SEC's Challenge on Rio Tinto: Self-Delusion or Fraud?
This post originally appeared in Money Stuff.
There is a certain rather exhausting set of characteristics that you would expect to find in successful chief executive officers. They dream big. They relentlessly pursue their goals. They have high expectations of their subordinates, demanding total loyalty and commitment and effort and creativity. They think outside the box. They don't take no for an answer.
There is a problem with this list of characteristics, beyond how exhausting it is. Imagine the CEO of a mining company that buys a giant coal mine in inland Mozambique for $3.7 billion, and then finds out that there's no way to get the coal to the coast for shipment. "Sorry boss," say his subordinates. "That mine is worthless now." How would you expect him to react? Well of course he is going to demand that the subordinates find a way to get the coal out. Of course he is going to continue to believe that the mine is worth more than the $3.7 billion he paid for it. Of course he is not going to change his mind just because the government rejects his plans to barge out the coal, or because building a railroad to get it out would be prohibitively expensive. Of course he is not going to be deterred by the negativity of the subordinates who tell him that there's no solution and that the mine is worthless. Of course he is going to tell them that the problem is with their attitude, not with the mine. Of course he is going to tell anyone who'll listen that the problems will be resolved and that the mine is, if anything, undervalued.
And then the subordinates will go back to the drawing board, put in 120-hour weeks, and, inspired by the CEO's vision and commitment, will come up with a way to get the coal out. It will be a massive success, and the CEO's most optimistic projections will be realized and exceeded. It will be taught as a case study in business schools. Years later, the subordinates will bond over beers and reminisce about how hard they worked for the CEO, and how it ruined their marriages and their health, and how it was nonetheless the best thing they ever did. For once, they felt truly alive, inspired by a higher purpose, filled with the deep satisfaction that can only come from succeeding against impossible odds.
Or not! Or the subordinates will go back to the drawing board, put in 120-hour weeks, and not come up with a way to get the coal out. Time will pass, the coal won't come out, and it will get harder and harder for the company's accountants and auditors and directors to justify the $3.7 billion valuation. Eventually the company will write down the value of the mine, and sell it for a nominal amount. And all those people who bought the company's stock or bonds in the interim -- back when the CEO was insisting that nothing was wrong, that the mine was undervalued, and that all this nonsense about not being able to get the coal out was not even worth mentioning to investors -- will feel a bit ... well, the traditional word is "defrauded."
This week the Securities and Exchange Commission brought a fraud case against Rio Tinto plc and two of its former executives "for inflating the value of coal assets acquired for $3.7 billion and sold a few years later for $50 million." Rio Tinto bought the Mozambique project in 2011 and quickly realized that they wouldn't actually be able to transport nearly as much coal out of the mine as they had expected. By early 2012, internal valuations for the project showed negative values. But Rio Tinto did not impair the value of the project in its public financial accounts, and raised billions of dollars of bonds in March 2012. It eventually wrote down the project in January 2013, and sold it for $50 million in 2014.
Was it fraud? Were Rio Tinto's chief executive officer and chief financial officer colluding to conceal bad news from Rio's directors, auditors, shareholders and bondholders for their own selfish reasons, as the SEC alleges? Or were they just so sure that they would succeed that no amount of bad news could deter them? The complaint is horrible reading either way. The SEC describes a meeting where the CEO "specifically rejected a proposal for Rio Tinto to construct a new, $16 billion ('greenfield') rail line," and instead basically told the employees to find a way to do it cheaper. At one point Rio Tinto prepared a paper for its audit committee discussing but rejecting the idea of writing down the mine; the CFO's "only comment was to question whether it was really appropriate to highlight potential impairment matters so early in the year." Another paper, for Rio Tinto's auditors, "went one step further and claimed with no reasonable basis in fact that 'a potential value of $5.1 billion' gave an 'indication of value' for RTCM, and that on top of the $5.1 billion, there was an additional '$1 billion of value designated as possible upside.'"
There are a few hints that the SEC is right -- at one point, after reserve estimates were lowered, the CFO told the CEO "that 'the market won’t see' what Rio Tinto assumed for the acquisition," allegedly implying that they could trick investors into thinking that the lower reserves were baked into the original purchase price -- but no real smoking guns. Rio Tinto's valuation was wrong, sure, and its CEO and CFO ignored the reports of employees who told them that the valuation was wrong, but that doesn't tell you why they ignored them. Self-delusion can look a lot like intentional fraud, and vice versa.
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