The South Sea Bubble: Less Told Story of Financial Fraud

Financial fraud refers to the intentional act of deceit or misrepresentation involving money, financial transactions, or financial assets with the purpose of gaining an unlawful or unfair advantage. It is often carried out by individuals, or companies and can range from simple schemes to highly complex operations. Financial fraud can occur in many forms such as embezzlement, insider trading, Ponzi schemes, accounting fraud, identity theft and more.

Financial scams impact investors’ confidence and trust in financial institutions and markets, causes monetary losses and on a larger scale can trigger economic downturn including economic recessions, job losses, and decreased economic growth as happened during the 2008 global financial crisis.

The history of financial markets is filled with incidents of speculative bubbles and frauds, driven by human psychology and the chase of wealth. One of the earliest and most infamous financial frauds was the South Sea Bubble of 1720, which brought the British economy to its knees and ruined thousands of investors including Sir Isaac Newton.

The South Sea Company was founded in 1711 in London during the War of Spanish Succession, primarily to manage the Britain’s national debt of ~ GBP 10 million (a significant sum for the era) which the government was struggling to pay back. In exchange for assuming a portion of the national debt, in 1713, the company was granted exclusive trading rights to supply enslaved Africans to South America, which was then under Spanish control. The promise of substantial return from extensive trade lured investors. However, these trade rights were mostly illusory as Spain heavily restricted trade. Despite this, the company’s stock attracted investors interest due to government backing and promises of future profits.

In 1720, the company proposed a scheme to take over a large portion of Britain’s national debt in exchange of shares of the company. The proposal was accepted by Parliament, and the company was given more privileges. Investors became more fascinated for South Sea Company shares as they believed the company will be an enormous success. The stock price soared from around GBP 128 in January 1720 to over GBP 1,000 by August of the same year. The company’s valuation turned to be completely disconnected from its fundamentals, profitability or trading operations.

By mid-1720, signs of trouble began to emerge. Many insiders, including directors, politicians and other influential individuals began selling off their shares because they recognized that the company's stock price had become dangerously inflated and the company’s financial fundamentals did not justify such high valuations. Also, the company’s financial model was unsustainable as it was using funds from new investors to pay high dividends to existing ones, tactic known as Ponzi scheme and the pool of new investors was drying up, hence the company would struggle to sustain its stock price and dividend payouts. This led to loss of confidence in the stock and as panic set in, shareholders rushed to sell their shares, but there were no buyers. The collapse began in August 1720, when the price of the stock that had reached over GBP 1,000 per share i.e., total market capitalization of around GBP 200 million plummeted to GBP 200 within few weeks. By the end of the year, the stock was trading at less than GBP 100, wiping out the savings of thousands of investors. The bursting of the bubble triggered a broader financial crisis in Britain causing widespread economic distress, bankruptcies and unemployment.

Report states the interesting story of famous mathematician Sir Isaac Newton being the victim of the South Sea Bubble. Newton first invested in South Sea Company shares in early 1720, before the bubble reached its peak and sold his shares in April 1720 making significant profit of GBP 7,000 (equivalent to over GBP 1 million today). However, as the company's stock continued to rise touching new heights, Newton re-entered the market in June 1720, buying shares at a much higher price and suffered a loss of GBP 20,000 (equivalent to GBP 3-4 million today) when bubble burst in August 1720.

Psychological Factors in Financial Bubbles

The South Sea Bubble highlights several psychological factors that contribute to the formation of financial bubbles, many of which are still relevant today.

1. Herd Mentality: Investors tend to follow the crowd, believing that if everyone else is investing, it must be a good decision. In the case of the South Sea Bubble, the sight of friends, family, and even public figures profiting from the rising stock prices encouraged others to follow the trend.

2. Overconfidence: During financial bubbles, investors often become overconfident, believing that they can predict market movements or that the bubble will continue indefinitely. This leads them to ignore warning signs and invest recklessly.

3. Fear of Missing Out (FOMO): The fear of missing out on potential profits drives investors to buy into bubbles, even when they know the assets are overvalued. In the South Sea Bubble, many investors rushed to buy shares because they feared being left behind as others made easy money.

4. Greater Fool Theory: Many investors believe that even if they buy an overvalued asset, they can still sell it to someone else at a higher price. Such mentality contributed to the South Sea Bubble, as investors bought shares with the sole intention of selling them at a profit, rather than holding them for long-term value.

Preventing Financial Fraud

1. Regulation and Oversight: Governments have created numerous agencies, such as the Securities and Exchange Commission (SEC) in the U.S. or the Securities and Exchange Board of India (SEBI) in India or the Securities Board of Nepal (SEBON) in Nepal, to regulate financial markets and prevent fraud. These agencies enforce laws that require transparency and accountability in financial dealings.

2. Audits and Internal Controls: Organizations can help prevent fraud by conducting regular audits of their financial statements, implementing strong internal controls, and establishing a culture of ethical behavior. Auditors play a key role in verifying the accuracy of financial information and ensuring compliance with laws.

3. Due Diligence: Investors can protect themselves from fraud by performing due diligence before making investments. This involves researching companies, analyzing financial statements, and understanding the risks involved. Avoiding "too good to be true" opportunities is a common guideline to avoid potential fraud.

4. Education and Awareness: Public awareness campaigns and financial education can help individuals and businesses recognize the signs of fraud and understand how to protect themselves from financial fraud.

5. Diversification: Diversifying investments across different asset classes and industries can help protect against the risks of bubbles and market crashes. Many investors in the South Sea Bubble put all their savings into the company, believing it was a sure bet.

Conclusion

The South Sea Bubble highlights how financial fraud can lead to devastating consequences for investors and the broader economy.

Financial fraud is a pervasive problem that affects individuals, businesses, and economies worldwide. Whether it's a Ponzi scheme, insider trading, or accounting fraud, the consequences of financial deception can be severe, leading to financial ruin for victims and instability in the markets. While governments and institutions have put systems in place to detect and prevent fraud, vigilance, transparency, and ethical behavior remain essential in safeguarding against these crimes.

About the Author:

Ayushi Agrawal, MBA
Senior Research Analyst
Garima Capital Limited