Maintaining Transparency
April 4, 2010 5:32 PM   Subscribe

How do professionals uncover fraud, scams, and corruption?

After reading about the cases of Enron and Bernie Madoff, I'm interested in the methods used by professionals to uncover unsavory activity by businesses, individuals, and governments. I was recently approached by an acquaintance about investing in a private business venture, but I'm a naturally suspicious person when it comes to unsolicited propositions. This guy seems to be awash in cash and his business supposedly owns several assets, but I am unable to find any public information about his company or records of ownership. Something just seems "off" here, and I realized that I want to learn how professionals detect scams, frauds, and corruption so I can more critically examine stuff like this. This sort of information intrigues me, so I'll ask some specific questions as well.

Accountants: How do you discover accounting fraud by businesses? Are there any telltale signs of suspicious activity that you can immediately recognize? What about off-balance sheet entities and complex financial instruments - are there ways to unravel these and stop guys like Jeff Skilling and Andy Fastow?

Lawyers: How do you deal with multiple corporate entities that are set up with the purpose to defraud? Are there ways of uncovering the complex layers of trusts and shell companies, etc. to get to the bottom of things? In your experience, are there easily recognizable signs of scams / unsavory dealings (from both individuals and businesses)?

Journalists: How do you expose corruption, especially when you don't have inside sources or are facing a hostile or secretive organization?

For anyone with experience in these matters: how does the game change when you're dealing with a particularly intelligent or motivated fraudster?

The forensic aspects of tracking down scammers is the most interesting to me, but I'm sure there are a lot of people with experience in detecting / preventing this kind of activity, so I'm interested in hearing from you as well.

A big thanks in advance to anyone who contributes!
posted by Despondent_Monkey to Work & Money (10 answers total) 8 users marked this as a favorite
 
There are lots of methods to detect fraud.

Here are a couple of things forensic accountants and financial analysts will look for regarding the cash flow statement (applies to publicly traded firms following US GAAP):

Stretching accounts payable

Financing accounts payable

Securitizing accounts receivable

Repurchasing stock to offset dilution

Specific to Enron:

Insufficient operating cash flow (CFO exceed net income, but some transactions should have been classified differently)

Pressure to support stock price and debt ratings

Revenues reported using mark to market accounting (note this is different than valuing assets using mark to market accounting)

Excessive revenue reported in the last half of the year (booking revenues ahead of actual sales in order to make quarterly/year-end numbers--specifically, EPS projections)

Inflated sales to special purposes entities

Mark to market accounting for equity-method investments

Significant use of related party transactions (Fastow's investment in the SPEs, for example)

Senior management compensation and turnover was excessive

(All of these examples taken from my CFA text...)
posted by dfriedman at 5:39 PM on April 4, 2010


Oh, and regarding Bernie Madoff: in a nutshell, the annual returns that his operation reported to its clients were too smooth to be real returns. The stockmarket is a volatile enterprise; even those who routinely can generate alpha (that is, returns in excess of the market) have returns series (annual returns for a series of years) that bounce up and down all over the place in an essentially random pattern.

Madoff's reported returns were too smooth to be real; this is why some lawyers are saying that the institutional investors who invested with him, who presumably should have been aware of the random nature of stock returns over time, should have not invested with him. These lawyers further argue that these institutional investors are therefore culpable. As I am not a lawyer I won't comment on the validity of this argument.

Hindsight, of course, is 20/20, but a cursory review of Madoff's reported returns does suggest that those returns are not genuine.
posted by dfriedman at 5:44 PM on April 4, 2010


Investigating requires lots of grunt work digging through public records, just getting as much info as you can about a person. In terms of fraud, you have to look for patterns or obvious numbers that don't match up.

Liquor licenses and court cases (e.g. bankruptcy filings) can be pretty revealing, but aren't too common. Other stuff like land records or political contributions can help you build up a complete profile of a person or company. (people usually use the same mailing addresses for everything) Private companies aren't generally required to file a lot of info about themselves, but if you dig around enough you can usually find most of the affiliated stuff.

You aren't going to uncover a lot of well-thought-out scams from public records, but you may get a good idea of where to look.
posted by ropeladder at 5:52 PM on April 4, 2010


John Hempton, an Australian fund manager, has blogged about investigating his suspicions of two hedge funds, Astarra and Paradigm Global. Most of what he did was reading the funds' own websites, checking government databases, and scrutinizing timelines.
posted by djb at 5:55 PM on April 4, 2010 [1 favorite]


I am sorry to say that my nose begins to twitch as soon as there is financial trouble, and particularly as bankruptcy looms. People just seem to steal like crazy when they think the ship is going down.
posted by bearwife at 6:08 PM on April 4, 2010


You may find the book 24 Days: How Two Wall Street Journal Reporters Uncovered the Lies that Destroyed Faith in Corporate America of interest. It was written by the reporters who broke the story, and it shows exactly how they did the reporting and uncovered the facts. I loved it.
posted by SisterHavana at 6:22 PM on April 4, 2010


One data point, payments to third parties or other countries are a huge red flag. Why don't you want the money going to you in your own country?

Any money spent on someone working for a government is probably a bribe.

"I would like to put this doctor on retainer." From someone in a pharm company this is really bad.

The hardest stuff is the Enron stuff of keeping expenses off the books. Any decent accountant can hide that stuff so that an auditor can not find it without specific suspicion.
posted by caddis at 6:23 PM on April 4, 2010


First of all, if your gut is "off" about an investment, don't make it. We often ignore our gut for some reason or another, but that feeling serves a purpose. It's evolutionary. It's a product of the surrounding circumstances, and it helps guide our decision making even if we lack any rational explanation. It works.

Second, your general questions. I've worked in this field (uncovering fraud). The type of fraud work we handled was smaller, relatively, than Skilling or Madoff. It was all under 100 million or so per scam, so it was chump change comparatively. (And so I can't really speak about super massive scams you ask about). We saw lots and lots and lots of fraud: mini-Madoff scams (hedge fund ponzi schemes), insurance fraud, credit card fraud, medical fraud, art fraud, real estate investment schemes, etc. etc.

Where did it come from? Angry investors primarily. Either individuals who get screwed, or financial institutions who have been taken for a run. The person making the scam has either made a deal big enough that the higher-ups at the bank are aware of it personally, or they've done some typical action to tip off the bank for a closer review. Large companies, like the major credit cards, have their own Fraud departments that use their own internal methods to combat fraud. There are various different actions that their customers can take that will trigger red flags, and therefore a personal review by someone in the fraud department. Some of these red flags are dictated by statute, others by the banks own internal policies. For instance: by law, a bank MUST look into and report any cash transaction over 10,000. These angry investors take their issues to a prosecutor.

Once some real evidence of a crime has been given to the prosecutor, the investigative work begins in earnest. Usually there's enough evidence for the prosecutor's to begin subpoenaing bank records, and sometimes there's even enough evidence for a search warrant (to get bank records, company financial statements, etc.). Then it's just a very easy game of "follow the money" to wherever it may lead. This is the simple part. You ask about "unraveling corporate shells", and going through complex layers of business entities, but the reality is much more mundane. Fraud crimes are easy crimes to prosecute, because there is a direct money trail. It's like if someone committed a murder but decided that they would plant little markers every five feet along the way. Here's where I purchased the weapon. Here's where I loaded the ammo, etc. etc. In other types of crimes, prosecutors will often need corroborating circumstantial evidence, will rely on witness testimony, etc. With financial crimes, the bank records will speak for themselves.

Like I said earlier, the reality of fraud crimes is more mundane than the romanticized versions found in the media. Most, if not all, of these crimes are not well covered-up. They are committed by people who are in a pinch, need money, and decide to get it by screwing over someone else. Often a friend, family, business associate, or someone they've established trust with. At the time, people committing fraud are usually thinking "Shit, I need money, and I need it now". They aren't planning ten steps ahead to figure out how to try and erase evidence of the financial crime from the financial record. Plus a lot of these people are running ponzi schemes, which require paying off old investors with money from new ones. This leads to a vicious circle of illegal behavior, where you constantly have to run faster and faster to just to keep up. Again, this doesn't lend itself to advanced planning.

So I don't think the game changes when you deal with someone who is very intelligent or motivated. I'm failing to think of any situation where it becomes difficult for prosecutors, and their teams of forensic accountants, to find out if a crime has been committed, once their attention has been brought to the situation. From what I read about in the papers, this was the same deal with Madoff and Skilling. Once someone actually realized that these guys were committing fraud, and someone looked into it, it was clearly fraudulent activity. The problem was just getting the SEC to pay attention in the first place.
posted by HabeasCorpus at 6:32 PM on April 4, 2010 [2 favorites]


I examine fraud suspicions all the time for work witrh the Federal government. The first places I look for signs of fraud are the publicly available documents (like tax or SEC filings) and the internet. I pull the incorporation documents and look for the associated agents' names. Before I ever have to delve into using clearances or access that is only available to be in my official capacity I have usually dredged up all sorts of juicy tidbits that can give me a direction to dig. Agents will be associated with other businesses, accounting won't add up, SEC filings will show something far different from tax accounting or fine print that leads to numerous legal actions or "corrections".
posted by Pollomacho at 4:56 AM on April 5, 2010


I don't know math for jack, but I have read about some interesting finds using expected number distribution.

The idea is that if you are cookin' the books, or darn near anything, really, numbers you come up with ("Yes, a 7.72% return sounds nice and random...") won't be distributed with the same frequency as they would in the real world.
posted by BleachBypass at 2:11 PM on April 5, 2010


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