Arrest in $40 Million Scam a Wake-Up Call on Controls
John S. Burnett, BOL Guru
In our November Security Spotlight, we reported on the breaking news that David Verhotz, a former senior vice president with KeyCorp, had been arrested in Cleveland and charged with embezzling $40 million from his bank.
Initial reports alleged that Verhotz had begun about ten years ago to create fraudulent loans on the accounts of foreign banks doing business with Key. Yet in testimony given at a bond hearing on November 16, 2006, investigators alleged that Verhotz admitted to using the bogus lending scam for over 10 years, since very early in his career at KeyCorp.
Among the other revelations at the hearing were statements that Verhotz, who reported annual income of $110,000 from his KeyCorp position, had bought his fiancée a $1.1 million engagement ring, and had set aside $2.2 million to buy a home in New York City. Those sums were in addition to $5.7 million Verhotz had paid for a Long Island home.
By now, we would hope, you are asking yourself, "How could he possibly have gotten away with it for so long?" Bring the numbers down to less stratospheric levels, and you can wonder if your bank's controls would be able to detect such a scam. Do you have executives who could "pull off" such a defalcation without being detected?
In June 2005, the FDIC published an article on enforcement actions against individuals in the Summer 2005 edition of its Supervisory Insights series. In its Overview article, FDIC staff analyzed agency actions against individuals who were bank insiders, and reported on some common threads that appeared in many of the loan fraud and embezzlement cases:
- Concealment of loan problems in a branch or portfolio
- Financial vulnerabilities
- Lifestyle expenses
- Debts from a divorce
- Gambling debts
According to the FDIC report, financial institution weaknesses were apparent in each of the fraud cases, "with the overarching weakness being lax internal controls." Among the shortcomings listed were:
- Failure to properly segregate duties, allowing one individual to process a transaction without supervision.
- Inadequate supervision, by an immediate supervisor or by management and the board of directors.
- Misplaced trust in longtime employees, whether or not in management.
- Management members who misused authority to involve subordinates in the fraud. This could involve active involvement or failure to report on the manager's questionable activities.
Executive Steps:
The Verhotz case should be a "wake-up call" for management at all financial institutions. While the investigation into David Verhotz's activities at KeyCorp will undoubtedly continue for several months, bank management should be reviewing now the adequacy of their controls for detecting questionable insider activity.
- Review the series of articles on enforcement actions against individuals in the FDIC's Supervisory Insights publication.
- Review the adequacy of your policy on segregation of duties. Are current controls capable of detecting transactions or scams that can flourish because of inadequate "checks and balances."
- Determine whether your institution has any way to detect employees "living beyond their means."
- Are employees undergoing personal financial challenges -- divorce, uninsured medical costs, apparent gambling debts -- subjected to extra scrutiny to detect (or prevent) fraud?
- Are managers and senior managers subject to appropriate controls?
- Is there any evidence of "abuse of position" that could lead subordinates to participate in a supervisor's fraud, or to "look the other way" to avoid supervisory reprisals? Does your institution have a well-publicized and strongly-supported "whistleblower" program?
- Is the audit of your institution's controls "neutral" with regard to issues of longevity and apparent trust?
- Are loan audit confirmation procedures adequate to detect loan fraud of the type that Verhotz is charged with?
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First published on BankersOnline.com 12/07/06
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