EquinoxGlobalLimited

FraudandAccountingScandals

ByJosephMcNamara

VicePresidentofCredit&PoliticalRisk

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CorporateCollapsesandScandals

Corporatecollapsesandscandalsmayormaynotaffectyouandyourcompany,howevertheonesthatdocouldprovetobeverydevastatingandhaveacatastrophiceffect,especiallyifthereisaninsolvencyorbankruptcy.

Asacreditmanager,financialanalystorunderwriterthesethoughtsareenoughtokeepyouupatnight.• Accuracyoftheinformation• Whatifthefinancialstatementsarewrong• Ifthereisamisrepresentation,isitunknowinglyoronpurpose

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Fraud&Bankruptcy

• “Manyofthecompaniesthatcommitfinancialstatementfraudaredealingwithadverseperformanceissuesandcommittingfraudtocoverthoseup."

• Asignificantproportionofthem,20percentwillendupfilingforChapter11(bankruptcyprotection).TobyBishop,directoroftheDeloitteForensicCenter.

• Fraud-linkedbankruptcieslikeEnron,WorldCom,andAdelphiahavekeptU.S.courtsbusyforyears.Companiesthatwerecitedforfinancial-statementfraudweretwiceaslikelytofileforbankruptcyasthosethatwerenotcited.AccountingWEB

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AlarmingNumbers

• MorethanhalfofU.S.organizationsthatexperiencedfraudinthepastthreeyearsreportedanincreaseinthenumberofoccurrences,accordingtoareportbyPricewaterhouseCoopers(PwC)data.Italsofoundariseinaccountingfraud,briberyandcorruption,withcybercrimemovingtotheforefrontofU.S.companies’concerns.

• PwCUSfoundacontinuingupwardtrendinthefrequencyanddetectionofeconomiccrime,accordingtotheGlobalEconomicCrimeSurvey2014.About45%oforganizationsintheU.S.reportedbeingvictimizedinsometypeoffraudinthepasttwoyears,morethantheglobalaverageof37%.

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WaveofScandals

Althoughaccountingfraudhashappenedthroughouttheyearstherewasawaveofscandalsthathappenedintheearly2000’swithsomenotableonesthatendedinbankruptcy.

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Enron

• Enron: Aglobalgasandoilproductmanufacturer.– ItwasbelievedthatEnronwashighlyprofitable,becausethecompany’senergy

commoditiesweresoheavilytraded.– In2001theSECnoticedirregularitiesinEnron’sfinancialstatements.Enronwas

bookinground-triptrades,withprearrangedbuyingandsellingagreementswheretheywouldsellandbuybackthecommoditiesatthesameprice,andnoactualprofitwasrecognized.

– Heavytradingenticinginvestorstobuythecompany’sstock.– SubstantialbankborrowingsthatwerechanneledthroughotherEnronmadeupcompaniesandweremadetolookliketheborrowedfundscamefromsubstantialtradingdeals.– Investorswithdrew,andinDecember 2001Enron– filedforbankruptcyprotection.

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WORLDCOM

• WorldCom: anAmericantelecommunicationcorporation.– Wasmetwithfailuresinitslongdistancetelephoneventures,duetotechnological

advancementsincommunications.– Hitwithfallingstockpricesandafailedsharebuybackscheme.– Itwasfoundthatdirectorsusedfraudulentaccountingmethodstopushupthe

stockprice.– Theirinternalauditteamfoundirregularaccountingentrieswhichultimately

spurredanSECinvestigation.– Therewas$11BillioninfictitiousA/Rentries.– StockholderspulledouttheirinvestmentsandWorldComfiledforbankruptcyin

July2002.

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Parmalat

• Parmalat: amultinationalItaliandairyandfoodcorp.– Enteredintotheworld’sfinancialmarketsafteritmadeseveralinternational

acquisitions,financedwithdebt.– Manyoftheirdivisionswereproducinglosses.– Startedtousethederivativemarketwiththeintentionofhidinglossesanddebt.– Plannedonraising300MEurosthrunewbondissuanceandthiswassurprisingto

themarkets,thebondissuancewasdroppedbutpublicconcernsraisedovertransactionswithamutualfundEpicurum,aCaymanbasedcompanycausedtheirsharestosignificantlydepreciate.

– WithoutfundingandcashneededtopaydebtsandbondpaymentsParmalatfiledforbankruptcyprotectioninDecember 2003.

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Sarbanes-OxleyAct

• HighprofilepubliccasesthathadfinancialscandalsandfraudintheUSmountedintheearly2000’sincludingotherslikeTycoandAdelphiaCommunications.

• Investorslostfaithinintheauditedreportstheywerelookingat.USCongresssteppedinandpassedtheSarbanes-OxleyActinJuly2002(alsoknownasSOX)toprotectshareholdersandthegeneralpublicfromaccounterrorsandfraudulentpractices,aswellasimprovingtheaccuracyofcorporatedisclosures.

– TheSECadministerstheact,whichsetsdeadlinesforcomplianceandpublishesrulesonrequirements.

– TheSOXactnotonlyaffectsthefinancialsideofcorporations,butalsotheITdepartmentschargedwithstoringacorporation’selectronicsrecords.Itdefineswhichrecordsshouldbestoredandforhowlong.

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IncreasedTechnology,IncreasedRisk

• Asorganizationsrelymoreontechnology,theyincreasinglydobusinessina“borderlesseconomy”wheretheyaremoresusceptibletothreatsfromallsides. PwC

– Watchoutforinternalperpetratorsoffraud,butalsoremainwaryoftheexternalperpetrator.

– FraudatU.S.organizationsinitiallydetectedbyexternalmeasuresorbyaccidentin2014morethandoubledfrom2011levels:32%in2014comparedto15%in2011,andwasinitiallydetectedthroughexternaltip-offsmoreoftenthananyothermethod. (AccountingFraudontheRiseatUSCompanies)

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SEC’sSteppedUpAction

• IntheUStheSEC’spushtostepupitspolicingofaccountingfraudhasledtoasurgeofcasesandinvestigations.

• Newagencyfiguresshowanupturn,theSEC’sfirstyear-over-yearincreaseinsuchenforcementactionssince2007,up46%from2013.

• Thenewcasesareonasmallerscaleandtypicallyinvolveconductthatisfarlessegregiousthantheaccountingscandalsoftheearly2000s,suchastheimplosionofenergygiantEnronCorp.

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SECSanctions

• Noneoftherecentaccounting-fraudcaseshavebeenblockbusters,buttheSEChasbeenissuingsanctions:

• CVSCaremarkCorp:paid$20Mlastyeartosettleallegationsofmisconductincludingimproperacquisitionrelatedaccountingadjustmentsthatboostedreportedearningsin2009.• BankofAmericaCorp:paid$20MinAugust2014toresolvetheirpartof

its$16.6Bmortgagesettlementwiththegovernment.BofAadmittedfailingtodiscloseuncertaintiesaboutpotentialhighercostsrelatedtomortgage-repurchaseclaims.

• DiamondFoodsInc.:paid$5MinJanuary2014tosettlechargesithadboostedearningsbynotrecordingalloftheircosts.

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CommonTypesofFraud

• Frauddoesnotdiscriminateagainstanyspecificcountryorbusinesssector,asitisborderlessandisdonewiththeintentofdeceivingitsinvestors.

– SheilaSmith,headofreorganizationservicesatDeloittesaid,Therearetwodistinctgroupsofpeoplewhoareengaginginthesefrauds:

– thepeoplewhoareattemptingtopropupthecompanyinthehopesthatthebankgivesthemmoreliquidity

– thosethataredoingitmorefortheirownpersonalbenefit

Themostcommontypeoffrauddetectedatbothbankruptandnon-bankruptcompanieswasimproperrevenuerecognition.Followedbyimproperdisclosuresandmanipulationofexpensesalsoshowedupfrequentlyinbothgroups.(FraudandBankruptcyGoHandinHand)

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OWBunkercase

• OWBunker:TheDanishFuelTraderfoundedin1980,wasoneoftheworld’slargestMarineFuelTradersthatoperatedin29countrieswentfromanIPOtobankruptcyineightmonths.– Althoughtheirbusinesswasconsideredalowmargin,thehighvolumewas

attractivetomany.– OWBunkerwentpublicinMarch2014andquicklyamassed20,000new

shareholdersandthecompanyvaluegotcloseto$1BillionontheNASDAQOMXCopenhagenexchange.

– TheIPOwasbelievedtobeasuccess,butafterthespringseasonderogatorynewssurfacedinearlyOctober2014aboutweakprofitwarningsduetounrealizedaccountlossbeforetax,triggeredbytheslideinoilpricesofabout$24M.

– Bythe5th ofNovembertheOMXsharesweresuspendedfromtheNASDAQ,andonthesamedayOWBunkermanagementdeclared alossof$275M.

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OWBunkercase

• ThereweretwoseparateissuesbehindtheOWBunkerscandal:

– Afraudwasdiscovered,schemedbysenioremployeesinapreviouslyunknownSingaporesubsidiarynamedDynamicOilTrading,resultingin$125Minloss.

– A“riskManagementloss”inadditiontothe$24Malreadymentionedabovefoundafterareviewof“OWBunkersriskmanagementexposure”thetotallosswasestimatedat$150M.

Withthisinformation,theirlendingpartnerspulledbackontheircreditlinesandwithnootherviablesolution,OWBunkerfiledforbankruptcyprotectiononthe7th ofNovember2014inDenmark,andotherfilingsinthefollowingdaysinotherjurisdictionsandcountries.

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OWBunkercase

ThemostalarmingpartoftheOWBunkercasewasthefactthatthiswasarecentIPOandtheirrecordsandbookswerebeingscrutinizedbytheirlendingfacilityandbankingconsortium,legalprofessionals,aswellasauditingfirmsgoingoveralloftheirrecordsindetailineffortstopresenttheirIPOprospectus.

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UnderInvestigation

• TescoPLC: aBritishmulti-nationalgroceryretailer.Foundedin1919,itisthesecond-largestretailerintheworldbasedonrevenuesandhasstoresin12countriesthroughoutEuropeandAsia.

– InSeptember2014,Tescoannounceditoverstatedfirst-halfprofitsbyabout$424M,blamingincorrectbookingofpaymentsfromsuppliers.

– TheFinancialConductAuthorityoriginallyspearheaded investigations,buttheSeriousFraudOffice(SFO)intheU.K.steppedin,classifyingitasacriminalinvestigationfocusingonaccountingirregularities.

– Tescowasaccusedofbringingforwardpaymentstomaketheirfinancialresultsbetterassalesfell.

– TheSFOisnowlookingatTesco’sauditedresultsforthepastfouryears,includingtheroleofitsauditingfirm.Expected finesareintheareaof$700M.

– InFebruary2016,Tescoagreedtopay$12MtosettleaUSlawsuit,duetosufferingADRlosses(AmericanDepositaryReceipts)fromNY.AnothersuitiscomingfromOH,aswell.

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UnderInvestigation

• ToshibaCorporation: aglobalJapaneseelectronics,partsandcomponentmanufacturer,datingBackto1875.

– InJulyof2015anaccountingscandaltied$1.3Billioninoverstatedoperatingprofits,overthepastsevenyears.ThereportreveledthatCEO’splacedimmensepressureonsubordinates,andwaitedforthecorporateculturetoturnouttheresultstheywanted.

– Datingbackto2008underoneCEOandcontinuedthrutwootherCEO’sto2015.– Foundevidenceofbookingfutureprofitsearly,pushingbacklosses,pushingback

chargesandotheroverstatedprofits.– Companyleadershiphandeddownstrictprofittargets,aka:Challenges, to

businesspresidents,oftenwiththeimplicationthatfailurewouldnotbeaccepted.– Acorporateculture,demandedobedience tosuperiors,wasanimportantfactor

enablingtheemergenceoffraudulentaccountpractices.– December 2015announcedcutting7,000jobs,sellingitsIndonesiaTVfacilityand

expectslossesof$4.53BillionforYEMarch2016.

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HowcanCreditProfessionalsPrepare

Twoofthemostimportantareastoconsiderarethestrengthofacompany’screditteamandtherelationshipsithaswithitscustomers.

• CreditAnalyststhatcandissect,collateanddecipherinformationintoaneasilyreadableformat,cantracktrends,thatmayhelptospotearlywarningsofpossibleirregularities.

• Buildstrongrelationshipswithcustomerstofullyunderstandtheirbusinessprocess,needsandcustomerbase.

• Lookdeeperintothesupplychainandriskmanagementprocedures.• Onclientvisits,pickupvisualcluesthatcouldhelpyouinyourcredit

assessment.• Don’tbeafraidtoaskquestions,specificallyopenedquestions.• LookforRedFlags.

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RedFlags

• CatlinGlassaforensicanalystwithForensicStrategicSolutions,Inc.saysagoodforensicaccountantorinvestigatorcouldhelpyou,buttherearesomeredflagstolookoutfor.

– Complexwebsofrelationships(usuallybusinessrelationships)– “Insider”vendorsand/orvendorswithextensiveconnectionstothecompany– Unusuallyhighsalesperemployeecomparedtopeergroup– Patternsinthefinancialtransactions– Lackofinformation– Missingassets– Poorrecordkeeping– Extensivecashactivity– Spikesininsidertrading

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SecuritizationAlternatives

• Theforensicredflagsaregreatadvice,andkeyareastolookfor.Butinrealitytheyareveryhardtospot.

• MichaelMaloney,chiefaccountantintheSEC’senforcementdivision,saidfinancialfraudisnow“inmanycases,hardertodetect”thanthoseearlierscandals.

• Alternativesthatareavailabletocombatuncertainty,andprovidesecuritization.– Sellingreceivablestoabankingorfinancingfacility– TradeCreditInsurance– FloorPlanning,orFactoring– PUTOptionAreallsolutionsthatcanprovidebeneficialsecuritytoprotectyourcompany’sassetsagainstcustomerDefault,Uncertainty,andFraud.

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ClosingSummary

• Fraudisunpredictableandisdifficulttospotthesignsuntilitistoolate

• Fraudisdevastatingandcanhaveacatastrophiceffect

• Businesstodayisina“borderlesseconomy”wheretheyaremoresusceptibletothreatsfromallsides

• Creditprofessionalscanpreparetohelpbetterspotwarningsigns

• Therearesecuritizationalternativeavailable

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