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2011-11-24 08:31:43
It is unfortunate, but words often associated with money and fortune are
"cheat," "steal," and "lie." Who among us hasn't "accidentally" taken two $500
bills from the Monopoly bank, or forgotten at least once to pay $5 back to a
friend? Chances are you were never called on it because your friends trusted
you. Just as we trust our friends, we put faith in the investing world.
Investing in a stock takes a lot of research, but it also requires us to make a
lot of assumptions. For example, we assume reported earnings and revenue
figures are correct, and that management is competent and honest. But these
assumptions can be disastrous.
Understanding how disasters happened in the past can help investors avoid them
in the future. With that in mind, we'll look at some of the all-time greatest
cases of companies betraying their investors. Some of these cases are truly
amazing; try to look at them from a shareholder's standpoint. Unfortunately,
these shareholders had no way of knowing what was really happening as they were
being tricked into investing.
ZZZZ Best Inc., 1986 - Barry Minkow, the owner of this business, posited that
this carpet cleaning company of the 1980s would become the "General Motors of
carpet cleaning". Minkow appeared to be building a multi-million dollar
corporation, but he did so through forgery and theft. He created more than
10,000 phony documents and sales receipts without anybody suspecting anything.
Although his business was a complete fraud designed to deceive auditors and
investors, Minkow shelled out more than $4 million to lease and renovate an
office building in San Diego. ZZZZ Best went public in December of 1986,
eventually reaching a market capitalization of more than $200 million.
Amazingly, Barry Minkow was only a teenager at the time! He was sentenced to 25
years in prison.
Centennial Technologies Inc., 1996 - In December 1996, Emanuel Pinez, the CEO
of Centennial Technologies, and his management recorded that the company made
$2 million in revenue from PC memory cards - the company was really shipping
fruit baskets to customers. But the employees then created fake documents to
appear as though they were recording sales. Centennial's stock rose 451% to
$55.50 per share on the New York Stock Exchange (NYSE). According to the
Securities and Exchange Commission (SEC), between April 1994 and December 1996,
Centennial overstated its earnings by about $40 million. Amazingly, the company
reported profits of $12 million when it really lost about $28 million! The
stock plunged to less than $3. Over 20,000 investors lost almost all of their
investment in a company that was once considered a Wall Street darling.
Bre-X Minerals, 1997 - This Canadian company was involved in one of the largest
stock swindles in history. Its Indonesian gold property, which was reported to
contain more than 200 million ounces, was said to be the richest gold mine
ever. The stock price for Bre-X skyrocketed to a high of $280 (split adjusted),
making millionaires out of ordinary people overnight. At its peak, Bre-X had a
market capitalization of US$4.4 billion. But the party ended on March 19, 1997,
when the gold mine proved to be fraudulent, and the stock tumbled to pennies
shortly after. The major losers were the Quebec public sector pension fund,
which lost $70 million; the Ontario Teachers' Pension Plan, which lost $100
million and the Ontario Municipal Employees' Retirement Board, which lost $45
million.
Enron, 2001 Prior to this debacle, Enron, a Houston-based energy trading
company was, based on revenue, the seventh largest company in the U.S. Through
some fairly complicated accounting practices that involved the use of shell
companies, Enron was able to keep hundreds of millions worth of debt off its
books. Doing so fooled investors and analysts into thinking this company was
more fundamentally stable than it actually was. Additionally, the shell
companies, run by Enron executives, recorded fictitious revenues, essentially
recording one dollar of revenue multiple times, thus creating the appearance of
incredible earnings figures. Eventually, the complex web of deceit unraveled,
and the share price dove from over $90 to less than $0.70. As Enron fell, it
took down with it Arthur Andersen, the fifth leading accounting firm in the
world at the time. Andersen, Enron's auditor, basically imploded after David
Duncan, Enron's chief auditor, ordered the shredding of thousands of documents.
The fiasco at Enron made the phrase "cook the books" a household term once
again.
WorldCom, 2002 - Not long after the collapse of Enron, the equities market was
rocked by another billion-dollar accounting scandal. Telecommunications giant
WorldCom came under intense scrutiny after yet another instance of some serious
"book cooking". WorldCom recorded operating expenses as investments.
Apparently, the company felt that office pens, pencils and paper were an
investment in the future of the company and therefore expensed (or capitalized)
the cost of these items over a number of years. In total $3.8 billion (yes,
with a 'b') worth of normal operating expenses - which should all be recorded
as expenses for the fiscal year in which they were incurred - were treated as
investments and were recorded over a number of years. This little accounting
trick grossly exaggerated profits for the year the expenses were incurred; in
2001, WorldCom reported profits of around $1.3 billion. In fact, its business
was becoming increasingly unprofitable. Who suffered the most in this deal? The
employees - tens of thousands of them lost their jobs. The next ones to feel
the betrayal were the investors who had to watch the gut-wrenching downfall of
WorldCom's stock price, as it plummeted from more than $60 to less than $0.20.
Tyco International (NYSE: TYC), 2002 - With WorldCom having already shaken
investor confidence, the executives at Tyco ensured that 2002 would be an
unforgettable year for stocks. Before the scandal, Tyco was considered a safe
blue chip investment, manufacturing electronic components, healthcare and
safety equipment. During his reign as CEO, Dennis Kozlowski, who was reported
as one of the top 25 corporate managers by BusinessWeek, siphoned hordes of
money from Tyco in the form of unapproved loans and fraudulent stock sales.
Along with CFO Mark Swartz and CLO Mark Belnick, Kozlowski received $170
million in low-to-no interest loans, without shareholder approval. Kozlowski
and Belnick arranged to sell 7.5 million shares of unauthorized Tyco stock for
a reported $450 million. These funds were smuggled out of the company, usually
disguised as executive bonuses or benefits. Kozlowski used the funds to further
his lavish lifestyle, which included handfuls of houses, an infamous $6,000
shower curtain and a $2 million birthday party for his wife. In early 2002, the
scandal slowly began to unravel and Tyco's share price plummeted nearly 80% in
a six-week period. The executives escaped their first hearing due to a
mistrial, but were eventually convicted and sentenced to 25 years in jail.
HealthSouth (NYSE: HLS), 2003 - Accounting for large corporations can be a
difficult task especially when your boss instructs you to falsify earnings
reports. In the late 1990s, CEO and founder Richard Scrushy began instructing
employees to inflate revenues and overstate HealthSouth's net income. At the
time, the company was one of America's largest healthcare service providers,
experiencing rapid growth and acquiring a number of other healthcare related
firms. The first sign of trouble surfaced in late 2002, when Scrushy reportedly
sold HealthSouth shares worth $75 million, prior to releasing an earnings loss.
An independent law firm concluded the sale was not directly related to the
loss, but investors should have taken the warning. The scandal unfolded in
March, 2003, when the SEC announced that HealthSouth exaggerated revenues by
$1.4 billion. The information came to light when CFO William Owens, working
with the FBI, taped caught Scrushy talking about the fraud. The repercussions
were swift, as the stock fell from a high of $20 to a close of $0.45 in a
single day. Amazingly, the CEO was acquitted of 36 counts of fraud, but was
later convicted on charges of bribery. Apparently, Scrushy arranged political
contributions of $500,000, allowing him to ensure a seat on the hospital
regulatory board.
Bernard Madoff, 2008
Making for what could be an awkward Christmas, Bernard Madoff, the former
chairman of the Nasdaq and founder of the market-making firm Bernard L. Madoff
Investment Securities, was turned in by his two sons and arrested on December
11, 2008, for allegedly running a Ponzi scheme. The 70-year-old kept his hedge
fund losses hidden by paying early investors with money raised from others.
This fund consistently recorded a 11% gain every year for 15 years. The fund's
supposed strategy, which was provided as the reason for these consistent
returns, was to use proprietary option collars that are meant to minimize
volatility. This scheme duped investors out of approximately US$50 billion.
Conclusion
The worst thing about these scams is that you never know until it's too late.
Those convicted of fraud might serve several years in prison, which in turn
costs investors/taxpayers even more money. These scammers can pick a lifetime's
worth of garbage and not even come close to repaying those who lost their
fortunes. The SEC works hard to prevent such scams from happening, but with
thousands of public companies in North America, it is nearly impossible to
ensure that disaster never strikes again.
Is there a moral to this story? Sure. Always invest with care and diversify,
diversify, diversify. Maintaining a well-diversified portfolio will ensure that
occurrences like these don't run you off the road, but instead remain mere
speed bumps on your path to financial independence.
For further reading, see the Investment Scams tutorial and Playing The Sleuth
In A Scandal Stock.
Playing The Sleuth In A Scandal Stock
The pervasiveness of business-related scandals has changed the way that many
analysts and investors think about corporate governance. For example, no longer
do senior executives get a free pass when they botch an acquisition or their
company misses earnings - they can be sued, along with their company, insurance
carrier and anyone else even remotely involved in event.
The good news is that an investor's willingness to hold management's feet to
the fire will probably lead to fewer corporate scandals going forward. But
there will always be rotten apples that will continue to manage recklessly and/
or just plain steal from their shareholders.
In any case, the possibility that a corporate scandal could emerge in the
future means that investors should be prepared, not only to investigate the
scandal on their own, but also to make their own assumptions based on the
potential damage to shareholder value and the underlying stock price. In this
article, we'll show you what to look for and how to keep a scandal from
tainting the value of your portfolio.
Take Matters Into Your Own Hands
Some will suggest that an investor would be better off leaving the
investigation (and the resulting valuation) up to the press and the analysts
that cover the company. In fact, there are a few reasons why an investor would
be wise to play the role of detective. The first, and probably the most
important, reason would be to preserve capital and to avoid "opportunity lost".
It could easily take weeks or even months for a journalist or analyst to fully
uncover the depths of a given scandal. By completing your own analysis on a
timely basis, you'll be able to get out of the stock in question before the
herd tries to sell. Furthermore, an investor's own analysis might find that the
scandal is not be as bad as the media has implied, providing investors with an
opportunity to get involved in the stock at a very low cost. (To read more
about this, see Common Clues Of Financial Statement Manipulation.)
Clues to Look For
There are several facets an investor should look at when analyzing a potential
scandal stock. First, the investor should try to determine exactly who is
involved and to what degree. Logic should dictate that if the chief executive
officer is involved, there may be others under that person that may have acted
as accomplices. If this is the case, the scandal (and the lies) will probably
multiply until the dust settles. Also, as a rule of thumb, the more elaborate
the deception and the more accomplices, the larger the dollar value of the
fraud. A great example of this was Enron, where the scandal spread from Ken Lay
and Jeff Skilling, to subordinates such as Andrew Fastow and a number of other
"C-suite" execs. (To learn more, see The Biggest Stock Scams Of All Time.)
Conversely, if a lower level manager looking to advance his or her career was
caught fudging the numbers, one might assume that this person may have been
acting alone or with only a few other minor accomplices. In other words, the
fraud is more likely to be contained, and less damaging to the overall
organization. For example, Raymond Stevenson, a former vice president of
taxation at Tyco, pleaded guilty in 2006 to failing to report more than $170
million in income on a 1999 Tyco International tax return. However, because the
shenanigans were essentially limited to one man and because Tyco is such a huge
company, most analysts agree that the company will survive.
Stock scandal sleuths should also pay attention to the portion of the company
the scandal encompasses. If it is the company's primary revenue source, one
could assume that the scandal could take an enormous toll on its financial
statements, and by proxy, its stock. On the flip side, as mentioned above, if
the scandal is limited to a smaller or discontinued operation, the likelihood
that the damage will be contained goes up significantly.
Check Out the Financials
Balance Sheet
After the major players and the divisions they represent are identified, the
next step is to analyze the company's financials. Specifically, an investor
should review the last balance sheet for several items. First, take a look at
how much cash the company has, because this will be its lifeline. Can the
company afford to weather inquiries from the major regulatory bodies and a
shareholder suit if one should emerge? If not, consider selling out the
position!For example, a large company with $9 billion in cash and cash
equivalents on its balance sheet would be in a much better position to weather
a scandal than a company with fewer assets and a smaller number, such as $309
million, on its balance sheet.
Liquidity
Next, calculate the company's liquidity situation by examining its current
ratio. The current ratio is calculated by dividing current assets by current
liabilities. This ratio will help you to determine what kind of breathing room
the company will have if things get real hairy. Depending on how conservative
you want the estimate to be, you can change the composition of the current
assets value. Keep in mind that not all short-term assets (such as inventory)
can be easily liquidated to pay off liabilities. For the most conservative
estimate, you can just use cash and cash equivalents as assets. (To learn more
about this ratio, see Do Your Investments Have Short-Term Health?)
In a current ratio, current assets should outnumber current liabilities by a
ratio of at least 2:1. If a company has a lower ratio, it will have an awfully
difficult time juggling its debts - not to mention a pile of legal bills - if
it is involved in a scandal.
Footprints in the Footnotes
Next, look at the accompanying footnotes to the financials in the company's
latest filings with the SEC. In those footnotes, the company may reveal whether
it holds an insurance policy that could offset some of the legal costs that
might arise in a scandal. Incidentally, these same footnotes may also reveal
whether the company has set aside any money in a reserve account for the same
purpose. An insurance policy and/or a reserve account would signal that at
least some sort of cushion exists that could protect the common shareholder.
(For related reading, see Footnotes: Start Reading The Fine Print and How To
Read Footnotes - Part 1, Part 2 and Part 3.)
Assessing the Damage
The next goal for the investor should be to determine what the ultimate
financial impact of a scandal might be on a particular company. How many
quarters of earnings will need to be restated if any? Will the numbers being
restated be significantly askew from the new numbers?
Obviously, some guessing will be involved. By listening to the facts of the
case and doing one's own homework, the investor should be able to come up with
an educated guess. For example, when news broke that Enron's officers had been
masking debt by conducting a sizable number of off-balance sheet transactions
and booking revenues improperly, it could be assumed that multiple quarters
would be affected, and that the dollar amounts of fraud (while not precisely
quantifiable) would render previous earnings reports meaningless.
In some cases, it may be impossible to comprehend the potential future
financial impact of a scandal. In these instances, entire years of previously
filed financial statements may have to be restated.
Reaction to the Scandal
What should investor's do if they find themselves holding a scandal stock?
The only logical answer is to sell the stock and to avoid becoming involved
again unless and until the outlook for the company and the common shareholder
clears.
Bottom Line
Corporate scandals have and will continue to make headlines, but rather than
wait for the media to cover the event, investors should conduct their own
investigations in an effort to either preserve their capital and/or to isolate
an appropriate entry point into the stock before it rebounds.
by Glenn Curtis