Chapter Twelve

During the nearly 400 days I served in federal prison, I recorded my daily activities. It was a strategy that helped to ensure I was always productive and working toward the goals that I had set. I could use the daily journal entries to measure progress and to analyze whether my actions were consistent with my commitment to lead a values-centered life.

We didn’t have access to computers in prison, so I wrote everything out with blue Bic pens that I purchased from the commissary for 38 cents each. I sent my writings home every day and my mother, Tallie, typed them for me and posted the writings on a daily blog I kept at

When I was writing those entries, I hoped that my work would help others understand that regardless of what bad deeds a person had made in the past, individuals could always redirect their lives. At any time, we could cease making decisions that led to disgrace and begin making decisions that would help us reconcile with law abiding society.

Upon my return to society I had opportunities to log onto my Web site and interact with people who found value in my writings from prison. Most of the visitors I received were encountering their own troubles with the criminal justice system. They suffered through months of hopelessness as they tried to make sense out of their tragic decisions that had taken them so far away from the lives they had aspired to lead.

People reached out to me for guidance because my postings on the Web showed a day-by-day record of growth through the adversity of confinement. They needed that assurance that they could create meaning in their lives again. By pleading guilty to felony charges, many of the people with whom I communicated through my Web site felt as if they had lost their identities. They looked in the mirror and did not recognize themselves. Depression darkened their lives, making it difficult to meet family and personal responsibilities, or even to climb out of bed. Ryan was in such a shape when he posted a message on my Web site during the wee hours of the morning.

“It’s 2.17 in the morning and I’ve been reading your postings on the Web for the past four hours. I’m going to federal prison. I don’t know for how long—maybe five years. I can’t take it. I don’t know how I’ll survive. Please help me. I’m not cut out for this.”

When I woke in the morning I responded to Ryan, completely identifying with his sense of loss. He had been the chief financial officer of a large retailer that was based in the Northeast, a publicly traded company that had been growing rapidly. Before joining the retailer, Ryan had been working on the accounting team at a large firm that audited the retailer in its infancy, when it operated seven stores. Alex, the retailer’s president and chief operating officer had worked closely with Ryan. Impressed with Ryan’s competence and work ethic, Alex offered Ryan an attractive compensation package that included stock options if he would come on board as the retailer’s chief financial officer. Ryan accepted.

Six years after Ryan joined the retailer it had grown into a chain of 81 stores with combined revenues that exceeded $500 million; four years later the retailer had more than 300 stores in 30 states with combined gross revenues of $2.8 billion. Its growth did not come without problems and Ryan explained how pressures from the job grew in geometric proportions, like a giant snowball that eventually buried him under an avalanche.

“I can’t believe how I let myself get trapped in this mess,” Ryan and I spoke through my Web conferencing system, and I could see his distress. He was wearing a bathrobe over pajamas, and his face was unshaven despite it being afternoon in his time zone. “It all started with one bad decision. Once I crossed that line, there just wasn’t any turning back.”

It sounded like a cliché, but Ryan expressed sentiments that I experienced as I was passing through my own struggles with the criminal justice system, and sentiments that I heard from so many others who contacted me for consultations. Individuals may study through their university years with the best of intentions. They may earn positions of distinction and trust in their chosen careers. Yet if they allowed pressures to influence their good judgment, as Ryan and so many others discovered, it became easier to violate ethics, possibly even criminal laws.

I asked Ryan to describe the pressures that began his ethical slide. “The problems all began when I discovered a slide in our company’s gross profit margin.” Ryan recalled. “It wasn’t much, just a percentage point or two. But we were growing extremely fast. We had numerous financial partners and analysts who followed our performance closely. At the time we were operating about 70 stores and our target gross profit margin ranged between 16 and 17 percent; I created financial reports that would monitor how we were doing and my boss and I would discuss our performance every Tuesday morning.”

“Who was your boss,” I asked. “The CEO?”

“I reported to Alex, our company’s chief operating officer and president. He and I had worked closely together for years.”

Ryan explained that he and Alex worked together to investigate the cause for the slight drop in gross profit margins. Every fraction of a percent counted because financial analysts would scrutinize the company’s quarterly financial reports for institutional investors. If the analysts discovered the drop in gross profit margins, they could conclude that the company’s rapid expansion was coming at the expense of effective management. Such a report, Ryan and Alex understood, would bring unwanted selling pressure on the stock, thereby lowering the market capitalization, possibly lowering the company’s credit rating and raising the costs creditors would demand for the company’s debt. Both Ryan and Alex were determined to avoid the downward spiral by discovering the cause of the sinking gross profit margins.

“Our initial investigation revealed that one of our company’s major suppliers was shipping less merchandise than it was billing our company to pay. Armed with the data from our investigation, Alex confronted our suppliers. He negotiated a seven-figure financial settlement. Once those funds were credited to our account, and our suppliers implemented systems to ensure the improper billing patterns would not persist, Alex and I celebrated, congratulating ourselves on solving the problem.”

“And,” I asked. “What happened?”

“All we did was put a bandage over the problem,” Ryan said. “We didn’t solve it.”

Ryan explained that despite Alex’s successful negotiations for a financial settlement with the retailer’s suppliers, weekly financial reports that Ryan prepared showed that the gross profit margins continued to fall below expectations by at least one percentage point.

“When Alex and I reviewed the disappointing results, he instructed me to keep quiet about them. He didn’t want me to reveal the reports to either the CEO or the board despite my obligations. Doing so would have raised awkward questions about Alex’s performance as the company’s chief operating officer. That was the moment our deceit began. Alex took it upon himself to alter the financial records so that the gross margins would match the historically expected margins. The scheme understated losses and reflected nonexistent profits.”

“But if you were the CFO,” I asked, “how could Alex alter the financial reports? Did he understand the accounting system so thoroughly?”

“It was simply a matter of manipulating spreadsheets,” Ryan explained. “Alex understood our accounting system completely. He was the CFO before I came on board and he had put the original accounting system in place. We began working closely together when I was an auditor for the company’s outside accountants and our history made me feel an allegiance to him. At first, I was hesitant to participate, but since Alex began the initial alterations, and since he was my superior, I just shrugged and went along with it.”

“I understood the pressure,” I said, “but you had to know the complications that first decision could bring. Once Alex started to manipulate the numbers, how could you ever expect to balance them again? I mean, this wasn’t a small enterprise. You guys had hundreds of millions in revenue. How could you juggle those numbers and still know where you really stood, or stay in control?”

“Well Alex started the manipulation of records, but I was sitting right beside him the whole time. He just started inserting the percentages we wanted in the appropriate columns, and we both understood the implications. We generated two sets of financial reports, and that became our regular pattern. One set of reports contained the false, altered numbers and the other set contained the real numbers. We tallied the difference between the real and falsified figures in a separate account that we called the sub-ledger. It became routine, week after week.”

Ryan told me that the falsified reports understated liabilities and overstated earnings. The sub-ledger, meanwhile, contained net losses and remained secret between Ryan and Alex. The only financial reports the team distributed were the false reports, which they identified as “the board” reports.

But Ryan and Alex understood that it wasn’t only the company’s board of directors and chief executive officer that would rely upon the falsified financial reports. Every quarter, the Securities and Exchange Commission would require the company to file financial reports that all investors could review. As the company’s chief financial officer, Ryan had an obligation to sign the reports, authenticating that the SEC financial filings accurately reflected the financial status of the company.

Title 18 of the United States Code, Section 1350, attached severe criminal penalties to corporate officers who filed false financial reports with the SEC. Ryan said that he understood those penalties could include fines of up to $5 million and 20 years imprisonment for each report that falsely represented the company’s financial status to the SEC and investors.

“I understood the rules of strict compliance with Sarbanes-Oxley.” Ryan identified the legislation that subjected him to criminal sanctions. “The funny thing was, once Alex and I started, we deluded ourselves into thinking that we were pulling off something spectacular. We got caught up in the excitement of creating a ploy that supposedly outfoxed everyone else. Neither of us considered the possibility of getting caught. We were getting away with it week after week, month after month, just digging ourselves into a deeper and deeper mess without even realizing it.”

When making presentations to the company’s lenders and investors, the chief executive officer unknowingly relied upon falsified financial reports that Ryan and Alex created. Those reports led a consortium of banks to increase credit lines by more than $150 million; they convinced private equity groups to purchase more than $300 million worth of the company’s stock; they served as the basis to persuade investment houses to infuse the retailer with more than $100 million in exchange for 10-years secured notes that the company issued. All of that liquidity contributed to the company’s massive expansion and inflated the price of the stock under false pretenses. What began as an effort to conceal a decline of gross profit margins escalated into a fraud of massive proportions that ultimately victimized thousands of individual investors.

“But how did you keep the fraud going for so long?” It seemed to me that with so many professional investors involved, someone would have discovered it. “Didn’t the false numbers eventually stand out like a bright light?”

“The numbers didn’t stand out because we offset them.”

“With what?”

“With exclusivity funds.” Ryan explained that Alex had negotiated with several vendors who agreed to make large payments to the retailer in exchange for exclusive rights to supply the retailer’s growing number of stores with particular types of merchandise. “During the first year we were able to offset all of the losses in the sub-ledger with these funds.”

“Weren’t you supposed to records those exclusivity funds as income?”

Ryan answered my question by explaining that, according to generally accepted accounting principles, the exclusivity payments should have been amortized over the term of the contract. The retailer should have recognized a portion of the income each year and accounted for the balance as a liability that the retailer would have to repay if it broke the contract.

“We circumvented the accounting problem in the same way we got around the other problems—by manipulating the financial spreadsheets and reports to suit our needs. Income from the exclusivity deals was like a slush fund with millions that we used to conceal the fraud. That money bailed us out of one problem but it created another. Both Alex and I knew we had crossed the point of no return.”

That sub-ledger and the exclusivity funds enabled both Ryan and Alex to hide other inappropriate personal benefits. They diverted corporate funds for personal use, to pay for such costs as home improvements, jewelry, vacations, and automobiles. What’s more, neither Ryan nor Alex declared those embezzled funds as income on their personal tax filings; such omissions exposed each to felony charges of tax evasion, in violation of Title 26 of the United States Code, Sanction 7206.

“How could that happen?” I scratched my head, puzzled on the thought that no one in the accounting department would have discovered such a diversion of funds. “You’re telling me that the company could disperse checks to contractors, jewelry stores, hotels, and car dealerships? Wouldn’t someone have noticed?”

“If we would have made the disbursements through appropriate channels someone may have noticed and raised questions. But we concealed them.” Ryan described how he used a standard typewriter to write the checks instead of processing them through the computer system. By using the typewriter he could avoid detection from others who worked in the accounting department and he could prevent leaving a trail for auditors. He manipulated corporate ledgers with falsified receivables to offset expenses and make accounts appear to balance.

“Didn’t the accountants who audited the business’s operations become suspicious with all of the discrepancies?” The size of the fraud that Ryan and Alex were juggling seemed too large to manage for a period of years without detection.

Ryan told me that, on average, the retailer was adding one new store to the chain each week, bringing the total number of stores to well over 100 when the fraud was in full operation. Although the sub-ledger he created with Alex concealed more than $40 million in corporate losses and inappropriate expenditures, he kept auditors from discovering the fraud by inflating inventory levels in stores that he knew the auditors would not visit.

The elaborate, calculated scheming that Ryan described contradicted assertions he made about not setting out to ruin his life by engaging in fraud. He had earned his accounting degree and his MBA at New York University. While there, he said that be participated in the requisite ethics courses.

“I aced my way through NYU, “he said, “and I always thought of myself as an honest, ethical person.” Before he accepted the CFO position his career required continuing education, including ethics evaluations. “Every performance review I received at the accounting firm showed me to have the highest ethical standards when it came to ethics.”

Obviously, Ryan lessened his allegiance to those high standards when he fell under the influence of Alex, his direct superior and chief executive officer who hired him. He described the moment of his initial slide.

“When I brought the weekly financial report to Alex, and it showed that the gross profit margins continued to disappoint, I wasn’t considering fraud as a potential solution. But Alex looked at me, scraped his fingers through his hair and shook his head. Then he pulled the spreadsheet up on his computer, and when he saved it under a different name—as the board report—I had an inkling of what he was thinking. Then he clicked a few keys, changing percentages that would manipulate the totals. He made a comment about how easy it could be to fix the problem. Instead of objecting right then, I simply went along, not fully seeing how far we would take it.”

I probed in order to understand more about the underlying reasons for Ryan’s decisions. After listening to my questions, he leaned back in his chair and thought for a while in silence. As he shook his head, rubbed the back of his hand over the whiskers on his chin, I could see the humiliation. His explanation of wanting to conceal disappointing profit margins and support his boss didn’t seem sufficient reason to actively participate in fraud.

“Deep inside,” he finally said, “I suppose I was concerned about the value of stock options I had. They represented a significant portion of my net worth, but they were still under restriction, prohibiting me from cashing out for another six months. If I hadn’t agreed, I knew that Alex and I would have had no choice but to disclose the disappointing numbers. We may have lost our jobs, but the real pain would have been the market. Institutional investors would have dumped the stock, decimating the value of my positions. I just never thought it would get so out of hand. Once we started, we couldn’t turn back without exposing the crime.”

The crime, as Ryan came to acknowledge, began to torment him more when the fraud reached out into the stratosphere. He feared arrest, imprisonment, humiliation. He sought psychological counseling, took antidepressant medications. When the losses exceeded $50 million, he couldn’t cope with the anxiety further and voluntarily exposed the fraud to the United States Attorney’s Office.

“How did federal prosecutors respond to your confession?”

“There were three, and they listened to me for four hours,” Ryan said, “with a stenographer and a tape recorder. Despite their repeated requests of whether I wanted an attorney, I declined. I just needed to get it all off my chest. The guilt was crushing me, suffocating me. I had to let the chips fall. At that point I didn’t care what happened. I wanted to cleanse myself.”

“Did you eventually retain an attorney?”

“Oh yes, and when I did, he scolded me for saying anything without consulting an attorney first. But in the end, I think, I did the right thing—the best I could do.”

The prosecutors told Ryan that—based on his confession and all the schemes he participated in—the government could charge him with numerous crimes. One included Interstate Transportation of Property Obtained by theft or fraud, codified at Title 18 of the United States Code, Section 2314. It provides that:

Whoever transports, transmits, or transfers in interstate or foreign commerce any goods, wares, merchandise, securities or money, of the value of $5,000 or more, knowing the same to have been stolen, converted, or taken by fraud…Shall be fined under this title or imprisoned not more than ten years, or both….

For every unauthorized check that Ryan caused to be issued, prosecutors said he could face a separate criminal count. He also faced numerous charges including mail fraud, wire fraud, bank fraud, securities fraud, and filing false income tax returns.

“When the prosecutors finally finished reciting all the charges I faced, I thought they might be burying me under the prison. But my full cooperation helped. Because of my confession and my exposing the crimes voluntarily, the government agreed to charge me with a single count of fraud that would expose me to a maximum of five years. I know it could’ve been worse, but I don’t even think I’ll be able to handle what’s coming.”

Chapter Twelve Questions

  • What purpose does the Sarbanes Oxley legislation that Ryan described serve?
  • In what ways does accounting fraud influence the public markets?
  • Who bears responsibility when investors base sales or purchase decisions on falsified financial reports?