Cracking the Books II: Reliving Equity Funding, Part 2 - TheStreet

Cracking the Books II: Reliving Equity Funding, Part 2

The second half of <I>TSC's</I> look at a 1970s-era swindle.
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Continued from Part 1

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

(BSC)

. 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.

Auditors Make Changes

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."