Forensic Accounting case: Michael Milken, the junk bond king

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Chapter 2: The Legal Environment of Forensic Accounting

Understanding—Legal Environment

Law

Governance by cumulative body of legal principles

Rule of law doctrine

Basic functions

Dispute resolution

Protection of property

Preservation of the state

Enforcement by sanctions

Definition and Functions of Law

In the United States, we advocate a rule of law doctrine, which proposes that governance via a cumulative body of legal principles is superior to the rule of any human leader (for example, a dictator, king, or president) and that all people stand equal in the eyes of the law—that is, no person is above the law. Black’s Law Dictionary defines law as the “legal order, system, or regime that orders human activities and relations through systematic application of the force of politically organized society, backed by force.” According to this definition, the law serves to influence, protect, regulate, and maintain our society. Moreover, it suggests that the law is fluid, forever evolving in response to social, economic, and political forces.

Law has three basic functions: (1) dispute resolution (criminal and civil actions), (2) protection of property (such as use and contract rights), and (3) preservation of the state. The law is enforced with the use of sanctions. In criminal cases, sanctions include imprisonment, home confinement, probation, day reporting, fines, or even capital punishment. In civil cases, sanctions generally involve compensation for loss or wrongs suffered (for example, economic damages).

Understanding—Legal Environment

Law and justice

Constitutional promise of justice

Forms of justice

Civil justice

Criminal justice

Personal justice

Social justice

Substantial justice

Law and Justice

U.S. citizens enjoy the constitutional promise of justice, which appears in the Preamble to the United States Constitution.

Justice is a profound concept generally defined by its context. For example, Black’s Law Dictionary defines multiple forms of justice:

• Civil justice. Justice concerned with the private affairs of citizens and their respective rights, including certain freedoms of speech and action and equal treatment,

protection, and opportunities regardless of race, sex, or religion.

• Criminal justice. A system directly involved in the apprehension, prosecution, defense, sentencing, incarceration, and supervision of those suspected of or charged

with criminal offenses.

• Personal justice. Justice between parties to a dispute, regardless of any larger principles that might be involved.

• Social justice. Justice that conforms to a moral principle (for example, all people are equal).

• Substantial justice. Justice fairly administered according to the rules of substantive law (such as a fair trial). In a legal setting, justice is

viewed as both a process and an outcome.

As a process, justice implies fair and equal treatment (rights and protections) within the judicial system. The judicial process is administered and managed by the court, acting as the trier of law. Two components of the judicial process that are important to forensic accountants include procedures and evidence, both of which are discussed in later sections of this chapter. Outcomes (or verdicts) are determined by the trier of fact, which is the jury in a jury trial or the judge in a bench trial. Verdicts are (or are expected to be) decided based on the evidence presented during the trial.

Figure 2-1—Classification of Law

Procedure: The Anatomy of a Trial

Different from what is shown on television shows or the movies

Three stages

Pleading

Discovery

Trial

What most of us know about our justice system comes primarily from television shows or the movies. Such portrayals, however entertaining, do not represent reality. Our experience suggests at least five key differences:

The law is not fast. There is no one- or two-hour litigation. Rather, civil trials commonly last two days, following a year (or more) of pleadings.

There is rarely (if ever) a “gotcha” moment (such as “You can’t handle the truth!”). The discovery process (discussed in a later section) serves to eliminate such surprises at trial. Moreover, witnesses are generally well prepared by counsel.

TV shows are about drama. Given the extended discovery process, real trials (aside from the verdict) rarely provide much drama— that is, unless you are the plaintiff or defendant.

Jury selection and opening statements are the most important parts of a trial—not cross examination and closing arguments, as often represented on TV. Selecting who is responsible for rendering the verdict is, of course, paramount. Opening statements provide the first chance for the parties to connect with jurors and tell their sides of the story.

The role of the jury is not passive. Because jurors serve as the trier of fact, they must actively evaluate the evidence and decide who and what to believe. To operationalize these concepts, let’s consider the anatomy (or structure) of a civil trial, which includes three basic stages: pleading stage, discovery stage, and trial stage. As previously noted, a civil action is a non-criminal complaint involving private property rights.

The three stages of trial are: pleading, discovery, and trial.

Procedure: Pleading Stage

Filing of complaint

Identifies the parties

Outlines facts and violations

Demand for relief

Defendant files answer

Failing to file may result in default judgment

Default judgment: Binding judgment against a party based on some failure to take action

A civil proceeding starts with the filing of a complaint (or lawsuit), which identifies the parties, outlines the alleged facts and one or more violations, and presents a demand for relief.

Once a defendant has been served with the complaint, the individual or entity has a limited amount of time (20 days) to respond by filing an answer. The answer addresses each paragraph of the complaint by admitting, denying, or claiming lack of sufficient knowledge to respond. The answer also asserts affirmative defenses. Failing to file a timely response can result in a default judgment, which is a binding judgment against a party based on some failure to take action (similar to a forfeiture in sports).

Procedure: Discovery Stage

Allows for gathering of information

Interrogatories, requests for production of documents

Subpoenas and depositions

In civil cases, process governed by Federal Rules of Civil Procedure (FRCP)

Discovery allows for the gathering of information from the opposing party as well as third-party witnesses. Information is typically gathered (discovered) via a request for production of documents, subpoenas, interrogatories, and depositions. In federal courts, the discovery process in a civil case is governed by the Federal Rules of Civil Procedure (FRCP).

What typically gets discovered?

Procedure: Trial Stage

Selection of jury

Selected through a process known as voir dire

Opening arguments by both parties

Plaintiff presents case

Defendant presents case

Closing arguments by both parties

Verdict

Trial Stage

Following completion of discovery, the proceeding advances to the trial stage. In the case of a jury trial, this stage begins with the selection of a jury. The jury is selected through a process known as voir dire, wherein the judge and the attorneys question prospective jurors about their backgrounds and beliefs. As previously emphasized, the selection of the jury is a critical part of the trial. Generally, there are twelve jurors in a criminal case and six in a civil case. These individuals collectively serve as the trier of fact, with the responsibility of rendering the verdict. Following jury selection, the attorneys for both parties make their opening arguments (statements). The first to present is the plaintiff, whose opening statement serves to outline its theory of the case and any supporting evidence.

The plaintiff is followed by the defendant. After opening arguments, the plaintiff presents its witnesses, which the defendant may cross-examine. The plaintiff continues the presentation of its case (known as the “case in chief”) until complete. A similar process is then followed by the defendant. After the defendant completes its presentation, the plaintiff is afforded an opportunity for rebuttal witnesses, which is then followed by the defendant’s opportunity for sub-rebuttal witnesses. Closing arguments are the last opportunity for the parties to summarize the testimony and highlight key points Following closing arguments and instructions by the judge, the case proceeds to jury deliberation. During this time, the jurors collectively evaluate the evidence to render a verdict.

Structure of a Criminal Case

Criminal complaint with investigator’s affidavit

First appearance—arraignment

Defendant informed of charges and rights

Defendant pleas guilty or not guilty

Discovery stage

The trial stage

Defendant found guilty

Sentencing stage

The basic structure of a criminal case is similar to that of a civil case, with the addition of a fourth stage—sentencing. Criminal cases are initiated with a criminal complaint accompanied by an investigator’s affidavit that summarizes the evidence against the defendant. During the first appearance (arraignment), the defendant is informed of the charges and advised of his or her rights. At this time, the defendant also enters a plea to the charge or charges—guilty or not guilty. This is followed by the discovery stage and the trial stage, as discussed previously. If the defendant is found not guilty, the case is over; if found guilty, the case then moves to the sentencing stage. The verdict in a criminal case (guilty or not guilty) differs from the verdict in a civil case, wherein the defendant is found either liable or not liable (for damages). Prior to sentencing by the court, the case is evaluated by the probation department, which prepares a pre-sentence report (PSR). The PSR summarizes the case (including the crime, the case facts, and the offender’s profile) and offers a recommendation for sentencing.

Table 2-1 : Comparison of Civil and Criminal Actions

A comparison of the key elements of civil and criminal actions is provided in Table 2-1.

Burden of Proof and Alternative Dispute Resolution

Burden of proof

Obligation of the plaintiff

Defendant presumed innocent

Alternative Dispute Resolution (ADR)

Mediation

Arbitration

ADR preferred over litigation

Less expensive and faster

Greater privacy

Burden and Standards of Proof

The burden of proof is the obligation of the plaintiff or prosecution to prove liability (in a civil case) or guilt (in a criminal case). The defendant is not required to prove his or her innocence—it is presumed.

Alternative Dispute Resolution

Litigation is not the only means for settling disputes between parties. Forensic accountants may also participate in alternative dispute resolution (ADR), the most common forms of which are mediation and arbitration. Mediation is a non-binding informal process wherein a mediator (mutually selected by the parties) evaluates the arguments of both sides and helps the parties reach common ground. If mediation fails, the parties may proceed with litigation. Arbitration, on the other hand, is a “mini trial” wherein each party presents its case to one or more arbitrators, who render a binding decision that generally cannot be appealed. Arbitration is often voluntary but can also be mandatory (required by a statute or a contract between the parties). ADR may be preferred over litigation because it is less expensive, is generally faster, and allows for greater privacy. Moreover, ADR is often used in disputes regarding complex or technical issues, because mediators or arbitrators with the necessary expertise can be selected.

Figure 2-2 : Ascending Levels (Standards) of Proof

The presumption of innocence must be overcome by a certain standard of proof, which describes the amount of evidence the plaintiff must present to prove its case. In a civil case, the requisite standard is a preponderance of the evidence—more likely than not (>50% probability). Some civil cases (such as civil fraud) must be proven by clear and convincing evidence. Clear and convincing is greater than a preponderance, but no specific percentage can be assigned. In a criminal case, the prosecution has a legal obligation to prove all elements of an alleged offense (such as fraud, tax evasion, or murder) beyond a reasonable doubt. Again, no percentage can be assigned. The applicable burden and standard of proof are explained to the jury by the judge and included in the jury instructions. Figure 2-2 illustrates the ascending levels (or standards) of proof. The forensic accountant must understand the requisite standard of proof for any litigation engagement and articulate his or her opinion accordingly. For example, in a civil case with a preponderance standard, the expert’s opinion must be stated within a reasonable degree of professional certainty, meaning more probable than not (>50%). This is critical, because expert testimony that does not meet the necessary threshold will be rejected by the court.

Evidence and the Expert

Evidence: Something that tends to prove or disprove the existence of an alleged fact

Relevant evidence

Tendency to make a fact more or less probable

Of consequence in determining the action

Probative value: Evidence be sufficiently useful to help prove something during the course of a trial

Evidence is something, including testimony, documents, and tangible objects, that tends to prove or disprove the existence of an alleged fact. In other words, evidence is presented to persuade the fact finder (judge or jury) of the probability of the truth of some fact asserted in the case.

According to FRE 401, relevant evidence must have the “tendency to make a fact more or less probable than it would be without the evidence,” and the fact must be “of consequence in determining the action.”

Expert Methodology

Daubert challenge

Conducted before the trial judge

Purpose is to measure the validity of expert’s opinion

Set forth several factors to be considered when evaluating expert testimony

Either party can initiate a challenge

Judge acts as a gatekeeper

The Daubert Trilogy

Applied to all expert testimony

A Daubert challenge is a special hearing conducted before the trial judge to determine the relevance and reliability of an expert’s opinion—that is, to rule on its admissibility. For an expert’s opinion to satisfy the reliability requirement, the expert must be qualified in the relevant field, and the expert’s opinion must be the product of sufficient relevant facts and data, reliable methodology, and the reasonable application of the methodology to the case facts.

Daubert established that a trial court judge has the duty to act as a “gatekeeper” under the FRE to ensure the scientific validity of the expert’s testimony. Moreover, it set forth several factors that should be considered when evaluating expert testimony:

• Whether the methodology employed has been tested

• Whether the theory has been peer-reviewed

• What the known or potential error rate of the method is

• How well accepted the methodology is within the professional community

• Whether the expert’s methodology existed before the subject litigation began

As provided in Daubert, the “court must focus on the methodology, not on the conclusions generated by the methodology.” In other words, a Daubert hearing is not to decide whether the expert is correct. Opposing evidence (including opposing expert opinions) and cross-examination are traditional and appropriate means of attacking dubious but admissible expert testimony.

The Daubert Trilogy

Four years after Daubert, in G.E. v. Joiner (1997), the Supreme Court limited appellate review of the trial court’s decision to admit or exclude expert testimony. Later, in Kumho Tire v. Carmichael (1999), the Supreme Court directed that the Daubert factors be applied to all expert testimony, including testimony of a non-scientific nature (such as forensic accounting). In this ruling, the Supreme Court also granted trial courts freedom to consider other factors. Together, these three cases, known as the “Daubert trilogy,” serve to interpret Rule 702.

Privileged Communication

Legal principle that protects communications within protected relationship

Attorney–Client Privilege

Privileged communication is a legal principle that protects communications taking place within a protected relationship. Commonly recognized protected relationships include attorney–client, husband–wife, doctor–patient, and clergyman–penitent. The privilege is a legal right of the source (for example, the client or patient rather than the lawyer or doctor). The underlying theory of privileged communication, articulated by the U.S. Supreme Court in Upjohn Co. v. United States (1981), is that in certain instances, society is best served by the suppression (protection from disclosure) of information. Suppression of information, however, is inconsistent with the general duty to disclose and is thus closely guarded by the courts. As previously discussed, in the discovery phase of civil litigation, each party is obligated to disclose to the opposing party all relevant and nonprivileged evidence it proposes to use at trial, whether favorable or unfavorable.

Privileged Communication

Attorney–Client privilege

Client’s right to refuse to disclose and to prevent any other person from disclosing confidential communications between the client and the attorney

Communication must

Relate to the rendering of legal services

Be made in confidence

Be made to a person the client believed was an attorney

Work product doctrine

Protection from discovery of documents, interviews, statements, and other items prepared by attorney

Attorney–Client Privilege

Attorney–client privilege, the oldest of the protected privileges in law, is defined as the “client’s right to refuse to disclose and to prevent any other person from disclosing confidential communications between the client and the attorney.” The requisite elements for establishing privilege include a communication that:

• Relates to the rendering of legal services,

• Is made in confidence, and

• Is made to a person the client reasonably believed was an attorney.

The attorney–client privilege is intended to encourage individuals involved in legal disputes to be candid with their attorneys, thus enabling the attorneys to give sound legal advice. Once the attorney–client privilege has been established, it may be extended to non-attorneys (such as subordinates and consulting experts) who assist attorneys in rendering legal advice or services.

The Work Product Doctrine (1947) provides protection from discovery of documents, interviews, statements, and other items prepared by an attorney in anticipation of trial. The work product doctrine allows lawyers to prepare for litigation without risk that their work will be revealed to court adversaries. Consistent with the rules governing attorney–client privilege, the work product doctrine can be extended to items prepared by non-attorneys who assist in rendering legal services.

Extending Attorney–Client Privilege and the Work Product Doctrine

Communications between attorneys and consulting experts are generally protected under the attorney–client privilege and/or work product doctrine. Until recently, no such protection was afforded to communications with a testifying expert. This changed in December 2010, when FRCP 26(b)(4) was amended to allow the extension of work product protection to most attorney–expert communications and to all draft expert reports. This was a highly practical change, which served to reduce the cost of litigation and make the process more efficient.

U. S. vs Bonnie Bain

…..it’s all about the evidence

U S vs Bonnie Bain

U.S. vs Bain- Summary of Events

Oct 2007 Regional cash manager notices unusual cash activity- involves bank analyst then Internal Audit then Corp Invest. Div

Bank Corp Investigation Division investigates , hypothesis Bain embezzled funds from 2000-2005

Bank presents investigative findings to federal authorities

U S Attorney files criminal complaint against Bain

Bain hires forensic accountant

Before trial Bain pleads guilty to false bank entry but disputes amount

Bain sentenced to 30 months/prison and pay restitution of $293,000 ( $250/mo)

Anything unusual?

1) Investigation 2+ years after embezzlement so must have had IC failures for this to go unnoticed for so long

2) Big issue for BBT: investigation only covered certain period since some records were missing. Investigation found problems with missing documents, failed audits, policy violations.

3) It will take Bain over 90 years to pay back entire amount

US vs Bain- summary of numbers

(in thousands)

Cash shortage at bank $1,973

BB&T internal investigation 640

US Attorney’s investigation 640

Forensic accountant for Bain 293

Bain admits to at least 200

Final Settlement $ 293

What happened? Bank out $2m but gets $293

You are the CSI experts- evaluate the report of the BBT corp investigators, US government, and Bain’s forensic accountant

BBT Internal Investigation by Corporate Investigations Division (CI)

Benefits

1) Full disclosure of facts will promote meaningful management decisions regarding how to handle this and what changes in controls need to be made going forward.

Limitations

Internal fact finding, not an independent investigation. Internal investigation limited to internal records therefore can be kept quiet from public. Lawsuit would be public and allow for discovery on both sides.

Procedures and findings – may be restricted intentionally as expectation is that report would some day be made public

CI hypothized that embezzlement extended from 2000- Oct 2005 however, scope limitation (May 2004-Oct 2007) due to missing records and other internal control issues, failed audits and policy violations . This is very damaging.

It appears they did not interview Bonnie.

Was their methodology appropriate for the circumstances? ( transaction analysis)

U S Government Investigation

Benefits

Used Secret Service and FBI to obtain Bain financial records and obtain info on lifestyle. Interviewed witnesses -her friends and relatives, but apparently not Bain

Limitations

Without additional records from bank had difficulty determining additional amounts above CI findings.

Forensic Accountant Investigation

Benefits

1) Used accepted approach- net worth method- no change in Bain net worth so looked at amt embezzled -interviewed witnesses and Bain, looked at Bain’s records, lifestyle,etc.- look at consumption and deduct legitimate income to come up with amount embezzled. Why this approach- because bank did not have complete records. What happened to the rest of the money?

From page 36 Issues

Forensic accountant questioned the following from the corp investigation:

Policy violations make it difficult to determine if the differences are due to theft or just lack of supervision or proper mgt.

No concrete proof of how or when the money was taken

Possible that BBT purchased the embezzlement when it acquired the bank

Forensic acct discovered failures in the BBT report:

No investigation of access by others to the vault

No investigation of access by others to identifying controls ( passwords, teller numbers)

No investigation or consideration of co-conspirators

Investigation provides an indication of internal control failures, but not proof of the amount of money taken by Bain.

Findings are speculative and not presented within a reasonable degree of professional certainty.

US vs Bonnie Bain

Why was the investigation conducted by BB&T limited in scope to its internal documents and interviews of its employees?

Why did the BB&T investigators make observations and present information favorable to Bain’s defense?

Why was Bain put on administrative leave?

Difference- preponderance of the evidence and beyond a reasonable doubt?

Develop a list of items the defense might seek to obtain through the discovery process.

Any risks to BBT going forward from this issue?

Enterasys Networks- SEC/DOJ Complaints and Actions 2002-13

Parent Cabletron – network hardware and software

Large cap NYSE - Sales $1.5b Market cap $20b

NH headquarters- one of largest employers in state

Strong cash position $2.5b but weak sales growth

Corp reorganization – split up Cabletron into 4 public companies

Enterasys spin off in August 2001

Enterasys management team was new

Enterasys- Key events during 2002

Contract that appeared to be altered identified

Company notified of SEC informal inquiry

Company initiates independent investigation- led by corporate lawyers ( Ropes & Gray) and Deloitte forensic group

Findings included numerous potential fraud items

Findings of investigation presented to SEC/DOJ

What does Company do during this period of the investigation?

Enterasys- SEC Criminal Charges Phase (2003-7)

SEC identifies potential complaint issues: backdating and altering documents, undisclosed side agreements, wire fraud, securities fraud , financial statement fraud

Files criminal complaints against certain management

SEC agrees to plea bargains for certain lower level management. Mgt received prison sentences/ fines

SEC goes to court with criminal charges for senior mgt and wins convictions for 4 or 5 members of mgt. Mgt receives jail sentences

Enterasys SEC Civil Phase (2007-13)

SEC files civil charges of securities fraud against management seeking unspecified fines and return of ill gotten gains

Settlement of some charges with significant fines while other charges were dropped

Handout SEC civil complaint and review charges. Similar to charges in criminal complaint. Several but not all of defendants were convicted of criminal charges and sentenced to prison terms. This civil action is to require them to pay fines for their misdeeds.

Lower level employees were also charged( criminal and civil) and some entered into plea agreements. Discuss Tony Hurley- pled guilty to one charge of wire fraud and participated as a witness in the criminal charges of more senior managers. He served jail time and paid a fine. See SEC release.

Auditors- see representation letter and discuss violations. What protection is the rep letter to auditors?

Enterasys - Final Resolution (2013)

Most members of management- terminated

SEC issues resolved- cease and desist order

Shareholder class action lawsuits- settled

Company sold to a private company so no longer public.

Enterasys stockholders at time of investigation lost almost all of their money ( over $2bill )

Elapsed time from discovery to resolution- 12 years

Financial Shenanigans

…….management misleading investors about financial performance

Accounting maneuvers may lead to fraud

Small changes that may become significant

Management testing to see what they can get away with

Test internal accounting management

Test external auditors

Test Board of Directors

Environmental issues of concern

Inadequate checks and balances among management

Powers of the CEO

Family members

Board of Directors lacking competence or independence

Auditors lacking objectivity and appearance of independence

Inadequate checks and balances- Tyco CEO and CFO too powerful. Too much control over acquisition accounting. Adelphia had family member issues

BOD- HP/Autonomy

Enron

Auditors lacking objectivity- Enron