How to Prevent Fraud in Times of Economic Uncertainty

In times of economic crisis, the risk of fraud becomes a critical concern for investment firms. Consider the FTX collapse, which cast a spotlight on operational risk and compliance challenges for investment management firms.

From embezzlement to financial statement manipulation to Ponzi schemes, fraud can take many forms. And its impact can be devastating — for investors, for the business, and for the industry as a whole.

That’s why it’s essential for investment firms to implement effective fraud-prevention strategies. Here, we’ll examine the heightened risks of fraud during an economic downtown and how firm leaders can mitigate it.

Understanding the Risks of Fraud in Times of Financial Downturn

During times of economic instability and crisis, the risk of fraud can increase significantly. PwC’s Global Economic Crime and Fraud Survey 2022 reported that 51% of respondents had experienced fraud in the last 24 months — the highest number in PwC’s 20 years of research.

Fraudsters are often motivated to act during times when there is increased pressure on individuals, companies, and the economy. Businesses struggling financially may be more likely to engage in fraudulent behavior, and employees may be more tempted to engage in unethical behavior to maintain their financial position or gain a competitive advantage, especially if they feel that their jobs are at risk.

One of the most infamous examples of this was the Madoff scandal in the late 2000s in which the financier used a Ponzi scheme to defraud investors out of billions of dollars. The incident serves as a cautionary tale about the dangers of fraud and the importance of effective fraud-prevention strategies.

Another cause of fraud during economic crises is a lack of oversight and control. A 2020 Global Fraud Study reports that organizations lose an average of 5% of revenue to fraud each year.

Without effective internal controls and risk-management practices, firms are more vulnerable. For example, inadequate monitoring of financial transactions can make it easier for fraudsters to manipulate records and steal funds. Therefore, it’s crucial to implement proper internal controls and regularly review and update them to stay ahead of potential fraud.

Fraud From Outside Sources: Data and Cybersecurity

While fraud has often been viewed in financial institutions as transaction-based and internally generated, identity-based fraud in the form of cyberattacks and data breaches from outside sources can be even more threatening and represent an even greater loss; both in terms of economic impact and reputational damage.

In times of economic uncertainty, finding innovative ways to safeguard customers’, clients’, and employees’ sensitive and personal identifiable information is paramount. At leading investment firms, there needs to be a concerted effort to bring together efforts on financial crime, fraud, and cybercrime. Investment firms should focus on both business practices and technology architecture to mitigate risk and protect against fraudulent activity.

6 Effective Fraud-Prevention Strategies

Fraud, regardless of the form it takes, can have a severe impact on any business, but it can be particularly devastating for firms that deal with investments. The consequences of financial losses, reputational harm, and legal actions can be catastrophic.

Let’s examine some of the most effective ways to implement fraud-prevention strategies:

1. Establish a strong culture of compliance

By establishing a strong culture of compliance within your organization, you can cultivate an environment in which ethical behavior is expected and reinforced. By clearly communicating expectations and providing training and resources, employees are better equipped to recognize and avoid fraudulent activities. Additionally, holding employees accountable for their actions sends a strong message that fraudulent behavior will not be tolerated, which can deter potential fraudsters from attempting to commit fraud. Creating a culture of compliance promotes a sense of responsibility and ownership among team members, which can help to reduce the risk of fraud within the organization.

2. Hold employee training on appropriate activity

We all know ignorance of the law is no excuse for breaking it, and neither is ignorance of a firm’s nor the SEC’s expectations. Thus, you must regularly train employees at all levels of your organization to address:

• What constitutes appropriate behavior
• What an employee should do if they detect fraudulent activity

This type of training is generally most beneficial when you use independent compliance consultants or your legal counsel to ensure that you present the most current information to your employees. Certification of an employee’s attendance and acknowledgment of the material presented should also accompany any training sessions.

3. Conduct due diligence on investment opportunities

Conducting due diligence enables investment firms to identify any red flags or warning signs that may indicate potential fraud or misconduct. By carefully reviewing financial statements, conducting background checks on individuals involved, and verifying the information provided, investment firms can gain a better understanding of the legitimacy and risks associated with an investment opportunity. This process supports risk mitigation and prevents the firm from investing in fraudulent or high-risk opportunities. It also helps to protect the firm’s reputation and credibility by ensuring that it’s only investing in legitimate and ethical opportunities.

4. Implement effective internal controls and risk-management practices

Instituting internal controls and risk-management practices is an effective strategy because it creates a system of checks and balances within the organization, making it harder for fraudulent activities to occur undetected. By segregating duties and limiting access to sensitive information, employees are less likely to have the opportunity to engage in unethical behavior. Monitoring employee behavior also acts as a deterrent, making it less likely for employees to attempt fraudulent activities. Instilling these practices in your organizational culture helps build an environment of accountability and transparency, reducing the likelihood of fraud.

5. Use external service providers

These third-party professionals can provide a fresh perspective and an unbiased evaluation of a company’s internal controls and risk-management practices. External service providers can also bring specialized expertise and experience in identifying potential fraud risks and developing effective fraud-prevention strategies. Additionally, having an external service provider can deter potential fraudsters from fraudulent activities as they know that the company is actively monitoring and preventing them. In the event fraud does occur, an external service provider can provide a more objective and independent investigation into the matter.

6. Rely on ongoing monitoring, testing, and reporting to expose vulnerabilities

Consistent and thorough testing enables organizations to detect and prevent fraudulent activity in a timely manner. By regularly reviewing financial statements and conducting internal audits, organizations can identify potential fraud and take action to prevent it from escalating. This should include penetration testing in which you use simulated cyberattacks against your computer systems to check for exploitable vulnerabilities. Finally, reporting any suspicious activity to senior management can help firms ensure that fraudsters are held accountable for their actions. Routine monitoring is a proactive approach to fraud prevention that can help organizations stay ahead of potential threats.

The Bottom Line

In times of economic crisis, the risk of fraud can increase drastically. However, by implementing the right combination of fraud-prevention strategies and appropriate risk controls, firms can protect their businesses and minimize the risk of fraud.

Preventing fraud should always be a top priority for any organization. If you need assistance with developing or implementing a fraud-prevention strategy in your business, consider partnering with Arootah Business Advisory. Our compliance experts can provide valuable insights and guidance to support you in navigating these challenging times and protect your firm from fraud. Book a 30-minute strategy call now to learn more.

Disclaimer: This article is for general informational purposes only and does not constitute legal, investment, financial, accounting, or tax advice, or establish an attorney-client relationship.  Arootah does not warrant or guarantee the accuracy, reliability, completeness, or suitability of its content for a particular purpose. Please do not act or refrain from acting based on anything you read in our newsletter, blog, or anywhere else on our website.