Tag Archives: board of directors

For Appearance Sake

By Rumbi Petrozzello, CPA/CFF, CFE
2017 Vice-President – Central Virginia Chapter ACFE

Last Thursday, the 15th of June 2017, the New York State Senate Committee on Ethics and Internal Governance met. The previous sentence reads like a big yawn with which no one, beyond perhaps the members of the committee itself, would be concerned. However, this meeting was big news. The room was packed with members of the media and every member of the committee was in attendance. Why? Because this was the first meeting the committee had empaneled since 2009, as confirmed by the committee’s published archive of events. It turns out that it was indeed a big deal that all committee members were in attendance because, for eight years straight, none of the committee members had attended a single meeting.

If you are thinking that the ethics committee did not meet for eight years because there were no ethical issues to discuss and our state’s legislative leadership practiced only ethical and upright behavior, you would be sorely mistaken. John Sampson, the State Senator who chaired the committee at that last meeting in 2009 was found guilty, of obstruction of justice and of lying to federal agents in 2015 and sentenced to jail time in January 2017. Evidently, taking their cues from the tone at the top evidenced by the leadership of their ethics committee, during the same eight-year meeting hiatus, seven other state senators were convicted on charges that included mail fraud, looting a nonprofit and bribery.

So, you might ask, what happened at the meeting last week? The committee had come together to discuss stipends, that are supposed to go to committee chairs, that were apparently also being paid to committee vice-chairs (and, in one case, to a deputy vice-chair, whatever that is). There was a motion proposed to stop making these payments to anyone but the committee chair. It seems that just coming together was more than enough work for the committee and, therefore, they tabled the motion, a motion that would not even have been binding, until its next meeting. It should be noted that two of the senators receiving this chair stipend, as vice-chairs, serve on the ethics committee and both voted to postpone voting on the motion. It would be laughable if it were a laughing matter.

Think about where you work and about all the clients with whom we work, as fraud examiners and forensic accountants. We work with our clients and with those who employ us to suggest comprehensive policies that cover good business practices and ethical behaviors and actions. Reading about the shenanigans of the State Senate Committee on Ethics recalled several thoughts:

The assumption that personnel will automatically be motivated to behave as corporate owners want is no longer valid. People are motivated more by self-interest than in the past and are likely to come from backgrounds that emphasize different priorities of duty. As a result, there is greater need than ever for clear guidance and for identifying and effectively managing threats to good governance and accountability.

Even when different employee backgrounds are not an issue, personnel can misunderstand the organization’s objectives and their own role and fiduciary duty. For example, many directors and employees at Enron evidently believed that the company’s objectives were best served by actions that brought short term profit:

—through ethical dishonesty, manipulation of energy markets or sham displays of trading floors;
—through book keeping that was illusory;
—through actions that benefited themselves at the expense of other stakeholders.

Frequently, employees are tempted to cut ethical corners, and they have done so because they believed that their top management wanted them to; they were ordered to do so; or they were encouraged to do so by misguided or manipulative incentive programs. These actions occurred although the board of directors would have preferred (sometimes with hindsight) that they had not. Personnel simply misunderstood what was expected by the board because guidance was unclear or they were led astray and did not understand that they were to report the problem for appropriate corrective action, or to whom or how.

Among our clients, lack of proper guidance or reporting mechanisms may have been the result of directors and others not understanding their duties as fiduciaries. Directors owe shareholders and regulators several duties, including obedience, loyalty, and due care. Recognition of the increasing complexity, volatility and risk inherent in modern corporate interests and operations, particularly as their scope expands to diverse groups and cultures has led to the requirement for risk identification, assessment and management systems.

  • If our client businesses want to do an excellent job at implementing effective ethics programs, orientation of new employees should always involve a review of the code of ethical practice by the staff tasked with compliance and with enforcing policies. How many entities are actively practicing what they preach during such sessions? The values that a company’s directors wish to instill to motivate the beliefs and actions of its personnel need to be conveyed to provide the required guidance. Usually, such guidance takes the form of a code of conduct that states the values selected, the principles that flow from those values, and any rules that are to be followed to ensure that appropriate values are respected.
  • After orientation, what steps are companies taking to maintain their ethics programs on an on-going basis? Principles are more useful to employees than just rules because principles facilitate interpretation when the precise circumstances encountered do not exactly fit the rules prescribed. A blend of principles and rules is often optimal in maintaining of a code of conduct in the long term.
  • Is leadership periodically coming together to talk about where their firm stands when it comes to ethics and compliance? A code on its own may be nothing more than ‘ethical art’ that hangs on the wall but is rarely studied or followed. Experience has revealed that, to be effective, a code must be reinforced by a comprehensive ethical culture.
  • Is anyone reviewing how whistleblowing claims are being dealt with? Does the company even have a whistleblower program? If so, does the staff even know about it and how it works? Whistle-blowers are part of a needed monitoring, risk management and remediation system.
  • Is leadership setting a positive tone at the top and displaying the behaviors that it is demanding from employees? The ethical behavior expected must be referred to in speeches and newsletters by top management as often as they refer to their health and safety programs, or to their antipollution program or else it will be viewed as less important by employees. If personnel never or rarely hear about ethical expectations, they will perceive them as not a serious priority.

Once, I worked at a company where senior management smoked in the office; behavior that is illegal and was, on paper, not allowed. When staff members complained to human resources, no corrective action was taken. Frustrated, some staff members called the city hotline to file a report. Following visits from the city, human resources put up no smoking signs and then notices encouraging employees to keep reports of inappropriate staff smoking internal. By only paying lip service to policy, this company’s management seemed populated by future candidates for the State’s Senate Ethics Committee. But my former employer doesn’t stand alone as evidenced by frauds at Wells Fargo and at others. A company can pull out screeds of rules and regulations, but what matters most is what the staff knows and what the leadership does.

In the case of the New York State Senate Committee on Ethics and Internal Governance, what it did was delay a vote on the issues before it until the next meeting. And when will the next meeting be? After taking eight years to set up its last meeting, the committee was in no hurry to set a date for the next. They adjourned without scheduling the next one. They did, however, take a moment to congratulate themselves on attending this meeting. You can’t forget the important stuff.

The CFE, Management & Cybersecurity

Strategic decisions affect the ultimate success or failure of any organization. Thus, they are usually evaluated and made by the top executives. Risk management contributes meaningfully and consistently to the organization’s success as defined at the highest levels. To achieve this objective, top executives first must believe there is substantial value to be gained by embracing risk management. The best way for CFEs and other risk management professionals to engage these executives is to align fraud risk management with achievement (or non-achievement) of the organization’s vital performance targets, and use it to drive better decisions and outcomes with a higher degree of certainty.

Next, top management must trust its internal risk management professional as a peer who provides valuable perspective. Every risk assurance professional must earn trust and respect by consistently exhibiting insightful risk and performance management competence, and by evincing a deep understanding of the business and its strategic vision, objectives, and initiatives. He or she must simplify fraud risk discussions by focusing on uncertainty relative to strategic objectives and by categorizing these risks in a meaningful way. Moreover, the risk professional must always be willing to take a contrarian position, relying on objective evidence where readily available, rather than simply deferring to the subjective. Because CFEs share many of these same traits, the CFE can help internal risk executives gain that trust and respect within their client organizations.

In the past, many organizations integrated fraud risk into the evaluation of other controls. Today, per COSO guidance, the adequacy of anti-fraud controls is specifically assessed as part of the evaluation of the control activities related to identified fraud risks. Managements that identify a gap related to the fraud risk assessments performed by CFEs and work to implement a robust assessment take away an increased focus on potential fraud scenarios specific to their organizations. Many such managements have implemented new processes, including CFE facilitated sessions with operating management, that allow executives to consider fraud in new ways. The fraud risk assessment can also raise management’s awareness of opportunities for fraud outside its areas of responsibility.

The blurred line of responsibility between an entity’s internal control system and those of outsourced providers creates a need for more rigorous controls over communication between parties. Previously, many companies looked to contracts, service-level agreements, and service organization reports as their approach to managing service organizations. Today, there is a need to go further. Specifically, there is a need for focus on the service providers’ internal processes and tone at the top. Implementing these additional areas of fraud risk assessment focus can increase visibility into the vendor’s performance, fraud prevention and general internal control structure.

Most people view risk as something that should be avoided or reduced. However, CFEs and other risk professionals realize that risk is valued when it can help achieve a competitive advantage. ACFE studies show that investors and other stakeholders place a premium on management’s ability to limit the uncertainty surrounding their performance projections, especially regarding fraud risk. With Information Technology budgets shrinking and more being asked from IT, outsourcing key components of IT or critical business processes to third-party cloud based providers is now common. Management should obtain a report on all the enterprise’s critical business applications and the related data that is managed by such providers. Top management should make sure that the organization has appropriate agreements in place with all service providers and that an appropriate audit of the provider’s operations, such as Service Organization Controls (SOC) 1 and SOC 2 assurance reports, is performed regularly by an independent party.

It’s also imperative that client management understand the safe harbor clauses in data breach laws for the countries and U.S. states where the organization does business.  In the United States, almost every state has enacted laws requiring organizations to notify the state in case of a data breach. The criteria defining what constitutes a data breach are similar in each state, with slight variations.

CFE vulnerability assessments should strive to impress on IT management that it should strive to make upper management aware of all major breach attempts, not just actual incidents, made against the organization. To see the importance of this it’s necessary only to open a newspaper and read about the serious data breaches occurring around the world on almost a daily basis. The definition of major may, of course, differ, depending on the organization’s industry and whether the organization is global, national, or local.  Additionally, top management and the board should plan to meet with the organization’s chief information security officer (CISO) at least once a year. This meeting should supplement the CFE’s annual update of the fraud risk assessment by helping management understand the state of cybersecurity within the organization and enabling top managers and directors to discuss key cybersecurity topics. It’s also important that the CISO is reporting to the appropriate levels within the organization. Keep in mind that although many CISOs continue to report within the IT organization, sometimes the chief information officer’s agenda conflicts with the CISO’s agenda. As such, the ACFE reports that a better reporting arrangement to promote independence is to migrate reporting lines to other officers such as the general counsel, chief operating officer, chief risk officer (CRO), or even the CEO, depending on the industry and the organization’s degree of dependence on technology.

As a matter of routine, every organization should establish relationships with the appropriate national and local authorities who have responsibility for cybersecurity or cybercrime response. For example, boards of U.S. companies should verify that management has protocols in place to guide contact with the Federal Bureau of Investigation (FBI) in case of a breech; the FBI has established its Key Partnership Engagement Unit, a targeted outreach program to senior executives of major private-sector corporations.

If there is a Chief Risk Officer (CRO) or equivalent, upper management and the board should, as with the CISO, meet with him or her quarterly or, at the least, annually and review all the fraud related risks that were either avoided or accepted. There are times when a business unit will identify a technology need that its executive is convinced is the right solution for the organization, even though the technology solution may have potential security risks. The CRO should report to the board about those decisions by business-unit executives that have the potential to expose the organization to additional security risks.

And don’t forget that management should be made to verify that the organization’s cyber insurance coverage is sufficient to address potential cyber risks. To understand the total potential impact of a major data breach, the board should always ask management to provide the cost per record of a data breach.

No business can totally mitigate every fraud related cyber risk it faces, but every business must focus on the vulnerabilities that present the greatest exposure. Cyber risk management is a multifaceted function that manages acceptance and avoidance of risk against the necessary actions to operate the business for success and growth, and to meet strategic objectives. Every business needs to regard risk management as an ongoing conversation between its management and supporting professionals, a conversation whose importance requires participation by an organization’s audit committee and other board members, with the CFE and the CISO serving increasingly important roles.

From the Head Down

fishThe ACFE tells us that failures in governance are among the most prominent reasons why financial and other types of serious fraud occur.  Often the real cause of major corporate scandals and failures detailed in the financial trade press is a series of unwelcome behaviors in the corporate leadership culture: greed, hubris, bullying, and obfuscation leading to fantasy growth plans and decisions taken for all the wrong reasons; so, that old saying remains true, fish rot from the head down.

CFE’s find themselves being increasingly called upon by corporate boards and upper operating management to assist as members of independent, control assurance teams reviewing governance related fraud risk. In such cases, where a board has decided to engage a third party, such as a consulting firm or law firm, to assess the risk associated with certain governance processes and practices, a CFE member of the team can ensure that the scope of work is sufficient to cover the risk of fraud, that the team’s review process is adequate, and that the individuals involved can provide a quality assessment.  Thus, if the CFE has suggestions to make concerning any fraud related aspect of the engagement, these can be shared with the review team as a whole.

As the fraud expert on a review team identifying governance related risks, the ACFE recommends that the CFE keep an open mind. Even the best boards, with the most experienced and competent directors, can fail. Examples of red flag, fraud related governance risks to consider include:

–Organizational strategies are approved and performance monitored by executives and the board without reliable, current, timely, and useful information;
–There is too great a focus on short-term results without sufficient attention to the organization’s long-term strategy;
–Oversight by the board is limited by a lack of directors with the required business, industry, technical, IT, or other experience;
–The board’s dynamics do not include sufficient challenge and skeptical inquiry by independent directors;
–Oversight by the audit committee is limited by a lack of experience in financial reporting and auditing;
–There have been instances in the past of the external auditors having failed to detect material misstatements because part of their team lacked the necessary industry experience and understanding of relevant accounting standards;
–Board oversight of risk management is constrained by a lack of risk management experience;
–Strategies approved by the board are not linked to individual goals and objectives of managers in operating departments or over key business processes;
–IT priorities are not consistent with business and organizational priorities due to a lack of communication and alignment of goals and incentive programs;
–Employees do not understand the corporate code of business conduct because it has not been clearly communicated and/or explained to them.

Once the team has identified and assessed the principal governance-related risks, the first step is to determine how to address them. The review team should take each in turn and determine the best approach. Several options might be considered. Using generally accepted traditional control approaches, many governance-related risk areas (such as awareness of the corporate code of conduct, alignment of management incentive plans and organizational strategies, or the quality of information used by the executive leadership team and the board) can be addressed without too much difficulty.

Next, the CFE needs to consider which fraud risks to recommend to the team for periodic re-assessment in recurring risk assessment plans. It’s not necessary or appropriate to periodically assess every identified governance-related fraud risk, only those that represent the most significant on-going risk to the success of the organization and its achievement of its overall fraud prevention objectives.

In a relatively mature organization, the most valuable role for the CFE team member is likely to be that of providing assurance that governance policies and practices are appropriate to the organization’s fraud risk control and management needs – including compliance with applicable laws and regulations – and that they are operating effectively.  On the other hand, if the organization is still refining its governance processes, the CFE may contribute more effectively to the governance review team in an anti-fraud consulting capacity advising or advocating improvements to enhance the evolving fraud prevention component of the organization’s governance structure and practices.

Within the context of the CFE’s traditional practice, there will be times when the board or general counsel (which has so often historically directly engaged the services of CFEs) wants the assessment of a particular governance fraud risk area to be performed by the in-house counsel.  In such instances, the CFE can directly partner with the in-house staff, forming a relationship alternative to performance as a review team member with another type of assurance provider or outside consultant.  This arrangement can offer significant advantages, including:

–Ensuring that the CFE has the benefit of the in-house legal team’s subject-matter expertise as well as knowledge of the company;
–Allow more CFE control over the scope of work, the way the engagement is performed, the conclusions drawn, and over the final report itself; for example, some CFE’s might feel more confident about expressing an opinion on whether the fraud risk under review is managed effectively by the board with in-house counsel support.

A risk-based fraud prevention plan is probably not complete unless it includes consideration of the risks inherent in the organization’s governance processes. Selecting which areas of governance to review should be based on the assessed level of risk, determined with input from management and (in all likelihood) the board itself. Different governance risk areas with fraud impact potential may merit different CFE involved review strategies, but, whatever approach is taken, careful planning is always a must.

Reviews of fraud risk related to corporate governance are never easy, and they often carry political risk. However, they are clearly important and should be given strong consideration as a component of every fraud prevention effort – not just because they are required by professional assurance standards, but because governance process failures can contribute so devastatingly to financial frauds of all kinds.