Ruby, wanted nothing more than to be a pre school teacher. She defied her parents’ demands to become a doctor in order to pursue her passion to work with young children. Early on, Ruby understood that she could have the greatest impact on society, if she devoted herself to working with young children in underserved communities. She also accepted the fact that a career in childcare would not pay as well as a doctor’s salary in the U.S. This was a sacrifice she was willing to make.
Ruby’s devotion to children became evident to everyone around her and she quickly rose through the ranks of her organization, landing as the Executive Director of a non profit childcare center chain. Although she missed the classroom, she flourished in her new management roll. Along the way, she picked up professional development hours in business management at industry conferences and in-service trainings. However, nothing prepared her for managing a chain of childcare centers, employing more than 350, handling a multi-million dollar budget and answering to a demanding Board of Directors.
Ruby was relieved to have her friend and Chief Financial Officer, Nancy, at her side to manage the finances and a small group of talented board members. The Board members included past and present parents and a local high ranking public official. The public official, Frank Blunderwood, generously used his status to steer vendors to the organization, negotiate terms of large contracts and often serve as an intermediary. Frank often convinced Ruby to allow him to collect payments on behalf of the organization as an added “layer of protection.” Frank persuaded vendors to believe that it was his responsibility to negotiate contracts and receive payments on behalf of the organizations.
Admittedly, Ruby did not have the business acumen to manage an organization of this magnitude but she felt the people surrounding her, complimented her skills and insulated her from liability. Honestly, Ruby preferred to handle the program related matters over finances.
Five years into the executive director position, Ruby was astonished to receive a criminal subpoena followed by a civil subpoena a few weeks later. The lawsuits alleged that Ruby, by and through her agents committed fraud, embezzlement, and negligence. The IRS, Employment Development Department (“EDD”), Franchise Tax Board (“FTB”), insurance carrier investigators and police detectives were all champing at the bit to speak with Ruby.1
Dumbfounded, Ruby called the President of the Board to ask for direction, but without hesitation the President replied,”I am represented by legal counsel and I have been instructed to cease all communication with you. Good luck!” Ruby tried to contact the other board members who responded similarly except for the loyal CFO, Nancy. Nancy, felt awful because she knew Ruby counted on her and she couldn’t believe this could happen. However, Nancy warned Ruby that she could only attest to the proper handling of tuition. All other revenue was outside the scope of her responsibility.
To Ruby’s disbelief, she later discovered that Frank Blunderwood and the Finance Committee Chair, were in cahoots. They absconded with $250,000 of school money syphoned from cash, vendor contracts, fundraising, credit card transactions and government subsidies.
Naively, Ruby placed her trust in the Board members and staff to ensure every penny was accounted for and that there were procedures in place to safeguard against theft. Upon further investigation, Ruby discovered loop holes that allowed for the duo to steal money from the school for the past 3 years. During the investigation, detectives informed Ruby that not only had the duo run off with money, but they failed to pay federal and state taxes.2 The insurance company denied the claim to recover the 2 $250,000 because of a prior allegation of malfeasance by the finance committee. This ordeal has left Ruby and the Board in a vulnerable position and completely reliant upon Nancy. Now what?
Why is this important to you?
Well intentioned leaders have fallen prey to allegations of fraud, because of their ignorance about the law, blindly trusting others, an aversion to managing finances, the absence of safeguards, checks and balances, policy and protocol. In law, those who fail to act reasonably or those who aid or abet others in a commission of a crime can be held equally culpable for the crimes committed by others. Ruby, although unwittingly, is entangled in a web of crime and deceit.
What do you need to know about fraud?
Above and beyond breaching their fiduciary3 duties as trustees of the organization, 3 Frank and the Finance Chair are suspected of committing crimes. Fraud and embezzlement, a type of fraud, are among the crimes with which they could be criminally charged and sued in civil court. As always, the first step is to understand the legal terms.
Embezzlement a.k.a. Financial Fraud
Embezzlement is the act of withholding assets for the purpose of theft, by one or more persons to whom the assets were entrusted, either to be held or to be used for specific purposes. Embezzlement is a type of financial fraud.
Embezzlement usually is a premeditated crime performed methodically, with the embezzler taking precautions to conceal their activities of the criminal conversion of the property of another person, because the embezzlement is occurring without the knowledge or the consent of the affected person. Often it involves the trusted individual embezzling only a small proportion or fraction of the total of the funds or resources they receives or controls; in an attempt to minimize the risk of the detection of the misallocation of the funds or resources.
In our story, Frank and the Finance Chair were trusted members of the organization in a prime position to embezzle portions of the money for several years.
When successful, embezzlements may continue for many years without detection. It is often only when a relatively large proportion of the funds are needed at one time; or they are called upon for another use; or, when a major institutional reorganization requires the complete and independent accounting of all real and liquid assets; that the victims realize the funds, savings, assets or other resources, are missing and that they have been duped by the embezzler.
Fraud is commonly understood as dishonesty calculated for advantage. In the U.S. legal system, fraud is a specific offense with certain features. Fraud is a false representation of a matter of fact—whether by words or by conduct, by false or misleading allegations, or by concealment of what should have been disclosed—that deceives and is intended to deceive another so that the individual will act upon it to her or his legal injury.
Fraud is a crime that many people equate with theft, but there is a distinction. There is also a distinction between criminal fraud and civil fraud.4 The basic difference between 4 theft and fraud is that theft generally involves taking something through force or by stealth, where fraud revolves around a purposeful misrepresentation of fact, and the basic difference between criminal fraud and civil fraud lies in who is pursuing legal action in the case. A single act of fraud can be prosecuted as a criminal fraud by prosecutors, and also as a civil action by the party that was the victim of the misrepresentation.
Fraud must be proved by showing that the defendant’s actions involved five separate elements:
- (1) a false statement of a material fact,
- (2) knowledge on the part of the defendant that the statement is untrue,
- (3) intent on the part of the defendant to deceive the alleged victim,
- (4) justifiable reliance by the alleged victim on the statement, and
- (5) injury to the alleged victim as a result.
Let’s unpack these elements.
These elements contain nuances that are not all easily proved. First, not all false statements are fraudulent. To be fraudulent, a false statement must relate to a material fact. In order to be considered material, it should substantially affect a person’s decision to enter into a contract or pursue a certain course of action.
Second, the defendant must know that the statement is untrue. A statement of fact that is simply mistaken is not fraudulent. To be fraudulent, a false statement must be made with intent to deceive the victim.5 This is perhaps the easiest element to prove, once 5 falsity and materiality are proved, because most material false statements are designed to mislead.
Third, the false statement must be made with the intent to deprive the victim of some legal right.
Fourth, the victim’s reliance on the false statement must be reasonable. Reliance on a patently absurd false statement generally will not give rise to fraud; however, people who are especially gullible, superstitious, or ignorant or who are illiterate may recover damages for fraud if the defendant knew and took advantage of their condition.
Finally, the false statement must cause the victim some injury that leaves her or him in a worse position than she or he was in before the fraud.
A statement of belief is not a statement of fact and thus is not fraudulent. Puffing, or the expression of a glowing opinion by a seller, is likewise not fraudulent. For example, a car dealer may represent that a particular vehicle is “the finest in the lot.”Although the statement may not be true, it is not a statement of fact, and a reasonable buyer would not be justified in relying on it.
The relationship between parties can make a difference in determining whether a statement is fraudulent. A misleading statement is more likely to be fraudulent when one party has superior knowledge in a transaction, and knows that the other is relying on that knowledge, than when the two parties possess equal knowledge. For example, if the seller of a car with a bad engine tells the buyer the car is in excellent running condition, a court is more likely to find fraud if the seller is an auto mechanic as opposed to a sales trainee. Misleading statements are most likely to be fraudulent where one party exploits a position of trust and confidence, or a fiduciary relationship. Fiduciary relationships include those between attorneys and clients, physicians and patients, stockbrokers and clients, and the officers and partners of a corporation and its stockholders.
Fraud vs. Theft
Fraud resembles theft in that both involve some form of illegal taking, but the two should not be confused. Fraud requires an additional element of False Pretenses created to induce a victim to turn over property, services, or money. Theft, by contrast, requires only the unauthorized taking of another’s property with the intent to permanently deprive the other of the property. Because fraud involves more planning than does theft, it is punished more severely.
When a person is accused of criminal fraud, the case is brought by either local, state or federal prosecutors, who have to prove that they intended to commit the misrepresentation and to gain from it. These cases can be pursued even if the fraud was not successful and nobody was actually harmed. Common examples of criminal fraud include:
- Mail fraud
- Wire fraud
- Securities fraud
- Identity theft
- Tax evasion
- Bankruptcy fraud
- Bank fraud
By contrast, a civil fraud case is brought to court by the person who was defrauded, who needs to prove that the defendant materially misrepresented the fact, that the fact was false and they knew that it was false, that they did so with the intention of getting the victim to act on the misrepresentation and that the victim acted reasonably in believing the misrepresentation. In addition to all of these elements, the victim needs to show that they suffered a damage as a result of the misrepresentation. The biggest difference between a civil fraud case and a criminal case, beyond who is pursuing it, is that actual damage needs to have occurred in a civil case.
The goal of pursuing both a criminal fraud case and a civil fraud case is to get justice and punish the wrongdoer, but the punishments that result from a guilty verdict are very different. In the case of criminal fraud, the accused faces the possibility of incarceration or probation, as well as of having to pay fines and possibly make restitution to any victims that may have been damaged. In a civil fraud case, the punishment sought is generally compensation for the damage that was suffered by the victim.
How to apply the law to the scenario
In our scenario, Frank served as a fiduciary to the organization. He was entrusted to protect and act in the best interest of the organization. This special relationship means Frank was ethically bound to refrain from conflicts of interest and above all, stealing money.
Frank placed himself in a position to negotiate contracts and accept money from vendors. The story is silent about whether he disclosed his shenanigans to the Board and got approval. Absent disclosure and approval by the Board, Frank should never have held or taken money on behalf of the organization. Proving intent or “guilty mind” should not be difficult based on the facts given. So we know Frank was up to no good, but what about Ruby?
Ruby was not complicit in the crimes of Frank and the Finance Committee Chair, but she would nevertheless be held accountable for the lack of oversight. Ruby had a multitude of safeguards at her disposal and she neglected to use any of them. Here are a few steps Ruby could have taken to prevent the situation.
- Compliance first! In business, small and large, compliance with the law and managing money are at the forefront. Second to none, financial management and oversight is critical.
- Confront your shortcomings – If your quantitative skills are subpar, bring them up to speed so that you can effectively safeguard the money you earn. At the very least, you must be able to hold intelligent conversations with accountants, advisors and the bank.
- Safeguards – Never should one person handle the money. At a minimum, dual signatures should be required on checks and disbursing funds above the petty cash amount, should require layers of approvals.
- Policy and protocol – Establish a procedure for handling money and stick to it. No exceptions. This includes fundraising, special events, and petty cash. You are vulnerable if people think no one is watching.
- Guillotine – Place the CFOs neck in the guillotine first. Waste no time! Let it be known that the first head on the chopping block is the person ultimately responsible for the finances. The Board will be pointing fingers at the CFO as soon as the investigators arrive. The flip side of holding the CFO accountable for everything is making sure he/she knows and approves of everything. All financial reports related upon by the Board should be vetted through the Finance Committee and the CFO. If your CFO is able to say “I had no idea”…look out! This is a red flag and you are headed for trouble.
- Red Flags – Don’t ignore the signs.
- lack of transparency
- lack of disclosure
- side deals outside of the regular course of business
- lack of oversight
- unusual behavior
- financial problems / desperation
- Crime – an unlawful act punishable by a state or other authority
- Embezzlement – act of withholding assets for the purpose of theft, by one or more persons to whom the assets were entrusted, either to be held or to be used for specific purposes.
- Fraud – false representation of a matter of fact—whether by words or by conduct, by false or misleading allegations, or by concealment of what should have been disclosed —that deceives and is intended to deceive another so that the individual will act upon it to her or his legal injury.
- Fiduciary – a person or organization that owes to another the duties of good faith and trust. The highest legal duty of one party to another, it also involves being bound ethically to act in the other’s best interests. A fiduciary might be responsible for general well-being, but often it involves finances – managing the assets of another person, or of a group of people, for example. Money managers, bankers, accountants, executors, board members, and corporate officers can all be considered fiduciaries.
- Tax evasion – willful attempt to evade or defeat the payment of taxes due and owing.
1 This phrase (or idiom) comes from the sport of kings: horse racing. A bit is part of the apparatus that goes in the horse’s mouth and connects to the bridle and reins so the horse can be controlled and directed by the jockey on its back. The bit fits into a toothless ridge of the horse’s mouth, so the horse never really bites the bit. But it can grind his teeth or jaw against the bit, and if it does, it means that the horse is either nervous, or really excited about racing. That’s how the phrase “champing at the bit” entered everyday communications: to indicate extreme eagerness.
2 Tax fraud against the federal government consists of the willful attempt to evade or defeat the payment of taxes due and owing (I.R.C. §7201). Depending on the defendant’s intent, tax fraud results in either civil penalties or criminal punishment. Civil penalties can reach an amount equal to 75 percent of the underpayment. Criminal punishment includes fines and imprisonment. The degree of intent necessary to maintain criminal charges for tax fraud is determined on a caseby-case basis by the Internal Revenue Service and federal prosecutors.
3 A fiduciary is a person or organization that owes to another the duties of good faith and trust. The highest legal duty of one party to another, it also involves being bound ethically to act in the other’s best interests. A fiduciary might be responsible for general well-being, but often it involves finances – managing the assets of another person, or of a group of people, for example. Money managers, bankers, accountants, executors, board members, and corporate officers can all be considered fiduciaries.
4 Federal and state criminal statutes provide for the punishment of persons convicted of fraudulent activity. Interstate fraud and fraud on the federal government are singled out for federal prosecution. The most common federal fraud charges are for mail and wire fraud. Mail and wire fraud statutes criminalize the use of the mails or interstate wires to create or further a scheme to defraud (18 U.S.C.A. §§ 1341, 1342).
5 Criminal intent is a necessary component of a “conventional” crime and involves a conscious decision on the part of one party to injure or deprive another. “The act is not culpable unless the mind is guilty.”