Mickey monus

INTRODUCTION

In December 1995, the flamboyant entrepreneur, Michael “Mickey” Monus, formerly president and chief operating officer (COO) of the deep-discount retail chain Phar-Mor, Inc., was sentenced to 19 years and seven months in prison. Monus was convicted for the accounting fraud that inflated Phar-Mor’s shareholder equity by $500 million, resulted in over $1 billion in losses, and caused the bankruptcy of the twenty-eighth largest private company in the United States. The massive accounting fraud went largely undetected for nearly six years. Several members of top management confessed to, and were convicted of, financial-statement fraud. Former members of Phar-Mor management were collectively fined over $1 million, and two former Phar-Mor management employees received prison sentences. Phar-Mor’s management, as well as Phar-Mor creditors and investors, subsequently brought suit against Phar-Mor’s independent auditors, Coopers & Lybrand LLP (Coopers), alleging Coopers was reckless in performing its audits. At the time the suits were filed, Coopers faced claims in excess of $1 billion. Even though there were never allegations that the auditors knowingly participated in the Phar-Mor fraud, on February 14, 1996, a jury found Coopers liable under both state and federal laws. Ultimately, Coopers settled the claims for an undisclosed amount.

PHAR-MOR STORES 1

Between 1985 and 1992, Phar-Mor grew from 15 stores to 310 stores in 32 states, posting sales of more than $3 billion. By seemingly all standards, Phar-Mor was a rising star touted by some retail experts as the next Wal-Mart. In fact, Sam Walton once announced that the only company he feared at all in the expansion of Wal-Mart was Phar-Mor.

1 Unless otherwise noted, the facts and statements included in this case are based on actual trial transcripts.

The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. It is not intended to illustrate either effective or ineffective handling of an administrative situation.

Mickey Monus, Phar-Mor’s president, COO and founder, was a local hero in his hometown of Youngstown, Ohio. As demonstration of his loyalty, Monus put Phar-Mor’s headquarters in a deserted department store in downtown Youngstown. Monus—known as shy and introverted to friends, cold and aloof to others—became quite flashy as Phar-Mor grew. Before the fall of his Phar-Mor empire, Monus was known for buying his friends expensive gifts and he was building an extravagant personal residence, complete with an indoor basketball court. He was also an initial equity investor in the Colorado Rockies major league baseball franchise. This affiliation with the Colorado Rockies and other high profile sporting events sponsored by Phar-Mor fed Monus’ love for the high life and fast action. He frequently flew to Las Vegas, where a suite was always available for him at Caesar’s Palace. Mickey would often impress his traveling companions by giving them thousands of dollars for gambling.

Phar-Mor was a deep-discount retail chain selling a variety of household products and prescription drugs at substantially lower prices than other discount stores. The key to the low prices was “power buying,” the phrase Monus used to describe his strategy of loading up on products when suppliers were offering rock-bottom prices. The strategy of deep-discount retailing is to beat competitors’ prices, thereby attracting cost-conscious consumers. Phar-Mor’s prices were so low that competitors wondered how Phar-Mor could turn a profit. Monus’ strategy was to undersell Wal-Mart in each market where the two retailers directly competed.

Unfortunately, Phar-Mor’s prices were so low that Phar-Mor began losing money. Unwilling to allow these shortfalls to damage Phar-Mor’s appearance of success, Monus and his team began to engage in creative accounting so that Phar-Mor never reported these losses in its financial statements. Federal fraud examiners discerned later that 1987 was the last year Phar-Mor actually made a profit.

Investors, relying upon these erroneous financial statements, saw Phar-Mor as an opportunity to cash in on the retailing craze. Among the big investors were Westinghouse Credit Corp., Sears Roebuck & Co., mall developer Edward J. de Bartolo, and the prestigious Lazard Freres & Co. Corporate Partners Investment Fund. Prosecutors say banks and investors put $1.14 billion into Phar-Mor based on the phony records.

The fraud was ultimately uncovered when a travel agent received a Phar-Mor check signed by Monus paying for expenses that were unrelated to Phar-Mor. The agent showed the check to her landlord, who happened to be a Phar-Mor investor, and he contacted Phar-Mor’s chief executive officer (CEO), David Shapira. On August 4, 1992, David Shapira announced to the business community that Phar-Mor had discovered a massive fraud perpetrated primarily by Michael Monus, former president and COO, and Patrick Finn, former chief financial officer (CFO). In order to hide Phar-Mor’s cash flow problems, attract investors, and make the company look profitable, Monus and Finn altered Phar-Mor’s accounting records to understate costs of goods sold and overstate inventory and income. In addition to the financial statement fraud, internal investigations by the company estimated an embezzlement in excess of $10 million.2

Phar-Mor’s executives had cooked the books, and the magnitude of the collusive management fraud was almost inconceivable. The fraud was carefully carried out over several years by persons at many organizational layers, including the president and COO, CFO, vice president of marketing, director of accounting, controller, and a host of others.

The following list outlines seven key factors contributing to the fraud and the ability to cover it up for so long.

2 Stern, Gabriella, “Phar-Mor Vendors Halt Deliveries; More Layoffs Made,” The Wall Street Journal, August 10, 1992.

[1] The lack of adequate management information systems (MIS). According to the federal fraud examiner’s report, Phar-Mor’s MIS was inadequate on many levels. At one point, a Phar-Mor vice president raised concerns about the company’s MIS and organized a committee to address the problem. However, senior officials involved in the scheme to defraud Phar-Mor dismissed the vice president’s concerns and ordered the committee disbanded.

[2] Poor internal controls. For example, Phar-Mor’s accounting department was able to bypass normal accounts payable controls by maintaining a supply of blank checks on two different bank accounts and by using them to make disbursements. Only those involved in the fraud were authorized to approve the use of these checks.

[3] The hands-off management style of David Shapira, CEO. For example, in at least two instances Shapira was made aware of potential problems with Monus’ behavior and Phar-Mor’s financial information. In both cases Shapira chose to distance himself from the knowledge.

[4] Inadequate internal audit function. Ironically, Michael Monus was appointed a member of the audit committee. When the internal auditor reported that he wanted to investigate certain payroll irregularities associated with some of the Phar-Mor related parties, Monus and CFO Finn forestalled these activities and then eliminated the internal audit function altogether.

[5] Collusion among upper management. At least six members of Phar-Mor’s upper management, as well as other employees in the accounting department, were involved in the fraud.

[6] Phar-Mor’s knowledge of audit procedures and objectives. Phar-Mor’s fraud team was made up of several former auditors, including at least one former auditor who had worked for Coopers on the Phar-Mor audit. The fraud team indicated that one reason they were successful in hiding the fraud from the auditors was because they knew what the auditors were looking for.

[7] Related parties. Coopers & Lybrand, in a countersuit, stated that Shapira and Monus set up a web of companies to do business with Phar-Mor. Coopers contended that the companies formed by Shapira and Monus received millions in payments from Phar-Mor. The federal fraud examiner’s report confirms Coopers’ allegations. The complexity of the related parties involved with Phar-Mor made detection of improprieties and fraudulent activity difficult. During its investigation, the federal fraud examiner identified 91 related parties.

ALLEGATIONS AGAINST COOPERS

Attorneys representing creditors and investors pointed out that every year from 1987 to 1992, Coopers & Lybrand acted as Phar-Mor’s auditor and declared the retailer’s books in order. At the same time, Coopers repeatedly expressed concerns in its annual audit reports and letters to management that Phar-Mor was engaged in hard-to-reconcile accounting practices and called for improvements. Coopers identified Phar-Mor as a “high risk” audit client and Coopers documented that Phar-Mor appeared to be systematically exaggerating its accounts receivables and inventory, its primary assets. Phar-Mor’s bankruptcy examiner would later note that the retailer said its inventory jumped from $11 million in 1989 to $36 million in 1990 to a whopping $153 million in 1991.

Creditors suggested that the audit partner’s judgment was clouded by his desire to sell additional services to Phar-Mor and other related parties. Such “cross-selling” was common, and it was not against professional standards; however, the creditors claimed Coopers put extraordinary pressure on its auditors to get more business.3 The audit partner was said to be hungry for new business because he had been passed over for additional profit sharing for failing to sell enough of the firm’s services. The following year, the audit partner began acquiring clients connected to Mickey Monus and eventually sold over $900,000 worth of services to 23 persons who were either Monus’ relatives or friends.

3 Subsequent to Coopers & Lybrand’s audits of Phar-Mor, cross selling of certain services (e.g., information systems implementation, aggressive tax strategies) was prohibited for public company auditors by the Sarbanes-Oxley Act of 2002 and related rulings of the PCAOB, SEC and AICPA.

INVESTORS AND CREDITORS—WHAT COURSE OF ACTION TO TAKE?

After the fraud was uncovered, investors and creditors sued Phar-Mor and individual executives. These lawsuits were settled for undisclosed terms. Although many of the investors were large corporations like Sears and Westinghouse, representatives from these companies were quick to point out that their stockholders, many of whom were pension funds and individual investors, were the ultimate losers. These investors claimed they were willing to accept the business risk associated with Phar-Mor; however, they did not feel they should have had to bear the information risk associated with fraudulent financial statements. One course of action was to sue Phar-Mor’s external auditors, Coopers & Lybrand. However, although the investors and creditors were provided with copies of the audited financial statements, they did not have a written agreement with the auditor outlining the auditor’s duty of care. As is common with many audits, the only written contract was between Coopers and Phar-Mor.

Thirty-eight investors and creditors filed suit against Coopers, under Section 10(b) of the Federal Securities Exchange Act of 1934 and under Pennsylvania common law. All but eight plaintiffs settled their claims with Coopers without going to trial. However, the remaining plaintiffs chose to take their cases to a jury trial.

COURTROOM STRATEGIES

The Defense

Attorneys for Coopers continually impressed upon the jury that this was a massive fraud perpetrated by Phar-Mor’s management. They clearly illustrated the fraud was a collusive effort by multiple individuals within the upper management at Phar-Mor who continually worked to hide evidence from the auditors. The auditors were portrayed as victims of a fraud team at Phar-Mor that would do, and did, whatever it took to cover up the fraud. After the verdict the defense attorney said:

The jury [rightly] saw that a corporate fraud had been committed, but it mistakenly blamed the outside auditor for not uncovering something no one but the perpetrators could have known about… It’s a first…that effectively turns outside auditors into insurers against crooked management. (Robert J. Sisk, chairman of New York’s Hughes Hubbard & Reed)

The Plaintiffs

The plaintiffs opened their case by acknowledging the incidence of fraud does not, by itself, prove there was an audit failure. Moreover, they did not allege that Coopers knowingly participated in the Phar-Mor fraud; nor did they allege Coopers was liable because it did not find the fraud. Rather, plaintiffs alleged Coopers made misrepresentations in its audit opinions. The following quotes from plaintiff attorneys’ statements to the jury illustrate the plaintiffs’ strategy:

… [W]e’re not going to try to prove in this case what happened at Coopers & Lybrand. That’s not our burden. We don’t know what happened. We do know that we invested in Phar-Mor on the basis of the financials of Phar-Mor, with the clean opinions of Coopers & Lybrand. We’ve now lost our investment, and it’s a very simple case. We just want our money back...[l]f Coopers can demonstrate to you that they performed a GAAS audit in the relevant time periods, then you should find for them. But if you find based upon the testimony of our experts and our witnesses that Coopers never, ever conducted a GAAS audit...then I submit you should ultimately find for the [plaintiffs]. (Ed Klett, attorney for Westinghouse) So the question, ladies and gentlemen, is not whether Coopers could have discovered the fraud. The question is whether Coopers falsely and misleadingly stated that it conducted a GAAS audit and falsely and misleadingly told [plaintiffs] that Phar-Mor’s worthless financial statements were fairly presented. And the answer to that question is yes. (Sarah Wolff, attorney for Sears)

Throughout the five-month trial, the plaintiffs continually emphasized the following facts in an effort to have the jury believe the auditors were motivated to overlook any problems that might have been apparent to a diligent auditor:

■ The fraud went on for a period of six years, and, therefore, should have become apparent to a diligent auditor.

■ Coopers was aware that Phar-Mor’s internal accountants never provided the auditors with requested documents or data without first carefully reviewing them.

■ Greg Finnerty, the Coopers partner in-charge of the Phar-Mor audit, had previously been criticized for exceeding audit budgets and, therefore, was under pressure to carefully control audit costs.

■ Mickey Monus, Phar-Mor’s president, was viewed by Finnerty as a constant source of new business.

The areas where the plaintiffs alleged the auditors were reckless and did not perform an audit in accordance with GAAS centered around the accounting for inventory and its corresponding effects on both the balance sheet and the income statement. The plaintiffs’ allegations centered on the five major issues detailed below.

EARLY WARNING SIGNS—THE TAMCO SETTLEMENT

The Fact Pattern

In 1988, internal gross profit reports at Phar-Mor indicated serious deterioration in margins. Phar-Mor was facing an unexpected $5 million pretax loss. It was determined, with the assistance of a specialist from Coopers, that the drop in margins was due mainly to inventory shortages from one of Phar-Mor’s primary suppliers, Tamco. Tamco, a subsidiary of Giant Eagle, Phar-Mor’s principal shareholder, had been shipping partial orders, but billing Phar-Mor for full orders. Unfortunately, Tamco’s records were so poor that it could not calculate the amount of the shortage. Likewise, Phar-Mor had no way to determine the exact amount of the shortage because during this time period Phar-Mor was not logging in shipments from Tamco.

A Phar-Mor accountant performed the only formal analysis of the shortage, which he estimated at $4 million. However, negotiations between Phar-Mor and Tamco (along with its parent company Giant Eagle) resulted in a $7 million settlement. Phar-Mor recorded the $7 million as a reduction to purchases, resulting in a pretax profit of approximately $2 million in 1988. Because Tamco and Phar-Mor were both subsidiaries of Giant Eagle, the settlement was disclosed in a related-party footnote to the financial statements.

Trial evidence indicates the final settlement amount was determined, in part, by looking at Phar-Mor’s profitability in prior years. After the settlement, Phar-Mor’s gross margin was nearly identical to the prior year. After the fraud was uncovered, it was determined there were signals that Phar-Mor’s profitability had slipped in 1988.

Plaintiff Allegations

The plaintiffs claimed the settlement was a disguised capital contribution and thus simply a vehicle to artificially inflate Phar-Mor’s earnings. The plaintiffs alleged Coopers acted recklessly by not obtaining sufficient persuasive evidence to support this highly material transaction. The following excerpts are from testimony given (in a deposition) by Pat Finn, former CFO of Phar-Mor, and Charles Drott, an expert witness for the plaintiffs:

There was really no way to support the amount of the settlement. We did a number of tests, but based on our in-house review, we didn’t think that we could support $7 million. Mickey [Monus] did an excellent job of negotiating with David [Shapira] and he got us $7 million. (Pat Finn, former CFO of Phar-Mor) What Mr. Finn is basically describing is that, although there may well have been some shortages, that what Phar-Mor was really doing was entering into a transaction, which would enable them to manipulate its profit to overcome losses, to hide losses. So, essentially what he’s describing is fraudulent financial reporting...[T]he Coopers & Lybrand workpapers contain no independent verification, nor was there any attempt by Coopers & Lybrand to determine the actual amount of the shortages. It simply just was not done. (Charles Drott, expert witness for the plaintiffs)

Plaintiffs also alleged the footnote documenting the receipt and the accounting treatment of the settlement was misleading. Although the footnote disclosed the nature and amount of the related-party transaction, the plaintiffs argued the footnote should have more clearly indicated the uncertainty in the settlement estimate. And plaintiffs felt the footnote should have explicitly stated that without the settlement, Phar-Mor would have shown a loss.

Defense Response

A copy of the analysis conducted by the Phar-Mor accountant indicating a $4 million shortage was included in Coopers’ workpapers. However, Coopers considered the analysis very crude and included it only as support for the existence of a shortage, not the dollar amount. Although the workpapers contained relatively little documentation specifically supporting a $7 million settlement, Coopers, who audited all three companies party to the negotiation, did perform a number of procedures to satisfy themselves of the propriety of the settlement. After the internal investigation pointed to Tamco, Phar-Mor began to maintain a log of Tamco shipments. Coopers tracked the results of the log and in every subsequent Tamco shipment shortages were found. Coopers also contacted another company that had received Tamco shipments during this time period and learned that retailer was also experiencing shortages from Tamco.

Coopers’ experts examined Tamco’s operations and confirmed the shortages were due to a new computer inventory system at Tamco. Greg Finnerty, Coopers’ partner in charge of the audit, explained the auditors’ position as follows:

...[I]t’s a related-party transaction, and we don’t have the responsibility to validate the amount. The responsibilities in accordance with GAAS standards are twofold. One, in any related-party transaction, is to understand the business purpose of the transaction; and two, to agree to the disclosure of the transaction...[W]e understood the business transaction, and the disclosure was adequate. It talked about the $7 million transaction; and we saw a check, not just an intercompany account. We did a lot of those transactions, so we fulfilled our two responsibilities that are the standards for related-party transactions. I was not in that settlement session, nor should I have been. That was between the two related parties. When the discussions were over with, I talked to both parties separately, myself, and talked to them about the settlement, the reasonableness of that settlement. I, in fact, asked David Shapira—and I specifically recall asking David Shapira—of the $7 million, is that all merchandise or is there any sense that you are—you or the board of directors of Giant Eagle—passing additional capital into Phar-Mor through this transaction? And I was given absolute assurance that he was satisfied that the $7 million was a reasonable number; and, in fact, he indicated that this was a number much lower than what Phar-Mor thought it should have been. So it seemed to me that there was a reasonable negotiation that went on between these parties. (Greg Finnerty, engagement partner for the Phar-Mor audit)

Regarding the footnote disclosure, Coopers pointed out the footnote was typical of related-party footnotes, and that it was rather obvious that without the $7 million settlement, Phar-Mor would have reported a loss. Evidence also showed that, prior to the release of the financial statements, Phar-Mor met with investors and creditors to cover the terms and significance of the settlement. Finally, to this day, none of the parties involved—not Tamco, Phar-Mor, or Giant Eagle—have suggested the settlement was part of the fraud. Further testimony in the trial suggested the Tamco settlement was not an issue of concern with investors and creditors until their attorneys made it an issue years later in the litigation.

THE PRICE TEST

The Fact Pattern

Inventory at Phar-Mor increased rapidly from $11 million in 1989 to $36 million in 1990 to $153 million in 1991. Phar-Mor’s inventory system did not include a perpetual inventory record. Therefore, Phar-Mor used the retail method for valuing inventory. Phar-Mor contracted with an outside firm to physically count and provide the retail price of each item in inventory twice per year. Phar-Mor would then apply a cost complement to determine the cost of inventory. Phar-Mor’s initial strategy was to mark all merchandise up 20%, resulting in a gross margin of 16.7% and a cost complement of 83.3%. However, to be competitive, Phar-Mor lowered the margins on certain “price sensitive” items to get customers in the door. As a result, Phar-Mor’s overall budgeted gross margin fell to 15.5%, resulting in a cost complement of 84.5%.

Coopers identified inventory valuation as a high-risk area in its workpapers. As a detailed test of Phar-Mor’s inventory costing, Coopers annually attended the physical inventory count at four stores and selected from 25 to 30 items per store to perform price testing. Sample items were selected by the attending auditor in a haphazard fashion. Purchase invoices were examined for the items selected and an overall gross margin for the sample was determined. In the years 1988 through 1991, Coopers’ sample gross margins averaged from 16.1% to 17.7%. Coopers explained the difference between the expected 15.5% gross margin and the sample gross margin resulted because the sample taken did not include many price sensitive items, and, therefore, the sample gross margin was higher than Phar-Mor’s overall margin. Coopers concluded the difference noted was reasonable and consistent with expectations.

After the fraud was uncovered, it was determined that Phar-Mor’s actual margins were really much lower than the budgeted 15.5%, because the price sensitive items made up a relatively large percentage of sales. When Phar-Mor’s management saw the fiscal 1989 gross profit reports were coming in below historical levels, it started changing the gross margin reports because it feared Giant Eagle would want back some of the $7 million paid in Tamco settlement money. Management continued to alter the gross profit reports from that time until the fraud was uncovered.

Plaintiff Allegations

The plaintiffs argued that had the Coopers auditors employed a more extensive and representative price test, they would have known what Phar-Mor’s gross margins actually were, no matter what the fraud team was doing to the gross profit reports. Plaintiffs alleged the way the auditors conducted their price test and the way they interpreted the results, were both woefully inadequate and unreliable due to the sample size and acknowledged lack of representativeness.

...[T]he attitudes of the people involved in this were simply that even though there was clear recognition in the workpapers that this test was so flawed that it was virtually worthless, did not produce anything to them that they could use in their audit, yet they still concluded year after year that everything was reasonable, and that’s—that defies my imagination. I don’t understand how that conclusion can come from their own recognition of that, the test was so severely flawed. Also, they gave consideration to doing a better price test, but in fact never made any attempt to do so because in each of the four years they did the same exact kind of test, year after year after year, even though they knew the test produced unreliable results. (Charles Drott, expert witness for the plaintiffs)

The plaintiffs also pointed to Coopers’ workpapers where the auditors had indicated that even a one-half percent misstatement in gross margin would result in a material misstatement. Plaintiffs argued the auditors recklessly ignored the sample results indicating a material misstatement.

The plaintiffs also argued the gross profit schedules could not be used to independently test the cost complement because the calculated profit margin and ending inventory were a function of the standard cost complement that was applied to the retail inventory balance derived from the physical inventory.