Global Fraud Report 2007-2008


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Kroll commissioned The Economist Intelligence Unit to conduct a worldwide survey on fraud and its effect on business during 2007.

A total of 892 senior executives took part in this survey. A third of the respondents were based in Europe, 32% in Asia-Pacific and 30% in North and South America. Ten industries were covered, with no fewer than 50 respondents drawn from each industry. The highest number of respondents came from the financial services industry (18%) followed by professional services (11%) and manufacturing (11%). Fully 38% of the companies polled had global annual revenues in excess of US$1billion.

This report brings together these survey results with the experience and expertise of Kroll and a selection of its affiliates. It includes content written by The Economist Intelligence Unit and other third parties. Kroll would like to thank The Economist Intelligence Unit, Dr. Paul Kielstra and all the authors for their contributions in producing this report.

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Global Fraud Report 2007-2008

  1. 1. Annual Edition 2007/2008Global Fraud Report Global and local issues discussed. Sector by sector analysis. Economist Intelligence Unit overview. Prevention, detection & response.
  2. 2. Kroll commissioned The Economist Intelligence Unit to conduct aworldwide survey on fraud and its effect on business during 2007.A total of 892 senior executives took part in this survey. A third of therespondents were based in Europe, 32% in Asia-Pacific and 30% in Northand South America. Ten industries were covered, with no fewer than50 respondents drawn from each industry. The highest number ofrespondents came from the financial services industry (18%) followed byprofessional services (11%) and manufacturing (11%). Fully 38% of thecompanies polled had global annual revenues in excess of $1billion.This report brings together these survey results with the experienceand expertise of Kroll and a selection of its affiliates. It includes contentwritten by The Economist Intelligence Unit and other third parties.Kroll would like to thank The Economist Intelligence Unit, Dr. Paul Kielstraand all the authors for their contributions in producing this report.Please note that some of the names and events have been changedin Kroll case studies to prevent identification of subjects and clients.While every effort has been taken to verify the accuracy of this information,neither The Economist Intelligence Unit Ltd., Kroll nor their affiliates can acceptany responsibility or liability for reliance by any person on this information.© 2007 The Economist Intelligence Unit and Kroll. All rights reserved.
  3. 3. CONTENTSGlobal Fraud Report INTRODUCTION ......................................................................2 CONSUMER ............................................................................22 Brand integrity: CHAIRMAN’S VIEW ...............................................................3 Anti-counterfeiting, piracy and tainted goods .....................22 The sharp rocks under the water .............................................3 CONSTRUCTION ...................................................................24 EIU OVERVIEW........................................................................4 Audits, screening, and expertise help to build integrity .....24 The Economist Intelligence Unit overview ..............................4 Transparency is the key to monitoring the supply chain...................................................25 FINANCIAL SERVICES ............................................................6 Red Flags: Identity theft prevention: A looming requirement................6 Behavior that may reveal problems .......................................26 Operation Malaya: Corruption in the Spanish real estate sector ...........................7 FRAUD VULNERABILITY ....................................................27 Private equity, hedge funds and emerging markets: Where business is feeling the heat ........................................27 Playing risk for returns ..............................................................8 Alternative securities: EMERGING MARKETS ........................................................28 Opportunity for fraud and reward ..........................................9 The investment herd stampedes into Lagos: Dangers of fraud in a booming market ................................28 PROFESSIONAL SERVICES .................................................10 The impact of United States regulation on Preventing risk in the people business ..................................10 other countries .........................................................................29 Culture, compliance and China...............................................30 MANUFACTURING ...............................................................11 Procurement data can help fight fraud.................................11 FRAUD PREVENTION ..........................................................31 A proactive strategy for operational risk ..............................31 HEALTHCARE, PHARMACEUTICALS Human resources: & BIOTECHNOLOGY ...........................................................12 The frontline in protecting your business .............................32 Hijacking pharmaceutical brands: Protecting your investments ...................................................33 A study ......................................................................................12 Counterfeiting in the pharmaceutical industry: FRAUD DETECTION .............................................................34 Ten pieces of advice .................................................................13 Up to the top: Financial statement fraud..............................34 TECHNOLOGY, MEDIA & TELECOMS ............................14 Protecting data sources from internal theft .........................35 Machinations in the Japanese entertainment industry .......14 Making employee hotlines work............................................36 Old-fashioned fraud: FRAUD RESPONSE ...............................................................37 A case study from China ..........................................................15 Investigative tactics under scrutiny in the United States .....37 NATURAL RESOURCES .......................................................16 Who is taking responsibility for losing sensitive data? ........37 Challenging corruption in the energy sector ........................16 U.S. Government increases controls over contractors ..........38 Profiting from stolen information .........................................39 TRAVEL, LEISURE & TRANSPORTATION .......................18 Unique profile of the airline industry ....................................18 KROLL CONTACTS ...............................................................40 The gambling industry and money laundering ....................19 KROLL SERVICES ..................................................................41 RETAIL, WHOLESALE & DISTRIBUTION ........................20 Commodity trading and shipping fraud................................20 Working out weak points can pay off ...................................21 Kroll Global Fraud Report | 1
  4. 4. INTRODUCTIONIntroduction T he risk of fraud is a part of doing mature economies and markets. While the business. It can even be considered a belief often exists that fraud and corruption consequence. No further evidence is are greatest in foreign cultures or emerging needed than a glance at the business markets, the largest frauds in history have section of any major newspaper any day of taken place in the developed world, in the week. The appearance of fraud at a economies with highly evolved legal and company is not necessarily, or even usually, regulatory systems which exact severe a sign of negligence or ethical laxity at the penalties against fraudsters. Both top. It is instead often the result of large, companies and investors logically tend to complex organizations doing business in be more cautious and vigilant when many different venues, currencies, legal examining business operations or frameworks, and cultures, often at the same opportunities in countries which are time. This context creates severe challenges unfamiliar to them. But sometimes they for today’s managers, legal counsels, and forget that just like car accidents, most compliance officers, who must be all-seeing fraud occurs close to home. and all-knowing, and never sleep. It may be that fraud is perceived as more While frauds have existed throughout prevalent in emerging markets. But without history, one might argue that the risks of doubt the severity of it – the cost, and the fraud for business are greater today than in reputational impact – is as high, or higher, the past. Recent events, be they the in developed economies. bankruptcies of once fabled companies This first annual Global Fraud Report such as Enron or Worldcom, the presents the collective knowledge of some manipulation of the financial system byAndrés Antonius is President of Kroll’s Consulting of the world’s most talented and diligentGroup and previously occupied high ranking drug traffickers and terrorists, or the fraud fighters. Kroll’s team of experts ispositions in the Mexican Government. He holds a emergence of complex derivatives, have composed of top forensic accountants,Ph.D in Economics from Harvard University heightened the sensitivities of authorities, computer forensic and IT specialists, regulators, and the investing public. Even former leading prosecutors, regulators, law the whiff of a fraud may sometimes be enforcement and intelligence officers, and sufficient to place a company under severe some of the most distinguished scrutiny or in financial distress. investigative journalists in the market. However challenging this context may be, They represent decades, if not centuries, strategies exist to minimize the risks in any of experience in fraud prevention and given industry or situation. All of them detection. And the diversity of their skill have a common starting point: the explicit sets and international backgrounds means and declared intent by management to that they can effectively address any make fraud detection and prevention a top situation in any locale in the world. corporate priority. Any strategy which fails The Global Fraud Report also contains a to emphasize this point will necessarily be fascinating survey carried out by The limited in its success. Economist Intelligence Unit which provides Edmund Burke famously said “The only insights into the frauds that have the most thing necessary for the triumph of evil is impact on companies around the world for good men to do nothing.” In the fight and the top risks that today’s managers against fraud, complacency is often the perceive. One survey result that stands out biggest obstacle. Complacency regarding is that while internal financial fraud was fraud arises for many reasons, but mostly reported as one of the most pervasive and because some see the inevitability of fraud frequent types of fraud, it was not considered occurring as evidence that it cannot be as important a threat as information theft, prevented. This confusion may itself create money laundering, or the theft of physical an atmosphere of tacit acceptance, or at assets. Is this not itself evidence of the least one in which the questioning of complacency we must avoid? certain decisions or transactions is frowned upon and seen as an impediment to doing business, when in fact it is often the opposite. Complacency is also sometimes paradoxically the result of operating in ANDRÉS ANTONIUS2 | Kroll Global Fraud Report
  5. 5. CHAIRMAN’S VIEW traditionally had opaque financial systems.The sharp rocks The sheer growth of these economies provides a greater opportunity for corruption, false accounting, and other aberrational activities. The controls areunder the water under greater stress, the pace of activity is more intense, and the reward system often based on output and profitability rather than controls and ethical behavior. The multinational corporations and various IT crimes and false reporting by institutions that plan for further expansion asset managers, were rarely seen 25 years in emerging markets need to devote a ago. The expansion of economies and greater share of their control efforts to dramatic increases in liquidity have also certain major risks: opened the door to problems becoming more substantial, based on scale and the ࡯ Corruption is endemic in some countries speed of activity. Fraud occurs to a far and it will take many years for that to greater extent away from the home office change. The recent rise in the number of Foreign Corrupt Practice Act (FCPA) cases and more distant operations create a in the U.S. is a testament both to disproportionate number of incidents. increased activity by law enforcement as Controls are more difficult to regulate and well as to intense competition for there are fewer people “minding the store” markets. Further complicating these in these remote locations. The examples in cases is the wide variation in the extent the 1990s included Daiwa, Sumitomo, of the rule of law in BRIC countries. China Barings, and Bre-X. These all occurred at a has historically had weaknesses in its distance from the home office, although judicial system but it is progressing, as is fraud can also be perpetrated at the center. Russia. Brazil and India are much further Much of today’s effort to control exposure along the road toward established legal to fraud is driven by administrative systems, but allegations of judicial regulations, accompanied by criminal corruption remain common. enforcement. As the stakes have gone up, ࡯ Second, there is a broad-based effort in many societies have increasinglyRecent months have shown that criminalized activities that 25 or 30 years certain countries to misappropriate theturbulence in financial markets ago would have been dealt with intellectual property of the companiesreveals rocks at the bottom of the administratively, such as accounting that developed it. The lack of a properstream. They have always been restatements and insider trading. The legal system is aiding this type of fraudthere, but only when the water policing of these matters has often arisen and alternative deterrents will have to belevel drops do the sharp edges developed. Counterfeiting is only one from new laws, such as Sarbanes-Oxley andbecome exposed. aspect of the problem, but it is becoming related rules, which came about as a direct more perilous as pharmaceuticals andF inancial instruments that are overly result of some of the more notorious frauds critical equipment are being copied. complex and not understood by many, that were uncovered from 2000 to 2003 These counterfeits can kill and in recent unregulated players and the such as those at Enron, WorldCom, Ahold, months China has begun to address thecreditworthiness of counterparties in Parmalat and others. As one can see from issue slowly.certain sectors have already been exposed the results of our commissioned survey andas major vulnerabilities. Numerous frauds recent headlines, institutional exposure to ࡯ Third, there is a continuing series of IT-will be uncovered at a time like this and fraud does not seem to be lessening despite based frauds that will multiply and causethen the finger pointing will begin. As substantial increases in oversight activity more substantial damage. Theseusual, the presence of fraud emerged once both internally and by third parties, such exposures range from ID theft,the water level dropped precipitously. as the audit profession and specialized misappropriation of assets andThroughout the 35-year history of Kroll Inc., organizations such as Kroll. information, wholesale financialour mission has been to help our clients embezzlement and the manipulation of As we look ahead, it is clear that theachieve greater transparency and a deeper accounts or even trading systems. increased use of information technologyunderstanding of the underlying facts in a tools combined with dramatic growth in Technology, as my friend Sir Martin Sorrellrange of situations and to assist with the world economy will lead to more recently said, is our “Frenemy.” It can be thesolutions. challenging times. Nowhere will the effect tool which is used to commit the act or toWhen one reviews some of the results from be greater than in the newly developing unearth the crime. I hope we will use ourthis latest survey on fraud, it is clear that markets where growth continues to be very resources to train and our technology tocertain types of exposures have increased significant. The culture of these societies, arm against the constant threat of fraud inand that all of the old ones persist to some best epitomized by the BRIC countries the As our society has become more (Brazil, Russia, India, China) will bereliant on information technology, challenging, if profitable, for a newincreased globalization and greater generation of entrepreneurs. We should payinterconnectedness, certain exposures have particular attention to the integrity of theexpanded right along with them. financial information since manyDramatically new frauds, such as ID theft, companies in these economies have JULES B. KROLL Kroll Global Fraud Report | 3
  6. 6. EIU OVERVIEW business in general and within particular industries, and to explore the approaches that companies take to minimize their exposure to these threats. The findings are based on a survey, commissioned by Kroll, of nearly 900 senior executives worldwide, 40% of whom are C-level, or board-level executives. The key findings include the following: Corporate fraud is a serious, widespread challenge that takes multiple forms: ࡯ In the past three years, four out of five firms have suffered from some form of corporate fraud. Particularly widespread is the theft of physical assets or stock, which was experienced by 34% of surveyed respondents, while one-fifth of firms suffered from information theft, management conflict of interest, financial mismanagement, internal financial fraud, procurement fraud, and corruption and bribery. ࡯ Over the same period, the average damage from corporate fraud among large companies – defined as those with an annual turnover of more than $5 billion – was more than $20 million, with about 1 in 10 losing more than $100 million. ࡯ The theft of, loss of, or attacks on information are a major concern, with 20% of respondents describing themselves as highly vulnerable here and 31% believing that IT complexity has increased their exposure to fraud. ࡯ More generally, nearly half of companies rank themselves as at least moderately vulnerable to a very wide range of threats: regulatory or compliance breach (50%); management conflict of interest (49%); financial mismanagement (49%); procurement fraud (47%); theft of physical assets (47%); corruption and bribery (46%); and intellectual property (IP) theft (45%). The prevalence of corporateA lthough often reluctant to discuss it, Industries also vary in terms of the extent almost every business will at some to which they are addressing the problem. fraud has held steady recently, point have been the victim of For example, financial services which, given but new business models drivencorporate fraud. The extent to which the nature of their business, face especially acute threats from internal financial fraud by globalization are increasingindustries experience different categoriesof corporate fraud varies according to the or money laundering, are obliged from a exposure at most companies:nature of their business. For example, regulatory perspective to demonstrate that they have strong controls in place. Less ࡯ Respondents are divided as to whethercompanies that deal with physical assets, heavily regulated industries may not have corporate fraud is on the increase.such as consumer goods and retail, are this impetus, but they nevertheless are Roughly one-third of those surveyed thinkmore likely to suffer from the theft of likely to adopt some measures – whether that the prevalence has stayed the same,physical assets or supplier fraud. financial controls or information one-third say that it has increased, andMeanwhile, those that operate in the technology (IT) security – to prevent or one-third say that it has decreased.“knowledge economy”, such as professional detect fraudulent or technology, are more likely to be ࡯ Eighty-one percent of firms report thatconcerned about information theft or The objective of this report is to examine their exposure to corporate fraud hasintellectual property issues. the problem of corporate fraud, both for grown.4 | Kroll Global Fraud Report
  7. 7. EIU OVERVIEW࡯ The most frequent cause of this increased (28%), Western Europe (18%), and North The frequency of the most exposure is high staff turnover, which is America (14%). widespread types of corporate cited by 32% of respondents. Close behind ࡯ Regional variations with intellectual fraud, and those giving rise to are complex IT arrangements (31%), entry property theft and counterfeiting are into new markets (28%) and increased closely linked to countries rather than the most concern, vary relatively collaboration between firms (26%) – all of regions. Among firms operating in the little by region: which are factors that are closely tied China, 38% have experienced such fraud with modern business practice. Entry into ࡯ Theft of physical assets was reported by in the past three years, compared with new markets is of particular concern for between 32% and 40% of firms in all just 14% in rival developing economy larger firms (38%). India. The latter compares favorably regions. with the overall figure of 19%, and even ࡯ Between 24% and 31% of companies hadCompanies treat corporate the 9% reported among Canadian and suffered information attack in most U.S. respondents. That one in eleven areas, except North America (16%) andfraud as largely a financial firms in the latter still suffer from this Latin America (18%).and IT issue, but too many are problem, however, speaks of relativeinsufficiently prepared for rather than absolute success inthese and other risks: addressing it.࡯ Most businesses (58%) give the internal Percentage of companies affected by IP audit/finance function the lead role in dealing with corporate fraud. The most theft in last 3 years in selected countries widespread strategies used to combat the problem are financial controls (used in % Affected 0 5 10 15 20 25 30 35 40 this respect at 79% of firms) and IT China security (70%). This approach makes Overall Average sense, as many of the biggest fraud Italy problems relate to finance and technology. Germany Singapore࡯ The same numbers suggest, however, that a surprising 21% of firms do not use India financial controls for this purpose and United States 31% do not use IT security. Malaysia Canada࡯ These strategies also only indirectly Australia address the most frequent form of United Kingdom corporate fraud – theft of physical property – against which only two-thirds of firms have measures in place to protect themselves. Percentage of companies suffering from various types of frauds in last 3 yearsAlthough this report focuses % Affected 0 5 10 15 20 25 30 35 40on differences in corporate Theft of physical assetsfraud between sectors, certain Information theft, loss or attackrisks are far more strongly Management conflict of interestcorrelated with company size Financial mismanagementand location: Vendor, supplier or procurement fraud Regulatory/compliance breach࡯ Larger companies are obviously bigger Corruption and bribery targets. On average, they lose six times Internal financial fraud or theft more money to corporate fraud than IP theft, piracy or counterfeiting smaller ones. Money laundering࡯ The extent of corruption and bribery varies widely from one region to another. The proportion of firms that has recently suffered from it in the Middle East and Percentage of companies suffering from Africa (39%) is by some distance the corruption/bribery in last 3 years by region highest. But more than twice as many Eastern European respondents have % Affected 0 5 10 15 20 25 30 35 40 experienced the problem than those from Middle East and Africa Western Europe, (14%), and more than Eastern Europe three times as many from Latin America Latin America (29%) as from North America (9%). Asia-Pacific࡯ Internal financial fraud shows a similar Western Europe geographic pattern: Middle East and North America Africa (46% of firms), Eastern Europe Kroll Global Fraud Report | 5
  8. 8. FINANCIAL SERVICESIdentity theftprevention:A loomingrequirement? ࡯ Detect these red flags in connection withI dentity theft is a rapidly growing released a proposed new federal rule, problem for financial institutions and commonly known as the “Red Flags Rule”. the opening of an account or activity in their customers. More than 600,000 The proposal, if adopted, would require any existing account;consumers become victims each year in the financial institutions to put in place a ࡯ Assess whether these detected red flagsU.S. alone, and four of the top five techniques written identity theft program emphasizinginvolve financial services: opening new the detection, prevention, and mitigation of prove a risk of identity theft;credit card accounts; using existing ones; this crime. The program would have to ࡯ Mitigate this risk as appropriate for itsopening new deposit accounts; and contain reasonable policies and procedures degree;obtaining loans. Financial institutions will to address the risk of identity theft in order ࡯ Train staff to implement the Red Flagincreasingly absorb much of the economic to protect customers as well as the bank. Program;loss from this kind of fraud. The proposal outlines, in some detail, 31 ࡯ Oversee service provider arrangements;In the past, many banks have not involved patterns, practices, and specific types ofthemselves, other than to sympathize with activity that should raise a “red flag”, signaling ࡯ Specifically for credit and debit cardaffected customers. Even as the frequency a risk of identity theft in connection with an issuers, develop policies and proceduresof identity theft issues has risen, many existing account or the opening of a new one. to assess the validity of a request for abanks have thought it sufficient to assist change of address followed closely by a The proposal would require financialvictimized customers by giving them request for additional or replacement cards. institutions to:telephone numbers to call, directing themto the appropriate credit bureau agencies, ࡯ Verify the identities of persons opening How do financial institutions feel about thisor providing other advice on what the accounts; proposed rule? Not surprisingly, in the wakecustomers could do for themselves. of the U.S. A Patriot Act, further compliance ࡯ Identify red flags relevant to possibleIn July 2006, however, the United States risks of identity theft which could harm burdens have not been well received,federal financial institution regulatory customers or the safety and soundness especially when some already form part ofagencies and the Federal Trade Commission of the institution or creditor; Customer Identification Programs. In addition to the outlined obligations, there REPORT CARD FINANCIAL SERVICES will undoubtedly be additional information Financial Loss: Average loss per company over past three years: U.S.$14.6m (218% of average) security burdens as well. Prevalence: Percentage of companies suffering corporate fraud loss over past three years: 83% Increase in Exposure: Percentage of companies where exposure to fraud has increased: 83% Happy or not, although the rule has not Areas of High Vulnerability: Information theft, loss or attack (26% of sector firms indicate been finalized, financial institutions are on that they are highly vulnerable) • Management conflict of interest (18%) notice of what some agencies contend Areas of Frequent Loss: Regulatory or compliance breach (29% have experienced in past three years) Internal financial fraud or theft (28%) • Information theft, loss or attack (27%) • Theft of physical assets should be minimum standards. Institutions or stock (26%) • Financial mismanagement (23%) • Management conflict of interest (23%) should be taking steps now to prepare % 0 10 20 30 40 50 60 70 80 90 100 programs that will prevent the theft of Corruption and bribery customers’ identities. It is ultimately a Theft of physical assets or stock small price to pay for maintaining their Money laundering own safety and soundness while building Financial mismanagement loyal customer relationships and Regulatory or compliance breach implementing strong prevention programs. Internal financial fraud or theft Information theft, loss or attack Liz Marchese is a director in Miami. She has over 20 Vendor, supplier or procurement fraud years of banking operations, security and compliance IP theft, piracy or counterfeiting experience, most recently at Union Planters Bank. Management conflict of interest She has served three times as president of the Financial Institutions Security Association (FISA) and Highly vulnerable Moderately vulnerable Minimally vulnerable Don’t know/Not applicable is a qualified expert witness.6 | Kroll Global Fraud Report
  9. 9. FINANCIAL SERVICESCASE STUDY EIU SURVEYOPERATION MALAYA: Corporate fraud at financial services companiesCorruption in the Spanish is a very expensive problem. The particular forms that it takes result from three features of the sector: that it deals with moneyreal estate sector itself; that this is held largely in an electronic form; and that sector activities are closely regulated.S ince the beginning of the 1990s, Spain’s ࡯ The loss per firm is $14.6m, well over twice “economic miracle” has brought an the average for all industries and the exponential increase in investment highest in our coastal areas. Marbella, the world ࡯ Increasingly complex informationfamous tourist resort of the international technology has left 43% of respondentsjet set, has seen money, mostly foreign, more exposed to risk. Consequently 27%pour into real estate. Sumptuous villas have suffered from information theft inhave appeared, accompanied by the rapid, the past three years, and 28% considerdisorderly spread of houses, apartments themselves highly vulnerable to this most widespread worry for the sector.and commercial centers. ࡯ In practice, regulatory and complianceThe frantic activity of real estate breaches make up the most commonpromoters, backed by flexible and problem, having affected 29% of executives and owners of some of the companies. This risk represents an area ofinventive banks, has driven growth by companies with which our client had high vulnerability for 17% of respondents.allowing Spaniards to think that they wanted to work. Following our report, our ࡯ Money laundering is understandably awere making safe investments. particular problem in financial services,Speculators, however, helped by client was able to find other partners and although less common than the othersinadequate regulation, brought with them his only loss was a few months’ time. discussed. More than one in ten firmsmoney laundering, corruption, coastal Without the due diligence study, he consider themselves highly vulnerable to itand environmental devastation and would probably now be trying to explain and a similar number have actuallyexploitation of limited natural resources to a judge and to the press his presence suffered from it in the past three years. as a shareholder of some of the indicted Given the attention that governments,such as water to build golf resorts. businesses. regulators and security agencies pay toThe Importance of Due Diligence illicit cash flows in the post 9/11 world,In this context, an important foreign The Mechanism: Land Rezoning these figures are far too high. Failure here Operation Malaya exposed the fraud risks will attract little sympathy or leniency.institutional investor asked Kroll to assist that can be involved in the real estate ࡯ Internal financial fraud is significantlyhim in a due diligence study of certain sector when certain conditions are more common, hitting more than one-major construction companies in the quarter of firms, but theft of physicalregion with which he hoped to form an present. A generally positive perception of property is rarely a problem. The assetongoing relationship. We found, mainly real estate development – along with a worth stealing in this industry is moneythrough documentary analysis, that some lack of clear rules and scrutiny – allowed rather than stationery.of these firms did not have a clear politicians and developers to illicitly split The sector is working harder than most tobackground – incomplete accounts, overly the gains from real estate sales in combat corporate fraud, but could do more.rapid growth, lack of long-term personnel exchange for construction licenses and ࡯ The use of most anti-fraud strategies is far– and that some were too close to local rezonings of protected land. Construction more widespread within financial servicespoliticians. We concluded that there was firms paid huge amounts to politicians, than among other businesses. For knowing that an extraordinarily receptive example, 85% use financial controls toa serious risk that these companies might market would pay any price for houses, combat such problems (compared with anbe involved in improper business practices, average of 79%); 80% use IT securityand advised our client accordingly. commercial centers and resorts. To make measures (compared with 70%); and 69% things run smoothly, all such use staff background screening (comparedThe biggest difficulty was explaining to arrangements were handled through one with 57%).our client why our findings were of the Town Hall’s advisors, who was in ࡯ Formal risk management systems are moresufficient to cause him concerns complete control of real estate operations than one-and-a-half times more commonregarding his investment. He wanted hard in Marbella. Although citizens suspected in this sector than overall.evidence, while we had strong indicators. corruption existed, the magnitude of the ࡯ Financial services companies are muchOur professionals met with the client and scheme once fully exposed left more likely to plan to invest in financialeventually he understood our position. indignation and bewilderment. controls, IT security and management controls to combat fraud than theirIn March 2006, less than one month after Due diligence, even if it does not produce counterparts in other sectors.we delivered the report to our client, a smoking gun, can make clear which ࡯ However, although 85% of firms useOperation Malaya made national and companies to avoid and why. financial controls against fraud, this meansinternational headlines. After a year-long that nearly one in six financial servicesinvestigation, police arrested most of firms do not. In this industry, such Alessandro Nurnberg is a senior arrangements should be second nature,Marbella’s city government on charges of director in Madrid specializing in and would help with some of the biggestcorruption, money laundering, and investigations into offshore vulnerabilities.several other offenses. The operation structures. He previously worked as a tax and legal advisor for TS Group The financial services industry is workingcontinued in other Spanish regions, in Lugano, Switzerland and later much harder than most but, given theincluding most of the South, Madrid and financial and legal costs of failure, it needs advised clients on M&A, public salethe Basque Country. As a result, 86 people offers and fiscal offshore structures at Ernst & Young. to do even more.are undergoing trial, among them the Written by The Economist Intelligence Unit Kroll Global Fraud Report | 7
  10. 10. FINANCIAL SERVICESPrivate equity, hedge funds and emergingmarkets: Playing risk for returnsY ou cannot pick up a newspaper today Credit Suisse Tremont Hedge Fund Index, January 2007 without seeing an article that HEDG Emerging Markets 36 Months ending November 2006 35,000 175 discusses a new hedge fund, a new Growth of USD100*investment strategy, incredible returns, and 30,000 Assets (USD) in Emerging Markets Sector 150the successful bets against the market thathave made an unknown manager famous. 25,000 125 Growth of USD100 Assets ($mil)Around the world, hedge funds are seeing 20,000 100tremendous capital inflows: In Q1 2007these totaled an estimated $60 billion, four 15,000 75times the figure for Q4 2006.1 Total assetsnow are usually estimated at around $2 10,000 50trillion, with some putting the figure as 5,000 25high as $3.5 trillion.The attraction is simple: Historical returns 0 0 Aug-04 Aug-05 Aug-06 May-04 May-05 May-06 Nov-03 Nov-04 Nov-05 Nov-06 Feb-04 Feb-05 Feb-06for hedge funds have bested nearly everyother investment opportunity. The newsfrom emerging markets is even better: * Performance of the Credit Suisse/Tremont Hedge Fund Index (Emerging Markets sector) if one had invested $100 at inception of the graphReturns in Q2 2007 averaged around 9.7%according to Morningstar, Inc., and inrecent years such investments have seen past year the University of Texas, Harvard Composite Stock Price Index. While its20% growth. Consequently, hedge funds University, and other schools have managers were highly regarded, investorsfocused on emerging markets have announced plans to increase their questioned the soundness of the fund’sexploded from $2.6 billion in assets under allocations in emerging market funds. internal risk controls. Last year, Charlesmanagement in 2003 to nearly $32 billion Schmitt, the Hong Kong-based head of theby late 2006, according to a recent Credit The performance has also, however, CSA Absolute Return Fund, was sentencedSuisse report (Chart 1). compounded risk: An increasingly large to four and half years in prison for number of funds flush with capital are channeling over $190 million from investorsSuch performance has attracted a broad competing over a limited number of into shell companies administered on hisarray of investors including endowments investments. A larger number are very behalf, some of which were used to pay hisand state pension funds. Endowments and young and headed by managers with little personal expenses, which included astate pension funds continue to expand to no track record. Low barriers to entry Hawaiian home.their holdings into hedge funds andalternative investments in emerging and low thresholds of regulatory oversight Funds investing in emerging marketsmarkets. By March 2006, the California continue to allow new funds to proliferate. require extra due diligence. Investors,Public Employee Retirement System had Many are small – over half have fewer than particularly institutional ones, mustinvested more than $300 million in a 10 employees – and depend heavily on only undertake responsible efforts to understandvariety of Asian hedge funds, and in the a few people for their performance, driving with whom they are doing business and up operational risks. the types of investments being made. With the amount of capital such institutional A few simple questions may help More problematic still, although China, India, investors bring to the table, they are in a protect the investor from fraud: and Brazil still draw interest, the race to keep unique position to pressure fund managers ࡯ Was the investor introduced to the returns high has pushed some funds into for additional transparency and manager/investment opportunity riskier investments in “new emerging information about the fund’s operations, through trusted sources? markets” such as Colombia, Angola, Vietnam, performance, and risk controls. and Mongolia. Investors in these markets ࡯ Does it all sound too good to be true? Adequate due diligence is a cost of doing have to be prepared to guard against business in any market, especially an ࡯ What impressions did the investor corruption and unpredictable political and emerging one, and should be viewed as part get when meeting with the hedge economic climates. Those buying into the of the investment, not a sunk cost. It is fund management team? funds, however, may have little knowledge certainly cheaper than undertaking of where their money is going. litigation, chasing assets, and repairing ࡯ Were they candid and helpful? While the news is dominated with stories reputations after a failed investment. ࡯ Who are the third party service of the collapse of large scale funds, a host 1 Hedge Fund Research Inc. providers for the fund – lawyers, of lesser known ones are closing in emerging accountants, back office administrators? markets. Some have made bad investments. Peter Turecek is a managing director in New York. Are they reputable? Can they provide Others have fallen victim to outright fraud. He specializes in hedge fund related intelligence, independent confirmation? In 2005, the Aman Capital Global Fund, corporate contests and securities fraud. ࡯ Who is the fund manager? once the flagship of Singapore’s hedge fund industry, collapsed after only one and half Julian Grijns is an associate managing director in ࡯ What are his or her credentials? New York. He previously worked at Towers Perrin in years when it lost an estimated 18% of its their competitive intelligence program. assets on derivative trading on the Korea8 | Kroll Global Fraud Report
  11. 11. FINANCIAL SERVICES The industry has changed and aging baby-ALTERNATIVE boomers have fueled a “bustling market” for unrated Death Bonds, which first emerged in Europe and now are hot in the Seven red flags ࡯ The company had no track record,SECURITIES: and the principals had no real United States, according to Business Week. experience in the industry; This market, however, has attracted its ࡯ The business operated in an essentially share of fraudsters, and regulators haveOpportunity reissued warnings about illegal and unethical practices: ࡯ A 2004 Kroll due diligence investigation unregulated industry or was able to skirt weak or newly emerging regulation; ࡯ The principals provided resumés thatfor fraud of a viatical firm revealed that its founder had formed the company solely to take advantage of a hot market. His previous were lacking in detail and, upon investigation, proved to be inaccurate;and reward two businesses, in distinctly different industries, left a trail of litigation and he had previously sought personal ࡯ The principals did not provide adequate information on, let alone audited statements of, the financial performance of their current or past ventures; bankruptcy protection.T he collapse of the sub-prime mortgage ࡯ The investment involved a needlessly market has rekindled a debate about ࡯ From the mid 1990s until 2004, Mutual complicated corporate structure and the the economic impact of fraud in the Benefit Corp., a Florida-based life principals controlled multiple shell orinsatiable markets for high yield alternative settlement company, bilked 30,000 investors out of $830 million. In 2004, the related party companies;investments. Did the fraudulent practices ofa few originators and issuers of these Securities and Exchange Commission ࡯ The principals were reluctant to sharemortgages spark the downfall of the market, sued to shut it down. In 2007, its executives information about their current or pastor was it due to cyclical economic forces? were convicted of federal crimes and the business partners;Watchdog organizations often spend years company, now in receivership, pleaded ࡯ The principals, their previous partners,after the fact trying to find the answer. guilty to racketeering and investment or their companies had been subjects ofInvestors should ask a more important fraud charges. significant civil and criminal litigation,question: could the potential fraud have been and had numerous liens or judgments.identified in advance and therefore avoided? Alternative Energy Investments With oil prices close to all-time highs, theJust like any stock-picker or analyst, traditional and alternative energy marketsfraudsters follow the market, recognizing a markets for greenhouse gases, suggesting are booming, and so are investment market as a ripe one. Fast-paced capital some organizations are paying for Investors looking for a quick return aremarkets are always creating new emissions reductions that do not take losing millions of dollars in sham oil andinvestments, providing fertile ground for place.” Among other things, it found gas investments. In January 2007, the Northmodern-day Charles Ponzis to develop organizations buying “worthless” credits, American Securities Administratorsschemes that are more complicated and industrial companies profiting from doing Association reported that, over thetake longer to unravel. At first glance, the “very little” and brokers providing preceding two years, state and provincialneo-fraudster might seem to be using new “questionable” services. regulators had opened more than 260 casesand exotic investment vehicles and involving oil and gas-related schemes andmethods in order to bilk investors, but a History: An Investor’s Guide issued 122 cease and desist orders againstcloser look usually reveals a simple daisy promoters. In particular, a flood of Market history and lessons learned fromchain or Ponzi scheme. investments into companies with “new” due diligence can reveal potential fraud inTwo trendy investments are life settlement- technologies that have no industry advance and may help predict the strengthbacked securities and alternative energy. expertise harks back to the boom of a particular security or market. Just as anThere are regular media reports about fraud and bust of the 1990s. actuarial or bond rating house uses empiricalin these markets, although the underlying data to predict the quality of an investment,economics are sound. Appropriate diligencecan separate the scams from the true Appropriate diligence can a due diligence investigation of the persons involved and their record allows investorsopportunities. separate the scams from to understand the potential risks. the true opportunities.Death Bonds Michael Fellner is a senior managing director andA recent Business Week cover story reported The alternative energy market has even head of the Chicago office. He specializes inthat in May more than 600 Wall Street seen a scam involving an entirely phony corporate contests, embezzlement and political corruption and bankruptcy fraud cases. Previouslybankers “gathered at a conference in New exchange. In May 2007, a federal judge he worked as a journalist and ran his ownYork to talk about the next exotic investment entered a default judgment against investigations agency.coming down the pike: death bonds,” now American Energy Exchange and Yorkcalled life settlement-backed securities. Commodities after the U.S. Commodity Lisa Silverman is a managing director based in Futures Trading Commission charged them Chicago. She specializes in investigative cases forIs this a resurgence of the discredited viatical corporate contests, theft of trade secrets, patent with fraudulently soliciting customers tomarket, which emerged in the 1990s in the infringement and product tampering. trade non-existent energy futures on a non-wake of the AIDS epidemic? Sellers, typically existent exchange through a fraudulentthe elderly or terminally ill, sold the right Mark Skertic is a director based in Chicago. broker. Prior to that he worked for over 20 years as anto their eventual life insurance policy death award winning investigative journalist at thebenefits for an up front payment. Bundled Fraud also appears on legitimate Cincinnati Enquirer, Chicago Sun-Times and theviatical policies were marketed as securities exchanges. In April 2007, the Financial Times Chicago individual investors. reported on “widespread failings in the new Kroll Global Fraud Report | 9
  12. 12. PROFESSIONAL SERVICES EIU SURVEY Preventing risk in The professional services industry has a low the people business exposure to fraud relative to other sectors F rom one side of Kroll’s London offices, ࡯ The loss per firm for the past three years is one has a splendid view of $2.3m. This is equivalent to around one- St Paul’s Cathedral. From another, third of the survey average and is one of there is a vista of Fleet Street, long the the lower figures. home of the British press; and from a third, ࡯ Respondents believe that the prevalence of the harsh lines of the Old Bailey, London’s fraud has stayed the same over that period. Central Criminal Court. ࡯ Fewer professional services firms have If management ever needs a reminder of centralize or co-ordinate risk management. experienced each category of corporate the risks faced by the modern professional The only answer is to treat individuals as fraud than the average, except for services firm, a swift walk around the individuals, and get buy in – while also information and IP theft. In particular, only building should suffice. Reputational, leading from the top, to ensure that 20% suffered from theft of physical assets. ethical and legal issues abound. The central everyone knows that rules are rules. Although this arises partly from the sector issue, for professional services firms, is being knowledge-intensive without a about governance: getting everyone to These are people businesses, so physical product, the figure is still the address the issues systematically and management of human capital is critical. lowest for any industry. globally, to link together diverse functions Professional qualifications and licensing are This sector includes professions that actively (financial, legal, HR), and above all to get important, which means ensuring that combat fraud, or for which suspicion of fraud billable professionals to devote scarce and background screening is carried out and presents an increased danger because valuable time to risk prevention. that staff references are taken up. Conflict reputation is so important in maintaining checking systems are essential – but so is clients. This has several effects on the nature Like many professional services firms, Kroll the training and education that enables of, and response to, corporate fraud. has offices around the world with diverse people to understand how to operate them, ࡯ These companies are more likely to deal cultural backgrounds, histories and legal and how to make sensitive judgments with the issue directly and combat the frameworks, and getting a common about what constitutes a conflict and how problem themselves. Sixty-one percent say approach is a challenge. The solutions tend to handle it. that they manage it in house compared to lie in pragmatic answers: working with the grain of the business and getting each A critical issue for professional services with 45% of all companies. office and region involved. Legal, risk and firms is the vetting of projects before they ࡯ Accordingly, professional services firms are are taken on. Kroll, like many such firms, compliance functions need to co-operate. half as likely to turn to the big four has regional risk committees that review Standard operating procedures need to be accountancy firms (16% compared with projects assessing whether legal, clear, but also simple enough to adapt to a 33% for the average). reputational and financial issues are in line wide variety of operating environments. ࡯ In the past three years, a slightly lower with the law, standard operating percentage of companies than average has Many such companies are made up of procedures, and our business model. suffered from bribery and corruption (15% individuals who either are, or operate as, compared with 19%), regulatory breaches partners: they own the business, and that (15% compared with 19%) and money can be a great strength, conferring a sense Andrew Marshall is a managing director based in laundering (2% compared with 5%) of responsibility and focus. But at the same London and Washington, having previously held the roles of chief risk officer and head of strategy EMEA. The sector faces the usual problems of a time, it can make the business harder to He spent 15 years as a journalist including serving knowledge industry, but may not be navigate: people are jealous of client as Foreign Editor and Washington Bureau Chief for addressing them aggressively enough. relationships, reluctant to discuss “their” The Independent newspaper. business, and ill-disposed to efforts to ࡯ The most frequently reported types of fraud are information theft (29%) and IP theft (21%). These are also two of the REPORT CARD PROFESSIONAL SERVICES three areas where the greatest number of Financial Loss: Average loss per company over past three years: U.S.$2.3m (34% of average) respondents feels highly vulnerable (26% Prevalence: Percentage of companies suffering corporate fraud loss over past three years: 83% and 19% respectively). Increase in Exposure: Percentage of companies where exposure to fraud has increased: 89% ࡯ Complex IT structures have increased Areas of High Vulnerability: Information theft, loss or attack (26% of sector firms indicate exposure to fraud at one-third of companies. that they are highly vulnerable to this threat) • Management conflict of interest (21%) ࡯ However, the proportion of companies Areas of Frequent Loss: Information theft, loss or attack (29% have experienced in past three years) IP theft, piracy or counterfeiting (21%) • Management conflict of interest (21%) using IT security and countermeasures to Theft of physical assets or stock (20%) combat fraud is only 69% and just 57% say % 0 10 20 30 40 50 60 70 80 90 100 that they intend to increase investment in Corruption and bribery that area. Both of these figures are slightly lower than the average. Meanwhile, only Theft of physical assets or stock one-third of professional services firms say Money laundering that they engage in IP monitoring – this is Financial mismanagement lower than the average – and just 37% are Regulatory or compliance breach looking to invest in this area. Internal financial fraud or theft The professional services sector should pay Information theft, loss or attack particular attention to IT security and IP Vendor, supplier or procurement fraud monitoring, especially as legal and IP theft, piracy or counterfeiting accounting firms should already be strong in Management conflict of interest other aspects of fraud control. Highly vulnerable Moderately vulnerable Minimally vulnerable Don’t know/Not applicable Written by The Economist Intelligence Unit10 | Kroll Global Fraud Report