Understanding and preventing corporate fraud. How to avoid investing in the next Theranos.

Getting caught by a company engaged in law-breaking or dishonest business practices has always been a risk in any investment opportunity. With high-profile cases such as Theranos still hitting the headlines, we ask what constitutes corporate fraud, how it is different from other forms of white-collar crime, and how you can reduce the risk of being duped.
By Peter Gorne
October 7, 2021

I’ll know it when I see it: What is corporate fraud?

The phrases “corporate crime,” “corporate fraud,”’ “business fraud” and “white-collar crime” are used interchangeably in colloquial speech. To understand the differences between them, we look to the academic study of these practices.

There are numerous definitions of corporate crime and its subsets depending on which field is referring to the phenomenon. The definition of corporate crime in sociology literature and research has focused on the close relationship between the state/public bodies and private actors/large corporations. Researchers have addressed how large corporations both support and are supported by the State.

This covers the “too big to fail” concept that underpinned the US government’s assistance in the 2008 financial crisis. While this theoretical understanding can help social scientists pinpoint the underlying social causes of corporate crime, it is too broad to help us understand the practical implications.

Conversely, rather than being an umbrella categorization, in the study of criminology, the name “corporate crime” has been used to cover a subset of so-called white-collar crimes. White-collar crime is defined by the FBI as “synonymous with the full range of frauds committed by business and government professionals.”

As a subsection of white-collar crime, the FBI notes that the majority of corporate fraud investigations involve “accounting schemes designed to deceive investors, auditors, and analysts about the true financial condition of a corporation or business entity.” Here we see that corporate fraud relates to crimes committed for the benefit of the company or corporation, rather than only benefiting one individual.


Corporate fraud relates to crimes committed for the benefit of the company or corporation, rather than only benefiting one individual.

The FBI investigates the following types of corporate fraud:

Falsification of financial information

  • False accounting entries and/or misrepresentations of financial condition;
  • Fraudulent trades designed to inflate profits or hide losses; and
  • Illicit transactions designed to evade regulatory oversight.

Self-dealing by corporate insiders

  • Insider trading (trading based on material, non-public information);
  • Misuse of corporate property for personal gain; and
  • Individual tax violations related to self-dealing.

Fraud in connection with an otherwise legitimately operated mutual hedge fund

  • Late trading;
  • Certain market timing schemes; and
  • Falsification of net asset values.

Madoff, Theranos and more: Examples of corporate frauds

Eyes around the world are glued to Elizabeth Holmes’ trial for her part in the Theranos scandal. Details of how so many high-profile investors were duped by the failed company are coming to light, from whistleblower reports to Holmes’ poetry efforts. The fact that Theranos drew millions of investment dollars from well-established business professionals, such as Rupert Murdoch, before the company was shown to be fraudulent demonstrates how easy it can be to fall prey to corporate fraud.

It is not only private investors that can be victims of corporate frauds. Berkshire Hathaway had to take a $377 million charge in recent years after investing in a now-notorious Ponzi scheme purporting to offer investment opportunities in renewable energy.

Corporate fraud covers a range of dubious business practices. For example, Wells Fargo was required to pay $3 billion in fines to the US SEC and Department of Justice after their scheme to book sales quotas with fake accounts opened under the names of existing customers. This makes it one of the biggest ever examples of corporate fraud.

Other contenders for the title of “largest corporate fraud” are Enron and Arthur Anderson, who together hid Enron’s losses in shell accounts; ZZZZ Best carpet cleaning company which was valued at $300 million before it was discovered that more than 90% of the company’s customers were fictitious.

More than just greed: What are the causes of corporate fraud?

As with most forms of crime, greed is the most common cause of corporate fraud. However, in today’s cut-throat financial climate, perpetrators can be motivated by other factors, sometimes dressed up as legitimate business practices.

The need to attract or retain investors and show the promised company results can be a major factor. Many corporate fraud schemes use fraudulent accounting schemes to make a company seem more profitable than is actually the case.

Problems with the company’s product can also be a driver behind corporate fraud. In the Theranos case, rather than stop production to perfect the technology behind their system, executives chose to falsify results. At the Holmes trial, former lab workers shared how they were asked to manipulate data to make it appear that their system was more accurate than was the case.

Because I can: What makes corporate fraud possible?

In the simplest of terms, corporate fraud continues to be a problem because the perpetrators can get away with it.

As corporate fraud often involves the use of sensitive information and complicated accounting procedures to hide fraudulent behavior, it can be hard to detect. In the case of the German Wirecard company, approximately $2 billion was missing before the false reporting came to light.

Even when a fraud is detected it can be difficult to prosecute corporate crime. A variety of different legal approaches can be combined to prosecute corporate fraud. Chapter 47 of the US Code covers several different types of fraud. However, corporate fraud does not fit squarely between the provision on Chapter 47 on fraud and false statements or the Chapter 63 provision for mail and other frauds.

To further complicate the situation, not all questionable corporate dealings are covered by existing laws. Legal scholars point to the subprime crisis as an example where, even following immense disruption to the financial markets due to questionable activities, few prosecutions were actually made because the actions performed by most players were not actually illegal.

How to know if a company is fraudulent?

While some cases of corporate fraud are so well concealed that even those with a trained eye might be none the wiser, most have clear warning signs that could be detected. It has been suggested that the consistently stable returns offered by Bernie Madoff’s firm, even at times that the market was dropping, should have raised a red flag.

Thorough operational due diligence could uncover the information needed to call an investment into question. In the case of Theranos, their many investors handed over millions of dollars without asking Holmes to provide financial statements audited by an independent public accounting firm. While checking a company’s financial records will give an indication of the current standing of a company, the history of key personnel can be an equally important factor to consider. History of past legal actions, employment history, and adverse media coverage can all be warning signs of potential fraud.

In the case of Berkshire Hathaway’s ill-fated investment in the Ponzi scheme that proposed to be offering renewable energy solutions, a thorough background check might have saved them from financial loss. An Intelligo background check of the company founder, Jeffery Carpoff, uncovered evidence that would have called his reliability as a CEO into question.

The AI-powered background check was able to delve into legal records and find that Carpoff had not only previously filed for bankruptcy, but he was also listed as a debtor in 35 tax liens, amounting to over $7.5 million in debt. He was also a defendant in 25 traffic and misdemeanor cases. Having discovered negative information about Carpoff does not guarantee that he would steal millions of dollars from investors, however. But with careful analysis, it does paint a picture of an individual of questionable character and a seeming lack of respect for other people’s money. This is someone that a cautious investor would think twice about trusting.

For most corporations, uncovering pertinent and thorough background check information can only be performed by external background check providers as they have existing systems for reviewing a wide range of information sources. As most data sources are now digitized, it is more feasible than ever to receive detailed information on any potential investment.

The Ostrich effect: Why do companies ignore the risk of corporate fraud?

With such a significant risk posed by corporate fraud, why do so many companies overlook taking more stringent measures to investigate their possible investment opportunities?

When the financial imperative to make every possible effort to avoid investing in companies involved in corporate fraud are clear, to understand why many investors fail to make those efforts, we must look to psychological motivations.

One psychological factor is the reluctance to accurately access negative information in a financial setting. Studies have shown that investors spend less time monitoring their portfolios at times when the market is low. Even though one might expect investors to take more interest in their business dealings at times when the market is low, researchers have found that human nature is to avoid negative information especially if there was initially more positive information on the same topic.

In addition to simply avoiding negative information that is readily accessible, in some cases managers avoid doing the necessary due diligence research in the first place. When investigating a business opportunity, a background check could bring negative information to light that would affect the viability of moving forward.

While the logical thing to do is to perform a thorough background check into a company and key management figures before finalizing an investment deal, many individuals encounter a psychological phenomenon referred to as the “Ostrich Effect.” Much like an ostrich buries its head in the sand to avoid danger, we often choose to bypass negative information or avoid collecting any information in the first place, closing ourselves off completely to conflicting facts that could adversely affect a business deal.

This psychological anomaly poses a threat to intellectually honest, informed decision-making. Consumed by the onerous due diligence process, ODD managers might delay running a background check if other aspects of their research, such as on-site visits and interviews, present a promising outcome.

Not only do individuals reject unfavorable feedback, some will also go as far as to omit certain procedures so as not to find themselves in a situation where negative information can even present itself. While feigned ignorance is partly attributed to the Ostrich Effect, there are additional reasons as to why some would want to avoid conducting background checks. When the numbers add up to a promising transaction and the onsite visit checks out, executives are eager to close a deal as quickly as possible. Many executives see background checks as time-consuming, delaying negotiations and causing the agreement to be susceptible to reconsideration.

Thankfully that is no longer the case. New developments in automated company background checks mean that investors can now receive a thorough and accurate view of a company’s dealings. The Intelligo risk intelligence platform uses a combination of AI-powered solutions to provide company information, including regulatory sanctions; inclusion on watchlists; county, state, and federal legal filings; and global and US media coverage.

As an automated online platform, Intelligo is able to return initial findings within a few hours, dramatically cutting the time needed for due diligence and streamlining the process. Armed with this information, investors are then able to make informed decisions about every opportunity.

Do your homework to help prevent corporate crime

The cost of poor operational due diligence is rising. Corrupt corporate behavior has evolved from an intermittent scandal to a growing epidemic. A PwC survey revealed that “68% of external actors committing the fraud are “frenemies” of the organization – agents, vendors, shared service providers and customers.” With white-collar crime near at hand, it’s time to dig our heads out from the sand and recognize the value of operational due diligence.

The repercussions of the Ostrich Effect and justification for ignoring the screening process are no longer an acceptable excuse. A lack of transparency will ultimately result in inadequate decision-making, and could lead to considerable monetary losses. It’s imperative to prioritize due diligence and background check processes to help prevent corporate crime.

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