Title Slide Detecting Corporate Fraud 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    

Francis !eo

Financial and investigative reporter for !e Wall Street Journal in Washington, D.C. He has worked for BusinessWeek, footnoted.com, Bloomberg News, the Arkansas Democrat-Gazette and local papers in New Jersey and Alaska; he has also written for !e 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 !rm that was cited in !e New York Times and !e Wall Street Journal.

Twitter: @theofrancis Web: theofrancis.com

Boyd Roddy

Investigative reporter and founder of the Southern Investigative Reporting Foundation. He has worked for Fortune Magazine, the New York Post, !e New York Sun and Institutional Investor News; founded "e Financial Investigator website; and wrote "Fatal Risk," on the collapse of AIG. An independent nonpro!t, SIRF provides document-driven investigative and accountability reporting on publicly traded companies.

Twitter: @boydroddy Web: SIRF-online.org

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)

Bottom line: Fraud boils down to to saying one thing and doing another, for pro!t.

One de!nition:

“Business fraud is, very simply, fraud in any business activity that resorts to

deceitful practices to cause economic injury.”

-- Cochran law !rm (plaintiffs’

attorneys)

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  

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 !lings to government

regulators.

Image:  Nathan  Larkin,  h;p://flic.kr/p/edaTDF  

Finding fraud What they do (and what they did) •  out there in the world.

•  signs of it are online, in print and in !lings.

At its heart, corporate fraud reporting Is accountability reporting.

Image:  Jack-­‐Benny,  h;p://flic.kr/p/ePdxxP  

Caveat reporter •  No one red $ag 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  

!en there’s… •  Johnny Earl Satterwhite

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 !lings 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  

Basics: !e Filings Key points: •  Mostly publicly traded companies •  Limited regulatory review •  Disclosure, not substance •  Dense, complex and long. Where to !nd them •  SEC’s Edgar database: http://1.usa.gov/1f3TpOM How to use them: •  Reynolds Center’s SEC !ling primers: http://bit.ly/1f3Tt0P

Get a grip: !e 10s Primary !nancial 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  

Get a grip: Other "lings S-1 •  Primary !ling for companies about to go public (pre-IPO) •  Updated by multiple amendments 8-K •  Recent developments •  Press releases •  Widely variable

Get a grip: Key elements 10-K, 10-Q, S-1: •  Business •  Risk Factors •  Litigation & regulatory

S-1 •  Capital structure •  Origins of the company •  Key investors

Proxy & S1 •  Compensation

(what gets rewarded?) •  Bene!cial ownership

(major investors)

Get a grip: What to look for •  Late !lings

•  10-Ks & 10-Qs especially •  Consider the explanation

•  Does the business make sense?

•  Has the business changed fundamentally? •  Multiple times?

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

Get a grip: What’s core? Everyone knows General Electric •  Power turbines •  Jet engines •  Medical imaging •  Dishwashers

•  Subprime debt?! (https://app.seclive.com/#f/57cd417f )

•  Today: $46B = 31%

Get a grip: Next steps •  Company website

•  It’s PR, but still useful

•  Press releases •  BusinessWire, PR

Newswire, Yahoo! Finance, etc.

•  Company transcripts (Seeking Alpha’s are free)

•  Former employees

•  Customers

•  Vendors

•  Investors (current and past)

•  Wayback Machine

Get a grip: Go Wayback InternetArchive.org •  (Almost) Nothing on the Internet ever dies

•  Why no cure for AIDS & the common cold? •  http://tinyurl.com/mevqfww

Who’s Who: Know your principals

People matter

Who’s Who: !e Filings 10-K, S-1, proxy: •  Executive & director bios Proxy •  Insider stakes (bene!cial 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  

Who’s Who: What to look for Initially, hoover it up. •  Names, names, names

•  People, companies, even charities

•  Previous ventures

•  Addresses

•  Look for connections

Who’s Who: What to look for "ings that make you go, “Hm…”

•  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

Who’s Who: What to look for More innocuous (usually)

•  Crummy jobs

•  A layoff or two

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

Who’s Who: What to look for Don’t forget the help •  Lawyers

•  PR !rms — DreamTeamGroup (http://bit.ly/1guGmFU)

•  Consultants

•  Exceptions? •  Crisis PR !rms •  Defense lawyers •  etc.

Who’s Who: What to look for Scenario: Ditching the troubled founder •  Really? •  Relatives & associates •  LLCs

"e blame game CEO on top of everything… … buy pinning operational problems on others •  Short-sellers •  "e media (that’s us) •  Regulators

Who’s Who: What to look for Red #ags

•  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 !nancial and personal relationships •  “Related party transactions” (more in a moment)

“  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. "e 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 … "e 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

“  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 $ights •  $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.”

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

Who’s Who: Next steps What to check •  Educational institutions & degrees

•  Oregon Department of Education (unaccredited schools)

•  Military •  DOD Form DD-214 (within 24 hours) •  Discharge (honorable or ?), tours of duty, “special forces”

•  Past jobs •  Independent con!rmation •  Past coworkers

Interlude: Cool tools •  SECLive (www.SEClive.com)

•  Stanford Securities Class Action Clearinghouse (securities.stanford.edu)

•  SEC Info (http://www.secinfo.com/)

Ties that bind: Related party transactions

It’s  not  just  who  you  know  —  it’s  also  what  they  do  for  you.  

Ties that bind: !e "lings Proxy •  “Related party transaction” section 10-K •  sometimes

AKA •  Related Party Transactions •  Related Person Transactions •  Certain Transactions •  etc.

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

Ties: What to look for Less worrisome (maybe): •  “"e 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… •  "at’s up from $447,000 in 2011.

Ties: 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. "e 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. "ese !ndings have been accepted by the Company and Mr. Goldstein.”

Ties: Another 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. "ese 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) …”

Ties: Chesapeake cont’d. Chesapeake:

•  More – how Reuters mined !lings: http://slidesha.re/1!xhPl •  Brian Grow, Anna Driver, Joshua Schneyer, John Shiffman,

Carrick Mollencamp

•  While McClendon owned 19% of the Oklahoma City "under •  Chesapeake:

•  Paid $2.9 million + for naming rights •  Signed 12-year, $36-million sponsorship agreement •  Millions more for additional tickets & advertising

Ties that bind: Next steps •  Location, location, location

•  Google

•  State corporation !lings •  Secretary of state, state incorporation office, etc.

•  Legal databases

•  Court documents

Ties that bind: Exercise 1 •  Nanoviricides

•  Link: http://1.usa.gov/1fTUWSJ •  “Certain Relationships and Related Transactions”

•  Find 2-3 things that make you go “hmm…”

Ties that bind: Exercise Nanoviricides

•  CFO married to CEO (can’t be compelled to testify)

•  CEO and chairman have large stake in major investor ("eraCour )

•  "eraCour owns all of Nanoviricides’s intellectual property

•  Opaque and confusing preferred stock deals between executives and the two companies.

Ties that bind: Exercise •  DHB Industries (later Point Blank Solutions Inc.)

•  Link: http://1.usa.gov/1fTUbJ7 •  Same thing

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.

Measuring up: !e "lings 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.

Measuring up: Financials "e basics: •  Income statement

•  Pro!t & loss •  Revenue (sales) •  Net income (earnings)

•  Balance sheet •  Assets & liabilities

•  Cash-$ow •  Circulatory system

Other resources: •  Reynolds Center 10-Q !nancial basics: http://bit.ly/1jskFFp •  Mark Tatge’s “Funny Money: How companies play games with

numbers”: http://slidesha.re/1jsjG8c

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

Measuring up: Payables Accounts payable Money the company owes, generally to suppliers •  Pro!table company with rapidly increasing A/P

•  Implies the company may not be paying its bills

Bottom line: •  It’s all relative

•  3% increase in revenues… •  but what’s happening with net income, receivables, etc.?

•  It’s about change over time •  Big spikes? Sudden drops?

•  Check the details: •  Has the change been disclosed? Related party?

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 multi-year contracts all at once

•  Recognizing sales too late •  Recording them early the following quarter, if this quarter is

already going well

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 (pro!ts). •  Reversing part or all of a reserve increases income (pro!ts)

•  On paper

Cookie-jar accounting •  “Releasing” reserves to generate income •  Arti!cially in$ating reserves for later release

Measuring up: More fun Manipulating expenses

•  Worldcom & capitalizing operating expense Manipulating inventories

•  Spiking inventory value, esp. coupled with big borrowing Rearranging deck chairs

•  new segments à hard to compare over time Endless adjustments

•  updates à uncertain accounting? Ballooning debt with little !nancial growth to show for it

Measuring up: Bottom line

Big swings?

Big questions.

Measuring up: Arthrocare ArthroCare Corp. (ARTC) •  Link: https://app.seclive.com/#f/cc0af284

or •  10-Q for Sept. 30, 2007: http://1.usa.gov/1fTVuYA

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

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.

Red #ag factories: “Soft tells” •  Some warning signs are simply that: indicators

•  "ese often have straightforward explanations

•  But when the red $ags start multiplying, take a closer look

Red #ag factories: !e "lings 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

Red #ags: Director departures •  Sudden resignations

•  Detailed complaint letters •  Accounting problems •  Regulatory inquiries •  Board cliques

•  Companies sometimes !le responses

•  WellCare Health Plans & Regina Herzlinger •  http://1.usa.gov/1dRlsvX

Red #ags: Auditor oddities •  Big company, small auditor

•  Audit vs. consulting fees

•  Sudden departures

Red #ags: Next steps •  PCAOB (Public Company Accounting Oversight Board)

•  http://pcaobus.org •  Audits the auditors •  Insight into an accounting !rm’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.