Category Archives: Concealment Strategies

Reaching Behind the Curtain

Not too long ago a close friend of one of our Chapter members paid a substantial sum of money to a relative, the owner of a closely held corporation, in exchange for a piece of the relative’s real estate to which, it turns out,  the relative/owner did not have clear title.  The relative apparently used a substantial portion of the funds to immediately clear debts of his corporation of which he and his wife are the sole officers and shareholders.  He now claims that, since he used the sale proceeds for corporate purposes, the refund of the purchase price he owes our Chapter member’s friend is a debt of the corporation and not of his personally.   Our Chapter’s friend has engaged an attorney at the suggestion of our certified Chapter member.

Our legal system recognizes that corporations have a separate existence from their shareholders/owners and are treated as ‘individuals’ under the law. There are two ways for a wrong-doer to use the existence of a corporation to avoid efforts to recover a money damage judgment from him or her:

–As in this case, the scammer argues that the corporation and not the shareholder/owner committed the offense, and therefore the shareholder’s personal assets and property should not be used to satisfy any judgment for the offense.

–Argues that the wrongdoer/shareholder’s property is held in the name of the corporation, and therefore s/he has no personal assets that can be used to satisfy a judgment against him  or her.

The first reflects the classic doctrine that shareholder/owners are not liable for the debts or liabilities of the corporation. Of course, if the shareholder/owner also controls the corporation and personally acted wrongfully, s/he may still be liable for her misconduct, and the corporation may simply be jointly and severally liable together with her. Whether the wrongful conduct was that of the corporation or that of an individual shareholder usually is a question of fact to be decided by the jury.

The second reflects the corporation’s ability, as a separate legal entity, to own its own property. If the corporation owns the property, then the individual shareholder does not.  Since both pre-judgement attachment writs and writs of execution can only reach a defendant’s interest in leviable assets, a wrongdoer can appear without assets and judgment proof – and your client can be unable to satisfy a money judgment against her- if the wrongdoer/shareholder has transferred title in her personal assets to the corporation. This does not apply to a non-money judgment to recover specific money or property which can reach proceeds or property in the hands of the wrongdoer or of third persons. Of course, if the wrongdoer’s transfer of assets to the corporation was to defraud creditors, the injured party can seek to have the transfers set aside.

However, even where a corporation apparently shields the defendant or his or her property, the wrongdoer and her leviable property can still be reached if the court can be convinced to disregard the corporation or to regard it merely as her alter ego. The court may do so if it can be proved that the corporation is merely a sham whose sole purpose is to help the wrongdoer fraudulently avoid liability for her conduct. This is sometimes called piercing the corporate veil.

If the corporation is found to be the alter ego of the shareholder, then either or both of the following consequences apply, depending on the goal in piercing the corporate veil:

–The wrongdoer is no longer shielded from liability for the corporation’s misconduct because the wrongdoer and the corporation are viewed by the court as one and the same.

–Corporate property can be reached to satisfy a judgment against the wrongdoer because the property is now regarded, properly, as the wrongdoer/shareholder’s property.

One of the factors to consider in attempting to pierce the corporate veil is whether the corporation is closely held; i.e. owned or directed by one or by a small or limited number of shareholders, officers, and directors (often all the members of the same family). Obviously, the larger the number of shareholders, and the more broadly the corporation’s directing positions are distributed, the less likely it is to be a sham or alter ego for one person. However, given the lawful goals and purposes of incorporation, even a small, closely held corporation may be legitimate. Conversely, the existence of other shareholders or other directors and officers may not mean that the corporation is not a sham.

The ACFE tells us that there is no hard and fast test to determine whether a corporation is a sham. Instead, courts will look at a variety of factors to determine whether to pierce the corporate veil. These factors include:

–As in this case, does the wrongdoer exercise sole or ultimate control over the activities of the corporation?

–Does the corporation’s charter describe the approved activities of the corporation with some specificity, or is it left largely to the discretion of the wrongdoer?

–Does the corporation fail to hold director’s and shareholder’s meetings, record minutes of those meetings, and otherwise observe the formalities of corporate existence?

–Is the corporation so undercapitalized as to raise questions about its viability as a separate entity?

–Are the corporation’s finances so intertwined or identifiable with those of the wrongdoer as to raise questions about its separate existence?

–Does the corporation own property which does not seem to reasonably relate to its activities, particularly as described in its charter?

–Does the wrongdoer use the corporation’s property as if they were her own, personal assets, including but not limited to whether she uses them for purposes not within the corporation’s approved activities?

These and similar or related facts can indicate that the corporation is a sham and has no true, separate existence from the wrongdoer/shareholder. In that case, the court would be justified in ruling that the corporation should be regarded as an alter ego of the wrongdoer and that the corporation and the wrongdoer be considered as one and the same ‘person’ for purposes of determining liability or levying on assets to satisfy a money judgment.

Many thanks to our member for bringing this case to our attention!

Empty Shells

I attended an out of town presentation not too long ago on investment and tax avoidance scams targeting well-to-do retirees. An especially interesting portion of the CFE presenter’s presentation (a recent retiree himself), focused on the use of paper or shell corporations and companies as tools by the perpetrators of such schemes.

Our presenter emphasized that regulators and other law enforcement personnel attempt to identify instances of fraud against retirees and others in order to prosecute the perpetrator and return the fraudulently obtained goods to the victims. However, such frauds tend to be an under-reported crime as victims may be embarrassed that they easily fell prey to the fraudster or may remain connected to the offender because of the engendered trust cultivated. Reluctance to report the crime can stem from a belief that the fraudster will ultimately do the right thing and return any fees or funds. In order to stop such fraud, regulators and law enforcement must be able to detect and identify crime, caution potential investors, and prevent future frauds by taking appropriate legal actions against the perpetrators.

He went on to say that one of the foremost reasons for the existence of the underground economy is to escape taxation, which in some countries can be as high as 51 percent of a person’s nominal income. Swiss bankers have a saying, “There would be no tax havens without tax hells.” As the rate of taxation increases, so does the cost of honesty. The higher the tax burden, the more incentive people have to attempt evading those taxations. Because it is illegal, tax evasion always involves financial secrecy.

Every few years the Internal Revenue Service (IRS) releases its top 12 most blatant tax scams affecting American taxpayers. Over the years the Service has repeatedly warned retirees not to fall for schemes peddled by scammers for the avoidance of taxes featuring the use of dummy corporations (or shells) associated with off-shore accounts in tax havens and emphasizing that there is no secret trick that can eliminate any senior’s tax obligations. Every tax payer should be wary of anyone peddling any of these scams.

The IRS aggressively pursues taxpayers and promoters involved in promoting abusive offshore transactions to wealthy seniors. Such promoters pitch seniors in the use of methods to avoid or evade U.S. income tax by hiding income through shells with accounts in offshore banks, brokerage accounts, or through other entities. Such actively promoted scams feature the use of offshore debit cards, credit cards, wire transfers, foreign trusts, employee-leasing schemes, and private annuities or life insurance plans. The IRS has also identified the use of shells in abusive offshore schemes including those that involve use of electronic funds transfer and payment systems, offshore business merchant accounts and private banking relationships.

But, as our speaker pointed out, shell companies aren’t just for big and medium-sized tax evaders anymore. They have become the financial and deception vehicle of choice for some of the most corrupt, dangerous and ruthless individuals and entities on the planet. Arms dealers, drug cartels, corrupt politicians, scammers, terrorists and cybercriminals are just a few of the most creative and frequent users of shells.

It’s also important to emphasize that not all shell companies are used for nefarious purposes; assurance professionals and investigators need to be aware that there are legitimate uses for these entities, such as using one as a holding company or creating a shell company (in name) to preserve future business rights or opportunities. Not every shell is involved in a criminal conspiracy, so it’s important to understand why someone might use a shell for criminal purposes.

The primary purpose of the use of a shell in a fraud scheme is like that of the fraud itself: to conceal fraudulent activity. This may include the nature, origin, or destination of misappropriated funds and/or concealment of the true owners and decision-makers of a criminal act or conspiracy.

In many instances, one shell company isn’t enough; fraudsters create networks. Dozens of shells, nominee directors, addresses and fake shareholders might be required to fully conceal a scheme or criminal plot. Big-time criminal conspirators will utilize shell incorporators to do the heavy lifting and help create a corporate web of disguise that can perplex and confuse even the best of investigators.

Shells can come in all different shapes and sizes, and the jurisdiction in which they reside can help further the concealment. Some fraudsters create shell companies for single uses and then discard them. Or they may use them repeatedly and have them change hands multiple times. They also may form what our speaker dubbed shelf companies and not use them for a period of time. A shelf company has a better chance of appearing legitimate and fooling a novice investigator or basic due diligence mechanisms because it appears to have existed longer than it really has. An older shelf could have a creation date predating any specific areas of investigative concern, which would allow it to engage in business activities when it otherwise couldn’t without arousing suspicion.

Given the intent, with a small sum of money, time and patience, fraudsters can set up a very elaborate web of shell companies in little time. But establishing the company name is only the first step in creating a shell network of deception. The company needs nominee directors and shareholders, often illegitimate, to further the concealment.

Scammers use nominee directors, and in some instances, other shell companies, to disguise true owners of entities while giving the appearance of legitimacy. Some nominees simply sell their names to fraudsters who use them on company documents. Others actually provide limited services for the shell companies such as processing corporate records, signing for company documents and forwarding mail. These nominee directors are the linchpins to linking and disguising international criminal organizations and operatives. Their use is so widespread that IRS conducted searches among entities frequently disclose nominee directors crossing paths. Some are even listed as directors for the same shell entities.

So what does our speaker recommend that individual CFEs do if we think that one of our clients may be unwittingly doing business with a nefarious shell?

— A shell company can be set up practically anywhere, but successful incorporators have learned to use particular countries and regions. Advantages can include lack of government enforcement or specific laws protecting corporate secrecy. A good source of a high-risk country list is the U.S. State Department’s annual list of major money-laundering countries.
— Use SWIFT codes – a SWIFT code is a unique identifier that’s associated with particular financial and non-financial institutions around the world. If you can identify the SWIFT code for the financial entities the suspected shell is dealing with, you might consider monitoring for any funds originating from or being disbursed to these banks or check to see if any of your client’s customers/vendors have bank accounts associated with these specific institutions.
–Review all available internal data that contains contact, banking, address and ownership information, such as vendor/customer data, wire transfer data, ship to/ship from locations for sales and purchases, purchase orders and invoice support documentation.

Look for :

• Information that doesn’t make sense given the nature of the business relationship with the entity.
• Entity information mismatch: address, phone, fax, ship to, bank, cell contact, etc. in different geographic locations.
• No discernible online presence when compared to the goods/services and the amount of money changing hands.
• The entity “representative” is associated with numerous other companies.
• Payment is made to or received from an unrelated third party. Review incoming/outgoing wire transfer documents.

Our speaker summarized that involvement with shell companies and those associated with them can be very bad news for any of our client companies. Fraudsters within your client organization might make use of them as vehicles of corruption or asset diversion. External perpetrators can passively use them as money-laundering vehicles against your client organization.

All assurance professionals should attempt to stay current with the latest types of abuse associated with the shell company model, trends in international corruption, fraud and asset diversion, and money laundering. ACFE training is, as usual, an excellent resource to do this. To the extent possible, try to screen information on your client’s customers, vendors and employees on an on-going basis. Cross-reference known bad actors and shell companies in the news against the entities with which your clients are doing business. Contact authorities if you and/or your client determine that it has become the victim of a shell company related scheme.

Concealment Strategies & Fraud Scenarios

I remember Joseph Wells mentioning at an ACFE conference years ago that identifying the specific asset concealment strategy selected by a fraudster was often key to the investigator’s subsequent understanding of the entire fraud scenario the fraudster had chosen to implement. What Joe meant was that a fraud scenario is the unique way the inherent fraud scheme has occurred (or can occur) at an examined entity; therefore, a fraud scenario describes how an inherent fraud risk will occur under specific circumstances. Upon identification, a specific fraud scenario, and its associated concealment strategy, become the basis for fraud risk assessment and for the examiner’s subsequent fraud examination program.

Fraud concealment involves the strategies used by the perpetrator of the fraud scenario to conceal the true intent of his or her transaction(s). Common concealment strategies include false documents, false representations, false approvals, avoiding or circumventing control levels, internal control evasion, blocking access to information, enhancing the effects of geographic distance between documents and controls, and the application of both real and perceived pressure. Wells also pointed out that an important aspect of fraud concealment pertains to the level of sophistication demonstrated by the perpetrator; the connection between concealment strategies and fraud scenarios is essential in any discussion of fraud risk structure.

As an example, consider a rights of return fraud scenario related to ordered merchandise. Most industries allow customers to return products for any number of reasons. Rights of return refers to circumstances, whether as a matter of contract or of existing practice, under which a product may be returned after its sale either in exchange for a cash refund, or for a credit applied to amounts owed or to be owed for other products, or in exchange for other products. GAAP allows companies to recognize revenue in certain cases, even though the customer may have a right of return. When customers are given a right of return, revenue may be recognized at the time of sale if the sales price is substantially fixed or determinable at the date of sale, the buyer has paid or is obligated to pay the seller, the obligation to pay is not contingent on resale of the product, the buyer’s obligation to the seller does not change in the event of theft or physical destruction or damage of the product, the buyer acquiring the product for resale is economically separate from the seller, the seller does not have significant obligations for future performance or to bring about resale of the product by the buyer, and the amount of future returns can be reasonably estimated.

Sales revenue not recognizable at the time of sale is recognized either once the return privilege has substantially expired or if the conditions have been subsequently met. Companies sometimes stray by establishing accounting policies or sales agreements that grant customers vague or liberal rights of returns, refunds, or exchanges; that fail to fix the sales price; or that make payment contingent upon resale of the product, receipt of funding from a lender, or some other future event. Payment terms that extend over a substantial portion of the period in which the customer is expected to use or market the purchased products may also create problems. These terms effectively create consignment arrangements, because, no economic risk has been transferred to the purchaser.

Frauds in connection with rights of return typically involve concealment of the existence of the right, either by contract or arising from accepted practice, and/or departure from GAAP specified conditions. Concealment usually takes one or more of the following forms:

• Use of side letters: created and maintained separate and apart from the sales contract, that provide the buyer with a right of return;

• Obligations by oral promise or some other form of understanding between seller and buyer that is honored as a customary practice but arranged covertly and hidden;

• Misrepresentations designed to mischaracterize the nature of arrangements, particularly in respect of:

–Consignment arrangements made to appear to be final sales;

–Concealment of contingencies, under which the buyer can return the products, including failure to resell the products, trial periods, and product performance conditions;

–Failure to disclose the existence, or extent, of stock rotation rights, price protection concessions, or annual returned-goods limitations;

–Arrangement of transactions, with straw counterparties, agents, related parties, or other special purpose entities in which the true nature of the arrangements is concealed or obscured, but, ultimately, the counterparty does not actually have any significant economic risk in the “sale”.

Sometimes the purchaser is complicit in the act of concealment, for example, by negotiating a side letter, and this makes detection of the fraud even more difficult. Further, such frauds often involve collusion among several individuals within an organization, such as salespersons, their supervisors, and possibly both marketing and financial managers.

It’s easy to see that once a CFE has identified one or more of these concealment strategies as operative in a given entity, the process of developing a descriptive fraud scenario, completing a related risk assessment and constructing a fraud examination program will be a relatively straight forward process. As a working example, of a senario and related concealment strategies …

Over two decades ago the SEC charged a major computer equipment manufacturer with overstating revenue in the amount of $500,000 on transactions for which products had been shipped, but for which, at the time of shipment, the company had no reasonable expectation that the customer would accept and pay for the products. The company eventually accepted back most of the product as sales returns during the following quarter.

The SEC noted that the manufacturer’s written distribution agreements generally allowed the distributor wide latitude to return product to the company for credit whenever the product was, in the distributor’s opinion, damaged, obsolete, or otherwise unable to be sold. According to the SEC, in preparing the manufacturer’s financial statements for the target year, company personnel submitted a proposed allowance for future product returns that was unreasonably low in light of the high level of returns the manufacturer had received in the first several months of the year.

The SEC determined that various officers and employees in the accounting and sales departments knew the exact amount of returns the company had received before the year end, when the company’s independent auditors finished their fieldwork on the annual audit. Had the manufacturer revised the allowance for sales returns to reflect the returns information, the SEC concluded it would have had to reduce the net revenue reported for the fiscal year. Instead, the SEC found that several of the manufacturer’s officers and employees devised schemes to prevent the auditors from discovering the true amount of the returns, including 1), keeping the auditors away from the area at the manufacturer’s headquarters where the returned goods were stored, and 2), accounting personnel altering records in the computer system to reduce the level of returns. After all the facts were assembled, the SEC took disciplinary action against several company executives.

As with side agreements, a broad base of inquiry into company practices may be one of the best assessment techniques the CFE has regarding possible concealment strategies supporting fraud scenarios involving returns and exchanges. In addition to inquiries of this kind, the ACFE recommends that CFE’s may consider using analytics like:

• Compare returns in the current period with prior periods and ask about unusual increases.

• Because companies may slow the return process to avoid reducing sales in the current period, determine whether returns are processed in timely fashion. The facts can also be double-checked by confirming with customers.

• Calculate the sales return percentage (sales returns divided by total sales) and ask about any unusual increase.

• Compare returns after a reporting period with both the return reserve and the monthly returns to determine if they appear reasonable.

• Determine whether sales commissions are paid at the time of sale or at the time of collection. Sales commissions paid at the time of sale provide incentives to inflate sales artificially to meet internal and external market pressures.

• Determine whether product returns are adjusted from sales commissions. Sales returns processed through the so-called house account may provide a hidden mechanism to inflate sales to phony customers, collect undue commissions, and return the product to the vendor without being penalized by having commissions adjusted for the returned goods.