ZZZZ Best: A Case Study in Fraud

1. ZZZZ Best: A Case Study in Fraud Dr. Donald K. McConnell Jr.

2. The Major Conspirators • Barry Minkow • Boy “genius” started a carpet cleaning business in family garage at age 16 • Charming con artist from day one • Multimillionaire by age 21 • Mark Morze • Most lettered UCLA athlete in history • Majored in physical sciences at UCLA • Had a small bookkeeping practice in L.A. • Small time business consultant hired by Minkow to obtain loans • Self described master manipulator • “Virtuoso” of the copy machine • Neither were very well versed in accounting and finance

3. Facts of the Case • Working capital shortages in “rug sucking” business motivated: • Credit card forgery • Check kiting schemes • Thefts • Age and charm allowed Minkow to escape early brushes with the law • Mark Morze secured small-business short-term loans on a commission basis* • Morze induced to go to work full-time for Minkow securing loans for commissions

4. Facts of the Case (con.) • Minkow: A/R an amazing thing! • To obtain bank loans against fictitious accounts receivable: • Paid an insurance claims adjuster $100 per week to confirm bogus minor restoration work to lenders • Led adjuster to believe such was to circumvent bureaucratic red tape and insurance industry • This led to increasingly large amounts of bogus insurance restoration business • Fictitious insurance restoration became major revenue source

5. Facts of the Case (con.) • Tiring of being one step ahead of creditors, Minkow decided to take ZZZZ Best public • “You have to pay back loans. You don’t have to pay back stockholders.”

6. Scamming the Auditors: Barry Minkow • Minkow bragged about steering the auditors to do 90 % of their work in the 10 % of his business (carpet cleaning) which was legitimate • When pressed for information: • “You guys are just grinding me.” • “I’ll bet Coopers would love to have our account.” • Intimidation techniques • Middle management out of the loop, so fewer had to lie

7. Scamming the Auditors: Mark Morze • Says he never outsmarted the “triumvirate” (CPA’s, securities lawyers, underwriters); he manipulated them • When asked a tough question for which he had no answer: • Caused fake cell phone to ring • Buying time to research the issues • Allowed uncomfortable silence to give him “wiggle room” when asked about an unusual circumstance: • Auditors would often ultimately suggest an explanation, resulting in a, “That’s it!” • Morze: “Don’t help the fraudster!” • Look for the truth, not the accuracy

8. The IPO Showdown • Auditors insisted upon physically examining several major restoration locations before signing off on IPO • These did not exist! • Minkow, in a rage, contends unnecessary and proclaims on a Friday afternoon, “ The deal is off” • Intentional manipulation to let underwriting syndicate stew over the weekend: big underwriting fees were “flying away”

9. The Showdown (con.) • Underwriting meeting following Monday morning • Minkow, sheepishly, “You guys were right, and I overreacted.” • “You can observe, but only one location.” • Experts manipulated and accepted scope restriction to save the deal • Now, how could Minkow find a building to be observed?

10. Auditors Manipulated and Scammed Again • Morze found a building under original construction in Sacramento • Posed as a corporate leasing agent seeking rental of several floors of the six floor building • Fictitious building had 16 floors!* • From outward appearances,could have appeared to be a restoration • Auditors were asked to tour building on a weekend

11. Auditors Scammed Again (con.) • Auditors toured the single allowed facility on the weekend, as required • Security guards had been bribed $100 each to warmly greet Minkow, as if they knew him • Workers were wearing ZZZZ Best T-shirts • Phony signs were hung in the building: “Another ZZZZ Best restoration in progress.” • Satisfied, the auditors were in and out in 15 minutes

12. Auditors had signed a Conditional letter of acknowledgement • Not to disclose location of building to any third parties • Not to make any follow-up telephone calls to contractors, insurance companies, building owner, etc. • Only one auditor was allowed to tour the phony restoration project • Incredible scope restrictions imposed by client!

13. Other Problems in the Audit Process • Entire $7 million plus contract contained on a single 8.5x11 page! • Should have been hundreds of pages of building and construction permits, specifications, etc. • Contract reflected sales tax of $301,000. • California didn’t impose sales tax on such • 66% profit on a competitive bid job? Morze: “Put away your calculators, and look beyond the numbers!”

14. Other Problems in the Audit Process (con.) • Inadequate industry knowledge: ZZZZ’s restoration revenue > total restoration revenue in entire U.S. for previous 3 yrs. • Sixteen story building shrank to six floors! • Warning sign: Auditors consistently only given copies of documents • There were no original documents; these had to be fraudulently prepared • Incredible reported profits, but no cash

15. The House of Cards Collapses • Questioning Minkow’s integrity after several events, auditors resigned • L.A. Times article: housewife previously scammed on rug cleaning complains • ZZZZ Best issued press release of record profits without notifying auditors • Anonymous letter to auditors warns of the fraud • Letter signed: “Very truly , B. Cautious” • Audit evidence confirmed some of anonymous allegations

16. ZZZZ Best: Aftermath • Barry Minkow was convicted of securities fraud; sentenced 25 yrs. • Later paroled, becoming a fraud consultant, and preacher in L.A. • Mark Morze refused to implicate CPA’s, lawyers, and Underwriters, though govt. attys. were convinced conspirators lacked sophistication to have acted alone • Morze now lectures, and is an ethics professor at Pepperdine University