Fraud and the Funneled Funds

Investing in the growth of an established, highly profitable company looked like a low-risk proposition. It wasn’t.

Andrew D. Pappas, CPA

In a closely knit suburban business community, people who own an enormously successful company tend to stand out. Such was the case with Ted and Raymond, owners of Cover-Up Arizona Roofers, a $20 million supplier and installer of roofing materials.

The co-owners were a good match. The gregarious Ted was the deal-making public “face” of the company, while Raymond was generally regarded as the brains of the operation, staying in the background and dutifully tending to the details.

The local construction industry was booming, so much so that the demand for Cover-Up’s products and services began to strain the company’s financial resources and infrastructure. To line up needed capital, Ted and Raymond began talking to their bank and to private investors. Attracting money to Cover-Up was like attracting flies to a picnic, and in less than 30 days Ted and Raymond had $3 million in bank financing and $5 million more from five new shareholders who were eager to passively participate in Cover-Up’s inevitable growth.

Everything went according to plan. Cover-Up expanded its facilities and inventory. Sales and profits soared. Debt payments were made on time. And the silent shareholders received satisfactory checks with their monthly financial reports.

Warning Signs

Most of the shareholders paid little attention to the financial information that Cover-Up provided, confident that Ted and Raymond were on top of things. Even after the monthly payments began to decline, only one investor, Luther, took the time to delve into the financials, and what he saw was troubling.

In contrast to the first six months after Luther made his investment, during which Cover-Up’s sales and gross profit grew at a consistent rate, in month seven he saw a spike in the cost of goods sold. In the next month, sales were up again, but the gross profit margin was cut by nearly a third. This was followed by another increase in the cost of goods sold. Not coincidentally, the payments that Luther and his fellow investors received steadily declined.

Smelling a rat, Luther called Cover-Up’s bank and spoke to the company’s loan officer, who told Luther that Cover-Up’s loan was current and that the bank was not concerned about the company’s recent profit fluctuations.

Investigation

Still not satisfied, Luther placed another call, this one to Pappas & Company. A few years earlier we had conducted a fraud investigation at another company in which Luther had invested, and we had discovered some areas for needed improvement in that company’s internal controls.

Luther explained to me the situation and his suspicions, and he asked me to investigate Cover-Up.

Key People. Our investigation included interviews with the company’s managers, clerks, sales people, warehouse workers, drivers and installers, and we were uniformly impressed with the knowledge and professionalism of everyone we interviewed – everyone, that is, except the accounting manager, a woman named Myra.

In contrast to her fellow employees, Myra clearly was under-qualified for her job, and her demeanor suggested that she was overwhelmed by her workload. Prior to joining Cover-Up a year earlier, she had worked mostly in non-financial positions, and her educational background was not what we expected of the accounting manager of a growing $20 million company in a complicated, competitive industry. Nonetheless, her annual salary was just over $120,000.

Bad Numbers. Our concerns did not end with the accounting manager. When she showed us the company’s accounts receivable aging summary, the names of two customers immediately jumped off of the page. I knew that both companies were bankrupt; one had a $150,000 balance in the 60-90 column and the other had a $115,000 balance in the 30-60 column. The latter was remarkable in that the company had closed its doors more than four months earlier.

The aging summary had been audited by the company’s CPA firm, so we called the partner responsible for Cover-Up’s accounting services to ask why balances from defunct companies were still being carried on the books. His reply didn’t require a lot of interpretation: “Raymond told us to leave them on there to keep the bank happy.”

Two more red flags unfurled when we reviewed Cover-Up’s check register.

Questionable Vendors. First, we found that, in the preceding 90 days, eight checks totaling nearly $250,000 had been issued to Tejado de Suciedad Manufacturing. Invoices for the first three checks were computer-generated. The next three were hand-written. For the last two checks there were no invoices at all. And all were charged to cost of goods sold.

I tried to call Tejado de Suciedad to get copies of the missing invoices, but there was no phone number on any of its invoices. Further, it was not in the phone book, despite a remittance address to a local post office box. And it did not show up in a Google search. The bottom line: the company didn’t exist.

Two weeks after the final payment to Tejado de Suciedad, Cover-Up issued the first of five checks, totaling about $283,000, to Cerveza Maxima. Again, all of the checks were charged to cost of goods sold. As for Cerveza Maxima, that was a name I recognized: It was a restaurant and bar that a few weeks earlier had been written up in one of the local business newspapers as the state’s top retailer of a particular brand of beer. When we called Cerveza Maxima to ask the bookkeeper what he knew about large checks from Cover-Up, he innocently replied, “Oh, I think that’s Ted and Raymond’s other company.”

Despite its robust sales of beer, Cerveza Maxima was circling the drain and required frequent infusions of cash – from Cover-Up – in what ultimately proved to be a vain effort to stay in business.

We found more, of course, including the practice of booking sales orders as actual sales to help Cover-Up’s financial ratios comply with the loan covenants required by the bank.

Breakdown. The climax of our investigation occurred when Myra – already straining under her heavy workload, lack of competence, and reluctant participation in cooking the company’s books – broke down after being confronted with our findings. She ratted out Ted and Raymond and their scheme to redirect borrowed and invested funds to a failing enterprise in which Cover-Up’s passive shareholders had no ownership interest.

Epilogue

In the end, Ted and Raymond were ousted from their positions at Cover-Up, and Luther and his fellow investors replaced them with a trusted manager whom we helped to recruit. Relieved of the financial burden of supporting a failing restaurant and bar, Cover-Up immediately resumed its profit growth.

Lessons. As we see time and again, there is no substitute for due diligence as a prerequisite for placing investment capital under the control of others — no matter how successful and prominent they are. Spending some time in the company’s offices may have alerted sophisticated investors such as Luther, et al., to the problems that led to Ted and Raymond’s undoing. Certainly, spending ten minutes with the beleaguered Myra would have tipped off the investors to an important weakness in the company’s financial management.

As for the accounts receivable, recognizing the inflated nature of the aging summary required more investigative prowess than most investors have. In a company that makes a high percentage of its sales on credit, due diligence should include a review and analysis of the aging summary by an outside professional.

While the preceding account is based on an actual case, the facts have been simplified and the names of all parties have been changed.

Printable Version