Nervous System: The Computer Crime of the Century

Auditors in 1973 were not expecting to need to audit a company’s software in addition to its bookkeeping. In this month’s history of cybersecurity, David Kalat explores how Raymond Dirks was able to reveal Equity Funding’s fraud—and have a lengthy court battle with the SEC for his efforts.

The landmark case of Raymond L. Dirks v. Securities and Exchange Commission established our modern understanding of “insider trading.” That case also set important precedents regarding the treatment of whistleblowers and the press.

Before that, though, came the 1973 fraud scandal that engulfed whistleblower Dirks in the first place. He was a securities analyst who helped uncover an epic accounting fraud at the Equity Funding insurance company (“Equity”). At the heart of the $2 billion fraud was a computer system dedicated to inventing thousands of fictional insurance policies that the company then resold as if they were real.

Ostensibly, the company’s flagship product was an “equity funding program” for life insurance. The company would sell mutual fund shares to a consumer for cash. Then the company would sell the same consumer a life insurance policy, but instead of the customer paying for the insurance, Equity would pay the insurance premium, recording those payments as a loan. Equity would hold the mutual fund shares as collateral for the loan. The enterprise was a bet that the income from the mutual fund would offset the cost of the insurance and the interest on the loan. After ten years, the consumer would sell off a portion of the mutual fund holdings to pay off the loan with interest, and still be left with some residual holdings plus the value of the fully vested life insurance policy.

But the market did not rise as expected to support the loans the company made. Equity started manually inflating entries in its ledgers to make the company appear profitable, even as it sank deeper into the red.

Prospects improved for Equity when it started selling these equity-funded policies to reinsurers at handsome profit margins. The profits were so handsome, though, that Equity decided to resell more policies than in fact it had. Computer programmers were brought in to engineer software to concoct fictional policies to feed to the reinsurance market.

It was a peculiar kind of computer crime. Equity’s fraud relied on taking the typical expectations of how a business would use computers in 1973 and inverting them.

Other insurance companies had salespeople and underwriters whose work with consumers resulted in a body of insurance policies that then would be input into a computer’s data bank. The business then could run analysis on those computerized records to generate financial figures. Equity, however, used computer programs to generate fake policies automatically at a scale no human fraudster could match. Once the fake policies were on the books, the tabulations to the company’s financial records were done by hand.

When auditors tried to check the company’s records, another custom program filtered the data to conceal the fake insurance policies from the auditors. Auditors in 1973 were not expecting to need to audit a company’s software in addition to its bookkeeping. Without a programming expert looking at the code, however, no auditor was in a position to discover that Equity’s books were mostly fictional.

At the time it unraveled in 1973, Equity’s $2 billion scandal was the largest single company fraud and second-largest bankruptcy in U.S. history. The press dubbed it the “crime of the century,” and it was the first widely publicized instance of computer crime. Twenty-two people were convicted on federal charges, over fifty civil suits were filed, and the litigation consumed courts for decades.

Of the cases that resulted from the fraud, one of the most consequential was that of the man who brought it to light.

Raymond Dirks was a registered broker-dealer primarily serving institutional investors. Dirks received a tip that Equity was engaged in a large-scale fraud. The tipster was a former employee of Equity, and his accusations sounded like the stuff of a paranoid Hollywood thriller. Despite the sensationalistic claims, and the obvious incentive for the tipster to seek revenge on the company that had fired him, Dirks was persuaded to start investigating.

Dirks was naturally inclined to be an activist. He counted Clarence Darrow and Gandhi as his personal heroes. Once Adlai Stevenson stopped running for president, Dirks stopped voting. He was an atheist and tried to register as a conscientious objector (which, in a catch-22 move, atheists could not do at the time). He authored the muckraking “Insurance Confidential” newsletter. And his investigation found plenty of evidence to corroborate the tipster’s claims. Once he started talking to Equity’s computer technicians, it all fell into place.

Dirks gave his information to a journalist at the Wall Street Journal, but the writer was worried that the highly scandalous allegations needed stronger support in order to be published. Dirks met with the SEC to share his findings with them. The agency took no immediate action.

Meanwhile, Dirks continued to share the story with institutional investors he advised. In turn, many of those investors hastily disgorged their portfolios of any Equity shares. The sudden dumping of stock caused noticeable disruptions in the market, and the New York Stock Exchange halted trading in Equity Funding. This started a domino effect, quickly resulting in the public revelation that around 70 percent of the assets of Equity Funding’s major subsidiary actually did not exist.

The SEC then censured Dirks. Despite his efforts to inform the public at large and the regulators, the fact was he had given inside information to investors who were likely to sell their shares of the fraudster’s stock to members of the public who did not have access to the same information.

Dirks appealed and lost, repeatedly, until finally his appeal reached the Supreme Court. The Justice Department sided with Dirks against the SEC, worried that the SEC’s position threatened to chill whistleblowers. In 1983, ten years after the debacle had started, the Court found for Dirks, finding that he would have owed only a fiduciary duty to Equity’s shareholders if the material nonpublic information he received had itself originated from a breach of fiduciary duty, and Dirks had been aware of that breach. This standard is now known as the “Dirks Test,” which the SEC uses to evaluate when someone has engaged in insider trading.

 

The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group, LLC or its other employees and affiliates.