When we examine issues such as corporate fraud and identity theft, we must first consider how those involved could have avoided ensnarement and becoming victims of financial crime. Is the problem the inherent “I must have more” culture or the delusional belief that a total stranger is going to give you something for nothing? Taking simple steps to ensure you know whom you are dealing with – either as a company, an investment advisor or employee – can save much anguish, financial loss and reputational damage further down the road.
This commentary explores some of the different types of fraud prevalent today and the most effective way to avoid falling foul of the fraudsters and criminals operating in the financial industry today.
Corporate fraud is one of the fastest growing financial crimes in terms of identification and prosecution, and carries heavy sentences in both the US and China. In simple terms, it is described as the falsification of financial information, such as false accounting entries, bogus trades designed to inflate profit or hide losses, and false transactions designed to evade regulatory oversight.
It also encompasses the following actions:
- Self-dealing by corporate insiders including insider trading, ‘kickbacks’, backdating of executive stock options, misuse of corporate property for personal gain and individual tax violations related to self-dealing.
- Fraud in connection with an otherwise legitimately-operated mutual or late trading, certain market timing schemes, falsification of net asset values and any other fraudulent or abusive trading practices by, within, or involving a mutual or hedge fund.
- Obstruction of justice designed to conceal any of the above-noted types of criminal conduct, particularly when the obstruction impedes the inquiries of the US Securities and Exchange Commission (SEC), other regulatory agencies, and/or law enforcement agencies.
Unfortunately, there are numerous examples of these types of fraud cases in the industry today. In the case of Comverse, a New York-based designer and manufacturer of telecommunication systems and software with revenues of US$1.2bn in FY 2005, the chief executive Kobi Alexander, chief financial officer David Kreinberg and general counsel William Sorin were charged with fraud related to illegal compensation. Their method of fraud was simple and easily traced because it was fuelled by greed. The executives got stock options and backdated the grant date to when the stock price was at its lowest. Alexander made US$8m, Kreinberg US$1.5m and Sorin US$1m from this scheme. Alexander is currently in custody in Namibia, southern Africa, pending extradition.
And this is not the only type of financial crime rife within the industry today. See the box below, which highlights significant cases of fraud in areas, such as healthcare, real estate and insurance.
Reactions to Corporate Fraud
The US reacted to the problems emanating from corporate fraud with the creation and enforcement of the Sarbanes-Oxley (SOX) Act, which affected US and international businesses in a number of ways. The Sarbanes-Oxley Act of 2002 was passed in response to the scandals of Enron, WorldCom and Adelphia and established general legal principles. It gives the US SEC primary responsibility for writing specific rules to implement the law. The Act applies to all public companies that are required to file reports with the SEC under the 1934 law.
SOX makes it quite clear that: ‘It shall be unlawful for any person that is not a registered public accounting firm to prepare or issue, or to participate in the preparation or issuance of, any audit report with respect to any issuer.’ The purposes of the Act also make it quite clear that:
- Companies should comprise of independent directors only.
- Approve the hiring and compensation of auditors.
- Provide procedures to receive confidential, anonymous submission by employees of the company about possibly questionable accounting or auditing matters.
- Pre-approve any non-audit services provided by the auditor.
A primary goal of SOX as it relates to audit committees and auditors is to ensure that auditors are independent of the companies they are auditing. This is more likely to be the case if they do not have other business that is dependent upon maintaining the goodwill of the company and if personal relationships – or potential jobs with the company – do not create pressure to downplay problems. Independent auditors are more likely to provide an honest and fair audit. Under the new rules, an accounting firm that performs an audit is prohibited from providing many other accounting services, however the law still permits the auditing firm to provide tax services, which many critics believe can involve a conflict of interest.
Auditor independence is clearly essential. To help ensure that auditors remain independent from the company they are auditing, SOX requires that auditors ‘rotate off’ a given company’s audit after a specified time. As interpreted by the regulations this means ‘The lead and concurring partners on an audit must rotate off after five years and stay off at least five years before returning to that company, although rules for other audit team members are less stringent’.
Not all services that might be provided by the auditing firm are expressly prohibited by SOX. If a non-audit service is not expressly prohibited, the auditing firm may provide that service if the audit committee gives its prior approval. In some cases, the audit committee may set up rules and procedures for approval without actually reviewing each individual action.
The ACT also introduces standards for lawyers – a refreshing decision for some, no doubt! For example, SOX requires the SEC to prescribe minimum standards of professional conduct for lawyers appearing and practicing before it in the representation of companies that must report to the Commission. The standards require an attorney to ‘Immediately inform the chief legal counsel or the chief executive officer of the company of any evidence of a material violation of securities laws or breach of fiduciary duty or similar violation that he or she finds by anyone within the company’.
SOX – Compliance Leads to Risk Management
One of the most important developments as a result of SOX is the fact that compliance leads to risk management. This is a development that may not be welcomed by some but has had an interesting effect on companies who previously thought they were regulator and bomb proof. SOX compliance efforts are forcing companies to develop a structured approach to managing risk. The reporting requirements have companies outlining all their issues in a single document, which helps them plan for the future.
Companies can use their current risk assessments to evaluate their operating needs, facilitating planning and decision making on issues, such as sales and marketing, changes in the customer base and software needs. The legislation provides a springboard for streamlining operations. One company’s analysis of potential future risks was to reduce redundant controls at a key site, which led to changes in workflow and staffing, thus reducing overhead and improving productivity. One has to suppose that job losses are good for business!
Six Common Types of Fraud to Watch Out For
Securities and commodities fraud
Securities and commodities fraud is a serious problem within the industry today and is demonstrated by the case involving the International Management Associates (IMA) – a high-yield hedge fund managing more than US$184m in assets, including those from a group of current and former National Football League (NFL) players. In February 2006, the Securities and Exchange Commission filed a complaint against Kirk Sean Wright, the founder and chief executive officer of IMA. He was charged with 22 counts of mail fraud and three counts of securities fraud relating to his improper operation of IMA while athletes requested disbursements from their investments. Wright is alleged to have misappropriated the investors’ assets with the losses from this fraud estimated at more than US$150m.
Internet pharmaceutical suppliers arrived on the scene as Bansal Corporation. This investigation was focused on the Philadelphia-based Internet pharmacy drug distributor in April 2005, which smuggled drugs into the US from India and selling them over the Internet. They shipped thousands of packages per week to individuals around the country. Twenty-four individuals were indicted on charges of distributing controlled substances, importing controlled substances, involvement in a continuing criminal enterprise, introducing misbranded drugs into interstate commerce, and participating in money laundering. The results for law enforcement are considerable in that over US$8m has been seized to date.
Throughout 2006, 2,423 cases investigated by the FBI resulted in 588 indictments and 534 convictions of health care fraud criminals resulting in US$373m in restitutions, US$1.6bn in recoveries, US$172.9m in fines and US$24.3m in seizures, and many cases are still pending plea agreements and trials. These appalling statistics are, I would suggest, only the tip of the iceberg when consideration is given to the amount of money spent in that country on non-essential medical work, such as the beautification of those who are sadly past that stage.
With the current problems in the property market, mortgage fraud came to the fore in the form of AMERIFUNDING, a mortgage brokerage owned and operated by Gerald Small in Colorado. This long running enquiry culminated in 2005. His operation was symptomatic of the type of lavish lifestyle supported by other peoples’ money. Small maintained two ‘warehouse’ lines of credits at large federally insured financial institutions in the US. He supported a lavish lifestyle and created fictitious loans to live off the lines of credit. The borrower information, name, and social security number were invented until, eventually, one of the creditors asked for verification of identification and exposed the fraud. Thank goodness for due diligence programmes! Small then placed an advertisement for a US$100,000+ per year account representative position at his company. As you can imagine, applicants supplied names, social security numbers and copies of driver’s licences, which were used for more fictitious loans. In the end, Small obtained US$200m in fraudulent mortgage loans from the identities of 47 job applicants.
In the meantime, Midtowne Restoration brought bogus real estate to the forefront of fraud cases for the last couple of years. Brent Michael Barber purported that he and Midtowne Restoration was a real estate investment company. ‘Straw buyers’ were solicited in schemes where they were paid US$2,000 for use of their identity and credit profiles to obtain mortgage financing for properties. Investors were recruited for properties that were described as refurbished and appraised at amounts far in excess of their true value. Barber assured the investors that tenants would be found to service the mortgage and maintenance costs of the properties so there would be no risk. The schemes involved about 300 fraudulent mortgage loans worth US$19.6m. The net result was losses to financial institutions of US$11.8m.
Identity theft happens, as everyone now fears it will, with his or her name on it. Take the case of Mr. Olatunji Oluwatosin who, late in 2005, traded as Pacific Collections and gained access to a consumer database and obtained personal information on consumers. He used the identities of over 165,000 people to establish fraudulent business accounts. This information was used to take over existing credit card accounts or establish new accounts in the victims’ names.
Even the American Red Cross (ARC) is not exempt from attack, as we have seen in a number of cases. In June 2006, Harold McCoy decided that this venerable organization could help fund his ‘lifestyle change’ and used ARC blood donors in the Philadelphia area. He obtained the names and personal information of blood donors from an employee of ARC. He then used the stolen information to obtain credit loans, bank loans and cash counterfeit checks. Overall, he managed to get his hands on US$800,000 from various financial institutions. As a result of the fraud, there was considerable damage to ARC’s reputation and many people stopped donating blood – two corporate donation centres stopped their blood drives when the media reported the crime. The consequences were very serious for those who required blood transfusions and the Philadelphia area blood supply was jeopardized.
The ARC came under attack again when they were at their busiest dealing with Hurricane Katrina. The circumstances were particularly appalling when the victim of the fraud is the very organization that relies on the charity of individuals to assist those in great need at a time of natural disaster. Following Hurricane Katrina, ARC established a national call centre in Bakersfield, California, to process and disburse relief funds to victims where they noticed large amount of payouts in the Bakersfield area. It is estimated that US$500,000 was lost due to fraud by workers at the call centre and so far a total of 73 individuals have been indicted in the case, including 24 ARC contract employees.
A viatical settlements company, Mutual Benefits Corporation (MBC), was a company offering interests in insurance policies to investors worldwide. Up to and including 2004, over 28,000 investors worldwide were defrauded of US$956m by MBC who misrepresented the investment. In addition, MBC falsified the life expectancies of the insured and paid kickbacks to physicians for signing fraudulent documents that were provided to investors.
Mass marketing fraud
Human nature being as fragile and easily influenced as it is, we cannot be surprised at the amounts of money made through mass marketing fraud. Thousands of US citizens were victims in a telemarketing scheme that purported to sell foreign lottery chances. The crooks collected an average of US$5m a week during this scam and laundered more than US$27m through one bank account. Perpetrators resided in the US, Canada, Australia, Vanuatu and Costa Rica. US$35m was traced to bank accounts worldwide and personal property was restrained. The sage advice of ‘if it appears to be too good to be true, it probably is’ should be paid more attention than it is.
Advanced fee schemes have always been one of the most common types of frauds. And what makes the following case particularly bad is the fact that it involved the manager of one of the largest banks in the world. An advance fee credit card and US Federal Grants fraud scheme was set up whereby victims were duped so that they received a credit card or grant after paying the fraudsters a small fee. The targets were those who were less well off and often in need of financial assistance. After obtaining bank account information from the victims, payments were withdrawn from their accounts and it goes without saying that no credit cards or other services were provided. This company defrauded over 100,000 victims with a total loss of US$30m. Of the 31 individuals arrested, one was an assistant manager of HSBC bank in New York
The simple application of well thought out practices and procedures, the core essence of which will minimize but not eradicate risk, may also identify a core business opportunity. However, it is not a fail-safe device. Setting common standards and developing an ethical culture in a company can also relate to the individual. Dealing with some of these ‘business opportunities’ should be viewed in the same manner with which we cross the road. Look one way, look the other, look again and if it is clear then cross over while still being observant of what is going on around you. We are all responsible for our actions, whether the consequences are positive or negative. Hiding behind a corporate veil in a negative scenario because of slipshod, lazy or no due diligence is not an option.
Create a due diligence culture with constant training and practical updates on methods and developments in the field of fraud and financial crime. Use trainers with practical experience in the subject matters, not theorists, and be sure to encourage questions while at the same time discouraging assumptions.
Following the basic tenet of knowing who you are dealing with – whether a company, an employee or a representative of a noted organization offering a product that you desperately need but would not under present circumstances qualify for – will prevent significant problems later on.
Remember: “The fraudster is the person who sells nothing for something to people who want something for nothing.”
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