Middle West Utilities Company & Samuel Insull

The fraud case of Middle West Utilities Company can almost entirely be contributed to one man: Samuel Insull. At the age of 22, Insull moved to America to work as a secretary to Thomas A. Edison through a recommendation from his employer, E. H. Johnson (Columbia University Press, 2010). The young secretary worked for the inventor for a decade during which time he played a large role in the creation of several of Edison’s early companies including Edison General Electric Company, known today as General Electric Company (Childs I, 1932).

In the formation of this company, Insull was appointed vice-president in charge of manufacturing as a reward by Edison for all of the hard work he had put in over the years (Boman, 2001). After a short time in this position, and with Edison’s help, he was made the head of the Commonwealth Electric Company in Chicago (Childs I, 1932). Five years later, Insull formed the Middle West Utilities Company through a series of mergers and buy-outs (Columbia University Press, 2010). Before the formation of Middle West Utilities Company, electricity was a “high-cost luxury” which only the very wealthy could afford (PBS.org, 2011).

Through the acquisition of all of the competition in the area, Insull’s company monopolized the electricity market in Illinois as well as neighboring states (Britannica Biographies, 2010). Holding this power gave him and his company the ability to set the prices at what ever they wished (PBS. org, 2011). Samuel Insull broadened the market by selling to anyone and everyone he could (Hutchinson’s Biography Database, 2003). Prices were set low enough to enable small businesses and households to obtain electricity, and what was once only seen as a luxury soon became commonplace (PBS. org, 2011).

Insull battled it out with the city in order to buy the gas company in Chicago. After many bitter words and attempted black mailings, he was successful and his company now monopolized all of the energy in the Chicago area and beyond (Childs I, 1932). However, their newly purchased gas company was anything but up to date. The entire company needed to be modernized, and a great deal of hard labor was required. The Gas Workers’ Union was formed and it did not take long for workers to voice their demands: shorter hours and higher wages. The company declined to meet these demands and a strike was declared.

Insull and his executives feared not being able to supply the large city with gas and the consequences which may have come with it. A temporary settlement was agreed upon however, the value was not disclosed to the public (Childs I, 1932). In 1925, Insull was as the peak of his power. Everything in his life was as one would want it to be. He was happily married with a son who had graduated from Yale who would, one day, take his place (Childs II, 1932). He had the mayor as well as the entire brigade of police on his side giving him control of the entire city (Childs II, 1932).

He was not only the head of an extremely large company which monopolized electricity and gas in a huge metropolitan area, he was also head of the Illinois State Council of Defense (Childs II, 1932). Insull was once quoted saying, “You know, I can do what ever I want to in this state now (Childs II, 1932). ” With all of his power and money, Insull invested a huge sum into The Chicago Civic Opera Company and was appointed president soon afterward (The New York Times, 1922). He built the largest, most luxurious opera house in the world, however, its deficit grew significantly each year (Childs II, 1932).

Middle West Utilities Company had purchased enough interests an enormous number of small holding companies in order to have control over them, and money was simply moved back and forth among these entities in order to simulate profits (Traylor, 1935). One of these holding companies, known as Commonwealth Subsidiary Corporation, allowed Insull’s company to indirectly invest any extra income in stocks and bonds of their competitors (Childs III, 1932). Over 56% of the company’s assets were investments in other utility companies (Traylor, 1935).

Although it should have shown a loss since the first day of organization, the corporation manipulated accounts so grossly that a nearly quarter of a billion dollar deficit no longer existed on the books (Childs III, 1932). Long before his big downfall, Insull came up with a financial instrument known as an “open-ended mortgage” to help fund his projects (Wasik, 2006). This was an ever expanding line of credit backed by the corporation’s bonds. This large amount of available cash allowed Insull and his company make large investments in order to grow the already large company even larger.

However, when the stock market crashed in 1929, those banks which had loaned him enormous amounts of cash suddenly demanded repayment of the borrowed funds (Wasik, 2006). However even after the crash, Insull continued to invest (Childs III, 1932). Had he halted his expansion, rather than deepening his debt, he may have been able to pay the loans back (Childs III, 1932). It is said that the final “nail in the coffin” was placed by a $110 million dollar loan Insull took to pay a premium for stock in several Chicago utility companies (Childs III, 1932).

He pledged $440 million worth of his stocks in order to receive the loan and over the following two years stock prices fell (Childs III, 1932). The investment value fell below the value of the $110 million loan used to buy them, and nothing could be done to raise the money needed to pay back the debt (Childs III, 1932). The frauds involved in the Middle West Utilities Company very closely resemble those of more recent times in the Enron scandal a few years ago. It almost seems as though the perpetrators at Enron took a page out of the book of Insull for tips on how to commit fraud.

Those who were well read on the scandals of Samuel Insull felt a bit of deja vu when the more recent scandal was uncovered. The fraud of Samuel Insull involved shuffling of accounts such that huge losses would disappear and large false profits would shine through (Childs III, 1932). The company showed huge amounts of assets on its books, when they were actually very small and were obtained through loans (Traylor, 1935). Assets were grossly overstated in order to increase stock prices and make the company seem as if it was worth much more than it actually was (Traylor, 1935).

The company created a sort of “special purpose entity” in which it made up a fictitious company that it controlled in order to obtain loans, falsify profits, and purchase large amounts of stock in the competition (Traylor, 1935). Using these companies, money could be shifted from one hand to the other in order to simulate business transactions and profits (Dawson, 1934). Within this fraudulent web, each company owned a significant amount of their own stock, and therefore collected their own dividends when they were paid, and showed it as dividend revenue, although it was their own money to begin with.

In addition, the corporations’ depreciation expense was accounted for as a capital expenditure rather than deducted directly from income (Dawson, 1934). A $1. 42 earnings per share was reported in 1930, however, if everything had been correctly accounted for, a net loss, rather than gain, would have been shown (Traylor, 1935). As stated previously, the blame for the entire scandal can be placed entirely on Samuel Insull. Although he may have been the ring leader, there is no way that one man could perpetrate a fraud as huge as the Middle West Utilities Company fraud without any help from others.

Other employees of the company must have known of the wrongdoings and misstatements at the time that they occurred. However, with all of the power Insull held, being friends with much of the Chicago police force, it probably was not hard for him to get his subordinates to comply with his orders (Childs II, 1932). Samuel Insull was the only one who faced legal ramifications resulting from this scandal. For a short time after the downfall of this utility giant, Insull remained in Chicago. Rumors say he traveled in a bulletproof limousine and was protected by bodyguards at all times (Childs III, 1932).

As soon as people began to demand an investigation over the company’s failure, Insull fled to Europe where he hid out in Greece (Hutchinson’s Biography Database, 2003). After only two years, he was forced to return to Chicago (Boman, 2001). In 1934, he was charged with mail fraud, violation of federal bankruptcy laws, and embezzlement (Hutchinson’s Biography Database, 2003). In trial, the government spent four weeks presenting all of the evidence against Insull, but in the end, they were unable to convince the jury that he had “criminal” intentions and knew what he was doing was wrong (Dawson, 1934).

While on the stand, Insull was quoted as saying, “I’d do it again, sir! I’m a believer in that method of accounting (Dawson, 1934). ” Insull was tried three times, but acquitted each time (Britannica Biographies, 2010). After his trials, he returned to Europe where he lived off “modest pensions” until he died in 1938 (Boman, 2001). In all frauds, there are three common components: incentive, opportunity, and rationalization or attitude (Cook, 2009). Incentives refer to the benefit that the perpetrator will experience if they commit the fraud (Turner, 2009).

Examples of incentives can include financial or market pressures (Turner, 2009). Opportunities refer to the ability for one to commit the fraud (Cook, 2009). Opportunities for fraud can arise from a lack of internal controls (Turner, 2009). The third component, rationalization, refers to the justification that the fraudulent employee uses to condone their own immoral behaviors (Cook, 2009). The incentives and pressures which increased the likelihood of the Middle West Utilities Company fraud include Samuel Insull’s greed for power.

Greed is obviously involved in every fraud and Insull’s case is no exception. Although he started as only a lowly secretary, he quickly gained ranks and climbed the corporate ladder until he was at the top (Childs I, 1932). Even after he reached the top, he controlled his company in a very aggressive manner (Columbia University Press, 2010). His once small electric company began absorbing nearly all of the competition in the area and continued to grow and expand the coverage area (Columbia University Press, 2010). His ruthless management approach obviously showed his need for power.

Another action which illustrated his greed for power was his misappropriation of assets on the financial statements. This misappropriation overstated the company’s assets, earnings per share, and company value (Childs III, 1932). Each period that he made the stock prices of his company increase it also boosted the public’s perception of his management skills. Although his company should have been showing net losses, Insull continued to gain power and wealth (Childs III, 1932). The second component found in every fraud is opportunity.

In Insull’s case, the opportunity arose as he reached the peak of his power. He was the head of his Middle West Utilities Company and the Illinois State Council of Defense, had close ties with the mayor and the entire brigade of police, and had donated large sums of money to support different organizations and political campaigns (Childs II, 1932). With all of the power he held, there was no way anyone could tell him, “No,” when he asked his employees to help him commit his fraud. He also didn’t have anyone who outranked him to confront him about his activities.

Anyone who did outrank him was his friend and ally. Another opportunity for Insull was the lack of controls and standards. This fraud occurred in 1932- decades before the standards we have today were put in place. The third component involved in every fraud is attitude or rationalization. One must have both the right attitude as well as the mental reasoning to justify why it is okay for them to perpetrate the fraud. Insull rationalized his fraud when he was quoted saying, “You know, I can do what ever I want to in this state now (Childs II, 1932).

” From this quote, we can see that his rationalization was that he believed he could use his power to get away with anything. He believed that since he knew all the right people, he could get away with anything he wanted to do. Samuel Insull also had the attitude required to commit fraud. He was a relentless, power hungry man who would do anything to get ahead of the competition and to get to the top of the food chain (Columbia University Press, 2010). The downfall of this utilities giant opens our eyes to many changes which need to be taken to ensure nothing like

this, or Enron for that matter, can or will happen again. We can look deep into past frauds, such as Middle West Utilities Company in order see how our current controls and standards are lacking. We can study how fraudsters such as Samuel Insull committed such elaborate schemes and enact policies to ensure these same frauds cannot be committed again. In order to avoid a scandal like this, several steps should be taken. First, all high ranking executives should only be given a set, shorter amount of time in their position and they should be elected by the corporation’s board of directors.

When Samuel Insull was in power of his company for an extended amount of time, he felt a sense of immortality. He believed that he could do what ever he wanted without consequence. If executives were forced to face a board of directors every few years in order to be re-elected, the executive may try harder to do what is best for the company and not just himself. The high ranking official should be required to compete to retain his or her position. This extra competition within the company would keep executives on their best behavior.

Second, there should be an internal audit committee who assesses the executives’ performance and ensures he or she is not committing any fraudulent behavior. This committee would serve as an extra check to make sure the high ranking managers and officials in the company are only doing that which is in the best interest of the company. If this committee had been in place during Insull’s scandal, the auditors would have been able to catch the false transactions occurring with the special purpose entities. The committee should also have access to all of the executives’ and high ranking officials’ personal finances.

The committee would be able to recognize any abnormal gains of money for the officials and it would be easier to compare the personal bank accounts with that of the company in determining if fraud is occurring. Since Insull never directly stole money from the company, this aspect would not have stopped this particular fraud, but it could stop others. All corporations’ internal audit committees should include a team who focuses on forensic accounting and who investigate the possibility of fraud within the organization.

If all corporations were required to have accountants who specialize only in looking for and reducing the risk of fraud, such scandals as in Middle West Utilities Company would not have been possible. If someone had been there to make sure there were only legitimate business transactions going on, Samuel Insull may not have been able to get away with his elaborate web of special purpose entities, false transactions, and misappropriations in the financial statements. Another part of the internal audit team should be required to test the company’s internal control system.

Extremely strict internal controls should be put in place and enforced. This control system should include physical controls, access controls, and hacking controls. The team should ensure that there are adequate segregation of duties. The entire system should be very secure and no exceptions should be made for any aspect of the internal control system. All employees, including executives should be required to take a course on ethics in the workplace. They should also be required to pass a written test upon completion of the class.

Knowledge of what is and what is not fraud could easily cut down the amount of fraud and misappropriation among employees of all ranks within the organization. The employees should be educated on ways to avoid committing fraud and sticking to their morals when someone else tries to pressure them into committing fraud. In Samuel Insull’s case, even after the fraud, he continued to insist he had not done anything wrong and that his method of accounting was correct. Had he had the proper training on ethics, he would have known that his misappropriations and special purpose entities were not ethical.

An anonymous tip line should be enacted in every organization. Whistleblowers can face serious negative consequences when they expose a wrongdoing. Although they are doing the right thing, many times, the tattletale can face harsh penalties. The tip line will allow employees to remain anonymous while still doing the right thing and exposing the fraud or potential fraud. This is essential for every organization, and it will keep pressure high for anyone who is considering committing fraud because they will know that if anyone even suspects them of fraud, they can easily be turned in.

Since Insull held so much power, if anyone had wanted to report him or turn him in, they had no way of making the wrongdoings known. Had an anonymous tip line been present, employees who knew of the fraud could have discreetly made the fraudulent activity known to others. Although some of these changes I have suggested seem a bit extreme for some organizations, implementing them would make committing fraud virtually impossible. All frauds cannot reasonably eliminated because the steps that would need to be taken, such as those I have stated above, are not reasonable for all organizations to implement.

Enacting all of my recommendations would increase expenses and many smaller companies would not be able to stay in business if they were forced to implement all of these. However, each recommendation can decrease the likelihood of fraud to an extent, however each one alone cannot eliminate it altogether. Works Cited: Boman, J. (2001) “Samuel Insull (1859-1938)”, Cambridge Dictionary of American Biography. Britannica Biographies. (2010) “Insull, Samuel”, Encyclopaedia Britannica. Childs, M. (1932) “Samuel Insull.

I: The Rise to Power”, New Republic, 142-144. Childs, M. (1932) “Samuel Insull II: Chicago in His Vestpocket”, New Republic, 170-173. Childs, M. (1932) “Samuel Insull III: The Collapse”, New Republic, 201-203. Columbia University Press. (2010) “Samuel Insull”, Columbia Electronic Encyclopedia. Cook, M. (2009) Financial Fraud 101: understanding the fraud triangle, April 19, 2011, http://www. examiner. com/financial-fraud-in-national/financial-fraud-101-understanding-the-fraud-triangle. Dawson, M. (1934) “Insull on Trial”, Nation, 611-613. Hutchinson’s Biography Database.

(2003) “Samuel Insull (1859-1938)”, Hutchinson’s Biography Database. The New York Times. (1922) “Samuel Insull Now Heads Chicago Opera”, The New York Times. PBS. org. (2010) “Samuel Insull”, Who Made America?. March 25, 2011, http://www. pbs. org/wgbh/theymadeamerica/whomade/insull_hi. html. Traylor O. (1935) “The Insull Trial”, Journal of Criminal Law and Criminology, 782-787. Turner, L. (2009) Accounting Information Systems: Controls and Processes. Hoboken, NJ: John Wiley & Sons, Inc. Wasik, J. (2006) “Mane Who Set the Pattern for Bringing Power to Our Cities”, The Washington Times, B08.