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Conflict of interest

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Written by: Paul Catchick, CFE
Date: January 1, 2014
Read Time: 12 mins
Ethics Fraud Investigation and Examination Fraud Prevention and Deterrence
Corruption can take many forms, but its genesis often starts with the same issue: a conflict of interest, whether it’s an employee’s relative with whom a company does business or a manager choosing to hire a friend’s unqualified son. The author outlines why conflict of interest can lead to corruption and how this information can help CFEs detect and prevent this type of fraud for their clients or organizations.

Cynthia began working for a regional office of a multinational corporation, XYZ Inc. Her brother, Clyde, happened to own a company selling office supplies to XYZ. Although Cynthia was fully aware that Clyde’s company conducted business with her employer, she never mentioned this to her colleagues. Cynthia had a conflict of interest, but because she wasn’t abusing her position for her own benefit, she thought the situation was benign.

Subsequently, however, Cynthia became an assistant in XYZ’s procurement department, but she still failed to declare her conflict of interest. Occasionally, she processed purchases from Clyde’s company at the request of her supervisor, but at this initial stage, Cynthia wasn’t involved in awarding business to her brother’s company.

After she processed orders for Clyde’s company for some time, Cynthia realized that she was able to influence the awarding of business to her brother; she even became a director of his company. She then took advantage of her incoming supervisor’s inexperience to begin allocating business to Clyde’s company more frequently. Furthermore, she would also intercept purchase requisitions meant for more junior procurement colleagues and tell them to make the purchase from her brother’s company.

The new supervisor was happy to let Cynthia run things because it reduced his workload. However, he failed to realize that his inaction allowed Cynthia to direct business toward her brother’s company, even though it was more expensive than competitors. XYZ was now spending six-figure sums annually in multiple small- to medium-sized transactions (and was entering transactions just below the threshold that would have required competitive tendering).

My investigation concluded that Cynthia had engaged in corrupt activity. Her company fired her and dropped Clyde’s company as a supplier.

(I’ve changed the names and details of this and subsequent real cases to avoid identifying individuals.)

This case illustrates how an apparently benign conflict of interest was the first step on the route to outright corruption. Indeed, in the broadest sense every act of corruption must first involve some kind of conflict of interest. The intention of this article is to demonstrate why this is so and to suggest ways of targeting corruption through identifying conflicts of interest. If an organization is able to manage and control conflicts of interest, it can better manage corruption.

DEFINING THE LINK TO CORRUPTION

To understand why corruption must always involves a conflict of interest, let’s look at the definitions of the respective terms. The Organisation for Economic Co-operation and Development states: “Conflict of interest occurs when an individual or a corporation (either private or governmental) is in a position to exploit his or their own professional or official capacity in some way for personal or corporate benefit.” 

In other words, a conflict of interest exists when someone could abuse his or her official position for private gain.

The World Bank has provided a very succinct definition of corruption: “the abuse of public office for private gain.” While the World Bank definition focuses on public-sector corruption, the definition is largely interchangeable with private sector corruption since the term “public office” can equally apply to any official or any office — whether public or commercial — held by an employee.

A comparison of these definitions shows why the two concepts are so closely intertwined. A conflict of interest exists where an official could abuse his or her position for private gain, whereas corruption exists where an official does abuse his or her position for private gain.

Thus while a conflict of interest doesn’t always lead to corruption, corruption always requires a conflict of interest.

For example, accepting bribes is an example of corruption. The bribe taker has put his or her private gain — the receipt of the bribe — above the need to act in the best interests of his or her employer. Thus, there’s both a conflict of interest and resulting corruption.

Employees also can find themselves in initially benign conflict of interest situations as Cynthia was before she took the further step of taking advantage of it.

Indeed, the mere act of having a conflict of interest isn’t necessarily, in itself, inappropriate or even avoidable. After all, employees can’t be faulted simply for having financial or family connections to businesses that their employers subsequently decide to trade with. What’s important is how the employees and their employers respond to the conflicts of interest. It’s the response — rather than the conflict itself — that determines whether the employee has acted with integrity.

AWARENESS AND RESPONSE

Employees’ and management’s correct responses to conflict of interest situations, in turn, rely on an awareness of what it means and the potential implications. This isn’t always as straightforward as it sounds. Conflicts of interest and corruption may be subject to differing interpretations.

Criminal codes relating to conflict of interest vary widely depending on the jurisdiction, so it’s hardly surprising that some employees may misunderstand the concept. This can particularly affect larger multinational organizations that work across different geographic, ethnic and cultural borders, but the effects of globalization can even mean that smaller local enterprises may be composed of employees with differing value systems. Therefore, any organization that wishes to enforce a strong conflict of interest policy must ensure that staff understand it and are aware of the ramifications and how they should respond. After all, an employee who doesn’t fully understand the concept can’t necessarily be expected to react appropriately when faced with such a situation.

It helps to distribute codes of conduct to all new employees, but this in itself may be insufficient. After all, even Enron had a 64-page code of ethics. Conversely, if we can prove that an employee knew the rules, it will be easier to build strong evidence in a subsequent investigation. In one investigation, I was able to rebut an employee’s claims that he knew nothing about conflict of interest after I pointed out that he had signed an attendance register for a conflict-of-interest awareness session.

Although there are various strategies for responding to and managing a conflict of interest, invariably the most straightforward course of action for any employee is simply to declare the conflict to their managers, who can then decide how to manage the situation. This simple system will work only if management is supportive and sets a good tone at the top in which the employee knows he or she won’t be vilified for the mere act of having a conflict of interest.

In some professions, such as audit, it’s actually a professional requirement that staff declare any conflicts of interest — either periodically or before commencing an audit assignment. However, even without a professional requirement, it’s always desirable for any employee to declare a conflict of interest, particularly for those staff engaging with external parties, such as procurement, project management, finance and even warehousing.

Suppose Deborah works in a company’s administration department, and the company moves its headquarters. The managing director has seen a new office and asks Deborah to negotiate a contract. Deborah, who up until this point knew nothing of her boss’ plans, realizes that her husband’s firm owns the new building. Thus, through no fault of her own, Deborah is in a position in which she has a conflict of interest. What matters now is her response. There are a number of possibilities:
  1. If she says nothing and proceeds to negotiate the lease contract with a view to giving her husband the best possible price at her own company’s expense, this would be a case of corruption. Again, we can see that the corrupt activity can only exist with the pre-existing conflict of interest.
  2. Even if Deborah had negotiated the lease contract with the genuine interests of her company in mind and without any thought to personal profit, a failure to declare her conflict might still reflect badly on both her and her company to anybody else who became aware of her connection. (This would be a “perceived conflict of interest.”)
  3. If, on the other hand, Deborah promptly declared the conflict of interest to her boss, then her boss would have to mitigate her involvement and manage any perceived conflict of interest — perhaps by asking somebody else in the department to negotiate the contract. Deborah has avoided accusations of impropriety, and her boss has dealt with the matter fairly and knows that the lease negotiations will be conducted objectively.

It’s best to declare a conflict of interest in writing because it will enable the employee to show any auditors or investigators later that he or she responded properly. And if management subsequently fails to deal with the matter appropriately, it will face difficult investigation questions rather than the employee who held — but correctly declared — the conflict.

DETECTION

When it comes to investigating corruption, establishing the conflict of interest is key to establishing the motive for the corrupt activity. In addition, awareness of the link can also assist in formulating detection strategies. The fraud examiner is most likely to be interested in identifying conflicts of interest that haven’t been declared.

Failure to declare is most likely to arise in one of two main situations:

  1. The employee doesn’t understand the potential seriousness of having a conflict of interest or the organization’s policy relating to it.
  2. The employee is deliberately trying to hide the conflict. (There can be few valid reasons for staff not declaring conflicts of interest, assuming that employees have been made fully aware of their responsibilities.) 

An employee with a conflict of interest may not necessarily engage in corruption; however, management may view a failure to declare with a high degree of professional skepticism and could lead the investigator to finding more serious misconduct.

Fraud examiners will be familiar with many of the strategies for detecting conflicts of interest between staff and suppliers, including cross-referencing of employees’ names, contact details and bank accounts against those of vendors.

However, the company should require due diligence performance in a variety of circumstances in which external suppliers are involved. Auditors, especially those who are also fraud examiners, should be checking that appropriate due diligence has been performed and be on the lookout for conflicts of interest. The Institute of Internal Auditors has issued an internal audit standard (2120.A.2), which specifies that internal auditors must evaluate the potential for the occurrence of fraud and how the organization manages fraud risk (emphasis added).

A company’s failure to conduct due diligence may itself be a red flag for conflict of interest or corruption. Other red flags include the overriding of procedures, segregation of duties or authority levels.

Of course, employees may conceal conflicts of interest that management can’t easily detect with conventional audit-style checks — especially when they covertly accept bribes from suppliers with whom they have no obvious connections. However, plenty of “low-hanging fruit” still exists, as our opening case illustrates. Although Cynthia only became a director of her brother Clyde’s company years after XYZ hired her, it would have made sense for her firm to conduct regular due diligence on itself given the large quantities of business awarded to Clyde. That periodic scrutiny would have revealed her directorship of Clyde’s company and then spurred management to act much sooner.

Conflicts of interest and corruption don’t have to relate solely to financial matters. Conflicts of interest in recruitment may lead to nepotism or cronyism, which are also forms of corruption. Ironically, even the U.S. Department of Justice (DOJ) has recently been faulted for systematic nepotism, which perhaps goes to show that conflicts of interest — and their consequences — can occur in any cultural setting. (See the DOJ’s Office of Inspector General PDF, “Report Regarding Investigation of Improper Hiring Practices in the Justice Management Division.”) 

Let’s consider another example. Fred, an IT official, repeatedly appointed the same consultant to help implement projects on behalf of his organization even though the consultant, a young lady, clearly wasn’t the most qualified individual. When I subsequently asked Fred why he continually recommended the same consultant, he said the consultant was “kind of cute,” and he hoped he could continue seeing her. This could have been a stronger motivation for corruption than mere money.

Motivations can also be more convoluted and involve multiple factors. In another case, Lewis, as acting office manager when his boss was on leave, bypassed every control in the purchase system to award a consultancy contract and give a large advance payment to an untested and unqualified trainer without performing any background checks on her suitability. The trainer subsequently did poor work and failed to fulfill the terms of her contract. However, Lewis still authorized her full payment and recommended that she be hired again.

Although Lewis and the trainer had no known business or personal relationship, he’d signed the trainer’s contract at the request of his office assistant, with whom he was having an affair and who was the trainer’s cousin. Lewis was motivated by pleasing his girlfriend, who was motivated by arranging profit for her cousin. When the office manager returned from leave, he saw that Lewis overrode the controls and signed the trainer’s procurement contract when the manager was out of the office, but he failed to confront Lewis over the matter.

The internal auditors told the firm’s internal investigator about this case. The investigator discovered Lewis’ overriding of controls and lack of due diligence, his girlfriend’s misconduct and Lewis’ manager’s negligence.

LESSONS LEARNED

Conflicts of interests can exist in any organization or cultural setting. Employers may wish to respond to it by doing the following:

  • Ensure that all employees have a thorough understanding of 1) the concept of conflict of interest and its relationship with corruption and 2) how they’re expected to respond when they’re in conflict of interest situations or know of other staffers who are.
  • Get staff to confirm in writing that the company has made them aware of these points through an attendance register at an awareness session and/or gathering their signatures on a document stating they understand the organization’s code of conduct.
  • Alert managers and auditors to conflict of interest situations and the potential problems they may cause, especially when employees haven’t declared them.
  • Ensure that management properly and regularly conducts due diligence, particularly when the organization is spending large sums.
  • Consider adding a conflict of interest component to internal auditors’ standard audit programs.
  • Examine correspondence files, due diligence, and transaction documents and reports to help identify conflicts of interest.
  • Conflicts of interest can develop over time; you may not pick them up during initial due diligence checks.
  • Consider strategies to deal with evolving conflicts such as conducting periodic or surprise due diligence or enacting a rotation policy for staff in vulnerable positions.

While it would be naïve to think that you can eliminate misconduct, any organization that properly manages conflicts of interest can minimize its exposure to corruption.

SIDEBAR:

In two cases, wife and over-friendly project manager cross the line

Anna worked as a secretary in an organization’s media production department, which was outsourcing the filming of a series of corporate video productions. Although she wasn’t directly involved in the procurement tender process, she had access to similar contracts from previous years.

Anna secretly emailed the confidential details of these contracts to her husband, Sam, who ran a small video production company. Sam submitted a bid based on the previous contract values and won the job. The organization could have avoided this conflict — and the subsequent corrupt activity — through basic due diligence by comparing the names of employees in Sam’s company with those in the media department; the identical surnames of both Anna and Sam would have raised suspicions.

Howard was a project officer for a donor organization that engaged a non-governmental organization (NGO) to undertake a community-based project in a developing country. Although the donor legitimately selected the NGO, Howard soon became good friends with the NGO’s manager, Simon. Howard began suggesting to Simon ways in which the NGO could discretely inflate its expenses to increase the amounts it could claim.

The donor organization could have detected the conflict by examining the project file, which would have shown the evolving tone of the correspondence between Howard and Simon from professional to over-friendly.

Paul Catchick, CFE, is the senior internal investigator at the Organization for Security and Cooperation in Europe (OSCE), based in Vienna, Austria. The OSCE is the world’s largest regional security organization, with 57 participating states. 

The Association of Certified Fraud Examiners assumes sole copyright of any article published on www.Fraud-Magazine.com or ACFE.com. Permission of the publisher is required before an article can be copied or reproduced.

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