Category Archives: The Final Fraud Report

Just Like Me

During a joint training seminar between our Chapter and the Virginia State Police held a number of years ago, I took the opportunity to ask the attendees (many of whom are practicing CFE’s) to name the most common fraud type they’d individually investigated in the past year. Turned out that one form or another of affinity fraud won hands down, at least here in Central Virginia.

This most common type of fraud targets specific sectors of society such as religious affiliates, the fraudster’s own relatives or acquaintances, retirees, racial groups, or professional organizations of which the fraudster is a member. Our Chapter members indicate that when a scammer ingratiates himself within a group and gains trust, an affinity fraud of some kind can almost always be expected to be the result.

Regulators and other law enforcement personnel typically attempt to identify instances of affinity fraud in order to prosecute the perpetrator and return the fraudulently obtained goods to the victims. However, affinity fraud tends to be an under reported crime since victims may be embarrassed that they so easily fell prey to the fraudster in the first place or they may remain connected to the offender because of emotional bonding and/or cultivated trust. Reluctance to report the crime also frequently stems from a misplaced belief that the fraudster is fundamentally a good guy or gal and will ultimately do the right thing and return any funds taken. In order to stop affinity fraud, regulators and law enforcement must obviously first be able to detect and identify the crime, caution potential investors, and prevent future frauds by taking appropriate legal actions against the perpetrators.

The poster boy for affinity fraud is, of course, Bernard Madoff.   The Madoff tragedy is considered an affinity fraud because the vast majority of his clientele shared Madoff’s religion, Judaism. Over the years, Madoff’s list of victims grew to include prominent persons in the finance, retail and entertainment industries. This particular affinity fraud was unprecedented because it was perpetrated by Madoff over several decades, and his customers were defrauded of approximately twenty billion dollars. It can be debated whether the poor economy, lack of investor education, or ready access to diverse persons over the internet has led to an increase in affinity fraud but there can be no doubt that the internet makes it increasingly easy for fraudsters to pose as members of any community they target. And, it’s clear that affinity frauds have dramatically increased in recent years. In fact, affinity fraud has been identified by the ACFE as one of the top five investment schemes each year since 1998.

Affinity frauds assume different forms, e.g. information phishing expeditions, investment scams, or charity cons. However, most affinity frauds have a common element and entail a pyramid-type of Ponzi scheme. In these types of frauds, the offender uses new funds from fresh victims as payment to initial investors. This creates the illusion that the scam is profitable and additional victims would be wise to immediately invest. These types of scams inevitably collapse when it either becomes clear to investors or to law enforcement that the fraudster is not legitimate or that there are no more financial backers for the fraud. Although most fraud examiners may be familiar with the Madoff scandal, there are other large scale affinity frauds perpetrated across the United States almost on a daily basis that continue to shape how regulators and other law enforcement approach these frauds.

Perpetrators of affinity frauds work hard, sometime over whole years, to make their scams appealing to their targeted victims. Once the offenders have targeted a community or group, they seek out respected community leaders to vouch for them to potential investors. By having an esteemed figurehead who appears to be knowledgeable about the investment and endorses it, the offender creates legitimacy for the con. Additionally, others in the community are less likely to ask questions about a venture or investment if a community leader recommends or endorses the fraudster. In the Madoff case, Madoff himself was an esteemed member of the community. As a former chair of the National Association of Securities Dealers (NASD) and owner of a company ranked sixth largest market maker on the National Association of Securities Dealers Automated Quotations (NASDAQ), Madoff’s reputation in the financial services industry was impeccable and people were eager to invest with him.

The ACFE indicates that projection bias is yet another reason why affinity fraudsters are able to continually perpetrate these types of crimes. Psychological projection is a concept introduced by Sigmund Freud to explain the unconscious transference of a person’s own characteristics onto another person. The victims in affinity fraud cases project their own morals onto the fraudsters, presuming that the criminals are honest and trustworthy. However, the similarities are almost certainly the reason why the fraudster targeted the victims in the first place. In some cases when victims are interviewed after the fact, they indicate to law enforcement that they trusted the fraudster as if they were a family member because they believed that they shared the same value system.

Success of affinity fraud stems from the higher degree of trust and reliance associated with many of the groups targeted for such conduct. Because of the victim’s trust in the offender, the targeted persons are less likely to fully investigate the investment scheme presented to them. The underlying rationale of affinity fraud is that victims tend to be more trusting, and, thus, more likely to invest with individuals they have a connection with – family, religious, ethnic, social, or professional. Affinity frauds are often difficult to detect because of the tight-knit nature common to some groups targeted for these schemes. Victims of these frauds are less likely to inform appropriate law enforcement of their problems and the frauds tend to continue until an investor or outsider to the target group finally starts to ask questions.

Because victims in affinity frauds are less likely to question or go outside of the group for assistance, information or tips regarding the fraud may not ever reach regulators or law enforcement. In religious cases, there is often an unwritten rule that what happens in church stays there, with disputes handled by the church elders or the minister. Once the victims place their trust in the fraudster, they are less likely to believe they have been defrauded and also unlikely to investigate the con. Regulators and other law enforcement personnel can also learn from prior failures in identifying or stopping affinity frauds. Because the Madoff fraud is one of the largest frauds in history, many studies have been conducted to determine how this fraud could have been stopped sooner. In hindsight, there were numerous red flags that indicated Madoff’s activity was fraudulent; however, appropriate actions were not taken to halt the scheme. The United States Securities and Exchange Commission (SEC) received several complaints against Madoff as early as 1992, including several official complaints filed by Harry Markopolos, a former securities industry professional and fraud investigator. Every step of the way, Madoff appeared to use his charm and manipulative ways to explain away his dealings to the SEC inspection teams. The complaints were not properly investigated and subsequent to Madoff’s arrest, the SEC was the target of a great deal of criticism. The regulators obviously did not apply appropriate professional skepticism while doing their jobs and relied on Madoff’s reputation and representations rather than evidence to the contrary. In the wake of this scandal, regulatory reforms were deemed a priority by the SEC and other similar agencies.

Education is needed for the investing public and the regulators and law enforcement personnel alike to ensure that they all have the proper knowledge and tools to be able to understand, detect, stop, and prevent these types of frauds. This is where CFEs and forensic accountants are uniquely qualified to offer their communities much needed assistance. Affinity frauds are not easily anticipated by the victims. Madoff whistleblower Markopolos asserted that “nobody thinks one of their own is going to cheat them”.  Affinity frauds will not be curtailed unless the public, we, the auditing and fraud examination communities, and regulators and other law enforcement personnel are all involved.

The Multi-Purpose Final Report

ACFE training has long told us that a prudently crafted final examination report can have a variety of important uses. As we know, when the fraud investigation has been completed, the investigator writes a formal report. The report itself plus expert opinions and testimony are then used as needed to support the resolution of issues that can relate to a whole host of matters potentially concerning taxes, employment, regulatory reporting, litigation (civil and criminal), and insurance claims.

Because the report can be used for such varied purposes, it should always be constructed under the assumption that it will be challenged in court. This requires that the report meet very high standards; any errors or misstatements in it may be used to undermine the credibility of both the report and of the investigator who wrote it.

Frauds typically result in business losses. For income tax purposes, such losses may be classified as either deductions or offsets to reportable revenues depending on the type of loss and the taxing authority. In cases of misappropriation, almost any type of asset can be fraudulently converted, and in some cases, a valuation expert might be needed to determine the dollar amount of the loss.

In cases of occupational fraud, the financial records can be so damaged from the fraud scheme that an exact determination of the loss is impossible. In such cases, the report may attempt to estimate the loss using any reasonable means available because taxing authorities often permit estimation of losses in cases of destroyed records.

Some occupational fraud schemes result in so much damage to the financial records that the entity will not have enough information to file tax returns. This can happen, for example, if the revenue records are either destroyed or rendered unreliable as a result of fraudulent transactions and journal entries. In such cases, it might be necessary to conduct a major reconstruction of the accounting records before losses can be determined, reliable financial statements can be generated, and tax returns can be filed. In fact, in some cases, the fraud investigator’s report might need to focus on the loss due to destruction of the financial records and leave open the issue of misappropriation pending reconstruction of the financial records. Of course, depending on the scope of the investigation and the available information, the investigator might both reconstruct the financial records and report on any misappropriation losses.

Another tax-related issue involves the embezzlement of funds set aside to pay payroll taxes. The U.S. federal tax system sometimes refers to such funds as trust fund taxes because under tax law, these funds belong to the Internal Revenue Service (IRS) from the moment they are collected. The business and the owners merely serve as trustees in collecting the taxes on behalf of the IRS.

Employers who terminate an employee for committing fraud can eventually battle the employee in litigation. In some cases, the former employee may sue for wrongful termination of employment, defamation, or discrimination. In other cases, an employee who is to be fired might have collective bargaining rights that require an arbitration process with a right of appeal. Fired employees may also attempt to claim government unemployment compensation benefits.

As a general rule, employees who are fired for serious misconduct (e.g., fraud) are not entitled to benefits. However, employees may argue that their termination was not deserved and may request a hearing to argue their side of the story. If this occurs, a fraud investigation report could serve as important evidence.

Whether a fired employee receives unemployment benefits may be important in determining the amount the company is required to pay for unemployment insurance. As a result, an employer who routinely fires employees runs the risk of incurring considerable increases in the cost of unemployment insurance. To make things even worse, if a fired employee was the one in charge of making unemployment insurance contributions but did not make them on time, a penalty rate of 150 percent could be applied to the employer’s future contributions. The exact consequences depend on the particular state involved because rules for unemployment insurance for state and federal governments differ. As a result of the possible tax and legal consequences as well as of possibly embarrassing publicity, employers are frequently reluctant to fire dishonest employees. Instead, they do things to encourage dishonest employees to leave voluntarily after taking measures to prevent them from continuing the fraud. In some cases, employers actually give dishonest employees favorable recommendations for future jobs.

Sometimes, a fraud investigation report may trigger mandatory reporting of the fraud to a government agency. For example, §1233.3 (a) of Title 12 (Banks and Banking) of the U.S. Electronic Code of Federal Regulations states the following:

‘A regulated entity shall submit to the Director a timely written report upon discovery by the regulated entity that it has purchased or sold a fraudulent loan or financial instrument, or suspects a possible fraud relating to the purchase or sale of any loan or financial instrument.’

A fraud investigation report can sometimes be more helpful in ruling out fraud than in ruling it in. For example, a report might read, “A detailed examination of the financial records did not reveal any intentional irregularities or evidence of fraud or misappropriation.” On the other hand, when there is fraud, the report might read something like, “There was a series of irregular computerized journal entries made in the accounts receivables ledgers and corresponding shortages in the cash account. The employee in charge of the computerized journal entries left the company before this investigation began and was not available for an interview. The owner states that only she and the former employee had access to the journal in question.”

The wording in this report suggests that the former employee may have embezzled funds from collections on account by making irregular journal entries. But the report cannot guarantee that s/he did so, nor can it definitively conclude that a fraud occurred. As a general rule in advance of an occupational fraud investigation, interested parties should not assume that the investigation will result in a report that gives a definitive answer to whether a fraud occurred. A more reasonable outcome is a report that identifies missed or damaging records or missing assets.

Fraud reports can be very helpful in both criminal and civil litigation. However, they can be less than satisfying in trying to persuade authorities to prosecute a suspect. What happens too often is that police or prosecutors browse through a fraud investigation report looking for a clear statement that identifies the guilty person. But, of course, such statements don’t appear in independent fraud investigation reports written by CFEs.

In many cases, a fraud investigation report is enough to at least persuade authorities to look at a case, especially with the hope of getting a quick confession. But if the suspect denies everything or lawyers up, law enforcement quickly realizes that they will need to hire a forensic accountant (because it is unlikely that they have one of their own) and will be forced to try to understand what they consider to be arcane and obscure accounting concepts.

The saying in law enforcement circles (as with the news media) is “if it bleeds, it leads.” In a metropolitan area, police quickly send a dozen squad cars, a SWAT team, and a helicopter to pursue someone who robs a liquor store of $100 with a penknife. But the same police respond with glassy eyes if the owner of the same liquor store reports that his accountant has robbed the business of $100,000 using a computer to manipulate the accounting records.

Although it does happen, most victims do not sue their fraudsters, primarily because fraudsters are typically judgment proof, meaning they do not have sufficient assets to repay their victims. However, criminal courts can and do order restitution, which can provide a strong motive for the victim to prosecute the perpetrator. In some jurisdictions, courts order convicted fraudsters to make regular restitution payments directly to the court, which then distributes them to the victim.

Finally, many companies have insurance with coverage for losses related to fraud. This coverage can include losses such as those due to the costs of preparing a proof of loss, losses due to embezzlement, losses of valuable papers and records, and loss of income. Independent fraud investigation reports can be very helpful in supporting insurance claims. Furthermore, one nice thing about embezzlement coverage is that some polices are written so that it is necessary only to prove that a loss has occurred, not who the guilty party is. The usefulness of a fraud investigation report with respect to losses of valuable papers and records, and loss of income, depends on the scope of the investigation. In many cases, the scope does not include determining the amount of losses of income or damage to valuable papers and records.