Litigation lessons for financial executives: in cases related to embezzlement, executive compensation and Ponzi schemes, litigation involving accounting and financial executives could have been avoided. Here's how.

Author:Hopkins, Sheryl
Position:Legal Issues

Litigation is often where (he rubber meets the road for business executives and board members. Business decisions that appeared reasonable at the time they were made are examined in lawsuits under a microscope by adverse parties with the benefit of hindsight, making the decisions sometimes appear less than stellar. Bad outcomes are used to infer bad motives, forgetting that the business executives and board members did not have a crystal ball at the time they made the decision. Examining issues in business litigation can offer valuable insights and cautionary tales for executives and board members, which can be instructive in making future decisions.

Here are three "real-world" cases involving embezzlement, executive compensation and Ponzi schemes (for which the cases have been modified to preserve confidentiality).

The Best Defense Is Often a Good Offense

In litigation it is critical not to just defend against the plaintiff's allegations but also to examine what plaintiff may have done that contributed to or caused any damages plaintiff incurred. In other words, the best defense can be a good offense. The following case demonstrates this principle and shows the importance of effective internal controls.

Two of ABC Co.'s employees embezzled hundreds of thousands of dollars from their employer utilizing a fictitious bank account they set up at Defendant Bank ("bank"). ABC contended the bank was negligent, acted in bad faith and failed to follow reasonable commercial standards of fair dealing by accepting checks and wire transfers into the fictitious account without proper endorsement.

ABC also claimed that the embezzlement scheme created liquidity and working capital problems that ultimately resulted in its bankruptcy. ABC sued the bank, both for its direct losses of almost $1 million and for consequential damages of more than $10 million An investigation by M.S. Grace & Co. ("HSG") revealed that the employee who had initiated the embezzlement scheme (named "Smith") had started work for ABC as a low-level accounts payable clerk more than a year before the account at the bank was opened. Almost immediately after Smith started he was given responsibility for both preparation of bank reconciliations and check writing authority.

ABC alleged that Smith commenced the embezzling scheme when he opened the account at the bank and that a few months later the company controller ("Jones") discovered Smith's actions and was brought in on the scheme.

Investigation of ABC's records and bank records, however, revealed that Smith had actually begun embezzling shortly after he started at ABC--over a year before he opened the account at the bank--and had actually employed accounts at three other banks and a variety of means to embezzle from ABC. The reason Smith was able to do this was because of the very weak internal controls at ABC, which he had identified a few clays after he started working at the firm.


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