EQUITY FUNDING CORPORATION OF AMERICA Introduction : Equity Funding was a financial institution primarily engaged in life insurA?­ance. In 1964, its top management commenced to perpetrate a fraud that...

EQUITY FUNDING CORPORATION OF AMERICA

Introduction:

Equity Funding was a financial institution primarily engaged in life insurA?­ance. In 1964, its top management commenced to perpetrate a fraud that would take almost ten years to discover. The intent of the fraud was to inflate earnings so that management could benefit through trading their securities at high prices.

History:

In 1960, Equity Funding Corporation of America was founded by four individuals, who assumed equal partnership interests in the firm. Soon after its formation, two of the partners resigned, leaving the small company to Stanley Goldblum, who held the title of president, and Michael Riordan who served as Chairman of the Board. The principle line of business was the selling of life insurance policies. 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. The development of this innovative financial investment was the trademark of Equity Funding. In 1964, Equity Funding went public and was soon recognized across the country as one of the most innovative companies in the conservative world of life insurance.

Michael Riordan was killed January 1965 in a mudslide that destroyed his home in the Brentwood suburb of Los Angeles, California. With Riordan gone, Stanley Goldblum was appointed the Chairman of the Board. Fred Levin who was a company employee since 1967 was selected by Goldblum to serve as the executive vice president in charge of life insurance operations. Together Goldblum and Levin significantly increased Equity Funding's revenue and earnings under aggressive, growth oriented management policies.

By 1972, Equity Funding was one of the ten largest life insurance companies in the United States and was the fastest growing company in the industry. When Equity Funding went public in 1964, its assets totaled $9 million and its pretax earnings was $620,000. Eight years later, Equity Funding total assets approached $500 million with pretax earnings of $26 million. Because of the great success of Equity Funding, security analysts recommended Equity Funding common stock as their most popular investment.

As a result of the rise in stock prices in the early 1970s, Goldblum and Levin became staggeringly wealthy and even though both men came from modest backgrounds, they were accepted into the intermost circles of Los Angeles' celebrity social circuit. Goldblum was a college dropout working in a meat packing plant ten years earlier. Levin on the other hand earned a law degree from DePaul University in Chicago and worked briefly with the state's regulatory agency whose responsibility was to oversee the state's insurance industry. While Levin was quick witted and charming and enjoyed wining and dining business associates, Goldblum was a loner who preferred to spend long hours working out on weights. Goldblum saw great promise in Levin when he joined Equity Funding in 1967. Levin reportedly had no qualms about humiliating employees publicly and kept a tight rein over the insurance sales personnel that he supervised. Levin saw advantages of having a network of well connected friends and business associates and used this to his advantage. Both men were widely respected in their professions.

Fraud:

The Equity Funding fraud, like most financial fraud, had a modest beginning. Goldblum was concerned that Equity Funding's earnings were too low. 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. Goldblum supplied his subordinates with inflated earnings per share figure and instructed them to make whatever increases necessary to support this figure.

The fraud progressed through three major stages: the "inflated earnings phase," the "foreign phase," and the "insurance phase." The inflated earnings phase involved inflating income with bogus commissions supposedly earned through 1oans made to customers. Equity Funding had a funded life insurA?­ance program whereby customers who bought mutual fund shares could obA?­tain a loan from the company to pay the premium on a life insurance policy. After some years the customer would sell off the mutual fund holdings to repay the loan. The mutual fund shares should have appreciated sufficiently so only a partial sale of shares would be required. Thus, the customer had the cash value of the insurance policy and the remaining mutual fund shares as assets from the investment.

The inflated earnings obtained via bogus commissions were supported by manual entries made on the company's books. Even though supporting docuA?­mentation did not exist for the entries, the company's auditors failed to detect the fraud. However, the inflated assets did not bring about cash inflows, and the, company started to suffer severe cash shortages because of real operating losses.

To remedy the cash shortage situation, the fraud moved into the second stage, the foreign phase. The company acquired foreign subsidiaries and used these subsidiaries in complex transfers of assets. Funds were brought into the parent company to reduce the funded loans asset account and falsely repreA?­sent customer repayments of their loans. However, even this scheme proved inadequate.

The third stage, the insurance phase, involved the resale of insurance poliA?­cies to other insurance companies. This practice is not unusual in the insurA?­ance business- when one company needs cash immediately and another comA?­pany has a cash surplus. Equity Funding created bogus policies. In the short run it attempted to solve its cash problems by selling these policies to another insurance company. In the long run, however, the purchasing company exA?­pected cash receipts from premiums on the policies. 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. Thus, it was only a matter of time before the fraud could no longer be concealed.

The computer was not used in the fraud until the insurance phase. The task of creating the bogus policies was too big to be handled manually. InA?­stead, a program was written to generate policies. These policies were coded as the now infamous "Class 99."

Discovery

In the spring of 1973, Equity Funding collapsed in a period of a few weeks when a disgruntled employee who was involved in the fraud but had been fired by Equity Funding management disclosed the existence of a massive financial fraud within the company. The story was so bizarre that many parties associated with the company refused to believe the story. At the request of Equity Funding's court-appointed bankruptcy trustee, the accounting firm of Touche Ross performed a lengthy audit. This audit disclosed that the company had generated more than $2 billion of fictitious insurance policies. Most of these bogus insurance policies were sold to reinsurance companies. To disguise the fictitious nature of these policies from insurance examiners and outside auditors, Goldblum and other company executives would regularly hold midnight "file-stuffing" parties. These parties were held to generate supporting documentation for the thousands of nonexistent policyholders that had allegedly purchased life insurance policies from Equity Funding.

The truth was that Equity Funding was never profitable. Prior to collapsing, the company was technically insolvent even though Goldblum had just issued a press release reporting record earnings for 1972, up 17 percent over 1971.

The most alarming feature of this fraud was the number of individuals who were aware of its existence. Dozens of individuals, both Equity Funding employees and external third parties, helped perpetuate and/or conceal the company's fraudulent schemes. Eventually, federal prosecutors would convict or obtain guilty pleas from twenty-two individuals associated with the company, including three of the company's independent auditors. As many as fifty additional Equity Funding employees, primarily clerical personnel, participated directly or indirectly in the fraud; however, prosecutors chose not to bring criminal charges against them.

The investigation into the Equity Funding fraud revealed that Goldblum and Levin gradually and deliberately induce their co-conspirators to become involved in the fraud. More often than not, these individuals were persuaded with significant monetary rewards in the form of stock rights, large salaries and bonuses, and exorbitant expense accounts while Goldblum and other executives reaped the greatest reward from the sale of their Equity Funding stock. In fact, Goldblum reportedly earned more than $5 million from the sale of his stock.

The motivation behind this major fraud appeared to be Goldblum's persistence to keep the price of the stock high. In fact during 1972, several of Equity Funding co-conspirators pleaded with Goldblum to report flat earnings for a period of years. They argued that by doing so the company would have an opportunity to stop the fraudulent practices and become a total legitimate operation. Goldblum refused to cooperate, pointing out that it reported earnings did not increase each year, the company's stock price would fall.

To protect this scam, Equity Funding executives went to great lengths to conceal their fraudulent activities from the insurance examiners and independent auditors. Examples of these activities included Levin ordering the Equity Funding offices that were being used by the state insurance examiners to be bugged so that he would know the specific questions or issues that they were addressing. Also, company officials ushered out several auditors from their offices on the pretense of lunch at an elegant and busy local restaurant hoping that they would leave their files unlocked. In fact the auditors did and while at lunch other company employees were copying down the insurance policy numbers that had been randomly selected by the auditors for testing. With these numbers on hand, company employees could ensure that these selected files could be created and pass audit inspection.

Aftermath

The stockholders and companies that Equity Funding defrauded suffered hundreds of million dollars in losses. In fact, the value of the stock dropped by more than $15 billion within one week. The conspirators received modest sentences compared to the losses they inflicted.

Goldblum served four years in the Terminal Island federal prison in Long Beach, California, before being paroled. Goldblum returned to the business world as president and chief executive officer of a company that operated a chain of medical care clinics. The auditor of this company at the time was Seidman & Seidman. This was the same audit firm that audited Equity Funding. Shortly after Goldblum was hired, Seidman & Seidman resigned and forfeited the $40,000 annual audit fee because they did not want to be associated with another company that had Goldblum as its chief executive officer.

Levin served only two and one-half years at the same facility before being paroled. In fact after his release from prison, he embezzled $250,000 from a small plastics company while acting as its president.

Questions

1. Is it necessary or appropriate for independent auditors to trust the executives of a client? If so, to what extent should auditors trust client management?

2. In evaluating the integrity of the executives of a prospective client, what types of information should auditors obtain, and from what sources would they generally collect this information?

3. In your opinion, was it appropriate for Seidman & Seidman to resign as the audit firm of Goldblum's new company after he was elected its president and chief executive officer? Under what conditions is it appropriate for a professional firm, such as a CPA firm, to choose not to provide professional services to a company or individual requesting such services?

4. In your opinion, what did the Seidman & Seidman do to contribute to the continued success of the Equity Funding fraud? What could they have done to detect the fraud earlier?