ESTRATEGIAS DE POSICIONAMIENTO

Chapter 2 – Who Commits Fraud and Why

Learning Objectives

After completing this section of the course, you should be able to:

1. Identify the various types of fraud perpetrators, describe their characteristics, and explain their reasons for committing fraud

2. Assess fraud risk and the benefits of fraud prevention techniques

When a new fraud is discovered, one of the most frequently asked questions is “Why in the world did they do it?” The question is asked so frequently because the perpetrator is often a well-respected employee who seemingly has everything to lose and not much to gain by committing the fraud. This chapter explains who commits fraud and why they commit it. Anyone who wants to prevent or detect fraud must understand who it is that commits fraud and what motivates him or her to do so. We will first discuss what is known about fraud perpetrators to see if we can build a profile that will help us spot potential perpetrators. We will then turn our attention to societal forces that contribute to the increase in fraud.

Profile of the Fraud Perpetrator

Researchers at Brigham Young University conducted an empirical study to answer the question “Are fraud perpetrators, as a group, different from the normal population, and are they different from other property offenders?” The researchers conducted the study by comparing the

personality, criminal, and demographic characteristics of incarcerated fraud perpetrators (those in a position of responsibility who illegally appropriated money from their employers) with those of other incarcerated property offenders and normal population (represented by a group of

students).

Significant differences were found between the fraud perpetrators and the other property offenders. Fraud perpetrators:

• Were more likely to be first-time offenders;

• Were less likely to get arrested, convicted, incarcerated, or to serve long sentences; • Were older (possibly because it usually takes a while to get in a position of

responsibility);

• Were more likely to be women (30 percent, as compared to only two percent of the property offenders);

• Had a more stable family life (more likely to be married, less likely to be divorced). • Had more children;

• Were better educated;

• Were more likely to be active church members; • Were less likely to use alcohol and drugs;

• Were less likely to be criminally inclined or to have a past criminal record; and • Were in better psychological health. They were more optimistic, kind, empathetic,

socially conforming, and ambitious. They had higher self-esteem, self-control, and self- sufficiency. They had less depression, self-degradation, impulsiveness, hostility, dependence, and family discord.

Chapter 2: Who Commits Fraud and Why

The researchers found few differences between the fraud perpetrators and the normal population. As compared to the normal population, the fraud perpetrators were:

• More dishonest; • More independent; • More sexually mature; • More socially deviant; • More empathetic; and • Suffered more psychic pain.

Most of the above differences can be explained by the differences in the ages of the two populations. On average, fraud perpetrators are older than the normal population. Therefore, you would expect them to be more independent and sexually mature. Also, you might expect incarcerated fraud perpetrators to be more dishonest, empathetic, and to have suffered more psychic pain.

This and other studies show that the profile of property offenders, such as bank robbers and burglars, is different from that of the “normal” population. In contrast, fraud perpetrators tend to mirror the general public in terms of education, age, religion, marriage, length of employment, and psychological makeup. In other words, there are not enough differences between fraud perpetrators and the normal population to distinguish them from the general public.

Many fraud perpetrators are regarded as ideal employees; that is, dedicated, talented, intelligent, well-educated, and hard-working. Before committing the fraud, they considered themselves to be honest, upstanding citizens who were valued and respected members of their communities. This is born out in a study of 212 actual cases of fraud. In that study:

1. Many audit directors responding to the fraud survey stated that the defrauders had to be among the best employees in order to perpetrate and cover up the fraud while performing at least satisfactory work.

• Thirty-eight percent of the perpetrators were described as being among the company’s best employees prior to the detection of the fraud.

• Fifty-nine percent were described as being average employees. • Three percent were described as being among the worst employees. 2. Most of the perpetrators were between the ages of 26 and 45.

• Fourteen percent were younger than 26.

• Thirty-eight percent were between the ages of 26 and 35. • Thirty-five percent were between the ages of 36 and 45. • Thirteen percent were older than 45.

3. Most perpetrators were not able to operate their fraud for very long before they were caught.

• Fifty-one percent of the frauds were committed for less than a year. • Twenty-two percent were committed from one to two years.

• Thirteen percent were committed from two to three years. • Fourteen percent were committed for more than three years.

Chapter 2: Who Commits Fraud and Why

• Fifteen percent were employed between three and five years. • Thirty-one percent were employed between five and 10 years. • Twenty-one percent were employed between 10 and 20 years. • Seven percent were employed more than 20 years.

5. The older the perpetrator, the greater the amount of the fraud. 6. Most perpetrators were not college graduates.

• Fifty-two percent had some high school education or had graduated from high school. • Sixteen percent had some college education.

• Twenty-six percent were college graduates. • Six percent had some graduate school education.

7. Over 40 percent of the perpetrators were women. The amounts women took were, on average, less than that taken by the men. A possible explanation is that the women had been employed for a shorter period of time than the men. Therefore, there were fewer women in positions of trust and more women in what would be called clerical positions. Because fewer of the women were in positions of trust, they were less able to take large sums of money.

8. Seventy-one percent of the frauds were perpetrated by a single individual; 29 percent involved collusion. This is probably due to the fact that bringing another person into the fraud is risky. In addition, most perpetrators do not want to share their ill-gotten gains unless it is necessary to do so.

9. Few frauds (18 percent) were uncovered by auditors. This is not unusual in that most audits are not conducted specifically for the purpose of detecting frauds. On the other hand, it is disturbing that so few of the frauds were actually uncovered during the course of a normal audit.

10. Forty-nine percent of the frauds were uncovered by accident, and 33 percent were uncovered by anonymous tips. This illustrates that one effective way to detect fraud is to set up some mechanism, such as a fraud hot line, to encourage anonymous tips.

When the results of these two studies are combined, we can conclude that it is relatively difficult to profile fraud perpetrators or to predict who will move from being an otherwise honest, upright citizen to becoming a perpetrator of a fraud.

The above profile describes “noncareer” criminals. Recently more “career” criminals have found fraud to be a lucrative occupation.

Example: FBI director Louis Freeh testified before the Senate Special Committee on Aging that cocaine distributors in Florida and California are switching to less risky but equally profitable health-care scams. Their chances for detection are much less than with trafficking drugs, and the profits are staggering. The bureau has some 1,500 cases backlogged and would need to double the size of its 249-agent investigative team to be taken seriously by scam artists who trade in bogus medical cards and phony insurance claims.

Social Forces Contributing to Fraud

There are a number of societal trends or conditions that directly or indirectly contribute to fraud. These social forces are influenced by political and economic conditions and social expectations.

Chapter 2: Who Commits Fraud and Why

We will discuss five of them:

1. Ostracism of the whistle-blower; 2. Failure to report fraud;

3. Failure of businesses to prosecute fraud perpetrators;

4. Failure of law-enforcement officials to prosecute fraud perpetrators; and 5. Light sentences given to perpetrators.

Ostracism of the Whistle-Blower

Ostracism of the whistle-blower is one societal factor that indirectly contributes to fraud. There are numerous cases where the person blowing the whistle on a fraud has suffered more than the perpetrator. When others see what happens to those who blow the whistle, they are reluctant to come forward themselves. In essence they say, “I do not want what happened to [the

whistleblower] to happen to me.”

Example: One executive became a mole for a governmental agency and fed them information about his employer’s illegal activities. When the case went public and his name was accidentally disclosed, the whistleblower suffered severe consequences. His

employer charged him with theft, he was fired and locked out of the company’s headquarters, his name was dragged through the mud by the press and news agencies, the people in town stopped speaking to him, and his kids were picked on in school by other children. He finally attempted suicide to escape what was happening.

Failure to Report Fraud

Many companies are reluctant to report detected frauds (less than 10 percent in one study) because a highly visible fraud is a public-relations disaster. In some cases, the company loses more from the adverse publicity than from the fraud itself. It also reveals the vulnerability of their system, thereby possibly attracting more acts of fraud.

Failure of Businesses to Prosecute Fraud Perpetrators

Many businesses do not prosecute employees that commit a fraud. There are a number of reasons for this.

• Often the perpetrator has spent the money that was stolen and has no assets to recover. • Lawsuits are costly to pursue.

• Law-enforcement officials are not particularly interested in pursuing fraud cases in court. • The company does not want to open themselves up to a countersuit for defamation of

character, wrongful termination, etc.

Failure of Law-Enforcement Officials to Prosecute Fraud Perpetrators

There are a number of reasons why law enforcement officials and the courts do not prosecute fraud perpetrators.

• Law-enforcement officials and the courts are so busy with violent crimes that they have little time for fraud cases where there is no bodily harm.

• Fraud is time-consuming to investigate:

o It is difficult to obtain court-admissible evidence; o It is costly to prosecute; and

Chapter 2: Who Commits Fraud and Why

o As a result, it is harder to successfully prosecute fraud cases and to get convictions than it is for many other types of crime.

• Many law-enforcement officials, lawyers, and judges lack the skills necessary to investigate, prosecute, and evaluate some types of fraud, such as computer fraud. • Law-enforcement officials are reluctant to prosecute cases when the companies recover

all or most of the funds lost.

• The definition of fraud is so vague no one really knows how much it really costs, so there is not much motivation to go after fraud cases.

• Law-enforcement officials sometimes do not have adequate laws to go after fraud perpetrators and make the charges stick.

Example: In one case, law-enforcement officials did not have a law that dealt specifically with computer fraud. They had to prosecute using laws written for other purposes.

The problem of an inadequate computer-fraud law was partially resolved in the United States in 1986 when Congress passed the Fraud and Abuse Act. The law makes it illegal to knowingly gain access to computers with intent to defraud; and buy and sell computer passwords.

The computer fraud is a felony if more than $1,000 of software is damaged or if money, goods, or services are stolen. The penalties are severe: 1-5 years for the first offense, 10 years for the second offense; and 20 years for three or more offenses. The range of possible fines is up to $250,000 or twice the value of the stolen data.

Light Sentences for Perpetrators

When fraud cases are prosecuted and a conviction is obtained, the sentences received are often very light. Jack Anderson, a columnist, was quoted as saying that the average sentence for a fraud perpetrator was one year in jail for every $10 million stolen.

Example: One judge, when sentencing convicted white-collar criminals, stated that all of them were God-fearing men, highly civic-minded, who have spent their lifetimes in sincere and honest dedication and service to their families, their churches, their country, and their communities. He said he could never send them to jail.

Example: A man who stole $1 million from a phone company was sentenced to 40 days in a work-release program and fined $8,500.

Example: One of the most famous cases of a light sentence was that of C. Arnold Smith. He was the owner of the San Diego Padres baseball team and was named Mr. San Diego of the Century. He was very involved in the community and made heavy political contributions. However, Mr. Smith was also charged with the theft of $200 million from his bank. He pleaded nolo contendre to the charges and he was given a sentence of four years probation and a $30,000 fine. The fine was to be paid at the rate of $100 a month for the following 25 years, with no interest. Mr. Smith was 71 at the time. The embezzled money was never recovered.

Chapter 2: Who Commits Fraud and Why

found:

Χ Fifty-one percent of the perpetrators were prosecuted;

Χ Ninety-eight percent of the prosecutions resulted in convictions; Χ Thirty-one percent of those convicted were incarcerated; and

Χ Seventy-two percent of those incarcerated received a sentence for a year or more. Putting those percentages together, only 15.5 percent (0.51 x 0.98 x 0.31) of the detected

perpetrators were prosecuted, convicted, and incarcerated. Only 11 percent (0.51 x 0.98 x 0.31 x 0.72) were incarcerated for a year or more. If we conservatively estimate that only 25 percent of frauds are detected, then less than four percent of all fraud perpetrators go to jail.

For perpetrators of computer fraud, the odds are even better that they will pull off the fraud without even being detected. The FBI estimates that only one percent of all computer frauds are detected.

A study of actual cases of computer fraud showed that only 12 percent are reported to the law. Eighteen percent of those reported are convicted and imprisoned.

If these estimates represent what actually exists in the world of business, a computer-fraud perpetrator only has a one in 4,630 chance [1/(0.01 x 0.12 x 0.18)] of being detected, prosecuted, convicted, and incarcerated. Those are pretty good odds considering that the average loss to computer fraud is over $500,000.

The Fraud Triangle

Research shows that three conditions are necessary for fraud to occur: Χ A situational pressure (a nonsharable financial need);

Χ A perceived opportunity to commit and conceal the dishonest act (viewed as a way to secretly resolve the nonsharable pressure); and

Χ A flaw in the individual’s personal integrity that allows them to rationalize their dishonest behavior.

Chapter 2: Who Commits Fraud and Why

Pressures

Pressures refer to the non-sharable problems individuals have that motivate them to act

dishonestly. It is a person’s incentive or motivation for committing fraud. Three common types of pressures that lead to employee fraud are shown in the Employee Pressure triangle

One type of pressure motivating misappropriation of assets, or employee fraud, is financial in nature. Examples include living beyond one’s means, having heavy financial losses, or high personal debt. Often, the perpetrator feels such pressures cannot be shared with others and believes fraud is the only or the best way out of their difficult situation. For example, Raymond Keller worked his way up from driving a coal truck to owning a grain elevator. He made money by trading on commodities and built a lavish house overlooking the Des Moines River. His financial situation declined and Raymond had a severe cash shortage and went deeply into debt. He asked some farmers to wait for their money, and he gave others bad checks. Finally, the seven banks to which he owed over $3 million began to call in their loans. So Raymond began to sell grain that did not belong to him (he stored it for local farmers) to cover his losses. When a state auditor showed up at his door unexpectedly, Raymond chose to take his life rather than face the consequences of his fraud.

A second type of employee pressure is related to emotional feelings or problems. Many employees are motivated by greed. Some employees turn to fraud because they have strong feelings of resentment or believe they were treated unfairly. They may feel that their pay is too low, that their contributions to the company are not appreciated sufficiently, or that the company is taking advantage of them. In one case, an accountant in California, who was passed over for a raise, increased his salary by 10 percent, the amount of an average raise. When apprehended, he defended his actions by saying he was only taking what was rightfully his. When asked how he would have felt if he had increased his salary by 11 percent, he responded that he would have

Chapter 2: Who Commits Fraud and Why

been stealing 1 percent. Other people are motivated by the challenge of “beating the system” or subverting system controls and breaking into a system. In one case, a company boasted in its advertisements that its new information system was so secure that outsiders would not be able to break into it. Within 24 hours of the system’s implementation, a team of individuals had broken into the system and left a message that the impenetrable system had just been compromised. A third type of employee pressure is related to a person’s lifestyle. These include the need for funds to support a gambling habit (or pay off gambling debts) or support an addiction or problem with drugs or alcohol. Some people commit fraud to keep pace financially with other family members. For example, one plastic surgeon, making up to $800,000 a year, defrauded his clinic of over $200,000 so that he could compete with family members who engaged in a game of financial one-upmanship.

The three types of organizational pressures that motivate management to misrepresent their financial statements are shown in the Financial Statement Pressure triangle. The most prevalent financial pressure is a need to meet or exceed earnings expectations to keep the stock price from falling. Management can also create significant pressure for themselves with unduly aggressive earnings forecasts that they then feel they have to meet. They can also create unrealistic

performance standards or incentive programs that motivate themselves and others to falsify