Tag Archives: bribery and corruption

The Flavor of the Month

revolving-doorsUnsurprisingly, given issues raised by the press during the recent presidential election about cabinet candidates and the rapidly revolving door between the private sector and government, conflict of interest is again the fraud flavor of the month among the pundits.  To keep the matter in perspective, these same concerns about appointments are raised to a greater or lesser degree following every presidential election.

The ACFE tells us that a conflict of interest occurs when an employee, manager, or executive has an undisclosed economic or personal interest in a transaction that adversely affects the company, or, in the case of government, his or her office.  As with other corruption cases, conflict schemes involve the exertion of an employee’s influence to the detriment of his or her employing organization.

The clear majority of conflict cases occur because the fraudster has an undisclosed economic interest in a transaction. But the fraudster’s hidden interest is not necessarily economic. In some scenarios, an employee acts in a manner detrimental to his organization to provide a benefit to a friend or relative, even though the fraudster receives no financial benefit from the transaction herself.  A manager might split a large repair project into several smaller projects to avoid bidding requirements. This allows the manager to award the contracts to his brother-in-law. Though there was no indication that the manager received any financial gain from this scheme, his actions nevertheless amount to conflict of interest.

It’s important to emphasize that to be classified as a conflict of interest scheme, the employee’s interest in the transaction must be undisclosed. This is a crucial important point and one that’s often overlooked.  The crux of a conflict case is that the fraudster takes advantage of his employer; the victim company is unaware that its employee has divided loyalties. If an employer knows of the employee’s interest in a business deal or negotiation, there can be no a conflict of interest, no matter how favorable the arrangement is for the employee.

If an employee approves payment on a fraudulent invoice submitted by a vendor in return for a kickback, its bribery. If, on the other hand, an employee approves payment on invoices submitted by his own company (and if his ownership is undisclosed), this is a conflict of interest. The distinction between the two schemes is obvious. In the bribery case the fraudster approves the invoice in return for a kickback, while in a conflicts case he approves the invoice because of his own hidden interest in the vendor. Aside from the employee’s motive for committing the crime, the mechanics of the two transactions are practically identical. The same duality can be found in bid rigging cases, where an employee influences the selection of a company in which she has a hidden interest instead of influencing the selection of a vendor who has bribed her.

The concern voiced in the press and other media is legitimate and justified because there are vast numbers of ways in which an employee (or high level government appointee) can use his or her influence to benefit an organization in which s/he has a hidden or even a disclosed interest.

Purchase schemes and sales schemes are the two most common categories involving conflict of interest. Most conflicts of interest arise when a victim company unwittingly buys something at a high price from a company in which one of its employees has a hidden interest, or unwittingly sells something at a low price to a company in which one of its employees has a hidden interest. Most other conflicts involve employees stealing clients or diverting funds from their employer.

The ACFE says its research indicates that most conflict schemes are over billing schemes.  While it is true that any time an employee assists in the overbilling of his company there is probably some conflict of interest (the employee causes harm to his employer because of a hidden financial interest in the transaction), this does not necessarily mean that every false billing will be categorized as a conflict scheme. For the scheme to be classified as a conflict of interest, the employee (or a friend or relative of the employee) must have an ownership or employment interest in the vendor that submits the invoice. This distinction is easy to understand if we look at the nature of the fraud. Why does the fraudster overbill his employer? If she engages in the scheme only for the cash, the scheme is a fraudulent disbursement billing scheme. If, on the other hand, she seeks to better the financial condition of her business at the expense of her employer, this is a conflict of interest. In other words, the fraudster’s interests lie with a company other than her employer. When an employee falsifies the invoices of a third-party vendor to whom he has no relation, this is not a conflict of interest scheme because the employee has no interest in that vendor. The sole purpose of the scheme is to generate a fraudulent disbursement.

A short rule of thumb can be used to distinguish between over-billing schemes that are classified as asset misappropriations and those that are conflicts of interest: if the bill originates from a real company in which the fraudster has an economic or personal interest, and if the fraudster’s interest in the company is undisclosed to the victim company, then the scheme is a conflict of interest.

Not all conflict schemes occur in the traditional vendor-buyer relationship. Some involve employees negotiating for the purchase of some unique, typically large asset such as land or a building in which the employee had an undisclosed interest. It is in the process of these negotiations that the fraudster violates his duty of loyalty to his employer. Because he stands to profit from the sale of the asset, the employee does not negotiate in good faith to his employer; he does not attempt to get the best price possible. The fraudster will reap a greater financial benefit if the purchase price is high. In a turnaround sale or flip an employee knows his employer is seeking to purchase a certain asset and takes advantage of the situation by purchasing the asset himself (usually in the name of an accomplice or shell company). The fraudster then turns around and resells the item to his employer at an inflated price. A write off of sales scheme involves tampering with the books of the victim company to decrease or write off the amount owed by an employee’s business. For instance, after an employee’s company purchases goods or services from the victim company, credit memos may be issued against the sale, causing it to be written off to contra accounts such as Discounts and Allowances. Many reversing entries to sales may thus be a sign that fraud is occurring in an organization. Finally, some employees divert the funds and other resources of their employers to the development of their own business. While these schemes are clearly corruption schemes, the funds are diverted using a fraudulent disbursement. The money could be drained from the victim company through a check tampering scheme, a billing scheme, a payroll scheme, or an expense reimbursement scheme.

The bottom line is that every management has an obligation to disclose to the shareholder’s significant fraud committed by officers, executives, and others in positions of trust. Management does not have the responsibility of disclosing uncharged criminal conduct of its officers and executives. However, when officers, executives, or other persons in trusted positions become subjects of a criminal indictment, disclosure is required. The inadequate disclosure of conflicts of interests is among the most serious of frauds. Inadequate disclosure of related-party transactions is not limited to any specific industry; it transcends all business types and relationships.

On the detection side, CFE’s continue to point out some of the more tried and true  methods that can be used including tips and complaints, comparisons of vendor addresses with employee addresses, review of vendor ownership files, review of exit interviews, comparisons of vendor addresses to addresses of subsequent employers, and interviews with purchasing personnel for favorable treatment of one or more vendors.

The Joker in the Pack

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Suddenly everyone in the news, even presidential candidates, seems to be accusing someone else of a conflict of interest.  It may be that an exact definition would be helpful in clearing the air and clarifying matters a little so as to identify the real joker in the corporate pack.  From a fraud examiner’s point of view, just what exactly constitutes a conflict of interest?  According to the ACFE a conflict of interest occurs when an employee, manager, or executive has an undisclosed economic or personal interest in a transaction that adversely affects the company. Unaware that its employee has divided loyalties, the company is taken advantage of by the fraudster. As with other corruption cases, in a conflict of interest scheme an employee exerts his influence to the company’s detriment. In many cases, the fraudster does not benefit economically; instead, he uses his influence for the benefit of a friend or relative.

Motive is the difference between a bribery scheme and a conflict of interest scheme. For instance, if an employee approves payment on a fraudulent invoice submitted by a vendor in return for a kickback, this is bribery. On the other hand, if an employee approves payment on invoices submitted by his own company – a real company, not a shell company – this is a conflict of interest. In the bribery case, the perpetrator receives a kickback. In the conflict of interest case, the perpetrator has a hidden interest in the vendor. Similarly, in a bid-rigging case, an employee influences the selection of a company for which he has a hidden interest, rather than influencing selection of a vendor who has bribed him.

However, many conflict of interest schemes do not mirror bribery or bid-rigging schemes. An employee can use her influence to benefit a company in which she has a hidden interest. Any way in which a fraudster exerts his influence to divert business to his hidden interest company is considered to be a conflict of interest. In a purchasing conflict of interest scheme, an employee purchases goods or services from a company in which he has a hidden interest, resulting in purchases that are typically either overbilled or unnecessary. Employees in purchasing who have access to bidding information determine the bid amounts from other vendors, then pass this inside information to their hidden interest company so it will be better equipped to win the contract. Perpetrators also use bid waivers to avoid a competitive bid process in order to award a contract to their hidden interest company. Or, a fraudster could ignore his employer’s purchasing rotation and direct an inordinate number of purchases or contracts to his hidden interest company. Some fraudsters engage in what is known as a turnaround sale or flip whereby an employee personally purchases goods he or she knows the employer needs, and then sells them to the employer at an inflated price.

Two types of conflict schemes are associated with the victim company’s sales. The first, and most harmful scheme, involves under-billing a vendor in which the perpetrator has a hidden interest. The victim company ends up selling its goods or services below fair market value, which results in a diminished profit margin or loss on the sale, depending upon the size of the discount. The other type of sales scheme involves tampering with the books of the victim company to decrease or write off the amount owed by the employee’s business. For instance, after an employee’s company purchases goods or services from the victim company, credit memos may be issued against the sale, causing it to be written off to contra accounts such as discounts and allowances. In other cases, the perpetrator might not write off the sale but simply delay billing. This delaying tactic is sometimes done as a “favor” to a friendly client, and not considered an outright attempt to avoid paying the bill. The victim company eventually gets paid, but loses the use of the money and the interest that might have been earned on the payment.

In a client diversion scheme, an employee starts his own business and competes directly with his employer. While still employed by the victim company, the employee diverts clients to his own business. In a resource diversion scheme, an employer’s funds and other resources are diverted to the development of an employee’s personal business. A fraudster obtains the resources using a check tampering, billing, payroll, expense reimbursement, or one of the other asset misappropriation schemes discussed so often in this blog. With the exception of the fraudster’s motives, conflict of interest schemes are similar to other asset misappropriation frauds; they are concealed and converted in the same way. In other words, if the fraudster uses a check tampering fraud to commit a conflict of interest crime, then the employee would conceal and convert using the same techniques employed in check tampering frauds. The fraudster can also convert the misuse of influence into personal gain by profiting from the growth or earnings of a hidden interest company.

So what are the red flags? Many of the red flags associated with other fraud schemes also point to a conflict of interest scheme. For instance, while a particular red flag might suggest an employee is committing a fraudulent disbursement scheme, a conflict of interest problem might exist as well. In addition, certain red flags pertain directly to conflict of interest schemes. The following point to some of the warning signs that an employee could have a conflict of interest; the absence of clear company policies regarding an employee’s disclosure of outside interests and the commitment expected of the employee to act in the company’s best interests. Likewise, complaints, especially if they are frequent or in sales and purchasing. If a particular vendor is being favored, then competing vendors might file complaints. In addition, employee complaints about the substandard service of a favored vendor may lead to the discovery of a conflict of interest. And finally, a large number of reversals to sales entries.

The ACFE recommends that CFE’s consider proposing the following techniques and procedures to our clients to help prevent and detect conflict of interest schemes …

–Create company policies to directly address conflict of interest issues. Outline the responsibilities of employees to disclose all outside interests that might conflict with the interests of the company. Make sure that employees and vendors are aware of the company’s policies concerning conflicts of interests. Require employees to complete an annual disclosure statement; this may reveal potential conflicts of interest.

–Provide vendors with a direct line to complain about unfair practices, and keep a descriptive log of vendor complaints. Review the log regularly to identify patterns that might point to a fraud scheme. Also, devise a way for employees to discreetly let the company know of suspicious activities.

–Compare vendor addresses with employee addresses, and look for vendors whose addresses are listed as post office boxes. This is the same investigative technique used to locate bogus vendors.

–Review vendor ownership files. When a vendor is chosen, a complete file of vendor ownership should be maintained. If the vendor is required to update the file annually, then changes in ownership also will be disclosed. A comparison of vendor ownership and employee files may reveal conflicts of interest.

–When an employee leaves the company, compare the address of his new employer to vendor addresses. If there is a match, a possible conflict of interest may have existed.

–Interview purchasing personnel. Employees are generally the first to observe that a vendor is receiving favorable treatment. Ask employees if particular vendors are receiving favorable treatment; this may uncover conflicts of interest that would otherwise go unnoticed.