His future business partner, Simon Leary, was very different. Introverted and a bit shy, he met Herbert at CCC Computer Corp., where Simon managed the assembling and tech support departments while Herbert was a star marketer. With his calm but exacting demeanor and even-keeled management style, Simon had become invaluable to salesmen like Herbert, who often promised more than the company could realistically deliver.

After several years with CCC, Herbert grew frustrated by the lack of a salary increase and decided to start his own venture. He believed he had found an ideal partner in Simon, a team builder and back office organizer. Herbert’s business plan for his new company, Gamma Computer, Inc., was to lure customers away from CCC and win new large accounts of his own.

Herbert knew that his timing was right. During his tenure at CCC, he had learned how to deal with the unique needs and requirements of government agencies and other not-for-profit organizations. Tightened budgets in the public sector had recently changed the rules; virtual no-names like Gamma were now being allowed to bid on large government contracts. Winning a contract with one of these entities could result in deals involving huge quantities of computer hardware. The greater the quantity of units assembled and parts ordered, the better the profit margin.

From the very beginning, Gamma showed an ambitious and steep growth rate, which made it a valuable customer to the Second Savings Bank, one of the largest financial institutions in the country. Second Savings backed Gamma by pre-financing its growing accounts receivable, more than 95% of which were from national and local government entities. The public sector is known for paying its bills slow and late, but every outstanding payment would come in sooner or later. For Second Savings, this meant it was guaranteed almost 100% collectibility on Gamma’s accounts receivable, which it accepted as collateral for the financing.

Gamma’s rise happened during one of the longest and most sustained bull market phases the stock markets ever experienced. It was the dawn of the Internet, and nearly every business in the technology industry was making money. As more companies started to play the mergers and acquisitions game, Gamma Computer, with sales of $100 million, was quickly targeted for takeover. The Netherlands Holding Company, itself a rising star in booming Amsterdam, made a lucrative offer to purchase 100% of Gamma’s stock. For Herbert Kearns, this was his ultimate dream—to sell his company and start a new life as a wealthy man at the age of 45.

As part of the deal, Gamma’s former owners, Herbert and Simon, had to stay on for three years after the sale. The price of the shares they sold to the Netherlands Holding Company was tied to certain success criteria like sales and recoverability of accounts receivable. Therefore, Herbert and Simon were able to cash in only one-third of their acquisition proceeds, and had to earn the rest through another three years of successful business operations.

‘That’s Odd’

A few weeks after the sale, Simon suddenly tendered his resignation, citing “family reasons.” Astonishingly, his departure meant that he voluntarily sacrificed two-thirds of the sales price of the company because he failed to remain for the required time period.

At approximately the same time, Gamma Computer’s outstanding credit line at Second Savings Bank surpassed its limits. Consequently, Gamma’s account should have been moved to the large commercial accounts section, a special department within the bank in which all big accounts are pooled. But this shift would mean that Jim Muller, Gamma’s long-time account representative, would have to pass the account on to someone else. Both Gamma and Jim decided that this was not a desired outcome, so—in violation of bank rules—Gamma remained within the regional branch office.

Only weeks after the sale of the shares to the Netherlands Holding Company, Jim received a strange call. A manager of a well-known bank competitor informed him that it was buying all of Gamma Computer’s receivables and that it would pay Gamma’s outstanding credit because Second Savings would no longer be holding the receivables as collateral. But the bank also asked for a guarantee that it could sell back the receivables to Gamma at any time, and that Second Savings would finance it. Because the overall risk picture for Second Savings didn’t change, Jim agreed, but thought the transaction was very odd. When Jim asked Herbert about the reason for this strange arrangement, he was told that the Holding Company asked for the move.

The sale of the receivables was finished by March 15—only two weeks before Gamma’s March 31 fiscal year-end. Eight weeks later, Gamma Computer bought back the entire group of receivables, which were again pledged to Second Savings for financing. So within three months, the situation looked the same as before: Second Savings Bank had outstanding credit backed with receivables of Gamma Computer.

Here Today, Gone Tomorrow

In October of that same year, Gamma Computer, Inc., declared bankruptcy because it could not pay its invoices on time. Herbert had always maintained that Gamma’s steep growth would continue if only it had more financing. But the increased sales didn’t materialize and the company was deeply in debt.

The sudden death of Gamma Computer was a shock for Second Savings Bank. It was totally unaware of the deep financial troubles of its customer—or so it said. But the bank was in a relatively comfortable position because it owned all the insolvent company’s receivables as a backing for the credit line. And because those receivables were owed by slow but steady-paying government agencies and departments, Second Savings thought that it would be only a matter of time before the outstanding credit would be reimbursed. Second Savings was wrong.

When payments on the receivables failed to materialize, Second Savings became worried and decided to contact each debtor and ask for direct confirmation of the outstanding balances. The responses were devastating. The bank learned that in every instance, the receivable either never existed or had been paid months—or years—earlier. This was especially surprising considering Second Savings’ policy that only receivables less than 180 days old could be accepted for collateral. At this point, Second Savings decided to hand over the case to the public prosecutor’s office, which engaged a forensic accounting firm to check the allegations against Gamma and its management team—primarily Herbert Kearns.

The investigation began by analyzing how the receivables had been created within Gamma’s accounting system. Strangely, duplicate databases were found with very different data in each. Accounts receivable lists with the same date were also discovered, but with very different totals. When questioned, Herbert simply explained that the company had experienced many problems when recording the sale and repurchase of the receivables, which resulted in the alternate versions of the accounting data found on Gamma’s computers.

However, further analysis revealed several versions of certain receivables that appeared with different dates of origin and different dollar amounts. It seemed that at least some of the receivables had been made to look younger by changing their dates. Obviously, the bank’s 180-day rule could be met more easily if Gamma could simply make its receivables appear current. This was evidence that Gamma may have defrauded the bank by giving it falsified data.

The only way to be certain of the validity of the receivables was to check every single one with the original customer. In the end, only two individual receivables totaling $2,000 appeared not to have been falsified. This raised the obvious question: How was it possible to defraud Second Savings in such an appalling and complete manner? The bank received new accounts receivable lists every month, and no one ever suspected anything.

Based on the forensic accounting firm’s findings, the prosecutor charged Herbert Kearns and his management team with defrauding Second Savings by presenting falsified evidence of the legitimacy of Gamma’s receivables. But where normal fraud stories usually end, this one took another bitter turn for Second Savings Bank. The trial started with the testimony of the defendants. Herbert contended that Gamma could not possibly have defrauded the bank because Second Savings was aware of the situation for a long time. Herbert claimed that not only had the bank been aware of Gamma’s receivables juggling, but that it had actually helped the company cover the situation with the sale and repurchase of the receivables. He also admitted that the roundtrip transaction was undertaken solely to get the phony receivables off Gamma’s books at year-end because they “never would have passed even the simplest audit.”

The longer the court proceedings went on, the more doubts surfaced about the role of Second Savings. The questioning of bank employees in the credit department painted a picture of incompetence and bad internal communications at the bank. One witness described the complete auditing process for the receivables lists as checking to make sure a total was listed, performing spot checks for receivables older than 180 days, and filing the lists in a three-ring binder.

As a final blow to Second Savings’ case, Jim Muller eventually admitted that he had daily telephone conversations with Herbert about Gamma’s true financial condition. Although it was clear that false statements were made to the bank, in the end the court was convinced that the bank knew the truth, at least during Gamma’s final years, and did nothing to protect itself or mitigate its losses, which totalled approximately $30 million. Ultimately, the defendants were found not guilty of defrauding the bank; however, they received a two-year prison sentence for perpetrating a tax fraud scheme in which they induced the IRS to refund $1 million in “overpaid” taxes related to their business.
Because of the now-visible losses to the bank, the bankruptcy trustee sued Second Savings, claiming that the bank’s negligence made it possible for Gamma to survive longer than it would have if Second Savings had been properly guarding outstanding credit with diligence. That portion of the case was settled out of court.

Lessons Learned

Lesson 1. Obviously, Second Savings Bank had extremely weak controls. Even if it did not conspire with Herbert, it was certainly harmed by the failure to check Gamma’s collateral. The accounts receivable pledged by Gamma were from federal and state agencies and other public sector entities. Consequently, the bank acted negligently in its controls because it assumed the debt would be paid.

Lesson 2. If a transaction does not seem to have a sound business purpose, something is probably wrong. This was the case with the sale of Gamma’s receivables to the bank competitor only weeks before its fiscal year-end. Additionally, the factoring bank informed Second Savings that it planned to sell back the receivables in two to three months. At that point, the bank should have smelled a rat. Second Savings should have asked Gamma and its parent company why this transaction was economically necessary. If a deal does not make good business sense, a red flag should go up. In this case, Gamma wanted to get its receivables off the books before year-end, hoping that the auditors would not test accounts that were not part of the financial statements. Even the simplest auditing procedures would have brought to light the falsification of the accounts receivable.

Lesson 3. Another red flag in this case appeared when one of Gamma’s founders, Simon Leary, quit his job only weeks after the sale of his shares to the Netherlands Holding Company even though the sales price was contingent on his staying with the management team for the next three years. He cited “family reasons” as the reason for his departure, but an investigation would have revealed that he started a new and similar venture and, once again, his partner was Herbert Kearns.

Recommendations to Prevent Future Occurrences

Establish effective auditing procedures. The collateral auditing department at Second Savings Bank was undeniably inadequate. Effective auditing starts with healthy skepticism. Auditors should not accept every piece of information they are given as truth; they should proactively look for irregularities.

Using the collateral auditing department as an example, the bank should have required its staff to perform the following simple procedures with regard to the accounts receivable lists: