Learning From Phoney Vendor Schemes:

A Case Study Analysis

2013 ACFE Canadian Fraud Conference

Toronto, Ontario, Monday, September 9, 2013

Reid Lester Laishley Reed LLP

Introduction

• Internal Controls Versus Fraud

• Three Case Studies

• Internal Controls Lagged Behind Growth

• Internal Controls Breached

• Internal Controls Did Not Exist

• Recoveries

Trade-Offs

• Internal controls take time and effort

• Different levels of effort depending on size and complexity of organization

• But: certain themes emerge from the case studies

• Periodic review of internal controls needed to ensure policies are up-to-date and followed

Case Study 1

Shifty Sean

Shifty Sean

The Organization:

Large national drug store chain

Products and services identical in all stores

“Parent” company had extensive quality control process in place, including use of external vendor to do testing

Only one vendor did this work: took three years to test all products (@ 50 products/month)

Shifty Sean

The Employee:

Assistant Manager of Quality Control

Employed 5+ years

Trusted by his Manager (of Quality Control)

Authority to approve certain invoices

Interacted with testing company

US citizen

Shifty Sean

The Fraud:

Sean convinced his Manager of Quality Control that they needed a second external vendor for testing

Suggested “Q.E.S.” as vendor and Manager of Quality Control agreed

Q.E.S. sent invoices to Sean for approval

Shifty Sean

The Fraud (cont’d):

In fact, Q.E.S. was a phoney entity operated by Sean’s wife. Address was a P.O. box and no work was done

Total loss: $500K

Shifty Sean

The Discovery: Manager of Quality Control met with accountants

every quarter to review expenses

Quality Control expenses were unusually high over past few months

Manager approached Sean to inquire: Sean said “nothing to see here”

Sean’s wife called the next day: Sean’s mother is sick, Sean needed time off

Shifty Sean

The Discovery (cont’d):

Sean then resigned by fax

Subsequent review of invoices showed Q.E.S. billing for tasks already carried out by legitimate testing company

Sean “got greedy” which is why expense review revealed loss

Shifty Sean

The Recovery: Norwich Order: bank statements and cheques

proved fraud beyond doubt and identified assets

Money transferred to Virginia and Florida; home in Florida

Determined that he had left Canada for the US; no assets in Canada

Judgment obtained in Ontario and enforced in Virginia and Florida

Inadequate fidelity insurance

Shifty Sean

Internal Controls:

Segregation of duties: Sean selected vendor, approved work and invoices

No proper system for selecting external vendors

Inadequate system for review and approval of invoices

Good management of expenses

Case Study 2

Malevolent Mike

Malevolent Mike

The Organization:

Large public gas company

Company carried out remedial work on gas lines; resulted in ground being dug up

Dug-up areas had to be restored and organization used external vendors to do some of this work

Malevolent Mike

The Employee:

Mid-level manager

Employed for 25+ years

Authority to approve invoices of up to $5,000

Interacted with external vendors on restoration work

Responsible for some administration re: restoration work

Malevolent Mike

The Fraud:

One of external vendors befriended Mike; suggested scam

Phoney invoices prepared by vendor and his “accountant”; hand-delivered to Mike for approval

Mike approved invoices, added account coding and sent to accounting

Malevolent Mike

The Fraud (cont’d):

Accounting approved invoices based on Mike’s approval; no independent review

Kick-backs paid to Mike

Four different vendor names used over six year life of fraud (so as to reduce suspicion)

Total loss: $6.5 million

Malevolent Mike

Discovery:

In 2007, six years after fraud started, Manager of Operations noticed that an expense category was way over-budget

Subsequent investigation revealed one vendor that had billed a very large amount

Investigation revealed many suspicious circumstances

Malevolent Mike

Discovery (cont’d):

When questioned, Mike gave evasive answers

Efforts to contact vendor revealed no such entity existed

Reviews of invoices showed Mike approved dollar amounts far beyond his level of authority; invoices contained obvious errors

Mike “got greedy” which is why the expense review revealed loss

Malevolent Mike

Recovery:

Norwich Order: obtained banking information

Bank information conclusively proved fraud and identified other assets

Fidelity insurance responded

Mareva and Anton Piller froze everything

Malevolent Mike

Recovery (cont’d):

Settled with Mike for $2 million

Obtained summary judgment against the two other fraudsters on basis of “knowing existence of breach of fiduciary duty” and bribery

Malevolent Mike

Internal Controls:

No system for vetting and choosing external vendors

Inadequate segregation of duties

Inadequate vetting of invoices and failure to follow procedures

Some review of expense numbers, which finally led to discovery

Case Study 3

Brazen Bruno

Brazen Bruno

Organization:

Large municipal transit organization

Maintains bus stations which periodically require paving work (maintenance)

Paving work is carried out by external contractors, hired through open tender process

Brazen Bruno

Organization (cont’d):

Paving jobs are generally scheduled as maintenance so there is predictability to workflow

Specific standards in place regarding the depth of asphalt. Roughly one metric tonne is required to cover 10 metres

Thus, easy to look at invoice and estimate volume of asphalt used for given paved area

Brazen Bruno

Employee:

Employed for 25+ years

Had sole responsibility, for 10 years, for administering the paving contract with external contractors

Had substantial control over the tender process (setting the criteria by which the bids were judged)

Brazen Bruno

Employee (cont’d):

Little direct supervision

Had authority to approve work done by contractor, and to approve and sign off on all invoices

Brazen Bruno

The Fraud:

Bruno conspired with paving contractor ABC Inc.

Fraud took place over seven year period

Paving contracts are “cost-plus”. Contractors use a certain amount of asphalt per square metre in order to achieve a particular and specified depth of asphalt

Brazen Bruno

The Fraud (cont’d):

ABC Inc. systematically over-charged for the amount of asphalt used on each legitimate paving job

In some cases, “over-charging” was obvious to anyone who reviewed the invoices since asphalt “volume” numbers greatly exceeded the predicted amount for given area of paving

In other cases, invoices falsified the area that was paved

Brazen Bruno

The Fraud (cont’d):

Still other invoices were wholly fraudulent

Bruno approved the invoices and received kick-backs through companies controlled by him, and by his wife and his son

Bruno also rigged the bidding process in several ways. The bids by ABC Inc. were always the low bid and therefore appeared to be legitimate

Brazen Bruno

The Fraud (cont’d):

However, the criteria for the bids were selected by Bruno. The bidders were asked to provide prices on six or seven different services. Bruno fraudulently over-weighted two categories for which, in reality, there was very little demand

Brazen Bruno

The Fraud (cont’d):

ABC Inc. then bid extremely low prices on those categories, while bidding market rates on the other categories. Other bidders submitted market rates for all categories. Thus, ABC Inc. bids were always the lowest

Bruno shared, in advance, the confidential volume estimates with ABC’s principal, and told him what numbers to use

Brazen Bruno

The Discovery:

Whistleblower informed of fraud and of paving jobs done by ABC Inc. at Bruno’s home

Subsequent surveillance and investigation showed evidence of pumped-up invoices

Review of all invoices from ABC Inc. over eight year period revealed fraudulent mark-ups

Brazen Bruno

Recovery:

Norwich Order gave us bank records and led us to certain corporations over which Bruno and his wife and son had signing authority

Bank records then proved fraud and kick-backs beyond any doubt

Notices were registered on title to five properties; injunction froze bank accounts and properties

Brazen Bruno

Recovery (cont’d):

Settled for roughly full amount of the provable loss ($800K)

Fidelity insurer notified, but no claim presented due to strong recovery

Brazen Bruno

Internal Controls:

Segregation of duties: Bruno had complete control for 10 years over administration of paving contracts

Vendor selection

Review of invoices

Tender process

Lessons

Balancing costs and benefits. You can scrutinize every vendor and invoice, but at some point cost of prevention exceeds potential benefit

Some things are obviously necessary:

Segregation of duties

Verification of external vendors

Scrutiny of invoices

Coding of expenses

Lessons (cont’d)

Different organizations have different needs

Once procedures are in place, they must be adhered to

Professional assistance? Forensic consultants can help

QUESTIONS

Reid Lester Laishley Reed LLP

505-3 Church Street Toronto, ON M5E 1M2

Tel: 416.981.9415, Fax: 416.981.0060 Email: rlester@laishleyreed.com

Thank you!

Reid Lester Laishley Reed LLP

505-3 Church Street Toronto, ON M5E 1M2

Tel: 416.981.9415, Fax: 416.981.0060 Email: rlester@laishleyreed.com

Background Reid Lester is a Partner at the firm of Laishley Reed LLP, in Toronto. Mr. Lester was admitted to the Ontario bar in 1990 after graduating from Queen's University with a Bachelor of Laws in 1988. He received a Bachelor of Arts in Economics (Honours) from the University of British Columbia in 1981, and a Masters of Arts in Economics from Queen's University in 1982. He also worked as an Economist in Ottawa for 4 years from 1983 – 1987 before completing his law degree. Mr. Lester has spent his entire legal career in Toronto, where he articled and worked at a large National firm in the early 1990’s before moving to an Insurance “boutique” firm where he practiced for over 11 years. He spent a further three years as a Partner at another National firm before moving to Laishley Reed LLP in 2007. Areas of Practice Mr. Lester practices in the areas of Fidelity Insurance Law, Commercial Fraud, Banking and Bills of Exchange, Insurance, E & O and Indemnity and other property insurance recovery actions. Professional Experience Extensive background in Fidelity Bond claims (both Crime policies and Financial Institution Bonds) providing coverage advice and defences where necessary, strategic guidance on issues and claims, underwriting and policy-drafting advice and guidance, as well as recovery work. Extensive experience in Commercial Fraud matters relating to Subrogation claims, Recovery claims, including Mareva injunctions, Anton Pillar orders, and tracing orders. Extensive experience in matters relating to Financial Institutions concerning bills of exchange issues, breach of trust matters, Canadian Payment Association clearing rules issues, and errors and omissions claims. Extensive background in liability and property insurance, both in providing coverage advice to insurers, and in defending liability claims and asserting subrogated recovery actions. Professional and Community Activities Frequent contributor to industry seminars on Fidelity Insurance, commercial fraud, and banking litigation issues Member of the Canadian Bar Association Member of the Association of Certified Fraud Examiners, Toronto Chapter Member of the American Bar Association (Tort and Insurance Practice Section (Surety and Fidelity))

Reid Lester, Laishley Reed LLP 505-3 Church Street - Toronto, ON M5E 1M2

Tel: 416.981.9415 o Fax: 416.981.0060 o Email: rlester@laishleyreed.com