1/18/2018. Fraud Prevention and Detection: Special Investigations, Information and Examples. Office of the State Auditor Role and Responsibility

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1 Fraud Prevention and Detection: Special Investigations, Information and Examples 2018 MACO Annual Winter Conference Thursday, February 15, :15-12:00 Mark Kerr, JD, CFE Special Investigations Director Office of the State Auditor This outline is an educational resource. This outline is not legal advice and should not be Relied upon in lieu of legal advice. The contents of this outline may be changed at any time. Office of the State Auditor Role and Responsibility Constitutional Office Financial oversight includes: Counties Cities School Districts Towns Police and Fire Relief Pension Funds Soil and Water Conservation Districts Port Authorities TIF Districts As well as approximately 150 other special districts Office of the State Auditor Divisions Audit Practice Pension Tax Increment Financing Government Information Legal/Special Investigations 1

2 Legal/Special Investigations Division The Legal/Special Investigations Division investigates allegations of theft or misuse of public funds. It also provides legal compliance information and training to local government officials. Types of Fraud Theft Minn. Stat Includes temporary taking Even small amount of public funds is a felony Embezzlement Minn. Stat and Refuse or omit to turn over public funds Felonies Types of Fraud (continued) False Claims Presenting (Minn. Stat ) Allowing or paying (Minn. Stat ) Felonies Forgery Check forgery (Minn. Stat ) Altering a public record with intent to defraud (Minn. Stat or ) Felonies Misuse of Public Funds/Assets 2

3 The Fraud Triangle Motive/Incentive (Financial Pressure) Rationalization Opportunity Key: Reduce Opportunity: Internal Controls: Segregation of Duties Other Internal Control Procedures Strong Control Environment COSO Framework: Five interrelated components: Control Environment, Risk Assessment, Control Activities, Information and Communication, Monitoring. Document to demonstrate effectiveness and enable proper monitoring. Fraud Recent Examples 2012 City of Dixon, IL. $53.7 Million Stolen by City Treasurer Rita Crundwell (over 20 years) 3

4 Fraud Recent Examples Eau Claire County, WI. $1.39 stolen (over 13 years) by the former County Treasurer and an assistant. Reconcile Bank Statements Check Fraud Example Minnesota local government Minnesota Statutes, section Stowell v. Cloquet Co-Op Credit Union, 557 N.W.2d 567 (Minn. 1997). Review the agreement with your financial institution. How long do you have to identify fraudulent items and mistakes? Reconcile Bank Statements Each month (or more frequently), someone not involved with writing checks/making payments should reconcile the bank statement to records of claims approved. Amount altered? Proper payee? Void check cashed? Checks out of sequence? Unauthorized payments? EFT policy controls - Minn. Stat , subd. 3a (discussed below) 4

5 Involve the Bank No cash withdrawals Periodically obtain from bank a list of all county bank accounts. Dixon, IL Consider moving to Positive Pay system. Problem: Receipts Not Deposited Skimming Cash removed prior to deposit (unreceipted cash) Lapping Receipted cash replaced with unreceipted checks Solution: Build in Double Checks Someone other than person collecting money compares items sold to money collected (movie theatre example) Person collecting money is not person preparing deposit Person collecting money receives periodic report of deposits Second person OKs all voids/refunds Small entities or departments: involve elected officials or other employees 5

6 Solution: Internal Controls for Receipts Daily deposits Reconcile receipts with deposits daily Do not leave receipts unattended Know the amount in any change fund (starting balance) Consolidate cash collection points Periodic report of deposits to department collecting payments Solution: Internal Controls for Receipts (continued) Pre-numbered receipts for all payments/sales Note if payment is by cash or check (& check number) & compare to deposit Deposits made intact Beware of voids & refunds No cashing of personal checks out of undeposited receipts No borrowing from public funds (no IOUs or markers ) Problem: Unauthorized Payments County funds used for personal purchases Credit card Petty cash Expense reimbursements Electronic fund transfers 6

7 Internal Controls for Credit Card Claims Minn. Stat : County board may authorize use of a credit card by a county officer/employee otherwise authorized to make a purchase. If an officer/employee makes a credit card purchase that is not approved by the county board, the officer or employee is personally liable for the amount of the purchase. Credit card purchases must otherwise comply with all statutes, rules, or county policies applicable to county purchases. The employee should submit the original receipt from the point of sale to support payment. Include the specific vendors, not just credit card company, on claims approved by the county board. Imprest Cash Fund Internal Controls for Petty Cash Cash funds established by the county board with appointed custodian to be used if it is impractical to pay claims in other manner (Minn. Stat , subd. 1) Cannot be used for salary or personal expenses of a county officer or employee. The county board appoints a custodian of each imprest fund. The custodian presents an itemized claim for all the various disbursements that have been made from the fund at the next county board meeting. The county board acts upon it as in the case of other claims. An imprest fund to advance money for travel can also be authorized by the county board. Internal Controls for Reimbursements In general, require original invoices & original itemized receipts. Reference claims approved (with amounts) in minutes if possible 7

8 Declaration Requirement Amendment to Minn. Stat , subd. 1: [T]he board or officer authorized by law to audit and allow claims shall not audit or allow the claim until the person claiming payment, or the person's agent, reduces it to provides to the board or officer an itemized list in writing or in an electronic transaction record, in items and signs a declaration to the effect. By making the claim for payment, the person making the claim is declaring that such the account, claim, or demand is just and correct and that no part of it has been paid. The board or officer may in its discretion allow a claim prepared by the clerk or secretary of such the board or officer prior to such the declaration by the claimant if the declaration is made on the check or order-check by which the claim is paid, as provided in section , subdivision 2. ETF Procedures Electronic funds transfer is the process of value exchange via mechanical means without the use of checks, drafts, or similar negotiable instruments. Minn. Stat , subd. 3. A school district local government may make an electronic funds transfer for the following: (1) for a claim for a payment from an imprest payroll bank account or investment of excess money; (2) for a payment of tax or aid anticipation certificates; (3) for a payment of contributions to pension or retirement fund; (4) for vendor payments; and (5) for payment of bond principal, bond interest and a fiscal agent service charge from the debt redemption fund. ETF Procedure New definition for purposes of Minn. Stat : [L]ocal government" means any county, local social services agency, school district, town, or home rule charter city of the second, third or fourth class, or any park district. 8

9 ETF Procedures Minn. Stat , subd. 3a The authorization in subdivision 3 extends only to a school district local government that has enacted all of the following policy controls: (a) the school board governing body shall annually delegate the authority to make electronic funds transfers to a designated business administrator or chief financial officer or the officer's designee; (b) the disbursing bank shall keep on file a certified copy of the delegation of authority;. ETF Procedures Minn. Stat , subd. 3a (c) the initiator of the electronic transfer shall be identified; (d) the initiator shall document the request and obtain an approval from the designated business administrator, or chief financial officer or the officer's designee, before initiating the transfer as required by internal control policies; (e) a written confirmation of the transaction shall be made no later than one business day after the transaction and shall be used in lieu of a check, order check or warrant required to support the transaction; (f) a list of all transactions made by electronic funds transfer shall be submitted to the school board governing body at its next regular meeting after the transaction ETF Procedures Under Minn. Stat , subd. 2, cities and counties have clear authority to accept payment by use of debit cards. Debit card and electronic or wire funds transfer are listed separately. The OSA has noted that, in contract, there has not been any clear authority to make payments using debit cards. See Minn. Stat , subd. 1 ( electronic or wire funds transfer is listed, but debit card is not). The OSA has recommended that entities not use debit cards. See OSA Statement of Position Credit Card Use and Policies The new procedures indicate the Legislature does not consider debit cards an authorized form of electronic or wire funds transfer for making payments under Minn. Stat , subd. 9

10 Contractors Performance and Payment Bonds Minn. Stat : [Generally] a contract [ over $100,000] with a public body for the doing of any public work is not valid unless the contractor gives (1) a performance bond to the public body with whom the contractor entered into the contract, for the use and benefit of the public body to complete the contract according to its terms, and conditioned on saving the public body harmless from all costs and charges that may accrue on account of completing the specified work, and (2) a payment bond for the use and benefit of all persons furnishing labor and materials engaged under, or to perform the contract, conditioned for the payment, as they become due, of all just claims for the labor and materials. Contractors Performance and Payment Bonds City of Minneapolis v. Redflex Traffic Systems, Order (U.S.D.C., July 1, 2013). This Federal court case involved a 2005 contract with a vendor (Redflex) for installation and operation of cameras for a traffic law enforcement program in Minneapolis. The program permitted use of an automated traffic enforcement system to detect motorists failure to stop at red lights. Contractors Performance and Payment Bonds In general, the vendor (Redflex) agreed to indemnify the city for legal liability based on actions challenging the legality or constitutionality of the program and claims challenging the City s use of the program, including the validity of the citations issued, prosecuted and collected. No performance or payment bonds were procured. (It is a complicated case. Our discussion is limited to the importance of the lack of performance and payment bonds.) 10

11 Contractors Performance and Payment Bonds The legality of the program was challenged in several underlying cases. One class action suit was settled by the city. The city indicated the settlement cost over $1.3 million. The city was also found liable to an unpaid subcontractor (Collisys). The city sued Redflex for breach of contract (and alternatively, equitable relief). Contractors Performance and Payment Bonds Consequences of not having contractors bonds. [A]ll claims, asserted by either party, based on the existence of a valid contract fail as a matter of law. See Minn. Stat , If performance and payment bonds are not given, the contract for doing public work is not valid. No equitable relief on subcontractor s claim that the city paid it was based on the city s liability under the Bond Act. See Minn. Stat : If no payment bond is procured, the public body for which work is done... is liable to all persons furnishing labor and materials... for any loss resulting to them from the failure.... Contractors Performance and Payment Bonds - Verification 2017 News: Minnesota man convicted for mail fraud and money laundering. He fraudulently obtained at least $3 million in government construction contracts, costing those who did business with him hundreds of thousands of dollars. Commissioner of Commerce is quoted as saying the man "created fraudulent insurance documents to win construction bids, unfairly taking business away from honest contractors, and "He then victimized his clients and subcontractors by leaving behind unfinished projects and unpaid bills without the financial protection that legitimate insurance bonds would have provided." 11

12 Contractors Performance and Payment Bonds - Verification Public entities can take steps to verify both the company issuing the surety bond and the existence of the bond. Whether a company is licensed to write surety bonds in Minnesota can be verified on the Commerce Department s website: n.us/licenselookupmain.html The National Associations of Surety Bond Producers (NASBP) urges bond obligees to take further steps to verify the authenticity of the bond they receive. Consider: Sending the pertinent information, possibly including a scanned or faxed copy of the bond, directly to the issuing bond company requesting that they verify the existence of the bond. Minnesota law requires fidelity bonds for many elected and appointed officials and some employees. Fidelity bonds are also used in other contexts In general, a fidelity bond protects against theft, dishonesty or failure to faithfully perform duties. In at least one recent lawsuit federal, an insurer has attempted to rescind a fidelity bond based on an alleged misrepresentation. This is an ongoing civil lawsuit, and the facts should not be considered to be finally established. 12

13 Statute: Minn. Stat. 60A.08, subd. 9, which states: No oral or written misrepresentation made by the assured, or in the assured's behalf, in the negotiation of insurance, shall be deemed material, or defeat or avoid the policy, or prevent its attaching, unless made with intent to deceive and defraud, or unless the matter misrepresented increases the risk of loss. This subdivision shall not apply to life insurance or accident and health insurance. A question on the application for renewal of the fidelity bond asked whether the credit union s officers, employees, etc. had knowledge of any act, error, or omission which might give rise to a claim... Covered under... The Bond...? The [credit union] manager who filled out the application checked no. Problem: The credit union subsequently discovered that the same manager had embezzled in excess of $3 million.... Neither party disputes that [the credit union manager] lied by checking no because she was stealing from [the credit union] at that time. (March 17, 2017, order denying motion for summary judgment.) 13

14 The insurance company sought to rescind the fidelity bond based on the misrepresentation on the application for renewal of the bond. The credit union s liquidating agent filed a complaint seeking a declaration that the insurer owed coverage under the fidelity bond. The insurer filed a motion for summary judgment arguing it rightfully rescinded the fidelity bond under Minn. Stat. 60A.08, subd. 9, because the manager s misrepresentation increased the insurer s risk of loss. (March 17, 2017 federal court order) Minn. Stat. 60A.08, subd. 9, covers an application for insurance. An insurer does not have to prove that it would not have issued the policy but for the misrepresentation. All that is required to trigger the statute is an increase in the risk of loss. Here it is clear that the [insurer s] risk of loss increased due to the managers omission that she was stealing from [the credit union.] Question: Can the misrepresentation can be attributed to the insured [credit union], so that the bond can be rescinded? Answer: No, not this time -- the insurer cannot rescind the contract under Minn. Stat. 60A.08, subd. 9. But beware this is a narrow exception. 14

15 The court stated: Here, the Court concludes that because [the] only misrepresentation was about the fraud itself as opposed to misrepresentation tangentially related to the fraud, such as the existence of internal controls the misrepresentation is not imputed to Plaintiff. [T]he Court reiterates the narrowness of its holding: it is only when an employee who active adversely to her employer by embezzling from the company misrepresents her knowledge of that embezzlement on an application for fidelity insurance that the employee s knowledge will not be imputed to the company to allow the insurer to rescind the fidelity insurance. The Court concluded: [t]he Court denies [the insurer s] Motion for Summary Judgment. It should be noted, however, that discovery was not even begun, and it may bear out in discovery that [the insurer] is entitled to rescission. Control Environment The same rules apply to everyone Don t belittle internal control procedures Don t allow management to override procedures Avoid conflicts of interest (Minn. Stat ) Appropriate discipline for violations Be alert to employee s outside interests It s the public s money 15

16 Suspect Fraud? Reporting Requirement Minn. Stat County employee/officer who discovers evidence of theft, embezzlement, unlawful use or misuse of public funds or property Must promptly report to state auditor (in writing) and to law enforcement Identity of reporter is private data (Minn. Stat , subd. 2) Reporting form is on OSA website Thank You! Office of the State Auditor 525 Park Street, Suite 500 St. Paul, Minnesota, Mark Kerr, JD, CFE Special Investigations Director (651)