Financial Fraud: Trouble from Honest Mistakes and Dishonest Conduct

Reprinted from:
Published 4/12

Law firms are at far greater risk for, and have far fewer protections against, the more traditional security risks that come under the heading of financial fraud. Funds can come up missing in any law firm, and the cause typically involves one of two scenarios: either there has been an honest mistake, or there has been intentional theft that qualifies as fraud or embezzlement. Lawyers and law firm staff can be involved in either case.

Theoretically, fraud should not be a concern. For lawyers, 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, deviations from the straight and narrow by lawyers or staff can happen in any firm. Consider the two scenarios mentioned above: honest mistake and intentional theft.

"Honest Mistakes" in Trust Accounting

The formal term is "Interest on Lawyer Trust Accounts," but most lawyers simply call them IOLTA accounts. Under the Rules, every client's payment for work that has been performed is to be deposited into a lawyer's general account and 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: Money is received in settlement of a claim and deposited into the clients' trust account. Checks are then written to lien holders and mailed. Some of the lien holders fail to cash the check, but they (not the lawyer or the client) are still entitled to the funds.

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.

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. 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 mistakes. When state bar regulations require a paper trail that includes retaining canceled checks and other features of an older era, lawyers often are inadvertently out of compliance. Banks have moved completely to the electronic age and few banking institutions, if any, still return canceled checks. They send photocopies and, after a short time, destroy the canceled checks, fully in compliance with the federal Check Clearing for the 21st Century Act. The problem is that Model Rule 1.15 requires lawyers to keep "complete records" of account transfers – and that has been interpreted to include the canceled checks.

The ABA has recognized this situation is untenable. In August, 2010, the American Bar Association's House of Delegates adopted the new Model Rules for Client Trust Account Records to replace the Model Rules on Financial Recordkeeping, in effect since 1993, enabling lawyers to use electronic tools to comply with Model Rule 1.15. The new rules 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 offsite, if these records are readily accessible, can be printed upon request, and preserve full client confidentiality. But remember that the rules are very explicit. Failure to provide accurate accounting records on a State Bar inquiry means very bad news. Banks are required to notify the Bar of any defalcations, and a bounced check from an IOLTA account immediately starts Bar disciplinary proceedings.

"Dishonest Mistakes" Through Financial Fraud

Actual fraud is another issue entirely, and the motivations for funds to go missing can be as varied as the people who take the money. In today's tough economic conditions, it is all to 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 is aided and abetted by the fact that a trusted staff employee who has been with the firm for years is given 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. That is too often when bad things happen.

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.

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.

The person who is given incoming funds when they are received should not be the same person who deposits those funds.

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.

Yet another person, preferably an accountant from an outside CPA firm, should review and "audit" all financial records quarterly.

Create a "safety valve" by having more than one person trained and capable of doing each of the first four steps, and switching 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, whether by mistake or outright fraud.

Lawyers are the owners of the firm and have ultimate financial stewardship for it, particularly when it comes to guarding the integrity of funds. Financial integrity requires that every document, check and ledger entry be treated as important. Not recognizing that importance is to invite misconduct, State Bar inquiry and trouble.

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