Anatomy of a Financial Fraud - Part I

            Any mention of "financial fraud" will likely conjure images of Bernard Madoff or any number of other big-ticket fraudulent schemes that have been exposed over the past several years.  Financial fraud is more rampant and insidious on a much smaller scale, however, and frequently, closely-held businesses are the targets and victims of that fraud.  Not too long ago, one of our clients came very close to losing several million dollars in a transaction which, initially, looked perfectly legitimate.  The client's instincts, however, caused it to dig deeper into the bona fides of the transaction, which subsequently exposed a broad but ultimately superficial scheme that had been created to defraud the client of its funds.  This article describes the nature of that fraud and the client's and our joint efforts which exposed it.

             The client is a lending institution which originates loans that are collateralized by publicly-traded securities.  During the term of these loans, the client holds the securities in its own name with an account that it has established with its own brokerage firm.  Once the terms and conditions of the loan are agreed upon, the loan transaction typically closes on a "delivery versus payment" ("DVP") basis, in which the securities are transferred into our client's account at the same time as the loan funds are transferred into the borrower's account. 

             A prospective borrower came to the client seeking a multi-million dollar loan that was to be secured by a basket of blue-chip stocks, which were then held in an eTrade account.  The borrower presented several months' worth of eTrade account statements showing the existence and value of that stock and gave our client personal references and the name of his eTrade account representative.   His only unusual request was that the transaction be closed through an escrow account that would be managed by his attorney at a prominent, nationally-known law firm.  The borrower gave our client the attorney's name and contact information, as well as a copy of correspondence from the attorney on the law firm's letterhead and a copy of the escrow agreement that the attorney had purportedly drafted.      

              The escrow arrangement conflicted with our client's internal underwriting requirements, which ratcheted the transaction into a more rigorous underwriting environment.  The transaction would clear this rigorous environment only if the escrow agreement could be modified to meet certain standards.  Our client asked us to assist with the negotiation of those modifications while the client completed the remainder of its underwriting.  We first contacted the borrower's attorney through the contact information which the borrower had provided.  We later researched the nationally-known firm of which this attorney was a member and attempted to contact him through the law firm's switchboard.   The attorney that we then contacted, however, had no knowledge of this transaction nor of the borrower.  The transaction and the underlying scheme began to unravel shortly after this latter contact was made.

             Upon closer examination, we discovered that the law firm stationery we had seen included a correct building address, but a different suite number for the borrower's attorney.  Further, the attorney's email address that we had been given included a slightly different domain name extension than the extension used by all of the other email addresses listed on the law firm's website.  Simultaneously, our client compared the borrower's eTrade account statements with other eTrade statements in its possession and determined that the account number listed on the borrower's statements was one digit longer than other eTrade statement numbers.  We ultimately conducted a "WHOIS" domain name search on the domain extensions for both the borrower and his attorney, and discovered that the domain names for all of the email accounts we had been given were registered and owned by the same party. 

            It quickly became apparent that this prospective borrower had prepared forged eTrade statements and law firm stationery, had enlisted one or two accomplices to play the role of attorneys and account representatives, and had concocted a thatch of websites, all of which had a gloss of legitimacy yet none of which withstood a closer inspection.  The client then referred the matter to the US Attorney's Office, and the prospective borrower has since been indicted.

             Our client in this transaction was fortunate to have enacted strict internal procedures which precluded it from being a victim.  Statistics in this area are hard to come by, as many firms which have been victims of fraud either do not report the fraud or are not able to grab the attention of a prosecutor who is then willing to pursue the perpetrator.  The individuals who enact these schemes will generally be long gone before the fraud is uncovered, and the victims will have little recourse as a result.

             The best course of action for any company is therefore to impose internal procedures that are designed to catch the fraud before it affects the company.  The second part of this article, which will be published shortly, includes a series of suggestions for internal controls that are designed to prevent fraud.  Fraudulent schemes remain rampant throughout the world of closely-held businesses.  Time- and cash-strapped business owners may well groan over the prospect of the additional work required to implement these procedures, but in light of the alternative, that additional work may well be the best investment of time and cash that the business owner has ever spent.