I recently listened to a Great Courses series of lectures entitled Crashes and Crisis: Lessons form a History of Financial Disasters, hosted by Professor Connel Fullenkamp. It was so entertaining that this week I am considering some great economic disasters from history to see what lessons they might impart for the compliance professional. Yesterday, I considered the Dutch Tulip Bubble from the 1630s, today I review the South Sea Bubble of 1720.
Fullenkamp said of the scandal, “The South Sea Company went from an obscure British trading organization in the early 18th century, with a share price of £128, to England’s most important company, with its shares trading at more than £1000—over the course of just 6 months. The company was at the center of one of history’s most interesting stock bubbles, one largely built on stock price manipulation and corruption. The South Sea bubble is a complex, fascinating story about the early days of the stock market in England and a cautionary tale about the dangers of mixing private enterprise and government finance.”
What does the South Sea bubble teach us about the nature of bubbles and crashes? Fullenkamp identified three general points. First, “When governments get too involved in any asset market, there’s bound to be danger. People interpret the government presence as a sign that the asset can’t lose, so they’re willing to overpay for it .” Second, the South Sea bubble, similar to the tulip bubble that preceded it, “was made possible by easy credit. The ability to buy stocks on credit, with absurdly low down payments, made people all too willing to buy the company’s shares.” The third and final point is that “Market manipulation can, and does, play a role in bubbles. And manipulation can be difficult to detect until after a bubble bursts.”
Focusing on the fraud and market manipulations of the South Sea Bubble, James Narron and Richard Skeie, in their article “Crisis Chronicles: The South Sea Bubble of 1720—Repackaging Debt and the Current Reach for Yield”, found four factors. (1) Start with insider trading, here by picking up the British National Debt; (2) Pay bribes to those who have to approve the deal, here Members of Parliament; (3) Ban rivals, here the South Sea Company persuaded Parliament to pass the ‘Bubble Act’ which banned corporations in competition with the South Sea Company; and (4) Repackage worthless old debt for new investors, here think “Asset-backed securitization and collateralized debt obligations” in 1720 and you begin to see the problem.
For the compliance professional, the experiences of those investors who lost money during the South Sea Bubble would seem to be consistent with what compliance practitioners intuitively understand. It is that companies with poor ethics and compliance, which lead to bribery and corruption, are not only less likely to make money but more likely to lose money. This was borne out in a study by Paul M. Healy and George Serafeim, entitled “An Analysis of Firms’ Self-Reported Anticorruption Efforts”. In this paper, the authors looked at the issue of not simply profitability of companies, which had more robust anti-corruption compliance programs but also what was the direct effect on the companies’ return on equity (ROE) in countries which were perceived to have a high incidence of corruption. Not surprisingly, in countries with a low risk for corruption, there was not much difference in the sales growth for companies with robust anti-corruption compliance programs and those business which fall into the authors’ ‘cheap talk’ category. However, when it came to growth in countries with a high propensity of corruption, there was a dramatic difference.
When quantitative types say, “The magnitudes of the estimated coefficients are economically interesting”; it is a HUGE deal. These findings are equally large and important for the Chief Compliance Officer (CCO) or compliance practitioner. The authors conclude by making several observations. First, companies which have more robust compliance programs are from countries which have more robust enforcement and monitoring. Second, the more robust your compliance program is the lower your sales growth may be but the higher your overall return in a high-risk country will be going forward. Finally, even if a company sustains high sales grow in a high-risk country, if it does not have a robust compliance program, the sales will drop off dramatically and may well lead to negative ROE.
All of this information points to companies which are on the Ethisphere list of the World’s Most Ethical Companies and their financial performance. They not only do they have better than average financial performance because they are better run. Indeed, the 2019 World’s Most Ethical company Awardees collectively had a delta of 10.5% higher return than the S&P 500 for the most recent three-years. The World’s Most Ethical Awardees are on this list because they have robust finance internal controls which include compliance internal controls. To mix metaphors, robust internal controls around compliance do not slow you down but allow you to go faster and move more safely into high risk countries.
So, the next time some business type tries to say that following the law, by having a robust Foreign Corrupt Practices Act (FCPA) anti-corruption compliance program in place, slows him down you can correct him. Spikes in sales in high-risk countries do not translate into sustained growth and without an effective compliance program in place your company may actually lose money.
At the end of the day, the South Sea Bubble was never going to be sustainable because of the returns promised not only to the investors but the British government for assuming the countries debt. When you couple this with margin purchases of South Sea Company stock on as little as 10%, you being to see the problem. Add on bribery and corruption and the entire scheme was doomed to failure.
Join us tomorrow when we consider the Mississippi Company.
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