‘Brazen red flag’: Fraud accusation triggers share plunge for Afterpay owner Block

Afterpay owner Block is embroiled in controversy after a report from short seller Hindenburg Research alleged the fintech overstated its customer base, as well as facilitating fraud and other criminal activity with Cash App, the pay-anyone service Block is planning to bring to Australia.

Block said it would explore legal action against Hindenburg, but it did not prevent the dual-listed stock continuing its plunge on the ASX on Friday, diving as much as 21 per cent to $86.49 before closing 18 per cent lower. It closed 15 per cent lower at $US61.88 ($92.62) in New York trading overnight.

Block CEO Jack Dorsey is under attack by short sellers.Credit: Bloomberg

Analysts raised concerns the accusation could lead to more regulation of Block services such as Cash App.

The Australian Prudential Regulation Authority said Block was not an entity it regulated.

“As such, we are not in a position to comment,” said APRA.

Another concern raised on Friday was whether Block’s response was strong enough.

“We had hoped Block’s response/refutation would be more detailed and believe ‘exploring legal action’ will likely not be enough to settle investors’ concerns,” Citi said in response to the short report.

Hindenburg, the firm run by Nathan Anderson that bolstered its profile with a scathing report on billionaire Gautam Adani’s business empire earlier this year, conducted a two-year investigation into Block, it said in a report published on its website and distributed via Twitter. The chairman of Block is Jack Dorsey, also a co-founder of Twitter.

The billionaire’s fortunes took a significant hit from the short attack, which wiped more than $US500 million ($748 million) from his net worth.

In its investigation, Hindenburg alleged it found that Block’s popular Cash App was likely facilitating scammers taking advantage of US government-stimulus programs during the pandemic. In response to a public-records request, the state of Massachusetts told the short seller that it sought to claw back more than 69,000 unemployment payments from the bank behind Cash App accounts, an amount that exceeded those it sought to reverse from major banks such as JPMorgan and Wells Fargo, which have far more customers.

Hindenburg made waves earlier this year with a scathing report on billionaire Gautam Adani’s business empire earlier this year.Credit: Bloomberg

“Block ignored both internal and external warnings that multiple individuals using the same bank account number to receive government funds was a brazen red flag of fraud,” Hindenburg said in the report. “Multiple key lapses in Cash App’s compliance processes facilitated billions in government payment fraud.”

Morningstar analyst Brett Horn did not pay much heed to the allegations but was concerned about how it could shape the incomplete regulatory regime around peer-to-peer payment providers such as Cash App.

“The risk of regulatory rules affecting the long-term economics of the space is meaningful,” he said.

The short seller also took aim at Block’s $US29 billion purchase of Afterpay.

“Afterpay was designed in a way that avoided responsible lending rules in its native Australia, extending a form of credit to users without income verification or credit checks. The service doesn’t technically charge ‘interest’, but late fees can reach APR [annual percentage rate] equivalents as high as 289 per cent,” the report said.

Investors have become more critical of the deal as losses tied to those loans have soared in recent quarters and regulators have taken aim at the underlying business of buy now, pay later.

“The acquisition is flopping. In 2022, the year Afterpay was acquired, it lost $US357 million, accelerating from 2021 losses of $US184 million.”

Hindenburg cited a Fitch Ratings report that Afterpay delinquencies through March 2022 had more than doubled to 4.1 per cent, from 1.7 per cent in June 2021.

Australian investors exchanged $US29 billion worth of Afterpay shares for Block stock at the start of 2022.

“I don’t think most Australian investors understand, or know, what Block does,” says payments veteran Grant Halverson, who heads consultancy McLean Roche.

The issue of alleged fraud has been swirling for some time across the industry in the US, he says.

Block has highlighted Afterpay’s critical role in linking its merchant payment business, Block, with its pay-anyone business, Cash App. And it has plans to introduce Cash App to Australia, which is Afterpay’s largest market.

“We are building a commerce platform, a commerce engine, with Afterpay that over time will enable you to actually see the interesting opportunity to buy something within the app,” Amrita Ahuja, Block’s finance chief, said last week.

“So that sort of threading together of social to financial services to commerce is something that we can uniquely do with Cash App.”

Block said it intended to work with the US Securities and Exchange Commission “and explore legal action against Hindenburg Research for the factually inaccurate and misleading report they shared about our Cash App business today.”

“We have reviewed the full report in the context of our own data and believe it’s designed to deceive and confuse investors. We are a highly regulated public company with regular disclosures, and are confident in our products, reporting, compliance programs and controls.”

Hindenburg has gained prominence after its Adani report in January, which wiped $US100 billion from the value of various Adani-related companies.

Adani owns and operates the controversial Carmichael coal mine in Queensland.

The conglomerate’s flagship Adani Enterprises has dropped 48 per cent since the report, even as the group denied Hindenburg’s allegations of accounting fraud and stock manipulation.

Hindenburg’s report on electric-vehicle maker Nikola Corp in September 2020 sent the stock plunging and led to criminal charges against the company’s founder, Trevor Milton. He was convicted in October of defrauding investors.

Block’s status as a stockmarket darling had already somewhat faded. The firm’s market value peaked at almost $US130 billion in 2021, and its shares are down more than 75 per cent since August of that year. Dorsey and co-founder James McKelvey collectively sold more than $US1 billion of stock during the pandemic, Hindenburg said in the report.

Investors have long worried about Cash App as well as many of its mobile-money rivals such as PayPal’s Venmo, which have faced scrutiny in recent months as fraudsters have seized the technology to fool consumers into sending them payments. But in its research, Hindenburg alleges Cash App’s problems go deeper and can be traced back to shortcomings in compliance protocols.

Hindenburg alleged that Block was overstating the number of users of Cash App, citing an acknowledgment from the company that “certain of these accounts may share an alias identifier with one or more other transacting active accounts.”

Hindenburg demonstrated the laxness of Block’s controls by setting up accounts, and conducting transactions, in the names of Donald Trump and Elon Musk.

Other allegations from Hindenburg are more damning. This includes the use of Cash App to allegedly facilitate criminal payments for drugs, and murder – the app is even specifically referenced in rap songs on these subjects – and sex trafficking.

Hindenburg cited a news story from non-profit group Polaris, saying Cash App was “by far” the top app used in reported sex-trafficking cases in the US.

Investors have been on high alert about inflated user numbers since PayPal last year announced it closed 4.5 million accounts and lowered its forecast for new customers after finding “bad actors” were taking advantage of its incentives and rewards programs. The company abandoned a long-term goal for increasing the number of new users on its platform and now focuses on enticing existing customers to use it more.

Interchange fees

The short seller also took aim at Block’s collection of so-called interchange fees, which banks collect from merchants each time a consumer swipes a debit card at the checkout. That’s one of the key revenue drivers for Cash App, which has an accompanying debit card provided by Sutton Bank.

But big banks have taken aim at large tech companies partnering with tiny regional lenders for such a business. That’s because Congress has capped what banks such as JPMorgan and Bank of America can charge for those swipes, while smaller banks aren’t subject to the same rules.

Block shares tumbled on Wall Street. Credit: AP

Hindenburg noted that PayPal has disclosed that it is under investigation by the SEC for the practice, though it has no proof that Block faces a similar query.

‘Good value’

“We view the stock as good value, but are concerned with the prevalence of any criminal activity and how this could impact investor sentiment,” Robert W. Baird & Co analysts David Koning and Robert Bamberger said in a note to clients about the Hindenburg report. “It’s hard to know exactly what impact this could have, though in a pretty dire case, if they shed 20 per cent of accounts, it could be about 8 per cent of total gross profit impact.”

Cathie Wood’s ARK Investment Management holds 1.66 per cent in Block, according to data compiled by Bloomberg, with the exchange-traded fund buying shares as recently as yesterday. The stock is also the flagship ARK Innovation ETF’s fifth-biggest holding on a weighting basis.

This is not the first time Block has been accused of misleading investors. Last year, a Block shareholder filed a complaint against the company, accusing it of waiting several months to disclose that an ex-employee took customers’ names and brokerage information. The disclosure sent share prices plunging.

Stock owner Donna Esposito specifically accused both Dorsey and chief financial officer Amrita Ahuja of participating in issuing misleading press releases and SEC filings.

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