Employee fiduciary responsibility and fraud

May 2017 | LEGAL & REGULATORY | FRAUD & CORRUPTION

Financier Worldwide Magazine

One challenge that fraud investigators face is the ability to report all of the facts when the fraudulent activity is pervasive with multiple schemes occurring simultaneously. The question of an employee’s fiduciary responsibility to their employer may also become another focal point of the investigation. Breach of fiduciary duty is one of the principal categories of white-collar crime listed in the US 2016 Fraud Manual, issued by the Association of Certified Fraud Examiners. It states, “Establishing a breach of fiduciary duty claim is easier than establishing a claim for fraud because a breach of fiduciary duty claim does not require proof of wrongful intent”.

Fiduciary duty is a “legal obligation of one party to act in the best interest of another. The obligated party is typically a fiduciary, that is, someone entrusted with the care of money or property”. Generally, there are two components to employee fiduciary duty – duty of loyalty and duty of care. While it is more common that upper level managers, corporate directors or those subject to employment agreements are considered subject to fiduciary responsibility, it is possible for lower-level employees to be ‘fiduciaries’ as ‘agents’ of their employers. An agent is a “party that has express (oral or written) or implied authority to act for another so as to bring the principal into contractual relationships with other parties”.

The duty of loyalty includes a number of expectations. For example, employers expect their employees to behave honestly and act in the employers’ best interests, employers expect their employees not to compete with them or be unfair in any transactions between them, and employees should not seek to advance their personal interests while harming their employers. Among other features are protecting confidential information and trade secrets and avoiding or, at a minimum, disclosing possible conflicts of interest.

Duty is an “ethical, legal or moral accountability owed always or for a certain period, especially to someone who has a corresponding right to demand satisfaction of an obligation”. Duty of care is an employee’s responsibility to avoid reasonably foreseen acts or omissions likely to cause harm to their employer. Additionally, the employee needs to perform their duties with proper care and diligence as would be expected of people in similar positions.

When an employee engages in transactions that are dishonest and not in the best interest of their employer, the employee might have breached their fiduciary duty to the employer. Some of these acts occur within various types of fraud schemes such as conflicts of interest, bribery, corruption and theft of intellectual property. While there are some subtle differences between these schemes, the end result is harm to the employer.

A conflict of interest occurs when an employee has an undisclosed personal or economic interest in a matter that could influence decisions made as an employee of the company. As long as these relationships are disclosed and the employee is not receiving a financial benefit, then the conflict of interest may not create a violation of fiduciary duty.

Conflict of interest fraud schemes occur when the employee is deriving a financial benefit and the employee’s interest is not disclosed to his or her employer. The core concept is that the employee takes advantage of their employer, and the employer is unaware that the employee has divided loyalties. There are a number of ways whereby an employee can benefit from this hidden interest. Some of the more common methods to benefit a hidden interest may be found in purchasing schemes, sales schemes, financial disclosures (or the lack thereof), business diversions, delayed billings and resource diversions. For any of these schemes to meet the definition of a conflict of interest fraud scheme, the employee (or a friend or relative) must have some sort of ownership or employment interest in the non-employer entity. This is a key principle for conflict of interest schemes in which an employee breaches the concepts of employee fiduciary duty.

In one case, a conflict of interest scheme came to light through the use of a ‘doing business as’ application (DBA) on a state business application. Three employees were noted as owners of this DBA business. Four employees were actively conducting business operations of the DBA, including billing their employer (Company A) for products and services while using Company A’s resources to conduct business of the DBA entity.

During the day while working at Company A, these employees actively conducted operations of the DBA business using Company A’s employees to perform work for the DBA business. They implemented specific phone numbers and pagers for the DBA on Company A’s phone contract. Additionally, web page designs for the DBA business were found on Company A’s computers, along with payments made unknowingly by the employer for hosting the website and the site’s annual fees. Moreover, the DBA business was selling products to Company A’s competitors that allowed these competitors to offer the same types of benefits and services. There were no payments made to Company A by the DBA business for these services.

The key difference at this point is that all of these employees were improving the financial condition of their DBA business at the expense of their employer. Had the employees set out to get only cash from their employer, the fraudulent activity would have been simply a fraudulent disbursement or billing scheme, rather than a conflict of interest fraud scheme. A simple disbursement-billing scheme may not meet all of the components of an employee breach of fiduciary duty. By constructing the fraudulent activity, as in this particular case, the employees developed a conflict of interest scheme by having an active interest in pursuing business for the DBA. Each employee had an undisclosed financial interest generating personal financial gains that influenced their decisions when performing their duties for their employer. Thus the actions of the employees met the definition of a conflict of interest fraud scheme because Company A had no knowledge of their involvement in the DBA business.

The conflict of interest scheme in this case included the two key components that meet the breach of employee fiduciary duty: the duty of loyalty and the duty of care. Providing to Company A’s competitors similar services that were previously a selling advantage of Company A is an act that caused harm to Company A. Another key issue is that the employees were not performing their duties at Company A with the proper care and due diligence of other employees in similar positions. These issues bring the employee’s motives into question and thus their duty of care to their employer.

Under the duty of loyalty component, the employees did not behave honestly and act in the best interests of Company A through their development of a DBA business, thus creating a conflict of interest and not reporting this conflict. By developing the conflict of interest scheme using the DBA business, these employees were able to compete with their own employer. Furthermore, the employees’ actions advanced their own personal interests while harming the interests of their employer.

While there were multiple misappropriation of cash schemes occurring simultaneously with the conflict of interest scheme, the employees also misappropriated inventory for the purpose of reselling the inventory to their employer’s competitors through their own DBA business. The revenues from these sales were recorded in the DBA business and never transferred to Company A. Again, these actions represent a breach in the duty of loyalty to their employer.

Actions of an employee may be both fraudulent and represent a breach of fiduciary duty. Courts have differing opinions upon whether an employee has breached their fiduciary duty to the employer. In the US, the question of employee fiduciary duty is determined at the state level and subject to the laws of each state. However, many questions arise over the duties of ‘loyalty’ and ‘due care’, and courts tend to look at the specific terms of the employment contract to determine if there is a fiduciary duty or responsibility for the employee. However, it is important to look at the specific elements of employee fiduciary duty when investigating potential fraudulent activity. Sometimes the scheme used by the perpetrator (employee) suggests an employee breach of fiduciary duty. In conflict of interest fraud schemes, the actions of the employee reveal the breach of fiduciary duty.

Finally, employers need contracts with their employees that will provide them the protection that they need when the question of fiduciary duty arises. Employers also need to educate their employees regarding their responsibilities and the importance of reporting possible conflicts of interest as soon as they occur. Furthermore, employers need to implement a conflict of interest policy to protect themselves when an undisclosed conflict of interest is found and require an annual disclosure document to include other business ownerships, income and investment information. As a final point, employers should also have a reporting procedure for their employees to report their concerns about possible fraudulent activity, especially vendors receiving favoured treatment.

Pam Mantone is a director at Elliott Davis Decosimo. She can be contacted on +1 (423) 756 7100 or by email: pam.mantone@elliottdavis.com.

Pam Mantone

Elliott Davis Decosimo