Fraud: The great unmanaged risk?

The true scale of commercial fraud may be hard to calculate accurately, but by general consent the sums involved are huge. Current estimates indicate that economic crime is costing UK businesses alone as much as £40bn per year. Yet many top executives remain distinctly uncomfortable when discussing issues of corporate dishonesty and how to deal with them.

By comparison, it is not uncommon for those same board members to put their signatures to big cheques to protect the business against natural or man-made disasters. Not surprisingly, their willingness to respond positively to requests for budget in this area has increased in the wake of September 11 in the US and, more recently, July 7 in the UK.

Though devastating in human terms such problems rarely bring a business to its knees. The same is not true of corporate theft, as high profile examples on both sides of the Atlantic continue to show. The loss of life following a terrorist attack is, of course, devastating. Yet in purely financial terms, the fraud perpetrated by Nick Leeson did more damage to UK plc than the London bombings.

So, why is it that fraud, with its potentially fatal commercial consequences, is so often ignored by senior management?

The bagel theory

On the face of it, it seems hard to explain. Yet the experience of Paul Feldman, a Washington bagel seller, provides an insight into why there is often an unwillingness to face up to the threat of corporate malfeasance.

In their book, Freakonomics, Steven Levitt and Stephen J Dubner chronicle the story of Feldman, an ex-naval defence analyst who sold bagels to office workers in Washington. Each morning he would deliver boxes of bagels to different offices, together with an honesty box, which he collected later each day.

His business quickly grew - delivering 8,400 bagels each week to some 140 offices - and using his previous research experience he kept a detailed analysis of losses. Overall he found that staff were very reluctant to steal money - on average he lost just one 'honesty box' in 7,000 to theft each year - yet were less reticent about stealing bagels.

Over the period 1992-2001, overall theft increased significantly to an average of 13%, yet more detailed analysis highlighted some interesting comparisons. He found, for example, that he collected more money from smaller companies than larger corporations - typically between a three to five per cent better return. Similarly, there was a demonstrably lower level of theft from those businesses that were going places and where staff were happy, than in companies where morale was low and staff were uncertain about their jobs.

Most tellingly, where he delivered to different floors within a company, he found that his losses on the executive floor were consistently higher than those floors occupied by more junior staff.

Feldman speculated that, 'perhaps the executives cheated out of an over-developed sense of entitlement'. Levitt's and Dubner's less charitable view was that, 'perhaps cheating was how they got to be executives'. Yet the truth may be more universal, if equally simple - that, in many executives' eyes, not all fraud is bad.

Clean hands

This appears to be borne out if we look at the different types of commercial fraud perpetrated by individuals, or groups, within an organisation:

THEFT OF ASSETS: This covers a wide range of criminal activities, from stock losses, diverting funds and stealing cheques to shop-lifting and robbery, and is typically undertaken by shop floor staff or managers below board level. As a rule, companies are comfortable when handling such lower level fraud: they have sound and well-established policies for identifying such activities and will take a strong line in dealing with those involved.

In short, in areas where a company takes wrongdoing seriously, it will generally have effective mechanisms in place to tackle the issues involved and be happy to talk publicly about them.

PROCUREMENT AND SALES FRAUD: Here we start to enter a grey area of fraudulent activity, with a less clear-cut and unequivocal determination on the part of many businesses to stamp it out. Like asset theft these frauds are very common, but here the perpetrators are more likely to be senior managers and directors.

Such activities generally involve some form of collusion, often in the form of kickbacks from a third party contractor or payments for fictitious suppliers. In particular, where a large-scale infrastructure project is completed way over budget, the chances are that a significant part of the overspend will be found to be as a result of some form of procurement fraud.

Much of this form of wrongdoing is hard to identify with routine controls and some companies see it as more convenient and less publicly damaging to sweep it under the carpet.

Yet, as many more scrupulous - and, it must be said, highly successful - businesses continue to demonstrate, if the will is there, it is not impossible to put effective procedures in place to expose and eradicate much of this type of activity. Used creatively, and with specialist input from auditors or third party consultants, data mining is just one example of several tools which can provide an effective defence against such threats.

BENEFICIAL FRAUDS: There is a third category of fraud, which directly benefits the company and then its directors. An example, in the US in particular, hardly a day goes by without a major blue-chip corporation coming under scrutiny for alleged false accounting; one of the most recent being K-Mart as it filed for Chapter 11 bankruptcy protection.

False accounting includes manipulation of sales figures (often to meet stock market expectations), recording out-of-date stock at full value, inflating reserves of natural assets (such as oil) and hiding bad debts.

In 2002, for example, senior executives at manufacturing conglomerate, Tyco - including the former CEO, Dennis Kozlowski - were indicted and subsequently convicted of accounting frauds from which they benefited by $430m.

Similarly, in 2004, the founder of leading US cable company, Adelphia Communications Corp, John Rigas and his two sons were accused of 'using the company as their own private piggy bank' in stealing more than $100m and boosting Adelphia's profits by concealing more than $2bn in debt from investors. Recently convicted, they now face 15 years and 20 years in jail respectively.

On the face of it, the UK and Europe have a much better record in this area - with Parmalat perhaps being a conspicuous exception. Yet this is not necessarily a cause for celebration: without the equivalent of Sarbanes-Oxley and regulatory bodies pursuing it with similar vigour on this side of the Atlantic, the question is, who knows?

There are a number of other frauds which are expressly designed to benefit the business. Paying bribes to win contracts is still often seen as the only way to do business successfully in some parts of the world, and much more sophisticated - and less easily detected - techniques are now adopted than the traditional 'cash in a plain envelope' payments.

Collusive tendering, or 'losers' clubs', are most prevalent in sectors where there are few providers realistically capable of bidding for large contracts. Similarly, in seeking to keep prices artificially high in a particular market, price fixing cartels are more common where there are a small number of major suppliers. Solid evidence may be provided by a whistleblower - as happened in the European cement industry - or as a result of the authorities searching premises to seize documents.

The EU and the Office of Fair Trading (OFT) regularly investigate such claims: in the past two years, both have looked at the cost of cross channel ferry fares for example. Such cases do not always hit the headlines, but the potential penalties are huge - up to 10% of annual turnover - and so can put participants out of business.

Again, there are examples of companies, in the arms and food industries in particular, circumventing export embargoes by using intermediaries.

Similarly, some electronics and clothing manufacturers have sought to reduce or avoid customs duties by providing false documentation as regards valuation or country of origin.

Finally, VAT fraud and VAT repayment fraud, together with false claims for grants or subsidies from the EU and other government or public bodies are also committed by directors and senior managers looking to increase profits and thus the share price of their companies. Here, unlike the name-and-shame approach of the OFT and Monopolies Commission, the Inland Revenue and Customs & Excise do not release information regarding their investigations or penalties imposed: it is more likely therefore that companies found guilty will escape exposure to public censure.

Such activities are not confined to the commercial environment. Since the 1980s there has been greater transparency over public sector performance, with managers open to public scrutiny. Inevitably perhaps, such pressure has led to alleged manipulation of targets, as the continuing debates over hospital waiting lists and examination results in education show.

In the US, some police forces were found to be cooking the books concerning official crime statistics, exaggerating the numbers of gangs and gang members in order to secure more federal funding. In the UK too, in 2003 The Guardian reported that in 11 forces checked by HM Inspector of Constabulary in 2000, almost one quarter of all reported crimes had been accidentally or deliberately mis-recorded.

In none of these examples has there been there any suggestion of deception for personal financial gain: yet the resulting distortions are likely to affect the judgment of those exercising scrutiny and budgetary control over public bodies.

Leadership

The view that much white-collar crime is somehow victimless has long since been exposed as a dangerous delusion. Yet equally damaging is the distinction between internal and external ethics operated by many companies.

For example, for many years Enron's code of ethics, published on its website, was held up as a model of best practice. In reality however, there was a marked difference in standards between how staff within the company conducted themselves internally and how the company operated corporately in the global marketplace.

Many of these concerns would, of course, be dismissed as hopelessly naive and unrealistic by those who believe that you have to roll your sleeves up to win in today's tough commercial world. Yet in recent years, the commercial and regulatory framework in which most organisations operate has begun to change, with growing pressure on companies to 'put their house in order'.

On the one hand there is growing legislative pressure to reappraise reporting procedures and look more closely at mechanisms for detecting and preventing fraud. Further, whistleblowing provisions seek to encourage and protect those exposing wrong-doing, while the sentences now being handed down to senior executives highlight the hardening attitude in this area of criminal activity.

All of this leads to an inevitable conclusion - that in order to tackle corruption top management must, above all, have clean hands. Only then will it be possible to put in place effective mechanisms for dealing with fraud. It is also essential, in order to demonstrate to regulators and auditors, and all company stakeholders, that the company is a truly responsible business. If the tone at the top is right, everything else will fall into place.

- Allan McDonagh is a director of Fraud-i Ltd, Tel: 0845 241 2114, www.fraud-i.co.uk MECHANISMS TO DEAL WITH FRAUD

- A clear, unequivocal and comprehensive fraud prevention policy with processes and policies in place to communicate them effectively to employees and third party suppliers and contractors
- A process of education and training to ensure all staff understand what constitutes fraud.
- A straightforward mechanism for staff to express concerns and speak up against fraud at all levels within the business.