Unveiling and Preventing Common Expense Fraud Schemes in China | Morgan Lewis | #employeefraud | #recruitment | #corporatesecurity


In this LawFlash, we outline the expense fraud scheme reported in a 2019 case involving the crime of illegal sale of “fapiaos,” examine some typical expense fraud schemes in China, and provide our practical takeaways with regard to preventing expense fraud.

Expense fraud, in which employees submit fictitious expense reports to get reimbursement from their employers, has become a major compliance concern for almost all businesses around the globe, regardless of size or industry. In China, particularly in the pharmaceutical sector, employers often see expense fraud when employees funnel improper payments to healthcare providers in order to influence the providers’ prescription decisions.

Although China has intensified its scrutiny of business-related expenses of pharmaceutical companies and vowed to clamp down on bribery in the sector, expense fraud has not been eradicated due to its history and prevalence in China. In the meantime, we continue to see different patterns of expense fraud in China, and the schemes have become increasingly covert and harder to detect.

Case Brief

In a judgment handed down by the Beijing Xicheng District People’s Court on March 7, 2019, four individual defendants were convicted of the illegal sale of fapiaos. [1] The judgment was not released until June 12, 2019. In this case, Guo Feng (Guo), the owner of Beijing Yashide Technology Co., Ltd. (Yashide), acted as an intermediary between fapiao buyers and sellers, and he conspired with some restaurants’ staff to provide fabricated fapiaos to his customers for reimbursement purposes.

The number of fabricated fapiaos at issue exceeded 500, at a total face value of more than RMB 1.8 million (US $270,000). Guo was sentenced to a prison term of 14 months and disgorged all his illegal gains. The other defendants were also sentenced to prison terms, but were given reprieves due to their minor roles in the scheme.

Specifically, when Guo’s customers, mostly employees of pharmaceutical companies, wanted to obtain fapiaos for fraudulent reimbursement purposes, Guo contacted his complicit restaurants to fabricate fapiaos based on the details specified by Guo’s customers, including the date and expense amount. Upon receipt of the fabricated fapiaos, Guo and his employees at Yashide would forge itemized receipts (IRs) and point-of-sale (POS) slips to match the transactions in question. Guo charged his customers 15–20% of the face value of a fabricated fapiao, and paid 8–10% of the value to compensate the cooperative restaurants’ staff.

In the judgment, Guo was described as a known figure for people in the pharmaceutical industry to contact for fabricated fapiaos. Implicated in this case were employees of some international drug makers, or their joint ventures in China, and their testimonies against the defendants were quoted in the judgment. To date, there is no further information on whether these employees will be charged or whether their employers will be investigated by Chinese government.

Typical Expense Fraud Schemes

Guo’s case represents one pattern where a fapiao is fabricated with no occurrence of the underlying transaction. In practice, many employees will approach restaurants directly for phony fapiaos after they become acquainted with the restaurants. With a lack of oversight by tax authorities on fapiao issuance in the catering sector, the only burden on the restaurants seems to be the 6% value-added tax (VAT). Restaurants may be less reluctant to issue fabricated fapiaos to their regular customers as long as the customers cover the VAT—thus providing the restaurants a stable revenue stream through the scheme.

Fake Fapiaos

Fake fapiaos have long been used by employees as a way to defraud employers. Fake fapiaos are produced with specially designed printers and are counterfeit in nature. They differ from fabricated fapiaos as the latter are “genuine” in formality despite no underlying transactions existing. The sale of fake fapiaos used to be widespread in China, and people could easily purchase them from peddlers at main transportation depots or online sellers.

However, fake fapiaos are becoming less popular due to harsh government crackdowns in the last decade, including the launch of fapiao verification websites by local Chinese tax authorities. The authenticity of a fapiao can be checked on an online portal in seconds by entering the fapiao code associated with the merchant and the serial number on that fapiao for the specific transaction. Therefore, the use of fake fapiaos can be easily detected, especially in large organizations with established internal control mechanisms. Nevertheless, employees may still exploit fake fapiaos in small businesses where the finance employees are less diligent.

Different Expense Nature

Employees may spend money on items other than food and drink in restaurants, such as tobacco, alcohol, gift cards, or dining coupons, either to enrich themselves or to use them as gifts for government officials or business partners. These items are generally not reimbursable under their employers’ policies, and the employees collude with the restaurants to fabricate dining fapiaos bearing the same amounts. They also forge IRs and other required expense-related documentation by themselves or through the restaurants, and submit all the expense documentation for reimbursement.

Inflated Expenses

Employees may frequently dine at cheap restaurants where the per capita expense amount is within US $10, and in most cases these restaurants are less decent and inappropriate for business entertainment meals. But some employees may request fabricated fapiaos from these restaurants, and submit them for reimbursement.

As the prices for dishes are usually very low at these restaurants, some employees choose to overstate the expense amounts by adding expensive dishes or alcohol to the IRs, despite these items never or rarely being served in these types of restaurants.

Cancelled Expenses

In this scenario, employees go to a restaurant and place an order of many dishes. They ask the restaurant’s servers to print out an IR listing all the dishes being ordered, swipe their cards to produce the POS slips, and have the restaurant issue fabricated fapiaos. Shortly afterward, they ask the server to cancel all dishes that were ordered, and receive refunds from the restaurant through remittance to their personal cards or in cash. They then submit the fabricated fapiaos to their employer for reimbursement.

In other cases, employees may choose to partially cancel the dishes they have ordered, usually the expensive dishes or alcohol that was ordered to inflate the bill, but then still submit the fapiao for the full amount, thus perpetrating the fraud by embezzling the difference.

Expense Split

There are also cases where employees split a single expense into two or more transactions, most likely to bring the value of each transaction within the expense limit permitted by their employers. Sometimes the expense excess is beyond the employees’ control or happens inadvertently, and employees intending to receive full reimbursement have to split one bill into multiple ones with different dates and items. In addition, restaurants are not bothered by splitting the bills because their total tax burden remains the same.

Substitute Fapiaos

It is not uncommon for employees to submit substitute fapiaos for reimbursement purposes. They may claim that they could not obtain the due fapiaos onsite from merchants because the fapiao issuance machines were broken or the merchants had run out of fapiaos. Thus they purportedly have to submit substitute fapiaos for reimbursement purposes, including (1) a backdated fapiao issued by the same merchant, (2) a fapiao issued by an allegedly affiliated merchant, or (3) a fapiao with the same or similar amount for different items. While there are legitimate situations for employees to submit substitute fapiaos, especially when they expend in mom-and-pop restaurants where merchants may be less compliant with tax regulations, the substitute fapiaos can nonetheless be abused by employees in the absence of sufficient oversight.

Fabricated Business-Related Expenses

Another common situation is where employees may seek reimbursement of a personal expense that is not business related. For example, they may incur meal expenses with family or friends, but claim in the expense reports that the meals were held to entertain their customers. The fapiaos or other receipts issued by the restaurants do not show whether the expenses were personal or business in nature, so this kind of expense fraud is more difficult to detect.

Expenses Not Self-Initiated

An employee may also submit dining fapiaos ostensibly for business entertainment events, but the events were not initiated by the employee. In fact, the events were initiated by local government officials or business partners who asked the employee to pay the bills for the events. The employee may feel vulnerable in this situation and choose to pay for the events to maintain relationships with government officials or business partners. The employee then submits the expense-related documentation to reimburse their own spending, but has to make up reasons why preapproval procedures, if applicable, were not followed in the said transactions.

Takeaways

The impact of expense fraud goes beyond the financial losses suffered by defrauded businesses, and the underlying motives of fraudsters and final beneficiaries warrant further investigation. As revealed in a well-known 2013 case and a number of probes into the Chinese pharmaceutical industry, expense fraud is routinely exploited to harbor “slush funds” for bribery payments as the expenditures can never be accurately and fairly recorded in the financial books and records. This may expose the businesses in question to severe liabilities under both Chinese laws and the US Foreign Corrupt Practices Act (FCPA), and the huge penalties enacted on the pharmaceutical companies in those enforcement actions should serve as a recurring warning.

Practical Solutions

While there might be no quick way to root out expense fraud in entirety, we provide below some practical solutions, derived from numerous investigations we have conducted, that businesses may adopt to combat expense fraud and manage relevant risks.

Implement Proactive Expense Reviews

In most businesses, the finance department is the main function in a business to review claimed expenses. Oftentimes, finance employees may merely verify whether the formality requirements of a submitted expense document are met, e.g., the consistency of amounts across different documents, the genuineness of the fapiao, and satisfaction of per capita amount limits. Unless anomalies are so obvious they cannot be overlooked, the finance employees will not conduct further reviews or queries. Finance employees may assume that other stakeholders in the approval process will examine the expenses substantively and thus they are responsible for the figures only. This passive stance may induce certain employees to manipulate their expense reports, provided they can submit all the required documentation.

We recommend that businesses implement audits in the course of the expense reviews rather than after the reimbursements. The audits may take many forms, and verification with the restaurants in question, either by phone calls or spot checks, may adequately identify irregularities or suspicious amounts in the expense reports.

In addition to verifying whether the restaurants or VIP rooms in question exist, businesses may attempt to verify the validity of expenses in the restaurants’ backup systems, since the underlying records in the systems may be solid evidence to reveal any or all of the expense fraud schemes discussed above. But businesses may face difficulties in securing the cooperation from restaurants, and they need to be well prepared for different scenarios that may happen onsite.

We understand that finance departments have different responsibilities and may sometimes be short-staffed, and therefore it is not feasible to audit every expense before it is approved. A possible solution is to increase random and regular expense audits, and businesses may establish a system of metrics to determine what anomalies on expense reports warrant audits. Finance departments can also engage other stakeholders, including internal audit, compliance, and in-house legal departments, to carry out the preapproval audits. Further, businesses should let employees know that this process is in place, which may help deter future fraud.

Enhance Management of Restaurants

Most western-styled businesses may have their own lists of third-party vendors and apply certain procedures when engaging new vendors or seeking quotes from existing vendors. But the restaurants or other catering service vendors where employees hold business entertainment activities are often not covered in the lists. In this regard, businesses may consider establishing a separate database by inputting the names of restaurants on employees’ expense reports and intensifying oversight.

We see the necessity of this solution because the restaurants mentioned in Guo’s case were almost all chain restaurants with branches in different locations, and it means that expense fraud may take place in both large chain and single entity restaurants. That being said, businesses cannot determine the risk profile of a restaurant solely by its reputation and scale, and an objective and uniform review and approval process should be employed.

On the other hand, businesses should revisit submitted expense reports, check whether their employees visited any of the restaurants implicated in Guo’s case or other reported cases, and conduct audits on the underlying expenses accordingly. If a business concludes that any restaurant is involved in expense fraud against it, it may blacklist the restaurant in question and notify its employees that future expenses at that restaurant will not be reimbursable.

Also, as for Yashide and other third parties embroiled in expense fraud or other scams, businesses should examine internally whether they are retained vendors, and if so, proceed to terminate their engagement. This is an ongoing effort, and requires a business to periodically update its blacklist and communicate the same to its employees.

Adopt Automated Expense Reviews

As opposed to manual review, using an automated expense review solution may not only shorten processing time, but also help track all business-related expenses in different categories. Automated review provides reviewers with a full view of expenses over a given period of time, and shows the spending patterns of certain employees or departments.

With an automated solution in place, reviewers are able to benchmark the expense data of one employee against other reports involving the same restaurants, and may detect red flags through this dynamic process. For example, if IRs or POS slips submitted by one employee are totally different in patterns from those issued by the same restaurants and submitted by his/her peers around the same time, further review of the underlying expenses and a verification with the restaurants in question might be advisable.

Maintain a Defined and Enforceable Policy

A written expense policy is required for all types of businesses, and it should clearly articulate allowable expenses, prohibited behaviors, approval processes, and ramifications for breach of policies. The provisions of the policy should be realistic and periodically updated to root out grey areas identified in its implementation. Regular trainings need to be provided to employees at all levels, and employees are encouraged to raise any questions about the policy.

The value of a policy lies on enforcement, and the tone at the top is a must. Management should reiterate the zero-tolerance principle and model the policy the way they expect from their subordinates. The policy should be strictly enforced throughout the organization and applied uniformly to all levels of employees.

Harsher penalties to the extent within a business’s internal rules should be considered, up to and including termination of employment. Strict policy enforcement coupled with severe sanctions may send the right message to all employees and deter future fraud.

Be Aware of Collateral Risks

In this final takeaway, we would specifically address the collateral risks faced by those multinational pharmaceutical companies mentioned in Guo’s case and the like. The publication of employees’ expense fraud scams may expose such companies to separate investigations and lawsuits in China. In the meantime, if such companies are subject to foreign legislation such as the FCPA or UK Bribery Act, the case reported in China may well draw the attention of foreign enforcement agencies, possibly resulting in parallel investigations and lawsuits.

We have seen instances where foreign lawsuits originate from a court judgment or media report in China, and understand that this trend is on the rise as China increasingly publishes judgments or enforcement actions online. As such, businesses operating in China should closely monitor case databases and news media on a regular basis, and take immediate actions to address any negative reports against them. Businesses will need to conduct thorough internal investigations to verify whether accusations against them are substantiated, and proceed with tailor-made remedial efforts. They may also need to work with public relations or crisis management professionals in order to safeguard their reputation, denounce any unsubstantiated reports, and timely deliver the right message to their shareholders and the public.


 

[1] A fapiao is the tax receipt in China issued by Chinese tax authorities. It is provided by businesses that sell products or services, and Chinese tax authorities rely on fapiaos to track revenues generated by businesses. Although businesses are obliged to issue fapiaos for every single transaction and tax evasion may be subject to severe penalties, it is not consistently enforced.

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