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This article was originally published on the White Collar Forensic blog.

Some surprises in business are pleasant – most are not. But in the context of compliance investigations – the element of surprise may be the only thing working in your favor. 

Consider the following examples. A food distributor that specialized in Asian cuisine and seafood had an asset backed lending agreement with a major commercial bank. It was secured by accounts receivable and product inventory. The company made regular payments on the line of credit for several years without incident. Then the company owner was hospitalized. Soon after, dozens of checks he had written to pay down the line of credit and other obligations bounced. The bank retained my team to investigate. The investigation revealed numerous surprises – the unpleasant kind.

  • The owner had multiple, similar companies, each with its own asset backed line of credit with a different bank.
  • Most of the “receivables” were ineligible for use as collateral since they were intercompany transactions with related parties.
  • Checks drawn against one line of credit were consistently used to pay down the other lines of credit creating the appearance of cash flow when, in fact, it was a charade.
  • The company’s outside accountant was a defendant in a lawsuit with a bank alleging asset-back lending fraud.
  • And the company warehouse was full of inventory consisting primarily of spoiled food and empty boxes.

As if the foregoing wasn’t enough, there were two distinct sets of books labeled “real accounting records for the CPA” and “fake accounting records for the bank.” 

Now you must be thinking this last part is just to get your attention but it happened just the way it is described. It was reminiscent of an experience from years earlier when, during a search warrant in an organized crime investigation, an unusual scrapbook was located. It contained newspaper clippings of unsolved mob hits. Found in the same hidden compartment as the scrapbook, there were automatic weapons, silencers, a grenade and “The Anarchist’s Cookbook” – an instruction manual of different ways to kill people. Like a career handbook for psychopaths.    

Had the bank exercised its right to audit – a surprise audit – they would’ve seen the decaying fish and the pallets of empty boxes, the fraudulent recordkeeping and the fact that the operation was a tenth the size their fraudulent recordkeeping indicated, and would have realized the assets underlying the line of credit were worthless.

Instead, over $50 million was lost and the bank was forced to close down their Southern California asset-backed lending operation.

Leveraging the element of surprise

A better example of when the element of surprise worked to the company’s advantage is the following.

During an exit interview, an employee said, “you have less equipment than you think you do”.  He elaborated that the company’s venture partner was requesting reimbursement for high-priced machinery that either didn’t exist or had been diverted away from the joint venture.

The company took swift action. Drones were deployed in each city in which the company had a joint operation. The drones surreptitiously shot videos and took photos providing some level of assurance that much of the equipment that was called into question – worth tens of millions of dollars – was where it was supposed to be.

The day of the surprise inventory, teams of forensic accountants, investigators and client personnel arrived at the gate moments after the company CEO called his J.V. counterpart with the request: “please grant my auditors unrestricted access to your facilities so we can perform an equipment audit”. Surprise. 

At each location, the teams were granted access with no difficulties. After a painstaking full day of checking the make, model and serial numbers of hundreds of high value pieces of equipment, the teams were able to not only account for all of the machinery we were hoping to find, but there was also additional equipment the company didn’t know about.  

The company took great pains to treat their J.V. partner with respect from the initial phone call from the CEO and in all the interactions the day of the inventory. There were concerns this action could have been construed as adversarial and damaging to an important relationship.  But the thoughtful and respectful approach and the partner’s cooperation debunked the allegations, while at the same time, put the partner on notice the company was paying close attention. An important message was conveyed along with a deeper understanding between the two business partners. 

The element of surprise is one of those fundamentally important components of investigations and internal audits. In law enforcement, it is the reason for “dawn raids”. They catch people off guard, often when they are sound asleep, metaphorically or quite literally. No time to move equipment or inventory around to fool the auditors. No time to brief workers and managers on what to say and what not to say. And no shredding of documents and deletions of emails.

Surprise investigations in business settings

In business, people don’t like to feel blindsided. Because of that, surprises are to be avoided and are not normally a part of business operations. 

This unspoken rule not to perform surprise audits on colleagues and business partners works to the advantage of the corrupt and the ethically challenged. Sometimes, we have to suspend these unspoken norms of business behavior in favor of trying retake the advantage when someone is suspected of wrongdoing.

Surprise audits and inventories, monitoring for suspicious transactions, email filtering and scheduling of witness interviews with little to no notice are all important tools in the compliance and investigations toolkit. It may take people off guard and that’s the whole point.  As long as people are treated with respect and these activities are done with an eye toward minimizing disruption to business operations, people will weather the storm and maybe even form a newfound respect for their colleagues or business partners who are committed to keeping fraud and corruption out of their business operations.