Worldwide: Looters Have a Foothold

Accounting fraud is the corporate criminals’ weapon of choice.

PAs are very aware of the rise in global securities fraud and are working hard to combat it. Terrorists and insurgents frequently use fraud to finance their operations and launder their funds. When fraud becomes endemic in a nation, it can produce radical political changes that bring to power leaders who are hostile to market economies and democracy and who often are strongly anti-American.

Executives who strip corporations of money for their own use (called “looting control frauds” in criminological circles) use accounting fraud as a weapon of choice to inflate income and net worth. They also use normal corporate mechanisms to convert corporate assets to their own personal benefit before the company collapses. Because of the vigilance of the American accounting profession and tough new regulations such as the Sarbanes-Oxley Act, the problem in the United States may pale in comparison to other corners of the world.

Looters are succeeding in various parts of the globe because of several factors. The expansion of privatization of state-owned enterprises (SOEs) over the last two decades has led to a dramatic global upsurge in commercial enterprises, which increases the potential for private-sector looting. The mishandling of privatization creates the incentives for looting. For example, many of the SOEs in the former Soviet Union were noncompetitive and likely to produce long-run losses. The plants were obsolete, environmental disasters. In China, SOEs received subsidies through bank “loans” from other SOEs. Of course, the state banks were insolvent, but they too were implicitly subsidized by the state. By virtually guaranteeing the noncompetitive SOEs would not be permitted to fail, the Communist Party created an incentive for the managers to loot “their” SOEs.

Regrettably, these waves of privatization were undertaken without providing regulations strong enough to make an advanced private-sector economy effective. The economists who designed the systems had no experience in fraud prevention and seem to have assumed that the necessary control mechanisms would develop spontaneously. Instead, without a rule of law, honest courts, real banks or effective secured transactions, the result too often was endemic fraud.

In Latin America, privatization should have been more successful because those nations often had moderately effective institutions. Corruption was rife in the process, which frequently meant government officials sold valuable SOEs to cronies at a fraction of their true market value. Unfortunately, political cronies rarely are selected for business acumen, and many of the privatization efforts failed.

As the world has seen, fraud and corruption can endanger our very lives:

• A Chechen suicide bomber used a tiny bribe to escape arrest and bypass airport security and thus he was able to bring down an airliner.

• The former governor of Illinois recently was convicted of corruption. One part of that scandal involved bribes that led to the fraudulent award of commercial trucking licenses to hundreds of unqualified drivers—and, ultimately, the bribes led to fatal accidents that killed innocent people.

• Terrorists willing to pay under-the-table money could very well penetrate our national security.

We cannot “win” a decisive battle against fraud. We need to be eternally vigilant against fraud and work cooperatively with other nations. The Institute for Fraud Prevention (IFP) can help build those alliances—and CPAs and lawyers are vital to the effort. CPAs ensure the reliable accounting essential to any well-functioning enterprise; lawyers have taken the lead in helping to create a rule of law in emerging states.

The time-tested virtues of independence, professional skepticism and competence have never been so important. We have to take control fraud (that is, fraud perpetrated by management) seriously—that means recording it when we detect it (the Justice Department does not keep statistics on control frauds) and conducting research to learn how to spot it before it causes catastrophic damage. The results of the IFP’s research will provide the guidance to expand the education of auditors, to improve the management of audits and to better regulate securities. The information gathered by the IFP will be a major factor in the global effort to detect and prevent fraud.

—William K. Black, PhD, JD

Mr. Black, the executive director of the Institute for Fraud Prevention, is an associate professor of economics and law at the University of Missouri at Kansas City. He began his career as an attorney, became a regulator during the savings-and-loan debacle in the 1980s and, after obtaining a doctorate in criminology, joined the academic community at the LBJ School of Public Affairs at the University of Texas at Austin. Mr. Black is a highly regarded expert in the area of management fraud and corruption.

Business Leaders’ Take on Fraud: Corrosive

U.S. GIANT RESPONDS QUICKLY TO BID-RIGGING CHARGES
Michael G. Cherkasky, president and CEO of Marsh & McLennan Cos. Inc. (MMC), has had a distinguished career as a manager, prosecutor, investigator and trial attorney and spent 16 years in the criminal justice system, including serving as chief of the Investigations Division for the New York County District Attorney’s Office. In October 2004, New York Attorney General Eliot Spitzer filed a civil action against Marsh & McLennan, charging it with bid rigging and accepting kickbacks from selected insurers for steering business to them. The company’s board of directors acted quickly and within two weeks named Cherkasky as the new CEO. Cherkasky vowed to resolve the legal and regulatory issues and to revamp MMS’s business practices. Although there is the potential for litigation by other states, MMC settled with Spitzer in January 2005 for $850 million to be paid over four years.

JofA: What went wrong at MMC to bring forth allegations of bid rigging and kickbacks? Is this a common industry practice, or was it unique to MMC?

Michael G. Cherkasky: I would certainly not call it a common industry practice; the vast majority of business people are honest and ethical. In our case, a small group of individuals put their own interests above those of the company. We had paid these individuals for profit, not for service, which was a mistake. Organizations must maintain a delicate balance between encouraging performance and discouraging illegal or unethical conduct to achieve results.

Being a former prosecutor, I’ve seen companies handle these crises two ways. They can deny the allegations and fight, usually unsuccessfully, in the courtroom, or they can take ownership of their conduct and fix the problem. I can’t emphasize it enough; the latter is the only correct choice.

JofA: Did your strong law enforcement background play a role in your being selected as the new head of MMC?

Cherkasky: There is no question that that had much to do with my being named CEO. This company was on the brink of being in real trouble. We initially lost $10 billion in market capitalization. It took us a full year to recover, but now we have turned the corner. That is a lesson that companies should learn from us. The conduct at MMC was not material to the financial statements as a whole, but when it comes to high-profile cases, there is no such thing as “immaterial” fraud. The financial impact to our company was many times that of the alleged illegalities. That is why it is vitally important that organizations have processes and procedures to prevent wrongdoing in the first place. Our business, like most others, is based on trust. The board recognized this critical concept and decided that MMC was going to be as clean as possible. That is the real lesson other organizations can take away from our situation. Great companies have had, and will continue to have, the same kinds of issues. It is how the company reacts that will make the difference.

JofA: How will MMC prevent such conduct in the future?

Cherkasky: Obviously, the first thing is to set the proper tone at the top. Now, everyone in the company knows that we not only expect but demand ethical behavior. We have greatly improved our audit process to ensure that our financial transactions have adequate documentation. We now have a compliance infrastructure that is world-class. We make better use of our internal audit function to test compliance, and we constantly seek ways to improve it.

JofA: Since MMC is a global entity, what fraud issues concern you the most?

Cherkasky: When a company like ours does business globally with countries that are not as regulated as those in the United States, it is important those countries comport with our norms, not the other way around. For example, we know that a common way of getting business in some nations is to pay for it with bribes and kickbacks. Not only is that conduct illegal for American companies but it is not the right way to do business. MMC has made the decision not to engage in ventures in certain countries. In others we have greatly improved our audit and management practices to ensure we comply with the law. Private-sector companies must realize they cannot count on government to reduce fraud; this is a task that companies must undertake themselves. It is up to the public sector to set standards, but the private sector must enforce them. Certified fraud examiners and CPAs play a critical role in this task.

MAKING HEADWAY IN EUROPE
Max-Peter Ratzel is director of the European Police Organization—Europol. Previously, at the German Federal Criminal Police Office, he was senior adviser and head of units in information and technology, organized crime, property crime and international cooperation. As head of the BKA Department of Organized and General Crime in Wiesbaden, Germany, he coordinated the prevention of and the fight against international illicit drug trafficking, child pornography, Internet crime, the spread of counterfeit money and trafficking in human beings.

JofA: Businesses operate in Europe in much the same way as businesses in the United States. Does that mean fraud schemes familiar in the United States are functioning in the European economies?

Max-Peter Ratzel: The Northern and Atlantic parts of Europe show signs that “boiler room” fraud is on the rise again, and of course the Nigerian or 419 fraud is still all over Europe. Most Americans are familiar with 419 frauds, although perhaps not by that name. In a typical scenario, the victim receives a letter or e-mail from a person falsely claiming to be the recipient of millions of dollars and willing to share the loot with someone who will deposit it in a U.S. bank. But the fraudster requests various “fees” from the victim first. Once those monies are paid, the fraudster disappears. The 419 frauds are a variation of advance fee swindles.

A particularly complicated type of fraud that is rapidly developing in the same region is called “liquidation constructions.” These frauds get liquidities out of corporate tax shelters without being taxed. We are especially concerned because skilled professionals, such as accountants and lawyers, are offering their services as financial facilitators for the target companies to mount these constructions, eagerly using offshore and tax havens all over the world.

JofA: Are financial statement frauds active in Europe?

Ratzel: Those frauds are problems in Europe to the extent they are problems all over the world. A number of spectacular financial statement fraud cases have been exposed throughout Europe and vigorously covered by the world press. Fraud at Super Club, Philips, L&H, Parmalat, Hold, Shell, ELF Aquitaine and other companies has troubled many institutional and private investors.

Since we live in a global economy, the disastrous consequences of large-scale fraud in Europe affect the American stock exchanges and vice versa. Several companies have been driven to the edge of bankruptcy and several billion euros in capitalization vaporized when stock prices dropped as a result of “cooking the books.” The long-term effects on the well-being of citizens is devastating, affecting pension benefits and eroding employment. I am convinced that creating an awareness of the socially and economically disruptive nature of this fraud has a long way to go. The capital market is based on reliable and correct information. Society has to make sure the quality and reliability of that information is assured—if need be by criminal legislation as the ultimate remedy.

JofA: Have European nations passed any major laws similar to the Sarbanes-Oxley Act?

Ratzel: Over the last decade Europe began to develop corporate governance codes for the mandatory assessment of the internal audit activity, company risk-assessment processes; conflicts of interests and related-party transactions, controls restraining misappropriation of company assets that could result in the material misstatement of the financial statements; procedures for handling complaints and for accepting confidential submissions of concerns. Representative codes are the U.K. Combined Code of July 2003, the German Corporate Governance Code of December 2004, the French Lois de Security Financiered of July 2003, the Dutch Tabaksblat Code of 2005 and the Belgian Corporate Governance Code (Lippens) of 2005. None of that legislation is as stringent as Sarbanes-Oxley, particularly concerning corporate and criminal fraud accountability and white-collar crime penalty enhancements. There is a definite tendency in Europe to be less permissive toward corporate fraud together with an awareness of the harm it does both to the economy and to individuals. Corporate governance legislation in Europe will inevitably evolve from a voluntary approach to a more compelling conception like Sarbanes-Oxley.

CHINA: GET RICH QUICK AT ANY COST
Tommy Seah, CFE, is professor of economics at the China Institute of Directors in Shanghai. He is also a member of the Singapore Institute of Management, a fellow of the Institute of International Accountants and a chartered banker. He is an expert on fraud in the Chinese economy.

JofA: China’s new market economy does not seem to square with its communist ideology. What are the reasons the Chinese government has embraced capitalist ideals?

Tommy Seah: Reality hits home. The extreme view is that the Chinese have come to terms with the fact that ideology does not feed an empty stomach. A more moderate reason would be that the government cannot keep marching backward when almost everyone else is marching forward. They also understand that it is economic growth that will give them the recognition they so badly need.

JofA: Are these economic reforms likely to continue, even when the current administration in China changes hands?

Seah: Absolutely; the masses have seen the light. There is no turning back. No amount of bureaucracy is going to change that. The Chinese people have changed. The new generation accepts capitalism as the norm. I have yet to meet a young Chinese who will introduce himself as a member of the Communist Party.

JofA: Do you believe the overall rate of fraud in China is higher, lower or the same as in America?

Seah: I believe the rate of fraud in China is greater. You have an oppressed people who are suddenly given some autonomy over economic decision making. The burgeoning economy in China means more opportunities to commit fraud. And although the penalty for white-collar crime is more severe in China than in America, the Chinese see fraud as an opportunity to break out of the chain of poverty. Lots of Chinese people have now traveled internationally; they see the good life capitalism brings, and many are impatient to get rich quickly. Some see no shame in committing fraud because they believe they are just getting back what was theirs in the first place.

JofA: What other cultural differences affect the rate of fraud in China?

Seah: Most Western businesses adhere to corporate governance that is built on accounting principles, competition and disclosure, but for centuries Chinese business has relied upon “Guanxi,” or connections. Most transactions are not covered by contracts, but by verbal commitments sealed with a handshake. Nepotism is not only common; it is accepted. China is also struggling with its lack of experience with modern-day methods of commerce. The Communist Party spent much of the last century destroying traditional Chinese values in an attempt to replace them with its own brand of puritanical morality. However, those values were largely destroyed as a result of the influences of the Cultural Revolution, and today’s Chinese haven’t yet defined their own system of ethics. Now the citizens are being told that “to get rich is glorious” without the corresponding acceptable constraints.

JofA: What are some of the common ways Chinese enterprises defraud the American companies that invest there?

Seah: Foreign investments can be made only with the approval of the Chinese government. U.S. companies either invest directly in the Chinese enterprise or become partners. Whichever the case, local management and labor are used extensively, which gives rise to possible fraud in several areas. For instance,

It is quite common for corrupt employees and management to bill American investors for goods and services in excess of market prices and pocket the difference.

Local workers may set up competing businesses using the foreign investor’s technology and other resources and divert sales to the new business. Or crooked employees can falsify production records and sell part of the investor’s product “out the back door.”

They may use the investors’ assets to secure loans for themselves; China has not yet developed a good system to track assets pledged as collateral, so it is sometimes difficult for U.S. companies to even know their property has been mortgaged.

Dishonest executives of Chinese ventures can cook the books just like those of their U.S. counterparts.

JofA: How do American companies and investors protect themselves against fraud in China?

Seah: The same basic ways they protect themselves with their other foreign investments. Know whom you are dealing with by conducting sufficient due diligence. Make sure the agreement is structured in a way that gives the investor unfettered access to the operation and the accounting records. Hire a reputable international accounting firm to perform audits under international accounting standards. Provide hands-on oversight. Finally, keep in mind that most businesses in China operate honestly. It is the investor’s obligation to see that they remain that way.

PAY-TO-PLAY IS KING
Paul Volcker is the chairman of the board of trustees of the Group of Thirty, commonly called the G30, in Washington, D.C. He was chairman of the Federal Reserve from 1979 to 1987, undersecretary of the U.S. Treasury for international monetary affairs and president of the Federal Reserve Bank of New York. Having developed a reputation as a brilliant investigator, Volcker was assigned by the United Nations to research possible corruption in the Iraqi Oil-for-Food Program (OFFP) in 2004. In its concluding report of September 7, 2005, the Volcker committee called the program the “largest, most complex and most ambitious humanitarian relief effort in the history of the United Nations.” It achieved the goals of helping deprive Iraqi deposed dictator Saddam Hussein of weapons of mass destruction while at the same time maintaining minimal standards of nutrition and health for the Iraqi people in the face of a potential crisis. Of the approximately $110 billion in the OFFP, Volcker and his colleagues estimated that Hussein had manipulated about $1.8 billion to his own benefit. The report also was critical of the relationship between the son of U.N. Secretary-General Kofi Annan and a Swiss contractor for the OFFP. The committee concluded that most of the problems with the program related to its administration and the lack of adequate controls.

JofA: What can our readers learn from the OFFP investigation as it pertains to the global state of fraud and corruption?

Paul Volcker: There certainly is a lot. For example, we discovered that fully half of the program’s 4,500 contractors were paying kickbacks to do business with the Hussein government. To the credit of American contractors, most of them refused to participate. But that void was quickly filled by former Eastern Bloc contractors, principally Russians, and also the Chinese.

JofA: The United States frowns on corruption, and criminal prosecutions are commonplace. What is the situation elsewhere?

Volcker: Certainly, corruption is more egregious in many countries—in Africa, the Middle East and the former Soviet Union, to name a few. However, these acts simply don’t have the same stigma attached as they do here at home. Many international companies and even governments view kickbacks as a necessary cost of doing business. Moreover, criminal prosecutions, in general, seem to be the exception and not the rule. Interestingly, in Australia, where corruption is frowned on, the Australian Wheat Board has found itself under a major investigation for allegedly paying $200 million in bribes to secure contracts with the previous Iraqi government.

JofA: With fraud and corruption endemic, how can the United States help control the problem?

Volcker: There is no easy solution. Certainly, the U.S. Foreign Corrupt Practices Act, which prohibits the payment of kickbacks by U.S. companies to foreign officials, is a strong deterrent for American business. United Nations regulations prohibit corruption, as does the World Bank. Although they don’t completely stop the problem, they do provide enforcement mechanisms. But because of the rapidly expanding pace of international trade, I expect the total volume of corruption in general will get worse before it gets better.

JofA: In the United States, Enron and WorldCom have put accounting fraud center stage. But even without those two cases, the Securities and Exchange Commission has reported record restatements of company earnings. To what do you attribute this seeming wave of fraud?

Volcker: First, the complexity of financial information makes it easier to mask fraud. Second, the huge compensation packages afforded executives—particularly stock options—provide great incentives to act dishonestly. Third, the public has not demanded honesty and accountability from business. Finally, I believe that CPAs can, should and will do a better job detecting and preventing fraud. Reliance on credible financial information is vital to the nation’s economy.

TRADITIONAL FRAUD MEETS FOREIGN VISITORS
Rosalind Wright, a barrister, is chairman of the United Kingdom Fraud Advisory Panel and an independent director of the Office of Fair Trading and the Department of Trade and Industry. She also chairs the supervisory committee of OLAF (the European Anti-Fraud Office), an agency of the European Commission. She was the director of the Serious Fraud Office and general counsel and an executive director for the Securities and Futures Authority, one of the principal U.K. financial services regulators. She is considered one of the U.K.’s most knowledgeable authorities on fraud.

JofA: Please explain the background and function of the U.K. Fraud Advisory Panel.

Rosalind Wright: The panel is an independent body of volunteers drawn from the public and private sectors. Our role is to raise awareness of the social and economic damage caused by fraud and to develop effective remedies. Panel members include representatives from the law and accounting professions, industry associations, financial institutions, government agencies, law enforcement, regulatory authorities and academia.

Established in 1998 through a public-spirited initiative by the Institute of Chartered Accountants in England and Wales, the panel works to encourage a truly multidisciplinary perspective on fraud. No other organization has such a range and depth of knowledge, both of the problem and of the means to combat it. Today it is a registered charity and company limited by guarantee and funded by subscription, donation and sponsorship.

JofA: Are there particular fraud schemes that seem to be growing in the United Kingdom at present?

Wright: We see a steep rise in the incidence of identity thefts of all types, including phishing, pharming and theft of corporate identity. We also see a rise in traditional fraud schemes, such as theft by employees, advance fee frauds, high-yield investment schemes and the use of fictitious prime bank instruments to deceive investors. Much of the fraud practiced on U.K. investors comes from overseas, particularly from countries that were part of the former Soviet Union (computer-related crime and attempts to obtain confidential customer information from institutions) and Nigeria and Canada (advance fee frauds).

JofA: What programs does the Fraud Advisory Panel advocate to curb fraud?

Wright: We advocate greater emphasis by government on the risk of financial crime. At the moment, fraud is not a policing priority and, therefore, is not adequately funded by the U.K. Home Office. There are insufficient numbers of trained and specialist police officers and police financial investigators to deal with the amounts of fraud reported to them. Consequently, a large amount of major fraud goes uninvestigated.

We also advise businesses and the professions to report fraud to law enforcement. Many of the major frauds committed by employees and directors go unreported and therefore add to the numbers that are not investigated by the police.

We urge businesses and their advisers to raise the profile of fraud risk and to manage it effectively. We would like more emphasis on good business ethics within companies and more responsibility taken at the highest corporate level for managing fraud risk. We also alert the public to the more obvious attempts at fraud that crooks make daily.

JofA: In general, how effective do you think the U.K. accounting profession has been in deterring and detecting material frauds in organizations?

Wright: There is no doubt that an external audit is a deterrent to fraud, although it cannot be relied on to prevent or detect all frauds—or even all frauds that are material to the financial statements. Frauds can be well-disguised, involving collusion among a number of parties, and therefore very difficult to uncover. Audit is by its nature an unproductive cost; managers tend not to suspect fraud in their own organizations and pressure auditors to reduce costs, minimizing audit procedures to only those the auditors need to justify their opinions.

Auditors’ contributions to the fight against fraud also have been reduced in recent years by the steady increase in the audit exemption limit, meaning that small companies no longer are required to have a regular audit, nor even have a regular relationship with a professional accountant.

Against this, professional accountants tend to advise clients routinely on the internal control procedures they should have in place to minimize business risks, including fraud. In addition accountants are bound by their professional ethics to ensure that their names are not associated with any documents they believe to be misleading. Accountants would normally undertake at least some level of review of, say, the tax returns with which they are associated, to ensure they are clearly not fraudulent.