October, 2006 THE BANKING LAW JOURNAL

October 2006

BY STANLEY I. FOODMAN

In the author’s view, banks should be taking extra care to insure they are not deceived into making loans to applicants who are intent on defrauding lending institutions to enrich themselves.

Whose interests does a bank represent? Funds loaned by a bank are the deposits of its customers. Every bank has a fiduciary obligation to protect its depositors’ interests. History shows that in certain cases lending officers and bankers do not possess the requisite understanding of financial information and the “professional skepticism” required by their fiduciary responsibility.

In today’s world, given the existence of easily manipulated accounting software, banks and their records which are better protected from manipulation are a resource of last resort for the protection of the public and the bank’s deposit customers.
A closer relationship between lenders and auditors with experience in fraud investigation and protection could go a long way toward reducing the incidence of banking fraud.

While in some cases bankers alert state and federal law enforcement agencies regarding suspicions of fraud, many lending fraud investigations are the result of federal criminal income tax investigations and consumer complaints. Regulated lenders are better suited for gate keeping than any of these other groups. They have information at their fingertips every single day that is easily investigated for authenticity. That they do not always fully investigate the information in their hands seems to be a reflection of naiveté and the inherent conflict between their fiduciary duty to protect customer deposits and their requirement to lend.

REVENUE STREAM

A bank’s stream of revenue is tied to two basic categories – interest charged on monies loaned and service charges. They also receive insurance commissions and brokerage fees.

The banking industry has traditionally relied on the objectivity, independence, and ethics of CPAs who prepare financial documents.

The American Institute of Certified Public Accountant’s Statement of Auditing Standards (SAS 99) Accountant’s Consideration of Fraud in the Preparation of Financial Statements, requires CPAs to exercise “professional skepticism” – that’s a polite way of saying, don’t trust your client. It requires CPAs to view the auditing and analysis of financial statements from an inquisitive, suspicious point of view and to maintain the avoidance of even the mere appearance of conflicts of interest while recognizing the potential of a company’s management for “cooking the books.”

LOAN SUITABILITY

Bankers have their own tests for determining the suitability of a loan. In large banks, virtually all loans are by committee. These banks may have different committees considering loans of different sizes and risk. In “smaller banks” that have only one or two locations, loan officers at different levels of management may have independent lending’ authority ranging from let’s say $10,000 to $100,000. The amount of lending authority is not important. The example is important. In both cases the organizations are engaging in an exercise of risk management. As organizations become larger and banking relationships more impersonal, lending decisions are increasingly formula driven. While it appears that bankers with individual lending authority would be more susceptible to risk management failure, banking institutions driven by formula may be even more susceptible to risk management failure.

Bankers routinely receive income tax returns, business financial statements, and personal financial statements from loan applicants as support for loan applications. In a significant number of loan applications all of these documents are prepared by CPAs. In other cases they are prepared by the applicant.

Where documents are prepared by the loan applicant, individual bankers and loan committees are assuming a greater degree of responsibility because there is no objective independent “review” of these documents by an uninterested third party.

Historically, there is a presumption that CPA prepared documents accurately reflect the financial position, income andcash flows of individuals and businesses. Since the emergence of the accounting scandals of Enron, Tyco, Adelphia, and others, that presumption of professional integrity has been eroded. That presumption ignored the conflict inherent within the triangle involving CPAs, clients and bankers.

Loan applicants pay CPAs for preparing financial information with an expectation of success. CPAs know that their clients expect success. Bankers assume that CPAs have objectively and independently vetted at one level or another the financial information contained in loan application documents. There is a built-in conflict of interest between the interests of bankers, CPA loan package preparers, and loan applicants. In addition, bankers do not always understand the qualitative differences within the different levels of financial information prepared by CPAs.

LIMITING FIDUCIARY RESPONSIBILITY

For as long as it has existed, the American Institute of CPAs has gone out of its way to limit the fiduciary responsibility of CPAs for the financial statement information they produce. The transmittal letters that accompany unaudited financial statements invariably attempt shifting responsibility for the numbers from the CPA preparers to the clients requesting them. The professional standards under which CPAs operate both require and dilute responsibility. These same standards are usually encoded by reference into the state statutes controlling the licensed practice of public accounting.

So what are bankers to do? Keeping in mind that borrowers may have limited resources, lending institutions would probably be better served by engaging independent CPAs with no relationship to borrowers for preparing submitted financial information. These costs could be passed on to borrowers either by requiring up front payment from the borrowers to the bank or by their incorporation into the final loan proceeds. This would go a long way toward eliminating the intrinsic conflicts of interest within the CPA/client/banking relationship when loan documents are prepared.

At other times banks may innocently participate in embezzlement activities affecting their own depositors.

A BANKING FRAUD CASE

A construction supply company was defrauded of at least $2 million by an organized group of people consisting of its own controller, a particular customer, a merchant processor’s employee, and a bank employee. The controller and the customer formed a company with a name similar to the name of the defrauded construction supply company and applied for a merchant account number through the same bank in which the defrauded construction supply company maintained its accounts. The merchant processor recommended by the bank to set up the new merchant account was the same merchant processor who handled the construction supply company’s legitimate merchant account. The employee of the merchant processor who opened the fraudulent merchant account also opened the account of the defrauded construction supply company. The banking officer who handled the day to day business for the defrauded construction supply company not only recommended the same merchant processor, bur also handled the day to day banking for the fraudulent company. Credit card payments that should have been deposited to the account of the defrauded construction supply company were processed though the fraudulent merchant account. More importantly, the bank officer handling the day to day banking operations for both companies was depositing checks made to the defrauded construction supply company into the account of the fraudulent company. All of these individuals including the employee of the merchant processing company received benefit from the fraud.

In this case, the bank was not aware of the activities of its employee who facilitated the embezzlement. However, the bank had the responsibility to prevent checks made to one company from being deposited into the account of another company. There is a risk management issue at the core of this case. The degree of oversight of the bank employee involved was a factor contributing to the length of time the fraud went undetected and the amount of money that was embezzled. As such the bank was responsible for reimbursing its customer the defrauded construction supply company, for the monies unrecoverable from the embezzlers that passed through the bank’s accounts.

PROFESSIONAL CODE OF CONDUCT

Just as it is important for cross training to occur in the banking environment, so it is important for bankers to more fully understand the professional Code of Conduct governing the behavior of CPAs practicing within the United States. The Code of Professional Conduct for CPAs is divided into seven general areas.

  • Principles of professional conduct
  • Rules: applicability & definitions
  • Independence, integrity and objectivity
  • General standards – accounting principles. Responsibilities to clients
  • Responsibilities to colleagues
  • Other responsibilities and practices

The Principles of Professional Conduct embody six articles from which flow all other areas of the code of professional conduct.

Without a clear understanding of the six articles, and other standards that flow from them, it is difficult, if not impossible, for bankers to assess the quality of reporting services provided by CPAs to financial institutions and their customers. More importantly, understanding these six articles is fundamental to a bank protecting depositors’ interests.

Article I imposes a responsibility by CPAs to all those who use their professional services.

Article II requires CPAs to behave in a way that serves the public interest, honors the public trust and demonstrates a commitment to professionalism.

Article III makes it dear that integrity is an element of character that is essential to professional recognition, is the quality from which the public trust arises and is the benchmark against which a CPA must ultimately test all of his or her decisions. Most candidly, integrity is measured in terms of what is right and just; requiring a CPA to observe both the form and the spirit of technical and ethical standards.

Article IV requires CPAs to maintain their objectivity free of conflicts of interest while discharging professional responsibilities. They should be independent in both fact and appearance when providing auditing and other attestation services. Maintaining objectivity and independence requires a continuing assessment of client relationships and public responsibility. Even CPAs who are not in public practice have the responsibility of maintaining objectivity while rendering professional services.

Article V is due care. It dearly obliges a quest for excellence, which is the essence of due care. Due care requires discharging professional responsibilities with competence and diligence; imposing the obligations to perform to the fullest extent of one’s ability and with concern for the best interest of those for whom services are performed consistent with responsibility to the public.

Competence arises from a synthesis of education and experience. Beginning with mastering the common body of knowledge required for the CPA designation, its maintenance requires a commitment to continuing education throughout a CPA’s professional life.

The principle of competence dictates that consultation or referral may be required when the needs of a professional engagement exceeds one’s personal competence. It requires the planning and adequate supervision of any professional activity for which any CPA is responsible.

The final article is Article VI. It states that a CPA should observe the principles of the Code of Professional Conduct in serving the scope and nature of services provided. In order to accomplish this, CPAs should have in place internal quality control procedures to competently deliver and adequately supervise services.

CPA should judge whether the scope and nature of non-audit services provided to an audit client creates a conflict of interest in the performance of the audit function of that client and assess whether the activity is consistent with their role as professionals.

BANKING FRAUD IS BIG BUSINESS

Dependence upon the prosecution of fraudulent loan applications or other illegal banking activities is after-the-fact deterrence. When a CPA is involved in these matters from the beginning, the Code of Professional Conduct obligates exposure of potential or actual fraudulent activity.

One would like to believe that publicized problems would have alerted the banking industry of the need for a different quality of loan application analysis. But it apparently hasn’t. According to the July 7, 2006 edition of BankersOnline.com, U.S. News and World Report conducted what was considered the most in depth study in the area of check fraud and new account fraud that has been done to date. The study reported that financial institutions in the United States lose about $12 billion a year to check fraud alone.

An article in the publication Mortgage Originator quotes the FBI as saying the fastest growing white collar crime in the U.S. is mortgage fraud. According to the FBI, mortgage fraud is currently in excess of $1 billion. Because the FBI figures are the result of the analysis of “suspicious activity reports” there is no official reporting that includes unreported incidents. The only known fact is that the true cost of mortgage fraud far exceeds figures reported by the FBI. According to Dollar, up to ten percent of loan applications taken annually contain some element of fraud. If remotely accurate it would point to approximately $30 billion of exposure to lenders – an industry threatening proportion.

Plainly stated, for the past five years, banks have made too many loans to people who should not have received them based on traditional qualifications. This is where mortgage brokers working for commissions can unwittingly be caught in the middle of a fraud. Mortgage brokers are trapped between borrowers and real estate agents who want to dose transactions. Because banks make money by lending, there is a natural potential for becoming unwitting participants in a conflict of interest between their requirements to protect depositors’ monies and meeting the lending needs of the bank.

While borrowers can be co-conspirators in mortgage fraud, they can also be victims. In cases when they do not meet traditional lending qualifications they typically cannot service the debt. At first blush, the recent explosion of adjustable rate mortgages allowing people to purchase homes far in excess of what their real income qualifies them to acquire might be viewed by hungry attorneys as a form of predatory lending. Given that $1 trillion worth of adjustable rate mortgage loans actually are set to become fully indexed in 2007 it should not surprise anybody in the banking industry when their foreclosure rate explodes.

DECEPTIVE MORTGAGE BROKERS

Another problem for the banking industry is the quality of the reporting it requires when making loans. There is a disconnect between the amount and quality of information banks need to obtain and the cost of obtaining that information. It is one thing to request a copy of a taxpayer’s official IRS transcript of his or her income and another thing to require, at a minimum, full blown personal business and financial statements.

There is virtually no cost to obtaining an IRS transcript. It requires nothing more than the taxpayer making a phone call and requesting it. On the other hand, the cost of financial statements whether prepared on typical bank credit grantor forms or on the stationery of a CPA can create sticker shock.

Banks have different levels of required documentation for different sized loans. A simple compiled or reviewed financial statement that is prepared for a business with the required accompanying notes and transmittal letter can have a minimum preparation cost of between $1,000 and $5,000. Preparing audited financial statements in today’s climate created by the failure of Enron and other financial scandals such as Tyco and Adelphia requires a greater degree of due professional care by CPA preparers and consequently higher preparation costs for borrowers that range from $10,000 to $25,000 or more.

CASE OF LOAN FRAUD

In a recent successful federal prosecution, a number of defendants were charged with fraudulently transferring real estate to their own names through the use of falsified quit claim deeds. As soon as the properties were fraudulently transferred, the defendants applied for mortgage loans on the properties, stripping the land and structures of their equities and convening the proceeds of the loans to personal use. The defendants were licensed real estate and mortgage brokers – one of whom had previously engaged in similar activity without consequence other than losing her mortgage broker’s license. In several cases fraudulently received properties were resold to unknowing third parties, who also became victims.

The loans made by the banks were based completely on the perceived market values of the properties involved without regard to the defendants’ ability to repay. The apparent belief of the lending banks was that the properties would continue to increase in value providing the banks with an equity cushion which would allow the defendants to eventually sell the properties and repay the loans or allow the banks to foreclose and sell the properties without a deficiency.

The banks never evidenced any suspicion about the volume of the quit claim deed transfers and the loans they represented. They naively assumed the honesty of the defendants, one of whose mortgage brokerage licenses had been revoked.

The banks never requested any background information from the Florida Board of Realtors or from the Florida Office of Financial Regulation which oversees mortgage broker’s licenses.

By the time law enforcement authorities completed their investigation, arrested, tried, and convicted the defendants, the loss to the banking industry was about $4 million.

This is a case of the banks failing in their fiduciary responsibility to their depositors. Nobody at the involved banks ever thought about independently investigating the background or current activities of the defendants and their companies. On the contrary, the banks simply did nothing.

Even if some restitution is received by the banks, it will not be enough to cover their losses and will consequently lead to increased banking costs to customers and depositors.

Not only were the banks damaged, the actual legitimate property owners were also damaged as a result of the bankers’ lack of due diligence. At the very least this put the banks funder at risk for damage claims by the defrauded property owners since the banks played a pan, albeit unwittingly, in the fraud. Even if resulting litigation by the actual property owners were found to be without merit, the banks would still incur legal costs when arriving at that determination.

With an estimated $30 billion in banking fraud losses occurring in the U.S. while the cost of preventive measures is relatively low, it doesn’t take a rocket scientist to realize that something is being overlooked. Banks, while notorious for attempting to spend as little as possible, have helped plant the seeds of the estimated $30 billion of losses. Sometimes it pays to think outside of the box. Even though the criminals committing these acts over and over never seem to understand the ease of tracing these frauds, their stupidity doesn’t excuse the negligence of the banks.

How can banks achieve some acceptable level of assurance that preparers of loan information are meeting professional standards of ethics and honesty? One method used regularly by asset based lenders is contracting with CPAs whose mandate on behalf of the lender is reviewing all of the documentation supporting a loan request including, but not limited to, the working paper files of CPA financial statement preparers. This step would provide an additional safeguard for depositor funds, bank loan officers, bank loan committees, and borrowers who may inadvertently employ overzealous loan document preparers. It would also provide another layer of protection from those determined to engage in loan fraud.

For the protection of depositors’ interests, banks should be taking extra care to insure they are not deceived into making loans to applicants who are intent on defrauding lending institutions to enrich themselves.


Miami-based forensic accountant Stanley I. Foodman is a former auxiliary special agent for the Florida Department of Law Enforcement and has worked as a consultant to the Miami office of the U.S. Attorney in the area of civil RICO money laundering recoveries. He has an extensive background in accounting with a major accounting firm and Florida Power & Light. Mr. Foodman is a member of the Society of Certified Fraud Examiners and a former member of the Supreme Court of Florida Circuit Committees on the Unlicensed Practice of Law.