Feature

posted 10 Jul 2003 in Volume 6 Issue 3

Risk and the rogue partner: Turning hindsight into foresight

In last month’s Managing Partner, articles highlighted the importance of implementing a risk-management strategy in the face of an open-market insurance regime. This month, Frank Maher, a partner in Legal Risk and a consultant at Weightman Vizards, takes us a step further by focusing on the fraudster.

Hot on everyone’s lips at a recent, post-Enron, law-firm risk-management seminar in New York was the question: how do you spot a rogue partner? This article, which is based on a presentation I delivered to the Hildebrandt/Glasser LegalWorks’s Law Firm Global Management & Marketing Forum 2003, attempts to answer that question.

Who are we trying to catch?

This is not a detailed psychological profile of the culprits but an insight gained from cases I have investigated for insurers of firms that have suffered major defaults – many of which would read like a John Grisham novel. It covers the development of risk-management systems for the legal and other professional firms I advise, but it also ties in with published material on high-profile corporate frauds such as Barings and Maxwell, advice from a business psychologist, and published material on psychology.

I emphasise, however, that there are people who exhibit some of the characteristics I shall describe but are not engaged in fraud. Culprits have been variously described as:

Charismatic;
Inspiring confidence;
A bully;
Not tolerating dissent;
Persuasive;
Credible;
Very good at telling people what they want to hear;
Picking victims carefully – people who needed a helping hand and would not ask too many questions;
Offering something that was too good to be true.

The majority have been outgoing personalities, in many cases “larger than life” and very popular with colleagues and clients. Many have been involved in sports clubs – a chairman of a league football club, an England rugby captain, a member of a British Olympic team, a principal sponsor of a premier-league side and a solicitor who acted for many international football stars. Partners are reluctant to challenge people like this even if they have their suspicions. Many have enjoyed a lifestyle that was beyond the reach of their partners but at their expense.

The culprit may also appear outwardly to be highly successful: “The recovery in profitability has been amazing... leaving Barings to conclude that it was not actually terribly difficult to make money in the securities business.” This was Nick Leeson quoting Peter Baring, chairman of Barings prior to its collapse. It highlights the need to think about auditing success, or apparent success.

One case I dealt with involved a partner who was recording excessively high chargeable hours, way beyond other partners, even though he was not in the office any longer. He was overcharging the firm’s best client by recording fictitious time for types of work that were not chargeable under the client’s protocol and much of it after the matters were in fact concluded. He put at risk a substantial proportion of the firm’s income. With a structured crisis-management programme, involving an audit backed up by a customised database, we were able to help quickly identify the extent of the problem and repair the damage to the client relationship.

Many culprits I have investigated had direct access to client funds through trusteeships and other personal appointments. This is not atypical: US federal authorities accused the founder of a public company and his two sons of using the company as a “personal piggy bank”.¹

A significant proportion, possibly even the majority, do not initially set out to break the law but start by covering up a small problem, which then grows. In his book, Rogue Trader, Nick Leeson describes how he started by covering up for an employee who had made a mistake and did not even realise until much later on that he was dishonest. Doubtless he became motivated by greed in the end and the book has to be read with caution, as it is in part self-serving. A solicitor I interviewed after he had made off with £3m of client money told me how he had encountered financial difficulty due to the high cost of borrowing capital in his practice, which he could ill afford. Initially he intended to repay the money he “borrowed” but his finances did not improve, due in part to a collapse in the property market. He found theft easy and then set about financing a lavish lifestyle, which he attributed publicly to “an inheritance”. In fact, his benefactors were neither dead nor aware of their generosity.

A minority have been introverted, studious and, in some cases, technically very able lawyers. These have tended to be the people who were covering up mistakes rather than engaging in fraud for personal profit, sometimes in the mistaken belief they were acting in the best interests of clients. In either case, they may be reluctant to take holidays for fear of being discovered.

Psychology of fraud

Some help may be derived from psychological literature on white-collar fraud. Since the Leeson affair, even psychologists now use the word “rogue” to describe the wide range of criminal, fraudulent and “integrity-deficient” behaviour they had been researching well before Leeson’s book gave it a name. Although psychologists have been trying to identify personality traits associated with (the lack of) integrity and develop tests for it for years, the general impression, according to one psychologist I have been working with, is that they do not work very well.

Apart from developing integrity tests, psychologists have tried to develop models to predict opportunistic “roguishness” on the basis of motivation, personality and personal circumstances. Generally, however, these help explain why people did it after the event, but they cannot tell us who is going to do it next beyond identifying those most at risk. Duffield and Grabosky in The Psychology of Fraud2 identify three factors: a supply of motivated offenders; the availability of suitable targets; and the absence of capable guardians.

They explain that motivation is a combination of an individual’s personality and the situation in which they find themselves. Financial strain features in nearly all cases – a desire to possess what one cannot afford, even when true financial deprivation may not exist. The threat of loss is not only confined to material wealth but also power, status and pride. Fraud may be seen as a short-term solution to this problem – this ties in with my experience of many solicitors who have thought it was just to tide them over a short-term situation. Often featuring highly is the old-time detective’s explanation of what turns a person to fraud, that is, the hypothesis of the three Bs: babes, booze and bets.

Rogues are often narcissistic – they have a well developed sense of their own self-importance, are hugely confident in their own abilities and believe that they have been placed in this world to fulfil a grand purpose. They are driven by a need to uphold and maintain a false self. They have inordinate abilities to charm, convince, seduce and persuade. It is more common in men. Out of the dozens of cases of fraud I have investigated I can only recall one case of a woman solicitor – a sad case because, like so many, she was outwardly highly competent, well regarded and ended up weaving a web of deception to cover up a mistake. Far from taking client money to perpetrate the cover up, she actually used large amounts of her own money to make up the shortfalls.

Some had their sense of self-importance satisfied by being brought in to what they were told was the world of international finance but was in fact money laundering, advance fee or prime-bank instrument fraud on a grand scale. In one case, this led to a judgement in the American courts of $180m against a partner in a small-town, three-partner firm.

According to Duffield and Grabosky, about one per cent of the population is said to be narcissistic but not every narcissistic person will commit fraud. Unfortunately, this description fits a lot of very successful people as well. However, what seems to make the difference between the criminal and the merely arrogant is that the narcissistic “drive” is unfulfilled in the rogue’s case. These people need to feel superior, have a high profile and lavish lifestyle but they have not quite made it – hence they turn to fraud.

Risk-management tools

I have identified the following from my own firm’s experience of managing risk and defending other firms against several thousand professional-indemnity claims over the past few decades:

Internal audit: This is of paramount importance and many of the great frauds are linked to lack of, or inadequate, internal audit. It has also featured in nearly every case of solicitor fraud I have investigated.

Features include living beyond one’s means, being a defendant in an uninsured civil action, unreliable communications and reports, and having no or inadequate separation of duties between the service provision and the accounting functions (in which I include regulatory matters as well as financial accounting). Also common is not taking more than two or three days holiday – does your partnership agreement make taking of holiday compulsory?

Eyes and ears: Despite all the advances in computers and psychology these are still among the most important weapons in your armoury. How often have you heard people say after someone was caught that they had their suspicions? We dealt with one case where the rogue senior partner was out every afternoon; his partners thought he was “marketing” but had no idea what he might actually have been doing. He was in fact engaged in various nefarious activities with companies he had set up, which were tied to the firm’s financial-services department and were used to defraud clients. His lifestyle was way beyond the means of an honest partner in that firm.

As many culprits have enjoyed a lifestyle beyond the reach of their partners – hence my comments about using eyes and ears. How many firms ask their partners for a statement of assets and liabilities? Yet what is the difference in principle between the ignominiously failed Enron Corporation, with its off-balance sheet liabilities, and a professional partnership where the borrowings of partners are also off the balance sheet?

An example of financial embarrassment being a motivation for theft was the recent case of a successful, top-asset partner in a major London firm who is reported to have made off with £6.5m of clients’ money. He was said to be liable to his previous firm’s bankers for guarantees and personal borrowings of £12m.

Taking action when concerns are raised: Some ten years ago, I dealt with a case involving losses of £3m, when it was worth rather more than it is now. The senior partner in a firm of solicitors was found to be giving inappropriate undertakings and his partners asked him to stop. Yet they let him carry on as before, merely relying on his assurances that there were no more. They were clearly on notice and did virtually nothing about it. They ended up with substantial uninsured liabilities. The defaulting partner was a charming individual who derived no gain from his frauds, which were a misguided attempt to keep a valued client going.

The problems emerged when the client, a member of a then well known pop group, died prematurely in a motorbike accident and stopped repaying interest. One of the innocent partners, who lost out heavily, commented to me how he had noticed before discovering the fraud that the accounts showed record profits but no money in the business, only overdrafts. On visiting the bank he found there were several substantial loans of which he had no knowledge.

Similar failures to act on information already known have featured in major corporate failures, notably Robert Maxwell. Maxwell, a former Labour Member of Parliament, was the subject of a Department of Trade and Industry (DTI) inquiry in the 1970s in respect of his company, Pergamon Press. The inspector’s report said: “This man should never be allowed to control a public company.”

He not only took the helm of a major public company but through a combination of his domineering personality and effective use of libel laws, managed to intimidate auditors and press alike. A US report3 noted: “Though nearly every extended look at Maxwell mentioned the DTI verdict, most US reporters dismissed it as ‘ancient history’ or argued, in the words of a Time magazine profile (March 25 1991), that since Maxwell continued to make money: ‘The rebuff hardly stopped him.’ A number of reporters fell for Maxwell’s (false) assertion that he had been vindicated on appeal. In fact, Maxwell’s appeals had been dismissed, and in New York, where Steinberg sued for fraud, Maxwell and his bankers agreed to pay $625m to settle the suit.”

The DTI’s report into the collapse of the Maxwell business empire commented that criticism of Maxwell in the report into Pergamon Press should have been enough to alert some of the City institutions to the dangers of working with him and criticised the merchant bankers for failing to consider prior DTI reports.

The Barings debacle was another example. Nick Leeson lost £800m from derivatives trading. The disaster revealed a remarkable lack of control at the bank where he had control over both the trading desk and the back office. The Singapore and Osaka exchanges also drew attention for their failure to notice the size of positions.

On the Osaka exchange, Barings Futures had 20,000 contracts as against the next largest position of 2,500 contracts. High levels of bonus paid to Leeson and his superiors were identified as a contributory factor. An internal audit report warning of “excessive concentration of power in Leeson’s hands” was ignored by management.

Psychometric questionnaires: These are groundbreaking questionnaires we have designed with the help of business psychologists. They act as a cost-effective diagnostic tool designed to give a quick and efficient return on investment in risk management. The idea is that you can find out what is actually happening in your firm. Quality systems are fine – as long as people know what they are and comply with them. Although they will not make the fraudster confess, they will identify weaknesses in your control systems.

We worked with one eminently respectable firm where we found that a third of the staff did not know their money-laundering procedures, even though a solicitor had recently gone to jail for just that. Training was easily implemented once the need was identified.

Management information: A well run firm already has data available for ensuring profitability or managing cases. This data is largely unused for risk-management purposes but can readily be combined to identify fee earners and/or files at risk.

Much valuable data already exists on the firm’s computer systems for accounts, case and document management, and personnel matters.

Ideally, a database would be set up on the current management-information system with the additional information from other sources inputted to produce exception reports – both regular and emergency – showing exposures in a readily digestible form, for example, red/green/amber. Areas that can be monitored include chargeable and non-chargeable hours, and workload, for example:

New instructions exceeding cases settled;
Unpaid bills;
Unbilled work in progress;
Gross fees by claims handler per year;
Average time to close file by work type;
Amount of time written off per case handler;
Proportion of time spent by partner and assistant in each case;
Cases that have not moved for two months;
Missed deadlines (for example, under client- reporting protocols);
Holidays taken.

Other information that can be monitored is the firm’s records of claims, notified circumstances and complaints.

Transfers between accounts have featured on nearly every fraud case I have investigated. They are frequently a sign of something amiss, even if not dishonest. The most overt examples were transfers between client account and the partner’s drawings account, but even transfers not motivated by dishonesty can be an indicator of risk. For example, money put on deposit because the lawyer is not in a position to complete a transaction may indicate that his inability to proceed is due to overwork or previous oversight of some critical step, which needed to be taken first such as a search – we are lawyers not bankers. Transfers between clients are a greater cause for concern.

Transactions involving trusts or companies in which partners or staff are trustees or directors or have some other interest also warrant careful examination. These have featured on most of the cases I have investigated. Inevitably the culprits will try and work around any system so some random file selection is also important.

Monitoring complex work

Perhaps the greatest challenge going forward is the question of how you monitor highly specialised work that nobody else understands. The temperature has been raised on this issue by the investigations into Enron. A US Congressional report has been critical of the outside advisers. Whether or not they were at fault, lessons will doubtless be learnt but the following suggestions should help a first attempt on monitoring complex work:

If you cannot explain to your partners (even those who are non-specialist in your area), you probably cannot explain it to a judge (who is probably also not a specialist in your area); in that event, whether you are right hardly matters;
If your partners are doing work that they cannot explain to you, how can you assess the risk of practising in partnership with them? You are intelligent people – you should be capable of understanding an explanation for even the most sophisticated transactions;
No partner can afford to abdicate responsibility for your internal audit systems, which includes following up what is revealed by it, a point illustrated by Barings and Maxwell;
Accountability is critical;
Whistleblowing – have you a policy in place? Who do your employees call? Have you lined up somebody to take the calls – perhaps an outside firm to preserve anonymity?

A note of caution – I have previously commented that some genuinely successful people exhibit many of the same characteristics as fraudsters. For example, a former partner in a major international accountancy practice told me of a partner under him whose work he could not understand. The partner was a tax expert who did roadshows around the firm’s offices explaining his latest tax-saving schemes. The supervising partner audited the files at 10pm and could not follow them. The partner could not explain them to him in terms he understood. The Revenue did a raid. The partner lost his job. I am told he has now been cleared. Nonetheless, there are lessons to be learnt. The experience must have caused much pain to the partner and the firm, and nobody can afford the risk of doing work that they are unable to explain to their partners – for many years I have asked my secretary if she understands the matters I am handling.

Although fraudsters will always use their ingenuity to find ways around systems, with a combination of management tools already in use for financial planning and easily affordable risk-management procedures – above all, eyes and ears – it should be possible to prevent the vast majority of frauds or to catch the culprits before too much damage is done.

References:

Race, T., “Executives are smitten, and undone, by their own images” in New York Times, 29/07/02 www.narcissisticabuse.com/nytimesarticle.html
Australian Institute of Criminology, www.aic.gov.au/publications/tandi/ti199.pdf. See also Red Flags of Fraud www.aic.gov.au/publications/tandi/ti200.pdf.
Guttenplan, D.D., “‘Miracle Max’ and the Marveling Media” in Columbia Journalism Review, May/June 1992 www.cjr.org/year/92/3/maxwell.asp
Business Week online www.businessweek.com/2001/01_02/b3714009.htm
New York Daily News www.nydailynews.com/news/story/18669p-17595c.html

Frank Maher is a partner in Legal Risk, a niche firm of risk-management solicitors advising solicitors, insurers and brokers. He is also a consultant at Weightman Vizards. He can be contacted at Legal Risk, The Corn Exchange, Drury Lane, Liverpool L2 7QL, Telephone 0845 330 6791, Fax 0845 330 6792, e-mail frank.maher@legalrisk.co.uk, website www.legalrisk.co.uk