Preventing Employee Fraud in a Family Business

Every good business must place trust in its employees and those with whom they do business. It's quite simply an essential piece of any successful business. Unfortunately, that trust is what leads to the opportunity to commit fraud. Management offers access to data, documents, and money to those who have become trusted employees, and that access is what opens the door to fraud. Without access to the money and the information, no fraud could be committed. But what happens when it's a case of employee fraud in a family business?

Unfortunately, some of the worst fraud cases I've seen have been perpetrated by family members. In family businesses that experience internal fraud, the pain of the violation of trust is often even worse. Family ties don't protect the family business from fraud. The trust afforded by family members sometimes makes it even easier for the dishonest sibling, uncle, or cousin to rob the company blind.

When a family member is put into a management position, there is often the risk that the new executive is not fully qualified for the job. This can increase the potential for fraud, as an underperformer may feel the need to enhance the financial performance of their department or division in order to meet expectations. Many times there is also a feeling of entitlement by a family member in an executive position. This can lead to an abuse of expense reporting, payroll irregularities, or other theft of assets.

How to prevent fraud in a family business

What's a family business to do? It starts with fraud prevention. Especially in companies with executives who think that family members won't ever steal from them. Preventing fraud in a family business should be a top priority to protect the company from financial ruin.

Fraud prevention is much easier and more cost effective than investigating fraud and trying to recover the proceeds of fraud. Even when a family member is the thief, the potential recovery of stolen funds is still low. The average company will recover less than 25% of the proceeds of fraud and will incur significant costs in the process.

Policies and procedures are critical to fraud prevention in any business, even a family business. Lax adherence to the rules by family members can lead to employee fraud in a family business, and it might also cause other employees to disregard the standards, too. Inconsistent enforcement of rules can also create an atmosphere of disparity, another factor that could push employees toward fraud.

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Case study on family business fraud

Family businesses often pose a greater risk of fraud because their controls over assets and data are inadequate. 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.

The following case study is a real-life story of employee fraud in a family business, told from the perspective of a husband and wife team who had poured years of their lives into a small manufacturing business. They invested everything they had, only to have it stolen by an employee who was hired to help expand the business.

Fifteen years of our lives. Fifteen years. He took our money and he took our trust. He altered the way we view the world. We will never look at people in the same way.

Ten years into our business venture, we brought in Jack as our CFO. We needed someone with the financial expertise we didn’t have. We trusted Jack to protect our money. The expansion began, and we did whatever was needed to finance it. We refinanced our house, liquidated retirement accounts, and sold company stock to Jack.

But no matter how much money we put into the company, there was never enough. Sales were higher than ever, yet we never had even a few dollars to spare. Each time I questioned Jack about the fact that we never seemed to get ahead in spite of our booming sales, he calmed my fears.

The truth was that Jack was funneling money out of the company. He saw to it that suppliers were not paid and that our bank debt grew. Jack’s ultimate fantasy was a hostile takeover of our business with the money he stole from us. He prepared the creditors for the takeover by telling them that we were absentee owners who had no business sense. Jack would be the good guy who would come to the rescue and buy out the company.

At the very last moment, right before Jack was going to execute the takeover, we sensed something was terribly wrong and we locked him out of the company. Attorneys and accountants came in immediately to analyze our situation. It quickly became clear that Jack had perpetrated a massive fraud against the company, leaving us with no cash, little hard assets, and huge debts.

It was also clear that, based upon our sales and collection history, we should have had plenty of money. That conclusion was validated when we began seeing positive cash flow within 45 days after Jack was dismissed.

We got some relief from our creditors to attempt to salvage the business. We did well for a few months, but Jack had put us so far into debt (in order to fill his own pockets) that we were always one step away from failure. And then it happened. We lost one key customer and our business was done. Everything we had worked for over fifteen years was gone. We lost our good name and our good credit.

In five years, Jack (the CFO) destroyed everything the business owners had built. They tried to salvage the company but were unsuccessful. The family was left with no money and no assets. Here is their perspective on where they went wrong:

In looking back on our experience with Jack, we now see the many red flags that presented themselves. We had several opportunities to protect ourselves, but we just didn’t know enough about fraud.

First and foremost, we should have done a background check on Jack. We should have confirmed previous employment, as that might have yielded information that would have made us more cautious.

When Jack began firing long-time employees, we should have been suspicious. Key employees in all areas of the company were let go by Jack, and he replaced them with his own people. Most notably, he fired our accounting clerk and brought in his wife. Clearly, this was done to help cover his financial tracks.

Most importantly, we didn’t have any checks and balances in place. Jack made financial moves that didn’t require any authorization from us. We never should have allowed him to make financial decisions on his own. He called all the shots and his wife covered for him.

The family courageously regrouped and began again. They opened a new company, and they were able to re-establish relationships with certain customers. This is how they moved forward:

For better or worse, Jack changed the way we do business. We do not fully trust anyone. We purposely changed attorneys and banks in order to establish new professional relationships. We didn’t want to do business with anyone who had ties to Jack.

Even though our new business is only run by family, we have implemented more checks and balances. We require multiple signatures for significant transactions, and we use a lockbox for customer payments. Basic controls that we lacked in our former company have now been established.

We could not fathom that our business partner would ever cheat us. We found out the hard way that no one can be trusted when there is money on the table. We also found out that we were not alone. When we talk about our experience, we often find that something similar has happened to everyone. Sadly, this happens all the time.

Several years into their new venture, the family is finding success. They have been able to raise money to gradually expand, and they now have a financially healthy company with excellent long-term prospects. But their trust has been permanently broken.

Regardless of whether fraud is committed by family or non-family, it makes sense to actively prevent it. Fraud experts can help develop controls that are specifically designed to prevent fraud. Good controls are good business because they protect the employees, the family, and the bottom line.

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Tracy L. Coenen, CPA, MBA, CFE performs fraud examinations and financial investigations for her company Sequence Inc. Forensic Accounting.