The Wheatley Institution

Fellow Notes


The High Cost of Fraud

“In the end, fraud is not just a fraud problem. It is a business problem. Losses from fraud erase the effect of sales effort, cost cutting and other company initiatives.”

W. Steve Albrecht | May 26, 2015
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A large stack of one-dollar bills represent the high cost of fraud.



Over my career, I have worked extensively in preventing, detecting and investigating fraud. I have written many books and academic articles on the subject. I have been an expert witness in 36 major fraud cases, including Enron, Adelphia, Tyco, Lincoln Savings and Loan and Cendant. I have been very involved in the 70,000 member Association of Certified Fraud Examiners, including serving as its first president. I have interviewed and studied many individuals who have committed fraud. In the course of these activities, I have come to the realization that not many people understand the high cost of fraud and how it hurts both companies and entire economies. In this article, I use an example of a very public fraud to illustrate just how expensive fraud can be.

In the 1990s, a Buick-Pontiac dealer in Long Island, NY embezzled $436 million from GMAC, the financing arm of General Motors (GM). I won’t go into the details of the fraud here but it was very egregious and should never have been allowed to become as large as it did. After the fraud, I was asked to consult with GM to help them make sure they didn’t have another fraud like this one.

The McNamara fraud couldn’t have happened at a worse time as all the American automobile manufacturers were struggling. The effects of this fraud on GM were enormous. With $436 million stolen, GM’s net losses were $436 million higher than they would have been without the fraud. In 1991, GM reported losses of nearly $4.5 billion of which McNamara’s fraud accounted for nearly 10%. In that same year, ironically, GMAC made more than $1.4 billion. The $4.5 billion loss in 1991 was preceded by a $1.98 billion reported loss in 1990.

It is important to note that, during this same time period, both Ford and Chrysler were also reporting losses. In 1991, Ford reported a loss of $575 million and Chrysler reported a loss of $200 million. The loss to GM from the McNamara fraud was double the losses of Chrysler and just less than the entire loss of Ford. In fact, when adjusted for inflation, GM’s fraud loss in today’s dollars was $795 million.

To understand how damaging this fraud was for GM, consider the overall automotive market in the late 80’s and early 90’s. In 1991, the combined average gross margin percentage (gross margin divided by revenue) for General Motors, Ford, and Chrysler was 9.5%. Because GM’s gross margin percentage was only approximately 10%, GM would have had to generate 10 times the amount of the fraud in additional revenue, or $4.36 billion,[1] just to restore gross margin to what it would have been without the fraud. And, because there were selling, research and development and general and administrative costs that were deducted from gross margin to arrive at the bottom line (net income or net loss), the amount of additional revenue needed to restore the $436 million reduction to net income would have been much greater than the $4.36 billion needed to make gross margin whole.

McNamara’s fraud was not merely a fraud problem; it was a business problem

Viewed this way, McNamara’s fraud was not merely a fraud problem; it was a business problem. At the time, the average price of a new automobile was $16,017. Based on these figures, with a 10% gross margin, GM would have had to make and sell 272,211[2] additional cars just to restore gross margin to what it would have been without the McNamara fraud. To restore net income to what it would have been without the fraud, an even greater number, probably two or three times that many cars, would have had to been made and sold.

Now imagine what GM’s competitors were doing while GM was playing catchup for a dishonest dealer. They were getting ahead and pursuing profitable strategies. While they were moving forward, GM was suffering the effects of tremendous lost effort in sales and trying to make improvements to its internal control system.

With the Japanese putting enormous pressure on the “Big Three” American automobile manufacturers (Chrysler, Ford and GM) these companies needed to change. Ford and Chrysler did change. Ford became a model for productivity while designs for new models were developed by Chrysler. Meanwhile, GM continued to fall behind due to its low capacity and financial losses. While not only a result of McNamara’s fraud, the effect the fraud had on the bottom line compounded GM’s inability to compete and change.

Because of the McNamara fraud, there was a lower amount of cash on hand to pursue new strategies and production improvements. GM reported larger losses than other automobile companies, dampening the appetite of lenders to provide GM with needed funding. Without necessary funding, GM could not pursue desired strategies to keep up with the Japanese and other producers. GM’s stock price dropped taking executive and other equity awards underwater, thus discouraging key employees from staying with GM. The executive migration (brain drain) away from GM meant that key talent went to GM’s competitors. The lower stock price made it impossible for GM to raise money in the equity markets. While Ford, Chrysler, Toyota, and Honda continued to increase their production capabilities, GM was at a competitive disadvantage. As a result, its cars didn’t change and improve as much as Toyota’s or Hondas.

McNamara’s fraud pointed out problems that GMAC had in its lending practices. Because of the fraud, with its resulting losses and the reputational damage, GM replaced its CEO in an attempt to turn around the bleeding and damaged company. Roger Smith was replaced as CEO by Robert Stempel. Stempel served only a short time and was replaced by Jack Smith. Regardless of who had been CEO, it is hard for a company to play catchup when the returns they have from selling cars are evaporated by dishonest actions.

The effect of GM’s fraud losses and the need to play catch up continued to infect other sectors of the business. GM’s best-selling light trucks and automobiles fell behind the competition because they didn’t make timely design and productivity changes.

With the McNamara fraud, we can begin to see the effects that fraud can have on an organization. The fraud dampened GM’s ability to pursue competitive strategies. The lack of cash put GM at a tremendous competitive disadvantage. The money lost to fraud represented lost opportunities for GM to pursue desired strategies.

There was also tremendous reputational damage to GM. Analysts and investors lost faith because GM’s target forecasts were not achieved. As a result, GM’s stock price dropped precipitously. Lenders pulled back from plans to loan money because of distressed cash balances, reduced working capital and GM’s inability to generate profits. Customers didn’t buy GM vehicles because GM was not able to make changes to their automobiles as fast as the competition. The excitement about vehicles switched from GM to competitor brands. Many people rationalized that if GM could allow a McNamara-type fraud to occur, there must be other serious problems with the company. In every way, GM’s reputation was sullied.

Because of the fraud, the actions of top management were heavily scrutinized. Two different CEOs were replaced at GM soon after the fraud was discovered. And, while it can never be known how many creative designers and other employees moved to competitors, because competitor vehicles were more exciting and because of GM’s financial woes, there had to have been significant movement.

Once a fraud occurs, there are no winners. The perpetrator loses. The victim company loses

This case shows why it is so important for companies to prevent fraud. Once a fraud occurs, there are no winners. The perpetrator loses. The victim company loses. There is lower morale among coworkers. Reputational damage is costly. Lost cash makes pursuing desired strategies and financing alternatives difficult if not impossible.

Unfortunately, these same effects are true of entire nations. Think how many countries that were third-world countries when you were young are still third-world countries today. If you counted, you would realize that it is most of them. Very few third-world countries progress to become first-world economies. One of the major reasons for this lack of advancement is because of the fraud and corruption in those countries. Because of wide-scale dishonesty, those countries are always playing catchup while first- and second-world countries are advancing and becoming more productive. In a very real sense, just like fraud holds companies back, fraud holds entire countries back. I once testified to a congressional committee that fraud and corruption are the silent killers of advancement and progress.

While GM’s fraud was large, it wasn’t the largest corporate fraud by far. Companies such as WorldCom, Enron, Conseco, Inc., Global Crossing, Lehman Brothers, Refco, and Adelphia all went bankrupt because of large frauds. Other companies have had very costly frauds but have recovered. Tyco, Xerox, Waste Management, Cendant, Fannie Mae, HealthSouth and Qwest fall into this category. Then there are a larger number of companies that have had less well-known but very large frauds. I have worked on several of these, some as large as $3-$4 billion. GM is not an isolated case. But the McNamara fraud is a great case to shown the damaging effects of fraud on a company and its strategies. In the end, fraud is not just a fraud problem. It is a business problem. Losses from fraud erase the effect of sales effort, cost cutting and other company initiatives. Depending on a company’s gross margin and operating margin ratios, significantly higher amounts of revenue than the fraud losses are required to compensate for the fraud losses. Frauds put companies and entire countries at competitive disadvantages that are difficult to overcome.

 
[1] If gross margin is 10%, then cost of sales is 90%. This means that for every additional dollar of revenue generated, 90% goes to support cost of sales and only 10% is gross margin. Thus, to restore gross margin to its pre-fraud level, revenue 10 times greater than the fraud would be needed ($4.36 billion). The amount needed to restore net income to its pre-fraud level would have been much, much higher than the $4.36 billion. However, because GM actually had a net loss instead of net income, it is impossible to determine the exact amount of revenues that would have been needed to restore net income to its pre-fraud level.
[2] $4.36 billion in additional revenue divided by $16,017 per car equals 272,211 automobiles.