When Employees GO BAD

When Employees GO BAD
Conducting internal investigations, part one

FraudBasics

This FraudBasics article is adapted from part of the ACFE course, "Conducting Internal Investigations." For more information on this and other courses, visit Seminars.   

In a perfect world, employees wouldn't steal from their employers. However, this is far from a perfect world. Here are some basics in beginning an internal investigation.

As a new internal auditor at Jenkins Manufacturing Company, you've been reviewing work from previous audits. Two years ago, an audit was conducted of the purchasing function of a small division of the company in which the purchasing director, Thomas Brackens, was extremely uncooperative. While that might be a fairly common occurrence in audits, this audit was never completed.

There's a notation in the file that the CEO of the company asked the department to conduct another audit of an area that had been having serious problems as soon as possible, which required all resources to be pulled to satisfy his request. The internal audit department had planned to finish that audit but never did. The auditors who worked on the purchasing audit have since left the company as has the internal audit manager.

There were some notations that the auditors were having trouble locating some invoices and requisitions that had been selected for audit and that there were some purchases that looked like they had been split. The internal audit department had previously audited the area but they didn't note any major findings. In fact, there's a memo in the file from Jim Miller, the former director of purchasing (now retired) who thanked the internal audit department for its assistance and that he would implement its recommendations immediately.

With too many flags flying, you've decided it's time to start an examination. Here are some tips to get you started.

A perfect world 
In a perfect world, employees wouldn't steal from their employers, so there would be no need for internal investigations. However, this isn't a perfect world and employees do steal from their employers for a variety of reasons most of which involve need or greed. Sometime, auditors and fraud examiners need to conduct full-fledged fraud examinations.

Fraud examination
A fraud examination is a methodology of resolving fraud allegations from inception to disposition. More specifically, a fraud examination involves:

	obtaining evidence and taking statements;
	writing reports;
	testifying to findings; and
	assisting in the detection and prevention of fraud.

Initiating the internal investigation
Frauds are discovered by one of several sources - a tip or complaint, an auditing procedure, or by luck. No matter how the initial indicator comes to light, the accumulation of evidence to prove or disprove an allegation of fraud is substantially different than auditing.

Evaluating tips
According to a study, about a third of all internal investigations begin with a tip from a co-worker, manager, or other employee. Audits uncover about 20 percent of internal thefts, while the rest are discovered by "accident."
Companies generally should encourage a reporting system that allows anonymous tips to be furnished to security, audit, or management. Not all (or even most) tips are valid, and it's important to understand the motives of persons willing to supply information to evaluate whether the tip merits further inquiry. The three principal reasons people furnish tips are revenge, genuine concern, and money.

Revenge:	Co-workers frequently furnish information because of some grudge against a fellow employee. Through careful screening of the information, which often is without value, many investigations can be avoided.
Genuine concern:	The tipster observes some suspicious activity and feels obligated to report it.
Money:	Sometimes a tipster will furnish information for financial rewards. Fraud examiners should be circumspect in paying for information. Though the tipster may have valuable information, he may be lying to gain a little side money.

From the beginning, your counsel must direct the legal aspects of a case.

Examination methodology
Regardless of the nature of a fraud examination, three tools are available to the fraud examiner.

Document examination
The fraud examiner must be skilled in the examination of financial statements, books and records, and supporting documents. He or she also must know the legal ramifications of evidence and how to maintain the chain of custody over documents.

Interviewing
This is the process of obtaining relevant information about the matter from those with knowledge.

Observation
The fraud examiner is often in a position to observe behavior, to search for graphic displays of wealth, and in some instances, is able to observe specific offenses.

Steps in a fraud examination
Fraud examination methodology is constructed so that all cases are handled in a uniform fashion. The methodology involves working from the general to the specific beginning with the examination of documents.

Document examination
As a general rule, documents should be examined before interviews begin. This gains an understanding of the potential evidentiary value of the case and protects the security of documents.

Neutral third-party witnesses
After conducting sufficient document examination, witnesses should be interviewed in a logical fashion starting from the least likely to the most likely to be involved.

Corroborative witnesses 
Interviews from witnesses to corroborate facts should be done after the neutral third-party witnesses. These witnesses may be cooperative or not.

Co-conspirators
Those suspected of complicity should be interviewed next, from the least culpable to the most. If appropriate, law enforcement and prosecutors can frequently promise leniency in return for cooperation.

Subject
In general, the subject of the investigation is examined last. Even if it's felt the accused won't offer a confession, an interview usually is scheduled; in many instances, it can be used for later impeachment.

Elements of fraud
"Misrepresentation" fraud
To prove a civil claim of "common law" fraud, all the following elements must be proven:

	a representation (usually of fact)
	about a material point
	which is false
	and intentionally and knowingly so (or, in some circumstances, recklessly so)
	which is believed
	and acted upon the victim
	to the victim's damage.

Many criminal fraud statures don't require proof of all the above elements. A criminal offense is complete if a knowing false statement is made with the intent to defraud, even if the victim doesn't rely on it or suffer damage.

How to prove intent or knowledge
Intent or knowledge must be proven in all fraud cases. Knowledge, as defined by the courts, can vary from actual knowledge to negligent failure to inquire to "willful blindness."

There are no "accidental" frauds. Mistakenly entering incorrect numbers on a financial statement isn't fraud; knowingly entering incorrect numbers with the intent that someone will take action from relying on them, if the other elements are present, is fraud.

Intent can be the most difficult element to prove. Because intent or knowledge is a state of mind of the defendant, and therefore difficult or impossible to prove directly, the courts permit the jury to infer knowledge and intent from all the facts and circumstances in the case. In other words, intent or knowledge can be proven indirectly by circumstantial evidence. If proven circumstantially, the jury is instructed that the evidence must reasonably exclude all legitimate explanations.

Methods of proving fraudulent intent or knowledge recognized by the courts include evidence that the suspect:

	couldn't have had a legitimate motive for his or her actions;
	altered documents or took steps to conceal his actions by destroying evidence or attempting to obstruct the investigation;
	gave false, misleading statements concerning the matters under investigation ("false exculpatory");
	repeatedly engaged in activity of an apparent wrongful nature ("pattern evidence"); and
	personally gained from the fraudulent act.

Breach of fiduciary duty
An agent (including an employee or director) owes three fiduciary duties to the principal:

	duty of loyalty;
	duty of candor; and
	duty of care.

The duty of loyalty means that the agent must act solely in the best interest of the principal and may not seek to advance personal interest to the detriment of the principal. The duty of candor means that the employee has an obligation to answer reasonable inquiries about their work performance and work-related issues and to do so in an open honest manner. Finally, the duty of care means that the employee has a responsibility to the employer to be attentive in the performance of his or her duties and to protect the interests of the employer.

"Breach of fiduciary duty" is a civil action that can be used to redress a wide variety of conduct that may also constitute fraud, commercial bribery, and conflicts of interest.

The elements of proof of breach of fiduciary duty are considerably simpler than fraud, and don't require proof of wrongful intent. To state a claim for breach of fiduciary duty, the plaintiff must show that the defendant:

	occupied a position of trust or fiduciary responsibility with respect to the plaintiff (such as an employee or agent); and
	breached that duty to advance a personal interest.

Definition of evidence
Anything perceivable by the five senses and any proof, such as testimony of witnesses, records, documents, facts, data, or tangible objects, legally presented at a trial to prove a contention and induce a belief in the minds of a jury.

Direct evidence
Proves the fact directly; for example, eyewitness identification or a confession.

Circumstantial evidence
Proves the desired fact indirectly, and depends on the strength of inferences raised by the evidence. Circumstantial evidence can be as strong as or stronger than direct evidence. It must exclude all reasonable explanations other than guilt.

Burden of Proof
In criminal cases, the burden of proof is beyond a reasonable doubt. In the United States, the jury (if it's a jury trial) deliberates and tries to reach a verdict. Most states require unanimous agreement; however, Oregon and Louisiana are exceptions and, depending on the circumstances, can allow convictions with only 10 of 12 votes. U.S. federal criminal trials require a unanimous verdict.
In civil litigation, the standard of proof is much lower and may be decided by merely a preponderance of evidence. The verdict also doesn't necessarily have to be unanimous.

Admissibility of evidence
To be admissible, evidence must be both relevant and material.
Relevance
Evidence is relevant if it tends to make some fact in issue more than it would be without the evidence.
Some types of evidence considered relevant include:

	occupied a position of trust or fiduciary responsibility with respect to the plaintiff (such as an employee or agent); and
	breached that duty to advance a personal interest.
	motive for an offense;
	opportunity;
	elements of the offense;
	threats or expressions of ill will;
	means of committing the offense;
	physical evidence linking the suspect to the offense; and
	attempts to conceal or destroy evidence.

To know whether a piece of evidence is relevant or inadmissible, you must know what's offered to prove. The same piece of evidence may be relevant or not, admissible or not, depending on what it's offered to prove.

Material
Evidence is material if it's important (or potentially important) in the decision-making process of the victim. In other words, in most contexts, the victim must rely on the information to make a decision.

Evidence of other 'bad' acts
Evidence that the defendant committed other crimes, wrongs, or acts may be used to prove intent, absence of mistake, common scheme or plan, or other elements of the offense. Such evidence may not be introduced merely to prove bad character.