When fraud is present in the
company being financed or
its management team, it is
both costly and disruptive
to the victim. The costs can be measured
as real costs, opportunity costs and even
brand dislocation or wasting.
The Association of Certified Fraud
Examiner’s 2004 Report to the Nation is
a publication that summarizes its most recent
study of corporate fraud and is the
source that brings to light certain fraud
characteristics and the magnitude of corporate
fraud in the workplace. The following
are a few conclusions derived from
the Report:
• The Cost of Fraud – Fraud costs US organizations
an estimated $660bn annually.
• Frauds by Organization Type – Privately
held companies suffer the largest median
losses, followed by public companies,
not-for-profit organizations (a close first
through third in the ranking) and government agencies (a distant forth).
• Frauds by Organization Size – The
most costly abuses occur in organizations
with less than 100, or more than 10,000,
employees.
• Frauds by Position – The median loss
involving owners and executives is more
than 6 times as high as the median loss
caused by managers, and more than 14
times as high as the median loss caused by
employees.
• Frauds by Gender – Men and women
commit an equal number of frauds, but
the median loss is significantly higher in
schemes committed by men. • Frauds by Age – Nearly half of all frauds,
49%, are committed by individuals over
the age of 40, while only 17% are committed
by employees under 30.
• Frauds by Educational Background – Half
of all frauds are committed by perpetrators
with no more than a high school
education, but the median loss in schemes
committed by those with post-graduate
degrees is 6.5 times larger than the median
loss in schemes committed by those with a
high school degree or less.
So what does all of this mean to factors,
asset based lenders and other corporate
finance professionals?
It means that lending professionals that
manage and assess the risk of fraud within
their prospect companies do not have the
luxury of discriminating when to perform
such an assessment based upon the type
or size of the organization, the owners
or managers’ exact position or title, age
or gender. In fact, the crimes of fraud are
not limited to executives and owners, with
employees with an education no greater
that high school committing half of the
schemes. For sure, the problem is broad
and deep and of significant financial consequence
to those providing debt capital
to businesses.
Prevention Is the Key
The ACFE’s 2004 Report to the Nation
also reinforces the common belief that the most cost-effective way to deal with fraud
is to prevent it. According to its findings,
once an organization has been defrauded
it is less likely to recover its losses. The
median loss recovery among victims in
this study was only 20% of the original
loss. Nearly 40% of the victims recovered
nothing.
Simply put, prevention for factors and
lenders is the key to minimizing the risk
of fraud, and this means utilizing a “Best
Practices” approach to due-diligence and
post-closing monitoring. It also means
performing background investigations as
a regular part of the Best Practices duediligence
process.
An Industry Perspective
My purpose here is to present the case
for the utilization of background investigations
as a tool to prevent, detect and
manage fraud – before the receivable is
purchased or the loan is closed. I would
also like to advance the thesis that the performance
of background investigations as
an integral part of the due-diligence process
is more prevalent than in the recent
past, and should be part of the routine
due-diligence of a factor or lender. My top
10 list to support the ever growing need
to perform background investigations is
as follows:
1. Company owners and managers are involved
in more businesses than ever, many
of which are across state or country borders
and may involve different and multiple
partners.
2. Factors and lenders are more often participating
with other lenders and equity
providers in the same capital structure,
sharing increased risk with each other.
Participants are relying upon the lead
lender’s pre and post-closing due-diligence
in most cases.
3. The world market is a greater target for
new business and new business partners,
and factors and lenders are more in need
of the best worldwide information in order
to make an informed decision.
4. The media plays a more intense role
and is ever more real time. Factors and
lenders must know what the media knows
and more.
5. The world is ever more litigious, and
litigation costs real time and real money.
6. Information is more readily available
within a time frame that beats the bell at a
cost that doesn’t beat the bank.
7. Factoring and lending relationships are
frequently more transactional, less relationship
driven. Banking services are often
accepted by borrowers more ala carte,
in spite of banks’ best intentions to cross
sell expanded capabilities as the best value
proposition.
8. Time is more of the essence with competition
for the same deal ever more intense
and coming from ever more financing vehicles.
Lenders and borrowers share the
same desire for a speedy decision, requiring
the fastest due-diligence possible.
9. Corporate fraud, scandals and corporate
governance have become more common
in our business vocabulary. Corporate
scandals are now front page news, and the
executives convicted of these illegalities
against shareholders, investors and lenders
are being held accountable.
10. There are now regulations that require
a certain level of background investigation.
A few short years ago there were no
insurance requirements or federal statutes
that required a state or national bank or
federally chartered savings and loan institution
to check a list for terrorists, international
narcotics traffickers or those
engaged in the proliferation of weapons of
mass destruction. The FDIC and the FSLIC
changed all of that subsequent to the passing
of the USA Patriot Act of 2001.
Case Study Summaries –
A Fraud Prevented
Simply put, background investigations can
often prevent a fraud before it happens.
To demonstrate the variety of investigations
that can lead to a “Killed (Prevented)
Deal,” I offer you the following examples
from recent prospective cases. Left undetected,
and absent another reason to walk
away from the prospect’s request, had the
receivable purchase or loan been closed,
these situations would have resulted in an
immediate fraud, because of the deceit and
lack of disclosure by the prospect.
1. Securities Fraud – Undisclosed by the
prospect, the CEO of a U.S. public company
was found to have been under investigation
for securities fraud in Canada because
of allegations during his tenure as the CEO
of a Canadian public company prior to being
hired as CEO by the lender’s prospect.
The deal was killed by the lender and the
CEO was fired by the prospect’s board of
directors. The subject was subsequently
convicted of securities fraud in Toronto.
2. Sex Crime – Undisclosed by the prospect,
the CEO of a private company was
found guilty of sexual assault. Our client,
who had met with its prospect and his current
wife, business partner and investor
many times, is convinced that his wife and
partners were unaware of his past transgressions.
The client walked away from
the deal.
3. Accounting Fraud – Undisclosed by the
private equity firm that referred the prospect
to the lender and by the prospect’s
CEO, the CEO of the prospect company
was a convicted felon for 2 separate crimes
of tax fraud and tax evasion, the most recent
conviction resulting in a prison sentence
served within the last year. The client
walked away from deal and its source.
4. A Killing Event – Undisclosed by the
prospect, the CEO of a U.S. public company
was found to have been convicted for killing
an endangered species in a public park.
He was an aspiring member of a closet militia
group that required such an offense in
order to pass the hazing requirements for
membership. He failed the militia group’s
membership test and the background investigation
test. The CEO lost his job with the
prospect company, but not until the client
backed away from the deal.
5. Another Killing and Potential Brand
Wasting – The daughter and future son-inlaw
of the prospect company’s CEO were
killed execution-style in his Switzerland
villa within just days of the completion of
our investigative background report. Our
client was an asset based lending subsidiary
of a major capital markets institution,
representing a national brand name, and
was also the agent bank in the proposed
consortium financing. The prospect CEO
was a foreign national with a U.S company
with U.S. assets to secure the loan. The
client walked away from the deal and also
protected its good brand and reputation.
Again, it is a point of emphasis that the
above investments would likely have been
closed without the performance of a background
investigation on the companies
and their management teams. As a result
of the deceit, misrepresentations and lack
of disclosure to the factors or lenders by
the prospects, the frauds would have occurred,
with the funding sources left to
deal with the consequences of the fraud
somewhere down the road after the funding,
a worst possible outcome.
Background Investigations Best Practices
• Factors and Lenders should be consistent
about performing background
investigations.
• Hire a background investigations firm
that is consistent about its methodology as
well. Ask the firm about its best practices
methodology.
• An investigation must include a thorough
research effort into determining all of the jurisdictions
(counties or countries) in which
the subject has resided or done business.
• Research must be performed in every jurisdiction
where it has been determined the
subject has resided or done business. To except
even one jurisdiction could be to leave
out the one where the deal killer resides.
• An investigation into public records
(i.e., civil and criminal litigation histories,
tax liens, judgments and bankruptcies)
should always include a combination of
independent on-site and on-line research.
We find adverse public record information
in approximately 30% of the cases as a
result of performing on-site research that
we don’t find when performing on-line research,
using the best data bases available,
a percentage too high to ignore. 
And finally, a few general truths
to live by:
• Establish written risk management, duediligence
and background investigations
guidelines to live by, and follow them
without exception.
• Back up your best interviewing skills and
intuition with the best information.
• When in doubt, it’s always better to walk
away from a deal.
• It’s always management that ultimately
repays the loan. Know who the owners
and managers of the business really are.
• Maintain your sense of humor because,
when the collateral is gone and you’re left
to work out a deficiency with a known felon
who has ravaged his last three ventures
and committed untold acts of indiscretion,
you’ll need it.
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