Today convicted felon Barry Minkow, acting as an agent for a disgruntled litigant, Nicolas Marsch III, posted false and inflammatory accusations concerning Lennar.

And in another press release:

The dissemination of false statements about our company last Friday resulted in the selling of an unprecedented 58 million shares of Lennar Corp. (NYSE: LEN; LEN.B) stock and a 20 percent decline in our stock price. This has prompted numerous inquiries from investors, analysts and the media.

One of the issues discussed in the original report was Chinese drywall. The report (which I helped prepare in part and edit) stated:

Red Flag #7 In the dispute over the Chinese drywall, Lennar misses the real issue. In a statement released on December 23, 2008, Lennar said that it was not the fault of Lennar (those darn sub contractors just can’t be trusted), that the Chinese drywall was not authorized to be used in Lennar homes, but that the problem was not widespread enough to be deemed material.

Darin McMurray, Lennar’s Southwest Florida division president,43 stated:

So far, our investigation in Southwest Florida shows that independent subcontractors installed Chinese drywall in a very small percentage of Lennar homes built between November 2005 and November 2006…

This statement is problematic, first, because the investigation is not complete. Further, the issue is not how many (or how few) homes have been built with the faulty and unauthorized Chinese drywall. The real issue is that this is an apparent pattern of behavior seen across multiple divisions of Lennar.

This incident indicates an attitude of “cut costs no matter how it might hurt the victim homebuyer, joint venture partner, etc.” In other words, Lennar is a company with a track record of doing business in a manner that always seeks to place their interests ahead of the customers and stockholders. We therefore expect to find evidence of that behavior in multiple areas, and when one takes a closer look at the company, that does appear to be the case.

Lennar called us liars, but on January 23, 2009 the Business Journal reported:

Miami-based homebuilder Lennar Corp. said it has identified about 80 homes in Southwest Florida that are believed to have been built using Chinese drywall. The nation’s second-largest homebuilder (NYSE: LEN) said it has set up a special task force to address homeowners’ concerns and fix the problem.

80 homes and a “special task force” doesn’t sound like a small problem.  And now there’s further proof that the Lennar Chinese drywall problem is indeed massive. The Herald Tribune in Sarasota, FL reports:

Lennar started remediating homes more than a year ago — saying it had already figured out what needed to be done to fix the problem. One of the first affected communities the Herald-Tribune reported on in early 2009 was Lennar’s Heritage Harbour development in East Manatee County, where several dozen homes were built with tainted Chinese drywall.

Back then, Lennar said its research and that of its environmental consultant, Environ, showed that insulated wiring within the walls was not affected. Therefore, it could snip off exposed ends of the copper wires and continue to use the rest of them.

There is just one problem: They were wrong.

The story goes on to say:

During the trial, scientists presented case after case of documented instances in which insulated wiring had been damaged in homes. The testimony went beyond scientists hired by the attorneys themselves. Two representatives of national builder Beazer Homes, including one of the company’s vice presidents, testified that the insulated wiring was not immune to the drywall’s corrosive gases.

Ray Phillips, Beazer’s Florida vice president, said the effect on insulated wiring was “a surprise” compared with what the builder originally thought it would discover in the homes. But the revelation meant Beazer now removes all wiring and the entire electrical system from Chinese drywall-laden homes.

Lennar appears to have reached a similar conclusion sometime last year, as its protocol has changed — it now takes out all wiring, too.

But a fundamental question remains: What about those early homes in Heritage Harbour and elsewhere where the wiring was left behind? If that wiring is now known to be affected, representing a serious safety hazard, what will be done?

Lennar did not respond to questions from the Herald-Tribune on these issues.

So let’s recap. The initial report by FDI over a year ago pointed out that Lennar’s statement that the Chinese drywall problem was minor shouldn’t be trusted. First, it shouldn’t be trusted because the company hadn’t even completed its investigation so management couldn’t possibly know if the issue was material or not.  Second, the statement shouldn’t be trusted because Lennar has a track record of blaming others in an attempt to deflect attention away from the company’s problems.

Lennar promptly came out and publicly called Barry Minkow a liar, apparently trying to capitalize on his past as a convicted felon, and trying to deflect attention from Minkow’s present as a fraud investigator who has uncovered at least $2 billion in fraud.

And now an outside source …. well actually, apparently several sources… has/have confirmed that this Chinese drywall is a huge problem:

1. The fix is running about $100,000 per home.
2. Lennar has a dilemma because of all the homes Lennar “fixed” before they realized all the wiring had to be redone. Lennar now apparently re-wires all homes in which it’s fixing the drywall, but what about the homes that were done previous to this protocol?
3. Other builders are also adding another step to their remediation process, pressure washing homes after the drywall and wiring has been completely removed to make sure there isn’t a problem with toxic particles in the air. Lennar has rejected this step and instead only vacuums.

Do you think Lennar will issue a press release indicating that FDI and Barry Minkow were right about the Chinese drywall issue?

College of Business Administration and Graduate School of Management
Entrepreneurial Award
Tracy L. Coenen, Arts ‘93, Grad ‘96

Tracy Coenen may not know where the bodies are buried, but she knows how to follow the numbers. When it comes to forensic accounting, she wrote the book on the subject. In fact, she wrote three: Expert Fraud Investigation: A Step-by-Step Guide, Essentials of Corporate Fraud, and The CPA’s Handbook of Fraud and Commercial Crime Prevention.

A CPA who’s also certified in financial forensics and as a fraud examiner, Tracy clearly knows her business: catching bad guys. She has investigated hundreds of frauds, from embezzlement and financial statement fraud to investment fraud and insurance fraud. She has served as an expert witness in cases involving damage calculations, commercial contract disputes, shareholders’ disputes and criminal defense. She even blogs about money scams professionally. (Read the whole article here.)

Every year they increase spending. Here is a breakdown of the budget and enrollment by year:

The 07-08 budget was $1.19 billion. The 08-09 budget was $1.24 billion. The 09-10 budget was $1.34 billion.

And it’s worse if you look at spending per student. In 06-07, they spent  $12,976 per student. In 07-08 they spent $13,758 per student. In 08-09 they spent $14,520 per student. In 09-10, they spent $16,385 per student.

What do we get for all this spending? A huge number of children who can’t read or do math.

I concede that some costs don’t decrease even when the number of students decreases. So the costs to maintain the buildings and other fixed costs can stay high even when there are fewer students. (Although the people running the district should be doing something to plan for this type of situation!)

But the single biggest reason why it’s become so expensive to run MPS is because of the employee costs. The average salary for an MPS teacher is $56,500, and the average benefits package is $43,505, for total average compensation of $100,005.

Let’s leave the salary issue out of it for a minute. I believe the salaries for MPS teachers are too high, but let’s ignore that for the sake of this discussion, and focus on the benefits. There is simply no way any business can survive with such a large benefits package!

The benefits package costs 77% of the salary. In the real world (read: private industry which is self-sustaining), benefits typically cost about 30% of wages. MPS has a benefits cost nearly 2.6 times higher than the real world.

For this school year, MPS is employing 5,766 teachers. That’s a total cost of $577 million in wages and benefits. If the benefits package cost was reduced to the 30% level that the rest of the country receives, the cost would only be $424 million. Voila! $153 million of instant savings.

And here’s one specific way that MPS can save on benefit costs: Force the employees to choose a more cost-effective health insurance option. In this Journal Sentinel story I’ve linked to, the writer cites the two health insurance options available to employees. They’re both very good plans! One costs $23,820 per family, and the other costs $16,440 per family per year. That’s a difference of $7,380.

MPS employees have zero incentive to choose the cheaper option, even though it is an excellent plan. So why not eliminate the choice and start saving money right away? The big spenders say that shifting everyone to the lower cost plan would cause the per-family cost of that plan to rise because of the way health insurance is priced. I don’t dispute that could happen, but even if it does, there will still be a substantial savings to the district.

So here’s the bottom line… MPS can cry all they want about not having enough money. The fact is that they’re spending too much, and  the bulk of that spending is related to teacher costs which can and should be controlled. If the district is unwilling to stand up to the teachers’ union, then everyone needs to shut up. I don’t want to hear the whining about teachers losing their jobs or about class sizes being too large. With the current compensation structure, the only way to have any control over the budget is by reducing the number of teachers.

The teachers have made their choice.  It is the teachers alone who are causing budget problems, and they could force their union to solve this problem. They’d still have jobs with generous pay and very good benefits, and there would be money left over for all the things they want to do (but which have to be cut to meet teacher costs).

Medifast sued us for daring to say that their Take Shape For Life multi-level marketing division is a typical recruiting scheme and looks like a pyramid scheme. FitzPatrick has done years of research on MLMs, in large part using the numbers publicly released by companies to demonstrate how the vast majority of participants lose money. He wrote two formal reports on Medifast and their numbers – - he basically showed that the company’s financial gains in the last year or two have come almost solely from their multi-level marketing division. (The first report is here, and the second report is here.)

How dare FitzPatrick say such a thing, especially when the numbers demonstrate exactly what he reported!!!

FDI produced several press releases on the findings about Medifast, and I reproduced and quoted some of those releases and reports, as well as wrote my own analysis of the company… questioning whether TSFL could be considered a pyramid scheme.

So Medifast sued us. For what? They claim we defamed the company by writing untrue things about it, yet they have failed to point out any specific inaccuracies in the reports that were produced about Medifast. Instead, all they’ve really done is act insulted for being compared to Bernie Madoff and for being called an endless chain recruitment scheme. (I’ve yet to find a multi-level marketing company that is not an endless chain recruitment scheme, but what do I know?)

As many are already aware, there is a First Amendment right to free speech, and we are allowed to talk about our opinions on things, including Medifast and Take Shape For Life. (Won’t it be fun to have the court consider this issue of free speech?)

So litigation has commenced and none of us defendants seems scared. Pooh. That’s not what Medifast wanted. They wanted us shaking in our boots and vowing to never speak of them again. So much for that. It seems instead that Medifast will now fall victim to the Streisand effect, since all this hubbub just serves to shine a brighter light on their multi-level marketing business.

William Lobdell wrote up a list of ten questions Medifast could answer to end the controversy about its Take Shape For Life business. We say the TSFL business has accelerated because of recruiting. They say it’s not because of recruiting. Here are a few of Lobdell’s ten questions… which surely could put this issue to rest if only Medifast would be willing to pony up the data:

• On its website, Medifast has advertised two income scenarios: one based on the coach selling the meal replacements to clients, the other based on the coach recruiting new coaches. One showed $8,000 a month in income, and the latter, $20,000 a month. What percentage of all coaches who have worked for Medifast over the years have earned either of those illustrated income examples?
• What is the average income of all coaches from product sales to clients, not from bonuses and commissions derived from recruiting other coaches who recruit other coaches who recruit other coaches?
• What is the average monthly income of all coaches who were enrolled during a year, not just the active ones?
• Medifast advertises that financial health is a key element for success in losing weight and offers its “coaching” program as the prime means for achieving financial health. What is the average net profit  to the coaches gained from sales to clients, factoring in all normal business costs (i.e., advertising)?
• What percentage of all coaches earn more per month than the costs of the product and related business expenses?
• The Medifast pay plan rewards coaches to recruit more coaches. The majority of commissions, per sale, are transferred to recruiters in the upper levels, making recruiting more lucrative than retailing.  When are there too many coaches in any given area? Is the sales force expected to grow without limits in all market areas?

Check out ibizreporting.com for the full list of questions posed to Medifast.

So Koss was removed as audit committee chairman but remains on the board and on the audit committee. I think it’s time for the Strattec board members to ask themselves a serious question: If Michael Koss didn’t care enough about his own company to pay attention to the financial statements, what makes you think he’ll pay attention at Strattec?

I’ve been more than happy to publicly state that Michael Koss and the rest of the executives were asleep at the wheel while Sachdeva was stealing at least $31 million from them in a fraud scheme that lasted over five years.  And amazingly, the executives don’t seem to have plans to change much in wake of the fraud, as they stated in their most recent 10-Q (bold added by me):

Although numerous actions were taken beginning in late December 2009 following the discovery of the unauthorized transactions, including changes relating to the Company’s banking procedures and certain other internal policies and procedures, as well as the other actions described in the Explanatory Note, the Company implemented no formal changes in the Company’s internal control over financial reporting during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

The company hasn’t said anything regarding how the fraud was actually carried out or covered up, but they have detailed how much was stolen each year.

Why do you suppose they haven’t provided any details about how the theft occurred? My suspicion has been that they are going to look like complete idiots because the fraud and the cover-up were carried out in a very simple way.  I doubt that this was some elaborate scheme by Sachdeva. My guess is that she had a simple method and anyone with an ounce of brains in the C-Suite should have caught on quickly.

So back to Strattec… Michael Koss didn’t care enough about his own company to have his auditors or any other professionals do any additional work related to internal controls, which likely would have stopped Sachdeva’s fraud much earlier. Why do you think he’ll care about your company?

It’s not like Strattec isn’t looking out for it’s own interests. The company just fired Grant Thornton as its audit firm. I highly doubt that decision was made independent of the troubles Grant Thornton is having because of the Koss fraud. So why leave Michael Koss on the board of directors, and specifically on the audit committee?

Michael Koss is a clown. He does not belong on the board of directors of any company. He needs to be minding his own company, and until he can clean things up there, he should not be allowed to go outside and play.

And this story on WalletPop.com about a man on unemployment emphasizes why it is so important to reduce all welfare to the absolute minimum, helping only those who are worst off and in an emergency situation.

The story starts innocently enough: The failure of Congress to pass a particular bill means 1.2 million unemployed people won’t get extended unemployment benefits.

The author is entitled to his own opinion about whether or not this bill should be passed. I, of course, think it should not be passed because it expands government even more during a time when government should be shrinking. We don’t need another cost put on the working people and the entrepreneurs (who incidentally start companies that create jobs, unless the government makes it too risky or cost-prohibitive).

But the author of the article, Aaron Crowe, probably picks the worst possible person to hold up as a “victim” of this unpassed bill.

The “victim,” Richard Hutnik of Poughkeepsie, New York, has been on the government dole for  three years. He cites his weekly unemployment check at $430, and if you do the math, that works out to over $67,000 collected by Hutnik for the last three years for not working.

But Hutnik wants more. He’s 42 years old, and appears to have no responsibilities in life other than paying for a $630 dorm room he rents. Yet in three years he hasn’t been able to find gainful employment? NO. In three years he hasn’t found a job he wants to take, and why should he, if he’s able to survive on welfare for three years without ever lifting a finger? He even goes so far as to admit that he could have a job at Wendy’s if he wanted one, but obviously it’s a lot more convenient to sit at home and get $430/week for doing nothing than actually going to a job.

We’re supposed to feel sorry for Hutnik because after receiving $67,000 for doing nothing, he wants his unemployment benefits extended even more. Otherwise he’ll have to go live with his “emotionally abusive” father.

(UPDATE: The WalletPop writer has amended his article to say that the benefit of $430 was every two weeks, equalling annual payments to Richard of $11,180, for a total of$33,450. This makes his refusal to take a lower paying job even more ridiculous. Certainly there are jobs paying more than the $932 per month he’s receiving from unemployment. Even with an $8 an hour job, he could substantially improve his financial situation.)

Dude. Hutnik should have taken a job flipping burgers about 33 months ago, and should not have been allowed to collect unemployment for three years. Sure, he might have had to take a job he didn’t like, or one he felt over-qualified for, or one that is not in his field of expertise. But that’s what we as Americans should do…. support ourselves instead of expecting someone else to do it.

There was a time shortly after graduate school when I was working three jobs. I had a professional job, a part-time retail job, and a bar gig on the weekends. Why did I do it? Because I wanted to survive financially. And it didn’t kill me.

But why should Hutnik get a job if we’re going to allow him to sit on his butt for 3 years and get paid for it?

We don’t need more unemployment benefits. We need our citizens to be more motivated to take jobs that will help them get by. If they’re working and the government is handing out less money, then our economy grows. It’s simple economics that it’s better for people to be working and keeping the cash within the private sector, rather than having our government raise our taxes (which discourages job creation) and passing out money to those sitting around.

I realize that plenty of people can’t find jobs in their fields, and they won’t like the job or the pay that they may be able to find. But people should do what is necessary to get by until they can find a better or more suitable job.

Hutnik has a master’s degree in information systems and is supposedly looking for a job in his field. I don’t think he did himself any favors by tell his tale of woe to WalletPop. Imagine  being an employer interested in Hutnik and imagine doing a Google search. And up pops this article with him crying over not being able to feed at the government trough for more than three years. Would you hire him? I wouldn’t.

In criminal cases, the issues surrounding the income of an individual or business have even higher stakes. These cases are quite often tax-related matters, but cases involving white collar crimes and drug trafficking usually include questions about income too.

What happens when the government is alleging a defendant earned a certain amount of income from a legal or illegal activity? Tax cases often include the government’s determination of the amount of income a taxpayer failed to report, and the defendant is left to prove how much income really was earned. In a similar fashion, a defendant in a white collar crime case may find it important to prove the level of income earned in order to refute allegations of hidden income or ill-gotten gains.

How would a person in this position prove their income, particularly if some of it was indeed from undocumented sources or if the allegations of undocumented or unreported income are completely false? In these cases, the help of a forensic accountant or fraud investigator can be invaluable. This type of professional is usually proficient in reconstructing books and records, making the task of proving income something that can be completed accurately.

But what happens when there aren’t books and records from which to reconstruct income? The records may have been destroyed or discarded. Even worse, the income alleged to have been earned by the defendant may be all cash, meaning that there is no paper trail. How then, can a defendant’s earnings be reconstructed?

Of course it is next to impossible to “prove a negative” in the case of cash proceeds from legal or illegal activity. Someone is alleging that your client had cash income that wasn’t reported or documented anywhere, and you’re left to prove that the money didn’t really exist. Where would you start?

Lifestyle Analysis
Probably the most commonly used method of proving income for an individual is the “lifestyle analysis.” It is used by both government agencies and defense counsel to prove (or disprove) income (legal and illegal, reported and unreported). It is also sometimes called the “expenditures method,” signifying the analysis of a person’s spending patterns in relation to their known sources of funds.

The idea behind this analysis is simple, although the execution of it usually is not. A lifestyle analysis attempts to quantify the living expenses of an individual and compare those expenses to known sources of income and other funds. Any differences can be attributed to concealed income. It is a matter of looking at the cost of living the lifestyle of the target, and determining whether the reported income is sufficient to do so.

With enough information, this type of analysis can be fairly precise. Gaps in information require estimates to be made, and the more estimates made, the less precise the analysis becomes. In these cases, a forensic accountant or fraud investigator is looking for outside pieces of information that may support estimates and assumptions.

A simplistic example of a lifestyle analysis would include adding up the known expenses of a person and his family: mortgage, groceries, auto lease or loan, groceries, insurance, credit card payments, and income taxes. Of course, there are many more items that may be included in such a list, and the forensic accountant has to be sure to include things like vacations, recreation, loans made to others, and a variety of ways that money could be spent.

The total spending is compared to known sources of income or funds: wages, bonuses, stocks sold, bank loan proceeds, gifts from family, and gambling winnings. As with the expenses, the forensic accountant should be careful to consider all possible sources of income in order to be as accurate as possible.

If the money spent during the period analyzed exceeds the known funding sources, it is quite possible that there is another source of income. The logic is simple: The money has to come from somewhere. It’s up to the forensic accountant to continue searching for proof of sources of income that could reduce the difference. Any remaining unexplained difference is likely representative of the elusive unreported earnings or proceeds of white collar crime.

Related Analysis Methods
The other methods used to search for unreported or unrecorded income are very similar, and are recognized by courts as valid methods of calculating income. The Internal Revenue Service frequently uses “indirect methods” of calculating income, including the bank deposits method and the net worth method.

If the majority of a person’s income is believed to be deposited to known bank accounts, the bank deposits method is a simple way to estimate income. Quite simply, all deposits to bank accounts are deemed to be income, unless they can be traced to another source, such as a bank loan, a transfer from another account, a gift, or other documented source.

The net worth method is very similar to the lifestyle analysis. Like the lifestyle or expenditures analysis, the net worth method requires the forensic accountant to analyze the sources of funds and how those funds are spent. In addition, the net worth of the individual must be established for the beginning of the period in question, as well as the end of the period.

Changes in a person’s assets or liabilities will affect the net worth, and any changes in net worth over the period in question are factored into the overall determination of sources and uses of funds.

The Nuts and Bolts of Lifestyle Analysis
The lifestyle analysis begins with the documentation that supports the known income and expenses of the party: bank statements, investment account statements, mortgage statements, income tax returns, credit card statements, auto or boat purchase and lease documents, home sale or purchase documents, invoices related to home repairs or remodeling, and the like. There are literally hundreds of items that could contribute to this part of the analysis, but these are the most common.

These documents help establish the ordinary spending of the party, and they also document the known sources of income and funds. It’s often helpful to look at three years of records to get a good feel for the spending patterns of the individual.

There can be one-time expenses that should be noted as such, and recreational activities should be examined over a period of time to best understand the usual pattern. This method can be used effectively when a person or business hasn’t kept adequate records or the records have been destroyed by a fire or flood.

After all of the available documentation has been analyzed, the search is on for spending that occurred outside the documented accounts. If that spending can be pinpointed or estimated, this may be evidence of unreported income.

Additional spending is often found based on tips for insiders or circumstantial evidence. People who are in-the-know might be able to point the forensic accountant to vacations taken, vehicles purchased, or other business and recreational interests that cost money.

Basic knowledge of personal finance issues can lead the forensic accountant to estimate other items of spending. For example, fuel for an auto and groceries are two common items that a person needs to buy on a regular basis. If all the documentation suggests an unusually low level of spending on these types of items, the forensic account should try to create a reasonable estimate.

In the case of fuel, the investigator will probably take into account the person’s commute to work, the number of people in the household who may have access to the car, and personal activities that require driving. An estimate of mileage driven will be the result of this analysis, and in conjunction with historical prices of gas, a monthly estimate of spending on this item can be made.

Other items can be estimated in a similar fashion. Grocery expenses can be estimated based upon the size of a household, age of the children, and frequency of dining out.  When estimating various expenditures, it will be important to consider the historical spending of person and household. Any significant changes in spending patterns should be carefully analyzed to determine if there is a reasonable explanation for the change, or if the change is reflective of hidden income and spending.

When the lifestyle analysis results in a difference between known sources of income and known and estimated spending, it’s important for the forensic accountant to rule out additional sources and uses of funds. In cases like this, the spending often exceeds the known sources of funding, which is precisely why someone (the government or a third party) is alleging there is hidden income.

It is necessary to continue to search for other legitimate sources of funds that might make up for the difference between income and spending. This often involves thorough questioning of the client, in addition to careful analysis of documentation that might signal other sources or accounts. The forensic accountant must exhaust all possibilities, hopefully with the assistance of the client.

But in the end, there may still be spending that exceeds known sources of funding, and that result will be important in the litigation. If the result differs significantly from allegations by the government or other parties, the forensic accountant will be left to prove that sound methodology was used and that her or his results can be relied upon.

Problems with Analysis
Certain situational factors can affect the reliability of a lifestyle analysis, many of them legitimate. One such situation is the receipt of gifts or loans from third parties (especially if done in cash), for which the target of the analysis will not provide information or confirmation. Clearly, such sources of funds could be legitimate, but it’s not possible to factor them into an analysis if the recipient will not disclose them. Of course, this type of analysis is often done because of the fact that information remains undisclosed, so this isn’t so unusual after all.

It is also difficult to do a complete analysis when the person in question owns a business that provides some of the funds for the lifestyle. Items like paychecks or bonus distributions from the business are easy enough to track. But what about a company that pays for the person’s vehicle or contributes to the cost of a vacation? There are many items for which the business might provide funds, but for which the forensic accountant may have no data.

You can see that the difficulty arises with sources of income or funds that are outside the usual sources like paychecks, bank loans, and the like. Again, the reason why a lifestyle analysis is done is because of allegations of undocumented or unreported sources of income or funding, so this isn’t unexpected. It is, however, important to understand that there are legitimate sources of money that can factor into an analysis such as this, and the forensic accountant or fraud investigator must take these things into account.

Because an analysis like this will often include many estimates, it’s important for the forensic account to consider applying ranges to certain expenditures. There are lots of resources available to help estimate “normal” spending for a person or family, but every situation isn’t the same and averages won’t apply across the board. Offering a range of estimated expenses may help the user of the analysis put the situation in proper perspective.

Another option when calculating lifestyle and expenditures is doing a “worst case scenario.” In addition to estimating and calculating the most reasonable and supportable numbers, the forensic accountant might also calculate the figures that would represent the worst possible result for the client.

For example, suppose an executive of a public company is accused of embezzling $10 million from the company. The government has done an analysis which supports the accusations and documents an estimated $10 million of spending above the known sources of income.

The defendant hires a forensic accountant to do a complete analysis, which results in a determination that $3 million is the correct figure for spending above known sources of funding. This figure was calculated using the documentation available in conjunction with the most fair and reasonable estimates the forensic accountant could come up with.

In addition to this calculation, the forensic account may do a second calculation that uses estimates that are all detrimental to the defendant. For example, suppose that the forensic accountant determined that the executive spent $1,000 to $3,000 per month on entertainment expenses, paid for with cash. A middle figure of $2,000 was used in the initial calculations.

In the “worst case scenario” calculation, the figure of $3,000 is used and the same thing is done for all other items that were estimated. Using all of the worst possible figures for each line item, the forensic accountant determines that there may be $6.5 million of expenditures in excess of the executive’s known sources of income .

This type of calculation may not end up in the forensic accountant’s final report, but the information can be very helpful to defense counsel when developing a defense or working on a plea agreement. It is critical for defense counsel to have the worst possible results quantified in order to make informed decisions about the defense.

Results of the Analysis
What you’re left with in the end is a situation in which the level of income (legal or illegal) being alleged by a third party such as the government or a civil case opponent, is either confirmed or refuted based on the facts surrounding the lifestyle of the target.

One risk that always exists is the allegation of a secret bank account or investment account domestically or abroad, which holds all the alleged funds. The analysis of the forensic accountant might tend to disprove the government’s theory that there was an unreported source of income, but if there’s money hidden away, the government may still be right.

Of course, that is always possible in any case. However, if a thorough and accurate lifestyle analysis has been done, that allegation is probably much weaker. A successful lifestyle analysis will account for all the income and spending, and there will be no evidence of funds secretly stashed anywhere.

This is not to say that the fraud investigator or forensic accountant assisting with this analysis sets out to prove or disprove the allegations. The examination of the finances should be as objective as possible, and the forensic accountant should be independent enough to do a fair and reasonable calculation.

One day later, Medifast filed a defamation suit in California against Minkow, FDI, Robert Fitzpatrick, William Lobdell, iBusiness Reporting, me, my company Sequence Inc., and an anonymous message board poster. The suit seeks general damages of $270 million, plus other damages.

The complaint filed by Medifast contains pages of self-praise, along with attacks on the character of those involved in the investigation of the company. In one example of the attacks, Medifast falsely refers to multi-level marketing expert Robert FitzPatrick as “… a self-claimed expert in pyramid schemes.”  A brief look at FitzPatrick’s work clearly shows he’s not a “self-claimed” expert on pyramid schemes. In fact, regulators around the world have utilized his expertise. The Federal Trade Commission has received training from him. FitzPatrick has also testified in state and federal courts as an expert witness on pyramid schemes.

In addition, the civil complaint contains numerous unsubstantiated statements that the FDI findings were wrong. The company provides no basis for the assertion that the statements were false. Medifast says that following the release of the first report on Medifast Inc., the company “… issued a press release refuting all of Minkow, FDI, and FitzPatrick’s false allegations.” The press release didn’t actually refute much, other than to say their products are safe, that the company’s revenue is not primarily made from recruiting new coaches, and that the company’s growth isn’t really related to recruiting. Medifast hasn’t actually demonstrated how any of the detailed findings in the report are false, even though they presumably have in their possession all the data and documents that would allow them to do so.

Sam Antar, the former CFO of Crazy Eddie (and a convicted felon and excellent forensic accountant) questions why Medifast hasn’t actually gone through all the allegations and publicly refuted them. Shouldn’t that be an easy thing to do?

Medifast’s complaint also has several instances of false descriptions of the reports and blog postings about FDI’s findings in their investigation.  For example: I am accused of stating that Medifast’s auditor has a conflict of interest because BJL Wealth Management (an investment firm at the same address as the auditor) recommended the purchase of Medifast stock to someone. In fact, I detailed in my blog posting only what would and would not constitute a conflict of interest, and I did not give a conclusion on the Medifast situation.

The complaint also falsely states that I wrote that “…Medifast is not complying with some unknown and undisclosed legally mandated reporting requirements.” Again, I said no such thing. In the blog posting Medifast referenced, I actually said:

“We’ll never know for sure, as Medifast doesn’t disclose how much money the coaches are making, how much they spend on expenses of the business, what their attrition rates are, or how many recruits are actively selling or recruiting.”

The attorneys may want to consult a dictionary for the definition of the word disclose.  I said nothing about reporting requirements, only that the company doesn’t publicly release these statistics which might help investors and potential recruits evaluate the company’s Take Shape For Life (TSFL) “opportunity.”

There are plenty of other examples of false statements and misleading characterizations of the reports and press releases in Medifast’s civil complaint against us, but I’ll leave those for our day in court. Isn’t it a bit ironic that Medifast is filing suit because we were allegedly lying about them, but they are telling lies in the first court filing in the case?

Barry Minkow publicly responded to the lawsuit by saying:

“the bigger picture here is intimidation against the little guy who would dare come out with truthful information and question the practices of public companies.”

He also said that the investigation will be restarted, and the “Medifraud” website detailing our investigative findings would be put back online:

Minkow said the institute will repost the Medifast report and restart its investigations of the company. “It’s on now more than ever,” he said.

I eagerly await our day in court, and I am not intimidated by this lawsuit.

The company says they’ll be restating the financial statements for the fiscal years ended June 2008 and June 2009, at the very least, and also restate the quarterly reports filed so far for fiscal 2010. The company says their numbers will improve now that Sue Sachdeva isn’t stealing from them (bold added by me):

As previously reported, the Company announced that preliminary estimates of the Independent Investigation indicated that the amount of unauthorized transactions since fiscal year 2005 exceeded $31 million.  The Company’s results of operations have been affected during these years by the unauthorized transactions.  Although the Independent Investigation is not complete, it appears that approximately $5.0 million in unauthorized transactions occurred in the quarter ended December 31, 2009.  This $5.0 million amount is included in the total estimated amount of over $31 million of unauthorized transactions that occurred since fiscal year 2005. Notwithstanding the disruption resulting from the discovery of the unauthorized transactions, the Company is operating in the normal course of business and expects the absence of such unauthorized transactions to improve its future results of operations.

Koss also wants us to believe it had good controls in place while this fraud occurred over almost 6 years:

The Company maintains a system of disclosure controls and procedures that were designed to and believed to provide reasonable assurance that information, which is required to be timely disclosed, is accumulated and communicated to management in a timely fashion.  A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.  It is possible for even the best control system to be circumvented by those with the intent, knowledge and opportunity to do so.

It is unclear whether the company’s new auditors, Baker Tilly Virchow Krause have signed off on this 10-Q, although a review by the auditors is required prior to a 10-Q being filed with the SEC:

The Securities and Exchange Commission is adopting new rules and amendments to its current rules to require that companies’ independent auditors review the companies’ financial information prior to the companies filing their Quarterly Reports on Form 10-Q or Form 10-QSB with the Commission…

Frankly, I think it would be irresponsible for Baker Tilly to sign off on a filing that included the above language about the controls in place while Sachdeva was committing her fraud. Are we really expected to believe that the controls in place were good? Can Baker Tilly possibly believe such a thing? Have they done any sort of analysis of the previous controls to give them any reason to think the controls were “…designed and believed to provide reasonable assurance” about the accuracy of the numbers?

I wouldn’t touch that assertion with a ten foot pole, and Baker Tilly shouldn’t either.

There were questions about Medifast’s auditors,  but most notably, the company was criticized for the fact that its financial growth was due almost completely to the recruitment of new “coaches” into its Take Shape for Life (TSFL) division. A month ago, the most recent report on Medifast’s recruitment business was published by multi-level marketing expert Robert FitzPatrick, and Medifast’s management promptly misled shareholders by claiming these allegations were made by “convicted felon” Barry Minkow.

Yesterday FDI announced it is ending its investigation of Medifast. FDI has made it clear that the company has had no contact or affiliation with the class action law firm of Barrack, Rodos & Bacine, and was not aware of any lawsuits the firm had filed or was planning on filing. Simply put, FDI doesn’t work with class action law firms to coordinate the release of any information resulting from FDI’s investigations.

Why is FDI dropping the investigation of Medifast?

“We are a small firm with limited resources and must make decisions regarding the allocation of those resources,” said Barry Minkow, co-founder of the Fraud Discovery Institute Inc. “This means that some of our investigations must end in order to maintain quality control and continued investigative impact.”
…

“Companies like Lennar, Inc. (NYSE:LEN), InterOil Inc. (NYSE:IOC) and PrePaid Legal Inc. (NYSE:PPD) continue to expand and require a significant amount of our time, energy and capital but are worthy of the sacrifice and the commitment,” added Minkow.

Have no fear… Barry Minkow and FDI have no intention of stopping their investigations of companies that they believe are committing financial crimes.