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Ray
Dirks and the Equity Funding Scandal
Brian
Trumbore
President/Editor, StocksandNews.com
Over 30 years ago, a scandal broke
involving a large insurance company, Equity Funding
Corporation based out of Los Angeles. The central
figure ended up being a securities analyst at Delafield,
Childs, Inc., Raymond L. Dirks, who one day in March
1973 received a call from a disgruntled employee at
Equity Funding, Ronald Secrist. Secrist was upset
over his small Christmas bonus and he had a story
to tell. As you read what follows, you'll be reminded
of today's headline grabbing cases, ranging from Enron
and Parmalat to Martha Stewart. Yes, we've been here
before, and we'll just keep repeating the same mistakes,
over and over again until the end of time.
Equity
Funding had been creating false insurance policies
for years, which the company then turned around and
packaged to reinsurers, pocketing the cash. Incredibly,
the fraud was known by as many as a thousand employees.
As reporter Robert Cole wrote for the New York Times
back on April 15, 1973, "Those closest to (the scam)
were believed to have cleverly concealed their tracks
through intimidation, subterfuge, threats of violence
and the use of doctored computer tapes."
Equity
Funding would use the fake profits to maintain the
share price and the hope was that one day it would
be able to buy a major life insurance company and
then "go straight." Equity Funding's books were loaded
with fake bonds and CDs, but when questions arose,
the accountants trusted the explanations of company
officials. Remember, it was 1973 and computers weren't
in use anywhere near what they are today, so at times
the auditors accepted handwritten lists as proof various
positions existed. Employees involved in the scam
also created computer printouts and paper files during
late-night parties after receiving a specific auditor
request. And all this time that Equity Funding deceived
the auditors, the analysts on Wall Street and various
insurance industry watchdogs were taken in as well.
For
example, one month before it all unraveled, Cowen
& Co. issued a report where the analyst recommended
purchase of Equity Funding "for aggressive accounts."
Burnham & Co., Inc. said on January 30 "We regard
the stock, selling at 9.9 times estimated 1973 earnings,
an excellent value and rate it a Buy."
On
March 26, the day before the NYSE halted trading,
the analyst for Hayden, Stone, Inc. wrote a memo addressing
the fact that "several rumors have been circulating
which have affected Equity Funding's stock; we have
checked these rumors, and there appears to be no substance
to any of them." This particular analyst had checked
with insurance regulators in various states and each
one said they had no present intention of conducting
any inquiries.
As
for Ray Dirks, he told his favored institutional clients
of the scam and alerted the SEC. There was a mad dash
to get out, and those who didn't act quickly enough,
or who didn't have the knowledge, lost everything.
Overall, the fraud exceeded $300 million.
Dirks
ended up being censured by the SEC for his actions
and over the next ten years he fought the decision,
all the way up to the U.S. Supreme Court. Following
is an extensive excerpt from a brief filed by the
Justice Department, in defense of Dirks, before the
Supreme Court, October 1982. It's as good a description
of the issues in the case as you'll find anywhere.
---
[In
order to make this read a bit easier, I have substituted
"Dirks" for "Petitioner." Some of the quotes noted
in the brief refer to the original SEC case, as well
as the Appeals Court ruling.]
"Dirks
is a securities analyst, 'well-known for his investigative
talents,' who researched insurance company securities.
In March 1973, Dirks applied those investigative talents
to uncover a major fraud perpetrated by the officers
of a publicly-owned insurance company. As the court
of appeals observed, 'in two weeks of concerted effort,
at times resembling something from detective fiction,
Dirks investigated and confirmed rumors of massive
fraud by the Equity Funding Corporation of America,
an insurance holding company whose stock traded on
the New York Stock Exchange. Largely thanks to Dirks
one of the most infamous frauds in recent memory was
uncovered and exposed. Despite his efforts to uncover
and expose the criminal scheme at Equity Funding,
the Securities and Exchange Commission charged Dirks
with 'tipping' material inside information in violation
of Section 10(b) of the Securities Exchange Act of
1934.
"Dirks
first learned of the fraud at Equity Funding from
a former officer of the company, Ronald Secrist, who
met with him for several hours on March 7, 1973. 'Secrist
made a series of detailed but nearly incredible allegations
about Equity Funding,' including allegations that
the company had produced large numbers of spurious
insurance policies to inflate its sales revenues and
that 'its top officers had Mafia connections which
they used to threaten the lives of employees who objected
to the fabrications.' Secrist urged Dirks to verify
the existence of the fraud and then expose it. He
expected Dirks to transmit evidence of the fraud to
'his firm's customers' and 'clients,' thereby triggering
large-volume securities sales that would lead to a
full investigation: 'by jarring the stock, he would
jar the corporation - this was my plan - he would
jar the corporate officers and would also rattle the
Wall Street financial community to the extent that
someone would take action very quickly.' Secrist believed
that selling pressure would cause the price of Equity
Funding stock to 'drop close to zero very quickly,'
and thus 'reveal the fraud to the world' and 'prevent
its continuation.'
"During
their initial meeting, Dirks sought and obtained Secrist's
permission to convey evidence of the fraud to the
Wall Street Journal. Secrist warned, however, that
merely presenting the information to regulatory authorities,
including the SEC, would be abortive. Secrist stated
that employees who attempted to do this in the past
had been 'brushed aside with a comment that that's
a ridiculous story;' those employees also found that
the information was sometimes relayed back to Equity
Funding and that 'they were placed in personal jeopardy
as a result of having gone there.'?..
"In
addition to interviewing former employees of Equity
Funding, Dirks also met with Equity Funding's present
and former auditors in an attempt to spread word of
the fraud and bring it to a halt. As the Commission
explained:
'Dirks
also learned that Equity Funding's auditors were about
to release certified financial statements for the
company on March 26. He immediately contacted them
and apprised them of the fraud allegations, hoping
that they would withhold release of their report and
seek a halt in the trading of Equity Funding securities.
Instead, the auditors merely reported Dirks' allegations
to management.'
"As
early as March 12, 1973, Dirks also attempted to communicate
his evidence to the Wall Street Journal. 'Dirks expected
that a highly respected publication like the (Journal)
could be effective in helping him investigate the
Secrist allegations and to expose the fraud if it
proved to exist.' Those efforts also were unavailing.
'During
the entire week that Dirks was in Los Angeles investigating
Equity Funding, he was also in touch regularly with
William Blundell, the Wall Street Journal's Los Angeles
bureau chief. Dirks kept Blundell up to date on the
progress of the investigation and badgered him to
write a story for the Journal on the allegations of
fraud at Equity Funding. Blundell, however, was afraid
that publishing such damaging rumors supported only
by hearsay from former employees might be libelous,
so he declined to write the story.'
"Dirks
provided Blundell with 'the substance of all he knew,'
including his 'notes' and the 'names' of all witnesses.
Nevertheless, given the 'scope of the fraud,' Blundell
doubted that it could have been 'missed by an honest
auditor' and discounted the entire allegation.
"Increasing
circulation of rumors about the fraud led Dirks to
believe that it was 'unlikely that Equity Funding
stock would open for trading on Monday, March 26,
because trading would be halted by the NYSE.' This
did not occur, however, and Dirks again spoke to William
Blundell of the Wall Street Journal and urged him
to publish a story exposing the fraud. Blundell refused
to do so but stated that he intended to discuss the
matter with the SEC's Los Angeles Regional Office.
Blundell secured Dirks' permission to propose a meeting
with the SEC that would include himself and two other
key witnesses. Dirks then contacted the SEC and voluntarily
presented all of his information at the SEC's regional
office beginning on March 27 and continuing throughout
the next three days.
"During
the two-week period in which Dirks pursued his investigation
and spread word of Secrist's charges, the price of
Equity Funding stock fell precipitously from $26 per
share to less than $15. This led the NYSE to halt
trading in the stock on March 27. Shortly thereafter,
Illinois and California insurance authorities impounded
Equity Funding's records and uncovered evidence of
the fraud. Only then did the SEC file a complaint
against Equity Funding and only then did the Wall
Street Journal publish 'a front page story written
by Blundell but based largely on information assembled
by Dirks.' Three days later, Equity Funding filed
a petition (for bankruptcy).
"While
Dirks' investigative activities succeeded in revealing
in a few days that 'one of the darlings of Wall Street,
a company that had managed to produce continued high
earnings growth for a decade, was, instead, a gigantic
fraud,' government authorities with jurisdiction over
Equity Funding did not move so quickly. As early as
1971, the SEC had received allegations of fraudulent
accounting practices at Equity Funding. Moreover,
on March 9, 1973, an official of the California Insurance
Department informed the SEC's regional office in Los
Angeles of Secrist's charges of fraud. The SEC's staff
attorney 'stated that similar allegations had been
made about Equity Funding before by disgruntled employees.'
He nonetheless recommended 'delaying any type of inspection
of the Equity Funding operations until next year absent
further corroboration. Equity Funding's Chairman -
one of the principal architects of the fraud - testified
that, prior to March 1973, he received no questions
from auditors, state regulatory authorities, or federal
regulatory authorities that suggested 'they suspected
there was a fraud at Equity Funding.' When asked whether
Dirks was 'personally responsible for having uncovered
the events at Equity Funding,' he candidly stated:
'I think Mr. Dirks is entitled to personal credit
for that.'
"Following
public revelation of the Equity Funding scandal, a
federal grand jury in Los Angeles returned a 105 count
indictment against 22 persons, including many of Equity
Funding's officers and directors?[Guilty pleas or
convictions were obtained on all 22. Chairman Stanley
Goldblum received an 8-year prison sentence and a
substantial fine.]
"While
the Wall Street Journal's reporter, William Blundell,
was 'nominated for a Pulitzer Prize for his coverage
of the Equity Funding scandal,' Dirks was charged
by the SEC with violating the antifraud provisions
of the federal securities laws based on his selective
revelation of information about Equity Funding prior
to general public disclosure. Following an administrative
hearing, the Commission found that Dirks had 'tipped'
nonpublic information concerning Equity Funding in
violation of those provisions. It observed that 'Dirks
received the information from inside corporate sources.
From the nature of the information, the inference
must have been obvious that his sources had received
it during the course of their corporate duties, and
that the company intended that it should be kept in
confidence.'?
"Despite
its finding of a violation, the Commission imposed
only a censure - its mildest sanction - on Dirks.
It observed that 'it is clear that Dirks played an
important role in bringing Equity Funding's massive
fraud to light, and that he reported the fraud allegations
to Equity Funding's auditors and sought to have the
information published in the Wall Street Journal."
In
a 6-3 decision, the Supreme Court overruled prior
judgments and Dirks was finally cleared, ten years
later. Essentially, the Court ruled that for a recipient
of a tip to be guilty of insider trading, the insider
who provided the tip must have been seeking to profit
from the tip. There never was any evidence Ray Dirks
personally made a dime off of his actions.
Today,
Dirks is head of his own research / investment banking
shop, specializing in small companies steeped in controversy.
I'll leave it at that.
But
I do have to note a comment Dirks made during the
above proceedings concerning the New York Stock Exchange
and its internal procedures.
"There
is the question of the NYSE, a venerated American
institution which advertises the safety and security
of investing in its listed companies, but which, in
fact is an antique, costly and dangerous system perpetuated
for the convenience of its members." [Charles Geisst]
A
little ahead of his time, don't you think?
---
Sources:
U.S.
Department of Justice archives
Robert J. Cole / New York Times (1973)
Linda Greenhouse / New York Times (1983)
"The New York Times Century of Business" Floyd Norris
and Christine Bockelmann
"Wall Street: A History" Charles R. Geisst
Brian
Trumbore
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