Embezzlement Happens! (In Small & Midsize Law Firms, too!)

Embezzlement, also known as employee theft, occurs when someone wrongfully appropriates funds entrusted to him or her. Employee theft occurs in big organizations despite elaborate systems and procedures designed to prevent it. It happens in small and midsize law firms, too —more frequently than you might think.

EMBEZZLEMENT EXAMPLES IN SMALL/MIDSIZE LAW FIRMS

• Payroll Theft. A law firm’s Office Manager gradually raised her annual salary from $35,000 to $250,000 over an 18-month period. The fraud went undetected until the Managing Partner received a routine report from the firm’s actuary showing actual salaries and projected safe harbor profit-sharing contributions for the year.
• Use of Firm Funds for Personal Expenses. A law firm replaced its Administrator for issues unrelated to financial matters. The following week, he phones his successor to fess up about some “usual charges” likely to appear on the firm’s next credit card statement. The firm discovered that he tapped their business credit card for more than $90,000 including personal groceries and gasoline, department store purchases, and private school tuition.
• Phantom Vendors. A law firm administrator created various fictitious vendors — IT consultants, temporary staff, etc. — to channel $100,000 to family and friends who shared the proceeds with her.
• Padding Expense Reimbursements. A routine phone call to the Office Manager to verify out-of-pocket costs passed through on a client invoice uncovered $15,000 of fraudulent travel, lodging and meal expenses charged to multiple clients by a partner. Not a lot of money, but the partner was disbarred and the firm received a lot of unflattering press coverage.
• Supply Theft. Unhappy with the explanation provided by the Office Manager for increasing office supply costs, a young partner investigated. He uncovered the Office Manager’s side-business peddling office supplies, toner cartridges and paper products to small companies in office parks near his home. The errant supplies were invoiced to the law firm, but shipped to his home address for weekend delivery to his customers.
• Diverting Client Payments. After a partner left the firm to practice solo, the Accounting Department contacted a former client’s accounts payable manager to collect past due invoices 6-12 months in arrears. The AP manager emailed copies of the cancelled checks showing the past due invoices were paid on time… but to a client trust account payable to an IOLTA trust account bearing the former partner’s name.
• Trust Account Misuse. Noting the existence of several outstanding client trust account checks that were more than two years old, a firm administrator wrote and signed “replacement checks” to himself; but recorded the amounts as being reissued to the original payees in the accounting records. The theft went undetected until a partner discovered a photocopy of one of the illicit checks left on a shared printer.

HOW FREQUENT ARE EMBEZZLEMENT CASES IN SMALL/MIDSIZE FIRMS?

I’m not aware of any formal statistics regarding law firm embezzlements, but they happen more often than most would imagine. How can I back up that statement? The seven examples cited in the earlier section are first-hand accounts shared with me by Managing Partners who lived through those dramas. If you consider those seven employee theft cases against the size of my small network of law firms, then apply that percentage to the roughly 13,000 US law firms with 5-50 lawyers – the risk is very real.

WHY ARE LAW FIRMS SO SUSCEPTIBLE TO EMPLOYEE THEFT?

Willy Sutton robbed banks because, “That’s where the money is.” Employee theft occur disproportionately in small/midsize law firms because, “That’s where the vulnerability is.”

Employee theft occurs when there is motivation, rationalization, and opportunity. The motivation may be personal financial difficulties or a perception that he or she is underpaid or undervalued by the firm. The individual will then find a way to rationalize the reasonableness of the act. Lack of day-to-day senior supervision — all too prevalent in small/midsize law firms — and the informal nature of accounting operations due to small staff size provides the opportunity. This is not because lawyers are bad managers, but rather because their livelihood depends on their ability to solve client problems, produce new business, and generate billable hours — to the point that there is no time for overseeing day-to-day activities within their Law Firm Accounting Department.

ESTABLISHING CONTROLS TO PREVENT EMPLOYEE THEFT CASES

Motivation and rationalization are unpredictable factors and outside the firm’s direct control. However, opportunity can be curtailed by adhering to carefully crafted internal control procedures, such as:

• Always Performing Background Checks. Prevention begins by hiring the right people. Perform thorough background checks for all new personnel — for both lawyers and staff. Contact references; speak with past employers. (Sad fact: No background check occurred when the Office Manager cited in the Payroll Theft example was hired. Turns out she did the same thing at her previous employer).
• Watching for Subtle Warning Signs. Is someone suddenly living beyond his or her means, known to have a side business, or taking frequent jaunts to casinos? It could be a telltale sign.
• Establishing Anti-theft Policies & Procedures. Draft written policies and procedures for all financial transactions. Then, communicate and enforce those policies. Whenever an exception is made or deviation from the written guidelines occurs, require immediate documentation in writing and after-the-fact signed approval by senior management.
• Separating Financial Responsibilities. No one person should be solely responsible for all the steps involved in accounting for funds going into the firm or for recording all the funds flowing out from the firm. The person responsible for making the bank deposits should not also post those payments in the accounting system. Similarly, the person authorizing payments should not sign checks or process the electronic payments. Insist upon dual authorization (e.g., two signers) involving amounts in excess of specific dollar limits. Someone independent from the person making the deposits and withdrawals must perform the bank account reconciliations. If you have a small accounting department, consider using an outside party — such as a CPA firm or consultant — to do this work and/or review your internal control procedures from time to time.
• Showing Top-Down Involvement. Firm management sets the tone; do not over-delegate internal accounting controls. If firm management is not paying attention, bad outcomes are more likely. Insist upon a zero-tolerance of deviation from the written policies and procedures.

As Ronald Regan said in the context of nuclear disarmament: “Trust but verify.” Imposing strict internal control procedures does not mean you distrust anyone, but rather sets a standard for the partners and staff alike that ethical behavior in the workplace is the only acceptable standard for the firm. It is notable that Mikhail Gorbachev’s response to Regan’s “trust but verify,” which was a reference to a Russian proverb, was a quote from Ralph Waldo Emerson: “The reward for a thing well done is to have it done.” Well said, Mikhail.

As a helpful guide to internal control procedures, 4L Law Firm Services as developed an Internal Control Checklist. It is available here. You might find it useful, and it’s free!

A Silly Musical Interlude….

Working late in the darkness

I hear the sirens wail

Somebody’s caused a $$$$ing emergency

Somebody’s going to jail

If you have an internal control weakness

You better fix that fail

The wolf is always at the door

In a Law Firm Minute (ooh-oo-ooooh)

Everything can change

In a Law Firm Minute (ooh-oo-ooooh)

Numbers can get strange

In a Law Firm Minute (ooh-oo-ooooh)

Always think long-range

In a Law Firm Minute….

(with apologies to Don Henley)