Winning Investors Over. Baruch Lev
Crime and Punishment
And what about the perpetrators of reporting manipulations? Jonathan Karpoff, Scott Lee, and Gerald Martin examined all the SEC and Department of Justice (DOJ) enforcement actions for financial misrepresentations from 1977 to 2006, in all 788 actions, documenting the fate of persons targeted by these actions: 2,206 employees of the companies involved, 723 of whom were CEOs, presidents, or board chairs.44 The turnover rate of these corporate chiefs should give a long pause to any manager contemplating cooking the books. Almost 80 percent of the targeted executives left or were terminated before the public announcement of the SEC or DOJ action, and an additional 11 percent were dismissed by the end of the regulatory proceedings.45 The turnover rate was even higher (96 percent) for the nonexecutives targeted by the SEC or DOJ (it’s easier to dump those without golden parachutes). Thus, the likelihood of survival for an executive or employee targeted by an enforcement action is even slimmer than Evel Knievel’s chance of motorcycle jumping over fourteen Greyhound buses (he actually made it on October 25, 1975, in Kings Island, Ohio).
But losing one’s job is by no means the end of travails. The SEC initiated civil litigation against 87 percent of the 723 CEOs, presidents, and board chairs, resulting in a third of them barred from serving as officers or directors of public companies and a quarter being criminally indicted, 102 of whom were sentenced to an average of 5.7 years in prison. On top of all this, most of the targeted executives paid substantial fines. Even more bad news for perpetrators: the prosecutorial zeal and severity of punishment increased substantially in the wake of the early-2000s accounting scandals and the Sarbanes-Oxley Act. Justice Department data indicates that, between July 2002 and March 2006, there have been more than 1,000 convictions (including plea bargains) in corporate-fraud cases, including 82 CEOs, 85 presidents, 36 CFOs, and 102 vice presidents.46 Pretty scary stuff.
Trying to see the bright side, you may ask, what about all the undetected and unpunished manipulations? Don’t shareholders of these firms enjoy higher stock prices and managers richer compensation? In some cases, they do, when the business slowdown triggering the manipulation is temporary, and a quick recovery allows managers to “mend their ways” with nobody the wiser. But, one rarely knows ahead of time the duration of a slowdown, so that embarking on a manipulation gets you on a very risky path. And even if the manipulation somehow escapes exposure, the potpourri of SEC enforcement actions discussed earlier indicates that most manipulations adversely affect business operations. Thus, Gateway achieved its revenue targets by selling computers to previously rejected, poor-credit customers, essentially at a loss. Coca-Cola’s gallon-pushing program was enabled by a significant extension of credit to bottlers, “typically … from eight to twenty-eight or thirty days,” increasing Coke’s cost of funds. Charter Communications, striving to portray solid customer growth, continued to provide costly services to delinquent customers as well as to those who asked to be disconnected, obviously with no revenues to match. Daisytek’s large acquisitions of slow-moving, obsolete inventories ultimately drove it to bankruptcy. And i2 Technologies’ front-loading of revenues was costly too, as the SEC notes: “To close certain sales, i2 sales representatives exaggerated or oversold what certain software products could actually do. After these deals closed, i2 technicians were, in many instances, able to write code to create the promised functionality, but these efforts took much time, effort and expense … and i2’s relationship with some customers had been strained, due in part to the substantial post-license work i2 had to perform to make its software deliver what had been agreed upon” (emphasis mine).47 And don’t forget the taxes—actual cash outflows—paid on the inflated earnings.
These substantial costs of the SEC-sanctioned cases are clearly also present in manipulations that don’t see the light of day. Add to this the costs of needless investment and recruiting to portray an image of success, documented by Kedia and Philippon,48 and the loss from postponement or cancelation of R & D, advertising, or maintenance to make the numbers, and the weighty burden of information manipulation, detected or not, becomes clear. Obviously, there is no free lunch in information manipulation.
Manipulation in Good Cause
Like the Allies’ deceptions that helped win World War II, or a butterfly’s trickery to avoid a predator, there surely are “good earnings managements”—information manipulations in good causes. Here they are:
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Operating Instructions
DON’T EVEN THINK ABOUT IT. When operations stall and the specter of falling stock prices, intervention by activist investors, defection by disgruntled employees holding useless options, and adverse actions by concerned customers and suppliers loom large, the temptation to manipulate financial information naturally arises. Being convinced, like most executives, that the slump is temporary, you may even think that you do shareholders a favor by “smoothing out” the downturn in the financials so they don’t worry their pretty heads about it.Consider that many business slowdowns are prolonged affairs exacerbating the fraud, and that the likelihood of being caught cheating is constantly increasing in the post–Sarbanes-Oxley environment, further enhanced by the 2010 Dodd-Frank legislation encouraging whistle-blowers to go directly to the SEC and obtain rich rewards.49 And, when caught, you are almost sure to lose your job. Remember, even if not detected, the act of manipulation, as I’ve shown abundantly, is costly and exacerbates the downturn. So, like the warning at the top of the no-parking signs in Manhattan: “Don’t even think about it.”
DON’T CLAM UP IN TOUGH TIMES. When the going gets tough, the natural tendency is to withdraw from the market. Stop earnings guidance, shorten conference calls, send substitutes to shareholders meetings, file financial reports late, and reduce voluntary disclosure.50 These reactions are not smart. There is absolutely nothing to be gained and much to lose from such market pullback. The evidence of companies in distress stopping quarterly guidance, for example, shows that stock prices drop sharply on the announcement of guidance cessation and analysts abandon the stoppers (see chapter 6). When performance stalls, shareholders—your principals—should be doubly engaged (see further details in chapters 6 through 8).
THE VIRTUES OF CONSERVATISM. When the business deteriorates, exercise extra care with insider trading (yours, and those of other top executives) and avoid aggressive accounting procedures, such as understating loan loss reserves or switching from accelerated to straight-line depreciation, to increase reported earnings. Both insider trading and accounting trickery attract the attention of regulatory agencies, trial lawyers, and perceptive investors and reporters. A case in point: a Wall Street Journal article with the headline, “Is AIG on Slippery Slope?” discussing analysts’ and investors’ concerns with AIG’s change of accounting technique amid continuing problems with its subprime-linked securities.51
AVOID ELEVATED EXPECTATIONS. Manipulation is often “forced” on managers by overly optimistic investor expectations and inflated stock prices that have to be justified by ever-higher revenues and earnings. You have to nip such heightened expectations and overpriced shares in the bud by releasing realistic information to investors. If you procrastinate, you won’t be able to safely dismount the price tiger; you will not survive the large price correction when investors finally realize it was all a dream. Chapter 5 deals with overvalued shares, their consequences, and how to avoid this predicament.
COME OUT WITH IT, QUICKLY. If you or your predecessors engaged in misrepresentation, come out fully and cleanly as soon as possible. Spin, gloss, or half-truths about the manipulation—such as Coca-Cola’s claim that the reversal of the gallon-pushing scheme was a planned move—are harmful to shareholders and ultimately to you. Don’t hide the truth, like the “stealth restatement,” which is changing previously reported earnings or sales without alerting investors to it. Glass Lewis & Co. reports that no less than 254 companies tried to hide their restatements from investors in 2006.52 And don’t delay the bad news. Research has shown that announcements of earnings restatements without numbers—postponing the grim magnitude of the restatement for later—trigger a sharper stock price decline than when all the