October 23, 2012

Thinking About the Unthinkable: How to Guard Against Fraud and Embezzlement in Your Firm

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June 2009 Issue | Volume 35 Number 4 | Page 34

Thinking About the Unthinkable: How to Guard Against Fraud and Embezzlement in Your Firm

Here’s a look at how to spot the red flags and safeguard your practice against lawyers or staff that may have the motive, means and opportunity to commit fraud or embezzlement.

It’s sad to say, but it’s true. In reaction to tough times, some otherwise “honest” law firm professionals have chosen to resort to desperate measures, including fraud and embezzlement.

Stories of stolen trust account monies and forged legal documents are shocking. Our collective reaction is utter amazement that the person perceived to be a trustworthy colleague should be capable of such an unthinkable act. Nonetheless, it’s an ongoing fact that it happens in law firms. Many state bar associations even make provisions for a special client security fund to help reimburse clients who suffer a financial loss as a result of their lawyer’s dishonest conduct, such as theft of trust account monies.

With all the reports of defalcations in law firms, it’s surprising that firms are not more proactive in taking steps to prevent such malfeasance. Even the largest firms don’t commonly have appropriate safeguards in place to prevent partner, associate or employee fraud and embezzlement. Perhaps it’s because of a misplaced belief that the firm auditor will catch any attempts. Or, perhaps it’s just that we prefer to believe this type of problem would never happen in any law firm, let alone our own.

But, again, the facts show otherwise. Internal fraud and embezzlement have been very costly for many large and small firms in the United States and Canada. Consider this handful of recent examples:

  • At a solo practitioner’s office, a trusted legal assistant embezzled $60,000 from a bank account belonging to a trust on which the lawyer was serving as trustee. The lawyer only found out when the bank called about the irregularity of the large cash withdrawal.
  • At a small firm, a trusted staff person who had worked for the firm for 18 years funded a growing addiction to Internet shopping and auction sites by depositing client checks into her personal account through an ATM machine. Revenues were down and the staff person’s cash account was up over $100,000, which can cripple a small firm during a recession.
  • Two multiple frauds in Canada involved trusted long-term law clerks who were responsible for losses of $6 million. In one case, the lawyer was simply duped by a staff person. In the other case, the lawyer totally abdicated to a clerk the responsibility to monitor files and the trust account.
  • At a state bar association, a staff member embezzled more than $100,000 of rent monies paid by tenants at the bar’s headquarters during a time when some tenants were offered breaks on rent owing to building construction work.

These incidents contain a lesson for us: Like the old television crime program detective droned, it’s about motive, means and opportunity. Although we usually can’t control the motive part, we certainly can shore up our defenses against the means and opportunity for malfeasance in our firms. So what should you do?

A working knowledge of the mechanics of embezzlement and fraud is an essential first step to responding to or preventing such an act. First, though, let’s define what we mean by these terms. Fraud is the intentional and untrue assertion of fact or similar use of deceit, a trick or some other dishonest means to deprive another party of money, property, or a legal right. Embezzlement is the theft of assets, including money or other property by a person in a position of trust or responsibility over those assets, usually in an employment setting. Now, let’s look into how the three factors of motive, means and opportunity can result in a perfect storm leading to fraud or embezzlement.

The Motive

What motivates a partner, associate or staff member to commit embezzlement or fraud in the first place? It may be the serious need for cash owing to a financial reversal, an unaddressed addiction or mental illness, or some other catastrophic personal crisis. It may be a yearning to finance an unrealistic lifestyle. It may be an irrational desire to “set things right” because the person sees himself or herself as underpaid or underappreciated. In these hard, recessionary times, the person may not even self-justify the act—instead, it could be an act of desperation (virtually an act of professional suicide).

Who are you looking for then? Partners, associates or staff members who are undergoing financial stress, or who may rationalize their wrongdoing as a mechanism for surviving or effecting “justice.” Potential red flags are if they have begun to persistently ask for advances on their pay, or pay raises, or to complain about their performance review. This is not to sound unfairly alarmist, but merely to point out that these behaviors may indicate the person could be motivated to defraud your firm.

Beware the overly diligent employee who refuses to delegate anything, works extraordinarily long hours after everyone else has left the office, or never takes a vacation or sick leave. Not only does perpetuating a scam require constant attention, it is frequently the employees who are working the hardest for the same pay and recognition as everyone else who have the strongest motive to “even the score.”

Beware the person who exhibits an extreme change in personality or lifestyle. Drastic changes in temperament may be signs of the pressure of maintaining a fraud. Dramatic improvements in lifestyle, such as acquiring a brand-new luxury home, car and clothing, may reflect an employee’s flaunting wealth newly found at your expense. The embezzler at the small firm cited earlier was receiving almost daily deliveries from online shopping sprees at the office, and was receiving a lot of good-natured but naïve ribbing from co-workers.

Lastly, lawyers who are not meeting performance targets may be motivated to commit fraud or embezzlement and, consequently, be spending more of their time on nonbillable activities to conceal their acts of malfeasance. Partners without outside business interests, who may succumb to investing in clients’ businesses, are sometimes motivated to engage in fraud as well.

The Opportunity

Partners have the greatest opportunity to embezzle or commit fraud because their practices may be conducted with such autonomy and privacy that only their immediate subordinates know what they are doing at any given time. In addition, they are often in a position to override internal controls in the firm.

Partners—and sometimes associates—also have the direct client contacts that can function as an “early warning system” should the client become suspicious. If a lawyer owes a client money as a result of a business divert client A’s money to pay back client B and so on in a Ponzi scheme of “borrowing” from alternate clients to cover what they believe to be a “temporary” loan to cover a shortfall.

In addition, partners and associates who frequently set up holding companies for clients in the course of their work may become tempted to create a shell company into which embezzled funds can be directed. Which type of proceeds are at risk of being diverted is as varied as the practice areas in a firm: litigation lawyers, for example, may divert settlement funds; commercial and real estate lawyers may divert sale and mortgage proceeds; or estate administration and probate lawyers may divert funds from the liquidation of estate assets.

Staff members, on the other hand, rarely use dummy corporations or divert payments through clients of the firm. They may instead take advantage of flaws in accounting and internal control systems to divert payments to spouses or other family members, family businesses, or fictitious clients or suppliers. Often a wrongdoing staff member simply deposits a check payable to the firm into his or her private bank account, taking advantage of automatic teller machines to conduct the fraudulent transfer.

Plus, assistants get so good at “forging” their lawyers’ signatures as a matter of practice that these signatures no longer arouse suspicion when they are used for personal purposes. It’s hard to believe that a lawyer would allow and even direct an assistant to sign the lawyer’s name to a pleading in the lawyer’s absence. But this practice enabled one assistant to launch an 18-month embezzlement scheme where a “new” client turned over retainers that were embezzled. The lawyer knew nothing about the client and did nothing for the client. Eventually the client complained to the state bar. Unbelievably, the crafty assistant then destroyed all letters of investigation from the bar disciplinary section and even tendered the lawyer’s resignation to the bar when it became apparent that the lawyer was going to be subpoenaed for depositions.

Most firms may have formal checks and balances in place, but there are also often informal procedures—including assistants forging their lawyers’ signatures—that override the normal checks and balances for purposes of the “emergency” claim for a lien, mortgage, real estate or commercial transaction. It’s these exceptions that allow an employee to “backdoor” the normal process for his or her own ends. This includes anyone with the ability to bolt into a lawyer’s office from another part of the firm and ask for a “rush” approval signature for an “urgent” transaction. Partners who sign checks in this way are eliminating controls and opening an enormous window of opportunity. The formal practice of separate check-issuance and check-requisition approvals and other divisions of duties are often honored in the breach, which makes detecting irregular transactions much harder.

The Means

The embezzler or fraudster, by definition, is in a position of trust—typically meaning the person has been with the firm for a long time. These individuals are usually given an inordinate amount of discretion so they can circumvent normal office procedures without raising suspicion.

You may, for example, require two signatures on office checks over $3,000, but your bank will nonetheless insist that it is not responsible for ensuring that internal requirements are complied with. Thus, it is easy for single signature checks over the two-person limit to be negotiated, and your long-term coworker knows this. Be aware, too, that a frequent window of opportunity for rushing through checks arises near an accounting deadline to close the books, especially if it is late on a Friday afternoon when the usual check-signers have left for the weekend.

Again, allowing normal procedures to be overridden by trusted employees can provide the means to carry out embezzlement or fraud. If there are no checks and balances in place such as two-person execution and verification of checks, it becomes relatively easy for one person to pull off embezzlement. Allowing the same individual to open the mail, write the checks and reconcile the bank statement and the client ledger accounts enables (and even encourages) acts of malfeasance.

You may want to insist that all employees take at least one two-consecutive-weeks vacation each year, since irregularities can more readily be identified over a two-week period.

How to Spot a Fraud

Where to start your investigation? The usual suspects deal with wills and estates, plaintiffs’ personal injury work and large commercial practices (particularly commercial real estate)—areas where one can “borrow” large amounts of cash flow through the firm’s trust accounts. Within these practices, files involving vulnerable or institutional clients where bills are less likely to be scrutinized or questioned are most exposed. Beware also if the lawyer is the signing officer for corporate clients and refuses to bill the client for filing fees or work done. These may be red flags to be heeded.

How do you catch the lawyers or staff who prey on these practices? You can make these practices the focus of “surprise audits,” or rotate staff routinely, or enforce separation of duties. Also, have the accounting department check that clients and suppliers are regularly receiving the payments issued by the firm. Then review all firm checks for handwritten amendments to the payee or for double-endorsements of the checks when they come back from the bank. Insist on seeing the checks and the monthly bank statement. A wise option is to have the managing partner receive the bank statements at home, so the MP can either review them first or bring them into the firm unopened and process them along with the staff person who’s responsible for bookkeeping. It’s highly unlikely that the managing partner and staff member are co-conspirators.

Anything unusual, or any change in pattern, such as a sudden increase in payments to a particular person, may indicate double-billing or checks to “no arm’s length” or fictional persons. When employees embezzle, they generally alter, forge or destroy checks, sales invoices, purchase orders, purchase requisitions or receiving reports. Red flags to look for include missing documents, names of payees or customers that are similar to those of firm members, addresses that are similar to those of firm members, or P.O. box addresses.

Further investigation to see if firm payments are being redirected by staff is also warranted if the following occurs:

  • The firm is getting past-due account notices for bills that should have been paid on time.
  • There are second endorsements appearing on firm checks when they come back from the bank.
  • Documents appear altered, or handwriting on documents is questionable.
  • Original documents are missing.

The accounting department has a chance to find fraud at the concealment stage when it notices missing or altered documents, miscounts or other anomalies. Unfortunately, the accounting department often goes to the suspected party first for an explanation and, not suspecting fraud, is readily satisfied with the explanation or allows the suspected party a second chance to “substantiate” the transaction with forged documentation.

Those who work more closely with the perpetrator, on the other hand, often witness the fraudulent act and may comment on the “odd” way a transaction is being handled or explained. Also, because coworkers are familiar with each other’s personalities and usually have some knowledge of each other’s lifestyles, they are most apt to identify extreme changes in behavior, personal finances and the like. This is why most embezzlers or fraudsters are caught not by auditors, but by coworkers who provide their employer with an anonymous tip.

Therefore, having an anonymous whistle-blowing procedure in place will facilitate the detection and investigation of fraud and embezzlement. Honest employees who are vigilant for fraud are your most important investigative tools.

How to Deal with a Suspected Fraud

Acts of fraud and embezzlement often end up being more complex than they first appear to be. So what do you do if you suspect a fraud has taken place? You must respond with tact and care to ensure that you comply with your obligations under the rules of professional conduct, your malpractice carrier’s policy and employment law requirements.

Approach the investigation on the presumption that there is an innocent explanation for what has occurred. Only when all innocent explanations have been disproved can you conclude there’s been an act of fraud or embezzlement. All exculpatory evidence must be recorded and investigated. And don’t hesitate to pursue the investigation because a trusted longtime employee appears to be involved—sadly, again, they are the ones that have the greatest ability to misappropriate funds because of their position of trust.

If the fraud or embezzlement involves client trust funds or property, or if there is the possibility of a negligence claim, report the fraud to your malpractice carrier and fidelity bonding company. Also, your ethical duties under your state rules of professional conduct may require you to report another lawyer’s professional misconduct. ABA Model Rule 8.3 (a) states: “A lawyer who knows that another lawyer has committed a violation of the Rules of Professional Conduct that raises a substantial question as to that lawyer’s honesty, trustworthiness or fitness as a lawyer in other respects, shall inform the appropriate professional authority.”

Confront the suspect last. Be wary of an “incident” as people can react unpredictably if they feel threatened or have been under pressure for a long time. Any interviews should be done privately, with at least two management personnel present to serve as witnesses. Make sure that other employees are not nearby, and meet before or after work hours.

Equally important, do not invade the person’s privacy at the office, such as by looking into a briefcase, purse or other personal possessions without express permission. As to what may be found on a suspected person’s computer, a technology-use policy that explicitly gives you the

right to review e-mail and data on an employee’s computer can be very helpful in removing any question as to the ability to access this data.

Your firm should also, as a matter of course, have a departure checklist to use whenever you terminate an employee. Be sure to use it during the confrontation meeting. Retrieve any firm credit cards, office keys or other firm property the person may have. The suspected person should then be escorted out of the building and prohibited from returning to his or her office. Remember, this situation requires a great deal of sensitivity and tact. Until there is a police investigation and criminal proceedings, there is only a suspicion of fraud or embezzlement.

Of course, an ounce of prevention is worth a pound of cure, so every law firm will be best served by taking steps to prevent fraud or embezzlement before it can occur. The sidebar on the opposite page overviews basic mechanisms for doing so. Your efforts to proactively prevent fraud and embezzlement will not only help keep your firm safe in troubled times, they may also keep troubled employees safe so that they can get help with whatever problem has brought them to the brink of such desperate acts.

About the Authors

David Debenham is a partner and commercial litigator in the Ottawa law firm Lang Michener. As part of his practice, he uses his training in forensic accounting to trace funds and assert personal claims against directors and senior managers of corporate debtors. He is a Certified Fraud Examiner and author of The Law of Fraud and The Forensic Investigator (published by Carswell).

Sheila M. Blackford is Practice Management Advisor for the Oregon State Bar Professional Liability Fund. She is also a member of Law Practice’s Editorial Board.

Note: An earlier version of this article written by David Debenham appeared in LAWPRO Magazine.