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Investors Should Demand a Fraud Risk Assessment before Investing

April 24, 2018

The Business Commentary column in The Times of 23 April, under the heading “Our Regulators are in an Unholy Mess”, raised the question whether the “FRC should create a regime in which all listed companies, not only financial firms, are subject to prudential regulation. That is, companies having to prove that they have the means to withstand financial or operational shocks and empowering the regulator to intervene”.


The FRC has, however, rejected this and we are inclined to agree. That is not to suggest that we do not believe that companies should prove they have the means to withstand financial or operational shocks. Instead, we believe that it is incumbent on investors, as part of the investment evaluation process, to ask detailed questions and expect satisfactory answers as to whether a company has sufficient resources to withstand large, unexpected shocks. After all, investors have the power to go long of the shares, go short, or simply pass, based on their analysis. Regulators do not have that option. Smart investors always ‘stress test’ potential investments and if they don’t like the results, will make an appropriate investment decision, as evidenced, in the case of Carillion, by the number of short positions.


Investors do not generally, however, analyse companies from a fraud risk perspective, or seek evidence that companies are proactively implementing necessary fraud prevention controls. Yet, a major unexpected fraud has the potential to destroy a company and wipe out investors. It’s always advisable not to forget the two golden rules of investing - Rule No.1 Don’t lose money; Rule No.2 Never forget Rule No.1.


The conclusions to be drawn from research into companies’ attitudes to fraud are worrying, in particular:


  • Many companies have never conducted a fraud risk assessment

  • Many companies have not adequately identified key areas of potential fraud risk, and therefore, have not implemented necessary fraud prevention measures; it follows that it is not possible to test fraud prevention controls because in many cases these do not exist;

  • Senior Officials in many companies are guarded and reticent when questioned about their attitude to fraud prevention;

  • Many companies only pay lip service to fraud prevention, despite claiming otherwise;

  • The Whistleblowing function is often inadequate and ineffective. We note, however, and this is positive, that many companies are outsourcing the whistleblowing function to independent external professionals who have the capabilities to manage this effectively.


Available research also indicates that many companies are not up to speed with recent legislation, in particular, the Criminal Finances Act which gained Royal Assent in April 2017 and which targets corruption, money laundering and tax evasion.


In general, the Act makes companies and partnerships criminally liable if they fail to prevent tax evasion by either a member of their staff or an external agent, even where the business was not involved in the act or was unaware of it. Although clearly most relevant for the professional services sector, it has implications for the wider corporate community.


For a business to avoid criminal liability, it must show that it had implemented reasonable prevention procedures. In other words, businesses have to ensure that they have put in place procedures to minimise any risks, and undertake risk assessments of their products, services, client data and internal systems that could be used to facilitate tax evasion.


It is, therefore, crucial that businesses, as a defence, implement necessary procedures to cope with any such occurrences, including:

  • Making clear to employees that the firm is committed to preventing the facilitation of tax evasion;

  • Providing staff training on recognising and preventing financial crime;

  • Providing a safe whistle-blowing procedure;

  • Monitoring and enforcing prevention procedures;

  • Regular reviews of prevention procedures.


Many companies' and organisations' defences are inadequate or simply do not exist. We believe that investors should seek clear evidence that companies are up to speed with legislation and have the necessary fraud prevention controls in place, before committing to invest. Otherwise, the only sensible course of action is to avoid the shares, or even go short.

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