Companies can improve their financial bottom line by either making more money in the form of increased profits or by saving money by cutting costs.  Losses due to fraud and theft and the resulting litigation can come as a devastating and often unexpected blow to a company.  These costs can often be avoided or at least minimized by doing some good old fashioned research before jumping into a deal with both feet.  Remember the analogy of the flashlight in a dark room?    It won’t remove any of the obstacles in your way, but it will illuminate them.  Do your homework before you act.

   The Cost of Fraud

   Fraud is on the rise in a variety of areas.  People can acquire false identities with new names and credentials; corporations claiming to have strong track records can actually be front companies or “executive offices” without real employees; venture capitalists can pretend to be able to provide needed financing while in reality they are actually promoting “advance fee schemes” which only bilk companies out of large chunks of money.

   Failure to conduct a thorough due diligence investigation makes it possible for unscrupulous individuals to hurt companies.  Their actions, even if they are eventually caught, can leave a company in ruins.

   One recent example involved a struggling telecommunications company that was approached by an investor.  Since there were few strings attached to the money being offered, the company jumped at the offer of a cash infusion without bothering to check out the investor.  Why bother, the company reasoned, there is nothing to lose.  We can take his money at little or no risk.

   However, while the investor at first offered the money with very few strings attached—one-third of the voting stock and a percentage of the return—the relationship between the company and the investor began to change rapidly.

   The investor became increasingly interested in the company and was given access to a significant amount of proprietary information on the running of the company, including financial records.  The investor later used this information and access to transfer stock out of the name of the company president and into his own name.  He then used his fraudulently acquired stock to launch a hostile takeover of the company.

   Once he had control of the company, he took it into bankruptcy.

   After months of costly litigation, despite the evidence of fraud, the company’s president was forced to settle with the thief to the tune of $3 million to get his company back.

   Although the president now has regained control of his company, it cost him the $3 million he was forced to pay the investor plus an additional $3 million in legal fees.  The litigation is ongoing, the bills keep mounting, and as of this writing the company is still under Chapter 7 bankruptcy protection.

   Advance Fee Schemes

   Another start-up company seeking financing met with several venture capitalists.  Three of the firms were well-known and well-established; the fourth was a young company staffed by individuals who had worked for the more established companies, but who did not yet have a track-record of their own.  The start-up was attracted to the young capital firm because it agreed to better terms than the established competitors and because they liked the idea of working with another young firm.

   The capital firm first requested $5,000 in application fees from the start-up, explaining that it was a customary part of conducting business and that the up-front money would be “rolled in” to the amount provided to the start-up.  This should have been recognized as the first warning sign that something was amiss.

   The young venture capital firm continued to ask for more application fees, processing fees and “due diligence” costs, always providing documentation from the bank or other investors indicating the deal was close to closing.  The start-up also funded several European trips for the principals of the capital venture firm to visit prospective sources of funding.  After the start-up paid almost $50,000 in advance fees and expenses, the venture capital firm disappeared from sight.  Phones were disconnected, offices were vacated, and apartments were empty.

   It later turned out that none of the individuals in the venture capital firm had any significant financing experience.  They had simply fabricated their experience with the well-established firms and gambled (correctly) that no one would check.  None of the money ever went toward raising capital, and all documentation concerning the search for funding was forged.

   The financial loss (and wasted time and energy chasing the non-existing funding) brought the small company to its knees; the principles were forced to take second mortgages on their homes to keep the company alive.

   As a general rule, whenever a potential lender asks for up-front money for any reason, you are looking at an advance fee scheme.  Legitimate lenders and brokers will most certainly charge for their services, but these fees are collected when the loan is delivered—at the closing—not in advance as up-front money.

   Targets for advance fee swindlers are usually individuals and companies that have had difficulty obtaining a loan through normal sources.  These con artists usually offer a “guaranteed” loan, usually from a large, well-known lending institution, for a fee paid in advance.  The fee is usually a percentage of the gross loan amount.  The percentage usually runs around 5% for loans up to $1 million, with a decreasing percentage as the size of the loan goes up.

   The first question to ask the loan broker is why can’t you deal directly with the lending institution which supposedly will fund the loan.  The answer will always be “no” for one reason or another.  You may be told that the broker has a special relationship with the lender and if you try to contact them directly it will kill the deal, or the broker will simply refuse to divulge the lender’s name, citing confidentiality as the reason.  The second question to ask is for a list of other satisfied loan recipients.  In this case the swindler will either refuse to supply a list or provide you with a phony list of individuals who will vouch for him.

   The bottom line is this: Any time you are asked for money up front to secure a loan and there is a degree of urgency and secrecy surrounding the transaction, you better watch out.  Once the swindler has your money he will either disappear or keep you on the string, often asking for more and more money and giving more and more excuses why the loan is being delayed, while he bilks others like yourself.

   Other Forms of Company Fraud

   A perfume company executive received an anonymous tip saying one of the high-ranking officers in the company was stealing inventory and re-selling it to a discount perfume outlet.  The President hired a forensic accountant to look discretely into the possibility of theft.  After several months of careful investigation a small discrepancy in an inventory list for one of the company’s warehouses was noted.  This led the accountant to larger inventory problems.  Ultimately, the forensic accountant discovered the theft of large amounts of perfume from the warehouse by one of the Vice Presidents who had been hired into his position after the perfume company acquired his smaller perfume company.  The company estimated the cost of the loss in the several millions of dollars.

   Industrial espionage, a subject that will receive thorough treatment in the section on counterespionage, also falls into the category of fraud.

   A pharmaceutical company that had spent millions of dollars and more than six years developing a drug hired a native Korean research scientist when the project was in the final stages.  The scientist was US-educated and was considered well-respected in his field.

   He contributed greatly to the development of the drug, but shortly before the drug was scheduled for large-scale production, South Korea announced it had developed a similar drug and would be going into production one week before the US firm.  The pharmaceutical company became suspicious over the Korean connection and launched its own internal investigation.  The investigation revealed that the research scientist had provided all the proprietary information on the drug to the South Koreans for $75,000.

   A Further Word on Financial Fraud

   The explosive growth in the number of individuals anxious to increase their wealth by investing their extra money with high-return brokers has opened the floodgates for financial fraud.  Those with knowledge of financial markets have found that it is relatively easy to set up fake investment opportunities and recruit investors into them.  They use financial lingo, false revenues, and create documentation “proving” their high returns.  The documentation and other evidence is often so convincing that not only the inexperienced or uninformed investor is fooled, but even the savvy and knowledgeable investor can be taken.  These latter individuals often become inadvertently instrumental in perpetrating the scams, because once they are brought in—often after they have conducted their own inadequate due diligence—they lend additional creditability to the swindlers perpetrating the fraud.

   Despite the sophisticated methods these charlatans employ, a professional due diligence almost always uncovers clues that point to fraud.  At a minimum, it may show that the investment is far riskier than originally thought or portrayed.  The only way to protect investment is through professional, objective due diligence.

   The huge amounts of money involved make these scams seem unreal.  Some, like the well-publicized one involving Martin Frankel, receive extensive media coverage, while others remain basically secret.  Many people who have been defrauded do not report their losses to authorities because they are embarrassed over being taken in and believe the loss reflects badly on them.

   Rather than blaming the individual who set up the scam, they blame themselves for being “stupid.”  In fact, the scams are often so well planned and so well documented with forgeries, that there is almost no way for the potential investor to verify whether the investment is real without thorough professional assistance.

   In most cases, the individual behind the fraud is charming, has excellent references, is not overly pushy and sometimes suggests the investment is exclusive.  He or she may even encourage a potential investigator to do his own investigation (obviously hoping that they do not, or if they do, that the investigation is superficial and only covers the references provided by the con man).

   And if the potential investor actually does discover irregularities, the con man will happily explain them away, and likely will suggest that they not invest if they are uncomfortable.  As one individual who lost heavily stated, “He made me feel badly for doubting him.  He repeatedly told me that maybe this kind of investment wasn’t for me, that maybe I should look at safer, lower-return options, since I was so concerned about some of the items I had uncovered.  Of course, that made me want to invest even more.”

   The Martin Frankel Case

   Martin Frankel gained international attention for several reasons; the sheer amount of money he stole (initially estimated at close to $3 billion), his extravagant lifestyle, and because he fled the country and led investigators on a merry chase.  It was good newspaper and tabloid copy.

   Mr. Frankel ran a huge scam where he was supposed to invest money for several insurance companies, the Vatican and several major insurance regulation agencies, among others.  He successfully ran the scam for more than seven years by creating bogus statements to investors showing profits while he secretly moved the money off-shore into his own personal accounts, and to support his lavish lifestyle.  Mr. Frankel did not lose the money by trading it; he never invested it in anything but his own bank accounts.

   Those who invested with Mr. Frankel were stunned when they learned he had defrauded them.  They universally described him as smart, charming, and funny.  He was never pushy, they said, and always provided whatever documents they needed on demand.

   However, as is often the case, there were clear signs (is anyone had cared to check) that Mr. Frankel was not as squeaky clean as he appeared.

   As far back as 1991, he had been accused of defrauding investors and was ordered by the court to pay $975,000 in restitution.  Then, in 1992, he lost his stockbroker’s license and was banned from the securities industry by the SEC after investors had accused him of fraud.

   Mr. Frankel’s most recent scam also had several red flags.  The company he used was not registered or licensed, and the “corporate address” was Mr. Frankel’s home.

   Moreover, he was spending large amounts of money on exceptionally high-priced luxury items which far exceeded his declared income.  Although Mr. Frankel frequently used aliases in his new scam to obfuscate and distance himself from his previous record, there were various clues, including identical social security numbers, linking the aliases to Mr. Frankel.

   One who was conned by Mr. Frankel believes he should have seen the signals that popped up during the time he was investing, but, as he put it, “Sad to say, I was blinded by greed.”

   Stephen Smith

   Stephen Smith was arrested in 1999 in Florida for running a slick “ponzi” investment scam: While purportedly recruiting new investors for an oil-well project, he was actually taking the money for himself (there was no oil-well project) and using some of the money obtained from the new investors to pay dividends to older investors.

   Mr. Smith had only been running the scam for a few months, when he had already managed to convince several individuals in the Houston area of Texas to invest several hundred thousand dollars in his oil-well scheme.  One investor noted that Mr. Smith was highly convincing, and invited him to visit the wells himself.  The investor did, and Mr. Smith took him on a helicopter ride of the wells and showed him immaculate records of their production and profits.  The investor, who said he personally liked Mr. Smith very much after meeting him, was stunned to find out he did not own any of the wells and did not invest any money into any projects at all—oil-well or otherwise.  Of course, all of the records he was shown were forgeries.

   Investors into Mr. Smith’s recent scam also could have saved themselves a lot of money by doing some very basic research before the fact rather than waiting until after the damage had been done to check out Mr. Smith.

   The after-the-fact investigation revealed that Mr. Smith had been arrested then years earlier, in 1989, for running a similar ponzi scheme in his native Florida.  He was sentenced to 15 years in prison after being found guilty of 19 charges of grand theft for using fraudulent financial information to obtain loans and lines of credit, one count of racketeering, two counts of organized fraud, 122 counts of the sale of unregistered securities, and 122 counts of communications fraud.  In that scam, Mr. Smith defrauded approximately 700 investors out of $125 million.  One of the individuals he convinced to invest in his scam was his own grandmother.  He was released after serving only four years, but was strictly prohibited from engaging in any financial consulting activities.  Despite all of this, he couldn’t resist doing it all over again, and he is now back in the slammer.

   As a footnote to the story, when he was arrested in 1989, Mr. Smith had several properties in four states valued at around $1.6 million.  He also had $39 million in insurance policies, seven bank accounts totaling well over $2 million, jewelry, two Mercedes automobiles, four boats, six other vehicles (including three Aston Martins) and a Rockwell International Sabreline jet plane.  Additionally, he refused to cooperate with the receiver assigned to the case, despite the fact that more than $15 million from this scam was never accounted for.  Although he admitted to having offshore bank accounts in Bermuda and the Middle East, these leads were apparently never thoroughly researched, and the $15 million remains out there someplace, accessible only to Mr. Smith.

   Al Cunningham

   The leader of Greater Ministry International, Al Cunningham, was arrested in September 1999 for running an illegal investment ponzi scheme, and for using the money to create an armed enclave in the Caribbean.  Mr. Cunningham’s church offered followers a “unique opportunity” to invest in the “Caribbean market” and receive “higher than average returns.”

   Mr. Cunningham played on his purported religious affiliation to bring in investors.  According to one person who lost several thousand dollars of his retirement money, he was hesitant to ask for references because Mr. Cunningham was “a man of the cloth.”  Additionally, he provided bank statements and glossy brochures to investors, and frequently turned down potential investors the first time they approached him about investments.  By doing this he cleverly served to increase the desirability of his investment scheme.

   According to investigators on the case, they still do not yet know how much money Mr. Cunningham actually stole.  However, he was planning to purchase two Caribbean islands—each valued at several million dollars—and large amounts of grenade launchers, land mines, machine guns, shotguns, sniper rifles, handguns, flak vests, surveillance balloons, radar systems, and plastic explosives. 

   Not surprisingly, Mr. Cunningham has no legitimate religious affiliation.  He made large personal purchases during the time he ran the scheme, and he has a long arrest record.  A record that is filed in public courthouses and is available to anyone who wanted to check.  Unfortunately, no one did until it was too late for many of the investors.

   Other Cases

   Financial fraud is rampant and the kinds of cases are only limited by the imaginations of the tricksters.  Charlatans often operate internationally, to make it more difficult for US authorities to catch them, and to make the investment itself seem sexier.

   In one recent case, an individual was coaxed into investing with an Argentinean broker who claimed to be affiliated with a well-known US bank and brokerage firm.  A friend of the individual had been the recipient of several years of excellent returns (a paper increase in his portfolio from an investment of $4 million to almost $13 million) from the broker, and this success spurred the new investor to jump at the opportunity.

   But before giving the Argentinean broker any money, the investor decided to check him out.  He visited the broker in Argentina, dined with him, visited his home and office, met his wife and kids and dog, and even met the broker’s partner inside the bank where the partner claimed he worked.  (Unfortunately, the bank meeting consisted of a handshake in the lobby and then off to a local restaurant for lunch.  The investor never saw the banker’s office, and indeed he had no affiliation whatsoever with the bank.  He had merely adopted an alias identical to the name of a real official of the bank.)

   Convinced that the operation was legitimate, the investor returned to the US and began wiring money to the broker.  Over the next two years he sent a total of $5.5 million to the broker and received bi-weekly statements on the letterhead of the legitimate bank, and was in continual contact with the broker.

   The broker and the investor became close friends and the investor recommended him to a number of his friends and family, including his mother.

    Two years later, when the original $5.5 million investment had purportedly reached over $11 million, the investor received an anonymous letter tipping him off that the broker was a scam artist and advising him to pull whatever money he could out of the fund immediately.  The investor immediately hired an investigator who quickly discovered that the broker and his partner had no connection to the legitimate brokerage firm or the bank, neither were licensed to trade anything, and all of the statements the investor had received were forgeries.  The broker never invested any of the money; instead, he had stolen it all and sent it to his own offshore bank accounts.  And, during the entire six years he ran the scam, his lifestyle in Buenos Aires remained low-key and modest.

   If he doesn’t go to jail for his offenses (and he probably won’t, given the cost of prosecuting crimes such as these in Argentina) the scam artist will have ample time to spend the money he has stashed away—almost $10 million from these two investors alone.  And no, none of the money was returned when the investor requested it; the only thing the investor received was three months of promises and excuses, then silence.

   In yet another similar case, a Brazilian entrepreneur promised extremely high returns for a “select group of investors” on a secret project.  The potential investor checked the broker’s references and received enough information on the project to convince him it was a “once in a lifetime chance” and that it would succeed.  Before proceeding, however, this smart investor contracted for a professional due diligence on the entrepreneur and his group.  He sincerely believed the due diligence would be rote and would not show any problems (and really hoped this would be the case), but wasn’t going to take any chances.

   He was surprised and disappointed to learn the entrepreneur was not licensed to trade in securities, his firm was not registered, and he had previously been arrested for similar instances of investment fraud.

   The list of examples is endless.  It’s really amazing how so many people will bicker and bargain and comparison shop for small personal items like cameras, furniture, clothing and the like, but when it comes to spending millions of dollars on get-rich-quick investments they can be so willing to take a tip and send their life savings to unscrupulous tricksters. 

   Protect Yourself from Fraud

   Financial fraud is definitely on the rise.  For every individual who is arrested, there are many others who have never been caught or who have only recently started operating their schemes.  The scams are lucrative and easier to contrive today given the ease at which fraudulent documents can be created on a personal computer, enticing more and more criminals to enter the realm of financial fraud.

   There is no way to identify a fraud from simply meeting with the principals.  They are often extremely intelligent, charming, and personable.  As one investor who lost several million dollars stated, “This was no used car salesman.  I really liked the guy.”  They have the ability to manufacture extensive references and stellar credentials.  Moreover, they can show reams of documentation to attest to the value of their project or strategy, and will show potential investors whatever they require to convince them to invest their money in the scam.

   The best way to protect yourself from fraudulent financial scams is to conduct a professional due diligence on the individuals and companies involved before sending in any money.  Unless you are sure you are dealing directly with an established, reputable firm, failure to investigate up front could mean the loss of your entire investment.

   Reputational Cost

   In addition to the financial cost of fraud, there often is also a reputational cost to the person or company that is victimized.  A damaged reputation is often at least as devastating as financial loss, and it can sometimes be more difficult to recover than mere dollars.  The following are but a few examples of how reputations have been hurt by fraud.

    A high-tech company hired a vice president who came highly recommended and appeared to have strong credentials.  Approximately six months after he was hired, the vice president announced that he had negotiated a large sale of computer equipment to a Japanese company and an exclusive partnership arrangement with a highly reputable European company.  To produce the number of items required by the Japanese, the vice president rushed production and ordered workers to skip steps, resulting in a sub-standard product with several built-in glitches.  The Japanese returned the defective products and issued scathing statements about the company.

   At the same time, the European company announced it had no knowledge of a partnership and distanced itself from the high-tech company.  Because of the poor quality of the sale to the Japanese, the company lost many of its existing contracts and had to file for bankruptcy protection.  The company’s reputation was further damaged by a federal investigation into stock manipulation due to the European partnership press announcement which had stimulated the company’s stock to rise dramatically.

   Although the other executives in the company were found innocent of all charges, the top three company leaders suffered so much damage to their reputations that they have not been able to find employment elsewhere in the industry or to obtain funding to start another company.  Their association with shoddy workmanship and stock manipulation as a result of the vice president’s actions will never be erased.

   In another case, a cleaning company won the contract to clean the offices of a computer company that had several government contracts.  When the computer company received a telephone call from the FBI saying someone had attempted to access a secure government sight from the computer company offices, the company promised to investigate the matter.  The subsequent investigation revealed that a member of the cleaning crew had “hacked” into a relatively insecure company sight which contained a list of passwords for access to government sights.  The hacker then attempted to use the passwords to reach into classified sights.

   Although the hacker apparently never actually gained access to any classified data, and it was unclear whether he was doing it for fun—just to see if he could do it—or actually targeting classified documents, the breach of security resulted in the computer company losing its government contract, and being told “off the record” that it will not be considered for any future government contracts.  In the view of the US government, the responsibility for maintaining proper security from its end of the operation rested squarely with the computer company.

   Another example occurred when a medical company hired a new president.  He claimed to have 25 years experience in the medical field and touted himself as a specialist in medical implants.  After five relatively uneventful years with the company, one of the company’s implants caused severe damage to a patient.  The American Medical Association launched a large-scale investigation into the company and found that the president had attended only one year of medical school, and had actually falsified all of his credentials and experience.

   The resultant medical malpractice suits brought the company to its financial knees, but the real damage was due to the resultant loss of all credibility in the medical field.  Even products not associated with the new president were taken off the market because of their association with the disaster.

   Cost of Lost Opportunities

   Another cost that is difficult to measure is the cost of lost opportunity.  For example, a US utility company learned that the Government of Mexico was looking for a US partner.  The deal seemed perfect for the US utility company, but the utility had very little experience dealing with Mexico.  Recognizing this weakness, the company hired a Mexican consultant whose resume included ties to the Mexican ruling party and a high-ranking position in the state-owned utility company.

   The consultant was paid a good salary and was promised a sizable bonus if the US utility won the contract.  After six months of intense negotiations, the Mexican government decided to partner with another US company.  Although disappointed at losing the contract, the US utility company believed their consultant had negotiated in good faith and to the best of his ability.  The company believed that the Government of Mexico simply made the decision to hire another company that offered them a better deal.

   It was several months later that the US utility company learned the Government of Mexico had never even considered them because Mexico had never actually received a written proposal from the US utility.  The company then ran a background investigation on the consultant and found that he had lied about his credentials and did not have the access he claimed to have.  He was a complete charlatan.

   The consultant had provided written reports and other extensive documentation that made the company believe he was actively pursuing their interests, but he was actually using the trips as paid vacations and had taken the salary without conducting any business for the utility.  Despite these sizable financial costs, the chief executive of the US utility believes the largest cost to the company was the lost opportunity of winning the lucrative contract with Mexico.

   Identity Theft

   Another growing area of fraud occurs on a more personal level.  According to the Privacy Rights Clearing House, identity theft is becoming a significant problem, particularly in the US.  Identity thieves obtain personal information on unsuspecting individuals, and then—using fake drivers’ licenses, credit cards, and checks—they pose as those individuals to withdraw money from their bank accounts or to purchase items on credit that they never pay for.

   The individuals whose identities the criminals use are often left with ruined credit, large debts, and no way to recover their stolen money.  In one recent case, two San Francisco men stole $5 million using forged documentation.  Authorities arrested the men, but have only recovered approximately $78,000.  In another recent case, a convicted arsonist and murderer used the identity of the attorney who prosecuted him to hide from the authorities.

   There are also numerous cases where individuals use another identity—or make up details to make themselves more interesting—which they use in relationships.  For example, a woman who had been involved with a man for several years became distraught when he suddenly disappeared.  She spent months trying to contact his friends and attempting to track him through his apartment and employment with no luck.

   In desperation she hired an investigator who found out that the man had simply decided to end the relationship.  He was married (and had been throughout their entire relationship), and was living only a few miles from the apartment he and the woman had used for their meetings.  The apartment had been rented by the man in alias and only used for his extramarital trysts.

   Conclusion

   The above stories are not aberrations.  Similar incidents occur every day.  The companies and individuals who fall into the swindler’s traps are usually not naïve or stupid.  Most are well-seasoned, experienced business people who never thought they could be fooled.

   As one executive noted, his instincts had built him an empire, and had never been wrong before; he had a perfect track record until his assistant embezzled more than $100,000 in a few months.  He believes he was lucky to catch her before she did more damage.  While instincts can be right 99% of the time, the one time they’re wrong there can be disastrous consequences.

   A professional due diligence investigation provides a business assessment of a company.  This includes a history of the company, its operations, litigation, financial strength, reputation, profiles of key officers, and an overall assessment of the viability of the company.

   A background investigation provides a similar dossier on an individual.  It includes the individual’s personal history, employment, civil and criminal traces, pending litigation, employment history, personal and professional reputation, financial snapshot, property, liens, judgments, bankruptcies, and assessments of character.

   Be suspicious.  Don’t take everything at face value.  And especially when there is money involved, do your homework first.  Check them out.