BULL STREET - The art of the Con

ZZZZ Best Plan For Cleaning Up In The World

Barry J. Minkow’s mother was a telephone solicitor for a cleaning company and that was how, at twelve years old he started learning about the restoration business. While not yet in his twenties, he sensed an opportunity to become wealthy from that business and became what is known as a rug sucker, someone that goes into, usually a home, makes a lowball estimate on a cleaning job, takes the rug upon striking a deal and when the price is jacked up later the customer either has to pay or is out one rug. The lad was already involved in all the niceties of life, check kiting, forgery and theft from insurance companies by making phony claims. This was a dangerous way for a kid to be making a living and Barry believed that there had to be a better way.

Barry gravitated to a derivative of that business. ([148]) By specializing in rug cleaning and insurance restoration (after fire or flooding had substantially damaged substantial portions of a building), he would be satisfying a lucrative niche. He needed credibility, someone of standing that would vouch for his business acumen and success. He found the sucker at his Los Angeles health club; his name was Tom Padgett and insurance claims adjuster who Minkow agreed to put on his payroll at $100 per week if he would confirm that ZZZZ Best was legit. While still in high school, his vision flourished. Minkow already had hundreds of employees within a company with over $5 million in gross revenues. Minkow had named the company ZZZZ Best and he was the youngest chief executive officer of a major company in the United States, and soon had a luxurious home in a Los Angeles Suburb and naturally, a shinny new red Ferrari.

Already on a roll and with the motto, “The sky is the limit”, Minkow became a much in demand regular on the nation’s talk show where he chided people to try and accomplish more. Little did they know how he had achieved his success.  Minkow’s next move was to take the company public but he had to establish credibility in stages. Although he did not think of it at the time, Minkow was making him subject to the security laws of the United States Government and things became a little tricky. But he needed an independent auditor to do his books and hired an accountant by the name of George Greenspan; when Greenspan naively called Padget to confirm that ZZZZ Best indeed had restoration contracts the circle had closed. Now he had a set of books that would stand up to a degree of scrutiny, but he needed somebody more prestigious than George Greenspan if he was really going to make a major score. With that in mind hired the prestigious New York Law Firm of Hughes, Hubbard and Reed and dumped Greenspan for the Big Eight accounting firm of Ernst and Whiney to give his young company the additional cache that he believed, white shoe, top drawer professionals on your payroll has a tendency to do.

ZZZZ Best’s offering memorandum indicated that in 1986, he already had almost $25 million in "insurance restoration" business on the books scheduled for early completion, from thirteen projections ranging from hundreds of thousands of dollars to over $7 million. Minkow offered the public $13 million worth of stock, which was sold as a unit containing three shares of common stock and a warrant to buy and additional share. The offering went public at $12 bucks, which valued each of the shares at a tad less than four dollars if you assume the warrant had some nominal value.

By 1987, the company’s earnings from these projects were estimated by internal ZZZZ Best auditors at $40 million, and Minkow was being favorably compared to Watson (IBM) and Land (Polaroid) in terms of business acumen.  His company became known as the General Motors of the cleaning business. As his success seemed to continue unabated, Wall Street embraced Minkow. The price of ZZZZ Best stock soared, increasing Minkow’s net worth at one point to over $100 million.

The problem with this story is that although Minkow was only real in his own small way, his company was almost a total fabrication.  The preliminary prospectus that he issued made the claim that: "The company began its significant insurance restoration business in April 1985 and since then has performed restoration service for buildings ranging in size from 100,000 to 750,000 square feet. Restoration contracts, all of which are performed on a fixed price basis, have ranged from approximately $150,000 to $7,000,000. The Company has restored buildings located throughout California and in Arizona, with the majority being in Southern California. As of September 30, 1986, there were 13 insurance restoration projects in progress, under contracts aggregating $24,362,000 (including seven aggregating $15,068,000 through joint ventures), all of which are scheduled for completion within six months." 

This totally illusionary restoration business played great on Wall Street and investors loved the concept.  There was not one iota of truth or a scintilla of evidence that anything the Minkow had said was true, but people wanted to believe. He had been able to convince both his lawyers and his accountants that a thriving business existed when in reality, it was totally a figment of Minkow’s fertile imagination. Statements of Wall Street brokerage houses like Ladenburg, Thalmann & Company were repeated everywhere; "ZZZZ Best meets the criteria of a company that has the same potentially explosive sales and earning characteristics and market opportunities that permitted McDonald's and 7-11 to reach the success each has achieved--sales of over $1 billion in a relatively short time from inception." He was given their highest honor by the prestigious association of Collegiate Entrepreneurs calling him one of the leading young business founders in the United States.

His fraud cost the public over $70 million and Minkow was sentenced to 25 years in jail and fined $26 million. When accountants (at the time a big eight firm) Ernst & Whinney required on-site investigations of the restorations in progress, Minkow arranged for Ernst and Whinney to inspect buildings that had nothing to with ZZZZ Best. He would bribe workers on the premises to go along with his fabrications or in the alternative, he would rent empty buildings and create literally a “Hollywood set” of restoration work in process.

On one occasion, he was told by the attorney's and accountants that they would be examining a work in process at a restoration site in Sacramento.  Not having any restoration sites available because they didn't exist, it was no big deal for him to rent an old building for the day and bring in a number of people to act as though they were doing some work.  He dressed them up in cute little ZZZZ Best uniforms and the scam went so well that a totally nave Larry Gray, a senior auditor with Ernst & Whinney gave the following report:

"We were informed that the damage occurred from the water storage on the roof of the building. The storage was for the sprinkler systems, but the water somehow was released in total, causing construction damage to floors 18 and 17, primarily in bathrooms which were directly under the water holding tower; then the water spread out and flooded floors 16 down through about 5 or 6, where it started to spread out even further and be held in pools."

"We toured floor 17 briefly (is currently occupied by a law firm), then visited floor 12 (which had a considerable amount of unoccupied space) and floor 7. Morze pointed out to us the carpet, painting and clean up work, which had been ZZZZ Best's responsibility. We noted some work not done in some other areas (an in unoccupied tenant space). But per Mark, this was not ZZZZ Best's responsibility; rather it was work being undertaken by tenants for their own purposes"

"ZZZZ Best's work is substantially complete and has passed final inspection."

Compare the pathetic report by Gray who had examined a building that had literally nothing to do with ZZZZ Best.  Then looked at work that ZZZZ Best had nothing to do with and wrote a glowing report on a building that was hired for the day; with the report given in Congress by Mike Brambles a detective with the organized-crime intelligence division of Los Angeles Police Department on the same building.  He is being interrogated by Representative Ron Wyden who is a member of a subcommittee investigating the affair:

Wyden:                   Did the building ever have any damage, or could they found that out?

Brambles:              The building did not sustain any fire or waste damage. We ascertained that by checking with the building department of Sacramento in determining that in the previous two to three years there had been a very minor amount of construction work, that being only cosmetic in appearance and not involving fire and water restoration work.

Wyden:                   How long did it take your people to find out about the condition of the building?

Brambels:              Approximately ten minutes at the building department and then roughly one or two hours at the restoration site.

In some instances, Minkow and his associates even gave the addresses of empty lots to Ernst and Whinney, believing that based on recent history they would not show up.  Luckily for Minkow they didn’t.

Outsiders were soon tipping Ernst & Whinney and local newspapers that ZZZZ Best was a fraud.  However, with the first commandment of accounting being "hear no evil, see no evil, speak no evil," they did nothing about it.  Even worse, one Norman Rothberg told Ernst and Whinney in no uncertain terms that the ZZZZ Best Sacramento restoration site was a total fraud.  Shortly thereafter, Rothberg had been properly paid off by Minkow to the tune of $25,000, he recanted his story.  This incident did not cause Ernst & Whinney to blink an eye.

Ultimately, the evidence could no long be denied and even the accountants finally saw a massive fraud looming.  Ernst realized that it had been taken and resigned. Congress put Ernst and Whinney's Gray on the grill and Representative Lent had an interesting experience in interviewing him.

Lent:                       It came to your attention that Rothberg was talking about a certain company, namely ZZZZ Best.

                                Gray       Yes, sir. Yes, sir.

Lent:                       He was talking about fraud at ZZZZ Best and he mentioned that the Sacramento job was a phony job?

                                Gray:      That is correct. We heard that on May 19.

                                Lent:       You had been out there and you had walked that job, had you not?

                                Gray:      That is correct, sir.

Lent:                       So you must have wondered whether you had been taken for a ride, whether you had been deceived, and it is logical to assume that you might have gone back there and looked at it over again, or made some further inquiry of the building department, the property owner, the contract, or other contractors, et cetera? You did none of those things?

                                Gray:      No, sir.

In easily the most bizarre event in the annals of accounting, when Whinney resigned, Minkow replaced them with prestigious Price Waterhouse, which, contrary to every accounting tenet, made no concerted effort to determine the reasons for their predecessor’s resignation.  ZZZZ Best indicated that the auditors found no fault with the company's securities filings.  Ernst and Whinney added insult to injury by failing to disclose their reasons for resigning.

Worse still, once they were hired,  Ernst &  Whinney signed non-disclosure agreements that would have prevented any successor accounting firm or anybody else, for that matter, from finding out the location of ZZZ Best projects that they had visited.  Moreover, they gave written promises not to "… make any follow-up visits to the Project…."

"We will not disclose the location of, or any other information with respect to, the Project or the Warehouse, to any third parties or to any other members or employees of our firm; We will not make any follow-up telephone calls to any contractors insurance companies, the owner of the Project or of the Warehouse, or other individuals involved in the restoration projection;

We will not make any follow-up visits to the Project or the Warehouse, unless specifically authorized by the Company and Interstate Appraisal Services ("Interstate") [company set up to appraise ZZZZ Best renovation projects]."

The confidentiality letter raised more questions that it answered. One would wonder how you could check out whether something is real or not if you could only visit the site with the permission of your client.  An independent accountant cannot do his job and keep the public faith at the same time. If no follow up calls can be made to contractors, insurance companies, the owner of the Project or the Warehouse unless authorized by ZZZZ Best, the practice of accounting is laughable.

Another dialog between Congressman Wyden and Mr. Gray of Ernst and Whinney, which should have so embarrassed the accounting firm that they should have closed their doors on the spot:

`Wyden: "We go back to these confidentiality letters. They were signed by you personally, Mr. Gray, and they were signed also on behalf of Ernst and Whinney regarding the visits to phony insurance restoration jobs, one in Sacramento and San Diego. You mention personally in these letters on behalf of the firm that you won't disclose the location of the job sites to any third parties including other members and employees of the firm. You go on to proposals that you won't make any follow-up phone calls to any contractors, insurance companies, building owners, or other individuals involved in restoration projects. "

 

"I guess what raised my curiosity about these confidentiality letters is that I wonder how, after you signed them, you could then go out and independently verify material information given to you by ZZZZ Best management".

Gray:                      "The signing of the letters does nothing to restrict what I wanted to perform. We--in fact it was done at the client's request. We get requests from our clients many times to confirm our confidentiality relationship. As I stated earlier, we have the overriding responsibility to keep our clients' information confidential. So them asking me to do this, my purpose was to go on the site and see the work done. It did not restrict me being able to perform that and I did go on site to see the work done, and Congressman, if I would have had any questions that came up in the course of that review, I would have pursued those questions and gotten answers to satisfy myself, or I would have quit".

It is most interesting to listen to this total bilge coming out of Gray's mouth. We are not talking about trade secrets or a list of confidential customers, we are talking about imaginary insurance restoration projects that in their magical state have been for the most part completed.  What were the odds of another restoration job occurring on the exact spot of the previous one?  In addition, in the one out a million chance that the place flooded again, do you think for one minute that ZZZZ Best would stand a chance of getting the work after screwing things up the first time?  At that point, the odds would stand directly at zero.  Gray must have held a very low opinion of the intelligence of the Congressional investigators.

Wyden brought in Brambles once again to refute Gray's fabrications.

Wyden:                   "I just want to pin down that in San Diego, as at Sacramento, we had a situation where the building really didn't have any damage, and it wouldn't have been hard, as you said your own people could do, to determine that, is that correct?"

Brambles:              "Yes sir, what we did was, we went again to the building department of San Diego and checked their construction permits on file. What our investigation determined was basically that the application for cosmetic construction had been applied for and granted by the city of San Diego. Their permit was paid for, but it was never inspected by the building inspectors, it was never finalized. That took us approximately ten minutes to do that. We also checked to determine whether or not the building had received damage in the area of fire and water, and that turned up negative results as well."

Wyden:                   "…what you have told us is that essentially in just a few minutes your won people could determine the job was a fake. But somehow the auditors didn't discover it, and it seems amazing…" ([149])

In Dallas, ZZZZ Best did an even better job of confusing the auditors. They told the accountants they were getting a lot of business in Texas and needed a warehouse in Dallas.  When ZZZZ Best advised them that the warehouse was open, the auditors expressed an earnest desire to check it out.  In typical fashion, the company rented an empty building for the day and then shipped a bunch of recently designed ZZZZ Best uniforms and other items with which to stock the warehouse.  A telephone switchboard was installed, and when the people from the accounting firm were brought in to visit, everyone tried to look busy. Vehicles were in motion, products were being moved, trucks arrived and departed and the switchboard lit up like a Christmas Tree; not surprisingly with inquires from companies in the area wanting to use the services of ZZZZ Best for their insurance restoration work.  The scene had all of the earmarks of Class B Hollywood movie. Embarrassingly, Larry Gray was once again the fall guy for this cheap stunt and as usual, he fell for it hook, line and sinker. He even reported back to Ernst and Whinney the warehouse would have to be expanded due to the increased business.

Although it was hardly possible, Gray had pulled the wool over his own eyes even further when ZZZZ Best gave him the unconscionable story that he could have the address where work was currently being conducted on a restoration, but they indicated that he couldn't visit it because it was a hardhat area.  You would think that these guys were working with atomic bombs, not with paint, brushes and brooms, In reality, the address was that of an empty lot that ZZZZ Best had once again rented for the day.  Gray, who had screwed up every other portion of his due diligence campaign, once again fell for the ZZZZ Best "Red Herring".

Gray was so incompetent in his investigation of ZZZZ Best  that he should have been arrested for criminal stupidity. Not only did he set the all time record for negligence but, in addition, everything that occurred was theoretically a red flag that should have caused him realize that additional checking of the client should be in order.

I mean, a hardhat area in the rug cleaning business.  We believe that Gray deserves the "Millennium Incompetence Award". This, too, is a great honor, as it is only given once every hundred years. There have been centuries where there has not been anything done that was stupid enough to qualify for the prize and the committee chose not to nominate anyone. Gray's incompetence was not even open to question and we are proud of the that he was the first candidate since Pontius Pilot to win a unanimous election.

This puts Gray in the same league as previous winners. You are all aware of their names; they are legion, but for posterity's sake we will remind you of some of the recent winners. The most recent was the U.S. Senator who, in the later part of the 19th century, wanted to close the patent office because in his opinion  it had become a white elephant due to the fact that everything that had ever or would  ever be invented had already been patented.  He simply felt that there was nothing left to invent.  Marie Antoinette won the award in the previous century for her famous slogan, "let them eat cake". This was done when a starving population was begging for food because they had not had a square meal in months.  This award had been given because it shows how close Marie was to her subjects and what a caring person she really was.  The previous award was a one-time situation and uniquely, we gave a global award for those that wanted to burn Copernicus at the stake for his concentric theory of the universe.  Although Gray has never achieved the notoriety that his predecessors received, we feel certain that time will reward Gray with fame as word of his complete accounting incompetence spreads.

 

ZZZZ Best did not go quietly. Many Congressional investigations were launched into  the question of how this fairytale could have been constructed by an a literally prepubescent, inexperienced teenager. Moreover, the even more burning issue was how this same teenager, as were have seen above, could foil the due diligence process of the regulators, the accountants, the lawyers and the stock brokerage community?  The verdict seemed to be that without the incomprehensible ineptness of the accounting firm (Ernst and Whinney), the fraud couldn’t have gotten off the ground and that Ernst & Whinney had failed in their role of independent outside accountant and their successor, Price Waterhouse compounded the worst job of accounting since the dawn of time. 

John Dingell, who headed a House committee charged with looking into this type of fraud, literally couldn't believe his ears when the people from Ernst and Whinney started to testify. He already knew that someone had blown the whistle on ZZZZ Best by informing the accountants that the company was riddled with fraud. The newspapers had taken up the cudgel and the company was springing leaks all over the place. Dingell was trying to get a handle on whether the outside auditor, Ernst & Whinney, was representing the interests of the company or those of the public. He was interviewing Larry Gray who we have seen in action previously and Leroy Gardner, another principal of Ernst & Whinney, and seemed to get a lot more than he bargained for.  You can see how the scenario unfolds;

Dingell:                 What happened to the stock during this period between June 2 and the date of bankruptcy on July 11? Did it go up or down? 

Gardner:               I didn't follow the stock.

Gray:                      It declined with the adverse publicity that was coming out.

Dingell:                 As a matter of act, it lost about fifty percent of its value?

Gray:                      That may be the figure. I cannot recite the figures.

Dingell:                 The price per share on June 2, when you resigned, was around six or seven dollars. When the bankruptcy took place, which our colleague indicates was July 11, the stock fell to less than one dollar, something on the order of fifty to seventy-five cents; is that right? 

Gray:                      I assume.

Dingell:                 I am wondering, it there some responsibility on the part of Ernst & Whinney to shareholders and other investors in this firm, or do you just have a peculiar special relationship with the firm?

Gardner:               No, no. Our responsibility is to the public, to the investors.

Dingell:                 To the public and to the investors. How did you exercise that here? You initiated no contact with the SEC until July 16.

Gardner:               No, no.

Dingell:                 Your contacts with the SEC on the seventeenth and nineteenth were initiated by the SEC. You did not initiate that contact…

Gardner:               I am sorry.

Dingell:                 The SEC initiated the contact withy you on the seventeenth to the nineteenth. You were sitting tranquilly by, informing your former client, during that period of time?

Gardner:               That is not correct, sir.

Dingell:                 Your first communication to the SEC was on July 18?

Gardner:               After we talked with the SEC in early July, there was no point ---

Dingell:                 They initiated that discussion; you did not?

Gardiner:              That is correct. We knew at that point what they knew.

Dingell:                 Happily they called you up. But your first communication to the SEC was on the sixteenth. If the SEC hadn't called you on the seventeenth or nineteenth, would you have called the SEC?

Gardner:               Well, the fact is they did call us and they already knew the allegation.

Dingell:                 I know they called you. We are in agreement on that. That point is not in controversy. If they, however, had not called you on the seventeenth or nineteenth, would you have called them?

Gardner:               I can 't speculate about that.

As we can see from the above, one way that independent auditors can screw up is by not specifically identifying all of the assets that are referred to in the company’s financial data, thus is if the asset supplying the income does not exist, the income cannot exist either. Failing to consider all of the diverse sources of revenue and adapting accounting procedures to pasteurize the data so that it remains in balance becomes a product of consistent practice. However, unreasonably changing the form of the data also distorts the ultimate product by putting it into a form that is not realistically consistent with the general business of the account being audited. This lack of consistent product tends to distorts the facts.

What was particularly grating in this case was the total indifference of the accounting firm to the public interest.

Once again, Congressman Dingell gets the last word with the accountants and our kudos as well:

"…we keep seeing this tremendous number of cases where supposedly men of goodwill are diligently watching and doing their job, but the public is being skinned, corporations are going under, rascals are prospering, honest men are suffering and the situation seems to be not improved…We have this wonderful relationship that seems to exist between the accountants and the corporations."

At the end articles started appearing in local papers questioning the company’s veracity. In particular, the Los Angeles Times started running a series of stories inspired by a woman that had been ripped off by Minkow at an early stage in his career. She had been the victim of a markup on her credit card by Barry and from that date on she kept track of everyone that she could find that had suffered a similar fate at his hands.

Her actions created a collapse in the house of cards. Within a short time, ZZZZ Best was hit with shareholders derivative actions, which named the accountants, the lawyers, the brokers and the company. Everyone coughed up a chunk of money to make a non-public settlement, which totaled approximately $35 million.

The company was a sham and an interesting observation showed that while the company had a market capitalization of $220 million in July of 1987, an auction of its assets brought only $62,000.[150] As for Minkow, he was convicted on 57 counts of securities fraud and received a twenty-five year prison sentence for his trouble. While in prison, Minkow through a correspondence course received a bachelor’s and master’s degree in religion from the university founded by Jerry Farwell. He was released for good behavior and soon married a young lady that he met through an associate of Charles Keating who was doing time for his part in the Lincoln Savings debacle.

Ultimately Minkow became the senior pastor in a non-denominational church San Diego. Barry once again has climbed aboard the lecture circuit and is now telling FBI agents and CPAs how to ferret out financial fraud. In his lectures he makes an interesting point. “The average restoration job is $1,000 with a profit margin of 8 or 9 percent. “We were reporting an average job of $3 million with margins of 30 to 40 percent…and we got three clean opinions.” ([151])

 

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