When stock frauds go beyond gaming the numbers

This article appears in the March 2022 issue of Advisor’s Edge magazine. Subscribe to the print edition, read the digital edition or read the articles online.

The fraud conviction handed down in January to the former CEO of Theranos is a good reminder that inflated technology claims are often at the centre of investment scandals. As with accounting frauds, advisors need to be attuned to situations that seem too good to be true.

Luckily for advisors, Theranos never went public, though some well-known venture capitalists and sophisticated investors lost more than US$700 million in invested capital. At its height, Theranos was valued at roughly US$10 billion. The company made several novel claims surrounding its medical-testing technology, including the ability to run dozens of tests on just a few drops of blood. The technology proved unreliable and, instead of disrupting an industry, Theranos went down as another financial scam.

Canada has had its share of investment collapses tied to dubious or fraudulent claims of advanced technology. One of the largest was Timminco Ltd., which had a market cap north of $3.5 billion before it unravelled and the shares were delisted. The company claimed to have developed proprietary technology for low-cost production of high-purity silicon for solar panels. This was just prior to the global financial crisis, when the solar industry was booming and the price of polysilicon was skyrocketing. Advisors may have been tempted to ride the coattails of well-known investors in Timminco, and likely misconstrued the reserved interest of industry experts as indication of groundbreaking advancement.

Numerous institutional investors and industry experts lined up on both sides of the Timminco debate, asking whether the company’s technology was indeed low cost and could be scaled to the volumes needed to support the company’s massive valuation. Against the backdrop of the credit crisis, Timminco never delivered on its promises; the share price collapsed, and there was ultimately little to indicate a novel commercial advancement in technology.

But one of the strangest Canadian tech frauds must be the case of VisuaLabs Inc. and its founder, self-styled “mad scientist” Sheldon Zelitt. Two decades ago, the company reached a public valuation of roughly $300 million based on the promise of two breakthroughs. Zelitt claimed he could produce 3D TV images without the need for glasses or headsets, and create large LCD screens by stitching together smaller displays without distracting seams.

Both advancements were seemingly well-timed for exploding interest in 3D displays and superior LCD screens that could match the size of plasma alternatives. These also seemed like garden- variety accomplishments for a man who had boasted of astonishing achievements over the years, including building a spy satellite, dismantling a MiG jet and consulting for the CIA and Mossad.

In the end, the secretive and security- obsessed Zelitt was caught by his own board of directors while presenting the LCD technology at the company’s annual general meeting. The prototype screen proved to be a store-bought plasma TV, modified with a glass covering etched to appear as if assembled. Likewise, the 3D technology demonstration was eventually revealed as nothing but a recording of trick photography. Zelitt was fired and the company’s shares were obliterated overnight.

Technology-based investment collapses tend to share common red flags. As a companion to the accounting fraud checklist (see our column from the November 2021 magazine), advisors should watch for:

• claims of a quantum leap in technology, especially in an industry more accustomed to gradual change;
• a situation purporting to be best ever or world leading, especially in your own backyard;
• an unlikely combination of factors such as lowest cost and best performing;
• instances where senior executives and founders are garnering more attention than the science behind the purported discoveries — beware the engaging storyteller; and
• claims of technological advancement growing to support a ballooning valuation, rather than vice versa.

Similar to phantom-asset frauds like Sino-Forest and Bre-X Minerals, advisors should pause to consider whether something passes the smell test. Also ask how far outside your realm of expertise you are venturing. As an advisor to your clients, you are better suited to judge the business case for new technology or disruptive changes. Rarely should you find yourself in a position of assessing the scientific validity of something truly groundbreaking.

by Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE. They run Accountability Research Corp., providing independent equity research to investment advisors across Canada.