Article, Commercial Litigation Journal – August 2009
Legal / Disputes
Ben Douglas-Jones, of 5 Paper Buildings Chambers, and James Stanbury, partner in RGL's London office, examine the factors which typically need to be considered when instructing a forensic accountant.
The financial tide has well and truly gone out and, as Warren Buffett prophesied, we have found many companies and individuals swimming naked.
The credit crunch has not necessarily led to an increase in the commission of fraud. It has, however, undoubtedly led to a shift in the types of fraud being committed and, as has been widely reported, the recession has also led to an increase in the detection of significant fraud.
From a corporate perspective, there has been an increase in fraudulent trading to preserve companies in dire financial straits. Meanwhile, the commission of fraud motivated entirely by greed has waned: many frauds are motivated by financial survival.
From an individual perspective, there has been a massive increase in the detection and exposure of banking and mortgage fraud. This has been motivated, at least in part, by the banks' desire to demonstrate that they are taking active steps to prevent and combat fraud. No doubt banks are concerned that increased regulation and monitoring of due diligence will expose further deficiencies in regulation in the banking sector.
Commercial practitioners specialising in fraud need to be equipped to deal with the emerging trends. An increasingly important weapon in their armoury - as long as it is deployed effectively and used with precision - is a forensic accountant.
The key to effective use is meticulous preparation and forethought, concerning the ends to be achieved, at every stage at which there is contact with the forensic accountant.
How to use a forensic accountant
There are a number of considerations in both commercial and criminal litigation which will inform the relationship between lawyer and forensic accountant, and the quality of evidence that will be derived from the relationship.
At the inception of the case, the question should be asked: is a forensic accountant needed or desirable? If so, the next question is whether a forensic accountant should be instructed formally under CPR part 35 or informally in an advisory capacity. The latter provides advice and an assessment of the merits of the evidence, and may be asked to carry out an investigation into relevant issues.
The role of a part 35 expert witness
Unlike that of the expert adviser, this may be summarised as giving opinion and factual evidence relevant to establishing more complex facts of the case. It should also be noted that:
- their intervention in the proceedings is governed by permission and is directed by the court;
- they produce a written report;
- they may, with permission, give oral evidence;
- they are independent of the parties; and
- their duty is to the court above the parties.
Careful consideration needs to be given to the specific questions to be asked of the forensic accounts in the course of the instructions.
In fraud cases, there are usually two contexts to be considered: firstly, civil litigation, where, for example, an insurance company has to consider whether it can demonstrate that the claim arises from a deliberate act; and, secondly, criminal proceedings, considering the prosecution case for offences committed against the insurer. The prosecution under the Fraud Act 2006 will reflect the insurer’s defence.
It repeals numerous existing offences of dishonesty and creates a general offence of fraud in their place. The new offence can be committed in three principal ways:
- by making a false representation;
- by failing to disclose information; or
- by abusing a position.
This simplification of the law has substantially increased the scope of criminal liability. Importantly, it is not necessary to prove that a gain or loss was made, or that a victim was deceived. In a corporate context, company officers can face prosecution for offences committed with their consent or connivance.
Standards of proof
The insurer needs to prove its case on cogent evidence - see Re H & ors (Minors) (Sexual Abuse: Standard of Proof) . This case clarifies the law concerning the evidence required to prove a criminal allegation in civil proceedings. Whereas in the leading case of Hornal v Neuberger Products Ltd  the House of Lords described the standard of proof as a variable standard, whereby a heightened standard was required to prove a criminal allegation, in Re H Lord Nicholls made it clear that the standard of proof does not vary, but that the more improbable the event the stronger must be the evidence that it did occur if, on the balance of probability, its occurrence is to be established.
For example, the forensic accountant instructed by an insurance company hoping to demonstrate a fraudulent financial motive for the making of a bogus claim must show:
- the actual financial position of the company before the incident giving rise to the false claim; and
- its expected financial position after and but for this incident.
Both questions focus on whether the subject company was in a deteriorating or perilous financial position.
Alternatively, such analysis may demonstrate that there would be no claim for loss of profit, even without the event leading to the claim, because of the downturn in the market.
Assembling the relevant documentation
Where paper financial records do not survive and no electronic backup tapes were maintained off-site, the accountant will need to recreate the financial position, primarily from the following data sources: \
- Auditors and external accountants: copies of accounts/working papers.
- Banks and financial institutions: bank statements and facility or loan documents.
- HMRC: tax returns and assessments (annual accounts), and VAT records (quarterly sales and purchases).
- Customers: sales and debtors' data.
- Suppliers: purchases (fixed assets and trading expenses) and creditors' data.
Asking the right questions will enable the counterparty to prepare a full report which demonstrates a prima facie case for the existence of a financial motive by reference to the financial position of the company under investigation. For example:
- Have sales, margins and overall profitability declined?
- Have there been any significant personnel changes that affected trading patterns?
- How current was the company's stock?
- What were the age and condition of the fixed assets?
- What was the cash-flow position?
- Had the company breached any overdraft or loan covenants?
- Are the statutory returns and payments (for example, VAT) in arrears?
- Are there any alternative sources of finance available to enable trading out of the decline?
Implications of the expert's financial analysis
Where, for example, the expert's report provides evidence that there was no prospect of any upturn in sales; net losses had accumulated over the previous months; production machinery had been damaged and had been repaired by existing staff rather than third-party professionals, thereby impairing its usage and efficiency; and an analysis of the bank statements provided a wealth of evidence of the company’s inability to pay debts as the fell due, the insurer in some way to establishing evidence of financial motive at the higher standard of proof.
However, any evaluation is always finely balanced – after all; companies do incur losses and keep trading. In addition, it must be remembered that the financial analysis is only one facet to a fraud investigation: interviews, forensics and police support all contribute to the conclusion.
Instructing a forensic accountant on behalf of the insured
The insured must decide whether it needs to instruct its own expert or whether it is able to challenge the report of the insurance company without its own expert. While a report will usually be needed, the source evidence may dictate that a favourable report will not be forthcoming. Rather than instructing a forensic accountant under CPR part 35, whereby the obligation to disclose the fact that a report has been prepared will almost certainly arise (even if the obligation to disclose the report itself will not), advice may be sought from a forensic accountant (see Carlson v Townsend  below). This will preserve the relationship of confidentiality, and thus privilege. However, the adviser cannot then go on to be the independent expert.
Such advice, even when not favourable, is likely to provide a claimant with ammunition with which to challenge the defendant insurer's expert evidence.
The forensic accountant's report in criminal proceedings
The impact of tactical decisions taken by or on behalf of civil litigants on concurrent or prospective criminal proceedings is frequently ignored. Advisers should be aware that such a report is likely to be used by the police to found, bolster or inform an investigation which might otherwise falter through insufficient resources. The wisdom of issuing civil proceedings, given their implications in prospective criminal proceedings, should be explained to the claimant company.
Similarly, a failure to consider the ramifications of the criminal litigation may lead to the claimant company obtaining its own expert report without any appreciation of the fact that in certain circumstances the police may rely on the contents of that report.
The evidence of a forensic accountant may, if secured misguidedly under part 35 in the course of civil litigation, pave the way to the conviction of a company or its officers in criminal litigation. A conviction may, in turn, lead to the triggering of the lifestyle provisions (see Lifestyle Provisions below) in confiscation proceedings under the Proceeds of Crime Act 2002.
Whereas it might have been worthwhile for a claimant company to risk litigation over its loss of profits, that risk changes utterly when criminal proceedings are taken into account. Furthermore, the way advice is sought from a forensic accountant in criminal proceedings and the nature of such advice may also acquire importance if s35 of the Criminal Justice Act 2003 is brought into force.
Disclosure of defence expert
Under s35 of the Criminal Justice Act 2003, 'Notification of names of experts instructed by defendant' (which is not yet in force), it is proposed that a section 6D should be inserted into the Criminal Procedure and Investigations Act 1996, whereby:
“If the accused instructs a person with a view to his providing any expert opinion for possible use as evidence at the trial of the accused, he must give to the court and the prosecutor a notice specifying the person's name and address”.
Emerging trends in fraud dictate that forensic accountants are an increasingly important tool in commercial and criminal fraud. Meticulous consideration needs to be given to:
- what evidence is required to bring or defend a civil claim and whether a forensic accountant is necessary or desirable;
- whether civil proceedings should be brought at all when the potential implications of criminal and confiscation proceedings are considered;
- what is required of the expert at each stage in the proceedings by reference to the nature and detail of the instructions; and
- the disclosure implications of individual decisions.
Carlton v Townsend
The claimant in a personal injury matter gave the defendant a list of three medical experts, one of which the defendant objected to. The claimant instructed one of the other two experts and received a report from him. The claimant subsequently refused to disclose this report to the defendant and obtained a further report from another expert. The defendant initially obtained an order for disclosure, but this was overturned on appeal. The defendant then appealed to the Court of Appeal. Their lordships held that the claimant had failed to comply with the relevant protocol, but that the appropriate sanction would be based on directions, costs or interest, rather than disclosure of the report. The defendant’s contention, that the expert became jointly instructed once the defendant declined to object to him, was rejected.
The lifestyle provisions of the Proceeds of Crime Act 2002 can be activated by a conviction for a ‘lifestyle offence’, such as money laundering; an offence committed over a period of at least six months; or an offence forming part of a course of criminal activity. Once triggered, the lifestyle provisions require an unlimited enquiry into the defendant’s benefit from ‘general criminal conduct’. As part of this process a defendant faces the burden of rebutting the assumption that for the previous six years, everything they have owned or spent money on has represented the benefit of criminal conduct, and is therefore liable to be confiscated.
As appeared in Commercial Litigation Journal, August 2009.