Forensic Briefs

Directors and Officers (D&O) and Errors and Omissions (E&O) Insurance: Claims in a New Economy

The deteriorating economy has a direct impact on corporations and the increase of D&O and E&O claims. With corporate losses mounting, corporate scandals breaking every day, and bankruptcies on the rise, creditors and shareholders are looking to recover their losses. Insurance policies are increasingly seen as a potential source to fund financial recoveries. In recent news, the collapse of Bernard L. Madoff Investment Securities is spawning numerous law suits involving insurance companies. The losses from these suits have been estimated to range between $750 million to $3.5 billion.

The insurance industry is seeing a rise in both the number of claims and lawsuits filed. In the first quarter of 2009, securities class action lawsuits increased by approximately 20 percent. Further, increasing claim activity, combined with unique and challenging coverage issues are complicating the legal processes. This high-risk environment is resulting in tougher policy standards and increased claim scrutiny from carriers, including aggressive coverage positions and demands for more detailed claim support.

Whether submitting or evaluating a claim, supporting documentation and information is going to play an integral part in the process from a financial perspective. The focus will include analyzing the financial information for accuracy and relevance and evaluating the potential for fraud and/or misrepresentation. The complexity of the financial issues in the submitted claim requires skilled professionals to analyze, corroborate, reconstruct and evaluate the underlying financial transactions and records. As part of this process, it is necessary to have a proven capacity to analyze and assess an organization’s financial reporting processes/systems, identify areas of weakness, and investigate where the potential for fraud may exist. Often these skill sets may tip the scales between a successful and unsuccessful claims process.

The forensic accounting professionals of Parente Randolph have extensive experience in dealing with complex investigations and analysis arising from insurance claims. For more information on how we can assist, please contact:

Colleen Vallen (Philadelphia office)
215.972.2383 | cvallen@parentenet.com

David Duffus (Pittsburgh office)
412.697.6404 | dduffus@parentenet.com

Robert Gray (Dallas office)
214.658.6570 | rgray@parentenet.com

Auto Dealership Terminations

As the Big 3 automakers continue to develop and implement plans to restructure their operations, one common element that carries across the various plans, is a significant reductions in the number of dealers. Consider the following:

In a video conference with its dealers on April 28, 2009 General Motors (“GM”) announced that it will force up to 1,200 of what it deems to be underperforming locations to close their doors.  This is part of a broader plan to reduce its current dealer network by 2,600 dealerships, or 42 percent, by 2010.

In 2008, Chrysler shed 287 dealers, or approximately eight percent of its dealer network.  The automaker has also initiated efforts to pressure its dealers to consolidate brands under one roof, efforts which have been subsequently delayed as Chrysler has been forced to focus on its survival.  The impact of its bankruptcy plan and impending sale of assets will likely exacerbate the pressure on dealerships.

In 2008 Ford reduced its dealer network by 269, or approximately 7 percent.

In many cases, these reductions are a function of the current economic environment, which is causing many dealers to voluntarily close their doors. However, particularly in the case of GM, the reductions are or will be a direct result of overt actions to trim the dealer network, through the sale or elimination of brands (i.e., Hummer, Saturn, Pontiac and Saab), or through closure or consolidation of smaller and less profitable outlets.

Automobile dealers hold the right to sell vehicles under franchise agreements with the manufacturers. Typically, these agreements do not contain provisions that enable the manufacturer to break the agreement at will. As such, dealers who are forced to close their doors will have contractual rights to compensation if they are forced by a manufacturer to close or consolidate with another dealer. The compensation will likely be significant. For example, when GM made the decision to phase out its Oldsmobile brand in 2000, it spent approximately $1 billion to close 2,800 Oldsmobile dealerships.

The Forensic Accounting and Litigation Services professionals at Parente Randolph have a great deal of experience in performing business valuations and lost profit analyses for automobile and other vehicle dealerships. For further information on how we can assist you, please contact David Duffus, Robert Gray, or Glenn Newman.

Investment Fraud

Twenty-six alleged investment frauds, exposing to loss approximately $60 billion since the Madoff scandal erupted in mid-December 2008.¹ The Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) are the two federal agencies bringing forth lawsuits on behalf of the investor community. The charges coming from these agencies against the alleged perpetrators include claims they were operating Ponzi schemes and misappropriating investor funds. The Ponzi scheme continues to work on the "rob-Peter-to-pay-Paul" principle, as money from new investors is used to pay off earlier investors until the whole scheme collapses.²

The perfect catalyst for collapsing a Ponzi scheme is a downturn in the economy. Investors seek massive redemptions of their investments, and Ponzi scheme operators are unable to convert investments into cash. Ponzi operators can’t pay redemptions, because at an earlier point in time, they siphoned money meant for investing away from the investment pool leaving holes that could only be filled by new investors. Misappropriation boils down to a theft, the dishonest use of an investor’s money for personal use.

Investigating Ponzi schemes and misappropriations is a meticulous task requiring significant time and resources. Investigative measures can include documenting an understanding of the perpetrator’s operations, detailed data analysis, email and other communication discovery, and tracing volumes of cash and investment transactions. In addition, analytical assessments on investment returns and investment strategy are often needed. This analysis is sometimes relevant for the defense side of the matter as well. For example, if you’re an investor that got out earlier than others, then you are at risk for a “clawback” of your redemptions.³ A thorough analysis of the transactions and chain-of-events may avoid your redemptions from being recovered by the trustee or receiver.

The forensic accounting professionals of Parente Randolph have extensive experience in dealing with complex investigations such as Ponzi’s/investment fraud.  For more information on how we can assist you, please don’t hesitate to contact one of our forensic accountants – Robert Gray, James O’Brien and David Duffus.

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1) The count and dollar volume at the time this brief was finalized for release.

2) http://www.sec.gov/answers/Ponzi.htm

3) A “clawback” is an attempt by the Receiver or Trustee to recover early investor withdrawals for a future equitable distribution to all unpaid investors in the investment fund because of special circumstances – in this case a massively orchestrated fraud.

Riding Out the Subprime Storms

In a global financial crisis people face difficult tasks and many challenges. The outlook for 2009 is no exception, but the real questions are: how big will the shock waves be, how many of them should you expect, and how soon should you be expecting them? Questions of this type are difficult to answer and, depending on whom you speak to, you will get different responses. The hot topic of the subprime crisis and what it could mean financially is being forecasted as a significant earthquake to a catastrophic tsunami. This Forensic Brief is the first in a series of planned issues that will continue to address the uncertainties and challenges faced by our clients, friends and others.

A recent litigation case involving subprime assets that has continued to escalate is M&T Bank Corporation (“M&T”).¹ In this matter, M&T is suing Deutsche Bank Trust Company Americas (“Deutsche Bank”), et. al., and alleging that HBK Investments (“HBK”), et. al. wrongfully sold M&T a “series of notes known generically as collateralized debt obligations (CDO’s).”² The notes boasted a AAA rating by Standard & Poor’s (“S&P”).³ M&T claims that they were told by Deutsche Bank and HBK that the notes were “safe, secure, and nearly risk-free.” However, within nine months of the purchase, the value of the notes went from $82 million to $1.87 million, a loss of approximately 98 percent. M&T is currently seeking the $80 million of losses it suffered because of the “wrongful conduct by Deutsche Bank and HBK” as well as $100 million in damages.

A similar case involves American Eagle Outfitters Inc. in its lawsuit against Citigroup Global Markets Inc.⁴ The clothing retailer alleges it was fraudulently induced to buy $258 million worth of auction rate securities that it now can sell only at a significant loss, if at all. The suit says that Citigroup represented the securities as safe and liquid and therefore compatible with the retailer's conservative investment policies. Instead, American Eagle claims, Citigroup knew there was insufficient demand for the securities for them to be liquid. The suit claims that in February 2008 Citigroup stopped providing liquidity. Auction rate securities were once considered safe, but the market for these securities collapsed at that time amid the turmoil in the credit markets. This left thousands of investors nationwide holding damaged securities that couldn’t be readily sold for cash, according to securities regulators.

Recent financial news continues to uncover more stories about our troubled economy and has kept the subprime issues in the spotlight. As we move forward, questions and legal issues will continue to arise on such topics as:

• The allocation, use, and accountability of Trouble Asset Relief Program (“TARP”)⁵ funds;
• Will there be a combination of U.S. Generally Accepted Accounting Principles
  (“GAAP”)⁶ and International Financial Reporting Standards (“IFRS”) and how will it be effected by political pressures dealing with items like  “mark to market” and fair value accounting;
• Providers / professionals who were responsible for the sale of CDOs, collateralized mortgage obligations (“CMOs”)⁷, credit default swaps,⁸ and structured investment vehicles,⁹ among others;
• Scope and responsibilities of due diligence providers, and underwriting of the various investment vehicles;
• Professional malpractice issues related to audit, legal and other firms; and
• Director and officer duties and corporate governance.

If you are uncertain as to how the rising storms will affect your business, you are not alone. The professionals of Parente Randolph’s Financial Services Team have extensive experience in dealing with the above and other issues. For more information on how we can assist you, please don’t hesitate to contact our financial services experts – Robert Gray, James O’Brien and David Duffus.

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¹ M&T Bank Corporation v Deutsche Bank Trust Company Americas, et al, in the State of New York Supreme Court: County of Erie.
² http://www.investopedia.com/terms/c/cdo.asp
³http://www2.standardandpoors.com/
⁴ American Eagle Outfitters, Inc., et al, v CitiGroup Global Markets, Inc., Complaint, United States District Court for the Western District of Pennsylvania.
⁵ http://www.investopedia.com/
⁶http://www.investopedia.com/
⁷ http://www.investopedia.com/
⁸ http://www.investopedia.com/
⁹ http://www.investopedia.com/

Pyramids and Ponzis

The current economic crisis in the world has increased the risks of greed, corruption and fraud. The latest, and currently the largest, involves Madoff Securities. The epic size of the fraud scheme should sound warning bells and alarms to more than just those that lost investments. Are you at risk? How secure are your operations, investments and business relationships? The warning signs existed – the classic red flags were evident. Decades after Charles Ponzi duped thousands with his get rich quick scheme to buy and sell international mail coupons, Madoff enticed his investors with promises of double digit returns in a highly volatile market. In 1921, Ponzi raised $1 million in one three hour period. In 2008, Madoff was released from custody in exchange for $10 million bail and an ankle bracelet.

Victims are now looking for the deep-pocket sources to obtain some compensation for their losses. The court appointed trustee will be tasked with unwinding the financial linkages of the feeder funds that served as the pyramid upon which the fraud was built. Investors have lost fortunes – many of whom used this investment as their money market fund. The myriad of complex layering that existed will be unwound and the classic outcome of winners and losers will be developed. The theories of equitable distribution and recovery among all involved will be argued in the court system for many years. It’s not just the investors that are at risk - investment advisors, accountants, lawyers, and others are likely to face significant exposure.

As forensic accountants, we have reconstructed financial and other records and assisted clients in documenting such schemes. Those who have lost millions may have to disgorge the investment returns previously received. The IRS may take an aggressive position with the tax treatment of the sham transaction that was perpetrated, and in turn, may have to deal with significant tax deductions taken by those who suffered. Moreover, the extent of “insurance or protection” offered to investors is not clear cut given the size of the scheme. 

Like Mr. Ponzi’s scheme, this one likely will result in winners becoming losers and the losers recovering pennies on the dollar.

Trade Secrets

Companies around the globe, both large and small, keep secrets, most of which are closely guarded because if these trade secrets became public knowledge it could mean ruin for the company.  Examples of company trade secrets include the following: manufacturing processes; software and related documentation; designs; strategic plans; customer lists; vendor and supplier information; and pricing and cost information.

Trade secrets maintained by companies can result in some of the largest losses for a company if they fall into the wrong hands. For instance, imagine what would happen if the formula for Coca-Cola became public knowledge or if the source code for Windows Vista was disseminated. If either of these events occurred, Coca-Cola and Microsoft could lose their competitive advantage within their industries and stand to lose billions in revenues. Both of these companies have in fact almost lost control of their trade secret information. In 2006, a disgruntled executive assistant at Coca-Cola attempted to sell trade secrets to Pepsi Co, and in 2004 the source code of Microsoft’s Windows 2000 operating system was leaked on the internet. Both of these attempts were eventually thwarted by the companies and/or law enforcement personnel and the trade secrets were recovered, however, not all companies are this fortunate.

In 1997 Lexar Media lost trade secret information concerning the flash memory devices it was developing to Toshiba through a member of Lexar’s Board of Directors. Toshiba used this information to further their flash memory devices which were being developed in cooperation with SanDisk. The leak of the information was not discovered until 1999, after the damage had been done. At this point, Lexar’s only option was to control the damage and attempt to recover their losses from Toshiba. The problem for Lexar was calculating a loss on something that had no physical value attached to it. Enter the valuation expert.

Trade secret damage calculations, like other damage calculations, must follow court approved damage theories meaning that the economic damage expert must follow the appropriate theory from the jurisdiction of the case. Unlike patent and trademark law, trade secret law is not mandated at the Federal level, but rather is developed at the state level. In an attempt to bring some form of uniformity to the different state laws, the Federal government issued the Uniform Trade Secrets Act (UTSA) in 1985. To date, most states have adopted the Act in some form, while those that have not rely on common law. While the trade secret law followed in each jurisdiction may differ, the damage theories allowed in each jurisdiction remain similar. In the coming briefs, the role and importance of the economic damage expert as well as the methods for calculating damages in trade secret cases will be discussed.

Parente Randolph’s Newman, Gering & Press Co-Author Journal of Accountancy Article on Intellectual Property

Glenn S. Newman, Principal in Charge of Parente Randolph LLC’s Forensic & Litigation Services, along with Richard J. Gering, Principal, and Jeffrey N. Press, Senior Manager, co-authored an article that was just released in the Journal of Accountancy entitled “How Reasonable Is Your Royalty?”

The article outlines how a royalty rate may be determined by discussing the factors that govern the hypothetical negotiation between the licensor and licensee. The article relies on the case Georgia-Pacific v. United States Plywood Corp. as a framework for determining royalty rates. The article can be viewed in its entirety on the American Institute of Certified Public Accountants (AICPA) website.

Executors and Fiduciary Duties

In today’s society, fiduciary duty and estate planning live in a gray area, resulting in many dispute cases surfacing over the executor’s fiduciary duties, some requiring the use of a CPA expert. From a legal perspective, there is no clear consensus about who constitutes the best executor; only that the choice depends upon individual circumstances. The executor (or trustee) assumes five main functions:  collecting the assets, which involves taking an accurate inventory; managing the estate such as using funds to pay bills, collecting money owed, buying and selling assets; dealing with taxes; closing the estate; and distributing the assets. Choosing a person who will capably administer all of these roles is one of the most important decisions to be made.  This decision involves the application of art over science.

The complexities of estates and estate planning have given rise to multiple dispute litigation matters over the past years. One example of a case involving an outside executor of an estate is the Cailloux Case, famous for its jury award of $65.5 million.  Floyd Cailloux, the owner of a valve manufacturing company, appointed independent executors of his estate, a “Bank” and an “Attorney.” Also, he established a trust for his wife and children. The Floyd and Kathleen Cailloux Foundation, created in 1994, would receive 92 percent share from the estate or $60 million. An officer of the Bank was the director of the Foundation. Floyd’s wife and children filed suit against the Bank and the Attorney, claiming that the Attorney had conspired with the Bank “to formulate an estate plan favoring a family foundation which one of the bank officers directed and served as a board member.” Trial resulted in a $65.5 million verdict in favor of the Cailloux family finding the Attorney had failed to disclose all important information and breached its fiduciary duty toward Kathleen Cailloux (Floyd’s widow). Even though the jury verdict was reversed on appeal, the case crystalizes the significant exposure faced by executors and related professionals.

The above example illustrates the fact that fiduciary duty and estate planning are not science and involve a great deal of careful planning and thoughtful decision making.  Many different shades of gray exist when testator’s choose the best executor, whether it be a family member or a bank.

For more information regarding our Forensic Accounting assistance involving executors and estates, contact Glenn Newman at 215.972.2354.

Newman Co-Authors Special Report for AICPA

Glenn Newman, Managing Director of Parente Randolph's Forensic Accounting and Litigation Group, has co-authored Independence Integrity & Objectivity in Performing Forensic and Valuation Services, Special Report 08-1 for the AICPA.

The purpose of the special report is to provide practitioners with additional guidance with respect to the myriad of ethical issues that may affect a forensic accounting or valuation engagement, including the concepts of independence, integrity, and objectivity and the potential for conflicts of interest when those services are rendered.

The report may be purchased through this link.

New Forensic Credential to be Launched in the Fall 2008

The American Institute of Certified Public Accountants (“AICPA”) recently announced the creation of a new CPA specialty credential in forensic accounting.

The credential, Certified in Financial Forensics (CFF), combines specialized forensic accounting expertise with the core skills and experience that make CPAs among the most trusted business advisors, according to Glenn Newman, who heads up Parente Randolph’s Forensic and Litigation Services Group.

“We anticipate the Certified in Financial Forensics, or CFF credential will further strengthen the CPA’s role in a rapidly growing service area,” Newman said.

The CFF encompasses specialized forensic accounting skills that certain CPA practitioners apply in a variety of service areas, such as:

• bankruptcy and insolvency
• computer forensics / electronic discovery
• economic damages
• fraud and special investigations
• litigation support
• matrimonial disputes
• stakeholder disputes
• valuations
• combinations of the above

According to the AICPA’s governing council (who approved the new CFF credential), the CFF will launch in early this fall. In order to qualify, a CPA must be an AICPA member in good standing, have at least five years’ experience in practicing accounting, and meet minimum requirements in relevant business experience and continuing professional education.

The CFF evolves out of the CPA’s role as the premier provider of forensic accounting services. According to AICPA research, CPAs represented 94 percent of forensic experts hired over the past two years.

“The CFF has been in the planning stages for sometime. The AICPA surveyed users of forensic accounting services to determine its desirability and the Institute responded,” said James O’Brien, Principal of Parente Randolph. “The survey results showed the market would welcome this credential especially for the CPAs who practice in this niche.”

The CFF will be the fourth of the Institute’s specialty credentials. The others are Accredited in Business Valuation (CPA/ABV), Certified Information Technology Professional (CPA/CITP), and Personal Financial Specialist (CPA/PFS).