CASE 1.9

ZZZZ Best Company, \nc.

On May 19,1987,a short article in The WallStreetJournal reported thatZZZZ BestCompany,Inc.,of Reseda,California,had signed a contract for a $13.8million insur-ance restorationproject.This project was just the most recent of a series of largerestorationjobs obtained by ZZZZ Best (pronounced "zee best"). Located in theSan FernandoValleyof southernCalifornia,ZZZZBesthad begun operationsin thefall of 1982as a small,door-ta-doorcarpet cleaning operation.Under the directionof Barry Minkow,the extroverted16-year-oldwho founded the company and ini-tially operated it out of his parents' garage,ZZZZ Best experienced explosivegrowthin both revenuesand profitsduring the firstseveralyearsof its existence.Inthe three-yearperiod from 1984to 1987,the company's net income surged fromlessthan$200,000to more than $5 million on revenuesof $50million.

When 72ZZ Bestwent public in 1986,Minkow and severalof his close associatesbecamemultimillionairesovernight.By the late spring of 1987,the marketvalue ofMinkow'sstockin thecompanyexceeded$100million,while thetotalmarketvalueof72ZZ Bestsurpassed$200million.The youngestchief executiveofficer in the nationenjoyedthe"goodlife;which includedan eleganthome in an exclusivesuburbof LosAngelesand a fire-enginered Ferrari.Minkow's charm and entrepreneurialgeniusmadehim a sought-aftercommodityon the televisiontalk show circuit and causedtheprintand visualmediato touthim asan exampleof whatAmerica'syouth couldattainif they would only apply themselves.During an appearanceon The OprahWinfreyShow inApril 1987,Minkow exhortedhispeerswith evangelisticzeal to"Thinkbig,be big"and encouragedthemto adopt his personalmotto,"Thesky is the limit~

Less than two years after appearing on Oprah, Barry Minkow began serving a25-yearprison sentence.Tried and convicted on 57 counts of securities fraud,Minkow had been exposed as a fast-talkingcon artist who swindled his closestfriendsand Wall Streetout of millions of dollars.Federalprosecutorsestimatethat,ata minimum,Minkow cost investorsand creditors $100million.The company thatMinkow founded was, in fact,an elaborate Ponzi scheme.The reported profits ofthe firm were nonexistentand the large restorationcontracts, imaginary.As onejournalistreported,ratherthan building a corporation,Minkow createda hologramof a corporation.In July 1987,just three monthsafterthe company'sstock reacheda marketvalue of $220million,an auction of its assetsnettedonly $62,000.

Unlike most financial frauds, the ZZZZ Best scam was perpetrated under the

watchful eyeof the Securitiesand Exchange Commission (SEC).The SEC,a largeand reputableWestCoast law firm thatservedas the company'sgeneralcounsel,aprominentWall Streetbrokeragefirm,and an internationalpublic accounting firmall failed to uncover Minkow's daring scheme.Ultimately,the persistence of an

indignanthomemakerwho had been bilked out of a few hundred dollars by ZZZZBestresultedin Minkow being exposedas a fraud.

How a teenageflimflam artistcould makea mockery of the complex regulatorystructurethatoverseesthe U.S.securities marketswas the central question posed

by a congressional subcommittee that investigated the ZZZZ Best debacle.Thatsubcommitteewas headed by RepresentativeJohn D.Dingell,chairman of theU.S.House Committee on Energy and Commerce.Throughout the investigation,

109

SECTION ONE COMPREHENSIVE CASES

RepresentativeDingell and his colleagues focusedon the role the company'sinde-pendent auditors played in the ZZZZBestscandal.

TheZZZZBestprospectustoldthepublicthatrevenuesandearningsfrominsurancerestorationcontractswereskyrocketingbutdid not revealthatthe contractswerecompletelyfictitious.Wherewere theindependentauditorsand theothersthatarepaid toalertthepublictofraudanddeceit?t

Like many other daring financial frauds,the ZZZZBestscandal caused Congressto reexaminethe maze of rules that regulatefinancial reporting and serve as thefoundation of the U.S. system of corporate oversight. However, Daniel Akst, areporter for The Wall StreetJournal who documented the rise and fall of BarryMinkow,suggestedthatanother ZZZZ Best was inevitable."Changing the account-ing rules and securitieslaws will help,but everynow and then a Barry Minkow willcome along,and ZZZZBestwill happen again.Such fraudsare in the naturalorderof things,I suspect,as old and enduring as human needs.,,2

The Early History of ZZZZBest CompanyBarry Minkow was introduced to the carpet cleaning industry at the age of 12 byhis mother,who helped makeends meet by working as a telephonesolicitor for asmall carpet cleaning firm.Although the greatmajorityof companies in the carpetcleaning industryare legitimate,the natureof the businessattractsa disproportion-ate number of shady characters.There are essentially no barriers to entry: nolicensing requirements,no apprenticeships to be served, and only a minimalamount of start-upcapital is needed.A l6-year-oldyouth with a driver'slicense caneasily become what industry insiders refer to as a "rug sucker,"which is exactlywhat Minkow did when he founded ZZZZ BestCompany.

Minkow quickly learned that carpet cleaning was a difficult way to earn a liveli-hood. Customercomplaints,ruthlesscompetition,bad checks,and naggingvendorsdemanding paymentcomplicated the young entrepreneur'slife.Within months ofstrikingout on his own,Minkow faced the ultimatenemesisof thesmall businessper-son: a shortageof working capital.Becauseof his age and the fact thatZZZZ Bestwas only marginally profitable,local banks refused to loan him money.Ever re-sourceful,the brassyteenagercame up with his own innovativewaysto finance hisbusiness:check kiting,credit card forgeries,and the stagingof theftsto fleece hisinsurancecompany.Minkow's age and personal charm allowed him to escape un-scathedfrom his earlybrusheswith the law thatresultedfrom his creativefinancingmethods.The ease with which the "system"could be beaten encouraged him toexploit it on a broaderscale.

Throughout his tenurewith ZZZZ Best,Minkow recognizedthe benefitsof havingan extensivesocial network of friends and acquaintances.Many of these relation-ships he developedand cultivatedat a Los Angeles health club.After becoming afriend ofTom Padgett,an insuranceclaimsadjuster,Minkow deviseda schemeto ex-ploit thatfriendship.Minkow promisedto pay Padgett$100perweek if he would sim-ply confirm over the telephoneto banks and any other interestedthird partiesthatZZZZBestwasthe recipientof occasional insurancerestorationcontracts.Ostensibly,Minkow had obtained thesecontractsto clean and do minor remodelingwork onpropertiesdamaged by fire,storms,or other catastrophes.Minkow convinced the

1. This and all subsequentquotations,unless indicated otherwise,were taken from the following source:

U.S.Congress,House,Subcommittee on Oversightand Investigationsof the Committeeon EnergyandCommerce,Faitureof ZZZZBest Co. (Washington,DC: U.s.GovernmentPrinting Office, 1988).

2. D.Akst,WonderBoy,Barry Minkow- The Kid Who Swindled WallStreet(New York:Scribner,1990),271.

gullible Padgettthatthesole purposeof the confirmationswas to allow ZZZZBesttocircumventmuchof thebureaucraticred tapein the insuranceindustry.

Fromthismodestbeginning,theZZZZBestfraud blossomed.Initially,Minkow usedthe phony insurancerestorationcontractsto generatethe paperprofitsand revenueshe neededto convince bankersto loan him money.Minkow's phony financial state-mentsservedtheirpurpose,and he expandedhis operationsby openingseveralcar-pet cleaningoutletsacrosstheSan FernandoValley.Minkow soon realizedthattherewas no need to tie his future to the cutthroat carpet cleaning industry when hecould literallydictatethesizeand profitabilityof his insurancerestoration"business:'Within a short period of time,insurancerestoration,ratherthan carpetcleaning,be-came themajorsource of revenueappearingon ZZZZBest'sincome statements.

Minkow's"thesky is the limit"philosophy drove him to be evenmore innovative.The charmingyoungentrepreneurbeganusinghis bogus financial statementsto en-tice wealthyindividuals in his ever-expandingsocial networkto investin ZZZZBest.Eventually,Minkow recognizedthatthe ultimatescam would be to takehis companypublic, a move that would allow him to tap the bank accounts of unsuspectinginvestorsnationwide.

CASE 1.9 ZZZZ BEST COMPANY, INC.

111(

Going Public with ZZZZBestMinkow's decision to take ZZZZ Best public meant that he could no longer com-pletely control his firm's financial disclosures.Registeringwith the SEC requiredauditors,investmentbankers,and outside attorneysto peruse ZZZZ Best'speriodicfinancial statements.

ZZZZBestwas firstsubjectedto a full-scopeindependentaudit for the 12monthsended April 30, 1986.GeorgeGreenspan,the sole practitionerwho performed thataudit,confirmed the existenceof ZZZZ Best'smajor insurance restorationcontractsby contactingTom Padgett.Padgettserved as the principal officer of InterstateAppraisal Services,which reportedlycontracted the jobs out to ZZZZ Best.By thistime,Padgettwas an activeand willing participantin Minkow's fraudulentschemes.Minkow establishedInterstateAppraisalServicesand Assured PropertyManagementfor thesole purposeof generatingfakeinsurancerestorationcontractsfor ZZZZBest.

In testimonybefore the congressionalsubcommitteethat investigatedthe ZZZZBestscandal,Greenspaninsistedthathe had properly audited Minkow's company.Greenspantestifiedthatwhile planning the 1986audit he had performed variousanalyticalproceduresto identifyunusual relationshipsin ZZZZBest'sfinancial data.These procedures allegedly included comparing ZZZZ Best'skey financial ratioswith industrynorms.Regardingthe insurancecontracts,Greenspantestifiedthathehad obtained and reviewedcopies of all key documents pertaining to those jobs.However,Greenspanadmittedthathe had not inspectedany of the insurancerestora-tion sites.

Congressman Lent: Mr Greenspan,I aminterestedin theSECForm5-1thatZZZZBestCompanyfiledwiththeSEC ... Yousayin thatreportthatyoumadeyourexaminationin accordancewithgenerallyacceptedauditingstandardsandaccordinglyincludedsuchtestsof theaccountingrecordsandotherauditingproceduresaswe considernecessaryin thecircumstances....Youdon'tsayin thatstatementthatyoumadeanypersonalon-siteinspections.

Mr. Greenspan: It'snotrequired.Sometimesyoudo;sometimesyoudon't.1wassatisfiedthat tl7esejobs existedand I was satisfied from at leastsixdifferentsources,includingpaymentforthejob.Whatcouldyouwantbetterthanthat?

SECTION ONE COMPREHENSIVE CASES

Congressman Lent: Yourpositionis thatyouareanhonestandreputableaccountant.

Mr. Greenspan: Yes,sir.

Congressman Lent: Youwereasmucha victimassomeoftheinvestorsin thiscompany?

Mr. Greenspan: I wasa victimall right.... I amasmuchaghastasanyone.And everynightI sitdownandsay,whydidn'tI detectthisdamnedfraud.

Retention of Ernst& Whinney by ZZZZBestShortlyafterGreenspancompleted his audit of ZZZZBest'sfinancial statementsforfiscal 1986,which ended April 30,1986,Minkow dismissedhim and retainedErnst&Whinney to perform the following year'saudit.Apparently,ZZZZ Best'sinvestmentbanker insistedthatMinkow obtain a Big Eightaccountingfirm to enhancethecred-ibility of thecompany'sfinancial statements.At approximatelythesametime,andforthe same reason,Minkow retaineda high-profileLos Angeles law firm to representZZZZBestas its legalcounsel.

The congressionalsubcommitteeaskedGreenspanwhat informationhe providedto Ernst & Whinney regarding his former client. In particular,the subcommitteewanted to know whether Greenspandiscussed the insurance restorationcontractswith the new auditors.

Congressman Wyden: iHr. Greenspan,inSeptember1986,Ernst& WhinneycarneonasthenewindependentaccountantforZZZZBest.WhatdidyoucommunicatetoErnst& Whinneywithrespecttotherestorationcontracts?

Mr. Greenspan: Nothing.I did-there was nothingbecausetheynevergotin touchwithme.It'sprotocolforthenewaccountanttogetin touchwiththeoldaccountant.Theynevergotin touchwithme,andit'sstilla mysterytome.

Representativesof Ernst& Whinney latertestifiedthattheydid, in fact,communicatewith Greenspanprior to accepting ZZZZ Best as an audit client. However,Ernst &Whinney did not comment on the nature or content of that communication.(Greenspanwas not recalled to rebutErnst& Whinney'stestimonyon this issue.i

Exhibit 1 contains the engagementlettersigned by Ernst & Whinney and BarryMinkow in September 1986.The engagementletteroutlined four services that theaudit firm intendedto provide ZZZZBest:a reviewof the company'sfinancial state-mentsfor the three-monthperiod ending July 31,1986;assistancein the preparationof a registrationstatementto be filed with the SEC;a comfort letterto be submittedto ZZZZBest'sunderwriters;and a full-scopeaudit for the fiscalyearendingApril 30,1987.Ernst & Whinney completed the review,provided the comfort letterto ZZZZBest'sunderwriters,and apparentlyassistedthe company in preparingthe registra-tion statementfor the SEC; however,Ernst & Whinney never completed the 1987audit.The audit firm resignedon June 2, 1987,amid growing concerns thatZZZZBest'sfinancial statementsweregrosslymisstated.

The congressionalsubcommittee investigatingthe ZZZZ Best fraud questionedErnst& Whinney representativesat length regardingthe bogus insurancerestorationcontracts-contracts thataccounted for 90 percentof ZZZZBest'sreportedprofits.

3. After a lengthy investigation,theAmerican Instituteof Certified Public Accountants ruled in 1998thattherewas no "prima facie evidence"that Greenspan had violated theorganization'sCode of ProfessionatConduct during the time thatZZZZ Bestwas his client. A similar conclusion was reached by two stateboards of accountancy with which Greenspan was registeredto practice public accounting.

CASE 1.9 ZZZZ BEST COMPAr-IY. I"c. 113

September 12, 1986

Mr. Barry MinkowChairman of the Board

ZZZZBest Co., Inc.

7040 Darby AvenueReseda, California

Dear Mr. Minkow:

This letter is to confirm our understanding regarding our engagement as independent

accountants of ZZZZBEST CO., INC. (the Company) and the nature and limitations of the

services we will provide.

We will perform the following services:

1. We will review the balance sheet of the Company as of July 31, 1986, and the related

statements of income, retained earnings, and changes in financial position for the three

months then ended, in accordance with standards established by the American Institute of

Certified Public Accountants. We will not perform an audit of such financial statements, the

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:

"We have made a review of the condensed consolidated balance sheet of ZZZZBEST CO.,

INC. and subsidiaries as of July 31. 1986, and the related condensed consolidated

statements of income and changes in financial position for the three-month period

ended July 31, 1986, in accordance with standards established by the AmericanInstitute of Certified Public Accountants. A review of the condensed consolidated

financial statements for the comparative period of the prior year was not made.

A review of financial information consists principally of obtaining an understanding

of the system for the preparation of interim financial information, applying analytical

review procedures to financial data, and making inquiries of persons responsible for

financial and accounting matters. It is substantially less in scope than an examination

in accordance with generally accepted auditing standards, which will be performed for

the full year with the objective of expressing an opinion regarding the financial

statements taken as a whole. Accordingly, we do not express such an opinion. Based on

our review, we are not aware of any material modifications that should be made to thecondensed consolidated interim financial statements referred to above for them to be

in conformity with generally accepted accounting principles."

Our engagement cannot be relied upon to disclose errors, irregularities, or illegal acts,

including fraud or defalcations, that may exist. However, we will inform you of any suchmatters that come to our attention.

2. We will assist in the preparation of a Registration Statement (Form S-l) under the

Securities Act of 1933 including advice and counsel in conforming the financial statements

and related information to Regulation S-X.

3. We will assist in resolving the accounting and financial reporting questions which will arise

as a part of the preparation of the Registration Statement referred to above.

4. We will prepare a letter 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 data.

(continued)

EXHIBIT 1

ERNST 8.:WHlr-I1\EY'S

ZZZZ BESTE:\GAGBIEi'\TLETTER

CASE 1.9 ZZZZ BEST COMPANY, INC. 113

September 12, 1986

Mr. Barry MinkowChairman of the Board

ZllZ Best Co., lnc.

7040 DarbyAvenueReseda, California

Dear Mr. Minkow:

This letter is to confirm our understanding regarding our engagement as independent

accountants of ZZZZBEST CO., lNe. (the Company) and the nature and limitations of the

services we will provide.

We will perform the following services:

1. We will review the balance sheet of the Company as of July 31, 1986, and the related

statements of income, retained earnings, and changes in financial position for the three

months then ended, in accordance with standards established by the American Institute of

Certified Public Accountants. We will not perform an audit of such financial statements, the

objective of which is the expressing of an opinion regarding the financial statements taken asa whole, and, accordingly, we will not express an opinion on them. Our report on the financial

statements is presently expected to read as follows:

"We have made a review of the condensed consolidated balance sheet of ZZZZBEST CO.,

INe. and subsidiaries as of July 31, 1986, and the related condensed consolidated

statements of income and changes in financial position for the three-month period

ended July 31, 1986, in accordance with standards established by the AmericanInstitute of Certified Public Accountants. A review of the condensed consolidated

financial statements for the comparative period of the prior year was not made.

A review of financial information consists principally of obtaining an understanding

of the system for the preparation of interim financial information, applying analytical

review proceduresto financial data, and making inquiries of persons responsible for

financial and accounting matters. It is substantially less in scope than an examination

in accordance with generally accepted auditing standards, which will be performed for

the full year with the objective of expressing an opinion regarding the financial

statements taken as a whole. Accordingly, we do not express such an opinion. Based on

our review, we are not aware of any material modifications that should be made to thecondensed consolidated interim financial statements referred to above for them to be

in conformity with generally accepted accounting principles."

Our engagementcannot be relied upon to disclose errors, irregularities, or illegal acts,

including fraud or defalcations, that mayexist. However, we will inform you of any suchmatters that come to our attention.

2. We will assist in the preparation of a Registration Statement (Form S-l) under the

Securities Act of 1933 including advice and counsel in conforming the financial statements

and related information to Regulation S-X.

3. We will assist in resolving the accounting and financial reporting questions which will arise

as a part of the preparation of the Registration Statement referred to above.

4. We will prepare a letter for the underwriters, if required (i.e., a Comfort Letter), bearing in

mind the limited nature of the work we have done with respect to the financial data.

(continued)

EXHIBIT 1

ERNST & WHINNEY'SZZZZ BESTENGAGEMENT

LETTER

114

EXHIBIT 1-continued

ERNST & WHINNEY'SZZZZ BESTENGAGEMENTLETTER

SECTION ONE C()MI'REIIE"'~IVEC\~E~

5. We will examine the consolidated financial statements of the Companyas of April 30, 1987,

and for the year then ended and issue our report in accordance with generally accepted

auditing standards approved by the American Institute of Certified Public Accountants. These

standards contemplate, among other things, that (1) we will study and evaluate the Company's

internal control system as a basis for reliance on the accounting recordsand for determining

the extent of our audit tests; and (2) that we will be able to obtain sufficient evidential matter

to afford a reasonable basis for our opinion on the financial statements. However,it should be

understood that our reports will necessarily be governed by the findings developed in the

course of our examination and that we could be required, depending upon the circumstances,

to modify our reporting from the typical unqualified opinion. We will advise you, as our

examination progresses, if any developments indicate that we will be unable to expressan

unqualified opinion. Because our examination will be performed generally on a test basis, it

will not necessarily disclose irregularities, if any, that may exist. However,we will promptly

report to you any irregularities which our examination 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

our work. Among these are the general condition of the accounting records, the amount of

assistance received from your personnel in the accumulation of data, the size and transaction

volume of business, any significant financial reporting issues that arise in connection with

the SEe's review of the 5-1. as well as unforeseen circumstances. Based upon our current

understanding of the situation, the amount of our proposed billing for the various services

which we will be providing are estimated to be:

Review of the July 31, 1986 financial statements

Assistance in the preparation of the Registration StatementComfort Letter

Audit of financial statements as of April 30, 1987

$ 5,000-$7,5008,000-30,0004,000-6,000

24,000-29,000

We will invoice you each month for the time charges and expenses incurred in the previous

month and such invoices are due and payable upon presentation.

Larry D. Gray, Partner, is the Client Service Executive 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 be

pleased to discuss them with you. Please indicate your acceptance of the above arrangements

by signing and returning the enclosed copy. This letter constitutes the full understanding of

the terms of our engagement.

Very truly yours,

Ernst & Whinney

By Larry D. Gray, PartnerACCEPTED:

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

9/16/86

Congres.

To convince Ernst & Whinney that the insurance restorationcontracts were au-thentic,Minkow plottedand carried out a seriesof stingoperationsthatcollectivelycost millions of dollars.In the latefall of 1986,Larry Gray,the engagementaudit part-ner for ZZZZBest,told client personnelthathe wantedto inspecta restorationsiteinSacramentoon which ZZZZBesthad reportedobtaining a multimillion-dollar con-tract.Minkow sent two of his subordinatesto Sacramentoto find a large buildingunder constructionor renovationthatwould providea plausiblesite for a restorationcontract.Grayhad visitedSacramentoa few weeksearlier to search for the site thatMinkow had refusedto divulge.As chance would haveit,the building chosen by theZZZZBestconspiratorswas thesameone Gray had identified as the mostlikely siteof the insurancerestorationjob.

Minkow's two confederatesposed as leasing agentsof a property managementfirm and convincedthesupervisorof the constructionsite to providethe keysto thebuilding one weekendon the pretextthata large,prospectivetenantwished to tourthe facility.Prior to the arrivalof Larry Grayand an attorneyrepresentingZZZZBest'slaw firm,Minkow'ssubordinatesvisited the site and placed placards on the walls atconspicuous locations indicatingthatZZZZ Bestwas the contractor for the buildingrenovation.No detailswere overlookedby the two co-conspirators.They even paidthe building'ssecurityofficer to greetthe visitorsand demonstratethathe wasawarein advanceof their tour of the site and its purpose.Although the building had notbeen damagedand insteadwassimply in the processof being completed,the stingoperationwent off as planned.Exhibit 2 presentsthe memorandumGray wrote de-scribing his tour of the building-a memorandum included in Ernst & Whinney'sZZZZBestworkpapers.

Congressionalinvestigatorsquizzed Gray regardingthe measureshe took to con-firm thatZZZZBestactuallyhad a restorationcontracton the Sacramentobuilding.They wereparticularlyconcerned thathe neverdiscoveredthe building had not suf-feredseveralmillion dollars in damagesa few months earlier,as claimed by ZZZZBestpersonnel.

CASE 1.9 ZZZZ BEST COMPANY, INC.

1I5(

Congressman Lent: Didyoucheckthebuildingpermitorconstructionpermit?

Mr. Gray: No,sir Thatwouldn'tbenecessarytoaccomplishwhatI wassettingouttoaccomplish.

Congressman Lent: Andyoudidnotcheckwiththebuildings ownerstoseeifoninsuranceclaimhodbeenfiled?

Mr. Gray: SomeanswerIt wasn'tnecessaryI hadseenthepaperworkinternallyofourclient,thesupportfora greatamountofdetail.So,I hodno needtoask-to pursuethat.

Congressman Lent: Youunderstandthatwhatyousaw wasnotanythingthatwasrealin anysenseof theword?... Youaresayingyouwereduped,areyounot?

Mr. Gray: Absolutely

Before allowing Ernst & Whinney auditors to visit a bogus restorationproject,Minkow insistedthat the firm sign a standard confidentiality agreement.Exhibit 3presentsa copy of that agreement.Members of the congressionalsubcommitteewere troubledby the following stipulationof the confidentialityagreement"Wewillnot makeanyfollow-uptelephonecalls to any contractors,insurancecompanies,thebuilding owner,or other individuals involved in the restorationcontract:'Thisrestric-tion effectivelyprecluded the auditors from corroboratingthe insurance restorationcontractswith independentthirdparties.

116

EXHIBIT 2

ERNST & WHINNEYINTERNAL MEMO

REGARDING VISIT

TO ZZZZ BESTRESTORATION

PIW.lECT

SECTION ONE COMPREHENSIVE CASES

TO: ZZZZBest Co., Inc. File

FROM: Larry D. Gray

RE: Visit to Sacramento Job

At our request, the Company arranged for a tour of the job site in Sacramento on November

23rd [1986]. The site (not previously identified for us because of the confidentiality

agreement with their customer) had been informally visited by me on October 27. I knew

approximately where the job was, and was able to identify it through the constructionactivity going on.

On November 23, Mark Morse accompanied Mark Moskowitz of Hughes Hubbard & Reed and

myself to 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 Tom

Padgett's suggestion according to Morse) to oversee the renovation activities and the leasing

of the space. Roddy accompanied us to the building 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, causing construction damage to floors 17 and 18, primarily in bathrooms which weredirectly under the water holding tower, then the water spread out and flooded floors 16 down

through about 5 or 6, where it started to spread out even further and be held in pools.

We toured floor 17 briefly (it is currently occupied by a law firm) then visited floor 12 (whichhad a considerable amount of unoccupied space) and floor 7. Morse pointed out to us the

carpet, painting and clean up work which had been ZZZZBest's responsibility. We noted some

work not done 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 ownpurposes.

Per Morse (and Roddy) ZZZZBest's work is substantially complete and has passed final

inspection. Final sign-off is expected shortly, with final payment due to ZZZZBest in earlyDecember.

Morse was well versed in the building history and in the work scope for ZZZZBest. The tour

was beneficial in gaining insight as to the scope of the damage that had occurred and thetype of work that the Company can do.

Resignation of Ernst& WhinneyErnst& Whinney resignedas ZZZZBest'sauditor on June 2. 1987.following a seriesof disturbingeventsthatcaused the nrm to question Barry Minkow'sintegrity.First.Ernst& Whinneywasalarmedby a Los Angeles 7l'mesarticle in mid-May1987thatre-vealed Minkow had been involved in a stringof credit card forgeriesas a teenager.Second.on May28,1987,ZZZZBestissueda pressrelease,withoutconsultingor noti-fying Ernst& Whinney,that reportedrecord prontsand revenues.Minkow intendedthis pressreleaseto restoreinvestors'confidence in the company-conndence thathad been shaken by the damagingLos Angeles 7/'messtory.Third.and most impor-tant, on May 29, Ernst & Whinney auditors discovered evidence supportingallegationsmade severalweeks earlier by a third-partyinformant thatZZZZ Best'sinsurancerestorationbusinesswas nctitious.

Dear Barry:

1. We will not disclose the location of such building, or any other information with respect to

the project or the building, to any third parties or to any other members or employees of ourfirm;

Mr. Barry Minkow, PresidentZZZZBest Co., Inc.

7040 Darby AvenueReseda, California

1

,

'I"r

117

EXHIBIT 3

ERNST & WHINNF.Y'SC

SECTION ONE COMPREHENSIVE CASES

beforesubmittingitsexhibit letterto theSEe. In thatletter,Ernst& Whinney revealedthatZZZZBest'sinsurancecontractsmightbe fraudulent.

The congressionalsubcommitteewasalarmed that45dayshad passedbeforethechargesof fraudulentmisrepresentationsin ZZZZ Best'sfinancial statementsweredisclosed to the public.By the time theSEC releasedErnst& Whinney'sexhibit letterto the public,ZZZZ Besthad filed for protection from itscreditorsunder Chapter 11of the federal bankruptcy code. During the period that elapsed between Ernst &Whinney'sresignationand the public releaseof its 8-K exhibit letter,ZZZZBestob-tained significant financing from severalparties,including $1 million from one ofMinkow's close friends.These parties never recovered the funds invested in, orloaned to,ZZZZ Best.As a direct resultof the ZZZZBestdebacle,the SEC shortenedthe length of time that registrantsand their former auditors may wait before filingauditor change documents.

The congressionalsubcommitteealso quizzed Ernst& Whinney representativesre-garding the information they disclosed to Price Waterhouse,the audit firm Minkowretainedto replaceErnst& Whinney.4CongressmanWydenwantedto know whetherErnst & Whinney had candidly discussed its concerns regardingMinkow'sintegritywith PriceWaterhouse.

Congressman Wyden: I amgoingtoinsertintotherecordatthispointa memoentitled"Discussionwithsuccessorauditor,"writtenbyMr.GrayanddatedJune 9, 1987.RegardingaJune 4 meeting,Mr.Gray.withDanLyleofPriceWaterhouseconcerningtheintegrityofZZZZBest'smanagement,youstatedthatyouhadno reportabledisagreementsandno reservationsaboutmanagementintegritypendingtheresultsofa boardofdirectors'investigation.Thenyouwenton tosaythatyouresignedbecause,andIquotehere:"Wecametoa conclusionthatwe didn'twanttobecomeassociatedwiththefinancialstatements."

Is thatcorrect?

Thatis correct.Mr. Gray:

Mr. Wyden: ... Mr.Gray.youtoldthecommitteestaffonMay29,1987,thatwhenyouuncoveredevidencetosupportallegationsof fraudthatyoudecidedtopackupyourworkpapersandleavetheZZZZBestauditsite.How didyourleavingwithouttellinganybodyexcepttheZZZZBestmanagementandboardofdirectorsthereasonsforleavinghelpthepublicandinvestors?

A final twistto the ZZZZBestscandal was an anonymousletterErnst& Whinneyreceivedone weekafterthe firm resignedasZZZZBest'sauditor.At thattime,no oneother than Ernst& Whinney and ZZZZBest'sofficerswasawareof the firm'sresigna-tion.The letter,shownin Exhibit4,contained severalallegationssuggestingthatZZZZBest's financial statementswere fraudulent.According to the congressional testi-mony,Ernst&Whinney forwardedthis letterto theSEC on June 17,1987.

Collapse of ZZZZBestThe Los Angeles Times article published in mid-May 1987that disparaged BarryMinkow ultimatelydoomed the young entrepreneurand his company.Severalyearsearlier,a homemakerhad fallen victim to Minkow'screditcard forgeries.Minkow hadadded a fraudulentcharge to a credit chargeslip the woman had used to makea

4. Price Waterhousenever issuedan audit reporton ZZZZBest'sfinancial statements.ZZZZBestwasliquidated lessthan two monthsafterPrice Waterhousewas retained.

CASE '.9 2222BEST COMPANY, \NC. "9

June 9, 1987

Mr.GuyWilson

Ernst& Whinney515SouthFlower

LosAngeles,California90021

DearMr.Wilson:

I amanindividualhavingcertainconfidentialinformationregardingthe financialconditionofllllBestCo.,Inc. I havereadthe prospectusandyourReviewReportdatedOctober3, 1986andrecognizeyouhavenot donean examinationin accordancewith generallyacceptedauditingstandards,but that suchauditwill be forthcomingbyyou.

I wishto makeyouawareof the followingmaterialfactswhichrequireyouto confirmordisaffirm:

1. Theelectricgeneratorswhichappearon the balancesheetunderNote6 as beingpurchasedfor $1,970,000werepurchasedfor scrapfor lessthan $100,000thru intermediariesof llll Bestandresoldto llll Bestat the inflatedvalue.Thesolepurposewasto boosttheassetsonthe balancesheet.Thesegeneratorshaveneverbeenusedandhaveno utility tothecompany.

2. Note5 of the balancesheetdiscussesjoint venturesandtwo restorationcontracts.Thesecontractsarefictitiousasarethebookkeepingentriesto supporttheirvalidity.InterstateAppraisalService[sic]did not let suchcontractsalthoughtheyconfirmtheir existence.Thesameis truefor thealleged$7,000,000Sacramentocontractandthe $40-100millioncontractswith Interstate.

3. Further,checksmadeandpassedbetweenllll Best,its joint venturersandsomeof itsvendorsarenomorethantransactionsamongconspiratorsto supportthevalidityof theserestorationcontracts.

4. Earningsreportedbyllll Bestarebeingreportedas Billingsin excessof costsandestimatedearningson restorationcontracts.Thesecontractsdo not existnordo theearnings.Thiscanbeconfirmeddirectlybycontactingthe allegedinsurancecarriersaswell as physicalinspectionsasto theexistenceandextentof the contracts.

5. BillingsandEarningsfor 1985and1986werefabricatedbythe companybeforebeingpresentedto otheraccountantsfor certification.

Confirmationof theseallegationscanbeaccomplishedbya carefulduediligence.Suchduediligenceon yourbehalfis imperativefor yourprotection.

Verytrulyyours,

B. Cautious

(Signed)

paymenton her account. Despite her persistence,Minkow avoided repaying thesmall amount.The woman never forgot the insult and trackeddown, and kept arecord of, individualswho had been similarly harmed by Minkow.At the urging ofthis woman,a reporterfor the Los AngelesTimes investigatedher allegations.The

EXHIBIT 4

ANONYMOUS LETTER

RECEIVED BY

ERNST & WHINNEYREGARDING ZZZZBEST

6. C.Byron,'$26 Million in the Hole," WorlhOnline,March 1996.

7.M.Matzer.'Barry Minkow:' Forbes.15 August 1994.1:~4.

8.ISickinger,'Ex-Con Artist Helps Find Fraud." TheKansas CilySlar.IS October 1995.Bl.

1. Theamountscalledfor bythe insurancerestorationcontractswereunrealisticallylarge.

2. Thenumberof multimillion-dollarinsurancerestorationcontractsreportedlyobtainedby

Zlll Bestexceededthetotal numberavailablenationwideduringthe relevanttimeperiod.

3. Thepurportedcontractsfailedto identifythe insuredparties,the insurancecompanies,orthe locationsof thejobs.

4. Thecontractsconsistedof a singlepagewhichfailedto containdetailsandspecificationsof theworkto bedone,suchasthe squareyardageof carpetto bereplaced,whichwereusualandcustomaryin the restorationbusiness.

5. Virtuallyall of theinsurancerestorationcontractswerewith thesameparty.

6. A largeproportionof theZZZZBestinsurancerestorationcontractsoccurredimmediately,andopportunistically,priorto a plannedofferingof stock.

7. Thepurportedcontractsprovidedfor paymentsto ZZZZBestor Minkowaloneratherthanto theinsuredorjointly with ZZZZBestandthe insured,contraryto the practiceof theindustry.

8. Thepurportedcontractsprovidedfor paymentsby the insuranceadjustorcontrarytonormalpracticein the industryunderwhichpaymentsarecustomarilymadeby theinsurancecompanydirectlyto its insuredorjointly to its insuredandthe restorer.

9. ZZZZBest'spurportedgrossprofitmarginsfor its restorationbusinessweregreatlyin

I excessof thenormalprofitmarginsfor the restorationindustry.i10. Theinternalcontrolsat ZZZZBestweregrosslyinadequate.L..

121

EXHIBIT 5

TEN RED FLAGS

THAT ZZZZBEST'S AUDITORS

ALLEGEDLY

OVERLOOKED

pastorof a largenondenominationalchurch inSan Diego.Besideshis pastoralduties,Minkowservesas thespokespersonfor an Internetcom-pany,the Fraud DiscoveryInstitute,which mar-kets various fraud prevention and detectionservices.

Minkow regularlypresentslecturesand semi-nars acrossthe United Statesthat focus on his

"experience"with corporate fraud.He has spo-ken to groupsof CPAs,educational institutions,and,mostnotably,the FBIAcademyatQuantico,Virginia. Minkow, who typically delivers hislectures while dressed in an orange prisonjumpsuit,often chastisesthe accountantsandauditors in his audience.During one presenta-tion, Minkow noted that."CPAsare creaturesofhabit.You're interestedin making tick marksand footnotes,not in thinkingoutsidethebox:'sMinkow also chides auditors for being overly

ZZZZ BEST COMPANY. INC.CASE 1.9

Iy1995,Minkowbeganservingas theatepastorofan evangelicalchurch in anitynearhishometownof Reseda.Twoater,Minkowwas appointed the senior

stockholders$35million. However,the contri-butionof eachdefendant to the settlement

'P901wasnotdisclosed.6,BarryMinkowwas releasedfrom prison in

late1994.Minkowsecuredthe reduction in his

.~s.yearprisonsentencefor"goodbehaviorand:ffortsto improvehimseW7 These efforts in-~udedearningby correspondencebachelor's

d master'sdegreesin religion from Libertyri~ersity.Shortlyafterbeing paroled.Minkow

iedayoungwomanintroducedto him byfellowinmate.Thatinmatewasa formersub-

""i\:

IrdinateofCharlesKeating.the principal archi-ofthemassiveLincoln Savingsand Loan

120

ISECTION ONE COMPREHENSIVE CASES

woman'sdiary eventuallybecamethe basisfor theLos AngelesTimesarticlethat,forthe firsttime,castdoubt on theintegrityof the"boywonder"who wasthetalk ofWallStreet.

The newspaperarticle triggereda chain of eventsthat caused ZZZZ Best to col-lapse and disappear less than three months later.First,a small brokeragefirm spe-cializing in newly registeredcompanies with suspicious earnings histories beganshort-sellingZZZZBeststock,forcing thestock'sprice into a tailspin.Second,Ernst&Whinney,ZZZZBest'slaw firm,andZZZZBest'sinvestmentbankerbegangivingmorecredence to the allegationsand rumorsof financial wrongdoingby Minkow and hisassociates.Third, and most important,the article panicked Minkow and compelledhim to make severaldaring moves that cost him even more credibility.The mostcritical mistake was his issuance of the May 28, 1987,press release that boldlyreportedrecord profitsand revenuesfor his firm.

EPILOGUE

Among the partiesmostvilified for their role inthe ZZZZ Best scandal was Ernst & Whinney.TIle transcriptsof the congressional testimonyfocusingon the ZZZZBestfraud included a listof 10 "red flags"that the audit firm had al-legedly overlooked while examining ZZZZBest'sfinancial statements(seeExhibit 5).Ernst& Whinney officials flatly rejected assertionsthat their firm was even partially to blame forthe ZZZZBest fiasco.In his congressionaltesti-mony,LeroyGardner,theWestCoastdirectorofaccounting and auditing for Ernst & Whinney,maintained that when all the facts were re-

vealed,his firm would be totallyvindicated:

TheZZZZBestsituationprovesat leastonething:a well-orchestratedfraud will oftensucceedevenagainstcareful,honest,hard-workingpeople.... Thefactsthathavebegunto emergeestablishthatMinkow,alongwithconfederatesboth insideand outsideZZZZBest,went to extraordinarylengthsto de-ceiveErnst& Whinney.Forexample.ThomasPadgett,an allegedconspirator,revealedin arecenttelevisedinterviewthatMinkowspent$4 millionto deceiveErnst& Whinneydur-ing a visitto oneofZZZZBest'sjob sites....Ernst & Whinneynever misled investorsaboutthereliabilityof ZZZZBest'sfinancialstatements.Ernst & Whinneynever even

issuedan auditopinionforZZZZBest.... Weare notpart of theproblemin thiscase.Wewerepartof thesolution.

In one of the largestcivil suitsstemmingfromthe ZZZZBest fraud,a court ruled thatErnst&Whinney was not liable to a large Californiabank thathad extendedZZZZ Besta multimil-

lion-dollar loan in 1986.The bank alleged thatin grantingthe loan, it had relied upon the re-view reportissuedby Ernst&Whinneyon ZZZZBest'sfinancial statementsfor the three-month

period ending July 31,1986.However,an appel-late judge ruled thatthe bank was not justifiedin relying on the review report since Ernst &Whinney had expresslystatedin the reportthatit was not issuingan opinion on the ZZZZBestfinancial statements."Ernst,because it issuedonly a reviewreport,specificallydeclined to ex-pressan opinion on ZZZZBest'sfinancial state-ments.The report expressly disclaimed anyrightto relyon itscontent."s

In the late 1980s,ZZZZ Best'sformer stock-

holders filed a class-actionlawsuitagainstErnst& Whinney,ZZZZ Best'sformer law firm, andZZZZBest'sformer investmentbanker.An Inter-

net publication reported in March 1996thatthis lawsuit had been settled privately.The de-fendantsreportedlypaid the formerZZZZBest

5. "Ernst&Young Not Liable in ZZZZ BestCase;'Journal ofAccountancy.July 1991,22.

SECTION ONE COMPREHENSIVE CASES

willing to acceptweak formsof audit evidence,such as client representations.He warns audi-tors,"Don'tgiveup objectivityforconvenience."g

Journalists frequentlyinterview Minkow andask for his views on corporate fraud and re-lated issues.In January 2005, Minkow gavethefollowing responsewhen he was askedby CFOMagazine whether the Sarbanes-OxleyAct of

Questions

2002 would likely serve to mitigate or detercorporate fraud:"Let me tell you why this legis-lation is brilliant.Sarbox hit at a common de-

nominator of corporate fraud: bypassing sys-temsof internalcontroLI would not havebeen

able to perpetrate the ZZZZ Best fraud ifI had not been able to bypass the internalcontrols."10

1. Ernst& Whinney neverissuedan audit opinion on financialstatementsof ZZZZBestbutdid issuea reviewreporton thecompany'squarterlystatementsfor thethreemonthsended July 31, 1986.How does a reviewdiffer froman audit,particularlyin termsof the levelof assuranceimplied by theauditor'sreport?

2. SASNo. 106,'Audit Evidence;'identifiesthe principal"managementassertions"thatunderliea setof financial statements.The occurrence assertionwasparticularlycritical for ZZZZBest'sinsurancerestorationcontracts.ZZZZBest'sauditorsobtainedthird-partyconfirmationstosupport thecontracts,reviewedavailabledocumentation,performedanalyticalproceduresto evaluatethereasonablenessof the revenuesrecordedon the contracts,and visitedselectedrestorationsites.Commenton the limitationsof theevidencethatthese

proceduresprovidewith regardto the managementassertionof occurrence.

3. In testimonybeforeCongress,GeorgeGreenspanreportedthatone methodheused to audit the insurancerestorationcontractswasto verifythathis clientactuallyreceivedpaymenton thosejobs.How can such apparentlyreliableevidencelead an auditor to an improperconclusion?

4. What is thepurposeof predecessor-successorauditorcommunications?Which

party,thepredecessoror successorauditor,has theresponsibilityfor initiatingthesecommunications?Brieflysummarizethe informationthata successorauditorshould obtain fromthe predecessorauditor.

5. Did theconfidentialityagreementthatMinkow requiredErnst& Whinney to signimproperlylimit thescope of the ZZZZBestaudit?Why or why not?Discussgeneralcircumstancesunder which confidentialityconcerns on thepartof aclient mayproperlyaffectaudit planningdecisions.At whatpoint do client-imposedauditscope limitationsaffectthe typeof audit opinion issued?

6. Whatprocedures,if any,do professionalstandardsrequireauditorsto performwhen reviewinga client'spre-auditbut post-year-endearningspressrelease?

9. Ibid.

10. CFO Magazine, "TenQuestions for Barry Minkow,"CFO.com, I January 2005.