Double Damage

MATTHIAS K. KOPETZKY

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 oclock.

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. Herberts 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

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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 Computers

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 didnt 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.

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Thats 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 companys 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 didnt 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 Gammas

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 Companys

insatiable need for additional revenues to show on its consolidated balance sheets. Herbert

argued convincingly that Gammas steep growth would continue if only it had more

financing. But the increased sales didnt 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

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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 prosecutors

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 Gammas 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 Gammas

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

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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 couldnt 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 countrys leading law firms, denied

these accusations, but Herbert added another piece of evidence.

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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 werent even on the books, so the auditors

couldnt 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 dont 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.

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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, Gammas 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

banks 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 banks 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 Gammas 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 Gammas

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

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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 clients 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.

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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.

Gammas 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

How was this fraud perpetrated and how was it discovered?

What internal controls were lacking or overridden?