Utah Embezzlement

A Homeowners Association’s (HOA) board of directors acts like a mini government.  Like a government, it has the power to collect taxes, through assessments, and spend those funds, which it does through a wide variety of vendors, including property managers, contractors and attorneys. Like a government, this authority sometimes leads to corruption. Although it is impossible to guard against every imaginable type of fraud, directors should have a good understanding of their association’s vulnerability to “occupation fraud” and take steps to guard against it.

Most HOA fraud comes in the form of embezzlement by directors.  Embezzlement simply involves the fraudulent appropriation of property or money entrusted to him by another.  In some instances, this may be very easy to identify and prove.  If, for example, a director uses a credit card to finance a personal vacation, there may well be a clear paper trail to prove that finances were used for personal reasons.  In other circumstances, detecting fraud can be much more difficult.

In a recent California case, a property manager of a 268-unit homeowners association stole $1.5 million before he was caught.  His scheme was elaborate, beginning when he ordered a second set of consecutively numbered blank checks identical to those used by the association. He then periodically made out some of the duplicate checks with himself as payee, while at the same time presenting for signature to the association president and treasurer legitimate checks, which were made out to bogus vendors or to legitimate vendors whose invoices had already been paid. When he received the association’s monthly bank statements, he was able to substitute the seemingly real checks for the checks made out to and cashed by him, thus covering his tracks. He used photocopies with false payee and bank endorsements, and rubber stamps ordered at a local stationery store.  He was able to elude detection even while the board requested copies of cancelled checks and a full-blown audit.

In another recent case, a more brazen property manager set up his own private security company. He then hired that company to provide services for the gated community. With security expenses of more than $306,000 in just seven months, homeowners were paying more than $10,000 a week to manage a one guard shack that wasn’t even staffed with real, licensed security guards. Although the fraud was discovered in a relatively short period of time, the money was gone and the owners were faced a special assessment to cover the loss.

Even the best systems of internal control cannot provide absolute safeguards against fraud or irregular activity, but to help reduce the risk of fraud there needs to be basic countermeasures in effect. This starts with a basic understanding of the Fraud Triagle.

The concept of a “Fraud Triangle” originated in the early 1970s (_____cite) and is used as a model for explaining the factors that cause someone to commit occupational fraud.  It consists of three components: 1) the incentive to commit fraud, 2) the opportunity to carry out the fraudulent act, and 3) the ability to rational fraud. These three factors are present in nearly every case of occupational fraud. Identifying situations where these elements are present is an important safeguard against fraud.

The first element of the fraud triangle – incentive – typically involves a financial pressure which cannot be relieved through ordinary and legitimate means. This pressure may be rooted in personal matters, such as gambling, divorce, or a money sucking addiction. A bad investment, lost job or medical problem may be the source of the financial stress. Regardless of the cause, someone may be considered “at risk” in this category if it is known that they face extraordinary financial pressure.

The second element – opportunity – is created in many separate ways. Weak internal controls and the failure to separate of duties create many opportunities for abuse. If management is indifferent about their responsibilities, they may not enforce their own internal controls. There is also the ever present risk of collusion, which can undermine internal controls.

The third element – rationalization – takes place when individuals think they are justified because they are underpaid, or it’s for their family, or they need it now but they’ll pay it back before anyone notices. Human beings are capable of a wide range of “justifications” for bad behavior.

The Fraud Triangle’s red flags are warning signs that indicate conditions ripe for fraud. They are not evidence that fraud is occurring, but if multiple indicators are present, the situation should be closely reviewed. Most people who commit occupational fraud are not career criminals, but are trusted staff with no criminal history. But if these factors are present, there is a breeding ground for fraud.

Even the best systems of internal control cannot provide absolute safeguards against fraud or irregular activity, but to help reduce the risk of fraud there needs to be basic countermeasures in effect. This includes careful accounting of expenditures and a checks and balances system to detect fraud.

Here are things you can do to reduce the risk of fraud and protect your association.

1. Have someone who does not have check signing authority review and initial the bank statement monthly before giving it to the treasurer. This person is looking for red flags including: checks showing up in non-sequential order, checks made out to cash, cash withdrawals, checks written out to non-approved vendors, checks written for non-approved expenses, checks written out to individuals.

2. Never sign a blank check or a check made out to “cash.”

3. Every HOA should implement a policy that requires two signatures on checks that are written for over a specified sum of money.

4. Ensure all board members and employees are thoroughly vetted and that the election or hiring process is “transparent” — that is, not secretive.

5. Keep a wary eye out for a board member or employee who seems to be living beyond their means.

6. Question any delays in circulating financial statements and other organizational documents.

7. Segregate responsibilities — that is, have different people responsible for signing and banking checks and a third person for reconciling the two. Require two signatures on all checks.

8. Require at least two original copies of bank statements (that is, direct from the bank, not photocopies provided by someone inside the organization).

9. Scrutinize statements, looking for individuals or companies with similar names (one may be a legitimate recipient, the other not).

10. Set up a “positive pay” arrangement with the homeowners’ association bank. Under this system, you send your bank a list of checks that have been authorized and they then compare it with the actual checks they have.

11. Have your accounts independently and professionally audited, preferably every month but at least once a year.

12. Finally, just in case the worst happens, ensure you have full compensation protection through directors and officers insurance (known as “D&O”).

None of these measures individually will likely be strong enough to spot or stop homeowners’ association or other nonprofit fraud, but when combined you’ll find they create a formidable defense.