Financial fraud should, in theory, never be a concern for a law firm, where ethical considerations must predominate.
After all, Rule of Professional Conduct 8.4 states clearly that “[i]t is professional misconduct for a lawyer to … commit a criminal act that reflects adversely on the lawyer’s honesty, trustworthiness or fitness as a lawyer … [or to] engage in conduct involving dishonesty, fraud, deceit or misrepresentation.” That seems to cover the financial fraud waterfront pretty thoroughly. However, the fact that even people who know the “straight and narrow” can deviate from it is one of the biggest reasons why lawyers exist. Moreover, “fraud” comes in a variety of forms when it comes to law firm financial dealings.
Honest mistakes and errors in judgment can produce the appearance of impropriety, every bit as much as can outright theft. And dishonest conduct can be committed by others in the firm, for whom lawyers are still themselves ethically responsible.
Various factors make law firms susceptible to such problems: part-time lawyer management, lawyers’ lack of business competency and decentralized authority to bill clients and approve disbursements. Every firm should recognize and guard against these causes of actual or apparent financial impropriety.
Because law firm compensation typically rewards individual performance, lawyers tend to focus only on rainmaking and their own billable hours. But a lawyer’s ethical responsibility can be more than personal.
In California, for example, State Bar Rule 5.1 provides that partners and other lawyers with managerial authority must take reasonable measures to ensure that all lawyers in the firm observe the Rules of Professional Conduct, and that lawyers with firm managerial responsibility are personally responsible when other lawyers in the firm violate the rules.
Firm leaders preoccupied with their own practices may not be paying proper attention to catch the errors of others. That can create problems like the story several years ago of a St. Louis firm that sued a former associate who allegedly signed up and hid clients from the firm, preventing it from collecting legitimate fees.
Overdrawn credit line
There is substantial danger for law firms in paying staff salaries and even partnership draws by using their bank lines of credit. This kind of borrowing is especially an issue at year-end for many smaller law firms when tax accountants advise them to clear out the firm’s cash before year-end.
So firms turn to a credit line arrangement, on which they borrow and repay at will up to the amount of the credit line and which the bank regularly reviews. Such borrowing for payrolls, partner draws and tax payments is typically done in anticipation of collecting on accounts receivable. If for whatever reason the expected receivables do not materialize, the result can be a damaged credit rating, a default or even potential criminal penalties.
Poor trust accounting
It is an iron-clad rule that the client’s payment for work that has been performed is to be deposited into the firm’s general account and payment for work that will be performed is to be deposited into a client’s trust account. When payment is earned it must be transferred from the trust to the general account or the firm will be guilty of commingling personal and client funds, which is prohibited by the Rules of Professional Conduct.
However, trust accounts (especially in firms emphasizing debt collection, personal injury or real estate practices) can grow so large that the record keeping becomes flawed and develops errors. Every state imposes a fiduciary duty to properly account for clients’ trust funds to prevent misappropriation or negligence. Failure to use appropriate accounting software or an outside accountant to reconcile trust and bank account records each month is likely to invite error, state bar inquiry and trouble.
Incomplete client billing
Law firm bill padding has been called “the perfect crime,” but the degree of “perfection” in this ostensibly unethical action depends in part on how inattentive the client is to the lawyer’s bill, and how lacking in detail that bill is.
A billing entry like “work on motion for summary judgment, 20 hours” without breaking the time spent into its basic elements can create more than a few suspicions that would be defused by adequate billing detail. A bill that only says, “For legal services rendered,” or that is inaccurate or confusing, potentially opens the door to concerns, or actual allegations, that the bill is padded.
Inadequate internal controls
It is easy for even a longtime or trusted employee to lose his or her moral compass when money is readily available and not readily monitored.
The solution is for the firm to be consistent in its policies of handling cash, persistent in applying those policies and insistent that there be no shortcuts and no exceptions in the proper handling of funds. That requires strict adherence to cash management best practices.
All client receipts that are not electronically transmitted should be deposited immediately and in person at the bank by a responsible officer whose deposit receipts are regularly reviewed. Different individuals should open client checks received, deposit those checks and reconcile the bank statements. Bank statements should be reconciled immediately upon physical or electronic receipt, then double-checked by a second person. And several individuals should be trained and rotated on these functions, so that different hands and eyes come to bear on the financial process.
Lawyers are the owners of the firm and have ultimate financial stewardship for it. Every document, check and ledger entry attesting to financial integrity is important, and the appearance of impropriety is unacceptable. Nothing less than the firm’s professional standing is at stake.