Electronic Game Card had created an innovative new product. After spending hundreds of thousands of dollars on R&D, it had patented a small digital device, about the size of a credit card. The CEO said this device was in high demand; particularly from the lottery industry, where companies saw it as an alternative to the scratch card. Sales were growing and the company was profitable; the future looked bright.

But there was something not quite right about the company…Its customers had no online presence, and the company’s bank account and accounts receivable were linked to offshore P.O. boxes. The audit partner said everything was fine, and signed off on the audits. But when a new CFO flew to London to track down a bookkeeper, he uncovered the company’s dark secret.

I’m Michael McLaughlin, and this is Scheme.

Electronic Game Card, which I’m going to refer to as “EGC,” was incorporated in Nevada, with offices in New York and London. EGC wasn’t a large company; at the end of 2008, it had just 10 employees. But it claimed to have designed a revolutionary product for the lottery industry.

There are many different types of lottery games, but one of the more popular ones is called instant win. You buy a paper card, scratch off the front of the card, and instantly find out if you won. Lotteries had been making paper scratch cards larger so that customers could play multiple times and have multiple chances to win on the same card. But you can only make the card so large.

And that’s where EGC comes in. It designed a microchipped digital card that was operated by touch. The card had an LCD screen (so the player could see numbers or images) and a random number generator. The device was very small: about the size of a credit card, just 3 millimeters thick and weighing half an ounce. EGC called it the, “digital evolution of the scratch card, offering multiple plays and multiple chances to win.” The device was clearly a substitute for the paper scratch card, but there were applications in the promotional and education industries as well. EGC said it was developing games for children, so they could improve their matching and math skills.

Now from 2003 through 2008 EGC was led by Lee Cole, a British citizen who lived in England and Spain, and the CFO was also a British citizen, Linden Boyne. Business seemed to be going well. EGC reported $6 million of revenue in 2007, and more than $10 million in 2008. While those aren’t gargantuan revenue figures, the company had very high margins, earning an operating profit of $6 million in 2008. And the firm was poised for growth: EGC said it had distributors in Native American casinos, plus state and national lotteries in the U.S., Mexico, and Italy.

But at the start of 2009 the company’s executive chairperson, Lord Leonard Steinberg, decided it was time for a change in management. Lord Steinberg had made a name for himself in the British gaming industry as the founder of Stanley Leisure, a company that owned casinos and betting shops. Lord Steinberg owned 14% of EGC’s stock, so he had significant influence over the company. He brought in a new CEO, Kevin Donovan, in February of 2009. Donovan was a marketing guy, with 25 years of experience in brand building. Even though Donovan was technically the CEO, he continued to report financial disclosures given to him by the previous CEO, Cole, and the CFO Boyne. But then Lord Steinberg brought in a new CFO to replace Boyne 7 months later

And this is where things get ugly.

The new CFO was Thomas Schiff, an American who worked out of the new headquarters in Irvine, California. Schiff was a former KPMG auditor & had been the CFO of a digital security firm, and apparently, Schiff was not easily conned.

He demanded access to EGC’s general ledger, checkbook, bank statements, and sales contracts. But EGC’s former CEO, Cole, was still on the board and stonewalled him.

This should have been an immediate red flag, for several reasons. First, you’ve got 2 former officers in Cole and Boyne effectively running the firm. Second, you’re not giving the new CFO access to bank statements? What?!?

Cole and Boyne eventually said they would mail the documents to Schiff, but they never arrived. So what did Schiff do? He flew to London. I love this guy.

Cole and Boyne then tried to prevent Schiff from meeting with the bookkeeper in London, but Schiff tracked him down. And once Schiff saw the financial documents, he knew the company was a fraud. Schiff told Lord Steinberg what was going on…and Lord Steinberg died. I’m not kidding. On November 2, 2009 Lord Steinberg died suddenly at the age of 73.

So what exactly did Schiff find out? A heck of a lot, it turns out.

First, EGC hadn’t filed tax returns over a 5-year period. That doesn’t guarantee the company’s committing fraud, but it’s not a good start.

Second, EGC’s revenue was bogus. Most of its sales contracts were fake, and the manufacturer of its game cards said it’d been more than 2 years since it made any cards.  Most of EGC’s phantom “sales” were made to shell companies in the British overseas territory of Gibraltar; and these offshore entities were affiliated with Cole and Boyne.

Third, EGC overstated its assets. The company said it had $10 million cash in its bank account, but the bank account didn’t even exist.  The company said it had millions of dollars in investments, but most of the investments were held by Cole and Boyne’s entities in Gibraltar.

Fourth, EGC understated the amount of common stock outstanding by at least 10%. This made shareholders think they owned a higher percentage of the company and inflated the stock price.

Fifth, Cole and Boyne fraudulently issued and sold $12 million of EGC stock without investors’ knowledge. Here’s how they did it:

• First, they forged documents, such as the minutes of board meetings, to show that EGC’s board had approved a stock issuance when it really hadn’t.
  
• Next, they transferred the EGC stock to their entities in Gibraltar, had the Gibraltar entities sell the stock, and directed the proceeds to family members.
  
• In one transaction a Gibraltar entity sold $35,000 of EGC stock and wired the proceeds to Cole’s sister.
  
• For another Gibraltar entity, Cole’s brother-in-law had check-writing privileges.
  
• Cole and Boyne sold 20 million shares this way, generating $12 million.
  

If you’re wondering “Why didn’t the auditors catch this?” the answer is, they kind of did. The California-based Mendoza Berger & Co. was the company’s auditor, and the partner assigned to lead the audit was Timothy Quintanilla. Quintanilla’s team expressed skepticism about EGC’s financial reporting. They were concerned about sending the bank account and accounts receivable confirmations to offshore P.O. boxes, and they couldn’t find information to verify that EGC’s customers existed. A Google search turned up nothing, and several customers had the same address.

One auditor told Quintanilla in an email, “I significantly doubt the Company has any operations at all.” They thought EGC was either a means of defrauding investors, or a money laundering operation. But Quintanilla did nothing, and EGC received clean audit opinions year after year…

So the question is: was Quintanilla just incompetent, or was he in on the fraud?  It’s difficult to say; but when the PCAOB came to inspect his firm, Quintanilla had employees create & backdate documents to fill gaps in the EGC audit. Thus, Quintanilla must have known he didn’t do a proper audit.

After Schiff blew the whistle on the fraud, it was clear EGC had no future. The company filed bankruptcy on September 28, 2010.

The SEC conducted an investigation, and handed out punishments. It fined Cole & Boyne $29.6 million and banned them from serving as officers or directors of a public company. Neither of them were criminally prosecuted, and I’m assuming this is because they were British citizens and lived outside the U.S.

The CEO who took over from Cole, Kevin Donovan, was banned from serving as an officer or director of certain companies for 5 years. While Donovan didn’t start the fraud, the SEC said he saw lots of red flags. People warned him repeatedly that the financials were sketchy, but he did nothing.

And speaking of doing nothing, the SEC also punished EGC’s auditor, Quintanilla. He got hit with a $100,000 fine, and was banned from appearing or practicing before the SEC as an accountant. This means he can’t be involved with the preparation of financial statements for a publicly-traded company. Quintanilla’s audit firm, Mendoza Berger & Co., filed bankruptcy on June 8, 2012.

So what can we learn from all this? At one point EGC was valued at $150 million…but it was all a sham.

One could say that the lesson is to be wary of so-called penny stocks. EGC had a small market cap and traded for less than a dollar per share. Such companies are often targets of market manipulation and fraud. But I don’t think that’s the real lesson here.

This story is about the importance of a proper audit. We take auditors for granted, or see them as a nuisance, but they play an important role when they do their job right. In EGC’s case, there really wasn’t an audit.

Quintanilla failed to exercise an essential trait of an auditor: professional skepticism. Before EGC released its 10-Q in November of 2009, the company emailed Quintanilla a bank statement that Boyne had created in Microsoft Word. Like most documents, it was fake. And yet Quintanilla took it at face value.

This was wrong. You don’t just take the client’s word for it; you independently verify. Quintanilla and his team should have contacted the bank directly; they shouldn’t have relied on Word docs or confirmations sent to a P.O. box in Gibraltar. The auditor is supposed to be the watchdog, and this time the watchdog failed.