Case Study: Fundamental Errors Lead to a $43,000 Loss
Fundamental Errors Lead to a $43,000 Loss
I recently read a case[1] that presents an opportunity to use real-world facts to review some of the fundamentals of proper bookkeeping procedures for law firms. This law firm lost $43,000 as a result of poor fundamentals that allowed an employee to embezzle funds. The ultimate holding in the case, that the appellant law firm entered into a contract limiting their window to notify their bank of fraud, is not essential for this discussion. The relevant facts for this discussion are as follows.
A partner in a law firm embezzled funds from the firm by endorsing checks made payable to third parties and depositing them into his personal account using ATMs. This happened approximately twenty-nine times. In the fall of 2014 (the facts are unclear exactly when), the firm's bookkeeper received an inquiry from a third party about a check. The bookkeeper discovered that the check, made payable to the third party, was endorsed by a partner with his own name and cashed. The bookkeeper confronted the partner, who gave her an explanation and wrote two checks to reimburse the firm. Both checks bounced. In the next few months, the partner embezzled approximately $43,000 using the same method. The scheme was discovered in January 2015, and this time the bookkeeper notified the other partners. The account was audited. The audit determined that approximately twenty-nine checks totaling approximately $43,000 payable to third parties were endorsed and cashed by the partner. The firm notified the bank of the potential fraud in March 2015. The bookkeeper testified that she did not ordinarily scrutinize the check images unless she couldn't balance the account.
Takeaway 1: The account owner is always the best line of defense against fraud
An account owner, whether it's an individual or a firm, always needs to be the primary auditor of the account.[2] The owner is in the best position to police the account. Third parties may have policies or obligations that may help expose fraudulent activity, but they should only be relied on as a supplement to the account owner's vigilance. The account owner is the only party with access to all of the information that may expose fraud. Information that may be helpful includes internal bookkeeping records, external financial statements, invoices, and time sheets. At a minimum, the account owner has data for the entire account. Contrast that to a title insurance audit that is often limited to examining only transactions that involve the company doing the audit.
In Globe Motor Car Co. v. First Fidelity Bank, N.A., 641 A.2d 1136 (N.J. Super. Ct. Law. Div. 1993), affirmed, 677 A.2d 794 (N.J. Super. Ct. App. Div. 1996), cert. denied, 686 A.2d 764 (N.J. 1996), the court held that by providing the plaintiff with their financial records the bank gave the plaintiff the tools needed to police their own employee.[3]
One fact that jumps out in the dissent is the admission by the bank that it is not their policy to check the endorsement on checks of less than $50,000 that are deposited in ATMs. Amazing. The bank does not even match the signature on the back of a check with the payee on the front for a check less than $50,000. This is a basic level of review, and the bank does not do it. The dissent notes that it is unclear if this is an industry-wide practice.
Takeaway 2: Office culture needs to emphasize accountability
Firm culture needs to be an atmosphere of accountability at all levels. The business owners, in this case, the partners, set the tone for the office. Employees and other partners notice whether the owners are meticulous or complacent about handling funds and auditing accounts. If everyone knows the owners are careful about the preparation and auditing of transactions, people are less likely to attempt to embezzle funds. When they do try to steal funds, the scheme is usually exposed quickly.
A disturbing question is why the bookkeeper didn't notify all of the partners when she discovered the first check in the fall. We do not know the explanation Mr. Cohen gave the bookkeeper when he was confronted. We do know that Mr. Cohen, a partner, spoke to the bookkeeper, an employee, and agreed to reimburse the firm. The bookkeeper made a decision not to notify the other partners. Mr. Cohen then wrote two checks to reimburse the firm, and both checks bounced.
A firm should have a policy that all errors and questionable activity must be reported and acted upon immediately. Any suspicious activity should be brought to the attention of all relevant parties immediately regardless of who is involved in the transaction(s). In this case, that means all of the partners or a committee made up of multiple partners should have been notified. An employee (e.g., bookkeeper) is naturally going to be cautious and will often defer to her employer (e.g., a firm partner) when presented with the dilemma of causing a major uproar by "accusing" a partner of theft. When reporting is required it empowers the bookkeeper to act without fear of repercussions, and it emphasizes to everyone, including partners, that they will be held accountable for their actions. In this case, the bookkeeper missed at least two opportunities to notify all of the firm partners: in the fall when the first check was discovered and when the reimbursement checks bounced. Only later, after identifying a series of suspicious transactions, did the bookkeeper feel empowered to report the activity to the other partners. The delay cost the firm $43,000.[4]
Takeaway 3: Act fast
An account owner must act fast once a suspicious transaction is identified. An audit of the entire account must be a high priority. Eliminate the immediate problem and conduct a complete audit as fast as reasonably possible.
What ultimately cost the firm is that their actions were too slow. The bookkeeper acted too slowly in notifying the other partners, which allowed the scheme to continue. Based on the circumstances, I think the bookkeeper’s actions are understandable. The partners compounded this mistake when they acted too slowly after they were informed about the checks that were endorsed by Mr. Cohen. The partners should have immediately limited Mr. Cohen's access to the account and made auditing the account and notifying the bank a high priority. While we do not know the details of the audit, we do know it took nearly three months to complete and notify the bank. At that point, it was too late.
A proper audit would immediately address the known problem, which was Mr. Cohen endorsing checks made payable to third parties.[5] Regardless of the volume in the account, an initial review of the endorsements should have taken no more than a few days. The bank could have been notified within a week of the improperly endorsed checks while a more extensive audit continued. In this case, the partners were told in January, but the audit was not finished, and the bank notified until March.[6]
Takeaway 4: Know the warning signs of embezzlement
Everybody with responsibility for an account must know the warning signs of embezzlement and take action when they are recognized.[7] Signs of embezzlement are often easily explained individually but become serious warning signs that demand action when they exist in combination. Some warning signs are personal such as financial problems, showing up late for work, erratic behavior, drug abuse, alcohol abuse, and gambling. Other warning signs are professional such as an employee that is overly possessive of their work and doesn’t take vacations. When multiple warning signs exist concurrently, action must be taken.
One of the most significant warning signs: personal financial problems. Mr. Cohen's initial theft is a sign of personal financial problems. This scheme wasn’t even creative. Whatever the explanation Mr. Cohen gave the bookkeeper[8], his need to write two separate reimbursement checks and then both checks bouncing are obvious signs of personal financial problems. Bookkeepers and partners all need to know the warning signs of embezzlement.
This case is a good reminder that a lack of fundamentals can lead to financial losses. The firm could have saved thousands of dollars in costs and business disruption as well as the $43,000 by policing the account properly.[9] Every lawyer and title insurance agent is encouraged to audit their own firm's procedures before a triggering event.
[1] Levy Baldante Finney & Rubenstein, P.C., v. Wells Fargo Bank, N.A. and TD Bank, N.A. Superior Court of Pennsylvania No. 3241 EDA 2016 (https://law.justia.com/cases/pennsylvania/superior-court/2018/3241-eda-2016.html)
[2] Think about the costs and business disruption that could have been avoided, even if the firm won this lawsuit, by policing the account properly.
[3] The plaintiff company sued their bank for failing to catch one of their own employees from stealing over a million dollars. The court stated, "In considering the relationship of the parties and the nature of risks involved, there is no question that depositors such as (plaintiff) are better suited than their lending bank to manage their own affairs, hire and supervise their own employees, keep their own records, hire their own auditors and detect and deal with corporate theft. The bank's monthly reports to its creditors permits the depositor to determine if any deposits are missing or if checks are drawn without authority. A prompt examination of those records should have disclosed to the (plaintiff) that its office manager was a thief."
[4] I do note that, although it is unclear from the appellate opinion, the bookkeeper may have been extra vigilant after she discovered the first check. For that reason, she may have examined the checks closely as she did whenever the account wouldn't balance. If that is the case, it is possible that Mr. Cohen refrained from embezzling additional funds for a short period until he thought the situation had "blown over" and it was safe to steal again. Once he started again, the bookkeeper easily discovered the fraud and, with the additional proof, felt empowered to bring it to the attention of the other partners without the fear of accusing a partner without evidence. We do not know if a policy that the other partners would be notified would have prevented Mr. Cohen from attempting this scheme but it is highly likely it would have ended in the fall after the first check was discovered.
[5] As the court noted, this is significantly different from forging someone else's signature, which would take considerably more time and, even then, may not identify all of the checks. The court also noted that it will be a question of fact in a future case if the victim should be able to detect a forged signature.
[6] A complete audit of the account should have started immediately. Embezzlement takes many forms and the auditor should not assume the only method used by Mr. Cohen is the one that was already discovered or that Mr. Cohen was the only person involved.
[7] For a more thorough discussion of warning signs, please see the article: Identifying and Limiting Employee Theft in Solo and Small Law Firms.
[8] I am curious what the explanation was and if it was another warning sign.
[9] Most small firms cannot absorb a $43,000 loss.