Case 5-2 Zzzz Best 3e e826

Case 5-2

ZZZZ Best The story of ZZZZ Best is one of greed and audaciousness. It is the story of a 15-year-old boy from Reseda, California, who was driven to be successful regardless of the costs. His name is Barry Minkow. Minkow had high hopes to make it big—to be a millionaire very early in life. He started a carpet cleaning business in the garage of his home. Minkow realized early on that he was not going to become a millionaire cleaning other people’s carpets. He had bigger plans than that. Minkow was going to make it big in the insurance restoration business. In other words, ZZZZ Best would contract to do carpet and drapery cleaning jobs after a fire or flood. Because the damage from the fire or flood would be covered by insurance, the customer would be eager to have the work done. The only problem with Minkow’s insurance restoration idea was that it was all a fiction. There were no insurance restoration jobs, at least for ZZZZ Best. Allegedly, over 80 percent of his revenue was from this work. In the process of creating the fraud, Minkow was able to dupe the auditors, Ernst & Whinney (predecessor firm to Ernst & Young), into thinking the insurance restoration business was real. The auditors never caught on until it was too late.

How Barry Became a Fraudster Minkow wrote a book, Clean Sweep: A Story of Compromise, Corruption, Collapse, and Comeback, that provides some insights into the mind of a 15-year-old kid who was called a “wonder boy” on Wall Street until the bubble burst. He was trying to find a way to drum up customers for his fledgling carpet cleaning business. One day, while he was alone in the garage-office, Minkow called Channel 4 in Los Angeles. He disguised his voice so he wouldn’t sound not like a teenager and told a producer that he had just had his carpets cleaned by the 16-year-old owner of ZZZZ Best. He sold the producer on the idea that it would be good for society to hear the success story about a high school junior running his own business. The producer bought it lock, stock, and carpet cleaner. Minkow gave the producer the phone number of ZZZZ Best and waited. It took less than five minutes for the call to come in. Minkow answered the phone and when the producer asked to speak with Mr. Barry Minkow, Minkow said: “Who may I say is calling?” Within days, a film crew was in his garage shooting ZZZZ Best at work. The story aired that night and it was followed by more calls from radio stations and other television shows wanting to do interviews. The

calls flooded in with customers demanding that Barry Minkow personally clean their carpets. As his income increased in the spring of 1983, Minkow found it increasingly difficult to run the company without a checking . He managed to find a banker that was so moved by his story that the banker would agree to allow someone under aged customer to open a checking . Minkow used the money to buy cleaning supplies and other necessities. Even though his business was growing, Minkow ran into trouble paying back loans and interest when due. Minkow developed a plan of action. He was tired of worrying about not having enough money. He went to his garage—where all his great ideas first began—and looked at his bank statement, which showed that he had more money than he thought he had based on his own records. Minkow soon realized it was because some checks he had written had not been cashed by customers so they didn’t yet show up on the bank statement. Voila! Minkow started to kite checks between two or more banks. He would write a check on one ZZZZ Best and deposit it into another. Because it might take a few days for the check written on Bank #1 to clear that bank’s records (back then, checks weren’t always processed in real time the way they are today), Minkow could pay some bills out of the second and Bank #1 would not know —at least for a few days—that Minkow had written a check on his when, in reality, he had a negative balance. The bank didn’t know it because some of the checks that Minkow had written before the visit to Bank #2 had not cleared his in Bank #1. It wasn’t long thereafter that Minkow realized he could kite checks big time. Not only that, he could make the transfer of funds at the end of a month or a year and show a higher balance than really existed in Bank #1 and carry it on to the balance sheet. Since Minkow did not count the check written on his in Bank #1 as an outstanding check, he was able to double-count.

Time to Expand the Fraud Over time, Minkow moved on to bigger and bigger frauds like having his trusted cohorts confirm to banks and other interested parties that ZZZZ Best was doing insurance restoration jobs. Minkow used the phony jobs and phony revenue to convince bankers to make loans to ZZZZ Best. He had cash remittance forms made up from nonexistent customers with whatever sales amount he wanted to appear on the document. He even had a co-conspirator write on the bogus remittance form, “job well done.” Minkow could then show a lot more revenue than he was really making.

Minkow’s phony financial statements enabled him to borrow more and more money and expand the number of carpet cleaning outlets. However, Minkow’s personal tastes had become increasingly more expensive including purchasing a Ferrari with the borrowed funds and putting a down payment on a 5,000square-foot home. So, the question was: How do you solve a perpetual cash flow problem? You go public! That’s right, Minkow made a public offering of stock in ZZZZ Best. Of course he owned a majority of the stock to maintain control of the company. Minkow had made it to the big leagues. He was on Wall Street. He had investment bankers, As, and attorneys all working for him—the now 19-year-old kid from Reseda, California, who had turned a mom and pop operation into a publicly owned corporation.

Barry Goes Public Minkow’s first audit was for the 12 months ended April 30, 1986. A sole practitioner performed the audit. (There are eerie similarities in the Madoff fraud with its small practitioner firm—Friehling & Horowitz— conducting the audit of a multibillion-dollar operation and that of the sole practitioner audit of ZZZZ Best.) Minkow had established two phony front companies that allegedly placed insurance restoration jobs for ZZZZ Best. He had one of his cohorts create invoices for services and respond to questions about the company. There was enough paperwork to fool the auditor into thinking the jobs were real and the revenue was able. However, the auditor never visited any of the insurance restoration sites. If he had done so, there would have been no question in his mind that ZZZZ Best was a big fraud. Pressured to get a big-time A firm to do his audit as he moved into the big leagues, Minkow hired Ernst & Whinney to perform the April 30, 1987, fiscal year-end audit. Minkow continued to be one step ahead of the auditors – that is, until the Ernst & Whinney auditors insisted on going to see an insurance restoration site. They wanted to confirm that all the business—all the revenues—that Minkow had said were coming in to ZZZZ Best was real. The engagement partner drove to an area in Sacramento, California, where Minkow did a lot of work— supposedly. He looked for a building that seemed to be a restoration job. Why he did that isn’t clear, but he identified a building that seemed to be the kind that would be a restoration job in process. Earlier in the week, Minkow had sent one of his cohorts to find a large building in Sacramento that appeared to be a restoration site. As luck would have it, Minkow’s associate picked out the same site as had

the partner later on. Minkow’s cohorts found the leasing agent for the building. They convinced the agent to give them the keys so that they could show the building to some potential tenants over the weekend. Minkow’s helpers went up to the site before the arrival of the partner and placed placards on the walls that indicated ZZZZ Best was the contractor for the building restoration. In fact, the building was not fully constructed at the time but it looked as if some restoration work would have been going on at the site. Minkow was able to pull it off in part due to luck and in part because the Ernst and Whinney auditors did not want to lose the ZZZZ Best . It had become a large revenue producer for the firm and Minkow seemed destined for greater and greater achievements. Minkow was smart and used the leverage of the auditors not wanting to lose the ZZZZ Best as a way to complain whenever they became too curious about the insurance restoration jobs. He would even threaten to take away his business from Ernst and Whinney and give it to other auditors. Minkow also took a precaution with the site visit. He had the auditors sign a confidentiality agreement that they would not make any follow-up calls to any contractors, insurance companies, the building owner, or other individuals involved in the restoration work. This prevented the auditors from corroborating the insurance restoration contracts with independent third parties. The auditors clearly dropped the ball here as the firm failed to gather the evidence necessary to the existence of the work and revenue production from the insurance restoration contracts.

The Fraud Starts to Unravel It was a Los Angeles housewife who started the problems for ZZZZ Best that would eventually lead to the company’s demise. Because Minkow was a well-known figure and flamboyant character, the Los Angeles Times did a story about the carpet cleaning business. The Los Angeles housewife read the story about Minkow and recalled that ZZZZ Best had overcharged her for services in the early years by increasing the amount of the credit card charge for carpet cleaning services. Minkow had gambled that most people don’t check their monthly statements, so he could get away with the petty fraud. However, the housewife did notice the overcharge, complained to Minkow, and eventually he returned the overpayment. She couldn’t understand why Minkow would have had to resort to such low levels back then if he was as successful as the Times article made him out to be. So, she called the reporter to find out more and that ultimately led to the investigation of ZZZZ Best and future stories that weren’t so

flattering. Because Minkow continued to spend lavishly on himself and his possessions, he always seemed to need more and more money. It got so bad over time that he was close to defaulting on loans and had to make up stories to keep the creditors at bay, and he couldn’t pay his suppliers. The complaints kept coming in and eventually the house of cards that was ZZZZ Best came crashing down. During the time that the fraud was unraveling, Ernst and Whinney decided to resign from the ZZZZ Best audit. The firm never did issue an audit report. It had started to doubt the veracity of Minkow and his business at ZZZZ Best. The procedure to follow when a change of auditor occurs is for the company being audited to file an 8-K form with the SEC and the audit firm to prepare an exhibit commenting on the accuracy of the disclosures in the 8-K. The exhibit is attached to the form that is sent to the SEC within 30 days of the change. Ernst & Whinney waited the full 30-day period, and the SEC released the information to the public 45 days after the change had occurred. Meanwhile, ZZZZ Best had filed for bankruptcy. During the period of time that had elapsed, Minkow had borrowed more than $1 million and the lenders never were repaid. Bankruptcy laws protected Minkow and ZZZZ Best from having to make those payments.

Legal Liability Issues The ZZZZ Best fraud was one of the largest of its time. ZZZZ Best reportedly settled a shareholder class action lawsuit for $35 million. Ernst & Whinney was sued by a bank that had made a multimillion-dollar loan based on the financial statements for the three-month period ending July 31, 1986. The bank claimed that it had relied on the review report issued by Ernst & Whinney in granting the loan to ZZZZ Best. However, the firm had indicated in its review report that it was not issuing an opinion on the ZZZZ Best financial statements. The judge ruled that the bank was not justified in relying on the review report since Ernst & Whinney had expressly disclaimed issuing any opinion on the statements. Barry Minkow was charged with engaging in a $100 million fraud scheme. He was sentenced to a term of 25 years.

VIDEO LINK: http://www.youtube.com/watch?v=CdS16pWSKoE

Questions 1.

Do you believe that auditors should be held liable for failing to discover fraud in situations such as ZZZZ Best, where top management goes to great lengths to fool the auditors? Answer this question with respect to the ethical and professional responsibilities of audit professionals when conducting an audit.

Auditors should be held liable for failing to plan and perform the audit to discover material fraud. There were many red flags that the auditors could have observed and been tipped off to the fraud. The amount and type of restoration work by ZZZZ Best defied common sense. The auditors could have done a reasonableness test by determining the amount of square footage under restoration in the area; the newspapers coverage of the occurrences; and how much market share ZZZZ Best had of the work. Also all the water damages on the restoration contracts were on top floors but there were not any damages on the lower floors. Most important, the auditors never looked at construction contracts, abatement issues, and whether ZZZZ Best had the necessary permits to do the work. To say the auditors failed to exercise professional skepticism is an understatement. The auditors should have been liable for g a confidentiality agreement that was a limitation of scope. The auditors had an obligation to conduct the audit with integrity, objectivity, skepticism, independence, due care and with competence. Objectivity requires that an auditor should be skeptical and obtain independent evidence to information from the client. Ernst & Whinney failed to meet this obligation when they did not require corroboration of the insurance restoration contracts from independent third parties. When Ernst & Whinney resigned from the audit engagement, they had a professional obligation to disclose the reason for the withdrawal.

2.

Discuss the red flags that existed in the ZZZZ Best case and evaluate Ernst & Whinney’s efforts with respect to fraud risk assessment. Do you think Ernst & Whinney’s relationship with ZZZZ

Best influenced risk assessment and the work done on the audit? The red flags include rapid growth, kiting of bank transfers, cohorts confirming insurance restoration jobs, consistency of all the invoices, extravagant life style, a bigger than life founder, cash flow problems, and problems meeting loan payments. Ernst & Whinney did not want to lose ZZZZ Best as an audit client; after all Barry Minkow was the wiz kid on Wall Street. In his book, Clean Sweep: The Inside Story of the Zzzz Best Scam... One of Wall Street's Biggest Frauds, Minkow discusses having parties with partners and managers of Ernst & Whinney and inviting their wives. He knew that the wives would talk about what a nice young man Barry was. Being in awe of Minkow and his company, the audit firm did not maintain objectivity and skepticism. The audit firm did not independently the insurance contracts, restoration work, revenue sources, all of which were high risk items for ZZZZ Best.

3. These are selected numbers from the financial statements of ZZZZ Best for fiscal years 1985 and 1986: 1985 Sales $1,240,524 Cost of goods sold 576,694 s receivable 0 Cash 30,321 Current liabilities 2,930 Notes payable— 0

1986 $4,845,347 2,050,779 693,773 87,014 1,768,435 780,507

current What calculations or analyses would you make with these numbers that might help you assess whether the financial relationships are “reasonable”? Given the facts of the case, what inquiries might you make of management based on your analysis? Between 1985 and 1986 there is a 390% increase in Sales and 350% increase in Cost of goods sold. The auditors should question the increase in s receivable, which was 33% of sales and represents four months on an annualized basis. The auditors should question where the cash is from the collection of sales

(Sales of $4,845 less A/R of $693 less Cost of goods sold of $2,050). The company should have approximately $2 million to pay down liabilities or invest in assets. With the cash flow with borrowings of current liabilities and notes payable, the company had approximately $6.5 million before paying cost of goods sold or approximately $4.5 to pay down liabilities or invest in the company, yet cash only increased $50,000 for the year. Where was the cash used?

Barry: The Afterlife After being released from jail in 1995, Minkow became a preacher and a fraud investigator, and spoke at schools about ethics. This all came to an end in 2011, when he itted to helping deliberately drive down the stock price of homebuilder Lennar and was sent back to prison. The facts below explain what happened to Barry since 1995.

In 1997, Minkow became senior pastor of Community Bible Church in San Diego. Soon after his arrival, a church member asked him to look into a money management firm in nearby Orange County. Suspecting something was not right, Minkow used his “fraud-sniffing” abilities to alert federal authorities, who discovered the firm was a $300 million pyramid scheme. This was the beginning of the Fraud Discovery Institute, a for-profit investigative firm. Minkow managed to dupe the investment community again; several Wall Street investors liked what they saw, and sent him enough money to go after bigger targets. By Minkow's estimate, he had uncovered $1 billion worth of fraud over the years.

We assume Minkow missed the adrenalin rush of committing fraud that kept him going for so long in the 1990s, and in 2009 he issued a report accusing major homebuilder Lennar of massive fraud. Minkow claimed that irregularities in Lennar's off-balance-sheet debt ing were evidence of a massive Ponzi scheme. He accused Lennar of not disclosing enough information about this to its shareholders, and also claimed a Lennar executive took out a fraudulent personal loan. In an accompanying YouTube video, Minkow denounced Lennar as "a financial crime in progress" and "a corporate bully." Lennar's stock plummeted in the wake of Minkow's reports. From January 9, 2009 (when Minkow first made his accusations) to January 22, Lennar's stock tumbled from $11.57 a share to only $6.55. Minkow issued the report after being ed by Nicholas Marsch, a San Diego developer who had filed two lawsuits against

Lennar for fraud. One of Marsch's suits was summarily thrown out of court while the other ended with Marsch having to pay Lennar $12 million in counterclaims.

Lennar responded by adding Minkow as a defendant in a libel-and-extortion suit against Marsch. According to court records, Minkow had shorted Lennar stock, buying $20,000 worth of options in a bet that the stock would fall. Minkow also forged documents alleging misconduct on Lennar's part. He went forward with the report even after a private investigator he had hired for the case could not substantiate Marsch's claims. (In an unrelated development, it was also revealed that Minkow operated the Fraud Discovery Institute out of the offices of his church and even used church money to fund it—something which could have potentially jeopardized his church's tax-exempt status.)

On December 27, 2010, Florida Circuit Court Judge Gill Freeman issued terminating actions against Minkow in response to a motion by Lennar. Freeman found that Minkow had repeatedly lied under oath, destroyed or withheld evidence, concealed witnesses, and deliberately tried to "cover up his misconduct." According to Freeman, Minkow had even lied to his own lawyers about his behavior. Freeman determined that Minkow had perpetuated "a fraud on the court" that was so egregious that letting the case go any further would be a disservice to justice. In her view, "no remedy short of default" was appropriate for Minkow's lies. She ordered Minkow to reimburse Lennar for the legal expenses it incurred while ferreting out his lies. Lennar estimates that its attorneys and investigators spent hundreds of millions of dollars exposing Minkow's lies.

On March 16, 2011, Minkow announced through his attorney that he was pleading guilty to one count of insider trading. According to his lawyer, Minkow had bought his Lennar options using "nonpublic information." The plea, which is separate from the civil suit, came a month after Minkow learned he was the subject of a criminal investigation. Minkow claimed not to know at the time that he was breaking the law. The SEC had already been probing Minkow's trading practices. On the same day, Minkow resigned as senior pastor of Community Bible Church, saying in a letter to his flock that because he was no longer "above reproach," he felt that he was "no longer qualified to be a pastor." Six weeks earlier, $50,000 in cash

and checks was stolen from the church during a burglary. Though unsolved, it was noted as suspicious due to Minkow's itted history of staging burglaries to collect insurance money.

The nature of the "nonpublic information" became clear a week later, when federal prosecutors filed a criminal information action against Minkow with one count of conspiracy to commit securities fraud. Prosecutors charged that Minkow and Marsch conspired to extort money from Lennar by driving down its stock. The complaint also revealed that Minkow had sent his allegations to the Federal Bureau of Investigation (FBI), Internal Revenue Service (IRS), and SEC, and that the three agencies found his claims credible enough to open a formal criminal investigation into Lennar's practices. Minkow then used confidential knowledge of that investigation to short Lennar stock, even though he knew he was barred from doing so. Minkow opted to plead guilty to the conspiracy charge rather than face charges of securities fraud and market manipulation, which could have sent him to prison for life.

On March 30, 2011, Minkow pleaded guilty and was eventually sent to jail for five years and ordered to pay Lennar $584 million in damages—roughly the amount the company lost as a result of the bear raid. The ruling stated that Minkow and Marsch had entered into a conspiracy to wreck Lennar's stock in November 2008. With interest, the bill could easily approach a billion dollars—far more than he stole in the ZZZZ Best scam.

Questions (continued) 4.

What factors do you think motivated Minkow to return to his evil ways after becoming a respected member of the community following his release from prison in the ZZZZ Best fraud?

Minkow may have enjoyed being the center of attention and being ired for his business acumen. He may also have enjoyed thinking that he out-smarted people. Or as the case said he may have missed the adrenalin rush of committing fraud. Whatever the reason, Minkow must have thought he could get away with fraud a second time. Perhaps Minkow believed having been a preacher and helped the government by utilizing his fraud identification skills, he had built up trust that never existed before and he could use it to his advantage. 5.

Using Kohlberg’s stages of moral development, how would you characterize Minkow’s actions

after being released from prison in the ZZZZ Best fraud? Explain the effects of Minkow’s actions on the stakeholders who relied on him to act in a professional manner. After being released from prison, Minkow took a position as senior pastor of a church. Minkow was being egoistical and enjoyed the attention of his congregation. He was trying to reason at stage 5, social contract, but that didn’t last long. He violated the trust placed in him by the community when he itted to the congregation of no longer being “beyond reproach.” His efforts with the Fraud Discovery Institute while seemingly designed to help others, a stage 4 or 5 approach to decision-making, ultimately brought back the old feelings of “I can do whatever I want without checks on my behavior.” Minkow’s pursuit of selfinterests motivated his unethical actions in the Lennar case and he reverted back to a stage 2 way of thinking and acting.