Attorney, CFE, and forensic accounting professor David P. Weber examines the origins of fraud examination and white collar crime theory.
News flash: It’s 2020, and we are working through a pandemic and the steepest economic downturn since the great depression. It’s a tough time to be a professional investigator, particularly if you own your own business. But the pandemic and downturn make it a great time to be a fraudster.
This article, the first in a new recurring series, aims to marry the problem with the opportunity — helping you make these lemons into lemonade as a small business owner, by learning how an investigator can help clients head off fraud. So let’s get started.
What is fraud?
Fraud is very different from most crimes. It is sometimes hard to define, but like Supreme Court Justice Potter Stewart once said about pornography, we know it when we see it Jacobellis v. Ohio, 378 U.S. 184 (1964). Put simply, its modus operandi requires deception. Thus, is it does not encompass taking property by force (like robbery), or ordinary theft, such as taking that sirloin and running out of the supermarket (called larceny).
But if you combine larceny with deception, particularly when you are trusted by your employer, that is what we call fraud. As depicted in the Johnny Cash song One Piece at a Time, the deception could be secreting expensive components from a General Motors plant — in other words, inventory fraud. It didn’t work out so well for Johnny. But each year, it also does not work out well for businesses that are victims of fraud.
Specifically, the Association of Certified Fraud Examiners, of which I am a member, estimates that businesses lose up to five percent of their revenue on an annualized basis to fraud, which the ACFE projects to cost organizations $3.5 trillion – with a T! – to occupational fraud. That is BIG money. We investigators must play a role in stopping it.
Generally speaking, we professors believe that fraud must have the following seven elements:
- a representation
- about a material point
- which is false
- and intentionally or recklessly so
- which is believed
- and acted upon by the victim
- to the victim’s damage
Mens Rea
That fourth element, specific intention or reckless conduct, is what we call the mens rea, or the mental state of intent or premeditation necessary to prove the crime. Put a different way, our job as investigators is to show that the fraud was intentional or reckless on the part of the perpetrator. Since we cannot see inside the mind of the fraudster, we must prove the mens rea through physical or circumstantial evidence.
If you’ve read this far, I’m pretty sure you’re asking, “What is recklessness, and how can I prove that?”
Recklessness means that the perpetrator knew or should have known that harm could potentially be done. A simple example would be getting really drunk and then getting behind the wheel of your car. You do not have the mens rea of intending to kill someone. But, if something terrible happens on that drive home, surely you knew, or should have known, that you might be more likely to strike a pedestrian or another car, and that someone could get seriously injured or die as a result. Countless perpetrators have been convicted of crimes for this reckless state of mind.
Indiana University Archives
As investigators, this mens rea is frequently encountered in financial statement or “earnings” fraud. Earnings fraud is purportedly committed on behalf of the organization. In other words, senior management cooks the books to make the organization appear more profitable, often to mislead the market, investors, or sometimes the organization’s lenders or bondholders (who may have covenants in the loan or bond documents to require a certain level of earnings). Of course, this may benefit senior management as well, as their performance measures are frequently tied to the earnings of the organization.
At least with smart crooks, you won’t find a smoking gun email in a financial statement fraud case. You’ll have to rely on statements made to witnesses, or even circumstantial evidence. Take the case of Richard Scrushy, the former CEO of Healthsouth, which was involved in a massive accounting fraud scandal in 2004. Scrushy went so far as to check his people for wires in meetings. But he failed to find the tiny wire his CFO was wearing inside his tie, installed by the Birmingham Division of FBI. (The supervisory special agent who put that bug in the Scrushy’s tie is a friend of mine – Alton Sizemore. More on him in a future article. They ought to make a Netflix episode on that case ).
Occupational Fraud
Now we have the basics down, and we know occupational fraud is a thing. But why does it happen? And how does it work?
By way of tackling both questions, Dr. Donald R. Cressey developed the Fraud Triangle with his mentor Dr. Edwin Sutherland. (Sutherland coined the term “white-collar crime”). Interested in circumstances that caused white collar criminals to engage in fraud, Cressey and Sutherland in 1951 wrote an article titled Why Do Trusted Persons Commit Fraud? A Social-Psychological Study of Defalcators in the Journal of Accountancy. In 1953, Cressey published a text on the topic: Other People’s Money: A Study in the Social Psychology of Embezzlement.
To quote from Cressey’s book:
“Trusted persons become trust violators when they conceive of themselves as having a financial problem that is non-sharable, are aware that this problem can be secretly resolved by violation of the position of financial trust, and are able to apply to their contacts in that situation verbalizations which enable them to adjust their conceptions of themselves as users of the entrusted funds or property.”
Donald R. Cressey, Other People’s Money, (Montclair: Patterson Smith, 1973), p. 30.
In other words, Cressey first hypothesized what is today known as the Fraud Triangle, three factors defining the causes of occupational fraud: opportunity, pressure, and rationalization. For fraud to occur, all three elements must be present, and conversely, if a single element is missing, the fraud will not take place.
Opportunity Knocks Loudly
Opportunity is the single greatest place where we, as professional investigators, can help our clients prevent the fraud to begin with. We cannot stop drug addiction, sex addiction, or gambling addiction, just to name three pressures. (Do not underestimate the pressure of extra-marital affairs. Nookie can be expensive.) But we can do some simple things, as trusted advisors to our clients, to help them reduce opportunity.
Below, I discuss some simple steps ALL organizations should take, actions that you can suggest to your clients (with thanks to the ACFE’s 5 Fraud Tips site for these suggestions):
Take decisive action.
An organization should adopt a code of ethics that applies to everyone in the company hierarchy and post it for all to see. An investigator can help clients look for weak points in oversight that might provide opportunity for fraudsters. An attorney or ethics professor can help with the company code.
Have a deliberate hiring process.
Prospective employees should receive a background investigation, and it should be especially thorough for upper management candidates. A good investigator can go well beyond the rudimentary (and ineffectual) one-stop online background check. A real due diligence investigation should check resume claims like degrees earned, military service, and past employment, and look into criminal history and past (or ongoing) litigation. Check credit history if you can (legally, per GLBA & FCRA), and if resources permit, interview references.
Train employees to spot fraud.
Be sure everyone in the organization knows the signs of fraud and basic fraud prevention. Post the fraud triangle in a public space, and offer a briefing on fraud awareness during new employee orientation. Make shared responsibility for an honest workplace part of the organization’s culture.
Create an anonymous fraud hotline.
The people in the best position to detect fraud are those working closely with the fraudster. Give staffers, contractors, and clients a safe, anonymous way to communicate their suspicions or discoveries to authorities without fearing reprisal. Investigators can then discreetly follow up on these tips on behalf of the organization.
Make employees believe they are likely to be caught.
Organizational transparency and consistency will set the stage for a culture of trust and accountability. Clearly communicate your company’s anti-fraud policies, create safe reporting avenues for whistleblowers, and be clear about the consequences of fraudulent behavior by employees and executives. Make accountability universal. Act on tips so staffers will know they are being heard.
Conclusion
All professional investigators should understand what fraud is, why it occurs, and how to help their clients and communities prevent it. And of course, they should know how to investigate suspected fraud and document incidents for insurance, corporate governance, and law enforcement purposes. The five tips we shared, via the ACFE, will hopefully help you advise your clients on fraud awareness and make them more resilient to avoiding fraud going forward.
In our next article, we will look at specific types of fraud, including the frauds taking place during the pandemic.
About the author:
David P. Weber is a clinical assistant professor of accounting at the Perdue School of Business at Salisbury University. He is a certified fraud examiner, registered private investigator, and licensed attorney. He completed more than two decades of public service in 2013 as the Assistant Inspector General for Investigations at the U.S. Securities and Exchange Commission, the SEC’s Chief Investigator. He now teaches full time in Salisbury’s Fraud and Forensic Accounting Certificate Program, and leads a boutique law firm with an expertise in fraud examination and forensic consulting.