Understand and Identify the Many Forms of Commercial Fraud Before it is Too Late
He may be your neighbor or someone at your church. She may be your office manager or trust attorney. Perhaps you are a physician and all your colleagues are bragging about the person with whom they are investing and tempting you to get with the “can’t miss” investment program. He may be a member of your golf club or social club who seems so successful, always driving new cars and dressed impeccably.
There are indeed fraudsters among us who prey upon the trusting and uncareful. The purpose of this article is not to promote hysteria or paranoia. Rather, it is to remind the reader that when it comes to money, there is good reason to be careful and skeptical. As President Reagan once said, “Trust but verify.”
The CPAs in the audience for this article are critical in detecting and identifying a questionable investment, possible fraud or scam. CPAs prepare tax returns and review financial statements for clients and in many ways are the first line of defense to protect clients from fraudsters.
Embezzlement
Employee theft costs U.S. businesses trillions in dollars each year, and the number is growing. Put in another perspective, some authorities estimate fraud and error losses to average between three to six percent of an organization’s expenses.
Some signs of a possible embezzler engaging in employee theft are apparent. It could be a person who extensively visits casinos and gambles. It may be someone rumored to be having an affair, or a drug or alcohol problem. Perhaps, the person’s lifestyle is incompatible with his income. Maybe, this person has an unusually close relationship with a key vendor for the business.
Other warning signs of a fraudster in an office may not be particularly intuitive. For example, one of the warning signs could be the office manager who never takes a vacation and who never delegates tasks to subordinates. An employer may view that as a dedicated employee. However, these qualities may be pretext for a nefarious reason, to possibly cover something up and ensure no one finds out. The author’s experience in handling employee theft cases is that the embezzler usually steals to gain wants not needs.
As mentioned before, one does not want to promote distrust within an organization. But, a healthy dose of skepticism is appropriate, and thorough internal controls are critical. Internal controls may be as simple as making certain that the person who prepares checks is different than the person signing the check. Finally, every business should have an indemnity bond or employee defalcation insurance to cover losses attributable to dishonest employees.
Ponzi Schemes
Ponzi schemes may be named after Charles Ponzi, but the first known schemer was William “520 Percent” Miller who in or around 1899 defrauded thousands through the Frankin Syndicate in Brooklyn, New York. Bernie Madoff is the most recent notorious Ponzi schemer who created a false empire based on a Ponzi scheme.
A Ponzi scheme is an artifice which pays returns to investors from such investor’s own principal investments and from new investors. It is a house of cards which ultimately must fail because a Ponzi scheme is not based on any legitimate business enterprise. It sustains itself solely though new investor money.
The Madoff case is also a classic example of affinity fraud. Given Madoff’s celebrity and apparent success, investors from his synagogue, the charities with which he was involved and the socialites in Manhattan were drawn to Madoff’s apparent golden touch on investments.
Pyramid Schemes
Generally, multi-level marketing programs are lawful; pyramid schemes are not lawful. The distinction comes down to whether the program is about selling product (lawful) or recruiting sales people for downstream profits (not lawful). Both are based on the principal of the distribution of products (such as vitamins and essential oils) through a network whereby the originator of a distribution chain gets profits from sales of product from those he recruits to sell product.
Many MLM promoters claim their program is not a pyramid scheme; rather, it is “Just like Amway.” This statement has merit. The Federal Trade Commission brought a case against Amway in the 1970s which lasted several years in which Amway prevailed. In a 1979 decision, the Administrative Law Judge found Amway to be a legitimate business opportunity and came up with the three features making it legitimate:
- Amway representatives had to make at least 10 sales to retail customers as a qualification to get down line profit participation;
- Amway representatives are required to sell a minimum of 70% of previously purchased product before placing a new order; and
- Amway had an official “buy back” policy for unsold, unopened inventory.
Most MLM promoters can satisfy these rules. Nevertheless, the Federal Trade Commission fined Herbalife for $200 million in 2016, and a European Court in 2012 held that Herbalife was a pyramid scheme, and China bans Avon. Thus, the domestic and international law continues to develop on MLMs/Pyramid Schemes.
Cryptocurrency
Government regulators often have a difficult time keeping up with creative promoters. The latest example is the proliferation of cryptocurrencies. Promoters of cryptocurrencies claim to reduce the expense of raising money in capital markets by making “Initial Coin Offerings” or “ICOs.”
The strategy involves the presale of rights to receive tokens aka cryptocurrency to wealthy/accredited investors. The arrangement is sometimes referred to as a “Simple Agreement for Future Tokens” or “SAFT.” When a company has a viable product, the token can be used to buy the product. The coin itself is distributed to the investors who can sell the token.
The tokens do not provide any stockholder rights in the company, thus all the typical initial public offering disclosure is claimed to be unnecessary. The argument is that the tokens are not an investment because they have utility as a consumer use.
The Securities Exchange Commission is hot on the trail of promoters of cyptocurrencies. The SEC has within the last several months issued subpoenas to many promoters of cyptocurrencies. The SEC has warned that investors should only trade in digital assets that are securities that use regulated exchanges, alternative trade systems or broken deals.
Jon Titus practices law in the areas of investment fraud litigation and real estate development. He may be reached at jtitus@tbl-law.com or (480) 483-9600. Hewill present this topic at the Forensic and Litigation Services Conference on Sept. 6.
Originally published in AZ CPA July/August 2018.
