The 21st Century's Top 10 Frauds

The theory is there are no small frauds—only frauds that haven’t yet reached their full potential. So says Jim Ratley, president and CEO of the Association of Certified Fraud Examiners (ACFE).

According to the ACFE’s 2012 Report to the Nation, most occupational fraudsters are first-time offenders with clean employment histories. Approximately 87 percent have never been charged or convicted of a fraud-related offense, and 84 percent have never been punished or terminated by an employer for fraud-related conduct.

From the mass of fraud cases that have erupted onto front pages this century, we have chosen our top 10. Many are familiar names, committed to the annals of history for their ill-gotten gains. Are there lessons to be learned? We certainly hope so.

#1. Worldcom

The telecommunications company now known as MCI inflated assets by as much as $11 billion, leading to 30,000 lost jobs and $180 billion in losses for investors. The company’s internal audit department uncovered $3.8 billion in fraud. CEO Bernie Ebbers was identified as the main perpetrator, underreporting line costs by capitalizing rather than expensing, and inflating revenues with fake accounting entries. He was sentenced to 25 years for fraud, conspiracy and filing false documents. The CFO was fired, the controller resigned and the company filed for bankruptcy.

Ratley says that, in a less severe case of fraud, when an internal auditor finds red flags the offending numbers are generally just changed or written off. “With a case this big, they were bound to get caught, but in many more run-of-the-mill fraud cases, it’s still swept under the rug.”

What have we learned? “Not a lot,” says Ratley.

“It comes down to leadership,” explains Al Gini, chairman of the management department, Quinlan School of Business at Loyola University, Chicago. “No one should be sustained without scrutiny. So even if someone seems fine and has worked his or her way up the ranks, scrutiny is deserved before you become a member of the C-suite. The board of directors should be doing this. It’s not a symbolic role.”

John R. Boatright, director at Loyola’s Baumhart Center for Social Enterprise and Responsibility, agrees. “When I teach this case in my classes, I show my students that Ebbers was out of his league. If you look at his former experience he was not qualified to hold his role. His experience did not add up to CEO material. His business strategy was basically a rising stock price based on continual expansion. That’s flawed in so many ways, and a qualified CEO would never allow it.”

Brad Sargent, CPA/CFF, CFE, CFS, Cr.FA, FABFA, managing member of The Sargent Consulting Group LLC, and INSIGHT Forensics Insider columnist, has a different take. “In hindsight,” he says, “these individuals sitting at the top of these organizations, orchestrating these frauds, appear as nothing more than greedy crooks. However, they ascended to these positions of wealth, power and influence by hard work, diligence, tenacity and earning trust. None of them ever set out to commit fraud. They made a series of disastrous ethical decisions that led them, their organizations and stakeholders down the slippery slope to criminal behavior. A billion-dollar fraud isn’t perpetrated overnight by one individual using one set of accounting entries. It takes years of buy-in and trust to co-opt the entire leadership structure within an organization.”

#2. Waste Management

This Houston-based, publicly traded company allegedly reported a whopping $1.7 billion in false earnings, falsely increasing the depreciation length for their property, plant and equipment on the balance sheets. Charged in 2002 by the Securities Exchange Commission (SEC), the fraud allegedly had been going on for more than 5 years. Resolving the issue by settling a shareholder class-action suit for $457 million, the company’s new CEO (whose team had caught the discrepancy) instituted an anonymous hotline where employees could report dishonest behavior. According to the SEC, chief executives were the ones perpetrating this fraud.

Philip Rooney, president, ensured that required write-offs were not recorded and, in some instances, overruled accounting decisions that would have a negative impact on operations. He reaped more than $9.2 million in ill-gotten gains from, among other things, performance-based bonuses, retirement benefits and selling company stock while the fraud was ongoing.

James Koenig, CFO, was primarily responsible for executing the scheme. He also ordered the destruction of damaging evidence, misled the company’s audit committee and internal accountants, and withheld information from outside auditors. He profited by more than $900,000 from his fraudulent acts.

Thomas Hau, corporate controller and chief accounting officer, devised many “one-off” accounting manipulations to deliver the targeted earnings and carefully crafted the deceptive disclosures. He profited by more than $600,000.

Defendants allegedly concealed their scheme in a variety of ways, including making false and misleading statements about the company’s accounting practices, financial condition and future prospects in filings with the SEC, reports to shareholders and press releases. They also were charged with using accounting manipulations known as “netting” and “geography” to make reported results appear better than they actually were and therefore avoid public scrutiny. Defendants allegedly used netting to eliminate approximately $490 million in current period operating expenses and accumulated prior period accounting misstatements by offsetting them against unrelated one-time gains on the sale or exchange of assets. They were charged with using geography entries to move tens of millions of dollars between various line items on the company’s income statement to, in Koenig's words, “make the financials look the way we want to show them.”

Auditor Arthur Andersen was fined $7 million for its participation in the false reporting.

“It’s not unusual,” says Craig Greene, a certified fraud examiner and founder of McGovern & Greene CPAs & Forensic Accountants, “for high-level executives to be caught as a team. But more common, before Sarbanes-Oxley (SOX), was that the CFO would be the one to fall on his sword, with the CEO coming out as innocent of wrongdoing. This, of course, was not usually true, but it’s just the way things were done.”

What have we learned? That SOX was necessary, says Greene. “A CEO must be responsible for what is transpiring on his watch and by making him sign off on financials, it makes it so.”

#3. Enron

The Houston-based commodities, energy and service corporation kept huge debts off the balance sheets. Shareholders lost $74 billion, thousands of employees lost their retirement accounts, many employees lost their jobs and the firm filed Chapter 11 bankruptcy.

Sherron Watkins, a senior executive, blew the whistle when high stock prices fueled suspicion of wrongdoing. Auditing firm Arthur Andersen was found to be involved. CEO Jeff Skilling was sentenced to 24 years in prison. Former CEO Kenneth Lay passed away before serving time. Former CFO Andrew Fastow, who pleaded guilty to two counts of conspiracy, served jail time and forfeited $24 million, was quoted in a Denver Post article as saying, “There are people who look at the rules and find ways to structure around them. The more complex the rules, the more opportunity. The question I should have asked is not what is the rule, but what is the principle.”

What has Enron taught us? “For one, that boards of directors should not resemble social clubs more than business boards,” says Ratley. “Boards got tougher after Enron.” The rub, he says, is that fraud courses are now back down to pre-Enron levels, which were quite low. “Executives worried for a while and now their guard is back down. Not a good thing when you’re talking about fraud.”

#4. Tyco

This New Jersey-based, blue-chip Swiss security systems company was targeted by the SEC in 2002 for questionable accounting practices that inflated company income by $500 million and netted the CEO and CFO $150 million. The money was siphoned through unapproved loans and fraudulent stock sales, disguised as executive bonuses and benefits.

CEO L. Dennis Kozlowski and CFO Mark Swartz were sentenced to 8 to 25 years in prison. The company had to pay $2.92 billion to investors as the result of a class-action suit. At the height of the scandal, Kozlowski threw his wife a party on a private island, replete with a Jimmy Buffet performance, to the tune of $2 million. A company-issued report detailed his use of company funds for $14 million in renovations and redecorating for his Fifth Avenue apartment in New York. Among the most ridiculous items were a $6,000 shower curtain and a $2,200 wastebasket.

A tip or a complaint to the SEC is not de rigueur, according to Ratley. “There’s really no method set up to report to the SEC,” he says. “For the average company, an anonymous tip line is the best option, run by an external party. If it’s run internally, it tends to fail, either due to lack of reporting or lack of response because of a conflict of interest.” Smart companies have learned to provide a mechanism to self-police in the wake of Tyco.

#5. HealthSouth

This healthcare company allegedly inflated its earnings by $1.4 billion to meet stockholder expectations. CEO Richard Scrushy was accused of asking staff to make up numbers and transactions from 1996 through 2003. Cash and asset accounts were falsified and pre-tax income was inflated. The SEC became suspicious when Scrushy sold $75 million worth of stock the day before the company posted a huge loss.

Despite the fact that five senior executives pleaded guilty to federal fraud (including the CIO), Scrushy was acquitted of all 36 counts of accounting fraud. He was, however, accused of bribing the governor of Alabama, which led to a 7-year prison sentence. Scrushy still maintains his innocence and works as a motivational speaker.

“What belies the differential between average wage earners and CEOs is our naïve belief that these people are going to save us,” says Gini, referring to the exorbitant compensation Scrushy was paid. The shareholders’ attorney alleged that Scrushy received $226 million in compensation over 7 years while HealthSouth was losing $1.8 billion, but Scrushy disputed the numbers.

“It spans industries,” says Gini. “And it’s ridiculous. If you look at the wages of the JCPenney CEO last year, for example, he was paid thousands of times more than the average worker. And oh, by the way, JCPenney is in trouble. We have to stop thinking any of them has a magic bullet. No one is worth that much. We don’t seem to be learning our lessons, though, as we keep hiring executives with a less-than-stellar moral compass, who will maintain innocence in the face of overwhelming evidence to the contrary. We’ve learned very little from this scandal.”

#6. Freddie Mac

This federally backed mortgage giant misstated $5 billion in earnings, according to a SEC report issued in 2003. The organization paid $125 million in fines and fired its CEO, CFO and COO. Under the terms of the settlement, Freddie Mac’s board was required to review and revise its bylaws and the frequency of its meetings, along with the company’s codes of conduct. The board also was required to determine whether to impose limits on the terms of its members. Freddie Mac, in turn, was required to report on its internal controls and on plans for strengthening its internal audit function. Also, it was required to separate the jobs of chief executive and chairman.

“I’m not saying Freddie Mac was blameless,” says Gini, “but the intent here was not to amass personal wealth at the expense of others. Their worst crime was throwing good money after bad and trying to cover their mess. Chalk it up to Scandal #4,788. We take a deep breath and hope it won’t happen again. But it will.”

“If you’re receiving federal funds, you’re regulated even more heavily,” says Greene. “The lesson is simple: pay attention and do the right thing.”

#7. American Insurance Group (AIG)

This multinational company allegedly perpetrated an accounting fraud totaling $3.9 billion, along with bid rigging and stock price manipulation. It settled with the SEC (twice) for a combined $1.74 billion, along with several pension funds. CEO Hank Greenberg was fired but faced no criminal charges. Greenberg allegedly booked loans as revenue, steered clients to insurers with whom AIG had payoff agreements and told traders to inflate stock prices.

“Bid rigging is one of the more sophisticated but also one of the most common frauds,” says Greene. “The red flags are there and have been for years. This is a fraud that’s easy to spot for an auditor using due diligence. If you think you’re getting away with it, odds are not in your favor.”

Auditors, however, don’t seem to have learned this lesson, if a recent study is any indicator. Funded by the Center for Audit Quality, An Analysis of Alleged Auditor Deficiencies in SEC Fraud Investigations: 1998–2010, looks at 87 sanctions against auditors brought by the SEC in fraud cases involving public companies. The long-term analysis found that auditors sometimes didn’t question documents that appeared to be fabricated or overlooked discrepancies between real inventory and amounts on the books. Most of the cases involved multiple alleged deficiencies.

#8. Lehman Brothers

Forced into bankruptcy by poor practices, this financial services firm hid more than $50 billion in loans, disguising them as sales. Lehman allegedly sold toxic assets to Cayman Island banks, with the understanding they would be bought back in time. The SEC didn’t prosecute due to lack of evidence.

“Frauds are committed so they increase exponentially,” says Greene. “Lehman was a classic case of ‘I need to report an extra $20 million.’ The analysts are not expecting results to be $20 million less than they should be so to make it ok, I’m just stealing from the future temporarily. I’ll make it up next quarter. And so on and so on.”

The lesson learned here, says Greene, is that we needed stricter guidance on revenue recognition. “And we still don’t have it to the extent we need it,” he says.

#9. Bernie Madoff

Madoff’s Wall Street investment securities firm bilked investors out of $64.8 billion in the largest Ponzi scheme ever. Instead of paying returns to investors out of profits, they were paid with their own money or that of other investors. Facing $7 billion in redemptions, Madoff confessed to his sons, who turned him into the SEC the next day. The vault that held the fraudulent information was, ironically, an IBM AS/400 server dating back to the 1980s that Madoff refused to replace. Now we know why.

“When things are going too well, something is wrong,” says Gini. “This wasn’t just hurting wealthy investors who could stomach the hit,” says Greene. “This was bilking Granny out of her life savings.”

Lessons to be learned here are hard, since Madoff is a very extreme case. Many liken him to a sociopath or psychopath, a la Snakes in Suits by Paul Babiak. “You can’t extrapolate from that situation because it’s so unusual,” says Gini.

#10. Satyam

This global IT firm, based in India, falsely boosted earnings by $1.5 billion by falsifying revenue, margins and cash balances. Founder and Chairman Ramalinga Raju admitted the fraud in a letter to the company’s board of directors. He and his brother were charged with breach of trust, conspiracy, cheating and falsification of records. Both were released when the Central Bureau of Investigation failed to file charges on time.

In his letter to his board, Raju states: “What started as a marginal gap between actual operating profits and ones reflected in the books of accounts continued to grow over the years. It has attained unmanageable proportions.” Later, he describes the process as “like riding a tiger, not knowing how to get off without being eaten.”

Gini considers Raju just another example of the CEO as celebrity cult gone wrong. “Many of them are narcissists of the highest order. This is all about them. Not just about the money. It’s about playing the game. At a certain point, you’ve stolen so much that there is no way to spend it without being caught. You could never spend that much in a lifetime. It is a thrill to some of these people.”

The ultimate lesson? “Get back to basics and look at the character of those we put in authority,” says Gini. “By what rubric could you ever justify the actions of the Enron C-suite? And how did we get to the point where we let people like that run the show?”