- The art of the Con
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 () 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 plaintiffâ€™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 plaintiffâ€™s that Coopers knowingly participated in the fraud. However,
Coopers was charged with making false representation in the certified opinions.
Were the plaintiffâ€™s had trouble with Coopers was in the fact that they did
not believe that either Coopers had 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 (). 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 and what they would not and made the
record that they were presented conform to that theory.
While that is certainly is a big stretch, when you
take the statement into the prospective that the fraud was carried on between
three to six years, this would seem hard to digest. 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-Morâ€™s hands first and were probably sanitized. This argument
does not draw much rain either, because the auditor is expected to an independent
check of the companyâ€™s books. That means, having reasonable access to all materials
and data that would be necessary to perform their work product without outside
In the meantime, Coopersâ€™ 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
of two to get the job done more quickly. Once again, audit must conform to
certain standards and the fact the Coopersâ€™ people choose to cut corners in
order to keep peace with their employers only played into their hands. Once
again, we cannot sympathize with Coopers for pushing the envelope.
As we mentioned earlier, Phar-Morâ€™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 companyâ€™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-Morâ€™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 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 upward record. Coopers was able to show the item
in a footnote to the financial statement because of the related parities issue
involved and they were happy (). 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 couldnâ€™t get their inventory straight together with a company that was
falsifying their inventory 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
the auditor for Tamco and for Giant Eagle, the parent. Thus, the crux of the
matter seems to be that if Tamcoâ€™s books were in disarray and Phar-Mor didnâ€™t
even keep a record of what they had received, this would have sent signals flying
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 was truly out to lunch
in this instance.
The lesson that Coopersâ€™ 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 Coopersâ€™ 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 came, 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 failed miserably.
On this occasion, it was found that they 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 it didnâ€™t 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 see a certified audit, I am making the assumption
that this audit is correct down to the pennies and if the accountantâ€™s had to
make adjustments for whatever reason, they would have been footnoted. Certifications
are not meant to be, best estimates, which is 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 the
Coopers was using was too small to be meaningful. 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 companyâ€™s profit. There were effectively utilizing
an inventory test to prove the inventory. Thus, it was not a test at all.
Once again, Coopers twisted and turned about all
the things that they did or did not do and when all was said and done, it just
didnâ€™t matter. The numbers are the numbers and they certainly speak for themselves.
If Coopers were the forensic guys on the opposite side of the table, I am sure
that they would have argued exactly that way.
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 totally
to confuse the experts at 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 wasnâ€™t good enough. The fraud was perpetrated
by 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. ()
In reading the case; assuming the Coopersâ€™ wasnâ€™t
in on the fraud and we have know knowledge that they were, the only thing left
to conclude is that the Phar-Mor people were able to read the Coopersâ€™ peopleâ€™s
minds. They seemed to know just what Coopers would check and made sure that
those items were kept Kosher; on the other hand, the outside accountants missed
a massive inventory fraud, which reached unheard of proportions. Whatever Coopers
did or did not do, once again does not seem to be the issue. Neither is It
and 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 is that.
With all the money that was being taken, Plaintiffâ€™s
logically argue that Coopers was staring fraud in the face and turned the other
check. No evidence has ever shown that to be the case, but it was found that
Coopers work product in many instances was substantially doctored. We would
fault Coopers, if we accept their statement that they never saw a phony entry,
or never going back an 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
Everyone seemed to agree that it would have been
a Herculean task to analyze the entire General Ledger () 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 plaintiffâ€™s
make a telling case when they discuss Coopersâ€™ 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 & Lybrandâ€™ 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 Coopersâ€™ 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. This was followed
by the showing in court of a video tap starring one of the perpetrators saying
that the “fraud would have been all overâ€™, 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 we can only feel remorse for those that would use this
Coopersâ€™ team in the future.
The plaintiffâ€™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. () Management told two large whoppers to Coopers who mouthed
them down. 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 be telling Alice, not something real accounting people
would accept without checking the facts. You have to keep in mind that we 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 balls.
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. 5,000
creditors of Phar-Mor inc filed over 10,600 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 Monusâ€™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
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 companyâ€™s license was yanked for a time and they were penalized $40,000.
What had raised the Governmentâ€™s dander was the
fact that Phar-Morâ€™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 soon
had a really bad hair day. Judge Kennedy in the Circuit Court found Monus guilty
on all 109 counts that:
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:
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.”