Family lies: Fraud in family business

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Tracy L. Coenen

Trust is inherent in any good business. We continuously place trust in our employees and in those with whom we do business. But that trust which is so necessary to the operation of a business is also the impetus for thieves to profit.

It is unfortunate that fraud occurs when and where you least expect it. Blood may be thicker than water, but that doesn’t protect a company from theft by family members. In fact, it may be just that trust between family members that is exploited by a dishonest sibling, uncle or cousin.

Some fraud experts suspect that fraud occurs more often in family businesses than other businesses, and that the increased fraud risk is due to the trust factor. Family members put more trust in one another and therefore grant one another more access and opportunities for fraud. The controls in family businesses may be lax, particularly as they relate to the oversight of management’s activities.

The Problem

Whether children work their way up in a family business, or are brought into the business and immediately placed in management, the risk exists that they will abuse their positions. The average fraudster justifies behavior with a need they must fulfill or a feeling of entitlement. Heirs to family businesses have the same risk factors as other thieves, but also have added risks.

Exacerbating the normal fraud risk factors is the possibility that an heir may not have earned her or his position within the company. In the average business, an executive usually has solid experience and success in management. In a family business, however, the child of an owner may be unqualified and may not have a good work ethic.

Underperforming heirs are typically in little danger of being fired or demoted, yet they are still somewhat accountable for performance. An unqualified executive may consider fraud as an option to “enhance” the financial performance of a department, a division, or the company.

Lying Louie

Louie worked in a small family business for several years before getting the opportunity to buy out his uncle at a favorable price. He took over the company with little business sense, as he was never expected to manage the finances, the inventory, or the employees.

Immediately upon taking over the business, it began experiencing cash flow problems. It seems as though Louie thought the business was his own personal piggy bank.

Uncle had fully financed the buyout, but that debt was not a priority for Louie. His real priority was working as little as possible and siphoning as much money out of the business as he could.

As the financial status of the business worsened, Uncle did what he could to save the business. Every time Louie asked for a handout, Uncle believed that he just needed a little cash to get by until the next busy season. It was incomprehensible that a family member might be embezzling from the company. The business eventually went under with Louie owing lots of money to lots of people. Lucky for him, he hid plenty of money before any creditors could get their hands on it.

Uncle’s entire life’s savings was gone, pledged as collateral on Louie’s debt. He co-signed on loans that were theoretically meant to “save” an ailing business, but the money went straight into Louie’s pockets. Louie fleeced his family. Not only was Uncle left penniless, Louie’s siblings were left with no inheritance.

Why did he get away with it? No one thought he would defraud his own family. They knew Louie lived well, but the magnitude of his fraud was incomprehensible until much later. The family never considered that Louie didn’t really have the skills to run a successful business. Add that to his feeling of entitlement and his desire for the finer things in life, and you have a recipe for disaster.

The Solution: Prevention

Some may think that fraud in a family business should be a low priority. They may consider it equivalent to heirs taking “advances” against their inheritances. To some extent, this could be the case.

However, fraud by a family member can have serious unintended consequences for the company. The solvency of the business could be negatively impacted, or the value of the business may be reduced because of the fraud. In either of these situations, the fraud in the family business affects other owners, heirs, and employees.

Preventing fraud is much easier and more cost effective than tracking down fraudsters after they’ve done their deeds. Even when family members are the thieves, the potential recovery of stolen funds is still low. The average business will only recover less than 25% of the stolen funds and will incur significant legal costs in the process.

Policies and procedures are critical to fraud prevention in any business. It is particularly important to abide by policies and procedures in family businesses. Lax application of rules to family members can lead to fraud, and it might also cause other employees to disregard the standards. Further, inconsistent enforcement of rules can create a feeling of unfairness, another factor that could push employees toward fraud.

A family business offers a special challenge, as family members are often afforded more access to data and assets than regular employees. While this may seem like an important perk for family members, owners need to ask themselves whether that access is necessary to the successful operation of the business. Most times, it is not.

A common way for family members to enhance their compensation is through the expense reporting process. Reimbursement of personal expenses without any tax reporting is a violation of tax laws, but it is also unfair to the business and other employees.

Compensation is best addressed through payroll, not by siblings and children paying themselves via expense reports. To prevent expense report fraud, require all expense reports to be approved by someone other than the person requesting reimbursement. The reviewer doesn’t have to spend hours poring over expenses, rather a few minutes eyeballing the reports for any suspicious or excessive items.

Fraud experts can help develop controls that are specifically designed to prevent fraud. Experience investigating fraud is invaluable in helping to close “holes” in a system. An independent outsider can make valuable recommendations without concerns about job security or the fear of hurting a family member’s feelings.

Keeping Tabs on Family

Family businesses often pose a greater risk of fraud because their controls over assets and data are sometimes lax. The family atmosphere often leads to more trust, which leads to less control over processes. Inadvertently, non-family members may be afforded the same level of trust given to family members.

Unfortunately, some of the worst fraud cases I’ve seen have been perpetrated by siblings. Regardless of whether fraud is committed by family or non-family, it makes sense to actively prevent it.

Trust is an integral part of any business, but it should not be taken advantage of by dishonest employees. Good controls are good business because they protect the employees, the family, and the bottom line.

Tracy L. Coenen CPA, MBA, CFE is the president of Sequence Inc, a forensic accounting firm with offices in Milwaukee and Chicago. She is a nationally-recognized expert on fraud and financial investigations, and can be reached at [email protected] or 414.727.2361.