Supply Chain Fraud – Where is the threat?

What is a supply chain?

A supply chain is a way to describe every step that is involved in getting a finished product or service to an end consumer or customer. For some businesses, such as those involved in the manufacturing of real goods, it involves a complex system of logistics that converts raw materials into finished products. For the services industry, it might include agents, intermediaries, resellers, distributors and partners.

Whatever your business, there will almost inevitably be some form of supply chain, sometimes, multiple supply chains, to manage.

Why are supply Chains vulnerable to fraud?

The supply chain is often seen as the beating heart of business operations. The process of procurement and the supply chain serves as the gateway in and out of your business, making it one of the most at risk areas to fraud of all organisations.

Supply chains will typically have at least two parties in a contractual relationship focussed on supply and demand. That contract might be simple and short reduced to a small written contract, or the speed of demand for the supply might lead to informal agreements not committed to writing which naturally this creates exposure to the threat of those who might seek to exploit the fluidity of the arrangements to extract gains for themselves, be that financial or benefits in kind.

Supply chains might be complex affairs governed by large tender processes governed by law such as the Public Procurement Regulations or a private tender process seeing onboarding of panel suppliers through applications, audit requirements, governance agreements and / or detailed written contracts. In larger supply chains where there are greater volumes and scales of transactions they can become difficult for businesses to monitor, and greater reliance is often placed on the parties to adhere to the terms in good faith and for employees and agents to act with honesty and integrity in the performance of their duties.

Examples of supply chain fraud

1. Invoice Fraud: This is where fake invoices are generated, or legitimate invoices are altered to overcharge for goods or services, or to divert funds for seemingly genuine goods/services into a fraudster’s account. This is an area of risk typically associated with cybercrime.
2. Product Substitution: This is when there is substitution of products used in the supply chain for inferior or counterfeit materials. These are often of poor quality and can lead to the overall product being defective causing quality control issues and customer dissatisfaction.
3. Kickbacks and Bribery: This occurs when individuals within the supply chain accept bribes or kickbacks from suppliers in exchange for favouring their products or services, often at the expense of the victim company’s best interests. Company’s should also be aware of the Bribery Act 2010 [1] which (amongst other offences) states that a commercial organisation can be guilty of an offence if they fail to prevent persons associated with it from bribing.
4. Data Manipulation: Fraudsters may manipulate supply chain data, such as inventory levels, production figures, or sales data, to mislead stakeholders and create false financial statements. An example of this is the Patisserie Valerie scandal [2].
5. Ghost Employees and Vendors: This is where fraudster create fictitious employees or vendors to issue fraudulent payments and divert funds.
6. Collusion and collaboration: This is where multiple employees conspire together to bypass and/or override certain business protocols and transactions to undertake fraud. This can often include external third parties.
7. Sanctions violations: There are occasions where economic sanctions are put in place that restrict the flow of assets to or from certain countries. By importing goods from these countries businesses may be placed breach of these sanctions which can cause significant reputational damage (as well as monetary). There are many ways in which sanctions can be violated and this often takes the form of disguising where goods have come from. Examples of this are deliberately disabling a ship’s tracking system or setting up a complex and confusing network of companies to avoid detection.
8. Contract and Misrepresentation Fraud: This is where there is a misrepresentation in terms of pricing, ability to deliver a project based on experience or resource, or other aspects of the supply chain contract which can lead to losses for one of the contracting parties.

Practical tips to reduce the risk of supply chain fraud

1. Due diligence
   Due diligence is key. If alternative or additional suppliers are required, ensure it is done in good time, to allow robust due diligence checks to take place. Taking the time to get to know your suppliers is essential.
2. Self-insure
   Self-insure against the risk of disrupted supply chains by seeking wider panels of alternative or additional suppliers or agreements with competitors to help each other on short supply issues.
3. Watch out for pre-contract assurances
   If you are supplier, then be careful what pre-contract assurances you give regarding the ability to supply and timing of supply. If you are seeking supply, then ensure these assurances are written into the contract then at least you may have some financial remedy in the event of a failure to supply.
4. Check policies
   Check the company’s policies and procedures around bribery and other fraud. Ensure staff are aware of those policies and staff training is up to date. Consider having a whistleblowing policy if you do not already have one.

In supply chain fraud disputes, often a lot of direct and circumstantial evidence is needed to demonstrate dishonesty.  However, your organisation can alternatively bolster their contractual terms to anticipate dishonest conduct.  Breaching these terms can bring easier claims to terminate a supplier relationship and claim damages.

What to do if supply chain fraud is suspected

Whilst prevention is better than cure, if supply chain fraud is suspected, it is important to respond quickly and have an incident response plan in place.  This plan should include planning and reporting protocols and ensuring any relevant evidence is secured to increase the chance of recovering any losses. The strategy must be clear on how concerns should be escalated quickly to the appropriate people within the business.

If you require assistance in assessing the risk of fraud in your supply chain or need guidance on recovering from losses and terminating supplier relationships, we are here to help.

Author, Kelly Stott, is an experienced commercial litigation lawyer advising on commercial contractual disputes, claims arising out of sale of goods and services, fraudulent misrepresentation, professional negligence, breach of fiduciary duties and debt recovery matters for both UK and international clients.