Employee theft is a problem that can be limited by awareness and preparation. Many small firm lawyers and title insurance agents, preoccupied with legal and title work, make themselves a target for embezzlement by not paying enough attention to office operations. This is especially true in real estate focused firms where hundreds of thousands of dollars pass through their escrow account each month. This article will discuss some ways to prevent, detect, and limit embezzlement of trust funds in these small law firms and title insurance companies.
A lawyer is a business owner and, like all business owners that are victims of embezzlement will have to deal with the consequences of missing funds, including the possibility of going out of business. A lawyer that holds funds in a trust account[1] (e.g. IOLTA account) does so in the role of a fiduciary entrusted with someone else’s money. As a result, a lawyer has more issues to deal with than the average business owner when funds are embezzled from a lawyer's trust account. When an employee embezzles funds from a lawyer’s trust account, the potential repercussions include the need to replace stolen funds, loss of agent status with the title insurance company, an investigation by the state bar, and violations of the rules of professional conduct.
The definition of embezzle is to appropriate something, such as property entrusted to one’s care, fraudulently to one’s own use[2]. The reason that embezzlement often goes on undetected for a long time is that the embezzler is someone with a position of trust. In small firms, that person is often the office manager, paralegal, or bookkeeper. While the definition may be simple, ways to embezzle funds are limited only by the imagination of the thief[3]. While nothing can guarantee never becoming a victim of embezzlement, internal controls, and independent audits can reduce the odds and limit the losses.
Most cases of embezzlement have a few common characteristics. A supervisor’s trust, the ability to authorize disbursements, a “test” transaction[4], and a lack of checks and balances are a few. The lack of checks and balances is the framework that allows the success of the scheme to continue until an outside event triggers discovery. In most cases, a lack of checks and balances means the employee both processes transactions and reconciles the account.
Discussed below are some suggested minimum controls to prevent, detect, and limit embezzlement.
The lawyer needs to set up an atmosphere of accountability. The lawyer, as the business owner, sets the tone for the office. Employees notice whether a lawyer is complacent or meticulous about handling trust funds and auditing accounts. If the employees know that the lawyer is actively involved in the preparation and auditing of transactions they are less likely to attempt to embezzle funds. When accounts are audited regularly, embezzlement schemes are exposed quickly.
One overlooked internal control is a personal, not professional, skill. A supervisor must know their employees to the extent that they are able to detect signs of personal problems. Employees are people with life issues. Any person may develop financial difficulties, drug and alcohol dependencies, gambling, or other problems. These are the people that are more likely to attempt to embezzle funds. Signs that people have an addiction may include “frequent tardiness, inconsistent on-the-job performance, a lack of concern over personal appearance, and lower levels of productivity in the morning.”[5] A supervisor that spots changes in an employee may help prevent or limit embezzlement and get the employee help.
A lawyer must be involved in the preparation of all transactions. In a high volume office, transaction paperwork is often prepared by administrative staff. At a minimum, however, the lawyer should personally verify all transaction paperwork, sign all checks, and authorize electronic transactions. Most embezzlement schemes involving real estate transactions require checks to be signed. In many embezzlement cases the lawyer does not thoroughly review the paperwork and checks before signing them or, more frequently, the employee has access to a signature stamp[6].
A lawyer must personally check the bank statements against the transactions in the records. The lawyer should open all bank statements personally and thoroughly match the bank records to the bookkeeping records. Employees can edit the bookkeeping records, but they cannot edit the bank records. If the bookkeeping records do not match the bank records, the bookkeeping records need to be thoroughly audited. Consider this scheme: an employee enters all transactions into the bookkeeping records as they are listed on the transaction paperwork then voids selected checks and re-writes them payable to another party in the same dollar amounts. This scheme will continue if the lawyer does not match all of the payees on the bank statement to the payees on the transaction paperwork. Only by matching the bank records to the transaction paperwork can this scheme be stopped.
It is important that the lawyer randomly audit complete transactions[7]. When a transaction is subject to being fully audited at any time, the atmosphere of accountability is reinforced. The full transaction must be audited because, only by matching the complete list of deposits and disbursements and accounting for every penny, can a transaction be confirmed as correct. Small offices often process a large volume of transactions with a limited staff. In these instances, it may not be practical for the lawyer to audit every transaction, but it is vital that employees know that any transaction may be subject to a random audit.
Office structure must separate the payments and investigation functions. Most embezzlement schemes are exposed by the intervention of an outside party[8] questioning a transaction. The embezzler knows that the thefts will be discovered if another person examines the financial records. For this reason, the thief is often extremely “helpful” and volunteers to look into any matter that is questioned by an outside party. Later the thief will report that the matter has been corrected. If the same person is allowed to process the payments and investigate inquiries, it is only when an extraordinary outside event occurs, or a large volume of calls comes into the office that any suspicion is aroused. By that time the embezzlement has gone on for months or years and yielded thousands of dollars. If a phone call comes into the office inquiring about a payment, regardless of how small, it must be investigated by someone that did not handle the transaction.
A lawyer should have an independent auditor examine the records periodically. An independent auditor is an outside party that has no loyalties within the office that can look at the records objectively. This is also another way to reinforce the atmosphere of accountability. Instructions to employees need to be clear that the auditor has access to review all records and they need to cooperate with requests for records.
While nothing can guarantee that a lawyer is never the victim of employee theft, internal controls and independent audits can help prevent or expose the scheme before large amounts of money are stolen.
[1] Trust account means any account in which funds are held in trust for a third party, such as an IOLTA account and/or real estate escrow account.
[2] https://www.merriam-webster.com/dictionary/embezzlement
[3] In one of the earliest examples I came across (in the mid 80’s) of a third party exposing a scheme a bartender was embezzling funds by selling his own alcohol. He was printing his cash register tapes at home, which he switched with the actual tapes at the end of a shift and turned in to management. He brought his own alcohol, which he used for drinks so the stock numbers aligned with sales. This person was involved in a serious car accident and was hospitalized, unconscious, for several weeks. In the meantime, his spouse found the real register tapes in his trunk and brought them in to his employer because she thought they might be important.
[4] The “test” transaction is the initial theft, usually small and easily explained as a mistake that the employee uses to see if the scheme will be detected. In many cases, if the transaction is discovered, the scheme ends.
[5] https://www.promises.com/articles/addiction-intervention/employees-substance-abuse-problems/ see also http://nyproblemgambling.org/resources/warning-signs/
[6] Signature stamps are involved in a high percentage of employee theft cases. While this may seem like a good idea to save time, if you trust an employee enough to give them access to a signature stamp, you need to consider that you trust that employee too much and bring in an outside auditor periodically.
[7] Rules of professional conduct for lawyers and ALTA best practices require an individual ledger listing every deposit and disbursement of funds for each client matter / transaction. This is not a complete audit of the transaction, but it does help eliminate legitimate mistakes and indicate if the dollar amounts listed in the records are correct.
[8] See the example of the bartender, above. Also note that embezzlers are known for taking very little vacation because they are paranoid that someone else in the office will handle an inquiry and discover their scheme. For this reason, many financial companies have rules that require employees to take off a minimum number of days in succession at least once a year.