MATTHIAS K. KOPETZKY

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Double DamageMATTHIAS K. KOPETZKYAll his life, Herbert Kearns had been a salesman. At the tender age of five, hesold juice and snail shells to neighbors, proving his talent for deal-makingearly on. At every step along the job ladder, he excelled. However, he liked to liveabove his means, and this habit led to growing need for money and seeminglypermanent debt.His future partner, Simon Leary, was a quite different character. More introverted and abit shy, he met Herbert when they both worked at CCC Computer Corp. in Vienna,Austria. Simon managed the assembling and tech support departments, and Herbert was astar marketer. Unlike Herbert, Simon was a family guy interested in good pay to support acomfortable—but not extravagant—lifestyle. He did not like to work overtime, and youwould rarely find his car in the parking lot after five o’clock.But Simon was very good at team building, and he managed a well-motivateddepartment of almost 50 people. His style was calm but strict, and his staff valued his broadknowledge of computers and his ability to solve a myriad of problems. Even when the teamwas under stress to produce a big order, Simon acted without a hasty word and kepteveryone on track.With this attitude, he had become the invaluable backup for the stormy salesmen likeHerbert, who often promised more than the company could deliver. Herbert was willingto do almost anything to land new customers. He realized very early the importance of acharacter like Simon in the management team of an aggressively growing computerhardware reseller.After several years with CCC, Herbert, frustrated about a neglected salary increase,decided to start his own venture. He believed he had found his ideal partner in Simon,the team builder and back-office organizer. They started by working out of a small shopwith only four employees near downtown Vienna. Herbert’s business plan for the newcompany, Gamma Computer, Inc., was to lure away customers of CCC, and win newlarge accounts.During his tenure at the old company, Herbert had learned how to deal withgovernmental agencies and organizations. Their needs and requirements are often quitedifferent from those of private sector companies. Winning a contract with one of these527Wells4689_c55_1 05/31/2007 528entities often meant that you would need to move huge quantities of computer hardwarein one deal—and quantity is always an issue in the computer-assembly business. The moreunits you can assemble and the more parts you are able to order, the better the profitmargin.Herbert knew that his timing was right. Virtual no-names like Gamma were now beingallowed to bid on large government contracts. The tightening budgets in the public sectorfor governments to look beyond big companies like IBM and Siemens to see if they couldprocure what they needed at a lower cost from newcomers.From the very beginning Gamma showed an ambitious and steep path of growth, whichmade it an attractive customer to the Second Savings Bank, one of the biggest financialinstitutions in the country. Second Savings backed Gamma by prefinancing its growingaccounts receivable. It was a moderate risk. More than 95% of Gamma Computer’sbusiness was with national and local government entities, and its customer list included thedepartments of defense, agriculture, science, and education, and even the office of theprime minister. For Second Savings, this meant almost 100% secure accounts receivable,which the bank took in as collateral for the growing working capital needs of the company.The public sector was not famous for paying either fast or on time, but one could expectthat every outstanding payment would come in sooner or later. And so it was at GammaComputer, which showed a very low rate of write-offs within its accounts receivableduring these years.The rise of Gamma happened during one of the longest and most sustained bullmarket phases the stock markets ever saw. The 1990s were a gold rush time for investorsall over the world, and stock indices seemed to grow without limits. It was the dawningof the Internet, and nearly every business involved with computers and software wasmaking money. It was also the time when terms like ‘‘growth’’ or ‘‘cash-burn rate’’seemed to turn market valuations upside-down. To be able to fulfill expectations ingrowth, more companies started to play the mergers and acquisition game. GammaComputer, with sales upward of $100 million, soon came into focus as a takeovertarget. For Herbert Kearns, this was ultimate dream—to sell his company during amerger deal and start a new life as a wealthy man who could afford to stop working atthe age of 45.It didn’t take long before firms were approaching him. Herbert had several meetingswith a large investment group in Amsterdam. Gamma had just hit record high sales, andwithin a few short months, 100% of its stock was purchased by the Netherlands HoldingCompany, itself a rising star in booming Amsterdam.To keep the party rolling, the former owners, Herbert and Simon, had to stay on foranother three years. The price of the shares they sold to the Netherlands HoldingCompany was tied to certain success criteria, such as sales and recoverability of accountsreceivable. Therefore, Herbert and Simon were able to cash in only one-third of the totalprice for Gamma Computer and had to ‘‘earn’’ the rest through another three successfulyears of business.528 chapter 55 double damageWells4689_c55_1 05/31/2007 529That’s OddA few weeks after the sale, Simon turned in his resignation, citing ‘‘family reasons.’’ Thiswas quite astonishing—he left behind two-thirds of the sales price of the company, since hefailed to remain the three years as required. At Second Savings Bank, the outstanding creditline of Gamma Computer had surpassed its limits, which brought up some ‘‘difficulties’’for the company’s account representative. Gamma should have been moved to the LargeCommercial Accounts Section, a special department within the bank in which all bigaccounts are pooled. But this move would have been a significant change for Gamma andits longtime account representative, Jim Muller. Transferring the business would mean thatJim would have to pass it on to someone else. Both Gamma and Jim decided that this wasnot a desired outcome so—in violation of bank rules—Gamma remained within theregional branch office.Only weeks after the sale of the shares to the Netherlands Holding Company, Jimreceived a strange call. A manager of the leasing branch of a well-known bank competitorinformed him that it was buying all the receivables of Gamma Computer and that it wouldpay the outstanding credit to Gamma since Second Savings would no longer be holdingthe receivables as collateral. But the leasing bank also asked for a guarantee that it could sellback the receivables to Gamma at any time and that Second Savings would finance the sale.Since the overall risk picture for the bank didn’t change, Jim was agreeable, but thought thetransaction very odd. When Jim asked Herbert about the reason for this somewhat strangearrangement, he was told that the holding company asked for the move. Herbert addedthat he did not understand it either, but since Netherlands Holding Company was the newboss, he did not ask questions.The sale of the receivables was finished by March 15, only two weeks before Gamma’send of the fiscal year on March 31. Eight weeks later, Gamma Computer bought back theentire group of receivables, which were again pledged to Second Savings, and the bankguarantee was rescinded. So within three months, the situation looked the same as before:Second Savings Bank had outstanding credit backed with receivables of GammaComputer. The reason for this convoluted transaction would be become clear later.Here Today, Gone TomorrowIn October of that same year, Gamma Computer, Inc. declared bankruptcy because itcould not pay its invoices on time, which in Austria is a cause for bankruptcy. One of themain reasons for the sale to the holding company was Netherlands Holding Company’sinsatiable need for additional revenues to show on its consolidated balance sheets. Herbertargued convincingly that Gamma’s steep growth would continue if only it had morefinancing. But the increased sales didn’t materialize, and the company was deeply in debt.The sudden death of Gamma Computer was a shock for Second Savings Bank. It wastotally unaware of the deep financial troubles of its customer—or so the bank said. But thehere today, gone tomorrow 529Wells4689_c55_1 05/31/2007 530bank was in a relatively comfortable position because it owned all the receivables as abacking for the credit line. And those receivables seemed to be almost as safe as real moneybecause they were owed by slow but steady-paying government agencies and departments.Second Savings thought that it would be only a matter of time before the outstandingcredit would be reimbursed. It was wrong.Soon Second Savings became worried and decided to contact each debtor and ask fordirect confirmation of the outstanding balances. The responses were devastating. Thebank learned that in every instance, either the receivable never existed or the amount hadbeen paid months—or even years—ago. This was astonishing because the policy at SecondSavings stated that only receivables less than 180 days old could be accepted for collateral.At this point, Second Savings decided to hand over the case to the public prosecutor’soffice, which engaged our forensic accounting firm to check the allegations againstGamma and its management team—primarily Herbert Kearns.Federal police seized a large amount of company records and documents, a load ofalmost 5,000 three-ring binders, computers, hard disks, and other data. The main focuswas the allegation of the Second Savings Bank regarding the receivables, roughly $15million, which it had reason to believe were fraudulent. So my team and I started with thereceivables first and analyzed how they had been created within Gamma’s accountingsystem. Strangely, we found duplicate databases with very different data in each. Herbertcooperatively explained to us that the company had two accounting systems for two linesof business it engaged in: assembling services and direct sales. This fact, although strange,would not have been a problem if the two systems showed the correct combined amounts.But we found the same receivables in both. We also found many more databases, whichlooked like backup or trial copies. Herbert explained this was due to some technical issuesthey had with the integration of the accounting system of Gamma into the systems of theNetherlands Holding Company.Next, we found accounts receivable lists with the same date, but different totals—verydifferent. Herbert told the investigators that they had real problems trying to show the saleof the receivables to the leasing company within the accounting system. He claimed thatthis was also why alternate versions of the accounting data could be found on Gamma’scomputers. Even harder, he said, was getting the receivables back into the system when theleasing company sold them back to Gamma a few months later.We took the information and imported it into our data analysis software. The samereceivables could be found in different ‘‘versions’’ with different dates of origin anddifferent dollar amounts. It seemed that at least some of the receivables had been made tolook ‘‘younger’’ by changing their dates. Obviously, the 180-day bank rule could be metmore easily if Gamma could simply make the receivables seem current. These listings weresent to the bank every month to prove that the outstanding credit was backed with enoughnew receivables.This was hard evidence that Gamma may have defrauded the bank by giving it falsifieddata. When confronted, Herbert insisted that the changes were made with the fullknowledge of the bank because it knew that sometimes the government took longer than530 chapter 55 double damageWells4689_c55_1 05/31/2007 531180 days to pay. He also said that the bank told them it was all right to change the dates sothat the list would comply with the rule.We decided that the only way we could be certain of the validity of the receivables listwas to check every single one with the original customer. We started with the highestsingle amounts and descended. A lot of explanations were in order—for mostgovernment agencies and departments, it was strange to be asked if a certain receivablewas valid and still open. Some respondents failed to cooperate, and pressure from theoffice of the prosecutor was necessary to convince them to hand over information. Thisreluctance seemed odd to us, but Gamma had built very close relationships with theseentities, so there was a lot of sympathy for the company and its staff. Additionally, wefound signs of possible corruption. Gamma Computer had won the vast majority ofbiddings in the last few years. However, the prosecutor wanted us to concentrate on thealleged bank fraud, afraid that the matter could become unmanageable if it grew into afull-fledged corruption case.Not the Result They ExpectedOur investigators were able to check 75% of the total receivables listed, or about $11million out of the $15 million total. We only found two single receivables totaling $2,000that appeared not to have been falsified. This raised a question: How was it possible todefraud Second Savings in such a brute and total manner? The bank got new lists ofaccounts receivable every month, and we couldn’t understand why no one ever suspectedanything. The prosecutor charged Herbert Kearns and his management team withdefrauding Second Savings by presenting falsified evidence to prove valid receivables. Thiscaused the bank to give Gamma increasing credit and leave the borrowing limits open.But where normal fraud stories usually end, this one took another bitter turn for thedefrauded Second Savings Bank. I had been appointed as an expert witness by the chiefjudge and had to present my findings to the four-person tribunal during court proceedings.(Note: In Austria, unlike many jurisdictions, where experts are chosen by the partiesinvolved, expert witnesses are appointed. Also, in Austria experts are allowed to questionwitnesses.)The trial started with the testimony of the defendants—primarily Herbert, as the mainfigure. His argument was that Gamma Computer could not possibly have defrauded thebank because Second Savings had been aware of the situation for a long time.‘‘We had financial problems and the bank knew of them. But I think they had problemsinternally showing the risk of the outstanding loan amount, so they constantly asked us todeliver lists of open receivables to formally cover the credit volume,’’ Herbert told thecourt. ‘‘We had moved all of them to another group which cashed in the receivables, andthat unit was planning to pay back Gamma, but this required some time. The whole groupstood on shaky ground.’’Second Savings Bank, represented by one of the country’s leading law firms, deniedthese accusations, but Herbert added another ‘‘piece of evidence.’’not the result they expected 531Wells4689_c55_1 05/31/2007 532‘‘The bank knew that we had to juggle the receivables in and out of our accountingsystems. The real cash flows had been way too low not to raise eyebrows. In fact, SecondSavings actively helped us cover the whole mess with that factoring deal. If thesereceivables would have been on our books at fiscal year-end, it never would have passedeven the simplest audit. But because we managed to sell the receivables to the leasingcompany just before fiscal year-end, they weren’t even on the books, so the auditorscouldn’t check them.’’Deception is one of the indispensable ingredients of fraud. The longer the courtproceedings went on, the more doubts surfaced about the real role of the bank. Thecourt ordered Second Savings to produce Jim Muller as a witness, as well as otheremployees.The people from the Credit Department explained how they regularly audited thedebtor at least once a year, which was required under the internal rules of Second Savings.But the questioning brought up a picture of incompetence and bad communicationswithin the bank. I asked if they had all the published financial statements from GammaComputer. As it turned out, they only had an incomplete set. The bank also used interimstatements as final ones. The audited final statements were never checked.The Credit Department could show some activity, but the Securities Department couldnot prove any auditing. I asked one witness to explain the day-to-day auditing of thereceivable lists.Witness: Earlier, we received the list from Gamma Computer on paper. I checked thetotal on the last page and sent the figure to credit monitoring.Question: What does that mean … you checked the total on the last page?Witness: I looked to see if there was a total at all.Question: But that is not an audit procedure.Witness: But I needed the figure to pass it along to credit monitoring.Question: How did you know that the total was calculated correctly?Witness: I did not know. But I was sure, because it was a computer printout.Question: Did you check if there were only receivables younger than 180 days onthe list?Witness: Yes, by spot tests.Question: And what else did you do?Witness: I put the lists into a three-ring binder.Question: And?Witness: And what? That was it.Question: How did you get list by mail electronically?Witness: I don’t know who had the idea, but we wanted to get rid of the annoyingpaperwork. So we urged Gamma to send us the lists electronically.532 chapter 55 double damageWells4689_c55_1 05/31/2007 533Question: So then it was easier to conduct audit procedures more effectively?Witness: What kind of audit procedures are you talking about? I stored themelectronically from then on.Question: So do you have the old lists still on your hard disks? Could we see them?Witness: No, every time we got a new one, we deleted the old one so we always onlyhad the most recent one on file.Jim Muller, Gamma’s account representative at the bank, admitted that he had dailytelephone conversations with Herbert about the true company situation and whichpayments would be allowed by the bank.Later, the court asked to see the reports of internal audit at the bank and ordered thebank’s lawyer to bring them to trial next morning. Instead of the papers, the bank broughtits chief internal auditor to explain why there were no reports.This last witness was the trigger of a very unusual and surprising court ruling. It wasbecoming clear that there were false statements and damage to the bank. But in the end,the court was convinced that the bank was not deceived; it knew the true situation at leastduring the last years and did not take any steps to protect itself.The court found the defendants not guilty of fraud.Because of the now-visible deficits within the bank, the bankruptcy trustee suedSecond Savings, claiming that the bank’s negligence made it possible for Gamma to survivelonger than it would have if Second Savings had been properly guarding outstandingcredit with diligence. That case was settled out of court.Lessons LearnedObviously, Second Savings Bank had extremely weak controls. Assuming it did notconspire with Herbert, it was harmed by the failure to check Gamma’s collateral. The bankhad accounts receivable from federal and state agencies and other entities from the publicsector. This, in turn, caused it to be negligent in its controls because it assumed the debtwould be paid.The next lesson is an old one. If a transaction is too complex to be understood,something is probably wrong. This was the case with the sale of all of Gamma’sreceivables to the bank competitor only weeks before fiscal year-end. Additionally, thefactoring bank informed Second Savings that it planned to ‘‘sell back’’ the whole bunchin two to three months. At this point, the bank should have smelled a rat. It was not acheap deal, and the factoring bank made a lot of money out of this fairly risk-free shorttermposition.Second Savings should have asked Gamma and its parent company in Amsterdam whythis was necessary. If a deal does not make sense, a red flag should go up. In this case, itseemed that Gamma wanted to get those receivables off the books before year-end,hoping that the auditors would not bother to test accounts that did not appear on thelessons learned 533Wells4689_c55_1 05/31/2007 534financial statements. Even the simplest audit procedures would have brought to light thatall the accounts were falsified.Another red flag in this case was the fact that one of the two founders of the company,Simon Leary, quit his job only weeks after the sale of his shares to the Amsterdam investor.This was astonishing because two-thirds of the sales price was contingent on his stayingwith the management team for the next three years. By leaving his post, he left behindtwo-thirds of the ‘‘value’’ of his shares. He cited ‘‘family reasons’’ as the cause, but aninvestigation would have revealed that he had just started a new and similar venture, andonce again, his partner was Herbert Kearns.Recommendations to PreventFuture OccurrencesEstablish Effective Auditing ProceduresOne of the weakest departments in Second Savings Bank was the Collateral AuditingDepartment. Effective auditing starts with healthy skepticism. Auditors should notaccept the truth of every piece of information they are given. They should look forirregularities.Using the Collateral Auditing Department as an example, the bank should require itsstaff to perform these simple procedures and checks with regard to the accounts receivablelists: Check for changes in the layout (especially in comparison to recent lists). Verify that the list is complete and that there are no missing or omitted pages. Recalculate the totals and subtotals. Search for duplicates or omissions. Conduct a line-by-line comparison between current and previous lists looking for: Same line item, different date; Same amount, same date, different text; and Same amount, same text, different customer. Conduct random confirmations of items with the client’s customer. Cross-check with other accounting statements and information provided. Trace from invoices to line items.Test and Review the Functionality of ControlsControls need to be tested to ensure they work as planned. In the Second Savings case,a lot of lists and reports were just filed without attention. If reports are not being used,then they should be stopped and management should find out why. As with SecondSavings, a company could face liability if it receives information but take no steps toreview it.534 chapter 55 double damageWells4689_c55_1 05/31/2007 535Look for Anomalies or Deviances from Normal ProcedureRules are necessary for effective and efficient collaboration among businesses andindividuals. But they are also a constant target of open or hidden criticism from thosewho feel too restricted.Although many people are tempted to break or bend the rules, deviation can meandanger and risk for the entity and its employees. Salespeople and account representativesoften are tempted to ignore regulations to keep their customers happy. In this case, SecondSavings wanted Gamma as its customer, but the bank kept the companyat its own expense.Gamma’s account was supposed to have been transferred to the large unit of the bank.Presumably, that division would have been better equipped to review and audit thereceivables list.This rule also serves another function. Most of the problems with bank customers onthe company level surface when the representative is changed. Rules are effective only iftheyare followed. It is useless to institute a rule if nobodyensures that it is followed. Brokenrules could be a red flag and should be investigated.Matthias K. Kopetzky, PhD, CFE, CPA, CIA, is chief executive officer of BusinessValuation GmbH, in Vienna, Austria. The firm provides advisory services as expertwitnesses to courts in Austria, South Germany, and Liechtenstein. Mr. Kopetzkyteaches at different universities and, with Joseph T. Wells, wrote the German version ofthe Corporate Fraud HandbookHow was this fraud perpetrated and how was it discovered?What internal controls were lacking or overridden?

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