Fraud in Asia: U.S.-Based Companies Challenged in Fighting Corruption

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A stolen CD at airport customs years ago hardly indicts an entire region, but ingrained habits die hard. At least four senior judges in Shenzhen, China, are currently under investigation for alleged corruption including taking bribes in exchange for handing down verdicts favorable to their benefactors. "Judicial corruption has become a rampant problem on the mainland [China]," according to the South China Morning Post.² 

In another ongoing high-profile case, the top political official in Shanghai was removed from office following an investigation of his involvement in a scheme that diverted $500 million of pension funds to a real estate deal arranged by his cronies. The investigation exposed one of the largest corruption scandals to hit China in a decade. It began in Shanghai and has expanded throughout the country, implicating another high-level official who is now under investigation for yet unspecified acts of corruption.

So it would seem that there's basis to the popular notion that corruption is still widespread in Asia.

TRACKING CORRUPT COUNTRIES 

Each year Transparency International³ conducts a survey and assigns each country a "Corruption Perception Index" (CPI) number based on an evaluation of a multitude of factors. In the 2006 survey, the following countries were assigned the 10 lowest (most corrupt) CPI numbers and the 10 highest (least corrupt) CPI numbers, rated on a scale of 0 to 10:

Upon cursory review of the top- and bottom-10 lists, it appears that corruption has a high correlation with the economic wealth of nations. Accordingly, of the top 10 least corrupt countries on the CPI, there isn't one considered to have an "emerging market" economy. However, having an "advanced" economy doesn't guarantee a high CPI rank, as evidenced by several Asian countries. For example, since the early 1960s, South Korea has enjoyed economic growth that's the envy of many up-and-coming nations; today, it's the 11th largest economy in the world. Yet despite all the advances, South Korea still has a fairly low CPI rating in the 2006 survey (scoring 5.1 and ranking 42 out of 159 countries surveyed). This comes as no surprise because corruption remains endemic and largely accepted by the local business community as a necessary evil of commerce. (By comparison, Japan and Hong Kong scored 7.3 and 8.3, respectively, which translates to rankings of 17 and 16 on the CPI scale.)

The table below illustrates the CPI rankings of selected Asian countries.

Although the scores in the table provide a reference for the amount of perceived business corruption in these countries, even more insightful are current documented cases of fraud. In the past year, our firm completed numerous FCPA (Foreign Corrupt Practices Act) investigations in various regions of the globe including two cases involving Asian subsidiaries of U.S.-based publicly traded companies. In both, various failures of oversight and mismanagement resulted in potential FCPA violations as well as embezzlement of company funds by one (or possibly several) company employee(s).

Even though the following cases are singular examples, they speak to the general difficulty of managing the operations of companies and/or subsidiaries in foreign lands -- in this case, Asia.

CLIENT A: U.S. FIRM WITH REGIONAL HQ IN SOUTHEAST ASIA  

Client A is based in the United States but is a publicly traded corporation with operations worldwide including a significant presence in Asia.⁴ An internal auditor in the region initially discovered the irregular transactions, which raised concern for the company's management in the United States.

We investigated the bribery allegations made against an Indonesian tax official and embezzlement of company funds made against the regional controller, "Mr. X." Both issues centered on Mr. X, who orchestrated the theft of millions of dollars from the company and directed payments to an unknown Indonesian tax official, possibly with cooperation of various other employees.

The Indonesian joint-venture (JV), which facilitated the payments, shielded the tax official's identity. The JV thinly disguised the payments as legitimate business transactions by issuing invoices for vaguely described services.

Although the identity and type of payments to the tax official are still unknown and untraced, significant sums were made to some individual. Our forensic analyses and review of electronic and paper financial records yielded the compelling circumstantial evidence that the JV made improper payments. We identified the following:

• E-mails between a company employee and a JV employee discussed a tax problem which hinted of a "resolution fee."
• E-mails between a company employee and a JV employee referred to a third party described simply as "beneficiary" who was anxious to receive his "installment."
• A letter to the company on JV letterhead stated that a check issued in the amount of 60 percent of the funds received (presumed to be a tax refund) would be acceptable.
• An invoice from the JV issued to the company for several hundred thousand U.S. dollars contained the vague and unusual description: "For tax consultation services." The JV incurring charges of this magnitude for work unrelated to its core services raised a red flag.
• Tax analyses prepared by the company's tax manager contained provisions in each year for an unexplained fee representing as much as 60 percent of -- and in one year, greater than -- the total refund due to the company. This provision for another tax year was exactly the amount invoiced by the JV.

We found general ledger entries and bank statements confirming the payment of the invoiced amounts to the JV. Based on these findings, we expanded the analysis with manual as well as automated review of financial records in all but two of the eight years we reviewed; we identified other potential payments in violation of the FCPA. However, the missing piece in this mosaic was the evidence of actual payments to the unknown tax official. We lacked the basis to make that determination because we didn't have access to the JV's books and records.

Although the puzzle isn't yet complete, the findings were beneficial because they brought to light a number of the company's oversight failures that allowed such improprieties to go unchecked for as long as they did (from 1997 through 2004). The most glaring mistake was entrusting too much authority to Mr. X, the regional controller.

There was no check on Mr. X's authority across the dozen countries in his charge. He manipulated the inter-company accounting to facilitate the payments and later invoked his management discretion to conceal the transactions from scrutiny.

In almost all instances, the illicit transfers were booked as inter-company debits within the region, and later reversed via manual management adjustments, which Mr. X tracked on Excel spreadsheets. The reversals were booked against a secret slush account that he presumably built up over time by diverting a portion of income to an accrued liabilities account. He was free to do this because the regional business was very robust; the bottom line comfortably exceeded the budget even after Mr. X had skimmed some of the excess to build up his buffer.

Because Mr. X sanitized the region's financial data sent up to the head office, it appeared as if the regional inter-company transactions never took place. Within the region the transactions were supported by seemingly legitimate invoices, inter-company debit memos, and corresponding accounting entries, so they didn't raise any suspicions from the local auditors.

Client A could argue that the corrupt tax official held the company hostage by conditioning the release of tax refunds on a reciprocal payment to him, and Mr. X merely acted in the best interest of the company by securing at least a portion of the refunds. However, there could be no such noble justification for Mr. X's theft of millions of dollars of company funds to line his own pockets.

When confronted with a list of suspicious transfers totaling several million dollars, Mr. X confessed to taking the money and promptly refunded the questioned amount. And when the investigation uncovered additional millions that looked suspicious, Mr. X again admitted to the theft and wrote another check to pay it back. The burning question then was, if he's got that kind of cash sitting around, is it possible that he took more?

We devised a methodology to address that question by first examining how the known frauds were committed. To streamline the analysis (really, to make it feasible) the entire general ledger within the regional accounting system was downloaded, transmitted back to our technology team in New York and converted into a searchable database. We performed automated searches of the general ledger data and manually reviewed the bank statements for characteristics similar to the admitted thefts. We selected the samples and we requested all available documented support related to each suspicious payment.

The supporting documentation, including cancelled check copies for the more than 500 sample selections, took several months to produce and filled more than 30 boxes. Many of the identified samples indeed turned out to be additional thefts by Mr. X that were previously unknown, and totaled several million dollars. The methods we devised to identify the additional thefts seem robust because of the positive results and the consistency with which Mr. X booked the transfers. However, there could be -- and probably are -- other thefts that would be virtually impossible to fully identify, short of manually reviewing each one of the hundreds of thousands of transactions.

In retrospect, Mr. X managed to pull off an unremarkable scheme despite not raising any flags at the U.S. head office. In most of the thefts, funds were wired directly into Mr. X's personal bank account and many of the checks were made payable to him.

To anyone who has examined similar frauds, these might sound like the actions of an inept criminal or someone just begging to be caught. But Mr X didn't need to create any elaborate schemes to facilitate the thefts simply because no one was watching.

He recognized that his management of, and final authority over, the regionally consolidated financial statements meant that there was a gaping chasm between Asia and the United States. This allowed Mr. X license to book any number of apparently legitimate payments and simply erase them later.

And because no one was scrutinizing the Asia regional books (that, after all, was Mr. X's job), it didn't matter that his bogus booking entries and subsequent management reversals were creating a mess and that the inter-company accounts within Asia were out of balance with little or no hope of reconciliation. No one had reason to question him at the head office as long as he sanitized the consolidated results before sending it up the ladder of authority.

CLIENT B: MAJORITY-OWNED OPERATIONS IN SOUTH KOREA 

Client B is a U.S.-based service provider with international presence whose South Korean operation accounts for more than half of total overseas revenue. During a routine review of monthly management financial reports submitted to the U.S. head office, management noted that a particular expense category was unusually high.

The U.S. management sought explanations but the initial response was vague and evasive. However, the South Korean manager soon disclosed the full details of the expenditure that caused the spike. To the shock of the U.S. management team, the e-mail explanation stated very plainly that the expense was a payment to a tax official to make a very large tax liability "go away," and that it was necessary to protect the interest of the company. The choice came down to paying the full assessment or, as is "customary" in these situations, pay 1 percent of the assessment to the tax official to make him look the other way. Equally surprising was the ease with which the manager came forward with the admission to having paid the bribe and stating that many Korean companies resolve their tax issues in this way.

We launched an independent investigation to ascertain the facts and probe for other potentially illegal payments. We interviewed management and employees both on site in Seoul and at the company's U.S. headquarters; we reviewed the company's books and records and collected electronic evidence.

We interviewed the three principal actors (president, vice president, and director of finance) several times to reconstruct the events that led up to the payment of the bribe. Beginning with the fateful e-mail that explained the true nature of the expense and throughout the multiple interviews, we found that the undercurrent of sentiment among the principals was that they had done the right thing and that the investigation was a mere nuisance that had to be endured.

It was unusual that the director of finance claimed full responsibility for orchestrating the payment from the onset of the investigation. He stated that he worked alone but with the knowledge and consent of his bosses -- the other two principals -- who owned the minority interest in the Korean subsidiary. With the main piece of the puzzle already sorted out, all that remained was figuring out the how and the when. Easier said than done, as it turned out!

The seemingly straightforward case of bribing a tax official to avoid a large tax payment turned into a much more complicated medley of circumstances and participants. While some details fluctuated from one recounting to the next, certain twists with potentially weighty implications emerged as we interviewed many more people.

• The bribe was paid to multiple recipients at the tax office: the initially identified tax official and another mid-level official, their bosses, and their underlings. However, the physical transfers of cash involved just two mid-level tax officials.
• The cash to pay the bribes was withdrawn over a period of 10 days with deposits mixed in to intentionally complicate the accounting records.
• The cash withdrawals were booked as advances to the finance director and the receivables created on the books were later offset with a paper bonus grossed up to cover personal income tax.
• There was a suggestion (though never proven) of a local arm of an international accounting firm's involvement:
  - One of the tax officials and the local accounting firm partner were college buddies.
  - The accounting firm's engagement partner recommended the bribe strategy.
  - A member of the accounting firm was the alleged intermediary (or "bagman") for the payment.
• Approximately half of the total tax liability would have been owed by the local minority owners related to treatment of past compensation amounts.
• Of these revelations, the last two are particularly troubling. If a major, international accounting firm was indeed implicated in bribing foreign tax officials, it would become a major scandal with serious consequences. The tax accountants stonewalled our initial effort to interview them. They eventually relented but the interviews seemed barely more than gestures to appease the persistent requests.

All the tax accountants denied knowing anything about the bribe payment and had very little recollection of the tax audit itself, which occurred some six months earlier. The company's finance director dismissed the allegation and said the source of the information (the author of the fateful e-mail explanation) was misinformed about the details.

However, the two principals' tax liabilities are far less ambiguous. They certainly had a powerful incentive to avoid the tax payment -- several million dollars between them. In addition to the commission of an illegal act of bribing public officials, the principals effectively deprived the national coffers of substantial tax revenue.

The government's strong disciplinary action in this case could influence the behavior of prospective lawbreakers and provide a much-needed boost in the perception that the country is taking a step toward a more transparent business environment.

LESSONS LEARNED 

It's understandably a difficult task to effectively oversee international operations because of the distance -- both real and metaphorical (culture, tradition) -- that separate a parent company from its foreign subsidiary. Indeed, it might be impossible to overcome local tendencies in some parts of the world.

To cite one extreme, virtually no U.S. corporations conduct business in certain African countries due to the prevalence and expectation of bribes by government officials. In countries where such corruption is less common but still exists (such as South Korea and other parts of Asia), a thoughtful, diligent approach to managing overseas operations goes a long way in preventing and detecting questionable activities among subsidiaries operating half a world away.

In the case of Client A, there was one glaring shortcoming in its oversight of the regional accounting. Management placed too much trust and authority in the hands of one officer, Mr. X, the regional controller. Mr. X's superior in the region pre-signed a stack of blank checks because he trusted Mr. X. By doing so, he effectively ceded control of the account to him and rendered ineffectual the most fundamental of control procedures -- dual signatories.

Once Mr. X recognized the opportunity, he exploited it for years and amassed a personal fortune without raising an eyebrow. Although unproven, it's suspected that he also bought the complicity of his underlings by offering them cash bonuses from time to time. There were frequent withdrawals of cash in smaller amounts (US$5,000 to US$10,000), and the checks payable to Mr. X and wire transfers made to his bank account were typically well in excess of US$100,000 per occurrence. Within this context, all other measures designed to prevent fraud would have had little effect because total authority and complicity of others would have undermined any controls. Had the company adhered to some very elementary control processes, the thefts wouldn't have been as easy to perpetrate.

The alleged bribe paid in Indonesia remains shrouded in uncertainty because the Indonesian JV's financial records weren't made available for the investigation. There's suspicion that the entire story was a fabrication, and there was no tax officer demanding a kickback for approving the tax refunds. It's unproven but suspected that the JV defrauded the fraudster and extorted money from the company under the pretense of dealing with a local tax problem.

When confronted with the suspected bribe payments, the JV pinned the blame on one of its employees, produced a signed confession, and repaid several million U.S. dollars to the company including interest. Not surprisingly, the JV identified exactly the same payments identified as suspicious by the investigation.

The JV claimed that the money had been sitting in an interest-bearing account and was never paid to any tax official. However, bank statements in support of this claim never were produced. If true, the apparent willful and deceitful actions of the JV and its employees would have made their misconduct difficult to detect. However, had an agreement been in place for periodic audits of the JV's books, it might have discouraged such blatant frauds.

On the other hand, in the Client B case, the parent company oversight of the South Korean subsidiary seems quite robust by comparison. After all, it was a routine review of expense reports that identified an irregularity, which gave rise to the investigation. What led to the failure in this case was the lack of appreciation among the local employees for the rigorous regulatory requirements that a U.S.-based public company must meet.

The principal actors in the bribery scheme were utterly surprised by the intensity of the head office's reaction to the incident and were completely unfamiliar with the FCPA and the consequences of non-compliance. As part of the remediation efforts, management has instituted an internal program to educate the local staff and will improve management oversight on site by scheduling regular internal audits. Previous to the incident, the head office's internal auditor seldom made site visits simply because he didn't enjoy traveling to Asia.

Routine reporting does provide some assurance but a company shouldn't rely on it as the only measure against combating potential fraud. Frequent on-site audits and even the presence of an expatriate officer from the head office could provide added layers of governance. Further still, instituting thoughtful policies and providing training on hot topics such as FCPA compliance could go a long way in softening the severity of penalties when even the most comprehensive preventive measures fail.

The views expressed in the article are held by the author and aren't necessarily representative of FTI Consulting Inc.

John J. Kim, CFE, director in the FTI Forensic and Litigation Consulting practice, is based in New York City. He specializes in providing solutions to economic disputes, commercial litigation and corporate investigations through quantitative analysis and interpretation of large-scale data. His e-mail address is: .

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¹"Lay-Person's Guide to the FCPA Statute (June 2001), U.S. Department of Justice." www.usdoj.gov/criminal/fraud/fcpa/dojdocb.htm
²"Judges held in massive corruption inquiry. Many more facing investigation in Shenzhen's 'biggest judicial graft case.'" Chow Chung-yan in Shenzhen. Oct. 19, 2006. South China Morning Post.
³Transparency International is an international non-governmental organization devoted to combating corruption. (www.transparency.org/about_us)
⁴To ensure confidentiality, only generic references to the companies and people involved will be made.