All his life, Herbert Kearns had been a salesman. At the tender age of five, he sold juice and snail shells to neighbors, proving his talent for deal-making early on. At every step along the job ladder, he excelled. However, he liked to live above his means, and this habit led to growing need for money and seemingly permanent debt. His future partner, Simon Leary, was a quite different character. More introverted and a bit shy, he met Herbert when they both worked at CCC Computer Corp. in Vienna, Austria. Simon managed the assembling and tech support departments, and Herbert was a star marketer. Unlike Herbert, Simon was a family guy interested in good pay to support a comfortablebut not extravagantlifestyle. He did not like to work overtime, and you would rarely find his car in the parking lot after five o'clock. But Simon was very good at team building, and he managed a well-motivated department of almost 50 people. His style was calm but strict, and his staff valued his broad knowledge of computers and his ability to solve a myriad of problems. Even when the team was under stress to produce a big order, Simon acted without a hasty word and kept everyone on track. With this attitude, he had become the invaluable backup for the stormy salesmen like Herbert, who often promised more than the company could deliver. Herbert was willing to do almost anything to land new customers. He realized very early the importance of a character like Simon in the management team of an aggressively growing computer hardware reseller. After several years with CCC, Herbert, frustrated about a neglected salary increase, decided to start his own venture. He believed he had found his ideal partner in Simon, the team builder and back-office organizer. They started by working out of a small shop with only four employees near downtown Vienna. Herbert's business plan for the new company, Gamma Computer, Inc., was to lure away customers of CCC, and win new large accounts. During his tenure at the old company, Herbert had learned how to deal with governmental agencies and organizations. Their needs and requirements are often quite different from those of private sector companies. Winning a contract with one of these 527 Wells4689_c55_1 05/31/2007 528 entities often meant that you would need to move huge quantities of computer hardware in one dealand quantity is always an issue in the computer-assembly business. The more units you can assemble and the more parts you are able to order, the better the profit margin. Herbert knew that his timing was right. Virtual no-names like Gamma were now being allowed to bid on large government contracts. The tightening budgets in the public sector for governments to look beyond big companies like IBM and Siemens to see if they could procure what they needed at a lower cost from newcomers. From the very beginning Gamma showed an ambitious and steep path of growth, which made it an attractive customer to the Second Savings Bank, one of the biggest financial institutions in the country. Second Savings backed Gamma by prefinancing its growing accounts receivable. It was a moderate risk. More than 95% of Gamma Computer's business was with national and local government entities, and its customer list included the departments of defense, agriculture, science, and education, and even the office of the prime minister. For Second Savings, this meant almost 100% secure accounts receivable, which the bank took in as collateral for the growing working capital needs of the company. The public sector was not famous for paying either fast or on time, but one could expect that every outstanding payment would come in sooner or later. And so it was at Gamma Computer, which showed a very low rate of write-offs within its accounts receivable during these years. The rise of Gamma happened during one of the longest and most sustained bull market phases the stock markets ever saw. The 1990s were a gold rush time for investors all over the world, and stock indices seemed to grow without limits. It was the dawning of the Internet, and nearly every business involved with computers and software was making money. It was also the time when terms like ''growth'' or ''cash-burn rate'' seemed to turn market valuations upside-down. To be able to fulfill expectations in growth, more companies started to play the mergers and acquisition game. Gamma Computer, with sales upward of $100 million, soon came into focus as a takeover target. For Herbert Kearns, this was ultimate dreamto sell his company during a merger deal and start a new life as a wealthy man who could afford to stop working at the age of 45. It didn't take long before firms were approaching him. Herbert had several meetings with a large investment group in Amsterdam. Gamma had just hit record high sales, and within a few short months, 100% of its stock was purchased by the Netherlands Holding Company, itself a rising star in booming Amsterdam. To keep the party rolling, the former owners, Herbert and Simon, had to stay on for another three years. The price of the shares they sold to the Netherlands Holding Company was tied to certain success criteria, such as sales and recoverability of accounts receivable. Therefore, Herbert and Simon were able to cash in only one-third of the total price for Gamma Computer and had to ''earn'' the rest through another three successful years of business. 528 chapter 55 double damage Wells4689_c55_1 05/31/2007 529 That's Odd A few weeks after the sale, Simon turned in his resignation, citing ''family reasons.'' This was quite astonishinghe left behind two-thirds of the sales price of the company, since he failed to remain the three years as required. At Second Savings Bank, the outstanding credit line of Gamma Computer had surpassed its limits, which brought up some ''difficulties'' for the company's account representative. Gamma should have been moved to the Large Commercial Accounts Section, a special department within the bank in which all big accounts are pooled. But this move would have been a significant change for Gamma and its longtime account representative, Jim Muller. Transferring the business would mean that Jim would have to pass it on to someone else. Both Gamma and Jim decided that this was not a desired outcome soin violation of bank rulesGamma remained within the regional branch office. Only weeks after the sale of the shares to the Netherlands Holding Company, Jim received a strange call. A manager of the leasing branch of a well-known bank competitor informed him that it was buying all the receivables of Gamma Computer and that it would pay the outstanding credit to Gamma since Second Savings would no longer be holding the receivables as collateral. But the leasing bank also asked for a guarantee that it could sell back the receivables to Gamma at any time and that Second Savings would finance the sale. Since the overall risk picture for the bank didn't change, Jim was agreeable, but thought the transaction very odd. When Jim asked Herbert about the reason for this somewhat strange arrangement, he was told that the holding company asked for the move. Herbert added that he did not understand it either, but since Netherlands Holding Company was the new boss, he did not ask questions. The sale of the receivables was finished by March 15, only two weeks before Gamma's end of the fiscal year on March 31. Eight weeks later, Gamma Computer bought back the entire group of receivables, which were again pledged to Second Savings, and the bank guarantee was rescinded. So within three months, the situation looked the same as before: Second Savings Bank had outstanding credit backed with receivables of Gamma Computer. The reason for this convoluted transaction would be become clear later. Here Today, Gone Tomorrow In October of that same year, Gamma Computer, Inc. declared bankruptcy because it could not pay its invoices on time, which in Austria is a cause for bankruptcy. One of the main reasons for the sale to the holding company was Netherlands Holding Company's insatiable need for additional revenues to show on its consolidated balance sheets. Herbert argued convincingly that Gamma's steep growth would continue if only it had more financing. But the increased sales didn't materialize, and the company was deeply in debt. The sudden death of Gamma Computer was a shock for Second Savings Bank. It was totally unaware of the deep financial troubles of its customeror so the bank said. But the here today, gone tomorrow 529 Wells4689_c55_1 05/31/2007 530 bank was in a relatively comfortable position because it owned all the receivables as a backing for the credit line. And those receivables seemed to be almost as safe as real money because they were owed by slow but steady-paying government agencies and departments. Second Savings thought that it would be only a matter of time before the outstanding credit would be reimbursed. It was wrong. Soon Second Savings became worried and decided to contact each debtor and ask for direct confirmation of the outstanding balances. The responses were devastating. The bank learned that in every instance, either the receivable never existed or the amount had been paid monthsor even yearsago. This was astonishing because the policy at Second Savings stated that only receivables less than 180 days old could be accepted for collateral. At this point, Second Savings decided to hand over the case to the public prosecutor's office, which engaged our forensic accounting firm to check the allegations against Gamma and its management teamprimarily Herbert Kearns. Federal police seized a large amount of company records and documents, a load of almost 5,000 three-ring binders, computers, hard disks, and other data. The main focus was the allegation of the Second Savings Bank regarding the receivables, roughly $15 million, which it had reason to believe were fraudulent. So my team and I started with the receivables first and analyzed how they had been created within Gamma's accounting system. Strangely, we found duplicate databases with very different data in each. Herbert cooperatively explained to us that the company had two accounting systems for two lines of business it engaged in: assembling services and direct sales. This fact, although strange, would not have been a problem if the two systems showed the correct combined amounts. But we found the same receivables in both. We also found many more databases, which looked like backup or trial copies. Herbert explained this was due to some technical issues they had with the integration of the accounting system of Gamma into the systems of the Netherlands Holding Company. Next, we found accounts receivable lists with the same date, but different totalsvery different. Herbert told the investigators that they had real problems trying to show the sale of the receivables to the leasing company within the accounting system. He claimed that this was also why alternate versions of the accounting data could be found on Gamma's computers. Even harder, he said, was getting the receivables back into the system when the leasing company sold them back to Gamma a few months later. We took the information and imported it into our data analysis software. The same receivables could be found in different ''versions'' with different dates of origin and different dollar amounts. It seemed that at least some of the receivables had been made to look ''younger'' by changing their dates. Obviously, the 180-day bank rule could be met more easily if Gamma could simply make the receivables seem current. These listings were sent to the bank every month to prove that the outstanding credit was backed with enough new receivables. This was hard evidence that Gamma may have defrauded the bank by giving it falsified data. When confronted, Herbert insisted that the changes were made with the full knowledge of the bank because it knew that sometimes the government took longer than 530 chapter 55 double damage Wells4689_c55_1 05/31/2007 531 180 days to pay. He also said that the bank told them it was all right to change the dates so that the list would comply with the rule. We decided that the only way we could be certain of the validity of the receivables list was to check every single one with the original customer. We started with the highest single amounts and descended. A lot of explanations were in orderfor most government agencies and departments, it was strange to be asked if a certain receivable was valid and still open. Some respondents failed to cooperate, and pressure from the office of the prosecutor was necessary to convince them to hand over information. This reluctance seemed odd to us, but Gamma had built very close relationships with these entities, so there was a lot of sympathy for the company and its staff. Additionally, we found signs of possible corruption. Gamma Computer had won the vast majority of biddings in the last few years. However, the prosecutor wanted us to concentrate on the alleged bank fraud, afraid that the matter could become unmanageable if it grew into a full-fledged corruption case. Not the Result They Expected Our investigators were able to check 75% of the total receivables listed, or about $11 million out of the $15 million total. We only found two single receivables totaling $2,000 that appeared not to have been falsified. This raised a question: How was it possible to defraud Second Savings in such a brute and total manner? The bank got new lists of accounts receivable every month, and we couldn't understand why no one ever suspected anything. The prosecutor charged Herbert Kearns and his management team with defrauding Second Savings by presenting falsified evidence to prove valid receivables. This caused the bank to give Gamma increasing credit and leave the borrowing limits open. But where normal fraud stories usually end, this one took another bitter turn for the defrauded Second Savings Bank. I had been appointed as an expert witness by the chief judge and had to present my findings to the four-person tribunal during court proceedings. (Note: In Austria, unlike many jurisdictions, where experts are chosen by the parties involved, expert witnesses are appointed. Also, in Austria experts are allowed to question witnesses.) The trial started with the testimony of the defendantsprimarily Herbert, as the main figure. His argument was that Gamma Computer could not possibly have defrauded the bank because Second Savings had been aware of the situation for a long time. ''We had financial problems and the bank knew of them. But I think they had problems internally showing the risk of the outstanding loan amount, so they constantly asked us to deliver lists of open receivables to formally cover the credit volume,'' Herbert told the court. ''We had moved all of them to another group which cashed in the receivables, and that unit was planning to pay back Gamma, but this required some time. The whole group stood on shaky ground.'' Second Savings Bank, represented by one of the country's leading law firms, denied these accusations, but Herbert added another ''piece of evidence.'' not the result they expected 531 Wells4689_c55_1 05/31/2007 532 ''The bank knew that we had to juggle the receivables in and out of our accounting systems. The real cash flows had been way too low not to raise eyebrows. In fact, Second Savings actively helped us cover the whole mess with that factoring deal. If these receivables would have been on our books at fiscal year-end, it never would have passed even the simplest audit. But because we managed to sell the receivables to the leasing company just before fiscal year-end, they weren't even on the books, so the auditors couldn't check them.'' Deception is one of the indispensable ingredients of fraud. The longer the court proceedings went on, the more doubts surfaced about the real role of the bank. The court ordered Second Savings to produce Jim Muller as a witness, as well as other employees. The people from the Credit Department explained how they regularly audited the debtor at least once a year, which was required under the internal rules of Second Savings. But the questioning brought up a picture of incompetence and bad communications within the bank. I asked if they had all the published financial statements from Gamma Computer. As it turned out, they only had an incomplete set. The bank also used interim statements as final ones. The audited final statements were never checked. The Credit Department could show some activity, but the Securities Department could not prove any auditing. I asked one witness to explain the day-to-day auditing of the receivable lists. Witness: Earlier, we received the list from Gamma Computer on paper. I checked the total on the last page and sent the figure to credit monitoring. Question: What does that mean ... you checked the total on the last page? Witness: I looked to see if there was a total at all. Question: But that is not an audit procedure. Witness: But I needed the figure to pass it along to credit monitoring. Question: How did you know that the total was calculated correctly? Witness: I did not know. But I was sure, because it was a computer printout. Question: Did you check if there were only receivables younger than 180 days on the list? Witness: Yes, by spot tests. Question: And what else did you do? Witness: I put the lists into a three-ring binder. Question: And? Witness: And what? That was it. Question: How did you get list by mail electronically? Witness: I don't know who had the idea, but we wanted to get rid of the annoying paperwork. So we urged Gamma to send us the lists electronically. 532 chapter 55 double damage Wells4689_c55_1 05/31/2007 533 Question: So then it was easier to conduct audit procedures more effectively? Witness: What kind of audit procedures are you talking about? I stored them electronically from then on. Question: So do you have the old lists still on your hard disks? Could we see them? Witness: No, every time we got a new one, we deleted the old one so we always only had the most recent one on file. Jim Muller, Gamma's account representative at the bank, admitted that he had daily telephone conversations with Herbert about the true company situation and which payments would be allowed by the bank. Later, the court asked to see the reports of internal audit at the bank and ordered the bank's lawyer to bring them to trial next morning. Instead of the papers, the bank brought its chief internal auditor to explain why there were no reports. This last witness was the trigger of a very unusual and surprising court ruling. It was becoming clear that there were false statements and damage to the bank. But in the end, the court was convinced that the bank was not deceived; it knew the true situation at least during the last years and did not take any steps to protect itself. The court found the defendants not guilty of fraud. Because of the now-visible deficits within the bank, the bankruptcy trustee sued Second Savings, claiming that the bank's negligence made it possible for Gamma to survive longer than it would have if Second Savings had been properly guarding outstanding credit with diligence. That case was settled out of court. Lessons Learned Obviously, Second Savings Bank had extremely weak controls. Assuming it did not conspire with Herbert, it was harmed by the failure to check Gamma's collateral. The bank had accounts receivable from federal and state agencies and other entities from the public sector. This, in turn, caused it to be negligent in its controls because it assumed the debt would be paid. The next lesson is an old one. If a transaction is too complex to be understood, something is probably wrong. This was the case with the sale of all of Gamma's receivables to the bank competitor only weeks before fiscal year-end. Additionally, the factoring bank informed Second Savings that it planned to ''sell back'' the whole bunch in two to three months. At this point, the bank should have smelled a rat. It was not a cheap deal, and the factoring bank made a lot of money out of this fairly risk-free shortterm position. Second Savings should have asked Gamma and its parent company in Amsterdam why this was necessary. If a deal does not make sense, a red flag should go up. In this case, it seemed that Gamma wanted to get those receivables off the books before year-end, hoping that the auditors would not bother to test accounts that did not appear on the lessons learned 533 Wells4689_c55_1 05/31/2007 534 financial statements. Even the simplest audit procedures would have brought to light that all the accounts were falsified. Another red flag in this case was the fact that one of the two founders of the company, Simon Leary, quit his job only weeks after the sale of his shares to the Amsterdam investor. This was astonishing because two-thirds of the sales price was contingent on his staying with the management team for the next three years. By leaving his post, he left behind two-thirds of the ''value'' of his shares. He cited ''family reasons'' as the cause, but an investigation would have revealed that he had just started a new and similar venture, and once again, his partner was Herbert Kearns. Recommendations to Prevent Future Occurrences Establish Effective Auditing Procedures One of the weakest departments in Second Savings Bank was the Collateral Auditing Department. Effective auditing starts with healthy skepticism. Auditors should not accept the truth of every piece of information they are given. They should look for irregularities. Using the Collateral Auditing Department as an example, the bank should require its staff to perform these simple procedures and checks with regard to the accounts receivable lists: Check for changes in the layout (especially in comparison to recent lists). Verify that the list is complete and that there are no missing or omitted pages. Recalculate the totals and subtotals. Search for duplicates or omissions. Conduct a line-by-line comparison between current and previous lists looking for: Same line item, different date; Same amount, same date, different text; and Same amount, same text, different customer. Conduct random confirmations of items with the client's customer. Cross-check with other accounting statements and information provided. Trace from invoices to line items. Test and Review the Functionality of Controls Controls need to be tested to ensure they work as planned. In the Second Savings case, a lot of lists and reports were just filed without attention. If reports are not being used, then they should be stopped and management should find out why. As with Second Savings, a company could face liability if it receives information but take no steps to review it. 534 chapter 55 double damage Wells4689_c55_1 05/31/2007 535 Look for Anomalies or Deviances from Normal Procedure Rules are necessary for effective and efficient collaboration among businesses and individuals. But they are also a constant target of open or hidden criticism from those who feel too restricted. Although many people are tempted to break or bend the rules, deviation can mean danger and risk for the entity and its employees. Salespeople and account representatives often are tempted to ignore regulations to keep their customers happy. In this case, Second Savings wanted Gamma as its customer, but the bank kept the companyat its own expense. Gamma's account was supposed to have been transferred to the large unit of the bank. Presumably, that division would have been better equipped to review and audit the receivables list. This rule also serves another function. Most of the problems with bank customers on the company level surface when the representative is changed. Rules are effective only if theyare followed. It is useless to institute a rule if nobodyensures that it is followed. Broken rules could be a red flag and should be investigated. Matthias K. Kopetzky, PhD, CFE, CPA, CIA, is chief executive officer of Business Valuation GmbH, in Vienna, Austria. The firm provides advisory services as expert witnesses to courts in Austria, South Germany, and Liechtenstein. Mr. Kopetzky teaches at different universities and, with Joseph T. Wells, wrote the German version of the Corporate Fraud Handbook ANSWERS TO THE FOLLOWING QUESTIONS?.......HOW WAS THE FRAUD PERPETRATED AND HOW WAS IT DISCOVERED? WHAT INTERNAL CONTROLS WERE LACKING OR OVERRIDDEN??