At the Canadian Corporate Counsel Association’s spring conference earlier this week, MNP’s Greg Draper moderated a frank and provocative panel discussion on “Responding to Executive Misconduct,” where experts detailed strategies for prevention, detection and response to executive fraud.
The panel went beyond academic scenarios, though, and cited real cases like Hollinger, Niko Resources and Griffiths Energy to demonstrate what to do — and what not — when malfeasance is uncovered at your company.
The panel included:
- Draper, who is the VP of Valuations, Forensics & Litigation Support for MNP (and a former RCMP officer)
- Rob Kuling, Director, Internal Audit at energy services provider Tervita Corp.
- John Pozios, Director of the University of Manitoba’s Desautels Centre for Private Enterprise and the Law
Draper got the session started by citing some key stats from the Association of Certified Fraud Examiners. According to the ACFE’s 2012 global report, employee fraud is estimated to cost the global economy about 5% a year in revenue.
The average fraud for a low-level employee costs the company about $60,000, according to the ACFE. Frauds perpetrated by mid-level managers run around $180,000. Meanwhile, frauds at the executive or owner level average $573,000.
That’s a nice little pay day, to be sure, but Draper points out these are not material costs for the average public corporation. “You probably spend more on board lunches in a given year than some of the amounts involved. But it is something that you don’t want to see on the front page of the paper.”
Reputational risks, regulatory penalties, criminal convictions, and the consequent plunge in shareholder value — all these can destroy a company. Consider that, in the Hollinger case, after years of appeals and overturned convictions, only one fraud conviction stuck at the end of the day, relating to a $600,000 transaction attributed to Black.
While the conviction hinged on a financially immaterial transaction, the trial itself destroyed hundreds of millions of dollars in shareholder value, embroiling advisors like KPMG and Torys LLP, which paid millions in settlement.
“These events,” said Draper, “particularly at the executive level, are really an atomic bomb in the boardroom. These are circumstances that shape the foundations of trust.”
The irony, Draper noted, is that the immateriality of these fraud costs is precisely what makes them invisible to external auditors. “I think it’s very common for executives and board to say, ‘You know what, if the auditors are here once a year, and they haven’t found a problem, we’re good.’”
Tervita’s Kuling then went into more of the ACFE’s findings about employee fraud. … Apparently, 17% are committed by the owner or someone at an executive level; moreover, frauds at this level are usually detected 18 to 24 months after they’ve begun. “So if something’s going on,” said Kuling, “it’s probably been going on for about two years before the time that you’re going to detect it.”
The ACFE found that the most common way for detecting fraud was a tip: 43% of corporate fraud was discovered this way. Management reviews or internal audits also were a major factor in detecting fraud: 29% of frauds were discovered this way.
Among the least common mechanisms for detecting fraud were external audits (3%) and IT controls (1%). So, if you think your external audit combined with a great enterprise-management system is all you need, think again.
Kuling noted that, while boards are reluctant to implement a whistleblower hotline because they don’t like the idea of employees anonymously airing dirty laundry, these hotlines are highly effective–and also easily affordable, at about $1 per employee per year.
“It’s like a laser. It goes right into your organization and strikes right to the ethics of someone who might be up to something, and you find out quicker.”
Kuling also pointed out that, while a whistleblower program may seem like it’s more trouble than it’s worth, dealing with the occasional frivolous complaint is a lot better than having a whistleblower go directly to the Securities Commission or Department of Justice.
Moreover, Draper noted that it’s important to use an external service provider, rather than creating an internal hotline, so that employees feel assured that their confidentiality will be protected.
“It’s much better that people feel comfortable using an internal response or hotline … than to suggest that they have to go to the securities commission or to the police or to the media with an issue. It’s always much better to come to those stakeholders with answers, not questions.”
University of Manitoba’s Pozios was next, broaching the inherent conflict of interest between a general counsel’s duty to the company and their interest in supporting management. “Knowing, in your dual role … that perhaps management may not be giving the complete picture to the board, I think there are some inherent tensions in those roles.”
Pozios suggested that — just as the roles of chair and CEO have been split at many Canadian corporations — the board should consider going further and splitting the roles of general counsel and corporate secretary to the board.
The panel then listed some of the telltale signs that may point to instances of fraud. These “personal indicators” include:
- living beyond means
- financial difficulties
- “wheeler-dealer” attitude
- control issues
- divorce/family matters
- refusal to take vacations
- close vendor relationships
“People forget that [not taking vacations] is actually a very proven fraud indicator,” said Kuling, “because generally if somebody is doing something they can’t leave the job because the cycle of whatever they’re doing could be broken. … So, just some professional skepticism at your senior level might nip these things early.”
Kuling cited the case of Nick Lysyk, a BMO banker in Edmonton who seemed to be a diligent employee who was perceived as somewhat “nerdy” by co-workers. Outside the office, though, as Draper pointed out, his lifestyle was “hookers and muscle cars.”
The fraud (involving fake loans) was only uncovered when Lysyk was forced to take a vacation and a co-worker took over his loan portfolio. … By the time the investigation was complete, $15 million had been stolen.
Pozios then looked into the Hollinger case as an example of what not to do when stakeholders accuse the company of malfeasance. The dispute — as we all know by now — centred on “non-competition” payments made to Black and a a couple of the co-accused.
These payments, while objectionable to institutional investors like hedge fund Tweedie Brown,were not hidden. Tweedie Brown tried to convince the board that these particular payments — worth around $100 million — should have gone to shareholders, not to Black himself and a few of his cronies.
“This was a shareholder dispute that really had gone awry,” said Pozios. “This is probably something that could have been resolved if the CEO hadn’t been so obstinate. … Conrad Blake took the position: so sue me.”
Tweedie Brown, however, went one better: they went to the prosecution in the U.S. and suggested that what was happening was criminal — eventually leading to a 17-count indictment.
Pozios called Mark Kipnis — general counsel for Hollinger in the U.S. — a “tragic figure” in the case. Kipnis took no payments, aside from a $150,000 bonus, but was eventually convicted, put on probation and disbarred.
“The practical reality for Mr. Kipnis is that he was wiped out financially,” said Pozios. “As far as my research could tell, he continues to be unable to practice law in the state of Illinois, even though the conviction was overturned, and he currently holds a licence as a real estate broker. … So he’s gone from top-flight general counsel to selling real estate.”
“The question I always ask when I do this presentation is, ‘What would you have done differently? … It’s a very, very difficult question to answer, and the best I can come up with is, when things were starting to unravel, perhaps you couldn’t change history, but maybe as general counsel, as a senior member of the executive team, you had an opportunity to mitigate the damage to the corporation.”
“You have to ask yourself, is the CEO acting in the best interests of the corporation, and is there something we could be doing differently. Perhaps that means putting something in place, calling that person on to the carpet and doing something about it, and I realize it’s easy for me to say that. I’m not working for Conrad Black, who is a pretty big personality.”
Pozios then offered the case of Griffiths Energy as a diametric opposite, and an example of what could have been done differently in the Hollinger dispute.
The Griffiths case was the first voluntary disclosure litigated in Canada under the Corruption of Foreign Public Officials Act. It was discovered by executives that $2 million bribe was paid to the ambassador to Chad.
“This is an instance where the executives and the board decided that they knew about their conduct in Africa. They knew that the conduct could get them into some significant hot water under the CFPOA.”
Ultimately a penalty was levied was $10.35 million, but no probation was required. “They presented a complete investigation to the RCMP. They mitigated any further damage to the corporation and their reputation. They basically came clean.”
So what lessons can general counsel take from the session?
- Set up a whistleblower hotline: they’re cheap and your best line of defence against executive misconduct.
- Ensure the company has an internal audit in place: these are your second line of defence.
- Don’t rely on external auditors: the low costs of executive fraud make it invisible to auditors, who are looking for more than rounding errors.
- Separate the GC and corporate counsel positions: easier said than done for small companies, but worth considering.
- Watch out for “personal indicators”: these are telltale signs of fraud, like refusing to take vacations.
- When stakeholders come calling with legitimate complaints, don’t suggest they sue you: they just might.