De-SPAC Diligence Guide Part 2: Performing Financial Statement Fraud Red Flags Indicators Checks

Updated: Aug 18, 2021

Capital Markets * White Collar * Due Diligence * Americas * Asia * Global

Checks for Financial Statement Fraud (or, FSF) are an absolutely essential part of the due diligence process in any De-SPAC acquisition transaction. FSF makes up a significant portion of the total dollar losses due to fraud each year and has an outsized impact.

"[T]he full impact of financial statement fraud is astonishing. In addition to the direct economic losses resulting from such manipulations are legal costs; increased insurance costs; loss of productivity; adverse impacts on employees' morale, customers' goodwill, and suppliers' trust; and negative stock-market reactions. Another important indirect cost of financial statement fraud is the loss of productivity due to dismissal of the fraudsters and their replacements."

Dr. Joseph Wells, Corporate Fraud Handbook.

When it comes to SPACs, FSF is definitely on the radar of the regulators. Frauds are what short sellers hunt for. And, shareholders are also starting to sue over FSF. So, it is essential for SPAC managers to check for indicators of FSF prior to moving forward with an acquisition.

Financial Statement Fraud is an SEC Enforcement Priority

The U.S. Securities Exchange Commission (SEC) has limited protections for directors & officers of SPACs, even in cases where Financial Statement Fraud (again, FSF) is perpetrated by the De-SPAC target. In July 2021 SEC Chair Gary Gensler stated that lies by acquisition targets will "not absolve [the SPAC] of its failure to undertake adequate due diligence to protect shareholders". The sense that FSF is an enforcement priority was signaled in a March 2021 Division of Corporate Finance's Staff Statement on Select Issues Pertaining to Special Purpose Acquisition Companies, which noted that target companies must be prepared to meet the "books and records" and "internal controls" provision of the Securities Exchange Act of 1934. This was reinforced in a April 2021 statement by the SEC's Acting Director of the Division of Corporate Finance John Coats that the liability around SPACs may be higher, and that there was not only potential liability under securities laws but also state law.

The SEC has been bringing actions targeting FSF and SPACs. These include recent cases against Ability Inc (where management allegedly made a "rosy but false picture of Ability's existing business and projected future revenues") and Akazoo SA, amongst others.

SPACs have already been sued for making misstatements and omissions on financial statements, such as in Welch v Meaux.

Key Aspects of Checks for FSF Indicators

Financial Statement Fraud (FSF) is defined by Leonard Vona as "[T]he process of intentionally misleading the reader of the financial statements. It is the deliberate misrepresentation, misstatement or omission of financial data to provide the impression that the organization is financially sound."

Management is usually at the center of FSF, and may be conspiring to fool their own accountants and professional advisors. So, due diligence checks for FSF indicators should ideally be performed by third parties not under the control of management. For a SPAC team about to acquire another business, the SPAC management is expected by the SEC to independently check for indicators of FSF and to not blindly trust financial statements provided by the target company. SPAC managers must do their own diligence to "kick the tires and check underneath the hood".

There are many scenarios for FSF, each requiring their own sets of checks:

  1. Fictitious revenues to false customers. I-OnAsia has over two decades' experience investigating fraud. We have seen many (many!) cases where customers have been made up out of thin air. Beyond our own fraud investigation case logs, there have also been many (many!) other cases in the news of this type of FSF, such as Luckin Coffee. How many customers are checked depends on the type of business and the importance to the financials. In general, the scope of a FSF diligence check should include some checks to validate the existence of key customers. At I-OnAsia we use best practices to hunt for red flags associated with fictitious revenues, through a 7-Point Check. In more than one case, our field teams have arrived at a purported customer site for an un-announced check and found empty offices and ghost operations.

  2. False sales recorded for real customers. Checks for fraud indicators should be independent, fair and unbiased, and data-driven. Once customers have been validated as real, some digging is required to make sure that they are buying the same amount of goods or services recorded on the target's financial statements. Unfortunately, we've seen FSF victims did not ask the right follow-up questions when validating customers. At I-OnAsia, our expertise is at discreetly and confidentially getting answers to this type of question: "OK... so you are a real customer... that's great... how much, dear customer, do your records actually show you bought (vs. what the target company says you bought)?"

  3. Inflated/mis-timed sales to real customers. Lately there have been major headlines about this type of FSF. Unfortunately, the fraudsters are tricky and you have to dig in deep. Indeed, this type of FSF often involves management conspiring with customer representatives. In one major case in the FMCG space in Asia, management of Company A conspired with key Customer B managers to obtain huge sales order commitments from Customer B. Company A's managers knew they were being targeted for an acquisition by Acquiring Company C, and they wanted to get big payouts. A year into a deal, the fraud losses to Acquiring Company C were in excess of US$50 million. The fraud losses including costs of embezzlement, bribery, as well as other business losses. There were costs of litigation and shocks to the share price, losses of staff and other disruptions. Checking for fraud indicators of inflated or mis-timed sales to real customers requires a healthy amount of skepticism and detailed fact checking of customer's wherewithal to purchase the stated volume. At I-OnAsia we use best practices to hunt for red flags associated with inflated and mis-timed sales to real customers, through a 21-Point Check. For example, we hunt for indicators of channel stuffing, where there are large sales to distributors. In a 2015 SPAC transaction involving an Israeli company named Ability Computer, the target made up a "backlog" of false orders.

  4. Hidden liabilities or expenses. To check for this type of FSF, I-OnAsia focuses on the suppliers and hunting for any other entities that may have a claim on the business. We have discovered many instances where target companies have failed to disclose recent civil judgements, off-balance-sheet loans, and expenses from exchange fluctuations.

  5. Wrong asset valuations. When managers commit FSF they often abuse their powers of discretion to say what something is really worth. A recent high profile case in the United States involved the value of an undeveloped piece of property. The fraudsters presented one accounting to tax authorities who said the property was worth a low amount. They fraudsters presented another valuation to the investors they were defrauding, and a third valuation to local officials they were seeking to get approvals from. When an asset valuation is important, I-OnAsia gathers the facts to determine the veracity of disclosures.

Countries Coverage

Financial Statement Fraud red flags indicators background checks due diligence support is available in:

  • United States

  • Greater China (Hong Kong, Macau, Mainland, Taiwan)

  • United Kingdom

  • Japan

  • India

  • Canada

  • South Korea

  • Russia

  • Australia

  • Switzerland

  • Indonesia

  • Thailand

  • Vietnam

  • Malaysia

  • Singapore

  • Puerto Rico & Caribbean

  • Other areas upon request.

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I-OnAsia specializes in due diligence assignments at the instruction of corporate counsel, external legal advisors, lawyers, barristers and solicitors. I-OnAsia is recognized by Chambers.

To learn more about our SPAC and De-SPAC enhanced due diligence services, visit our website.

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