I.

FACTS OF THE CASE

Leslie Fay Companies

A women’s apparel manufacturer based in New York City and has a corporate
headquarters in the heart of Manhattan’s bustling district while its accounting office was
100 miles to the northwest in Wilkes-Barre, Pennsylvania.

It was founded by Fred Pomeranz after the World War II by the naming the company
after his daughter, Leslie Fay. It took the company public in 1952 but later held private
in the early 1980’s after the son of the founder, John Pomeranz became the CEO and
orchestrated a leveraged buyout. It became public again in 1986 after the young
Pomeranz pocketed $40 million and large bundle of Leslie Fay Stock.

The company’s management is aversive to the modern business practices and does not
do extensive market testing to gauge women’s changing tastes in clothes; instead, John
Pomeranz relied on his and his designers’ intuition in developing each season’s new
offerings.

Fred Pomeranz

He founder of Leslie Lays Company. He started as making to making uniforms for the
Women’s Army Corps in service his country before creating a company. He has been
referred to his subordinates and colleagues in the industry as a “character”. He has a
strong interest in gambling and enjoyed throwing extravagant parties.

John Pomeranz

He is the son of Fred Pomeranz and became the CEO of the company after his father
died in 1982.

Recession

The recession of the late 1980’s and early 1990’s has led to the large chains force to
merge with competitors or liquidate due to the consumer’s curtailment in their
expenditures and also the gradual change in the preference of the women’s clothing
taste causes the declining of dress sales.
Leslie Fay incurred a substantial loss in 1989 when it wrote off a receivable from
Allied/Federated Department Store after filing for bankruptcy. Despite the trauma
experienced by competitors, Leslie Fay remain upbeat to the industry by reporting
impressive sales and earnings throughout the late 1980’s and early 1990’s, even though
there is already falsification behind the numbers.

The Fraud

On January 29, 1993, Paul Polishan called John Pomeranz while on a business trip that
the company has a problem. Then he reported the accounting hoax that Donald Keina
secretively carried out over the past several years.

Pomeranz denied of any clue as to what might have motivated Keina to represent Leslie
Fay’s financial data during the press. He also stridently defended Paul Polishan who had
supervised Keina that Paul didn’t know anything about this.

The audit committee launched an investigation shortly after the Keina’s publicly
disclosed fraud and Polishan was being ordered to have a temporary paid leave. The
committee also retained Arthur Andersen & Co. to help complete the investigation.

BDO Seidman withdrew the auditor’s opinion on the company’s 1990 and 1991 financial
statements and was a defendant together with the Leslie Fay Company’s management
team against the stockholders during the large lawsuit case.

During 1993, the audit committee completed the 600-page, eight-month investigation
of the accounting fraud and was found out that the key focus of the fraudulent activity
was the “inventory.” Kenia and his subordinates had inflated the number of dresses
manufactured each quarterly period to reduce per unit cost of finished goods and
increase gross profit on sales. There is also a forging of inventory tags during the
physical inventory activity.

Other gimmicks used by Keina was failing to accrue period-ending expenses and
liabilities, “prerecording” orders received from customers as consummated sales to
boost Leslie Fay’s revenues near the end of an accounting period, failing to write off
uncollectible receivables, and ignoring discounts on outstanding receivables granted to
large customers experiencing slow sales of the company’s products. Keina allegedly
decided period what amount of the company should report. They also adjust Leslie
Fay’s key financial numbers until that profit figure was achieved.
From 1990 through 1992, approximately $130 million of bogus entries were made in
Leslie Fay’s accounting records and this overstated the company’s profits by
approximately $80 million. They molded the key financial statements so that key
financial ratios would be consistent with the historical trends. Instead of approximately
20% by early 1990’s Keina allegedly hovered the GP rate to 30%.

After the audit committee’s investigation in September 1993, John Pomeranz was
allowed by the board of directors to remain as the CEO but relieved him of all financial
responsibilities related to the company’s operations. The audit committee dismissed
Paul Polishan as CFO and senior vice president of finance and replaced him with an
Arthur Andersen partner who had been involved in the audit investigation.

The Auditors

BDO Seidman had served as Leslie Fay’s audit firm since the mid-1970’s and issued
unqualified opinions each year on the company’s financial statements. Because of the
emergence of fraud, SEC informed BDO Seidman that its independence was jeopardized
by those lawsuits, which forced the firm to resign as Leslie Fay’s auditor in May 1993.

Because the committee was questioned to the objectivity of the audit investigation, the
federal judge appointed an independent examiner, Charles Stillman, to prepare another
report but the result was still the same as with the audit committee. Still report went on
suggest that although there were likely “viable claims” against Keina and Polishan
based upon “presently available information”, the limited assets of those individuals
made it economically infeasible for the bankruptcy court to pursue those claims. Finally,
the Stillman Report indicted the quality of BDO Seidman’s audits of Leslie Fay and that
it is likely BDO Seidman acted negligently in performing accounting services for Leslie
Fay.

The unsubstantiated and unfounded allegations made by BDO Seidman are a classic
example of ‘revisionist history’ that attempt to divert their own negligence by blaming
others.
The Verdict

On July 1997, the federal judge approved a $34 million settlement to the Leslie Fay
Stockholders in which BDO Seidman contributed $8 million.

After several court hearings and private investigations behind the public, the federal
prosecutors convicted Paul Polishan on 18 of the 21 fraud count filed against him,
which included conspiracy, making false statements to the SEC, bank fraud, and wire
fraud. The federal judge denied Polishan’s appeal because of a much more consistent
with Keina’s testimony than of Polishan and a key factor was the unusual relationship
(domination, intimidation, and etc.) that had existed between Polishan and Keina during
their long tenure with Leslie Fay, which documented and discussed at length during the
trial.

In 2001, Kenia was sentenced to two years for pleading guilty to two counts in the
fraud scam. He is going to serve his 2-year sentence at Allenwood Federal Prison Camp
in Montgomery, Pennsylvania.

On January 21, 2002, Polishan was sentenced to a fine of $900 and to serve 9 years in
federal prison at Schuylkill County, Pennsylvania, in early September 2003 to begin
serving his 9-year sentence.

II. ANALYSIS

The case talks about the fraudulent activities done by Keina and his subordinates that
led to increased sales during the times of recession in the economy especially in the
garments industry. This overstatement has led to increase bonuses that will later result
to insolvency of the company. This scam was already foreseen by Polishan for the next
three years and that he orchestrated the said fraud to conceal him from any evidences
through Keina and his subordinates. This clearly indicates that he has either self interest
in inflating sales since Polishan has stocks in the company or he did this to maintain the
good reputation of the company and to encourage more investors or creditors. The
unforeseen situation was overlooked by BDO Seidman which led to their negligence and
impairment on the firm’s name. BDO Seidman was too confident upon the presentation
of financial numbers of the company without validating the accuracy of the data
presented, especially on the inventory side. The audit committee and the independent
auditor appointed by the federal judge which arrive at the same conclusion reveals the
true scheme of the fraud but it is already too late for the company to recover from
bankruptcy.
 III. EVALUATION

The close relationship of John Pomeranz and Paul Polishan has led to the blindness of
Pomeranz on the true intention of Polishan to the company.

The orchestration of Polishan on the scam was said to be the proximate cause of Leslie
Fay’s bankruptcy. If only Keina had tell the truth earlier or BDO Seidman conducted a
thorough audit of the company, this could have been prevented from happening. Also,

Polishan questioned the request of the management for a financial status that further
conceals the fraudulent financial information.

BDO was charged that the firm was reckless in auditing Leslie Fay’s periodic financial
statements during the early 1990’s. There has been an irregularity on the financial data
that is so-called red flags that shows implausible relationships between key financial
statement items, and unreasonably generous bonuses paid to top executives and
bonuses like Pomeranz had received a total of $3.6 million which is 3 times more than
the 1991 compensation of Liz Claiborne’s CEO, whose company reported sales more
than double of Leslie Fay’s. This negligence had resulted them to pay $8 million as
penalty to the fraud scam.

IV. RECOMMENDATION

Never trust too much on your colleague just like Pomeranz gained too much confidence
to Polishan that result to company’s bankruptcy.

The BOD must either conduct a surprise audit inspection by hiring staffs from the audit
committee or from the internal audit department or conduct a regular meeting
regarding the financial status of the company.

Exercise due professional care & sufficient professional skepticism when performing an
audit.

Be objective in conducting an audit and ensure that sufficient & appropriate evidential
matter is obtained.

Have a sound understanding of the audit client & the integrity of its management.

Maintain independence at all times.