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The Toronto Star, April 4, 1999, Page A19

The business of fraud

Canadian investors find opportunities and wealth of scams

By Charles Smedmor, Special to the Star

As we head toward the third millennium, we are becoming more comfortable with the globalization of marketing, telecommunications and information technology. But along the way, something more sinister is also becoming global: commercial fraud. And that puts Canadians, who are now aggressively pursuing international trade and investment, increasingly at risk of having their pockets looted by unsavoury characters. That risk is nowhere greater than in the impoverished former countries of Eastern Europe, which, since the fall of the Berlin Wall in 1989, have been actively courting outside investors.

Scams flourish wherever Greed, Opportunity, Need and Expectation of Not Being Caught exist together.

Fraud usually follows the GONE theory: Scams flourish wherever Greed, Opportunity, Need and Expectation of not being caught exist together. Eastern and Central Europe have those in spades. Little wonder that some choice "Wild East" scams are now starting to empty Canadian pockets. In addition, Canadians risk being caught up in webs of intrigue and vengeance if they unwittingly become "cut-outs" - the crime world’s nickname for fraud fronts operating behind the Maple Leaf. Faced with those risks, Canadian business people have to remember both where they come from, and where they’re operating overseas. Canada’s business scene is based on trust, fair laws, capable police and honest courts. In many emerging countries, trust is non-existent, government and business corruption is rampant, and the courts are not an effective remedy.

The annals of European fraud are already filled with classic scams - all of them cautionary tales.

The following are all real examples of fraud:

  • Under-invoiced sales
    Goods are shipped but under-invoiced, either with artificially low prices or under-recorded out at low prices or under-recorded quantities. In one case, a state-owned grain processing company being privatized sold output at low prices to shady international customers. These buyers then resold the product at world prices and rewarded the crooked grain company managers with cars, cash and "inspection trips" abroad.

  • The toughest competition, your own employees
    Managers at one branch of a food products distributor competed with their employer by setting up their own parallel company to distribute a competitor's line. The food products distributor did not have any on-site managers of its own or an international audit, so the local staff were free to do as they pleased.

  • Conversion of inventory to worthless receivables
    The same food distribution company managers financed their new business by stealing the employer’s inventory. Most stock was sold to a "suitcase" company, which then resold the stock to a third company controlled by the miscreant mangers. The third company sold off the product but did not pay the "suitcase" company, which then declared insolvency, leaving the international investors with an unrecoverable loss.

  • The poison pill in equipment form
    A state-owned food factory was to be privatized. One unscrupulous potential investor offered the factory managers secret bonuses if other bidders were deterred. In addition to being surly and un-co-operative, the managers bought, with scarce hard currency, major new backing equipment that was customised to the unscrupulous investor’s needs. Another investor learned of the equipment orders but prevailed, buying the company and paying cancellation fees on the equipment. The saboteur managers were dismissed, but the price paid for the food company shares was lower because of the sabotage.

  • Siphoning off cash through over-priced services
    While purchases of goods can be verified against delivery documents, services are more difficult to monitor. Local managers sometimes use their position of trust to hire people providing overpriced or fictitious outside services in return for a share of the excess billings.

  • Secret commissions
    In Canada, secret commissions are a Criminal Code offence. However, outside Canada, it is common to find that secret commissions are offered by vendors and expected by employees.

  • Bid rigging
    Tenders are a common tool to get the best available value for major purchases of goods and services. However, the benefits are frequently undone in emerging nations. In one instance for a major consulting project, all the short-listed suppliers organized into a cartel that decided who would win a specific tender and how high the unsuccessful tenders would bid to provide a healthy margin for the winner.

  • State employee extortion
    Overseas, it is common practice for poorly paid state employees to seek or receive extra payments and gifts. A major international company was importing tariff-free equipment to renovate its factory. However, the local customs director constantly put hurdles in the way of clearing the shipment. When the foreign executive was finally told that a bribe was expected, he was in a quandary, as corporate policy prohibited such payments. Eventually, he invited the customs director and his wife on a deluxe trip to "inspect" similar technical installations in a nearby country.

*    *    *

As the above examples illustrate, frauds beyond our shores are more daring and blatant that what Canadians have grown to expect at home. That, in turn, brings greater risks in doing business internationally.

How to avoid being defrauded

How to avoid becoming a victim? The key is to remember that Canada ends at Pearson Airport and emerging countries should be approached on a buyer beware basis.

Below are some guidelines for doing business internationally.

If you are selling or buying abroad:

  • make "trust but verify" your policy for doing business abroad;
  • ask the local Canadian embassy for advice about the local system, pitfalls and unscrupulous characters;
  • use the services of local branches of international banks - their service fees are cheap for the advice and protection provided;
  • verify the background and track record of all local employees, partners, key suppliers and distributors;
  • ensure every transaction has an understandable and legitimate business purpose; if not, the purpose may be to defraud; and
  • never provide false paperwork: the risk is real and the rewards illusive.

If you are investing, you should also:

  • be prepared for a society where corruption can prevail over rule of law;
  • conduct complete due diligence investigations to avoid expensive post-closing problems;
  • identify and develop good local partners and staff;
  • have all key agreements and activities reviewed by local offices of international legal and financial advisers to ensure the documents are properly structured and comply with local law;
  • initially staff key functions (sales, purchasing and finance/accounting) with loyal expatriate staff;
  • investigate every anomaly or red flag; do not assume away a warning;
  • not give too much credence to documents: substance should outweigh form;
  • anticipate that anything can go wrong and always have a plan B; and
  • make the effort to visibly be a good local corporate citizen.

Charles Smedmor, a chartered accountant who has worked extensively in central Europe, specializes in investigative accounting.

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