Fraud investigation -  
a report from the battlefield

By Rio Lam

Fraud investigation is difficult and challenging. Sometimes an investigator must work under extreme pressure on a tight schedule. But it brings great rewards and satisfaction when the objective is achieved. Below is a recent personal experience.

The senior management of a NASDAQ listed company suspected that certain irregular practices were being carried out by its subsidiary in Shanghai, PRC. The incidents were discovered when a whistleblower sent an email to the group's regional director in Asia. Stunned by the dreadful news, the director reported the alleged events to the group's audit committee right away. The committee acted immediately and sought legal advice from the company's counsel. The preliminary opinion obtained was that the incidents, if proven to be true, could mean serious violations of both USA and PRC laws. As the group was preparing the release of its annual report at that time, it was of the utmost importance to look into the alleged activities, assess their magnitude, and estimate the financial impact on the subsidiary and the group as a whole. Our forensic investigation team was called in to carry out an investigation shortly afterwards.

Quick incident response
A telephone conference with the US client was held on a Monday morning at short notice during which it was decided that an urgent inspection of the subsidiary's offices was necessary. The client expected a preliminary report within two days so we caught the last flight of the day and by around midnight of the same day, we checked-in to a hotel on the Bund, Shanghai.

By Tuesday morning, we had summoned a specialist team comprised of China service consultants, forensic accounting experts, PRC tax specialists and China-based auditors. The specialist team met with the group's US counsels who had been in Shanghai for almost a week to make enquiries into the alleged irregularities. The meeting was positive and constructive but key information was not conveyed. Regrettably, and quite understandably, information obtained by the US counsels was subject to professional legal privilege and therefore was non-disclosable. After introducing us to a few key people in the subsidiary, the counsels retreated and we began our work.

Excuses! Excuses!
Although they appeared to be cooperative, the local management were reluctant and very careful not to disclose too much information at first. One of the first things that an investigator pays most attention to is records relating to the subject matter. Thus, as always, we asked the local management for certain records.

In most situations, an investigator is given various excuses, such as (1) the records do not exist, (2) they are kept elsewhere, (3) the records cannot be produced in a format as requested, and (4) it will take time to gather them. Moreover, very often the key person in a company who promises to provide the requested information during an investigation vanishes and becomes non-contactable. In this particular case, we were unfortunate enough to encounter all of the above situations. Luckily, we were well-prepared for it. Given that we had less than one day to conclude our work, we could not afford to play hide-and-seek. Therefore, the specialist team decided to move on to deploy the second protocol: interviewing people.

Effective interviews
The types of question used in an interview vary from case to case, but the principle is somewhat similar: we start with general questions and move on to specific ones. Statements obtained from one interviewee can become very powerful tools to induce another to speak the truth. In addition, when conflicting statements are taken, investigators can focus on the discrepancies and seek an explanation from the interviewees, which usually leads to new discoveries.

According to the email from the whistleblower, the local management and sales staff offered kickbacks to certain customers in order to secure sale orders. To get a better understanding of the matter, we spent the next hour interviewing the general manager (GM) of the subsidiary. Given that the US counsels had probably gone through this with him, the GM quickly admitted that kickbacks were in fact offered and paid. When we enquired about the amount and how they were made, we were told that the kickbacks were paid through a number of intermediary companies and amounted to a sum of roughly half a million US dollars for the last financial year. Understanding the basic structure of the scheme, we turned to the subsidiary's accountant and asked her the same questions. However, she was not as forthright as the GM. In fact, during the interview, she tried to downplay her role and involvement in the scheme as much as possible, which only raised our suspicions in respect of her. Finding her response somewhat unconvincing, we asked for the relevant accounting records and payment details relating to the kickbacks. Unsurprisingly, she began to be obstructive, using several of the common excuses mentioned above.

The hidden truth
It was clear that this lady was hiding something from us. As the accountant in the organisation, she was the keymaster to the vault. She was the person who knew more information about the scheme than anyone else. Her excuse that some documents were kept elsewhere was far from convincing - it simply did not make sense to us. So, as we were promised full cooperation by the US counsels and the GM, we returned to the GM's office for the second time and explained our concerns to him. He reconfirmed that full cooperation would be provided and offered to have a quick word with the accountant. After a short private meeting between them, the accountant agreed to gather the information as sought. However, the next thing we knew, she disappeared and was not seen again for the rest of the day!

We knocked on the GM's door for the third time and made it clear that we must be given full access to the relevant records, failing which we would have no alternative but to call-off the investigation and report to the US client. The GM then quietly closed the door and began to tell the second part of story.

It turned out that what the GM had told us, although genuine, accounted for only half of the truth. It was later revealed that in addition to the kickbacks, the local management had also adopted the practice of paying unrecorded salaries to the subsidiary's salespersons, including the GM. These unrecorded salaries represented "legitimate" sale commissions that the GM and the salespersons were fully entitled to in accordance with the company's policies. However, to "assist" staff in avoiding PRC salary tax, the subsidiary managed to pay the staff through the same intermediary companies that the kickbacks were channeled through. The sale commissions were recorded as "other operating expenses" rather than as salaries in the subsidiary's accounts. The reason why the accountant was so reluctant to disclose the payment records to us was that the total payments to these intermediary companies far exceeded the reported kickbacks; the difference representing the unrecorded sale commissions. Therefore, the accounting records and payment details would bring the tax evasion scheme to light - the very thing that the accountant was trying to conceal.

The numerous interviews with the GM finally confirmed the unlawful activities as alleged, i.e. kickbacks. It also unfolded other illegal practices by the PRC subsidiary: a massive structured income tax evasion scheme involving most of the subsidiary's staff. Within two days, the specialist team was able to assess the magnitude of the kickbacks as well as the potential tax liabilities and the financial implications resulting from the tax evasion scheme. The US client responded positively to the discoveries, acted upon them immediately, and was able to carry out corrective measures within a short time, thus, minimising damages.

Global collaboration
The success of this investigation was the direct result of seamless collaboration between Grant Thornton member firms, solid and well-versed forensic experts, business consultants, tax specialists from the USA, Hong Kong and PRC member firms, and their ability to respond to enquiries quickly and attentively. We are pleased to see our member firms around the globe sharing skills and supporting each other. More importantly, members of the specialist team gained immense job satisfaction as a result of being able to successfully conclude the investigation within such a short timescale. 

rio.lam@gthk.com.hk

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