getting blindsided by the recent rash of corporate malfeasance.

Courtesy Mathew Weinschenk at Wall Street Daily (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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