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CASE 1.13
ZZZZ Best Company, Inc.
On May 19, 1987, a short article in the Wall Street Journal reported that ZZZZ Best
Company, Inc., of Reseda, California, had signed a contract for a $13.8 million insurance restoration project. This project was just the most recent of a series of large
restoration jobs obtained by ZZZZ Best (pronounced “zee best”). Located in the San
Fernando Valley of southern California, ZZZZ Best had begun operations in the fall of
1982 as a small, door-to-door carpet cleaning business. Under the direction of Barry
Minkow, the extroverted 16-year-old who founded the company and initially operated it out of his parents’ garage, ZZZZ Best experienced explosive growth in both
revenues and profits during the first several years of its existence. In the three-year
period from 1984 to 1987, the company’s net income surged from less than $200,000
to more than $5 million on revenues of $50 million.
When ZZZZ Best went public in 1986, Minkow and several of his close associates
became multimillionaires overnight. By the late spring of 1987, the market value
of Minkow’s stock in the company exceeded $100 million, while the total market
value of ZZZZ Best surpassed $200 million. The youngest chief executive officer in
the nation enjoyed the “good life,” which included an elegant home in an exclusive
suburb of Los Angeles and a fire-engine red Ferrari. Minkow’s charm and entrepreneurial genius made him a sought-after commodity on the television talk show circuit
and caused the print and visual media to tout him as an example of what America’s
youth could attain if they would only apply themselves. During an appearance on
The Oprah Winfrey Show in April 1987, Minkow exhorted his peers with evangelistic
zeal to “Think big, be big” and encouraged them to adopt his personal motto, “The
sky is the limit.”
Less than two years after appearing on Oprah, Barry Minkow began serving
a 25-year prison sentence. Tried and convicted on 57 counts of securities fraud,
Minkow had been exposed as a fast-talking con artist who swindled his closest
friends and Wall Street out of millions of dollars. Federal prosecutors estimate that,
at a minimum, Minkow cost investors and creditors $100 million. The company that
Minkow founded was, in fact, an elaborate Ponzi scheme. The reported profits of the
firm were nonexistent and the large restoration contracts, imaginary. As one journalist reported, rather than building a corporation, Minkow created a hologram of a corporation. In July 1987, just three months after the company’s stock reached a market
value of $220 million, an auction of its assets netted only $62,000.
Unlike most financial frauds, the ZZZZ Best scam was perpetrated under the
watchful eye of the Securities and Exchange Commission (SEC). The SEC, a large
and reputable West Coast law firm that served as the company’s general counsel, a
prominent Wall Street brokerage firm, and an international public accounting firm
all failed to uncover Minkow’s daring scheme. Ultimately, the persistence of an indignant homemaker who had been bilked out of a few hundred dollars by ZZZZ Best
resulted in Minkow being exposed as a fraud.
How a teenage flimflam artist could make a mockery of the complex regulatory
structure that oversees the U.S. securities markets was the central question posed by
a congressional subcommittee that investigated the ZZZZ Best debacle. That subcommittee was headed by Representative John D. Dingell, chairman of the U.S. House
167
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168
SECTION ONE
COMPREHENSIVE CASES
Committee on Energy and Commerce. Throughout the investigation, Representative
Dingell and his colleagues focused on the role the company’s independent auditors
played in the ZZZZ Best scandal.
The ZZZZ Best prospectus told the public that revenues and earnings from insurance
restoration contracts were skyrocketing but did not reveal that the contracts were
completely fictitious. Where were the independent auditors and the others that are
paid to alert the public to fraud and deceit?1
Like many other daring financial frauds, the ZZZZ Best scandal caused Congress to
reexamine the maze of rules that regulate financial reporting and serve as the foundation of the U.S. system of corporate oversight. However, Daniel Akst, a reporter for
the Wall Street Journal who documented the rise and fall of Barry Minkow, suggested
that another ZZZZ Best was inevitable. “Changing the accounting rules and securities laws will help, but every now and then a Barry Minkow will come along, and
ZZZZ Best will happen again. Such frauds are in the natural order of things, I suspect,
as old and enduring as human needs.”2
The Early History of ZZZZ Best Company
Barry Minkow was introduced to the carpet cleaning industry at the age of 12 by his
mother, who helped make ends meet by working as a telephone solicitor for a small
carpet cleaning firm. Although the great majority of companies in the carpet cleaning industry are legitimate, the nature of the business attracts a disproportionate
number of shady characters. There are essentially no barriers to entry: no licensing
requirements, no apprenticeships to be served, and only a minimal amount of startup
capital is needed. A 16-year-old youth with a driver’s license can easily become what
industry insiders refer to as a “rug sucker,” which is exactly what Minkow did when
he founded ZZZZ Best Company.
Minkow quickly learned that carpet cleaning was a difficult way to earn a livelihood. Customer complaints, ruthless competition, bad checks, and nagging
vendors demanding payment complicated the young entrepreneur’s life. Within
months of striking out on his own, Minkow faced the ultimate nemesis of the small
businessperson: a shortage of working capital. Because of his age and the fact that
ZZZZ Best was only marginally profitable, local banks refused to loan him money.
Ever resourceful, the brassy teenager came up with his own innovative ways to
finance his business: check kiting, credit card forgeries, and the staging of thefts to
fleece his insurance company.
Minkow’s age and personal charm allowed him to escape unscathed from his
early brushes with the law that resulted from his creative financing methods. The
ease with which the “system” could be beaten encouraged him to exploit it on a
broader scale.
Throughout his tenure with ZZZZ Best, Minkow recognized the benefits of having an extensive social network of friends and acquaintances. Many of these
relationships he developed and cultivated at a Los Angeles health club. After
1. This and all subsequent quotations, unless indicated otherwise, and each of the exhibits appearing
in this case were taken from the following source: U.S. Congress, House Subcommittee on Oversight
and Investigations of the Committee on Energy and Commerce, Failure of ZZZZ Best Co. (Washington,
D.C.: U.S. Government Printing Office, 1988).
2. D. Akst, Wonder Boy, Barry Minkow—The Kid Who Swindled Wall Street (New York: Scribner,
1990), 271.
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CASE 1.13
ZZZZ BEST COMPANY, INC.
becoming a friend of Tom Padgett, an insurance claims adjuster, Minkow devised
a scheme to exploit that friendship. Minkow promised to pay Padgett $100 per
week if he would simply confirm over the telephone to banks and any other
interested third parties that ZZZZ Best was the recipient of occasional insurance
restoration contracts. Ostensibly, Minkow had obtained these contracts to clean
and do minor remodeling work on properties damaged by fire, storms, or other
catastrophes. Minkow convinced the gullible Padgett that the sole purpose of the
confirmations was to allow ZZZZ Best to circumvent much of the bureaucratic
red tape in the insurance industry.
From this modest beginning, the ZZZZ Best fraud blossomed. Initially, Minkow
used the phony insurance restoration contracts to generate the paper profits and
revenues he needed to convince bankers to loan him money. Minkow’s phony
financial statements served their purpose, and he expanded his operations by
opening several carpet cleaning outlets across the San Fernando Valley. Minkow
soon realized that there was no need to tie his future to the cutthroat carpet cleaning industry when he could literally dictate the size and profitability of his insurance restoration “business.” Within a short period of time, insurance restoration,
rather than carpet cleaning, became the major source of revenue appearing on
ZZZZ Best’s income statements.
Minkow’s “the sky is the limit” philosophy drove him to be even more innovative.
The charming young entrepreneur began using his bogus financial statements to
entice wealthy individuals in his ever-expanding social network to invest in ZZZZ
Best. Eventually, Minkow recognized that the ultimate scam would be to take his
company public, a move that would allow him to tap the bank accounts of unsuspecting investors nationwide.
Going Public with ZZZZ Best
Minkow’s decision to take ZZZZ Best public meant that he could no longer control his firm’s financial disclosures. Registering with the SEC required auditors,
investment bankers, and outside attorneys to peruse ZZZZ Best’s periodic financial
statements.
ZZZZ Best was first subjected to a full-scope independent audit for the 12 months
ended April 30, 1986. George Greenspan, the sole practitioner who performed
that audit, confirmed the existence of ZZZZ Best’s major insurance restoration
contracts by contacting Tom Padgett. Padgett served as the principal officer of
Interstate Appraisal Services, which reportedly contracted the jobs out to ZZZZ
Best. By this time, Padgett was an active and willing participant in Minkow’s fraudulent schemes. Minkow established Interstate Appraisal Services and Assured
Property Management for the sole purpose of generating fake insurance restoration contracts for ZZZZ Best.
In testimony before the congressional subcommittee that investigated the ZZZZ
Best scandal, Greenspan insisted that he had properly audited Minkow’s company.
Greenspan testified that while planning the 1986 audit he had performed various
analytical procedures to identify unusual relationships in ZZZZ Best’s financial data.
These procedures allegedly included comparing ZZZZ Best’s key financial ratios
with industry norms. Regarding the insurance contracts, Greenspan testified that he
had obtained and reviewed copies of all key documents pertaining to those jobs.
However, Greenspan admitted that he had not inspected any of the insurance restoration sites.
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169
170
SECTION ONE
COMPREHENSIVE CASES
Congressman Lent: Mr. Greenspan, I am interested in the SEC Form S-1 that ZZZZ
Best Company filed with the SEC. . . . You say in that report
that you made your examination in accordance with generally
accepted auditing standards and accordingly included such tests
of the accounting records and other auditing procedures as we
consider necessary in the circumstances. . . . You don’t say in that
statement that you made any personal on-site inspections.
Mr. Greenspan: It’s not required. Sometimes you do; sometimes you don’t. I was
satisfied that these jobs existed and I was satisfied from at least
six different sources, including payment for the job. What could
you want better than that?
Congressman Lent: Your position is that you are an honest and reputable accountant.
Mr. Greenspan: Yes, sir.
Congressman Lent: You were as much a victim as some of the investors in this
company?
Mr. Greenspan: I was a victim all right. . . . I am as much aghast as anyone.
And every night I sit down and say, why didn’t I detect this
damned fraud.
Retention of Ernst & Whinney by ZZZZ Best
Shortly after Greenspan completed his audit of ZZZZ Best’s financial statements for
fiscal 1986, which ended April 30, 1986, Minkow dismissed him and retained Ernst &
Whinney to perform the following year’s audit. Apparently, ZZZZ Best’s investment
banker insisted that Minkow obtain a major accounting firm to enhance the credibility of the company’s financial statements. At approximately the same time, and for
the same reason, Minkow retained a high-profile Los Angeles law firm to represent
ZZZZ Best as its legal counsel.
The congressional subcommittee asked Greenspan what information he provided
to Ernst & Whinney regarding his former client. In particular, the subcommittee
wanted to know whether Greenspan discussed the insurance restoration contracts
with the new auditors.
Congressman Wyden: Mr. Greenspan, in September 1986, Ernst & Whinney came
on as the new independent accountant for ZZZZ Best. What
did you communicate to Ernst & Whinney with respect to the
restoration contracts?
Mr. Greenspan: Nothing. I did—there was nothing because they never got in
touch with me. It’s protocol for the new accountant to get in
touch with the old accountant. They never got in touch with
me, and it’s still a mystery to me.
Representatives of Ernst & Whinney later testified that they did, in fact, communicate with Greenspan prior to accepting ZZZZ Best as an audit client. However,
Ernst & Whinney did not comment on the nature or content of that communication.
(Greenspan was not recalled to rebut Ernst & Whinney’s testimony on this issue.)3
Exhibit 1 contains the engagement letter signed by Ernst & Whinney and Barry
Minkow in September 1986. The engagement letter outlined four services that the
3. After a lengthy investigation, the American Institute of Certified Public Accountants ruled in 1998
that there was no “prima facie evidence” that Greenspan had violated the organization’s Code of
Professional Conduct during the time that ZZZZ Best was his client. A similar conclusion was reached by
two state boards of accountancy with which Greenspan was registered to practice public accounting.
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CASE 1.13
ZZZZ BEST COMPANY, INC.
171
EXHIBIT 1
September 12, 1986
ERNST &
WHINNEY’S ZZZZ
BEST ENGAGEMENT
LETTER
Mr. Barry Minkow
Chairman of the Board
ZZZZ Best Co., Inc.
7040 Darby Avenue
Reseda, California
Dear Mr. Minkow:
This letter is to confirm our understanding regarding our engagement as independent
accountants of ZZZZ BEST CO., INC. (the Company) and the nature and limitations of the
services we will provide.
We will perform the following services:
1. We will review the balance sheet of the Company as of July 31, 1986, and the related
statements of income, retained earnings, and changes in financial position for the three
months then ended, in accordance with standards established by the American Institute of
Certified Public Accountants. We will not perform an audit of such financial statements, the
objective of which is the expressing of an opinion regarding the financial statements taken as
a whole, and, accordingly, we will not express an opinion on them. Our report on the financial
statements is presently expected to read as follows:
“We have made a review of the condensed consolidated balance sheet of ZZZZ BEST
CO., INC. and subsidiaries as of July 31, 1986, and the related condensed consolidated
statements of income and changes in financial position for the three-month period ended
July 31, 1986, in accordance with standards established by the American Institute of
Certified Public Accountants. A review of the condensed consolidated financial statements
for the comparative period of the prior year was not made.
A review of financial information consists principally of obtaining an understanding of
the system for the preparation of interim financial information, applying analytical review
procedures to financial data, and making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an examination in accordance
with generally accepted auditing standards, which will be performed for the full year
with the objective of expressing an opinion regarding the financial statements taken as a
whole. Accordingly, we do not express such an opinion. Based on our review, we are not
aware of any material modifications that should be made to the condensed consolidated
interim financial statements referred to above for them to be in conformity with generally
accepted accounting principles.”
Our engagement cannot be relied upon to disclose errors, irregularities, or illegal acts,
including fraud or defalcations, that may exist. However, we will inform you of any such
matters that come to our attention.
2. We will assist in the preparation of a Registration Statement (Form S-1) under the
Securities Act of 1933 including advice and counsel in conforming the financial statements
and related information to Regulation S-X.
3. We will assist in resolving the accounting and financial reporting questions which will arise
as a part of the preparation of the Registration Statement referred to above.
4. We will prepare a letter for the underwriters, if required (i.e., a Comfort Letter), bearing in
mind the limited nature of the work we have done with respect to the financial data.
(continued)
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172
SECTION ONE
EXHIBIT 1—
continued
ERNST &
WHINNEY’S ZZZZ
BEST ENGAGEMENT
LETTER
COMPREHENSIVE CASES
5. We will examine the consolidated financial statements of the Company as of April 30,
1987, and for the year then ended and issue our report in accordance with generally accepted
auditing standards approved by the American Institute of Certified Public Accountants.
These standards contemplate, among other things, that (1) we will study and evaluate the
Company’s internal control system as a basis for reliance on the accounting records and for
determining the extent of our audit tests; and (2) that we will be able to obtain sufficient
evidential matter to afford a reasonable basis for our opinion on the financial statements.
However, it should be understood that our reports will necessarily be governed by the findings
developed in the course of our examination and that we could be required, depending upon
the circumstances, to modify our reporting from the typical unqualified opinion. We will advise
you, as our examination progresses, if any developments indicate that we will be unable to
express an unqualified opinion. Because our examination will be performed generally on a test
basis, it will not necessarily disclose irregularities, if any, that may exist. However, we will
promptly report to you any irregularities which our examination does disclose.
Our fees will be derived from our customary rates for the various personnel involved plus outof-pocket expenses. Certain factors can have an effect on the time incurred in the conduct
of our work. Among these are the general condition of the accounting records, the amount of
assistance received from your personnel in the accumulation of data, the size and transaction
volume of business, any significant financial reporting issues that arise in connection with
the SEC’s review of the S-1, as well as unforeseen circumstances. Based upon our current
understanding of the situation, the amount of our proposed billing for the various services
which we will be providing are estimated to be:
Review of the July 31, 1986 financial statements
Assistance in the preparation of the Registration Statement
Comfort Letter
Audit of financial statements as of April 30, 1987
$ 5,000-$7,500
8,000-30,000
4,000-6,000
24,000-29,000
We will invoice you each month for the time charges and expenses incurred in the previous
month and such invoices are due and payable upon presentation.
Larry D. Gray, Partner, is the Client Service Executive assigned to the engagement. Peter
Griffith, Audit Manager, and Michael McCormick, Tax Manager, have also been assigned.
We greatly appreciate your engagement of our firm; if you have any questions, we shall be
pleased to discuss them with you. Please indicate your acceptance of the above arrangements
by signing and returning the enclosed copy. This letter constitutes the full understanding of
the terms of our engagement.
Very truly yours,
Ernst & Whinney
By Larry D. Gray, Partner
ACCEPTED:
ZZZZ BEST CO., INC.
Barry J. Minkow, Chairman of the Board (signed)
9/16/86
audit firm intended to provide ZZZZ Best: a review of the company’s financial statements for the three-month period ending July 31, 1986; assistance in the preparation
of a registration statement to be filed with the SEC; a comfort letter to be submitted to ZZZZ Best’s underwriters; and a full-scope audit for the fiscal year ending
April 30, 1987. Ernst & Whinney completed the review, provided the comfort letter
to ZZZZ Best’s underwriters, and apparently assisted the company in preparing the
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CASE 1.13
ZZZZ BEST COMPANY, INC.
registration statement for the SEC; however, Ernst & Whinney never completed the
1987 audit. The audit firm resigned on June 2, 1987, amid growing concerns that
ZZZZ Best’s financial statements were grossly misstated.
The congressional subcommittee investigating the ZZZZ Best fraud questioned
Ernst & Whinney representatives at length regarding the bogus insurance restoration
contracts—contracts that accounted for 90 percent of ZZZZ Best’s reported profits.
Congressional testimony disclosed that Ernst & Whinney repeatedly insisted on visiting several of the largest of these contract sites and that Minkow and his associates
attempted to discourage such visits. Eventually, Minkow realized that the auditors
would not relent and agreed to allow them to visit certain of the restoration sites,
knowing full well that none of the sites actually existed.
To convince Ernst & Whinney that the insurance restoration contracts were authentic,
Minkow plotted and carried out a series of sting operations that collectively cost millions
of dollars. In the late fall of 1986, Larry Gray, the engagement audit partner for ZZZZ Best,
told client personnel that he wanted to inspect a restoration site in Sacramento on which
ZZZZ Best had reported obtaining a multimillion-dollar contract. Minkow sent two of his
subordinates to Sacramento to find a large building under construction or renovation
that would provide a plausible site for a restoration contract. Gray had visited Sacramento
a few weeks earlier to search for the site that Minkow had refused to divulge. As chance
would have it, the building chosen by the ZZZZ Best conspirators was the same one Gray
had identified as the most likely site of the insurance restoration job.
Minkow’s two confederates posed as leasing agents of a property management
firm and convinced the supervisor of the construction site to provide the keys to
the building one weekend on the pretext that a large, prospective tenant wished to
tour the facility. Prior to the arrival of Larry Gray and an attorney representing ZZZZ
Best’s law firm, Minkow’s subordinates visited the site and placed placards on the
walls at conspicuous locations indicating that ZZZZ Best was the contractor for the
building renovation. No details were overlooked by the two co-conspirators. They
even paid the building’s security officer to greet the visitors and demonstrate that he
was aware in advance of their tour of the site and its purpose. Although the building had not been damaged and instead was simply in the process of being completed, the sting operation went off as planned. Exhibit 2 presents the memorandum
Gray wrote describing his tour of the building—a memorandum included in Ernst &
Whinney’s ZZZZ Best workpapers.
Congressional investigators quizzed Gray regarding the measures he took to confirm that ZZZZ Best actually had a restoration contract on the Sacramento building.
They were particularly concerned that he never discovered the building had not suffered several million dollars in damages a few months earlier, as claimed by ZZZZ
Best personnel.
Congressman Lent: . . . Did you check the building permit or construction permit?
Mr. Gray: No, sir. That wouldn’t be necessary to accomplish what I was
setting out to accomplish.
Congressman Lent: And you did not check with the building’s owners to see if an
insurance claim had been filed?
Mr. Gray: Same answer. It wasn’t necessary. I had seen the paperwork
internally of our client, the support for a great amount of detail.
So, I had no need to ask—to pursue that.
Congressman Lent: You understand that what you saw was not anything that was real
in any sense of the word? . . . You are saying you were duped, are
you not?
Mr. Gray: Absolutely.
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173
174
SECTION ONE
EXHIBIT 2
ERNST & WHINNEY
INTERNAL MEMO
REGARDING VISIT
TO ZZZZ BEST
R ESTORATION
PROJECT
COMPREHENSIVE CASES
TO: ZZZZ Best Co., Inc. File
FROM: Larry D. Gray
RE: Visit to Sacramento Job
At our request, the Company arranged for a tour of the job site in Sacramento on November
23rd [1986]. The site (not previously identified for us because of the confidentiality
agreement with their customer) had been informally visited by me on October 27. I knew
approximately where the job was, and was able to identify it through the construction
activity going on.
On November 23, Mark Morse accompanied Mark Moskowitz of Hughes Hubbard & Reed and
myself to Sacramento. We visited first the offices of the Building Manager, Mark Roddy of
Assured Property Management, Inc. Roddy was hired by the insurance company (at Tom
Padgett’s suggestion according to Morse) to oversee the renovation activities and the leasing
of the space. Roddy accompanied us to the building site.
We were informed that the damage occurred from the water storage on the roof of the
building. The storage was for the sprinkler systems, but the water was somehow released in
total, causing construction damage to floors 17 and 18, primarily in bathrooms which were
directly under the water holding tower, then the water spread out and flooded floors 16 down
through about 5 or 6, where it started to spread out even further and be held in pools.
We toured floor 17 briefly (it is currently occupied by a law firm) then visited floor 12 (which
had a considerable amount of unoccupied space) and floor 7. Morse pointed out to us the
carpet, painting and clean-up work which had been ZZZZ Best’s responsibility. We noted some
work not done in some other areas (and in unoccupied tenant space). But per Mark, this was
not ZZZZ Best’s responsibility, rather was work being undertaken by tenants for their own
purposes.
Per Morse (and Roddy) ZZZZ Best’s work is substantially complete and has passed final
inspection. Final sign-off is expected shortly, with final payment due to ZZZZ Best in early
December.
Morse was well versed in the building history and in the work scope for ZZZZ Best. The tour
was beneficial in gaining insight as to the scope of the damage that had occurred and the
type of work that the Company can do.
Before allowing Ernst & Whinney auditors to visit a bogus restoration project,
Minkow insisted that the firm sign a confidentiality agreement. Exhibit 3 presents
a copy of that agreement. Members of the congressional subcommittee were troubled by the following stipulation of the confidentiality agreement: “We will not make
any follow-up telephone calls to any contractors, insurance companies, the building owner, or other individuals involved in the restoration contract.” This restriction
effectively precluded the auditors from corroborating the insurance restoration contracts with independent third parties.
Resignation of Ernst & Whinney
Ernst & Whinney resigned as ZZZZ Best’s auditor on June 2, 1987, following a series
of disturbing events that caused the firm to question Barry Minkow’s integrity. First,
Ernst & Whinney was alarmed by a Los Angeles Times article in mid-May 1987 that
revealed Minkow had been involved in a string of credit card forgeries as a teenager.
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CASE 1.13
ZZZZ BEST COMPANY, INC.
Mr. Barry Minkow, President
ZZZZ Best Co., Inc.
7040 Darby Avenue
Reseda, California
Dear Barry,
In connection with the proposed public offering (the Offering) of units consisting of common
stock and warrants of ZZZZ Best Co., Inc. (the Company), we have requested a tour of the site
of the Company’s insurance restoration project in Sacramento, California, Contract No. 18886.
Subject to the representations and warrant
