Case Studies

Fraud

#1: Forensic Accounting, Prosecution

A bookkeeper, and family friend of the business owners, knew the accounting system inside out. He was also completely trusted and he decided to take advantage of the close relationship and total access to the money of the business. Over three years the bookkeeper stole several hundred thousand dollars.

An IRS audit ultimately blew the whole scheme apart. The outside CPA called the business owner and said that getting information from the bookkeeper for the audit was ridiculously hard and that none of the numbers were adding up. The owner responded by retaining Arxis to come in to the business to review the records. Within an hour it was evident that cancelled checks did not match the accounting records for the business and that many checks had been forged. The bookkeeper had established a bank account for a fake business and had written checks to this business.

Arxis conducted the investigation, prepared a report and supporting file, and the client submitted the evidence to the prosecutors’’ office. Criminal charges are pending against the bookkeeper.

#2: Forensic Accounting, Court Testimony

The accounting staff of a company discovered strange transactions on their monthly bank statement. The employee who normally opened the bank statement was unexpectedly out that day and one of the owners decided to take a look. It became quickly obvious, even to an untrained eye, that something was wrong. The initial assumption was that there was a bank error.

Arxis Financial was retained to resolve the problem. Once on-site, it became obvious to a trained eye that it was not a bank error, it was fraud. What began as a reconciliation engagement became a full-fledged fraud investigation and prosecution. After eight hours of forensic work, enough evidence was gathered to support a report proving the defalcation and quantifying the total loss.

Chris Hamilton eventually provided key evidence in Los Angeles Superior Court that was instrumental in proving the case against the employee.

#3: Bank Reconciliations, Internal Controls

Arxis was hired to do a review of the accounting records of a business because senior management was suspicious of the financial reports they were receiving from the controller. The reports just didn’t make sense and there was a sense that the accounting department was sloppy and out-of-control.

The first step was to review bank reconciliations. It was represented by the controller that they were current. However, it was quickly determined that bank reconciliations had not been completed for over 20 months. It was further established that the cash records were incomplete and as sloppy as perceived. And, this was just the beginning.

The result of the investigation was that there was no embezzlement. Every dollar was eventually accounted for. The controller had simply been exposed as under-qualified and overpaid. Arxis assisted in hiring a new controller and establishing a system of internal controls that would assure complete, accurate, and timely financial reporting. The owners of the business realized when the engagement was done how fortunate they were that the controller was not dishonest to the same level as they were incompetent.

#4: Forensic Accounting, Trial testimony, Defense

A prestigious law firm contacted Arxis with an unusual request. They had a client who was the defendant in a lawsuit alleging fraudulent behavior. The law firm requested that Arxis examine the records and develop an opinion regarding the case, how to present it, and most importantly they wanted an opinion as to whether their client was guilty of the allegations. This was the beginning of a series of cases extending over several years that resulted in one jury verdict and two bench verdicts all in favor of the law firm’s client.

Early in the case Arxis requested authorization to completely recreate and recast the financial statements for the entities involved in the alleged fraud. The client and the law firm gave the authorization and each transaction was analyzed, classified, and recorded. When the accounting work was done it was obvious the client was not guilty of the many accusations and the law firm had the basis to present a vigorous defense. In addition to the favorable verdicts, the client received a written apology from the plaintiff.

In one of the bench verdicts, the court noted that the testimony of Chris Hamilton was “His detailed testimony that followed was vastly more persuasive than any contrary evidence” and “his testimony was perceived as accurate and knowledgeable.”

#5: Embezzlement of Company Funds

Summary of Issue: Members of the board of directors contacted Arxis Financial, Inc. to discuss a strange pattern of information and lack of information being provided to the board. The conference call revealed that once the board began asking questions of management, the CEO resigned. After an initial discussion it was determined that the pattern suggested more than incompetence. Several facts pointed towards potential fraud.

Money involved: Over $200,000 was found to have been misappropriated.

Arxis’ work: We proposed a multi-stage engagement. Phase 1 was designed to establish whether there was evidence confirming fraud rather than simply incompetence or sloppiness by management. Phase 2 was designed to quantify a preliminary loss given specific parameters determined in phase 1. In simple terms, phase 2 was designed to pick the “low hanging fruit” and establish the basis for the board to determine a legal course of action, if any. Phase 3 was designed to complete the investigation and prepare for civil or criminal prosecution.

Phase 1 established that indeed there was evidence of both management sloppiness that allowed for unauthorized financial transactions, as well as evidence that such transactions had taken place. On the first day that Arxis was on-site the CFO resigned. The board was completely unaware that there were no internal controls.

In phase, 2 Arxis reviewed several years of bank reconciliations and traced cancelled checks and deposit slips back to the accounting records. This process exposed unauthorized payments as well as a sophisticated attempt to cover the payments so that reports to the board would not reflect the actual economic activity. Arxis presented the findings to the board and recommended that phase 3 was not necessary as there was no insurance to cover the loss and the board had determined that there would be no prosecution.

Result: Arxis assisted in assuring the security of the computer network and establishing a system of internal controls and reporting that, if maintained, would eliminate the possibility of continuing problems. The board of directors terminated several members of senior management and the outside audit firm. Arxis assisted the company with the identification and hiring of qualified accounting staff and replacement auditors.

#6: Fraud and Theft of Residential and Commercial Real Estate and Cash and Marketable Securities

Summary of issue: Arxis Financial was hired by plaintiffs, an elderly couple who believed they had been swindled. The couple was, at one time, very wealthy with extensive investment in residential and commercial real estate – all of which was completely debt-free. Additionally, they had substantial wealth in cash and marketable securities that were growing from the cash flow provided by the real estate holdings. Among the allegations was that defendants re-titled (stole) real property, encumbered the properties, that were not re-titled, with debt (proceeds disbursed to defendants) and that cash had been stolen from checking accounts. Arxis was hired to quantify the money that was stolen. Other experts were retained to deal with the real estate-related fraud.

Arxis’ work:

Discovery – Extensive research had been done prior to our involvement in the case – discovery was closed already. We were provided with 954 exhibits and several depositions including those of the defendants.

Forensic – Work was done to quantify the losses based on an incomplete record of transactions. It was unfortunate that we were retained “too late” in the case to assist with efficient and adequate discovery. 954 exhibits was a lot of information but much of it was incomplete or irrelevant.

Trial – Trial was held involving testimony from several experts. The accounting testimony took several hours and established the flow of money and evidence that the transactions were hidden or misrepresented to the plaintiffs. It was established that several hundred thousands of dollars were stolen.

Result: Verdict in favor of the plaintiffs. Real property was returned. Further restitution is still underway.

#7: Fraud & Identify Theft of Elderly Victim

Issue: Arxis was contacted to assist the elderly victim of abuse. The victim reported that she had not gotten mail in a while and that a strange lady had come into her home uninvited. The concern was that personal papers and forms of identity had been stolen thus exposing all of the cash, investments and other assets to theft. The client requested that we verify that current holdings were intact and to prevent the loss of cash and investments.

Arxis work: The fact that all mail had apparently been diverted caused concern that identity theft and other crimes had been in process for a long time. We immediately visited the banks and brokerage firms to discuss the activity in the accounts. It became apparent right away that our worst fears were realized. Hundreds of thousands of dollars had been stolen from several checking accounts and a brokerage account. We also found that serious attempts had been made to access additional accounts.

We determined that the first step was to shut down every account and consolidate all cash accounts into one bank account and all investment accounts into one. All credit cards were closed. The mailing address for all vendors and banks were established at a remote location under the control of a trusted caretaker of the records. Signature and password protection was established to prevent unauthorized access. Tracing was initiated that resulted in identifying the names and physical location of the people who were operating the scheme.

Result: Most of the stolen money was recovered through insurance claims filed by the banking institutions and our interfering with the theft that was actually in-process when we got involved. Interrupting the scheme allowed us to stop it, rewind some of it, and identify with significant confidence who was abusing our client.

Police reports were filed – to no avail. Apparently, elder abuse is so pervasive that the police do not have sufficient resources to pursue or prosecute crimes of this nature. The client was restored to her financial position before the theft took place. What took much longer was the restoration of her sense of security and personal safety. It resulted, ultimately, in her moving from her home before she felt completely safe.

#8: International Corporate Fraud & Internal Controls

Issue: A busy week was interrupted by a phone call from a person who, it turned out, was cold calling forensic accounting firms that might be able to help with a fraud examination. After a brief telephone interview, arrangements were made for a meeting later that same afternoon. The meeting was between the senior management of the firm, the shareholders, corporate counsel and Arxis Financial. After introductions, the management group began to describe the circumstances leading to their initial phone call.

For several years the company’s CFO was a trusted and reliable member of the management team. In fact, she had established herself as the most reliable resource in the firm and was viewed by management, owners, and employees as the de facto leader of the company. As such, she was completely trusted and never gave any reason to question that trust – until recently. They proceeded to describe a pattern of behavior that started as strange, progressed to bizarre, and then to simply unacceptable. In the midst of her behavior, there were increasing questions about her ability to do her job and nagging concerns about why the business was so cash starved. After a few questions it became obvious that the nature of the engagement was not primarily concerned with the question of whether fraud had taken place but rather how much had been stolen. This proved to be true.

Arxis Work: A fraud examination commenced immediately while the CFO was put on paid leave. What we found was astounding in two aspects. First, there were absolutely no internal controls. Second, the company’s exposure to potential loss was vast and while it was found that embezzlement had taken place it was nowhere near what it could have been. The loss was quantified and documented and insurance claims filed appropriately. The company made a decision whether to prosecute the now-retired CFO. In addition to quantifying the loss, Arxis Financial was very involved in establishing policies and procedures to prevent similar problems in the future.

The company had divisions in several countries located on all five continents of the world. As such, enormous amounts of money were moved via wire transfer on a daily basis. The CFO had complete control and sole knowledge of both sides of the transfers. She had the authority to make the transfers and record the transfers. There were no reconciliations done nor was reporting done to anyone else in the organization. All confirmations from the remote offices came to the company – via the CFO’s email. The exposure in just this area amounted to millions of dollars. Arxis Financial immediately initiated a change of all passwords and arranged with the bank to institute controls over the movement of money initiated by company personnel.

Arxis Financial also found that the CFO initiated all disbursements, signed checks, received and reconciled all bank statements, and recorded all transactions in the general ledger. Deposits were handled by an AR department but all deposit records were given directly to the CFO. All payroll and HR functions were under the control and authority of the CFO as were purchasing, receiving, and all subsidiary and divisional accounting. Arxis Financial, with the cooperation of management, established a system of internal controls to prevent the possibility of theft or errors going unnoticed. Accounting functions were assigned to several people rather than localized with just one person.

While this is a sad story, it is anything but an unusual event. Most fraud is committed by trusted employees who find a way to exploit that trust – or they take advantage of the opportunities right in front of them. The most basic elements of internal control were suppressed because of the long personal relationship with the CFO and the tremendous trust that came with years of faithful and competent work. However, when the personal life of the CFO began to unravel, there were no systems in place to prevent, or quickly expose, the embezzlement.

#9: Embezzlement Scheme: Lessons Learned

“I Can’t Believe It Happened to Me – I Should Have Known”

The shock of realization when a victim recognizes that a trusted employee – and even a friend – has stolen from them ranges from sad to tragic. It is a very personal feeling of betrayal and violation. It strikes fear in some, grief in others, and anger in most. In my experience, it is almost always accompanied by a sense that “I should have known this was going on.” The evidence of theft sheds a very bright light on the rearview mirror. Patterns and circumstances take on a clarity that contemporaneous experience either hid or obscured. Sometimes the clarity was there but for a variety of reasons it was ignored.

The following is just such a case – the victim immediately recognized the theft and simultaneously felt incredibly stupid for “allowing it to happen.” The lesson cost him several hundred thousands of dollars in uninsured losses. The recognition happened when his bookkeeper unexpectedly missed a few days of work and he ventured into the mail and opened a bank statement. The simple act of thumbing through cancelled checks from one month’s bank statement prompted a phone call to his attorney who directed him to a forensic accountant.

What developed was evidence of a simple and devastatingly effective embezzlement scheme. The bookkeeper had set up vendors that were very similar to existing real vendors. For example, if the real vendor was ABC Service Company then a fake vendor was established called ABC Service Co. The bookkeeper went to the bank and set up bank accounts for the fake vendors. That was the hard part. The rest was easy. The business owner signed hundreds of checks to the fake vendors thinking the checks went to legitimate business activity.

Since that worked so well, the bookkeeper began forging checks made payable to pay the vendors, personal expenses, and provide cash gifts to family and friends. And, since all that worked without any notice by the business owner, the bookkeeper got an unauthorized increase in salary. It was bold. It was also easily discovered and should have been easily prevented.

The bookkeeper was pretty quickly arrested and has spent some serious time in jail. The following are Fraud Prevention 101 steps that were ignored and could have prevented the fraud.

• Know your employee. In this particular case the business owner recounted that he knew the prior employer of the bookkeeper really well. He was aware that the bookkeeper had left the prior employer on less than positive terms but figured it was none of his business and hired the bookkeeper because of knowledge of the industry. A phone call to the prior employer/friend after the embezzlement was discovered revealed that the bookkeeper was probably stealing from the current employer to pay off a judgment obtained by the prior employer to recover embezzled funds.

• Embezzlers tend to be repeat offenders. This is an obvious follow-up to the prior point. A simple background check is not expensive, easy to do, and in this case would have prevented a really bad hiring decision. It would have confirmed the ill-at-ease feeling of the employer at the time of hiring.

• Open your own mail. Let the bookkeeper do the bookkeeping. You cannot abdicate other important (and seemingly unimportant) functions because the clerk is always around and does their job well. Vendor communications, bank statements, and bills from vendors and suppliers are important sources of information.

• Separate functions and duties. Many small business owners are so busy that they tend to overlook common sense when assigning work. In this case a bookkeeper was eventually given the responsibility for answering the phones, opening all the mail, writing checks, making deposits, preparing invoices, reconciling the bank statements, and preparing the financial reporting provided to the business owner and his outside tax preparer. As noted above, simply opening the mail would have prevented some of the problems – or would have caught it a lot earlier.

• Don’t accept bad answers to good questions. When the forensic accountant arrived on-scene, the business owner requested a report showing payments to all vendors. The request was preceded with a long list of qualifications recognizing that it was difficult to put such a report together, would take a long time, and would not be precisely correct. The accountant produced the report in about 90 seconds. The business owner was shocked – and the point was made. His bookkeeper, for a long time, had prevented him from seeing the very report that exposed the whole scheme. He had been given every reason in the book why the report couldn’t be produced.

• Force vacations. Nobody else had access to the bookkeepers work for over two years. Any other eyes on the accounting records would have exposed everything.

• Acknowledge your instinct. If the lifestyle of the employee exceeds what you know about their legitimate compensation there is good reason to look harder. If the bookkeeper can’t produce simple reports from “the books” they are keeping there is a problem. If you feel like you are working for the bookkeeper rather than them working for you, something is wrong. If it feels like the business is doing better than ever but there isn’t any cash there is good reason to find a reasonable explanation. All of the bullets were separate points of recognition by the business owner in this case – “I knew something wasn’t right. I should have known this was happening.” That is never good after-the-fact.

#10: Embezzlement: What the Auditors Could Not Find!

Type of Matter: The Board of Directors and senior management of a large company with several divisions began to suspect that a division controller was embezzling significant amounts of cash. They initially brought in the outside auditors to review bank reconciliations and other reporting for the division. The company spent material amounts of money for up to 6 staff members from the outside audit firm reviewing bank reconciliations for over a week. The Board members began to get uncomfortable with the results of that review and decided they needed a focused fraud examination and called Arxis Financial.

Arxis Work: At the initial meeting with Arxis Financial, the bank reconciliations were specifically excluded from the work scope approved for Arxis. While this was understandable due to the enormous cost of reviewing them already, it became a point of significant contention. Ultimately, we refused to take the engagement unless we were allowed to review the bank reconciliations – essentially covering the same territory as the outside audit firm. Either the reconciliations accurately reflected the activity in the accounts or they were being fabricated to hide illicit activity. Either way, it was the logical starting point.

Once we were authorized to review the bank reconciliations we began work. On the first day it was determined that the reconciliations were indeed problematic. What became apparent very quickly was that the beginning cash balance on any given reconciliation did not agree with the prior month’s ending cash balance. The client was relieved that it did not require a week of Arxis Financial’s time to evaluate the reconciliations.

Once we had proof that there were anomalies in the accounting for cash, further investigation was initiated to determine if the discrepancies were the result of human/software error or the result of intentional manipulation and misrepresentation.

Result: We found that material and significant misappropriation of company assets had taken place over an extended period of time. As a result of our fraud investigation, the Controller was terminated, arrested subsequently convicted, and is serving time in state prison. The method of hiding the embezzlement was so simple that apparently 6 auditors didn’t think to check it, which although disappointing to the company, is a key reason why a professional fraud investigation team should be engaged to investigate such suspicions.

We provided several recommendations for company management in order to minimize the chances of future embezzlement. The company was greatly pleased with Arxis Financial’s expertise, expediency, successful investigation and recommendations.

#11: 7 Simple Steps to Corporate Fraud Prevention: A Case Study

The shock when a victim discovers that a trusted employee – and even a friend – has stolen from him or her is absolute. It’s a feeling of betrayal and violation that strikes fear in some, grief in others and anger in most.

In my experience, it is almost always accompanied by a sense that the victim should have known it was going on. The evidence of theft sheds a bright light in the rear-view mirror. Patterns and circumstances take on a clarity that contemporaneous experience obscured. Sometimes the clarity was there but for a variety of reasons it was ignored.

A Case Study

A victim uncovered theft when his bookkeeper unexpectedly missed a few days of work and he opened a bank statement. The simple act of thumbing through cancelled checks from one month’s bank statement prompted a phone call to his attorney who directed him to a forensic accountant. The internal fraud was revealed, he felt stupid for allowing it to happen and the lesson cost him several hundred thousands of dollars in uninsured losses.

The forensic accountant uncovered evidence of a simple but effective embezzlement scheme. The bookkeeper had set up vendors that were very similar to existing real vendors. For example, if the real vendor was ABC Service Company then a fake vendor was established called ABC Service Co. The bookkeeper set up bank accounts for the fake vendors. That was the hard part. The rest was easy. The business owner signed hundreds of checks to the fake vendors thinking the checks went to legitimate business activity.

Since that worked so well, the bookkeeper began forging checks to pay the vendors, personal expenses, and provide cash gifts to family and friends. And, since all that worked without detection by the business owner, the bookkeeper took an unauthorized increase in salary.

It was bold. It was also easily discovered and should have been easily prevented. The bookkeeper was quickly arrested and has spent time in jail.

Fraud Prevention 101

The following are fraud prevention steps that were ignored and could have prevented the theft:

Know your employee. In this particular case the business owner recounted that he knew the prior employer of the bookkeeper well. He was aware that the bookkeeper had left the prior employer on less than positive terms but figured it was none of his business and hired the bookkeeper because of knowledge of the industry. A phone call to the prior employer/friend after the embezzlement was discovered revealed that the bookkeeper was probably stealing from the current employer to pay off a judgment obtained by the prior employer to recover embezzled funds.
Do a background check. Embezzlers tend to be repeat offenders. This is an obvious follow-up to the prior point. A simple background check is not expensive, is easy to do and, in this case, would have prevented a bad hiring decision. It would have confirmed the ill-at-ease feeling the employer had at the time of hiring.
Open your own mail. Let the bookkeeper do the bookkeeping. You cannot abdicate other important (and seemingly unimportant) functions because the clerk is always around and does his or her job well. Vendor communications, bank statements, and bills from vendors and suppliers are important sources of information.
Separate functions and duties. Many small business owners are so busy that they tend to overlook common sense when assigning work. In this case a bookkeeper was eventually given the responsibility for answering the phones, opening all the mail, writing checks, making deposits, preparing invoices, reconciling the bank statements, and preparing the financial reporting provided to the business owner and his outside tax preparer. As noted above, simply opening the mail would have prevented some of the problems – or would have caught it a lot earlier.
Don’t accept bad answers to good questions. When the forensic accountant arrived on the scene, the business owner requested a report showing payments to all vendors. The bookkeeper had previously argued that it was difficult to put such a report together, would take a long time, and would not be correct. The accountant produced the report in about 90 seconds. The business owner was shocked – and the point was made. His bookkeeper, for a long time, had prevented him from seeing the very report that exposed the whole scheme.
Force vacations. Nobody else had access to the bookkeepers work for more than two years. Any other eyes on the accounting records would have exposed everything.
Acknowledge your instinct. If the lifestyle of the employee exceeds what you know about their legitimate compensation there is good reason to look harder. If the bookkeeper can’t produce simple reports from “the books” they are keeping there is a problem. If you feel like you are working for the bookkeeper rather than them working for you, something is wrong. If it feels like the business is doing better than ever but there isn’t any cash find out why.

All of the steps above were recognized by the business owner in this case: “I knew something wasn’t right. I should have known this was happening.” That is never good after the fact.

#12: Fraud Examination with Surprising Results

Type of Matter: Business partners in multiple real estate transactions stretching over many years had a falling out that eventually resulted in a claim of fraud against one of the partners.

Background: Over 20 commercial buildings were acquired over several years. Some had been sold and some were still owned jointly. Neither of the partners, jointly or individually, maintained any formal accounting for the purchases, sales, or management of the properties. One of the partners took the lead role in buying, selling, and managing the properties. The non-active partner made claims of substantial amounts of cash that were unaccounted for and presumed stolen.

Arxis was retained by defense counsel to direct discovery and prepare a forensic accounting needed to establish whether the money had indeed been stolen.

Arxis Work: Documentation was needed to establish purchase date, purchase price, identity of property, and source of funds for each of the purchased properties. For properties that were subsequently sold, documentation was needed to establish the sale date, sale price, identity of the sold property, and the distribution of proceeds from the sale. For property that was retained, documentation was needed to establish the source (rent) and use (expenses) of funds for each individual property.

The traditional sources of such information were not available as formal accounting records were not maintained and most relevant records were not even preserved. Third-party sources were used to accumulate deeds, escrow statements, bank statements, and other data to allow us to piece together what actually happened.

Result: Contrary to all expectations, the evidence showed that the Plaintiff had already received substantially more proceeds than were originally invested in the projects. When adding together proceeds plus the fair market value of the property that was still owned, not only had his partner not stolen from him, but he had turned a very healthy profit. Even the defendant was impressed with his own success. Due to the lack of contemporaneous accounting neither party understood that their real estate partnership was actually quite successful.

#13: “Real Estate Fraud: How a Forensic Accountant Saves Clients Money — With Just a Few Questions!”

Summary: Arxis Financial was contacted to assist legal counsel in determining the validity of a fraud claim and the best approach to credibly establishing the claim. The victim was a network of inter-related entities that owned commercial property and undeveloped real estate. Significant cash flow from the entities was managed and controlled by one of the owners. The allegation was that millions of dollars had been fraudulently taken by the manager/owner. The initial contact by the law firm was to retain Arxis to do a preliminary forensic investigation to establish the equivalent of probable cause.

Arxis Work: In this case not a single document was reviewed. No forensic accounting was done. No damage calculations performed. Instead, a series of simple questions established that all the elements of fraud could be easily proven – except one. In this case, the disbursements to the owner were recorded as loans and reported on internal financial statements and tax returns. Therefore, the core of the case would revolve around whether the loans were authorized and whether the disclosures to the other owners over several years constituted ratification or approval of the transactions. Significant work might eventually be done to verify the accuracy and completeness of the accounting and to establish whether additional money was taken through other forms (expenses, distributions, payroll, etc.).

Result: The client was saved a lot of unnecessary accounting fees by redirecting the focus of the efforts away from an accounting and back to a legal question that would eventually be the core of the case.

#14: Fraud Examination with Disappointing Results

Summary: A volunteer in a charity organization noticed unusual relationships and transactions and decided to investigate. What he found was fraud – funds diverted by a staff member to friends.

Background: A religious, charitable organization was very active in matching available funds with specific needs of families. They did not hand out cash. Instead, they paid directly for groceries, car repairs, home repairs, etc. Detailed files were maintained for each of the “clients” providing information on dates of meetings, services needed, services provided, and vendor payment information. A dedicated volunteer noticed that some of the files were not being updated. In other cases, the relationship and payments were not documented at all. The reason given was that everyone was overworked, and they were more intent on meeting the mission of the organization than “filling out paperwork.” The volunteer, with the approval of the Board of Directors, began working on reconstructing data for the client files. It became obvious to the volunteer that payments were being made to one specific vendor on a regular basis when no services were being provided. At this point, the project went from cleaning up paperwork to investigating fraud.

The oversight board ignored warnings about what was discovered. They eventually ordered the volunteer to stop all work and to not discuss his “opinions” publicly. However, with the approval of one board member, the volunteer took the information he had gathered to local law enforcement. Prosecutors determined that there was good reason to look further but encouraged the volunteer to contact Arxis to help put together a well-documented case that they could prosecute.

Arxis Work: Thousands of pages of documentation were provided for review. The records provided were inconsistent and incomplete. This was due to limited information available to the volunteer without access to all relevant data. Work was done to complete an analysis of a single client from commencement of the relationship through payments of a vendor to establish expectations of process and documentation. Even this step was impossible. Without the ability to benchmark, it became nearly impossible to prove unusual or unauthorized transactions.

Analysis was done to determine the documents that would be needed to complete the investigation. In meeting with the volunteer, it became apparent that without the approval of the oversight board or key members of management the documents could not be obtained without the weight and reach of law enforcement. Since law enforcement already referred the matter out for documenting the case and providing evidence, it was obvious they were not able or willing to pursue that step.

Result: In a case where there was significant evidence of malfeasance, there was the inability to document it sufficiently to prove the legal elements of the crime to a trier of fact. This case highlighted two common hurdles to prosecuting fraud. First, it is not always possible to gather evidence sufficient to meet the standards required to pursue a conviction. Second, in an organization where there is a culture that tolerates or encourages fraud, it is difficult, if not impossible, for one or two people to identify and eradicate fraud. There is enormous pressure on nonprofit organizations to never publicly admit financial malfeasance. Therefore, in these situations, there is little motivation to pursue the matter when malfeasance is found.

Family Law

#1: Business Valuation, Forensic Accounting, Discovery, Settlement

A law firm representing the non-moneyed spouse in a divorce retained Arxis to assist in identifying and valuing assets as well as establishing income for the moneyed spouse. The marital estate consisted of a newly built home and non-control interests in two high profile businesses (high volume of cash) with celebrity control owners. There was enormous pressure on the moneyed spouse to keep the divorce low-profile and away from the businesses. The moneyed spouse was attempting to use that as leverage to make no disclosures and hide income.

Our client claimed that there were wall safes built into the home that contained enormous amounts of cash and jewels. There were also claims of an extravagant lifestyle. The opposing counsel and experts denied all such claims and continued to play hide-the-ball.

At the direction of Arxis, subpoenas were issued to the lender on the new home (construction loan). Additionally, copies of tax returns for the previous three years were obtained directly from the IRS and analysis was done on the income and expense declarations filed with the court compared to bank statements. The result of comparing the loan application, the tax returns, and income and expense disclosures exposed a number of profound discrepancies. For example, the tax returns submitted with the loan application, the I&E disclosures, and the IRS were all different. Additionally, the income claimed in support of the construction loan was multiples of what was reported to the IRS or to the court.

Rather than explain these discrepancies, and many others, the moneyed spouse settled on terms that were very satisfactory to our client.

#2: Criminal Contempt – Charges Dropped, Family Court, Settlement

A husband had, for several years, ignored the legal process surrounding his divorce. He admittedly failed to disclose assets, income, and significant economic activity in court filings and depositions. He had control of the marital assets and believed he could keep it that way. Once the legal process began to close in on him he realized it was time to take the process seriously and “come clean.”

Arxis was recommended to him as the firm that “shoots straight” and had the credibility to communicate to the judge and opposing counsel that the litigation was now being taken seriously and that the disclosures were complete and accurate. What followed was a series of meetings with opposing counsel and experts where full and complete disclosure was made. The pending criminal contempt charges were dropped and the case settled. Arxis was credited with providing the proper information in clear and simple terms that allowed all parties to recognize that the “games” were over and the case could be resolved with reliable information.

#3: Business Valuation, Hidden Assets, Forensic Accounting, Settlement

In one of the more complex divorce cases many of the participants had ever seen 12 businesses were involved in a scheme to hide assets, mask true economic activity, and divert income. Three accounting firms were retained to handle the forensic accounting that was required and each of them either gave up or were terminated because of their inability to understand and effectively sort out the data.

Arxis was the fourth firm hired and immediately began a painstaking process of “following the money.” It became immediately obvious that the accounting records were incomplete, inaccurate, and purposefully manipulated to satisfy the goals of the divorce litigation. Cash transactions for all 12 entities were recorded from source documents and merged into a single database. Then the transactions were traced back to bank statements to verify date and amount of each transaction. What emerged from the work was a true picture of what actually happened and the obvious observation that the records previously provided to the court were fraudulent. The result was a settlement of the significant financial issues without a trial.

#4: Shareholder Income from an S Corporation

In a recent family law matter, Arxis Financial, Inc. was retained by a spouse to establish her ex-husband’s income because he had petitioned the court for termination of spousal support. The husband claimed negative income (loss) of over $15,000 per month, while the wife claimed (based on our work) that husband’s income was over $11,000 per month, a difference of over $26,000 per month ($192,000 per year).

The difficulty in this case came from the fact that we were dealing with an S corporation. The husband is a shareholder and works for the business. Arxis Financial, Inc. showed total income that included salary plus cash distributions from the S corporation. The opposing expert showed total income (loss in this case) that included salary minus losses reported on the K-1. The only difference between the expert’s opinion was how the cash distributions from the S corporation should be handled.

The cross-examination was vigorous. It allowed Arxis to establish that our position in this case not necessarily applicable to every S corporation. Analysis of income from an S corporation is a facts-and-circumstances analysis.

Result: The court rejected the husband’s request to eliminate or reduce monthly spousal support. The court also indicated that, had the request been made, the evidence supported an increase in monthly support.

#5: Real Estate Investment Analysis Related to Marriage Dissolution

Summary of issue: Arxis Financial was retained in a family court matter that had dragged on for over 10 years. The couple was divorced a long time ago but the financial matters were never resolved. The marital estate consisted of over 20 residential rental properties including homes and single-family homes. Both parties over the years were alternatively motivated to stall the resolution process because of improving or declining market conditions. The crash of the real estate market and the general economy, starting in 2007, finally motivated both parties to come to the table to try to close the matter

Arxis work: Arxis Financial was retained in 2012 to prepare an analysis of property cash flows, tax basis, and imbedded gains. The economy had degraded so much that decisions regarding sell or hold were necessary. This was a complete reversal of prior years where the values were increasing so rapidly that capital gain taxes seemed like the biggest problem. Additionally, one spouse had control of the properties and the cash flow generated by the properties. Therefore, work had to be dome to trace proceeds and calculate reimbursement claims.

Result: Fortunately, economic conditions drove the parties towards settlement and the end of a very long divorce. Settlement was based on the analysis of net equity and annual cash flow for each property that allowed the parties to balance their respective needs for assets and income. The pie was divided – but it was a much smaller pie in current economic conditions.

#6: Comparative Analysis for Family Law Dispute

Issue: Arxis was contacted to assist in a family court matter involving complex tracing matters. There was an ongoing dispute regarding whether certain material assets were separate or community. Determining the nature of the assets affected the division of assets and, because the cash flow associated with those activities were substantial, reimbursement claims would be significantly affected. Both parties came into the marriage with considerable separate assets.

Arxis work: The case had been active for over a year before Arxis was brought into the matter. The correspondence in that year included settlement offers from both sides. Both offers were immediately rejected as preposterous and even insulting. After this “attempt” to settle, forensic accountants were retained and the forces were being marshalled for battle in court. Each side made substantial commitments to preparing tracings to prove respective claims in trial.

Arxis immediately began the work of preparing the tracings for several bank accounts covering the period of the marriage and the year since separation. Based on some of the data and the conclusions becoming evident from the records, Arxis suspended the tracing work and analyzed the two rejected settlement proposals more closely. To understand the two offers, side-by-side marital balance sheets were prepared. On the left was the Petitioner’s version of assets, debts, and reimbursement claims as reflected in their Section 1152 offer letter. Similarly, on the right was Respondent’s version of assets, debt, and reimbursement claims. At the bottom of each balance sheet was a calculation of the net equalization payment due based on each party’s assumptions and conclusions.

Amazingly, what the parties perceived to be a massive gap between the two positions (millions of dollars) was actually, when put in a side-by-side analysis, a relatively narrow difference of a couple hundred thousand dollars. The emotional attachment to some of the issues by both parties and the enormous accounting complexity had masked the proximity of potential compromise.

Result: Arxis approached our client and presented the prospect that staggering legal and accounting fees could be saved if there was an openness to compromise on a much smaller difference than the litigants previously perceived. Our client approached opposing counsel and requested a settlement conference with both sets of attorneys and forensic accountants. It took most of an eight hour day, but the case settled. The two litigants were initially stunned at how close their two seemingly opposite positions actually were. Significant fees were saved and it is likely that at least two years were cut from the dispute resolution process.

Business Valuation

#1: Court-appointed Expert

Four businesses were the subject of litigation and the judge contacted Arxis to prepare the valuations. Arxis was appointed as the court appointed experts to prepare the valuation reports.

#2: Business Valuation, Dissenting Shareholder, Joint Report

Arxis was retained by defense counsel to prepare a joint business valuation of a business that was the subject of costly dissenting shareholder litigation. Plaintiff’s counsel also retained an expert and the court appointed a third neutral valuation expert. Because of our knowledge of, and prior work against, both of the other experts the engagement was marked by professional courtesy and vigorous efforts to resolve the dispute. The result was the successful issuance of a joint report that was agreed to by all three valuation experts.

#3: Fair Buy-Out Price of Business from a Widow

Issue: What is the fair buy-out price of a widow after the untimely death of her husband?

Arxis Work: We met with the business partner of a man who had died an early and shocking death. There were several factors that made the meeting and situation that much more difficult. First, his business partner was his brother. Second, his brother had died right in front of him, his wife, and his children in a boating accident. All the nieces and nephews were present and were greatly traumatized. Third, the family was close. The two brothers had been inseparable and their respective families followed suit. The brothers were partners in a struggling personal service business that was very dependent on the skills, knowledge, and relationships of both partners. Historically, the business supplied a livable salary to each of the brothers. In short, the death of one of the partners meant the loss of half the business. There was no plan for the death of a partner – no life insurance, no shareholders agreement, and no buy-out plan. For the widow and her family, it also meant the immediate loss of income – the ability to pay bills. The estate/corporate attorney contacted Arxis with a request that I assist the parties in arriving at a fair price for the surviving brother to pay to the widow for her share of the business. By most definitions there was no value. Or, if there was value, it was minimal. However, the surviving partner knew all his brother left to his family was whatever he could pay for his share of the business. He knew the business had no value beyond the salary he earned but he wanted me to define and quantify some basis for a buyout so his sister-in-law would not feel like it was charity and also feel like the price was fair.

Result: Arxis worked off of an assumption that the standard of value was “fair value” meaning that there were no discounts for control or marketability. An analysis was done to determine how much the surviving partner could afford to pay over a period of time assuming some growth and cutting overhead. The value was agreed to and the surviving partner worked for several years to support both families. It is doubtful that the surviving family will ever fully understand the sacrifices he made to provide them a “fair” value. It was a difficult assignment for Arxis. However, it allowed us to assist a remarkable man serve his distraught and needy family.

#4: Valuation of an Earnout Provision in Acquisition

Type of Matter: Valuing a business certainly is not always straightforward. Sometimes it requires thinking outside the box to develop an approach that works for the particular situation. Such was the case when Arxis Financial was recently engaged in an acquisition that was about to get ugly with potential litigation.

A business owner sold their business and the negotiations involved how much would be paid after the close of the transaction and how much would be based on the future performance of the company. It is typical that such payments (earnout provisions) are put in contracts to incentivize the seller to work towards the buyer’s success. It also allows for the possibility that the seller can make some extra money on the sale than they might otherwise be paid.

For tax and litigation reasons, Arxis Financial was contacted in this particular case to value the earnout provision. The seller needed to know the fair market value of the potential earnout cash flow as of the date of sale.

Arxis Work: For the valuator, an earnout element adds to the complexity of determining and quantifying the differences between value, price, and proceeds. In this particular case, we knew the price but the actual value of the business and proceeds of the transaction were unknown. Potential earnout payments were based on future performance that may or may not materialize. Also, there were questions whether the company would actually be able to meet the required payments without permanently damaging the company.

Valuing a transaction as of the close date, when there are potential additional future payments, presents great difficulty in determining the Fair Market Value of the business as of that date. There is no real alternative to using the income approach since the cash flows are complex, uncertain, and maybe even speculative, depending on the negotiations and terms. Variations on the income approach range from a clear-cut discounted cash flow approach to complex Monte Carlo Simulation models addressing the probability that cash payments will be earned and paid out. It is also common to see probability-weighted return methodology applied within an income approach to valuing earnouts. The additional difficulty was that actual future performance could not be considered in valuing the earnouts. Only facts known or knowable as of the date of the sale could be considered in the valuation of the earnout.

In this case, the potential future benefit streams were probability weighted and then discounted using a discount rate that was derived from the actual transaction and then adjusted. The adjustments included consideration of additional risk factors such as transaction risk (the risk that the relationship between seller and buyer would deteriorate and/or that the additional compensation to the seller will actually be difficult for the company to honor) and performance risk (the risk that the business simply cannot achieve growth rates that exceed those contemplated in the original deal).

Result: An opinion of value was determined and accepted. The case settled and expensive litigation was avoided.

#5: Purchase Price Allocation

Type of Matter: A competitor business purchased 100% of the outstanding stock of a successful closely-held business. The business effect of the combination capitalized on synergies that would have been dormant had the businesses not joined forces. Shortly after the transaction was completed, the buyer’s auditors informed management that GAAP standards required an independent valuation report allocating the purchase price between tangible and intangible assets.

Background: When a business is acquired, accounting rules dictate how the transaction is to be disclosed for financial statement purposes. FASB ASC Topic 805 – Business Combinations (ASC 805) is the definitive guidance on business combinations for reporting all items related to the transaction in financial statements. ASC 805 is a comprehensive guideline for establishing the principles and requirements for how an acquirer recognizes and measures identifiable assets, recognizes and measures either goodwill or gain from a bargain purchase, and the disclosures to be made in the financial statements.

Arxis Financial work: First, even though a transaction just took place, the entire business enterprise must be valued under the specific guidelines of ASC 805. This is in recognition of the concept that price, value and proceeds are potentially very different. It is common for the enterprise valuation under ASC 805 to present a different value than the actual purchase price. This has to do with the potential for different standards of value in play during the deal than required under generally accepted accounting principles.

In this case, the buyer financed the purchase price with cash, preferred stock, notes, and assumption of debt. All those elements, particularly the preferred stock, presented complex valuation issues. Historical data was barely looked at during the transaction negotiations since the driver of the deal was the potential synergy of the combined operations. Therefore, the enterprise valuation under ASC 805 was prepared based on those projections. An enterprise value was determined using a Discounted Cash Flow approach which was supported and consistent with the results of using the market approach (private company transactions).

Once the enterprise value was determined, an allocation to tangible asset value was made and the remainder was, of course, intangible value. ASC 805-20-25-10 requires that, “The acquirer shall recognize separately from goodwill the identifiable intangible assets acquired in a business combination. An intangible asset is identifiable if it meets either the separability criterion or the contractual-legal criterion described in the definition of identifiable.” Extensive work was done to determine those intangible assets that met the criteria for identification and valuation, and then to apply the appropriate valuation methodology to placing a value on customer and vendor relationships, patents, trademarks, non-compete agreements, and employment agreements.

Result: A valuation report was issued (several hundred pages) and reviewed extensively by the auditors and their in-house valuation experts. The report was accepted without change and financial and tax reporting of the transaction was prepared based on the Arxis Financial valuation report.

#6: Valuation for Portion of Business Ownership to be Donated

Type of Matter: A non-control owner of a privately-held business wanted to donate a portion of her shares to a charitable organization. Time was short since there were several potential buyers approaching the business and it appeared that the business might sell pretty quickly.

Background: Depending on the size of the donation, the IRS requires a qualified appraisal of the common stock to substantiate the deduction. Large donations require that the valuation report be submitted with the tax return. The standard of value for tax valuations is “Fair Market Value.” IRS Revenue Ruling 59-60, Section 2.02 defines Fair Market Value as follows:

The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

Arxis Financial work: Two issues had to be addressed as the project developed. One was the premise of value. In most FMV valuations, the premise is “going concern” meaning that the business is assumed to continue in its present form in perpetuity. However, as the work progressed it became obvious that the business was likely to sell pretty quickly. Therefore, the valuation of the enterprise (a necessary first step) was prepared on the going concern premise and the non-control interest being donated was valued using a liquidation premise since the owner was going to be bought out and the interest would no longer exist. The practical implication of this was there were no discounts taken for lack of control and the consideration of marketability discounts was very slight. Both decisions are unusual when valuing a small minority interest in a closely-held business but perfectly appropriate given the circumstances.

The second issue was also posed by the imminent sale. There were several written letters of interest from potential buyers that included details of proposed terms and consideration. To the extent the offers are arms-length and serious they are a reasonable and even persuasive estimate of the Fair Market Value of a business. Here, because of the probability of a transaction very soon after the donation there was almost no choice but to use them to value the enterprise. The complexity arose due to IRS case law and regulations that state that personal goodwill cannot be donated. To the extent that consideration for the sale included covenants not to compete, earnouts, and compensation contracts for existing shareholders the prices considered to value the business must be allocated between personal and business goodwill. Using the assumption that the sale would take place and that the letters of interest reflected what the terms of the deal would eventually be, analysis and allocations of selling price to compensation for personal goodwill were excluded from the value conclusion.

Result: After determining the above fundamentals for the valuation of the enterprise, Arxis Financial completed the valuation on a timely basis and within budget. The report was accepted without change and financial and tax reporting of the transaction was prepared based on the Arxis Financial valuation report.

#7: Avoiding Litigation When Shareholders Leave

Type of Matter: A non-control owner/employee of a closely-held business was terminated as an employee and the other owners wanted to terminate the shareholder relationship, too. This was a matter that was wrapped in bad feelings and clearly heading for litigation to resolve the issue of how much the “out” partner was to be compensated for his/her shares.

Background: A shareholder dispute in a closely-held company is often referred to as a corporate divorce. The only real difference to the emotional difficulties of divorce cases in family court is that there are no children involved. Although, for some business owners the business might as well be called another child for all the similarities in sensitivities exposed in a dispute over the ownership and value of their “baby.”

Arxis Financial was retained by the remaining owners to place a value on the business primarily for the purpose of settling the case. Our clear instructions were to be fair to all sides, objective, and to prepare a compelling case supporting our opinion – whatever it was. It was our clients’ intent to share our report with opposing counsel in the hopes that the report and its conclusion would be persuasive enough to serve as the basis for agreement before formal litigation commenced. Unfortunately, there was no written shareholder agreement and there were several versions of what the oral agreements might have been.

Arxis Work: The financial history of the business was irregular and profitability was volatile. Consequently, historical results could not be relied upon to value the business so we asked for projections. There was no agreement among any of the partners as to what the economic future of the business would be. As a result, Arxis Financial looked pretty deeply at market transaction databases to identify similar private companies that had sold. While some were found that could serve as a means to value the company, we were dissatisfied with the persuasive nature of that evidence.

Arxis Financial had also asked for details about the buy-in transactions for current owners, as well as shareholder buy-out transactions over the history of the company. When analysis was done comparing the values in those transactions to current underlying operational metrics (sales, net income, EBITDA) a very compelling relationship was established that coincided with the multiples we found in market transactions that were obtained from independent transaction databases. Now we had a compelling story to tell.

Result: The valuation report was prepared, issued, and distributed. As a result, the valuation issues were negotiated and resolved before lawsuits were filed.

#8: The Impact of Valuation Errors on Estate Planning

Type of Matter: A large closely-held business had engaged expensive attorneys and valuation experts to facilitate a complex multi-year and phased gifting and estate plan commensurate with a large estate. The first five years into the implementation of the plan produced unusual results and the forecasted long-term results of a fully implemented gifting plan caused the board of directors to seek a second opinion.

Background: Arxis Financial was retained to prepare a current valuation and to prepare analysis of the previous reports and calculate values as of the previous dates using current assumptions. The board of directors had obtained two valuations over the five years of the plan. The company value dropped over 20% between those two valuation dates even though there had been little change in the operations. The board retained Arxis Financial to review prior valuation reports to provide affirmation of the value conclusions and the methodologies employed to arrive at the values.

Arxis Financial Work: Arxis Financial was retained to prepare a current valuation and to prepare analysis of the previous reports and calculate values as of the previous dates using current assumptions. We found several anomalies that clearly demonstrated that the company was being vastly overvalued and that the estate plan was completely overblown for the size of the business.

The valuation errors ranged from basic mistakes to subjective judgments that vastly misstated the reality of the business enterprise and the fractional interests being valued/gifted:

An after-tax risk rate was used to value pre-tax income. This is a common error that results in a theoretically inaccurate conclusion.
Risk rates (capitalization and discount) appropriate to value very large public companies were used to value the income of a comparatively tiny company.
The appraiser added back marketable securities held by the company as non-operating assets without asking management about the investments. Management inquiry would have prevented that mistake.
Discounts for lack of control and marketability for fractional interests in the business were negligible.

Result: Arxis Financial’s conclusion was that the business was overstated by more than 300%. As a result the complex gifting plan was abandoned, multiple prior gift tax returns were amended, and the estate plan was restructured to more reasonably reflect the size of the estate.

#9: Avoiding Litigation When Shareholders Leave

Result: The valuation report was prepared, issued, and distributed. As a result, the valuation issues were negotiated and resolved before lawsuits were filed.

#10: Reviewing and Critiquing a Valuation Report

Type of Matter: A business valuation was prepared immediately before a complex stock transaction was finalized. That valuation report was later scrutinized in response to a claim that it was improper and erroneous.

Background: A complex stock-for-stock transaction was contemplated between owners of a closely-held business involving over 20 subsidiaries. In contemplation of that transaction, the company retained a valuation expert to place a value on a portion of the business. The transaction was consummated at the value determined by that expert. Subsequently, the valuation conclusion was challenged and Arxis was retained to evaluate the report.

Arxis Work: A copy of the complete report and all documentation that was originally supplied to the valuation expert was provided to Arxis. With that information we attempted to replicate the calculations, assumptions, and conclusions presented in the report. As a result, numerous substantial errors were identified. It was a collection of some of the most common valuation errors wrapped up in one report:

An invested capital risk rate (WACC) was used to value a cash flow to equity benefit stream. This, by definition, results in an incorrect conclusion.
The expert properly concluded that public companies were inappropriate to use as guideline companies. However, throughout the rest of the report public companies were used to project cash flow, capital expenditure levels, and working capital.
Public company data was used to determine the WACC rate for the subject company. This was inappropriate given the conclusion that public companies were not comparable to the subject company.
The expert did not consider, or adjust for, non-operating assets and non-operating income and expenses.
The sale of similar privately held companies (Market Approach) was not considered. This was problematic since there were hundreds of transactions in the same SIC code as the subject company available.
Prior transactions (several) of company stock were not considered.

Result: The report was so flawed that all parties agreed it had to be set aside and a new valuation performed. A substantial amount of money had been spent on a valuation that was flawed on every level.

#11: Partner Dispute and the Business Valuation

Type of Matter:
A widow received a questionable offer to buy her departed husband’s business from his previous general partner. Questions arose and then litigation ensued.

Facts:
A woman became a widow very suddenly and unexpectedly. Unfortunately, the aftermath of that tragic death added salt to the wound. Throughout the marriage, the husband maintained all the finances and investments. He was a sophisticated investor. Included in the portfolio of investments was a limited partnership interest in a mid-size business located and operating in another state. His wife knew nothing about the business, or partnerships, or the relationships with the other partners that died with her husband. In the midst of her grief, she barely grasped the concept that his partners had now become hers, along with all the rights and obligations of ownership.

The general partner saw an opportunity. He approached his new widowed partner and offered her a sum of money to buy out her limited partnership interest. He had obtained an “appraisal of the business” and used it as the basis to value the limited partnership interest. He observed the obvious distress and naivete of his new partner and pressed for a quick conclusion to the transaction. Fortunately, she sensed that there was something wrong. She contacted a law firm that did not understand her situation any better than she did. Fortunately, she switched law firms and, finally, had an advocate who saw the issue and understood the realities of her situation and the possibility of concluding the matter in a much more satisfactory manner.

Arxis Work:
The law firm, after preliminary discovery and inquiries, recognized that valuation assistance was needed. They forwarded to Arxis the “appraisal of the business” that was used as the basis for the initial buyout offer. Almost immediately, we noticed that the appraisal was for the land and buildings only. The appraisal was inadequate and, mostly, a waste of time and money. We immediately recognized that a valuation of a non-control limited partnership interest was needed – not an appraisal of some of the assets of the business. In short, it was not an appraisal of the business at all. The appraisal did not include several assets, the most material being intangible asset (goodwill) value.

Result:
We prepared a valuation of the limited partnership interest and the case settled on the eve of trial. The buy-out price ended up substantially higher than originally offered. From that standpoint it was a typical case with a normal ending. But the case highlighted several observations and recommendations to avoid and resolve similar litigation:

When a business interest is in dispute, an asset appraisal is, with some rare exception, not relevant or helpful. Appraisals tend to address tangible asset values but ignore intangible assets. Intangible assets are, for most businesses, the most important and valuable assets of the business. Ownership of a business interest includes the value of all the assets, and debt, of a business.
The partnership agreement in this case described the method and manner of valuing the partnership interest for a departing partner. The “buyer” tried to ignore it and the “seller” did not understand it. Both were a little disappointed with the results. The owners’ agreement, with some exception, will drive the valuation process for better or worse. It is advisable that business owners understand that agreement before trouble comes.
A “standard of value” is a set of assumptions that must be used to arrive at the value. Fair Market Value (FMV) is the standard of value that most everyone has heard of – and is least relevant in litigation involving owner/partner/shareholder disputes. When parties to a dispute retain a valuation/appraisal expert they often tell the professional that they want to know the fair market value. Rather, the attorney and valuation/appraisal expert should discuss the relevant standard of value and proceed on that basis. A lot of money is wasted on valuation and appraisal reports using the wrong assumptions.

A distressed seller makes for potentially bad deals. Any transaction involving an interest in a closely-held business should be concluded only after review by a professional that understands valuation.

Damage Calculations

#1: Lost Income, Damages, Business Valuation, Forensic Accounting, Settled

Several years ago, several fires raced through Southern California pushed to the ocean by fierce Santa Ana winds. In the path of the fire storm were hundreds of homes and businesses. Some of the fires were either started or fed by the alleged negligence of various parties. The result was claims filed against the negligent parties and Arxis was contacted by the law firms handling the plaintiff’s litigation. Arxis was retained to calculate lost income damages and, for completely destroyed businesses, valuations of the business immediately prior to the destruction of the business.

Each of the cases was settled successfully without requiring lengthy litigation. Arxis, by preparing accurate, complete, and reasonable damage calculations assisted the parties in resolving the dispute.

#2: Forensic Accounting, Damage Calculations, Expert Testimony

Arxis was retained to provide forensic accounting and damage calculation analysis in a breach of contract matter and a shareholder dispute involving several companies. After analysis of accounting and financial records Arxis proposed a theory of damages and evidence presentation. The client and counsel agreed to the approach.

After the damage analysis was done, extensive testimony was provided at deposition and trial. The result was a verdict in favor of the client. The court noted in the decision the following regarding the work of Arxis: “It should be said that Mr. Hamilton, especially under cross-examination, exhibited good knowledge of the companies in the dispute…”

#3: Elder Abuse, Fraud, Forensic Accounting, Expert Testimony

Plaintiff’s counsel contacted Arxis for assistance in an elder abuse case. Over the period of several years several real properties and cash had been stolen and re-titled. Arxis was retained to recreate the accounting for several years, quantify the loss, and provide testimony in support of the conclusions and opinions reached as a result of our work. Trial was held in Superior Court and the testimony from Arxis was a central element of the case that was presented in a bench trial.

The court ruled in favor of the elderly couple and ordered a return of the stolen assets.

#4: Loan Agreement and Conversion to Equity – Fraud and Business Valuation

Summary of issue: Arxis was hired by defendant in a case alleging fraud and related claims. The case revolved around a loan agreement that provided for a conversion to equity under certain conditions. Our client loaned the money and, eventually, all of those conditions were met and our client exercised the conversion provision of the agreement. Plaintiffs (borrower) immediately sued for fraud and other claims surrounding related to the formation of the original agreement. Defendant counter-sued for damages associated with being “locked out’ of the business and not participating in dividend distributions.

Money involved: The business was valued at several million dollars. Alleged damages against our client was the value of the business as well as additional tort damage claims.

Arxis work:

Discovery – Plaintiffs refused to provide most of the financial discovery making the case highly forensic, meaning that there were very few records available that would normally be relied upon to express a value.

Valuation – The valuation work was based entirely on tax returns and other random information intentionally and inadvertently provided by Plaintiff. Opinion of value was based on distributions from the business (S- corporation) to the plaintiffs adjusted for reasonable compensation, taxes, and estimated capital investment required in the business. The result was a value that was likely conservative due to the inability to adjust draws for personal expenses paid through the business since that information was not available.

Testimony – A bench trial was held involving expert testimony of several hours.

Result: The court ruled in favor of the defendant and on the issues and deferred ruling on the damages. This allowed the parties to settle the remaining issues.

#5: Restaurant Economic Damages Litigation

Issue: Civil litigation was initiated in a property dispute between the owners of a restaurant and the owners of a neighboring piece of real estate. Arxis Financial was hired to quantify the financial impact of a parking injunction on the value of a restaurant. The injunction would prevent the restaurant from using a driveway that provided access to a parking lot at the rear of the restaurant. There was no other access to the parking lot and loss of that access would require the restaurant to initiate a parking valet service. This service would require additional cost to patrons and would necessarily limit the restaurant hours to dinner only since surrounding parking lots were fully utilized during daytime business hours. Breakfast and lunch business represented 40% of the profits of the business and would be impossible.

Arxis work: Two business valuations were prepared: A business valuation was prepared as-if the injunction did not happen and a second appraisal was prepared reflecting the permanent diminution in value had the injunction been made permanent. Because of the type of litigation, Arxis Financial was required to consider alternative uses of the building that might mitigate the loss of revenue. Cash flow and economic analysis was prepared for conversion to a smaller sized structure to make room for a driveway and the conversion of the existing space to either a smaller restaurant, walk-up retail, or a combination of both. When comparing the two valuations Arxis Financial was required to establish the “permanent” loss in value as opposed to temporary reduction in income. All of this was done in less than a week since the temporary injunction was filed and it was effectively choking the life from the business. There was an urgency to getting the valuations and declarations done so relief could be sought in court.

Result: The case settled with terms that preserved a landmark restaurant. A key aspect of the settlement was the valuation work, which demonstrated that the loss of business income was so significant that the driveway access issue had to be resolved. This caused the two parties to mutually resolve the matter in a way that was satisfactory to both, avoiding additional litigation.

#6: Bad Faith – Damages for Fire and Business Failure

Type of Matter: An insurance claim for a fire that destroyed one of two store locations was the catalyst for potential litigation against the insurance company.

Facts: In the middle of the Christmas shopping season, a high-end retail location was destroyed by fire in the early hours of the morning. Fortunately the store was closed so there were no injuries. However, the store was a total loss. Not only were holiday sales lost but there would be extensive repairs and remodeling to do before the store could be reopened. The rotten timing of the disaster was heightened by the fact that the store, like most other in its industry, was just beginning to recover from a deep and prolonged recession. A strong holiday season was needed to survive.

What followed was a fairly typical give-and-take between an insurance company, that wanted to pay as little as possible, and an insured, who wanted to get back up-and-running as quickly as possible. Eventually, the insurance company stopped paying on the policy because policy limits had been reached. The business needed more cash to effectively open the store.

The insured contacted an attorney whom in turn, contacted Arxis Financial to assess what, if any, damages may be recoverable.

Arxis Work: We confirmed that, under the policy, the contractual funds had been paid. However, it became obvious that the company had been starved of cash to the point that recovery was now impossible. An analysis of historical cash flow required to maintain the business was prepared and then compared to the cash flow available after the fire. This analysis showed that within 30 days of the fire cash was sufficient. However, within 60 days of the fire the cash deficit was over $100,000 and by the end of the first 12 months post-fire the cash deficit was well over $1,000,000. We prepared an analysis that clearly showed that if the insurance company had made timely payments, the business could have survived. In short, there were two disasters: first, the fire, and second, the bureaucratic delay and obstruction of the adjuster.

Unfortunately, the business was not able to recover from these disasters and ultimately failed. As noted above, the business actually consisted of two locations. One was destroyed by fire and the other remained open and was instrumental in helping to overcome the delay of the insurance company. Ultimately, the double disaster of the burned store took down the entire business as there was simply not enough cash flow to maintain inventory and get the store open. Arxis Financial prepared damage calculations showing the cumulative losses incurred after the fire, including the significant post-fire cash infusions provided by the owners.

Result: The insurance company rejected the premise that the business was lost because of their delay in paying on the loss. The case was heading towards litigation and seemed to be destined for a jury decision. At the eleventh hour a settlement was reached that closed the case. The insurance company paid a sum agreed upon in the settlement (terms cannot be disclosed), implicitly acknowledging that our theory of damages was credible.

#7: Lost Income via Facilities Management Company

Type of Matter: The owner of a parking structure contracted out the management of the facility. The management services included collecting the parking fee and remitting the appropriate amount to the owners. At some point the owners began to suspect that money was being stolen. They did an investigation that included reviewing video surveillance evidence and determined that there was reason to proceed with a more formal investigation. They reviewed surveillance videos for several days and determined rather precisely how many cars entered the facility that were not reported as paying cars. With that evidence in hand they replaced the management company and called an attorney who contacted Arxis.

Arxis Work: Arxis Financial initially reviewed the sampling of days that had been reviewed by management. There was little doubt that the amount of revenue actually collected on those days was materially understated. Based on the sampling we determined the methodology of the theft and, at least on those days, the amount of the theft. The methodology was confirmed by review of additional surveillance and documentation.

The next concern was to determine the period of time the theft took place so that the under-reported revenue could be quantified. Documents were reviewed and we found that the same company held the contract for several years and, additionally, the personnel hired by the management company to work at the parking structure had not changed since the beginning of the contract. The conclusion was that the loss period extended over the entire period of the contract.

Arxis Financial determined a ratio of reported cars to actual paying cars identified on the video surveillance and applied that ratio across the entire contact period to determine an amount of lost income. We compared our results with the actual results of income reported by the new management company and were satisfied that we had accurately estimated the lost income.

Result: A jury trial was conducted at which we provided expert witness testimony. The jury came back with a verdict against the defendants and awarded damages based on the lost income calculations prepared by Arxis Financial.

#8: Impact of Tainted Food Product – Lost Profits

Type of Matter: A food processing company was notified by Federal and state agencies that Listeria had been traced to their facility. This began a process of sourcing the Listeria and commencing extraordinary measures to recall tainted food, eradicate the contamination and try to recover the business. The result was a lawsuit against the food supplier that shipped the Listeria to the plant.

Background: Arxis was retained to determine lost profit damages associated with the events surrounding the Listeria contamination, including shutting the facility for a period of time, recalling product, and overcoming the incredibly negative publicity associated with food poisoning. The source of Listeria was never in doubt. The litigation was almost entirely related to the question of economic damages.

Arxis Work: Initially our analysis considered the prospect that there would be a permanent loss of some or all of the value of the company since, at best, the recovery would likely require several years. The certainty of the Listeria contamination and the appearance to the marketplace of negligence or other failings on the part of the company made the prospect of recovery very difficult. After extensive discussions with management we were persuaded that it was reasonable to assume that the company could eventually recover in spite of substantial loss of income, reputation, and goodwill in the industry in the interim.

The next step was to calculate the amount of damages required to compensate the injured party for the injury sustained, and nothing more; such as simply make good or replace the loss caused by the wrong or injury. Because our work was being done before the business had fully recovered, two projections were required. First, we projected financial results for the company as if there has been no Listeria contamination. The second projection involved looking at actual financial results since the damage event and projecting into the future until results matched the “without Listeria” projections signaling the end of the “loss period.”

The difference between financial results as-if the Listeria event did not happen minus the results (actual and projected) after the Listeria contamination was the lost income damages. Finally, the projected lost income was discounted to arrive at a damage amount as of the date of trial.

Result: After extensive discovery and deposition testimony, the case settled on the eve of trial. Arxis’ work in clearly and independently identifying the lost income was compelling and that factor, along with others, drove the parties to a pre-trial settlement.

Forensic Accounting

#1: Collusion and Fraud to Attract Business Investors

Summary of issue: Arxis Financial was retained to quantify the effect of an alleged fraud and breach of contract. The organizers of a new business made multiple and extensive representations about intellectual property that was owned by the business and the prospects of converting that ownership into rather healthy cash flows in the future. Our client was persuaded to invest hundreds of thousands of dollars in stock and then, in subsequent years, over a million more dollars in the form of loans. The loans were convertible to equity.

In the course of attracting investors, the defendants presented an image of success and a high profile celebrity presence. A valuation firm was even retained that opined in writing that the business was worth more than $20,000,000. All of this masked the reality that the business never made a profit. In fact most, if not all, of the revenue was simply business diverted from another business controlled by one of the defendants. The intellectual property that was the basis for the entire business venture was owned by some of the defendants – but not the business that was issuing stock and borrowing money.

Arxis work: Our initial involvement was to re-create accounting records and attempt to identify a pattern of transactions that would suggest or support a case of collusion and fraud. Because of the financial constraints our work was very targeted and limited. Our work was used to support and assist the work of the team of lawyers in depositions, interrogatories, and other discovery. Our work was also useful in identifying the realizable value of the funds loaned to the business. We also calculated the value of the business for purposes of determining the value of the equity investments of the plaintiffs. Needless to say, the value of the debt and equity was zero.

Result: A jury trial was held. Arxis Financial presented testimony at trial that was focused mostly on the valuation of a business and, more specifically, intellectual property. The trial lasted several days and the jury came back with verdicts for the plaintiffs.

#2: Embezzlement – What the Auditors Could Not Find!

Arxis Work: At the initial meeting with Arxis Financial, the bank reconciliations were specifically excluded from the work scope approved for Arxis. While this was understandable due to the enormous cost of reviewing them already, it became a point of significant contention. Ultimately, we refused to take the engagement unless we were allowed to review the bank reconciliations – essentially covering the same territory as the outside audit firm. Either the reconciliations accurately reflected the activity in the accounts or they were being fabricated to hide illicit activity. Either way, it was the logical starting point.

Result: We found that material and significant misappropriation of company assets had taken place over an extended period of time. As a result of our fraud investigation, the Controller was terminated, arrested, subsequently convicted, and is serving time in state prison. The method of hiding the embezzlement was so simple that apparently 6 auditors didn’t think to check it, which although disappointing to the company, is a key reason why a professional fraud investigation team should be engaged to investigate such suspicions.

We provided several recommendations for company management in order to minimize the chances of future embezzlement. The company was greatly pleased with Arxis Financial’s expertise, expediency, successful investigation and recommendations.

#3: Comparative Analysis for Family Law Dispute

#4: Found the Income! Asset Tracing in Family Law Cases

Type of Matter: In a divorce matter the “in-spouse” who controlled family business, real estate, and all other assets claimed minuscule monthly income, poverty, and no records. His wife knew better and didn’t believe any of it.

Background: After a lengthy marriage Mr. Husband decided to make some major changes in his life – including divorcing his wife. In the initial court filings, declarations of assets and debt as well as income and expenses are filed by both parties. In those disclosures Mr. Husband claimed minimal assets and poverty level income. He provided the filed joint tax returns for the previous several years to support his claims. These filings were contrary to the lifestyle described by his wife that included round-the-world travel, expensive cars, fine dining, and a growing inventory of real estate.

Arxis Work: After Mr. Husband filed financial disclosures with the court, his wife retained an attorney to provide some guidance. The attorney immediately knew something was wrong and called Arxis for assistance. A demand for production of documents was prepared and sent out. Buried in Mr. Husband’s response was the claim that all (everything) accounting records were unavailable because of a stolen computer. His wife had a decision to make – accept his story and her “fate” (poverty) or pursue the case at great risk and cost.

She decided to borrow the money to proceed with the case and that began the process of issuing subpoenas to all banks, escrow companies, credit card companies, etc. Once the records began rolling in Arxis began a full reconstruction of the accounting for the businesses and their personal accounts. The accounting was being recreated to cover as much of the marriage as possible as well as the separation period. Thousands of transactions were entered, reconciled, analyzed, and categorized. As records arrived in response to subpoenas, more data was included in the accounting.

What emerged from all the work was solid evidence of substantial assets, the marital standard of living, and evidence of preemptive sale and/or transfers of assets in anticipation of the divorce. Perhaps the most startling development was proof of average monthly income that was within $500 of what our client told us it was going to be.

Result: Our client took a significant risk to invest in a long and tedious forensic accounting process. That decision to move ahead with the accounting was vindicated when evidence was found supporting all her claims. The court was not happy with Mr. Husband. Likewise, he probably wasn’t happy with the court either as he was ordered to pay fees, sanctions, and sizeable monthly support – prospectively and retroactively.

Litigation Consulting

#1: Dissenting Shareholders in a Buyout – Litigation Consulting and Business Valuation Issues

Summary of issue: Recently, Arxis Financial was contacted to assist with the initial strategy discussion regarding a developing shareholder dispute. At issue was how to negotiate the departure of three partners without going through the process of expensive litigation.

The situation was that the majority of partners wanted the three partners to go. The three partners under the shareholder agreement had enough votes to block any formal move to force them out. Further, the written agreement clearly stated that the buy-in amount for each partner was $100 and the buy-out for each partner was $100. State law where the firm was located clearly stated that clients and cases were owned by partner- lawyers and not the firm. So, in addition to the $100, the departing partners could also take their clients with them.

Further inquiry revealed that the balance sheet of the firm was substantial, as it included minimal cash and substantial accounts receivable and work-in-process. The shareholder agreement established a formula for compensation of the partners that basically shared revenue equally, regardless of the partner’s contribution. A review of the history of the firm revealed that the shareholder agreement had been followed exactly for decades. Every incoming partner had paid $100 and every departing partner had received $100 and their clients. Compensation for decades had followed the formula.

So what was the issue here? The remaining partners all agreed that the three departing partners needed to go. However, under the shareholder agreement the three departing partners had enough votes to effectively prevent the forced departure. Stalemate!

Arxis work: Arxis Financial was contacted to discuss one question: What is the likely position of both sides if this case goes to court?

Our conclusion was that the remaining partners will hold the line at the shareholders agreement: $100 and their clients. The departing partners would likely pay for a valuation of the entire firm and claim that if the firm was sold, they were due the sale price times their ownership percentage. It seemed to us that the low end was $100 and the high end of the negotiating range was their portion of the value of the firm.

Result: It turned out that was exactly the position of both sides in this dispute. Given the potential for expensive litigation with devastating results to both sides (e.g., forced dissolution under the laws of the state where the firm was located), cooler heads prevailed and a settlement was reached.

#2: Real Estate Fraud: How a Forensic Accountant Saves Clients Money – With Just a Few Questions!”

Summary: Arxis Financial was contacted to assist legal counsel in determining the validity of a fraud claim and the best approach to credibly establishing the claim. The victim was a network of inter-related entities that owned commercial property and undeveloped real estate. Significant cash flow from the entities was managed and controlled by one of the owners. The allegation was that millions of dollars had been fraudulently taken by the manager/owner. The initial contact by the law firm was to retain Arxis to do a preliminary forensic investigation to establish the equivalent of probable cause.