Pappas article: Fraud and the Framed Controller

November/December 2008

Fraud and the Framed Controller

The hiring of an obviously unqualified employee proved to be a vital step in a restaurateur’s scheme to defraud his investors

Andrew D. Pappas, CPA

The following article is based on an actual Pappas & Company engagement. All factual references have been changed to protect the privacy of the parties. Any references to an actual person or company are unintended and purely coincidental.

“Eggzistential” was an Arizona chain of breakfast/lunch restaurants that, at its peak, had 14 locations in Phoenix, Tempe, Sedona, Flagstaff and Tucson. Living up to its name, it offered entrees ranging from the Nietzsche Super Omelet to Huevos Heidegger, plus the bottomless cup of Kafka Koffee. Eggzistential was a big hit with – well, with somebody, because ten years after it opened its first restaurant on Mill Avenue, the 14 locations combined were grossing well over $25 million a year.

Eggzistential’s founder, Søren Weary, was the sole owner of the Tempe restaurant. Each of the other restaurants was owned by a separate LLC in which Weary was the managing member and various investors were the members.

Keeping up with the chain’s rapid expansion appeared to be a management challenge for Weary, and some of his hiring decisions seemed to more closely reflect mainstream existential themes of dread, alienation and nothingness than any skill he may have had in attracting professional talent.

Nowhere were his management decisions more glaring than in his hiring of Debbie to be his controller. Debbie answered Eggzistential’s “help wanted” ad because The Plague was her favorite book and, like most fans of Albert Camus, she needed a job. Her qualifications for the position of controller consisted of two semesters of high school bookkeeping and one term as assistant treasurer of the ASU Facticity Club, sufficient to make “When can you start?” Weary’s toughest interview question .

Incredibly, Debbie survived as Eggzistential’s controller for nearly five years. With QuickBooks for Dummies always within easy reach (if not properly followed), she more or less managed the finances of all 14 restaurants. She reported directly to Weary, who, despite recognizing that she was generally unqualified for even the basics of her job, further strained her already limited capacity by periodically loading her down with more complex financial and administrative responsibilities.

In Debbie’s third year with the company, Weary instructed her to implement a bifurcated payroll system under which (a) part of the employees’ pay would be made by check and (b) cash would be withdrawn from the business and distributed by Weary to the employees. Unaware that such practices would be frowned upon by multiple state and federal agencies, and appreciative of the likely income tax savings she and her co-workers would enjoy, Debbie went along with Weary’s orders.

By her fourth year at Eggzistential, Weary had expanded Debbie’s responsibilities to include human resources management and health code compliance, with no additional help and no additional pay. When Weary deflected her request for a pay raise, Debbie began finding ways to redirect some company revenues for her benefit.

Debbie’s skimming continued for about a year, with Weary apparently oblivious to what she was doing. But one day an agitated Weary called her into his office, fired her, accused her of embezzling more than $500,000, and advised her that he was filing civil and criminal charges against her.

With the writings of Camus of little help to her now, Debbie did what most savvy existentialists would do in such a situation: She went to Google and typed “arizona fraud investigations” in the search window, and up popped Pappas & Company. Then she hired a lawyer.

Investigation. Debbie’s civil trial occurred first, and her lawyer in that action engaged us to investigate Weary’s allegations and to produce a report regarding their legitimacy. From the outset, our experience and instincts caused us to question whether Debbie had the opportunity and inclination to steal $500,000. She admitted to some modest skimming, but she vigorously denied taking anything close to the amounts with which she was charged.

Armed with a court order, we were given full access to Eggzistential’s financial records. However, what the court ordered and what we received from Weary were two different things. In responding to our request, the uncooperative owner gave us some information that was incomplete, some documents were redacted (and, of course, it was the redacted portions that we most needed), and some information he simply refused to provide.

With each receipt of financial information, our calculations of the amount of missing funds would change significantly, but in no event could we tie Eggzistential’s records to a loss that came close to $500,000. Ultimately we received most of the financial records, as well as the operating agreements of the 13 LLCs.

The villain. As always, our guiding principle in our investigation was something is wrong and someone is bad. In this case, it didn’t take us long to conclude that, apart from the nickel-and-dime transgressions of our client, the bad someone was the accuser, not the accused.

In the course of our investigation, we developed a keen appreciation for how bad (and, ultimately, how crooked) a businessman Weary was. As a practical matter, Eggzistential had no accounting systems or internal controls.

In a financial investigation, failure by an owner or manager to establish, maintain and monitor internal controls is an enormous red flag that signals an effort to facilitate concealment of information from partners, shareholders, the IRS, et al. In addition:

There were no physical inventory counts.
Debbie’s computer, which contained all of the company’s financial information and personnel records, was not password protected.
The company did not use a payroll service.
There was no segregation of duties, no cross-training, and no checks-and-balances.

It should be noted that such conditions do not mean that fraud occurred; rather, they are indicators of a high potential for fraud.

And here was the fraud: During Debbie’s five years on the job, Eggzistential issued checks to Weary that totaled $4.5 million more than the aggregate compensation that he was due from the 13 LLCs under the terms of their operating agreements. A more capable controller, backed by adequate internal controls, may have been alert to the excess disbursements. But, as Weary calculated from the beginning, a capable controller was the last thing he wanted, and that is why Debbie was his ideal candidate.

In interviewing the members of the LLCs, we learned that one member had started asking Weary some discomforting questions about the return the member was earning on his investment in the Sedona restaurant. That investor had turned up the pressure on Weary shortly before Weary fired Debbie and tried to make her the scapegoat of his embezzlement.

It should be noted here that, as she admitted, Debbie had indeed embezzled funds from the company. Depending on how we calculated some items, the amount she stole was in the range of $9,200 to $9,850. That’s a far cry from the $500,000 that she was accused of taking, and a very far cry from the $4.5 million that her accuser stole. The irony of this situation is that, if Debbie had not been wrongfully accused, she probably would never have been rightfully accused.

Aftermath. One of the peculiarities of this case was that a missing $4.5 million was sufficient to prompt only one of the more than 25 Eggzistential investors to confront Weary. Weary’s problems soon multiplied, however, as our report found its way into the hands of the other partners.

Based in large part on the findings contained in our report:

Weary dismissed his civil action against Debbie.
Weary was removed as managing member of the 13 LLCs.
Weary was sued by 19 of the 25 investors.
Debbie pled guilty to a relatively minor criminal charge.
Debbie paid a total of $6,000 in restitution to nine of the LLCs (more than $3,000 of the amounts she skimmed came from the Tempe restaurant that Weary owned solely).
Debbie filed a civil action against Weary for wrongful termination and defamation. ●

Printable Version