BULL STREET - The art of the Con

ESM 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. ([133]) They employed Alan Novick to handle the firm’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 client’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 America’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 can’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 portfolio’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 don’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 principal’s. Gomez became a super-patsy for ESM very early in his assignment when the firm’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 Novick’ 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 Gomez’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 plastic again.”[134]

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” ([135])

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 client’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, Summers’ 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.”

“They 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 didn’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 ([136]) 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. Braeburn’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.[137] Close encounter, the dog won the best of the show six months after Novick had died. It was probably Novick’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 rather quickly.

Eventually, everything went down the tube at once and because of Gomez’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 state’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 they’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 State’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 Ohio’s elected officials, have recovered almost all their money.” ([138])

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 company’s financial statements were showed dramatically varying sets of numbers. In spite of the fact that the information was available in Alexander Grants’ 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 clients’ 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.” ([139])

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.

 

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