zzzz best

LASE 1.4

ZZZZ BESTCOMPANY, INC.

On May 19, 1987,a shortarticlein TheWall StreetJournal reportedthat ZZZZ BestCompany,Inc.,of Reseda,California,hadsigneda contractfor a$13.8million in-surancerestorationproject. This projectwas just the most recentof a seriesoflargerestorationjobs obtainedby ZZZZ Best (pronounced“zeebest”) Company.Locatedin theSanFernandoValley of southernCalifornia,ZZZZ Besthadbegunoperationsin the fall of 1982 as a small, door-to-doorcarpetcleaningoperation.Under the direction of Barry Minkow, the ambitious sixteen-year-oldwhofoundedthe companyandinitially operatedit out of his parents’garage,ZZZZBestexperiencedexplosivegrowth in both revenuesandprofitsduring the firstseveralyearsof its existence.In thethree-yearperiodfrom 1984to 1987,thecom-pany’snetincomesurgedfrom lessthan$200,000to morethan$5 million on reve-nuesof $50million.

WhenZZZZ Bestwentpublic in 1986,Minkow andseveralof hiscloseassoci-atesbecamemultimillionaires overnight. By the late spring of 1987, Minkow’sstock in the companyhada marketvalueexceeding$100 million, andthe totalmarketvalueof ZZZZ Bestsurpassed$200 million. The youngestchiefexecutiveofficer in thenation~enjoyedthe“good life,” which includedanelaboratehomeinan exclusivesuburbof Los Angelesand a fire-engine red Ferrari. Minkow’scharmandentrepreneurialgeniusmadehim a sought-aftercommodity on thetelevisiontalk showcircuit andcausedtheprint andvisual mediato tout him asan exampleof whatAmerica’syouthcould attainif theywouldonly applythem-selves.During an appearanceon TheOprah WinfreyShowin April 1987,Minkowexhortedhispeerswith evangelisticzealto “Think big,be big” andencouragedthemto adopthispersonalmotto, “Thesky is thelimit.”

Less than two yearsafter his appearanceon The Oprah Winfrey Show,BarryMinkow beganservinga twenty-five-yearprisonsentence.Tried andconvictedon fifty-seven countsof securitiesfraud,Minkow hadbeenexposedas a fast-talking conartistwhobilkedhis closestfriendsandWall Streetout of millions ofdollars.Federalprosecutorsestimatethat, ataminimum,Minkow costinvestorsandcreditors$100 million. The companythat Minkow foundedwas,in fact, anelaboratePonzischeme.The reportedprofits of the firm werenonexistentandthe

Al

SECTION ONE COMPREI~ENSIvE CASES

hugerestorationcontracts,imaginary. As onejournalist reported,rather thanbuildinga corporation,Minkow constructeda hologramof acorporation.In July1987,justthreemonthsafterthe company’sstockhadreacheda marketvalueof$220million, an auctionof its assetsnettedonly $62,000. -

Unlike mostfinancial frauds,the ZZZZ Bestscamwas perpetratedunderthewatchfuleye of the SecuritiesandExchangeCommission(SEC).The scrutinyofthe SEC. oneof the largestWall Streetbrokeragehouses,a largeand reputableWestCoastlaw firm thatservedas thecompany’sgeneralcounsel,andan inter-nationalpublic accountingfirm hadfailed to uncoverMinkow’s daringscheme.Ultimately,thepersistenceof an indignanthomemakerwho hadbeenbilked outof a few hundreddollarsby ZZZZ Bestresultedin Minkow being exposedas afraud.

How a teenageflimflam artist could makea mockeryof the complexregula-tory structurethat overseesthe U.S. securitiesmarketswas the centralquestionposedby acongressionalsubcommitteethatinvestigatedtheZZZZ Bestdebacle.RepresentativeJohn D. Dingell, chairmanof the U.S. House CommitteeonEnergyandCommerce,pointedout, “The ZZZZ Bestprospectustold the publicthatrevenuesandearningsfrom insurancerestorationcontractswereskyrocket-ing but did not reveal thatthe contractswerecompletelyfictitious. Where werethe independentauditorsandthe othersthat arepaidto alert thepublic to fraudand deceit?”1Like manyother daring financial frauds, the ZZZZ BestscandalcausedCongressto reexamineandmodify themazeof rulesthat regulatefinan-cial reportingandserveas the foundationof the U.S. systemof corporateover-sight. However,Daniel Akst, a reporterfor The Wall StreetJournal who playedalarge role in exposingMinkow, suggeststhat anotherZZZZ Best is inevitable:“Changingtheaccountingrulesandsecuritieslawswill help,but everynow andthena Barry Minkow will comealong,andZZZZ Bestwill happenagain.Suchfraudsarein thenaturalorderof things,I suspect,as old andenduringashumanneeds.”2

THE EARLY HISTORY OF ZZZZ BEST COMPANY

Barry Minkow wasintroducedto thecarpetcleaningindustryattheageof twelveby his mother,who helpedmakeendsmeetby working as a telephonesolicitorfor asmallcarpetcleaningfirm. Althoughthegreatmajority of companiesin thecarpetcleaningindustry are legitimate,the natureof the businessattractsa dis-proportionatenumberof seedycharacters.Thereare essentiallyno barriers toentry: no licensing requirements,no apprenticeshipsto be served,and only aminimal amountof start-upcapitalneeded.A sixteen-year-oldyouth with adri-ver’s licensecan easilybecomewhat industryinsidersreferto as a “rug sucker,”which is exactlywhatMinkow did whenhe foundedZZZZ BestCompany.

1. This and all subsequentquotations,unless indicated otherwise,weretakenfrom thefollow-ing source:U.S. Congress,House, Subcommitteeon Oversight and Investigationsof theCommittee on Energy and Commerce,Failure of ZZZZ Best Co. (Washington,D.C.: U.S.GovernmentPrinting Office, 1988).

2. D. Akst, Wonder Boy, Barry Minkow—TheKid WhoSwindled Wall Street(New York: Scribner,1990),271.

Minkow quickly recognizedthat carpetcleaningwasa difficult way to earnalivelihood. Theeaseof entryinto thefield meantthatcutthroatcompetitionwasprevalentwithin the industry.Customercomplaints,badchecks,andnaggingvendorsdemandingpaymentcomplicatedtheyoung entrepreneur’slife. Withinmonthsof striking out on his own, Minkow facedthe ultimate nemesisof thesmallbusinessperson:a shortageof working capital.Becauseof his ageandthe —

fact that ZZZZ Bestwasonly marginallyprofitable, local banksrefusedto loanhim money.Everresourceful,thebrassyteenagercameup with his owninnova-tive waysto financehisbusiness:checkkiting, creditcardforgeries,andthestag-ing of theftsto fleecehis insurancecompany.Minkow’s ageandpersonalcharmallowedhim to escaperelatively unscathedfrom his earlybrusheswith the lawthatresultedfrom his creativefinancingmethods.The easewith which the“sys-tem” couldbebeatenencouragedhim to exploit it on abroaderscale.

Throughouthis shortbusinesscareer,Minkow realizedthe benefitsof havinganextensivesocialnetworkof friendsandacquaintances.Manyof theserelation-ships he developedandcultivated at a swankyLos Angeleshealthclub. Soonafterbecomingafriend of Tom Padgett,aninsuranceclaimsadjuster,Minkow de-viseda schemeto exploit that friendship.Minkow promisedto payPadgett$100per week if he would simply confirm overthe telephoneto banksandanyotherinterestedthird partiesthat Minkow’s companywas the recipiefit of occasionalinsurancerestorationcontracts.Ostensibly,thesecontractshadbeenobtainedbyMinkow to cleananddo minor remodelingwork on propertiesdamagedby fire,storms,or othercatastrophes.Thegullible Padgettwasled to believethatthesolepurposeof suchconfirmationswas to allow Minkow to circumventmuchof thebureaucraticred tapein theinsuranceindustry.

Fromthis beginning,theÿÿZZ Best fraud blossomed.Initially, the insurancerestorationwork, which was totally fictitious, wasa smallsidelinethat Minkowusedto generatepaperprofits and revenuesto convincebankersto loan himmoney.Minkow’s phonyfinancial statementsservedtheir purpose,andhe ex-pandedhis operationsby openingseveralcarpetcleaningoutletsacrossthe SanFernandoValley Minkow soonrealizedthattherewasno needto tie his futuretothe cutthroatcarpetcleaningindustrywhenhecouldliterally dictatethesizeandprofitability of hisinsurancerestoration“business.”Within ashortperiodof time,insurancerestoration,ratherthancarpetcleaning,becamethe major sourceofrevenueappearingon theZZZZ Best incomestatements.

Minkow’s “the sky is the limit” philosophydrovehim tobeevenmoreinnova-tive. The charmingyoungentrepreneurbeganusinghis phony financial state-ments to entice wealthy individuals in his ever-expandingsocial network toinvest in ZZZZ Best. Eventually,Minkow recognizedthat the ultimate scamwould be to takehis companypublic, a movethatwould allow him to tap thebankaccountsof investorsnationwide.

GOING PUBLIC WITH ZZZZ BEST

The decisionto takeZZZZ Bestpublic meantthatMinkow no longerwasableto completelycontrol his firm’s financial disclosures.Registeringwith the SECrequired auditors, investmentbankers,and outsideattorneysto perusetheZZZZ Best financial statements.Federalsecuritieslawsimposea duediligence

SECTION ONE COMPREHENSIVE CASES

obligationon theseparties;thatis, underthefederalsecuritieslaws,partiesasso-ciatedwith asecuritiesregistrationstatementmustattemptto determinethat theinformationthereinis materiallyaccurate.ZZZZBestwasfirst subjectedto afull-scopeindependentaudit of its financialstatementsfor the twelvemonths~endedApril 30,1986.GeorgeGreenspan,thesolepractitionerwhoperformedthataudit,confirmed theexistenceof ZZZZ Best’smajorinsurancerestorationcontractsbycontactingTom Padgett,the principal officer of InterstateAppraisal Services,whichreportedlycontractedthejobs out toZZZZ Best.By this time,Padgettwasanactiveandwilling participantin Minkow’s fraudulentschemes.Minkow hadestablishedInterstateAppraisalServicesandAssuredPropertyManagementforthesolepurposeof generatingfakeinsurancerestorationcontractsforZZZZ Best.

Accordingto Greenspan’stestimonybefore the congressionalsubcommitteethat investigatedthe ZZZZ Bestscandal,he not only confirmedthe existenceofthe insurancerestorationjobs but alsoobtainedand reviewedcopies of all keydocumentsregardingthosejobs.In addition,Greenspanperformedvariousana-lytical proceduresto determinethat the company’skey financial ratioswereinline with industryaverages.However,Greenspandid not inspectanyof the in-surancerestorationsites.The congressionalsubcommitteewassurprised,if notalarmed,that hehadnot personallyvisited at leasta few of thejob sites.

CONGRESSMAN LENT: Mr. Greenspan,I am interestedin the SEC Form5-1 thatZZZZ BestCompanyfiled with theSEC. . . . You say in that reportthat youmadeyour examinationin accordancewith generallyacceptedauditingstan-dardsandaccordinglyincludedsuchtestsof theaccountingrecordsandotherauditingproceduresas we considernecessaryin the circumstances.. . . Youdon’t sayin thatstatementthatyou madeanypersonalon-siteinspections.

MR. GREENSPAN: It’s not required.Sometimesyou do; sometimesyou don’t. Iwas satisfiedthat thesejobsexistedandI was satisfiedfrom at leastsix differ-ent sources,includingpaymentfor the job. Whatcould you want betterthanthat?

CONGRESSMANLENT: Your positionis that you arean honestand reputableac-countant.

MR. GREENSPAN: Yes,sir.

CONGRESSMAN LENT: You wereas muchavictim as someof the investorsin thiscompany?

MR. GREENSPAN: I wasavictim all right.... I amasmuchaghastasanyone.And

everynight I sit downandsay,why didn’t I detectthisdamnedfraud.

RETENTION OF ERNST & WHINNEY BY ZZZZ BEST

Shortly after Greenspancompletedhis audit of ZZ.ZZ Best’sApril 30, 1986, fi-nancialstatements,Minkow dismissedhim andretainedErnst& Whinneyto per-form the following year’s audit. Apparently, ZZZZ Best’s investmentbrokerrequestedthat Minkow obtaina Big Eightaccountingfirm to enhancethe credi-bility of the company’sfinancial statements.About the sametime, and for thesamereason,Minkow retaineda high-profile Los Angeleslaw firm to representZZZZ Bestas its legalcounsel.

CASE 1.4 Z~ BEST COMPANY, INC.

The congressionalsubcommitteeaskedGreenspanwhat informationhe pro-vided to Ernst& Whinneyregardinghisformerclient. In particular,thesubcom-mittee was interestedin whether Greenspanhad discussedthe insurancerestorationcontractswith thenew auditors.

CONGRESSMAN WYDEN: Mr. Greenspan,in September1986, Ernst& Whinneycameon as the new independentaccountantfor ZZZZ Best. Whatdid youcommunicateto Ernst& Whinneywith respectto the restorationcontracts?

MR. GREENSPAN: Nothing.I did—therewasnothingbecausethey nevergot intouchwithme. It’s protocolfor thenewaccountantto getin touchwith theoldaccountant.Theynevergot in touchwith me, andit’s still amysteryto me.

Representativesof Ernst& Whinneylater testifiedthat theydid, in fact, com-municatewith Greenspanprior to accepting ZZZZ Best as an audit client.However,Ernst& Whinney’s testimonydid not disclosethenatureor contentofthatcommunication,andGreenspanwasnot recalledto rebutErnst& Whinney’stestimonyon this issue.

Exhibit 1 containstheengagementlettersignedby Ernst& WhinneyandBarryMinkow inSeptember1986.Theengagementletter outlinedfour servicesthattheaudit firm intendedto provideZZZZ Best:a reviewof the company’sfinancialstatementsfor the three-monthperiod endingJuly 31, 1986; assistancein thepreparationof a registrationstatementto be filed with the SEC; a comfort letterto besubmittedto ZZZZ Best’sunderwriters;anda full-scopeaudit for thefiscalyearendingApril 30,1987.Ernst& Whinneycompletedthereview,providedthecomfortletter to ZZZZ Best’sunderwriters,andapparentlyassistedthecompanyin preparingthe registrationstatementfor the SEC; however,Ernst& Whinneynevercompletedthe 1987 audit.The audit firm resignedon June2, 1987,amidgrowingconcernsthatZZZZ Best’s financialstatementsweregrosslymisstated.

The congressionalsubcommitteeinvestigatingthe ZZZZ Best fraud ques-tionedErnst& Whinneyrepresentativesatlengthregardingthebogusinsurancerestorationcontracts—contractsthataccountedfor 90 percentof ZZZZ Best’s re-portedprofits. The congressionaltestimonydisclosedthat Ernst& Whinneyre-peatedlyinsistedon visiting severalof thelargestof thesecontractsites,andthatMinkow and his associatesattemptedto discouragesuch visits. Eventually,Minkow realizedthatthe auditorswouldnot relentandagreedto allow themtovisit certainof therestorationsites,knowingfull well that noneof the sitesactu-ally existed.

To convinceErnst& Whinneythattheinsurancerestorationcontractswereau-thentic,Minkow andhis associatesdevisedaseriesof stingoperations.In thelatefall of 1986,Larry Gray,theengagementauditpartnerfor ZZZZ Best,insistedonvisiting arestorationsite in Sacramentoon whichZZZZ Besthad reportedob-taining a multimillion-dollar contract. Minkow sent two of his cohorts toSacramentoto find a largebuildingunderconstructionor renovationthat wouldprovidea plausiblesite for a restorationcontract.Grayhadvisited Sacramentoweeksearlierto searchfor thesitethatMinkow hadrefusedto divulge.As chancewouldhaveit, thebuilding chosenby theZZZZ Bestconspiratorswas thesameoneGrayhadidentified asthe mostlikely siteof the insurancerestorationjob.

Minkow’s two confederates,whileposingasleasingagentsof apropertyman-agementfirm, convincedthe supervisorof the constructionsite to provide thekeys to the building oneweekendon the pretextthat a largeprospectivetenant

46 SECTION ONE COMPREHENSIVE CASES

EXHIBIT 1 september 12,1986Ernst & Whinney’s ZZZZ -

Best Engagement Letter

Mr. Barty MinkowChairman of the BoardZZZZ Best Co., Inc.7040 Darby AvenueReseda, Califomia~ -. . ., .

Dear Mr. Minkow: -

This letter is to confirm our understanding regarding our engagement as independent accoun-tants of ~Z BEST CO. INC (the Company) and the nature and limitations of the services wewill provide.

We will perform the Iollovdng services

1. We will review the balance sheet of the Company as of July 31, 1988, and the related state-ments of income, retained earnings, and changes In financial position for the three months thenended, in accordance with standards established by the American Institute of Certified PublicAccountants. We will riot perform an suds of such financial statements, the objective of which isthe expressing of an opinion regarding the financial statements taken as a whole, arid, accord-ingly, we will not express an opinion on them. Our report on the financial statements is presentlyexpected to read as follows:

-‘We have made a review of the condensed consolidated balance sheet of BESTCO., INC. arid subsidiaries as of July 31.1986, and ~herelated condensed consolidatedstatements ~ income and changes in financial position for the three-month period ended July31.1986. u~accordance with standards establ~shed by the American Institute of CertifiedPublic Aoc6untants. A review of the condensed consolidated financial statements for thecomparative period ofthe prior year was not made~

;.‘~ 1’A review of financial information eansists principally of obtainingan understanding ofthesystem for the preparation of interimfinancial information, app~ng analytical review proce-dures to financial data, and making inquiries of persona responsible for financial and account-ing matters.

it is substantially less than an examin~tlbn In accordance ~vithgenerally acceptedauditing standards, which will be performed forth, fuN yearwith the objective of expressingan opinion regarding the financial statements taker~ as a whole. Accordingly we do not ex-press such an opinion.

Based on o~ur review, we are not aware of any material modifications that shouid be madeto the condensed consolidated Interim financial statements referred to above for them to be inconformity with generally accepted accounting principles!’ ~

Our engagement cannot be relied upon to disclose errors, irregularities, or Ilegal acts, includingfraud or defalcatioris, that may e,dst. However, we will inform you of any such matters that cometo our attention.

2. We will assist in the preparation of a Registration Statement (Form S-I) under the SecuritiesAct of 1833 including advice and counsel m conforming the financial statements and related in--formation to Regulation S-X.

3. We will assist In resolving the accounting and financial reportIng questions which will arise asa part of the preparation of the Regietration Statement referred to above.

4. We will prepares latter for the underwriters, if required (I.e., a Comfort Letter), bearing Inmind the limited nature of the work we have done with respect to the financial c4pta.

5. We will examine the consolidated financial statements of the Company as of April 30, 1987,and for the year then ended and issue our report in accordance with generally accepted auditingstandards approved by the American Institute of Certified Public Accountants. These standards

CASE 1.4 BEST COMPANY, INC.

contemplate, among other things, that (1) we will study and evaluate the Company’s Internal con-trol system as a basis for reliance on the accounting records and for determining the extent ofour audit tests; and (2) that we will be able to obtain sufficient evidentiar matter to afford a res-sonable basis for our opinion on the financial statements. However, It should be understood thatour reports will necessarily be governed by the findings deveioped In the course of our examine-tion and that we could be required, depending upon the circumstances, to modify our reportingfrom the typical unqualified opinion. We will advise you, as our examination progresses, if anydeveiopments Indicate that we will be unable to express an unqualified ~opinion.Because our ax-amrnation wiN be performed generally on a test basia, it wilt not nec.ssarlly disclose lwegularlties,If any, that may e,dst. However, we will promptly report to you any Irregularities which Our miami-nation does disclose.

Our fees will be derived from our customary rates for the various personnel involved plus out-of-pocket expenses. Certain factors can have an effect on the time incurred in the conduct of ourwork Among these are the general condition of the accounting records, the amount of assis-tance received from your personnel In the accumulation of data, the size and transaction volumeof business, any significant financial reporting issues that arise in connection with the SEC’S re-view ofthe S-i, ~swell as unforeseen circumstances. Based upon our current understanding ofthe situation, the amount of our proposed billing for the various services which we will be provid-ing are estimated to be:

Review of the July 31, 1986 financial statements $ 5,000—$ 7,500Assistance in the preparation of the Registration Statement 8,000— 30,000Comfort Letter 4,000- 6,000Audit of financial statements as of April 30, 1987 24,000— 29,000

We will uivoice you each month for the time charges and expenses incurred in the previousmonth and such Invoices are due and payable upon presentation.

Larry D. Grass Partner, is the Client Service Exacutive assigned to the engagement Peter Griffith,Audit Manager, and Michael McCormick, Tax Manager, have also been assigned.

We greatly appreciate your engagement of our firm; If you have any questions, we shall bepleased to discuss them with you. Please indicate your acceptance of the above arrangementsby signing and returning the enclosed copy. This ietter constitutes the full understanding of theterms of our engagement.

Ve.ytruly yours, -

Ernst & Whinney

By Larry D. Gray, Partspr

ACCEPTED:

ZZZZ BEST CO., INC.

Barry J. Minkow, Chairman of the Board(signed)

9-16-06

EXHIBIT 1—continuedErnst & Whinney’s ZZZZBest Engagement Letter

wishedto tour thefacility. Prior to thearrivalof Larry Grayandan attorneyrep-resentingZZZZ Best’s law firm, Minkow’s subordinatesvisited the site andplacedplacardson the walls atconspicuouslocationsindicatingthat ZZZZ Bestwas the contractorfor the building renovation.No detailswereoverlookedbyMinkow’s lieutenants;theyevenpaidthebuilding’s securityofficer to greetthevisitorsanddemonstratethathewasawareinadvanceof their tourof thesite andits purpose.Although the building had not beendamagedand insteadwas

I48 SECTION ONE COMPREHENSIVE CASES

simplyin theprocessof beingcompleted,thestingoperationwentoff asplanned.Exhibit 2 presentsthe memorandumGray wrote describinghis tour of thebuilding—amemorandumthatwas includedin Ernst& Whinney’sZZZZ Bestworkpapers.

CongressionalinvestigatorsquizzedGrayregardingthe measureshe took toconfirm that ZZZZ Bestactually hada restorationcontracton the Sacramentobuilding.Theywereparticularlyconcernedthatheneverdiscoveredthebuildinghadnot sufferedseveralmillion dollars in damagesa few monthsearlier, asclaimedby ZZZZ Bestpersonnel.

CONGRESSMAN LE~r: ... did you checkthe building permit or constructionpermit?

Mit. Gi~x: No, sir. Thatwouldn’tbe necessaryto accomplishwhatI wassettingout to accomplish.

CONGRESSMANLEr’rn Andyou did not checkwith thebuilding’s ownersto seeifan insuranceclaim hadbeenfiled?

MR. Gi~y: Sameanswer.It wasn’t necessary.I hadseenthe paperworkinter-nally of ourclient, the supportfor agreatamountof detail. So, I hadno needto ask—topursuethat.

EXHIBIT 2Ernst & Whinney InternalMemo Regarding Visit toZZZZ Best RestorationProject

TO: ZZZZ Best Co., Inc. File

FROM: LarryD.Gray .

RE: Visit to Sacramento Job

At our request, the Company arranged tor atour of the job site In Sacramento on November 23rd[1986].The site (not previously Identified for us because of the confidentiality agreement withtheir customer) had been informally visited by me on October 27.1 knew approximately wherethe job was, and was able to identify it through theconstruction activity goIng on.

On November 23, Mark Morse accompanied Mark Moskowitz of Hughes Hubbard & Reed andto Sacramento. We visited first the offices of the Building Manager, Mark Roddy of

Assured Property Management, Inc. Roddy was hired by the Insurance company (at TomPadgett’s suggestion according to Morse) to oversee the renovation activities and the leasing ofthe space. Roddy accompanied us to the btMng site.

We were informed that the damage occurred from the water storage on the roof of the building.The storage was for the sprinkler systems, but the water was somehow released in total, causingconstruction damage to floors 17 and 18, primarily in bathrooms which were directly under thewater holding tower, then the water spread out and flooded floors 16 down through about 5 cr6,where it started to spread out even further~ndbe held in poois.

We toured floor 17 briefly (It is currently occupied by a raw firm) then visited floor 12 (which hada considerable amount of unoccupied spa~i and floor 7. Morse pointed out to us the carpet,painting and clean up work which had been~ Best’s responsibility. We noted some work notdone In some other areas (and in unoccupied tenant space). But per Mark, this was not ZZZZBest’s responsibility rather was work being undertaken by tenants for their own purposes.

Per Morse (and Roddy) ZZZZ Best’s work Is substantially complete and has passed final Inspec-tion. Final sign-off Is expected shortly, with final payment due to ZZZZ Best iWearty December.

Morse was well versed In the building history and in the work scope for BesLThe tour wasbeneficial in gaining insight as to the scope of the damage that had occurred~d the type ofwork that the Company can do.


CONGRESSMANLENT You understandthatwhatyousaw wasnot anythingthatwas realin anysenseof theword?... You aresayingyouwereduped,areyounot?

&IR. GRAY: Absolutely.

Congressionaltestimony disclosedthat one of the visitations by Ernst &Whinney forced ZZZZ Bestto leaseapartially completedbuilding and to hiresubcontractorsto do aconsiderableamountof work on the site. In total, ZZZZBest spentseveralmillion dollarsfor thesolepurposeof deceivingits auditors.

The successof thebogussite visitationswas duein largepartto Minkow’s in-;istencethat Ernst & Whinney andZZZZ Best’s law firm sign confidentialitytgreementsbeforethevisits weremade.A copyof onesuchagreementis shownn Exhibit 3. Membersof the congressionalsubcommitteeweretroubledby theollowing stipulation of the confidentialityagreement:“We will not makeany0110w-uptelephonecalls to anycontractors,insurancecompanies,the building)wner, or otherindividualsinvolved in therestorationcontract.”This restriction~ffectivelvprecludedtheauditorsandattorneysfrom corroboratingtheinsurance-estorationcontractswith independentthirdparties.

RESIGNATION OF ERNST& WHINNEY

Ernst& WhinneyresignedasZZZZ Best’sauditoron June2, 1987,following ase-riesof disturbingeventsthatcausedthefirm to questiontheintegrity of Minkowandhis associates.First, Ernst & Whinneywasalarmedby a Los AngelesTimesarticle in mid-May 1987 that revealedMinkow hadbeeninvolved in a string of

EXHIBIT 3Ernst & Whinney’sConfidentialItyAgreement withZZZZ Best RegardingVisits to RestorationProjects

Mr. Barry Mlnl~, President

7040 Darby AvenueReseda, California ‘. 4

Dear Berry: ,

In connection with the proposed public offering (the Offering) of tJnfts consisting orcon man ~-.

stock and warrants of ZZZZ kst Co., Inc. (the Company), we have requested a tour of the site ofthe Company’s Insurance restoration project In Sacramento, California, Contract No. ¶8886.Subject to the representations~and~*arrant~esb*~e Company has agreed to arrange such atour, which will be conducted by a*r~itafl~ 1I~ssured Property Management Inc. (theRepresentative), which company is unaffillated ~ InterstateAppraisal Services. The under-signed, personally and on behalf of Ernst & Whinney, hereby represents and warrants that

1. We will not disclose the location of such building, or any other information with respect to theproject or the building, to any third parties or to any other members or employees of our firm;

2. We will not make any follow-up telephone calls to~y contractors, Insurance companies, thebuilding owner, or other Individuals Irivelved in the restoration project

3. We will obey all on-site safety and other rules and regulations established by the Company,Interstate Appraisal Services and the Representative,

4. The undersigned will be the only representative of this Firm present on the tour.This Confidentiality Letter Is aiso being furnished for the benefit of Interstate Appraisal Services, -‘

to the same satent as Wit were furnished directly to such company.


creditcard forgeriesas a teenager.Second,on May 28. 1987,ZZZZ Best issuedapressrelease,without consultingor notifying Ernst & Whinney, that reportedrecordprofits andrevenues.The purposeof this pressreleasewas to restgrein-vestors’confidencein the company—confidencethathad beenshakenby thedamagingLosAngelesTimesstory.Third, andmostimportant,on May 29, Ernst&Whinney auditors discoveredevidence supportingallegationsmadeseveralweeksearlier by a thirdparty informant that ZZZZ Best’sinsurancerestorationbusinesswas fictitious. The informanthadcontactedErnst& Whinneyin April I1987andaskedfor $25,000in exchangefor informationproving thatoneof thefirm’s clientswas engagingin a massivefraud.Ernst& Whinneyrefusedto paythe sum,andtheindividual recantedshortlythereafter,but not until the firm de-terminedthat the allegationinvolved ZZZZ Best. (Congressionaltestimonydis-closedthat the individual recantedbecauseof a bribepaidto him by Minkow.)Despitethe retraction,Ernst & Whinney questionedMinkow andZZZZ Best’sboard of directors regardingthe matter, at which point Minkow deniedeverknowingtheindividualwhohadmadethe allegation.OnMay 29,1987,however,Ernst& WhinneyauditorsdiscoveredseveralcancelledchecksthatMinkow hadpersonallywritten to the informantseveralmonthsearlier.

BecauseZZZZ Best was a public company,the resignationof its independentauditorwasrequiredto be reportedto the SECin an 8-K filing. Onepurposeofthisrequirementis to alert investorsandcreditorsof thecircumstancesthat mayhaveled to thechangein auditors.At the time,SEC registrantswereallowedfif-teendaysto file the 8-K auditorchangeannouncement.After waiting the maxi-mumpermissibletime, ZZZZ Bestreportedthe changein auditorsbut, despiteErnst& Whinney’sinsistence,madeno mentionin the 8-K of the fraudallegationthathadbeensubsequentlyrecanted.The SEC’s rulesthatwere in effect at thetime alsorequireda formeraudit firm to file an exhibit letter to a formerclient’s8-K commentingon the 8-K’s accuracyandcompleteness.Formeraudit firmsweregiventhirty daysto file the exhibit letter,whichwasthe lengthof timeErnst& Whinneywaitedbeforesubmittingits exhibit letter to the SEC. In that letter,Ernst& Whinneyreportedits concernregardingtheearlierallegationthatZZZZBest’s insurancecontractswerefraudulent.

The congressionalsubcommitteewasalarmedthat forty-five dayspassedbe-fore the chargesof fraudulentmisrepresentationsin ZZZZ Best’sfinancial state-mentsweredisclosedto the public. By the timeErnst& Whinney’sexhibit letterwas releasedto the public,ZZZZ Besthadfiled for protectionfrom its creditorsunderChapter11 of the federalbankruptcycode.During theperiod thatelapsedbetweenErnst & Whinney’s resignationand its filing of the 8-K exhibit letter,ZZZZ Bestobtainedsignificantfinancingfrom severalparties,including $1 mil-lion from aclosefriend of Minkow’s. Thesepartiesneverrecoveredthefundsin-vestedin, or loanedto, ZZZZ Best.As a direct resultof theZZZZ Bestdebacle,the SECshortenedthe lengthof time that registrantsand their formeraiqditorsmaywaitbeforefiling the requiredauditorchangedocumentswith theSEC.

The congressionalsubcommitteealsoquizzedErnst & Whinney representa-tivesregardingtheinformationtheydisclosedto PriceWaterhouse,the auditfirmhired by Minkow to replaceErnst & Whinney.3 CongressmanWyden was

3. PriceWaterhouseneverissuedanauditreporton ZZZZ Best’sfinancialstatementsbecausethecompanywasUquidatedlessthantwomonthsafterthataudit firm wasretained.

CASE 1.4 U~ BEST COMPANY, INC. 51

concernedthatPriceWaterhousehadnot receivedall relevantinformationthatErnst& Whinneyhadin its possessionregardingits formerclient.

CONGRESSMANWYDEN: I amgoing to insert into the recordatthis pointamemoentitled “Discussionwith successorauditor,”written by Mr. GrayanddatedJune9, 1987. RegardingaJune4 meeting,Mr. Gray, with Dan Lyle of PriceWaterhouseconcerningthe integrity of ZZZZ Best’smanagement,you statedthatyouhadno reportabledisagreementsandno reservationsaboutmanage-mentintegrity pendingthe resultsof aboardof directors’investigation.Thenyou wenton to say that you resignedbecause,and I quotehere:“We cameto aconclusionthatwe didn’t want to becomeassociatedwith the financialstatements.”

Is thatcorrect?Mi~. GRAY: That is correct.MR. WYDEN: .. . Mr. Gray,you told the committeestaff on May 29. 1987, that

whenyouuncoveredevidenceto supportallegationsof fraudthatyoudecidedto packup your workpapersandleavetheZZZZ Bestauditsite.How did yourleavingwithouttelling anybodyexcepttheZZZZ Bestmanagementandboardof directorsthe reasonsfor leavinghelpthe public andinvestors?

Ernst& Whinney’sreluctanceto discloseits reservationsregardingMinkow’s in-tegrityquitepossiblystemmedfrom concernthatsuchdisclosuresmightresultinMinkow suingtheaudit firm.4

A final twist to the ZZZZ Bestscandalwasan anonymousletter receivedbyErnst& Whinneyexactlyoneweekafter the firm resignedas ZZZZ Best’saudi-tors. On that date,no oneotherthanErnst& WhinneyandZZZZ Best’sofficerswasawareof the firm’s resignation.The letter, shownin Exhibit 4, detailedanumberof allegationssuggestingthat the ZZZZ Bestfinancial statementswerefraudulent.According to the congressionaltestimony,Ernst & Whinney for-wardedthis letter to the SECon June17,1987.

COLLAPSE OF ZZZZ BEST

When theextremetynegativeandrevealingarticle regardingMinkow appearedin the LosAngelesTimesin mid-May 1987, thecollapseof ZZZZ Bestwasproba-bly inevitable.Severalyearsearlier,a homemakerhadfallen victim to Minkow’scredit cardforgeries.Minkow hadaddeda fraudulentchargeto the credit cardslip thewomanhadusedto makea paymenton her account.Despiteher persis-tence,Minkow avoidedrepayingthe smallamount.Thewomanneverforgottheinsultandindustriouslytrackeddown,andkepta recordof, the individualswhohadbeensimilarly harmedby Minkow. At the urging of this individual, a re-porterfor the LosAngelesTimesinvestigatedherallegations.The woman’sdiaryeventuallybecamethe basis for the Los AngelesTimes article that, for the firsttime, cast doubt on the integrity of the “boy wonder”who was the talk of WallStreet.

4. For a discussionof this issueandrelatedissues,seeM.C. KnappandF.M. E~~•,~’AuditorChangesandInformationSuppression,”Researchin AccountingRegulation4(1990).3—20.

52 SECTION ONE COMPREI4!NS1VE CASES

EXHIBIT 4Anonymous LetterReceived by Ernst &Whinney RegardingZ~ Best

‘June 9, 1987 -‘‘~d ‘~‘

~.t v’~i-

Mr.GuyWllson ..

,Emst & WWmney ~ .. .. -

515 South Flower ALos Angeles, Calhfofflia 90021

Dear Mr. Wilson:V. ., Iform tio&~~~~42n the financial condItion of

I am an Individual having certaIn confidentIal in.~.....gZZZZ Best Co., Inc. have read the prospectus and your Review Report dated October 3, 1986and recognize you have not done an examination In accordance with generally accepted auditingstandards, but that such audit will be forthcoming by you.

I wish to make you aware of the following material facts which require you to confirm or disaffirm:

1.’The electric’ deneretors which appear on the balance sheet under Note Gas being purchasedfor $1,970,000 were purchased for scrapfor lees than $100,000 thru intermediariesof Z~ Bestand resold to ZZZZ Best at the Inflated value.The sole purpose was to boost the assets on thebalance sheet. These generators have never ~een,usedand have no utilIty to the company

2. Note 5 of the balance sh~et discusses Joint ventures and two restoration contracts. Thesecontracts are fictitious as are the bookkeeping entries to support their Ikity InterstateAppraisal Service [aiddid not let such contracts although they confirm their existence.The sameis true for the alleged $7,000,000 Sacramento contract and the $40—100 million contracts withInterstate.

3. Fuflher~ cheds made and passed between ~Z Best, its lofrut venturers and some ofItsvendors are no more thanb~nsactions among conspirators to uu~ppor~ th~ validity ofthese

4. EarnIngs reported by ZZZZ Bestare being reported as Billings in excess of costs and esti-mated earnings on restoration contracts. These contracts do not exist nor do the earnlngs~ Thiscan be confirmed direcfly bybontacting the afleg~d insurance carriers as well as physical inspec-tions as to the existence and extent of the contracts.

5. Billings and Earnings for ~985and 1988 were1~bricated by the company before beingpre-’sented to other accountants for certification. ~ ~,

cfuugence.Confirmation ofthese allegations can be accomplished by a Such due dill-gence on your behalf is Imperative for your protection. ..+‘~

Very truly yours.

B. Cautious(Signed)

The newspaperarticle triggereda chainof eventsthatquickly spelledtheendof ZZZZ Best.First,a smallbrokeragefirm specializingin newlyregisteredcom-panieswith suspiciousearningshistoriesbeganshort-sellingZZZZ Best stock,forcingthe stock’sprice into a tailspin. Second,Ernst& Whinney,ZZZZ Best’slaw firm, andZZZZ Best’sbrokersbegangiving morecredenceto the allegationsandrumors of financial wrongdoingby Minkow andhis associates.Third, andmostimportant,thearticlepanickedMinkow andcompelledhim to makeanum-berof daringmovesthatcosthim evenmorecredibility.Themostcritical mistake

CASE 14 BEST COMPANY, INC.

washis issuanceof the May 28, 1987,pressreleasethat boldly reportedrecordprofits andrevenuesfor his firm.

EPILOGUE

Amongthe partiesmost criticizedfor their roles in the ZZZZ BestscandalwasErnst& Whinney. Includedin the congressionaltestimonyinto the ZZZZ Bestfraud wasa list of ten “red flags” that the audit firm hadallegedlyoverlookedwhileexaminingZZZZ Best’sfinancial statements(seeExhibit 5). In testifyingbe-fore thesubcommittee,Leroy Gardner,theWestCoastdirectorof accountingandauditingfor Ernst& Whinney,maintainedthatwhen all the factswererevealed,his firm would be totally vindicated.

The ZZZZ Best situationprovesat leastonething: awell-orchestratedfraudwill oftensucceedevenagainstcareful, honest,hard-workingpeople. . The facts that havebegunto emergeestablishthatMinkow alongwith confederatesboth insideandout-sideZZZZ Bestwent to extraordinarylengthsto deceiveErnst& Whinney. For exam-ple, ThomasPadgett,an allegedconspirator,revealedin a recenttelevisedinterviewthatMinkow spent$4 million to deceiveErnst& Whinneyduringavisit to oneof ZZZZBest’s job sites. Ernst& Whinneynevermisled investorsabout the reliability ofZZZZ Best’s financialstatements.Ernst& Whinnevneverevenissuedanaudit opinionfor ZZZZ Best. We are not part of the problemin this case.We were part of thesolution.

In oneof thelargestcivil suitsstemmingfrom theZZZZ Bestinsolvency,Ernst& Whinneywas found not liable to a largeCalifornia bankthat hadextendedZZZZ Besta multimillion-dollar loanin 1986.Thebankallegedthat in grantingthe loan, it had relied upon the review report issuedby Ernst & WhinneyonZZZZ Best’sfinancial statementsfor thethree-monthperiodendingJuly31,1986.However,an appellatejudgeruled that thebank wasnot justified in relying on

EXHIBIT 5Ten Red Flags that ZZZZBest’s Auditors AllegedlyOverlooked

1. The amounts called for by the insurance restoration contracts were unreaflstically large.2- The number of multimillion-dollar Insurance restoration contracts reportedly obtained by

ZZZZ Best exceeded the total number available nationwide during the relevant time period.a The purported contracts failed to identify the insureds, the insurance companies, or the

lodatlons of the jobs.4. The contracts consisted of a sIngle page, whIch failed to contain details and specifications

of the work to be done, such as the square yardage of carpet to be replaced, which wereusual and customary in the restoration business.

5. VIrtually all of the insurance restoration contracts were with the same party.6. A large proportion of the ZZZZ Best insurance restoration contracts occurred immedIately.

‘and opportunistically, prior to a planned offering of stock.7. The purported contracts provided for payments to ZZZZ Best or MInkow alone rather than

to the insured or Jointly with ZZZZ Best and the Insured~ contrary to the practice of the In-dustry.

S. The purported contracts provided for payments by the Insurance adjustor contrary to normalpractIce In the industry under which payments are customarily made by the insurance com-pany directly to Its insured or Jointly to its Insured and the restorer.

9. ZZZZ Best’s purported gross profit margins for Its restoration business were greatly inex-cees of the normal profit margins for the restoration industr~

‘10. The Internal controls at ZZZZ Best were grossly inadequate.


thereviewreportsinceErnst& Whinneyhadexpresslystatedin the reportthatitwasnot issuingan opinionon the ZZZZ Bestfinancial statements:“Ernst,be-causeit issuedonly areviewreport,specificallydeclinedtoexpressan opiniononZZZZ Best’s financial statements.The reportexpresslydisclaimedany~ght torely on its content.”5In the late 1980s, the former stockholdersof ZZZZ Best filed a largeclassactionlawsuitagainstErnst& Whinney,ZZZZ Best’sformerlawfirm, andZZZZBest’s formerbrokers.An Internetpublicationreportedin March 1996 that thislawsuithadbeensettledprivately. The defendantsreportedlypaid the formerZZZZ Beststockholders$35million. However,thecontributionof eachdefendantto the settlementpool wasnot disclosed.6

In December1994,Barry Minkow wasreleasedfrom prison.Minkow earnedthe reductionin his twenty-five-yearprisonsentencefor “good behaviorandef-forts to improvehimself.”7 Theseefforts includedearningby correspondencebachelor’sandmaster’sdegreesin religion from Liberty University, the univer-sity foundedby JerryFalwell. Shortly after his releasefrom prisQn, Minkowbeganservingas the associatepastorof a largeevangelicalchurchin a commu-nity nearhis hometownof Reseda.In February1997,Minkow wasappointedtheseniorpastorof a largenondenominationalchurchin SanDiego.

Besideshispastoralduties,Minkow presentslecturesandseminarsacrosstheUnitedStateson how to preventanddetectfinancial fraud.Minkow hasspokento groupsof CPAs,educationalinstitutions,and,mostnotably,the FBI AcademyatQuantico,Virginia. Manyof theanecdotesincludedin Minkow’s presentationsaredrawn from his autobiography,Clean Sweep,whichwaspublishedin 1995byThomasNelsonPublishers.Finally, in 1996,Minkow beganhostinga syndicatedradio talk showin whichhediscusseshis personalviews on financial andspin-tualmatters.By late1997,approximatelyforty radiostationsscatteredacrossthenationbroadcastMinkow’s talk show.

QUESTIONS

1. Ernst& Whinneyneverissuedanauditopinionon the financialstatementsofZZZZ Best; however,Ernst & Whinney did issue a reviewreporton the com-pany’squarterly statementsfor the threemonthsendingJuly31, 1986.How doesa review differ from an audit,particularlyin termsof the level of assuranceim-plied by theauditor’s report?2. SASNo. 31, “Evidential Matter,” identifies five key managementassertionsthatunderliea setof financialstatements.In thecaseof ZZZZ Best,the existenceassertionwasparticularlycritical with respectto the insurancerestorationcon-tracts. ZZZZ Best’s auditorsobtainedthird party confirmationsto support thecontracts,reviewedavailabledocumentation,performedanalyticalprocedurestoevaluatethe reasonablenessof therevenuesrecordedon thecontracts,andvisited

5. “Ernst& YoungNot Liablein ZZZZ Best Case,”JournalofAccountancy172(July 1991),22.

6. C. Byron, “$26 Million in theHole,” Worth Online,March1996.

7. M. Matzer,“Barry Minkow,” Forbes, 15 August1994,134.


selectedrestoration.sites.Commenton the limitationsof the evidencethattheseproceduresprovidewith regardto themanagementassertionof existence.3. Besidesexistence,what other managementassertionorassertÿÿnsshouldZZZZ Best’sauditorshaveconsideredcorroboratingfor theinsurancerestorationcontracts?Whataudit procedureswould havebeenappropriateto substantiatetheseassertions?4. In testimonybeforeCongress,GeorgeGreenspanreportedthat onemeansheused to substantiatethe insurancerestorationcontractswas to verify thathisclientactuallyreceivedpaymenton thosejobs. How cansuchapparentlyreliableevidenceleadan auditor to animproperconclusion?5. Whatis the purposeof predecessor-successorauditorcommunications?Whichparty, the predecessoror successorauditor,hasthe responsibilityfor initiatingthesecommunications?Briefly summarizethe informationthat asuccessoraudi-tor shouldobtainfrom the predecessorauditor.6. Did theconfidentialityagreementthat Minkow requiredErnst & Whinneytosignimproperlylimit thescopeof theZZZZ Bestaudit?Why or whynot?Discussgeneralcircumstancesunderwhichconfidentiality concernson thepartof aclientmayproperlyaffect auditplanningdecisions.At what pointwould theselimita-tionsbe so significantas to affect thetype of audit opinion issued?7. Whatprocedures,if any,do professionalstandardsrequireauditorsto performwhenreviewinga client’s pre-auditbut post-year-endearningspressrelease?

zzzz best

Documents