fraud and errors in auditing financial statements

Table of Figures Figure 1: compare between Fraud and Errors Figure 2: Types of errors Figure 3: Reasons lead to act of embezzlement Figure 4: Reasons lead to fraud on the Financial State

FRAUD AND ERRORS IN AUDITING FINANCIAL

STATEMENTS

BY CAN MAI HUONG

E0700241

BACHELOR OF BUSINESS (ACCOUNTING) HONS

HELP UNIVERSITY COLLEGE

OCTOBER, 2011

FRAUD AND ERRORS IN AUDITING FINANCIAL

STATEMENTS

BY CAN MAI HUONG

Declaration of Originality and Word count

DECLARATION

I here by declare that this graduation project is based on my original work except for quotations and citation that have been duly acknowledged I also declare that it has not been previously or concurrently submitted for any other courses/degrees at HELP University College or other institutions The word Count is words

Can Mai Huong

October, 2011

Acknowledgements

This project would not have been made possible without the assistance, support and encouragement of many people I wish to take this opportunity to thank all the people who have helped me during the time of completing the dissertation

Firstly, I would like to express my deep gratitude to my supervisor at the International School – Vietnam National University Ha Noi (ISVNU) He has kindly helped me and supported me all the way through For that, I am very grateful I also would like to express my thank to and at Help University College, who initiated the project and give so much instruction and support

In addition, a huge thank for all managers, accountants, personnel who sacrificed theirs time to answers my questionnaire

CAN MAI HUONG

ABSTRACT

FRAUD AND ERRORS IN AUDITING FINANCIAL

STATEMENTS

BY CAN MAI HUONG OCTOBER, 2011

Supervisor: PHAM DUC HIEU

During the audit, there are always fraud and errors which are not detected and falsify financial statements To reduce the risk of undetected fraud affecting seriously the financial statements and to express a right opinion on financial statements, auditors need to concern about fraud problem and the possibility of fraud during the audit In fact, there is always a difference between the expectations of users of financial statements expected from auditors and what auditors can meet Because the user thinks that auditors absolutely ensure honest and reasonable financial statements while it is very difficult for auditors to do this To narrow this gap, auditors have to not only explain the limitations and scope of the auditing industry to users of financial statements but also continuously improve the professional capacity of individuals to find out our fraud and errors falsifying financial statements seriously

Table of Contents

Declaration of Originality and Word count II Acknowledgements III ABSTRACT IV Table of Figures VIII List of Abbreviations IX

Chapter 1: INTRODUCTION 1

1.1 Research background 1

1.2 Problem statement 2

1.3 Research question 3

1.3.1 Fraud and Errors in the worlds 3

1.3.2 Fraud and Errors in Vietnam 5

1.3.3 Research statement 6

1.4 Thesis structure 7

Chapter 2: LITERATURE REVIEW 9

2.1 Definition of Fraud and Errors 9

2.1.1 Definition of Fraud 9

2.1.2 Definition of Errors 10

2.1.3 Compare Fraud and errors 10

2.2 The Forms of Fraud 11

2.2.1 Forms of fraud 11

2.2.2 Forms of errors 11

2.3 Factors affecting the fraud and errors 11

2.4 Related Theory 13

2.4.1 The Control Fraud Theory 13

2.4.2 The ―Fraud Created the Market‖ Theory 15

2.5 The common method to fraud in auditing financial statements 18

2.5.1 High declaration (or perjury) revenue 18

2.5.1 High declaration (or perjury) revenue 19

2.5.2 Note the year wrong 19

2.5.3 Conceal liabilities and expenses 19

2.5.4 Declare not enough information 19

2.5.5 Apply underestimated method 19

2.6 Motive for fraud and errors in financial statements of enterprises 20

Chapter 3 : RESEARCH METHODOLOGY 22

3.1 Research method 22

3.1.1 Quantitative methodology 22

3.1.2 Qualitative methodology 22

3.2 Data source 23

3.2.1 Secondary data 23

3.2.2 Primary data 23

3.3 Research tool 23

3.3.1 Internet tool 23

3.3.2 Questionnaire 24

Chapter 4: FINDING AND DISCUSSION 25

4.1 Questionnaire Results 25

4.1.1 Question 1: Among the following errors, please indicate types of errors that you often see in auditing the Financial Statements? 25

4.1.2 Question 2: In your opinion, for which of the following reasons lead to act of embezzlement? 26

4.1.3 Question 3: In your opinion, for which of the following reasons lead to fraud on the Financial Statements? 27

4.1.4 Question 4: In your opinion, which sectors or fields often occur high risk fraud: 27

4.1.5 Question 5: You tell me about the person who implements fraud often holds which position at the Company: 28

4.1.6 Question 6: In your opinion, in two age groups which groups often implement fraud: 28

4.1.7 Question 7: During forms of revenue fraud, which the following form you often face up to: 29

4.1.8 Question 8: In terms of business management, in your opinion, which factor plays a decisive role in preventing the frauds in the financial statements? 30

4.2 Interview results 30

Chapter 5 : CONCLUSION AND RECOMMENDATION 35

5.1 Lessons for Vietnam 35

5.1.1 Enhance responsibilities of auditor for fraud and errors: 35

5.1.2 Regularly update auditing standards including standards related to fraud and

errors: 35

5.1.3 Should release guidance on procedures for fraud detection 35

5.2 To raise the responsibility of auditors for fraud and errors in the audit of financial statements 36

5.2.1 Ministry of Finance still performs a key role in releasing auditing standards: 37

5.2.2 Take legal proceedings against the whole organizations of Vietnam association of accounting and auditing 38

5.2.3 Always update released auditing standards: 38

5.2.4 Should release detailed guidance 38

5.2.5 Attach special importance to human resource training to the regional level 39

5.3 Solutions for auditing companies 40

5.3.1 Strengthen controlling the internal quality of auditing companies 40

5.3.2 Strengthen procedures for detecting fraud in auditing program 40

5.3.3 Improve the training quality of auditors 40

5.4 Conclusion 41

APPENDICES 44

Table of Figures

Figure 1: compare between Fraud and Errors

Figure 2: Types of errors

Figure 3: Reasons lead to act of embezzlement

Figure 4: Reasons lead to fraud on the Financial Statements Figure 5: Fields often occur high risk fraud

Figure 6: Person who implements fraud

Figure 7: Age groups often implement fraud

Figure 8: Forms of revenue fraud

Figure 9: Factor plays a decisive role in preventing the frauds

List of Abbreviations

WTO: World Trading Organization

U.S: United Stated

BTCC: Bach Tuyet Cotton Corporation

A&C: Auditing and Consulting

ACCA: Association of Characted Certified Accountant CEO: Chief Executive Officer

CFO: Chief Financial Officer

ACFE: Association of Certified Fraud Examiners

VACPA : Vietnam Association of Certified Public Accountants ISA: International Standards on Auditing

KPMG: Klynveld Peat Marwick Goerdeler

E&Y: Ernst & Young

PwC: Price waterhouse Coopers

Chapter 1: INTRODUCTION

1.1 Research background

There always exist hidden fraud and errors causing mistakes to financial statements

To reduce risks of not discovering frauds which seriously affect financial statements and to give right opinions about financial statements, auditors need to study fraud and ability of fraud appearance during audit process In fact, there always exists difference between expectation of financial statements readers in auditor and what in fact auditors meet their expectation as readers know that auditors must ensure the absolute honesty and reasonability, but auditors cannot do that To address with this problem, besides explaining the scope and limitation of audit sector, auditors must incessantly improve their competence and professional knowledge to discover fraud and errors causing essential errors to financial statements

Within the framework of the market economy, the demand of information receipt and delivery, especially financial data which always plays an important role in making business decisions The transparency, truthfulness of financial data plays a key role

in stabilizing the securities market and the society

Recently, a lot of big financial frauds have occurred in the world, producing a stir in world opinion People are surprised about not only economic losses due to fraud but also the methods of fraud implementation Except for employees and senior leaders

of the company, independent auditors are also involved in implementing a fraud in which Enron fraud is a typical example

In Vietnam, many frauds have occurred on the Financial Statements in recent years The failure to detect fraud is caused by many reasons in which must include the responsibilities of auditor and auditing company Because independent auditing profession in Vietnam has just started for over 15 years, this period isn’t long enough

to have a professional staff of auditors corresponding to the world level In addition, the legal environment for auditing sector is taking steps to build and gradually complete; therefore, it’s still inadequate

Hence, improve the quality of independent auditing activities, strengthen the responsibility of auditor in respect of detecting fraud and errors on the Financial Statements is still a topical question with a view of enhancing the transparency, reliability of financial data in making economic decisions

Therefore we should incessantly study fraud and errors in accounting and auditing

To better understand such fraud and errors, I will present about the topic ―FRAUD AND ERRORS IN AUDITING FINANCIAL STATEMENTS‖

1.2 Problem statement

In order to better understand fraud and errors in auditing financial statements of recent companies, we need to answer some following questions: What is fraud and

errors? In broad sense, fraud is illegal behaviors to cheat then to gain benefits

There are three most common ways to make fraud, namely: appropriation, defrauding and embezzlement

In accounting aspect, according to international accounting standard No 10, fraud

and errors are defined as errors in calculation, in application of accounting policies, unreal explanation, fraud or intentionally missing out

In auditing aspect, according to international auditing standard No 240 in 2004,

fraud and errors are defined as follows:

Errors are non-intentional mistakes which affect financial statements such as missing out an amount of money or not declaring information in financial statements

Common examples about errors are errors during data collection and processing and presenting it in financial statements, errors in accounting estimations, or application

of underestimated accounting principles

The second question: Why are fraud and errors important in auditing financial

statement? In recent years, there have had much fraud in financial statements Inability to discover these frauds are due to many reasons including responsibility of auditors and auditing companies As the job as independent auditor has just been present in Vietnam for more than 15 years, this time is not long enough for auditors

to have an international professionalism and competence In addition, legal environment for auditing sector has been step by step established and completed, thus it still has many problems

Therefore, improving quality of independent auditing activities and enhancing responsibility of auditors in discovering fraud and errors in financial statements is a topical question so as to improve transparency and reliability of financial information

in economic-related decision making The thesis will focus on analyzing some

popular fraud in financial statements in the world and in Vietnam, then to propose effective approaches for auditors to discover fraud and errors in auditing financial statements In addition, the thesis also combines with macro solution group to complete legal corridor for auditing profession

The third question: Influences of fraud and errors in auditing financial statements

for enterprises in Vietnam? In the market economy, demand of giving and receiving information, especially financial information plays a highly important role in making business decisions

Transparency and honesty of financial information has great importance in stabilizing securities market and society

In recent years, there occur many financial frauds which produce a stir in world opinion People are not only surprised about economic detriments caused by fraud but also ways of making fraud People making fraud are not only staffs and senior managers of companies but also independent auditors

1.3 Research question

1.3.1 Fraud and Errors in the worlds

Fraud appears together with the appearance of human society Together with the development of the society, fraud is more and more sophisticated and shown in various forms Source of fraud is the transformation in which each individual from a separate life starts to live into community The embryonic form of fraud is the embezzlement of property in order to satisfy personal demands

Fraud develops together with the birth and development of the economy In the industrial revolution, there appeared a series of enterprises with the separation between ownership and management function This separation gave birth to a new form of fraud which was fraud between managers, staffs and their owner Manifestation of this form of fraud was embezzlement of property By 20th century, rapid development of the world’s economy, especially the importance of securities market – a most effective channel of capital mobilization of the world’s financial market, lead to many new forms of fraud which are made by some members in board

of Directors of among staffs

At the end of the 20th century, the bankruptcy of a series of world’s leading economic groups brought about serious downturn of a whole sector The society was once surprised by a fact that there are more and more frauds in the society, in which the most typical fraud at the end of 20th century were of Enron, Worlcom, Xerox, Nicor Energy LLC

Enron: In 1990s of the 20th century, Enron was one of world’s leading companies doing business in energy Its business had been highly efficient However, at the end

of the 20th century, its business results were more and more declining The late 6 months in 1999, the company’s profit was 325 million dollars while the late 6 months in 2000 its profit was just 55 million dollars To maintain trust of the public, Enron had exaggerated its profit in its financial statements The fraud was not only made by one person or some people but it was the collusion of many people including members in the Board of Management The group making fraud was the Governance of the Company and even the auditing company To hide its declining business, the Company had some ways such as:

- Use methods evaluating assets and debts according to market price If this method is used, there will appear in financial statements ―virtual‖ income which cannot be converted into money;

- Hide its debts and costs: To do this, Enron has established a series of child companies which act as buyer and seller to so that it can hide its debt and loss

Although the financial statements announced loans which were declining, in fact during early 9 month in 2000 its debt due increased dramatically During that time, Enron had borrowed additional 3.9 billion dollars, raising total debt by September of

13 billion dollars; ratio of due debt over total working capital accounts for 50%, in stead of 39% in 1999

Besides high declaration of its income and concealing its expenses, Enron also on its own initiatives change information about energy market in Texas, in California and bribe Government of foreign countries in wining energy contract in foreign countries

Worldcom: In Mart 2002, this Company was accused of making fraud though

capitalization of an operating cost of 3.8 billion dollars and thus making up a respective profit by U.S Securities and Exchange Commission, public prosecutor in

New York In addition, there was an illegal fraud of its founder – Mr Bernard Ebber who had borrowed an amount of 400 million dollars which had not been recorded and declared in its financial statements

Xerox: In June 2000, U.S Securities and Exchange Commission accused Xerox of

declaring wrong information in its financial statements for 5 years, high declaring an income of 1.5 billion dollars To correct its fault, Xerox agreed to pay a fine of 10 million dollars for U.S Securities and Exchange Commission and re-prepared its financial statements from the year 1997 honestly and transparently Board of Directors of the Company also committed to obey requirements of Securities Law and ensure there would have no fraud and error in its financial statements

Nicor Energy LLC: In July 2002, this Company made fraud in its financial

statements but the independent auditor had not discovered Its fraud was mainly high declaration of revenue and missing out costs After that, Nicor Energy LLC adjusted its financial statements and currently it has established a reliable accounting system Above fraud appeared in early the 21st century, this means that together with the development of the economy, fraud techniques are more and more developed, more sophisticated and made by collusion of many people While before the year 2000, fraud was mostly embezzlement made by some members in Board of Directors or staff of company, in recent years there have emerged new forms of fraud which are fraud in financial statements People making fraud are not one person or some people but a group of people including Board of Directors, Board of Management and Auditing Companies Adverse impacts of fraud are much greater and on many people

in the society

1.3.2 Fraud and Errors in Vietnam

In recent years in Vietnam, a series of fraud in economy, commerce and financial statements discovered have shown that fraud occurs in all form of enterprises: State-owned enterprises, joint stock companies, private enterprises and in all sectors: commerce, production, construction…Although these frauds are as not serious as in other countries in the world, it exerts great influences on the economy and belief of people in financial statements of companies, especially listed companies in securities market Typical examples of fraud in financial statements of listed companies are of Bien Hoa Confectionery Corporation - Bibica, Bach Tuyet Cotton Corporation

(BTCC) ), Ha Long Canned Food Stock Corporation, etc In addition, according to statistics of Stox.vn1, by 20th April 2009, among 357 enterprises listed in securities market, there have had at least 194 companies having disparity between results before and after auditing, in which many enterprises have great disparity in business results (more than 10%) And there have been 47 enterprises having difference in business results before and after auditing of up to 50%

Through fraud in financial statements of companies in recent time, we can conclude their ways of making fraud as follows:

Companies have made up its revenue and income, and recorded decrease of costs Recording decrease of costs are often made through capitalization of cost, not full depreciation of provisions, especially provisions for devaluation of financial investment, provision for bad debts Companies can also transfer some costs to next year or change methods used in prime cost accounting, method of calculating depreciation For example, for Bibica, concealing its loss in financial statements in

2002 was made by recording 5,565 billion dong of business operation expense into cost for construction in progress and making up income of 1,337 billion dong Or for financial statements of BBT, the company has not made depreciation for devaluation

of goods in stock, changed depreciation policies leading to decrease depreciation expense of about 1,253 billion dong compared to that of 2004; not accounted product advertisement expense which it has paid during the year

Motive for fraud is because managers have to suffer from pressure in which they have to reach a target about revenue, profit or company wants to maintain market price of its shares while it is facing difficulties in business and financial state

1.3.3 Research statement

According to Mr Ho Van Tung, Manager of Auditing Division, Auditing and

Consulting Company Ltd (A&C): ―Auditing is a job which has many risks as when

Auditors give their opinions about financial statements which have been prepared and presented by Board of Directors of the audited company, they can give wrong opinions when there are fraud and errors in the financial statements which have not

1

Stox.vn – Intensive securities financial information This is a website providing financial information about all Vietnam’s enterprises listed in securities market

been discovered On the other hand, the pressure of completing a great volume of work in short time easily make mistakes Thus auditing is a challenging job for auditors Therefore, this job not only requires auditors to have sufficient knowledge and skills in auditing and accounting, ability to supervise their work, ability to make judgments and discover auditing risks, but they also need to have good understanding about relevant regulations and law, have experiences and through understanding about business activities of customers‖ 2

Vietnam is on the first phase of market economy Vietnam’s auditing sector has been operating for 20 years, but it is still quite young compared to other countries Thus, knowledge I have learnt in the subject ACCA3 help me easily grasp changes in the sector as well as new regulations about accounting and auditing On the other hand, knowledge and skills of the course also help me to improve professionalism in my job

So why are fraud and errors important in auditing financial statements? Influences of fraud and errors in auditing financial statements for Vietnam’s enterprises?

In order to understand more about fraud and errors, this study will focus on fraud and errors in auditing financial statements

1.4 Thesis structure

The remainders of this research is organised as follow

Chapter 1: Introduction, conclusion, references and appendix

Chapter 2 ―Literature review‖ starts with definition of fraud and errors in auditing financial statements so that readers will have a general view about fraud and errors Some theories and researches related to fraud and errors concepts present through different collections, summaries and discussion Followed by parts: Forms of fraud and errors, factor affecting fraud and errors, common ways to make fraud and errors

in financial statements, responsibilities of auditors for fraud and errors, relationship

2 Source: www.ftmsglobal.edu.vn

3 ACCA: (Association of Chartered Certified Accountants) is one of certificates issued by

Association of Chartered Certified Accountants of the U.K which is acknowledged and highly

appreciated in the world ACCA is leading certificate in auditing – accounting – finance – banking in the U.K and other developing countries in the world

between fraud and errors and ethic issue At the end of this chapter, I myself will give some of hypothesises hereof

Chapter 3: Research method is presented with different parties such as, data source, research tools

Chapter 4 : The results of research, my findings through the questionnaire are available in the fourth chapter This chapter also presents the limitation during the research

Finally, Chapter 5 will give some implication for Government and Enterprises and eventually the conclusion of this research

Chapter 2 : LITERATURE REVIEW

2.1 Definition of Fraud and Errors

2.1.1 Definition of Fraud

Fraud is behaviors which intentionally make mistakes to economic and financial information implemented by many people in the organization or the third party, exerting influences on audited subject

In finance-accounting, fraud can simply be the behavior of intentionally violating property, embezzling public funds, embezzlement and corruption, etc Violating property often attaches with distorting accounting information such as incorrectly recording operations, faking or repairing vouchers, concealing documents and covering up clue, etc

For example: When checking the cutting down on sales revenue in some customers,

among selected operations, auditors have picked up an operation relating to revenue from a customer; based on business evaluation of other auditing, the auditor discovers that this customer is one main buyer This operation is not often and considered as being essential Documents relating to this operation have been collected, including evidence relating to payment of accounts receivable after the closing date of financial statements of the year However, document relating to waterway delivery have not been given After being analyzed, it proves that there is

no record about delivery process Although there is evidence about payment, nothing proves that goods had been delivered So more analysis is done, auditor asks for invoices of the company Auditor has proved that some invoices for ―special services‖ have been given to customer when they are paid These invoices are less detailed than other invoices in the document file and they cannot be clarified through orders or documents receivable These special invoices have shown that such sale operation is absolutely doubtful This problem is discussed with Financial Officer who gives an incorrect explanation After meeting Board of Management, the auditor meets the Financial Officer again and informs that the problem is being investigated The Financial Officer has colluded with Managing Director to make plan to increase sales so as to gain revenue target As the Financial Officer wants to validate the problem,, he chooses a main customer to involve in this He will instruct directly the customer to fill in the invoice and give it back within 30 days After that he will

coordinate and ―make up‖ virtual sale to company of the customer with respective amount of money Within 30 days paying this virtual sale, the customer will defer the payment At the end of accounting period, this dishonest sale will be recorded in to revenue This helps the Financial Officer to reach sales target

2.1.2 Definition of Errors

Errors are non-intentional mistakes influencing on financial statements such as missing out an amount of money or not declaring information in financial statements Common examples about errors are ones in data collection and processing and its presence in financial statements, errors in estimations or application of underestimated accounting principles Errors can be very serious such as violating regulations about finance and accounting, repeated errors or errors of big scale…however they are non-intentional

2.1.3 Compare Fraud and errors

 Similarity: Both of them are mistakes, causing misleading information and

reflecting incorrectly fact

- Errors are non-intentional behavior; they are just simple missing out information or due

to limited competence and carelessness in working… causing mistakes

Sophisticati

on

- As fraud is intentional behavior,

it is more sophisticated than errors

When making fraud, people are often well-prepared and have careful calculation, thus it is difficult to detect fraud than errors

- As errors are non-intentional behavior, they are as not sophisticated as fraud and it is easy to detect errors

Essence - Fraud is always considered as

2.2 The Forms of Fraud

2.2.1 Forms of fraud

 Distort, fake voucher and documents

 Repair accounting vouchers and documents

 Embezzle property

 Conceal or intentionally miss out economic information, document or operation

 Record economic operation incorrectly

 Intentionally apply underestimated accounting standards, principles, methods and system, financial policies

 Intentionally make incorrect mathematic calculations

2.2.2 Forms of errors

 Make mistakes in mathematic calculation or record wrongly

 Miss out or wrongly understand economic operations

 Apply underestimated accounting standards, principles, methods and system, financial policies non-intentionally

2.3 Factors affecting the fraud and errors

 Limitations in designing and performing internal control system

 Existing limitations of auditing activities

 Issues relating to probity or competence of Board of Directors, such as;

 Management is controlled by a person or a group of people, lacks effective supervision of Board of Directors or Board of Management

 Organizational structure of audited company is complicated intentionally

 Powerless in overcoming shortcomings of internal controlling system while such shortcomings can be absolutely overcome

 Frequently change chief accountant or responsible person in accounting and finance division

 Lack accounting staff in a long time

 Arrange person who is not specialized in accounting or being restricted by law to work as an accountant

 Frequently change law consultant or auditor

 Unusual pressure in the organization or from outside environment such as:

o It has difficulties in its fields of business

o Lack capital for doing business due to loss or too rapid expansion of company scale

o Enterprise is dependent on some products or some customers

o Financial pressure from investors or managing levels in the organization

o Pressure on staff to complete their work in short time

o Abnormal operations or economic events such as operations occur at the end

of accounting year have impacts on revenue, cost and results

o Complicated operations or accounting treatment methods

o Operations with related parties

o Costs are too high compared with provided services

 Difficulties relate to sufficient collection of reasonable auditing evidence:

 Accounting documents are insufficient or not provided promptly

 Insufficient archive about economic events and operations

 Great discrepancy between accounting book of the organization with confirmation of the third party, conflicts of auditing evidence, in ability to explain changes of operating indicators

 Board of Directors refuses to explain or their explanations do not meet auditor’s requirements

 Factors from informatics environment relate to above situations and events such as:

 In ability to get information from computer

 There are changes in computer programs but documents have not been saved, approved and tested

 Information and documents printed from computer are not compatible with information in financial statements

 Information and documents printed from computer are different each time

of printing

2.4 Related Theory

2.4.1 The Control Fraud Theory 4

Control fraud theory was developed in the savings and loan debacle It explained that the person controlling the S&L (typically the CEO) posed a unique risk because he could use it as a weapon

The theory synthesized criminology (Wheeler and Rothman 1982), economics (Akerlof 1970), accounting, law, finance, and political science It explained how a CEO optimized ―his‖ S&L as a weapon to loot creditors and shareholders The weapon of choice was accounting fraud The company is the perpetrator and a victim Control frauds are optimal looters because the CEO has four unique advantages He uses his ability to hire and fire to suborn internal and external controls and make them allies Control frauds consistently get ―clean‖ opinions for financial statements that show record profitability when the company is insolvent and unprofitable CEOs choose top-tier auditors Their reputation helps deceive creditors and shareholders

4

Source: http://bizcovering.com

Only the CEO can optimize the company for fraud He has it invest in assets that have no clear market value Professionals evaluate such assets-allowing the CEO to hire ones who will inflate values Rapid growth (as in a Ponzi scheme) extends the fraud and increases the ―take.‖ S&Ls optimized accounting fraud by loaning to uncreditworthy and criminal borrowers (who promised to pay the highest rates and fees because they did not intend to repay, but the promise sufficed for the auditors to permit booking the profits) The CEO extends the fraud through ―sales‖ of the troubled assets to ―straws‖ that transmute losses into profits Accounting fraud produced guaranteed record profits-and losses

CEOs have the unique ability to convert company assets into personal funds through normal corporate mechanisms Accounting fraud causes stock prices to rise The CEO sells shares and profits The successful CEO receives raises, bonuses, perks, and options and gains in status and reputation Audacious CEOs use political contributions to influence the external environment to aid fraud by fending off the regulators Charitable contributions aid the firm’s legitimacy and the CEO’s status S&L CEOs were able to loot the assets of large, rapidly growing organizations for many years They used accounting fraud to mimic legitimate firms, and the markets did not spot the fraud The steps that maximized their accounting profits maximized their losses, which dwarfed all other forms of property crimes combined

While agreeing that the S&L served as both a ―weapon‖ and a ―shield,‖ control fraud theory cast doubt on those metaphors Weapons and shields are visible; fraud is deceitful The better metaphors would be camouflage, or a virus Control fraud theorists rejected the economists’ metaphor, ―gambling for resurrection‖ (honest but unlucky risk takers) Gambling cannot explain why control fraud was invariably present at the typical large failure There were over 1,000 felony convictions of senior S&L insiders Accounting fraud made control fraud a sure thing-not a gamble Control fraud theory predicts the pattern of record profits and catastrophic failure and the business pattern of deliberately making bad loans Both patterns are inconsistent with honest gambling

2.4.2 The “Fraud Created the Market” Theory 5

In an August 16, 2010 opinion, the United States Court of Appeals for the Third Circuit rejected use of the so-called ―fraud created the market‖ theory for securities fraud claims Malack v BDO Seidman, LLP, No 09-4475 (3d Cir Aug 16, 2010) The ―fraud created the market‖ theory posits that a securities fraud plaintiff should not have to prove individual reliance upon alleged misrepresentations if the plaintiff can show that, absent the misrepresentations, the securities that the plaintiff purchased would not have been offered for sale at all, on the premise that under such circumstances the plaintiff’s reliance can be presumed The Third Circuit’s ruling adds to the split among the federal circuit courts of appeals on the viability of this controversial theory, thus potentially presaging an eventual resolution of the issue by the United States Supreme Court

Background

The plaintiff in Malack had purchased notes issued by a subprime mortgage originator Those notes later became worthless after the decline of the subprime mortgage sector The plaintiff sued the accounting firm that allegedly provided clean audit opinions that were used to obtain SEC registration of those notes, seeking recovery on his own behalf as well as certification of a class of allegedly defrauded purchasers of the notes

The plaintiff did not allege that he had read, reviewed, or directly relied upon the audit opinion that was the basis for his suit Nor did he allege that the notes (which did not trade on any securities exchange) traded in an ―efficient market,‖ such that their price could be presumed to promptly reflect all relevant information available to the investing public Instead, in order to establish reliance upon the audit opinion, the plaintiff alleged that ―without clean audit opinions, American Business would not have been able to register the Notes with the SEC, the Notes would not have been marketable, and Malack and the other investors would not have purchased the Notes.‖

The United States District Court for the Eastern District of Pennsylvania denied class certification, finding that Malack’s ―fraud created the market‖ theory lacked a legal

5

Source: www.chadbourne.com

basis, and that without the theory, individual reliance issues rendered class certification inappropriate The Third Circuit agreed and affirmed

The “Fraud Created the Market” Theory

The Third Circuit began its opinion by noting that a presumption of reliance has been recognized by the United States Supreme Court in two circumstances First, the presumption has been recognized where a defendant failed to disclose material facts despite having a duty to do so Second, reliance may be presumed under a ―fraud on the market‖ theory, which can be applicable when a plaintiff shows that the securities

at issue trade in an ―efficient market,‖ i.e., a market that can reasonably be presumed

to reflect the impact of false statements in the market price of securities, whether or not the particular plaintiff ever saw or read such statements

Some federal appeals courts, however, have recognized a third circumstance as being appropriate for a presumption of reliance upon the alleged misstatements Such courts have recognized a ―fraud created the market‖ theory, which ―posits that the securities laws allow an investor to rely on the integrity of the market to the extent that the securities it offers to him are entitled to be in the market place.‖ Thus, reliance should be presumed when a plaintiff shows that absent fraud, the securities

at issue would have been ―unmarketable,‖ and that the plaintiff ―purchased in reliance on the market.‖ The theory assumes that investors are entitled to ―rely on a security’s availability on the market‖ as an ―indication of its apparent genuineness.‖6

Other courts, though, have rejected the theory7

The Third Circuit’s Analysis

The court analyzed the proposed ―fraud created the market‖ presumption by looking

to the factors that have traditionally led courts to create factual presumptions Presumptions, the court wrote, have traditionally been recognized where courts conclude that the presumption is very likely to be accurate, such that it is ―sensible

6

This theory has been endorsed by the Fifth, Tenth, and Eleventh Circuits See Shores v Sklar, 647 F.2d 462 (5th Cir 1981) (en banc); T.J Raney & Sons, Inc v Fort Cobb, Oklahoma Irrigation Fuel Auth., 717 F.2d 1330 (10th Cir 1983); Ross v Bank South, N.A., 885 F.2d 723 (11th Cir 1989) 7

The theory has been rejected by the Seventh Circuit, see Eckstein v Balcor Film Investors, 8 F.3d

1121 (7th Cir 1993), and the Sixth, Eighth, and Ninth Circuits have declined to follow it in particular cases without expressly ruling on whether it could never in any circumstances be viable See Ockerman v May Zima & Co., 27 F.3d 1151 (6th Cir 1994); In re NationsMart Corp Sec Litig., 130 F.3d 309 (8th Cir 1997); Desai v Deutsche Bank Sec Ltd., 573 F.3d 931 (9th Cir 2009).

and timesaving‖ to apply a presumption Presumptions have also, the court wrote, been created to correct imbalances ―resulting from one party’s superior access to the proof,‖ or in order to further congressional policy, or to avoid a ―factual impasse.‖ Creating a ―fraud created the market‖ presumption, the court held, was not warranted

in light of these considerations Such a presumption would not be likely to accurately reflect reality, because ―common sense‖ fails to support ―the idea that securities on the market, by the mere virtue of their availability for purchase, are free from fraud.‖ In particular, the court noted that a security’s availability on the market should be taken as an indication of genuineness only if there were ―some entity involved in the process of taking the security to market that acts as a bulwark against fraud.‖ But to the contrary, the court wrote, all of the private actors involved in bringing securities to market have incentives to act in a self-interested, and perhaps dishonest, manner, so that it is not reasonable to assume that securities are free from fraud simply because they have been brought to market

Moreover, the court found that SEC approval of a securities registration statement does not provide a reasonable basis to presume that the securities offered are free from fraud, because the SEC’s role is limited to reviewing the registration statement

to ensure that it contains adequate disclosures The court noted that the SEC does not conduct ―merit regulation‖ of securities, seeking to determine whether the offered securities are, in fact, a good investment Nor does the SEC endorse offering documents or vouch for their truthfulness

The court further noted that even if a security were offered in a fraudulent manner, disclosure of the truth will seldom render the security truly ―unmarketable,‖ since

―disclosure of adverse information may lower the price of a security, but it will not prevent that security from going to market.‖ Finally, the court noted that unlike the fraud-on-the-market theory, the ―fraud created the market‖ theory lacks a basis in accepted economic theory

The court additionally explained that policy considerations did not support employing a ―fraud created the market‖ presumption In particular, the court wrote, such a presumption would actually reduce investors’ incentive to carefully read and review the offering materials and fully research their investment, since with the presumption they would be able to recover for any misstatements whether or not they had reviewed the offering materials; ―moreover, an investor might seek rationally to