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FRAUD RATIONALIZATIONS AND THE GUILTY MIND

Fraud perpetrators often use a variety of excuses to alleviate the culpability of their mental states because they know they can’t be convicted unless prosecutors can prove their criminal acts were accompanied by a guilty state of mind known as mens rea. By Frank S. Perri, J.D., CFE, CPA; and Edyta M. Mieczkowska, CFE, CAMS Fraud rationalizations and the guilty mind

At the end of a five-year investigation, the FBI discovered that Enron Corpora- tion — an American energy, commodities I don’t think and services company based in Houston, I’m a fool, Texas — used a variety of deceptive and but I think I fraudulent accounting practices to cover was fooled ... its financial reporting fraud. Corporate I can’t take officers created the illusion that Enron responsibility was making profits in the billions, and its for the crimi- stock soared. Between 1996 and 2000, En- nal conduct of ron reported an increase in revenue from someone inside $13.3 billion to $100.8 billion. However, the company. the company was actually losing money. Enron executives, who used insider - Kenneth Lay information to trade millions of dollars in Enron stock, knew the company was hiding losses in offshore accounts. Inves- tors were oblivious. CFO Andrew Fastow and some subordinates created off-book companies to manipulate transactions that Houston, April 4: Former Enron chairman Kenneth Lay during the midday break of provided himself with hundreds of mil- his fraud and conspiracy trial April 4, 2006, in Houston, Texas. (Photo by Dave Einsel/ Getty Images News/Thinkstock) lions of dollars in guaranteed revenue — all at the expense of the corporation and its stockholders. As Enron stock climbed, and a heart attack on July 5, 2006, after he was fraudulently take the money because it as Wall Street continued to promote it, a convicted but before he was sentenced.) was only a temporary loan. High-level executives and CEOs group of 29 Enron executives and directors Skilling also insisted he was a victim might try to distance themselves from began to sell their shares. These insiders and claimed he didn’t know enough about fraudulent behavior by claiming igno- received $1.1 billion by selling 17.3 million accounting to detect fraud at the company. rance to demonstrate they didn’t know of shares from 1999 through mid-2001. “I had no idea the company was in anything any organizational fraud to minimize the Enron founder, Kenneth Lay, and CEO but excellent shape,” he said in “Enron’s chances of possible indictment. They’ll Jeffrey Skilling also financially benefited Many Strands: The Former CEO: Darth Va- argue that subordinates who orchestrated from Fastow’s fraudulent schemes in the der. Machiavelli. Skilling Set Intense Pace,” the fraud scheme kept them in the dark. millions of dollars of stock they sold prior by John Schwartz, The New York Times, Feb. In most criminal trials, prosecutors to Enron’s collapse. 7, 2002, http://tinyurl.com/qzstldv. seeking a conviction must prove that the When Lay was indicted for fraud, he defendants showed a “guilty or culpable conveniently blamed Skilling, Fastow and ‘GOOD’ INTENTIONS AND MENS REA state of mind” — the legal concept of mens COO Richard Causey for Enron’s demise rea. Unfortunately for Lay and Skilling, and denied he’d known anything about the Fraudsters, like Lay and Skilling, com- Fastow testified at trial that his superiors accounting fraud. Before his trial, he in- monly proclaim their innocence by deny- encouraged him to make the financial sisted he was a victim in an interview with ing a guilty mental state. In a securities health of the company look as positive as “60 Minutes,” stating: “I don’t think I’m a fraud case, for example, management possible and to avoid public disclosure. So, fool, but I think I was fooled … I can’t take will artificially inflate an organization’s the jury found that Lay and Skilling knew responsibility for the criminal conduct of stock price and then claim it was only a exactly what they were doing. someone inside the company.” (See “En- temporary measure to get through a dif- In this article, we attempt to show ron’s Ken Lay: I Was Fooled,” by Rebecca ficult period and not an attempt to deceive how misconceptions about mens rea can Leung, “60 Minutes,” March 11, 2005, at anyone. Or in an embezzlement case, the affect our professional skepticism in fraud http://tinyurl.com/oyxm2rq.) (Lay died of perpetrator will say he never intended to cases. We’ll use examples of the different

44 FRAUD MAGAZINE MARCH/APRIL 2015 FRAUD-MAGAZINE.COM plan and the desire to engage in fraud. If this was true, prosecution would have to I had no idea prove intent using direct evidence (i.e., the company was an admission from the accused), and all in anything but a fraudster would need to say to avoid li- excellent shape. ability is that he or she never intended to commit the crime. Given the number of - Jeffery Skilling rationalizations that are readily available, few offenders realistically would admit that they were in any guilty state of mind. However, litigants can prove intent by in- ference through circumstantial evidence. Now, let’s delve into the three main classifications of mens rea.

INTENT Someone who has intent to commit a crime acts with a deliberate, purposeful resolve — a desire to bring about a par- Houston, May 1: Former Enron CEO Jeff Skilling leaves the courthouse after pro- ticular result. The amount of planning ceedings in his fraud and conspiracy trial May 1, 2006, in Houston, Texas. (Photo by that went into committing a criminal act, Dave Einsel/Getty Images News/Thinkstock) offender statements or a combination of both could indicate a particular resolve. types of a criminal state of mind to show confusion. No single state of mind applies For example, an individual charged with when a fraudster most likely has given to all fraud offenders. Nevertheless, most murder might admit that he or she wanted thought to his or her scheme. fraud schemes require proof of one of the to commit murder, which reveals his or (Some criminal laws, called strict following classifications of mens rea: 1) her thoughts or even a motive. However, liability laws, don’t require the identifi- intent 2) knowledge and 3) reckless con- don’t confuse motive as being synony- cation of any guilty state of mind. These duct. We define and apply these three clas- mous with the different types of mens laws say that regardless of an offender’s sifications of mental culpability because rea outlined in this article. state of mind, the act — such as the sale of anti-fraud professionals can encounter In the Enron scheme, the Securities alcohol to minors — constitutes a crime them in white-collar crime prosecutions. and Exchange Commission’s (SEC) com- and deserves criminal punishment.) Anti-fraud professionals who aren’t plaint against Fastow speaks of intent by thoroughly acquainted with criminal law referring to it as scienter (in legal circles, SHADES OF CRIMINAL might think “intent” to commit a specific, intent is sometimes referred to by this Latin name): “Fastow engaged in conduct … in CULPABILITY criminal act is the only necessary type of connection with the offer or sale of securi- Diverging classifications of criminal mens state of mind that will hold fraud offenders ties, by the use of the means or instruments rea accommodate different factual sce- accountable. They might believe that if the of transportation … use of mails with scien- narios so that individuals who commit prosecutors can’t prove intent to commit ter to defraud … by means of untrue state- criminal acts don’t avoid accountability, and a crime then an offender can’t be crimi- ments of material facts.” (SEC v. Andrew they also impact the severity of punish- nally liable. However, this perspective isn’t Fastow, 2002, http://tinyurl.com/oggn57b) ment an offender faces. entirely correct. Also, some anti-fraud Yet, interestingly, Fastow — speak- What types of state of mind are nec- professionals believe direct evidence (i.e., ing at the 24th Annual ACFE Global Fraud essary to demonstrate guilt? The various evidence that establishes a disputed fact Conference in 2013 — still attempted to classifications of criminal mens rea, and without any inference) is the only type minimize his mens rea by referring to their meanings, vary among jurisdic- of evidence that proves intent such as an what he did as a mistake and not a crimi- tions and laws, which can cause some offender’s statements that disclose the nal act. “I knew that what I was doing was

FRAUD-MAGAZINE.COM MARCH/APRIL 2015 FRAUD MAGAZINE 45 Fraud rationalizations and the guilty mind

misleading. But I didn‘t think it was illegal. I thought that‘s how the game was played. You had a complex set of rules, and the I never thought objective is to use the rules to your advan- anything like tage. And that was the mistake I made.” that would have (See “Debunking the Myth of the Out of gone on. I put Character Offense,” by Frank S. Perri, Rich- those people ard G. Brody, Justin M. Paperny, originally in place. I published in the Journal of Forensic & In- trusted them. vestigative Accounting, Vol. 6, Issue 2, 2014, at http://tinyurl.com/ndjrosw.) - Bernie Ebbers To determine if intent to commit fraud exists, fact finders — such as juries or judges — are allowed to consider all circumstances to establish knowledge of wrongdoing and its extent because fraud offenders rarely state the intentions behind New York, March 15: Former WorldCom Inc. Chief Executive Bernard Ebbers their actions. Consider how few fraud of- outside federal court. (Photo by Chris Hondros/Getty Images News/Thinkstock) fenders would be investigated, held crimi- nally liable or prosecuted if mens rea only put at risk of great bodily harm or death. Consider the case of WorldCom, could be proven through direct evidence. The offender might not have wanted to kill which began in 1999. WorldCom com- Circumstantial evidence tends to anyone, but the risk of such behavior can’t menced making large offsetting account- prove a fact by producing other events or be excused simply because the offender ing entries after the quarterly close to circumstances that offer a basis for a rea- didn’t want someone to die. Whether that achieve the aggressive revenue targets sonable inference to draw conclusion(s). person had the intent to murder becomes established by the company and the For example, if an employee takes a vaca- less relevant. The law recognizes that an financial community. The SEC Report tion and a fraud examiner found that fraud offender’s behavior can create outcomes (2003, http://tinyurl.com/mmh5n3a) was perpetrated at the time the employee that are harmful regardless if the offender found handwritten documentation at was present but no evidence of fraud was had the desire for a particular outcome. WorldCom that recalculated the differ- found during the period that the employee A fraudster who commits occu- ence between the actual results, found on was on vacation, such evidence could be pational fraud might claim that even the monthly revenue (internally referred used to support an inference of the em- though he committed the crime, he to as the MonRev report), and the target ployee’s involvement of the fraud. lacked the mens rea to commit fraud or needed numbers. Once the variance because of his personal belief that he’d was calculated, accounting entries were KNOWLEDGE eventually put the money back. How- made to cover the shortfall so that finan- Knowledge refers to a fraudster’s deliber- ever the focus isn’t on how a fraudster cial targets would be met. ate indifference to his or her behavior that interprets his behavior but rather on the CEO Bernie Ebbers maintained that almost certainly creates a risk that results consequences of his behavior — to take his CFO Scott Sullivan and his subordi- in a criminal outcome. The offender is property from an organization with- nates kept him in the dark about their aware of the nature of his conduct and out the authority to do so. Even though financial reporting fraud. Ebbers stated didn’t act through ignorance, mistake he perceived it as a loan — which is a he was, “Shocked … I couldn’t believe it. or accident. The focus is on the conse- non-criminal matter in his mind — the I never thought anything like that would quences of the fraudster’s act to determine fraudster acted with knowledge that, have gone on. I put those people in place. if the necessary state of mind exists for for example, exploiting weak internal I trusted them.” (See “Visionaries or False someone to be held criminally liable for controls for financial gain could cause Prophets” by Frank S. Perri, 2013, from the crimes with a “knowing” mens rea. financial harm to the organization. It’s Journal of Contemporary Criminal Justice, For example, a person who fires a gun the consequence of a fraudster’s behavior at http://tinyurl.com/lsurlng.) In turn, into a crowd acts knowingly because there that’s questioned here — not his own Sullivan testified that Ebbers knew of is a practical certainty that others will be personal motivations. the fraud and that Ebbers told Sullivan

46 FRAUD MAGAZINE MARCH/APRIL 2015 FRAUD-MAGAZINE.COM not to issue an earnings warning to Wall “What Were They Thinking? Insider UNDERSTANDING Street which gave Sullivan the green light Trading and the Scienter Requirement,” RATIONALIZATIONS to create false profits. by Donald Langevoort, the Georgetown Fraud offenders, like all offenders, have The SEC investigation also uncov- University Law Center, 2012, at http://ti- their own rationalizations to morally dis- ered a voicemail message from Sullivan to nyurl.com/lycn7kz.) tance themselves from their criminal acts. Ebbers that contradicted Ebbers’ claims: For example, they could show that the If a person lacks the mens rea required for Hey Bernie, it’s Scott. This MonRev fraudster who made statements involv- conviction, then that person isn’t guilty of just keeps getting worse and worse. ing the sale of securities had the intent or The copy, um the latest copy that you engaged in reckless conduct that resulted fraud. Familiarize yourself with the clas- and I have already has accounting in deceiving, manipulating or defrauding sifications of mens rea to improve your fluff in it … all one time stuff or junk investors. (http://tinyurl.com/lycn7kz) skills and try to understand how fraudsters that’s already in the numbers. With A government investigation also create legal rationalizations to neutralize the numbers being, you know, off as will focus on any and all facts that would their criminal culpability. far as they were, I didn’t think that suggest a fraudster’s motive to mislead The authors emphasize that partici- this stuff was already in there. … We investors or that suggest fraudulent red pants in the U.S. legal system might interpret are going to dig ourselves into a huge flags existed about facts the organization various legal distinctions on the different hole because year to date it’s disguis- knew and didn’t pursue. (See “Red Flags states of mind in this article when applied ing what is going on. for Fraud,” by Steven J. Hancox, State of to federal and state cases. Consider that not (See “Report of Investigation,” Special New York Office of the State Comptroller, just one type of state of mind can apply to Investigative Committee of the Board of at http://tinyurl.com/75lksbu.) fraud offenders regardless of legal nuances. Directors of WorldCom, Inc., by Dennis For example, the SEC’s complaint None of the material in this article can R. Beresford, Nicholas deB. Katzenhach, against Ebbers reflects the alternative be considered legal advice. Please consult C.B. Rogers, Jr., March 31, 2003, at http:// methods of using mens rea when it stated with your counsel. tinyurl.com/mmh5n3a.) that, “Ebbers knew, or was reckless in not knowing, that WorldCom’s true method Frank S. Perri, J.D., CFE, CPA, is RECKLESS CONDUCT of accounting for line costs was not dis- an attorney at the County of closed to WorldCom’s auditors.” (http:// Reckless conduct is when someone acts Winnebago. His email address is: tinyurl.com/nnk2noj) with a conscious disregard and exposes [email protected]. A CEO who continues to use a stan- others to unjustifiable risk. It represents a gross deviation from a standard of care dard investor presentation but doesn’t get Edyta M. Mieczkowska, CFE, CAMS, a reasonable person would take in a given regular updates to ensure information is a financial crime risk management situation. For example, states attach crimi- accuracy could be subject to a claim of advisory officer at MB Financial nal liability to deaths that are a result of recklessness if prosecutors later allege Bank. Her email address is: someone driving under the influence of the presentation contained material in- [email protected]. alcohol. These acts might be classified accuracies. Despite the fact the offender as reckless homicides. (See “Man Pleads didn’t intend to deliberately deceive a Additional references Guilty in Death of Illinois Officer,” WGIL, potential investor, the CEO’s inaction U.S. District Court, Southern District of Aug. 27, 2014, http://tinyurl.com/nogc5pt.) exposed others to risks, and thus he com- Texas, Houston Division complaint, U.S. The recklessness condition of mens mitted reckless conduct. A fraud exam- SEC v. Kenneth L. Lay, Jeffrey k. Skilling, rea suffices to establish criminal culpabil- iner could gather statements made by Richard A. Causey, http://tinyurl.com/ kxpevdv. ity under laws that prohibit fraudulent a potential fraudster to show a pattern “Enron the Incredible,” by Dan Ackman, of making material misstatements that activities in securities trading, especially if Forbes magazine, Jan. 15, 2002, http://ti- a fraudster goes beyond carelessness and were more than just being negligent. For nyurl.com/koa6253. shows a pattern of poor decision making example, Ebbers on multiple occasions “How Enron used the offshore system that could cause harm to others. during his tenure would state publicly to hide millions,” by Lucy Komisar, The To establish a securities fraud claim, that WorldCom was in good financial Komisar Scoop, San Diego Union, Jan. 23, 2002, http://tinyurl.com/msuu2qc. the U.S. government has options to phrase health, when in fact it was the fictitious “How Fastow Helped Enron Fall,” by Bill their complaints against offenders us- revenue that was making the company Saporito, Time magazine, Feb. 10, 2002, ing the different mens rea available. (See look good. (http://tinyurl.com/nnk2noj) http://tinyurl.com/llafctq.

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