By Ivor Gottschalk
Illustration: Sara Tyson
 HOW ONE FICTITIOUS FRAUDSTER SLIPPED THROUGH THE CRACKS IN A FLAWED INTERNAL CONTROL SYSTEM
Thomas MacNeil, president of General Manufacturing Ltd., listened in cold silence to the voice on the telephone. The caller, a would-be supplier, was accusing MacNeil's plant manager, Bob Adams, of accepting kickbacks from Equipment maintenance Inc., a company that had been awarded a maintenance contract by General Manufacturing in each of the past three years.
According to the caller, Equipment Maintenance was owned by Carl Brown, a former employee of General Manufacturing. Brown had lost his job not long after MacNeil had been hired by General Manufacturing with a mandate to turn the struggling company around. One of MacNeil's first moves had been to outsource all maintenance work, which meant the termination of the entire maintenance department, including its long-term manager, Brown.
MacNeil was disturbed by the allegation and met with his general counsel to determine how to proceed. They decided to retain an independent forensic accountant to conduct a discreet preliminary investigation to find out if the allegations had any substance. Experienced advisers will make it clear, at this early stage, that kickbacks are particularly difficult to prove. The reason is that the ultimate proof — direct evidence of a payment from Brown to Adams — is seldom easy to obtain as the payments won't show up in the client's corporate records. However, there are other successful investigative approaches.
In this fictional case, our investigator's first step was to meet with General Manufacturing's controller, who was briefed on the situation on the basis that she would keep the information confidential. She welcomed the opportunity to assist in the investigation, adding that she had raised concerns three years ago about the way in which Equipment Maintenance had been awarded a contract.
She had noticed that Adams circumvented the requirement to tender purchases of $50,000-plus by entering into quarterly contracts of $45,000 — for an annual total of $180,000 — with Equipment Maintenance. She insisted future maintenance contracts be tendered, which Adams agreed to. She also recommended that Equipment Maintenance not be allowed to participate in future bids. Adams, who had an aggressive personality, persuaded her to drop this request, arguing that future contracts were going to be tendered and, therefore, transparent.
Examination of the documentation involving the second contract revealed that Adams had indeed obtained bids from two other firms, in addition to Equipment Maintenance. The two new bidders were in the $225,000 range, while Equipment Maintenance, which retained the contract, came in at less than $200,000. Everything seemed above board, except for one disturbing detail.
The documents on file from the two unsuccessful bidders were photocopies, while Equipment Maintenance's bid was on original paper and the amounts of the other bids appeared altered. The unsuccessful bidders were contacted and provided copies of their bids — one was for $170,000 and the other $185,000. Even without knowing their bids were altered, both complained about Adams, who had not informed them of the results of the tender or returned their calls.
An examination of the tender process for the following and current years unearthed more disturbing evidence. Two unsuccessful bidders submitted their bids on letterhead that contained no phone number and only a post office box for an address. A background check showed that Brown had registered the companies. It was obvious these bids were false.
Although the evidence clearly suggested that Adams was colluding with Brown, there was no evidence any kickbacks had been paid or received. Nor did it seem that General Manufacturing was being overcharged by Equipment Maintenance. Although the company's bids were somewhat higher than its competitors, the difference was not substantial. Faced with this evidence, Adams could argue that Equipment Maintenance was worth the slight difference, especially since Brown knew exactly what the company needed. Also, the annual payment to Equipment Maintenance was less than what maintenance had cost before it was outsourced. Experience would suggest that a greater benefit was gained to have warranted all the deception and the investigation continued.
A closer analysis produced a file of invoices from Equipment Maintenance —all approved by Adams — for extra charges above the amount covered by the contract. The legitimacy of some charges was doubtful at best. None of the invoices was for a large amount, but by the third year the total extras charged almost equalled the amount of the contract.
Based on the evidence it had, General Manufacturing's counsel felt it best to confront Brown and Adams. Adams agreed to resign; Brown offered to cancel his contract with General Manufacturing.
A company in General Manufacturing's position has the option of reporting to the police who may pursue suspects for evidence of kickbacks, which are referred to as secret commissions in the criminal code. If General Manufacturing commenced a civil proceeding against Brown and Adams it could have taken advantage of powerful legal tools — a type of civil search warrant and orders to freeze suspects' assets — to secure evidence and improve the firm's prospects of recovery. Those contemplating this avenue must consider the associated risks and costs. Organizations with appropriate insurance coverage can also seek recovery from their insurer when faced with losses from employee fraud.
An expert interview of people in the position of Adams and Brown can lead to them confessing to the kickback scheme thus saving time and costs for the victim.
In retrospect, General Manufacturing realized Adams had been able to get away with his scheme because of a serious flaw in its system of internal controls. Because of personnel cutbacks, Adams had been allowed to act independently in conducting the tenders and in approving payments. His supervisor, who normally would have had oversight, had been let go by MacNeil and his position eliminated.
Instead, the controller was given responsibility for assuring that proper procedures were followed. She had detected Adams' attempt to circumvent the controls in the first year and thought she had put a stop to it. But because she was over-worked and unaware that a former employee ran Equipment Maintenance, she had decided not to take Adams on and, thus, let him include Equipment Maintenance in the tendering process.
On paper, General Manufacturing did have controls in place that should have prevented Adams from colluding with Brown. Most companies do. Where problems tend to occur is when companies fail to implement and enforce controls consistently. Too often, senior personnel (or difficult ones) are allowed to override controls. All too often, pressing deadlines or other work pressures take precedence over established procedures.
This was a costly mistake, because the best way to prevent kickback schemes (and other scams such as false invoicing, undercharging and excessive rebate payments) is by making it difficult to initiate them. General Manufacturing learned this lesson the hard way.
Combating kickbacks can also be accomplished by establishing a fair and ethical work environment. It is a widely accepted tenet in fraud prevention that top management sets the moral tone for all personnel. A company president known to use company funds to pay personal expenses — such as a spouse's birthday party — should not be shocked to discover one of his employees is using a company credit card for personal expenses.
Likewise, it's important for a company to treat and pay its personnel fairly. Many fraudsters rationalize their behaviour by convincing themselves they are "owed" the money. That doesn't justify fraud, but it can certainly contribute to their actions. When MacNeil joined General Manufacturing, he immediately reduced staff and scrapped the bonus plan for all employees not in sales. When confronted, Adams said he felt justified in breaking some rules to provide Brown, a 16-year veteran of General Manufacturing, with employment. Brown could rationalize the payment of kickbacks to Adams as compensation for the bonus Adams would have earned had he still been eligible for the bonus plan.
Adams also claimed he didn't know that what he was doing was wrong. It was a pathetic response, MacNeil argued, but General Manufacturing did not have written policies that clearly detailed what actions and behaviours were acceptable and expected and which ones were not. Nor did the company provide employees with fraud awareness training. Such simple measures might have improved General Manufacturing's prospects in litigation against Adams and Brown.
Kickback schemes can never be completely eliminated, as cunning fraudsters usually find a way to circumvent even the most rigid controls. But the potential for them to occur can be reduced through effective controls — especially the diligent implementation of them — and the introduction of fraud awareness training and a clear internal anti-fraud policy. General Manufacturing learned that lesson too late, but hopefully in time to help ensure it would not be a victim again.
Ivor Gottschalk, CA•IFA, CBV, is a partner in the forensic accounting & investigative services department of Grant Thornton LLP and board member of Alliance for Excellence in Investigative and Forensic Accounting.
Technical Editor: Roddy Allan, CA•IFA, principal of Kroll Lindquist Avey in Toronto. | 
