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 http://businessjournalism.org.

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. Theo
Francis
Financial and investigative reporter for The
Wall Street Journal in Washington, D.C. He
has worked for BusinessWeek, footnoted.com,
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: theofrancis.com

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: SIRF-online.org

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. What drives corporate fraud?
• Greed
• Pressure
• Make the quarterly
numbers — or else
• Incompetence
• Covering up for mistakes
• All three
Image:
liz
west,
h;p://flic.kr/p/4n42Ey

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://flic.kr/p/edaTDF

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://flic.kr/p/ePdxxP

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://flic.kr/p/bfBSC

9. Then there’s…
• Johnny Earl Satterwhite

11. 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://flic.kr/p/ePdxxP

12. 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: http://1.usa.gov/1f3TpOM
How to use them:
• Reynolds Center’s SEC filing primers: http://bit.ly/1f3Tt0P

13. 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://flic.kr/p/9rpM2p

14. 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

15. 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)

16. 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?

17. 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

18. Get a grip: What’s core?
Everyone knows General Electric
•
•
•
•
Power turbines
Jet engines
Medical imaging
Dishwashers
• Subprime mortgages?!
(https://app.seclive.com/#f/57cd417f )

19. 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)

20. Who’s who:
Know your principals
People matter

21. 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://flic.kr/p/a1LACk

22. Who’s Who: What to look for
Initially, hoover it up.
• Names, names, names
• People, companies, even charities
• Previous ventures
• Addresses

23. 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

24. Who’s Who: What to look for
More innocuous (usually)
• Crummy jobs
• A layoff or two

25. 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

26. 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

27. 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)

28. “
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

29. 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.”

30. 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:
http://bit.ly/1js5XOJ

31. Ties that bind:
Related party transactions
Photo
by
Flickr
user
Simon
James

32. Ties that bind: The filings
Proxy
• “Related party transaction” section
10-K
• sometimes

33. 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

34. 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.

35. 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.”

36. 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) …”

37. Ties that bind: Example
Chesapeake:
• More – how Reuters mined filings: http://slidesha.re/1fixhPl
• 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

38. 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

39. Ties that bind: Exercise
• Nanoviricides
• DHB Industries

40. 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.

41. 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.

42. 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.

43. 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: http://bit.ly/1jskFFp
• Mark Tatge’s “Funny Money: How companies play games with
numbers”: http://slidesha.re/1jsjG8c

44. 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

45. 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

46. 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

47. 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

48. 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

49. 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.

50. 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

51. 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

52. 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

53. 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

54. Red flags: Auditor oddities
• Big company, small auditor
• Audit vs. consulting fees
• Sudden departures

55. Red flags: Next steps
• PCAOB (Public Company Accounting Oversight Board)
• http://pcaobus.org
• 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.