Accounting is the language in which one business can communicate with another. When the message is transparent, communications are conducted fluidly with both sides having the satisfaction of knowing that they are perceiving the whole picture. When accounting is opaque or managed, business goes into suspended animation until both sides fully understand the intent of the statements. In international business, when the two accounting systems are based on different theories, interpreters have to be hired to explain what the statements mean.

The accounting profession has evolved into an industry where transparency has given way to translucence and the once hoped for universality of accounting has slipped dramatically into the dust. For the most part, the auditing industry is cutthroat, with the competing firms desiring the business literally at almost any cost. This “win at any cost” philosophy brought with it moral concessions to management that destroyed a portion of the Big Eight Firms during the Savings and Loan Crisis and caused consolidations in most of those remaining. More recently, the Big Five have acquiesced to clients’ demands at the expense of transparency. However, the stakes have grown geometrically in the last decade. Both the accounting firms and their clients have globalized, and interdependency among professional firms and their clients and among businesses as a whole has grown. As a result, major economic sectors are vulnerable to the fallout of fraudulent accounting.

We are told that rudimentary accounting began six or seven thousand years ago in the Nile Valley of Egypt, The Pharaohs ran the equivalent of a very large conglomerate utilizing massive amounts of manpower. They had to keep track of progress and outlays. How many massive bricks of what size and in what order would they need to finish the next pyramid? What about the logistics of feeding, housing, and clothing the tens of thousands of workers that made up the construction crews. How much water would they need and when would it have to arrive before the men started to collapse in the desert heat? They developed a dual system of advanced logistics and a complex, highly organized system of accounting:

“The ancient dwellers in the Nile Valley first combined to organize the artificial irrigation their fields, a bailiff was appointed in every small village along the river to look after the irrigation canals. Each farmer had to pay him a certain quantity of grain and flax after every harvest. When the farmer had done so, a rude picture of a grain measure was drawn on the wall of his house, together with a number of lines indicating how many measures he had paid. This was the primitive form of receipt.” ([1])

Accounting could not really have its day of glory until several things came together; the first and most important was the invention of money, the ultimate accounting common denominator. In early history, man probably started out to trade with his neighbors by exchanging one item of perceived value for another of equal perceived value, such as a metal digging instrument for food. As time went on a change took place, because the person that desired a particular item may not have had something that the maker wanted in return. In addition, there may have been a perishable commodity involved in the transaction. Without Internet, which although many are unaware of it, did not exist in the years before Christ, two people that had items that they wanted to trade were more likely than not, unable to find a third party to close the transaction’s loop.

Thus, I have a digging utensil that you greatly desire; you only have food, which I have in abundance. Although unknown to both of us, Caveman Albert, just over the mountain needs the digging utensil desperately and has numerous seeds to grow highly valuable golum ([2]), which is in amazing demand around these parts. Sadly, our society of that era does not stretch over that particular mountain, while Albert and his family are able to gorge themselves on mountains of golum, much goes to waste as does the excess digging utensils and there is much hunger in the village on the other side of the mountain. Because golum does not store well and Albert’s cave family is without a digging utensil, the following season brings disaster to the mountains inhabitants and those below as well.

Money came into existence by necessity, and it took many forms from beads to cattle, but ultimately it happened that the easiest way of doing trade was with a currency that had an inherent value of its own, a gold or silver coin for example was perfect and it had intrinsic value, a critical element in gaining market acceptance for money. Precious metals were replaced by paper money backed up by these same metals with the exception that instead of residing in the buyer’s pocket they resided in a common place such as a government vault, a goldsmith’s shop or in someone’s vivid imagination.

Money came into existence by necessity, and it took many forms from beads to cattle, but ultimately it happened that the easiest way of doing trade was with a currency that had an inherent value of its own, a gold or silver coin for example was perfect and it had intrinsic value, a critical element in gaining market acceptance for money. Many say that in the sixth century BC, Croesus, who was the king of Lydian Empire was the first to refine precious metals into coinage. The Lydian’s were warriors and many historians of the time such as Aeschylus wrote much about all the gold stored in Sardis, the capital of the Lydian Kingdom. This was where the original saying about a truly rich man originated, “rich as Croesus” indicated fabled wealth even in those times.

The residents of Sardis were said to have panned for gold in the rivers that flowed near the city. This gold was mixed with silver and cooper and thus had to be refined. “…The Lydians placed the raw material in small bowl-shaped hearths in the ground and, fanning hot coals with bellows, heated it in combination with lead to remove the trace metals. Then the remaining material, mixed with common salt, was subjected to prolonged heating in earthenware vessels until the gold was completely separated from the silver.

As time moved on, these valuable metals were mandated to exist by government decree and resided in the particular country's central bank. ([3]) Moreover, it was usually stated within the currency that holders could exchange their paper for the more intrinsically valuable precious metals.

Many times throughout history, governments have attempted to mandate value for their paper money without proper backing, and as you could well have expected, those attempts have generally failed. On the other hand, they only failed because the people had no confidence in the continuity of the government and economically most important of all, that government’s ability to collect taxes. As anarchy started to reign as it did in post World War I Germany, the people lost all their confidence in the country’s money and in spite of everything that the government could do to stop its decline, the post World War I German currency probably lost more as a percentage of its value in a shorter period of time than any other currency in history ([4]).

Until the emergence of money, by adding row upon row of dissimilar items together, one could figure out what gross assets an entity had, but no clue existed as to what it was worth. There was no common denominator. In other words, if I had as assets, two fish, one cow and one mud hut and the bank wanted to know what my assets were I would write out a slip saying that I owned: two fish, one cow and one mud hut, and sign it. Until a translation into a common denominator occurred, accounting could only go so far. Many different denominators were used in various civilizations, but once trade extended beyond the boundaries of the country, those symbols meant little or nothing. Let us assume that the Indians had only wanted Wampum for the Island of Manhattan. Since wampum had no cachet in the Western World, Manhattan would still belong to the Indians. Luckily, for us, they liked jewelry, gold, and trinkets.

Goods were probably first translated to standard coinage sometime during the Greek ascendancy, although it was not until the late fourteenth century that anything approaching double entry bookkeeping came into being.

The first paper money was really a form of negotiable receipt. It came into being during the Middle Ages, most probably because highwaymen were robbing so many travelers that they were giving travel a bad name. Early monetary transfer systems were rather rudimentary in that the transaction really consisted of the traveler depositing his valuable coins with a goldsmith who in turn would issue a receipt. Because the goldsmith’s reputation was impeccable, the receipt was readily transferable among all of the people that were familiar with the goldsmith’s reputation and this became the earliest form of paper money. The early United States tried to create paper money by government decree with the Continental Congress issuing reams of it during the revolutionary war and giving it value by mandate. The war for independence was not going well so there were not a lot of believers around in those times and the new money laid an egg.

As inflation took hold of the fledgling American economy, the currency started to lose value. Many of the members of the Continental Congress thought that this could easily be taken care of by edict. And in January of 1776, “Resolved, therefore, that any person who shall hereafter be so lost to all virtue and regard for his country as to refuse said bill in payment, or obstruct or discourage the currency or circulation thereof shall be deemed, published and treated as an enemy in this country and precluded from all trade or intercourse with inhabitants of these Colonies.” I think it was a frustrated George Washington that once said during the Revolutionary War, “it takes a wagonload of Continental Currency to buy a wagonload of feed.” When the smoke had cleared, the paper money that the government had issued at what they said was 100 cents on the dollar had plummeted to 2 cents. The new American Government learned the hard way that there were certain critical basic elements missing in their idea, and the two most important were non-existent, confidence in the longevity of the government and its ability to collect taxes on an ongoing basis.

The next time the United States looked at paper money was during the Civil War. The story of its rebirth had an interesting beginning when Lincoln sent his advisors to meet with Salmon P. Chase, the then Secretary of the Treasury to convince him that the North should be issuing paper currency. Chase told them to advise Lincoln that paper money was illegal and could not be issued by the government because it was also unconstitutional and he would have no part of the scheme. Lincoln replied to Chase, “If you take care of the money in the Treasury, I will take care of the Constitution.

With the North and South beating up on each other, people still were reticent about buying into the concept but they did accept the issuance of paper currency by their local banks with which they dealt and had confidence. This in turn led to the start of a new business, the objective evaluation of banking soundness. Thus, several companies started rating the banks that were issuing currency and their ratings were to be based on ability of the financial institution to exchange their worthless paper money for silver or gold. Thus, certain money issued by weaker banks could only be exchanged at a discount and in some cases, money issued by large banks were worth a premium.

A rhyme was created in 1801 to better acquaint students with the rules of the double entry systems.

“By Journal Laws—What I receive

Is Debtor made to what I give;

Stock for my Debts must Debtor be,

And Credit my Property;

Profit and Loss Accounts are plain.

I debit Loss, and credit Gain.” ([5])

Therefore, when you did your books in the old days, life was much simpler. There were no weasel words like “materiality,” whose only purpose seems to be to hide critical financial information from innocent creditors or shareholders. Accounting has now become something similar to neurology, in that you have to figure out all of the possible pathways a company’s books can lead through, then bring in a forensic accountant and a number of consultants in order to even begin to understand what is going on with the financial reports.

John Law Screws Up

I am reminded about the story of John Law, who grew up in the early 17^th century. John was precocious as a youngster, showing early signs of being a mathematical genius by solving exceedingly complicated analytical problems that had been enigmas to even the most clever people of his day. He also possessed two other distinct disadvantages, he was extremely handsome and an inveterate gambler. However, as his successes substantially exceeded his failures in all of his many pursuits, his fame spread far and wide, and eventually he caught the eye of Louis XIV of France. Louis, as opposed to Law, was having a bad time of it. He really wanted all the better things in life, but not having enough money in his own treasury, thought to siphon some from his neighbor’s kingdom. Alas, this was an colossal mistake, it seems that he had not chosen his adversaries propitiously and he barely escaped with his life, and do to his blunder, went much further into debt. King Louis XIV did not earn the nickname molasses brains without good reason.

Louis was bummed out and when Law, always on top of his game, came up with a startling pronouncement, “We’ll start a Royal Bank, and I’ll run it.” Louis retorted looked at Law as though the man had lost his wits, “What good will that do, nobody in the kingdom has a franc, I have glommed on to everything that the people didn’t tack down. How can they possibly have anything left to deposit in your silly bank”?

Law was not unprepared, “Lou, you know all those stories about the New World, all that gold and stuff like that”? Louis indicated he was indeed familiar with those stories but further indicated that he had heard that opposed to precious metals, his intelligence had indicated that unfriendly savages and pestilence primarily inhabited the land. “Look at all those strange diseases the Spanish soldiers brought home,” he countered. Law was non-plused and continued, “We start a company and sell stock in it to the peasants. You know yourself that if we hire a top-notch public relations firm and give the deal the right amount of hype, we can make the commoners believe anything. We play down the bit about diseases and savages and tell them that the streets are made of gold in the New World and those chumps will fall for it and they will take what is left their money out of hiding. We take all of the money that comes from them, put it in the treasury and pay off all of your debt, and Louis, there may be even a little left for some of those bizarre little trinkets you really like, you know, the really weird stuff.” Louis thought for a moment and concluded, “John, I think that is a capital idea, we have nothing to lose and if it works, I will be indebted to you really big time.”

Well the idea worked. The money came in from unexpected places by the gobs and the government’s debts were paid, and there was even enough left for Louis purchase a few of his bizarre little trinkets and to throw a party or two for his friends in the court. But wait!

The peasants, having lost all of their money, now could not pay taxes. They were thrown out of work, and the country went into a depression far worse than when John Law had originally been given his assignment. Louis became disenchanted with his erstwhile friend, and the people harbored extremely grave ill feelings against the man. John Law, a brilliant conceptualist who just hadn’t thought his plan through to its inevitable conclusion,; was run out of town and died a pauper. The plan he devised became know as the “Mississippi Scheme”, which along with England’s “South Sea Bubble”, almost drove Europe back into the dark ages. Economic planning and a good accounting background would have told both the King and Law that their proposal was a lose-lose situation, but they didn’t have Big Five Accounting firms to rely on and plot their course then, did they? As we continue on you will see how the many new accounting innovations could have been taken advantage of and more importantly, if you ever have a kingdom of your own, you will be in an extremely advantageous position to take advantage of these tricks of the trade, so to speak.

The World In Which We Now Live

However, today, choices among the numerous potential accounting pathways are dictated by the nuances of international tax regulations, transfer pricing; derivative oriented profit and loss along with complex currency computations. On the other hand, that and a subway token will only get you a ride in underground New York. You still will have to understand the nuances of tax-oriented transactions, inventory restatements, auditor changes and a world of highly complex accounting trails that amazingly are not there for information purposes but to hide the real facts and thoroughly confuse investors. And after you have diligently studied the financial statements, it is highly likely that you will have come up with the wrong answer because accountants today, take some much leeway with the facts and are so good at inventing new characteristics, which are totally opaque and they are no longer interested in making the books comprehensible in any form whatsoever.

Life was never intended by our ancestors to be so complex and the role of the outside accountant has shifted dramatically to that of a corporate advocate, not an honest third party entrusted with protecting the public interest. The interests of businesses that are too big or too powerful to be governed by the regulators are driving the evolution and resultantly, the demise of accounting as a useful tool. Despite endless tough talk by the regulators, little has been done to make derivatives more transparent. Because of peculiar nuances with the accounting term “materiality,” massive potential ([6]) losses can be hidden over a period of years and shareholders can be totally deceived.

More businesses practice tax evasion today than at any time in American history and that undertaking has become so pervasive that the U. S. Government has used every weapon at their disposal to slow it down, with little or no result. Today’s public company’s bottom would cause Hammurabi to turn over in his grave. Adding to the problem is the fact that the number of students studying for a degree in accounting in American Universities has dropped almost a staggering fifty-percent in the last several years. Although, we are aware that other industries offer a lot more excitement and possibly substantially more remuneration as well, we are just forced to speculate whether the younger generation with their environmentally uncontaminated attitude have not determined that the accounting profession presents a contaminated cesspool that is so totally polluted from conflicts of interest and gimmickry that almost anything may represent a better alternative.

Hammurabi in his infinite wisdom had a fantastic solution for excessive creative accounting; if the books did not reflect accurately the person or company’s affairs, the instigator was summarily put to death. This, theory has followed us through history; in recent history, the penalty for attempting to defraud by keeping incorrect books has been a substantial amount jail time, unless of course your inventive accounting was used to fool the King when tax time rolled around. In that case, the King had several options available; accountants who fudged were either boiled in oil under a slow flame or stretched on a horrible contraption until they no longer fit into their clothes. The later is somewhat of a misnomer in that at that point whether the accountant could wear his clothes or not was no longer relevant; he would not be needing them. Thus, accounting quickly became cleansed of those with visions beyond the books that they were auditing and the profession developed a reputation for a degree of piousness.

Maybe we should go back to simpler times and look at the books in the same way the kings did. Life probably would become much easier and it certainly tends to keep the game more honest. As you read the following, I will leave it to your decision whether you think that accountants, who fudge the numbers, should be placed on a rack in the center of town where each citizen could take one turn at the wheel.

Theodore Hook made up the following little rhyme when talking about paying the correct amount of taxes:

‘Here comes Mr. Winter, collector of taxes.

I advise you to pay him whatever he axes:

Excuses won’t do; he stands no sort of flummery.

Though Winter his name is, his presence is summary.”

Edna, The Guy with The Green Eye Shade Is Dealing From The Bottom of The Deck

We know of no service industry that has had the kind of attrition that the accounting industry has recently succumbed too. It does not seem to matter whether times of good or bad, these firms are equally able to fail under varying economic conditions. You only have to look at the number of letters in the names of each of the Big Five to see where they have been and what they have gone through. The amount of money that their litigation has cost the insurance industry is legendary. And yet, knowing that the accountants will regularly get caught trying this maneuver or that tactic in order to separate the public from its hard earned dollars does not seem to matter. While settlements for class actions, claims against the accounting industry have literally rocketed out of sight, so to have the premiums that the insurance companies charge to insure their longevity. Obviously, the ultimate provider of the funds to pay for the insurance are the accounting clients and it almost seems that they are starting to charge on a risk reward basis and not by they hour.

Accounting firms engage in heated negotiations when major firms are in the market to replace auditors. Often they will indulge in substantial “opinion shopping ([7])”, and discuss in advance with potential clients how aggressive these accounting firms will be when reporting earnings, hiding loses, carrying over profits and managing earnings, should they get the account. The sad part of this bizarre mating process is that opinion shopping or in the alternative, the threat of it, more often than not causes the once sacrosanct “corporate books” to sink to their lowest procurable common denominator, sending the industry standards into moral freefall. The following legal cases are not meant to be indicative of the total number of times that major auditing firms have either fudged earnings or looked the other way when management has become overly creative in their sales or earnings reports. It restricts itself to only those situations in which plaintiffs felt that their interests were compromised and that the accountant’s work was so egregious to be worth noting in a court of law.

The accountants always had their best faces on when it came to facing the news people relative to their countless screw-ups and historically have mouthed such homilies such as “we have our defenses to the charges and will be vindicated by a court of law,” or better yet: “we have not seen the charges so we are in no position to comment at this time,” “The firm stands by its work which we believe follows GAAP principals to the letter.” Usually after this initial round of weasel talk is over and the case goes against the accounting firm, their management comes up with a new series of responses when found guilty of breaking the public trust: “our attorneys advise us that we have substantial defenses to the charges and that we should be vindicated on appeal” or when caught “red handed”, “this has been a case where one bad accountant has spoiled it for an entire firm whose reputation to this point has been impeccable” and when all else has failed, “the firm and its managing partners will suffer no substantial monetary damage due to the massive award against us as our insurance carrier is responsible for the entire amount, naturally less the deductible”. We can count the number of outright victories by the major accounting firms on the fingers of one hand, at least in the examples that we cite.

In addition, if anything, the situation has gotten far worse as it appears that the U.S. Treasury is close to losing control entirely over both consistency and transparency in tax reporting. Significant American corporations and their accountants now visualize tax avoidance as an integral part of doing business in today’s globalized economy. Among other wondrous creations has become the formation of endless offshore insurance captives where money can be stashed for rainy days or can earn substantial additional dollars tax-free while providing insurance or reinsurance is ubiquitous. The countries in which these captives are based usually have accounting regulations that were created with the maximum tax latitude as a criteria. After all, the industry of tax avoidance may be that countries largest source of hard-dollars.

In a global economy, transfer pricing ([8]) is a critical strategy in insuring that taxes are paid to the most favorable domicile. Although transfer pricing is more of a daisy chain then offshore insurance captives, they are both equally effective in keeping money off of the tax rolls. Simply put, as the product moves through its various stages from gathering the raw materials to creating the end product, there are places where labor is cheap and places where taxes are low. Sometimes you can even find places where labor is cheap and taxes are low in the same country. These countries are usually called dictatorships and substantial rewards are usually bestowed on those in power in order to receive these munificent benefits. If a company is looking to save money on its tax bill, it will create its greatest profit where taxes are the smallest or perhaps non-existent, for the right price.

Monolithic international mega-mergers have become as normal as brushing your teeth in the morning, yet the European Community (EU), also sets up critical barriers that must be addressed when analyzing corporate strategy. How incredible it was to see the EU’s Monopoly Commission threaten to literally kill the proposed merger between two American Companies, Boeing, and McDonald Douglas. At first glance, it was the consensus that Boeing would tell the EU to stick it, but when faced with their planes not being allowed to land at European airports, carry European travelers or be purchased by EU countries the mood suddenly changed. Boeing blinked, and made serious concessions to the EU in order to get their blessing.

This is not exactly the point thought, the EU, however, had their own agenda, a competing plane built by Airbus and instead of the free trade envisioned by the World Trade Organization, (WTO), it would almost appear that among those that argued the strongest for bringing down the barriers, protectionism has come back to haunt us with a vengeance. All that has happened is the that large global villages have been created by organizations such the European Community, The Nafta Signatories, the ASEAN countries and the emerging Latin American Block.

Moreover, that is not to mention the fact that the “International Oil Cartel” which crosses all boundaries in their effort to act in restraint of trade and impoverish their benefactors. Why doesn’t the all-powerful EU attempt to place a food embargo on these countries in those arid regions where oil seems to come from deserts in enormous quantities and is regularly withheld by what is literally a criminal cartel of thugs. But, in their wisdom, the EU would rather chose to fight a far lessor battle then address the real needs of their constituents. We have indeed entered a strange new world where the inhabitants are like characters out of Alice in Wonderland. Morals have become a function of politics and economic battles are fought in the press, and not be governments. The battlefield is chosen relative to the chance of success, not the worthiness of the cause.

Another anomaly of our “New Age Accounting Based Economy” is the fact that in the last two years, a period in which the stock market climbed to unprecedented heights, unbelievably, corporate tax payments declined. However, during this same period, these same corporations publicly reported that their earnings dramatically increased. Talk about “Alice in Wonderland”. One has only to look at the outlandish accounting statements emanating from companies such as AOL, Cendant, Livent, and Waste Management and their high priced magical making accountants to wonder whether the world really hasn’t turn upside down and the Mad Hatter isn’t running things. Motorola, Compaq Computer, and WorldCom have all taken eye catching, one-time charges of astronomical proportions. Hammurabi and the king would have stretched new suits for all of these folks.

Outright fraud, over-aggressive accounting, and misleading numbers have taken away the time honored practice of requiring that corporate statements reflect how well the company has performed during a particular accounting period, when comparing that period with another one. No longer is this achievable because the accounting processes used to determine earnings and even sales may be totally inconsistent from period to period ([9]). More exasperating is the effect of companies changing accountants midstream when the current auditor will rightfully not allow a deduction or balance sheet item that another equal prestigious accountant thinks is acceptable. Obviously, when this occurs there is also a change in methodology and yet when looking at the footnotes, you cannot tell where one accounting firm has begun and another had ended. This is truly amazing and obviously has the tendency of making the accounting profession one of not only selling its sole to the highest bidder but dropping off a precipice and falling until it has reached the lowest possible common denominator. ([10])

Front-loading expenses and taking the “big bath” all at once are tricks that permit corporate earnings management; something that has concerned the Securities and Exchange Commission no end. The SEC’s chief accountant, Lynn Turner, in a meeting with officials of Big Five Accounting firms among others, states; “If the basic accounting foundation ever loses credibility with investors, then the whole process would fall apart.” Arthur Levitt Jr., in a speech delivered on September 28, 1998 sounded like he was talking a foreign language when he addressed these issues, which included, “Big Bath Charges,” “Creative Acquisition Accounting,” “Cookie Jar Reserves,” Materiality and “Revenue Recognition”.

It is critically apparent that the accounting profession discovered little or nothing from their near-criminal and criminal behavior in auditing the Savings and Loan industry. Recently, Big Five Accounting Firms have routinely started recommended extremely aggressive tax shelter positions for their clients. Creative new tax shelters are cropping up all over the place and have had such a huge impact on tax collections that the IRS has signaled its intention to scrutinize these ploys very closely. Henceforth, the IRS states, it will not only refuse to allow any deductions without a reasonable business purpose, but, in a deadly one-two punch, it will also require disclosure of the names of all tax shelter clients of the accounting firm. Not satisfied that these two solid ideas have done the job, the Administration has stated that they will put more IRS agents into the field to ferret out corporate cheating. Between managed earnings and sheltered income; transparency, as defined by GAAP, the SEC, The World Bank, The U.S. Treasury, the IMF, the United Nations, and the Bank for International Settlements and a host of other do gooders, has become a mirage. ([11]) Transparency can now be defined as a process that can only be foisted on underdeveloped countries and small public companies with limited resources. It is readily apparent that we are arriving at the never-never land of tax anarchy for the big and powerful. Thus, the meek and sickly will be forced to take on more of the burden in the years ahead if there isn’t a rude awakening.

When the time comes, and it has, that earnings can go through the roof while tax collections decline, financial reporting has obviously reached a new level of sophistication. Corporations have become mobile beyond comprehension. Chief Executive Officers (CEOs) are now able to maintain control over their divisions from almost any point on the planet. Of the 200 largest economies in the world, at least 100 are corporations. Because of the universalism of the Internet and globalization of manufacturing, the catch phrases “Made in the USA” ([12]) or “An American Corporation” have literally lost all of their meaning. Today you need a scorecard just to figure out where a company is really domiciled and even when you have pinpointed what you think may be correct, you will find that their portability is infinite. Their offices are in the corporate jet in which the CEO travels. Moreover, what does made in American mean anyway? Manufacturers have been avoiding a foreign label by having the buttons put on shirts made in Hong Kong in the American possession of Guam since the end of World War II. What you see has never been further from what you get in history. When the American Government determined that the term “Made in America” had become a total myth, the unions banded together and forced the Federal Trade Commission to reconsider its proposed changes. Once again, Alice and her friends prevailed over reality, and local interest groups have snatched truth out of regulation. Thus, we continue to live a sham.

Clients, especially dot.com companies, tell their accountants that aggressive tax accounting is critical to their global survival. Yet, the rules with regard to transparency and fraud have tightened. Moreover, the stock market has always been a wonderful equalizer, you can only blow smoke for so long but ultimately you will have to deliver. If that delivery day does not arrive within a reasonable interval, the stock market and then the public will severely punish both you and your accounting firm. Once again, the accounting industry is being set up for a fall but this fall will be even worse than the last.

Unprecedented numbers of reasonably capitalized companies will fail because of an number of factors: mis-guessing technological changes, not having the funds to keep up with competition, inexperienced management who were idea rich and delivery poor along with sudden unforeseen shifts in technology. Companies such as Amazon and Priceline who have promised much and delivered little will eventually cause their accounting firms severe financial indigestion when disgusted investors look for scapegoat. The simple consequence of being wrong in any of these areas has always been extremely severe. Jail time, corporate bankruptcy and lawsuits against accounting firms are a few of the tools available to an angry public and the class-action attorneys that are always circling the playing field like a vulture looking for carrion. The stock market is an economic “grim reaper” ultimately separating the wheat from the chaff; as high-tech anomalies that demanded unusual accounting treatment fall by the wayside, so will the accountants. Instead of the Big Five, we may soon be looking at the Big Zero and the day of the honest outside accountant dedicated to protecting the “public interest” will go the way of the Dodo Bird and the Wholly Mammoth.

Accountants are now looking for new ways to increase revenues: they have sought changes in the anti-rebate regulations of the American Bar Association and have acquired law firms, investment bankers, consulting firms in almost every industry. By dealing through their “independent” consulting arms, they have even learned to take stock in promising companies. By having their consulting arms in separate corporations, the accounting firms feel they have avoided some degree of legal risk, but in our world of expo facto justice, this will hardly win the day. The Mad Hatter and the Queen of Hearts set Alice straight, but who will send the accountants the message, “you will be the fall guys, one more time.” Or perhaps there is method in this insanity, ensconced management is only in it to take the money and run, live the good life and not worry about their junior partners who will take the brunt of today’s excesses.

The “Big Five” accounting firms have not acquitted themselves with flying colors when it comes to protecting the public interest. Both the public and private sector have prosecuted them all for incompetence, fraud, and theft. To give you some idea of how well the major accounting firms have protected the public trust and avoided conflicts of interest, we have listed below, a short synopsis of a selected list of fairly recent litigation. The list shows the names of the accounting firms, who they were auditing and what went wrong. Moreover, most of these cases ended up in court or with people going to jail. We have tried to synopsize these shortcomings in the auditor’s work. We have concentrated for the most part on public companies and Big Five auditing firms. The material that we have listed below comes from numerous other sources.

With their track record, the accounting firms should be more prescient. In simpler times, when accounting was tamer than it is now, these scandals occurred:

The Big Guys Went Wrong

Laventhal and Horwath,

· Went out of business rather than fight over $2 billion in litigation regarding their work product. Primarily caused by the Savings and Loan problem.

Ernst & Young.

Filed misleading audits of Republic Bank of Dallas, Texas. SEC filed charges in a complaint.
Settled with litigants for $335 million, one of the largest cases in accounting history; Cendant Corporation and the fat lady hasn’t stopped singing yet.

· BCCI, Accountants were sued by investors and regulators for $1.6 billion for there actions in covering up the bank’s fraudulent activities.

Part of Lincoln Savings and Loan. (Arthur Young).
In one of the great votes of confidence of all time, The General Accounting Office of the United States Government stated that Arthur Young’s audits of the Savings and Loan Industry, “did not meet professional standards.”
In November 1992, Ernst and Young agreed to pay $400 million in settlement of misleading regulators regarding the financial health of miscellaneous thrifts.
Resolution Trust Company as Conservator for Imperial Savings sued Ernst and Whinney for $26 million.
Ernst & Whinney was sued by the Federal Deposit Insurance Company concerning their audit of City and County Bank of Anderson Tennessee for $255 million. CIV-3-87-364
Ernst & Whinney was sued by the Federal Deposit Insurance Company regarding their audit of City & County Bank of Knox County. CIV-3-87-364 for $255 million. (See above)
Ernst & Whinney was sued by the Federal Deposit Insurance Company for their audit of First Peoples Bank of Washington County Tennessee.CIV-3-87-364 fir $255 million. (See above.)
Ernst & Whinney was sued by Federal Deposit Insurance Company for $255 million because of their audit of United American Bank of Knoxville, Tennessee. CIV-3-87-364 (see above)
The Federal Deposit Insurance Company sued Ernst & Young for $560 million concerning their audit of Western Savings Association.
Merry-Go-Round, Ernst & Young provided consulting services for the company and was charged by the Trustee in Bankruptcy of incompetence, fraud, and misrepresentation. Ernst & Young settled the matter for a stunning $185 million after being sued for an even more stunning $4 billion. This case had more conflicts of interest imbedded in it that probably any other accounting matter in history.
The General Accounting Office of the United States Government stated that Ernst & Whinny’s audits in the Savings and Loan Industry, “did not meet professional standards.”
Stockholder derivative actions were filled against Ernest & Whinney for tens of millions of dollars for failure to use even a modicum of due diligence in the amazing case of ZZZZ Best. This is an instance of a prepubescent child taking on one of the top accounting firms in the world and making them like utter fools.

Arthur Andersen,

Settled with investors regarding their accounting in the demise of Lincoln Savings & Loan for $30 million.
Settled with Federal Government for their errant accounting in the case of Lincoln Savings & Loan, approximately $25 million.
In July 1993, Arthur Andersen agreed to pay $79 million in the case of Lincoln and five other thrift oriented lawsuits.
DeLorean Motors, Arthur Andersen paid big bucks to settle with Trustee for inept accounting in motor deal gone bad in which drugs paid a critical role. Arthur Andersen was so awed by DeLorean that they couldn’t see either the conflicts of interest that he had created or the fact that their numbers we inaccurate.
Sunbeam, Company was guilty of fudging literally all of their numbers under the guidance of turnaround expert, Chainsaw Al Duggan. Duggan got rich while thousands of loyal employees got fired. Andersen did his bidding and when the smoke had cleared, they were totally taken in by Duggan homilies.
Waste Management, One of the biggest restatements of earnings in financial history because literally everything the company reported was fudged. Once again, Andersen ultimately paid a dear price.
HBOC, McKesson, Bought HBOC on strength of the their growth which was none existent. Almost everything about this company was a fraud and the accountants missed it. The shareholder’s derivative actions are immense and there is little way for Andersen to escape major claims
E. F. Hutton, Arthur Andersen made no bones about the fact that they were aware of a massive check kitting and money laundering operation going on at Hutton. They even warned the firm, but did not qualify their statements, report the mater to the authorities or resign. If ever there was a case of an accident just waiting to happen, this was it.

Deloitte & Touche,

Charged with fraud and negligence in audit of Executive Life Insurance Company.
Part of Lincoln Savings and Loan action. (Touche Ross)
Federal Deposit Insurance Company (FDIC) sued Deloitte & Touché for $400 million regarding their audit of First South, FA.
Resolution Trust Company sued Deloitte Haskins & Sells for their conduct in auditing Royal Palm Federal Savings & Loan for an undetermined amount.
Sued by Federal Savings & Loan Insurance Corporation (FSLIC) for $300 million over their audit of Beverly Hill Savings and Loan.
Sued by Resolution Trust as Conservator for Aspen Saving Bank regarding the audit of Commonwealth Federal Saving and Loan for $50 million.
Deloitte Haskins & Sells was sued by Resolution Trust Company regarding their audit of Peoples Federal of Oklahoma for $467,000
General Accounting Office of the U.S. Government made an example of them when they stated that their audits of Savings and Loans “did not meet professional standards.”
Livent shareholders have united to file a class action lawsuit against the company's auditors, Deloitte & Touche in Canada, and co-founders Garth Drabinsky and Myron Gottlieb. Suits have been filed against Deloitte for tens of millions of dollars. The auditors in this one seemed to have missed the fact that there were truly two sets of books.
Philip Services, a situation in which the SEC has accused Deloitte of almost filing no audit at all. To see how bad accounting can get, this deserves a look.
Deloitte & Touche settled along with Coopers for over $50 million to the administrator of Barings, for failure to weed out financial irregularities in the books of that company.
Cendant, This Company was one of the great accounting frauds of all time and the auditor’s, Deloitte Touche were ordered to repay over $300 million, a record to that point. Almost from the day of inception, there was not a lot that was real about this company.
Koger Properties, A jury found that Deloitte Touche aided in cooking the books of this company. They found against the company to the tune of $81 million. This was appealed twice and Deloitte won the third round in a question of causation. Plaintiffs are taking the matter to a higher court. The SEC sanctioned Deloitte’s auditor on the account because he was a shareholder of Koger and thus not truly independent. We have seen numerous instances of accountants holding stocks in companies that they are auditing and are totally mystified by the process. In one case, the Chairman of the Board of the accounting firm was a stockholder.

KPMG Peat Marwick

Resolution Trust Corporation sued for $100 million regarding misleading audits of Hill Financial Savings Association.
Sued by Resolution Trust as Conservator for audit of Duvall Federal Savings and Loan for $16.6 million.
BarChris Construction Company, a senior auditor, not a CPA, 30 years old and in charge of his first audit was asked to do the accounting of a company that built bowling alleys. He failed miserably in uncovering a fraud and Peat Marwick was found with others to be guilty of negligence in the classical case of its kind.
Crazy Eddie, Probably the classic fraud of the 1980s where the accountants, Peat Marwick made every mistake that was possible. Settlements with shareholders were substantial and Crazy Eddie is still in jail. Inventory was going out the backdoor faster than the accountants could keep track of it.
Wedtech, This Company rounds out the list of classical companies that Peat Marwick represented. They probably shot the new business partner after this one. This case undoubtedly set the all time record for politicians associated with a company going to jail. Once again, shareholders sued and collected substantial monies from the accountants for their auditing miscues.
Yale Express, While you can make a fairly good case that what Peat Marwick lacked in quantity it made up in quality. The BarChris, Crazy Eddie, Wedtech, and Yale Express cases are absolute classics in how not to do accounting. In Yale Express, Peat Marwick although warned several times would not force the company to make necessary adjustments in the financial statements to make them truly reflect the business conditions as existed. Because Peat Marwick never followed up, it was sued for its non-actions and ultimately settled for an undisclosed sum of money.

Price Waterhouse, Coopers

English lawsuit in the amount of $3.5 billion regarding their audit of BCCI.
Coopers and Lybrand charged by Phar-Mor for compensatory and punitive damages: Phar-Mor demanded that the accounting firm be held liable for civil actions filed against the chain.
Coopers and Lybrand was fined over $1 million and assessed costs of over twice that much for accounting errors in the Robert Maxwell fiasco, in which hundreds of millions of dollars were lost. Worst of all, Maxwell was using the employee’s profit sharing and retirement funds as his private piggy bank.
Coopers and Lybrand was accused of conspiring to overstate MiniScribe’s financial health to the bondholders. (Settled with bond holders for $40 million)
Conspired to overstate MiniScribe’s financial health to the stockholders. (Settled, amount unknown.)
ZZZZ Best, Took over the accounting of this sham company without kicking the tires causing massive stock market losses for investors. Involved in class action. A classic instance where one accounting firm has had enough and another blithely marches in without asking the right questions.
Silverado, Coopers agreed to pay the Federal Deposit Insurance Corp. $20 million over three years. Things probably would have been a lot worse if wasn’t for the fact that one of George Bush’s sons was a director. It may be that Coopers got off easy.
Guarantee Security Life Insurance Co., of Jacksonville, Florida, Coopers was charged with breach of fiduciary duty, negligence and breach of contract by Florida Regulators in a $300 million action.
Cal Micro, A situation so egregious that the SEC in an unprecedented announcement stated that they would try to ban Coopers from ever again signing off on a public audit. Obviously this was worked out behind the scenes but we are unaware of any other instance when the Securities and Exchange Commission became so enraged over a public audit.
Kurzweil Applied Intelligence, Coopers & Lybrand did the audit during the period when the company was going public. It was later announced that sales had been inflated by approximately 40%, which Coopers obviously had missed. When they ultimately caught the fraud, investors had already invested in the company and lost everything when the stock collapsed.
Barings settled with administrator along with Deloitte Touché, the predecessor accountant for Barings, for over $50 million for failure to catch financial misdoings in 1992 by Leeson.
Towers Financial, $450 million lost by investors with the principal claiming that he was aided in his fraud by Price Waterhouse, Barbados. While we don’t give any credence to the fact that Price Waterhouse aided in this blatant fraud, there is no question that a lot got by them in their audit responsibilities.
Emcore charged Price Waterhouse, Coopers and senior employees of Racketeering. SEC censures PricewaterhouseCoopers for not complying with the standards of independence. 1998. Once again we have an instance of the accounting firm creating their own conflict of interest.
Fidelity, Securities and Exchange Commission censures Pricewaterhouse- Coopers with not complying with the regulations covering auditor-independence. It seems that PricewaterhouseCoopers and Company had a lot of problems with keeping track of what companies their auditors owned stock in and thus, created a series of mistakes that could have easily been avoided.

TYCO, PricewaterhouseCoopers guilty of allowing some of the most innovative and aggressive accounting seen on this planet to that date. Case has set standard for how not to do books unless of course you want to have big time IRS and shareholder problems.
Robert Maxwell, Drained the pension fund right in front of the accountant’s noses. Used money to support lifestyle and acquisitions.
America’s Future, Charity headed by General Colin Powell used PricewaterhouseCoopers data that was both unchecked and incorrect to push phony charity claims. Pricewaterhouse acted in almost a disgraceful manner when they claimed that it wasn’t their fault because although they authored and issued the misleading report, they hadn’t conducted an audit. Sounds to me as though their public relations department should have left well enough alone.
W. R. Grace, Pricewaterhouse aided Grace in managing their earnings illegally and hiding the rise in compensation of retiring CEO.
Symington, Coopers & Lybrand, climbed aboard Arizona political machine in representing the governor, phonied up his books in exchange for political business. Also took care of incorrect fillings in his real estate company, which went under. Ex-Governor is now in jail and will be for foreseeable future.
Old Republic, PricewaterhouseCoopers allowed Old Republic through their strange sense of morality to literally steal the money belonging to their clients from an escrow fund. This was one of the most substantial breaches of the public trust that we have seen to date.
Coopers & Lybrand, were auditors for Phar-Mor, Giant Eagle, and Tamco. All three were literally owned by the same person who appears to have been swindled along with investors and creditors in one of the largest private companies ever to go under in the history of the United States. Estimates of the fraud vary from $500 million to $1 Billion. Coopers settled with creditors for a substantial payment. Coopers fell for one of the oldest inventory deceptions in the book on this one by not creating a large enough sampling and going back on their work.

“Phar-Mor, Leslie Fay, ZZZZ Best, Kendall Square Research, Crazy Eddie, Mini-Scribe, Kurzweil Applied Intelligence, New Era, the savings and loan crisis and First Executive. The list of notorious financial frauds and scandals in recent years goes on and on. And in each instance, angry investors and an incredulous public were left wondering: Where were the auditors? In most of the instances above, they were totally out to lunch. Any of the above frauds could have been easily uncovered by a motivated accounting student with a degree of paranoia in his soul. The deceptions were shallow to say the least and the fact that shareholders lost billions because of bumbling accountants is a crying shame.

However, for the auditors, that has proven to be a mighty expensive question. In the wake of those and other scandals; lawsuits against the green-eye shaded types have soared to a point of unbelievability. Burned investors – who along with government regulators in the Savings & Loan debacle – argued that accountants who did little to unearth questionable practices and thus, determined that they were just as liable as the corporate execs in actually misrepresenting the numbers. Moreover, plaintiffs won in court much more often than not. Accounting firms have spent upwards of $1 billion to settle civil lawsuits since the early 1990s.” ([13]) In addition, it has been estimated that the Big Five have spent over $400 million per year since 1990 just on litigation costs.

I Understand It Now, But Who Pays An Accountant To Be Independent?

In theory, the outside accountant provides a set of checks and balances on a public company in their financial communications with the public. Also relying on the independence of the outside auditor are regulators such as the Securities and Exchange Commission, which has a requirement that a public company has an independent outside accountant. Other regulators are also dependent on their reports such as the Self Regulator Organizations (SROs). Primarily, these are the stock exchanges and the National Association of Securities Dealers (NASD) who have regulatory status. Listing requirements vary from exchange to exchange, but a substantial negative change in a company’s outlook can get their listing removed. When they receive a warning (which they will) that such an action is in the works, it sends a strong message to shareholders to watch out. On the other hand, if the independent auditor is not doing his job, the message does not get sent and the public and the exchange are none the wiser until the bottom drops out and pandemonium rules the day.

On the other hand, we know what everyone thinks of squealers. These are not necessarily great people and usually they are willing to tell all about someone because something is in it for them. With the independent accountant, things are very different. If they tattled to the SEC every time that one of the companies that they audit does a no no, two things will become inevitable. First and foremost, they will probably loss that client, and secondarily and even more import, they will probably never get another client as long as they are in business. Yet the SEC has instilled them with them with the fact that they must be truly independent, which is impossible for the reasons above and the fact that they must follow the letter of the law when doing an audit. Although this is wonderful in theory, in practice, each company has its own vagaries. The risk of calling in the marshals on your own audit client can be just as bad in many instances as not doing it.

Thus, the accounting industry as practiced under existing regulations is about as logical as an old shoe. There just ain’t any winning in it for anyone. Moreover, it only has become a matter of how much you, the accountant, are going to lose and whether or not it can be made controllable through insurance and other insulating devices. One thing is for sure, this isn’t a business for the faint of heart. Imaging how long you would last if you were to be known to be in the business of ratting on your own clients, which is exactly what is expected by the regulators. The auditors fight tooth and nail over potential clients; this courtship itself creates an aura of mutual dependency that, in spite regulation, flies in the face of becoming a stoolie. But this isn’t a story that concerns itself with how hard it is for accounting firms to operate in this kind of regulated environment, the fact that it is tough is a given, however, this is a story of many accounting firms that went to far overboard under any set of circumstances in their efforts to keep a client alive. We are talking about those that went beyond both logic and the law and that seems to cover the accounting spectrum, at least on the high end.

Moreover, an accounting firm that consistently turned in its own customers to regulators would find that new clients were, kind of shying away from them with good reason. Historically, the rules require that an accountant take a neutral position toward his client, auditing the books as though he was working for an anonymous third party. In the real world, this assumption makes about as much sense as catfish jumping into a hot frying pan. However recently, the price of admission has been raised, requiring a more jaundice yardstick to be used when analyzing a client’s books. In the meantime, the public and private sectors have both paid a horrendous price for accounting firms’ lack of true independence, as well as their stupidity, laziness and lax standards.

Despite the regulators’ tough talk, the reality is that accounting standards have been lowered substantially and laxity regulating the dot.coms have taken accounting creativity to a new level which has now overflowed into non Internet companies. Either the SEC has grown unwilling to enforce the rules of the game or they have changed those rules dramatically to give some breathing room to Internet oriented technology companies to reach puberty. Ultimately, the public will be rewarded for this mistake on the part of regulators by paying a price even in excess of that which was the tab when the Savings and Loans went down. On the other hand, once the accountants for the dot.coms invent a new method of making their balance sheet unreadable, companies that are normally considered to be in the main stream, pick up the cudgel and join the party. Hell, if those guys can do it, why can’t we?

It appears that the public rather than the regulators ultimately creates a level playing field by filing litigation when earnings become inflated due to enchanted accounting. When investors lose money, everyone pays for the indiscretions. Litigation will increase in geometric proportion to the fall in technology stock prices and margin calls. We will soon be faced with the old boulder going down the hill scenario; the faster it goes, the more velocity it picks up, and eventually the only thing that can cause it to stop is its loss of dynamics. It has lost its pent-up kinetic energy. These lawsuits could well exacerbate market declines to the point where the process may spiral out of control.

In order to prove our point we will give numerous examples of how auditors closed their eyes to accounting misdeeds in order to maintain a client relationship. The SEC regulations state that outside accounting firms should take the position that their client is neither honest nor dishonest and treat the books accordingly. This is usually translated as: if the accountant suspects something amiss, the trail must be followed until the doubt is put to rest.

Sadly for the public, this rule is not followed about as often as an Atheist goes to church. Accounting firms have turned themselves into pretzels to accommodate the bizarre activities of some their clients. Again and again, the major accounting firms have proved that they are not really independent when it comes to auditing their own clients’ books. They have looked the other way consistently even in instances when they have been put on notice that something may well be amiss. In addition, often when an accounting firms resigns because it has serious doubts about its client, little or no checking is done by the new firm as to the motivation behind such resignation. Moreover, it is has been literally a game of musical chairs within the industry that when one accounting firms leaves, without letting the seat get cold, a new auditor “assumes the position”. Think of this; can you ever remember a situation no matter how bad the company that they were unable to get an auditor to do their books.

In many cases, no checks are made to confirm that sales booked have even been made. While costs can be fairly well established, when they are spread over fraudulent sales, earnings skyrocket because there is literally no charge against them.

The Banks Gone Bad

BCCI, Now Watch The Little Pea And Put Your Money On The Table.

“The Bank of Credit and Commerce International, S. A. (BCCI) story is important not just because a lot of people stole billions of dollars but because they got away with it right under the noses of the authorities and none of these watchdogs barked….This is a story of the breakdown of our institutions.” Larry Gurwin, Senior Investigator, The Investigative Group, Inc.

The bank was formed by Agha Hasan Abedi whose United Bank Ltd was nationalized in Pakistan by then President Zulfikar Ali Bhutto. Abedi was a good friend of Sheik Zayed bin Sultan al-Nahayan, a highly pro-Arab billionaire from Abu Dhabi. They were joined with Bank of American as the original investors in BCCI. The total capital of the bank was $10 million with the American Bank being by far the smallest investor. It didn’t take Bank of America long to see that the financial institution was not going in any direction that they would be contented with and they pulled out, stating that they did not trust various elements of the transaction. The Bank of Credit and Commerce International was chartered in Luxembourg and opened their doors there in 1972. Within a short time, they had opened five additional offices in The United Arab Emirates, Britain, and Lebanon. The bank probably grew faster than any previous similar enterprise in world history. Three years later, it had almost 150 branches in over 30 countries.

The bank was set up very shrewdly with the regulators in mind. It was everywhere and then again, it did not seem to rest anywhere. No major country with strict banking regulations seemed to want to call it their own, so no one did and the bank was allowed to move wherever and whenever it wanted to with no one checking its business or its capital. Robert Morgenthau put the matter succinctly when he indicted the bank in 1991:

“The corporate structure of BCCI was set up to evade international and national banking laws so that its corrupt practices would be unsupervised and remain undiscovered, this indictment spells out the largest bank fraud in world financial history”

The people that headed the bank were well versed in the game of bribery and were able to buy their way into Central Bank deposits from such countries as Barbados, Belize, Morocco, Panama and Jamaica as well as a host of others.

BCCI was even-handed in its operations. It dealt at the senior levels only in crimes of the first magnitude: drugs and illegal military shipments from Peru and Columbia, and money laundering in Panama. It was at the forefront in the financing of terrorism throughout the world, including Hungary, East Germany, Czechoslovakia, Yugoslavia, North Korea, and Cuba, while gaining substantial expertise in counterfeiting numerous types of documents. BCCI funded atomic weapons thefts and the purchase of unconventional weapons for radical Arab regimes. They became skilled at the creation of false end certificates, the nuances of bribery and the art of covering-up kickbacks. The bank became embroiled in countless murder investigations while serving as a front for political extremists throughout the Middle East. Moreover, they still had time to involve themselves as a substantial investor in CenTrust, a victim of the Savings and Loan fiasco, which cost American taxpayers over $2 billion. BCCI was even an important cog in siphoning $4 billion in U. S. Agricultural funds into Iraq, which indirectly aided Saddam Hussein’s war buildup. ([14])

Of all of the disturbing elements to arise from the ever-unfolding BCCI drama was the use of BCCI’s private airplane by the Secretary-General of the United Nations while on official business. When any entity provides amenities to heads of supposedly independent representative organizations, it shows a total lack of regulation and discipline on the part of those organizations. Ex-U. S. President Jimmy Carter’s introduction of BCCI to most of Asia was reprehensible; however, he was not representing his country when it was done.

Other Americans were also highly involved with BCCI, Bert Lance had $3.5 million in his debts paid off by the bank with a loan. Andrew Young while in office was a paid consultant to BCCI and Jesse Jackson received numerous favors. Among the rest of BCCI’s American help mates were former Secretary of Defense, Clark Clifford, former Senators and Congressmen, John Culver, Mike Barnes), former federal prosecutors, Larry Wechsler, Raymond Banoun and Larry Barcella, Former State Department Official, William Rogers, former White House aide, Ed Rogers and James Lake, former Federal Reserve Attorneys, Barldwin Tuttle, Jerry Hawke and Michael Bradfield. With that kind of ammunition you can certainly get your share of mileage.

Many people consider BCCI the greatest business scandal in history. Years later, lawsuits by the bank’s liquidators against the accounting firm of Price Waterhouse continue. Price Waterhouse is being sued for $3.5 billion and Ernst and Young for $1.6 billion. The complaints allege that they are partially responsible for losses by thousands of depositors. Even the Bank of England, which was the regulator for BCCI British-based operations, has been hit with suits totaling $898 million.

We can do no more justice than print an excerpt from the report issued to the Committee on Foreign Relations of the United States Senate by Senators John Kerry and Senator Hank Brown, in December of 1992. We are paraphrasing the report and to some degree changing its order:

BCCI's unique criminal structure -- an elaborate corporate spider-web with BCCI's founder, Agha Hasan Abedi and his assistant, Swaleh Naqvi, in the middle -- was an essential component of its spectacular growth, and a guarantee of its eventual collapse. The structure was conceived by Abedi and managed by Naqvi for the specific purpose of evading regulation or control by governments. It functioned to frustrate the full understanding of BCCI's operations by anyone.

Unlike any ordinary bank, BCCI was from its earliest days made up of multiplying layers of entities, related to one another through an impenetrable series of holding companies, affiliates, subsidiaries, banks-within-banks, insider dealings and nominee relationships. By fracturing corporate structure, record keeping, regulatory review, and audits, the complex BCCI family of entities created by Abedi was able to evade ordinary legal restrictions on the movement of capital and goods as a matter of daily practice and routine. In creating BCCI as a vehicle fundamentally free of government control, Abedi developed in BCCI an ideal mechanism for facilitating illicit activity by others, including such activity by officials of many of the governments whose laws BCCI was breaking.

BCCI's criminality included fraud by BCCI and BCCI customers involving billions of dollars; money laundering in Europe, Africa, Asia, and the Americas; BCCI's bribery of officials in most of those locations; support of terrorism, arms trafficking, and the sale of nuclear technologies; management of prostitution; the commission and facilitation of income tax evasion, smuggling, and illegal immigration; illicit purchases of banks and real estate; and a panoply of financial crimes limited only by the imagination of its officers and customers.

Among BCCI's principal mechanisms for committing crimes were its use of shell corporations and bank confidentiality and secrecy havens; layering of its corporate structure; its use of front-men and nominees, guarantees and buy-back arrangements; back-to-back financial documentation among BCCI controlled entities, kick-backs and bribes, the intimidation of witnesses, and the retention of well-placed insiders to discourage governmental action.

“BCCI systematically relied on relationships with, and as necessary, payments to, prominent political figures in most of the 73 countries in which BCCI operated. BCCI records and testimony from former BCCI officials together document BCCI's systematic securing of Central Bank deposits of Third World countries; its provision of favors to political figures; and its reliance on those figures to provide BCCI itself with favors in times of need.

These relationships were systematically turned to BCCI's use to generate cash needed to prop up its books. BCCI would obtain an important figure's agreement to give BCCI deposits from a country's Central Bank, exclusive handling of a country's use of U.S. commodity credits, preferential treatment on the processing of money coming in and out of the country where monetary controls were in place, the right to own a bank, secretly if necessary, in countries where foreign banks were not legal, or other questionable means of securing assets or profits. In return, BCCI would pay bribes to the figure, or otherwise give him other things he wanted in a simple quid-pro-quo.

The result was that BCCI had relationships that ranged from the questionable, to the improper, to the fully corrupt with officials from countries all over the world, including Argentina, Bangladesh, Botswana, Brazil, Cameroon, China, Colombia, the Congo, Ghana, Guatemala, the Ivory Coast, India, Jamaica, Kuwait, Lebanon, Mauritius, Morocco, Nigeria, Pakistan, Panama, Peru, Saudi Arabia, Senegal, Sri Lanka, Sudan, Suriname, Tunisia, the United Arab Emirates, the United States, Zambia, and Zimbabwe.

In 1977, BCCI developed a plan to infiltrate the U.S. market through secretly purchasing U.S. banks while opening branch offices of BCCI throughout the U.S., and eventually merging the institutions. BCCI had significant difficulties implementing this strategy due to regulatory barriers in the United States designed to insure accountability. Despite these barriers, which delayed BCCI's entry, BCCI was ultimately successful in acquiring four banks, operating in seven states and the District of Colombia, with no jurisdiction successfully preventing BCCI from infiltrating it.

The techniques used by BCCI in the United States had been previously perfected by BCCI, and were used in BCCI's acquisitions of banks in a number of Third World countries and in Europe. These included purchasing banks through nominees, and arranging to have its activities shielded by prestigious lawyers, accountants, and public relations firms on the one hand, and politically-well connected agents on the other. These techniques were essential to BCCI's success in the United States, because without them, BCCI would have been stopped by regulators from gaining an interest in any U.S. bank. As it was, regulatory suspicion towards BCCI required the bank to deceive regulators in collusion with nominees including the heads of state of several foreign emirates, key political and intelligence figures from the Middle East, and entities controlled by the most important bank and banker in the Middle East.

Equally important to BCCI's successful secret acquisitions of U.S. banks in the face of regulatory suspicion was its aggressive use of a series of prominent Americans, beginning with Bert Lance, and continuing with former Defense Secretary Clark Clifford, former U.S. Senator Stuart Symington, well-connected former federal bank regulators, and former and current local, state and federal legislators. Wittingly or not, these individuals provided essential assistance to BCCI through lending their names and their reputations to BCCI at critical moments. Thus, it was not merely BCCI's deceptions that permitted it to infiltrate the United States and its banking system. Also essential were BCCI's use of political influence peddling and the revolving door in Washington.

Federal prosecutors in Tampa handling the 1988 drug money laundering indictment of BCCI failed to recognize the importance of information they received concerning BCCI's other crimes, including its apparent secret ownership of First American. As a result, they failed adequately to investigate these allegations themselves, or to refer this portion of the case to the FBI and other agencies at the Justice Department who could have properly investigated the additional information.

The Justice Department, along with the U.S. Customs Service and Treasury Departments, failed to provide adequate support and assistance to investigators and prosecutors working on the case against BCCI in 1988 and 1989, contributing to conditions that ultimately caused the chief undercover agent who handled the sting against BCCI to quit Customs entirely.

The January 1990 plea agreement between BCCI and the U.S. Attorney in Tampa kept BCCI alive, and had the effect of discouraging BCCI's officials from telling the U.S. what they knew about BCCI's larger criminality, including its ownership of First American and other U.S. banks.

The Justice Department essentially stopped investigating BCCI following the plea agreement, until press accounts, Federal Reserve action, and the New York District Attorney's investigation in New York forced them into action in mid-1991. Justice Department personnel in Washington lobbied state regulators to keep BCCI open after the January 1990 plea agreement, following lobbying of them by former Justice Department personnel now representing BCCI.

Relations between main Justice in Washington and the U.S. Attorney for Miami, Dexter Lehtinen, broke down on BCCI-related prosecutions, and key actions on BCCI-related cases in Miami were, as a result, delayed for months during 1991. Justice Department personnel in Washington, Miami, and Tampa actively obstructed and impeded Congressional attempts to investigate BCCI in 1990, and this practice continued to some extent until William P. Barr became Attorney General in late October, 1991.

Justice Department personnel in Washington, Miami and Tampa obstructed and impeded attempts by New York District Attorney Robert Morgenthau to obtain critical information concerning BCCI in 1989, 1990, and 1991, and in one case, a federal prosecutor lied to Morgenthau's office concerning the existence of such material. Important failures of cooperation continued to take place until William P. Barr became Attorney General in late October, 1991. Cooperation by the Justice Department with the Federal Reserve was very limited until after BCCI's global closure on July 5, 1991. Some public statements by the Justice Department concerning its handling of matters pertaining to BCCI were more cleverly crafted than true.

When Hill and Knowlton accepted BCCI's account in October, 1988, its partners knew of BCCI's reputation as a "sleazy" bank, but took the account anyway. In 1988 and 1989, Hill and Knowlton assisted BCCI with an aggressive public relations campaign designed to demonstrate that BCCI was not a criminal enterprise, and to put the best face possible on the Tampa drug money laundering indictments. In so doing, it disseminated materials unjustifiably and unfairly discrediting persons and publications that were telling the truth about BCCI's criminality.

Important information provided by Hill and Knowlton to Capitol Hill and provided by First American to regulators concerning the relationship between BCCI and First American in April, 1990 was false. The misleading material represented the position of BCCI, First American, Clifford and Altman concerning the relationship, and was contrary to the truth known by BCCI, Clifford and Altman.

Hill and Knowlton's representation of BCCI was within the norms and standards of the public relations industry, but raises larger questions as to the relationship of those norms and standards to the public interest.

BCCI's decision to divide its operations between two auditors, neither of who had the right to audit all BCCI operations, was a significant mechanism by which BCCI was able to hide its frauds during its early years. For more than a decade, neither of BCCI's auditors objected to this practice.

BCCI provided loans and financial benefits to some of its auditors, whose acceptance of these benefits creates an appearance of impropriety, based on the possibility that such benefits could in theory affect the independent judgment of the auditors involved. These benefits included loans to two Price Waterhouse partnerships in the Caribbean. In addition, there are serious questions concerning the acceptance of payments and possibly housing from BCCI or its affiliates by Price Waterhouse partners in the Grand Caymans, and possible acceptance of sexual favors provided by BCCI officials to certain persons affiliated with the firm.

Regardless of BCCI's attempts to hide its frauds from its outside auditors, there were numerous warning bells visible to the auditors from the early years of the bank's activities, and BCCI's auditors could have and should have done more to respond to them.

By the end of 1987, given Price Waterhouse (UK)'s knowledge about the inadequacies of BCCI's records, it had ample reason to recognize that there could be no adequate basis for certifying that it had examined BCCI's books and records and that its picture of those records were indeed a "true and fair view" of BCCI's financial state of affairs.

The certifications by BCCI's auditors that its picture of BCCI's books were "true and fair" from December 31, 1987 forward, had the consequence of assisting BCCI in misleading depositors, regulators, investigators, and other financial institutions as to BCCI's true financial condition.

Prior to 1990, Price Waterhouse (UK) knew of gross irregularities in BCCI's handling of loans to CCAH/First American and was told of violations of U.S. banking laws by BCCI and its borrowers in connection with CCAH/First American, and failed to advise the partners of its U.S. affiliate or any U.S. regulator.

There is no evidence that Price Waterhouse (UK) has to this day notified Price Waterhouse (US) of the extent of the problems it found at BCCI, or of BCCI's secret ownership of CCAH/First American. Given the lack of information provided Price Waterhouse (US) by its United Kingdom affiliate, the U.S. firm performed its auditing of BCCI's U.S. branches in a manner that was professional and diligent, albeit unilluminating concerning BCCI's true activities in the United States.

Price Waterhouse's certification of BCCI's books and records in April, 1990 was explicitly conditioned by Price Waterhouse (UK) on the proposition that Abu Dhabi would bail BCCI out of its financial losses, and that the Bank of England, Abu Dhabi and BCCI would work with the auditors to restructure the bank and avoid its collapse. Price Waterhouse would not have made the certification but for the assurances it received from the Bank of England that its continued certification of BCCI's books was appropriate, and indeed, necessary for the bank's survival.

The April 1990 agreement among Price Waterhouse (UK), Abu Dhabi, BCCI, and the Bank of England described above, resulted in Price Waterhouse (UK) certifying the financial picture presented in its audit of BCCI as "true and fair," with a single footnote material to the huge losses still to be dealt with, failed adequately to describe their serious nature. As a consequence, the certification was materially misleading to anyone who relied on it ignorant of the facts then mutually known to BCCI, Abu Dhabi, Price Waterhouse and the Bank of England.

The decision by Abu Dhabi, Price Waterhouse (UK), BCCI and the Bank of England to reorganize BCCI over the duration of 1990 and 1991, rather than to advise the public of what they knew, caused substantial injury to innocent depositors and customers of BCCI who continued to do business with an institution which each of the above parties knew had engaged in fraud.

From at least April, 1990 through November, 1990, the Government of Abu Dhabi had knowledge of BCCI's criminality and frauds which it apparently withheld from BCCI's outside auditors, contributing to the delay in the ultimate closure of the bank, and causing further injury to the bank's innocent depositors and customers.

While to some degree we believe that we have somewhat pushed then envelope in quoting the Foreign Relations Report on BCCI, we wanted to make it crystal clear that this was no minor happening and without tremendous assistance from BCCI’s credible accounting firm, this scandal would have certainly be nipped before it became a global problem. While it is certainly true that Price Waterhouse was not the only culprit in this cesspool, they knew what was happening and when it happened and did not lift a finger to stop it.

Moreover, it is our belief that had the BCCI scandal transpired ten years later; it would have brought down the world’s financial systems. In the early 1980s, derivatives had not yet appeared on the scene and electronic transmission had not yet matured. The subversive power of today’s financial mechanisms would have triggered a decades-long global depression. Yet, the accounting firm’s that were auditing BCCI’s books to our knowledge, never brought any of those activities to the attention of regulators. They continued to allow the Bank to function as a going business long after they should have been closed and sent to pasture. They turned a blind eye when the bank to engaged in money laundering to such a large degree that they were cleansing funds for most major criminal organizations on the planet.

The same forces that would have turned a BCCI into the trigger for a world financial meltdown would make Credit Lyonnais’ debacle particularly dangerous.

Credit Lyonnais, Vive La France’

Credit Lyonnais was and is a chattel of the French Government, the victim of the biggest measured internal bank fraud in history. Today, over a decade after the French public decided that the bank’s mismanagement had gone on far too long, most of the pieces to the puzzle are still missing and investigations are still continuing.

For decades, the officials of Credit Lyonnais were literally “the gang that couldn’t shoot straight.” ([15]) Everything they ever did was wide of the mark, and it took the resources of the French Treasury to bail out the sinking ship. Bad loans on the bank’s books totaled a staggering $35 billion ([16]) when originally reported, but recently discovered indicate that even this number is far too conservative.

An in-house newsletter, published by the Consortium de Realization (or “CDR”), said: “investigations into Credit Lyonnais and its subsidiaries had shown how the bank’s senior management had allowed the fraud both in France and abroad. The further CDR’s team goes…the clearer it becomes: There was organized financial fraud until 1993…. The fraud was concentrated in seven subsidiaries…, which acted as the unbridled horsemen of this financial apocalypse. The real figures involved are substantially greater than those recently quoted, already huge.”

In March 1997, CDR’s Chairman, Michel Rouger, was quoted by a French legislator as telling a parliamentary commission that about five billion francs had been embezzled by bank executives and businessmen with links to the bank.” ([17]).

Credit Lyonnais’ banking practices during that period, can be illustrated by describing the bank’s relationship with an Italian thug by the name of Giancarlo Paretti, whose rap sheet was almost unlimited. The Bank, whose senior officers had been bribed by Paretti, knowing his criminal background, extended over $2 billion him, enabling him to acquire and run companies. His primary acquisition was MGM.

The crimes of which he was convicted included:

Fraud in connection with the bankruptcy of IL Dirario newspapers, sentenced to: 3½ years in prison. Under appeal. March 1990.

Fraud in connection with the Siracusa soccer team.1975

Fraud in connection with a Hotel company in Sicily. 1984

Forgery in connection with savings bonds in Sicily. 1984

Bankruptcy of a newspaper in Paris named Le Matin, 1986

Judgment, Credit Lyonnais, June 1997. $1,466 billion, MGM

Convicted perjury and evidence tampering, Delaware, 1996

Fugitive from justice, flight to avoid imprisonment, 1996

Parretti’ s partner in his dealings with the bank was Florio Fiorini, currently serving time at Champ Dollon prison in Geneva. According to Fortune Magazine (7/8/1996), “[Fiorini] has figured in every major financial and political scandal in Italy in the past two decades—and that’s saying a lot. He learned political bribery and global money laundering at the knees of the notorious Vatican-connected Italian bankers Michele Sindona and Roberto Calvi, whose violent deaths in the wake of banking scandals in the 1970s and 1980s remain unsolved.

His mentor was Bettino Craxi, the former Prime Minister of Italy and Socialist Party chairman; and Gianni DeMichelis, the former Italian Foreign Minister, who spent his nights in discotheques. According to Fiorini, Craxi and DeMaichelis took bribes from Paretti and Fiorini to induce the French government and its bank (Credit Lyonnais) to back the Italians’ purchase of MGM.

Parretti’ s background was no secret:

“According to Jerry Brodsky (head of due diligence for Drexel Burnham Lambert) Giancarlo Paretti asked Drexel in the late 1980s to help raise the money he needed to buy MGM. When Kroll’s (private detective agency) agents reported that Parretti had been convicted of fraud in Italy, Brodsky nixed the deal. Instead Credit Lyonnais loaned Parretti the money—something it’s since regretted, since much of the money vanished, along with Parretti himself” ([18]) ([19])

In spite of Credit Lyonnais, being informed of Parretti’s background and associates on numerous occasions, the Bank continued extending him credit, which exceeded $2 billion when it had had enough. The reason Paretti had been able to continue using the Bank’s money for his schemes was simply that he had bribed the senior Bank officers.

Georges Vigon – head of European lending for Credit Lyonnais until his ”departure.”

Jacques Griffault – head Credit Lyonnais, Milan branch.

Jean-Jacques Brutschi- head of Credit Lyonnais, Holland.

In Geneva, a judge eventually charged Credit Lyonnais Chief Executive Jean-Yves Haberer ([20]) and General Manager Francois Gill with fraudulent complicity. Haberer credentials were superb. He went to all the right schools, graduated at the top of his class, knew all of the right people, and did all of the right things. There was only one thing wrong; he just could not legitimately run a bank or probably anything else for that matter:

“An arrogant man, Haberer held himself aloof from everyone at the bank except his immediate colleagues, an inclination symbolized by his installation of a “floating floor” of felt, rubber and cork under his lavishly appointed office to insulate it from the noise of the street, the Metro, and, his detractors said, the real world. They started calling him “le megalo”—the megalomaniac.” ([21])

Within five months of the time Paretti took over MGM, with the help of Credit Lyonnais’ loans, it was bleeding at the rate of $1 million per day and was a bankruptcy candidate within five months. The Bank ultimately took over MGM and was forced to sell it at a staggering loss.

Now, too much of this kind of thing can give banking a bad name. These were trusted employees splitting the loot. If you can’t trust trusted employees, who can you trust? Credit Lyonnais, during a substantial period of time, was not just out of ratio; it was bankrupt, but doing business. Had the Government of France bet the country on a successful bailout, a true international debacle would have ensued. The French People will be paying a staggering price for many years to come. The only saving grace was that the Credit Lyonnais scandal occurred in the 80s rather than the late 90s.

And yet, in the midst of attempting to put a badly mangled house back in order, Credit Lyonnais again went on the offensive and found a way turn victory in defeat. Few felt that the bank’s management had anything but a death wish when, in Asia, they started lending everybody and anybody that they could find, knowing that the situation was perilous. Among a portfolio of bad investments, one item stands out, Garuda Airlines. Credit Lyonnais was there with the fastest check in the west and now, payments have stopped and the bank is “sucking wind.” “While the (Asian) loan problems are not expected to severely damage any of the banks, one bank could have serious problems: Credit Lyonnais, a long-troubled French financial institution.” ([22]) This is an ill-stared institution and the French would probably be better off pulling the plug and putting the bank out of its misery.

In the meantime, looking for a patsy, recently, Credit Lyonnais has filed an action against the Dutch subsidiary of KPMG looking for about $2 billion. The suit indicates that when the bank (Credit Lyonnais Bank Nederland) lent money to MGM, KPMG had already discovered a large-scale fraud in 1989 but provisions for loans in 1989, ’90 and ’91 were not only adequate but no addition investigation was necessary. In the action in question, the Dutch apparently feel so strongly that they got the shaft from KPMG that they are also holding 160 KPMG employees responsible for the action as well as the KPMG parent. Major league!

Now the bank is facing serious problems in the United States. A French whistleblower informed various parties that the transaction consummated in the early 1990s between the California Commissioner of Insurance acting as the liquidator of Executive Life and Credit Lyonnais was fraudulent. Executive Life was the largest American Insurer to go out of business to that time. It was taken down because of a combination of a proliferation of junk bonds in its portfolio and a bad market for debt instruments in general. The California Department of Insurance put the company and the portfolio up for joint bid and the winning bid was ultimately made by a consortium consisting of a group put together by Credit Lyonnais and a handful of ex-Drexel Burnham executives.

This wasn’t even a fair battle, the insurance commission was advised that the transaction put forth by this group was inferior to others that the background of the people was questionable to say the least, but he made the transaction anyway much to his long-term regret. Among the nuances of the transaction was the that neither the government nor bank; Credit Lyonnais could own an American Insurance Company under the existing Glass Steagall prohibitions. Furthermore, under California law, a foreign government could not own an California domiciled American insurance company. The California Department of Insurance and the Executive Life policy holders were still smarting over the mistakes of almost a decade ago committed by an Insurance Commissioner who was indirectly running for Governor of California the entire time he held that office.

He seemed more interested in making boisterous statements of how well he was doing than actually doing anything of consequence that would help anybody. When the whistleblower blew his whistle in California it seemed like an opportunity for the State to undo that entire transaction because of its illegality and they have filed lawsuits against the bank and just about everyone else that had anything to do with the matter. In the meantime, the Commissioner has called out just about everyone but the National Guard in an attempt to investigate the matter. The Federal Bureau of Investigation, The Justice Department, and Department of the Treasury are all conducting investigations into what will soon turn into a very serious matter. We believe that this is the second coming of Daiwa Bank who folded its tent in the United States after actions were filed against it for, in effect, lying to the Federal Reserve.

This case make may that one pale in comparison. It appears that Credit Lyonnais lied about their position from the very beginning to take advantage of something that they knew was illegal. Daiwa got themselves into a fix by accident and just did not know how to legally extract themselves from the problem. Two very different matters. The French Government is so concerned about the matter that they. The overall inquiry of what has occurred at the French Bank has been called the largest investigation of its kind ever conducted in France.

“…Even a former governor of France’s central bank has been questioned. Investigators have discussed with other top officials whether their actions or inactions might have fostered Credit Lyonnais’ frauds and losses. Prominent financiers, well-known in global banking circles, face possible imprisonment, financial calamity and public disgrace.” ([23])

Interestingly enough, Credit Lyonnais as already had been hit with a substantial fine in the MGM matter. In that settlement, the bank agreed to refrain from committing any felonies in the United States. If they violate that settlement, the penalties in that case skyrocket almost 400%. It would seem that there is no question that this has already occurred.

In today’s banking system, the presence of a BCCI along with a savings and loan scandal and/or a long-lead time disaster like that at Credit Lyonnais, could bankrupt the healthiest sectors of the world’s economies. The same court in Paris is hearing the claim against KPMG that years earlier fined Paretti one million francs for fraud in the same deal. When he didn’t show up to pay the fine, he was given an additional gift of four years in a French prison. With this kind of history, KPMG probably better start taking its checkbook out of the drawer and checking with its insurance carrier.

The Savings And Loan Crisis, One of The Most Costly Series of Frauds In American History.

All I Want Is A Couple Of Bucks Under The Table And You Can Have Your Jumbo Mortgage!

Sounds good in principal, but is it that good in practice? At the same time that the Savings and Loan crisis occurred in the United States, the banking system became simultaneously, totally insolvent. The two had roots in some of the same general problems. Real Estate values collapsed on loans made by both banks as well as by Savings and Loans. Believe it or not, values depreciated across the board and both industries had a pro rata share of disasters. Luckily for the banks, they were more diversified, and thus were cushioned by other loans. However, unluckily for the banks, their South American loans became worthless at the same time. If one was doing cost accounting on the simultaneous disasters and concentrated on both the top ten U.S. Banks and the top ten thrifts, it is my belief that they were all equally bankrupt. The thrifts from bad domestic loans and poor management, the banks from a combination of domestic and foreign loans.

In just 10 years, from 1980 to 1990, of the 13,500 banks in the United States, 1,500 failed. A survey conducted by Heidrick and Struggles Inc., an executive recruiter, and the American Banker, concluded that almost 50% of the bank officers currently employed were incapable of dealing with the problems that would exist in a deregulated environment.

New York had not had a bank failure since the 1930s, and when Greenwich Savings Bank collapsed in 1981, it caught everyone by surprise. After all, hadn’t The Greenwich been in business for almost 150 years, with assets in excess of $2 billion? Those that formed the line the day after also formed the nucleus of the first run on a bank in the United States in over 50 years. Nobody went to jail, there weren’t any really horrendous loans and with the exception of the FDIC, almost everyone was made whole. It was just a case of a bad economy and a Federal Government that either had not come to grips with the infrastructure problems that were being created or were stultified by their own inexperience.

“So what’s the big deal? I mean, for the most part here we are talking about serious fraud. We really aren’t interested in a bank that just went, there must be more to the story.”

Well, you’re right, but sometimes things just kinda happen, even when people really mean well, but just are kinda dumb when it comes to economics. You see, Jimmy Carter, a well- meaning guy, never found out that Savings Banks loan money for up to 30 years, while they borrow from customers for less than 5 years. If short-term rates ever became higher than long-term receipts for any protracted period of time, literally the entire industry would fail. The rates did and the industry did. It was only the magic of accounting and a government bailout of immense proportions that preserved anything at all. The banks, which were restricted from lending long, were able to prevent collapse despite holding as many disastrous real estate loans as the S & L’s, and struggling with defaulting Latin American debt. With the entire S & L industry stultified, banks were able to step into the breach with high interest loans and provide a perceived safe harbor for investor’s funds that had fled their competitors. The saving grace may well have been that the run on the thrifts caused money to pour into the drought filled banking industry.

The prime rate hit 21 percent in 1981, causing investors to withdraw their money from the Savings and Loans, which could not pay over 5.5 percent. The majority of the funds were deposited into money market funds and the banks, where six month CD’s were yielding 15 percent. Because failures were occurring faster than they could be absorbed by the system, the FSLIC changed the adequacy rules, allowing some breathing room for the regulators, while staving off total panic among depositors. The failure of the press to totally grasp the gravity of these events was the economy’s ultimate salvation. Having bought time to grab a breath or two, a few S & L’s were shorn up, merged or liquidated, and calm returned, for a time, to the system.

The Fed feeling that inflation had been brought under control turned the spigot on again in earnest. The regulations governing the S & L’s borrowing policies were loosened, and they borrowed to the hilt. Historically, the savings and loans were more a local enterprise, as opposed to a money center banking institution; they became overzealous lenders in an attempt to make back their losses of the previous 5 years. Loans were made everywhere and anywhere, in all areas allowed by the regulators, and frequently in areas that were not. Money was thrown at developers and cities like Houston, Dallas, Denver and Phoenix became monuments to the god of vacancy. The Savings and Loans had done it to themselves all over again.

The debacle of the Thrifts cost the taxpayers almost $100 billion dollars.

We have listed a few and they’re cost to taxpayers and disposition of principals in 1993:

Lincoln $2.6 billion Charles Keating, serving 10 Year

Sentence

Vernon $1.0 billion Don Dixon, 10-year sentence

CenTrust $1.6 billion not determined, Up to 10 years

Columbia $2.0 billion facing charges and $40 million in

Damages

Silverado $1.0 billion Director Neil Bush agreed to pay $50 million to settle charges.

What Hath Michael Milken Wrought?

Within three years, the industry literally collapsed twice, for two very different reasons, one the drought of funding and the other the riches of funding. Loopholes opened to provide survival escape routes in bad times were left open and created the excesses of the good times. The Savings and Loans have easy access to people with bankrolls that could acquire the weaker businesses of the very early 80s. The institutions were then allowed to merge and acquire beyond the scope of their charters. Junk bond funding provided much of the fuel for the conflagration, which was ignited by inept management. How soon we forget!

The Big Eight, Err Six, I Mean Five And The Savings And Loan Industry

What Do You Think I Am? A Squealer?

There were many accounting firms that got into trouble over their audits of Savings and Loans. Various explanations have been put forward for the fact that no member of the Big Six came away unscathed. In a general sense, there were a great number of inquiries into what could have caused everyone to have gone wrong simultaneously. Their report, in part, stated:

“The AICPA Audit and Accounting Guide for Savings and Loan Associations was last substantially revised in 1979. It contains little discussion of the risks associated with the land and ADC loans; ([24]) the effect of increases in restructured loans on collectability; coordinating audit work with the results of regulatory examinations; the importance of disclosing regulatory actions and violations to depositors, shareholders, regulators and other users of audit reports.”

Although the then Big Six now proclaim their innocence in the S & L crisis, (‘It wasn’t our job to find fraud,’ they insist), a General Accounting Office study of eleven bankrupt thrifts revealed that the audits for six of the S & L’s failed “to meet professional standards.’ The firms involved included Arthur Young, Deloitte Haskins & Sells and Ernst & Whinney. ([25])

Moreover, the cause was more one of unhealthy relationships between the S & L’s and their auditors, greed by accounting firms in bringing in business at any cost and, more important was the fact that the accounting firms just weren’t up to recognizing the sophistication of the new financial instruments being purchased by the Savings Banks. The latter problem bodes for firm requirements in accounting and for increased continuing education, within particular areas of audit. Additionally, if teams of industry specialized (dedicated) auditors had to be certified in order to conduct the certification process, the excuses given for the total incompetence of the Big Six in their S & L audit would have fallen under their own weight.

In many cases, management of troubled S & L’s contended that problem loans were collectible or, in cases of default, that collateral underlying the loans was sufficient to cover the outstanding loan balance. Standards require auditors to obtain independent corroboration that key management assertions are true – often a time-consuming, but necessary audit function. However, the CPA’s in our review did not always perform this function and, instead, often relied on management’s unsubstantiated oral assertions that problem loans were collectible.

“In two cases in our review, CPA’s did not point out in their audit reports that their S & L clients had materially misstated their income. In one of those cases, the S & L client had lost four times as much money as it had reported in its financial statements for that year.”

“In some cases, CPA’s did not report serious regulatory violations, such as excessive loans to single borrowers and formal cease-and-desist or similar orders by regulators. Thus, report users were unaware of those operating risks and the corresponding potential regulatory actions, all of which may have impacted the S & L’s operation.” ([26])

The Carter Years

During the Carter years, interest rates, as we all know, went through the roof. Savings and Loans had numerous restrictions on lending and borrowing (raising money in one form or another) that did not encumber the banks. Banks for example, would historically tie their loans to the "prime rate,” Libor or any number of other potential scenarios that could be thought up to work profitably on their behalf. Thus, the bank always had a profit locked in. The loan would carry an interest rate of, let us say prime plus two or whatever else. Whenever the prime rate changed the customer’s interest rate either rose of fell.

The Savings & Loans were not allowed this escape valve and they were constantly in a position of lending long and borrowing short. Thus, as rates rose, a number of very unpleasant things would happen to the Savings & Loan industry. In addition, Savings Bank's main source of funds was what we call certificates of deposit or CDs. These instruments were usually issued for a year at a time with a fixed rate of interest. On the other hand, they could be issued for another year or two if both the issuer and the purchaser agreed.

Therefore, by picking a starting date where all of our numbers are constant, the Savings Bank would have a portfolio consisting of mortgages that they had issued to people purchasing homes or business property and certificates of deposit that their customers had purchased from the institution. There is no question that there are other items, which make up the balance sheet mix but in comparison to these two, they would be insignificant. Undoubtedly, the S & L had equity; it probably had preferred and certainly had assets such as a home office, furniture and the like. It would also have money on deposit with the FSLIC or State insurance fund. These numbers when looking at the total health or sickness of an institution in this industry were just not consequential.

Having dispensed with that piece of housecleaning, let us make the assumption that the portfolio of our institution, Ajax Savings Bank is $100 million consisting of 2-year average maturity certificates of deposit paying their owners 5% interest per year. On the asset side of the ledger, we would see that Ajax had $100 million of mortgages receivable bringing in approximately 7 1/2% interest and averaging 25 years remaining on their maturity. By simple arithmetic we can easily see that under the circumstances outlined above, Ajax seems to be in good shape with income exceeding payments by $2.5 million per year before salaries, mortgage defaults, rent, professional fees and other sundry charges. Most probably, if Ajax is well managed, it will return a tidy profit to shareholders and principals.

Now, lets kick interest rates up a notch as the Federal Reserve did under the Carter Administration. With Burt Lance, a corrupt banker guiding him, America's ever faithful president from the state of George thought that more was better and allowed rates to climb into the stratosphere. Banks were charging 22% and people were happy to pay it and you could get 17 1/2 percent interest on your CD's. These rates eventually broke the real-estate market’s back. New buyers couldn't afford to buy anything and sellers unless they had transferable mortgages, were unable to provide financing for their properties. Building came to a screeching halt.

Hypothetically, the new Savings Bank picture looked as follows: The bank was still receiving 7 1/2 percent on the mortgages that had not run off. Assuming that no new mortgages were written, which was just about the case, and the average loan had been for 25 years, 2/25 of the mortgages no longer existed or about 8 percent. Eight percent subtracted from $100million gave the Savings and Loan about $92 million in mortgages and for the moment let us assume that everything else was equal, which it wasn't, $92 million in Certificates of Deposit. The Certificates of Deposit would have been re-written by this time and let's make the assumption that the rate was now 12 1/2 percent. (Which appears to be conservative under the circumstances) Thus, the Savings Bank under this scenario was now losing about $5 million per year and this was before any expenses. At this point in time were are talking about, $5 million in net capital for a Savings Bank was not a bad number and as you can see, the entire equity would have eroded within approximately eight months.

However, the story was far worse than that. People weren't sure what was going to happen next. They had completely lost confidence in the Carter Administration and if it made sense to squirrel their money under the bed that is what they would have done. The Federal Savings and Loan Insurance Corporation (FSLIC) was totally out of money as 500 institutions had already collapsed with thousands more on the brink. Banks on the other hand appeared much safer, the government seemed to be willing to throw money at them in order to restore confidence and keep them solvent, and the banks were not bogged down with the awful real-estate portfolios that were sinking the Savings Banks.

Actually, the banks were in much worse shape ([27]), in spite of having more diversified portfolios. The banks saw an opportunity to make quick money in Latin American, invested almost everything there, and the countries tanked. In order to prevent financial chaos, the Treasury came up with all manner of new rules, which made the worthless collateral that the banks were holding appear to have value, at least from a regulatory point of view. The American Government stiff-armed both the International Monetary Fund and the World Bank to throw dollars at the problems in Latin American and ultimately the countries were able to come back. Lastly, the government mandated that the usurious interest charged by credit card companies owned by the banks was somehow totally legal.

This form of debt floated with the prime rate and if the banks decided to make more money all that they had to do was widen the differential between lending and borrowing. The same option was available on Bank Savings Accounts, which normally paid interest based on either the prime rate, the discount rate or Libor, whatever worked the best for those institutions. Thus, while both the Saving and Loans and the banks were in equally precarious positions, the U. S. Government having only enough credit U.S. Government to save one or the other, naturally chose to save the banks.

The Reagan Years

An ex-actor named Ronald Reagan blew Carter out of the White House. Reagan concocted all kinds of new economic theories that sounded good but that nobody understood and that was the way it was meant to be. They did know that anything was better than the peanut salesman from Georgia and his band of crackers. Reagan espoused some unknown philosophy he referred to as deregulation. It was intended to let everyone do whatever they wanted. When we went to school, we called it anarchy and we were told that these kinds of people were murderers and even worse. By calling it deregulation, none of the college professors were able to determine what he meant and many said that it must be good.

However, it was good for some and very bad for others. Let us take a look at the differences between three very different industries; Banking, Stock Brokerage and Savings and Loans. We are only going to analyze them from one point of view and that is what effect deregulation would have on each of them. Let's take a look at the Savings Bank first. The average head of a Savings Bank knew every piece of property within his lending area. He had probably grown up in the neighborhood and inherited his position from his father. He or other people at the S & L knew the borrowers and what kind of people they were and what kind of jobs they had. They also knew what the replacement cost was on the property that they held as collateral and they knew what the percentage of equity they had.

All in all, they were very knowledgeable lenders and as long as anything didn't go too far askew, they would be in good shape. On the other hand, they knew nothing about the outside world, their employees were minimum wage people that lacked any skills whatsoever. They could be trained to perform reasonably in the one-dimensional job they had but, asked to split the atom or find their way downtown, they would be equally lost with either scenario.

These were the guys on the firing line when things did go askew and they were still there when the actor came up with his new plan to save the world. Deregulation was the Savings and Loan industry's poison pill. Suddenly, they could get involved in other securities, buy buildings instead of only lending on them, purchase corporate bonds and even take over their competitors. The only thing wrong with this is that they all tried at once to turn an industry that had not ever made a change in philosophy into one that didn't know which street to go barking up next. There was also this guy in New York at that big fancy brokerage firm called Drexel Burnham. You know, Members of the New York Stock Exchange, these guys had a fellow there that specialized in helping the Savings Banks get higher interest rates with things called junk bonds. Although they didn't sound very nice, he assured everyone that these bonds would perform and by buying these instead of putting on mortgages you could substantially improve your overall yield. These junk bonds came with things called kickers as well. They also had warrants, rights, and convertible features. They even came with things that were hard to understand called exploding equities.

Those young men from Wall Street would come to call in their pin striped suits and they would sell the savings bank people things called repo's and then they wanted them to buy reverse-repo's which seemed to be the opposite of the repo's. No one understood either so it didn't matter a lot but it appeared to be good and this became when of the best reasons for thrift failure the we are aware of. Some of these fellows explained to the heads of the Savings Banks that by lending the brokerage firms their hard earned collateral, they would become rich. They would give the brokers their collateral and get back something less. Usually the broker used the difference to support and affluent life-style. This allowed the broker to con even more savings & loan people because they saw the fancy cars and the planes and the beautiful women and homes and they wanted into the action as well. If by giving the broker some of their collateral it would get them the better things in life, they wanted in. What they got for their trouble, usually was a Chapter II filling, they weren't it was Chapter VII. They didn't seem to want to understand the highly difficult concept that there is really never any free lunch.

This was, when all was said and done, like taking candy from a baby. Not one of these schemes was destined to work for the Saving & Loans although the brokers made a pretty penny in the process. It was just a matter of highly educated people in pin stripped suits spouting a lot of big words doing to the S & L's what the traveling medicine men did to the same townspeople a hundred years before. The only difference was that most of the townspeople survived the medicine and were out only a couple farthings. The pinstripes left the S & Ls and buried and their guy in charge not only lost everything but stood a good chance of going to jail for among other things, criminal stupidity.

Along with these "tools for idiots" many of the Savings Banks started issuing instruments called "Jumbo CDs.” A Jumbo CD was a CD on steroids that carried a substantially higher rate that the regular issue variety. On the other had, the purchaser had to go for a lot more money and keep the CD on the rolls of the S&L for an extended period of time. These products only made the end come sooner to the institutions that were issuing them. The higher rates on a greater number of instruments made them only that much harder to service.

I think you are beginning to see the point but let me talk for a minute about the banks and the brokerage firms just to make a point. After the 1929 crash, the banks were very much made the fall guys for the fiasco. In spite of the fact that history has proven that they didn't do a lot of the things that they were accused of, there had been a heist in town and someone was going to dang well swing for it. The banks swung. An law called the Glass Steagall Act was passed and in general it prevented the banks from going into business that they owned other than banking, sticking within their territory, lending money and charging interest. Not a lot different than the regulations governing the thrifts.

While the United States Banks were hamstrung, the banks in the rest of the world resembled the Wild West. Regulations if they existed at all were weak and not enforced. After World War II had ended, the global banking systems were in taters and the only place on the globe where there was an appreciable amount of money was the United States. The American banks were not restricted from investing in foreign subsidiaries that had to conform with local laws, which more often than not didn't exist. American Banks somehow or another got into almost every business in the world through their overseas investments and whenever Congress determined that they were pushing the envelope, the banking lobby stepped up to the plate and brought the votes.

The Saving & Loans on the other hand were restricted from making these kinds of investments and was far from organized politically the way the banks were. They had no agenda and were staffed with people who were unaware of what was going on in the next neighborhood; forget about Europe or the Far East. Where money center bank employees came from the Ivy League, Savings and Loans senior executives went to the school of hard knocks and there was not a college graduate in the average institution throughout the 1960s and 70s. Deregulation to this group of locals was like throwing oil on a fire. It would consume them.

The stock brokerage business was similar to the banks. They had more leeway relative to product development and with the help and guidance of the Securities and Exchange Commission they were able to come up with a string of new products to entice investors. Pay on Wall Street in the employee of brokerage houses was even better than it was in the money center banks and the top of the “B” School class gravitated to the Street. Brokerage houses invaded Japan before the banks ever thought of the idea and they were in London soon after World War II had ended. Eventually their nets encompassed the free world and as in the case banks, overseas regulations were slim or non. Brokerage firms were highly qualified to exist in Reagan's deregulated environment. They had been doing it for 40 years. Matching these guys up against the S & Ls was just a game in seeing how long it took to literally clean the community they were in bone dry. Instead of deregulating, Reagan should have enlisted the help of the National Guard when the slaughter became uncontrollable.

Beverly Hills Savings & Loan, A Trustworthy Institution

Beverly Hills Savings and Loan is an institution that made everyone one of the mistakes listed above and probably a number that we haven't even touched on. Their first move was to change from a Federally Chartered S & L to a State Charted institution. Thus, they were able to become even more aggressive with their actions as the California Charter allowed even more leniency than did the Federal Charter. Jumbo Certificates of Deposit was the next important field of endeavor for Dennis Fitzpatrick, Beverly Hills Savings & Loan's (BHSL) chief executive officer. He went to the brokerage community for help and they were more than happy to oblige for a substantial fee.

The program was a success and mid-sized BHSL had grown in the four years from 1980 to 1984 from $290 million in deposits to $2.3 billion. The next order of importance was getting this money out-to-work profitably. The thrift entered into joint venture agreements with contractors that gave them a piece of the equity on the upside by literally giving up the comfort of being a creditor. Thus, they began betting big on the California real estate, which at the time was boiling. It soon turned ice cold.

In the midst of this no-lose program, a California developer noticed how BHSL had grown and bought a large block of the stock and announced that he was starting a proxy fight. Not wanting to share their potential profits with this interloper, BHSL brought in a white knight that was carrying around a lot of baggage. The white knight offered to help up proposed that he would exchange many of his properties for stock in BHSL. The stock would water the shares of the Savings Bank while putting more power in the hands of incumbent management. This temporarily kept the wolf from the door but took a big bite out of what had been a reasonable healthy institution. An independent study of one of the properties that had been assigned to BHSL by the White Knight should have sent a chilling message to the institution but they were forced to believe otherwise.

"With the exception of three buildings, the property has not been painted in some time, the gutters are falling down, the downspouts are off, porches have little or no screens, there is rotten wood, windows are broken, front doors are peeling, the landscaping is almost nonexistent, pavement is broken up, and large areas are not paved at all."

"Very large dogs roam the grounds, residents work on cars on Saturday and Sunday in the parking lots, motorcycles, bikes and neglected wood piles abound in breezeways, on patios, and on walks. Basketball goal sag, the word "pot" was spray-painted in white on the end of a two-story brick building. The laundry room, which was just completed six months ago, was filthy and looked about six years old. The pool area is scraggly; a cover on the pool has two feet of water on it. There is no pool furniture."

"An apartment was filled with sewage, under almost all of the building there is between three to fourteen inches of water, appliances are missing from almost all vacant units, all carpets need to be replaced, all appliances, if they are there, are in bad, if not inoperable condition, and should be replaced. This includes stoves, dishwashers, refrigerators, disposals, and traps.” ([28])

The White Knight had double dealt BHSL. The property discussed above turned out to be one of the better properties in the package that had been exchanged. BHSL in an effort to prop up their failing empire meet with Michael Millikan and his people. They were told to purchase some particular junk bonds that would solve all of their problems. Three hundred million was thrown at the junk bond market and it did not take long before the companies that they had invested in started to collapse like a house of cards.

In spite of new management assuming control, a close look at the books it now made it appear that things were going from bad to worse. In the third quarter of 1984, BHSL reported a $10 million loss as opposed to a profit in the previous period a year ago, but that was only the beginning. The 1984 audit of the company was delayed and a terse announcement made that the company could have suffered a loss of $100 million in the previous year. That was not particularly good news for shareholders in that the total assets of BHSL had only been $35 million at the start of 1984. Thus, anyone that had finished the second grade could swiftly figure out the fact that BHSL was under water by no less than $65 million.

There was no question that this represented a death knell for the company and everyone jumped in to find out what had gone wrong. Part of the report issued by the FSLIC was not kind to the auditors, Touche Ross. It said in part:

"…Touche rendered its written opinion that Beverly Hills Savings & Loan's consolidated financial statements "present fairly the consolidated financial position of Beverly Hills Savings and Loan Association and subsidiaries … in conformity with generally accepted accounting principles applied on a consistent basis.” At the same time Touché rendered these written opinions, it knew or should have known that such opinions were materially false, inaccurate and misleading in that BHSL's consolidated financial statements as of December 31, 1982 and 1983 did not present fairly the consolidated financial position of BHSL and subsidiaries as of those dates…” ([29])

Congress Takes A Look

This wasn't the only thing that Touche Ross did wrong. They had used some magical accounting in BHSL's entry into the construction business. When things didn't go as planned they switched to books around to reflect a deal, much different then the one that had originally had been made in order not to reflect the write-offs that would be necessary under the first arrangement. This Alice & Wonderland booking did not make any friends for Touche Ross in Congress and Mark Stevens in his Book, The Big Six once again shows us an interesting exchange that took place between Nelson Gibbs, a Touche Ross partner and Representative Dingell's subcommittee that was investigating the bizarre happenings at the Savings & Loan. Dingell ate Gibbs' lunch in an exchange.

Dingell: On what grounds could they be accounted for as loans?

Gibbs: Based on the contractual relationship between the parties and the equity in the interest

Dingell: What was the equity at this particular time?

Gibbs: The Amount of the equity?

Dingell: Yes

Gibbs: I don't know.

Dingell: Was there any equity?

Gibbs: I believe there was, yes.

Dingell: You believe or you know?

Gibbs: I believe there was. I don't know the amount.

Dingell: You don't know? You don't know the amount? You believe. Now, when one believes, one believes without knowledge. I believe in the Holy Trinity. I do not understand them. I have never seen them. I do not know what they look like. I do not know how they function together. But I believe in them. Bud I do now know. I believe.

But I know that you are sitting there at the witness table. That is knowledge. You understand the difference?

Dingell was only getting warmed up to the task at hand. Having philosophized with Gibbs relative to the meaning of life he got into the meaning of the agreements;

Dingell: What was it that caused Touche Ross to agree that these loans could be properly accounted for as loans rather than equity transactions.

Gibbs: The change in the relationship between the two entities, the legal form of the transaction, and the cross-collateralization agreement.

Dingell: Were any of these properties making money?

Gibbs: Most of the properties were servicing all prior debt, and in that context, there was positive cash flow.

Dingell: Positive cash flow, but were any of them making money?

Gibbs: Making money in a financial, accrual accounting sense, no.

Dingell: Okay. So in point of fact, money was moving through the books, but not enough to amortize the anticipated debt, is that right, to put it in layman's terms?

Gibbs: Yes, that would be a fair statement.

Dingell: So what they were doing, in point of fact, was really moving toward bankruptcy, is that right? When you have money moving through the books but not enough to pay off the debts, you are just moving slowly toward bankruptcy, or maybe you're moving very fast.

Once again, we come to rely on some of Mark Stevens’s research that appeared in his extraordinary book about the "Big Six.” He shows without question that the bank and everyone literally knew what was going on all the time. He quotes and internal memo from BHSL's internal auditor, Ellen Goodman that leaves nothing unsaid:

"We have completed nearly two years of audit procedures on the major loan files. The audit department's findings, McKenna's [McKenna, Conner & Cuneo, BHSL's outside legal counsel] findings and even the Leventhal [Kenneth Leventhal, a CPA firm specializing in real estate transactions] study all support the conclusion that remedial action is needed in major loan department operations. What is disturbing is not as much the severity of the errors as the volume of exceptions noted time after time. It would probably serve no useful purpose to correct most of the individual exceptions post mortem; however, the underlying fundamental issues do need to be addressed."

I would categorize these recurring problems as

(1) Violation of association policy and procedures

(2) Violation of regulatory requirements

(3) Inconsistencies and questionable practices…

Goodman went on to give chapter and verse:

"Staffing: It appears that everybody is conscientious and for the most part competent; however, the quality of the work is still lacking. With the rapid expansion of the department, it could just be that they are in over their heads with respect to organization, administrative abilities and technical expertise."

Regulatory Requirements: I have noted with one or two exceptions, no one in the major loan department has a copy of the California Guides. I recommend that several copies of these, and the regulations for other states in which the association conducts business, be maintained in the major loan department."

Goodman spoke plainly and there could be no question what was meant in the materials that she circulated in internal memos, which were given to the Touche Ross people. Their attorney admitted that the firm: "did review the internal controls at Beverly Hills and utilized the results of that review in setting the audit scope. Ms. Goodman's concerns as expressed at the time were taken into account in the course of the review."

We find it most pathetic that the internal auditor is telling everyone that wants to listen, literally that the institution is out of control, the accountants make absolutely no bones about the fact that they read the memo and yet the issued clean statements for the bank for the two years before it collapsed in a heap. We are talking about auditing errors literally in the hundreds of millions of dollars.

Once again, Congress wanted to know why the accounting firm had not listened to what they were being told. Touche while testifying and in particular discussing the records of former vice president Robert Newberry was told that all of his files were contained neatly in seven boxes and one box contained shredded paper work of the Newberry’s. Touche indicated to Congressman Wyden who was pressing the issue that it seemed odd that they could be happy with records that contained a shredded box:

"How can your firm be so sure in its conclusion that there were no irregularities when one of the eight boxes which contained relevant information was "accidentally shredded"?… Is the shredding machine at Beverly Hill big enough to shred an entire box of documents all at once, or do they have to feed the documents page by page? How an independent auditor could stand by and watch or, even worse, simply go along with the construction of an elaborate financial house of cards that ultimately consisted of nothing more that blue smoke and mirrors. When combined with an incredible series of poor investment decisions, mismanagement, and apparent self-dealing, the result was inevitable --total collapse."

We rest!

Call Me Mr. Keating, Sonny

Charles Keating was a former swimming champion and worked as a lawyer for raider Carl Lindner. It was from Lindner that he started his ball rolling by buying American Continental Corporation, a house-building company in Ohio in 1978. From there, he raised the money to acquire Lincoln Savings and Loan of California (Lincoln) through a junk bond offering floated by Drexel Burnham ([30]). In his commitment to the regulatory officials that controlled the thrift's license, Keating promised faithfully to stay with the course with the same management that existed before the takeover for the reason that the regulators felt that they had done such a good job. Moreover, the California regulators also extracted the promise form Keating that he would not sell jumbo CD's to facilitate the thrift's growth nor would he go out of the Savings & Loan's principal business of issuing home mortgages. Faster than you could say “liar, liar, your house is on fire”, Keating had fired the incumbent management, issued jumbo CDs and started working in concert with developers to get into massive proprietary real estate projects.

Once Charles became president of Lincoln and sold worthless bonds to 23,000 people, primarily California residents directly from the thrift’s branches, by causing them to somehow believe that the United States Government had guaranteed them. ([31]) When Lincoln was forcibly closed in 1989, only slightly more than 2% of the over $5 billion dollars in assets that Lincoln reported were in residential mortgage loans, almost 70% in risky land deals and eventually cost the taxpayers of the United States over $2.5 billion.

Lincoln’s investment philosophy under Keating’s guidance included takeover stocks, hotels, junk bonds, financial futures, and high-risk loans, which ultimately accounted for over 60% of the S & L’s assets ([32]). Keating took these investors for everything they invested, but that wasn’t all, the bailout paid for by American Citizens required another $2.5 billion before the loop was closed. Lincoln became the largest S & L failure in U. S. History and its conspirators were charged with concealment of illegal cash payments, securities fraud, racketeering, conspiracy, transporting stolen property, forgery, and false and misleading statements made to the regulators.

An example of the activities that were taking place during Keating’s reign at Lincoln is the following story that describes it to perfection:

“One of the most scrutinized of Lincoln’s multimillion-dollar real estate deals was the large Hidden Valley transaction that took place in the spring of 1987. On March 30, 1987, Lincoln loaned $19.6 million to E. C. Garcia & Company. On that same day, Ernie Garcia, a close friend of Keating and the owner of the land development company bearing his name, extended at $3.5 million loan to Wescon, a mortgage real estate concern owned by Garcia’s friend, Fernando Acosta, The following day, Weson purchased 1,000 acres of unimproved desert land in central Arizona from Lincoln for $14 million, nearly twice the value established for the land by an independent appraiser one week earlier. Acosta used the loan from Garcia as the down payment on the tract of and signed a non-recourse note for the balance. Lincoln recorded a profit of $11.1 million on the transaction—profit that was never realized, since the savings and loan never received payment on the non-recourse note.

In fact, Lincoln never expected to be paid the balance of the non-recourse note, Lincoln executives arranged the loan simply to allow the savings and loan to book a large paper gain. Garcia later testified that he agreed to become involved in the deceptive Hidden Valley transaction only because he wanted the $19.6 million loan from Lincoln. Recognizing a profit on the Hidden Valley transaction would have openly violated financial accounting standards if Garcia had acquired the property directly from Lincoln and used funds loaned to him by the savings and loan for his down payment. Acosta eventually admitted that his company, Wescon, which before the Hidden Valley transaction had total assets of $87,000 and a net worthy of $30,000, was only a “straw buyer” of Hidden Valley property. In a Los Angeles Times article, Acosta reported that Wescon “was too small to buy the property and that he signed the documents without reading them to help his friend, Ernie Garcia”[33]

Keating couldn’t have stolen $250 million without substantial help. Three accounting firms, Arthur Andersen & Company, Touché Ross & Company and Arthur Young and Company, along with three law firms, Kaye Scholer; Sidley and Austin and Jones Day, stock broker, Drexel Burnham Lambert and Michael Milken individually paid over $240 million in settlements regarding their actions in regard to Lincoln’s failure. These firms were charged with allowing Lincoln Savings and Continental to hide the truth about the real state of affairs underlying their financial data ([34]).

Keating could personally spend Lincoln’s money as fast as it could come in the Lincoln’s door. His lavish parities were the envy of the jet set and a literal cross section of Who’s Who would be present whenever it became known that Charlie was going to throw another bash. American Taxpayers, directly paid for spending of this nature, because Keating wrote a voucher for literally every nickel he ever spent and would turn them in and get re-paid back from Lincoln as a company expense. Luxury vacations, private jet planes and lavish lunches and dinners were only the start. Keating lived the good life on money illegally drawn down from Lincoln.

Keating also had a team of U. S. Senators to whom he had transferred $1.3 million in campaign contributions who would plead his case at the drop of a hat. Arizona’s DeConcini and former presidential candidate McCain, Cranston of California, Riegle of Michigan and former astronaut Glenn of Ohio became known as the “Keating Five” for their cozy relationship with him. He was also able to secure a job on the Bank Board as Commissioner to man that was substantially in debt to his institution. Talk about conflicts, it was the Bank Board that regulated Lincoln. He was also able to hire, now Chairman of the Federal Reserve to lobby for him to increase Lincoln’s “direct investments.” Eventually, Greenspan wrote a letter to a California bank regulator regarding Lincoln management stating: “seasoned and expert with a long and continuous track record of outstanding success in making sound and profitable direct investments.”

Keating remained arrogant until the end and once again we can sum up his attitude with a quote from the man himself:

“One question, among the many raised in recent weeks, has to do with whether my financial support in any way influenced several political figures to take up my cause. I want to say in the most forceful way I can: I certainly hope so.” ([35])

Keating collected other famous people in the same way he was able to draw in the senators, at his trial among the 120 letters were submitted by notables in his defense. One, from Calcutta; sent by Mother Teresa pleaded his case by pointing out how generous to the Indian poor he had been. Mother Teresa should have given some thought to the poverty his schemes had created in the United States. The money that was spent by the American people to rectify the damage caused by Keating could have fed every man, woman and child in the City of Calcutta for over a decade.

Their theory was that the Farm Home Loan Bank Board Chief, Edward Grey and other regulators were too tough on Lincoln. The ammunition for the theory was provided by an Arthur Young analysis, which gave Lincoln high operational marks. Incidentally, the author of the Arthur Young analysis, Jack Atchison, soon left for the employ of Mr. Keating at Lincoln at three times the salary ([36]). Congress asked a lot of question regarding Atchison’s dual role and in particular, Congressman Lehman was grilling an Arthur Young senior official, William L. Gladstone:

Congressman Lehman: Did anyone at Arthur Young have any contact with Mr. Atchison after he left and went to work for Lincoln?

Mr. Gladstone: Yes Sir.

Congressman Lehman: In the course of the audit?

Mr. Gladstone: Yes

Congressman Lehman: So he went from one side of the table to the other for $700,000 more?

Mr. Gladstone: That is what happened,

Congressman Lehman: And he—just tell me, what his role was in the audits…when he was on the other side of the table.

Mr. Gladstone: He was a senior vice-president for American Continental when he joined them in May 1988.

Congressman Lehman: Did the job he had there have anything to do with interfacing with the auditors?

Mr. Gladstone: To some extent, yes.

Congressman Lehman: What does “to some extent” mean?

Mr. Gladstone: On major accounting issues that were discussed in the Form 8-K, we did have conversations with Jack Atchison.

Congressman Lehman: So he was the person Mr. Keating had to interface with you in major decisions?

Mr. Gladstone: Him, and other officers of American Continental

It was unquestionable a conflict for Young to be interfacing with one of their former employees in their role as Independent Auditor for Lincoln. They had made some terrible mistakes and apparently didn’t know how to handle the resolution of them and were literally floundering. Kenneth Leventhal was asked to act as an independent forensic evaluator of what had occurred. They never mentioned anyone by name but there was no question to any one reading what they had to say as to who they felt the villains in matter really were.

“Seldom in our experience have we encountered a more egregious example of misapplication of generally accepted accounting principles? This association (Lincoln) was made to function as an engine, designed to funnel insured deposits to its parent in tax allocation payments and dividends. To do this, it had to generate reportable earnings. It created profits by making loans. Many of these loans were bad. Lincoln was manufacturing profits by giving money away.” ([37])

In their, take no prisoners report, Leventhal laid the blame where it should well have been placed. Arthur Young countered with the fact that, by number Leventhal had only check 15% of the real estate transactions that Lincoln had made and that under the circumstances, without getting a greater cross section, Leventhal retorted that their check covered approximately 50% of the transactions the Lincoln was involved in and there for Young was literally trying to blow smoke. In addition, they pointed out that of the transactions that they went over, something was literally wrong with every one.

Congressman Leach even found a problem with Young relative their approach with the investigating committee:

Congressman Leach: I am going to be very frank with you, that I am not impressed with the profession ethics of your firm vis-à-vis the United States Congress. Several days ago, my office was contacted by your firm, and asked we would be interested in questions to ask of Leventhal. We said. “Surely”. The question you provided were of an offensive nature. They were to request of Leventhal how much they were paid, implying that perhaps based upon their payment from the U.S. Government that their decisions as CPA’s would be biased. I consider that to be very offensive.

Now, in addition, one of the questions that was suggested I might ask of the Leventhal firm was: Could it be that their firm is biased because a partner in their firm did not make partner in your firm?

Mr. Gladstone: I do not know who contacted you and I certainly do not know how the questions were raised.

In effect, one of the senior partners of Young was indicating that he wasn’t sure that it was a Young employee or even whom it was that had provided the questions. Naturally, it would have extremely odd for the defense team representing Young not to have gone of the matters relating to Gladstone’s potential questions and answers from Congress. It was later determine of course, that it indeed was one of the people from Young that had provided the questions to the panel. Leach had time to reread the report and countered with:

Congressman Leach: I read that report very carefully, and I found no angry vengeful sweeping statement. But I did find a conclusion that Arthur Young had erred rather grievously. In any regard, what we are looking at is an issue that is anything but an accounting kind of debate. One of the techniques of Lincoln vis-à-vis the U. S. government was to attack the opposition. You are employing the same tactics toward Leventhal…. I think that is unprofessional, unethical and, based upon a very careful reading of their statement, irresponsible.

Now, I would like to ask you if you would care to apologize to the Leventhal firm.

Mr. Gladstone: First, Mr. Leach, I stated in my opening remarks that I believed that their report was general and sweeping and unprofessional, because (what) I would call unprofessional about it is the statement that looking at 15 transactions that therefore they would conclude that nothing Lincoln did had the substance—

Congressman Leach: I have carefully read their report, and they note that they have just been allowed to look at 15 transactions. They could not go into more detail, but they were saying that American Continental Corp. (Lincoln’s owner) batted 15 for 15, that all 15 transactions were unusual, perplexing, and in their judgment in each case breached ethical standards in terms of generally accepted accounting principles.

Your firm in effect saying, “We think that there may be some legal liabilities. There, we are gong to stonewall, an we are going to defend each and every one of these transactions.”

I believe that you are one of the great firms in history of accounting. But I also believe that big and great people and institutions can sometimes err. And it is better to acknowledge error than to put one’s head in the sand.

I think before our committee you have righteously done that.

Of particular interest is the fact that both the accounting and law firms involved had impeccable reputations both before and after the Lincoln debacle. If they had not cooperated, the repercussions of this felony would certainly have been less devastating. Keating, found guilty of felonies, is in prison and has declared bankruptcy. I am sure this has not assuaged his victims.

During the congressional hearing that had been enabled to review the thrift industry in general and Lincoln in particular so that it could be determined what went wrong. During the hearing Congressman, Jim Leach named everyone as guilty parties:

“I am stunned. As I look at these transactions, I am stunned at the conclusion of an independent auditing firm. I am stunned at the result. And let me just tell you, I think that this whole circumstance of a potential $2.5 billion cost to the United States taxpayers is a scandal for the United States Congress. It is a scandal for the Texas and California legislatures. It is a scandal for the Reagan administration regulators. And it is a scandal for the accounting profession.” ([38])

The Securities and Exchange Commission started an investigation on the various securities problems that had been inherent in the entire Lincoln mess. The biggest of the violations occurred when Lincoln set up offices in their facilities to push debt instruments which most people were led to believe were guaranteed by the government. Richard Breeden was particularly vocal about the fact that Arthur Young was not helping the SEC in any way with their investigation:

Commissioner Breeden: We subpoenaed the accountants (Arthur Young) to provide all of their work papers and their back up.

Congressman Hubbard: Do you know if they were forthcoming and helpful in helping you resole some of these questions, or helping the SEC resolve some of these questions?

Commissioner Breeden: No. I would characterize them as very unhelpful, very unforthcoming, and very resistant to cooperate in any way, shape or form. ([39])

Remember Lance Ito, the California Judge that received so much publicity during the O. J. Simpson trial. Ito also was the presiding judge in the Lincoln case. Well, Ito was no Keating fan and sentenced him to 10-years in jail for securities violations. In a concurrent case running in federal court, it must have been felt that Keating had gotten away with murder under Ito’s guidelines and they handed him an additional 12 years behind bars just for good measure.

But Keating was if anything, a gladiator, he appealed the Ito decision claiming that incorrect instructions were given to the jury. He was found to be correct and Ito was overturned on appeal. This same judge was simultaneously hearing an appeal of the federal case on the same grounds. If he overturned one, how could he not overturn the other? It seems that the Judges in both cases did not check to see if any of the jurors were aware of Keating’s conviction in the rival case and because some had been aware of what had gone on before, it was determined that Keating did not receive a fair trial.

By this time, Keating had already been jail waiting the outcome of his various appeals. The government announced that rather than see Keating walk, they were going to retry the case. When push came to shove, no one really wanted to do that whole thing all over again and just before the trial was to reconvene, both sides worked out a deal. Keating would agree that he had indeed done something terribly wrong ([40]) and for their part, the government would agree that he had been in jail long enough and would let him go.

Out of a total of 22-years in sentences that Keating had been given, he only served approximately 25% of that time in jail. In the meantime, everyone else involved with Keating suffered substantially in the derivative lawsuits that had been brought against one and all for helping to create the disaster. Three accounting firms were involved with Keating and Lincoln in one way or the other and the costs to all of them were not insubstantial. Young’s bizarre defense was a disaster waiting to happen and it did. They really came out looking like the villains in the case because of the hardball manner in which they conducted their defense. In the end, it did them little good and made the firm look like the villain, not an innocent party that had been set up by an ogre.

Silverado Banking Savings & Loan, Just Plain Lost Its Luster

The progeny of high-ranking officials benefit in strange ways from their father’s office. So it was with Neil Bush and a bizarre financial Institution called Silverado Banking Saving & Loan. The Kansas Federal Home Loan Bank was the ultimate regulator for Silverado. Although regulators auditing the bank in 1986 found a massive fraud, their efforts to close it by serving a cease and desist order on March 10,1987 were reversed by Kermit Mawbray, president of Kansas Federal. Because of Mawbray’s actions, it has been estimated that the fraud’s cost to American Taxpayers rose from about $400 million when the scam had been discovered to almost a billion when the institution was finally closed down due to Mawbray’s intransigence.

Eventually, the Federal Deposit Insurance Corporation sued the Board of Directors of Silverado for $200 million for their part in the fraud and more specifically for their negligence in allowing the thrift to make high-risk loans and investments while simultaneously concealing its virtual insolvency. According to government officials, the high-risk loans produced substantial fees for Silverado, which in turn paid outrageous salaries to its top officials. Many of the major developers who were recipients of the Savings Bank’s largesse were business associates of Neil Bush, the son of then President George Bush. The reputations of those people were highly questionable and several in depth stories have been written about their backgrounds

In the meantime, one of the men, Bill L. Walters, had loaned a substantial amount of money to Neil Bush before he was affiliated with Silverado, once appointed to that board of Directors, Bush repaid Walters’ generosity in spades. Bush was helpful in getting Walters a series of loans amounting to over $100 million, with the help of the rest of the Silverado board. After the books on the thrift’s debacle had been closed, the Office of Thrift Supervision (OTS) estimated that those particular Walters loans had cost American Taxpayers $45 million.

The final score in the closing of the thrift was that the American people were out $1 billion. Of the $200 million accessed the directors of Silverado by the Government, a Directors and Officers liability policy took care of $26.5 million and another $23 million had been held out by the savings bank early on for use on a rainy day. Well it was pouring; $23 million was paid from that fund in a total negotiated settlement of the problem. Bush got a cease-and-desist order from the OTS for his part in the matter, which is about as small a penalty as was conceivable. A push was made with U.S. Attorney General Thornburgh to appoint an independent prosecutor to investigate both Bush and Silverado. You know that that idea didn’t go anywhere.

Michael R. Wise, the former CEO of Silverado, was indicted in 1992 by a Federal Grand Jury regarding a loan to him by his own bank. Ultimately, Wise beat the case and walked with only a simple cease and desist order. It would have been hard for the government to have convicted Wise of anything when it probably would have also brought in other Silverado directors and officers into the case. On the other hand, Wise was sentenced to 3 ½ years in Leavenworth in 1999 after he plead guilty of stealing $9 million in an unallied matter from Aspen investors in a case fraught with wire fraud. The strangest twist that this case took was the fact that Wise had 23 year-old filing clerk by the name of Anne Liv Slemmons. She watched all of the stealing going on and grabbed $110,000 for herself. She got 96 months of hard time to Wise’s 42 months in a white-collar facility. You could kind of wonder how they figured that one out; then again, the wheels of politics sometimes grind in strange ways.

Many people were interested in what the government had actually uncovered in the Silverado affair but all attempts to view papers covering the matter that were forwarded to the OTS were denied. Interestingly enough, Bush’s defense along with that of other defendants was the fact that everything that he done while on the Board at Silverado was approved or sanitized by the OTS itself. They too had asked for the records so that they could prove that fact in court. If you believe that one, I think that you will love this bridge I have for sale. The fact is that Bush probably knew that the information was never going to be released and used it to his own advantage. We call this on Wall Street a “red herring.” Many say that it was only this ploy that enabled the government to make the very favorable settlement with the President’s son as well as others.

Coopers and Lybrand were the auditors for Silverado and consistently proclaimed that the thrift was in excellent shape. At the time that Coopers was putting out audited statements showing the Savings Bank’s health to the tune of positive earnings in 1986 of $15 million, the real number turned out to be a loss of the same amount of money in that very same year. When you aren’t paying attention it is not hard to change a minus sign to a plus sign. As opposed to being the picture of health, Silverado was a disaster and hardly solvent. Coopers was also hit with a cease and desist for its “abusive and self-serving actions.” One week to the day after the cease and desist had been presented, they received a lucrative contract from Resolution Trust to manage almost $300 million in loans and real estate from other failed thrifts.

Hey, when you are on the right side, you are on the right side.

Bank Management Is Weak and Unprepared For an Unregulated Environment.

So, you don’t lose track of recent history, return with us now to those thrilling days of yesteryear, just a couple of years ago, when the banking and the wild west were synonymous. Just so we don’t forget, the following represent a series of vignettes concerning recent problems in the banking industry. Rumors had started to spread that the Bank of New England was in trouble.

“Worried depositors phoned their banks for reassurance. And the three phone lines at Veribanc Inc., a Wakefield (Mass.) company that ranks banks’ safety, were jammed for days after the run on BNE. “It’s sad,” says Warren Heller, Veribanc’s research director. “There’s beginning to be a recognition that not all banks are safe.”

“Why are folks so worried? It can’t help that the nation has plunged into recession. Or that a war may be waged in the Mideast. That’s enough to set people on edge. But depositors have more direct reasons to fret. One big concern is that the regulators might not be as generous in future bailouts. Indeed, the FDIC paid big depositors at New York City’s Freedom National Bank, a black-run bank that counted Jackie Robinson among its founders, just 50 cents on every dollar on deposit above the $100,000 maximum when it failed last November. Those that have lost money include not just wealthy individuals and businesses, but local churches and charities….

“Yet the banking industry these days is far from healthy. Commercial real estate loans continue to sour as office-vacancy rates rise and the real estate market deteriorates. “It’s not unique to New England,” observes Lawrence K. Fish, Bank of New England’s Chief Executive. “The economy, and particularly the real estate markets are continuing to slip.” Loan write-offs are 10 times higher than a decade ago. Making the industry’s fundamental troubles more worrisome is the plunging balance in the FDIC’s bank-insurance fund…

The Day Boston Ran Out Of Money

“So the FDIC moved in Sunday night. Almost from the start, regulators agreed to guarantee all BNE deposits. Their big fear: public confidence had been so damaged that other big, troubled New England banks—Bank of Boston and Shawmut among them—would find themselves besieged by depositors clamoring for their money. “Given the condition of the financial system in New England, it would be unwise to send a signal that large depositors weren’t going to be protected,” Seidman said. Moreover, the Fed was concerned about wider damage to the banking system and possible international repercussions. BNE, like other large banks, held over-the limit deposits from other banks, which would have been hurt by getting less than full repayment…

“Nonetheless, the bailout is only a band-aid on one of the industry’s many grave wounds. Economists fear the credit crunch could worsen in New England, condemning the region’s economy to a lengthy recession. With much of the staff at BNE unsure about their future, many fear that lending officers will spend more time getting their resumes together than looking for new business. ([41])

Global banking as a rule has not been as safe as many in the industry would have us believe. We tend to forget yesterday’s failures and concentrate on today’s successes. But then again, that is human nature. The Economist in their April 12, 1997 issue put it well:

“…Since 1980, more than 100 developing countries have suffered some kind of serious banking-sector crises. In some of them, reckless lending has left banks with unrecoverable loans that far outstrip their shareholders’ capital. In others, banks have been sculptured by a sudden loss of confidence that led to runs by depositors.

“Many bank-watchers worry that, on the evidence of the past few years, things are getting worse. In Africa, banking systems have been going down the tubes at the rate of two a year. According to the World Bank, between 1988 and 1996, systemic banking crises struck in 20 African countries, five of which had to spend more than a tenth of their GDP to mend the damage.

“In Eastern Europe, banks in almost every country have run into trouble as they swapped communism for capitalism. Hungary’s government has thrice had to bailout state banks that had been sliced off from its communist-era Central Bank, taking with them huge portfolios of bad loans to smokestack industries. Over the past five years, the financial systems of all three Baltic States have been rocked by explosions among the new breed of private banks. The Czech Republic, one of the region’s star economic performers, blotted its copybook with a series of banking scandals and bust-ups that last year threatened a systemic collapse. In Bulgaria, a failure to reform state industry and banking supervision has left banks with a collective negative net worth of over $1 billion.

“Banks in Latin America have been just as accident-prone. Chile suffered a devastating banking crisis in the early 1980s. The currency turmoil in Mexico at the end of 1994 came on top of banks’ over-expansion and careless lending binges that had stored up trouble. Mexico’s problems also tripped up Argentina’s already-wobbly banks as panicky customers drew out 40% of their deposits in early 1995. Venezuela’s banks were brought to their knees by a combination of incompetence and fraud. Several billion dollars-worth of bail-outs later, they are only just learning to stand again.”

“Banking crises are not confined to emerging countries. Over the past decade or so, the rich world too, has had to deal with various financial traumas, including a property-lending fiasco in Scandinavia, America’s $150 billion savings-and-loan disaster and Japan’s current bad-debt mountain. But, except in Japan, these problems have long since been fixed. In the past five years, the most serious problems in rich countries have cropped up at individual banks, such as Britain’s Barings, which collapsed under the weight of ill-advised derivatives deals, and France’s Credit Lyonnais, which ran up $4 billion ([42]) of loan losses. In emerging markets, by contrast, banking troubles have more of a habit of spilling over into the economy at large.”

“Moreover, such crises have growing international implications. The “tequila effect” produced by the Mexican debacle, not only spread south to Argentina, but briefly reverberated in financial markets, as far away as Thailand. The risk of contagion, economists now say, may be growing as emerging markets forge stronger links with each other – for example, through increased cross-border trade, investment and lending – an become part of global markets. The financial ties between rich and poor countries are also strengthening all the time. Private capital flows, from all sources, to emerging markets have risen steadily, despite the peso crisis. Last year, they reached $239 billion, more than four times higher than flows of international aid.”

This has caused fears that banks, which provide much of the plumbing to carry these flows, will become ever more vulnerable, without a concerted international effort to avert such crises. Multilateral officials have become preoccupied with this fragility. James Wolfensohn, the President of the World Bank, says that banks are the “Achilles heel” of emerging economies, and that one in five of these economies faces a banking crisis. His counterpart at the IMF, Michel Camdessus, has said that the next mishap of the Mexican kind is likely to start with a banking crisis, and has promised that the IMF will concentrate harder on bank supervision. America’s Treasury and central bankers’ committee of the Group of Ten (G10) have joined the chorus of concern.” ([43])

Neither governments of highly evolved first-world countries nor those of emerging nations, are able to control the international impact of their internal policies; some global oversight is necessary. Threats to our worldwide financial system can come from over-zealous multinationals, wayward employees, itinerant bankers and naïve governments.

Barings, A Singapore Sling

Barings was special. We have only to quote the Duc de Richelieu reply in 1817 when he was asked about the six great powers in Europe; “England, France, Prussia, Austria, Russia and Baring Brothers”, he replied. Barings was broker to the Queen of England while being the oldest merchant bank in the country. It was always customary for the Baring people to arrive late for meetings with customers so that their clients would realize how honored they were to be in that kind of company.

Johann Baring was the founder of the lineage we know of as Barings and after starting out as a wool merchant, married well and died as one of the richest people in his community. His third son, Francis had a penchant for banking and started the ball rolling by successfully acting as a guarantor in commodity contracts. On the other hand, Francis was also a natural speculator and oversaw a series of disasters such as the time when he attempted to corner the markets in both soda ash and cochineal and got his head handed to him in each.

As the years rolled by, calmer heads took over at Barings Brothers and the company concentrated on financing the British Government’s various wars. Among which were the American Revolution and the war with France. Barings also helped the United States finance the Louisiana Purchase in spite of the fact that this indirectly aided England’s enemy, France who was scurrying hither, and yon trying to finance their coming battle against Great Britain. When Alexander Baring succeeded his father upon his death as head of the banking empire, it was already the largest merchant bank in Europe with the possible exception of the Rothschild’s.

Alexander was brilliant and the bank prospered. Ultimately the line of succession grew stale, and an American Joshua Bates was brought in to run the show. Other than the fact that Joshua shared Francis’s penchant for attempting to corner markets and got creamed in an attempted to control tallow in 1830, things were uneventful. As the years wore on, the Baring’s men acquired beautiful women as wives, expensive paintings as hobbies and peerages in their natural right of succession. By the middle of the century, the bank was the prime financer to the United States and Canada. Barings was headed by a succession of over-reaching people who in 1890 made a classical blunder.

The bank had been so successful in everything else that it had taken on that it believed that the name Barings, had enough cache’ to sell anybody anything. That was at the time when the Buenos Aires Water Supply and Drainage Company came calling. Baring’s people were not all that familiar with the nuances of Argentina and found that the bank was in the unenviable position of owning literally all of a dismal deal. Great Britain had their own, “too big to fail” criteria even then and determined that should the bank go under, it could well cause a financial crisis in the country. They were bailed out at the last minute.

On the other hand, the individual partners were first responsible for the debt that had been run up and it took the sale of everything that had been accumulated over the last 100 years by the partners to make the bailout work. The family named this period “Deca-Dance” for some unknown reason, but they had learned an extreme lesson during this time. Speculation had now become a no-no for the Baring Brothers but arrogance was still in.

The only thing that Baring Brothers seemed to accomplish through most of the early twentieth century was their decision not to finance Germany’s recovery from World War I, which avoided another disaster when that country inflated dramatically. Scandals were about the only excitement that the family generated and the ones that leaked out were legendary. In 1985, the “Big Bang” came to England with its regulations that allowed for banks to own brokerage firms and the like. Finally, Barings expanded and jumped into the fray, one small toe at a time. Their sole move in the direction of moderninity was the acquisition of Henderson Crosthwaite a small firm specializing in Pacific Rim securities. The deal had little to make note of other than the fact that the Baring Family were said not overjoyed by the banks acquisition of a firm run by Catholics. The man in charge of Henderson Crosthwaite was Christopher Heath who became the highest paid person in London in 1986 with a salary and bonus from Baring Brothers of well in excess of $4 million. This made the Baring family both happy and sad. He was making money for them but at the same time, some said that they did not like paying anyone of his religion that kind of money.

Markets in the Pacific Rim continued to be good for both Barings and Heath. Japan, especially was a place where Heath could make his presence felt. Barings Bank became the focal point of English Language research coming out of that area and Barings was the place to go if you needed information about anything that was going on in the region. Barings seeing the light of day opened offices in Singapore, Geneva, Los Angeles, Taipei, Bangkok, Osaka, Manila, Kuala Lumpur Karachi, Seoul, Melbourne, Sydney, Jakarta, and Paris. Heath who started with 15 employees now had almost a thousand and his division was accounting for no less that half the bank’s total profits.

Nick Leeson was born Nicholas William Leeson on February 25, 1967. His father was a plasterer and mother a nurse at a hospital for the insane near London. Leeson was a slightly above average student in school and had shown some promise in sports. On the other hand, Leeson couldn’t get into college because of his grades and took a job at Coutts & Co., a subsidiary of the National Westminster Bank. It was there that Leeson began to receive his early financial education. After several years, he left Coutts for Morgan Stanley. Morgan Stanley taught Nick how the back office worked and how integral it was in the total operation. Leeson became particularly adept at settling futures-and-futures option trades in Japan. When Baring Securities needed someone to run their Japanese back office, Nick Leeson was chosen from numerous applicants.

Leeson was still hanging out with his old cronies from his former neighborhood on the weekends, whom at best could be called a bunch of hooligans. While at work he had adopted the air and demeanor that fit the bill of an up and coming banker. When a problem developed in Indonesia, it was Leeson that got the call to straighten it out. Leeson impressed everyone with his work ethic including people at the Hong Kong and Shanghai Bank who asked for Leeson’s assistance in their own operations. In the meantime, Leeson had arrived for his assignment in Indonesia with a slightly wet-behind the ears attractive female associate from Barings in London. They worked very closely together in Indonesia and as a result, they became engaged soon after the job had been completed.

No sooner, had Leeson arrived back at headquarters than he was able to clear up an account that was illegally trading through Barings that ultimately would have resulted in a substantial problem had it not been caught. Once again, Leeson received accolades and his long-term success at the Bank had been assured.

Leeson, as a result of a job well done and the respect that he had established among his cohorts, got the nod when an office was opened by Barings in Singapore in 1992. “Besides running the back office, the person who ran the office would also execute clients’ orders on the floor of the exchange.” ([44]) Leeson had no knowledge of trading whatsoever but believed in himself and took the assignment. This indeed became the beginning of the end for Barings, as we knew it at that time.

Manhattan Investment Fund Ltd.

When an employee is put in the job of doing the trading and simultaneously has the responsibility for the back office, it is straightforward to envision the ability that this person has to create havoc with the books and records of his employer. People’s motivations run the gauntlet from just wanting to be loved by showing better performance as we observed in the Leeson debacle, to out right robbery of the petty cash, to fraudulently jacking-up earning to increase a bonus pool, as was the situation with Joseph Jet when he single-handedly destroyed Kidder Peabody. But it has been rare when the boss himself gets his hands dirty with unequivocally cooking the books.

In most larger businesses it is necessary to have the inside accountant involved with the boss when he is cooking the books because he needs his assistance in making the illicit entries. Thus, while employees independently can operate their own brand of independent in-house crime syndicate, the bosses must act in concert with others, most of the time. Manhattan Investment Fund was a horse of another color. Funds of the Manhattan type (Offshore hedge funds which generally preclude American investors) ([45]) essentially depend on two factors for their income stream, funds under management and the profitability of the fund itself ([46]). It stands to reason that the less profitable a fund is, the fewer people will be interested in owning it and thus, the less management will bring to their bottom line. Enormous funds such as Tiger and Soros guessed the market wrong in recent years and the result is Tiger is just about out of business and Soros is no longer the powerhouse that they once were. On the other hand, the rewards for success are tremendous, a piece of the money under management and a nice slice of the profits, in this case 20%.

On occasion a fund that guessed the market wrong, just does not want to deal with their defeat and once in a while they come up with various fraudulent methods of making their performance look substantial better than what it really was. This is what Michael W. Berger, now 29 years old, an Austrian citizen and a New York resident, as well as the manager of Manhattan Investment Fund tried to get away with.

Manhattan Investment Fund Limited was incorporated as an open-ended investment company under the laws of the British Virgin Islands and came with a Tortola address. Berger who at that time was only 24 years of age founded it in 1995. In spite of the fact that he had dropped out of college under strained circumstances ([47]), Berger desperately wanted to be a big time fund manager and he went to work for Salzburger Sparkasse ([48]) Bank as a financial analyst. He soon felt that he had outgrown the job and began publishing a newsletter called “SmartMoney, later called Wall Street Notes, about the U.S. stock market” ([49]) and moved to the United States where he intended to become rich and famous. Before much time had passed, Financial Asset Management Company of Columbus Ohio hired Berger as a technical consultant on the stock market used his market letter in mailings to their clients and he managed some money for them as well. After a short period of time spent in learning the territory, he opened a Park Avenue office and simultaneously retained a Paris based marketing firm to land him investors for his new concept, a money management vehicle, Manhattan Investment Fund.

He also utilized a high-powered public relations campaign in Europe to bring in investors by telling them that the Dow was going to tank and that Internet stocks would drop by as much as 80%. On the other hand, he was a one-horse shop; there were no professionals that worked for Manhattan in any capacity, a fact that should have drawn some investor interest ([50]). On the other hand, his message was not entirely illogical; he thought that the market in various areas was over-priced and that the fund would coin money by shorting these stocks. People bought his concept and the money flowed in, over $500 million of it, primarily from investors in Europe. Not having an existing track record was not a burden to young Berger, as an aid to bring in business, Berger created a record for his performance going back to 1992, three years before the fund was even in existence. He was able to make such a good case relative to his performance in those non-existent years that it helped him originally get the deal off of dead center. As we know, Berger made what seemed to be a logical bet but in spite of the fact that he had guessed miserably wrong, he liked his job, its power and the accoutrements and did not want to give up his position.

He found a simple solution. The firm that was executing his trades was clearing through Bear Stearns & Company, a large New York Stock Exchange Brokerage firm. They sent customers statements to Manhattan Investment Fund where Berger intercepted them and fashioned a similar to the format on the monthly brokerage house statements to which his investors had grown accustomed but changed the name from Bear Stearns to Financial Asset Management, an impressive sounding but hardly sizable, Columbus, Ohio brokerage firm that executed most of Berger’s trades. ([51]) ([52]) While Bear Stearns reports continued to reflect Berger’s dismal performance, Manhattan, considering the investments that they were making, seemingly performed in outstanding fashion, on paper that is ([53]). Instead of consistently losing vast amounts of money, Berger showed gains of 15% in 1996, 30% in 1997, 12% in 1998 and 14% in 1999. In reality, only about 10% the investor’s funds or less remained when the doors were forcibly shut.

In the new fangled electronic world that we live in, rumors of Berger’s appalling performance soon started circulating on the net as well as by world of mouth. Berger logically attempted to stem the tide and put these rumors to bed. He filled a lawsuit against five companies that were not named in the court documents that he swore were saying that his fund was down 30% when in effect, according to Berger, his fund had improved over 7% during the year. While this action was obviously never pursued, the rumors did go away for a time and Berger got a small reprieve that did more harm than good. He started playing even more heavily in those same investments that had already almost totally destroyed his fund and didn’t guess the market any better than he had before.

The outside accountants did not determine to compare the Bear Stearns statements with those furnished by Financial Asset Management and when the dust had cleared, approximately $400 million had been dissipated. ([54]) It was only after Deloittte & Touche, Manhattan’s accounting firm demanded to see additional documentation that they were fired. Naturally, this brought in the Securities & Exchange Commission as well as the class-action lawyers.

Another strange accounting relationship with Manhattan is the fund’s administrator; Fund Administration Services of Bermuda was an Ernst & Young subsidiary. They also resigned when the facts surfaced ([55]). People close to the situation indicated that both Fund Administration and Deloitte were getting the stock pricing information directly from Manhattan and not from the clearing broker, Bear Stearns, a critical and highly unusual mistake. Apparently though, it was Bear Stearns that ultimately blew the whistle when they received a call from one of the fund’s investors trying to confirm its performance figures. It was apparently at this point that Bear Stearns thought that something was amiss and called the SEC.

Worse yet, when Deloitte & Touche sent letters to Bear Stearns and Financial Asset Management (FAM) requesting pertinent financial information, Berger requested that FAM forward the auditors’ request directly to him, which for some strange reason, they did. Berger in turn sent on the fictitious financial information to Deloitte & Touche, but first he reprogrammed his fax machine to make it appear as though the information was coming directly from FAM. The SEC stated: ”Although Deloitte & Touche also received information from Bear Stearns in response to its inquiries, Berger instructed Deloitte & Touche, through the Administrator, to ignore that information, claiming that it was not reflective of the Hedge Fund’s entire portfolio. Deloitte & Touche followed those instructions. Deloitte &Touche issued unqualified audit opinions on the Hedge Fund’s financial statements for the years ending December 31, 1996, 1997 and 1998. However, because of Berger’s intentional overvaluations of the Hedge Fund’s performance and assets, those financial statements were grossly inaccurate.”

Cromer Finance, Ltd, a British Virgin Islands based company filed a lawsuit in the United States District Court, Southern District of New York and contained therein is an interesting quote relative to the culpability of Deloitte, “Experienced accounting experts described the failure to reconcile the Bear Stearns custodial reports with the information provided by Berger as “mind-numbing.” Howard Schilit, head of the Center for Financial Research & Analysis, Inc, in Rockville, Maryland, stated: “It is very unusual for an auditor not to have carefully studied records from Bear and used that as authentic information. Any reports that didn’t tie into it would raise significant red flags to auditors that something is wrong.”

Particularly hard hit in the disaster were the customers of the Credit Suisse Private Banking Group who made up a substantial percentage of the fund’s investors. Also feeling heavy pain over the situation was Bank Austria AG, Cromer Finance, Ltd. and Scotia Nominees, a wholly owned subsidiary of Bank of Nova Scotia Channel Islands Trust, which has already commenced legal action against Manhattan Investment.

Simultaneously, federal district Judge, Denise Cote froze the company’s assets. Some of the suits that have been filed name the normal list of suspects, Manhattan Investment Fund, Ltd, Michael Berger, Deloitte & Touche, Fund Administration Services, Bear Stearns and the usually number of John Does. One of the charges is rather interesting; it is against Bear Stearns and it accuses them of extending “margin credit in excess of Bear Stearns’ own internal, New York Stock Exchange and generally accepted margin limitations.” ([56]) But it doesn’t stop there, it also charges that Bear Stearns knew that these guys were skating on the edge the whole time and never once blew the whistle. The fact that they may have known that the funds performance was stinking up the neighborhood is one thing, but blowing the whistle on one of their clients for performing miserably may be a different subject entirely. Possibly, if Bear Stearns knew that the information being provided to the investors was being altered from what the statements that Bear Stearns was issuing, that’s one thing, but in a court of law, I think that they will find that people that bet big to win big can also lose big and that is just part of the game. When you go into one of these deals you sign an agreement that you are a big boy and you know that the game can go either way.

Many were flabbergasted that this new kid on the block could pull-the-wool over the eyes of so many sophisticated people and all at the same time. While the only explanation for his getting away with is total negligence on the part of many of those concerned, Barron ran a story by Jaye Scholl that at least made an attempt at explaining how it could have happened. “Some industry observers have suggested that the administrator and auditors agreed to Berger’s request ([57]) because they may have been low-paid and unsophisticated employees. Chris Sugrue, CEO of PlusFunds.com, a new service that provides real-time online valuations of hedge funds, describes the administrative and accounting firms as offering a buffet of services where the depth of inquiry can be a function of cost. “Some funds buy services at the lowest end of the spectrum,” comments Sugrue. An audit may look like an audit, he says, but in reality, it may be only “an informed opinion.”

This certainly can be classified under my category of, you learn something new everyday department. These are smart folks and their theory certainly goes a long way in explaining what occurred here but I always was of the opinion that an audit was an audit. In other words, GAAP states pretty clearly what has to be done to conduct an inspection of the books and how this inspection should take place. It tells the auditors how to investigate the items that make up the balance sheet and the profit and loss statements and I am not aware of the fact that they allow for degrees of certification or latitude within the process. I would have thought that if this was the case, they would have published the fact that this was a class IX audit which for example, only included looking at the books and records that the client furnished and not checking any deeper than that. Well that’s OK if that is what they told us, but I just don’t believe that things happen that way in the real world. Doing an audit from a menu, hmmpf. Even Deloitte Touche’s Rick Hansen announced that he had never heard of different levels of services within an audit and proclaimed that theirs had been accomplished within the framework of accounting principals.

Meanwhile, not to be outdone, the Securities and Exchange Commission filed a complaint against Michael Berger, Manhattan Investment Fund Ltd. and Manhattan Capital Management, Inc. stating in part “Defendants created account statements that materially overstated the performance and value of the Hedge Fund and have caused the Hedge Fund’s administrator to send false and misleading account statements to investors. In addition, defendants have paid certain shareholders who have redeemed their shares more than the value of those shares, to the detriment of remaining shareholders.”

Manhattan Capital Management ultimately filed for protection under the Chapter II provisions of the Bankruptcy Act. The receiver that was installed to correct the mess seems to have his hands full, it was reported that the fund’s assets were about $36 million and its liabilities were $100 million. It does not appear that there is going to be a lot left over to pay back any of the poor investors. This caused a new eventuality to pop into the picture. In 1999, it was estimated that there $75 million in fund redemptions. Had Berger redeemed these shares at their net asset value, the story would have come out immediately about the huge losses. In order to keep the troops quiet, many people believe that the fund paid out those that redeemed shares, at the inflated prices that they were fraudulently reporting to shareholders. If that is the case and it makes perfect sense that it is, the shareholders that stuck with the fund into it its demise will unquestionable be going after those that cashed out earlier. In effect what was going on was the fact that the people that opted out early (the smart ones) were really taking along with them some of the money of those that stayed with the fund.

There doesn’t seem to be any question that from a legal point of view, in spite of the fact that they may well have been innocent of any knowledge of the distortions, the early out-opters are going to have to give some of the money that they received back. This is going to be one wild and wholly mess. Of the 280 known fund clients, less than ten of them had addresses in the United States. Thus, a lot of people are also going to have to be doing a lot of traveling if they want to see that justice ultimately gets done in this matter.

We think that this story contains a number of elements that are not part of any other chronicle contained within these pages. In just about every situation, the bad guys had earned the trust of at least some of their associates in order to get into a position of power where they could begin their life of crime. In other words, it is not really possible to steal a lot of “white collar” money unless you are either placed in a position of trust or people believe in you for some other reason. The plainly is that you can’t be a “white color” criminal without some charisma. This lad had never succeeded at anything, formed the fund and hired a public relations firm to weave a story of the boy’s prowess at investing other people’s money when in reality he had literally little or no experience in anything of the kind. Money flowed in like rivers during a monsoon and this inexperienced child had soon accumulated $500 million that he would soon find a way to squander. I wonder whether someone isn’t going to sue the marketing company that literally created Berger, for misrepresentation. If they didn’t make up a total fantasy, these are the kind of guys I would like working for me when I want get rid of all of my left shoes.

While Berger denies that he stole any money, the fact that he took fees based on erroneous amounts of money under management, fraudulent performance and phony accounting hardly would classify him as Mr. Nice Guy. Berger summed up his feelings with the following, “I don’t expect anyone to like me, I feel bad about the entire situation. The intention of what I did wasn’t bad. I’m cooperating with the U. S. Government to clarify the situation.” ([58]) A bit of the cooperation that Berger was involved in was the turning over his passport so he can’t leave the country while the proceedings against him are going on. Youngsters in the financial business have a way of growing up a little too fast.

Accounting Serves Its Function

As we can see from the above story, the accountants gave credence to a totally fake story and probably caused substantially more people to lose money than if there were no accounting at all. Savvy investors, the world over, want someone watching the store when they invest even though the story might sound great. Reporting companies, those that are listed on the various American Exchanges and traded on NASDAQ are required to provide an outside auditor who is supposed to represent a neutral party in going through the books. Because so much faith is placed in the fact that they have issued an unqualified opinion, more is lost when they blow it because that comfort always investors to pay a somewhat higher price than they would have otherwise.

There is no particular rule governing accounting when non-American’s purchase interests in what are called offshore investments. It would seem to me that the same rules would apply there; if you don’t have a certifiable track record and are not subject to a major accounting firms audit, there are too many alternative investments available globally to cause anyone to buy what I would call a “pig-in-a-poke. But there are investments that American’s can make that are not subject to the same scrutiny that is provided by individual listed companies. Those are investments made by what are called qualified investors, people who have had $200,000 or more in income the last two years and have a net worth of in excess of $1 million. And as we know, there are more of those than you can shake a stick at these days.

The American alternative for the offshore fund is called a hedge fund. It has no definable meaning and is allowed to do whatever its charter calls for. They can invest in stock market new issues, commodities or the Alice in Wonderland Stock Exchange if that is what they want to do. They American regulators are not going to get involved as long as what they said they were going to do in their original offering is what they wind up doing. Because we are in a universe that is moving a little faster than we are used to, often, what you see is not what you get and the market’s volatility and upward climb have lent credence to a naivety among sophisticated investors that has not been seen in this country since Ponzi.

While it is a bit off the subject, we are going to talk about a couple of hedge funds that did not have auditors or any particular reporting procedure, but in spite of the totally opaque investment climate, rich people shelled out substantial money into these schemes and all it got them was the ability to say that they had paid for the promoter’s brand new sports car and his mansion. They always used to say on Wall Street, “Where are the customers yachts?” That saying was never truer than it is now.

And why don’t they want to give you the information to that you check out the facts for yourself. Oh, they’ll think up stuff faster than you can believe. How about this one? “Our strategy is highly technological and our outstanding performance is based on that proprietary intellectual property. Should someone have to audit our books we would have to disclose how we are making so much money to a third party and could no longer guarantee that if that party went into competition with us, we would still be able to perform as well as we had been.” This is a pretty standard story and only a tad more believable than the hopeless soul that would have us believe that he is a Nigerian jail cell and if we would just give him the name of our bank and our account number therein, we will be able to share untold riches.

You get the idea and if you hear either one of these stories, run, do not walk in the other direction as fast as you can. There are plenty of ways of protecting proprietary information and still get a damn good accounting job performed with risking anything, and of course, nobody sends money anymore to people in Nigerian jail cells, or do they. The amount scammed from people who fell for that one undoubtedly exceeds all the money lost in Long Term Credit, the biggest disaster in financial history.

Maricopa Funds

David Mobley graduated from vocational high school and then began his working career starting on a Jeep assembly line in Toledo. His father, a truck driver, had been careful with his savings and upon his death, he left the family some miscellaneous inner city property which had some value. David, ever the opportunist, attempted through expansion along with some misguided ideas to his inheritance into a fortune. This was not to be and David at the age of 25 years old had substantial overextended his empire and declared bankruptcy.

He was a man who had no college education but told all that would listen that he had been trading stocks in a highly successfully fashion since he was 13 years old. For some unknown reason, people seemed to believe him and soon almost 200 mostly retired millionaires in and around Naples, Florida had given Mobley money to trade for them. He continued to prosper and ultimately announced that he was managing over $400 million, a tidy number wherever you happen to live. However, many ultimately questioned that and any number of other things that Mobley had said, but then again that was only after an article had appeared in Barron’s showing that the real Mobley was not the same guy that they thought they were giving their money to.

People started to become concerned and they asked Maricopa either for an audit or their money back. “Mobley said on Thursday that he’s interviewing firms to conduct an audit and hopes to make an announcement to investors about audit plans by February 22, 2000. “We have had some investors request an audit. After the Barron’s article we saw that it was needed,” Mobley said.”

Mobley had previously declined to provide investors with audited statements of the hedge funds results conducted by an independent outside party. He indicated that in doing so, it could jeopardize his secret computer trading strategies and allow other investors to take positions against the funds, Mobley said Thursday.” ([59]) “Our systems are so simple and powerful that I simply must protect them to keep them for my family.” ([60]) Historically, Mobley has prepared performance figures for his investors personally with the help of his now estranged wife Gwen. Until 1996, his work was prepared by Brigid Soldavini, but they were just a compilation, which means that what you saw wasn’t necessarily what you got and Brigid wasn’t going to risk her good name by certifying a word of anything that she didn’t look at in depth and she was out the door before any substantial funds had been put in the company anyway.

Talking about protecting his family, Mobley seems to be the ultimate nepotist. His brother William, an ex salesman for Waste Management’s garbage collection systems is the president of Maricopa, David Jr. his 20ish son who was a runner for a time on the Chicago Board of Trade is his head trader and the lovely Gwen in spite of the fact that they are not longer living together is the company’s CFO. Gwen’s cousin Lori, at 25 years old holds down the fort as Maricopa’s treasurer and David Radosti, Mobley’s son-in-law, who had never had exceeded the job title of restaurant manager doesn’t seem impaired by his lack of background in holding down the job as the firm’s systems-development manager.

Well, as Barron’s indicated in their King Of Naples story of 2/14/2000 by Jonathan R. Laing, “…Today, at age 43, he lives in the affluent enclave of Naples, on Florida’s Gulf Coast. Mobley is having a multimillion-dollar home built in Quail West, an exclusive gated golf community near a fancy house that he owns but which is now occupied by his estranged second wife, Gwen, and their three daughters. He regularly flies by private jet to the Bahamas and to his sumptuous digs near Vail, Colorado, where he indulges his passion for snowboarding. As the founder and major underwriter of a Naples-area scholarship fund called the Quest Educational foundation, Mobley has been photographed hobnobbing with the likes of former President George Bush, retired General Norman Schwarzkopf, New York Times columnist, Will Safire and other luminaries who have spoken at Quest’s luncheons.” In addition, Mobley drives around Naples in a Porsche that is estimated to have cost him close to $100,000 while wintering in a $2 million home in Vail Colorado.

Well, the denizens certainly felt that anyone that lived that kind of life style must have both money and brains. This was their first mistake. And that wasn’t all of the credibility that Mobley had going for him, Van K. Tharp who gives lectures on securities trading all over the country gave Mobley the highest compliment that anyone can give a hedge fund operator. Tharp told Barron’s that Mobley was a “fantastic trader and businessman and a wonderful human being.” And he added that he had given Mobley the majority of his own money to manage, a hell of a compliment. We will see how much Tharp gave him and what it is now worth as the Maricopa disaster scenario evolves a bit further.

Mobley was also, at least according to him, one hell of a businessman. He owned a lot of different things in and around Naples including a sports bar, a cigar lounge, a stock brokerage firm and a mortgage lending company, an Internet game distributor, a golf course and a stadium. Mobley was hit by a terrible run of what he called “bad luck”, others said, “Mobley just didn’t really know what he was doing.” The brokerage firm went under as did the mortgage company followed by the restaurant . The Stadium was a disaster resulting in a multimillion dollar debacle and an ensuing scandal[61] which nobody has heard the last of as investigations have sprouted up all over the place like weeds in an empty lot. The golf course never made a nickel while he owned it and only after he left and sold his interest did it turn around. The Cigar Bar, is still hanging on with greatly reduced hours. Regulars are not seen at the bar nearly as often as had been the case in the past and this to could easily become a mortality as well which would square the circle around Mobley’s outside business acumen.

On the other hand, Mobley kind of snickered when talking about returning people’s money almost as if to say, “Of course I’ll give back anyone’s money dumb enough to take it.” After all Mobley’s Funds had been returning in excess of 50% a year since inception back in 1992 and $100,000 put into one of his funds at that point was now worth in excess of $2 million. And this mind you is after his enormous take from an exorbitant management fee. Moreover, he has stated that he had only five negative months in the over seven year history of the hedge-fund. And that isn’t all, the fund started with only $100,000 and now has, would you believe, $400 million. And if you could believe that anyone convicted of passing bad checks twice in 1983, who was sued in 1991 for screwing his partners in a real estate transaction out of their end of the profits and then indicted for grand theft in 1992 you can certainly believe Mobley. More recently he has been involved in bribery and conflict of interest charges. In addition, both Mobley and Maricopa were involved in a New York Federal lawsuit regarding false representations that had been to an investor in Maricopa.

In February of this year, the Securities and Exchange Commission had seen enough and accused Mobley of massive fraud. No one lost $400 million because it was never there to begin with, but between his bad investments and the payouts to hedge fund investors, there was only $20 million left. The SEC said that Mobley swindled folks out of $59 million but as in the case of Manhattan Investment Fund Limited that we discussed earlier, many of the earlier investors were probably substantially overpaid to keep a lid on the fraud, so this will be no less of a mess and there are going to be a lot of angry folks that thought they had missed the bullet. The difference between the two scams in terms of the investors is the fact that in the Berger matter, the patrons were wealthy off shore operators brought in primarily by their own banks, in Maricopa, they were primarily retired people without substantial outside income.

The scene as described by the Naples Daily News when agents of the Federal Bureau of Investigation and the Internal Revenue Service held a joint raid on the Maricopa Funds complex. Picture the parking lot filed with luxury cars with aging retirees watching the sorted event almost as you would a movie not knowing what was going to happen next. Records were being removed from the premises, the area was cordoned off and with it probably went the life savings of many of the observers. The agents would not discuss what was going on with the onlookers making their fears even more intense. Sources close to Mobley indicate that he flew to Washington and made a full confession over a two day period of time in between tears of anguish probably caused by his getting caught. That he confessed to numerous serious crimes and will probably not be visiting his relatives in Naples for some time to come.

The retirees may have some other problems facing them. The tax strategy employed by Mobley consisted of a series of offshore intertwined corporations that were set up, according to him, as a tax avoidance measures. Many of the people that cashed out will not only have to give a substantial portion of the money they received back, in the form of an even handed settlement but may also be hit with massive IRS claims. Not the kind of thing you want to get involved in when you are retired and do not have an outside income. These are indeed the things that dreams are made of.

Cambridge Partners

It seems that you have to profess a strong commitment to your community and to God as well in order to become a really first-rate confidence man. People like to know that you believe in the community that you live in and worship in the same church that they do. If you can make them have faith in the fact that you are really serious about those things, you have passed your test in “Scams and other criminal activity, 101”. Sad to say, these are the elements of that make for fraud. You are just not going to give anything to someone that you do not believe in.

John C. Natale, who had used his experience as a Chicago Board of Options trader to gain knowledge of securities became the managing partner of Cambridge Partners in Red Bank New Jersey and had been administrating the hedge fund since its inception 1992. He was a family man, no criminal record, a coach in three different sports for the neighborhood kids, a regular church goer and was recently voted the Man of the Year by the local Republican Club with the statement by its past president, Patrick J. Alwell to the effect that “He’s touched the lives of literally thousands of young people in our town.” Little did Patrick suspect at the time exactly how the 44 year-old resident of Holmdel ([62]), a small New Jersey community had been touched by this man.

As it turned out, 180 people had signed on as investors in Natale’s Cambridge Partners and they when the smoke had cleared it turned out that they were swindled out of no less than $59 million by the affable sports coach. No one had a clue that anything untoward was going on and as opposed to Maricopa where danger signals were coming out of the woodwork, there wasn’t a sign of any impropriety involved with Cambridge whatsoever. Natale had been explaining his enormous success to his investors as being primarily a result of his intimate knowledge of a little known trading method called the “Japanese Candlesticks Strategy”. This technique used a comparison pricing method that takes account of the opening, closing, high and low price of the stocks that are being traded by the fund on a regular basis. By somehow accentuating the positive and eliminating the negative, something magic is supposed to occur. While the system makes literally no sense to me at all, at least Natale had a system. All of the other folks that we have written about seem to flying mostly by the seat of their pants.

Although the investors were getting monthly statements that showed that the fund was performing in admirable fashion, in reality the $59 million that investors had originally sunk into the partnership had shrunk to only $3 million and another liquidation by a needy investor or two would leave the fund totally exposed. This, by the way was starting to occur on a regular basis due to the fact that the bad press coming from other fraudulent hedge funds and offshore funds were getting on the partners nerves. They weren’t really concerned that it could happen here with such a prestigious citizen being involved, but this part of New Jersey is on the conservative side and many felt that it was better to be safe than sorry.

However, their beliefs aside, one morning Natale woke up and hiked himself down to the local Attorney General’s Office. He gave them chapter and verse of what he had done and asked for a leniency because he had been such an upright human being. I kind of wonder whether his neighbors that he had wiped out will agree that the State should go along with that program just because Natale was good enough to turn himself in and save the State the money to indict, convict and house him in a convenient jail for the next decade or so.

Townspeople were beyond mystified by this turn of events. No one had been more highly thought of in the neighborhood than Natale and his investors had just gotten word that their fund’s assets had increased substantial in recent months. The original investment of $59 million was now worth more than $70 million they said incredulously. In reality, Natale just as Mobley before him, had believed that the market was overbought and sold almost everything short. He was dead wrong and his friends are the poorer for it.

And once again, even those that got squeamish and had the sense to ask for their money back have the same surprise coming in this situation that they got with Mobley and Berger before him. Natale got caught in the same predicament that the others had to face. If he did not pay out the old investors the purported value of the fund, not the real value, they would immediately know that something was amiss and he would be instantaneously out of business. Sadly, these folks are going to learn that being smart enough to get out a tad early in a hedge fund or an offshore fund doesn’t quite guarantee you the price of a loaf of bread. You have to be smart in the first place and not invest in a fund that does not certify their books through a large and highly regarded accounting firm. You also need a third party acting as custodian for the investors. The brokerage firm most be sending the statements directly to the accounting firm and the escrow agent simultaneously and even then it isn’t anywhere near a sure bet. At least under those circumstances you have developed a deep pocket to turn to if there had been a fraud committed.

Kind of a double set of checks and balances, if the accounting firm doesn’t do the job they say they are going to do, you go to court and sue their pants off and more often than not, you will collect. If they do a legitimate job of auditing the fund, you only have to worry about the manager’s performance, not a fraud. At least you will have eliminated a part of the problem that has become so pervasive in recent years and is only going to get worse.

Natale was an early bloomer. He started sending out phony accounting statements almost the day he opened his doors for business. He bet on the wrong stock and got creamed right off the bat and had to cover it up. The next seven years were more of the same and he never could exactly get the investing process quite right. When people wanted to see a certified audit, Natale was fully prepared to give them one. He created an accounting firm out of thin air and ultimately had one of the numerous imaginary partners certify the Partnership audit. After several years of that type of activity, it was painless to convince another accounting firm that the one he had been using was going out of business, and Natale would they take on the task. Natale kept right on going with his fabled ruse. He was also able to attract addition funds to his partnership by paying off or lying to web sites that recommended money managers on Internet.

And Natale wasn’t a really a good guy at all, he set up a brokerage firm by the name of CAJ Trading and when trades went bad, naturally his partners were given the short straw and when things worked out, CAJ, which he owned personally made a neat profit. Or how would you like to have been one of a number of Natale’s investors that regularly received 1099s showing illusionary income which they had to pay tax on. These folks have to be a tad unhappy right now.

His firm is now in receivership, Natale is awaiting sentencing and he is out on $500,000 bond, he has been ordered to make restitution and he is looking forward to about 10 years in the slammer. This may be preferable to living in the community that he ransacked. The New Jersey World in which he lived still finds it hard to believe what has happened to them and most of them are still shaking their heads trying to make sense out of what has occurred.

We believe that there are a number of disasters out their in the global trading world that have already occurred but had not yet been unearthed and because of all the jerks that are cooking the books, misleading the accountants or just plain to stupid to know what they are doing when they take on the responsibility of handling other people’s money; they have caused losses that will not go away no matter what the investors do about it. It is like a stick of dynamite that is going to explode, the fuse has already been lit but nobody knows how long it is. Starting a stampede by demanding your money back will only hasten the day the fund’s managing partners are put away, but it doesn’t save the poor investors one penny. There ought to be a law.

Omega Trust and Savings

Talk about blue collar, you haven’t seen “Blue Collar” until you have seen Mattoon, Illinois. We are talking about a main street that looks like the illuminated playing field of a pinball machine until about 9:15 P.M. when they close the who thing down. The diners and bars outnumber the retail shops and most of the folks in the neighborhood work on an assembly line or for some manufacturing company in the neighborhood. When I was very young and lived in the Chicago area, the folks that lived where I did, on the South Side of town were serviced by the Illinois Central Commuter Railroad. A friend of mine and myself were bored out of our minds one hot summer day and none of our associates were in the area so we went over to the Illinois Central ticket counter and ordered two roundtrip tickets to the end of their line. The lady at the ticket desk looked at us quizzically through he glasses and said, “that’s Mattoon young man, surely you aren’t going to Mattoon.” That only peaked our interest and my friend and I insisted that this was exactly where we were going, now certain that something really breathtaking lie at the end of the line, maybe, all of the ends of all lines, for that matter. No one we knew had ever been to the end of any line and we weren’t even sure that we wouldn’t fall off the face of the earth, but when you are young these are the gambles you take and we certainly were not dissuaded by the ticket sellers reservations.

Well, the end of the line was certainly Mattoon, and it was more a train yard than a town. What we hadn’t fully understood was the fact that when trains weren’t running, they had to be stored somewhere and the most logical place was always at the beginning or end of the line, whichever was which. Having already spent all of our money, we determined to make the best of it and see what Mattoon was really like. Interestingly enough, during the half hour between our train’s arrival and the next train departure, we saw literally nothing but weeds and hibernating trains. Literally no buildings, no people, no cars, no nothing, just weeds and railroad cars. However, that was almost sixty years ago and perhaps it has changed a tad since. I understand that it is a progressive town today with folks actually living there. Their mayor, a real person, sixtyish, Wanda Ferguson, was plucked right out of the local donut shop where she worked and was asked by local politicians to run for the mayor’s office when the job was going begging.

You can imagine my surprise when I heard that one of the rankest frauds that we have seen in years originated right out of this sleepy little village. You knew something was up when you saw all the businesses and homes being duded-up, new cars and trucks all over main street and some of the folks actually starting to throw some money around. One of the people that had lived in Mattoon said that he began to wonder about what was going on when one of his friends traveled all the way to Chicago, about 30 miles up the track, just to buy a new suit from one of those fancy tailors in the Loop ([63]). We can certainly see that this must have been an intense indication that something big was up.

What was up was the fact that eleven of the most stalwart inhabitants in town led by Clyde D. Hood, a 66 year-old retired electrician were involved in a massive fraud that had managed to separate over 10,000 people, from all over the world, from their hard earned money, millions and millions of it. Hood started up what he called Omega Trust and Trading and promised folks a return of no less than 50 times on their money in a short period of time. He represented himself as having worked in high level jobs for various Fortune 500 companies; as a person that was extraordinarily familiar with international banking and a member of a unique international banking cliché that controlled vast portions of the world’s money supply. It was for this reason, Clyde explained that he was uniquely capable of returning geometric returns on people’s money. He used to say that “there were people on the inside and people on the outside, the people on the outside worked for the people on the inside, but no one knew who they were and where their power base came from. Clyde openly admitted that he was one of the proportionate few on the inside and that he was literally the first to admit his role as such. Ominously, he reported that by going public with his position, he was taking a great risk of retribution from both the United States Government and the International Bankers.

Luckily for Clyde, he didn’t put the touch on anyone in Mattoon for an investment in Omega or they would have laughed themselves sick, especially the part where Clyde promised investors that for every $100 invested they would get back $5,100 in 275 days and if they “rolled the money over” they would receive another $250,000 in the same amount of time. No one bothered to figure out that at that rate, every investor would be worth more money than existed on earth within one generation. But the people that were being solicited were not particularly sophisticated and Clyde didn’t bother to have an accountant check his numbers. Holy Socks!

Clyde was not essentially a bad electrician most people said, but what he knew about money could have fit inside an ant’s brain with plenty of room to spare. Clyde used a more sophisticated tactic to separate the suckers and their money. He did it in the name of God with phrases such as “keep the Lord’s warehouse full, or “a dollar invested in Omega is more than twice blessed.” How could you turn someone down that had a relationship with the Lord as Clyde did? It was readily apparent that you were not only going to make a killing, but God was going to appreciate what you were doing for him as well. And as for having all the money on earth, if you were doing the Lord’s bidding, that wasn’t necessarily all that bad.

Naturally, Clyde made it understood that when investors sent in their funds, they had to do it in cash or money orders wrapped in silver foil. No one seemed to understand what that meant or why they were asked to do it but one long term investor said that he had interpreted it to mean that the foil helped The Lord locate the investor and that this was an extremely important part of the investing process. Well if Clyde says so, then maybe this was helpful.

Well, as with all good things, Clyde was arrested and charged with almost one-hundred counts of fraud. His defense was astonishing which consisted of stating along with several of his compatriots in crime that the United States Government does not exist. Moreover, this may help us understand why he wanted the money wrapped in foil, or maybe it doesn’t. Clyde wasn’t finished yet, he added that “any judicial proceeding, determination, ruling, order, decree, entry, penalty, fine or arrest warrants which issues from these “courts” is null and void.” This little communiqué was sent to the local police department in town, the sheriff office and the United States Supreme Court.

And the amazing part of this deal is that it was not a Ponzi Scheme. Ponzi couldn’t afford to have paid the interest that Clyde and his friend’s were offering for more than a week without going down the tube and these guys had kept the fraud alive for over six years. They added a touch that hasn’t been seen too often in schemes that are used to bilk the public. When you called to complain about not getting the promised return on your investment more often than not you were automatically connected to a message that ranted and raved for some period of time about the fact that the United States Government was holding up the distribution. On alternate weeks, the fact that there was a cabal of bankers that were apprehensive about Clyde’s going public with his work and that they had placed roadblocks in his way relative to forwarding their profits to them. Strangely enough, people went along with all of the weird rantings and ravings of this gang that couldn’t shot straight and the game went on for what much longer than it should have if anyone had even used a modicum of intelligence.

On the other hand, with the deputy sheriff being part of the conspiracy along with a former local police officer, it helped to keep the law enforcement community at arms length for a time. Their A-team also included a minister and a lawyer, a rather strong lineup when you consider that we are really taking about middle-America.

Extraordinarily enough, no one is particularly up-in arms over what happened. The amounts that were invested usually hadn’t been enough to wipe anyone out and most of the people who invested felt that Clyde was a really a good Christian down deep and would not have been going to jail at all if it wasn’t for those greedy bankers and the United States Government not wanting the common people to benefit from a good thing. On the other hand, in a real sense, the townsfolk of Mattoon did see unheard of prosperity come to Mattoon and are highly grateful for what Clyde and his friends accomplished. The fact that the money was stolen for others that created the temporary prosperity does not seem to register.

There are no accountants to blame in this story and it is included mealy to illustrate simply how naïve people can be when they are promised outlandish returns in the name of both God and conspiracies, a never miss combination. While everyone in Mattoon had some idea of what was going on, the folks in the outside world believed on that this was a good Christian investment in which they could make lots of money. My daddy always taught me that when it looks to good to be true, it usually is. Thanks dad.

In The Beginning

Many of the financial debacles of the recent past are a direct result of the tendency of financial institutions to place too much authority in the hands of literally unsupervised traders. Nick Leeson, a 28-year-old purported whiz kid, engineered the demise of Barings PLC, the oldest merchant bank in Great Britain (founded in 1762), devising a flawed electronic trading system and covering it up through forgery and lies. ([64]) Initially, Lesson’s primary interest was speculatively arbitraging the 10-year Japanese Government Bond against the highly volatile Nikkei-225 stock index futures and options. As time went on, he graduated to unhedged bets on the Tokyo Stock Exchange. Leeson lost almost immediately and had accumulated a loss of almost $4 million within several months.

In addition to supervising the trading department of Barings’ Singapore operations, Leeson was also responsible for overseeing settlements. Thus, in his dual role, he could manufacture fictitious reports. By the end of 1994, Leeson had made quick work of his benefactor as his losses already exceeded Barings’ yearly profit. For the most part, Leeson was brought down by the Kobe Earthquake, which decimated the Japanese Stock Market. In his final trading hours; at one point, he was able to control over 88 percent of the open interest in the June Contract for Japanese Government bond futures. Leeson gave the market adequate warning by being the central figure in other contracts as well.

Even massive margin calls did not create concern on the part of Barings’ management. ([65]) It was only when irregularities appeared on the Barings’ Singapore Settlement’s books that the home office became concerned. When these discrepancies could not be resolved, and Leeson was asked to explain, then and only then, did the roof collapse. Examinations were commenced and when the smoke had cleared, Barings’ Leeson oriented loss had become a staggering $1.4 billion. The markets became erratic, prices fell, margins were raised and the aftershock produced dislocations all over the globe. ([66])

Coopers and Lybrand, who also shared notoriety as the auditors for Robert Maxwell, were also the auditors for Barings Bank. London’s Joint Disciplinary Scheme lost little time in preparing a claim against Coopers. Apparently this same committee also had filed charges against them in the Maxwell matter. London also has it in for Coopers relative to a company called Resort Hotels and their boss, Robert Feld who was jailed for eight years on a fraud indictment.

Coopers was directly on the firing line in the Barings matter, as it was that firm that was in charge of both the audit of the parent company in London and also Barings Futures in Singapore. Coopers and Deloitte & Touché, the predecessor auditor, eventually settled with Barings’ administrators for about $50 million. It is interesting that it was the Administrators, Ernst and Young that brought the action against the accounting firms for failure to find irregularities in their 1992 audits.

Bankers Trust, or DisTrust As The Case May Be

I guess that we can understand a breach of the public trust by an insurance company but a large, money center bank just couldn’t take the risk for a couple of measly bucks. I mean a federally chartered bank would just not do anything untoward, at least not the kind of things that Old Republic did, (p. 142) they just don’t happen that way in the real world.

We do admit thought that Bankers Trust has had some moral issues relative to management decisions that seem to crop up on a fairly regular basis but when taken together the rest of the Banks highly honorable relationships we would not want to get into a discussion about these small items. On the other hand, why don’t I let you decide whether or not this is a high-class institution.

Bankers’ needed some additional earnings in the mid-1990s. They put out an all alerts into the securities processing division telling them to turn on the profits and the folks there stepped up to the plate to meet the challenge. They had to be very resourceful due to the fact that as a rule that division, was one which was not ordinarily considered to be a profit center. However, these folks were “team players” and in spite of enormous obstacles, rose mightily to meet the challenge. This division had lots of dividend and interest credits that regularly went through the bank’s hands on the way to their customer’s accounts. When the customers couldn’t be located over a period of time and after a reasonable attempt had been made to locate the client, the funds would then theoretically escheat to the state.

Bankers Trust did not do a very good job of looking for the benefactors of dividends and interest and pocketed the money whenever they couldn’t find the person to whom the funds rightfully belonged. This reduced divisional costs dramatically and the resultant theft was about $60 million from both the state and from the rightful recipients. The evidence clearly showed that the transaction was illegal and Bankers Trust pled guilty and paid a fine of $63 million.

B. J. Kingdon was the ultimate head of the division, which siphoned customer’s funds out of their accounts and into those of Bankers Trust. He and three former Bankers Trust managers received target letters from the authorities for their efforts on Bankers behalf. Kingdon’ s lawyer says that his client is “astonished and outraged”: over the affair and doesn’t know that anything that was being done was unlawful. The fact that a guy running a major division of one of the biggest banks in the world that doesn’t know that taking money from customers accounts without their permission is wrong indicates that more likely than not, he was probably the wrong man for the job. After all, if every bank had someone like Mr. Kingdon who seemed to became easily confused as to which money belonged to the bank and which money didn’t, we just couldn’t trust the bank now could we?

Well, Kingdon who had shown that he was over his head had his lawyer really get right to the crux of the matter. His counsel indicated in effect that whatever happened was not done in the darkness of night. That a substantial amount of money came into the bank’s coffers through the division. The bank was monitoring that activity and knew from whence the funds had come. I think we can see where he is headed on this.

What the lawyer seems to be saying in simple terms is the fact that, over $60 million was received by the bank from the division. Officials at the bank knew exactly where the funds had come from and what their purpose was. It would seem that Mr. Kingdon’s lawyer was sending a message to bank officials that his client would not be the only one to fry over this affair. While we can understand Kingdon’s attorney’s interest in his client’s well being, his approach is a bit harsh.

Bankers Trust is the same bank if you recall, that screwed a bunch of their own clients by literally stealing their money in a series of complex derivative transactions. They took Proctor and Gamble, Gibson Greeting Cards, Air Products and Chemicals, and Sandoz along with others and when they got caught, legal actions were taken against them ([67]). Unfortunately for Bankers, many of the embarrassing moments were on tape and we especially like the one where one of their top salespeople discusses how he is able to regularly screw the bank's clients but even in terms that are far more vivid. This and other solid evidence seemed to be enough to have Bankers Trust run for cover and they hastily settled all of the derivative oriented litigation.

“According to P&G: ``Fraud was so pervasive and institutionalized that Bankers Trust employees used the acronym `ROF'--short for rip-off factor, to describe one method of fleecing clients.'' An internal document about a proposed derivative for Federal Paper Board allegedly says that Bankers would make $1.6 million on the deal, including a ``7 [basis point] rip-off factor.'' In a different instance, two Bankers employees are discussing a client's loss on a trade. One then tells the other: ``Pad the number a little bit.'' P&G quotes another Bankers Trust employee saying to a colleague: ``Funny business, you know? Lure people into that calm and then just totally f--- 'em.'' Procter & Gamble, through discovery, obtained 6,500 tape recordings, as well as 300,000 pages of documents from Bankers Trust. The material concerned nine Bankers Trust clients who lost money dealing with the bank. From this evidence, P&G is alleging that Bankers Trust:

(1)-- Engaged in a pervasive pattern of fraud spanning a number of years and involving numerous victims (2)-- Induced customers to purchase complex derivative deals that produced high profits for the bank and often big losses for many of its clients (3)-- Misrepresented to clients the pricing, current value and risks of the products it sold (4)-- Refused to share its secret pricing models and other proprietary devices (5)-- Caused customers who had suffered losses to engage in ever more complex transactions that were supposed to recoup losses but that often brought on even more problems ([68])

When the smoke had cleared, the traders that had been involved on Banker’s side were either barred, fined or suspended in an agreed settlement with the Securities and Exchange Commission. Bankers Trust also agreed to pay a fine of $100 million to the Commodities Futures Trading Commission (another regulator that is similar to the SEC but is only involved in commodities), Gibson got back $14 million, Procter $35 million and Air Products and Chemicals headed the class with a recovery of $67 million.

Well, you ask what was the end result of all of this? Obviously this gang of thieves had to get jail time for what they were trying to do. They couldn’t possibly have profited by ripping off their trusting clients now could they. Well yes they could, Deutsche Bank merged with Bankers despite all of the handwriting on the wall. The acquiring German bank became saddled with over $1.7 billion in write-offs and still paid almost $200 million to top management for inking the deal. I guess that crime pays when you are a senior officer of Bankers, when you are a junior officer, you go to jail. The moral is, be the guy at the top that thinks this stuff up and you eventually get a big bonus. But run a division and you can be sure as the snow in the winter that you will have your head handed to you.

“What about the accountants?” you ask. Well, there can’t be much question that they knew about what was going on just like Kingdon’s lawyer said top management did. Banks are particularly exact in their audits because so many levels of regulatory people are looking over their shoulders. To give you list of the national and international regulators that are interested in the affairs of a bank the size of this one would take next five pages but let me give you a sample. The Bank for International Settlements which determines who can play in the global marketplace based on their capital adequacy would be looking long and hard at Bankers. The Federal Reserve, The State of New York, The Federal Deposit Insurance Corporation, The New York Stock Exchange as Bankers was a public company and the Securities and Exchange Commission to name a very few. With this crew watching the store, it would almost impossible for this to happen in a vacuum. There almost had to be collusion somewhere.

“Well if that’s the case and it makes sense that it is, why didn’t the authorities step and fine the accountants as well? Interesting question and the answer kind of goes with the territory. First of all, no class action suits needed to bring in other defendants because the bank was in itself, a deep pocket and everyone knew that when push came to shove, the bank would pay up, especially when caught with their hands in the cookie jar. Next, some of the high-ranking people at Bankers Trust were big time political folks and had a lot of friends, as long as someone was going to get indicted, and they did, the regulators saw no reason to send an additional message. Was this right? Absolutely not but considering the fact that after this incident, all of the top level management at Bankers left in disgrace, probably at least some price was paid and a message was sent to others. On the other hand:

“Washington, (Dec. 7, 1998) Business Wire--The following notice is issued by the law firm of Cohen, Milstein, Hausfeld & Toll, P.L.L.C. on behalf of its client, who, on December 7, 1998, filed a lawsuit in the United States District Court for the Southern District of New York, on behalf of persons who sold or otherwise disposed of Bankers Trust (NYSE:BT) common stock or call options or purchased Bankers Trust put options during the period between October 26, 1998 and November 20, 1998, inclusive.”

“The Complaint charges that Banker Trust, Deutsche Bank A.G. and certain officers and directors of those Companies during the relevant time period violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. Specifically, the Complaint alleges that defendants falsely denied that Deutsche Bank and Bankers Trust were engaged in takeover discussions and negotiations during the Class Period in order to artificially depress the price of Bankers Trust stock so that Deutsche Bank could purchase Bankers Trust at an artificially low price. The Complaint alleges that members of the Class who sold or otherwise disposed of their Bankers Trust common stock did so at artificially depressed prices.

We can tell you this though, just because a building has a sign saying that it is a bank doesn’t mean that you shouldn’t read you statement. Just because the president has white hair and is in the Rotary is no reason to trust him. Banks are business people like everyone else and larceny is not the sole domain of second story men or axe murderers, it is sometimes done in the lap of luxury between large mahogany doors.

Penn Square Crumbles

The Penn Square Bank of Oklahoma City got its start in 1960 as a small financial institution and was located in a small shopping center for 22-years. In 1972, William “Beep” Jennings took over control of the bank and simultaneously OPEC started moving the price of oil higher. Nobody’s fool, Jennings knew a good thing when he saw one, and created a new department to make loans to the oil-and-gas-industry in Oklahoma. These were also times when people did not care much what their return was going to be as long as they were able to take a bite sized write-off from their tax returns.

Thus, although Jennings was at the right place at the right time, he did not realize that not everyone who claimed to be looking for oil really was. Those who were not, were looking for deductions and the more that they could leverage their write-offs, the less they would have to pay Uncle Sam. Penn Square was also a dinky bank as far as banks go, and had a lending limit that could not have accommodated the drilling of one deep well. Thus, the bank had to either find a way to accommodate the real players or concentrate on the mixed bag of not quite serious folks whom they were attracting.

It did not take the aggressive new management of Penn Square long before they found the right way to position themselves. Being in the heart of oil country, they could act as an introducing agent to other banks and sell them their overage loans. Thus, they could get into a market where there were real players. This seemingly did a couple of really good things for banks like Chicago’s Continental and New York’s, Chase. Both banks fancied themselves as oil experts. All banks in the country were saddled by branch banking restrictions. Thus, by buying loans instead of making them, they would effectively acquire a branch in Oklahoma without evading the Banking Regulations. In addition, who would know the oil field in Oklahoma better then a bank that is right there? Little did they realize that his was at best wishful thinking.

In the meantime, Jennings did the same thing that Lincoln Savings and Loan along with others had attempted. He set up a department to market jumbo CDs that paid substantially higher interest rates than the garden variety. Considering the hot oil market and the fact that Penn Square’s clientele was really the larger money-center banks, it didn’t take a long time before a massive amount of this highly questionable paper was regularly walking out the door.

Penn Square soon stopped taking any part of the loans they were putting on, and concentrated on turning them around to the city slickers for the one-percent they got for making the loan and some additional vigorish that they received for servicing the debt. However, Penn Square was not being at all careful about who they were loaning to and why. Money was available from the “big city boys” for all comers and rarely if ever was an oil loan refused. Thus, Penn Square had a severe conflict of interest with their loan buying bank customers. However, Penn Square saw this deal is the second coming and foolishly, the money center banking people totally relied upon Penn Square for their due diligence. Little did they know at the time that the people at Penn Square Bank had never even learned how to spell the word.

To Penn Square, servicing a loan meant keeping the pot boiling and getting the loans out the door. Loans were sold where literally none of the documentation had been checked, there were contracts where documents were missing, there were agreements that were never signed, there were contracts where no UCC filings had been made., Jennings would make oral commitments without any paperwork, fund the loans and thus thereafter the borrower had little interest in coming back to the bank to complete the paperwork. He felt that he probably wasn’t even liable because he never signed anything and maybe he was right. Moreover, the unfinished loans could not be resold in the secondary market because of among other problems, their lack of uniformity.

If things looked bad at this point, they soon got a lot worse. When the loans started backing up, Penn Square didn’t want to ruin their reputation by having their bank customers get stuck with defaulting collateral so that a determination was made by the bank that rather than have anyone ever know that a Penn Square loan had gone bad, the bank would make the payments for the client and the funding institution would never be the wiser. Continental and Chase never received to their knowledge, a bad Penn Square credit, which made them even more contented with the situation and they clamored for more and more paper. Penn Square on the other hand didn’t have all of the ready funds to take on what was becoming an avalanche of defaults, so they kicked the plot up a notch by making a new loan to each defaulter, and selling that paper to the money center banks as well. Thus, they had created their own cache of money to repay whatever went bad by sticking the banks that didn’t know that there already had been a default with more paper from the same bad credit. “This was surely a wondrous idea,” said Jennings in a moment of self-glorification.

It was becoming readily apparent that some of Jennings’ loan officers just couldn’t get the paper out the door fast enough and they were replaced with people that would not need to carefully document their work. The top dog in Jennings oil and gas department became Bill Patterson ([69]) who although he was still in his twenty’s was entrusted with the entire oil and gas department accounting for over 80% of Penn Square’s business. This was a man that had been called “Monkeybrains,” by his friends. However, Patterson married into a lot of money and the family was in Texas style banking. He was able to get a job working for one of his father-in-law’s institutions but was not allowed to make a decision, loan out money or talk to clients of the bank. Jennings must have seen something in Patterson and brought him aboard at Penn Square with great fanfare. Patterson played his role for Jennings to the hilt, Patterson soon became renowned by one and all for his idiosyncrasies, such as “wearing a Mickey Mouse hat while doing business with prospective clients and drinking beer from his cowboy boots at swank Oklahoma City watering holes.” ([70]) His father-in-law, we are told, started celebrating the moment Patterson left his bank, and considering what happened, for all we know may still be celebrating the event today.

Paterson did what Jennings wanted; he ran a truly loose ship. One of Paterson’s traits was to never check on whether the money that the bank loaned went for what was agreed to in the loan documents. When the bank closed, in the cases of many loans that had been made, you couldn’t even find the drilling rig, the pipe, or the location of a well. Paterson always said that he was loaning with his heart and no one could argue with that statement. If that hadn’t given the bank enough headaches, the oil blip did not last forever because of excellent conservation measures put in place by the administration and over-production by OPEC, oil prices tanked. Even the occasional, well-documented, legitimate loans soon became an anathema to Penn Square and their bank partners. The world had gone from energy short to dramatically over produced in just a few short years. Many projects, especially those that entailed deep drilling, soon became economic dinosaurs.

The bank examiners and regulators were aware of what was happening in the oil patch and forced Penn Square to tighten its controls over loans. They also demanded that the bank hire a full-time professional president, increase its reserves, bring in addition executives with substantial banking experience, and tighten up lending requirements. However, the game was already a little “long in the tooth” and the regulators demands were too little and too late. Seeing the handwriting on the wall, Penn Square attempted to lend themselves out of trouble and only made things a hundred times worse. The quality of borrowers continued to decrease and loan defaults went through the roof.

The borrowers were also hip to the fact that when you owe a bank a small amount, they are your creditor. When the loan becomes larger, they become your partner. Many savvy Oklahomans kept edging their loans right into the stratosphere and Paterson was always quick to oblige.

Penn Square’s money also went to political contributions. One the large borrowers from Penn Square was J. D. Allen, the co-chairman of the Finance Committee of the Republican National Committee. Allen went bust after Penn Square collapsed and his debts in bankruptcy exceeded $300 million. Continental or Chase must have eventually discovered that their money was literally given away in political contributions. Robert Hefner III, listed as one of the richest men in America, was another major customer of the bank. When the banks started to look for collateral to grab, all they found was a man whose debts exceeded his liabilities.

Continental Bank of Chicago, who was on the receiving end of the Penn Square fiasco to the tune of $1 billion, went belly up in large part because of that and because the bank was determined to be “too big to fail” it became the recipient of a $5 billion government bailout. The bank was never the same after that and even today, its character is drastically altered. Seattle First National had to be merged with Bank of America in order to save it. Chase had other problems that made those at Penn Square seem almost incidental but managed to get by because of a much larger capital base. Penn Square and it commando loan officers certainly left their mark on banking in the United States.

By the spring of 1982, regulators came back to Penn Square for another look at what was going on. What they discovered was literally unbelievable. The bank had now gotten into so much trouble that the Federal Reserve arranged an emergency loan for the bank. This gave examiners a chance to get some breathing room while they took a more critical look. It was determined that there was literally no helping the bank and when Penn Square’s doors were closed by the FDIC bank examiners on July 5, 1982, the bank’s total assets had risen from $29 million in 1974 to over $500 million at the time of its closing and it became the seventh largest shuttering of a bank by that institution. More startling yet was the fact that a bank with only $500 million in assets could lose more that $2 billion, the biggest single bank loss in the history of the United States to that time.

Arthur Young had been the auditors in the bank’s earlier days and for the years of 1976 through 1979 they gave the bank a clean bill of health. In 1980, the auditors did not like what they were seeing and qualified its audit relative to whether or not loan reserves were sufficient to cover potential problems. Young found that the paper work backing up the bank’s loans was literally a mess. Jennings was not at all pleased with Young’s decision to qualify their opinion and summarily dumped the accounting firm and replaced it with Peat Marwick and Mitchell.

We know that it represents good business practice for the incoming accounting firm to check with the outgoing firm to find out what the relationship was between the client and the accounting firm and why they were leaving. At this point we get two totally separate stories. Peat Marwick stated that they had made such an inquiry and were told in no uncertain terms that Young had told them that the company was “free of significant problems.” Young’s position, which can’t really be refuted, is the fact that they had qualified the audit and whether they brought it to Peat Marwick’s attention or not is really not an issue. Young really couldn’t do more to wave a red flag than to qualify their opinion.

In spite of the knowledge that they may be stepping on a powder keg, Peat Marwick moved into the breach. They joined the team just in time to be hit by lightning and as such, they came in for some really rough treatment when congress tried to figure out what had occurred. Peat Marwick enraged the House of Representatives by making the statement that their audit (which had been clean) was intended only for the bank’s directors. Yet various members of the house including a usually calm Fernand St. Germain, Chairman of the investigation reacted violently. He made the following comment:

“You are not aware of the fact that the people at Penn Square dealing with brokers gave your reports … to people, credit unions, S&Ls around this nation who put enormous sums of money into this institution based on your audit reports, since that was all that was available… Did it come as a complete and total surprise to you, like the fact that when you get to be 10 years old you find out that there is no Santa Claus?”

Naturally, the Peat Marwick and Mitchell partner that had given the stunningly imbecilic response to the House Committee had a really bad hair day. Peat Marwick’s situation is doubly troublesome because Arthur Young & Company who had been doing the audit pre-1980 had determined in 1980 that they would be issuing a qualified opinion. In 1981, Jennings fired Arthur Young and hired Peat Marwick. Peat Marwick was intimately aware that the reason that Young wanted to qualify the audit was their opinion that loan loss reserves were substantially low. This in turn meant that expected loan failures, especially from Young’s point of view, were heading skyward.

Peat Marwick did not find doing Penn Square’s books clear sailing. As a matter of fact they were bothered enough by the condition of the bank’s books and records to tell the Board of Directors at Penn Square that they had better get their act together. However, in spite of that, Peat Marwick neither qualified their opinion, footnoted the financials nor informed the shareholders. A discussion on that subject was conducted during a meeting of the congressional subcommittee examining the events leading to the Penn Square debacle. This particular skirmish was between Congressman George Wortley and Peat Marwick’s Jim Blanton and it was indeed enlightening:

Congressman Wortley: Were Penn Square’s internal controls adequate?

Mr. Blanton: No, sir. We don’t believe they were adequate.

Congressman Wortley: Well, did you criticize them in the public statement?

Mr. Blanton: No, Sir.

Congressman Wortley: You only criticized them in the management letter?

Mr. Blanton: That is correct.

Congressman Wortley: Do you think that is fair to the public? And is that a custom of the profession?

Mr. Blanton: I am not sure that I can determine what is fair or unfair to the public. I can say that it is a normal procedure to issue a management letter, and that we do not address in the financial statements or in footnotes all of the problems of a client.

Congressman Wortley: Well, do you not feel that you have a responsibility to someone other than your client, in this case Penn Square? Is the whole purpose of an audit not to make certain that things are verified and the public is adequately informed of it, and shareholders and investors and depositor?

The Office of the Comptroller of the Currency (OCC) was also introduced into the Congressional testimony and it certainly was not helpful to Peat Marwick’s position in view of the fact that both the OCC audit and that of the accounting firm were undertaken simultaneously:

“The unqualified opinion was rendered despite the identification of excess collateral exceptions, discovery of incidences where the bank was making payments of principal and interest to the correspondent banks on certain participations without first receiving payment from the borrowers, and acceptance of a reserve for possible loan losses which was deemed inadequate by the examiners during their review of the loan portfolio.”

Not only did Peat Marwick take the account, but they gave Penn Square an unqualified report card. Moreover, they did it at a time when Peat Marwick’ s Oklahoma City partners had two million in loans outstanding to Penn Square and a line of credit of a million dollars. Clearly, this represented an unacceptable conflict of interest, but that didn’t seem to bother the Peat Marwick people in the least. Penn Square did make an effort to get rid of the loans and sold them off, but four days before the bank closed, they were back on the books. I must say that we are speechless, but as usual, the accountants that do the kind of work Peat Marwick did in this case seem to always pay a price.

In the meantime, the shareholders got even, they filed lawsuits totaling over $1 billion against the Peat Marwick firm and charged them with just about every crime in the book. The U.S. Department of Justice filed actions against a dozen of the accountants current and former employees and to wrap up the dirty details, the FDIC sued Peat Marwick for $90 million. All of the incidents above were settled and the exact details are not public information. On the other hand, there isn’t much question that Peat Marwick paid dearly for its short-term romance with the people at Penn Square Bank.

Patterson was found guilty of twenty-six counts bank fraud. A similar case took place in federal court in Chicago, which ended in a mistrial. When the day was over and a plea bargain had taken place, Patterson pled guilty of misapplication of banks funds a was sent to federal prison for two years. An associate of Patterson also was sent to jail for similar bank related problems.

Ponzi Schemes For Better Or Worse

Trust Me, I Have This Plan And We Can Really Clean Up

Barry J. Minkow’s mother was a telephone solicitor for a cleaning company and that was how, at twelve years old he started learning about the restoration business. While not yet in his twenties, he sensed an opportunity to become wealthy from that business and became what is known as a rug sucker, someone that goes into, usually a home, makes a lowball estimate on a cleaning job, takes the rug upon striking a deal and when the price is jacked up later the customer either has to pay or is out one rug. The lad was already involved in all the niceties of life, check kiting, forgery and theft from insurance companies by making phony claims. This was a dangerous means for a kid to be making a living and Barry believed that there had to be a better way.

Barry gravitated to a derivative of that business. ([71]) By specializing in rug cleaning and insurance restoration (after fire or flooding had substantially damaged substantial portions of a building), he would be satisfying a lucrative niche. He needed credibility, someone of standing that would vouch for his business acumen and success. He found the sucker at his Los Angeles health club; his name was Tom Padgett, an insurance claims adjuster who Minkow agreed to put on his payroll at $100 per week if he would confirm that ZZZZ Best was legit. While still in high school, his vision flourished. Minkow already had hundreds of employees within a company with over $5 million in gross revenues. Minkow had named the company ZZZZ Best and he was the youngest chief executive officer of a major company in the United States, and soon had a luxurious home in a Los Angeles Suburb and naturally, a shinny new red Ferrari.

Already on a roll and with the motto, “The sky is the limit,” Minkow became a much in demand regular on the nation’s talk show circuit where he chided people to try and accomplish more. Little did they know how he had achieved his success. Minkow’s next move was to take the company public but he had to establish credibility in stages. Although he did not think of it at the time, this move was making Minkow subject to the security laws of the United States and things soon became a little tricky. He needed an independent auditor to do his books and hired an accountant by the name of George Greenspan; when Greenspan naively called Padget to confirm that ZZZZ Best indeed had restoration contracts the circle had closed when Padget gave accolades. Now he had a set of books that would stand up to a degree of scrutiny, but he needed somebody more prestigious than Greenspan if he was really going to make a major score. With that in mind hired the prestigious New York Law Firm of Hughes, Hubbard and Reed and dumped Greenspan for the Big Eight accounting firm of Ernst and Whiney to give his young company the additional cache that he believed that white shoe, top drawer professionals on your payroll has a tendency to do.

ZZZZ Best’s offering memorandum indicated that in 1986, Minkow already had almost $25 million in "insurance restoration" business on the books scheduled for early completion, from thirteen projections ranging from hundreds of thousands of dollars to over $7 million. Minkow offered the public $13 million worth of stock, which was sold as a unit containing three shares of common stock and a warrant to buy an additional share. The offering went public at $12 bucks, which valued each of the shares at a tad less than four dollars, if you assume the warrant had some nominal value.

By 1987, the company’s earnings from these projects were estimated by internal ZZZZ Best auditors at $40 million, and Minkow was being favorably compared to Watson (IBM) and Land (Polaroid) in terms of business acumen. His company became known as the General Motors of the cleaning business. As his success seemed to continue unabated, Wall Street embraced Minkow. The price of ZZZZ Best stock soared, increasing Minkow’s net worth at one point to over $100 million.

The problem with this story is that there was nothing much real about Minkow except his gift of gab and a startling imagination. His company in turn was almost a total fabrication. The preliminary prospectus that he issued made the claim that: "The company began its significant insurance restoration business in April 1985 and since then has performed restoration service for buildings ranging in size from 100,000 to 750,000 square feet. Restoration contracts, all of which are performed on a fixed price basis, have ranged from approximately $150,000 to $7,000,000. The Company has restored buildings located throughout California and in Arizona, with the majority being in Southern California. As of September 30, 1986, there were 13 insurance restoration projects in progress, under contracts aggregating $24,362,000 (including seven aggregating $15,068,000 through joint ventures), all of which are scheduled for completion within six months."

This totally illusionary restoration business played great on Wall Street and investors loved the concept. There was not one iota of truth or a scintilla of evidence that anything the Minkow had said was true, but people wanted to believe. He had been able to convince both his lawyers and his accountants that a thriving business existed when in reality, it was totally a figment of Minkow’s fertile imagination. Statements of Wall Street brokerage houses like that of Ladenburg, Thalmann & Company were repeated everywhere; "ZZZZ Best meets the criteria of a company that has the same potentially explosive sales and earning characteristics and market opportunities that permitted McDonald's and 7-11 to reach the success each has achieved--sales of over $1 billion in a relatively short time from inception." He was even given the highest honor by the prestigious association of Collegiate Entrepreneurs calling him one of the leading young business founders in the United States.

His fraud cost the public over $70 million and Minkow was sentenced to 25 years in jail and fined $26 million. When accountants (at the time a big eight firm) Ernst & Whinney required on-site investigations of the restorations in progress, Minkow arranged for Ernst and Whinney to inspect buildings that had nothing to with ZZZZ Best. He would bribe workers on the premises to go along with his fabrications or in the alternative, he would rent empty buildings and create literally a “Hollywood set” of restoration work in process.

On one occasion, he was told by the attorney's and accountants that they would be examining a work in process at a restoration site in Sacramento. Not having any restoration sites available because they didn't exist, it was no big deal for him to rent an old building for the day and bring in a number of people to act as though they were doing some work. He dressed them up in cute little ZZZZ Best uniforms and the scam went so well that a totally naïve Larry Gray, a senior auditor with Ernst & Whinney gave the following report:

"We were informed that the damage occurred from the water storage on the roof of the building. The storage was for the sprinkler systems, but the water somehow was released in total, causing construction damage to floors 18 and 17, primarily in bathrooms which were directly under the water holding tower; then the water spread out and flooded floors 16 down through about 5 or 6, where it started to spread out even further and be held in pools."

"We toured floor 17 briefly (is currently occupied by a law firm), then visited floor 12 (which had a considerable amount of unoccupied space) and floor 7. Morze pointed out to us the carpet, painting and clean up work, which had been ZZZZ Best's responsibility. We noted some work not done in some other areas (an in unoccupied tenant space). But per Mark, this was not ZZZZ Best's responsibility; rather it was work being undertaken by tenants for their own purposes"

"ZZZZ Best's work is substantially complete and has passed final inspection."

Compare the pathetic report by Gray who had examined a building that had literally nothing to do with ZZZZ Best. Then looked at work that ZZZZ Best had fabricated and wrote a glowing report on a building that was hired by the day; with the report given in Congress by Mike Brambles a detective with the organized-crime intelligence division of Los Angeles Police Department on the same building. He is being interrogated by Representative Ron Wyden who is a member of a subcommittee investigating the affair:

Wyden: Did the building ever have any damage, or could they found that out?

Brambles: The building did not sustain any fire or waste damage. We ascertained that by checking with the building department of Sacramento in determining that in the previous two to three years there had been a very minor amount of construction work, that being only cosmetic in appearance and not involving fire and water restoration work.

Wyden: How long did it take your people to find out about the condition of the building?

Brambels: Approximately ten minutes at the building department and then roughly one or two hours at the restoration site.

In some instances, Minkow and his associates even gave the addresses of empty lots to Ernst and Whinney, believing that based on recent history they would not show up. Luckily for Minkow they didn’t.

Outsiders were soon tipping Ernst & Whinney and local newspapers that ZZZZ Best was a fraud. However, with the first commandment of accounting being "hear no evil, see no evil, speak no evil," they did nothing about it. Even worse, one Norman Rothberg told Ernst and Whinney in no uncertain terms that the ZZZZ Best Sacramento restoration site was a total fraud. Shortly thereafter, Rothberg had been properly paid off by Minkow to the tune of $25,000, he recanted his story. This incident did not cause Ernst & Whinney to blink an eye.

Ultimately, the evidence could no longer be denied and even the accountants finally saw a massive fraud looming. Ernst realized that it had been taken and resigned. Congress put Ernst and Whinney's Gray on the grill and Representative Lent had an interesting experience in interviewing him.

Lent: It came to your attention that Rothberg was talking about a certain company, namely ZZZZ Best.

Gray Yes, sir. Yes, sir.

Lent: He was talking about fraud at ZZZZ Best and he mentioned that the Sacramento job was a phony job?

Gray: That is correct. We heard that on May 19.

Lent: You had been out there and you had walked that job, had you not?

Gray: That is correct, sir.

Lent: So you must have wondered whether you had been taken for a ride, whether you had been deceived, and it is logical to assume that you might have gone back there and looked at it over again, or made some further inquiry of the building department, the property owner, the contract, or other contractors, et cetera? You did none of those things?

Gray: No, sir.

In easily the most bizarre event in the annals of accounting, when Ernst & Whinney resigned, Minkow replaced them with prestigious Price Waterhouse, which, contrary to every accounting tenet, made no concerted effort to determine the reasons for their predecessor’s resignation. ZZZZ Best indicated that the auditors found no fault with the company's securities filings. Ernst and Whinney added insult to injury by failing to disclose their reasons for resigning.

Worse still, once they were hired, Ernst & Whinney signed non-disclosure agreements that would have prevented any successor accounting firm or anybody else, for that matter, from finding out the location of ZZZZ Best projects that they had visited. Moreover, they gave written promises not to "… make any follow-up visits to the Project…."

"We will not disclose the location of, or any other information with respect to, the Project or the Warehouse, to any third parties or to any other members or employees of our firm; We will not make any follow-up telephone calls to any contractors insurance companies, the owner of the Project or of the Warehouse, or other individuals involved in the restoration projection;

We will not make any follow-up visits to the Project or the Warehouse, unless specifically authorized by the Company and Interstate Appraisal Services ("Interstate") [company set up to appraise ZZZZ Best renovation projects]."

The confidentiality letter raised more questions that it answered. One would wonder how you could check out whether something is real or not if you could only visit the site with the permission of your client. An independent accountant cannot do his job and keep the public faith at the same time, if no follow up calls can be made to contractors, insurance companies, the owner of the Project or the Warehouse unless authorized by ZZZZ Best. If this is the way the practice of accounting works then the work product has to be laughable.

Another dialog between Congressman Wyden and Mr. Gray of Ernst and Whinney, which should have so embarrassed the accounting firm that they should have closed their doors on the spot:

Wyden: "We go back to these confidentiality letters. They were signed by you personally, Mr. Gray, and they were signed also on behalf of Ernst and Whinney regarding the visits to phony insurance restoration jobs, one in Sacramento and San Diego. You mention personally in these letters on behalf of the firm that you won't disclose the location of the job sites to any third parties including other members and employees of the firm. You go on to proposals that you won't make any follow-up phone calls to any contractors, insurance companies, building owners, or other individuals involved in restoration projects. "

"I guess what raised my curiosity about these confidentiality letters is that I wonder how, after you signed them, you could then go out and independently verify material information given to you by ZZZZ Best management".

Gray: "The signing of the letters does nothing to restrict what I wanted to perform. We--in fact it was done at the client's request. We get requests from our clients many times to confirm our confidentiality relationship. As I stated earlier, we have the overriding responsibility to keep our clients' information confidential. So them asking me to do this, my purpose was to go on the site and see the work done. It did not restrict me being able to perform that and I did go on site to see the work done, and Congressman, if I would have had any questions that came up in the course of that review, I would have pursued those questions and gotten answers to satisfy myself, or I would have quit".

It is most interesting to listen to this total bilge coming out of Gray's mouth. We are not talking about trade secrets or a list of confidential customers, we are talking about imaginary insurance restoration projects that in their magical state have been for the most part completed. What were the odds of another restoration job occurring on the exact spot as the previous one? What’s so confidential? In addition, in the one out a million chance that the place flooded again, do you think for one minute that ZZZZ Best would stand a chance of getting the work after screwing things up the first time? At that point, the odds would stand directly at zero. Gray must have held a very low opinion of the intelligence of the Congressional investigators.

Wyden brought in Brambles once again to refute Gray's fabrications.

Wyden: "I just want to pin down that in San Diego, as at Sacramento, we had a situation where the building really didn't have any damage, and it wouldn't have been hard, as you said your own people could do, to determine that, is that correct?"

Brambles: "Yes sir, what we did was, we went again to the building department of San Diego and checked their construction permits on file. What our investigation determined was basically that the application for cosmetic construction had been applied for and granted by the city of San Diego. Their permit was paid for, but it was never inspected by the building inspectors, it was never finalized."

"That took us approximately ten minutes to do that. We also checked to determine whether or not the building had received damage in the area of fire and water, and that turned up negative results as well."

Wyden: "…what you have told us is that essentially in just a few minutes your own people could determine the job was a fake. But somehow the auditors didn't discover it, and it seems amazing…" ([72])

In Dallas, ZZZZ Best did an even better job of confusing the auditors. They told the accountants they were getting a lot of business in Texas and needed a warehouse in Dallas. When ZZZZ Best advised them that the warehouse was open, the auditors expressed an earnest desire to check it out. In typical fashion, the company rented an empty building for the day and then shipped a bunch of recently designed ZZZZ Best uniforms and other items with which to stock the warehouse. A telephone switchboard was installed, and when the people from the accounting firm were brought in to visit, everyone tried to look busy. Vehicles were in motion, products were being moved, trucks arrived and departed and the switchboard lit up like a Christmas Tree; not surprisingly with inquires from companies in the area wanting to use the services of ZZZZ Best for their insurance restoration work. The scene had all of the earmarks of Class B Hollywood movie. Embarrassingly, Larry Gray was once again the fall guy for this cheap stunt and as usual, he fell for it hook, line and sinker. He even reported back to Ernst and Whinney that the warehouse would have to be expanded due to the increased business.

Although it was hardly possible, Gray had pulled the wool over his own eyes even further when ZZZZ Best gave him the unconscionable story that he could have the address where work was currently being conducted on a restoration, but they indicated that he couldn't visit it because it was a hardhat area. You would think that these guys were working with atomic bombs, not with paint, brushes and brooms, In reality, the address was that of an empty lot that ZZZZ Best had once again rented for the day. Gray, who had screwed up every other portion of his due diligence campaign, once again fell for the ZZZZ Best "Red Herring.”

Gray was so incompetent in his investigation of ZZZZ Best that he should have been arrested for criminal stupidity. Not only did he set the all time record for negligence, but, in addition, everything that occurred was theoretically a red flag that should have caused him to realize that additional checking of the client should be in order.

I mean, a hardhat area in the rug cleaning business. We believe that Gray deserves the "Millennium Incompetence Award.” This, too, is a great honor, as it is only given once every hundred years. There have been centuries where there has not been anything done that was stupid enough to qualify for the prize and the committee chose not to nominate anyone. Gray's incompetence was not even open to question and we are proud of the that he was the first candidate since Pontius Pilot to win a unanimous election.

This puts Gray in the same league as previous winners. You are all aware of their names; they are legion, but for posterity's sake we will remind you of some of the recent winners. The most recent was the U.S. Senator who, in the later part of the 19^th century, wanted to close the patent office because in his opinion it had become a white elephant due to the fact that everything that had ever or would ever be invented had already been patented. He simply felt that there was nothing left to invent. Marie Antoinette won the award in the previous century for her famous slogan, "let them eat cake.” This was done when a starving population was begging for food because they had not had a square meal in months. This award had been given because it shows how close Marie was to her subjects and what a caring person she really was. The previous award was a one-time situation and uniquely, we gave a global award for those that wanted to burn Copernicus at the stake for his concentric theory of the universe. Although Gray has never achieved the notoriety that his predecessors received, we feel certain that time will reward Gray with fame as word of his complete accounting incompetence spreads.

ZZZZ Best did not go quietly. Many Congressional investigations were launched into the question of how this fairytale could have been constructed by an a literally prepubescent, inexperienced teenager. Moreover, the even more burning issue was how this same teenager, as we have seen above, could foil the due diligence process of the regulators, the accountants, the lawyers and the stock brokerage community? The verdict seemed to be that without the incomprehensible ineptness of the accounting firm (Ernst and Whinney), the fraud couldn’t have gotten off the ground and that Ernst & Whinney had failed in their role of independent outside accountant and their successor, Price Waterhouse compounded the worst job of accounting since the dawn of time.

John Dingell, who headed a House committee charged with looking into this type of fraud, literally couldn't believe his ears when the people from Ernst and Whinney started to testify. He already knew that someone had blown the whistle on ZZZZ Best by informing the accountants that the company was riddled with fraud. The newspapers had taken up the cudgel and the company was springing leaks all over the place. Dingell was trying to get a handle on whether the outside auditor, Ernst & Whinney, was representing the interests of the company or those of the public. He was interviewing Larry Gray who we have seen in action previously and Leroy Gardner, another principal of Ernst & Whinney, and seemed to get a lot more than he bargained for. You can see how the scenario unfolds;

Dingell: What happened to the stock during this period between June 2 and the date of bankruptcy on July 11? Did it go up or down?

Gardner: I didn't follow the stock.

Gray: It declined with the adverse publicity that was coming out.

Dingell: As a matter of act, it lost about fifty percent of its value?

Gray: That may be the figure. I cannot recite the figures.

Dingell: The price per share on June 2, when you resigned, was around six or seven dollars. When the bankruptcy took place, which our colleague indicates was July 11, the stock fell to less than one dollar, something on the order of fifty to seventy-five cents; is that right?

Gray: I assume.

Dingell: I am wondering, it there some responsibility on the part of Ernst & Whinney to shareholders and other investors in this firm, or do you just have a peculiar special relationship with the firm?

Gardner: No, no. Our responsibility is to the public, to the investors.

Dingell: To the public and to the investors. How did you exercise that here? You initiated no contact with the SEC until July 16.

Gardner: No, no.

Dingell: Your contacts with the SEC on the seventeenth and nineteenth were initiated by the SEC. You did not initiate that contact…

Gardner: I am sorry.

Dingell: The SEC initiated the contact with you on the seventeenth to the nineteenth. You were sitting tranquilly by, informing your former client, during that period of time?

Gardner: That is not correct, sir.

Dingell: Your first communication to the SEC was on July 18?

Gardner: After we talked with the SEC in early July, there was no point ---

Dingell: They initiated that discussion; you did not?

Gardiner: That is correct. We knew at that point what they knew.

Dingell: Happily they called you up. But your first communication to the SEC was on the sixteenth. If the SEC hadn't called you on the seventeenth or nineteenth, would you have called the SEC?

Gardner: Well, the fact is they did call us and they already knew the allegation.

Dingell: I know they called you. We are in agreement on that. That point is not in controversy. If they, however, had not called you on the seventeenth or nineteenth, would you have called them?

Gardner: I can 't speculate about that.

As we can see from the above, one way that independent auditors can screw up is by not specifically identifying all of the assets that are referred to in the company’s financial data, thus is if the asset supplying the income does not exist, the income cannot exist either. Failing to consider all of the diverse sources of revenue and adapting accounting procedures to pasteurize the data so that it remains in balance becomes a product of consistent practice. But unreasonably changing the form of the data also distorts the ultimate product by putting it into a appearance that is not realistically consistent with the general business of the account being audited. This lack of consistent product tends to distort the facts.

What was particularly grating in this case was the total indifference of the accounting firm to the public interest.

Once again, Congressman Dingell gets the last word with the accountants and our kudos as well:

"…we keep seeing this tremendous number of cases where supposedly men of goodwill are diligently watching and doing their job, but the public is being skinned, corporations are going under, rascals are prospering, honest men are suffering and the situation seems to be not improved…We have this wonderful relationship that seems to exist between the accountants and the corporations."

At the end articles started appearing in local papers questioning the company’s veracity. In particular, the Los Angeles Times started running a series of stories inspired by a woman that had been ripped off by Minkow at an early stage in his career. She had been the victim of a markup on her credit card by Barry and from that date on she kept track of everyone that she could find that had suffered a similar fate at his hands.

Her actions created a collapse in the house of cards. Within a short time, ZZZZ Best was hit with shareholders derivative actions, which named, the accountants, the lawyers, the brokers and the company. Everyone coughed up a chunk of money to make a non-public settlement, which totaled approximately $35 million.

The company was a sham and an interesting observation showed that while the company had a market capitalization of $220 million in July of 1987, an auction of its assets brought only $62,000. ([73]) As for Minkow, he was convicted on 57 counts of securities fraud and received a twenty-five year prison sentence for his trouble. While in prison, Minkow through a correspondence course received a bachelor’s and master’s degree in religion from the university founded by Jerry Farwell. He was released for good behavior and soon married a young lady that he met through an associate of Charles Keating who was simultaneously doing time for his part in the Lincoln Savings debacle.

Ultimately Minkow became the senior pastor in a non-denominational, San Diego church. Barry once again has climbed aboard the lecture circuit and is now telling FBI agents and CPAs how to ferret out financial fraud. In his lectures he makes an interesting point. “The average restoration job is $1,000 with a profit margin of 8 or 9 percent. “We were reporting an average job of $3 million with margins of 30 to 40 percent…and we got three clean opinions.” ([74])

Bennett Funding, Ponzi Would Have Been Proud

New Era’s (P. 246) Bennett, was a swindler with the same last name was around about the same time as Patrick Bennett that brought us Bennett Funding. We will be seeing more about him down the road and for whatever damage he was ultimately able to do, was literally small potatoes compared with Patrick Bennett, Bennett Funding Group of Syracuse, New York who is unrelated to the Bennett of New Era. When the smoke had cleared in what the government has called the biggest pyramid scheme in American history, $1 billion was owed to 200 banks and the 12,000 investors that had put money into the venture, which dealt in office equipment leases. The trustee has reported that he is unable to find any trace of over $600 million of the stolen money.

Yet, Bennett Funding was voted the business of the year in Syracuse. With that in its background, how could the company be all bad? This Bennett was engaged in a classic Ponzi scheme, as was his predecessor. The only difference between the two was the fact that when the smoke had cleared, at New Era, there was something left, at Bennett Funding, most of the money had gone into bizarre investments and high living by the principals. Bennett’s dad had started the finance company and for many years, it had been thought of as a legitimate leasing institution. The son, Patrick, was able to play upon his dad’s reputation as an astute and honest businessman, and in doing so led the sheep out for a massive shearing.

According to the SEC, Mr. Bennett was selling investors either fake leases or leases in which as many as seven people, each unwittingly held simultaneous interests unknown to each other. The leases were basically on small items such as photocopiers and fax machines. Because of the fact that the people leasing the equipment were primarily government agencies, it was not hard to discount this highly rated paper. If this wasn’t enough, Bennett first borrowed as much money as he could from banks with the leases as collateral, thus giving the banks first lien on any recovery. There were no less than 245 community banks that got taken in the fraud and among them were the Hibernia Savings Bank of Quincy, Mass., LSB Financial Corporation of Lafayette, Indiana, and Mid Am Inc. of Bowling Green, Ohio. For the most part, these institutions accepted the paper at face value and never looked beyond the agreements they were holding. After the banks had already taken down the paper, Bennett thought it good business to resell the same paper all over again to individuals.

“Richard Breeden, the former chairman of the Securities & Exchange was appointed the bankruptcy trustee to overseeing the mess.” ([75]) One lease, maybe more was sold seven times.” ([76]) Some leases were totally fictional and were created “Equity Funding” (P. 144) style at the Bennett offices. So far, over $205 million has been recovered but because of prior liens, all of it goes to the banks not the individual purchasers. The Trustee, Richard C. Breeden, stated that although the company was taking in $13 million a month in lease payments, it was paying investors $30 million in principal and interest.

Breeden went on to say:

“The money all went into a giant “honey pot,” which Patrick Bennett, the son of the founders and the chief financial officer, could use as he wished. Some of the money went to pay off early investors; the Bennett family also used the money “to plunge very heavily into gambling properties, and lost their shirt in every last one.”

What made this bizarre case a little worse than the others is the fact that instead of pleading guilty and blaming everyone else for the theft of so much money from so many, Bennett used the embezzled funds to purchase Vernon Downs race track. ([77]) As his wife continues to battle for control of the track, the horses keep on running as a grim reminder to investors of where some of their hard-earned dollars went. In the meantime Bennett remains free to pursue whatever interests he desires, while, Kenneth Kazarian, a Bennett lieutenant who lied to regulators while helping to cover up the scheme, pled guilty ([78]) and is awaiting a sentence that can put him away for as long as 30 years.

Additionally, eight others have been charged with criminal actions in the matter and five have already pleaded guilty. Among them are Michael A. Bennett, Patrick’s Brother, Charles Genovese, a partner in the accounting firm engaged in auditing Bennett’s books and Gary Pfeiffer, an attorney.

Patrick R. Bennett, the man that made Ponzi look like a piker, did not play well to the regulators. While his lawyers tried to convince the jury that instead of being a criminal, Patrick was really a clod who was so inept at business that he couldn’t get anything right. While this was undoubtedly true, it didn’t change the jury’s mind that he was also a crook. After he had finally been convicted during two trials on charges of bank fraud, money laundering, securities fraud, and perjury, he and his wife went through substantial machinations in attempts to hide their ill-gotten funds from the people from whom.

It is readily apparent that presiding Judge John Martin doesn’t particularly like Mr. Bennett and there seems no question that he has absolutely had enough of his continuing maneuvering. He offered Bennett’s wife, Gwen a strange offer that she can turn down or not as she sees fit. If, Gwen Bennett gives up the residence that she and her husband have been trying to shield from creditors, Judge Martin who apparently has some sentencing leeway, will give Patrick a solid 20-years in jail. If she does not give up the residence, Bennett will be sent to prison for 30-years. Keep tuned here to see what Gwen decides. With this bunch, you can never be quite sure. Judge Martin added the comment, “For me, one of the most devastating impacts for the investors is to see themselves living at poverty levels while Mrs. Bennett lives on a horse farm.”

We think that the judge’s temperament was determined early in the trial by Gwen when she indicated that she had never discussed the purchase of the “horse farm-residence with her husband. If the judge couldn’t believe his ears on that whopper you can believe that he went ballistic when she said the money for the purchase came out of joint funds in 1992 two years after the fraud started she went on to say that her husband had absolutely no knowledge of what she had done. Judge Martin had a little something to say about this in rebuttal: “The statements are absolutely incredible as well as false and perjurious.” He went on to deride several other statements that Gwen had ventured as “hogwash.” Well we can certainly feel good that the judge did not lose his judicial decorum over Gwen’s inability to distinguish the truth from fiction. Many in the court said that her inability to discern fact came from living with Patrick Bennett for so long.

Therefore, the question before the court is whether Patrick gets 20 years of hard time or 30 years of hard time. In either case, the sentence will probably set a record for white-collar crime. At the moment, the decision is solely in the hands of his loving wife, who, we are positive, will do the right thing by husband and all of the poor people that lost money in this fiasco. Let me tell you a little about Gwen to help you predict how she will vote. Patrick took her to Vernon Downs Race Track on their first date, his horse won and they both screamed. Her father was an equestrian, and her local restaurant catered to the horsy set. Vernon Downs was built in 1953, and is located in a magnificent area between Syracuse, and Utica, New York. It is a harness racing track and is three quarters of a mile around, an excellent size. The track opened to a rush, and during the glory years of the 60s and 70s, as many as 10,000 would show up for a night of innocent gambling.

Gwen Bennett was the guiding force when Vernon Downs’ incumbent management started botching up things. They were aided by alternative forms of gambling, such as the State lottery and off-track-betting parlors. On the other hand, the track had minimal overhead, no debt, and a solid portfolio of investments. It didn’t need a lot to survive. Patrick Bennett became the controlling shareholder in 1992 when he bought out his father and two other men. He relished the announcement that the Oneida Tribe was going to be opening up gambling a few miles away, and determined to erect a hotel that would accommodate people at the track and at the Indian Site. On the other hand, should he be convicted and sent to jail, the New York Racing Commission would more than likely yank his license. In late 1995, he transferred his ownership to a company controlled by the lovely Gwen. Strangely, he made her sign a promissory note for $1.9 million, a true bargain, but once in possession of the note he immediately resold it to a friend. Could that have ticked Gwen off?

In the meantime, she was now the owner of 54% of the stock in the track and Patrick Bennett started to talk to the other directors of Vernon Downs about letting Gwen get more involved. He told them that she had always loved horses, and that someone with so much love of the animals in the sport could never be a truly bad person. Logically, the track management retorted unmistakably that it didn’t want a lot to do with either of the Bennett’s at this juncture. Gwen, on the other hand may not have felt that her husband had espoused her caused quite strongly enough. Did she hold a grudge against Patrick for his inept handling of a board of directors of a company in which she herself owned 54% of the stock?

By this time, Mrs. Bennett was back working at a horsy restaurant in one of their hotels. She had plenty of time to brood about what had occurred, and things were not getting any better. When she was asked about how she was going to pay the note on her stock back from her restaurant salary and she indicated that it was going to be miraculously accomplished by dividends on her stock in the track. When she was informed that the track hadn’t paid a dividend in a number of years, she was not dissuaded. She indicated that she would find a way. Lawyers for the note holder pointed out that her business judgment was severely lacking considering the overall state of affairs that the track was in. Coopers and Lybrand the auditors for the track abruptly walked out as both the affairs of the Bennett’s and the handle at the track continued to slide rapidly downhill.

Gwen nominated her own board of directors to the track’s inner sanctum when she heard that the corporation that controlled Vernon Downs was going to borrow money without being able to pay it back. Her slate was literally a disaster. She nominated Robert McSweeney, the day manager at Comfort Suites Hotel, and Jeremiah Law, who was the owner of the Squat and Gobble restaurant where she had been a waitress. To say that track officials were appalled would be on of the great understatements of all time. Strangely, Neil Wager, the Long Island businessman who had acquired Gwen Bennett’s note on the track from Patrick also put up a slate and when the smoke had cleared, two of Mrs. Bennett’s candidates and one of Mr. Wager’s had been elected. The incumbent officers of the company, in a sly move tacked on three new seats to the board and returned their defeated candidates to office.

Gwen became frustrated, she had just removed them from of their positions with the track and indicated, “I did this because I cared about my community.” Strangely, this event didn’t occur when they got married nor did it take place in 1990 before the fraud started, this event occurred in 1997 after the regulators had already determined that Gwen’s husband had just outdone Ponzi in the fraud department. The lovely Gwen somehow was able to write a $4 million check to get a stake in the track through a small public company. Richard Breeden has stated that the $4 million represents money missing from Bennett Funding, but never mind.

Breeden had some additional, very logical concerns relative to the track; should control get into the Bennett’s hands, with all the to-do over Ponzi schemes, theft, embezzlement, and fraud, it may make it difficult to raise additional money to keep the track operating he rightly thought. Thus, the innocent, shareholders of the track would be caused even more substantial damage should this occur. As you can imagine, the scene became totally bizarre:

“Afterward, the lawsuits started flying. Mrs. Bennett, who has four more candidates she wants on the board, has sued in State Supreme Court in Albany to force the Vernon Downs directors to schedule another election. Mr. Breeden, the bankruptcy trustee, has sued in Bankruptcy Court in Utica to get control of the shares he says were really paid for by the Bennett investors. And last month, Mr. Wager sued Mrs. Bennett in Supreme Court in Minneola, N.W. on Long Island, saying that because she has defaulted on her note, the Vernon Downs shares really belong to him.”

“The race track remains in a financial bind. The Oneida County government has offered to lend the track money to preserve jobs, but not until the ownership issues are resolved. Track officials contend that no one will lend the track money as long as the Bennett’s are involved, and Mrs. Bennett says she can bring in local investors, but not until the current management is out. ([79])

Mrs. Bennett was not a happy person and she badly wanted her track. “I wish for the days when we were entertaining our friends, going to Vernon Downs and watching the beautiful horses race.” Apparently she thought long and hard and if it was going to be a choice of letting her husband spend an extra ten years in a jail cell or giving up her life style, she thought it best that he serve the extra jail time. She determine that the time would go by quickly for him there and in the meantime, even if she lost the track, she would have her horse farm and those lovely creatures to keep her company. On April 29^th, 2000, Patrick R. Bennett was sentenced to thirty-years in jail by Judge John S. Martin of United States District Court in Manhattan, one of the longest sentences in history for a white-collar crime. Good Going Gwen!!

Michael Bennett wore the mantle of deputy chief executive of Bennett Funding. His outside background was even more interesting in that he was a substantial backer in George E. Pataki’s run for New York’s governorship, was engaged in local real estate restorations and was a large donator to local charities. Michael Bennett was also looking for a quick way out of troubles and admitted that he had lied to the Securities & Exchange Commission when talking about the fact that the company had not used any accounting tricks or maneuvers to make the company’s health appear more robust than it was. When push came to shove, Michael A. Bennett pled guilty to perjury, obstruction of justice and conspiracy leaving himself open to 15 years in jail and almost a million dollars in fines.

Kenneth P Kasarjian was an even more interesting case in point. He was a Senior Vice President of Bennett and in that job, he was able to organize a network of brokerage firms to re-market their leases to customers who really didn’t know what they were buying. He was the man that was singularly responsible for raising a ton of money from individual investors so that the collateral could be sold at least twice. He was also the person that invented many of the shams and internal transactions that were geared at throwing the auditors off the track.

Criminality doesn’t come cheaply and Kasarjian was well paid for his efforts and among his other trophies was a home in Mahwah, N. J. that was featured in Architectural Digest. Kasarjian had borrowed the money from Bennett Funding to buy the house and when he saw that his mortgage would soon be uncovered if he didn’t do something, he came up with the only possibility, he totally destroyed it. After lying to everyone about the facts in the case, Mr. Kasarjian’s efforts were about to bring him up to 30 years in jail. When the enormity of the sentence dawned on him, he saw a vision and determined to set things straight. This included squealing like a stuck pig on his good friend Patrick Bennett.

Edmund and Kathleen Bennett were the founders of Bennett Funding Group and the parents of Patrick R. Bennett and Michael Bennett. They were not involved in the government’s case against their children but wanted to make sure that enough blame was placed everyone to totally muddy up the waters. They charged that Breeden was at fault because he had frivolously quarterbacked the case against the boys. They continued that Breeden had manipulated the group’s books so that the company would become insolvent. These bizarre statements were probably brought about by Mr. Breeden’s audacity in suing the elder Bennett’s, asking for the money back that they had illegally received.

What Patrick Bennett was thinking about when he embarked on his life of crime is beyond on comprehension. Sometimes when things go bad, there becomes a race to pocket as much money as possible before the law closes in. Investment schemes prey on the herd instinct; if your neighbor is doing well, you want to do well also. As we enter the global neighborhood, we all become each other’s neighbors and ostensibly successful ventures become popular at the speed of light. While Ponzi’s scheme affected primarily Boston, Bennett’s was basically confined to Upstate New York. Although Hoffenberg proclaimed his success internationally, it only effected investors within the lower forty-eight states. The days when criminal acts could be confined within national borders are over. With no competent watchdog on the net, people can be fleeced even before breakfast is served. The toll is already being taken; we just don’t know which schemes have succeeded and how much money has already been lost.

When the Securities & Exchange Commission got involved, the fur began to fly. Their complaint reads:

“The Commission’s Complaint alleges that Patrick Bennett, Bennett Funding Group (BFG), and Bennett Management and Development Corporation (BMDC) also engaged in numerous sham transactions that enabled BFG to issue audited financial statements for 1992 and 1993 showing it to be a profitable company, when in fact it was losing money. In 1992 BFG reported pre-tax income in excess of $2 million, when it should have shown a net loss of at lest $1.5 million. Similarly, in 1993, BFG reported pretax income in excess of $2.6 million, when it should have shown a net loss of at least $2.5 million. The complaint alleges that these transactions were facilitated by false invoices and other documents that Patrick Bennett caused to be created, and that Patrick Bennett and BFG lied to the company’s auditors to conceal the fraud. The Complaint alleges that the fraudulent financials were included in the offering documents provided to investors in connection with the sale of an estimated $150 million in notes. “

In addition, the SEC alleged that a total of $900 million was transferred to BMDC from BFG’s general operating account – an account funded, in part, with the proceeds of the sale of BFG Lease Assignments and Notes. The Complaint alleges that since 1992, BMDC has paid Patrick Bennett over $10 million, and BMDC has also paid over $30 million to various people and entities connected to Patrick Bennett and members of his family.

Moreover, you rarely see a major fraud in which an accountant does not feature prominently. In this instance, the guilty party was Charles Genovese, a name partner in the firm of Genovese, Levin, Bartlett & Co., who was named in a classic indictment containing forty-three counts of securities fraud for his roll in the Bennett Funding fraud. The final indictment pointed out that 12,000 investors and over 200 banks were fleeced while $700 million was being blithely stolen. “Genovese, allegedly conspired with Bennett Funding Group (BFG) on sham financial transactions designed to inflate BFG’s financial picture, and then tried to conceal those transactions from the Securities & Exchange Commission. If convicted, he faces up to five years in prison. “ ([80])

Toward the end of March, 1998, two additional accounting firms were brought into the witches’ brew of Bennett Funding. Arthur Andersen and Mahoney Cohen & Company were sued for substantial damages for their role in the mess. Anderson had earlier been an accountant for the company and had resigned.

Regina Really Didn’t Clean Up At All

Regina was clearly what you would call an old-line company having started out in 1892 in the business of manufacturing music boxes. When technology turned the corner, Regina hopped on the electric broom business band-wagon and literally ended up owning that industry. Although they were not setting any sales records, the company was indeed prospering. Regina was owned by General Signal Corporation, a conglomerate who was not all that excited over their under performing subsidiary who they felt had only limited growth prospects.

As a thirty-eight year old business school graduate Donald D. Sheelen knew in his heart that he was ready for the big time. He took over Regina, and by adding products, beefing up marketing and most importantly, substantially cooking the books, he was off and running. Donald’s ride up the ladder was fast, but his ride down was even faster. When he was forcibly removed from the company to start his prison work-release program there was nothing left but ashes. His legacy was one of lawsuits and corporate bankruptcy.

Donald never took his blinders off, he set his goals and plowed dead ahead when he made up his mind. If he did not achieve his benchmarks legitimately he would still make sure that the outside world believed that he had succeeded. Whenever there was a shortfall in projections, the financials were adjusted by underlings to meet Sheelen’s earlier projections, even if they never came close. His rise was meteoric. His family was middle-class but he seemed to excel at whatever he did. He was a splendid athlete in school, playing football and basketball, he was the President of his class at Dayton University and graduated with a degree in marketing. He ultimately received an MBA from Syracuse. Donald became a stockbroker at a large Wall Street firm and from there went to work in accounting at Johnson & Johnson. He arrived at Regina in 1980, and was soon made the person in charge of marketing. It was the long hours and his unrelenting drive for success that got him noticed by management, and he proceeded to perform, vowing to succeed at any cost.

Donald became president of Regina in 1984 after displaying an uncanny ability to improve margins by adding a series of high end products. General Signal indicated to Donald that they would consider a leveraged buyout by employees. Sheelen somehow got a hold of $750,000 and purchased the majority of that stock. With control in his hands he proceeded to take the company private. Never one to get caught standing still, the following year, Regina once again went public and Sheelen and along with certain other company executives were able to cash in their stock to the tune of $10 million. Sheelen continued to offer hot products, and between knowing what the public wanted and a substantial advertising budget, he was seemingly able to make the company’s numbers purr.

Wall Street fell in love with him and what he was doing, and the stock soared. He was a no frills guy and soon announced that he was going to take on the industry leader, Hoover. The stock was now up over 500% from its price when he first took it public. His personal earnings were on a par with those of heads of major public companies in the United and he and his wife, originally a Franciscan nun, started really living the good life with nothing spared. Cars, home, servants, and all the niceties were his for the asking.

The problem was that the whole thing was only hype and no substance ([81]); the equipment that Regina was turning out was under engineered, inadequately manufactured and over glorified. The company soon began to be inundated with product returns. Sheelen’s chief financial officer was Vincent P. Golden, a team player from the word go. Sheelen directed Golden that if they didn’t record the returns, which were now running an astounding 16% ([82]), no one would be any the wiser. It would give the company time to correct the problem and, just as in all the fairy tales, everything would turn out alright. Apparently because Golden had believed in fairy tales as a child, he went along with a scheme that not only had to fail, but one in which everyone would suffer grave consequences.

Golden and Sheelen were off and running with all those things that make corporate life worth living. They merrily created phony sales through the construction of false invoices, had expenses evaporate into thin air and returns had amazingly vanished. Sheelen indicated that he inform Golden what the earnings and sales were going to be and Golden had darned better hit the target. But Sheelen was not finished trying to sucker the public. He wanted to show that he could ultimately tame Hoover and had non-production model of his competing vacuum cleaner, hand tooled with a secreted. super-powerful suction engine hidden in the motor housing. His machine sucked up all of the cereal that he dropped on the floor and his magical results put Hoover to shame. His audience went bonkers. The fact is that this machine could not have been produced for a number of logical reasons ([83]) had nothing to do with the demonstration he put on for the Security Analysts on Wall Street. The analysts came away very impressed, not knowing that they had been taken down the “garden path”.

Eventually the police came calling and with fanfare he confessed to his wife, his family and his priest followed by the United States Attorney in Newark. He then canceled the company’s annual meeting and resigned. Sheelen ultimately cooperated with the government and received a year in jail and a small fine for committing mail fraud in connection with falsifying financial records. He served his sentence at the Goodwill Industries Community Correction Center in Florida. This was obviously not exactly hard time; the place had no bars and no locks on the doors. As a matter of fact a number of the people that had stayed there called it Santa’s Village probably because of the colors that decorated the facility. Sheelen’s partner in crime, Golden, was treated reasonably well considering the pain and suffering that he caused. He was obligated to spend six months in the same type of correctional facility.

The company was left a shambles and ultimately filed for bankruptcy reorganization under Chapter II of the federal code. The filling showed that the company’s earning had been a mirage and that the debts exceeded assets by over $10 million. Regina filed lawsuits against both Golden and Sheelen. The secured lenders came up with enough money to keep Regina going until it was acquired by TRC Acquisition Corporation, a unit of Electrolux. The National Association of Securities Dealers also got into the act when they discovered massive short selling in Regina’s stock several weeks before the earnings were restated. Would you believe that the volume in the stock shot up to twenty times the average of what it had been previously?

As a postscript to this story, it was the company that withdrew its financials and it was the company that asked the auditors to re-examine Regina’s previous filings. Peat Marwick, which had prepared the audits for the company, was summarily replaced by Coopers and Lybrand. According to company announcements, the switch was made because a restatement would have to be made, disclosures would have to be given, and a thorough analysis of events would have to be performed and published. In a more formal vein, they said that they replaced Peat Marwick “for failing to give an audit opinion for the 15 months ended September 30.” ([84]) Were they saying that they thought the auditors were responsible and therefore no longer credible? Regina stated specifically “Peat Marwick took their position in order to remain as the company’s auditors and have access to the company’s records in connection with its own defense.” In an allied article, the Wall Street Journal pointed out that “Peat Marwick, with some $900 million in annual audit revenues, has the largest U.S. audit practice and appears to be the biggest target for disgruntled investors.“ ([85]) That Journal story went on to say that:

“…The Regina case, however, may prove the most nettlesome. The U. S. Attorney’s office in Newark, N.J. is investigating possible criminal charges against former Regina executives. And the SEC has begun studying Regina’s financial statements. “Where there’s been a big change in numbers, the SEC normally looks at the accountants,” one SEC attorney says” ([86]) Regina hasn’t been helpful to Peat Marwick’s cause when the indicated that the accounting firm had a degree of complicity, “Returns of faulty products weren’t deducted from sales, some sales invoices were fakes and revenue was inflated.” Shareholders claimed that everyone could have recognized the warning signs, when Regina started lying in the commercials about how they were outperforming Hoover. There was no secret that Hoover sued, and that Regina pulled the false commercial. ([87]) This should have given the accountants notice that something was slightly rotten.

“But some Peat Marwick officials privately worry that the SEC may again make the firm an “object lesson” to the entire auditing profession. In 1975, the SEC strongly censured Peat Marwick for failing to perform proper audits for five companies that collapsed soon after getting clean opinions. Peat Marwick was suspended from taking new public audit clients from May through October 1975, and was forced to undergo a peer review of its audit procedures by outside accountants that year. Additional but limited reviews were conducted in 1976 and 1977.” ([88])

Anthony De Angelis and His Magic Water Tanks

This story is a little different than the ones that have preceded it. Previously we have discussed companies that have not been exactly what they appeared to be on the surface. Either by duping their accounting firms or having them act in complicity with them, the public had gotten bilked. On the other hand, they always made some semblance of being in business. DeAngelis, made literally none but because he had totally conned the company that owned the storage tanks, it didn’t matter, they gave him credible warehouse receipts that were as good as cash. He was able to discount this paper with local banks. De Angelis had also had several run-ins with the U.S. Government for his proclivity to attempt to move large amounts of phony letters of credit involving pork.

Anthony De Angelis had been around for a while. He was an elderly guy who is credited with stealing a $1 billion dollars from folks when that was real money, back in the early sixties. De Angelis knew a little about salad oil because he cut his teeth as a commodity trader and one of the bits of obscure information that he was aware of was the fact that when you mix together water and salad oil, the later will float to the top. De Angelis, never much of an angel, thought to exploit this anomaly and rented some of American Express’s storage tanks in New Jersey. In them, he placed a mixture of about 1% salad oil and about 99% water. As we have previously elucidated, the salad oil, like a charm, popped to the top and unless someone put on a scuba diving suit there really wasn’t any way of not believing that the tank was full wasn’t filled to the brim with salad oil.

American Express was acting as both the lessor of the tanks and the guarantor of tanks contents as well. Once American Express was satisfied that the salad oil was in place, it would issue a warehouse receipt guaranteeing the products existence. \this instrument in turn was purchased by a third party with its existence was guaranteed by an irrevocable bond. In this case there was no one to blame beyond whoever was responsible for due-diligence at the American Express. There was no accounting firm to blame. American Express had only one job to do and they jeopardized their entire company by bungling it.

One of the most interesting sidelights of the affair, was the fact that the loses run up on the disappearing salad oil were actually more than the net worth of American Express itself. The stock tanked and people were not sure whether the company would be able to stay in business or not. Then, even worse news hit. It turned out that American Express when it was formed began existence as a bank. Its charter was a bank charter and strangely even though banking was only a small part of its business, the charter remained the same. Banking laws had been changed after many banks had disappeared during the crash and one of those changes made shareholders in banks liable for two-times the stock’s par value. As we recall, American Express had a par value of $100 per share, which was substantially more than the stock was selling at. Shareholders panicked when they learned that they could be liable for substantially more than, not only what they paid for the stock but up to four-times what it was then priced at. Another classic American company, Kemper Insurance was also involved in the matter but less directly. Once again, their highly paid attorneys are probably the only reason that Kemper is still around.

Luckily, American Express survived by tanking the subsidiary and hiring a team of very creative lawyers, but until the matter was negotiated out, it was touch and go for one of Americas premier, blue chip companies. On the other hand, at least two major brokerage firms bit the dust, one of them, J.R. Willliston Beane who had as its name partner, the Beane that originally adorned the masthead at Merrill Lynch. Thinking he could do better with his own firm than he could at Merrill, literally his first move was his last and he forever rued the day that he ever heard the name, Tino DiAngelis, as he was known. The swindle was called by the Wall Street Journal, one of the “all-time financial crimes.”

The swindle was not created in vacuum. De Angelis was using the American Express warehouse receipts to purchase soybean-futures. Soybeans were an integral part of salad oil and by running up the price on the beans
Tino thought that he could make a large enough profit on the futures to cover any deliveries that he may chose to make on the salad oil. When the fraud was discovered, De Angelis’s position in soybeans was liquidated also causing the old-line commodity firm of Ira Haupt to collapse into an irrecoverable heap.

Billy Sol Estes We Are Proud of You, The Boy’s In Fertilizer You Know

They brought this elderly 70-year old into the court and some thought that they had heard the name. “What’s he being tried for?” asked a local wag. “Oh, I’m not sure, I think something about tax evasion.” Replied another onlooker. “A guy that old, still hustling on his taxes, I can’t believe that.” Replied the first. Another bystander rejoined, “Guys, that’s Billy Sol Estes, the biggest crook ever produced in West Texas and that guy don’t know how to do anything but steal.”

This case was not a major event in Estes’ life, if what the family said is true, he may not even know that it happened. His lawyer pleaded insanity as a defense against the eight-count indictment on tax fraud that Estes was facing in the District Court in Brownwood, Texas. Relative to some of Billy Sol’s other exploits, this one was pretty tame. Billy and some of his cohorts started a charity, an alcoholism halfway house, and then treating it as a for-profit company, at least as far as the partners being able to siphon funds out of the company and pocketing the money. Many had pointed to Billy’s more charitable ways but they didn’t know the truth. In reality, this was minor league stuff and Estes was a major leaguer.

Billy Sol, who lived in Pecos Texas had done bigger things in his life and stealing from a halfway house charity is hardly fitting for a criminal with such excellent credentials. Years ago, Estes was an influential cotton grower who made a fortune by using his neighbors’ acreage to grow cotton during the years when the U.S. Government was paying a fancy premium for those sorts of things. He was always politically plugged in, which certainly helped a lot when it came to getting government subsidies. However, the agriculture department determined that there must be something wrong with getting government money to raise cotton on some else’s land on a fully subsidized basis. When the inquiries started coming in droves, Estes decided that he was getting bored with producing cotton and determined to get into a new line in which he could make money without even having to have a product. After substantial research he determined that this non-product would be an imaginary liquid fertilizer tank farm.

Estes and DeAngelis came upon the same sort of scam thousands of miles from each other, almost simultaneously. Estes as opposed to DeAngelis had always been successful and had accumulated a substantial poke, most of which came from dealings with many of his political friends in Texas who he supported with a flourish when they were running for office. Tino DeAngelis was a nickel and dime crook that was always getting into trouble with the law if for no other reason than the fact that he just didn’t have Estes’s influence with the right people. Both used tank farms to create assets that were non-existent. Both convinced sophisticated institutional suckers to throw money at their schemes, both made a fortune in their illegal activities,. both caused a substantial number of people to suffer extreme financial hardships. Both were approximately the same age. The only difference between the two was DeAngelis made every effort to fill every one of his tanks no matter what they contained, Estes never put anything in the tanks. He couldn’t have because the tanks themselves didn’t exist.

Why I came from, people wouldn’t just buy a pig in a poke but Estes didn’t buy that. His theory was that big institutions did lousy due diligence and that making the scheme work would not represent any problem. Estes went to the finance companies and told them that he had acres of tanks filled with fertilizer . If they would lend him money, he would segregate the tanks’ contents with a seal and a cast-iron imbedded nameplate, permanently bearing the name of any institution that would finance him on the basis of the tanks’ purported contents. He offered his lenders the right to send inspectors of their choice to scrutinize the tanks without advance notice to verify Estes’ assignment of rights to them.

Many institutions considered this great collateral; Estes was able to borrow real money on the liquid fertilizer that he claimed filled his tanks. The trouble was that while a few tanks contained the liquid fertilizer, the ratio between these tanks and the empty tanks was colossal. The institutions regularly did verify their collateral’s existence. However, what Billy Sol knew and what they didn’t was that in West Texas, where the tanks were, there was only one airport that could logically be used to get to his tank farm to do an inspection. That airport had a handful of rental car facilities, whose employees all worked on Billy Sol’s payroll as a sideline. When an Eastern auditor showed up with a corporate credit card, they called Billy or one of his people. As soon as they could be sure that the traveler was a creditor of Billy’s, they trotted out the shiny new nameplate bearing that creditor’s name, removed the old creditor’s plate, and soldered the new one onto the tank. When the due diligence auditor came calling, naturally he found his company’s name embossed on the tank just as Mr. Estes had promised. Moreover, he found that it contained exactly what it was supposed to include.

Every inspector in turn became a salesman for Billy Sol. They all went back and told their constituents that everything was as advertised and for the most part, this herd industrial sheep were more than happy to have Mr. Estes load another non-existent tank with imaginary liquid fertilizer and give him a little more money.

Ultimately, Estes’ secret was revealed, and banks and finance companies all over the country went into a period of mourning. Estes had stolen them blue. The problem in this instance had been the fact that the tanks purportedly belonged to Estes and thus, there was no independent warehouse receipt. In the DeAngelis case, victims would have recourse against the issuer of the warehouse receipt, American Express. In this case there was no third party receipt, no insurance, and the money had vanished. Estes went to federal prison for his trouble and once again he went to the big house in 1979 for income-tax evasion. It appears that unless his insanity plea falls upon friendly ears he will have the government as his host for the third time at an age where a rest home would have been much more fitting, the tender age of seventy-two.

As a sidebar, Estes never quite knew when to let well enough alone. He gave an interview with VSD, a big French Weekly in April of 1999 in which he claimed that Lyndon Johnson ordered the assassination of Kennedy. In addition, he raises in that article a point that he did not raise in the United States when he plead insanity. That point is that he indicated that the reason for this astounding statement was the fact that he is dying of prostate cancer and wants to “set the record straight before he dies.”

He went on to say that one Cliff Carter, a crony of Johnson and Malcolm “Mack” E. Wallace were also involved with Johnson in all kinds of nefarious stuff. The story in the French magazine gets crazier and crazier so we won’t honor it with anything further except to say that Estes indicated that “He also has recording of all of his conversations with Wallace, Carter and Johnson.

After Estes got out of prison the second time, he had a message waiting from God or somewhere else, in which he was told to clear the air. Estes told the world about his relationship with LBJ and a slush fund that he had personally set up for him. He went on to recount chapter and verse of murders, pillaging and other strange and bizarre experiences, which the former President was involved in. On the other hand, everyone that he was talking about had died and even the fact that he had told this story to a Texas Grand Jury had little effect on the world at large.

The U.S. Justice department hearing about this testimony asked Mr. Estes to visit them. Estes said that he would tell them about seven murders that Johnson was directly or indirectly involved including President Kennedy if they would give him immunity. No deal was ever reached and so we are unaware of what could or would have happened had they worked something out. It appears to us that Mr. Estes should have used the defense of insanity a little earlier in his career. This guy is certainly one strange dude.

Finance Companies Gone Bad

Towers Financial, A House Of Mirrors

Steven Hoffenberg owned a company by the name of Towers Financial, which was ultimately closed by regulators and left investors holding the bag for $460 million. The New York Times called Tower one of the largest Ponzi schemes on record; Hoffenberg took 3,000 investors from literally every state in the Union by selling them worthless promissory notes. And yes, Towers reported to the SEC, which claimed that it too, had been defrauded, not by Towers, but by Hoffenberg’s accountants and lawyers, who were issuing phony financial statements and making false claims.

Apparently the SEC had it right. Dan Girard, an attorney representing the Tower investors said, "Because Hoffenberg’ s company is now bankrupt, the people who purchased Towers’ promissory notes, and lost an average of $80,000 each, will never recover even a fraction of the amounts they lost unless they are able to hold Hoffenberg’s accountants, lawyers and investment ratings advisors responsible.”

Ultimately, Steven Hoffenberg pled guilty on March 7, 1997 to criminal conspiracy and for his efforts received a 20 year prison sentence along with a $1 million fine and the order to pay restitution of $462 million for his roll in defrauding thousands of investors. Hoffenberg agreed that he had deliberately falsified Towers’ financial statements to show none existent assets or to inflate those that existed. The same was true of revenues and net income. In typical Ponzi fashion he used money from the later investors to pay off earlier maturing notes. Pension funds and individual retirement accounts were the major losers in the transactions. Tower ultimately implicated Price Waterhouse in Barbados. In his guilty plea, Hoffenberg stated that Price Waterhouse issued phony financial statements for Towers, which allowed him to sell the fraudulent instruments that he was peddling.

But the SEC wasn’t done with the accountants yet; The Commission instituted public administrative proceedings pursuant to Rule 102(e) of the Commission's Rules of Practice against Leslie Danish, a CPA practicing in New York with the firm Richard A. Eisner, LLP. The Commission found that Danish engaged in improper professional conduct in connection with his audits of the financial statements for five subsidiaries of Towers Financial Corporation. The five Towers subsidiaries filed for protection under Chapter 11 of the Bankruptcy Code in March 1993, along with their parent. The Towers Chapter 11 Trustee determined that the financial statements for the Towers subsidiaries materially misrepresented the value of their assets, which were purportedly receivables purchased from healthcare providers with a value of $155 million.

The Chapter 11 Trustee concluded the net realizable value of these assets was only $28.5 million. The Commission also found that the Towers subsidiaries had made under-collateralized loans to two of the most significant healthcare providers, instead of purchasing receivables from them, and that the Towers subsidiaries had not reported these loans at their net realizable value, with an appropriate allowance for doubtful accounts. The Commission found that Danish departed from professional auditing standards by failing to exercise due care and to maintain an attitude of professional skepticism in the performance of the audits. With respect to the under-collateralized loans, the Commission found that Danish relied excessively on management representations, and concluded that there was no need for an allowance for doubtful accounts without seeking and obtaining sufficient competent evidential matter. (Rel. 34-39931; AAE Rel. 1030; File No. 3-9594)

Mercury Finance

Mercury Finance seemed to have everything going for it. They were a sub-prime lender in the iffy business of making auto loans to people with poor credit. They were able to charge in excess of 25% per year, rates that made it easy to gloss over an occasional default. Earnings grew accordingly, and they averaged growth of around 23% for the last five years, certainly an enviable record. They did so in spite of the bad credit ratings of their clients. Somehow Mercury was beating the odds and bringing home the bacon by skillfully maximizing recovery.

They became the largest second-hand automobile finance company in the United States. Wall Street pundits said they had the Midas Touch, and their list of shareholders read like an edition of Who’s Who Among American Institutional Investors. They had 231 offices in 31 states and the white shoe accounting firm of KPMG Peat Marwick was signing off on the financials. Most of Wall Street analysts rated the company as a screaming “buy.” Management was said to be top-drawer. How could they be anything else after putting together forty-nine consecutive record breaking quarters? Their Chief Executive Officer brimmed with confidence and with the kind of record that he had put together, who could blame him:

“Since inception, results at Mercury have been extraordinary. Our consistent earnings improvement has been supported by controlled expansion. We have and will continue to target quality growth, not just growth for growth's sake. Since becoming a public company in 1989, Mercury has recognized the importance of its commitment to its shareholders. The Company strives to provide the highest possible return on investment while enhancing shareholder value through dividend increases and stock splits.”

This was the kind of stuff that dreams were made of and everyone had a warm and fuzzy feeling when it came to Mercury and their management. Little did they know what was in store for them.

Ultimately disaster struck, Mercury announced that it had overstated its earnings for 1996, as well as the three previous years, by in excess of 100%. James A. Doyle, Mercury’s Controller, didn’t ameliorate matters when he totally vanished. Those in the know said that he was in a “safe house” cooperating with the Government in one of the most far-reaching investigations in the history of the finance business. It didn’t surprise anyone when Doyle was fired after not showing up for work for a while, but rumor had it that he had been telling Federal Authorities that the Company was nothing more than a “charade.” In exchange for a sweetheart deal for himself.

The Mercury news continued to go from bad to worse, as First National Bank of Boston announced that the previously approved merger of their auto lending division with Mercury was permanently off. Moreover, the poor investors, who had had no clue that anything so unsavory was afoot, totally lost confidence in company management and started selling Mercury Finance shares at whatever the market would bear. The New York Stock Exchange, where Mercury was traded, was besieged by sell orders, and ordered a halt in trading. When the smoke cleared, the stock had tanked by a full 85% of its value, from fourteen dollars a share to just a tad over $2 per share, on a volume of 42 million shares.

Additionally, almost $100 million in corporate debt was up for renewal. Lenders were not in the mode to pony-up any more funds for what was beginning to look like an out-of-control finance company. Moreover, to make a bad hair day even worse, rumors ran rampant on the Street that the Securities and Exchange Commission had launched a massive investigation of the company. It wasn’t more than a day or two later that no less than four stockholder derivative suits were instigating charging everyone in sight with every malfeasance known to man. Some said that this was overreaching, but then again, no one had ever marked up annual earnings by 100% before. The Company had made financial history. Such prestigious names as the Minnesota State Board of Investment, T. Rowe Price, the Ohio Public Employees’ Retirement System, the Florida State Board of Administration, and the administrator for the company employees’ 401K plan, all jumped on the class action bandwagon.

The charges were mostly the same: Mercury had disseminated false and misleading information, and had violated just about every part of the 1934 Securities Act. Suits also contained charges that the company had engaged in deceit, negligent misrepresentation, and consumer fraud. In addition, litigants charged that the accountants had not prepared the company’s books under generally accepted auditing standards.

Moreover, the bonuses of Mercury’s senior management were tied into the company’s earnings. In this respect, Mercury was far ahead of most frauds; as examples of such arrangements did not become rife until later in the ‘80’s. This practice had particularly unpleasant results at Kidder Peabody when James Jett inflated his profits dramatically and everyone’s salary was raised. No one wanted to blow the whistle on Jett because they were all coining money, and as long as they weren’t directly in the line of fire, so what. While in the Kidder case, everyone just watched, mystified and pleased, as Jett continued to rack up unsupportable profits, at Mercury the entire upper management was clued into the bonus pool and everybody was sharing in doing their part of the dirty work.

Officials with the State of Minnesota indicated that suits seeking damages of over $1 billion had already been filed. In the time the auditors were also brought into the fray and were equally named on most of the lawsuits that were been filled. There is an unusual twist to this story. The auditors, KPMG Peat Marwick, found the fraud, told management, and hung tough. Ultimately they were fired, but they had made their point and the Company’s earnings were restated to conform to the auditors’ requests. Naturally things were not copasetic between management and the accounting firm, and Arthur Andersen was brought in to finish to books. The Company prepared a public statement concerning its substitution of auditors, and tried to put the best possible face on it. William A. Brandt, Jr. the company’s CEO and President, made the announcement:

"Under the circumstances, Mercury Finance will be best served by a new public accounting firm, which can bring a fresh independent point of view to the situation. We have asked Arthur Andersen to proceed as expeditiously as possible."

While making the best of a bad situation is what management is supposed to do, Peat Marwick did not think that the company statement went far enough and they elucidated:

“Mercury Finance Company's announcement today loses sight of the fact that KPMG discovered the irregularities while conducting its audit of Mercury's 1996 financial statements -- and immediately brought it to the board's attention.’

“KPMG is disappointed in Mercury's decision to change auditors. We had been working closely with the company as part of the solution to help get Mercury back on its feet. In fact, KPMG was in the best position to assist Mercury in promptly getting accurate financial information to the public. We had expected to complete Mercury's 1996 audit by late March.”

“It should be noted that on January 23, 1997, Mercury Finance Company issued a news release concerning its 1996 earnings -- before completion of the audit of 1996 financial statements and over the objection of KPMG.”

While it sure looks like Peat Marwick did the right thing in forcing the issue and we certainly believe that have the better of the two public relations releases but that will not get you a one cent discount in court. The fact is that this company was able to mis-state it’s earning by a humongous amount and the accounting people were out to lunch. Among the many easy catches that Peat Marwick missed was the capitalizing of lawyers fees, for the most part, in acquisition deals. These amounted to a substantial amount of money and were just put in the wrong place on the balance sheet giving earnings an additional jolt. A junior accountant right out of college would have noted that one in a flash, so we are at somewhat of a loss to understand what really happened here. One of the actions filed against Peat Marwick read as follows:

“19. (a) Defendant KPMG caused and allowed its opinions to be included in the Forms 10-K that Mercury filed with the SEC on or about March 31, 1994. Further, KPMG caused and allowed its opinions to be included in Mercury's 1993, 1994, and 1995 Annual Reports filed with the SEC on or about March 21, 1994, March 21, 1995, and March 19, 1996, respectively. As a result, KPMG rendered materially false and misleading reports on the financial statements of Mercury for the fiscal years ended December 31, 1993, December 31, 1994 and December 31, 1995, respectively.”

“(b) In the course of rendering services to Mercury, KPMG became aware (or recklessly disregarded) that Mercury was improperly reporting revenues and improperly recording earnings as part of a plan and scheme to inflate reported net income during fiscal 1993, 1994, 1995 and 1996. KPMG knew (or recklessly disregarded) that the financial statements of Mercury suffered from serious reporting deficiencies that made the Company's reporting improper under Generally Accepted Accounting Principles ("GAAP"). KPMG's issuance of an unqualified "clean" opinion with respect to Mercury's fiscal 1993, 1994 and fiscal 1995 financial statements did not comport with GAAP or Generally Accepted Auditing Standards ("GAAS").”

Peat Marwick wasn’t able to raise a lot of defenses. They were the ones that had caught the fraud. The fact that the accountants had given the company a clean bill of health was their downfall. And, in the “for whatever it’s worth” department we give what has come to be standard accounting language for an unqualified report. This was one of many similar reports issued by the accounting firm assuaging investors, that above all else, they were watching the store, what a warm and cuddly feeling shareholders get when they read these:

“We have audited the accompanying consolidated balance sheets of Mercury Finance Company and subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of income, changes in shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1993. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by the management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercury Finance Company and subsidiaries as of December 31, 1993 and 1992, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1993, in conformity with generally accepted accounting principles.”

The officers were not only paid well in bonuses but almost to a man, they had loads of stock, much of which they received as stock options, which they weren’t at all afraid to dump as soon as the shares were registered. They foisted millions of dollars of stock on unsuspecting investors who were unaware of the financial fraud was being committed on an ongoing basis.

Wall Street had been caught totally unaware and stock market losses became substantial. However, anyone reading between the lines would have concluded that Mercury had telegraphed their punch. In their second quarter 1986 financials, they admitted that they had double-booked their reserves in Mercury’s life insurance subsidiary. Thus, if they had double the reserves on paper, but only had one-half of that amount backing up insurance claims in reality, these folks were soon going to be in very deep dodo. It was plainly there for all to see.

The finance company was also required by the SEC to file an amended 10-Q with the Commission. The 10-Q is primarily a financial statement that discusses earnings in the last reporting period. This is filed with the SEC and then through their good offices becomes readily available to the public. Double booking is bad enough, this is like absolutely losing track of where your money is, but when it is an amount in excess of 10% of total net income, we are talking really serious stuff.

On another front, Mercury’s success was also a partial cause of their demise. They attempted to prove that people with poor credit would pay their car loans under the right circumstances and if not, proper safeguards could be put in place to minimize loan loses. On the public relations front, we believe that Mercury did an excellent job. They had made their point so well that any number of competitors looking at Mercury’s bottom line determined foolishly that it may well be true that the higher fees and interest that could be obtained in this business would more that offset the risks involved. As more competition jumped into the arena, Mercury’s loan quality started to decline precipitously. Any number of security analysts seeing that trend developing talked about jumping off the “high risk auto lending” bandwagon.

The most interesting comment on the company was made by Westergaard Research. “You are dealing in a business where the company is indicating that there is an enormous amount of write-able business available. Your after-tax returns are running thirty percent. You are paying out forty percent of your profits in dividends. Would it not have been a better idea to pay out less in dividends to maximize the net return even further and more importantly, with the stock selling at a price-earning ratio, wouldn’t it have been more logical to have gone back into the equity markets for more money.” The stock was once of Wall Street’s darlings and raising substantial funds at a reasonable cost was certainly in the cards. Westergaard postulated that under the circumstances, the only logical explanation was the fact that the Company did not want to have anyone doing excessive due-diligence on the books because they couldn’t stand the heat. Westergaard was right on the money, but their logic would indicate that they also didn’t have a lot of confidence KPMG Peat Marwick’s ability to get to the bottom of things.

Before you could blink an eye, Mercury hired Salomon Brothers to figure out how they could tap the financial markets in consideration of their horrid state of affairs. As an additional “red herring,” Mercury hired two prestigious law firms to investigate its accounting practices. The only good thing about the affair was the fact that the company had indicated that they were about to branch out; being so dependent on sub-prime auto loans. They were going to start lending people with bad credit money for plastic surgery, one of the really dumbest concepts in financial history. You know what happened next. The company filed for reorganization under Chapter II. The world had been spared their next idea.

The Brokers Took No Prisoners Either

If You Listened When E. F. Hutton Talked You Were In Deep Trouble

Edward F. Hutton the investment banker that founded the brokerage firm that bore the same name was born in New York City in 1877. His family was poor and his father died when he was just ten. He was forced to drop out of school to help support his family and started his working career as a mail boy. Eventually, Hutton became a stockbroker, married well, and founded a small brokerage house with his father-in-law’s help. His big break came when he opened up an office in San Francisco at the time of the 1906 quake. Interestingly enough, Hutton had just about the only direct telegraph line to New York when no one else did and when the quake hit, he was able to rack up big profits before anyone else even knew what had happened.

Hutton ran an open shop at the brokerage house and encouraged each and every employee to let him know directly if they had any ideas for bettering the firm. Paradoxically, Hutton’s shop was almost anarchistic; if you were not mature enough to make your own decisions, you really were not made of the stuff that Hutton was looking for. Whatever the logic, E. F. Hutton the brokerage company grew until it was the second largest firm of its kind in the United States next to Merrill Lynch.

Hutton had worked himself up through the ranks, ultimately becoming the Chairman of General Foods as well as the head the brokerage company. E.F. Hutton, the brokerage house was merged into Shearson Lehman Brothers in 1987, and that firm is now called Salomon Smith Barney (part of Citigroup). The brokerage house became widely known for the slogan: “When E. F. Hutton speaks, people listen.”

Hutton’s management remained aggressive even after their leader’s death in 1962. This aggression manifested itself in an awesome rejection rate of Hutton checks from Bank of America’s data processing equipment. Bank of America noticed that easily 50% of the checks that Hutton wrote could not be processed by computer, fully 50 times the national average, and all of the checks that bounced out of the electronic system had to be individually re-entered. The bottom line was that this scam allowed Hutton to profit from a much longer than average float on their checks. Hutton was thusly able to take advantage of the much longer float on their checks. This little trick was accomplished in a number of ways. When a greasy substance was rubbed into the check, it would bounce more often than not. When a staple was placed in the bar coding, it would not clear the system a high percentage of the time, and when an edge of the check was folded, the check could not make it through the data processing equipment.

Hutton’s shenanigans were causing a severe backup at Bank of America, and after a careful evaluation of what was going on, the bank voiced its suspicions that Hutton’s checks were being deliberately doctored. Bank of America gave Hutton two choices: either they would stop playing with the checks, or the Bank would close their account and report them to the Treasury. Hutton complied.

However, Hutton had already found a new way to beat the system. It devised a “use of funds” system that predicted almost exactly how much money E. F. Hutton would need in a particular branch on any given day. Whatever was in excess would be bundled up and wired out by 1:00 P:M so that it hit Hutton’s money center account the same day and started to pay interest immediately. Hutton felt that in order for the system to work properly, they needed the total co-operation of their branch managers; 10% of the interest received was paid to the office managers as a bonus for helping defraud local banking institutions.

This was not a bad idea as far as managing money was concerned, but it created a lot of problems as soon as the managers realized that the systems could easily be rigged in their favor. By drawing down excessive amounts of money, the manager created excess in the interest account against uncollected funds in his local account. Small town banks did not have the oversight systems in place to figure out what was happening; indirectly they were being robbed blind by greedy Hutton managers who were selling their souls to the Devil for 10% of the action.

Historically, in 1978, Hutton’s management was not thrilled by its bottom line. The firm had become a money-eating machine. One possibility discussed among Hutton’s senior officials was that the firm go into an “overdraft mode” and subsist on the float. Even if they were caught, the banking regulators had no oversight over a brokerage firm, and Hutton would get off Scott-free. However, Hutton’s legal analysis was fatally flawed. When regulators finally got wind of the scheme, they concluded that it actually constituted a radically illegal mail fraud.

By 1980, the checks heretofore written for a thousand dollars or more were being replaced with multi-million dollar overdrafts, an act of theft against the banks that were clearing the transactions. From Hutton’s point of view the plan was a startling success, and in that year, Hutton was able to cut its bank borrowings on a daily basis from almost $400 million to a more manageable $200 million per day. Assuming that Hutton was paying 10% interest on the money, a figure that would probably have been conservative for that time of high rates, they would have saved almost $20 million in 1980 alone, a very pretty penny.

Branch managers were pushed to do even more by senior executives. Those that didn’t perform up to expectations were given a written memorandum showing in detail the difference between the monthly commission that they actually received and the one that they could have gotten for being more productively involved in the plot. They received the difference in monopoly money.

New York State Corporation owned the Genessee County Bank, a small upstate bank at which E. F. Hutton had just opened an account. The management at the bank soon noticed that Hutton was writing checks for millions of dollars that it was far from being able to cover. Hutton was depositing uncollected funds from the United Penn Bank in Wilkes-Barre, Pennsylvania. New York State Corporation officials called the United Penn Bank asking whether or not there were good funds behind the checks. The response went, something like, “Hutton never has good funds.” United Penn Bank told the caller that the check that they had issued to Genessee was indirectly backed by a third bank-check probably issued by Manufacturers Hanover, Hutton’s primary bank.

New York State Corporation officials told the Genessee Bank to bounce the Hutton check. ([89]) They then called upon the manager responsible for issuing the check at Hutton. He indicated that his orders were coming from higher up and he was only a small cog in the chain. He gave them his superior’s phone number and up the daisy chain they went. The buck stopped at a very senior level, and the seriousness of what had just transpired was firmly impressed upon the executive with whom they spoke. Hutton offered to deposit $30 million to its Genessee Bank account to cover any inconvenience that Hutton may have put them through. Genessee officials accepted the funds an hour later, and promptly froze the account. Thus, $30 million of Hutton funds was tied up in the small bank for over 90 days.

In late December of 1991 Genessee officials wrote to “the state and federal banking regulators, the FBI, and the Secret Service describing everything Hutton had done. A few days earlier, United Penn had notified the Federal Deposit Insurance Corporation, a federal banking regulator about their problems with Hutton. As the complaints flowed in, the banking regulators realized they had a potentially significant problem on their hands. They had to investigate.” ([90])

As though Hutton didn’t already have enough problems, a new account started depositing astronomical amounts of money in the firm on a daily basis. An examination was commenced by the U. S. Government, supposedly with Hutton’s offer to be cooperative. Just as the Government was about to close in for the kill, they found out that the accounts in question had been closed and the money had be removed based on a tip to the account from Hutton management. Government investigators, which included FBI chief Louis Freeh, were incensed with Hutton’s backstabbing. Hutton had unquestionably made a very bad enemy.

In 1983, Hutton overdrafts totaled one-half billion dollars and its bottom line effect on the brokerage firm was that this form of interest income accounted for 75 percent of the retail brokerage division’s profits. The Justice Department of the U. S. Government soon discovered this intricate system and began an investigation. Their conclusion was released in 1985 when Hutton “pled guilty to 2,000 counts of mail and wire fraud, charges stemming from the use of the nation’s postal service and telecommunications networks by Hutton to defraud its banks via the draw down system. The firm teetered on the brink of insolvency until 1988, when it was bought by Shearson Lehman Brothers, one of its major competitors. ([91])

Congressional investigators were particularly galled in the way Hutton’s auditors mischaracterized the overdrafts on in Hutton’s financial statements. There was no “overdraft” item on Hutton’s balance sheet; Hutton accountants used the term “Drafts & checks payable” instead. The two terms mean entirely different things, and Congress correctly concluded that this was merely a smokescreen. They were also not to happy with the fact that while Andersen had sent a memorandum for the files to Hutton regarding their management procedures, nothing was completed and Arthur Andersen never followed it up. Congressman Hughes had a little discussion with the accountant’s audit partner regarding this matter:

Congressman Hughes: Mr. Miller, what did you do after the meeting that took place on March 7, to check the accuracy of what was related to you?

Mr. Miller Well, after the meeting, sir, I reflected on the entire meeting; the fact that I had a hundred bank confirmation with no exceptions noted…the fact that I found no evidence of checks bouncing, I found no unusual fees being charged by the bans to Hutton..

Congressman Hughes: That’s not my question. My question is: what did you do after the meeting? Because, frankly, to your credit, you did see that there were some problems…Did you ever get to the bank’s point of view on the system?

Mr. Miller: No, Sir.

Congressman Hughes: Well, here’s what you say, “Joel Miller then stated that he would discuss the matter with other partners at Arthur Andersen and Company whose clients include major money-center banks, to ascertain what the banks’ point of view is regarding these transactions.”

Mr. Miller: Sir, I had a hundred confirmations from the banks. When I got back to my office and reflected on the entire meeting, I concluded that none of the banks had notified me of any problems—

Congressman Hughes: So you didn’t follow through.

Mr. Miller: Well, I followed through in that I reflected on the entire problem and I concluded I would stick by the opinion that I believe Mr. Rae gave me.

Congressman Hughes was not all assuaged by Miller’s testimony or lack thereof. He called Brilloff to discuss the fact that in spite of the that the Justice Department had been examining Hutton with a fine tooth comb for over two years, there was not a peep about that matter from the usually ebullient Andersen other than an obscure footnote:

“The company and its subsidiaries are defendants in legal actions relating to its securities, commodities, investment banking, insurance and leasing businesses. Certainly these actions purport to be brought on behalf of various classes of claimants and seek damages of material [sic} for indeterminate amounts. In the opinion of management, these actions will not result in any material, adverse effect on the consolidated financial position of the company”;

Congressman Hughes: In your opinion, was this disclosure adequate, given that it was a little more that a month before Hutton pleaded guilty to 2,000 counts of mail and wire fraud, that obviously, at this time, Andersen was on notice of the ongoing grand jury investigation, and, in fact, had been subpoenaed?

Professor Brilloff: This disclosure was very much like a bikini bathing suit, what it revealed was interesting, what it concealed was vital.

Whatever Andersen tried to do to have the matter corrected was largely wasted effort. While they did the right thing by going to the audit committee and pointing out various problems that they had uncovered. They might not have been aware that the audit committee was little more than a rubber stamp and that none of the committee members had the slightest idea of what was going as they were apparently picked solely based on their lack of expertise on any subject. One of the more auspicious members was a movie actress that was a granddaughter of Edward F. Hutton who had not concept of accounting principals.

The Government was never able to affix the blame for this fiasco on any particular person or group of people. The branch managers blamed the executives, the executives blamed the internal auditing staff, and they in turn blamed the outside auditors, who blamed the branch managers. There was no particular paper trial for the government to follow. Out of frustration, the Justice Department literally determined to indict the whole firm. In spite of that fact, there was a hearing before a congressional subcommittee to look into the matter. The committee asked the famous accountant, Abraham Brilloff to look into the matter and give the committee some insight into what he discerned:

“Where has Arthur Andersen failed?…At the outset and most importantly, they failed to follow through on what they absolutely saw and understood, as early as 1980, as to what was going on. They questioned counsel and counsel said, “Go away, we’re too busy to respond.” It is my view that had Arthur Andersen really fulfilled its responsibilities under the circumstances, the money-management excesses would have been stopped dead no later than 1980 or 1981.”

Edwin Meese was the attorney general of the United States in 1985 and found the Hutton case was so egregious that he personally took charge of the announcement of its disposition, which read:

“The Department of Justice today filed a criminal information charging E.F. Hutton & Company, one of the nation’s largest securities dealers, with two thousand counts of mail and wire fraud. The essence of the charges was that Hutton obtained the interest-free use of millions of dollars by intentionally writing checks in excess of the funds it had on deposit.”

Congressman Mazzoli put Andersen’s roll in the Hutton scheme into perspective:

“Maybe some of the newer practitioners of accountancy have lost sight of the traditions and lofty history of the profession because they walk into firms now that are groveling for money just like the most mercantile of companies. Maybe they are incapable of having this high fiduciary standard that we, at least in my generation, grew up with in law, and accountancy and in medicine.”

With 2,000 different counts against it and substantial fines to pay, the firm merged itself out of business. Arthur Andersen had done the accounting for Hutton and knew all about what was going on. They had indicated that the overdraft scheme was highly questionable. They did not resign, nor did they go to the authorities or qualify their opinion. Seems like just another average day in the life of the accounting firm. Edward F. Hutton probably turned over one more time in his grave.

J. B. Hanauer Brokerage & Money Laundering

One of the most regulated businesses in the United States is that of the Securities Industry. After having been in the securities business for most of my life as an officer of a brokerage firm, it began to seem that hardly a day ever went by that some regulator or other didn’t have some question to ask. Because brokerage firms deal with the public and that they are insured by SIPC, it seems that every regulator has an opportunity to look at the books.

Whether a brokerage firm is public or not, they are obligated to have an outside accountant review their books on a regular basis. This is primarily done to insure that the firm is in capital compliance with the various securities regulations. It is very painful when a securities dealer fails and if the regulators are able to have some notice that there may be such a danger, at least they can merge the firm out before the trouble gets even more critical.

More often than not, securities firms get into trouble buying their own stocks to support them. Often no other market makers are willing to buy someone else’s deal, so the only buyer is the original broker that carried out the company’s initial underwriting. After the firm’s salesmen have gone through all of their customers, there is no one else left to call. If they don’t support the issue the brokerage house could fail. Their accounts are loaded with the stock and just the loss that potentially exists relative to margin calls may be enough to totally sink the firm.

One of the most import aspects of the outside auditor’s job is doing the books and then checking with the customer (confirming) whether everything that appears on his statement belongs to him and that the statement is essentially correct. This prevents brokers from pilfering funds out of client’s accounts, making sure that stocks are not in the account that don’t belong to the client and that the brokers client is fully aware of what is happening. The stock certificate is categorized the same way as finished merchandise would be in a manufacturing company. In manufacturing, the process is more selective than it is in securities as everyone gets a confirmation letter from the outside accountants. The reason that the securities industry has to be so carefully regulated is that you never see the final product. The industry has gone totally paperless and the only way that you can be sure that you really own something is to look at your brokerage statement. At the same time you have to be sure that the statement is issued directly by the broker, not be a salesman with a fertile imagination and a printing press.

There are a number of different types of brokerage firms. Some are what we call “full service” meaning that they specialize in all facets of the business, others pick smaller niches where they can be a big fish in a smaller pond. Some firms specialize in over-the-counter trading, others concentrate on clearing transactions for other brokerage firms and you also have broker-dealers that do not directly take in money and only deal in mutual funds.

There are also brokerage firms that only deal in municipal bonds. It is one of these firms that we want to discuss here. Remember, the confirmation process is critically important and having a strong outside auditor can protect both the brokerage firm and the public simultaneously. Municipal bonds are issued by non-federal governments, that can mean, city, county, state, school districts or just about any non-federal taxing authority that your mind can imagine. The only criteria is that the issuer is a taxing authority able to pay the interest on the bonds. The quality of taxing authorities is ranked by the rating services as to their ability to pay the interest on their obligations. The better the rating, the safer the bond, the lower the interest rate. There are also municipal bonds that are called industrial revenue bonds. The only thing warranting any return at all on these instruments is the success of the particular, for profit company that they are aligned with. These types of bonds are not as significant as they once were because of any number of fraudulent transactions that occurred, a cut-back on the number that can be issued by local & federal regulators and the proliferation of the industrial junk bond market.

Municipal bonds are, for the most part, granted an exemption from federal taxation. Most states also give an exemption from state taxes to residents that live within the state that issues the particular debt instrument. Thus, many municipals are triple tax exempt, which means that you never really have to worry about paying anything to anybody if you own one of them.

Many people try to use money that has been laundered in some fashion to purchase triple tax-free bonds. The benefit is that when the purchaser takes possession of the bond, no one really knows where it went and by clipping the coupons a nice income came be built up without anyone being any the wiser. Regulators have recently attempted to have customers keep these bonds in “street name” (at the brokers office in his name) so that by culling the broker’s statements they can see who might be cheating on their taxes or laundering money. For that reason, more often than not, a bond that is physical possession of the owner can command a premium in price to one in street name.

Municipal Bonds are also, what we would call a blind item. Unless you are interested in the extremely large cap issues, there is no reliable place for the public to go to get quotes on their portfolio. For the most part, this is an industry in which bonds move up or down with long-term interest rates and they are further affected by the Federal Government’s current income tax rate. The most import factor in municipals, may be “the what the traffic will bear” department. Shaving a few points here or there can result in making a municipal brokerage firm very rich in not too extensive period of a time. The client generally is buying the bonds for the long term and therefore not particularly concerned about the day-to-day fluctuations that would effect the stock market so he is usually none the wiser when a firm takes advantage of him. Basically, what we have described above are the various elements that are contained in a transaction of municipal securities. If you add to what we have already learned, the fact that any transaction in which a cash deposit is made at the brokerage firm by the customer for more than $10,000, it must be reported to the government. The circle is now squared and your education is complete.

Thus, if you had a brokerage firm whose management had convinced the outside accountants not to send confirmations to various selected customers and then that firm arranged for customers to make deposits in denominations of just under $10,000 by taking in smaller amounts on successive days you can see that we are not dealing with a totally up and up situation. And, if that same firm was unduly marking up the cost of the bonds because of the nefarious service that they were providing, you would have the Municipal Firm of J. B. Hanauer & Company, a New Jersey Municipal Bond dealer. This event happened some time ago and the company has new management and personnel but it happened and it is a story worth repeating. Also involved on the periphery were the accounting firms of Touche Ross & Company and its predecessor, J. K. Lasser & Company and Eisner and Company. (This was because J. B. Hanauer had a very friendly outside accountant doing their books by the name of Stanley Goldberg, wherever Goldberg went, that was where Hanauer wanted to go).

On February 12, 1982, The Securities & Exchange Commission charged J. B. Hanauer with running a cash-laundering operation. “Employees of the firm, often sold municipal bonds to customers for large sums of cash, and sometimes delivered the bonds at such unusual locations as restaurants, bars, and on one occasion, an airport parking lot. The bonds were often purchased using fictitious names to conceal the customers’ identity, ([92]) and the customers often were overcharged. The firm encouraged its salesmen to solicit business of person who, for income-tax avoidance or other reasons, such as anonymity in their bond transactions.”

In September of 1983, Stanley Goldberg was sanctioned by the Securities and Exchange Commission for his illegally narrowing the scope of the audit that he was obligated to perform regarding the J. B. Hanauer.. In 1984, the firm pleaded guilty of criminal charges resulting in their failure to comply with the requirements of the Currency and Foreign Transactions Reporting Act.

Well, none of the customers filed a class action suit against the accountants, because they actually had become a party to the fraud in spite of being ripped off. The brokerage firm ultimately survived after going through some harrowing moments. The only party that really got screwed in this case was the regulators and after what they thought was ample punishment, (eighteen employees of Hanauer were sanctioned and two of the firm’s executive officers were barred indefinitely from working in the securities industry. The accountant should have been barred for life for one of the most egregious vilification of American Law on record.

Plain Vanilla Theft

Robert Maxwell, Everything Has To Be In Motion Or The Game Will Stop

Robert Maxwell was an Englishman of ordinary background who went to the top of his profession in meteoric fashion by acquiring over 400 companies in rapid succession. Among his possessions was the Mirror Group of Newspapers, which formed his base of operations. Through his substantial largesse, Maxwell could always count on numerous politicians and bankers for advice and help in all of his endeavors. He went first class in his hiring of accountants as well, and was ably represented by Coopers and Lybrand, who handled almost all of his acquired companies as well as the highly endowed, Mirror Employees Pension Fund.

Although not known to all of Maxwell’s associates, a good portion of the money that he was employing was coming from his extremely aggressive exploitation of the Mirror Employees Pension Fund. Interestingly enough, beneficiaries of the pension fund saw what was happening and reported the matter countless times to the authorities, to no avail. Finally after the pension funds had not given an account their status for some period of time, Maxwell committed suicide, probably due to the fact that an investigative reporter seemed to be totally on to him and his methodology.

Moreover, it turned out that Maxwell was indulging in just about every kind of manipulation known to man. He borrowed against his assets from the banks in order to purchase his stocks to prop them up and he insisted that the external pension fund managers who were supposed to be independent also join the group of those rigging the markets in his securities. In the final analysis, some 16,000 people whose retirement dollars were at stake had lost almost $750 million. Eventually the public went ballistic and an investigation was initiated at the urging of The Institute of Chartered Accountants in England & Wales. The result of that inquiry is quoted below;

“The verdict on the Maxwell auditors, Coopers & Lybrand (now part of PricewaterhouseCoopers) was delivered in February 1999, some seven years after Maxwell’s suicide. A three man panel found that a lack of objectivity in dealing with Mr. Maxwell and his companies lay at the heart of many of the 35 complaints laid against the firm and four of its partners. The Joint Disciplinary Scheme (JDS) concluded that “The complaints reveal shortcomings in both vigilance and diligence and a failure to achieve an appropriate degree of objectivity and skepticism, which might have led to an earlier recognition and exposure of the reality of what was occurring.” The report concludes that the “firm lost the plot” and “got too close to see what was going on”. The firm admitted 59 errors of judgment. “

“Most of the blame is allocated to the main audit partner Peter Walsh, who died in 1996. According to the JDS report, four Coopers & Lybrand partners failed to meet the required professional standards in auditing various parts of the Maxwell empire. The next senior partner John Cowling, against whom twenty complaints were listed, is censured and ordered to pay costs of £75,000 and fined a total of £35,000. The report says that Cowling had never encountered fraud before and criticized him for too easily accepting management explanations (see note 7) . He failed to qualify the accounts of London & Bishopsgate Investment; a business controlled by Maxwell, even though it had failed to maintain proper records or adequate control systems and did not reconcile clients’ money. Of the other three partners involved, two paid costs of £10,000 each and were admonished. Another partner paid costs of £5,000.” ([93])

Maxwell was able to get away with his illegal activities only because of the fact that so many people who knew what was going turned their heads in the other direction rather than blow the whistle. Although the accounting firm was severely reprimanded for their actions in this matter, it will not get the pensioners who worked their lives for various Maxwell enterprises, one dollar back.

ESM Government Securities

Not every business is obligated to have an outside accountant. Those that are public companies are usually required to do so (if they are reporting companies) and those institutions that are regulated and those who deal with the public also have that requirement. Brokerage firms fall under the later category and even if they are dealing in what were once called exempt securities (i.e. government bonds), the public trust is involved and are regularly analyzed for capital sufficiency among other things by their outside auditor.

ESM Government Securities Inc was founded in late 1975 and capitalized at less than $100,000. When it opened for business, the partners were Ronnie Ewton, George Mead and Bobby Seneca. Ewton who had a rather checkered history assumed the top job. ([94]) They in turn employed Alan Novick to manage the firm’s proprietary trading account. ESM was one of a group of brokerage firms that sprung up during the late seventies that for the most part indicated that they were in the business of attempting to improve their client’s overall portfolio yield. This supposedly could be accomplished by a complex system of lending and re-borrowing of securities for fee. This process is called a “repo” (a repurchase agreement) or its more complex cousin, the “reverse repo.” (reverse repurchase agreement) Interest rates were high during this time and savings banks had many restrictions relative to the dividend rates that they could pay on CDs which was virtually the only way that they could attract substantive money. Thus, they were in a position of always lending long and borrowing short and in situations where rates were going against them the institution could potentially fail.

One of the problems with the industry was the fact that it was basically unregulated. Because of America’s growing internal debt, Uncle Sam wanted to make it as easy as possible to sell their own securities. They came up with the theory that you literally can’t lie when selling a Federal Government instrument. No matter what you would articulate about its safety would probably be an understatement, and on a relative basis, this indeed may have been very true. The second methodology that the federal government used to move their paper was allowing government dealers and their clients the opportunity of literally unlimited leverage. While margins on stocks have been set by the Federal Reserve at 50% and have remained at that level for decades, you are able to leverage government instruments at whatever the traffic will bear. This became the undoing of many small brokerage firms specializing in this business because they over-leveraged in a volatile environment.

Many devices were used primarily by saving & Loans in an attempt to survive these interest rate orchestrated problems. The purchase of “junk bonds” and the purported magical Repo’s being served-up up by brokerage firms such as ESM could theoretically improve your yield while not substantially increasing your risk. During their period of significance, many of these brokerage firms failed for varying reasons and when they did, they often took their clients, whose securities they were holding, down the drain with them. Oddly enough, most of the individuals managing the firms were characteristically heartless, inveterate gamblers and self-centered individuals that were more interested in providing themselves with a substantial livelihood than helping their clients. Names like Beville Bresler & Schulman and Lombard Wall all flourished and collapsed during this period to time bringing down many clients with them. Strangely, these Government Securities dealers that were offering their clients a form of “Black Magic” almost universally had their beginnings in Memphis, a city that seemed to cultivate the right climate for securities fraud.

Being an outside auditor for these types of companies was not an easy task as the firms were able to construct inconceivably complex products at the drop of a hat, that only the makers seemed to totally understand. (Probably best described as a forerunner of the derivative) This made accounting for the portfolio’s current value a job and a half. In derivatives, auditing firms and the product’s innovators seem to have found a way around accounting for these products by hiding behind the accounting term, materiality; which literally means that if the investments do not account for more than five percent of a firms assets, they don’t have to individually accounted and can be bundled.

Materiality was not something that could be hidden behind in those years, it literally become a day to day struggle between the accountants and the firm’s managements as to whether the books could ever be totally sorted out. These so-called government brokers were dealing in the leasing, purchasing, "repo-ing,” and trading in government securities. The ultimate question that could arise was that of, who was smarter, the accounting firm or the principals of the government dealer.

Into this bizarre environment stepped Jose Gomez, the son of Cuban emigrants who started his life in what then was called “Little Havana” in Miami. His first job was as a bag packer in a supermarket which he stuck with for quite awhile. He stayed in the same industry when he tried to get enough money for college and became a buyer for another grocery store. Simultaneously he went to school at the University of Miami where he obtained a degree in accounting. He was bright and glib and was soon hired by the sixty-year old, Alexander Grant & Company (Now Grant Thornton) to handle the audit for ESM a government bond dealer. He was assigned to them in 1977 and not only carried out his assignment but became close friends with the firms principal’s. Gomez soon became a super-patsy for ESM when the firm’s principals found that they could hide offensive accounting items from him almost at will. Alan Novick, an ESM principal and bond trader became particularly adept at moving the loses into crannies that Gomez would not conceive of looking in.

In spite of Gomez acting as Alan Novick’ s unpaid Huckleberry, in 1979 he became a partner at 31 years of age, at Grant and as such was certainly one of the youngest to achieve that position. Gomez was an extraordinary go-getter and was on the boards of many fabled charities in the Miami area. His theory was that in order to succeed in accounting, you had to go where the money was; a most noble idea. However, not everything was so simple in Gomez’s life. Gomez confided in his newfound friend, Alan Novick that his credit card debts were strangling him alive. This of course was all Novick had to hear. Gomez gratefully took $20,000 from Novick at the end December in 1979 and got rid of some of his more pressing problems. On the other hand, Gomez had just bought the farm.

Credit card debt was not the only thing strangling the young accountant, he seemingly owed everyone for just about everything and set up numerous meetings with his benefactor, Alan Novick, in order to convince him to have ESM, take care of the rest of what he owed. In exchange ESM newly indentured servant, Gomez was extremely helpful to ESM in arranging to cover up close to a fifty million dollar hole in their balance sheet to close out the year 1979.Gomez later confessed the reasons for his foolishness:

“I was a young man in a hurry. I needed more money than I was making. I wanted nice clothes for my wife. I had to have a nice home, be seen at the right places. Take a trip to the Super Bowl. Do whatever was necessary to further my career. Use the plastic, the credit cards. When the plastic limit was reached, borrow and pay off the balances. Then use the plastic again.” ([95])

In the meantime, one of the most bizarre events in financial history occurred and as quickly as it had happened it once again vanished from sight. One of the senior partners at ESM was named Bobby Seneca. He had recently unloaded his wife in a divorce matter but she decided that her settlement was not nearly adequate enough. After all, “The loans, piled on top of the generous salaries, were feeding a lifestyle that was increasingly ostentatious. There were luxury home, the lavish parties, Mercedes and Jaguars, lots of jewelry for the wives. She saw how the other ESM wives were living, and she remembered the $70,000 Vatican wedding, the countless grams of cocaine, the mink capes, and the $8,000 Rolex watches” ([96])

In the court trial, Bobby Seneca was represented by Gene Strearns of Arky, Freed who strangely “confessed” in court that ESM and its principals were actually broke. Furthermore, Stearns argued in court, “if news of the facts that he was enumerating in court ever got out, countless people would be wiped out, and the firm would collapse in a heap.” Seneca won the issue relative to support and ESM was the beneficiary of a true miracle when the judge bought Strearns' argument about secrecy, hook, line and sinker. Thus, the conspirators had been saved to pilfer more of their client’s money, essentially under the good graces of the American Court System.

Besides all of the good things that the partners were buying for themselves, the firm was investing a substantial amount of customer money in energy oriented transactions. They believed that the investments that they were making were so solid the even if everything else continued to go wrong with ESM, the investments would certainly bail them out eventually. Gomez by this time was

now a more than willing “worker bee” in showing “the boys” how to falsify their records in ways that Alexander Grant would never imagine investigating.

Novick determined to get even and he bet over a “billion dollars” that interest rates would decline. Either Novick was the worst trader that ever lived or just plain unlucky is not an issue for the moment, but naturally, as with everything else he was doing, he should have stayed in bed. Novick was killed by his bet and in reality wound up the year of 1980 with a $13 million loss, which when added to his previous total, bought ESM a $144 million hole. Interest alone was running ESM $20 million per year. However, the now debt-free Gomez was rock solid during this; period when he was desperately needed and imaginatively produced a $12 million profit for ESM totally out of illusionary profits for the year of 1980.

On the other hand, Pete Summers, a senior officer and shareholder of ESM decided that the game was getting a little to rough for him and wanted out. He would sell his stock back to the company for the inflated book value and keep his mouth shut. In order to make his point, Summers’ lawyer composed a scenario for the folks at ESM to read and it went this way in part:

“Example: Customer owns $50 million worth of collateral. ESM tells them they will give him $25 million for the collateral. ESM in turn puts the collateral out and receives $40 million. ESM nets out $15 million which they use to cover the loss ESM Government Securities took. They do this example three times to raise money to cover losses taken in the market. “

You may ask why any legitimate Savings Bank would give up $50 million in collateral in exchange for $25 million. In reality, there is no real problem, as long as the management’s of the Savings Banks were receiving enough money under the table from ESM, nobody seemed to be overly concerned. In any event, Summers was on the mark with his example and was quickly paid out by ESM management in exchange for a non-disclosure agreement and the promise to let them alone and to go bother someone else.

The rest of the news for ESM was both good and bad. They had dodged the bullet in a problem with the Federal Home Loan Bank Board and another with the Securities & Exchange Commission through the magic that Gomez ([97]) was able to construct with his magical use of the pitiful ESM numbers. However, these were nervous times for Novick who was seemingly now putting out one fire after another. However, when he left the office, there was a lot to go home to. A loving wife and three children that he adored. Race horses; show dogs and an imperial, castle like dwelling in Fort Lauderdale. The horses were an expensive hobby and for the most part could see all of the others when they raced from their usual position in the rear. On the other hand, his dogs were world-beaters and one; Ch. Braeburn’s Close Encounter won the best of the show award at Madison Square Garden, marking the dog as the world’s best that year.

Sadly for his family and partners, Novick died at the age of 44 from a heart attack just three months before ESM was officially closed. ([98]) Close encounter’s victory at the dog show occurred fully six months after Novick had died. It was probably Novick’s death more than anything that caused the ultimate unraveling of ESM, because he was the glue that was holding things together and when the glue was no longer available the unraveling occurred rather quickly.

Eventually, everything started going down the tube at once and because of Gomez’s fancy accounting work on behalf of Alexander Grant, the accounting company became the vehicle of choice by creditors to repay everyone’s losses. There were four-hundred-seventy partners of Alexander Grant at the time and each one of which was jointly & severely liable to both each other and the creditors. On the other hand, Grant had the foresight to have purchased a $500,000 deductible policy to the sum of $190 million. Caught with their hands in the till, there was never much question about how much Grant would pay, and ultimately by a series of shrewd negotiating maneuvers, the partners were let off the hook for their $1000 per man, deductible amount with the insurance company picking up the remainder.

What had occurred was theft and greed of the highest order. The results of these efforts by ESM management to pillage their company and others is listed below:

“The ESM merry-go-round screeched to a halt and devastation followed when the firm declared bankruptcy in March 1985. Its collapse caused pain and hardship to clients throughout the U.S., from Washington and Nevada to Texas and Pennsylvania. Ohio was hit hardest; ESM lasses bankrupted the state’s second largest S & L, Home State Savings of Cincinnati. A frightening panic followed, and a week later Governor Celeste was forced to shut down 68 other S & Ls. Half a million depositors endured agonizing weeks worrying if they’d ever see $4 billion of their money again. True tragedy struck when two of the ESM players committed suicide. Another died at his desk. Marvin Warner, Home State’s owner who was once worth $100 million and who had served as Ambassador to Switzerland, was forced in bankruptcy. He and an associate recently had criminal convictions overturned on technical legal issues, but further appeals and retrial loom for the in the months and years ahead. In the end, a large measure of justice was brought to the victims. The system creaked and groaned, it moved in fits and starts; but the thieves are in jail and the victims with the help of a very able lawyer of Ohio’s elected officials, have recovered almost all their money.” ([99])

George Mead and Nick Wallace, two principals of ESM had seen enough and hired legal counsel for protection. It was soon evident what had occurred at ESM and that $300 million was missing. The ESM principals were advised to cooperate with the regulators and close down the firm because when the nature of what had occurred became known, there well could have been a major panic in the financial markets in this country. The biggest creditor was a New York Stock Exchange listed company (a savings and loan) and there were still billions of dollars in open positions that had to be prudently unraveled.

ESM had set a number of standards when they were closed up for good. It was probably the largest financial crime that had ever been committed up to that date. The accountants were so involved in the deception that the audits done by them had to be restated for 1978 – 1984 inclusive. This was probably the landmark in restatements as well. In several instances, the entire fraud had come perilously close to coming unglued yet no one had ever thought of blowing the whistle. The most interesting aspect of this affair was the fact that all reports to the IRS were essentially correct and through the use of subsidiaries, the numbers were clearly available as to what was going on should there have been a desire to look. Obviously, Most bizarre was the fact that Grant was doing both the IRS returns as well as the company’s financial statements and they showed dramatically varying sets of numbers. In spite of the fact that the information was available in Alexander Grants’ records, no senior person thought to compare the two. Lastly, the entire sordid affair was given, chapter and verse to a divorce court when the issue of increased support had been raised; the court sealed the verdict and the information because it had determined that it would have been adverse to ESM. I guess we should ask the Judge, what about the creditors and the depositors?

Congress opened an entire subcommittee hearing on the matter and the words of congressman Ron Wyden probably expressed the feelings of the committee as a whole after they had gotten a dose of what occurred:

“The auditors tell us that they had no choice but to rely on second-party confirmations—in this case, the word of Mr. Gomez—that the collateral for these large loans did exist and did adequately secure their clients’ interest. What disturbs me is that the system literally breeds this kind of buck-passing. If the auditors went as far as the system and the rules of their profession require in confirming the collateral, any reasonable person would conclude that once again, the auditing system has failed…it is my view that the only watchdogs throughout this sorry spectacle were either asleep, forgot how to bark, or were taking handouts from the burglars.” ([100])

Ewton got a 24-year sentence for his efforts, Novick died of a heart attack, Arky and one of the accountants who was convicted and sentenced to jail both committed suicide. Grant was sanctioned by the Florida Board of Accountancy, received a 60-day suspension from accepting new clients and was absorbed by Grant Thornton never to be seen again.

Bre-X, King Midas Revisited

Indonesia is a country that has been doubly blessed with natural resources and its oil industry is the envy of its neighbors. The local mining industry is also world class and there are not too many days that go by when an another “elephant find” is discovered in one of the many thousands of islands, which comprise the country. Indonesia is the largest producer of the robusta coffee beans, which make instant coffee, it is the second leading producer of cocoa and palm oil and one of the world’s largest producers of rubber. It is one of the largest exporters of oil and has vast amounts of copper and aluminia. It therefore was not a major bombshell then, when a small Canadian mining company announced that they had discovered gold in Borneo, one of the islands that make up the archipelago of Indonesia.

As the weeks went on, the find’s size increased regularly until it eventually became by far the richest mother-lode since creation. Bre-X, of Calgary, Alberta, a junior company that only had a secondary listing on the Toronto Stock Exchange, announced that the find exceeded 200 million ounces of gold, ($120 billion) the stock soared on the Canadian Stock Markets, starting at pennies and raising to stratospheric heights.

In reality, the stock started life at 12 cents per share and before the magic carpet ride was over the price had risen to over $281. Fidelity Investments, one of the largest financial money managers in the world sunk substantial money into the company, as did a number of Canada’s largest pension funds. It’s geologist, John Felderhoff, won prospector of the year award because of his purported discovery and with an associate he shared the distinction of being mining men of the year. The market capitalization at the peak on Bre-x was $6 billion and class action suits have been filed against everyone within serving distance to the tune of $3 billion once it was discovered that they story was totally fabricated.

A team of highly trained geologists had evaluated the gold samples and pronounced that they were legitimate which had sent the stock even higher, and the frenzy assumed unstoppable proportions. More importantly, Freeport McMoran, a highly regarded expert in the field announced that they were creating a joint venture with Bre-X were also advancing substantial funding for the mining venture. l.

At this point the strangest of things occurred, the world-renowned chief geologist for Bre-X, Mike De Guzman, seemingly became disoriented aboard his helicopter and stepped off the plane into the ocean, thousands of feet below. Although this caused some consternation, pundits disregarded the aerial circus by remarking that “Mike always was tripping over himself.” While this homily satisfied many, an investigation was begun and Forensic Investigative Associates was hired to look into the claims that had been made. They found that the gold had been salted and that De Guzman had committed suicide. They named one Cesar Pupos as De Guzman’s accomplice.

Others have far more esoteric theories on Guzman’s demise and a have placed a broader conspiracy spin on the overall Bre-x hoax. There are some that are convinced that sometime before Guzman’s outrageous stories of gold all over the landscape first emerged, he was kidnapped by an Indonesian group and informed that he had to find lots of gold on the property or they would resort to serious dismemberment of his torso. These conspiracy buffs were led by a respected author in the Philippines, who just happens to have a book coming out in which she accuses Indonesian factions of helping to plot the scheme which resulted in the largest mining scandal in history.

In the early West, when someone wanted to sell his mining claim and then move along to greener pastures, he would often take gold and fill his shotgun shell casings with it, load the shells into his shotgun. From there it was a simple task of taking aim at his mine site and pulling the trigger. Gold particles became imbedded deeply into the rock and when a sample was taken it appeared as though the claim was awash with the precious metal. Mr. Guzman used modern technology to salt his claim and the saga of what has become known as the “bungle in the jungle,” a fiasco in which a global record six billion dollars was stolen from investors in the greatest scam in dollar terms in history. On November 5, 1997, the Court of Queen’s Bench, Alberta put Bre-X Minerals Ltd. into bankruptcy.

This Phoenix Kept Coming Back Just Like The Bird

We have seen many companies over the years that I would call “tortured.” What I meant by that was the fact that management just didn’t know when to let well enough alone. Effectively, there was a death-wish surrounding these companies and in many cases if they had only been managed a little less, they could have succeeded. That was not the case with our next case study. Of all of those, the most tortured that l ever ran across was a small company located in the San Francisco area by the name of Phoenix Laser. The company was headed by the despotic Steven Schiffer, a Wall Street alumnus who was literally too bright for his own good. Schiffer knew all of the tricks and used them all.

Phoenix Laser was a rather earlier entrant in the field of computerize-laser eye corrective surgery. The field was in its infancy when Phoenix entered and no company in the industry had done enough work to get a blanket FDA approval for their product. However, there was a company by the name of Summit Technology that had paved the way and had a big lead. The numbers that people were able to throw around were mind-boggling. As an interesting example, there could well have been 300 million near sighted people in China alone. Assume that you could cure all of them, wouldn’t that indeed be a wonderful thing and think of all the money you can project by multiplying 300 million times the cost of the surgical procedure.

Because the industry was in its infancy, the company was able to make claims about anything and everything, and were not bashful at all about doing it. Phoenix Laser’s public relations firm’s hired other public relations firms to help them tout the stock. Anything and everything was done to keep the company in the public view. Certain officers of the company literally spent all of their waking moments visiting with brokerage firms and giving brokers a pep talk, and more, on why this was a wonderful stock to own. If they had spent one tenth as much time developing a workable product, they could have changed the world.

Schiffer was an interesting study, his reading material was literally unworldly and his library contained the works of many of the world leaders in the games of mind control. He was able to create an allegiance from the public relations people by offering them stock that they may or may not get several years down the road if they performed some unknown task solely based on Schiffer’s unilateral approval of their work product. Nobody ever knew what performance really meant and whether it would have mattered or not, not very many qualified for Schiffer’s largesse as he kept most of the leavings for himself.

On the other hand, Schiffer knew every registration trick in the book and was able to raise money by selling stock under various securities regulation exemptions that were more than somewhat of a stretch. Foreign buyers were exempt from the same regulations that American Citizens were bound by and if they owned stock, it could be legally sold and they could use the proceeds to put money back into Schiffer’s Company. Kind of a perpetual motion daisy chain.

The stock seemed to go up and down like a yoyo and whatever direction it was going in, seemed not to satisfy Schiffer. It seems that he had an unusual clause in one of his offering memorandums relative to one of the classes of preferred stock that allowed him to convert into more shares of stock s its price declined. This has to be the most unusual clause in the history of public securities, when a chief executive officer of a company is allowed to profit more substantially from his own stock’s decline than from its advance. I guess you would call it a bonus for failure. The company would free up shares for the faithful under various securities exemptions and the more that got freed up, the lower the stock would go. At that rate It wouldn’t have taken a lot longer before Schiffer himself owned every single share.

We are talking about a company that was desperately in need of money to finish the development of their highly complex laser eye-surgery device. Even when the machine was completed, it would take a small fortune to get FDA approval. Thus, management should be hoarding every penny that it could in order to get over the hurdles it was facing. Not exactly! On August 8, 1990, Phoenix Laser made one of its first and most startling announcements. It announced that the board had authorized a stock buyback of up to 5 percent of the outstanding preferred and common stock in the open market over a period of time. They made the concept sound good by also stating that the trials being held at the prestigious Barraquer Institute in Bogotá, Columbia had been concluded. They didn’t indicate on what note that the studies had been concluded, only that they had been concluded. It would probably not have been a push to figure out that things had gone well if the company was going to buy back its own stock. While this announcement portends violations of disclosure regulations and just about everything else under the sun, the happy shareholders only wanted to think the best but they soon got another message.

The shareholders started to get the message where things were headed in January 20, 1992 when the company not only declared a 1-for-10 reverse stock split but also increased the number of authorized common shares from 25 million to 75 million. The reverse split was effective immediately and as though that weren’t enough, management was able to railroad through a resolution limiting the rights of shareholders to either call present proposals a corporate meeting. But the company had even more tricks up its sleeve. Through their control of the proxies they were able to get approval of a strange new class of preferred, designated preferred A, and there would be 50 million of those along with 25 million shares of another bizarre instrument called class B stock which could be converted into common. This single incident probably represented the greatest inside job every pulled on a public American Company since the Robber Barron’s had their own stock printing presses.

By January of 1993 the fat was in the fire. Schiffer, never anyone to give a gift without a rubber band around it that would bounce back into his pocket should the need arise, had created a trust earlier where the control of the company was held. He had appointed the seemingly independent and irreplaceable Sun Sun Chan as successor voting trustee of those shares. Whenever anybody thought that Schiffer was over-reaching he would point to the fact that the controlling shares were held by Mr. Chan, not himself and if I remember correctly he would finish the thought by stating that Mr. Chan was a highly responsible individual and the head of the SEC in Hong Kong. Well that certainly sounded good enough.

On the other hand, it turned out that if you were to read the very small print, it also went on to say that Schiffer could replace Chan whenever he wanted to and did so at that time. Apparently Schiffer was still concerned that he had not explained away getting rid of Chan after all of those niceties about him that had been explained in intricate detail earlier. He had to make more of a statement and that he did. Schiffer noted that “in recent weeks there has been substantial volume in its common stock on the American Stock Exchange and that he had reason to believe, without total certainty, that a substantial number of common shares previously subject to the voting trust agreements have been sold. Since the persons who executed the voting trust agreements retained the right to sell their shares subject to such agreement with knowledge or approval of the trustee. I kind of wonder what kind of a voting trust you are talking about when anyone involved in it can sell shares whenever they feel the urge. If that indeed are the terms, then we can only wonder what mortal sin Chan committed.

On April 5, 1993 it was announced by Phoenix that a dissident group including Sun-Sun Chan may seek to rescind the creation by the company of Advanced Medical Laser Company (AML) into which they had poured a substantial part of Phoenix Laser’s assets. Furthermore, the company had announced that they were going to do a substantial private placement of the stock in AML and Mr. Chan and his group were proposing to have the whole deal nullified.

Moreover, certain other investors were becoming cognizant of what was really going on and on April 21, 1993, Bernard Szeto filed a suit against the company stating the Phoenix Laser had transferred substantially all of its assets to two new companies, which would not be controlled by Phoenix. Szeto further announced that he was going to launch a proxy fight to gain control of the company. Apparently, Phoenix had gotten wind of the fact that Szeto had about enough of the shenanigans that were going on and in a preemptive action filed just short of two-weeks earlier, charged Szeto with misappropriation of funds. We don’t see how Szeto could have done that because he does not appear to have been a corporate officer or director. Maybe this is what made the accountants start to get nervous and they did become very nervous.

After the smoke had cleared things became a little clearer. Szeto had applied to the State of Delaware for an “inspection” of various books and records of the company in order to commence a proxy fight. A lawsuit was instigated against Szeto by Phoenix more likely than not to prevent him from seeing any of the company’s books and records. Without the litigation, he probably would have had clear sailing in getting everything he needed to make a sound case against management. It seems that the company realizing this, blew smoke into Delaware and Szeto was only granted a few of the things he had requested. On June 6, 1993, the court also ruled that Szeto was acting in concert with another major Phoenix shareholder named Chan and thus the restrictions. We don’t know what Delaware found that made two people unable to get what one could have gotten without any trouble. Phoenix Laser’s press release went something like this:

“Phoenix Laser said the court determined Szeto was acting in concert with another investor, Sun-Sun Chan, and that the two had ''caused their counsel to write threatening letters to two potential acquisition candidates'' and others. The company said the court said it found it ''troubling'' that Szeto ''has not undertaken any of the steps that obviously will be necessary if he is to mount a proxy battle with any hope of success.''

''We are very pleased with the court's decision, which we believe recognizes Phoenix's legitimate interests in protecting itself from the harmful activities of Mr. Szeto and Mr. Chan.'' ([101])

On October 8, 1993, the company announced that undisclosed foreign investors would purchase two million shares of stock if all the incumbent board members were re-elected. Considering what was going on at the time with Phoenix, this statement must have seemed like something out of Alice in Wonderland. Why on earth would anybody want to keep these folks in office one day longer than necessary. As if on schedule, Phoenix management announced that the deal was not going to happen for some reason or other. On the other hand they had never indicated whom these people were that were going to buy the private placement anyway, so nothing was perceived to be lost other than the fact that management’s statements were becoming more and more transparent to the accountants, the regulators, the shareholders and the law.

On October 18, 1993, in spite of all the twisting and turning, the management slate was voted out of the company and as you would expect they found fault with the vote and management announced predictably that they would challenge it. I think that it would be interesting to note at this point that incumbent management has a tremendous advantage in proxy fights. They have the names and addresses of the shareholders, most people blindly vote for management anyway and they also have the company’s purse strings. Most important, the election is usually run by management under their terms, at their place and at their convenience. It is a difficult job to get rid of entrenched management no matter what they do. Obviously in this case management had done a lot and then some.

In November of 1993, when Phoenix Laser’s Board with the sole exception of John K. Vyden resigned as part of a settlement with the litigants it became crystal clear who were to good guys and who wore the black hats. Apparently instead of dipping into the till as Phoenix management had accused the belligerents of, it would appear that the dispossessed directors had the goods on management and a bad settlement was preferred over the bloodshed that would have gone on in court. Apparently wanting to clean the company up, new management agreed to put money into the company as well as amending various reports filed with the SEC that were substantially in error. All lawsuits that had been filed were dismissed without prejudice and why not, the bad guys had been routed and new management was now in place

On September 9, 1993, Schiffer strangely became ill, resigned all of his offices with Phoenix Laser and hurriedly left the company. This may have had something to do with the fact that foreign investors had agreed to put up $10 million into the company pulling Schiffer’s bacon out of the fire. On the other hand, the whole deal was contingent on Phoenix Laser’s filing a 10K ([102]) This of course was easier said than done because of the pending resignation of the accountants.

Apparently simultaneously with Schiffer’s resignation, two of the founders of another public company somehow became involved in Phoenix Laser. Barry Witz, a California lawyer with a history of being involved with public companies talked his associate Chadha, the head of Osicom, into getting mixed up with Phoenix in spite of its checkered history of nothing but lawsuits and its astounding lack of a product. Chadha became Chairman of the company and indicated that he was going to do a financing based on SEC Regulation S. The deal was supposedly with Hibernian International financial Services Company. In the strangest twist of all, Chadha in an interview with Barron’s indicated “he was really trying to sabotage a deal put in place by his predecessor.” I would assume that he is talking about Stephen Schiffer. The deal tanked and two months later, in November of 1993 Chadha resigned as Chairman of the company. One stranger chapter in the life of the most bizarre public company on earth.

I have always had the concept that taking the role of director in a company is an issue of the public trust. In this amazing story, Chadha would have us believe that two uncanny things happened in tandem. First, his associate, Witz had asked for his help with Phoenix and he came to his aid by killing a financing started by former management. We do not know what was so inconceivable bad (if that was the case) about the financing, but if it was not a good deal, Chadha was Chairman and could have killed it by relaying the facts, not dealing in sabotage. The other strange occurrence was the fact that he served on the board for only two months and then resigned. Why on earth would anyone take upon the kind of liability that is concurrent with a renegade company like Phoenix Laser for only two months?

On February 3, 1994, it was announced by Phoenix Laser that “three former employees and Microdyne Inc. filed involuntary Chapter 7 bankruptcy proceeding against the company.” Naturally, the new Phoenix management found something wrong with all of the claims. Employee contracts had been rescinded and claims by Microdyne had no merit. The said that the claims are “spurious and malicious” attempts by former management to hurt the company. So apparently the folks that had resigned under pressure had come back to haunt the company once again. Well no one ever said that life was fair.

This was apparently the straw that broke the camel’s back for BDO Seidman who formerly resigned in the same month without completing the year-end audit or the 10K. In one of the strangest declarations of all times, Phoenix Laser put out a press release in early April of 1994 that they had not been able to find anyone to replace Seidman because of the liability involved in doing so. This company had gotten so bad that even the jaded accountants didn’t even want to step in to problems.

And it was not just Schiffer that ran out, Directors Jon Solow, Doug Hege and John Zee also departed for greener pastures probably figuring that the game was already over. Three new board members that probably didn’t have a clue as to what they were getting themselves into replaced them.

Among other things that came out, was the fact that the company would report a loss of $17 million for the year-end 1993 which followed a loss of almost $38 million the previous year. This mind you is for a company that has almost no employees, no products and no sales. They topped that off by saying that there was insufficient cash to last out the year and that it’s “pie –in-the-sky” product, the Ophthalmic Surgical Workstation and accompanying hand-held laser could not be completed under the circumstances. In reporting the brighter side of the matter, Phoenix Laser indicated that they lost a lot less because they weren’t hit by $7 million in stock offering costs that they had to pay in 1992.They also were able to avoid the massive write downs that they were suffering in their DGRI unit which was sold in June of 1993.

On the other hand, who was to know what the true facts of the matter were: Phoenix Laser explained away its estimated filling because of a number of reasons,

'…'due to the unsuccessful efforts to date in engaging an independent accounting firm and assessing the legal and financial complexities related to the poorly drafted and ambiguous contract for the sale of the company's subsidiary, DGRI and the lack of proper documentation underlying the financial records related to this sale.''

As if this saga would never end, on March 17, 1994 the bankruptcy court in California dismissed the Chapter 7 petition as frivolous. The court left standing only the claims that the company may have against those that had filed the petition in the first place.

''This was clearly an harassment suit, frivolous in content and designed to tie Phoenix up in a humongous web of suits and legal costs,'' said Richard Bliss, chief executive officer. ''But we will not be deferred from our focus on completing successfully our technology for refractive laser surgery.''

Phoenix Laser was finally able to get an accounting firm to represent them on March 20, 1994 and the unlucky company was Dohan & Co out of Florida. This also has to be the record for trying to find an accounting firm that will take your money but with Phoenix going in and out of bankruptcy like a rubber ball, directors resigning and lawsuits flying all over the place you can not blame anyone for being a tad cautious.

They didn’t have to wait too long to get indoctrinated. On May 26, 1994 the FDA issued a recall on what they called, Phoenix Laser’s Model 1000, Ophthalmic Laser Workstation. They indicated that things weren’t going that well on the research front either. The FDA report said in part: The device was found to lack an emission indicator for the aiming beam, the warning logotype label carried inaccurate HeNe output information, and the operator's manual lacked calibration procedures. New management didn’t really need to hear that.

Every time we think we have seen last of these folks they seem to come out of the woodwork once again. On January 30, 1995, a demand was received by the company from holders of almost seven million shares of B-1 preferred stock. The demand stated in essence that the company would be in default if they didn’t redeem these shares for 87.5 cents each immediately. The shareholders “maintain that they have the right to cause the company to repurchase their shares because of the company’s failure to register the common stock issuable upon conversion of the shares and list such common stock for trading on a national securities exchange.” The company stated that it had neither the obligation nor the money to do what was requested. If it were ultimately determined that the series B-1 stockholders had the right to sell their shares to the company, and the company failed to purchase such shares, the series B-! Stockholders would have the right to foreclose upon certain of the company’s patents, including the patents for its principal product, the Laser Knife. The company’s prospects would be highly uncertain should this occur”

I used to go to the movies on Saturday afternoon when I was a kid and the best thing about the show was a continuing segment called “The Perils of Pauline.” Every week, Pauline would get herself into some unbelievable spot and you could see her tied to the train tracks with the express bearing down on her or her going off a cliff without any hope of survival. This saga reminds me of those Saturdays I spent as a kid watching Pauline clutch victory from the jaws of defeat as we would see the real end of the previous weeks segment the following Saturday. But by the end of the reel, Pauline would be back in deep dodo again. It would seem that Phoenix Laser’s management contingency program was unlimited in its scope and just about every time the good guys attempted to get the ship righted again, a new scheme is polished off and brought to bear.

This is the company that the word bizarre was created for. They may have had a higher percentage of “stock offering costs” per dollar raised than any company since the beginning of time. Part of the costs were public relations oriented, I remember when I went to visit their facility in San Francisco, the scene was literally out of the Keystone Cops. All of the employees worked out of an elegant house in one of the better sections of San Francisco. As the clock hit high noon, people started assembling in the garden where a caterer had set up tables and was preparing a magnificent selection of cuisine. New faces suddenly appeared as if from nowhere for what was described as an everyday event at Phoenix. It almost looked liked someone had called a theatrical casting company and hired appealing people to make pleasant conversation. It was somewhat odd that these people never identified themselves or indicated what department they worked for at Phoenix but yet, every once in a while they would throw in some incongruous statement about how wonderful the company and its senior management was. The entire house could only hold, maybe ten or twelve people and we easily must have had fifty or more for lunch. It seemed that we were once again revisiting Alice and Wonderland.

The next surprise was the following day when Steven Schiffer took us out to the research facility personally. He talked about how “state of the art” the place was and indeed, that was what it looked like when we stepped inside. Machinery, wires, gadgets that we couldn’t discern, strange lights going off and on, but most significant was the presence of the requisite Israeli female Scientist. This was right out of James Bond, she was about six feet tall, dark and beautiful with so many degrees from so many great universities that we totally lost track. She was to be our guide within the plant. As best as I can gather, more people were in the plant seemingly working on wondrous things than were listed in the company’s report to the SEC as being employed in the entire company. Once again, it seemed that Hollywood Casting had come to the aid of Phoenix Laser and the show we were witnessing was an absolutely first class performance.

But the piece de resistance was yet to come. We were to be taken to see the doctor that was experimenting with the finished eye-laser devise and we were going to absolutely see it in operation. We were taken to a hospital in the San Francisco area and from there into a lab, which once again would have made Buck Rogers proud to be associated with it. The only problem was that we were the only ones on the floor. The doctor that ran the 25^th century device apparently had gotten his signals crossed and did not show. We felt that this was rather odd in that we had traveled all of the way to San Francisco from New York, not to have lunch at the pretty house on the hill, not to see the research facility with all of the wires and machines, but to see the corporation’s pride and joy, they eye-laser that was going to cure the entire Asia Continent of near sightedness. I became depressed.

We never saw the machine in action as the company filed for bankruptcy in December of 1995 for the second time. Once again it was not of its own volition. The petition in bankruptcy was approved and an attorney for the company indicated that “the company has no officers and only three directors and has not been operating for some time.” Shortly thereafter, VISX acquired the rights to Phoenix’s patent portfolio. The package represented 11 issued U.S. Patents and two that were pending. This was the last of the assets that had once been the property of the company.

The Securities and Exchange Commission by this time was all over the company and on August 7, 1997 they released the following report:

Today, the Securities and Exchange Commission ("Commission") filed a Complaint in the United States District Court for the Southern District of New York, alleging market manipulation, insider trading, the making of false and misleading statements in Commission filings, and the sale of unregistered securities, all in violation of the federal securities laws. All of these activities related to Phoenix Laser Systems, Inc. ("Phoenix"), a now-defunct company that was in the business of developing a laser workstation to perform eye surgery. The defendants are: Steven H. Schiffer (former chairman and chief executive officer of Phoenix), Joann R. Schulz (Phoenix's former president and chief operating officer), Gary S. Kramer (former investment relations representative of Phoenix), Jonathan Solow (formerly Phoenix's vice president, secretary, and director), Frank J. Cannata (a stockbroker and consultant to Phoenix), and Peter G. Mintz (a stockbroker and analyst, who covered Phoenix for his firm).

According to the Complaint, between May 1992 and August 1992, Schiffer, Kramer, Solow, Cannata, and Mintz, manipulated Phoenix's common stock to increase and/or stabilize its price in order to maximize the price of future stock sales. Based on this activity, the Complaint alleges that these defendants violated the antifraud and anti-manipulation provisions of the Exchange Act, Sections 9(a)(2) and 10(b) and Rule 10b-5 thereunder. The Complaint also alleges that from May 1990 to April 1992, Schiffer and Schulz caused Phoenix to make materially false and misleading statements in Commission filings concerning the status of its Food and Drug Administration ("FDA") applications, the number of orders for Phoenix's product, and anticipated revenue from the sale of its product. Based on this activity, the Complaint alleges that Schiffer and Schulz violated the antifraud and reporting provisions of the federal securities laws: Section 17(a) of the Securities Act, Sections 10(b) and 13(a) of the Exchange Act, and Exchange Act Rules 10b-5 and 13a-1.

The Complaint further alleges that from January 1991 through July 1993, while in possession of material, nonpublic information concerning the true status of the company's FDA applications, the number of orders that it had received, and realistic anticipated revenues, the same matters they caused the company to misrepresent in its filings, Schiffer sold approximately 1.5 million shares of Phoenix stock directly for approximately $4.2 million, and he sold approximately 2 million shares through the purported Regulation S transactions described below, for approximately $11 million, thereby avoiding losses of $15.2 million. Similarly, between December 1991 and September 1993, while in possession of such material, nonpublic information, Schulz sold a total of 251,050 shares of Phoenix stock for approximately $626,000, thereby avoiding losses of $626,000. Based on this activity, the Complaint alleges that Schiffer and Schulz violated the antifraud provisions, Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder. Finally, the Complaint alleges that, between September 1992 and July 1993, Schiffer and Kramer violated the Securities Act of 1933 ("Securities Act") by selling approximately 2 million shares of unregistered Phoenix stock for approximately $11 million. They disguised these sales as transactions that appeared to, but did not, comply with Regulation S, an exemption from the registration requirements of the Securities Act. Based on this activity, the Complaint alleges that Schiffer and Kramer violated the registration provisions, Sections 5(a) and 5(c) of the Securities Act.

In its Complaint, the Commission is seeking injunctive relief against each of the defendants. The Complaint also requests that the Court order Schiffer, Schulz, Kramer, and Cannata to disgorge all profits that they made and/or losses that they avoided as the result of their violations of the federal securities laws, and that they pay prejudgment interest on those profits and losses avoided. The Complaint further requests that all of the defendants pay civil monetary penalties. Finally, the Complaint requests that the Court issue an order barring Schiffer from serving as an officer or director of a public company.

The Commission acknowledges the assistance of the American Stock Exchange in this matter.

On February 11, 2000, the Securities and Exchange Commission made a deal with the broker involved in the case, Frank J. Cannata, who agreed to leave the securities industry for five-years for his role in the Phoenix matter. Looking at the consent decree will give you a pretty good idea of what the manipulation was all about:

“The Commission's complaint in the District Court action includes the following allegations: Between May 1992 and August 1992, Cannata and four other defendants manipulated the price of the common stock of Phoenix Laser Systems, Inc., a now-defunct company that was in the business of developing a laser workstation to perform eye surgery. During this period, Cannata was associated with registered broker-
dealers headquartered in New York, New York; and, beginning in July 1992, he was simultaneously employed by Phoenix as a consultant pursuant to a written agreement which provided that he would receive thousands of dollars of monthly compensation from Phoenix. As part of the scheme to manipulate the price of Phoenix common stock, which
traded on the American Stock Exchange, Cannata caused a number of purchases of Phoenix common stock to be executed for the accounts of his clients. These purchases were executed during the day and often at or near the end of the trading day, in a manner that increased the price of the stock. The end-of-day purchases frequently caused
Phoenix's daily closing price to be higher than it would have been in the absence of those purchases. Although Cannata solicited and caused a number of these purchases to be executed while Phoenix and a registered broker-dealer simultaneously employed him, he did not disclose to the broker-dealer or to his customers that he
had entered into an employment agreement with Phoenix. (Rel. 34-42416; File No. 3-10146)”

The Securities & Exchange Commission was on a roll. On June 2, 2000 they grabbed another broker for manipulating Phoenix Laser stock at the company’s behest. We will paraphrase their report:

The Commission's complaint in the District Court action includes the following allegations: Between May 1992 and August 1992, Mintz and other defendants manipulated the price of the common stock of Phoenix Laser Systems, Inc., a now-defunct company that was in the business of developing a laser workstation to perform eye surgery. During this period, Mintz was associated with a registered broker-dealer headquartered in New York, New York. As part of the scheme to manipulate the price of Phoenix common stock, which traded on the American Stock Exchange, Mintz, at the direction of Phoenix's CEO and vice president, caused a number of purchases of Phoenix common stock to be executed in nominee accounts. These purchases were executed during the day and often at or near the end of the trading day, in a manner that increased the price of the stock. The end-of-day purchases frequently caused Phoenix's daily closing price to be higher than it would have been in the absence of those purchases. For further information see LR-15435 (Aug. 7, 1997); Rel. 34- 42416 (February 11, 2000). (Rel. 34-42880; File No. 3-10216)

Another method of manipulating the stock that was used by the conspirators was to get a credible analyst to recommend the stock of Phoenix Laser in a newsletter. In Jerome Allen, Phoenix Laser had found their man. In September of 1997, Allen acknowledged in a court action that he had produced phony reports on a number of securities in exchange for cash payments. Along with recommending Phoenix Laser, under the prestigious sounding name Cambridge Research, the play for pay, Jerome Allen put out a buy recommendation on the stock of “Main Street.” He then recommended Ferrofluidics and pled guilty to felony charges for his role in that stock where he tried to cover up payments he received of over $1 million. Jerome Allen produced other bogus reports. He was also paid under the table to recommend Seiler Pollution Control Systems and York Research Corporation. Mr. Allen did some of his best work in writing a company orchestrated research report on Phoenix Laser. That report seemed to highlight the company’s phony press releases and progress reports giving the company substantial credibility on the “Street.” Mr. Allen for his part in this an other matters was facing sentencing on criminal income tax evasion charges but could get some kind of pass because he was turning state’s evidence in some other above cases.

From the looks of things, the SEC has only recently gotten down to housecleaning in this matter and we would expect much more to be coming out soon. Not to pick on anyone in particular, let’s just look at what one person accomplished with Phoenix in a very short time and what an accounting firm missed. Steven Schiffer, manipulated Phoenix Lasers common stock, he issued false and misleading statements to the SEC concerning, the status of its equipment as it related to the FDA, he issued false statement relative to projected revenue form the product and the number of products that had been sold. During the short time he ran the company he was able sell 3.5 million shares of stock for $15.2 million..

That’s a pretty good job of taking candy from a baby. Schiffer was running the company and knew exactly what was going on. He was telling his good buddies on Wall Street what a super company it was going to be and whenever they would buy based on his recommendation, he would always be selling. I would think that having stuck his associates with tens of millions of dollars in losses, whether Schiffer goes to jail for his actions is incidental. I would think he will be looking around every corner that he passes for the rest of his life.

The accountants were there during the whole messy period and BDO Seidman conducted themselves in extremely poor fashion. There was nothing correct about the financials, the company’s product, its sales or the Wall Street research reports that had been issued. Violations had been made in regulatory reporting, earnings and registration of shares, all using data accumulated by the accounting firm. They never blew the whistle and yet it would have seemed that they had to know that very strange things were occurring right under their noses. They resigned at the last possible moment and only when things had gotten so bad that another accounting firm could not be hired to replace them for months. (we have never seen this in any company). The fact that the accounting firm has not been named in the SEC action is somewhat astounding.

I have been around the securities industry for a long time and during that period I have literally thousands of SEC releases. I do not remember anything worded like this one during that entire time. These guys as officers and directors were seemingly rigging the stock literally every day of the week. They were equally adept at going in both directions and were thus able to benefit from the stock’s movement no matter whether it rose of fell. Some pumpkins!

California Micro Devices Corporation The Home of Vanishing Sales

California Micro Devices Corporation (Cal Micro) was a fast growing supplier of high-tech products primarily to the computer industry. Early on, Price Waterhouse LLP, their auditor, had seen the handwriting on the wall, questioned the company’s financial controls, and raised numerous other red flags including some regarding the quality of people responsible for financial reporting. Ultimately, Price could not come to terms with Cal Micro management and resigned the account. Coopers & Lybrand were offered the assignment and accepted without any substantive discussion with either the company or Price Waterhouse about their concerns. ([103])

It must have seemed to the Cal Micro folks that they had found a patsy in Coopers because it didn’t take too long before the company’s senior management began to generate sales out of thin air in order to make their projections. The transgressions were so onerous that two senior officials of Micro pleaded guilty of insider trading and were sent to prison. Six more were investigated with two of the former group ultimately convicted by the SEC on charges of both insider trading and financial reporting fraud.

Coopers & Lybrand was in the middle of doing the company’s books when it announced that it was writing off a large percentage of its receivables. The stock tanked and lawsuits were filed by irate shareholders that believed that they had been defrauded. In spite of these actions, within a short period of time, astoundingly, the accounting firm gave Cal Micro a clean bill of health. Two auditors from Coopers & Lybrand, Michael Marrie, and Brian Berry were charged by the Securities and Exchange Commission (SEC) with improper professional conduct relative to the audit that they conducted of Micro in 1994. The basis for the SEC charges against Marrie and Berry were the fact they missed numerous accounting irregularities in spite of the fact that Cal Micro had been singled out for special attention. “Even though the management at Cal Micro still committed fraud, Coopers should have done its job properly and it didn’t. They basically audited with blinders on and ignored red flags.” ([104])

“The auditors did increase the number of so-called confirmation letters sent to customers with outstanding bills; the letters covered 91% of the accounts receivable. But, according to the SEC, the auditors ignored warning signs flickering from some of the responses. Of the 37 replies to the auditors' 54 letters, the SEC says, one-third raised serious issues with Cal Micro's bookkeeping.” ([105])

Numerous employees testified in court that they gave the auditors chapter and verse on what was taking place and they had chosen to ignore the warnings. Ronald Romito, who was Cal Micro's chief accountant, testified in federal court in San Francisco that he asked the auditors if the company could book revenue on products sold but shipped after the close of the fourth quarter in June 1990 -- a practice almost universally considered improper. "And they said yes," What makes things more opaque is the fact that Cal Micro had no revenue-recognition policy -- that is, no guideline dictating at which point in a transaction it could be treated as a sale. We are also unaware of any guidance by Coopers in initiating one, certainly a very strange situation where the company’s CEO is also sitting on the audit committee, a very unusual state of affairs considering the fact that in almost all cases, this committee is reserved for outside directors.

“Cal Micro managers faced aggressive revenue goals, and by late 1993 were relying on ever-easier definitions of a "sale.” Besides the outright faking of product shipments, trial testimony showed that managers began booking revenue for products shipped before customers even wanted them; they often didn't reverse sales when customers returned goods; and they paid distributors "handling fees" to accept products that sometimes had unlimited rights of return, then booked the products as sales. “To keep track of it all, clerks compiled memos titled "delayed shipment," which became a euphemism for fake sales. Soon, even low-level workers were "joking about" the fraud, a former Cal Micro administrator, Karen Pujol, testified at the criminal trial.” ([106])

Substantial evidence was presented by the Securities and Exchange Commission that in spite of red flags flying all over the place, the accounting firm brought in junior personnel that in many cases were even unfamiliar with even the most basic accounting terminology. More specifically the SEC has charged the Coopers auditors with granting Cal Micro a clean bill of financial health while recklessly failing to conduct their audit in compliance with professional standards. Among other things, that the Securities and Exchange Commission looked at with particularity was the fact that Cal Micro wrote off over one-third of its account receivables. Such an obvious red flag would normally send a strong message to other auditors. In this case, it did not even create a ripple. The SEC therefore sought among other things to bar the offending accountants from ever doing a public audit again.

Ernst & Young were hired to re-audit the books and in 1995, Cal Micro restated its fiscal 1994 results. The Ernst & Young numbers showed that the company had lost $1.88 instead of the 62-cent profit that it had earlier reported. What is particularly disturbing about this situation is the fact that Coopers could have simply checked the company’s cash flow against its sales. Obviously, the numbers would not match. You can book all of the phony sales that you want but in the end, the whole thing explodes when the cash is not in the bank. This is the most simplistic form of accounting and it seems not to have been practiced by either Cal Micro or their accountants.

Crazy Eddie & The Cooked Books and Vanished Electronics

Eddie Antar never finished high school but that didn’t make him any less the entrepreneur. Eddie was a strange sight around the neighborhood; he was a body builder whose muscles had muscles. That along with his ritual outfit gym sweats that it seemed he never took off and the massive guard dog that was his pet, it didn’t take everyone in the area to know who Eddie was. Upon leaving his Brooklyn high school he started selling television sets door to door in his neighborhood. He ultimately opened up a unpretentious 150 square foot facility in Coney Island to sell consumer electronics in partnership with his cousin.

If you lived on the East Coast at the time, you can probably remember a fast talking pitch master who would recite the names of products so fast that you couldn’t even discern what he was saying. He would wind up this garbled spiel by telling you that you should shop at Crazy Eddie’s because his prices were insane!!! And effectively Antar’s pricing was first rate. If you walked into one of his early stores and if he was there ([107]), if you tried walking out the door without making a purchase, he would block your way, quote you lower and lower prices on the goods that you had been looking at, until he had made the sale. This was when Antar received the nickname Crazy Eddie. Antar continued to expand Crazy Eddie until he had established over forty stores selling almost $400 million in merchandise a year. Antar created other innovations such as the “double dip” warrantee. Effectively, Antar would have store customers purchase an additional warrantee when in reality they were already covered by the manufacturer. When a customer made a claim on defective merchandise, Eddie would reclaim the cost from the manufacture and was able to make a tidy profit. If Crazy Eddie was able to sell all their client warrantees, he discovered that he could sell his inventory at cost and still make a sizeable profit.

Eddie had so much power with the manufacturers because he was buying in such large quantities that he could resell to smaller dealers at prices that even the manufacturers themselves wouldn’t match. While no one other then Eddie Antar and his smaller clients were happy with this practice, numerous attempts to pull the plug on this part of Crazy Eddie’s business were unsuccessful.

It did not take the Crazy one long to start cashing in on his hard work. The company by this time had gone public and it would seem that Antar was a natural seller of his own stock. He kept on selling until he had dumped over $70 million worth of shares in his own company ([108]). Then again, Antar knew something that the public didn’t. His prices may well have been insane, but Eddie Antar sure knew how to cook the books when it came time to report earnings. When Crazy Eddie’s was taken over by another group in a proxy fight, they found that his inventory had been dramatically overstated and the profits that he had been consistently reporting were a total illusion. Antar ultimately pled guilty to a racketeering conspiracy charge relative to his scheme to defraud investors of over $74 million.

Antar had impressed Wall Street with his no-nonsense approach to the retail business. He was, would you believe, a grammar-school dropout who wore a sweatshirt to the office and carried on conversations in which every other word was literally unprintable. Street analysts advised him on what numbers he had to achieve in order to have his stock perform well and in Antar’s mind, if he didn’t hit those numbers, he could fabricate them. In the meantime, he was consistently peddled his stock, as did his dad, who pocketed almost $20 million by also misleading shareholders.

In the meantime, without knowledge of the “Street,” Crazy Eddie was running into the same kinds of problems that every business has to go through. The cycles in the consumer electronic business were dramatic and Crazy Eddie was now caught in a vicious downturn. Being public had placed an additional strain on management with all of the reporting that was required along with the necessary Wall Street interviews. Employing executives that were hired solely for their loyalty (relatives) instead of their competence soon began to exact a price and that problem escalated when Eddie and his wife split up. The divorce was horrendous and the relatives took sides in the disputes. In the meantime, Eddie’s brother was the CFO and doing the books, a job where he was clearly over his head.

The store chain closed when the vendors’ cut off all credit, and Crazy Eddie’s net worth dropped from healthy (albeit phony) positive numbers to almost $26 million in the red. The new board, which had committed to try and keep things going, threw in the towel when they learned that both the company’s credit and its net worth were literally zero or less. The Securities and Exchange Commission in an investigation that they conducted found that the books had been cooked by Crazy Eddie’s almost from the minute that they had gone public. He would constantly overstate inventory while understating his accounts payable. Another trick that Eddie used was most unusual, he would take the sales that he had been making to other stores and assign them internally to his own shops. This made the financials appear that sales were ever increasing on a same store basis; a critical part of the Wall Street security analysis process. For a guy that was forcibly retired from school at 16, Antar certainly knew how to cover his bases.

The case reads like a detective novel, and in 1990 Antar did not appear in court to answer charges by the Securities and Exchange Commission. He thought that he was better off taking up residence in Israel than facing the music. His flight cost Antar dearly, the option of appealing the case which was instead, decided in his absence. The fact is that when Antar saw that the regulators were moving in, he not only fled to Israel but changed his name five times in his attempt to avoid arrest. He was not heard from again until investigators cornered him and forced Antar back to the states to face charges.

It took two years to bring Antar back because, although he had civil judgments, at that time, had not been criminally indicted. Eventually a Grand Jury supplied the needed criminal documentation and the U.S. Marshals who had been keeping track of his whereabouts simply plucked him off the street. When arrested, he was carrying a Brazilian Passport in a phony name. Antar had become an Israeli citizen but was unfortunately for him was not entitled to any protection from extradition because of the fact that his crimes predated his citizenship. He had been living in a luxury apartment in Yavne, Israel, a suburb of Tel Aviv. The big question on everybody’s mind at this point was whether or not Antar had an attorney or not. The lawyer that had been representing Antar made a hasty exit when Antar fled the country and became a fugitive. He said something about the fact that his client, whose innocence he was proclaiming far and wide, was making him look like a jerk.

When he was returned, and finally pled guilty to assorted crimes, the U.S. Attorney in Newark, Faith S. Hochberg said of Crazy Eddie, that he was, “The biggest stock-fraud schemer in New Jersey history has admitted his quilt.” For his efforts, Eddie Antar was convicted on 17 counts of racketeering, conspiracy and mail fraud. The judge remanded him to prison for over 12 years and ordered him to pay restitution of in excess of $120 million. Strangely, on the case’s appeal it was shown that the judge that had heard the case was negatively biased against Antar and the verdict was thrown out. Similarly to the Keating case, rather than go at it again in court, the two sides sat down and worked out a plea bargain. Eddie got a seven-year sentence but while he was awaiting trial and retrial he had already served a substantial amount of that time. When the smoke had cleared, Antar had to serve only two additional years of his sentence.

In another similarity to a case in this book, Edie’s brother Sam the accountant also received jail time. As in the ZZZZ Best case, (p. 76) Sam hit the lecture circuit when he got out and started explaining to the auditors and other regulators how it all happened, how it could be spotted and how to prevent it from happening again. He even went into the details of how he had been chosen to go to accounting school by his brother who had footed the bill, so that an outsider would not be privy to the company’s books and records. Barry Minkow after being released from prison had followed the same line. Sam also showed the same remorse that had been expressed by Minkow although you never really know whether these people are serious or not. It just probably played well on the lecture circuit. He admitted in his speeches that he was a cold-blooded thug and an willing participant in an expansive criminal action. “I hurt a lot of people. A lot of people lost their life’s savings...Accountants had to pay out money for crimes they did not commit, although they were negligent.” ([109])

Eddie Antar along with his brother, Mitchell ([110]) and according to the SEC, Antar’s father and his brother-in-law, used every device known to man in order cook the books for the years 1984 to 1987 ([111]). Primarily though, his imaginary inventory and artificial sales were his preeminent efforts. This produced over $45 million in illusionary profits that made Crazy Eddie stock scream ever higher. When the sorted tale came to light, new management had already been installed and Antar tried to shift the blame unto them, saying he wasn’t there when it all happened. When no one believed poor Edie’s story, things started to really unravel and Crazy Eddie was forced into bankruptcy. This is the time when Antar booked his plane reservations for overseas points. The other family members were left holding the bag and ultimately were hit with the short end of $72.7 million in court ordered judgments for their role in the matter.

This is a unique situation from another point of view though. Crazy Eddie had two sets of accountants during the period of time in question. The first were a company called Penn & Horowitz who represented the company before it went public. During the period (which is when most of Eddie Antar’s magic bookkeeping took place) of the public issue and thereafter, the accounting firm of Main Hurdman had taken over. Peat Marwick later merged with Main Hurdman so that their names eventually replaced Hurdman’s on the financial reports. Touche Ross in turn replaced peat Marwick when the new owners took over.

Hurdman quickly evolved conflicts of interest by having some of their people internally employed at Crazy Eddie. In addition to auditing Crazy Eddie, Hurdman also acted as their consultant and as such supplied Antar with a huge computerized inventory control system at a multi-million dollar cost. It was that inventory system that Antar was able to manipulate so effectively to throw Hurdman off the track when he indulged in his book cooking practice. Moreover, Antar soon found out that it was easier to fool the auditors with the quill pen approach and soon after installing the high-tech accounting machinery, went back to keeping the company’s inventory by hand. This, of course created both chaos and an inability for the accountants to find anything that they were looking for.

Almost the entire fraud took place under the Main Hurdman-Peat Marwick watch. What is unique here is that both accounting firms settled major class action lawsuits for substantial amounts of money after being charged with either knowing what was going on or the that they should have known what was happening. ([112]) Shareholders legal actions were substantial and most ghastly of all was the fact that so many of the documents requested relative to finding the facts in this matter had either been destroy or had conveniently disappeared.

We are unfamiliar with the quality of accounting that had occurred before the public offering but what went on thereafter was shameful. For Eddie Antar and his brother to be able to inflate inventories and earnings in the fashion that they did was absolutely shameful. The percentage of non-existent inventory reported in each financial report that the accountants certified will probably stand as a record in the annals of accounting screw-ups. I mean, we are not talking about General Motors here, yet the inventory inflation was over $80 million. That probably was more by double than the actual inventory that Crazy Eddie carried. This would literally indicate that the accounting firms never even scrutinized the inventory when they were doing their audit and while that doesn’t sound conceivable, what else could have happened?

The bottom line was that in 1993 a universal settlement was reached relative to the civil part of the Crazy Eddie litigation. Both the accounting firms Penn & Horowitz and Peat Marwick became part of that settlement which totaled $42 million. It was never disclosed who paid what. I was invited to the victory celebration in the offices of Sirota and Sirota. Howard Sirota was the lead lawyer for the plaintiff’s in the civil action and had put in massive time in helping the authorities along with his clients. At the victory celebration were the prosecutors, the bankers, the plaintiffs and an assortment of hangers on. It was a joyous affair and we were served carryout Chop Suey.

The Old Republic International Corp. Does It Their Own Way

The Old Republic International Corporation is a Chicago based insurer that is involved in writing insurance in the life, title, mortgage and property fields along with providing escrow services. Their management, it seems has some strange theories about what is above-board and what isn’t. They were reinforced in their peculiar beliefs by accountants at Coopers & Lybrand that seemed to feel that it was good business for their client to pocket the excess cash held by the company’s customers in firm escrow accounts.

Just as in almost every other case that we have talked about in this memorandum, we really believe that Coopers didn’t think that Old Republic was doing the right thing. The auditor, Gerald Fisher that managed the account for Coopers indicated that there were a number of factors that caused him not to blow the whistle. Each of them is a poor excuse for not reporting plain and simple theft of funds but let’s give Fisher and his accounting firm the benefit of the doubt. His first claim for not reporting the theft was that he couldn’t quantify how much it was. (An inauspicious start) That is an interesting claim, when a bank is robbed they can’t always tell right away how much has been stolen but in the old days, when they caught the robber, they hung him from the nearest try before a judge and jury could even convene. This is excuse wins the lame justification of the decade award.

Bad start, Gerry, but let’s give you another chance in the interests of being even handed. Mr. Fisher next tells us the because the liability couldn’t be quantified, it was not material. Subsequently to Mr. Fisher’s grim determination of immateriality, a substantial lawsuit was filed by the State of California against the company and Old Republic has already handed over $24 million that it finally agreed had belonged to hard working men and women throughout the United States. It was their money, Mr. Fisher and you didn’t do much about seeing that they got it back other than determine that their money wasn’t material. I would have thought that if it had been your money that had been illegally lifted by your client, you would have run to the nearest police station as fast as your legs could carry, you material or not. In all fairness, Mr. Fisher, you are not doing well at all and that is two strikes, one more and you are out.

Now Mr. Fisher, you mentioned to us that you didn’t like the fact that Old Republic was stealing customer funds but for the various absurd reasons given above, you did not do anything about it. Tell us Mr. Fisher what you did about the practice when you left Coopers and went to work for Old Republic as its auditor in 1994. Incidentally, we should point out that you still have the job as we speak. What have you done to change the policies relative to this money that you took from the people it belonged to. The bottom line was that the thievery existed when you were the company’s outside auditor and when you were their employee. Thanks, Mr. Fisher, but no thanks.

No matter what Fisher says, nothing would ever have been done about returning the stolen funds unless a whistleblower had come forward in California and informed authorities how Old Republic was stealing the own customer’s funds. The State of California thought enough of the charges that it claimed that Old Republic violated California’s false-claims act and unfair-competition and business-practices laws. In English that means that Old Republic “enriched themselves at the public’s expense” by failing to return unused and unclaimed escrow funds to home buyers or the state and at the same time, creating false records to cover-up the larceny. Moreover, they kept themselves business destroying or altering documents, pocketing interest on escrow-account funds; and imposing illegal or excessive fees and in some cases failing to provide the service for which a fee was paid.”([113])

California has raised a number of issues in this mater relative to the auditors who are now the merged, PricewaterhouseCoopers. Non-disclosure is one of the issues and California is now stating that the amount that is owed to residents of that state alone has skyrocketed to almost $70 million. We are certainly not talking about nickels and dimes. And What about the issues of independence when the Coopers guy became the internal auditor for the company? What about theft of poor people’s money? These people ought to be sent to jail like anyone else that aids and abets in a crime. Coopers, the keepers of the public faith, have certainly let us down big time and Fisher has not even been able to give us any solid double-speak to avoid his three strikes.

Everybody in California seems to be up and arms about the situation but we believe that Jared Kopel, of Wilson Sonsini Goodrich & Rosati said it best, “if independent auditors turned a blind eye to fraudulent activity for a number of years and continue to certify a company’s financial statement, then certainly a good case could be made that the auditors were aiding and abetting the company’s fraud. Amen!

Equity Funding And Counterfeiting

How many of us remember the folks at Equity Funding, a West Coast Insurer that was perceived by Wall Street analysts as one of the foremost growth companies in the United States. Its management style was cited countless times as being tops in their field and its seven-day a week work ethic was hailed by many as the primary reason for their success. Ultimately it was discovered that the round the clock work day put in by the executives was required to keep the company growing primarily because it was on nights and on the weekends when the company’s officers would fuel their growth by creating brand new, totally bogus insurance policies.

Regulators within the states that Equity Funding operated never caught on to its racket and it was only through the efforts of a securities analyst by the name of Ray Dirks that the plot was finally uncovered. Dirks reported his findings to his clients, the press, the SEC and State of California Regulators and was strangely suspended from the securities industry for his efforts in saving additional investors from getting creamed by the Equity Funding policy manufacturing company.

It would have seemed that cash receipts when weighed against insurance written would have quickly put an end to this sham, but a major accounting firm did not see fit to analyze the company from that point of view and regulators in turn say that they relied on the outside accountants.

But we are getting far ahead of our story. Equity Funding had so little about it that was real that we hardly know how to begin, but I think that when we unfold the entire story, any fair thinking individual would go along with our choice of awarding the Babe Ruth Award for financial scandals and the Gold Medal Award for accounting hoaxes to the Company and their prestigious accountants. Equity Funding in this regard become our first time double winner and the folks that brought us all the enjoyable reading material about how they did it, will be able to retire the trophies if they ever get out of jail. I guess you get the point, there is fraud and then there is Equity Funding, forever to remain a cut above the McKesson’s, The Billy Sol Estes’ and the Tino DiAngelis.

As a matter of fact we are so sure that you would agree, that we have now taken the liberty of placing Equity Funding ahead of both the legendary Sam Insull and Ponzi. For separating people from their money, we are convinced that Equity Funding has never had an equal. And yet, its fearless leader, Stanley Goldblum chaired the prestigious ethics committee of the Los Angeles branch of the National Association of Securities Dealers. In a book co-authored by Ray Dirks, “The Great Wall Street Scandal”, he pointed out that Goldblum was quick to weed out those how he didn’t believe were toeing the ethics mark closely enough. “He was harsh on transgressors…and gave substantially stiffer penalties than had been anticipated.” Something like the pot calling the kettle black I guess. On the other hand, these were people that came before him in his role as an NASD regulator. The same rules were hardly followed at Equity Funding.

The company was founded in 1960 by four equal shareholders. Two of the shareholders miraculously pulled out soon after the company was formed and the remaining executives became, Michale Riordan, the Chairman and Stanley Goldblum, a college dropout suddenly was named its president. The company became public in 1964 and a quickly gained a solid reputation as an innovator with a host of unique products. Riordan was killed in early 1969 by mudslide that encompassed his Brentwood, California home. Goldblum took over Riordan’s role as Board Chairman and simultaneously appointed Fred Levin as an executive vice-president and assigned him the responsibility of managing the company’s insurance operations.

Levin, before he had joined Equity Funding had received a law degree and had gone to work for Illinois State Department of Insurance, the state’s insurance regulator. Levin was much in demand on the Wall Street speaking circuit and always had a fast answer for the toughest of questions. In one such session Levin wowed his audience when asked what Equity Funding’s management philosophy was; “We’re conservative in our financial management…We are innovative in product development…and we are very traditional in our conviction that be serving the public’s real needs, we will continue to grow in accordance to the objectives we set for ourselves.” ([114]) The two proved to be a powerful team and soon they were able to substantially increase the company’s sales and earnings. By 1972, Equity Funding had achieved the stratospheric status of being named one of the 10 largest life insurance companies in the country. ([115])

Moreover, not long afterward, the West Coast based seller of insurance and mutual funds was ranked by Fortune as the fastest-growing financial conglomerate in America. And then again, a year later the company literally was no more. Not that Equity Funding blew out after its rookie year; no way. This Company had been around for a lot of years and continued to swindle the public for almost 10 years. Believe it or not, we are talking about longevity unknown in the history of financial scandals. When you are committing a major crime, your best bet is to share your little secret with as few people as possible, just in case someone gets a guilty conscience or wants to make a deal with a regulator. In this case, a virtual army of people was aware of what was going on, both within and without of company; many regulators have put that number at around the century mark. A number that is literally mind boggling when you consider that this scam was operated seven-days a week, on holidays and Sundays and even on Christmas. These folks were among the most dedicated criminals ever to appear on the face of the earth.

As a New York Stock Exchange listed company, this company’s regulators had regulators and yet even with all of those people looking over their shoulder, they bamboozled everyone. Maybe what they were doing was so outrageous that the auditors could not even dream that anyone would attempt to get away with such a gross theft. The deception started gradually. First the customer would buy a mutual fund and then at the end of the year, the fund owner would borrow on some of the fund’s equity and use it to purchase insurance. Theoretically, if the market performed well, the increase in value of the fund’s shares would cover the interest payments on the borrowed money to purchase more insurance. Nothing really wrong here so far but Equity Funding wasn’t bringing enough to the bank with this project so the planning group at the company held a special meeting to try to figure out what they could do to improve their bottom line.

Their first move into penitentiary-ville was to plainly and blatantly overstate the commissions that they were earning on the business that they were writing. All of the major executives in the company were involved in that decision including the CEO and the CFO. As their overbooking system started working magic with the company’s bottom line, management saw that this was good and made immediate plans to go public on the basis of such solid financial growth. But these were not sanguine folks and things were still not moving fast enough so another special meeting was held. In this session it was determined that the more money that Equity Funding had available, the more it could bring to the bottom line and the higher the stock would go. The insiders now determined to borrow money on non-existent assets. The more assets they could create, the more insurance Equity Funding could write so it was entirely logical to this little band of criminals that they could easily pay back the banks that were funding them from the increased cash flow that the policies would generate. Conceptually brilliant but this bunch had not counted on either of two things, human nature (the more you want the more you want) and plain old greed. (Why pay back anything when the company could continue parlaying the proceeds?)

The cohorts then indicated that they were being very foolish, if they didn’t show the money that they borrowed, they could go to other institutions and get money from them as well, and yes, what about the stock market? There is preferred financing and bond financing and equity financing, let’s make plans to do them all and do everyone else while we are doing that they said in a chorus.

Why not set the company up to do a mammoth funding and then go straight. Management determined that the accountants would have gotten suspicious if the company carried little or no debt, so the financial people started disguising the nature of their indebtedness through the use of highly sophisticated transactions activated within the company’s subsidiaries or within the subsidiaries of subsidiaries. Everything that our merry midnight workers had accomplished to this point was really in the minor leagues though, what really sets this company apart is what they did next. They determined to manufacture insurance polices. If they just issued policies and showed them to the banks and accountants, they could probably borrow a couple of additional bucks but that would take far to much work. What they thought up was literally amazing. By setting up a production line to create phony insurance policies, they could reinsure the imaginary policies and get the insurance company that they had laid them off with to pay them substantial money in front. This motion carried without argument. Soon everyone was clamoring for Equity Funding’s reinsurance and it

was then that the management started putting in 365-day years and 24-hour days to keep up with demand. They had truly arrived.

Someone came up with a problem. “What if the re-insurers ask to see the application forms or the medical reports on the policies, what are we going to do then? The folks at Equity Funding were not only hard workers but they were also quick on their feet. They created a division known within the office as the Maple Hill Gang. The Gang, which was primarily made up of middle-aged women, was offered a arrangement that they couldn’t turn down. As long as no one asks for the backup records for the policies we are inventing, you can party here at the office all day long. We will supply the champagne but remember, you guys are on call for serious counterfeiting should we request your services. The regulators, accountants and re-insurers were not particularly interested in looking at the backup material for the policies so for the most part, the Maple Hill Gang, drank their champagne, downed their Quaaludes, did their knitting and all in all, had a magnificent time. However, these were not lethargic women, in the few instances where they were needed, they performed flawlessly.

As technology advanced and as the fraud became more sophisticated, programmers were not only able to randomly create authoritative new policies by computer, but their software guru was also able to have imaginary policy holders die at regular intervals in keeping with historic census statistics. It is interesting to note that the computer seemed to go haywire for a spell as it was spewing out the deaths of far too many people. The techies traced the problem back to four guys that were running a little business for themselves while working for the company. They would generate phony death claims and then endeavor to collect on them. Senior management thought that this stunt was so good that instead of throwing them out the door, they were given a raise and ordered to create a much needed death claim unit for the parent company itself. Equity Funding’s management never got rid of a body that had larceny in it and were always able to turn a good fraud innovation into a exploitable corporate product..

Toward the end of Equity Funding’s existence, fully 50% of the policies outstanding, 64,000 with a $2 billion face value, were phony, and 70% of those written in the last year were about as good as a three dollar bill ([116]). Shortly before the regulators closed in, Stanley Goldblum, the company’s president was asked how Equity Funding could turn in this sort of performance on a regular basis he stated that, “Quite obviously, this kind of production can only be generated by a professional, thoroughly dedicated group of people.” What a guy. Later, Goldblum, along with twenty of his confederates, either pled guilty of engaging in a crime or were convicted. Goldblum spent some period of time as a ward of the state and soon after he got out became the chief executive officer of a small chain of medical care clinics. Interestingly enough, literally the day that Goldblum took over the top spot in that company, Seidman & Seidman, Equity Funding’s auditors at the time of its demise were horrified and submitted their resignation while walking a way from a handsome fee that they had already earned. Goldblum next became the comptroller of Primedex and was once again indicted for criminal charges relative to that company. Among other things, he was charged with was bilking the State of California out of millions of dollars in what was described as the largest workers’ compensation fraud in state history.

“Prosecutors charged that the defendants defrauded insurance companies and employers by, among other things, charging for medical services that were never provided, providing illegal kickbacks to doctors and chiropractors, and submitting ghostwritten medical reports.” ([117]) While in court attempting to beat his ongoing State of California rap, policeman nabbed Goldblum, handcuffed him and took him off to jail. It turns out that this arrest had absolutely nothing to do with his workers’ comp fraud. It turned out that he was then arrested for submitting false information and phony collateral in obtaining a $150,000 bank loan. Poor Goldblum; life just isn’t any fun when you are seventy-two years old and keep getting arrested.

Meanwhile back at the ranch, prosecutors were expecting that evidence would prove that the boys had carefully planned every move they had made for years, and that some illusive mastermind had carefully structured this colossal rip-off. However, no such grandiose scheme existed. This was a case of reaction rather that action. When the boys needed to produce more profit, they sat down and thought up endless magical ways to mystically create phony revenue. When they needed medical reports and backup material, they formed an entire group that they could call on at a moment’s notice to produce endless copies. Everyone was on the team and pitched in to create phony policies. Until the end, a good time was had by all.

Moreover, everyone helped to create an environment that could devise foolproof schemes. Once in a while they got off track. One of the detours makes a rather interesting story and indicates how hit or miss the operation really was. The boys were allocating reinsurance based on the size of the company that was purchasing it, how comprehensive they would be in doing a background check, and the money that they would receive in exchange for the phony policy. Thus, every re-insurer took its piece of the action, and the computer abused all of the re-insurers based on the predefined formula. One of the senior executives at a re-insurer made an anti-Semitic remark the primarily Jewish staff of Equity Funding took umbrage. Wanting to get even they had the computer reallocate a substantially higher percentage of phony policies to that re-insurer from that moment on. As the guys used to say at Equity Funding, bigotry can get to be a very expensive diversion.

Equity Funding’s outside accountant compounded their own problems early on by bringing in a senior auditor who arrived with immense baggage. That he was not necessarily all that bright was only the beginning of the story. His son was on Equity Funding’s payroll; thus, he had an immense inherent conflict. But considering his other problems, this wasn’t the most serious. He was a big bettor and lost habitually. When he was broke, he would go to one of the Equity Funding executives for money. His conflicts, his need for money and his lack of understanding of insurance created a perfect scenario of the boys at Equity Funding. This guy was in their pocket and the outside auditor would certainly not present a problem.

The people from the State were a different matter. Once again, “the boys” got together and came up with a simple and straightforward strategy to cover any potential problems that could come from this direction. They “wired” the room that the state people were using to evaluate Equity Funding’s records. Thus, they always had advance warning when a regulator became suspicious and immediately turned the matter over to the Maple Hill Gang for corrective action. If the problem was more complex and needed the attention of top management, the midnight oil would brightly burn. Equity Funding, in spite of red flags flying all over the place, was consistently getting great marks from the auditors and the regulators. As we have always said, hard work is the key to success. One of the regulators had indicated that he had felt that Equity Funding possessed the most pre-emptive management relative to problem solving that he had ever seen in the insurance industry.

There were endless clues about the criminality that was occurring daily at the company and yet the scenario continued unabated. As Lee Seidler of Bear Stearns indicated, the most telling of all was the fact that while sales were growing at a torrid pace, the expenses to produce those sales hardly budged. Seidler made one other statement that in retrospect is beyond comprehension. Seidler said, “No major fraud has ever been discovered by auditors.” He says he has repeated this assertion for years and has never been challenged on it.

Well, we can’t end the story without telling how the thieves got caught. There was a guy who had worked and then been fired from Equity Funding (it took a lot to get fired) named Ron Secrist. After trying to tell everyone one he knew about what was going on, he found a receptive listener in Ray Dirks, a Wall Street insurance analyst.

Dirks knew insurance cold and flew out to take a look at Equity Funding under the guise of his day job as a security analyst. It did not take Dirks long to be convinced that Secrist was right, and just as Secrist had done before him, reported the matter to literally all of the regulatory people that would listen. In the meantime, Dirk’s called his top clients who started dumping their stock in the company.

As the stock started to collapse, the SEC stepped in and confirmed for themselves what they had been told previously by both Dirks and Secrist. That was the beginning of the end of the story as far as Equity Funding was concerned, but as far as Dirks was concerned, it was only the beginning. The SEC certainly hadn’t listened to Dirks when he originally blew the whistle, costing investors and reinsurance companies substantial losses that well could have been prevents. However, they decided that Dirks had committed various securities crimes by calling his people and having them sell. They mumbled something about insider trading, but by this time, Dirks had published just about everything that existed regarding the Equity Funding fraud and was certainly, far from dealing in a vacuum. Eventually, the case was taken all the way to the Supreme Court, which found for Dirks and sarcastically suggested that the SEC did not really understand their own regulations.

Shareholders lost hundreds of millions of dollars when Equity Funding collapsed; as a matter of fact the market value of its stock diminished by $15 billion just in the week that the scandal became public. Goldblum served only a tad more than four years in jail and his compatriot, Levin received a sentence of only 30 months. Levine may well have been helped by his impassioned plea to the court on the eve of his sentencing, “Someday when this nightmare is over, I will conduct myself in a highly ethical manner which hopefully will repay for some of the crimes and fraud I committed.” ([118]). As we discussed earlier, Goldblum when released from prison didn’t take long to once again turn back to his criminal ways. After the speech that Levin gave you would not of though him capable of that kind of action. You’d have been wrong if you agreed. Believe it or not, soon after Levin’s release from jail, he was back in business running a small plastics company. It wasn’t too long after he had started to live the puritanical life that he told the court about when Levin was once again arrested, this time for stealing $250,000 from his own company’s pension fund. His indictment charged Levin with literally dozens of counts including forgery.

Fraud, or Worse

Cendant, A Deal Gone Super Sour

Cendant Corporation (Cendant) did not make anybody’s day when it announced on April 15, 1998, that the Company was going to be restating earnings due to the fact that they had uncovered “potential accounting irregularities.” The stock lost almost half its value the next day with shareholders out $13.9 billion when the smoke had cleared on the 16^th. Ultimately earnings were restated for a number of years previously and the amounts were in the $100 million range.

Cendant was a creation of a merger between current CEO, Henry Silverman’s company, HFS, a real estate conglomerate, and CUC International, a direct marketing organization. According to Cendant management, it turns out that CUC was playing fast and loose with general accepted accounting principals and overstated earnings a tad. A grand total of only $650 million in three years by “widespread and systemic, accounting fraud with “intent to deceive.” ([119]) From the looks of things, it appears that CUC dredged up every accounting trick known to man to deceive shareholders and their acquisition partners as well. The list includes booking non-existent sales, the fact that the company lost track of returned merchandise and due to that fact, never deducted the items from sales. They amortized their market expenses; hiding millions that should have been deducted under the column “sales expense,” and while they were at it, they also magically conjured up extensive make-believe assets in the form of accounts receivable.

For their trouble, ex-CUC principals are facing innumerable lawsuits (over 70) including chief honcho, Cendant Ex Chairman, Walter Forbes who rather unbelievably has indicated that he did not really know what was going on. Forbes was personally ridden out of town on a rail when, in an unprecedented action, forty-four Cendant executives beseeched the board to fire him, stating logically that even if he did not know what was going on, he certainly should have known. What is doubly embarrassing about this whole affair is the fact that the phony numbers were so unnecessary. We are talking here about a company that has subsidiaries such as Avis, Century 21, Caldwell Banker, Days Inn, Super 8, Knights Inn, Travelodge, Villager, Howard Johnson, and Ramada. Not exactly a shabby list of affiliates. It also franchises Avis rental cars and Century 21 real estate and sells memberships in discount travel and shopping clubs.

Oh and by the way, the accountants in this scenario were our old friends from Ernst & Young, who seem more often than not to be in the middle of things when they start to go wrong. It turns out that at least four of CUC's financial managers once worked at Ernst & Young. Ernst has said it's "ludicrous" to make any implication that these ties affected the firm's independence. Whatever the fact, the charges went something like this:

“The pension funds said in suits that were consolidated in Federal District Court in Newark that in certifying 3 annual reports, 7 quarterly reports and as many as 20 federal registration statements, Ernst & Young "knowingly or recklessly misrepresented" that its audits of CUC International were conducted according to proper auditing standards.” ([120])

They bought themselves out of lawsuits, which claimed that they were involved in aiding and abetting the fraudulent inflation of earnings of Cendant. Their restitution of $335 million topped the old record for settlements in shareholders actions by a pretty penny, and approached the $400 million Ernst & Young had to pay the Federal Government to negotiate their way out to the accounting misdeeds that they got themselves into so much trouble with during the Savings and Loan mess. Ernst & Young issued the standard statement indicating that they were a victim along with everyone else of the mess at Cendant but if you believe that one, you would want to buy this bridge that I acquired on the cheap that spans New York’s East River between Manhattan and Brooklyn. If you want, you can set up a tollbooth and charge every car to cross.

It was only a matter of a short time before a new set of phony earnings were published on April 15, 1998, Cendant offered for sale by prospectus a collection of securities called Feline Prides. This was followed by a statement by the company that there had been accounting irregularities. Thus, the earnings within the offering memorandum were admittedly incorrect. That made Ernst & Young’s position very sticky indeed.

"Ernst & Young failed to perform their watchdog function and Cendant shareholders paid the price," said H. Carl McCall, the New York State Comptroller and the sole trustee of the New York State Common Retirement Fund. The fund lost $26.5 million when Cendant’ s share price plummeted, said Theresa Bourgeois, a spokesman for Mr. McCall, adding that the five New York City pension funds lost $35.9 million and the California Public Employees Retirement System lost $26.9 million. Mr. McCall's office and several accounting experts said that in the highest previous settlement of a class-action suit by shareholders against an accounting firm, Arthur Young, a predecessor of Ernst & Young, agreed to pay $63 million to shareholders of Lincoln Savings and Loan in 1992. Another accounting firm, Arthur Andersen, paid $22.85 million in the same case, Mr. McCall's office said. Shareholders contended that they were led to believe they had invested in government-insured savings instruments, which turned out to be securities.

“In 1990, Arthur Young merged with Ernst & Whinney to form Ernst & Young. Mr. Bowman, who maintains an accounting industry database, said that two years after Ernst & Young paid record federal fines and penalties in 1992, another firm, Deloitte & Touché, paid $312 million in fines and penalties to settle similar federal claims arising from the savings and loan crisis. Referring to the Cendant case, Mr. Bowman said: "Anytime something like this happens everybody has to step back and ask, 'are we doing the things that ought to be done?’ Ernst & Young has to say, 'Where did our internal controls fail?’ " ([121])

The New York Times in an article by Joseph B. Treaster, on Saturday, 18^th, December, 1999 entitled, Accounting Fraud, Ernst & Young to Pay Millions, put it succinctly:

“Even though Ernst & Young said in a statement that it had been duped itself in the Cendant case and had done nothing wrong, accounting experts said it was a sad day for the profession and that perhaps new procedures were needed. The auditors are supposed to be smart enough that they don't get duped," said Howard Schilit, the president of the Center for Financial Research and Analysis, an accounting watchdog organization in Rockville, Md.”

"If the auditors of this particular company are completely exonerated," he added, "you have to look at the auditing procedures in general and say there is something very wrong with them. Other experts said Ernst & Young's failure to detect the fraud might have been a consequence of increased reliance by big firms on younger, less experienced auditors. Ernst & Young is the world's third-largest accounting firm. To maintain the profit margin, they send in young, inexperienced people to do a lot of the work," said Arthur W. Bowman, the editor of Bowman's Accounting Report, an independent monthly newsletter. "And then they rely on their experienced staff to review the work."

In addition to the amounts stated that were paid in by Ernst & Young, additional settlements were made totaling $2.8 billion. But Ernst & Young’s problems were not over yet. Cendant filed a lawsuit accusing the accountants of malpractice and breach of contract. While Ernst & Young parried with a counter suit stating that whatever misinformation they gave out was a result of what was given to them by Cendant employees. While this makes interesting reading, it doesn’t speak to well for the accounting profession when the outside accountant that is supposed to be checking on management seems to be admitting that they accepted gratefully whatever information they were given. To add insult to injury, there is still the U.S. Attorney in Newark who is investigating insider-trading issues and the omni-present SEC lurking in the background as well.

One June 13, 2000, three senior executives of CUC International pled guilty to Federal charges in what the government termed, the largest and longest running accounting fraud in the history of this country which cost investors almost $20 billion and was an ongoing fraud for 12 years. The executive that admitted to guilt indicated that the fraud was created from almost the inception of the company's going public. Management was most interested in meeting Wall Street expectations and keeping the stock up at literally any price. Cosmo Corigliano, the former chief financial officer of CUC put what had occurred in prospective when Judge William H. Wall asked him what had happened; "It was a culture that had been developing over many years, it was just ingrained in all of us by our superiors over a very long period of time, that that was what we did. The conspiracy to falsify the books had been directed by his superiors."

Casper Sabatino, one of the accountants involved in the numbers management was extraordinarily frank when questioned by the Judge as to what really happened. Judge Wall had been listening to what he considered double talk about what went on for a while and ultimately grew tired hearing long weasel words that Mr. Sabatino was using to describe what happened. Judge Wall interrupted Sabatino and got right to the point:

Wall: "Don't we call that cooking the books?

Sabatino "Yes Sir"

Wall: "Why did you do it?”

Sabatino: “Your Honor, I just thought I was doing my job."

On June 19, 2000, Cendant Corporation filed an amended complaint contending that “by 1997 at the latest, Ernst & Young knew that the financial statements of CUC did not fairly reflect its financial position and furthermore, knew that CUC senior management was fabricating the supposed support for its financial statements.” The complaint continues, that at first, Ernst & Young was able to conceal the fraud “first by negligence, then by conscious avoidance and eventually by active facilitation.” Cendant further stated that CUC Officials “were careful not to place Ernst & Young, in the awkward position of knowing too much or lacking documentation for its audits. They recognized that although Ernst & Young would facilitate the fraud, it would insist at all times on deniability.” The new complaint goes on to say that Ernst & Young partner, Kenneth Wilchfort was involved in inflating a merger reserve that ultimately was mixed in with corporate papers to make them appear that they had been originated by the company.

However, Ernst & Young in a counterattack is suing Henry Silverman, former head of HFS and currently the head of Cendant, “We are suing Henry Silverman and others responsible at Cendant because they knew there was fraud and did not inform their auditors or anyone else. They made the conscious decision to keep that from the public. We are ready, willing and able to litigate this case in the courts,” said Larry Parnall, an Ernst & Young representative.

You bet they are ready to litigate the case in court, if they do not, there will be a default judgment against Ernst & Young and they would additionally lose their insurance coverage. What is this person talking about? Can you imagine Ernst and Young making the statement, we are guilty, we have no defenses and we are not ready to go to court. Not Exactly! Joseph R. Lewis, special agent in charge of the FBI investigation stated: "Some people have referred to this as a case of earnings management. That is an attempt to sterilize the crime. It's about lying, deceit and fraud."

Thomas H. Newkirk associate director of enforcement for the SEC said: "For more than a decade, these and other employees of CUC manipulated and falsified CUC's earnings, their goal was one that has become all too familiar -- to inflate the company's stock price and meet the earnings expectations of analysts by reporting 25 percent earning increases every year." Neil Schorr of the Postal Inspection Service joined the chorus when he said, "Please keep in mind that the real story is about people, the investors who trusted, and the greedy people who today admitted that they breached that trust."

The people that plead guilty have agreed to cooperate with the Government. What this means in ordinary terms is that these people either have already or about to turn in their superiors. The company itself is readying addition litigation against all concerned and although the sentences in the cases that have just been adjudicated are substantial, the ones that will follow concerning those at the highest levels of management who do not have sweetheart government arrangements will insure that most of the leaders in this conspiracy will probably be spending a good portion of the remainder of their lives in jail.

One of the most interesting aspects to come of one of the weirdest cases in the history of accounting fraud is how the lawyers fared in the settlement. Out of total settlements of $3.1 billion the lawyers were awarded $262 million by a federal court in New Jersey on August 21, 2000. The firms of Bernstein Litowitz Berger and Grossman of Manhattan and Barrack, Rodos & Bacine in Philadelphia will divide the pot, which works out to 24,123 hours of legal work performed and a fee of $10,861. When the State of New York saw what the lawyers were getting on an hourly basis they went through the roof. On the other hand, this was a most unusual case and the plaintiff’s side of the matter had been put out for bid by the court. The winning firms in the bidding hit the jackpot and New York thought that they had been overpaid. On the other hand, New York was the only objector to the award. The case turned out to be the largest payment by defendants in a security fraud matter in United States litigation history by more than double the $1.4 billion, ultimately paid by various defendants in the Prudential Securities Case in 1994.

The whole thing seems to be a crying shame.

Livent, One of The Best Shows On Wall Street, But It Closed Early

We have all heard of Livent by this time. You know those lovable show business folks personified by Garth Drabinsky and Myron Gottlieb who told us that they were going to revitalize Broadway by bringing new shows and exciting performances to the Great White Way. And they did. They raised money from some very influential people both in and out of show business. They raised more money from people that had nothing to do with show business, people that trusted them. They made Broadway exciting and in the same motion they dissipated millions of dollars of investors’ money by keeping two sets of books, one with totally phony results and the other which showed exactly how bad they were doing.

“But that’s old hat - every crook since the beginning of time has played that trick. What makes this deal different than all the others? Tell us something different.” “Ok, I’ll tell you something these guys did that was different from anything that we have seen before. They hired the former chief auditor on the Livent account at Deloitte Touché, Maria Messina, and put her to work as the chief financial officer of Livent. Talk about getting the fox to guard the hen house. Talk about accountants protecting the public interest. This one takes the cake.” Oh, people have hired an employee from an accounting firm before. And some of them even did it at an outrageous salary, which normally couldn’t have been justified unless you added in all the extras that they expected to recoup. But we do not know an instance where it was done during an audit and the accounting turncoat was literally able to inter-relate with her former employees in going over the books and records and determining relevancy. She knew how their audit was done, what they would look for and best of all, she knew how to hide whatever was necessary from her former associates at Deloitte.

So when the chronicle of Livent’s problems began to leak, stockholders and investors filed class actions that named anybody and everybody as defendants. Early on though, people just didn’t catch on to the fact that Livent and Deloitte had committed just about the biggest no-no in the accounting professions code of ethics. They walked into an audit without clean hands, then certified that Livent’s books were in good condition, despite having condoned Livent’s capitalization of unrecoupable expenses for shows that had already closed.

Deloitte, already in over its head, should have had the common sense to at least footnote the fact that Maria Messina was one of theirs. The lawsuit that was filed against Deloitte indicated that it had “recklessly disregarded the facts when it audited Livent.” The statement of claim goes on to state that “Deloitte & Touche produced three sets of false and misleading financial statements. Deloitte either knew or recklessly disregarded the facts, which indicated that Livent’s financial statements were materially false and misleading, As a result, Deloitte issued unqualified opinions on Livent’s fiscal 1995,1996 and 1997 financial statements, when such financial statements materially overstated the company’s revenues, net income, total assets and stockholders’ equity. These unqualified audit opinions and reports greatly enhanced and facilitated the fraud.” Sounds like a reasonable conclusion to us, at least based on what facts we have available.

After all, didn’t the Securities and Exchange Commission file a civil suit against both men charging them with accounting fraud and insider trading. In addition, weren’t Drabinsky and Gottlieb both indicated in New York on sixteen counts of conspiracy and securities fraud? Isn’t it also true that the two men also fled the United States in order to avoid standing trial and have refused to defend themselves in this country? Isn’t it a fact that Maria Messina as Livent’s chief financial officer plead guilty to one count of filing false financial statements with the Securities and Exchange Commission? Wasn’t the head of Livent’s audit committee charged with engaging in fraudulent transactions along with his associates; a man that was in a job that was supposed to be sacrosanct.

Strangely, the accounting profession has no particular rule against “revolving-door accountants” and with SEC telling them in no uncertain terms that they had better address the problem before the government does it for them has caused no little consternation within the industry. We would strongly believe that action will be taken in this regard because the conflict is so obviously egregious. We would look for the Accounting Independence Standards Board, which has been around for three years without accomplishing a great deal, to either make the accounting industry toe the mark, or you can bet that the SEC is going to force the issue. We seriously have to wonder what the people in this industry are thinking about when it comes to protecting the public trust, or just about anything else for that matter when they allow conflicts of this kind and then do nothing remedially about it.

As to Messer’s Drabinsky and Gottleib, when U. S. Attorney for the Southern District filed 16 felony counts of fraud and conspiracy against the two, she had indicated that in spite of the fact that the co-conspirators were now living in Canada and had flown to avoid prosecution, she would see that they were brought back to stand trial. So far, that has not been the case a in spite of the massive amount of money that went through Drabinsky’s hands he has now gotten another hoard. He has recently announced that he is bringing the play, “The Island,” to Toronto next May. As for money, Drabinsky indicates that “a

number of splendid friends and individuals” have staked him to another chance. We would ask, another chance at what?

Philip Services Corporation Is Really Proactive

I think that the accounting industry has provided us plenty of fodder to vilify them without going too far a field. We would like to end this part of our story with what we consider to be a high note. A situation that encompasses almost every form of accounting and corporate fraud known to man. We take our hats off to both Philip Services and Deloitte Touché for creating what we believe is an impossible situation to match. A scam that embraces it all.

Philip Services was a fairly new company to Wall Street but their list of underwriters were to be the who’s who of the financial community. Merrill Lynch, Salomon Brothers and CIBC Oppenheimer made up just a few that were involved in the listing, which came out $16.50 per share.

However, even before the issue came out, the company started to have problems, which were covered up by a concerted effort between Deloitte and Philip, but we are getting ahead of our story. Lets hear what the Financial Post Company in a story by Sandra Rubin had to say on 9/15/1998.

"Members of Deloitte's audit team frequently joked with employees in the company's accounting and finance department that GAAP meant 'Generally Accepted Accounting at Philip.' At least three of Philip's high-ranking financial managers had been Deloitte auditors who were offered jobs at "substantially higher salaries than they were currently earning while ... engaged in the audit of Philip. Moreover, if an auditor raised issues regarding Philip's financial statements, Deloitte removed that auditor from the audit The Deloitte office that handled the Philip account was owed more than $1 million in fees when it OK'd the use of its 1997 audit for the NYSE offering, the suit says.

We don’t have all of the facts but I must admit that it isn’t too often that you get a stock that is listed on the New York Stock Exchange at $16.50 that drops before you can blink an eye to 1 1/8. You don’t often find such a stunning lack of due-diligence among Wall Street professionals where they raise money for a company that takes $400 million in write-downs faster than you can blink an eye.

We are talking about a shareholders lawsuit that is one-hundred fifty-seven pages long and it names just about everybody that ever was involved with the company and charges that they committed everything just short of murder in order to get their underwriting and exchange listing completed. Deloitte, Philip, their employees, the investment bankers are among those that are feeling the substantial wrath of disillusioned shareholders. We particularly like the line in the complaint, which goes, “Deloitte’s so-called audits amounted to almost no audits at all.”

The suit also alleges uniquely that the accounting firm was out in front in making recommendations on how to capitalize items that should have been written off. We would like to take this opportunity of giving Deloitte the Accountant’s Shame Award for coming up with the story that the Philip should use the excuse that they were training imaginary workers which could be capitalized instead of writing off a facility in South Carolina that had lost $8 million. We have seen a lot of things in this world but if this is true, Deloitte deserves a different form of punishment than what is commonly reserved for others that err severely in the accounting profession.

The suit is not always so serious. We thought that it does deserve a paraphrase of two.

. "Philip Fracassi, the company's [former] executive vice-president and CEO, routinely met with the company accountants and directed them to ensure that Philip meet the revenue and earnings numbers which were expected by Wall Street analysts," it says. As a result of this pressure, Philip's top accounting officers devised various schemes to report positive earnings growth, despite the fact Philip was a company in dire financial trouble."

There are additional stories about how the company tried to shift the blame for their problems to employees and how they were able, with assistance from the accountants to book non-recurring trading income as recurring profits from operations. There are other stories about how the Philip used barter agreements to build up capital without making note of the fact that a payable existed on the other side of the transactions. The whole litany is unnecessary, Philip Services filed protection under the provisions of Chapter II of the Bankruptcy code in June of 1999 and doesn’t look to be recovering anytime soon.

To put the matter to bed once and for all, on 4/30/99, the Securities and Exchange Commission announced that they were opening a formal investigation, following restatement of Philip Services operating results for 1997, 1996 and 1995, Once again in the for whatever it is worth department, we enclose part of the bankruptcy filing which if you will take a careful look shows that there are over $500 million in liabilities in excess of assets. If you consider that the company raised several hundred million its American Underwriting alone, the scope of the fraud can be perceived more clearly.

“WASHINGTON (FFBN) -- Philip Services Corp.'s Chapter 11petition, filed late Friday in the U.S. Bankruptcy Court in Wilmington, Del., lists assets and liabilities of $1.1 billion and $1.6 billion, respectively. Although the Canadian integrated metal recovery and industrial services company estimated the existence of over 1,000 creditors, Philip Services also predicted that funds would be available for distribution to unsecured creditors. As widely reported, Philip Services and 135 affiliates filed for bankruptcy in the U.S. as well as insolvency in the Ontario Superior Court of Justice on Friday In a press release, Philip Services said it has also reached an agreement in principle with Canadian and U.S. class action plaintiffs to settle all class action claims in return for 1.5% of the common shares of the restructured company, subject to court approval.”

Making Phar-Mor, Phar-Less

Phar-Mor was a private company that was in the super-giant drug chain business. It had achieved exponential growth and was already being compared to Wal-Mart as one of the great American success stories. The company had grown in just seven years (1985-1992) from just a few stores to hundreds. Sales went from literally nothing to over $3 billion. The founders had become pillars of their communities owning sports teams and contributing substantially to local charities. Ultimately it turned out that the company was engaged in a massive fraud with literally all senior management involved in funneling misinformation to investors. Those personnel including the president and Chief Operating Officer, Mickey Monus, the CFO and all of the internal audit staff, misinformation was also given to the accountants, the creditors and debt holders as well as everyone else in the outside world that had anything to do with the financial side of Phar-Mor. Class action lawsuits were filed against the company by investors and ([122]) creditors while the accountants, Coopers and Lybrand were named under the Federal anti-fraud provisions of section 10b of the Securities Exchange Act and additional actions were commenced by the State of Pennsylvania under their statutes.

The company went under in one of the biggest bankruptcies in U.S. history of a private company. Five hundred million was lost by debt-holders and creditors, management was assessed a total of $1 million in fines and two senior officials of the company were given jail sentences. Cooper & Lybrand LLP (Coopers) was sued for over $1 billion and they lost in court over what seemed to be the fact that they had made reckless representations to the plaintiff’s without regard to the truth of those statements.

To some degree, this case differs from almost everything else we have written about because of the fact that there was no charge made by the plaintiffs that Coopers knowingly participated in the fraud. However, Coopers was charged with making false representation in the certified opinions. Where the plaintiff’s had trouble with Coopers was in the fact that they did not believe that Coopers had either performed its audits in accordance with General Accepted Accounting Principals (GAAP) or generally accepted auditing standards (GAAS). Putting it more succinctly, creditors argued that they made they investment in Phar-Mor almost solely based on the clean opinion that Coopers had given the company and that effectively shifted the ultimate burden for performance from Phar-Mor to Coopers. As a matter of fact, chief lawyer for the plaintiffs challenged the jury with the statement, that if you can find that the GAAS audit was done when it should have been, the way it should have been done, then Coopers wins and we lose, if you find to the contrary, Coopers loses and we win ([123]). Certainly an interesting challenge.

Coopers portrayed themselves as a victim of a massive fraud, not a participant. They charged that Phar-Mor Management forged documents, lied, and “scrubbed” any material that was given to Coopers so that it bore no trace of any cover-up. In effect, Coopers was saying that everything they got from management was sterilized. Coopers people charged that the Phar-Mor internal audit team was literally made up of forensic accountants that were able to predict what Coopers would buy into and what they would not. They then made a record that would conform to that theory and for the most part, they predications were accurate.

Furthermore, there were certain documents that Coopers had constantly requested and had never received. The best thing Coopers could say in their defense was the fact that they always went through Phar-Mor’s hands first and were probably sanitized. That statement would seem both self-serving as well as being unresponsive. This argument does not draw much rain either, due to the fact that the auditor is expected to do an independent check of the company’s books. That means, having reasonable access to all materials and data that would be necessary to perform their work product without outside interference. .

In the meantime, Coopers’ chief auditor, Greg Finnerty was consistently running over-budget and the people at Phar-Mor were raising quite a fuss about it. This does not seem to be in question and because of the testiness of the situation, it appears that Finnerty was cutting a corner or two just to get the job done more promptly. Once again, the audit must conform to certain standards and the fact the Coopers’ people choose to cut corners in order to keep peace with their employers only played into their hands of those that were promulgating the fraud.

As we mentioned earlier, Phar-Mor’s president, Mickey Monus had all kinds of outside activities. He was on the boards of numerous companies and Finnerty believed that if they performed for him on cue, it could well lead to substantial additional business.

In 1988, Phar-Mor suffered an unusual and unpredicted loss of approximately $5 million. This would have been fatal to the company’s growth and a team was assembled to determine from whence the problem stemmed. It turned out that Tamco, a suppler to Phar-Mor who was owned by Giant Eagle, a company that was also Phar-Mor’s principal shareholder and whose owner, David Shapira was the Chief Executive Officer of Phar-Mor as well as Giant Eagle, was the culprit. Tamco told the assembled team that it had been shipping partial orders to Phar-Mor and had been billing them for the entire shipment. What happened next was enough to make a grown man cry. Internal auditors at Phar-Mor said that they could not determine the shortfall because they had not booked the Tamco transactions. (We are unaware of the reason for this but assume that it had something to do with the fact that both companies were subsidiaries of the same parent. While this normally would have absolutely nothing to do with anything, we are left with that as the only alternative)

Tamco for their part admitted that their books were in total disarray. They indicated that they could not figure out anything by examining them. However, a miracle occurred when everyone concerned sat down to try to work things out. It was determined, even though internal auditors had estimated that the inventory shortfall was only $4 million, that the correct number should be $7 million. That really saved the day because Phar-Mor was now able to show a profit and continue their unblemished track record. Coopers was able to show the item in a footnote to the financial statement because of the related parities issue involved and they too were happy ([124]). A miracle had indeed occurred.

Now that everything was back to status quo, Phar-Mor came up with the idea of buying Tamco from Giant Eagle in what they said was an additional effort to solve the inventory and billing problems. How by putting a company that couldn’t get their inventory straight together with a company that was falsifying their inventory certainly sounds like an accident waiting to happen, but all concerned thought that the transaction made a lot of sense, and it soon became a done deal.

Most damming though was the fact that Coopers was also the auditor for Tamco and for Giant Eagle, the parent. Thus, the crux of the matter seems to be that if Tamco’s books were in disarray and Phar-Mor didn’t even keep a record of what they had received, this should have sent warning signs soaring all over the place. In the meantime, when the settlement was arrived at, it was arbitrary and had nothing to do with remedying the problem or determining a more correct number. There were no work papers according Coopers that would have supported either the $4 million or the $7 million inventory shortfall. This is like flipping a coin and saying here is what I will need to make me whole and that would become the magic number. Coopers seemed to be truly out to lunch in this instance. The lesson that Coopers’ learned from this was the fact that apparently, Tamco was stiffing everyone by shorting them on their inventory. When they investigated further, Finnerty found that there was a new computer inventory system in place at Tamco and that was what was causing the problem. While Coopers’ rejoinder to the issues that had been raised contained enough bobbing and weaving to make a middleweight champion proud, there is no one fact that they raised in their defense that would have changed anything contained above one wit.

The next problem that arose for everyone was the inventory situation where Phar-Mor went from carrying $11 million in inventory in 1989 to $153 million in 1991. This in itself is not a problem because the number of stores was growing very quickly but as it turned out, essentially it was the inventory that did the company in.

Phar-Mor used a third party to conduct a physical inventory check twice a year. Coopers participated in that physical check to a limited degree. When the inventory results appeared, two numbers were applied to the inventory to determine profitability of the operation. The first was on non-price sensitive items where a higher number was used and the other, obviously on price sensitive merchandise, which had to remain competitive with other stores. In this case, a lower number was used. It was arbitrarily determined how much inventory was price sensitive and how much was not. Thus, by using this formula, basically one would be coming up with what earnings ought to be. The formula never having been tested failed miserably. On this occasion, it was found that the price sensitive inventory had been grossly understated causing profits to drop. On the other hand, no one found this out until the fraud was uncovered and at that point this useful information arrived to late to do anyone much good. Creditors did not have to argue long and hard to make their point.

The numbers were proven to be wrong and therefore there was not much question that Coopers did not do as thorough a job as they should have done. When I personally analyze a certified audit, I am making the logical assumption that this audit is correct down to the pennies and if the accountant’s had to make adjustments for whatever reason, they certainly would have been footnoted. Certifications are not meant to be, best estimates, which is apparently what Coopers delivered. It was further, rightly pointed out that a very small error in the inventory would create a massive and materially skewing of the books and thus, the sample that Coopers was using was too small to be meaningful sample. In addition, using the inventory as a form of checks and balances was obviated by the fact that the inventory was material issue in the companies profit. They were in effect utilizing an inventory test to prove itself, a vicious circle to say the least which at it best proves nothing. Thus, it was not a test at all.

With regard to the inventory, once the independent folks had signed off on their work, the Phar-Mor people would do some kind of rain dance on the whole thing which in the essence of time, seemed to totally confuse Coopers. While there seems to be no question that Coopers checked the Phar-Mor numbers up, down and sideways there is also no question that whatever they did wasn’t good enough. The fraud was perpetrated by the Company’s throwing the missing inventory into other accounts (bucket accounts). These accounts would carry the missing material during the year and to avoid detection would be thrown back into the individual stores a year-end under various and sundry descriptions. Coopers neither found the bucket accounts or the transfers back to the stores. ([125])

In reading the case; assuming the Coopers’ wasn’t in on the fraud and we have no knowledge that they were, the only thing left to conclude is that the Phar-Mor people were able to read the Coopers’ people’s minds. They seemed to know just what Coopers would confirm and made sure that those items were kept Kosher; on the other hand, the outside accountants missed a massive inventory fraud, which had reached unheard of proportions. Whatever Coopers did or did not do, once again does not seem to be the issue. Neither is It an issue of whether the Phar-Mor people had some “third sense” or even as some have suggested, that they were not from this planet, Coopers, plain and simply missed an inventory fraud that was super massive and that seems to be that.

With all the money that was being taken, Plaintiffs logically argue that Coopers was staring fraud in the face and turned their heads. We would fault Coopers, if we accept their statement that they never saw a phony entry, on never going back and re-examining their own records. One look at what they had done previously would have shown that their materials had been altered and the story we are writing would have been different. Rather than giving Coopers credit for never having seen a phony entry, we would give them a large demerit. This shows that they lacked thoroughness and were really trying to cut corners.

“Coopers' audit work in this inventory compilation area, because of its failure to investigate all of these fraudulent entries which were obvious, suspicious entries on their face, their failure to do this is a failure, in my opinion, that is reckless professional conduct, meaning that it is an extreme departure from the standard of care. They had the entries in front of them, and they chose to do nothing whatsoever to investigate. Had they done so, they would have found the fraud right then and there.” Charles Drott

Everyone seemed to agree that it would have been a Herculean task to analyze the entire General Ledger ([126]) of Phar-Mor. However, no one seems to argue the fact that had it been done, the fraud would have been uncovered on the spot. The plaintiff’s make a telling case when they discuss Coopers’ own manual and what it contains. The following is part of Sarah Wolff submission to the Jury:

“I want to talk about the issue of general ledger...All we ask you to do in this issue is, don't listen to what the lawyers have told you . . . what we ask you to do is look at Coopers' own words. Look at Coopers' training materials. The auditor must also review for large or unusual nonstandard adjustments to inventory accounts. Read Coopers & Lybrand’ s own audit program for this particular engagement that has steps nine and steps eleven that say look for fourth quarter large and unusual adjustments. Those are their words, ladies and gentlemen. That's their audit program, and you have seen witness after witness run from those words.” (Sarah Wolff)

Furthermore, it was pointed out that Coopers’ inventory audit program for the company required the auditors to examine large and unusual entries. Moreover, as we have seen, when the “bucket” entries were reversed back to the stores, they were very large, millions and millions of dollars. This was followed by the showing in court of a video tape starring one of the perpetrators saying that the “fraud would have been all over’, if Coopers had asked for the backup of any of the fraudulent journal entries.

Coopers defended their actions by indicating that it was customary to ask the client whether there were any large and unusual entrees that had been during the year. If this question was asked, the answer was either no or yes and we are not sure where we go with either one. If the question was not asked would can only feel remorse for those that would use this Coopers’ team in the future.

The plaintiff’s argued that a red flag should have hit the auditors between the eyes when they saw a spike in individual store inventory at the end of each year. ([127]) Management told two large whoppers to Coopers who seemed to have bought them hook line and sinker. The first was the fact that they always reduced their inventory prior to the time it would be audited in order to facilitate the count. Secondarily, they said that they always raised inventory before the Fourth of July Weekend. While both of these stories show a terrific degree of innovation on the part of management, it sounds a little like something that the Mad Hatter or the Queen of Hearts would have been telling Alice, not something real accounting people would accept without at least checking the facts. You have to keep in mind that were are not talking about nickels and dimes here. These folks were moving in excess of $140 million up and back on their books as though they were rubber bands.

So the company went bankrupt, the accounting firm was forced to pay a substantial amount of money to work their way out the litigation and the trustee in bankruptcy started to handle the claims of creditors. Five-thousand creditors of Phar-Mor inc filed over ten-thousand six hundred claims, Many of the claims pathetically were people who were literally ruined, but within all of that misery, one claim was particularly laughable. That was the claim of the man that engineered the $1.1 billion fraud, Mickey Monus himself. The bankruptcy court at this to say about Monus’s claim:

“The sheer notion that Phar-Mor could be indebted to Monus in any way would be laughable if the depth of the harm caused by Monus to the company were not so serious.” Monus claimed that he was due the money because of “wrongful discharge, malicious prosecution, termination of insurance coverages, vested pension, wages and accrued expenses unreimbursed and defamation and slander.” On the other hand, Monus will not provide any material regarding his claim standing behind his rights under the fifth amendment. Because of the fact that 109 criminal counts are still overhanging Monus, he stated: “Pleading specifics and arguing specifics as to these claims would invariably implicate his Fifth Amendment privilege.” Is the way a motion filed by the defendant is worded.

In the meantime, Monus continues to attract flies. It turns out that he owned Superior Beverage Group Ltd., a wholesale liquor dealer whose prime customer was Phar-Mor. The Federal Bureau of Alcohol, Tobacco and Firearms, determined that Superior was guilty of restraining trade in interstate commerce. In exchange for his violations the company’s license was yanked for a time and they were penalized $40,000. What had raised the Government’s dander was the fact that Phar-Mor’s liquor purchases were determined by what side of the bed Monus would wake up on in the morning. If Monus wanted to see the money in his pocket he would overcharge Phar-Mor, if he wanted to help their earnings, he would undercharge them.

This was not major damage to Monus but soon he had a really bad hair day. Judge Kennedy in the Circuit Court found Monus guilty on all 109 counts that:

“charged him with conspiracy to commit mail fraud, wire fraud, bank fraud, and transportation of funds obtained by theft or fraud under 18 U.S.C. § 371 (count one); with bank fraud under 18 U.S.C. § 1344 (counts two and three); with wire fraud under 18 U.S.C. § 1343 (counts four, five, eight, ninety-one, and ninety-two); with mail fraud under 18 U.S.C. § 1341 (counts six and seven); with interstate transportation of property obtained by theft or fraud under 18 U.S.C. § 2314 (counts nine through ninety, and ninety-three through 106); with filing false income tax returns under 26 U.S.C. § 2706(1) (counts 107 and 108); and with obstruction of justice under 18 U.S.C. § 1503 (count 109). Defendant raises several assignments of error. For the following reasons, we affirm defendant's convictions on all counts, vacate his sentence, and remand to the District Court for sentencing consistent with this opinion.”

On the other hand, Monus never suffered from a lack of chutzpah, he appealed his 109-count indictment to a higher court. After carefully considering all of the fact they came to the following conclusion:

“For the foregoing reasons, we affirm defendant's conviction on all counts. We vacate his sentence and remand to the District Court for sentencing in a manner consistent with this opinion.”

And his bad hair day was not quite over, The Securities & Exchange Commission wanted to put the matter into proper perspective in their Litigation Release No. 14716 / November 9, 1995 SEC v. Michael Monus, Patrick Finn, John Anderson and Jeffrey Walley, Case No. 4:95 CV 975, (N.D. OH, filed May 2, 1995)

“The Securities and Exchange Commission announced that an Order of Permanent Injunction was entered against Michael Monus on November 2, 1995, by the Honorable Kathleen O'Malley, District Court Judge for the Northern District of Ohio. The Order also bars Monus from serving as an office or director of a public company. Additionally, the Order leaves open the issue of determining the appropriate amount, if any, of disgorgement, prejudgment interest and civil penalties to be imposed. Monus is the former President and Chief Operating Officer of Phar-Mor, Inc.”

“Previously, on May 2, 1995, the Commission filed a complaint against Monus, as well as Patrick Finn, Jeffrey Walley and John Anderson, alleging violations of the antifraud provisions of the securities laws. The Complaint alleged that from at least 1987 through 1992, Monus, Finn and Anderson, and, beginning in July 1990, Walley, while employed at Phar-Mor, engaged in a fraudulent scheme in which they falsified Phar-Mor's books, records and financial statements in order to artificially increase corporate profits. As a result of the defendants' fraudulent activities, from fiscal year 1987 through 1991, Phar-Mor cumulatively overstated income by $290 million. (In fiscal year 1992, the year in which the fraud was detected, Phar-Mor overstated income by approximately $238 million.) Further, the complaint alleged, false financial statements and records concealed Phar-Mor's growing financial problems and, during the course of the fraudulent scheme, induced investors to invest over $500 million in Phar-Mor.”

Investing In Azerbaijan

When the former Soviet Union split up it was almost as though the bad genie had gotten out of the bottle. While most people in those countries seem to be stand up citizens trying to make the best out of bad thing, there are bad apples in every crate, and some of them have unfortunately found their way to American shores.

Much of the money that was made in that country was accumulated through the business of buying and selling privatization vouchers. For the most part, the vouchers were issued to most citizens and they allowed the holder to own a piece of what had been formerly State-owned property. As there was no advantage on owning only one voucher, a market quickly developed in these pieces of paper and by being both smart and politically connected, great fortunes were soon made. Naturally, the majority of the people did not prosper greatly in this arena so this arena quickly became focal point for fraud.

When the vouchers were worth something, massive media campaigns were instigated throughout the country demeaning the assets value but at the same time offering to pay for the vouchers just to take them off people’s hands as a favor. Others took that reverse route and bought television and media time and touted their worthless vouchers as being able to provide enormous returns and many people were duped by the glitzy publicity as well. For the most part, whatever you did was wrong and eventually they seem to gotten to almost everyone in the country with illegal transaction or other.

In this country we hadn’t actually experienced the way that game worked until Viktor Kozeny, a Czech national hit these shores and gave us an outstanding initiation. This wasn’t just an ordinary Iron-curtain promoter, Viktor was a Harvard Graduate that seemed to have graduated from the “School for Scoundrels” not the prestigious Ivy League institution. Fresh from milking almost a million people in his homeland of over $200 million, the man known there as the “Pirate of Prague” used some of those funds to purchase a multi-million home in Aspen, Colorado so that he could promote American’s. Viktor’s home, a modern miracle was built large enough that both his wife and mistress could live in it without having to ever see each other for weeks at a time.

Kozeny became an elegant host when he blew into town and started throwing massive parties with so much caviar and $1,000 bottles of Chateau Petrus that even the jaded inhabitants of Aspen were overwhelmed ([128]). Kozeny’ s theory on how to readily separate American’s from their money was simplistic and had only two basic elements. The first, a story that made some sense. He came up with an unusually good one. He indicated that the State owned oil company of Azerbaijan was extremely profitable, and that was indeed true. He next indicated that he could buy up vouchers and purchase the oil company from the government for pennies on the dollar and was convincing enough to have made a killing.

However, the government of Azerbaijan pointed out that not only wasn’t the oil company for sale at this point in time, but it had never been for sale. He told his unsuspecting partners that he would purchase the vouchers and put them into the partnership at exactly what they cost him. He bought them at 40 cents apiece and sold them to the partnership at $25, which certainly is close enough. Kozeny also told his excited investors that he had only some 300,000 excess vouchers when the actual number apparently was over 8 million and perhaps more than 10 million.

The second part of Kozeny’ s two pronged theory was that even if you make up a story that is totally untrue, if you can find some dupe that has credibility to verify the fact that everything that you are making up is indeed true, you are on your way to a massive payday. Mr. Kozeny was able to complete the second part of his plan when he found the folks at the large accounting firm of Grant Thornton., Now that the facts are out and everyone is aware that they have been swindled, the investors are saying that no one really knew Kozeny and that they were all totally relying on the Grant Thornton report. District Judge Lewis T. Babcock of the Denver Federal District has already indicated that the investors are probably right on both counts. Kozeny has engaged in a stunning fraud and that the Grant Thornton report on which they may have relied is highly questionable. In part Judge Babcock’s decision indicated that the plaintiffs had demonstrated evidence that Kozeny had “engaged in racketeering activity by perpetuating frauds and laundering monetary instruments or funds.”

To indicate how well the plan worked, Kozeny found two investors, Leon G. Cooperman the Wall Street hedge fund manager and American International Group, one of the largest insurance companies in the world. Both, Cooperman’ s hedge fund and AIG did not get rich making deficient investments, but when you have an accounting firm that has Grant Thornton’s credentials telling you that everything the promoter is saying is true, you know two things, the first is that you can probably rely on those statements, but if they are not, you have a very deep pocket through which to recover your investment should they have screwed up. That seems certainly to be the case in this situation.

Cooperman and AIG each wired $75 million to a Swiss Bank that Kozeny designated. The mathematics of the transaction are rather simple, They got 3 million warrants in exchange for their $75 million which would indicate a price of around $25 a piece. Kozeny paid 25 cents for each of his warrants and there for made a profit of $24.75 for each one he sold giving him a payday of over $73 million. It appears that Kozeny was really a busy little beaver in this one and that while we are only using two of the investors as examples, it looks like Americans were stuck for at least $450 million in total and most of them are probably names that you would be familiar with. When the investors found out that the Azerbaijan State Oil Company was not for sale, they really began to smell a rat and lawsuits were instituted in four different locations simultaneously. Aspen, London, the Bahamas and the British Virgin Islands all granted court orders allowing an attempt to freeze Kozeny’s assets. Apparently all four courts have bought into the fact that the odds are that a massive fraud has been committed and they have taken the side of the investors.

The New York Times reported on Friday, June 16, 2000 that according to court documents, some of those assets consisted of:

“The assets include some odd items, like a couch hand-sewn with 33 alligator skins, art and furniture collections from the 17^th, 18^th and 19^th centuries;; a wine cellar with 500 bottles of rare merlots and 23 cases of vintage Port; a sprawling Bahamas home; a London mansion; and a 23,0000-square-foot aspen chalet.”

Mr. Kozeny who is now 36 made his first $100 million while still in his twenty’s had his own spin on the situation and indicated that the investors were filled with “rabid greed”. On the other hand, when Mr. Kozeny had cleaned out everyone he knew in the Czech Republic, he had said that it was “hurtful to be unappreciated.” This is the man who convinced everyone that the privatization vouchers had worth when the only thing of value in the entire country was not for sale and everything else was not worth owning.

Indeed, Kozeny had been well taught at Harvard. Kozeny himself said words to the effect that the investors knew that they were making an outright speculation that was extremely iffy and that the odds from the beginning were that they could well lose their investments. He called the investment, “extraordinarily reckless and imprudent speculation. The exhibits tell a story of the extraordinary risks men possessed with rabid greed will take when they see a one-in-a-lifetime chance to reap billions.” As it turns out, almost $10 million of the money that Cooperman and AIG invested went right into Mr. Kozeny’ s home in Aspen. That’s called, “not giving a sucker and even break”.

Grant Thornton will probably be digging deep into their pockets on this one. They have already been sued for $160 million by Cooperman and AIG for misleading them about how many vouchers were really outstanding. They indicated that they had relied on the representation that Kozeny had only 300,000 extra options, made by Grant Thornton. On the other hand, Grant Thornton indicated that they had not signed an official audit, they were really acting only as bookkeepers. I think we have heard that talk before and we don’t think that it will do Grant Thornton much good. Thornton has literally admitted that they supplied the investors signed documents through Kozeny with material that was not correct.

This early storm only includes a small portion of the money that has gone south. With, Kozeny’s global presence and Harvard background, they are not going to get much money back from him no matter how many judgments that they receive. You may also believe that Kozeny will no longer be visiting his residences in the Bahamas, London, Aspen or the British Virgin Islands for a while. Look for Mr. Kozeny to be wintering in Vanuatu and the accounting firm and their insurance company to be left holding the entire bag.

Globalization and Its Effect on Accounting

When I was a kid I grew up in a world that just didn’t want to become involved in extra-national affairs. We had just fought a “War to End all Wars” and Germany was already at it again. The terms “American First” and isolation were major parts of everyone’s vocabulary. “We’re not going to bail Europe out again, let them fight their own wars” was a common rallying cry the Roosevelt had to overcome.

The reason for this had its roots in several important areas of America’s background. The United States was the colonized, not the colonizer and we obviously didn’t have territorial obligations because we had no empire. Possibly of more importance was the fact that our corporations as well as those of everybody else’s were for the most part, purely domestic, having assets all over the planet was not yet feasible. Communications were still rudimentary, managerial talents were inbred, (nepotism was more important than ability) not learned and as such, highly suspect, and banking in far flung countries, not only was a logistical nightmare, it was a physical impossibility. Literally the only way to send funds to and from certain locations was to carry them by hand, not always a logical thing to do.

How did you get from here to there? Not easily, planes were not yet the answer and luxury liners only went to the better places. Globalization did not exist and it certainly wasn’t around the corner so everyone stuck to their internal knitting and the world would wait another generation or two before getting involved globally. Pre World War II the average American had only traveled 50 miles from where he was born, during his entire lifetime. We were not about to get involved in “someone else’s war”; that is until the Japanese sent us an invitation that we couldn’t refuse. Once aroused, the nation pulled together and the most industrialized nation on earth moved forward at a geometric pace once the need arouse.

We geared up all during the War; literally until the Axis surrendered and then speculated on what was going to happen next. The country had literally unlimited capacity to produce whatever goods the world needed and that was a lot. The trouble was that no one had money to pay for all these badly needed supplies and the tools for rebuilding. And what about the GI’s, they were coming back from overseas and were going to need jobs. Where would we find jobs for over 12 million American’s if we could not find some way to export what was being produced.

The United States, out of necessity, not altruism came up with the solution. It was called the Marshal Plan named after one of the outstanding American Generals of World War II. This program was a system of credits that allowed purchasers to pay for goods over a period of time. Unheard of until this point, after bombing Europe into submission we were now going to fund their rebirth. Along with gearing up the production of homes and cars for the returning GI’s along with all the other things that represent a better way of life, we smartly moved out of the rut we had been in. We mobilized our powerful production engine in a way that would help rebuild the bombed out cities of Europe and Asia, and while doing it we made a couple of bucks.

To show how well the Marshal Plan worked, one only has to look at the most devastated countries and see what had happened to them. These would have Japan and Germany immediately after war’s end. Within ten years, their cities had been rebuilt and they had assumed the mantels of the second and third most important economies in the world. And improbably they accomplished it while paying reparations and without a significant male population of working age.

Along the way, the United States’ industry started developing interests in all the countries that they were supplying and soon, the larger corporations were entering into joint venture agreements, purchasing companies and setting up representative offices throughout the globe. Transportation and communications for the first time were allowing travel within time limitations to far off spots. We became an “industrial colonizer.”

When the Korean War broke out, we no longer had the view that it was not our problem. We jumped into the fray without being pushed by our friend’s in either Europe or Asia. Moreover, when the French pulled out of Vietnam, we stepped into their shoes without hesitation and as demonstrated during Desert Storm, the United States had indeed become the world’s policeman for the reason that we now had something of our own to protect.. Times were really no different then with the colonial interests of old; when their was an uprising in the territories, they would deliver an army to the spot of the insurrection to put it down wherever it was occurring at the blink of an eye. However, we were not protecting territory as they were, we were protecting assets but similar rules apply..

This has been the story for the half century since World War II had ended and other than a murmur from Japan every now and again, we have unquestionably dominated the world. We literally control the World Bank, The United Nations and the International Monetary Fund. They were all set up under our rules and for our benefit at Brenton Woods. Things are now changing in this age of radical economic movement and with them will come nuances that we cannot conceive of at this time.

Of the 200 largest economies in the world, would you believe that 100 are companies. Talk about no representation. These guys literally make the world go round and are neither nor have votes in international forums. The manufacturing world has become diverse, shoes are made in Cambodia from leather that comes from Brazil with labor from Laos. The goods are transported to docks erected by the Koreans, onto ships owned by Nordic Companies and transported to Guam, where the shoelaces are inserted and the label of made in the U.S.A. is inserted and the duty is reduced.

This then is globalization and goods and services are found where the prices are cheapest and the quality can be high. India has become a world-class software innovator and diamond cutting and polishing center literally over night. (It is said that the average diamond travels to eight countries before it lands on a woman’s finger) . Malaysia, a country that three decades ago had one of the lowest standards of living on earth is now vying to be the high-tech capital of the earth. Everyday we read about another technology business from Israel being taken over by an American High-Tech Company for colossal prices and yet, two decades ago, the country was third-world to say the least, their banking industry was in disarray, their stock market had crashed, unemployment was rampant, they had just ended a debilitating war with the Arabs, they were attempting to acclimate new citizens from such diverse countries as Russia and Ethiopia simultaneously and yet they could barely produce enough agricultural product to sustain their population’s existence. The world has certainly become a dramatically different place.

Along with the industrial skills, communications sophistication and management competence that were becoming highly honed, other opportunities soon developed that shed a different light on things. As the raw materials turned into finished goods by traversing from one country after another where huge corporations had facilities, it dawned upon the Baron’s of industry that it would not be such a bad thing to become very profitable in that particular country along the daisy chain that had the lowest taxes. (transfer pricing) This was one of the ultimate mechanisms ever thought up by the corporate tax guys for avoidance. For the most part, it was legal for the simple reason that the government collection people couldn’t even fathom what was going on nonetheless address it.

The same kind of thinking that created transfer pricing also came up with the concept of establishment of subsidiaries where services could be loaded up as well. The best example of this is in the field of offshore insurance. Bermuda has become a particularly good spot for setting up a wholly owned insurance company to take part of its parent's international and national risks. In the meantime, taxes are so low in Bermuda as to be immaterial (that’s what our accountants call anything that produces less than 5% of the company’s earnings). Thus, money can be accumulated offshore by setting up reserves. If that big American Company wants to hide some revenue, all they have to is buy some insurance from a captive, overpay and then reserve against it. When the company has a bad year, they can reanalyze the reserve account and pull the money out in order to make their Wall Street projections. The Securities and Exchange Commission has recently figured out the ploy as well as the Internal Revenue Service, so we would look for some startling tax motion in this direction sometime between the in the 22^nd and 24^th centuries.

Global corporations also discovered something else. The learned that money is essentially a measure of power. If you had money when Asia was in a state of collapse, you could have bought the whole Pacific Rim for a song and wouldn’t have needed an army to defend your purchase. If the funds aren’t available, the other guy is going to be able to acquire the business you would have wanted at a fraction of its true value and you are going to be left out in the cold. The inroads that American Companies were able to make in the Pacific Rim during their problem period are legendary and they did it on their own terms because no one else had the kind of money to get in the door. First we sold them on Democracy and then used its nuances to buy their assets in the bargain basement.

Thus, a new type of thinking has started to pervade the globalized corporate world, what are the big corporations really getting for their tax bucks. It appears that the big wars of the future are going to economic, not the historical kind fought with bombs and planes. The days where the king provided protection to the people in exchange for the ability to tax and conscript them seems to have gone the way of the Carrier Pigeon. Corporations are not particularly getting military protection, they believe that they are paying a disproportionate share of taxes and literally not getting anything of substance back for it. A label saying that goods are made in the U.S. has recently become meaningless other than for duty purposes because quality standards are up all worldwide. In many cases, low-tech goods are interchangeable other than for the fashion end of the makeup.

With this attitude in mind, accountants have begun telling their large clients to shelter as much income as they can using highly sophisticated international tax avoidance strategies. After all, the client’s are told, the odds are only one in ten that you are going to get caught and if you do, nobody goes to jail for it anyway, you negotiate for while and then wind up paying what you would have at the outset. These schemes have become so pervasive that while after tax earnings of American Corporations has risen substantially over the last two years, taxes paid on these earnings have nose-dived while taxes rates have remained constant. The difference clearly is the fact that we have entered into a new era where, because corporations feel that there is not a lot the government can do

about their tactics, they might as well go ahead and push the envelope for all its worth.

While we believe that in the course of globalization, certain things were absolute naturals to occur such as transfer pricing which was like day following night and offshore subs sheltering secondary costs was almost as easy to figure. But between the accountants telling the clients that they are 800-pound gorillas and can do as they chose and their customers believing what they are being told, the situation is rapidly deteriorating. A kinder and gentler IRS has arrived at the wrong time to receive much serious attention and the Securities and Exchange Commission for all of its talk, can’t even get the accountants to make derivatives “material” on a supposedly transparent balance sheet.

In an article entitled The SEC Explores Role of Accountants In Providing Tax Shelters To Clients, by John D. McKinnon that appeared in the Wall Street Journal on March 24, 2000 the issue from the SEC’s point of view was put a least partially into perspective. We quote in part;

“In response to the proliferation of shelters, the SEC has begun trying to determine whether accounting firms are providing shelters and other aggressive services to audit clients. The SEC is particularly focused on whether accounting firms are providing such services on a contingency-fee basis, meaning they collect a percentage of the savings they produce. The SEC and other regulators worry that such arrangements give the auditing firm too much of a stake in the company's bottom line, putting pressure on auditors to uphold the tax strategies, even if they believe the plans aren't proper.”

“We have talked to firms regarding contingency fees, asking them to go back and take a look at their own practices and ensure that they aren't getting into contingency-fee arrangements that aren't permitted" under state rules or the profession's own standards, said Lynn Turner, the SEC's chief accountant. "We would be troubled if auditors have been advocating these tax shelters and putting themselves out there in an inappropriate position of advocating for a client, or have done it on a contingency-fee basis Peter Faber, a New York tax lawyer and former chairman of the American Bar Association's tax section, said he has seen contingency fees of as much as 40% for firms marketing tax shelters. In addition, he said, "I've talked to plenty of accountants who say they market ideas to audit clients...You wonder whether that creates an independence issue if you get a percentage of tax savings from an audit client." Mr. Faber recently testified about potential conflicts of interest stemming from tax shelters before the Senate Finance Committee. The panel is considering legislation to further restrict shelters.”

The thunderous upheaval caused by the Internet has also played a roll in the mystical times we see unraveling in front of our eyes. Everyone is so concerned about not intimidating the internet before it has matured that our legislators are stepping all over themselves wanting to be the first to state that, “there is not going to be taxation on the net.” Thus, anyone that wants to avoid sales tax only has to make their purchase on the net and if the cost with shipping comes to less than the same item would cost down the street, might as well buy it on line. I will probably get it just as promptly and won’t have to leave home. We are seeing a form of “transfer taxation” occurring here as well. The local store that has been dutifully paying its taxes is competing in a battle that because the odds are so badly stacked against them, it one that they ultimately unless circumstances change dramatically.

Street retailers will have to either come up some singularly unique solutions or suffer vendor obsolescence. Assuming that the establishment goes under, it discontinues paying and collecting taxes. The City, State and Federal Government will have lost a tax paying entity to the net, where, by the time these folks get around to figuring things out, the goods will be purchased from an e-commerce site located in Antigua and be droop-shipped out of a local warehouse in Memphis. This will create no taxable event under current regulations. Thus we are faced with the question of who is ultimately going to pay for the American infrastructure, the Antiguan Government? The company that is domiciled there that doesn’t pay taxes anywhere? Who? The answer is no one.

Shifting gears a bit, the IRS has recently stated that they are going to get really tough with offenders that execute a transaction without a discernable business purpose for the sole purpose of avoiding taxes. They have said that these guys are going to go to jail, and paying up their taxes will not be enough. Well, I haven’t seen any of them behind bars yet, have you? Then they said that if an accountant (or anyone else) offers customers a tax savings device, he must send a copy of the scheme to the government along with a list of everyone that purchased the shelter. Well I haven’t seen the first accountant grounded for that either. They talk about the demise of the abused “materiality” 5% standard that some how or other has become GAAP sacrosanct . Now they have gone even further and are pronouncing that you had better not hide behind materiality, Especially if you are only using it to withhold the realistic reporting or earnings in order to consistently generate earning that hit Wall Street expectations. They couldn’t get the derivatives to become visible even when the SEC, GAAP, The U.S. Government and just about everyone else in the world demanded a rule’s change. This one just isn’t going to happen either.

In a speech entitled “Tackling the Growth of Corporate Tax Shelters,” Treasury Secretary Lawrence H. Summers made the following remarks to the Federal Bar Association, Washington, D.C. on February 20, 2000

“Today there is growing evidence that abusive corporate tax shelters pose a similar threat to our tax system. Since 1990, the gap between book income and taxable income has more than doubled, in real terms, to more than $90 billion and is now wider than at any time since the mid-1980s. Even in a very good year for the corporate sector, last year corporate tax receipts fell by 2 percent. Although some of this gap can be attributed to other causes, there is no doubt that there has been a striking growth in abusive tax shelters.”

“As we made clear in the Treasury's White Paper on corporate tax shelters last year, abusive shelters have a number of malign effects:

Shelters reduce the corporate tax base and thus raise the burden on other taxpayers.
Shelters undermine the vitality of our voluntary tax system. Companies feel obliged to follow the lead of competitors who abuse the tax code in a "race to the bottom.” The New York State Bar recently highlighted the "corrosive effect" of shelters, stating: "The constant promotion of these frequently artificial transactions breeds significant disrespect for the tax system, encouraging responsible corporate taxpayers to follow the lead of other taxpayers who have engaged in tax advantaged transactions."
Shelters complicate the tax code by forcing legislators to take remedial action. In the past few years alone, nearly 30 narrow statutory provisions have been adopted in response to abuses further complicating the code.
And shelters divert resources from productive investment in the real economy. As a former tax official, now a leading member of a well-known law firm, has said: "You can't underestimate how many of America's greatest minds are being devoted to what economists would all say is totally useless economic activity."

Another anomaly of our “New Age Stock” economy is the fact that in the last two years, a period in which the market as ascended to unprecedented heights. One has only to look at the bizarre accounting statements emanating from companies such as AOL, Cendant, Livent and Waste Management, aided and abetted by their high priced accountants to marvel at what is really going on. Motorola, Compaq Computer, and WorldCom have all taken eye catching, one-time charges of astronomical proportions. Outright fraud, over-aggressive accounting, and misleading numbers have taken away the time honored practice of requiring that corporate statements reflect, in utter transparency, how well a company is or is not doing. The more open our society becomes, the increasingly opaque its accounting has turned out to be. At the rate we are going, nobody will know anything worth discerning about a public American Company audited by a Big Five Accounting firm in the next five years. The books of the average American Company will be so mired in muck that trying to make sense out of the average financial statement will take no less then the work of a forensic accounting firm.

Front-loading expenses and taking the “big bath” all at once are tricks that permit corporate earnings management; something that has concerned the Securities and Exchange Commission for some period of time. The SEC’s chief accountant, Lynn Turner, in a meeting with officials of Big Five Accounting firms among others, states; “If the basic accounting foundation ever loses credibility with investors, then the whole process would fall apart.” Arthur Levitt Jr., in a speech delivered on September 28, 1998 sounded like he was talking a foreign language when he addressed these issues, which were, “Big Bath Charges, Creative Acquisition Accounting, “Cookie Jar Reserves,” Materiality and “Revenue Recognition”.

Any of these innovations had they been practiced at an earlier date would have landed their advocates in jail. Not today, we are dealing with government agencies that on the one hand want to manage everything that has anything to do with the economy such as the Federal Reserve and Securities & Exchange Commission. Their theory seemingly is, “the economy is groovy, the stock market is fantastic and so what if some people are getting away with things that would have been considered literally criminal in another era, we are not going to screw things up just to nab a few bad apples”. And every time someone comes up with a solution that makes some sense, we have every do-gooder in the country outraged for the reason that some how or other, it is going to affect their rights to privacy. An additional issue that this broaches is the concern that crime has become high-tech and that many methods used to trap the criminals violate people’s rights to privacy. Some mess.

Moreover, an additional problem is the inconsistency of accounting standards once you cross U.S. borders. The United States talks much of transparency and that the rules elsewhere just don’t deliver in the same manner that U.S. regulations require. If you ever want to visually see the difference between U.S. standards and that of other countries, just look at new foreign listings on the New York Stock Exchange. The New York Stock Exchange demands compliance with American GAAP Standards but does not require the reporting company to translate these same earnings reports elsewhere. Thus, the earnings that are reported by a Japanese Company reporting in the United States can be vastly different than those reported in their home country. By comparing a listed company’s earnings here and then looking at it overseas, you will continually see that corporate earnings are substantially higher elsewhere, everything else being equal. The United States is gradually attracting the overseas big guys into our markets and we are telling them that if they want to get financing here, they better conform to our GAAP standards. But we are simultaneously sending a conflicting point, that there are plenty of loop holes in GAAP with more springing out like leaks a dike every day. If you are going to fudge your accounting and are a foreign company, please do it the American way by finding holes in GAAP. A stunning message for the rest of the world to follow.

However, the Europeans say that this is just another power grab by the United States and they are absolutely right. It looks like the inertia is working against the Europeans, which may include the fact that their vaunted currency, the EURO has never really gotten off the ground. But international standards are not even close to being right around the corner and when each country has its own rules, this leaves a lot of opportunity of fudging in one place of another. Europe after a long effort presented us with their compromise on accounting principals and in spite of what appeared to be an honest albeit inept effort, it was rejected out of hand. One of the great accounting fiascos of recent times was the fudging that Germany and France were doing in order to meet the standards that had been laid down for entrance in the EU. I think that the kinds of stunts that these countries circulated before ultimately settling in were an embarrassment for them and the conservative Bundesbank came in for very special heat over some revolutionary ideas espoused, especially by Germany during that period.

Politics hasn’t helped, campaigns cost a fortune today and the candidates spend more on just a primary than the price tag of a presidential election 20 years earlier. If the candidates want to persist in raising money on a parity with their competition, they had better be friendly to business, and if that means letting contributors get away with a little something extra, hey, that’s just they way things are. What is ultimately going to transpire because of this laxity is that the tiger is going to get larger than his cage and when he gets hungry, there better be something around to feed the beast. I really am beginning to worry that there won’t.

This country was not doing all that well when we embarked on a ten-year bull market. FDIC funds were non-existent, banks didn’t have the wherewithal to make a loan and social services were failing apart. New York didn’t have the funds to move the drug pushers out of Bryant Park in mid-town Manhattan and most central cities were in a terrible state of disrepair. Charitable donations had dropped so substantially that benevolent institutions were closing their doors because of lack of funding. We forget awfully quickly about how things used to be like in the antediluvian days of the early 1990s.

The excesses of the stock market have temporality glossed over those problems with unprecedented influx of tax collections. The market has retreated a bit and is now at levels, which will more fairly reflect what collections will look like down the road. The laxity that has gone before us and the technological changes that are creating a public and private anarchistic society will create an awesome price unless we reign in the excess now.

Really Bad Accounting Practices

McKesson & Robbins, The Case Of The Missing Auditors

McKesson's roots go back a long way, it was founded as a small neighborhood drugstore in 1833. The company grew and prospered over the years but was not without controversy. Currently they are making history for the second time relative to bizarre happenings relative to their audits and the U.S. Securities and Exchange Commission has notified the company that it is starting an investigation into the company’s affairs.

When you ask questions about where were the auditors you will sometimes bring a tear to the eyes of the old-timers as they recall the first time that regulators and public shareholders started holding the accounts responsible for inaccurate financial reporting. This was a fraud that culminated in 1937 where the company

was caught having enriched their bottom line by $1.8 million, their sales by $118 million and their assets by $19 million. This was big money at a time when the country was still digging out of a depression. Because of the Securities Acts of 1933 and 1934 with the anti-fraud provisions contained therein, this was literally the first case to be tested under the theory that the outside accountants were really to be independent of the company for whom they worked and thus could and would be held accountable for failures to keep the public trust in this regard. The Company was McKesson and the time was almost 65 years ago. The case was a first. When looking for a theme for this part of the article we had thoughts that dwelt tentatively on McKesson, the First and the Worst or in the alternative, McKesson, The First and Last. Sadly, the accounting fraud McKesson will neither be either the last or the worst.

McKesson acquired HBOC, a health care software firm in Atlanta. It was not long before McKesson announced that there were some serious problems with that deal. It seems that they found $42 million in sales at HBOC that were improperly recorded. That wasn’t quite all, McKesson also made the startling proclamation that it would have to redo all four of its previous quarters and that earnings and sales in the next year would also dramatically impacted. The old timers said, “here we go again” and the stock tanked by over 50%. Next came the lawsuits and they were not particularly benevolent. The seemed to take McKesson to task for one of the largest one-day diminishments in shareholder value, 39 points in stock market history. Moreover, for the most part they talked about how top management cooked the books on both profits and sales in the acquisition. This deal probably takes the cake for total lawsuits filed in one matter, thirty, count them thirty. That’s a lot of people to have out their digging up information that can be used against you ([129]).

What appears to have happened is that when HBOC and McKesson were to merge, it was agreed that Charles McCall the former chief executive would become Chairman of McKesson, Jay Gilbertson of HBOC who was president and chief financial officer would sign on as a director in the combined company. These folks had options and shares and their shares had shares ([130]). When it came to making a deal, obviously the more sales and earnings HBOC could bring to the table, the bigger piece of the McKesson pie they would get. William Audet, of Alexander, Hawes & Audet, chief plaintiff’s counsel in one of the class actions that has been filed was rather succinct in his theory of what had occurred, "Without question, the accounting shenanigans are rising to the level of securities fraud, When they admit they 'improperly recorded' revenue, those are industry buzzwords for 'Oops, we screwed up, and someone may have been cooking the books.’ "

Well it didn’t take McKesson very long to see things Audet’s way. McKesson made a rather clean sweep of things by getting rid of just about everyone in a position to have influenced the situation in negative terms, McCall was bounced along with President Mark A. Pulido and Chief Financial Officer, Richard H. Hawkins.

In the meantime, alongside of the countless class action lawsuits that have been filed, the SEC has been asking a lot of questions about the work the accountants did or perhaps didn’t do. HBOC’s auditor is Arthur Andersen & Company and McKesson is reviewed by Deloitte & Touché LLP. Both firms are probably going to bear the brunt of this one because they both had a substantial responsibility, although Anderson appears to been a more active participant.

Moreover, the narrative doesn’t end there. Apparently, someone got wind of what was going on quite some time before McKesson announced that they were restating earnings. Fully six weeks before the company came clean, some lucky lottery winner was buying tons of puts on McKesson Stock on the Pacific Coast Stock Exchange. As you know, the purchase of a put is a bet that the stock will fall and essentially, it is a sophisticated type move. To have known enough to have purchased a significant number of puts would mean that management spent a little too long figuring out what to do about their problem and not enough time reporting it or in the alternative, keeping the problem under raps. Thus, depending upon who hit the Pacific Coast Jackpot, will be critical in determining how much additional liability everyone is gong to have. You can bet that all of the securities regulators know exactly who bought the puts and naturally, in due course, a deal will be made with the purchaser to give his information in exchange for a little less jail time. That is of course unless it is an officer of the McKesson. The Exchange is also conducting their own full-blown investigation into what had occurred and who was the guilty party. This one is not going to take a brain surgeon to figure out who did what to who.

Dale Carlson a spokesman for the Exchange said that their attorneys had already been in touch with federal regulators. “Our compliance people have an investigation under way and we will file a report with the SEC if we find anything that warrants further attention.” I would proffer that if they don’t find anything that warrants further attention, someone isn’t doing their job. You don’t buy a gaggle of puts on a stock that has just made what appears to be, the best acquisition in their history without knowing a little something.

McKesson is so concerned about what is going to happen next that they have hired the big New York Law Firm of Skadden Arps to evaluate where they stand and to aid the company through what they believe will be a long and debilitating legal and regulatory experience. PricewaterhouseCoopers has contributed their forensic accountants to the McKesson brain trust in order to get key answers, a move that is akin to closing the barn after the horse has been long gone; on the other hand, it usually plays well with the unsophisticated and the news media. As best we can figure, McKesson has now in its employee, 60% of the “Big Five”, most of them running around in circles, with some investigating each other. What a mess.

A couple of other players that are in the deal and I am sure they would just as soon be anywhere else. Bear Stearns looked at the BBOC deal for McKesson as did Morgan Stanley for HBOC. Anderson and Deloitte signed off on the thing literally for both sides. Company spokesman indicated that everyone including the lawyers said to go ahead with the transaction, so why is everyone looking at McKesson management in such a funny way? Well, quite simply because the blew it really big time.

One serious reason may be the fact that The Center for Financial Research & Analysis in Rockville, Md., had warned investors both in 1997 and 1998 that HBOC was booking sales before they received cash. Christopher Teeters, the analyst for the center said that “They were booking revenue on software sales when they hadn’t collected the cash yet and they were getting more and more aggressive at it.” Isn’t it interesting that these guys seemed to have known what was going on, they made a public statement of their findings and that is spite of it all, McKesson’s lawyers, accountants, and management give the deal the go-ahead.

Out of the morass came even another legal action, which stated in effect that anyone that had gotten a proxy from McKesson and relied on it had been defrauded on the face of it. Thus, the lawyers who brought those charges have given up their claim in the class action and are moving their clients to yet another forum There they are going to charge the following:

“1 Charge that McKesson, HBOC, certain of their officers and directors, certain financial advisors and HBOC's auditors violated Section 14(a) of the 1934 Act;

2. Charge that the November 27, 1998 Proxy Statement omitted material information concerning the fairness of the transaction, the sufficiency of McKesson's due diligence investigation and true condition of HBOC's business, earnings, growth and financial condition;

3. Charge that by soliciting votes through this false Proxy Statement, defendants consummated a merger with HBOC to the detriment of long-term McKesson shareholders, grossly diluted McKesson shareholders' equity and damaged McKesson's business;

4. Seek to hold responsible the financial advisors accountants and lawyers who substantially participated in the solicitation of proxies and approval of McKesson shareholders of the merger with HBOC; and

5. Seek to set aside the merger with HBOC, rescind the issuance of common stock in connection with the merger to HBOC shareholders or recover monetary damages to compensate the existing shareholders of McKesson stock for their damages. “

Southmark

Nobody ever said that life was particularly fair. Gene Phillips, started a company named Southmark which after hundreds and hundreds of millions of dollars went down the drain, declared bankruptcy in one of the largest cases of its kind in American history. He left investors clawing, for even pennies back on the dollar and cumulative losses totaling over a billion dollars. Interestingly enough, at the time the investors were paid off at a rate of 5 cents on the dollar, it was estimated that the asset value of the company was almost three times that high. Moreover, Phillips and his partner were able take millions out of Southmark and latter went on to lead the good life from the assets that they had glommed on to that had belonged to the company.

Originally, Southmark was a Drexel Burnham client and as such, Drexel along with Michael Milken had raised them substantially in excess of over $500 million. Once the funding had been completed, Drexel put Southmark’s funds to work in other junk issues that they were pushing which among other things ultimately led to Southmark’s collapse. When Southmark declared bankruptcy and the trustee thought that there was something fishy about the entire Drexel relationship with the Company and hired Coopers & Lybrand to evaluate the work that Drexel had done. Primarily he was looking to see whether or not Southland would have a claim against Drexel, Milken, or both. While that was going on, in February of 1990 Drexel filed for protection under the bankruptcy code, making a complex matter even more difficult.

With Drexel in bankruptcy, Southmark needed permission from the court to retain Coopers which was granted. Coopers was expressly directed by the court to investigate, among other things, Drexel’s dealings with Southmark. Coopers disclosed at the time of its retention that it did some accounting work for Drexel, but the firm failed to disclose the kind and degree or work it did, or the fact that Coopers did substantial auditing work for Drexel. This confused the situation even more and when Southmark alleged that Coopers did not satisfactorily investigate Drexel’s exposure to claims based upon South mark’s ill-fated junk bond investments people had to get a scorecard to see what was really going on.

To add insult to injury, in April of 1993 a Coopers employee, by the name of Galbally charged that he was removed from this aspect of the Southmark account when he recommended investigating claims against Drexel to his superiors and was ordered to desist because (unbeknownst of Southmark) Drexel was one of Coopers’ largest accounting clients. In the end, Coopers submitted a report to Southmark that downplayed the viability of these particular claims against Drexel. Southmark, now totally confused elected not to pursue these claims by filing a timely proof of claim in the Drexel bankruptcy case.

Instead, Southmark focused its now limited resources on seeking recovery against Michael Milken, the mastermind behind Drexel’s junk bond operation, who unlike Drexel, had not filed for bankruptcy protection. Southmark developed claims against Milken that it asserts are identical to the claims it could have raised against Drexel if Coopers had completed its investigation in legitimate fashion. Southmark did eventually reach a settlement agreement with Milken that could yield more that $20 million from his settlement funds.

On the other hand, when Southmark’s general counsel later met with Galbally and he once again alleged that Coopers had thwarted his efforts to investigate the Drexel claims. Southmark, thereupon filed a disgorgement motion in the bankruptcy court seeking reconsideration of the court’s previous award of fees to Coopers for its work as the Southmark Examiner’s accountant. After extensive discovery, briefing and a hearing, the bankruptcy court awarded Southmark $585,042.48 in recovery from Coopers in a modified final order entered in April of 1995. Basically this represented the repayment of what Coopers had charged Southmark. Effectively, the court was saying that the accountants work-product was not worth a penny.

Three days later, Southmark commenced the a case for damages against Coopers in a Texas state court, alleging that the accounting firm had held back from a full investigation of certain potential claims by Southmark against Drexel; failed to disclose this omission; and misrepresented its investigative efforts because Drexel was a large audit client of Coopers. Additionally, Southmark alleged that Coopers failure to investigate prevented Southmark from pursuing potential claims against Drexel or filing a proof of claim in the Drexel bankruptcy. Southmark’s claimed breach of contract, fraud, breach of fiduciary duty and negligent misrepresentation alleging that Coopers’ conduct caused it to suffer damages including the total fees it paid Coopers during its bankruptcy case and the amounts it would have recovered on timely claims against Drexel.

Ultimately, Coopers fought the case hammer and tongs; most importantly, primarily because matter is basically a malpractice litigation, and it certainly is not the kind of situation that the accounting firm could afford to lose. When the smoke had cleared so time later, this matter had been heard by state courts, federal courts and had been appealed to the United States District Court for the Northern District of Texas. Along the way, Coopers even enjoined Southmark’s former general counsel as a third-party defendant. The court decided in an extremely complex decision that Southmark should have gone right back to the bankruptcy court for relief, not to the state and federal courts. By virtue of this, Coopers, for the moment, side steps the bullet in what appears to be a substantial miscarriage of justice.

Southmark was founded by Gene E. Phillips and his associate, William S. Friedman. Gene was Southmark’s chairman, president and CEO and was born and raised in Draytonville, South Carolina. After coming on the doorstep of receiving a PhD from Virginia Polytechnic he left school for a job in real estate development and soon, through a vehicle known as Phillips Development, he became the largest builder in that region. Almost as quickly, he overextended himself and went under in the largest bankruptcy filing ever made in South Carolina history; over $30 million.

Friedman, his partner was a canny New York Lawyer that had met Phillips while he was liquidating what was left of Phillips construction empire. He and Phillips parleyed and Friedman explained to Phillips that he had not done the job in the most efficient manner. If he was really interested in making money, why shouldn’t Gene buy pre-existing property available at distressed prices, mark-it-up and then sell it into real estate limited partnerships. Thus, if the deal succeeds, Phillips gets a percentage, but if it is a failure, it becomes the partnership’s problem, not Phillips’. Gene was partial to that idea and the two men formed a relationship that was to last through some of the most interesting and bizarre moments in American real estate history.

Phillips went on to Greensboro where he found a job with McCoy Development. It was here that he thoroughly learned the syndication business and within four years, in 1977, he bought out McCoy and renamed McCoy Development, Syntek Investment Properties. It was Syntek that ultimately purchased Southmark Properties, a then public company which Phillips and Friedman believed was selling at a substantial discount to liquidating value.

Phillips and Michael Milken soon met and became fast friends. This was like opening Pandora’s box or worse on an unsuspecting universe. The world would never quite be the same again. With Milken supplying the money, Southmark went on a buying spree that consisted of the acquisition of companies, in insurance, real estate and in finance. As Milken supplied financing to these entities, they showed their thanks by purchasing institutions that could acquire Milken’s work product, junk bonds. And purchase it they did, helping to fund the largest financial daisy chain ever created in economic history. It was not too long before even Milken couldn’t control Phillips, soon Southmark developed a new self-destructive philosophy, if it was out there and for sale, they he wanted it, and they wanted it now. Phillips, Friedman and Southmark had acquired interests in Gambling casinos, real-estate brokerage, energy, nursing homes and just about everything else that was for sale.

The partners rise to the top was breathtaking and their fall from success was equally sharp. Southmark had purchased hundreds of companies which had became part of their empire. They were also either a general partner or somehow otherwise related to additional hundreds of real estate limited partnerships and Southmark’s financial statement showed the company’s assets topping the $9 billion. However, in 1989, the accountants saw a deterioration of the assets and chose to write-down almost $1 billion, this caused the company to have more liabilities than assets, it had become insolvent and would soon be bankrupt.

As often happens in these kinds of cases, investors become disgruntled when bankruptcy occurs, especially when management has been telling them how well things have been going as they did here. This caused a series of lawsuits that may have set a record in American legal annals. Within a short period of time, over 800 lawsuits had been filed against the various entities, including the partnerships, Southmark, Friedman and Phillips. Nasty charges were bantered about and it became ominously clear that many folks were incredibly unhappy.

“The bankruptcy examiner described the doings of Phillips and Friedman as “the mother lode” of bankruptcy examination. He noted questionable transfers to insiders and affiliates prior to bankruptcy at close to $700 million. To 15 insiders alone, he noted payments of over $49 million in wire transfers and automatic debits that he deemed questionable, and this was before other very large, highly questionable transactions.” ([131])

The amount of self dealing going on was beyond classical, and it seemed that all roads led right into the pockets of the company’s righteous leaders, Phillips and Friedman. One notable incident occurred soon after the stock market crash in 1987. Phillips and Friedman were heavily margined and had their Southmark stock up at their broker as collateral; the securities firm took one look at the concentration in both men’s accounts and told their people to liquidate everything. The board, extremely sympathetic to the needs of their leaders approved the company wiring the necessary funds to the broker so that the men would not be thinking of their own financial problems when the board thought it made more sense for them to be worrying about Southmark.

In the meantime, the company did not really have to worry about how much money that Phillips and Friedman needed, as they were doing quite nicely, thank you. In addition, to show their gratitude to the fellow board members for their help in their hour of need, neither man ever bothered to totally repay Southmark for the money that had been extended. As a matter of fact, they were so happy with the board’s action, they determined to create a new way to enrich themselves at the company’s expense.

This consisted of taking those deals that appeared to be too speculative for Southmark and to put them into the partner’s accounts. Several things that were interesting about these new partnerships, the first, if the “brain trust” had been tapped out from the stock market crash, where was the money going to come from to finance the purchase of these so-called, speculative interests. This was quickly disposed of by Southmark’s Board agreeing to use company funds to purchase the senior partner’s interests. Not only did Southmark advance $70 million plus all of the expenses, but also the boys were being indemnified by Southmark for judgments against them. Wow!

Within a short period of time, Southmark’s shareholders were almost $30 million worse off because of unrepaid advances to the speculative partnership that the out of control Southmark Board had authorized. Not only didn’t the shareholders stand to benefit at all from this boondoggle, but even worse, Phillips and Friedman had worked things out so that the tax benefits inured directly to them, a tidy amount of just under $25 million.

Phillips and Friedman hung around with a pretty fast crowd. It seemed as though you could have put most of them in a line-up and without question, a great number would be fingered. Many had been convicted or were under investigation for savings and loan fraud and other nefarious activities. The examiner determined that Southmark senior management was guilty of “Outsider Cronyism” and when the day was over, they seemed more interested in profiting their senior officers than their own shareholders. The ultimate gift that Southmark could give to their friends was a deal that they made with ICH, a company that had been subject to merger talk between the two. The examiner pointed out:

“For a number of years in the 1980s, Southmark engaged in discussions about business combinations with the Louisville, Kentucky based financial service company ICH. Until the market reacted negatively, there had even been plans to merge the two companies in late 1987. (After the Crash). Instead of merger, though, at the very end of 1987, ICH and Southmark decided to buy $50 million of each other’s preferred shares. This, as the examiner noted, had the effect of “enhancing the equity stated on each company’s balance sheet. Then, in January 1988, Southmark, which had suspended dividends on its common stock, made a financial command decision. In order to avoid paying the preferred dividend to ICH, Southmark traded Southmark 17.4% senior notes for the Southmark stock held by ICH. As the examiner noted, “Beyond the waver of accumulated, deferrable Southmark preferred dividends of approximately $2 million, Southmark received no other even faintly measurable value for stepping up the position of ICH from a holder of near worthless equity to the significant position of a holder of Southmark senior notes…”Moreover, even though ICH was also distressed, Phillips did not ask ICH to swap its preferred for senior ICH notes. It was close to a pure gift from Southmark to his cousins in the Milken family, ICH.” ([132])

Southmark also carried out substantial business with such upstanding people as the convicted Charles Keating of Lincoln Savings and Loan. There were scores of nearly simultaneous transactions on both company’s books which totaled more than $600 million. It was difficult to really determine what had occurred but Resolution Trust figured out that Southmark was involved in a plan to keep Keating alive by rotating his debt and filed a lawsuit against Phillips charging him with aiding and abetting a fraud.

And then there was Herman K. Beebe who at one time simultaneously controlled 19 banks and savings & loans in Texas and Louisiana. Beebe and his associates were easily as good at nepotism as his friends at Southmark. A substantial amount of the loans issued by the banks flowed right into Beebe’s hands or those of his other cohorts. Ultimately, Beebe was indicted on 21 counts of defrauding the Small Business Administration on a loan that he surreptitiously arranged. Later he would plead guilty of bank fraud and cooperated with the government to keep his sentence down to a minimum. One would think that a convicted criminal would not be a great candidate whom to make loans. That of course would be the case if you were anyone else other than the boys from Southmark. They made loans to Beebe before his problem with the government occurred and to be consistent, they made loans to Beebe after his conviction. The gross sum of loans approached $100 million and in case you are wondering how this could be, you have only to look at Southmark’s Series E preferred which Beebe controlled almost 62% of to figure it all out. What we are saying is that the relationship here was not exactly what you would call arms-length.

Another one of Phillips’ friends was the notorious Morris Shenker was has for a long time been reputed to be associated with both the St. Louis and Vegas crime families. When Shenker started having trouble keeping his California and Dunes Hotel properties afloat he turned to Phillips. Southmark, refinanced the two parcels on a better than sweetheart deal for Shenker and in doing so overpaid dramatically. In addition, Phillips caused Southmark to purchase 1.2 million shares of the public stock in Dunes Hotel and Casino in Las Vegas that they needed like a third arm and which ultimately became worthless.

Phillips and Friedman had settled some of the Southmark litigation earlier by guaranteeing to pay a hefty sum of money in the failure of a former Southmark subsidiary, Pacific Standard Life Insurance Company. For some outlandish reason, the shareholders thought Phillips and Friedman were to blame and thus the forced settlement. Well, would you believe that the dynamic duo missed the interest payment and the litigants are back in court fighting over the same matter. Phillip’s position on the subject is that he wants to renegotiate it. That’s just terrific, you make a settlement under a court order and then you treat the contract as though it was of no consequence and then endeavor to redo the deal. That takes a good deal of chutzpah, but then again Phillips doesn’t have any lack of that. Steven J. Green a deputy California attorney general said, “I don’t know what there is to renegotiate, Phillips and Friedman owe $11 million if they default on the settlement.”

Not satisfied with just taking everything that they could scoop up, a new opportunity soon presented itself. Southmark had completed a roll-up of 35 limited partnerships called National Realty. The general partner was Southmark Asset Management Inc. (SAMI), a wholly owned subsidiary of Southmark. It had now become apparent to Friedman and Phillips that the game was over with Southmark, so sweet-talked company’s board to pass control of National Realty to them. There apparently was no consideration was involved in this transaction and it just was one more gift that the company was bestowing on their leadership.

This management contract proved to be a cash cow in any number of respects. The first was the fact that the price of National Realty continuously sold a major discount under liquidating value and Phillips took advantage of the situation by buying back huge chunks of the entity in the open market. The other advantage was that almost $20 million a year in fees went to “the boys” for managing the operations and it was this money they could use for reacquiring the investor’s interests. Thus, not only were the investors keeping them supplied with substantial cash flow, but they were also writing the scenario for the company’s ultimate termination. It was obvious that when Phillips had accumulated enough of the company, he would liquidate the investments and make an enormous score.

The lawyers that handled the bankruptcy for Southmark were well aware that Phillips had literally stolen National Realty with the help of the board. When it turned out that they were getting short changed a tad in the legal fee that they were charging Southmark’s estate, it didn’t require them to make a stretch in knowing where to go for the excess funds. It wasn’t long before Phillips and Friedman agreed to cough up $13.2 million into the lawyers underpayment fund and you had better believe that the deadly duo wouldn’t have gone for a nickel if they weren’t totally convinced that the lawyers would follow them into the grave to get their money.

The Southmark operation was both devious and ingenious. Southmark would buy a property for a particular price and them mark it up approximately 100%. They would then sell the property, virtually back to themselves by sticking their partnerships with the overpriced property. They would make the package more attractive by including the first payments so that no payments in the mortgage and no default could happen in the first several years. Obviously, what would then happen was that the property could not come close to supporting the mortgage that encumbered it and a default would occur, but by then, the boys from Southmark were long gone. Southmark had booked an enormous profit and its stock performed flawlessly on hopelessly fraudulent numbers. ([133])

As a result of these kinds of hanky-panky, Southmark, Friedman, and Phillips have been sued by the Insurance Commissioner of the State of California, The Resolution Trust Company, The U.S. Attorney, The Federal Office of Thrift Supervision and by their own investors in Federal Court in the Northern District of California. Phillips, a model husband was also arrested by Dallas police after he tried to strangle his wife at their home.

Forbes had a particularly telling comment in their story called The Old double Dip by Gretchen Morgenson published on July 7, 1997: “They say on Wall Street of limited partnerships: In the beginning, the limited partners have the money and the general partner has the experience. In the end, the roles are reversed. Especially if Gene Phillips is in the picture. Stories such as that one made things harder for poor Gene Phillips and in an interview with the Star-Telegram, Phillips said that the “perception that people were raped and robbed” by enterprises under his control in the past was hindering his return to previous heights. Another quote from the same source is right on the money. “I don’t think that Phillips is a bad guy when it comes to managing real estate, unfortunately, he has the ability to use real estate owned by everyone else to his own benefit.” ([134]) He said he had instead turned to raising money from foreign investors. And you know that Phillips isn’t pulling our legs with his story as we can see from what happened to him several years later.

Therefore, the chickens came home to roost on June 14, 2000 when Gene E. Phillips was indicted of racketeering, pension fraud and wire fraud in a securities case where he had apparently attempted to separate union members from the funds by using one of his rinky-dink markup tricks. He was arrested by the Federal Bureau of Investigation who simultaneously picked up over one hundred different people. It appears from the indictment that all of the New York Mafia families were involved in a money laundering transaction, which found Phillips at the head of a Dallas real estate trust through which everything flowed. Phillips is charged with enough to bring him a good 53 years worth of criminal down time. If he gets everything coming to him, he will probably be spending the rest of his life behind bars and one can’t see why he wouldn’t be deserving of whatever he gets.

The company that everything allegedly went through is labeled American Realty Trust and that in turn is owned by BCM, a trust operated by Phillips for the benefit of his children. The scheme included using both labor leaders and mafia figures to market a securities issue of American Realty Trust. For every $10 in stock that was purchased by either Mafia related broker firms ([135]) or union pension funds, $2 was returned in cash, under the table to Phillips cooperators. Just to make the cheese a little more binding, offshore accounts were set up for the conspirators so that there would be no record of the nefarious transaction in this country.

Mary Jo White the United States Attorney from Manhattan called the case the “largest securities fraud takedown in history…and the biggest dent we’ve ever made in the mob’s influence on Wall Street.” It took 600 FBI agents to make the arrests and because of the number of people indicted, they had to be arrested over the span of several days. According to officials at the U.S. Attorney’s Office, “money managers, brokers, pension fund officials, lawyers and even a New York Police Department detective who just happened to be the treasurer of the Detectives’ Endowment Association. These guys better start counting their money and see how much Phillips glommed. Boy, I would sure hate to be serving time and have that bunch chasing me. The total loss has been estimated at cool $50 million and still counting. The Richard Walker of the SEC said that most of the people that were conned were elderly, they were promised 100% returns, and they bought penny stocks that were supposed to be top-notch Dot-Com’s.

And having said all of that, you remember how we started this story. Coopers and Lybrand were hired by the bankruptcy trustee to evaluate whether or not they had been ripped off by Drexel Burnham. You recall that Coopers was forced to give up all of the fees that they had earned because of among other things; they had been less than forthcoming relative to their stating their cozy relationship with Drexel. After that, Southmark went after them in case that then seemingly went on forever. For some strange reason, Coopers was hired by Phillips to analyze Basic Capital Management, part of the Phillips empire. Christopher Flocken, who was a senior manager at Coopers reviewed the management company for an investors and commented, “I came away duly impressed, at each level of the operation I found highly competent people.” I wonder if any of the competent people were pulled in recently in the FBI sweep. What are these people thinking about?

Emcore, Racketeering By the Numbers

“Under existing accounting principals, partners -- and their spouses and dependents -- can't own stock in corporate audit clients, even if the partners aren't involved in the audits, said Arthur Siegel, executive director of the Independence Standards Board. The board is a panel of top-level accounting and SEC officials convened by SEC Chairman Arthur Levitt to bolster agency rules governing auditor independence; Mr. Schiro, the PricewaterhouseCoopers Chief Executive Officer, sits on the board. The American Institute of Certified Public Accountants' auditing rules also restrict auditors from owning stock in corporate-audit clients” ([136])

While the rules seem crystal clear, we can certainly understand that auditors cannot remain truly independent when they are shareholders in the company they are auditing no matter what they articulate or think. As we see the problem, when two accounting firms merge, it would appear that all of the employees in the merged companies owning shares in the new clients brought in as a result of that merger would be obligated to sell those shares. While, with taxes being what they are and tax planning in an instance of this kind, not being an available alternative in this highly regulated industry we can certainly sympathize with those caught up through no fault of their own, in a regulatory morass. On the other hand, rules are rules and if accountants are not interested in following them, they should either give up the practice of accounting or form a small firm where one can control their clients and not get any surprises.

In the cased of Emcore, the Securities and Exchange Commission noted this problem and then tapped PricewaterhouseCoopers on the shoulder and reminded them of their duties as independent accountants as several severe violations had occurred of their independence had occurred. This did not happen in a vacuum as the accounting firm had some prior experience. PricewaterhouseCoopers had been dumped by Fidelity Funds when the same conflict occurred there and that was followed by a formal censure by the SEC on grounds of lack of auditor-independence. I think the kind of mismanagement that allows censurable events to occur in a company involved in the public trust speaks poorly about that firms chances of being able to complete an audit without screwing it up.

I am not a brain surgeon, but I can certainly figure out that when new employees are hired they should be obligated to list all of the securities they hold. All employees should then give an account of any of their portfolio changes, as they occur so that the firm, at any given time has a complete record of holdings by its employees. Moreover, when one accounting firm merges with another it becomes less than nuclear physics to give the department within the accounting firm that follows stock holdings a report on the new clients that have been acquired either by merger or otherwise. By simply matching a computer based listing of employee holding against a list of the accounting firm’s clients, conflicts will pop out of the computer. When a match occurs, the employee should be given a short, time-certain to eliminate the position. If he is auditing the company merged into the network, he must immediately sell the stock no matter what his situation or be transferred to some other audit. When the sale takes place, a copy of the transaction must be provided to the monitoring department.

A far better policy would be to have all employees agree to have the brokerage firm make copies of brokerage statement and mandatorily have them sent on any and all transactions by the brokerage firm to the accounting monitor for employees’ accountants. In addition, every employee when hired would sign an agreement with the accounting firm that they will follow the conflict regulations to the letter. With these controls in place and in addition a simple statement in the employment agreement stating that if the employee, through his actions endangers the accounting firm’s reputation, accounts or earnings in any way due to not following rules mandated by a government agency such as the Securities and Exchange Commission, it will be cause for immediate dismissal. With these safeguards in place and the monitoring group set up so that they are seriously addressing the problem on a day-to-day basis, it would seem that any infractions would become assignable in litigation, at least to some degree, back to the employee. After all, the only time an infraction could occur would be when that employee disobeyed both company edicts and SEC Regulations.

I would believe that this would also present a strong defense to counter both regulators and the plaintiffs.

We do not believe that it is defensible for the SEC to know that ten senior employees of PricewaterhouseCoopers LLP owned 140,000 shares of Emcore and that the accounting firm was either unaware of it or in the alternative, not equipped to do anything about it. This would not seem to be the kind of accounting firm that the average company should have watching its “nuts and bolts,” so to speak. To add insult to injury, the James Schiro, the chief executive officer of PricewaterhouseCoopers LLP had the audacity top sell Emcore shares during an audit of the company’s books about a year ago.

Because of PricewaterhouseCoopers’ actions, a secondary offering to raise money for Emcore had to be withdrawn while new auditors were brought in. Deloitte & Touché did the re-audit while months went by rolled by. When the Deloitte audit was finally concluded, the stock price was lower and the ultimate proceeds to the company were resultantly, millions of dollars less than they otherwise would have been. In addition, Emcore had been attempting to conclude a joint venture with General Electric and according to company officials, when they could not deliver a current, credible audit, the deal tanked.

PricewaterhouseCoopers lame rejoinder was that the audit was not compromised in any way by their actions. This, of course flies in the face of reality. What PricewaterhouseCoopers was doing was plain and simply breaking the law and there seems not to be any question about whether it happened the way Emcore says it did or not. The fact that Emcore had to hire a new firm to re-audit the books obviously requires dislocation of employees for a substantial period of time while bringing the new auditors into total familiarity with the corporate picture.

In this case, there was even more to it than just that, a funding and a joint venture both were held up. Whether the joint venture would have happened under other circumstances is beyond our ken, but the fact is that there is a time-value of money and that would be one of the first things that PricewaterhouseCoopers would be preaching if it were on the forensic side of this transaction. The fact that it had happened before in the Fidelity matter is only icing on the cake that, at least within this area, the accounting firm was unquestionably out of control.

The CEO’s rejoinder that he only held a modest number of shares, which in turn were restricted, and that they were sold as soon as the legend on the certificate had been removed, not only seems to fly in the face of reality but is in itself, very telling. The fact the head of PricewaterhouseCoopers does not know that his firm is in the middle of an audit or possibly knew and potentially took advantage of inside information makes the picture look even worse. The Accounting firm issued the statement that “Schiro sold the restricted Emcore stock valued at a few thousand dollars as soon as the restriction was lifted in compliance with the independence rules.” It would seem that in PricewaterhouseCoopers case, we need one more rule and it should go a little like this. When a stock that has been restricted becomes freely tradable the monitoring group should be advised so that a check can be made as to whether the firm is in the middle of an audit or not. If there is an audit going on, the shares should be put in the monitoring group’s escrow account and sold at the earliest time available once the news covering the audit has been made public.

On the other hand, that is not the way that legend stocks are freed up. The legend remains on the stock until the holder receives a letter of opinion is given by corporate counsel to the effect that the stock has conformed with all of the 144 rules and is now free. But that in itself is not the basic problem, SEC regulations currently make a stock free after one year if the company is reporting, which was the case with Emcore. Where on earth did the employees of the accounting firm ever get unregistered shares in Emcore if was not from Emcore itself. If that was not the case, they had to purchase the shares from someone that was an insider and fall into that person’s shoes. Would that not have required a separate footnote on the financials? At the minimum, this would have triggered an internal reporting event. The transaction in which a company gives the head of an accounting firm stock in his company while his firm is auditing the company seems even worse, it would have been illegal on its face and inconceivable in any event. Thus, with the rules being what they are, we cannot both believe the accounting firms position that the shares were held for some period of time (indicating long period of time) and freed up. Furthermore, we don’t believe that either Emcore gifted the stock to these people or that they had the idiocy to accept it. As a matter of fact, it is hard to really fathom the facts in this matter, but they certain don’t seem to be discernable in what we have read and maybe the accounting firm likes it that way.

“Emcore, though, went to the auditing firm's offices to see if the matter could be settled out of court. PricewaterhouseCoopers officials "were arrogant in their response," "They admitted to the independence violations, blamed the SEC for the company's damages, and were not willing to make Emcore whole.” ([137])

In the overall scheme of things, this was not an earthshaking event in terms of shareholders getting screwed over or people sitting around the back office inventing numbers. This though in many ways is much more egregious in the fact that a major accounting firm not only broke the law once but it broke it twice. It apparently treated its client as though they had done no wrong when management should have been genuflecting all over the place over getting their hands caught in the proverbial cookie jar. If these folks can’t live by the rules, they don’t deserve to be independent auditors and we would certainly propose sterner medicine to prevent another occurrence. On the other hand, don’t hold you breath.

What’s Happening Now

Sadly, the bad guys are getting worse and have found new ways to separate investors from their money. The SEC does more fence sitting than corralling the bad guys, but nevertheless, they come up with some interesting tidbits.

“The Securities and Exchange Commission said a yearlong review of auditor conflicts of interest at PricewaterhouseCoopers LLP turned up massive violations. The report, which was released by the agency Thursday, says about half of the Big Five firm's 2,700 partners, including 31 top executives, owned investments in corporate audit clients, in violation of the SEC's auditor independence rules. All told, the report found 1,885 staffers committed a total of 8,064 violations; 45% of the infractions were carried out by partners who work on audits of public companies. The report said a large percentage of the violations came about because of the July 1998 merger between Price Waterhouse and Coopers & Lybrand, in which each firm's staffers owned investments in the other's audit clients. But "an even larger portion is not" a result of the merger, the report said. It added that the infractions stemmed from "widespread" noncompliance, which reflects "serious structural and cultural problems in the firm." Most of the infractions involved stock or holdings in individual mutual funds that the firm audits.”

And the SEC reporting continued by stating:

“The SEC said it is most troubled by the new report's finding that random tests indicated 76% of the firm's partners failed to report at least one violation. SEC Enforcement Chief Richard Walker declined to say if the SEC would pursue cases against individual partners. The investigation is continuing, he said. The report is yet another embarrassing black eye for Pricewaterhouse-Coopers, and comes at a time when the SEC fears auditors have gone soft on corporate audits. The SEC demanded the review as a result of its earlier censure of PricewaterhouseCoopers in January 1999. In that matter, the agency uncovered 70 instances in which Coopers & Lybrand LLP employees, (primarily in the firm's Tampa, Fla., office), and Cooper’s retirement plan continued to own stock in the merged firm's audit clients after the union was completed.” ([138])

Tyco, The Home Of The Doubly Big Bath

By this time, all of us that follow accounting have heard of the term “big bath”. For those of you that are not familiar with the term, we will give a very short definition. Big Bath accounting occurs after a transaction is finished and the acquirer takes a one-time charge, writing down everything but the kitchen sink. This type of accounting allows the company to continue controlling its earnings once the acquisition quarter is over and in most instances they report earnings in two manners anyway. The first would be as though the transaction and its underlying expenses did not occur at all and the second and more realistic reports the real time expenses in getting the deal done. Wall Street tends to concentrate on the earnings produced by the first case scenario because in many respects it does reflect more accurately what is going on within the company on a day to day basis.

In an article in the Wall Street Journal, Floyd Norris, the reporter , I think came up with a new one. When describing Tyco’s accounting he used the term “The Case of the Hidden Bath.” What Tyco did in two of its recent acquisitions, AMP Inc. and U.S. Surgical, is have those companies take their bath before they were acquired by the Tyco. The bottom drops out of sales and expenses go through the roof in this type of accounting, and what’s more, by completing the acquisitions before the financials are due, the accountants insure that shareholders never see the manipulations within the framework of the merged entity.

Securities analyst Mark Swartz told Floyd Norris that “they aren’t disclosed clearly.” But he further stated that the company “had complied with SEC disclosure rules.” If you were in the mood, he indicated that the way to get the correct numbers would be to look up the filings of the various companies with the Securities and Exchange Commission and work backward. Probably in some other lifetime you will be able to come up with what Tyco had done. This type of accounting certainly flies in the face of the kind of transparency that folks are looking for in today’s marketplace and makes its users highly suspect. If indeed, Tyco has complied with the SEC regulations, then we too would make the point that the SEC ought to make sure that they don’t substantially delay making some major changes to the way companies are allowed to report.

I’ll bet you can’t figure out who audited Tyco’s books. Right, Pricewaterhouse-Coopers, in this case out of their office in Hamilton, Bermuda due to the fact that Tyco is a Bermuda chartered company. And as the seasons follow each other since almost the beginning of time, so does an SEC investigation follow really inventive accounting. On December 10, 1999, the SEC announced that they were targeting Tyco’s accounting. You can imagine that the stock, which had already been under performing got even worse when the SEC entered the picture. But Tyco’s troubles did not end there.

Almost exactly two weeks later, the law firm of Cohen, Milstein Hausfeld & Toll, P.L.L.C. filed a lawsuit against Tyco in New Hampshire Federal Court (Tyco’s operation headquarters in the United States). The law firm issued the following charges:

“The Complaint charges that Tyco and certain of its officers and directors violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 as well as Rule 10b-5 promulgated thereunder. Specifically, the Complaint alleges that defendants caused Tyco to utilize accounting methods which made it appear that U.S. Surgical Corporation and AMP Inc., two of the companies recently acquired by Tyco, were experiencing healthy growth after they were acquired by Tyco. In fact, the appearance of growth was misleading to investors since it was not disclosed that defendants caused U.S. Surgical and AMP to write off large assets just prior to these acquisitions being finalized. Because the extent and nature of these write-offs were not fully and clearly disclosed in SEC filings or elsewhere, purchasers of Tyco securities during the Class Period were misled and paid artificially high prices for their Tyco securities.”

Well, you can believe that even if Tyco just thought up this grandiose program and our friends at PricewaterhouseCoopers certified it, they are already in deep dodo. The purpose of the program seems to be to suppress the facts from the investing public. By being tricky, PricewaterhouseCoopers looks like they are going to be implicated in this one, big-time unless, Tyco stock performs a miracle and bails everyone out. On the other hand, we don’t think that this is going to stop the SEC from clobbering this group of accounting magicians for being a just a tad too innovative.

Koger Properties, Inc, A Strange Bequest

Koger Properties, was formed in Jacksonville, Florida in 1957 and immediately generated a lot of positive publicity with their “office park” concept. Koger grew quickly and in the early 1990s had already expanded to over 40 office parks located throughout the United States. It had become a New York Stock Exchange listed real estate construction and management firm. In 1988 the company caught the attention of an accountant named Michael Goodbread who had become familiar with Koger because of the fact that they were literally located in his backyard.

Koger’s auditors were Deloitte & Touche LLP. After a bankruptcy filing by the company, there was an extraordinary drop in the price of Koger Properties Inc.’s stock Koger). Because shareholders believed that they had been misled, a class action was filed against a number of defendants including the accountants. In a federal jury trial. Deloite & Touche LLP was ordered to pay $81.3 million for their part in the 1990 affair.

Although there did not seem to be much question that Koger was cooking their books and that in spite of disagreements between Koger and Deloitte, the books had been certified anyway. The court on the other hand thought long and hard about the fact that the precipitous drop in the stock occurred only when the company cut its dividend and not because of any misstatement of financial data.

''No evidence supports a conclusion that Deloitte's misrepresentations were a substantial cause of the decline in the value of plaintiff's KPI stock,'' Appeals Court Judge Emmett Cox.

This decision was reached in spite of the fact that shareholders made an excellent case in saying that they never would have purchased Koger stock to begin with if they had realized that the earnings that appeared publicly were not correct.

The facts are these, Deloitte had been conducting the annual audits for Koger for three years. The accountant was in a constant state of argument with the company over whether certain items should be expensed or capitalized. Deloitte eventually gave in and the company reported substantially higher cash flow than would have been the case had Deloitte stuck to their guns. In real-estate oriented companies, it is usually the cash flow that the company generates which determines the dividend and thus the payment was kept for some period of time at an arbitrarily high figure. Koger filed for Chapter 11 bankruptcy in 1991 and in 1993 was merged into an affiliated company, Koger equity Inc.

The appellate court ruled in a 3 to 0 decision that the defendant’s (Deloitte) misrepresentations had nothing to do with the decline in value of the stock, thus, there was a failure to show loss causation a critical element in the case. Attorneys for the plaintiff’s were horrified by this turn of events and indicated that they will either seek a rehearing before the full 11^thCircuit or appeal to the Supreme Court.

While the decision in this case is based on strictly causation and we see that there is no direct relationship between the two events, certainly an excellent case has been made for the fact that had the truth been known, the stock would undoubtedly been purchased by anyone that had gotten through 1^st grade. Picture the scene, the accountants come out with an announcement which says that the company has been cooking its books, is probably going to go bankrupt within a short period of time and to put frosting on a rotten cake, is going to totally eliminate their dividend. If the court thinks that this kind of announcement is going to cause a warm and fuzzy feeling for the shareholders, they are crazy.

Moreover, we are convinced that there were two causations, both legitimately in play relative to the Fraud ruling contained in Securities Regulation 10b-5. Had the accounting firm not helped in cooking the books, the cash flow would not have been significant enough to pay the dividend, thus the shares would not have been purchased by the complaining shareholders to begin with. We would think that in appeal to the full Circuit or the Supreme Court, a wider scoop will be applied and it may well be shown that there were two causations.

It is most interesting to note that in this case, the original verdict was rendered by a jury in Federal Court. A second verdict was issued upholding the first verdict by the district on appeal, which sustained the jury decision. It was only at the appellate level that Deloitte came away with a victory. Plaintiff’s lawyers presented an excellent case, which states as follows:

The test for causation that the appellate court looked at was far to narrow, and that it is not incumbent on the Plaintiffs “to show that a defendant’s wrongful act was the sole and exclusive cause of the injury suffered…rather, plaintiffs need only show that it was substantial, i.e., a significant contributing cause” According to the brief, the 5^th, 8^th, and 9^th Circuits agree that “defendants who have created a risk of foreseeable injury will not escape liability merely because some circumstances change before the damage materializes.”.

The decision in this case is a blow against shareholder’s rights and it must appear to be an equally damaging setback against everything that the Securities & Exchange Commission is attempting to do to promote transparency. We can hardly call outside auditors, outside auditors when they seem to be fearful of going contrary to management’s decisions when it comes to cooking the books. While we are certainly glad to be living in this country where there is a modicum of protection for investors against this kind of conspiracy, we can only feel the deepest sympathy for those in other country’s where the cooking of books is even more of a national pastime than it is here.

I believe that someone pointed out the drop in earnings suffered by foreign companies when applying for listing on the New York Stock Exchange. This was caused by the fact that they had to apply American accounting standards to their earnings. As I recall, the average drop in earnings was over 33%. When we compare the hypothetically high price of the American Markets, we are thus restricted to comparing it with itself and its historic price earning levels. When compared with companies in Japan, where accounting is done by government edict, not by GAAP, there is just no suitable comparison because you can not say with certainty even if the companies have any earnings at all under their system. At least in GAAP terms. Maybe in our more globalized society, residents of other countries are becoming increasing aware of the better shake that investors are getting over here, at lest in terms of transparency. Considering the fact that this so called American transparency is more illusionary than real, it certainly casts a shroud over what is going on elsewhere.

Our regulations that give redress for illegal actions to investors are not complex and easily addressed. We believe that the decision in the Koger case creates a roadblock to transparency, a safe house for conspiracy between accountants and their employers and a step backward from whence we have come. While we have no bone to pick with Deloitte, a jury fund that they conspired with management and took actions detrimental to shareholders. They found this to the tune of more than $81 million, not a small figure.

While Deloitte has been already punished for their actions in both reputation and monetarily, as their trips to court have cost them dearly, the only penalty for making up phony books cannot be the fact that because their was not direct causation, there is no penalty. This is like saying that the books can be as phony as the company or the accountants desire provided that no case can be made that there is a direct connection between loses that are suffered and the amoral accounting. While we do not have a clue as to what the right answer is in this and similar cases, it would appear that the jury has already voiced an opinion that a security fraud had taken place under rule 10b-5. While there is no direct causation, what about indirect causation? The people that bought the shares for the high dividend rate. These are probably folks that were living on a fixed income and one way or another the accounting firm help do them in.

Thus, the question becomes, before this road becomes any better traveled, the Securities and Exchange Commission should amend 10b-5 to cover this type of situation or invoke other penalties for actions of this sort. Among those that we would suggest are talking away, the right for accountants that engage in these unseemly processes to deal with the public. This is the first thing that the SEC seems to do when they find that management has defrauded their own shareholders. They get out a consent decree and jam in into management’s face and make them agree that they will not ever again be an officer of a public company or be on the board of a public company again. They have defied the public trust and therefore their right to deal with the public is taken away. Without the help of the accounting firm’s, the particular situation we are looking at in Kroger could not have happened. There must be some piper to pay.

Almost unnoticed with all of the goings on, the Securities and Exchange Commission found that the Deloitte auditor on the job was also a shareholder who seemed to pick a propitious time to dump his shares. His name was Michael Goodbread and by the time that he was asked to get involved in the Koger audit, he had already been a CPA for approximately two decades. In addition he became a partner of Touche Ross in 1981 and when Deloitte & Touche acquired that firm he also became a partner of that firm. Goodbread was the audit partner in the Jacksonville office of both Touche Ross and of the successor firm, Deloitte & Touche and as we had pointed out earlier, Goodbread was the proud possessor of 400 shares of Koger stock, as we are aware, a major “no no” for the person who would be overseeing all facets of the company’s audit. He signed the audit planning memorandum that would determine Deloitte’s strategy. In conducting the audit he later signed the audit report record which is the precursor to Koger’s getting an unqualified opinion from the accounting giant. On December 10, 1996, in release no. 38035 or the Securities Exchange Act of 1934 and Release No. 861 of the Accounting and Auditing Enforcement Regulations, they issued the following release, which we reprint here in part.

In the Matter of : Order Instituting Proceeding And Opinion and Order Pursuant Michael Goodbread, C. P. A. : To Rule 102(e) of the Commissions Rules of Practice

The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative proceedings be, and they hereby are, instituted pursuant to Rule 102(e) of the Commission's Rules of Practice, 17 C.F.R. 102(e),1/ against Michael Goodbread ("Goodbread").

II.

In anticipation of the institution of this administrative proceeding, Goodbread has submitted an Offer of Settlement, which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying any findings set forth herein, except as to the jurisdiction of the Commission over him and over the matters set forth herein, which he admits, Goodbread consents to the issuance of this Order Instituting Proceedings And Opinion

1/ Rule 102(e)(1), 17 C.F.R. 201.102(e)(1), of the

Commission's Rules of Practice provides in relevant part:

The Commission may deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission after notice of and opportunity for hearing in the matter . . . (ii) to be lacking in character or integrity or to have engaged in unethical or improper professional conduct . . . .

And Order Pursuant To Rule 102(e) Of The Commission's Rule Of Practice ("Order") and to the entry of findings and imposition of the remedial sanctions as set forth below.

III.

On the basis of this Order and Goodbread’ s Offer, the Commission finds that:

A. Goodbread

Goodbread is a certified public accountant who has been licensed by the State of Florida Board of Accountancy since February 1973. In 1981, Goodbread became a partner with the Jacksonville, Florida office of Touche Ross. In December 1989, Touche Ross combined its practice with Deloitte, Haskins & Sells, whereupon Goodbread became a partner with the Jacksonville, Florida office of Deloitte & Touche. Koger Properties, Inc. ("Koger"), a Florida corporation located in Jacksonville, Florida, at all material times was engaged in the business of developing, constructing, operating and managing office centers located in the southeastern and southwestern United States. Koger common stock is registered pursuant to Section 12(b) of the Securities Exchange Act of 1934 and trades on the New York Stock Exchange.

Goodbread purchased 400 shares of Koger stock at $26 per share in December 1988. At the time of his purchase, Koger was an audit client of Deloitte, Haskins & Sells. However, after the effective date of the combination, Koger became an audit client of the new merged entity, Deloitte & Touche. After the combination of the two firms, Goodbread was assigned to be the audit partner in connection with Deloitte & Touches audit of Koger’ s financial statements for the fiscal year ended March 31, 1990. In that capacity, Goodbread had final responsibility within the firm for planning and supervising the performance of the audit in accordance with generally accepted auditing standards ("GAAS"). Goodbread signed the Koger Audit Planning Memorandum on February 21, 1990. Audit planning for the engagement and/or field work was conducted from that time until June 26, 1990, on which date Goodbread signed the Audit Report Record, signifying completion of the Koger audit.

Notwithstanding Goodbread's capacity as a partner in the combined firm of Deloitte & Touche after the combination, and particularly his final responsibility for the independent audit of Koger beginning on or about February 21, 1990, Goodbread did not sell his 400 shares of Koger stock until May 10, 1990. 2/

B. Lack of Independence

1. Violation of Commission's Independence Rules

Koger's financial statements were required to be audited by an independent accountant for the fiscal year ended March 31, 1990. Regulation S-X requires auditors of publicly filed financial statements to be independent, stating in rule 2-01(a) that the Commission "will not recognize any certified public accountant or public accountant as independent who is not in fact independent." (17 C.F.R. 210.2-01). Rule 2-01(b) states, "an accountant will be considered not independent with respect to any person...in which...he, his firm or a member of his firm had, or was committed to acquire, any direct financial interest or any material indirect financial interest..." Owning shares of stock in an entity is clearly a direct financial interest in the entity. Accordingly, section 602.02.b of the Codification of Financial Reporting Policies (FRC) states that any stock ownership in a client impairs independence, and that "materiality is not a consideration in the case of a direct financial interest."

It is clear from Section 602.01 of the FRC that had Goodbread sold the Koger stock when the merger of the accounting firms became effective that no question would be raised about his independence. However, it was not just his status as engagement partner on the audit that caused a lack of independence, but also his status as a partner of a firm that is the auditor of record for an SEC registrant. As noted above, rule 2-01 of Regulation S-X is clear that a direct financial interest by any member of an accounting firm would impair the firm's independence. The rule goes on to say that, "the term member means (i) all partners, shareholders, and other principals in the firm." Thus even if Goodbread had not been the engagement partner for the Koger audit, his ownership of Koger stock was a direct violation of the independence requirements of Regulation S-X.

2. Violation of GAAS and Code of Ethics

Regulation S-X requires the audit report to state whether the audit was conducted in accordance with GAAS. GAAS expressly requires that the auditor be independent "[i]n all matters relating to the assignment." Codification of Statements on Auditing Standards, AU 150.02 (Codification hereafter cited as ("AU "). AU 220.04 further provides that: "[t]he profession has established, through the AICPA's Code of Professional Conduct, precepts to guard against the presumption of loss of

2 Goodbread sold the stock for $20.75 per share. independence. . . Insofar as these precepts have been incorporated in the profession's code, they have the force of professional law for the independent auditor.” (emphasis in original).

The AICPA Code of Professional Conduct expressly prohibited Goodbread's Koger stock ownership during the time of the Koger audit. The Code states that "independence shall be considered to be impaired if . . . during the period of a professional engagement, or at the time of expressing an opinion, a member or a member's firm . . . [h]ad or was committed to acquire any direct or material indirect financial interest in the enterprise." AICPA Professional Standards, ET 101.02 (Jan. 12, 1988).

If an auditor is not independent, "any procedures he might perform would not be in accordance with generally accepted auditing standards and he would be precluded from expressing an opinion on such statements." AU 504.09. Accordingly, under such circumstances, GAAS requires an accountant to "disclaim an opinion with respect to the financial statements" and to "state specifically that he is not independent." Id. Goodbread held a direct ownership interest in Koger stock while participating in the initial phases of the audit of Koger's financial statements. Notwithstanding this lack of independence from Koger, Goodbread caused Deloitte & Touche to issue an unqualified audit report, contained in Koger's Form 10-K for the fiscal year ended March 31, 1990, stating that Deloitte & Touche was independent and that the audit was conducted in accordance with GAAS. Under the circumstances, Goodbread's ownership of stock specifically precluded any representation that the audit was conducted in accordance with GAAS and required Goodbread to make sure that Deloitte & Touche disclaimed an opinion on the financial statements and disclosed the lack of independence.

C. Unethical and Improper Professional Conduct

Based on the foregoing, Goodbread engaged in unethical an improper professional conduct by:

1. failing to immediately divest himself of stock ownership of an SEC client when he became a partner of the merged firm;

2. violating GAAS by owning stock of a client during the time of an audit engagement;

3. failing to inform his firm of his stock ownership in order to make sure the firm disclaimed an opinion on the financial statements and disclosed the lack of independence; and

4. causing his firm to issue an unqualified audit report on a client's financial statements under these circumstances.

The Commission will continue to aggressively enforce its rule that an auditor's direct, although immaterial, interest in an SEC client causes the auditor to lack independence, in fact and appearance, with respect to that client.

IV.

Based on the foregoing, the Commission deems it appropriate and in the public interest to accept the Offer of Settlement submitted by Goodbread, and accordingly,

IT IS HEREBY ORDERED, effective immediately, that:

A. Goodbread be, and hereby is, censured;

B. Goodbread will comply with all applicable Commission rules and regulations regarding the independence of auditors from their audit clients as long as he practices before the Commission as an independent accountant;

C. Goodbread, or any firm with which he is or becomes associated in any capacity, is and will remain a member of the SEC Practice Section of the American Institute of Certified Public Accountants Division for CPA Firms ("SEC Practice Section") as long as he practices before the Commission as an independent accountant; and

D. Goodbread will comply with all applicable SEC Practice Section requirements for periodic peer reviews, concurring partner reviews, and continuing professional education, as long as he practices before the Commission as an independent accountant.

By the Commission.

Jonathan G. Katz

Secretary

The commission found that the audit was compromised by an unethical conflict of interest. Goodbread did a naughty thing and his firm should have been on top of it and not have let him handle the account to begin with. What did the Securities and Exchange Commission do to cause Goodbread or Deloitte not to do the same thing again. They told Goodbread to “comply with all applicable Commission rules and regulations regarding the independence of auditors from their audit clients as long as he practices before the commission as an independent accountant.” Hey, does that mean that he can continue to do what he has been doing without even a slap on the wrist? Some onions!

Well considering the fact that a jury found that the accounting firm was guilty of a fraud that cost investors over $81 million I can understand the Commission’s reasoning in coming down so hard on poor Mr. Goodbread. I am sure that all of the people that lost their investments in this case can breath a sigh of relief knowing that the SEC’s enforcement arm is out there looking at this type of thing a that Goodbread is back auditing another public company.

A Saving Grace, Not!

In 1846, a young Irish lad of thirteen from a named William R. Grace went to the sea and never once looked back. From an economic viewpoint, during the next half-century, Grace had literally conquered South America and when he died he left a legacy which has carried over almost until today. The Grace history almost deserves the word astounding when referring to what he accomplished. Grace became the first Catholic mayor of New York and performed his job in stunning fashion. And during the later half of the 19^th century he also served as Grover Cleveland’s right hand during the time that Cleveland was President of the United States. While occupied with politics, he also assembled one of the greatest merchant fleets in world history. This is the legacy that was left by the W. R. Grace founder and his name was carefully nourished and esteemed over the ensuing generations. The last Grace that will ever run W. R. Grace and Company, Peter Grace, through a combination of the better things in life, greed and avarice, totally broke the mold. He mucked up the Grace name and history eventually may well forget William's astounding accomplishments and only remember Peter's shame. We believe that both acts should be remembered for posterity, William's for his empire building and Peter for milking the loyal shareholders that had faith in him out of everything that he could squeeze out.

We have seen companies do just about everything to boost their earnings including the innovation of completely spurious transactions. However, we have not yet dealt with a company that had an unusually good year and wanted to reserve part of its good fortunes so that it could continually show an increase in revenues over a longer period of time. Smoothing its earnings to make it appear to be a solid growth company in Wall Street’s eyes. We have also not dealt with a situation where the former chief financial officer became a “whistle blower” because he was removed from his job for questioning this illegal management of earnings. Moreover, we also do not think that we have ever seen such a clear cut case of an accounting firm catching their client in the act of doing something totally illegal, bringing it to the attention of management not once but a number of times, and then as though the event never occurred, certifying the numbers that they themselves have found to be inaccurate.

In this case they gave the company a clean bill of health along with an unqualified opinion without even footnoting the matter. But then again, Pricewaterhouse Coopers seems to make its own rules when it comes to decisions of this sort.

In the “for whatever it’s worth” department, managing earnings in this fashion is just as illegal as making up non-existent sales, because it gives an appearance of ongoing robustness that just does not exist. When a company continually shows exceptional growth, the market places a higher premium on the company as well. Thus, many regulators point out that this action is every bit as criminal, due to the fact that the management of earnings gives the company a cache that would only be attributed to the kind of concern that had that type of growth. Thus, the stock instead of selling at ten times earnings that the normal cycle company would command, it would instead trade at thirty times earnings which historically been a stratospheric pinnacle usually reserved for only those with breakthrough products that have a lock on a perceived critical market niche which will take years to fill.

Assuming the company had 100 million shares outstanding, this earnings management would a create a multibillion dollar loss once the company ultimately returned to their more established earnings pattern. By this time, company executives would have exercised all of the stock options that grateful shareholders had bestowed upon them in the belief that they were extraordinary corporate managers, not nefarious earnings administrators. When push came to shove, total earnings over the aggregate period would not be modified one wit, but those buying the stock as it rose based on criminally skewed numbers would have been defrauded, just as though the earnings had been make-believe.

W. R. Grace was just another company in the overcrowded and mostly lackluster packing and specialty chemical industry for generations when it acquired an interest in a company in the health care business ([139]). Its politically well-placed Chief Executive Officer, Peter Grace, had run the company for what had seemed like an epoch. As Peter grew older, new management came onboard. However, Peter did not really want to leave the company and as he thought of all of those wonderful perks ([140]) that he had been getting over the years going up in smoke, he became more resistant to packing it in. He formulated a plan that allowed him to keep everything that he had accumulated and for good measure, add a few supplementary benefits without working for them. Even Peter realized that it would be looked at sternly by the regulators and the shareholders if he appeared to be earning more money in retirement than he had when serving as a full time officer of the company so he determined to withhold knowledge of the entire matter from the shareholders. The Securities and Exchange Commission thought allowing this nefarious action by the new management was in rather poor taste, to say the least. First of all, shareholders are entitled to know what the retirement benefits of a former officer are and beyond that, how can they possibly improve when the retiree is sunning himself on a tropical beach. ([141]). What’s more, there just seems to be a tad of transparency mislaid in this scenario and the SEC seemed to agree.

“On September 30, 1997, the Securities and Exchange Commission the issued a Report of Investigation Pursuant to §21(a) of the Securities Exchange Act of 1934 Concerning the Conduct of Certain Former Officers and Directors of W.R. Grace & Co. The Grace report is significant in that it purports to impose on corporate officers and directors, including outside directors, an obligation to question and take affirmative steps to ensure that the corporation's public disclosures are complete and accurate in compliance with federal securities laws. Under the policy articulated in Grace, outside directors may no longer be permitted to rely in certain circumstances on the existence of internal corporate procedures and on determinations made by securities counsel as to the propriety of such disclosures.’ ([142])

When Peter Grace ultimately retired ([143]), the aggressive new management headed by CEO Jean-Paul Bolduc and CFO Brian J. Smith took the reins and immediately got into trouble by accept as true that putting excess earnings in a “rainy day reserve” was a neat thing to do. Beyond tinkering with the Grace retirement program, they were also involved in the matter of some windfall profits derived from a kidney dialysis division that was in the process of being divested. The management determined to under-report the subsidiary’s earnings and reserve the remainder conceptualizing that by under-reporting earnings in that matter, they could control when the stock would over-perform the market, thus, taking advantage of recently granted stock options.

Once again, the U.S. Securities and Exchange Commission didn’t see things quite that way. As a matter of fact, Richard Walker, the enforcement director of the SEC, said, “Extra earnings were put into a reserve to save for a rainy day so they could use it when they wanted to goose up the numbers.” Testimony was given by the people at Grace that Wall Street seemed super happy with 24% growth per year and that the difference could well be salted away for a rainy day.

There was a lot of logic in what these conspirators were trying to do. They were not naïve and believed that their kidney division could not sustain anywhere near the 30% per year growth rate that it was miraculously achieving. Thus, in their ultimate wisdom they came up with the formula for hiding the earnings which would give Grace an overall growth rate of 24% for the foreseeable future, a lot of which would be coming from the hidden reserve. Well as we said before, the conspirators had a lot of eyes and ears watching their movements, including our friend the whistleblower, who reported them to the SEC at his first opportunity.

In exchange for their indiscretions, the Securities and Exchange Commission is seeking civil fines and injunctions against seven former officers of the Grace Company. “The commission has also filed cease-and-desist proceeding against seven former Grace officers (among them CEO J.P. Bolduc), of whom three get special attention. These three, who include Grace’s former chief financial officer, Brian Smith, are licensed CPAs whom the SEC views as having engaged in “inappropriate professional conduct.” So the commission wants an administrative judge to bar them practicing before the SEC. That means that could not play any part in preparing the financial statements of publicly owned companies or any other SEC registrants.” ([144])

Once again we find that our friends at Pricewaterhouse Coopers were willing to blaze new trails in their ground-breaking approach to new and revolutionary management theories on the subject of reserving of earnings. Pricewaterhouse announced that they stood by the financial reports and wouldn’t comment further on a customer’s affairs. This particular accounting firm, uniquely creative in separating investors from their hard earned dollars, should have been more forthcoming at least once they had gotten caught deceiving shareholders.

Pricewaterhouse’s sorted record, which has caused so many problems in past audits of a multitude of companies was given a chance to partially redeem themselves with the investing public openly admitting an error. By playing hardball they once again, they have snatched defeat from the jaws of victory just as they had closed in on the gold ring. For their troubles, The SEC got two partners of the accounting firm to agree to cease-and-desist orders. “At least six Pricewaterhouse auditors and Norman Eatough, Grace’s former in-house audit chief, questioned the propriety of Grace’s accounting maneuvers. Mr. Eatough even took the bold step of complaining to the board’s audit committee – to no avail”

New management, which at this point does not include any of the rogues who were charged with cooking the books, made an interesting settlement on June 30, 1999, of the outstanding accounting problem. “Grace consents to a cease and desist order without admitting or denying the SEC’s findings. Grace also agrees to establish a $1 million fund to be used for programs in the public sector to further awareness and education relating to financial statements and generally accepted accounting principals.” ([145]) In any event, rumor has it that the SEC may give Pricewaterhouse something more to think about relative to certifying audits that they believed were fraudulent.

We are certainly hopeful that a little of that money can be used to educate Pricewaterhouse-Coopers as well. They seem to need more indoctrination than anyone else. But maybe they didn’t really need it. Last year PricewaterhouseCoopers received $11.3 million for their accounting of Grace’s books. I guess justice is never really served.

Waste Management, We Specialize In Collecting Sorted Garbage

No sooner had Arthur Andersen gotten the bad news that they were going to be the patsy’s for the horrendous mistakes of Chainsaw Al Dugan and Sunbeam, (p.276) and summarily fired from doing the company audit than they learned that their audit-boat was leaking from yet another problem. They were literally forced into a settlement with Waste Management shareholders in another egregious accounting matter to the outrageous tune of $220 million. The penalty was shared by the company and the accounting firm because of a minor issue of earnings overstatements that occurred during a five-year period exceeded $1.3 billion.

There are a lot of bad guys in this scenario but past President of Waste Management, Rodney Proto takes the cake. When he knew that earnings estimates were going to fall $250 million (yes you heard it right) under expectations and that a warning would be issued to Wall Street, Proto got in ahead of everyone and dumped his shares. Hey, they couldn’t say this guy was napping. Naturally, the dumping of shares on inside information and the earnings estimate being so far off that it was laughable, the two events eventually triggered the Securities and Exchange Commission attention.

Investigations are now covering both the earnings warning and the sales by insiders of securities ahead of a release of information. Among the stranger accounting moves in auditing history, Waste management reported a pre-tax profit in the closure of landfill operations. While I guess you could conceivable make a case for profiting when something is closed, I haven’t figured out how you do it. It seems that the property was worth more when it was inoperative than when it was performing. If that indeed had been the case, it would have been showing a loss throughout its existence. If all the closed properties were losing money and only showed profits when they stopped producing, how then did the company make money? Apparently, Waste Management Officials nor Arthur Andersen could figure out what they were talking about and the entry was summarily reversed, the ill-conceived profit was became a loss and Waste Management’s world came to an abrupt end. ([146]).

Well, this kind of financial accounting did not sit too well with the shareholders who started getting pummeled in the market. Naturally, they filed a lawsuit against all concerned with very special emphasis on Proto (as well they should have) who was able to dump 300,000 shares for almost $16.5 million without so much as a thought about shareholders.

In the meantime, Waste Management has filed a lawsuit in federal district court accusing Eastern Environmental Services, a company that Waste Management had acquired, with overstating their earnings and using those numbers to make themselves attractive to Waste Management. The people at Waste are also charging a whole bunch of people with conspiring, aiding and assisting the bad guys. Most of the people are John Doe’s so at the moment we can’t tell who did what to who, but it appears that a lot of these folks were insiders at Waste that were just interested in enriching themselves. Apparently they had watched the way Proto operated and took the cue from him. After all, we have always heard that management has to lead by example, but lead they did even if it was illegal.

This may be some kind of first. Here is a company, Waste Management that systematically inflated their earnings over a five-year period and had their officer’s bail out on the public while having inside information and now these guys are charging one of the companies that they had acquired with doing the same thing. I wonder if Eastern wouldn’t a pretty good counter argument that they were suckered in because of Waste Management phony bookkeeping. Worse yet, what if Eastern received stock in Waste Management before the news of their restatement murdered the share price. This could well become a Mexican standoff with the accountants hung out to dry. Keep tuned.

In the meantime, adding to the complexities of the legal issues involved in this case is the Securities and Exchange Commission continuing investigation into the consulting services that Anderson was also providing to Waste Management. In analyzing the fee structure involving Anderson’s work, it is interesting to note that while accounting fees have been estimated to have run $10 million in the seven-year period from 1991 to 1997, the consulting income that Anderson earned at the same time was approximately five-times that amount, or about, $50 million. People close to the investigation indicate that the SEC may be looking at the fact that because the consulting fees were so prodigious, Anderson was not as rigorous as they possibly could have been in conducting the Waste Management audit. The SEC has been concerned recently about how the consulting fees affect auditor independence and more aggressive accounting practices. Tying consulting fees into auditing negligence has been next to impossible to prove historically, but the SEC may have found the smoking gun in this one.

These Folks May Have Just Been In Over Their Heads

BarChris “De”-Construction Corporation ([147])

After World War II had ended and the returning servicemen had been to some degree been integrated back into society, there became a dramatic need for recreation. During the War, most of these kinds of activities were cut back drastically in order that the “War Effort” be singularly pursued. Money was freer and people now wanted to pursue forget the war and pursue recreational activities.

One of the early winners in this arena was bowling, it promoted much of the required criteria; it was inexpensive, it could be enjoyed by the entire family and it also could provide the family breadwinner with an innocent night out with the guys to let off some steam. Bowling, soon to be automated, took the country by storm and ultimately became the leading American indoor sport. When eventually automated, the pins were reset, quickly and accurately, thus eliminating whatever shortfall may have occasionally occurred due to the human factors. In addition, automation reduced ongoing costs dramatically and allowed bowling to remain competitive relative to other contending sports almost indefinitely.

In 1946, two partners, Vitolo and Pugliese set up a predecessor company to BarChris Construction Corporation (BarChris) ([148]) and started to construct bowling alleys. These were high-end complexes with all of the trimmings. They also contained bars and restaurant facilities, which to some degree was unique in this era. Their properties were referred to as “bowling centers” to create a degree of separation from those bare bones operations that were springing up everywhere.

Vitolo never went beyond high school in his education and Pugliese left school after the seventh grade. In spite of a lack in schooling, they could not have picked a more appropriate time to get into business, new leagues were forming and literally every affinity group had a bowling afternoon or evening. Publicity took place almost at no cost, as bowling was an ideal medium for television. It was easy to shoot, cameras were a simple to erect, and programming required very little manpower. People loved the televised sport which along with wrestling, bowling dominated early television further enforcing its role as the sport to be involved in. In spite of the fact that neither of the partners knew the very first thing about financial matters, business poured in with Pugliese handling the construction and Vitolo cranking out new business.

As the company grew, it did not do so in a vacuum, in 1959, a Peat Marwick employee by the name of Kirchner was hired as controller and the next year he became the company’s treasury. At that time, another Peat Marwick employee, Trilling took the controllers job and with two ex-Peat Marwick people running the financial show, who else but Peat Marwick could possibly became the auditors. While the auditing firm thought that they had scored a coup in signing BarChris, they soon had reason to rethink that position.

At the same time, a young lawyer named Birnbaum was hired as in-house- counsel and he became corporate secretary as well in 1961. They also hired a man by the name of Russo, who had told them that he had some accounting background and this certainly seemed to be reason enough to make him an executive vice president. This also turned out to be a very bad move, as it was Russo’s work product that was the cause of the disaster that has become a classical case of securities fraud, lack of due-diligence and accounting underperformance.

BarChris innovative financing edge was basically they way the advanced their operations. In principal it was rather simple, they would extract a significantly small down payment from a customer, construct and equip the bowling complex and when everything was finished, the client would give them notes which in turn were discounted with a factor ([149]). They in turn received a portion of the gross value of the notes back from the lender (minus a reserve) in what really turned out to be a very expensive financing ploy but an excellent sales tool. As far as the company was concerned though, obviously this form of financing left no margin for error and it was only a matter of time before BarChris would go down the drain.

It must of become apparent to all concerned that the company was not going anywhere with the financing arrangement that they had in place so management came up with a new plan, which although it had some very interesting elements, practically insured, immediate disaster. The plan was somewhat complex for the times and it consisted of BarChris building and installing what they called an “interior package.” ([150]) When the “interior” was completed, BarChris would then sell it to the factor that they had been using, James Talcott, Inc, The factor would in turn lease the interior to the to BarChris’s client or to BarChris itself which would then lease it to the client. While there were certain innate benefits to this new concept, BarChris’s cash needs actually increased substantially because they were now not getting any money whatsoever as a down payment. Thus they were financing everything themselves.

BarChris’ fortunes had improved as the sport took off and by 1960, it was estimated that the company was installing 3 percent of all bowling alleys constructed in the United States ([151]). On the other hand, business was so good that the company literally could not keep up with its financing needs. In December of 1959, BarChris went public by having the brokerage firm of Peter Morgan & Company offer the public 560,000 shares of stock at $3.00 per share. However, the funds received in that offering made only a small dent in its needs. For its efforts, Peter Morgan & Company was also named a party to the litigation which commenced when the house fell in.

By 1961, the company once again began combing the capital markets for additional funding. BarChris was successful in floating a debt issue, which was led by Drexel & Company but once again it turned out to be only a temporary fix and in 1962, the company filed for bankruptcy and simultaneously defaulted on its newly assumed debt. ([152]) Unbeknownst to investors, BarChris was having two major unreported problems simultaneously, the first was that its clients were just not paying their bills and BarChris, as a result was getting deeper into debt with Talcott. Secondarily, but essentially part of the same problem, the industry had become overbuilt. Competitive bowling alleys existed everywhere and clients that had only a short time earlier had been profitable now found it impossible to pay their bills. BarChris had continued building in spite of the handwriting on the wall and were now selling the wares to less and less satisfactory credits. The bowling boom had ended with a soft thud.

All of the clues as to what was going on in BarChris were available to anyone who desired to take a serious look. The obvious incestuous relationship of Peat Marwick with their ex-employees did not make the situation any more transparent. Little due-diligence was required to determine what was happening; we must assume that was what the judge had this in mind when he rendered his opinion, which named literally everyone as contributors to the catastrophe. The accountants got into major trouble for their use of a series of estimates when rechecking the numbers ([153]). By not checking everything in the manner that accounting rules required, the accountant’s got themselves in big trouble. Peat Marwick, led by their senior accountant, Berardi, took what they thought to be a representative sampling of all jobs that had been completed by BarChris. On the other hand, Berardi screwed up and the following paragraph by Judge McLain will give you a clue as to why:

“Berardi was then about thirty years old. He was not yet a C.P.A. He had had no previous experience with the bowling industry. This was his first job as a senior accountant. He could hardly have been given a more difficult assignment.” ([154])

After Peat Marwick had tabulated BarChris’s actual costs on these jobs, and subtracted the cost from the contract price to determine the profit. They then applied a percentage to the profit, which was used to determine all other work in process. Thus, Peat Marwick made a number of fatal accounting blunders.

For whatever reason, the jobs randomly selected by Peat Marwick seemed to conform synergistically with the model that had been developed and yet the business had become dynamic, it was moving quickly in the wrong direction and the Peat Marwick model had not taken this shift into account. As time went on, BarChris was bidding closer and closer on jobs, so that the numbers on jobs in process would always have been substantially inferior to those that had already been completed or those used in the accountant’s model. While they were at it, Peat Marwick missed the fact that BarChris was booking sales and profits on the construction of imaginary facilities and mischaracterizing balance sheet items in favor of BarChris. ([155]) Worse yet, Peat Marwick allowed BarChris to carry items long overdue as current receivables, which in some cases were never paid at all. In one case, a company called Federal declared bankruptcy while the financial statement was effective. ([156])

When looking at the overall picture, Judge McLain treated Berardi almost kindly when he stated the obvious:

“Accountants should not be held to a standard higher than that recognized in their profession. I do not do so here. Berardi's review did not come up to that standard. He did not take some of the steps which Peat, Warwick’s written program prescribed. He did not spend an adequate amount of time on a task of this magnitude. Most important of all, he was too easily satisfied with glib answers to his inquiries.”

The Judge further found that the accountants had not accurately depicted the situation as it related to loans to officers. Because of the fact that this was materially misstated it further caused the prospectus to substantially deficient.

“The prospectus impliedly, if not expressly, represented that there were no loans from officers outstanding as of May 16, 1961. In fact there were then outstanding and unpaid loans from officers in the aggregate amount of $386,615. BarChris paid this amount after May 22, 1961 out of the proceeds of the debenture issue.”

“The total of the officers' loans (not including B.C.L. Realty) and the Manufacturers Trust Company loan was $628,615. It is clear that in the first instance, at least, BarChris used a substantial part of the financing proceeds in a manner not revealed in the prospectus, i.e., to pay its debts. It also used over $400,000 more of the proceeds to pay construction expenses incurred before May 23, 1961. And it used $120,000 of the proceeds to make a loan to Russo's friends. The question is whether or not by reason of these facts the 'application of proceeds' paragraph in the prospectus was false or misleading”.

Justice McLean was appalled by this particular work of accountants and made the following statement relative to it:

“I am well aware that this question of adequate reserves must be determined in the light of the facts as they existed at the time, not as they later developed. Nevertheless, I believe that the prospects for Federal were so bad, even on December 31, 1960, that some reserve should have been set up against the probability…”

The Judge was also not very ecstatic when confronted with intercompany receivables that were taken as assets on the BarChris balance sheet. In effect what had occurred was the fact that BarChris was double booking receivables by listing them as payable by both its outside clients and its own subsidiary. ([157]) Peat Marwick kept adding insult to injury by booking all of the money receivable from the factor as current assets. There is not much question that in some cases this money was to be received over a period of many years. The court also found that BarChris had an unreported contingent liability to Talcott on the paper of its customers. The accountants substantially misrepresented the amount that would be owed in the case of default of contingent liabilities. Obviously the accountants were out to lunch or worse when they did this audit. But that is the reason that the saga of BarChris Construction has become a classic in the annals of how not to do an audit. ([158])

In addition, the plaintiffs allege that basically BarChris was in the Bowling Alley operations business, which it did not include in its prospectus as one of the areas of its interest. It was found in court that building a bowling alley is a far cry from running one and that its exclusion in the prospectus was indeed misleading.

“Operating an alley is obviously quite a different business from constructing one, with different problems and different risks. There is not a word of this in the prospectus. It was something that purchasers of the debentures were entitled to know. I find, therefore, that the omission of any reference to this subject rendered the description of BarChris's business incomplete and therefore misleading.”

Once in court, it became pretty apparent to all concerned that either some of the defendants or all of them were going to pay a big price in the proceedings. Naturally, each group of defendants tried to distance themselves from the others and lay the blame where they thought that it out to be placed, on the other guy. A big fight arouse among the defendants regarding who expertised the prospectus with literally, once again everyone condemning one and all. This was very helpful for the plaintiffs in the discovery process because evidence flowed like water out of a spigot with almost all of the condemned developing oral diarrhea in attempting to point out the other guy’s culpability. However, the judge did not seem to have too much problem in picking the penultimate culprit and specified Peat Marwick in unambiguous terms:

“Before considering the evidence, a preliminary matter should be disposed of. The defendants do not agree among themselves as to who the 'experts' were or as to the parts of the registration statement, which were expertised. Some defendants say that Peat, Marwick was the expert, others say that BarChris's attorneys, Perkins, Daniels, McCormack & Collins, and the underwriters' attorneys, Drinker, Biddle & Reath, were also the experts. On the first view, only those portions of the registration statement purporting to be made on Peat, Marwick's authority were expertised portions. On the other view, everything in the registration statement was within this category, because the two law firms were responsible for the entire document. The first view is the correct one. To say that the entire registration statement is expertised because some lawyer prepared it would be an unreasonable construction of the statute.”

A lot of the accounting within the company was so skewed that nothing could reasonably be determined from looked at the figures. We see the judge pondering learnedly in an attempt to come to grips with what the true number might have been and failing in that miserably:

“'The Company as of March 31, 1960, had $2,875,000 in unfilled orders on its books. As of March 31, 1961, the comparable amount was approximately $6,905,000. Substantially all of the latter orders are scheduled and are expected to be completed in 1961.”

“Plaintiffs contend that the figure of $6,905,000 was erroneous. There is no doubt that it was, to a substantial extent. It is impossible to determine, however, precisely what the figure should have been.”

“The difficulty results from the fact that BarChris's books did not contain a record of unfilled orders as of March 31, 1961. Russo testified that he prepared a list of them, which was the basis for the figure in the prospectus. The list was never produced. Its absence gave rise to controversy as to what alleys were on the list and what were not. Despite all the testimony and argument on this subject, the matter was never completely settled.”

“Out of all this testimony, however, some things clearly emerge. Although it is not possible to specify each and every alley, which was included in the total of $6,905,000, there is no dispute about the fact that certain alleys were included. And it is clear that alleys were included for which BarChris, as of March 31, 1961, held no valid enforceable contracts.”

The Judge seemed equally upset by the fact that BarChris included seven bowling alleys purportedly sold to an independent group of investors in their list of assets. Far from being independent, the alleys in question were being purchased from BarChris by corporate insiders and the funding was contingent on money being raised by the same underwriter that had done the original equity financing for the company.

“I have made due allowance for the fact that BarChris's contract draftsmanship was frequently inartistic. Consequently, I do not regard as determinative the fact that the T-Bowl documents were carelessly drawn and executed. But the difficulty here goes beyond such defects in form. The evidence shows, and I so find, that Tumminello's agreement made in late 1960 or early 1961 to purchase the interior equipment of the six alleys was contingent upon the future organization and successful financing of the corporation which turned out to be T-Bowl International Inc. Whether or not this could ultimately be accomplished was by no means certain on March 31, 1961. Indeed, one may wonder how purchasers were found in September 1961 for the stock of a new corporation starting out in life with a 'negative working capital of $229,058.79.”

Among other problems in this litigation aside from the obvious conflicts of interest that arose, was they fact that in one of the instances, BarChris had announced with great fanfare the construction of a new bowling alley. In a vacuum there would have been nothing wrong with the statement but the facts showed otherwise. The facility could not have been built because the land underneath it had already been condemned by the state highway commission for a new highway. ([159]) Alice in Wonderland happenings continued crop up in the accounting when the judge also raised grave questions about the company’s backlog:

“Woonsocke; It is undisputed that $725,000 was included in the backlog figure for this job. There is testimony that BarChris made a contract in 1960 with a purchaser for this alley and that the purchaser later cancelled the contract. The contract was never produced and the date of cancellation was never specified. The minutes of BarChris's executive committee meeting of March 18, 1961 lists this job as one of those which was then or about to be under construction without a contract. “

BarChris built this alley and operated it itself. At the end of 1961 it was eliminated from 1961 sales because it was an intercompany transaction. The judge found that it was inaccurate and misleading to have it included it in the backlog figure

It was obvious to all that for the company to fail so soon after doing a debt financing, something was dramatically wrong and a lot of folks were going to have a great deal of questions to answer. If the financial statements even close to correct this could not have happened.

“The fundamental fact is that in May 1961 BarChris was so hard pressed that it borrowed over $600,000 and held up payments to construction creditors totaling more than $400,000. It used the financing proceeds to pay these obligations totaling over $1,000,000. It used $120,000 more to assist St. Ann's. There is no doubt that in May 1961 BarChris's officers intended so to use the proceeds.”

“There is no hint of this situation in the prospectus. According to the prospectus, $1,745,000 of the proceeds (the amount remaining after defraying the costs of the new plant, the new equipment line and the loan to BarChris Financial) was to be utilized as 'additional' working capital in the 'expansion' of alley construction. There is not the faintest suggestion that over 60 per cent of this sum would be immediately expended in other ways, primarily in paying prior debts incurred as a result of alley construction already undertaken. I cannot escape the conclusion that in failing to reveal these facts, the prospectus was false and misleading. I so find.” ([160])

It was not a stretch to assume that someone had not correctly critiqued the numbers, and that literally no one had done any due diligence on the issue before it came out. The plaintiffs charged that the prospectus contained materially false statements and material omissions.

“But this is by no means the whole story. It is clear beyond question that the prospectus, although literally true, was impliedly false. It gave the unmistakable impression that BarChris's problems with customers' credit and performance were minimal and that BarChris's experience in this respect had been and continued to be eminently satisfactory. As of the effective date of the prospectus, nothing could have been further from the truth. Indeed, it is fair to say, on all the evidence, that it was only by dint of Russo's skillful negotiations, understandably enhanced by Talcott's awareness of the fact that BarChris stood to receive over $3,000,000 on May 24 from the sale of the debentures, that Talcott was induced to refrain from making formal demand on BarChris to repurchase all Dreyfuss and Stratford notes and, in all likelihood, all notes of Leader and Federal as well. BarChris could not have complied with such a demand before May 24. As of May 16, BarChris's situation vis-à-vis Talcott was highly precarious. There is no suggestion of this in the prospectus. The failure to disclose it was misleading.” “[161]”

In addition, it was alleged that the company had overstated its sales, profits, and customer orders. ([162]) In the meantime, officers had been using the corporate treasury as a piggy bank and that fact also had never been disclosed. The complaints went on and the lawsuit began.

District judge, McLean ruled that:

“The average prudent investor is not concerned with minor inaccuracies or with errors as to matters which are of no interest to him. The facts, which tend to deter him from purchasing a security, are facts, which have an important bearing upon the nature or condition of the issuing corporation or its business. Judged by this test, there is not doubt that many of the misstatements and omissions in this prospectus were material. This is true of all of them which relate to the state of affairs in 1961, i.e., the over-statement of sales and gross profit, the understatement of contingent liabilities, the over-statement of orders on hand and the failure to disclose the true facts with respect to officers’ loans, customers delinquencies, application of proceeds and the prospective operation of several alleys.”

The judge attempted to sum up his findings by encapsulating each point, they are listed as follows: 1960 Earnings Overstated, 1960 Sales, Overstated, 1960 Net Operating Income, Overstated, 1960 Earnings per share, Overstated, 1960 Current Assets, Overstated, 1960 Contingent Liabilities, Understated, Contingent Liabilities for April 30, 1961, Understated, Earnings for Quarter ending March 31, 1961, Overstated, Gross Profit for that Quarter, Overstated, Backlog for that Quarter, Overstated, Failure to Disclose Officers’ Loans, Outstanding and Unpaid on May 16, 1961, Failure to Disclose Use of Proceeds in a Manner Not Revealed in the Prospectus, Failure to Disclose Customers’ Delinquencies in May 1961 and BarChris’s Potential Liability with Respect Thereto, Failure to Disclose the Fact that BarChris was Already Engaged, and was about to be More Heavily Engaged in the Operation of Bowling Alleys.

Keep in mind, that in the paragraph above we are only talking about what Judge McLain found wrong with the prospectus that was issued by the company in order to obtain their debt financing. The Judge’s decision was devastating, he literally held that everyone that had anything to do with the situation was guilty of something or other opening the door for plaintiff’s attorneys to come down hard on BarChris Construction Corporation, its underwriters (eight investment banking firms), the auditors, (Peat, Marwick, Mitchell & Company) ([163]), and all of the signers of the registration statement including BarChris’s directors, controller, attorney and others.

Kaypro Corp

Talk about idyllic, a company that was the acknowledged leader in the hottest industry around, personal computers. Their idea of giving away free software with a computer purchase had set the industry agog and orders were multiplying like hamsters reproducing. Their facilities ([164]) are located so close to the Pacific Ocean that some of the company’s managers hold their meetings in the surf, the company facilities also include a free juice bar with fresh-squeezed vegetables available at all hours, only for the asking. Moreover, Kaypro seems to have been the first company to publish what could be described as a public interest newsletter for its clients. In the short span of two years, sales unbelievably, had gone from $5 million to substantially over $100 million, and were still rising like a hot air balloon that had broken its moorings. For the family management of Kaypro Corporation life couldn’t be better. Management had shown itself to be innovative, resourceful, and motivated. The year was 1984 and anything that looked like growth was being gobbled up by hungry investors. With this background, people were saying that this could be the hottest ticket of all.

The company headquarters resembled a resort facility with almost all of the windows facing the Pacific Ocean, where the sun would always be shining down in the afternoons. Despite the sunny atmosphere, nepotism abounded; if you were not part of the immediate family, you were on the wrong career path. Andrew Kay, Kaypro’s founder and resident genius, ran the company despotically in spite of cramming relatives into the plant’s every nook and cranny. David, one of Andrew’s sons, whose life experience included surfing and selling windmills, was anointed marketing vice president. Andrew, the oldest son, got the nod as Executive Vice President, probably because of his age, and son Allan became Vice President of Administration. Mary, Andrew’s wife, was Kaypro’s secretary. Stephen, Andrew’s brother, was in charge of the print shop, and Frank, Andrew’s father was running maintenance at the age of 94.

The family’s roots were in New Jersey, where Andrew Kay, Kaypro’s CEO, was raised. He later went to Massachusetts Institute of Technology, where he received a degree in engineering. Soon after graduation, he married and moved his family to Southern California. At about this time he invented the digital voltmeter and found a ready market for it in the aerospace industry. The business was highly successful and provided an excellent lifestyle for the emerging family.

Andrew, always the tinkerer, became a student of the new fangled personal computer early on, and determined to build one that would take the market by storm. In the very early 1980’s he started to market an economical and dependable machine called the Kaypro 2, which soon became a extraordinary hit. He soon started believing his press releases, which portrayed him as the Henry Ford of the computer industry: "I like to think we are giving as much value for the dollar as Henry Ford did. Henry Ford did not get into the marketplace by making a car better than the Pierce Arrow or the Stanley Steamer, He made a car cheaper. I consider the Kaypro as basic to the computer industry as the Model T was to the automotive industry. The Model T was the most successful product ever in American industry. We are constantly upgrading our product, just like Henry Ford did. The Ford Motor Company is still around."

Kaypro seemed to have everything that Wall Street was partial to, except of course, an over abundance of Kay’s. In later years, one wag said that the company “had to many Kay’s and not enough pro’s.” But in the meantime, Wall Street pundits pronounced the company a smashing success. The company’s stock was brought public in 1982 at a price equivalent to 59 cents. By the following year, the stock had climbed to $11, an almost 1800 percent increase in its original offering price. On the other hand, that was the highest price the stock ever saw. It declined steadily for the next several years until Kaypro applied for protection under the Chapter II bankruptcy code.

Moreover, the folks at Kaypro seemed to be good at only one thing, innovation. When it came to keeping records, analyzing trends, and setting up marketing programs, their failures were legendary. From the very beginning, part of Kaypro’s problem was its ineffectiveness in evaluating inventory, and the balance sheet that they presented to the SEC when they were planning to go public turned out to be just a tad out of whack: 50%, to be more specific. The SEC filed suit against the company and Andrew F. Kay, charging that they defrauded buyers of the company’s common shares by reporting false information regarding Kaypro’s financial condition.

“In preparing its third-quarter report, the SEC said Kaypro "estimated its inventory and cost of sales percentage (in a way) that disregarded the fact that using said percentage would materially overstate net income and inventory."

The suit cites instances in which, the SEC alleges, Kay ignored the advice of employees, including accountants and the company's controller, and proceeded with his methods of accounting.

The suit said Kay also rejected the advice of the controller and outside consultants and accounting firms that inventories were being overstated. It was only during the company's annual fiscal year-end 1984 audit by an outside independent accounting firm, the SEC said, that adjustments were made to Kaypro’s books.

The adjustments, the SEC said, resulted in Kaypro posting a loss in the fourth quarter of $10.3 million and an annual loss of $268,000. For fiscal 1983, the year in which Kaypro went public with a stock offering and netted $27.5 million, the SEC noted the company reported net income of $12.9 million.”

The SEC analysis and the restatement of earnings triggered a massive stockholder derivative action. The suit charged the company with every evil known to man as well as with several brand new sins. Naturally, the company panicked and promptly settled the litigation for almost $10 million dollars, a tidy sum at that time. The insurance folks coughed up the money as they usually do in cases such as this one, and by getting the matter behind them, Kaypro was able to get unqualified financial statements from their auditors, Peat Marwick & Mitchell for the years 1984 and 1985. The underwriter, Prudential-Bache Securities and Peat, Marwick were also attacked by shareholders for their lack of due-diligence. When the smoke had cleared, everyone had joined the settlement with the exception of Peat Marwick, who protested too much. The complaint against Peat Marwick alleged that they:

"knew or recklessly disregarded facts which indicated that the financial statements in the prospectus and in the 1983 annual report and Form 10-K report were materially misleading in that they purported to comply with standards and doctrines of fair reporting but did not so comply.” And members of the class "have suffered injury by the loss of the value of their investment in Kaypro "

In addition, the suit made some more general, but no less interesting points:

Kaypro "is suffering liquidity and management problems, has not been able to successfully introduce either the workslate (a lap-size portable computer) or IBM-compatible transportable computer, while its new Robie desk-top computer product has been a complete marketing failure with sales well below those forecast, and has suffered an almost complete exodus of its top `professional management, who were unable or unwilling to work with the Kay family.” In addition, the suit said: "prior to July 1, 1984, Kaypro did not have a computerized inventory control system, that ongoing attempts to measure and/or control Kaypro 's inventory of parts with Kaypro 's computer systems had failed, and that the company was unable to accurately measure or control its rapidly growing inventory of computer parts."

The inventory problems seemed to stem from the top, and really addressed the chief executive officer’s desire to get bargains at any cost. Kaypro was always being enticed by discounts for volume purchases, and its appetite was always bigger than its stomach. Everyone at the company had an opinion on the problem, but the end result seemed the same. The former national sales director for Kaypro, Christa Wagner, said that “We always ordered more than needed because sales projections were usually off the top of the head.” C. E. Smith, the former head honcho for purchasing, added insult to injury: “In my tenure at Kaypro, there was a complete lack of verifiable sales forecasts, which is mandatory for proper scheduling, our material ordering schedules were always greater than our shipping schedules.” One of Kaypro parts suppliers added the biggest dig of all, “Never in my 30 years of manufacturing experience have I seen delicate electronic equipment handled so carelessly and under the damaging environmental conditions found at Kaypro.” The quotes about what the outside world thought of the Kay family’s management skills were legion, and almost all were as harsh as those quoted here. On the other hand, I think you get the idea.

As if that wasn’t enough to make it a bad hair day, the company was also informed that the Equal Employment Opportunity commission was pursuing a complaint by some female employees of Kaypro, charging that they were receiving substantially less money than men were for the same work. The company indicated that they had very few women doing the same job as men, which does not seem to be particularly responsive to the charges, but as with all of Kaypro’s other problems, this one could have been solved with money.

Andrew’s fast-on-the-draw responses to serious problems did nothing to help. When a number of vendors filed lawsuits against the company for non-payment of bills, Kaypro’s boss didn’t take a second to reply, “We don’t pay people who ship us junk – material that is not as warranted…Lawsuits are almost always over quality – the parts didn’t meet our specifications. “ Hey, go get ‘em Andrew but you are not making a lot of friends with this kind of stuff.

While the Kay’s were a close-knit family away from the office, when they were working they were like gladiators. No one thought anyone else was doing anything right, which was always at least partly true. Andrew ruled with an iron fist, but he did not know much about running a public business. He was so used to doing things in his own way that he could not relate to a world of mass production and mega-million dollar sales. He was used to operating at his own pace without reporting to anyone. This homey philosopher’s shortcomings were glaring; Kaypro was a leader in the hottest market place of all time with a dynamite product; yet it made money during only two years of its existence.

Andrew, the ultimate parts junkie, constantly bought components for new machines far in excess of the company’s production capacity and vastly in excess of existing orders. Not having a clue about what to do with the parts, which quickly became obsolete, the company erected a circus tent on their grounds to store the excess until they could figure out what to do with it. ([165]) Naturally, the tent was a logistical nightmare to police. In no time it became a big attraction in the neighborhood, and burglars, second story men, shoplifters and curious neighbors walked off with millions of dollars in unusable inventory. Strange as it may sound, those folks that robbed Kaypro blind probably did the company a favor; what didn’t get carried off was done in by the weather. The tent wasn’t waterproof, and the delicate computer components got nice and wet whenever it rained.

In spite of having a near mountain of replacement parts and components sitting in his nearby porous tent, Andrew was in no way assuaged. He was always waiting for the monster order that never quite arrived, and some members of the Kay family ultimately revolted over his illogical excesses. Son David, ballistic over what was going on, moved his desk to the loading dock and when a shipment arrived that contained excess materials, they were turned away.

About this time, the new state of the art 15-pound portable computer that they had just developed was announced with great fanfare. On the other hand, they were not able to deliver it. This created a number of additional problems: inventory that became totally worthless, unhappy dealers who had pre-sold the product, and customers who never received computers that they had ordered and did not want to repeat the experience. A similar problem had occurred just two years earlier when the company, late to adjust to industry innovations, moved from 8 to 16 bytes, causing a $14 million inventory write-off. The Kay’s did not learn from their mistakes.

In the meantime, Andrew was the sole member of the corporate planning committee. While he was an extremely talented innovator, he wasn’t always as alert as he should have been to what was going on in the rest of the industry. International Business Machines’ (IBM) new operating system, MS-DOS, soon became an industry standard. Kaypro’s computer was quickly relegated to the status of a curiosity, because without software compatibility, no serious people would buy it. The MS-DOS debacle increased the rancor between Andrew and David. To shut his son up, Andrew named David President, a job that was at the time without a job description. As President, David had zero authority, but he was into fancy titles and the move temporarily placated him.

One of the new President’s first challenges was the discovery that a key chip was faulty and that machines containing it had to be recalled at a huge cost. Worse, there was no immediately available replacement chip, and Kaypro could neither fix machines in consumer’s hands nor produce any new ones. Dealers went bonkers and Kaypro’s vaunted reputation for system integrity went up in flames.

But time marches on, and in due course Andrew turned to dealers’ complaints about untimely shipments, a problem for which he devised what he thought was a wonderful solution. The company would set up warehouses all over the country and ship from the closest location directly to the dealer. David thought the idea uneconomical and unworkable. In spite of the disagreement, by this time you know who won the battle and the distribution centers were erected at substantial cost. The fact that David turned out to be right did little to help the company’s bottom line and certainly did not bring him and his overbearing father closer together. The money was spent, the warehouses were opened, the money was lost, and the warehouses were closed. A very tidy and momentary cycle at best, but one that was very costly to the shareholders.

Mistakes were eating the company’s lunch and it was obviously now getting into severe financial trouble. Family discussion groups abounded, and each member had a different solution. The discussions turned into shouting matches, and family life disintegrated into that of a debating society. Andrew by this time was getting a little long-in-the-tooth, and some of his ideas seemed to have little relationship to reality, but he was the boss and what he said still became company policy. He proposed to double the sales force, causing it to compete with Kaypro’s own distributors. The Board was uniformly against the idea, but the project went ahead, making enemies of trusted clients. In another instance, when his, Allan converted from the Unitarian Church to the Church of the Latter Day Saints, he told his father that Mormons had been so trusted by Howard Hughes that he should bring them in to have them help with his decisions. Andrew, a great Howard Hughes fan, determined that this made sense.

Thus, son Allan was put in charge of recruiting members of the Mormon Church. When jobs became vacant, Allan would reach out for a Mormon, and often found that them either unavailable or unqualified. There were soon a lot of square pegs in round holes at Kaypro, hastening its downward spiral.

Kaypro, never much for credit checks, took an order from an unknown client and made delivery. It wasn’t until they discovered that the check in payment for the merchandise had never arrived that they began to realize that they had a major problem. Many in the family said that when this occurred they just threw up their hands and said, “this is it.”

David couldn’t stand to see what was happening with the company and in 1988, after it was much to late, resigned in disgust. Andrew now turned to a so-called turn-around guru for advice. Unluckily, he guessed wrong one last fatal time. His choice was thirty-four year old Roy Salisbury, an imposing individual about 6 feet 5 inches tall and weighing almost 400 pounds. Once in charge, it was Salisbury who took Kaypro into bankruptcy reorganization. He then brought in two other companies to assist in Kaypro’s reorganization. One of them, KMG International, was a company of indiscernible history and no known business. KMG itself ceased functioning shortly after Salisbury brought them on board, leaving vendors holding hundreds of thousands in unpaid invoices. The disappointed creditors promptly began to dun Kaypro.

Salisbury may not have been the man that Andrew had thought he was. In an article entitled, “Roy Salisbury leaves trail of confusion, debt ex-head of Kaypro now guiding psychological studies school” by Craig D. Rose of the San Diego Union-Tribune, 04/14/1991, a bit of dialogue is related between Salisbury and Rose. Salisbury indicated to Rose that in his 34 years he had already had been responsible for the organization of 25 different companies and had consulted for many others.

Rose: Could he provide the names of associates who found their involvement with him fruitful or profitable?

Salisbury: "No," he said. "You can draw your conclusion from that. I do not see the need to defend myself to that degree. There's no doubt that when you do what I do you make a lot of people mad. But I'm not going to subject my friends and associates to that."

Rose at this point indicates that Salisbury never finished high school, had a reading level equivalent to that of a sixth-grader, and enlisted in the Marine Corps. Upon returning to civilian life, he organized Roy Salisbury Logging in New Hampshire. Within two years, the company filed for bankruptcy.

Salisbury: "That's how I learned about bankruptcy," said Salisbury. "I went through it and lost everything I owned."

Salisbury went on to say that since then, he said he specialized in working with bankrupt companies. But Salisbury also boasted, "I have a tendency to personally guarantee and back the projects I get involved in."

The Rose article chronicles the suffering of former Salisbury clients, one of whom bitterly described his influence on her company: "He turned it around, all right -- straight into the ground.” According to Henchey, Salisbury's strategy involved huge expenditures. Eventually, Henchey fired him, but not before more than $250,000 in debts had been run up. She also said she got a restraining order to keep him off the premises. "There's always an emergency or he needs a certain amount of money to get from `X' to `Y' to make things happen. But all these things never happen."

Another Salisbury client, Donald Newton, got involved in a pool of businesses created by Salisbury, that left him in debt for $200,000. Many of Salisbury’s former associates declined to be identified, citing concerns including the possibility of protracted legal attacks from Salisbury or fear of physical retaliation. "His whole life is fighting these fights," said one. Typically, Salisbury would create other companies while still in the employ of a client. These companies were used to siphon off cash to Salisbury’s personal use.

This pattern persisted after Salisbury left Kaypro. Salisbury contracted to purchase a 14-year-old psychological school where students paid upward of $6,000 for master's degree programs and about $18,000 for Ph.D. programs. Classes were held at the two-classroom headquarters facility in Mission Valley and at centers in Woodland Hills or Tustin, with plans to soon open an additional site in Moreno Valley. After eight months of Salisbury management, one thing was apparent, said one employee: "There is a large amount of overhead here not related to the school.” A spokesman for the school's board, Joseph Marcello -- himself formerly with Kaypro -- said he was leading efforts to land scientific or "think tank" contracts for PRI Foundation, which was occupying space at the same address as the school. He characterized PRI as a non-profit, shell company that formerly ran the school.

Salisbury's overall holding company, Strong Point Inc., occupied sparsely furnished offices one floor above the school in Mission Valley. Soon after his arrival at the school, a bench warrant for Salisbury's arrest was issued by a court in San Marcos, in an attempt to force his appearance in a case brought by a former employee for back wages. Other aggrieved former employees abandoned pursuing Salisbury for debt because the trail was so complex or they fear not being able to identify his assets.

Eventually, Andrew saw the errors of his way relative to Salisbury and in spite of the fact that the company was in bankruptcy sought to oust Salisbury and re-take control of the company. Salisbury was not the cause of Kaypro’s destruction, he was just one in a long line of inconceivably disastrous decisions. Even before he had arrived on the scene in 1989, the company’s books were in such disarray that its own outside auditors would not take responsibility for them. Kaypro was forced to admit this fact in their publicly issued 8-K statement filed with the Securities and Exchange Commission. Among other problematic items listed by the SEC was the absence of sufficient records to establish Kaypro’s actual financial status.

On the other hand, Salisbury had already shown his mettle by making the claim in bankruptcy that Andrew Kay and the company were being investigated for possible violations by the Securities and Exchange Commission and the San Diego County Sheriff’s department for bad checks that the company had written to the tune of $365,000. In addition, Salisbury pointed out that the company owed the IRS about $1 million in unpaid employee withholding taxes. The timing was not so illogical, Kay had kept his Chairman’s position and one other seat, which he gave to his wife Mary. Salisbury had his own and one other which was held by Mark Seaver, Salisbury’s alter ego on the workout team hired by Kay. Of course, at this point, everyone hated everyone else. Thus, the company had created a Mexican Standoff, although the choice between the two men would not have been easy at best. The Judge in the Bankruptcy litigation was to make a decision as to which of two slates to favor and Salisbury had played his trump card.

In 1992, the battle ended when U.S. Bankruptcy Judge James Myers converted Kaypro from Chapter II to Chapter 7. Chapter 7 liquidation is used when all other alternatives to resurrect the company have been tried without success. Claims against the company have reached $20 million while assets at best are listed at around $1 million. In a most interesting situation for bankruptcy where many of the obligations of the debtor are stayed, in Kaypro’s case, when the final book was written on the company, they had absorbed another $2 million in debts during the two-year bankruptcy period. In Kaypro’s case, liquidation was a form of euthanasia.

Kurzweil Didn’t Apply Intelligence

Raymond C. Kurzweil, a computer prodigy, at 28 invented a device that could scan the printed page and read it aloud to the blind using a synthesized form of speech. Kurzweil Applied Intelligence, which was founded in 1982, was to be his vehicle to commercialize his speech-recognition research; in this case, by means of computers to transform spoken words into printed text. Kurzweil was also able to attract some serious money to his program and included among his early investors were Harvard University’s endowment fund along with Xerox’s venture-capital group.

Kurzweil with the money in the bank was now in a position to start attracting talent and one of his first hires was Bernard F. Bradstreet, a Harvard Business School graduate, a former Marine fighter pilot and combat instructor, a devoted family man, historically incorruptible, highly motivated corporate employee who had won kudos for his performance during his past work history. In 1985, he left a promising position to join Kurzweil as chief financial officer. He was attracted by what he considered to be an extremely promising technology. The company at this point had only several dozen employees and literally no sales.

Bradstreet soon become conscious of the fact that Kurzweil’s product would be too costly to deliver to a broad-based market and as an alternative refocused the company’s efforts concentrating on the medical field. Whereas the product may have been beyond the purse strings of the general public, he felt that the doctors could afford the technology and it could ultimately represent a quantum leap for the medical profession to be able to get their notes into print effortlessly

However, the a largest amount stock Bradstreet had ever owned in Kurzweil was just over three percent of the company, a nominal amount under the circumstances. Progressively, Bradstreet took on enhanced roles at Kurzweil, first as president, then as co-CEO with Ray Kurzweil, while also retaining his CFO job and by 1991, he was in charge of all day-to-day operations.

Both Bradstreet and Ray Kurzweil, remained co-CEO’s until 1994 but Bradstreet was concerned chiefly with technical matters, while both were itching to take the company public. However, according to the testimony of several Kurzweil employees, Bradstreet was convinced that the company needed to post six straight quarters of improving results to make the “Initial Public Offering” (IPO) occur. The problem was, Kurzweil’s systems were a difficult sell, requiring big financial commitments from hospitals and an off the budget commitment to a largely unproven new technology; a move that few administrators wanted to bet their jobs on.

In the meantime, due to the above, penetration of the medical market was not going a quickly as had been anticipated, but finally in 1992, those working on the project felt that a breakthrough was near. Sales started picking up and the company was getting a lot of excellent publicity on the product. Moreover, company revenues had grown to over $10 million and the bottom line was now showing a small profit. It was at this point that the company’s accountants were asked by Bradstreet to somehow show substantially increasing sales and earnings in spite of the fact that the did not exist. Management had determined that the time for a public offering was at hand and the numbers had to conform with “Street” expectations.

The cheating was inconspicuous at first with only items that company officials believed would be sold in the very near future becoming fodder for dishonest reporting. These items would be sent to the company’s FOB America warehouse in Chelsea, Massachusetts, and when the sale was finalized, re-shipped to the customer. This was a stretch as generally accepted accounting principals mandate that a sale can only be booked once it is on the way to the client, on the other hand, management felt they had the right karma on their side and thus, everything would somehow work itself out. While this maneuver created additional expenses by double shipping of the same goods first to the FOB warehouse and then to the ultimate client. However, for all other purposes the transaction was literally invisible to the outside accountants.

Once pierced, the dike often becomes a torrent, karma or otherwise, and as the torrent became a flood, and a historically methodically organized Kurzweil Applied Intelligence soon became an undisciplined, catch as catch can effort to book sales and earnings in whatever way possible, legal or not. The beginning of the end began on the last day of December, 1992 when James Hasbrouck, Kurzweil’s Atlanta salesman, forged his customer’s signature on two purchase orders under pressure from his boss. The orders were booked as sales and made it into year end financial statements. In the meantime, Hasbrouck was never able to complete the transaction and the goods rotted in the company’s warehouse until the fraud was uncovered seventeen months later.

Coopers & Lybrand sent the client a confirmation letter asking whether they had indeed ordered the goods in question and luckily for Kurzweil, Hasbrouck was able to put out the fire by intercepting the questionnaire and then forging the client’s signature, confirming indeed that the goods in question had been ordered. Coopers, none the wiser, feeling that they had done a first-rate job, in turn, gave Kurzweil a clean bill of health which meant an unqualified.

In the meantime, the Company had dodged another bullet and everyone breathed a another sigh of relief. It was believed among management personnel that sales would be taking off momentarily and with the public offering only slightly further down the road, it would be easy sailing once these barriers had been passed. However, nothing come to pass as planned and more chicanery had to be quickly implemented to maintain the company’s momentum. Bradstreet, feeling that the company needed to have a real shot in the arm before the offering, took a purchase agreement that at best was a contingency arrangement and booked it as a completed sale. Once again, the sale never closed but Kurzweil’ s numbers were starting to look terrific and Wall Street was beginning to take notice. Brokers all of the country were pleading for stock in the proposed new issue.

The underwriters were exultant with the financials and their clients were standing in line to purchase the offering, which consisted of 2.4 million shares at $10 in exchange for 35% interest in the company. Management believed this single action would right the ship and that things would now take care of themselves. With all of this money in the bank, the sales effort could be substantial amplified, the phony inventory in the warehouse could be dumped, and a legitimate company could take the place of the old one with no one any the wiser. Once again, this thinking would prove to be far too optimistic. The company for whatever reason was unable to meet its new projections and sales had to be supplemented in order to give Wall Street the warm and fuzzy feeling that they considered necessary. In the year ending January 31, 1994, almost 40% of the sales booked by the company were totally fraudulent.

Bradstreet and his team did all of the conventional illegal accounting moves to insurance the success of their new and more upscale fraud. They forged customer signatures, hid documents, altered contracts, and moved goods between warehouses to conceal them from the outside accountants. They produced imposing earnings growth and $24 million was poured into the company’s underwriting for all of the wrong reasons. Robertson, Stephens & Co., handled the public offering and with all of their “due diligence,” they could not uncover a problem with Kurzweil’s books. As luck would have it, not to long after this time the fraud accidentally came to light and the investors hard earned funds went up in smoke.

When Coopers found a shipping invoice from FOB America for an item that had been reported sold and delivered almost a year before, management began to believe that the game was up. They emptied the FOB America warehouse and sent the goods to another location unknown to Coopers. This move was already too late and the outside directors started hiring their own forensic experts to determine what was going on, Coopers people were seen everywhere and anywhere, investigating everything that they could find and in the middle of it all Bradstreet came up with his last idea, “Let’s send the stuff back from the second warehouse and claim that it had been returned by customers unbeknownst to us.”

Debra J. Murray, the treasurer of Kurzweil and a close Bradshaw associate by this time had had it with his brilliant ideas and confessed her role in the affair rather than sink even deeper into the muck.

The Kurzweil fiasco, somewhat like Equity Funding was extremely unusual considering the number of people that were in on the fraud. Usually when the number begins exceeding two or three, someone gets nervous and runs over to the United States Attorney’s Office to expunge themselves before the others can get there and ink a deal. Although there were ten or more senior people involved in cooking the books, there were no “rats” in this deal, the motley crew was ultimately hoisted by their own petard. Their petard turned out to be the highly intelligent and consistent testimony of Debra J. Murray who knew where every single body was buried.

Naturally, Bradstreet did whatever every CEO has historically done when his hand was found deep in the cookie jar. He did the highly honorable thing and blamed a number of his trusted employees while pleading with the court to believe that he did not know a thing about it until the end. Bradstreet had not counted on Debra J. Murray ratting him out. She presented the court with “chapter and verse” on Bradstreet’s wheeling and dealing within Kurzweil with notes, letters, documents, dairies, times and dates to back her up. As a prosecution witness, she showed a great deal of star quality.

After Debra finished doing Bradstreet, the court determined that she was not only, somewhat of a victim but that she had been extremely helpful in bringing the affair into the open and received probation. The Kurzweil Vice-President of Sales, Thomas E. Campbell, was offered up as bait by junior executives in exchange for their ability to take a walk and the supervisor of sales was found guilty of fraud and conspiracy when his underlings gave him up as well.

Bradstreet and Campbell were subsequently found guilty by a jury of five counts of conspiracy, securities fraud, and falsification of corporate books and records. Bernard F. Bradstreet was sentenced to two years and nine months in prison along with a $2.3 million fine. Thomas E. Campbell, the venerable sales head of Kurzweil got a well deserved eighteen months in the slammer. Both could have cooled their heels for a lot longer under sentencing guidelines but the judge considered their spotless past and went a tad easy on them.

The Securities and Exchange Commission also got into the act by laying down sanctions against Bradstreet, Campbell and Murray who all signed consent decrees agreeing that they would be bared from serving as an officer or director of any public company and enjoined them from future violations of the antifraud provisions of the federal securities laws and those provisions relation to the falsification of an issuer’s books and records and the making of false statements to the auditors.

In the, “it is never over until the fat lady sings” department, Bradstreet, in spite of all of the evidence in the world against him, appealed his case. This turned out to be the worst move of his life. The decision came down on January 28, 1998 and talk about really dumb moves, this one takes the cake. On appeal, the court determined that the deal struck by Bradstreet and the lower court as a first time offender did not accurately follow the guidelines. The appeal was thrown out, the conviction was upheld, and under the re-drawn guidelines, Bradstreet will be spending substantial additional time as a guest of the state.

Although the accountants in this case did not overlook clues that were dropped in their laps, they did certify a statement that was adjudicated to be wrong by almost 40%, an extraordinary number, perhaps even setting a record in accounting annals. If indeed, letters were sent out confirming the sale of merchandise, we are hard put to understand how a company where earnings are entirely fraud based and almost as many sales are non-existent as those that are real could get away with this kind of thing.

Coopers catch was almost accidental but once they were on to the fraud, they held on like tigers. No accolades here, but at least a good recovery effort once confronted with a job poorly done. Naturally, substantial litigation was commenced against the accountants, the company, the underwriter, and the principals as well it should have been.

National Student Marketing Becomes Unglued

National Student Marketing was incorporated in the District of Columbia in 1966 and for a short time, it enjoyed almost unparalleled success. The company as its name implied, was in the business of marketing products to students, mainly those going to college. The theory was that one of the most dynamic markets in the country was that of kids going to college. If you could hook them early enough, they could possibly remain loyal to a particular brand name for life if they could only be indoctrinated early enough. Randell, the company’s CEO had about as much business background as a frog, but he was readily able to overcome that obstacle by staffing the company with business school graduates from his alma mater, the University of Virginia. The corporate theory was that people marketing to schools were both localized and disorganized. If they could be brought seamlessly together in a more homogeneous pot, everyone would benefit from increased earnings and sales. The students themselves would come out ahead because of the economies of central purchasing of mass produced goods. In addition, the prices that other vendors had been charging in this market would probably also drop.

The Company determined to expand it operations after it successfully gone public and earmarked companies in similar businesses for acquisition by 1969. The company’s management was believed to be capable and had a reputation of integrity and honesty. They had surrounded themselves with “white shoe” firms in both the legal community, having hired White & Case and in the accounting community, by bringing aboard Peat Marwick ([166]) who suddenly replaced Arthur Andersen who had resigned under unknown circumstances([167]). Both Cortes W. Randell ([168]), National Student Marketing’s CEO and James F. Joy, SVP of NSMC were both highly regarded by Wall Street and enjoyed good reputations. Furthermore, Cortes G. Randell, an international-business consultant, Cortes W’s father was the company’s Chairman of the board and brought a wealth of business experience and knowledge to the table. Another board member was Dr. Frank G. Dickey whose major sideline was being the Executive Director of the National Commission on Accrediting. This organization could give or withhold university accreditation. Certainly an interesting guy to have around when you are in a business trying to get schools to sign on the dotted line.

Cortes was known as Cort to his friends, which were just about everyone around the office. No one could have ever criticized Cort’s spending habits, he was just your average American six foot three inch, 30 year old multi-millionaire that had a castle with a dungeon and mote on the Potomac, a fifty-five foot yacht that could sleep twelve and a world class hydrofoil. He also had one of the largest collections of radio-controlled model boats, quite a feat in the late 1960’s along with apartments at the Americana and the Waldorf Hotels in New York and of course the obligatory, Lear Jet with two full time pilots.

On the other hand, he put in prodigious hours in much the same fashion, as did the merry-men at Equity Funding. The only difference between the two was that with Equity Funding the midnight workers were toiling over the creation of phony new insurance policies for which they could get ready cash from the re-insurers while in the case of National Student Marketing, the only people that they were trying to deceive were the accountants, with contracts that had been forged or hastily reconstructed with grander numbers contained therein. For these and other reasons, Cort certainly believed that he deserved all of the perquisites that the company could heap on him.

Favorable articles about the company were appearing throughout the media and Business Week did an especially favorable piece. Ad Age started talking to seriously National Student Marketing because the NSMC was hitting the advertising market exactly where all the agencies and their clients wanted to concentrate their business. The younger people that were believed to be the trendsetters were literally the company’s own back yard. If you wanted to get to them, you had better be on good terms with National Student Marketing was the company’s rallying cry.

Early on, NSMC had almost six hundred part time campus representatives selling everything to the students including the kitchen sink. Paper dresses were a big cash items as were psychedelic wall posters, freshman photo books, summer employment guides, campus telephone directories, calendar desk pads with campus events and advertising, Cliftex, a manufacturer of men’s sport jackets, Transplex mobile units set to advertise existing products, American Airlines Youth Fare Cards, wire bound notebooks with advertising and beer mugs were all big things among college students of the era. In the meantime, National Student Marketing also was distributing at no charge, voluminous copies of student school guides, and a thing called Campus Pacs that contained razors, blades, soap, toothbrushes, and other assorted items. These were theoretically to be paid for by advertisers or by free ads that the company received an override on ([169]). For the most part, this theory proved to be highly illusionary.

In addition, the company had developed a computerized resume’ service which although it lost a substantial amount of money, received accolades for its inspirational qualities. Cort even bought a book cover manufacturer for the sole purpose of being able to sell advertising on the inside covers. When the company acquired another business already in the trade of manufacturing college-student-oriented products, there was some chance of success but without fail, nearly every single product that was dreamed up by National Student Marketing was an abject failure. One would have thought that they would have cut their loses and run, but part of their dismal corporate philosophy was the “invented here” syndrome. They badly wanted Wall Street to believe they were producing something of value so they could trumpet the inauguration to the skies but this was just not the case. In other words, they stayed with products that were home office innovations long after the product had outlived its useful life.

Moreover, the college bookstores were not very happy with this upstart that was putting representatives into direct competition with them. The fact was that National Student marketing was caught between a rock and hard place. In reality, their student sales representatives were another fiasco that could not have made money no matter what and how much they sold because of the extraordinary logistic baggage that was inherent in the package. In the meantime, this evolutionary company was driving campus bookstores to the point of banning the products of National Student Marketing, which would have caused a major problem because the companies that NSMC was buying for the most part were their own suppliers. Luckily for them, the company folded before they had to deal with the issue.

National Student Marketing was the top performing stock of 1968 rising in the stock market by a greater percentage than any other. It was also way up there when you look at acquisitions. National Student Marketing had closed the year with twenty-two buyouts bested only by fast growing Dolly Madison Ice Cream who had bagged thirty-five ([170]). The company’s shares were highly valued and were purchased by Morgan Guaranty, Donaldson, Lufkin & Jenrette ([171]), as well as the prestigious Harvard Endowment Fund. The company’s stock was flying high having come out at $6 per share in the spring of 1968 and was trading at $144 by mid-December 1969.

Management was convinced that if they could exchange appreciated paper for substantive acquisitions, it would allow them to expand substantially faster. As long as the stock sold a high multiple, the acquisition company’s earnings were always theoretically greater than the market evaluation of National Student Marketing on a price earnings basis. In theory, the idea makes a lot of sense but the literal demise of even the word conglomerate did not bode well for the company’s ultimate success in pushing this premise. Not wasting any time, according to court documents, “At a stockholders meeting held October 8,1969, National Student Marketing (NSMC) shareholders approved an increase in the company’s authorized shares and approved a merger with Interstate National Corporation (which sold insurance to students) along with five other companies.” Well, they did not really sell insurance to students but that was what the press releases trumpeted trying to prove that the company was sticking to its plan making synergistic acquisitions. The actual fact was that the main lines that the company wrote were, for insuring race tracks and greenhouses. Sure, they wrote an occasional policy to a student but it was more a sideline than a business.

This was also period when the word conglomerate had fallen on disfavor because literally every company that had advertised itself as such had suffered dramatic problems of one sort or another and the entire group had become an anathema to the Street. From infinite price-earnings rations, now, the best of them were going for about ten-times earnings. It was important to Cort to make a distinction between the acquisitions that he was making and those that the “conglomerates” were involved in. He came up with the declaration that conglomerates merged in non-synergistic companies in the hopes of creating cost savings and financial homogenization, National Student Marketing specialized in taking over only companies within its own industry and that in all cases the guiding determination was that the acquired must deal with students. Wall Street bought the story hook, line and sinker and nobody ever bothered to analyze the fact that literally everything that Cort was acquiring had not only seen better days but was not in step with trends.

However, the basic premise was all wrong. fully half of NSMC’s gross sales and probably the great majority of the profits came from non-student type of enterprises. On the other hand, Cort was always trying to make the left shoe fit on the right foot. As an example of this, he took over a company that National Student Marketing had acquired that was solely in the business of supplying socks to wholesalers. What this would have to do with students no one could figure out until the every pervasive Cort came up with the answer everyone had been looking for. The company would start a student hosiery club that he would get off the ground with 250,000 members. The story had legs and achieved its purpose but the students didn’t gravitate to the concept at all and we know of no one that signed up for this gruesome idea.

The next move in the direction of the student market was the acquisition of school buses. The problems that soon appeared were two-fold; the first was that the average users of the buses were either in nursery school or kindergarten, thus substantially bringing down the average age of his target market. This did not make the NSMC advertisers very happy but ultimately they became enraged when they finally found out that Cort was trying to sell them advertising on school buses ridden by children that could not read. It may also be the fact that these passengers did not have a substantial amount of discretionary income and that seemed to bother the ad people even more.

Another acquisition that didn’t go anywhere was that of Arthur Frommer's; you know, the people that can send you around the world on $5 a day. There was not much question that the school kids liked the books, but they weren’t really going to travel anywhere. This was the sixties and they just didn’t have the money to travel to the places that Frommer was pushing. Frommer and National Student Marketing were hoping for a big splash at the Frommer Affiliated Hotels from the acquisition but, in spite of the advertising to the contrary, these guys weren’t renting any rooms at $5 a day and the college crowd returned no business whatsoever to the company. Frommer’s life work pretty much went up in flames when NSMC tanked.

One of the few reasonable ideas that National Student Marketing came up with was the renting of refrigerators to students for their dorms. While this idea made a lot of sense, most of the available outlets in dormitories did not allow for enough energy to power the machine and therefore, the refrigerators were considered a fire hazard by most college administrators. Ultimately, NSMC was able to find a refrigerator manufacturers that had a machine that used far less current and through a major public relations campaign was able to get the devise onto many campuses. The problem with the refrigerators was, that while they were ultimately able to safely operate from just about any wall outlet, they made a prodigious amount of noise which totally eliminated the students ability to study or talk on the phone while they were plugged in. In spite of this major pitfall, the business did succeed for a time until NSMC ran out of money. On the other hand, when the students wanted to sleep, they had the option of turning off the refrigerator and having the food ruined or getting a good night’s sleep. Certainly one of the ultimate “Catch 22” questions.

National Student Marketing had told the companies to be acquired that NSMC was doing fantastically and that earnings for the nine-months ending May 31, 1969 would be substantially up on a year-to-year basis. Many of the companies to be acquired at that time had asked Peat Marwick for a comfort letter concerning NSMC’s unaudited interim financials. This certainly shouldn’t have represented any big deal because the quarter had ended literally five months earlier. When Peat Marwick went to work on the comfort letter in earnest they determined that contrary to previous representations, $500,000 should be adjusted to deferred cost, a $300,000 write-off of unbilled receivable ([172]), and an $84,000 adjustment to paid-in capital be made retroactive to May 31 and be reflected in the comfort letter delivered to the companies being acquired.

The only problem with what the accounting firm wanted to do was the fact that it would have caused National Student Marketing to show a deficient for this period other than the substantial profit that they had projected to all of the company’s they were acquiring. All of the transactions were to be on an exchange of shares basis taken as on a polling of interest basis. There would be a blood bath following the announcement of the readjustment, in that the deals would tank and so would the stock. The closing was scheduled for Friday, October 31, 1969 and when all had been gathered at White and Cases offices and the comfort letter was not part of the closing documents, there was a bit of unrest that came from the crowd ([173]).

The deal could not be consummated without the comfort letter and a hasty call was made from the law office to Peat Marwick’s Washington office to inquire about it. The partner in charge of the account, Anthony M. Natelli, dictated to Eplye’s (White & Case Senior Lawyer) secretary the comfort letter. This was along the lines that Peat Marwick had originally gone over with NSMC but of course, no one else in the room had ever seen it. There were substantial discussions about whether the mergers should be concluded but more assuaging by both White & Case, National Student Marketing Executives and Peat Marwick. Because of the fact that the announcement had already been made as to the acquisition, the shareholders vote had already taken place in both companies and the people in the room only had an hour to agree to the deal, it was signed with some serious misgivings ([174]) .

The only way the projections came close to being met was by selling the Canadian subsidiary, CompuJob back to the original owners. They only had received stock when NSMC bought the company from them so that they had no cash to pay for the repurchase. It was determined that the Canadian’s would pay a price, substantially more than what the company had been purchased for by NSMC with the collateral for the sale to be some of the National Student Marketing stock that the principals had been received in the original deal. These transactions were concluded a full ninety-days after the fiscal year had ended on August 31, 1969 yet, consul gave an opinion that the transactions indeed had been closed in time to qualify for inclusion in the previous audit. “In the opinion of counsel in both transaction negotiations and agreements of sale were in effect consummated prior to August 31, 1969…” Thus, the company was able to come close to their target numbers, but a couple of more deals like this and National Student Marketing would be a thing of the past.

Moreover, in 1969, a new item for more than $500,000 appeared on the balance sheet, deferred product development costs and the footnote indicated that this item, which included expenses, incurred during the year for products that would make it to market at some latter date. Apparently, a lot of salaries and other items were added to the deferred number to beef it up. This created additional earnings because costs associated with the nebulous products would now be amortized over the useful life of the new products rather than to have employees salaries expensed as they should have done. One of the problems with this little accounting item is the fact that there were no products that would be coming to market to offset the charge. Certainly a very creative way for the accountants to have handled the matter and ultimately a very costly move on their part.

Additionally, the balance sheet showed hefty increases in the “unbilled receivables” column. Once again, the balance sheet neither states nor explains what the statement means or why the figure for 1967 has mysteriously changed without footnotes and of even greater magnitude, why it no longer what appeared in the original financial figures. In addition, losses from “unamortized cost of prepared sales programs” rose substantially, avoiding a deduction from income, which would have been fatal for the company right then and there. Moreover, the footnotes went even further to point out that included in the 1969 results were acquisitions that had been agreed to in principal and not yet consummated.

We don’t understand all of the bizarre accounting gimmicks that were used to get this one through the auditors, but if it hadn’t, the company’s profit would have been negligible and the stock would have tanked. When shareholders raised that as an issue, “the Chairman of Peat, Marwick, Mitchell’s Ethics Committee who was present at the NSMC annual meeting to read the portions of the accounting principles code that required acquisitions made shortly after the close of a fiscal year to be included in that year’s statements” ([175]) We are not sure how the regulations read at this point in time, but we don’t think that they ever intended that a deal consummated over three months after the year had ended ethically reflected business in the prior fiscal year. The SEC and the GAAP people also did not see things the same way as the Chairman of the Peat Marwick Ethics Committee and rescinded the regulations that had allowed this carry-over combination in earnings. Heretofore, financial affairs happening in one quarter would be reported in that quarter and only in that quarter.

In February 1970, at a meeting of more than 2,000 top money managers gathered at the New York Hilton for the Institutional Investors Conference an impromptu poll was taken of what the best performing stock in 1970 would be. The consensus choice was National Student Marketing that was then trading at more than $140 per shares. It wasn’t too long after that meeting when the press started raising some serious questions about the financial data that National Student Marketing and their auditors were feeding the Street. Barron’s was the first to call into question literally all of the accounting magic that the company was using. The day after the report hit the street, National Student Marketing stock dropped twenty-points and the retreat was on. Barron’s, Abelson who had written the story, had a pretty high credibility rating with “street” pros and there seemed to be a degree of truth to that and other negative stories circulating in the financial press. The stock started to plummet.

Remember that the Institutional Investor Conference thought the National Student Marketing was “all world” in early February of 1970. Well, right about that time, February 24, 1970, Cort had lined up some substantial deals and their closing would certainly have promulgated the National Student Marketing myth for a few more years. Champion Products with $50 million in sales was going to acquired as was National Tape with $60 million and Josten’s, a New York Stock Exchange listed company with $70 million in sales. The only problem was that just as the deals were about to be concluded, the Peat Marwick folks finally got cold feet. They announced that the first quarter, which had been touted as going to a triple was actually going to be a significant loss of $1.2 million. As if this wasn’t bad enough, several days later the loss was increased to $1.5 million. The earlier error it appeared had been caused by a technical translation problem, something else we don’t seem to understand. Once again, Wall Street was shaken up.

Nevertheless, one way or the other, this cooked the NSMC goose. During this period of time as more acquisitions had been made, more and more of the voting stock was getting into the hands of people that had exchanged their stock for stock in National Student Marketing. They now controlled the company from a voting point of view. For the most part, these had been hard working folks who had devoted their lives to making their own companies successful and had worked hard to fit into the corporate structure of NSMC as well. They determined that Cort’s leadership was illusionary and that the Street no longer believed that his dream was anything but a mirage. It was now time to produce results and that could best be accomplished with different leadership. Cort told the troops that he was resigning for medical reasons and left the company that he had conceptualized forever.

The company started going through new CEO’s like a duck goes through water. Reorganizing the company was becoming a horror. All the subsidiaries that had been recently, acquired wanted a rescission. (they wanted their acquisition undone) Shareholders were filing lawsuits all over the place, the SEC was investigating under every rock, the stock was now three bucks a share when word came from the Post Office Department, that a mail-fraud investigation had been launched against Cort in 1964. The banks pulled their lines, Wall Street had no additional interest in funding National Student Marketing, and the rescinding subs didn’t want to upstream money into a parent that may have illegally acquired them. After it had been in free-fall for a while, investor’s lawsuits were brought against the company and the Securities and Exchange Commission announced that they would be taking a closer look at the company’s affairs.

When the smoke had cleared, the SEC named everybody involved including the lawyers and accountants of violating the antifraud provisions of the Securities Act of 1933. Held out by the SEC for particular hostility was Peat Marwick and in Accounting Series Release (“ASR”) No. 173 directed entirely at Peat Marwick the Securities & Exchange Commission burned their hide for sins of omission and commission in connection with National Student Marketing, Republic National Life Insurance Company, Penn Central, Stirling Homex and Talley Industries. Sanctions were instituted against the accounting firm in probably one of the most far reaching actions ever taken by the SEC against a large accounting firm.

Additional complications were added to the mergers when various people from Interstate and other the senior officers demanded the right to sell as part of their original agreements. While those contracts were only partially kept, it was accomplished in a vacuum as the shareholders of neither company were yet aware of the changes in the earning projections contained in the “comfort agreement.” The law on the matter was fairly simple,

“President and counsel of merging corporation (Interstate) violated the antifraud provisions of the federal securities laws through their participation in the closing of the merger and through their sales of stock of the surviving corporation immediately following merger, in each instance without first disclosing the material information contained in unsigned “comfort letter” which revealed that the surviving corporation’s interim financial statements, used in securing shareholder approval of the merger, were grossly inaccurate.” ([176])

The law firms did not escape the wrath of the SEC and the Commission brought an injunctive action that charged them with aiding and abetting a securities fraud based on the theory that the vote taken by shareholders was based on totally incorrect financial data or as they put it, containing materially misleading financial information. The SEC’s position was that the lawyers should have insisted that another vote be taken after the financials had been reintroduced with the updated information supplied in new proxy material. Thus, in the first instance in American financial history, the SEC said that outside corporate counsel was literally both a watchdog and a whistle-blower relative to his clients. They did not stop there, they also named the lawyers for “Interstate” stating that they too should have been aware of the situation and stopped the transaction. The SEC stated that Max E. Meyer and Louis F. Schauer aided violations of the Securities Laws and failed to stop them.

“Counsel for merging corporation had a duty to the merging corporation’s shareholders to delay the closing of the merger pending disclosure and re-solicitation with corrected financials after counsel received, at the time of closing, an unsigned “comfort letter” which revealed that the surviving corporation’s interim financial statements were grossly inaccurate, and such breach of duty constituted a violation of the antifraud provisions of the federal securities laws through aiding and abetting the merger transaction…” Securities Act of 1933, 17(a), 15 U.S.C.A. a 77q(a); securities Exchange Act of 1934, 10(b), 15 U.S.C.A. 78j(b). ([177])

Individual actions were instigated and in 1970, a group of shareholders brought a class action suit seeking damages against National Student Marketing Corp., the law firm of Lord Bissell & Brook (Meyer & Schauer), Peat Marwick & Mitchell accounting firm and the Law firm of White and Case charging them with violations of provisions of the federal securities law and common law fraud. The accounting firm settled the case out of court by paying the plaintiffs more than $6 million.

The tally of losses in National Student Marketing was over $100 million and almost all the professionals were forced to settle for substantial sums of money. Cort got the worst of it as well he should have and spent some serious time in the slammer as a guest of the U.S. Government after he had been indicted and confessed to charges that he had fraudulently misrepresented National Student Marketing’s financial condition and operating results in his company’s proxy statements. “Furthermore, Randell confessed to altering or concealing key features of commitment letters obtained by National Student Marketing, including those obtained from the Pontiac Division of General Motors and Eastern Airlines. For example, Randell admitted that he had changed a letter received from Pontiac to make it read as a formal commitment letter.” ([178])

When he got out of jail some time later he announced that he had found Christ which many of those that in this story that stole substantive money from innocent people also resorted to. He was once again charged by the SEC of looting a Virgin-based finance company. This time he was convicted on seven counts of securities fraud, one count of making false statements to the Veterans Administration, four counts of interstate transportation of funds obtained by fraud and five counts of mail fraud getting him a seven-year sentence at a serious correctional facility. The last we had heard, Cort was out of jail and very successfully running a Washington D.C transcription service.

As for the accountants, Anthony Natelli and Joseph Scansaroli who had acted for Peat Marwick; they were indicted for “willfully and knowingly making and causing to be made false and misleading statements with respect to material facts.” More specifically the two were charged with causing the earnings that appeared in the 1969 proxy statement to be misrepresented. Furthermore, without the help of the accountants, the company could have never overstated their earnings for that period. Natelli and Scansaroli were obligated to serve a short time in jail and both also were hit with fines. Judge Tyler who oversaw the case commented at the sentencing, “The accounting profession, like the legal profession, frequently failed to understand its public responsibility.” ([179])

As seems the rule in these cases, the accountant’s convictions although fairly moderate were appealed. The theory of the defense was that Peat Marwick had not been hired to verify certain material contained in the proxy statement and therefore he should not have been convicted. In United States versus Natelli, the court rejected the argument with the statement, “The issue on this appeal is not what an auditor is generally under a duty to do with respect to an unaudited statement, but what these defendants had a duty to do in these unusual and highly suspicious circumstances.”

Conversely, Scansaroli, who had received the lessor sentence was vindicated on the same appeal. The court ruled that Natelli alone made the decision to include the incorrect financial data in the proxy statement. Among other things that set Scansaroli apart from Natelli was the production of a memo that he had written in January of 1970 while he was employed as National Student Marketing’s assistant controller. In the memo Sansaroli threatened to tender his resignation if the Company’s aggressive reporting methods weren’t reigned in and if they did not start to exercise proper control over its financial and accounting reporting practices.

The U.S. Attorney, Franklin Velie, prosecuting the men added that while they had started out by making a mistake, which didn’t make it a criminal mater, but then they tried to cover it up and that was criminal. Valie went on to say that “People who read those financial statement were cheated. The proxy statement gave no hint of what the auditors knew – that National Student Marketing was a losing proposition.” ([180])

Chairman Arthur Levitt, Securities and Exchange Commission, “The Numbers Game”, Remarks At The NYU Center For Law and Business, NY, September 28, 1998

Thank you very much. Dean Daly, Dean Sexton and to everyone gathered this evening, thank you for welcoming me tonight. I am honored to be here on such an auspicious evening for both NYU and Bill Allen.

The creation of the Center for Law and Business recognizes an important truth: we cannot continue to view the worlds of business and law as parallel but separate universes. And NYU could not have selected a more qualified or thoughtful individual than Bill as its first director. His leadership of the Delaware Court of Chancery—acknowledged as the nation’s most influential arbiter of corporate law—confirmed his reputation as a great thinker who effortlessly bridges the worlds of law and business. I’ve heard from friends on Wall Street that it’s a far less stressful experience to hear Bill lecture in front of a classroom than from his former seat on the bench.

Seven months ago, I expressed concerns about selective disclosure. Through conference calls or embargoed press releases, analysts and institutional investors often hear about material news before it is made public. In the interval, there is a great deal of unusual trading. The practice had been going on for a long time. And, while everyone was aware of it, and most were extremely uncomfortable with it, few spoke out. As the investor’s advocate, the SEC did and we will continue to do so.

Well, today, I’d like to talk to you about another widespread, but too little-challenged custom: earnings management. This process has evolved over the years into what can best be characterized as a game among market participants. A game that, if not addressed soon, will have adverse consequences for America’s financial reporting system. A game that runs counter to the very principles behind our market’s strength and success.

Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. Too many corporate managers, auditors, and analysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation.

As a result, I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting. Managing may be giving way to manipulation; Integrity may be losing out to illusion.

Many in corporate America are just as frustrated and concerned about this trend as we, at the SEC, are. They know how difficult it is to hold the line on good practices when their competitors operate in the gray area between legitimacy and outright fraud.

A gray area where the accounting is being perverted; where managers are cutting corners; and, where earnings reports reflect the desires of management rather than the underlying financial performance of the company.

Tonight, I want to talk about why integrity in financial reporting is under stress and explore five of the more common accounting gimmicks we’ve been seeing. Finally, I will outline a framework for a financial community response to this situation.

This necessary response involves improving both our accounting and disclosure rules, as well as the oversight and function of outside auditors and board audit committees. I am also calling upon a broad spectrum of capital market participants, from corporate management to Wall Street analysts to investors, to stand together and re-energize the touchstone of our financial reporting system: transparency and comparability.

This is a financial community problem. It can’t be solved by a government mandate: it demands a financial community response.

The Role Of Financial Reporting In Our Economy

Today, America’s capital markets are the envy of the world. Our efficiency, liquidity and resiliency stand second to none. Our position, no doubt, has benefited from the opportunity and potential of the global economy. At the same time, however, this increasing interconnectedness has made us more susceptible to economic and financial weakness half a world away.

The significance of transparent, timely and reliable financial statements and its importance to investor protection has never been more apparent. The current financial situations in Asia and Russia are stark examples of this new reality. These markets are learning a painful lesson taught many times before: investors panic as a result of unexpected or unquantifiable bad news.

If a company fails to provide meaningful disclosure to investors about where it has been, where it is and where it is going, a damaging pattern ensues. The bond between shareholders and the company is shaken; investors grow anxious; prices fluctuate for no discernible reasons; and the trust that is the bedrock of our capital markets is severely tested.

The Pressure To “Make Your Numbers”

While the problem of earnings management is not new, it has swelled in a market that is unforgiving of companies that miss their estimates. I recently read of one major U.S. Company, that failed to meet its so-called “numbers” by one penny, and lost more than six percent of its stock value in one day.

I believe that almost everyone in the financial community shares responsibility for fostering a climate in which earnings management is on the rise and the quality of financial reporting is on the decline. Corporate management isn’t operating in a vacuum. In fact, the different pressures and expectations placed by, and on, various participants in the financial community appear to be almost self-perpetuating.

This is the pattern earnings management creates: companies try to meet or beat Wall Street earnings projections in order to grow market capitalization and increase the value of stock options. Their ability to do this depends on achieving the earnings expectations of analysts. And analysts seek constant guidance from companies to frame those expectations. Auditors, who want to retain their clients, are under pressure not to stand in the way.

Accounting Hocus-Pocus

Our accounting principles weren’t meant to be a straitjacket. Accountants are wise enough to know they cannot anticipate every business structure, or every new and innovative transaction, so they develop principles that allow for flexibility to adapt to changing circumstances. That’s why the highest standards of objectivity, integrity and judgment can’t be the exception. They must be the rule.

Flexibility in accounting allows it to keep pace with business innovations. Abuses such as earnings management occur when people exploit this pliancy. Trickery is employed to obscure actual financial volatility. This, in turn, masks the true consequences of management’s decisions. These practices aren’t limited to smaller companies struggling to gain investor interest. It’s also happening in companies whose products we know and admire.

So what are these illusions? Five of the more popular ones I want to discuss today are “big bath” restructuring charges, creative acquisition accounting, “cookie jar reserves,” “immaterial” misapplications of accounting principles, and the premature recognition of revenue.

“Big Bath” Charges

Let me first deal with “Big Bath” restructuring charges.

Companies remain competitive by regularly assessing the efficiency and profitability of their operations. Problems arise, however, when we see large charges associated with companies restructuring. These charges help companies “clean up” their balance sheet—giving them a so-called “big bath.”

Why are companies tempted to overstate these charges? When earnings take a major hit, the theory goes Wall Street will look beyond a one-time loss and focus only on future earnings.

And if these charges are conservatively estimated with a little extra cushioning, that so-called conservative estimate is miraculously reborn as income when estimates change or future earnings fall short.

When a company decides to restructure, management and employees, investors and creditors, customers and suppliers all want to understand the expected effects. We need, of course, to ensure that financial reporting provides this information. But this should not lead to flushing all the associated costs—and maybe a little extra—through the financial statements.

Creative Acquisition Accounting

Let me turn now to the second gimmick.

In recent years, whole industries have been remade through consolidations, acquisitions and spin-offs. Some acquirers, particularly those using stock as an acquisition currency, have used this environment as an opportunity to engage in another form of “creative” accounting. I call it “merger magic.”

I am not talking tonight about the pooling versus purchase problem. Some companies have no choice but to use purchase accounting—which can result in lower future earnings. But that’s a result some companies are unwilling to tolerate.

So what do they do? They classify an ever-growing portion of the acquisition price as “in-process” Research and Development, so—you guessed it—the amount can be written off in a “one-time” charge—removing any future earnings drag. Equally troubling is the creation of large liabilities for future operating expenses to protect future earnings—all under the mask of an acquisition.

Miscellaneous “Cookie Jar Reserves”

A third illusion played by some companies is using unrealistic assumptions to estimate liabilities for such items as sales returns, loan losses or warranty costs. In doing so, they stash accruals in cookie jars during the good times and reach into them when needed in the bad times.

I’m reminded of one U.S. Company who took a large one-time loss to earnings to reimburse franchisees for equipment. That equipment, however, which included literally the kitchen sink, had yet to be bought. And, at the same time, they announced that future earnings would grow an impressive 15 percent per year.

“Materiality”

Let me turn now to the fourth gimmick—the abuse of materiality—a word that captures the attention of both attorneys and accountants. Materiality is another way we build flexibility into financial reporting. Using the logic of diminishing returns, some items may be so insignificant that they are not worth measuring and reporting with exact precision.

But some companies misuse the concept of materiality. They intentionally record errors within a defined percentage ceiling. They then try to excuse that fib by arguing that the effect on the bottom line is too small to matter. If that’s the case, why do they work so hard to create these errors? Maybe because the effect can matter, especially if it picks up that last penny of the consensus estimate. When either management or the outside auditors are questioned about these clear violations of GAAP, they answer sheepishly...”It doesn’t matter. It’s immaterial.”

In markets where missing an earnings projection by a penny can result in a loss of millions of dollars in market capitalization, I have a hard time accepting that some of these so-called non-events simply don’t matter.

Revenue Recognition

Lastly, companies try to boost earnings by manipulating the recognition of revenue. Think about a bottle of fine wine. You wouldn’t pop the cork on that bottle before it was ready. But some companies are doing this with their revenue—recognizing it before a sale is complete, before the product is delivered to a customer, or at a time when the customer still has options to terminate, void or delay the sale.

Action Plan

Since U.S. capital market supremacy is based on the reliability and transparency of financial statements, this is a financial community problem that calls for timely financial community action.

Therefore, I am calling for immediate and coordinated action: technical rule changes by the regulators and standard setters to improve the transparency of financial statements; enhanced oversight of the financial reporting process by those entrusted as the shareholders’ guardians; and nothing less than a fundamental cultural change on the part of corporate management as well as the whole financial community.

This action plan represents a cooperative public-private sector effort. It is essential that we work together to assure credibility and transparency. Our nine-point program calls for both regulators and the regulated to not only maintain, but increase public confidence, which has made our markets the envy of the world. I believe this problem calls for immediate action that includes the following specific steps:

Improving the Accounting Framework

First, I have instructed the SEC staff to require well- detailed disclosures about the impact of changes in accounting assumptions. This should include a supplement to the financial statement showing beginning and ending balances as well as activity in between, including any adjustments. This will, I believe, enable the market to better understand the nature and effects of the restructuring liabilities and other loss accruals.

Second, we are challenging the profession, through the AICPA, to clarify the ground rules for auditing of purchased R&D. We also are requesting that they augment existing guidance on restructurings, large acquisition write-offs, and revenue recognition practices. It’s time for the accounting profession to better qualify for auditors what’s acceptable and what’s not.

Third, I reject the notion that the concept of materiality can be used to excuse deliberate misstatements of performance. I know of one Fortune 500 company who had recorded a significant accounting error, and whose auditors told them so. But they still used a materiality ceiling of six percent earnings to justify the error. I have asked the SEC staff to focus on this problem and publish guidance that emphasizes the need to consider qualitative, not just quantitative factors of earnings. Materiality is not a bright line cutoff of three or five percent. It requires consideration of all relevant factors that could impact an investor’s decision.

Fourth, SEC staff will immediately consider interpretive accounting guidance on the do’s and don’ts of revenue recognition. The staff will also determine whether recently published standards for the software industry can be applied to other service companies.

Fifth, I am asking private sector standard setters to take action where current standards and guidance are inadequate. I encourage a prompt resolution of the FASB’s projects, currently underway, that should bring greater clarity to the definition of a liability.

Sixth, the SEC’s review and enforcement teams will reinforce these regulatory initiatives. We will formally target reviews of public companies that announce restructuring liability reserves, major write-offs or other practices that appear to manage earnings. Likewise, our enforcement team will continue to root out and aggressively act on abuses of the financial reporting process.

Improved Outside Auditing in the Financial Reporting Process

Seventh, I don’t think it should surprise anyone here that recent headlines of accounting failures have led some people to question the thoroughness of audits. I need not remind auditors they are the public’s watchdog in the financial reporting process. We rely on auditors to put something like the good housekeeping seal of approval on the information investors receive. The integrity of that information must take priority over a desire for cost efficiencies or competitive advantage in the audit process. High quality auditing requires well-trained, well-focused and well-supervised auditors.

As I look at some of the failures today, I can’t help but wonder if the staff in the trenches of the profession have the training and supervision they need to ensure that audits are being done right. We cannot permit thorough audits to be sacrificed for re-engineered approaches that are efficient, but less effective. I have just proposed that the Public Oversight Board form a group of all the major constituencies to review the way audits are performed and assess the impact of recent trends on the public interest.

Strengthening the Audit Committee Process

And, finally, qualified, committed, independent and tough- minded audit committees represent the most reliable guardians of the public interest. Sadly, stories abound of audit committees whose members lack expertise in the basic principles of financial reporting as well as the mandate to ask probing questions. In fact, I’ve heard of one audit committee that convenes only twice a year before the regular board meeting for 15 minutes and whose duties are limited to a perfunctory presentation.

Compare that situation with the audit committee which meets twelve times a year before each board meeting; where every member has a financial background; where there are no personal ties to the chairman or the company; where they have their own advisers; where they ask tough questions of management and outside auditors; and where, ultimately, the investor interest is being served.

The SEC stands ready to take appropriate action if that interest is not protected. But, a private sector response that empowers audit committees and obviates the need for public sector dictates seems the wisest choice. I am pleased to announce that the financial community has agreed to accept this challenge.

As part eight of this comprehensive effort to address earnings management, the New York Stock Exchange and the National Association of Securities Dealers have agreed to sponsor a “blue- ribbon” panel to be headed by John Whitehead, former Deputy Secretary of State and retired senior partner of Goldman, Sachs, and Ira Millstein, a lawyer and noted corporate governance expert. Within the next 90 days, this distinguished group will develop a series of far-ranging recommendations intended to empower audit committees and function as the ultimate guardian of investor interests and corporate accountability. They are going to examine how we can get the right people to do the right things and ask the right questions.

Need for a Cultural Change

Finally, I’m challenging corporate management and Wall Street to re-examine our current environment. I believe we need to embrace nothing less than a cultural change. For corporate managers, remember, the integrity of the numbers in the financial reporting system is directly related to the long-term interests of a corporation. While the temptations are great, and the pressures strong, illusions in numbers are only that—ephemeral, and ultimately self-destructive.

To Wall Street, I say, look beyond the latest quarter. Punish those who rely on deception, rather than the practice of openness and transparency.

Conclusion

Some may conclude that this debate is nothing more than an argument over numbers and legalistic terms. I couldn’t disagree more.

Numbers in the abstract are just that—numbers. But relying on the numbers in a financial report are livelihoods, interests and ultimately, stories: a single mother who works two jobs so she can save enough to give her kids a good education; a father who labored at the same company for his entire adult life and now just wants to enjoy time with his grandchildren; a young couple who dreams of starting their own business. These are the stories of American investors.

Our mandate and our obligations are clear. We must rededicate ourselves to a fundamental principle: markets exist through the grace of investors.

Today, American markets enjoy the confidence of the world. How many half-truths, and how much accounting sleight-of-hand, will it take to tarnish that faith?

As a former businessman, I experienced all kinds of markets, dealt with a variety of trends, fads, fears, and irrational exuberances. I learned that some habits die hard. But, more than anything else, I learned that progress doesn’t happen overnight and it’s not sustained through short cuts or obfuscation. It’s induced, rather, by asking hard questions and accepting difficult answers.

For the sake of our markets; for the sake of a globalized economy which depends so much on the reliability of America’s financial system; for the sake of investors; and for the sake of a larger commitment not only to each other, but to ourselves, I ask that we join together to reinforce the values that have guided our capital markets to unparalleled supremacy. Together, through vigilance and trust, I know, we can succeed.

Thank you.

A Charity of a Different Color

New Era Philanthropy Tries An Old Con

John G. Bennett Jr., 57, was chief executive officer of the Foundation for New Era Philanthropy, a charity based in Radnor, Pennsylvania, which he began in 1989. A former drug-program administrator, who advised nonprofits on management and fund-raising techniques, Bennett became a popular and influential figure in Philadelphia’s philanthropic and cultural circles, thanks in part to the prayer breakfasts he often officiated at.

New Era soon became the answer to a lot of prayers: Bennett promised charitable organizations and wealthy individuals that he approached for donations, a 100% return on their contributions within six months ([181]), thanks to anonymous donors who would match their gifts. New Era would only keep the interest earned during the search. It sounded too good to be true, especially since the mysterious benefactors were known only to Bennett. However, when Bennett delivered on his early promises, the news spread and donations in New Era increased exponentially; last year it rivaled the Rockefeller Foundation in its largesse (total: $100 million). Cathryn Coate, executive director of the Greater Philadelphia Cultural Alliance, says; ‘the word on the street was that Bennett was a super credible man, impeccable. You hear things like, ‘Oh, I’ve known Bennett for 15 years.’ It’s not like a bunch of quick-fix guys duped a bunch of bozos.’

Bennett was only doing what Charles Ponzi did in Boston back in 1919, paying back one group of investors with money he received from ensuing waves. Like Ponzi, Bennett was something of a civic hero for a while, and like Ponzi, he was careful not to draw attention to himself with a flamboyant life-style.

Listed among New Era’s creditors and or donors were sophisticated people such as Laurance Rockefeller ($11.4 million) and William E. Simon, former U. S. Treasury Secretary ($6.5 million). They were joined in their misery by the former head of Goldman Sachs & Co., John Whitehead, entertainer, Pat Boone, The Mayor of Philadelphia, Edward Rendell, world-renowned hedge fund boss, Julian Robertson and mutual fund guru, John Templeton. Although not as famous, the biggest loser of all was the Reverend Glenn Blossom of Dresher, Pennsylvania who lost almost $30 million trying to get enough money to build a seminary. Other charities were taken in and a few of the more prominent ones were The University of Pennsylvania, The Nature Conservancy, The American Red Cross and the Detroit Institute of Arts. Overall, New Era claimed $555.1 million in liabilities against just $80 million in assets when they closed their doors.

One of the none believers was Albert Meyer, who taught accounting at Spring Arbor college in Michigan. He was dumbfounded when he found out that his own school had joined the harebrained parade of investors in the New Era scam. He took it upon himself to call Bennett personally and when he was not satisfied at what he heard on the phone, Meyer proceeded to write to the Securities & Exchange Commission, The Internal Revenue Service, the U. S. Attorney General’s office, and the Wall Street Journal. In spite of this gaggle of mail going to serious people, nothing took place immediately to thwart Bennett’s New Era. It was only when the lawyers for the supposed charity were not forthcoming with necessary backup documentation that many began to feel that they had been fleeced.

“Bennett’s secret was that he was able to marry two powerful but seemingly contradictory human instincts: greed and charity. Those who threw in with New Era were so anxious to give, and to get, that they overlooked the obvious. But the greed and charity have met before. Charles Ponzi’s biggest extravagance was a $100,000 donation he made to an orphanage.” ([182]) Furthermore, he was able to convince his lawyers, accountants, and investment bankers to wave the flag for him with investors whenever they had the opportunity. They all got a little too carried away with their roles, and eventually each paid an horrific price for his involvement.

Particularly hard hit in the settlement was the investment banker, Prudential Securities, which seized more that $40 million in New Era funds that was placed by donors in a margin account at that firm for future charitable donations. The hold was put on the account when the Securities & Exchange Commission announced that it was conducting an investigation into the affairs of New Era. One could well wonder what was going through the brokerage firm’s collective mind when they knew that something must be wrong or the SEC would not be all over the account, but yet, they continued taking in money into the account “from charities and philanthropists, without notifying them of the account’s status.” Whew!!!

For whatever reason, the money had been placed in that account to cover a loan taken out by New Era. When Prudential thought that something might be amiss, they glommed onto the account. On the other hand, Prudential’s office in Kenosha, Wisconsin was part of the fraud’s epicenter. Participants in the scheme were told that their money was secure because it was held in “quasi-escrow” accounts at the brokerage firm. They received written confirmation of that fact in spite of substantial commingling within a single account. Prudential, when they found out about the fact that their employees were erroneously telling people that the co-mingled account was an escrow account sent a series of backdated letters to New Era categorizing the situation correctly but the was merely covering their backside after the horse was already out of the barn. On the other hand, neither New Era nor Prudential ever said one word about the problem to the people whose money they were collecting, and after the initial correspondence with New Era, the problem was literally forgotten. Moreover, it was this account that was used for money (loans) to make payouts to charitably donations, interest and other necessities. The trustee went on to charge that Prudential, “without instructions, approval, or written authorization from New Era, converted a cash account it into a margin account and began charging interest.” ([183])

The trustee in bankruptcy charged that Prudential Securities “overlooked repeated and obvious signs the charity was fraudulent out of a desire to earn commissions and “excessive” interest…the lawsuit, filed in U.S. Bankruptcy Court in Philadelphia, is the third New Era-related suit against Prudential since the charity collapsed into bankruptcy in May 1995. But unlike the first two suits – filed by nonprofit organizations and a philanthropist who lost money in the debacle – the trustee’s suit contains what is alleged to be extensive behind-the-scenes details of Prudential’s dealings with New Era gleaned from interviews with some of the firm’s employees.” ([184])

The trustee charged in a lawsuit that either “Prudential knew, should have known, or had a reasonable basis to suspect that New Era was operating…a scheme to defraud its creditors,” The trustee went further by saying that because of Prudential’s knowledge of what was going on they should not only return $160 million in funds that the loaned New Era or held for them in a brokerage account but when the dust had cleared, they should be obligated to stand at the end of the creditors line before collecting one penny back. Eventually, Prudential settled out their involvement at a cost of almost $20 million.

Early donators instructed that the money New Era received from their largesse go to charities of their choice. These original donors received literally, what had been represented to them, two dollars donated to the charity for each dollar the donor gave. As word of the munificence of certain anonymous people that were matching the funds spread, it caused a stamped of well-heeled benefactors to cross New Era’s palm with a torrent of funds. The problem that the matching donors were really funds that came from suckers that were getting in late in the game, thus the charity was no different than what Ponzi had done decades earlier.

On the other hand, when the scheme fell apart and a bankruptcy trustee was appointed by the federal court to sort out the mess, Arlin Adams, the court appointed trustee has asked that the charities that had received the double-donations early in the game, give the money back. Would you believe that these highly moral individuals had a problem with this. Thus, there was substantial resistance and many usually laid back charities have shown what they were really made of but playing hardball with stolen funds. Some of the charities that have been reported to have profited from the swindle were “Southfield Christian School, Baptists for Life in Grand Rapids, Young River Ministries in Farmington and Marantha Bible & Missionary Conference in Muskegon.” ([185]) Adams points out that there were several very unusual twists to this bizarre phenomenon.

The first is the fact that over 1,300 charities were beneficiaries of New Era’s donations. Secondarily, Bennett did not for the most part pocket any substantial part of the money as did Ponzi and others that succeeded him in the classic device for separating suckers from their money. The only reason for the fact that Adams was able to ultimately pay back victims of the massive fraud is because of the fact that the money for the most part had not walked. It was in the hands of the charities that got into the deal early on. Because the money trail was so unambiguous, charitable institutions that were scammed were able to eventually able to recover approximately 63 cents on every dollar. On the other hand, the philanthropists, many of whom had filed claims in court—will not get a cent.

Hey, that’s a pretty good gimmick. Pretend the money is going to charity; give everyone $2 in deductions for every $1 they put up. Not bad, but nobody would get suckered into another real Ponzi Scheme, and any way it couldn’t happen because the SEC would catch them before anyone got hurt. As a charity, there was no one looking over their shoulders. Mr. Bennett pleaded no contest to 82 counts of fraud, money laundering, and received 12 years in prison without any possibility of parole in exchange for his raising of $354 million based totally on fraudulent premises. For whatever it is worth Mr. Bennett’s attorneys are saying that he meant no harm, he was only a person that suffered from delusions and was not sure what he was doing most or the time.

The Securities and Exchange Commission put what happened into perspective in their Litigation Release No. 15095, United States of America V. John G. Bennett:

“The indictment states that, in order to obtain funds from benefactors and nonprofit organizations, Bennett made various representations about the operation of New Era, all of which were false. Some of these representations are: 1) That the anonymous donors existed, that they provided matching funds, and that there were trust agreements with these anonymous donors, when, in fact, there were no anonymous donors and money from later donors provided the matching payments for earlier donors; 2) That Bennett was not paid for his work at New Era, when, in fact, he transferred over $3.3 million from the New Era accounts to the accounts of Bennett-related entities; 3) that money from benefactors and non-profits was being held in escrow or “quasi-escrow” accounts at Prudential Securities, Inc. during the holding period, when, in fact, the funds were being used to secure a large loan at Prudential, and some of the funds used to repay contributors to New Era were paid from the loan account; and 4) that New Era had a board of directors of prestigious individuals, when, in fact, Bennett was the only director.”

Nevertheless, the guys that make the frauds really work to perfection are the accountants. Without their help in leading the lambs to the slaughter, most financial crimes could not be committed. In this case, John McCarthy & Company out of Lafayette Hill, Pennsylvania was the New Era accounting firm and were it not for the friendly accountant assigned to the New Era audit, Andrew Cunnigham, the whole affair could have never have progressed nearly as far as it did. The federal court said that Cunnigham knowingly issued false financial information, that for his provided potential investors in Bennett’s fraud with totally false information he received 30 months in jail for his efforts. He had violated the public trust by filing false audits and equally phony federal tax returns. It was these documents, which ultimately convinced investors that their money could indeed be doubled in six months. Originally, Cunningham was scheduled by federal sentencing guidelines to be going up the river for 46 to 57 months but the accountant ratted on his former employer, Bennett, and received the reduced sentence in exchange for squealing. But then again, this has become the American way.

America’s Future, Not Really An Audit?

Collin Powell earned kudos for his military stewardship of the Iraq War and was thought of so highly at one point that it was publicly discussed that he would not only make a good presidential candidate but should he run. He would probably be elected. He wasn’t just the choice of one party, both the Republicans and the Democrats thought that this guy would make one hell of a candidate and each would have gladly given up their first born to have him in the fold.

Powell turned them down with the intimation that he had other, more important agendas to pursue. It now seems readily apparent that the good General was talking about America’s Future, an organization that was created to help children with the essentials that they would need to ultimately help themselves to a better life, certainly a wondrous cause.

The charity did not get off to a respectable start, from the get go they refused to disclose the salaries that their top people were receiving and although this wasn’t necessarily an indictment against America’s Future, it certainly was unusual to say the least. (Powell not included) Moreover, the charity started taking credit for donations that they had nothing to do with, charitable officers did not register the charity in certain places that they were doing business, they overstated their results and then they publicized something that their “consulting accountants”, PricewaterhouseCoopers, called a “performance study” to widely circulate completely inaccurate information on how the charity was performing. ([186])

We think that the fact that PricewaterhouseCoopers donated their time to this worthy cause and then issued misleading information is almost always the price you pay for trying to get something for nothing. Pricewaterhouse for its part indicates, that the “report was not a rigorous audit by its own accountants, but an analysis by its consultants of information provided by America’s Promise. The consultants, who never talked directly to any of the companies or charities working with General Powell’s group, have acknowledged that the information might indeed be inaccurate, and could include multiple companies taking credit for the same effort. Pricewaterhouse insists that this study was not an audit or an attempt to verify commitments ” ([187])

Picture the scene, I receive literature in a glossy envelope containing the prestigious name of PricewaterhouseCoopers on it and open it up. I read through the substantial description of what this charity has accomplished and what it can do with more funding, and all of this is for underprivileged children. Pricewaterhouse’s message has tears running down side of their letter before I finish reading it and without any hesitation I send in my check to aid in this undoubtedly superlative movement. However, before too much time has passed, information comes out that a lot of what I read was totally imaginary. The people that put out the performance fictitious study pronounce that it isn’t their problem because they only wrote up what they had been told by others. Thus, it appears that the accounting firm is indicating that their role was that of a fictional author, not that of a consultant or that of an accounting firm.

I become furious and believe that I have been totally pillaged. It would seem that when this outfit sends things out in the future under their own letterhead, the damn well better stand behind it without the weasel words that they only relying on the information from others. The check that I put into the mail to the charity was based on by reliance on Pricewaterhouse’s evaluation of the work that the charity was performing, I accepted that fact based on the reputation of the accounting firm. I think that when they send out their material in the future, and when they are acting only as reporters without verification from others, we ought to know about it and you better believe that with this episode in mind, the mail will be tossed into the nearest fireplace without any second thoughts.

PricewaterhouseCoopers was attempting to cash in on some free public relations because of Colin Powell’s name in what seemed on the surface to be a good cause. They screwed up and once again are shamed. Colin Powell at least had the guts to put things into perspective; “We may not have been as smart as we should have been” Maybe we ought to hear PricewaterhouseCoopers mouth those same words just to give us a warm and fuzzy feeling, but historically, this is not in the repertoire.

When Is An Audit Not an Audit? When It Is Solv-Ex

The United States, Canada, Venezuela among others have enormous quantities of what are sometimes called “tar sands” that contain oil and a number of other minerals within a gunky material that is highly viscous. These tar sands are known to contain literally trillions of barrels of oil, enough to last the needs of the world literally as far into the future as we can now foresee. The only trouble with these “tar sands” is the fact that extracting the oil from the primordial gunk is a both complicated and expensive process.

Global economics are for ever on a perpetual-motion see-saw which is constantly going up and down in violent contractions. When the Oil Exporting Producing Countries join together along with their non-member friends and withhold or cutback oil for any length of time, the world’s reserves drop and resultantly the price skyrockets. However, nations then pass strict conservations regulations and use is dramatically diminished causing prices to collapse for a period of time. Another reason for the disintegration in prices is the fact that the nations that form OPEC are just about the most non-homogeneous assemblage of nations that you can find anywhere on the globe. They include such forthcoming places as Iraq, Iran, and Libya along with those sometimes American friends such as Saudi Arabia and Kuwait. Most of the time these folks can’t agree on the time of day and that entire portion of the world has reservations from day to day about who might have designs on whom.

Thus, due to the fact that these people can’t get along with each other for any sustained period of time and therefore, the tendency to fudge is quite high; because there are numerous conservation measures available to curtail petroleum use throughout the world and because, in spite of the arbitrary amount of oil pumped, there is substantially more production capacity available at any given moment than there is demand; spikes in the price of oil are usually rather short. Moreover, this has caused the search for alternative, most usually higher-priced methods of producing oil to be rather haphazard in times of low prices and on the verge of hysteria when prices are skyrocketing.

In the United States, substantial oil can be produced from farm stocks such as corn, barley, and sugar cane. These feeds when blended together or used individually can be fermented and aged into an alcohol type product are identified as ethanol. Many farm states have completed substantial investigation in that area because it represents a rather pleasant alternative option for getting rid of the farmer’s excess product. On the other hand, while the benefits of using this type of fuel are substantial, (among other things, it burns cleaner while keeping emissions down to a minimum), it has been found to be substantially more expensive to produce than oil and must be heavily subsidized to remain competitive. Brazil, with literally no indigenous petroleum production almost exclusively uses ethanol type products. In addition, the country has been producing an excess of the farm products relative to world needs and at times plants lay fallow from the lack of a market. Thus, this become a literally no cost option for them. What would happen during times of crop shortages is quite another matter and at that point, economics will take over.

While tar sands are found residing in tar-gunk, another substantial oil reserve is found to be located in shale (oil shale). While there is probably every bit as much oil contained in the shale as there is in the sand, extraction processes have not as yet proved particularly practical in allowing for economical separation of the oil from this particular host. Many of the Western American States have substantial reserves of oil shale and it will only take some small additional price increases in oil to cause speculators to start this risky type of production. On the other hand, the United States is able to provide substantial subsidies to those willing to take the risk of erecting facilities. These take the form of direct subsidies, tax credits or indirect subsidies.

Much more promising from an economic viewpoint, but a product having many of the same environmental problems as regular oil is the material found in tar sands. Canada, the leader of innovation in this area found that the only way to make this process work was with massive infrastructure spending and the movement of huge amounts of bitumen (the product that the oil resides in) through a complex maze of sophisticated equipment produced on a mammoth scale. Plants have been erected in Alberta within the Athabasca River area, (thus the material found in this region is called the Athabasca Tar Sands) by both Suncor and Syncrude, consortiums mainly comprised of large oil companies along with substantial funding and tax credits from the Canadian Government. After years of frustration, these companies have finally made the process economically efficient but there is economics and then there is economics.

No matter what the price that oil is selling for in the world marketplace, it can probably be produced cheaper by someone, somewhere else. As an example, the wells in Kuwait, Saudi Arabia and Iraq can probably make money at any oil price over a dollar a barrel including shipping. When fully geared up and operating at optimum efficiency, producers like Suncor and Syncrude would probably be extremely contented to produce their product at anything under $10 per barrel ([188]). Thus, there is consistently the problem that at any point that low cost foreign producers seriously determine that their best interests can be solved by putting the tar-sand producers out of business, at least from an economic point of view, they would have no particular problem. On the other hand, the cost for them to do it would be so massive that it is unlikely that those producing countries would ever get around to doing something which would cost them so dearly. At the moment, tar-sand production is not even a pimple on an elephant’s back, but it will continue to grow with increased oil prices and represents an interesting alternative to Middle-Eastern energy blackmail.

Thus, we have a product that costs almost nothing to produce and whenever it becomes essential, the spigot can be turned on a notch more and these folks producing oil from sand could well find themselves in an unprofitable business, but I do not believe that this is the name of the game. In the real world in which we live, this is not practical because, nations for their own security will always want alternatives available to combat this possibility just from the point of view of avoiding economic blackmail by a group of rogue nations. Furthermore, environmentally, oil is not the product of the future, but who of us can tell where the future resides. We are already using cars that run on electrical batteries or a combination of electrical batteries and oil. There is a limit on how much the oil price can move up because at some point, it is no longer necessary to subsidize the clean burning ethanol and new fuels are being developed almost daily, one of which may well reduce our dependence on oil altogether.

That is from an economic and developmental point of view. But what about oil from the geopolitical standpoint. Iraq invades Kuwait, the United States drives Iraq out of Kuwait, Iraq sets Kuwait’s oil fields ablaze, American specialists put those fires out. OPEC reduces production and raises oil prices to gouge the non-oil exporting states, and everyone sits there and decries what has happened including the Arabs who say that they have been running their countries on a negative cash flow for over a decade. There is nothing that will dampen a healthy economic environment faster than a prolonged bout with high priced oil. When, the Western economies start slowing down, the oil dependence begins to lessen and the price starts to fall. So we continue to go through these periods of higher and lower prices.

One of the simplest means of solving America’s oil problem would merely be to let Iraq invade and conquer both Kuwait and Saudi Arabia. When they had finished the process, our politicians could stand up and make wonderful speeches about how we will become the slaves of Iraq unless we do something about what has occurred. Once again we through down the gauntlet in the name of righteousness and march through Saudi Arabia, Kuwait and then take over Iraq in the name of Democracy. However, by this time the leaders of Saudi Arabia and Kuwait are now living in London, Cairo and Paris, partying it up every day. Next time around it will provide no less a degree of embarrassment than that which occurred during our recent war with Iraq. It seemed during the last engagement that the richer families from the region were looking forward to an invasion as a good way of having a good time and really partying.

However, there is one change to the old scenario, this time, we do not give anything back and form an free oil producing region within that territory under the aegis of the United Nations. All of the countries have reserves that will last several hundred years under the worst of conditions and by that time, we will be using solar, wind or wave power anyway so no matter that we have totally depleted their reserves. The United Nations Mandate will be to run the spigot of the “free oil producing regions” full out. The United Nations will set an arbitrary price on the black liquid which will provide for the budget of the entire United Nations along with funding for all the underdeveloped countries which are in good standing with that organization.

Thus, with the United Nations watching the store and becoming a beneficiary of this largesse, there will probably no tears shed over the deposed dictatorial regimes in the Middle East. And you really don’t have to worry about them either, the leaders have socked away enough money to live forever and in some cases even longer. Most of the people that reside within Kuwait and Saudi Arabia have no rights anyway and we will be part of a process that will free women and various other slaves, a noble pursuit if there ever was one. Maybe we should start the sixth crusade where instead of wearing the banner of Christianity, our U.N. volunteers will wear the colors of the oppressed and enslaved. This time, maybe it will work.

That isn’t a very nice attitude, you say. Well, the look what is happening Microsoft just because they built a magnificent mouse trap and what about Standard Oil before that. If a block of companies or one company with dynamic control had gotten together to rig the price of any product in the United States, the Justice Department and their attorney’s would have them for breakfast so to speak. Why we put up with this form of economic blackmail, from a group of dictatorial countries that can’t even defend themselves is beyond reason. We go in a remove the despots and then they gouge us. This certainly is the ultimate form of Sadomasochism.

But so much for all of the good things in life. We are talking here about companies, the people that run them and those that evaluate their books and records. What on earth could that possibly have to do with such a broad brush approach to geo-political challenges.

In the real world, an upstart company by the name of Solv-Ex made the statement in 1996 that “You’ve Probably Never Heard of Us. You Soon Will Because Our Technology Will Reduce American Dependence on Middle East Oil.” Wow, the guys are going to be knocking all of my great ideas for subversion, invasion and conversion into a “cocked hat” if they can do all of that stuff and it must be true because it appeared in bold type in the Wall Street Journal. This small American Company based in Albuquerque, New Mexico had recently received a concession for tar sand lands in the Athabasca region of Alberta, Canada, just a stones throw from where those guys we talked about earlier were setting up shop and showing a modicum of promise, Suncor and Syncrude.

Solv-Ex purportedly had some pretty good management, some great leases and some excellent intellectual property (or at least that is what they said in countless press releases) that would lead to a improved way of separating the oil from the sand and at they were going to do it at a more economical price. The only problem was that this is a rich man’s game and Solv-Ex didn’t have any money. Its also extremely sophisticated and it just turns out that Solv-Ex didn’t have any patents covering what they stated that they were going to be doing ([189]). Moreover, they didn’t have the trucks to move the product to their plants and they didn’t have the plants to remove the oil from the tar sands if they could have gotten it there in the first place. If there ever was an accident about to happen, this was the classic example.

Neither did the company’s early history breed an awful lot of confidence in management’s decision’s or the credibility of their announcements.

“For example, in 1983, the company received a letter of intent for $42 million loan guarantees from Synthetic fuels Corporation, a federal agency created to help the U.S. become less dependent on foreign oil. In exchange for the loan, Solv-Ex was supposed to build a fuel plant in New Mexico to refine oil from tar sands in New Mexico and Utah. On the strength of this agreement, Solv-Ex went public, selling $4 million of stock at a price of $4.25 per share.”

“Yet the tar-sands extraction agreement fell through shortly after the public-offering when it became clear that the quality and quantity of the mineral resources were much less than Solv-Ex had previously said. According to the Washington Post, Rendall ([190]) said at the time that he believed that “the potential loss of these reserves was not significant.”

“In addition, former Solv-Ex executive Sam Francis was convicted of fraud in the trading of penny stocks in 1993.” ([191])

It shouldn’t surprise you to learn that having analyzed the preceding facts, many people determined that the company must be a fraud or an accident waiting to happen and the company’s securities attracted short sellers in swarms. These folks in turn spread the gospel to every regulator and investor that would pay them heed including such scary places as the SEC and the Federal Bureau of Investigation. Between management’s omnipresent announcements of Solv-Ex bringing a brighter tomorrow and ending our dependence on Mid-Eastern oil by some magical formula and the short sellers blasting everybody and everything having anything to do with the Company, the stock went up and down like a ping pong ball. The stock didn’t bounce around much, but it went from $8 to $38 and two months later, back to $6 two months after that. Then to $28 another two months out. If this isn’t volatility, I have never seen it. The FBI which usually doesn’t get involved in stock manipulation literally couldn’t believe what was going on and for their part, they started to pay a lot of attention to who was buying the stock, who was selling the stock and why they were doing it.

In the meantime, the company was using a form of private placement called a Reg S to raise money in Europe. This was particularly appealing type of financing for Solv-Ex because while the stock went up and down like a cork in a hurricane, Reg S ([192]) allowed the company to make European institutions a deal so good they couldn’t turn it down. As an example, when the stock hit $35 dollars they would offer the shares to institutional European investors for half of that, let’s say $17.50 a share. The stock became registered and fully saleable instantaneously under Reg S and the European institutions could sell it out immediately at an astronomical profit, which they did as fast as their little feet could get them to their stock broker’s office. This in turn would drive the price of the stock down once more, but in the meantime, Solv-Ex once again had bucks in the bank and could once again play the old cork in the hurricane routine. They would now announce that their financing was in place and production would be starting on this or that date. This in turn would cause the stock to, once again appreciate and the entire process would be repeated over and over again like a bad novel.

The Investor’s Relations Department at Solv-Ex was consistently coming up with new and credible appearing ways of separating American Public investors from their money. An example of one of these packages is quoted below and the content is so basically flawed that we will not even waste your time commenting on it:

“A world leader in developing new technologies for co production of oil with metals and minerals. Albuquerque, New Mexico-based Solv-Ex holds 18 patents and has applications for 12 more. As a result of a recent acquisition of the Fort Hills lease from Petro-Canada, Solv-Ex holds two adjacent leases comprising 56,000 acres with about 4 billion barrels of oil resources. This equals nearly 200 barrels for each share of SOLV ([193]) common stock. Analysis of representative materials from core holes indicates that the value of the metals and minerals in the oil sands (particularly aluminum, titanium, gold and industrial minerals) is about three times the value of the oil.”

A publication by the name of Richard Geist’s Strategic Investing came upon Solv-Ex and the company told him of their plans and what they could do. Geist came out with some blockbuster statements which recirculated what he had been told by management. The company included many of his rantings in their own periodic report that was sent to shareholders. One of them is quoted below:

“The potential on the mineral side is quite astounding. If the economics are justified by what the Company does at the Suncor tailing plaint, in several years we could be looking a plant that produces 2 million tons per year of aluminia. At $200 per ton, SOLV would be generating $400 million in revenues with operating costs of about $50 per ton. Aluminia is 40 million ton per year market. Between the tailings and the lease development, we could be looking at 10% of the world’s supply coming out of an area that is politically stable. There are obvious issues which will need to be dealt with in this scenario. For example, these quantities of materials could impact the aluminia market and the traditional sources of supply, and pricing wars could ensue as SOLV threatens to replace other producers…”

Barron’s did a piece on this type of practice in their story of April 29, 1996. The story had nothing particular to do with Solv-Ex but by quoting several parts of the article we can give you a feeling on what happens when this process is abused.

“How would you feel if you bought stock in a company for $8 a share only to discover that the company is selling comparable shares overseas for $4 apiece? And imagine that the company in question did not have to inform the Securities and Exchange Commission or its shareholders about these foreign shenanigans – ever.”

“Well, imagine no more, Such dealing take place routinely – and legally – under something known as Regulation S, a rule added six years ago to the Securities Act of 1933. The change was put in place by the SEC to allow U.S. companies to raise funds more easily from foreign investors. But, unintentionally, Reg S created a shady source of cash for hundreds of questionable companies. It also allowed company insiders to sell their shares without informing the public, and it gave rise to a trove of opportunities for scamsters.”

“Perhaps worst of all, by allowing companies to skirt federal disclosure laws, Reg S encourages cagey players to make quick profits overseas at the expense of million of unsuspecting investors here in the U.S. To being with, Reg S deals put more of a company’s shares in circulation, and as a result, the value of each share shrinks. Unfortunately, these dilutive effects remain hidden until long after the Reg S deals are done.”

“All too often, Reg S seems to be helping vampire companies, the ones that would be one step closer to the grave if it weren’t for regular infusions of cash from offshore stock sales. These companies get their cash all right, but the blood is subsequently sucked out of their U.S. holders as Reg S shares are sold back into the U.S. market…”

Solv-Ex raised $70 million in these bizarre private placements, without giving their shareholders any substantive information of how they were carrying on the money raising process. Extraordinarily, an American investor reading the public relations put out by Solv-Ex could become encouraged by what he was reading and call his broker to purchase the stock. He could well be doing that at say $35 per share when a European was being offered the exact same registered shares at half that price. Hardly, a level playing field. Worse than that, the European would dump his recently purchased shares and the American, sooner rather than later would be left with a gigantic trading loss. Full disclosure would have thought mandated that at the minimum, investors would have been advised about what was occurring in the money raising category within the framework of the press releases that were constantly touting how well the company was doing. This company had an inability of reporting bad news or for that matter of giving a sucker an even break.

The New York Times started investigating the situation at Solv-Ex and found out about their regular use of European private placements under Reg S, to dilute their American Shareholders:

“…And a way for swindlers to get cheap stock they can sell back into the U.S. at a fat profit after holding it only 40 days. Reg S shares are usually sold overseas at a discount to the U.S. price. Earlier this week, shares of Solv-Ex Corp. Declined 15 1/8 to 7 3/8 amid reports of a federal grand jury investigation of trading in the stock. Among items interesting to the grand jury, possible stock manipulation tied to two Reg S offerings the company did this year. Solv-Ex said it only knows of the investigation through press reports… [Emphasis Added].” ([194])

In a class action lawsuit filed in Untied States District Court in the Southern District of New York, it was stated that the company had completed no less than 20 of these private placements, many of them pursuant to Reg S in the last seven years. Furthermore, this gravy train created a lot of wealth for the purchasers of the stock. It seems that Morgan Grenfell Asset Management was the big buyer of many of the more recent private placements and their chief honcho in charge of this area, Peter Young was using shell companies to make the purchases. It seems that using shells to make this kind of purchase is not particularly cricket under British law and authorities

“…are currently investigating the matter, but the implication is that both Morgan Grenfell and Young personally benefited by agreeing to purchase these Solv-Ex securities, either by receiving shares at a deep discount to the current market value or though direct bribes from either FIBA Nordic Securities, the company placing the shares, or from Solv-Ex management itself…In a conference call earlier this year, Solv-Ex CEO and chairman John Rendall at first said that he wasn’t aware that Morgan Grenfell purchased any of the company’s Reg S shares. Yet some sources claim that Rendall himself discussed the sales with Young in Morgan Grenfell’s offices. In an early September report in the British press, Rendall publicly defended Young as an outstanding individual.”

“The British investigation apparently follows up on leads generated by ongoing FBI and SEC investigations into trading in the company’s shares, which was originally announced in late March by Bloomberg Business News, CNBC’s Dan Dorfman, and other financial media. Specifically, a Los Angeles grand jury was said to be looking into possible ties between Solv-Ex and international stock manipulators Thomas Quinn and Arnold Kimmes.” ([195])

One of the problems that the company had was the ever expanding amount of shares in the float ([196]). Each time that the company raised more money from doing a private placement with registered securities underlying the transaction, more and more freely tradable shares were added to the float. When this selling was added together with the dumping that was going on by the shorts who thought that the company was your basic everyday security fraud, you had a situation where there was a very negative basis on the stock price no matter what publicity the company released. One of the interesting things that has not come to light in the ongoing saga of Solv-Ex was the fact that one of the quirks of Reg S was the fact that the shares had to be held for 40 days after being purchased in order to be freely tradable.

Thus, the normal practice by European purchasers of private placement Reg S American shares was to short-sell the amount that they were going to buy at the time of making their purchase, thus locking in the difference between what they sold the shares for and the substantial discount they could purchase them at while avoiding the possibility of the shares going down before they were fully tradable. Many of the short sellers that seemed to so concern Solv-Ex may well have been their own investment bankers. We are not knowledgeable of the propriety in this but it has come to light that they were recommending the shares while they were selling them, either long or short.

Management had people that were very adept at solving difficult problems such as credibility. This was worked out when the company told its shareholders straight-up that it was literally at war with the shorts and that it was in the best interest of the company to have shareholders pull their Solv-Ex securities from their brokerage house accounts and to put those shares in their own safety deposit boxes. The shareholders believing that this indeed was in the best interests of the company complied en mass. The primary way in which shares can be borrowed to support a short sale is if those shares reside in a margin account at a brokerage firm. The firm borrows from its own securities box or that of another brokerage firm and lends the securities to the short seller for a substantial fee. If no shares reside in any brokerage firm securities boxes, naturally, there would be no shares to support delivery for a short sale.

This would have two effects, the first of which is the fact that no new short sales could be made stopping a large percentage of the selling in the company’s stock. The second reason though is even more critical. Shares that were already shorted would have to be repurchased when the stock loan was called ([197]). This instead of having a negative effect on the price of Solv-Ex shares created another strong buying interest. The shares would now run up on company announcements and then as sure as morning follows the night, run down again on sales of Reg S stock in Europe. A most confusing scenario to say the least. A short description of his the stock was manipulated was found in the class action lawsuit filed by Alfonso L. Sedita, a shareholder, against the company and its officers described what the company did to hype its stock::

(i) “Solv-Ex organized and held conference calls on a regular basis in which defendant Rendall and other senior executive and/or officers of the Company and Morgan Grenfell would provide information on the Company and its business to investors as well as answering questions from investors. During these conference calls, defendants made numerous materially false and misleading statements about the business and operations of Solv-Ex. Investors participated in the conference call by calling a toll-free telephone number,

(ii) “As described below, Solv-Ex widely distributed a package of documents to investors and other interested parties which contained numerous false and misleading statements about the Company and its business;

(iii) “Solv-Ex offered various benefits and other forms of inducement to certain brokers, newsletter writers and publishers and other market participants to tout the stock.”

Feeling that they were really on a roll, the company next filed a lawsuit against the shorts in the District Court for the State of New Mexico, (Second Judicial District, Bernalillo County) charging them with conducting a campaign to destroy the company as an ongoing concern, revealing confidential information about the company and manipulation of its common stock. Being squeezed by a lack of borrowable stock and being sued for disseminating confidential information made it an uncomfortable time hot for these bear market traders. What was the information that was released by the shorts that was so sensitive. As best we can figure it out It appears that several studies were conducted by engineering consultants that were used to evaluate the company’s project. One was put together by Pace Consulting of Jacobs Engineering Group for the company and a technical due diligence study by the Vancouver-based Weir-Jones Engineering Consultants was bank rolled by a consortium of short sellers of Solv-Ex stock.

If you are not thoroughly confused by this time, we will try to make sure that you a completely befuddled by this company with the next series of statements. It appears that the Pace Study which was prepared at company request was not what it was purported to be. The Financial Post indicated that Solv-Ex misrepresented its own study and it quoted Pace V.P. Dan Foley with the following: “We reviewed a feasibility study they ([198]) prepared; audit is their term. We only commented on U.S. $2.25 portion of the U.S. $5.21. We’re not used to our name being kicked around in these kinds of circles. We weren’t hired to give opinions for the public market…Throwing a number out without backup on what those numbers mean can be misleading to the public.” What is more disconcerting about what Pace itself has stated is the fact that what Solv-Ex had indicated what they had done was an audit, Pace who did the study disagreed and indicated that they were not even hired to prepare one. ([199])

In the world of oil and engineering, an audit can be more important than an accountants certification report. The audit attempts to evaluate that the various facts being used to arrive at an ultimate methodology are put together from credible numbers and those underlying facts or published to fairly represent what the products chance of success may be. I full “audit” in this case would have evaluated the project from almost an infinite number of points of view. Among those would be the quality of the lease which contained the raw material. The ability to remove the raw material, the cost and feasibility of doing it as well as getting the residual product to market. The chance that the intellectual property being used in this particular case is correct from both a scientific and practical point of view. The economics future economics in the oil industry as to pricing and the possibility of alternative products being used that may be more competitive. Literally none of the factors were considered in the Pace “audit” and because of that, the chickens ultimately came home to roast.

This case was even worse, it seems that not only was there no audit but the underlying facts were also highly misleading. Pace did not even comment on enough of the total data available to put together a full audit and even if they had, the auditor that represented the shorts indicated that the data they were using was substandard. Examples given of inferior data are the fact that higher grade materials than were usually found on the claims of Solv-Ex were used to determine recovery profits, costs for the building of the extraction were not only underestimated but even had they been correct, there would not have been enough cash flow to pay the debt service using the best of numbers.

Apparently there was a lot of truth the foregoing in that on July 14, 1997, Solv-Ex filed for protection under the Companies Creditors’ Arrangement Act of Canada (the “CCAA”) and on August 1, 1997, just two weeks later filed for protection under Chapter II of the United States Bankruptcy Code. Along with those actions the company announced that it could not produce audited financial statements for the year ending June 30, 1997. That along with the fact that without audited financial statement, no Form 10-K could be compiled, a critical element of continued listing on NASDAQ, the stock was delisted on September, 1997.

The company in evaluating what had occurred produced a white paper in which a number of interesting excuses were given for the disaster:

1. “In the course of start-up operations, it became apparent that modifications to the water recirculation circuit would be required in order to operate the extraction plant on an extended or continuous basis. This was caused by settling of fine clay’s more rapidly than had been anticipated in a unit of equipment that was not designed to capture the clays. Although the extraction plant could be successfully operated and the process demonstrated for several hours before the build up of clays required shutdown and clean out, rumors were circulated that the technology did not work. “

2. “In April 1997, Solv-Ex learned that plans by other companies were moving forward to install additional pipeline capacity into the area as early as late 1998. Although this was a very positive development for the long term, it did adversely impact transportation and marketing arrangements with Gibson Petroleum which did not want to allocate substantial addition capital to purchase of trucks which would only be used for a relatively short time as Solv-Ex moved to full capacity of 15,000 barrels per day. Gibson advised Solv-Ex that it would only handle transportation and marketing on a best efforts basis unless Solv-Ex wanted to provide the required capital…”

3. “Throughout the entire period, Solv-Ex was subjected to a tremendous amount of negative publicity concerning its technology and the status of construction of the initial extraction plant. Notwithstanding pleas by Solv-Ex to regulatory authorities to bring a halt to false reports being disseminated by short-sellers, nothing was done and even the false information began to establish credence in the market place. The price of Sol-Ex Common stock, as quoted on Nasdaq Small Cap Market dropped from $13 per share on April 1, 1997 to about $10.50 by the end of the month and further dropped to about $6.50 per share by the end of May.”

4. “On or about May 28, 1997, Merrill Lynch announced via a Form 144 filing with the Securities and Exchange Commission that it was selling up to 1,100,1000 shares of Solv-Ex Common stock issued in the name of John S. Rendall, Chairman and Chief Executive Officer of Solv-Ex to liquidate a margin account of Mr. Rendall with a debit balance of nearly $4.4 million. In fact, only about 634,000 shares were sold during 5 trading days (through June 3, 1997) to liquidate the debit balance. However, the impact on the market was more severe and the price per share of Solv-Ex Common Stock dropped to approximately $3.25 by June 30, 1997.”

5. “The number of shares which Solv-Ex was required to reserve for issuance upon conversion of the convertible debentures was to be determined based upon 80% of market price of the Common Stock. As the stock price declined, the number of shares which were required to be reserved for issuance increased proportionately to a point where the Company no longer had other authorized shares which to raise additional capital.”

6. “In May, June and early July, 1997, Solv-Ex worked closely with UTS in an effort to establish a joint venture for the project with a major industry partner or financial institution for the purpose of ensuring completion of the initial stage plant with a partner having the financial capability to proceed with expansion. Several parties expressed a high degree of interest and two separate sets of negotiations proceed to the advanced stage of drafting contractual documents. In the final analysis, however, the Company unable to complete such a venture.

7. By the end of June, 1997, it had become apparent that secured and unsecured claims of unpaid trade creditors in Canada relating to construction of the initial phase oil extraction plant totaled at least $10 million. Solv-Ex did not have funds on hand to pay these claims, could not raise additional equity through sales of Common Stock because of limitations on its authorized capital as hereinbefore described and was unable to borrow any significant amount of money. Solv-Ex had also learned that it was rapidly approaching a date when the Company could become subject to involuntary liquidation proceedings instituted by Canadian creditors under Canadian bankruptcy laws.

What the company seems to be saying in this piece was that they had a really good thing going but a lot of bad people tried to screw them to the wall. In reality, what they said was that the process really didn’t work, they had not way to ship the product even if they could produce it, the shorts lied about the company, the president sold out his shares which was not a very timely move, as the price dropped because of the presidents sale, more shares needed to be issued to raise the same amount of money and couldn’t be done anyway because there weren’t any authorized shares available, nobody wanted to do a joint venture with the company even though many had came to the table and there was no money left to pay their bills.

On February 8^th, 1996, CNBC correspondent Dan Dorfman reported that the SEC was investigating trading in the common stock of Solv-Ex and could well be charged by the Commission with stock manipulation. Naturally the officers of Solv-Ex denied that this was happening and Campbell gave a quote to Reuters that said that the Dorfman report was “blatantly false.”

Among other things that the Company found wrong with Dan Dorfman’s statements was the fact that he did not mention the fact that Charlie Maxwell had said that the company could well become the world’s leading oil producing company by the year 2008 or David Snow’s analysis that showed that Solv-Ex could be at $200 within two years and at $1,000 within a decade.

While this guilds the lily more than a large tad, we give the SEC statement to you in the Company’s own words:

“As contemplated in the Disclosure Statement, an action was filed on July 20, 1998 by the Securities and Exchange Commission against the Company and two of its executive officers, John S. Rendall and Herbert M. Campbell II. The complaint alleges that the defendants violated the securities laws through the issu8ance of false misleading or deficient public statements and filings during the period January, 1995 through April, 1997 regarding the Company’s processes developed to extract oil and industrial minerals from oil sands, as well as its technology to produce metallic aluminum. The complaint also alleges that Solv-Ex understated its outstanding common stock by 3 million shares in the form 10-Q filed for the period ending March 31, 1996. The allegation relates to a 3 million share certificate issued in the name of Mr. Rendall in connection with a transaction which was never completed.”

It would sure seem to indicate that by reading the company’s own statement that the shorts had the whole thing figured out right from the beginning and that the company was playing fast and loose with the truth. You can see by the fact that the company couldn’t even account for 3 million shares, this had to be one of the reasons that they couldn’t get an audit.

Naturally a number of lawsuits were filed against the company one of which by Alfonso L. Sedita naming Solv-Ex, W. Jack Butler, Herbert M. Campbell II, John S. Randall and Deutsche Morgan Grenfell, Inc. as defendants. Basically, the lawsuit indicated that “The Individual Defendants participated in the drafting, preparation, and/or approval of the various public and shareholder and investor reports and other communications complained of herein and were aware of or recklessly disregarded the misstatements contained therein and omissions therefrom, and were aware of their materially false and misleading nature. Because of their Board membership and/or executive and managerial positions with Solv-Ex, each of the Individual Defendants had access to the adverse undisclosed information about Solv-Ex’s business prospects, technologies and financial condition and performance a particularized herein and knew (or recklessly disregarded) that these adverse facts rendered the positive representations made by or about Solv-Ex and its technologies and business issued or adopted by the Company materially false and misleading.“

The lawsuit was not kind to Morgan Grenfell in particular when it said that they “permitted and/or caused Solv-Ex to distribute its written analyses to the investing public while knowing or recklessly disregarding that the contents were materially false and misleading because they failed to disclose certain material facts as set forth herein, but were being used by Solv-Ex and its representatives to tout the stock. Morgan Grenfell’s duty of disclosure and liability derives from, among other things, its knowledge that Solv-Ex was distributing its research analyses to the investing public and that investors would be relying on the statements made therein in making their investment decisions with respect to the purchase and sale of Solv-Ex stock.

The plaintiff went on to make a rather incestuous case against Morgan Grenfell saying that the analyst covering the stock and disseminating the write-ups, Charles Maxwell, was not objective in that he owned a substantial number of shares in Solv-Ex and that it was in his best interest to have the shares at a higher price. They added that if that wasn’t enough of a problem, it turned out that Maxwell had formerly worked for Butler, a senior officer of Solv-Ex and a party to the litigation. Furthermore the suit went on, Morgan Grenfell was a consistent buyer of Solv-Ex stock in the numerous private placements that the company had been involved in and was consistently purchasing the stock at a discount in the placement and selling at a premium in the open market, something like buying wholesale and selling retail. As a rule, this is not a very good thing to be doing to people that believe in you

As a fitting end to the saga of Solv-Ex, the U.S. District Court for New Mexico issued a Permanent Injunction and other relief against Solv-Ex Corporation John. S. Rendall and Herbert M. Campbell on May 17, 2000. It goes as follows:

“The Court’s Final Judgment enjoins Solv-Ex, together with John S. Rendall, the Company’s Chairman of the Board of Directors and CEO, and Herbert M Campbell, present Director of the Company and a former Vice-President and General Counsel, from: (1) employing any device, scheme, or artifice to defraud, or (2) obtaining money or property by means of any untrue statement of a material fact or omission to state a material fact; and (3) filing or causing the filing with the Securities and Exchange Commission of any periodic report on behalf of any issuer, which contains any untrue statement of material, or which omits to state a material fact necessary in order to make the statements made, not misleading. In addition, the Court’s Final Judgment imposes a civil penalty in an amount of $5,000 each against the individual Defendants, Rendall and Campbell.”

Management That Just May Have Been Very Confused

SensorDramatic, Can’t Stop The Con

Sensormatic is the world’s largest manufacturer of unique security systems (electronic tags) that primarily protect merchants against shoplifting. The Boca Raton based company was seemingly always in the right place at the right time as demand for their products seemed to grow endlessly because of the nature of American shoppers to occasionally forget to stop by the cash register when they are walking out with their newly acquired merchandise. Americans have become so forgetful about paying that Sensormatic say an amazing opportunity.

The company was coming up with world class earnings growth on a quarter-by-quarter basis and topped the charts with 30 consecutive quarters that showed a 20% earning spike or more. Sensormatic was founded by Ronald G. Assaf, who indicated that the inspiration for the company’s creation came the day that, as he was managing a grocery store, a shoplifter grabbed some of the store’s merchandise and ran off with it clutched under his arm. After a tiring chase, Assaf determined that their had to be a better way, and came up with the electronic tags that set off an alarm when they are not properly removed by the store’s cashiers.

Many people today believe, though, that Sensormatic was better at managing earnings and creating numbers by accounting manipulation than they were in administrating a business. You see, Sensormatic was extremely perceptive to making the projections that Wall Street predicted, and if the quarter wasn’t shaping up the way the company’s management believed the “Street” would have been partial to they would change them to make them conform. Early on they had adopted a simple trick of leaving the current quarter open until enough business had come through the doors to do the job.

This was accomplished by three methodologies, two of them rather arcane, the other high-tech. In the more basic management of earnings ploy, Sensormatic resorted to the old, “let’s ship it to a warehouse and call it a sale” routine which we have seen over and over again within this story. This ploy was used along with the tried and true old double invoice trick. This was achieved through shipments directed at two different warehouses, where according to records the same goods were doubly reported as sales. This more sophisticated approach consisted of simply moving back the company’s computer clocks until they had booked the number of sales that would meet their internal projections. This would cause sales to be automatically recorded on whatever date the company was tuned into. This scenario could recur until the desired result was achieved. Ernst and Young who had early opined on all of the phony creative work on the part of senior management retreated and openly stated that Ronald G. Assaf, the company’s founder, was well aware of what it called “out-of-period” revenue reporting.

The usual lawsuits were filed against the company for its admitted cheating on earnings statements and special charges were brought against many in senior management who used the concept of managed earnings to unjustly enrich themselves. It seems that almost all of the directors and senior management were dumping shares onto the market while telling shareholders how well they were doing.

The Securities and Exchange Commission launched an investigation into the pattern of managed earnings, but many investors had already had enough. It seems that Michael E. Pardue, the former Chief Financial Officer, had seen it all coming as well, and had resigned shortly before the public announcement of the company’s accounting mess. He did not help senior management too much when he testified at a deposition conducted by the Securities and Exchange Commission that he had gone over the fact that the company was involved with “out-of-period” ([200]) shipments with two board members who were still active with the company, James E. Lineberger and Jerome M. LeWine. Naturally, both men as one would suspect, deny any recollection of such a conversation.

The SEC eventually came down with their opinion on what had occurred at the company and on March 25, 1998, they issued the following paraphrased report:

“In the first of three separate administrative Orders issued today, the Commission found that Sensormatic violated the antifraud, reporting, internal controls, and books and records provisions of the federal securities laws in connection with its manipulation of its quarterly revenue and earning in order to reach its earning goals and thereby meet analysts’ quarterly earnings projections.”

The SEC went on to say that it was seeking permanent injunctions and civil penalties in the United States District Court against the following three former senior officers of Sensormatic; Ronald G. Assaf, formerly Sensormatic’s President and Chief Executive Officer and currently the Board Chairman, Michale E. Pardue, the former Chief Operating Office and Lawrence J. Simmons, former V.P. of Finance for Sensormatic. Simultaneously with this announcement, it was also confirmed that several other senior employees had settled administrative proceeding with the SEC for various other violations.

The SEC then proceeded to give chapter and verse on exactly how the crime was carried out:

“Sensormatic carried out this fraudulent scheme by improperly recognizing revenue through several different practices. The conduit, which occurred over a number of years and involved employees throughout the organization, primarily involved recognizing and recording revenue in one quarter from product shipped in the next quarter. At the end of each quarter Sensormatic turned back its computer clock that recorded and dated shipments so that out-of-period shipments, and consequently revenue, would be recorded in the prior quarter. According to the Order, revenue also was recognized though the following improper practices: recognizing revenue in one quarter when products were shipped to warehouses leased by Sensormatic, instead of in the next quarter, when the products whipped to customer; slow shipments, whereby revenue was recognized on shipments which were mad during the last days of a quarter buy which were not scheduled to arrive at the customers’ location until well into the next quarter; and recognizing revenue on goods at the time that they were shipped to customers even though the customers’ contracts with Sensormatic contained an FOB destination provision… “

“The Order also finds that, as a result of the fraudulent scheme, Sensormatic filed materially false and misleading periodic reports as well as registration statements for the sale of securities that incorporated thee periodic reports by reference. The reports were false and misleading because they misstated Sensormatic’s quarterly results of operations, including revenue and net income. They also falsely stated that the company recognized revenue upon shipment, when in fact, it intentionally and prematurely recognized revenue for shipments made in the succeeding period or periods, and did not comply with generally accepted accounting principles (“GAAP”) or the company’s stated revenue recognition policy. I addition Sensormatic issued a press release that overstated its preliminary estimates of earning for the fourth quarter of fiscal year 1995 by over 40%, and for the year by over 18%. During the relevant period, Sensormatic’s misstatements of its quarterly net income ranged from an understatement of about $1.9 million (9.1%) in the second quarter of fiscal year 1994 to an overstatement of about $5.2 million (40.5%) in the fourth quarter of fiscal year 1995.”

The Securities and Exchange Commission also charged Sensormatic with concealing the recognition of revenue from its independent auditors and shareholders and that various management people falsified records, lied and distorted material financial facts.

Simultaneously several class action law suits were brought against the company and others. That action which was consolidated on November 29, 1995. The charges were no different than those of the Securities & Exchange Commission and the defendants named were, Ronald G. Assaf, CEO, Michael E. Pardue, EVP, Dennis C. Gillette, SVP, Lawrence Simmon, VP for Finance, along with an assorted mixture of other directors and officers. Also named in the Consolidated Complaint as a Defendant was the accounting firm of Ernst & Young. The claims against Ernst & Young related solely to its conduct for the 1994-year end audit, and its opinion contained in Sensormatic’s Annual Report and Form 10-K for the year ended June 30, 1994.

The Company, its officers and directors and the accountants ultimately settled a host of shareholders lawsuits for $53 million while company founder Assaf was forced to pony up $50,000 to individually settle the actions by the SEC.

Sensormatic just couldn’t get their act together which is rather startling because their products seem to be both “state of the art” and in high retail demand. Robert A. Vanourek, an ex-army officer and Pitney Bowes alumnus took over the CEO job to attempt a restoration of confidence by the street and a consistency of earnings development without having to fudge all of the time. Vanourek took the job on a platform of creating earnings growth and no sooner had he uttered those words than he was eating them. His first problem didn’t take very long to arise. He quickly found out to his consternation that there was no inventory list for the twenty-seven warehouses that the company had in Europe. His next surprise was the fact that the company had no central purchasing. Plants literally created their own business plans without a semblance of centralization. Thus, when it came to purchasing, duplicates of a substantial number of items were ordered by each of the plants. Thus, volume discounts, a way of life in American Industry, literally did not exist for Sensormatic.

On August 14, 1997, Sensormatic suddenly stopped paying dividends and announced that it was taking a substantial after-tax charge. As a result, almost 20% of the European workforce was laid off, and the company took restructuring charges that sent the entire year of 1997 into the red. The vaunted increase in gross revenues was a disappointing 3.1%, pretty much in line with inflation. So that when all the information had been recorded, instead of the predicted profit, Sensormatic produced a loss; instead growing a substantial pace, the company literally did not grow at all and instead of an assured dividend, there was now, none, not a very auspicious start for poor Vanourek.

At the worst possible time, Sensormatic’s public-relations adviser moved into the enemy camp at Checkpoint. He was able to mount a publicity campaign, which gave chapter and verse of exactly how screwed up Sensormatic was. This became a short-seller’s dream, and stories were planted in all of the financial journals on exactly how badly run the company was. As if that wasn’t enough, almost all of the foreign operations of Sensormatic simultaneously tanked and have yet to recover.

Vanourek made the classic response when asked what had gone wrong; “We could have had higher earnings if we had not gone with the reinvestment program.” While that makes a lot of sense, he seems to be saying that if we did not put more money back into the business we would have done a lot better. This is such a terrible statement that it flies in the face of basic business theory and literally deserves no further comment. But, he was just warming up, so that know one would think that the buck could possibly stop with him, he proceeded to blame the company’s outdated computer systems, lack of management controls and expenses that were out of control for the company’s ills. He went even further and indicated what seems to be fact, that when he had taken the job, he really didn’t know what he was getting himself into. “The job is certainly more challenging than anyone anticipated in 1995.” Thus, it seems to have taken the CEO two years to realize that everything in his house was not in order. One would certainly have thought that after he had made his grandiose projections on what he was going to accomplish as CEO and then saw that he had over-reached he would have sent a signal to shareholders that all was not well.

The kinds of activities that Sensormatic has been previously engaged in do not bode well for the future. They are in a very competitive industry and their primary competition, Checkpoint, seems to lower their prices every time Sensormatic announces another problem, compounding management’s ability to deal with everything at once. The industry structure currently, substantially favors Checkpoint and with Sensormatic management unable to get a hold of what is going on in their company will find it difficult to respond to competitive pressures, especially when they are not even sure what their costs are.

During Vanourek’s reign, the company has established just about the worst record on Wall Street. “…Partly as a result of that unpredictability, the company is the worst performer for the five years ended December 31, 1998 among 1,000 companies included on the Shareholder Scoreboard. Its average compound annual total return over the period was minus 27%. If you invested $1,000 in the company at the end of 1993, your stake would have dwindled to $208 at the end of last year. Sensormatic’s five-year performance also puts it at the top of the Scoreboard’s Laggard List. That’s a list of 43 companies, ranked by five-year performance, that place in the bottom 20% of companies evaluated over one-, three-, five- and 10- year periods through year-end 1998.” ([201])

With that in mind, on August 10, 1999, the Board of Directors of Sensormatic called a halt to Vanourek’s reign and named Per-Olof Loof as its president and Chief Executive Officer. Mr. Loof comes from NCR where he was a senior vice president. Although Mr. Loof’s strength is in Europe and this is where the company’s primary troubles seem to originate, Sensormatic’s game of musical chairs may not be over yet. The Company’s sales are still under their level of several years ago and for a growth company used to instantaneous gratification, this does not bode for management longevity.

American Public Automotive Group Runs Out of Gas

American Public Automotive Group Inc. (APAG) was formed for the purpose of creating a national automobile dealership in huge auto malls that were connected to traditional shopping centers. Management was certain that these were heady times and it wouldn’t be long before APAG would be public and money would be pouring in.

James O’Neal and Patrick Baker, APAG’s founders, started with a poke of a tad under $20 million and regularly informed investors that a major acquisition was imminent. O’Neal was not new to this game; he had tried the same gambit under the name Arnold Palmer Automotive Group, Inc. Undeterred by a Florida conviction for misappropriating taxes and an assessment of $350,000 in restitution, O’Neal used APGA as his personal piggy bank. Eventually his partners sued him for misappropriating funds, and got a seven figure judgment in against him.

O’Neal was probably just misjudged. Stage left; enter Ernst & Young with a vengeance. APAG made the mistake of hiring Ernst & Young in 1996 to audit both its financial statements and those of Massey Group, its parent. Another company, BOH, was trying to purchase Massey Group, and hired Ernest & Young as its exclusive financial adviser in the acquisition. In addition, Ernst was handling the personal tax filings of James O’Neal Jr., President of APAG, who had already stolen $4 million of the Company’s funds and converted them for his personal use. After all, doesn’t everyone need five farms and two homes in Florida?

When the scheme had completely collapsed, a lawsuit filed by investors charged that Ernst and Young was, “not only aware of O’Neal’s misappropriation of funds, but helped him disguise those withdrawals as loans, which later appeared as assets on the corporation’s balance sheet.” The lawsuit went on to say that Ernst & Young knew that O’Neal could never repay those loans, given that his personal tax return (courtesy of Ernst & Young) listed $18 million in debts and no income. ([202])

The plot thickens. In 1996, Ernst & Young Partner C.J. Roach, who had been around for O’Neal’s last disaster, the Arnold Palmer Automotive Club, became a member of APAG’s board of directors. Under those circumstances, Ernst & Young could hardly claim that they didn’t know O’Neal’s history.

APAG never entered into a business of any kind in spite of numerous announcements to the contrary. O’Neal had glommed on to what little money the company had left, and Ernst & Young was all over the place when the inevitable happened - the company filed for bankruptcy. At that point, there was only $500,000 left in the till, but creditors agreed to forgo a piece of what was left in order to roll the dice in what looked to be the sure-fire success of a lawsuit against Ernst & Young.

It just seems that accounting firms can’t get it straight. You can’t represent everyone at the same time. It just doesn’t work, as we saw here. The facts are crystal clear in this one, and Ernst & Young can only hope that the creditors settle this out before everyone finds out what a sleazy job they did.

The Not-so-Merry Go Round

Leonard (“Boogie”) Weinglass, was a great dancer who also had some marketing skills and a knack for fashion. Boogie had a real nose for trends in teenage fashion, and his small shop, “Merry Go Round,” on Peachtree Street in Atlanta quickly became a screaming success. He created a public company named after the store, and with the help of some other key personnel, opened new mall-based shops all across the United States. In no time Merry-Go-Round was listed on the New York Stock Exchange, and a Hollywood studio made a movie called “Diner” patterned after his success. At this point, sales had just about reached the $1 billion level.

Things started to go wrong for Boogie during the Christmas season of 1993. For the first time, Boogie miss-guessed the fashion market and Merry-Go-Round’s warehouses filled with merchandise that was not moving. At about the same time, the company bought a men’s clothing chain with almost 500 stores known as “Chess King.” Unfortunately, Chess King’s product lines often duplicated Merry-Go-Round’s and the stores were located in the same malls.

For the first time in twenty-five years, Boogie was in trouble. However, there was over $100 million in the bank, a substantial cache relative to the ongoing business needs, and management thought they could turn the situation around easily. Merry-Go-Round hired a Washington-based law firm, Swidler & Berlin, for advice in evaluating their options. Swidler recommended that they hire the consulting branch of Ernst and Young to help turn the company around. The company’s directors thought that this idea made sense, and approved the transaction.

In its presentation to Merry-Go-Round’s Board, Ernst & Young offered to assign Ben Evans to the task. Ben had earned kudos as a restructuring expert through his work with Ames Department Stores and Phar-Mor Inc, two extraordinarily difficult workouts. However, Ernst & Young neglected to inform Merry-Go-Round that Evans was not its employee at all, but a retired consultant who would be working on commission. Evans left after only one disastrous month at Merry-Go-Round.

Ernst & Young said, “not to worry” and immediately brought in a recently named English Partner named Mark Hopkins, who had spent most of his short career (he was 35 years old) as a London Banker and shipping expert. As he later admitted to all concerned, he had literally no experience dealing with retailers and not very much as a turn-around expert. He was backed up by two lads in their 20’s who knew as much about the industry as Hopkins did. We will spare you the gory details.

The Ernst team made about every mistake in the book. They did not file for bankruptcy in order to get our of non-performing outlets’ leases, and were slow to close multiple stores in similar locations. The Board of Merry-Go-Round told the Swidler law firm that Ernst was making a bad situation worse and recommended that they be removed. Unbeknownst to Merry-Go-Round management, Ernst and the Swidler law firm had reciprocal referral arrangements. Swidler had little incentive to recommend that Merry-Go-Round remove Ernst.

“Ernst & Young, it turned out, was a major client of Swidler Berlin, the law firm that recommended hiring it. According to a document filed in court, Swidler Berlin had been paid $5.3 million for representing Ernst & Young or a predecessor firm in 13 matters over the seven years before the consulting firm was hired by Merry-Go-Round. Yet, neither Swidler Berlin nor Ernst & Young mentioned this in papers filed with the bankruptcy court in January 1994, when Merry-Go-Round filed for Chapter 11. “

“Indeed, a document signed by a Swidler Berlin partner stated that, to the best of Merry-Go-Round's knowledge, "Ernst & Young has no connection with the Debtor, its creditors ... or with their respective attorneys or accountants." [203]

Even worse, Ernst was courting Rouse, the builder and landlord of many of the malls in which Merry-Go-Round was located. Merry-Go-Round could have walked away from the Rouse leases by filing bankruptcy, but this wouldn’t have gotten the budding Ernst/Rouse relationship off to a very auspicious start. In fact, Ernst & Young had just received a substantial assignment from Rouse. To Rouse’s credit, they asked Ernst whether there were any conflicts of interest at the time they were hired. Ernst, in typical accounting fashion, thought long and hard and then indicated that none existed.

While Ernst was playing their cards close to the vest on the disclosure side of the ledger, they were zipping along famously on stopping the hemorrhaging at Merry-Go-Round. Ernst’s disastrous advice included a bizarre “adding to inventory program” almost finished the company off right then and there. After a year, Ernst came up with a plan to save the company $11 million a year. Sadly, the company’s annual losses were running $186 million at the time.

As things continued careening out of control, the creditors brought in a new CEO, Thomas C. Shull, who had arranged the R. H. Macy turnaround. In 1994 Shull had been told that Merry-Go-Round was breaking even on a cash flow basis, when the company actually lost $170 million dollars and had a deficit cash flow of $52 million. Shull started laying off bodies and closing stores. He even recommended that Ernst & Young’s responsibilities and pay be dramatically cut back. Of course, Swidler Berlin sprang to Ernst & Young’s defense, arguing that such a change would be disruptive and inefficient.

By 1996, the creditors determined that enough was enough and closed Merry-Go Round. The trustee, Ms. Devan, was hired to liquidate what was left of the company, and didn’t take long to put all of the pieces in perspective. She hired the Baltimore law firm of Snyder, Weiner, Weltchek & Vogelstein to look for recovery from the guilty parties. The Trustee and the Snyder Law Firm filled a lawsuit against Ernst & Young for incompetence, fraud and crucial misrepresentations.

“The bankruptcy trustee for the defunct retailer Merry-Go-Round Enterprises has sued Ernst & Young LLP. The suit contends that the accounting firm let the company take too long to liquidate, thus hurting creditors. The lawsuit, first reported by The Wall Street Journal, accuses the accounting firm of fraud and is seeking $1 billion in compensatory damages and $3 billion in punitive damages.’

‘The damages are the largest amount ever sought from an accounting and consulting firm, bankruptcy experts say. But it will be hard for the unsecured creditors to recover anything close to that, when their claims total about $300 million.” ([204])

The lawsuit sent a very large message to Ernst & Young that the game was over causing them to settle for one of the largest amounts ever paid in a matter of this kind, a payment of $185 million. ([205])

Rite Aid, A Prescription For Disaster

One of the SEC’s key proposals for strengthening the integrity of the corporate reporting process is remaking the rules relative to the power of the outside accounting firm and enlarging the role of audit committees. Regulations proposed by the SEC and now under discussion by government officials, force audit committees to confer with accountants relative to the accuracy of corporate financial statements, and would further require auditors to identify what information they had conveyed to the audit committee. Issues include the increased liability of the audit committee members, should it be determined that they had a duty to act on the basis of such disclosures.

Alex Grass founded Rite Aid and under his stewardship, the company had become the third largest pharmaceutical chain the United States. They had recently gone through both changes of policy and changes in management. Because of internal pressures and conflicts, Alex made the fatal error of turning the management reins of the company to his son Martin who had little or no experience at running anything.

The company under Martin Glass soon became involved in a major expansion program in which PCS Health Systems, Thrifty Payless Inc., K&B Inc and Harco Drug Inc. were acquired in rapid succession. In this mad scramble to expand at literally any cost, debt was rising like a rocket and had already reached a literally unserviceable level. The company and its accountants were communicating about as well as a couple about to get divorced. To make matters worse, a number of state governments were not particularly happy with some of the company’s economic ideas.

So let’s put this bizarre scene into the perspective it deserves; in the recent past, Rite Aid had received substantial criticism for its peculiar decision to eliminate brokers and manufacturers’ representatives, what has become a case history in disaster. These people were an integral part of the supply chain and the company could never adequately replace them without adding a substantial cost factor to company’s infrastructure and even then, any hoped for improved results would at best be iffy. Had they capably overcome hurdle one, it was logically argued that they could not replace the talent that they had eliminated, probably at any cost. The Securities and Exchange Commission had informed the company that it was opening up a formal investigation regarding its corporate accounting practices. In Philadelphia, a class-action suit was commenced which involved charges of violations of consumer protection laws and fair trade regulations for a period of the previous six years. Should the plaintiff be victorious in that case, Rite Aid would be talking about a paying over a very substantial amount of money.

The Office of the Attorney General in Florida added to a very bad hair day for the company by charging Rite Aid with wire fraud, theft, racketeering and unfair and deceptive trade practices. Last but not least, “the U.S. attorney in Harrisburg, Pa ([206])., has launched an investigation of possible criminal fraud in connection with Rite Aid Corp.'s past accounting practices, according to people familiar with the situation.’ ([207]) Frank Bergonzi, Rite Aid's former chief financial officer, had received a subpoena to produce documents in connection with the probe, these people say, and investigators working on the matter have interviewed a number of other people.

Rite Aid was certainly an accident waiting to happen when the company’s auditors, KPMG, indicated to the audit committee that they could no longer have confidence in any information that would be forthcoming from the company in the future, as what had come down from senior management in the past had been at best, inaccurate and had caused the auditors to make restatements. They were particularly negative on any communications that had with Rite Aid’s CFO and considered him most unreliable.

As for the Audit Committee, what, for example, was the appropriate course for them to take when KPMG advised them that the company could no longer be trusted relative to financial data? In particular, the auditors had put the Rite Aid on notice that the information provided by the Company’s CFO was highly suspect. Thus, what were the proper steps for that supposedly independent committee of board members to take next?

The timeline of Rite Aid’s troubles reads something like this:

June 30, 1999 – During a meeting with the Audit Committee, Rite Aid’s auditors, KPMG, did not, according to the Audit Committee, disclose their reservations about either the company’s CFO or its financial controls, and failed to announce that they would not issue quarterly reports on Rite Aid’s financials. There seems to be no question however that they did deliver a letter to the Audit Committee expressing their reservations about the Rite Aid’s internal controls.

July, 1999 - Rite Aid issued quarterly financials that did not even footnote KPMG’s reservations.

“In June 1999, Rite Aid Corp. restated its profit downward by 9% for the year ended Feb. 27, reversing some aggressive accounting maneuvers.

The company also disclosed in a Securities and Exchange Commission filing that $35 million, or 42% of its restated fourth-quarter pretax income of $82.7 million came not from operations, but from onetime gains relating to the settlement of two lawsuits the company had filed against manufacturers. That big boost to results wasn't disclosed in the company's initial March 29 news release reporting the quarter's results. A Rite Aid spokeswoman declined to provide details or to identify the manufacturers involved.

The nation's No. 3 drugstore chain said its earnings for the year were $143.7 million, or 54 cents a diluted share, down from the previously reported earnings of $158 million, or 60 cents a share. Rite Aid also made minor adjustments to its results for the two prior years …” ([208])

October 18, 1999, Martin Grass, son of Rite Aid’s founder, Alex Grass, resigned as Chairman and CEO in the wake of an 80% drop in the company’s stock price and reports that its cash burn rate could end in the company’s bankruptcy;

November 11, 1999, KPMG orally advised the company and a member of the company’s audit committee that KPMG was resigning as the company’s auditor because they were unable to continue to rely on management’s representations. ([209]) Also cited were the company’s high charges for replacement of damaged and outdated goods.

In its Current Report 8-K filing, Rite Aid admitted that the SEC had advised it, that it was under formal investigation;

November 15, 1999, Leonard Green, Chairman of an investment-banking firm that committed funds to shore up Rite Aid, was elected Chairman of the Board, with a promise to restore financial discipline. A search for a new CEO and CFO began.

February 2000 Robert Miller, former Vice President of Kroger Co., was hired to turn Rite Aid around and restore confidence in management.

Management had asked KPMG to capitalize $32,700,000 in expansion costs that should have been listed as expenses would tend to inflate earnings reports. These infractions on the other hand were quickly corrected when investigated by the SEC, included, by Rite Aid’s own admission were improper charges of $25,700,000 in costs against reserves set up for prior acquisitions, which should have been booked as regular expenses. Expenses were further reduced by $24,700,000 in 1999 by the amazing trick of assuming, without conferring with its suppliers, that the latter would reduce their bills to Rite Aid for goods shipped by about $11,000,000. Again without picking up the phone, Rite Aid assumed that banks that rejected $7,000,000 in credit card charges would change their minds.

Adding insult to injury, a class action law suit was instigated against the Company by the bond holders who charged that the company’s executives had violated federal securities laws by making false and misleading statements relative to the company’s financial statements that had been publicly issued. The bonds had fallen by 30% on the day that the company had to restate its earnings for the previous three years. The bondholders could not at this point be described in any way as happy campers. Not only were the bond holders upset with management but shareholders had taken a number of severe jolts, the company appeared to be heading for delisting by the New York Stock Exchange, and trading had been halted.

The stock had fallen by ninety-percent from its high, no bidders seemed to be interested in the Company’s overtures to be acquired, the head of company’s marketing, who had done a workman like job in bringing a number of worthwhile transactions to the table, abruptly resigned. The chief financial officer resigned under the strangest of circumstances and would no longer communicate with anyone, the audit committee would not comment for attribution about anything that the company was doing and lastly, KPMG would only refer people to their public statements if they called. Thus, the situation was made to seem even worse than what had happened because of the fact that everyone from management, to employees, to creditors, to accountants and shareholders were really running scared. None of them had a clue of what the next shoe that was going to fall could be.

The timing of these events suggests that KPMG, who had been accommodating Rite Aids financial machinations for some time, got cold foot when they received word of the SEC investigation and decided that the time had come to resign. This resignation took place long after the horse a already long fled the barn, but KPMG had seen a succession of improbably bad things happen with the company in amazingly short order and was not in the mood to be surprised again.

Who is the proper responsible party for calling in the cops before the situation had gotten this far out of control? Should it have been the Audit Committee, as the SEC’s new rules suggest, or KPMG, or the CFO? There appears to have been enough willful blindness to go around. We would suggest that they all were partially to blame for blithely going along with one crises after another without a word of warning to shareholders or regulators. Furthermore, no one stepped to the plate to suggest that a management change was in order while there was still something to save.

Whatever the final outcome of this sorted affair, it appears that the insurance companies are going to have to pay a lot of money eventually to accommodate the litigation that was filed when the facts became known. It would seem appropriate that it be the accountants, who were closest to what was going on to have blown the whistle, resigned at an earlier date than they did or called attention to the fact that the company was literally out of control, was in a position to have save a lot of people a substantial amount of pain. Instead of taking a stronger position relative to not going along with management’s efforts to pad their earnings and to capitalize the expenses the accounting firm in reality aided and abetted a criminal action. These people at a minimum are the keepers of the public trust and obligated to make sure the books are in order when they give a non-qualified opinion.

We are staggered by the fact that with all of this going on, KPMG took so long to come to the conclusion that they were dealing with people that were more interested in bamboozling the shareholders and the public markets than doing a professional job of reporting the company’s true state of affairs ([210]). Obviously, if you are the accountant that is on the firing line and you have been previously been forced to restate the company’s financials and the same management is still in charge, it would be a not inconsiderable push to believe that these folks are about to come to their senses.

Whatever KPMG wants to say to the contrary, they were indirectly and aider and abettor by not picking up the phone and calling the Securities and Exchange Commission right after they had resigned instead of waiting to find out how long it would take to have the government all over them ([211]). This is called the ostrich syndrome, you know, sticking your head in the sand when trouble is lurking nearby. We are not talking about a minor restatement of earnings here, over the three years that are in question, Rite Aid had to write down $500 million in pretax earnings, not a paltry figure to say the least. Most sadly of all, it took the SEC to force the changes, not the accountants.

Politically Oriented Criminal Behavior

Politics, The Good, The Bad and The Symington

Governor Symington of Arizona was born into wealth; his great-grandfather was one of America’s classic steel barons. Symington had gone to the right schools, met the proper people and did all the appropriate things. These included graduating from Harvard, and marrying Ann Olin Pritzlaff, none other than the heiress to the Olin fortune. Although the story sounds pretty rosy, it was not. Symington’s previous wife got rid of him for being a n’ere-do-well who had never held a job. His mother and second wife were continually bailing him out of financial tight spots because of his capacity for getting into trouble. Naturally, his Arizona gubernatorial campaign was based on his business expertise and his success as a real estate developer, which although it was non-existent, was strangely not brought up by his opponents in the campaign. This was at a time when every loan that Symington had made was already underwater and the only thing keeping him alive were his fraudulent bank filings, his mother’s kindness, and his wife’s money. He adamantly refused to answer questions relating to the details of his business during his campaign although he ran on it.

Symington was really a developer first and a politician second. He had gotten into deep trouble when the real estate market in Phoenix went south. In his anxiety to save the company he prepared financial statements that, to be kind, did not accurately reflect his true financial condition. Interestingly enough, Symington’s campaign treasurer, John Yeoman, was a Coopers & Lybrand partner. The Governor was pushing a state cost reduction program called State Long-term Improved Management (SLIM). The Governor’s Deputy Chief of Staff, George Leckie, was kind enough to let Coopers, through Yeoman, know exactly what the competition was bidding to get this contract. Coopers received illegal information that caused them to drop their bid by $440, 000, and not surprisingly, they won the contract.

In order to repay Symington’s kindness in rigging the bid for them, Coopers, started reducing the fees that Symington personally owed them, in effect creating a rather challenging to trace kickback. In spite of the cover-up, somehow or other, the District Attorney smelled a rat and began investigating the situation. It turns out that when the District Attorney started to interrogate a Coopers’ secretary of Yeoman’s, Joyce Riebel, and as though going through a catharsis, she just couldn’t wait to convey to the state government what was really going on.

She proceeded to give them chapter and verse about what had happened. Joyce in her exuberance also indicated in her that she kept a number of different financial statements in her drawer. Each one contained information that was created to satisfy a different lender. When one of the banks needed an updated financial statement, Riebel was instructed to mail out the appropriate statement to the requesting bank. No two of the statements were ever the same and in court, Symington was proven to have given statements showing materially different net worth statements to every institution that he had borrowed money from.

While listening to Symington’s secretary spew out a calamity filled scenario of illegal transactions, through a quirk, the District Attorney also came up with a “spreadsheet that mapped how the accounting firm reduced its bid by $440,000. It was dated two days before the selection committee advised all bidders to whittle their bottom lines.” ([212])

When all was said and done, Symington bought the farm, Leckie and Yeoman were indicted, and Coopers was forced to cough up almost $2 million. Yeoman died in a motor accident, and Leckie walked because once Yeoman died there was no one to testify against him.

As a result of the open and shut case presented by Arizona Attorney General Janet Napolitano, Symington was convicted on seven counts of bank and wire fraud. Moreover, he also resigned as Governor when the indictments came down. “Prosecutors alleged that Symington gave false personal financial statements to lenders to get millions of dollars in loans to fund his failing projects in the 1980s and early ‘90s. Symington prepared some of the statements and others were prepared or reviewed by his accountants. (Coopers & Lybrand) Symington contended that his inflated net worth and other mistakes in the documents were unintentional and should have been caught by Coopers accountants ([213])

We don’t feel that the Symington incident is going to teach us anything new about creative accounting and thus will not dwell on the matter. This is an instance of pure greed and avarice on the part of the accountants and a real estate developer turned politician. We will close one of the most sordid episodes in this memorandum with a quote that seems to put everything in wonderful perspective.

“Symington was involved in negotiations with the bank to obtain a loan to develop the Camelback Esplanade. Symington wanted to avoid an audit by a CPA, so he insisted that Dai-Ichi Kangyo Bank (DKB) accept an accountant’s compilation letter that was based on a personal financial statement prepared on a Valley National Bank form. The compilation letter from Coopers & Lybrand indicated that they had not conducted an audit, but had only reviewed his methodology in preparing the statement to see if it was consistent with previous statements. Attached to this report is a copy of this letter. Also attached is a copy of a letter from Symington to Coopers in which Symington accepts responsibility for the statement’s representations. He also submitted a 1988 financial statement, which showed a net worth of $10.8 million, and a 1989 statement, which showed a net worth of $11.9 million. Most of the guilty verdicts in this case are based on this 1989 personal financial statement. A copy is attached. DKB accepted the statements and lent Symington’s Esplanade partnership the money. These statements contained material errors and omissions.”

“These loans had provisions that required Symington to maintain a net worth of at least $4 million. He also had to provide DKB with annual personal financial statements during the terms of the loans. Symington submitted payment requests and borrowers affidavits to DKB to continue drawing on these funds. From May 1987 to June 1992, DKB provided over $120 million in loans.”

“Symington provided conflicting financial information to another bank during this period. During June and July, 1991, Symington submitted personal financial statements to First Interstate Bank. One statement indicated that as of December 31, 1990, he had a negative net worth of $4.1 million. The other statement indicated a negative net worth of $26.5 million as of May 31, 1991. In August 1991, Coopers & Lybrand completed a statement, which showed Symington’s net worth a negative $22.6 million. At the time Symington was trying to negotiate with FIB regarding his personal guarantees of a construction loan. Neither of these statements was provided to DKB. In fact, Symington lied about his financial condition to DKB and continued to submit affidavits and statements, which indicated his net worth was over $4 million.”

In the, there ain’t any justice department, soon after Symington’s trial, he filled bankruptcy stating that he had maybe $50 - $60 thousand in assets against more than $25 million in liabilities. His mother died six month later leaving him tens of million of dollars in untouchable trusts. (meaning creditors cannot pierce these trusts when attempting to get money out of Symington in spite of existing judgments. When Symington gets out of jail, whenever that may be, he will once again be able to lead the good life, once again being bailed out by his mother.

In spite of the fact that Coopers lost its identity, things worked out for them as well. They hadn’t been doing to well, with all of those law suits and all and were able to arrange a last minute merger with our Pricewaterhouse that saved the partner’s bacon.

I guess you can really say that crime pays big dividends.

Wedtech Corporation, The Whole House Came Apart At The Seams

You have all heard of the South Bronx. The Bronx is one of the five boroughs that make up New York City. When the economy turned down and times became tough in New York, the South Bronx was the first to feel it. People were out of work, they did not pay their rents, without the rent money coming in, the buildings deteriorated and most in the area became so damaged that it had to be destroyed. Ultimately the landscape looked either like a battlefield or a component of the moon. Almost nothing was left standing on the formally productive property of the South Bronx, neither buildings nor bushes, and the residents, most of whom had nowhere to go, ingested drugs in order to make their days more livable while they hung out in front of the burned and bombed out tenements.

New York politicians were looking for just about any solution to the South Bronx state of affairs that they could find. In the first place, the South Bronx population was primarily black and Hispanic which made up a serious part of New York’s electorate. Moreover, the pestilence that was plaguing the South Bronx was gradually being exported into the mainstream of New York life and the number of murders, robberies, and drug selling crimes skyrocketed. The undermanned and underpaid New York Police Department often would not venture into that area themselves and the city could only pray for a savior.

The City and its politicians were constantly on the lookout for some method of making the area both livable and productive again. Schemes like tax-free zones were created in order to be a magnet for business. Additional incentives were fashioned to establish businesses in the area with money being put up by both New York City, New York State and the Federal Government as well. Nobody bit in spite of the fact that the bait was tantalizing. It was beginning to seem that nothing was going to work and when John Mariotta, an uneducated, for the most part, out of work tool and die maker with Puerto Rican ancestry, came along with his plan to create a defense initiative in the area that would put hundreds to work, while simultaneously training countless of the indigent. God had come to the South Bronx and without hesitation, politicians from all of the country wanted to climb on the Mariotta bandwagon.

Not that these characters were trying to be do-gooders; that is not necessarily the way politics is practiced in New York. Putting these people to work and restoring the South Bronx would make anyone involved a sure bet to sway voters in the coming election as that candidate would in all probability carry both the black and Latino votes, big time. Mariotta’s success represented electability and his medicine was what hard money is to a rabid political campaign, ambrosia, the stuff that is only good enough for the gods.

His fledgling company would be involved in everything that voters are about, putting people to work, rebuilding the area, eliminating a drug culture and making a very dangerous neighborhood, safe to live and work in again. No one needed a picture drawn for them, like lemmings, they all jumped on the bandwagon from then, President Reagan on down. Local politicos got involved with the project in the same way rats are attracted to cheese and the chorus became a crescendo with all of the opportunists that were descending upon this little factory in exchange for political recognition. On most days early in the businesses history, there were more politicians on the plant’s premises than workers.

Mariotta’s company was originally named Wellbilt Electronic Die Corporation, which made baby carriages. Then he brought in a partner and they each put up a couple of thousand dollars and name was changed to Wedtech. The company would bid on defense contracts and as a minority manufacturer employing indigent people, they would probably be successful in winning everything that they could handle. Mariotta and his partner, an out of work die maker named Freddie Neuberger soon started to knock them dead. The Federal Government rolled out the red carpet and started designating the facility for every benefit in the government’s repertory.

Freddie Neuberger was a mechanical engineer, an expert metal fabricator, and a member of Mensa. With that combination, Neuberger was able to interpret complex, defectively worded government contracts that no one else could read and understand much less bid on. It was this quirk that really gave Wedtech its flying start. Neuberger was a tough guy that wore expensive suits, smoked long cigars, used complex words that nobody seemed to understand but were offered up in frightening fashion and when he supplemented to them, his fabled frown, that seemed to be embedded into Neuberger’s, it face made him a very scary kind of guy. As if that were not enough, Neuberger always packed heat and whether it was just for show or not, many believed that he would use the object at the drop of a hat.

An example of that was given by many people who knew Neuberger well. Whenever Freddie had a free minute or two he would go out in back of the Wedtech plant, pull out the weapon and start killing rats or whatever else was living back there at the time. The rats may not have been the only things that he did away with as rumors of Neuberger’ s second wife’s bizarre suicide and third wife’s mysterious disappearance always seemed to point right back to him. Neuberger’ s game was fear and he would often boast around the Wedtech Plant about how many people that he had killed as an Israeli commando. Everyone seemed to take him very seriously and not a lot of people were about to call Freddie’s bluff.

Although Mariotta and Neuberger were equal partners at Wedtech, the firm was not really a minority because the government’ criteria was “majority owned.” Neuberger made aware of this minor glitch in his plan, forged some documents, which superficially made Mariotta a 2/3rds partner while the real documents resided in Neuberger’ s safe. It had not taken these two much time to embark on their life of crime, as far as it went.

Mariotta had not been particularly successful in anything that he had touched and Ronald Reagan who was running for election to the Presidency in 1980 needed to affiliate with a winner. It seemed to Reagan’s people that Mariotta couldn’t screw up what was going on the South Bronx if he tried, so they joined the Mariotta bandwagon in earnest. For a time the partnership delivered to each of the participants exactly what they were looking for. Reagan in a speech at the Waldorf introduced Mariotta with the words, "Today, through Wedtech, he not only has built a successful corporation, he's helping hundreds of people who would otherwise be condemned to menial jobs or a life on the dole.” Reagan hitched himself to the right star and for the next several years everything seemed to work as planned. Wedtech had booked over $250 million in orders and a lot of Russian and Hispanic immigrants had become ensconced in productive jobs.

Mariotta and Neuberger were quick learners and started making friends with everyone and anyone they could glad hand in Washington. They bid on non-competitive minority contracts and early on were unsuccessful when their bids always seemed a tad to high, like double or triple the next highest bid. On the other hand, they now had friends in high places and determined to maximize these relationships. Lyn Nofziger took to the brash young men and tried to help. He contacted Elizabeth Dole, then head of the office of public liaison. She twisted an arm or two and soon they were the proud processors of a contract to build $32 million worth of small engines for the army.

So, you had these two partners that were going out to save the world. The first was a supposedly a minority Hispanic who seemed to have few roots to the community and did not understand a word of the language. He had failed at just about everything in life that he had attempted and although Wedtech seemed like the really thing, it could never have survived its management. Neuberger, as we have pointed out seemed to make it clear to any concerned that crossing him would be the fastest way to the grave that anyone could ever conceive of. These people set out to change the world and to some degree, they did.

The only problem was that the whole thing was a fraud and a bunch of people got caught in what happened next.

“Mariotta's firm would become a symbol of one of the nation's worst modern scandals one brimming with shakedowns, pay-offs, thievery, forgery, racketeering, fat-cat lobbying and plain old-fashioned influence-peddling.”

“John Mariotta, the South Bronx success story, would go to jail. And so would a who's who of Bronx politicians: 10-term Rep. Mario Biaggi, a highly decorated ex-cop with mayoral aspirations; the once- promising Rep. Robert Garcia, and Stanley Simon, the Bronx borough president.”

“The web of corruption spread even wider to three retired generals, a couple of politically connected Maryland legislators and a gaggle of political operatives close to Edwin Meese, a White House lawyer and later Reagan's attorney general.”

“In all, 20 government officials, along with Wedtech’ s officers, would be convicted. Meese himself, despite being a Wedtech investor, would be exonerated of any wrongdoing by a special prosecutor.” ([214])

Nofziger was well paid for his help in shares of the company and when a public offering was completed of Wedtech shares he became overjoyed with his new found good fortune. He wasn’t alone in trying to get a good deal. Of all of the politicians that came to call, none was more over-reaching than Mario Biaggi, the senior congressional representative from New York. As Neuberger testifying to in court, “Biaggi threatened to destroy Wedtech unless his law firm was given consulting fees and $1.8 billion in stock.” Neuberger went on to say that the congressman was “like a cop on the beat, putting the arm on the corner bookie.” ([215])

While Biaggi’s demands were absurdly unreasonable, many were met. Everyone else wanted in on the gravy train as well, even if it was just to be a high-paying no show job for a distant relative. Both Mariotta and Neuberger learned that they now had developed a magnet that would attract every politician from miles around. The worm had now turned full circle, instead of being the beneficiaries of political largesse, the boys had now become the donors.

While both Mariotta and Neuberger had become paper multi-millionaires and Reagan had seen his first four years in the White House go smartly by, it was now time for another election and the President once again determined to make Mariotta the key element in his campaign. Wedtech’s income at this point was not keeping pace with its expenses and they had recently discovered that by double-billing the government, lagging cash flow could be improved dramatically. A production line was set up to turn out phony invoices which soon surpassed the astronomical level of $6 billion and simultaneously, Neuberger was slowly eating Mariotta’s lunch. Neuberger thought that Mariotta was to stupid to be of any further use and had him relegated to an inferior position. This was a big mistake as the company could no longer be really considered a minority firm and things soon started to go to hell in a hand basket.

Neuberger was primarily concerned with the fact that he thought that Mariotta was a weak link in all of the criminal transactions that Wedtech was involved in. Neuberger was convinced that should a problem come up, Mariotta would start singing on everybody. With this in mind he initiated discussions with other senior officials about the possibilities of sending Mariotta on an early trip to the great beyond. Neuberger met with everyone including some Teamster officials that were on the Wedtech payroll and discussed the fact the Mariotta could squeal and that wouldn’t bode well for any of them. The teamster people were extremely sympathetic to Neuberger’ s point of view and the demise of Mr. Mariotta was actively pursued until the fraud that was Wedtech was uncovered, and at that point whether the man lived or died no longer mattered.

Another important player in the Wedtech conspiracy was Anthony Guariglia, a highly respected accountant with the firm of KMG Main Hurdman and one day while doing his work, Guariglia found some strange things going on with Wedtech’ s financial statements. At this point Wedtech had been cooking their books for a great number of years. “Obligated under the law to expose his findings, Guariglia opted instead to conceal the company’s fraud and strike a handsome deal to go to work for Wedtech. This was a perfect situation for Wedtech because Guariglia had appeared clean and was intimately knowledgeable about the manner KMG Main Hurdman went about doing their audits. Guariglia was installed as an $80,000-a-year senior officer and received a large block of company stock. By 1984, his salary with bonuses was $155,769 and increasing. During this time, Guariglia also had developed a huge gambling habit, squandering thousands of stolen company dollars in Atlantic City’s glittering casinos.” ([216]) Guariglia had indeed become a trusted employee and merrily went about leading the Main Hurdman people down Wedtech’ s South Bronx garden path.

Neuberger, Mariotta and Guariglia were joined in their endeavor by Mario Marino, Neuberger’ s right hand person. Mareno was the Hispanic that Mariotta could not be, the mingler that Neuberger because of his gruff demeanor was not and as an academic, a person that could figure how to get things done in a hurry. Marino was a diseased gambler that was so warped that at times it was more important for him to be at the tables than to be tending to business. On the other hand, he lived such an inconspicuous life away from gambling, that it was literally incongruous. He owned a small home in the Bronx that cost him $80,000 and secretly furnished it with almost a million dollars stolen from Wedtech, including an opulent swimming pool and an upscale greenhouse.

Two years later, in 1986, Wedtech went under and the as the regulators started to move in, the canaries began to sing in unison in exchange for lighter sentences. Mariotta was convicted of running a racketeering enterprise, tax fraud, and bribery. Simon, Garcia, and Biaggi ([217]) along with others were found guilty of racketeering and extortion. Nofziger was indicted as well. Garcia and Nofziger later were exonerated but they had already been too closely tied to Wedtech and its strange goings on to ever regain their former stature ([218]).

Among the charges against Wedtech was that it really wasn’t a minority firm. In addition, Wedtech was charged with selling securities to the public based on totally fictitious financials and flawed projections. It is interesting to note that Wedtech at all times had a negative net worth and lost money on every single contract that it ever received. Yet, the accountants certified the totally fraudulent numbers causing the public and probably the government as well to lose $100’s of millions of dollars. The litigation went on for six years and it was ultimately determined that accountants, Peat Marwick Main, successor to KING Main Hurdman and Touche Ross & Company, were derelict in doing their accounting, that the underwriters hadn’t done their due-diligence for the public offering and the law firms representing the corporation had been even less that forthcoming. Thus, although the Securities & Exchange Commission never took action in the case, probably because of the harm it would have done to many high-ranking political figures, a substantial recovery was made for the shareholders and creditors from funds recovered from the under-performing professionals. The total recovery was $77.5 million, the most ever recovered in a class action to that date and it equaled almost seventy percent of the total losses incurred.

In allied Wedtech maters, Alphonse D’Amato had received an illegal campaign contribution from the company in exchange for the Senator’s help in securing military contractors. In the meantime, D’Amato became a substantial advocate of Wedtech causes. Wedtech subcontracted with a company by the name of Steamco for a job that D’Amato had secured for the Wedtech. Steamco also had contributed to the D’Amato fund raising campaign. D’Amato’s former Chief of Staff, John Zagame was went to work for Steamco. Steamco was barely into the deal when Wedtech tanked causing D’Amato an extreme case of stomach problems.

We’ve seen a lot of important people fall by the wayside because of the shenanigans pulled off by the Wedtech people and most of it was pretty serious stuff. In the just having fun department, the gremlins that seemed to follow Wedtech were not finished yet. The company was bankrupt and yet the facility was still in reasonably good shape. The Board of Education of New York thought that the manufacturing facility could be easily converted into a school. Thus, the school board entered into an agreement with which they believed were the then owners of the property to lease it for 15 years at a rental of $12 million of the life of the lease. In addition, the board agreed to put in another $12 million in alterations in order to facilitate a 1,000-student high school.

The only problem with the deal was the fact that the people with whom the Board of Education entered into their agreement did not own the property. Once the agreement with the Board was inked, the Holand family of the Bronx purchased the property for $400,000 at a foreclosure sale. In reality, they already held a mortgage on the property for $400,000 so they were able to literally pay themselves the money for making the transaction. In effect what had occurred was that they now had a property that was free and clear of any encumbrances and were ready to embark on a new and more lucrative transaction with the brain dead, New York City Board of Education. To add insult to injury, the mortgage originally was $6 million which the Holand’s purchased for $400,000 when the owners of the mortgage were led by the purchasers to believe that nobody would probably ever again be interested in this bad-luck property.

Naturally, the Holand family had brought in some serious talent to finesse the deal’s timing. They hired Robert A. Shahid who had been a supervisor in the Board of Educations real estate division where he had overruled an architect’s finding that indicated that the property was unsuitable to be used as a school. It turns out that Shahid did not only grant the Holand family the benefit of his wisdom, but he did the same for a number of others after he left the board.

Shadid didn’t seem to think that he was breaking the law but the stench from what he had done caused a total stoppage of a $170 million conversion scheme. For whatever it is worth, the New York City Board of Education conflict-of-interest law forbids former employees for being paid for thing that they were in charge of while employed by the city government.

Chainsaw Al Dunlap Defoliates Sunbeam

Sunbeam, which was founded in 1897 by two partners, John Stewart and Thomas Clark under the name Chicago Flexible Shaft Company, was an industry innovator in many spheres and enjoyed a well-earned reputation for superior products. Originally, the company started corporate life as a manufacturer of agricultural tools, the accomplished partners soon saw that a market existed for superior kitchen utensils. Soon innovations like the first automatic coffee maker, first pop-up toaster and the first Mixmaster started rolling off the assembly lines to the delight of upscale housewives.

Chicago Flexible became Sunbeam in 1946, in a move that management felt more adequately reflected the non-agricultural business that for some time had been the company's principal business. The Sunbeam acquisition of Oster gave the company a full product line and made it appear very attractive to companies that wanted the creditability of name brand products along with top-flight management. Sunbeam was favorably compared to General Electric, which was widely regarding to hold the industry top spot.

Sunbeam, in reality, shone out above the crowd and it didn't take long for another Chicago based company, IC Industries, the old Illinois Central Railroad who had been on an acquisition kick to take a serious interest. In 1980, they made an unfriendly tender offer and in the middle of series negotiations between the two companies, Alleghany International headed by Robert Buckley, toped the bid and the company became a division of Alleghany.

Buckley had a thirst for high living at company expense along with an ego that required a constant flow of acquisitions and accolades. Not all of Buckley's deals were profitable and his style of living creating an enormous drain on corporate profits, soon Sunbeam became nothing short of a cash cow for Alleghany. Funds were up-streamed into the parent at an alarming rate and the infrastructure along with new product development were left to die on the vine.

Buckley made one bad decision after another and was relieved of his management position in 1986. The company’s senior administration went into divestiture frenzy and sold divisions while laying off thousands. When the smoke had cleared, things had gone from bad to worse and in 1987and the company filed for reorganization under Chapter 11 of the bankruptcy code. Paul B. Kazarian, an ex-Goldman Sachs official with the backing of two large hedge fund shareholders took charge of the company after several years of heated proxy battles. Kazarian turned out to be made of the right stuff and quickly turned the company around. On the other hand, many considered Kazarian's management style bizarre and another palace coup was strung together by the same hedge funds that had put him into office.

This time a former high-ranking official from General Electric, Roger Schipke was given the mantel at Sunbeam to see what he could do about turning things around. Schipke had created a great name for himself in the corporate culture of General Electric by working long hours and bringing home the bottom line. Ultimately, Schipke had to take leave from GE because he had worked himself right into the ground. On the other hand, apparently Schipke just didn't have the background to work for a company that was trying to dig itself out of hole. In addition, Schipke was a high-grade individual that may not have had the necessary tools to be in that top job which required trench warfare and probably a complete a reorganization.

Enter, stage left, Al Dunlap who had made quite a name himself on Wall Street as a no-nonsense guy who could turn a company around under the most difficult of conditions. Al never took any prisoners and seemingly had no friends. Turning a company around was war and in the heat of battle, the motto was win or perish. Perhaps that is how he got the nickname Chainsaw Al and it certainly showed where he came from. On the other hand, the real origin of the nickname according to Dunlap was that it was given to him by "John Aspinall, a British Naturalist who had said that he was like a chainsaw that cuts away the fat and leaves a great sculpture. Dunlap joked that the epithet made him sound like a serial killer. He much preferred the designation given to him by his mentor, Sir James Goldsmith, who dubbed his American friend, "Rambo in Pinstripes." ([219])

Al was a graduate of West Point where he received his early directives on trench warfare and fought the good fight everyday of his life. On the other hand, he graduated near the bottom of his class at the point and for that reason figured out that he wasn’t going anywhere in the military. Al got out as soon as he served the time he had committed for as he additionally determined that there were not going to be any big wars coming up that could enhance his chance of promotion. In the meantime, at home Al was totally loathsome to his wife and child and in spite of her firm Catholic roots, she despised Al so thoroughly that she was willing to sign off on a divorce that only granted her $15 a month in alimony. His family received no better treatment. In order to make himself appear more a self made man than he really was, Al made up the story that he came from extremely poor parents and had to fight for everything he ever got.

According to family members, Al was delusional and none of that ever occurred, but it didn't really matter because Al had determined that he wanted nothing more to do with his family. In spite of Dunlap's quick temper and inability to get along with anyone close to him, he needed to bring in his troops to do the dirty work when it came to firing people. He talked a good game but when the chips were down, he left the dirty work to his lieutenants to carry out. On the other hand, by this time, Sunbeam was hardly a prize, Its factories were old and out-of-date, its products were uncompetitive having been last redesigned over a decade before, and new and fierce competition had entered the marketplace such as Black & Decker. Sunbeam's warranties were costing the company a fortune because of the company’s mediocre quality controls. The prestigious name recognition which Sunbeam had relied upon was fast becoming history as non-homogeneous logos replaced the consistency of recognition that the company had once known.

When the final chapter on Sunbeam and its was written and analysis of how it had fared under Al’s guidance many said that Al’s preordained epitaph had to be revised a bit since recent information has been released and the original title which was to be, “If you want a turnaround, Al’s your guy.” The revisionists have changed the title to, “When it comes to pillaging a company, Chainsaw has never had an equal.” What original appeared to be good management, in retrospect now appears to have been an act of, working a bonus pool out for himself relative to reducing costs at any price and just as Sherman did to Atlanta, burn what remained to the ground, gut it and line up at the pay window to collect the proffered bonus. Interesting enough, as it related to Chainsaw Al, the second he left the pay window he socked his loot away in government securities so that he could not be taken in by anyone else’s claim at corporate restoration. Chainsaw Al knew better.

In retrospect, Chainsaw’s only real success was at Scott Paper where he did his usual quadruple amputation on management and personnel. Somehow, not only did Wall Street buy his act, but as though a gift from God, the stock skyrocketed when a purchase of the company was arranged buy Kimberly-Clark, whose management seemed to be mesmerized by the public relations material being released by Hacksaw’s public relations people. They thought that indeed, he had performed a turnaround miracle. This bailed out all of the pathetic souls that had this not happened would have seen the real result of Al’s handiwork in the price of their shares. On he other hand, Kimberly-Clark was left holding one enormous bag. Chainsaw Al had left them with so much excess inventory that what was supposed to be a $100 million fourth quarter profit for Scott mystically turned into a $60 million loss. By that time though, Al was gone and $100 million richer in Kimberly stock.

Al cashed in and moved on to Sunbeam Corporation and was originally looked upon as the second coming. At first no one really caught on to the fact that Sunbeam was all hype and no substance.

While Al was sending employees to the unemployment lines with his glib comments about the fact that it was either him or Doctor Kevorkian, his dogs, Cadet III & Brit, were doing living in style at a suite in a posh hotel near the Sunbeam plant. Some said, maybe he should have treated his employees as dogs, then they would have been better off. Dunlap's will called for his bodyguard to get custody of the dogs, with $1 million for each mutt to maintain the lifestyle to which it had become accustomed. By comparison, Dunlap did not attend the funerals of his mother or father. He had virtually no contact with his first son, Troy. Dunlap did call his son after the boy talked to a reporter about the old man. ([220])

"You may get your five minutes of fame," Dunlap told his son. "but I guarantee you and your mother a lifetime of aggravation." ([221]) These and other pleasant stories about Al tell us a little about the man himself. The Chainsaw man had so many threats against his life that he walked around wearing a bulletproof vest not to speak of the omnipresent bodyguards that followed him everywhere he went.

The Business Week story of September 24, 1998, Where are the Accountants?, quick makes a most interesting point:

“To take just one of the headline screamers, how did auditor Andersen miss the red flags at Sunbeam Corp. last year, when inventories began piling up and accounts receivables soared? Chief Executive Albert Dunlap had never been exactly reticent about his desire to do all he could to keep his high-octane stock levitating. So shouldn’t someone have noticed when the company reported surging sales of heating blankets in the summer and barbecue grills in the late fall? Yet at a board meeting on June 9, a partner at Anderson assured Sunbeam directors that the 1997 number complied with standard accounting procedures. Four days later, the scheme unraveling, Dunlap was fired. Sunbeam later acknowledged it was booking sales before the goods were actually delivered to stores.”

Naturally the Securities and Exchange Commission’s interest was peaked by this strange story and Sunbeam publicly announced this event, shareholders ran for the hills. Al was terrific with the books, he turned operating expenses into restructuring charges and then capitalized them, a most bizarre accounting maneuver. Having done that, for an encore he booked sales before the goods had been shipped, making earnings soar and the stock rise. If that hadn’t been enough, in order to bring in short term earnings he guaranteed merchants discounts but only after sales had been made at retail. In other words, when he sold the goods to merchants he had dramatically higher immediate net but no accounting hit because the goods had to be sold in order for the rebate to kick in. When it kicked in, Al was kicked out because the bottom fell out. He had sold the company’s future for immediate earnings. Al, in typical Chainsaw fashion indicated that he was unaware of any accounting irregularities that had occurred at Sunbeam.

His creative accounting forced an earnings restatement and all of 1997 dropped into the toilet from $1.41 that had been reported to $.60. In addition the first quarter loss was raised by about 20% on readjustment. The Inventory losses are still to come. With all of that, I guess you would tend to believe that Sunbeam and Al Dunlap are not exactly on friendly terms. Well, tough times make strange bedfellows is the only way we see it. Both Al and the company are both facing massive litigation from shareholders and investigations from the SEC. Deloite & Touche has been brought in to draw up a bill of particulars relative to who did what to whom and when they have concluded their investigation, the fur is really going to fly. In the meantime, it seems wise that Andersen and Dunlap work together to defuse as much of the potential damage as possible. A commonality of interest has been agreed upon with mutual decision being made that the accountants and Dunlap did it all.

The real problem that occurred while Al was at Sunbeam was the fact that the accountants at Anderson were somewhat awed by his previous reputation. They sat idly by when Al said he was going to do this or that even though they knew or should have known that this would have come back to haunt them all. Now, of course that part of Al’s mission was to not only to fire as many people as possible but also to cook the books in sterling fashion in order to goose the stock. Pathetically, Anderson went along with the game without a whimper.

Today Al lives in Florida in a multimillion-dollar home, not to far from where he used to work at Scott Paper. There are a lot of people out there that would still like to get a piece of Chainsaw Al and guards are with Al wherever he goes. Was making all this money on the backs of working people really worth it Al?

Mattel & Barbie and Their Legacy

I know this is going to seem hard to believe, but Mattel, the people that make Barbie and all of her friends started as a toy maker right after World War II had ended. Ruth and Elliot Handler, the company’s founders along with Harold Matson who did not stick around very long, didn’t get around to designing “Babs” ([222]) until 1959, but, then again, we are getting ahead of our story.

Elliot was a stay had home designer and Ruth was a whirlwind. She handled corporate affairs while also pushing the company’s sales. They made a pretty good team and by 1955, the company had assets of $500,000. Ruth had an idea, the new Mickey Mouse Club had just hit television and every kid in the United States became glued to their televisions when the musketeers were on. Ruth thought that it would make a lot of sense to advertise on that show if the Handlers and Mattel were ever going to get to the big leagues. Elliot noted that the company had been growing well, they were well fixed and the ads on the Disney program were gong to cost an arm and a leg. So much so, that if the idea didn’t work, if could well jeopardize the entire company.

Ruth won the argument and Mattel invested the requisite 40% of their assets to become one of the show’s sponsors. The idea clicked and Mattel had immediately joined the big leagues. Their distribution and production were now growing exponentially and they needed new products to throw into the mix. Four years latter, Barbie was introduced, once again by the sheer willpower of Ruth, who was told by literally everyone that a full figured doll didn’t have a chance with the prepubescent female market. It is coincidental that the concept for Barbie came from three almost pornographic, European, Lilli dolls. This concept totally changed the way dolls were marketed. After all, Barbie’s measurements according to engineers would have weighed in at 39-18-33 had they been translated to the human scale. At that point in time, all dolls had been babies that the child could take care of, with Barbie; it seemed to fulfill a vision of the future for the child. Once again, the world was proven wrong and Ruth was right.

Today, Barbie dolls are sold in 160 countries around the world and over one billion have been produced in one form or another. A Barbie fan club was started and within a decade, there were 600,000 members, more members than any other organization catering to girls of this age group, other than the Girl Scouts. Soon Barbie’s success also brought her detractors and many felt that the doll had become a sex symbol. This was countered by the introduction of Midge who was followed by Barbie’s black cousin Francine. This seemed to calm the waters a bit and today, the average American girl between the ages of three and eleven owns the staggering average of 10 Barbie dolls and in Italy, France and Germany the average is five.

Barbie went through transformations as the time changed and we had, Malibu Barbie, aerobics workout Barbie, yuppie Barbie complete with credit card, Dr. Barbie and Astronaut Barbie among others. Moreover, each one had to have their own set of clothes and their own accoutrements. The Handlers had named their original doll, Barbie after their daughter Barbara. They thought that it was time that Barbie had a handsome consort and what better a name to use then Ken after the name of their son, Kenneth. Ken was a handsome lad, but as opposed to Barbie, there was no way of determining whether he was atomically correct because he wore non-removable shorts. A twist that the innovators thought would work better, concerning the little girl market that they were aiming at.

Ultimately, an official Barbie museum was created in Palo Alto and soon thereafter, a Barbie website was sprang into being. Barbie’s were non-sectarian and came from all parts of the globe. There was an Islamic Barbie for the Arab countries, there was a Hispanic Barbie for the Spanish and Portuguese speaking countries and there was Chinese Barbie to cover most of the rest of the world.

Ruth had been right consistently and she started to believe in her own press clippings. Mrs. Handler believed that she was a special person and that with her drive and intellect, she could not know failure. With this in mind, the company hired Seymour Rosenberg a Litton industry alumnus. Rosenberg came from a culture where you grew by acquisition; a very different formula then had been used by the Handler’s whose growth to that point was entirely internal. Rosenberg told the Handlers that the fact that their stock was selling at an extremely high multiple to earnings could be used to his advantage in making, relatively inexpensive acquisitions in exchange for equity.

The Handlers and the rest of the board bought the story unreservedly. Rosenberg pointed out that Mattel’s current structure did not lend itself to diverse acquisitions because management and distribution were so centralized. By breaking the company into a number of autonomous division, the board determined that the company’s expenses would go up substantially. Moreover, Rosenberg had knocked them dead at Litton and there was no reason that he couldn’t do it again.

Well, as you know in life, not everything always goes the way we plan it and instead of exponentially growing the company, Rosenberg had brought in a bunch of pretty ghastly deals. Because the company had de-centralized, the cost of operating the new companies started to eat Mattel’s lunch and in short order a series events occurred that could not have been worse for Barbie and her friends. Mattel’s general business started to slow down because of the general economics of the period, a critical warehouse in Mexico went up in flames just as Mattel was getting into its season and a longshoreman’s strike in the Pacific Rim prevented important shipments from getting to the United States.

Rosenberg’s concept clearly had not worked and it was determined that the company should once again centralize its operation, eliminate the under performing ex-Litton hotshot and go back to what they knew how to do best before they went under. The board elevated one of the company’s own employee’s, Albert Spear, to put Humpty Dumpty together again. Spear started his new position by becoming more familiar with the company’s books. The more he uncovered the more uncomfortable he became. Ultimately, he was absolutely certain that Mattel’s books were being systematically cooked and had been for some period of time.

When this information was released to the in 1974, everyone went bonkers. The stock tanked, the Securities & Exchange Commission paid the company a very serious visit and the shareholders filled actions against everyone in sight, including Arthur Andersen, under whose watch the catastrophe had occurred. The outside directors instituted an investigation and soon found that the company’s executive officers including both of the Handler’s, had been in on the deception and that it had been going on for some time. The Board summarily asked for the Handler’s resignations and hired Price Waterhouse to analyze what had actually occurred. Price was not particularly kind to Anderson and stated that: In general, Price Waterhouse concluded that Arthur Andersen’s audit procedures and tests weren’t as comprehensive as they should have been in many areas and that certain information contained in the accountant’s working papers should have been further pursued. If this had been done, it could have led to the discovery of irregularities in the fiscal 1971 and 1972 financial statements.” ([223])

The class action that was commenced against all concerned was settled in March of 1976 and contributions were made by the insurance company’s, the former executives, the Handlers, Rosenberg and Arthur Andersen who was led into the settlement kicking and screaming that they had done no wrong. This reluctance to settle by Andersen came in spite of the fact that the Securities & Exchange Commission had already indicated that what Price Waterhouse had told Mattel’s Board was essentially correct. If Andersen had done their job with a little more vigor, the SEC indicated that they believed that underlying problems would have been discovered substantially earlier and investors would have been substantially better off. The government was not finished with their campaign against former management and a grand jury indicted Rosenberg, Ruth Handler and four other executives of falsifying financial statements.

Mattel was using a number of methods of inflating sales simultaneously. They would internally book sales that had not yet been shipped with the simple rouse of having their shipping clerks forge the carrier’s copy of the bill of lading. What this created though was even worse for the company than the crime itself. The company as we had point out earlier had gone back to centralized management and warehouses. As the amount of unshipped merchandise grew, those inventories were bundled with the normal inventories. This caused several additional problems; no physical inventory audit could be meaningful or even carried out because the latent discrepancies would immediately be discovered. One company’s shipments were being homogenized with those of others. Shipments became inexact and generally the warehouse which had previously run like a well oil machine was now grunting and groaning under the pressures of keeping the “con” alive.

In reality, the amount of man-hours that were being used to facilitate the cover-up became too substantial and the company ultimately determined to render null and void the previous transaction. The only way that the gross sales numbers could be reversed without everyone going directly to jail for financial fraud would be to borrow sales from the future. Everyone seemed to agree that they would take a little bit from each period and no one would ever be any the wiser. The only problem was that when they started undoing their nefarious plot, seasonally, some months were showing negative sales, hardly the thing to report when your stock is selling at 50 times earnings and you are supposed to be a growth company.

The brain trust once again convened and came up with what proved to be a totally unsatisfactory solution to the problem. They went back to their earlier shenanigans for just one month, May 1971 and once again created $11 million in sales to cover up what would have been a disastrous month. Moreover, the plotters recorded their handy work in the general ledger but not in their accounts receivable ledger. Now, instead of the warehouses being totally screwed up, the books had become a catastrophe as well.

As the year progressed, sales finally turned a tad better than expected and it was determined to steal some of those sales and make the books balance. This was all well in good but the game essentially was already over. By moving sales out of the current year, the company was now understating their earnings and sales, a financial prestidigitation almost equally as illegal as what they were correcting. The Securities and Exchange Commission indicated that the accounting manipulations should not have been difficult to spot and that Andersen had pure and simply “blown it”. Furthermore, Andersen had been shown to be quite capable in their job of sending confirmations to Mattel clients. The only problem was that Andersen auditor’s never bothered to ask management what the term “bill & hold” meant. ([224])” The Andersen auditors never realized that the two signatures on most of the bills of lading both belonged to Mattel employees and additionally they never noticed that they “bill & hold” oriented slips were never properly filled out.

In spite of finding the reversing entries, Andersen never properly followed them up and therefore never found the fraud. Numerous additional methods were used to deceive the shareholders, confuse the accountants and in general to subvert the financial reporting process. One of the most egregious things that Mattel management did was to substantially underpay on royalties by constantly moving their break-even date forward. This was done by assigning non-relevant costs to items that were produced under royalty agreements. This jacked up their short term earnings while effectively stealing money from their licensors.

Mattel used the accounting term, “deferred tooling costs” to elevate their earnings. All that was necessary for Mattel to write off the expenses associated with product development over a substantially longer period of time than would normally be the case. In this instance, Andersen caught Mattel officials with their hands in the cookie jar, over and over again, but that did not dissuade the book cookers from going back and using the same subterfuge over and over again. Andersen allowed Mattel to substantially fudge their figures on industry obsolesce and in a number of cases, substantial amounts of goods were held in inventory at values that did not come close to reflecting their true worth.

The SEC had several things to say about Andersen letting Mattel get away with all of this. They felt that Andersen had accepted management’s characterizations “with little or no verification of documentation.” They went one to indicate Andersen’s lacked enough in-depth knowledge of the industry they were auditing, “Auditors must acquire and apply sufficient knowledge of their clients’ industries to enable them to intelligently audit their business operations and to evaluate the client’s explanations of those operations.” The Securities & Exchange Commission also criticized Andersen’s approach in conducting the audit itself and that they had exhibited, “insufficient control, coordination, and supervision’ during the Mattel audits.” Ultimately, Andersen was censured by the SEC for their shoddy audit.

Mattel bit the bullet and ultimately things returned to normalcy. Old management had gone on to other pastures and new people had been brought in to take over. On the other hand, something seemed to be in the water that wouldn’t go away. In November of 1997, most of the Attorneys General in the United States filed an antitrust action again Mattel and a few others for literally acting in restraint of trade relative to their distribution of their merchandise. In settling the matter, Mattel agreed to deliver almost $1 million in toys to the states over three consecutive holiday seasons ending in December of 1999. Furthermore, the agreement required Mattel to provide a broad variety of toys from its current inventory, and instead, Mattel shipped a limited variety of toys that were outdated or impractical.

Mattel had gotten themselves into another public relations nightmare as the announcement was made concerning Mattel’s actions that “Not only did Mattel violate the agreement, but worse, it knew that the see toys were to be distributed through the Marine Corps’ Toys for Tots program. Mattel’s actions could have potentially disappointed thousands of underprivileged children across the country that might not receive any other presents at Christmas. Among the toys that were delivered to the states were empty Hot Wheels collector car cases, small plastic Belle dolls from the 1991 Disney movie “Beauty and the Beast and plastic 101 Dalmatian puppies that are designed to wet.

The advertising guys saw a nightmare in the making since Mattel had tried to cut corners in their own market, the kids. The State’s Attorney Generals were going to have Mattel on a platter for Christmas and before they got done, the company was going to make Scrooge look like the most benevolent human being that had ever lived. Give them anything they want hollered the PR people who saw themselves in bread lines over the holidays unless some fast action was taken. Mattel didn’t even have time to think about what they were going to do. They grabbed double the number of toys right off their current production line, that they had originally been obligated to deliver, out of their current inventory and had it literally hand carried to the Marine Headquarters Philadelphia. This seemed to satisfy the regulators and a happy Christmas was to be had by all.

However, the company was still accident prone to say the least and on October 4, 1999, Mattel announced that they would miss forecasts by as much as 55 percent because of slow software sales. Primarily, this loss stemmed from the recently acquired Learning Company, which not only didn’t make optimistic projections but the $3.6 billion acquisition apparently, was not anywhere near the synergistic fit that the company had predicted. The stock had its biggest one-day drop in almost seven years and was selling at only 25% of its price a year earlier.

The lawyers started sharpening their pencils and before you could blink an eye, any number of lawsuits were filed against officers and directors of the company. It turned out that although most of Mattel was operating at or close to projections, The Learning Company was a disaster waiting to happen. Mattel announced that the division would produce a loss of as much as $100 million. In addition, Mattel indicated that their costs had skyrocketed in the areas of advertising and promotion. Moreover, there would be a massive write-off of bad debt at their software division.

To simplify your understanding of what the shareholders thought had happened we are going to give a one paragraph quote from the lawsuit filed by Cohen, Milstein, Hausfeld & Toll, P.L.L.C,

“The complaint alleges that throughout the Class Period, Mattel and its officers and directors falsely represented that The Learning company was an excellent strategic fit with Mattel’s business and that its acquisition would be immediately accretive to Mattel’s 1999 and 2000 results. Based on these representations, the price of Mattel, Inc. common stock rose to a Class Period high of $30 5/16 per share during the critical acquisition; pricing period between April 1999 and May, 1999. Then, just a few months after The Learning Company acquisition closed, Mattel disclosed that The Learning Company had experience millions of dollars in product returns and bad debt write-offs and that The Learning Company would incur a $50 to $100 million loss rather than the large profit forecast for third quarter of 1999.”

We are not going to get into long song and dance over what happened because the jury is still out. Nevertheless, there is not much question that either someone did a big time job of screwing up the due-diligence process or in the alternative there was fraud committed upon Mattel. That of course can not be explained away simply by saying that the Learning Company people turned out to be bad guys. It takes two to make an acquisition and if Mattel, their attorneys, accountants and investment bankers had looked closely into the situation they would certainly have discovered that al of the elements at The Learning Company had already seen better days. In spite of its great branded labels such as National Geographic, Carmen Sandiego, American Greetings and the Myst, they were all apparently headed south. The joint proxy seemed to concur:

“The Mattel board reviewed pro forma financial data for Mattel and Learning Company after giving effect to the merger. The Mattel board considered favorably the expectation that the combined company might be able to realize synergies in its combined operations. The Mattel board also considered the potential cost savings, preliminarily estimated by Mattel’s management to be approximately $20 million to $25 million annually, that could result from the consolidation of administrative and support function, including the elimination of duplicative expenses such as public reporting and investor relations expenses, the combination of sales force capabilities and the increased leverage of the combined company’s execution management team.”

The charges against the company where many and varied. Shareholders stated that the financial results for the 3^rd and 4^th quarters of 1998 were artificially inflated. The Learning Company recorded revenue on “sales’ where it had granted the right to return unsold merchandise thus none of those sales could legally have been recorded until the company was assured that the merchandise was not coming back. The Learning Company’s software business was performing much more poorly than had been publicly represented. To conceal the very troubled nature of this business and make The Learning Company appear more attractive, The Learning Company’s top executives were granting customers rights of return and other contingencies to boost reported sales of their products. The fact that the combination of the two companies would instead of having a positive effect would result in no revenue growth and in reality, revenue declines. That there was actually no synergy at all in the combination and in fact, The Learning Company had been able to talk their way into merger discussions with Mattel by revenue manipulations.

These statements seem to be born out by the fact that the two senior officers of The Learning Company, Kevin O’Leary and Michael Perik had unloaded enormous amounts of freely tradable Mattel stock just a short time before the lowered earnings projections were due out. It these guys weren’t totally aware of what was going on, why on earth would they have chosen that point in time to make a sale as transparent as this one. If indeed they knew what the earnings would be, they probably are guilty of insider trading. Both of these fine gentlemen sold almost everything they had. A great vote of confidence for everyone concerned.

Although many other companies have made serious mistakes and come back to achieve successes, Mattel with its tremendous brand recognition seems constantly in a position of an accident waiting to happen. To have gotten into two instances of cooked books and one major problem with the State Attorney’s General, you would have thought that these people would have learned from their mistakes. Sadly, that is not the case and we have not yet heard the end of this particular problem.

Yale Express, Life In The Fast Lane

Yale Express was started in 1938 by Benjamin Eskow and had shown almost continuous growth during the next several decades. Yale Express was in the short haul trucking business which was substantially aided by World War II and the economy that succeeded it. Business remained so good that ultimately the company went public, and a substantial portion of the shares remained owned by the Eskow Family.

Over the course of years, Gerald Eskow, Benjamin’s 39 year old son took over as President and Chief Executive of the company. Gerald’s work ethic was excellent and he became totally focused on building on what his father had created and showing the world that he was every bit the man his father was. It was the younger Eskow that embarked the company on a dynamic expansion program.

In 1963, Yale Express Systems acquired Republic Carloading & Distributing Company, a freight forwarder. The freight forwarding business consisted of taking less than carload lots, consolidating them to make larger shipments, which would result in an economy of scale. The acquisition seemed a natural because Yale could handle a lot of the business that Republic was putting together. Furthermore, there would be substantial economies of scale and the two companies could be operated with substantially less personnel than currently was the case. The Republic management did not mind being taken over because Yale Express stock had done very well and that company was growing even faster than was Republic. The deal was consummated by an exchange of stock in the two companies and managements of the companies were integrated with Yale keeping the top executive jobs. However, what looked like a sweet deal was really the beginning of the end for Yale.

Republic retained its identity as a wholly owned subsidiary of Yale Express and the job of treasurer went to long time Republic employee, Irving Goldberg. Goldberg in the role of treasurer also was in charge of the accounting function and due to the fact that Yale Express was smaller than its own subsidiary, the function that Goldberg ran was critically relative to reporting of earnings. Yale Express had achieved substantial growth over the years by among other things, using aggressive accounting tactics. On the other hand, Goldberg came from the old school and played financial numbers by the book. When the two cultures combined, it was never discussed that the two companies would ultimately have a real problem relative to meshing conflicting philosophies in filing consolidated earnings statements.

On the other hand, Peat Marwick had been Yale Express’s outside auditors for some time and had gone along to a large degree with the company’s aggressive accounting tactics so that it was felt they would bear a significant enough influence on Republic’s Goldberg to solve any internal arguments relative to financial reporting. Goldberg’s boss at Yale Express was a gentleman by the name of Fred Mackensen who held the title, of administrative vice president. Mackensen had been instrumental in Yale’s acquisition of Republic and both he and Goldberg had developed a cordial relationship during the time when the two companies had negotiated their combination.

Mackensen looked at the overall numbers that Yale Express had generated during the previous period and believed that a little creative accounting by all concerned could make the overall numbers appear more like something Wall Street would be pleased with. He went to Goldberg and told him to change the numbers so that a $250,000 profit would replace the recent loss that Republic had racked up. Four months later, Mackensen was back at Goldberg’s desk complaining about what had now become a $900,000 loss and ordered Goldberg to use his efforts to reduce the loss to $100,000.

The two apparently started fighting like cats and dogs over what the correct numbers ought to have been. Republic being a freight forwarder had as their major expense, the direct cost of shipping customer’s goods. One of the problems that the industry had was timely reporting. Transportation companies were notoriously slow in getting out their bills and when this happened over a cutoff period for reporting, companies were normally forced to estimate what that amount should realistically be. This number had remained a fairly constant 84% of transportation charges for many years. When Mackensen suddenly determined that the number should be 78%, Goldberg went ballistic but was ultimately convinced that for the benefit of the business he should go along. Goldberg in spite of his better judgment was the signature to a report that was filed with the Interstate Commerce Commission by Republic.

This was not a great move for Goldberg as the following year; Yale Express executives used the phony report in securing a loan from a group of insurance companies. Retrospectively, Goldberg’s only excuse for his actions was the fact that he had been put under extreme duress by Mackensen and other Yale Express executives. He had been told that without his going along the company would be wrecked and various statement were bandied about relative to the effect that Goldberg was not a team player.

Goldberg testified that not only had he raised grave questions about the materiality of the accounting issues but the outside auditors did as well. According to Goldberg, Peat Marwick asked Yale Express management to substantially raise its transportation expense accrual and then for some bizarre reason or other compromised on the number even though they knew it was totally inaccurate. In a shareholders class action that was filled sometime later, after Yale Express had gone under, one of the principal complaints against Peat Marwick was the fact that they had been put on notice about a problem and had done nothing about it. The judge in the case indicated that:

“The elements of good faith and common honesty which govern the businessman presumably should also apply to the independent public accountant…the common Law has long required that a person who has made a representation must correct that representation if it becomes false and if he knows that people are relying on it.” ([225])

Goldberg suffered a nervous breakdown and took a leave of absence from Republic. He had remained under sedation and the care of doctors for some time until he felt well enough to return to work. Upon his return, he learned that he had been demoted to a low level clerk’s job. Needing the money because of his medical bills, Goldberg took the demotion in stride and effectively believed that the lesser position would not be a stressful. He shortly learned to the contrary.

Goldberg upon his return soon found out that while he was gone, Mackensen was once again playing fast and loose with the transportation expense numbers and reported the mater to the Yale Express Board of Directors. Logically enough, Peat Marwick was assigned to look into Goldberg’s allegations. Peat Marwick indicated that Goldberg had been substantially correct and that the profit that Yale Express had shown the previous year should have been a substantial loss. This report did not fully assuage Goldberg and as he saw it, Yale Express’s financial condition was getting worse by the day. He indicated to the Chief Executive Officer of Yale Express, Gerald Eskow that if something wasn’t done, and quickly, Yale Express would soon be a bankruptcy candidate.

Eskow suggested that Goldberg still had his head screwed on wrong and was not the sort of employee that the company needed. He indicated that it would be in everyone’s best interest if Goldberg submitted his resignation at his earliest convenience. When Goldberg hesitated at resigning, he was summarily fired by Mackensen who indicated that the clerk’s position, which Goldberg occupied, had been summarily phased out by upper management.

Just as Goldberg predicted, the pigeons ultimately came home to roast. In short order, the financial fraud at Yale Express was uncovered, senior management was bounced, the company filed for bankruptcy reorganization and Eskow and Mackensen were convicted of more than thirty counts of fraud. As happens in these cases, several class action lawsuits were filed against the company, its officers, and the deep-pocketed Peat Marwick. These lawsuits were ultimately settled by all concerned.

This a pure case of greed on the part of Yale Express management, one of survival on the part of Goldberg who apparently really needed the income that the job was providing and a case confusion relative to the outside accountants, Peat Marwick. This situation puts Peat Marwick’s role somewhere between that of a co-conspirator and that of an inferior accounting firm. Early on, Goldberg had informed Peat Marwick as to what was going on. This did not happen once but it happened at least twice. In spite of that, they signed off on the books in a way that was not in keeping with standard accounting practices. They were well aware of what they were dealing with in the bizarre Yale Express management group but they were neither forceful in making their points for change nor did they resign at the point at which it would have become their only alternative.

Most important they knew that in Goldberg they were dealing with at best a loose cannon that had already spent some time at the funny farm over what was going on. They could have bet the ranch that when the roof fell in, Goldberg would be a witness against them. Just to put frosting on the cake, Peat Marwick also delayed disclosing its findings to the SEC relative to fraudulent interim 1964 audits that it was not involved in, which were also both false and misleading. For some reason that is both not related to this issue and highly bizarre, Peat Marwick apparently was covering up what had occurred beyond the time when anyone with control of their senses would long before have folded their cards and left the game while they still had chips in front of them. The best we can say about Peat Marwick’ s role in this sorted affair is that they were both misguided, greedy and dumb.

As the affair came to a close everyone began circling each other in order pin the blame where it undoubtedly belonged, on someone else. Eskow, who along with Mackensen had been indicted by a federal grand jury was particularly aggressive in attempting to screw Peat Marwick to the wall. He started by filing a $20 million lawsuit against the accounting firm and his theme was that Peat Marwick had attempted to hide the company’s true condition from the officers. You have to admit that Eskow had a lot of nerve in this totally unique type of filing which was a blatant attempt to shift the blame away from himself. The Wall Street Journal did a story titled “Yale Express System Former President Sues Auditor, Peat Marwick which stated the following:

In Mr. Eskow’s complaint is an allegation that a Peat Marwick staffer on or about August 21, 1964, prepared a “cash flow” work paper that “advised and alerted” Peat Marwick and the other defendants that Yale Express’s alleged profit” of $717,000 in the first half of 1964… “was false, misleading and fraudulent” and, instead, a loss of $1,615,000 had been sustained. But Peat Marwick “did nothing to correct these errors or to advise (Mr. Eskow) or third parties thereof.”

For his efforts, Eskow, along with Mackensen were both convicted on 32 counts of fraud. Both men also received substantial fines. Eskow appealed his case all the way to the Supreme Court who rejected his appeal. Peat Marwick contributed a nominal amount to settle the class action suit that had been filled against it. In a very strange twist of fate though, Peat Marwick became the largest creditor in the bankruptcy action against Yale Express and when there was no money left in the treasury to Peat Marwick, the court order them to be paid in stock in the company. Thus, the accounting firm became the largest shareholder in its client, which is of course illegal, but then again, they were no longer doing the audit. The Company could no long be resuscitated.

Medical Fraud And More

Paracelsus Poorcare

“Philippus Theophrastus aureolus Bombastus von Hohenheim, known to history as Paracelsus, was a kind of Timothy Leary of his day; a utterly egotistical 16^th-century Swiss alchemist who also dabbled in metaphysical medical hokum (as well as some real medicine) and whose vagabond life came to a sudden end, it is said, either though poisoning or during a drunken debauch. So it might seem odd that a modern hospital company would honor itself with the name of a medieval charlatan who, when he was not hastening his patients’ deaths with mystic moonshine, was forever trying to turn base metals into gold.” ([226])

Paracelsus Healthcare medical facility began as the vision of Dr. Hartmut Krukemeyer and in 1981, he began building his empire in West Covina, California. Times were good for Dr. Krukemeyer and before you know it he had built a substantial empire. By 1986, Paracelsus knew that they had hit the big time because the U. S. Attorney in Los Angeles charged it with mail fraud in an attempt to extort money from Medicare. The charges were the normal ones in a case like this; the fact that Paracelsus had: “billed unallowable expenses such as golf tournaments in Monterey, California, and Lake Tahoe, Nevada; spousal travel; country club dues and expenses; gifts to physicians; limousines and charter jets; political contributions; expenses for foreign acquisition and expenses for unsuccessful domestic acquisitions.”

For awhile, Paracelsus argued that the money was used as intended by Medicare but when faced with solid evidence, the company was forced to cough up over $3 million in order to make the government whole in exchange for what had been stolen. But Paracelsus was not done with their government related problems just yet; in 1988, the Los Angeles County Department of Health started filing deficiency statements against the company charging its Hollywood facility with sloppy record-keeping, poor training procedures, failure to follow-up regarding know medical problems, deficient and faulty blood transfusion and lack of security for drugs.

Almost exactly the same problem occurred the following year and this time it was the Orange County district attorney that filed charges regarding the company’s conduct at another California facility. On this occasion, the company was able to avoid the bullet because they were able to show that the problems were employee driven. Mail fraud charges were ultimately leveled against several of the facility’s senior management personnel. Whether the company was involved directly or not, they’re seemed to be no question that Paracelsus management control systems were either non-existent or totally unmanageable.

Although, the empire was substantial, due to a number of disconcerting events, it was not making any money. The good doctor ([227]) was Chairman of the Board of directors of Paracelsus and the beneficial owner of all of its outstanding stock and started searching for a merger partner that could turn a legitimate profit. He came up a great candidate, the smaller, profitable and public company by the of Champion Healthcare Corporation, listed on the American Stock Exchange and selling at around $8 per share. .

The combination of the two ultimately became a public company specializing in acute care and specialty hospitals in California, Florida, Georgia, Kansas, Louisiana, Tennessee, and Texas. On October 9, 1996, Paracelsus announced that its results for the third quarter would not meet expectations and that it would have to restate the three previous three quarters. The stock dropped literally overnight by over 50% and the standard lawsuits were commenced. Simultaneously, Angelo Mozilo, who had served on the board for some time, resigned and has since been incommunicado relative to anything concerning the company. The outside directors retained special counsel; the big Washington law firm specializing in securities matters, Wilmer, Cutler & Pickering to find out why the company had been asleep at the switch.

In September of 1997, a RICO suit was filed against the company in U. S. District Court in Los Angeles. This action was by several large insurance companies charging almost exactly what Aetna had charged, years earlier. Moreover, in January of 1998, the Department of Justice of the United States alleged that the Company had defrauded the Federal Medicare and Medicaid programs by billing them for treatments patients never received. In what is almost unbelievable chutzpah, the facility would have the patients come in for alcohol or drug treatment and then release them without a doctor ever seeing them. The government contended that in most cases the patients’ treatments did not meet the government’s requirements for reimbursement and when the company realized that their claims would be turned down, company officials lied about what had occurred.

This case may never have come to light had it not been for whistleblower James C. Mays, who brought it to the government’s attention and who will receive almost six-hundred thousand dollars for his efforts.

Paracelsus Healthcare Corporation announced the settlement of shareholder lawsuits. “The suits were filed after an investigation by outside directors and attorneys found massive “errors and irregularities” in the Houston Company’s books. As a result of the findings, Paracelsus reported a $233.2 million loss for 1996 to cover problems that had not been evident before. The company will also restate earnings for 1992 through 1995, reducing them from a total of $62.4 million to $44.6 million. A significant part of the problem was the company had reported it was due millions of dollars in Medicare reimbursements even though it was unlikely it would ever be paid by the government.” ([228]) Management as usual was able to put a good twist on a bad occurrence, “Signing the global settlement agreements is a major achievement, they will mark a welcome end to the distractions and problems that have haunted us since the merger.” ([229])

On October 12, 1999, Paracelsus Healthcare Corporation announced that it was transferring the stock of its subsidiary, which held substantially all of its Salt Lake City, Utah assets, including five hospitals with 640 beds to IASIS ([230]) Healthcare Corporation. Basically, the company received $280 million, which was just about enough to bring down all of the senior bank debt with a small amount of money left over to pay some of the bills. Simultaneously the company sold Senatobia Community Hospital to Associates Capital Group, literally in exchange for getting off the hook on a bunch of debt. Overall, after the completion of the two transactions, when all the good news was announced and the partying had ended, the company found itself with about 35% fewer beds and almost as close to insolvency as it had been before the transaction. Unbelievably, Paracelsus indicates that they made a gain on the sale to IASIS of $75 million and a gain on the sale in Senatobia of about $2 million. Between the two sales, the company has just collected $280 million in cash and $77 million in pre-tax profits and the situation is doing nothing but getting worse.

To illustrate how quickly the company is dropping below the horizon one only has to compare the year-to-year sales results for the most recent month, March 2000. In 1998, the sales were $186 million, in 1999, the sales were $150 million, and in 2000, the sales were $95 million. Seems like a trend. In another amazing surprise, the company lost 28 cents per share in December 1999, the quarter that they were had already announced was going to bring in that enormous $77 million non-recurring gain. It just seems to have vanished right off the face of the earth.

On March 10, 2000, Paracelsus Healthcare Corporation announced that James G. VanDevender resigned as Interim Chief Executive Officer and Director effective February 29, 2000. I wonder whether or not it was material that the corporation did not have a CEO for ten days. Undoubtedly what happened was the fact that VanDevender said something like, “Guys, I just can’t take the pressure anymore, I’m history, and he said that 11 days ago. The boys were trying to talk James out of his decision for the over a week and when they saw that they couldn’t, they were forced to announce it almost two weeks late.

Then these brilliant strategists came up with the fact that Robert L. Smith was replacing VanDevender on March 27, 2000. Isn’t that just the strangest situation, one guy resigns 11 days before it is announced and he is being replaced by someone that isn’t going to come on board until 17 days from the date of the press release. God knows what is going to happen between February 29 and March 27 at Paracelsus, but I sure wouldn’t want to be the interim CEO during that period of time.

On March 15, 2000 Paracelsus announced that it did not expect to pay on March 16, 2000, the scheduled interest payment of $16.25 million on its $325 million 10% Senior Subordinated Notes. The interest payment originally was due on February 15, 2000, and is subject to a 30-day grace period that will expire on the 16. To make that day even worse, it was also announced that a wholly owned, second-tier subsidiary of Paracelsus, PHC Finance, Inc. had filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code with the U.S. Bankruptcy Court.

After these two announcements, back to back, you wouldn’t believe that the company could create a positive spin could you but just look at what they came up with: “In the past several years, Paracelsus has sought to improve its operating and financial performance by focusing on a solid group of hospitals, disposing of unprofitable operations, sharply reducing debt, streamlining our cost structure, and resolving litigation. The latest developments represent an effort to continue the improvement process by addressing capital structure issues at the parent company level that still stand in the way of our plans to restore the company’s financial health,” I guess that if you believe that missing a dividend payment on your debt and a subsidiary go bankrupt at literally the same time is good news, then I really don’t want to be around if they are going to say something bad. If this company improves any more than it has lately, there won’t be a thing left to save.

Almost every day has been a bad hair day for Paracelsus and in an effort to keep the ball rolling, on May 17, 2000, the New York Stock Exchange said that the company no longer meets minimums for total market capitalization and stockholder equity of $50 million each, as well as the exchange’s $1 minimum price and it was being delisted. In the meantime, trading is suspended on the stock until the Exchange takes final action. Ultimately the stock will be traded on the NASD OTC Bulletin Board with the symbol, “PLHC.”

In the meantime, in August of 1996 the company issued $325 million of Senior Subordinated Notes and 4.6 million shares of stock at $8.50 per share. As we discussed above, the company was already in the process of restating their earnings less than two months later. Alternatively, to put things more succinctly, let us read from the court documents. We are first going to quote from an announcement made by the company on October 10, 1996:

“The company is not in a position at this time to quantify the amount or range of its expected earning shortfall and does not expect to do so until either November 15, 1996, when it anticipates filing its Form 10-Q for the third quarter, or when the internal inquiry is completed. Presently it is not possible to provide any specific timeframe as to when the inquiry will be completed. The Company anticipates that once the inquiry is completed and acted upon by the Board of Directors that the results will be disclosed as appropriate.”

The Plaintiff’s point out that these stunning announcements came less than two months after Paracelsus completed its acquisition of Champion for about $168 million of Paracelsus stock, issued and sold $325 million of debt securities and issued and sold nearly $40 million of common stock ([231]). Once Dr. Manfred Krukemeyer ([232]) had inked the merger deal with Champion and told them how excellent his earnings were going to be, the good Doctor declared a dividend for himself of $21.1 million. ([233]) Naturally, Krukemeyer knew that things were not going too well and he thought that nobody would notice either the $21 million had disappeared or the fact that he had totally distorted his financial projections in order to make sure that the deal closed. By this time, Krukemeyer was getting highly professional advice and by now had hired one of the most prestigious firms on Wall Street, the prestigious, Donaldson, Lufkin & Jenrette. They moved quickly and had the stock moved from the American to the New York Stock Exchange itself, where the stock proceeded to lay a large sized egg and went nowhere.

The prospectus on the deal that was issued by the brokerage firm contained some interesting reading if anyone took the time to bother, they related to the cost of the settlement of some litigation earlier in the year before the talks with Champion had begun:

“No details of the litigation were given in the prospectus, although it did divulge that the company had paid a total of $22 million to end the court actions. However, in part, the settlement, which has been sealed, dealt with a suit filed against Paracelsus by Aetna Life Insurance, which had accused the health-care concern of massive fraud.” ([234])

What wasn’t included in the sealed court documents seemed to be the following:

“According to court records, Paracelsus, over several years, allegedly bribed telemarketers to tout insured but clinically healthy persons to various Paracelsus hospitals, which then concocted bogus medical records to evidence medical problems and billed insurers for “treatment” of non-existent ailments. Thus, according to papers filed by Aetna, a person who might be temporarily glum because of a weight problem, lack of attention from the opposite sex, religious doubt, a tiresome spouse, too much boozing, loss of a job or some other not-uncommon travail might be offered free round-trip airline tickets to a Paracelsus facility in sunny Southern California, with promised side-trips to Disneyland and Venice Beach thrown in. There, the papers allege, Paracelsus, having made kickbacks to the telemarketer, would diagnose the “patient” as having “major depression,” “suicidal inclinations” or the like, and send Aetna or some other insurer a tidy bill.”

“Individuals who had been told by telemarketing salespeople to expect “a restful atmosphere… in a “resort” or “spa-like” setting,” the Aetna complaint says, would be “admitted to psychiatric hospitals in decaying urban areas…”where, allegedly, they would receive care for compulsive-eating disorders; for the treatment of religious doubt through baptisms, Bible studies, “praise and worship” and even exorcisms; or treatment of chemical dependency in an unlicensed facility. “

The Aetna complaint goes on and on but the bottom line was always the same, as little as possible was spent on the patient, they were coerced to stay until their insurance ran out and when it did, they were summarily dumped. The company in several cases came close to being charged with kidnapping by not releasing patients when they wanted to stop their treatments and leave the facility. Aetna made it clear in their filings that literally everyone in Paracelsus senior management either was involved or knew what was going on.

The suckers, err—Plaintiff’s also named R. J. Messenger, the President, CEO and Board Member, of Paracelsus and James T. Rush, Vice President, Finance and Chief Financial Officer of Paracelsus and indicated that they both had access to adverse non-public information about its business and finances via access to internal corporate documents including Paracelsus’s operating plans, budgets and forecasts and reports of actual operations compared thereto), conversations and connections with other corporate officers and employees, attendance at management meetings and via reports and other information provided to them in connection with their responsibilities.

The defendants were charged with basically accruing inadequate reserves for bad debts and collection expenses associated with retrieving from third party payers on revenue it had recognized in the first and second quarters of fiscal 1996. In the third quarter of fiscal 1996, the insiders again caused the Company to inappropriately fail to adequately reserve for bad debt and collection expenses. These practices caused the Company’s financial statements to be presented in violation of Generally Accepted Accounting Principles (“GAAP”) and to be false and misleading.

This transaction, unless we are missing something somewhere literally looks like theft of the first magnitude. We are somewhat surprised that no one has sought fit to inform these folks that if they continue to issue inflammatory press releases they are going to get into more and more trouble as time goes on. It is interesting to note that several of the senior people that came aboard the company in early times are still with management. That the stock is still controlled by the good doctor and these folks just seem to be set to go their own way, no matter what the consequences are to their shareholders and themselves. In the meantime, the company is a mere shell of what it was.

Drugs Made It Turn Bad

The DeLorean, Cars, Cocaine and Closed

John DeLorean was the heir apparent at General Motors, then the largest company in the world. He appeared to be the perfect executive, highly respected, an excellent manager and socially acceptable by one and all. Things didn’t quite work out the way John wanted at General Motors for a number of reasons, and when he saw the top spot was not going to be his, he determined to launch a new company, one that would compete toe to toe with GM’s most profitable line, the Corvette, a car that had taken the upscale yuppie market by storm and a niche which DeLorean thought could stand a lot more competition.

DeLorean wasn’t much of a student of the history of the automobile business. He should have known that the odds were very much against a new, independent automobile company succeeding. It may well be that DeLorean didn’t care a lot one way or the other whether his venture was successful, and may have only been looking for a method of maintaining a lifestyle appropriate to a person of his social charms. The fact that Tucker, Crosley, Bricken, Cimarron Corvair, Kaiser-Frazer, American Motors, Studebaker, Edsel and LaSalle had bitten the dust along with a list of others that is too long to count had nothing to do with Delorean’s decision. Ego and greed were his compelling factors.

DeLorean determined to build a gull-winged, stainless steel sports car in Northern Ireland where the British government was interested in making a substantial investment to alleviate persistent unemployment linked to social unrest. Many have compared DeLorean to his predecessor Preston Thomas Tucker, who in 1948 built a rear-engined sedan with disc brakes, seat belts and an independent suspension system. What the two had in common is that they were both charismatic, they were both indicted by the United States Government for fraud on numerous counts, they were both ultimately found to be not guilty ([235]) and both were way ahead of their times in terms of what they tried to produce. ([236]) They differed in the Tucker was trying to build a sports car that would appeal to the masses and saves lives whereas DeLorean was attempting to deliver an overpriced automobile that not only couldn’t be properly produced and whose bugs had bugs.

DeLorean raised money from everyone that would listen to his fantasy. His presentations were public relations dreams. Like Ponzi’s schemes, everyone wanted to get in on Delorean’s sure thing. DeLorean was well prepared for them. He set up a Panamanian Company, which was to do substantial although unspecified work for DeLorean Motors but basically wound up being a conduit leading to a Swiss post office box. It seems that over seventeen million dollars found their way from DeLorean Motors to Panama, then to Switzerland and from there to Swiss and Dutch banks. The next step in this highly sophisticated money laundering operation said to be right back to DeLorean’s personal account in the Untied States.

DeLorean went first class in everything he did and in line with that, he hired the prestigious accounting firm of Arthur Andersen to do his books. Anderson saw DeLorean as a super-charged customer who would always be in the public view. Due to their anxiety to please DeLorean, they were not as careful in auditing the books, as they perhaps should have been.

Courts in both Great Britain and the United States found Andersen’s audits overlooked what appeared to be a number of instances of fraud but particularly zeroed in on the Panamanian fiasco. In addition, an Anderson memorandum was found that indicated that some were on to DeLorean and that the whole project would collapse if the sensitive material involved ever became public. Andersen, for its part, lamely explained the memo away with the strange story that it involved something else relative to DeLorean that had been solved and had nothing to do with the point in question. Whether it was or was not, the memo itself would certainly indicate that in order to protect the public trust, Andersen should have dug deeper into the books. When they didn’t, they ultimately got hammered for their failure to follow “good accounting principals” and to make appropriate public disclosures.

All of this became almost secondary when the U.S. Government took some pictures of DeLorean making a huge drug buy. If anybody had any doubts before about the fact that something strange was going on with the ex-General Motors honcho, this certainly should have put the matter into clearer focus. But John DeLorean was not just making a drug buy. He was making a world-class drug buy that probably set the standard for that era. This spelled the death knoll for DeLorean Motors and certainly didn’t do their accountants any good either.

The DeLorean experience probably has cost Andersen $100 million ([237]), including both the American and British settlements along with a decade of attorneys’ fees and costs. The courts both here and abroad did not seem to even think twice about the question of Anderson’s dereliction. When this number is put into perspective, it becomes even larger. Probably $160 million was the total that was raised for DeLorean from all sources. The fact that Andersen alone paid over 60 percent of the total amount raised is probably a record even within the world of accounting litigation where conflicts and lawsuits seem to be as normal as a walk in the park.

DeLorean fought tooth and nail to avoid jail and bankruptcy. While he was successful in the former because of an entrapment defense, he was declared bankrupt several years ago. In a fitting end to the strange tale of John DeLorean, his home of many years is becoming a golf course and little of his empire remains.

Equity Fudging

So, how many times have you said after a scandal is disclosed in the papers, gosh, I just knew something had to be wrong with that company. Boy, I sure did when the word came out about the disaster at ZZZZ Best. I had followed the company for some time and what really bothered me was the fact that this skinny, prepubescent dropout could be making that kind of money cleaning rugs. I didn’t have anything solid to go by, but there seemed to be a lot of really strange characters hanging around the lad and these were the kind of folks that would eat you and your lunch. I knew some of these characters and they circled money in the same way the buzzards circle carrion. Something was up, but what did it matter - I didn’t own any stock, I wasn’t about to short ([238]) any and I was not a security analyst, so it wasn’t my job. Let the Securities and Exchange worry about whatever is going on over there. It just isn’t my problem.

The next company that I followed that we write about here was Equity Funding Insurance. As an institutional salesman at one of the big Wall Street houses, I was a little closer to that one and knew some of the players. I was working at one of the major institutional brokerage houses, and our firm loved the stock. Not only that, we had bought a ton of it for the all of the house accounts and owned it for ourselves as well. I had reason to have lunch with Stanley Goldblum, the CEO of Equity Funding, one afternoon. Stanley seemed like a nice enough guy, but didn’t seem to know beans about insurance. How in the hell can a guy that doesn’t even know the basics of insurance be running the company that is supposed to have the best growth prospects on the Street?

Our firm was so hot on this deal that I was really trying to figure out why, and knew something about how to read an insurance company’s financial statement. The year was either late 1974 or early 1975, and interest rates had been soaring. When interest rates go up, the value of portfolio bonds goes down. Most good insurance companies have a lot of decent bonds in their portfolios, as Equity Funding professed they did.

Because theoretically bonds are supposed to be held for a period, insurance companies are not supposed to speculate. The State Insurance Departments uniformly allow insurers to carry portfolios at cost or market, whatever is higher. This operated to their advantage during the Carter years as the bonds in the average company’s portfolio were selling at less than 60 cents on the dollar. If you took the current value of all of the bonds held by all of the insurance companies in the United States in those years and subtracted their loss reserves, there wouldn’t have been a solvent insurance company in the country. On the other hand, regulators knew that interest rates vacillated. This rule allowed the logic of long term investing without penalizing the companies for interim interest rate swings.

This is about all I knew about Equity Funding. They were doing well in a market that was collapsing and this poor soul I was lunching with certainly didn’t seem to be a brain surgeon. Well, I thought I would try and find out how much Goldblum knew about the solvency of his company, and said, as he was taking a bite from his sandwich, “Stanley, what are you going to do about the fact that your company is currently insolvent?” Stanley didn’t know what the hell I was talking about, and felt that his con-job was up. He thought that somehow I had uncovered the plot. After he went ballistic a few times, I said, “Hey, Stan, it’s not my problem.” I went back to the office and told any all concerned that they were a little top heavy in Equity Funding stock and ought to get rid of it. When asked why I thought so, I tried to explain my little experiment with Mr. Goldblum. My associates were unfamiliar with the term “statutory insurance statement”. I left the brokerage firm which was Edwards and Hanley, and within a short time, it failed, pushed over the edge by the sudden demise of Equity Funding along with a bunch of other problems.

Had I been a shareholder that owned as much stock as Edwards and Hanley did at the time I think I would want to independently check to see what was really going on. I never thought about what rights I might need at that time to do my own audit of suspect books and believe it or not, I don’t think about it much today either, but if you ever get the urge, these are the facts. Most shareholders have what we call “inspection rights” to look at a corporation’s books under the laws of every state in the union. Because of the fact that insurance companies are not Federal in nature, the laws vary dramatically from location to location, but whether you are an individual investor or an institution, those rights are inherent.

In Delaware, a state normally conceived to be favorably inclined to corporations, as little as one share will get you into the door.([239]) Many other states believe that while “inspection rights” are the way to go, by setting the bar too low, cranks would attempt to take advantage of the rules and make a farce of the regulations. Thus, the threshold in other states may run as high as 5% of the outstanding stock.

Universally, all that is usually necessary to get into the corporate door is a letter sent to the company under oath, stating that the person desiring to see the books is a shareholder; that the reason that he wants to look at the books is “proper” ([240]), and he should lay out the records that would suffice for his edification to whatever is bothering him. Normally, this should be enough, but if you have hit a nerve somewhere or other, you’d better believe that no one is just going to rollover and let you blow the whistle without a fight. Obviously, though, you have struck a nerve.

Should the company refuse such a request, the shareholder may then go to court and ask for “summary judgment”, laying out the request and why he wants to see the books. This motion will not take long for the court to decide and should not be too expensive.

The management is going to have to do one large fandango dance to get away with not opening their books to you. If they really play hardball, you can certainly draw an inference from that as well and you might decide that it is cheaper in the long run to just sell your investment and wait for something better to come along. You might also get a kick out of eventually seeing the offending company, crash and burn because of some hidden agenda that they were a little too concerned about.

Another option could be that you send a letter to the Securities & Exchange Commission giving them your suspicions with the fact that you have lawfully asked for an inspection and the company is unreasonably refusing to open its books. The SEC at that point in time may well act as your “friend of the court” and intercede or start their own investigation. This may be counterproductive because the entire world will find out simultaneously the result of the SEC inquiry simultaneously which will not benefit you one wit, other than if you only were out for revenge.

These “inspection rights” can be used for a lot of different situations depending on how liberal the jurisdiction is. In takeover battles, having your own people pour over the books will usually give you a better idea of whether you are barking up the right tree or not. In the meantime, you can also take a look at the shareholders list so that you can make your case to a lot of people that you would ordinarily not know how to get in touch with. You are allowed to get names, addresses, numbers of shares and other information, which would just not be available, anywhere else.

You may also have a hunch that something is afoot and maybe when you find it, instead of the taking the matter into the public arena, you can privately settle the differences you have with the company for a large amount of money, possibly something along the lines of what is called in Wall Street parlance, “greenmail”. One of my ex-associates, Carl Icahn became the world’s authority on that subject and honed his skills until he became the most feared raider on the street. Carl doesn’t have to do that anymore because he has enough money behind him to literally put any company that he desires “into play”. ([241])

Another reason to want to take a look at the books may be because of the mystical term the accountants use called “materiality”. Let’s assume that you think that XYZ has tremendous exposure in the derivatives that they have written and you just can’t get a clue from the balance sheets because the accountants are telling you that it just isn’t material. Remember that the accountants are using an arbitrary five percent rule to cover their opinion on materiality. What if XYZ National Bank has taken the whole five percent and sold puts on the Euro as most Japanese financial institutions did. Also consider that shareholders equity in a bank may not be much more than 5 percent of the total assets of the institution. Thus, you may want to take a peak and see if your holding is still solvent, the accountants are not going to tell you. This may be your only way to find out.

The first you will hear on that subject will probably be a simultaneous announcement from the New York Stock Exchange and the New York Federal Reserve with the Exchange’s statement going something like this, “the stock in XYZ National Bank has been temporarily halted on the New York Stock Exchange pending an announcement from the New York Federal Reserve”. The New York Federal Reserve statement is a little more explicit, “while auditors for the Treasury were doing their normal spot check of XYZ National Bank, they discovered that the bank’s liabilities are now substantially greater than their assets. The Federal Reserve has closed XYZ Bank as of 9:00 A: M this morning, EST and all accounts will be transferred to ABC Bank. The changeover will be orderly and keep in mind that all accounts are insured to the FDIC limit. Good news for some, bad for others. The depositors, if they are small enough will get their money back, the larger ones will get a percentage of what they had in the bank. Those that have Certificates of Deposit may get nothing and certainly when all is said and done, the shareholders will be left sucking wind. Think of all of the public banks that we have discussed in this report that were absolutely bankrupt and the accountants kept them afloat.

The Euro, A Strange Idea, Countries Cheat As Well

The Euro, Makes A Lot Of Sense When Looked At On Paper

Who has the right to say that they have either built the better mousetrap or essentially, who has created the world’s dominant economy. The statistics are confusing and although nothing of dramatic import can be gleaned from them, a look at the current who’s who roster of global economics is illustrative of the major shifts that have occurred while we weren’t paying particular attention. The United States with a population of 263 million has a 19.6 percent share of world trade, Japan’s population is 125 million and they have a 20.5 percent share of world trade and the European Union when totally joined together will have a population of 370 million and a 38.3 percent share of world trade. Did you think that the United States was third?

Another interesting statistic is U. S. Foreign exchange reserves in 1996 were $49.1 billion dollars while the EU had $349.8 billion. With numbers like these, there can’t be much question that a European Union administrated without the ever-present political backbiting and with the elimination of historical animosities would represent an awesome force to be reckoned with. The problem is that the bickering is legendary, the prejudice, grievous and the egos, untenable.

Other interesting statistics that made an interesting case for the Euro the fact that the United States has gone from Global creditor to the unchallenged champion debtor nation in just a few short years. Few realize that as early as the 1870’s, the United States was already the world’s largest economy. During World War II and the remaining years of the forties, the United States accounted for almost 40% of the entire world’s output of goods and services while today that figure has eroded to just a hair over 20% and is headed down in spite of the greatest and lengthiest economic boom in American history.

Furthermore, the United States is extremely constrained by a population that has among the lowest savings rates on earth. Is the position that America has enjoyed over the years where, when it ran up a debt to another nation, it just printed more currency instead of having to re-supply hard currency reserves coming to the end of an era. We do not believe that the fat lady has sung as yet. Interesting enough as opposed to the literally zero percent saving rate in the United States, Japan alone harbors one third of all the world’s savings, creating the world’s largest piggy bank and an enticing resource to be tapped at will whenever the Government needs funding for favored projects.

With gold no longer a reserve currency and in spite of the fact that over 100,000 tons are stored above ground having a value of in excess of $1 trillion, only a third of it is held by nations for reserve use which hardly covers the inter-governmental transactions that take place hourly. As a secondary reserve, gold probably has some value in a dire emergency and here the United States again fails the litmus test, their gold reserves are only just a touch better than 50% of Europe’s. Currently during periods of national or international turmoil, the dollar either collapses or goes into orbit, depending upon what event is occurring. It’s sharp peaks and valleys sometimes make alternative planning difficult and there is little question that an equivalent reserve currency would be well received by everyone ([242]).

As awesome as the full European Union appears, if you just looked at the core countries that make up the initial membership within the common currency alliance, you will find out that we are not talking about featherweights. Their combined economies would be equal to that of Japan and almost 70 percent of the GDP of the United States. The gross international trade of this nucleus would exceed that of the United States, although this number includes trade with countries that will become members and therefore is slightly skewed. The cost of the changeover to the Euro for computers all over the world made the “year 2000” ([243]) problem pale in its wake. After all of the fanfare and expense, the Euro limped into the new millennium as it went into free fall from the opening bell and never looked back. Aside from massive losses suffered by Japanese Banks that bought the currency and cheaper exports that are helping bring down unemployment in Europe, the Euro has turned out to more even less than a non-event.

Something Tells Me That Germany didn’t Give Up On The Thought Of World Domination In 1945

Germany found out after World War I that, when people lose confidence in their national currency, there is nothing short of a different government can break the slide. While, on paper the idea of the Euro had shown great promise and a lot of logic behind it, in practice it required a number of things to come together in perfect harmony to make it work. They didn’t, and the Euro has become a second rate currency, for the moment.

Among other necessary components, transparency and commonality among the ting countries involved is a critical element. If the accounting regulations for each was different, no commonality of regulation could be established. It was for that reason that it was necessary for everyone to be together on the same page. It didn’t take the European nations very long to make an effort to change the rules while telegraphing what they had in mind, not a very auspicious start.

Great disappearing acts seem to be in vogue. They require a receptive audience, a viable idea and a certain amount of credibility. The European Community, led by the Bundesbank, determined that by combining the currencies of all the members into a single monetary unit, unemployment will vanish and prosperity will reign supreme upon the land. Big Julie, Billie Sol Estes, and Tino DeAngelis would be proud of these guys. We wonder whether it isn’t another attempt by Germany, which after failing to take Europe by force in two wars hasn’t determined to take a page out of “Big Julie’s book and sell Europe the Brooklyn Bridge.

Whether the practice of transparency has become an example to live by, or a cover-up for just another nefarious scheme to bilk the innocent, we really can’t judge at this point. But, this new currency idea that these people have come up with under the guise of God and Country is beyond imagination. Although in a perfect world there is merit in formulating mutually advantageous economic unions, Europe has been the home to revelries, revolutions and wars among the constituents of this pact for at least the last ten centuries. If this hasn’t given them enough cause to question the merits of big brother’s suggestion, then they deserve what they will get.

The Germans for there part have made tremendous strides in creating a transparent society and in doing so have attempted to set an example for the rest of the world to adhere to. In 1945, the people of Germany were so tormented by the loss of literally all of their civil rights during Hitler’s regime that they ratified a constitutional amendment, which for all time protected their right to privacy. This eternal document held sway until the 1970’s when “government exigencies” caused the bans against telephone taps and mail intercepts to be substantially watered down, but the remainder of the constitution was to live on in perpetuity if nothing else as a reminder to the people of the rights that they had lost during the Nazi years. Perpetuity does not last very long in Germany. Its parliament has now concluded that the urgent Gestapo-like imperative of global transparency in all facets of life is more important than a smattering of civil rights. Electronic surveillance in all of its glory will return to a Germany that has forgotten its heritage. Bravo for transparency.

Europe started trading its common currency (euro) in 1999. Before that could happen, the EU called a meeting and set tough economic standards for admittance that nations had to comply with in order to join the alliance, yet the rewards of cooperation appeared so great that the temporary discomfort of compliance was thought to be of only passing consequence. The rules are complex, but for the most part they require that the members inflation rate be controlled, its internal debt be less than 60 percent of gross domestic product and that the deficit be less than 3 percent of GDP.

Germany, one of the plan’s staunchest allies, ran an unexpectedly large deficit caused by larger than expected reunification costs, and could no longer meet the strict criteria. After all this whole thing was really their idea, what were they going to do? They did what every American corporation that is publicly traded that has a Big Five accounting firm would do. They revised their international accounting practices to squeeze their budget into the standards by revaluing gold reserves at current market prices instead of cost. Thus the treasury was set to report a one-time gain of $7 billion dollars, until they got caught with their hands in the cookie jar. The German Central Bank became so upset with this economic wizardry that they did something never before heard of in the polite world of Germany’s banking circles; they went public with their abhorrent disgust over what they considered to be a truly cheap shot.

We would certainly wonder how transparent, conservative Germany would continue to be whenever the chips are down. If Germany is unable to conform to the standards other than by gimmickry and illusion, how will the other nations possibly be able to comply? If they also attempted to use the same type of accounting magic practiced by Germany, what possible value could their currency have and what is really going to happen to Europe, if this indeed is their plight?

You’re Not Watching Closely Enough, The Pea Is Under The Shell

Last year, the shoe was on the other foot when German officials expressed horror with a French scheme to reduce its 1997 deficit by several billion dollars by mysteriously transferring profits earned in the pending privatization of the Government-owned Telephone Company, France Telecom, into a Euro credit account. Since the Germans got caught with their hands in the economic cookie jar, they determined to follow the French plan. They resolved to meet their goals by dumping assets through early then anticipated privatizations, at bargain basement prices.

“The wheezes being deployed to get round the Maastricht criteria for economic and monetary union are ever more ingenious. France started the ball rolling by tapping state-owned France Telecom for FFr37.5bn in return for assuming its pension fund liabilities. This was quickly superseded by Italy’s partly reimbursable one-year tax and Germany’s scheme, now shelved, to revalue the Bundesbank’s gold. Clearly anxious not to be outdone by its European partners, France looks like its coming back with some jiggery-pekery: grabbing tens of billions of francs from state-owned Electricite’ de France.”

What is so bizarre about the French proposal is that these substantial reserve funds were allocated for the eventual dismantling of their 50 nuclear reactors and the reprocessing of nuclear fuel. Moving the money from one hand to the other, in a move that is opaque to no one, does not delay for one second the time when either these funds or other French funds must be utilized for the original purpose intended. How these people think that they can get away with such amateur book cooking and still expect to maintain the respect of the rest of the World’s Central Banks is impossible to believe.

‘It is an extremely sensitive question,’ said Holger Fahringkrug, an economist at UBS Securities in Frankfurt. ‘If Germany is allowed to go ahead with this kind of move, then it opens the door for countries like Italy or Greece to do the same thing.’” New York Times, 5/29/97 D7

As we recall, the last time Germany indulged in this type of dis-information, it occurred the day before they invaded the Sudatenland. On the other hand, had the German Treasury used the services of one of the Big Five, the transaction probably would have gotten buried so deep that even a hint of its existence would never have come light. Government’s, indeed have a hard time getting used to the terms outside, independent accountants who are hired guns, changing the rules as they fearlessly move numbers around the balance sheet like chess pieces.

The Germans have always taken authority to heart, and if someone in a high position states something affirmatively, it is usually accepted at face value. While the euro has few redeeming features, what is more important is the fact that it has sponsorship at high levels in the various governments, which more negates any requirements that its value be supported, by facts.

On June 4, 1997, a little more than a week after the German Government attempted to pull the tackiest economic maneuver by a major country in this decade, the highly regarded German institution, the Bundesbank (Germany’s Central Bank) reversed this childlike attempt at subterfuge with a combination of authority and logic. It is far too late in the day to add new taxes to make up the difference under the “Maastricht limits”. ([244]) Left with few alternatives, Germany will resort to additional privatization sales such as the Deutsche Telekom Ag. At the moment, Germany has no choice but to compromise ([245]). France, under their new government didn’t make much additional effort and surprisingly Italy who many thought, didn’t have a prayer, has come through with flying colors. In the end morality won over necessity and the Euro came to pass. Almost every country in Europe that were the original partners of Euro trading got caught as did Germany and France, trying to cook their books to facilitate entry.

And when the final tome was written, the vaunted Euro collapsed. Is that all bad? Not necessarily, although the Europeans have lost much face in the international community, their goods are now selling for substantially less than before and unemployment has dropped a tad. Maybe in the future, we should consider healthy conclusions over temporary ego fixes; something that long-term planning is really all about.

Bernard Baruch was asked what the key to his success in the stock market was. We think he summed it up rather succinctly when he said, “Never pay the slightest attention to what a company president ever says about his own stock. And second, when good news about the market hits the front page of the New York Times, sell.”

John Wanamaker had an excellent background in bookkeeping and one of the reasons for his great success was the fact that his records were always current and by looking at them, he could tell exactly what was going on in his new store. He opened for business in 1861 and told a friend what had occurred. “At the close of the first day the cash drawer revealed a total intake of $24.67. Of this, $24 was spent for advertising and 67 cents was saved for making change the next morning.”

Will life be so simple as it was ever again? Not in Europe apparently

Political Screw Ups

First Executive Life, Much Ado About A Lot

First Executive Life ran into problems when in 1989 it was forced to write down the value of its portfolio by $776 million because of substantial slippage in its junk bond oriented portfolio. This in turn caused policyholders to run for the hills. They cashed in their policies by the carload and when the smoke had cleared, two things had occurred, the first, a massive $3 billion in face value policies had been repurchased by First Executive and second, they were still standing. By liquidating the higher grade portions of their portfolio they were able to cover the run on the insurance company and even came in for a little good luck. The Junk Bond market was recovering and the portfolio was beginning to show a little life.

On the other hand, there was good news and bad news. The good news was that most of the remaining policies on First Executive books were locked in for life, the bad news was that John Garamendi had just become the first elected insurance commissioner in California history and he was bringing a different philosophy to that office. ([246]) Now John was not a bad guy at all and he had all of the obligatory educational background to handle most jobs. He was a great athlete, all PAC-8 lineman, heavyweight wrestling camp, Peace Corps Veteran, MBA from Harvard, had served in the California Assembly and the California Senate where he was named legislator of the year by the League of California cities. He is handsome and bright, but insurance is more of something that you live rather than learn from books and Garamendi sure didn’t have any first hand knowledge. His was getting into a situation that was more than just over his head.

In the meantime, Fred Carr who was running First Executive was looking for a way of the mess he was in. He called on The Hartford Insurance Company that after substantial negotiations agreed to purchase over 150,000 of Executive’s whole life policies. Leon Black, who cut his teeth at Drexel Burnham with Michael Milken, had come up with French bankers ([247]) that would buy enough of the junk portfolio to take the remaining pressure off Executive and Carr. First Executive would still have potential surrenders of another $1 billion but they would also have another $1 billion in the bank. If another run had occurred it could have been covered with room to spare. This seemed to be a brilliantly constructed package and it was in turn presented to Garamendi as was appropriate.

Not surprisingly, no one ever heard from Garamendi on the proposal, but that was not illogical. Being his first major case and desiring to run for governor of California down the road, Garamendi had painted First Executive along with their senior executives as the devil incarnate. He had already indicated that there would be very little recoverable from the junk bond portfolio and indirectly, while he may not have exactly caused the panic, he certainly hadn’t assuaged anyone that everything would be all right. I guess that is the kinds of things that people running for governor are want to do. In the meantime he was able to blame his predecessor literally for everything that had gone on:

“…Of course, policyholders couldn’t expect to be made completely whole. As he told a packed meeting room in Los Angeles’s Sheraton Townhouse Hotel on August 7, 1991. That chance passed when his predecessor, Republican appointee Roxani Gillespie, had “looked idly on as junk-bond defaults rose to astronomical levels,” thus triggering “the biggest policyholder run on an insurance company in history.” And unfortunately, Fred Carr had sold off most of Executive Life’s best assets to meet the torrent of surrenders and policy loans.” ([248])

As some old expressions go, what is good for the goose may be not so good for the gander. The man that had put together the French Bank’s portion of the bid that Carr delivered to Garamendi was Leon Black, one of the most knowledgeable people in the country relative to Carr’s portfolio. He had been intimately involved in it’s structuring and had been influential in arranging the original issues of much of the debt. It would have seemed that if he was interesting in buying, there must have something pretty valuable in that portfolio or at the worst it was probably not as bad it had appeared on the surface. Now that Garamendi had not seen fit to respond to the offer, Black suddenly felt that he could possibly turn what would be Executives misfortune to his own advantage.

The last straw occurred when First Executive’s auditors, Arthur Andersen were preparing to close out the company’s 1990 books, and in early 1991 wanted to know from the insurance commissioner whether or not he was going to seize the insurance company. It was critically important from the accountant’s point of view in terms of writing the going business section in their opinion letter. Andersen did not want to be in the position of saying that they believed that First Executive could continue as a going concern and then have the ex-wrestler close the company down faster than you could blink an eye. Andersen had been in enough litigation over the years to know that this could lead to massive law suits.

However, Garamendi literally made the prophesy self fulfilling when he refused to discuss that matter with the people from Andersen. Now, Andersen was potentially put into a position that they could be damned if they did and damned if they didn’t. According to financial sources, the reasons for Garamendi’s actions were based on the fact that he did not feel that Fred Carr continued leadership was in the best long term interest of Executive Life’s insured and that a controlled liquidation was decidedly better than a sudden momentous disaster.

If they didn’t qualify their opinion and said that First Executive was in shape to survive as a going concern and later, Garamendi came along and pulled the plug, they would have been easy victims for anyone that purchased insurance during that period of time. There would become a whole host of other that could have potential actions against Andersen for saying the company would survive and it tanked. On the other hand, if they issued a qualified opinion that stated that, they weren’t sure whether the company would make it or not, that in itself would be enough to send the company to its demise.

When, as literally planned by the California Commissioner of Insurance, Executive Life (Executive) failed in the spring of 1991 it was the largest insurance company in the United States to fail up to that point. A New Jersey based insurance company by the name of Mutual Benefit Life, has since gone by the boards and some of the records set by Executive Life may have gone down the drain in that collapse. One thing seems absolutely certain, thanks to shoddy accounting, a portfolio of illegal junk bonds, and a lot of secondary real estate, the recoveries in the normal course of events will not be substantial. On the other hand, there were so many shenanigans involved with the company that recovery from litigation may set another record. Furthermore, this will be the biggest bailout in the history of this country ($2 billion) no matter what is recovered.

Executive Life had issued over 350,000 policy and annuity holders throughout the country; furthermore Executive life had acted as a guarantor for a number of municipal bond offerings and through the Executive Life Contracts, many thousands of people had purchased indirect interests in the insurance company itself tied to retirement savings programs. Furthermore, Executive Life issued “guaranteed investment contracts” (GICs) that carried a fixed rate of return. Many GICs were tied to real estate interests that the insurance company had and they would sell the GICs to customers based on a spread between what was coming in and what was going out. In theory, if it was underwritten correctly, it would have worked well for people that had retired and were living on a fixed budget. Sadly and unusually the GICs were tied to junk bonds and therefore nothing else needs to be said that is meaningful.

In a different world, the scenario would have ended in another fashion where much could have been saved. The company’s junk bonds would have paid off and the less expensive insurance they were selling because of the higher yield that they were bringing to their bottom line would have worked to everyone’s benefit. Sadly, that was not the case. The beneficiaries of Executive Life’s problems are literally a pathetic lot. Let’s take a look a couple illustrations.

A company does an analysis on its pension fund and finds that it is over-funded or a raider comes along and takes over the company. In either case the over funded pension fund represents an asset that can be used by the company or even taken as a profit when the over funded portion is moved back to the corporation. Those are fairly standard circumstances, but let’s look at the situation when the corporate pension fund such as those at Unisys, Xerox, and Marathon traded in their historic pension assets for the much less expensive GICs. In theory, the higher the return to the beneficiary, the lower the cost to the corporation and the higher the risk.

In spite of this, it was accomplished to the disadvantage of retirees and others and worse yet, in spite of the fact that most states have insurance pools to pick up the slack when a company goes out of business, many of the states do not cover this particular kind of investment. These people are just plain out of luck and the only alternative they are left with is to sue their employers or ex-employers. Many of the company’s that bought into Executive Life’s GIC program were so embarrassed by their own stupidity that they made good on the money that had been lost by their pensioners. On the other hand, companies such as Unisys are saying that an investment in a GIC is the same thing as investment in the stock market; you place your wager and take your chances. This position has literally no connection with reality whatsoever and ultimately there is not much question that the policyholders will take Unisys to the cleaners over their bizarre hardball position. In addition, pension funds are federally insured and annuities are not.

Then we have an even more extreme case, those were the disabled people that had collected money either through medical malpractice court adjudicated actions or insurance coverage. These people had a one-time shot coming and many of their lawyers, accountants, or advisers recommended the Executive Life annuities, which of course tanked along with the company. It is possible that some of these people will be able to recover a portion of that money from state funds but when push comes to shove, a lot more of them will be faced with poverty or in the alternative, the potentially uncomfortable position of filing legal actions against the people that recommended the disastrous investment.

On a more positive note, the Labor Department didn’t take it too kindly to the fact that anyone that had a fiduciary responsibility would buy a policy from Executive Life. This seems to us like 20/20 hindsight and they have filed actions against employers that left their personnel hanging out to dry. Laggards such as Revlon and the Bulova division of Loews have already made agreement with the Labor Department to address the issue. Furthermore, Allan Lebowitz, a deputy assistant secretary of Labor indicated that a rule was going to be initiated by labor, that would mandate that companies will have to buy from the safest source, not the least expensive. Now they tell us.

In any event, Executive Life got into trouble because of the purchase of low quality, non-liquid junk bonds by their canny boss, Fred Carr. They were represented by Michael Milken and his firm, Drexel Burnham Lambert. Forbes Magazine did a story on the situation in their 3/14/1994 issue by Ellie Winninghoff. It went like this:

“A year after the junk market began to slide, First Executive was sitting with a paper loss of nearly $3 billion on its bond portfolio, which was mostly junk bonds. Was First Executive insolvent? No more so than almost every bank in the country was insolvent in 1981, when surging interest rates eroded the theoretical value of their portfolios. No more so than many banks were insolvent in 1990, when collapsing property values slashed the theoretical value of their real estate loans. A substantial proportion of First Executive’s junk bonds were still current on their interest payments. Held to maturity, most of them would be money-good. Markets recover from panics.”

The article goes on to say that when a company becomes “distressed,” they have to have their portfolio marked to market. Thus, as long as the individual segments insurance portfolio continues to perform, there is no loss in portfolio value to the insurance company for statutory purposes. In reality the rule is usually that the portfolio will be valued at the higher of acquisition cost or the market price. The theory being that everything eventually comes back if you wait long enough and thus, there is no reason to force companies to liquidate assets under panic conditions. On the other hand, there are times when cash flow can get a little tight even though for regulatory purposes the company might appear to be in great shape. There is more than a lot of truth to the article and the author is right on target. The problem with junk bonds is in the name. They are not the cream of the investment crop and while it is most unusual to see Fortune Five Hundred Company on the “distressed list,” it is the rule rather than the exception when it comes to junk.

So now the rest of the scenario starts playing itself out. Garamendi seizes Executive Life and immediately begins negotiations with Leon Black and Credit Lyonnais, the big French Bank can’t seem to avoid problems no matter which way it turns. Remember, Garamendi said that he didn’t trust Carr, but who was the bigger of the devils. Once again, Forbes asks some pretty darn good questions:

“…The public was in a tizzy about junk bonds and wanted blood. Carr, moreover, was hated in the insurance industry for offering yields that more conservative companies could not match. Yet Black had been a principal in Drexel Burnham and a leading figure in the leveraging of U. S. business. Was he a more sterling figure than Fred Carr? And what of Credit Lyonnais, sinking in losses and now embarrassed by huge loans to shady Italian financiers? This much is certain: No soon had he seized the company than Garamendi began negotiating the sale of Executive Life’s junk bonds to Leon Black, Credit Lyonnais and their French partners. “

Black knew the bonds inside out, he knew the market in which the bonds traded because at one time, he was the market, he knew the companies and he knew the business cold. He knew how to charge fees to companies, he knew who could reorganize them, and he knew what assets they had that were worth something. Black against Garamendi was like taking candy from a baby. Garamendi should have had the sense to hire Black a consultant for the State and have him liquidate the portfolios for a fee and he would have become governor with votes to spare, but this guy, like they said in the “Music Man”, “didn’t know the territory. Everyone would have come out a lot better. There were a lot of people that had an interest in bottom fishing and Garamendi had avoiding taking a lot of solid advice relative to a enhanced way to go. He now had suffered two strikes on two pitches in his first game in the major leagues and the manager was starting to become agitated in the dugout.

Garamendi determined to sell and when push came to shove, Black was not the only real bidder, however, on the other hand, he knew the portfolio cold not only because of the substantial work he had done on it at Drexel but more importantly, he had brought himself up to speed during his substantial and time consuming negations with Carr. There was somewhat of a bid-off between three parties and when one could not commit to certain obligations that Garamendi wanted covered, they were dropped as a serious contender ([249]). Once again, Garamendi because of his lack of knowledge passed and excellent bid by Warren Hellman that in the long run would have amounted to substantially more than that of Black’s but Black offered cash and that swung the deal.

In spite of appearances that Garamendi made the worst deal since the Indians sold Manhattan for some beads, he made great political hay with his string of announcements that played well to those that just didn’t know any better. He could tell the people that the company was liquidated and in record time, that they would be getting 50 cents on the dollar (he had gotten them ready to believe it would be less) and could show everyone how decisive and tough he was.

“To Garamendi and his crew, the junk-bond portfolio seemed a time bomb, as the junk-bond market was sinking fast. But where Garamendi envisioned disaster, Black and Cogut (Black’s advisor) knew there was potential value—plenty of it—because their outfit had firsthand knowledge of many of the junk-bond issues. Garamendi’s advice came from a team led by money manager GB Capital Management, Inc., a Mill Valley (California) group criticized by some Wall Streeters at the time for an alleged lack of junk-bond experience, a criticism GB Capital refutes.” ([250])

One of the more interesting pieces of litigation that has arisen in the case was the lawsuit filled by a number of policyholder groups in the California Court of Appeals charging that when the portfolio was sold to the Lyonnais subsidiary, Altus, it had already risen in value almost $1 billion. The policyholders are trying to get Altus to foot the bill for the increase. It would seem that they would be better off suing the State of California for incompetence in liquidating the portfolio for less than it was worth. It isn’t exactly Altus’s problem that the State with three bidders actively participating in the contest still made a bum deal, they just had an inexperienced commissioner that had an agenda that didn’t include either what the facts were or how many people would be hurt.

If the State had taken the Hellman offer, which contained a piece of the action provision based on performance, they would already have been better off and the deal had just closed.

Garamendi kept having bad hair days. He next tried to get some of the GIC holders to be declared junior creditors and not policyholders, thus making a smaller pie to be divided up among policyholders. Why he determined that the GIC holders were bad guys and other policyholders is hard to fathom but it may be that the people that owned the GICs were primarily out of state residents and wouldn’t be voting for Governor. What was left over would be the insurance business that he had sold along with the junk bonds as a package for around $300 million. This would have substantially reduced the company’s debts but it simultaneously would have wiped out any claims that this group had against the assets.

Naturally, The California Court of Appeal once again didn’t see it the Insurance Commissioners way and ruled against him. Now the commissioner was in real trouble. He had taken the position that the deal was a package and now the package was coming unglued. He wasn’t going to be able sell the now non-existent insurance business and therefore if the package deal no longer existed if the insurance side had tanked. Thus, additional lawsuits were instigated charging that the entire transaction was invalid and that Black and the Lyonnais subsidiary should return their profits to the policyholders.

So it now had turned out that it was not a package deal at all. Black and his associates had gloomed onto their junk bonds and were happy as can be. The insurance side went out of existence with the court ruling. These sort of mistakes started to take a toll on Garamendi and the first to take a shoot was the Action Network for the Victims of Executive Life who stated annunciating for all to hear that effectively the commission had been a little less than truthful in explaining the deal’s components. Even the California chapter of the American Civil Liberties Union got into the act by saying to the effect that Garamendi was using threats of lower recoveries to stifle any views that differed from his own.

When he was asked about his series of disasters, Garamendi responded, “I’m not into hindsight, It was the path that worked at the time” ([251]) Not being into hindsight, the insurance commissioner initiated lawsuits against a number of former Executive Life officers and in order make sure that he had a quorum, also named, A. M. Best Co., Moody’s Investors Service, Standard & Poor’s Corporation, Michael Milken and Deloite Touche the accounting firm that preceded Arthur Andersen. The charges almost sounded like the ravings of a mad person. The Bond Buyer Magazine had an article on the subject by Kathie O’Donnell on 2/28/92 and will attempt to paraphrase from it:

The Officers

“…The complaint charges that under direction of Executive Life’s chief executive officer, Fred Carr and other officers, the company filed bogus reports, used improper and false surplus relief arrangements, and other accounting tricks to continually inflate its net worth. Mr. Carr and the other simultaneously engaged in a deceptive advertising and promotional campaign regarding the safety of their insurance products and the soundness of the junk bonds the company invested heavily in. These misrepresentations were made with the intent to gain state permission to market its products and defraud policyholders, by failing to disclose the truth about the company’s fiancés, their actions constitute negligent misrepresentation.”

The Rating Agencies

“In name the rating agencies, the complaint says, “while Executive Life was purchasing junk bonds at an imprudent rate, and far in excess of any other insurance company, (these agencies) gave Executive Life high rating…Moreover, such rating were given out even though the rating agencies had access to confidential, inside information about Executive Life that belied the ratings they assigned to it.” The suit charges the agencies with fraud and deceit, negligent misrepresentation and negligence.”

Milken

The complaint also charges the Mr. Milken, as head of Drexel Burnham Lambert junk bond operations, ran a vast financial network called the “Drexel Daisy Chain” consisting of entities including Executive Life that provided him a market into which he could sell billion of junk bonds. During that time, Mr. Milken and some associated, called the “Milken Group” in the suit, held large equity stakes in the company and caused other members of the daisy chain to purchase equity interests in Executive Life’s parent and other subsidiaries in order to control the company’s investment decisions. Milken and two others with fraud and deceit, constructive fraud, negligent misrepresentation, intentional and negligent breach of fiduciary duty, and unjust enrichment.”

The Accountants

The complaint also alleges that Deloitte & Touche, formerly Touche Ross and co., Executive Life’s accounting firm, either knew of or recklessly disregarded evidence revealing negative facts about the company’s business and finances.”

The Wall Street Journal had something to add to the charges in their article of 2/28/1992 by Rhonda L. Rundle entitled California Insurance Official Charges S&P, Moody’s, Best as Well as Milken:

“Furthermore, Deloite & Touch played a central role in illegal acts leading to Executive Life’s demise and became the auditor of choice of the daisy chain. The accounting firm issued clean opinions of Executive Life and First Executive, thus furthering the illusion that they had sufficient financial resources to issue and/or purchase Drexel sponsored securities…Mr. Garamendi criticized Deloitte & Touche’s former partner in charge of the 1990 First Executive audit, William L. Sanders, for giving the company a “clean” audit and then joining the company as chief financial officer.”

As best we can fathom, the timing of the lawsuit seems to coincide with the negotiations with Milken, who was in jail, to settle the civil end of his problems for around $1.3 billion. This filing would give Garamendi a presence at any negotiation. His presence produced a universal settlement of $36 million from all parties to the action with the exception of Milken and Drexel. Deloitte would be putting up by far the largest amount, $22 million. The lawyer for the policyholders, Mel Weiss seemed to want to concentrate on what the accounting firm had done wrong. “Deloitte failed in both regulatory and GAAP audits of Executive Life to properly account for the junk bond inventory by not marking the bonds to reflect their true values. A proper audit would have revealed that Executive Life’s finances were impaired. Federal regulators would not have allowed the company to load up on junk bonds and carry junk bonds at inflated values.”

Well, time has marched on and Garamendi is no longer Insurance Commission of the State of California, nor is he Governor. His successor, Chuck Quackenbush bringing up long dead news suddenly pronounced that the whole deal was a fraud and the French had literally screwed the State of California. Maybe he is running for Governor as well but he has not yet learned that Executive Life is not an excellent springboard. The California Department of Insurance issued a press release on the matter and we will tell it like it is:

“…These rogue individuals and their corporate partners came to California with a scheme shrouded in lawless deceit, so they could evade regulations intended to protect innocent policy holders and consumers. Although the deeds were done on another Commissioner’s watch, I am going to ensure that the foreign financiers who perpetrated this scheme are made to pay, and that fast operators never again think they can manipulate and evade state authority. Specifically alleging fraud, deceit, mis-representation and unfair competition, the Commissioner has sued Altus Finance S. A., C|DR Enterprises, Credit Lyonnais, S. Q. Mutuelle Assurance Artisanale de France, Mutuelle Assurance Artisanale de France Vie S.Q., Omnium Geneve S. A., Jean-Claude Seys, Jean-Francois Henin and Jean Irigoin. The lawsuit seeks compensatory damages according to proof, punitive damages, and disgorgement of profits.”

From what I have seen of California Insurance Commissioners, they always seem like they are standing on a soapbox and running for Governor. Now this isn’t meant to disparage anything the gentleman said and if he found people with their hands in the cookie jar, our advice is to go at it. Commissioner Quackenbush said the following: “…Unknown to the Commissioner, Altus, (wholly owned by Credit Lyonnais secretly entered into agreements with some of the French investors which provided that Altus, not the investors, would own the new company. Further, Altus and some of the French investors secretly agreed that management of the new insurance company would be controlled by Altus.

Altus and the French investors then filed false and misleading documents with Commissioner Garamendi, which purported that the new company was owned by the French investors. Commissioner Quackenbush believes hat California law would have barred Altus from being approved as the owner of the new insurance company, and further, ownership of an insurance company by Altus might have violated the federal Glass-Steagall Act. The Glass-Steagall Act generally prohibited banks from owning insurance companies. Through its deception, Altus, literally a part of Credit Lyonnais, acquired the junk bonds, which are believed to have generated billions in profits.”

It turns out that a French Whistleblower ([252]) provided the information under which the State of California filled their action. It is interesting that this guy didn’t come out of mothballs for almost 10-years and all that could have possessed him to do so now would have been a reward provided by the California Insurance Department based on some percentage of recovery. For something like this to have simmered for so long, speaks to the number of enemies that Credit Lyonnais has made over the years.

We couldn’t agree more and at all times, Garamendi knew exactly who he was doing business with when he entered into negotiations with the French Bank, one of the least credible in the history of the world. Credit Lyonnais was the second most corrupt bank that ever existed on the face of the earth ([253]) next to BCCI. Milken was in jail and Garamendi was doing business with his number two henchman, everyone from Merrill Lynch on down told Garamendi that he was getting screwed by making the deal that he made and he went through with it anyway for his own political reasons. It really isn’t hard to figure out who the culprit is in this deal. We knew who the French were and so did Garamendi, but the office of the Governor was just too appealing a shoot for him to care who he stepped on, who he hurt and what eventually would be the bottom line.

United American Bank Busts

The United American Bank’s accountant’s, Ernst & Whinney in late January of 1983 indicated that their audit of the bank had been completed and although the news wasn’t all that good ([254]), the opinion was unqualified and there was no question in the auditors mind as to the Bank’s ability to function as a “going concern.” Literally simultaneously, The Federal Deposit Insurance Corporation who had also been looking at United’s books indicated to the bank that they were not in agreement with the accountants and the thought the bank’s situation was serious. The Bank was asked to recheck their figures and they dutifully took a closer look. They realized that they had greatly erred and announced publicly that they would indeed be taking some additional bad-loan write-offs as suggested by the FDIC. As if to keep the beat going, to everyone’s surprise, the next move was by the Commissioner of Banking of the State of Oklahoma who declared United insolvent due to loan loses and promptly shut the doors. Believe it or not, this entire scenario took place in a period of twenty days.

Jacob Franklin Butcher, Jake, had brought the World’s Fair to Knoxville, Tennessee and as such became its "fair haired boy”, but not for long. Jake Butcher’s dad, Cecil Hilgie Butcher Sr., who began his career as a farmer and general store proprietor from rural Maynardville, Tennessee could point to his roots in the area 200 years earlier. He had started out his business life as a schoolteacher. He went from that to buying produce from local farms and then would peddle his goods from the back of his open truck. Ultimately, he was elected to a county school board seat, which he proudly held for over 50 years. Eventually he bought a small local financial Institution by the name of Union County Bank in 1950 and it became such a center point of the community where hot lunches were served there every day for anyone that was interested. Butcher Sr. stated that the criteria for getting a job at his bank was, “I only hire people who can cook. Anyone can count money.”

Butcher’s two sons expanded his empire until, in 1980, they controlled twenty-seven banks in Tennessee and Kentucky with over $3 billion in assets. In addition, the two boys were responsible for building the two largest skyscrapers in Knoxville. The two brothers that controlled the Butcher Empire were Jake, and his sibling, Cecil Hilgie Jr, or "C.H.” he was called. The two boys were as different as night was from day. Jake was charming, well dressed and urban while his silver-white hair made it easy to pick him out in a crowd. With his banking success, he had become used to imported wine along with the very best of Champagnes. He had put together all the necessary elements for the good life by living in a magnificent mansion, having an enormous yacht, marring an actress, Sonya Wilde ([255]), running for governor of the State of Tennessee twice and as we have previously mentioned almost single-handedly successfully brought Knoxville, the World’s Fair in 1982.

His brother did not dress in custom made suits and imported shirts; instead, he wore denims and a big nine-gallon hat and just loved home cooking. His wife, Shirley Rutherford had been his childhood sweetheart and his home was an English Tudor estate with tennis courts, and swimming pool and was located on the highest point between the two adjoining counties. C. H. Jr. retrospectively said of himself, “I wasn’t good for anything except shooting pool, drinking beer and wrecking cars.” That was not exactly true, although he had flunked out of college and served in the army, when he got from his tour of duty he went back to school and received a banking degree.

In 1981, C.H. Jr. bought Shirley a $165,000 Rolls Royce Corniche, complete with bar and telephone. C.H. Jr. was just making good on a 1957 promise he made to Shirley that he would replace her 1950 Oldsmobile, which he had wrecked. Beside the necessities of life, the brothers also had time to purchase some of the luxuries as well, horse and cattle ranchers, private jets and helicopters were just a few of the things that made life a little more bearable for the hard working brothers.

The brothers worked well together with Jake concentrating on acquisitions in the larger cities and C.H. concentrating in the smaller towns. Jake would cater to the industrialists and C.H. would convince the farmers that his institution was the place to bank. They had divided their empire almost down the middle with the cities going to Jake and the outlying areas becoming the domain of C.H.

The world had never looked rosier; nevertheless, disaster was right around the corner. Jake who said he did not know the word failure, used some bizarre methods to raise the necessary money for the World’s Fair, and came under substantial political attack for how he had manipulated the funds he had garnered. ([256]) Would you believe that the day that the World’s Fair closed, 200 bank examiners descended upon the property. It was not long thereafter that the examiners were able to confirm their worst fears and within days, the United American Bank; the flagship facility of the family empire was closed by State Officials. The entire family house of cards quickly started to collapse and within a short period of time, another twenty-one affiliated & family banks had bitten the dust in the collapse of enormous proportions.

On the heels of the banks’ collapsing, C.H. Butcher’s, uninsured Southern Industrial Banking Corporation, a thrift went belly up leaving thousands of depositors broke and despondent. Federal and State Investigations were initiated into the affairs of both of the Butcher Brothers and the brother’s families. This started a chain reaction, which ended in bankruptcy filings for almost everyone in both families. Eventually, Jake Butcher pled guilty to stealing $17 million from his own banks through a convoluted program of illegal self-lending. He also was hit with substantial assessments by the Internal Revenue Service for unpaid taxes. They said that Butcher lied on his returns for 1967 – 1972 and reported losses when he had actually made a lot of money. Indictments were also handed down against Jake’s dad, two other family members, a number of friends, and a family accountant.

Jake’s rotund and balding younger brother did not escape the authorities notice; C.H. was indicted on 26 counts of mail, wire and securities fraud and was thrown into jail because he was determined to be not a good bail risk. C.H. Jr. had been cooling his heels in county jails for a while because of charges that he was a major cocaine addict and a heavy gambler and therefore could not be trusted on the outside. That wasn’t the only reason that C.H. wasn’t going to be allowed out on bail, it wasn’t the fact that he had cheated on his wife for 12 years or that prosecutors believe that he had $5 million in hidden assets overseas, it was the fact that C.H. himself has said that he will “never go to jail and never be poor.” This poor sole just did not know when to shut his mouth.

Ultimately he coped a plea and was handed 25 years in the slammer for his part of the machinations, which included bankruptcy and tax fraud. ([257]) The judge also ruled that because of C.H’s role in trying to hide his assets from the court, his debts would not be forgiven in bankruptcy and that when he got out of jail, he would have to pay them off. In the final count, C.H. Jr and his wife were saddled with $210 million that they are going to have to repay, Jake somehow has got to get his hands on $180 million to give back and Sonya who came out of the affair better then the others remains liable along with Jake for $17.6 million in federal tax claims.

C.H. did not do as well with his plea bargain as did Jake. When the smoke had cleared, his sentence turned out to be five years longer. As part of the deal with the government, that C.H. made was the fact that he would turn over various and sundry assets that he had laying around. It made an interesting scene when he brought in 132 oil soaked bags filled to bursting with silver coins, most of which had been buried underground in 55-gallon drums. There were also the $2 million in gold coins that had been hidden in the Cayman Islands; there were the furs that had been stored in hidden rooms in his house and jewels that were squirreled away in bank vaults under nominee names. He also gave officials some musty envelopes that contained treasury notes and coupons worth more that $700,000. Last but not least, the horde contained $10,000 in cash. Also turned over to the government were two Mercedes-Benz, a Rolls Royce, and a condominium. It turned out that C.H’s wife Shirley was an active participant in hiding her husband’s assets from creditors. She too was looking at severe downtime relative to her actions. As part of an overall deal, Shirley worked out an arrangement that limits her jail time to three-years.

As kind of a postscript to the matter, it seems that C.H. was not exactly a model prisoner while he was awaiting trial. The judge had given Butcher the opportunity to met with his lawyer for a few hours every day in order to sort out his affairs. Guards in search butcher’s cell during a normal check found that he was buying drugs on the outside and bringing them back for use in his cell. If that wasn’t dumb enough, they also found letters from his girlfriend describing their sexual encounters while Butcher was supposedly on the outside seeing his lawyer. The Judge was not at all pleased.

Also indicted were Jake’s dad, at that point, 84 years old, H.’C ‘s son a lad in his twenties that couldn’t even understand what he was being charged with and his girl friend, but for various differing reasons they all were ultimately given a pass. Sentences were handed out for things like bankruptcy fraud, covering up a crime, concealing funds from bankruptcy creditors and failure to report the cashing of negotiable certificates for over $10,000. G. W. Ridenour Jr. who was general counsel to the United American Bank during its salad days was also sentenced to prison for his part in the affair which included helping Butcher set up bank accounts in the British West Indies to avoid detection and the creation of phony corporation.

One example of Ridenour’s work was the purchase of the Pasqua Yaqui Indian bingo concession in Arizona. It was purchased from the Pan American Corporation for $550,000 at the close of 1993. The money for the down payment mysteriously came from a Swiss bank in the Cayman’s. The indictment was rather far reaching and said that Ridenour had created “17 “shell” corporation in Tennessee, Kentucky, Texas, Florida and Delaware and opening accounts at banks on Grand Cayman and Grand Turk islands in the British West Indies to hide and launder more than $4 million.” When C. H. wanted to buy a stable of expensive horses, he turned once again to trusty Ridenour who arranged a $600,000 down payment from the same Cayman Island bank. Just your everyday kind of catch all lawyer for a rural bank.

One of Jake’s big problems was that just wasn’t too careful with who he hung around with. His closest associate was Jesse A. Barr, who had earlier been convicted of bank felony. Barr had already served time for bank fraud and in it just didn’t show a lot of good judgment having him hang around. Ultimately, the chickens came home to roust and Jesse was hit with 32 counts of bank fraud when United American went under.

Jack H. Patrick who had run the real estate lending at the bank was treated equally appallingly. On the other hand, the courts determined that Patrick was the bank official that was siphoning off money to Butcher so that he could acquire other banks. In addition, it was shown that Patrick also a major beneficiary of the fraudulent loans. It just happens that he was also the president of a mining company, which was the recipient of a substantial amount of bank funds. Both Patrick and Barr were starring down the barrel of 150-year sentences each. Although their plea bargains brought that sum down substantially, they didn’t exactly get away with a light sentence. Both of them were given double digits in jail-time.

The judge in the case, District Judge, William K. Thomas didn’t believe one word of it when Barr said “he had gotten into the fast lane out of loyalty to his friend Jake Butcher.” Thomas’s retort was telling: “Maybe you helped Butcher out of loyalty or because he gave you a job when you got out of jail, but that does not show a lack of intent. You were the key player who made possible his million-dollar thefts.”

Regarding, Jesse Barr, it would have seemed that if you are in the banking business you would not want the world to know that your first in command had already been in the slammer. I mean that this would especially true if you are going to be tinkering with the inner workings of banks in an illegal fashion. Beyond that, because of his previous conviction, Barr was banned from working in banking so Jake solved the problem by hiring Barr’s wife, through a consulting company at a heft salary.

It was at Union Planters Bank in Memphis that Jake and Barr first met and that meeting worked out famously for Butcher in that Barr convinced the bank to lend him $5 million so that Jake could acquire his second bank. Jake had one other problem besides his inability to understand how to pick friends. Just like his baby brother, he had a tendency of talking just a tad too much. When people would ask how he had been able to build the huge banking empire, he would reply to anyone that asked, “We’d borrow money, buy a bank, pay it off, then borrow more money, and buy another one.” The fact that Jake advertised his illegal borrowing to one and all and it did not help his case in the least when he was arrested.

The bank failures were rather colossal in scope without even taking into consideration the ripple effect that they had on other institutions. The FDIC estimated that the affair cost taxpayers over $700 million and that the United American failure was the third biggest in United States banking history.

The Butcher’s operations were fairly average business transactions. They included all of the normal business tools that are universally used. Money laundering, drugs, gambling, pay-offs, tax evasion, illegal loans and fraud are just a few of the tricks of the trade that the Butcher’s fell back on when need be. In order for you to get the picture a little more clearly, we will spend a short time on an affair that included C.H. and a young man by the name of Joe Duncan. Joe was the son of a congressman, John Duncan, a Republican from Tennessee. Joe Duncan at the time was the Senior Vice President of Knox Federal Saving & Loan, a financial institution highly coveted by C.H.

The two conspirators had numerous meetings during which discussions were held as to how Joe could be instrumental in torpedoing the present management of Knox and causing the institution to have to turn to C.H. for help. With their devious planning finished, C.H. sat down with his tax advisors to do a little something for Joe. It was arranged that a serious of fraudulent loans would be put through on of C.H’s banks in the sum of over $300,000. Joe would be the recipient of the funds and somehow the loan would never have to be paid back.

Joe for his trouble in this affair was indicted for income tax evasion. The accountant, Michael Downing who had been helpful in the planning of the conspiracy was charged with conspiracy and with aiding and assisting Joe Duncan in filling of fraudulent tax returns. On this deal alone, Duncan and Downing could well be hit with eleven years in prison and Butcher could get five.

Ernst and Whinney, the accounting firm that had done the bank’s audits was sued by the Federal Deposit Insurance Corp. (FDIC) for over $250 million ([258]). The lawsuit stated that it was because of the accounting firm’s faulty audit that the damage had been accomplished. An FDIC attorney, Cecil Underwood, in setting out the government’s position indicated, “The agency believed that Ernst & Whinney was extremely negligent in their audits and that the suit represents substantial liability exposure on the part of the accounting firm.” The FDIC indicated that once the money was forthcoming from Ernst ([259]), it would be used to replenish the insurance fund used to compensate depositors when banks fail. This lawsuit represents the largest of its kind ever filed by the agency.

Ray Groves, Ernst & Whinney’s Chairman indicated that the FDIC was only seeking to spread the blame around a bit and that it too had an obligation of audit relative to the shuttered banks. Groves added that the FDIC was doing a simultaneous audit when they discovered the problems and did not share their results with the accounting firm. The fact that Groves’ does not understand that the mandate of the two organizations was dramatically different. The FDIC if they had shared half cooked information with the outside auditor would be forcing an issued which would then have to be brought to a head by the outside auditors. This could have caused a run on the bank and without all the facts; it could have resulted in a disaster that may have been unnecessary. Moreover, I do not believe that a government agency would have been legally able to share its work product at least at that point with the outside accountant, who was in the employee of the bank, at least at that point in time.

In the meantime, things were a little more complex than that. As it turns out, Walter Boruff, the Ernst & Whinney partner in charge of the audit had borrowed $53,000 from one of Butcher’s banks during the time that the audits were being performed. The FDIC’s position was not illogically that such a conflict of interest would impair the audit’s independence. Under the circumstances, does Groves think for one minute that the FDIC knowing this fact, is going to let Boruff in on what is going on so that he can give the information to the Butcher’s? Not on your life! Groves was asked about the loan by reporters and said he had not had time to study the lawsuit by the FDIC. I wonder what on earth the lawsuit would have to do with the fact that the senior auditor on the account from Butcher’s firm was playing “patty cake” with the client should have totally incensed the man. Well who are we to talk about human nature, with accountants, you don’t know if they have any or not.

However, the FDIC was not through with Ernst and Whinney just yet. They further charged them with covering up the fact that mail confirmations covering $16 million in loans made by the Butcher Banks were never sent. The confirmation process is generally the most important step in the audit. It is what differentiates the independent auditor from his client. If the auditor misses that procedure, there can be no certainty that any of the loans are real. In effect, they could be pieces of paper created by the banks to cover their backsides. When this had occurred, Ernst & Whinney was already on trial over $180 million that the FDIC wanted back from the accounting firm over their handling of the audit of Continental Illinois Corporation.

One of the reasons that things were going so poorly for the accounting firm was the fact that this failure was big enough to get the attention of congress. A sub-committee was impounded to investigate what had occurred and their view was expressed by Peter Barrish a staff director of that committee. “The two-year federal probe of the Tennessee bank failure had produced evidence of the biggest insider bank fraud in U.S. history. The committee also came down hard on the FDIC for not watching the store well enough.

In the meantime it was evident that Ernst & Whinney was getting plenty worried. “Worried about the pending court cases, accounting firms have been increasing the training of their bank auditing staffs. Ernst & Whinney this summer will test up to 120 of its auditing supervisors with a computer model simulating a bank’s operations. The supervisors will pretend that they are bank lending officers and have to decide, for example, whether their “bank” should accept deposits from middlemen.” ([260]) Somehow it seems a little late to be teaching bank auditors about the banking business, why didn’t think of something logical like this before they started trying to do the books?

This new “get tough” approach by the FDIC was caused by the fact that a greater number of banks were failing at this time and the insurance reserve fund had been sorely depleted. In addition, maybe this would send a wakeup call to the auditors; some of those other banks that had yet not failed could be saved if they could just get in time. In a Wall Street Journal Article entitled, Hard Numbers: Bank Auditor’s Job Gets Much Tougher; Some Firms are Sued by Lee Berton, 5/9/1984: “

“The Federal Deposit Insurance Corp. Also is said to be considering court action against five accounting firms, including Peat, Marwick, Mitchell & Co. and Ernst & Whinney, involving audits of banks that later failed, were closed or were sold to other banks. The FDIC insures individual bank deposits for up to $100,000, and as its insurance losses mount, it is looking for reimbursement from the outside auditor for some of those losses. “Based just on the 90 bank failures we had in 1983 and in 1982, we’ve made out-of-court settlements of $6 million with six CPA firms over the past year,” says Cecil Underwood, an FDIC attorney with a special section on accountants’ liability set up late in 1980, “But the big settlements or suits…will come this year and in 1985,” he adds.”

By no means was this all of the bad news that Ernst & Whinney was about to receive. They were sued in a class action lawsuit by a group of irate shareholders. The case was brought in the Bank’s own back yard, Knoxville, Tennessee, in Federal District Court on March of 1983. The litigation alleged that Ernst & Whinney had committed securities fraud and had made misrepresentations of financial figures. The more telling part of the lawsuit was the fact that it included the allegation that United American Officials had been warned by the FDIC that the bank was undercapitalized and that it would require additional funding to be able to clean up its loan portfolio.

What people suddenly started to discover was the inter-bank transactions that were being conducted among the affiliates. For example, United American Bank sold $16 million in substandard loans to Southern Industrial (The bank owned by the Butcher Brothers’ father) and one month later repurchased the same loans. Regulators stated that the repurchase showed the bank’s tendency to buy back “adversely classified credits.” Information was released showing that the Butcher’s were able to continuously build their empire by taking loans out at their own banks to purchase additional financial institutions.

In examining the bank's working papers, many forged loan documents appeared. At the same time, many of the documents that should have been available were missing and regulators accused the Butchers of destroying bank records and evidence.

At least three Grand Juries were hearing evidence on Jake simultaneously but when the smoke had cleared, he had been indicted on over one-hundred counts. The total sentence that this would have ordinarily brought would have been five-hundred and one years in jail. Jake didn’t think that he would last that long and pled guilty in a plea bargain which sent him up the river for only 20 years. A lot of people that had ripped off would have preferred that Jake fight the conviction so that they would put him away for ever.

So You Want To Be In Pictures

Cannon Group, Inc

Picture the story: two immigrants from Tiberius Israel, who are in love with American movies travel to the United States from Israel to see the bright lights. And where do the bright lights shine the brightest, Hollywood! On the other hand, these fellows don’t have a dime and want to make a big name for themselves. What to do? They have seen American movies while living in their native country and they agree that this seems to be a super business to be involved in. You meet all kinds of stars, eat at the better places, go to power meetings and get your name in the newspapers all of time. Most important, the immigrants see an opportunity to make a lot of bucks.

Menahem Golan and Yoram Globus are cousins and by borrowing money from friends and negotiating a tight transaction, in 1979 they come up with the $350,000 necessary to purchase a small movie studio called Cannon Group, Inc. By making a succession of blood and guts films, which whet the American moviegoers’ appetites, they soon knock ‘em dead. The cousins become wealthy, on paper at least, and get to hang out with really important people ([261]). (In effect, they could just as well only hang out with each other because they are now important too, but they don’t know that yet) In reality, Golan went to City College of New York where he studied film and then onto Hollywood were he apprenticed under Roger Corman, the master of the quickie movie while Globus attended business school after spending two years with the Israeli Defense Force. (In reality, these guys were far from stupid)

From this point on, this is a story more about Hollywood-type accounting then it is about the success or failure of two immigrants that got lucky for a time. You can believe that the key person in making a movie is the producer no matter what you have been told. Normally he is the one who comes up with the bread to get the film off the ground and into the “can” ([262]). Once the money is raised, talent can be purchased for a price. If the producer or the people he taps to get the money bring home the bacon, they make a lot of money (maybe) and maybe even get to hang out with stars and go to power meetings. Usually, this is not the case because of the highly imaginative manner in which the movie industry keeps its books.

The movie industry has gone through various stages, and during the seventies and early eighties, movies were the beneficiaries of some major loopholes in the federal tax codes that allowed a number of remarkable benefits to investors. If they invested in a film (or for that matter any number of similar investments) and for example, didn’t put up any money at all, but went to the bank and borrowed it all, the taxpayer would be able to deduct 100% of the interest charged them by the lending institution as well as a good portion of the principal. They were also entitled to a write-off for, what is called an investment tax credit. We don’t see this gismo much anymore because it was to much of a license to steal and with tax collections being down and all, well, you know what I mean.

This scheme was originally used by the United States Government to convince people to make energy-oriented investments after the oil problems that were created as an aftermath of the six-day war. This credit would allow the investor to receive a direct deduction for a specific part of his investment right off of his taxes, an overwhelming incentive. The ultimate benefit the investor received was that he was able to amortize his investment fairly quickly, based on the perceived life of the film.

Thus, an individual borrowing money to invest in a movie would literally receive astounding tax deductions without risking a penny. Moreover, even if the film turned out to be a disaster, which was true in most cases, the investor at least received the opportunity of moving his taxes forward and probably came out about even after paying off the bank loan. These and a multitude of even more aggressive tax shelters were exploited during this period, until the IRS determined that, for the most part, they were abusive and would no longer be permitted.

The new regulations were doubly harmful to investors because they basically stated retroactively, that because these shelters were a subterfuge, existing only to avoid taxes, they therefore had no real business purpose and all bets were off. The interest deduction went the way of the Dodo Bird and was designated, caput. Conjure up during the Carter years, borrowing money at 21% and then not even being able to deduct the interest from your income tax. Many people that should have known better went broke or even worse, over these new regulations especially in the most dependable event, when the movie failed as well.

During these years, Hollywood was basically investor financed as opposed to an earlier era when it was studio bankrolled. After the fiasco created by the IRS finished wiping out the individual investors, financial institutions and Wall Street perceived techniques, which allowed them to indirectly invest in movies without substantial downside. For the most part, they became lenders to the studios whose celluloid assets bore tremendous inherent value and for the first time, financial institutions started to realize it and competed heavily for Hollywood’s business. Almost all of these films had been amortized down to zilch on the studios’ books and with the advent of television, cable and the resurgence of the European viewing market, abruptly these stultified assets grew legs and became enormously valuable. New technologies such as re-dubbing, colorization, and digitalization brought pictures long believed to have no redeeming artistic value back into play.

In the beginning, the financial institutions had to be extremely careful because Hollywood studios had literally invented creative accounting for years in order to separate both actors and the investing public from their hard earned money. ([263]) The institutions were somewhat suspicious that the studios didn’t know how to play without a stacked deck and they could be left sucking wind the same way that individual investors had always been. Giving the other guy the short straw was as much part of Hollywood as was Grumman’s Chinese Theater. Stars that worked for a piece of the net usually found to their chagrin that the studio always lost money, thus they never quite seemed to earn a penny as an incentive fee, but it took them tens-of-thousands of dollars in legal fees and court costs to have it really sink in. Investors who bought into hit movies (seemingly), also found that mysteriously, the films consistently lost money.

The studios were absolutely expert at amortizing their costs over the length and breadth of the studio property if, of course, the net belonged to an outsider and keeping expenses to an absolute minimum when the studio itself produced the film. Now that everyone has been totally fleeced by Hollywood, it is a rare sucker that still doesn’t know enough to stay out of the other guy’s game. Pictures were definitely the other guy’s game.

Getting back to Hollywood accounting, we mentioned earlier that the film would be amortized over the useful life of the property, and that is as it should be. In real property, the IRS has definitive guidelines as they do in just about everything else on the tax table but not in films. You can call the IRS and get a depreciation schedule on just about anything, and if you follow their guidelines, you have little to fear that an agent of Uncle Sam is going to come knocking at your door. Films are very different - what is the value of “Ben Hur” or “Gone With The Wind”, and over what period of time should they have been written off? Originally, nobody could ever tell with either film before the audiences themselves voted with their money plunked down at the box office, whether it would be a hit or a miss. (Either people went to view the film or they did not, why they went or what made them go was extremely elusive and if anyone solved that enigma, all films would be theoretically be profitable and we would all be attending the plethora of movies every waking moment).

The choice on taking amortization is solely that of the studios along with their accountants, and I would imagine that if the production company were public and the studio’s management were to continue to depreciate ([264]) films that audiences were no longer viewing over excessive time periods in order to manage their earnings for the public, you can be sure that the Feds will find where they live and pay them a visit.

If the government proved that you, as the studio, knew that you had a clinker and yet continued to carry it as a significant asset on your balance sheet, you would have committed no less than three crimes if you were a public company. The first one is that you were indirectly rigging your stock by reporting higher earnings than would have been the case if the dog had been given a punctual burial and not left to smell up the backyard. The second crime would be that you were effectively overvaluing your inventory. The film was worth, purely the value of the celluloid on the roll after audiences had already turned up their noses, and the reviewers had unanimously agreed that the director should have been tarred and feathered for even thinking of making the picture. The third technique is that they can accuse you of cheating by managing your taxes in such a way that they you can be sheltered literally for ever. By keeping a string of flops on the balance sheet as assets, whenever you have a hit you can offset the taxes by dredging up one of the worthless films in your inventory and giving it a belated but decent burial.

But who is really ever to say that something is utterly worthless and indeed, when does this event occur in the real world? Look at what happened after television came into its own. Films that had already been written down by the studios became golden. Early on, television was not equipped for complex entertainment and films along with sports, such as wrestling really filled the bill. Valueless films once again became hits and with companies like Turner Broadcasting having the sense to buy the entire inventory of various studios, it also acted to impair the competition from competing without unduly arousing the ire of the Justice Department.

The studio with the largest quantity of movies by volume usually got the biggest price for their libraries. The issue at the beginning was much more quantitative than qualitative; because television executives were interesting in filling in the blank spots that appeared on the screen when there was no programming available and there didn’t seem to be much question in anybody’s mind that viewers would only watch guys in shorts running around a small ring trying to maim each other having monikers such as Gorgeous George, Killer Kowalzki and the Blue Orchid. Who would have thought that the Three Stooges movies ever would have been worth anything, at least after the reels had been stored after the original viewing. How often do they now reappear on your viewing box at home? If the producer had written these movies off over 60 years, I doubt that the government could have argued effectively against it.

If the government had forced an inventory write-down and television suddenly happened, you can see that some poor IRS agent would probably gotten a lot of egg on his face. The studios, however, sold their libraries in totality, but only for limited commercial usage. Free commercial television. They didn’t imagine that their luck would continue to hold, but once again, they were in the right spot at the right time. When cable became popular, the library could be sold once again. In the first instance, the film was sold for free consumption, and the bill was paid in the by the advertisers; in the second, the consumers ultimately paid the bill. Hollywood, sat back and, kind of said to itself, “what a deal, we make it, we sell it and we still have it.” This type of product confused the tax collection people no end. They weren’t sure whether they could ever bring a successful case against the studios in spite of the fact that there was not much question that many of them were extremely profitable, yet they paid little or no taxes.

While everybody was thinking about how to approach the situation, as we have mentioned earlier, the European market started buying American movies and once again, Hollywood was able to disintermediate the market. Their lawyers had carefully worded the contracts so that the sales that they had entered into earlier had not included any foreign rights. The Hollywood moguls went to the bank and literally laughed at the tax collection people.

And Hollywood had other gimmicks that Uncle Sam hadn’t even begun to grapple with. In the early days of movies and up until fairly recently, actors were under long-term contracts with their studios. They could be rented or loaned out to a competitor, but basically, if you worked for say, Metro Goldwyn Meyer, you were purely a chattel. Thus, the film studio determined the useful life of its actors, which may or may not have corresponded to the term of their contract. This gimmick has worked startling well for sports teams and virtually insulates them from paying heavy tax bills. The money a team or movie studio pays an athlete or movie star has little to do with what and when the write-off occurs. Suffice it to say that without this substantial advantage, sports teams could not afford to pay anything close to what players are getting today; but they are Johnny-come-lately's to this world of high finance. Hollywood literally invented it the scheme. Interestingly enough, as long as salaries continue to go up, it gives management a higher and higher write-off but as soon as they have a bad period, the old amortization table catches up very quickly causing a down hill slide.

Hollywood has been able to legitimately enjoy consistent “big bath” accounting throughout its history. Some of the historic advantages that Hollywood believes were its birthright stem from the fact that movies for years have acted as the propaganda machine for the United States Government. When the United States needs to sway public opinion relative to the war effort, energy or anything else, someone in Washington sends a message indicating that the studios should get behind this or that effort, and the studios have had an amazing record of falling right in line. While, this scenario has changed dramatically because of television and more recently the Internet, (effectively Hollywood has lost much of its power to influence opinion) the IRS has not particularly chosen to change the formula. Occasionally, Hollywood couldn’t help but have an actor or actress fall from a tree such as Jane Fonda did during the Vietnam War, but in reality that war was already the start of a new age. It was the first war that became a documentary while it was occurring. The public became disenchanted very early on because a number of things. The most important was the fact that for the first time the American Public was getting the news as it was happening, not the way the American Government quite wanted us to distinguish it. We were getting the uncensored, unvarnished facts for the first time in the history and no one in this country like what they saw.

Meanwhile back at the ranch now that you understand everything about the film industry. So, lets say I am two savvy foreigners that have just sunk every nickel into this studio and I want to make movies with other people’s money, what do I do. Well if I am as smart as Menahem Golan and Yoram Globus were, I do it all and do it all at once. So, I decide to produce a movie and long before it is “in the can” (completed) I go over to HBO, Showtime, and a few more cable companies and get a little bidding war going over my intended flick. Incidentally, you ask how they can buy something they haven’t seen and may not ever be completed for an absolute host of potential reasons? Simple, our friends at Canon, Golan, and Globus buy what is called “completion insurance.” It insures that either the film will be completed one way or the other by the funding party or the present producers depending upon the agreement. In terms of how well it will draw, this can more often than not be determined by the star that is appearing in the movie.

Harrison Ford and Julia Roberts are names that can literally be taken to the bank and they always are. Their agents are sophisticated enough that they can get $20 million per and up, they just aren’t going to let their clients get stuck with a clinker and lose their meal ticket. Or sure, they are going to make a mistake now and then, just as Shirley Temple’s agent blew it with the Wizard of Oz and gave Judy Garland a chance to be a star, but in this deadly business of only being as good as your last film, there is just, no margin for error.

At this stage, the bank thinks the film is a winner, the studio thinks it is a screamer, Ford’s agent loves it and he has convinced his client to do it and last of all, HBO has put up substantial bread. Next stop, are the pay TV rights, the video rights, the foreign rights and the pay for view rights. In addition, if they directors are particularly commercially oriented and can get away with it, there are also opportunities available to sell particular advertising spots within the movie, the star is smoking Camel Cigarettes and driving an Aston Martin. Do you for one minute think that in a big production, anything remotely commercial gets on the golden screen without substantial money or other valuable commodities changing hands. (we call this barter and we wonder how much taxes the studio’s pay for that)

Thus, if you are two Israeli’s with a decent track record, a good script, a decent director, insurance, and a proven star, you may just have the opportunity to break the bank. If you can control your production costs, you can recoup more money than the film cost to you make before you even start shooting and we haven’t even mentioned the fact that in the days we are talking about here, you could have gotten suckers to put up money just to play big shot and get the tax right-off. Impossible you say, listen up Bunkie, in those days, our brokerage firm, the one I was president of financed substantial portions of all of these deals. We did some of the Superman films, The Rambo films and a host of other very well known individual productions.

Both of the first two, set records for attendance when they were released. Guess what we received for putting up tens of millions of dollars; as I remember it, it came to a tad over $100,000. Oh, don’t shed any tears for us. We were in the business those days of selling tax oriented private placements to investors along with our doing own stock brokerage business. The commissions that we took in on these deals paid the rent and although the government changed the rules, after the fact, I had no complaints, we got what we bargained for, the bad end of the deal, which wasn’t that terrible, but again, we were dealing with Hollywood and everyone has a right to be a little naïve once.

So now that you know everything about making movies and all the nuances that come with it, let’s give you the last piece of information that is necessary to understand how the operation functions. We have seen that, when to write-off, a picture is purely subjective and no two people, especially when you consider all of the variables involved, could ever come up with the same evaluation. Moreover, it has never been hard for clients to do what is called, “opinion shopping” for an accounting firm to do the books the way that would give the studio the biggest bang for the buck. Very often, when the studio and the independent accountant have varying ideas of how best to handle the tax aspects of the movie, they discuss it rationally and when the accountant disagrees; more often than not, the studio will tell the auditor in no uncertain terms that it isn’t going to be their judgment call. If the auditor doesn’t like it, they will float their proposal to more receptive accounting competition.

In the movie business, in particular, the accounting firm doesn’t need to be composed of nuclear physicists to realize that the client is certainly going to be able to find a competitor with ideas that more closely match what the studio is aiming for then the position that they are currently taking. Now the accounting firm can either take it or leave it. Because, as we have discussed earlier, it is so difficult for the government to say that it should be written off in this or that time period, the accounting firm knows, that in spite of certain risks, they probably will be able to get away with very aggressive tax treatment of the studio’s property.

Forbes Magazine did an interesting study of Canon’s costs and profits that is worth repeating here. It is a story that appeared in the September 8, 1986 issue and it was entitled, Now You See It…As A Film Company, Cannon Group Seems To Walk On Water. (Movie Bookkeeping Accounting Assumptions, by Tatiana Pouschine:

“…In 1985 Cannon’s amortization rate was 57.2% versus competitor Tri-Star’s 77.6%. In short, Cannon seemed to be spending only $572 to get $1,000 in revenues while Tri-Star was spending $776. Impressed by these numbers, investors lapped up Cannon stock. Weren’t movies the quintessential business in the postindustrial society? And wasn’t Cannon an efficient producer? In 1985, Cannon generated earnings of $15.2 million, up from $12.2 million the year before. Rival Tri-Star Pictures, Inc. earned only $1.6 million revenues of $258 million; rival Orion lost $31.9 million on revenue of $198.1 million.

Was Cannon really so much more efficient? Were its movies so much more profitable? Maybe.

But maybe not. Maybe Cannon was just slower in writing down its inventory of released films.

Forbes traced the economic progress of each Cannon film released in 1985, all 20 of them. We discovered that these films took in around $9 million each on average—from theatrical showings, video, television, foreign, the works.

What did these films cost? About $5 million each for the film and $2.4 million in marketing costs—advertising, prints, and promotion. Overhead and interest add about $1.2 million per film. In all, the costs come to $8.6 million per film—just under what the films take in.

So where’s the profit? Cannon makes something from running movie theaters but nothing like the $16.6 million it reported as pretax profit for 1985. Where, then, did the profit come from? The skeptics conclude it can come only from the under amortization of film costs.

Is there a smoking gun? No. Just a corpse. The corpse is that Cannon’s film inventory is mounting fast. The figure was $121 million at the end of 1984; it was $213 million at the end of 1985. Some of this bulge is the result of the fact that Cannon has been making more films each year than the year before. Even so, the bulge seems excessive. While inventories of films already released were mounting by more that 60%, film revenues, including TV, rose only about 30%. A $50 million-plus increase in releases produced only a $26 million increase in revenues.

At $213 million, Cannon’s total inventory is actually higher than Paramount’s $199, even though Paramount has something like eight time Cannon’s revenues. The suspicion is that Cannon is booking revenues faster than it is recognizing costs. Anyone who does this is a candidate for a fat write down somewhere down the line.”

So, Golan and Globus continued their production of films at an absolutely torrid pace. The made “The Delta Force” with Chuck Norris, “Over The Top” with Sylvester Stallone, “La Brava” with Dustin Hoffman, “52 Pickup” staring Roy Scheider and Ann-Margaret, “Masters of the Universe” with Dolph Lundgren, “Death Wish Three”, with Charles Bronson, “Runaway Train” with Jon Voight, “Superman III” and “Superman IV” with Christopher Reeve and Margot Kidder, “Duet for One” staring Julie Andrews, “Cobra Top” staring Sylvester Stallone, and “Ordeal by Innocence” staring Donald Sutherland, Faye Dunaway and Sarah Miles. You can say what you want about these guys, but they certainly went first class when it came to talent.

In an attempt to up the ante, the Cannon studio turned out forty-three movies in 1986, a literally stupendous number especially when you consider that all aspects of the films were done in-house including the production and distribution. Management stated for attribution that the average age of their employees is 27 and that because of that fact, they are hard charging, lean, and mean. When they first started producing pictures at Cannon, the stuff that came out the door made “B” films look like a Rolls Royce’s. They soon acquired the nickname, the “schlockmeisters of Hollywood.” On the other hand, with no bucks what else can you do? It was when they started pre-selling everything but the kitchen sink, that quality started entering into the equation.

Cannon did another thing that was a little different. As soon as it was able to get some breathing room, management started acquiring movie theater chains. They never forgot mistake number one. That was determining to distribute their films with a touch of class. They made an exclusive distribution deal with MGM who they thought were the top of the heap only to promptly be taken for a ride, or at least that is how they viewed and they vowed, “never again.” In order to control their own destinies, Golan and Globus felt that controlling the distribution of their own films was critical and by controlling the theaters as well, they could surely be the masters of their own destinies. This was a very expensive mistake, because it took whatever small financial cushion that Cannon had available and left them it a very tight financial condition. This was especially true in Hollywood where there are not a lot of independent producers that were able to beat the system. A System in which the so-called majors had a call on nearly unlimited money and talent.

On the other hand, the boys didn’t fall into the normal Hollywood type traps. They weren’t awed by the scenery. They stuck to their knitting and worked twelve hours a day, seven days a week according to the best possible source, themselves. However, in spite of their best laid plans, their films started to lay eggs, the stock market crashed in late 1987 and people were watching their bucks and worst yet, the Securities and Exchange Commission had come calling relative to some of their more bizarre accounting practices. The Company started losing money and the only way that they could survive was to sell their very valuable film library to Warner Communications (formerly Warner Bros.) for $75 million and even in spite of that, they were forced to reduce their film production to 12 –15 movies a year.

The Securities and Exchange Commission was not kind in their assessment of what happened at Cannon.

“The Cannon Group Inc. defrauded investors, inflated profits, submitted false documents to the Securities and Exchange Commission and had its chief banker on its payroll…From January 1983 through at least November 1986, Cannon and Mr. Globus employed devices, schemes and artifices to defraud in connection with the company’s securities, also making false statements of material fact and omitting material facts. Cannon consistently and materially under amortized film costs in the first year of each film’s release, resulting in inflated earnings. Moreover, Cannon stepped up its overestimation of film revenue during the second quarter of 1984, when it was planning one of its public offerings. Thus, reported earnings for the quarter were inflated by at least $1 million. Cannon submitted false annual and quarterly reports to the SEC, and that during the SEC investigation, Cannon executives submitted financial schedules that were consistent with earlier false documents rather than with the company’s own books and records.

Cannon failed to disclose promptly that Frans Afman, an executive at Credit Lyonnais Bank, was a managing director of Cannon Productions N.V. with a three-year contract valued at $75,000 a year through 1987. Credit Lyonnais has been Cannon’s main bank, and Mr. Afman, Cannon’s main contact there, also got consulting fees of $100,000 from Cannon in fiscal 1986.” ([265])

Well that doesn’t sound very good to me, but what do I know? If I am reading between the lines, these guys may have missed committing murder and a few other heinous crimes but not very many. The SEC and the Cannon Group sat down, worked out a settlement in which the boys said that they weren’t going to ever do that kind of thing again, and agreed to lop off $32 million in shareholders equity off their books. Now, from where I come from, that’s a lot of bread. The shareholders were more than in a tizzy over that news and the Cannon stock fell like a rock. This made shareholders even more annoyed and any number of them started actions against the company and anybody else remotely connected to the bloody affair.

This was not the best of times for the Israeli’s and even though they thought things couldn’t get worse, they did. With prodding from their newly hired auditors, they announced that their long overdue 1986 financial report would probably not be coming out as scheduled if at all. The noted that there were several substantial problems with the filing. It was qualified, meaning that the accountants didn’t even want to put their name on the thing as to warranting anything up, down or sideways. In addition Cannon announced that it was “impracticable” to restate financial results because in reality, it just plain cost to much and it would take too much time.

While the company did say that the results of previous years should be taken with a “grain of salt”, Arthur Young, the new accountants on the Cannon block, indicated that they had severe questions as to whether or not the movie maker would be able to continue in business. Add to that problem, the fact that without publicly unqualified statements, Cannon could not go back to the public markets for money, you had a pretty darn bleak picture. Not letting well enough alone, the Feds were going to do a formal investigation of what had occurred and in addition, a special audit was to conducted by Arthur Young. Holy Molly!

Until October 1, 1986, Mann Judd Landau of Beverly Hills had been the outside auditors for Cannon. In a lawsuit filed in U.S. District Court in Los Angeles, it was charged that the accounting firm, “”violated federal securities laws by preparing materially false financial statements and earnings reports. Forget about what eventually happened in the lawsuit and let’s talk about how long justice really takes, in May of 1992, that is six years later, “The California State Board of Accountancy filed an “accusation ([266]) ” against the accounting firm of Mann Judd Landau. In related actions, the licenses of certified public accountants Brian Morgan and Barry Lublin, formerly associated with Mann Judd Landau, were suspended. ([267])

Lublin was Landau’s partner in charge of the Cannon Group audit from 1979 through 1984 and from there on, Morgan took over until he left Mann Judd Landau and became the CFO of the Cannon Group. Lublin was suspended from his practice for one year and is going to have to serve a probationary period of five years where he can’t practice in front of the SEC. Morgan’s punishment is somewhat lighter, he got a 30-day suspension and three years of probation.

The California Board explained their actions through Carol Sibmann, an executive officer of the Board, “The auditors were grossly negligent in issuing unqualified opinions on the 1982 through 1985 financial statements of Cannon Group. The auditors’ gross negligence stemmed from their failure to plan the audits properly to identify material weaknesses in Cannon Group’s system of internal accounting controls, and detect Cannon Groups’ misapplication of certain accounting standards applicable to the firm industry. The auditors also prepared or caused to be prepared false information which they submitted to the Securities and Exchange Commission in connection with Cannon Group’s S-1 filing in April of 1986...”

Probably the unkindest cut of all was when the auditors were ordered to take a course in ethics and reimburse the board $20,000 for investigating and prosecuting them. Hey, these folks in California just don’t fool around. We sometimes wish that the SEC was made of such stern stuff.

And there was more to come, The Cannon Group settled the class-action matters in late 1988 with a pot of $33 million to made available for the benefit of the shareholders. Of that amount, Cannon committed $9 million and “insurance carriers for certain of the company’s directors and its former accountants and auditors will be contributing $24 million.

As a point of law, what I find difficult to understand is the fact that these insurance folks are always so quick to pony up money in issues such as these. Now don’t get me wrong, there is a lot of silly litigation that can be brought by litigious people where public funds are involved, and we are gradually coming to grips with it. These changes have come about through the most recent changes in the securities regulations, which were passed in 1996. They made it infinitely harder to bring class-action lawsuits in securities matters. Another relative new device was allowing defendants in frivolous actions to sue the lawyers that brought the case. The Federal Regulation is called Rule 11 and most states have something similar but probably without the same teeth.

I am all for principals in public companies being protected by insurance in spite new remedies being enacted, but that is not this point. In the first place officers, directors, managers and outside professionals employed by public companies ought to be able to go to bed at night without worrying about risking everything the own the next morning, when it once again becomes decision time. They shouldn’t have to move their money off shore or put it in their wife’s name to avoid potential bankruptcy over some bizarre form of litigation by a crackpot. But when we say this, we are talking about serious managers who are trying to both follow the rules and at the same time, do the best possible job for the shareholders. We are not naïve enough not to believe that the previous statement is anything but the ultimate oxymoron. In spite of that, I think that, we know of no way other than that to make the point.

Now in every insurance policy that I have ever read, there is an exclusion for fraud committed on the part of the insured. If the Cannon case doesn’t represent cold-blooded fraud, I don’t know what does. Even if you want to be extremely kind and say, “give the lads a break, they are not from this country and didn’t know the rules;” how many instances have you have seen in this memo of outright fraud committed by officers, directors, management, and outside professionals, primarily accountants. I have not read of one instance where the insurance company hasn’t paid up in a flash to settle the matter. There is no question that this contributes to the problem and worse yet, the good guys by staying out of trouble are literally subsidizing the insurance premiums of the bad guys.

And why do the insurance companies continue this suicidal policy. For several rather obvious reasons, the first and most important is the fact that if they even hesitated in paying a claim, if it involved Jack the Riper, they would probably never sell any Directors and Officers (D&O) or Errors and Omissions (E&O) policies to anyone ever again. How is to decide what fraud really is and if management has to litigate their insurance policy while fending off class action lawsuits and the SEC, it become hardly worth the price of admission. Secondarily, and probably more importantly, they make money in spite of the bad guys claims, its built right into the good guys rates. Bad guys bum out and good guys pay; is the insurance company’s motto.

Now we will offer up to you what this exercise has been all about, if everyone was to write to Congress and the SEC and tell them that the insurance companies are screwing their shareholders and probably committing a crime by illegally paying out on fraud cases, cases where management had knowledge and still illegally fudged the books or whatever, insurance rates would drop and bad guys would stop being so bad. Just watch how fast the accountants would get the picture. No more insurance paid for by the good guys to bail you out of massive litigation such as that entered into by the Resolution Trust Company over the Big Eight Accountants role in the Savings and Loan Debacle. (Effectively, your accounting is costing you more than you think, they are the big users of insurance and it only the insurance that allows them to stay in business, Once again the guys that don’t cause trouble are subsidizing the guys that do.

The next step would to define fraud in simple terms so that the insurance people get the message, loud and clear. You will not under any circumstances pay out a claim where a fraud may have been performed by the insurance beneficiary. Once again, as to public companies, I would make the SEC the authority on what is or is not fraud subject obviously to court oversight. We desperately need an honest broker to make sure that this whole concept doesn’t get abused. As an offshoot of this concept we can also make insurance subject to one bit at the apple, if a claim is brought against you and it is proven to be fraudulent, you no longer will be entitled to that type of coverage. Thus, we have done away with all of the licensing problems where regulation works to slowly. It would not be so unusually to consider an applicant an undesirable risk once he had already committed fraud.

What is the penalty for not following the rules; send the offending insurance folks to jail. With one fell swoop we have cleaned up the accounting profession, we have made business people more honest, (inherently they really have a problem here; Wall Street makes life especially hard if you don’t bring in the numbers) and we have lowered the insurance rates for all of the good guys. I rest my case.

But yet time and time again we have read these stories about accounting firms committing the same dumb acts over and over again. Why do they do it, are they really that stupid. Not at all, they know that no matter how big the civil hickey is, they are probably going to get bailed out by their insurance policy.

De Laurentiis Entertainment

Now that you have finished movie-making 101 in which we studied the basics of the filmmaking business, you are now ready for a more advanced look at the industry. We have to discuss, De Laurentiis Entertainment whose chief honcho, Dino De Laurentiis is a true movie making legend. De Laurentiis was the son of a pasta maker in Naples, Italy where he was born. Dino told his dad as a teenager that he would like to become an actor and was promptly sent to cinema school in Rome to learn the trade. However, his father had told young Dino that in spite of his tender age, if he had not made it in one year, dear old dad was going to pull the plug.

While he became an extra in several parts by the age of 18, he determined that the life of an actor was not really, where it was at as far as he was concerned. What he really wanted, Dino decided was to be a producer-director, and you know the guy that is in charge of everything from soap to nuts. You have got to give this kid credit though; at a young age, he knew what his dream was and went after it with a vengeance. He moved to Turin where put together all of the accoutrements to shoot a movie should that day ever arrive.

While sifting through potential products he watched a Swedish film that he believe would work even better in Italy, approached the producer for the rights to remake the film and was off and running. The film was far from a disaster and it showed the Dino had some potential talent, but this was not to be the time or the place. The war had come to Italy and he was called up into the army. His tour of duty ended abruptly when Mussolini was killed and Italy surrendered to the allies. At the time he was stationed in Trieste and in order to complete his army deactivation he wended his way back to Naples

When the war was over he went back to his first love, that of movie production and had people who later became world famous directors, such as De Sica, Visconti, Rossellini and Fellini work for him. His films were shot in natural settings and had a vigor about them that people started to call neorealism. Soon Dino was attributed with creating the Neorealism School of movie making. He put the movement into much more believable prospective, “Neorealism was invented by newspapers, they claimed some directors and writers wanted to do neorealism. Not true. Italian industry was so poor we have no money for studios, to create the set, to go anyplace. Therefore, we had to shoot everything in the street. “

De Laurentiis won his share of Academy Awards for best foreign films with LaStrada and Nights of Cabiria, which were both, directed by Fellini. Buoyed by this success, De Laurentiis created a gigantic studio near Rome and fondly called it Dinocitta (Dino city). Dinocitta was the location from which, War and Peace starring both Henry Fonda and Audrey Hepburn, “The Bible,” starring George C. Scott and Ava Gardner and “Waterloo” starring Rod Steiger were shot. You have heard of them all but in reality, none was a great success at the box-office. This would be the problem that would plague De Laurentiis all of his life.

In the meantime, Dino had a proclivity that drove him to hire American Stars for his movies, whit good reason, they were excellent draws at the box office. The Italian Government thought the movie business was a good idea, but believed in the old axiom, Italy for Italians. Whereas they had been subsidizing films in the country to the tune of 50% and more allowing producers to hire actors from anywhere they desired, the Italian Government determined that this did not make any sense and they changed the law to a new one that required Italian actors to star in movies made with Italian money. Dino sold Dinocitta to the Italian Government, booked his ticket for Hollywood, and arrived in 1972. He like American actors.

In the United States, he produced equally well-known films but at the box office where the public votes, they were only so-so. He produced such films as Orca, Hurricane, Flash Gordon, Ragtime, The Bounty, Dune, Red Sonja, and Tai-pan all of which were losers. He had an occasional winner with movies like Serpico, Death Wish, Three Days of the Condor and King Kong. The misses continued to outnumber the hits and in 1988, De Laurentiis Entertainment took the gas pipe and went bankrupt.

In spite of having, at best a mediocre record, he always seemed to be able to raise money to do the next movie but eventually that came to end due to his checkered success record and his consistent demand to be paid $1 million per film, win lose or draw. At this point, De Laurentiis brought his movie-making vehicle public under the name of De Laurentiis Entertainment Group. His theory was that, if he was not going to be able to tap his historic sources, he would have to find new ones and Wall Street for their own reasons seemed willing to play.

He was able to tap the Street to the tune of $85 million with some substantial fanfare and while he was at it, formed De Laurentiis Film Partners a public partnership that took another $20 million from investors ([268]). Almost simultaneously with that, he also did a money raise in Australia selling 53% of a new company to be formed there for $20 million. However, literally from the opening trade, it was all downhill. With a couple of bucks in Dino’s pocket, he purchased Embassy Pictures, a movie distribution company, as well as a sizeable film library. In an attempt to recreate Dinocitta, he bought a studio in Wilmington, North Carolina and spread the word that this was the best move he had ever made. With labor costs being what they were in that area, De Laurentiis said, he was convinced that he could churn on movies for 50% less that the same film would cost a major studio and it was possible that he would have been right if only people would have paid to see his films.

Many doubted that De Laurentiis could make anything work. Once again, we have the Wall Street Journal making a quite accurate prediction:

“His age aside, he is regarded as something of a dinosaur because of his heavily European style and his penchant for producing expensive, turgid epics. Besides, the major studios typically get first crack at the best projects and they have development and production staffs that dwarf those of De Laurentiis Entertainment.” ([269])

The public company started bleeding red ink because of a host of money losing pictures and the stock plummeted to a third of what it had been only a short time before. Creditors were already starting to close in and the film library, which had literally just been purchased, was approaching foreclosure. Sadly, films like “The Lion in the Winter”, “The Graduate,” and “Carnal Knowledge” were some of the more important films that he would lose should the creditors foreclose. Wall Street, who does not abide failure well, had unquestionable soured on Dino and the money window seemed to have slammed tightly shut.

To give you somewhat more of an idea of who bad things had become, De Laurentiis’s daughter Raffaella who had worked side by side with him, resigned and he hired, count them, two investment banking firms ([270]) to find some way of getting bailed out. Of all the people that talked about the reasons for the studio’s failure, to a man, they all believed that De Laurentiis, just didn’t know how pick films that would be box office successes and he also didn’t know a thing about distribution when he got into the business. They did not realize that the distribution system has to be feed on a regular basis because it is geared to constantly move film product.

When you cannot keep the pipeline filled, you are dramatically increasing the average costs per movie. In other words, the distribution infrastructure is going to be there whether it is used or not. The rent has to get paid, the salaries become due, and people have to be taken to diner. If you have a fixed overhead cost of $1 million per year and are moving only 10 pictures through the distribution chain, your per picture cost is $100,000. If you able to produce 40 titles a year, the cost goes down to $25,000 per flick. This is the reason that the majors always were sitting in the catbird seat along with some production line type independents like Cannon, The number that we have used above to illustrate the costs are in the first instance representative of De Laurentiis and in the second more of what you would see with Cannon who at its peak was a prodigious production facility. The economic difference between the two is dramatic.

One of De Laurentiis’s ex-directors, Marshall Manley, put the matter rather simply. “The problem is simple, No hits.” “Since 1985 De Laurentiis has churned out one turkey after another. Only two of the 12 movies the company released last year grossed more than $10 million. King Kong Lives, which cost $25 million to make in 1986, took in only $4.6 million at the box office. And this year’s Million dollar Mystery was a resounding flop on which De Laurentiis took a $5.4 million write-down. ([271]) In the meantime, in spite of De Laurentiis’s talk about his work ethic, you don’t often see the movie mogul in the office after lunch. His driver pulls the glimmering Rolls Royce up to the front door and ushers Dino and his closely associated 34-year-old companion Martha Schumacher into the car. They are often gone for literally hours. In the meantime, Dino considers that it is absolutely critical that he has a two-hour afternoon nap everyday. All in all, with the joyride and the nap, you are not going to see much of Dino at the office. Making things even worse is the fact that Ms. Schumacher is always with him. Now she is supposed to be the president of the North Carolina Movie Complex, not a concubine. Well, what to do?

Nepotism is also a way of life with De Laurentiis. We are aware of the fact that his daughter, 34-year old, Raffaella was the studio’s executive in charge of production, but what isn’t well known is the fact that he hired his son-in-law who has literally no movie experience what-so-ever to produce a number of films for De Laurentiis Films. Moreover, what about the brother in Italy that got the Italian distribution rights to some of the De Laurentiis properties and proceeded to screw everything up so badly that it became hopeless.

Another rap on De Laurentiis was the fact that whether the picture made money or not, he was in for $1 million per flick. Although true, there were flaws in that agreement such as the fact that Dino owned over 70 percent of the outstanding stock in De Laurentiis Productions and therefore would be losing more on each picture from the depreciation of his common stock than he was bringing on his advance producers arrangement. Another interesting argument against what De Laurentiis was doing was the fact that Hollywood had learned that when you open all of your distribution channels (theaters) simultaneously, you could save a lot of money advertising the film by doing bulk and national advertising. It also works better for getting mileage from the stars when they do their talk show tours. On the other hand, opening a prodigious number of screens simultaneously is extremely expensive and the advantages of simultaneous openings seem to economically outweighed by the increased cost. This problem too, came back to bite De Laurentiis in the foot.

No matter what the reason, investors were hopping mad that they had lost so much money in such a short period of time. De Laurentiis was not alone in going public during that period and if for no other reason than the stock markets own vicissitudes, everybody that had purchased a newly public independent movie producer was now in deep dodo. Aaron Spelling Productions, Kings Road Entertainment Inc., Vista Films, Heritage Entertainment Inc., Cannon Films, and De Laurentiis Productions were all selling at a fraction of what they had come out at in late 1987 and early 1988. The Wall Street Journal put the plight of the independents into perspective:

“…But the problems at De Laurentiis and other small producers explode the myth that any film maker can cover its risk at the box office by tapping the markets for videocassettes, cable TV, foreign rights and syndicated television. The swarm of newcomers with mediocre movies has saturated those markets. Video stores are glutted with B movies, and the troubles of independent TV stations have left the market for television reruns and movies in the doldrums. A studio’s success, it turns out, still depends primarily on producing hits – and on having a library of popular films to fall back on when new movies fail.”

After De Laurentiis’s offering, the company produced a string of flops, including “Tai-Pan,’ “Red Dragon” and King Kong Lives.” Some of the company’s transactions were far better for Mr. De Laurentiis than for shareholders. The company bought the rights to “King Kong Lives” for $21 million from two firms controlled by Mr. De Laurentiis, a deal so awful for the purchaser that the p4ice was later reduced to $10.2 million.

The company, like many of its rivals, spent large sums on salaries and overhead. De Laurentiis Entertainment paid top executives over $500,000 a year and gave Mr. De Laurentiis perks such as a Rolls-Royce and driver and a year’s lease on a sprawling hilltop mansion in Los Angeles. His daughter, Rafaela, went on the payroll as production president. She has since resigned, effective at the end of the year, and several major investors have refused to provide a much-needed cash infusion while Mr. De Laurentiis himself remains in charge.” ([272])

Troubles always come in bunches and the Australian movie venture that De Laurentiis had pumped with assets could not get off the dime. They had announced only one movie since they opened for business and even that was put on hold indefinitely. In reality, what was going on was the fact that because of the situation with the American shareholder (De Laurentiis and Company) who had contractually agreed to act as distributor for the Australian affiliate. Thus, should a movie be produced in Australia and be given to De Laurentiis to hand world wide production and in the middle of the transaction, De Laurentiis went bankrupt, no one would ever be able to put Humpty Dumpty together again. On the other hand, they had a firm agreement to only distribute through Dino’s American company, they could legally go nowhere else, the ultimate Catch-22.

The head of the Australian Affiliate, De Laurentiis Entertainment Ltd. was Peter Joseph. At a shareholders meeting he tried to explain to one and all what was going on with their American movie deal:

“Mr. Joseph told the meeting that De Laurentiis Entertainment Group’s (DEG) financial troubles in the U.S., following some major film flops, including Million –Dollar Mystery, had taught DEG “in no uncertain terms the vagaries of the movie industry”. DEG had problems almost from the start of its U.S. float, and in 1986 made a $US$1 million loss and by late last year, despite its practice of making largely low-budget films, it was showing a loss for 1987 of some $US20 million. Last December, DEG in the U.S. faced a deadline from its financiers by which it needed to raise $US20 million. Although it made it through that time. , Mr. De Laurentiis left its board and by that time De Laurentiis Entertainment Ltd’s relationship with the parent had soured.” ([273])

The whole De Laurentiis mess was put in perspective by Forbes in their March 7, 1988 issue entitled No, Thank you, Painewebber. By Richard Behar; “Today the money is gone, De Laurentiis Entertainment Group’s working capital is an estimated negative $54 million, and that’s counting some very dubious receivables at face value. Film distribution reportedly has been temporarily halted. The company owes $174 million to banks, debenture holders and trade creditors. Its movie library and its studios in North Carolina ([274]) are for sale, and the proceeds will go to the banks. The stock, which was offered at $12 in 1986 recently sold at 87 cents. The junk bonds go for 13 cents on the dollar.”

On August 17, 1988, De Laurentiis Entertainment Group filed for protection from its creditors under Chapter 11 of the federal bankruptcy laws. The company’s stock, which is traded on the American Stock Exchange and had reached as high as $19.25 a share, a scant two years earlier closed the day at 37.5 cents. De Laurentiis at the time of the filling had $163.1 million in assets as opposed to $199.7 million in liabilities. Talk of substantial self dealing between De Laurentiis Entertainment, Dino De Laurentiis personally and other Del Laurentiis entities has arisen. Questions have cropped up as to the multi-layered system of buying things from another entity and then selling them to the public company. In the case of one disastrous movie, “King Kong Lives,” $22 million seemed to flow directly from the shareholders equity right into Dino’s pockets.

If you think that this was bad performance, you only have to look at the De Laurentiis Entertainment Group’s semi-captive, De Laurentiis Film Partners. The stock was probably one of the worse performers in the history of the stock market. It went public at $16.25 On February 27, 1987 and by December of 1987, the very same year, it was selling at 75 cents. The problem with the partnership was that they were formed to invest only in De Laurentiis movies and they got very unlucky when they put most of their money into “Million Dollar Mystery,” a multi-million dollar bomb. This amounted to a drop of 95.38% in less time than it takes to blink an eye.

As if to provide the final straw, the company announced that although they had not issued an earnings statement in some time, they expected that the company would lose $69 million for the year ending February 29, 1989. This number when coupled with the previous years loss totally lost the every penny that was put into the company in the public offering. When you consider the fact that a period of only two years had gone by, this scenario has to rank as one of the poorest jobs by management in American history.

Things were not getting any easier for Dino, his firms had failed to produce a hit-movie, the company lost all of the money given to it from its public offering, the company Australian affiliate had disowned it, Dino De Laurentiis had resigned from the company in order to avoid being run out of town on a rail and De Laurentiis Entertainment filed for bankruptcy all in short order. The crowing blow to Dino came when his own company charged him with a series of fraudulent business transactions in a lawsuit. The suit asks for $50 million to be returned by De Laurentiis. The suit seeks damages for alleged violations of federal racketeering laws and indemnity for and any loss the company suffers as a result of certain class-action suits against it.

The Securities and Exchange Commission wasn’t at all pleased with what they saw when they went through De Laurentiis Entertainment’s books and stated that they were going to be charging the company with a number of bookkeeping and accounting violations. The Company among other things was charged with improperly accounting for interest and overhead costs in quarterly reports.

A number of class action lawsuits were filed against the company and the company’s founder claiming that the defendants sold millions of dollars worth of securities to the public, while misrepresenting or not disclosing information that would have been important to the investors. They further charged that the company’s directors and other participated in the wrongdoing in order to continue and prolong the illusions of the company’s success and that they wasted corporate assets in lavish spending and knowingly raised public funds for such purposes.

Now A Word From PricewaterhouseCoopers

PricewaterhouseCoopers has pointed out that between 1992 and 1998, the number of securities lawsuits based on the need to restate audited financial statements increased by 750%. While this figure in itself is absolutely horrific, what about another one that the accounting giant came up with. It showed that easily two-thirds of the chief financial officers in public companies had come under substantial pressure to misrepresent their financial results. Of that number, 12% had given in to management’s plea’s to massage the earnings. In just two years, between 1995 and 1997, claims based on alleged accounting irregularities increased from 25% to 49%. It is no wonder that Arthur Leavitt and the Securities & Exchange Commission are pulling their hair out.

At the rate the incidence that financial earnings management is soaring, in several years, everyone will be into the act and financial statements along with accountant’s unqualified statements will probably mean in the United States the same thing they do in Japan. Literally nothing. That society is entirely smoothed so that all of the bumps in the road are removed. Well, while this may be all well in good for a palliated patient in a mental ward, it does take a tad away from a competitive environment. The rating services have just lowered Japan’s credit rating and in spite of the government’s enormous move to spend their way out a recession by creating massive infrastructure projects, the people’s lack of confidence in the country has dramatically changed their spending habits. If they don’t start consuming soon, tax collections will drop and you are looking at a shell of what Japan had recently been. It took the Japanese Government 30-years to address their banking crises which had been brought on by a country that didn’t want to admit that bank’s bad loans substantially exceeded their assets continually during that period.

Accountants Do Not Always Check Out Their Facts

On Wall Street the other day, the FBI got together and arrested about 120 people that had been involved with various Mafia operations. The office of the U.S. Attorney in the Southern District of New York stated that this was the largest roundup of criminals in the history of that department. To give you some idea of the enormity of the operation, it took over 600 people from the Federal Bureau of Investigation, just to collar the crooks.

A highly elaborate operation had been set up in Wall Street offices which included a prestigious address, swank headquarters and all the trimmings that would normally be involved in a legitimate operations. You could come to their office and if you had a great idea for separating people from their cash, these folks would happily supply backup personal, money and ancillary services if they bought into the idea. This, indeed, had become the Mafia’s, Venture Capital central.

The prestigious accounting firm of Ernst and Young has an award they give out every year for the business people they think have contributed the most towards demonstrating their prowess in successfully dealing with highly complex economic problems. The honor role of people that have been given the award in the past reads like the Who’s Who of American business, and to win it is indeed a high honor.

Ernst & Young had announced early on that George Nadoff and Sebastian Rametta of Ranch 1 were on the list for this year’s award based on their management skills. The only problem with the two gentlemen was that they were part of the Wall Street sting that had taken place. Sebastian Rametta was indicted for stock fraud and in addition, Federal Authorities accused him of having connects to one of the prominent mob families. While George Nadoff was not named as having anything to do with the Mafia or securities fraud, Ernst & Young had enough. They revised their list with the two men, no longer on it. The accounting firm attempted to make people believe that the revised list was the only list that had been created. Not a good move, Ernst & Young.

The New York Post thought that something was fishy about the whole thing and found the original memo put out by Ernst & Young. Reporters from the Post then called the accountants and were told by Stephanie Sun, the accountant’s spokesperson that: “It was mutually agreed that they would withdraw this year, especially after Sebastian Rametta resigned, we would love to have them back in the competition next year.” That has got to be one of the strangest quotes in the history of Ernst & Young or anywhere else for that matter.

The embarrassment suffered by Ernst and Young in the Ranch 1 affair was probably not even close to what was suffered by a PricewaterhouseCoopers lobbyist during a session with congress in which they were talking about accountants pushing tax shelters. The background article appeared in the August 21, 2000 issue of the Wall Street Journal and was written by John D. McKinnon. It goes something like this:

“Testifying before Congress, the PricewaterhouseCoopers lobbyist chided Texas Democratic Rep. Lloyd Doggett for suggesting that the accounting firm peddled tax shelters. "Oh, Mr. Doggett, we don’t advise people on tax-avoidance schemes,” PwC’s Kenneth Kies said at the hearing in the spring of 1999. But in the fall, an unmarked envelope arrived at the Treasury Department containing the outline of a new PwC tax offering. Dauntingly complex, it had a simple objective: giant losses that a taxpayer could use to offset income. Soon, Rep. Doggett had a copy of the tax plan, which PwC called by the acronym Boss.”

“Within days, PwC’s Mr. Kies was testifying before Congress again, explaining how his firm advises clients on “ways in which to legitimately reduce their tax liability.” As the hearing’s final seconds ticked away, Rep. Doggett broke in, waving a sheaf of papers bearing a PwC logo. “Let me ask you, sir,” he said, if “your company is still promoting the Bond and Option Sales Strategy that you call the Boss plan…”

“I am not even familiar with that transaction. I would be happy to look at it and get back to you,” Mr. Kies said.”

“I’m sure you would,” snapped Rep. Doggett.

“The confrontation became the talk of the tax world. That materials outlining BOSS went up on Web sites. And 30 days later, the Treasury Department announced that it considered BOSS an improper and “very aggressive” tax scheme, and would oppose any taxpayer’s effort to claim a deduction through it. “

“…Also caught up in the controversy were the big bank, First Union Corp., whose financial advisers marketed the shelter for PwC and futures broker Refco Inc., which was to provide financing to carry out BOSS’s series of complicated transactions. But the blowup has been a vindication for some financial advisers who, briefed on the plan and its offshore maneuverings, worried that it was too aggressive and passed on it.”

When the smoke had cleared, the only saving grace to PwC was the fact that they hadn’t yet written their final opinion on the strategy, but money had to be returned [275] and a lot of influential people had gotten egg on their faces because of what Calvin Johnson, a Texas law professor says is “a masters-of-the-universe attitude that I can do anything, because I’m so bright and quick-footed. It’s really like putting a red-light district across from the Capital.

View From The Top

In December of 1999, Richard H. Walker, the Director of the Division of Enforcement of the U. S. Securities & Exchange Commission when speaking at the 27^th Annual National AICPA Conference on Current SEC Developments attempted to show what progress regulators were making in terms of solving the problem of increased financial fudging by accountants and their clients. While the commission had some reason for optimism because a drop in certain types of write-offs, there was still a lot of problems relative to aggressive accounting tactics leading to outright fraud.

Walker attempted to put the matter into perspective and we have paraphrased his comments to a substantial degree. We hope that in trying to highlight the critical issues that he was addressing we have not changed the message. We have perhaps poorly attempted to highlight parts of his speech where he was giving statistics relative the war on financial fraud and how that war was being waged:

“In August of this year, National Economic Research Associates (NERA) issued a report on recent trends in securities litigation. NERA found that 51 of the securities fraud cases that were brought during 1998 were based upon financial restatements; this is a 750 percent increase over the two cases of this type brought in 1992. Fifty-three companies already have announced financial restatements so far this year, which means that the number of restatement cases may continue to grow even higher. Some companies have restated more than once. In at least two instances, the same auditors issued unqualified opinions on both the initial and restated financials.”

“In addition, NERA found that a whopping 55 percent of all securities class actions in the first half of 1999 were based on claims of fraudulent accounting. This is a material increase over the numbers from the early 1990s which ranged between 30 and 40 percent…Take for example our case against Livent, the Canadian producer of Broadway shows, that we charged with orchestrating a massive fraudulent scheme in which the company maintained two separate sets of books. In that case, Livent's General Counsel, whom we charged as a participant in the fraud, was quoted as saying: "I have to keep all the lies straight. I have to know what lies I'm telling these people. I've told so many lies to different people I have to make sure they all make sense."

“Of similar import, in our earnings management case against Unison Healthcare, the company's CEO, when toying with the numbers, asked Unison's controller to leave the room, saying she did not need to see "how sausage is made.” The CEO then called the controller back into the room, handed her a piece of paper and said, "here's the numbers we need to get to," and "I don't care how we get there."

“Obviously, the Commission and the Enforcement Division do care how companies arrive at their numbers…This brings me to our enforcement program and a discussion of our recent cases. Our 1999 fiscal year ended on September 30, and we recently finished tallying our enforcement statistics for the year. We brought approximately 90 financial statement and reporting actions, a 15 percent increase over the 79 actions we brought in 1998. The cases cover a broad spectrum of conduct – from multi-faceted pervasive frauds to more subtle instances of earnings management to situations involving violations of auditor independence rules. We also brought our first financial fraud sweep this past September. On the one-year anniversary of Chairman Leavitt’s "Numbers Game" speech, we announced the filing of 30 enforcement actions against 68 individuals and companies for engaging in financial fraud. The conduct of those charged resulted in the fraudulent financial reporting by 15 public companies…”

… Perhaps most important, we will give closest scrutiny to intentional misstatements by senior management, even if small in amount, and particularly if designed to manage earnings. We brought 18 actions last year specifically alleging that the purpose of the fraud was to engage in earnings management for the purpose of meeting projections and compensation benchmarks. Many, if not most, of the remaining actions involved schemes to manipulate earnings for similar purposes. These actions shared a common blueprint: companies either recorded non-GAAP or fictitious sales, or, as we alleged in the case of W.R. Grace, created cookie-jar reserves.

The cases also confirm the conclusion of the Committee of Sponsoring Organizations (COSO) of the Treadway Commission that in a very high percentage of cases – 83 percent in the COSO Study – the frauds occurred at the direction, or with the active participation, of senior management. In our recent financial fraud sweep, we charged CEO's in 11 of the 15 actions. I join Walter Schuetze in urging the auditor community to stand tall, resist the pressures to bend or stretch the rules and help put an end to improper earnings management…

About one-third of the actions we brought – 32 of the 90 – involve improper revenue recognition. These actions primarily involve side letters, rights of return, consignment sales, and shipping unfinished product. Another 12 cases involve the booking of fictitious sales. You should pay close attention to SAB 101, issued this past Friday, for guidance in the area of revenue recognition.

The other most common income statement fraud is the failure properly to record expenses. Here, we brought 13 cases. On the balance sheet side, overvaluation of assets is the common denominator of financial fraud. Seventeen of our cases last year involve fraudulent asset valuations. Next in number were cases involving improper capitalization of expenses, of which we brought 12 actions.

In addition to these time-honored methods of inflating results, companies are also using novel and creative methods to cook the books. For example, we are beginning to see an increase in the use of "barter" transactions, especially among high-technology companies, where the assets received in exchange for goods and services provided are greatly overvalued. We brought 4 "barter" cases last year… Last year, only three cases named issuers without naming individuals. All told, our actions of the past year charged 120 corporate officers and employees with participating in financial frauds… And we don't limit our sights to just senior officers. In many cases, there are multiple participants in fraudulent activity. We look up and down the ladder to assess culpability of all involved and rationally apportion sanctions. For example, in our recent action against Knowledge Ware, we charged eleven individuals, ranging from the CEO down to three district sales managers. For other examples, I'd direct you to Livent, where we charged eight officers, and W.R. Grace, where we charged seven.

… In addition to examining the conduct of those within a company, we also review the conduct of those without the company who have responsibilities for financial reporting. This includes the auditors and others as well. We brought actions against 12 auditors last year for violating GAAS Our focus on company outsiders does not stop with the auditors. For example, in our case against Computone, we charged the president of a Computone customer with causing Computone's financial fraud. We allege that he issued a confirmation to Computone's auditors falsely stating that his company owed Computone money for products held on consignment and not yet sold.

… We will use the full range of remedies available to us. Against those affiliated with issuers, we regularly seek injunctions and significant money penalties. In addition, we brought 23 proceedings under Rule 102(e) against officers of issuers who were CPAs. Eighteen of these persons have settled with us, and the sanctions were stiff – 6 took permanent bars and another 6 took 5-year bars. We also sought officer and director bars, a sanction reserved for particularly egregious conduct, against 21 persons. Auditors who violated the law while performing audits faced, for the most part, Rule 102(e) proceedings.

As I previously mentioned, we brought 12 102(e) actions against auditors. Six of the twelve individuals have settled, all but one to permanent bars…And I'm sure that it has not escaped anyone's attention that increasing numbers of our cases are also accompanied by criminal charges. For example, in Livent, the U.S. Attorney's Office for the Southern District of New York indicted Livent's Chairman, Garth Drabinsky, and its CEO, Myron Gottlieb. With the active assistance of our partners in the U.S. Attorney's Offices, we are moving towards turning the "Numbers Game" into a game of Monopoly – that is, cook the books, and you will go directly to jail without passing go.

…We will not tolerate clients misleading their auditors. Eighteen of our cases last year included charges under Exchange Act Rule 13b2-2. This rule prohibits officers and directors from either lying to or concealing material information from auditors. The inclusion of these charges in our cases should underscore the importance of truthful and accurate reporting.

While Walker makes a tough sounding case, it does not appear that we are wining the war on financial fraud. Moreover, on the contrary, I believe that we are losing the battle decisively. While the SEC makes a big issue out of the number of fish they are frying, it is readily apparent that they are only frying small fish that don’t have a lot of meat on them. Thus, you have a situation where the big companies are over-managing their earnings at an ever-increasing degree. The SEC’s examples of victories over financial fraud are companies that many of us have never heard of and because of a number of factors, may just have been easy pickings. Maybe if they had thrown the head of AOL in jail for taking undo liberties with “big bath accounting” procedures people would have sat up and taken notice and things would have started to straighten out.

They have kept so far away from the big fish in the pond you would almost get the impression that there is direct relationship between size and actionable practices. Maybe the logic is even simpler. Could it be that they are smarter than I would give them credit for and applying the principal of “not throwing the baby out with the bath water. “ Maybe, just maybe, they are trying to set an example with the little guys to get the big guys to fall into line. Maybe, they don’t want to punish the innocent shareholders of widely held public companies by indicting the people that caused the company to overachieve in the first place. I really don’t know the answer, but it must be highly complex.

What about the accounting firms? Walker talks a very tough game, but if the smaller firms did what the Big Five are regularly getting away with, they would not pass go for one second, they would depart right to jail. It also may be that they have made a decision that the economics of this era requires a segment of the accounting industry to be both large and healthy. We have seen case after case where auditing higher-ups were in absolute collusion with their clients and for the most part, the accounting folks were almost always able to walk. Oh sure they made this claim and claim about being deceived and the rest, but everyone was aware that this was a bunch of poppycock. Nobody that had half a brain bought into any of it. What we were seeing was an economic change pure and simple.

Bigness was proven to be an element of survival and you had to do what you had to do to attract clients. Possibly, there is something that I don’t know about what is going on here and I sure would appreciate it if someone would drop me a line and fill me in. I am not big on conspiracy theories but something is going on that just doesn’t make any sense. The example that is being set by the regulators, corporate management and their independent auditors is not something that we will be able to look on with a lot of pride and it sure isn’t setting any great example for those that are just coming into the work place.

While this type of justice is hardly what the founders of the country were talking about when they referred to “equal rights for everybody under the law.” Maybe some of us are more equal than others. There is no question that our society is being managed just like the earnings of many companies. One only has look at the way the Federal Reserve is handling the economy to see that we have come a long way from the laissez-farie principals that have governed this country since its origination. It is a given that SEC Commissioner Arthur Levitt is no fool. I further believe that in the ordinary scheme of things, he can’t be compromised. Thus, I believe that what we are seeing is an attempt to create a greater good. But please clue me in because something just doesn’t make sense.

In the real world, this kind of management can only continue for so long because the number of variables is constantly increasing and the ability of controlling geometrically changing alternatives is totally impossible. The peaks and valleys that we suffered through our entire economic existence acted to some degree as a catharsis, and after the valley, the system came roaring back leaner and meaner every time. Oh sure, we didn’t always learn a lot from the last episode, that’s just human nature, but as the speed of economic and political change became ever greater, the time between economic incidents became shorter. The regulators seem to have gotten it through their heads eventually, what would work and what would not. It is an absolute certainty that you can only control events for so long and the rubber band starts to break. When that rubber band breaks it comes roaring back with more intensity than if you had not had an over-regulated economy. It would seem that there would be so many pent up distortions that are just lying in wait for a vacuum to be created so that they can explode into it.

Large corporations have reached a size that so many of them may now be “to large to fail” and that is not only from an economic point of view. For the first time in America’s history it would seem that we are talking about a regulatory point of view as well. Levitt and Greenspan have been doing a pretty darn good act for some time now, but I believe that they rubber band has gotten worn to a frazzle. Hey guys, lets make an example of one of those sacred cows and people will start to believe you are serious. At the moment, it looks like we are headed right for corporate anarchy and a broken rubber band that will never be able to be mended until it snaps back and burns us all.

The Nuances

Selling, Short Selling and Options Trading

Newton in his third of three laws of physical motion stated that “every force has associated with it an equal and opposite force. Among other things, Newton meant by his statement the fact that all physical things are reacted upon by natural forces and if you did not have to deal with friction, an object hanging from a string would go to the left and then would come back and go to the right an exactly equal distance. Without friction, this process would go on forever with the object going the exact same distance each time. Nature created an amazing balance for all physical things that she created, and she did it with some only slight miscues. We were left with a world in which we have substantial equilibrium. Forces play on everything in life to create a level playing field and the distortions that exist between similar objects have come to be known as anomalies. The age of electronic information has leveled the playing field even more for nature’s human element.

While distortions are constantly all around us, those that can be used for motives of profit soon find their degree of discrepancy gradually lessoning due to the faster ebb and flow of information. Being in an age of electronic information distribution, this process now takes seconds whereas only a hand full of years ago it took days, months or even years. The stock market in the United States has been described as an almost perfect economic vehicle because equal information is readily available to all who would wish it under the law. Thus, although some may temporarily have an edge because of their ability to garner information earlier than their competitors, the market quickly closes the gap as the information becomes disseminated to all who require it within a short period of time.

An interesting information distribution story which I am sure you have heard, concerned the value of timely knowledge relative to the English Rothschild family at the time of Napoleon’s battle at Waterloo. If the battle was lost, the cost to England could have been massive and the entire nation would have had to retrench. Should they win, they could continue their quest lands in the “new world” ever expanding their empire and economic benefits of having these areas under their control. Under normal conditions, it would have taken no less than a week for the battle’s outcome to reach London. Baron Rothschild came up with a magnificent scheme, he sent an emissary with a number of carrier pigeons to scrutinize the battle and when it was over, the emissary would send the report by way of the pigeon, back to London and into Rothschild’s hands.

As we know, the English won a decisive victory, but Rothschild wasn’t satisfied with just that. A brilliant tactician, he sent his brokers onto the floor of the London Stock Exchange with orders to sell everything they could get their hands on short. (selling something that you don’t own in hopes of buying it back cheaper at some later date). The other brokers knowing Rothschild’s cunning assumed that somehow he had gotten word that the English had lost the battle. This totally panicked the crowd and they proceeded to sell along with him. Unbeknownst to these members of the brokerage community Rothschild had others in the crowd situated to buy everything available once the panic had set in. While Rothschild would have made a small fortune just by his having inside information, he added a slick nuance to it, making a large fortune. There probably would be nothing illegal if that transaction in the exact manner described was made on an American Stock Exchange today. The intelligent use of generally available information is not a crime and people are rewarded substantially for being able to correctly interpret the meaning of financial matter in advance of their adversaries. The only difference between the transaction today and in Rothschild’s day would have been the fact that although you can sell unlimited amounts of shares short provided you are able to make a timely delivery, you can use short selling to drive down the market. Regulations today require that you would need the stock to trade at an uptick over the previous different way transaction to be able to pull of this maneuver. On the other hand, Rothschild today would have sold short the averages, (the Dow Jones or the Standard and Poor’s as well as others) which are generally speaking treated commodities, and are neither subject to the short sale restriction or the fifty percent margin requirement.

Should a stock go up or down dramatically, several things may abruptly occur. If the stock movement is too radical, the exchange where the company’s stock is traded may halt transactions within those shares until the principal’s disclose any material information that has not yet reached the public’s ears. The Securities and Exchange Commission requires prompt disclosure of any change in material facts which might affect a company’s performance in the marketplace; certainly an attempt to legislate a level playing field. If that exchange did not halt trading possibly because the company did not have all its ducks-in-a-row relative to deal they were in the middle of; for example they were in heated merger negotiations but the papers had not quite been signed yet. In our hypothetical example, there had been much concern within management about leaking these negotiations too early because of the potentially negative effect that it would have on the employees of both companies. Both companies managements believe that the transaction was extremely synergistic and it would result in the layoffs and firing of a substantial number of people in both companies and management wanted to have the entire transaction inked before resistance by the unions could be mounted. In spite of all their efforts, while nothing material had yet occurred, news of the potential merger had leaked and certain people had become privy to the negotiations. Although the company would not want to make an announcement at that stage because nothing had yet been finalized, the financial press would level the playing field by quickly announcing whatever rumors were circulating on the floor of the exchange relative to the target. Picture the stock market channel noticing the fact that the normally quiet XYZ was up several points on substantial volume, much higher than normal. They would have their people all over the place, interviewing anyone that they could get a hold of looking for statement of what they thought was happening. Sooner or later one of the interviewees would come up with the rumor or fact that XYZ and another company were talking merger.

All of the exchanges along with the SEC have an obligation to monitor both prices and volumes of securities, being always on the lookout for unusual trading patterns. Upon discovery of any distortions in the trading picture if it is accompanied by a dramatic rise or fall in the price of the particular securities being monitored, the Exchanges and the SEC will send out questioneers to the brokerage firms that engaged in that trading and request for the names of their customers who were involved. If there is a feeling that anything untoward has occurred, the regulators will bring in the customers for questioning under rather unpleasant circumstances. I have sat in that seat a number of times and believe me it is not a lot of fun with all those folks interrogating you.

Years ago, options were traded in the over-the-counter market and they were not particularly regulated. They weren’t a stock and they weren’t a bond and they weren’t issued by the underlying company. They gave the buyer or seller either a call or put on the underlying security. During that period, when insiders wanted to make a score on their own stocks or others, they could readily purchase these options from a potpourri of unregulated dealers. The only trail left by the options would be the possible hedge by the individual selling the option. One of the most unusual types of transaction in this arena was called the “down and out option.” This was an unusual instrument but is extremely well positioned for insider transactions. As a matter of fact, this was more of a banking transaction than a stock market trade for the writer of the option due to the fact that the parameters of his risk were set in the beginning of the trade.

The “down and out” gave the purchaser the right to buy the shares in the underlying security for a very nominal price, but if the stock should fall under a certain level, the purchaser would lose his position. Thus his interest was, “down and out”. For example, one of the officers of XYZ company believes for good reasons that his company is going to be taken over at thirty dollars a share in the next several days. (he is probably in the meetings and helping with the negotiations) In our hypothetical example, the merger negotiations have been going on now for some time and all the difficult problems have been already put to bed and it is now only a matter for the attorneys to ink the deal and give it to XYZ’s officers to sign. Our purchaser is a rather despicable character who has become deeply in debt because of a severe gambling problem and sees the purchase of options in this matter as a way out of his dilemma. He determines to purchase a number of “down and out” calls for a number a reasons. ([276])

The first is the fact that he is an insider and taking advantage of material, inside information could well be a criminal offense and if discovered he would also be obligated to disgorge whatever profits he made. Neither being a terrific option, he picks the “down and out” choice because, being unregulated and for the most part undiscoverable, it represents a superb way of avoiding both the reporting requirements and having his actions undiscovered. The second advantage is that there is no ongoing market in over-the-counter “down and outs.” Thus, lets say that our insider knows that the last sale on XYZ is $20 and the target price is $30. He calls the dealer and is quoted a price of $100 for the call, but if the stock falls under $19 ½ he loses his position. Knowing that with what is going on in the company there is little risk in purchasing the call under those conditions, he orders the “down and out” call.

The selling party will most probably simultaneously purchase the underlying shares of stock in order to protect himself from loss. Thus, if that is what is done, the following occurs; the two companies announce at $30 a share and the stock goes right to $28 where our insider exercises his options and sells the shares. He grosses $8 per share less the $100 he paid for the call plus his commission on the sale. Probably a return of close to 700% but when you consider that the transaction only took several days to complete, the percentage return becomes almost infinite, seven times his money times (lets say he held the stock three days) in 1/120 of a year or something around a 84,000 percent return. The seller doesn’t do so badly himself, he bought the stock and paid a commission. He held the stock for three days and made $100 minus his commissions charges, let’s say they amount to $10 per share. He also has a three day cost of money and lets call that one-percent of $2,000. (100 shares at $20) or a total of $20. Adding together $20 and $10, he is out of pocket in the amount of $30 and made a profit of $70 for three days work. Calling three days, 1/120 of a year multiply he also comes out with a nearly infinite return. The same call purchased through exchange traded options would have left one party with a loss and the contra-side with a profit, the transaction would have been reported and the government would have been all over everyone concerned. It is indeed possible in the world of ‘down and outs” for both sides to always win, and it is almost impossible for both to lose.

What if the deal, which has been moving smartly along runs into a hitch and after the call has been purchased, it tanks; what happens to all involved? Well, our buyer would now be out his $100 dollars and that is it. If any rumors of the deal had circulated at all, the stock was probably up $5 already and it would probably go back to that price. Thus, if our insider purchased the call, he was at least $400 better off than if he had purchased the stock outright. However, this is by no means a coherent comparison, because he couldn’t have purchased the stock in the open market without going to jail and if did buy anyway it in spite of all the risks involved, he would never have purchased as many shares as he would have by way of buying, the options.

The seller of the options purchased the shares, sold the call and then almost simultaneously put in a stop loss order to sell the stock with his broker should it decline to $19½. Let’s say that when the deal collapses, his broker only gets him out of the stock $19 3/8. Once again he pays commission to sell the stock of our hypothetical number of $10 per hundred shares. He has paid two commissions of $10 and has incurred an interest cost of arbitrarily say $10, so the call writer is now out thirty bucks. On the other hand, he has the $100 he earned for writing the call and his net after taking in all aspects of the transaction is about $2 ½ per shares. Not exactly a disaster for a deal that didn’t work out.

Many people find other ways to get around the insider rules as well as the margin requirement regulations of the Federal Reserve Board which now stand at 50%. Considering that there is always more than one way to “skin a cat”, our nefarious insider is not familiar with “down and outs” or where to buy them even if he was. But he does have a friend in Europe that runs a small bank. He calls his buddy at the Credit Colostomy Bank of Prague, Czechoslovakia. What interest would the banker charge for the purchase of 100,000 shares of XYZ and how much collateral would the banker want? In addition our insider asks if the banker will take his restricted profit sharing stock as collateral for the transaction? The European banker is extremely savvy and explains to our insider that American regulations do not pertain to people or institutions in Europe and if the shares go down in XYZ he is readily able to sell them without any predicament relative to the restrictions that they contain. He goes on to explain that the American margin regulations also do not effect his bank and he can loan whatever he desires against the insider’s purchase. He indicates that he would be extremely comfortable with 50,000 restricted shares of XYZ and if he had them in his possession he would allow the insider to purchase an additional 100,000 shares of the company’s stock. ([277])

In addition, his country does not have any obligation to disclose the name of the ultimate buyer of the security to American officials so that there is no risk of anyone ever finding out the purchaser’s name[278]. On the other hand, the costs will run substantially more than in the United States. In Europe, more often than not, the banks their act as brokers and in most cases they set arbitrarily high commission rates because they are the only game in town. The friendly banker indicates that the fees will run as follows, the commission will be 50 cents per shares, the deliver, receipt and escrow charges will also run 50 cents per shares. The interest rate will run 22% and will be charged for no less than 90 days no matter how long the loan stays on the bank’s books. Thus, our insider’s charges in this transaction are a purchase price of $20, commissions of and other fees of $1 per share along with interest (100,000 x’s 20 = $2,000,000 22% of that figure on a ninety day basis would be the equivalent of 5 ½ percent per year on the $2 million). Thus, the interest would run approximately $100,000, win or lose. Thus, the charges for doing the transaction in Europe will amount to the equivalent of two points. The purchase is at a price of twenty, the sale is at twenty-eight, leaving six points of pure profit and we mean pure profit. ($600,000)

What has our insider gained on the transaction beside his monetary reward? Several important things, the first is the fact that the odds of his being discovered have now dropped to near zero and he can sleep like a baby at night. Furthermore, in most European countries, there is no capital gains tax and certainly, if he does not bring the money back to the States his windfall will not be discovered from the regulatory point of view either. Big Louie in Atlantic City and Larry the Thug in Vegas can both have their indebtedness deposited in a European Bank of their choice where because of the substantial number of international transactions that they are involved in, the money can easily be laundered back into the United States should that be their desire. Thus, Larry and Louie are overjoyed, our insider has potentially learned a serious lesson and will give up gambling (not a chance) and everyone will live happily after.

The Professional Short-Sellers

People in most of the rest of the world think in terms of buying or selling stocks but almost never do they dream of selling something that they don’t physically own in the hopes of repurchasing it later at a profit. As a matter of fact, a number of countries such as Japan believe that selling short is a mortal sin and for the most part it is not allowed on any of the exchanges in that country. Even more importantly, on every trade a short seller is potentially looking at an unlimited loss when he indulges in that pastime as opposed to an investor’s risk which may be limited to only what he put in, if he is not on margin. Thus, if we purchase a stock at $1 it can only go down 1 point thus limiting our potential loss to the $1 we put in. If on the other hand, we sold the stock short at a dollar, the most we can make is $1 but the loss can be infinite.

We have seen instance after instance where a company’s outlook appeared absolutely dismal, causing every short-trader in sight to jump on the bandwagon. What they occasionally overlooked in their feeding frenzy was the total lack of freely tradable securities (float) available in the marketplace to so that the borrowing of securities becomes a question. Should delivery not be made by settlement by a retail customer of a short sale, the brokerage house holding the position will probably by the stock in. There is never a guarantee that the stock sold short can be borrowed. Thus, as the stock rises, the shorts start to get margin calls ([279]) thus creating a cascading effect of one margin call feeding on another. People that had never seen the likes of the bull market that we have witnessed for most of the decade of the 90s could not believe their eyes and many jumped into the water with short sales even though they had never played that side of the market previously. When their loses started to mount the either cover the transaction adding fuel to the bull market or sold even more short thus only temporarily avoiding a disaster that was soon to come anyway.

When a company first goes public, underwriters like to have the insiders sign a “lockup agreement”, which prevents the sale of any additional shares for a particular period of time. The underwriter thinks that the stock is the second coming and believes it should go higher, thus holding his clients in and buying more. The shorts believe that the company is utter garbage. But the stronger they believe in the fact that the stock is worthless, the more entrapped they become in the occasional “short squeeze” that occurs when there are too many overzealous disbeliveers. More often than not, the battle ends in underwriter waging war again the short sellers and winding up with a position that represents just about all the freely trading stock in the company. This is called, “dominance and control” by the NASD and while the shorts seem to be allowed great latitude in their trading, the brokerage can get severely censured, fined or barred for getting caught owning all the outstanding freely tradable securities.

We remember the Empire Millwork story in the late 50s when a guy named Gilbert was convinced that taking over a similarly situated publicly traded company was a logical move for his company. Gilbert started buying the target company’s stock at under $10 per share. He continued buying even as it soared over $100. Along the way, the stock had attracted short sellers in the same way that a dog attracts fleas. At somewhere over $200 per share Gilbert and his adversaries started to collect proxies so that a vote could take place determining who would wind up with the company. As expected, he wound up with over fifty-percent of the stock outstanding but so did management because of all the stock that they both had acquired from short sellers. Naturally the shorts couldn’t deliver proxies on stock that they never owned and because of this no one could rightfully determine who won the battle. The longs and the shorts sued each other and arrived in court with everyone throwing allegations all over the place. The judge in the matter ordered a settlement by mandating that the shorts must cover (buy in their positions) at something over $250 per share, one of the biggest baths ever taken in history by a group of short sellers.

Regulators believe that short sellers serve a leveling purpose and encourage the practice. These are contrarians that the Securities and Exchange Commission in the past has stated, “do good research”. With the odds against you, people not liking what you are doing and the economic odds against you, it can get to be a lonely kind of life. On the other hand, because of the risks involved, the short sellers must constantly be at the top of their games and they must also be able to credibly distribute their research on companies that they are attacking to get both attention and reliance of both the regulators and the investing public. This type of trading is never done in a vacuum. When a short-seller finds something really inconceivable bad going on in a company that he follows, he first sells all of the shares he can afford, short and then he sends a letter outlining his research to everyone and anyone that he thinks will have any interest in what he has to say whatsoever. His hope is that this move will cause shareholders to dump their stock and the regulators to start an investigation.

In the late 1980s, I was asked to testify by one the “House Committees’ relative to the excesses of short sellers. So many complaints had come to congress from local companies and local investors who in turn complained to the local congressman (many of them could well have been the biggest industries in the congressman’s district and the company additionally could well have been one of the largest donators to the congressman’s campaign) that they had lodged complaints saying that the regulators had stacked the cards against them. Small public companies were over-represented at this session with none of the invited short sellers showing up. Congress called in the exchanges, the NASD and just about everyone else that they could find in order to grill them on whether the cards were really so badly stacked against small public companies. There is no question in my mind that their conclusion was the fact that indeed the deck was stacked.

A number of the firms specializing in short selling that had offered to show up and backed down at the last minute, sent in letters that explained their position. I have never read such unbelievable stuff in my life. These people were using examples that they knew congress would no be familiar with that were totally off base and inaccurate. I was as by Congressman Barnard’s Committee to evaluate the material. Each letter was a job in itself because they had been so skillfully constructed to both avoid the issues and skit the facts using words that are even in the dictionary. As I remember, it took me an entire week just to thoroughly read three responses. I had to analyze the statements they contained, literally on paragraph at a time, with both a dictionary, a thesaurus, and about fifty books on stock market history, the rules of both the New York Stock Exchange and the NASD as well as the complete securities acts of 1933 and 1934. It was only after I was able to put the letters into prospective that I was able to determine just how much gobeldy gook I had been reading.

In spite of unimaginable doubletalk, the inquiry raised more questions than it answered but some facts were incontestable. These fact were that the shorts were usually, at least partially right and that they were acting in their own way as a field leveler against too many out of control companies that were more interested in hyping their stocks then delivering a legitimate top notch product. There was little question that the people at the Securities and Exchange Commission valued highly the information that they got from the shorts and more often than not had acted upon it. This process made the job of shorting, self fulfilling. Find a problem within a small public company, short its stock and report the conclusions to the SEC. When they announce that they are conducting an investigation into the trading and business affairs of the target company, it is more often than not spelling the death knoll for the company in question. The stock tanks and it is also no longer able to raise money because of the stigma that has been placed on it.

Moreover, the brokerage firms love short sellers because the shorts have to borrow stock to insure timely delivery and the brokerage firm charges the shorts for taking care of that problem. The brokerage firm is paid for their services by receiving the income that is derived from the delivery of the borrowed shares to the buyers broker who at that time pays in full for the transaction. The broker gets the stock from his “box” ([280]) which contains shares held on margin with the firm. Those clients that are on margin have signed an agreement with the broker that the firm can hypothecate those shares should they desire. Thus, picture the transaction, the short seller sells 100 shares of General Motors at $70 per share. The broker takes his customer’s certificate from his “box” and makes delivery. The customer doesn’t even know that the broker has used it because it continues to show as a long position on the monthly statement he gets from the brokerage firm. The brokerage firm pockets the $7,000 in cash until such time as the short sale is closed out. The $7,000 goes into the broker’s bank accountant and immediately starts drawing interest which when you add the effect of thousands of customers shorting millions of shares of stock you are starting to talk about this interest effect creating real money for the broker.

The transaction that we have described is really one of orderly facilitation which literally hurts no one, and the anomaly is the fact that the ultimate lender of the securities does not even know that his stock is no longer in the possession of the broker. However, what happens when someone wants to sell short a stock that is not marginable or is not to be found in a broker’s “box”. This become a horse of a different color, and there are very strict delivery rules that cover this situation. If the brokerage firm has reason to believe that it can not make delivery on a reasonable basis, they can not take an order to sell short in a customer’s account. On the other hand, market makers (dealers and specialists) have for the most part been granted exceptions to this rule over the years and this gives the profession short seller yet another edge. By becoming a broker-dealer-market maker he can sell short stocks that he can’t even borrow. Today, almost all of the big firms involved in the bear side of the market are broker-dealers or have broker-dealer affiliates.

While this would seem to fly in the face of fairness, in spite of the heat taken by the NASD because of the publicity garnered by a select group of highly vocal short-sellers, the Association still believes that in order maintain orderly markets broker-dealer short-sellers are uniquely entitled to some latitude in making delivery. This accommodation to those that have become market makers only to avoid the regulations, gives the impression of unfair competition between the longs and shorts. The longs must currently pay for securities purchased in 3 days time while those dealers that are making markets in the stocks that they are short, can literally avoid making delivery through a series of obvious subterfuges such as waiting till the last minute and then selling the short position to a friendly dealer who will return it when he is facing the same rules limitations. If the equivalent thing were done by dealers that have purchased securities to arbitrarily inflate their value for brokerage house capital purposes, this would be identified as “parking”, an extremely substantive offense which could result in fines, penalties as well as criminal charges. In the securities industry, what is sauce for the goose isn’t naturally sauce for the gander.

The Securities and Exchange Commission allows the unlevel playing field to exist in the short selling arena, to level the playing field in the financial information dissemination field. The SEC believes that allowing the short sellers to prosper insures a continuing flow of valuable information relative to companies that aren’t following the rules.

In the days before the “Crash of 1929” pools would get together and publicly engage in stock market rigging. They found that it was easier to push stocks down and cause margin calls then to push them up. In those days, margin requirements were more of a local option and were not set by any government agency. Thus, people could easily borrow 90% of a stock’s value and leverage it on up from there. With the “pools” in operation this became a dangerous game and with that kind of margin you could be wiped out in the wink of an eye. Particularly egregious in those days were the trades made by the then CEO of Chase Manhattan Bank who knew that the institution was going to substantial under-perform relative to the public’s expectations. He proceeded to short hundreds of thousands of shares of his own stock and when the news came out as he expected; cleaned up a fortune. Today this would be a violation of about a dozen securities regulations, selling short on a down-tick, dealing on inside information, selling stock in a company that he was an insider and not filing a 13 D along with a host of other regulations. But those days were more like the “Wild West” and before the Securities Acts of 1933 and 1934 were passed, almost anything went.

The Tip of the Iceberg

As we have seen in this report, a lot of strange things have gone on among folks that hold a special position of public trust primarily as high-ranking officers of public companies and independent accounting firms.. What we have witnessed here are only those problems that have come to the surface and made news. Do you think for one minute that we have even scratched the surface of all the problems, hidden financial time bombs and phony investment schemes. Human nature is difficult to evaluate but if you follow the rule that people will seek the lowest common denominator when morality is called into question. Therefore, there is no question in our minds that the accidents waiting to happen (in reality, waiting to be found out would be more like it) may be even greater than those already uncovered. In addition the tricks of the trade that we have introduced you to are readily available to those that are experts in the field of securities.

How many corporate presidents have illegally sold shares overseas and not been caught? How many accountants have “front run” good earnings or bad earnings announcements by buying “down and out options” or by having accounts offshore with their friendly bankers. We think it would be naïve to believe that they don’t. After all, accounting firms today are global in scope and these are knowledgeable people have foolproof information at their fingerprints. The folks were talk about in these pages couldn’t all have been corporate dupes, covering up for their employers because they represented a paycheck. No way.

We have also seen, the same mistakes committed over and over and over again. It is beyond comprehension that these people can not seem to learn from their mistakes. Conflicts of interest continue to abound as though there was no preclusion of it. And the excuses that are given by senior management are so hackneyed that it is more embarrassing than anything else, when the state things like, “when all the facts are know in this matter, the public will realize that we did not violate the public trust.” It usually is about five minutes after that statement is made when the accounting firm sits down with their errors and omissions insurance carrier along with the opposing class action attorneys and talk about how much is going to change hands to settle the matter.

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