Bringing Down the House: Extra Effort Found Roots of Federal Housing Funds Fraud

Executives at a large housing management firm stole thousands of federal dollars from low-income, rural rental housing projects. An extensive fraud examination found more than the initial investigation.

"I'm not the only crook at that firm!"

Now my interest was piqued. The voice at the other end of the telephone didn't say, "That's not true," but rather, "I'm not the only one." The voice was that of the recently discharged executive director of a large apartment management firm, Low Income Housing Management Inc. (LIHM), which managed more than $140 million in rural rental housing projects in two southern states, Texas and Louisiana , financed by the U.S. Department of Agriculture (USDA). That conversation and a little extra effort excavated more fraud damages than we had anticipated at the beginning of the investigation of irregularities at LIHM.

I am an auditor with the USDA's Southwest Regional Office of the Inspector General. Auditing USDA contractors is my business. My recent experience had been auditing management companies that managed USDA's portfolio of low-income, rural rental housing projects.

In March of 1998, I was preparing to assist another USDA-OIG region with a nationwide audit of management companies whose managed USDA properties were in poor repair, unhealthy, and unsafe for the tenants of those properties. A prior survey of similar properties indicated that the management firms were skimming equity from those properties especially when there were "identities of interest" (professional and/or business relationships) among the owners, management companies, and/or vendors to those properties. While we didn't initially find any serious health and safety concerns in the LIHM-managed properties, we did discover "prima fascia" evidence of equity skimming in two executive memos.

The official description of equity skimming is when a project owner, agent, or manager – who is in custody, control or possession of a secured property – willfully uses, or authorizes the use of any part of the rents, assets, proceeds, income, or other funds derived from the property, for any purpose other than to meet actual or necessary expenses of the property. An amendment to Section 515 of the Rural Housing Act of 1949 made that practice a criminal offense punishable by five years in prison, a fine of $250,000, or both. Rural Development, a USDA agency, finances and administers Section 515 housing.

The two memos, one from LIHM officials and the other from their independent auditors, described the discovery of some improper transactions. They reported that LIHM – or specifically, the executive director – had authorized the USDA's Section 515 housing projects to write checks to three vendors totaling almost $80,000. Once LIHM received those checks they weren't distributed to the respective vendors but were deposited in an LIHM account. Of course, the work was never completed.

When independent auditors were auditing certain Section 515 projects, they had asked the executive director for the invoices supporting vendors' charges to the projects. The executive director told an LIHM accountant to fabricate the requested invoices. The fabricated invoices were faxed from one office, within LIHM, to another office, also within LIHM. The executive director had programmed one of the fax machines to indicate that the fax originated with an out-of-town firm that normally issued only handwritten invoices. Suspicious invoices from the other two firms were prepared on a computer. The independent auditors accepted the faxed and computer-generated invoices and issued unqualified opinions about the operations of those projects. A healthy bit of skepticism would have gone a long way towards catching this fraud earlier. Random verification of select invoices at local vendors would have been an excellent audit procedure especially since many more invoices from small- and medium-sized producers are generated by computer software than are generated manually or typed on watermarked, plate-designed, pre-numbered invoices.

When the project payments on those fabricated invoices were deposited to the LIHM checking account, the executive director recorded it on LIHM's books at $13,000 less than was actually deposited and had written a check to his company, on the LIHM account for that $13,000 difference. When LIHM received the bank statements containing the cancelled checks, the executive director removed the $13,000 check. Because the LIHM accountants were required to consult the executive director when they had trouble reconciling the bank statements, he believed he was relatively secure that he could cover-up the transaction.

When the independent auditors began investigating the source of a $13,000 deposit to one of the executive director's accounts kept at the LIHM offices, the accountant who fabricated the invoices was assigned to assist them. He found the $13,000 deposit discrepancy between LIHM's books and the bank statement and that a check for that amount was missing. Under pangs of conscience, he told the auditors about the fabricated invoices, which supported the last year's audits of certain projects. The independent auditors then investigated the fraudulent transactions and complying with the requirements of generally accepted government audit standards, informed the USDA's OIG of the misappropriations of section 515 property assets.

When I arrived at LIHM headquarters, they presented me with deposit slips and copies of checks "enough evidence to support that LIHM had reimbursed all the section 515 properties for the questionable transactions. Within days of my arrival, LIHM fired a vice president. Its independent auditors had discovered that he had embezzled two IRS refund checks totaling more than $125,000. Subsequent inquiries revealed that his embezzlement also affected the USDA's section 515 properties. The vice president, who took advantage of poor internal controls at LIHM (failure to separate duties and establish receivables), had taken nearly $500,000 from LIHM and their managed properties for more than three years.

The vice president opened an account at LIHM's bank in the name of an LIHM business that hadn't paid its state taxes for years. That account became the repository for funds stolen from LIHM, its affiliated companies, and its managed properties. Contrary to the advice of its accountants, LIHM previously hadn't filed the paperwork to close that business with the state's comptroller. Also, if LIHM's bank had been more diligent to verify the authorization to open another account, LIHM's owner might have discovered the vice president's shenanigans much sooner.

LIHM also reimbursed the section 515 projects for the vice president's defalcations, which totaled more than $10,000. Amazingly, the vice president had stolen other funds from LIHM in past years, but it had forgiven him, allowed him to repay the stolen funds, and to retain responsibility for LIHM's and affiliated firms' cash assets. By all accounts, the executive director didn't know about the vice president's fraud, but the vice president knew of the executive director's schemes and that of others within the firm.

By reviewing project records, applications to build and manage Section 515 properties; and interviewing select vendors, we discovered that the owners of certain section 515 projects had not taken the allowed 8 percent ownership return (a return investment) that was to be paid annually by fiscally sound USDA projects. The failure of the owners to take the allowed ownership returns indicated that they might have taken other funds from the properties "skimming equity." The hint of equity skimming was further supported by (1) the undisclosed identity of interest relationship between the owner and the executive director of LIHM" the LIHM owner had loaned $485,000 "seed money" to the executive director1; (2) the undisclosed identity of interest between the executive director and an out-of-town vendor to the section 515 properties1; (3) the LIHM owner and the executive director themselves, and through affiliated companies, acted as general partners for many of the limited partnerships owning the section 515 projects; and, (4) the executive director and other non-owners received a percent of the profits of the management company, the affiliated maintenance company, and an affiliated construction company.

We uncovered essentially the same fraud that the auditors had initially reported to OIG, except in this scheme the executive director bilked more than $85,000 in deposits from section 515 projects to the affiliated maintenance company only. No invoices supported those deposits. The LIHM-affiliated maintenance company reimbursed the section 515 projects in the amounts they improperly paid. LIHM management assured me then that I, and they, had found all the problems that were to be found. At that time, LIHM and affiliated firms had reimbursed section 515 properties more than $175,000.

Despite LIHM's assurances, we continued to trace deposits in affiliates' accounts to invoices supporting those deposits and costs supporting the invoices and tested for other fraudulent transactions in 1996 and 1997. We ultimately identified more than $800,000 in excess and unsupported charges to section 515 properties and found that LIHM had charged section 515 properties for expenses already covered by management fees, management company expenses, and expenses of other projects. I determined that LIHM had charged USDA properties management fees at rates higher than those approved on unoccupied units and on non-income producing units assigned to project managers. I identified excessive profits by LIHM-affiliated firms and other charges not supported by attendant costs.

We discovered that LIHM had improperly charged managed properties for worker's compensation insurance premiums. Though employees of Texas projects paid higher premiums, on average, than Louisiana projects for worker's compensation, LIHM aggregated the premiums charged for all employees, including management and affiliated company employees, and charged all managed projects a pro rata share of those costs. This caused Louisiana projects to share in Texas projects' higher premiums and forced all projects to pay for LIHM and affiliated companies' employees' premiums.

We further identified a scheme to underinsure by more than $11 million for over 50 properties for fire and casualty losses. The reduction in coverage meant a reduction in premium costs. However, contrary to its contracts with USDA's Rural Development, LIHM hadn't obtained permission to do this, nor did it inform Rural Development of these reductions when they were accomplished as required.

We presented the evidence of "equity skimming" to an Assistant U.S. Attorney (AUSA). The AUSA investigation determined that the basic conspiracy with LIHM involved profitable projects paying the expenses of non-profitable projects and generating excess illegal profits from excessive charges made to those profitable projects. Though LIHM's owner and executive director acted as general partners for most of those managed properties, a separate partnership composed of different limited partners actually owned each property. However, the AUSA determined that the bulk of the more recent fraudulent transactions occurred in the construction and rehabilitation of USDA- and HUD-financed projects rather than in the operations of those properties. Though USDA required a line-by-line itemization of the costs of constructing or rehabilitating projects, including the builder's profit, LIHM principals schemed to increase the costs of the projects by inflating the payments made to subcontractors and, in some cases, obtaining kickbacks of a portion of the inflated amounts. Intrinsic to that scheme was the LIHM's principals hiding the identities of interest between the developer and the builder from USDA officials. Rural Development's regulations allowed the project owner to select the auditor to certify the construction costs. Consequently, the owners sought to choose the weaker and more pliable CPA firms to conduct those cost certifications, which almost guaranteed an amenable result to the owners.

The adjudication of the principals involved in the various fraudulent transactions included not only charges related to equity skimming but also to wire and mail fraud. The fraudsters used the telephone, wire services, interstate freight, and the U.S. Postal Service to contact their partners, send fraudulent documents, transfer the proceeds of their schemes, and make other transactions to further their schemes.

Following were the sentences of the principals in the more recent frauds (The statute of limitations had run out on the frauds we discovered in 1996 an 1997):

• The owner of LIHM repaid one of the limited partners investing in multiple rural housing projects more than $1.5 million; reimbursed the Federal Home Loan Bank more than $2.6 million; paid $131,000 to 11 limited partnerships; and paid a fine of $500,000.
• The former executive director of LIHM, the president of LIHM, and the builder each paid $60,000 fines. An LIHM-affiliated firm paid a $500,000 fine.
• The LIHM owner, executive director, president, builder, and the affiliated firm were all excluded from participating in any USDA programs.
• The individual persons participating in the frauds were sentenced to terms in prison ranging from two months to 60 months, with subsequent supervised releases of one to four years.

OIG officials, in conjunction with the AUSA investigation, confiscated (from the principals) more than $2 million in $50 "gold eagle" coins and other assets. OIG converted the confiscated gold to cash and partially used it to purchase computers and other equipment.

I relearned a lesson on this case: exhaust all the fraud examination techniques. More than likely you'll find more losses than you could imagine.

The views expressed in this article aren't necessarily the views of USDA's Office of Inspector General.

James E. Goodwin, CFE, CPA, is a senior auditor with the U.S. Department of Agriculture's Office of Inspector General in Temple, Texas .

1. Identity of interest relationships were required to be disclosed to Rural Development by the owners of section 515 properties