Ray Dirks

Ray Dirks and the Equity Funding Scandal
By Brian Trumbore, President/Editor, StocksandNews.com

Over 30 years ago, a scandal broke involving a large insurance company, Equity Funding Corporation based out of Los Angeles. The central figure ended up being a securities analyst at Delafield, Childs, Inc., Raymond L. Dirks, who one day in March 1973 received a call from a disgruntled employee at Equity Funding, Ronald Secrist. Secrist was upset over his small Christmas bonus and he had a story to tell. As you read what follows, you'll be reminded of today's headline grabbing cases, ranging from Enron and Parmalat to Martha Stewart. Yes, we've been here before, and we'll just keep repeating the same mistakes, over and over again until the end of time.

Equity Funding had been creating false insurance policies for years, which the company then turned around and packaged to reinsurers, pocketing the cash. Incredibly, the fraud was known by as many as a thousand employees. As reporter Robert Cole wrote for the New York Times back on April 15, 1973, "Those closest to (the scam) were believed to have cleverly concealed their tracks through intimidation, subterfuge, threats of violence and the use of doctored computer tapes."

Equity Funding would use the fake profits to maintain the share price and the hope was that one day it would be able to buy a major life insurance company and then "go straight." Equity Funding's books were loaded with fake bonds and CDs, but when questions arose, the accountants trusted the explanations of company officials. Remember, it was 1973 and computers weren't in use anywhere near what they are today, so at times the auditors accepted handwritten lists as proof various positions existed. Employees involved in the scam also created computer printouts and paper files during late-night parties after receiving a specific auditor request. And all this time that Equity Funding deceived the auditors, the analysts on Wall Street and various insurance industry watchdogs were taken in as well.

For example, one month before it all unraveled, Cowen & Co. issued a report where the analyst recommended purchase of Equity Funding "for aggressive accounts." Burnham & Co., Inc. said on January 30 "We regard the stock, selling at 9.9 times estimated 1973 earnings, an excellent value and rate it a Buy."

On March 26, the day before the NYSE halted trading, the analyst for Hayden, Stone, Inc. wrote a memo addressing the fact that "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." This particular analyst had checked with insurance regulators in various states and each one said they had no present intention of conducting any inquiries.

As for Ray Dirks, he told his favored institutional clients of the scam and alerted the SEC. There was a mad dash to get out, and those who didn't act quickly enough, or who didn't have the knowledge, lost everything. Overall, the fraud exceeded $300 million.

Dirks ended up being censured by the SEC for his actions and over the next ten years he fought the decision, all the way up to the U.S. Supreme Court. Following is an extensive excerpt from a brief filed by the Justice Department, in defense of Dirks, before the Supreme Court, October 1982. It's as good a description of the issues in the case as you'll find anywhere.

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[In order to make this read a bit easier, I have substituted "Dirks" for "Petitioner." Some of the quotes noted in the brief refer to the original SEC case, as well as the Appeals Court ruling.]

"Dirks is a securities analyst, 'well-known for his investigative talents,' who researched insurance company securities. In March 1973, Dirks applied those investigative talents to uncover a major fraud perpetrated by the officers of a publicly-owned insurance company. As the court of appeals observed, 'in two weeks of concerted effort, at times resembling something from detective fiction, Dirks investigated and confirmed rumors of massive fraud by the Equity Funding Corporation of America, an insurance holding company whose stock traded on the New York Stock Exchange. Largely thanks to Dirks one of the most infamous frauds in recent memory was uncovered and exposed. Despite his efforts to uncover and expose the criminal scheme at Equity Funding, the Securities and Exchange Commission charged Dirks with 'tipping' material inside information in violation of Section 10(b) of the Securities Exchange Act of 1934.

"Dirks first learned of the fraud at Equity Funding from a former officer of the company, Ronald Secrist, who met with him for several hours on March 7, 1973. 'Secrist made a series of detailed but nearly incredible allegations about Equity Funding,' including allegations that the company had produced large numbers of spurious insurance policies to inflate its sales revenues and that 'its top officers had Mafia connections which they used to threaten the lives of employees who objected to the fabrications.' Secrist urged Dirks to verify the existence of the fraud and then expose it. He expected Dirks to transmit evidence of the fraud to 'his firm's customers' and 'clients,' thereby triggering large-volume securities sales that would lead to a full investigation: 'by jarring the stock, he would jar the corporation - this was my plan - he would jar the corporate officers and would also rattle the Wall Street financial community to the extent that someone would take action very quickly.' Secrist believed that selling pressure would cause the price of Equity Funding stock to 'drop close to zero very quickly,' and thus 'reveal the fraud to the world' and 'prevent its continuation.'

"During their initial meeting, Dirks sought and obtained Secrist's permission to convey evidence of the fraud to the Wall Street Journal. Secrist warned, however, that merely presenting the information to regulatory authorities, including the SEC, would be abortive. Secrist stated that employees who attempted to do this in the past had been 'brushed aside with a comment that that's a ridiculous story;' those employees also found that the information was sometimes relayed back to Equity Funding and that 'they were placed in personal jeopardy as a result of having gone there.'?..

"In addition to interviewing former employees of Equity Funding, Dirks also met with Equity Funding's present and former auditors in an attempt to spread word of the fraud and bring it to a halt. As the Commission explained:

'Dirks also learned that Equity Funding's auditors were about to release certified financial statements for the company on March 26. He immediately contacted them and apprised them of the fraud allegations, hoping that they would withhold release of their report and seek a halt in the trading of Equity Funding securities. Instead, the auditors merely reported Dirks' allegations to management.'

"As early as March 12, 1973, Dirks also attempted to communicate his evidence to the Wall Street Journal. 'Dirks expected that a highly respected publication like the (Journal) could be effective in helping him investigate the Secrist allegations and to expose the fraud if it proved to exist.' Those efforts also were unavailing.

'During the entire week that Dirks was in Los Angeles investigating Equity Funding, he was also in touch regularly with William Blundell, the Wall Street Journal's Los Angeles bureau chief. Dirks kept Blundell up to date on the progress of the investigation and badgered him to write a story for the Journal on the allegations of fraud at Equity Funding. Blundell, however, was afraid that publishing such damaging rumors supported only by hearsay from former employees might be libelous, so he declined to write the story.'

"Dirks provided Blundell with 'the substance of all he knew,' including his 'notes' and the 'names' of all witnesses. Nevertheless, given the 'scope of the fraud,' Blundell doubted that it could have been 'missed by an honest auditor' and discounted the entire allegation.

"Increasing circulation of rumors about the fraud led Dirks to believe that it was 'unlikely that Equity Funding stock would open for trading on Monday, March 26, because trading would be halted by the NYSE.' This did not occur, however, and Dirks again spoke to William Blundell of the Wall Street Journal and urged him to publish a story exposing the fraud. Blundell refused to do so but stated that he intended to discuss the matter with the SEC's Los Angeles Regional Office. Blundell secured Dirks' permission to propose a meeting with the SEC that would include himself and two other key witnesses. Dirks then contacted the SEC and voluntarily presented all of his information at the SEC's regional office beginning on March 27 and continuing throughout the next three days.

"During the two-week period in which Dirks pursued his investigation and spread word of Secrist's charges, the price of Equity Funding stock fell precipitously from $26 per share to less than $15. This led the NYSE to halt trading in the stock on March 27. Shortly thereafter, Illinois and California insurance authorities impounded Equity Funding's records and uncovered evidence of the fraud. Only then did the SEC file a complaint against Equity Funding and only then did the Wall Street Journal publish 'a front page story written by Blundell but based largely on information assembled by Dirks.' Three days later, Equity Funding filed a petition (for bankruptcy).

"While Dirks' investigative activities succeeded in revealing in a few days that 'one of the darlings of Wall Street, a company that had managed to produce continued high earnings growth for a decade, was, instead, a gigantic fraud,' government authorities with jurisdiction over Equity Funding did not move so quickly. As early as 1971, the SEC had received allegations of fraudulent accounting practices at Equity Funding. Moreover, on March 9, 1973, an official of the California Insurance Department informed the SEC's regional office in Los Angeles of Secrist's charges of fraud. The SEC's staff attorney 'stated that similar allegations had been made about Equity Funding before by disgruntled employees.' He nonetheless recommended 'delaying any type of inspection of the Equity Funding operations until next year absent further corroboration. Equity Funding's Chairman - one of the principal architects of the fraud - testified that, prior to March 1973, he received no questions from auditors, state regulatory authorities, or federal regulatory authorities that suggested 'they suspected there was a fraud at Equity Funding.' When asked whether Dirks was 'personally responsible for having uncovered the events at Equity Funding,' he candidly stated: 'I think Mr. Dirks is entitled to personal credit for that.'

"Following public revelation of the Equity Funding scandal, a federal grand jury in Los Angeles returned a 105 count indictment against 22 persons, including many of Equity Funding's officers and directors?[Guilty pleas or convictions were obtained on all 22. Chairman Stanley Goldblum received an 8-year prison sentence and a substantial fine.]

"While the Wall Street Journal's reporter, William Blundell, was 'nominated for a Pulitzer Prize for his coverage of the Equity Funding scandal,' Dirks was charged by the SEC with violating the antifraud provisions of the federal securities laws based on his selective revelation of information about Equity Funding prior to general public disclosure. Following an administrative hearing, the Commission found that Dirks had 'tipped' nonpublic information concerning Equity Funding in violation of those provisions. It observed that 'Dirks received the information from inside corporate sources. From the nature of the information, the inference must have been obvious that his sources had received it during the course of their corporate duties, and that the company intended that it should be kept in confidence.'?

"Despite its finding of a violation, the Commission imposed only a censure - its mildest sanction - on Dirks. It observed that 'it is clear that Dirks played an important role in bringing Equity Funding's massive fraud to light, and that he reported the fraud allegations to Equity Funding's auditors and sought to have the information published in the Wall Street Journal."

In a 6-3 decision, the Supreme Court overruled prior judgments and Dirks was finally cleared, ten years later. Essentially, the Court ruled that for a recipient of a tip to be guilty of insider trading, the insider who provided the tip must have been seeking to profit from the tip. There never was any evidence Ray Dirks personally made a dime off of his actions.

Today, Dirks is head of his own research / investment banking shop, specializing in small companies steeped in controversy. I'll leave it at that.

But I do have to note a comment Dirks made during the above proceedings concerning the New York Stock Exchange and its internal procedures.

"There is the question of the NYSE, a venerated American institution which advertises the safety and security of investing in its listed companies, but which, in fact is an antique, costly and dangerous system perpetuated for the convenience of its members." [Charles Geisst]

A little ahead of his time, don't you think?