St. Valentine's Day Massacre (revisited)

Alex was the assistant operations manager of a sports dome in a large city in Washington state. Because he was in a key position within the entity, he was able to compromise the internal control system by colluding with a legitimate vendor to manipulate purchasing transactions and cause his employer to issue disbursement checks for personal benefit. This false billing scheme resulted in losses of $491,829 within 10 years.

In the ACFE's Fraud Tree, false billing schemes are a subset of fraudulent disbursements, which is a subset of cash schemes. A false billing scheme attacks the disbursement and payable cycle with bogus claims that induce the victim organization to unknowingly issue fraudulent payments for goods or services, which it never received.

The perpetrator of these schemes usually is an individual whose duties include authorizing purchase transactions on behalf of the entity. However, in this case, the perpetrator approved his own purchases, even though this act wasn't part of his normal duties and responsibilities. After he approved the fictitious transactions, they continued through the normal disbursement cycle until the entity created valid checks for the expenses. The end result was that the perpetrator purchased many assets for personal benefit.

Collusion among employees is sometimes used to overcome a strong internal control environment. In this false billing scheme, the collusion was between the assistant operations manager (the employee on the inside) and a legitimate vendor (a company representative on the outside) who was very hungry for business from the sports dome.

Collusion is difficult to detect through normal audit procedures because no one can “see” the unauthorized or hidden activity in the background. Therefore, informed individuals who provide tips to the proper authorities about inappropriate activities detect most collusion cases.

ST. VALENTINE'S DAY MASSACRE

When gangsters murdered seven men on Valentine's Day in 1929, this brutal Chicago massacre became the most notorious gangster killing of the Prohibition Era. It involved hostilities between two rival gangs — one led by Al Capone and the other by George “Bugs” Moran. No one was ever tried or convicted for these murders. However, the massacre brought Al Capone to the attention of the federal government. The rest is history, with Capone later convicted of federal tax evasion.

How does this past event relate to this false billing scheme? Well, only because the fraudster's 10-year run of raiding the treasury of the city's sports dome came to an abrupt end on this lovers' holiday. Unlike the Chicago murders, city police officers didn't fire any shots when arresting the assistant operations manager for fencing stolen property through multiple pawn shops. The police nabbed Alex during a traffic stop that specifically targeted him. He was on one of his frequent automobile trips to purchase items on behalf of the sports dome (and then later sell for personal benefit).

BEHIND-THE-SCENES ACTIONS THAT SPAWNED THE SCHEME

Alex was the No. 3 executive at the city's sports dome. One of his duties was to process bid requests for the facility's maintenance and operations equipment. As the organization's focal point for these purchasing contracts, he naturally became personally acquainted with the business managers for the vendors that supplied items for the sports dome.

After Alex observed several years of bidding activity, for some unknown reason he became concerned that the vendors who submitted the winning bids on these purchasing contracts most frequently were located in a larger nearby city. He was determined to find out why, so he met with the major vendor in his city who had unsuccessfully bid on many of the prior contracts. After exploring all the options, it became clear to Alex that this vendor would never be a successful bidder because of the pricing structure resulting from its overall operating costs.

Alex then began negotiations with this vendor in an attempt to bring winning contract bids to his city. He was honest when he told the vendor that he would never be a successful bidder under any circumstances. So, the vendor would have to play by Alex's rules.

Alex and the vendor made a secret, verbal agreement. They reasoned that no one could blow the whistle on them because the deal wasn't on paper.

Once the vendor agreed to participate in irregular purchasing activities, Alex began a scheme to purchase assets for personal benefit by using their agreement to his advantage.

Alex first ordered fixed assets — electric motors and chain hoists, for example — from the vendor. When he picked up these purchases at the vendor's business location, he gave his accomplice a sheet of paper detailing exactly how he wanted the vendor to bill the city for a transaction. Instead of listing a fixed asset purchase on an invoice, Alex told the vendor to submit several small invoices to him for payment of consumable items over the next several months. After the vendor completed the billing process as Alex instructed, the vendor received full payment for the fixed assets Alex purchased even though the vendor had to wait for a delay in payment — a nominal inconvenience to get the business.

Because the vendor submitted invoices for consumable items over a period of time, the city's accounts payable staff didn't notice anything wrong with these transactions. This worked in Alex's favor because it also eliminated the need to account for the missing fixed assets at the sports dome because no one maintained accountability for consumable items.

Also, Alex set up everyone at the city for failure by falsely claiming that the traveling shows frequenting the sports dome routinely stole everything that wasn't nailed down at the facility. This representation was almost accurate because these traveling shows actually did take almost everything they could during visits to the sports dome. As a result, the staff expected to see repetitive purchases of consumables to replace the frequently lost or missing items. Alex stored the ill-gotten fixed assets in his garage and sold them whenever he could. Ironically, his primary customers were the various traveling shows that rented the sports dome. Alex's wife thought nothing about her husband's personal business venture. And the scheme was easy money.

Alex ran his illicit business for almost a decade. Then his personal illegal drug use escalated, and he quickly needed more money to buy cocaine. He changed his modus operandi and began abusing the city's business charge accounts to buy items, which he then sold at local pawn shops to get the money for his addiction.

The city police department detected this scheme when they were routinely monitoring stolen property reports from pawn shops. They asked: Why does the No. 3 manager at the sports dome keep showing up on multiple pawn shop reports? 

This change in schemes led to his arrest on Valentine's Day. To get some idea about how far out of control he was, losses from the pawn shop activity in the 2½ months of the final year of his scheme were as much as all losses during the entire previous year. (My advice to fraudsters is to not change schemes that have worked for long periods of time.)

VENDOR TRACKED ALL TRANSACTIONS WITH THE SPORTS DOME

The only reason the vendor agreed to enter into the collusion agreement with Alex was to increase sales. The good news, if there's such a thing in this case, was that this vendor was not all bad.

He knew the purchasing process was wrong, so he kept immaculate records on all the inappropriate transactions in case anyone should ever question them. The vendor retained all these records in a three-ring binder, including the invoices for the original purchase of the fixed assets, Alex's hand-written list of consumable items the vendor had to use to prepare invoices for the city and the actual invoices the vendor submitted to the city for payment.

The vendor immediately came forward to report his illicit business activity with Alex when it became public knowledge that the city's police department had detected the fraud and arrested Alex. The vendor gave all his records to the police investigators and became the major cooperating witness in this case. As a result, the vendor wasn't prosecuted and is still an important vendor supplying goods to many of the city's departments.

FALSE INVOICE

Study one of the actual false vendor invoices (below). The invoice contains several red flags that the sports dome management, the city and the city's external auditors didn't detect for a decade. Would you have been able to spot one or more of these clues before the city's police department detected the fraud by other means? 

[Figure 1 is no longer available. — Ed.]

LESSONS LEARNED

Let's review some of the finer points of fraud detection that we've learned so far from this false billing scheme case study.   

• Entities should always establish an appropriate separation of duties between employees in the purchasing cycle who order merchandise, sign the receiving reports and approve the invoices for payment. 
• Fraud examiners should carefully review purchasing invoices to identify red flags that make the transactions high risk and worthy of additional research.  

 PART TWO OF THIS CASE STUDY

I'm sure you have many questions about this case. However, I can't yet divulge any additional information. So, hold your thoughts until the next issue of Fraud Magazine. Sometimes, suspense is grand.

Regent Emeritus Joseph R. Dervaes, CFE, CIA, ACFE Fellow, is retired after more than 42 years of government service. He's president emeritus of the ACFE's Pacific Northwest Chapter.

 

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