Lifting the floorboards: what dirty secrets are revealed by fraud investigators and what can be learned

October 06, 2010

By Tim Le Cournu and Gerard Rolton
Published in the Cayman Islands Journal, October 2010

Section 1, Introduction of the ‘Guidance Notes on the Prevention and Detection of Money Laundering and Terrorist Financing in the Cayman Islands’ starts with the following: “Having an effective anti-money laundering / countering the financing of terrorism regime has become a major priority for all jurisdictions from which financial activities are carried out. One of the best methods of preventing and deterring money laundering and terrorist financing is a sound knowledge of a customer’s business and pattern of financial transactions and commitments. The adoption of procedures by which Financial Services Providers ‘know their customer’ is not only a principle of good business but is also an essential tool to avoid involvement in money laundering and terrorist financing.”

Reading this introduction carefully, one identifies the three essential elements to a good anti-money laundering system.

One, have a sound knowledge of the customer’s business. Second, have a sound knowledge of the customer’s pattern of financial transactions. Third, have a sound knowledge of the customer’s commitments.

Let’s dissect this a little further. What is “sound knowledge”? A culling of the Internet determined that while there is no specific definition, it is usually associated with being thorough, reliable or well founded. That means more than just a passing glance. It means being able to answer questions with intelligent responses.

It is useful to note that the introduction says nothing about filling in check-lists and having anti-money laundering policies and procedures. While these are for their own reasons helpful, they do not replace sound knowledge. And yet this seems to have become lost when we discuss parties’ duties and obligations under the anti-money laundering law.

This article serves to recognise that it is a necessary function of preventing and detecting money laundering and terrorist financing that directors and service providers embrace a model where they are willing to look beyond basic checklists and procedures and adopt a much more comprehensive and thorough knowledge of their customer’s business, pattern of transactions and commitments. And therefore this means constant monitoring, a good understanding of their customers business, constant vigilance and a high standard of oversight ensure that there are no surprises ‘under the floorboards’.

In the past two years the world has seen financial frauds of the size and shrewdness never before seen. In September 2008 Lehman Bros went bankrupt and we all learned about a little magic accounting trick called “Repo 105”. In an article appearing in Wealth Daily on 15 March 2010, Repo 105 is described as follows: Lehman entered into repurchase agreements with banks in the Cayman Islands. Under the deal, Lehman would “sell” toxic assets to the other bank — with the understanding that they

would buy them back in a short time. The trick made Lehman Brothers look much healthier — on paper, at least.

The writers are not involved in the Lehman liquidation, but it does make one wonder whether the banks in the Cayman Islands had a sound knowledge of the business. If they did, how was it that they were willing to participate in such a venture, knowing their anti-money laundering obligations?

Three months later Madoff disclosed his business of over 30 years was a Ponzi scheme. Our Firm is involved as liquidators for the Fairfield Fund and have knowledge of a number of other Cayman based Madoff Fund of Funds. While we are not at liberty to discuss the circumstances of these cases, there have been various references to the red flags surrounding his split/strike conversion strategy and the two man accounting firm that audited him. Again it looks like having a sound knowledge of the business was missed.

But are these just two extreme examples of complex frauds in which it can be argued that even the best of the best were not able to find the fraud. After all, the Securities Exchange Commission, the largest regulator in the world, didn’t find the fraud despite the red flags.

We are management members of an insolvency firm. We conduct investigations into a number of entities where significant losses occur and in some instances where fraud is found. In conducting those investigations we have identified numerous instances where directors and service providers have not gained sound knowledge of their clients to recognise when matters go astray. In some recent cases we have seen the failure of directors or service providers to perform basic due diligence, appreciate when the services they provide are outside their expertise or conflict each other, or ignore ‘red flags’ which may have contributed to the frauds being perpetrated or at the very least allowed them to continue undetected for far too long. We highlight a couple of these cases.

The first case involves a group of funds based in BVI and the Cayman Islands where significant red flags were overlooked and little due diligence was conducted to ensure a sound knowledge of the business was obtained. Any sort of basic investigation into the customer’s business would have drawn to the attention of the directors various allegations of fraud made against the fund manager. An Internet search would have revealed that a foreign regulator had taken steps to prevent the manager from soliciting funds from German investors. Further, a visit of the manager’s operations would have found that it was run from an empty flat on-shore. Due diligence on the principal would have identified his chequered background of failed nightclubs and real estate deals and his arrest in Europe in 1986.

Initial findings by the liquidators indicate the fund entered into circular transactions with a number of US and UK investment firms to give the perception that it managed significantly more capital than it actually did. It then used the allegedly falsified financial records to obtain loans from major international banks and others. A sound knowledge of the customer’s pattern of financial transactions would have revealed that they were circular in nature. Red flags such as the fund reporting returns of 825 per cent were also ignored by the directors.

Further the fund ‘invested’ in multimillion dollar residential property in Florida, luxury cars, boats, private jets and helicopters. The significant losses incurred by these companies and the extensive personal use of the assets make it difficult to see any commercial purpose for these transactions. These assets were then used as collateral on loans which were reinvested back into the funds, further advancing the notion the funds had more capital under management than they did.

The second case involves two funds where more than 95 per cent of the funds’ investments were made into two entities which were also controlled by the promoter/manager/director of the funds. This is always a volatile cocktail in the fund industry and a red flag for many frauds. The ‘investments’ involved rights to use natural resources which had not reached commercial exploitation. No plant existed and construction of a plant needed a significant investment. Despite no plant, no sales and no financial commitment to develop these, the investment was valued in excess of $200 million. In the meantime the investment manager was paid millions of dollars in performance fees on the back of a net asset value, struck by the investment manager, which allegedly had no commercial basis.

In retrospect, despite the close control the promoter/manager/director had in the business, there were others, including arguably the independent directors, the administrator and the auditor, who should have been providing the checks and balances assuming they gained the necessary “sound knowledge”. If they did, they would have recognised the investment in the European entity required further significant expenditure (sound knowledge of commitments) to commence operations and to justify the valuation of $200 million (sound knowledge of business).

They also seem oblivious to the amount of performance fees paid from the funds, which were in essence the amounts being invested by investors, leaving the value in the fund to being the value of the two principal entities owned by the promoter.

Service providers need knowledge that is thorough, reliable or well founded. To do this, financial institutions need to look beyond the documents for third party verification, independent advice and follow up any red flags that are identified, leading to additional due diligence measures which may uncover significant fraud. Such measures may include;

Extra vigilance where a director of a fund is also the investment manager, administration manager or is associated in any entities in which the fund is investing;

visit and kick the tires of key service providers and key investments;

conduct internet searches and conduct third party inquires into service providers;

determine whether the business makes sense or is it circular, overly complex (see Madoff split/strike conversion) and not commercial;

confirm whether proper segregation of key functions is in place and measures are in place to control risks.

What is essential is that service provider’s move to a scenario where they follow the spirit of the AML legislation by ensuring they are able to confirm they have sound knowledge of an entity by doing substantive due diligence which is update on a regular basis.

Reading this introduction carefully, one identifies the three essential elements to a good anti-money laundering system.

Extra vigilance where a director of a fund is also the investment manager, administration manager or is associated in any entities in which the fund is investing;
visit and kick the tires of key service providers and key investments;
conduct internet searches and conduct third party inquires into service providers;
determine whether the business makes sense or is it circular, overly complex (see Madoff split/strike conversion) and not commercial;
confirm whether proper segregation of key functions is in place and measures are in place to control risks.