Written by Francine McKenna and Originally Published in Forbes on June 5, 2013
As her renown in the elite world of quarter horse breeding grew, Rita Crundwell kept her unglamorous day job as the $80,000-a-year comptroller of Dixon, Ill., a working-class city of nearly 16,000, most famous as the boyhood home of Ronald Reagan. Year after year, she delivered the bad budget numbers to councilmen and department heads–numbers that meant streets couldn’t be repaved, ambulance equipment couldn’t be purchased, and replacement radios for cops and firefighters would have to wait. Eventually the city workforce was cut.
When asked in 2011 about the city’s worsening cash crunch, Crundwell blamed lagging payments from the state, which collects and remits Dixon’s share of tax revenues. It was a display of chutzpah worthy of Bernie Madoff. In fact, the money had arrived, and she had spent it–on herself. Between 1991 and April 2012 she embezzled $53.7 million from Dixon, using the loot to acquire 400 quarter horses (the quintessential American racehorse), a ranch in Dixon and horse trailers and trucks. She traveled to equestrian competitions in a $2 million motor home and remodeled her Illinois home with an in-ground pool and a chandelier made of old revolvers and spurs, in addition to buying another home in Englewood, Fla., minks, jewels, and a 1967 Corvette convertible.
Local residents who saw Crundwell’s stables and spending grow–she was the American Quarter Horse Association’s top breeder-owner for eight consecutive years–naively assumed she was making money from show horses, which (as horse people know) more often generate tax writeoffs than profits. Instead, to spend more, she stole more. In the six years before an FBI agent confronted her in April 2012, she pocketed $30 million–more than half the town’s revenue.
The 60-year-old Crundwell pleaded guilty to one count of wire fraud in November and now sits in federal prison while she appeals a 19?-year sentence for what ranks as the largest municipal embezzlement in U.S. history and eighth-largest U.S. embezzlement of any kind, according to a tally kept by Christopher Marquet, a Boston-based security consultant. (Runner-up in the muni category: Harriette Walters, the real estate tax assessments manager for Washington, D.C., who, before her 2007 arrest, issued phony tax refunds to herself totaling $48 million over two decades. The biggest embezzler overall, according to Marquet, is Peregrine Financial Group founder Russell Wasendorf Sr., who pleaded guilty last year to siphoning $215.5 million from customers’ accounts over 20 years.)
Crundwell’s crime was extraordinary, but Dixon’s failure to heed its most famous resident’s dictum to “Trust, but verify” is all too common among municipal governments. While auditing in corporate America is far from perfect, the standards public companies must adhere to are stringent compared with what’s required of local governments, whose sometimes shoddy accounting practices enable not only rogue embezzlers but also corrupt elected officials and those who would cook the books to hide fiscal mismanagement.
This long-standing problem should alarm the individual investors holding nearly $3 trillion in municipal debt, because increasingly they, not insurance companies, will be on the hook if bond issuers default. Back in 2005, 57% of new municipal bonds carried insurance that protected investors from losing principal and even interest in the event of a default. Today, in the wake of the financial crisis, only one firm, Bermuda-based Assured Guaranty Ltd., writes muni insurance. In 2012 it covered $13 billion in new bonds–only 3.5% of the $373 billion in new muni bonds Morgan Stanley reports were issued. So far this year it has covered just 1.5% of new issues.
To be fair, muni bond defaults, while rising, are still rare and mostly occur among tax-exempt bonds issued for special purposes–say, to build multifamily housing, medical facilities or parking garages. States themselves can’t file for bankruptcy and usually step in to bail out failing cities, meaning general obligation bonds backed by tax revenues are still pretty safe. But the number of overall muni defaults has been creeping up and is far greater than commonly believed, since the ratings agencies–Moody’s, S&P and Fitch–report only on defaults of rated issues. Last year economists at the New York Federal Reserve tallied defaults for all muni bond issues, including those that weren’t rated, and found 2,366 had occurred from 1986 through 2011, 50 times the 47 defaults S&P reported for that period. (The Fed researchers say they don’t know how many issues there were overall and therefore can’t calculate a default rate.)
Moreover, local governments can and do sometimes default, particularly when fraud and fiscal mismanagement are present. In November 2011 Jefferson County, Ala. filed for the largest municipal bankruptcy in history, owing investors more than $4 billion, with $3 billion of that debt resulting from a huge upgrade to its sewer system. The sewer debt had been mixed with very risky auction rate securities and interest rate swaps intended to synthetically fix the rate of the variable interest bonds. When the auction rate securities market froze up in February 2008, the county couldn’t pay interest on the debt nor post collateral on the swaps. Three Jefferson County officials and one private “consultant” were sentenced to jail for bribery and corruption in connection with the bonds. JPMorgan Chase settled SEC charges that it made $8 million in illegal payments to win the sewer-bond underwriting business; it paid a $25 million fine and $50 million to Jefferson County, as well as forfeited $647 million in termination fees it had claimed the county owed. Two former JPMorgan execs are still fighting civil fraud charges.
While Jefferson County residents have suffered (an emergency response team was sorely missed when a tornado hit last year), investors have so far been spared as Assured Guaranty, which covered the sewer bonds, has continued to make interest payments. Thanks to insurance, investors have also been thus far spared the pain of Stockton, ?Calif.’s bankruptcy filing, which was allowed by a judge (over Assured’s objections) this past April. Now other California cities such as Compton and Hercules are looking shaky, as is Detroit. There’s a pattern among the endangered: real estate busts and job losses exacerbated by financial mismanagement or corruption (sometimes both), often accompanied by shoddy audit practices.
The SEC certainly seems worried. Although its enforcement in the muni area has traditionally focused on bond underwriters and salesmen, this year the agency has brought three groundbreaking cases–against the state of Illinois, Harrisburg, Pa. and Victorville, Calif.–alleging public officials deceived bond investors. At an April roundtable on municipal finance, SEC Commissioner Dan Gallagher expressed serious concerns on behalf of retail investors about potential California bankruptcies. “You tack that on to rising interest rates and we’ve got a real Armageddon on our hands here,” he warned.
Last July the SEC released a 150-page report on the muni market that included recommendations for strengthening auditing and oversight. Among the ideas: Give the agency legal authority to oversee accounting standards and to require audits for municipal bond issuers.
It’s a great idea, but don’t hold your breath. The Government Finance Officers Association (which represents public sector accounting and finance execs) has a history of successfully fending off as “unfunded mandates” efforts to give the SEC more authority or even to require government units to use Generally Accepted Accounting Principles. (Most, but not all, do.)
That doesn’t mean there are absolutely no standards. Federal law currently requires any state or local government or nonprofit that spends $500,000 or more in federal grants in a year to have an “independent” audit. And like most states, Rita Crundwell’s home state of Illinois requires an audit to be performed by a state-licensed public accounting firm. The problem is that Illinois, like California and most other states, files these audit reports away without any real oversight. Illinois’ comptroller has no legal authority, let alone funding, to perform his or her own audits of local finances.
With no one auditing the supposedly “independent” municipal auditors, the results are depressingly predictable. A Los Angeles Times investigation, for example, found that independent auditors of public agencies in California frequently ignored fraud and chronic mismanagement and got more work as their reward. Those that didn’t play the cover-up game were fired.
Which brings us back to how Crundwell got away with fraud for so long, even though, as her own lawyer pointed out, her scheme wasn’t that sophisticated. In 1990 she opened what appeared to be a city account at a local bank, now part of Fifth Third Bank. Crundwell had sole signing authority over that account, and the checks were imprinted RSCDA c/o Rita Crundwell. (The initials supposedly stood for “Reserve Sewer Capital Development Account.”) She then created phony invoices, 179 in all, mostly from the State of Illinois; wrote checks from a real town account (the Capital Development Fund account, also at Fifth Third) to pay those invoices; deposited the city’s checks into the RSCDA account; and wrote checks from RSCDA to her personal accounts.
Dixon’s external auditor, CliftonLarsonAllen, was a licensed accounting firm, as Illinois law requires, but hardly independent. That’s because it was paid to do Dixon’s bookkeeping while it audited the town’s financial statements. Incredibly, the same partner who oversaw work for Dixon also prepared Crundwell’s personal tax returns, which showed large sums inexplicably flowing in. (The partner has so far faced no public sanctions.)
In 2005–at a point when Crundwell’s thievery was ramping up–Dixon became subject to the federal requirement for an independent audit, and CLA decided it could no longer perform the town’s audit. So it recruited Janis Card Associates, a tiny two-person CPA firm, to sign Dixon’s audits, according to a negligence lawsuit filed by Dixon against the two accounting firms. After that, the suit alleges, CLA continued to do most of the audit work, performing what it called a “full disclosure compilation.” Janis Card owner Samuel S. Card signed off on the audits, but his firm was paid only $7,000 for the 2011 audit, compared with the $34,750 CLA billed Dixon for its “audit” work.
How is it the firms never caught Crundwell’s scheme? According to the city’s lawsuit, they never asked for documentation to support even one of her amateurishly prepared State of Illinois invoices, which looked very different from real state bills–no logo, no contact information, nonexistent dates. Attorneys for the city say CLA, which advertised its expertise in government audit, should have noticed the difference between Crundwell’s fakes and legitimate state paperwork. Both accounting firms have denied liability in the suits but declined to talk to FORBES.
What finally did Crundwell in was taking too much time away from work for her horse hobby. In 2011 she took 4 weeks paid and 12 weeks unpaid off from work. While she was away she had a relative pick up Dixon’s mail and sort out the RSCDA statements that were addressed to her personally. But in October 2011 her temporary replacement asked Fifth Third to send over all the city’s bank statements and noticed the unfamiliar RSCDA account. She called it to the attention of Dixon’s mayor, who called in the FBI.