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A commonsense approach to financial fraud cases.

The omnipresence of financial fraud in the United States means that attorneys may face these cases almost daily. Despite the perception that the current financial scandals are difficult to understand and complicated to untangle, they largely emulate past incidents.

In recent years, even companies with no product and negative cash flow maintained exorbitant stock prices. High-flying technology companies and Fortune 100 firms used aggressive, and sometimes fraudulent, accounting practices with the excuse that "everybody is doing it." In the lenient atmosphere of Wall Street, accounting sometimes crossed the line into outright manipulation of financial information, including inflated numbers, misleading projections, and falsified sales of products.

Attorneys can identify and challenge financial fraud by learning from history and following three rules.

Rule #1

The first rule in determining whether a case involves financial fraud is to follow your instincts. If it sounds too good to be true, it usually is.

In the 1970s and 1980s, tax law allowed real-estate investors to take write-offs on investments in partnerships that had no economic substance. The laws let them pursue other practices that generated rates of return far above those offered by legitimate investments, and greed prevailed over good sense.

More recently, companies abandoned fundamental investment principles, such as having a product ready to market before going public or basing financial projections on historic trends instead of on speculation about the future. This led to soaring NASDAQ price/earnings ratios (the current price per share divided by its company-reported earnings), rising from an average 40 to 1 in 1996 to over 240 to 1 in 1999--numbers that are just too good to be true.

Rule #2

The second rule in analyzing a financial fraud case is to keep it simple. Some of the largest financial frauds in history relied on basic scares. For example, the "Ponzi" scheme, born in the early 1900s, simply used new investments in worthless securities to pay the returns on old investments--a pyramid destined to collapse. In the real-estate bubble, developers used false appraisals to overvalue properties and took out loans on them that exceeded the properties' worth. In the recent accounting debacle, companies inflated revenues by reporting sales that never took place and recycled cash using a scheme similar to money laundering. There is nothing new under the sun when it comes to financial fraud; the purpose of recent scams is just to steal other people's money.

Rule #3

The third rule is to look in the right places. Take advantage of online resources that describe the cases being discussed and prosecuted.

Many firms that handle securities cases subscribe to specialized business information sites, but a wealth of free information is also available on the Internet, including chat rooms where people who have been affected by financial fraud exchange information. Several Web sites contain information about companies under investigation and the "red flags" that triggered the probes. These sites include:

* the SEC filings database, called EDGAR, at

* a corporate defense counsel information bank at



The collapse of Enron and other multibillion-dollar corporations has heightened the government's desire to stop financial fraud, but it cannot solve the whole problem. Accounting firms, once considered the "public watchdogs" of corporate financial responsibility, now need a special oversight board to watch them. That board, created by the Sarbanes-Oxley Act last year, has taken little action except to decide that the board members will be paid over $450,000 per year. SEC staff has also recommended watering down many of the Sarbanes-Oxley regulations. For example, it will allow auditing firms to provide tax services to their clients, softening a critical rule on auditor independence.

Recently, New York Attorney General Elliot Spitzer, after investigating an analyst who recommended a stock in public while telling his best clients to sell it, reached a $1.4 billion settlement with several large Wall Street investment banks. This settlement is only the tip of the iceberg. Losses from the financial abuses of the recent bubble are in the trillions.

There is no quick fix, and new, undetected financial frauds are hatched every day. Sending those who betray the public trust to prison is a start, but a private bar willing and equipped to prosecute civil cases is critical to a long-term solution.

Your comments welcome

Please address all correspondence to Letters to the Editor, TRIAL, 1050 31st St., N.W., Washington, DC 20007-4499, fax to (202) 965-0030, or send e-mail to TRIAL reserves the right to select, edit, and excerpt letters to the editor for publication.

Bruce L. Simon is a partner with Cotchett, Pitre, Simon & McCarthy in Burlingame, California.
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Author:Simon, Bruce L.
Date:Apr 1, 2003
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