Echoes of the Corporate Frauds of Past Recessions

By Jim McCurry and Kevin Shergold

"If the facts don't fit the theory, change the facts" Albert Einstein once suggested. This view has been adopted time and again by financial statement fraudsters who, particularly as economic prosperity wanes, present fictitious assets and understate liabilities whilst hoping for a reversal of fortunes. According to the US-based National Bureau of Economic Research, the economic tide has been ebbing in the United States since the end of 2007 while the rest of the developed world moved into recession during 2008. Since then, economists and politicians worldwide have nervously opined on the likely duration and impact of the current global economic slowdown, as recent high profile cases follow a grim list of corporate frauds that tend to emerge when the boom times retreat from view.

The connection between economic decline and corporate scandal is more complicated than a purely linear relationship, but the correlation between the two is undeniably strong. In this article we have attempted to highlight the historical and current relationship between recessions and corporate fraud; why economic decline enables the identification of corporate fraud; and what companies can do to increase their vigilance and approach to fraud during economic downturns.

Fraud in a Recession

As financial institutions continue to unravel in the United States and around the world, it's difficult to shake the feeling of déjà-vu. The savings and loan crisis of the 1980s and early 1990s produced the greatest collapse of US financial institutions since the Great Depression. Over the 1986-1995 period, 1,043 financial institutions with total assets of over US$500 billion failed. The large number of failures overwhelmed the resources of the Federal Savings and Loan Insurance Corporation, so US taxpayers were required to back up the commitment extended to insured depositors of the failed institutions. As of December 31, 1999, the savings and loans crisis had cost taxpayers approximately US$124 billion and the financial services industry another US$29 billion, for an estimated total loss of approximately US$153 billion. Estimates have placed 20-30% of this cost at the feet of fraudsters who include loan applicants, loan officers, bank directors and others in a massive scheme that led to five US Senators being accused of corruption.

Large corporate scandals have usually followed hot on the heels of a recession: In the 1990-91 recession that followed the 1987 stock market crash, frauds at Polly Peck (1990) and BCCI (1991) among others, shook the corporate world. Following the Kobe earthquake which sent Asian markets into turmoil, came the unprecedented Barings collapse (1994). Then, consider the early noughties' recession linked to the bursting of the technology bubble. In 2001 Enron suffered its own personal and now infamous liquidity crisis. A year later, Worldcom took its place among the largest ever corporate frauds. History, it would seem, has a habit of repeating itself.

Many studies suggest that people who commit fraud generally do so because there is opportunity, pressure, and rationalization (first presented by the 20th century Criminologist Don Cressey's in his "Fraud Triangle"). A recession is likely to make all these factors more prevalent:

• Increased financial pressure on families as pressure to maintain compensation at historical levels or avoid redundancy provides an incentive for employees to manipulate results, enter into side-agreements with customers or suppliers, or simply to siphon funds for themselves.
• Rationalisation is easier as fraudulent activity might be deemed necessary for survival or to maintain a standard of living.
• Opportunities increase as a result of cost cutting exercises that can weaken key internal controls. For example, redundancies leave fewer back office finance staff to review and approve transactions, or comply with segregation of duties requirements.

While it is generally accepted that fraud increases in a recession, we believe the level of fraud may not change significantly; rather the fraudulent activity is more difficult to conceal and perpetuate due to declining liquidity.

Why is More Corporate Fraud Revealed in a Downturn?

Recessions include among their attributes a decline in investment and corporate profits—both translate directly into a reduction in the availability of funds. This will impact different fraud schemes in different ways, but in all cases fraudsters find it more difficult to either sustain their schemes without taking greater risks, or can no longer conceal their improper activities. Consider the following examples:

• Revenue pull-forward schemes (recognizing sales in current periods that belong in next years' financials) and other aggressive or improper revenue recognition policies cannot be sustained without increasing trading.
• "Ponzi" schemes in which early investors are paid with the money put in by subsequent investors are by design reliant on growth and on fresh capital to perpetuate the scam. They will collapse as liquidity dries up, as recent news stories make clear.
• Weakening corporate performance can occur in all business cycles but it is accelerated during a recession. Management can be tempted to conceal the bad news and attempt to ride out the storm. If real results do not improve and the economic tide continues to ebb, at some point the lie becomes too big. For example, there may simply be insufficient funds to repay creditors, new financing proves elusive and the cycle is broken. The onset of the New Year brought with it yet more examples of this in the business press.

There are also secondary effects of a reduction in funds that cause frauds to be more readily identified by market participants:

• Companies are required to conduct regular impairment reviews. A downturn in the economy will cause businesses to consider the realisable value of their assets, such as stock, property, and intangible assets such as goodwill (i.e., a proxy for future earnings of acquisitions). An impairment review demands a closer look at the accounting treatment for, or existence of, key assets. This might reveal where financial reporting has been manipulated or whether there has been asset misappropriation of some kind.
• Cost cutting exercises inspire more detailed review of procurement or disbursement activities which may be found to have been manipulated for personal gain, rather than for business purposes. These exercises and associated recoveries are more vehemently pursued by organizations as the economy slides into recession.
• Redundancies can cause a reallocation of duties, and certain tasks are performed by different individuals. Irregular activity becomes easier to identify when new reviewers are put in place.

What Can Companies Do?

A comprehensive anti-fraud programme is an organisation's best hope of preventing or detecting fraud, in any business cycle. This encompasses many elements. However, such an approach does not appear to have been adopted by even the biggest organisations.

Ernst & Young's ninth Global Fraud Survey revealed that 72% of companies surveyed did not provide training to their employees on their anti-fraud policies, and 42% of companies did not have a formal anti-fraud policy. While many companies have improved their processes in detecting and preventing fraud, regular and repeated assessments are necessary.

Where an anti-fraud programme has been absent or ineffective, businesses will still benefit from early detection and action. This can be achieved through a number of mechanisms that are essentially all components of an anti-fraud programme:

• Stakeholders should be more mindful of traditional "red flags" to mitigate their exposure. One well known red flag, for example, is management who avoid straight answers to reasonable questions. The vagaries that existed to explain BCCI's incredible returns prior to its collapse provide lessons learned that appear to have been forgotten.
• Organizations should respond more aggressively to mitigate potential control breaches (such as those uncovered by routine internal audits) and should take a fresh and more skeptical look at whistleblowing complaints.
• Focus on key fraud risks and related controls. Fraud risks will be unique for each entity and each line of business, so there is no standard formula. A fraud risk assessment will: define the fraud risk universe the organization faces; prioritize those risks; identify the key controls to mitigate those key risks; and correct or improve where gaps might exist.
• Conduct fraud awareness training. This is an opportune time to raise the awareness of fraud in employees minds through organization-specific anti-fraud training. Providing real life examples of corporate fraud and the red flags that would have identified that fraud improves the likelihood of identification.
• Ensure a measured response to concerns or allegations of fraud (i.e., have a robust and considered fraud contingency plan), as an ill-considered reaction can expose you further. For example, a premature confrontation with a suspected fraudster can undermine company morale if in fact the allegations prove to be false or misplaced. If the allegations are true, then the suspect has been given the chance to deny the allegation, destroy evidence and potentially hide misappropriated assets.

A Longer Term Solution

As was the case after Enron, Worldcom and Parmalat, corporate governance and additional regulatory oversight will likely be seen as the panacea for avoiding corporate fraud in the future. The success of a company's system of corporate governance will always be a function of the vigilance of all its stakeholders and, importantly, watchfulness should not be conserved for recessions.

While standards of governance and oversight continue to vary from jurisdiction to jurisdiction, stakeholders should seek the application of the following principles:

• Consistent financial reporting and external auditing standards.
• Comprehensive regulation to include critical areas of corporate governance.
• Regulators that are independent and have the authority and tools to enforce existing regulations.
• A skeptical and independent business press.
• Shareholders that are actively focused on holding companies accountable to the highest standards.
• Effective oversight and leadership from non-executive board members.

All stakeholders must ultimately ask whether a company's financial results make sense. Can a company's out-sized performance compared to its competition be explained by a competitive advantage and one that flows through to the financial statements? This type of questioning should be applied by regulators, individual shareholders, institutional investors, auditors and non-executive board members.

Getting Worse or Getting Better?

Recent corporate frauds will take their place in the chronology of major corporate scandals and provide us with rather ominous reminders of the past. Similar scenarios may well be played out over the coming months as the recession and lack of liquidity continues to lay bare historical fraud and deceptions around the globe.

To avoid a repeat of this cycle, the corporate world would do well to remind itself of another of Einstein's gems: "Learn from yesterday, live for today, hope for tomorrow. The important thing is not to stop questioning."

Jim McCurry is a Partner in Ernst & Young's Fraud Investigation & Dispute Services team. Contact Details: Tel: + 44 (0)20 7951 5386 Email: jmccurry@uk.ey.com

Kevin Shergold is an Assistant Director in Ernst & Young's Fraud Investigation & Dispute Services team. Contact Details: Tel: + 44 (0)20 7951 8919 Email: kshergold@uk.ey.com