April 29, 2014

Organizational controls to protect against check fraud

Posted in Commercial Litigation by Gene Killian |

Those of you who frequently read our posts may notice occasional references to Larry Donnithorne’s little gem of a book, The West Point Way of Leadership, which is required reading at our firm.  In the book, Donnithorne recounts a lecture given by Jack Welch, the then-Chairman of GE, at an Ivy League University. 

Welch proposed the following hypothetical to the students in attendance:  You are representing a U.S company in a South American dictatorship, and are about to close a deal that would mean $90 million to the company.  Your counterpart in the arrangement assures you that the deal looks very good, and that the contract is close to being signed. The only loose end is the matter of depositing $1 million in a certain Swiss bank account.

“How many of you would make the deposit?” Welch asked the audience.

About a third of the students raised their hands, which left him momentarily speechless.

Finally, he said, “They’re not teaching you everything you need to know here.”   (Let me head the jokes off at the pass. Mr. Welch meant that no one should have raised their hand…not that the other two-thirds were behind the curve.)

The book was written in 1993, and in light of what happened in the years to come in the financial markets, the Jack Welch story was prescient.

Many of us who are involved in business litigation and insurance litigation have seen our share of sad stories over the years.  And here’s a new one for the list. Gregory Luhn was once an attorney in New Jersey. In 2005, Luhn was hired by a company called Custom Travel Incentives and Promotions, Inc., in the belief that Luhn was a specialist in tax law.

I’m going to stop right here for a moment. Had Custom Travel done any research on Luhn, Custom Travel easily would have discovered that Luhn had been disbarred after stealing $300,000 from his former law firm, and another $200,000 from a later employer.  And he went on to steal $267,000 from yet ANOTHER employer. Luhn pleaded guilty in 2002 to stealing from his law partners and eventually served four months of a six-year prison sentence.  Not exactly a paragon of virtue.  And probably not a guy you would want to hire as your lawyer.

How do things like this happen? They happen because we’re busy, we make assumptions, and we take people at their word. I know of a major law firm, for example, where a legal assistant informed his bosses that he would be attending law school at night, and therefore needed to leave work early every day.  They consented. After three years, he told his bosses that he’d passed the bar exam. The firm promoted him to a lawyer position, and he began representing clients, including a major pharmaceutical company. One problem:  He actually had never taken the bar exam, or even set foot in a law school classroom. He was exposed by a tip from an old undergraduate classmate, and eventually was prosecuted for fraud.

In Attorney Luhn’s case, Luhn convinced Custom Travel’s principal, Lawrence Karg, that Karg should forward estimated tax payments to Luhn.  Luhn claimed that he would then deposit the payments into his firm’s trust account, and would wire the money to the tax authorities.  Based upon Luhn’s advice, Karg made Luhn the payee on the checks, and wrote Luhn’s name in the “pay to order line.” I think you can see where this is headed. Luhn stole all the money.

Luhn didn’t actually have a bank account. He used his wife’s account at TD Bank to deposit the (fifty!) checks that Karg had given him (payable to Luhn).  This went on for three years. When the fraud was finally discovered, Karg tried to recoup the money from TD Bank, the payee bank. 

The Court absolved TD Bank, writing:  “The Plaintiff, a non-customer, had no direct dealings with TD Bank from which a duty could arise. Instead, Plaintiff’s remedy is against its bank, Bank of America, the payor bank who debited Plaintiff’s account upon Mr. Luhn’s presentment of the checks to TD Bank…An action for conversion of an instrument may not be brought by the… issuer or acceptor of the instrument.” 

Citing the comments to §3-420 of the Uniform Commercial Code, the Court wrote: “There is no reason why a drawer should have an action in conversion. The check represents an obligation of the drawer rather than property of the drawer. The drawer has an adequate remedy against the payor bank for recredit of the drawer’s account for unauthorized payment of the check.”  (Here, of course, that would be a difficult remedy to pursue, since the checks had actually been made out to the defrauder and there was no forgery.  Bank of America was named as a defendant in the suit, but the decision doesn’t say how that turned out.)

The Court also noted that TD Bank was protected as a holder in due course under U.C.C. §3-302, writing:  “A holder in due course is a person who in good faith has given value for a negotiable instrument that is complete and regular on its face, is not overdue, and, to the possessor’s knowledge, has not been dishonored. TD Bank gave monetary value for the checks which appeared complete and regular on their face. It is undisputed that the signatures of the drawer and the payee were not forged.”

This case is painful to read, but it contains a number of valuable lessons. First, many defrauders are “confidence men.” They gain a position of trust in an organization (financial officer, accountant, attorney) and then gradually begin siphoning off funds. No matter how much you trust an employee, someone needs to be watching. Kind of like this. Proper monitoring protects the employee as well as the organization.  Second, it’s important to review bank records and be alert for red flags. Here, the fraud went on for three years. A routine inspection of Karg’s bank records could have disclosed that the checks were not deposited into a trust account as promised, but rather into the account of Luhn’s wife.  And finally, make sure your organization’s employee theft coverage is adequate for the risks involved.

-        Gene Killian