In times of financial downturn and diminishing returns, complicated corporate frauds that were previously hidden by the previous successful expansion of a business often emerge. The current recession, sparked by the credit crunch, is no exception and we have seen a number of cases over the past year in which sophisticated and long running frauds have been revealed, exposing investors and creditors to substantial losses.  

Fraudulent schemes that are reliant on fresh streams of income are quickly unmasked when that source of income dries up. In this month's newsletter, we highlight:  

  • some recent cases in the media and issues we have that we have come across over the last six months that affect Japanese companies; and
  • practical tips for minimising the risk of fraud.  

Recent cases and issues affecting Japanese companies  

The last year has seen a number of high profile claims in which the victims of frauds, often financial services companies, have sought to recover large sums of money.  

Ponzi schemes  

The Madoff scandal highlights how a huge fraud can go undetected for years, and in this case despite the US authorities carrying out two investigations into the fraudulent company. Many banks and financial institutions poured money into Madoff's fraudulent Ponzi scheme, and it would appear that in many cases, this was carried out without adequate due diligence. With the economic downturn creating cash flow difficulties coupled with a restricted credit environment, it increasingly became difficult for Madoff to disguise the missing funds. The United States Securities and Exchange Commission has described this as "a stunning fraud…of epic proportions".

The Stanford scam is another allegedly fraudulent Ponzi scheme, where Sir Robert Allen Stanford is accused of misappropriating approximately $8 billion of investors' money. Stanford has denied the allegation that for years Stanford International Bank duped savers by lying about the performance of their savings. Banks affected include those in Antigua, Venezuela, Ecuador, Colombia, Peru and Panama.  

Complex trading structures and internal credit risk procedures  

International trade arrangements often involve complex transactional structures, and we are increasingly seeing disputes arise where such structures, although they showed no signs of difficulties when the economy was buoyant, quickly fell apart when the economy collapsed to reveal exaggerated trading, fraudulent counterparties and major outstanding debts. Many of these frauds were only possible because the internal credit risk procedures established by the victims were not robust enough or were deliberately evaded.

Inconsistent risk compliance procedures across subsidiaries  

In other cases, it has been apparent that the companies involved in the fraud neglected to standardise their risk compliance procedures across all of their group companies and subsidiaries. This has created a situation in which individual members of staff, often in overseas offices, can make representations and decisions on a fraudulent basis without risk of the fraud being uncovered by the central compliance function of the company.  

Insufficient due diligence on investments made into Japan  

Many foreign companies who entered the Japanese market a few years ago neglected to carry out proper due diligence. These companies invested at a high-pace and did not research the market they were entering, nor did they have a proper system of safeguards in place to ensure that their investment was protected.  

Practical tips for risk compliance procedures  

One of the likely fallouts of the current economic downturn is increased regulation of companies and markets, and we have already seen governments take steps to introduce new regulatory regimes for this purpose. It is to be expected that one of the features of such increased regulation will be that companies will be required to improve their internal risk, compliance and regulatory procedures so as to ensure that the risk of fraudulent activity is minimised.  

However, in the meantime, and in anticipation of the likely measures that will be required, the following is a list of practical steps that companies should take in order to reduce the risk of fraud:  

  • Maintain internal controls - operate proactive fraud risk management reviews and regular internal audits.
  • Create an effective reporting structure - allocate a senior member of management or a board member with fraud-reporting responsibility.
  • Provide training to all staff about fraud awareness and prevention and ensure that employees are aware of their reporting duties.
  • Follow up on unusual employee behaviour (e.g. an employee not taking holiday entitlement may be an attempt to ensure that the fraud is not discovered in his absence).
  • Standardise the monitoring of all subsidiaries, both domestic and international.
  • Ensure that there are internal fraud investigations procedures in place to assist with the efficient management of an investigation.
  • Consider insurance implications – ensure that notification requirements are followed on discovery of a fraud and check if the costs of liaising with an investigating authority are covered.