Fraud and the Crooked Brothers

One of the most valuable roles that an attorney can play is in helping guide the pre-investment due diligence process, and clients must be made aware of the importance of the attorney’s function

Andrew D. Pappas, CPA

Two Arizona brothers, Nathan and Richard, were the shareholders in L&L Global, Inc. Both brothers had earned advanced degrees and compiled impressive résumés.

Nathan and Richard formed a limited liability company, Door Nail Mall LLC, for the purpose of building and managing a shopping center. Nathan was Door Nail Mall LLC’s managing member. The two brothers attracted capital from a number of investors to fund the construction of the project.

Nathan and Richard contracted with a company called Hand-in-Glove Builders to act as construction manager. Construction of the mall appeared to be progressing nicely when, suddenly, 60 days before the scheduled opening, the LLC ran out of money. All work on the project came to an abrupt halt, and the lender initiated foreclosure on the property.

The two biggest investors, Mr. Morgan and Mr. Ford, were committed to the project. They could not understand how the LLC could become insolvent, and they suspected that Nathan and Richard were at the root of the LLC’s financial woes. Morgan and Ford bought out the other investors, made peace with the lender and, as the LLC’s new managing members, took over the project.

Their first move was to fire Hand-in-Glove Builders and to bring in a construction management firm that, on previous projects in which Morgan and Ford invested, had proven to be capable.

Their second move was to file a lawsuit against L&L Global, Inc., and against Nathan and Richard personally. The attorneys for Morgan and Ford engaged Pappas & Company as a financial expert to perform a number of investigative functions, including:

• examining the accounting records maintained during the time period that L&L Global and Nathan and Richard controlled Door Nail Mall LLC;

• evaluating the LLC’s accounting methodologies and practices; and

• reviewing various transactions to help determine the propriety of the use of the LLC’s funds by L&L Global, Nathan and Richard.

Our examination of the financial records revealed that the LLC’s accounting systems and procedures were deficient and that there were essentially no internal controls. It is management’s responsibility to establish, maintain and monitor the accounting systems and procedures; based on the financial records provided, it was clear that management had not maintained even a minimal standard.

When we turned our attention to Hand-in-Glove Construction Management, we quickly determined that what we initially diagnosed as shoddy recordkeeping on the part of Nathan and Richard was, in fact, malfeasance. It turned out that Hand-in-Glove was an LLC whose sole owner was – surprise – L&L Global.

While it was in charge of construction, Hand-in-Glove had paid top dollar for supposedly top-quality materials, purchased from the best suppliers, to enhance the appearance and value of Door Nail Mall. While it was true that Hand-in-Glove paid top dollar, the materials purchased were largely below-grade, and the companies that supplied the cheap, substandard materials were other LLCs owned by L&L Global.

For its part, Hand-in-Glove reported that it no longer had any accounting records, claiming that it had turned everything over to its on-site project manager. Predictably, the on-site manager denied receiving any records.

Morgan and Ford were able to salvage only a smattering of the LLC’s records, which were of minimal value to our investigation.

Our examination also took us to the offices of Door Nail Mall LLC’s public accounting firm, Halt & Lame, which could not locate any files for that particular client. We determined that the conflicts of interest involving the CPA firm were nearly epidemic, as its list of clients, in addition to Door Nail Mall, included Nathan, Richard, L&L Global, Hand-in-Glove, and nearly a dozen other related entities.

During our analysis we also encountered a number of transactions that we determined to be improper and/or not related to building or managing the mall. For example:

• Richard wrote a $300,000 check to himself, from the Door Nail Mall account, for which he initially offered no reasonable explanation and for which we found no documentation. Ultimately, in his deposition, Richard admitted that the money was to pay for items to furnish and decorate a rental property that he and Nathan were building near a Colorado ski resort.

• A $1.75 million check to the general contractor was written directly from the checking account instead of from the construction loan that had been obtained to pay for construction costs. Records that Morgan and Ford’s attorneys subpoenaed from the general contractor showed that the payment was for completion of another of Nathan and Richard’s projects, since the contractor would not begin working on Door Nail Mall until he had been fully paid for the prior project.

• There were several checks written to L&L Global for which there was no documentation and no apparent business purpose.

• L&L Global was to have been paid a construction administration fee of $250,000 for overseeing the development of the project but instead received $500,000.

Lessons. Investing in publicly traded stocks and bonds involves risk, but there are laws, oversight and enforcement in place to mitigate the risk of fraud. Investing in private business deals involves substantially more risk, since these deals generally are less transparent and receive less scrutiny. Therefore, investors should exercise more due diligence before entering into private investments where they are entrusting their funds to others.

Due diligence should involve, at least, engaging an attorney and an accountant. The attorney can review the contracts, research the entities involved to determine if there are undisclosed relationships, perform background checks on the promoters, and ensure that all of the disclosures comply with applicable securities laws. The accountant can review the business arrangements, such as the profit split and compensation to the promoters, to determine if they are reasonable and comparable to similar investments. They can also determine if the required frequency and type of reporting to the investors is appropriate.

Finally, investors in the promoters’ other projects should be contacted to determine if they have experienced any problems in their dealings with the promoters.

Investors should be especially cautious of transactions in which the promoters do not have a substantial financial stake. If a deal isn’t good enough to attract the promoters’ cash, investors should question whether it’s good enough for theirs.

In short, investors should develop a real knowledge of the people with whom they’re placing their money.

Attorney Roles. Nowhere is “an ounce of prevention is worth a pound of cure” more applicable than in the avoidance of fraud. Once fraud has been committed, detection is expensive; even if fraud can be proven, recovery of damages is usually difficult.

One of the most valuable roles that an attorney can play is in helping guide the pre-investment due diligence process, and clients must be made aware of the importance of the attorney’s role.

In addition to shepherding the due diligence process, attorneys are often instrumental in shaping the terms of the deal. In a syndicated transaction, the attorney’s ability to influence the terms may be limited; in a negotiated transaction, the attorney can have considerably more influence. For example, the attorney can insist that the operating agreement empower investors to demand financial investigations by a forensic accountant whom the investors select. (Audited, reviewed and compiled financial statements are valuable management tools, but they generally do not uncover fraud.)

In the preceding case study, had Mr. Morgan and Mr. Ford performed adequate due diligence, they may never have invested in Door Nail Mall LLC. Even if the due diligence had not unfurled red flags sufficient to keep them from investing, surprise forensic accounting procedures may have detected the fraud and limited their losses.

While the preceding account is based on an actual case, the facts have been simplified and the names of all parties have been changed.

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