The delinquent borrower: an esteemed bank manager turns to fraud after falling behind on his loan payments.

STEVE PATRICK WAS THE KIND OF employee everyone loved. His supervisors viewed him as hard working, experienced, and knowledgeable. Other employees enjoyed his light-hearted work style and desire to help out when needed.

Patrick served double duty as a loan officer and manager of customer service at West Side Community Bank (WSCB), a small financial institution in the southwestern United States. With a tight budget and limited resources, management at WSCB recognized the importance of hiring employees with adequate professional experience, an array of skills, a positive attitude, and the ability to "hit the ground running"--all attributes that Patrick clearly demonstrated during his interview with the bank.

When asked during the interview why he was changing jobs at this point in his career, Patrick noted that he was looking to leave his current situation to work closer to home. Satisfied with this response, WSCB disregarded company policy and hired Patrick without doing a bondability check. Management was impressed with Patrick's resume and did not even bother to call his former employers.

Had the bank followed standard protocol and checked into Patrick's references, it would have discovered that he, in fact, was not currently working and had been fired from the last financial institution where he was employed. Additionally, a background check would have revealed a suspicious situation at another bank where Patrick had worked, involving missing cash from the vault and many red flags signaling Patrick's involvement. However, a background check was not conducted, and Patrick was hired, bonded, and viewed as a positive, energetic employee with good work experience.

With approximately 15 employees, WSCB was something like a family and, once hired, Patrick treated it that way. He often brought his young children into the bank to meet the employees and play in his office while he was working.

Because Patrick supported his family of five on his modest salary from WSCB, it seemed odd that he was able to take frequent extravagant vacations. However, many employees believed Patrick's financial stability was due to significant help from other family members.

What Patrick's co-workers didn't know was that he had incurred significant personal debt with WSCB. During his first few years at the bank, Patrick had racked up a mortgage, a home equity loan, a credit card, a car loan, and an overdraft loan, all of which carried considerable balances. Although he was probably not qualified for a large portion of these loans, the bank had more lax lending standards when it came to its employees. In addition, it helped that Patrick had become very close with his supervisor, the vice president of loans, who personally approved all of Patrick's loan applications.

In reality, Patrick could not manage the high debt load and apparently did not have the family help everyone assumed. Consequently, he fell behind on paying several of his loans with WSCB. In light of Patrick's delinquent borrowing status, management decided to take away his duties as a loan officer; however, he was left in charge of the customer service department, a managerial position. Patrick was upset over the removal of his loan granting authority, and he frequently complained to fellow employees about it. Because of his popularity at WSCB, many employees sided with Patrick and voiced their feelings about his situation to management and the board of directors.

The cutback in his employment status at the bank started a snowball effect of financial troubles for Patrick. With the removal of his loan officer status, Patrick's salary was reduced. Clearly, the decrease in salary made the repayment of the loans even less likely. Nonetheless, management notified him that they expected all of his loans with the bank to be paid up to date.

As a routine security measure, the bank's internal auditor, Victoria Dorris, was notified of any situations involving employees who had become delinquent on their loans. As such, Dorris periodically began reviewing Patrick's WSCB accounts and sampling some of his banking transactions. Approximately two months after his demotion, one transaction--a large check deposited into Patrick's WSCB account from Western National Bank (WNB)--stood out, and Dorris determined that further analysis was required.

A portion of this particular check was used to make a payment on Patrick's overdraft loan, bringing the loan current, and the remainder of the funds were deposited into Patrick's checking account. Because no other information was provided on the check, Dorris decided to contact WNB to determine the purpose of the payment. After several calls, Dorris spoke to Robert Watts, an employee at WNB who provided some useful information concerning the check and its origins.

Dorris determined from her discussion with Watts that the deposit into Patrick's account represented the proceeds from an unsecured loan taken out at WNB to pay off the delinquent overdraft loan at WSCB. Apparently, Patrick was attempting to create cash flow to bring his WSCB loans current so that he could get his loan officer status reinstated.

From further investigation and a discussion with Samantha Smith, the WSCB teller who processed Patrick's deposit, Dorris determined that Patrick had used his managerial position and general goodwill with his co-workers to apply the check proceeds as he wanted, rather than according to his stated intent when he obtained the new loan. According to Watts, the entire check was to be used to pay off Patrick's overdraft loan at WSCB in full; however, only one payment was made on the overdraft loan. Patrick used the remainder of the funds from WNB to bring some of his other loans current and to pay other expenses. The net effect of Patrick's manipulative use of the funds was that both WNB and WSCB were defrauded. Patrick was able to increase the amount of unsecured loans granted to him without the knowledge or consent of the lenders, which deceitfully raised the credit risk to both institutions.

Smith, while speaking with Dorris, noted that Patrick explicitly directed her not to pay off the entire loan, which she believed was permissible because he was a manager. Although WSCB management did find fault with Smith's failure to follow protocol, the situation was understandable, as Smith thought she was simply following orders from her superior. As a result, Smith was disciplined for her action but not terminated.

When Patrick was presented with Dorris' discoveries, he acknowledged what he had done, but claimed that he believed his actions were justified because management had taken away his loan officer status "for no reason." Patrick also stated that he thought he was just doing what WSCB's management wanted because he was paying his loans and keeping them up to date. Further, Patrick said, he did not believe his transactions at another financial institution were the business of WSCB management.

Based on Patrick's admission that he willingly violated the restrictions placed on the new loan proceeds and intentionally misused funds appropriated for repayment of an WSCB loan, an incident report was prepared and submitted to the bank's bonding company. As a result, Patrick lost his bond and was terminated from the bank. With his history of dishonesty and less than stellar employment record, Patrick struggled to obtain work. He finally landed a job as a cashier at a local discount superstore. Not surprisingly, Patrick eventually defaulted on his loans with WSCB. In the end, the bank charged off US $215,000 in uncollectible loans that had been extended to the once-esteemed manager.

LESSONS LEARNED

Small organizations face unique and difficult internal control issues. Often, the employees at such organizations are much closer than employees at large institutions, which can increase the trust factor and allow workers to justify circumventing established internal controls. To help prevent a scheme like Patrick's from successfully penetrating an organization, internal auditors should keep in mind several recommendations.

* Always conduct background checks on new hires. Additionally, in industries that require employees to be bonded, make sure the company conducts a bondability check. Bonding companies can be a fantastic resource for small companies with meager budgets.

* When employees with significant authority appear to be living above their means, carefully investigate ways in which they could abuse their authority and defraud the company. Also, increased scrutiny of their work and financial transactions, if applicable, may be a reasonable response to the potential risk.

* Companies' internal lending standards should not be loosened for employees. Standards are in place for a reason and should apply to all applicants, regardless of where they are employed. Clearly, the bank increased its default risk by making loans to Patrick that it would not have made to a typical customer.

* All employees, even those who are well-liked and respected, should fall under the scrutiny of internal audits and internal controls. Often it is easy to overlook issues or become too comfortable with employees in a small-business environment where everyone knows each other personally.

* All employees must report unusual or unethical requests, even if they are from a manager, to another manager or the internal audit department.

ERIC SUMNERS, CPA, is an assistant professor of accounting at the University of Maryland University College in Adelphi, Md.

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EDITED BY ANDI MCNEAL