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Identifying Red Flags for Fraud

November 29, 2016

Silhouette of a discussion

Red flags are sets of circumstances or patterns that are out of the ordinary and may indicate that fraud or other misconduct may be occurring in a given organization. While they may not necessarily be violations in and of themselves, they can serve as early warning signs, thus allowing for more efficient reporting of fraud. As such, it is imperative that both employees and management be able to identify and recognize red flags for fraud, as this can help prevent losses and costly violations. 

It can often be difficult to detect red flags, especially if the patterns have been in place for long periods of time. Organizing red flag patterns into different categories can make it easier to analyze behavior and thus react or report accordingly. The following are various categories by which fraud red flags can be organized.

Recognizing Fraud — Types of Red Flags for Fraud

When dealing with red flags for fraud, it helps tremendously to organize them into various categories. Many company policies already do this, as it is a step toward training management and employees to be familiar with how fraud patterns work. Categories can include:

General Red Flags for Fraud

  • Missing documents
  • Excess purchases
  • Use of business funds for personal reasons
  • Conflicting statements (especially with fraud involving disclosure)
  • Stifling of reporting mechanisms

Behavioral Red Flags

  • Lifestyle changes, such as drug or alcohol use, or gambling
  • Significant personal debt or credit problems
  • Financial pressures such as medical debt, family problems, divorce, etc.
  • Refusing to take sick or vacation leave

Management and Director Red Flags

  • Disproportionate compensation schemes
  • Disregard for regulatory agencies or rules
  • Weak/non-existing internal controls
  • Frequent changes in external auditors, banking contacts, or bank accounts
  • Significant amount of downsizing in a healthy market environment
  • Sale of company assets under market value

Accounting Red Flags

  • Excessive or unaccounted for cash transactions
  • Unreconciled bank account statements
  • Unusual amount of expense items, supplies, or employee reimbursements
  • Sudden activity in inactive accounts

These are just some of the possible categories and corresponding red flags to keep an eye out for. The important thing is to train team members to be cognizant of red flags, and to learn what options they have for internal and external reporting. The success of the company can depend on such vigilance and willingness to take steps toward preventing fraud. 

Differences in Fraud Across Industries

Besides these different categories of fraud red flags, red flags can also differ across industries. For instance, red flags for financial or securities fraud can involve highly technical financial metrics and data, which might only be recognizable to a skilled professional working within the field. 

In comparison, healthcare fraud tends to involve many people and organizations; it can often involve an entire “web” or network of persons contributing to and perpetuating the fraud. These types of fraud can cost the company large amounts of profit and may affect shareholder interests, thus leading to additional litigation. In the healthcare industry, one needs to look for broader, more systematic flags of fraud, as the fraud can involve the entire processes of referral, prescription, marketing, and other channels. 

An example of this is in a recent case filed against American Renal Associates, Inc. (“American Renal”). The case alleges that the defendant American Renal was engaged in various fraudulent schemes steering patients away from Medicare and Medicaid plans into more expensive ones, in order to obtain greater reimbursements. In these types of cases, the red flags might involve long-standing, complex patterns that can take weeks or months to unfold.

The case also involved false and misleading statements in connection with the company’s initial public offering (IPO). Thus, misrepresentation can have far-reaching effects beyond the parties that are directly affected by the fraud. It is important to consider the different nuances in fraud for each individual industry or sector being reported. 

Acting on Fraud Red Flags

The costs and negative consequences of fraud can be massive; beyond company lost profits, fraud can also result in:

  • Loss of shareholder confidence
  • Deterring of potential shareholders from investing
  • Legal consequences for violations
  • Lowered public opinion and perception of the company

Thus, it is important for companies and funds to have workable mechanisms in place for reporting fraud. Ideally, anti-fraud mechanisms should be built into company operating procedures.

Perhaps the most concerning consequence of fraud is that each incident or occurrence serves to perpetuate a culture of dishonesty and misrepresentation in corporate settings. It is especially important to be able to identify patterns of fraud in upper management levels and at the policy-making levels, as these can then filter down into more day-to-day operations (as was the case in the recent Wells Fargo scandal). In this regard, the cooperation and participation of whistleblowers is extremely valuable in the identification and reporting of corporate fraud. 

The fight against fraud is ongoing and will continue to be of great importance for the investment community. If you have any questions, concerns, or reports regarding corporate fraud, contact us today at Kessler Topaz. We represent investors and classes across the world, and are well-known for our work on behalf of major institutional investors. Our work is driven by the goal of protecting investors and consumers from fraud, misconduct, and abuse by businesses and fiduciaries.