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The Many Faces of Fraud, Part Two

We continue to sharpen our focus on our search for white-collar criminals as we review the legal definitions of the principal types of fraud. In the March/April issue of The White Paper we reviewed the main fraud categories of misrepresentation of material facts, concealment of material facts, and bribery. In this issue we conclude with conflicts of interest, theft of money or property, theft of trade secrets or intellectual property, and breach of fiduciary duty. This article is excerpted from the Fraud Examiners Manual, 2.201-2.207, Third Edition Updated 2000-2001 2000 Association of Certified Fraud Examiners. Conflicts of Interest Statutes in every state and the federal system (as well as common-law decisions in all jurisdictions) prohibit people from engaging in conduct that involves a conflict of interest. A conflict of interest may be prosecuted civilly or criminally. The criminal statutes vary widely and include prohibitions on public officers from accepting employment with government contractors or lobbying government agencies during specified time periods. Elements of a typical civil claim for conflict of interest include: an agent taking an interest in a transaction ... that is actually or potentially adverse to the principal ... without full and timely disclosure to and approval by the principal.

An agent includes any person who, under the law, owes a duty of loyalty to another, including officers, directors, and employees of a corporation, public officials, trustees, brokers, independent contractors, attorneys, and accountants. People who don't occupy positions of trust with another party, such as arms-length commercial parties, don't owe a duty of loyalty to each other and therefore aren't subject to conflict-of-interest restrictions. The defendant in a civil conflict-of-interest case must repay any losses that the conflict caused and must "disgorge" any profits he earned as a result of the conflict even if there was no actual loss to the principal. The "disloyal" party also might be required to forfeit all compensation received during the period of disloyalty. The victim of a conflict of interest also may void any contracts entered into on its behalf that were the result of or influenced by the conflict. Theft of Money and Property Theft is a term often used to describe a wide variety of fraudulent conduct. Many state statutes, for example, describe misrepresentation fraud as theft by deception or larceny by trick. As used here, the term theft is limited to embezzlement, larceny, and misappropriation of trade secrets and proprietary information. Embezzlement Embezzlement is the wrongful appropriation of money or property by a person to whom it has been lawfully entrusted. Embezzlement implicitly involves a breach of trust, although it's not

necessary to show a fiduciary relationship among the parties. The elements of embezzlement vary somewhat by jurisdiction, but generally are: the defendant took or converted ... without the knowledge or consent of the owner ... money or property of another ... that was properly entrusted to the defendant.

Larceny Larceny is defined as the wrongful taking of money or property of another with the intent to convert or to deprive the owner of its possession and use. In larceny, unlike embezzlement, the defendant never has lawful possession of the property. The elements of larceny typically include: taking or carrying away ... money or property of another ... without the consent of the owner ... with the intent to permanently deprive the owner of its use or possession.

Theft of Trade Secrets Theft or misappropriation of trade secrets may be prosecuted under a variety of federal and state statutes and the common law. Trade secrets include not only secret formulas and processes, but more mundane proprietary information, such as customer and price lists, sales figures, business plans, or any other confidential information that has a value to the business and would be potentially harmful if disclosed. The elements of a typical theft of trade secret claim are: that a party possessed information of value to the business ... that was treated confidentially ... that the defendant took or used by breach of an agreement, confidential relationship, or other improper means.

It's critical that the information being sought to be protected was treated confidentially, although absolute secrecy isn't required; it's sufficient if the information was "substantially" undisclosed. Limited disclosure to people with a need to know or pursuant to confidentiality agreements won't void the secret. Methods of demonstrating that information was intended to be kept confidential include a written policy describing the information as proprietary or secret; strict limitations on distribution of the information; and physically securing the information to prevent unauthorized access and use. The owners of the information also should enforce restrictive agreements and act promptly to remedy any inadvertent disclosures. Failure to do so might be construed as a waiver of confidentiality and make it impossible to prevent future use or disclosures. The most typical defense is that the information was developed independently. If the aggrieved party demonstrates that the information came to the defendant as the result of or during a confidential relationship, the burden of proof shifts to the defendant to demonstrate independent discovery. The defendant also might defend a misappropriation claim by showing that the information wasn't in fact a secret, that the third party's use was authorized, or that the trade secret or proprietary information had been abandoned by the owner. Remedies of Trade Secret Theft

Civil Action An aggrieved party may file a civil action for damages or request an injunction under a variety of federal and state statutes. Civil damages include reimbursement for actual losses caused by the defendant such as lost profits, reimbursement of development expenses and overhead costs, and the cost of efforts to protect the secret or recover damages, as well as for reduction in the value of business. Damages also can be measured by the defendant's profits, which may be ordered to be paid to the plaintiff. Punitive damages and attorney's fees also may be awarded. Injunctions In addition to or in lieu of money damages, the plaintiff in a civil action for theft of trade secrets also may obtain an injunction prohibiting further use of the information. To obtain an injunction, the plaintiff must demonstrate that: it's the proper owner of the trade secret; an unauthorized person has taken or used the trade secret; there's a high probability of improper disclosure; the plaintiff will suffer irreparable injury (meaning that the plaintiff couldn't be adequately compensated by money damages); and the plaintiff probably will win the case.

Injunctions are difficult to obtain, however. Injunctions have been issued in numerous trade secret cases to prevent the use of stolen information, to prohibit an employee in possession of a trade secret from accepting employment with a competitor, or to order the wrongdoer to return the misappropriated information. The injunction usually prohibits use of the trade secret only for that period it would have been required for its legitimate independent development. Breach of Fiduciary Duty People in a position of trust or fiduciary relationship, such as officers, directors, high-level employees of a corporation or business, and agents and brokers, owe certain duties imposed by law to their principals or employers. The principal fiduciary duties are loyalty and care. Duty of Loyalty The duty of loyalty requires that the employee/agent act solely in the best interest of the employer/principal, free of any self-dealing, conflicts of interest, or other abuse of the principal for personal advantage. Thus, corporate directors, officers, and employees are barred from using corporate property or assets for their personal pursuits, or taking corporate opportunities for themselves. More traditional fraudulent conduct, such as embezzlements, thefts, acceptance of kickbacks, and conflicts of interest also violate the duty of loyalty, and may be prosecuted as such in addition to or instead of the underlying offense. A breach of duty of loyalty is easier to prove than fraud. The plaintiff doesn't need to prove criminal or fraudulent intent or the other elements of fraud. To prevail, the plaintiff must show only that the defendant occupied a position of trust or fiduciary relationship as described above and that the defendant breached the duty to benefit personally. A breach of fiduciary duty claim is a civil action. The plaintiff may receive damages for lost profits and recover profits that the disloyal employee earned - in some instances, even the salary paid to the employee or agent even if the principal didn't suffer an actual loss. The plaintiff also may void

any contracts entered into on its behalf that were the result of or were influence by the employee's or agent's disloyalty. Duty of Care A corporate officer, director, or high-level employee, as well as other people in a fiduciary relationship, must conduct business affairs prudently with the skill and attention normally exercised by people in similar positions. Fiduciaries who act carelessly or recklessly are responsible for any resulting loss to the corporate shareholders or other principals. Damages may be recovered in a civil action for negligence, mismanagement, or waste of corporate assets. People in a fiduciary relationship, however, aren't guarantors against all business reverses or errors in judgment. The Business Judgment Rule protects corporate officers and directors from liability for judgments that were made in good faith (e.g., free of self-dealings or conflicts) and that appeared to be prudent based on the then-known circumstances. Corporate officers breach their duty of loyalty if they accept kickbacks, engage in a conflict of interest, or otherwise are disloyal. Corporate officers who carelessly fail to prevent such conduct, to enforce controls, or pursue recovery of losses might breach their duty of care. Corporate defendants in such cases might raise the Business Judgment Rule in defense by showing that they had no reasonable grounds to suspect such conduct or that the cost of prevention or recovery was too high compared to the anticipated returns. Correction The FraudBasics article in the March/April 2002 issue of The White Paper, excerpted from the Association's Fraud Examiners Manual, stated that an accountant may be liable for fraud if he or she "falsely states that the audit was conducted in accordance with generally accepted accounting principles." Because the article refers to an audit, the sentence should read "in accordance with generally accepted auditing standards." The Association of Certified Fraud Examiners assumes sole copyright of any article published in Fraud Magazine. Fraud Magazine follows a policy of exclusive publication. Permission of the publisher is required before an article can be copied or reproduced. Requests for reprinting an article in any form must be e-mailed to: