How to Identify When Borrowers and Insiders Are Most Likely to Deceive

Introduction: Won’t Get Fooled Again?

Will Rogers hinted at the market for fraud decades ago when he observed, “You can’t fool all of the people all of the time. But it isn’t necessary.” Then, some 50 years ago in 1971, The Who released Won’t Get Fooled Again:¹

Unfortunately, just talking and singing about the problem didn’t really solve it. Twenty-one years ago in 2001, Enron declared bankruptcy, but the consequent criminal convictions of its executives Ken Lay, Jeffrey Skilling, and Andrew Fastow, as well as the collapse of its auditor Arthur Andersen, didn’t stopped more corporate fraud—Tesco, Olympus, Tyco, Theranos, Worldcom, Valeant.² During the slow rebound from the Great Recession, 10 years ago, the RMA Journal published my “Character and Fraud: Protection and Prevention,” based on some fraud presentations I conducted for various RMA chapters.³ Drawing on a study conducted by the Association of Certified Fraud Examiners (ACFE),⁴ I shared its survey of relative effectiveness of fraud prevention tools and its recommendations for helping borrowers to improve their fraud defenses. However, fraud continues and during the COVID-19 induced recession, the Small Business Administration (SBA)-administered Payroll Protection Program (PPP) loans have resulted in numerous frauds as highlighted in the Coleman Reports’ “Fraud Friday” column,⁵ where recent stories report on fraudsters spending loan proceeds to pay off credit card debt, purchase luxury autos, acquire Rolex watches, take Caribbean cruises, and even buy a rare Pokémon card for $50,000.

So, what is this article all about? The pandemic has upped the ante on borrower fraud perpetrated on lenders. What can bankers do to identify, monitor, and prevent possible fraud?

The good news is that the ACFE has published a new 88-page study that offers some new insights on fraud and its prevention.⁶ As you will soon see, the costliest frauds tend to start at the top of the house, and those are the people bankers like to meet. What should you be looking out for?

2,500 SURVEYS + 125 COUNTRIES

$3.6 BILLION IN LOSSES

Fraud Findings: First Come, First Served⁷

The report evaluated over 2,500 surveys from 125 countries adding up to $3.6 billion in losses; fraud losses are estimated to run about 5% of annual revenues. The report’s international scope suggests that the causes and consequences of fraud are universal. As anthropologist Margaret Mead observed, “Always remember you are absolutely unique, just like everyone else.” Here is a brief summary of the report’s findings on factors that contribute to higher fraud risk. They tend to overlap, e.g., tenure and age, position and collusion, etc.:

1. Position
2. Tenure
3. Department
4. Gender
5. Age
6. Education level
7. Collusion
8. Criminal background
9. Employment history
10. Non-fraud related misconduct
11. Human resources-related red flags

1-Position. The fraud perpetrator’s level of authority within an organization tends to strongly correlate with the size of a fraud. Owners/executives accounted for only 20% of the frauds in the study, but the median loss in those cases ($600,000 in U.S.) far exceeded the losses caused by managers and staff level employees. This is consistent with AFCE’s past studies, all of which found that losses tend to rise with a fraudster’s level of authority. Owners/executives are generally in a better position to override controls than their lower-level counterparts, and they often have greater access to an organization’s assets. Both of these facts might help explain why losses attributable to this group tend to be so much larger.

2-Tenure. The longer a fraud perpetrator works for a company, the more damage that person’s scheme is likely to cause. Those who had been with the victim organization for at least 10 years stole a median $200,000, which was four times greater than the median loss caused by employees with less than one year.

4-Gender. More than 70% of the perpetrators in the study were males. Men also caused a significantly larger median loss ($150,000) than women ($85,000). This is consistent with ACFE’s past studies, all of which have found a significant gender disparity in fraud loss and frequency. However, distribution of occupational fraudsters varied based on geographic region. In the United States and Canada, males accounted for 59% of occupational fraud perpetrators, but in Southern Asia, the Middle East, and North Africa, men committed more than 90% of the occupational frauds. The study’s examination of gender distribution and median loss data based on the perpetrator’s level of authority revealed that at all levels of authority (employee, manager, and owner/executive), males committed a much larger percentage of frauds than women did. Male owners/executives and managers also accounted for much larger losses than their female counterparts, especially at the owner/executive level, where the median loss caused by men ($795,000) was more than four times larger than the median loss caused by women ($172,000). At the employee level, however, losses caused by males and females were equal.

5-Age. The age distribution of fraud perpetrators was bell-shaped, with 53% of fraudsters between the ages of 31 and 45. Median losses, on the other hand, tended to rise with the age of the perpetrator. Those in the 56-to-60 and 60+ age ranges together accounted for less than 10% of all cases, but they caused median losses of $400,000 and $575,000, respectively, which were by far the highest losses in any age range.

6-Education Level. The report also found a correlation between the perpetrator’s education level and median loss. Fraudsters with a high school degree or less caused a median loss equal to $80,000 while those with a postgraduate degree caused a median loss of $200,000. Generally, we would expect losses to correlate with education because those with higher levels of education tend to hold higher positions of authority and might also have greater technical capabilities for committing fraud.

7-Collusion. About 51% of frauds in the study were committed by two or more fraudsters working in collusion. Losses tended to increase with multiple perpetrators—particularly when three or more individuals conspired to commit fraud. One reason collusive frauds might be more costly is that multiple fraudsters working together might be better able to undermine the systems of separated duties and independent verification that are critical to many anti-fraud controls.

8-Criminal Background. ACFE’s past studies have shown that most occupational fraudsters have no prior criminal history before they commit their crimes, and this latest study corroborates those findings. However, 41% of the occupational frauds in this study were never reported to law enforcement, which is also consistent with past research. So the true number of repeat offenders is probably higher than what can be determined through criminal records.

9-Employment History. Some 86% of fraudsters had never been punished or terminated for fraud-related conduct prior to the crimes reported in this study. This suggests that most occupational fraudsters are first-time offenders. Still, like the criminal conviction data, this data might understate the true number of repeat fraudsters. To wit: Five percent of fraudsters received no internal punishment, 10% were permitted to resign, and 11% signed private settlement agreements with the victim organizations. Therefore, a significant number of occupational fraudsters will have no record of employment-related discipline even after having been caught by their employers.

10-Non-Fraud Related Misconduct. To determine if there is a correlation between fraud and other forms of workplace violations, survey respondents were asked whether the fraudster had been engaged in non-fraud-related misconduct prior to or during the time of the frauds. Forty-five percent of occupational fraudsters had engaged in some type of non-fraud-related misconduct. The most common was bullying or intimidation (20% of cases), followed by excessive absenteeism (13%), and excessive tardiness (12%).

11-Human Resources-Related Red Flags. In some circumstances, negative events surrounding a person’s conditions of employment, e.g., poor performance evaluations, loss of pay or benefits, fear of job loss, etc., can cause financial stress or resentment toward the employer, which might play a role in the decision to commit fraud. Around 42% of fraudsters had experienced some form of HR-related red flags prior to or during the time of their frauds, and the most common of these were negative performance evaluations (13% of cases) and fear of job loss (12%).

The typical occupational fraud scheme lasts 14 months before it is detected. During this time, the perpetrator will often display certain behavioral traits that tend to be associated with fraudulent conduct. The most common indicators by percentage of cases, according to the report, were:

1. Living beyond means: 46%
2. Financial difficulties: 26%
3. Unusually close relationship with vendor/customer: 19%
4. No behavioral red flags: 15%
5. Control issues, unwillingness to share duties: 15%
6. “Wheeler-dealer” attitude:13%
7. Divorce/family problems: 12%
8. Addiction problems: 9%
9. Complaints about inadequate pay: 8%
10. Refusal to take vacations: 7%
11. Excessive pressure from within organization: 7%
12. Past employment-related problems: 6%
13. Social isolation: 6%
14. Complaints about lack of authority: 5%
15. Past legal problems: 5%
16. Excessive family/peer pressure for success: 4%
17. Instability in life circumstances: 4%
18. Other: 4%

Significantly, all these red flags had been identified by someone in the respective victim organizations before the frauds were detected. At least one behavioral red flag was present in 85% of the cases in the study, and multiple red flags were present in 49% of cases.

At least one of the seven most-common red flags had been identified before the perpetrator was caught in 76% of all cases. At the very least, managers should be aware of the longer red flag list and especially the top seven red flags.

An Ounce of Fraud Prevention or a Pound of Fraud Cure?

It is in the lender’s interest to ensure that a borrower has a fraud prevention program in place. Here are seven key components that a lender might suggest:⁸

1. Start at the top. The board of directors and executive management must set the tone.

2. Educate the staff. Employees must be trained to understand which types of behavior or acts constitute fraud, how costly it is to the firm, and how to report suspicious activity.

3. Change the culture. First- and second-generation companies may find it easier to make their cultures more fraud-intolerant than more established firms because employees in younger companies usually have more of a personal stake.

4. Conduct surprise audits. The ACFE reports that companies that conduct surprise audits tend to have lower fraud losses and usually detect fraud more quickly. Fraudsters commit fraud if they think they will not get caught.

5. Check employee backgrounds. Human resources should confirm all work history and education claimed in an applicant’s résumé and contact references. The ACFE recommends that new and current employees’ compliance with company ethics and anti-fraud programs be incorporated into performance reviews.

6. Prepare a data-breach response plan. Information loss and data breaches are now the most common form of fraud, so it is critical to implement a response plan for these events. In preparation, get answers to the following questions: Who will regularly review information policies and procedures, and who will monitor and test the physical security of the information assets? Government regulations have raised the penalties for firms that fail to protect their data.

7. Make sure the board of directors focuses on fraud. Corporate boards are held accountable for risk management and fraud. The board should be monitoring the firm’s fraud prevention controls, demanding explanations for fraud incidents, and requiring fixes for fraud losses.

Summary and Closing: Verify Before You Trust?

The ACFE continues its efforts to guard against fraud and mitigate fraud risk. There is plenty of anecdotal evidence that the pandemic recession and turbulent economy have stressed both organizations and individuals. As Abe Lincoln noted, “Nearly all men can stand adversity, but if you want to test a man’s character, give him power.” A recent study finds that corporate financial managers do a great job of detecting signs of potential fraud but are less likely to voice these concerns externally when their company is under pressure to meet a financial target. The researchers also found that two other variables played a significant role: Executives who had been with their company for a longer time were more likely to keep quiet about their concerns, and CFOs who came from a finance or banking background were much less likely to go public with their concerns than CFOs with accounting backgrounds.⁹

A banker doesn’t need to be an internal auditor or a certified fraud examiner to conduct a basic fraud risk review of a potential or existing borrower. A lender should be aware of the basic elements of fraud risk—position, tenure, department, gender, age, education level, collusion, etc. Not so coincidentally, a borrower’s chief financial officer tends to be highly educated (perhaps an MBA or master’s in finance), hold a powerful position (reports directly to the president or CEO), and manage potentially collusive accounting and financial employees (the heads of the finance, accounting, or internal audit department).

So, while you are there, why not ask about the organization’s fraud prevention program? If there isn’t one, slide this article across the desk and suggest management take a look at the seven-point fraud prevention program outlined in the previous section. Remember the fraudster’s favorite quote from Groucho Marx: “The secret of life is honesty and fair dealing. If you fake that, you’ve got it made.” You can counter that advice with this observation from Mark Twain: “If you tell the truth, you don’t have to remember anything.” All you have to remember is to verify before you trust.

Notes