How the New York Stock Exchange, the Life Insurance Industry, the Sec and a Host of other Guardians

Equity Funding Corporation of America, a financial-services institution, began operations in 1960 with $10,000. Its "Product" was a new way to purchase life insurance. You bought shares in a mutual fund; you borrowed against that equity to pay your life-insurance premiums. In effect, you used your money twice--and if the stock market went up in the interval, you made money on the deal.

By 1973, Equity Funding listed assets of nearly $750,000,000. It managed mutual funds and a savings and loan association worth another $320,000,000. Its record of growth in the (continued on page 146) How The New York Stock Exchange... (continued from page 129) previous decade had exceeded that of all major diversified financial companies in the United States.

In the last days of January 1973, Stanley Goldblum, the corporation's chief executive officer and one of its founders, a multimillionaire with a colossal build gained first by slinging sides of beef as a butcher and later by weight lifting in his private $100,000 gym, ordered a massive cut in the company's budget. In mid-February, Ronald Secrist, an obscure officer in one of Equity Funding's subsidiaries, paid a routine visit to the home office in Los Angeles, only to learn that he was fired. Early in March, Secrist made two phone calls that triggered the collapse of Equity Funding and exposed its record growth as a fiction. The assets were real enough, for the most part, but they had been obtained by fraudulent means.

One of Secrist's calls was to the New York State Insurance Department. The other was to Raymond L. Dirks, a financial-securities analyst specializing in insurance stocks. (This article is a collaboration--as is The Great Wall Street Scandal, the book from which it is adapted--but because Ray Dirks was a central participant in events leading to disclosure of the fraud, the portions involving him are told hereafter in the first person.) Secrist alleged that Equity Funding had created thousands of fictitious life-insurance policies, then sold these policies to other companies; that the company had made up fake death certificates; that it had created fake assets and counterfeit bonds; that the officers of the company not only were involved in the plot but were its architects; that middle management carried out the fraud knowingly; that a substantial number of people inside and outside the company knew about the fraud; and that the fraud had evolved because of a need to boost the price of Equity Funding stock, so that the company could acquire other companies through a trade of shares. The acquisition of profitable companies could cover up the lack of profitability inherent in the Equity Funding operation.

His charges seemed incredible. His strategy--which he freely acknowledged--required that I investigate the charges and relay to my clients the information I uncovered.

My clients include some of America's largest financial institutions. Their sale of the stock, Secrist reasoned, would so decimate the price of Equity Funding's stock that investigators would be compelled to intervene before the company could cover up the fraud.

That, more or less, is what happened. Within three weeks, Equity Funding stood revealed as the perpetrator of what is possibly history's greatest hoax. The $400,000,000 had been swindled by inducing the American public to purchase securities based upon fake assets and phony insurance policies. Its stock, which had sold as high as $80 a share, was suspended from trading on the New York Stock Exchange. The corporation filed for bankruptcy. The hoax came instantly to be known as "Wall Street's Watergate."

In November 1973, 22 men--20 of them former employees of Equity Funding, the two others accountants who audited the company's books--were indicted by a Federal grand jury in Los Angeles on 105 counts of fraud and conspiracy. A similar indictment was returned by a grand jury in Illinois, where Equity Funding's principal life-insurance subsidiary was chartered. Still more criminal indictments were being prepared by other grand juries in states where Equity Funding did business. Myriad civil actions by stockholders and creditors are likely to continue for years. So will ruminations and calls for reform of the public and private agencies that monitor America's business.

The Equity Funding scandal can be understood in its magnitude only when one analyzes the weakness of the investment system on which it thrived. Had even one of the system's components functioned with strength, the fraud could not have occurred.

• • •

In 1959, Equity Funding was little more than an idea. Eleven years later, it was one of the most actively traded issues on the New York. Stock Exchange. Its rise to prominence in the world's most dominant and exclusive financial trading market epitomized the American dream.

Yet Equity Funding had no right to a listing on the N.Y.S.E. It was this very listing that gave the company the endorsement it needed to perpetuate its fraud. That Equity Funding managed to be listed is only one of the overdue indictments against the New York Stock Exchange. This venerated institution is not the guardian of the free-enterprise system it proclaims to be. It is an expensive and outmoded monopoly.

The thrust of the Stock Exchange's message is that its listed stocks are the nation's biggest and best companies. The ultimate objective of a go-go corporation like Equity Funding is to interest financial institutions in the purchase of its stock, so that the stock will sell at a high multiple of earnings. The objective focuses on a Stock Exchange listing. There, the presence of legitimate blue-chip stocks presumably rubs off on other listed securities.

Equity Funding began as a company whose shares were held by its founders. The first step for an ambitious corporation is to go public. By selling shares to the public, the corporation raises the money with which to finance its operations and growth. True, the founders dilute their holdings, but the larger the enterprise, the larger the salaries and perquisites, and the greater the opportunities for expansion. Moreover, the founders' shares are immediately priced at market levels.

Equity Funding made its debut as a publicly held corporation in the over-the-counter market. Some of the nation's most reputable corporations are traded in this market, but essentially it remains a testing ground for smaller, newer companies in training for the big time.

The next step up for such corporations, frequently, is a listing on the American Stock Exchange. This exchange can be likened to the triple-A minor leagues in baseball--good sport but not the big time.

After a few years on the American Exchange, Equity Funding reached sufficient size to apply for a New York Stock Exchange listing.

The N.Y.S.E. has certain requirements for listing and maintains departments whose job is to enforce those requirements. The staffs of those departments looked over Equity Funding and found its application deficient. One objection was that its board of directors was not large enough and did not contain enough members from outside the corporation. A second, more significant objection was that the auditing firm employed by Equity Funding had neither sufficient size nor reputation.

These objections contained Equity Funding for some months. But eventually politics prevailed. The public interest that the exchange's regulations are meant to guard became secondary to the interests of certain N.Y.S.E. firms who found this new "concept" stock romantic and liked the way it "performed."

Equity Funding's listing was authorized in October 1970 on the condition that the company would expand its board of directors and secure the services of a national auditing firm. The company did expand its board, but its effort to comply with the auditing requirements was sheer comedy. Wolfson, Weiner, the small firm that had been used as auditors, simply used the Equity Funding account as the bait for a merger with a big accounting firm. Eventually, it sold out to Seidman & Seidman at a nice profit. More than a year after Equity Funding went on the big board, Seidman & Seidman took over the audit. What the New York Stock Exchange never realized was that the same individuals who had audited the Equity Funding books for Wolfson, Weiner were now auditing them for Seidman & Seidman.

Allowing Equity Funding to be listed goes to the heart of the question of the New York Stock Exchange's ability to (continued on page 200) How The New York Stock Exchange... (continued from page 146) function as the regulator it proclaims itself to be. Clearly, there was a conflict between the standards of the exchange--the presumed stockholders' watchdog--and the interests of its member firms. The latter's interests prevailed.

Once the stock was listed, the exchange should have determined that its requirements had been met. There may have been some effort in this regard, but none vigorous enough to establish that Equity Funding had effectively winked at the order to obtain new auditors. For all practical purposes, the change was in name only.

Such laxity puts the lie to the New York Stock Exchange's proclamations of itself as a self-regulating institution--and yet it is this very status that the Stock Exchange enjoys. Technically, the exchange comes under the jurisdiction of the Securities and Exchange Commission, but in reality, it operates as an autonomous club.

There is justification for the self-regulation of an industry, if the industry can do the job. But the New York Stock Exchange has not remotely acquitted itself of its responsibilities as a self-regulating body. Not only is it incapable of monitoring its listed companies, it is incapable of monitoring its member firms. It hasn't the mechanism or the ability to comprehend the fraud and inefficiency in its own house. The greatest example of this deficiency is the Stock Exchange's failure to foresee the impending bankruptcy of many of its brokerage firms in recent years. It has even failed to prevent various versions of Equity Funding among its own member firms.

The exchange proclaims itself the hub of the business world. Its image transcends its reality. It is really nothing more than a physical place where brokers buy and sell from one another, reflecting the orders of their customers. It began under a buttonwood tree in 1792 as a central place where stocks could be traded. There was an obvious advantage in congregating people in order to make a market place. The more people, the greater the market and the more likely that buyers and sellers would find one another. For years, the exchange provided this central mechanism. It grew, prospered and moved indoors. But its basic nature remained unchanged. The only major changes were the telephone. which permitted orders to be transmitted to the floor of the exchange rather than carried there; the introduction of the specialist system, wherein one person would keep a continuing record of all unfilled orders, and use his own capital to try to maintain an orderly market; and the ticker tape, which enabled investors to watch the market action from remote stations. But the manner of selling remained the same. Brokers gathered around one another in a single location. That was the way it was done in 1792, and that's how it's done today.

But the system disserves its customers. They pay more when they buy and obtain less when they sell. The existence of a physical market place puts a limitation on the number of brokers who can work there. That automatically limits the market. Moreover, it defines the kind of market that can be maintained. Trading is restricted to an auction market centered on one specialist. There is no room on the floor for others.

Dealers throughout the United States can offer to buy or sell securities listed on the New York Stock Exchange at prices that, in many cases, are more favorable than those available on the floor. But brokers who belong to the exchange are prohibited from seeking better prices away from the floor. What that means, effectively, is that an order given to a member firm for a stock listed by the New York Stock Exchange must be handled on that exchange. That's profitable for the members of the club, but it can be costly for their clients. The clients would be far better served if their order to buy or sell a stock could be offered to dealers everywhere; only then would they be assured of the best possible price.

There is an infinitely more appropriate market, and the technology to produce it. It's called a dealer market. Instead of one specialist standing in one place making a market, there are ten, 20 or more market makers willing to buy and sell through the facilities of a computerized visual-display system that functions on a national basis. Whereas the auction market is a monopolistic system, the dealer market encompasses everyone. A system called NASDAQ tells which dealers anywhere in the country are willing to buy or sell a stock. A seller need only push a button to find the highest bidder for his shares.

If many specialists were permitted to make a market in a stock, the price would invariably be the most advantageous possible to the customer. So would the cost of doing business. Competition would produce smaller price Spreads and lower commissions. But as long as the stocks of the most important companies in the country can be traded only on the New York Stock Exchange, NASDAQ cannot fully function.

Wall Street today is the most poorly managed industry in the country. Any monopolistic situation breeds resistance to change. Inevitably, the monopolistic practices on Wall Street have produced inefficiency among its member firms and lack of depth in their work. Such conditions immeasurably assisted the rise of Equity Funding.

• • •

The Equity Funding scandal would not have occurred had analysts done their job. The function of security analysts, like that of investment bankers, is to determine the real worth of a company, so that investors will pay a fair price for its securities. No price was fair for the stock of Equity Funding--but numbers of analysts touted it.

"Why were so many analysts recommending Equity Funding only months and in some cases days before the collapse?" The Wall Street Journal wondered in the aftermath of the exposure.

The answer is not reassuring.

Most investors, even professionals who manage large funds, are not really disciplined to arrive at values as opposed to fads and fashions and snap judgments. A lot of them--and I include myself--have a gambler's instinct. They are willing to plunk down money based on swift impressions rather than solid research. Few men in the Street dig deep. Superficiality is the name of the game.

After the Depression, stock analysts paid strict attention to corporate balance sheets, which reflected the net worth of companies. But gradually, as the economy strengthened again, the money men became increasingly preoccupied with a company's earnings potential and less concerned about its present financial condition. Earnings can change swiftly, but net worth changes slowly.

Today, analysts for the most part project prices of stocks by using an oversimplified measure known on the Street as "performance." They try to determine what the normal true growth rate of a company is in terms of its earnings per share, and then determine the degree of confidence they have in that growth rate. From this calculation they then assign a multiple of earnings to a stock. If a stock earns one dollar a share in a given year with a projected growth rate of ten percent per year, and the degree of confidence is high, then an analyst might feel that the stock warrants a price 20 times earnings, or $20 a share. If the confidence factor is lower, then the multiple-of-earnings figure would be commensurately lower, say ten times earnings, and the stock would warrant a price of only ten dollars a share.

The keys to the confidence factor are the consistency and growth of reported earnings. For how many straight quarters have earnings risen, and what percent? If they have followed a consistent pattern of quarterly growth, then the analyst or fund man assumes that the earnings will continue to grow. Many analysts made this very assumption about Equity Funding--whose "growth" in the late Sixties and early Seventies exactly followed the pattern.

There are other problems as serious as the analysts' singular reliance on performance. One of the worst habits analysts have developed is to rely on the reports of other analysts. A good financial public-relations firm will arrange for a friendly analyst to visit a company, then write a favorable report--which the public-relations firm, in turn, will then distribute to other analysts.

The easiest way for an analyst to do his job is to copy another analyst's work. Part of his function is to read what the competition is saying. But when an analyst uses another's work to produce his own, a line of integrity has been crossed. This line is repeatedly crossed on Wall Street.

A harried analyst with much work to do receives a 25-page report from a large firm, written by a prominent analyst. He makes a few perfunctory checks, which seem to be in line with the conclusions of the detailed report. He churns out a report of his own.

What the analyst may not know is that the report has been monitored, managed or even partially written by the very company it purports to judge.

It is common practice on Wall Street for an analyst to send a draft of his report to the company. Such submission, in these cases, has been a condition of access to the company's inner sanctum. The company does not say, "We want to censor you." It says, "We want to read your report to check for inconsistencies. We don't care what you say or what your opinion is, we just want to make sure everything in it is accurate." In fact, the company is exercising censorship. Often, it may rewrite sections of the report.

Most companies think it is their prerogative to see any report an analyst writes about their affairs prior to publication. They will then attempt to correct any negative impressions.

The analyst is not the most powerful man in a brokerage house. He may have a good reputation, but he doesn't have much a stature. Suddenly, he is dealing with top management of a major company. As sturdy an individual as he may be, he feels a great deal of pressure. Unless he has an enormous amount of self-confidence, he is going to be persuaded, or intimidated, into doing what the company wants.

There's yet another problem. It's human nature to want to believe in the people with whom you're dealing. Such tendencies, however, are contrary to the interests of investors who must rely on the analyst's assessment.

Conflicts of interest militate still further against hard analysis. A brokerage house earns its money on commissions from the buying and selling of shares. Most analysts aren't really analysts; they are essentially salesmen motivated by the need to generate commissions. There is a Wall Street axiom to the effect that "negative stories don't sell." No one but the man who owns a stock wants to hear something bad about it--and even he is uncomfortable with the revelation, because it tells him that he made a bad judgment. All other investors want a positive story, one that tells them about a stock that might make them some money.

The major consequence of this condition is that very few analysts go after negative stories. There is much more money to be made in the recommendation of a buy, which implies the possibility of profit, than in the recommendation of a sell, which usually implies a loss.

The analyst who writes negatively about companies may eventually find himself with no one to talk to. Companies are unlikely to cooperate with an analyst with the reputation of a skeptic. While an analyst must go afield to form his ultimate judgment, his impressions of management are vital to his assessment. Consciously or unconsciously, the analyst who wants to remain an analyst either doesn't dig deep enough or doesn't disclose with sufficient force the facts that he uncovers.

So the general course of "research" on Wall Street goes like this: An analyst hears management's story and, if he's favorably impressed, writes up a report. (If he's not impressed, he generally does nothing.) The report is then submitted to management, management corrects it and sends it back to the analyst, the analyst then persuades his firm to send the report out, the report is distributed to the firm's salesmen--who are not analysts--and these salesmen, in turn, distribute the report to their customers as gospel. No wonder the general tenor of most brokerage-house reports is overly favorable to management.

Equity Funding was an analyst's darling. Perhaps the brokerage firm most embarrassed by the scandal was Hayden Stone. One day before the N.Y.S.E. halted trading, the company issued a report that said: "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."

Hayden Stone's analyst said he had checked the insurance departments of Illinois, New Jersey and Washington, three states in which insurance companies owned by Equity Funding were licensed. "Each man told us that he is not conducting an investigation of Equity Funding or any of its subsidiaries, has no present intention of conducting an investigation and knew of no other insurance department that is conducting such an investigation."

In the case of Illinois, the man to whom the analyst spoke was in fact directing an investigation.

"There's no way of adjusting for massive fraud in analyzing a stock," Laurence A. Tisch, Loews's chief executive, said after the Equity Funding fraud had been disclosed. "There's just no answer to it. Either you believe the whole system of investing is based on fraud or you do business on the basis of audits, insurance regulation and other safeguards."

That is true. But clues were available long before the formal investigation of fraud--and analysts should have caught them.

One printed clue could have given the game away as early as 1967. It is contained in a comparison between what Equity Funding said it had sold in the way of insurance in 1966 and what another company said Equity had sold.

In its first years, Equity Funding was an agency. It had no insurance company of its own. Much of the insurance the company sold to clients it placed with Pennsylvania Life Insurance Company. In 1966, according to an Equity Funding prospectus of May 1967, the company sold a face amount of $226,300,000 worth of life insurance, the "greater part" underwritten by Penn Life. But Penn Life's prospectus one month later stated that it had underwritten only $58,600,000 in policies for Equity Funding in 1966.

No one caught the discrepancy.

Another clue was the sale of Equity Funding stock by key insiders. Consider Stanley Goldblum, the largest individual stockholder. On the day trading was halted, he owned some 240,000 shares. But several years earlier, he had owned close to 500,000 shares. All sales by insiders are reported to the SEC and duly published, but none of the many favorable reports on Equity Funding noted that Goldblum had been a steady seller of some $10,000,000 worth of Equity Funding stock.

None of the analysts who spoke of Equity Funding's aggressive sales force properly evaluated the sales figures. The salesmen were not selling nearly the amount of life insurance or mutual funds the company's figures indicated. Had even one analyst interviewed a random sample of salesmen, averaged their sales and multiplied that average by the 5000-man sales force, he would have known immediately that something was wrong. Even granting that all 5000 salesmen were bona fide, the total would not have come close to the figure presented each year by the company. But all of the salesmen were not bona fide. Some worked part time; others produced very little. So the total would undoubtedly have been even further removed from the figure alleged by the company.

In addition to clues like these, there were questions analysts might have asked.

Why should Equity Funding have grown at a far faster rate than any other company in its field?

Why was Equity Funding successful with a product that no one else could sell?

Why, in the recession year 1970, was Equity Funding able to go against the current and report its customary increase in sales and earnings?

Why, in a period when it was increasingly difficult to sell life insurance and mutual funds, was Equity Funding able to increase the sales of both?

No one asked these questions. I didn't either. I refused to take Equity Funding seriously, because I never believed in the concept. Borrowing against a mutual fund seemed like an expensive and risky way to buy insurance. And that, as it turned out, was the most telling clue of all.

Equity Funding projected its concept as a modern approach to life-insurance protection. Only the means of purchase was new. The product was just as old--and flawed--as what other insurance companies sold.

• • •

The critics peering through the rents in our social fabric for an explanation for the Equity Funding fraud could do worse than contemplate the large object in the foreground--the life-insurance industry itself.

Equity Funding might never have come into being had the life-insurance industry provided the consumer with modern alternatives to its outmoded products.

The life-insurance industry is the bluest of the chips. It controls more assets than any other industry in the country. It is all but immune to change. The great social concerns that butt up against other industries make a detour around the insurance industry. Life insurers do not pollute the environment. Nor are they obliged to change their model each year; their customers do not trade in their old policy for a new one every few years, because it would cost them dearly to do so. But what most distinguishes the life-insurance industry is that year after year, it makes settlements with cheaper dollars than those it has been paid.

The life-insurance industry, moreover, enjoys a favorable tax position. There is a special tax law for life-insurance companies. The industry is one of the few that file income-tax reports on other than a regular corporate income-tax form. It enjoys special tax deferrals.

For all these reasons, life-insurance companies like to keep things quiet. They broadcast an image of solidity. They build huge office buildings to concretize the image. They give the policy-holder the feeling that his investment is solid.

The notion is ridiculous.

Most life-insurance companies are misleading, at best, in their representations to consumers. This is particularly true of mutual life-insurance companies, which are theoretically owned by their policy-holders. Prudential Insurance and Metropolitan Life, the largest in the business, are prime examples. Their policyholders may own a minuscule portion of the equities of the company, but they are offered none of the company, but they are offered none of the perquisites of ownership.

Policyholders may own a mutual company, in theory, but in fact they have no say in the management of the company and no way to exercise their rights as owners. Managements, answerable only to their policyholders, have the power of czars. They control their companies, and there is no appeal from their rule. There is an annual meeting, which policyholders may attend or to which they may send proxies. But policyholders in the bigger companies number in the hundreds of thousands; they are not organized into any cohesive public-interest group to determine whether or not management does a good job.

The motivation of a mutual-life-insurance-company management is actually at cross-purposes with that of its policyholders. Management wants to get bigger, in order to command more prestige and pay. Its means to do so are limited. It cannot readily make acquisitions or merge with other companies because it's not a stock company. The investments it makes must be inherently conservative. So the only route to greater size is to sell more life-insurance policies. The way to accomplish that is to invest the company's earnings in the hiring of salesmen.

But the policyholder's interest in mutual companies would best be served if the company were to stop selling insurance and liquidate. Then, and only then, would he get the fruits of ownership. There would be no expenses incurred in the search for new business, no commissions, no expansion of offices. Assets could be sold and the proceeds paid out in dividends. All the company would need would be a sufficient amount of capital to protect the interests of the policyholders. The surplus could be paid out immediately.

Mutual life-insurance executives, and their enormous force of salesmen, would find such a thought heretical. Their well-being depends on the maintenance of this gigantic system of accumulating assets.

Still more misleading--and more damaging--is the representation life-insurance companies make to consumers about the product they sell. For years, the insurance industry has been able to put savings and protection against death under the cloak of life insurance. What you, the policyholder, bought was really death insurance and an inferior lifetime savings plan that may pay as little as three percent a year.

There are two types of whole life policies sold by insurance companies. One is participating, the other nonparticipating. Nonparticipating policies offer a fixed guaranteed return; you get no percentage of any additional profits the company might earn on the investments it makes with your money and the money of others. Participating policies, which are sold primarily by mutual companies, pay you according to how well they do with the money you give them.

Insurance companies mostly own bonds and mortgages. When interest rates go up--as they have in recent years--bond prices go down. A life-insurance company that were to sell all of its bonds today probably could not meet its obligations; if all the policyholders turned in their policies, the company might not be able to pay them off. Until the late Sixties, bonds were a horrible investment, averaging a yield of two to four percent a year. These were the bonds that insurance companies bought in quantity. So if you bought a participating policy 25 years ago, the annual yield on your investment had been roughly three percent--reflected in the increase in cash value of your policy. To the extent that a mutual company might have invested in stocks, and the stocks performed well, you might have earned extra money. But it's not likely; it's not the nature of the breed.

Any way you look at it, whole life insurance is a terrible investment, yet insurance companies and their salesmen, with few exceptions, try to sell you whole life. They say, "Don't buy stocks until you have a tremendous amount of life insurance that includes a big savings program." They don't say that if you buy term insurance they won't get much commission.

People don't like to think about their death. Life insurance, accordingly, is not something they go out and buy. It has to be sold. Most life insurance is sold because an agent finds someone and talks him into buying it.

Agents receive a huge front-end "load" on any policy they sell. The load may be anywhere from 50 percent to more than 100 percent of the first-year premium. Some companies have been known to pay their agents 120 percent of the first-year premium, adding their own dollars to the money coming in. Each renewal year for up to ten years, an agent may receive ten percent of the premium.

It's a wasteful system, fraught with deception and opportunism.

The thrust of any selling pitch ought to be simplification. The individual should be told what he's paying for in terms of an investment program. That almost never happens.

Years ago, an old friend looked me up, took me out to dinner and tried to sell me a policy. "What do I need one for?" I asked. "I'm twenty-three and single."

"You ought to buy one, to be sure you have it," he argued. "Suppose you have a heart attack or a disease?"

My death, at that point, made no difference to the support of anyone. I simply didn't need a life-insurance policy; surely I wouldn't benefit from it. I tried to explain that to my friend. "The insurance industry ought to have a policy for a person like myself, guaranteeing me the right to buy insurance when I really need it. I'd pay $100 a year just to be able to buy the insurance should I marry and have a family."

"We don't offer that," he said.

Now, as then, salesmen swarm around colleges and universities, urging students to sign up before they start to work. Premiums will cost less, they argue, because you're buying at a younger age. They fail to add that you'll pay for more years.

Think of the dividends you'll receive, they go on. They don't explain that you're not getting a reward, you're simply getting some of your money back, plus a small return on your investment.

Then the salesmen argue that if you pay in for 20 years, you'll eventually get all your money back. You could do better yourself, avoiding the salesman's commission, plus the overhead and profits of the life-insurance company.

The salesmen argue that a permanent life-insurance policy is an enforced savings plan, that if you don't have a life-insurance policy, you'll spend the money. That may be the best argument they've got. But there are other forms of enforced savings plans that offer better yields.

Equity Funding wouldn't have been possible if life insurance hadn't been the poor investment it was. Somehow, the public sensed that it was poor, and gradually their savings dollars began to find their way into savings and loan associations, banks, mutual funds and the stock market. But they still needed some kind of protection.

The lure of Equity Funding was that it seemed to overcome these deficiencies. You could put it all in one package, send one check a year that would take care of your insurance and your investments. You could "leverage" your money--use it twice. You didn't have to arrange to borrow the money; Equity Funding took care of that. The program didn't affect your credit. Additionally, if the market went up, you would, in fact, come out ahead.

At first glance, the concept had appealed to investors because they had come to see the life-insurance industry as sleepy, backward, putting its money into conservative bonds and mortgages. Suddenly, here was a company saying, We're going to take this client's money and invest it for him aggressively. The basic appeal of the product was that you could have your cake and eat it, too. You could have your life insurance and that big pot at the end of the ten-year period. You had the element of conversation and the element of speculation.

But on close inspection, Equity Funding's program didn't fill the investor's needs nearly so well as it had seemed to. What was wrong with the whole insurance concept of saving was equally wrong with the funded program offered by Equity Funding. You were saddled with an antique form of savings, with no special compensation. If you were making money under an Equity Funding program, you would also be making money through your own investment--without the costs of the funded program and the antique form of insurance.

The Equity Funding program couldn't withstand the inevitable fluctuations in the market and in market psychology. Coincidentally, it was in 1969, the first bad year for mutual funds and insurance companies, that the company's insurance fraud began. The public had begun to recognize that the Equity Funding program had the inherent weaknesses of any program that attempts to combine life insurance and investment. The program, which had sounded so promising, just didn't fit the needs of enough people.

Equity Funding was a leveraged company in its own right. It borrowed heavily to run its business. It couldn't convince enough customers to do the same. The real reason Equity Funding failed was that people suspected its product.

• • •

And so a product of uncertain social value disappoints its creators, the creators issue false reports to a Wall Street disposed to unsubstantiated success stories and Wall Street kites the stock.

What defense remains to the public if the New York Stock Exchange--or some other exchange--has failed it?

Basically, there are two--independent auditors, who must certify the company's figures, and the Securities and Exchange Commission, which regulates financial markets. But because Equity Funding involved an insurance company, there was a third line of defense, the state insurance departments under whose jurisdiction it operated.

If the Equity Funding scandal proves anything, it is that auditors as safeguards are worthless. The independent auditor is not independent. He is paid by the firm being audited. He is worried about keeping the account.

The first person I went to after I had assembled enough evidence of fraud was a partner in Seidman & Seidman, the accounting firm that had taken over the Equity Funding audit. I truly believed that I was doing this nationally ranked firm a favor. It was about to publicly certify a report I believed was fraudulent. Instead of acting in the public interest by reporting the matter to the SEC, the auditor applied the most narrow interpretation to his role and went directly to Equity Funding. When I asked him why he had done so, he replied, "They're clients of mine."

"Aren't you independent auditors?" I asked.

"Sure we're independent, but we have an obligation to our clients."

The two postures are irreconcilable.

Corporate managements understandably want to control their destinies. Our system places a check and balance on this very tendency; it requires a corporation to justify itself to the independent public accountant. The public accepts what this independent auditor certifies. But when an auditor is beholden to a corporation, his certification may be worthless. Equity Funding constituted a large percentage of the business of Wolfson, Weiner. It was unrealistic to expect that firm to function independently.

Forgetting for the moment the ambivalent economic position in which the auditor is placed, forgetting the possibility of collusion, there is the additional problem of human inadequacy.

If auditors do nothing else, they should determine that the assets listed by a company actually exist. If the assets are there, nothing too serious can be wrong. Equity Funding's auditors either didn't diligently check the corporation's assets or were hoodwinked when they did.

When the computer expert hired by the Illinois Insurance Department belatedly arrived at Equity Funding as the scandal was exploding, he asked the manager of the company's computer operations if he had spoken to the auditors about his control system. "I never met with any auditors," the manager replied. "At no time did the auditors come down and ask me for tapes or files."

Had the auditors done so, they would have found telling discrepancies. There was, for example, no computer file of insurance policies--real or alleged--that reconciled with the amount of reserves the company carried on its balance sheet.

Whether or not the auditors would have understood what they found is yet another question. Few auditors understand computers.

Much has been made of "computer fraud" since the disclosures at Equity Funding. Computer experts react with legitimate outrage. Computers are just "big dumb adding machines," as one computer specialist put it. Only when a human mind puts computers to devious purpose do they become accomplices to fraud.

But computers do have the facility to create impressive-looking print-outs that never existed before. A fraud of the magnitude created by Equity Funding is inconceivable without the support of computers. For auditors to be meaningful regulators of corporate morality, they must master the tools of their clients.

A frequently heard comment after the Equity Funding scandal became public was that "routine auditing procedures aren't designed to detect fraud." If routine auditing procedures cannot detect 64,000 phony insurance policies, $25,000,000 in nonexistent bonds and $100,000,000 in missing assets, what is the purpose of audits?

What can be said of independent auditors engaged by corporations can also, unhappily, be said of another line of the public's defense--the state insurance departments.

New York's insurance department is considered the best in the country. In April 1973, the department concluded a two-year study of its operations with a doleful finding. Under the existing system of insurance examination, Malcolm Mackay, then the department's first deputy superintendent, concluded, the department "asks the wrong questions and gets the information too late."

There are 1821 life insurers in the United States today. They write a volume of business ten times what it was in 1945. In 1972, they took in premium income of 24 billion dollars on policies with death-benefit values of 1.6 trillion dollars. They are regulated not by the Federal Government but by the states. Some states have ample departments. Others must hire outsiders to perform the examinations on insurance companies that are supposedly mandatory every three to five years. But even the best departments fall behind in their work. California's insurance department did not adhere to the regular three-year audit schedule in the case of Equity Funding. The last full-scale examination of the company was in 1968.

The audit of a large insurance company can take as long as two years; the results may not be available for another two years. By the time the audit is published, it's all but irrelevant. If a crime is discovered, it could, by then, be protected from prosecution.

Like the independent auditors, the state's examiners lag behind the insurance companies in technological competence. All insurance companies use computers, but few state insurance departments have personnel knowledgeable about computer systems. State examiners were on the job at Equity Funding for almost three weeks before they found a clue.

Another problem: The range in which the insurance departments operate is inherently too restricted to detect fraud if a parent company is involved. The insurance department normally has no charter to inspect the parent company. Consequently, the department can't possibly know what's happening overall.

There is a more intrinsic problem yet--the coziness of the insurance departments with the industry they regulate.

The relationship of a state insurance department to a resident insurance company is something like that of a hotelier to a paying guest. The companies pay far more for the privilege of operating than the states pay to maintain them. Illinois, for example, takes in $48,000,000 in taxes on the premium income of the insurance companies it regulates. The state spends $3,600,000 on regulating these companies. Insurance departments, viewed by their state governments as moneymakers, suffer accordingly.

The flow of manpower between the industry and its policemen is inexorable. Executives of insurance companies are appointed insurance commissioners or deputies. Insurance commissioners resign to become officers and directors of insurance companies. A chumminess develops that cannot assist regulation.

In June 1973, the insurance commissioners of the 50 states met in Washington, D.C., with the Equity Funding scandal foremost in mind. They agreed that they should set up a commission to find out what went wrong and how they should fix it. They agreed that the study should be financed by the insurance industry.

When regulators ask those they regulate to finance a study on how to better regulate them, something is wrong with regulation.

The ultimate objective of insurance regulation is to make certain that companies remain solvent. To achieve this objective, insurance departments tend to fall back on a strategy that protects the inefficient. Insurance commissioners propound rates and policies that enable the weakest companies to survive. This means that policyholders in the strongest companies pay premiums as though they had bought insurance in the weakest companies.

"The informed buyer would avoid some 80 percent of the insurance companies doing business in the United States because of their lack of financial strength," Herbert Denenberg, the insurance commissioner of Pennsylvania, has declared. Caveat emptor.

• • •

The final line of defense against fraud for the public is the Securities and Exchange Commission. The commission came into being in 1934 under the Securities Exchange Act. The first commissioner was Joseph P. Kennedy. He was qualified, it was felt, because he had engaged in many of the acts he would now seek to prosecute.

The five Securities and Exchange Commission members, including the chairman, are appointed by the President of the United States. Ultimately, therefore, the quality of regulation of the securities industry reflects the quality of those individuals elected by the people. Richard Nixon appointed three SEC chairmen in the four years and three months that preceded the Equity Funding scandal. All three have been accused of subordinating their public trust.

The SEC is staffed primarily by young attorneys looking for two to four years' experience they can convert into plush jobs in private practice. Presumably, they would then know the career SEC people, as well as the rules of the game.

The backbone of the SEC, its permanent staff of attorneys, can be faulted for neither integrity nor zeal. They have chosen careers in public service at far less money than they could make in private practice. But they are hobbled, first, by political realities and, second, by the impossible task of policing the colossal securities industry with a staff of 1716 people--a total that includes every last clerk-typist.

If an SEC chairman quashes an investigation of a corporation deeply enmeshed in political intrigue--as happened in 1972 in a case involving the International Telephone and Telegraph Corporation's merger with the Hartford Fire Insurance Company, the largest merger in corporate history--there is little the permanent staff of the SEC can do. But it was the second inherent weakness of the SEC--lack of appropriate manpower--rather than political considerations that led to its dismal performance in the matter of Equity Funding.

The SEC was informed of allegations of fraud at Equity Funding on March 9, 1973--almost three weeks before it acted. On that date, Edward J. Germann, a lawyer for the California Insurance Department, walked over to the SEC's Los Angeles office and met with Les Ogg, an SEC attorney. He specifically mentioned the possibility of fake insurance policies, fake mutual-fund shares and fake bank certificates. According to Germann, Ogg expressed interest but said a manpower shortage precluded active SEC participation at that time.

Ogg later contended that Germann had been vague in his description. Germann, he said, spent most of his time asking for information on mutual funds and funded programs. But if an attorney for the California Insurance Department presents himself to the SEC and so much as utters the word fraud, it seems reasonable to expect the SEC to elicit his story. Not only did it fail to do that on March ninth, it failed to do it 14 months earlier, when a former employee of Equity Funding indicated that he could implicate the company in a story of fraud. The SEC in Washington had received anonymous reports about misstatements of assets at Equity Funding. In the course of its investigation of these reports, the SEC's Los Angeles office had contacted the former employee, who had recently been discharged. Twice he asked for immunity and twice the SEC refused to grant it. Had the SEC been able to come to terms with this informant, it could have had a far more detailed story than the one Secrist told more than a year later.

The Securities and Exchange Commission would like the public to believe that it would have exposed the fraud if only Secrist and Dirks had gone to its investigators. But if the SEC wasn't alerted in 1971 by one former employee to the existence of a scandal, why would it be alerted by another in 1973? If the SEC didn't take the allegations seriously when they were related by an attorney with the California Insurance Department, why would it have listened any more seriously to the story of a securities analyst?

• • •

All of these out-of-court indictments add up to the fact that the individual investor is not adequately protected, not by the securities markets or their brokers, not by auditors or regulators. Equity Funding was not simply a computer fraud nor an accounting fraud nor an insurance fraud nor even a business fraud. It was an all-American fraud. Its dimensions cannot be comprehended simply in terms of the thousands of policies invented or the millions of dollars of assets faked, nor even the hundreds of millions of dollars lost by investors. It can be understood only in terms of the people involved.

They were not special people. They were products of the system. They were not big-time crooks. They were functionaries of business. It is not the magnitude of their fraud but the distortion of their values that is ultimately so suggestive.

Years ago, the operant American ethic was, "It's not whether you win or lose, it's how you play the game." Today, the American sermon is drawn from the football playbooks: "Winning isn't the main thing, it's the only thing."

Perhaps one special man took advantage of many ordinary men and, by so doing, exploited the system. But, if so, it was the system that supplied his objective.

Wall Street demands big winners. Corporations must perform. In turn, they demand performance from their employees--not just loyal and zealous performance but overloyal, overzealous performance.

The requirements set by Wall Street may not be realistic for some companies, but all companies must answer to Wall Street, so their employees must answer to them.

Wall Street is not the villain. It simply expresses the American ethic, which leaves small room for individual choice.

The American way of life today reflects few of the attributes and many of the deficiencies of team sports. The individual subordinates his will to the group. This is healthy to a point. It becomes unhealthy when the group's objective should be questioned and isn't.

In government, the operative phrase is "game plan." In the business world, it's the "money game." It's not how you play the game that matters, it's whether your team wins.

Individuals seldom pause to examine either the method or the prize. They simply play the game. Few members of Equity Funding's fraud team joined the company knowing it was crooked. Some committed crimes without realizing the significance of their acts. If the system's corrupt, then corruption is normal and a little corrupt conduct on their part is neither abnormal nor immoral. "These things go on all the time," a man from Boston said early on. It's not the individual's fault. Coach told him to do it.

Even those games played according to the rules are marked by fouls the referees don't call. Corporations project themselves as something they're not. Employees sustain the projections.

A single idea can start a fortune. A few men gather a small nucleus of talented sales people who go out and push product Y. After a bit, the founders go to an underwriter and say, "Look at the sales we're generating."

"That's terrific," says the underwriter. "Just keep on growing. Don't worry about money; we'll get you all you need." After a bit, the underwriter takes the stock public at a price many times higher than the founders' privately held shares, so that the only people risking their money are the public investors.

Everyone cheers the expansion of volume. No one questions the virtue of size. But bigness generates its own problems; the first is a tendency to go soft.

National competence has been one of the assumptions of our culture. We're not simply the biggest but the best. We may have been able to indulge ourselves in this fantasy until recently, but we can't do so any longer.

One of the most shocking revelations of the Equity Funding scandal was the slackness of effort it exposed. It demonstrated a failure not simply on the part of the financial exchanges and regulators but by those who had a stake in the company and stood to lose heavily from irresponsible work.

Underwriters looked the company over carefully. Banks did intensive analyses before lending the company money. Lawyers were paid unbelievable fees to verify each prospectus. Consulting actuaries certified the insurance reserves. Auditors blessed the books. Every last one of them failed.

Were these men incompetent? Not likely. More probably, they had immersed themselves so totally in technicalities that they ignored the essentials, such as character and purpose.

Equity Funding was not a trip down the rapids by a group of reckless adventurers. It went adrift in the American mainstream.

The burden of Equity Funding is not that all men are venal. The evidence doesn't support the charge. One thousand men and women worked for Equity Funding. Fewer than 30 were indicted.

There are lessons galore from this repellent event. Auditing processes must change, stock exchanges must democratize, surveillance must be more meaningful, publicly held corporations must become truly public.

But what Equity Funding tells us more than anything is where we have come as individuals in regard to our institutions. What matters most is not that the values of a few men were perverted but that the consciences of many were stilled.

What is ultimately most distressing is not that some people defrauded others. That has gone on forever, and that alone can't bring down a free society. What can bring down a free society is when people do not feel they can live by the rule of law.

Not one of the people whose witness enabled me to expose the fraud had been willing to go to the authorities.

They were afraid the authorities might do nothing. They were afraid they wouldn't be believed. They were afraid the authorities would take their information back to the company--thereby exposing them. They were afraid their careers would suffer and that they might expose themselves to physical harm. They were afraid, at the very least, that they would carry the taint of "informer."

When conscience is immobilized, public trust has disappeared. At that point, by default, institutions become omnipotent.

May Equity Funding tell us, at a minimum, that there is work to be done--not simply to police our commerce but to redeem the efficacy of will.