Recognizing the Elements of Fraud
By Mark R. Simmons, CIA CFE
A government agency official directs the owner of a company doing business under contract to provide equipment and contractor staff that will be used to perform non-contract related work for the agency. When seeking payment, the contractor bills the hours for non-contract work as having been expended on contract related activity. The billing occurs with the knowledge of the agency official, and the agency official instructs lower level staff to approve the bill for payment from agency accounts. Because the contract is part of a federally funded program, the agency in turn files a claim for reimbursement with the federal government, which the federal government, in good faith, pays. Some people might say that the agency official is a creative manager. I’d say that agency official is a crook.
FRAUD occurs when all of the following elements exist:
- an individual or an organization intentionally makes an untrue representation about an important fact or event:
- the untrue representation is believed by the victim (the person or organization to whom the representation has been made);
- the victim relies upon and acts upon the untrue representation;
- the victim suffers loss of money and/or property as a result of relying upon and acting upon the untrue representation.
Fraud can be for the benefit and gain of an individual, or for the benefit and gain of an organizational entity or program. When an individual commits fraud, the benefits and gains may be direct (receipt of money or property), or indirect (reward of promotions, bonuses, power and influence). When an organization (actually an employee acting on behalf of the organization) commits fraud, the benefits and gains to the organization are usually direct, in the form of financial gain.
Some states have specific fraud statutes. Other states may have specific laws to deal with bribery and corruption; and may prosecute other types of fraud under larceny, robbery, embezzlement or other specific statutes. Whenever the U.S. government is injured through fraud, the matter falls within the jurisdiction of the US Justice Department and the federal courts. Therefore, a fraud could be prosecuted as a felony under both state and federal laws. In addition, under U.S. federal Law, anyone who engages in fraudulent activity and uses telephones, telegraph and/or the Postal Service to discuss or either send or receive correspondence or documents in furtherance of the fraud, can be prosecuted for felony mail fraud and/or wire fraud; and if two or more persons act in collusion to defraud, U.S. federal conspiracy statutes also apply. Also, under U.S. federal law, anyone who has knowledge that a felony fraud has actually been committed against the U.S. government; fails to report the fraud to appropriate authorities; and helps to conceal the fraud by giving false information, concealing facts, obstructing justice, or taking some other positive action, is also guilty of a felony crime punishable by up to three years in federal prison.
In addition to the general laws governing fraud, there are U.S. laws that deal with and/or regulate specific industries and business transactions. These laws also usually contain specific statutes for prosecuting fraud. Some examples would be statutes pertaining to bank fraud, forgery or insurance fraud.
Generally, there are twelve crimes that fall under the umbrella of Fraud.
Bribery is the giving, receiving, offering, or soliciting of any “thing of value” in order to influence an official in the performance of, or failure to perform, the lawful duties of that official. This includes influencing or soliciting the commission, or collusion to commit, any other type of fraud; or influencing an official, or soliciting by an official, to do, or omit to do, any act that violates the lawful duty of that official. Bribery defrauds the victim (usually an organization or political entity) of the right to honest and loyal services from those employed by the victim.
2. Commercial Bribery
Commercial bribery is the giving, receiving, offering or soliciting of any “thing of value” in order to influence a business decision without the victim’s (usually a business organization’s) knowledge or consent.
3. Illegal Gratuity
An illegal gratuity is the giving, receiving, offering or soliciting, after the fact, of any “thing of value” for or because of an official act that has been taken.
Following are examples of bribery and illegal gratuities:
- A government inspector solicits payment from the owner of a business regulated by a government agency. In return, the inspector fails to report important safety and financial violations discovered during the last inspection. In this situation, the victims are those who rely upon the honest reporting of deficiencies, and the loss is salary paid to the inspector for work not performed, plus any damages that result from failure to perform.
- The owner of a company doing business under contract for an organization knows that the manager responsible for overseeing the contractor’s activities plays an influential role in deciding whether or not the contractor is satisfactorily meeting the performance terms and conditions of the contract. The manager uses personal influence and position to assure that the contractor receives satisfactory performance evaluations and is paid, even though the contractor’s work is substandard, and lower level staff in the organization have legitimate concerns about the cost of the contract and the contractor’s ability to perform. The contractor secretly gives financial and other incentives to the manager in return. In this situation, the victims are those who expect satisfactory performance of contract terms. The loss is dollars paid for unsatisfactory work.
- A senior organization official accepts financial and other incentives from a contractor to assure that a request for proposals is written in such a way that only that one contractor will be able to submit a satisfactory bid proposal. In addition, the senior official uses personal influence and position to persuade other senior officials that a good faith effort to obtain competitive bids has been made. As a result, the favored contractor wins the bid award at a noncompetitive price. In addition, once the contract is in effect, the same senior official approves and justifies several high cost contract amendments, for which additional illegal gratuities are received. In this situation, the victims are those who expect a fair and impartial competitive procurement process. The loss is dollars needlessly spent as a result of noncompetitive pricing and price gouging.
4. Conflict of Interest
A conflict of interest occurs when a person or organization acts on behalf of another individual or organization; and has, or appears to have, a hidden bias or self-interest in the activity undertaken; and the hidden bias or self-interest is actually or potentially adverse to the interests of the individual or organization being represented; and the hidden bias or self-interest is not made known to the individual or organization being represented. When a person’s conflict of interest results in economic or financial loss to the individual or organization on whose behalf the person is acting, then fraud has occurred. Conflict of interest can exist on its own, or can be an intricate part of other frauds such as bribery and illegal gratuities. Conflict of interest laws apply to government employees and those doing business with government. In the non-public sector, conflict of interest may not be a prosecutable offense, although the criminal results of such conflict would be.
- The examples given for bribery and illegal gratuities are also examples of conflict of interest resulting in fraud.
- Conflict of interest can also occur and result in fraud without the presence of bribery and illegal gratuities. This happens when an individual or organization acting on behalf of another individual or organization has a hidden financial interest in the outcome of an event or transaction. The typical example is that of a company official or employee, or an immediate relative of an official or employee, who has a hidden financial interest (stock or direct ownership) in a vendor doing business with the company. If the official or employee is in a position to influence the amount of business the vendor does with the company, then a conflict of interest exists. If that conflict of interest results in unnecessary orders being filled, or paying higher than fair market prices for the goods or services, then fraud has occurred. This is because the involved individuals will benefit financially through higher valuation of stock or direct distribution of proceeds from doing business with the company. The victims here are those who expect company officials and employees to act in the best interests of the company, rather than in self-interest. The loss is dollars needlessly spent on overpriced or unnecessary goods and services.
- Conflict of interest can also exist and result in fraud when an organization has a hidden interest or benefit from the outcome of an event or transaction. In a government environment, for example, this more subtle type of conflict of interest could occur if government officials, acting on behalf of the government, either alone or in conspiracy with providers of services, obtain state and federal funds and use those funds for other than intended program purposes. In this instance, the government agency, in acting as the conduit of state and federal funds, has a hidden self-interest that is actually or potentially adverse to the interests of the state and federal government. An example of this would be the following situation: An agency official directs the owner of a company doing business under contract with the agency to provide the agency with equipment and contractor staff that will be used to perform work for the agency that is unrelated to the terms and conditions of the contract, and unrelated to the federal program under which the contract is funded. This favor and benefit creates a conflict of interest because there is no longer an arms length relationship between the agency, which acts on behalf of the government, and the contractor. When seeking payment, if the contractor intentionally bills the hours for non-contract work as having been expended on contract related activity, then the contractor has committed fraud. If the fraudulent billing occurs with the knowledge of the agency official; and/or the agency official instructs lower level staff to approve the bill for payment from agency accounts; and the agency in turn files a claim for reimbursement with the federal government, which the federal government, in good faith, pays, then the agency official has also committed fraud under federal law. The example given is a fraudulent act resulting from conflict of interest because the actions of self-interest by the contractor and the official acting on behalf of the agency are hidden from the state and federal governments, and constitutes obtaining state and federal funds under false pretense (see False Statements and False Claims, below). The victims are the state and the federal government, from which the funds were obtained, and the loss is the funds illegally obtained.
5. False Statements and False Claims
A false statement fraud and false claims fraud occur whenever anyone knowingly and willfully falsifies a material fact or makes a false or fictitious representation or files a false or fictitious claim that results in economic or financial loss to the party to whom the false representation has been made.
Example of False Statements and False Claims:
- An employee prepares and submits a monthly payroll time report, and intentionally falsifies the document by not reporting unpaid leave taken while the supervisor was away on business. As a result, the employee is paid for the time not worked. The same principle applies to an employee who falsifies a travel voucher by reporting expenses that were not incurred. The victim is the employer, and the loss is the money wrongfully paid to the employee.
- A senior company official disagrees with a court decision for which all legal remedies have been exhausted, and which the company must therefore comply with. The decision has a significant financial impact on operations. The senior official knowingly and intentionally continues practices that the court decision has prohibited. The failure to comply with the ruling results in the chief operating officer filing false statements, reports and vouchers with the government. The victims are those who rely on accurate reporting to the government, and the loss is funds illegally obtained or expended; or economic or property losses incurred because of the improper reporting.
- A company performs contract work for a government agency. Under the direction of company managers, staff charge time to a government program that reimburses 75% of incurred costs, instead of charging the time to the actual government program that they worked on, which only reimburses 50% of incurred costs. The employees recognize that the wrong program is being charged for their time, but are unaware of the differing reimbursement percentages. When the employees question their instructions, the company managers tell them not to worry since both programs are paid from government funds, and the cross-charging doesn’t really matter. The government is subsequently fraudulently mischarged as a result. The company managers have engaged in fraudulent activity that results in false statements, false claims, and probably mail fraud. Under U.S. law, the employees who filed the false time reports are guilty of conspiracy to defraud. Though the employees neither benefited from the mischarging, nor were aware that the mischarging was illegal, they are also parties to false statements, false claims, mail fraud and conspiracy statutes. The employees knew they were improperly charging their time, and by falsely preparing the time documents, the employees concealed the fraud. Whether they knew that the mischarging was illegal is not a consideration. As a result of the employees’ actions, when the government was billed for reimbursement, the company managers were able to defraud the government of costs that should have been borne by the company.
Extortion occurs when a person or organization obtains something from another individual or organization under color of official office and/or through the use of actual or threatened force or fear, including fear of economic or fiscal loss.
Examples of Extortion:
- A government inspector solicits payment from the owner of a business regulated by a government agency, and in order to secure the payment, the inspector threatens the business owner with charges of severe code violations and heavy fines. Faced with a threat of economic and fiscal loss, the business owner makes the payment. In this situation, the victims are those who rely upon the honest reporting of safety issues and deficiencies. The loss is salary paid to the inspector for work not performed and the money extorted from the business.
- An official responsible for contract procurements also has a great deal of influence among contract procurement officers in other companies and government agencies. The official informs a contractor that in order to continue receiving contracts, the contractor must provide special gratuities, favors or services without compensation to the contractor. If the contractor fails to cooperate, the official threatens to blacklist the contractor and cut the contractor off from any further work. Faced with a threat of economic and fiscal loss, the contractor complies. In this case, the victims are those who rely upon the official to carry out duties and responsibilities with honesty and integrity. The loss is the cost to the contractor of providing non-reimbursed services.
7. and 8. Mail Fraud and Wire Fraud
Under U.S. federal law, anyone who engages in fraudulent activity and uses telephones, telegraph and/or the U.S. Postal Service to discuss or either send or receive correspondence or documents in furtherance of the fraud, can be prosecuted for felony mail fraud and/or wire fraud.
Examples of Mail and Wire fraud:
- If any of the perpetrators of the previously described crimes used the postal system to mail reimbursement claims, mail bid announcements, exchange correspondence with co-conspirators or victims, submit/return contract amendments, or in any way used the postal system to carry out the fraud, then they can be prosecuted for mail fraud. Similarly, if a modem was used to electronically exchange data or file claims related to the fraud; or if co-conspirators discussed related activities over the telephones, or in any way used telephones or telegraph to carry out the fraud, then they can be prosecuted for wire fraud.
Conspiracy occurs when there is the specific intent that a crime be performed; and there is an agreement with another person to engage in or cause that crime to be performed, and one of the conspirators commits an overt act in furtherance of the conspiracy. At state and local levels, there are various degrees of conspiracy, ranging from misdemeanors to felonies, depending upon the crime that is committed. Under U.S. federal law, conspiracy is a felony. When two or more persons conspire to defraud the United States, or any agency of the United States, for any purpose or in any manner, each person is subject to a $10,000 fine and imprisonment of five years.
Examples of Conspiracy
- All of the crimes previously described could be prosecuted under conspiracy statutes if the elements of conspiracy exist.
10. Breach of Fiduciary Duty
A breach of fiduciary duty occurs when a person, who is employed by and owes a duty to an organization or another individual, does something that is not in the best financial interest of that organization or individual. Breach of fiduciary duty is a civil matter, not a criminal offense. However, as a civil offense, the elements of proof required for conviction are considerably simpler than for criminal fraud, and it is not necessary to prove wrongful intent.
Examples of Breach of Fiduciary Duty:
- All the previously cited examples of bribery, illegal gratuities, fraudulent conflict of interest, and making false statements are felony crimes. They are also breaches of fiduciary duty. This means that in addition to criminal charges, the persons who have committed wrongful acts can be sued for damages in civil court.
- There are other types of breach of fiduciary duty. These fall under the umbrella of gross negligence, gross mismanagement, and abuse. An example would be failure to design adequate systems of internal controls that ensure the accuracy of data and information upon which company funds are disbursed. The victim is the organization, and the loss is the funds inappropriately disbursed.
Embezzlement is the fraudulent conversion of personal property by a person in possession of that property where the possession was obtained pursuant to a trust relationship.
Examples of Embezzlement:
- Typical examples are the use of a kiting or lapping scheme to steal money.
Kiting can occur when a bank allows withdrawals to be made on checks deposited by a customer but for which the actual funds have not yet been collected from the bank on which the check is drawn. In reality, the cash could either be in transit or non-existent. Goods and services are then purchased, or cash is obtained from legitimate sources, by writing checks against non-existent account balances. The fraud is perpetuated by continuous “kiting” from bank to bank checks that are drawn on non-existent funds . In a kiting scheme, the victim is usually the bank that has paid out on uncollected deposits, and the loss is the money paid out by the bank.
Lapping is the use of funds received from payment of accounts receivable to cover a theft of cash. The perpetrator initially steals cash tendered in payment of an outstanding receivable. To cover the initial theft, a payment made by a second customer is charged against the account from which the initial theft was made, thus “lapping” the two accounts. Payment from a third customer is used to cover the second account, and so on. The victim in a lapping scheme is usually the company from whom the money was stolen, and the loss is the amount of money stolen.
12. Failure to Report a Federal Felony to Appropriate U.S. Law Enforcement Authorities
If an individual: knows that a fraudulent act has been committed under federal law; and fails to report the fraudulent act to appropriate U.S. law enforcement authorities; and then actively engages in concealing the fraudulent act or evidence of the fraudulent act; then that individual is guilty of a felony crime punishable by up to three years in U.S. federal prison. Examples of acts to conceal fraud include: changing, hiding or destroying official records in order to conceal the fraudulent act; suppression of evidence regarding the fraudulent act; directly or indirectly causing others to withhold or suppress information pertaining to the fraudulent act; making false statements to investigators regarding the fraudulent act; or any other affirmative action designed to conceal the fraudulent act from authorities. Consider the implications of this for auditors: Since the auditor’s primary duty is to examine, evaluate and report, if an auditor becomes aware of fraudulent activity, and fails to report it to appropriate law enforcement authorities, a prosecutor could argue that the failure to report is an “affirmative act” by the auditor to conceal the fraud. (For a discussion of the legal implications facing an internal auditor who has discovered wrongdoing, I suggest the article “Dealing With Known Corporate Wrongdoing”, by Michael Meier, J.D., and Larry Rittenburg, PhD, CIA, CPA, that appeared in the April 1986 issue of Internal Auditor magazine.)
How can the potential for fraud be dealt with? One crucial weapon in the internal auditor’s arsenal is a comprehensive fraud policy, such as the example presented in the article “Fighting Fraud”, which appeared in the August 1992 issue of Internal Auditor Magazine.
We have an obligation to exercise reasonable and due care in our work, and must be alert to the possibility of wrong doing and conflict of interest in our organizations. In this article, we’ve looked at the overall issues associated with fraud, and some of the many fraud risks involved. However, this article on recognizing the elements of fraud is meant only to inform. It is not a substitute for professional legal advice. As always in matters of law, he who counsel’s himself has a fool for a client. If you need legal advice or an interpretation of law, seek out a qualified attorney.
Copyright © 1995 Mark R. Simmons www.facilitatedcontrols.com
Some of the concepts used in this article have been adapted from material contained in the Certified Fraud Examiner’s Manual (published by the Association of Certified Fraud Examiners) and in a presentation on fraud by W. Michael Kramer, J.D., CFE. The example of false statements and claims that resulted from cross-charging government programs was adapted from the article “Avoiding Corporate Self-Incrimination”, the Internal Auditor Magazine, April 1986