Five tips to steer clear of the courthouse: how CPAs help companies reduce litigation through risk management.

Alarmed at the rising toll of litigation costs, more and more companies are taking steps to stop lawsuits before they begin. As part of their risk nanagement strategies, finance executives, internal auditors and risk managers increasingly are turning to CPAs to review policies and controls and scrutinize internal procedures to help keep their companies out of the courthouse. In 2000 when court costs, attorneys' fees, insurance premiums, payments to claimants and "every other conceivable expense were added up" reports Loretta Worters, director of media relations at the Insurance Information Institute in New York, the legal tab hit $179 billion. How does a business distance itself from legal problems? Here are some tips from CPAs who work as litigation consultants on how they helped their corporate clients identify issues and implement strategies to manage risks and avoid legal conflicts.

TIP2 PROMOTE ETHICAL BEHAVIOR

It was just one of those serendipitous things, says Cheryl Sparkes, CPA and partner in charge of litigation advisory services at the New York office of Ernst & Young LLP, referring to a consumer products company's retaining E&Y for a fact-finding mission. The client had asked the firm to settle a dispute involving a disgruntled employee who had accused a senior manager of taking kickbacks from a vendor. Eventually the manager was exonerated. But what Sparkes saw at the company aroused concern. "The manager was not taking kickbacks, but we found the company lacked ethics policies," she says. "We discovered salaried employees were working as consultants for other companies. They weren't doing anything wrong, per se, but they were exposing their employer to allegations of self-dealing and conflicts of interest"

Because the CPA firm alerted it to the risks, the company took action. Management instituted a code of ethics as part of its efforts to ensure good corporate governance. Now, Sparkes says, when the company hires a salaried employee, he or she agrees not to take on outside work lest there be a conflict of interest. Moreover, employees are required to shun improper relationships with vendors, such as the accepting of gifts valued above a certain dollar amount--"a trip to Hawaii," for example, says Sparkes. If employees become compromised, a company may have to defend itself against charges of restraint of trade, self-dealing, failure to use competitive bidding practices and even insider trading violations.

What began as a nasty episode, Sparkes says, had favorable results. Not only was the manager absolved of any wrongdoing, but the company--which Sparkes describes as "young and successful" and one that had planned to take care of back-office issues "later rather than sooner"--dodged potential legal and ethical bullets by tightening up its internal controls.

Once a company has a code of conduct in place, how does management improve ethics awareness among employees? CPAs who are accustomed to assessing controls can recommend these "best practices" to their clients:

* Incorporate ethics policies into the company mission statement and publicize them to employees.

* Inform employees of responsibilities through training, procedure manuals and other internal communications.

* Conduct periodic reviews of compliance programs to keep them current.

* Put a senior executive in charge of compliance and regulatory matters to signal the importance of corporate integrity.

TIP 2 ENCOURAGE ALTERNATIVE DISPUTE RESOLUTION 

One way businesses reduce litigation costs is to avoid going to court whenever possible. CPAs can encourage their clients to include arbitration clauses in their contractual agreements or to select alternatives to litigation when disagreements arise. Alternative dispute resolution (ADR) methods, such as arbitration and mediation, offer a variety of techniques for resolving conflicts with the aid of a neutral party and without resorting to litigation. Arbitration and mediation provide timely and economical results and are widely used to settle business controversies without the delays and public exposure of lawsuits. Thomas Emmerling, CPA, managing partner and litigation consultant at Dopkins and Co. in Buffalo, New York, advises clients to include a demand for alternative dispute resolution in contracts with suppliers and vendors and adds that these agreements are commonly used in many industries to handle employment, labor and insurance issues.

Sometimes parties need ADR when other options fail. For example, business interruption insurance claims frequently require a loss appraisal prepared by both the insurer and the insured. If the valuators cannot agree on the amount of the loss of business income due to the suspension of operations, the parties may ask a CPA to serve as a mediator to settle the claim. (For more details on ADR, visit the American Arbitration Association Web site at www.adr.org. For a look at how ADR works, see "Stay Out of Court" Jof A, Sep.98, page 77.)

The insurance industry supports the use of ADR by its policyholders as an economical alternative to litigation. William Bailey, special counsel to the Insurance Information Institute, says providers of legal liability policies use a system of discounts and rebates as an incentive for companies to implement specialized training and litigation prevention programs to address ethical, contract and employment issues. "You'll find the insurance industry invests a lot of money in loss prevention and mitigation of damages. Insurers build discounts into the premium price structure to encourage customers to conscientiously avoid the risk of litigation," says Bailey.

TIP 3 ASSESS HR PROCEDURE

In addition to helping companies resolve economic disputes, CPAs can assist in protecting them against problems involving discrimination in hiring and promotions, sexual harassment allegations and wrongful termination. Well-developed hiring practices can be key to blunting problems before they occur. While most large companies likely have a well-trained human resources department in place, the CPA can add another pair of eyes to monitor the existing system for any potential red flags. But it is at small and medium-sized companies where a CPA can really play an important role, says Grace Ghezzi, a CPA at Green & Seifter in Syracuse, New York. The CPA, accustomed to detecting problems, is able to spot issues throughout an organization before they arise and share insights and concerns with owners and top managers, observes Ghezzi. "The CPA is the one professional who sees businesspeople every year, usually at tax time" she says. "I'll ask my clients what they're doing in the areas of employment practices and controls, hiring procedures and what policies are in place to protect them from an unhappy employee. The CPA can add awareness."

By instituting an effective screening process, companies can prevent themselves from hiring persons with the potential to engage in risky behavior, including drug and alcohol abuse, fraud, theft and mismanagement. CPAs can work closely with the human resources department to make sure a company maintains a state-of-the-art employee manual governing employment policies and hiring procedures including conducting background checks and checking employee references, says Ghezzi. She also recommends companies do a credit check, particularly for persons working in sensitive positions where they are collecting money or writing checks. It may be necessary to insist that persons in such positions permit ongoing credit checks once they have been hired.

"The Fair Credit Reporting Act imposes strict limits on the ability of a company to do a credit check on an employee without his or her permission" she says, "so it's wise to get permission in writing during the employment process." Recently, Ghezzi worked on a fraud case where the company suspected someone was stealing cash. In such cases she recommends reviewing the credit history to see what the individual owns and owes. "If the person is accumulating assets, which can be essential in pinning down fraud, unless he can show he is the recipient of an inheritance, he'll have a lot of explaining to do," says Ghezzi. But in this example the company hadn't received permission to do a criminal background check during the hiring process and couldn't conduct an investigation without notifying the employee.

Another important precaution for companies, advises Ghezzi, is to have written policies specifying hours of employment, holidays, grievance procedures, and prohibitions against discrimination on the basis of race, sex or age, as well as detailed policies proscribing sexual harassment. Ghezzi urges CPAs to suggest companies secure written statements showing that employees have been informed about such policies and understand the consequences. The importance of having written rules cannot be overstated. For example, Ghezzi says she saw a company sued for damages when one of its staff members had a three-martini lunch and caused a car accident on the way back to work. Because the company did not have a "no drinking" policy in writing, it was vulnerable in a civil lawsuit.

Furthermore, all employees and managers should attend training sessions on workplace policies. This allows an employer to demonstrate that, in the case of a lawsuit, it did not just warn employees and managers about inappropriate behavior, but required training to help prevent it. Ghezzi also recommends that companies provide a hot line to make it possible for employees to communicate problems anonymously.

TIP 4 EXAMINE CONTRACT LANGUAGE

Most CPAs say their analytical expertise is very attractive to businesses when dollar losses are at stake. Thus companies are likely to summon them to guard against cases involving fraud and embezzlement and breach-of-contract and intellectual property (IP) disputes. CPAs can structure companies' royalty payment agreements, for example, to conform to the terms of the licensing deal in order to avoid intellectual property squabbles--an increasingly common area of contention in the technology and pharmaceutical fields (see "Techniques to Turn Intellectual Property Into More Profitable Assets," Jof A, Sep.01, page 20).

Badly constructed royalty agreements result in misunderstanding among parties and lawsuits, says Christian Hughes, CPA, partner at PricewaterhouseCoopers' dispute analysis and investigations practice in Boston. Too often, he says, companies use a sloppy and haphazard process to protect their intellectual capital. "Very often we see people signing agreements based on the last one they had and they just change the names in the contract," says Hughes. "We see smaller companies start without input from legal professionals or advisers with business savvy, which is a good way to invite lawsuits," he adds. Simply employing a CPA with real-world experience in IP matters can save businesses a lot of"suspicion and confusion" later.

One common area where lawsuits arise, says Hughes, is in calculating royalties derived from licensing IP. The terms of the agreement can specify "10% of the profits" but in practice the parties can interpret the term profit differently. For example, an inventor of a software program assumes it refers to gross profits, only to find herself with little or nothing because a licensee is paying 100% of after-tax profits. Hughes observes the parties can avoid a dispute simply by agreeing on a noncontroversial payment formula that is easy to understand. When Hughes' firm helps clients prepare such royalty contracts, it tries to simplify the calculations by using 10% of the amount shown (on line 36, for example) on the client's monthly income statements--a formula Hughes calls "simplicity of verification." He suggests such precautions go far toward helping clients avoid legal problems.

TIP 5 BE WILLING TO WORK WITH A THIRD PARTY

If a business sees certain signs such as missing funds or critical documents or troublesome customer complaints, it may be time to call on the CPA litigation consultant. A former FBI agent who is the regional director of forensic accounting at a Big Five firm and who asked not to be named says: "CPAs are trained to spot weak controls. Management may have blinders on. Sometimes you need a third party to look around and show that bad decisions are being made"

Before a company chooses an outside expert to implement risk management processes, it needs to evaluate his or her credentials. Ghezzi says company risk managers must be sure a CPA litigation consultant has the right expertise, such as training in interview techniques, and industry-specific experience, particularly if the parties anticipate the possibility of testifying in court.

For companies with foreign subsidiaries, CPAs can offer their expertise to unearth schemes to siphon off funds, launder money and even bribe government officials (see "The CPA's Role in Fighting Money Laundering," Jof A, Jun.01, page 26). Both businesses and government bodies engage CPAs to ferret out corruption and install competitive bidding systems, ensuring that goods and services under contract are needed, priced fairly and actually delivered--making it harder for bid-rigging, kickbacks and graft to occur.

Where do companies find the CPA experts? Ghezzi markets her services through state CPA societies and the Association of Certified Fraud Examiners. "My work comes through word of mouth and referrals," says Paul Regan, CPA, certified fraud examiner from Hemming Morse Inc. in San Francisco, whose assignments have included the Miniscribe and Sunbeam investigations. Often companies against whom Regan has testified have enlisted his services for subsequent engagements. Once a company has selected the litigation consultant, typically it is the corporate general counsel's office that hires the individual or CPA firm.

Many regional CPA firms and consulting companies that specialize in forensic accounting and litigation services are adding preventive work to their portfolio. "We're seeing increased interest from companies that want to limit their exposure to potential fraud and manage their risk," says Diane Womack, CPA, director in the New York office of FTI Consulting, an Annapolis, Maryland-based consultancy specializing in financial and litigation advisory services. "More companies are taking preemptive steps to detect problems early rather than waiting for them to develop," says Womack. How does a company know it got its money's worth of risk reduction services? The litigation expert achieves success when the client doesn't get sued.

EXECUTIVE SUMMARY

* AS PART OF THEIR RISK MANAGEMENT strategy, companies are increasingly hiring an array of experts, including CPAs, to review their policies and controls and scrutinize internal procedures to help keep them out of the courthouse.

* CPAS ACCUSTOMED TO ASSESSING controls can recommend these "best practices" to their clients: Incorporate ethics policies into the company mission statement; inform employees of responsibilities through training, procedure manuals and other internal communications; conduct periodic reviews of compliance programs to keep them current; and have a senior executive in charge of compliance and regulation to signal the importance of corporate integrity.

* CPAs CAN ENCOURAGE THEIR CLIENTS to include arbitration clauses in their contractual agreements or to select alternatives to litigation when disagreements arise.

* BESIDES RESOLVING ECONOMIC DISPUTES, CPAs can help companies protect themselves against problems involving discrimination in hiring and promotions, sexual harassment allegations and wrongful termination. In such cases, CPAs can work closely with human resources departments to identify problems in advance.

* CPAs STRUCTURE ROYALTY PAYMENT agreements for companies to avoid intellectual property squabbles--an increasingly common area of contention in the technology and pharmaceutical fields. CPAs can help their clients avoid disputes by offering them simple payment formulas that are easy to understand.

* IF A BUSINESS SEES CERTAIN SIGNS of weak controls, it may be time to call on a CPA consultant. Before a company chooses such an expert to implement risk management processes, it needs to evaluate his or her credentials.

RELATED ARTICLE: Risk management programs need improvement.

In a study assessing current practices, most (65%) senior executives from 400 companies in a wide range of industries said they lacked confidence their risk management programs identified and managed all potentially significant business hazards.

Source: Risk Management: An Enterprise Perspective, survey by Andersen and Financial Executives International, 2001, www.andersen.com and www.fei.org.

PAUL SWEENEY is a freelance writer in Brooklyn, New York. His e-mail address is [e-mail].