Fraud's Red Flags

Ten signs your company may be fostering a corporate culture conducive to wrongdoing

Directors and CEOs are more concerned than ever about understanding the corporate culture of their companies, and, if necessary, doing something to improve it. The consequences of lapses earlier in the decade that led to the great accounting and options back-dating scandals are still being felt today, both for those who are serving time in "Club Fed" and those serving on public boards.

Outside directors now have a heightened concern about personal liability, partially as the result of the class-action settlements at Enron and WorldCom in which the directors made personal contributions. The result is a greater emphasis on director independence, shorter CEO tenures as boards became quick to fire CEOs for failure to adhere to ethical standards, and a general increase in the importance of the director's watchdog role. Governance rating agencies, regardless of the merit of their ratings, now wield significant influence in director elections and transactions, and activist shareholders are quick to threaten to remove directors for alleged shortcomings in the oversight of management. Accordingly, there is increased pressure to ensure that compliance programs are effective and that employees throughout the organization are behaving ethically.

Almost every article on the subject of governance, compliance, and ethics includes some formulation of the importance of the "tone at the top." All the consultants and gurus stress the importance of leadership by the CEO and the board. These are "empty bottles"—fine principles, but not the sort of concrete, specific ideas that provide a basis for directors and executives to take effective action.

Mission statements and codes of business conduct go only so far as well. They may be good starting points, but the proof is in what the employees are doing and saying day in and day out.

Many boards are holding more frequent and longer meetings. Many are regularly having "executive" sessions without the presence of management. The thrust of these changes is an increase in the openness of communications at the board and committee levels. Some boards are going further and encouraging director communications with senior and middle managers, outside the presence of the CEO. Some boards are also requiring directors to visit company facilities and talk to managers there.

All of these processes are now considered generally accepted practice by many boards, but what separates the boards that take their fraud-detection responsibility seriously are those that focus on fraud's telltale "red flags." Following are some examples of indicators that something might be amiss.

"Red Flags" that Point to Fraud

1. "The old rules don't apply." Most companies encourage creativity and value innovation. One of the most significant risks of the recent increased focus by investors and others on governance, compliance, and transparency is that companies may become less likely to venture into new areas. Yet when it comes to compliance with laws and regulations, and conducting business ethically, the old rules may be the best rules. The latest accounting and tax schemes may or may not be legal; only future cases will tell for sure. The fundamental precepts of ethical behavior have changed very little since the ancient philosophers taught their lessons.

If the allegations against Enron are true, it was a company whose senior executives allowed fraud to thrive under the guise of an innovative business model in which the old rules no longer applied.

Another manifestation of this pitfall is to defend it through hubris. When managers begin to think that they are invincible or can do no wrong, it is time for the board to change policies, managers, or both. When talk turns to a "new paradigm" or "new economy," look out!

2. "It seems too good to be true." How many times do we say this or think it to ourselves? How often does it turn out that it was too good to be true?

One example is MassMutual's CEO's deferred-compensation account.

According to press reports, its phenomenal success was not the result of investment acumen, but rather 20-20 hindsight in allocating portions of the account to hypothetical investments in companies whose shares had already appreciated in value.

Another prime example is the tax shelters purchased by the top two executives of Sprint from the company's accounting firm. The shelters did not merely convert the gain upon exercise of option shares from ordinary income to capital gain and did not just defer recognition, they virtually eliminated tax liability altogether. If the shelters had been successful, imagine how beholden the two executives would have been to the accounting firm. When, as it turned out and might have been foreseen by the board, the shelters failed, could the board expect the two executives to be able to continue to work effectively with the company's accounting firm? Apparently, the company took employment-compensation tax deductions for the amount of the gain on the option shares when the options were exercised, creating just the sort of conflicting positions certain to lead to a serious challenge from the IRS. For both positions to succeed was, of course, too good to be true.

This is not to say that extremely positive results are always suspect, or that seemingly fabulous plans should not be pursued. It is only a reminder for the exercise of common sense and a visit from the resident devil's advocate. When something seems extraordinarily favorable, it bears extra scrutiny.

3. "We will do it just this once." Robbing Peter to pay Paul is still robbery, and it's a slippery slope. The reports from the trials of WorldCom and HealthSouth executives contain numerous examples of this red flag. How many times were lowerlevel managers promised that "reallocating funds" was a one-time necessity? In fact, they were really being asked to falsify financial statements, something they knew was wrong. In so many cases, senior executives made arguments and devised rationales like these for "crossing the line." Often, they argued that the falsifications were necessary to save the company, its share price, or its employees' jobs; in essence, that the ends justified the means. Once funds were reallocated to the current time period, the next period was already behind, and since business trends tend to continue, the next period required an even bigger "reallocation," and so on, until the situation became untenable.

Consider this real-life example of a young mid-level accounting executive: Senior management was excited about his performance and progress and had high hopes for his advancement. The accounting manager and his wife had plans to build their dream home, and he intended to finance it from the sale of option shares which had appreciated substantially. Unfortunately, at about the time he needed the money, the share price had fallen significantly. He found an alternative financing source by setting up dummy vendor accounts in whose favor he approved payments of false invoices. He temporarily avoided telling his wife that they would not be able to build their dream home, but soon had to explain that he had lost his job and might face criminal prosecution. He said he fully intended to repay the money he had "borrowed" from the company, but it was, of course, too late.

This red flag is an indication of selfdelusion, pretense that something known to be wrong is not. If this flag is flying, directors need to restore reality.

4. "Everybody else does it." This is one of the most dangerous red flags because it is so common, and it reflects an utter lack of thought about right and wrong. This is a rationale that is often used to justify accounting practices that may be technically defensible but do not result in "fair presentation" of financial results or conditions.

One of the most ironic examples is the alleged failure by some accounting firms to credit their clients for rebates received for airfare charges for travel on client business. Press reports include several arguments by senior management at the firms explaining why clients should not receive the rebates.

The most common was that it would have been too difficult to determine how to allocate the rebates among clients. This from firms that specialize in cost accounting!? The rebate practice continued at one firm long after a whistleblower sounded an alarm internally. As long as "everyone else was doing it," how could the firm be criticized? The accounting firm learned the answer the hard way.

It is true that some measure of ethical behavior derives from current standards and practices. Hence, the long-standing Wall Street Journal test: Proposed action or inaction is judged by predicting reactions of people reading about it on the front page of the WSJ. One could argue that in an era in which scandals are so prevalent, this test may have become diluted beyond usefulness.

5. "The lawyers, or accountants, said it is okay." Here is another red flag that was apparently flown at Enron and World-Com. You can just imagine how many times at each of these companies some senior or middle manager was told that something was okay because the attorneys, auditors, or boss said so. Yet, in many cases, the person asked to falsify the financial records or pass judgment on the specialpurpose corporations knew better.

One of the many lessons to be learned from the 21st century corporate scandals is that unthinking reliance upon senior officers or outside experts can be dangerous to one's financial security, reputation, and even personal liberty. Sometimes, the representations were true; other times, they were not; and still other times, they were half-truths, misleading at best. So how does the individual employee know when to follow orders and when to ask questions? After all, even though corporations are not the military, they cannot function efficiently if everyone questions every directive. The answer is that there is no substitute for sound judgment and common sense. Each individual employee must bear a measure of personal responsibility, commensurate with his or her position in the company, for knowing right from wrong. After all, stealing is still stealing, even if some corporate officer or outside expert has okayed it.

6. The dating game. The pressures from Wall Street for short-term results at public companies have been much discussed, debated, and written about; I won't belabor them here. According to press reports, those pressures led executives at companies like Adelphia and Computer Associates to back-date contracts to enable the financial impact of transactions to be booked when the company wanted or needed it. In Computer Associates' case, it was reported that even the company's general counsel, who should have known better, was involved. In the many companies at which options were backdated, the temptation to attract employees or reward them proved too much for executives.

There are, however, situations in which parties to a transaction agree that the effective date of the transaction shall be "as of" a certain date, generally one later in time than the date of the agreement. Often the documents are not, and in some cases, cannot be, finalized by the selected date. The documents will be effective "as of" one date, but the document will be signed on a later date.

The difference between one dating situation and another is whether or not there is an intention or reasonable prospect of misleading other affected constituencies, including the company's shareholders, investors, the IRS, the Securities and Exchange Commission, and other regulators. Sure, "gray areas" may exist, but that is why companies pay handsome compensation to their executives for sound decisionmaking, and hefty fees to outside advisers for expert advice. The selection of correct timing for a transaction comes not just from competence and expertise, but must spring from good judgment and common sense.

7. Wives' birthday boondoggles (personal use of company assets) If the press reports are accurate, Tyco is probably the "poster child" for this red flag, but by no means had a monopoly on it.

How many times do we read about top executives using corporate condominiums and jets for personal use? Some of them must figure that if these practices are acceptable, then it is also okay to use corporate cash. Hence, the allegations of looting at Adelphia, Tyco, and many others. The misuse of corporate assets affects not only the corporate "bottom line," it calls into question senior management's judgment and questions their credibility in enforcing the company's code of business conduct and implementing compliance programs. Is it reasonable to expect that middle managers and "rank and file" employees will adhere to rules about use of corporate property when senior executives are openly acting to the contrary? No wonder that employee theft is a natural reaction to this hypocrisy: "If they can do it, so can I."

There is a similar problem with executives' use of their positions to get personal "perks." A good example comes from the press reports of the receipt by WorldCom executives and others of "hot IPOs" from a Wall Street financial firm. (Of course, WorldCom was not the only company whose executives received steady allocations of "hot IPOs" and its investmentbanking firm was not the only one whose brokerage department was allocating them to senior executives at investmentbanking and prospective clients.) The allocations were made to the individuals because of the executive positions they held at the companies. As such, the gains should have been corporate assets. The benefits conferred on the executives were intended to influence their decisions about allocating and pricing lucrative investment-banking business. How could shareholders or employees reasonably expect that the selection and negotiation of fees would be in the best interests of the company, when the senior executives were, in essence, receiving cash from one or more firms that supplied services to the company?

8. Conflicts of interest. Dozens of companies have suffered serious scandals and shareholder revolt because management has had financial interests in enterprises that do business with, or compete against, their company. Just consider the "special-purpose entities" at Enron that created conflicts of interest for the company's CFO Andrew Fastow.

Some argue that "zero tolerance" for conflicts of interest is impractical. Suffice it to say that significant financial interests between senior management, the company, and third-parties represent a strong warning signal to the board for further investigation. It is just human nature that executives' judgment will be affected by their personal interests, no matter how hard they try to avoid it. Moreover, senior managers with conflicts of interest are not in any position to ensure that middle managers and other employees avoid conflicts of interest. It is also no surprise that the pressures on subordinates are so great that they are reluctant to "blow the whistle" on senior management conflicts.

9. Chronic adverse relations with regulators. Some entanglement with federal, state, and local regulators is probably to be expected. Circumstances change, new laws are passed, new regulations are imposed, technology keeps advancing, and some regulators abuse their discretion, occasionally for political purposes. There are plenty of excuses for run-ins with regulators.

How many times have we read about the regulatory problems of the same health care third-party billing systems are complicated, but investors would hope that after a few expensive lessons, management would get the message.

When these occurrences are repetitive and consistently of serious magnitude, it may be a sign that the corporate culture does not place sufficient value on compliance. If the company is perennially "under fire" for infractions that should have been corrected, or if illegalities are "winked at" within the company, board attention is required. A senior management that condones relatively minor infractions will have difficulty holding the line regarding more serious violations. For example, cheating on pollution regulations in order to increase capacity in times of temporary high demand may be tempting because the fines, if levied, will be more than offset by additional income. Once employees learn that it is okay to break some rules, however, they are very likely to slide down the "slippery slope" to more serious and continuing violations.

10. Too many euphemisms. Labels are important. Would we eat as much sushi if it were called "raw fish," carpaccio if it were called "raw beef," or sweetbreads if they were called "organ meat?" The same idea is at work in the business world.

One of the recent reminders of the dangers of euphemisms is the Hewlett-Packard scandal over the investigation by the chairman of the board, of outside directors' alleged leaks of confidential information. It seems unlikely that the company officers who were involved would have proceeded with "pretexting" if it were called "obtaining private, personal information under false pretenses."

Companies often put a "spin" on bad news, when it might be called issuing false or misleading statements. Resume´ "embellishment" might not be rampant if it were called "applicant fraud." Just ask the former CEO of Radio Shack or the former dean of admissions at MIT. "Perks" from suppliers of goods and services might be less frequent and lavish if they were called "bribes." Just ask the employees involved at Jefferies and Fidelity. Company "perks" for executives might be less costly to shareholders if they were called "personal benefits at company and shareholder expense."

The foregoing list and descriptions are not intended to be exhaustive. There are other warning signs of fraud and many more examples of companies where the "red flags" were undiscovered or went unheeded. As CEOs and directors, both new and long-tenured, search for understanding of their own companies' corporate culture, keeping an eye out for these "red flags" can be useful in reaching conclusions or, at least, starting discussions with senior management.

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