Why do we see more fraud in an economic downturn?

In recent months we have seen several major alleged frauds exposed across the world – Satyam in India, Madoff in the United States, and L&G in Japan. Besides these high profile cases, numerous others are reaching the headlines and many more do not even make the news. Why are they all coming to light now and why do more frauds seem to be uncovered in an economic downturn?

As for the numerous Ponzi schemes, the answer is simple: they rely on a constant influx of new money to feed the abnormal returns offered to existing investors. In the current economic climate, this flow has simply dried up. No longer able to pay the promised returns, the funds collapse.

To understand the more general increase in other frauds, though, we need to examine the motives of, and opportunities for, fraudsters in the light of an economic downturn.

For most frauds to occur, a motive and an opportunity must exist. Certain individuals will always deliberately set out to defraud their employers or a business, and will simply wait for the chance to arise before they do so. Such frauds take place whatever the economic climate, although it may become more difficult to cover them up in a recession as companies focus much more heavily on examining their profit and loss figures and controlling expenditure.

A tough global economic climate, however, brings noticeable changes to the behavior and motivations of normally trustworthy people who hold positions that provide them with the opportunity to commit fraud. These individuals fall into two groups:

Seekers of Personal Gain: As the credit crunch bites, some individuals’ personal financial circumstances will come under strain. People used to living beyond their means with expensive cars, large mortgages, and private school fees may find that bonuses are no longer at the levels to which they are accustomed, or that partners have lost their jobs. A certain number will resort to theft or fraud in order to continue financing their extravagant lifestyles or to meet increasing credit commitments and levels of debt.

Corporate Saviors: These are perhaps the hardest cases to predict. As the recession kicks in, those with responsibility for a company’s finances may be more likely to “cook the books”, not for personal benefit but because they incorrectly believe that they are acting in the best interests of the company or its employees. Often they do not even realize that their actions would be considered fraudulent, or the damage that they might cause to others. Thus, they cover up the true financial position of the company in order to:

Generate higher bonuses;
Prevent redundancies;
Cover up breaches of banking covenants;
Obtain credit from suppliers;
Raise new debt or equity.

In other words, they want to protect people’s pay, jobs, or even the firm’s existence. Often the individuals involved hope that falsifying the statements will be only a temporary measure that can be quickly reversed when the business improves its performance in a few months. They frequently discover, however, that the company continues to lose money. As a result, the cover up becomes worse and more difficult to reverse as time goes by. Eventually the fraud is uncovered, but the fraudster does not necessarily realize the financial damage he has caused to third parties, such as investors who brought shares, banks that lent money, or suppliers who provided credit – all of which maybe facing their own difficulties in the downturn. It is this type of accounting fraud that is fast becoming exposed as the credit crunch kicks in.

In boom times, the worst in human nature engenders fraud: in a recession, we must be careful that the best does not do the same.

Richard Abbey is a managing director and head of financial investigations in London. He specializes in managing complex and multi-jurisdiction frauds and asset tracing including the collapse of Parmalat SpA and Barings Bank. Prior to this he worked at Ernst & Young. He is a chartered accountant and Certified Fraud Examiner (CFE).