“Equity Funding: Could It Happen Again?”

by David R. Hancox, CIA, CGFM

If you didn’t detect 64,000 phony transactions with a face value of $2 billion, $25 million in counterfeit bonds, and $100 million in missing assets,1 what would people think of your competence as an auditor, or of the credibility of your audit organization? For three auditors who did not report evidence of large scale fraud at Equity Funding Corporation of America it resulted in their being found guilty of fraud by a jury in California. The court sentenced them to serve two-year prison terms, spend four years on probation and do 2,000 hours of charity work.2

The notorious Equity Funding scandal proved to be an embarrassment to the securities industry, the insurance regulatory agencies and the auditing profession. In early 1973, when the world started learning of the magnitude of the fraud that had occurred, many questions were raised: Where was the Securities and Exchange Commission, the Federal agency responsible for monitoring publicly traded companies? Where were the various state insurance departments responsible for monitoring the activities of insurance companies? And where were the auditors? How could they not find a fraud of such towering magnitude?

After studying this case, and examining the reasons the auditors did not put a stop to the fraud that occurred under their noses, I suspect the same kind of detection failure could happen again today to many auditors and audit organizations. Working in State government, I’ve had an opportunity to review the activities of state insurance departments, to observe the activities of public accounting firms providing services to state agencies and to see how auditors approach their work.

It is important the story of Equity Funding does not simply slip into the archives. The lessons this case provides for internal and external auditors are just as important, and just as relevant today, as they were more than twenty years ago when the scandal broke. If we want to be worthy of public trust in our competence and credibility, we must be constantly vigilant that we are meeting the standards of our profession. We can succeed at this if we try to understand past mistakes, like those made by the Equity Funding auditors. We then have to challenge ourselves to do better.

Equity Funding: The Company

Gordon McCormick was an insurance and mutual fund salesman. He came up with the bright idea of combining these products in a package deal for investors. Here was how the deal worked: first, the customer would invest in a mutual fund; second, the customer would select a life insurance program; third, the customer would borrow against the mutual fund shares to pay each annual insurance premium. Finally, at the end of ten years, the customer would pay the principal and interest on the premium loan with any insurance cash values or by redeeming the appreciated value of the mutual fund shares. Any appreciation of the investment in excess of the amount paid would be the investor’s profit.3

This kind of leveraging of dollars is a concept used by sophisticated investors to maximize their returns. They use an asset they already own to borrow money in the expectation that earnings and growth will be greater than the interest costs they will incur. However, it’s a concept that is fraught with risks for the investor and should not be promoted by an ethical company without fully informing the investor of the risks.

Stanley Goldblum, a young and ambitious insurance salesman, teamed up with Mr. McCormick and their fledgling firm grew dramatically. But, day-to-day tensions grew and ultimately Mr. Goldblum gained control of the company.4 This upstart company had a huge sales force. The thrust of the salesman’s pitch to a customer was that letting the cash value sit in an insurance policy was not smart; in fact, the customer was losing money. The customer was encouraged to let his money work twice by taking part in the above deal.

The Scam

Equity Funding was growing dramatically. Mr. Goldblum began to take over many other companies, and these acquisitions required money. Therefore, it became critical to Mr. Goldblum to maintain the price of the stock of Equity Funding so he could use the stock to compensate the owners of the companies he was buying out. To keep the value of the stock up, generating earnings growth each year was important. The fraud began in 1965, when Mr. Goldblum told the chief financial officer of Equity Funding to make fictitious entries in certain receivable and income accounts.5 By inflating these accounts, the earnings per share increased and the stock price rose to higher than expected levels.

Fictitious entries alone do not bring in cash. But selling policies for fictitious customers could – and did – produce cash for Equity Funding, much of it from other insurance companies. The insurance industry is like a club; trust develops between corporations based on the contacts people make over the years. Some executives of Equity Funding traded on this trust by manufacturing phony insurance policies and selling them to other insurance companies.6 Even when other companies came to verify the policies, they simply examined records; they did not confirm with the actual policyholders to make sure the policies were legitimate. Here’s how the scam worked.

In the insurance business, there is a practice called reinsurance. One company will sell another insurance company some policies it has to generate immediate cash and to mitigate the risk of a large payout that could occur. In a typical reinsurance deal, the selling company receives $1.80 from the buyer (the reinsurer) for every $1 in policy premiums. The price takes into account the heavy first year commissions the seller has paid to obtain the policy (of course, they paid none in Equity Funding) and affords the seller a small profit. In succeeding years, the buyer may get 90 cents on every premium dollar, allowing 10 cents to the seller, who handles all the policy accounts and claims.7 The only way the reinsurance company makes money on the policies is through the policyholders’ payment of subsequent years’ premiums. Since these policyholders were nonexistent, Equity Funding planned to pay for the premiums through the sale of more phony policies, or through the “death” of fictitious policyholders.

The sales of these phony policies required still more work. To get the records to look right, Equity Funding also had to establish the existence of phony reserves to offset the insurance allegedly in force.8 Manufacturing phony policies takes a lot of chutzpah.

Who did it?

On November 1, 1973, a Federal grand jury in California indicted 22 executives and employees of Equity Funding, including Mr. Goldblum, the chairman and chief executive officer. The grand jury said that Mr. Goldblum wanted to achieve a level of growth that was not attainable through legitimate business operations. According to the indictment, Mr. Goldblum arranged for various officers and employees to make fictitious bookkeeping entries to inflate the company’s income and assets. He also directed employees to create fictitious insurance policies. On November 2, 1970, an employee was instructed to write a computer program creating fictitious policies with a face value of $430 million and a total yearly premium of $5.5 million.9 In 1971, some phony policies were reinsured and some employees were instructed to create death claims on some of the policies. How they accomplished it.

Creating phony accounting entries is relatively easy, but creating the documentation for 64,000 phony policies was too big a challenge, even at Equity Funding. Management wanted to be able to satisfy the auditors, who would ask to see a sample of policies for review. The auditors would examine the policies’ documentation on file, and then cross-check for premium receipts and policy reserve information. However, in all but a handful of cases, there were no policy files available. To solve this problem, management created an in-house institution – the forgery party!

At Equity Funding, policy files the auditors requested would often be “temporarily unavailable.” That night, a half-dozen to a dozen employees would work to forge the missing files to have them ready the next day. As one participant said, “It takes a long time and you have to be careful about date stamps and other details. But I had fun being the doctor and giving the guy’s blood pressure and all that.”10

But this was not the only time the auditors were duped. One night, an auditor left his brief case unlocked. An Equity Funding executive, in full sight of others, opened the case and took the audit plan and was able to anticipate the auditor’s next steps. Another time, an auditor wanted to send out policy confirmations to a sample of policyholders. Equity Funding officials, eager to help, did some clerical chores for the auditor. The result was letters addressed to branch sales managers and agents, who dutifully filled out the forms for the fictitious policyholders.11

The folly of the auditors became apparent only after an ex-employee sought out a securities analyst to tell the tale. It seems that the auditors had missed a host of fraudulent activities, including borrowing cash without recording the liability, booking nonexistent securities investments and inflating existing asset values.12

An analysis of the cause

Many people did an autopsy of the Equity Funding scandal. An AICPA Committee concluded that “customary audit procedures properly applied” would have reasonably ensured detection.13 Maybe, maybe not. Let’s explore the problems confronting the auditors at Equity Funding. We can classify them as follows:

• The ethics and integrity of management and employees
• Management’s philosophy and operating style
• The independence of the auditors
• Professional skepticism of the auditors
• External impairments to the audit

The ethics and integrity of management and employees

The Equity Funding scandal was a massive scheme, concocted by management and supported on at least a passive basis by a number of employees who knew, or could have reasonably suspected, that something was wrong. Obviously, the participants, and those who knew about their activities, had little integrity and poor ethical values. In an audit performed under AICPA audit standards, the auditors could have assessed the control risk at the maximum; in doing so, they would not have to evaluate the internal controls, but could have done substantive tests instead. If it had been an audit done under Government Auditing Standards, the auditors would have had to understand the internal control system. Today, we are expected to assess the control environment, which includes the ethics and integrity of management. But how do you assess that? Asking whether someone is ethical or has integrity just doesn’t cut it. Looking for a code of conduct is a step in the right direction, but the reality is, most people probably don’t pay attention to such codes anyway. Just ask any auditor whether he or she consults a code of ethics on a regular basis.

The only way to really assess control environment, including the ethics and integrity of management and employees, is to observe their actions over time. This means that the auditors must watch the auditee’s day-to-day activities. While some of the policyholders in Equity Funding may have been sophisticated enough to understand the risks, many unsuspecting policyholders depended on the information provided to them by the agents peddling the policy. But auditors are expected to have an understanding of the organization they are auditing. The auditors should have realized that Equity Funding was peddling a risky concept. This should have caused them to further assess management’s integrity and ethical values.

In a financial audit, auditors normally assess internal controls at the beginning of the job to determine the extent of the work they must do. However, understanding control environment issues may require more than this. It may be that we need to develop a new audit model – one in which we do evaluations of internal controls at several stages in the audit, including a final evaluation at the end of the job to help assess the cause or causes of the problems uncovered during the audit.

I suspect many auditors have a hard time assessing this critical element of internal control. However, it must be done. Without integrity and ethical values, there is no foundation for the rest of the control structure.

Management’s philosophy and operating style

Closely tied to management’s ethics and integrity is management’s philosophy and operating style. In the Equity Funding case, management was intent on becoming a giant conglomerate at all costs. It was because of this philosophy that the fraud saw the light of day. This operating style produced aggressive sales tactics, convincing unsophisticated ordinary investors to become involved in a highly leveraged concept. Leveraging money can work in a rising market. However, most people do not have enough information or foresight to anticipate a bad market. Eventually, the leveraged investor will get caught in such a market.

An auditor assessing internal controls is asked to examine the nature of the business risks accepted. Obviously for an organization to be successful, it must be willing to accept risk. But at what stage does risk taking turn into reckless behavior? This is a very difficult issue to assess. In hindsight saying someone was reckless is easy. But in examining current operations, we are now into a very judgmental area. And when should the auditors judgment supersede the judgment of management? In the case of Equity Funding though, there were sufficient red flags to cause the auditors to be more skeptical. Management was very aggressive, seeking to expand at a rapid rate and engaging in activities that would cause unsuspecting people to take unnecessary risks. The cumulative effect of these actions should have been enough to cause the auditor to pause and reflect on its possible meaning.

The independence of the auditors

Most auditors argue they are independent. But often, that independence is impaired by a variety of factors that limit the independence needed to successfully “call it like it is.” The auditors at Equity Funding compromised their independence in a number of instances. For example, one of the auditors earned $130,000 to $150,000 a year, largely because this company was his firm’s largest client. Equity Funding paid the auditing firm $300,000 in 1970, more than twice the amount paid by the firm’s next three largest clients. The second auditor was given 300 shares of Equity Funding in 1965, which he kept in his wife’s former name until he sold them in 1967. The third auditor received a $2,000 loan from an Equity Funding officer.14 Finally, these auditors (who were subsequently found guilty of fraudulent activities) were allowed to continue auditing Equity Funding—at the insistence of Mr. Goldblum—when another accounting firm bought out their firm.15

Two of the above examples (receiving stock and accepting a loan) illustrate a clear conflict-of-interest. However, the decision to maintain a client because of the revenue the client’s business can generate represents a subtle, but more pervasive potential conflict of interest. It is the latter threat to auditor independence that afflicts all too many public accounting firms. It is a conflict inherent in the system we use to hire auditors. Because auditors are hired by the audit committee of the Board of Directors, they argue they are “independent” of the management they are auditing. All too often, however, the management of a company also sits on the Board. So, just how independent of management can the auditors be? Ultimately, auditors’ fees come from the people who hire them. Therefore, it is unlikely that the tough calls will always be made in the best interests of other stakeholders, like stockholders or the public. Until we develop a more rational system, we cannot reasonably expect to have auditors who are truly independent in their thinking.

This independence in thinking is best illustrated by Raymond Dirks, the analyst who exposed the fraud at Equity Funding. “I went to [the CPA firm] truly believing I was doing this nationally ranked auditing firm a favor,” he said. “It [the firm] was about to certify a report I believed was fraudulent. Instead of reporting the matter to the SEC, the auditor applied the most narrow interpretation to his role and went directly to Equity Funding. When I asked him why he had done so, he replied, ‘They’re clients of mine.’ ‘Aren’t you independent auditors?’ I asked. ‘Sure we’re independent, but we have an obligation to our clients.'”16 It is this obligation to the client that has the potential to impair an auditor’s ability to draw truly independent conclusions.

Professional skepticism of the auditors

When auditors allow management extended periods of time to pull the records needed for the audit, they might as well pack up their bags and go home. Such a situation allows management to cull the records, add data that didn’t exist, clear out data that is harmful and to generally sanitize the information going to the auditors. This is a shameful situation, and one that should never exist. I cannot think of a situation that would require management to do the auditors’ work for them. If an auditee’s records are computerized, the audit retrieval software that exists today allows auditors to review records without management’s help. If an individual auditor, or the audit team, is not proficient in using such software, they should decline such an engagement because they do not collectively possess the skills necessary to adequately complete the job.

Another red flag that the auditors did not seem to pursue was the rapidly increasing revenue and accounts receivable accounts. One of the problems with accrual accounting is that revenue can be reported without any corresponding increase in cash. Aggressive entrepreneurs try to inflate sales. But inflating sales (and accounts receivable) doesn’t bring cash into the organization. Thus, the auditors need to examine accounts receivable closely to ascertain the aging of the account and whether the expected cash is arriving within acceptable time frames.

However, the Equity Funding auditors missed the ongoing fraud, not because they lacked technical know-how, but because they did not follow the basics of auditing. Beyond analytical reviews and examining documentation, a fundamental tenet of auditing is to verify the existence of the asset. If the auditors missed 64,000 phony insurance policies, $25 million in counterfeit bonds and $100 million in missing assets, they simply weren’t doing their job.

One reason they weren’t doing their job was that management had corrupted them into going along with fraudulent transactions. In 1968, when Mr. Goldblum devised a scheme to inflate $11 million in genuine Equity Funding assets to $35 million, the auditors informed the company they would disclose this matter in the audit. The auditors were called into a meeting with Mr. Goldblum. When they came out, the audit had been approved and a footnote was written to misrepresent the assets.17

The Lessons Learned

The Equity Funding case should provide lessons for all of us. It requires that we study our profession and our audit standards, and examine a number of important issues:

• Independence is such an important concept that we must struggle to overcome the daily impediments that are put in our path.
• We must keep up on the technological changes that are sweeping the workplace so we, the auditors, will not be bamboozled by management.
• Our ethics are just as important as the ethics of management. We live in a glass house. We should be above reproach.

Never forget the basics of our profession. As we become more technologically proficient, it is easy to think of assets in terms of bits and bytes on a computer. Failing to verify the existence of an asset has been at the heart of many frauds that auditors missed.
The Equity Funding scandal happened. It was the auditors’ failure to use due professional care that enabled the fraud to go on for as long as it did. A good, honest auditor could have put a stop to it within the first year of its existence. Are you such an auditor?

Endnotes

1. Raymond L. Dirks and Leonard Gross, The Great Wall Street Scandal (New York: McGraw-Hill Book Company, 1974), 272.
2. Wall Street Journal, July 17, 1975. “Three Auditors Get Jail In Equity Funding Case”
3. Ibid., Dirks, 19 – 20.
4. Ibid., Dirks, 26
5. Ibid., Dirks, 232
6. Ibid., Dirks, 108
7. Wall Street Journal, “A Scandal Unfolds”, April 2, 1973, page 14
8. Ibid., Dirks, 137
9. Ibid., Dirks, 233
10. Wall Street Journal, “A Scandal Unfolds”, April 2, 1973, page 14,
11. Ibid.
12. The Woman CPA, July 1976, Page 11, “Equity Funding: The Profession Reacts”
13. Wall Street Journal, June 5, 1975, “Unit Says Properly Used Auditing Rules Would Have Found Equity Funding Plan”
14. Wall Street Journal, January 10, 1975, “Three Equity Funding Auditors Go on Trial in Massive Fraud Case”
15. Wall Street Journal, January 8, 1975, “As Trial of Three Equity Funding Auditors Opens, Responsibility of CPA Is Debated”
16. Ibid., Dirks, 270
17. Wall Street Journal, January 10, 1975, “Three Equity Funding Auditors Go on Trial in Massive Fraud Case”