Fraud in the Family?

Reading about the Satyam case does give rise to a concern - are family owned/ controlled companies more prone to fall victim to bad corporate governance and fraud?

I have worked with some UK banks in helping them understand the various facets of fraud. One of the most interesting and dangerous one is internal fraud - fraud where an internal employee is involved. Banks have been putting in various systems to identify patterns in employee transactions as well as system usage and phone usage that may point to suspect fraud. One of the frameworks that I found most useful to understand which employee is more likely to commit fraud is the "Fraud Diamond". As can be seen in the picture, an employee will be more likely to commit fraud if he has the incentive, opportunity, capability and either a lack of ethics or a way of rationalising his actions.
Can we apply this framework to fraudster CEOs? I think - yes. Looking at some of the recent fraud cases - Satyam, Madoff, Fannie Mae etc the incentives may well have been different. In Satyam's case it was power mania of the Raju family. In Madoff and Fannie Mae it was pure greed. However, all of the CEOs were given ample opportunity. Indian companies, with the prevalent hierarchical management style where the CEO is never questioned, does provide him enough leverage to do anything he desires. And in a country where corruption is part of most transactions and the black economy is as large, if not larger, than the white economy there is a tacit understanding between all parties involved .

However, it is not only the Indian companies which are susceptible to falling victims to their CEOs. Madoff scared off his investors so much that no one dared ask him questions - giving him the power to do as he wished with their money. Fannie Mae's docile board gave enough power to its CEO and Chairman, Franklin Raines, to let him get away with cooking the books.

The next question is about capability. Can anyone hold a hand to their heart and say that they think that the CEO can cook the books on his own? How many CEOs can play with complex financial systems to manipulate numbers? Was Madoff the only person in his entire office who knew about the ponzi scheme. Well the others must be complete idiots - including his sons, if thats the case. I will speculate that it is very unlikely. Whether it is PWC or Anderson, auditors have tried to "assist" the management in working around tax issues and "helped" them potray the right picture by meeting earning targets.

And then comes the rationalisations. People like Madoff and Raines don't even bother providing any explanation. Raju is slightly better off - he claims that he wanted to ward off any hostile takeover.

Looking forward, can we use the fraud diamond to predict future corporate fraud at the CEO level? Would Stuart Rose be as likely to cook the books of Marks & Spencer as Raju was for cooking those of Satyam? Rose also has protected M&S from takeovers from Philip Green in 2004. He has consolidated power by becoming the CEO and Chairman. He is also getting his own guys on the board. The only element remains rationalisation. If M&S performance deteoriates beyond expectations would he resort to such extreme measures to retain M&S' independence? What are the checks and balances in place to stop that?

Investors, careful. It might not only be the family owned companies who have skeltons in the cupboard.