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Case Study Zzzz

In: Business and Management

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Words 3832
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CASE 1.9

ZZZZ Best Company, \nc.

On May 19,1987, a short article in The Wall Street Journal reported that ZZZZ Best Company, Inc., of Reseda, California, had signed a contract for a $13.8 million insurance restoration project. This project was just the most recent of a series of large restoration jobs obtained by ZZZZ Best (pronounced "zee best"). Located in the San Fernando Valley of southern California, ZZZZ Best had begun operations in the fall of 1982 as a small, door-ta-door carpet cleaning operation. Under the direction of Barry Minkow, the extroverted 16-year-old who founded the company and initially operated it out of his parents' garage, ZZZZ Best experienced explosive growth in both revenues and profits during the first several years of its existence. In the three-year period from 1984 to 1987, the company's net income surged from less than $200,000 to more than $5 million on revenues of $50 million. When 72ZZ Best went public in 1986,Minkow and several of his close associates became multimillionaires overnight. By the late spring of 1987,the market value of Minkow's stock in the company exceeded $100 million, while the total market value of 72ZZ Best surpassed $200 million. The youngest chief executive officer in the nation enjoyed the "good life;which included an elegant home in an exclusive suburb of Los Angeles and a fire-engine red Ferrari. Minkow's charm and entrepreneurial genius made him a sought-after commodity on the television talk show circuit and caused the print and visual media to tout him as an example of what America's youth could attain if they would only apply themselves. During an appearance on The Oprah Winfrey Show in April 1987,Minkow exhorted his peers with evangelistic zeal to "Think big, be big" and encouraged them to adopt his personal motto, "The sky is the limit~ Less than two years after appearing on Oprah, Barry Minkow began serving a 25-year prison sentence. Tried and convicted on 57 counts of securities fraud, Minkow had been exposed as a fast-talking con artist who swindled his closest friends and Wall Street out of millions of dollars. Federal prosecutors estimate that, at a minimum, Minkow cost investors and creditors $100 million. The company that Minkow founded was, in fact, an elaborate Ponzi scheme. The reported profits of the firm were nonexistent and the large restoration contracts, imaginary. As one journalist reported, rather than building a corporation, Minkow created a hologram of a corporation. In July 1987,just three months after the company's stock reached a market value of $220 million, an auction of its assets netted only $62,000. Unlike most financial frauds, the ZZZZ Best scam was perpetrated under the watchful eye of the Securities and Exchange Commission (SEC). The SEC,a large and reputable West Coast law firm that served as the company's general counsel, a prominent Wall Street brokerage firm, and an international public accounting firm all failed to uncover Minkow's daring scheme. Ultimately, the persistence of an indignant homemaker who had been bilked out of a few hundred dollars by ZZZZ Best resulted in Minkow being exposed as a fraud. How a teenage flimflam artist could make a mockery of the complex regulatory structure that oversees the U.S.securities markets was the central question posed by a congressional subcommittee that investigated the ZZZZ Best debacle. That subcommittee was headed by Representative John D. Dingell, chairman of the U.S. House Committee on Energy and Commerce. Throughout the investigation,
109

SECTION ONE

COMPREHENSIVE CASES

Representative Dingell and his colleagues focused on the role the company's independent auditors played in the ZZZZ Best scandal. The ZZZZ Best prospectus told the public that revenues and earnings from insurance restoration contracts were skyrocketing but did not reveal that the contracts were completely fictitious. Where were the independent auditors and the others that are paid to alert the public to fraud and deceit?t Like many other daring financial frauds, the ZZZZ Best scandal caused Congress to reexamine the maze of rules that regulate financial reporting and serve as the foundation of the U.S. system of corporate oversight. However, Daniel Akst, a reporter for The Wall Street Journal who documented the rise and fall of Barry Minkow, suggested that another ZZZZ Best was inevitable. "Changing the accounting rules and securities laws will help, but every now and then a Barry Minkow will come along, and ZZZZ Best will happen again. Such frauds are in the natural order of things, I suspect, as old and enduring as human needs.,,2

The Early History of ZZZZ Best Company
Barry Minkow was introduced to the carpet cleaning industry at the age of 12 by his mother, who helped make ends meet by working as a telephone solicitor for a small carpet cleaning firm. Although the great majority of companies in the carpet cleaning industry are legitimate, the nature of the business attracts a disproportionate number of shady characters. There are essentially no barriers to entry: no licensing requirements, no apprenticeships to be served, and only a minimal amount of start-up capital is needed. A l6-year-old youth with a driver's license can easily become what industry insiders refer to as a "rug sucker," which is exactly what Minkow did when he founded ZZZZ Best Company. Minkow quickly learned that carpet cleaning was a difficult way to earn a livelihood. Customer complaints, ruthless competition, bad checks, and nagging vendors demanding payment complicated the young entrepreneur's life. Within months of striking out on his own, Minkow faced the ultimate nemesis of the small businessperson: a shortage of working capital. Because of his age and the fact that ZZZZ Best was only marginally profitable, local banks refused to loan him money. Ever resourceful, the brassy teenager came up with his own innovative ways to finance his business: check kiting, credit card forgeries, and the staging of thefts to fleece his insurance company. Minkow's age and personal charm allowed him to escape unscathed from his early brushes with the law that resulted from his creative financing methods. The ease with which the "system" could be beaten encouraged him to exploit it on a broader scale. Throughout his tenure with ZZZZ Best, Minkow recognized the benefits of having an extensive social network of friends and acquaintances. Many of these relationships he developed and cultivated at a Los Angeles health club. After becoming a friend of Tom Padgett, an insurance claims adjuster, Minkow devised a scheme to exploit that friendship. Minkow promised to pay Padgett $100 per week if he would simply confirm over the telephone to banks and any other interested third parties that ZZZZ Best was the recipient of occasional insurance restoration contracts. Ostensibly, Minkow had obtained these contracts to clean and do minor remodeling work on properties damaged by fire, storms, or other catastrophes. Minkow convinced the
1. This and all subsequent quotations, unless indicated otherwise, were taken from the following source: U.S.Congress, House, Subcommittee on Oversight and Investigations of the Committee on Energy and Commerce, Faiture of ZZZZ Best Co. (Washington, DC: U.s. Government Printing Office, 1988). 2. D.Akst, Wonder Boy, Barry MinkowThe Kid Who Swindled Wall Street (New York: Scribner, 1990),271.

CASE 1.9

ZZZZ

BEST COMPANY, INC.

111(

gullible Padgett that the sole purpose of the confirmations was to allow ZZZZ Best to circumvent much of the bureaucratic red tape in the insurance industry. From this modest beginning, the ZZZZ Best fraud blossomed. Initially, Minkow used the phony insurance restoration contracts to generate the paper profits and revenues he needed to convince bankers to loan him money. Minkow's phony financial statements served their purpose, and he expanded his operations by opening several carpet cleaning outlets across the San Fernando Valley.Minkow soon realized that there was no need to tie his future to the cutthroat carpet cleaning industry when he could literally dictate the size and profitability of his insurance restoration "business:' Within a short period of time, insurance restoration, rather than carpet cleaning, became the major source of revenue appearing on ZZZZ Best's income statements. Minkow's "the sky is the limit" philosophy drove him to be even more innovative. The charming young entrepreneur began using his bogus financial statements to entice wealthy individuals in his ever-expanding social network to invest in ZZZZ Best. Eventually, Minkow recognized that the ultimate scam would be to take his company public, a move that would allow him to tap the bank accounts of unsuspecting investors nationwide.

Going Public with ZZZZ Best
Minkow's decision to take ZZZZ Best public meant that he could no longer completely control his firm's financial disclosures. Registering with the SEC required auditors, investment bankers, and outside attorneys to peruse ZZZZ Best's periodic financial statements. ZZZZ Best was first subjected to a full-scope independent audit for the 12 months ended April 30, 1986. George Greenspan, the sole practitioner who performed that audit, confirmed the existence of ZZZZ Best's major insurance restoration contracts by contacting Tom Padgett. Padgett served as the principal officer of Interstate Appraisal Services, which reportedly contracted the jobs out to ZZZZ Best. By this time, Padgett was an active and willing participant in Minkow's fraudulent schemes. Minkow established Interstate Appraisal Services and Assured Property Management for the sole purpose of generating fake insurance restoration contracts for ZZZZ Best. In testimony before the congressional subcommittee that investigated the ZZZZ Best scandal, Greenspan insisted that he had properly audited Minkow's company. Greenspan testified that while planning the 1986 audit he had performed various analytical procedures to identify unusual relationships in ZZZZ Best's financial data. These procedures allegedly included comparing ZZZZ Best's key financial ratios with industry norms. Regarding the insurance contracts, Greenspan testified that he had obtained and reviewed copies of all key documents pertaining to those jobs. However, Greenspan admitted that he had not inspected any of the insurance restoration sites.
Congressman Lent:

Mr.

Mr Greenspan, I am interested in the SEC Form 5-1 that ZZZZ Best Company filed with the SEC ... You say in that report that you made your examination in accordance with generally accepted auditing standards and accordingly included such tests of the accounting records and other auditing procedures as we consider necessary in the circumstances .... You don't say in that statement that you made any personal on-site inspections. Greenspan: It's not required. Sometimes you do; sometimes you don 't.1was satisfied that tl7esejobs existed and I was satisfied from at least six

different sources, including payment for the job. What could you want better than that?

SECTION ONE

COMPREHENSIVE CASES

Congressman Lent: Mr. Greenspan:

Yourposition is that you are an honest and reputable accountant.

Yes,sir.

Congressman Lent:

You were as much a victim as some of the investors in this company? I was a victim all right.... I am as much aghast as anyone. And every night I sit down and say, why didn't I detect this damned fraud.

Mr. Greenspan:

Retention of Ernst & Whinney by ZZZZ Best
Shortly after Greenspan completed his audit of ZZZZ Best's financial statements for fiscal 1986,which ended April 30, 1986,Minkow dismissed him and retained Ernst & Whinney to perform the following year's audit. Apparently, ZZZZ Best's investment banker insisted that Minkow obtain a Big Eight accounting firm to enhance the credibility of the company's financial statements. At approximately the same time,and for the same reason, Minkow retained a high-profile Los Angeles law firm to represent ZZZZ Best as its legal counsel. The congressional subcommittee asked Greenspan what information he provided to Ernst & Whinney regarding his former client. In particular, the subcommittee wanted to know whether Greenspan discussed the insurance restoration contracts with the new auditors.
Congressman Wyden: iHr. Greenspan, in September 1986, Ernst & Whinney carne on as the new independent accountant for ZZZZ Best. What did you communicate to Ernst & Whinney with respect to the restoration contracts?

Mr. Greenspan:

Nothing. I did-there was nothing because they never got in touch with me. It's protocol for the new accountant to get in touch with the old accountant. They never got in touch with me, and it's still a mystery to me.

Representatives of Ernst & Whinney later testified that they did, in fact, communicate with Greenspan prior to accepting ZZZZ Best as an audit client. However, Ernst & Whinney did not comment on the nature or content of that communication. (Greenspan was not recalled to rebut Ernst & Whinney's testimony on this issue.i Exhibit 1 contains the engagement letter signed by Ernst & Whinney and Barry Minkow in September 1986.The engagement letter outlined four services that the audit firm intended to provide ZZZZ Best: a review of the company's financial statements for the three-month period ending July 31, 1986;assistance in the preparation of a registration statement to be filed with the SEC;a comfort letter to be submitted to ZZZZ Best's underwriters; and a full-scope audit for the fiscal year ending April 30, 1987. Ernst & Whinney completed the review, provided the comfort letter to ZZZZ Best's underwriters, and apparently assisted the company in preparing the registration statement for the SEC; however, Ernst & Whinney never completed the 1987 audit. The audit firm resigned on June 2, 1987, amid growing concerns that ZZZZ Best's financial statements were grossly misstated. The congressional subcommittee investigating the ZZZZ Best fraud questioned Ernst & Whinney representatives at length regarding the bogus insurance restoration contracts-contracts that accounted for 90 percent of ZZZZ Best's reported profits.

3. After a lengthy investigation, the American Institute of Certified Public Accountants ruled in 1998 that there was no "prima facie evidence" that Greenspan had violated the organization's Code of Professionat Conduct during the time that ZZZZ Best was his client. A similar conclusion was reached by two state boards of accountancy with which Greenspan was registered to practice public accounting.

CASE 1.9

ZZZZ

BEST COMPAr-IY.

I"c.

113

EXHIBIT 1

September

12, 1986

ERNST 8.: WHlr-I1\EY'S

ZZZZ
Mr. Barry Minkow Chairman of the Board ZZZZ Best Co., Inc. 7040 Darby Avenue Reseda, California Dear Mr. Minkow:
LETTER

BEST

E:\GAGBIEi'\T

This letter accountants services

is to confirm

our understanding

regarding

our engagement and the nature

as independent of the

of ZZZZ BEST CO., INC. (the Company)

and limitations

we will provide. the following services: sheet of the Company and changes with standards of an opinion as of July 31, 1986, in financial position established an audit regarding and the related for the three Institute of the taken as statements, statements

We will perform

1. We will review the balance statements months Certified objective a whole, statements of income, retained then ended,

earnings,

in accordance

by the American the financial

Public Accountants. and, accordingly, is presently

We will not perform we will not express

of such financial on them.

of which is the expressing expected

an opinion

Our report

on the financial

to read as follows: consolidated and the related position balance sheet of ZZZZ BEST CO., consolidated period

"We have made a review of the condensed INC. and subsidiaries statements of income as of July 31. 1986, and changes

condensed

in financial

for the three-month

ended July 31, 1986, in accordance with standards established by the American of Certified Public Accountants. A review of the condensed consolidated Institute financial statements for the comparative information data, accepted period of the prior year was not made. of obtaining of persons an understanding applying than analytical for for responsible information, less in scope regarding A review of financial of the system financial review procedures in accordance statements consists of interim principally financial inquiries standards, an opinion

for the preparation to financial matters.

and making auditing

and accounting

It is substantially of expressing

an examination

with generally taken as a whole.

which will be performed the financial such an opinion.

the full year with the objective

Accordingly,

we do not express

Based on

our review, we are not aware of any material modifications that should condensed consolidated interim financial statements referred to above in conformity Our engagement with generally cannot be relied accepted accounting principles." errors, irregularities, we will inform

be made to the for them to be

upon to disclose may exist.

or illegal

acts,

including fraud or defalcations, that matters that come to our attention. 2. We will assist Securities and related in the preparation

However,

you of any such

of a Registration advice and counsel S-X.

Statement

(Form S-l)

under

the statements

Act of 1933 including information

in conforming

the financial

to Regulation

3. We will assist

in resolving

the accounting of the Registration

and financial Statement

reporting referred

questions to above.

which will arise

as a part of the preparation

4. We will prepare a letter mind the limited nature

for the underwriters, if required (i.e., a Comfort Letter), bearing of the work we have done with respect to the financial data.

in

(continued)

CASE 1.9

ZZZZ

BEST COMPANY, INC.

113

EXHIBIT 1

September

12, 1986

ERNST

& WHINNEY'S
BEST

ZZZZ
Mr. Barry Minkow Chairman of the Board
LETTER

ENGAGEMENT

ZllZ Best Co., lnc.
7040 Darby Avenue Reseda, California Dear Mr. Minkow: This letter accountants services is to confirm our understanding regarding our engagement and the nature as independent of the

of ZZZZ BEST CO., lNe. (the Company)

and limitations

we will provide. the following services: sheet of the Company and changes with standards as of July 31, 1986, in financial established an audit and the related for the three Institute of the statements,

We will perform

1. We will review the balance statements months Certified of income, retained then ended,

earnings,

position

in accordance

by the American

Public Accountants.

We will not perform

of such financial

objective of which is the expressing of an opinion regarding the financial statements taken as a whole, and, accordingly, we will not express an opinion on them. Our report on the financial statements is presently expected to read as follows: consolidated and the related position balance sheet of ZZZZ BEST CO., consolidated period

"We have made a review of the condensed INe. and subsidiaries statements of income as of July 31, 1986, and changes

condensed

in financial

for the three-month

ended July 31, 1986, in accordance with standards established by the American Institute of Certified Public Accountants. A review of the condensed consolidated financial statements for the comparative information data, accepted period of the prior year was not made. of obtaining of persons an understanding applying than analytical for for responsible information, less in scope regarding A review of financial of the system financial review procedures in accordance statements consists of interim principally financial inquiries standards, an opinion

for the preparation to financial matters.

and making auditing

and accounting

It is substantially of expressing

an examination

with generally taken as a whole.

which will be performed the financial such an opinion.

the full year with the objective

Accordingly,

we do not express

Based on

that should be made to the our review, we are not aware of any material modifications condensed consolidated interim financial statements referred to above for them to be in conformity Our engagement with generally cannot accepted accounting principles." errors, irregularities, or illegal acts,

be relied upon to disclose may exist.

including fraud or defalcations, that matters that come to our attention. 2. We will assist Securities and related in the preparation

However,

we will inform you of any such

of a Registration advice and counsel S-X.

Statement

(Form S-l)

under the statements

Act of 1933 including information

in conforming

the financial

to Regulation

3. We will assist in resolving as a part of the preparation 4. We will prepare mind the limited a letter nature

the accounting of the Registration

and financial Statement if required

reporting referred (i.e.,

questions to above.

which will arise

for the underwriters,

a Comfort

Letter),

bearing

in

of the work we have done with respect

to the financial

data.

(continued)

114

SECTION ONE

C()MI'REIIE"'~IVE C\~E~

EXHIBIT 1continued
ERNST

5. We will examine auditing standards internal the extent understood course standards control

the consolidated approved

financial

statements Institute that

of the Company as of April 30, 1987, with generally accepted These the Company's evidential in the matter be of Certified Public Accountants.

& WHINNEY'S
BEST

and for the year then ended contemplate, system of our audit that

and issue our report in accordance by the American other things,

ZZZZ
LETTER

ENGAGEMENT

among tests;

(1) we will study and evaluate sufficient

as a basis for reliance and (2) that will necessarily and that basis for our opinion

on the accounting on the financial be governed

records and for determining However, it should developed

we will be able to obtain

to afford a reasonable

statements. depending

our reports

by the findings

of our examination progresses, opinion.

we could be required, unqualified indicate if any, that

upon the circumstances, to express an

to modify our reporting examination unqualified report

from the typical

opinion.

We will advise you, as our generally on a test basis, it

if any developments our examination irregularities,

that we will be unable may exist.

Because disclose

will be performed

will not necessarily

However, we will promptly

to you any irregularities

which our examination

does disclose. personnel records, involved plus outof of

Our fees will be derived of-pocket assistance volume expenses. received of business, our work. Among these

from our customary factors are the general

rates for the various of the accounting

Certain

can have an effect condition

on the time incurred of data, that billing

in the conduct the amount

from your personnel any significant

in the accumulation reporting issues

the size and transaction with

financial

arise in connection for the various

the SEe's review of the 5-1. as well as unforeseen understanding of the situation, the amount which we will be providing are estimated to be: statements

circumstances.

Based upon our current services

of our proposed

Review of the July 31, 1986 financial Assistance in the preparation Comfort Letter Audit of financial We will invoice month statements

of the Registration as of April 30, 1987 for the time charges upon

Statement

$ 5,000-$ 7,500 8,000-30,000 4,000-6,000 24,000-29,000 incurred in the previous

you each month

and expenses presentation. assigned

and such invoices

are due and payable

Larry D. Gray, Partner, Griffith, Audit Manager, appreciate

is the Client Service and Michael your engagement with you. Please the enclosed

Executive

to the engagement.

Peter

McCormick,

Tax Manager,

have also been assigned, we shall be arrangements of

We greatly pleased by signing the terms

of our firm; if you have any questions, indicate your acceptance constitutes of the above copy. This letter

to discuss

them

and returning

the full understanding

of our engagement.

Very truly yours, Ernst & Whinney By Larry D. Gray, Partner ACCEPTED: ZZZZ BEST 9/16/86

co.,

INC. of the Board (signed)

Barry J. Minkow, Chairman

Congres.

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