According to risk consulting firm Kroll, 19 percent of businesses endured vendor, supplier or procurement fraud in 2015. If you are not familiar with what procurement fraud is and are a business owner, it might be in your best interest to become educated in the matter.
Here is a hypothetical situation in which it occurs and how to handle it effectively:
A month ago, you fired the head of your IT department. The man had been slipping for a long time even though he was with you since the inception of the company. Ultimately, he put you in a difficult position and it was very hard for you to let him go.
He went through a problematic divorce several years ago. While that experience seemed to knock him for a loop, he held it together for a while. Then the heavy drinking started, meetings were missed, project costs starting going through the roof and complaints about the company’s IT systems began multiplying. Despite the numerous warnings that were directed toward him, it got worse.
Now his replacement has come into your office with a puzzling discovery. Your company has been paying $5,000 a month for maintenance on software. The new employee looked into it and has been told that the company took that software off its computer systems years ago. For reasons that are not clear, the company has been paying $60,000 a year for something that literally does not exist.
This is the classic way in which a company is alerted to the possibility that it has been the victim of procurement fraud. This is a crime that affects businesses of every type, nearly every size. It costs businesses billions of dollars a year.
Simply stated, procurement fraud is a fraud that occurs somewhere in the procurement cycle of a product or service.
It is typically perpetrated or facilitated by someone inside your organization, usually in exchange for a kickback or bribe. The offender allows the organization to buy things that it does not need, pay for things at greatly inflated prices or purchase things that are never received.
The different ways in which the fraud may be perpetrated are endless. But in most instances, it involves a trusted insider who has discretionary authority to spend money. This individual is operating without meaningful oversight and is colluding with a vendor all too happy to capitalize on the employee’s disloyalty.
The first hint that this may be happening is often something similar to what is described in our hypothetical situation—some discrepancy, not in itself very large, that might be indicative of dishonestly but could also be chalked up to nothing more than sloppiness. Before you convince yourself of the latter, there are three issues that must be explored in some detail.
First, you must ask yourself: Does this individual fit the profile of a fraudster? That requires you to put aside whatever personal experiences led you to trust him in the first place and consider what professionals believe to be the warning signs. Second, how big is the problem? Is it truly isolated or are there other “mistakes” that suggest the possibility of a pattern? And third, who else might have been involved?
Identifying every involved employee and vendor will be essential to a successful outcome and ensuring that such a thing never happens again. What you do in the first hours, days and weeks after you receive the tip may well determine whether you get your money back or you sustain an enormous loss that you did not even see coming.
Who is the employee?
In evaluating a person who might have committed fraud, lawyers and auditors who specialize in fraud talk about the “fraud triangle” consisting of opportunity, pressure and rationalization.
In our hypothetical, the individual who continued paying for unneeded software had two important sources of opportunity: insider status and technical knowledge. You trusted that person. Odds are that you were not looking over his shoulder because you knew him well. You believed that whatever else might be going on in his life, he would never steal from you.
Second, he had specialized knowledge that you did not have. He is an information technology executive. When he told you that you needed some new software or equipment, you believed him, because you trust him and also because you do not know enough about computer technology to question his judgment. For this reason, IT-related procurement fraud is particularly common and often arises in small to medium sized companies where a single person is responsible for important technology acquisitions and the technology budget.
Pressure can come from many sources. In our hypothetical, the employee went through a bitter divorce and has a drinking problem. The employee’s divorce may have put a significant strain on his financial resources and his drinking may have begun to affect his judgment. Experience teaches that employees who experience significant personal hardships, particularly when coupled with financial stress and substance abuse problems, are much more likely to engage in fraud and other forms of work-related dishonesty.
Lastly, rationalization is a process by which a formerly loyal employee allows himself to succumb to temptation—or at least justify it to himself. Sometimes it is no more complicated than the need for money. More often, the employee grows to feel resentful over some perceived slight, such as a bad performance review or a sense that he is underpaid and not sharing adequately in the fruits of his labor.
It is very important that no one be accused of wrongdoing without sufficient evidence. Otherwise, it is possible to be sued by an individual wrongly accused. But when simmering resentment is joined with the other two elements of the fraud triangle, the stage is set for procurement fraud.
Exactly how big is it?
The discovery of a discrepancy such as the one in our hypothetical requires, above all, a targeted audit of employee’s activities. It is best that this be conducted by a forensic accountant with the close involvement of legal counsel experienced in such investigations. This is because the extent of the problem and hence the involvement of other insiders will be unknown. It is also best that as few other employees as possible be involved in the process. The professionals used to conduct the audit should come from outside the company’s legal and accounting departments.
If it appears that the problem is small, and likely the result of isolated sloppiness or negligence, the recommendation will usually be to let sleeping dogs lie. The individual who failed to cancel the software contract is gone. There is no real basis to sue a former manager for unintentional mismanagement. The matter is best looked at as a lesson learned.
On the other hand, the recommendation is different if it appears that the problem is not small. The employee may have in fact engaged in procurement fraud. If that is the case, a very thorough investigation conducted under the direction of experienced legal counsel must be undertaken immediately.
The hunt for co-conspirators
The number one concern of companies that are victimized by a sizable procurement fraud is usually restitution: getting the money back. A close second is the need to understand who was involved so that implicated insiders can be discharged and implicated vendors taken off approved lists. A distant third is to see that those involved are punished, usually with criminal prosecutions.
It is not that victims do not care about punishment. The majority do. The problem is the first priority will be to ensure that the lost money is recouped and that goal may conflict with the objective of law enforcement, which is always punishment of the guilty. You should always receive assistance of legal counsel when seeking the decision of when, how and if you are going to alert the authorities.
The sad fact is that employees who are caught committing procurement fraud seldom have much of the money left to return. What that means in practical terms is that you will be most interested in identifying vendors who conspired with your employee to cheat the company. Vendors often have the money, but there are two problems that you will face in convincing them to return it.
The first is that because they have money to pay you, they also have the resources to fight back and they will do so. Aggressively. The quality of your evidence will convince them that resistance is futile or embolden them to force you to sue them.
The second problem, related to the first, is that fraud cases require a very high order of proof and are frequently met with skepticism by reviewing courts. It is often said by courts that fraud cases must be pled with particularity, meaning that the complaint must lay out the case in excruciating detail, chapter and verse. Moreover, the standard of proof in a fraud case is typically higher. It is not the preponderance of evidence standard in a typical civil case, but a showing of clear and convincing evidence.
A careful collection of evidence during the investigatory phase is therefore essential. Bank records, commercial documents, emails, reliable witness accounts and other essential evidence will be gone or incomplete when fraud investigations are conducted haphazardly or late. The end result may well spell doom to any chance you had to recover the money.
What all of this means is that even if every instinct is telling you that the employee made a mistake, explore it a bit before you consign it to simple error. By the time you realize your own mistake, it may be far too late to do anything about it.
Mr. Samuel J. Samaro is a partner at the law firm of Pashman Stein Walder Hayden and the chair of its Employment Law practice group. He can be reached at (201) 488-8200 or at firstname.lastname@example.org.