Reading Financial Reports for Dummies (55 page)

Part VI

The Part of Tens

In this part . . .

Here you find quick information about some juicy

topics. I tell you about financial reporting scandals

that shook the world, and I give you ten indications that a company may be falling on hard times.

Chapter 24

Ten Financial Scandals

That Rocked the World

In This Chapter

▶ Checking in with cheats

▶ Taking a look at foul play

▶ Finding fallout from faulty bookkeeping

I’m sorry to have to say this, but the hard part of writing this chapter was narrowing the list down to ten. Too many candidates were competing for a spot on this list. Since 2000, more than 500 companies had to restate earnings after company executives, the board of directors, or the Securities and Exchange Commission (SEC) found problems with their financial statements.

Because of these misstated earnings, stock prices dropped and investors lost billions of dollars on the stocks they held in their portfolios; some even had their entire retirement savings wiped out. Clearly, our entire financial reporting system needs a major overhaul.

Although the Sarbanes-Oxley Act of 2002 (you can find details about the changes that bill requires in Chapter 3) improved things a little, the mortgage mess of 2007 showed how much more needs to be done as financial institutions around the world shocked their shareholders when they lost billions due to mortgage-backed securities. Some of these securities were held on the books, but others were held off the books, Enron-style. Corporate lobbyists are still trying to get Congress to weaken Sarbanes-Oxley, but the 2007 banking scandals will probably make their job more difficult.

Drumroll, please! And the winners are . . .

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Enron

Was there ever a doubt that Enron wouldn’t make this list? Enron (once the world’s largest energy trader) has practically become synonymous with “corporate scandal.” Sure, some major scandals occurred before Enron, but the downfall of this company in 2001 rattled the markets with the massive scope of the misdealings that came to light. The final word on how much Enron misstated its earnings is still to come, but Enron definitely overstated its profits and improperly used
off-the-books
(not shown on its financial statements) partnerships to hide more than $1 billion in debt and give investors a false impression about its financial position. You can follow the ongoing cases at The Enron Fraud (www.enronfraud.com).

Enron’s misdeeds didn’t stop with only misleading investors; company insiders also manipulated the Texas power market and the California energy market and bribed foreign governments to win contracts abroad. Enron’s lead in the energy-trading scandals exposed the manipulation of the energy market by other key energy companies, including CMS Energy, Duke Energy, Dynegy, and Reliant Energy.

The Enron scandal also took down one of the big five accounting firms, Arthur Andersen, which was convicted of fraud for its role in the scandal. I talk more about Arthur Andersen later in this chapter.

Enron declared bankruptcy at the end of 2001. Now the bankrupt company is facing about $100 billion in claims and liabilities from shareholders, bondholders, and other creditors.

Some executives pleaded guilty to felony charges. A federal jury in Houston indicted two of Enron’s former chief executives, Kenneth L. Lay and Jeffrey Skilling, on charges of fraud and insider trading in 2004. Former Enron finance chief Andrew S. Fastow, who allegedly pocketed $60 million in company money without the board’s knowledge, pleaded guilty and cooper-ated with the investigation. He was sentenced to ten years in prison on one count of conspiracy to commit wire fraud and one count of conspiracy to commit securities fraud. Lay died before the criminal case was completed, but Skilling was sentenced to 24 years and is serving his time in the Waseca, Minn., Federal Correctional Institution.

Today, the company is much smaller and is operating under the supervi-sion of a bankruptcy court. Its new name is the Enron Creditors Recovery Corporation. It’s liquidating its remaining assets to reorganize and pay off creditors. After the creditors are paid from the asset sales, the corporation will cease to exist.

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321

Citigroup

Financial institutions certainly didn’t learn anything from the Enron scandal, and Citigroup made the biggest mistakes of all. Citigroup hid its problems from shareholders by keeping a large portion of its questionable mortgage-backed securities holdings off the books.

In December 2007, Citigroup brought $49 billion in these mortgage assets back onto the books, and as of July 2008, it was still trying to recover from the mess it created, and it probably will be for years to come. Shareholders had no idea that Citigroup was so deeply invested in subprime mortgages until after the damage was already done.

Citigroup’s board finally pushed its Chairman and CEO, Charles Prince, out the door in November 2007. In May 2007, Citigroup’s stock was selling for $51.01 a share. By December 2007, when Citigroup finally fessed up and took the bad debt back onto its books, shares were selling for $28.24. As more information came to light, Citigroup’s stock continued to drop like a stone and was at $18.69 in July 2008.

While shareholders lost billions, Prince walked out with a $40 million severance package and still has an office and an assistant in Citigroup’s headquarters. He also has a car and driver.

Adelphia

Adelphia (a broadcasting and cable TV company) makes the top-ten list because of its greedy top executives: John Rigas, founder of the company, and his son, Timothy Rigas. The Rigases used the corporation as their personal piggy bank, stealing $100 million from the company and using it for luxurious personal residences, trips, and other items so they could live a life of luxury.

In 2004, John and Timothy were found guilty of concealing $2.3 billion in loans, which were hidden in small companies left off Adelphia’s books.

The SEC charged that in addition to hiding debt, Adelphia inflated earnings to meet Wall Street expectations between at least 1998 and March 2002.

Adelphia also falsified statistics about the company’s operations and concealed blatant self-dealing by the Rigas family, which founded and controlled Adelphia.

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Two other executives from Adelphia were arrested in 2002 after the scandal broke. Michael Rigas, another son of John Rigas, and Michael Mulcahey, the company’s former director of internal reporting, were both found not guilty.

Adelphia went bankrupt and is currently liquidating real estate assets and handling bankruptcy and litigation issues.

WorldCom/MCI

WorldCom (a telephone company) overstated its cash flow by improperly booking $11.1 billion in company assets, but the total turned out to be a lot higher when all the pieces were put together. Some put the total loss to investors at $79.5 billion.

In addition to sloppy and fraudulent bookkeeping, the post-bankruptcy audit found two important new pieces — WorldCom had overvalued several acquisitions and lost $48.9 billion, including a $47 billion write-down of impaired assets. So instead of a $10 billion profit in 2000 and 2001, WorldCom had a combined loss for the years 2000 through 2002 (the year it declared bankruptcy) of $73.7 billion. When you add $5.8 billion of overvalued assets, the total fraud at WorldCom amounted to $79.5 billion.

Bernard Ebbers, WorldCom’s founder, was given $400 million in off-the-books loans by the company. Criminal fraud charges were filed against Ebbers and former chief financial officer (CFO) Scott Sullivan. Sullivan pleaded guilty to three criminal charges related to the fraud as part of a deal to cooperate with prosecutors in their case against Ebbers. Ebbers was sentenced to 25 years in prison and is serving his time at Oakdale, Louisiana, Federal Corrections Institute.

Investor groups filed a class-action case against WorldCom’s former directors and executives, 18 banks, and former outside auditor Arthur Andersen.

A few of these plaintiffs settled out of court in 2004; the settlement included a $50 million payment by some former WorldCom directors and a $2.65 billion settlement by Citigroup, the bank that had promoted WorldCom’s stocks and bonds as good investments, even though it had concerns about WorldCom’s rocky financial position.

WorldCom filed for bankruptcy protection in 2002. The company emerged from bankruptcy as MCI in 2004, which is the name of a company it bought along the way to building its kingdom. As part of the bankruptcy settlement among the company, the courts, and the creditors, the company’s debt was reduced by 85 percent to $5.8 billion, still leaving many creditors with little or nothing. Shareholders also were left with nothing, and their shares were worthless after the company emerged from bankruptcy. In December 2005, Verizon bought MCI/WorldCom.

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Sunbeam

Sunbeam (once a household name for electric appliances and camping equipment) was one of the first companies exposed for its questionable accounting gimmicks and fraud, which involved overstating earnings and jacking up the stock price.

In the 1990s, Sunbeam CEO Albert Dunlap ordered the company’s managers to get the stock price up. They did so by overstating sales. The company’s board of directors caught them after the firm reported robust sales of electric blankets during the summer months — how many people buy electric blankets in the summer? Another clue was the increasing barbecue grill sales in late autumn, just in time for winter cookouts — yeah, right! What the managers were really doing is
channel stuffing
— selling these goods at significant discounts to distributors and middlemen so company sales would look better than they really were. (I discuss channel stuffing in greater detail in Chapter 23.)

Sunbeam’s board of directors finally caught on to these deceptive practices in 1998 and ousted Dunlap. The board also replaced the company’s auditor, Arthur Andersen. In May 2001, the SEC filed a complaint alleging that Dunlap and former finance chief Russell Kersh perpetrated a fraudulent scheme to create an illusion that they successfully restructured the company to sell Sunbeam at an inflated price. The SEC also alleged that Sunbeam’s scheme resulted in overstating its earnings by $60 million.

Sunbeam declared bankruptcy in 2001, and the stock is no longer trading.

Arthur Andersen paid $110 million to settle a shareholder lawsuit against the firm for its role in the deception. In 2002, the SEC started an investigation of Dunlap and his cohorts, but no indictment was ever filed.

Tyco

Tyco (a diversified manufacturing and service company) was used as a personal piggy bank by some of its executives, according to charges filed by the SEC. In 2002, former chairman and CEO L. Dennis Kozlowski, former CFO

Mark Swartz, and former chief counsel Mark Belnick allegedly stole more than $600 million from Tyco, which they deny.

The SEC says that they took out hundreds of millions of dollars in loans and paid excessive compensation to key executives, which they never disclosed to shareholders. In addition to the SEC charges, Tyco sued Kozlowski, seeking backpay and benefits since 1997 totaling $244 million, as well as forfeiture 324
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of all his severance pay. A 2004 trial based on the SEC charges ended in a mistrial after a juror received a threatening letter from an unknown source.

In 2005 they were found guilty. Kozlowski was convicted on charges of grand larceny and sentenced to up to 25 years. He’s serving his time in Mid-State Correctional Facility in Marcy, N.Y.

Fortunately, Tyco has gotten past this scandal and is on the road to recovery with a new management team that’s getting high marks from analysts for reviving cash flow and implementing new corporate rules to prevent similar mismanagement in the future. On June 29, 2007, Tyco shareholders received shares in two new companies: Covidien (Tyco’s healthcare unit) and Tyco Electronics.

Waste Management

Waste Management (a waste services company) restated its earnings by $1.7

billion in 1998 after an SEC investigation found that the firm’s former top executives had inflated earnings, which allowed them to take home millions in personal profits and other benefits while duping the company’s shareholders by giving them the impression that the company’s earnings were higher than they actually were.

Their scheme unraveled in 1997 when a new CEO ordered a review of the company’s accounting practices. In 1998, the company restated its earnings based on financial statements that inflated earnings from 1992 to 1997. In this case, the company prepared a corrected financial statement that showed the differences for each of the years in question. The impact these differences had on the firm’s earnings was reflected in the restatement of earnings filed with the 1998 financial reports.

Arthur Andersen and three of its partners, which were the auditors for Waste Management during the period, were fined $7 million in 2001 for their roles in the scandal. In 1999, Arthur Andersen settled a $220 million lawsuit filed by shareholders who bought Waste Management stock between 1994 and 1998.

In 2001, Waste Management settled a shareholder lawsuit by paying shareholders $457 million.

In 2002, the SEC filed fraud charges against former Waste Management executives, including founder and former CEO Dean Buntrock, former president and chief operating officer Phillip Rooney, former CFO James Koenig, former controller Thomas Hau, former general counsel Herbert Getz, and former vice president of finance Bruce Tobecksen. These charges were settled out of court in 2005 with no admission of wrongdoing.

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Bristol-Meyers Squibb

Bristol-Meyers Squibb (a pharmaceutical company) stuffed its channels with drugs and improperly booked about $1.5 billion in revenue from the first quarter of 2000 through the last quarter of 2001, according to the SEC. The SEC filed a civil fraud action against the company in 2003. To meet Wall Street expectations, Bristol-Meyers Squibb shipped a lot of inventory to its distributors in consignment-like sales near the end of each quarter so its numbers would look better. This channel-stuffing practice built up inventory at distributor levels and risked the company’s ability to sell additional drugs in the future, which ultimately would lower its earnings.