Scherzer Blog

Decisions in two cases to set precedence for auditors’ fraud liability

It all started in 1905 with the lawsuit Smith v. London Assurance Corporation whereby an auditor was held liable for failing to audit its client’s branch office and detecting embezzlement.

Now more than 100 years later, the legal liability of auditors in detecting corporate fraud will be decided in two cases that were heard on Tuesday, September 14, 2010, in the New York Court of Appeals, potentially increasing the Big Four accountants’ exposure to multibillion-dollar shareholder lawsuits for malpractice. In both cases, the court will rule whether auditors can rely on the legal doctrine of in pari delicto (“in equal fault”) to reject claims for fraud allegedly committed by company insiders. The doctrine prevents someone from recovering damages from a defendant if that someone is also at fault. The argument is whether the shareholders, as owners of the company, can be held at fault for frauds committed within the company and barred from suing its auditors for not discovering the wrongdoing.

The first lawsuit facing scrutiny was filed by the shareholders of AIG against PricewaterhouseCoopers (PwC), the insurer’s auditor. The shareholders claim that PwC failed in its job as auditors in the early 2000s, when various AIG officers and directors, including ex-CEO Maurice Greenberg, allegedly engaged in fraudulent transactions to pad AIG’s bottom line. Authorities subsequently caught the fraud, and AIG had to restate years of financial statements that “eventually reduced stockholder equity by $3.5 billion.” AIG ended up paying more than $1.5 billion in fines, and the shareholders say that since PwC missed the fraud, they should be allowed to sue PwC for malpractice. The Chancery Court in Delaware dismissed their request to sue PwC, and the case was appealed in Delaware’s Supreme Court. That court asked the New York’s Court of Appeals to decide whether the shareholders have a claim under New York law.

The second case relates to protracted litigation by the bankruptcy trustee of Refco Inc., the failed futures broker, seeking damages from a number of the firm’s professional advisers, and auditors including Grant Thornton, KPMG LLP, Ernst & Young LLP, PricewaterhouseCoopers LLP, Mayer Brown, LLP, et al. The trustee alleges that Refco’s outside counsel Mayer Brown, and several other insiders are liable for defrauding Refco’s creditors by helping the defunct company conceal hundreds of millions of dollars in uncollectible debt. The U.S. Court of Appeals for the Second Circuit found that the trustee’s argument to revive claims against the corporate insiders raised unresolved questions concerning his standing under New York law to sue third-parties for Refco’s fraud.

|Fraud, Judgment|

Illinois Employee Credit Privacy Act (096-1426)

Effective January 1, 2011, the Act will prohibit employers, in many circumstances, from inquiring about or using an employee’s or prospective employee’s credit history as a basis for employment, recruitment, discharge, or compensation. The Act also will prohibit an employer from retaliating or discriminating against a person who files a complaint under the Act, participates in an investigation, proceeding or action concerning a violation of the Act, or opposes violation of the Act. Pursuant to the Act, an employer will not:

Fail or refuse to hire or recruit, discharge, or otherwise discriminate against an individual with respect to employment, compensation, term, condition, or privilege of employment because of the individual’s credit history or credit report.
Inquire about an applicant’s or employee’s credit history.
Order or obtain an applicant’s or employee’s credit report from a consumer reporting agency.

Exceptions to the Act are as follows:

State or federal law requires bonding or other security covering the individual holding the position.
Duties of the position include custody of or unsupervised access to cash or marketable assets valued at $2,500 or more.
Duties of the position include signatory power over business assets of over $100 or more per transaction.
Position is managerial, and involves setting the direction or control of the business.
Position involves access to personal or confidential information, financial information, trade secrets, or state or federal national security information.

The Act also states that nothing in its provisions shall prohibit employers from conducting a thorough background investigation which may include obtaining a consumer report and/or investigative report without information on credit history, as permitted by the Fair Credit Reporting Act (FCRA).

|Educational Series, Employment Decisions, Legislation|

The FCRA and Employer’s Obligations

In recent years, negligent hiring and retention lawsuits have seen a dramatic rise, with settlement payouts averaging over a million dollars. These cases are predicated on the theory that an employer may be held liable for its negligence in placing a person with certain known propensities for criminal or other unfit behavior in an employment position where the individual poses a threat to others. The most common defense against negligent hiring or retention actions is based on foreseeability, which is often determined through a background investigation. Some courts have been more flexible than others in damage awards, but regardless of their stance, the closer the connection between the perpetrator’s dangerous propensity and the actual tortious conduct, the stronger the case against the employer. The law in both negligent hiring and negligent retention also recognizes that a company’s duty to avoid employing dangerous people does not end when an individual is hired–it extends to negligent supervision, negligent training and negligent firing.

Nearly every investigation that touches on employment is covered by the Fair Credit Reporting Act (FCRA), which defines employment (purposes) as “evaluating a consumer for employment, promotion, reassignment or retention as an employee.” If an employer uses a third party screening service to conduct a background investigation of an applicant or employee, that company is considered a “consumer reporting agency” (CRA) under the FCRA. The CRA’s reports, known as consumer reports, may contain information from educational institutions, professional licensing boards, former employers, courts, credit bureaus, references, motor vehicle departments, regulatory entities, media sources, etc.

The FCRA is a complex federal statute that has been significantly revised since 1970. But the Act’s primary mandate remains that CRAs adhere to “reasonable procedures” to protect the confidentiality, accuracy, and relevance of consumer information. Under its Fair Information Practices, the FCRA has established rules concerning personal information that include rights of data quality (to access, dispute and correct), data security, usage limitations, data destruction, disclosures, user consent, and accountability. The FCRA requires the employer/user to affirm to the CRA that it is in compliance (with FCRA) and has enacted the following directives prior to the initiation of a consumer report:

Verified that there is a legitimate need for requesting a consumer report
Certified that written permission was obtained from the applicant or employee and proper disclosures were provided
Stated the reason for requesting a consumer report
Certified that the information will be used for employment purposes only.

Before any adverse action is taken based on information in the consumer report, the FCRA obligates the employer to provide the applicant or employee a copy of the report and summary of consumer rights prescribed by the FCRA. And if adverse action is taken, the employer must deliver an “adverse action notice” to the affected individual. Further, the employer must certify that it will not use any information from a consumer report in violation of the applicable federal or state equal opportunity laws and regulations.

The FCRA makes a distinction between a “consumer report” and “investigative consumer report.” Its delineation of a “consumer report” is that it is comprised of verifications of facts about education, employment or other claims made by the applicant, while an “investigative consumer report” is a compilation of information about character, general reputation, personal characteristics, or mode of living through interviews. Thus, an employer who uses investigative consumer reports must comply with the provisions of the FCRA that apply generally to consumer reports as well as the provisions that are specific to investigative consumer reports which include “clearly and accurately” disclosing in writing that it may obtain the aforementioned information. This notice must contain a statement advising the individual of the right to request additional disclosures concerning the nature and scope of the inquiry, along with a written summary of consumer rights. Also, for an investigative consumer report, the disclosure must be made within three days after such report is requested, while in a consumer report, notice must be given before the report is procured.

The FCRA rules also apply when an employer uses a third party to investigate employee misconduct. The employee must be notified “clearly and conspicuously” and authorize, in writing, the undertaking of an investigative consumer report. If the employer disciplines or adversely treats the employee based upon the information in the report, the employer must provide the employee, within 60 days of the adverse decision, the following:

Notice of the disciplinary action
Name, address and telephone phone number of third party that prepared the report
Statement that said third party had no input into the decision to discipline the employee and thus will not provide information about the action taken
Notice that the employee is entitled to a free copy of the report and can request that the employer state the reason for the disciplinary action.

The FCRA does not apply to investigations of misconduct conducted by internal personnel or by third parties which do not regularly prepare such reports.

Violations of the FCRA can lead to civil and/or criminal penalties for the CRA and the employer. Civil penalties may carry nominal damages (up to one thousand dollars if no actual damages exist), actual and punitive damages, and attorneys’ fees and costs, if there is “willful noncompliance.” Civil penalties for “negligent noncompliance” are confined to actual damages and attorneys’ fees and costs. Criminal penalties may be imposed when a party knowingly and willfully obtains information from a CRA under false pretenses.

Establishing a relationship with a reputable CRA is one of the best assurances of FCRA compliance. An experienced company can provide guidance not just in the legal process of the FCRA, but also instill trust that it has met its related obligations.

|Educational Series, Employment Decisions, Legislation|

Fake your way into a dream job for under $60

The job market is tight and fake-your-career services are in bloom. Buy a Job Reference, which describes itself as a “shameless service,” boasts that in the first six months of 2010, it assisted nearly 400 clients in gaining employment (but links to success stories do not work so maybe the stories are fake too.) For the low price of $59.99, payable through credit cards and PayPal, the company will supply a personalized fake employer name, phone number and address, suitable for any occupation you choose. And if you need a new apartment to go with that new job, for $29.99 the company will set you up with glowing previous landlord references.

CareerExcuse.com, a self-proclaimed “world’s largest network of job reference providers” since July 2009, is more expensive with a $65 set-up fee plus an undisclosed amount for a 30-day answering service, and a $20 monthly subscription. This basic package includes a “professional voicemail system that many banks and large companies use, calls that are returned from voicemail within 24 hours armed with positive references provided by you, and a toll-free number and e-mail addresses for your references.” If you really want to impress a prospective employer, there is a premium plan for $195+ that will upgrade the verifications to a live receptionist. But once you land that dream job, most likely you will have to wait a while before you accrue any paid time off. Guess what? For $35 you can get some bereavement days with CareerExcuse operators standing by to verify that your designated relative is deceased, and avail a real funeral home Web site and address for flower delivery. CareerExcuse apparently wants to be a one-stop shop for all your fibbing needs, as it also provides links to instant “real university degrees.”

According to several Internet sources, including ABCNews.com, Alibi HQ also is or has been in the fake reference business; however, its Web site address, www.alibihq.com, leads only to a spam-type search page. ABCNews.com said in its August 2009 article that Alibi HQ charges $199 for the first 90 days and $50 for each additional month for the fictitious declarations. Mark Stevens, a purported Alibi HQ spokesman, told ABCNews.com that the company, which also offers fake landlord references and fake doctor’s notes, has been operating for several years, and that customer interest in employment references has skyrocketed over the last year (2009) with calls from people seeking Alibi HQ’s services quadrupling.

So how do these companies get away with such slippery handicraft? Each claims that it will not do anything that defies the law, including providing references for loan purposes. CareerExcuse contends that in a segment by KENS-5 in San Antonio, the Better Business Bureau did not question the legality of its services, although it did not give the company a “ringing” endorsement. But legal experts say that such companies and the clients they serve may ultimately find themselves as defendants in lawsuits filed by duped employers.

|Educational Series, Employment Decisions, Fraud|

FTC proposes changes to improve credit reporting notices

The Federal Trade Commission announced on August 16, 2010 that it is proposing revisions to the notices that consumer reporting agencies provide to consumers, and to users and furnishers of credit report information under the Fair Credit Reporting Act (FCRA). The FCRA requires the FTC to publish model notices for several forms that must be provided by consumer reporting agencies. The proposed changes are designed to reflect new rules that the FTC and other financial regulators have enacted under the Fair and Accurate Credit Transactions Act of 2003, and to make the notices more useful and easier to understand.

In addition to revising the general Summary of Rights notice, which informs consumers about their FCRA rights, such as how to obtain a free credit report and dispute inaccurate information, the FTC is proposing improvements to the notices that credit

reporting agencies provide to users and furnishers of credit report information.

The FTC is accepting public comments on the proposed changes until September 21, 2010.

(The FTC contact is Pavneet Singh, Bureau of Consumer Protection, at 202-326-2252.) See http://www.ftc.gov/os/fedreg/2010/august/100816fcranotice.pdf for the full text of the proposed revisions.

|Educational Series, Legislation|

Belford University: another diploma mill case from our files

So why did the applicant for a professional level position with one of our clients choose Belford University in Humble, Texas to get a Bachelor of Science degree in accounting? Maybe because Belford grants original degrees printed on traditional degree paper with a gold-plated seal which identifies it as a degree from a reputed and reliable institution. Or perhaps because the university offers free three-day shipping on a complete $249 degree package (a 4.0 GPA is $75 extra), consisting of one original accredited degree, two original transcripts, one award for excellence, one certificate of distinction, one certificate of membership and four education verification letters. We will never know for sure. But we do know that the university’s claims on its two Web sites (www.belforduniversity.net and www.belforduniversity.org) of being “an accredited institution recognized by two renowned accreditation agencies for on-line education, namely the International Accreditation Agency for Online Universities (IAAOU) and Universal Council for Online Education Accreditation (UCOEA)” are meaningless as the accreditations are not approved by the U.S. Department of Education. It is a bit suspicious too that on its “.org” site, the links to “University Briefs” are inactive, and thus we cannot find out the details of Belford’s “Clair’s Award for Excellence” and why Clair (spelled without an “e”) is giving out awards.

The Houston Press got on Belford’s haft in 2006 when it exposed the institution as a degree mill, operating from Humble, Texas with an indeed humble office (so humble that it’s non-existent as someone closed its account at the USA 2ME mailbox drop.) An entry in the Wikipedia stated that the degrees are actually mailed from the United Arab Emirates. The Houston Press checked out some of the names of Belford’s professors and its distinguished alums, which include Michael Fonseca, who was “promoted to the post of Divisional Head for Romuna Securities, a subsidiary of Romuna Group.” But the impressive-sounding Romuna appears to have its empire only in the mirage of Belford University.

David Linkletter of the Texas Higher Education Coordinating Board said that the board reported Belford to the state Attorney General’s office in March 2006, noting that “this is not a legitimate institute of higher education, as no legitimate university offers a complete degree on the basis of one’s life experience…To the extent that Belford University is in Texas, it is operating in violation of the Texas Education Code.” Since September 2005, the code makes it illegal to use a fraudulent or substandard degree for purposes of employment, business promotion or to seek admission to a university.

Despite Belford’s history of bamboozlement, as many as 500 resumes in LinkedIn, including those of a New York-based director of human resources and a CEO in the pharmaceutical industry, boast degrees from this university, according to a February 2010 post on a “consumer ally” Web site.

|Educational Series, Employment Decisions, Fraud|

Bienville University not so bien

In our second diploma mill case this year, an applicant for a professional level position with one of our accounting firm clients claimed a bachelor of business administration degree from Bienville University in Baton Rouge, LA. Our research analyst quickly discovered that the university was shut down by state action several years ago, but subsequently began peddling degrees in Mississippi for $5,000 for the BS program and $7,500 for a master’s program (according to an Internet “rip-off” posting.) A colorful, official-looking Web site for Bienville University still can be found at http://www.3cdf.com/3rdwebs/bu3/menu/menu.html but its pages for various information categories are not active. An entry in the Wikipedia said that Bienville University was exposed as a diploma or degree mill in a 2003 report by KVBC News 3, as it was never recognized or approved by any accreditation agency of the US Department of Education.

And there is more…Bienville University’s founder, Thomas James Kirk II (also known as Thomas McPherson) was the operator of several other fraudulent higher education institutions (diploma mills), including the University of San Gabriel Valley, Southland University, and LaSalle University (Louisiana.) He was indicted for fraud in 1996 and, after a plea agreement, was sentenced to five years in a federal prison.

|Educational Series, Employment Decisions, Fraud|

Common securities fraud schemes on the Internet

Pump and Dump: These types of schemes are quick manipulations of the stock price. The schemers buy thinly traded stocks and then transmit optimistic messages about the stocks, which cause investors to buy, thus driving up the price. The ownership interest that the schemers have in the particular stock is not disclosed. The schemers then sell the stock for significant gains. Their messages are transmitted through official looking e-mails, bulletin board posts or Web sites.

Dump and Diss: This is the pump and dump scheme in reverse. The schemers short-sell a stock and then transmit negative messages to investors causing the investors to sell, which in turn drives down the price. No disclosure is made of the negative position that the schemers have in the stock. They then buy the lower valued stock to fill their earlier sell orders and make a profit on the difference.

Insider Trading: The recipients of non-public information use the insider information to trade ahead of the information’s release, and subsequently realize profits.
Unregistered Offerings: Purported issuers of securities offer and/or sell securities through the Web without being registered or exempt from federal and state securities laws.
Pre-IPO Offerings: Purported issuers offer and/or sell shares of their company to investors based on the premise that the company soon will be going public. Some of these companies do not exist or are marginally successful.

Private Placement Offerings: Purported issuers offer and/or sell shares of their company with the usual promise of high returns, with the help of slick promotional materials. The companies turn out to be nonexistent.

Prime Bank Offerings: Purported sellers offer and/or sell interests in some type of prime bank instrument. The investors are advised to put their money into the prime banks of Europe in a program that generally is available only to the very wealthy, but because there is a “shortage” for the particular program, it is being offered for a smaller minimum investment. Prime bank instruments do not exist.

|Educational Series, Fraud|

Navigating through civil case jurisdictions in state and federal court systems

Courts within the federal judicial system:

Federal district courts are courts of original jurisdiction. District courts, as all federal courts, are also courts of limited subject-matter jurisdiction, meaning that they have the authority to hear cases of a particular type or relating to a specific subject matter, primarily based on federal questions and diversity of parties. The statute for federal question jurisdiction, 28 U.S.C. § 1331, provides that the district courts have subject-matter jurisdiction in all civil actions arising under the Constitution, laws, and treaties of the United States. This jurisdiction is not exclusive; state courts also can hear claims based on federal law. The statute for diversity jurisdiction, 28 U.S.C. § 1332, provides the district courts jurisdiction in actions that meet two requirements: 1) complete diversity – no defendant is a citizen of the same state as any plaintiff, and 2) amount in controversy exceeds $75,000. Federal courts also have removal jurisdiction, which is the authority to try cases removed by defendants from state courts.

Circuit courts are courts of appellate jurisdiction as they are authorized only to review decisions on appeal from district courts, certain specialized federal courts or federal administrative agencies. There are thirteen federal circuit courts; twelve for each one of the geographic circuits and one designated as the Federal Circuit which hears appeals from various specialized federal courts. Appeals from many of the administrative agencies are held in the Court of Appeals for the District of Columbia Circuit.

United States Supreme Court has original jurisdiction over cases affecting ambassadors and actions in which states are parties. Its appellate jurisdiction over all other types of cases is mostly discretionary.

Courts within the state judicial system

Courts of limited subject-matter jurisdiction are authorized to hear specific types of cases, such as small claims, traffic, landlord-tenant, or probate.

Courts of original and general jurisdiction hear all cases not exclusively apportioned to courts of limited jurisdiction, such as state claims and federal questions that also could be brought in federal district courts. State courts of general jurisdiction are often at the county level, and vary in their designations, e.g., Superior Court in California, Circuit Court in Virginia, Court of Common Pleas in Ohio and Supreme Court in New York. In some states, courts of general jurisdiction also hold appellate jurisdiction over cases originally tried in courts of limited jurisdiction.

Intermediate appellate courts exist only in more populous states. In some jurisdictions, the decision of the intermediate appellate court is final for most fact-bound and “routine” cases, such as domestic relations, and subject to discretionary appeal for constitutional questions.

Courts of appellate jurisdiction are variously called the Supreme Court, the Court of Appeals, or, in Massachusetts, the Supreme Judicial Court, and have the authority to change decisions and rulings of lower courts. Depending on the case type and original decision, an appellate review may consist of an entirely new hearing (a trial de novo), a hearing whereby the appellate court gives deference to factual findings of the lower court, or a review of specific legal rulings of the lower court (an appeal on the record.) An appeal from the intermediate appellate court to this higher court is mostly by permission, with the exception of a small number of cases selected by legislatures, such as administrative law actions.

To decide a case, a court must have a combination of subject-matter jurisdiction (defined previously) and either personal jurisdiction (defined as having the power to render a judgment against a particular defendant) or territorial jurisdiction (defined as having the power to render a judgment involving events that occurred within a well-defined territory) along with adequate notice (a requirement that the parties be aware of the legal process affecting their rights, obligations and duties.)

|Educational Series|

Federal Trade Commission’s Red Flags rule enforcement for accountants and other professionals is postponed

The American Medical Association (AMA), the American Bar Association (ABA) and the American Institute of Public Accountants (AICPA) all have brought legal actions against the FTC on the Red Flags rule. In the most recent suit filed on May 21, 2010 by the AMA, the American Osteopathic Association, and the Medical Society of the District of Columbia, the groups argued that the FTC will require them to start verifying their patients’ identities before they agree to treat them. In August 2009, in a suit brought by the ABA, the district court barred the FTC from applying its Red Flags rule to lawyers. The FTC appealed the ruling in February 2010. A decision in the appeal is pending.

The AICPA’s suit, filed on behalf of its members on November 10, 1009, charged in part that the FTC exceeded its statutory authority by extending the rule to regulate accountants and public accounting firms. The AICPA said that “it did not believe there is any reasonably foreseeable risk of identity theft when CPA clients are billed for services rendered.” That suit is now linked to the outcome of the appeal of the ABA ruling. AICPA members have been granted a 90-day grace period – a 90-day delay of enforcement of the rule – from the date on which the U.S. Court of Appeals for the District of Columbia Circuit renders an opinion in the ABA’s case against the FTC.

On May 28, 2010, the FTC announced that it again delayed the implementation until December 31, 2010 of a proposed Final Rule relating to Identity Theft Red Flags under the Fair and Accurate Credit Transactions Act of 2003. The proposed “Red Flags” rule is designed to help prevent identity theft among credit providers and financial institutions.

|Educational Series, Judgment|

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