HOW GOOD INTENTIONS CAN MASK RATIONALIZATIONS AND FRAUD. Kristin Rivera 1

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1 The White Collar Crime Committee Newsletter, Summer/Fall 2017 (ABA Criminal Justice Section) HOW GOOD INTENTIONS CAN MASK RATIONALIZATIONS AND FRAUD Kristin Rivera 1 The situation was tight, but the longer-term outlook was promising. The company needed one more round of funding to tide it over until the anticipated IPO was within reach. Without that funding, layoffs would ensue and everything the company had worked so hard for could be lost. But to convince investors to facilitate that next round, the financial performance needed to reflect what they believed the true potential of the company to be. So the CFO posted a journal entry he knew was inaccurate, certain that when the promised order came in, he would be able to reverse the entry, and all would be well. He wasn t doing this for personal gain, after all, but for the future of the company a company he not only cared deeply about, but one he had every reason to believe would be successful and for the benefit all of its stakeholders. In his mind, he was doing the right thing, for the greater good. When that big order failed to materialize the following month, the company s financial condition worsened. One inaccurate entry led to several more, designed to perpetuate the scheme and prevent its detection. When an ensuing investigation discovered the unsubstantiated journal entries, the CFO argued that his intentions had been good. The company s audit committee saw it differently. Knowing financial misrepresentation is unacceptable no matter what the intent. I. WHAT CONSTITUES FRAUD? IT DEPENDS WHOM YOU ASK Most people would regard intentional financial misrepresentation regardless of motive or mechanism as fraud, pure and simple. But experience shows that, depending on the professional perspective and the circumstances, fraud can have very different meanings. According to PwC s latest Global Economic Crime Survey, 1 in 3 global organizations report having experienced fraud and economic crime in the past 24 months. Fraud can take many forms but experience shows that how fraud is defined depends on whom you ask. 2 1 Kristin Rivera is a partner at PwC. She may be contacted for deeper discussion at or kristin.d.rivera@pwc.com. 2 PwC s Global Economic Crime Survey 2016.

2 To an accountant or an auditor, when an officer knowingly lies, misrepresents or omits facts in a way that has an impact on financial reporting, he or she has engaged in fraud. But to a securities lawyer, without proof of willful deception often called scienter, or malicious intent it may be hard to prove that fraud has occurred. For businesses, there s a big difference between fraud committed for personal gain (such as embezzlement, or false reporting intended to boost compensation) and fraud committed for corporate motives (such as company survival, protection of the workforce or even of the community). In our experience, material financial reporting fraud is typically driven by corporate motives. You might call it altruistic fraud. This presents a dilemma for prosecutors, investigators and plaintiffs, who, when faced with evidence of financial misrepresentation, generally look for the smoking gun of financial gain. What happens if they can t find one? II. THE FRAUD TRIANGLE AND THE SCIENTER CONUNDRUM Forensics practitioners and auditors frequently refer to the so-called fraud triangle framework generally, the preconditions necessary for an individual to commit fraud. Those three factors are pressure (or incentive); opportunity; and rationalization. All three are typically present for an act of fraud to occur. Therein lies the conundrum. If rationalization is a precondition for most people to commit fraud, then they must have a privately credible excuse for doing so. In other words, they must have convinced themselves that what they were doing was somehow right, or at least justifiable. In such situations, it is often difficult to demonstrate the existence of scienter, of willful malfeasance, especially when the culprit has convinced themselves the number-fudging was justifiable. Attorneys conducting investigations therefore should be mindful of this double bind when trying to prove scienter. Rationalization, a condition precedent for accounting fraud, can masquerade as the lack of malicious intent or scienter, making it difficult to prove fraud under some legal standards. III. STOPPING FRAUD BEFORE IT STARTS Many organizations spend a great deal of time focusing on ways to prevent fraud before it occurs. Of the three sides of the fraud triangle pressure, opportunity, and rationalization the bulk of the effort over the last 15 years has gone to addressing the opportunity to commit fraud, primarily through internal controls. Such controls have been greatly fortified in recent years thanks to the 2002 Sarbanes-Oxley Act and the application of information technology.

3 Still, because fraud is the result of the intersection of human choices with system failures, it s important to be wary of the false sense of security that internal controls, even well-designed ones, can bring. Collusion, and the ability of management to override controls, means that no system can fully prevent fraud. (For example, senior executives those most likely to commit large-scale accounting fraud are often well placed to collude with others and override such controls.) Corporate-sized frauds are generally connected to corporate pressures and the pressure to commit fraud can arise at any level of the organization. At the highest level, such pressure can include an altruistic desire to save the company by hitting key funding targets or otherwise satisfying external expectations. In the middle ranks of the organization, these pressures can manifest as unrealistic sales expectations, poorly designed compensation structures, unreasonable supervisors, or a desire to recoup or avoid losses. The pressure driver can be addressed at least in part by careful management of compensation structures to make sure they are not incenting undesirable behaviors. A well-publicized open-door or hotline policy can also help not only as a pressure-release valve, but also as an early-warning system of structural problems. If employees feel they can bring bad news to their superiors, they re less likely to hide it by cooking the books. IV. THE SLIPPERIEST SLOPE OF THE TRIANGLE: RATIONALIZATION More than 1 in 3 US organizations report having been victimized by fraud and economic crime in the past 24 months. Top types of fraud include asset misappropriation (55%), cybercrime (54%), procurement fraud (22%) and accounting fraud (16%). 3 When it comes to the most serious (in terms of monetary loss) economic crimes experienced, in the US, senior management jumped from 4% (2014) to 18% (2016) as the perpetrator of internal fraud. 4 What factor contributed most to the economic crime committed by internal actors? 11% say rationalization; 20% say incentive/pressure to perform; 57% say the opportunity or ability to commit the crime. 5 The organizational impacts of these frauds can be devastating. They can include hits to reputation/brand strength, altered relations with regulators, and declining employee morale. 6 3 PwC s Global Economic Crime Survey Id. 5 Id. 6 Id.

4 What can companies do? Based on our experience, it s of critical importance to have a plan. Organizational culture, consistent training, and repetitive cognition exercises can also help address potential bad behaviors. 7 While pressure and opportunity can to a great extent be controlled by the organization, the element of rationalization is the wild card. That s because it lives, not on a computer, or in a procedural manual, but inside the mind of a human being. Executives who override internal controls to prop up a company s performance ( We ll fudge this just this once and make up for it next quarter ) learn too late that such altruism can be a slippery slope. As the fictitious example at the top of this article illustrates, a deception, once entered into, must be maintained which can lead to another misstatement and then another, until the altruistic perpetrator is locked in and the fraud becomes increasingly difficult to conceal. So what steps could companies take to avoid that slippery slope? First, accept the simple fact that rationalization is part of human nature, and that controls and other internal measures will never be 100% effective at stopping fraud. Once you work with that reality, potential solutions start to become clear. Culture is a good place to start. Establishing (and demonstrating) a culture of honesty and openness, from the top down, is critical to imbuing honesty and accountability across the organization. Consistent training is another key element. If people clearly understand what constitutes unacceptable actions and what are the consequences of taking those actions it becomes that much harder for them to rationalize or justify fraudulent activity (and, incidentally, that much easier for an investigator to determine scienter). Another effective solution is to have employees periodically sign certifications or other statements confirming that they have followed company protocols. Studies show that people are far less likely to lie if they re given adequate time to prepare for the question, and if the question is posed in a non-confrontational way. This kind of regular day-of-reckoning exercise can be a powerful deterrent to the rationalization of bad behavior. V. HAVE A PLAN Regardless of how financial misrepresentation comes to light, as with any other form of crisis management, it s helpful to be prepared with an action plan to deal with the many legal consequences your organization may face. Scenario planning; being clear about what and when you would need to 7 Id.

5 report to the audit committee, the SEC, and/or counsel; and knowing how and when to begin an internal investigation, are a great place to start. And of course, once the dust has settled, it is wise to begin to plug whatever holes became manifest as a result of your investigation, and to begin the process of remediation immediately so that once again, altruistic instincts can align with good business practice.