Falsifying Government Claims and Insider Trading

Fraudsters are still skittering out of the woodwork to get their share of U.S. stimulus money. However, the federal government is hitting back vigorously. Here is how to protect your organizations and clients from government claim fraud and insider trading.

Excerpted and adapted from Chapter 5 of "Managing the Risk of Fraud and Misconduct: Meeting the Challenges of a Global, Regulated, and Digital Environment," by Richard H. Girgenti, J.D., and Timothy P. Hedley, Ph.D., copyright 2011 McGraw Hill. Additional contributors to this chapter are Graham J. Murphy, Amanda Rigby and Nimna Varghese.

The U.S. False Claims Act (FCA) — enacted in March 1863 to battle abuses of federal contractors during the Civil War — is a primary weapon aimed at helping stem the tide of false claims by government vendors. In 2010 alone, the U.S. government recovered more than $3.1 billion from organizations and individuals that prosecutors say had filed false claims for services or products.

In one recent case, the U.S. Department of Justice took action against an educational organization for falsely filing student recruitment information to obtain federal student aid. The top cases, however, have primarily involved allegations against pharmaceutical or health-care companies for billings made to Medicare and Medicaid. A published report says 80 percent of the fraud is in the health-care sector, though defense, education, transportation and oil and gas are also targets. Nearly 10 percent of the annual U.S. budget, by some estimates, finds its way into the hands of individuals and companies through such fraud.

Tough economic times, meanwhile, have exacerbated the situation — on both sides of the equation: individuals seeking to make a quick buck or simply meet a corporate sales goal will file a claim for payment for a service or product that was not delivered while the federal government's need to protect every last dime in the budget has forced stepped up investigations and enforcement actions.

The U.S. economic crisis that began in 2007 through 2008 has led to unprecedented amounts of federal spending, most notably the U.S. Troubled Asset Relief Program (TARP) and other economic stimulus programs enacted in late 2008 and 2009. It has also made scrutiny of potential government fraud, waste and abuse a mantra of the federal regulatory and law enforcement community.

Organizations now have more exposure to the risk of procurement fraud as governments at every level have increased investigations and prosecutions. Current efforts to expand U.S. governmental health care appear to assume that potential additional costs can be funded, in part, from the prevention and detection of fraud and waste.

The financial crisis has spawned new regulations and helped federal enforcement in the U.S. American Recovery and Reinvestment Act (ARRA, or Recovery Act) and the U.S. Fraud Enforcement and Recovery Act of 2009 (FERA). The financial crisis, the authorization of hundreds of billions of dollars in new federal funding and a desire to strengthen regulatory and oversight controls have put fraud, waste and abuse on center stage. New standards for transparency and accountability provide powerful incentives for companies to improve governance practices and related compliance and anti-fraud programs and controls. Whether an entity directly receives federal funding or is a federal contractor, few businesses are exempt from the expanding oversight.

In addition to the federal government's commitment to catch those who steal stimulus money, the feds are vigorously pursuing insider trading with data-mining techniques and wiretapping.

CFEs should be armed with the latest knowledge of federal regulations and investigative methods so they can further prevent and deter fraud in their organizations and for their clients.

TRIED-AND-TRUE FALSE CLAIMS ACT

The FCA has been the primary mechanism for recoveries in fraud actions in a broad cross section of industries doing business with the government, including health care, pharmaceutical, medical device, defense (including contracts in the Afghanistan and Iraq conflicts), oil and gas, computer, import-export and real estate and construction.

Universities and other educational and research institutions that receive government money also fall within the purview of the FCA. FCA actions have been brought in the areas of disaster relief and assistance loans and agricultural subsidiaries. The recent rash of foreclosures will likely result in additional FCA prosecutions for falsified applications for HUD-assisted mortgages.

Enacted in 1863 to curb corruption in the procurement of Civil War material, the FCA provides for substantial civil penalties and treble damages from any person or organization that makes a false or fraudulent claim to the U.S. government for money or property. Under the statute [False Claims, U.S. Code 31 (2009), §§ 3729-33 et seq.], a person can be held liable for "knowingly" 1) presenting or causing the presentment of a false or fraudulent claim for payment or approval, 2) making a "false record or statement to get a false or fraudulent claim paid or approved by the Government" or 3) conspiring to defraud the government "by getting a false or fraudulent claim allowed or paid." Point 2 is important, because it means that criminal liability need not involve proving that a fraud was committed — it is sufficient, and often easier, for the government to prove that there was a falsification of material fact simply by pointing to, for instance, a false statement on an application for federal moneys.

Qui tam is another important provision of the FCA; it is short for a Latin phrase, "qui tam pro domino rege quam pro se ipso in hac parte sequitur," which roughly means "He who brings an action for the king as well as for himself." The qui tam provisions of the FCA empower private individual whistleblowers (dubbed "relators") to file suit on behalf of the government and share in any recovery. For high-dollar frauds, the bounty can be lucrative: 15 percent to 25 percent of the total proceeds of a successful suit if the U.S. intervenes in the qui tam action and up to 30 percent if the U.S. declines, and the relator pursues the action alone.

Although the FCA was enacted in 1863, new laws and regulations continue to expand its reach. The FCA became a significant enforcement tool after Congress enacted amendments in 1986, including stiffer penalties and damages and the expansion of the rights of private citizens to bring actions. In November 2008, a new rule was finalized that amended the Federal Acquisition Regulation to require mandatory disclosure by federal government contractors of 1) violations of any federal criminal law involving fraud, conflicts of interest, bribery or illegal gratuities connected to any aspect of a federal government contract or subcontract; 2) violations of the civil False Claims Act; or 3) any "significant" overpayments on a contract. The mandatory disclosure must be made as a "timely" written disclosure, and contractors that violate these rules can face hard penalties, including suspension or debarment from government contracting.¹

As a result of the economic recession, states and municipalities facing similar financial pressures to those of the federal government have also passed false-claims laws. These new laws have been critical in many fraud investigations at the state level in health care and other industries. Effective January 2007, Section 6031 of the Deficit Reduction Act of 2005 offered a financial incentive — a 10 percent reduction in Medicaid payment owed to the federal government — to states enacting false-claims laws that are "at least as effective" as the federal FCA.

In May 2009, the FERA was signed into law, which modified the FCA in a way that increases the liability exposure of every company that does business with the federal government, as well as those that provide goods or services that are reimbursed by federal funds. FERA legislatively overruled a 2008 Supreme Court decision [Allison Engine Co., Inc. v. United States ex rel. Sanders, 128 S.Ct. 2123 (2008)] that the FCA only applied to frauds directed against the federal government directly and not to frauds indirectly committed by subcontractors against prime contractors working on projects funded by federal dollars. This means that FCA liability may now be triggered by any false claim made to any recipient of federal money so long as that money is used to "advance a Government program or interest."

The practical implication is that FERA enhances law enforcement capabilities across a staggering array of federal programs and assistance areas, including financial services, energy, housing, health care, disaster relief, agriculture, education, defense and infrastructure.

Where does all this lead? In November 2009, the U.S. Department of Justice (DOJ) announced it had secured $2.4 billion in settlements and judgments in cases involving fraud against the government during its 2009 fiscal year ending September 30, almost double the $1.34 billion in penalties collected just one year earlier.3 According to DOJ statistics, a total of more than $21.6 billion was recovered under the civil FCA between 1986 and 2008. More than $14.3 billion was recovered from the health-care industry (broadly defined to include pharmaceutical and medical device industries), according to "Fraud Statistics—Health and Human Services," Oct. 1, 1986-Sept. 30, 2008.Two-thirds of the 2009 total came from health-care fraud recoveries, the biggest going to the Department of Health and Human Services (HHS) through its Medicare and Medicaid programs.²

Earlier in 2009, HHS announced the creation of the Health Care Fraud Prevention and Enforcement Team (HEAT), a task force to raise the level of interagency coordination in criminal and civil enforcement of health-care fraud. The Civil Division of the Justice Department is pursuing allegations of a variety of schemes including engaging in "off-label" marketing, which is the illegal promotion of drugs or devices that are billed to Medicare and other federal health-care programs for uses that were neither found safe and effective by the Food and Drug Administration nor supported by the medical literature; paying kickbacks to physicians, wholesalers and pharmacies to influence drug or device purchases; establishing inflated drug prices for federal reimbursement and then marketing the "spread" between federal reimbursement and the provider's lower cost; and failing to report accurately the "best price" for a drug in order to reduce rebates owed under the Medicaid program.³

Because health care is such a significant proportion of all federal spending, a lightning rod for cost and funding debates and a rich environment for abuse, safeguarding the integrity of government programs in this area is expected to remain a top law enforcement priority.

Of course, there are other new laws that will likely influence FCA enforcement in the near term. Speaking about the American Recovery and Reinvestment Act (ARRA) of 2009 and TARP only a month after ARRA became law, Earl Devaney, chair of the Recovery Act Transparency and Accountability Board, observed, "I'm afraid that there may be a naive impression that given the amount of transparency and accountability called for by this act, no or little fraud will occur. My 38 years of federal enforcement experience tells me that some level of waste and fraud is unfortunately inevitable." Devaney gave his comments in the March 13, 2009, article "Stimulus Overseer: Waste ‘Inevitable,' " in The Washington Times.

Following that increasingly common view, the inspectors general of almost all federal agencies have increased their staffs with additional funds through ARRA and have been vocal about enhancing and implementing additional anti-fraud programs and controls to carry out their mandate.

At a 2009 conference cosponsored by KPMG LLP and Willkie Farr & Gallagher, Neil Barofsky, the (now former) special inspector general for TARP (SIGTARP), observed the challenge for his office: "You can't push $3 trillion out as quickly as the government is without there being opportunities for them to corrupt the process. We want to make sure that those considering crossing the line know someone's watching." Barofsky was quoted in the Oct. 4, 2009, article, "Neil Barofsky: Bringing Transparency to TARP," in The Metropolitan Corporate Counsel.

Through Sept. 30, 2009, SIGTARP had opened 61 investigations and had 54 ongoing criminal and civil investigations. These investigations cover complex issues concerning suspected TARP fraud, accounting fraud, securities fraud, insider trading, bank fraud, mortgage fraud, mortgage servicer misconduct, fraudulent advance-fee schemes, public corruption, false statements, obstruction of justice, money laundering and tax-related investigations.

In the case of organizations accepting government funding or working with the government, there should be a heightened sense of awareness of the possibility of procurement and contracting fraud. Some of the measures an organization may institute to prevent and detect such instances include the following:

• A written code of ethics that, in addition to establishing general standards of business conduct, also addresses permissible and prohibited employee interactions with government officials, including specific limitations on gifts, entertainment and political contributions as well as what constitutes lobbying. Since prohibited interactions with government employees and government contracting requirements vary not only between the states and federal governments, but also from state to state, the code should also provide appropriate guidance to employees in all locales in which an entity operates and, at the same time, be detailed enough to address issues specific to certain geographies.
• Do not leave nuances of the code to the interpretation of the employees and provide adequate guidance to the employees to allow them to act judiciously. Since the requirements of government contracting can be challenging to understand, even among those experienced in such activities, many leading organizations have established government contracting units or positions within the general counsels' offices to provide guidance. Some have even gone further, requiring deal boards to approve all government proposals and contracts. To effectively navigate the various state and federal laws on pay-to-play activities, some organizations require preapproval for any gifts, entertainment expenses or political contributions to ensure compliance with the myriad requirements.
• Hold periodic training for the employees who deal with government officials to help them understand their responsibilities in interacting with those officials, including pay-to-play requirements, lobbying considerations and requirements for government contracting.
• Monitor and oversee interactions with government agents or government employees via the compliance group within an organization.
• Put in place hotlines or an ombudsman for employees, customers, suppliers, investors and other key stakeholders to alert the organization regarding a potentially fraudulent matter. Such a mechanism should be accompanied with protection for the whistleblower from purported retaliation.
• Provide adequate resources to the compliance group members so that they can help the organization meet expected ethical standards.
• In the case of an entity that deals with governmental or quasi-governmental agencies, when an employee of the organization acting as the latter's agent engages in a fraudulent act, or the organization itself is a victim of fraud, the entity should inform the appropriate regulatory agency.

Many more measures and mechanisms may be instituted; ultimately, the organizations should choose one action or make one decision over another, which may result in negative consequences.

INSIDER TRADING: LAW ENFORCEMENT IS LISTENING

In late 2009, the DOJ and the Securities and Exchange Commission (SEC) announced an unprecedented insider-trading scheme allegedly perpetuated by Raj Rajaratnam, the founder of the hedge fund Galleon Group. With each passing day, more details emerged that suggested far-reaching implications for the hedge fund industry, which was still reeling from the impact of the recent market crisis. The Galleon matter represented the first time that court-authorized wiretaps had been used to target significant insider trading on Wall Street.

In unveiling the case against Galleon and its founder, U.S. Attorney Preet Bharara said:

Today, we take decisive action against fraud on Wall Street. This case should be a wake-up call for Wall Street. It should be a wake-up call for every hedge fund manager and every Wall Street trader and every corporate executive who is even thinking about engaging in insider trading. As the defendants in this case have now learned the hard way, they may have been privy to a lot of confidential corporate information, but there was one secret they did not know: we were listening. Today, tomorrow, next week, the week after, privileged Wall Street insiders who are considering breaking the law will have to ask themselves one important question: Is law enforcement listening?

Illegal insider trading refers to buying or selling a security in breach of a fiduciary duty or other relationship of trust and confidence while in possession of material, nonpublic information about the security. The prima facie insider trading case is a simple exchange of cash for misappropriated, nonpublic material information. In the case of Galleon, the DOJ and the SEC alleged that Rajaratnam went too far for a trading edge. They described a tangled web of hedge fund managers, analysts, C-level executives and consultants who all traded tips with one another. The quid pro quo often involved money, sensitive information or sometimes even the promise of future favors.

There may be more such cases going forward, especially as the SEC expands its use of sophisticated data-mining systems to track suspicious trading patterns. Ironically, the activities at Galleon were discovered by traditional techniques that are most often used in organized crime, such as wiretaps and informants.

The rules governing the broad definition of illegal insider trading stem from Section 10(b) of the Securities and Exchange Act of 1934.

Rule 10b5-1, Trading "on the Basis of" Material Nonpublic Information in Insider Trading Cases, lays out the conditions when a transaction may be deemed to be "on the basis of" material nonpublic information. Subject to the affirmative defenses in Rule 10b5-1, a purchase or sale of a security of an issuer is "on the basis of" material nonpublic information about that security or issuer if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a preexisting plan, contract or instruction that was made in good faith.

Rule 10b5-2, Duties of Trust or Confidence in Misappropriation Insider Trading Cases (from the U.S. Securities and Exchange Commission Selective Disclosure and Insider Trading Act, Exchange Act Release Nos. 33-7881, 34-43154, IC-24599), clarifies how the misappropriation theory applies to certain non-business relationships:

• "Whenever a person agrees to maintain information in confidence;
• "Whenever the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality; or
• "Whenever a person receives or obtains material nonpublic information from his or her spouse, parent, child, or sibling, provided, however, that the person receiving or obtaining the information may demonstrate that no duty of trust or confidence existed with respect to the information, by establishing that he or she neither knew nor reasonably should have known that the person who was the source of the information expected that the person would keep the information confidential, because of the parties' history, pattern, or practice of sharing and maintaining confidences, and because there was no agreement or understanding to maintain the confidentiality of the information."

Subsequent legislations in 1984 and 1988 codified in Section 21A of the Securities Exchange Act include civil penalties for insider trading violations of up to three times the sum of profit gained or loss avoided by any person purchasing or selling a security while in possession of material nonpublic information; in the case of controlling persons, the monetary penalty shall not exceed the greater of $1 million or three times the amount of the profit gained or loss avoided as a result of such controlled person's violation.

As information has become increasingly commoditized, hedge funds have relied on everyone from doctors and meteorologists to corporate executives to give them an informational edge. This has created more ambiguity as to when engaging in legitimate, shoe-leather research and trading rumors ends and when illegally paying for market-moving information begins. With more sophisticated tools at its disposal, the SEC has increased its scrutiny of potential insider trading violations. Figure 1 at left shows the SEC's year-by-year enforcement of insider trading. The SEC brought 61 enforcement actions in 2008 versus 42 actions in 2004. [Image no longer available. —Ed.]

In 2009, the SEC's Enforcement Division announced that it was launching national specialized units, three of which will focus on derivatives and securitized products, broad-based insider trading and market manipulations and fraud among hedge funds and investment advisors. Some recent actions by the SEC highlight the pervasiveness of insider trading across industries and geographies and the increased scrutiny by regulatory agencies on insider trading and other market abuses.

• The vice chair of International Securities Exchange Holdings Inc. (ISE), along with two of his associates at a financial consulting firm, Marshall Tucker & Associates LLC, traded on material nonpublic information regarding the merger of ISE and Eurex Franfurt AG that resulted in illegal profits of more than $1 million. The SEC action occurred at the same time as a criminal complaint against the three men in the U.S. District Court for the Southern District of New York, according to the March 13, 2008, SEC release, "SEC Charges Vice Chairman of ISE Holdings and Business Partners with Insider Trading."
• An Italian resident, Cristian De Colli, used insider information on a potential merger between DRS Technologies, Inc., an American company, and Finmeccanica S.p.A, an Italian aerospace company, to reap illegal profits of $2.1 million on an initial investment of approximately $422,000, according to the May 16, 2008, SEC release, "SEC Obtains $2.1 Million Emergency Asset Freeze and Charges Rome resident within Days of His Alleged Insider Trading." This move by the SEC highlights the fact that enforcement action against insider trading has assumed greater priority.
• The SEC charged seven individuals and two companies involved in an insider trading ring, alleging that Matthew Devlin, a former registered representative at Lehman Brothers Inc., traded on and tipped his clients and friends with confidential, nonpublic information about 13 impending corporate transactions. Some of the individual's clients and friends, three of whom worked in the securities or legal professions, tipped others who also traded in the securities of the companies involved in the transactions, according to the Dec. 18, 2008, SEC release, "SEC Charges Wall Street Professionals and Others with Widespread Insider Trading." In this instance, the illegal profits amounted to $4.8 million.

In a speech on Nov. 5, 2009, Robert Khuzami, director of the SEC Division of Enforcement, said:

There is a basic principle that governs our capital markets, and that is that there is one set of rules, and everyone is expected to play by that one set of rules. That principle gives investors confidence that the markets are fair. Insider trading is a corruption of that basic principle. ... Those who commit insider trading, who think that there are two sets of rules, run the risk of detection by law enforcement. And that is a trade with only one rule — and that rule is, if we prove our case, your misconduct will be known to all, you will be penalized, and you may well go to jail.

PREVENTING INSIDER TRADING

Some of the measures that can be initiated by management to prevent illegal trading include the following:

• As with every compliance program, a strong code of ethics defines insider trading and encourages personnel to not do it. For instance, investment advisors subject to the Investment Advisers Act of 1940 Rule 275.204A-1 are required to establish, maintain and enforce a written code of ethics that, at a minimum, establishes standards of business conduct and reflects fiduciary duties. The code should set out ideals for ethical conduct premised on fundamental principles of openness, integrity, honesty and trust. In the wake of scandals like the Galleon case, companies outside of financial services may need to rethink whether and how their codes of ethics approach insider trading.
• Most importantly, make the code of ethics easily accessible. Further, create appropriate means to resolve any doubts or queries employees may have on certain requirements in the code, for example, a dedicated legal and compliance team for personnel issues and a summary of frequently asked questions.
• Set up ethical wall barriers within the organization to prevent the appearance of, or the actual sharing of, information among groups with conflicting business interests. Material nonpublic information should be limited to individuals on a "need to know" basis. The ethical barriers should be a combination of physical and technological segregations.
• Give all employees periodic training on both the legal framework within which the company operates and the different types of activities that are or appear to be insider trading.
• The training should also highlight to the employees that not only may insider trading be dependent on one's actions, but that providing information to another may also be construed as such in the eyes of the regulators, thereby explaining the relevance of being vigilant. Some companies instruct employees to end conversations with third parties the moment these conversations begin to give the employee more information than the employee needs to know. Following periodic training, ask employees to certify their understanding of what is being required of them. Retain such certifications.
• Have stringent rules around personal trading by employees. In the case of global organizations, make the rules region-specific and adhere to the company's code of ethics. Employees may be required to obtain prior approval before directly or indirectly acquiring beneficial ownership in any security in an initial public offering or in a limited offering. The purpose is to help employees not misappropriate investment opportunities that should first be offered to eligible clients or that employees do not receive a personal benefit for directing client business or brokerage. Require that employees report their personal holdings and transactions on a periodic basis.
• Set up mechanisms to report any violations of the code of ethics promptly to the chief compliance officer or to any other person designated in the code of ethics. Create an environment that protects persons who report violations and encourages them to speak freely, such as preventing retaliation or permitting anonymous reporting.

COMPANIES NEED TO TAKE HEED

The U.S. federal government is vigorously pursuing those who are falsifying claims and insider traders. Ensure that your company is not caught in the new snares. Learn the new regulations and communicate preventive and deterring anti-fraud practices. The feds are not only listening; they're taking names.

Richard H. Girgenti, J.D., CFE, leads KPMG's LLP's Forensic Services. He is a former KPMG board member, a veteran state prosecutor and a previous director of criminal justice for New York State.  

¹ Federal Acquisition Regulation, Subpart 52.203-13 (December 2008); Federal Acquisition Regulation, Subpart 9.406-2 (August 1995); Federal Acquisition Regulation, Subpart 9.406-2 (August 1995); Federal Acquisition Regulation, Subpart 9.407-2 (August 1995). 
² Department of Justice, "Justice Department Recovers $2.4 Billion in False Claims Cases in Fiscal Year 2009"; Department of Justice, "More than $1 Billion Recovered by Justice Department in Fraud and False Claims in Fiscal Year 2008." 
³ Ibid. 
 

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.