2008 Autumn, Pg. 24. PREVENTING FRAUD: From Fiduciary Duty to Practical Strategies.

AuthorBy Attorney Michael DeLucia(fn1)

New Hampshire Bar Journal

2008.

2008 Autumn, Pg. 24.

PREVENTING FRAUD: From Fiduciary Duty to Practical Strategies

New Hampshire Bar JournalVolume 49, No. 2Autumn 2008PREVENTING FRAUD: From Fiduciary Duty to Practical StrategiesBy Attorney Michael DeLucia(fn1)"It couldn't happen at our place, everyone who works here is just like family." -- "Loss Prevention Bulletin," Zurich North America(fn2)

INTRODUCTION

The purpose of this article is to help both nonprofit and for-profit organizations identify the possibilities for fraud and embezzlement in their organizations and understand the steps they need to take to prevent these behaviors. The article emphasizes the need for boards of directors to take the lead in engaging their officers and employees in crafting policies and procedures to minimize the possibility for fraud and embezzlement. Although the focus of this article is primarily on the nonprofit sector, the lessons to be learned are applicable equally to all sectors, including religious organizations. No organization is immune to fraud, including state and federal governmental agencies.(fn3)

  1. NONPROFIT BOARD OF DIRECTORS/FIDUCIARY DUTY

    Fiduciary Duty. Because boards of directors have a fiduciary duty to protect charitable assets, fraud and embezzlement are issues that must be addressed at the board level. Governing boards should implement internal controls, work with their auditors to identify vulnerabilities in their organizations, and, most importantly, create an anonymous reporting system for employees that ensures confidentiality. Other initiatives for boards to consider include educational sessions for officers and employees and insurance to cover employee theft. Each of these items is discussed more fully below; and there is a summary "Ten Tips" sidebar in this article.

    Scope of the Problem. In a recent scholarly publication, the authors estimated that the cost of fraud in the charitable sector is approximately $40 billion dollars annually.(fn4) That sum is a staggering percentage of the charitable giving that donors contribute annually to nonprofit organizations. The authors examined recent data and pointed to a set of conclusions: that fraud may be easier to perpetrate in nonprofit organizations because of factors such as (i) an atmosphere of trust, (ii) weaker internal controls, (iii) lack of financial expertise, and (iv) reliance upon voluntary boards.(fn5) If these conclusions are correct, then nonprofit governing boards need to focus quickly and efficiently upon ways to deal with these vulnerabilities.

    One basic problem in the nonprofit sector is the limited number of volunteers at the board level with skills in scrutinizing financial statements or in providing the tough oversight function that is needed. For those boards that lack members with financial skills, the ability to detect and deter fraud is significantly hampered. "[T]hese factors can result in a board that is unwilling or unable to ask the tough questions necessary to detect financial mismanagement or fraud."(fn6) To put it bluntly: "Active involvement of [financially knowledgeable individuals][is important in] deterring fraudulent activity."(fn7) Consequently, nonprofit boards should make it a priority to identify and include board members with financial and related skills.

    Fraud appears regularly in both for-profit and non-profit organizations, whatever their size.(fn8) Recent cases in New Hampshire have included a religious organization in Portsmouth, where its long-serving treasurer embezzled $1,600,000, leaving his church with $100.(fn9) The New Hampshire cases also include a serial embezzler, who embezzled $15,000 from her first employer, was indicted and convicted, and later plead guilty to embezzling $340,000 from a later employer.(fn10) One recent national commentator, pointing to New Hampshire, summarized the situation as follows: "The spreading disease of embezzlement from charitable organizations seems to reach everywhere."(fn11) Indeed, recent cases include embezzlement at law firms, medical facilities, and youth sport leagues.(fn12)

    Proliferation of Charitable Entities. The potential for fraud in the charitable sector is likely to increase, given the rapid proliferation of charities in the United States. The Internal Revenue Service reports that in 1996 there were 654,186 registered 501(c)(3) organizations.(fn13) By 2007, the number of registered 501(c)(3) organizations had increased to 1,128,367. In 2007 alone, the IRS approved 68,278 new 501(c)(3) organizations, which calculates into 32 new 501(c)(3) organizations per work-hour or one new 501(c)(3) organization every two minutes of the workday. This proliferation of charitable entities has been occurring in New Hampshire as well, with approximately 500 additional charities being registered annually in this state. Given this proliferation, the need for informed board members skilled in financial and management issues and alert to identifying "red flags" is more urgent than ever.

    TEN TIPS

    The following ten tips are designed to help a board devise a strategy suitable for its own organization. The two major building blocks are (i) creating a positive culture in the organization and (ii) strengthening internal accounting controls.

    1. train volunteers and staff regarding fraud

    2. obtain employee theft insurance

    3. have someone other than the treasurer review the monthly financial statements

    4. create a positive, ethical environment "at the top"

    5. require independent directors

    6. specifically direct the audit committee to detect fraud

    7. require background checks on all employees that handle cash

    8. create a whistleblower protection system

    9. educate employees on the consequences of fraud

    10. brain-storm with staff on the problem

    For a comprehensive discussion of anti-fraud initiatives, see Edward McMillan's book, Preventing Fraud in Nonprofit Organizations (John Wiley and Sons, Hoboken, New Jersey, 2006).

  2. CERTIFIED FRAUD EXAMINERS

    In July 2008, the Association of Certified Fraud Examiners (ACFE) released its 2008 "Report to the Nation" on occupational fraud in the United States. The Report is analytical, comprehensive, and an excellent source of data on fraud. It is accessible on the ACFE's website.(fn14) The Report estimates that U.S. organizations lost approximately 7% of their annual revenues to fraud, with the lack of adequate internal controls being a major factor in allowing the fraud to occur. Of special interest is the fact that only 7% of the perpetrators of fraud had prior criminal convictions...

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