9TH INTERNATIONAL ANTI-CORRUPTION CONFERENCE

13 OCTOBER, 1999

FRAUDFRAUDEFFECTIVE USE OF LEGAL

REMEDIES FOR CORRUPTION

Daniel J. Herling, PartnerGordon & Rees, LLP

Embarcadero Center, 20th Floor

275 Battery Street

San Francisco, CA 94111

Voice: 415/986-5900

Facsimile: 415/986-8054

E-Mail: dherling@gordonrees.com

This Session’s Agenda

• Learn How and Where these companies were defrauded and what you can do to protect your company.

• Change = Opportunity

• Case Study Examples• International Investment Fraud I (China)

• International Investment Fraud II (German, Australia, United States)

• Foreign Currency Scheme (South America)

• Stock Fraud (Latvia, Poland and United States)

• Scenario Based Solutions

• Group Discussion Period

Change = Opportunity

Fraud is a Business.

How Does Change Affect Risk?• Business Risk is a measurement based on known

environmental elements.

• Environmental Elements include:• Political Stability.

• Capital Considerations.

• Market Conditions.

• Changes to these three elements cause macro level reactions which drastically alter the risk equation.

• Fluid Risk = Fraud Opportunity.

Why Does This Create Opportunity?

• During rapidly changing situations, details get lost int he evolving whole.

• Management focus becomes diffused.

• Standard test results become meaningless.

• Procedural and Control Requirements are often bypassed or circumvented in the name of speed.

• Expectation of Loss ...

• Tolerance for Creativity ...

INTERNATIONALINVESTMENT SCHEME I

U.S., Canadian, EC Investors,PRC and Pacific Rim Real Properties

BACKGROUND: How Did It Begin?

• The Investors: A disorganized collection of small syndicates mostly consisting of entrepreneurs. Mostly recruited through personal contact.

• The Investment: Short-Term Construction Financing for International Companies building facilities in the Far East.

• The Sell: Pre-Approved Long-Term Financing. AAA-Rated Credit. Guaranteed Returns with Short Cycles.

Why Here? Why Now?

• Following the record earnings in the investment sector through the ‘90s, many investors became used to high reward vehicles.

• Risk components had become irrelevant.

• High Volume of at-risk capital searching for profitable investments.

The Scheme:• The fraudster structured an international financing project. He

encouraged individual investors to syndicate their involvement, developing a “pool” of over US $25,000,000,000.

• The pitch included short-term financing for large-scale construction projects with high returns.

• Project risk was listed as zero, as the projects were already supposed to be fully funded.

• The net effect was a complete loss to the investors in excess of

US $15,000,000.

How Was It Accomplished?

• By taking advantage of the investor’s greed and naivete in international financing transactions, combined with falsification of documents, forgery of banking forms, and promises of increased profits, the fraudster managed to avoid detection for 15 months.

Why Was The Scheme Not Detected?

• Three primary reasons:

– Syndicates developed around personal relationships, friends, family, trusted colleagues.

– Apparent profitability dissuaded question.

– Skill at providing the answers that the syndicate leaders would accept.

• Failure to remember if it sounds too good to be true, it is ...

How Did He Get Caught?

• Projects failed to deliver profits at deadlines.

• Syndicates stopped receiving correspondence.

• Disgruntled investors contacted authorities.

What Happened Next?

• The investors:• Filed complaints.• Contacted a lawyer.• Demanded their money.

• The fraudster:• Threatened to withhold “profits” unless the

complaints were dropped.

How Was This Resolved?

• It was not.

• Many of the investors were persuaded that the delay was due to overbuilding in Asia (true, but irrelevant).

• The criminal prosecution and securities investigation became stymied by lack of victim interest.

• The remaining investors refused to fund the litigation necessary to pursue the case.

INTERNATIONALINVESTMENT SCHEME II

German and Australian InvestorsSwiss, Canadian and U.S. Fraudsters

BACKGROUND: How Did It Begin?

• The Investors: Individuals ranging from entrepreneurs (German and Swiss) to individuals hoping to develop a retirement nest egg (Australians and New Zealanders)

• The Investment: “Prime Bank Instruments” guaranteeing yields up to 40% per year.

• The Sell: Very high-yielding “paper business.” Invest $500,000, two months later return of $1,000,000. Fraudster sold himself as (1) partner in Canadian company that exported commodities; (2) part owner of company that introduced IPOs on the NYSE; and (3) had access to current bank instruments.

The Scheme:

• Initial offer to invest $1.2 million in bank trading operations (bank debentures) - rejected. Follow-up offer to borrow $100,000 and to pay interest during term to establish “bona fides.”

• Loan made, papers signed.

• Written demand return of $100,000.

The Scheme:

• Fraudster indicated unable to return $100,000; money invested in new company where money was tied up in Asian investments; fraudster had done business in past with new company.

• Fraudster informs victim $1,000,000 available. Offer to borrow $1,000,000 less $50,000 finder’s fee to invest in certain high-yielding instruments at least one time over the next year.

• Fraudster represents $950,000 will be returned upon three-months’ notice.

How Did He Get Caught?

• Unable to return $950,000 upon demand.

• Fraudster continued to correspond with investors continuing to make promises about payments to come.

• Disgruntled investors contacted Canadian authorities.

• Authorities not helpful as fraudster left jurisdiction.

• Fraudster permitted investor to wire money directly to new company. (New company had property in the United States.)

What Happened Next?

• The Investors:

• Contacted a lawyer.

• Demanded their money.

• Filed lawsuits in jurisdiction where property located.

How Was This Resolved?

• Not yet.

• Lawsuit is continuing in both California state court where property is located and California federal court.

• Issue is jurisdiction over fraudster.

• Settlement negotiations are ongoing with property owner who received one wire transfer deposit.

Stock Fraud:

• Latvian investors, U.S./Polish assets and U.S. stock fraud.

BACKGROUND: How Did It Begin?

• The Investors: Former Soviet Army officers who were successful in currency speculation in new Russia: Earned 30 to 40% return on money.

• The Investment: Regulation S Investments in corporation whose major asset was distribution rights of fast food and in former Eastern European Bloc country (Poland).

• The Sell: Opportunity to get in on ground floor of new market area.

Why Here? Why Now?

• Investors familiar with Poland.

• Promise of 30 to 40% return not red flag to investors.

• United States stock market safer environment than Russian (speculation).

The Scheme:

• Fraudsters filed public record with 10Ks, 10Qs and 8Ks” talking up” the stock.

• The stock rose, the fraudsters dumped the shares at a big profit.

• Distribution rights to fast food franchise moved to second corporation in which investors had no interest but fraudsters controlled.

• Investors left holding majority interest in corporation with no assets.

How Was this Accomplished?

• By taking advantage of investors’ belief in stable U.S. economy, naivete in U.S. stock transactions combined with falsification of documents, forgeries and conspiracy between investors, consultants and fraudsters.

What Happened Next?

• Investors.

• Hired CPA firm to investigate fraud.

• Hired attorneys to prosecute civil action.

• The fraudster: Counter-claim with allegations of libel, slander and defamation.

How Was this Resolved?

• Action filed in U.S. Federal Court.

• Resolved for $.40 on dollar (fees expended to achieve result over $500,000.)

Currency Conversion

A lesson in economic change and abuse.

BACKGROUND: It Always Starts Small!

• The Company: A worldwide multinational. The smallest division, with activities throughout Central and South America and the Caribbean.

• The Employee: Financial Manager-Controller for a single country.

• Division and Corporate Management: Focused on the big picture — Growth, Market Share, and Profitability. Limited oversight since his unit made the budgeted profits.

Losing Fraud In The Details:

• Successfully making budget profits.

• Sending cash to corporate.

• Location, location, location.

• Controls are simply words unless implemented.

• Manual Systems — an auditing nightmare.

What Did They Do?

• The Controller subverted the processes to allow for the continual skimming of funds allocated to foreign currency transactions.

• Using a dummy company they funnel funds out of the company, always leaving the budgeted profits.

• They then developed additional companies to hide the growing theft of cash.

• Highly profitable divisions = highly desirable targets for fraud.

How Was It Accomplished?

• In the economic upheaval that was affecting the country, inflation was high, and the government controlled the foreign exchange process.

• As the chaos calmed, the Government eased regulation of currency conversion.

• Taking advantage of the improved exchange and inflation rates, the fraudster managed to avoid detection for 30 months.

Why Was He Able To Get Away With It?

• Simplicity. Since the projected margins were achieved, this business unit avoided undue scrutiny.

• The unit was located in an inhospitable location, few corporate managers wanted to spend time on-site, creating a dependence on financial reporting.

• Complicity of his co-workers and subordinates ensured management was always given sanitized documentation.

What Led To Discovery?

• Peer review process noted deficiencies in the reconciliation process.

• Failure to correct the deficiencies led to his removal for performance reasons.

• It would be weeks after his removal before the scheme was uncovered and the co-conspirators identified.

How Was The Matter Resolved?

• Criminal charges were filed by the local fraud squad.

• Civil lawsuits were initiated against the various beneficiaries and the companies they controlled.

• The corporate crime policy allowed for a 90% financial recovery.

A Look At The Falsified Practices In Manual Systems:

• Look at addresses, phone numbers, etc.

• Look at quantities ordered.

• Look at vendor number.

• Look at the approval signature.

• Look at the amount.

• Look at the “return to” identifier.

• Look at the sales tax.

• Look at internal codes.

• Look at coordination of coding along the document chain.

Internet Fraud:

On-Line Trading Volume:

• 222,000 trades a day — second quarter 1998.

• Increase of 17% from first quarter 1998.

• Increase of 95% from second quarter 1997.

• On-line trades account for 20-25% of all retail trades.

“The Internet Is Clearly the Marketing Vehicle of Choice for Con

Artists in the ‘90s. It’s Cheap, It’s Speedy, It’s Anonymous — All

Tremendous Advantages for Fraud Artist.”

– Bill McDonald, Chief of Enforcement for California Department of Corporations

RESPONSE: U.S. Securities Regulators, the FBI and the U.S.

Attorney’s Office Launch Task Forces and Special Hit Teams to check off the

rapid growth of Internet fraud.

• U.S. S.E.C. Office of Internet Enforcement — Cyberforce of attorneys, accountants and investigators.

• Sixty-six Internet cases brought by the FCC in 1998.

Why Internet?

• Before Internet — even slickest white-collar crooks could only target a few hundred victims at a time.

• With Internet

• With many millions on-line around the world, cyber swindlers have easy access to vast pools of investors.

• Committing fraud over the Internet is a lot easier than doing it the old way. For $50, anyone can buy a software package and operate out of your living room. In the old days of boiler rooms, you had to rent a place, buy a lot of phones and hire people to make cold calls.” John Heine, SEC spokesman.

Sampling of Most Common Internet Investment Scams:

Phony Stock Investments:

• Swindler’s tout fake investments in hi-tech companies that sound realistic.

• Unwary investors send in seed money for startups, initial public offerings and other bogus business endeavors.

• Three-thousand on-line investors sent $190,000 for hi-tech startup called Directive Products and Services.

• No business.

Pump and Dump Scams:

• Classic fraud, con artists pay people to talk up weak microcap stocks through newsletters, on-line chat rooms and scam e-mail.

– When the stock rises, the crooks dump the shares at a big profit.

– Reverse strategy:

– Con artists “trash talk” a stock, causing shares to fall.

• Fraudster takes profit from a falling stock price by selling the stock short.

Fake Web Sites:

• Fraudsters design phony websites to manipulate the market and lure on-line investors into trading on obscure stocks.

• Pair Gain Technologies, Inc. employee built a bogus Bloomberg news site and wrote a fake story that the company was about to be bought.

• Stock shot up 30% in NASDAQ trading.

• One of victims who traded the inflated price: James Cramer, a well-known hedge firm manager, co-founder of TheStreet.com financial website.

• Bogus earning reports for E-Trade on Yahoo’s financial website preceded actual report by several hours.

Suspicious Activity:

• Examples of suspicious activity according to Alert Global Media.

Suspicious Wire Transfer Transactions:

• A wire transfer that moves large sums to secrecy havens such as the Cayman Islands, Hong Kong, Luxembourg, Panama or Switzerland.

• An increase in international wire transfer activity in an account with no history of such activity or where the stated business or the customer does not warrant it.

• Customer frequently shifts purported international profits by wire transfer out of the U.S.

Suspicious Activity in Credit Transactions:

• A customer’s financial statement makes representations that do not conform to Generally Accepted Accounting Principles.

• A transaction is made to appear more complicated than it needs to be by use of impressive but nonsensical terms such as “munition rate,” “prime bank notes,” “standby commitment,” “arbitrage,” and “hedge contracts.”

• Customer requests loans to off-shore companies that are secured by obligations of off-shore banks.

Suspicious Commercial Account Activity:

• Business customer presents financial statements noticeably different from those of similar businesses.

• Large business presents financial statements that are not prepared by an accountant.

• Corporate account shows little or no regular, periodic activity.

Suspicious Trade Financing Transactions:

• Customer seeks trade financing on the export or import of commodities where the stated prices are substantially more or less than those in a similar market situation.

• Customer makes changes to a letter of credit beneficiary just before payment is to be made.

• Customer changes the place of payment in a letter of credit to an account in a country other than the beneficiary’s stated location.

• Customer receives many small incoming wire transfers and then orders a large outgoing wire transfer to another country.

Suspicious Investment Activity:

• Customer uses an investment account as a faster vehicle to wire firms, particularly to off-shore locations.

• Customer wants to locate a large position through a series of small transactions.

Suspicious Employee Activity:

• Employee exaggerates the credentials, background and financial ability and resources of a customer in written reports the bank requires.

• Employee frequently is involved in unresolved exceptions or recurring exceptions on exception reports.

• Employee lives a lavish lifestyle that could not be supported by his or her salary.

• Employee frequently overrides internal controls where established approval or authority or circumvents policy.

Suspicious Employee Activity:

• Employee uses company resources to further private interests.

• Employee assists transactions where the identity of the ultimate beneficiary or counter party is undisclosed.

• Employee avoids taking vacations.

Conclusion

• Identification of Risk and Reward

How Can These Case Studies Help Your Organization?

• Internal and external fraudsters look like everyone else. There is no one profile, type, sex or level.

• They respond to internal motivations by exploiting their positions of trust.

• They identify and act on weaknesses specific to the organization.

• They internally justify their actions and rarely appear “guilty.”

What Steps Should You Take When You Suspect Fraud?

• Identify the allegation Is it credible

• Determine if it is possible. Could it have happened?

• Identify the potential controls Who would or could have and ensure compliance/violations. known? And did they?

Questions & Answers

• Investigating Fraud During Periods of Economic Transformation

Jonathan Turner

Daniel J. Herling