From mobsters to fraud to ridiculous levels of leverage, these corporate meltdowns were not your run-of-the-mill bankruptcies. Learn how what went wrong and how to protect yourself from becoming a victim of the next big collapse.
Background: The Franklin Square National Bank in Long Island, NY was the 20th largest bank in the U.S. when it failed in 1974. It was the largest bank failure in U.S. history up to that point.
The circumstances surrounding the failure are the stuff mobster movies are made of. In 1972, Michele "The Shark" Sindona bought a controlling interest in Franklin Square. Sindona built his $450 million fortune by serving as the banker and financial advisor to a number of legitimate and illegitimate Italian companies, including the Vatican and the Sicilian drug .
After allegedly used his political connections to push out his rivals, Sindona began using Franklin Square as a money laundering operation and conduit for foreign exchange speculation. After a stock market crash in 1974 led to a $30 million foreign currency loss, the bank was declared insolvent.
In 1980, Sindona was convicted of 65 counts of conspiracy, fraud and perjury in the United States and was later extradited to Italy to face murder charges. In 1986, he committed suicide (or was murdered, depending on who you talk to) by drinking cyanide-laced coffee while serving a life sentence in Italy.
What Went Wrong: This is obviously an extreme case, but when a big, new shareholder steps in and takes over, make sure his interests align with yours.
How to Protect Yourself: Know the management of every company you own.
2) Enron -- The smartest guys in the room eventually get outfoxed.
Background: Enron, an American energy company based in Houston, Texas, wove a tangled financial web until 2001, when it was finally discovered that the company was hiding billions of dollars of debt from failed deals and projects. It currently reigns as the second-largest U.S. bankruptcy of all time, and is the only corporate bankruptcy to inspire an award-winning Broadway production.
A number of factors led to Enron's downfall, but it was ultimately due to its use of clever, but deceptive, accounting practices. Under the guidance of President and COO Jeffery Skilling, Enron began calculating "anticipated" future profits as current assets, allowing the company to record "gains" that actually turned out to be losses. The company's financial statements were so convoluted that few people were diligent enough to really examine them.
All of this was done to ensure share prices continued to climb. Enron survived as long as it did because of investor's willingness to provide capital, and Skilling knew that a drop in stock prices would push the debt-ridden company over the edge.
Once Enron's history of accounting violations surfaced, nervous investors started to jump ship. Shareholders lost nearly $11 billion as Enron's stock price plummeted to less than $1. In the end, 16 people pleaded guilty for crimes committed at the company, and five more were found guilty at trial.
Enron's downfall could also legitimately be called the biggest failure in the history of auditing. Enron's charade went on much longer than it should have, thanks in part to Arthur Andersen, the accounting firm that performed the company's audits. While an audit should have revealed Enron's creative accounting tricks, Arthur Andersen was happy to cover them up; Enron's audit and consulting bill accounted for more than 25% of the Houston office's public client fees.
What Went Wrong: Don't let a rising share price keep you from asking questions about a company's opaque policies.
How to Protect Yourself: Ask tough questions, even if the respondent tries to make you feel stupid for doing so. Be wary if a company can't respond with good, clear answers.
3) Long-Term Capital Management -- Two Nobel prizes plus one Russian currency collapse equals one big bailout.
Background: This U.S.fund failed spectacularly in 1998, leading to a massive, $3 billion Fed-supervised bailout.
LTCM had the credentials to be successful. It was founded in 1994 by the former vice-chairman and head of bond trading at Salomon Brothers, and two members of its Board of Directors, Myron Scholes and Robert Merton, won the 1997 Nobel Prize in Economic Sciences.
Throughout its first few years, the fund earned enormous annual returns (over +40%) by taking advantage of tiny fluctuations in sovereign bond prices. Eventually the company felt pressure to increase profits by making more aggressive trades with highly-leveraged positions. When the Russian government defaulted in 1998, panicked investors fled to U.S. Treasury bonds, toppling LTCM's carefully crafted house of cards and causing it to lose $1.85 billion in one month.
Fearing that LTCM's failure could spark a massive chain reaction throughout the banking system, the Federal Reserve secretly organized a bailout of over $3 billion. The banks were given 90% of the fund and it was quietly unwound over the next several years.
What Went Wrong: Overconfident and over-leveraged hedge fund managers ended up in a pickle when the foundation for their risky trades came apart at the seams.
How to Protect Yourself: Devote only one portion of your portfolio to risk-driven investments, like hedge funds or speculative companies; anyone solely invested in LTCM during the crash would've gone down with the ship.
4) South Sea Company -- One of the first in a long history of bubbles.
Background: Established in 1711 and defunct by 1720, the South Sea Company was created by the British government to facilitate a clever debt-for-equity swap.
When British government officials realized they could no longer afford the debt they'd accrued during the Spanish War, they came up with a brilliant plan: They created the South Sea Trading Company and granted it a trade-monopoly in South America.
Holders of government bonds were encouraged to exchange them for shares in the new company and reap the potential of the New World. Several rounds of this exchange took place after the government realized it worked like a charm.
Throughout the ruse, the South Sea Company managed to shroud itself in an aura of legitimacy. To promote the impression that the company was thriving, its management spent money furnishing offices with luxurious goods. Investors fell for it, hook, line and sinker, and sent the share prices through the roof.
Finally, in the summer of 1720, the South Sea Company's management team realized that the company's share price in no way reflected its actual value -- so they quietly sold their shares, hoping investors wouldn't notice the dismal shape the company was in. When word got out, people tried frantically to sell the now worthless shares they were left with. Panic spread and the South Sea Bubble quickly burst.
In the aftermath of the company's crash the British government outlawed the issuing of stock certificates, a law that wouldn't be repealed until 1825.
What Went Wrong: Investors wrapped up in speculation forgot to take time to determine what was really driving up share prices.
How to Protect Yourself: Remember the importance of fundamental analysis.
5) Refco -- Fake companies can be extremely useful in cleaning up a.
Background: Refco, a New York-based financial services company, collapsed when it was discovered that its CEO had concealed hundreds of millions of dollars in bad debts.
In 2005, Refco was the largest broker on the Chicago Mercantile Exchange. That year it decided to go public, and its IPO in August 2005 drew heavy interest from investors drawn to the firm's strong earnings reports and solid balance sheet. On the day of its IPO, investors drove the stock price up by 25%, valuing the company at $3.5 billion. Only two months later, Refco announced to the public that CEO Phillip Bennett had perpetrated an elaborate ruse to move $430 million in bad debts off Refco's balance sheet.
As early as 2000, Refco had bad debts that needed to be written down to their market value. But because that would adversely impact Refco earnings, Bennett decided that he would find someone to buy the debts at full value.
The "someone" he found was a secret entity that only Bennett knew about, Refco Group Holdings. The plan unfolded like this: a legitimate Refco subsidiary would lend a hedge fund some money, and the hedge fund would turn around and lend it to Refco Group Holdings. Refco Group Holdings would then buy the bad Refco debt. Refco was essentially lending money to itself to buy its own bad debt.
Bennett managed to keep the balls in the ai until October 2005, when someone questioned a mysterious $430 million loan receivable that Refco listed on its balance sheet. On October 19, 2005, trading of the stock was halted. Before the halt, Refco stock traded at $28. By the time trading resumed, it was at $0.80.
Bennett was charged for securities fraud, and the company filed for bankruptcy, hoping to protect itself from its creditors. At the time of the collapse, Refco had about $75 billion in assets financed with about $75 billion in liabilities.
What Went Wrong: A wayward CEO scammed investors, lenders, and his own company into thinking things were better than they were.
How to Protect Yourself: It's hard to predict when a high-ranking executive is going to throw you for a loop, but even prior to this scandal, Refco had earned a bad reputation with regulators. Always double check that any company you invest in has a clean slate.
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