Procurement fraud – an old fraud flourishing in emerging markets and costing businesses billions

September 2017 | LEGAL & REGULATORY| FRAUD & CORRUPTION

Financier Worldwide Magazine

September 2017 Issue

Procurement fraud is likely one of the oldest frauds that companies must confront. In recent years, this fraud has flourished in emerging markets. Whether in a public or private setting, procurement fraud is often ‘quid pro quo’, whereby a favour or advantage is given in exchange for something. In a typical procurement fraud scenario, the vendor is awarded the contract, typically well above market prices; the procurement manager receives cash, material goods or other benefits in exchange for awarding the contract. A vendor could provide many types of services to a company such as raw materials, manufacturing of goods, transportation, logistics, independent sales and distribution of products, warehousing, consulting or other services.

Procurement fraud is considered one of the most common frauds perpetrated by managers operating in emerging markets, and the big losers of this fraud are businesses and their shareholders. Companies lose billions of dollars annually because companies are not paying the fair market value for the services and goods sold by vendors. Consider the increased profits a company would have if it paid 20 to 50 percent less for the goods and services the vendors provide. The Association of Certified Fraud Examiners (ACFE) found that companies lose 5 percent of revenue each year to fraud, which amounts to nearly $3.7 trillion globally. Much of this fraud loss can be attributed to procurement fraud.

Most procurement frauds have many of the same modus operandi, and are typically uncovered by anonymous complaints filed by disgruntled vendors or employees. It is common for procurement fraud scenarios to include the following: (i) senior managers or procurement officials who have personal ties to the vendors; (ii) bids for contracts are manipulated by using fictitious vendors; (iii) vendor costs or fees are significantly inflated and can range from 40 to 100 percent above market prices; (iv) senior managers or procurement officials are silent partners of vendors; and (v) cash payments of bribes or kickbacks averaged 15 to 25 percent of each awarded contract.

One recent two-year procurement fraud investigation conducted on behalf of a publicly traded manufacturing company with operations throughout Asia uncovered a fraud worth in excess of $1bn. This case was initiated by a disgruntled vendor, and the investigation determined that the vice president (VP) of the company’s Asia division conspired with several employees and numerous vendors to fleece the company for over eight years. With the assistance of other employees, the VP used the names of family and friends to establish numerous shell entities which then acted as brokers of raw materials and various goods used at the company’s multiple manufacturing facilities. The VP directed procurement to purchase hundreds of millions of dollars of goods from the shell entities that marked up the cost of the goods purchased from other vendors by 50 to 100 percent. The profits generated by these shell entities were split between the VP, conspiring employees and the family and friends of the VP.

A recent case in India found that a senior executive received a $60,000 cash payment from a vendor just to get on the company’s approved vendor list with no guarantee that the vendor would be awarded a contract. The vendor called the company hotline to lodge an anonymous complaint that started the investigation. Another case in Malaysia found that two senior managers required certain vendors to submit fictitious invoices so that they could use half of the funds to bribe government inspectors and tax officials. The remaining monies from the fictitious invoices were split between the managers and vendor owners.

Interviews conducted with hundreds of vendors in emerging markets such as Asia, Africa and South America have found that vendors are ‘expected’ to provide some form of a kickback to managers to win contracts. Vendors often say, ‘That is just how business is done here’. Most kickbacks consist of a 15 to 20 percent cash payment of the awarded contract, but kickbacks can come in many other forms. It may include paying a manager’s children’s tuition at a private school, paying for a family vacation, or payments made to shell companies or bogus non-profit organisations controlled by managers.

As procurement fraud schemes are difficult to detect, global companies continue to struggle to prevent, identify and resolve massive kickbacks to procurement managers in growth markets. It can be a challenge to uncover such schemes for a number of reasons, chief among which are: because most are ‘off-the-books’ and are not detected during audits; because procurement and accounting are not integrated into the company’s system; because corruption is common in the operating country; or because vendor due diligence is non-existent or wholly inadequate.

Procurement fraud is often discovered by anonymous complaints levied by disgruntled employees or vendors. These complaints commonly detail a procurement manager having close personal ties to one or more vendors or a manager living beyond their financial means. Managers who receive kickbacks often own multiple high-end homes, drive expensive vehicles and travel to exotic places, all of which are well beyond their financial means. This demonstrates why it is imperative that companies have ethics hotlines that are operated by well-trained staff. Employees and vendors in emerging markets are often very afraid of retribution if they file complaints to senior managers, so a hotline allows these complainants to report misconduct anonymously.

Some other steps companies can take to help combat procurement fraud are: (i) perform risk-based due diligence on vendors, including source interviews and site visits to verify company operations and owners; (ii) integrate accounting systems (operations in emerging markets often are not integrated into SAP or other accounting systems, enabling fraud); (iii) rotate procurement staff and establish on-site management with strong oversight over procurement practices; (iv) provide ethics, compliance and bribery training for all employees and vendors; and (v) perform periodic and unannounced audits of the procurement department.

Procurement fraud is not only an old fraud, but is one of the fastest growing frauds in emerging markets. Global companies operating in emerging markets have lost and will likely continue to lose billions of dollars from such frauds if they do not take the necessary preventative steps. These losses can be curtailed significantly if the right due diligence protocols are put in place.

David P. Nolan is vice president of Klink & Co. He can be contacted on +1 (212) 292 5116 or by email: dnolan@klink-co.com.

David P. Nolan

Klink & Co.