Small Company Suffers Massive Embezzlements

Koss Corporation is a relatively small, reasonably profitable, and mostly family-owned company with about a quarter of its shares listed on NASDAQ (ticker symbol: KOSS). The almost unbelievable story that continues to unfold around this Milwaukee-based company is that an employee used a large number of unauthorized transactions to embezzle mindboggling amounts of money from her employer. The fraud exceeded the reported earnings in some years at a cost to the company of $31.5 million over five years. This case provides ethical lessons of value to all organizations.

Sujata “Sue” Sachdeva, Koss’s trusted, long-serving vice president of Finance, corporate secretary, and principal accounting officer, faces a six-count indictment accusing her of wire fraud for embezzling money for a lavish lifestyle and extravagant shopping sprees.

The sequence of events was rapid. American Express blew the whistle on the scheme because of the huge transfers from Koss’s bank to pay Sachdeva’s credit card bills. Within days, on December 21, 2009, trading in KOSS on NASDAQ was halted as the company reported the unauthorized transactions. Sachdeva was terminated on December 23, 2009. On December 24, 2009, the Koss audit committee published word that the financial statements for 2006, 2007, 2008, 2009, and first quarter of 2010 “should no longer be relied upon.” Baker Tilly Virchow Krause was appointed as the new independent audit firm on January 5, 2010, and on January 11, 2010, Koss’s stock resumed trading on the NASDAQ, with the price plunging 24%. On January 18, 2010, Koss announced the hiring of a new executive vice president, CFO, and principal accounting officer.

A Koss Securities & Exchange Commission (SEC) filing made on January 11, 2010, showed preliminary estimates of the amounts of the unauthorized transactions (see Table 1).

According to wire service reports, the indictment alleges that Sachdeva authorized numerous wire transfers of funds from bank accounts maintained by Koss to pay for her American Express credit card bills. In addition, Sachdeva used money from Koss’s bank accounts to fund numerous cashier’s checks, which she also used to pay for clothing, furs, purses, shoes, jewelry, automobiles, china, statues, household furnishings, travel expenses for herself and others, renovations and improvements to her home, and to compensate individuals providing personal services to her and her family. She faces a maximum penalty of up to 120 years in prison and fines of up to $1.5 million, plus restitution.

Failure to regularly instill new thinking and perspective into the board governance structure as well as the resulting complacency of board meetings has long been considered a likely factor for enabling fraud to occur within a company, and the long tenures of Koss’s board members suggest that this might have been a contributing factor to the apparent breakdown of board oversight to detect the large-scale fraud that occurred. The Koss proxy statement for the 2009 annual meeting of shareholders shows that the board met four times during the year. Two of the six board members have the name Koss. Except for a relative newcomer elected to the board in 2006, the length of service for the remaining five averaged 32 years. Excluding founder John Koss from the calculation, the average length of service was more than 27 years.

The 2009 proxy statement reported that the audit committee consisted of all four non-Koss board members and met three times during fiscal 2009. The chair, who has been a director since 1987, is the president of a holding company established for the purpose of acquiring established companies involved in distributing products to industrial and commercial markets. The designated financial expert on the committee is the retired president of a manufacturer and seller of portable household appliances. In relating the background of committee members, the proxy statement includes no mention of specialized accounting or financial experience.

It appears that the audit committee may have relied heavily on the internal control work of Grant Thornton, according to the committee’s report contained in the proxy statement. The report notes that the committee “meets twice a year with the Company’s independent accountants to discuss the results of their examinations, their evaluations of the Company’s internal controls, and the overall quality of the Company’s financial reporting.” This report also states that the audit committee “oversees the audit work performed by the Company’s internal accounting staff,” hinting that there may have been an internal auditing function.

Grant Thornton has somewhat disputed the conclusion that it was involved in evaluation of Koss’s internal controls. In the January/February CFO Magazine, a spokesperson for the firm says that Koss “did not engage Grant Thornton to conduct an audit or evaluation of internal controls over financial reporting.” Audit fees paid to Grant Thornton were $151,000 in 2009 and $71,000 in 2008. Fees amounting to $97,000 in 2009 and $118,000 in 2008 were paid to PricewaterhouseCoopers for tax compliance, tax advice, and tax planning services.

Koss’s 2009 Annual Report on Form 10-K contained various assertions that Koss “maintains a system of internal control to provide reasonable assurance that assets are safeguarded and that the books and records reflect the authorized transactions of the Company.” Further assertions are made that management, namely Michael Koss, president, CEO, COO, and CFO, had evaluated internal controls over financial reporting (ICoFR) and believed they were effective. Because of its size, Koss isn’t yet subject to the Sarbanes-Oxley Act (SOX) requirement that this control assertion by management be attested to by its independent auditor.

The Koss Code of Conduct, published in 2004, sets forth procedures for employees to follow in reporting misconduct, including that Koss “may” implement a corporate compliance hotline for employee, supplier, and customer use. The Code also notes that “when a report relates to an accounting or auditing issue, the complaint procedures adopted by the Audit Board supersede these provisions.” The Audit Board could refer to the audit committee of the board.

The only provision in the audit committee charter published in 2006 dealing with ethics is that the committee should “receive, investigate, and retain complaints regarding accounting, internal accounting controls, and auditing matters, including concerns that employees have about questionable matters.” Two accountants were terminated because they failed to report the unauthorized transactions to top management or the audit committee.

In summary, the Koss case provides an excellent example of the dangers of:

• Massive weaknesses in internal controls,
• Poor financial oversight by the board of directors and audit committee,
• An apparently obsolete and ineffective ethics and compliance program,
• The external audit firm misunderstanding or not fulfilling expectations of the senior management and audit committee, and
• Failure to report wrongdoing.

How an Embezzler Stole Millions from a Small Company

New details have emerged on the methods used and the outcomes following the case of 47-year-old convicted embezzler Sujata “Sue” Sachdeva. Sachdeva was the trusted 15-year veteran VP of Finance, secretary, and principal accounting officer of Koss Corporation. During a span of more than five years, she stole nearly half the company’s pretax earnings. The scheme was uncovered when American Express noticed her credit card balances were being paid through large wire transfers originating from a company bank account. Koss is the Milwaukee-based, mostly privately held small company that’s a prominent global designer and marketer of stereophonic headphones.

Sachdeva’s criminal case concluded after she pleaded guilty to embezzling $34 million from her employer, an increase of $2.5 million over earlier estimates. The six felony fraud counts carried a maximum penalty of 120 years in jail, but 15 to 20 years is appropriate under federal sentencing guidelines. Because she cooperated with authorities from the very beginning of their investigation, the judge limited her sentence on November 17, 2010, to 11 years in federal prison plus restitution to Koss of $34 million. Her physician husband filed for divorce after the sentencing hearing. Federal officials have seized most of her assets, including a 2007 Mercedes-Benz, timeshares, jewelry, shoes, furs, and other luxury items—some that were never worn because they were put into storage for lack of space. Sachdeva’s attorney claims she has a bipolar disease of compulsive shopping disorder and is an alcoholic.

Countering the defendant’s plea for a lenient sentence because of mental illness, Koss CEO Michael Koss asked the judge to sentence Sachdeva to the maximum 15 to 20 years, writing that she “stole from the hardworking employees of the company and their families, and ultimately the stockholders of the company.” In a presentencing letter, he stated, “The full extent of the damage to the reputation of the company and its employees caused by Ms. Sachdeva’s criminal acts cannot be expressed in words.” He added that the damage will continue to tarnish Koss and subject it to ridicule long after her sentence ends.

In addition to Sachdeva, the Securities & Exchange Commission (SEC) has charged Julie Mulvaney, former Koss senior accountant, with assisting Sachdeva to conceal the theft on Koss’s financial statements by overstating assets, expenses, and cost of sales and by understating liabilities and sales. The SEC accuses both of them in a civil case of maintaining fraudulent records so that Koss filed materially false current, quarterly, and annual reports with the Commission over a period of years. The theft was accomplished through a variety of means, including fraudulent cashier’s checks, fraudulent wire transfers, and unauthorized payments from petty cash. A third person, Tracy Malone, a Koss accountant who was fired because she knew about the theft but said nothing, hasn’t been charged.

The SEC’s August 30, 2010, complaint provides details of the means used by Mulvaney and Sachdeva to get cash by circumventing the internal controls of the corporation. Sachdeva admitted stealing $15 million by authorizing issuance of more than 500 cashier’s checks to pay her personal expenses. Cashier’s checks were issued directly to retailers, such as Nieman Marcus and Saks Fifth Avenue, and other vendors. Sometimes acronyms were used, like N-M and S.F.A. In addition to using cashier’s checks, Sachdeva fraudulently authorized and directed numerous wire transfers, including wiring company funds to American Express to pay for personal purchases on her credit card. From 2008 through December 2009, Sachdeva fraudulently authorized more than 200 bank wire transfers totaling more than $16 million to American Express.

Other methods of fraudulently misappropriating cash for personal use described in the SEC complaint include misuse of petty cash. Sachdeva issued checks payable to “petty cash,” had Koss employees then negotiate and return the money to her, which she then used to pay personal expenses. Sachdeva also converted unused traveler’s checks that the company had purchased for use by its employees travelling on company-related business and fraudulently used them for herself.

It appears that Mulvaney didn’t receive any of the benefits of the massive embezzlements, and she hasn’t been charged with theft. But she did materially participate in the cover-up of the fraud and was therefore charged with civil fraud. According to the SEC complaint, the pair were able to hide the huge amounts of missing cash by means of top-side general journal entries. Mulvaney maintained a “red book” containing numerous false journal entries to the company’s accounting books and records. She wrote the false journal entries in the red book and then entered them in the company’s accounting books and records. By means of those entries, Mulvaney purported to adjust or reclassify the amount of company cash without supporting documentation or any legitimate explanation.

The complaint notes that Mulvaney also prepared falsified accounting books and records and maintained them in a series of colored folders, called the “rainbow files.” The rainbow files consisted of seven folders covering fiscal years 1995-2000 (green folder), 2004 (orange), 2005 (blue), 2005 (orange), 2006 (blue), 2007 (yellow), and 2008 (green). The rainbow files included more than 100 fraudulent transactions on the company’s books and records.

The rainbow files also reflected a scheme to conceal the receipt of funds by the company through a debit/credit wipe (DC Wipe). A DC Wipe made it appear that a certain transaction (e.g., a sale to a customer and the receipt of funds by the company) never took place. For example, in December 2007, Koss received funds totaling more than $100,000 from an overseas customer. Mulvaney falsified the books and records to make it appear that the company never received the funds. In an attempt to avoid detection, she reduced five separate sales accounts by different amounts that collectively totaled the exact amount—instead of reducing a single sales account by the whole amount.

The fraudulent accounting cover-up also involved the company’s sales over the internet and at its retail outlet. From fiscal year 2006 through the time the fraud was discovered during the second quarter of fiscal year 2010 (December 2009), Sachdeva and Mulvaney didn’t record in Koss’s books any sales made over the internet or at the company’s retail outlet, totaling $1.8 million.

Although Sachdeva’s fate seems settled, at least for several years, no punishment for Mulvaney has been revealed yet. In a November 17, 2010, Milwaukee Business Journal article titled “Sachdeva throws Mulvaney under the train,” additional details emerged from the sentencing hearing that show Mulvaney’s enabling role in the fraud. Apparently, each year Sachdeva would review the company’s cash position a few weeks prior to a scheduled visit from Koss’s outside auditors, Grant Thornton. She would presume the difference between the cash in the company’s bank accounts and the related ledger accounts was because of her theft of company funds. In a panic, Sachdeva would then call Mulvaney into her office and show her the numbers. Mulvaney would respond by saying, “Let me look at everything and get back to you, and don’t worry” and then apparently make the journal entries that no one questioned.

There are other unanswered questions, such as how it was possible that Grant Thornton didn’t discover such a massive defalcation. Answers may be forthcoming in the lawsuit Koss has filed against the firm in Cook County, Ill. The complaint alleges that “Grant Thornton, the company’s auditor, failed to properly perform audits of the company’s financial statements and failed to properly assess the company’s internal controls, thus allowing the embezzlement to continue and the damage to the company to escalate.” Surprisingly, the lawsuit claims specifically that “Grant Thornton repeatedly assured Koss’ management and its board that the company’s internal controls were effective and that Koss could rely on those same internal controls and Grant Thornton’s work.”

Koss’s attorney, Michael J. Avenatti, said, “Grant Thornton was paid hundreds of thousands of dollars to properly audit the company’s financial statements, and they failed miserably. This failure included repeatedly assuring the company and its board that the company’s internal controls were effective. A company should be able to rely on its auditors.” For its part, the firm has stated it was not engaged to provide a separate opinion on internal controls. Sarbanes-Oxley Section 404(b) doesn’t apply to Koss because it is too small.

The many lessons to be learned from this case seem obvious, especially that smaller companies need to be particularly aware of the possibility of fraud.

Comptroller Steals $53 Million from City Funds

Dixon, Ill., is a town of nearly 16,000 located about 100 miles southwest of Chicago. Its major claim to fame has been that it’s the boyhood home of President Ronald Reagan. In April 2012, Dixon began to receive national attention again—this time focused on the massive fraud that the city’s 59-year-old comptroller, Rita A. Crundwell, is alleged to have achieved almost single-handedly.

A May 1, 2012, federal indictment charges Crundwell with wire fraud and embezzling approximately $53 million from the city of Dixon since 1990. Over a 20-year period, this works out to about $3,300 for every man, woman, and child living in Dixon. If Crundwell is found guilty, this case would represent one of the largest embezzlements of public funds ever perpetrated. The prison time could be as much as 20 years.

Rita Crundwell graduated with honors from Dixon High School in June 1971, having begun her work at City Hall in 1970 as part of a work-study program. Working for the city, Crundwell continued to gain new responsibilities and move up in job titles. She was appointed comptroller in 1983. She also reportedly played first base during the 1980s for the softball team of Clifton Gunderson, Dixon’s independent audit firm at the time. She seemed to avoid politics, having no record of voting since 1998, even in city elections.

During the years, Crundwell pursued an interest in breeding and showing horses. She inherited her first farm property from the estate of her mother, who died in 1984, and kept the property after her 1986 divorce. Crundwell built the first horse stables in 1997, although her salary at the city was a modest $20,000. In 2000, she undertook a major expansion to the house, doubling the living space to nearly 3,500 square feet. She also built a nearly 20,000-square-foot horse barn in 2006 on another 88-acre property in the area, which she purchased from Richard A. Humphrey, Sr., a family member.

Crundwell specialized in breeding horses known as quarter horses, which can run extremely fast for short distances. According to David Giuliani, in his article, “Piecing Crundwell Together” (McClatchy-Tribune Business News, April 28, 2012), by 2002 Crundwell was “wowing audiences” at the annual world quarter horse championship and on her way to national fame and prominence. She told the local newspaper at the time, “I just love to do it, but there is also the agony of defeat that goes with it. There’s a lot of that, too.”

Over the years, Crundwell became “one of the nation’s most famous and most successful horse breeders—her ranch has produced 52 world champions,” according to Jim Bret Campbell, spokesman for the American Quarter Horse Association (AQHA). “Rita has owned more world champions than anyone else in our industry,” Campbell said (Alyssa Anderson, “Small Town’s Comptroller Steals $30 million from City’s Coffers,” Left Justified, April 22, 2012). Most people assumed that the success of her horse farms in Wisconsin and Illinois generated the income for Crundwell to maintain her lavish and wealthy lifestyle.

According to the government’s indictment, on December 18, 1990, Crundwell opened a bank account in the name of the City of Dixon, listing “RSCDA c/o Rita Crundwell” as the account holder. Between December 1990 and April 2012, Crundwell used her position as comptroller to transfer funds between the various bank accounts maintained by the city. For example, the FBI sworn affidavit states that from September 2011 through February 2012, a total of approximately $2.8 million was received representing Dixon’s share of distributions from the state of Illinois. During the same period, the affidavit states that Crundwell transferred $1.8 million into the RSCDA account she controlled. Between September 2011 and March 2012, she withdrew $3.3 million from the account. Of this amount, only $74,274 was related to city operations.

The FBI affidavit also alleges that Crundwell used Dixon funds to pay for her own personal and private business expenses, including horse farming operations, personal credit card payments, real estate, and vehicles. The affidavit identified Crundwell’s vehicle purchases that used funds said to be fraudulently obtained from the city, which included a 2009 Liberty Coach Motor Home for $2.1 million, a 2009 Kenworth Tractor Truck for $146,800, a 2009 Freightliner Truck for $140,000, a 2009 Chevrolet Silverado pickup truck for $56,646, and a 2009 Featherlite Horse Trailer for $259,000.

The sworn affidavit also reports a review of documents provided by American Express showing that between January 2007 and March 2012, Crundwell incurred charges of more than $2.5 million on her personal credit card account. Fifth Third Bank records show that all of these charges were paid by online payments with City of Dixon funds. Charges included more than $339,000 for jewelry from various vendors, averaging more than $5,380 per month.

While Crundwell was living it up, Dixon was experiencing fiscal difficulties. City workers, for example, have had no raises in the past three years. Crundwell covered for the missing funds by taking advantage of the well-known fiscal difficulties of the State of Illinois and claiming that the city’s hard times were due to nonpayment by the state. While payments from the state were usually late in arriving, they did come.

Crundwell was known as a smart, hands-on executive. She was in charge of picking up the city’s mail at the post office, according to the affidavit. One of Crundwell’s relatives—who isn’t a city employee—performed this task at her direction. Crundwell was out of town frequently because of her horse business, taking an additional 12 weeks of unpaid time in 2011 in addition to the four weeks paid for by the city. She told a horse enthusiasts’ publication in 2003 that her coworkers at City Hall had been accommodating, saying, “They are used to me being gone in August, October, and November.” She said she carried a portable computer back and forth, giving her access to her city email, and also called City Hall every day.

In spite of not being in her office all the time, she was able to fool a number of mayors, finance commissioners to whom she reported, and other city council members. Jim Dixon, the mayor from the mid-1980s to the early 1990s, said, “She was pretty much in charge…she was the go-to person.” And former Finance Commissioner Roy Bridgeman praised her upon his leaving office last year, saying, “She looks after every tax dollar as if it were her own.”

It took the sharp eyes of Kathe Swanson, Dixon city clerk, to uncover the fraud in late 2011. Swanson had made a routine request for all bank statements so she could prepare the monthly treasurer’s report in Crundwell’s absence. She noticed the “secret” account with Crundwell’s name and took it to Mayor Jim Burke, who notified the FBI. Over the years, Crundwell misled the independent audit firm hired to express its opinion on Dixon’s financial statements by allegedly creating fictitious invoices purported to be from the State of Illinois to show that the funds she was fraudulently depositing into the RSCDA account were being used for legitimate purposes.

CliftonLarsonAllen, as Clifton Gunderson became known after its January 1, 2012, merger that made it the eighth-largest U.S. accounting firm according to Accounting Today, was Dixon’s audit firm for many years through fiscal 2005. At that time, it recommended that Samuel S. Card, a CPA from the nearby town of Sterling, Ill., perform the audit. Thereafter, Dixon continued to retain the Clifton Gunderson firm, but only to accomplish a compilation of its financial statements and not to express a professional audit opinion on them.

The city plans to hire a new firm to handle the audit for the fiscal year that ended in April. At its May 8, 2012, meeting, the City Council hired the firm of Wipfli LLP to restate the earlier audits that are believed to be flawed. Headquartered in Milwaukee, Wis., Wipfli is one of the 25 largest U.S. accounting firms and has an office in Dixon.

It’s ironic that President Reagan’s popular often-quoted saying, “Trust, but verify,” should be so relevant in his own hometown so long after his departure.