Fraud Ascendant

One plague follows another. Recession-battered companies are at greater risk for criminal violations, warn experts who study corporate malfeasance. Like a virus that takes hold in a weakened immune system, fraud rears up when corporations are fighting for their lives.

"If you look back at history, when there's an economic downturn there's always a spike in fraud," says Richard Plansky, a managing director in Kroll's business intelligence and investigations division. "The reason is pretty simple: Every fraud starts with a motive, and in times like this there are motives everywhere."

Some frauds begin when people lose their jobs or when deals go bad. Other schemes crop up when employees are merely trying to keep the business afloat. And then there's the simple fact that receding financial waters expose crimes that have been there all along.

"If you look back at 1990--the S&L scandal--there was a 52 percent jump in white-collar crime," Plansky says. "On the one hand you see that bad times lead to bad behavior. On the other hand, it's magnified by the fact that in flush times people aren't looking."

Whatever the cause, if historical patterns hold true, general counsel had better redouble their prevention and detection efforts because experts believe things will get worse before they get better.


One-Two Punch

Bankrupt companies are at particularly high risk. A recent Deloitte study shows that companies that are issued Accounting and Auditing Enforcement Releases (AAERs)--the mechanism by which the SEC initiates enforcement actions--are more than twice as likely to enter bankruptcy. It also shows three times as much financial statement fraud at bankrupt companies as at those in the black.

In other words, financial reporting fraud increases your risk of bankruptcy, and vice versa.

Sheila Smith, a Deloitte principal who focuses on reorganization, says fraud investigations and bankruptcy filings both tend to trail the economy.

"The lag has little to do with when the fraud was committed, but when the SEC starts to investigate," she says. "Bankruptcy is very transparent." Attorneys, financial advisers, the creditors' committee, an equity committee and other committees are all digging around, and they may find that fraud was committed before the bankruptcy, Smith adds.

Not surprisingly, the hard-hit retail sector faces the broadest exposure to the dreaded one-two punch of bankruptcy and fraud, and sees the greatest correlation between the two. In retail, crimes frequently occur below the corporate suite, and the motivation is less than nefarious. Often, Smith says, employees commit fraud thinking they are serving the greater good.

"They look around and can see people being laid off and want to retain jobs," she says. "Or they think, 'If I just convert this inventory to a receivable and I make the quarter, the sales will come.'"

Companies beset with financial troubles may inadvertently concentrate authority as they cull the headcount. That lays the foundation for wrongdoing.

"It's a gross oversimplification," Smith says, "but the person who writes the checks should not be the person who reconciles the checkbook."

Hot Spots

While the retail sector is on the front lines, there's more than enough risk to go around in the current economy.

"Rather than a disproportional increase in one type of fraud, you see a general, steady, across-the-board climb in all types," says Plansky. "That speaks to this deep and broad downturn that really has affected every sector. Over the next three to five years, you're going to see this trend continue."

According to Kroll's annual fraud report for 2008, companies are reporting more instances of fraud, and the frauds they report are larger than ever. Plansky says part of the reason is that companies are getting better at detecting fraud, and in this climate they are looking for it more intensively.

One of the key risk factors the Kroll study identified was high employee turnover.

"In markets like these where there are layoffs, where there is general uncertainty about whether people will have their jobs from day to day, it creates a [risky] environment," Plansky says.

Other hot spots Kroll cited include theft in the manufacturing and retail sectors and money laundering, financial mismanagement and compliance breaches in the financial services sector.

According to the Kroll report, theft of electronic data is on the rise, and the trend is likely to continue. In the vulnerable health care sector, companies had an average financial loss of $7.8 million during the past three years, and 89 percent of companies surveyed reported an increased exposure to data theft (see "Breach Patrol").

"Typically the business is far ahead of its understanding of the technology," Plansky says. "But if you don't understand what you have, where it is, who has access to it and how it's protected, you're asking for trouble."


Do Diligence

Exposure is clearly on the rise, but at many companies legal staff has been cut and law department budgets slashed. General counsel have to do more with less, but they should not skimp on fraud prevention efforts.

"If I could give advice in one word, it would be: verify," says Plansky. "It's extremely important in this climate to verify everything."

That means vetting the companies and individuals with whom you do business with a particular focus on their litigation and regulatory infraction history.

"One thing we see over and over again as an investigative firm is that past behavior is a great predictor of future behavior," Plansky says. "I've seen a number of deals killed recently because of solid due diligence on business partners. The fraudsters come out in environments like this, and you have to do your homework if you want to ferret them out."

Looking internally at employees whose responsibilities may have shifted as a result of reorganization is a good idea too. The same goes for vendors or contractors that may be covering work traditionally handled in-house. Blind spots abound when a company is struggling to weather a bad economy.

Times may be tough, but there's always a clear case for due diligence.

"Fraud comes off your bottom line," Plansky says. "Companies and counsel who are successful getting the support they need to get this right can make a financial case for it."

Contributing Author

Steven Andersen

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