Phar Mor Fraud Case Analysis

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In 1981, Giant Eagle acquired the Monus family grocery store run by Michael “Mickey” Monus. David Shapira, CEO of Giant Eagle, became familiar with the Monus family and was somewhat intrigued with Mickey’s talent as a hard bargainer and master retailer. In late 1982, Mickey and David decided to open up deep discount retail drug store called Phar-Mor after visiting the store of a successful deep discounter located in Cleveland.

Phar-Mor’s strategy was to undercut the competitor’s prices on a variety of goods by power buying inventory in bulk at deep discounts and selling large volumes at a low gross profit margin (similar to Wal-Mart’s strategy). The first store was a huge success and led to the opening of several other Phar-Mors in the coming years.

Beginning in the latter part of the 1980’s, the deep discount retail industry more than doubled in size and became extremely competitive.

To keep up with the industry, Phar-Mor opened several more stores, eventually opening its 300th store in 1990. Unfortunately, the increase in competition reduced Phar-Mor’s profit margins and caused it to sustain economic losses throughout the last six years of its life. To avoid reporting net losses for accounting purposes, Phar-Mor manipulated inventory and earnings, hiding the evidence in various fraud accounts and reporting net income on its books. Eventually a check written for Mickey Monus’ World Basketball League crossed the desk of a large Phar-Mor investor who brought the unauthorized check to the attention of CEO David Shapira.

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Words Ending In Mor

Management Fraud and Litigation

Giant Eagle held a majority stake in Phar-Mor and therefore controlled a majority of the seats on Phar-Mor’s board of directors.2 Mickey’s father, Nathan Monus, was retained and paid a substantial sum as a consultant to the board of directors. In substance, COO Mickey Monus, ran and controlled the day-to-day business of the company, periodically submitting results from Phar-Mor’s operations to CEO and board member David Shapira. The fraud team, under Mickey Monus’ direction, included CFO Patrick Finn, head accountant John Anderson, Jeffrey Walley as Vice President of Finance and Stan Cherelstein as Controller (both former Coopers and Lybrand auditors).

CFO Patrick Finn plead guilty to violating federal and state laws and agreed to cooperate with authorities in exchange for a commuted sentence. Monus was ultimately convicted of over one hundred counts of violating federal law and severed a commuted sentence of ten years in prison. Phar-Mor’s trustee in bankruptcy sued Coopers on behalf of Phar-Mor creditors and investors for over $1 billion on a theory of fraud where recklessness is equivalent to intent. Eventually the plaintiffs settled with Coopers for an undisclosed fraction of the amount demanded in the suit.4

Incorporating the Fraud Diamond

Fraud Diamond

If the Coopers had assessed the risk of fraud using the Fraud Diamond model, they would have uncovered evidence of opportunity, pressure, rationalization and capability, within Phar Mor’s management environment.

a. Opportunity

Monus’ discretion to run the company with little oversight from Phar Mor’s board members or CEO Shapira gave him the opportunity to divert company funds for his personal use. Monus could authorize unusual journal entries, destroy evidence without auditor detection. Several of Phar-Mor’s vendors were known to be owned either wholly by Monus, Monus-managed companies, or other related parties. In several cases, Monus would cause Phar Mor to overpay suppliers owned by Monus. After the fraud was uncovered, it was discovered that Monus had diverted over $10 million in Phar Mor assets through related parties to finance operating expenses of the World Basketball League. Phar-Mor didn’t have an internal audit until function until the last years of the fraud. It was the inquiries of the newly hired internal auditor that ultimately led to the discovery of the Phar-Mor fraud.

b. Pressure

When the gross margin of Phar-Mor began to decline rapidly, Mickey faced a lot of pressure from various parties such as banks, suppliers and vendors. At the same time, Mickey’s World Basketball League was broke. It was losing games as well as losing money. People lost confidence in the team, except Mickey. He continuously diverted money from Phar-Mor to his team, which just make the things worse. In order to maintain the appearance of a healthy basketball league, health company, and maintain performance goals for both. Mickey had to find a way to stay afloat.

c. Rationalization:

Mickey is very confident. He always believed that “things would improve”; “future profits will reverse temporary “adventure”. Every time Monus would divert company funds to pay the operating expenses of his basketball league he maintained that they were advances backed by his word to some day pay them all back. He admitted that he did accounting fraud intentionally to avoid detection of audit techniques and procedures.

d. Capability:

Mickey had a strong personality. Although he is not the CEO, Phar-Mor was under the control of Mickey himself. Monus’ management team either feared physical harm or disappointment. It is also possible that the fraud team honestly believed that Monus could turn the company around if they could only hide the fraud a little longer. More likely, Mickey had an uncanny ability to keep straight face. Even though the evidence at trial showed Monus was guilty of criminal fraud beyond a reasonable doubt, he continued plead his case that he acted in good faith in directing the fraud and did nothing criminal.

Audit Failures

Insufficient and Unreliable Evidence

Coopers relied heavily on the Phar-Mor accounting department’s compilation of evidence of account balances and details instead of independently verifying management assertions in high risk areas. Coopers was aware that Phar-Mor’s accountants never provided the auditors with requested documents or data without first carefully reviewing them.5 Evidence at trial revealed that Coopers would have uncovered fraudulent account balances and journal entries had they reviewed sub-ledger accounts and supporting documents. Coopers would have likely uncovered the unauthorized checks written for Mickey Monus’ basketball league expenses by focusing on controls over the cash disbursement process at Phar-Mor. Substantive tests of details with respect to the authorization, valuation, and existence assertions would have revealed fraudulently overstated inventory. Scanning for unusual journal entries or investigating zero-balance accounts with management may have uncovered the existence of fraud.

The Perfect Storm: Management Fraud and Inexperienced Auditors

Phar-Mor’s fraud team was well-versed in the art of auditing accounting firms; two of the five members of the fraud team were former Coopers and Lybrand auditors. Additionally, Coopers’ audit team was composed largely of junior level staff inexperienced in detecting fraud, let alone management fraud. The auditors based their assessment of Phar-Mor’s books primarily on compilations of data and documents that were carefully screened and manipulated by Phar-Mor management to conceal any evidence of fraud. The audit team alerted Phar-Mor management well in advance of any planned visits to individual stores for a physical inventory inspection. During a given year, the auditors would verify the existence and valuation assertions at four individual stores by haphazardly sampling 25 – 30. By 1990, Phar-Mor’s fraudulent subledger accounts concealed almost $40 million. In order to hide these losses from year-end auditors, the fraud team added $200,000 to the inventory account of each store that they knew would not be audited.6

The auditors tested the reasonableness of Phar-Mor’s cost of inventory ending based on management’s gross profit margin schedule and a third party’s physical count and valuation of inventory items. The auditors concluded that Phar-Mor’s ending inventory was fairly stated because their gross profit margin schedules were reasonable. Oddly enough, the auditors then concluded that Phar-Mor’s gross profit schedules were reasonable because the cost of inventory was fairly stated (which was originally derived from the gross profit schedules). The auditors claimed to have performed additional procedures on the gross profit schedules by tracing inventory costs to purchase orders. Any differences the auditors noticed between their expected gross profit margin and the recomputed gross profit margin were excused as sampling error.7

Physical Inventory

Inventory at Phar-Mor increased rapidly from $11 million in 1989 to $36 million in 1990 and $153 million in 1991. Coopers identified inventory valuation as a high-risk area in its working papers. However, Coopers told Phar-Mor beforehand which locations it would be testing for inventory. Only 4 of 310 stores were tested and only 25-30 items were selected at those stores to perform price testing. Although, Coopers claimed they did additional procedures on inventory schedules to compensate for weaknesses in the “price test”, these additional tests were based on locations Phar-Mor had already manipulated inventory prices. The holes in Coopers’ inventory audit left Phar-Mor management free to overstate inventory at all other unaudited locations. Phar-Mor’s fraud team admitted to increasing the price of Coke, which normally sold for $0.89, to more than $2 a bottle.8

Mechanics of the Fraud

Conditions for the Fraud

A primary driver of the fraud on Phar Mor stakeholders was the increasingly competitive landscape in which Phar-Mor operated. The deep-discount retail market had virtually cornered its marketplace within a relatively short period. Between 1985 and 1990, the number of deep discount stores increased from 313 to over 700 stores, with at least 300 of them being Phar-Mor. The chain itself had over that time become Wal-Mart’s primary competitor, vowing to undersell its ambitious competitor by low margin selling and “power buying” business strategies. However, as competition in this market continued to increase, Phar-Mor’s gross margins (a key factor for its retail performance) eroded rather significantly. In fact, by 1990, its real gross margin had been reduced to less than 15.5%, a fact that demonstrates that Phar-Mor could no longer maintain its existing price structure.

Obstinate and ambitious as he was, Monus pushed Phar Mor’s expansion ahead refusing to believe his low margin, power buying model could not sustain the companies’ blistering pace8. Rather than identifying practical ways to remain competitive, Monus resorted to fraud to maintain the healthy appearance of his company. Monus was able to temporarily offset the companies’ yearly losses by booking as sales revenue multi-million dollar exclusivity payments he had negotiated with vendors. As gross margins continued to go south, so did Phar Mor’s ability to pay off its vendors. Monus nearly avoided bankruptcy amid pressure from his suppliers by a last minute $200 million capital infusion from private investor Corporate Partners, LLC. Monus believed that by temporarily understating liabilities on Phar Mor’s books he could buy enough time to reverse the effects of the fraud when Phar Mor’s gross margins improved.

Company Appearances

Monus had the innate ability to maintain the appearance of control over his business and over his business associates, including those employed within the Phar-Mor accounting and financial reporting functions. He was able to accomplish this in a number of ways, but most notably through his continual appearance in charitable, social, and athletic spheres. His World Basketball League was his primary outlet to establish the greatness and the presence of Phar-Mor as a large company. The league was a collection of 11 teams represented small towns across the country (like Youngstown). Monus personally oversaw the development of the league, and used Phar-Mor funding to finance its success.

In the midst of the company’s struggle to secure private equity financing, Phar-Mor hosted its own golf tournament, where Monus personally distributed thousands of dollars in award checks to participants. The extravagance of Monus’ social display closely mirrored his modus operandi at Phar-Mor, which was to maintain the appearance of a healthy company at any cost. By the time the fraud at Phar-Mor had been exposed, it appeared that Monus’ primary responsibility was managing the fraud through his power over the accounting and financial reporting staff.