Cryptocurrencies, Blockchain and Fraud

The Ghosts of Enron May Haunt Blockchain

The spectacular collapse of Enron exposes million of dollars of fictitious revenues.

As predicted by many, Blockchain technology is becoming a disrupter in business enterprise models and governmental applications. The simplicity of a shared ledger among participants that creates a safe, chronological and unalterable record of events is showing signs of success. This, in turn, attracts attention from more and more people searching for technology to improve their business model. The shared ledger of Blockchain is similar to a ledger-based accounting system as found in Generally Accepted Accounting Principles (GAAP). One caveat to consider: The ledger can accurately record numbers, but cannot measure the truthfulness of the transactions or the integrity of the people behind the transactions. It has always been possible, and will always remain possible, that incorrect or fraudulent numbers can be accurately recorded in the journals and ledgers. The information then flows into the financial statements. The success of GAAP accounting therefore depends on the honesty of the participants.

Open vs. Closed Blockchain models

The original 2009 Blockchain model was incorporated into Bitcoin protocol as an open-sourced ledger system where untrusted participants called Nodes evaluate and approve each transaction before being added as a new block to the existing Blockchain. In this model, the Nodes did not have to know or trust each other. Since the Bitcoin ecosystem was open-sourced, any one with access to the internet could obtain the free software and participate in the mining process for Bitcoin. The design makes it impractical, but not impossible, for sufficient numbers of nodes to band together and override the Blockchain ledger. This became known as the 51% attack where over half of the existing Nodes work together to exert control over Blockchain transactions.

Subsequent Blockchain systems using only trusted participants (Nodes) in a closed environment have shown promise in a variety of business and government applications, and have fueled the interest and growth of Blockchain. But how does Blockchain affect the world of fraud?

There is no accounting system, computer software or hardware, that can prevent fraud schemes or prevent determined people to cheat and steal from one another. Accounting systems are designed to standardize record keeping protocols to create reliable records of financial transactions. Corrupt people working together, of course, will find ways to defeat any control system to lie, cheat, and steal. To counter the fraudsters, we rely on GAAP accounting rules, government regulators, and highly trained auditors to enforce the rules to create reliable financial reports.

Blockchain cannot prevent fraud. However it can be argued that a closed Blockchain system where Nodes are chosen may be a valuable ally in preventing and discovering known schemes such as – Business Email Comprise (BEC)schemes, Email Account Compromise (EAC) schemes, employee embezzlements , theft of Intellectual Property, corrupt vendor schemes, bribery and kickback schemes, and a host of others. These schemes may escape the eyes of management or auditors by hiding in blizzards of transactions . But Blockchain may serve as a deterrent since varying Nodes must unanimously approve each transaction before being added as a new block.

A strong argument can be made that having other participants (Nodes) reviewing and approving transactions before being added to the Blockchain may make such schemes more difficult to perpetrate and more likely to be discovered at early stages.

What Happened at Enron?

The investigation of Enron exposed a massive accounting fraud causing the collapse of the seventh largest company on the Fortune 500 company list and the sixth largest energy company in the world. The $100 billion company was a financial house of cards that concealed massive debt from the Board of Directors, internal and external auditors, investors, and regulators. Attempts to compare present-day capabilities (Blockchain) to historic fact patterns (Enron)can be tricky if the past cases are no longer relevant to current conditions. However, it can be demonstrated that fraudulent financial statement abuses are commonplace today. Here are some of the main accounting abuse issues found by SEC regulators in the Enron investigation:

  • Executives fraudulently used Reserves within Enron’s wholesale trading businesses to manufacture and manipulate reported earnings.
  • Executives manipulated Enron’s “business segment reporting” to conceal losses at Enron’s energy business known as Enron Energy Services (EES).
  • Executives manufactured earnings by fraudulently promoting Enron’s broadband unit, Enron Broadband Services (EBS).
  • Executives used Special Purpose Entities (SPEs) and company partnerships to manipulate Enron’s financial results.
  • Executives profited from illegal insider trading techniques to sell large amounts of Enron stock at inflated prices.
  • Executives made False and Misleading statements concerning Enron’s financial results and the performance of its businesses. These misrepresentations were also contained in Enron’s public filings that generated unlawful proceeds of approximately $63 million.

Given the advancements of Blockchain technology, some may argue that frauds like Enron may have been prevented or discovered earlier had Blockchain systems been implemented. A closer look at the above listed SEC findings indicates a strong, collusive collaboration within the top executives at Enron.

Could Collusion among Corrupt Corporate Executives Defeat Blockchain Advantages?

One would have to assume that corporate executives would be aware of the accounting procedures of a company. If executives were instrumental in designing and adapting Blockchain to their business model, could they appoint themselves as Nodes, or use complicit subordinates as Nodes to implant fraudulent information into the Blockchain? We do know that corrupt Enron executives at the highest levels of the company conspired to hide debt, manipulate profits, and falsely inflate stock prices for their selfish benefit. They successfully concealed the fraud from other company officials, internal and external auditors, bankers, and regulators. They worked hard to find the gray areas of GAAP accounting to justify their actions.

Blockchain developers are fearful of the dreaded “51% attack” that could undermine the advantages of Blockchain. The same concern could be raised by the possibility of corrupt collusion between Nodes to bake fraudulent transactions into the Blockchain, or work together to avoid the scrutiny of other participants.

Conclusion: The internal controls in the best designed GAAP accounting system remain vulnerable to collusion between fraudsters, and Blockchain may be no different. The corrupt Enron executives argued at many judicial proceedings that they were within the gray areas of accounting and therefore did not commit the alleged crimes. Fortunately, juries and judges disagreed and stiff prison sentences followed.

The lessons of Enron can provide guideposts to the applications of present-day technology: The success of any system will depend on the integrity of the participants. The numbers do not lie but liars can make the numbers.

The Ghosts of Enron will always remind us that when people are involved, fraud will find a way.

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