An overview of an equity funding scandal from the early days of computing,

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Equity Funding of America
Computer Law and Ethics
Michael Heron

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Introduction
 Crime – crime never changes.
 To paraphrase the opening sequence to the Fallout games.
 While computers have enabled an awful lot of crime, very little
of it is truly new.
 People trespassed before computers.
 People made illegal copies of things before computers.
 Even things like ‘rights management’ were in place long ago.
 Map makers used to include identifying ‘mistakes’ to help police
copyright infringement.
 What computers have mostly done is increase the scope and
scale of crime.

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Waves of Computer Crime
 1960s
 Hacking began as exploration and problem solving.
 Specialised fraud
 Blackmail
 1970S
 Privacy violations
 Salami slicing
 Phone phreaking
 Distribution of illegal materials.

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Waves of Computer Crime
 1980s
 Software piracy
 Copyright violations
 Viruses
 More phreaking
 Commercialisation of illicit material distribution
 1990s
 IP spoofing
 FTP abuse
 Phantom nodes
 Protocol flaws

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Waves of Computer Crime
 2000s
 Automated hacking
 Desktop forgery
 International industrial espionage
 Transnational organised crime
 Terrorism
 2010s
 ???
 As computers evolve, so too does the sophistication of crimes
committed.

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Early types of computer crimes -
Damage
 Root access to a computer offers large scale access to the underlying
system.
 Who watches the watchers?
 Real risk when employees are terminated.
 Hard to keep an angry sysadmin in line.
 One of the reasons why IT employees are often escorted from the
premises as soon as they are dismissed.
 Limits the danger of retaliation.
 But doesn’t eliminate it entirely.
 Systems can be highly tailored.
 Systems can be full of valuable data.
 Some types of computer damage cannot be repaired.

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Blackmail
 Value of data often more than the value of computers.
 And the software on which they run.
 Blackmail with computers often involves holding data ransom.
 For example, one of the programmers working on Concorde
demanded £250,000 for the backups of the test data he destroyed.
 Data can be costly or impossible to replace.
 Nothing new in the crime, only new in the details.
 And the ease with which it can be done.

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Fraud
 Small scale fraud commonly involves very specific, very
personal adjustments to computer code.
 Slicing fractions of pennies off of thousands of transactions and
siphoning them off into another account.
 A programmer coding an accounting system that ignores
withdrawals on a specific set of accounts.
 A programmer writing a program that scans for ‘dead’ accounts and
then transfers the money elsewhere.
 Losses usually too small for a large company to worry about.
 Most banks have a threshold at which they say ‘We expect to lose
this amount to fraud every year’
 Too costly for zero tolerance.

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Equity Funding Corporation of
America
 The Equity Funding Company of America (EFCA) was
responsible for one of the largest corporate frauds in American
History.
 Something like an Enron of the 1970s
 Dramatized in the BBC Horizon programme ‘the billion dollar bubble’
 Functioned through investing in mutual funds.
 Put money in a mutual fund.
 A collective pot of money produced by investors clubbing
together.
 This pot is then invested in a portfolio of stock managed by a
mutual fund company.

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Equity Funding Corporation
 The company took out life insurance policies which paid out if a
person died.
 The premiums for this are paid annually.
 The company borrowed against the mutual fund to pay the
annual premiums.
 After ten years, the fund ‘matures’ and gives out the
accumulated incresed value.
 This is used to pay back the loans that were taken out against the
fund.

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Equity Funding Company
Mutual Fund
Life Insurance
Loan
PaymentonDeath
AnnualPremiums
Borrowagainststock
Investment
Value after 10 yearsPROFIT

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So far, so good
 The company started to expand by taking over new companies.
 And they had a huge sales force.
 The acquisitions cost lots of money.
 Which were funded largely through Equity Funding’s stock price.
 New companies were bought with stock in EFCA
 To keep the value up, generating yearly earnings growth was
important.
 This would allow for more acquisitions and more wealth.

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But then…
 A problem with their mainframe meant they couldn’t extract
yearly revenue details for 1964.
 Oh no.
 The annual report was not going to be ready on time.
 During the delay, the company co-founded (Stanley Goldblum)
came up with an idea to use a creative accounting method to
‘temporarily’ increase sales figures.
 He directed the company CFO to make fictitious ‘advance’ entries
with regards to income.
 Essentially saying ‘Here’s money we’ll be getting in the future,
now’

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Escalation
 Now he needed to find real money to back up those ‘sales’
 In order to pass the audit required by the Securities and Exchange
Commission.
 Then came the idea…
 Let’s take out real insurance policies on fictional people.
 Originally done by a handful of trusted employees doing overtime.
 The process worked through the value of ‘reinsurance’
 A company sells a portion of its policies to another company.
 This creates instant cash flow.
 It also mitigates against future catastrophes.

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Escalation
 So
 The company created fake insurance policies.
 They then sold these faked policies as legitimate policies to
insurance companies.
 They then used the income to pay a portion of the fake policies
premiums.
 Making the sales seem credible to the auditors.
 This created cash flow out of nowhere.
 And also hugely jacked up the stock price for the EFCA
 As of yet, this isn’t a computer crime.

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Enter the Mainframe
 Making up fake accounts had become too time consuming.
 Time to introduce a computer.
 At the time, auditors couldn’t audit computer systems.
 Too specialised.
 No auditing meant that program code never went examined.
 This meant that the computer could be used to streamline the
process of defrauding the reinsurance companies.
 Goldblum paid a programmer to write a program that created
fake policies.
 Access to the program was restricted based on a secret password.

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Scale of the Crime
 This automation led to EFCA having $425M of life insurance
policies on their books in 1968.
 With $100M in mutual funds sold.
 From 1969 to 1973:
 64k faked accounts were created.
 Reported revenues of $1.8B
 Every so often, a few policies would be ‘killed off’
 Brining that money in from the reinsurers.
 Plans were afoot to automate even that.
 Killing off fake policy holders at a statistically appropriate rate.

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Whistleblowers
 It eventually came to light after an ex-employee blew the
whistle.
 Ronal Secrist.
 Securities analysts Ray Dirks also came forward with evidence.
 And was later rewarded with insider trading charges being filed
against him.
 He was eventually acquitted by the Supreme Court.
 Fraud was unsustainable.
 Eventually they would have had to be insuring the whole country.

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Crime and Punishment
 Goldblum and 18 others pleaded guilty to taking part in the
fraud.
 Three others were convicted in a 1975 trial.
 Goldblum served jail time for his part in the fraud.
 He never learned his lesson.
 At the age of 72, he was arrested for submitting false information to
obtain a $150k loan.
 Crime remains one of the most significant in terms of scale.
 Computers serve a role in managing scale.

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Fooling the Auditors
 One night, an auditor left an unlocked briefcase.
 An EFCA executive, in full sight of others, opened the case and
got access to the confidential audit plan.
 This allowed EFCA to have plans in place to deal with audit
requests.
 One auditor wished to send out policy confirmations to a
sample of policyholders.
 ECFA did the clerical work for the auditor.
 Letters were instead addressed to branch managers and agents of
ECFA, who filled out the information for the fictional policyholders.

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Why Did Nobody Notice?
 Auditor responsibilities fell to the State Audit Office.
 Responsible for identifying if businesses are acting according to the
law.
 Auditors responsible for checking inputs and outputs.
 Sales of insurance policies
 Money coming in
 Reported earnings
 However, auditors couldn’t audit everything.
 Accountants did not have the specialised knowledge required to
audit systems.
 IBM protected proprietary secrets, and were the ones producing the
mainframes used to perpetuate the fraud.

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Auditing Around a Company
Equity Funding Corporation
of America
INPUTSOUTPUTS
examine
examine
AUDITORS

23. + Auditing Through a Company
Equity Funding Corporation
of America
INPUTSOUTPUTS
examine
examine
examine
AUDITORS

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Why did it happen?
 Unchecked greed and territorialism of managers.
 A lack of ethics and professional standards amongst
management and involved employees.
 The philosophy of the management.
 The independence of the auditors and their inability to audit
computer systems.
 Lack of effective oversight by the auditors.
 Letting the company do some of the work? Come on, guys.

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Why did it happen?
 The fraud was a massive scheme.
 Concocted by management.
 Supported by dozens of employees.
 Each of which knew or suspected that something was going on.
 Why did no-one report until so late into the scandal?
 The management were intent at becoming a huge
conglomerate at all costs.
 Without worrying about the risks of these activities.
 Rampant territorialism drove much of the acquisitions.

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Auditors
 The auditors compromised their professional independence during
the investigations.
 One was earning $130k to $150k, because they were contracted by
EFCA and were the largest quiet.
 A second auditor was given shares in the funding, which he kept
under his wife’s former name until they were cashed in 1967.
 Another auditor received a loan of $2,000 from the company.
 All three auditors were later found guilty of fraudulent activities.
 Some auditors were at least partially complicit in the incident.
 Allowing for the company to take a direct hand in auditing violated
accountability.

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Class Exercise
 In groups of 3-4
 Imagine yourself in a similar kind of company in the modern day.
 How would you use computers to perpetuate economic fraud?
 Outline a company structure, significant individuals who would be
involves, risks and points of weakness.
 You’ll get some time to come up with this plan, and then:
 Swap your plans with another group
 Try to identify how you’d effectively audit their system.
 Identify skillsets needed
 Identify weakness in your auditing.
 Identify ‘human factors’

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Conclusion
 This is not a new or especially novel crime.
 It was in no way sophisticated, or only possible because of
computers.
 There was no grand plan behind it all.
 And no escape route – escalation was mandatory because of the
pyramidal nature of the acquisitions.
 Crimes committed nowadays are usually far more organised
and significant.
 We have a better idea of what people might do and how we should
counter it as a society.
 That doesn’t mean that fraud is dead, of course.