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
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.
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.
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.
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.
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
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.
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.
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
Today, Gone Tomorrow
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.
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
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.
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.
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.
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.
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
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.
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.
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.
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.
to Prevent Future Occurrences
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.
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: