How to Detect and Prevent Fraud

By Ken Springer

Fraud is like ice cream: there are thousands of different flavors and you never know what could be the most popular until you sample them all. From Ponzi schemes to insider trading and from money laundering to embezzlement, fraud is an unfortunate reality in business.

For more than 30 years, I have been detecting and preventing corporate fraud, first as a Special Agent with the FBI and now as the President of Corporate Resolutions Inc.

Within the last year, the most prevalent forms of corporate fraud have had one common theme: concealing information. Yes, that is a simplified way of explaining it, but that is what it all comes down to. This type of fraud happens across a range of businesses (from the biggest publicly-traded companies to the smaller mom-and-pop-style businesses), and the fallout impacts investors, board members and other victims. Fortunately, the perpetrators always get caught — eventually.

Even in the sad and twisted case of Jerry Sandusky, Penn State officials knowingly engaged in a cover-up of Sandusky’s behavior — a deliberate process of keeping things secret that brought down not only the university officials involved but also the reputation of the school and its storied athletic program.Scott Thompson showed us (and the Yahoo board) that it is crucial to be accurate and honest on your resume or bio, or else you might lose your big job. Brian Dunn was forced to quit Best Buy when he did not disclose his affair with a younger employee. Walmart faces extreme fines by the Department of Justice for failing to disclose widespread bribery in its Mexican subsidiary.

With these very public examples of how fraud, in its different forms, can affect large companies, we see that the pervasive theme is that the individual or the company intentionally did not bring the relevant material information to the proper authorities or to board members. This falsifying of information is what has become the most common type of fraud today.

So now that we know what it is, at least on the big scale, how do you spot a fraud? Using the most recent instances of fraud from both the headlines and from our own case history, we can find commonalities and clues in components of fraud.

The Accountants

We have witnessed Bernie Madoff, Robert Allen Stanford and, this summer, Russell Wasendorf Sr. all rely on small, no-name accounting “firms” to execute (or play a part in) sizable frauds.

Madoff relied on David Friehling, who pled guilty to falsely auditing Madoff’s books, effectively giving Madoffcarte blancheto accomplish one of the largest Ponzi schemes ever. R. Allen Stanford, another famed fraudster, also relied on a tiny accounting firm: a one-man operation in Antigua. Lastly, Russell Wasendorf Sr. used Jeannie Veraja-Snelling to audit $500 million in (false) assets belonging to Peregrine Financial Group.

Unless each of these accountants had the intelligence of the character based on Professor John Nash (the co-winner of the 1994 Nobel Prize in Economic Sciences) in the film “A Beautiful Mind,” it is inconceivable that they could have audited and effectively overseen the amount of money controlled by these firms. So when you look at your next investment, you should ask whether the accounting firm in charge of the company’s financials is capable of the job.

Several years ago, we were asked to conduct a background check on a CFO of an investment fund and discovered he had filed forpersonalbankruptcy protection twice within a 10-year time frame. Wondering how the CFO could manage the assets of a multi-million dollar investment firm if he could not manage his own family’s balance sheet, our client decided not to go ahead with the deal.

Vetting these lesser-known accountants is a good idea. We learned from Sam Israel III and his friend/accountant, Dan Marino, that maintaining an independent accounting firm could often be a hoax. Israel (who faked his own suicide and ultimately pled guilty to fraud and conspiracy in 2005) ran Bayou Hedge Fund Group, and Marino served as the firm’s CFO.  Bayou’s “independent” accounting firm was actually run by Marino. This mythical transparency should have (and would have) been discovered through a background check of Marino or the accounting firm.

The Credentials

People lie. Whether it is to impress or to fool (or both), certain people will embellish or completely falsify professional credentials. Scott Thompson’s resume-gate was just a recent example, and the gaffe in that situation was not even as egregious as others I have seen over the years.

I have seen resumes wherenothingis accurate: from the dates of employment to the position served to the degrees received. And there are of course the minor discrepancies in CVs and biographies that are just as telling as the bigger lies, such as falsely claiming CFA certifications, memberships with bar associations or dual undergraduate or graduate degrees. Because these exaggerations often mirror a person’s character, it is critical that investors, board members, employers and others independently confirm as much information as possible. This part, actually, is among the easiest components in identifying fraud.

To confirm most undergraduate and graduate degrees and attendance in various university/college programs, you can either call the registrar of the respective school or, as is more common, use the National Student Clearinghouse (NSC), a company that maintains an online trove of school records. Many schools have delegated NSC as the third-party company to maintain degree and enrollment information.  Some schools, however, still prefer to keep their records in-house, and others require a signed release in order to verify attendance. Nonetheless, verifying this information can be relatively easy to do.

For professional licenses, every state has a specific department that oversees the licensing of certifications for attorneys, certified public accountants, engineers and many other professions. Confirming an individual is licensed requires a Google search to locate the number or website for the appropriate department, which can confirm that a license/membership exists after you submit a person’s name. Most states will also maintain information about any disciplinary actions or violations that have been filed against a licensee.

Lastly, you can use a tool that is often overlooked: regulatory agencies. Checking with FINRA, NFA and the SEC to find information about individuals and firms in finance is a step many investors have unfortunately neglected, thus missing opportunities to assess the shady practices of scammers like Stanford and Wasendorf. For years before he was arrested, Stanford had a colorful history of disciplinary actions and arbitrations involving allegations of fraud that were on file with FINRA. Of course, not every regulatory slap on the wrist foreshadows a multi-million dollar Ponzi scheme, but, like everything else, the key is having the informationbeforecommitting to the deal.
A few years ago, we were asked to look into an investment professional who was starting his own hedge fund in Hong Kong. While our research in the United States and Hong Kong did not uncover anything that reflected poorly on the guy’s character, our analysis determined there was a two-year gap in his resume. That absence, we later discovered, reflected the time he was sanctioned by the Securities and Exchange Board of India (SEBI) for insider trading. Again, with this information, our client decided to pass on the investment.

It’s also important to not be too easily impressed with achievements. Madoff was on the board of Nasdaq and Wasendorf was an advisory board member of the NFA.  Madoff and Wasendorf manipulated investors into thinking these sorts of accolades legitimized their stature as trustworthy experts in their field.
If you want to find a simple example of the importance of collecting and analyzing information, go to a racetrack.See how much time people spend reviewing daily racing sheets before making a $10 bet. If investors, board members and others could devote the equivalent amount of time before making million dollar bets, they would be better protected.
Proactive steps, like confirming an individual’s credentials and identifying inconsistencies or discrepancies, are critical components to preventing fraud. Information is like artillery: the more you know about a person, the better armed you are to respond to anything that comes your way.
The Network
The Department of Justice (DOJ) has amped up its focus on companies that violate the Foreign Corrupt Practices Act (FCPA). Most recently, as previously mentioned, Walmart has been charged with FCPA violations for alleged bribery at its Mexican subsidiary. Walmart is not the first, and will not be the last. Over the past two years, numerous well-known companies, both U.S.-based and foreign, have been investigated for, or charged with, FCPA violations: e.g., Avon, Diageo plc, Alcoa and Tyson Foods.
Both public and private companies with an international presence need to assess all of their relationships with third-party vendors and government officials to ensure compliance with the FCPA. For years, many businesses with locations overseas relied on local practices of bribery and favors in exchange for contracts, and for years these actions were accepted or overlooked.
However, these days, The DOJ is no longer asleep. Any company that has multinational operations should ensure that all employees and vendors are in compliance with a proper code of ethics and compliance. Moreover, every company that falls into this category should conduct rigorous background checks of all companies (including vendors) with which they do business, to ensure that there is no risk of FCPA violations.
Being the target of the DOJ is bad for the balance sheet and the reputation of a company, because the fines are exorbitant and the exposure is always negative.
The Disclosure
FCPA violations, resume fraud and investment fraud have been the biggest trends in corporate misconduct. However, in each of these flavors of fraud, you see one common ingredient: disclosure. Had Walmart disclosed and tried to repair the actions of its Mexican subsidiary, the DOJ would have scaled back its investigation and handled the situation with a much softer stick.
The Penn State debacle also illustrates how the intentional cover-up of information can bring down an institution, university officials, famed football coaches and others. The same holds true with the story of Brian Dunn, the CEO of Best Buy: had he told the board about his extra-marital relationship with a subordinate, the fallout would not have been as tragic (or public).
Parting Thoughts
To avoid becoming a victim of fraud, you must gather as much information as you can. Background checks are one of the most reliable tools for investment fraud prevention. The information gathered through background checks illuminate patterns or inconsistencies that would have alerted investors to some of the biggest aforementioned frauds. And, once the background check is complete, there is always more digging to be done.
Contacting former employees of a company to identify information about a person that may not be in the public record, such as allegations of sexual harassment or drug use, is another under-utilized resource that we use to protect our clients’ vulnerabilities.
Implementing a whistleblower hotline is also an ideal way to have a set of eyes on the inside of a company; it instills a sense of awareness to employees that their efforts are valued and preserved, and sends a cautionary message to potential fraudsters that their actions will be monitored.
Collecting the information is just as important as knowing what to do with it. You must apply expertise and analysis to understand the gravity or levity of information uncovered through a background check. It is more than just reviewing public record resources that empowers investors and others to assess (accurately) the risk of any transaction or investment.
All of these efforts help neutralize corruption and mitigate your susceptibility to fraud.