The following article is from George Mannes's story "Cracking the Books II: Reliving Equity Funding, the Cal Ripken of Stock Frauds," published in TheStreet.com on October 22, 1999 and can also be located by clicking here.
The fraud at Equity Funding Corp. of America ranks as a landmark event in the history of cooking the books. In 1972, the seller of mutual funds and insurance was a Wall Street wonder, ranked by Fortune as the fastest-growing financial conglomerate in America. A year later, the company had virtually collapsed amid the revelation that earnings were completely fabricated, the soundness of its business a sham.
Yet Equity Funding is a dim recollection, at best, in Wall Street's collective memory, remembered only by fraud aficionados such as short-seller Manuel Asensio, who last year issued a press release celebrating the silver anniversary of the scandal.
Equity Funding's obscurity is a shame, though, because its monkey business was remarkable by several measures.
First, there was the longevity. Fraud at the company lasted nine years, from 1964 to 1973. That makes it the Cal Ripken of stock frauds, compared to such flash-in-the-pans as the irregular accounting at Cendant (CD:NYSE - news), which appears to have blown its streak in its fourth year.
And there was the manpower involved. At Cendant, maybe 20 employees are alleged to have been in on the deal. But at Equity Funding, at least 50 and maybe more than 100 people knew what was happening. Given the number who were aware of misdeeds, it's shocking to think how long it took the organization to spit out the disgruntled former employee who blew the whistle.
Finally, there were the results. When miscreants at what became Cendant's CUC International business allegedly manufactured some $500 million in revenue from 1995 to 1997, their invention boosted CUC's operating income by 50%, according to Cendant. By comparison, when Equity Funding reported $114 million in false income -- about $450 million in today's dollars -- it wasn't padding profits; rather, it was creating them out of thin air. In truth, the company had been operating at a loss for at least eight years, according to the trustee who took over after Equity Funding's collapse.
How did executives and underlings at Equity Funding achieve this under the noses of auditors, analysts and investors? After all, this was no mere bulletin board stock flying under the radar of scrutiny; it was a NYSE-listed company with assets -- in theory, at least -- of more than $700 million. For the long version of the story, you can consult three books written in the mid-1970s: The Equity Funding Papers, The Impossible Dream and The Great Wall Street Scandal: Inside Equity Funding. But here are the Cliffs Notes.
It started with a good gimmick. Since 1960, the company had been selling an innovative financial product, one that was perfectly legitimate at the start. Called the "Equity Funding Program," it was a package of insurance and a mutual-fund investment. Under the program, customers would sign up to buy fund shares every year, then borrow against them to pay annual premiums on a life insurance policy.
A captivating idea, except it didn't make enough money. So some executives -- led by the president, chief financial officer and head of insurance operations -- got a little more creative with the numbers on their books.
The company apparently started in 1964 by overstating the commissions earned on sales of the Equity Funding program. Then came borrowing money without recording the liability on its books, or disguising it through complicated transactions with subsidiaries.
But what really made the fraud memorable was its final stage, reached after the company had cut deals to have other companies reinsure the life insurance policies it sold.
Equity Funding wasn't selling enough policies to meet the demand that other companies had for policies to reinsure. So Equity Funding made them up.
As the fraud progressed, more and more employees got recruited to help, and people started to get really creative. The problem with phony policies was that the company's auditors would randomly select some every now and then and ask to see the real-world files behind them. There were no files, of course, since there was no insurance. So to prop up the scam, conspirators threw late-night "fraud parties" to create phony files. When that solution proved inadequate, conspirators set up a secret office devoted exclusively to fabricating medical records and application forms on demand. The employees at the office, known as the Maple Drive Gang, spent most of their days killing time with knitting, champagne and Quaaludes, according to The Impossible Dream -- except when the clueless auditors at the main office would ask to see files for phantom policies. That's when the Maple Drive Gang would spend a frenzied few days creating dozens of policy files -- then return to their endless round of office parties.
Meanwhile, a computer programmer had created software especially for concocting policies out of thin air. And at the time the fraud collapsed, the company was developing additional software that would easily "kill off" a certain number of phantom policyholders without arousing the suspicions of the reinsurers. By the time the company collapsed, more than half of the insurance policies on the company's books were fake.
In a 1971 press release trumpeting all the insurance that the company had supposedly written, Equity Funding quoted President Stanley Goldblum saying, "Quite obviously, this kind of production can only be generated by a professional, thoroughly dedicated group of people." In hindsight, that statement drips with irony. Goldblum, along with 18 of the other 21 indicted conspirators, pleaded guilty to taking part in the fraud. (The remaining three were convicted in a 1975 trial.)
Despite the creative use of computers, the people who studied Equity Funding's remains say this was no sophisticated computer fraud. The people behind it had no grand plan -- they just made it up as they went along.
For example, according to one account, after they'd allocated a certain number of fraudulent policies to different reinsurers, an executive at one of those companies offended them with an offhand anti-Semitic remark. So they went back to the office and reallocated the policies to stick that reinsurer with an extra helping of the booby-prize policies.
And the conspirators had a real eye for talent as well. In 1972, management discovered that four employees, quite separate from the fraud that the company was perpetrating, had teamed up to embezzle funds for themselves, mostly by filing phony death claims. When discovered, the quartet wasn't fired -- instead, three were rewarded with stock bonuses and all of them got a new assignment: supervising phony death claims on behalf of the "official" conspiracy.
It helped that the outside audit of the company was led by an accountant who was utterly incompetent. He had a son on Equity Funding's payroll and borrowed money from an Equity Funding executive, apparently for an expensive gambling habit. Emboldened by their success in fooling the auditor, Equity Funding insiders, in the final days before the jig was up, went so far as to bug the temporary offices that were to be used by state insurance inspectors who were coming to investigate the company.
Despite the auditor's failure, there were clues to Equity Funding's shenanigans in publicly filed documents, says Lee Seidler, managing director emeritus of Bear Stearns. As is pointed out in The Equity Funding Papers, which Seidler co-edited, revenue from securities-sales commissions jumped to $5.3 million in the fourth quarter of 1970 from $3.2 million in the second quarter, according to company filings. Yet, oddly enough, the expenses required to produce those commissions stayed flat at $1.2 million. "Equity Funding certainly did have a remarkable sales force," the co-editors note dryly.
The Equity Funding scandal had an indirect effect on the accounting profession, Seidler says. By the 1960s, he says, auditors had de-emphasized the antifraud nature of their work. But Equity Funding helped change that, he says. "Equity Funding was so egregious, I think it had a fair impact on the turnaround of the profession."
Not that auditors have a good record of uncovering fraud. "No major fraud has ever been discovered by auditors," Seidler claims -- a pronouncement he says he's repeated for years and never been challenged on.
Perhaps Equity Funding's most significant legacy is the court battle fought by stock analyst Ray Dirks, now the director of research at Security Capital Trading. Back in 1973, when ex-Equity Funder Ron Secrist tipped Dirks off to the fraud, Dirks brought Secrist's then-unproven allegations to the Securities and Exchange Commission -- but only after he passed on his concerns about Equity Funding to his clients, who were able to sell off their stock before the scandal broke and the stock collapsed. In a classic case of killing the messenger, the SEC pounced on Dirks; the charge was insider trading.
The Supreme Court cleared Dirks, saying that it wasn't against the law to trade on insider information as long as the insider supplying the information didn't benefit or breach a duty to disclose it to stockholders.
Other players in the Equity Funding saga created their own little legacies. Sometime after Goldblum, the president, served jail time for his Equity Funding misadventures, he was indicted on fraud-related charges stemming from his work as comptroller of Primedex, a California-based chain of medical clinics that allegedly defrauded employers and insurance companies. Earlier this year, at the ripe old age of 72, he was arrested for allegedly submitting false information to obtain a $150,000 loan. Neither of these cases, which were reported originally in the Los Angeles Times, has gone to trial yet.
Seidler says auditors will continue to miss fraud because much of their work is predicated on the assumption that separation of duties -- say, one person holds the money and another person keeps track of it -- prevents fraud. The Equity Funding case "shakes the foundations of auditing, in that so much is based on the assumption that people don't collude, or they wouldn't collude very long," Seidler says. "And these people worked together as an efficient team for a very long time."
The following relevant article was pulled from the Casualty Actuarial Society's website.