Take the money and run: white collar crime at DHR patio homes, LLC (1).

Sherman, Herbert ; Rowley, Daniel J.

CASE DESCRIPTION

This is a field-based disguised case which describes how a small family business deals with crimes committed by a trusted employee. The problem for the characters in question is how to deal with their most trusted employee, someone they treated like a family member, who they discovered had stolen nearly $25,000 from them over a two year period. Several factors complicate the owners' decision as to how to proceed: the person in question was their most tenured employee and had become part of the family, the employee and his family were renting a house built by the protagonists for the employee until the employee could establish his own credit, and the employee's brother worked for the firm. The case has a difficulty level appropriate for a sophomore or junior level course in business ethics or small business management. The case is designed to be taught in one class period (may vary from fifty to one hundred minutes depending upon the course structure and the instructional approach employed, see instructor's note) and is expected to require between four to eight hours of outside preparation by students (again, depending upon instructor's choice of class preparation method).

CASE SYNOPSIS

Derived from observation, field interviews, and e-mails, the case describes how two college professors operating several businesses were confronted with the fact that their most senior and competent employee appeared to have purloined nearly $ 25,000 in company funds. The employee in question, Alan Thompson, was originally hired with his wife Wilma to finish basements in Davis and Hodgetts' rental units. This project was such a success that as the business moved into private home construction Alan became the defacto on-the-job contractor. Growth in their business cost them their bookkeeper and they secured the services of James Carroll, CPA for the firm. When examining the firms' books, Mr. Carroll noticed that certain expenses were either for personal items or duplicates for similar expenses incurred a short time ago. An audit indicated that Alan Thompson was the culprit for these expenses as well as the fact that several charge card receipts had a signature that was not Mr. Thompson's. Davis and Hodgetts had to decide what if any legal action would they take, if they wanted to try to recover any of the stolen funds and if so, how; and how do they want to confront Alan with their findings?

"Jim," Richard Davis managing partner of DHR Patio Homes, LLC shouted in disbelief, "are you trying to telling me that over the past two years my right-hand man and foreman, Alan Thompson, has embezzled nearly $25,000?" "Figures don't lie but liars figure," retorted James J. Carroll, CPA, the new accountant for the firm. "I've audited your three firms' accounts for the past two years and found that purchases have been charged to Thompson's corporate credit card that either have nothing to do with the business, like the purchase of a Christmas tree, or seem implausible, like buying gasoline six times in the same day for the same vehicle. Worse, I've noticed that for several purchases the signature on the receipts do not even come close to matching the signature on the back of the corporate credit cards. I think someone who is not authorized has used this card--that's not only embezzlement, my friend, that's credit card fraud and forgery!"

COMPANY BACKGROUND & HISTORY

Davis and Hodgetts owned three firms: D & H Management LLC, DHR Construction LLC, and DHR Patio Homes, LLC. See Figure 1, below.

[FIGURE 1 OMITTED]

Business #1

D & H Management LLC was started in August 2002, when the Dow Jones Industrial Average dipped under 8000. Davis and Hodgetts, friends and coauthors, were lamenting their ever shrinking retirement funds. Neither was getting any richer on a faculty member's salary nor did they expect any windfalls from relatives, their book sales, or lottery tickets. As Hodgetts was fond of saying "America believes in education: the average professor earns more money in a year than a professional athlete earns in a whole week." (2)

After a long discussion, they decided that they could not longer bear "the slings and arrows of outrageous fortune" (3) and consequently needed to become masters of their own economic fate. Davis had done preliminary research on the real estate market in their area and convinced Hodgetts (who had a bad experience renting his house several summers ago) that there was money to be made becoming what Hodgetts half jokingly called "slum lords."

The basic premise behind their business was quite simple. New starter homes (3 bedroom, 2 bath) in their area sold for about $175,000 and could be purchased with as little as a 5% down payment. Davis was working with a real estate agent who noted that there were numerous families looking to get into these starter homes. However they either did not have enough cash for the down payment and/or had a poor credit history and could not qualify for a mortgage. These families lived in either mobile homes or apartments and were paying rents ranging from $1100 to $1400/month. They seemed to be willing to sign a three year lease on a new home with an option to buy. The three years would allow these families to build up a positive credit history and/or a down payment.

Davis and Hodgetts, with the assistance of Davis's real estate agent, found six families in three months and worked with these families to find them homes in the $175,000 price range that the families would be happy to lease and eventually purchase. The deal was so attractive that they even had a waiting list for new tenants. The six homes though had gobbled up their initial investment of $100,000 and required an additional $80,000 (which Hodgetts loaned the company) although their monthly cash flow was positive ($1,500/month).

Business #2

The second business started off as just a small capital raising venture. Hodgetts and Davis would finish off the basements of their rental homes, get the homes reappraised, and then remortgage the properties pulling out an additional $10,000--$20,000 per home. These funds could then be used as down payments for future rental homes.

Davis and Hodgetts had originally approached several builders in the area who priced the job at about $15,000. In discussing the prospect of finishing off basements with their renters, one renter claimed that he could finish off his own basement and save the firm from $2000 to $5000. This was Alan Thompson, who, with his wife Wilma, moved from a trailer home to become one of Davis and Hodgetts' first renters. They would not be able to do any of the technical work i.e. HVAC (Heating, Ventilation, Air-Conditioning), plumbing, or electrical, but would be able to do all the other work including framing, dry walling, finishing and painting.

In chatting about this matter further will Alan and Wilma, Davis and Hodgetts proposed that Alan and Wilma also finish off all of the other basements of their tenants. Davis explained to them that they would have to form their own LLC and act as any other subcontractor. They would have to obtain their own business insurance and home construction permits, pay their own taxes, and supply their own tools and raw materials. Alan and Wilma estimated that they could make at least $2000 per job, since the work was labor intensive. They both could work on the weekends to complete the basements in a timely fashion. From Davis and Hodgetts' perspective, even if they were to save only $2000 per home, that would net them a $12,000 savings on their six homes. This would free up cash for future home purchases. Davis and Hodgetts went on to purchase six more homes, five of which had their basements completed by Alan and Wilma (as A&W Construction, LLC). This was an excellent arrangement for Alan and Wilma since they could finish off a basement in about a month's time and net a profit of about $2000 per basement. This income was of great benefit to Alan and Wilma since Wilma was a stay-at-home Mom who was home teaching her four children and Alan was a low wage day laborer.

Alan and Wilma enjoyed working on these basements so much that they approached Davis and Hodgetts about figuring out a way that they could keep them occupied all year round. The gist was that Alan wanted to quit his job and come work for Davis and Hodgetts. However, there was nothing that Davis and Hodgetts could do for Alan and Wilma at that time. Yet a few days later the situation changed dramatically. Their basement designer, David Russ, was Davis's student. He approached Davis with the idea that Davis and Hodgetts could cut out the middle man in terms of the rental business if they built their own homes. Davis thought that Russ was crazy at the time but they talked after class and Russ said that he would be happy to act as the general contractor. Russ also stated that he knew all of the subcontractors who were needed in order to construct new homes. Alan and Wilma would do all of the interior work, and Alan could hire some part-time workers to help out. In any event, Davis and Hodgetts could build the rest of the homes they wanted to rent under a different company name, sell it to themselves for a profit, and then make a profit renting the homes. On a $150,000 home Davis and Hodgetts would net about a 20% profit, that's around $30,000 over a two to three month time period (the time it took to build a 1200 square foot three bedroom, two bath home).

The profit derived from this little construction company lead Davis and Hodgetts to backward integrate their operation. They were now going to build homes for public consumption as well as for D & H Management (as rental units). In May, 2003 DHR Construction LLC was formed and broke ground on their first construction site in the St. Andrews development.

This shift in strategy however uncovered some troubling operational problems. While on the surface everything seemed to be going fine, an undercurrent of discontent was running through the ranks of DHR's subcontractors, especially Alan and Wilma. They complained bitterly to Adrienne Davis (Richard's wife) that Russ was both crude and rude in his dealings with them and the other subcontractors. Further, Russ had threatened to fire them if they protested his actions to Davis and Hodgetts. Other subcontractors were complaining to both Davis and his wife as well. They'd be called into a project by Russ either too early, when the work was incomplete (and therefore they could not do their own work), or too late (they'd have to work around someone else's work). Property was also disappearing from the work sites, especially with wrong orders where goods would have to be picked up for return by the deliverer. Homes were running over budget and the quality of the work being performed was inconsistent and not always up to building codes.

Less than two weeks into construction at St. Andrews, Adrienne decided to intervene and have a chat with David Russ. She wanted to give him a chance to reflect on the negative feedback that she was getting from all of the subcontractors. The meeting went well according to Adrienne, however the situation was getting worse. She confided in Hodgetts a week after the meeting that David Russ was undermining Davis and Hodgetts' relationships with various subcontractors by setting unrealistic deadlines. Alan was the one who smoothed things over with the subcontractors once David Russ left the job site; otherwise the subcontractors would have walked off the site.

Hodgetts had a nice chat with Richard Davis who concurred that a meeting would put this issue to bed once and for all. The meeting went well according to Davis but David Russ's deplorable behavior did not desist. This matter came to a head only a few weeks later, in early July, when Richard Davis and his wife took a two week trip to Europe. Hodgetts also planned to be out of town at the same time. This left Davis's son Robert to represent both Davis and Hodgetts' interests while they were away and Robert was given the formal authority to act on Davis and Hodgetts' behalf.

Robert had scheduled a luncheon appointment with each of the subcontractors during the time his parents were away in order to give him a chance to connect with all of the subcontractors and catch up on events. The fact that Robert was speaking to subcontractors without permission from David Russ caused David Russ to become quite agitated. David Russ then proceeded to threaten Alan and Wilma, saying that none of the subcontractors were to speak to anyone but himself and that he would report any information necessary to the Davis' or Hodgetts. Wilma reported this conversation back to Robert Davis, who immediately forwarded this information onto Richard Davis and Hodgetts. In July, 2003, Hodgetts and Davis reluctantly agreed that they needed to rid themselves of their co-owner, David Russ, given the negative reports they had received from their subcontractors and Davis's son. Both Davis's wife and son found Russ's behavior intolerable and evidently these behaviors were not going to be corrected in the near term. Davis was forced to choose between his family and his business partner and his business partner drew the short straw.

In November 2003, Davis and Hodgetts bought out David Russ's interests in DHR Construction. By January 2004 they had completed three homes at St. Andrews. They then shifted their building site to another location, the Florence Development, which they felt had a more up-scaled look and would allow them to build nicer and more expensive homes. By April, 2004 they had built three homes in Florence, had plans to build five more in that area, and were looking at other developments for future growth and expansion. On April 12, 2004 the Florence Development Corporation failed to pay their landscapers and each of the properties that were owned by Davis and Hodgetts in the development had a substantial mechanic's lien placed on it. This made it impossible for Davis and Hodgetts to build on these properties until the matter was resolved.

Business #3

While a deal was being brokered to clear Davis and Hodgetts' liens, in June 2004 Davis had located a brand new development about 10 miles east of where they currently were building, in an area called Snowy Mountains. Snowy Mountains was a unique project for the area since the developers had built lakes, a golf course, and a club house (including a three star restaurant) and had very specific designs for community development. The housing currently in the development (phase one) ran the gamut of homes, from two bedroom condominiums (that started around $140,000) to million dollar estate homes on the lake. Every member of the community was given access to the club house (which included a pool and a play ground), the several lakes dotting the development, and a discount at the restaurant and golf course. The developers also sponsored fishing, golfing, boating, and concert events. There was even an island that could be rented out for weddings and other parties and included fully equipped restrooms with showers, electricity, and a kitchen service cabana.

Davis believed that he and Hodgetts lucked out in that one of the home construction companies in the Snowy Mountain development had pulled out of their project, Mountain Trails, after a disagreement with the developers. The company had built approximately ten patio homes (4) starting in 2002 in a forty-five lot area, leaving the remaining lots vacant. Thirty-three of the lots had been sold back to Snowy Mountain; the other two lots were in foreclosure and held by two different banks. This was the last remaining section of Phase One which needed to be completed before Phase Two could be developed. Justin Martin, the developer, was reluctant to open Phase Two without a commitment from a home builder for the rest of Phase One. He was afraid that the Phase One property would remain dormant. Homeowners in this section of the development were getting quite upset that no action had been taken to complete their part of Snowy Mountains and clearly a solution was needed before the developer faced possible legal action. After several discussions with the local residents, Davis and Hodgetts felt that they were like white knights coming to the rescue of both the developer and the neighborhood.

DHR Patio Homes, LLC was therefore established in August 2004 by Richard Davis and Stephen Hodgetts in order to separate their construction projects in Florence from their latest project, Mountain Trails. DHR Patio Homes developed a simple business model. Homes would be priced at 20% above cost with Richard Davis acting as the architect and head of operations of construction. His job was to work with the subcontractors to ensure that their work met schedule and building code requirements and to make sure that subcontractors' bills coincided with the work provided. Alan would work with Richard Davis on the job by helping to coordinate the subcontractors as well as continue his own subcontracting work dealing with wall hanging, lining, spackling, molding, and painting. Wilma worked along side Alan (though Wilma was paid by Davis and Hodgetts directly) while Alan also hired his younger brother Marvin in order to help out. There was plenty of work to do and Alan wanted people he could trust. Alan's LLC received $6000/month to pay himself and his brother and pay federal income tax.

TEAM BUILDING

Davis and Hodgetts, both being academics, had a much more egalitarian approach to management and business ownership than a typical small business contractor. Although both held Ph.D.'s and were fairly well published and therefore considered experts in their own fields, they took a democratic approach to business operations and did not laud their education over their workforce. On many occasions they would meet with their subcontractors to brainstorm how a home should be designed and built, soliciting input from their subcontractors as often as possible. They treated their subcontractors as colleagues, specialists in their own fields, and it was clear from the feedback they received from their subcontractors that this style of management was both refreshing and appreciated.

Alan and Wilma, having worked with Davis and Hodgetts the longest of all of the subcontractors, seemed to flourish under this leadership style. Alan was a soft-spoken individual who had really never been given the opportunity to work the way he wanted to work. Davis gave Alan the autonomy to purchase tools and other building materials as needed, allowed him to use the business truck as his own vehicle, and gave Alan the authority to deal directly with the other subcontractors. Alan was therefore the point man for the building operation and focused on quality workmanship by building a solid network of subcontractors.

Davis and Hodgetts' trust in Alan and Wilma seemed to be reciprocated by their devotion to the business. Alan and Wilma had stuck with Davis and Hodgetts through the business's tough times and they developed what the Davis family thought were strong social bonds. Alan was always the man on the spot who worked weekends to get the job done on time and Wilma was always there to lend him a hand. This dedication to the job and to the business was taken very much to heart by the Davis family who, on many occasions, would invite Alan and his family to barbeques, dinners, and family outings (i.e. sports events). Hodgetts, who was at arms length from the business because of his own academic interests, was always impressed with how close the Davis' had become with Alan and Wilma and was always pleased to see Alan, Wilma, and their family at the Davis household during Davis and Hodgetts' weekly business meetings. Hodgetts could not recall a major business event (i.e. Christmas party, business opening, or anniversary) where Alan and Wilma were not in attendance. When Alan's brother Marvin came on board for the Mountain Trails project, social events included Marvin's family as well. This cemented the familial bonds within the business. Davis and Hodgetts were even renting the home that they had built for Alan and Wilma to them until their credit was established and they could obtain a decent mortgage rate. All seemed to be well from Davis and Hodgetts' standpoint given their previous trials and tribulations since the business now seemed in solid hands with Alan and Marvin.

PARTING IS SUCH SWEET SORROW

Typical of most small business owners, Davis and Hodgetts employed a friend of the family, Sally Stone, a bookkeeper, to keep the records of the businesses in order. Sally would take all of the monthly receipts, deposits, and bills from Adrienne, record them in the firm's journals, and write out any checks for outstanding bills. Adrienne would then receive a monthly statement from Sally for each of the businesses which she would then share with her husband Richard. Richard in turn would pass a copy to Stephen Hodgetts during one of their weekly brainstorming meetings where they would discuss the ramifications of the statements.

As the operation grew, however, Sally realized that she was getting in over her head and that the services of an accountant were needed. For example, the real estate management firm held most of the firms' assets and therefore any loan that Hodgetts made to the business' operations were done through D & H Management LLC. However, on many occasions the funds secured by this company were used by one of the construction companies; in essence D & H was lending money to another firm and the books of all of the firms involved needed to record this transaction. Sally knew how to record these transactions but was afraid that there may be more that Davis and Hodgetts needed to know that she was not aware of. With a heavy heart, Sally informed Davis and Hodgetts that she could not longer properly service their firms and that she would reconcile the books at the end of their fiscal year, December 31, 2004 and then depart.

Although Hodgetts and Davis understood Sally's reasoning, they were surprised that Sally would give up such a fast growing company. Sally, to her credit, had provided them with a list of local accountants that she subcontracted with, yet none of them had any experience with real estate management firms and construction companies. Davis and Hodgetts felt that if they had to hirn an accountant, they wanted one who was not only familiar with the construction industry but had several construction clients. Furthermore, they decided they wanted to work with a small accounting firm (best case scenario: a sole proprietor) since it was their belief that they would obtain the most personalized service from a small, independent accountant.

ENTER THE ACCOUNTANT!

After chatting with several of the other small local builders, and one or two larger ones as well, Davis made several phone calls to prospective accountants. They all seemed very competent, but one in particular, James J. Carroll, CPA, not only understood the business but also owned rental property. Davis and Hodgetts met with Carroll in early February 2005 and hit it off quite well with him. It turned out that Carroll was a professor of accounting at another local college and shared their passion for learning, Shakespeare, and Sherlock Holmes. Carroll immediately had several suggestions for the businesses including setting up a 401K retirement plan. Hodgetts and Davis turned over a copy of the books to him directly at the end of the meeting.

A few days later, Carroll, having just landed another construction company as a client, was perusing Davis and Hodgetts' books to obtain a feel for the company's expenses and revenue streams as well as the way in which the company's bookkeeper checked receipts against claimed expenses. "Let's see ... digging into October 2004 corporate credit card charges ... This is strange ... I've got six gas receipts charged on the same credit card for the same day for the same vehicle .. how is that possible?" Digging into the older receipts Mr. Carroll noticed numerous strange credit card charges to the same credit card: a Christmas tree and gifts from Home Depot, over two hundred dollars of food purchased at Wal-Mart, and fifteen to twenty specialty tools purchased over and over again in a span of just a few weeks.

Carroll, having worked with several other small businesses, knew that some small business owners would charge family expenses to their corporate credit cards. He hoped that this was not the case. Mr. Carroll was a highly ethical accountant and always explained to his new accounts that personal expenses could not be treated as business expenses. Mr. Carroll would not service any client who mixed these expenses, specifically, those clients who hid personal expenses in their businesses. He decided that before he would discuss the ramifications of this behavior with Davis and Hodgetts, that he better do more digging. Perhaps he could discern a pattern which would explain such behavior.

THE SEARCH IS ON

Carroll felt like Sherlock Holmes as he plodded through all of the receipts, checks, and journal entries. He was astounded at what he found. First, Davis and Hodgetts had set up separate credit card accounts for each of their corporations, an extremely sound practice since this made it quite easy to track and separate corporate expense. This built a paper "wall" between the businesses. Most small business owners with multiple LLC's that Mr. Carroll advised had to be taught to divide up expenses by business; Davis and Hodgetts were ahead of the game. This lead Carroll to assume that Davis and Hodgetts had some awareness as to the proper handling of business expenses. Perhaps these personal charges were at best accidental or at worst temporary "loans" that they would pay back their businesses. Yet more digging revealed additional interesting data.

When Davis and Hodgetts set up these corporate accounts, they were intelligent enough to assign a specific card to each person who was issued a corporate credit card. There were usually three cards issued per account; one to Richard Davis, a second to his wife Adrienne, and a third to Alan Thompson. The credit card company tagged each card so that when the company reported the monthly charges they did so by the person who accrued the expense for the firm. It was therefore possible to track individual spending patterns and determine who spent how much on what. Carroll quickly noticed that the personal expenses all seemed to be made by only one person, Alan Thompson. Carroll tabulated these expenses, along with expenses he thought were perhaps frivolous or questionable (for example, the purchase of the same tool three or four times in a three to four month time span), and found about $25,000 of these types of expenses over a two year time period. Mr. Carroll also checked the signature of the Thompson's card (Davis and Hodgetts had made copies of each of the credit cards, both sides, in case they got lost or were stolen) and noticed that on several occasions the signature was different on the signed credit card receipt than on the actual credit card.

He took his findings to Richard Davis, who, at first, was totally incredulous. However, after examining all of the evidence knew that he had a real problem. The question is, what should he do about it? He decided to talk with Stephen Hodgetts and his wife Adrienne before he took any action.

THE MEETING

Richard Davis recapped the situation of the misappropriated funds to his partner Hodgetts, who sat still throughout the entire proceedings. When Richard came to the end of his tale of woe, the silence was deafening.

"So now what do we do?" Stephen said to break the stillness. "Clearly Alan has abused his corporate credit card and we must put an end to that immediately." "Done" interrupted Adrienne. "I have called the credit card company and immediately cancelled his card. I told Alan not to use his credit card since we are in dispute with the credit card company over some charges." "So you lied to him" responded Richard. "You don't think that he will now put two and two together and figure out that we're onto him?" "What else could I do, Richard? Cancel the card without telling him and have him find out that the card is no longer valid when he tries to use the card? That would seem even more suspicious! Or worse, should I have allowed him to continue to put unwarranted expenses on the card? What would you have had me do?"

"Wait a minute, slow down the both of you!" chimed in Hodgetts. "We can't fight amongst ourselves on this, that won't get us anywhere. Let's look at all of our options and what we immediately need to do to protect our businesses. If we have cut off Alan from his ability to spend company funds then we have at least dealt with one short-term issue." Both Richard and Adrienne nodded their heads in agreement. "Good" continued Hodgetts "then what are the next steps we need to take in order to protect ourselves and deal with this theft of funds?"

"Good question" exclaimed Richard. "I see that we have at least three issues to deal with. One, what if any legal actions can we take and do we want to take at this time? Two, do we want to try to recover any of the stolen funds and if so, how? Three, Alan and his family have been part of our businesses since the beginning. What actions do we want to take with Alan and how do we want to confront him with our findings?"

Adrienne seemed very disturbed by the entire conversation. "We are all struggling with this feeling of loss and betrayal" she said in a saddened tone. "These are tough decisions we need to make. I think we need an objective view, so I'll contact our lawyer first thing Monday morning. His advice will be extremely helpful." "An excellent suggestion my dear" Richard declared. "Let's hear what our lawyer has to say about this terrible debacle and see what sense he can make out of it. In the interim, mums the word to Alan, his wife, or his brother. I don't want to accuse anyone of anything until I know what the possible liabilities are for us if such accusations are contested or worse, wrong!"

ENDNOTES

(1) This is a disguised case. The name of the company and the characters in the case have been changed at the request of the owners.

(2) http://www.quotationspage.com/search.php3, August 27, 2003.

(3) Hamlet (III, i, 56-61)

(4) A patio home is a detached form of condominium. The homeowners association performs all exterior maintenance and collects fees from the individual homeowners.

Herbert Sherman, Southampton College--Long Island University

Daniel J. Rowley, University of Northern Colorado