In the Wake of Wirecard What is to be Done about Corporate Fraud? Part 1

Corporate fraud is a twin of corporate misgovernance. 

The two are frequently companions.

 “طيزين في سروال واحد “. 

Or, if you are a film buff like A, “طيزين بلباس “. 

I’ve written before on this topic but in relation to “corporate governance”. Here and here.

To launch this discussion intended to consist of three posts, let’s begin by looking at a proposal Edward Hadas made in an article at Reuters. 

When a sharp incisive journalist like Ed writes a piece, it’s always a good idea to take a close look.

In his article, he proposes the use of private sector forensic accountants to conduct investigations to uncover fraud.  

They would be funded by a portion of the fees that companies pay their "regular auditors" so that the "fraud busters" could be independent of the economic considerations that are often considered impediments to financial auditors' full performance of their duties.

The “fraud busters” would not check all companies but only those where they “sniff out suspicious activity”.

How?

Either from tips from stock analysts, whistleblowers, worried bankers, and/or investigative journalists. Or from their own ratio analysis, etc.

The “fraud busters” might also choose to focus on industries that “attract miscreants”.

They would be given “a government license to pry”, presumably at a minimum to conduct investigations and compel the company to provide access to confidential information. 

They would also have “the authority to prevent regular auditors from signing off on accounts.”

An interesting proposal.

However, I think this system would be difficult to institute and would pose several significant challenges.

First, the “government license to pry” and the authority “to prevent auditors certifying financial statements” imply that the “fraud busters” would be granted legal powers akin those to enjoyed by governmental agencies.

If so, this is likely to result in potential conflicts between the “fraud busters” and the governmental agencies.

Why?  

Because unlike investigative journalists, security analysts, etc. they would be able to compel testimony and the provision of records as well as issue binding judgements, e.g., on financial auditors.

Would the “fraud busters” or a government agency have the final say about inception, the determinative process, and disposition of a potential case?

As well, in order to the prevent the “fraud busters” from interfering with ongoing or contemplated non-public official investigations, they would need to be informed about them.

Official agencies would naturally be reluctant to provide this information for fear that it would be “leaked” in one way or another, thus alerting the “target”. 

Or potentially causing harm to the "target" before the process was complete. 

Or that such “inside information” would be misused for “insider trading”.

Second, and more importantly, giving private sector companies rights typically the monopoly of government agencies would raise significant constitutional and legal issues regarding due process and the rights of a defendant. And probably not only  in the USA. 

What would be the “probable cause” standard for a “fraud busters” investigation?

It would seem that at least it would have to be equivalent to the standards that governmental agencies must meet before formally commencing an investigation, including the legal right to compel testimony and provision of records. 

Think of the steps required for an SEC Formal Order of Investigation or the judicial processes associated with US DOJ actions. Or of “discovery” in civil cases.

There are operational issues on exactly how this would be arranged (structure) and managed (process) for "fraud buster" investigations to ensure the rights of “targets” are protected. And confidentiality were maintained.

I think these legal issues are particularly important because as I read Edward’s article—and apologies to him if I have misread it—the “fraud busters” seem to have fairly wide latitude to begin an investigation.

They seem to be “financial bounty hunters” or a version of the Met “Flying Squad” set free to range far and wide to uncover frauds.

For example, as per his article, they might “focus” on companies in an industry they judge “attracts miscreants”. This might be characterized as “guilt by association” by targets.  And even harder to justify on a “probable cause” basis if legal objections were raised by the target.

Other justifications would be “tips” as mentioned above from third parties and financial ratio analyses the “fraud busters” conducted themselves.

How would the credibility and “weight” of the “tips” be assessed? Particularly, when many of the tips are likely to originate from sources that do not have first hand access to inside information of wrongdoing.  

Or where the “tipper” has an economic interest in lowering the price of the target’s stock? Think Herbalife. 

All these raise issues about probable cause in a USA context. 

Should their investigations be limited to the subject of the tip? Or might they like Kenneth Starr range far and wide beyond their initial scope to find wrongdoing once they commenced an investigation?

Initial suspicions on NMC concerned overvaluation of acquisitions. What turned out to be the “real” problem was unrecorded liabilities. There were no tips that I am aware of on that problem until information came out at the final stages of the company’s unraveling.

What should be the impact of ostensible independent third party’s report that it found no evidence of fraud?

As per “Management” Note 2.5 on page 97 of Wirecard’s 2018 audited annual report a Singapore law firm, Rajah and Tann, conducted an investigation which cleared Wirecard at least preliminarily. A Government of Singapore investigation was still ongoing at the time.  

This may seem like pettifogging. 

But if we hope to see criminal or civil penalties imposed on fraudsters, we need to make sure that they have no defense from shortcomings in due process or violations of defendants' rights.

Third, if, as asserted, economic considerations motivate auditors to not properly execute their responsibilities, wouldn’t “fraud busters” be subject to the same temptations?

In their case the issue would not be doing too little but doing too much.

Investigation for the sake of investigation because presumably, they will be paid for the number of investigations they conduct. 

With the lure of a sizable “bounty” for uncovering a fraud perhaps providing  additional incentive to “keep digging” or to overstate wrongdoing.

There are other difficulties.

For example, because they receive their authorities from national governments, cross border investigations would likely be more limited that those by governmental agencies. That is not to assert that national governmental agencies have an easy time with cross border cases.

Similarly, granting the “fraud busters” powers similar to governmental agencies probably would require as well the provision of legal immunity regarding their investigative actions in order for them to discharge their duties.  

In the next post I’ll outline an alternative proposal—admittedly imperfect—that seeks to leverage existing structures to increase the detection of fraud.