Financial Impropriety

A report from the Professional Liability unit of CNA Insurance compiles recent examples that should give pause to any law firm managing partner or management committee: 1) In Virginia, a former account manager and bookkeeper forged law firm checks totaling more than $500,000 to fund personal investment accounts.; 2) In Minnesota, a long-time partner embezzled close to $2 million from his law firm and clients during 16 years by submitting false expense reports; 3) In Georgia, an associate at a national law firm stole more than $500,000 by submitting false invoices to clients for investigative services; and 4) In Pennsylvania, a paralegal forged signatures of estate executors to steal $100,000-plus from her firm to help cover $285,000 in restitution she had to pay to her former firm.

See “The Threat from Within: Theft and Fraud Inside Law Firms” (October 2011), http://www.cnapro.com/pdf/Theft%20and%20Fraud%20In%20side%20Law%20Firms.pdf.

In today's tough economic conditions, it is all too easy for someone who has real or imagined financial hardship to lose his or her moral compass when money is readily available and not readily monitored ' the temptation can simply be too strong. More often, however, the real problem is that the opportunity is there. Lawyers in charge of the firm can be so focused on their practice matters that they lose sight of the business side and never realize what's occurring. Often, this gives opportunity to a trusted staff employee who has been with the firm for years and has free rein and little scrutiny. When the practice of law is so demanding, it is very easy for the lawyer to turn over authority to such people and assume that they are doing what is right.

A five-step process can greatly reduce the chances of financial fraud occurring in any firm, provided that each step is followed consistently. They all embody the same principle: The more people who are involved in handling funds and financial records, the less likelihood there is that any one person can cause problems: 1) The person who opens the mail that contains client checks in payment for invoices should not have any responsibility for handling the firm's financial records. 2) The person who is given incoming funds when they are received should not be the same person who deposits those funds. 3) A third person not responsible for handling either the profit-and-loss financial records or the deposit of funds should reconcile the firm's bank accounts at least monthly, and ideally much more frequently if the firm uses online banking. 4) Yet another person, preferably an accountant from an outside CPA firm, should review and “audit” all financial records quarterly. 5) Create a “safety valve” by having more than one person trained and capable of doing each of the first four steps; switch off occasionally between those people so that different sets of hands and eyes come to bear on the financial process.

The one iron-clad rule for every person involved in this entire process is to make sure every single person takes a vacation at least once a year. That is the ideal time for a different person trained at the same function to look at what has been done. Often, the “diligent workers” who never take vacations are the ones who are afraid to do so for fear that their misconduct will come to light if they are not there to deflect scrutiny.

The net effect of this process is to create a system of checks and balances that no one person, or even several persons in collusion, can circumvent. The checks and balances process can and should be extended to the firm's entire operations, and is fundamental to best practices in “The Business of Law'.” A law firm run as a business will approach business operations with the kind of checks and balances that eliminate financial irregularities.

For example, every firm should maintain separate payroll and general accounts, placing in the payroll account the full amount of gross payroll (including employee portion of taxes) on the day that payroll is due. This eliminates the temptation to “borrow” payroll and payroll tax funds in the expectation that enough accounts receivable will be collected to cover them. If the money does not come in, and the “borrower” is exposed, the result will be civil and potential criminal penalties for the individual and the firm.

Unintentional Mistakes

Under the Rules of Professional Conduct for “Interest on Lawyer Trust Accounts” (IOLTA accounts), every client's payment for work that has been performed is to be deposited into a lawyer's general account. Payment for work that will be performed is generally to be deposited into a client's IOLTA account. The lawyer is a fiduciary who must keep accurate accounting records of transfers under every state's rules of professional conduct. Failure to do so can lead to discipline, up to and including disbarment.

Even so, IOLTA money can, by honest mistake, go missing. This can happen in many ways: 1) Money is received in settlement of a claim and deposited into the clients' trust account; 2) Checks are then written to lien holders and mailed; 3) Some of the lien-holders fail to cash the check, but they (not the lawyer or the client) are still entitled to the funds; 4) A conflict arises over disbursement of trust account funds, the dispute lingers, is never resolved, and is forgotten ' but the disputed funds remain in the account; 5) Funds for a real estate deal are held back for a triggering event, such as landscaping that never happens, but no-one tells the lawyer who is waiting for disbursement instructions; 6) An employee in the law office makes an erroneous or incomplete bookkeeping entry in trust account records, which is not found until long after the employee takes a new job. Now the lawyer, who did not make the entry, has funds whose owner's identity is no longer clear.

Every state imposes a fiduciary duty to properly account for clients' funds to prevent misappropriation (theft) or negligence. But if such mistakes happen and the state bar doesn't know about them, the temptation is there for a lawyer to fudge things. One approach is to hire an outside accountant to go through every document, check and ledger, and reconcile the account, then quietly clean things up without telling clients or the bar. An equally plausible approach is to open and operate through a new IOLTA account with scrupulously “clean” records, while allowing the old account to sift through until only the few questionable items remain. Both, however, completely miss the point: Accurate trust account record-keeping is a must.

Technology raises another avenue for compliance problems. ABA Model Rule 1.15 requires lawyers to keep “complete records” of account transfers ' and that has been interpreted to include the canceled checks. Yet few banking institutions, if any, still return canceled checks. The ABA recognized this problem and in 2010 adopted the new Model Rules for Client Trust Account Records. They permit lawyers to use substitute checks or electronic images of checks as an alternative to pre-numbered canceled paper checks. They also allow a lawyer or firm to maintain IOLTA account records in electronic, photographic, computer or other formats, in the law office or off-site, if these records are readily accessible, can be printed upon request, and preserve full client confidentiality. But banks are still required to notify the bar of any defalcations, and a bounced check from an IOLTA account immediately starts bar disciplinary proceedings.

Judgment Calls

There is plenty of room for additional financial problems in law firms beyond these scenarios, and they often involve poor management judgment. For example, a firm may draw on its credit line (especially at year-end) to cover payrolls, partner draws and tax payments in anticipation of collecting on accounts receivable. If the expected receivables do not materialize to cover the loan, the result can be a damaged credit rating, a default or even potential criminal penalties. Law firm bills can create additional concerns. A busy lawyer's billing entry like “work on motion for summary judgment, 20 hours,” without breaking the time spent into its basic elements, can create more than a few suspicions that would be defused by adequate billing detail. A bill that only says, “For legal services rendered,” or that is inaccurate or confusing, potentially opens the door to malpractice allegations that the bill is padded.

Any such concerns, as well as the inadequate controls discussed earlier, simply are a mark of poor judgment. Lawyers are the owners of the firm and have ultimate financial stewardship for it. Every document and process affecting financial integrity is important, and the appearance of impropriety is unacceptable. Nothing less than the firm's professional standing is at stake.

Ed Poll, J.D., M.B.A., CMC, is Principal of LawBiz Management. He can be reached at 800-837-5880, http://www.law%20biz.com, www.lawbizblog.com, and www.lawbizforum.com. Edward Poll ' All rights reserved ' 2013.

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Law firms are at great risk for financial impropriety. Funds can come up missing in any law firm, and the cause can be intentional theft that qualifies as fraud or embezzlement, or an unintentional mistake that shows poor judgment. Lawyers and law firm staff can be involved in either case, but when dishonest conduct is committed by others in the firm, the lawyers are still themselves ethically responsible. Various factors make law firms susceptible to such problems: part-time lawyer management, lawyers' lack of business competency, and decentralized authority to bill clients and approve disbursements.

Theoretically, financial impropriety should not be an issue in a firm that adheres to accepted ethical standards. For lawyers, ABA Model Rule of Professional Conduct 8.4 prohibits any “criminal act that reflects adversely on the lawyer's honesty, trustworthiness or fitness as a lawyer” as well as “conduct involving dishonesty, fraud, deceit or misrepresentation.” The Rules are equally clear for staff: The commentary on Rule 5.3 notes that “a lawyer must give ' assistants appropriate instruction and supervision concerning the ethical aspects of their employment.” However, in an accounting sense, deviations from the straight and narrow by lawyers or staff can happen in any firm. Consider the two scenarios mentioned above: intentional theft and unintentional mistake.

Intentional Theft

A report from the Professional Liability unit of CNA Insurance compiles recent examples that should give pause to any law firm managing partner or management committee: 1) In Virginia, a former account manager and bookkeeper forged law firm checks totaling more than $500,000 to fund personal investment accounts.; 2) In Minnesota, a long-time partner embezzled close to $2 million from his law firm and clients during 16 years by submitting false expense reports; 3) In Georgia, an associate at a national law firm stole more than $500,000 by submitting false invoices to clients for investigative services; and 4) In Pennsylvania, a paralegal forged signatures of estate executors to steal $100,000-plus from her firm to help cover $285,000 in restitution she had to pay to her former firm.

See “The Threat from Within: Theft and Fraud Inside Law Firms” (October 2011), http://www.cnapro.com/pdf/Theft%20and%20Fraud%20In%20side%20Law%20Firms.pdf.

In today's tough economic conditions, it is all too easy for someone who has real or imagined financial hardship to lose his or her moral compass when money is readily available and not readily monitored ' the temptation can simply be too strong. More often, however, the real problem is that the opportunity is there. Lawyers in charge of the firm can be so focused on their practice matters that they lose sight of the business side and never realize what's occurring. Often, this gives opportunity to a trusted staff employee who has been with the firm for years and has free rein and little scrutiny. When the practice of law is so demanding, it is very easy for the lawyer to turn over authority to such people and assume that they are doing what is right.

A five-step process can greatly reduce the chances of financial fraud occurring in any firm, provided that each step is followed consistently. They all embody the same principle: The more people who are involved in handling funds and financial records, the less likelihood there is that any one person can cause problems: 1) The person who opens the mail that contains client checks in payment for invoices should not have any responsibility for handling the firm's financial records. 2) The person who is given incoming funds when they are received should not be the same person who deposits those funds. 3) A third person not responsible for handling either the profit-and-loss financial records or the deposit of funds should reconcile the firm's bank accounts at least monthly, and ideally much more frequently if the firm uses online banking. 4) Yet another person, preferably an accountant from an outside CPA firm, should review and “audit” all financial records quarterly. 5) Create a “safety valve” by having more than one person trained and capable of doing each of the first four steps; switch off occasionally between those people so that different sets of hands and eyes come to bear on the financial process.

The one iron-clad rule for every person involved in this entire process is to make sure every single person takes a vacation at least once a year. That is the ideal time for a different person trained at the same function to look at what has been done. Often, the “diligent workers” who never take vacations are the ones who are afraid to do so for fear that their misconduct will come to light if they are not there to deflect scrutiny.

The net effect of this process is to create a system of checks and balances that no one person, or even several persons in collusion, can circumvent. The checks and balances process can and should be extended to the firm's entire operations, and is fundamental to best practices in “The Business of Law'.” A law firm run as a business will approach business operations with the kind of checks and balances that eliminate financial irregularities.

For example, every firm should maintain separate payroll and general accounts, placing in the payroll account the full amount of gross payroll (including employee portion of taxes) on the day that payroll is due. This eliminates the temptation to “borrow” payroll and payroll tax funds in the expectation that enough accounts receivable will be collected to cover them. If the money does not come in, and the “borrower” is exposed, the result will be civil and potential criminal penalties for the individual and the firm.

Unintentional Mistakes

Under the Rules of Professional Conduct for “Interest on Lawyer Trust Accounts” (IOLTA accounts), every client's payment for work that has been performed is to be deposited into a lawyer's general account. Payment for work that will be performed is generally to be deposited into a client's IOLTA account. The lawyer is a fiduciary who must keep accurate accounting records of transfers under every state's rules of professional conduct. Failure to do so can lead to discipline, up to and including disbarment.

Even so, IOLTA money can, by honest mistake, go missing. This can happen in many ways: 1) Money is received in settlement of a claim and deposited into the clients' trust account; 2) Checks are then written to lien holders and mailed; 3) Some of the lien-holders fail to cash the check, but they (not the lawyer or the client) are still entitled to the funds; 4) A conflict arises over disbursement of trust account funds, the dispute lingers, is never resolved, and is forgotten ' but the disputed funds remain in the account; 5) Funds for a real estate deal are held back for a triggering event, such as landscaping that never happens, but no-one tells the lawyer who is waiting for disbursement instructions; 6) An employee in the law office makes an erroneous or incomplete bookkeeping entry in trust account records, which is not found until long after the employee takes a new job. Now the lawyer, who did not make the entry, has funds whose owner's identity is no longer clear.

Every state imposes a fiduciary duty to properly account for clients' funds to prevent misappropriation (theft) or negligence. But if such mistakes happen and the state bar doesn't know about them, the temptation is there for a lawyer to fudge things. One approach is to hire an outside accountant to go through every document, check and ledger, and reconcile the account, then quietly clean things up without telling clients or the bar. An equally plausible approach is to open and operate through a new IOLTA account with scrupulously “clean” records, while allowing the old account to sift through until only the few questionable items remain. Both, however, completely miss the point: Accurate trust account record-keeping is a must.

Technology raises another avenue for compliance problems. ABA Model Rule 1.15 requires lawyers to keep “complete records” of account transfers ' and that has been interpreted to include the canceled checks. Yet few banking institutions, if any, still return canceled checks. The ABA recognized this problem and in 2010 adopted the new Model Rules for Client Trust Account Records. They permit lawyers to use substitute checks or electronic images of checks as an alternative to pre-numbered canceled paper checks. They also allow a lawyer or firm to maintain IOLTA account records in electronic, photographic, computer or other formats, in the law office or off-site, if these records are readily accessible, can be printed upon request, and preserve full client confidentiality. But banks are still required to notify the bar of any defalcations, and a bounced check from an IOLTA account immediately starts bar disciplinary proceedings.

Judgment Calls

There is plenty of room for additional financial problems in law firms beyond these scenarios, and they often involve poor management judgment. For example, a firm may draw on its credit line (especially at year-end) to cover payrolls, partner draws and tax payments in anticipation of collecting on accounts receivable. If the expected receivables do not materialize to cover the loan, the result can be a damaged credit rating, a default or even potential criminal penalties. Law firm bills can create additional concerns. A busy lawyer's billing entry like “work on motion for summary judgment, 20 hours,” without breaking the time spent into its basic elements, can create more than a few suspicions that would be defused by adequate billing detail. A bill that only says, “For legal services rendered,” or that is inaccurate or confusing, potentially opens the door to malpractice allegations that the bill is padded.

Any such concerns, as well as the inadequate controls discussed earlier, simply are a mark of poor judgment. Lawyers are the owners of the firm and have ultimate financial stewardship for it. Every document and process affecting financial integrity is important, and the appearance of impropriety is unacceptable. Nothing less than the firm's professional standing is at stake.

Ed Poll, J.D., M.B.A., CMC, is Principal of LawBiz Management. He can be reached at 800-837-5880, http://www.law%20biz.com, www.lawbizblog.com, and www.lawbizforum.com. Edward Poll ' All rights reserved ' 2013.

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