Wall Street History

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Wall Street History

02/06/2004

Ray Dirks and the Equity Funding Scandal

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.

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[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?

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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

Wall Street History will return February 13.

Brian Trumbore

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