Learning to live with fraud

When accountants finish tallying losses in the recent, high profile Bernard Madoff fraud, the tab may reach $60 billion (Dh220.2 billion). Madoff stands accused of perpetrating a gutsy Ponzi scheme. He has also earned a place in the fraudsters' hall of fame and, if convicted, the penitentiary.

These days, Madoff shares the limelight with many other sticky-finger types. Indeed, one can make an entertaining evening by looking up "fraud" on Google and reading the better-than-fiction results. However, experts say that despite its current visibility, fraud is not increasing but rather becoming a bigger concern during these financially troubled times.

Michael Adlem, Director of Forensic Services for KPMG in Abu Dhabi, was a British police officer later employed by financial institutions to investigate fraud cases. Adlem believes that little has changed nor will it in the future.

"Five per cent of all people are honest, 5 per cent are dishonest and the rest or somewhere in between."

But during difficult times companies search for ways to improve their bottom lines and reducing fraud often becomes top-of-mind. "In times of plenty, it's easy to make money," says Adlem. "Business people want to stay focused on selling products - not looking for fraud."

Tough times also lay bare fraud schemes that otherwise might not see the light of day. It's hard to say, for example, whether Madoff could have kept his scam rolling if the economy had remained strong. But, alas, the financial crisis pricked his nefarious investment bubble.

But just how much fraud awaits discovery? That depends on your definition. Fraud includes situations where management "cooks the books" of the business. But other variations exist - and they have become far more diverse with the growth of international money laundering, credit card usage and the internet.

Attorneys also have their take on the subject. Fraud can be either civil or criminal, notes law professor Damien Horrigan at the American University in Dubai. To pass muster in court, proof must exist that the victim has taken some action based on a false representation. When criminal charges are involved, the government has a higher burden of proof.

Some estimates say that as much as 7 per cent of corporate revenue is lost to fraud. Adlem thinks this number may be on the "low side." Simon Charlton, Managing Director Mena Region for Forensic & Dispute Services at Deloitte Corporate Financial Limited says the extent of fraud is hard to measure especially in the UAE where statistics on fraudulent activities are not yet readily available.

That's an enormous hit. If an employee steals $500,000 that's only the tip of the iceberg, Charlton says. A company with a 10 per cent profit margin must sell $5 million to make up the loss. Unfortunately, many businesses look at the money spent on prevention as a "cost centre" subject to budgetary cuts during downturns. Charlton advises otherwise. "Look at fraud prevention as a profit centre."

Adlem says that knowing how much to spend on fraud prevention is difficult though one strategy is to compare notes with other companies in the industry. Still, the pay-off on some measures like establishing a "whistleblower hotline" is likely to be positive. In general, companies should focus on identifying high risk areas - what Charlton calls "heat maps."

Hot spots are often identified by the "fraud triangle." Perpetrators, the moniker for people who commit fraud, tend to share three traits. The first is motivation, particularly financial problems like high personal indebtedness. In fact, most perpetrators are under financial strain.

Second, perpetrators can rationalise fraud - an employee passed over for promotion may feel entitled to "compensation." And third, risk is increased by opportunity. For example, a potential fraudster may see a way to circumvent internal controls for cash handling. Not surprisingly, businesses which deal with large amounts of cash tend to see the highest fraud rates.

Fraud detection has become quite sophisticated. For example, perpetrators, especially neophytes, are usually overwhelmed by fear and guilt. Investigators know that this causes behavioural changes - a normally "nice" person becomes mean or angry. Other changes can be a tip off - a person begins "living large" with a new car and luxury vacations.

On the high-tech end, software packages can now ferret out anomalous patterns in financial data. For example, it is possible to predict the number of times that each digit (1, 2, 3 and so forth) will appear in a sequence of numbers. Fraud perpetrators who create bogus numbers can be detected because they usually violate this pattern. But techniques can also be as simple as ratio analysis. For example, observers had long been warning that Madoff's reported financial returns were "too good to be true."

Fraud investigators are also trained to interview people - truthful people answer questions one way; liars differently. They also learn to judge honesty using pencil and paper tests, graphology, voice stress analysis and polygraphs. Once accused, perpetrators often exhibit crisis behaviour - a predictable sequence of denial, anger, rationalisation or bargaining, depression and then acceptance.

Both KPMG and Deloitte conduct engagements for clients to help deal with or prevent fraud. While senior managers are often responsible for "big ticket" frauds, many frauds involve trusted employees who have been with the business for years. Maybe the employee encounters family financial problems.

Often fraud starts with a small indiscretion but then, says Adlem, "the employee realises how easy it is." Taking a bit more and then more eventually puts the employee onto a treadmill. Larger and larger frauds must be committed to cover those already committed. That's often why, Adlem observes, when perpetrators are confronted, they respond "thank goodness, it's over."

Many services rendered by professionals like Adlem and Charlton involve investigating frauds already committed. Says Charlton, these include conducting investigations, unravelling the circumstances of the fraud and applying forensic technologies to collect information from electronic sources like hard drives. In recent years, these fraud auditing services have mushroomed.

But increasingly, services are proactive. Charlton notes that company surveys can identify high risk areas for frauds before they occur. For example, Adlem says, old computer systems are easy pickings for hackers.

Another strategy is to help senior managers better understand how good controls on fraud are in their own companies. For example, some surveys show that 90% of senior managers characterise their companies as "well controlled" while only half of the mid-level managers agree. At lower levels, 90% say that the company is not well-controlled.

If nothing else, senior managers who understand this will also come to recognise that the single most important action to prevent fraud is to establish a "positive tone at the top." When subordinate employees observe that senior managers are disinterested in prevention, fraud risk increases. Senior managers who establish a zero-tolerance culture are likely to be rewarded with a lower incidence of fraud.

Hiring is another "hot spot". Companies need to conduct due diligence when recruiting employees. Oddly enough, Adlem says, the higher that new hire is, the less likely a company is to do their homework. "For a few thousand dollars, you can find out a lot. Don't trust anyone."

Can fraud prevention come from outside? For example, did the 2002 Sarbanes-Oxley Act passed by the US Congress in response to the spectacular Enron frauds make a difference? Both Adlem and Charlton have lukewarm feelings about regulation.

Charlton notes that major frauds have occurred before and after passage of the law while Adlem thinks it went too far. Some provisions are "not key issues" and often get in the way of customer service. "You have to have balance," Adlem stresses, "between controls versus the freedom to get on with work."

In the past, companies preferred not to "hang out their dirty laundry," says Adlem. Instead, they might simply dismiss the fraudster and even provide a reference letter. But all that changed in the 1990s with the press for better corporate governance, more transparency and higher standards of due diligence. It's true, says Adlem, that "still a lot is not reported" but things have improved.

The UAE experiences no more or less fraud than in other countries, says Adlem. Also, the UAE and Dubai have made major efforts to bring governance and transparency to the level of international standards recognising that this is the admission price to the big leagues.

For example, Abu Dhabi's Accountability Authority in outlining its 2009 strategic highlighted plans to adopt international standards of transparency in government departments and state-owned enterprise, including fraud risk assessments and the requirement to appoint internal and external auditors to monitor finances. The focus appears to be on preventing fraud through improved internal control, observes Charlton.

Adlem also believes that Dubai has gone through a sea change with fraud, and has over the past few years has made impressive strides to increase enforcement noting that many people, including senior managers, have been arrested recently.

As for the ploy of leaving the keys in the car at Dubai International, both Adlem and Charlton seem dubious. The fraudster who skips town is likely to find that a warrant is being sought for extradition back to the UAE through international law enforcement officials if losses are significant. In any event, says Charlton, the fraudster will "probably have to keep running."

Ponzi schemes have an amazingly successful track record for luring suckers. The scheme is named for Charles Ponzi, an Italian who immigrated to the United States in 1903, though Ponzi did not originate the idea. But the size of Ponzi's fraud attracted celebrity status at the time and the name stuck.

A classic Ponzi scheme begins when the fraudster collects money from investors and promises extraordinarily high returns. Sure enough, investors soon receive an attractive "profit." The word spreads and friends flock in to share the feast. They too soon receive impressive rewards.

In fact, the money invested usually earns some legitimate return. But to create those too-good-to-be-true profits, actual returns are supplemented by paying out a portion of the original investment which is also passed off as profit.

As long as the scheme expands, the fraudster stands a chance of covering his tracks. But during a downturn, new money stops flowing in and it becomes impossible to conceal the fact that the original capital is depleted because it was paid as fictitious profits causing the scheme. Then, the bubble bursts.

Rod Monger is an independent journalist who writes on economic, business and political issues.