Fraud traps await unwary associations

Homeowner associations are rocked by a triple whammy when they discover they are victims of fraud.

First, there’s the financial loss, which may be substantial. Next, the association members have to deal with the betrayal of trust. And third comes the nagging realization that this might have been prevented.

Fraud at nonprofits and small businesses -- both categories that include homeowner associations -- mostly involves conflict of interest, bribery and illegal gifts, false reimbursement of expenses, billing issues, check tampering and cash theft, according to the Assn. of Certified Fraud Examiners, based in Austin, Texas.

Perpetrators may be board officers or members, managers or other staff, association homeowners or outside parties such as vendors or tradespeople doing business with the association, said Ronald S. Stone, professor of accounting and information systems at Cal State Northridge and a certified fraud examiner.

Homeowner associations, as nonprofits handling large sums of money -- in reserve and replacement funds, and daily operating accounts -- are especially at risk, Stone said, because they lack the checks and balances, and financial acumen, of most commercial businesses.

But at the same time they are expected to exercise prudent judgment and maintain detailed financial records.

“They have a fiduciary responsibility to all the owners to exercise good business judgment,” Stone said, adding that they must also keep adequate books, records and files, including copies of major contracts, paid bills, bank statements and detailed collection records.

Red flags can include missing bank statements and other documents, photocopies instead of originals, unexplained cash shortages, duplicate payments to vendors and payments for unspecified services.

Stone recalls a case in the early ‘90s in which a Calabasas community manager used phony invoices and false bank statements to steal more than $1.5 million of association funds. He was eventually sentenced to six years in prison for check forgery and grand theft.

Many warning signs went unheeded in that case as the manager of the 268-unit association set up a system involving duplicate checkbooks, hidden bank accounts, bogus and real vendors, photocopies of documents and a set of false financial statements, Stone said.

Boards often are composed of well-intentioned volunteers, unit owners who typically are elected; however, they undergo no screening or background checks, Stone said, and may lack financial training or experience.

State legislation mandating three hours of board member education failed last year; the latest version of that bill, rather than make the education compulsory, would require members only to disclose whether they have taken such a course.

Yet another bill seeks to usher in education and training under the umbrella of a state bureau of common-interest developments that would be funded, at least in part, by a charge on community association homeowners.

Too much trust -- in fellow board members, board officers, vendors, the manager or management company -- and too little oversight, mixed with complacency and a reluctance to confront people and ask hard questions, can be a recipe for disaster.

Sometimes homeowner apathy is so widespread that the normal oversight flowing from the involvement of interested and caring residents is missing; this lack of participation may be extreme -- and leave associations especially vulnerable to criminal abuse -- in associations with high numbers of absentee owners.

David Harvey, treasurer of the association at Diamond Head, just west of Valencia, for seven years and now the association president, believes an obsession with the minutiae of association politics among many board members blinds them from seeing the bigger picture.

“Nobody watches the money,” he said. “Most of them are not businesspeople; they’re busybodies. They’re only interested in trying to control their neighbors.”

Meanwhile, property managers, who may have half a dozen properties, could be doing kickback deals with vendors, landscapers, painters and other suppliers, he said. “That’s what you need willing volunteers to watch out for.”

Pasadena attorney Kelly Richardson, co-founder and managing partner of Richardson & Harman, a law firm specializing in real estate and community association issues, recommends that to minimize fraud risk -- and even questionable actions that can appear illegal -- boards need to know what they’re doing, keep accurate records and operate as transparently as possible.

Looking back over some of the cases he’s been involved with, Richardson blames bad judgment, poor management and lack of documentation rather than dishonesty or intent to defraud.

Richardson said that even when accusations are unfair and unfounded, boards too often react by refusing to disclose information. “They make themselves look defensive and crooked when they aren’t.”

He said the law grants broad access by board members and homeowners to most association records, and when information is improperly withheld it unnecessarily elevates the level of mistrust and conflict.

Stone believes much fraud is driven by ego, greed and hubris. “People think they’ll get away with it. It’s like stealing cookies from the cookie jar. It takes a while to be detected but time works against them and eventually the fraud gets found out.”

Still, the fraud examiners association believes a great deal of general fraud goes unreported, perhaps because organizations do not realize it’s happening -- the association says most instances of small-business fraud are discovered by accident -- or they want to avoid bad publicity and other awkward consequences.

Among 1,134 cases of fraud between 2004 and 2006 that were surveyed in the association’s 2006 national report, about 800 were referred to law enforcement. Though some cases were still pending at the time of the survey, preliminary results suggested that almost 89% were prosecuted.

Richardson said prosecutors and police are more likely to be interested when there’s a lot of money involved and clear evidence of embezzlement.

In situations involving elected members or officers, where the chances of conviction and recovering the losses are slight, it may be best to “plug the leak, get the people out of office and move on.”

If an association discovers funds are missing, there are a number of steps it can take, Stone said, starting with removing the suspect from a position of control and securing books and records.

Richardson also recommends putting a stop on all bank account activity and asking the bank to call before it processes any checks or withdrawals. It may also be a good idea to consider closing accounts and opening new ones, at the same time reviewing bank signature cards and, if necessary, changing the authorized signers.

Other moves suggested by Stone include gathering all documents and other evidence, contacting the association attorney and insurance agent, and considering reporting the matter to the police.

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Built-in safety checkpoints

Ronald S. Stone, a professor at Cal State Northridge and a certified fraud examiner, offers these tips to prevent fraud against homeowner associations:

Require two signatures on checks or transfers of a predetermined amount such as greater than $500.

Never make checks out to cash or sign blank checks in advance.

Obtain multiple bids for all major contracts and check references.

Avoid conflicts of interest by not soliciting or accepting bids from board members, their friends or relatives.

Set low limits on credit cards issued to board members or employees.

Verify that expense reimbursements are legitimate and supported by receipts.

Thoroughly review invoices and supporting documents before signing checks.

Keep association records up to date.

Review bank statements and financial reports every month.

Keep minimum petty cash and count it periodically on a surprise basis.

Update bank signature cards whenever an authorized signer leaves.

Consider a thorough financial review or audit when management companies change.

-- Frank Nelson