Kroll - Global Fraud Report 2011

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  • 1. GlobalFraud ReportIssue 13 May 2011The strategic impact of fraud,regulation, and compliance An Altegrity Company
  • 2. The information contained herein is based on currently available sources and analysis andshould be understood to be information of a general nature only. The information is notintended to be taken as advice with respect to any individual situation and cannot be reliedupon as such. Statements concerning financial, regulatory or legal matters should beunderstood to be general observations based solely on our experience as risk consultants andmay not be relied upon as financial, regulatory or legal advice, which we are not authorizedto provide. All such matters should be reviewed with appropriately qualified advisors in theseareas. This document is owned by Kroll, and its contents, or any portion thereof, may not becopied or reproduced in any form without the permission of Kroll. Clients may distribute fortheir own internal purposes only. Kroll is a business unit of the Altegrity family of companies.II  |  Kroll Global Fraud Report
  • 3. The strategic impactof fraud, regulation,and complianceFraud is an ever-evolving threat.Its changing forms inevitablyspark new regulatory responsesin the ongoing battle betweenfraudsters, their victims andthe authorities. Business mustadjust its own complianceefforts to such new marchingorders, as part of its role in thefight, even when new legislationall too often is clearer about theultimate goal than the actual corruption in southern Italy’s renewable energy is inevitably shaped by local exigencies. These sector, to be able to respond to the complex are seeing rapid change in major markets fromdetails of its requirements. levers of power within the societies of different the United States and United Kingdom to Indian regions, or even to be aware of Brazil, as well as smaller ones such asAs companies know, however, the risks of surprising aspects of Chinese corporate law. Mongolia, which these articles help to explain.fraud and falling afoul of anti-fraud regulationpermeate almost all business activity. Achieving such an understanding is never a We hope that this edition of the Global FraudAddressing them properly therefore affects finished task. Anti-fraud strategies and Report provides useful input as you shapebusiness strategy in numerous ways. This compliance programs need to be an integral a business strategy consistent with the everissue of the Global Fraud Report shines part of ongoing operations. Their specific form changing regulatory environment.a spotlight on a series of fraud andregulation-related issues both to illuminatespecific concerns and, collectively, to provide Compliance: Why ‘by the book’a better idea of the proper breadth of a is good for the books p2strategic response to fraud. From Barings to Madoff: “Events, dear boy, events”:As many of the articles show, to Lessons learned p19 Paying attention to political risk p4make such a response effective lrequires action on several levels. ona PreAn essential start is the underlying Emerging regulatory risks rati Geopolitics in clean tech p5 e in the United States p17 de Opattitude toward compliance: it alneeds to be approached as a toolto engineer a better-run, moreprofitable company rather than “They can’t say that, can The complexities ofa burden to be endured. they?” Protecting your compliance in India p6 n/ name on the Internet p16 mpation letioThis is likely to help with another acqnve o rkey to success: a willingness to I g e ui Resolving commercial int t c sti rimg Infrastructure and waste indevote the time and resources s ng/ disputes in China: Po Brazil: Two lucrative butneeded to developing a detailed A case study p14 challenging investments p8understanding of risks andopportunities in existing, andespecially new markets. Depending Remember to breathe: Investing in Mongolia:on the circumstance, for example, a Compliance and the United Opportunities and risks incompany may find it essential to Kingdom Bribery Act p12 the newest hot market p10 Private equity and the Foreignknow how to avoid the dangers of Corrupt Practices Act p11 Issue13  May 2011  |  1
  • 4. Compliance: Why ‘by the book’ is good for the books By Tommy Helsby A year ago, the Global Fraud Report highlighted the return of the active regulation of businesses. Tommy Helsby argues that effective controls, far from inhibiting growth, actually build better, stronger business performance.2  |  Kroll Global Fraud Report
  • 5. between prosecutors is now the norm ratherThe past twelve months have brought not than the exception.only tougher regulation, including theDodd-Frank Act in the United States and the Inevitably there has been a backlash from theBribery Act in the United Kingdom, but also regulated. Most visible, from where I sit, is themore active enforcement – notably increased response to the new UK Bribery Act, which willresources devoted to corruption investigations take effect on July 1. The objections seem to mein the US at the Department of Justice and either ill-informed or inappropriate. They arethe Securities and Exchange Commission as generally some variation of, “I could be arrestedwell as a similar business crime focus in for taking my client to a football game” – thatBritain at the Serious Fraud Office. Meanwhile, won’t really happen unless you bribe the emerged as an issue in an increasinglystoried magistrates elsewhere in Europe – referee to get your client’s preferred result. complicated world; and you could add plentyJoly in France, Garzon in Spain, DiPietro in People also still insist to me that paying bribes more to the agenda.Italy – have been succeeded by a new is the only way business gets done in some parts of the world, so aggressive extraterritorial Although I prefer to leave forecasting togeneration policing of corruption will be a serious economists and astrologers, I see two otherof officials keen to make their names. disadvantage to British companies operating specific issues that should be added to theProsecutors in Germany, often in cooperation there. The same argument was voiced by list. Globalization and communicationwith their counterparts in the United States American businesses when the Foreign Corrupt technology have together changed the gameand elsewhere, have successfully targeted Practices Act (FCPA) was passed forty years for privacy issues. Regulation, though, is stilla series of major domestic businesses. ago, yet US companies have remained effective very inconsistent and local, and compliance isIn emerging markets, institutional competitors in all those difficult markets. similarly variable. After all, why comply withdevelopments may be slower, but public laws that don’t exist? But sensitive data may ‘Good business’ – meaning fully compliant –attention to fraud issues, especially relate to individuals in one country, be turns out to mean good business in terms ofcorruption, is intense. Looking only at the controlled in a second, and accessible in a commercial and financial performance. Siemens,BRIC countries in just the last few months: in third: prudence dictates that the highest following a massive bribery scandal severalBrazil, both Vivendi and Credit Suisse paid regulatory standard should apply. years ago, changed its culture (along withmulti-million dollar settlements – without many of its senior management), established a The second issue may be a surprise: humanacknowledging wrongdoing – in relation to dynamic compliance operation, and has been rights governance. This generally sits in theallegations of investment fraud and insider more commercially successful ever since. Even corporate social responsibility agenda, iftrading, respectively; in Russia, President in the most challenging markets, business anywhere, and is often viewed as importantMedvedev has proposed that fines in can be conducted legitimately, and both the but not business-critical. There are, however,corruption cases should equal up to 100 times deal and the market will be better for it. movements towards making corporationsthe size of the bribe; in India, the Prime legally responsible for direct and indirectMinister, Manmohan Singh, recently bowed to There is a broader conclusion to draw from violations of human rights, such as use of this. Procedures for ensuring that business child labor, tacit support for unsavory regimesdemands to initiate an investigation of practices are compliant with the UK Bribery through trade or investment, or sale ofcorruption in the award of third-generation Act or the FCPA should already be in place: equipment used in repression. The UN’smobile telecom licenses; and in China, the a well-run business is already operating initiatives have been taken up by the OECD,two top executives of the country’s largest comfortably within the requirements of these and it may be recalled that the OECD’se-commerce firm,, resigned after laws and the only additional requirement the initiatives on anti-corruption measures haveacknowledging that the company had failed laws bring may be the need to document that spurred much of the new legislation on respond to external fraud issues. Further fact. The enterprise should operate that wayafield in Asia, 28 governments have now A well-run business should engage in because it is better for the business, not justsigned up to the Anti-Corruption Action Plan forward-planning to make sure that the because the law requires it: opportunitiesfor Asia and the Pacific, overseen by the OECD necessary resources and relationships are in won without corruption are more secure andand the Asian Development Bank. competitive, and likely to lead to more of the place before a problem emerges. By doing so, same; corrupt deals are risky, expensive, and companies will be less likely to allow currentThe exposure for companies operating in vulnerable to further bribe demands or a preoccupations to distract them from the wideemerging markets is not just to local change of regime. range of regulatory risks.regulators but also to their home regulatorsacting extraterritorially: corrupt operators For the past few years, bribery issues havecannot rely on lax or venal local prosecutors Tommy Helsby is Chairman of Kroll dominated seminar and conference agendas, Eurasia based in London. Since joiningto turn a blind eye. Indeed, United States in the way that money laundering concerns Kroll in 1981, Tommy has helped foundprosecutors have successfully pursued did for the five years before that. If you and develop the firm’s core duenon-US companies for alleged offenses diligence business, and managed many measure by the size of the fines, though, of the corporate contest projects forcommitted outside that country when they competition issues need to be on the list of which Kroll became well known in thehave been able to show some US nexus or a company’s compliance concerns. If you 1980s. Tommy plays a strategic role both for the firm andinterest. Law enforcement agencies elsewhere consider overall cost, in terms of both money for many of its major clients in complex transactions and disputes. He has a particular interest in emerginghave told Kroll that they intend to follow the and reputation, then environmental regulation markets, especially Russia and India.same path and cross-border cooperation remains paramount; trade sanctions have Issue13  May 2011  |  3
  • 6. “Events, dear boy, events”Paying attention to political risk By Jason WrightIn 1914 Henry Noel Brailsford, aprominent British journalist, notedconfidently: “The frontiers of ournational states are finally drawn.My own belief is that there will beno more wars among the six greatpowers.” A few months later, thosesame powers were engaged in WorldWar I, perhaps the most devastatingwar ever fought between them.This is but one example of the hubrisinvolved in prediction.Recently, numerous commentators spoke of it is also about less dramatic matters, such reputational due diligence from different setsthe security and stability of Hosni Mubarak’s as understanding the role of local politicians of consultants. These categories, however, doregime in Egypt mere weeks before a national in authorizing a new plant or the expense not exist in isolation. A better approach is touprising drove him from power. By some imposed by a corrupt political culture in examine them together, a service Kroll providescriteria, such as the risk of default on which bribes are commonplace. The link in its integrated due diligence offering.Egyptian bonds as measured in the credit between high levels of political instability and Due diligence is only a step toward a greaterdefault swaps market, Egypt was even rated fraud is no coincidence. The same phenomena understanding of political risk. Companies,as a more stable investment than Portugal – such as poor governance, inadequate legal for example, will also need to consider a widerprior to this revolt. structures, and elites that condone or expect range of extreme scenarios in their planning. illicit gain – can often induce both.The consequences of poor foresight apply to No commentator or consultant can predict withbusinesspeople as well as politicians. World A second, equally important truth is that certainty what will happen in world affairs,War I brought extensive economic dislocation. political risk cannot be dealt with independently but they can give investors better informationNow some foreign investors, particularly of commercial, legal, or reputational risk. Often and comprehensive analysis to help them dealthose who partnered with businessmen close a political event has an economic impact. with the changing environment. The trick forto the Egyptian or Tunisian regimes, are The unrest in Libya, for example, led to a executives will be using this information touncomfortably exposed in North Africa. sharp increase in the oil price, creating an adjust as history unfolds around them. economic risk even for countries andThe financial crisis was an object lesson in Harold Macmillan, British Prime Minister from companies with limited or no direct exposurethe perils of incorrectly valuing investment 1957 to 1963, when asked what might blow to Libya. On a smaller scale, a company his government off course, supposedly replied,risk. As the developed world cleans up the competing in an emerging market against a “Events, dear boy, events.” Companies will haveresultant mess, recent events in North Africa business controlled by the son-in-law of the to learn to adjust to surprising political eventsprovide a warning to investors turning their president may suddenly find that it is subject in order to prosper in an uncertain world.attention to booming emerging markets to to new legislation, or that its customers areavoid similarly mispricing political risk. Even being “encouraged” to go elsewhere. In suchin some European countries, political risk has circumstances, any purely commercial Jason Wright is a senior director inbecome a significant factor; sparked by issues Kroll’s London office. He originally analysis of the business that does not take joined Kroll’s Italian Businesssuch as protectionist policies in Italy and into account these political factors will not Intelligence and Investigations practiceabrupt regulatory change in the renewable provide an adequate model of future earnings. and has recently focused on multi-energy sector in several EU countries. How jurisdictional transactions, particularly In fact, companies are increasingly realizing where there are significant politicalshould investors incorporate this risk into risks and corruption issues. Jason is a key point of contact that commercial due diligence projects whichtheir pre-transaction assessments of for Kroll’s private equity clients; he works extensively fail to take into account political risk, both with clients in the sector throughout the deal cycle,businesses and into their ongoing geopolitical and local, will be an unreliable managing projects such as pre-transaction due diligenceunderstanding of operational risk? and risk analysis. He has particular expertise in deals guide. In the past, investors have tended to involving the alternative energy sector, majorA key point one must recognize is that political commission commercial due diligence, infrastructure projects and central bank contracts.risk is not just about revolutions and uprisings; political risk assessments, and integrity or4  |  Kroll Global Fraud Report
  • 7. issued an unexpected new legislative decree on tariffs in the renewable energy sector, leading to concern and uncertainty among investors, contractors and developers. Meanwhile, local regulatory frameworks can also create significant risks for investors. In Italy, risk arises from lengthy and bureaucratic regulatory and authorization procedures, as well as from divergent clean technology policies at the national, regional, and local levels. These all create delays in obtaining licenses and putting plants into operation. This has led in the south of the country, where solar and wind plants are concentrated, to the rise of intermediaries who claim to be able to obtain all the necessary authorizations for investors and to sell them what are essentially turnkey projects. Clearly, this heightens the risk to investors of becoming involved in corruption or even of infiltration by organized crime. Several factors make the renewable energy sector particularly attractive to organized crime in Italy, including: advantageous Geopolitics feed-in tariffs; the central role of potentially corruptible local politicians; the opportunities for laundering money; the trading of plots of land; and the opportunity to use illegal workers. In Sicily, Calabria, Apulia, and other regions, a number of investigations – such as in clean tech the “Via col vento” and “Eolo” inquiries – have led to the arrest of entrepreneurs, developers, city mayors, and public officials on charges of corruption and often of criminal association. Many domestic and foreign investors who had dealings with such dubious counterparties subsequently had their authorization applications delayed or blocked, or even had plants already in operation seized. Moreover, By Marco Tavolieri they saw their names in Italian and international media reports alongside those ofThe latest developments in Europe’s clean technology sector figures allegedly connected to the Mafia, causing serious embarrassment andshow how investors can be subject to significant political and reputational damage.regulatory risks even within developed countries such as Spain, As the Italian example shows, political riskthe Czech Republic, and Italy. Where these risks are present, and fraud often go hand in hand. Investors need to be as aware of these twin dangers infraud is often not far behind. Europe as anywhere else in the world.In order to reach the European Union’s (EU) decrease the level of these feed-in of obtaining 20% of energy from Certain jurisdictions made major amendments Marco Tavolieri is a director inrenewable sources by 2020, member to existing regulations retroactively with Kroll’s Milan office. He specializes in business intelligence projects rangingcountries had guaranteed favorable feed-in devastating effects on investor confidence. from reputational due diligence totariffs to investors in the renewable energy In the photovoltaic sector in Spain and the competitive intelligence and hostilesector for periods of 10 to 20 years. The Czech Republic, for example, recent tariff takeover cases. Marco also has anti-fraud expertise includingsovereign debt crisis, however, as well as changes have affected some plants that are multi-jurisdictional matters and international tax haventechnological improvements that have already in operation; it comes as no surprise investigations. He works across a wide range ofdecreased the cost of equipment such as solar that this has led to a substantial decline in sectors including private equity, renewable energy, waste management and gaming.panels, have pushed some EU countries to investment. In March of this year Italy too Issue13  May 2011  |  5
  • 8. The complexities ofcompliance in India By Richard Dailly First consider how India got to where it is: the sub-continent was unified in the third century BC and over the next 1,500 yearsAs the breadth and depth of the globalized economy expands, created one of the world’s most advancedmultinational corporations and investors find themselves societies. Islam arrived from the West, leading to the establishment of the Mughal Empireassessing new opportunities in unfamiliar regions. alongside the Hindu Maratha and RajputInternational business norms suffused in the legal practices Empires. Thousands of years of interplay andof the West, where they largely evolved, are increasingly overlap between competing Asian cultures and religions, followed by colonization by thecoming into conflict with how business has traditionally been British, created a multifaceted society whichconducted in developing parts of the world. varies dramatically from region to region.6  |  Kroll Global Fraud Report
  • 9. reduce such emigration and give the companySome notable risks boycotted the democratic process and admit to leading an “armed struggle” in states which a real voice in the local society. Maintaining aA particular legacy of the British Raj is the rank among India’s poorest. Investors may be culture of anti-corruption might initially seemall-pervasive nature of bureaucracy. Some local pressured to pay these insurgents to operate impossible, but if a local official’s vote bank islaws might seem archaic to outsiders and locals in the area and, if a bribe is not forthcoming, dependent on jobs in the community, thenalike: the need, for instance, for companies to the rebels might use their influence to disrupt the threat of pulling out would turn popularkeep a book of attendance. The truth is that a company’s operations. It may be tempting opinion against the bribe-seeking politician.these mechanisms can allow poorly paid to capitulate, but investors need to be aware thatofficials to ask for under the table payments. A culture of anti-corruption is essential from this would be a high-risk strategy, potentiallyUnwittingly, businesspeople can find a legal and compliance point of view, but exposing them to India’s terrorist financing laws.themselves open to requests for bribery. simply ignoring the problem is unlikely to Many Maoist groups are proscribed under Indian be an effective strategy. Knowledge of theIn the same way but on a larger scale; the anti-terrorism legislation and so payments to local community should lead to broadsize of India’s bureaucracy has created an them could constitute a serious offense. engagement with it in which researchers,army of retirees, many of whom become Kroll has learned through numerous analysts, trusted community liaison staff,consultants or join the boards of companies investigations in challenging parts of India corporate communications, and CSRas independent directors. While these that these risks often overlap and interact professionals work seamlessly.individuals are able to open doors and facilitate with one another, though how this happensintroductions, their use requires extreme Kroll suggests that elements of this strategy is unique to every location.caution. It is not uncommon for a former might include the following:official to be seen as a breadwinner among a A company, for example, might experience K Commission independent consultants toteam of current civil servants. “Commissions” hostile pressure from the media and labor provide an in-depth analysis of thepaid by a company to a former official-turned- unions. Further investigation may then geography, local culture, and historicconsultant are often no more than bribes. reveal that these critics are being issues in the region; manipulated by a local official attempting toCash payments in order to make things happen, K Make contact with the media, academics,to both officials and non-officials, are normal; use his influence for personal gain – environmental groups, local officials,in many sectors it is not seen as unethical blackmail, essentially. If the business agrees unions, lobbyists, NGOs, and others inand simply seen as a price attached to doing to pay the official, the hostility will cease. order to better understand the fault lines;business. Firms committed to high standards The official may even justify his actions by saying that the money will be partially fed K Consider recruiting a well vetted localof corporate integrity need to think seriously back to the community or aid development liaison officer;about how these issues could affect them. and alleviate poverty in the region, thereby K Make tough policies on compliance andIndia’s democracy is often well intentioned increasing his political influence. Bowing to governance well-known in the localtoward the poor. The combination of a extortion of this nature will leave a foreign community. This might include a wellpolitically enfranchised lower class and company exposed to breaching business publicized policy of non-payment ofpoverty, however, can produce unintended compliance and governance laws, not just commissions, whistleblower hotlines, wellresults, such as the predominance of single- in India but potentially in its home country. advertised compliance and anti-corruptionissue politicians. Occasionally, these individuals It also gives the corrupt official and his policies, even “open door” policies, to nurturewield inordinate amounts of power in local accomplices the “green light” to continue a culture of transparency and accountabilitycoalitions. For example, a representative extorting in such a way.elected by slum dwellers might see as a K Consider meaningful contributions tothreat infrastructure development which could the local community, not a “name-only”lead to the re-housing, and therefore loss, of Mitigating the risks CSR program;his constituents. It could When operating in such a complex culture, a K Consider ways of using the local communitybe in his interests to oppose redevelopment sophisticated understanding of the local area in the operation, making them stakeholders.unless other incentives – notably bribes – is essential. For example, in cases such as thecome into play. Similarly, land acquisition is a Entering a new, unfamiliar culture does not corrupt local official above, in Kroll’scontentious and opaque issue in India, rife with mean a company has to compromise its experience companies usually have morecorruption. Any major infrastructure project will governance standards but it does need to leverage than they realize. A sophisticatedalmost certainly encounter problems – from the learn how best to maintain them in these analysis of wealth, demographics, movementunethical removal of local residents to insider unfamiliar conditions. of people, and other societal factors can adddealing on the value of land – which can have significantly to a company or investor’sclear and serious compliance consequences. understanding of the environment in which Richard Dailly is a managing director and head of Kroll’s operations in India.Mining and power generation companies they are operating. A thorough He has over 20 years of experience inlooking to invest in India’s central eastern states understanding, for instance, that the global risk for the British government and Kroll. Richard has a deepwill face the added difficulty of working in areas population of an area is diminishing through understanding of investigative andwhich are subject to a Maoist insurgency. These economic emigration, leading to a lessening intelligence gathering techniques, andgroups, professing an agrarian communist of support for a corrupt local official, could assessment and analysis, in support of corporate investigations, political risk, litigation support, and multi-ideology, could be seen to present a sovereign influence an investor’s decisions. Meanwhile, jurisdictional cases.threat to the national government. They have meaningful investment into poor areas could Issue13  May 2011  |  7
  • 10. Infrastructure and waste in Brazil: Two lucrative but challenging investments The vast opportunities related to the By Vander Giordano and Eduardo Gomide rebuilding and expansion of Brazilian infrastructure are attracting foreign investors.In November 2009, The Economist noted that “Brazil has been Some estimates put the likely cost of the planning and construction of Olympic sportsdemocratic before, it has had economic growth before and it has venues alone at $15 billion. The costs ofhad low inflation before. But it has never before sustained all rehabilitation or building of stadia for thethree at the same time. If current trends hold (which is a big if), World Cup, along with improvements in ports, upgrading of public transport and roads, andBrazil, with a population of 192 million and growing fast, could the expansion of airports necessary for bothbe one of the world’s five biggest economies by the middle of events will involve at least another $18 billion. These figures may even be underestimates.this century, along with China, America, India and Japan.” Taking part in the infrastructure boom in Brazil will almost always involve a publicBrazilians as well, in recent years, have arising from new environmental legislation bid. The major infrastructure projects, such asbegun to call the country “a bola da vez” – – show that a lack of such care can be costly. hydroelectric plants and enhanced powerthe cue ball. The media has reported grids, as well as new ports, highways, andextensively on how Brazil is finally tapping Playing the game cleanly airports are largely backed by agencies withinto opportunities in a changing world Brazil is about to host two major international full or partial government ownership,economy and fulfilling all the potential of its sporting events. In 2014, the World Cup will including the Brazilian Development Bank.large population, fertile lands, vast mineral be played in Rio de Janeiro and 12 other The second phase of the national Growthresources, and now huge deepwater oil leading cities. Two years later, Rio will Acceleration Program (PAC), the largestreserves discovered in the last decade. welcome the Olympic Games. Analysts are public sector investment program of the pastHowever, economic growth and prosperity predicting an enormous impact on the 20 years, will open up US$220.2 billion in– Brazil’s GDP rose roughly 7% in 2010 – also economy, with infrastructure investment as opportunities for foreign investment in Brazilbring the risks associated with excessive the driving force. A study by Brazil’s Sports over the period 2011 to 2014. The State hasoptimism and a gold-rush mentality. On top Ministry estimates the potential economic also established the Olympic Public Authorityof the “big ifs” listed above, investors and impact from the World Cup alone to be near to coordinate the works for the Olympic andcompanies need to pay careful attention to $100 billion between 2010 and 2014, of Paralympic Games. Companies must be awaredetails when it comes to where they put their which 73% will be indirect – and cites an of the risk of getting caught up in briberymoney. A consideration of just two areas – the expected $5.13 billion in incremental tourism, or corruption schemes in violation of Brazil’spotential pitfalls of Brazil’s rapidly growing $9.18 billion in tax collection and the creation own laws as well as the US Foreign Corruptinfrastructure sector and compliance issues of 330,000 permanent jobs1. Practices Act and the UK Bribery Act.8  |  Kroll Global Fraud Report
  • 11. Once such cautionary tale involves aEuropean company which came under TOP FRAUD RISKSscrutiny by both European and Brazilian Buyer beware. Maybe the local partner K Look into the complex Brazilian laborauthorities in 2009. The company had appears to be the right one with the right regulations and find out how your businesssubcontracted a European engineering firm connections. But a closer look can often partners are dealing with it, including itsfor their infrastructure projects. Authorities reveal problems. If a foreign investor doesn’t subcontractors. In a joint venture, everybegan to suspect that a $6.8 million expense do their homework, they could wind up with: member is responsible for the fulfillmentthey had on their books was, in fact, made to of all legal labor obligations arising from Unqualified partners that contractual relationship. A grouplocal public officials in order to win a K Check out reputation and integrity history of investors in a São Paulo construction$45 million subway project in Brazil. – carry out extensive analysis of your company learned that the hard way. partner’s past contracts and legal history, Much to their surprise, a few monthsFurther investigation revealed that this same especially involving the government and after completing their transaction, theycompany made close to $200 million in state controlled agencies. were informed at a board meeting that thesuspicious payments in connection with a construction company was now liable for K Know your suppliers – in the wastehydroelectric project in Brazil. The scheme labor claims filed against a subcontractor treatment case, the company chosen toallegedly involved a consultancy contract treat the waste had neither the credentials who had worked on one of the company’swith a Panamanian company. nor the organizational structure necessary projects in northern Brazil. Because the to meet the contractor’s disposal needs. subcontractor was unable to meet thoseThe consultant was hired to provide information A check of the supplier’s background and claims, the responsibility was now help in the bidding process for the history, searching for references or perhaps even some on-the-ground investigation Corruption and bribery riskhydroelectric power plant. But both Brazilianand European investigators are convinced could have reduced the risk exposure. K Watch out for conflicting businessthat the Panamanian company never provided relationships through shareholders or Regulatory and compliance breaches contractors. And consider some backgroundany consulting services and that their sole K Pay attention to compliance. Foreign checking on key employees. In the wastepurpose was to act as a go-between to management case highlighted, there were companies need appropriate advisors whodeliver bribes to secure the contract. understand local laws and regulations and discrepancies in the company’s records.Meanwhile, the European engineering can help make sure compliance structures Much was due to the fact that one of thecompany is prohibited from participating in are in place. The consequences of non- employees responsible for the process –contract bids in Brazil until the investigation compliance can be great, as with the example the weigh scale operator – was receiving of the European engineering company who kickbacks from the waste collectionconcludes, effectively barred from the cannot enter into any new business until company, who received more resources forinfrastructure boom. their Brazilian legal process is concluded. a lower actual amount of garbage removed.An investment gone to waste?Brazil produces 150,000 tons of garbage The company, along with others which Kroll’s reports supported efforts by the foreignannually. Its comprehensive National Policy outsourced waste management to a particular acquirer’s lawyers to prove that the newon Solid Waste, passed into law last July, is garbage treatment and disposal business, shareholders of the petrochemical companythe culmination of a long line of policies was being included in a civil action. The had acted in good faith. The responsibility forstrongly emphasizing the use of recycled waste treatment company was not compliant the violations of the waste law was thereforematerials. Nevertheless, despite the efforts of with the new law in some of its processes: assigned to the former owners.the national government, states, municipalities, waste, for example, was being discarded Brazil’s economy provides substantialagencies, and industry organizations, up to without treatment. This left the petrochemical opportunities for foreign investors. To fully43% of waste collected in Brazil may not be company also in violation of the law and profit from them, however, companies need toadequately treated. subject to heavy fines. learn about the risks.Compliance with the new law’s regulations Kroll was hired to investigate the matter and 1. Global Finance Magazine, September 2010on business will require many companies to found that the risk could have been managedinvest in new technology and procedures, as during the due diligence process had thewell as spend considerable amounts on auditors at the time done a more thorough Vander Giordano, a managing directormonitoring and auditing activity. For investors review and spent more time looking at the in Kroll’s São Paulo office, hasin the country, meanwhile, due diligence extensive experience in investigative waste disposal company’s record. Evidence and business intelligence matters,should now go beyond assessing the already existed about its failings as did including fraud investigations, assetbackground, reputation and integrity of a searches and competitive intelligence. complaints about operational activities. Kroll’sbusiness to include compliance with the new He is a member of the Brazilian and evaluation of waste disposal documentation International Bar Associations.waste management regulations. Otherwise, also found large discrepancies in weight andbuyers risk inheriting liabilities that might outright falsifications. In some cases, theeventually jeopardize their entire investment. waste management truck did not even enter Eduardo Gomide is a managing director and based inRecently a foreign group acquired a Brazilian company premises, although the contractor São Paulo. With over 10 years of financial and riskpetrochemical company. Eight months later, had a record of trash removal. Similarly, field consulting experience, Eduardo has managed a wide variety of complex assignments with special emphasisthe firm’s legal department received a interviews indicated that some of the waste on financial investigations and forensic auditing.subpoena from the State District Attorney. was simply thrown in the city’s public dump. Issue13  May 2011  |  9
  • 12. Investing in Mongolia Moreover, lines between the public and private sector remain blurry, with conflicts of interest being common. Complicating matters further, investigators in Mongolia cannot relyOpportunities and risks on the official public record to identify ownership and control of locally-registered businesses. Instead, Kroll uses human sourcein the newest hot market inquiries and knowledge about Mongolia’s elite to understand who actually controls a company. Sometimes these inquiries lead to prominent political families, at which point risks arising from the United States Foreign Corrupt Practices Act need to be thoroughly evaluated as well. It is also common to find that company control is quietly exercised by powerful, sometimes controversial, individuals from Mongolia’s neighbors, Russia and China. Information on Mongolian individuals is also hard to obtain, making it difficult for foreign companies to understand the track record, reputation, and liabilities of potential business partners. Currently, litigation, bankruptcy, or criminal record databases do not exist, and Mongolian news research is a tool of limited value. Many domestic news outlets are quietly controlled by politicians who inevitably have a particular agenda. Allegations of corruption against businesspeople or politicians often appear in print with no further mention anywhere in the public record. Those interested have to dig deeper in order to Policy and regulatory changes that have determine which allegations of corruption are By Jack Clode opened up Mongolia to foreign investors and grounded in fact and whether any such claims businesses have helped bring about its rapid in the press resulted in legal sanctions.Mongolia is an enticing investment growth. Now, however, the government faces serious challenges, such as creating a mature, Due diligence in such an environment islocation. In 2010, its economy was exciting work. Interesting intelligence often transparent, and stable regulatory environmentthe world’s second-fastest growing1, and establishing controls and enforcement comes to light which help our clients negotiateand it is expected to be among the mechanisms to minimize corruption. the restructuring of financial terms or management structure, and sometimes leadstop three in 2011. Its equity market is The country is gradually strengthening and to an exit from the proposed transaction.acting accordingly, with the Mongolia empowering its control institutions. In 2006, Such research is essential in a rapidly growing,Stock Exchange Top 20 Index more for example, the government passed an imperfectly regulated economy, and because anti-corruption law and formed a specializedthan doubling in 2010, and has again the country is small, with a powerful business Anti-Corruption Agency.doubled since the start of this year and political elite, we frequently see the same Nevertheless, efforts to create the necessary names reappearing in our investigations.Mongolia’s primary driver of growth, the environment remain far from complete. Our extensive experience and deep expertise The application of laws and regulations is in Mongolia therefore helps us to advise ourmining sector, is attracting substantial unpredictable. In November 2010, the clients quickly on a deal’s prospects.foreign investment. Companies from government surprised the internationalNorth America, Russia, China, and community by suddenly suspending 254 gold 1. Eurasia Capital: Mongolia Outlook 2011elsewhere are developing significant mining licenses, citing a 2009 law which protects Mongolia’s forests and river basins. Jack Clode is a managing director inand profitable operations out of the Some international companies have appealed Kroll’s Business Intelligence &country’s massive deposits of coal, and had their licenses reinstated; others have Investigations division in Hong Kong. With over 12 years at Kroll as a frontgold, copper, rare earths, and other not yet been successful. These types of line investigator, case manager andminerals. Private equity funds, incidents damage investor confidence and are office head, Jack supports clients not limited to the mining industry. More than across the broad range of Kroll’scommodity traders, and other services, including due diligence, business intelligence, one large hotel project in Ulan Bator has beeninvestors are also rushing to the country competitive intelligence, security, internal investigations suspended because of disputes over the and external search of the right opportunities. interpretation of real estate regulations.10  |  Kroll Global Fraud Report
  • 13. Private equity and the methodology of due diligence can help avoid surprises later in the investment lifecycle.Foreign Corrupt Practices Act As investment discussions continue, any evidence or rumor of suspicious behavior or governmental contacts should be thoroughly investigated. These are the situations in which By Peter J. Turecek and Michael E. Varnum enhanced due diligence or actual investigative efforts may help provide deeper factualMore private equity firms are investing internationally. In doing so, they are encountering a understanding or context around a rumor or evidence of behavior. The PE firm and portfolioregulatory environment shaped by increasingly aggressive enforcement of the United States companies should review all of the deal-relatedForeign Corrupt Practices Act. In particular, regulators at the Department of Justice and the documentation available for accuracy, detailSecurities and Exchange Commission have beefed up their investigative teams and are now and adherence to standard internal codes oflooking more carefully at majority investors in entities alleged to have violated the law. conduct and accounting procedures, including sufficient record of gifts, contributions,While no private equity (PE) firm has to date top that corruption and related practices will reimbursements, travel and entertainment.been charged for Foreign Corrupt Practices Act not be tolerated, either at the parent company(FCPA) violations by a foreign portfolio company, or within portfolio businesses. Appointing a The Department of Justice (DOJ) hasthe threat is real. Exposure to penalties compliance officer, creating a thorough set of demonstrated leniency in some FCPA casesarising from such violations depend on, policies and procedures for employees and because of mitigating factors, includingamong other things, the level of management agents, and conducting regular staff training self-reporting, past and continuing cooperationand oversight provided by the PE firm. The and audits reinforce an appropriate tone to with the investigation, implementation ofgreater its involvement in the portfolio business, guide the firm’s behavior. These steps should remedial measures (including an FCPAthe deeper regulators will probably look up the support a corporate ethic rather than force an compliance program), and the absence ofownership structure in assessing culpability. aversion to risk. It is important to understand prior similar conduct. However, the failureSimple ignorance will not serve as an adequate that regulators will look for documentation of to carry out adequate due diligence can havedefense. PE companies that are currently active these policies and consistent adherence to a devastating impact. Consider eLandiaor expanding abroad therefore need to enhance, them, should an FCPA issue be identified. International, which acquired Latin Node inor where necessary establish, effective 2007 only to learn afterwards of potential Before entering a transaction, PE firms needcompliance and due diligence procedures. FCPA violations. The company self-reported to to undertake appropriate due diligence,The difficulty facing PE firms and other which includes looking at all local third party the appropriate authorities, but the ensuinginvestment vehicles is that the nature and participants, agents, representatives, investigation, fines, penalties, and terminationextent of “appropriate” due diligence are not consultants, and joint venture partners. Are of employees decreased the value of theclearly defined by regulators. At a minimum, the agents exclusive? What connections, if any, purchase by over $20 million, according toboth PE firms and their portfolio businesses exist with the local government or state- reports at the time. Eventually, eLandia wroteshould have well-documented internal FCPA sponsored agencies? Who are the beneficiaries off the entire business.compliance policies as well as evidence of an of the joint venture partners? An inability to Self-reporting to regulators – after receivingappropriate level of due diligence investigation answer these questions may indicate that the appropriate legal counsel – is neverthelessfor transactions. This level will vary by PE firm or portfolio company doesn’t sufficiently usually the best policy for PE firms that identifyjurisdiction, with locales known for corruption understand the relationships of their business possible FCPA violations, either in the courserequiring enhanced due diligence measures partners and activities, leaving them of acquisition due diligence or in a portfoliobefore entering deals or engaging agents. vulnerable to potential FCPA violations and company’s ongoing operations. To receivePrivate equity companies also need to ensure regulatory attention. While it is often the benefit of such action, though, companiesthat these FCPA policies are rigorously followed. impossible to investigate every thread to its need to have policies and procedures in placeThis begins with a clear message from the conclusion, a consistent, documented and adhere to them. Failure to do so could prove disastrous. 10 Perceived to have Figure 1: CPI vs FDI Note: Kroll analysis based upon Forecast of Stock of FDI in 2014 low levels of corruption information as provided by the IMF 9 and UNCTAD; Kroll compared Peter J. Turecek is a senior managing director in the New $10B - $100B countries in the EMEA regions with Public Sector Corruption Perceptions Index 2009 FDI stock greater than $10 billion to York office. He is an authority in due diligence, multinational $100B -$500B 8 G-7 and BRIC countries. investigations, and hedge fund related business intelligence $500B - $1,000B 7 Size of circle represents projected services. He also conducts a variety of other investigations G7 Country Average FDI. Sources: Transparency related to asset searches, corporate contests, employee >$1,000B International, IMF, UNCTAD 6 United Arab Emirates integrity, securities fraud, business intelligence, and crisis management. He has appeared on MSNBC, CNBC, Fox News, 5 and NPR and has served as a guest speaker on a number of Turkey United Kingdom for various investment and professional groups. topics 4 Italy Brazil Romania China 3 Egypt India Michael E. Varnum, CFE is managing director in the Azerbaijan 2 Nigeria Algeria Reston, Virginia office. He is a former senior executive of the Ukraine FBI with specialized experience in anti-corruption, economic Russia 1 Angola crimes and fraud. He has become an authority in FCPA related business intelligence, third party compliance screening Perceived to be 0 and international anti-corruption and fraud investigations. highly corrupt 0% 5% 10% 15% 20% 25% He has also developed, conducted and managed bespoke Stock of inward FDI CAGR 2009 to 2014 investigations and security risk assignments. Issue13  May 2011  |  11
  • 14. Remember to breatheCompliance By Melvin Glapion “Remember to breathe” is good advice for someoneand the experiencing acute stress. It is, in essence, what I am telling many clients in anticipation of the UK Bribery Act.United Admittedly, though, this is hard to do when, at every seminar they attend, the speakers serve fear with canapés.Kingdom Some of the bribery law’s unique provisions certainly should give businesses pause, in particular: i) strict corporate liability for failing organizations are now thoroughly investigating, on an annual basis, every current and prospective associated thirdBribery Act to prevent bribery, whether by employees or third parties; ii) disallowance of facilitation payments; and iii) extra-jurisdictional party vendor, agent, or supplier – a prohibitively expensive and logistically arduous practice which is neither practical, enforcement. Most large or medium-sized economic nor commercially-savvy. companies, though, already have the Businesses will benefit by taking a structured infrastructure, policies, and procedures to and considered approach to conducting meet this compliance challenge. Despite the reputational due diligence which takes into stringency, the United States Foreign Corrupt account the conditions that exist in the real Practices Act (FCPA) has made us better world. As described below, a company should: equipped to recognize, prevent, investigate, prioritize due diligence on third parties; and report incidences of corruption. establish a process for third-party compliance The change in corporate liability and with anti-corruption policies; manage the increased exposure to third party activity has costs of diligence; and use the findings to sparked panic among businesses. In order to gain competitive advantage. Take a deep achieve Bribery Act compliance, some breath and let’s begin.12  |  Kroll Global Fraud Report
  • 15. Prioritizing investigations The best way to manage this dilemma is by through a secure, online platform. Information using the results of the risk assessment to form collected from partners typically includesinto third parties a risk matrix profile (Figure 1.2). The matrix affirmation to our client’s code of conduct,Clients seeking help with prioritizing their addresses two assumptions of the dilemma: answers to a risk-related questionnairedue diligence efforts often ask three things: K All companies should be screened pertaining to business history and controlswhere to start, to which third parties to give pragmatically – this approach fails to go and backgrounds of key management, as wellmost attention and how often to screen them. deep enough in assessing riskier companies. as commercial references. A client dashboard allows clients to sort third party data byThe best tool for answering these questions is K Screen everyone at the highest level many risk factors, including their risk score,a risk scoring system that compares a population – again, an inflexible approach which is geography, industry type, and other emergingof firms, (for example, distributors) using markers cost prohibitive and potentially disruptive threats, to help determine the appropriate levelof potential corruption risk (Figure 1.1). to operations. of due diligence in each case. The platform also enables clients to create a structured, consistent 1.1 Conduct a risk assessment and auditable repository of client data. Country Reliance upon # of sub- specific government partners 1.1 Conduct a risk assessment Country Is this a risky 20 (corrupt) Reliance upon To what extent 20 (reliance on # of sub- How much 20 (sub-partner Using compliance as a public sector) dependent) specific jurisdiction? is Government business dependent upon partners oversight is possible? Risk competitive advantage 20 (corrupt) government? 20 (reliance on 20 (sub-partner Score Is this a risky To what extent How much jurisdiction? is business public sector) 1 (reliance on oversight is 1dependent) (company Compliance activity is not typically considered 1 (transparent) dependent upon private sector) possible? dependent) Risk a key source of competitive advantage. government? Score 1.2 Use risk scores to(transparent) level of due diligence on determine 1 (reliance 1 (company However, we have seen several due diligence 1 private sector) dependent) investigations where the information 1.2 Use risk scores to determine level of due diligence gathered has helped clients create or improve business relationships, for example: K to secure an exclusive arrangement with Low risk score Moderate risk score High risk score an agent in an important growth market after research showed that other agents in Red Flag Level 1 Level 2 Investigative DD Low risk score Moderate risk score High risk score the region had serious reputational issues; Red Flag Level 1 Level 2 Investigative DD K to obtain better terms from a distributor to account for its moderately higher risk profile; If most medium-sized or large companies K to press for changes in the ownershipThese markers might include: the Transparency were to display the results of their risk structure or management team at aInternational Corruption Perception Index score scorings in a distribution, they would potential distributor; andfor the jurisdiction where the distributorconducts most of its activities; the degree to resemble the bell curve. Somewhere between K to gain greater insight or control over awhich it relies on government contracts or 10-15% of third parties would fall into the partner’s code of ethics, communications,relationships for its business; the extent to relative low risk category; the vast majority, and reporting policies.which it has knowledge, control, or oversight 70-80%, into the moderate risk category; and The Bribery Act is here to stay andof the distributor; the length of the relationship the final 10-15% would be high risk. businesses need to adjust accordingly to itsbetween the firm and the distributor; its While the eventual costs to the firm remain place in corporate life. This shouldn’t meancorporate ownership structure; or the scale of its significant when using a risk-based system, banning corporate hospitality or halting allbusiness. Select the three or four markers most it matches the level of due diligence to the operations in far-flung territories, but thereappropriate for the group of companies being perceived risks of each third party. This are compliance expectations to be met. Whileranked and then establish a grading scale to enables companies to better balance best most are in a good position, using a riskdetermine the appropriate level of due diligencerequired in each case. Hence, a distributor practices in compliance while managing costs matrix, matching diligence to actual risks,operating in Mumbai with several agents and to the bottom line. and employing information from diligenceover half of its sales to private sector clients research as a competitive tool is the best waywill be more thoroughly investigated than Implementing a reasonable to implement a compliance structure that is both effective and economical. Now based in Manchester with no agents and & proportionate responserevenues derived entirely from the private sector. As outlined above, the majority of large and medium-sized companies have invested in Melvin Glapion leads Kroll’s businessBalancing the costs of intelligence practice in London. He has developing sophisticated anti-corruptiondue diligence with the over 16 years of experience of M&A, policies but the challenge is to get third-party corporate strategy and financialneed for compliance analysis experience, leading multi- contractors, suppliers and distributors to disciplinary and multi-jurisdictionalFor large and medium-sized firms, with comply with such policies in a consistent and teams in conducting cross-borderhundreds, sometimes thousands, of third auditable manner. Kroll has developed a new, market entry, due diligence and competitive intelligenceparties, the cost of due diligence very quickly on-line third party screening program, which engagements. Previously he advised on corporate strategy initiatives at KPMG, and has held several otherbecomes prohibitive unless a risk-based enables clients to acquire and manage data strategy roles within the private sector.approach is taken. about their vendors, agents and suppliers Issue13  May 2011  |  13
  • 16. Resolving commercial disputes in China A Case Study By Violet Ho “Business in China is booming and we have a well-connected manager who has secured recurring large government contracts. We don’t know much about these customers because he’s dealing with them through an intermediary – apparently that’s the way things are done there. He’s been faithful for years, so we trust him, and anyway we can take over the business any time we want.”Such sentiments may look suspicious in How to address suspicions activity that they discover is usually just the tipwriting, but things can feel different when of the iceberg. Amateur efforts may even make A panicked reaction to a potential problem can the investigation more difficult. Searchingthe dollars are rolling in and there is no time damage the chances of a smooth resolution. emails in the wrong way, for example, canfor questions. Executives at Kroll client CliCo When red flags go up or a whistleblower makes destroy or compromise vital evidence.Ltd – a pseudonym for a well-known US an allegation, a company may contact thelisted company – know this only too well. In CliCo’s case, getting information was accused wrongdoer too soon. If the allegationsIts operations in China started out as a joint difficult but what eventually came to light are true, this could give the culprit time toventure. After restrictions on foreign was startling. The local CEO had been using destroy evidence and settle on a story withinvestment were eased, CliCo converted his accomplices before an investigation starts. CliCo’s money to operate a string of otherthe business to a wholly foreign-owned Reacting to a false allegation, on the other businesses during his tenure. There wereenterprise by acquiring the shares hand, can demoralize a company’s workforce, fraud and embezzlement issues as well aspreviously held by its Chinese partner. create mistrust, and damage its reputation. potential exposure to the United States Foreign Corrupt Practices Act arising out of transactionsEveryone was happy until a large account If suspicions are raised, remain practical and with Chinese government agencies.receivable began building up with a key plan ahead. Decide whether you want tocustomer about whom CliCo corporate investigate the merit of an allegation, find outheadquarters had no identifying information. what damage has been done, or gather evidence Chop and changeUnsatisfied with the local CEO’s response to identify the source of the wrongdoing. The above advice is relevant in many parts ofCliCo, without seeking legal advice, sent in Also, consider if your objective is court action, the world, but Chinese law creates somean audit team while the CEO was away termination of the CEO – dismissal of an particular nuances in such cases. Once aon a business trip. Word reached him via employee in China for cause requires proof of company has gathered enough evidence toloyal local employees, and he angrily wrongdoing – or an exit from the relationship. prove wrongdoing, the next step maybe todemanded that CliCo remove the team. The element of surprise is vital, particularly in terminate the CEO and take over the operation.The company complied, but its relationship the early stages of an investigation, so Like in the case of CliCo, the company wronglywith the errant CEO deteriorated further. maintain a close-knit team and work out who assumed that 100% equity control gave it fullFinally, after the account receivable had can be trusted. Most important, a company management control. In Kroll’s experience, thissignificantly increased, CliCo engaged should engage external expert support early. misconception is one of the most commonexternal legal advice and started considering Too often clients do not contact Kroll until after causes of disputes in China. In order to resolveremoving the CEO, who by now had cut off they have attempted to investigate the problem an issue like this one, two things are needed:communications entirely. themselves, not realizing that any fraudulent control of the company chop, an instrument14  |  Kroll Global Fraud Report
  • 17. used to put an official mark on company positive thing, actually made CliCo’s situation K Build and maintain your own relationshipsdocuments; and the approval of the legal more difficult when they tried to remove him. with government regulators;representative, the person legally authorized to He also had the backing of the workers’ K Do not place all your confidence in equityenter into transactions on behalf of the company. union, and CliCo faced a group walkout from control, which does not equate exactly to local employees when it attempted to remove operational control; andIn CliCo’s case, the local CEO refused to him. This highlights that there is never a K Make sure you have a policy on thereturn the company chop and threatened vacuum in a company: if someone does control of the local company chop, andto report the company’s behavior to the something wrong, someone else will always maintain a paper trail to avoid fictitiousgovernment. CliCo would then face a real know or play a part in it. On the other hand, contracts which have to be honored.risk of losing its business license altogether. not all employees are corrupt. For both theseAt the client’s request, Kroll carried out In our case study, CliCo’s usual caution had reasons, post-termination internalin-depth personal profiling of the CEO and been overwhelmed by the kind of gold-rush communication is invaluable. This will helphis government supporters as part of making mentality commonly seen in developing transfer loyalty from the former ringleadera threat assessment. A forensic accounting markets. The company needed a Chinese back to the company and promote a zero-exercise uncovered records of deals which partner and saw no reason to find anything tolerance attitude to fraud. amiss with him. It was unfortunate for CliCowere done with the CEO’s handshake as that his opportunity to commit fraud arose afterwell as evidence of records that had been Stop a problem before it starts it injected cash to change the subsidiary’saltered. Kroll also looked closely at emails structure. China is a great place to do business,to work out who was who within the fraud Companies like CliCo can avoid such a dispute, but always be careful, call on outside help asscheme and to identify the external parties or at least reduce the risk of it happening, by early as possible, and remember that it is neverand what they knew. Working with external putting in place some key measures: too late to start your due counsel, Kroll put together an exit K Hire trusted people. This requires thoroughstrategy involving plans for negotiations due diligence on a range of matters including Violet Ho is a managing director andand possible arbitration in relation to the whether the candidate has been in disputes head of Kroll’s operations in China.termination and prosecution of the CEO. before with foreign or local partners; Violet has managed a wide range of risk consulting projects in Greater ChinaThe investigation went on for months. CliCo K Visit your sites in China rather than relying ranging from fraud prevention tosuccessfully got rid of the CEO but he walked on a quarterly report from your subsidiary; investigations of white-collar crime andaway with a significant sum of money. distribution scams. She also manages K Create checks and balances so that power investigative due diligence inquiries and assignments on business controls, intellectual property protection,The errant CEO’s close relationships with local does not become concentrated in one or a employee risks, corporate security and crisis management.officials, which had once seemed such a few people; Issue13  May 2011  |  15
  • 18. in the Gulf of Mexico. In addition to campaigns against the company on blogs and Facebook, the company had to contend with messages sent from a fake Twitter account, the seemingly real sounding BPGlobalPR. At one point, the phony public relations Twitter account had more followers than the company’s actual Twitter account. The challenge for BP became responding to a multi-pronged Internet attack. There was no single ISP or website to address the multitude of attacks. At times, even responding can backfire. Attempting to suppress material on the Internet can result in it being exposed to a wider audience. This irony has become known as the “Streisand effect,” named for the singer-songwriter Barbra Streisand. In 2003, an environmentalist posted photos of Streisand’s Malibu, California beach home on the Internet. She went to court in an effort to have the photos removed, but the publicity her lawsuit generated brought more than a million people to the website to look at the interests such as protecting trademarks or photos of her home. Businesses understand By Mark Skertic proprietary works. Who polices what appears that by trying to take down a site that on a website? In 2010 the Danish Supreme illegally targets them they may inadvertentlyThe Internet is the largest public Court, for example, upheld a lower court draw attention to a critic’s blog or Facebook decision which requires Internet service posts, boosting the detractor’s audience,forum ever created, a virtual providers (ISPs) to block access to any websites and further hurting the company’s reputation,arena for the conduct of that contain – or link to – other sites that undermining consumer confidence and makingcommerce and the exchange of infringe on copyrights. In the United Kingdom it an even bigger target for such attacks. and other countries, citizens can petition ISPsinformation and ideas. As Often, an investigation can determine who to remove material that violates the law.companies have learned, though, the anonymous individual is behind a blog In the United States, the Digital Millennium without involving authorities or filing ait is also a place where hidden Copyright Act protects an ISP from a third lawsuit. In 2010, the owner of a small firm infoes can carry out virulent attacks. party’s copyright infringement as long as the the Midwest was the subject of attacks on a ISP has no knowledge the work is protected. blog about his industry. Most troubling to the Once the copyright holder notifies the ISP, the business owner was indications the bloggerA few years ago, Internet crime often meant material has to be removed and the website had access to insider information about thea company’s website was vandalized, taken user who posted it notified. Then a back and company. A discreet investigation usedover by hackers and defaced with virtual forth commences, with the website user given Internet website registration information,graffiti. Companies had to guard against an opportunity to assert a good faith belief the blogger’s email and information postedphishing attacks or they contended with that the material is not protected. on other websites, including a Facebook page,devastating viruses delivered via email to determine the blogger had ties to someoneattachment. These threats still exist, but many Fast food chain Domino’s Pizza faced a public whom the business firm owner has beenmore have joined them: angry former employees relations nightmare when two employees at a in litigation with.creating hostile web pages, sometimes franchise videotaped themselves intentionallyembellishing facts or outright lying for maximum conducting unsanitary acts while preparing In this instance, the firm owner was able toeffect; short sellers blogging and tweeting food. The videotape was posted to the free use this information to inform the blogger thatabout a company’s perceived problems, site YouTube, which led to their firing and the attacks needed to cease before litigationhoping to drive down the stock price; or arrest. The Domino’s franchise owner used began. The incident never ended up in court orcritics launching potentially libelous assaults the Digital Millennium Copyright Act to have in newspapers, and the problem was resolved.on YouTube or in social media forums. the offending video removed. The company did have another use for YouTube. It used the Mark Skertic is a director in Kroll’sThere is no single set of rules governing how website to post an apology to customers from Chicago office. A former journalist,to respond to such crimes. More than 90 he covered the airline industry and its chief executive officer.countries have adopted laws ensuring the financial markets for the Chicagopublic’s access to information, but there are Some attacks are more sophisticated and can Tribune and was an investigative reporter at the Chicago Sun-Times.also restrictions on that openness, part of an be harder to address. In 2010, BP waseffort to balance Internet freedom with assailed online over its handling of the spill16  |  Kroll Global Fraud Report
  • 19. Emerging regulatory risksin the United States By Marcia Berss, David A. Holley, and Lisa SilvermanThe regulatory fallout from the financial crisis continues across the economy.The underfunding of state and municipal pension funds is sparking new regulatoryattention for both the funds themselves and the financial service companies whichservice them. At the same time, the whistleblower and proxy access provisionsof the 2010 Dodd-Frank Wall Street Reform Act, for example, will present long-term challenges for corporate compliance and governance. This article reviewssome of the emerging regulatory risks that companies need to address.Underfunded pension Unit. The increased scrutiny of law enforcement funds. The state immediately settled with the and regulatory agencies in this area will SEC, signing a consent decree in which itliabilities: Everybody’s directly affect the financial services industry. neither admitted nor denied wrongdoing anddirty, not so little, secret paying no monetary fine. In January of this year, Some economists are estimating that publicThe $2.8 trillion municipal securities market reports surfaced that both Illinois and California pension funding shortfalls could be as muchis under fire for allegations of misconduct and were being investigated for underfundingsystematic underfunding of public pensions. as $1.5 trillion, when adjusted for future their pension liabilities. That same month,In 2008, the Securities and Exchange pension liabilities. In August 2010, the SEC The New York Times claimed that states withCommission (SEC) warned these funds to pay charged the state of New Jersey with civil significant per capita liability for unfundedgreater attention to their responsibilities under fraud because it had “misrepresented and pension benefits include Connecticut, Hawaii,federal securities laws and last year formed failed to disclose material information regarding Illinois, New Jersey, Kentucky, Massachusetts,the Municipal Securities and Public Pension its underfunding of” its two largest pension Mississippi, Rhode Island, and Alaska. Issue13  May 2011  |  17
  • 20. Public pensions are pressuring their external Corporations facing proxy access nominees Mitigating the adverseproviders to find innovative ways to make up will have to answer a basic question: “Who effects of Dodd-Frankthe financial gap. In turn, these external are these guys?” Today, companies identifyadvisers are shifting money to riskier director candidates using executive recruiters, whistleblower provisionsinvestments, which have the potential for suggestions from current directors, or other The Dodd-Frank Act’s whistleblower provisions,huge losses. Recent surveys show that over sources and then conduct due diligence on found in Section 922, have also created70% of public pension funds have invested in them. With proxy access, a company will have substantial concern for American companies.derivative securities, up from only 50% just 14 days after the end of the nomination The section mandates rewards for employeesa few years ago. In December 2010, Detroit’s period to decide whether it will include who voluntarily provide “original information”two public pensions reported losses of more a given nominee in its proxy statement or which leads to a successful SEC enforcementthan $480 million from investments that give reasons for exclusion. A bigger concern action. Critics fear that this will turn employeesranged from hedge funds to vacant land in looms. Although current regulations forbid into corporate bounty hunters who ignore theTexas and Hawaii and a Pittsburgh casino. shareholders from using proxy access to normal compliance chain in search of riches.Adding to the potential for abuse, public seek a change in corporate control, any such The Act, however, need not mean the deathpension plans are not governed by federal nominees will probably be adversarial to the of an organization’s compliance program.pension laws like corporate plans. Instead, existing leadership. After all, if the nominating Instilling a culture of compliance – throughthey are overseen by boards that often shareholders were happy with the current effective training, communication, andinclude municipal labor leaders and politicians. board, they would not nominate new directors. investigations – will convince employees thatThe funds’ money managers may also have Current directors, for their part, fear that board the best way to bring forward a complaint issplit loyalties. Many handle investments for elections will become like political campaigns. within an existing corporate program.corporate pension and 401(k) plans, which Proxy access nominees will therefore warrantcan create a conflict of interest if managers This requires, among other things: special scrutiny by companies. Issues tofeel pressure to add the stocks of their corporate K An effective mechanism for allowing consider include:clients to public pension fund portfolios. employees to report fraud, including a K Independence: Will a proxy nominee be 24-hour hotline and processes to let theRecently, the SEC has enacted regulations able to represent all shareholders given whistleblower know that a complaint hasdesigned to curtail abuses among public any existing ties to the nominating ormoney managers and Congress has been acted upon; other shareholders?introduced pension reform legislation, K Comprehensive and fully documented K Personal issues: Does, for example, theexposing the industry’s not so little secret. investigations which thoroughly examine nominee have a history of litigation in his/ all reports and suspicious activity; and her personal life that might reflect likely K A strong tone from the top that letsProxy access is coming: boardroom behavior? employees know that the executives, theWill you know who your K Record: Has the nominee been involved board of directors, and management havedirectors are? in prior shareholder litigation, faith in, and rely on, the compliance bankruptcies, or questionable corporate program for ferreting out fraud and abuse.Proxy access permits shareholders to nominate governance practices? Has he or she beendirectors on a company’s proxy statement; a dissident director on, or nominee for, The post-crisis regulatory environment is stillwithout it, shareholders wishing to nominate other boards? Most important, has the evolving. Employers must continue to instill adirectors typically face an expensive proxy fight. nominee helped create long-term culture of compliance and reporting among shareholder value? In comment letters to their employees and not be deterred byFor a decade, businesses have opposed SECplans to require proxy access, arguing that the SEC, the CEOs of AT&T, Dow Chemical, Section 922. As these efforts take hold, trustthe commission lacked the necessary authority and IBM all cited the threat of “short- and loyalty will likely prevail over the hopesto do so. To remedy that, the Dodd-Frank Act termism” by proxy access directors who of riches and the predicted backlog of casesexplicitly empowered the SEC to issue such may seek changes that yield a short-term stemming from the new arrangements.regulation. In July 2010, one month after rise in the stock – like special dividends –Dodd-Frank became law, the commission but undermine long-term investment. Marcia Berss is an associate managing director in Kroll’smandated proxy access for shareholders who K Transparency: Under current rules, Chicago office specializing in public securities filings,have owned at least 3% of company stock for nominating shareholders may provide a corporate finance and corporate governance issues.three years. Each qualifying stockholder can She began her career as a corporate finance associate 500 word statement of support for their with Warburg Paribas Becker and was vice president innominate up to 25% of the board. Shareholders nominees. Does that statement include M&A for Dean Witter Reynolds.can also aggregate their holdings to reach the relevant details such as the above?3% level. Business groups immediately sued Supporters of proxy access argue that it has David A. Holley is a senior managing director and theto block the regulations and implementation head of Kroll’s Boston office. Since joining Kroll in 2000,has been delayed pending a resolution of been standard practice for years in many David has led investigations including environmentalthe legal issues. Most corporate governance countries and the recent financial crisis matters, contests for corporate control, internalobservers, though, believe that some form demonstrates a need for more accountability. investigations and white-collar crime investigations.of proxy access will be in place for the 2012 Opponents claim that proxy access will openproxy season. It will mean a sea-change the board room to short-term investors and Lisa Silverman is a managing director based in Chicago.for publicly-traded companies in the United special interests. Both agree on one thing: She specializes in investigative cases for corporate contests, theft of trade secrets, patent infringement andStates, and lawyers recommend that they mandating proxy access is a watershed product tampering.begin now to amend their by-laws. moment for US corporate governance.18  |  Kroll Global Fraud Report
  • 21. From Barings to Madoff: Lessons LearnedRegulations are no match for human financials scams, which – while perhaps less The great American circus impresario P.T.failings. As lawyers, financial colorful and certainly less publicized – Barnum is credited with coining the phrase resulted in financial ruin for unsuspecting “A sucker is born every minute.” While thatinvestigators and chastened investors investors across the globe. offhand dismissal of human gullibility maycontinue to pick through the rubble of be accurate when applied to individualthe Madoff scandal and other massive What are the chances that, after the latest investors, surely large corporations, with theirfrauds, new, more inventive versions bout of pain caused by Madoff, investors and institutional checks and balances will not be companies will remain more alert to red flagsof the same old story are being written so easily duped the next time. “The lesson and more vigilant in applying the regulations that should have been learned is that every and controls designed to thwart the scammers?On December 16, 2008, shortly after Bernie company can be defrauded and that you can’t It may be comforting to think so, but perhapsMadoff’s arrest, a team of FBI investigators ignore that in good times,” says John Slavek, not realistic. “The problem,” notes Zoe Newman,sealed off the crime scene at Bernard L. a 13-year Kroll veteran, who heads a financial a 10-year Kroll veteran, who has investigatedMadoff Investment Securities LLC in mid- investigations team out of the Philadelphia fraud and corruption cases from the Ukraine to office. “The fact is,” adds Slavek, “that withouttown Manhattan and started to sift through China, “is that controls and compliance systems fraud, companies could be doing even better.”the evidence. Former FBI Special Agent Keith are implemented and operated by humans.” While crime pays (at least until you get caught)Kelly, who joined Kroll earlier this year as amanaging director in its financial investigations Humans, of course, are imperfect. The Madoff so too, argues Slavek, does fraud prevention.unit in New York, was leader of the FBI Ponzi scheme and the Icelandic Bank So what is the likelihood that more companiescriminal investigation. For months, he and his collapses are not so much tales of inadequate will start making fraud prevention a priority?fellow sleuths combed through 13,000 boxes regulations or controls, but rather tales of Again, it’s mostly wishful thinking. “Very fewof records in Madoff’s New York and London people in charge who failed to implement and companies are pro-active,” concludes Slavek.offices, revealing details of the scheme that operate those systems correctly and investors “CEOs shake their heads at problems in otherbilked investors of an estimated $18 billion. who looked the other way. companies. Then it happens to them and theyWhile still ongoing, the criminal investigation are shocked. When clients call us, there is Glitnir Bank provides a perfect illustration.has led to five arrests, three guilty pleas and usually a crisis and they are already feeling Civil complaints filed by the bank appear tonearly $8 billion recovered in forfeitures, helping the pain.” suggest that although the bank had set up ato ease the pain caused by a massive scam risk committee to analyze and approve loans More than two years after the collapse ofthat, for over 20 years, had fooled everyone. in line with best practice, in reality it was Lehman Brothers and the unearthing of often a formality. It is alleged that individual Madoff’s elaborate Ponzi scheme, outrage andThe question now is – committee members were dominated by the urgency are fading. The financial markets haveWill we be fooled again? bank’s powerful CEO, who personally recovered and many companies are enjoying approved many of the loans. record profits. In other words, conditions areTo answer that question, let’s first turn theclock back to 1995, when a rogue futures The Madoff case is a similar blend of ripe for more fraud. “People don’t want to dotrader by the name of Nick Leeson based in incompetence and denial. In hindsight, the preventative work to see if it’s too good to beSingapore lost a staggering $1.3 billion on problems, the lapses, the inconsistencies all true. People move to the next big deal and itunauthorized trades, leading to the collapse seem so glaringly obvious. Despite numerous starts all over again,” says Abbey.of Barings, London’s oldest merchant bank. sweeps of Madoff’s operation, SEC examiners And the next big thing might just as likely be“After Barings, people said ‘This can’t happen never found evidence of fraud. And yet in one of the high-risk emerging markets ofagain,’” observes Richard Abbey, head of Madoff’s elaborate hoax could have easily India, China, Brazil, among others, which areKroll’s financial investigations practice in been uncovered if someone had done some attracting international investors in droves.London, “but then came Madoff.” due diligence on Madoff, particularly the “The big money is moving to new and phantom securities that he claimed to have un-regulated jurisdictions,” observes Abbey.But the Madoff scam was hardly an anomaly. purchased on behalf of his clients. “There’s little doubt that some investors willOnly three months before Madoff gained instant get burned.”worldwide notoriety, the collapse of Iceland’s As for the investors, they easily rationalizedthree biggest commercial banks in quick their consistently high returns. If Madoff was As for the Madoff scam, we will still be talkingsuccession led to a financial crisis that quickly a fraud, they told themselves, he would have about it for many years to come. Studies willspread to major investment funds across Europe. been caught out long ago. “In the end people show how the system broke down and that aThe bank failures spawned allegations of share believe what they want to believe,” says Kelly. lot of players in the market wittingly ormanipulation, non-disclosed related party “That’s human nature.” unwittingly aided and abetted Bernie’s grandlending and shareholders yielding undue larceny. “It always comes out that someone Human nature is unlikely to change any timeinfluence over the bank operations. Richard should have known,” observes Abbey. “It’s a soon. Once the good times return, the painfulAbbey headed a team of Kroll investigators similar pattern that repeats and repeats.” memories will fade, complacency will set intasked by a government appointed trustee to and companies and investors will go back to Like his colleagues, Kelly is under no illusioninvestigate the Glitnir Bank case. the same patterns of denial. “Within a year, that the Madoff case represents a watershedBarings and Madoff were not rare or isolated everything will be forgotten,” predicts Kelly. in human history. “They may come incases, just spectacular bookends. In between “It’s clear that risk aversion is already starting different shapes and sizes,” concludes Kelly,those two events was a constant torrent of to decline.” “but there will always be Madoff schemes.” Issue13  May 2011  |  19
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