Avoiding Import and Export Fraud Disasters

Fraud examiners who work for global corporations need to protect their employers by being savvy with the latest "under/over-invoicing" schemes used by money launderers and terrorist fundraisers. If they don't, the courts might find their businesses criminally liable. 

 

Ali Aqaba appears to be an obscure clothing merchant in Maicao, Colombia. But he actually is a member of a terrorist financing network looking for a way to finance its operations. He's found it. Through extremely complex machinations involving "under-/over-invoicing" and several accomplices, he's able to launder U.S. currency and successfully siphon it offshore for terrorist activities. An American company might even unwittingly receive some of the tainted funds through a subsidiary and be criminally liable. 

 

Though we've fictionalized this case, it involves actual convoluted methods that shady characters use in international fraud, terrorist financing, and money laundering - methods that corporations and their fraud examiners must understand, or they risk the consequences of unknowingly being used to finance horrific, unlawful activities. 

 

AVOIDING EXPLOITATION 

Corporate internal investigations, once rare outside the privileged context of litigation, are now an indispensable part of a company's ability to enforce its own standards of conduct, ensure compliance with legal and regulatory requirements, and manage risks and crises. Knowing when to conduct such investigations and how to conduct them properly is challenging enough in the domestic realm, where it's all too easy for an unwary company to be exploited. These challenges are magnified when a company is engaged in the international marketplace. 

 

To illustrate some of the risks that are especially prevalent in the international environment and the role corporate investigations can play in avoiding them, we'll discuss two closely related practices commonly used in international fraud, terrorist financing, and money-laundering: under-invoicing and over-invoicing. We provide an overview of these practices, demonstrate the essential elements of common schemes used through examples and case studies, and outline some of the questions companies should ask and investigative measures they should use to avoid being victimized by such schemes, or worse, adjudged complicit in them. 

 

UNDER- AND OVER-INVOICING: A TWO-HEADED SNAKE 

The dual practices of under-invoicing and over-invoicing can be used to exploit a particularly vulnerable area for corporations doing business internationally. Although these practices have been common in international commerce since Greek and Roman times, recent events have highlighted their potential for serious harm; they're ideal artifices for financing international terrorism, corruption, and the narcotics trade. Under-/over-invoicing can easily be adapted for these purposes because they're common illegal international business practices used to move wealth from one jurisdiction to another while avoiding government-imposed restrictions, duties, and taxes. 

 

Historically, the harms associated with under-/over-invoicing schemes have been viewed mostly in terms of lost revenue to governments. Consequently, they've generally remained "below the radar" of law enforcement and security agencies especially when clever criminal actors use them. However, the perils to companies trapped in these schemes go far beyond being caught for failure to pay customs duties. 

 

Companies, more than ever, need to be concerned about becoming complicit in money laundering or terrorist financing schemes. It can happen to any company regardless of stringent policies and the ardent wishes of top management. 

 

Even before international terrorism became a paramount concern and "globalization" became a household word, the U.S. government was asserting extraterritorial jurisdiction in ways that made a company's overseas operations and commercial dealings increasingly vulnerable to civil or even criminal liability if they weren't monitored properly. As early as the 1970s, American corporations found it necessary to investigate the marketing activities of their foreign subsidiaries to uncover violations of the Foreign Corrupt Practices Act. Since then, law enforcement agencies have focused more attention on the international flow of illicit goods and money and have sought to impose affirmative duties on companies to monitor and report their transactions. "Know your customer" rules exemplify this trend, as do developing legal doctrines such as "willful blindness" that exact heavy penalties for ignorance.1 

 

Globalization, post-9/11 concerns about terrorist financing, and the post-Enron interest in corporate transparency have made it imperative that companies know all their business partners. In this environment, under-/over-invoicing schemes, which are carried out with the collusion of an "insider" or a corrupt trade partner not known to the company's management, can pose serious risks. Companies shipping products to developing countries that aren't integrated into the functioning core of global commerce are especially vulnerable because of the increased difficulty of obtaining the information needed to satisfy transparency standards. 

 

DEFINITIONS OF OVER-/UNDER-INVOICING 

A working definition of over-invoicing is the act by which an invoice price is inflated above the actual cost of the merchandise sent or received. Usually this is done by inflating the unit price of the merchandise on the invoice. Under-invoicing is the act of deflating the actual cost of the merchandise sent or received. This is usually accomplished by lowering the unit price of the merchandise. Another variation of the scheme is altering the number of units on the invoice. Fraudsters move money illegally from one country to another by under-invoicing exports and over-invoicing imports.2 

 

Customs services are well aware of these schemes. They've compiled extensive data on the average prices for internationally traded goods, which are guideposts for identifying transactions that are out of the normal range for trade prices on specific kinds of goods. However, these average price ranges are in the public domain and known to criminal actors in the schemes. Therefore, it's not difficult to construct a scenario "below the radar" to avoid detection. 

 

Examples of Money Laundering Using Under-/Over-invoicing 

1. Under-Invoicing

A drug trafficker seeking to launder US$1 million from the United States to a foreign country could: 

• Establish a U.S. company 
• Buy 200 laptop computers at $5,000 per unit 
• Sell to a foreign firm (owned by the trafficker or by a confederate) at a selling price of $5 each
   

The foreign firm now has $1 million in computers for which it paid only $1,000. The money-laundering cycle is complete when the foreign company sells the shipment of computers at true market value. 

 

2. Over-Invoicing

Over-invoicing involves importing a product at prices above market value. For example, if a drug trafficker desired to launder US$1 million from the United States to a foreign country, it could be accomplished this way: 

• Establish a foreign company 
• Buy 10,000 ballpoint pens at 10 cents each 
• Sell the 10,000 pens to a U.S. company (owned by the trafficker or a confederate) for $100 each
   

The foreign company would receive $1 million in return for goods that cost only $1,000. 

 

Not so common is the scheme that alters the number of units along with the unit price. For example, if a drug trafficker wished to launder US$1 million from the United States to a foreign country, it could be accomplished this way: 

• Establish a U.S. company
• Buy 200 laptop computers at $5,000 per unit
• Sell to a foreign firm (owned by the trafficker or a confederate)
• Alter the sales/invoice/shipping documents to reflect two laptops at $500 per unit

 

The foreign company acquires $1 million worth of laptop computers for $1,000. 

 

If the proceeds transferred through these schemes were from specified unlawful activity, the conduct would be criminal and the proceeds subject to criminal and/or civil forfeiture under U.S. law. Moreover, there are international treaties and agreements that are congruent with U.S. money laundering laws. Most developed countries in the integrated core are signatories to agreements to thwart money laundering and international terrorism. 

 

Beyond these simplistic examples are more complicated renditions of these elementary schemes that make the criminal activity harder to detect for both the company's management and law enforcement officials. 

 

A NOT TOO UNREALISTIC CASE STUDY 

Let's get back to the case study we introduced at the beginning of the article. The case, which draws from the actual experiences of one of the authors, is hypothetical, but the backdrop in South and Central America is real. It illustrates how terrorists use over-/under-invoicing techniques to finance their activities and how they can make an American company their unwitting accomplice. The fictionalized case gets rather complex, but stay with us! First, some background. 

 

The Setting 

In the city of Maicao, Colombia (located on the Caribbean Northern Coast called the La Guajira), there's an enclave consisting of an admixture of Middle Eastern merchants. Most of them are second-generation immigrants believed to be from Syria, Egypt, and Iraq - "believed to be" because in Maicao everybody minds their own business. It's dangerous to be too inquisitive. 

 

The local population of merchants in Maicao consists of three main ethnic groups: Hispanics from Colombia and Venezuela who are referred to as "Interiores," Middle Easterners who are referred to as "Turcos," and the aboriginal peoples who are referred to as "Chinitos." The Chinitos are fearlessly independent and make up the majority of the labor force. The Interiores are merchants who deal in cigarettes, liquors, and electronics (CD players, TVs, VCRs). The Turcos mostly deal in clothes, shoes, and appliances. An unwritten law forbids trespassing on another group's commercial turf. 

 

Historically, Maicao has been a center for contraband, although, this is gradually changing because of U.S. pressure. It also has a reputation as a "Wild West" town known for smuggling, guns, gangsters, rebels, and government corruption. It's a region that for generations has been pitted in battle against the central government in Bogota. In the past, it was so dangerous that the National Bank of Colombia refused to establish a branch there. The customs house has been fire-bombed at least twice in the past few years. 

 

Maicao is a main portal for the entry of smuggled goods into Colombia and Venezuela. (For years, the "Aruba Free Zone" was the main supplier of goods, but that has shifted to the "Colon Free Zone" in Panama and the free zone in CuraÁou, D.W.I.) This smuggling activity is referred to as the "gray market" in polite commercial circles and the "black market" to the central governments of Colombia and Venezuela. It's not illegal to sell products in the free zones of Panama, CuraÁou, and Aruba to any customer who's willing to pay in a hard currency (U.S. dollars) and is willing to pick up the product and take it somewhere else. But citizens of these countries are forbidden to make purchases. In fact, it's against the law to buy free-zone products and sell them domestically and for citizens to purchase goods within the free zones. 

 

Free zones work much like duty-free establishments in airports and ports-of-call. There are more than 42,000 "free-zone/duty-free" locations worldwide dealing mostly in consumer goods such as tobacco, perfume, cosmetics, liquor, clothes, shoes, appliances, electronics, jewelry, gold, and tires. Because the smugglers won't be able to legally import the products (the "white market"), they find it difficult to acquire hard currency to pay for the goods purchased because, as contraband, they don't have the required import documentation. Absent bribery of customs officials, which isn't unheard of, the smugglers must get the hard currency from illegal money brokers. This situation is ideal for the laundering of narcotics proceeds. Therefore, the money they acquire is likely to be tainted. 

 

The Panama-Colombia Problem 

Colombia has a large network of outlets for foreign-made goods in the illegal economy known as the SanAndresitos. A 1997 Colombia National University-Bogota study found the SanAndresitos network was responsible for about 12 percent of Colombia's GDP. The SanAndresitos, a national institution, is a ready-made vehicle for money laundering and terrorist financing. The dominant money laundering scheme in the region is the Black Market Peso Exchange (BMPE).3 (Also see "Money Laundering: Black Market Peso Exchange," by Javier Sarmiento, CFE, CPA, in the July/August 2007 issue of Fraud Magazine.) And in 2006, the U.S. Treasury's Financial Crimes Enforcement Network (FinCEN) issued an advisory to U.S. financial institutions warning of a nexus with Mexican banking institutions and the BMPE. 

 

Panama is by far the greatest beneficiary of the SanAndresitos. Leading global manufacturers have a presence in the Colon Free Zone in Panama. The global Fortune 500 actively supplies goods and services in this zone. In addition, this zone is supplying those goods to the SanAndresitos through the smuggling portal of Maicao and other ports on the Pacific coast of Colombia. 

 

A Hypothetical Case of Terrorist Financing 

Ali Aqaba, the clothing merchant in Maicao, is a member of a terrorist group's financing network. Although he doesn't deal in liquors, he has a side business; he buys Scotch whiskey from another merchant, Victor Lugo (one of the Interiores), across town, who buys from a Colon Free Zone merchant, Enrique Hernandez. Lugo has a "capital flight" scheme going with Hernandez that moves money out of a traditional high inflationary, unstable economy with a constantly devalued currency (Colombian peso) to a stable currency like the U.S. dollar. 

 

In this arrangement, Lugo has opened an account in the name of a trusted friend in a bank at the Panama airport. Lugo buys liquor from Hernandez and pays in tainted U.S. dollars obtained from a money broker in the BMPE. Hernandez over--invoices Lugo and, when paid, gives the excess amount to Lugo's trusted friend (listed as a consultant to Lugo's company), who then deposits it in Hernandez's account. 

 

Hernandez's supplier is a distiller in Scotland - a "whiskey house." An American multinational company has recently purchased the whiskey house. The general counsel (GC) for the American parent is well aware of the under-/over-invoicing schemes so prevalent in Central and South America and the dangers of being an unwitting conspirator to money laundering and terrorist financing. The GC has notified the Scottish sales representatives, by written instruction, that this "mode of operation" to accommodate customers will no longer be tolerated and is to cease within the next billing cycle. Any employee engaged in this activity in the future will be subject to disciplinary action including dismissal, he writes. 

 

Scotland Supplier 

Regis Owens, a sales rep for the whiskey house, is responsible for sales to the Iberian Peninsula and Latin America. Perplexed by this new directive from the GC, he's convinced that his job and commissions are very much in doubt. And just as he was thinking about getting into a new line of work, he receives a call from Richard Burton, a Welsh freight expediter, with whom he had done a little business in the past. Burton is aware of Owens' problem and asks for a meeting the following week in Edinburgh to discuss a possible solution. At the meeting, Burton suggests the following arrangement: 

• Burton can be Owens' expediter for shipments to Latin America and handle all the paperwork for a fee. 
• Burton can handle the shipping bills, insurance, fees, and invoicing for sales to Owens' customers. 
• Any previous invoicing "arrangements" Owens had with his Latin American customers would be honored in this new logistics cycle. 
• The focus of the new arrangement would be the free zone merchants in Colon, Panama. 

 

So (hopefully, you're still with us), Aqaba is now buying liquor from Lugo and selling it to an associate in the SanAdresitos, who pays him in U.S. dollars. Aqaba then pays Lugo, who pays Hernandez in Panama on inflated invoices in quantity and price of unit shipped. With the profits from the sale of the liquors, Aqaba pays his associate and sends the payment by courier or wire transfer in U.S. dollars, again based on phony invoices, to his supplier/associate in Colon. The Colon supplier then wires the money to an operative in Aqaba's terrorist organization who replenishes the coffers for future operations. 

 

MANAGING THE RISK 

The American parent company in the previous hypothetical case, if it receives tainted funds, might be criminally or civilly liable for the actions of its subsidiary in Scotland. If, for example, a government investigation establishes that the subsidiary engaged in money laundering through the under-/over-invoicing methods, the risk of potential criminal prosecution and forfeiture will be greatly expanded. The company and its employees, agents, and management might be liable if they know of or are willfully blind to the fact that the subsidiary is being used to facilitate money laundering and/or a terrorist financing scheme. Even if it escapes legal sanctions, its reputation might suffer if it's linked to a terrorist financing scheme especially if a government agency or journalist first exposes it. 

 

This convoluted, but not unrealistic, international intrigue involves both organized crime and international terrorism - a combination that presents a significant challenge to any global corporation's management. Vigilance is required to maintain a company's profitability, reputation, and status as a good corporate citizen. 

 

Detecting the Warning Signs 

More often than not, situations that erupt into public scandals are preceded by warning signs, which, if heeded, can prevent or mitigate damage to the corporation. These signs can come through an audit finding, a whistle-blower, or even an anonymous letter. At some point, and on some level, the company will likely receive the kind of information that would motivate a reasonable person to think that a matter needs to be investigated - what in law enforcement parlance is sometimes called "proper predication." 

 

In the hypothetical case study, the predication might come in the form of an allegation or suspicion related to the foreign subsidiary. In whatever form it arrives, immediately heed the warning sign by launching an internal inquiry to consider these questions: 

• Who negotiates the price structure for goods purchased or sold? 
• How are the prices reflected in the invoice? 
• Are there any internal controls already in place to make sure that the prices of goods sold are the prices previously negotiated? 
• How are the records of these transactions kept? 
• Are there any internal control mechanisms already in place that make sure the records reflecting the costs of goods bought and the monies received for the goods sold are the actual monies received and paid for the goods? 
• Who's responsible for assuring the number of units appearing on the invoice is the actual number of the units shipped/received? 
• What controls are in place to assure that the number of units shipped/received corresponds to the number of units appearing at the import/export entities? 

 

If the results of the company's inquiry leave important questions unanswered, it might be necessary to proceed to a full investigation. 

 

Structuring the Investigation 

An investigation into possible international over-/under-invoice schemes, like most corporate investigations, should be approached not as a "whodunit," but as a "what happened" exercise. Structuring the investigation begins with the information or event that gave rise to it, which might suggest obvious first steps, such as interviewing a whistle-blower or auditor, or looking closely at certain records or transactions. 

 

At some point early in the process, the corporate investigator can profitably employ the "fraud theory approach."4 This approach is analogous to a scientific hypothesis. The fraud theory starts with the assumption - based on the known facts - that a fraud has occurred or is occurring. You test the assumption to determine if it's accurate. Procedurally, the fraud theory entails: 

• Analyzing available data 
• Positing a hypothesis
• Testing the hypothesis
• Refining and adjusting the hypothesis as new evidence is developed

 

In the fictionalized case history, such a hypothesis might be that Burton and Owens were involved in an over-/under-invoicing or capital flight scheme. You check and recheck this hypothesis as the investigation proceeds. 

 

Evidence Gathering 

In structuring this phase, it might be helpful to visualize a series of rings, with the innermost ring representing the core actors in the suspected wrongful conduct. For security purposes, it's usually advisable to begin at the outer rings, which consist of documents that you can easily and securely obtain using the company's resources and cooperating witnesses who are likely to conduct themselves with discretion. 

 

During the "outer ring" phase of the investigation, seek to acquire a complete mastery of the company's relevant paper and electronic records including company policies and procedures, old audit reports, and financial documents relating to a specific transaction. This will not only lead to relevant evidence but often reveal much about the culture of the organization. For example, you might find deviations from policies and procedures that reveal the ways the company actually operates in the real world and disclose "sub-systems" that fraudsters use to get around policies that are unworkable or that interfere with certain personal agendas. 

 

Another early step in this phase of an investigation is the review of internal company records that aren't within the custody and control of the suspect that might shed light on internal controls or deviations of procedures. This would be a detailed scrutiny of customer accounts to identify memoranda of adjustments, accounting anomalies, suspect forgeries, altered documents, and missing records. You must be fluent in accounting procedures and record keeping - the language of business - to uncover evidence. 

 

After you review the record in detail, you'll want to start selecting potential subjects to interview. Again, the procedure is to start at the outer ring for conducting interviews and work back towards individuals who might be directly involved in the misconduct. 

 

The outer-ring phase of evidence gathering can also include using the company's or your network of contacts among customers, security, and compliance personnel in the relevant industry, and friendly law enforcement personnel (for example, customs officers) to learn, among other things, if the suspected scheme has been detected elsewhere. In the hypothetical scenario, for example, it might be useful to contact a friendly security officer working for a beer exporter. 

 

Even in domestic corporate investigations, evidence gathering can be a complex process that needs to be handled with great skill. In the international environment, there are additional pitfalls to avoid: 

• In some countries, it might be illegal to take business records out of the country, even those belonging to an American parent's foreign subsidiary. So you'll have to explore other means to obtain the needed information without undo expense. For example, it might be perfectly legal to fax documents out. 
• Rules concerning the disclosure of proprietary information might differ among countries. 
• Some countries are particularly sensitive about examining personnel records. 
• Just as American states differ in their laws concerning consensual monitoring of conversations, you must check the laws of the relevant countries. 
• Even voluntary depositions, interviews, or other investigative techniques might present legal problems when done on foreign soil. 
• Obviously, consult with the company's legal advisors including its in-country counsel. 

 

As you collect and analyze the data and your investigation proceeds to the inner rings, re-check the original hypothesis and modify it, if necessary. Eventually, if the evidence warrants proceeding that far, the persons and entities directly involved in the scheme might have to be confronted. 

 

Drawing Conclusions 

If you've diligently pursued these investigative steps and it's clear that you've uncovered an over-/under-invoicing scheme, you'll usually notify the appropriate government agencies and use your company's internal standards and procedures to deal with the miscreants. 

 

Your investigation might establish that no wrongdoing occurred. In conducting due diligence or "know your customer" investigations, however, it's important to remember that you might need to question some apparent indicia of reliability. For example, many persons who engage in international commerce believe that transfers from well-known U.S. banks provide an assurance of legitimacy. Such transfers, however, can be one of many stops that illicit money makes in the course of a laundering operation. You might need to go further and determine the origin of the funds wired from the U.S. bank. 

 

Many illicit transactions, of course, don't involve banking transactions. In addition to overtly criminal activity, such as bank robberies and narcotics trafficking, organized crime and terrorist groups often use smuggling operations to finance their activities. Cigarettes, liquor, perfume, gold and gold jewelry, and gasoline are among the most popular commodities because there's usually a demand for them and, by changing their packaging, smugglers can make them very difficult to trace. Accordingly, companies dealing in such commodities need to be especially alert. 

 

AVERTING OTHER PERILS 

Under-/over-invoicing schemes comprise a fraction of the challenges that face corporations seeking to preserve both their profitability and integrity in the international marketplace. However, a company that can respond properly to these kinds of schemes by fully utilizing its investigators and other internal compliance mechanisms likely will have the culture and competence needed to avert other perils. 

 

ACFE Regent Emeritus Michael M. Ryman, CFE, was an FBI agent specializing in anti-fraud, organized crime, and corruption of public officials; an assistant inspector general for three U.S. government agencies; and chief investigator and senior policy advisor to the U.S. House of Representatives Government Operations Committee. He has advised governments and corporations throughout the world. He is principal with Sentry Business Safeguards LLC in Rockville, Md.   

 

Howard T. Anderson, J.D., is a Washington, D.C., attorney specializing in corporate compliance matters including independent investigations and monitorships. He has prosecuted organized crime and official corruption cases and investigated foreign intelligence activities and other international issues for congressional committees.   

 

1 A line of cases beginning with United States v. Bank of New England, 821 F.2d 844, 856 (1st Cir.) (upholding jury instruction that willfulness element of criminal charge is established by "flagrant organizational indifference"), cert. Denied, 484 U.S. 943 (1987), has made it more difficult for corporations to ignore misconduct by establishing the principle that the "flagrant indifference" or "willful blindness" of employees can, under some circumstances, satisfy the intent requirement in a criminal case. "Know your customer" rules in banking and recent anti-terrorism measures are likely to expand this trend.  

 

2 The descriptions of over-/under-invoicing in this article are based on Richard S. Fechter's Over/Under Invoicing, internal working memorandum, Plave, Manten, Inc., Aventura, FL: 1994. Used with permission.  

 

3 FinCEN Advisory Issue 9 (November 1997) discussed in detail a large-scale, complex money laundering system that is used extensively by Colombian drug cartels to launder the proceeds of United States narcotics sales. The system is called the Black Market Peso Exchange (BMPE) because its purpose is to facilitate "swaps" of dollars owned by the cartels in the United States for pesos already in Colombia, by selling the dollars to Colombian businessmen who are seeking to buy United States goods for export . . . the Black Market Peso Exchange system operates through brokers who purchase narcotics proceeds in the United States from the cartels and transfer pesos to the cartels from within Colombia. The dollars are placed - that is, "laundered" - into the U.S. financial system by the peso broker without attracting attention; the dollars are then "sold" by the brokers to businessmen in Colombia who need dollars to buy U.S. goods for export; and goods ready for export are often actually paid for by the peso broker using the purchased narcotics dollars on behalf of the Colombian importer. This underground financial and trade financing system is a major - perhaps the single largest - avenue for the laundering of the wholesale proceeds of narcotics trafficking in the United States. It also reflects the desire of Colombian importers (who might otherwise be legitimate businessmen) to avoid paying extensive Colombian import and exchange tariffs by smuggling goods into Colombia. Finally, this system exploits U.S. exports in the recycling of narcotics dollars. The U.S. Customs Service believes that the "United States exports that are purchased with narcotics dollars through the BMPE system often include household appliances, consumer electronics, liquor, cigarettes, used auto parts, precious metals, and footwear."  

 

4 This approach is the modus vivendi of the Certified Fraud Examiner. The available literature is generously laced with this approach as the initial starting point of any fraud examination.  

 

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