Who’s in Control Here? Anatomy of a Bank Infrastructure’s Failure

A prominent Woodbridge, N.J., attorney, who served as the town’s municipal counselor, had been missing for more than 24 hours. Stephen J. Domenichetti had vanished on July 7, 1994, just hours before he was scheduled to surrender to police on charges of defrauding a local savings bank of $8.4 million in a mortgage loan scheme. When he failed to turn himself in that afternoon as promised, a warrant was issued for his arrest.

The next day, traffic was streaming by the Cheesequake Rest Area on the Garden State Parkway. It seemed like everyone was trying to get an early start to the Jersey shore for the weekend. At about 3:45 p.m., a motorist called police after spotting a middle-aged man slumped over inside a late model Mercedes parked in the rest area’s commuter lot. The man turned out to be Domenichetti, dead from a self-inflicted gunshot wound to the head. With this act he put an end to an incredible four-year scheme, which apparently provided a very comfortable lifestyle and fed his gambling addiction. (He was known to be a frequent visitor and high roller at the casinos in nearby Atlantic City.)

He left two suicide notes in his car, one addressed to his wife and the other to the prosecutor. The note to the prosecutor indicated that he’d find a tape and other letters in Domenichetti’s office. On the tape, Domenichetti said he was sorry, and that he had tremendous regret for what he’d done. He blamed both external forces and himself, but clarified that he’d acted alone. The investigation that commenced “after the fact” confirmed that statement, for no evidence of a co-conspirator was ever uncovered.

The Lawyer and his Target 

Domenichetti was a partner in a small, local law firm, Domenichetti & Hook. The firm specialized in all phases of real estate, banking, commercial, and government law. He was remembered as a hard worker who was active in community and professional organizations. He was on the board of directors of the Perth Amboy and Old Bridge regional hospitals from 1983 to 1990, a member of the Perth Amboy Kiwanis for 12 years, president of the board of a camp for underprivileged children, and chairman of the board of trustees for the Elks Lodge in East Brunswick.

One of the financial institutions he represented was Pulse Savings Bank, a savings bank holding company, which in 1989, acquired all the stock of Pulawski Savings and Loan, a small savings and loan with headquarters in South River, N.J. Typical of most S&Ls – and as described in the annual Form 10K filed with the Securities and Exchange Commission – the bank’s principal business was accepting savings deposits from the general public and originating mortgage loans obtained for constructing, financing, or refinancing family dwellings and other improved residential and commercial real estate. In addition, the bank purchased investment and mortgage-backed securities.

Domenichetti had served the bank in a number of capacities since 1988 and was named general counsel in 1992. From this position of trust, he built an elaborate embezzlement scheme that defrauded the institution of millions of dollars. How he did it and got away with it for at least four years and to the tune of $8.4 million dollars is a case study in internal control system failures and greed. A group of fraud examiners was hired to determine what went wrong, ascertain if there were any co-conspirators, verify the amount of the defalcation, and make recommendations to prevent the scam from happening again.

The Heart of the Scam 

At the heart of the scam was the “bridge loan.” A bridge loan is offered for a term of up to six months to an individual who is closing the purchase of a new home and hasn’t yet closed the sale of his present home. The buyer of the individual’s present home must obtain a commitment letter from his financial institution, which assures the seller and his bank that the buyer will follow through with purchase of the present home. In the typical bridge loan, a substantial sum is advanced in contemplation of two independent uncertainties: (1) the seller will close with the buyer, and (2) the seller will use the proceeds of the settlement on the existing house to pay off the bridge loan. If either of these expectations fails, the lender has made a large, unsecured loan. For this reason, many bankers consider this type of loan to be risky.

To perpetrate his fraud, Domenichetti falsified documents to support equally false bridge loan applications. Because of his position within the community and familiarity with the various parties involved in local real estate transactions, Domenichetti had access to signatures, documents, and letterheads of the various attorneys, title insurance policies, realtors, and financial institutions. Thus, he was able to duplicate their documents, contracts, and letterhead, and forge the entire loan file.

He channeled the loan proceeds through his made-up clients’ escrow accounts, and then cut checks on those accounts and either deposited the checks into shell company or personal accounts. He also converted some of the checks into cash and concealed the money. He made sure the interest was paid on time, and, when the notes came due, paid them off with the proceeds of other phony loans – a scam known as “lapping.” The files examined in the investigation indicated that Domenichetti never provided supporting documentation on original forms. Title policies and homeowners’ policies weren’t presented as complete, but as copies of binders, which basically are commitments from the insurers to issue a policy at a later date, pending the insured meets the qualifications. It also seemed that he intentionally omitted or delayed certain documents to make the scheme appear more realistic.

Because Domenichetti held a senior position in the organization, he was able to override the existing internal controls. The loan officers and underwriting staff were undoubtedly awed and intimidated by Domenichetti, who was highly respected by senior management, had an enviable reputation in the business community, was politically well connected, and regarded as a real estate expert. He also was older than anyone in the bank’s day-to-day management and had a commanding personal presence. Whenever a problem arose with one of the bridge loans, the bank’s employees would turn to him for a solution, and, of course, he would provide it. The underwriting department regarded him as the single point of contact for bridge loans and all matters were resolved by direct liaison with him.

For instance, in 1991, the Internal Revenue Service questioned why the borrowers’ Social Security numbers were missing on the bank’s Form 1098s. Domenichetti was right there to resolve the matter. He simply had the bank’s underwriters place his Social Security number on all the files. From that point forward, the bank began requiring Social Security numbers as part of the underwriting process, but the request was ignored and never followed or questioned again.

In addition to the bank investing so much trust in Domenichetti, it also considered his bridge loans to be highly profitable and safe, contrary to the opinion of most bankers. The loans had favorable interest rates and they paid out a significant origination fee – one percent for a less than six-month loan. They also were paid off at maturity. No one at the bank was interested in upsetting this apple cart. It seemed greed had blinded senior management from seeing the numerous red flags in Domenichetti’s transactions.

According to other bankers and real estate attorneys, bridge loans are generally reserved for the bank’s best customers. A banker at one of New Jersey’s largest institutions was quoted in the press shortly after the incident, saying, “If I have done 20 bridge loans in 20 years, I would be surprised. They are dangerous loans to make.” Yet this small S&L in Central New Jersey processed approximately 370 in a four-year period and no one seemed to question this exceptional volume until it was much too late.

The Discovery 

It was the bank’s chief lending officer who finally questioned the bank’s steady increase of bridge loans in an otherwise weak real estate climate. On July 5, 1994, the chief lending officer called a real estate salesman listed on one of Domenichetti’s loan documents and was told that the salesman had no knowledge of such a loan. He then reviewed several other files and discovered that none of the loan applicants were listed in the telephone book. The lending officer then decided to drive to one of the properties in question only to find that it didn’t exist!

The bank contacted the state department of banking, which directed the inquiry to the prosecutor’s office. On the morning of July 7, fraud examiners met with Domenichetti in his office, where he readily admitted his complicity when confronted with the information. He agreed to turn himself in that afternoon, but within hours, he ended his life.

What went Wrong? 

The internal audit function at Pulse was in its infancy in late 1990 when the bridge loan defalcations began. The new internal auditor had been working for the bank’s long-term external auditing firm prior to joining the bank’s internal staff. She hadn’t been in public accounting long enough to become a CPA or to gain significant audit experience. Because the bank was relatively small, its administrative employees were required to perform multiple functions, and, at that time, the internal auditor was not immune. She was frequently distracted from internal audit work by collateral duties, allocating 60 percent of her time to internal audit, and 40 percent to other duties. The internal auditor did, however, manage to develop audit programs, establish the audit calendar, and create an audit committee. However, her experience, age, and credentials might have made her susceptible to Domenichetti’s influence and possibly caused her to suppress her professional skepticism.

The investigation revealed that the bank’s internal audit plan didn’t comprehensively address the possible exposure areas. The work papers reviewed by the fraud examiners, instead, suggested the bank’s plan was more of a “recipe book,” or a mechanical approach to the internal audit function. A comprehensive plan would have demonstrated the bank’s control environment, accounting system, and daily operations through narratives, checklists, and/or flow charts. These documents then would have been the basis for identifying the critical audit areas. The fraud examiners found no evidence of such work papers. There also wasn’t any evidence that analytical procedures were applied in the audit planning or work tested. This would have alerted the auditor to the significance of the bridge loans and helped in planning and focusing the nature and extent of the audit procedures.

The external auditors – a large, well-regarded regional accounting firm that specializes in auditing financial institutions – also missed the boat on this one. After reviewing their work papers, the fraud examiners met with the partner-in-charge of the engagement, an experienced bank auditor with many years of involvement with the bank and the industry. In his defense, he made four points in particular:

1. He claims he expressed his concern about the bridge loans to the bank’s president and senior loan officer on various occasions, and was assured there was no need for concern.
2. He clarified that his firm was engaged to perform a financial audit and not a “fraud” audit.
3. He made reference to the bank’s loan approval process, emphasizing that all the bridge loans were approved by the senior loan officer and the president, and then went to the loan committee for final approval.
4. And finally, he pointed out that the bridge loans were never delinquent, and most showed on the bank’s records as having been paid on a timely basis.

The fraud examiners assessed that the external auditors missed at least three significant areas:

• Had they performed effective analytical procedures, it’s quite possible that they might have uncovered the fraud early on. For example, the outstanding balance of bridge loans went from a zero balance on Sept. 30, 1990, to approximately $3 million to $7 million in the three succeeding years, and finally to $8.4 million when it was finally discovered. In addition, the number of loans increased in each of those years to a total of 370 over the period. No one on the audit team seemed overly concerned, and other than asking a few questions of senior management, didn’t pursue the matter.
• The auditors used the wrong type of confirmation. There are two types of confirmation requests: positive and negative. The positive form requires an affirmative response on the part of the recipient. The negative form requests the recipient to respond only if he disagrees with the information stated on the request. According to SAS No. 67, “Negative confirmation requests may be used to reduce audit risk to an acceptable level when (a) the combined assessed level of inherent and control risk is low, (b) a large number of small balances is involved, and (c) the auditor has no reason to believe that the recipients of the requests are unlikely to give them consideration.” Negative confirmations typically are used for small consumer loans or to confirm savings account balances. Bridge loans with balances ranging from $75,000 to more than $250,000 aren’t comparable.
• Because the auditors didn’t have valid addresses for mailing confirmations – unbelievable as this may sound – they mailed them to Domenichetti. Auditors should only direct a confirmation request to a third party who is independent of the entity being audited. To direct the confirmations to Domenichetti was worthless, because it was asking a member of management, in this case, the general counsel and perpetrator, to verify the validity of the loans he had falsely created.

The Final Analysis 

It would be pure speculation to say that one telephone call to verify a transaction with a real estate broker, title insurance company, attorney, or financial institution would have torn away the veil and exposed Domenichetti’s scheme. But if enough of these calls had been made, certainly enough doubts would have been raised and the scheme might have been exposed earlier. Had the bank followed the most basic procedures (i.e., requiring that the borrowers make their applications in person at the bank, or that a bank representative make a simple drive-by to verify a property’s existence), the scheme probably would’ve been exposed or avoided.

The examination into the scheme revealed that the bridge loans totaled $53.7 million over four years and resulted in an actual defalcation of $8.4 million. The bank finally recovered $2.9 million of its losses from Domenichetti’s estate and from insurance carriers. It recorded an increase to its provision for loan losses of $2.5 million to cover the losses resulting from the fraudulent bridge loans and wrote off $3.6 million – an expensive breakdown of an internal control structure.

The fraud examiners submitted a three-page letter of recommendations to improve the bank’s internal control procedures relating to bridge loans. Some of the recommendations included:

• All first mortgage underwriting policies apply to bridge loans.
• Such loans should be considered only upon written applications that are fully complete and signed by the applicants.
• The application process can only be originated by the applicants visiting any branch of the bank during normal business hours, at which time the application requirements would be discussed with the borrowers. Subsequently, the application process could be completed in person, by mail, or through the applicant’s attorney.
• Bridge loans should only be advanced in those real estate transactions in which the bank is financing the purchase of the new property. Any inconvenience to existing customers would be regrettable, but if the borrowers are moving from the area serviced by the bank, they should be advised to arrange interim financing with the institution that will finance their new purchase.
• Applicants must demonstrate credit worthiness. The underwriting department must obtain a completed application and a credit report on the borrower indicating a capacity to repay the loan.
• The loan-to-value ratio should not exceed 75 percent of the property value less outstanding liens. The value of the bridge property can be the agreed sales price, substantiated by a firm sales contract and formal appraisal.
• All monies due on the sales contract must be assigned to the bank.
• Appraisals must be conducted for all bridge loans.
• Title and casualty policies must be final, not binders, and they should be assigned to the bank.
• The contract to purchase the borrower’s property must be firm, without contingencies.
• A note and mortgage must be executed for both the old and new properties. The note and mortgage on the bridge property will be recorded upon closing of the bridge loan. The note and mortgage on the new property will be recorded in the event that the borrower defaults.
• Original documents, as needed, and complete documentation should be required before loan disbursement.
• It is critical that the internal audit function be restructured. A formal audit plan, timetable and audit emphasis should be prepared at the beginning of each fiscal year. The purpose is to direct the internal audit effort to the higher risk areas, which can vary from year to year. This plan would then be reviewed and approved by the audit committee.
• Careful examination of bridge loan documentation should be continued to support the assertions in the loan file regarding property and borrower existence, application and documentation completeness, property valuation, and rights and obligations of both parties. Photocopies of key documents and missing documents mustn’t be permitted.
• Independent verification of existence and value, such as appraisals and mail confirmations, should be required.
• The loan register should be scanned during each audit to appreciate the “big picture,” as in identifying patterns that could indicate fraudulent activity, unsound business practices (i.e., concentrations of loans by individuals or in risky geographic areas), or deviations from bank accounting policies and procedures.
• All bank staff must strictly adhere to the audit schedule.
• Insure proper staffing of the internal audit function. Consider skill levels, number of personnel, demands on time for special projects or routine accounting, and the need for continuing professional training.
• The internal audit department should establish a formal records and retention policy for its work papers and audit reports.

Tone at the Top 

There is certainly enough blaming and finger-pointing to be shared, but the blame, in my opinion, belongs mostly in one place – with senior management. In any internal control structure the “tone at the top” is critical. Senior management and the board of directors- either by explicit or tacit approval of the control functions- set the organizational tone as to what is and isn’t permissible. A bank can have the most airtight internal control structure imaginable, but if senior management sends out signals that some people in the organization are above these rules, major frauds can result.

Was it solely Domenichetti’s gambling habit that prompted him to commit this fraud? Why in mid-career with a growing practice and solid reputation would he embark on such a scheme? He must have known that his lapping operation couldn’t last forever. Each year the bridge loans grew in number and dollar volume. It was only a matter of time before the fraud examiners would knock on his door and it would all be over. Perhaps that is why he was so cooperative with the investigators when they finally did arrive. Perhaps, in his mind, he already had his final exit strategy in place.

Edward A. Suarez, CFE, CPA, spent more than 20 years with a major international accounting firm as an accounting and auditing partner before co-founding Knepper, Bernardi, Suarez & Associates in the Philadelphia, Pa., area. He specializes in forensic accounting, litigation support, economic damage claims, and accounting and auditing issues.