The Short- and Long-Term Effects of COVID-19 on Investors
A consequence of COVID-19 is that existing frauds and corporate misfeasance are being exposed. The closure of premises and restrictions on trading have caused an immediate and severe cash flow problem for many businesses. This has been coupled with extreme volatility in the stock market and rapid decline in the price of oil, causing many corporate and individual investors to liquidate their portfolios. Unfortunately, some investors are now beginning to see that their returns are a fraction of what they thought they would be worth and there are allegations of fraud or misfeasance surrounding their investments.
Medium to Long Term
In times of economic crisis there are always parties who will look to exploit the situation for their own advantage, and it is anticipated that there will be an increase in fraudulent activity due to COVID-19. Exploitation can happen in several ways, whether it's misusing government support packages, such as the furlough scheme or Coronavirus Business Interruption Loan Scheme (CBILS), or seeking to entice people to move their pension funds to fraudulent investment schemes. In addition, directors of insolvent companies trading through this period owe their duties to creditors rather than shareholders and their actions during this time will be the subject of office holders’ investigations, should they subsequently enter into a formal insolvency process.
What is the Impact of COVID-19 on the Level of Internal Fraud Suffered by Corporates?
There has been much talk over recent months on the impact COVID-19 has had on fraud; within just a few months there have already been several headlines about fraud and corporate misfeasance that have been exposed as the proverbial “financial credit line tide has gone out," leaving many corporates exposed. But to a certain extent such cash flow and credit pressures are exposing past, pre-COVID-19 wrongdoing. A corporate clean up if you like.
So, what does the future hold and how can investors, debt holders and creditors protect themselves in this constantly evolving corporate landscape? Will there be more fraud? Is this environment breeding a new generation of wrongdoers, intent on depriving corporations of their ever harder-to-earn profits? The internal “non-obvious” threat of fraud is where we are focusing our attention; the external threat will always be there and is continuously on the increase. However, we have considered those individuals who are not necessarily innately criminal, but may find themselves in that situation due to circumstance and what causes this to happen?
In attempting to answer this question, it’s logical to frame a less sensationalist response around the “fraud triangle”—a framework which has long been used as a model for explaining the factors that cause someone to commit fraud. So, when considering the impact of COVID-19, it is important to consider what factors are present, using the fraud triangle as a basis, and to then assess whether they—individually or collectively—are likely to result in an increase in internal fraud in companies.
The first of the three factors is pressure. This is the real risk and existential threat that is most likely to cause the apparently “professional” director, CEO, chief financial officer or mid-management employee to cross the line. An increase in pressure in any organization contributes to a heightened fraud risk. In the context of COVID-19, pressure is relentless as we are seeing a considerable increase in financial distress placed on corporates due to reduced revenues. Companies are facing liquidity challenges, leading to missed obligations such as rent or loan repayments, and many are having to consider alternative sources of finance. There is also huge pressure on supply chains arising from the need to work around travel restrictions and lockdown requirements. In addition, there are the less tangible pressures such as reduced morale and the challenges of keeping teams running from people’s homes. The pressure of delivering results to shareholders and meeting loan covenants can create a motivation to book sales in advance and delay provisions that at first may be well intentioned, but creates an environment which can escalate out of control.
The next factor in the fraud triangle is opportunity. Working from home and having a vastly reduced workforce in the traditional place of work presents a considerable opportunity for fraud. Many of the controls and processes in place to mitigate fraud are severely compromised, and as a result individuals may be presented with an opportunity to commit a fraudulent act. Internal audit can’t effectively perform its function remotely, outside of the business; compliance and legal teams are physically separated from the frontline functions, making it more difficult to engage and, more generally, employees aren’t talking to each other in the natural way they once did in an office environment. As a result, psychologically, employees are likely to feel more and more detached from both their employer and their colleagues, resulting in them being more vulnerable to the opportunity for wrongdoing. Another factor contributing to the opportunity for fraud to arise as a result of COVID-19 has been the huge volumes of emergency funding that have been provided, both at a government level and via NGOs and multilaterals, without the usual level of oversight.
The final factor in the fraud triangle is rationalize. It is possible in the COVID-19 context, with large numbers of employees being made redundant or furloughed, that some individuals may rationalize committing fraud. They may believe they are in some way helping the business in the short term, or only temporarily “borrowing” company funds due to personal financial circumstances. This might be compounded, due to the emergency funding being provided by governments, by the feeling that the company isn’t the victim of the fraud, but instead some other authority.
So, what does this mean for the future? The empowerment of compliance and the strength of the governance process is ever more important, just at a time when investment in it is likely to be diverted. So, the truth is yes, there will be more fraud within corporates, but most likely of the opportunistic nature, as a result of the operating environment COVID-19 has created, as opposed to an increase in the malicious intent of employees. As a result, companies, investors and lenders need to rely heavily on the three lines of defense and the audited financials, just at a time when both are in flux.