Peering into Financial Fraud

Crazy Eddie’s cousin Sam now trains Feds in spotting white-collar crime

Remember Crazy Eddie?  The 1980s electronics retailer with the famous television commercials bellowing uncontrollably about the company’s prices being “insane!

Well, despite over $300 million in annual sales at its peak, Crazy Eddie went bankrupt in 1989 after being exposed as an 18-year, $100 million accounting fraud.  The company was the Enron of its generation.  Eddie Antar, its CEO, fled the US for Israel at the time of the criminal investigation, was later extradited, pled guilty to several counts of financial fraud and served seven years in the slammer.

Eddie’s cousin Sam, the company’s CFO, cooperated with federal prosecutors and got off with just six months of house arrest (home confinement) and 1,200 hours of community service.   Now 56, Sam has gone straight and, since 2009, has been coaching FBI and Justice Department agents on how to spot accounting fraud.

iStock_000013468099XSmallIn an interview with MarketWatch this month, Sam revealed that, from the time Crazy Eddie started out as a private company in 1971, the Antars skimmed cash from its sales and understated its earnings so as to evade income taxes.   After the company went public in 1984, the Antars devised various ways to overstate its income so as to sell their stock at inflated prices.  The latter scheme was designed to take advantage of the stock’s earnings multiple – in other words, if Crazy Eddie had a P/E ratio of 30 at the time, the Antars were happy for the company to pay taxes on its inflated income at a rate of 30%, say, in exchange for their earning a 3,000% return on the sale of their stock.

Sam says that accounting fraud is most often uncovered by bounty-hunting tipsters and short sellers rather than independent auditors. “The last thing any criminal wants is an adversary with a profit motive,” according to him.  Recent examples are Bill Ackman’s relentless assault on Herbalife’s alleged pyramid scheme (see Short-Swing Profiteers) and Muddy Waters’ exposure of inflated assets and earnings at Sino-Forest.

In Sam’s view, independent audits give stockholders a false sense of security by inspiring confidence in the integrity of financial statements.  Outside auditors, however, generally don’t detect fraud because they’re not trained in the psychological misdirections used by professional fraudsters to carry out their accounting crimes.

In Sam’s view, independent audits give stockholders a false sense of security by inspiring confidence in the integrity of financial statements.  Outside auditors, however, generally don’t detect fraud because they’re not trained in the psychological misdirections used by professional fraudsters to carry out their accounting crimes.  To Sam, fraud is not found in documents; to root it out, you need to understand the behavioral manipulations of the fraudster.

External audits, moreover, are not designed to uncover accounting deceptions.  The field work outside auditors perform is intentionally of limited scope; auditors just take samples of the financial items they inspect.  Their examinations are designed to uncover accidental, material bookkeeping errors, not deliberate fraud.  To catch fraud, auditors would have to account for every single dollar coming into and out of the company, which is clearly impossible.

The most common financial statement frauds are fictitious sales, understated expenses, inflated asset valuations, hidden losses or liabilities, undisclosed related-party (insider) transactions and ‘cookie-jar’ accounting practices in which revenues are improperly shifted from one period to another so as to smooth out earnings volatility.

“You have to be a good bullshit artist to be an effective white-collar criminal,” says Sam.  Not surprisingly, he views the JOBS Act (see Private Placements for Total Strangers) — which relaxes the ban on private company advertising and allows small businesses to crowdfund — as an open invitation to financial fraud. “It makes me want to reconsider my retirement from crime,” he says.  “Any time you take away a layer of oversight, the criminals are going to take advantage of it.”

Criminals adapt to advancing technology – like the Internet – just like other people.  They will use it to commit old crimes and invent new ones.  So crime will evolve and never go away.  “It’s as old as the Bible,” Sam says, “and most white-collar criminals are not going to be deterred because someone else got caught.  They take precautions, so the possibility of jail time is not going to deter them.”