Avant-OCTN-MA Q of E Diligence and Fraud Discussion Items 052615JD
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Transcript of Avant-OCTN-MA Q of E Diligence and Fraud Discussion Items 052615JD
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Quality of Earnings Diligence, Forensic Accounting & Fraud Issues
FOREWARNED IS FOREARMED
James F Davidson, CPA/CFF, CFE, CFS, CGMA, CM&AA, CBA, CIRA, CTP
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Lessons from True Stories
• Misleading Financials - Loss of Value – Millions!
• True Stories / Actual Experience
$40 million investment Gone – Consumer products (private; California)
$600 million Bankrupt – Plastics manufacturer (public; Pennsylvania)
$300 million Distressed – Consumer products (international private; Utah)
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Lessons from True Stories
• Misleading Financials - Loss of Value – Millions!
• True Stories/Actual Experience
$60 million Distressed – Industrial products manufacturer (private; South Carolina)
$100 million Bankrupt – Restaurant chain (private; Oklahoma)
$100 million Defunct; Principals Imprisoned–Design / Office services; furniture distribution(private; New York)
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Lessons from True Stories
• Misleading Financials - Loss of Value – Millions!
• True Stories/Actual Experience
$50 million Distressed – Software/E-Commerce (private; Colorado)
$100 million Bankrupt – Electronics manufacturer (private/public; California/China)
$150 million Bankrupt – Construction (private; Florida)
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Lessons from True Stories
• Misleading Financials - Loss of Value – Millions!
• True Stories/Actual Experience
$150 million Bankrupt – Medical devices; consumer products (private; Toronto)
$150 million Distressed – food service; consumer products (private; Hawaii)
$300 million Uncertain– E-retailing; consumer products; (private; California; China)
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Lessons from True Stories• Misleading Financials –Related Topics – Takeaways
• What, How, and Why?
• Poor Financial Diligence and / or
• Weak Quality of Earnings Ignored
• External audits detected only 3% of frauds
• Ranked poorly in limiting fraud losses
• External audits have preventive effect
• Usefulness for uncovering fraud is limited
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Quality of Earnings• Confusing to many even sophisticated investors
• Many believe CPA audit sufficient, but different focus
• Focus on EBITDA alone leaves underestimated risks and limitations
• Not true cash flow • Ignores capital expenditures, working capital requirements,
current debt payments, and taxes• Surrogate for operating cash (not investing/financing)• No GAAP definition increases manipulation risk
• Pending investor requests:• 13 Week Rolling Cash Flow• TTM and listing of assets/liabilities
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Quality of Earnings
• Objectives
• Determine Normalized / Recurring EBITDA• Assess and validate EBITDA adjustments• Determining true “one-off” requires judgment
• Firstly, ensure EBITDA based on GAAP• Quality of Assets focus, e.g., valuations and reserves
• Inventory and receivables are most problematic• Affects both sales and gross profit• Changes in reserves/assumptions?
• All liabilities included? (affect working capital and expenses)• Foreign exchange effects included• Stock/option/compensation included• Management fees included
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Quality of Earnings• Objectives
• Secondly, evaluate seller proposed adjustments• Scrutiny of underlying documentation mandatory• Objectively determine in context of the business• Ensure truly nonrecurring/extraordinary?• Don’t confuse GAAP with other add-backs
• Next, apply diligence adjustments, e.g., items not identified by seller/management, e.g., corporate allocations/carve-out issues, etc.• Deferral of discretionary expenses, e.g., R&M, R&D, marketing• Standalone before pro forma synergies• Operating lease versus capital or rent versus owned
• Finally, assess nonfinancial items• Quality of Management • “Stickiness” of customers• Commodity and supplier risk
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Key Topics
Focus – Poor Diligence and/or Portfolio Monitoring
Fraud Schemes
• Asset Misappropriation
• Corruption
• Financial Statement Manipulation
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• Taking something through deception or concealment (intentional)
• Fraud often indistinguishable from incompetence or mismanagement but same result
• Occupational frauds are in connection with fraudster’s occupation (i.e., employment)
• http://www.acfe.com/fhc.aspx?Site=ACFEWEB – Costs of Fraud
Fraud Overview
What Conditions Create Opportunity?
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Opportunity
• Tone at the Top (Senior Management, Board, culture, ethics, etc.) http://view.vzaar.com/929183/player (ACFE / AICPA)
http://www.acfe.com/content.aspx?id=4294975036&terms=(video)+
• Weak internal controls (segregation of duties, supervision)
• Poor record keeping
• Extreme trust
• Lack of action for previous frauds
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FINANCIAL STATEMENT MANIPULATION
• Revenue Overstatement
Most common misstatement
Fictitious
Timing
Improper cutoff
Bill and hold
Intercompany & related party
Channel stuffing
Unissued credits
Conditional and consignment
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FINANCIAL STATEMENT MANIPULATION
• Inventory Overstatement
Second most common misstatement
Capitalized SG&A Expenses
Capitalized variances in WIP, top-side
Applied overhead is larger than actual
Capitalized “idle capacity” i.e., excess overhead
Obsolescence not recognized / understated
Inventory turnover by SKU not provided
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FINANCIAL STATEMENT MANIPULATION
• Asset (EBITDA) Overstatements
Capitalized repair & maintenance expenses
Non-removal of replacements
Judgments warrant special scrutiny
Concerns with EBITDA
Supplement or replace with ROA, RONA, ROTA, etc.
Impairments deferred
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FINANCIAL STATEMENT MANIPULATION
• Liability / Expense Understatements and EBITDA Overstatements
Under-valued liabilities
Invoices (liabilities/expenses) not recorded
General accruals overlooked
Sales returns /credits (contra) understated
Trade debt renegotiated as long term debt
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Red Flags & Warning Signs(Don’t ignore them!)
• Incomplete Reporting
Erratic, incomplete, late, financial information (classic)
Unreconciled accounts, especially cash/bank
Topside entries not pushed down to individual companies
Acquisitions preventing comparable period analysis
Numerous / excessive adjustments
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Red Flags & Warning Signs(Don’t ignore them!)
• Incomplete Reporting (continued)
• Historic financial information not reproduced from information systems
• Excessive number of manual checks
• Continuous adjustments to inventory
• Weak, tenuous, inconsistent explanations
• No audit or downgraded CPA involvement
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Red Flags & Warning Signs(Don’t ignore them!)
• Questionable Accounting Involvement
Management, particularly CEO, override of controls
Tight management control or involvement by principals
Heavy accounting staff turnover
Different audit firms for related companies
CFO not involved or distances from reported numbers
Accounting personnel work in “silos” and absolveresponsibility beyond narrow sphere
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Red Flags & Warning Signs(Don’t ignore them!)
• Ineffective Corporate Governance
Minimal board oversight; or
Excessive board involvement or micromanagement
No outside /independent directors (separation of duties)
Undocumented or poorly drafted policies and procedures
Frequent / unusual related party transactions and/or complex legal structure
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Red Flags & Warning Signs(Don’t ignore them!)
• Performance Too Good to Be True
• Rapid growth beyond reasonable expectations
• Company not materially impacted by external forces • Recession• Supply limitations• Infrastructure constraints
• Company outperforms competitors, industry, etc. without clearly delineated reason
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Red Flags & Warning Signs(Don’t ignore them!)
• Unavailable or Missing Records
Lack of timely documentation
Documentation subject to frequent “revisions”
“Those documents were destroyed / lost” e.g., system conversion lost traces of data
Failure to maintain original documents, e.g., shippers / receivers, etc.
Customers, vendors, lenders express concerns about information (e.g., excessive credits/adjustments)
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Red Flags & Warning Signs(Don’t ignore them!)
• Principal Domination or Excessive Management Control
Restrictive control of information by key management
Information filtered or “reviewed” before release
Individuals “walled-off” or unwilling to speak freely in presence of key individuals
Employees provided titles without actual responsibility
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Red Flags & Warning Signs(Don’t ignore them!)
• Audit Delays
Company delays or skips collateral or financial audits
Repeated excuses or confusing explanations
Fails to provide requested information
Hinders audit process
Limits time frame for audit or diligence
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Red Flags & Warning Signs
(Don’t ignore them!)
• Site Inspection Inconsistent with Performance
Minimal Level of activity
Key personnel are not present
Amounts, volume, types of inventory
Information not readily available
Operational indicators inconsistent with reported sales or financial information
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Red Flags & Warning Signs(Don’t ignore them!)
• “Twitchy” Non Executives and Gossip
Comments that don’t add up or make sense
Worries and concerns
Staff whispers and rumors that “not is all right”
Information not readily available
Confidentially shared information among lower level or operationally oriented employees
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Red Flags & Warning Signs(Don’t ignore them!)
• Overdrafts and Other Signs of Liquidity Issues
Particular concern when “apparent” good performance
Borrower has repeated overdrafts
Borrowing base over-advances
Repeated late payments
Trade creditor “overstretching” and complaints
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Red Flags & Warning Signs
• Be Wary of Emotion, Time, and Costs Invested
• More Costly Later?
• Case Study - XT?
“Death by a Thousand Cuts”
Lack of transparency and cash Flows
Inability to reconcile reported revenues to cash
No clarity of cash flows by company
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XT Red Flags and Risk Factors
Incomplete Reporting
Topside journal entries (not pushed down to individual company ledgers)
Historic financial information could not be accurately reproduced from the information systems
Disparate information systems
Acquisitions prevent comparable period analysis
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XT Red Flags and Risk Factors
Incomplete Reporting (continued)
Erratic, incomplete, and late reporting of financial information
Accruals not timely recorded
Change in fiscal year ends
Unreconciled subsidiary to general ledger accounts, particularly bank accounts
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XT Red Flags and Risk Factors
Questionable Accounting Involvement
Management, particularly CEO, overrides controls
Tight control (involvement) by CEO in financial information
Heavy turnover of accounting staff
CFO distancing himself from historic reporting process and reported numbers
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XT Red Flags and Risk Factors
Questionable Accounting Involvement (continued)
Accounting personnel work in “silos” and absolve responsibility beyond small sphere of influence
CEO heavily involved with prior year audit and only person with knowledge and explanations of journal entries
CEO computing EBITDA adjustments over and above CFO computations
CEO computing obsolescence reserve calculations
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XT Red Flags and Risk Factors
Unavailable or Missing Records
Lack of timely documentation
Documentation subject to frequent “revision”
Original records, e.g., receiving / shipping records not available at the Company
IT system conversion potentially “masking” or “erasing evidence of accounting malfeasance
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XT Red Flags and Risk Factors
Excessive Domination and Control By Principals or Key Management
Unreasonably restrictive control on financial or business information by CEO
Financial data “filtered” through CEO prior to release
Senior executives “walled off” or unwilling / afraid to speak freely in presence of CEO
CEO “share” of EBITDA adjustments with CFO to get CFO on “same page”
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XT Red Flags and Risk Factors
Site Inspection Inconsistent with Performance
Level of activity, inventory, and other objective indicators of performance not coinciding with sales or scale of purported operations
Key employees not present and critical information not readily accessible
“Twitchy” non-executives and office gossip
Employee concerns about something not adding up or information not making sense
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XT Red Flags and Risk Factors
Audit Delays
Company delayed financial review
Downgraded from audit to financial review
No physical inventory performed in years
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XT Red Flags and Risk Factors
Overdrafts and Other Signs of Liquidity Issues
Company repeatedly over-advanced on borrowing base
Company resorting to credit cards because no more credit available
All disbursements must be cleared by bank before release
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Describe relationship with auditors.
What types of audit adjustments were identified?
What type of internal audit function exists?
What’s degree and nature of audit committee involvement?
Do you formally respond to deficiencies?
Fraud Detection Inquiries - CFO
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• What is nature of recommendations issued by CPA’s?
• Communicated to the board or audit committee?
• Material control weaknesses?
• Significant deficiencies?
• Nature and amount of audit adjustments?
• Waived audit adjustments?
Fraud Detection Inquiries - CFO
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• Why key management and accounting personnel turnover?
• Why the delays in financial reporting?
• Has there been turnover in major providers (i.e., legal counsel, lenders, auditors, vendors, etc.)?
• What is nature of recommendations by outside CPA’s?
• Material control weaknesses? Significant deficiencies?
Fraud Detection Inquiries - CFO
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• Can you explain performance of the company in light of current events (e.g., why are sales increasing in a declining market?)
• Has the company changed accounting policies and / or procedures? Why?
• Are there any unusual transactions?
Fraud Detection Inquiries - CFO
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Telling Financial & Ratio Analyses
• Banish M Score Powerful predictor of financial manipulation Better predictor of manipulation than misappropriation Five and eight factor formulas
• Altman Z Score 80%-90% accurate predictor of bankruptcy Two of five ratios standalone indicator of fraud Distress and fraud oftentimes related
• F-Score Predicts material misstatements 28 ratios; 2/3 relate to revenues and soft assets Higher percentage off balance sheet financing (e.g., leases)
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BENIESH “M” SCORE Example(PARAMETERS)
Year 2012 2013
Net Sales 93,823 93,685
Cost of Goods 52,155 49,193
Net Receivables 1,174 1,373
Current Assets 73,717 67,991
Property, Plant and Equipment 2,532 2,058
Depreciation 1,696 1,716
Total Assets 86,291 84,832
SGA Expense 32,426 33,013
Net Income 5,741 9,888
Cash Flow from Operations 8,416 2,877
Current Liabilities 26,297 26,275
Long-term Debt 1,232 1,470
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BENIESH “M” SCORE (Example)
Derived Variables
Other L/T Assets [TA-(CA+PPE)] 10,042 14,783
Days Sales in Receivables Index 0.85
Gross Margin Index 1.07
Asset Quality Index 0.67
Sales Growth Index 1.00
Depreciation Index 1.13
Sales, General and Administrative Expenses Index 0.98
Total Accruals to Total Assets (0.03)
Leverage Index 0.98
M-score5 variable model -3.168 variable model -2.83if M > -2.22, firm is likely to be a manipulator
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BENIESH “M” SCORE Formula
(Equation)
5 variable equation
M = -6.065+ .823 DSRI + .906 GMI + .593 AQI + .717
SGI + .107 DEPI
8 variable equation
M = -4.84 + .920 DSRI + .528 GMI + .404 AQI + .892
SGI + .115 DEPI -.172 SGAI + 4.679 Accrual to TA -
.327 Leverage
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ALTMAN “Z” SCORE
• Predicts likelihood of bankruptcy within two years
• Test highly accurate
• May be monitored each year for corrective action
• Across industries and company sizes and types• Public• Private• Manufacturing • Service
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ALTMAN “Z” SCORE
Z Z1 Z2
LEGEND Public Private General
Mfg. Mfg. Use
Financially sound if greater than 2.99 2.9 2.6
Caution required if between 2.77 - 2.99
Likely bankrupt within 2 years if between 1.8 - 2.7
Likelihood of bankruptcy is high if below 1.88 1.23 1.1
Average for non-bankrupt companies 5.02 4.14 7.7
Average for bankrupt companies -0.29 0.15 4.06
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ALTMAN “Z” SCORE (PARAMETERS)
Income statementNet sales 200Operating income 10
Balance sheetCurrent assets 95
Total assets 150
Current liabilities 80
Total liabilities 125
Retained earnings 25
Public companiesMarket value of equity 300
Private companies (book value of equity) 200
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ALTMAN “Z” SCORE
(CALCULATIONS)
Z-Score 3.3 2.4 3.3
Z Z1 Z2
Factor Public Private General
Mfg. Mfg. Use
Working capital/Total assets X1 0.1 1.2 0.717 6.56
Retained earning /Total assets X2 0.17 1.4 0.847 3.26
EBIT/Total assets X3 0.07 3.3 3.107 6.72
Market value of equity/Total liabilities X4 2.4 0.6
Book value of equity/Total liabilities X4A 1.6 0.42 1.05
Net sales/Total assets X5 1.3 1 0.998
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ALTMAN “Z” SCORE - XT
(PARAMETERS)Income statement
Net sales 103,952 Operating income 603
Balance sheetCurrent assets 46,219
Total assets 56,794
Current liabilities 60,199
Total liabilities 61,759
Retained earnings (4,967)
Private companies (book value of equity) (4,965)
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ALTMAN “Z” SCORE XT
(CALCULATIONS)
Z-Score 4.4 1.6 -1.9
Z Z1 Z2
Factor Public Private General
Mfg. Mfg. Use
Working capital/Total assets X1 (0.2) 1.2 0.7 6.6
Retained earning /Total assets X2 (0.1) 1.4 0.8 3.3
EBIT/Total assets X3 0.0 3.3 3.1 6.7
Market value of equity/Total liabilities X4 4.9 0.6
Book value of equity/Total liabilities X4A (0.1) 0.4 1.1
Net sales/Total assets X5 1.8 1.0 1.0
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• Trust your “gut,” because downside too great
• Don’t ignore Red Flags
• Revenue / receivables should be first concern
• Inventory overstatements should be second concern
• Use proven financial ratios, e.g., M Score, Z Score, F-Score and CCC, among others
Just a Few Takeaways?
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• Scrutinize related party transactions carefully
• Non-consolidated affiliates are particularly suspect
• Evaluate related party transaction trends in relation to total sales and total assets
• Overly complicated corporate structure
• Granularity and disaggregation of data are key
Just a Few Takeaways?
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• Remember, the “devil is in the details”
• Don’t trust and rely upon financial audits
• Staff oftentimes inexperienced and not focused on fraud
• Not generally fraud or forensic oriented
• Review or worse, no external CPA involvement
Just a Few Takeaways?
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Action Steps(Early and Decisive to Mitigate Loss)
• Identify/Articulate Specific Concerns
• Discuss issues and suspicions with independent observers
• Vocalize any indications of fraud
• Use analysis to:• Confirm “gut” feelings• Evaluate various options, including exiting the
relationship or investment• Bring in specialized resources • Consider legal options and requirements, e.g., reporting
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Action Steps(Early and Decisive to Mitigate Loss)
• Bring in Others at First Sign of Fraud
• Internal / external for fresh perspective
• Existing portfolio manager or lending officer may:
• Be emotionally invested• No longer objective
• Consider involvement of Special Assets personnel
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Action Steps(Early and Decisive to Mitigate Loss)
• Preserve All Records
• Emails and other electronic files
• Paper files
• Financial statements
• Loan applications
• Underwriting
• Credit Files
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Action Steps(Early and Decisive to Mitigate Loss)
• Meticulously Document Borrower Communications
• Wary of lender liability claims
• Expand supervisory involvement
• Closer scrutiny
• Ongoing monitoring
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Action Steps(Early and Decisive to Mitigate Loss)
• Identify All Relevant Credit and Lending Relationships
• Inter-creditor relationships
• Business and personal bank accounts
• Loans to related entities or guarantors
• Evaluate Cross-Defaults
• Asses flow of funds among entities
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Action Steps(Early and Decisively to Mitigate Loss)
• Notice of Default
• Proactively and quickly issue notice
• Misrepresentations of financial condition
• Misappropriation of funds
• Other misconduct by principals
• Other fraudulent conduct in events of default under agreement
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Action Steps(Early and Decisively to Mitigate Loss)
• Regulatory Reporting
• Report fraud and other suspicious activity by filing Suspicious Activity Report (“SAR”)
• Other legal and compliance requirements
• For example, properly treat as non-performing asset under regulatory guidelines
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Action Steps(Early and Decisively to Mitigate Loss)
• Outside Professionals
• Determine if needed for conducting forensic investigation to determine scope of fraud and/or sources of recovery, etc.
• Determine if CRO or receiver is appropriate
• Evaluate risk of litigation by borrower, guarantor, or
third parties
• Assess potential for bankruptcy
Representative Financial Firm Clients
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