Fake it until you make it: Fraudulent founders

In 2015, Trevor Milton founded green vehicle and energy company Nikola Corp., which garnered a big win in 2020 with the signing of a $2 billion General Motors partnership. Weeks later, investment-research firm Hindenburg Research reported that the company’s success was “an intricate fraud,” based on “an ocean of lies.” According to the report, to counter skepticism over the truck’s functionality, Nikola staged a video showing it at high speed. Hindenburg uncovered former employees’ texts, showing an elaborate ruse that involved filming the truck after being towed to the top of a hill and released. The report and numerous allegations resulted in Milton stepping down as board chair and chief executive officer (CEO) and his subsequent arrest. (See “Nikola: How to Parlay An Ocean of Lies Into a Partnership With the Largest Auto OEM in America,” by Hindenburg Research, Sept. 10, 2020.)

Last year, Manhattan federal court Judge Edgardo Ramos sentenced Milton to four years in prison and fined him $1 million stemming from his 2022 conviction for embellishing claims about Nikola’s production of zero-emission 18-wheel trucks. Because of Milton’s false statements, investors lost thousands of dollars. “Over the course of many months, you used your considerable social media skills to tout your company in ways that were materially false,” said Ramos. (See “Nikola Corp founder gets 4 years prison for exaggerating claims on zero-emission trucks,” by CBS/AP, Dec. 18, 2023.)

Recent news stories indicate that Milton’s fraud isn’t an anomaly. California-based Ozy Media, student-aid startup Frank, health care tech startup Theranos, mobile-app testing company HeadSpin, Chinese property giant Evergrande Group, cryptocurrency lender Celsius Network Limited, cryptocurrency exchange FTX, and Singapore-based Terraform Labs have all made headlines thanks to their founders’ fraudulent and allegedly fraudulent ways.

Here we’ll explore some of these high-profile cases for a better understanding of what’s behind this phenomenon of founders committing fraud.

Javice: Finding magic numbers

Charlie Javice, founder of student loan assistance company Frank, got into hot water with the U.S. Securities and Exchange Commission (SEC) over the $175 million sale of her startup in 2021 to JPMorgan Chase Bank. Last year, the agency charged Javice with violating the anti-fraud provisions of the Securities Act, claiming she enticed JPMorgan to purchase Frank by lying about the robustness of its student database. In a statement last year, Gurbir S. Grewal, director of the SEC’s Division of Enforcement, said Javice “engaged in an old school fraud” and fabricated data “to support her claims.” (See “SEC Charges Founder of Frank with Fraud in Connection with $175 Million Sale of Student Loan Assistance Company,” SEC press release, April 4, 2023.)

JPMorgan sued Javice in 2022, alleging that she falsified data by paying a professor to fabricate accounts and instructing employees to change “public-facing numbers” to 4.25 million customers in January 2021; the number was actually less than 300,000. According to the suit, one Frank employee asked in a Slack thread: “Do we really have 4.25M students?” One employee wrote, “Charlie is king of finding magic numbers.” According to the suit, Javice justified the change in user stats by telling employees that website visitors counted as customers. Her trial is set for October 2024. (See “Frank founder accused of fraud was dubbed the ‘king of finding magic numbers’ by former employee,” by Luisa Beltran, Fortune, June 16, 2023.)

HeadSpin: Cooking the books

In 2015, Manish Lachwani co-founded Silicon Valley-based software startup HeadSpin, which raised more than $100 million from investors from 2017 to 2020, leading to a valuation of approximately $1.1 billion. He then inflated revenue numbers, falsely claimed that Apple and American Express were customers, and created fake invoices to hide his tracks. For example, Lachwani used a tracking spreadsheet with overstated revenue figures for certain customers and included revenue figures for customers who hadn’t contracted with HeadSpin. These inflated figures flowed into financial statements, which landed in the hands of investors. (See “Silicon Valley Start-Up Founder Sentenced To 18 Months In Prison For Wire Fraud And Securities Fraud,” U.S. Attorney’s Office press release, April 19, 2024.) According to the criminal complaint, HeadSpin’s revenues from 2018 to the first half of 2020 totaled $26.3 million, not the $95.3 million originally reported. (See “USA v. Manish Lachwani,” Thomson Reuters, Aug. 20, 2021.)

In his 2023 plea agreement, Lachwani admitted to wire fraud and securities fraud charges, obtaining investments in his company by providing false and overstated revenue metrics to potential investors. This year, he was sentenced to 18 months in prison and fined $1 million. In response to the sentence, U.S. Attorney Ismail J. Ramsey said it should “send a message to other entrepreneurs who may be tempted to cross the line into fraud and to ‘fake it until they make it.’” (See “Silicon Valley Start-Up Founder Pleads Guilty To Securities Fraud For Overstating Revenue To Investors,” U.S. Attorney’s Office press release, April 27, 2023.)

What patterns exist in these cases and others?

Fraudulent founder cases share several noteworthy commonalities. These are the top three I’ve observed:

1. Exaggerated claims.
2. Lack of oversight.
3. Not-guilty pleas.

Exaggerated claims. These cases featured exaggerated claims to investors, shareholders and the public. Javice allegedly lied about the number of students in Frank’s database, and Lachwani overstated revenues. Prosecutors accused Theranos founder Elizabeth Holmes of intentionally misleading investors. Out of the more than 200 blood tests advertised, the in-house “Edison” machines could analyze only a small number and routinely produced inaccurate results. Alexander Mashinsky, former CEO of now-bankrupt crypto-lending platform Celsius, allegedly pitched his company as a modern-day bank to keep crypto assets safe and earn interest, as he made risky investments and lied to investors about how that interest was generated. (See “Elizabeth Holmes and the Theranos Case: History of a Fraud Scandal,” by EQS Editorial Team, Nov. 22, 2023 and “Founder of Bankrupt Crypto Firm Celsius Is Arrested on Fraud Charges,” by David Yaffe-Bellany and Matthew Goldstein, New York Times, July 13, 2023.)

Lack of oversight. Anti-fraud professionals understand that oversight serves as a deterrent to bad behavior. Fraudulent founders leveraged a lack of oversight, painting rosier pictures of profits, capabilities and other business details.

HeadSpin, for example, had no chief financial officer, no human resources department and no audits. FTX had similar gaps in oversight. Following the exit of founder Sam Bankman-Fried, John Ray III became the new CEO of FTX. He’s guided dozens of companies, including Enron, through bankruptcy and restructuring. In December 2023, Ray told members of the U.S. House Financial Services Committee about the lack of oversight and financial controls he discovered after taking over FTX. He found a loan in which Bankman-Fried was both the issuer and the recipient. He found expenses approved by emoji. More concerning, he learned that FTX didn’t have accountants. For financial recordkeeping, employees used QuickBooks, prepackaged software typically used by small- and medium-sized businesses. At its peak, FTX’s market value topped $30 billion. (See “FTX Group CEO John Ray Testifies Before Congress,” The Wall Street Journal, Dec. 13, 2022.)

Not-guilty pleas. HeadSpin’s founder, Lachwani, pleaded guilty to obtaining investments in his company by providing false and overstated revenue metrics to potential investors. Such an admission is a rarity among founders accused of fraud. Not-guilty pleas seem more commonplace. For example, Milton, maintained his innocence in court, delivering an emotional statement late last year in which he described his heroic actions and sincere intentions to produce trucks that wouldn’t harm the environment. Without apologizing to investors or anyone else he’d harmed, he asked the judge not to impose a prison sentence. (See “Nikola Corp founder gets 4 years prison for exaggerating claims on zero-emission trucks,” by CBS/AP, Dec. 18, 2023.)

Pressure, opportunity and rationalization

The founders examined here satisfied all three elements of the Fraud Triangle. They experienced immense pressure to succeed, perceived an opportunity to get away with fraud and rationalized their decisions. From what I’ve observed, these founders share common traits: delusions of grandeur, heroic intentions and the need for success, all of which form the foundation for pressure and rationalization. A lack of oversight provides the opportunity for their frauds to flourish. And each case illustrates the buildup and residual damage that occur when those three sides of the triangle merge.

In the case of Holmes, she ignored or tried to obscure the failures of her company’s novel blood-testing technology. By closely monitoring and isolating employees from one another, she created a culture of secrecy. Wall Street Journal reporter John Carreyrou described Holmes as unwilling to listen to criticism or doubts about the feasibility of the company’s technology. (See “What Can We Learn from the Downfall of Theranos?” by Sachin Waikar, Stanford Graduate School of Business, Dec. 17, 2018.) Holmes hit every leg of the Fraud Triangle, relying heavily on rationalization instead of reality.

Key takeaways from the top

From these founder-executed frauds, we can see the fundamental components to combating occupational fraud: tone from the top that discourages fraud and the need for internal controls at all levels. While the mantra of “fake it until you make it” can be empowering in certain circumstances, it can also be disastrous. Integrity is paramount to the success of any company, regardless of size, intention or scope of operations.

As fraud examiners, we can take comfort in U.S. Attorney Damian Williams’ words about the Celsius case: “Whether it’s old-school fraud or some new-school crypto scheme, it doesn’t matter one bit. It’s all fraud to us. And we’ll be here to catch it.” (See “Celsius Founder And Former Chief Revenue Officer Charged In Connection With Multibillion-Dollar Fraud And Market Manipulation Schemes,” U.S. Southern District of New York press release, July 13, 2023.)

Sophia Carlton, CFE, is a fraud risk director with SoFi. Contact her at sophiacarltoncfe@gmail.com.

This article has been updated from the original print version to reflect that Autonomy founder Mike Lynch was aquitted of fraud charges in June 2024.