DETECTING, INVESTIGATING & DOCUMENTING FRAUD

PART TWO

PRESENTED BY William K. Black

BILL K. BLACK

Mr. Bill K. Black is an Associate Professor of Economics and Law at the University of Missouri – Kansas City (UMKC). He was the Executive Director of the Institute for Fraud Prevention from 2005-2007.

Black was litigation director for the Federal Home Loan Bank Board (FHLBB) from 1984 to 1986, deputy director of the Federal Savings and Loan Insurance Corporation (FSLIC) in 1987, and Senior VP and the General Counsel of the Federal Home Loan Bank of San Francisco from 1987 to 1989, which regulated some of the largest thrift banks in the U.S.

Source: www.pbs.org

OVERVIEW

WHAT MADE THE S&L CRISIS DIFFERENT?

• SUBSTANTIAL DEREGULATION

• COMPETITION FOR LAXITY IN THE STATES

• GARN–ST. GERMAIN DEPOSITORY INSTITUTIONS ACT

• UNINTENDED CONSEQUENCES

Garn–St. Germain Depository Institutions Act

A law enacted by Congress in 1982 to enable banks and other savings institutions to compete more readily in the money market. It got rid of the interest rate ceiling that they once had to abide by, authorized them to make commercial loans and gave the federal agencies the ability to approve bank acquisitions.

This act was one of the contributing factors of the Savings and Loan Crisis. The S&L crisis was one of the largest government bailouts in U.S. history costing approximately $124 billion. The bailout came to help the 747 savings and loan associations in the U.S. but failed, partly due to the Garn-St. Germain Depository Institutions Act.1

1 http://www.investopedia.com/terms/g/garn-st-germain-depository-institutions-act.asp

CONTROL FRAUD

ACCOUNTING FRAUD FORMULA • INCREDIBLE GROWTH IN A SHORT TIME PEIOD

• APPROVE RISKY LOANS WITH PREMIUM YIELD

• EXTREME LEVELS OF LEVERAGE

• TRIVIAL RESERVES

WEAPON OF CHOICE: GAAP

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES The common set of accounting principles, standards and procedures that companies use to compile their financial statements. GAAP are a combination of authoritative standards (set by policy boards) and simply the commonly accepted ways of recording and reporting accounting information.

GAAP are imposed on companies so that investors have a minimum level of consistency in the financial statements they use when analyzing companies for investment purposes. GAAP cover such things as revenue recognition, balance sheet item classification and outstanding share measurements. Companies are expected to follow GAAP rules when reporting their financial data via financial statements.

That said, keep in mind that GAAP is only a set of standards. There is plenty of room within GAAP for unscrupulous accountants to distort figures. So, even when a company uses GAAP, you still need to scrutinize its financial statements.1

1 http://www.investopedia.com/terms/g/gaap.asp

GEORGE AKERLOF

Source: bukabench.com

George Arthur Akerlof is an American economist and Koshland Professor of Economics at the University of California, Berkeley. He won the 2001 Nobel Prize in Economics (shared with Michael Spence and Joseph E. Stiglitz).1

In 1993 Akerlof and Paul Romer brought forth “Looting: The Economic Underworld of Bankruptcy for Profit”, describing how under certain conditions, owners of corporations will decide it is more profitable for them personally to 'loot' the company and 'extract value' from it instead of trying to make it grow and prosper.1

"Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.”2

1 https://en.wikipedia.org/wiki/George_Akerlof

2 1993 George Akerlof and Paul Romer, "Looting: The Economic Underworld of Bankruptcy for Profit", Brookings Papers on Economic Activity 24, Brookings Institution, Washington, DC, 1993, as quoted in Yves Smith (2010), Econned, Palgrave Macmillan, ISBN 978-0-230-62051-3 pages 164-165

FRAUD RED FLAGS

• THE FINANCIAL INSTITUTION CREATES EXTRAORDINARY PROFITS

• THE FINANCIAL INSTITUTION PROVIDES EXTRAORDINARY COMPENSATION TO ITS TOP OFFICERS

• ADHERENCE TO ACCOUNTING FRAUD FORMULA - GROW LIKE CRAZY

- MAKE RISKY LOANS WITH PREMIUM YIELD - EXTREME LEVERAGE - TRIVIAL RESERVES

CASE STUDY: ENRON

Source: wikipedia.org/wiki/kenneth_lay

THE FRAUD FORMULA HAPPENS! ENRON CREATED EXTRAORDINARY PROFITS:

• In 2000 alone, Enron's top five executives received payments of $282.7 million

• Roughly 80% of the total compensation came from cashing in stock options.

EXTRAORDINARY COMPENSATION:

• In 2000 alone, Enron's top five executives received payments of $282.7 million

• Roughly 80% of the total compensation came from cashing in stock options.

ADHERANCE TO FRAUD FORMULA

• Enron stock increased 87% in 2000, compared to a 10% decrease for the index during the same year

• Enron regularly made risky energy trades

• Enron’s overleveraged was carried off Enron's balance sheet • Enron used cash reserves to prop up earnings

THE MORTGAGE CRISIS

SHORT CUT TO GROWTH

Q: HOW DO YOU GROW YOUR BUSINESS IN A MATURE MARKET?

Q: HOW DO YOU INCREASE PROFIT WHILE EXPANDING?

Q: HOW DO YOU INCREASE EFFECTIVE DEMAND?

THE MORTGAGE CRISIS

Source: The Credit Blog

FORMULA FOR FRAUD BANKS INCREASED EFFECTIVE DEMAND BY PURSUING HIGH RISK BORROWERS • LOW CREDIT SCORES • UNDOCUMENTED INCOME • UNSOPHISTICATED BORROWERS

CREATED NEW CATEGORIES OF LOANS • SUB-PRIME LOANS - Low credit scores - History of loan defaults • ALT- A LOANS - High credit score - Income documentation issues

COLLATERALIZED DEBT OBLIGATIONS

Source: The Credit Blog

THE OLD SYSTEM • Banks lent to borrowers and kept the mortgages

THE NEW SYSTEM • Loans were packaged into bundles and sold to investment bankers

• investment banks sold the bundles to pension funds, hedge funds, and other financial institutions as mortgaged back securities

• The banks used the money raised by the CDOs to lend to more borrowers and the cycle would start again

COLLATERALIZED DEBT OBLIGATIONS

Source: The Credit Blog

MARKERS OF FRAUD

LIAR LOANS • Stated Income loans • NINA (No Income/No Assets) • 50% of sub-prime loans were liar loans (2006)

• 33% of all loans were liar loans (2006)

• Over 2 million fraudulent loans in 2006 alone

SEC RULE 10B-5

Rule 10b-5: Employment of Manipulative and Deceptive Practices: It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a)  To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

SEC RULE 10B-5

ELEMENTS OF THE OFFENSE

1.  MANIPULATION OR DECEPTION; 2.  MATERIALITY; 3.  "IN CONNECTION WITH" THE PURCHASE OR SALE OF SECURITIES 4.  SCIENTER

PRIVATE PLAINTIFFS HAVE THE ADDITIONAL BURDEN OF ESTABLISHING: - STANDING - PURCHASER/SELLER REQUIREMENT - RELIANCE - LOSS CAUSATION - DAMAGES

CHRIS SWECKER

Source: sas.com

2004 FBI CONGRESSIONAL TESTIMONY ON MARTGAGE FRAUD

“…IT HAS THE POTENTIAL TO BE AN EPIDEMIC,…”

”…WE THINK WE CAN PREVENT A PROBLEM THAT COULD HAVE AS MUCH IMPACT AS THE S&L CRISIS,…”

ASST FBI DIRECTOR (RETIRED)