Delusion, fraud and the role of the SEC - the General Electric long-term care case

Luckin Coffee just settled with the SEC for a fine which I guess will be paid by shareholders. Given that the whole thing is a massive admitted fraud being paid by "shareholders" is a pretty moot case. There is not much evidence that the shareholders have anything left. Other than any part of the fine that might be distributed to them I doubt the shareholders ever get a penny.

Whatever: this prompted a twitter debate about the fine paid by General Electric after their long-term-care debacle.

This tweet by Francine McKenna is where it started.

To put it in perspective, Luckin pays $180 million fine for faking $300 million in rev. $GE's lack of disclosure of bad accounting and deceptive manipulation of estimates that led to $24 billion in write-downs should have cost them nearly $15 billion, not $200 million.

— Francine McKenna (@retheauditors) December 16, 2020

I disagree sharply. 

First let's explain what that $24 billion cost at GE was.

a). GE wrote a lot of business in now sold/closed insurers insuring against the need for people to go into nursing homes. It would pay for the nursing home if that unfortunate situation actually arose. This insurance is called "long-term care insurance".

b). Long-term care insurance has been a near universal disaster for the insurance industry. Almost everyone who touched it lost money. The reason is that people lived longer than expected, they lived more of those years in nursing homes than people expected and the cost of nursing homes went up more than expected. Insurers did not deliberately lose money in long-term care - but everyone lost money in the end. That is the nature of insurance - it is full of surprises - and the surprises are mostly negative.

c). GE had a keepwell agreement with (State) Insurance Commissioners that required that they keep the long-term care subsidiaries capitalised at 300 percent of statutory minimums. This meant that negative surprises at the subsidiaries caused a cash call on the parent company of 3x the negative surprise. 

d). The long term care companies were under-reserved by $8 billion - a mistake that was common in the industry - but in this case a pretty nasty mistake.

e). Because of the keepwell agreement the cost to the GE Parent company was $24 billion. If the book of business runs off as GE currently expects much of that $24 billion - will be returned over time. After all the bulk of it is agreed "excess" capital.

By constrast Luckin Coffee was a fraud from when it listed and was purely a device to extract money from shareholders.

The GE long-term care business was not a fraud from when it listed. Indeed they were blithely writing long-term care insurance in the expectation it would be profitable. So were many other insurance companies.

At some point they will pay out far more than they took in (and the business will not have been profitable). I am not even sure that line has been crossed yet - but as of a couple of years ago when GE took the charge it had not been crossed.

But at some point on that path it will become obvious to anyone who takes a dispassionate view that the line will be crossed someday in the near future.

There is a sequence here.

First there is an honest mistake (writing the business).

Then there is just error - not noticing the models that you wrote too are wrong by a large enough amount to cause problems.

Then the error - under-reserving - becomes delusion. After all it is very hard to admit a mistake even to yourself. I have held a stock way too long when I am wrong and most people who invest have done this. Error is human. And sometimes that error becomes delusion and that is human too.

But there is a nasty line here. Sometimes that delusion becomes fraud. It is fraud when you start to lie about it and know you are lying about it. 

Luckin Coffee was a fraud from before the IPO. To even equate it to the GE thing is to downplay how much malice was involved in the Luckin Coffee fraud.

Now GE did pay a fine. 

I have a strong view here. If the SEC could prove that certain GE execs crossed the line between human delusion and fraud they should have criminally prosecuted.

And if they could not prove that then they should have not fined at all (except maybe for insufficient financial controls). 

As far as I know they could not prove it. But hey - GE settled quickly on a civil case. 

I can see how this happens. The SEC has lots of powers and it sort of forces GE to settle. But this is not what should happen. 

Either the SEC has a case - in which case it should have been criminal - or they have no case at all - in which case the fine is inappropriate.

My guess here is that the fine is just inappropriate. It makes me respect the SEC less. 

So was the fine against Luckin' Coffee appropriate?

By my own logic the fine against Luckin' Coffee was not appropriate either - what should have happened is criminal charges.

But the SEC has a real problem. The real problem is that the malefactors are in China. 

And it is awful hard to criminally prosecute them.

They may want to come to the United States (or some country with an extradition treaty one day). So settling for a fine works for them.

Whether it works for America I do not know. Sure some money came back Stateside - and maybe that was all that was ever able to be recovered.

The SEC notes it is really hopeless. To quote the press:

“While there are challenges in our ability to effectively hold foreign issuers and their officers and directors accountable to the same extent as U.S. issuers and persons, we will continue to use all our available resources to protect investors when foreign issuers violate the federal securities laws,” said Stephanie Avakian, director of the SEC’s division of enforcement, in the regulator’s announcement on Luckin.

The SEC is nastier against GE because it can be

The Luckin case was criminal - and all it got was a fine. That was because the malefactors were in China.

GE was probably not even fraud - and they got a fine.

That is because they were American. Nothing more.

Yeah, it is not fair.

But that is the world we are in. 

Francine McKenna pontificating just exaggerates that unfairness. But whatever.

John