12 May 2009

Economic Impact: Hedge Funds Beware...

In a recent ACFE study on the impact of an economic recession, the results are eye opening. More than half (55.4 percent) of respondents said that the level of fraud has slightly or significantly increased in the previous 12 months compared to the level of fraud they investigated or observed in years prior.

Additionally, about half (49.1 percent) of respondents cited increased financial pressure as the biggest factor contributing to the increase in fraud, compared to increased opportunity (27.1 percent) and increased rationalization (23.7 percent).

The survey also found that:

  • Employees pose the greatest fraud threat in the current economy. When asked which, if any, of several categories of fraud increased during the previous 12 months, the largest number of survey respondents (48 percent) indicated that embezzlement was on the rise.
  • Layoffs are affecting organizations' internal control systems. Nearly 60 percent of CFEs who work as in-house fraud examiners reported that their companies had experienced layoffs during the past year. Among those who had experienced layoffs, almost 35 percent said their company had eliminated some controls, while 44.2 percent said the layoffs had no effect on controls and only 3.2 percent said their company had increased controls.
  • Fraud levels are expected to continue rising. Almost 90 percent of respondents said they expect fraud to continue to increase during the next 12 months. Additionally, the fraud most expected to increase is embezzlement.

These results are not too surprising. Internal control systems could be an issue if there are layoffs in the risk management departments or reallocated enterprise resources. The embezzlement schemes come in many forms and they know where and what areas will be neglected in oversight during the economic belt tightening.

Most of these fraudsters are brilliant "con men". They know how to prey on the human factors of greed and fear. Powerful emotions must be monitored by a "Corporate Vigilance" and awareness program. This preempts potential breaches and crisis incidents that will ultimately impact personal and corporate reputations.

Three factors are generally accepted as being necessary for a fraud to occur: pressure, opportunity, and the ability to rationalize illegal behavior. Unfortunately, the presence of each of these factors may rise in periods of economic hardship. Organizations and individuals alike can experience the pressure of increased financial strain. Opportunities for fraud could proliferate as many companies cut their workforces and otherwise reduce expenditures, perhaps leading to reduced internal controls and fewer proactive fraud prevention measures. And bombardments of bad financial news could cause mounting feelings of helplessness, pessimism, and isolation, which may, in turn, allow individuals to rationalize previously unthinkable acts.

So what can you do to detect early the potential existence of a suspected fraudster in your organization without subjecting current employees to retribution or put them into harms way? One effective strategy is to hire an outside entity to perform ongoing interviews and investigations that is independent of the internal audit department or OPS Risk staff. The other step is to compartmentalize the unit in terms of information exchange and to increase overall operational security.

Harry Markopolos, who is responsible for investigating Bernie Madoff for 8 or 9 years did exactly this and for good reason. His team was operating in the field under his direction and was kept secret even while he was talking to the SEC. Why? Some of the off-shore funds Madoff was doing business with were only a few steps removed from organized crime, according to Markopolos. If these firms new that Mr. Madoff was stealing them blind, they could have put some adversarial actions into play.

Once the fraudster gets the indicator that any one is getting close to the point of questioning their behavior, you can bet the evidence will begin to be destroyed or masked. This destruction of evidence can begin with simple deleting of e-mails, documents or the creation of new e-mails or data to mask or cover up the trail of fraudulent activities. This is when the use of Digital Forensic examinations on weekends or evenings while employees are away from the workplace can help reveal the presence of "Anti-Forensics."

The presence of anti-forensic tools to cover their tracks, e-mails or where they are visiting on the Internet might be the first sign that you may have an actual fraud scheme in operational mode. Hidden or encrypted files found on an employees laptop or desktop utilizing unauthorized sofware tools or downloaded freeware is a huge "Red Flag."

It's important for any investigator to consider the human factors and the behavior associated with people under pressure and close to the end of their hidden occupational fraud operation. These typically have been going on for up to 24 months before they are discovered and you can be sure that they have thought about the day when they are finally discovered. The fight or flight mode kicks in at this point and organizations are obligated to mitigate the risks of harm to fellow employees.

Effective Corporate Integrity units in global enterprises require the right internal resources, independent outside expertise and a comprehensive OPS Risk framework to be more successful.

Hedge Funds have been on alert for months now. Marc Dreier, the New York law firm founder accused of defrauding hedge funds by selling $700 million in phony promissory notes, might face life in prison after pleading guilty to fraud charges.

According to prosecutors, victims of the fraud included Amaranth Group Inc., Perella Weinberg Partners, Eton Park Capital Management LP, Concordia Advisors LLC, Novator, Meyer Ventures LLC, Blackstone Group LP’s GSO Capital Partners and Elliott Management Corp.

The case is U.S. v. Dreier, 09-cr-85, U.S. District Court, Southern District of New York (Manhattan).

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