Author: Andrew Haskins, ASIP

Introduction

It is widely believed that most financial scandals reflect complex frauds which can only be understood by specialist auditors and lawyers with decades of experience. Nothing could be further from the truth.

In fact, many of the most brazen frauds have been remarkably simple. It should have been possible to spot them earlier, before huge damage was done to investors, shareholders or the general public. In some cases, clear warning flags were raised early on, but too often these flags were ignored. 

This series of articles explains how various major financial scandals in different markets were perpetrated and eventually exposed. Over my career as a head of research, I followed four of the scandals particularly closely, because I was working in the same market or sector. In one case, I explicitly warned that potential disaster could come years in advance.

More importantly, the series aims to provide some simple lessons for analysts, investors and business managers. Many elements of major frauds recur regularly, making them easier to spot and hopefully prevent. Watch out – someone could be committing a similar fraud within your company right now! 

Barings Bank (Asia/Europe, 1995): don’t only believe what you want to believe, and keep trading and settlement far apart

The fraud committed by Nick Leeson that brought about the demise of Barings, a venerable British merchant bank, was a classic rogue trading scandal that will be familiar to more mature UK-based readers. Leeson, a derivatives trader in his late twenties, had enjoyed rapid promotion due to his successful trading, and in 1993 he was sent to Singapore as general manager of Barings’ newly opened Futures and Options office in the city. After arrival, he continued trading. focusing on Japanese financial markets. 

The essence of the fraud was simple. Leeson made unauthorised speculative trades in Japanese stock index futures that initially made large profits. Because he was general manager of the Singapore branch and so responsible for both front-office and back-office activities, Leeson could hide any losses on bad trades by placing them in “error accounts” (notably one with the notorious number 88888) designed to correct minor losses in authorised trading. 

The Japanese Nikkei stock index had more than halved between its peak at the end of the “Bubble” era in 1989 and mid-1992. For the next two and a half years, the index traded in a relatively narrow range. Lesson kept betting that the Nikkei would rebound significantly. Every time he lost money, he bet double the amount to recoup the loss. A separate back-office manager would have spotted that the amounts in the error accounts regularly exceeded likely losses from minor trading mistakes, but this fact was not noticed when net settlement reports were sent to head office in London. 

Over late 1994, it was observed in the Tokyo equity market that unusually heavy trading in Japanese index futures was happening in Singapore. I remember this well because, at the time, I was working in Tokyo as an analyst for a large securities firm. Equity salesmen were talking about the trading to their clients, and strategists were mentioning the topic in their reports, with some suggesting that aggressive trading activity was providing artificial support for the overall market.

Leeson’s trading strategy worked well until December 1994, by which time the error accounts were hiding large trading losses. Over the first couple of January 1995, Leeson kept doubling his bets on the Nikkei staying above the 19,000 level. Then came the Great Hanshin Earthquake of 17 January, 1995, which ravaged the city of Kobe and pushed the Japanese stock market down sharply.1

Over the following month, Leeson doubled and redoubled his bets that the Nikkei would rebound, but this did not happen. His trading losses ballooned to US$1.4 billion – a sum which was impossible to hide and enough to wipe out equity on Barings’ balance sheet. Leeson eventually served four years in prison in Singapore for financial crime, while Barings was sold to the Dutch bank ING for £1. 

The first simple lesson from the Leeson scandal is that you shouldn’t only believe what you want to believe. Given the widespread talk about aggressive trading of Japanese futures in Singapore, it is hard to believe that Barings’ senior managers in the UK were completely unaware of the level of risk being taken by their star employee. Market rumour would not have given firm details of what was going on, but it ought to have opened eyes to the possibility of unauthorised activity. It seems that Barings’ top managers simply did not wish to believe that the goose laying golden eggs might not be real after all. 

The second lesson from the Leeson scandal is the importance of separating trading and settlement within financial firms. Clear separation of these functions is now standard within investment banks and asset management institutions in nearly all major markets. The Leeson fraud would be harder to commit today, although rogue trading scandals have continued. 

Worldcom (US, 1999-2002): what happens when operating expenses are classified as investment

Worldcom was a US domestic long-distance telephone operator in the early 2000s and a darling of Wall Street. The company reported both higher EBITDA margins and higher capital expenditure/sales ratios than rival long-distance operators. Fawning analysts and corporate financiers close to the company attributed its apparently superior profitability to the sector-leading growth rates and aggressive investment delivered by an astute and highly driven management team.  

At the time, I was working as a global telecoms equity analyst for a major investment bank in London, covering the US telecoms market among others with a senior colleague. Together with other sceptics, we noted in reports that Worldcom’s superior margins were unlikely to be sustainable in an environment of high competition and vicious price cutting in the US long-distance telephony market.

As it turned out, Worldcom's apparently high margins resulted from accounting tricks2. The company used many tricks, of varying degrees of complexity, but one stood out: it treated certain operating expenses as capital expenditure. The most important items were line costs, i.e., the cost of leasing lines from other telecoms operators such as AT&T, and (from my understanding) interconnect charges, i.e., the fees payable for delivery of telephone calls to another operator’s network. Worldcom referred to these costs under the heading “prepaid capacity” – a term that it made up. 

As a result of this deliberate misclassification, major headings of costs were entirely absent from Worldcom’s profit & loss account, and only appeared in the cash flow statement. This was the key explanation of Worldcom’s sector-leading EBITDA margins. The misclassification did not boost net operating cash flow, since the inclusion of line costs and interconnect expenses also inflated capital expenditure. 

The fact that reported EBITDA margins and capex/sales ratios were both significantly higher for Worldcom than for its peers, and that the high margins did not help generate large cash flow surpluses, should have been a warning sign. As it was, Worldcom's apparently superior profitability encouraged many US banks and investors to back Worldcom strongly, driving up its share price and helping the company expand through an aggressive acquisition strategy. 

The fraud was exposed by Worldcom’s vice-president of internal audit and her team, who bravely ignored pressure from both the top management and the company's external auditors (the defunct Arthur Andersen) to stop asking difficult questions. Worldcom eventually admitted to the US SEC that it had overstated its profits by US$3.8 billion over five quarters. The stock price plunged, and the company filed for Chapter 11 bankruptcy protection on 21 July, 2002.  

The Worldcom bankruptcy was the largest corporate failure in US history to that date – larger even than the Enron failure the previous year. Later investigations revealed that Worldcom had overstated its assets by over US$11 billion between 1999 and 2002.

The SEC filed civil fraud charges against WorldCom on June 26, 2002, alleging that the company had engaged in a concerted effort to manipulate earnings to meet Wall Street targets and support its stock price. The SEC stated that the scheme had been "directed and approved by senior management," including the CEO, Bernie Ebbers. In 2005, a jury in a criminal trial found Bernie Ebbers guilty of fraud, conspiracy, and filing false documents with regulators. He was sentenced to 25 years in prison. 

The Worldcom scandal stands out for the sheer simplicity and brazenness of the underlying fraud. If more analysts or investors had pressed Worldcom about how it defined operating costs and capex, or if they had asked questions which prompted replies using obscure terms like prepaid capacity, suspicion that Worldcom was engaging in creative accounting might have arisen sooner. The lesson for investors here is to maintain healthy scepticism, and never to be afraid to ask tough questions. 

1: For further details, see, e.g., https://www.britannica.com/event/bankruptcy-of-Barings-Bank.  
2: See Business and Financial Law, The WorldCom Accounting Scandal: Fraud and Bankruptcy at https://legalclarity.org/the-worldcom-accounting-scandal-fraud-and-bankruptcy/ (14 December, 2025) for a helpful summary of the scandal. 

Coming up:

Part Two 
Satyam (India, 2008-2009)/Wirecard (Europe, 2019-2020): pretending there is cash in the bank 

Part Three 
Chinese residential property crisis (c.2019 onwards): beware the obvious flaw in the underlying business model