When Markets Sour, Stuff Suddenly Oozes from the Woodwork

“The bezzle shrinks”: LendingClub, Theranos, Breitling Energy

LendingClub, the largest of the marketplace lenders, disclosed today that founder and former CEO Renaud Laplanche and his family had taken out 32 loans from LendingClub in order to inflate the company’s loan volumes – a key metric by which investors determine the company’s value – “in periods after December 2009.” It was a crucial moment: just before April 2010, when the company raised $24.5 million from investors including Foundation Capital, Morgenthaler Ventures, Norwest Venture Partners, and Canaan Partners.

While it was at it, LendingClub also said that its internal probe had uncovered that investment funds managed by a subsidiary had not followed GAAP accounting standards when valuing loans. As a result, it would reimburse $800,000 to those who’d bought the loans.

Laplanche left in May after other loan irregularities had come to light, including that employees had falsified documentation when they sold $22 million of loans to an investor. The company also found that he hadn’t disclosed his stake in a fund that LendingClub later invested in.

The disclosure at the time battered not only the company but the entire industry, which is already reeling from rising loan defaults and investors that are now shying away from buying these loans.

When it went public in December 2014, LC soared 67% from its IPO price of $15. This was meticulously hyped on CNBC. Lending Club would “transform the entire banking industry,” Laplanche explained. Shares quickly made it all the way to $27.90. Then the hot air started hissing out. In May, they plunged to a low of $3.44 before bouncing off, including today’s 7% jump, to $4.60. They’re still down 70% from their IPO price and down 84% from their peak.

So today, LendingClub announced that loan volumes in Q2 have plummeted by about a third from the $2.75 billion it had reported in Q1. Some money managers lost their appetite for LendingClub’s loans.

Oh… and, of course, it would slash up to 12% of its workforce.

To whet investors’ appetite for these loans, the company would spend $9 million in Q2 on incentives, and another $20 million on employee retention, severance, due diligence, and advisory relationships. And it would write down its 2014 acquisition of Springstone Financial by $40 million.

In boom times, none of this happens. Investors don’t care as long as the shares soar and valuations go up. Where were the auditors and corporate governance in 2014 and 2015? Why didn’t investors poke around a little more? No one knows. But when markets sour, suddenly stuff oozes from the woodwork. And stuff has started to ooze recently.

On Friday, for example, the SEC filed a lawsuit against Chris Faulkner, CEO of fracking outfit Breitling Energy, three related companies, and seven other individuals for raising funds and then cheating investors out of $80 million, starting in 2011. According to Reuters:

Based upon inflated estimates of the oil and gas that his companies controlled, the charges said, Faulkner lured hundreds of U.S. investors to back his firms. Their investments were largely used to pay personal expenses for Faulkner, his associates, family and friends, the SEC alleged.

Where were the auditors and corporate governance? No one knows. It was the fracking boom. Auditors and corporate governance just got in the way. And investors didn’t care. Everyone would get rich.

Reuters also pointed out that Faulkner “faced a spate of lawsuits in the early 2000s in connection with his previous web hosting business.”

Note the timing: both sets of legal problems came into the open after the respective booms – fracking and dotcom – had imploded.

Among the recent standouts was Theranos, the blood-testing startup once considered one of the hottest unicorns with a $9-billion valuation that in April came into the cross hairs of the SEC, the FDA, the Centers for Medicare and Medicaid Services, the US Attorney’s Office for the Northern District of California, and other federal and state regulators. Bloomberg:

Chief Executive Officer Elizabeth Holmes was profiled as a wunderkind after dropping out of Stanford University to found the company, attracting glowing media profiles that described promises to upend the medical diagnostics business with inexpensive tests using just a few drops of blood.

Turns out, that incessantly hyped miracle technology didn’t work. What worked was a whole bunch of smoke and mirrors. And the whole house of cards just collapsed.

In The Great Crash 1929, originally published in 1955, John Kenneth Galbraith calls this sort of thing – actually the amounts involved – the “bezzle.” From Chapter VIII, a passage that today is more relevant than ever (paragraph break added):

At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars.

It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.

After the Financial Crisis, most of the “bezzle” was studiously covered up by bailouts, QE, and free money, and so “commercial morality,” as Galbraith put it, was not “enormously improved.” On the contrary, moral hazard is what we got instead.

But now, these are smaller companies – not megabanks. There are no bailouts in sight. As money tightens and investors and perhaps even regulators start opening their eyes and look a little more carefully at the miracles being performed on a daily basis, more of these shenanigans are going to come to light. Nothing shrinks down the “bezzle” like the crash of an industry under the weight of its own hype.

Business optimism in the US is already “lowest since the height of the Financial Crisis.” Read… How Vulnerable is the Shaky US Economy to Brexit Fallout and European Bank Meltdown?

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Wolf Richter

In his cynical, tongue-in-cheek manner, he muses on WOLF STREET about economic, business, and financial issues, Wall Street shenanigans, complex entanglements, and other things, debacles, and opportunities that catch his eye in the US, Europe, Japan, and occasionally China. WOLF STREET is the successor to his first platform… TP-Title-7-small-200px …whose ghastly name he finally abandoned in July 2014. Here’s the story on that. Wolf lives in San Francisco. He has over twenty years of C-level operations experience, including turnarounds and a VC-funded startup. He earned his BA and MBA in Texas and his MA in Oklahoma, worked in both states for years, including a decade as General Manager and COO of a large Ford dealership and its subsidiaries. But one day, he quit and went to France for seven weeks to open himself up to new possibilities, which degenerated into a life-altering three-year journey across 100 countries on all continents, much of it overland. And it almost swallowed him up.