"The customers didn't exist. Their mutual fund shares didn't exist. The funded loans didn't exist. The phony customers phony pledges of the phony fund shares to buy phony insurance ultimately became numbers on a computer tape, which then printed out phony assets for Equity Funding Corp.'s phony books."
The Wall Street Journal, explaining the Equity Funding Corporation to its readers, August, 1973.

64 thousand fake transactions - $2 billion dollars worth - $25 million in counterfeit bonds, $100 million in missing assets, the Equity funding fraud, entirely undiscovered by regulatory authorities and the auditors.

As described by David Hancox, it began this way: "Gordon McCormick was an insurance and mutual fund salesman. He came up with the bright idea of combining these products in a package deal for investors. First, the customer would invest in a mutual fund; second, the customer would select a life insurance program; and third, the customer would borrow against the mutual fund shares to pay each annual insurance premium. Finally, at the end of ten years, the customer would pay the principal and interest on the premium loan with any insurance cash values or by redeeming the appreciated value of the mutual fund shares. Any appreciation of the investment in excess of the amount paid would be the investor's profit." Perhaps put more simply, the customer was signing up to buy shares in the fund every year, then borrow against this value to pay yearly premiums on a life insurance policy.

McCormick was joined by Stanley Goldblum, and together the two salesmen began to grow the company, control later taken over completely by Goldblum. As growth continued, Goldblum began an acquisition program of other insurance companies, something that soon required more and more money to do. And for the buying to be effective, it was critical to maintain Equity Funding Corp.'s stock price; a higher price made it easier to compensate the owners of the companies being bought out. Earnings growth for Equity Funding was, therefor, critical. Continued Hancox: "The fraud began in 1965, when Mr. Goldblum told the chief financial officer of Equity Funding to make fictitious entries in certain receivable and income accounts. By inflating these accounts, the earnings per share increased; and the stock price rose to higher-than-expected levels. Fictitious entries alone do not bring in cash; but selling policies for fictitious customers could - and did - produce cash for Equity Funding, much of it from other insurance companies."

The fraud involved the practice of reinsurance. Reinsurance occurs when one insurance company sells to another some of its policies for cash and to offload part of the risk should a large payout on the policy occur. "In a typical reinsurance deal", says Hancox, "the selling company receives $1.80 from the buyer (the re insurer) for every $1 in policy premiums. The price takes into account the heavy first year commissions the seller has paid to obtain the policy - of course, they paid none at Equity Funding - and affords the seller a small profit. In succeeding years, the buyer may get 90 cents on every premium dollar, allowing ten cents to the seller, who handles all the policy accounts and claims. The only way the reinsurance company makes money on the policies is through the policyholders' payment of subsequent years' premiums. Since these policyholders were nonexistent, Equity Funding planned to pay for the premiums through the sale of more phony policies, or through the 'death' of fictitious policyholders."

The creation of these fake policies and associated fake files required a lot of work. "As the fraud progressed", writes thestreet.com "more and more employees got recruited to help...The problem with phony policies was that the company's auditors would randomly select some every now and then and ask to see the real-world files behind them. There were no files, of course, since there was no insurance. So to prop up the scam, conspirators threw late-night 'fraud parties' to create phony files. When that solution proved inadequate, conspirators set up a secret office devoted exclusively to fabricating medical records and application forms on demand. The employees at the office, known as the Maple Drive Gang, spent most of their days killing time with knitting, champagne and Quaaludes...except when the clueless auditors at the main office would ask to see files for phantom policies. That's when the Maple Drive Gang would spend a frenzied few days creating dozens of policy files -- then return to their endless round of office parties."

At the same time as the Maple Drive Gang spent their days either knitting or in a frenzy of creation, Equity Funding Corp was writing special software to create some of the insurance policies, thus saving time for the Gang, and when the fraud was discovered the company was in the process of updating the software to 'kill off' a set number of the created policies each year without making the re insurers overly suspicious. Half the insurance policies of Equity Funding Corp were fake by the time the fraud was discovered.

And within Equity Funding Corp itself, there was plenty going on. In 1972 management discovered four of its employees had gotten together embezzling funds for themselves (apart from the fraud the company was already engaged in) by registering fake death claims. But instead of firing the employees, three were rewarded with stock bonuses and all four were put to further work supervising fake death claims on behalf of the company for its own frauds.
(thestreet.com/pf/stocks/brokerages/791614.html)

None of this activity was ever discovered by the auditors. For their tardiness, the court gave the audit team two-year prison terms, 4 years probation and 2000 hours of charity work. Goldblum, along with 18 of the 21 other indicted employees, pleaded guilty to the frauds and all received prison sentences.

Further references:

Hancox, David R. Could The Equity Funding Scandal Happen Again? Available online at findarticles.com/p/articles/mi_m4153/is_n5_v54/ai_20057314

Seidler, Lee J., The Equity Funding Papers, John Wiley and Sons, 1978

The Great Wall Street Scandal: Inside Equity Funding.
Buyandhold.com/bh/en/education/history/2004/ray_dirks.html