Weights That Don’t Measure Up: False Billing Scheme Case Study (Part 2)

This column was adapted from a case study by Joseph R. Dervaes, CFE, ACFE Fellow, CIA, that was published in “Fraud Casebook: Lessons from the Bad Side of Business,” edited by Joseph T. Wells, © 2007 by the Association of Certified Fraud Examiners Inc. Published by John Wiley & Sons Inc. Available in the ACFE Bookstore. 

Part 1 of this false billing scheme case study in the July/August issue discussed the perpetrators, the organization, and the initial investigation of a huge disbursement fraud. This column discusses the investigation, lessons learned, and recommendations to prevent future occurrences of false billing schemes.

To summarize the case, a legitimate vendor named “Richard” submitted false invoices to the Washington State Liquor Control Board and received almost $840,000 in unauthorized payments over a three-year period for services he didn’t provide. “Gerry,” an accounts payable clerk, processed the fraudulent transactions. These transactions included inflated weights on legitimate deliveries, deliveries that didn’t occur, and duplicate billings. In fact, 76 percent of all invoices from this vendor were false!

THE INVESTIGATION 

Perhaps due to a guilty conscience, Gerry eventually hired a lawyer. Upon the advice of her attorney, she disclosed the details of Richard’s scheme to state authorities. Gerry’s disclosure came to me for investigation because I was the audit manager for special investigations in the Washington State Auditor’s Office. After making an initial assessment of the scope of this case, I appointed my colleague, Franklin Smart, to review all payments Gerry’s employer had made to Richard’s firm during the five years of his vendor contract.

As we began the investigation, Smart and I believed we might have our hands on one of the largest fraud cases ever investigated by our office. Smart spent six laborious months entering the case’s information into a database. I then verified the accuracy of the information and Smart’s conclusions prior to completing the audit. All of Gerry’s allegations were confirmed. This, indeed, was the largest fraud case we’d ever investigated. It was a complicated case that demanded a tremendous amount of coordination among several agencies to resolve.

First and foremost, there was the Washington State Liquor Control Board. The executive director made all staff available for the audit and police investigation. In addition, the board’s internal audit staff was responsible for assembling all freight vendor invoices from its disbursement files and all freight delivery documents from its central warehouse.

The liquor control board provided office space for the auditors and police investigators who worked on the case. The internal audit staff analyzed a sample of the fraudulent transactions to demonstrate that Richard’s firm was, in fact, overpaid. The control board used this information to suspend him from performing future work. The state patrol used this same information to establish probable cause for the bank subpoenas needed for the police investigation.

Our office auditors used computer-assisted techniques to identify all payments the liquor control board made to Richard’s firm. The auditors and police investigators worked closely to ensure the information the auditors developed would be exactly what the police investigators needed to build their case against Richard.

Our office also created a database of all the fraudulent transactions including vendor invoices, agency disbursement documents, the checks, and documents for all freight shipments from the central warehouse. The auditors analyzed the information in the database and calculated the loss amount. (Strangely enough, the auditors also determined that Richard hadn’t submitted invoices to the liquor control board for some legitimate deliveries he had actually made.)

The state patrol reviewed the results of the audit, conducted all interviews, subpoenaed Richard’s business and banking records, and made recommendations for charges to the county prosecutor. Representatives from the attorney general’s office and our office provided legal guidance throughout the audit and police investigation.

The Washington State Treasurer’s Office initially had custody of the original checks associated with the case. Once the auditors prepared a list of the fraudulent disbursements, the treasurer’s office removed the checks used in the scheme from its files and carefully placed them in plastic bags to preserve fingerprint evidence. The treasurers’ office then delivered them to the state patrol, which used them in its investigation and held them in case they would be needed for any subsequent trial. All checks were made payable to and endorsed by Richard’s firm.

The county prosecutor in the state capital region prosecuted the case. During the course of the investigation and audit, the prosecutor met with the auditors, the state patrol, and Richard’s defense attorney. Ultimately, the prosecutor was able to arrange for a plea bargain to resolve the case. Richard agreed to make full restitution for the amount of the loss and audit costs. However, due to jurisdictional issues, the county prosecutor eventually transferred the case to another county prosecutor in the region where Richard’s firm was located. There was no trial.

AUDIT’S FINDINGS

The audit revealed several weaknesses that allowed this scheme to occur and go undetected for more than three years.

First of all, prior to making payments for services rendered, the accounts payable staff failed to compare reported deliveries or the weights of deliveries from freight vendor invoices to the central warehouse computer records of actual freight shipments.

Secondly, the liquor control board’s review of Richard’s invoices was inadequate. Gerry, an employee who was now assigned to a position outside the accounts payable function, received and approved Richard’s invoices for payment. She then gave the invoices to the accounts payable staff to process as if they’d received them normally. A subtle compromise of the accounts payable system then occurred when Richard’s checks made a “u-turn” in the check distribution section and were returned to Gerry for hand delivery to Richard.

Finally, Richard’s firm wasn’t required to submit original invoices to the agency for payment. Instead, he submitted invoices by fax, and it accepted and processed them.

IDENTIFYING THE SCHEMES 

Here are summaries of the fraudulent transactions of the case:

• Inflated weights on legitimate deliveries ($123,161.12 in losses): Payment for deliveries was determined by multiplying the weight of the freight load by the rate established in a contract between the state board and all freight vendors. Richard made 1,103 freight deliveries during the audit period. He inflated 600 of these deliveries by more than 5,000 pounds (i.e. 54.39 percent of all deliveries).
• Deliveries that didn’t occur ($600,527.84 in losses): Richard submitted 1,100 invoices that reported 1,370 deliveries that never occurred.
• Double-billing ($116,017.94 in losses): Richard submitted 238 invoices that requested payment for 273 deliveries that the state board had already paid.
• Unbilled legitimate deliveries: Richard didn’t bill the state board for 382 legitimate deliveries that were valued at almost $68,000. The auditors gave him credit for this oversight, which reduced the total loss to $771,863.59.

During his five years with the liquor control board, Richard sent invoices that totaled $1.1 million. Almost 76 percent of these invoices were bogus.

THE FALLOUT 

When state patrol officers visited Richard’s home to arrest him, they discovered that he had fled the state to avoid prosecution. The state formed a regional fugitive apprehension task force to track him down. Richard remained on the lam for six months. Acting on a tip, U.S. marshals traveled to another state and arrested Richard without incident at a friend’s home. He was temporarily held in a county jail, waived extradition, escorted back to his home state, and placed in jail to await prosecution for his crime.

“Richard doesn’t have anything left but memories. He’s penniless. The proceeds from the scheme have been squandered,” the county prosecutor said. Richard even qualified for a public defense attorney because he was broke.

Richard eventually pleaded guilty and went before a superior court judge. His defense attorney tried to obtain a reduced sentence by citing that Richard was a first-time offender who had drug and alcohol problems. The judge denied first-time offender status based on the length of the scheme. Each false bill Richard submitted was considered a separate event, and practically all counts in the case involved first-degree theft – the most serious crime in the state.

“Drug and alcohol rehabilitation can be obtained while he is serving his time in the state penitentiary,” the judge assured Richard and his lawyer. The judge then sentenced Richard to 57 months’ confinement in the state penitentiary – the maximum sentence permitted for this crime by state law. The court also ordered restitution for the full amount of the loss plus audit costs. The likelihood that Richard will repay any money to the state is slim to nil.

Gerry, who had disclosed the details of Richard’s scheme to the liquor control board, was placed on administrative leave pending the outcome of the audit. After the state auditor’s office issued its report, the board terminated Gerry for neglect of duty, gross misconduct, and willful violation of the organization’s rules and procedures. Her case was also referred to the State of Washington Executive Ethics Board for violating the ethics law applicable to all state employees.

Gerry wasn’t prosecuted as an accomplice in this case. Instead, the prosecutor decided to use her testimony as a cooperating witness against Richard if necessary; she’d unknowingly assisted Richard in perpetrating this crime at first, and then she blew the whistle on his fraudulent billing scheme. These findings worked in her favor.

Richard was the only individual who received the proceeds of the scheme. Gerry merely enjoyed some of the benefits from these funds, while Richard spent the money on an extravagant lifestyle. However, before agreeing to this resolution, the county prosecutor insisted that Gerry return the final $4,000 that she hadn’t yet returned to Richard from the $10,000 loan he’d given her. She did.

TIGHTENING UP INTERNAL CONTROL WEAKNESSES 

The liquor control board’s auditors learned a great deal about fraudulent billing schemes because of this case. In the future, managers will look for a “straight line” from the initiator requesting payment to accounts payable staff and the individual distributing the checks. The risk of fraud increases when a check makes a u-turn in the accounts payable or check distribution functions and is returned to the initiator or to an accomplice, as in this case. Transactions such as these automatically become exceptions to the internal control structure and require intense scrutiny and monitoring.

Any compromise of the accounts payable system will be documented on a manual exception log to identify all transactions that have been processed outside normal parameters. These compromises include any type of written or verbal communication that employees make with the accounts payable or check distribution staff. It also includes picking up checks after issuance when it’s not the organization’s normal procedure.

Managers also periodically review the manual exception log. If any undesirable trends are identified, the managers review the validity of the supporting documents for each transaction, as well as the bank endorsements on the checks.

Accounts payable duties will no longer be performed by anyone who works outside the accounts payable function. Also, fraud examiners will examine vendor contracts in cases where the transaction analyses or analytical review procedures suggest high, increasing, or unusual volumes for specific vendors.

For example, the examiners might sort all expenditures by vendor and by accounting year and then list them from highest to lowest dollar amount. Then, the examiners will compare the current accounting year to the prior accounting year for unusual or unexpected variances. If something appears out of the ordinary, an explanation from management officials will be required. The examiners then will make a professional judgment about the conditions found.

If vendors are selected through competitive bidding, fraud examiners will review the contract selection files for completeness, determining if the selection process was documented properly and appears reasonable.

RECOMMENDATIONS FOR FRAUD PREVENTION 

In addition to the operational changes noted above, the following preventive measures were also recommended by the auditors:

• Conduct a comprehensive review of the company’s internal controls, accounting procedures, and management practices.
• Review all payments for accuracy regardless of the size of the transaction.
• Implement procedures to closely monitor the work of key employees.
• Train staff members on fraud and ethics matters. The financial division eventually received fraud training from the state auditor’s office, internal control training from the office of financial management, and state ethics law training from an attorney general’s office representative.

CASE IN REVIEW 

Let’s review some of the finer points of fraud deterrence and detection for false billing schemes, as illustrated in this disbursement fraud:

• Accounts payable staff should compare information from vendor invoices to the agency’s shipping records for agreement.
• No one outside the accounts payable function should perform accounts payable duties.
• The internal control structure is compromised when disbursement checks make a u-turn in either the accounts payable or check distribution functions.
• Management should review contract selection files for completeness and determine if the selection process was documented properly and appears reasonable.

The next series of articles will concentrate on another huge disbursement case study involving computer fraud. Stay tuned!

Regent Emeritus Joseph R. Dervaes, CFE, CIA, ACFE Fellow, is retired after more than 42 years of government service. He remains the vice chair of the ACFE Foundation Board of Directors.