COVID-19 heightens risks of fraud and director liability


With the World Trade Organisation (WTO) predicting two years of economic hardship stemming from the COVID-19 pandemic, companies are advised to create risk-management systems to prevent instances of fraud that often arise during periods of financial instability.

The difficult double role of managing boards

During crises like the current pandemic, a managing board plays a difficult double role in a company. On the one hand, it must report correct information on the company's financial results, position and organisation, and establish internal controls via risk management. On the other hand, managing boards also influence these results through decisions on profit and growth strategy and cash management with the company's interests being the priority.

When determining a strategy, business continuity should be the only goal. In difficult times, the board exercises a certain margin of discretion in order to guarantee continuity through restructuring and reorganisation. If the continuity of the company is at stake, the managing board must put the interests of the creditors first.

Crises and emergency situations breed fraud

Pressure is the fundamental cause for undesirable behaviour and fraud on the part of management and staff. During boom periods, people commit fraud out of greed. In times of crisis, fraud is committed more out of need. According to the criminological 'strain' theory, pressure or anticipated pressure (e.g. fear of failure, job loss, financial instability) can lead to 'criminal' behaviour as individuals respond to this strain.

Pressure renders morals more flexible and ways are sought to reach a goal without considering the consequences. Based on this theory, companies in financial distress will break laws to cut costs or find alternative sources of income, thus leading to fraud or other criminal actions.

Entrepreneurs with liquidity problems are more likely to be manipulated by criminals, using their empty premises for drug labs, fictitious sales for money laundering and obtaining illegal loans. Past experience in Italy has shown that entrepreneurs in needs give organised crime the chance to act. During economic recessions, as companies face intense pressure to reach their financial goals, external supervision often becomes less strict as economic concerns lead to cost cutting and the reduction of supervisors in regulatory bodies.

Previous crises have revealed examples of fraud of this type as entrepreneurs under stress have constructed castles in the sky that eventually collapsed. The crises of 1929 and 2008 were both rife with such scandals.

Risk of fraud

Accountants have already pointed out that the Temporary Emergency Bridging Measure to Preserve Employment (NOW), created by the Dutch government to support companies, is sensitive to fraud. Since the outbreak of COVID-19, the Social Affairs and Employment inspection office, the Financial Intelligence Unit and the Employee Insurance Agency have received more than 200 reports of possible fraud connected with this governmental-support measure.

Aside from the 'strain' theory, routine fraud has been linked to trading and the current restricted environment that supports the aphorism 'opportunity makes the thief'. With social-distancing regulations making it difficult for Dutch tax authorities to visit companies to check financial books, supervision is decreasing and opportunities for fraud increasing. The European Securities and Markets Authority (ESMA) declared that national supervisors may be more lenient towards businesses that were unable to publish their financial results before 1 May due to the COVID-19 crisis. The Netherlands Authority for the Financial Markets (AFM) and the European Banking Authority (EBA) warn of new forms of money laundering and the financing of terrorism during the COVID-19 crisis. According to the EBA, history has proven that in times of crisis, criminals often increase their activities and develop new techniques to commit crimes like laundering money. The EBA states that cybercrime, COVID-19 related fraud, scams targeting vulnerable individuals and companies and fake donation-recruitment campaigns are increasing.

Extra vigilance for fraud risks and crisis management

The COVID-19 crisis has increased the risk of fraud by managing directors and employees in businesses for the purposes of maintaining a company's continuity or for personal gain. For a managing director, an active role in committing fraud or a passive role in preventing it can obviously result in director liability. In cases of intentional fraud by the board, D&O insurance will not cover damages. As a result, deceived creditors or the liquidator will be able to bring claims against the board, including the CFO, personally.

We therefore strongly advise that the managing board be able to deal with a possible 'fraud crisis'. Boards need to be prepared. A thorough and reliable policy that minimises the risks of fraud during the COVID-19 crisis and the creation of a framework for monitoring and controlling the implementation of this policy and measuring its success are also recommended. Boards should also consider engaging expert advisers and, if necessary in the event of fraud, form a crisis team to limit damage to the company's business and reputation.

For more information on protecting your company from the risks of fraud during the current crisis, contact your CMS client partner or local CMS experts.