Navigating related party relationships.
Related parties transactions are not a new concept in business and should not be viewed as being inherently fraudulent, unless there is evidence to the contrary. As long as these relationships are disclosed and transparent there is usually no need for concern. However, their nature suggests that one party may have increased influence over the transaction. Consider this example:
The Steel Company decides to build a new factory. Its general manager (GM) is responsible for purchasing the land upon which the factory will be built. The GM proceeds to sell land, owned by himself, to the Steel Company.
While there can be several valid reasons for preferring the GMs land over another property, an in-depth understanding is recommended to ensure that the sales price is fair, the land is suitable, and the GM has not misused sensitive information to purchase the land knowing that it can easily be sold to the company.
The booming economic growth experienced in the Middle East over the past few years has not only resulted in increased foreign investment in the region, but has also driven Middle Eastern investment around the world. Joint ventures (JV) allowed Middle Eastern companies to limit their investment in new jurisdictions by leveraging a local partners existing infrastructure. The following is a common example of how this relationship can deteriorate over time:
The foreign, Middle Eastern, partner appoints the individuals that manage the JVs financial reporting and control functions. These individuals are eventually terminated or resign and the partners have difficulty in agreeing on their replacements. This leads to the positions remaining unfilled or the appointment of individuals who have an informal affiliation with one partner.
This can create stress within the organisation and provides one partner with control and visibility that is not shared with the other; thereby increasing the opportunity for fraud schemes and manipulation of financial information to reduce the revenue shared. A common scheme includes leveraging related parties to siphon funds from the JV. For example, the JV may enter into agreements with related parties which are priced unfavorably, or recruit individuals for key positions to increase control over the JV and provide additional opportunities for collusion.
Consider the following real life example:
A large Middle Eastern conglomerate partnered with local stakeholders to create a JV in an Asian country. This JV followed a pattern similar to the one described above where the Asian partner ended up with a great deal of control leaving the Middle Eastern partner with little visibility into the JVs operations. Our investigation uncovered how the Asian partners were able to use their influence to classify lavish vacations as business trips; falsify invoices; set up competing businesses using JV assets; and purchase land that was intended to be sold to the JV for a sizeable profit.
While internal controls are critical in detecting fraud, it is important to understand that the right amount and level of collusion can be used to circumvent just about any control. The following are a few red flags that may indicate the need for further investigation:
Concerns related to misconduct or inappropriate behavior of key individuals. These allegations should be investigated by an independent third party to ensure the process is free of bias and both partners have clear visibility into the results. The partners should agree on the guidelines and criteria that will be used to evaluate these individuals and, if necessary, the recruitment and hiring process to bring on replacements.
Ambiguous reporting or lack of visibility into certain aspects of the business. If requests for clarity are met with resistance, the parties should consider exercising their audit rights. The underlying agreement between the two parties should include an option for either party to exercise its right to audit the books or records at their discretion.
Uncertainty or difficulty in identifying all related parties. In certain regions it can be difficult to identify all related parties, because certain information is considered confidential and may not available in the public domain.
A good measure would be to conduct an intelligence exercise to identify all known related parties. Additionally, it may be useful for the partners to provide each other with list of related parties. The JV agreement may also provide for a penalty for any transactions conducted with an undisclosed related party.
Unexpected losses. Vague explana- tions for losses could be an indicator of fraud. However, they should be differentiated from poor market conditions or bad business decisions, which may also result in a loss but do not necessarily warrant an investiga-
tion. Additionally, the JVs profitability should be considered alongside the local partners profitability and/or the relevant individuals lifestyles.
An effective tool in detecting fraud is an independently operated whistleblowing hotline. Over 50 per cent of fraud cases globally have been escalated by a whistleblower and an independently operated hotline provides them with a mechanism to do so.
Data analytics can also be used to identify trends that warrant further review. Advancements in technology have made it easier to identify transactions that are not in line with market trends; operating results that are inconsistent with competition; and areas that do not fit the expected pattern in a given organisation, industry or region. Leveraging this technology, along with understanding the potential risks early can influence agreements providing both parties with clarity, accountability and visibility into their investments.
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