The enemy within: Fraud within companies is a risk that can never be eliminated, just managed

The enemy within: Fraud within companies is a risk that can never be eliminated, just managed

Mar 1st 2014 | From the print edition

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BUSINESS has always been plagued by fraud: witness the South Sea Company in the 1710s (which enveloped the British economy in a giant bubble) or Charles Ponzi’s Securities Exchange Company in 1920 (which gave the world the Ponzi scheme) or the Enron and WorldCom scandals in the early 2000s. Ambitious fraudsters are attracted to businesses for the same reason that Willie Sutton, a contemporary of Ponzi, reportedly said he robbed banks: “Because that’s where the money is.”

Some frauds are committed by people at the top such as Bernard Madoff or Allen Stanford. Others are committed by hired-hands lower down the organisation. But all frauds involve abusing people’s trust and diverting corporate resources for personal ends. Fraud by wayward employees, be they high or low, can never be eliminated. Directors and executives can, however, treat it like any other unavoidable risk, and manage it professionally.

The risk is particularly acute at the moment. Companies are straining the bonds of loyalty. They are making ever more use of contractors and temporary workers. They are putting more pressure on employees to hit targets; they are also holding down the wages of the majority of workers while increasing the boss’s pay. This is all happening at a time when economic activity is shifting to the emerging world (where corporate fraud is rife) and to the internet (where fraudsters are having a field day). Kroll, a security consultant, found that 70% of the companies that it studied were affected by fraud in 2013, up from 61% in the previous year.

At the same time the punishment is harsher than ever. Companies nowadays run the risk of being held liable for their employees’ misbehaviour unless they can show they had done their best to prevent it. Directors who play even the smallest role in frauds can now go to prison. America’s Foreign Corrupt Practices Act and its European imitators have made a serious crime of something once seen as normal business practice: bribing foreigners. Companies infected by fraud can incur all sorts of other costs. Their licences to trade may be withdrawn, they may be barred from bidding for government work and they may be subjected to online campaigns urging customers to boycott them.

What can companies do to uncover internal scams? A new book, “Corporate Fraud: the Human Factor”, by Maryam Hussain, an investigator at EY, an accounting firm, provides a timely guide. One answer is to look for the telltale signs. Some of the biggest corporate tricksters were people whose flamboyant personalities often raised suspicions: think of Robert Maxwell, or Augustus Melmotte in Anthony Trollope’s “The Way We Live Now”, perhaps the best novel about corporate fraud. Boards have a duty to pluck up the courage to challenge such larger-than-life bosses.

However, most corporate fraudsters do not have swishing reptilian tails as a giveaway sign. In many instances they are not borderline psychopaths, just ordinary people gone wrong. Frequently, they start with small crimes and then engage in ever bigger misdemeanours to conceal their wrongdoing. Nick Leeson, who destroyed Barings Bank by losing £862m in bad bets on derivatives, said, “It all started when I tried to cover for a junior colleague who had lost £20,000.” Ramalinga Raju, the chairman of Satyam, who admitted to inflating the computer-services company’s revenues by $1 billion, said, “It was like riding a tiger, not knowing how to get off without being eaten.”

A second answer is to put procedures in place to detect frauds. The Sarbanes-Oxley law passed in America after the Enron and WorldCom frauds requires the boards of public companies to commission independent audits of their internal financial controls. But rigorous procedures can easily lure companies into a false sense of security. The employees most affected by those rules may be precisely the ones most capable of finding ways around them, as was the case with Mr Leeson and Jérôme Kerviel, a renegade trader at Société Générale.

Many companies seek reassurance that all is well by installing cyber-security tools to monitor employees’ e-mails and internal accounting systems for suspicious activity. But fraudsters are often quicker at harnessing technology to disguise what they are up to (for instance, using instant messaging on their smartphones as a back-channel to communicate with accomplices) than companies are at using it to spot them. Those running scams may also be skilled at tricking colleagues into giving them passwords—a technique Edward Snowden may have exploited to devastating effect.

Praising the bearers of bad news

The most powerful weapon against fraud is not an algorithm or a checklist but a whistleblower. The Association of Certified Fraud Examiners calculates that three times as many frauds are discovered by tip-offs than by any other method. It also notes that firms with fraud hotlines, which staff can call anonymously, suffer smaller losses from fraud, and cut by seven months the “exposure gap” between the start of an illicit scheme and its discovery. Governments are increasingly providing whistleblowers with legal protection and financial incentives: America’s Securities and Exchange Commission has created a $450m fund to reward them.

Companies that dither, blather or launch half-hearted inquiries when presented with evidence of employee misconduct often end up regretting it. JPMorgan Chase lost billions in its “London Whale” rogue-trader scandal, initially dismissed by the bank’s boss, Jamie Dimon, as a “tempest in a teapot”. Besides doing more to encourage whistleblowers, businesses must take decisive action to close the exposure gap. A botched investigation can tip off a fraudster and make it easy for him to cover his tracks. A suspicion of deliberate foot-dragging can render an entire company vulnerable. The damage done by corporate fraud can last long after the culprits have been identified.

 

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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