The Cost of Employee Fraud (and How to Prevent It)

According to StatisticBrain research institute, employee theft is a crime that costs U.S. businesses $50 billion annually. On a global scale, the Association of Certified Fraud Examiners reported that the median loss to businesses due to employee and executive fraud is $145,000- or an aggregated $3.7 trillion annually. More specifically, a study by global specialist insurer Hiscox found that the financial services sector had the highest level of losses due to employment fraud across all industries. In 2016 losses were over $120 million. How can these alarming figures be avoided to prevent future devastating losses to businesses?
By Ariella Serman
December 6, 2020

The Price Paid for Trouble Made

We are all familiar with the following infamous cases: the collapse of Enron, the Theranos catastrophe, and the Bernie Madoff debacle. These scandals were notorious for the magnitude of financial disaster they caused and the ripple effect they had on the national economy. Below we outline the cause and the cost of some of the most well-known fraud debacles in U.S. history.

Enron: In 2001, America’s fifth-largest company, according to Forbes magazine, filed for bankruptcy—the largest filing in American bankruptcy history at the time. A report of the investigation by the Special Investigative Committee of the Board of Directors of Enron Corp revealed that executives were inflating profit reports to shareholders while pocketing millions of dollars from undocumented partnerships. Among those convicted of fraud-related crimes were Jeffrey Skilling and Kenneth Lay, former CEOs of the company. Amid the scandal, Enron’s stock price plummeted from $90.75 per share to 50 cents per share in a single year, and the total losses were estimated at $74 billion.

Theranos: This tech startup was initially known as a company revolutionizing the healthcare industry. Using technology that could test small amounts of blood for various conditions, it had an estimated valuation of $9 billion. Theranos’s investors included pharmacy giant Walgreens and supermarket chain Safeway. But just as quickly as the venture took off did it shut down. The U.S. Securities and Exchange Commission charged founder and CEO Elizabeth Holmes with ‘massive fraud’ and the Justice Department charged her with nine counts of wire fraud that could land her in prison for up to twenty years. A $600 million loss is estimated as a result of this defamation from government, business, and international finance. The biggest financial blows were suffered by investors, including Walmart founders, the Walton Family ($150 million investment), American media mogul, Robert Murdoch ($121 million investment) and U.S. education secretary, Betsy DeVos ($100 million investment).

Bernie Madoff: What may, not surprisingly, be known as the worst (but most successful) Ponzi scheme in history, Bernie Madoff was sentenced to one hundred and fifty years imprisonment after pleading guilty to eleven felony counts including securities fraud, investment advisor fraud, money laundering, and perjury. Investors included famous celebrities Sandy Koufax, Steven Spielberg, Kevin Bacon, and others, some of who poured their life savings into Madoff’s promise of low-risk, high return investments. In 2013, the U.S. government arranged the Madoff Victim Fund to help investors recover their lost funds. The total cost of this life-shattering scheme was evaluated at $65 billion.

Fool Me Once…

When analyzing the aforementioned cases, it’s hard to believe that history continues to repeat itself in this regard. But it does. And it will. How can investors actually cultivate a relationship based on trust, and differentiate between people like Holmes and Madoff, and the rest? Obviously, in retrospect, it is much easier to see how, where, and what went wrong. Although we can’t fix past mistakes, we can learn from them to prevent future ones.

First of all, most C-suite executives who are caught up in a host of fraudulent activities are not your average-looking criminals—and that’s not just because they’re suit-and-tie kind of people. Jeffrey Skilling of Enron earned his MBA from Harvard Business School and graduated in the top 5% of his class as a Baker Scholar. Kenneth Lay was promoted to lieutenant in the U.S. Navy and was the special assistant to the Navy Comptroller and Financial Analyst at the Pentagon. Elizabeth Holmes was born into a wealthy, prominent family with a mother who worked in foreign policy and defense aid on Capitol Hill and a father who worked in executive positions in various government agencies after serving as the vice president of Enron. Bernie Madoff founded his own market maker firm and helped launch the Nasdaq stock market. He sat on the board of the National Association of Securities Dealers and was an adviser to the U.S. Securities and Exchange Commission on trading securities.

Not So Crazy When You Think About It

Evidently, questioning these individuals’ credibility and integrity seems not only foolish but also irrational. On a cognitive level, the halo effect is a cognitive bias that helps explain why investors wouldn’t have dug deeper into these fraudsters—and why you may not have either. The halo effect is a cognitive bias in which our overall impression of someone influences our assessment of his/her specific traits. So if you think John is an overall nice guy, you will also think he is smart, funny, and/or ambitious.

Looking at the achievements of the above-mentioned executives, it is uncontested that they were successful and well-accomplished individuals. Because of our overall evaluation that these people are successful, we also make the assumption that they are honest, hard-working, likable, genuine, and another fill-in-the-blank-with-positive-adjectives type of people. Due to our perception that they are first-class individuals, why waste time and resources on due diligence when we know it will have negative returns? Obviously, these people rose to prominence for good reason, and therefore we can accept the legitimacy that society has granted them.

The halo effect obscures our vision with rose colored lenses, convincing some investors that conducting due diligence on these individuals doesn’t seem to make a whole lot of sense. But what can we do to overcome this psychological bias to ensure that past mistakes are not repeated in the future, to remove the lenses and gain full clarity to an individual’s character?

Red Flags from Retrospect

Suggesting that due diligence should have been performed on these executives seems like a frivolous solution to the problem considering their shining star backgrounds. However, a closer look at their past could have revealed some pieces of information worthy of a double take.

Harry Markopolos, a fraud investigator, noted that Madoff’s investment returns graph sloped at a constant 45 degree upward angle. But obvious even to the less educated is that the only thing constant about investment return graphs is change. Markopolos also noted that Madoff invested in the market six to eight times a year with money remaining in the market for only a couple of days to a couple of years. Somehow, he knew when the market was going up and only invested then. When he thought the market would decline, he transferred everything into cash. Madoff always had cash at the end of the year… just in time for audit season.

Sherron S. Watkins, Enron’s vice president who tried to warn executives about the impending implosion of the company, testified that in June 2001, around twelve Enron assets were being hedged, or guaranteed against loss by the Raptors vehicles which were off the books structures. The Raptors vehicles only contained Enron stock and were interconnected with CFO Andrew Fastow.

Elizabeth Holmes revolutionized the healthcare industry in the U.S. with her $9 billion startup Theranos. And yet, Holmes herself had absolutely no science or medical training and her board of directors consisted of almost no one with healthcare credentials. The board included primarily individuals with political and military backgrounds.

Attention to Prevention

Despite their external appearances, these executives did have red flags brewing below the surface. Looking at their stories as separate and unrelated pieces would not have revealed anything exciting, but putting the pieces together could have, in the case of Theranos, saved lives—literally.

That is why performing due diligence on investors is not only recommended but is crucial to the protection and safety of the investment. Even though an investor may have the credentials you would naturally be looking for, it is important to dig deeper in order to discover the true character of the investor and their potentially hidden motivations. So next time you’re thinking of transferring your funds to what may be known as an ideal investor, spend the extra time and do some due diligence—because the alternative could really cost you.

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