Uncovering Business Fraud: Look Beyond Pronouncements and Acts
March 2009
The best at finding fraud are those who
look far beyond the advice established by acts and accounting pronouncements
to seek and pursue compelling symptoms of wrongdoing.
by
Scott Langlinais
Langlinais
Fraud and Audit Advisory Services
Following is a short list of pronouncements and acts issued by the U.S.
government and accounting bodies in response to various forms of business
fraud.
- Sherman Antitrust Act (1890)—Designed
to prohibit attempts to monopolize trade by entities such as Standard
Oil Trust.
- Federal Trade Commission Act (1914)—Established
the Federal Trade Commission to prohibit unfair practices and deceptive
acts in or affecting commerce.
- The Securities Exchange Act of 1934—Stipulated
audits of publicly traded companies, including procedures "designed to
provide reasonable assurance of detecting illegal acts that would have a
direct and material effect on the determination of financial statement
amounts."
- The Foreign Corrupt Practices Act of 1977—Enacted
in response to the admission by 400 U.S. corporations that they paid "in
excess of $300 million in corporate funds to foreign government
officials, politicians, and political parties," including bribes to
foreign officials to secure favorable action for the companies by the
foreign governments.
- The Committee of Sponsoring Organizations
of the Treadway Commission (COSO)—A private sector assembly
formed in 1985 by five national accounting and audit organizations to
study the factors that can lead to fraudulent financial reporting.
- Statement on Auditing Standards (SAS) 82—Published
in 1997 by the Auditing Standards Board of the American Institute of
Certified Public Accountants to establish standards for auditors related
to considering fraud in a financials statement audit.
- Statement on Auditing Standards (SAS) 99—Published
in 2002 to supercede SAS 82 and establish standards for auditors related
to considering fraud in a financials statement audit.
- Sarbanes-Oxley Act of 2002—Established
the Public Company Accounting Oversight Board; established standards for auditor
independence, corporate responsibility, and management accountability;
and enhanced definitions of fraud relative to fraudulent financial
reporting.
And yet, despite all of these acts and pronouncements (this is a very
abbreviated list), men like Kenneth Lay, Bernie Ebbers, and most recently,
Bernard Madoff are able to oversee publicly audited companies which
perpetrate massive frauds on the American public. How is this possible?
Obvious to you, no doubt, is that this question is rhetorical and based
on the false premise that laws and pronouncements stop bad behavior. Yet, in
a typical book or article on fraud deterrence, more often than not the
author refers to the historic merits of SAS 99 or COSO or any of these other
pronouncements and their role in fraud prevention.
Compelling Indicators of Fraud from the Madoff Case
On December 11, 2008, the U.S. Attorney's Office filed a criminal action
against Bernard Madoff, who is alleged to have lost $50 billion in investor
money in history's largest documented Ponzi scheme. Of the more than $50
billion invested in Mr. Madoff's firm, it is reported that as of December
only $200-300 million remained.
It does not matter that Mr. Madoff violated many of the acts and
standards above. What matters is there are no reports of anyone (including
the SEC which was tipped off to the Ponzi scheme several years ago) seeking
symptoms of fraud within Madoff Investment Securities, LLC.
Three different factors can elevate a fraud from an annoyance to a
disaster: amount, duration, and nature. What makes Mr. Madoff's fraud so
uniquely troubling, likely the reason it is receiving so much press, is that
his fraud presents a rare case which falls under all three factors: $50
billion in losses over nearly 2 decades in a scheme victimizing, among
others, at least 148 charities which are in aggregate exposed for over $2
billion.
If you were to research this case, you would come across some questions
such as how the SEC could miss such an enormous theft, especially when they
were tipped off and actually investigated Mr. Madoff's hedge funds on at
least three occasions. How could so many sophisticated investors, from
British Bank HSBC ($1 billion exposed) to Carl Shapiro ($545 million
exposed) fail to heed the concerns raised by many that Mr. Madoff's reported
strategy could not possibly have resulted in the type of consistent returns
he was delivering? How could the auditors fail to notice?
Symptoms of fraud are often simple and obvious, discoverable by anyone:
cash missing from the vault or someone's photocopied receipts for their
expense report. In complex entities such as Mr. Madoff's investment firm,
professionals must recognize and understand symptoms which are more subtle
and indirect.
Two compelling indicators of fraud emerging from the Madoff case are
quite instructive to the manager or auditor who seeks to arm themselves with
better tools for finding fraud.
Lack of Transparency
One of the symptoms was lack of transparency. Denial of access to
reasonable records, and aggressive behavior toward those who seek access,
constitute a compelling indicator of fraud. Mr. Madoff's hedge fund was not
registered with the SEC until late 2006, and the firm's auditor was an
accounting firm owned by his brother-in-law. He openly resisted outside
audits, ostensibly protecting his proprietary trading strategy.
One of my professional colleagues has a rule of thumb: if an auditor is
denied information because of "trade secrets" or "proprietary information,"
100 percent of the time they are hiding a fraud. If there is some sensitive
data in the audit sample, fine. In that case, the client can conceal the
trade secrets while revealing pertinent financial data. Money being
transferred from an operating account into an offshore bank account is not a
trade secret. An invoice or cash transfer demonstrating the purchase of a
third jet for the president is not a trade secret.
One person close to Mr. Madoff claimed, "He could be gruff to the people
who gave him money to invest, threatening to expel those who asked too many
questions." Andy Fastow, former chief financial officer of Enron, was
notoriously similar in his behavior. He would threaten Wall Street
investment banks with loss of future business if their analysts openly
questioned Enron's mark-to-market accounting practices that ultimately
turned out to be a sham. It is the last—and quite effective—defense of the
guilty to discredit anyone who questions them.
Unrealistic Performance
The second compelling indicator of fraud within the Madoff scenario is
unrealistic performance. Within your own company, this concept may manifest
itself in one of your salespeople who always hits their quota exactly, or
your financial executives who always report earnings which nail analysts'
earnings per share projections to the exact penny.
One of Mr. Madoff's hedge funds designed to invest in the S&P 100 claimed
to increase in 2008 by 5.6 percent during a period when the S&P 500 was down
37.65 percent. Since inception, one fund heavily invested with Mr. Madoff
has averaged a rather pedestrian 10.5 percent annual return. But what was
unique about the fund's returns was that it almost never had a down month.
When everyone else was losing money, funds invested with Mr. Madoff
continued to tick up or at least remain flat.
A New York trader familiar with Mr. Madoff's reported trading style wrote
a detailed letter to the SEC demonstrating his analysis of 174 months of
data of a fund heavily invested with Mr. Madoff's firm. In only 7 of those
months did that fund lose money: the greatest monthly loss was -0.55
percent, and there were no consecutive losing months. The lowest rolling
12-month return from 1990 to 2005 was 6.23 percent, and most shocking were
his returns in the market bust years of 2000, 2001, and 2002, in which the
fund returned 11.55, 10.68, and 9.33 percent, respectively. Such performance
over the long-term is not only remarkable, it is impossible.
Even Mr. Madoff's golf scores reflected abnormal consistency. The
Wall Street Journal recently reported
he never shot below an 80 or above an 89 in 2 years; inside Tiger Woods's
book, How I Play Golf, is a photograph
of his handicap card at his home course, Isleworth Country Club. Over 20
rounds, Mr. Woods's scores ranged from 61 to 72. Tiger Woods was not nearly
as consistent at his home course as Bernie Madoff.
Auditors and Managers Must Understand Compelling Symptoms of Fraud
Professionals reviewing frauds learn to check outliers, meaning unusually
high or low figures outside of a couple standard deviations from the norm.
But an equally improbable, if not impossible, situation is consistent
performance over the long-term with little or no standard deviation.
Seek and follow-up on all symptoms of fraud—and not just the textbook
symptoms. Try charting long-term performance of your company's
rainmakers—salespeople, investors, branch managers—and seek unusual levels
of consistency. Map their performance against independent data, such as
their colleagues' or competitors' performance, results of other companies in
the industry, or relevant macroeconomic indicators. It is a compelling
symptom of fraud to see a steady, upward line on the chart when all others
are swinging wildly.
Finally, take particular care in areas where a manager or executive is
behaving aggressively toward questioning or is apparently concealing data.
If the manager or executive is well connected in the organization or is one
of the ranking members of the company, then you may have to seek air-cover
from the board or the chief executive, and you must be prepared to seek
their assistance. What you cannot do is submit to the intimidation or
stonewalling, because as uncomfortable as the initial confrontation is, it
could be far worse if you are seen as negligent in your duties to find
fraud. Auditors and finance/accounting professionals are now being held
liable, and in some instances jailed, for demonstrating gross negligence in
their duties or enabling fraud to persist.
Sources
Securities and Exchange Commission, "Testimony Concerning Investigations
and Examinations by the Securities and Exchange Commission and Issues Raised
by the Bernard L. Madoff Investment Securities Matter," January 27, 2009.
Harry Markopolos, "The World's Largest Hedge Fund is a Fraud: November 7,
2005 Submission to the SEC."
Wall Street Journal, various
articles from December 2008 through February 2009.
Benefit Technology, "Private Foundations: Preliminary Estimates of Madoff
Exposure," compiled for Nicholas Kristof, New
York Times.
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