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The Biggest Stock Scams Of All Time

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