Fraud, An Ever Present Danger

by Jerry Oldham January/February 2007
This article addresses corporate fraud and malfeasance as a given in today’s business finance environment. Not that it is prevalent in every corporate financing transaction, or even in a majority or them — but when it is present in a company being financed or its management team, it is both costly and disruptive to the victim. The costs can be measured as real costs, opportunity costs and even brand dislocation or wasting.

In its 2004 Report to the Nation, The Association of Certified Fraud Examiners (ACFE) summarizes its most recent study of corporate fraud. The report brings to light certain types of fraud, their characteristics and the magnitude of corporate fraud in the workplace. The following are a few conclusions of the report:

  • The Cost of Fraud — Fraud costs U.S. organizations an estimated $660 billion annually.
  • Frauds by Organization Type — Privately held companies suffer the largest median losses, followed by public companies, not-for-profit organizations (a close first through third in the ranking) and government agencies (a distant fourth).
  • Frauds by Organization Size — The most costly abuses occur in organizations with less than 100, or more than 10,000 employees.
  • Frauds by Position — The median loss involving owners and executives is more than six times as high as the median loss caused by managers, and more than 14 times as high as the median loss caused by employees.
  • Frauds by Gender — Men and women commit an equal number of frauds, but the median loss is significantly higher in schemes committed by men.
  • Frauds by Age — Nearly half of all frauds, 49%, are committed by individuals over the age of 40, while only 17% are committed by employees under 30.
  • Frauds by Educational Background — Half of all frauds are committed by perpetrators with no more than a high school education, but the median loss in schemes committed by those with post-graduate degrees is 6.5 times larger than the median loss in schemes committed by those with a high school degree or less.

So what does this mean to asset-based lenders and other corporate finance professionals?

It means that lending professionals that manage and assess the risk of fraud within their prospect companies do not have the luxury of discriminating when to perform such an assessment based upon the type or size of the organization, the owners or managers’ exact position or title, age or gender. In fact, crimes of fraud are not limited to executives and owners, with employees with an education no greater than high school committing half of the schemes. For sure, the problem is broad, deep and a significant financial consequence.

Prevention
The ACFE’s 2004 Report to the Nation also reinforces the common belief that the most cost-effective way to deal with fraud is to prevent it. According to its findings, once an organization has been defrauded it is less likely to recover its losses. The median loss recovery among victims in this study was only 20% of the original loss. Nearly 40% of the victims recovered nothing.

Simply put, prevention for lenders and other secured creditors is the key to minimizing the risk of fraud, and this means utilizing a “Best Practices” approach to due diligence and post-closing monitoring. It also means performing background investigations as a regular part of the best practices due diligence process.

The Due Diligence Process — A Brief Recap
Broadly speaking, in addition to management interviews and site visits by the lender, the due diligence process often includes the following key components, many of which are frequently outsourced because of the demand for specialization:

  • Background Investigations — These include investigations performed upon the borrowing entity and the management team.
  • Financial Statement Reviews & Analysis — These include audits and field examinations.
  • Collateral Evaluations — These include appraisals of personal and real property.
  • Legal Reviews — These include reviewing corporate fitness and business legitimacy.

A Historical Perspective
My purpose here is to present the case for the utilization of background investigations as a tool to prevent, detect and manage fraud — before the loan is made. I would also like to advance the thesis that the performance of background investigations as an integral part of the due diligence process is more prevalent than in the resent past, and should be part of the post-closing and on-going due diligence. My Top Ten list to support the growing need to perform background investigations is as follows:

  1. Company owners and managers are involved in more businesses than ever, many of which are across state or country borders and may involve different and multiple partners.
  2. Lenders are more often participating with other lenders and equity providers in the same capital structure, sharing increased risk with each other. Participants are relying upon the lead lender’s pre and post-closing due diligence in most cases.
  3. The global market is a greater target for new business and new business partners, and lenders are more in need of the best worldwide information in order to make an informed decision.
  4. The media plays a more intense role and more than ever works in real time. Lenders must know what the media knows and more.
  5. The world is more litigious, and litigation costs real time and real money.
  6. Information is more readily available within a time frame that “beats the bell” at a cost that doesn’t “beat the bank.”
  7. Lending relationships are frequently more transactional and less relationship driven. Banking services are often accepted by borrowers more a la carte, in spite of banks’ best intentions to cross sell expanded capabilities as the best value proposition.
  8. Now, more than ever, time is of the essence with competition for the same deal much more intense and coming from various financing vehicles. Lenders and borrowers share the same desire for a speedy decision, requiring the fastest due diligence possible.
  9. Corporate fraud, scandals and corporate governance have become more common in our business vocabulary. Corporate scandals are now front-page news, and the executives convicted of these illegalities against shareholders, investors and lenders are being held accountable.
  10. There are now regulations that require a certain level of background investigation. A few short years ago there were no insurance requirements or federal statutes that required a state or national bank or federally chartered savings and loan institution to check a list for terrorists, international narcotics traffickers or those engaged in the proliferation of weapons of mass destruction. The FDIC and the FSLIC changed all of that subsequent to the passing of the Patriot Act of 2001.

Case Study Summaries — A Fraud Prevented
Simply put, background investigations are the best tool to prevent fraud. To demonstrate the variety of situations the can lead to a “Killed (Prevented) Deal,” I offer you the following examples, categorically, from recent prospective lending cases that we have investigated. Left undetected, and absent another reason to walk away from the prospect’s request, had the loan been closed, these previous crimes would have resulted in an immediate fraud as well, because of the deceit and lack of disclosure by the prospect.

  1. Securities Fraud — Undisclosed to the lender, the CEO of a U.S. public company was found to have been under investigation for securities fraud in Canada because of allegations during his tenure as the CEO of a Canadian public company prior to being hired as CEO by the lender’s prospect. The deal was killed by the lender, and the CEO was fired by the prospect’s board of directors. The subject was subsequently convicted of securities fraud in Toronto.
  2. Sex Crime — Undisclosed to the lender, the CEO of a private company was found to have sexually assaulted and molested his then four-year-old daughter, 12 years before. He subsequently remarried, had another daughter — which at the time of our investigation was four years old — and started another business. Our client, who had met with its prospect and his current wife, business partner and investor many times, is convinced that his wife and partners were unaware of his past transgressions. The lender walked away from the deal.
  3. Accounting Fraud — Undisclosed by the private equity firm that referred the prospect to the lender and by the prospect’s CEO, the CEO of the prospect company was a convicted felon for two separate crimes of tax fraud and tax evasion, the most recent conviction resulting in a prison sentence served within the past year. The lender walked away from the deal and its source.
  4. A Killing Event — Undisclosed to the lender, the CEO of a U.S. public company was found to have been convicted for killing an endangered species in a public park. He was an aspiring member of a closet militia group that required such an offense in order to pass the hazing requirements for membership. He failed the militia’s group’s membership test and the background investigation test. The CEO lost his job with the prospect company, but not until the lender backed away from the deal.
  5. Another Killing and Potential Brand Wasting —
The daughter and future son-in-law of the prospect company’s CEO were killed execution-style in his villa in Switzerland within just days of the completion of our investigative background report. Our client was an asset-based lending subsidiary of a major capital markets institution, representing a national brand name, and was also the agent bank in the proposed consortium financing. The prospect CEO was a foreign national with a U.S company with assets to secure the loan. The lender walked away from the deal and also protected its good brand and reputation.

Again, it is a point of emphasis that the above “prospective” loans would likely have been closed without the performance of a background investigation on the companies and their management teams. As a result of the deceit, misrepresentations and lack of disclosure to the lenders by the prospects, the frauds would have occurred, with the lenders left to deal with the consequences of the fraud somewhere down the road and after the loan was funded — a worst possible outcome.

Background Investigations Best Practices
A summary of a few Best Practices will follow, but as an introduction into this topic I would like to take a further look behind the “Best Practices Methodology” that leads to the information, which revealed the undisclosed crimes and acts of indiscretion that punctuated the cases discussed above. I will do so in numerical order and highlight the key factors.

  1. A “media search performed in Canada” — because the subject of the investigation was a Canadian citizen — brought the securities fraud case in Canada to light. Additionally, our U.S. media searches, which are a routine part of our investigations, always include the across border Canadian media. A media source in Toronto picked up the outstanding securities fraud case, which lead to further inquiry with the Toronto regulatory authorities.
  2. A “relocation search” into a jurisdiction in which the subject has lived 15 years before brought the sexual assault/child molestation case to light. The subject was using a derivation of his name used when the crime was committed and a stolen social security number.
  3. Key to this discovery was that the senior lender hired us to perform the background investigation in the first place. The lender followed a “best practice” routine to engage this work to be performed independently when in doubt of the reputation of the background investigations firm being used by the source private equity firm or when the source refuses to share the results of a background investigation that had been presumably performed. A “criminal litigation search” revealed the two felonies. Upon further inquiry by our client of its source, the private equity firm informed the lender that this felony finding should not be material to its decision to fund.
  4. There was nothing unusual here, just good “research into a second jurisdiction” where the subject owned a recreation cabin as a second home. The subject didn’t think he would get caught — by the park ranger who caught him in point blank range or by us who did the same. A second ingredient was the subject’s stupidity, a common trait among “bullet proof” executives.
  5. “Foreign country research into property ownership and criminal history” brought this tragedy into focus not just in the country of domicile, but also in the country where the subject owned a second home villa.

As emphasized below, “multiple jurisdictional searches” are an essential best practices component when it is discovered that the subject resides or does business in more than one county or country.

Additional Best Practices Tips

  1. Lenders and lessors should be consistent about the methodology they employ. Lenders that perform background investigations by exception rather than as a standard practice will be compromised exceptionally — when it happens.
  2. Hire a background investigations firm that is consistent about its methodology as well. Ask the firm about its best practices methodology.
  3. An investigation must include a thorough research effort into determining all of the jurisdictions (counties or countries) in which the subject has resided or done business.
  4. Research must be performed in every jurisdiction where it has been determined the subject has resided or done business. To except even one jurisdiction could be to leave out the one where the “deal killer” resides.
  5. An investigation into public records (i.e., civil and criminal litigation histories, tax liens, judgments and bankruptcies) should always include a combination of independent on-site and on-line research. We find adverse public record information in approximately 30% of the cases as a result of performing on-site research that we don’t find when performing on-line research, using the best data bases available, a percentage too high to ignore.
And Finally, a Few Truths to Live By

  • Establish written risk management, due diligence and background investigations guidelines to live by, and follow them without exception.
  • Back up your best interviewing skills and intuition with the best information.
  • When in doubt, it’s always better to walk away from a deal.
  • It’s always management that ultimately repays the loan. Know whom the owners and managers really are.
  • Maintain your sense of humor because, when the collateral is gone and you’re left to work out a deficiency with a known felon who has ravaged his last three ventures and committed untold acts of indiscretion, you’ll need it.

Jerry Oldham HeadshotJerry Oldham is co-founder, chairman and CEO of 1st West Financial Corp. Oldham has a broad senior management background in commercial banking and corporate and real estate finance. He frequently serves as a consultant or expert witness in litigation and settlement negotiations involving complex corporate finance, real estate, banking and lending practice issues. Oldham often acts as a consulting team leader to manage the overall due diligence process on investment decisions for 1st West clients. He received a B.S. in Finance and Real Estate from The Pennsylvania State University and an M.S. in Banking and Finance from Colorado State University.

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