Twenty to twenty five years ago, investment was mainly a matter of investing on the stock market, but now the possibilities are wider.
“Now there are possibilities of investing on the alternative investment market, investing in venture capital, it’s possible to buy loan stock and shares of small non-public companies through crowdfunding,” said Nasdaq Tallinn’s listing and supervisory committee member and managing partner of the investment management company Avaron, Kristel Kivinurm-Priisalm on the Äripäev radio programme "Kasvukursil".
But many of the alternative investments, including even savings and loans, are not supervised by Financial Supervision Authority and are riskier for the investor.
Attorney at law Marko Kairjak of Ellex Raidla law firm noted that companies not under Financial Supervision Authority oversight may not report enough information about themselves. “The ones who are not subject to supervision are obliged only to submit the basic annual report.”
This may not reflect the most accurate information about the company. “It should be taken into account that the report for the previous annual report must generally be filed by June of the following year. The reports currently available are for 2021 and if anyone wishes to make an investment, they must take into account this blind spot. The public information will soon be 15 months old,” said Kairjak.
Grant Thornton Baltic’s partner and head of audit and assurance services Mart Nõmper agrees that it is a golden age for fraud. "Every investor’s own responsibility and level of duty of care is significantly higher now.”
Nõmper referred to a master’s thesis that profiled companies with a larger than normal likelihood of fraud. “Such companies are usually small, they lack an audit committee and internal audit, they were making a loss prior to the fraud and the management has a very significant role in influencing decision-making,” he said, adding that the risk criteria are met in the case of many companies listed on First North Tallinn.
Kivinurm-Priisalm said one red flag and indicator suggestive of possible fraud was if a company lacked an auditor completely or had a very small audit firm providing the assurance service. “For example, the companies on the main list of Tallinn stock exchange are all without exception audited by the four biggest audit companies, while only one-fifth of the ones on First North are handled by the largest auditors. 40 per cent of First North companies are audited by companies that employ less than four people.”
Kivinurm-Priisalm says small audit companies are not suitable choices for publicly listed companies, because they simply lack the resources and people to manage the necessary competence for such weighty work. “In addition, it must be possible for auditors to discuss the more complicated cases with others,” she noted. “So if a company is audited by a small firm called Man and Dog, it should trigger a warning light for the investor. Bernie Madoff’s notorious company was also audited by a similar small business”.
In addition, Kivinurm-Priisalm recommends that investors check the quality of the auditor that is looking for their business, and this can be done via the website ajn.ee. High-quality auditors are the ones who were given a green or yellow assessment, while orange and red by the auditor’s name is a sign of substandard quality. “For example, Lahendused Pluss, which audited ERIAL was red in 2021 and orange last year,” noting that the investors who parked their money in the savings and loan would have been able to easily do their research and see the red flag.
Kivinurm-Priisalm emphasizes that although the Tallinn stock exchange’s listing and supervisory committee is engaged in risk mitigation, they cannot evaluate a specific company’s business model. “What we can do is look at the company’s risks,” she said.
One risk vector, according to Kivinurm-Priisalm, is when a public company raising funds has a management board of one. “That substantially increases the risks for investors, because responsibility is not shared, complicated issues are not decided on collectively.”
Nõmper says fraud falls into two categories – some are committed by employees and other that are committed by management or owners. “Frequently an accountant or warehouse worker will perpetrate fraud and they wind up with the company’s property.” That is the first type, he said. “Yet the impact of such fraud incidents are ten times lesser than management-perpetrated fraud. The latter are harder for auditors to detect as well. Small companies do not have control systems or the management can circumvent them.” The four-eyes principle should be applied, he said. He added that statistically speaking, whistleblowers uncover the most cases of fraud.
The expert notes that the risk of fraud increases if the triangle of fraud based on psychology has been fulfilled. “Three aspects that lead to fraud are: the motive to commit fraud, the fraudster must have a justification or reasoning for their action, and they must have opportunity to do it.” “For example, a justification might be that investors want to see higher profit figures, the motive is the bonus or stock options received for it and the inefficient control environment creates the opportunity, which is weaker in smaller companies, while companies in the stock market’s main list have an audit committee to hedge the risk,“ Nõmper said.
Experts also recommend devoting attention to what is on the balance sheet of a company seeking financing. “Many companies have a great deal of intangible assets. The auditors should examine whether they have been properly valuated but if there are only 1-2 people with the right skillsets it is hard to see that they will be able to say what the value of the intangible assets are for a specific company,” Nõmper said, referring to the aspect of why it is important to find an auditor. “If intangible assets exceed owners’ equity and are not assessed correctly, it may be that the company in fact has no assets.”
Kairjak noted that the need to assess the balance sheet undoubtedly exists, but it is not always worth counting on a very good auditor. „The Wirecard scandal is a good example of how, no matter how good the regulations or auditors are, deliberate fraud is still a possibility.” What happened in that case was that Wirecard was a regulated payment institution and one of the biggest fintech success stories, but it turned out that the balance sheet was largely air. It did not actually have the money that investors were told it had, plus payment service clients who used the platform also lost their money.”
Still, if such an incident occurs, there may be a way of holding the auditor accountable. And for that to happen, it is very important that the auditor is properly selected because the size of the sum to be collected depends on the extent of the auditor’s liability insurance coverage. Auditing companies are generally “thin” counterparties and there is not much to collect in damages from them. But they are required by law to have insurance coverage so that the insurer pays for the auditing company if there is trouble. A minimum policy is often taken out – 64,000 euros. Larger offices have the advantage of affording greater coverage, which may not be less than the value of the two largest client contracts.
In addition, Kivinurm-Priisalm recommends checking the management board members of the company being invested in. “The easiest is to methodically Google the people on the management board and supervisory board and see what turns up, whether they have been afoul of the law or other matters,” said the expert.
Kivinurm-Priisalm also recommends running a check on other companies related to the members of management bodies. It is easy to do this using the teatmik.ee site, which shows tax arrears, tax deferrals, court rulings. ”Anything that could switch on a warning light in the investor’s head.”
This sort of pre-investment check is especially important for non-listed companies that are not under the supervision of Financial Supervision Authority. “Otherwise, usually the Financial Supervision Authority will do this work for you, but not on the unregulated market,” said Kairjak. He added that going to court is the only recourse when getting one’s fingers burned investing on the unregulated market. “At the same time, the legal costs involved in recouping one’s investment may be larger than the investment itself,” he warned.
Looking at the future, Kivinurm-Priisalm said Estonian investment culture will catch up to the rest of the West. For instance, a possible area for improvement would be if local listed companies publicly disclosed the management’s forecasts for the year. Likewise, if listed companies have companies related to the owners providing services to them, where the expenses might not be visible to small shareholders. “It’s important for smaller investors to learn what the management thinks, for many of today’s First North companies financial forecasts simply consist of a hockey stick graph that the management doesn’t really believe.”
In closing, Kivinurm-Priisalm recommends that every investor should look at the risks bound up in the promised investment return. “Many investors do not understand the relationship between risk and reward. If they prefer crowdfunding to a bond with an 8-10% yield, they don’t realize that they are also taking a higher risk. The latter is not subject to oversight and if trouble arises, the investor has to deal with the consequences,” she said. “Venture capital investments can be made, but then the risks should always be diversified. The share of alternative market companies could be capped at 5% of the portfolio.”
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