Economic uncertainty and fraud
February 2024 | SPECIAL REPORT: CORPORATE FRAUD & CORRUPTION
Financier Worldwide Magazine
February 2024 Issue
Periods of economic and financial adversity invariably precipitate a rise in corporate fraud. When a downturn bites and business revenues start to dry up, employees who are under pressure to meet earnings targets, or even to keep a company afloat, sometimes resort to fraudulent practices to do so. As Warren Buffett famously said: “only when the tide goes out do you learn who’s been swimming naked’’.
Indeed, recessions are littered with examples of companies cooking their books to project a false image of financial health, and defrauding creditors, investors and customers through other fraudulent schemes to generate cash to mitigate falling revenues. However, the UK government has recently made tackling fraud, and particularly corporate fraud, a major priority.
The passage of the UK Economic Crime and Corporate Transparency Act (ECCTA) in October 2023 will, going forward, make it much easier for UK law enforcement authorities to prosecute corporates that fail to prevent fraud in connection with their business activities, including during economic downturns.
False accounting
False accounting is one of the most common types of fraud during times of economic adversity. Many companies work on wafer-thin margins such that even a limited amount of market volatility or a standalone adverse event, such as an international conflict, can be enough to plunge a business into serious financial jeopardy or, in a worst-case scenario, kill it altogether.
Corporates in financial distress will sometimes seek to conceal the extent of their difficulties from investors, creditors, regulators and customers either by inflating assets or understating liabilities in the corporate’s accounts. False accounting impacts businesses of all sizes, including major enterprises with supposedly sophisticated corporate governance structures and anti-fraud controls.
One of the most notorious cases of accounting fraud was the Enron Corporation scandal, in which the company fraudulently inflated its revenues and used subsidiaries to hide significant debts, which culminated in Enron going bankrupt in 2001 and the subsequent collapse of its auditor, Arthur Andersen LLP.
In the aftermath of the financial crisis of 2007-08, several UK companies resorted to false accounting to conceal drops in earnings. In 2017, Tesco Stores Limited (TSL) paid a £129m fine under a deferred prosecution agreement (DPA) with the Serious Fraud Office (SFO) after accepting responsibility for false accounting practices in 2014.
After announcing its first fall in profits in nearly 20 years in 2013, which was partly due to adverse economic conditions, TSL employees who were under significant pressure to meet financial targets wrongly recognised £257m of commercial income in TSL’s accounts. This figure comprised legacy from earlier financial years and income that was pulled forward from future accounting periods. At the time of the DPA, TSL operated the UK’s largest supermarket business, demonstrating that even the biggest and most sophisticated organisations can fall victim to false accounting.
More recently, in September 2023, the SFO brought fraud charges against four individuals who allegedly oversaw the financial collapse of the high street bakery chain Patisserie Valerie in 2019. The SFO charged the suspects, who included the chief financial officer and financial controller of Patisserie Holdings plc, with conspiracy to defraud for inflating cash in Patisserie Holdings’ balance sheets and annual reports between 2015 and 2018, including by providing false documentation to auditors. This coincided with a period in which several high street restaurant chains experienced financial distress, including certain of Patisserie Valerie’s competitors.
Defrauding customers, creditors and investors
In addition to false accounting, companies experiencing financial adversity are also liable to engage in other fraudulent practices to secure cash from creditors, customers and investors to offset falling revenues.
In 2023, for example, the SFO successfully prosecuted three executives of British steel trading company Balli Steel plc in connection with a scheme to defraud over 20 banks. Balli Steel collapsed in 2013 in the aftermath of the financial crisis with debts of around $500m.
The SFO alleged that one of the executives orchestrated a $500m fraud to keep Balli Steel afloat, which involved the company securing loans from banks based on fake contracts for non-existent steel shipments. According to the SFO, the shipping documents were certified by an in-house shipping company, which was registered in the Cayman Islands and operated by fax machine via Balli Steel’s Marylebone offices.
Fraudulent schemes targeting customers and investors can be difficult to anticipate and prevent because they tend to evolve with the times. Indeed, rogue employees often look to take advantage of new customer and investor preferences when conceiving fraudulent schemes. For example, the growing appetite for ‘green’ products in recent years has already resulted in a considerable rise in greenwashing and other scams catering to the demand for environmental sustainability.
For example, in 2023, the SFO charged three directors of Ethical Forestry Ltd with fraud offences after an investment scheme relating to tree plantations in Costa Rica collapsed, resulting in 3500 UK investors losing millions of pounds.
Similarly, in 2018, six individuals were found guilty of fraud offences in connection with a £17m scheme to sell solar energy panels purportedly enabling customers to generate extra income in addition to the UK government’s feed-in tariff.
Organised crime and state-sponsored activities
External threats which are assisted by internal means whether deliberately, negligently or by accident can also cause significant risk requiring corporates to be increasingly vigilant. Criminal gangs, many of which are now state-sponsored, are using increasingly sophisticated methods to defraud businesses and other organisations, frequently with internal assistance.
According to the UK’s National Cyber Security Centre, ransomware continues to be the most significant organised crime threat faced by the UK. Not only does this have economic consequences, but it can have a significant impact on the social fabric of a country, potentially causing unrest.
Authorised push payment (APP) scams, in which victims are tricked into paying a fraudster instead of a genuine payee, are also on the rise with around £240m being lost to APP scams in the UK in the first half of 2023 alone. Although the Payment Systems Regulator and the Bank of England are introducing a mandatory reimbursement scheme by October 2024 for victims of APP fraud, where victims are tricked into paying a fraudster instead of a genuine payee, these scams are increasing and will continue to rise.
A new brake on corporate fraud?
Fraud continues to be a major issue in the UK. In the year ending September 2022, fraud amounted to over 40 percent of all crime in the UK. Corporate fraud is especially pernicious as it can leave a long trail of victims, including investors, creditors, customers and workers.
More broadly, when corporate fraud becomes endemic, it compromises the integrity and competitiveness of the UK marketplace, which can exacerbate the effects of economic turbulence. In an attempt to tackle fraud the UK government has introduced legislation in the form of the ECCTA.
The ECCTA introduces a new failure to prevent fraud offence, which requires corporates to implement measures to prevent fraud offences at source. Under the new offence, an in-scope organisation will be criminally liable if an “associated person” commits a relevant fraud offence intending to benefit either the organisation or those to whom the associated person provided services. “Associated persons” include employees, agents, subsidiaries and other persons who perform services on the organisation’s behalf.
The offence currently only applies to organisations that meet at least two of the following requirements in the financial year preceding the year of the fraud offence: (i) more than 250 employees; (ii) more than £36m in turnover; and (iii) a balance sheet total of more than £18m. It applies in respect of a range of underlying fraud offences. including fraud by false representation, by failing to disclose information and by abuse of position, as well as false accounting and fraudulent trading, among others.
An organisation will have a defence to the failure to prevent offence if it can establish that, at the time the fraud was committed, the organisation had in place reasonable procedures to prevent fraud. In the next few months, the government will publish guidance on what constitutes “reasonable procedures” for the purpose of preventing fraud, after which the new offence will come into force.
In addition to the new failure to prevent fraud offence, the ECCTA modifies the regime for establishing corporate criminal liability for certain economic crime offences, including fraud offences. Under the new regime, an organisation will be criminally liable for an offence if the offence is committed by a senior manager acting within the actual or apparent scope of their authority.
A “senior manager” is any person who plays a significant role in making management decisions about all or a substantial part of the organisation’s activities, or in actually managing or organising such activities. For in-scope offences, there will no longer be any requirement for a prosecutor to establish that the individual who committed the underlying criminal acts was the organisation’s “directing mind and will” – a difficult test to meet and one that has long thwarted prosecutions of corporates for offences requiring proof of a mental element.
These reforms should make it easier for prosecutors to hold corporates criminally liable if they fail to implement reasonable procedures to prevent fraud, including false accounting, and other schemes to defraud creditors, investors and customers. Corporates will need to enhance their existing corporate governance structures and anti-fraud controls to mitigate the increased risk of corporate criminal liability for fraud, which should make it harder for employees to create fraudulent schemes. This may help to stem the tide of corporate fraud during economic downturns, when the pressure on employees to resort to fraud is at its greatest.
However, as corporates seek to drive growth and impose ambitious financial targets and a high-pressure culture, either through financial incentivisation or the need for job security, employees will continue to try to conceal signs of financial distress, resorting to practices which circumvent enhanced anti-fraud controls. Only time will tell who is naked.
Ian Hargreaves is a partner and Matthew Beech is an associate at Covington & Burling LLP. Mr Hargreaves can be contacted on +44 (0)20 7067 2128 or by email: ihargreaves@cov.com. Mr Beech can be contacted on +44 (0)20 7067 2310 or by email: mbeech@cov.com.
© Financier Worldwide
BY
Ian Hargreaves and Matthew Beech
Covington & Burling LLP
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