The aim of crime as a business is to acquire wealth. There are broadly two ways of doing this: by taking it without the owner’s consent, or by persuading him to part with it voluntarily even if afterwards he does not want you to keep it. The first kind accounts for most of what people think of as “crime” but it is a self-limiting business. It cannot be disguised. A blown safe can’t be passed off as a safe the accountant lost his temper with.

Leslie Payne, The Brotherhood: My Life with the Krays

“We’re going to be the General Motors of the carpet cleaning industry.” What a pitch, especially in 1985 when General Motors held widespread admiration. While savvy readers might suspect that Barry Minkow and ZZZZBest Incorporated’s tale won’t bode well for investors in a book about commercial fraud, let’s be real, if the prospect of diving into the ground level of the carpet cleaning equivalent of General Motors fails to pique even a modicum of interest, your capitalist spirit might be missing a beat.

Barry would initially draw you in with this grand concept, only to reveal the industry’s harsh reality—carpet cleaning was a tough gig. He, a stylish twenty-year-old bodybuilder sporting a chic bouffant hairdo, had established ZZZZBest (“Zee Best,” with a preferred Southern Californian twang) before high school graduation. With an assembly of peculiar characters—oddballs, gym enthusiasts, alcoholics, mafiosi, and Nazis—he expanded it into a chain of outlets. This lineup hinted at the industry’s inherent problems. Easy entry into carpet cleaning led to abysmal profit margins, relying on low initial prices then aggressively upselling clients on additional services to turn a profit. The business attracted smooth talkers with lax ethics, causing frequent bankruptcies.

The real money lay in “restoration jobs.” When buildings suffered fire or water damage, insurers aimed to restore them, entrusting this to specialized companies. Contractors on a trusted list secured fixed-price contracts, focusing on efficiency and minimizing complaints rather than securing the best price. With strong ties to insurers and sharp business acumen in sourcing materials and managing cleanup teams, profits three or four times the industry norm were feasible.

Sounds convincing, right? Or perhaps a tad too good to be true, depending on your mood. Barry emphasized the critical economic fact—ZZZZBest received payment upon satisfying the insurer, yet expenses for suppliers and workers needed immediate settlement. This cash flow mismatch necessitated loans, the fundamental element—the elementary particle, if you will—of commercial fraud. Despite Barry’s fabrications, the carpet cleaning and restoration industry’s structure revolved around these buyer-seller relationships and trade credit patterns.

The ZZZZBest saga underscores the pivotal role of trade credit in the economy. People don’t risk lengthy prison terms for matters of insignificance.

Barry Minkow and ZZZZBest will reappear in this chapter as a compelling introductory case study, showcasing various fraudulent activities with blatant and straightforward tactics. We’ll explore busting out a business, employing counterfeit collateral, and kite checks. These offenses fall under the basic category of fraud—the “long firm.” While each crime has its nuances, keep focus: time and trust are their fundamental components. They involve making promises, influencing actions based on these promises, and ultimately reneging on them later.

The time factor is pivotal. As J. K. Galbraith observed, fraud uniquely involves this time element, creating a period when the perpetrator knows they’ve stolen but the victim remains oblivious to their loss. He termed it “the bezzle,” suggesting its fluctuations might explain elements of the business cycle. However, at this stage, let’s start with the most straightforward example—a traditional Mafia “bust-out.”

How to do a bust-out

Vincent Teresa’s fate remains a mystery—whether deceased or possibly relocated under the Federal Witness Protection Program—after divulging details about the New England Mafia. Before vanishing completely, he collaborated with Thomas Renner on the book “My Life in the Mafia.” Amidst the endless and eventually tiresome anecdotes of senseless violence due to perceived disrespect, the book contains practical insights for those seeking illicit gains. While most of these insights involve significant risks of death or imprisonment, scattered among tales of car thefts, hijackings, and rigged horse races is a description of an age-old scam observed worldwide in various guises.

Vincent and his cohorts commenced their operation in spring, utilizing a front man with sound finances and a clean record. They purchased toys or household appliances from manufacturers, establishing a trading reputation over the summer. Closer to Christmas, they substantially ramped up their orders, prompting manufacturers to issue invoices due in January, following standard practice. The trading company sold what it could to the public in December, then offloaded the remaining stock to a “fence” early in the New Year, culminating in bankruptcy after Mr. Teresa dispatched a skilled arsonist to an empty warehouse.

Two distinct frauds unfold here, relatively easy to differentiate. The act of insuring goods and feigning their destruction to claim insurance is a straightforward affair, historically crucial during the development of capitalism when insurable items were limited to ships and their cargoes (refer to page 219). The other facet of the fraud involves purchasing goods on credit, selling them for cash, and subsequently declaring bankruptcy. Referred to by the Massachusetts underworld as a “bust-out,” this practice traces back to the early 19th century as the “long firm.”

Etymologically, “long firm” bears no connection to duration or formal entities. Its debut in printed English stems from slang dictionaries and thieves’ jargon, where both terms carry archaic connotations. “Long,” originating from the Anglo-Saxon gelang, denoted “fraudulent,” relating to fault or failure. Meanwhile, “firm” (akin to the Italian firma) historically referred to a signature and was later used to denote an organization. Thus, a “long firm” translates to a “gelang firma”—a fusion of Saxon and Latin words—pertaining to the act of endorsing a deceitful bill of goods. Understanding the long firm arguably provides deeper insights into the realities of business than what most professional economists grasp.

Payment terms and trade credit

If you’re vending sandwiches at a railway station, you receive cash during lunch hours but need to purchase bread and cheese in the morning. While you could opt for a bank loan to acquire supplies, it’s more customary to request credit from food suppliers. Across nearly every industry, there’s a recognition that trade customers must manufacture and sell their goods before having the cash to pay for their inputs. Often, suppliers are better positioned to offer credit, bridging this financial gap more effectively than the traditional banking system.

Why is supplier credit prevalent? Convenience plays a significant role. As one fraudster explained, envisioning a commerce system where every transaction is cash-based and nothing is prepaid or settled later would mean purchasing a shovel-full of coal every time you wanted to light a fire.

Primarily, it’s relatively cost-effective. Opting for credit sales saves on warehousing costs, especially for perishable items like fresh bread, with a limited shelf life. Moreover, it fosters sales by enabling transactions on credit terms, accommodating startups and customers facing temporary cash shortages, rather than restricting sales to those with immediate funds. Furthermore, suppliers often perceive less credit risk compared to banks. They have a real-time insight into a customer’s business by observing their orders. Also, when extending credit for goods like bread and cheese, they’re aware that the credit is used for purchasing ingredients, reducing the risk of misuse compared to cash loans.

Nevertheless, there comes a point when payment must be settled. If it isn’t met on the due date, the supplier encounters a scenario where goods or services were provided without compensation, akin to losses through typical theft. The core of the long firm lies in the act of obtaining goods on credit and failing to make payment.

Who carries the risk? Every entity faces cash flow challenges and prefers upfront payments while handling supplier credit. Determining the terms between parties is intricate, influenced by negotiation power, supply-demand dynamics, and competitive forces. This complexity remains consistent across diverse businesses, whether it’s retail in a toy store, online drug trade, or the carpet cleaning industry. Examining payment term patterns offers deeper insights into an industry’s structure compared to standard “five forces” or “SWOT” analyses.

Credit control

Collateral and the Golden Boos

When we last addressed Barry’s situation, we highlighted his cash flow predicaments in obtaining upfront funds for his restoration jobs. This predicament arose because the credit pattern was shaped by industry power dynamics. The insurance companies, assigning these jobs, were less replaceable compared to the largely interchangeable contractors vying for them. However, for ZZZZBest, this presented a specific problem as most of their restoration jobs were entirely fabricated. Tom Padgett, a fired insurance executive, was set up in an office by Barry and his accomplice, the master forger Mark Morze. Operating under the name Interstate Appraisal Services, Tom concocted bogus paperwork for non-existent cleanup jobs in buildings.

While the absence of actual jobs slashed costs for carpet and cleaning products, the lion’s share of ZZZZBest’s expenses wasn’t in operating costs but in the cash siphoned off by Barry Minkow and his associates, funding their lavish lifestyles reminiscent of young tycoons in Los Angeles during the hair metal era. Ferraris and McMansions with a “Z” in the pool didn’t come cheap. Throughout their trading, Barry’s crew hustled for borrowed cash.

Initially, their primary cash source was the savings of affluent Los Angeles residents—a source Barry tapped into, akin to Vincent Teresa’s loan-sharking operations in New England during the ’60s. However, ZZZZBest’s folks didn’t always appear to be reliable credit prospects. Their key reference, Tom Padgett, was linked to controversial affiliations, and Maurice Rind, their financial advisor, had ties to the New York Mafia. Barry himself, though seemingly clean-cut and averse to drugs, was young and often diverted from business due to motivational speaking tours. Overcoming such glaring issues of character and competence to secure loans required collateral—a segue into another tangent, I’m afraid.

A Boston hotel room notice mandated by state law warns against “making a show of leaving baggage to acquire credit.” This regulation stemmed from the practice of “making a show,” where one would ostentatiously leave a trunk filled with valuables with an innkeeper, run up a substantial bill, and abscond before the deception was uncovered. An adept at this was Barbara Erni, renowned in eighteenth-century Liechtenstein as “Golden Boos” for her red-blond hair.

Golden Boos frequently visited southern German Alps with an unusually large and weighty trunk, known for both her hair and physical strength. She stayed in upscale hotels, accumulating a sizable tab for food and drink, reassuring innkeepers with her seemingly valuable trunk, insisting it be locked securely overnight. However, during her surprise departures, the trunk was often found empty. Golden Boos elevated the scam by utilizing her luggage to conceal either a child or a small man who would pilfer additional valuables from the room before absconding. Although executed in 1784, her intriguing story persisted in local folklore, commemorated with a “Golden Boos Lane” in Eschen, her hometown.

As the Liechtensteinian innkeepers recognized, holding a customer’s valuables (or “taking collateral”) eased extending a loan to a business or individual, minimizing risk in two ways. Firstly, appraising the quality of goods is typically simpler than assessing individuals, hence, managing the collateral risk is more feasible. Secondly, when the collateral exceeds the loan amount, defaulting entails more substantial losses for the debtor, prompting earnest efforts to repay. The pinnacle of this scenario is establishing a legal right to repossess the debtor’s house, rendering mortgage loans one of the safest credit forms. This aligns with the bankers’ adage:

Mortgage lenders have no cares Whatever happens They get theirs

Collateral functions as a stand-in for trust but heavily hinges on robust legal systems to ensure that it can be claimed in case of a debtor’s default. The legal maneuvers of “perfecting an interest” or securing assets constitute a significant chunk of what lawyers bill bankers for. The legal complexity escalates in uncertain scenarios, especially when borrowers begin manipulating the situation.

Barry Minkow’s investors received two types of collateral pledges—over certain industrial cleaning machines and power generators, and against the restoration job contracts. However, issues arose in both instances. Firstly, the machines had been pledged to multiple lenders, leading to potential legal clashes among creditors vying for physical assets. Furthermore, ZZZZBest’s ownership of these cleaning machines was dubious; some were leased from Maurice Rind’s company, while others were entirely fictitious, fabricated merely to justify bribes to mob-affiliated investors.

The collateral value tied to restoration-job contracts fared even worse. Ignoring their counterfeit nature momentarily, these contracts only held value upon the insurance company’s payment for completed jobs. Bankrupt carpet cleaning companies, especially those where external investors siphon off funds, tend to abruptly cease operations, leaving unfinished jobs. This scenario highlighted what bankers term “wrong-way risk”—where the collateral’s value closely aligns with the event the collateral aims to hedge against.

Despite earnest efforts by the investors, their precautions were futile. The contracts stipulated that the funds were solely for the specified restoration job, independent of the carpet cleaning business or other projects. However, once in Barry’s possession, there was no effective financial oversight. Attempts to scrutinize ZZZZBest’s operations merely revealed a staged facade—temporary telemarketers and a Potemkin-like set, orchestrated by high schoolers paid a nominal fee.

Creditors demanded contract documentation, easily susceptible to forgery, and building photographs. This posed challenges, especially when instances like Tom Padgett failed to verify the existence of an eight-story office building in Arroyo Grande, resulting in a manipulated Polaroid photograph. Another incident involved renting unfinished office floors in San Diego, spending a substantial sum to simulate a completed building subjected to water damage and restoration, all to mislead auditors during a fundraising drive.

Only in America

Understanding the bust-out and collateral scam is akin to learning the fundamental scales in corporate fraud—a basic showcase of the critical role credit plays in scenarios where there’s a time gap, thus opening avenues for potential fraud. However, in the modern USA, they aren’t prevalent models of crime like check kiting.

At its core, check kiting is the act of obtaining money or valuables by using a check that you know (or should know) will bounce due to insufficient funds in the account. Known as “paper hanging,” this tactic, while sometimes born out of desperation or perpetrated with stolen checkbooks, has inherent drawbacks—chiefly, revealing personal information.

Frank Abagnale, depicted in “Catch Me If You Can,” elevated paper hanging to an art form by adopting a nomadic lifestyle as an airline pilot, evading permanent residency, and exploiting checks continuously. However, as a commercial fraud executed by business figures, check kiting operates differently, capitalizing on an aspect of the American banking system.

The USA’s vastness, coupled with varying state banking regulations, historically hindered the standardization of payment systems. Checks played a prominent role, requiring transportation over long distances, until the recent shift towards electronic check clearing. Consequently, American banks, owing to this reliance on paper checks and extended check-clearing cycles, permitted businesses to utilize “uncleared funds” from deposited checks—a unique aspect not widely mirrored globally.

The modus operandi involves setting up accounts in two banks, say Bank A and Bank B, each with a nominal sum. You then write a check from the “trees” account (Bank A) to the “sports cars” account (Bank B), creating a false appearance of funds. Leveraging the delayed clearing, you repeat this cycle, perpetuating the illusion of wealth.

Although this strategy may seem self-contained, any attempt to withdraw or spend the money exposes the fraud. Yet, creating the illusion of substantial bank accounts, coupled with historically generous interest rates on deposits, proved lucrative during the 1980s. Despite check kiting’s decline due to lower interest rates and automated detection systems, variations and complexities in the scheme persist, as seen in EF Hutton’s case exploiting different check-clearing cycles across branches. Their intricate maneuvers, reliant on delayed mail and regional variances, led to substantial interest income and eventual legal repercussions.

While check kiting’s heyday has passed, its legacy endures, warranting examination in the context of figures like Barry Minkow.

How to train your banker

When we last caught up with Barry, he was living large, cruising in his Ferrari sporting the ZZZZBST plate, while paying scant attention to the day-to-day operations of his carpet cleaning business, focusing instead on duping investors with sham restoration contracts. Yet, his challenges were mounting rapidly. To maintain the façade of a thriving enterprise, he had to assure investors of smooth progress in these restoration projects. However, successful completion of these jobs meant impending repayment demands from lenders. Thus, concocting new fictitious jobs became a norm, supported by forgeries from ZZZZBest’s chief, and sent for approval to their fabricated insurance office overseer, aiming to persuade existing investors to reinvest or to raise new loans for settling the old debts.

He tirelessly toiled on this scheme, entangling himself with various Mob-linked personalities like Jack Catain, individuals one wouldn’t want to leave unpaid. Despite managing to gather enough funds to cover the rollover of these fabricated project debts, timing the exact amounts on specific days posed a challenge, leading to a flurry of bounced checks.

However, Minkow’s approach wasn’t to discreetly conceal his check-kiting, but rather to revel in his reputation as a check bouncer. He coupled this with charm offensives and, depending on gender, flirtation with bank staff. Earlier luck with a main business bank’s collapse led federal employees, overseeing it due to the deposit insurance fund, to sometimes accept blame for missing payments. ZZZZBest’s routine transaction involved a hefty bounced check, followed shortly by a larger deposit—sometimes from another kiting bank, but occasionally from major investors, now advancing up to $2 million at a time. Barry leveraged these large deposits to briefly become one of the largest account holders at local savings banks, using this status to request loans.

He’d shower the female staff with flowers, offer camaraderie and party invitations to males, all while donning an aw-shucks persona, sometimes hinting at high-paying jobs. Occasionally, a bank would tire of the act and ask ZZZZBest to take their business elsewhere. However, Barry managed to spin his kiting reputation into a positive angle. He convinced loan investors that his profit-making ability in restoration stemmed from his knack for securing stellar carpet deals instantly, sidestepping administrative hurdles like account balances. Thus, the plethora of insufficient-funds checks, in many ways, showcased Barry Minkow’s distinctive acumen and entrepreneurial zeal.

Accentuating the positive was a recurring theme in Barry’s banking relationships. Unlike legitimate carpet companies receiving corporate checks from insurers for restoration work, ZZZZBest, dealing in fabricated contracts, issued cashier’s checks to investors during persuasive loan pitches. Any query about the absence of corporate checks was dismissed with a convenient excuse—banks were wary due to Barry’s past, refusing to allow him to endorse checks.

This pivotal theme underscores a crucial strategy: while a proficient fraudster identifies the weaknesses in checks, a mastermind targets the system’s strengths. ZZZZBest’s success wasn’t about evading scrutiny; it was staying a step ahead of it, leveraging Mark Morze’s forgery skills and Barry Minkow’s knack for persuading people, even when glaring red flags waved. Evading detection wasn’t the aim for someone like Barry.

The economic geography of fraud

Check kiting is a distinctly American form of crime, but like unique national cuisines, other countries have their own fraudulent practices. One such example involves creating a fictitious asset with a catch—like a sizable bank deposit under a freezing order or a stash of gold bars requiring tax payments to validate ownership. The perpetrator then approaches the victim, narrating the asset’s problems and proposing shared ownership if the victim contributes to resolving the issue. This scam, universally known today as “Nigerian advance-fee fraud,” earned its geographic tag due to Nigeria’s enthusiastic adoption of this method by its criminal circles from the 1980s onward, evolving from a simple advance-fee scam.

The pivotal technological breakthrough for Nigerian fraudsters was their ability to forge stamps, enabling international communication with potential victims. Nigeria, with an inflationary economy and a history of corrupt governments, boasted an oil industry with educated English speakers familiar with international business dealings. In this environment, it was natural for fraud schemes to mirror colonial-era scams (like fake tax collectors in the 1910s), exploiting Nigeria’s international reputation for corruption and oil wealth.

Few frauds become eponymous due to local fame, but generally, frauds align with economic geography shaped by a nation’s institutions. For instance, Canada deals with securities and mining fraud due to its high-trust economy, prospecting tradition, and fragmented securities regulation stemming from its federal structure. This led to multiple regional securities commissions, facilitating international scammers’ exploitation, like fraudulent Chinese companies using dormant Canadian shell companies for stock market listings.

However, these national variations stem from universal equilibrium principles. Efforts to prevent fraud should balance the cost of checks against the savings from avoiding fraudulent transactions. Alternatively, minimizing business dealings, especially with non-network entities, reduces exposure to risk. Trust functions as a social technology substituting checks, while “mistrust” serves as a rational response when fraud risk is perceived as high. Additionally, the actual incidence of fraud differs from public perception, influenced significantly by culture and history.

Exploring historical development in fraud awaits our framework establishment. Meanwhile, the long firm strategy offers plenty of nuances to contemplate.

series-1

Fraud: The Art of Stealing Wealth and Trust - The basics (Ch. 2)

Table Of Contents