No Substitutes For Vigilance, Attention To Detail in Preventing Business Fraud

Eugene J.M. Leone
BNA, Inc. Real Estate Industry & Law Report
October 7, 2008

We were preparing for closing of a large purchase and financing recently, when one of my associates made an interesting observation about the electronic transmission of documents.

“We prepare and deliver multiple documents electronically, we send these documents to people with whom we have rarely spoken and who we have never met, and we receive executed documents by PDF file or facsimile. Documents arrive from numerous locations. Our clients then lend millions of dollars entirely on the basis of these electronic transmittals. Does anyone worry about fraud?”

My response was brief, “Attorneys think about fraud, and they know that it is always lurking out there. Fortunately, most of our deals involve reputable borrowers, institutional lenders, recognized law firms and known accounting firms. It’s just not prevalent. But don’t ever let your guard down.”

From time to time, I have reflected on the conversation. Does a young lawyer understand what it means not to let one’s guard down? Just what do we do to keep our guard up?

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Not long after my 1982 graduation from law school, the ingenious fraud of O.P.M. Leasing Services became national news. O.P.M., an acronym for Other People’s Money, borrowed lots of it. The business model was fairly simple and, for nearly everyone in the commercial equipment lease financing business other than O.P.M., legitimate. It worked in this way: An equipment vendor would purchase equipment (primarily main frame computers) from a manufacturer, preferably on terms not requiring payment for sixty days. The vendor would lease the equipment under a “hell or high water lease” to a creditworthy user. (The "hell or high water" term refers to an obligation to pay under all circumstances.) The equipment lease would serve as collateral for a loan that the equipment vendor would use to pay the cost of the equipment. By not having to pay the equipment manufacturer for sixty days following delivery, the equipment vendor hoped to sign a lease and close the loan before the sixty-day period expired. The loan proceeds would then be applied to pay the cost of the equipment before the vendor had to come out of pocket to pay the manufacturer. The equipment vendor (which was also the lessor), would then sell the equipment to investors who desired the investment tax credits and depreciation benefits of ownership.

Although the business was a profitable one for many firms, OPM concluded that the business could be infinitely more profitable if the same equipment could be financed and sold again and again. A fraud was born.

O.P.M. financed and sold the same equipment multiple times. No one checked to ascertain that (1) the collateral even existed or that it existed in a particular location, (2) serial numbers identifying the equipment matched the serial numbers marked on a sales invoice or the serial numbers etched on the collateral, or (3) the equipment user or lessee had in fact signed a lease. On the few occasions in which a lender sought independent confirmation of the existence of a lease, no one bothered to determine if the representative of the equipment user or lessee was, in fact, such a representative. A representative of O.P.M. would provide the fraudulent estoppel certificate.

The well-designed and artfully managed fraud of O.P.M. came to a crash when Rockwell International discovered, in response to a lender’s inquiry, that it was making lease payments to O.P.M. under two leases for which Rockwell lacked documentation. Rockwell notified the United States Attorney. Indictments of the principals of O.P.M. followed, as did a bankruptcy filing for O.P.M. Losses for defrauded lenders exceeded 0 million (in 1981 dollars).

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My associate’s inquiry about electronic document delivery provoked my recollection of O.P.M. It also gave me the chance to question my associate’s understanding of just why we collect certain pieces of paper. "Legal opinions, incumbency certificates, estoppels, lien searches, financial statements, certificates of formation and resolutions. What does all this mean?"

Somewhat tongue-in-cheek, the associate offered a not altogether surprising answer: "All these things . . . are on the checklist."
"Look at it this way," I countered. "We need independent confirmation and internal support for a host of things. The independent confirmation consists of such items as financial statements, lien searches, and estoppel certificates from third parties. We usually confirm that a legitimate third party prepared and delivered these items. In some instances, we have a reasonable basis to believe that a legitimate third party did so. In all events, we take steps to ensure the accuracy of these deliveries. "

Legal opinions are often an essential part of the independent third party confirmation. It is not so much what the opinions say that is important. The inquiry and the investigation that goes into an opinion, and the reliability of the law firm providing the opinion, are the bulwark of a good opinion.

With regard to internal support, we look to incumbency certificates, certified agreements, authorizing resolutions and legal opinions that speak to both the authorization, execution and delivery of documents, and the formation and existence of the entities providing those documents.

If the attorney evaluates the items of independent confirmation and internal support, and keeps his or her eye on the conduct of the principals and their attorneys, it may be possible to avoid becoming a victim of fraud. The package of deliveries are designed to get at "the truth of the matter." Taken together, they should enable someone to ferret out evidence of fraud.

There is no substitute for vigilance, however. "Keep your eye on what comes through your computer or across your fax machine."

Reproduced with permission from Real Estate Law & Industry Report, Vol. 1, No. 2 (Oct. 7, 2008) pp. 54-55. © 2008 by The Bureau of National Affairs, Inc. (800-372-1033)