Editor’s note: This article originally appeared in the August 1973 edition of Fortune.
The last session of the board of directors of Equity Funding Corp. of America will surely rank as one of the more memorable business meetings of 1973. The board had nine members, and all were on hand for the meeting, which took place in Los Angeles on the afternoon of April 1—a Sunday. It would have been obvious even to a casual observer that something special was up when Rodney Loeb, an executive vice president of the company and its general counsel, called the meeting to order.
For one thing, seven lawyers were present in addition to the directors. Three of the lawyers, including Loeb, were from the company’s own legal staff. Two others were partners in the Washington law firm of Freedman, Levy, Kroll & Simonds, which had represented Equity Funding for more than ten years in matters involving the Securities and Exchange Commission. Finally, there were two men present who had not previously been involved in the company’s affairs. They were principals in Buchalter, Nemer, Fields & Savitch, a Los Angeles firm with special expertise in bankruptcy.
The site of the meeting offered further evidence that something unusual was going on. Equity Funding’s elaborately appointed boardroom on the twenty-eighth floor of 1900 Avenue of the Stars, in Century City, was not the site. Instead, the meeting was held in a rather nondescript conference room in the Buchalter, Nemer offices, in the same building but eighteen floors lower down. As Loeb explained to the directors, there was a compelling reason not to meet in their own boardroom. Several days earlier, a cleaning woman had discovered a tape recorder in the private bathroom adjoining the office of Stanley Goldblum, chairman, president, and chief executive of Equity Funding. Plugged into the tape recorder was a cord that disappeared into the ceiling. It was not quite clear where the cord led to, but the boardroom was adjacent to Goldblum’s office. In the circumstances, a change of venue seemed prudent. Goldblum himself listened impassively to this explanation and made no comment.
Some “bizarre” rumors
The call for the meeting, which had gone out the previous Thursday, was triggered by some stunning intelligence Loeb received that day. He was, naturally, baffled by some rumors that had sent the company’s stock into a steep decline and had led the New York Stock Exchange on Tuesday to halt trading in Equity Funding shares. The rumors suggested that one of the company’s life-insurance subsidiaries had phony policies on its books. Goldblum and Fred Levin, the No. 2 man in the company, had given repeated assurances that they knew of no basis for the rumors. Levin had even described them as “bizarre.” The Securities and Exchange Commission had asked for detailed affidavits in support of these assurances, and so far as Loeb knew, Goldblum was planning to file an affidavit or testify personally on the following day.
But at noon on Thursday the assurances collapsed. Goldblum’s personal lawyer walked into Loeb’s office and announced that his client would not make the affidavit. Furthermore, said the lawyer, he would advise Goldblum to take the Fifth Amendment if his client were subpoenaed. Loeb, a Harvard Law School graduate who had once served a three-year hitch in Washington with the SEC, was thunderstruck. As he puts it, “The next sound you heard was my jaw hitting the floor.”
Canceling out in Brussels
The man who traveled farthest to get to the board meeting was Robert Bowie, sixty-four, a distinguished professor of international affairs at Harvard. He had been a director of Equity Funding since 1970. When Loeb reached Bowie Thursday afternoon, he was in Brussels, where he had gone to deliver a speech at the Royal Institute of International Relations. The next day he canceled the speech and flew to Los Angeles.
Bowie was one of four outside directors. Two of the remaining three came from the East Coast. Nelson Loud, fifty-nine, had been a director since 1964, when New York Securities Co., an investment-banking firm he had cofounded, managed the first public offering of Equity Funding’s stock; later Loud left New York Securities and formed his own financial-consulting firm. He was a director of several other companies as well as Equity Funding, and he was a trustee of New York’s Union Dime Savings Bank, which several months earlier had suffered a $1.5-million embezzlement.
A third outside director, Judson Sayre, flew in from Miami, where he has lived since his retirement. Now seventy-four, Sayre made his indelible mark in the business world at Bendix, when he pioneered and brought to market the first automatic home washing machine; later he was vice president of Borg-Warner Corp. He had joined the board in May, 1971, as had Gale Livingston, now fifty-seven, the other outside director. Livingston is president of three divisions of Litton Industries and lives in Century City. The inside directors were Goldblum, Levin, Samuel Lowell, the company’s chief financial officer, and two executive vice presidents, Herbert Glaser and Yura Arkus-Duntov.
The physical arrangements for the board meeting were less than ideal. Because it was a Sunday, the air conditioning in the building had been turned off. The conference room quickly filled with smoke, and eventually with the aroma of half-eaten pastrami sandwiches brought in from a nearby delicatessen.
When the meeting began, Stanley Goldblum was seated at the head of the table. At forty-six, he is a physically imposing man of about six feet four who stays in shape by lifting weights. Goldblum immediately questioned the presence of the outside lawyers, suggested that the meeting had been called improperly, and generally tried to take charge. For a while, at least, Gale Livingston aligned himself with Goldblum, whom he had known since 1962 and had always esteemed. Livingston was himself impatient with the proceedings and skeptical that there was any substance to all those rumors. Thinking that he could put an end to the meeting, he turned to Goldblum and asked, “Stanley, I want to know one thing. Did you put your fingers in the till ? If you answer no, I’ll leave right now.” Goldblum replied that he would not answer on the advice of counsel. At that point, Livingston says, he felt “as though the earth would open and swallow me.”
A question about vacations
The exchange immediately transformed the spirit of the proceedings. One of the lawyers present recalls that the conference room, which had already begun to smell like a locker room, now began to sound like one. Everyone began speaking at once, and some epithets were hurled in Goldblum’s direction.
The coolest head in the crowd belonged to Professor Bowie, who increasingly dominated the proceedings. Firmly, and with a presence that was more than a match for Goldblum’s, he told the chairman that if he and Levin and Lowell would not agree then and there to testify before the SEC, they would have to resign from the company. (The SEC had, in fact, already issued an ultimatum that unless the three resigned immediately, it would force the company into receivership on Monday.) Goldblum protested that the company could not be run without them, and that only they could clear up the matters under investigation. But Bowie and the other directors stood firm. Goldblum then asked what the directors had in mind in the way of vacation and severance pay. Bowie summoned the patience to say these were not matters for negotiation.
Finally, Goldblum offered to resign. Levin and Lowell agreed that they had to go too. Levin, however, coolly offered his services to help straighten things out and said that, in fact, he had already begun arranging discussions with two sizable companies that could give Equity Funding a lot of help. There was no direct response to this startling proposition.
After the three men had left the room, the meeting continued for four more hours, until 10:30 P.M. Some of this rump session was given over to a report by three accountants from Seidman & Seidman, the company’s auditors. They had been asked the previous week to investigate the rumors surrounding the phony policies, and their findings were hardly reassuring. Acting on tips received Thursday night from employees of the suspect subsidiary, Equity Funding Life Insurance Co., they had made a telephone survey of some policyholders listed in certain suspicious blocks of insurance. Of thirty-five “policyholders” they were able to reach by telephone, only six confirmed that they had the policies they were supposed to have.
In the next few days, the directors, along with a fair number of investors and creditors, got some ideas about the magnitude of the catastrophe they were involved in. On Thursday, April 5, the company filed for reorganization under Chapter X of the Federal Bankruptcy Act. Measured by assets, it is the second-largest Chapter X proceeding in history; according to the SEC, only the Associated Gas & Electric reorganization in the 1940’s is known to be larger. Investors in Equity Funding stock, some of whom had paid over $80 a share (the high was reached in 1969), and some of whom had been rushing to buy at recent bargain prices (around $15 just before trading was suspended), now discovered that it was worthless.
Some bankers with a problem
When the petition was filed, Equity Funding and its subsidiaries had $217 million in long-term debt outstanding. Some $80 million of that is owed to the purchasers of debentures sold in public offerings in 1969, 1970, and 1971. The largest single creditor is First National City Bank, which was the leader of a four-bank group participating in a $75-million revolving-credit agreement made in June of last year. Equity Funding had borrowed $50.5 million under the agreement, $23.6 million of it from First National City. Two of the other participating banks, Wells Fargo and Franklin National, had lent $10.1 million each, and the National Bank of North America (a subsidiary of C.I.T. Financial Corp.) had lent $6.7 million. In addition, both First National City and Wells Fargo had lent the company $5 million apiece in separate transactions.
It is not yet clear when and to what extent all the debts can be paid. Robert Loeffler, a former executive of Investors Diversified Services who became Equity Funding’s trustee in April, says he is “reasonably confident” that the company’s assets are worth as much as its liabilities—at least, they are if the liabilities are taken to exclude the stockholders’ equity and the contingent claims represented by some fifty lawsuits seeking millions in damages from the company. But it may be years before a plan for the reorganization of the company is finally approved.
Meanwhile, those investors and creditors will doubtless be fascinated to learn that Equity Funding came close to publishing a 1972 annual report extensively detailing its health and solidity. Proofs of that report show year-end assets at $737 million, stockholders’ equity at $143 million, and profits for the year at $22.6 million. About $110 million of those assets are known to have been made up out of thin air, but the exact figure will not be established until next winter when Touche Ross & Co.—the accounting firm called in by the trustee—has finished its audit. Of the missing assets, $24.6 million are represented by fictional bonds Equity Funding Life was supposed to have. Some $8 million involved commercial paper allegedly, but not actually, owned by Equity Funding, and another $74 million was created by inventing bogus receivables and grossly inflating the value of loans to customers.
The phony assets are far greater than the approximately $75 million Equity Funding said it earned over its entire thirteen-year history. Some liabilities (e.g., deferred taxes and policy reserves) are also overstated, by an amount as yet unknown. But on balance it seems entirely possible that over the long run Equity Funding was a losing operation—a rather startling thought when one considers that for much of its life it was a darling of Wall Street and that its earnings in recent years were reported to have been growing at an annual average rate, compounded, of some 25 percent.
The company was established in 1960 and was organized to sell a new product. The product was a combination of mutual-fund shares and life insurance known as an “Equity Funding” program. The idea was that a customer who signed up for the program would buy some fund shares every year, then borrow against them to pay the annual premiums on a life-insurance policy. In recent years—there have been slight alterations in the provisions from time to time—the minimum annual premium allowed under the plan was $300, the minimum annual fund purchase $750. Customers could buy funds and insurance separately, but the salesmen tried to sell the package.
A program lasted for ten years; when that time was up, the customer sold enough shares to pay off the loans. The sales pitch pointed out that, if the funds performed well, the shares left over might be worth as much as the customer had invested over the years—in which case he would have received ten years of insurance coverage for nothing. Indeed, as the salesmen never failed to mention, there was even the possibility of the customer making a nice profit.
The team was effective
When Equity Funding went public in 1964, it was controlled by three men: Stanley Goldblum, president; Michael Riordan, executive vice president; and Eugene Cuthbertson, senior vice president. Cuthbertson left the company the following year, and it soon became clear that Riordan and Goldblum made an effective team. Riordan was an extrovert—genial, hard drinking, and fun loving. He was also shrewd and tough—a good “deal man” and a great promoter. He was plainly the force behind the company’s marketing organization—which by 1964 had some 500 salesmen.
Goldblum was altogether different: he stayed in the background, managed the organization, and never developed the personality traits associated with promoters. He was endlessly concerned with boosting the price of Equity Funding stock; yet security analysts found him arrogant and offensive. With them, as with most strangers, Goldblum had an irresistible penchant for putdowns. In addition, he had a straitlaced quality one doesn’t expect to find in freewheeling businessmen. Lawrence Williams, the vice president for compliance at Equity Funding, who had been an enforcement officer at the SEC, says resignedly, “I was completely taken in by Stanley Goldblum. He gave you the impression that if he caught somebody stealing, he wanted him out. He seemed so upright.” Others have referred to an “almost puritanical” streak in the man.
Yet it was clear that he also had an affinity for high living; there was nothing Spartan about the house in Beverly Hills where he lived with his wife and two children—and where a maroon Rolls-Royce and a Ferrari shared the garage. His large and elaborate corner office on the twenty-eighth floor of the company’s headquarters was an elaborate display of gaudiness. The gilt-edged leather surface of his desk seemed to serve no function except that of supporting a large baroque inkwell and other striking ornaments. He kept the desk bare of papers. Not even a telephone marred the setting; Goldblum had it stashed away in a drawer. His total compensation in 1972, including salary and a stock bonus, came to $304,000, and he got $36,000 for entertainment expenses besides.
Two ways to cheat
The Equity Funding fraud, it is now clear, had two distinct elements. The first involved phony loans to the participants in the company’s programs, and it may have begun soon after the 1964 public offering. This element in the fraud led to some overstating of assets and certainly contributed to the high multiple commanded by Equity Funding stock—which, in turn, made possible some important acquisitions in the late 1960’s.
The second element in the fraud was more self-destructive. It involved the sale of phony insurance policies to other companies, and it created a whole new range of problems that were almost certain to grow geometrically, until the entire fraud collapsed under its own weight. The evidence suggests that this second element came into play in 1970.
During 1964 and 1965, the company derived the bulk of its revenues from commissions. It had no mutual funds or insurance companies of its own at that point, but it charged customers for acting as their agent when they bought fund shares and/or policies. Most of the mutual funds sold in this period were those of the Boston-based Keystone organization; almost all of the insurance business went to the Pennsylvania Life Insurance Co., the Philadelphia subsidiary of a Santa Monica holding company.
Before the public offering, the company had financed all the customers’ premium loans by selling notes on the collateral (i.e., the funds) to various lenders. The loans to customers were assets, of course, and these equaled borrowings against the notes, which were liabilities.
The fraudulent bookkeeping may have begun as early as 1964, when Equity Funding first reported it was financing some program loans on its own. The fraud had almost certainly begun by 1966. In that year, according to a later prospectus, the company sold $226.3 million worth of life insurance, most of it in policies of Pennsylvania Life. Penn Life, on the other hand, stated in one of its prospectuses that Equity Funding had sold only $58.6 million of its insurance. (This discrepancy seems not to have been noticed by any auditors or regulatory officials until Barron’s reported it in April.)
U.S. mutual-fund sales had taken a nose dive in 1966. And yet Equity Funding reported a 47 percent rise in profits and an increase in program loans of about $6 million, or 58 percent. The company claimed to have financed over $4 million of the increase on its own. These allegedly self-financed loans probably never existed, but they constituted evidence that a certain amount of insurance had been sold. It appears that, in order to make the books internally consistent, the company also overstated commission revenues and profits.
The rising earnings kept up the price of the stock, of course, and also sustained the beliefs of many securities analysts in the underlying strength of the Equity Funding concept. In 1966 the company started its own mutual fund, Equity Growth Fund of America. This seemed a sensible move; Equity Funding had an organization that could sell the fund, and, in addition, it could now collect a fee for managing fund assets.
In 1967, buoyed by public support of their own stock, Riordan and Goldblum embarked on an aggressive acquisition program. The company bought Presidential Life Insurance Co. of America, a small Chicago company. One of Presidential’s officers, who came with the deal, was Fred Levin.
With the company’s stock still rising sharply a year later, Equity Funding bought a savings and loan association and also went into the oil and gas exploration business. Analysts scratched their heads over those moves, and some fears were expressed that they might dilute earnings. Overriding these objections, the company bought itself another mutual-fund management company that year and began negotiating two other deals, both of which were closed in early 1969. One put the company into the cattle-breeding business; the other involved the purchase (for $10 million in cash, notes, and stock) of the domestic assets of a sales organization and fund-management company that had been owned by the Swiss-based Investors Overseas Services. The SEC had earlier ordered I.O.S. to divest itself of the company, which was called Investors Planning Corp.
The disasters of 1969
In 1969 a lot went wrong at Equity Funding. In January, Mike Riordan was killed in his bed when a mudslide crashed through the roof of his home in Brentwood, a suburb of Los Angeles. Then the acquisition of Investors Planning turned out to be a disaster. Its 2,000-man sales force was almost as large as Equity Funding’s own (reportedly 2,500 at that time), but it was generally of low caliber, and the salesmen had to be retrained to sell Equity Funding’s products. And with Riordan gone, the company lacked the management it needed to handle this problem.
Meanwhile, expenses were soaring. The company had acquired twenty-nine additional branch offices in the Investors Planning deal, and this overhead was a burden in a year when mutual-fund sales were off badly. In addition, 1969 was the year the company moved into its posh and expensive offices on the Avenue of the Stars.
None of these problems showed up in Equity Funding’s financial reports—where earnings were up nearly 40 percent. It now seems fairly clear that the overstatement of earnings reported in 1969 was more ambitious than ever. For example, program loans financed by the company were alleged to have risen astoundingly, from $19.9 million to $29.5 million.
Within three months after Riordan’s death, Goldblum made Levin executive vice president in charge of insurance. Levin took over Riordan’s old job of representing the company on the outside, and steadily increased his sphere of operations. He negotiated the acquisitions of Bankers National Life Insurance Co. of Parsippany, New Jersey, and of Northern Life Insurance Co. of Seattle. And he brought in three young men who later assumed key jobs in the company.
One was Jim Smith, who was hired from Minneapolis National Life (he had earlier served for seven years in the actuarial department of Metropolitan Life). At thirty-four, Smith became a vice president of Equity Funding and chief administrator of its life-insurance subsidiaries.
Another important Levin find was Lloyd Edens, then twenty-five, who came to Equity Funding from the Los Angeles office of Ernst & Ernst. He became vice president for financial services, with responsibility for two rather sensitive areas: accounting in the life-insurance companies and handling commissions paid to the Equity Funding sales force.
The third man Levin brought in was Arthur Lewis, then twenty-six, who came to be regarded as one of the most brilliant and creative men in Equity Funding. He was the chief actuary. He also had control of a small I.B.M. System 3 computer, which was separate from the company’s main data-processing operations and was apparently used to design computer programs that would enable top management to stay abreast of the underlying realities as the frauds grew larger and more complex.
Youth was served well
Levin and his protégés were surely among the most remarkable young executives in American business. Levin himself, at thirty-five, was earning $80,000 in salary this year and receiving stock bonuses worth another $169,000, and $12,000 for entertainment. Smith was getting $118,000 in salary and stock bonuses. Edens and Lewis each had a total of $83,000; altogether, Equity Funding may well have set a record for compensation of executives under forty.
Levin was obviously capable of great charm. He once told a friend that his greatest asset was an ability to “mesmerize” people. But he also had a nasty streak that put some people off. On the day after Equity Funding acquired Bankers National in 1971, Levin fired fourteen executives of that company. In anticipating the event, he joked with his colleagues that he planned to stage a “the-lady-or-the-tiger” act at the headquarters in Parsippany. He would station Vice President Jim Smith in an office that was connected by an inner door to the office that Levin himself would be in. At first, the idea was, Levin would do the firing and Smith would give pep talks to the employees being retained. Knowing that the office grapevine would quickly spread word of this arrangement, Levin and Smith would then switch offices—thereby preparing an extremely unpleasant surprise for anyone who thought he was going in to see Smith for a pep talk. In the end, Levin didn’t actually go through with this plan. But when he returned to Los Angeles, he said he had, just because he thought it was such a great story.
Shortly after Levin’s promotion in 1969, Presidential entered into a large coinsurance agreement with Ranger National Life Insurance Co., a subsidiary of Anderson, Clayton & Co. Such agreements are fairly common in the insurance industry. They provide, typically, that the coinsurer (in this case Ranger) make a substantial payment for the policies and also assume responsibility for setting up reserves to cover them. In return, the original insurance company (Presidential) turns over to the coinsurer most of the premium payments coming in on the policies. Presidential already had coinsurance deals with other companies, including Pennsylvania Life.
A guarantee for Ranger
The new agreement provided that Ranger would take on all of Presidential’s business not coinsured elsewhere in the second half of 1969, and would also get certain other new business through 1973. Over the entire four-and-a-half-year period, Ranger would coinsure business represented by a maximum of $15 million in first-year premiums. At the end of 1972, Ranger held some $835 million of insurance in force that had been ceded from the Equity Funding subsidiary.
There was one peculiar aspect to the deal. Presidential, whose name was changed to Equity Funding Life Insurance Co. in 1970, guaranteed a “persistency rate” of 85 percent in the second year. That is, it guaranteed that policyholders representing 85 percent of the first-year premiums would also pay in the second year—or E.F.L.I.C. would make up the difference. This unusual provision served as a “kicker” that enticed the coinsurers to pay more than they normally would have for the business. Under most coinsurance agreements, the coinsurer pays around 100 to 120 percent of the first-year premium (which is a bit less than what it would have cost the coinsurer to write the business itself). But the persistency guarantee assured the coinsurer of getting back most of its cash outlay by the second year; in addition, the guarantee strongly implied that E.F.L.I.C. viewed the policyholders as loyal. For these reasons it was able to get 180 percent—and, in some recent agreements, 190 percent.
It did a lot for profits
In practice, this meant that E.F.L.I.C. would keep the first-year premium and receive an additional 80 percent (or 90 percent) in cash from Ranger. The arrangement naturally did a lot for E.F.L.I.C.’s profits. The costs charged against the coinsured business in the first year showed up as a little less than the amount of the first-year premium. Hence E.F.L.I.C. netted a little more than the coinsurance payment. In 1969, thanks to several such coinsurance arrangements, E.F.L.I.C. contributed significantly to Equity Funding’s profits. Altogether, it accounted for about 20 percent of the parent’s reported after-tax earnings.
Most, probably all, of the business coinsured in 1969 was real business. But in 1970, E.F.L.I.C. began inventing business. The reason for this fateful decision can only be guessed, but it probably began with the simple fact that real business wasn’t very good in 1970. Investors were shying away from mutual funds, which meant that E.F.L.I.C. had less insurance business, and, of course, less real business to sell to coinsurers. By inventing business, the subsidiary “solved” these problems. That year its contribution to Equity Funding’s profits was 43 percent of the total—again all accounted for by coinsurance. Without E.F.L.I.C.’s contribution, Equity Funding’s reported profits would have been off by 24 percent in 1970. As it was, profits were up by 9 percent.
Putting off the day of reckoning
Accountants digging into Equity Funding’s affairs in recent weeks have managed to find the relationship between the phony insurance, the phony program loans, and some of those missing bonds. Beginning in 1970, it appears, the parent would “lend” money to bogus program participants (creating assets for Equity Funding) and credit E.F.L.I.C. through an intercompany account with similar amounts of money in premium income. E.F.L.I.C. in turn paid out sales commissions to the various marketing subsidiaries of Equity Funding, and these payments were debited against the intercompany account. The premiums credited to E.F.L.I.C. exceeded the commissions it paid out, however, so the parent owed money to its life-insurance subsidiary at the end of the year. To clear this account, the parent transferred securities, rather than cash, to the life company. Those securities—in this case $24.6 million in bonds—are the ones that don’t exist.
It is hard to view the creation of the phony coinsurance business as anything but irrational and self-destructive. Coinsuring phony business was, of course, great for earnings in the first year. But it created enormous cash problems in later years. In the second and all succeeding years, E.F.L.I.C. would have to turn over to the coinsurer 90 percent of the annual renewal premiums that were presumably being received on the business. If the business was phony, there were, of course, no renewal premiums. To get enough cash to pay the coinsurers, E.F.L.I.C. invented more phony policies and had them coinsured. That postponed the day of reckoning, but it made the eventual problem greater.
The geometric growth of Equity Funding’s coinsurance problems may be suggested by a calculation performed for FORTUNE by an accountant experienced in insurance auditing. Using a set of assumptions drawn from general industry experience, and from the known details of the Ranger agreement, he estimated that if E.F.L.I.C. sold off policies whose premiums came to $1 million in year one, the company would have to concoct $250 million of phony insurance by year five. In the tenth year alone, it would have to concoct over $3.7 billion of phony insurance—i.e., it would have to sell off that much to be able to pay all the renewal premiums due on phony business written earlier. By the tenth year the company would be claiming over $7 billion of phony insurance in force. E.F.L.I.C. was claiming only $3 billion of insurance in force last year; about $2 billion of that was phony.
More and more phony policies were created at the company in 1971, and by 1972 virtually all the business reinsured—represented by over $7 million of first-year premiums—was phony. (By that time the company had negotiated two other significant coinsurance agreements, with Great Southern Life and Kentucky Central Life.) By now, furthermore, the fraud was becoming a drain on the company’s management resources as well as its financial health.
Efforts had, of course, been made to keep the phony business a secret, but there were probably at least two dozen lower-ranking employees involved in various aspects of the recordkeeping who eventually came to suspect that something major was amiss. The fraudulent business was centered in insurance identified on the computer as coming from Department 99. It was obvious that the department’s business was growing rapidly, and the company attempted to explain all this activity by saying that Department 99 was conducting “mass-marketing operations” (e.g., mail-order sales). But no bills were ever mailed on this business, a fact that some data-processing employees knew and wondered about.
The company had a so-called mass-marketing office at 341 North Maple Drive, a small building a couple of miles from the company headquarters. The office was run by Art Lewis’s younger brother and was staffed by a few young women who seem not to have grasped its real mission. This was to invent phony files (e.g., applications and health records) to go with the phony insurance policies. Eventually, every phony policy was to have a file, but the girls had come nowhere near completing this task when the scandal broke.
By 1972 suspicions about Equity Funding’s insurance operations were spreading to other subsidiaries. Many of the executives at Bankers National were being exposed to, and were questioning, a lot of the company’s accounting. Many were appalled by the way the company was being run, and quit. One man, who served for a while as vice president for investment at Bankers National, and was under pressure to shift assets to the parent, offered his resignation in January of 1972, after only three months on the job. Levin heard that he was leaving, and offered him a big raise if he’d stay on. The executive insisted firmly that he was leaving and explained why. He remembers that Levin then attempted to appeal to him by professing admiration for his integrity. “If I had met you before we started this, maybe I wouldn’t have done it,” he remembers Levin saying, and then adding: “But now we’re trapped.” The young investment officer was not exactly mesmerized by this line of talk, but the parting seems to have been fairly amicable.
Firing the wrong man
Another executive who had gone to work for E.F.L.I.C. in 1970, and who had also worked at Bankers National, eventually told everything he knew. He is Ronald Secrist, and he was fired by Jim Smith last February. On March 7, Secrist told his story, first to the New York State Insurance Department, and, second, to Raymond Dirks, a thirty-nine-year-old insurance analyst with a New York brokerage firm.
Secrist began talking on a Wednesday. By the end of the week his story had been relayed to the Los Angeles office of the SEC and to the Illinois and California insurance departments. (Both state departments have regulatory responsibilities for E.F.L.I.C. because it is incorporated in Illinois but operated from Equity Funding’s headquarters in Los Angeles.) On the next Monday, March 12, two Illinois insurance examiners arrived, without prior notice, at 1900 Avenue of the Stars, pretending to be conducting a routine triennial audit. The next week a California examiner appeared, also claiming to be doing routine work.
This front did not fool Fred Levin for long. From his own experience—he had worked for three years in the Illinois Insurance Department—he knew that companies are usually given prior notice of a state audit. Levin’s suspicions appear to have led to some countermoves by Equity Funding management. On Saturday and Sunday, March 24 and 25, some E.F.L.I.C. employees made an effort to mix up the phony business and the good business, so that it would be harder for investigators to find out how much phony business there was. At some point they also counterfeited bonds, but these were apparently never put to use—perhaps because the quality was so poor.
Meanwhile, during the week of March 26, Ray Dirks was telling his story to the SEC. In retrospect, the SEC, which had heard the rumors two weeks before, seems to have been slow to get involved in the case. But its energetic regional administrator, Gerald Boltz, moved swiftly after hearing from Dirks and several former employees; Boltz now demanded affidavits from Equity Funding’s top officials.
Their hearts were in their mouths
During the last few days of March, events began to move rapidly. On Tuesday, March 27, trading in the shares of Equity Funding Corp. was halted. On Thursday, three young employees of the company who had pieced together some details of the fraud volunteered them to Seidman & Seidman, the company’s auditors. (That was the day Executive Vice President Rodney Loeb had called the directors.) By Friday, Larry Baker, the No. 2 man in the California Department, had decided to act. He got a “summary seizure” order, and on Friday evening he stalked into E.F.L.I.C.’s offices, slapping copies of the order on everyone in sight (including several auditors from Seidman & Seidman). But Baker was less self-confident than he appeared. “At that point we had not found one fake policy,” he admits. “We had nothing but stories. Our hearts were in our mouths.”
But that same afternoon the Illinois examiners, previously flimflammed at length about E.F.L.I.C.’s assets, turned up some hard evidence. On a visit to the American National Bank & Trust Co. in Chicago, they found that $24.6 million in bonds, which were presumably part of the assets on December 31, had never been in the bank.
By the time the board of directors assembled on April 1, the SEC had substantiated enough of the scheme to demand the departure of six company employees in addition to the three directors. Three on the list were the young men Levin had recruited back in 1968-69—Jim Smith, Lloyd Edens, and Art Lewis. The other three were lesser employees of the life company. The next day, a tenth man implicated in the scheme, Michael Sultan, the thirty-year-old controller of Equity Funding, was suspended at the request of regulatory officials. One former vice president, David Capo, twenty-nine, who was responsible for accounting for funding programs, has also been implicated in the fraud. He resigned from the company last February. Except for Goldblum, who is forty-six, none of the ten men forced out of the company was older than thirty-five. (Levin had his thirty-sixth birthday in June.) Their average age is only thirty-three.
So far, no employee or former employee of Equity Funding has been formally charged with any wrongdoing. A federal grand jury has been investigating the matter since May, and indictments are expected within several weeks.
Putting off the auditors
There is little evidence that the men involved in the fraud had any coherent plan for extricating themselves from the hole they were in. Eventually, Levin may have planned to merge E.F.L.I.C. with a large insurance company and somehow “bury” the missing assets. Late last year he was attempting to acquire American National Insurance in Galveston (assets: $1.6 billion). One executive insider says there was also some hope that E.F.L.I.C.’s good business would begin to increase so rapidly that it could be substituted for the phony business, in which case E.F.L.I.C. would report only a portion of its new business until its books were “clean.” Asked how such a plan could have escaped the auditors’ attention, the executive told a little joke whose punch line was, “We’ve been lucky so far.”
Like the great salad-oil swindle of a decade ago, the Equity Funding frauds seem especially alarming for what they suggest about the inability of auditors to detect massive wrongdoing. And, as in the salad-oil case, one moral of the story may be that it is almost impossible to detect some frauds when they go right to the top.
There were at least four accounting firms that might have uncovered the fraud: Haskins & Sells, one of the “Big Eight” accounting firms, had audited E.F.L.I.C. since 1968. Wolfson, Weiner, Ratoff & Lapin had audited Equity Funding itself since the original incorporation. Seidman & Seidman had acquired Wolfson, Weiner early in 1972. And Peat, Marwick, Mitchell, another “Big Eight” firm, had done a special review of E.F.L.I.C.’s business for Ranger (Anderson, Clayton is one of its clients).
Peat, Marwick never audited either the parent company or E.F.L.I.C. (and so never had any responsibility to the shareholders), but it may have come closest to uncovering the scheme. The firm became involved because T.J. Barlow, the canny president of Anderson, Clayton, believed that prudence dictated some check of the business its Ranger subsidiary was coinsuring. Anderson, Clayton had no particular reason to question the business; still, Barlow wanted to make certain that, as he puts it, the policyholders weren’t “fenceposts.”
The checking-out process provided a real challenge for E.F.L.I.C.’s management. On three occasions—once in early 1970 and twice in 1971—a young Peat, Marwick accountant accompanied by a Ranger official visited E.F.L.I.C. to make examinations. On the first visit, the business being checked out was the 1969 business, which was presumably good. On the second visit early in 1971, more than 20 percent of the sample selected by the accountants involved some “exceptions” (in some cases the files were missing). Peat, Marwick decided to investigate further.
Unfortunately, no auditor ever confirmed a policy directly with a policyholder until after the rumors of fraud began to circulate. Such confirmations are not standard operating procedure in life-insurance accounting and are not required even in the long-awaited audit guide published last December by the American Institute of Certified Public Accountants. Levin had always forbidden auditors to mail confirmations to policyholders on the theory that it would “upset the salesmen.”
Peat, Marwick decided, therefore, to confirm the questionable policies by writing directly to the salesmen who had sold them. Some sixty-six letters went out to Equity Funding’s various branch offices. Forty-nine came back with positive confirmations. One man who was in on the fraud has the impression that the branches were told the requests had been sent by “mistake” and should simply be confirmed and routed back to the accountants. Still, some branches didn’t get the word, and a few of the confirmations came back negative. Rising to the challenge, some E.F.L.I.C. officials now concocted an elaborate plan under which some of them, posing as salesmen around the U.S., would sit in their Century City offices and await calls from one of their colleagues. He would put the calls through in the presence of the accountant, and they would “confirm” the policies over a speaker telephone. It is not clear whether the plan was finally implemented.
When the accountants returned later that year for a third visit, the harassed E.F.L.I.C. officials made it clear that they were simply too busy to help with the backup work required for the examination. The men from Peat, Marwick and Ranger left, and never came back.
Haskins & Sells audited E.F.L.I.C. from 1968 to 1971. The firm believed, with some logic, that the best proof those policyholders existed was that the premium income kept coming in from the parent—or, at least, kept showing up on those intercompany ledgers. A Haskins & Sells spokesman today insists that the auditors always wrote for and received their own confirmations on the assets held by the banks. It may well be that in 1970 and 1971, despite the phoniness of much of its business, E.F.L.I.C. managed temporarily to put together the assets it said it had. In December of both years, Equity Funding borrowed money publicly ($20 million in 1970, $35 million in 1971), and there are indications that some of the proceeds may have been diverted to E.F.L.I.C. to hold during the audit.
Even if the assets were there, some in the insurance industry believe that Haskins & Sells may have been overly liberal with its client. Specifically, there has been criticism of the firm’s allowing E.F.L.I.C to take the coinsurance payments into income in the first year, rather than spreading them out over the term of the coinsurance agreement.
Loyalty to Wolfson, Weiner
But most of the real accounting failures occurred in the parent company itself. Seidman & Seidman became Equity Funding’s auditor in February, 1972, when it bought Wolfson, Weiner, a small Los Angeles firm. Over the years, Goldblum had resisted considerable pressure from Wall Street to hire a more prestigious national firm. He explained that Julian Weiner had been a great help to the company in the years when it was struggling and that he wanted to repay that loyalty. After Seidman & Seidman acquired the firm, it not only kept the Equity Funding account but also replaced Haskins & Sells as E.F.L.I.C.’s auditor.
The executive in charge of the audit for Wolfson, Weiner was Solomon Block, forty-four, who had his own office on Equity Funding’s executive floor. The fact seems incredible, but until this year Block had never been able to pass the tests required to become a certified public accountant. He nevertheless remained on the account after the merger with Seidman & Seidman. Just how much Block knew, or suspected, about the frauds is unclear.
One official who has been involved in the investigations since the scandal broke believes that Block and others were “induced to look the other way, or not to look at all” but that they did not willingly participate in the fraud. Says the official: “At present I see it more as a situation where if questions were raised in the work sheets, they wouldn’t get answered. The auditors would get a nonsensical answer, a non-answer, and let them go.” This official believes that a proper audit of the parent company would have easily uncovered the fraud.
The auditors’ most inexcusable oversight was their failure to establish that all those program loans supposedly being financed by the company did not exist. On its year-end 1972 balance sheet, Equity Funding reported $117.7 million of assets represented by program loans, only $40 million of which were financed by outside lenders. Since the scandal broke, no one has uncovered a shred of evidence to suggest that any other loans exist (except for about $3.5 million that was in the pipeline to be financed externally). The rest, some $74 million, are phony.
Although there were actually about 20,000 Equity Funding programs in effect at year-end, the company would have reported 50,000 in its 1972 annual report. Seidman & Seidman was bamboozled about this matter by a relatively simple device. Each funding program was identified in Equity Funding’s own records by a five-digit number. In the printout given Seidman & Seidman, the 20,000 account numbers included enough repetitions to get the total up to 50,000. In this printout, however, the first two digits were left off, so that there would be nothing inherently suspicious in any number being repeated.
In checking over these programs, Seidman & Seidman had selected 2,000 to verify directly with the holders. Someone in on the fraud got hold of the sample and ran it back through the computer, thereby retrieving the actual names and addresses and also identifying the duplicates. For these, the tireless con men at Equity Funding simply substituted other names and addresses. Some names and addresses were those of friends who could be persuaded, perhaps unwittingly, to send back confirmations; one story is that some of the names were taken from the invitation list for Arthur Lewis’s wedding.
The A.I.C.P.A. has formed a committee to study how auditing techniques should be changed in the wake of the Equity Funding scandal. One change that will almost certainly be called for is a requirement that insurance-company auditors get confirmations from policyholders directly. There is also apt to be a call for a major new program to train accountants in computer-auditing techniques.
Levin takes a new job
The ramifications of the great Equity Funding frauds will be echoing through many courtrooms for quite a few months. Several participants in the fraud are lying low, but several others have gamely taken new jobs. The irrepressible Fred Levin, Equity Funding’s former executive vice president, is selling cars under an assumed name. He has told some of his old friends that he is making more money these days than he did at Equity Funding. It is possible, of course, that he is exaggerating—he tends to do that. But one thing is certain: whatever he is making is worth a lot more than all the Equity Funding stock bonuses he ever got.
Research associate: Linda Grant Martin