Marketing

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Introduction

Most small businesses fail in their first five years. Hindsight reveals that ZZZZ Best should have been among them. How did Barry Minkow take a small carpet cleaning service, run from his parents’ garage, to a multimillion dollar public stock offering by the time he was 21 years old?

humble Beginnings

In 1981, high school sophomore Barry Minkow began ZZZZ Best (pro-nounced “zee best”), a small carpet cleaning business, in his family’s garage.

He learned about carpet cleaning as a child, first from accompanying his mother to work and later working for the carpet cleaning business where his mother was employed. Barry Minkow possessed charm, energy, and intel-ligence. He instinctively understood personalities and generally made a posi-tive impression on everyone he met. He was not completely polished, but this passed for innocence, which was an important aspect of his mystique. He was young, with little education and no inherited wealth. He worked hard, and by the time he graduated from high school he led a rapidly growing company (Akst 1990).

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Contents

Introduction ...81 Humble Beginnings ...81 A Public Offering ... 82 ἀ e Scheme Unravels ... 86 How Did It Happen? ... 88 Minkow Today ... 89 Conclusion ... 89 References ... 90

ἀ e business he started at age 15 grew into a public company with a peak market value exceeding $211 million (Akst, July 9, 1987, 1). ἀ e phe-nomenal growth of his company allowed him to move out of his parents’

modest home into a condominium when he was 19. Not long afterwards, he bought a 3,600-square-foot Spanish-style house in a gated community (Akst 1990, 76). Minkow’s taste was extravagant, and his ego was enormous. He acquired numerous luxury automobiles. His Ferrari had a “ZBest” license plate. He gave extravagant gifts and hosted extravagant parties. He required that everyone in his office, including his mother (who worked for him), call him Mr. Minkow.

Very early on, the company incurred losses and Minkow had trouble meeting payroll. He borrowed first from banks, then from questionable con-tacts with ties to organized crime. By the time this credit ran out, his debts were so large that only a public stock offering would cover them.

From all appearances, the business grew quickly. Minkow repeatedly vowed to make his company the “General Motors of carpet-cleaning” (Akst 1989, 126). By 1985 the company reported that it was expanding into the building restoration business. During 1985 and 1986, ZZZZ Best reported high profits from several large restoration projects.

A Public offering

When ZZZZ Best stock was offered to the public, it quickly became one of the hottest stocks on Wall Street. Barry Minkow enjoyed enormous popu-larity. He was recognized by the Young Entrepreneurs Organization as one of the 100 top entrepreneurs in America. He also received two commenda-tions from Los Angeles Mayor Tom Bradley. ἀ e first praised Minkow as a fine entrepreneurial example for obtaining the status of a millionaire at the age of 18; the second, which came later, recognized his philanthropy. Mayor Bradley also declared Saturday, November 8, 1986, Barry Minkow Day (Akst 1990, 10). Minkow was featured in Newsweek and in USA Today, as well as many other newspapers. He appeared on the Oprah Winfrey Show (Akst 1990, 181).

Minkow facilitated his company’s public stock offering by merging ZZZZ Best into Morningstar Investments, a public Utah shell corporation that ZZZZ Best would ultimately control. In this way, the company could quickly and cheaply become a public concern “without all the expensive, embarrass-ing and time-consumembarrass-ing disclosures that would be required if it tried to go public by itself” (Akst 1990, 86–87). However, as Minkow began the process of going public, it was necessary to involve independent auditors and Wall Street attorneys. During the public-offering process, Ernst & Whinney con-ducted a review of the ZZZZ Best financial statements for the quarter ended

July 31, 1986, with the promise of an audit to come. ἀ us, Ernst & Whinney’s name appeared in the prospectus (Akst 1990, 169). However, audited ZZZZ Best financial statements were never produced.

Minkow convinced auditors and attorneys that his business was legiti-mate. He produced documentation to support the earnings reported in ZZZZ Best financial statements. ἀ ough he never had an accounting class, he understood the importance of documentation in the audit process. Minkow described one of his associates as a master of the copy machine: Mark Morze could make any document; as long as it could be copied, Morze could produce it (Association of Certified Fraud Examiners 1991). Further, the quality of his work was exceptional (Akst 1990, 135). Morze helped Minkow produce ficti-tious invoices, checks, and restoration contracts. With them, Minkow pro-vided documentation to support fictitious claims that customers owed ZZZZ Best for services. Legitimate accounts receivable would have been collected in a fairly short period of time. Cash that would be collected thus represents a significant asset. ἀ e accounts receivable reported by ZZZZ Best, however, did not exist.

One reason that Minkow’s scheme worked for a time was that he also understood the auditor’s process for verifying accounts receivable. When one of his customers was contacted for confirmation of a receivable, Minkow knew it because the customers were fictitious. He had created numerous front companies as his customers and as his suppliers as well. Correspondence to these companies ultimately came to him. When a confirmation was sent, Minkow complained to the auditors that they were interfering with his busi-ness and that they would cause him to lose a large contract. He threatened to take his audit elsewhere, using the competitive environment for accounting and auditing services of the 1980s to his advantage. ἀ e auditor did not want to report to his managing partner that he had lost a major audit client or that a client was planning to sue the auditing firm for loss of business.

Minkow further manipulated audit procedures by documenting subse-quent payment of the fictitious receivables. Subsesubse-quent payment is important in substantiating the validity of accounts receivable. If a customer subse-quently pays an account receivable, the payment provides confirmation that the customer did, in fact, owe the company.

However, in the case of ZZZZ Best, the subsequent payments were part of a kiting scheme. Unlike the customer confirmations, Minkow did not object to the auditors’ verification of bank account balances. His kiting scheme supported the information found in the bank statements. Kiting is a com-monly used method of overstating cash by recording the same cash twice or, in Minkow’s case, three or four times. A kiting scheme involves writing, but not recording, a check on one bank account near the end of the period, then depositing the check in another bank account, being sure that the deposit is made late enough in the period so that the check does not clear the first

account until after the end of the period. Such a scheme should be revealed by the auditor’s tests of interbank transfers (Arens, Elder, and Beasley 2003).

For ZZZZ Best, there is no indication that the auditors’ tests, which would have revealed the kiting scheme, were conducted. Minkow so often resorted to check kiting to create funds that for his 21st birthday his cronies gave him a giant kite with a blowup of a check on it (Akst 1990, 117).

ZZZZ Best would raise money from investors, banks, or anyone else and then pay the money out to Marbil Marketing, supposedly an employment contractor that hired workers to perform the ZZZZ Best restoration jobs awarded by Interstate Appraisal. Marbil would recycle the money back to ZZZZ Best. Both Marbil and Interstate were private companies and there-fore beyond the scrutiny required of a public company. Checks were paid to ZZZZ Best from Interstate Appraisal for restoration work performed. ἀ e checks, by design, matched deposit slips; this was part of the scheme to fool the auditors. In 1986, about $10 million moved between Marbil and ZZZZ Best; in the first half of 1987, the amount was $44 million. In this way, Barry and his friends made it appear that his company was generating revenue and receiving payments like a legitimate business (Akst 1990, 106). Purportedly, Interstate Appraisal provided the lucrative refurbishing jobs that accounted for nearly 90 percent of ZZZZ Best revenue, while Marbil Management was serving as a contractor working on restoration jobs on behalf of ZZZZ Best.

Examiners later described this scheme as a “monstrous check kite” and a

“cash racetrack” (Akst 1990, 222).

Minkow also manipulated the auditors by establishing social contacts with them and their wives. He later said that he had wanted the auditors’

wives to see him as a “nice kid” so that if the auditor expressed concern about ZZZZ Best, the wife would come to his defense. He also diverted the audi-tors’ attention by seeking their advice about improving a particular store’s performance (Association of Certified Fraud Examiners 1991).

Another tactic Minkow used was to steer auditors to the legitimate part of his business, his carpet cleaning. As long as they focused on his carpet-cleaning business, they dealt with a work force that was not involved in the fraud. Only upper management was part of the fraud team. Minkow tried to shift attention away from the restoration business, which generated 80 percent of the reported income, citing confidentiality agreements with his custom-ers. It was only because of the auditors’ insistence that Minkow reluctantly consented to an auditor’s visit to a $7 million restoration site in Sacramento.

Since there was no restoration project, Minkow dispatched two of his assis-tants, Tom Padgett and Mark Roddy, to scope out a likely site. Upon arrival in Sacramento, they soon discovered that only one building in the city was large enough to have $7 million damage. ἀ ey quickly leased the space and cre-ated Assured Property Management, complete with office, furniture, phones, and copying privileges. ἀ e fictitious firm was supposedly in the business of

looking after the interests of the insured party in restoration jobs, and it pro-vided Roddy the credibility to represent the building’s owners, managers, and insurers, each of whom would prove troublesome if contacted directly by the auditor. Several props were positioned to make the space appear to be legiti-mate, including a ZZZZ Best tee shirt, and all was prepared for the visit of the auditor and an attorney (Akst 1989, 126–127). ἀ e independent auditor agreed in writing “not to disclose the location of the site to anyone, even at their own firms.” ἀ e letter also stated that he would “not make any follow-up telephone calls to any contractors, insurance companies, the building owner, or other individuals (other than suppliers whose names have been provided to this firm by the Company) involved in the restoration project” (Akst 1990, 151). ἀ e auditor was left with no objective means to verify that actual restora-tion work was occurring; contact was permitted only for fake companies that were within the control of Minkow and his fraudulent associates.

ἀ e auditor later insisted on visiting another site on which restoration had purportedly just begun. Padgett and Roddy were again dispatched, this time to San Diego. A building was located, and the auditor’s visit was hast-ily arranged. When ZZZZ Best reported that the project was nearly done, the auditor insisted on seeing it again. Minkow and his team went to great lengths to lease the same building and arrange for a contractor to wire, dry-wall, paint, carpet, and otherwise complete six floors of office space in ten days (Askt 1989, 132). ἀ e auditor did not notice during this visit that, in some rooms, the ceilings were dropped so low that closet doors would not open. Both site visits were arranged for the weekend so that other occupants of the building would not be around to talk with the auditor.

In addition to visiting these “construction sites,” the auditor also visited two warehouses, one in California and one in Texas. He saw “$168,000 worth of the cheapest carpet they could get” in California. Later, the auditor saw carpet in a warehouse in Texas; it was the same carpet he had seen in San Diego earlier (Akst 1990, 129). Minkow’s newly developed building restora-tion business was reporting contracts that were four times as large as those of legitimate restoration businesses at the time. ἀ ey had no payroll records or OSHA reports. A multimillion dollar restoration contract was a single-page document. ἀ e auditor did not check for a construction permit, talk to the local public-safety officials, contact the building’s owners, or call around in the restoration business to see if anyone knew of this particular job or if such large jobs were even plausible (Akst 1990, 170).

Minkow also duped his attorneys. He obtained a registration statement (part of the process for public offering of his company’s stock) from a pres-tigious Wall Street law firm. ἀ e attorney insisted on seeing a restoration project as the auditor had done, and he actually accompanied the auditor to the first staged restoration site. Like the auditor, the attorney signed the writ-ten statement that he would not follow up with independent verification with

other companies and individuals involved in the restoration project (Akst 1989, 127).

Minkow defrauded numerous banks, borrowing more than $20 million from 15 different banks. In addition, he borrowed large sums of money from several private individuals. Anytime an auditor, an attorney, a banker, or the press raised questions about the legitimacy of his business, Minkow leveraged one against the others. To the auditor, he would point out that the Wall Street law firm, the banks, and the press said he “was gold.” If the banker doubted the wherewithal of the company, he pointed him or her to the phenomenal growth of the stock price (Association of Certified Fraud Examiners 1991).

The Scheme unravels

Minkow’s undoing, while inevitable, was hastened by a phone call to the Los Angeles Times from a young mother who had been overcharged for flowers she had sent to an ailing friend. Robin Swanson chose a flower shop close to the hospital, Floral Fantasies. She placed the order by phone, using her Bank One Visa card to pay $23.95 for the flowers. When her statement arrived, the charge was $601.11. Mrs. Swanson called Floral Fantasies to complain and was referred to the owner, Barry Minkow. He thanked her for calling and promised that her account would be credited right away. However, when her next bill arrived, the charge was still there, along with an additional $23.95 (the original price for the flowers). After repeated appeals to have the charges removed, first to Minkow and then to the bank, Swanson was enraged. She was also tenacious. She took her cause to the Los Angeles Police, the Los Angeles County District Attorney’s Office, and the State Attorney General’s Office, all to no avail. ἀ en, on November 17, 1986, she called the Los Angeles Times and reached Daniel Akst, a reporter who had just completed a story reporting on Barry Minkow’s ties to a notorious gangster and ZZZZ Best’s enormous debt and its reliance on a single customer, Interstate Appraisal (Akst 1990, 157–161). After reports that ZZZZ Best and a flower shop owned by a top executive submitted phony credit card billings for many customers and the other investigations that ensued, ZZZZ Best stock prices began their fall from a high of $18.375 to pennies, and trading was suspended by the SEC as the story unfolded (Akst, July 7, 1987, 5).

Minkow’s explanation for the overcharges was that unscrupulous for-mer subcontractors, who had been caught and fired, were responsible. ἀ is explanation contradicted the company’s public offering statement, which indicated that “the company hires no subcontractors for any of its residen-tial or commercial carpet cleaning jobs” (Akst, July 7, 1987, 5). As investiga-tive reporters uncovered more and more instances of overcharges to carpet

cleaning customers’ credit cards, they soon found also that the company’s restoration contracts were largely fictional.

ἀ e firm engaged as the company’s auditors, Ernst & Whinney, resigned just 2 weeks after the Los Angeles Times reported that ZZZZ Best used cus-tomers’ credit card numbers to run up at least $72,000 in inflated charges. It never completed its initial audit. ZZZZ Best said the resignation was not over accounting differences. After Ernst & Whinney, ZZZZ Best hired another auditing firm, Price Waterhouse & Company. When allegations of fraud and unanswered questions about management integrity surfaced later, Price Waterhouse also resigned.

ZZZZ Best was cited in congressional hearings as proof that “the SEC’s system for reporting changes of auditors…must be overhauled completely and replaced with one that gives shareholders and the public real and timely warning when management is perpetrating financial skullduggery” (Kull-berg 1988) ἀ at reform was subsequently enacted. No reform will eliminate fraud, but as a result of these changes, “auditors can and should plan a more effective role in narrowing the odds that illegal and irregular practices will persist in companies” (Kullberg 1988).

Amid investigations by various law enforcement agencies for alleged offenses ranging from misstating financial results to laundering drug money, the assets of ZZZZ Best, which had been listed in its bankruptcy filing at

$4.4 million, sold for $62,000 at auction. ἀ ese assets included carpet-clean-ing machines, office equipment, and computers from the 21 carpet cleancarpet-clean-ing stores. ἀ e company’s liabilities were listed at $26.7 million (Jeffrey 1987).

ἀ is scam had many victims. ZZZZ Best had 715 shareholders of record when it collapsed. ἀ e actual number, however, was substantially higher, since trust companies and others acting as stand-ins for many were counted as one. Also, there were about 3,000 creditors in the company’s bankruptcy.

ἀ e biggest losers among the creditors were banks and investment firms; one bank lost $7 million (Akst 1990, 271).

Minkow and 11 ZZZZ Best insiders were sentenced to prison. Most agreed to a plea bargain. Barry Minkow did not. He seemed to think that he could con the jury as he had conned so many investors. However, this time he was not successful. In December 1988, Minkow was convicted of 57 counts of fraud (Adelson 1988, D13). He was later sentenced to 25 years in federal prison. In his sentencing memorandum, the judge described Barry Minkow as a remorseless liar and a thief; his schemes had cost victims more than $100 million. His sentence was, for many years, the largest on record for white collar crime. He was also ordered to pay $26 million in restitution to victims of the ZZZZ Best fraud scheme. He served 7½ years, including 1 year in solitary confinement, before being released on parole. ἀ is is more time behind bars, Minkow notes, than “disgraced junk bond wizard Michael Milken, insider trading kingpin Ivan Boesky, and tax cheat Leona Helmsley

combined” (Carey 2004). While in prison, Minkow rose at three o’clock in the morning most days to bake bread and doughnuts, a far cry from his lav-ish lifestyle before his fall. Also in prison, Minkow completed his bachelor’s and master’s degrees, and he worked toward completion of a doctorate in theology (Matzer and Linden 1994). Minkow says he was paroled because the judge was convinced that he had changed and was ready to be given a second chance.

how Did It happen?

ἀ e rapid growth of ZZZZ Best was unbelievable, but the idea that a young man with a high school education could pull off such an audacious fraud scheme seemed even more unbelievable. What is so amazing is not that the scheme fell apart, but rather that it lasted as long as it did.

ἀ e company’s debt load was enormous, and it was completely

ἀ e company’s debt load was enormous, and it was completely