Cooking the Books—and Screwing the Shareholders
Why the SEC won’t protect your wallet from the next Enron, WorldCom, Theranos, Bernie Madoff, and their ilk
I much prefer a stock to go down, not up, right after I’ve bought it.
You might think that’s weird. But my attitude is very simple: I only buy stocks that fit my investment criteria—stocks I have sound reasons to expect will rise in value over time. And I only pay what I consider to be a bargain price.
So if a stock I like goes down, it’s an even better bargain. And if there’s something I like more than a bargain, it’s an even better one.
This is opposite to the kinds of companies Wall Street analysts usually like. They want companies that consistently report higher earnings, predictably and consistently, quarter after quarter. So when one of their companies misses its target, even by a fraction of a cent, the stock gets hammered.
As a result, lots of CEOs keep Wall Street happy by massaging the quarterly numbers.
Going Over the Edge
And then there are those who simply can’t resist the temptation to use every possible tool to ramp up their stock price. Four of the biggest such scandals in recent American financial history:
1. Jeffrey Skilling and Kenneth Lay of Enron—which filed for bankruptcy on December 2, 2001.
2. Bernard Ebbers of WorldCom, which went bust on 21 July 2002.
3. Theranos Inc.: founder and CEO Elizabeth Holmes convicted of defrauding investors in 2022.
4. Bernie Maddoff: sentenced to 150 years in prison for his $64.8 billion Ponzi scheme—the largest in American history.
For several years these outfits had given Wall Street—and, presumably, investors—exactly what they wanted. Higher earnings predictably, consistently, and—most importantly—every quarter.
For this achievement they were lauded. They were “heroes of Wall Street,” darlings of the financial press until they both fell—or should I say, crashed—from favor.
Fortune magazine even named Enron “America's Most Innovative Company” six years in a row!
Fortune was right: not even WorldCom held a candle to Enron when it came to “creative accounting”: one of the many ways losses were hidden were in offshore, supposedly “arms-length” companies while profits, of course, were reported in full.
Like a Ponzi scheme, the entire pyramid collapsed: stocks that reached new highs for nearly ten years in a row crashed and burned.
Enron peaked at $90 a share in August, 2000, having multiplied in value nine times since 1992. By January 2002, you could buy Enron stock for a couple of cents.
WorldCom’s stock price multiplied over ten times from 1994 to its peak of $63.50 in June 1999; three years later it had crashed to 9 cents.
Elizabeth Holmes claimed that she’d “invented a device that could conduct sophisticated blood tests from a tiny amount of blood drawn from a finger prick”⁽⁷⁾ which would replace drawing blood samples from a vein with a needle. Her blood-testing method was touted as:
“faster, cheaper and more accurate than the conventional methods.”
It wasn’t.⁽⁸⁾
What’s more, this device didn’t even exist!
Nevertheless, a “Who’s Who” of “smart money” people were suckered by her story to invest a bundle into Holmes’ company, Theranos Inc.—and lost the lot:
⁽⁷⁾ Raymond Bonner, “Elizabeth Holmes, Theranos founder, conned America,” The Weekend Australian, 7 July 2018
⁽⁸⁾ Ibid
⁽⁹⁾ John Carreyrou, “Theranos Cost Business and Government Leaders More Than $600 Million,” The Wall Street Journal, 3 May 2018.
In addition, supermarket chain Safeway lent Theranos $30 million and began renovating its stores to accommodate Theranos’ blood-testing machines. While Walgreens invested $325 million to create testing centers in its stores.
PLUS: Elizabeth Holmes had lined up a stellar list of directors for her company including former secretaries of State George Shultz and Henry Kissinger, former senators Sam Nunn and Bill Frist, former Secretary of Defense William Perry, and James Mattis, a retired Marine Corps general and Defense Secretary from January 2017 to December 2018.
Not one of these people or companies saw the “revolutionary device”—or even asked to see it with the one exception of Walgreens whose request to visit Theranos’s labs was turned down.
Talk about a hustle!
So, as Elizabeth Holmes (among many others) demonstrated, smart people can still be suckered.
How?
Firstly, we don’t always admit our ignorance. Clearly—with the benefit of hindsight—after we’ve been suckered our mistake becomes obvious and we realize we didn’t really know what we were doing.
Secondly, we can always be impressed. And Ms. Holmes’s line up of directors was really impressive. Surely, we would have thought had we been asked to invest, those people must know what they were doing.
Third: we want to believe. It’s such a great idea (such a great story!) that the potential profits are enormous.
Finally, the great hustler is an incredible salesperson. For example, Elizabeth Holmes—
“. . . had this intense way of looking at you while she spoke that made you want to believe in her and want to follow her,” said one of her best friends at Stanford, who Holmes convinced to work for Theranos.⁽¹⁰⁾
In May 2018, Ms. Holmes was charged by the SEC with defrauding investors.
Bernie Madoff was a conman who flourished for decades in New York, the most financially literate city in one of the world’s most financially literate countries—directly under the “watchful” eye of the SEC.
Which had investigated his operations several times—and found nothing!
Only when two of Madoff’s employees blew the whistle was Madoff arrested and his Ponzi scheme—which had scooped up $64.8 billion—revealed.
Madoff’s Story was his consistently high returns. Which weren’t funded by a successful investment strategy but, as in a Ponzi scheme, from the inflow of new “investments” from impressionable suckers.
The new suckers enabled him to pay out “dividends” to the earlier suckers. Hence “confirming” his impressive “track record.”
And where were those so-called watchdogs, the “Guardians” of investor interests back then?
Well, Wall Street analysts and brokers, those self-appointed prognosticators of investment value, were falling over themselves to see who could blow their trumpets loudest for Enron, WorldCom, and their ilk.
And unlike the US Cavalry—which in those old Western movies always appeared over the hill just in time to rescue the beleaguered heroine from a fate worse than death at the hands of the Indians—the SEC (as usual, I might add) roared into town with its guns blazing, its lawyers firing writs and its enforcers slapping miscreants in handcuffs long after the horse had bolted . . . I mean, the money had flown the coop.
So now, courtesy of the SEC, Ebbers, Lay, Skilling, Holmes, Maddoff, and their associates in “cooking the books” have enjoyed long vacations at “Club Fed,” courtesy of the taxpayers.
Once again, the SEC succeeded in its mission of protecting investors.
Or did it?
If you were unfortunate enough to be an “investor” in WorldCom, Enron, Theranos, or Bernie’s Ponzi fund, you might feel a satisfying sense of revenge at seeing these CEOs sent to jail—but it won’t do your wallet any good.
Fact is, if you want to protect your money, as an investor you’re entirely on your own.
⁽¹⁰⁾ Bonner, op. cit.
A Short Course in “Cooking the Books . . .
There’s no need to follow Ebbers, Lay, Skilling, Holmes, Maddoff, et. al,, and go outside the law to “manipulate” earnings. There are lots of areas where there’s plenty of legal discretion to over- (or under-) state earnings. A few examples:
Subscription revenue: Publishers love it when a subscriber takes advantage of those big discounts they sometimes offer for renewing your magazine subscription 5 years in advance. They can book the promotion cost today, while the revenue is amortized over 5 years. A great tax shelter.
Years ago, AOL got into trouble for doing the reverse: to pump up earnings, they booked the full revenue for such long-term subscriptions as this year’s income. Great for the management whose stacks of stock options soared in value.
Pension plans: Simply increase the expected return on the money in your company’s pension plan by 1%, and you can release a nice chunk of money from the pension plan’s reserves and add it to the bottom line.
Which may mean that your pension plan is woefully underfunded.
No matter . . . so long as you, as manager, act within the legal limits of discretion.
“Non-performing” loan reserves: If you’re a banker or in the business of making loans, what portion of your loans should you hold as reserves against bad debts? Within reason, the choice is yours. The more you put in the reserve, the lower will be this year’s profits. Of course, if your reserves are too low, you’ll have to take a big loss . . . sometime in the future.
And with any luck, by then you’ll have cashed in your stock options and be sunning yourself on a beach in Florida or the south of France.
Insurance: Insurance companies take in premiums today and pay out claims later—often decades later. To fund those future claims, you must establish reserves so you can pay the claims.
How much should those reverses be? That depends on what returns you expect on the investments you can make with the premium money before you have to pay out any claims . . . and how big those claims are likely to be.
As in the banking business, the lower your reserves, the more premium income you can book as profits today.
As insurance can have a very “long tail” (some asbestos claims were still being adjudicated decades after the policies were issued) there’s probably more room in the insurance business than anywhere else to use “creative assumptions” to “massage the numbers.”
Indeed, Warren Buffett has gone so far as to say that in the insurance business you can practically report any result you want to from quarter to quarter.
. . . and Screwing the Shareholders”
There’s just one problem: use all these completely legal shenanigans to inflate current earnings and you incur an additional cost.
Tax.
The higher your profits today, the bigger your current tax bill.
That doesn’t matter too much if you’ve persuaded analysts and investors to focus on pseudo-measures of profit performance like EBITDA (earnings before the major, major expenses of interest, taxes, depreciation and amortization). Then your earnings can look great . . . even if they won’t cover your annual interest bill!
That’s just one more tool you can use to dazzle Wall Street, ramp up your stock price, and cash in your options at an inflated price—all, ultimately, at the shareholders’ expense.
You see, every dollar that a company pays out in tax is one less dollar for shareholders, and one less dollar it can invest to make shareholders more money in the future.
So if your aim is to increase shareholder value in the long term, you’ll be as conservative as you can legally be in maximizing reserves against potential future losses . . . and minimizing today’s earnings—and today’s taxes.
More importantly, when the next recession sends those competitors who under-reserved out of business, you’ll be around to pick up the pieces . . . and increase your market share.
This is, of course, exactly the business model of one of the world’s best-managed insurance companies: Warren Buffett’s Berkshire Hathaway.
Buffett is as conservative as you can get when it comes to money, so you can bet he’s doing the exact opposite to Ebbers, Lay, Skilling, & Co.: pushing those loss reserves to the limit, so making Berkshire Hathaway, as a friend of mine described it, “a giant tax shelter.” Completely, 100% legally!
And it’s also what makes a great investment: a company whose management is focused on maximizing shareholder value in the long term—even if it doesn’t bring them any friends on Wall Street.
Remember: the SEC will only protect you by putting shady CEOs in jail after your money has long gone to “money heaven.”
If you don’t believe me, think Bernie Maddoff. He was sentenced to 150 years in prison for bilking the investors in his fund of billions of dollars.
Yet—from 1960 to 2008, when the market crash scattered his house of cards to the four winds, he’d been investigated several times by the SEC and other financial regulators. Aside from a few slaps on the wrist, the Fed gave him a free pass.
Your money will be much safer if you take the time and trouble to invest only in companies whose management puts shareholders’ interests first. And (among other things) takes every legal avenue available to reduce taxes and other expenses now so they can make much more money for you in the future.
Be aware: such companies are unlikely to be current Wall Street favorites, as the last thing they’re trying to do is ramp up the stock price next quarter. But if you’ve done your homework, and the stock falls after you’ve bought it, like me, you’ll find yourself very happy to buy even more.
Of course, if you’re speculatively inclined—and can spot the next Enron or WorldCom as they’re on the way up—you can ride the momentum to a small fortune.
So long as you bank your profits before they disappear!
*****
If you want to understand the intricacies of the insurance business Warren Buffett is the best teacher. And his Letters to Shareholders are a good introduction.