Wirecard: a giant’s collapse

The vicious sell-off of the stock came after shares were suspended on the floor of the Frankfurt Exchange for 60 minutes on Thursday, June 25th, pending announcement of the company’s insolvency. The announcement leaves the eminent German fintech player with very few avenues. The resignation, and ensuing arrest (after turning himself in) of long-serving CEO Markus Braun for false accounting and manipulative business practices has not helped matters.The crisis calls into question the authenticity of financial statements, which are the sole prop buttresses the reliability of the firm, based on which investors, regulators and creditors take decisions. This mismanagement is reminiscent of the Enron crisis that shook the USA markets in the early 2000s.

Wirecard’s once-celebrated Ex-CEO Markus Braun. Source: AP

What really transpired?

The spiral commenced when EY (formerly Ernst and Young), the long-time auditor of Wirecard refused to sign off on the 2019 books of the company on June 18th, claiming a missing $2.1 billion (€1.9 billion). It was unable to confirm the existence of the amount in cash balances on trust accounts, conforming to the findings of an external probe by KPMG in April. EY cited “clear indications that this was an elaborate and sophisticated fraud, involving multiple parties around the world in different institutions, with a deliberate aim of deception.” KPMG was unable to verify €1 billion in revenue from third parties in a six-month long probe. Wirecard insisted that the money was kept in an escrow account in the Philippines. Chaos ensued, causing the shares to nosedive 80% over two days of trade and CEO Markus Braun resigning on June 19th. The torrid 48 hours had more to offer- The two banks in which the money was alleged to have been deposited washed their hands off the situation, with BDO Unibank Inc. (the other one being the Bank of the Philippine Islands) publicly announcing that Wirecard “is not a client of the bank” and the documents claiming the existence of a Wirecard account were in-fact “falsified” and “carried forged signatures of bank officers.”

Matters waned further, with COO Jan Marselak suspended on the 22 nd and CEO Markus Braun suggesting that Wirecard themselves had been caught up in a fraud of epic magnitude- “It cannot be ruled out that Wirecard AG has become the aggrieved party in the case of fraud of considerable proportions”. Mr. Braun himself owns 7% of the company’s stock. The corporation announced that the money “probably does not exist.”Wirecard also pulled the plug on the release of audited results for the whole year 2019 and the first quarter of 2020, due to be published on the 19th of June. The failure ofpublishing the audited accounts has left creditors with the right to terminate €1.75 billion in a revolving credit facility loans to the company.

The cash-balance’s mysterious ‘disappearance’ has cast aspersions on the regulatory authorities of Germany, which allowed Wirecard AG (WDI) to trade in the prestigious Frankfurt DAX index in late 2018. The company soared, reaching a peak worth €25 billion ($28 billion) by market capitalization.

Once regarded as Germany’s hottest fintech prospect, the accounting fraud probe now leaves the company mired in controversy and uncertainty. The creditors of Wirecard, including Commerzbank AG and ING face an uphill battle of recouping losses and are in for long drawn negotiations about clarity post-insolvency with administrators in exchange for the extension of $2 billion in credit to Wirecard. Visa and Mastercard licenses are also set to be revoked for the firm if clarity of the missing money isn’t found. Credit Rating’s agency Moody’s lowered the firm’s rating by 6 levels, putting it just one tier above junk debt on release of the news.

Markus Braun was replaced by James Freis as interim CEO on June 18th. Mr.Freis was tipped to join the board as a compliance executive and has previously served as the chief compliance officer of the German stock exchange. He now faces the prospect of steering a sinking ship through a regulatory storm, with persecutors, shareholders, and creditors looming. DWS, the largest stakeholder of Wirecard, is weighing legal steps to take against the company. It is still unclear whether Wirecard’s subsidiaries (including Wirecard Bank) will be involved in the regulatory and insolvency proceedings, with the final say lying with the German financial regulatory body, BaFin (Bundesanstalt für Finanzdienstleistungsaufsicht).

The payment processing giant has scrambled for a lifeline, appointing investment firm Houlihan Lokey to find a ‘sustainable financial strategy’ to carry out. Wirecard is in ‘constructive talks’ with major creditors including Commerzbank AG, LBBW and ING. It is looking for the continuation of business operations and suggested a restructuring of debt and termination of business outposts.

Stock prices plummeted after the missing balances and insolvency announcements. Source: Google widgets

Wirecard: It all starts with a good intention

Wirecard AG is a relatively unknown online payments processing firm, linking merchants, banks, and customers, as well as providing related financial services and loans through its banking wing, Wirecard Bank. Founded in 1999, in a small Munich suburb of Aschheim with modest origins, Wirecard hopped onto the dotcom bandwagon as a call center operation and went public in 2000. The Dotcom bubble burst arrived soon enough, leaving the pioneering business to restructure itself. Morphing into a secure online payment provider, Wirecard was well received.

The willing adoption of technology in finance and Ecommerce made it a darling for investors. In tandem with its mantra of a “cashless society”, Wirecard became one of the first players in the market to adopt the HCE (Host Card Emulation) technology, where a smartwatch could be used for payments in 2016. Wirecard laid a business model- where it penetrated young markets to innovate, create new payment methods that allow the fast adoption of technology. This drive to revolutionize digital payments made Wirecard a force to be reckoned with.

Under the Austrian’s leadership, Wirecard consolidated its position in the German market, in as well as dabbling in Asia as a partner to AliPay and Wechat, as well as linking up with obscure third-party vendors in Dubai, Singapore, and the Philippines. Between 2014 and 2018, Wirecard made 11 acquisitions worth €1.3 billion, particularly in the Asia-pacific region, in a set of oddly structured deals, with the abstruse acquisition of an Indian payments firm in 2015 for €340 million. In 2016, Wirecard took a giant step into the North American market by buying a prepaid payment business from Citigroup.

In the December of 2017, Markus Braun revealed that the company had received a €150  million loan from an undisclosed lender with his own shares pledged as collateral. The company peaked in 2017-2018, when it briefly crossed Deutsche Bank on the Tec-DAX index (with a then valuation of €21 billion ($24 billion), over Deutsche bank’s €20 billion), making it the most valuable financial services provider in Germany, despite allegations over balance sheet discrepancies. Its revenue reached €1.5 billion, with a balance sheet value of €5 billion. In 2017, it was proclaimed as one of Germany’s 30 most valuable companies. In 2018, Wirecard reported to have 5000 employees, with 250,000 merchants including over 100 airline companies, and a valuation of more than “40 times that of next year’s expected earnings”. The fairytale didn’t end there- in 2019, Wirecard secured an investment of €900 million from Japanese tech-fond conglomerate Softbank, despite questions being raised over various dealings of the company. The same year, Wirecard launched an investment grade bond issue worth €500 million, further taking advantage of the goodwill on its side. Markus Braun seemed to be the beau ideal leading a colossal fintech firm set to challenge Silicon Valley.

The stellar Y-o-Y figures reported by Wirecard. Source: Wirecard

In essence, the company’s announced profits and stellar growth seemed to make investors flock at its door. However, this impressive record of accomplishment seemed to good to be true and was not without its own scars. Despite Mr. Braun’s optimism and glitzy track record, questions were being raised.

Share performance over 2019-20. Source: Wirecard

BaFin, Financial Times, whistleblowers, and short sellers: the whole kit and caboodle

first attacks on Wirecard started as early as 2008, where it was accused of balance sheet
irregularities by the head of a German shareholder association, prompting a special audit
by EY. This heralded the start of a long history of association between Wirecard and EY,
with the latter replacing a small Munich firm as its auditor. The critic was subsequently
persecuted by authorities and was handed a prison sentence for ‘price manipulation’.

In 2015, the Financial Times launched its scathing lambaste on Wirecards’s accounting
and disclosure practices through their ‘House of Wirecard’ series, reporting a €250
million hole in the books of the German conglomerate. The Financial Times were
adamant that the corporation had inflated sales and profits in order to seem more
attractive. In response, Wirecard proposed legal action and hired London based PR firm,
FTI consulting to look after its external public relations.

The same year, J Capital Research, an independent research firm registered in Hong Kong and USA reported (based on primary research) that the Asian side of Wirecard’s business was more phony than genuine: “Wirecard is ostensibly spending heavily to acquire growth in Asia by buying companies in Vietnam, Laos, Cambodia, Singapore and India. We visited several of these acquisitions and found either string operations or no presence at all. We think that fictional assets in Asia may be hiding the uncomfortable truth that there is no profit.” The Research firm also reported that they found “little evidence of legitimate acquiring volumes”. The report also added- “Wirecard’s original and possibly only market is the online gambling netherworld… the company bears significant risk of fraud, default, reversed transactions and merchant insolvency” suggesting an unsavory business model. They signaled that the stock of the company be shorted. Shorting, or short selling, is when an investor borrows shares and immediately sells them, hoping he or she can scoop them up later at a lower price, return them to the lender and pocket the difference.

The Co-founder of J Capital Research Tim Murray decided to “step away” after things got really murky – “there was speculation about kidnap threats. We were hacked. We suspected it was probably being used by Russian mafia to launder funds through illegal gambling.” Wirecard predictably disparaged the report citing that J Capital “fundamentally misunderstands the Wirecard business model”, while also questioning the independence of the firm.

This was not the first-time critics have been targets for hacking campaigns. In a report by the Citizen Lab, a part of the University of Toronto’s Munk School, an India linked hacker-for-hire group by the name of ‘Dark Basin’, was responsible for 28,000 web pages created by hackers for personalized “spear phishing” attacks designed to steal passwords from targets including advocacy groups and journalists, elected and senior government officials, hedge funds, and multiple industries, in a campaign that has spanned for years. With regards to Wirecard, the report concluded the “unifying thread behind this targeting was its aim at individuals who held short positions in Wirecard AG around the time of the targeting and financial reporters covering the Wirecard AG case.” The orchestrators of the attacks have not been found to date.

A page from the ‘Zatarra Leaks’ website, a page produced by hackers. Source: The Citizen Lab

The substantive challenge to Wirecard’s facade of honesty arrived the following year, in the form of a report by anonymous and low-key Zatarra Research. Incorporated in the British Virgin island, the company was previously unheard of, making it a ghost entity, comprising of “investment professionals, analysts and forensic researchers.” It emerged online just hours on February 24th, before releasing its singeing report. Zatarra Research vilified Wirecard’s accounting practices and accused the company of “wide scale corruption and corporate fraud.” Zatarra’s bearish report was filled with discriminatory evidence, claiming the company was involved in “money laundering and transmitting illegal monies to the USA”, and that they (Zatarra) aimed to “profit from the fall in the stock.” The 102-page report connected Wirecard to money laundering for offshore poker operations. Numerous hedge funds in the UK and the USA were also heavily shorting the companies’ stocks, making it one of the most shorted stocks on the pan-European Stoxx 600 index, as per Markit data.

The report was met with restraint on the market, but still managed to set the share price tumbling by 25%. Markus Braun immediately responded to the “slanderous” and “baseless allegations” and promised legal action. German financial watchdog, BaFin opened an investigation into Zatarra’s actions for market manipulation in collusion with short sellers. BaFin did not concern itself with Wirecard and focused “solely” on Zatarra Research. Zatarra also revealed to Reuters that they were in touch with the United States Secret Services, while BaFin did not respond to their findings. Mr. Roddy Boyd, the Editor of Foundation for Financial Journalism, in a study of its Indian dealings, slated Wirecard as a ‘roll-up’. A roll-up is a term used to describe a company primarily built through the acquisition of smaller companies at a rapid pace. Critics argue that roll-ups are a way to use generated revenue to mask problems with organic growth.

Meanwhile in the May of 2018, within the Singapore office of the company, an internal investigation was launched by in-house legal staff, looking into three members of the finance team after a whistleblower revealed backdated contracts and creative accounting practices, implicating senior Wirecard official Edo Kurniawan, accusing fraud on a large scale to “launder money” via third parties. Markus Braun assured the Reuters that the issue was a “non-event”, despite preliminary evidence from the findings of externally hired law firm Rajah & Tann suggesting “serious offences of forgery and/or of falsification of accounts”, according to a Financial Times report released in 2019. Wirecard called the Financial Times report “inaccurate, misleading and defamatory.” The Singapore authorities were “looking” into the matter while Munich authorities looked the other way as the misconduct did not take place on German soil.

In the background, the Company was doing better than ever, with investors and creditors herding together to fund the company, poised to do better than ever. The company’s shares peaked to €191 in August 2018, with a widespread bullish outlook towards the company.

Matters came to the fore in the January of 2019, when Financial Times launched a series of deprecations against the company, backed by the claims from an insider from the Singapore office. The whistleblower emphasized concern over the lack of actions being taken against the corporate fraud committed by a blue-chip institution. The Financial Times report pushed the Singapore authorities to raid Wirecard’s regional office and seize electronics and laptops. The Financial Times article led to the share dropping 44% within a week of its publishing.

Wirecard categorically rejected the story, raising “substantial doubts” over the whistleblower story. The tumble of the stocks urged German regulatory body BaFin to put a ban on the short-selling positions of the stock for two months starting February 2019. This was the first time BaFin had taken such a measure for a single company outside of the 2008 financial crisis, where it had banned short selling on a cohort of stocks. It cited Wirecard’s “importance to the economy” and the threat the Financial Times reports had on “market confidence” as reasons for the ban. In addition, BaFin announced that it would investigate Financial Times for “market manipulation.” The BaFin also announced that it would not be looking into Wirecard’s financial reporting, as it was under the purview of the German Financial Reporting Enforcement Panel, Germany’s quasi-governmental accounting regulator.

In the remainder of 2019, the Financial Times released a series of reports that listed third parties that processed payments on behalf of Wirecard with offices in the Philippines, Dubai and Singapore and paid a hefty commission for it to the German firm. This outsourced business made up a lion’s share of Wirecard’s revenue and subsequent profits. The Financial Times reports included inflated sales and profit figures, as well as staff tallying discrepancies, in order to mislead prime auditor EY. In some cases, offices were understaffed, as seen in Wirecard’s Dublin and Dubai office, while in other cases, there were no offices present. In an amusing encounter, Financial Times revealed that while visiting the registered office address in the Philippines, they were instead greeted by a retired sailor and his family, who were non-privy to the fact that they lived on the supposed site of an international payments operations setup.

While visiting the offices of Al Alam, a Dubai based third party acquirer’s office, the Financial Times uncovered a “threadbare” operation, with 6-7 employees, despite the acquirer generating half of Wirecard’s international profits in 2016. They also reported that the firm has almost no online presence, despite being a staple in Wirecard’s payment routing networks. The Financial Times also released further exposés slamming Wirecard for opacity regarding money from third party processing operations being held in “trustee accounts.” A trustee account holds pooled money of the beneficiaries- the merchants and the processors. Any money in the trustee accounts should not be accounted for as cash. The Financial Times revealed that said money was included in Wirecard’s net cash flow, treated as a non-restricted, cash equivalent. Wirecard responded with a staunch defense- “management believe that trust accounts held in third-party acquiring business is cash equivalent, part of operating cash flow and not restricted.”

In response to the reports, Wirecard decided to sue the Financial Times– “Our objective is to seek a halt to the incorrect use of business secrets for the purposes of reporting, as well as damages,” Wirecard said in a statement. In addition, legal suits were launched against the Singapore authorities. Markus Braun rubbished the reports and announced a host of compliance measures for Wirecard. In December, under pressure from investors, audit firm KPMG was hired as a special external auditor to exonerate itself of the “faulty” allegations of the Financial Times.

A snippet from Wirecard’s Q3 2019 results. Source: Wirecard

KPMG, covering a “major share” of the operating profit of the firm between 2016-2018, were “not sufficiently able to forensically trace the existence of the transaction volumes” to the tune of €1 billion in missing bank statements of escrow accounts, citing “obstacles” to their work. In tandem with KPMG’s findings, released on April 28th of 2020, the audited financial reports for the full year 2019 and the first quarter of 2020 of Wirecard by EY were postponed three times- from March to the end of April and then again to June. Deka Investment, a 1.3 per cent stake holder in Wirecard, called for a further investigation into Wirecard’s third-party acquiring following the postponement of the results. Activist investors, led by British fund manager and regular short seller Sir Christopher Hohn, publicly called for the removal of Markus Braun by the board of Wirecard, which “is legally obliged to intervene.”

Mr. Braun remained optimistic over the signing of the audited accounts, but patience was running thin amongst the authorities. In a turn of events, Wirecard’s offices in Munich were raided on the 5th of June, on the request of BaFin, which alleged wrongdoing on Wirecard’s part. The current crisis started when the cash-trail hit a dead-end in the Philippines, with EY being informed by the BPI and BDO that the documents requesting proof of €1.9 billion were “spurious.”

Wirecard’s quarterly publications for the past year. Due to scandal and controversy, Wirecard has withdrawn publications of its 2019 FY and 2020 Q1 results. Source: MarketScreener

The Big shorts: Prophesizing the collapse

Journal reported that short sellers of Wirecard’s stock were in for a hefty windfall in the region of $2.6 billion. Vocal critic and former shareholder of the company, Chris Hohn’s Children’s Investment Fund alone made £100 million from shorting Wirecard’s shares. The windfall comes after years of wrangling with Wirecard’s seemingly bottomless resources and legions of lawyers under its payroll. Some firms informed that they spent years shorting the stock below the threshold, so as to not trigger any suspicion from the company. In 2016, at the time of Zatarra Research’s report, €1.2 billion of the company’s shares were taken on loan, approximating to 23 per cent according to Markit. It has been a costly endeavour- despite a hefty payday in the end, many previous short bets were obliterated by surges in the stock price.

Short sellers continued to appear over the years, despite the companies aggressive efforts to deter them. Short sellers and critics listed the companies lack of accounting transparency attracted them to short the stock, like moths flying to a light. Years of clandestine acquiring, lending, and financing operations cast serious doubts over the company’s long-term sustainability and risk exposure. The company’s debt hit the roof from expansions, reaching €1.3 billion in September 2018 from a comparably paltry €100
million in 2012, with little clarity over where it was used and how it was used. Despite outperforming the industry average growth rate consistently, the absence of financial disclosure regarding shifting clients to different providers, fees from third party sellers, interest generated from financing loans to merchants prompted heavy bets against the company.

Many critics and avid short sellers of the stock also recalled substantial legal fees in fighting the company, as well as encounters with “being followed” by company hired private investigators. Such activities persuaded many to give up on their shorts, in fear for their own safety. Dan McCrum, the spearhead of the Financial Times’ attack on Wirecard, revealed after the company filed for insolvency on June 25th that he was “going a little bit mad and paranoid”, often believing that he was being followed. Wirecard launched criminal proceedings against Mr. McCrum in Germany following his investigations into the company’s affairs. “Today is a partial vindication for myself and other critics”, said Fraser Perring, one of the authors of the vehement report on Wirecard by Zatarra Research in 2016. This is absolution and exoneration for Mr. McCrum and other persistent critics, who have fought tooth and nail for their position.

The short bets (loaned shares) against the company rose in the beginning of 2016,

‘Chinks’ in the regulatory armor

on the German regulatory authorities, who are left with a tedious and expensive cleanup
procedure. They have been susceptible to sleeping on the wheel on various occasions in
the past- when Volkswagen manipulated Diesel engines to cheat on emissions tests,
Siemens being accused of bribing officials for foreign contracts, Deutsche Bank breaking
money laundering rules, and allowing BerlinAir and Solarworld to go bust- the list is
quite illustrious and long.

BaFin faces a regulatory storm following the Wirecard scandal. Source- Photo-Alliance

BaFin falls particularly under the radar with this one- as Dan McCrum put it- Wirecard
seemed to have the “ear” of regulatory authorities. Only in 2019, as the events developed,
BaFin’s chief, Felix Hufeld conveyed at a press conference that his organization could
“not simply pin a Sheriff’s badge to our lapel and ride off to arrest anyone we are
suspicious of.”

Following the breakneck pace of events in 2020, Felix Hufeld emerged with a resolute
defense of BaFin’s actions– “It starts with looking at complete failure of a senior
management, despite many, many hints to discover the facts,” he said. “It goes on to the
scores of auditors who couldn’t dig up the truth and it goes on with a whole range of
private and public entities including my own who have not been effective enough to
prevent something like that happening.” He claimed that Wirecard’s activities were a
“shame” and the implications of the scandal were a “disaster”. Mr. Hufeld praised the
longstanding critics in his statement too- “I salute those, let it be journalists, analysts or
yes, let it be short sellers, who have been digging out inconsistencies persistently and
rigorously. We don’t know the facts today, nobody knows the right facts today, including
those who asked the right questions.” He was supported by Germany’s Finance minister, Olaf Schulz, who asserted that the regulators “worked very hard and did their job.” To all
intents and purposes, this goes on to say a lot about the “job” done by the authorities. The
Economy Minister, Peter Altmaier, voiced his disbelief- “We would have expected such a
situation anywhere in the world, but not in Germany.”

Theoretically, BaFin is only supposed to monitor the activities of Wirecard’s banking
wing, Wirecard Bank. This has given BaFin a way out of sorts- at a press conference on
the 23rd of June Felix Hufeld declared Wirecard was a “technology” firm rather than a
financial one directly supervised by his institution, despite of Wirecard brandishing its
full banking license. Such regulatory deficiencies point to the inefficiencies of the
system. On June 28th, the newspaper, Frankfurter Allgemeine (FAZ) reported that in lieu
of the January 2019 events with respect to Wirecard, BaFin commissioned Germany’s
Berlin-based financial accounting inspectorate FREP, but only one employee was tasked.
In an Op-ed in the Financial Times, Bernd Zeisemer, the chairman of the Cologne School
for Journalists, was critical of BaFin- “BaFin, Germany’s financial markets watchdog,
failed particularly miserably as an institution.” He called out their “bureaucratic excuses”
and their targeting of journalists, who were mere seekers of truth.

Many have come out since the crisis to criticize the management of the company.
Investors seek legal action against the company, and for once, have been left puzzled by
the events. Twitter warriors who defended the company are silent. A select few have
raised questions on EY and its functioning. Akshay Naheta, the executive who
shepherded Softbank’s investment in the German giant took to Twitter to express his
alarm regarding EY’s handling of the issue-“As an organization that is meant to protect
all stakeholders, creditors and shareholders, in companies, both public and private, they
have materially failed in their fiduciary duties.” The ability of EY as an independent firm
has been questioned- The firm’s failure to detect fraud for 3 years as well as reliance on
screenshots from Wirecard and third-party confirmations has stoked the fire further.
German shareholder group SdK has launched criminal proceedings against the auditor for
“negligence of its professional duties.” German auditing watchdog Abschlussprüferaufsichtsstelle (APAS—Auditor Oversight Body (AOB)) has also
launched an investigation into EY’s work.

What next? An uncertain future

The confusion that followed the missing money balances was expected- on-the-edge
creditors and bondholders sought clarity from the regulators regarding the extension of loans to the company, while the company looked to steady the ship by darting for an
extension of the credit line. BaFin’s credibility as Germany’s sovereign authority for
financial markets has taken a hit, but it now faces a chance at redemption following the
termination of the contract with Financial Reporting Enforcement Panel (FREP), the
accounting watchdog, responsible for examining financial reporting of publicly listed
companies. The FREP is a private sector body, that was given pseudo-governmental
powers following the Enron scandal in 2004. The FREP worked in tandem with BaFin to
regulate financial bodies in Germany. All of FREP’s regulatory and supervisory powers
have been shifted to BaFin, according to the Financial Times.

Germany’s top brass are looking for “radical reforms”, as per a statement by Jörg Kukies,
Germany’s deputy finance minister. “We have to think about how the regulatory regime
should be changed,” he said in a statement to the Financial Times. While Mr. Hufeld,
head of BaFin did not see the need for an upheaval, he pointed out that measures will be
reviewing laws later, and as of now, the organization is in “crisis mode”.