New England Biz Law Update
Although a large-scale corporate fraud invariably raises numerous “red flags” of wrongdoing within the affected company, management’s failure to stop a fraud sooner is not necessarily the result of corruption or incompetence.
Several valid business practices make it more difficult for in-house counsel, compliance officers, and auditors to detect fraud, particularly when those practices are taken to extremes. In fact, these seemingly innocuous business practices are often “red flags” themselves.
Since these “red flags” are readily accessible, understanding them can help supervisory personnel avoid the traps that foster financial scandals. Better still, by turning these business practices upside down, corporate officers charged with spotting fraud can significantly improve their detection and compliance efforts.
Scrutinize the leaders, not just the laggards
In business, managers typically give profitable business units more latitude than unprofitable ones. It’s only natural to scrutinize the laggards more than the leaders. After all, the leaders appear to know what they are doing, while the laggards have room for improvement.
This understandable business practice can lead to disaster when compliance is concerned. Financial frauds typically occur in a company or a division that is – or at least appears to be – unusually profitable. That’s because the object of any financial fraud is making money, even if it is the result of engaging in illegal transactions, defrauding customers or shareholders, or simply faking the profits.
Since financial frauds generate large profits, they are self-concealing. Often supervisory and compliance personnel mistakenly assume that a profitable business is running smoothly, and manage it more lightly than other units. In other instances the supervision is so minimal that the supervisors seem to suffer from an almost willful blindness. Either way, the profitable company or division gets less attention from managers inside and outside the unit.
But when detecting fraud is concerned, profit is a reason to give a business more scrutiny, not less. To use just two recent examples, plaintiffs and prosecutors have alleged that wildly outsized profits were earned by the accounting firms that sold “abusive tax shelters” and by the hedge funds that late-traded mutual funds.
Perhaps even more poignantly, the options back-dating investigation was spurred by an academic study, which concluded that executives’ option grants were timed so fortuitously that they must have been back-dated.
Unusually consistent profitability is also a warning sign. Perpetrators of accounting and trading frauds typically cause their companies to make or exceed their projections quarter-in and quarter-out, year after year. These unrealistic patterns should lead to skepticism, not credulity.
So, the first rule of preventing a financial fraud is to scrutinize profitable business units at least as carefully as unprofitable ones. Although the laggards obviously have the biggest business problems, the leaders may well have the biggest compliance problems.
Look in the cracks
Another sound business maxim is empowering your personnel. If they are subordinates, delegate to them. If they are coordinate managers, respect their positions on the organizational chart. And if they are specialists, allow them to do the jobs they were trained to do.
But corporate frauds mushroom when delegation degenerates into abdication and specialization devolves into disengagement. Sometimes it’s a matter of a personal style gone amok, with a manager who is “hands off” to a fault. Often the fraud takes place in a new business area where lines of authority are not yet clearly established.
Or perhaps the affected business unit is in a different location, even country, from management, and receives minimal day-to-day scrutiny. For some or all of these reasons, suspicious activity falls “between the cracks.”
This phenomenon leads to a second rule: In-house counsel and compliance officers should focus particular attention on the “cracks” – the new business lines, distant subsidiaries, and segments of the business run by light-handed managers. Compliance officers and in-house counsel are responsible for the whole company.
And while it may be a good business practice to respect the independence of different business units and the competency of employees, the best compliance practice is to concentrate on the areas of the business that are most vulnerable to fraud.
Don’t look at your competitors
Companies regularly conduct industry reviews of their competitors’ practices and benchmark them against their own. Based on this information, companies adopt their competitors’ best practices every day.
Although “benchmarking” is a sound business principle, it can permit and even promote fraud. Questionable transactions typically implicate internal corporate policies, which brings them to the attention of legal or compliance personnel. Business people often justify those transactions by pointing to their competitors’ activities. If apparently reputable companies are engaging in similar transactions, they argue, then surely the transactions must be acceptable.
Time and time again, legal or compliance personnel buy this rationale and approve the transactions, even after carefully reviewing them. The result is that a questionable activity becomes market practice for a particular industry.
Worse yet, competitors “race to the bottom,” modifying an acceptable practice until it crosses the line from aggressive to fraudulent or illegal. This pattern is evident in most industry-wide scandals, with firms engaging in increasingly problematic variants of the transactions in question.
In-house counsel and other supervisory personnel can readily avoid this mistake by recognizing one of the fundamental lessons of the post-Enron era: The prevalence of particular conduct will not be considered an exculpatory or mitigating factor by regulators or prosecutors. If a particular transaction implicates the law, the company’s internal policies, or ethical considerations, the company must evaluate the situation on the merits (or ask outside counsel to do it).
Whether the competition engages in similar transactions is irrelevant. Competition is good for business; it’s not necessarily good for compliance.
Easier said than done
Of course, turning these common business practices upside down is easier said than done. Monitoring profitable business units will engender significant resistance from powerful segments of the company.
Divisions that are accustomed to being independent are certain to balk at close supervision. And it won’t be easy to convince the business people to refrain from transactions that are making money for their competitors.
But in-house counsel and compliance officers should know that these factors are almost always present in major frauds. Armed with this knowledge, they can resist the seemingly innocuous practices that foster fraud and stop corporate frauds before they have catastrophic consequences.
Stephen L. Ascher is a partner at Jenner & Block LLP in New York City. He has represented civil and criminal defendants and institutional plaintiffs in litigation arising out of the major financial scandals of the last decade. He can be reached at [email protected]
