Theories of Fraud

Case Study I – Yellowstone Partners, LLC

Friday, November 16, 2018

Former Owner and CEO of Yellowstone Partners Investment Firm Indicted for Fraud

BOISE - David Hansen, 47, formerly of Idaho Falls, was indicted yesterday, by a federal grand jury sitting
in Boise on 17 counts of wire fraud and six counts of tax fraud, U.S. Attorney Bart M. Davis announced.

Hansen was the 90 percent owner and chief executive officer of Yellowstone Partners, LLC, an
investment management firm headquartered in Idaho Falls. The indictment alleges the following:
Yellowstone Partners managed its clients’ investment funds pursuant to management agreements that
provided for Yellowstone Partners to collect fees for its services. The actual client funds were kept in
accounts at national brokerage firms. Yellowstone Partners would receive its fees by submitting billing
requests to the brokerage firms. Those requests were supposed to comply with the fees set forth in the
management agreements between Yellowstone Partners and its clients.

The indictment furthermore alleges that: From 2008 to 2016, Hansen systematically and intentionally
overbilled many of his clients’ accounts. He personally submitted fraudulent billing requests to a
brokerage firm, and he also directed certain of his employees to do the same. The fraudulent billings
resulted in the transfer to Hansen and Yellowstone Partners of client funds in amounts far in excess of
what was allowed for under the management agreements. It is estimated that Hansen defrauded his
clients of at least $9,448,941 through his overbilling scheme.

The indictment furthermore alleges that: In 2012 and 2013 Hansen aided and assisted in the preparation
of false and fraudulent income tax returns for Yellowstone Partners and himself. Specifically, as part of
the overall fraud at Yellowstone Partners, Hansen caused Yellowstone Partners’ revenue and his own
income to be significantly underreported.

The indictment finally alleges that: if convicted of wire fraud, Hansen shall forfeit $9,448,941.

The charge of wire fraud is punishable by up to 20 years in prison, a maximum fine of $250,000, and up
to five years of supervised release.

The charge of aiding and assisting in the presentation of a false and fraudulent tax return is punishable
by up to 3 years in prison, a maximum fine of $250,000, and up to one year of supervised release.

This case is being investigated by the Federal Bureau of Investigation and the IRS-Criminal Investigations
Division.

An indictment is a means of charging a person with criminal activity. It is not evidence. The person is
presumed innocent until proven guilty beyond a reasonable doubt in a court of law.

(Source: The United States Attorney’s Office – District of Idaho)

Published by: The Internal Auditors Online

The Unscrupulous Advisor

Internal auditors at investment firms should look out for schemes to overbill clients — even when they
originate at the top of the organization.

A federal grand jury has indicted the CEO of an investment management firm on 23 counts of fraud, the
Idaho State Journal reports. Federal prosecutors say David Hansen, majority owner of Yellowstone
Partners LLC, headquartered in Idaho Falls, Idaho, overbilled client accounts by submitting false billing
requests to a brokerage firm. Last year, former Yellowstone Partners employees told the Post Register
newspaper they had found "significant irregularities" in some customer accounts in 2016. Prosecutors
estimate Hansen's alleged scheme defrauded clients of more than $9 million. The indictment also
charges Hansen with aiding in preparing false corporate and personal income tax returns that
underreported the company's revenue and his own income in 2012 and 2013.

Lessons Learned

The CEO of the investment management firm in this story allegedly has run afoul of the U.S. Securities
and Exchange Commission (SEC) and more particularly Section 206 of the Investment Advisers Act of
1940 (the "Advisers Act"). In part, Section 206: "prohibits misstatements or misleading omissions of
material facts and other fraudulent acts and practices in connection with the conduct of an investment
advisory business. As a fiduciary, an investment adviser owes its clients undivided loyalty, and may not
engage in activity that conflicts with a client's interest without the client's consent."

In addition to the general anti-fraud prohibition of Section 206, other sections of the act regulate several
practices relevant to the alleged fraud in this story. These include disclosure of fees, investment advisor
advertising, custody or possession of client funds or securities, and disclosure of investment advisors'
financial and disciplinary backgrounds. All of these rules were allegedly broken in one way or another in
this case.

Internal auditors should consider measures to help their organization prevent and detect the kind of
fraud represented in this story. Two main areas of concern surround disclosure obligations:

"The Brochure Rule" (Advisers Act Rule 204-3), requires every SEC-registered investment advisor to
deliver to each client or prospective client a Form ADV Part 2A (brochure) and Part 2B (brochure
supplement) describing the advisor's business practices, conflicts of interest, background, and its
advisory personnel. Advisors must deliver these documents to a client before or at the time the advisor
enters into an investment advisory contract with a client. In addition, advisors must provide them
whenever there is a material change to the advisor's profile.

Both investors and auditors need to be aware of how business practices and conflicts of interests can be
hidden or manipulated. Hansen is a partner at Elite Advisor Institute, a company that trains and coaches
investment advisors. Was this partnership disclosed, and were some of the people involved in the
overbilling scheme at Yellowstone Partners trained there?
A further step that needs to be taken is to cross-check an investment advisor's background with those
who regulate and accredit them such as the SEC (registration information is available on the SEC's
website). The Financial Industry Regulatory Authority also offers information about the professional
designations used by advisors as well as measures that investors can take to avoid investment fraud.

The SEC mandates that an investment advisor disclose to clients all material information regarding its
compensation such as whether the advisor's fee is higher than the fee typically charged by other
advisors for similar services. In most cases, this disclosure is necessary if the annual fee is three percent
of assets or higher.

Investors and auditors should be proactive in regularly reviewing investment transactions to determine
what fees are being incurred, as an early way to detect overbilling. The investment industry should
continue to be obligated to regularly and transparently disclose fees to clients. A good practice would be
to disclose such fees monthly, although often this is only done annually.

A further part of this transparency is to carefully monitor the use of other mechanisms that incur fees
such as performance fees and referral to third-party fees. Another mechanism susceptible to overbilling
is a "wrap fee program" where advisory and brokerage services are provided for a single fee that is not
based on the client's account transactions.

Discussion

The main objective of auditing is to ensure the financial reliability of any organization; detection of fraud
is just an incidental object.

Independent opinion and judgment form the objectives of auditing. The job of an Auditor is to ensure
that the books of accounts are kept according to the rules stipulated in the Companies Act; an Auditor
also needs to ensure whether the books of accounts show a true and fair view of the state of affairs of
the company or not.

The following are the three distinct types of fraud −

misappropriation of cash, misappropriation of goods, manipulation of accounts (summarized as

management fraud and employee fraud)

Misappropriation of Cash

Misappropriation of cash is the easiest way of fraud especially in large business houses where there is
limited or no communication between the owner of an organization and the cashier. Following are some
of the ways through which embezzlement or misappropriation can be done −

1. Theft of cash receipts and petty cash and showing fictitious payment to workers, creditors,
purchases, etc.
 2. Showing false payments or excess payments in cash book.
3. By using the Teeming and Lading method, the money received from any customer can be
pocketed and the money received from another customer can be shown as money received
from the former. (Teeming and lading is a bookkeeping fraud also known as short banking,
delayed accounting, and lapping. It involves the allocation of one customer's payment to another
customer's account to make the books balance, often to hide a shortfall or theft.)
4. Cash sale can be shown as credit sale.

Strict internal control system should be followed in receipts and payments of cash so that the work done
by one person should be automatically checked by another person.

Misappropriation of Goods

Misappropriation of goods can be done in the following ways −

1. Goods may be stolen by employees or with the help of employees.

2. By issuing false credit notes to customer on account of goods return.

Detection of misappropriation of goods is more difficult rather than detecting misappropriation of

money, especially where management is not much vigilant and sound system of book-keeping, internal
control and adequate system of securities are not available. To keep control on the physical verification
of goods, reconciliation of physical stock with books and careful checking of sale and purchase is must.

Manipulation of Accounts

Two types of manipulation of accounts are mainly done by top management to mislead some parties for
some specific purpose.

1. Showing higher profits − Following are the reasons behind showing higher profit than actual
2. To obtain credit or to enhance existing credit from financial institutions and also to show credit
worthies to suppliers of the company.
3. To maintain confidence of shareholders.
4. To hike the market price of shares of the company and enable the sale of those at higher price,
it may be done by declaring higher dividends on shares.
5. To get more commission where commission is calculated on the basis of profit earned.
6. To declare dividend at higher rate.

Showing low profits − Following are the reasons behind showing lower profit than actual –

1. To avoid or to reduce Direct Taxes of the company (Income Tax, Wealth Tax).
2. To purchase shares at lower price.
3. To give wrong impression to the other competitors of the business.
Manner of Manipulation of Accounts

Manipulation of accounts may be done in the following ways −

1. Window dressing is a manipulation or miss-representation of financial data in such a way that it

seems better than what it actually is. Some of the method of window dressing is given as
hereunder.
2. Over valuation of closing stock
3. Under valuation of Liabilities or Over-valuation of assets
4. Purchases and expenses of current year may be deferred to next financial year
5. Charging revenue expenses as capital expenditure
6. Sale and other incomes of preceding year may be shown as income or sale of the current year.
7. Secret reserves of previous years may be used in the current financial year to inflate the profit
or secret reserves may be created to suppress the profit of the current financial year.
8. Stock may be under or overvalued. Income and sales may be suppressed or inflated. Expenses
and purchases may be suppressed or inflated.

The Fraud Triangle: Three Conditions That Increase the Risk of Fraud

The key to deterring fraud is to understand how and why people commit fraud. Knowing the “how”
helps managers and business owners create policies and design internal controls to reduce the
occurrence of fraud. The “why” is much more complicated, but just (if not more) important. There are
three conditions that, when present in varying degrees, increase the risk of fraud: (1) the pressure to
commit fraud, (2) the opportunity to commit fraud, and (3) the rationalization of committing the fraud.
The pressure, or incentive, to commit fraud is the reason why a person commits fraud. There are several
reasons a person would feel the need to commit fraud: feelings of resentment toward a manager or the
company as a whole, personal financial problems (e.g., mounting medical bills, gambling debts, spouse
laid off from their job), employee’s compensation tied to financial performance, and greed among
others. The reason the employee commits the fraud can change over time. For example, several of the
fraud investigations we have worked on started off as embezzling funds to take care of a personal
financial problem and then changed to greed once the financial hardship had been solved. Companies
can help alleviate some of this pressure by providing programs where employees can seek anonymous
help in their time of need. These programs can range from providing resources for a person battling
addiction, to setting achievable, realistic goals for compensation purposes based on input from the
employee.

The opportunity to commit fraud is the circumstances that allow fraud to occur and is the only condition
over which the company has complete control. For example, an employee who is in a position that gives
him or her the ability to add vendors and write checks realizes he or she has the opportunity to write
checks to a ghost vendor. Opportunities to commit fraud are more commonly present in organizations
that have poor internal controls because it makes it easier for the employee to commit fraud and
provide a low-risk environment for getting caught. However, companies with ample internal controls are
still susceptible to fraud if controls can be overridden by management. If the internal control system is
designed in a way that the risk of getting caught is too high, the employee will likely not exploit the
perceived opportunity for his or her personal gain. Without opportunity, fraud generally cannot occur.

Rationalization of committing fraud is the most difficult condition to observe because it takes place in
the mind of the perpetrator. Rationalization has to do with justifying the fraud. Since many fraudsters
view themselves as honest, ordinary people and not as criminals, they have to come up with some
reasoning to make the act of committing fraud more acceptable to them. Some common rationalization
statements are “I’ll just take this money now and pay it back later,” “No one will notice,” or “I deserve
this after all these years with this company.” Some fraudsters rationalize his or her behavior by
reframing their definition of wrongdoing to exclude his or her actions.

All three conditions (i.e., pressure, opportunity and rationalization) must be present in varying degrees
in order for fraud to occur. A financially strapped employee is not going to commit fraud if the
opportunity is not available, or if the risk of getting caught is too high. Similarly, a person who perceives
an opportunity to misrepresent financial statements and has the incentive to commit the fraud is
unlikely to do so if he or she cannot rationalize the fraud. However, the more pressure a person feels to
commit fraud, the easier he or she can justify it. Being aware of these three conditions can help
managers and business owners minimize the risk of fraud in their organizations.