- The art of the Con
Government Securities Shell Game
Not every business is obligated to have an outside
accountant. Those that are public companies are usually required to do so (if
they are reporting companies) and those institutions that are regulated and
those who deal with the public also have that requirement. Brokerage firms
fall under the later and even if they are dealing in what were once called exempt
securities (i.e. government bonds), the public trust is involved and are regularly
looked at by their outside auditor.
ESM Government Securities Inc was founded in late
1975 and capitalized at less than $100,000.When it opened for business, the
partners were Ronnie Ewton, George Mead and Bobby Seneca with Ewton who had
a somewhat checkered history assuming the top job. () They employed Alan Novick to handle the firmâ€™s proprietary
trading account. ESM was one of a group of brokerage firms that sprung up during
the late seventies that for the most part indicated that they were in the business
of attempting to improve their clientâ€™s overall portfolio yield. This supposedly
could be accomplished by a complex system of lending and re-borrowing of securities
for fee call a “repo” (a repurchase agreement) or its more complex cousin, the
“reverse repo.” (reverse repurchase agreement) Interest rates were high at
this time and savings banks had many restrictions on them relative to the dividend
rates that they could pay on CDs which was virtually the only way that they
could attract money. Thus, they were in a position of always lending long and
borrowing short and in situations where rates were going against them the institution
could potentially fail.
One of the problems with the industry was the fact that it
was basically unregulated. Because of Americaâ€™s growing internal debt, Uncle
Sam wanted to make as easy as possible to sell their own securities. They came
up with the theory that you literally canâ€™t lie when talking about a government
instrument. No matter what you would say about its safety would be an understatement,
and on a relative basis, this may just have been very true. The second methodology
that the federal government used to move their paper was allowing government
dealers and their clients the opportunity of literally unlimited leverage. While
margins on stocks have been set by the Federal Reserve at 50% and have remained
at that level for decades, you could leverage government instruments at whatever
the traffic would bear. This became the undoing of many small brokerage firms
specializing in this business.
Many devices were used by these institutions to
attempt to survive these interest rate orchestrated problems such as the purchase
of “junk bonds” and the Repo magic supposedly being survived up by these brokerage
firms that could improve your yield. During their period of significance, many
of these brokerage firms failed and when they did, often they took their clients
whose securities they were holding, down the drain with them. Most of the people
running the firms were heartless inveterate gamblers and they were more interested
in providing themselves with a substantial livelihood than helping their clients.
Names like Beville Bresler & Schulman and Lombard Wall all flourished and
collapsed during this period to time bringing down many clients with them.
Strangely, these Government Securities dealers that were offering their clients
a form of “Black Magic” all had their beginnings in Memphis, a city that seemed
to have the right climate for securities fraud.
Being an outside auditor for these types of companies
was not an easy task as the firms were able to construct inconceivably complex
products at the drop of a hat that only the makers seemed totally able to understand.
(Probably best described as a forerunner of the derivative) This made accounting
for the portfolioâ€™s current value a job and a half. In derivatives, accounting
firms and the products makers seem to have found a way around accounting for
these products by hiding behind the accounting term, materiality, which literally
means that if the investments do not account for more than five percent of a
firms assets, they donâ€™t have to individually accounted and can be bundled.
Materiality was not something that could be hidden
behind in those years it literally become a day to day struggle between the
accountants and the firms management as to whether the books could be totally
sorted out. These so-called government brokers were dealing in the leasing,
purchasing, "repo-ing,” and trading in government securities. The ultimate
question that could arise was that of who was smarter, the accounting firm of
the government dealer.
Into this environment stepped Jose Gomez, the son
of Cuban emigrants who started his life in what then was called “Little Havana”
in Miami. His first job was as a bag packer in a supermarket which he stuck
with for quite awhile. He stayed in the same industry when he tried to get enough
money for college and became a buyer for another grocery store. Simultaneously
he went to school at the University of Miami where he obtained a degree in accounting.
He was bright and glib and was soon hired by the sixty-year old, Alexander Grant
& Company (Now Grant Thornton) to handle the audit for ESM a government
dealer. He was assigned to them in 1977 and not only carried out his assignment
but because close friends with the firms principalâ€™s. Gomez became a super-patsy
for ESM very early in his assignment when the firmâ€™s principals found that they
could hide offensive accounting items from him almost at will. Alan Novick,
an ESM principal and bond trader became particularly adept at moving the loses
into crannies that Gomez would not think of looking in.
In spite of Gomez acting as Alan Novickâ€™ s unpaid
Huckleberry, in 1979 he became a partner at 31 years of age at Grant and as
such was certainly one of the youngest to achieve that position. Gomez was
an extraordinary go-getter and was on the boards of many fabled charities in
the Miami area. His theory was that in order to succeed in accounting, you
had to go where the money was; a noble idea. However, not everything was so
simple in Gomezâ€™s life. Gomez confided in his newfound friend, Alan Novick
that his credit card debts were strangling him alive. This of course was about
all Novick had to hear. Gomez took $20,000 from Novick at the end December
in 1979 and got rid of some of his problems. Gomez had just bought the farm.
Credit card debt was not the only thing strangling
the young accountant, he seemingly owed everyone for just about everything and
set up numerous meetings with his benefactor, Alan Novick, to convince him to
have ESM, his client take care of the rest of what he owed. Gomez helped ESM
to cover up close to a fifty million dollar hole in their balance sheet to close
out the year 1979 in exchange for additional help on his debts. Gomez later
confessed the reasons for his foolishness:
“I was a young man in a hurry. I needed more
money than I was making. I wanted nice clothes for my wife. I had to have a
nice home, be seen at the right places. Take a trip to the Super Bowl. Do whatever
was necessary to further my career. Use the plastic, the credit cards. When
the plastic limit was reached, borrow and pay off the balances. Then use the
In the meantime, one of the most bizarre events
in financial history occurred and as quickly as it had happened it once again
disappeared. One of the senior partners at ESM was named Bobby Seneca. He
had recently unloaded his wife in a divorce matter but she decided that her
settlement was not nearly adequate enough. After all, “The loans, piled on
top of the generous salaries, were feeding a lifestyle that was increasingly
ostentatious. There were luxury home, the lavish parties, Mercedes and Jaguars,
lots of jewelry for the wives. She saw how the other ESM wives were living,
and she remembered the $70,000 Vatican wedding, the countless grams of cocaine,
the mink capes, and the $8,000 Rolex watches” ()
In the court trial, Bobby Seneca was represented
by Gene Strearns of Arky, Freed who strangely “confessed” in court that ESM
and its principals were actually broke. Furthermore, Stearns argued in court,
“if news of the facts that he was enumerating in court ever got out, countless
people would be wiped out, and the firm would collapse in a heap.” Seneca won
the issue relative to support and ESM was the beneficiary of a true miracle
when the judge bought Strearns' argument about secrecy, hook, line and sinker.
Thus, the conspirators had been saved to pilfer more of their clientâ€™s money,
essentially under the good graces of the American Court System.
Besides all of the good things that the partners
were buying for themselves, the firm was taking a substantial amount of customer
money and re-investing it in energy oriented transactions. They believed that
the investments that they were making were so solid the even if everything continued
to go wrong with ESM, the investments would certainly bail them out eventually.
Gomez by this time was now a more than willing “worker bee” in showing “the
boys” how to falsify their records in ways that Alexander Grant would never
think of investigating.
Novick determined to get even and he bet over a
billion dollars that interest rates would decline. Either Novick was the worst
trader that ever lived or just plain unlucky is not an issue for now, but naturally,
as with everything else he was doing, he should have stayed in bed. Novick
was killed by his bet and in reality wound up the year of 1980 with a $13 million
loss which when added to his previous total bought ESM a $144 million hole.
Interest alone was running ESM $20 million per year. However, the now debt-free
Gomez was rock solid during this; period when he was desperately needed and
imaginatively produced a $12 million profit for ESM totally out of illusion
for the year 1980.
Pete Summers, a senior officer and shareholder of
ESM decided that the game was getting a little to rough for him and wanted out.
He would sell his stock back to the company for the inflated book value and
keep his mouth shut. In order to make his point, Summersâ€™ lawyer composed a
scenario for the folks at ESM to read and it went this way in part:
“Example: Customer owns $50 million worth of
collateral. ESM tells them they will give him $25 million for the collateral.
ESM in turn puts the collateral out and receives $40 million. ESM nets out
$15 million which they use to cover the loss ESM Government Securities took.”
do this example three times to raise money to cover losses taken in the market.
You may ask why any legitimate Savings Bank would
give up $50 million in collateral in exchange for $25 million. In reality,
there is no problem, as long as management of the Savings Banks were receiving
enough money under the table from ESM, there didnâ€™t seem to be any objection.
In any event, Summers was on the mark with his example and was quickly paid
out by ESM management in exchange for a non-disclosure agreement and the promise
to let them alone and go bother someone else.
The rest of the news for ESM was both good and bad.
They had dodged the bullet in a problem with the Federal Home Loan Bank Board
and another with the Securities & Exchange Commission through the magic
that Gomez () was able to construct with his magical use of the pitiful
ESM numbers. However, these were nervous times for Novick who was seemingly
now putting out one fire after another. On the other hand, when he left the
office, there was a lot to go home to. I loving wife and three children that
he adored. Race horses; show dogs and an imperial, castle like house in Fort
Lauderdale. The horses were an expensive hobby and for the most part could
see all of the other when they raced from their usual position in the rear.
On the other hand, his dogs were world-beaters while one; Ch. Braeburnâ€™s Close
Encounter won the best of the show award at Madison Square Garden making the
dog, the worlds best that year.
Sadly for his family and partners, Novick died at
the age of 44 from a heart attack just three months before ESM was officially
closed. Close encounter, the dog won the best of the show six months
after Novick had died. It was probably Novickâ€™s death more than anything that
caused the ultimate unraveling of ESM, because he was the glue that was holding
things together and when the glue was no longer available the unraveling occurred
Eventually, everything went down the tube at once
and because of Gomezâ€™s fancy accounting work on behalf of Alexander Grant, the
accounting company became the logical choice by creditors to repay everyone.
There were four-hundred-seventy of Alexander Grant at the time and each one
of which was jointly & severely liable to both each other and the creditors.
On the other hand, Grant had the foresight to have purchased a $500,000 deductible
policy to the sum of $190 million. Caught with their hands in the till, there
was never much question about how much Grant would pay, and ultimately by a
series of shrewd negotiating maneuvers, the partners were let off the hook for
their $1000 per man, deductible amount.
What had occurred was theft and greed in the highest
sense. The results of this efforts by ESM management to pillage their company
and others is listed below:
“The ESM merry-go-round screeched to a halt and devastation
followed when the firm declared bankruptcy in March 1985. Its collapse caused
pain and hardship to clients throughout the U.S., from Washington and Nevada
to Texas and Pennsylvania. Ohio was hit hardest; ESM lasses bankrupted the
stateâ€™s second largest S & L, Home State Savings of Cincinnati. A frightening
panic followed, and a week later Governor Celeste was forced to shut down 68
other S & Ls. Half a million depositors endured agonizing weeks worrying
if theyâ€™d ever see $4 billion of their money again.”
“True tragedy struck when two of the ESM players
committed suicide. Another died at his desk. Marvin Warner, Home Stateâ€™s owner
who was once worth $100 million and who had served as Ambassador to Switzerland,
was forced in bankruptcy. He and an associate recently had criminal convictions
overturned on technical legal issues, but further appeals and retrial loom for
the in the months and years ahead.”
“In the end, a large measure of justice was brought
to the victims. The system creaked and groaned, it moved in fits and starts;
but the thieves are in jail and the victims with the help of a very able lawyer
of Ohioâ€™s elected officials, have recovered almost all their money.” ()
George Mead and Nick Wallace, two principals of
ESM had seen enough and hired legal counsel for protection. It was soon evident
what had occurred at ESM and that $300 million was missing. The ESM principals
were advised to cooperate with the regulators and close down the firm because
when the nature of what had occurred got out, there well could have been a major
panic in the financial markets in this country. The biggest creditor was a New
York Stock Exchange listed company (a savings and loan) and there were still
billions of dollars in open positions that had to be prudently unraveled.
ESM had set a number of standards when they were
closed up for good. It was probably the largest financial crime that had ever
been committed up to that date. The accountants were so involved in the deception
that the audits done by them had to be restated for 1978, 1979, 1980, 1981,
1982, 1983, and 1984. This was probably the landmark in restatements as well.
In several cases, the entire fraud had been hung out to dry and yet no one had
ever thought of blowing the whistle. The most interesting aspect of this affair
was the fact that all reports to the IRS were essentially correct and through
the use of subsidiaries and the like, the numbers were clearly available as
to what was going on should there have been a desire to look. Obviously, Grant
was also doing the IRS returns as well as the companyâ€™s financial statements
were showed dramatically varying sets of numbers. In spite of the fact that
the information was available in Alexander Grantsâ€™ records, no senior person
thought to bother to look. Lastly, the entire sordid affair was given chapter
and verse to a divorce court when the issue of increased support had been raised;
the court sealed the verdict and the information because it had determined that
it would have been adverse to ESM. I guess we should ask what about the creditors
and the depositors?
Congress opened an entire subcommittee hearing on the matter
and the words of congressman Ron Wyden probably expressed the feelings of the
committee as a whole after they had gotten a dose of what occurred:
“The auditors tell us that they had no choice
but to rely on second-party confirmations—in this case, the word of Mr. Gomez—that
the collateral for these large loans did exist and did adequately secure their
clientsâ€™ interest. What disturbs me is that the system literally breeds this
kind of buck-passing. If the auditors went as far as the system and the rules
of their profession require in confirming the collateral, any reasonable person
would conclude that once again, the auditing system has failed…it is my view
that the only watchdogs throughout this sorry spectacle were either asleep,
forgot how to bark, or were taking handouts from the burglars.” ()
Ewton got a 24-year sentence for his efforts, Novick died of
a heart attack, Arky and one of the accountants who was convicted and sentenced
to jail both committed suicide. Grant was sanctioned by the Florida Board of
Accountancy, received a 60-day suspension from accepting new clients and was
absorbed by Grant Thornton never to be seen again.