The Steep & Slippery Road to Fraud — A Hypothetical Example of “Why”
Ten years ago, things were good. Bob’s business was profitable, and he was working hard every day, making ends meet with a decent amount left over. He’d just added additional staff to handle some of the daily grind, and he was focusing more on the growth of the company.

Over the next five years, the business started to expand. Bob needed more trucks, more people and more credit from his suppliers. Bob’s bank was only too happy to finance the new trucks he needed and nice new cars for Bob and his wife. The suppliers loved Bob, too. Some of them not only offered a higher credit line, but also went so far as to extend Bob’s terms to allow for a longer pay period. The company hired a full contingent of back office staff, doubled its capacity in the shop and moved into a new building, purchased by Bob’s new company, Bob’s Real Estate Holdings, LLC.

Then, slowly at first, it started to happen. Over the course of several years, Bob’s largest customers began to stagnate. Bob’s sales stopped growing; then they started to drop. Employee healthcare costs increased. The price of raw and other direct materials went up significantly and Bob’s contracts didn’t allow him to pass the higher costs through to his customers. All the new staff and equipment drove Bob’s cost of sales higher. Without the increase in volume enjoyed in past years, profitability began to suffer. The company began increasingly to rely on its vendors and bank lines of credit, which slowly edged closer and closer to its limits.

Finally, with cash at zero, payroll due on Friday, the company’s largest customer demanding a price cut, vendors holding shipments and the bank line of credit nearly out of availability, Bob did it. In a desperate move, Bob and his controller opened an account at a new bank, deposited some of the week’s cash receipts into the new account (money that contractually should have gone to pay down the company’s line of credit) and paid the week’s payroll from there.
It was fraud, and Bob knew it was wrong. But he also knew that it was just a one-time thing. He didn’t have to report anything to the bank until month-end; he’d be able to make up the difference within the next week, so everything would be OK again. And it was.

But two months later it happened again. This time, it took a little longer to get the diverted funds paid back, but he still did it. Unfortunately, the timing of this diversion was such that it crossed over a month-end reporting period. Bob’s controller had to report to the bank: balance sheet, income statement and borrowing base report for the line of credit. It wouldn’t do to show a separate bank account, and without the receivable balance, the line of credit was actually at a negative availability and thus out of formula. But, again, it was only temporary, so Bob and his controller delayed the reporting. When they did file the required reports, they back-dated the corrections and reported no problems as of month-end. In other words, they falsified the bank reporting.

It was fraud again, and Bob knew it again. But he also knew that it was just a one-time thing. Sure, he’d reported falsely to the bank, but he fixed the balances within a week or two and he’d been able to make payroll again. Heck, if he couldn’t make payroll, he’d be forced to close down. Then, where would the bank be? Over the course of the next twelve months, it got so bad the company actually ended up tracking two sets of books for its accounts receivable; one within the internal accounting system that tracked reality, and one for the bank reporting. The bank grew suspicious and began to require weekly borrowing base reports. It was having trouble understanding how Bob’s accounts receivable kept going up, along with his borrowing, while his sales and profitability were dropping.

At this point, the bank scheduled a review of Bob’s books and operations. It was bringing in a consultant and had the right to do so under the terms of the loan agreements. Not only did Bob have the line of credit outstanding, but also all of the new equipment notes, a couple of mortgages and the loans for the nice cars he and his wife drove. While delaying the consultant’s access to the company as long as possible, Bob and his controller tried to shore up the false reporting by creating false backup documents, reconciling schedules and the like. Bob’s descent into the world of fraud was complete.

The Psychology of Fraud: Why Did They Do It?

In reviewing recent cases involving Amherst Partners, we have found that a number of financial advisory cases in the last two to three years (and nearly every case of significant size) have involved some aspect of fraud or potential fraudulent activity.

The following summary of an actual Amherst case provides a recent example of a bank fraud scheme, the review method that ultimately uncovered the fraud and the basic psychology of the individuals who ultimately perpetrated the fraud.

Empty Pockets, Empty Boxes

Fraud Identification and Description — Representing the debtor, a plastic injection molder, Amherst reviewed the balance sheet and performed a standard inventory analysis, which indicated reported inventory balances weren’t moving through the system in tandem with corresponding production and shipments. Upon further investigation, Amherst found the company had been placing packing stickers on empty boxes and stacking them in various places throughout the warehouse. These empty boxes were then counted as full of finished goods, inflating the company’s borrowing availability from its lender and providing false indication of the ability to ship to customers in a timely manner.

Detection — The lender in this case had performed standard audit procedures without catching the inflated inventory. Standard collateral audit procedures are not designed sufficiently to catch most forms of fraud, and they generally leave out the best place to start — a simple common-sense snapshot review of operations, not the tick and tie auditing most collateral audits provide. Amherst’s review of the balance sheet in this case generated one simple question, “For a company having difficulty paying its vendors in a timely manner, why do they have so much inventory?” Following the trail to find the answer uncovered the empty box scheme.

Psychology of the Fraudster — The owner of the company had started this business 30 years ago, was nearing retirement and was working toward handing over the reins to his son when the Great Recession hit the automotive industry hard. As a result of the automotive downturn, the plastics industry suffered tremendously, and the company was unable to make its loan payments or pay vendors on time. In the belief that the industry was going to return, and with the goal of providing the next generation with something that the owner had worked so hard on for so long, he made the conscious decision to falsify bank reporting to gain more availability on his bank line of credit.

Motivation — Love of one’s children and desire to not lose what was built over a lengthy period of time.

As we can see from our hypothetical example with Bob, as well as the real life example above, many fraudsters don’t set out to be that way. A set of circumstances, some of which are truly out of their control, lead fraudsters down a path to committing the crime.

Five Lender Techniques to Help Reduce Bank Fraud

What can a lender do to increase the likelihood it will detect fraudulent activity early in the process? Financial institutions generally have a number of procedures and techniques available to help prevent fraud. The frequency of use of these procedures and techniques, however, is up to the individual. As a primer, we have listed below five items a lender can be aware of that may provide indicators that a deeper look may be necessary:

Balance Sheet / Income Statement Relationships — Most simple ratios don’t readily bridge the gap between operations and the balance sheet. To do so, ask questions that require both sides of the financial statements to answer. How much inventory is on hand in comparison with monthly sales? How does the total accounts receivable balance or aging compare with monthly sales? What changes have taken place in fixed assets in comparison with the overall profitability of the company?

Third Party Verifications — Consider verifying not only a few accounts receivable, but several accounts payable as well.

Slow Moving Inventory — Slow moving inventory items are prime areas to hide false assets. Test counting the slow moving inventory can lead to any number of discoveries.

Original Documentation — Always insist on original reports from a company’s internal accounting systems. Allowing a company to report in summary format using external software and without any detailed original documentation leaves the door open for easy manipulation.

Kick the tires — Don’t be afraid to walk around the plant, the shop floor, the showroom or the building itself and take note of anything out of the ordinary or that you simply don’t comprehend. Ask questions until you gain full understanding.

Poor economic conditions increase the likelihood that fraud will be committed. Although some economists believe we are now at or past the bottom of the most recent economic trough, it is reasonable to believe that upward trends in the occurrences of fraudulent actions will continue for at least another two to three years.
This article was first published in Vol. 33, Issue 1 (Spring 2013) of the Michigan Business Law Journal.

Brian Phillips is a managing director of Amherst Partners. He specializes in turnaround and crisis management, profit enhancement, debt restructuring and litigation support services.

Scott A. Eisenberg is the managing partner and co-founder of Amherst Partners. His experience includes merger and acquisition transactions, restructuring and turnaround engagements and a wide variety of management advisory services.