Fraud's Red Flags

If the massive $7-billion alleged fraud at French bank Societe Generale teaches us anything, it is that fraud is always a possibility. It can be perpetrated at almost any level, from the corner office to a rogue mid-level employee.

Here in the United States, the Sarbanes-Oxley Act of 2002 has initiated a focus on internal controls and fraud prevention, but no one will claim that the systems this legislation mandated are fool-proof guards against fraud, nor have they done much to change what is often the biggest contributor to egregious corporate conduct: culture.

Directors and CEOs are more concerned than ever about understanding the corporate culture of their companies, and, if necessary, doing something to improve it. The consequences of lapses earlier in the decade that led to the great accounting and options back-dating scandals are still being felt today, both for those who are serving time in “Club Fed” and those serving on public boards.

Outside directors now have a heightened concern about personal liability, partially as the result of the class-action settlements at Enron and WorldCom in which the directors made personal contributions. The result is a greater emphasis on director independence, shorter CEO tenures as boards became quick to fire CEOs for failure to adhere to ethical standards, and a general increase in the importance of the director’s watchdog role. Governance rating agencies, regardless of the merit of their ratings, now wield significant influence in director elections and transactions, and activist shareholders are quick to threaten to remove directors for alleged shortcomings in the oversight of management. Accordingly, there is increased pressure to ensure that compliance programs are effective and that employees throughout the organization are behaving ethically.

Almost every article on the subject of governance, compliance, and ethics includes some formulation of the importance of the “tone at the top.” All the consultants and gurus stress the importance of leadership by the CEO and the board. These are “empty bottles”—fine principles, but not the sort of concrete, specific ideas that provide a basis for directors and executives to take effective action.

Mission statements and codes of business conduct go only so far as well. They may be good starting points, but the proof is in what the employees are doing and saying day in and day out.

Many boards are holding more frequent and longer meetings. Many are regularly having “executive” sessions without the presence of management. The thrust of these changes is an increase in the openness of communications at the board and committee levels. Some boards are going further and encouraging director communications with senior and middle managers, outside the presence of the CEO.

Some boards are also requiring directors to visit company facilities and talk to managers there.

All of these processes are now considered generally accepted practice by many boards, but what separates the boards that take their fraud-detection responsibility seriously are those that focus on fraud’s telltale “red flags.” Following are some examples of indicators that something might be amiss.

"Red Flags" that Point to Fraud

1. “The old rules don’t apply.”

Most companies encourage creativity and value innovation. One of the most significant risks of the recent increased focus by investors and others on governance, compliance, and transparency is that companies may become less likely to venture into new areas. Yet when it comes to compliance with laws and regulations, and conducting business ethically, the old rules may be the best rules. The latest accounting and tax schemes may or may not be legal; only future cases will tell for sure. The fundamental precepts of ethical behavior have changed very little since the ancient philosophers taught their lessons.

If the allegations against Enron are true, it was a company whose senior executives allowed fraud to thrive under the guise of an innovative business model in which the old rules no longer applied.

Another manifestation of this pitfall is to defend it through hubris. When managers begin to think that they are invincible or can do no wrong, it is time for the board to change policies, managers, or both. When talk turns to a “new paradigm” or “new economy,” look out!