PART I
WHEN FRAUD IS COMMITTED
Reading the headlines about another fraudulent scam is upsetting on many levels. When the story is one in which the money stolen is in the billionsâand thus beyond conceptualization for the average person, who never crosses paths with such large sumsâthe media accounts stoke rage and provoke calls for justice.
In the allied professions of management and accounting, similar feelings are aroused. Such outrage is more complex in reality and includes feelings of betrayal by peers, colleagues, or even management or capitalist heroes. Legislatures are called upon, grand speeches are delivered, and references are made to times when people were honest, a man earned a living with his hands, and communities (and markets) were based on trust.
In the end, the widespread loss of trust, personal and corporate reputations, and market confidence is the greatest casualty of a catastrophic fraud.
As more and more resources are put into addressing the problem of fraud, sometimes it just looks as though too little is being done too late, and at other times the efforts don't seem to make a dent at all. The fraud problem simply seems to be increasing in scope and frequency, and newspaper headlines continue to highlight how the last major financial loss has just been surpassed by the most recent.
Consider this curious case of theft. A man named Arthur âthe Brainâ Rachel gained notoriety for stealing the 45-carat Marlborough diamond from a London jewelry store three decades ago. He was sentenced in 2012 to eight and a half years in prison for racketeering. He had already served many years in jail for other crimes, and he was 73 years old when he received this sentence. When the judge announced the sentence, he asked Rachel why he continued to commit crimes after so many years in prison. Rachel reportedly replied that he and his comrades were bored and had nothing better to do.1
Fraud is theft, and it is often explained in the media as being motivated by greed. For instance, Pedro Espada Jr., a former New York State senator recently convicted of tax evasion and stealing from a health care network he founded, truly had a ârags-to-ill-gotten-richesâ story. He survived homelessness in his youth to rise to the highest echelons of state government and brazenly abused his position, perhaps motivated by greed. Before he was indicted, Espada remarked, âThere's no way there's a chapter in this story that includes me going to jail. . . . It's surreal. Not a part of my plan or my script.â Commenting on his grandiose sense of entitlement, Eastern District of New York U.S. attorney Loretta E. Lynch called him a âthief in a suit.â She concluded, âPedro Espada Jr. could have chosen the high road. Every time he had a choice, Pedro Espada chose himself.â2
In contrast, as noted earlier, Arthur Rachel stole items of immense value, but he was not motivated by greed. In both of these cases, might criminal investigations and psychology shine a new and more brilliant light on fraud motivations to broaden and deepen our understanding?3
Beyond the solutions currently applied, new ones are needed. With personal computers becoming popular in the 1980s, computer crime (including hacking) also flourished. This naturally led to the new field of computer forensics viz., forensic methods of examining digital media for identifying, preserving, recovering, analyzing, and presenting facts and opinions, which collectively constitute electronic evidence. Financial forensics has made impressive gains and is also rapidly evolving as a specialized discipline. Financial forensics refers to the plethora of tools, techniques, methods, and methodologiesâwith a primary focus on analysis and surgically precise dissection of numbers and scenariosâapplicable to virtually any large or small economic or financial matter, whether civil, criminal, or involving dispute.4 With the rising incidence of fraud and the realization that fraud is committed by sentient human beings, there is an urgent need for the field of behavioral forensics to exploit the insights of the behavioral disciplines to understand, address, and respond to fraud and perhaps even preempt it.
To understand how fraud happens, new thinking is required to answer this simple question: Why do people commit fraud?
Notes
1. âJail for Chicago's âBrain' in Racketeering Case,â Wall Street Journal, June 8, 2012.
2. Mosi Secret, âEx-Legislator Guilty of Theft Gets 5-Year Prison Sentence,â New York Times, June 15, 2013.
3. For instance, psychologist Michael Apter argues that it is to keep boredom at bay that youths in wolf packs engage in the practice of âwildingââan expression that seems to mean âbeing wild for its own sake,â or being violent. He proceeds to ask, âBut how is it that hurting others can produce thrills?â See Michael J. Apter, Danger: Our Quest for Excitement (Oxford, UK: One World Publications, 2007), 6. We will discuss some of Apter's theories later in this book.
4. D. D. Dorrell and G. A. Gadawski, Financial Forensics Body of Knowledge (Hoboken, NJ: John Wiley & Sons, 2012).
CHAPTER 1
Fraud Is Everywhere
Fraud is an interesting concept, because it is both so common and so serious. Fraud is generally everywhere around us; most people do something fraudulent, unwittingly or not, in their lifetimes.
Even such an innocuous thing as two employees chatting for a few minutes in the workplace about last night's baseball game can be a minor form of fraud. After all, they are on company property and are being paid to do other things. Assuming that they are being paid for their time, and that biological needs as well as needs for breaks are providedâmany professional service firms bill by the hourâthey are defrauding their employer if they are aware that they should be working rather than talking.1
This example may be considered a small infraction, and few people would think of it as fraud, but it could become so, depending on the degree. Association of Certified Fraud Examiners (ACFE) founder and chairman Joseph Wells wrote in the prologue to his autobiography, âEveryone [has lied]. Everyone. We do so for two basic reasons: either to receive rewards or to avoid punishment (or a combination of both). Although lying is not endemic to the human species, we learn it very early in life. Fraud, though, is a lie with a special twistâit is committed to deprive an innocent victim of money or property.â2
Of course, in cases of revenge fraud, the victim may not be so innocent after all.
The Pervasiveness of Fraud
If you ask a room full of midcareer professionals whether they have committed a crime in the past week, almost no one will respond (and perhaps understandably so). Some will be offended by the very nature of the question. But if you then ask them whether they drove just one mile over the speed limit in the past week, they will become sheepish.
âOf course,â they will reply, âbut it was only a couple of miles an hour. The cops don't care.â That may be true, but legally speaking, it is a violation of well-understood traffic lawsâand therefore a crime. In most cases it may be unintentional (speedometers tend to be subject to margins of error), but in cases of reckless driving, intentional violation of traffic laws unambiguously makes it a crime.
Tom Tyler, Macklin Fleming Professor of law and a professor of psychology at Yale Law School, provides two useful perspectives on legal compliance. The first is the instrumental perspective, wherein he argues that people who take this view obey the law because they fear punishment. The second is the normative perspective, wherein people who believe in social norms and perceptions around equity and fairness feel morally obliged to comply with the law, regardless of the fear of punishment.3 Authorities prefer that citizens hold the normative perspective because it removes the need for law enforcement. Nevertheless, it must be pointed out that people espousing the normative perspective may still decide not to pay their taxes if they believe the tax authorities are unjust. As for those holding the instrumental perspective, their decision primarily relies on weighing the pros and cons of compliance with the law. Stricter enforcement is the only way to dissuade such people from breaking the law.
Fraud, in various small ways, is so common we cease to recognize it. It is just the way people are. It is the normal course of human behavior. Distinguished behavioral economist Dan Ariely makes compelling arguments to provide answers to the following unsettled questions:
- Does the chance of getting caught affect how likely we are to cheat?
- How do companies pave the way for dishonesty?
- Does collaboration make us more honest or less so?4
More than three decades ago, sociologists Edwin H. Sutherland and Donald Ray Cressey offered the âdifferential association principleâ as an explanation for why people act this way. They argued that âpeople violate the law because the world, the nation, and even the family have multiple moralities.â Consequently, subjectivity and contextual interpretation make âlearning to behave in terms of a morality which could land you in jail . . . as easy as learning how to drive your car faster than 55 miles an hour.â5 They concluded that we can only persuade people to follow the right course of action especially true for those people who adopt the instrumental perspective when deciding whether to obey the law.
David Saunders of the Behavioral Sciences Department of Mathtech, a strategy and consulting services firm, asserted that management fraud can be thought of as a âperversion of effective management behaviorââof executives turning to the dark side. He persuasively described the resulting scenario as follows:
Nobody would deny that our system of economic incentives rewards imagination applied in the pursuit of profit, and that it rewards managers who exploit profit opportunities. Nobody would deny that this should be so. Yet this often has the effect of encouraging managers to operate as closely as possible to the borderline between legality and illegalityâthe borderline between what is ethical and what is unethical. And it follows, in turn, that for any of a variety of reasons, an individual manager or management group may cross over the line [emphasis added].6
Former Securities and Exchange Commission (SEC) chairman Arthur Levitt echoed these ideas in a 1998 speech titled âNumbers Gameâ delivered at New York University:
[Too] many corporate managers, auditors, and analysts are participants in a game of nods and winks. . . . Managing may be giving way to manipulation; integrity may be losing out to illusion . . . how difficult it is to hold the line on good practices when their competitors operate in the gray area between legitimacy and outright fraud. A gray area where the accounting is being perverted; where managers are cutting corners; and where earnings reports reflect the desires of management rather than the underlying financial performance of the company.7
On Making (Up) the Numbers
Many human beings use cosmetics to enhance their appearanceâthe color of their lips, skin, or hairâor to improve the way they smell. Cosmetics are also called makeup. To make up is to pretend, to create a false impressionâto create a new reality, much as a child may create an invisible friend in the course of play. Misleading others by creating a false impression is called apple polishing for a fruit seller, puffery in advertising, and window dressing when used in financial statements that portray a rosier picture of the financial position than is warranted. A...