Sell Block

As the desiccation of liquidity exposes businesses and financial firms, instances of fraud, both on a grand scale and relatively minor offenses, seem to be emerging on a daily basis.

As the desiccation of liquidity exposes businesses and financial firms, instances of fraud, both on a grand scale and relatively minor offenses, seem to be emerging on a daily basis. Bernard Madoff's ponzi scheme is obviously the most talked about transgression in recent months, though similar cases involving lawyer Marc Dreier, venture capitalist William "Boots" Del Biaggio, and Illinois Governor Rod Blagojevich has given the CSI set more scams than they can handle in a given news cycle. The M&A market, while spared of any major hoaxes so far in 2009, is by no means immune.

"In good times people steal; in bad times people really steal," Joseph Spinelli, co-founder and chief operating officer at Daylight Forensic & Advisory, tells Mergers & Acquisitions.

Yogesh Bahl, a partner at Deloitte Financial Advisory Services LLP, notes that financial duress serves to "ferret out fraud," as most schemes require a continuing influx of cash. "As soon as the funding stops, that's when people start asking questions," he says.

At the same time, Bahl notes that downturns can often present "a more fertile landscape" for fraud or collusion, as incentive schemes aren't readjusted to deal with the new environment. At the same time, companies are cutting back on the infrastructure and compliance designed to root out fraud and employees will assume new responsibilities that make collusion easier.

In M&A, fraud can take on a number of forms. Perhaps most common is the instance in which a target company has manipulated the books and views a sale as an easy out. Marketwatchers will likely remember it was The Blackstone Group, through its due diligence, that reportedly uncovered the fraud at Parmalat. The disclosure ultimately led to the dairy producer's bankruptcy filing.

Another high-profile case, again involving a private equity firm, occurred when former Refco CEO Phillip Bennett was caught hiding $430 million of bad debt. This case highlights how much damage instances of fraud can trigger to the ancillary players. Bennett received 16 years in prison, but in the aftermath shareholders also went after Thomas H. Lee Partners, which acquired Refco and profited on its IPO; Grant Thornton, the company's auditor; and a slew of investment banks, which underwrote and financed the company.

Malfeasance in M&A is not confined to target companies either. Deloitte's Bahl notes, "You also see it happen from the acquirer's perspective. Once these companies start mixing up the financials it clouds the level of transparency that once existed."

Most recently, this cropped up at National Lampoon, whose CEO orchestrated a scheme providing kickbacks for stock purchases. The aim, which fell flat, was to artificially inflate the company's stock price to improve its capital position for all-stock deals and potentially pump up the company's valuation for a sale to a strategic.

In other cases of fraud, companies will use M&A to create enough noise that the din distracts regulators from seeing through to the swindle. In 1999, the Securities and Exchange Commission had investigated Tyco to determine whether or not the company was using its merger-related accounting to overstate its performance. That was three years before it was finally uncovered that Tyco's CEO Dennis Kozlowski had looted $96 million from the company. In a perhaps bigger scam, WorldCom tallied an almost $80 billion overstatement, using M&A as part of and to camouflage the manipulation.

Because of this, it's on the shoulders of both buyers and sellers to be aware of the potential for fraud. Prospective red flags can be easy to spot. As the Madoff case demonstrates, the first tip off might be performance that is too good to be true. "Anything that looks like an anomaly deserves further attention," according to Bahl.

Another area that warrants investigation, Bahl says, is the incentive structure. If an opening for fraud exists, there's a chance people will look to exploit it.

A background check of the key people can also shed light. Spinelli mentions one deal involving a bank, in which the principals involved appeared "cleaner than Caesar's wife." A deeper investigation revealed two convicted felons.