|Subject Terms:||Repair & maintenance services|
Repair & maintenance services
|Classification Codes:||9520: Small businesses|
8340: Electric, water & gas utilities
8305: Professional services
|Companies:||ZZZZ Best CoDuns:11-880-2537|
ZZZZ Best Co
|Copyright Euromoney Publications PLC Nov 1995|
Everyone always said that Barry Minkow was one of a kind. It's just that, before he went to prison, those words were generally spoken as a compliment rather than a prayer. As it turned out, either meaning made good sense.
The US securities laws, written in the wake of the Great Depression, were intended to protect investors in public companies. The congressional committee that drafted the 1933 Securities Act noted that these laws would replace the rule of cayeat emptor with a prophylactic system that extended liability far beyond the issuer of securities to the underwriters, accountants and others whose expertise was referenced in the selling prospectus. The 1934 Exchange Act expanded liability to acts of fraud in the open market, and now serves as the basis for high-stakes claims against law firms, stock analysts, venture capitalists and virtually anyone else associated with a company where wrongdoing is alleged to have occurred.
The premise for such wide-ranging liability was simple. It has always been assumed that diligent bankers, lawyers and accountants could protect against the risk of fraud. One consequence of this legal presumption is that significant financial failures are now inevitably followed by a flood of class action lawsuits against any solvent entity that has been affiliated with an alleged wrongdoer. The Big Six accounting firms, for example, report that at least 10% of their revenues go to the defence or settlement of such cases. Another predictable result has been the creation of a costly and cumbersome securities litigation industry that wages epic legal battles over the precise scope of liability in these bet-your-company cases.
Great debate has focused on litigation reform and the wisdom of this vast expenditure of public and private resources. But substantially less attention has been paid to the underlying presumption that competent and honest professionals can protect investors from fraud. The story of Barry Minkow and his company, ZZZZ Best, is instructive as to the vulnerability of those who are presumed to be the protectors of the marketplace. The unfortunate lesson for these attorneys, accountants and bankers is that there may be very little that they can do to protect themselves from being the victims of a highly sophisticated fraud.
The classic entrepreneur
Barry Minkow was, in many respects, a classic entrepreneur. When he was a child in suburban Los Angeles, Barry's mother would save the expense of a babysitter by bringing Barry with her to work as a telephone sales person for a small carpet-cleaning operation. Before he was a teenager, Barry began making his own customer calls and soon established himself as a star salesman. Barry seemed to understand instinctively what it took to close a sale, including impromptu money-back guarantees, the promise of discounts and personal assurances of quality.
At the age of 15, Barry started his own carpet cleaning business, ZZZZ Best, paying rent to his father for use of the family garage. It was clear to the young Minkow that carpet cleaning was a potentially lucrative market with low barriers to entry, no recognized industry leader and numerous fly-by-night operators. With this high level of consumer demand and suspicion, Barry recognized that establishing public confidence in ZZZZ Best could be the key to his success.
A 1980s-style celebrity
The combination proved to be an ideal business environment for Barry, who was brilliant at generating publicity and instilling confidence. As a hard-driving teenager with his own start-up company, Barry became a 1980s-style celebrity who was featured on the Oprah Winfrey television show and in the pages of People magazine. Minkow was a charismatic speaker with an Horatio Alger life story who preached an unrelenting work ethic and a drive to be the best. While it was clear that this young entrepreneur was going places, no one could have imagined that those places would include Terminal Island and the Lompoc Penal Camp.
Of course, Barry also worked relentlessly to promote this image and his celebrity status. From his early days in business, long before he employed Wall Street lawyers and accountants, Barry had a publicist on retainer. Every new triumph of the ZZZZ Best empire was replayed for TV viewers and splashed across the pages of USA Today, Newsweek or Inc Magazine. When Barry Minkow met with private investors in early 1986 to raise cash for the expansion of his successful carpet cleaning business, they met a businessman who had been named one of the top entrepreneurs in the county, had spoken to sellout crowds at the Wharton School of Business, and offered glowing testimonials from dozens of other richly-rewarded investors. Of course, they were also meeting a businessman who was not yet old enough to buy a drink.
A natural predator
Years later, the federal prosecutor who obtained Minkow's criminal fraud convictions described him as a "natural predator." If so, Barry's natural talent included an understanding that fraud works best when it is based on irrefutable truth. The ZZZZ Best fraud did not last long, but it grew to multi-million dollar proportions because Barry was masterful at mixing fact and fraud, shifting the two so deftly that the illusion was complete. Even years later, his victims testified that they still couldn't understand why Barry had gone wrong. After all, it was apparent that he could have been a huge success in business without resorting to deceit.
For example, Barry's prodigous energy and acumen were legendary. He was a workaholic who, like the senior executives at GM (to which he likened ZZZZ Best), suffered an ulcer and worked himself to exhaustion. Like other responsible corporate citizens, ZZZZ Best contributed generously and conspicuously to the community. Minkow gave thousands of dollars to Narcanon and led a well-publicized anti-drug crusade (including a photo of Barry cleaning a carpet of pills, needles and contraband that was captioned: "My Act Is Clean. How's Yours?"). Like other successful young tycoons, Barry discovered a market niche and seized the opportunity to fill it.
Barry Minkow Day
Indeed, the ZZZZ Best carpet-cleaning business flourished for all the reasons that it should have succeeded. Barry's growing celebrity status (such as the City of Los Angeles proclaiming "Barry Minkow Day" in his honour) gave his company the name-recognition and credibility that the market craved. Barry's polished and professional advertising campaign kept demand throttled, and his highly motivated employees were trained as sales people and service providers. The fact is--and the grave concern for professionals must be--that America's most elaborate pyramid (or Ponzi) scheme was built on the base of a perfectly legitimate business.
The problem for Barry was that he simply was not content with a legitimate (and somewhat pedestrian) business. He wanted commanding wealth and power, and he thought he knew how to get it. Barry believed that he could steal enough money to create a bonafide business empire, pay off most of the suckers and exit gracefully. Of course, Barry also operated without conscience and was willing to risk a 25-year prison sentence if this strategy failed.
The making of a conman
As a teenager, Barry had been unable to obtain bank financing for his fleding company because he did not even have a driver's licence. This experience forced Minkow to seek start-up funding from local factors, and taught him several important lessons. Barry learned that he could raise money by pledging, or factoring, his accounts receivable for work under contract. Barry also recognized that his age cast him as the irresistible underdog, and served as the perfect excuse for his unproven track record and occasional mistakes. Perhaps most importantly, Barry realized that his ability to overcome institutional scepticism, and later to tell others of how he succeeded despite the doubters, made it all the easier to victimize subsequent institutional sceptics.
With his early success in promoting carpet-cleaning, it was a natural transition for Barry to go from building confidence to selling it. It also seemed natural for ZZZZ Best to expand from residential carpet cleaning into the lucrative insurance restoration business. Commercial buildings that were damaged by smoke, fire or water created a demand for quick-response cleanups on a large-scale basis. These jobs required far more up-front funding for carpeting, building and other supplies, but generated a healthy profit that was guaranteed by the applicable business interruption and commercial insurance policies.
It was not lost on any ZZZZ Best investor that Barry could penetrate the insurance restoration industry because he was masterful at establishing business and personal relationships. Witnesses later testified that Minkow could walk into an all-hands prospectus drafting session and charm each banker, lawyer, accountant and venture capitalist as if he were a chess grandmaster playing multiple boards. It came as no surprise, then, when Barry explained that he had established a close professional relationship with Tom Padgett, an independent insurance claims adjuster who had the authority to award large restoration contracts for several prominent carriers.
Investors learned from Barry how this relationship was profitable to both ZZZZ Best and Padgett's agency, Interstate Appraisal Services. Banry explained how he used their cash contributions to bargain for large-volume carpet discounts, confident that he could pass on his savings and secure a greater market share. Padgett bragged that his business was flourishing as well because the upstart ZZZZ Best was willing to respond to emergency calls day or night, saving his clients costly business interruption losses. As Barry and Padgett told investors, every successful restoration job made the next job even easier and more profitable.
With a Ponzi scheme, of course, Barry constantly needed to raise cash. He understood that it was possible to raise large sums based on his receivables, and he told investors that ZZZZ Best's expansion into the insurance restoration business provided both a constant demand for funding and the potential for huge profits. Barry also understood perfectly that his most fervent supporter was the investor who had been paid most recently, and that any investor who made a significant profit would clamour for the opportunity to invest even more.
The business did not exist
Although the insurance restoration business accounted for a majority of ZZZZ Best's revenues by 1986, there was a very significant problem with this segment: it didn't exist. There were thousands of pages of invoices, correspondence and payments, and plenty of very real cash apparently flowing from these jobs, but there were never any genuine insurance contracts. The only business conducted by Interstate Appraisal was as a showcase to deceive investors or investigators.
Likewise, ZZZZ Best had abundant documentation to support every penny of its steady profit stream, but all of it was phony. Each job file folder was bulging with contracts, cost accountings and receipts for raw materials, all carefully manufactured on misappropriated or falsified letterhead. ZZZZ Best offered photos of its prior work and thank you letters from satisfied customers, and its early financial statements had been audited by a genuine firm that specialized in start-up businesses. Moreover, because Barry was so successful in funding new projects, delighted investors continued to reap profits on what they thought were the existing restoration contracts.
Unlike most Ponzi scheme operators, Barry did not intend to take the money and run when the pyramid's exponential growth outstripped the supply of fesh cash. Barry's solution was to conduct a multi-million dollar public offering that would give him money that he was not required to pay back. If he could use the public's money to repay most of his private investors, and then build a genuine carpet-cleaning enterprise, Minkow was sure he could gradually ease out of the phony restoration business. Indeed, if ZZZZ Best's stock performed well, there would be plenty of opportunities for legitimate deals and less need for bogus restoration jobs.
The ZZZZ Best insiders who went to prison all believed that Barry missed getting away with this multi-million dollar fraud by approximately 48 hours. Although there is a strong argument that suspicions would inevitably have led to a discovery of the fraud, it is undeniable that ZZZZ Best had been investigated by the Securities and Exchange Commission (SEC), the Federal Bureau of Investigation (FBI), private detectives and dozens of attorneys, accountants and investment bankers without any such finding. The grim reality for these professionals is that their conventional due diligence techniques were simply no match for this highly developed fraud, and that the collapse of the ZZZZ Best Ponzi scheme was triggered by mere chance.
Defeating due diligence
To pull off the ultimate fraud--to "find the cure" as Barry said--meant that this 20 year-old wunderkind had to take on Wall Street. Minkow's exit strategy required a public offering followed by an active market for ZZZZ Best shares. This, in turn, required the deception of sophisticated investment bankers, lawyers and accountants. As Barry lamented later, it surely would have been easier (and cheaper) if he just could have bribed these professionals.
But Barry realized that what he needed most was the credibility derived from an affiliation with professionals who could not be compromised. ZZZZ Best's success and community standing gave Barry initial access to a Wall Street law firm and premier accountants, which he knew were precisely the credentials that he could take to the bank. Barry was also prepared to do anything, spend anything, and risk anything to victimize these professionals.
In 1986, when the due diligence investigation of ZZZZ Best began, Barry launched a multi-million dollar campaign of deception. When the professionals wanted to see the contracts, receipts, invoices and other supporting paperwork for the insurance restoration revenues, Barry gave them more than 16,000 fabricated documents. When the professionals wanted verification of Tom Padgett's position in the industry, Barry was able to bribe a manager at Crawford & Co, the country's largest independent insurance adjuster, to vouch for Padgett and Interstate Appraisal Services. The accountants dutifully sent out dozens of contract verification requests to suppliers and subcontractors, all of which were returned (with the appropriate postmarks) by confederates in the coverup.
No expense spared
Although Barry attempted to restrict the involvement of the accountants by retaining them for only a limited review rather than an audit, he spared no expense in disguising the insurance restoration fraud. When the accountants and lawyers said they wanted to inspect ZZZZ Best's largest restoration job, Minkow and his agents found a newly renovated high-rise in Sacramento that fit perfectly the building they had described. Phoney blueprints and construction permits were created, and Padgett gave the professionals a full tour of his local offices (borrowed for the occasion) and the building site, access to which had been obtained by payments to security guards (who greeted Padgett, on cue, as the professionals arrived).
Once the ZZZZ Best insiders had committed multiple felonies, the risk of not continuing their deception became greater than the danger of plunging ahead. So, for example, when the accountants surprised Minkow in early 1987 with another request for an inspection of a specific insurance restoration job, Barry felt he had no choice. In one frenzied week, Minkow had to find and gain access to a building in downtown San Diego that could support his claim of a new multi-story restoration project in that city.
Barry struck gold at 4th Street and Cedar. At that location in the heart of the San Diego business district was the framework of a building that had been under construction. After the skeleton was erected and several floors built out, the developer of the building project had gone bankrupt. When Barry stumbled onto the site, it looked exactly as if it were a building that had just survived a fire on the upper floors, which were then being cleared out by ZZZZ Best crews.
When the accountants came to inspect the San Diego site Minkow was well prepared. He gained control of the site by promising to buy the property, and had filled a nearby warehouse with hundreds of rolls of carpeting. There were ZZZZ Best trucks parked at the site, and workers wearing the company's T-shirts. When the accountants finished the San Diego inspection in January 1987, they had personally toured two significant ZZZZ Best restoration jobs of their choosing (as well as several smaller fabrications) and had seen for themselves everything that the paperwork documented.
No deception too extravagant
By this point, no detail was too small and no deception too extravagant for Barry. To impress a bank's loan officers, Minkow hired away one of their promising junior employees at twice his salary and sequestered him to a legitimate part of the ZZZZ Best business. To ensure that his Harvard Law Review attorney would get a supportive message at home, Barry carefully built a social relationship with the lawyer's wife and family, and celebrated holidays and their children's birthdays together. To fortify the image of Tom Padgett as an important insurance industry executive, Barry had Padgett casually contribute $100,000 to the movie project of a Beverly Hills investor. But not even Minkow could have anticipated the audacity of his final illusion.
Three months after the accountants made their initial visit to the San Diego site, they shocked ZZZZ Best by announcing their plan to revisit the job site so that they could see the completed renovations. Although Barry had twice miraculously found buildings that matched his description of jobs in Sacramento and San Diego, he now faced the prospect of his accountants returning to the same 4th and Cedar location to which he no longer had access. ZZZZ Best had, of course, never actually bought the building and the owners of the 4th and Cedar property were furious with Minkow for having disappeared after his earlier promises. Even more terrifying to Minkow was the fact that no work had ever been done to any of the floors that supposedly were renovated by ZZZZ Best.
A good fraud can beat a good audit
All of which goes to show that a good fraud can beat a good audit every time. Minkow's stock had gone from $4 per share to $18, and Drexel Burnham Lambert was about to finance a buyout by ZZZZ Best of the nation's largest retail carpet cleaning franchise. Barry was worth more than $100 million, and he knew that if he could fool the professionals one more time, there were surely more deals and profits ahead. Besides, if he failed to perpetuate the fraud, Barry would be a 21 year-old phenomenon facing a 25 year prison sentence. For Minkow, the decision to spend more than $2 million in just two weeks to deceive the accountants was simply a "no-brainer".
Barry flew overnight to Colorado to apologize to the owners of the San Diego property for the prior "misunderstanding" and to pay $500,000 in cash, in advance, for a six-month lease. A team of architects was retained, expedited plans were approved, and three construction crews immediately began working around the clock. When the accountants returned to 4th & Cedar, just 20 days after they had announced their plans to do so, they toured a newly (and authentically) renovated building. No one could fault them for believing Barry when he bragged about the company's lightning-quick response to a renovation emergency; it was true. In fact, the only detail that was not planned in advance nonetheless managed to reinforce the deception. The owner's representative unexpectedly walked up to the tour and enthusiastically complemented ZZZZ Best for the fine work it had done.
The price of victimization
Two days before the scheduled May 1987 close of the $40 million Drexel-financed acquisition, the Los Angeles Times ran a story about credit card overcharges by a Minkow-owned flower shop that had occurred two years earlier. The report was not news. During the December 1986 public offering, Minkow had explained the incident as theft by employees, for which he promptly made repayments to the overcharged customers and fired the wrongdoers. But the newspaper report nonetheless sent ZZZZ Best's stock price skidding. This stock drop, while unrelated to the restoration fraud, forced Barry to tell additional lies about how he had jump-started his carpet cleaning business.
As it turned out, nobody ever uncovered the Ponzi scheme. Barry ultimately quit in exhaustion when he concluded that its collapse was inevitable. Barry had survived private investigators, the FBI and SEC, but the professionals had insisted upon an independent investigation to clear the air and the accountants then resigned when they grew suspicious of Barry's explanations. Although by June 1987 it was too late for Barry to stem the tide, he never lost his touch. Barry retained another (then) Big Eight accounting firm, which worked for more than a month on ZZZZ Best's year-end audit without ever discovering the fraud. Then, less than one week before Barry walked away from ZZZZ Best in shame and scandal, he convinced one of his board members to give him $1 million to invest in a non-existent restoration project.
Eleven ZZZZ Best insiders were eventually convicted for duping the professionals, but this only meant that the true wrongdoers were insolvent and never a target of the class action litigation that followed. These lawsuits claimed $129 million in damages and focused almost exclusively on the deep pocket professionals. Under the Ninth Circuit's proportionate fault rule of Franklin v Kaypro, the pre-trial settlements with these convicted felons did not lessen the disproportionate effect of joint and several liability for the institutional defendants. Because the culpable individuals paid nothing in settlement, their settlements were not accompanied by an order barring contribution actions against them. Thus, if there had been a finding of liability against any solvent defendant, the entire damage award could have been collected from this party (who would then have been left with uncollectible claims against the real perpetrators).
The sad conclusion for professionals may be that there is no safeguard, in fact or in law, against the likes of Barry Minkow. The emerging field of fraud auditing has shown the utility of specialized financial inquiry when wrongdoing is suspected, but this provides little help in the absence of red flags. Experienced fraud detectors concluded that an exemplary due diligence inquiry could not have penetrated a scheme so intricate that the US Attorney's office was never able to determine how much money had been stolen. Although Barry Minkow managed to deceive the prominent law and accounting firms for less than a year, his fraud subsequently permitted one set of his victims (assisted by class counsel that traditionally collects 33% of any recovery) to prosecute claims for more than seven years against the bankers, lawyers and accountants that were identified by both Barry Minkow and law enforcement agencies as another set of Minkow's victims.
It is unclear whether the securities laws will continue to expose professionals to such massive fmancial risks that are beyond their ability to control. In the ZZZZ Best securities litigation, Judge Ronald Lew read very narrowly the Supreme Court's recent decision in Central Bank of Denver that eliminated aider and abettor liability under section 10(b) of the 1934 Exchange Act. Although other courts have since criticized Judge Lew's ruling, the ZZZZ Best decision permitted primary liability claims to go forward based on an alleged affiliation with wrongdoers rather than any alleged misstatement or omission attributable to the professionals. Similarly, proposals to limit joint and several liability have been included in several legislative packages, but it remains to be seen whether there will be any significant change in this inherently disproportionate allocation system.
After 89 months, the most time served by any white-collar criminal, Barry Minkow is now out of prison. Indeed, he has returned to the Oprah Winfrey show (and to Tom Snyder, Phil Donahue and others), is back in the bookstores (Clean Sweep) and is again prominent on the lecture circuit (the FBI has hired Barry to instruct at several bank fraud seminars). Minkow insists that religion has changed his life and that he will never go back to the highflying fraud of ZZZZ Best. You can be certain that there are plenty of bankers, accountants and attorneys who fervently hope that Barry's conversion is permanent. After all, at the age of 29, his career may have just begun.