Why fraud and management are two sides of the same coin

To truly understand a business, think how you would swindle it.

by Dan Davies
Last Updated: 11 Jul 2018

Here's a thought experiment for your next coffee break; consider the thing you're responsible for from the point of view of a criminal.

Pretend that you were trying to commit a fraud against it. Decide how you would go about extracting cash – through loans, dividends, a company bonus system or transactions with connected parties. Work out what you would need to falsify in order to set things in motion, and what you would then need to do in order to cover your tracks. How would you keep things going over time? How much money could you extract?

When you've finished your pipe-dream fraud, look back at the notes you made (probably best to do this in private so that nobody gets the wrong idea). You might find that you've got quite an interesting document. It will tell you how cash enters and leaves your sphere of control, what kind of indicators are used to measure your performance and how they might be manipulated. You will have a picture of what a good set of numbers look like and a sense for how that picture could be misleading. ‘Thinking like a fraudster’ is not a bad way to develop ideas about how a business works if you're ever put into an unfamiliar situation or a consulting assignment.

But slightly more unsettlingly, the trick works the other way round too. If you sit down to the less amusing task of compiling a list of the management controls and measurement systems that apply to a business or to one of its units, you've got a document that will usually present a clear template to a criminal. To know how to manage something is to know how to defraud it, and vice versa.

The reason why is that management and fraud are both driven by the same problem of information economics – the problem of taking the complexity and variation of any business more complicated than a lemonade stand, and reducing it down to something that a single individual can hold in his or her head. Or in other words, to literally ‘make it manageable’. You can't observe everything that you are responsible for, and every decision about what you are going to check up on is, necessarily, also a decision about what you are not going to check up on. Consider the case of the Great Salad Oil Scandal, for example.

The Salad Oil Scandal might have been more famous if it didn't hit the press on the same weekend in 1963 when President Kennedy got shot. It caused a loss of the equivalent of $1bn in today's money to American Express, and forced the Chicago Mercentile Exchange to have to bail out one of its member firms.

It was a fraud based on a very simple control weakness in the precautions taken by Amex to verify the collateral they were lending against – the fact that oil floats on water. And specifically, that because of this, it isn't quite as easy as it ought to be to tell the difference between a tank full of valuable vegetable oil, and a tank full of seawater with a few gallons of salad oil floating on top.

Tino De Angelis, the founder of American Crude Vegetable Oils, knew the business well, and so he knew how to manipulate the scenery so that his bankers would lend him many multiples of the true value of his assets.

In retrospect, the people who got conned in the salad oil scam look pretty daft. So the victims of OPM Leasing who pulled off a similar scam with forged lease contracts instead of tricky oil tanks, for not noticing that the company was literally named ‘Other People's Money’.

And so do lots of scam victims going right back to the 1820s, when people bought the sovereign bonds of the Republic of Poyais without realising that there was no such country. But, as I argue in my book ‘Lying For Money: How Legendary Frauds Reveal The Workings Of The World’, we should not feel too much smarter than the people who fell for these things.

Because it's not really the case that the system failed. It's rather that the fraud was designed around the system, to take advantage of the fact that any management system, to do its job, involves reducing the information set to the manager. Systems of checks and audits are good for catching little thefts, but they won't catch big crooks, because there is a difference of style as well as size.

The real management lesson from the fraudsters is that it pays to change your worldview every now and then. Big frauds tend to get busted because they grow very quickly, and their growth takes them into the field of vision of someone who looks at things in a different way. A scam that has been designed to slip around one set of controls can be comically obvious to another.

This isn't just about criminality.The reason that fraud exists is that management is difficult, and one of the ways that we try to make it less difficult is to ignore things. But what you don't know can hurt you. Every now and then, look at things in a way that they haven't been looked at before. You might find something that would surprise you.

Dan Davies is former regulatory economist at the Bank of England and author of Lying For Money: How Legendary Frauds Reveal The Workings Of The World.

Image credit: Dietlinde B. DuPlessis/Shutterstock

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