Detecting Corporate Fraud at NICAR with Theo Francis and Roddy Boyd


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Theo Francis of The Wall Street Journal and Roddy of the Southern Investigative Reporting Foundation present "Detecting Corporate Fraud." Sponsored by the Donald W. Reynolds National Center for Business Journalism, this workshop preceded the Investigative Reporters & Editors NICAR Conference in Baltimore on Feb. 26, 2014.

For more information about business coverage training for journalists, please visit

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Detecting Corporate Fraud at NICAR with Theo Francis and Roddy Boyd

  1. 1. Detecting Corporate Fraud Title Slide Theo  Francis,  reporter   The  Wall  Street  Journal     Roddy  Boyd,  founder   Southern  Inves-ga-ve  Repor-ng  Founda-on     NICAR  conference,  Bal8more,  Md.,  Feb.  26,  2014    
  2. 2. Theo Francis Financial and investigative reporter for The Wall Street Journal in Washington, D.C. He has worked for BusinessWeek,, Bloomberg News, the Arkansas DemocratGazette and local papers in New Jersey and Alaska; he has also written for The New York Times DealBook blog, Quartz and NPR’s Planet Money blog, among other outlets. In 2013-2014, he founded and ran an independent research and training firm that was cited in The New York Times and The Wall Street Journal. Twitter: @theofrancis Web:
  3. 3. Roddy Boyd Investigative reporter and founder of the Southern Investigative Reporting Foundation. He has worked for Fortune Magazine, the New York Post, The New York Sun and Institutional Investor News; founded The Financial Investigator website; and wrote "Fatal Risk," on the collapse of AIG. An independent nonprofit, SIRF provides document-driven investigative and accountability reporting on publicly traded companies. Twitter: @boydroddy Web:
  4. 4. What is corporate fraud? A few kinds of corporate fraud •  Securities fraud •  Ripping off investors •  Consumer fraud •  Ripping off (retail) customers •  Tax fraud •  Ripping off taxpayers (that’s you) One definition: “Business fraud is, very simply, fraud in any business activity that resorts to deceitful practices to cause economic injury.” -- Cochran law firm (plaintiffs’ attorneys) Bottom line: Fraud boils down to to saying one thing and doing another, for profit.
  5. 5. What drives corporate fraud? •  Greed •  Pressure •  Make the quarterly numbers — or else •  Incompetence •  Covering up for mistakes •  All three Image:  liz  west,  h;p://  
  6. 6. Finding fraud As simple — and as hard — as comparing what they say to what they do. What they say •  online •  in brochures •  at meetings and conferences •  especially in filings to government regulators. Image:  Nathan  Larkin,  h;p://  
  7. 7. Finding fraud What they do (and what they did) •  out there in the world. •  signs of it are online, in print and in filings. At its heart, corporate fraud reporting is accountability reporting. Image:  Jack-­‐Benny,  h;p://  
  8. 8. Caveat reporter •  No one red flag always indicates fraud. •  Not every example that raises eyebrows amounts to fraud. •  Michelle Leder’s “mosaic” principle. •  Talk to the company. Image:  Rutger  van  Waveren,  h;p://  
  9. 9. Then there’s… •  Johnny Earl Satterwhite
  10. 10. Disclaimer !   Just because we mention a company or use an example in this presentation, doesn’t mean it’s an example of fraud. Some of the examples we cite are meant to illustrate particular points about using SEC filings for understanding companies generally, evaluating the potential for fraud and determining whether in fact fraud exists. Image:  Jack-­‐Benny,  h;p://  
  11. 11. Basics: The Filings Key points: •  Mostly publicly traded companies •  Limited regulatory review •  Disclosure, not substance •  Dense, complex and long Where to find them •  SEC’s Edgar database: How to use them: •  Reynolds Center’s SEC filing primers:
  12. 12. Get a grip: The 10s Primary financial and operational disclosures for established public companies. 10-K •  Annual •  Audited •  Comprehensive 10-Q •  Quarterly (3x a year) •  Unaudited •  More incremental Image:  Heather,  h;p://  
  13. 13. Get a grip: Other filings S-1 •  Primary filing for companies about to go public (pre-IPO) •  Updated by multiple amendments 8-K •  Recent developments •  Press releases •  Widely variable
  14. 14. Get a grip: Key elements 10-K, 10-Q, S-1: •  Business •  Risk Factors •  Litigation & regulatory S-1 •  Capital structure •  Origins of the company Proxy & S1 •  Compensation (what gets rewarded?) •  Beneficial ownership (major investors)
  15. 15. Get a grip: What to look for •  Late filings •  10-Ks & 10-Qs especially •  Consider the explanation •  Does the business make sense? •  Has the business changed fundamentally? •  Multiple times?
  16. 16. Get a grip: What to look for •  Frequent reshuffling •  Strategies •  Core products & services •  Restructuring •  Poor acknowledgement of costs or risks •  Repeated stock issuance (dilution) •  Unexplained & poorly explained capital raises
  17. 17. Get a grip: What’s core? Everyone knows General Electric •  •  •  •  Power turbines Jet engines Medical imaging Dishwashers •  Subprime mortgages?! ( )
  18. 18. Get a grip: Next steps •  Company website •  It’s PR, but still useful •  Former employees •  Customers •  Press releases •  BusinessWire, PR •  Vendors Newswire, Yahoo! Finance, etc. •  Investors (current and past) •  Company transcripts (Seeking Alpha’s are free)
  19. 19. Who’s who: Know your principals People matter
  20. 20. Who’s Who: The Filings 10-K, S-1, proxy: •  Executive & director bios Proxy •  Insider stakes (beneficial ownership) Forms 3,4,5 •  Insider transactions •  Executives, directors & big investors Schedules 13G & D •  Big investors •  Voting agreements Image:  Jonathan  Mueller,  h;p://  
  21. 21. Who’s Who: What to look for Initially, hoover it up. •  Names, names, names •  People, companies, even charities •  Previous ventures •  Addresses
  22. 22. Who’s Who: What to look for Things that make you go, “Hmm…” •  Resume gaps •  Undisclosed jobs •  Same names crop up in different roles •  Keeping it in the family •  (Stock) dips & pops •  Buying & selling •  Repeated over-promising, under-delivery •  Missing disclosures Photo  by  Flickr  user  Andreas  Poike  
  23. 23. Who’s Who: What to look for More innocuous (usually) •  Crummy jobs •  A layoff or two
  24. 24. Who’s Who: What to look for Check it out •  Education, especially: •  Specialized degrees/expertise •  Attendance vs. degree •  Diploma mills & dubious online schools •  Litigation •  Corporate •  Personal •  Professional Photo  by  Flickr  user  un.sospiro  
  25. 25. Who’s Who: What to look for Don’t forget the help •  Lawyers Scenario: Ditching the troubled founder •  Really? •  Relatives & associates •  LLCs •  PR firms •  Consultants •  Exceptions? •  Crisis PR firms •  Defense lawyers •  etc. The blame game Pinning operational problems on others •  Short-sellers •  The media (that’s us) •  Regulators
  26. 26. Who’s Who: What to look for Red flags •  Domineering CEOs •  Surrounded by yes-men •  Demands results without fail •  No tolerance for dissent or missed targets •  “Culture of corruption” •  Tone at the top •  Tangled financial and personal relationships •  “Related party transactions” (more in a moment)
  27. 27. “   Who’s Who: Buried treasure “In December 2008, the Company purchased an extensive collection of historical maps of the American Southwest from [Chairman & CEO] McClendon for $12.1 million, which represented his cost. A dealer who had assisted Mr. McClendon in acquiring this collection over a period of six years advised the Company that the replacement value of the collection in December 2008 exceeded the purchase price by more than $8 million. The maps have been displayed at the Company’s Oklahoma City headquarters for a number of years, during which the Company has been insuring the maps in exchange for their display. ... Our employees and visitors appreciate the maps … The Company was interested in continuing to have use of the map collection and believed it was not appropriate to continue to rely on cost-free loans of artwork …” — 2009 proxy
  28. 28. Who’s Who: Buried treasure Aubrey K. McClendon, Chesapeake Energy •  $2.9 million in salary & bonus •  $16.8 million in stock •  $875,000+ in perks for 2010, including •  $500,000 in personal jet flights •  $375,702 of “other” perks, including: “$250,000 for the costs related to personal accounting support provided to Mr. McClendon by our employees, net of reimbursement, and (ii) $119,135 for personal security provided to Mr. McClendon and his family.”
  29. 29. Who’s Who: Next steps Who to background •  Executives •  Directors •  Major investors •  Lawyers •  PR people •  Consultants (especially in technical industries) •  LLCs & similar entities •  Reynolds Center on backgrounding people & businesses:
  30. 30. Ties that bind: Related party transactions Photo  by  Flickr  user  Simon  James  
  31. 31. Ties that bind: The filings Proxy •  “Related party transaction” section 10-K •  sometimes
  32. 32. Ties: What to look for •  Commodity transactions •  Why is the insider the best choice? •  Confusion, dead-ends, obfuscation •  Layers of LLCs or other private companies •  Especially if they tie back to the same people •  Especially if those people are executives, directors or big investors Exceptions? •  Private-equity investors •  Founders & founding families
  33. 33. Ties: What to look for Less worrisome (maybe): •  “The father of Mr. Dimon has been employed by the Firm as a broker since 2009, and for 2012 received compensation of $1,599,616, including annual salary, commissions, and an equity award.” — JPMorgan Chase proxy (2013) •  Previously a broker for Bank of America Still… •  That’s up from $447,000 in 2011.
  34. 34. Ties that bind: Example Las Vegas Sands Corp., 2010 proxy: “As previously disclosed, during 2008, a subsidiary of the Company performed work at a home owned by Robert G. Goldstein, the Company’s Executive Vice President. Mr. Goldstein believed, and the Company acknowledged, that some of the work was not performed in an appropriate manner. The matter was referred to an independent expert, who concurred about the quality of the work and concluded that Mr. Goldstein should not be obligated to pay the $0.4 million incurred by the Company for costs and overhead on the job. These findings have been accepted by the Company and Mr. Goldstein.”
  35. 35. Ties that bind: Example Chesapeake again: “As of December 31, 2011 and 2010, we had accrued accounts receivable from our Chief Executive Officer, Aubrey K. McClendon, of $45 million and $30 million, respectively, representing joint interest billings from December 2011 and 2010. These amounts were invoiced and timely paid in the following month. Since Chesapeake was founded in 1989, Mr. McClendon has acquired working interests in virtually all of our natural gas and oil properties by participating in our drilling activities under the terms of the Founder Well Participation Program (FWPP) …”
  36. 36. Ties that bind: Example Chesapeake: •  More – how Reuters mined filings: •  While McClendon owned 19% of the Oklahoma City Thunder •  Chesapeake: •  Paid $2.9 million + for naming rights •  Signed 12-year, $36-million sponsorship agreement •  Millions more for additional tickets & advertising
  37. 37. Ties that bind: Next steps •  Location, location, location •  Google •  State corporation filings •  Secretary of state, state incorporation office, etc. •  Legal databases •  Court documents Photo  by  Flickr  user  Daniel  Moyle  
  38. 38. Ties that bind: Exercise •  Nanoviricides •  DHB Industries
  39. 39. Ties that bind: Exercise Nanoviricides •  CFO married to CEO (can’t be compelled to testify) •  CEO and chairman have large stake in major investor (TheraCour ) •  TheraCour owns all of Nanoviricides’s intellectual property •  Opaque and confusing preferred stock deals between executives and the two companies.
  40. 40. Ties that bind: Exercise DHB Industries • Rents space from CEO’s wife’s company ($369,000) • Buys key components from CEO’s wife’s company ($17.6 million) • Leases space to CEO’s wife’s company to make products ($39,600 occupancy charge) • Sold key components to wife’s company at cost ($6.6 million) • Chartered plane from CEO’s company à (Ex) CEO sentenced to 17 years in August.
  41. 41. Measuring up: The filings 10-K •  Audited •  More comprehensive •  More history 10-Q •  Undaudited •  Narrower in focus •  Less history Earnings release •  Heavy on the PR •  Compare to 10-K or 10-Q S-1 •  New copanies Other options •  Google Finance •  Yahoo! Finance •  Etc.
  42. 42. Measuring up: Financials The basics: •  Income statement •  Profit & loss •  Revenue (sales) •  Net income (earnings) •  Balance sheet •  Assets & liabilities •  Cash-flow •  Circulatory system Other resources: •  Reynolds Center 10-Q financial basics: •  Mark Tatge’s “Funny Money: How companies play games with numbers”:
  43. 43. Measuring up: Receivables Accounts receivable Money owed to the company, generally by customers •  Big swings •  in dollar terms •  as a percent of revenue •  Collectability •  Concentration of risk •  Risk factors •  Footnotes •  Rising A/R should mean rising delinquencies, amounts past due for 90+ days •  Or company may be hiding uncollectable sales
  44. 44. Measuring up: Payables Accounts payable Money the company owes, generally to suppliers •  Profitable company with rapidly increasing A/P •  Implies the company may not be paying its bills Photo  by  Flickr  user  401(k)  2012  
  45. 45. Measuring up: Gaming sales Sales are supposed to be recorded in the quarter that the goods/services are delivered if payment is likely to be received. Possible games: •  Recognizing sales too soon •  “Accelerating” sales made early one quarter so they count for the prior quarter •  Recognizing sales too late •  Recording them early the following quarter, if this quarter is already going well
  46. 46. Measuring up: Cookie jars Reserves account for expected future costs: •  Some percentage of customers won’t pay their bills. •  Inventories become obsolete, spoil or otherwise lose value. Reserve math •  Establishing a reserve reduces income (profits). •  Reversing part or all of a reserve increases income (profits) •  On paper Cookie-jar accounting •  “Releasing” reserves to generate income •  Artificially inflating reserves for later release
  47. 47. Measuring up: More fun Manipulating expenses Manipulating inventories Rearranging deck chairs Endless adjustments Ballooning debt with little financial growth to show for it Photo  by  Flickr  user  Steve  Rhodes  
  48. 48. Measuring up: Arthrocare •  Accused of “parking” millions of dollars in merchandise with distributors •  to meet/beat forecasts •  booked $37 million in sales to one distributor •  but only $50,000 in net sales History: •  Investors raised questions. •  Arthrocare bought the distributor. •  Over time, $400 million in stock losses •  Two former SVPs pleaded guilty to conspiracy to commit securities and wire fraud in 2013. •  Two other executives facing trial.
  49. 49. Measuring up: Arthrocare •  ArthroCare Spine segment revenues (Sept. 30 quarter) •  to $11.4 million from $5.9 million •  to 15.1% of sales from 9.4% •  Extremely competitive market for spinal devices •  Competitors are bigger and well funded •  Johnson & Johnson, Stryker •  Kickback allegations •  Channel stuffing •  Disclosure
  50. 50. Red flag factories: “Soft tells” •  Some warning signs are simply that: indicators •  These often have straightforward explanations •  But when the red flags start multiplying, take a closer look
  51. 51. Red flag factories: The filings 8-Ks, 10-Ks, 10-Qs •  Auditor changes •  Director departures •  Letters to the board •  Litigation & regulatory action 10-K •  Auditor’s note Proxy •  Auditor fees Other •  SEC staff comment letters
  52. 52. Red flags: Director departures •  Sudden resignations •  Detailed complaint letters •  Accounting problems •  Regulatory inquiries •  Board cliques •  Companies sometimes file responses Photo  by  Flickr  user  Nguyen  Vu  Hung  
  53. 53. Red flags: Auditor oddities •  Big company, small auditor •  Audit vs. consulting fees •  Sudden departures
  54. 54. Red flags: Next steps •  PCAOB (Public Company Accounting Oversight Board) • •  Audits the auditors •  Insight into an accounting-firm’s quality •  Audit clients usually not named •  Always call departing directors •  Especially if there’s a letter •  Short interest •  If many investors are selling the shares short, why? •  Talk to investors, bullish and bearish.