BULL STREET - 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 ([127])  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 plaintiff’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 plaintiff’s that Coopers knowingly participated in the fraud.  However, Coopers was charged with making false representation in the certified opinions.  Were the plaintiff’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 ([128]).  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-Mor’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 company’s books.  That means, having reasonable access to all materials and data that would be necessary to perform their work product without outside interference.  .

In the meantime, Coopers’ 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 Coopers’ 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-Mor’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 company’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-Mor’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 ([129]).  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 couldn’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 Tamco’s books were in disarray and Phar-Mor didn’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 Coopers’ 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 Coopers’ 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 didn’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 accountant’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 company’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 didn’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 wasn’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.  ([130])

In reading the case; assuming the Coopers’ wasn’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 Coopers’ people’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, Plaintiff’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 Drott

Everyone seemed to agree that it would have been a Herculean task to analyze the entire General Ledger ([131]) 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 plaintiff’s make a telling case when they discuss Coopers’ 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 & Lybrand’ 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 Coopers’ 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 over’, 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 Coopers’ team in the future. 

The plaintiff’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.  ([132])  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 Monus’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 is worded.

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 company’s license was yanked for a time and they were penalized $40,000.

What had raised the Government’s dander was the fact that Phar-Mor’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:

“charged 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:

“For 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.”

 

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