Soft Dollar Fraud: Diversion of Funds from a Directed Brokerage Account

Some cash has become a lot more pliant in the last few years. Politicians frequently discuss “soft dollars” – money donated to political parties rather than candidates but nevertheless used to benefit those candidates or causes indirectly. While political soft dollars technically may be legal, their reputation is questionable.

Soft dollars also exist in the business world. Examples include free tickets awarded through airlines’ frequent flier programs, points given by medical device suppliers toward free training programs in exotic locations or on cruise ships to healthcare professionals who prescribe the suppliers’ products, and points from national suppliers for retail store owners who feature the suppliers’ items.

These examples have certain common denominators. Soft dollars:

• have a real value to the beneficiary;
• are expended at the direction of the beneficiary, in support of the beneficiary, or in accordance with the known wishes and desires of the beneficiary;
• are controlled by someone other than the beneficiary;
• don’t appear as an asset on the books and records of the beneficiary; and
• generally aren’t considered as revenue by the beneficiary and may not be subject to the beneficiary’s system of internal controls.

Neither the Financial Accounting Standards Board nor the Government Accounting Standards Board, which both set standards for financial reporting, have issued any authoritative guidance on soft dollar reporting. Consequently, a great deal of soft dollar activity goes unreported. The Florida State Board of Administration (SBA) – the organization that manages the more than $100 billion (yes- billion.) accumulated in the Florida Retirement System – recently had a bad experience that highlighted weaknesses in how it managed its directed brokerage program – a program that deals with soft dollars. (Directed brokerage arrangements at SBA instruct investment managers to direct trades to a particular broker-dealer. In addition to execution of trades, a broker-dealer establishes a commission banking arrangement and/or a commission recapture arrangement for SBA. Under commission banking arrangements, the broker pays third party providers for goods and services required by SBA. Under commission recapture arrangements, the broker provides cash rebates to SBA. Both arrangements are legal.)

Barbara Jacobs, a 13-year employee of the SBA, diverted more than $423,000 for her own use from a directed brokerage account managed by Donaldson & Co. Incorporated (DCI) – one of a number of broker dealers which participated in the SBA-directed brokerage program. Jacobs appears to have begun diverting funds from the DCI account in 1993 and she appears to be the only SBA employee involved in the scheme. The investment industry considered Jacobs an expert; she hosted or co-hosted a number of seminars on soft dollars and was an advocate of directed brokerage arrangements. When the U.S. Congress addressed soft dollar issues, Jacobs was a witness before the subcommittee in support of the concept. Her scheme demonstrated how well she understood the SBA process and how vulnerable it was to abuse.

The SBA experience can provide management a spur to inspect soft dollar relationships and fraud examiners methods to investigate suspected schemes.

SBA’s Directed Commission Process 

SBA’s chief, domestic equities, assumed primary responsibility for SBA’s directed commission program in October 1989. He delegated day-to-day administration of the program to Jacobs, a financial coordinator, who reported directly to him. Jacobs’ duties included:

• budgeting for directed commissions to broker-dealers;
• receiving invoices for goods and services from various department to be paid from the directed commissions accounts;
• scheduling SBA invoices for various goods and services to be paid by broker-dealers;
• obtaining approval for payments made by the broker-dealers;
• negotiating the ratio used to determine how SBA and the broker would share directed commissions ; and
• directing broker-dealers to pay for good and services delivered to SBA.

Each year, Jacobs prepared directed commission budgets based on spending requests from SBA managers. Once the executive director approved the budgets, Jacobs wrote letters telling SBA external investment managers the amount of directed commissions needed to carry out the approved budget. She also drafted letters informing cooperating broker-dealers to whom the commissions would be directed, what services or products they were to purchase for SBA that year and the broker-dealers responded with letters accepting the assignment. DCI was the cooperating broker-dealer that purchased miscellaneous items for SBA such as training registrations, subscriptions to industry journals, and some consultants.

Since the broker-dealers acted as bankers for SBA, the providers of some goods and services sent invoices directly to the designated broker-dealers for payment. In other cases, vendors forwarded invoices to SBA, which were routinely forwarded to Jacobs. She would determine which broker should pay the invoice and forward the invoice to that broker.

SBA used a number of broker-dealers but DCI managed its largest directed commission banking arrangement. Many of the SBA invoices directed to Jacobs were for subscriptions and conferences or other similar products and services. Twice each month – generally around the 15th and 30th – Jacobs would complete a Soft Dollar Payment Request form that listed all of the payments that were then due. She would attach the invoices to this form, and write and sign a transmittal letter to DCI directing it to pay for the goods and services.

Jacobs would then provide the package to the chief, domestic equities, and the chief, management policy, for review and approval and the chiefs would approve the invoices by signing the transmittal letter. Jacobs would then send the package to DCI via Federal Express.

DCI paid the invoices received from Jacobs. At the end of each month, DCI provided SBA a Directed Brokerage Statement detailing account activities. This statement included commission activity (commissions on directed trades), payment activity (invoices paid), and an activity summary showing opening and ending balances for the fund. The statement expressed balances in both “soft dollars” – the total amount of commissions from directed trades – and “hard dollars” – the amount of commissions from directed trades less DCI’s portion. The “hard dollars” was the amount SBA could direct the cooperating broker-dealer to pay for goods and services to be provided to SBA.

Disclosure of the Diversions 

In late 1998, Jacobs prepared a directed commission budget for calendar year 1999 that totaled $4.15 million – a substantial increase over the $2.46 million budget for calendar year 1998. She drafted letters to SBA external investment managers giving these firms the amount of brokerage SBA expected the manager to direct to specific broker-dealers. She also drafted letters to the broker-dealers giving them the type and nature of goods and services SBA expected them to pay during the year.

In the summer or fall of 1998, Jacobs’s doctor diagnosed her with carpal tunnel syndrome and she decided to have surgery for the problem during the early months of 1999. Because of her operation and recovery she was frequently absent from work during late January and February 1999.

Her supervisor, chief, domestic equities, retired from SBA effective December 31, 1998. He stated that Jacobs was aware of his decision by at least the middle of 1998.

The executive director appointed an insider to succeed the retiring chief. The SBA is a relatively small organization and the new chief, domestic equities, was quite familiar with the staff and operations of the department. Shortly after her appointment, she assigned responsibility for the directed commission program to the chief trader, domestic equities, and told Jacobs that that person would be her new supervisor.

The change appeared to upset Jacobs. According to the chief trader, Jacobs was uncooperative in showing an assistant trader the necessary files to handle the directed commissions program during her anticipated absences. She insisted there wouldn’t be any matters she couldn’t handle by coming to work periodically.

In late January 1999, SBA’s executive director reviewed the directed commission budget that Jacobs had developed for calendar year 1999 and was shocked at the magnitude of the increase. He directed SBA unit chiefs to reconsider their requests for directed commission expenditures and told the chief, domestic equities, to prepare a new directed commission budget that would substantially reduce SBA’s reliance on directed commissions.

During the next three weeks, the chief trader and assistant trader began to take control of the directed commissions program and prepare a reduced directed commission budget. They negotiated reduced ratios for directed commission arrangements and reviewed directed commission expenditures for past years.

Jacobs’ records for the directed brokerage program weren’t well-organized and because of her surgery and recovery she wasn’t available to assist. The chief trader asked DCI to provide a spreadsheet showing payments made for SBA during 1998 and the persons or groups at SBA that received the goods or services. The chief trader and the assistant trader then called the SBA recipients to confirm receipt and to determine their needs in the upcoming year. The spreadsheet showed that DCI had paid a firm named Data Resources to provide goods and services to one of SBA’s organizational elements. The chief of that element said he knew nothing about the firm.

On Monday Feb. 8, 1999, the chief trader called Jacobs at her home to ask her about Data Resources and she said she didn’t know anything about the firm.

Jacobs came to work on February 18, at about 1 p.m. The chief trader again asked her about Data Resources. Jacobs gave the chief trader documents from her office that showed that there were no payments to Data Resources. She said DCI had made an error and the chief trader should disregard the spreadsheets from DCI. According to the chief trader, Jacobs then left the office.

During a Feb. 19, 1999, telephone conversation between the chief trader and DCI, the chief trader, asked for the Dec. 31, 1998 balance in SBA’s directed brokerage account so she could present a completed directed-commissions budget to the executive director. The chief trader was surprised the balance was $183,613.62 because the November end of month balance had been about $600,000. During December 1998, DCI had paid numerous bills for SBA including two from Data Resources totaling $143,500. DCI faxed to SBA copies of the invoices from Data Resources. The chief of the organizational element who reportedly received the services or products provided by Data Resources, again said he didn’t know anything about the firm or any services it might provide.

During the morning of February 19, the chief trader attempted to contact Data Resources. The Data Resources invoice provided by DCI showed a post office box address in Dothan, Ala., but no telephone number. The chief trader couldn’t find a telephone listing for Data Resources in Dothan. The Dothan Post Office said Jacobs had opened the post office box in the name of Data Resources.

Executive Director’s Actions 

The chief trader told SBA’s executive director what she had found and he called the commissioner, Florida Department of Law Enforcement who secured Jacobs’ records and computer. The executive director also asked the Florida auditor general to conduct an audit of all SBA-directed brokerage accounts and hired a consultant to recommend changes.

How the Scheme Worked 

DCI provided copies of the Soft Dollar Payment Request forms and monthly Directed Brokerage Statements for the period January 1989 through January 1999. Auditors and consultants compared the DCI documents to those found in SBA files and discovered the following.

• At least 23 of the Soft Dollar Payment Request forms found in SBA files didn’t match the same forms provided by DCI. The forms found in SBA files didn’t list all the firms and payments shown on forms in DCI’s files. Transmittal letters found in DCI files contained only Jacobs’ signature. DCI officials said that they had never seen a transmittal letter that was signed by anyone other than Jacobs.
• For calendar years 1996 and 1998, the monthly Directed Brokerage Statements found at SBA didn’t show certain payments made by DCI that DCI listed on their monthly statements. The letterhead and format for monthly statements in SBA files were similar but not identical to those used by DCI. Someone had created false records. Additionally, Monthly Directed Brokerage Statements for 1995 and 1997 could not be located at SBA.

Law enforcement agents searched Jacob’s office and home computers and SBA’s network storage. Their search, and a subsequent search by the consultant, didn’t yield any evidence that Jacobs had created the monthly Directed Brokerage Statements.

How Much Was Diverted 

Two different types of diversions were identified: payments to recognized firms for products that appeared to be for Jacobs’ personal use and payments to non-operating firms. The first type of diversion included payments to mail order retail firms such as Paper Direct and ABC Distributing which were for products that SBA wouldn’t use in the normal course of business. These diversions, which began in 1993 and ended in 1996, totaled $5,061.63.

The second type of diversion, payments to non-operating firms, ranged from $11,500 to $98,500 and totaled $521,500. DCI made these payments, which began in 1996 and ended in 1998, to Capital Investment and Data Resources. Capital Investment is a Florida corporation registered in the name of Jacobs’ deceased father and Data Resources was a shell firm with no more than a post office box in Dothan, Ala.

Why the Diversions Weren’t Noticed Earlier

SBA didn’t identify the diversions earlier because of the following reasons:

1. Jacobs disguised the diversions as legitimate payments made by DCI. She destroyed some records and placed false records in SBA files to frustrate discovery.
2. The controls in place – supervision, internal review and internal audit – weren’t effective.
3. Other common controls – separation of duties and independent verification of balances – weren’t employed.
4. DCI perceived the financial coordinator’s role much differently than did SBA.

Jacobs’ false Soft Dollar Payment Requests and false Directed Brokerage Statements hid diversions from SBA officials, and the effect of those diversions. Jacobs showed them to the chief trader to support her contention that DCI had made a mistake. The payments weren’t questioned at DCI.

According to its founder and sole stockholder, DCI is a service organization. The company believed it was acting as a banker for SBA and paid invoices that were properly submitted. DCI’s arrangement with SBA stated that Jacobs was the appropriate person to direct payment and all payments made were supported by directions received from Jacobs in the form of Soft Dollar Payment Request forms.

Controls already in place at SBA that could have identified the diversions earlier included supervision, internal review, and internal audit.

Supervision and Internal Review  

Jacobs’ supervisor, chief, domestic equities, signed each of the transmittal letters indicating that he had reviewed and approved the attached Soft Dollar Payment Request forms and invoices and he hadn’t challenged Jacobs’ reports. In May 1994, he recommended Jacobs for an accomplishment award because she had made a presentation at a conference and had been selected to testify before the U.S. Congress concerning directed brokerage.

Others at SBA who observed Jacobs’ work habits reported that she often missed work. Administrative monitoring showed unreported absences and irregular attendance. Reportedly, the chief, domestic equities, then confronted Jacobs. However, the chief still gave Jacobs a good performance appraisal.

The chief, management policy, also routinely signed the transmittal letters. He said Jacobs always brought the package to him for his signature but always waited until he signed the document and then left with the transmittal letter. The chief said that if he was out of the office, Jacobs would always wait until he returned to obtain his signature. After signing the transmittal letter, the Chief would return the package to Jacobs. He didn’t think Jacobs’ practice was unusual because of the long-standing SBA culture of friendship and trust.

Internal Audit and other Controls 

SBA in September 1996 was considering adding commission recapture to its commission banking arrangements and amended the policy on directed commissions arrangements. At a Sept. 12 SBA staff meeting the director, financial operations, and others argued for separating duties and adding accounting controls over the directed commission program. The chief, domestic equities, and Jacobs argued that the program had never raised audit criticism, and they didn’t have to “fix something that wasn’t broken.” Those attending couldn’t agree on controls over the directed commissions programs.

Subsequently, the chief, operations, in a memo to the acting executive director, suggested three alternatives: install enhanced controls, yield to “department sensitivities” and conclude that no external review was required; or provide some secondary review that seemed non-threatening to the parties.

In the revised policy, the chief financial officer was authorized to review at his discretion directed commission programs. In November 1996, the assistant chief financial officer began an audit of the directed commissions program for calendar years 1995 and 1996. Her first step was calling a meeting with Jacobs. Jacobs said there were no written policies or procedures on how SBA was to spend its share of directed commissions, and SBA compared what it expected to spend and what it actually spent at year-end.

At that meeting, the assistant chief financial officer asked Jacobs to give her after the meeting a copy of the comparison between expected and actual for calendar years 1995 and 1996.

Jacobs didn’t present the document and continued to frustrate the Assistant Chief Financial Officer’s audit.
The audit file remained open but the audit incomplete until October 1997 when the assistant chief financial officer was promoted to chief financial officer. Because of the demands of the new position, she discontinued the audit.

Plea and Sentencing 

On Sept. 30, 1999, Jacobs appeared before Judge Robert L. Hinkle of the Federal District Court for the Northern District of Florida. She pled guilty to one count of mail fraud and one count of money laundering. According to an agreed statement of fact, Jacobs’ fraud scheme generated at least $521,500 and she had laundered at least $423,000.

Judge Hinkle sentenced Jacobs to 34 months in prison, three years supervised probation following release, and restitution of $423,000. Jacobs is now serving her sentence at a federal prison in Florida.

Friendly but Fatal Culture 

SBA had a culture of friendliness and trust. SBA internal controls over directed brokerage arrangements weren’t effective and other easily implemented internal controls weren’t installed. Jacobs controlled the process from start to finish. Although some SBA staff identified a need for additional controls, to insist on additional controls over the objections of others would have been going against the culture of trust. Additionally, because of that culture, the “badges of fraud” that are now apparent weren’t recognized. Some of those badges of fraud include:

• reluctance to give up total control over a set of resources or assets;
• reluctance to provide data that should be easily produced; and
• failure to provide all the data requested.

Jacobs is criminally responsible for the diversion of funds. However, responsibility for internal control belonged to SBA managers. As a fraud examiner, are you reminding your management of the dangers of soft money?

Francis Marvin Doyal, CFE, CPA, has been the compliance officer for the Florida State Board of Administration since 1999. Previously, in other positions he was a consultant, the chief inspector general of Florida, inspector general of the Florida Lottery and a 27-year veteran of the U.S. General Accounting Office.