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The high-profile and sudden failure of Silicon Valley Bank — which has been accused of hiding huge losses from its depositors, investors, and regulators — highlights the dangers of corporate fraud for our financial system. It confirms the kind of problems highlighted by a recent study published in the Journal of Financial Economics, estimating that only one-third of corporate frauds are detected, with an average of 10% of large publicly traded firms committing securities fraud every year. This means that the true extent of corporate fraud is much larger than what is currently being reported. The study also estimates that corporate fraud destroys 1.6% of equity value each year, which equals $830 billion in 2021.
These findings indicate a clear need for better risk management and oversight to address corporate fraud. As a highly experienced expert in this topic, I have consulted for many companies on how to mitigate the risk of fraud and the impact it can have on their business. In this article, I will share some insights and best practices for addressing corporate fraud, as well as some real-world examples of how this issue has affected companies.
Real-world examples of corporate fraud
While the situation with Silicon Valley Bank is still under investigation, we have plenty of well-known examples of fraud. FTX, a trading platform for crypto investors, was accused by the U.S. Securities and Exchange Commission of defrauding its investors by steering money from the company into another venture between 2019 and 2022. The company’s majority owner, Sam Bankman-Fried, allegedly used the cash to purchase homes in the Bahamas, invest in other companies, and fund favored political causes. When crypto assets took a significant plunge in 2022, the cash spigot went dry at both FTX and the other venture, leading to federal prosecutors stepping in to issue fraud charges and bankruptcy for the company.
Theranos — initially heralded as an innovative healthcare technology company — was exposed as having unworkable technology in 2015. Federal and state regulators filed fraud charges against the company, which dissolved in 2018. The company’s founder, Elizabeth Holmes, and former president, Ramesh “Sunny” Balwani, were both found guilty and sentenced to prison in 2022. Top-tier investors such as Rupert Murdoch, Carlos Slim, and Betsy DeVos lost millions from Theranos investments, with little hope of getting the money back.
Wirecard, an electronic payments firm based in Munich, Germany, faced the biggest corporate fraud case in German history in 2022, with former CEO Markus Braun and two senior executives facing multiple years in prison if convicted. Another senior executive, Jan Marsalek, is on the run and is reportedly hiding out in Russia. Wirecard declared insolvency in 2020 after authorities discovered $1.9 billion was missing from the company’s accounts, amid allegations from German regulators that the money never existed at all.
Luckin Coffee, a China-based company, was embroiled in a legal quagmire stemming from a 2020 fake revenue scandal. Internal financial analysts discovered the company’s growth was artificially inflated due to bulk sales to businesses linked to the company’s chairman, and management had fraudulently engineered the purchase of raw materials from suppliers. When these investigations became public, investors fled and the company’s share price slid. With the company delisted from Nasdaq and the senior executives involved in the scandal out of the picture, Luckin Coffee is now trading over the counter.
These are just several examples of serious fraud in the news. However, I’ve seen fraud occur in many smaller and mid-size companies as well. In fact, such occurrences in my experience are more common at smaller companies, which have less rigorous risk management and oversight policies.
Addressing corporate fraud through risk management and oversight
To mitigate the risk of corporate fraud, companies — big and small — need to have strong risk management and oversight systems in place. This includes having clear policies and procedures for detecting and preventing fraud, as well as regular training and education for employees on how to recognize and report fraud.
One important aspect of risk management is having an effective internal control system. This includes having a system of checks and balances in place to prevent fraud from occurring in the first place, as well as systems for detecting and investigating fraud if it does occur. This can include measures such as separating duties among employees, implementing segregation of duties and conducting regular internal audits.
Another important aspect of risk management is having an effective compliance program. This includes having policies and procedures in place to ensure that the company is in compliance with relevant laws and regulations, as well as having a system in place for identifying and reporting any potential violations.
Addressing cognitive biases that facilitate corporate fraud
Cognitive biases can also play a role in corporate fraud, as they can lead individuals to make irrational decisions and overlook potential red flags. For example, confirmation bias can lead individuals to only pay attention to information that confirms their preconceived notions, while ignoring information that contradicts them. This can make it difficult for individuals to recognize and report fraud. Theranos might be an example: despite the lack of evidence for their technology working, stakeholders persistently refused to see this reality.
The sunk cost fallacy is another cognitive bias that can lead to fraud. This occurs when individuals continue to invest in a project or venture, even if it is no longer viable because they have already invested so much time and resources into it. This can lead to individuals engaging in fraudulent activities in order to justify their previous investments. The situation with FTX falls into this category, with Sam Bankman-Fried refusing to accept losses at his crypto trading firm Alameda Research, and using customer funding from the FTX exchange to cover these losses.
To mitigate the impact of cognitive biases on corporate fraud, companies need to be aware of these biases and take steps to counteract them. This can include regular training and education for employees on how to recognize and overcome cognitive biases, as well as implementing systems and processes that help to counteract these biases.
For example, companies can implement peer review systems where multiple individuals review and approve financial transactions, rather than relying on a single individual. This can help to counteract the confirmation bias, as multiple individuals will be looking at the same information and can point out any potential red flags.
Another example is implementing an independent fraud detection and investigation team within the company. This team can be responsible for reviewing financial transactions and identifying potential fraud. This can help to counteract the sunk cost fallacy, as the team will not be invested in the project or venture and can provide an objective assessment of its viability.
Corporate fraud is a serious issue that affects companies of all sizes and industries. A recent study published in the Journal of Financial Economics estimates that only one-third of corporate frauds are detected, with an average of 10% of large publicly traded firms committing securities fraud every year. This highlights the need for better risk management and oversight to address corporate fraud.
Companies can mitigate the risk of fraud by having strong risk management and oversight systems in place, including an effective internal control system and compliance program. They also need to be aware of cognitive biases and take steps to counteract them, such as implementing peer review systems and independent fraud detection and investigation teams.
As a highly experienced expert in this topic, I have consulted for many companies on how to mitigate the risk of fraud and the impact it can have on their business. I strongly recommend that leaders of companies take the necessary steps to address corporate fraud, in order to protect their bottom line and reputation.