Unsurprisingly, given issues raised by the press during the recent presidential election about cabinet candidates and the rapidly revolving door between the private sector and government, conflict of interest is again the fraud flavor of the month among the pundits. To keep the matter in perspective, these same concerns about appointments are raised to a greater or lesser degree following every presidential election.
The ACFE tells us that a conflict of interest occurs when an employee, manager, or executive has an undisclosed economic or personal interest in a transaction that adversely affects the company, or, in the case of government, his or her office. As with other corruption cases, conflict schemes involve the exertion of an employee’s influence to the detriment of his or her employing organization.
The clear majority of conflict cases occur because the fraudster has an undisclosed economic interest in a transaction. But the fraudster’s hidden interest is not necessarily economic. In some scenarios, an employee acts in a manner detrimental to his organization to provide a benefit to a friend or relative, even though the fraudster receives no financial benefit from the transaction herself. A manager might split a large repair project into several smaller projects to avoid bidding requirements. This allows the manager to award the contracts to his brother-in-law. Though there was no indication that the manager received any financial gain from this scheme, his actions nevertheless amount to conflict of interest.
It’s important to emphasize that to be classified as a conflict of interest scheme, the employee’s interest in the transaction must be undisclosed. This is a crucial important point and one that’s often overlooked. The crux of a conflict case is that the fraudster takes advantage of his employer; the victim company is unaware that its employee has divided loyalties. If an employer knows of the employee’s interest in a business deal or negotiation, there can be no a conflict of interest, no matter how favorable the arrangement is for the employee.
If an employee approves payment on a fraudulent invoice submitted by a vendor in return for a kickback, its bribery. If, on the other hand, an employee approves payment on invoices submitted by his own company (and if his ownership is undisclosed), this is a conflict of interest. The distinction between the two schemes is obvious. In the bribery case the fraudster approves the invoice in return for a kickback, while in a conflicts case he approves the invoice because of his own hidden interest in the vendor. Aside from the employee’s motive for committing the crime, the mechanics of the two transactions are practically identical. The same duality can be found in bid rigging cases, where an employee influences the selection of a company in which she has a hidden interest instead of influencing the selection of a vendor who has bribed her.
The concern voiced in the press and other media is legitimate and justified because there are vast numbers of ways in which an employee (or high level government appointee) can use his or her influence to benefit an organization in which s/he has a hidden or even a disclosed interest.
Purchase schemes and sales schemes are the two most common categories involving conflict of interest. Most conflicts of interest arise when a victim company unwittingly buys something at a high price from a company in which one of its employees has a hidden interest, or unwittingly sells something at a low price to a company in which one of its employees has a hidden interest. Most other conflicts involve employees stealing clients or diverting funds from their employer.
The ACFE says its research indicates that most conflict schemes are over billing schemes. While it is true that any time an employee assists in the overbilling of his company there is probably some conflict of interest (the employee causes harm to his employer because of a hidden financial interest in the transaction), this does not necessarily mean that every false billing will be categorized as a conflict scheme. For the scheme to be classified as a conflict of interest, the employee (or a friend or relative of the employee) must have an ownership or employment interest in the vendor that submits the invoice. This distinction is easy to understand if we look at the nature of the fraud. Why does the fraudster overbill his employer? If she engages in the scheme only for the cash, the scheme is a fraudulent disbursement billing scheme. If, on the other hand, she seeks to better the financial condition of her business at the expense of her employer, this is a conflict of interest. In other words, the fraudster’s interests lie with a company other than her employer. When an employee falsifies the invoices of a third-party vendor to whom he has no relation, this is not a conflict of interest scheme because the employee has no interest in that vendor. The sole purpose of the scheme is to generate a fraudulent disbursement.
A short rule of thumb can be used to distinguish between over-billing schemes that are classified as asset misappropriations and those that are conflicts of interest: if the bill originates from a real company in which the fraudster has an economic or personal interest, and if the fraudster’s interest in the company is undisclosed to the victim company, then the scheme is a conflict of interest.
Not all conflict schemes occur in the traditional vendor-buyer relationship. Some involve employees negotiating for the purchase of some unique, typically large asset such as land or a building in which the employee had an undisclosed interest. It is in the process of these negotiations that the fraudster violates his duty of loyalty to his employer. Because he stands to profit from the sale of the asset, the employee does not negotiate in good faith to his employer; he does not attempt to get the best price possible. The fraudster will reap a greater financial benefit if the purchase price is high. In a turnaround sale or flip an employee knows his employer is seeking to purchase a certain asset and takes advantage of the situation by purchasing the asset himself (usually in the name of an accomplice or shell company). The fraudster then turns around and resells the item to his employer at an inflated price. A write off of sales scheme involves tampering with the books of the victim company to decrease or write off the amount owed by an employee’s business. For instance, after an employee’s company purchases goods or services from the victim company, credit memos may be issued against the sale, causing it to be written off to contra accounts such as Discounts and Allowances. Many reversing entries to sales may thus be a sign that fraud is occurring in an organization. Finally, some employees divert the funds and other resources of their employers to the development of their own business. While these schemes are clearly corruption schemes, the funds are diverted using a fraudulent disbursement. The money could be drained from the victim company through a check tampering scheme, a billing scheme, a payroll scheme, or an expense reimbursement scheme.
The bottom line is that every management has an obligation to disclose to the shareholder’s significant fraud committed by officers, executives, and others in positions of trust. Management does not have the responsibility of disclosing uncharged criminal conduct of its officers and executives. However, when officers, executives, or other persons in trusted positions become subjects of a criminal indictment, disclosure is required. The inadequate disclosure of conflicts of interests is among the most serious of frauds. Inadequate disclosure of related-party transactions is not limited to any specific industry; it transcends all business types and relationships.
On the detection side, CFE’s continue to point out some of the more tried and true methods that can be used including tips and complaints, comparisons of vendor addresses with employee addresses, review of vendor ownership files, review of exit interviews, comparisons of vendor addresses to addresses of subsequent employers, and interviews with purchasing personnel for favorable treatment of one or more vendors.
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