Under-the-Microscope Fraud Diligence
Test corporate claims against documents, incentives, assets, and operations
- Difficulty
- Advanced
- Time to result
- ~weeks to results
- Steps
- 6
- Confidence
- 96%
This diligence method moves from cheap signals to increasingly direct tests of a company's story. Begin with filings and promotional narratives, watching for claims crafted to satisfy investor psychology rather than convey operational facts. Interview management using concrete questions about costs, equipment, counterparties, and planned investments; vague answers from responsible executives are evidence, not proof. Investigate related-party transactions and whether supposedly independent appraisers or advisers are genuinely independent. Then inspect physical operations with domain expertise and compare inventory, equipment age, production conditions, and visible capacity with reported figures. Fraud confidence rises only when multiple evidence types converge. Before publication or investment, document factual claims, separate observations from inferences, and repeatedly try to falsify the thesis. The output is a defensible conclusion rather than a reaction to one dramatic red flag.
Origin
Block developed the method while investigating Orient Paper with a manufacturing consultant in China, combining equity-research analysis, legal writing, executive questioning, and physical inspection. Extracted from Masters in Business.
Core principles
- 01Treat promotional character claims as possible persuasion tactics
- 02Test whether executives understand their own capital plans
- 03Examine related-party transactions and independent valuations
- 04Compare reported assets and output with physical reality
- 05Escalate from suspicion to conclusions only when evidence converges
How to run it
- 1
Screen the narrative
Read filings, investor materials, and promoter claims for implausible numbers, internal contradictions, and messaging designed to exploit investor preferences.
Pro tip Flag character-based assurances that substitute for measurable governance controls.
Watch out A promotional narrative alone does not establish fraud.
- 2
Interrogate operational knowledge
Ask responsible executives specific questions about project costs, machinery, construction assumptions, suppliers, and expected returns.
Pro tip Use questions a genuine executive in that role should answer readily.
Watch out Allow for reasonable uncertainty, but note repeated ignorance of material plans.
- 3
Trace conflicts and counterparties
Examine related-party transactions, ownership, appraisers, advisers, and the flow of funds around major purchases.
Pro tip Ask who selected and pays each supposedly independent party.
Watch out A third-party label does not guarantee independence.
- 4
Inspect physical reality
Visit operations with a domain expert and compare the condition, quantity, and workflow of assets with reported values and capacity.
Pro tip Use simple reality checks that translate physical observations into financial implications.
Watch out A staged tour may hide facilities, constrain access, or create misleading activity.
- 5
Reconcile claims with capacity
Test whether reported revenue and production growth are possible given equipment, labor, inputs, facilities, and visible process improvements.
Pro tip Ask what changed operationally to make the claimed increase possible.
Watch out Do not mistake temporary inactivity for conclusive evidence without corroboration.
- 6
Challenge and document the conclusion
Separate facts, estimates, and allegations, then repeatedly search for explanations that could disprove the thesis before acting or publishing.
Pro tip Write the evidence in a form that can withstand legal and public scrutiny.
Watch out Overstating a conclusion creates investment, reputational, and litigation risk.
In the wild
Orient Paper reported roughly five million dollars of raw-material inventory. At the facility, Block and his consultant saw piles of discarded cardboard; after climbing one pile and inspecting the site, the consultant questioned whether the material could remotely support its stated value. Old equipment, water around paper production, missing lines, and unexplained output growth added independent evidence.
→ Converging documentary, managerial, and physical discrepancies led Block to conclude that the reported business was overwhelmingly fabricated.
The CFO said the chairman had personally acquired a photographic-paper line and would resell it to the company at a price established by a local appraiser. The CFO did not know the purchase price, and the claimed appraiser lacked the obvious independence Block expected for such a transaction.
→ The questioning exposed governance and valuation risks that justified deeper investigation.
Common mistakes
Stopping at the first red flag
One suspicious claim can have an innocent explanation; robust conclusions require evidence from several independent angles.
Relying only on audited statements
An audit opinion does not necessarily perform the anti-fraud function investors assume, especially where access and enforcement are weak.
Touring without domain expertise
A facility visit can create false confidence unless someone present understands the equipment, process, capacity, and likely staging tactics.
Is it for you?
Best for
It is best for concentrated investors, investigative analysts, and short sellers evaluating companies with opaque operations or unusually promotional narratives.
Not ideal for
It is not ideal for casual investors who lack the time, access, expertise, or legal support required for intensive forensic work.
From the transcript
“we're going to take a much harder look at this company and your company than anybody else has before.”
“if this is worth five million dollars, the world's a much richer place than I ever knew.”
“These numbers that they're reporting are total lies across the board.”
From the episode
Carson Block on the Short-Selling Market (Podcast)
Carson Block