Character and Fraud: Protection and Prevention [RMA Journal, The]

This article reprises presentations the author gave at RMA chapter meetings in Santa Barbara and Los Angeles, California.

Well before this latest economic crisis, bankers have employed The Five Cs of Credit as an analytical tool to evaluate their borrowers' willingness and ability to repay their obligations. The Five Cs are character, capacity, capital, conditions, and collateral, and four of them-capacity, capital, conditions, and collateral-measure ability to repay.

It is the fifth C, character, that assesses willingness to repay, and borrowers are not equal in this area because some are weak at the outset and others weaken under adversity.1 Playwright Oscar Wilde admitted, "The only way to get rid of temptation is to yield to it.... I can resist everything but temptation." The German philosopher Goethe advised, "You can easily judge the character of a man by how he treats those who can do nothing for him." And Abe Lincoln observed, "Nearly all men can stand adversity, but if you want to test a man's character, give him power."

So how do we ensure that our borrower's character is not undercut by the temptation of power, money, or personal aggrandizement? Is an ounce of prevention against temptation worth the pound of cure for the consequences?

Character: Able and Willing?

Character can be defined as the combination of mental and ethical traits marking and often individualizing a person, group, or nation. Its synonyms include decency, dignity, nobility, quality, reputation, worth, honesty, and integrity.2

Typically ranked first among The Five Cs in evaluating creditworthiness, character is a banker's judgment of a borrower's willingness to pay. Unfortunately, a borrower's resolve and determination to repay is often tested by hard times, poor business conditions, declining revenues, falling income, and cash shortages. The other Cs have their places, but if the borrower is tentative or hesitant in his promise to repay the debt, the lender is taking a risk at the outset of the credit extension so great that the other Cs are unlikely to mitigate it.

History is replete with examples of broken promises: Nazi Germany invaded the Soviet Union in 1942, despite Hitler and Stalin's 1939 Nonaggression Pact. Henry II imprisoned his wife Eleanor of Aquitaine for 16 years, from 1173 to 1189, for failing to love, honor, and obey him, especially after she supported their son Henry's revolt against him. Imperial disregard for promises seems to be an occupational hazard, and Napoleon summed it up royally: "If you wish to be a success in the world, promise everything, deliver nothing."

These examples of how power tends to undermine character suggest that bankers ought to expand character analysis to include a review of which controls a borrower has in place to remove temptation and shield the firm and its employees from other corruptive influences. The borrower may be willing to honor the firm's obligations, but in order to preserve the value the borrower puts on reputation, honesty, and integrity, it may be necessary to help others in the firm stay resolute.

Questions of Character: Don't Count Them Out

One way to communicate the importance of character to the bank's evaluation of creditworthiness is to tactfully integrate the following 12 questions into the loan interview or search for the answers through secondary sources and references.

1. Financial information: Is the firm or its principals unwilling to provide financial information?

2. Support from the principals: Are the principals unwilling to offer personal guarantees, provide collateral, or accept any conditions or covenants?

3. References: Are the principals unwilling or unable to provide references from colleagues, competitors, suppliers, lenders, customers, lawyers, accountants, etc.?

4. Communication: Are verbal, phone, or electronic communications difficult to establish and maintain? Does the borrower pass on only good news and pass over bad news?

5. Creditors: Has the firm or any of its principals ever walked away from a loan or refused to pay a creditor?

6. Taxes: Is the firm or its principals delinquent in payment of taxes, fees, licenses, etc.?

7. Fraudulent practices: Has the firm or any of the principals ever been involved in deceptive, misleading, or fraudulent practices?

8. Management competence: Do any of the firm's principals lack the skills, training, and experience necessary to perform their functional responsibilities?

9. Résumé fraud: Have any of the firm's principals misrepresented their background, experience, skills, training, or education?

10. Projection-budget performance: Does the firm fail to meet its projections and/or meet its budget?3

11. Unity in management strategy: Do the firm's management and major stockholders or its partners disagree about the firm's goals and objectives?

12. Site visit: Do the firm's facilities appear poorly maintained, look unsafe, or feel uncomfortable?4

These questions state the obvious, but most of them rest on the assumption that the banker is making contact with the borrower. In the aftermath of the Great Recession, lenders have learned the hard way that remote sensing techniques work fine in detecting the formation of hurricanes and tornadoes, but are less effective in ferreting out potential human devastators.

Personal contact with the borrowing firm and its principals is the cement for the building blocks of credit agency reports, creditor checks, lien searches, and deposit verifications and paves the road to a creditworthy relationship.

Temptation: Willing and Able to Give In?

American writer Rita Mae Brown says, "Lead me not into temptation; I can find the way myself." Unfortunately, the way is not hard to find, so how hard does your borrower make the way hard to find? Besides embezzlement and ordinary theft, we now see information theft, business model fraud, and business process fraud. Business model fraud covers the company that sells illegal or worthless products or services-for example, a drug company selling unapproved drugs or a mortgage company packaging subprime loans. Examples of business process fraud include ignoring safety regulations or window-dressing quarter-end financial statements.

The Association of Certified Fraud Examiners (ACFE) surveyed the effectiveness of various fraud controls by calculating the differences in losses when the control was in place (CIP) and when the control was not in place (CNIP). The table on this page ranks 15 common controls in terms of the largest reductions. At the top of the list, the hotline fraud control reduced losses from an average of $245,000 to just $100,000-a 59% reduction.5

The eye-opener for bankers is that audited financial statements and management certification of the financials rank near the bottom of the list. Far more effective are the hotline, employee support program, surprise audit, and fraud training for employees and management, probably because the mere existence and enforcement of these controls make it clear that the company is serious about fraud at all levels of the firm.

These fraud controls should be familiar to bankers because of the monetary temptations in the industry's workplaces. The ACFE suggests seven steps for organizations wishing to prevent fraud:6

1. Start at the top. The board of directors and executive management must set the tone.

2. Educate the staff. Employees must be trained to understand which types of behavior or acts constitute fraud, how costly it is to the firm, and how to report suspicious activity.

3. Change the culture. First- and second-generation companies may find it easier to make their cultures more fraud-intolerant than more established firms because employees in younger companies usually have more of a personal stake.

4. Conduct surprise audits. The ACFE reports that companies that conduct surprise audits tend to have lower fraud losses and usually detect fraud more quickly. Fraudsters commit fraud if they think they will not get caught.

5. Check employee backgrounds. Human resources should confirm all work history and education claimed in an applicant's résumé and contact references. The ACFE recommends that new and current employees' compliance with company ethics and antifraud programs be incorporated into performance reviews.

6. Prepare a data-breach response plan. Information loss and data breaches are now the most common form of fraud, so it is critical to implement a response plan for these events. In preparation, get answers to the following questions: Who will regularly review information policies and procedures, and who will monitor and test the physical security of the information assets? Government regulations have raised the penalties for firms that fail to protect their data.

7. Make sure the board of directors focuses on fraud. Corporate boards are held accountable for risk management and fraud. The board should be monitoring the firm's fraud-prevention controls, demanding explanations for fraud incidents, and requiring fixes for fraud losses.

Conclusion: Trust but Verify

Many people outside of banking have written about character and conclude that one either has it or lacks it. But simply identifying its absence or presence may be too shortsighted. Another way of viewing character is through its ebbs and flows over time, along with the tidal temptations of money and power. Jurist Oliver Wendell Holmes noted in an 1897 speech, "A man is usually more careful of his money than his principles."

To shore up a borrower's principles and reinforce his character, use the 12 questions offered above to measure and assess the stresses and strains on character. A borrower's straight answers to the questions, in combination with the most effective fraud controls, will help affirm a creditworthy character.

In the long run, character can be its own reward. Henry Wadsworth Longfellow explained its value this way: "It takes less time to do a thing right than it does to explain why you did it wrong." Examine character right, and you won't have to explain why it took you so long to learn what went wrong.

If the borrower is tentative or hesitant in his promise to repay the debt, the lender is taking a risk at the outset of the credit extension so great that the other Cs are unlikely to mitigate it.

Many people outside of banking have written about character and conclude that one either has it or lacks it.

Notes

1. Dev Strischek, "The Five Cs of Credit," The RMA Journal, May 2009, pp. 34-37.

2. Dev Strischek, "The Quotable Five Cs," The RMA Journal, April 2000, pp. 47-49.

3. Dev Strischek, "Airing Out Revenue Projections: Letting the Wind Out of Sales Forecasts, The RMA Journal, November 2010, pp. 40-45.

4. Dev Strischek, "Set Your Sights on Your Next Site Visit," The RMA Journal, April 2011, pp. 20-23.

5. Laton McCartney, "Where There's Smoke, There's Fraud," CFO Magazine, March 2011, pp. 46-51.

6. Ibid.

Dev Strischek is senior vice president and senior credit policy officer, SunTrust Banks, Atlanta, Georgia. He is also a member of The RMA Journal Editorial Advisory Board. He can be reached at [email protected].