The Equity Funding Scandal The following is a case of a large-scale fraud that occurred in the late sixties and early seventies at Equity Funding Corporation of America: In 1960 Equity Funding Corporation of America began its innovative “Equity Funding Program,” in which it sold life insurance and a mutual-fund investment in single packages. Under the program, customers would sign up to buy mutual fund shares every year, and then borrow against them to pay annual premiums on an insurance policy. This case is actually a good example of a failed innovative idea, because the program, unfortunately, did not make enough money. In 1964 Stanley Goldblum, Gordon McCormick (the leaders of the operation), and several other company executives decided to do something about it.
The scandal began with the overstating the commissions earned on sales. In order to keep share prices up, Mr. Goldblum instructed his CFO to make fictitious entries in certain receivable and income accounts. He, in turn, used these seemingly valuable stock shares to compensate owners of companies he started buying out.
The next part of the scam explains how the company was able to make money through the practice of reinsurance. Reinsurance is a practice in which one insurance company sells some of its policies to another insurance company in order to make immediate money and lessen the risk that a large payout could occur. In normal reinsurance deals, the seller usually gets about $1.8 for every $1 in policy premiums (this price is based on the fact that the selling insurance company had to pay high commissions to their employees who sold the policies in the first place). Through this policy of reinsurance, some executives of Equity Funding were able to make money out of thin air. They did this by making up fake clients and insurance policies and selling them to other companies. The reinsurance companies would obviously expect to make money on the future payments of yearly premiums by policyholders. Since these policyholders did not exist, Equity funding either paid premium through the sale of more fake policies or pretended that the policyholder had died.
In order to carry out such a complicated scam, Equity Funding recruited more and more employees to help and set up secret offices to carry it out. The hardest part was creating the fake files for policyholders in order to show auditors who, every so often, asked to see them. Many times when an auditor asked to see certain files, he would be told that they were temporarily unavailable. That same night, the conspirators would get together for a “fraud party” where they would create the files. In November of 1970 an employee was even instructed to create a computer program for making fake policies. The scam lasted for 9 years without being discovered until finally in 1973 a former employee ratted them out to the Securities and Exchange Commission. When all was said and done, Equity Funding had created 64,000 fake policies with a total value of $2 billion and had reported $114 million in false income. In addition, the company was also involved in selling $25 million in counterfeit bonds, and $100 million in assets were unaccounted for. Mr. Goldblum, along with 21 other conspirators pleaded guilty to fraud charges. Three auditors were also convicted of fraud and sentenced to serve prison terms for failing to report evidence of the scandal.
Although I know of no laws that arose from this particular scandal, I know that it had an effect on regulations of the accounting profession. Even though it was a bad event in itself, it ended up improving the quality of audit procedures and put emphasis on the antifraud nature of auditors’ work.
1) “Equity Funding: Could it happen again?” by David Hancox and
2) “Equity Funding Scandal – Billion dollar Bubble the Auditors Missed- Enron of the 1970’s”
Nick Leeson, the famous rogue trader, began his career in the financial sector in London during 1982. He started off with a relatively small job, but eventually worked his way up and earning a reputation while playing the Far Eastern currency markets. In 1992, he was posted to Barings Bank’s trading branch in Singapore. Within a year, he made more than £10 m from the Singapore International Monetary Exchange. This was almost 10% of Barings’ total profit for that year. He enjoyed a good life, earning a yearly salary of £50,000 and almost £130,000 in bonuses. But in late 1994, his losses began to increase to nearly £280m. This was a result of the Mexican economic crisis and the dampening economic outlook in Japan due to the massive financial costs expected to rebuild the earthquake devastated city of Kobe. In 1995, Leeson requested and received extra funds to help continue his trading activities. He wanted to clear his losses through more ambitious trading practices. Barings Bank was puzzled by this unusual request and they carried out an internal spot audit in February 1995. They were shocked to discover losses of up to £830m, almost the entire bank’s assets. Barings finally collapsed within a matter of months and was bought for £1 by a Dutch banking and insurance group called ING. Barings had been UK’s oldest merchant bank. Leeson managed to go unnoticed for so long by placing his large losses hidden in 2 accounts, which were reported to different managers and weren’t interlinked. With no checking system, it meant that only Leeson knew about this. Managers also tended to close an eye to abnormal practices if the trading ventures were bringing in the profits. After this incident, banks began a review of internal procedures, activities in trading rooms around the world were strictly controlled and governments worked with each other to clarify regulations of financial institutions with overseas branches. Leeson eventually served a prison sentence of 6 years in Singapore, after spending nearly a year as a wanted fugitive from the law. However, the risk of such losses is still present as financial institutions continue to reward those who bring in the profits. The Barings’ disaster is still a possibility. In 2001, Allied Irish bank’s US division suffered almost $750m in losses. A suspected trader had entered into many foreign exchange deals with “options’ deals to offset the potential risks. However the original deals went bad with great losses and had no protection against the losses, as the ‘options’ deals were all fakes. However AIB still reported a profit that year.
Tyco International case relates to the topics of money and banking in that the corporation showed economic profits that were actually losses when acquiring a telecommunications company. In June 2001, Tyco acquired Flag Telecom and claimed a $75 million profit over the acquisition when it was actually a
loss. This profit amounted to a hefty $24 million for Kozlowski and Swartz. Basically, the acquisition of Flag Telecom was linked to that of another company, Tycom. Shares of Tycom would be sold and that money would be used to acquire Flag. So Tyco had paid $11.4 million in cash and 5.6 million shares for Tycom. On June 22,2001 the shares were worth $89.3 million, for a total compensation worth $100.7 million. The difference of these two values equals $26.3 million, which was the economic loss of acquiring Tycom. Unfortunately, this loss was transformed into a bonus for the executives. In order to hide this loss, Tyco executives assumed that Tycom shares that were sold that day were of equal value to the purchase of Flag shares. Unfortunately, this was not the case, since they used the price of Tycom shares two weeks before the actual acquisition of Flag. In hindsight, accounting rules of the SEC were broken since the purchase price of Tycom was set two weeks in advance. Also, the fact that economic losses were transformed into profits was another violation of accounting rules. Unfortunately, the Tyco incident shows how such a large company can search for loopholes in accounting practices in order to benefit the executives of the corporation. Because of unethical activities of Tyco executives, there will be a strong case against them in court.
Norris, F. (2002, September 25). Tyco Took Profit on Bad Deal,
Then Paid Bonuses to Executives. The New York Times.
Retrieved October 2, 2002 from the World Wide Web:
In 2000, Citigroup bought Associates First Capital Corporation and began a huge scheme of stealing consumer’s money. The Federal Trade Commission filed a lawsuit against this company last year. When Citigroup bought out the company, it forced consumers to consolidate their debts into a single loan and promised lower monthly interest payments. The problem was that these loans often came with large fees that made them even more expensive than the original debt. Without telling consumers, Associates included credit insurance in the monthly loan payment which was intended to cover the borrower’s loan payments in the event of a death or illness. If consumers discovered this insurance, Associates used various deceptive practices to discourage them from removing the insurance such as making harassing telephone calls. The complaint also alleged that Citigroup broke federal regulations by using credit reports to solicit new customers and failing to keep proper records of their consumers. The Federal Trade said the company earned more than $500 million from 1995 through 1999 through their credit insurance sales. The Federal Trade Commission is working on an agreement with Citigroup that would allow about 2 million consumers to receive cash refunds or lower loan balances. This would help them recover some of their losses. By settling, Citigroup is not admitting to breaking the law. Because our economy is based on capitalism, everyone has the opportunity to earn money for themselves. Fraud makes the rich more powerful and the poor have even less money. It puts the money back into corporate hands. If we were in a communist economy everyone would get the same amount of money. If we were in a socialist economy everything would go to the king. In our economy, however, the more money in the hands of our people, the stronger our economy is. The idea is to keep money flowing. Fraud takes this out of our economy and does not allow the money to flow. Associates scheme was geared toward high risk credit people. They went after people with no other options. The people paying this insurance through their loan payments were unable to pay back the money on there own and could not borrow money from any other group because of their bad credit. They had to pay because they had no other options. When big companies take money out of the hands of the people, it causes a decrease in the value of a dollar. Depending on how big the penalty is, the insurance company has to pay out. They will raise insurance policies. The penalty can conceivably be passed back to the consumer and the price the consumer pays increases. Associates took advantage of the high risk credit people and convinced them that they were their only option. They did not exactly lie to them, but left out important information about what they were paying for with their loans payments. Associates broke the disclosure law. They failed to disclose what the insurance policies really were. The law explains that you have to fully explain to the customer exactly what they are purchasing. Even if the people found out, Associates did not explain to them that they could stop paying for the insurance. These people had no way of knowing that they were being deceived. These actions by Associates were very unethical and they only made it worse when they made harassing telephone calls to the consumers if they found out about this insurance. I feel that Associates knows that they were wrong in their actions and even though they say they are not admitting to doing anything wrong by settling, they know if their case is taken to court, they will be convicted of a crime and lose everything.
Jack Grubman and Salomon Smith Barney Salomon Smith Barney paid a $5million fine that the National Association of Securities Dealers sanctioned against them, claiming that their research was “materially misleading”. Jack Grubman has been blamed by Salomon and just about every one else for the recent accusations of inflating stocks prices and misrepresentation of information. Jack Grubman is a top telecommunications analyst for the securities company Solomon Smith Barney, whose parent company is Citigroup.1 Jack Grubman has been the focus of the fraud investigations since he was the main analyst who gave out good rating, buy or hold recommendations and inflated price targets to clients. He would advise clients to purchase or hold stocks such as companies like Winstar Communications, Global Crossing, WorldCom, XO Communications and Metromedia Fiber Networks claiming these stocks would reach unrealistic target prices, which ranged from 50 to 100 times what the stock was trading at. While at the same time Jack was making $20 million a year and now these companies have filed for bankruptcy .As the evidence against Jack increased and the investigation went further, Jack Grubman tried to justify his actions. 2 Jack Grubman started to speak out against Citigroup and Salomon Smith Barney. In recent news, he publicly claimed that he was under pressure by Citigroup’s investment baking division and to improve his rating on companies that were investment-banking costumers. Jack was ostracized if he put out a bad rating on any company that was an investment-banking client of Citigroup. Citigroup’s chairman Sanford Weil and other executives would then force Jack to change his ratings, to email out apologizes or statements taking back his previous statements. At the beginning it appeared that Jack Grubman would give out good ratings to bad companies to help improve that company, and at same time have conflict of interest because of other dealings with them. This is in violation of the Glass-Steagal Act. 3 The Glass-Steagal Act separated activities of commercial banks and securities industry. It prohibits commercial banks from underwriting or dealing in corporate securities, and prohibited investment banks from conducting commercial banking activities. Even though the act was recently repealed it still is very much a part of the situation, since the formation of Citigroup in 1998, when the merger of Citicorp bank and the Travelers Group an insurance company which was the parent of Salomon Smith Barney securities company, was as the time in violation of the act. The merger was approved because by giving Citigroup 2-5 years to sell off prohibited businesses, but before the 5 years were up the Gramm-Leach Bliley Financial Services Act repealed the law in 1999. It is not clear at the moment what will happen to Jack Grubman and Salomon Smith Barney of Citigroup, since most of what they did was legal. A major problem is determining weather they gave out false information, failed to disclose risks and inaccurately informed customers. It will also be difficult to determine who is responsible.4
1 “ Salomon Agrees to Pay $5Million To Settle NASD Probe of Research” WSJ.com, 9/24/2002
3 “Citigroup Now Has New Worry: What Grubman Will Say”
Wall Street Journal, Thursday, October 10, 2002
4 The economics of Money, Banking and Financial Markets, Frederic Mishkin
On February 20, 2002 the Allied Irish Banks reported that they lost $691 million due to currency fraud. It was suspected that John Rusnak, a trader for Maryland branch of AIB, Allfirst, lost $750 million and reduced the bank’s net income by 38 percent. The bank discovered that losses go all the way to 1997, which calls into question what kind of supervision the bank puts on traders. The bank’s Baltimore-based business, Allfirst appointed a very young employee to monitor currency trading over a year ago, the Wall Street Journal reported. At the time of this press release the bank stated that “The Irish Economy remains fundamentally strong and competitive, there are signs of recovery in the United States, the United Kingdom has proved resilient and interest rates have reduced significantly in Poland (where it has operations).” The bank made clear that the extent of its losses could not be concrete until a full investigation could be done. In another press release on March 14, 2002 the findings from the investigation where written. The investigators found that Rusnak had carefully planned this fraud. His actions included falsifying “key bank records and documents”, he manipulated the controls and regulations of the Allfirst Treasury, which the bank had great confidence in. The chairman of the board and the CEO of AIB group both resigned from the board during the board meeting on March 12 because “the losses raised questions of accountability and credibility at the highest levels:” The bank decided to employ some new risk management employees and work closer with the treasury to prevent the controls of the treasury from breaking down again. A decision that any trader that is making large trades should be closely supervised. AIB also stated that they would pay the stockholder’s back in a timely manner. Another interesting thing about this story is that the investigators found that no other person associated with Allfirst or AIB was involved in Rusnak’s fraud. This means that he had to plan everything perfecting if nobody saw anything happening until 5 years into the scam. This story highlights many problems with the rules and regulations of trading in the US and foreign markets. Traders are supposed to be closely supervised especially when they are dealing with a large some of money as Rusnak was. All the checks that Allfirst was supposed to perform failed to check Rusnak. This sent a signal to AIB and any other large trading corporation that is it important to have a high level of security and supervision over all trading that is going on inside and out of the company. AIB is a grouping of Ireland’s largest banks and also as other offices in Poland, Great Britain, and the United States. It provides all your financial needs also such as credit cards and mortgages. Its shares are traded on the Dublin, London, and New York stock exchanges. As you can tell from this information, AIB is a very large bank and has the possibility to influence many different sectors. This fraud in particular did not hurt the economy of Ireland, but there was some damage done in the United States where the fake currency was being made. This currency led the banks to believe that they had more deposits than they truly did. Banks make loans on the basis of what they hold in deposits. This amount of fake currency could have led the bank to make loans that it did not have the back up for. If there was a run on the bank as there was during the Great Depression AIB would be in big trouble, because they definitely would not be able to provide everybody with their money. Not having the correct amount of money in reserve also breaks the law set by the FED. The FED sets a reserve ratio that every bank must follow. Because this is an Irish based bank, maybe they do not need to be in alignment with the reserve ratio. Because the falsification happened in the United States the Federal Reserve was responsible to deal with AIB and Allfirst. Rusnak’s actions calls into question what regulations the government sets when it comes to creating currency. One of the main problems was that AIB has no control over the production of the American dollar so they could have easily missed any actions that Rusnak was taking because they where not looking for it and had put all of their trust in Allfirst to take care of all those types of transactions. You would think that a trader would not even be able to come close to falsifying $691 million. If the government has certain rules they need to be enforced better and more often so it does not take 5 years before somebody gets caught and the losses are so large. On May 14 there was a written agreement made between “Allied Irish Banks, plc, Dublin, Allfirst Financial Inc, Baltimore, Maryland, and Allfirst Bank, Baltimore Maryland.” This was the first time that the Federal Reserve entered into a written agreement with a foreign bank regulator. I think that all the parties involved realized that the only way to prevent this from happening again was too all work together to supervise what is going on in the financial market when a foreign bank has offices in the United States. Even though fraud is not a good thing, this instance has led to some new laws and regulations that will hopefully prevent this from ever happening again.
10 million for me, $50 million for
On September 30 of this year the Attorney General of New York, Eliot Spitzer, filed suit against five top telecommunications executives. The suit alleges that Bernard J. Ebbers, former chairman of Worldcom, Joseph P. Nacchio, former CEO of QWest Communications International, Philip Anschutz, former chairman of QWest, Stephen Garofalo, Chairman of Metromedia Fiber Network and Clark McLeod, former CEO of McLeod USA earned more than $1.5 billion in an unlawful manner, including $28 million in profits on shares of initial public offerings. Mr. Spitzer alleges that these five men received tips on "hot" IPO's from the Salomon Smith and Barney department of Citigroup in exchange for steering tens of millions of dollars worth of investment banking business from their companies to Salomon Smith and Barney and Citigroup. Individually, Bernard Ebbers earned more than $11 million in four years while Worldcom paid Salomon $107 million in fees from late 1997 through early this year. Clark McLeod made more than $9 million while McLeod USA paid $50 million in fees to Salomon. Joseph Nacchio and Philip Anschutz made $6 million while QWest paid $37 million in fees. Stephen Garofalo made $1.5 million as Metromedia paid $47 million in fees to Salomon. This type of activity is quite unethical. It is illegal in the United States to receive insider information for free, nevermind to bribe a company to give it to you. Though it may be hard to prove that these large profits were earned in an unlawful manner, it is quite suspicious that top executives in these companies would earn huge sums of money on stock in new firms that were being researched by Citigroup while at the same time doing large amounts of business with Citigroup. This a clear cut case of a conflict of interest.
Source: The New York Times
Global Crossing is an independent provider of undersea fiber optic telecommunications systems. Recently, it has come under a class action suit in California. The suit is filed on behalf of all people who were participants that would benefit from Global Crossing's 401(k) plan from September 1999 up until now. The prosecutors claim that the defendants breached their contract when Global Crossing's executive officers found out that Global Crossing stock would not be a good stock to hold in the 401(k) and did not let participants in the 401(k) know of the situation. Furthermore, they encouraged participants in the 401(k) plan to continue to make investments in Global Crossing stock. Clearly this is yet another case of unethical behavior, much like in the case of Enron. Thousands of Global Crossing's employees are being affected by this case and hope for some sort of restitution for the money they have lost from the decline in value of Global Crossing stock. The stock fell as a result of Global Crossing's inability to compete with data service providers when the demand for their own product fell, and revenue dropped. This information became available only in October 2001, well after holders of the stock in their 401(k) could have done anything to help themselves. What this case says about big business regulation in the US is that it needs much stricter laws and a body of some sort to watch over companies who evidently cannot be trusted.
Prime Bank Scam
This case relates to Prime bank fraud. In general, these scams attract investors by making outrageous claims about the returns on the investments they offer, all with little or no risk. They claim returns of 20 to 200 percent monthly, and even claim to be affiliated with a prestigious central bank, such as the International Monetary Fund. The truth is that they have no connections to any legitimate banks and the market for the “prime bank” instruments they trade does not even exist. In this particular scam, three bogus investment companies conned clients into investing $88 million dollars into non-existent “prime” bank instruments, treasury futures pools and certificates of deposit. At the center of the scam was the U.S. Reservation Bank and Trust; a supposed native American chartered “bank.” This entity was non-incorporated and granted business charters by the Rosebud Sioux, based in Scottsdale, AZ. The president of the bank since May 1992 was Edward J. Driving Hawk. This group raised “$78 million through sales of an investment combining a ‘Leveraged Profit Sharing Agreement’ with an uninsured CD issued by USRBT.” Officials of USRBT claimed that investors’ funds would be kept safe and used as “leverage” for trading programs involving United States Treasury notes and “bank debentures.” They also guaranteed investors would receive either the profits from the trading program or the interest on their USRBT CD; whichever was greater than 20%. In reality, the “bank” never leveraged or invested any funds, and instead used the funds to make false interest payments to the investors. Officials also misused investor funds by spending over $4 million on salaries and other personal expenses, including a horse racing stable and a casino development company. USRBT also had a sister scheme called Higher Investment Technologies, Inc, a Nevada corporation started by John M. Adams, the former vice president of USRBT. In this scheme HIT raised over $10.6 million from six investors and offered them the chance to participate in a program called a “Capitol Management Agreement.” HIT claimed it would use funds to trade Treasury bond futures and then share the profits with investors. In actuality HIT used only 10% of investors funds for such trading, and the rest went to personal and business expenditures. On April 3, 2002 the U.S. Securities and Exchange Commission intervened and brought the scam to a halt. They ordered the freezing of assets and a repatriation of funds that had been moved offshore. Other federal law enforcement agencies were involved in the investigation and the U.S. Attorneys office succeeded in recovering about $30 million in funds from the two entities and launched a search for the recovery of additional funds for the benefit of investors. This case raises some serious issues about the risk involved in investing funds as a result of asymmetric information. Clearly the agents of USRBT had a much better knowledge of their company than the investors did. The investors also should have used their knowledge of adverse selection to know that as a bank USRBT is a financial intermediary and so provides a link between lenders and borrowers. Any bank that pays extremely high interest rates on deposits is obviously charging an even higher interest rate on the loans it makes, and adverse selection predicts that only those companies with a high possibility of default are willing to pay such high interest rates. Investors should have immediately been suspicious of the high interest rate on the CD, but the possibility of such high profits probably clouded their judgment. Basically, it boils down to the fact that there is no such thing as a safe risk that yields spectacular profits; especially not Treasury or Savings bonds, which have the lowest possibility of default, and as a result the lowest interest rate. Also, though this case was an intended scam, it still illustrates the principle-agent problem. Because the investors had no control in the management of the corporation, the agents of USRBT were able to do whatever they wanted with investors’ funds. As a result, the agents of USRBT unethically spent most of their clients’ funds on personal expenses rather than the intended purpose. While monitoring a firm's activities can be costly, it is still very important to do so in order to avoid moral hazard problems. This case also illustrates the role of the SEC in the absence of the monitoring process. Here the SEC did not prevent moral hazard, but did help investors by freezing their assets and returning some of their funds. The SEC charged the companies with violations of several securities acts; laws that make investment scams and the unethical use of company money illegal.
Enron was a Houston based Natural Gas Company which was the largest in the world. It was also a major player in the world's energy markets. But on December 3rd Enron filed for bankruptcy after its stocks plummeted. This was at the time the largest bankruptcy in US history. The reason for this is that Enron lied on its accounting sheet and reported higher revenues then was actually the case. This was done so as to keep their stock prices up. By keeping up their stock prices they were able to give get bigger profits and hence bigger pays. But the problem is that stocks are basically loans, and since Enron was borrowing and spending far more then it was bringing in trouble was bound to happen. And it did when the stock market took a turn for the worst and in the end lead to Enron's demise. This has lead to a huge political rallying for "Corporate responsibility and ethics". The US at the time had too lax regulations on earning sheets and reporting. As a result there will probably be tighter regulations and checks on earning sheets.
After the breakdown of former Soviet Union the economic system has not been showing any kind of progress in most of the new countries. Financial markets are still underdeveloped or do not exist at all in large number of the separated states, so the innovations in the financial field have attracted uneducated public with its enormous returns to the investments.
One of those became pyramid schemes that have been already implemented in Europe and United State earlier in this century. A pyramid scheme is basically a bubble that grows by drawing in more and more participants who believe in its reality, mostly as a way of making money. One of the largest Russian pyramids was "MMM", which was created basically as an investment company with really great advertising policy which attracted people. The owner of the pyramid Sergey Mavrody played really well; he let the first wave of investors to gain some money, thus attracting more and more people. The pyramid worked by money-advertisement-money mechanism. But as it can be clear mathematically such mechanism cannot live long because the potential number of new people in the game is limited and, thus those at the bottom of the pyramid, the vast majority of the participants, lose money because there is no one below them. This was not the only problem in that scheme, by the time when IRS in 1994 started to work on this case the owner
Mavrody transferred money of those people who have already invested to his bank accounts in different countries around the world. So even the money that could help at least some people that took part in this game were gone now. The government was suing the company since 1994 and didn't reach the verdict and somehow a couple of years later let Mavrody who stole around 2-3 billions of dollars from people leave the country. Now he is hiding somewhere not only from IRS and government but also from angry investors that lost a lot of money with "MMM". After "MMM" around 10-15 companies like that were created and of course failed later also with owners disappearing with all the money of the public. The story has taught a lot people who now do not trust even legal financial institutions in countries of former Soviet Union, because the simply do not want to lose the last dollars in their pockets.
References: hronograf.narod.ru , mmm55.narod.ru , I used also a lot of generally known information because the entire country was talking about that.