http://dealbook.nytimes.com/2015/01/29/how-to-avoid-frauds-in-investments-and-personnel-hires/

How to Avoid Frauds in Investments, and Personnel Hires

By CARSON C. BLOCK

JANUARY 29, 2015 3:07 PM January 29, 2015 3:07 pm 2 Comments

Carson C. Block is the director of research for Muddy Waters, a research and investment firm. He is on Twitter at @muddywatersre

I’m often left scratching my head when seemingly smart investors get blindsided by a fraud. But I’ve learned that it isn’t reasonable to expect them to entirely avoid mistakenly getting taken in by what on the surface seems like a sound investment but turns out to be a fraud. A buying mentality is simply incompatible with the skeptical mentality needed to avoid scams.Although I short stocks, I am long talent, and am always looking to hire first-class professionals and investigators to add to our firm’s growing team. But in two cases, I’ve made the same mistakes in hiring that many buy-and-hold investors often make when buying into what turn into stock frauds.

This has taught me that I need to work with outside consultants who have a short-seller’s perception skills when evaluating potential hires. I think fund managers who are focused on long-term stock picks would be well served to do the same with respect to potential investments.

It turns out that hiring people is a lot like picking stocks. At their essence, each involves making an educated guess about future performance, weighing those guesses against the price (or the potential employee compensation) and often considering how the potential addition would fit into the bigger picture.

Historical information is critical to the extrapolation process in both investing and hiring. And the risks of getting it wrong are similar. It’s not uncommon to experience a total loss when investing in a fraud, and it’s not uncommon for an employer to be taken down by hiring a seemingly good hire who turns out to be a fraudster.

Companies don’t defraud investors, people do. The pathology that enables senior managers to invent financial statements and cook the books is the same one that drives rank-and-file employees to steal money, assets or intellectual property or commit other forms of fraud at the expense of their employers. Fraudsters have a dark side, yet outwardly, they usually appear normal and seem well pedigreed.

When picking stocks, the research process assumes the information the company provides is real. Asking questions based on this information is different from asking questions about the validity of the information itself.

The same holds true in the hiring process – analyzing a candidate’s potential to contribute is different from analyzing the candidate’s propensity to act dishonestly. The interviewing process illustrates this conflict.

When I interview someone, one of the things I’m trying to determine is whether I’ll enjoy being around that person. My technique is to establish a relaxed banter with the candidate, and then ask certain questions.

Over the years though, there were a couple of people who knew the answers I wanted to hear, had impressive pedigrees and had enough cunning and charisma to cover up their dark sides. I ended up hiring them, and eventually came to regret having brought these people on board. And because I’m “the fraud guy” when it comes to trying to identify problem stocks, I am usually the most skeptical person in any room. Thus, I am usually the person most disappointed when it becomes apparent that I had hired a bad employee.

For investors who meet a company’s top executives, watch their interviews or significantly weigh management quality in decision-making, the pedigree trap is a particular threat. The same is true in hiring. Investors and employers tend to give too much weight to impressive institutional backgrounds, military service and even athletic achievements. Having an impressive checklist of personal accomplishments doesn’t alone make someone a “quality” hire.

There is a misperception that investors who know how to pick good stocks should be skilled at avoiding frauds. As a result, being defrauded is fraught with visceral emotion, and is stigmatizing. Self-doubt and self-flagellation fill investors’ heads when they realize they’ve been had. This negativity can hurt an investor’s confidence and judgment until the wounds heal.

Some defrauded investors adopt the denial approach and go to great lengths to convince themselves that they didn’t make a mistake because the company isn’t a fraud. I felt this firsthand when I realized the awful truth of some of my mistakes. In fact, I only fully accepted what had happened when one of my close associates asked me: “If you were listening to a third party give the same factual description you just gave, what would you conclude?”

I have since realized that I’m largely unable to determine the honesty of a job candidate at the same time I’m trying to judge that person’s potential to contribute and fit in. This is not a shortcoming. Testing for chinks in someone’s armor is not only fundamentally different from developing a rapport with someone, it’s antithetical.

Instead, I turn to people whose focus is finding reasons to say “no” to a potential hire. At its most basic, this outside help constitutes a background check, which should include civil and criminal litigation checks, searches for mentions in the media and credit checks.

Our process now goes well beyond that. We involve outside experts in detecting problems when we sit down and interview our candidates. These consultants are looking for the holes in candidates’ stories the same way I do with public companies.

The lessons from my hiring mistakes are ones investors should adopt to better protect against being defrauded. If you’ve been defrauded, stop giving yourself a hard time. Instead, accept that when looking for the good in something, it’s difficult to see the bad. If you suspect you could be in denial about an investment being a fraud, try to take this to heart. If you can suppress the toxic emotions that surround fraud, you’ll be in a much better position to make decisions about the investment.

Fund managers would also do well to work with specialists who question their proposed investments. Skeptical people with accounting backgrounds are often well suited to this task (and cost less than investment analysts).

Above all, when you make a mistake, turn it into a positive and learn from it the next time you have to make a hiring decision, or an investment decision.