Corporate Fraud - It’s All In The Details
Written by: Randall D. Wilson [1]
SMART Business Advisory and Consulting LLC; Chicago
When corporate insiders devise an elaborate scheme to mask the true financial condition of their company and only receive passive push-back from their professional advisors, the stage is set for a potential corporate meltdown.
Refco and its subsidiaries employed thousands and serviced hundreds of thousands of customer accounts. They were a group of commodities and futures trading companies skilled in the execution and clearing of exchange traded derivatives and providing brokerage services.
In the late 1990s, Refco experienced losses in the hundreds of millions comprised of customer losses, proprietary losses and operating losses. Refco’s senior management team (the insiders) concealed the trading losses, disguised the existence of operating losses and inflated income attributable to operations.
The insiders devised sham transactions to mask their lack of business acumen and ultimately transferred the losses to an unconsolidated related party entity that was owned by certain of the insiders.
A few weeks after Refco’s 2005 IPO, the true financial condition of Refco began to emerge. The fraudulent scheme was revealed when a Refco employee (not a Refco professional advisor) discovered a multi-million dollar receivable owed to Refco from its unconsolidated related party entity. A demand was made for repayment of the debt from the insiders. A cover-up was attempted, but was unsuccessful.
From there, Refco’s market capitalization dropped by over $1 billion, its stock was delisted by the New York Stock Exchange and on Oct. 17, 2005 Refco et al [2] (“Refco”), filed for protection under chapter 11 of the U.S. Bankruptcy Code. In re Refco Inc., Case No. 05-60006 (RDD) Bankr. S.D.N.Y. (2005)
Management Override
Clandestine operations and deceptive practices are fraud’s distinctive characteristics. Corporate insiders, without a solid internal control function and determined oversight (both internally and externally), become very adept a covering their tracks (as long as the scheme does not become too large and difficult to track). In fact, some become so adept at their scheme that it makes it difficult for any audit or investigation to uncover their malfeasance.
Many professionals rely too heavily on internal controls to deter fraudulent conduct. Therein lays the problem. If management is determined to override internal controls to boost the bottom line or cover up criminal activity, they will find a way. Internal controls can only provide reasonable assurance of detection.
For several years at Refco, the insiders devised and implemented sham transactions to boost their bottom line at fiscal year ends. These transactions involved Refco, one of its unregulated subsidiaries, certain Refco customers and an unconsolidated related party entity owned by certain insiders.
The insiders directed the sham transactions and also developed and implemented fictitious interest income, currency trades and other misappropriations in order to falsify the bottom line of Refco.
Timing Is Everything
When key reporting dates are imminent and management is desperate to show increased earnings or enhanced operations, timing differences are a classic and effective method to develop fraudulent profits.
Timing of transactions is, and always will be, a significant tool in helping corporations influence the recording of income, expenditures and other factors that affect the bottom line.
At Refco, the insiders (at key reporting dates) transferred losses to an unconsolidated related party entity and involved Refco customers in order to give the appearance that those customers owed large amounts of money to Refco. Those transactions were unwound shortly after the reporting period.
Cash Is King
The pressure to show growth, stability and/or meet Wall Street expectations is a major driving force in most corporations. Capital raising activities and/or debt issuances may be an indication (without appropriate disclosure) that there are financial problems. To determine how much pressure is on management to show earnings, it is critical to determine the reason a company is attempting to raise additional funds through stock issues or borrowings.
At Refco, the insiders made a number of attempts at partial or complete sale of their interests in Refco. In the late ’90s, Refco sold a 10 percent ownership interest to a subsidiary of a Refco customer and granted an option to purchase an additional 10 percent interest in the company. A few years later, Refco explored the possibility of selling substantial portions, if not all to a customer or to third parties.
Eventually, Refco participated in a leverage buyout transaction that handed over a significant percent of the company to a new partner. Less than one year after the LBO, Refco and its new partner led Refco through an IPO. The IPO was allegedly structured with the goal of allowing the insiders to cash-out, as opposed to raising funds for Refco to reduce the enormous debt Refco had acquired in the LBO.
Financial Statements Don’t Tell the Whole Story
A careful reading of the financial statements and their disclosures may help the skeptical professional to find clues as to potential wrongdoing.
Fraudulent disclosures, in most instances, involve intentional omissions. Material events, unreported management fraud and inadequate scrutiny of related party transactions are all areas that deserve a skeptical look. What is the best course of action? Ask more questions and demand further diligence/investigation.
The requirement that financial statements and related notes include all necessary information for a user of those financial statements from being misguided is promulgated by generally accepted accounting principles. All significant information affecting the financial statements is obligated to be reported by management.
Refco, for its IPO, had to file an S-4 with the SEC to register senior subordinated notes issued in the LBO. Drafts of the S-4 registration statement submitted to the SEC for comment disclosed a “customer receivable” owed from an unconsolidated related party entity to Refco. Comments from the SEC caused Refco’s professionals to amend subsequent drafts of the S-4 registration statement to show the item as due from “equity members.” This was shown in the final S-4 filed with the SEC during 2004.
The final S-1, publicly filed with the SEC during 2005, did not disclose the existence of the multi-million dollar related party receivables and the sham transactions used to falsify the financial statements at fiscal year ends.
Who Designed the Internal Controls?
When internal control systems are designed, implemented and monitored by senior management, it is easy to see why it is relatively common to find that senior management is best at circumventing those controls. Such internal control systems are generally most effective in detecting accounting frauds resulting from lower level activities (i.e. embezzlement, asset theft, etc.) The alignment of shareholders expectations and goals are closely associated with those of senior management, and therefore make it practical to determine how certain frauds occur.
At Refco, the certifications that were signed by the insiders and included in the annual report and quarterly reports stated that Refco’s management had designed adequate disclosure controls, and that management had disclosed fraud whether material or immaterial that may have involved key management.
Because of the fraud that was perpetrated, financial statements for over five fiscal reporting periods could no longer be relied upon.
Conclusion
The use of professional skepticism to interpret operations, results and the substance of financial transactions is paramount to any professional’s involvement with complex corporations. Professionals that are qualified and diligent in understanding their client’s business may be able to detect a financial statement fraud that is material before it causes significant harm to the company.
It is all too easy to gloss over the necessary and reasonable steps required to prevent a major fraud. Client pressures, fee pressures, time pressures and the maintenance of long term relationships all play critical roles. In the end, what is overlooked by well-trained (or not so well-trained) professionals is what leads corporations to the courthouse.
The mindset should always be: what is the worst-case scenario? If management were to falsify the books and records, how would they do it? The pressure to perform is great. The need to maintain your reputation is greater.
Sources of Refco data:
Marc S. Kirschner, etc. v. Grant Thornton LLP, et al., C.A. No 1:07-5306
In re: REFCO INC., et al, Case No. 05-60006 (RDD) S.D.N.Y. (2005) (Final Report of Examiner)
[1] Randall D. Wilson leads the Disputes, Valuations and Investigations Practice Group for SMART Business Advisory and Consulting LLC in its Chicago office.
[2] Includes Refco Inc. (holding company formed in the 2005 Initial Public Offering), New Refco Group Ltd., LLC (holding company formed in the 2004 Leveraged Buyout), Refco Group Ltd., LLC, Refco Regulated Companies LLC, Refco Global Futures, LLC, Refco Securities LLC, Refco LLC, Refco Capital Holdings LLC, Refco Capital Management LLC, Refco Capital Markets Ltd., Refco Capital LLC and Refco Global Finance Ltd.