Environmental Fraud: More subtle than midnight dumping

Environmental issues often aren't the focus of traditional fraud examinations. But this type of fraud goes well beyond illegal midnight chemical dumping. It includes such schemes as falsification of data, marketing fraud, inflation of invoices, and fraudulent insurance claims. 

A site owner responsible for environmental, health, and safety compliance for a manufacturing facility is notified during the course of a periodic and routine monitoring program that elevated levels of contaminants appear to be in the groundwater wells used for detecting contamination and migration from the site of pollutants. He's concerned that this might reveal poor housekeeping practices, or even illegal activities (such as handling prohibited hazardous materials), so the owner decides to engage the services of a laboratory that employs an acquaintance willing to be bribed.

Together, they devise a sampling program that appears to be comprehensive and in accordance with regulatory requirements on the surface. But they switch the samples so the laboratory receives clean versions (or cleaner than expected). The site manager then uses these cleaner analyses as a basis to convince regulators that the company should undergo a less expensive remedial effort or none at all thus saving the potentially high costs of remediation and possible legal action by neighboring property owners. But such a fraud, undetected for years, could eventually cost the company hundreds of times more than the cost of an appropriate remediation.

While health-care fraud, identity theft, and construction schemes continue to grab the headlines, environmental fraud isn't often thought to be a great risk to companies. But environmental fraud goes well beyond disregarding environmental laws. It includes schemes such as falsification of data, inflation of invoices, and fraudulent insurance claims. Here we'll describe the ways environmental fraud is perpetrated and what can be reasonably done to limit it.

POTENTIAL FOR FRAUD IN ENVIRONMENTAL MATTERS
Mention environmental "issues" and the average person most likely will think of illegal polluters blatantly violating environmental regulations such as illegal midnight dumping. Although these are certainly problems that affect society, environmental fraud can and does occur in many more and diverse instances. Given the complexity of environmental projects, fraud has a very good chance of success particularly because most concerns are focused on transactions that involve payments and procurement, which leaves many other areas exposed.

An environmental project can include a number of different phases, involve several different companies, and last for many years. These projects can involve a number of participants from different disciplines, both internal and external to an organization, such as:

• environmental managers who work with clean-up companies, who are typically responsible for the entire remediation cycle including consultant selection, communication with regulators and authorities, and cost management;
• financial managers and accountants who are responsible for managing budgets and accruals for the liability represented by the environmental matter;
• consultants including laboratory personnel, engineers, and scientists involved in identifying levels of pollution and potential solutions plus firms that might perform the actual work, and individuals who negotiate these solutions with regulators;
• subcontractors who perform the actual cleanup or installation of remediation systems such as builders, electricians, plumbers, excavators, and pipe fitters;
• regulators responsible for upholding the requirements mandated by federal, state, and local laws;
• attorneys who negotiate with regulators on behalf of the company or who might represent parties that have suffered damages;
• suppliers of materials such as treatment systems, piping, and other equipment used in implementing the remediation; and
• insurance companies that are responsible for payments or claims covering all or some of the remediation costs.

As may be expected, the larger the number of parties and budget for remediation, the greater the risk of fraud.

TYPES OF ENVIRONMENTAL FRAUD
Based on the parties involved in a remediation project, there are a number of fraudulent schemes that may be devised.

Falsification of technical/laboratory data - To assist a company in justifying a less expensive remedial option, a laboratory might be convinced to falsify analytical data that's the basis for the selection of remediation or for the duration of the remediation. Groundwater cleanup, for example, may last for decades and run into hundreds of thousands of dollars a year. Manipulated results might be the basis for terminating the cleanup and thus eliminating or reducing the expense. Or, in the course of remediation of contaminated soil, a more favorable result might allow lower disposal costs. Case: A laboratory admitted to falsifying laboratory data reported to the Environmental Protection Agency regarding reformulated gasoline. The indicted managers admitted that they were motivated by a desire to please and retain the company responsible for blending the gasoline.

Product substitution/procurement - As with construction fraud, product substitution by contractors might result in considerable skimming of funds. Additionally, the long-term nature of many remediation projects might allow such a scheme to continue undetected for many years (or "low burn" in which fraud is perpetrated in small steps). Procurement managers, for their part, might also use these expenses to double-bill their employers or to set up phantom accounts to which payments are sent. Case: On a sophisticated groundwater remediation system installation project, the contractor opted to replace specific piping connections and joints with some that he had in stock that weren't in accordance with the engineering specifications. After operating the system for some time, an inspection revealed the product substitution and inability of the system to continue for the entire time of the remediation.

Accounting fraud - Environmental liabilities have a direct impact on a company's balance sheet and the ability to manipulate these may help embellish the bottom line. Conversely, in years of greater profits, environmental reserves for these liabilities might actually be overstated as a means to stash away revenue that might otherwise have to be distributed. If a company subsequently experienced a less successful year, the reserves set aside could be released by lowering the environmental liabilities and freeing some of those funds to improve the organization's bottom line. To successfully execute fraud in the area of accounting, companies might resort to a series of tactics including:

• being very careful about what to disclose and the timing of the disclosure to delay any negative impacts on the balance sheet;
• loosely interpreting the costs that are quantifiable and whether these are probable, possible, or remote thus "using" the Financial Accounting Standards 5 (FAS 5) guidance to its advantage;
• avoiding the aggregation of liabilities to keep the values low and therefore dismissing many as "immaterial" or using a long-time horizon to make the environmental matter "uncertain";
• declaring certain assets as "idle" to avoid requirements and to "buy time" and avoid public disclosure;
• selling and/or transferring a liability to another company (perhaps created ad hoc) that will indemnify the seller; and
• downplaying risks from activities, products (such as biotechnology or toxic substances) and/or base estimates on overly optimistic opinions (such as stating that remediation will be completed ahead of schedule).

Case: When a publicly traded company changed financial auditors, it was discovered that a number of remediation projects were greatly understated to reduce liabilities and hide some potential costs that would affect the company's value and attractiveness to shareholders. It was only when the environmental fraud specialists from the new audit firm tested the results that the underestimation was uncovered.

Insurance fraud - Insurance companies are also susceptible to fraud relating to environmental claims, either by the policyholders or by individuals who may denounce injuries or damages. These often include toxic tort matters and health and safety claims on behalf of workers whose injuries are due to exposure to particular substances.

Marketing fraud - Corporate responsibility and sustainability are relatively new trends in many industries. These reports, prepared in virtually every industry, are published to demonstrate to the public and stakeholders that a company pursues revenues and earnings while respecting the environment, its employees, and the communities in which they operate. These initiatives might include contributing employees' time to improve neighborhoods, investing in after-school programs, carefully examining environmental impacts before building a new facility, or creating recycling/energy reduction programs. These reports are then often used by companies to market their products, to gain entry into new countries or to secure contracts with governmental agencies. Fraudulent statements based on a company's efforts and achievements in environmental management can provide an unfair advantage because these reports, which can be easily accepted and published, aren't subject to "audits" the way financial statements are.

PREVENTIVE MEASURES
Environmental management's fraud prevention measures rely on the human element because many of the schemes might actually appear legitimate from a transactional standpoint. And, in many ways, managers responsible for fighting fraud need to integrate both in-house measures and independent outsider reviews by outsiders. Key approaches might include any of the following.

A clear mission statement - A key first step for any organization is to clearly communicate to its employees, clients, and contractors that environmental matters are taken seriously and any fraudulent activities related to the environment won't be tolerated. This policy should be stressed on a global level given the disparity that exists among environmental regulations from one country to another. Companies that are often singled out for excellence in environmental management are very specific in the statement of their standards and expectations and don't leave much room for interpretation as to what is considered responsible behavior. In addition, employees should be encouraged to report any instances of fraud they suspect or witness and be allowed to do so in a confidential manner.

Management guidance - As with a mission statement, an organization must provide its personnel with the necessary support to perform in a clear and honest fashion. These include policies and procedures, hotlines, documentation, and access to senior managers who can provide the necessary guidance. The advent of the Sarbanes-Oxley requirements has made it all the more urgent and relevant for many companies given the increased scrutiny by regulators, media, and investors to have controls in place and not just a mere promise to act responsibly or to return a profit for one's investment. Demonstrating a realistic and concrete effort is increasingly a part of how companies are viewed by the public. For example, to illustrate their commitment to anti-fraud programs, many organizations have instituted anonymous hotlines that are managed by external companies to provide an opportunity for all employees to report potential unsafe or illegal activities.

Evaluation and assessment of environmental policies - Environmental management shouldn't operate in a vacuum because its activities touch many areas within an organization. The evaluation and assessment of environmental policies, especially when conducted by third-party specialists, can include a number of specific objectives:

• reviewing policies and procedures and existing internal controls;
• testing environmental liabilities and expenses sustained in relation to the status of the remediation;
• auditing the reporting process from site project to management and validity of the values and information being communicated; and
• testing of reporting (to management and shareholders) against actual data.

As with other types of fraud, measures that might be in place need to be dynamic to adjust to changes in the market, locations, and standards. For instance, realizing the lack of formal policies and procedures provided an opportunity for malfeasance, a top waste management firm implemented a number of proactive measures and controls following a recent merger.

Benchmarking - As is true in many other operational areas, knowledge of best practices and understanding of what exposures other companies have had can be of great aid to a company. The global economy, while providing increased business opportunities, has also highlighted the disparity in environmental requirements among countries. Awareness of the limitations of environmental requirements in one country is just the first step in helping ensure standardization of requirements. Benchmarking also provides companies operating in different countries a means to measure and evaluate its environmental activities as an additional tool to prevent fraudulent activities.

Personnel rotation - The long-term nature of some remedial projects and the concentration of a number of projects in the hands of a single individual might make it easier to perpetrate and continue to commit fraud. As a safeguard, organizations might opt to have a number of projects moved periodically from one environmental manager to another or institute peer reviews. Also, there can be great strength in numbers. For example, a leading pharmaceutical company instituted a worldwide auditing program that includes personnel from other service lines and departments, in addition to independent consultants, to provide objectivity and a "best practices" look at liabilities and risks.

Diversification of subcontractors - Regardless of the positive experiences a company might have with a particular engineering firm, analytical laboratory or contractor, a company might wish to avoid an exclusive relationship that in turn provides a fraudulent scheme with more chances to succeed.

Screening of subcontractors and vendors - Inappropriate subcontractors can expose a company to a greater liability than the one caused by environmental impairment (such as a case involving a number of OSHA violations). Screening of partners and vendors should be an integral part of doing business.

UNEARTHING HIDDEN ENVIRONMENTAL FRAUD
As with virtually all fraud, environmental fraud is committed because perpetrators are confident that the misappropriations won't be detected. Environmental issues often aren't the focus of traditional anti-fraud examinations, despite the fact that corporations spend billions of dollars a year in remediation, sustainability efforts, and conservation.

Much of environmental remediation involves construction activities, such as trenching, well installation, excavation, and remediation systems operations and maintenance. And if construction fraud levels are any guidance, it would suggest that environmental matters could share in these schemes with the added risk that many environmental "activities" occur below ground and remain hidden from view until extensive testing is performed.

It's clear that no one measure or set of measures will completely eliminate all risks of environmental fraud. Vigilance and ongoing efforts are keys to success, and by applying some of the same approaches that are successful in other areas, such as in construction management, many issues might be dealt with effectively.

The views in this article are those of the author, and don't necessarily represent the views of Deloitte Financial Advisory Services LLP. 

Francesco Liberti, MBA, CFE, is a manager in the Forensic & Dispute Services practice of Deloitte Financial Advisory Services LLP.