Practice Management: Fraud Watch - Seven Internal Controls for Law Firms

5/17/2016 - By Zachary Farrington

By their very nature, law firms are vulnerable to embezzlement and fraud. Attorneys are, first and foremost, trained in the practice of law. Focused on revenue-generating activity, they may consider it easier to delegate day-to-day business and financial duties to other employees instead of managing these duties themselves. 

Without strict segregation of duties and strong internal controls, unscrupulous employees can take advantage of a lawyer’s lack of attention and perpetrate fraud. Compounding the matter, theft at a law firm is not limited by title and stature. In particular, senior and managing partners as well as senior staff members often find themselves immune from oversight, leaving the door open for malfeasance.

Essential Internal Controls

The good news is that appropriate oversight and supervision can help detect and prevent embezzlement of firm and/or client funds. Consider these seven essential internal controls for preventing fraud at your firm:

  1. Carefully screen potential employees. Law firms that do not perform complete background checks open themselves to the risk of internal fraud. In addition, they may open themselves to liability for any damage to third parties that is attributable to those unscreened employees. Consult with an experienced employment law attorney and then develop screening procedures that look for the warning signs of past embezzlement or fraud. 

  2. Establish reporting mechanisms. Provide formal anti-fraud training to all employees of the firm. At the same time, create a confidential means for them to report suspected fraud. It could be a trusted partner with whom employees can share reports of suspicious activity or even an anonymous reporting process such as a “fraud hotline.” Provide this reporting opportunity to your clients and suppliers, as well. 

  3. Segregate duties. This is the Golden Rule of fraud prevention — spreading the firm’s business processes, bookkeeping and reconciliation duties among at least two different employees. So, an account manager should not have custody of client trust funds and also be responsible for maintaining the related records. In addition to segregating duties, formal operating procedures should include appropriate supervision and review. 

  4. Review and reconcile promptly. With the proliferation of online banking, there’s no need to wait on monthly paper statements to reconcile your bank accounts. Periodically check the firm’s transactions online so you can quickly address any discrepancies. Likewise, consider establishing individual trust accounts for clients and allowing them to review their account activity online. 

  5. Watch your trust accounts. Misuse of client funds is one of the most common reasons for disbarment. Obviously, there is no legitimate way to borrow from a client trust account, but even “innocent” mishandling of such accounts can cause problems.  Sometimes lawyers simply fail to understand that they can’t pay bills such as their office overhead expenses directly out of a client trust account, even when the checks are being written out of funds that have already been earned. Consult The ABA Model Rules for Client Trust Account Records, which replaced the Model Financial Recordkeeping Rule on August 9, 2010, for further guidance.

  6. Monitor regularly. Establish predefined financial parameters for your firm and regularly monitor that you are within them. For example, create a simple report that monitors adjustments and write-offs by attorney so that adjustment percentages can be tracked, and any inconsistencies quickly become obvious. Also consider regular “surprise” inspections throughout the year — such as having your CPA receive and review the firm’s monthly bank statement before it is delivered, or sending the payroll control master directly to your CPA for review.

  7. Insure against fraud losses. Make sure the firm has the appropriate level of fraud loss insurance coverage. Employee dishonesty coverage (also called fidelity insurance or bonding) is a good place to begin. Ask your insurance provider whether you can purchase a “blanket bond” that will cover everyone in the office — this will keep you from having to update the names on the policy every time someone new comes on board.


Going a Step Further

Some firms take fraud prevention a step further by having a trusted accounting or consulting firm brought in for an external review of their internal controls. In addition, an operational audit may be commissioned to help ensure that the firm is enjoying efficient operations while minimizing the risk of fraud loss. 

Fraud, For Real

Fraud and theft in a law firm? You bet — and at all levels. Consider these recent real-world examples:

 

  • In Pennsylvania, a former paralegal was arrested for allegedly stealing more than $100,000 from a law firm and using the money to pay restitution in a case where she was found guilty of stealing $285,000 from another law firm. Source: USLaw.com
  • For almost six years, an associate at a large Atlanta law firm regularly performed work for clients and submitted fraudulent invoices to the firm’s accounting department. He deposited some $500,000 of the funds into his personal checking account. Source: Atlanta Journal Constitution
  • A long-time partner at an esteemed Minneapolis law firm was charged with stealing as much as $2 million from several clients and using the money for extensive renovations on a historic mansion. Source: St. Paul Star Tribune

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